From time to time, the reality of cash flow may dictate that related entities lend to or borrow from each other. The accounting treatment, in its most basic form, needs to mirror the flow or control of cash. Except when finances are presented on a consolidated basis, each party to the transaction will present an advance differently on its respective balance sheet.
In practice, the power to control cash defines it as an asset. In the case of an advance to a subsidiary, the entity receiving the cash has gained an asset because it has the spending power, or the ability to control how the borrowed cash is utilized. The receiver also has some kind of liability for repayment, which may or may not be documented.
Contrary to what may appear as intuitive, the accounting classification for cash advanced to a subsidiary does change. The advancing entity has in some respects given up control or use of a specific amount of cash, or spending power. Though the advance is to a related party, the asset has now taken on the features of an account receivable. The asset is current, probably collectible and easily measured but it is no longer cash that can be spent in another way.
Since the cash accounts of both the provider and receiver get decreased and increased accordingly, the more important classification arise in the offsets to these entries. From the perspective of the provider of the cash, it has now created an account receivable, albeit due from a related party. In turn, the receiver of the cash now has created an account payable or perhaps even a note payable depending on the nature and documentation of the advance.
Correct accounting presentation is important, particularly if management decisions are made independently by the related entities. In addition, creditors of the entities need some degree of transparency about the individual liquidity of related businesses.
Summary of Effects
When financial statements are prepared on a consolidated basis, with one set of statements describing the activities of all related entities, advances to subsidiaries will not be presented. They will have been adjusted via so-called "eliminating entries" in the consolidation process.
The pre-consolidated effect of an advance, however, could affect one entity's "face" that it presents to lenders, creditors, shareholders or other interested parties. Management may heave reason to present a particular entity as "cash rich," liquid or asset-heavy. Conversely, there may be motivation to portray an unconsolidated position of cash tightness or asset constraint.
Most importantly, the reasons behind cash advances must be clearly understood. The movement of cash between related entities for no adequate business reason should be a precursor for further analysis by interested parties.
- The McGraw-Hill 36 Hour Accounting Course: Robert Liduxon and Harold E. Arnett; McGraw-Hill Professional; 1993
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