© the mcgraw-hill companies, inc., 2004 slide 7-1 mcgraw-hill/irwin chapter seven consolidated...

© The McGraw-Hill Companies, Inc., 2004

Slide 7-1

McGraw-Hill/Irwin

Chapter Seven

Consolidated Consolidated Financial Statements Financial Statements – Ownership Patterns – Ownership Patterns

and Income Taxesand Income Taxes

1. Indirect Subsidiary Control

2. Mutual Ownership

3. Income Tax Accounting for a Business Combination


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1. Indirect Subsidiary Control

80% OwnershipFather

Son

Grandson

70% Ownership

Father-Son-Grandson

relationships occur when the

parent controls a subsidiary that controls other subsidiaries.

Father-Son-Grandson

relationships occur when the

parent controls a subsidiary that controls other subsidiaries.


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In effect, the Father company

indirectly controls ALL of the subsidiaries

in the chain.

Indirect Subsidiary Control

80% OwnershipFather

Son

Grandson

70% Ownership


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Be sure to always start from the

bottom and work up to the parent

company.



company.

Consolidation When Indirect Control Is Present

Compute realized income for the “grandson”.

Compute consolidated income for the “son” and “grandson”.

Compute consolidated income for the “father” and the “son”.


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company.



company.

Consolidation When Indirect Control Is Present

Compute realized income for the “grandson”.

Compute consolidated income for the “son” and “grandson”.

Compute consolidated income for the “father” and the “son”.

Let’s look at an example from your

text.

Let’s look at an example from your

text.


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Indirect ControlExample

Determine consolidated income for the business

combination by:

Combining Midway and Bottom to determine Midway’s realized income.

Combining Top with the realized income from Midway.

Determine consolidated income for the business

combination by:

Combining Midway and Bottom to determine Midway’s realized income.

Combining Top with the realized income from Midway.

70% OwnershipTop Co.

Midway Co.

Bottom Co.

60% Ownership


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2004 Income Figures For Each Company



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After adjusting for intercompany income, Bottom Co.’s realized

income is $80,000.

Midway gets 60% of $80,000.

After adjusting for intercompany income, Bottom Co.’s realized

income is $80,000.

Midway gets 60% of $80,000.


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Consolidation ProcessIndirect Control

The consolidation process requires making the

consolidation entries for: Each son/grandson

relationship, and then Each father/son

relationship.


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Using the consolidation entries previously described is sufficient to complete the father-son-grandson combination.

Essentially, the entries are duplicated for each relationship.


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Requires a separate computation for the “son” and the “grandson.”

Compute realized income for each company, starting with the “grandson.”

Requires a separate computation for the “son” and the “grandson.”

Compute realized income for each company, starting with the “grandson.”

Consolidation entries to the retained earnings account of son always updates son’s retained earnings. This is obvious but it is very important when a method other full equity method is being used. That is, the effect of the “C” entry must be taken into account

Consolidation entries to the retained earnings account of son always updates son’s retained earnings. This is obvious but it is very important when a method other full equity method is being used. That is, the effect of the “C” entry must be taken into account

See exercise 30, page 360 (Part a only)


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Indirect Subsidiary ControlConnecting Affiliation

Low Company

Side Company

70% owned

30% owned

45% owned

The combination of the parent’s DIRECT ownership and

INDIRECT ownership can result in control of

a subsidiary.

The combination of the parent’s DIRECT ownership and

INDIRECT ownership can result in control of

a subsidiary.High Company

In this case, High controls Side directly with 70% ownership,

and Low indirectly with 61.5% effective

ownership. ( 30% + [ 70% x 45% ])

In this case, High controls Side directly with 70% ownership,

and Low indirectly with 61.5% effective

ownership. ( 30% + [ 70% x 45% ])


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Indirect Subsidiary ControlConnecting Affiliation

Basic Consolidation Rules Still Hold:

Eliminate effects of intercompany transfers.

Eliminate sub’s beginning equity balances.

Adjust for unamortized FMV adjustments.

Record Amortization Expense.

Remove intercompany income and dividends.

Compute and record noncontrolling interest in subsidiaries’ net income.

The sequence of consolidation process

is as follows: Consolidate direct subsidiary

chain first (starting with “Grandson”) then

Consolidate “father” indirect interest in “grandson”

E.g. in this case, consolidate: Son-grandson (Side-Low) Father-son (High-Side) Father-grandson (High-Low)


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Up Company

Down Company

90% owned

20% owned

2.Mutual Ownership

Occurs when the subsidiary owns shares of the parent.

Two methods can be used to account for the mutually owned shares:

a) Treasury Stock Approach

b) Conventional Approach


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Mutual Ownershipa) Treasury Stock Approach

The predominant approach in practice. (simpler)

The cost of the parent shares held by the subsidiary are reclassified on the worksheet to Treasury Stock.

Intercompany dividends on shares of the parent that are owned by the subsidiary are eliminated as an intercompany cash transfer.


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Mutual Ownershipb) Conventional Approach

Treats each investment independently.

Both investments must be treated the same.

Requires the use of simultaneous equations to compute realized* income for the parent and the subsidiary.

A “Parent’s” Realized income =

“Parent’s” own operating income (adjusted for amortization) +

Equity Income Accrual of “Sub”


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Mutual Ownershipb) Conventional Approach (Cont’d)

Under this approach, the computation of realized income for the parent (PRI) and the subsidiary

(SRI) requires the use of simultaneous equations:

SRI = Sub’s Operating NI + Sub’s % of PRI

PRI = Parent’s Operating NI + Parent’s % of SRI

Under this approach, the computation of realized income for the parent (PRI) and the subsidiary

(SRI) requires the use of simultaneous equations:

SRI = Sub’s Operating NI + Sub’s % of PRI

PRI = Parent’s Operating NI + Parent’s % of SRI

Noncontrolling Interest in Noncontrolling Interest in Subsidiary NI is based on the Subsidiary NI is based on the

Parent’s % of SRI.Parent’s % of SRI.

Noncontrolling Interest in Noncontrolling Interest in Subsidiary NI is based on the Subsidiary NI is based on the

Parent’s % of SRI.Parent’s % of SRI.


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b) Conventional Approach - Example

Brother Inc. owns 80% of Cousin. In 2005, Brother has net operating income of

$400,000. There is also $4,000 of amortization expenses related to Brother’s acquisition of Cousin.

Cousin owns 20% of Brother, Inc. In 2005, Cousin has net operating income of

$120,000.

Compute each company’s realized income?Compute each company’s realized income?

Brother Inc. owns 80% of Cousin. In 2005, Brother has net operating income of

$400,000. There is also $4,000 of amortization expenses related to Brother’s acquisition of Cousin.

Cousin owns 20% of Brother, Inc. In 2005, Cousin has net operating income of

$120,000.

Compute each company’s realized income?Compute each company’s realized income?

Continue


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Substitute the PRI equation into the SRI

equation.


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equation.


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equation.

See exercise 31, page 361


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3. Income Tax Accounting for a Business Combination

Business combinations may elect to file a consolidated federal tax return for all companies composing an affiliated group.

The affiliated group will likely exclude some members of the business combination.

Business combinations may elect to file a consolidated federal tax return for all companies composing an affiliated group.

The affiliated group will likely exclude some members of the business combination.


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Income Tax Accounting for a Business Combination

Affiliated Group = The parent company + Any (domestic)

subsidiary where the parent owns 80% of the voting stock AND 80% of each class of nonvoting stock.

All others must file separately.

Affiliated Group = The parent company + Any (domestic)

subsidiary where the parent owns 80% of the voting stock AND 80% of each class of nonvoting stock.

All others must file separately.


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Benefits of Using an Affiliated Group

Intercompany profits are not taxed until realized.

Intercompany dividends are non-taxable.

Losses of one affiliated group member can be used to offset income earned by another group member.

Intercompany profits are not taxed until realized.

Intercompany dividends are non-taxable.

Losses of one affiliated group member can be used to offset income earned by another group member.


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Income Tax Accounting: Deferred Income Taxes

The tax consequences are often dependent on whether separate or consolidated returns are filed.

Transactions affected:

1. Intercompany Dividends


2. Goodwill2. Goodwill

3. Unrealized Intercompany

Gains

3. Unrealized Intercompany

Gains


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a) For accounting purposes, all intercompany dividends are eliminated.

b) For tax purposes, dividends are NOT eliminated if ownership is < 80%.

c) In such a case, a tax liability (on 20% of the dividend) is immediately created for the recipient.

d) A deferred tax liability is also required for the parent’s share of any of the subsidiary’s income not paid currently as dividend i.e. the retained portion. (even if reversal is not apparent)

e) An exception to d): If the subsidiary is foreign, a deferred tax liability should not be created unless its reversal is apparent


Rohan Chambers

Retained Income = Operating Income- unrealized gain- income tax expense- dividends


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2. Amortization of Goodwill

a) The Revenue Reconciliation Act of 1993 allows amortization of Goodwill over 15 years for tax purposes.

b) SFAS No. 142 prohibits amortization of Goodwill for financial reporting purposes, but an impairment test could result in reduced goodwill, therefore

c) A deferred tax liability must be recognized.

2. Amortization of Goodwill

a) The Revenue Reconciliation Act of 1993 allows amortization of Goodwill over 15 years for tax purposes.

b) SFAS No. 142 prohibits amortization of Goodwill for financial reporting purposes, but an impairment test could result in reduced goodwill, therefore

c) A deferred tax liability must be recognized.



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3. Unrealized Intercompany Gains

a) If consolidated returns are filed, the gains are also removed, until realized.

b) If separate returns are filed, the gains must be reported in the period of transfer.

c) This “prepayment” of taxes on the unrealized gains in b) above creates a deferred income tax asset.

3. Unrealized Intercompany Gains

a) If consolidated returns are filed, the gains are also removed, until realized.

b) If separate returns are filed, the gains must be reported in the period of transfer.

c) This “prepayment” of taxes on the unrealized gains in b) above creates a deferred income tax asset.



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Assigning Income Tax Expense

1. For the subsidiary’s separate tax return

(if not part ofan affiliated group)

2. To determ inethe noncontrolling

interest's share of thesub's net incom e.

W hen a consolidated return is filed, incometax expense m ust be allocated to the

separate parties for a couple of reasons.


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Assigning Income Tax Expense

Assign Tax Expensebased on relative

net incomes of thecom panies.

PercentageAllocation M ethod

Allocation based onrelative tax expense

IF they had filedseparate returns.

SeparateReturn M ethod

Tw o M ethods

Taxable Income See exercise 30, page 360 (Parts b -d)


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A liability (DTL) or asset (DTA) should be recognised for the deferred tax consequences of the differences between the assigned values (FMV) and the tax bases (e.g. BV) of the assets and liabilities recognised in a purchase combinations.

If the FMV exceeds the tax base, then a DTL is required. This DTL will reduce the BV of the acquired company, hence increase the Goodwill (if any)

Income Tax Accounting: Temporary differences generated by business combinations


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Previously, the NOL of an acquired subsidiary could be (and was) used to offset the profits of a parent company.

However, US Laws have now been changed so that virtually all of a NOL carryfoward can be used only by the company that reported the loss.

A valuation allowance to this DTA (created by the NOL) is required if future profits are 50% or less likely to occur. If future taxes are successfully reduced by this

NOL, SFAS109 requires that these subsequent benefits be recorded as a reduction to goodwill. If Goodwill becomes zero, then and only then, may income tax expense may be reduced

• e.g. Dr. Valuation Allowance & Cr. Goodwill or– Dr. Valuation Allowance & Cr. Income Tax Expense

Income Tax Accounting: Business combinations & NOL

Rohan Chambers

I think that these are the entries to make!


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Our grandson Our grandson is so good to is so good to

send us send us dividends on dividends on our share of our share of his company his company

each year!each year!

End of Chapter 7

© the mcgraw-hill companies, inc., 2004 slide 7-1 mcgraw-hill/irwin chapter seven consolidated...

Documents

ownership slide

consolidated income

income figures

intercompany income

mcgrawhill companies

income taxes

s realized income

business combination