What Is a Subsidiary?
The parent holds a controlling interest in the subsidiary company, meaning it has or controls more than half of its stock. In cases where a subsidiary is 100% owned by another firm, the subsidiary is referred to as a wholly owned subsidiary. Subsidiaries become very important when discussing a reverse triangle mortgage.
How a Subsidiary Works
A parent company buys or establishes a subsidiary to provide the parent with specific synergies, such as increased tax benefits, diversified risk, or assets in the form of earnings, equipment, or property. Still, subsidiaries are separate and distinct legal entities from their parent companies, which reflects in the independence of their liabilities, taxation, and governance. If a parent company owns a subsidiary in a foreign land, the subsidiary must follow the laws of the country where it is incorporated and operates.
However, given their controlling interest parent companies often have considerable influence with their subsidiaries. They—along with other subsidiary shareholders, if any—vote to elect a subsidiary company's board of directors, and there may often be a board-member overlap between a subsidiary and its parent company.
The purchase of an interest in a subsidiary differs from a merger: The purchase usually costs the parent corporation a smaller investment, and shareholder approval is not required to turn a company into a subsidiary as it would be in the event of a merger. Nor is a vote required to sell the subsidiary.
To be designated a subsidiary, at least 50% of a firm's equity has to be controlled by another entity. If the stake is less than that, the firm is considered an associate or affiliate company. When it comes to financial reporting, an associate is treated differently than a subsidiary.
A subsidiary usually prepares independent financial statements. Typically, these are sent to the parent, which will aggregate them—as it does financials from all its operations—and carry them on its consolidated financial statements. In contrast, an associate company's financials are not combined with the parents. Instead, the parent registers the value of its stake in the associate as an asset on its balance sheet.
As is common practice and per the Securities and Exchange Commission (SEC), public companies should generally consolidate all majority-owned firms or subsidiaries. Consolidation is typically seen as a more meaningful method of accounting than providing separate financials for a parent company and each of its subsidiaries.
For example, eBay reported total revenue on its consolidated income statement, for the year ended Dec. 31, 2017, totaling US$9.6 billion. The e-commerce firm notes in the annual report that the individual domestic and consolidated subsidiary, StubHub, generated revenue of $307 million.
The SEC states that only in rare cases, such as when a subsidiary is undergoing bankruptcy, should a majority-owned subsidiary not be consolidated. An unconsolidated subsidiary is a subsidiary with financials that are not included in its parent company's statements. Ownership of such firms is typically treated as an equity investment and denoted as an asset on the parent company's balance sheet. For regulatory reasons, unconsolidated subsidiary firms are typically those in which parent firms do not have a significant stake.
Benefits and Drawbacks to Subsidiaries
There are advantages and disadvantages to the subsidiary structure.
Subsidiaries can contain and limit problems for a parent company. Potential losses to the parent company can be limited by using the subsidiary as a kind of liability shield against financial losses or lawsuits. Entertainment companies often set individual movies, or TV shows up as separate subsidiaries for this reason.
The subsidiary structure can also offer tax advantages: They may only be subject to taxes in their state or country, versus having to pay for all the parent's profits.
Subsidiaries can be the experimental ground for different organizational structures, manufacturing techniques, and types of products. Fashion-industry companies often have a variety of brands or labels, each set up as a subsidiary. (For related reading, see "Understanding Subsidiary vs. Sister Company")
Easier to establish and sell
Synergy with other corporate divisions, subsidiaries
Extra legal, accounting work
Complex financial statements
Liability for subsidiary's actions, debts
However, subsidiaries also have a few drawbacks. Aggregating and consolidating a subsidiary's financials make a parent's accounting more complicated and complex.
Since subsidiaries must remain independent to some degree, transactions with the parent may have to be "at arm's length," and the parent may not have all the control it wishes. Yet the parent may also be liable for criminal actions or corporate malfeasance by the subsidiary. It may have to guarantee the subsidiary's loans, leaving it exposed to financial losses.
Real World Example of Subsidiaries
Public companies are required by the SEC to disclose significant subsidiaries under Item 601 of Regulation S-K. Warren Buffett's Berkshire Hathaway Inc., for example, has a long and diverse list of subsidiary companies, including Dairy Queen, Clayton Homes, Business Wire, GEICO, and Helzberg Diamonds.
Berkshire Hathaway's acquisition of many diverse firms follows with Buffett's oft-discussed strategy of buying undervalued assets and holding onto them. In return, acquired subsidiaries can often continue to operate independently while gaining access to broader financial resources. An exhibit to Berkshire's annual filing for the year ended Dec. 31, 2018, reveals that the firm owns upward of 270 subsidiaries.
Like Berkshire Hathaway, Alphabet Inc. has many subsidiaries. These separate business entities all perform unique operations that add value to Alphabet through diversification, revenue, earnings, and research and development (R&D).
For example, Sidewalk Labs, a small startup that is a subsidiary of Alphabet, seeks to modernize public transit in the United States. The company has developed a public transportation management system that aggregates millions of data points from smartphones, cars and Wi-Fi hotspots to analyze and predict where traffic and commuters are most congregated. The system can redirect public transportation resources, such as buses, to these congested areas to keep the public transit system moving efficiently.
For Alphabet, Sidewalk Labs provides it with a business unit that develops technology that can one day help the entire company. Since one of Alphabet's largest products is Google Maps, subsidiaries such as Sidewalk Labs can strengthen the company's overall business operations.