subsidiary preferred stock, consolidated earnings per share, and consolidated income taxation

10 - 1©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn

Subsidiary Preferred Stock,Consolidated Earnings per Share,and Consolidated Income Taxation

Chapter 10


Learning Objective 1

Modify consolidation proceduresfor subsidiary companies with

preferred stock in theircapital structure.


Subsidiaries with PreferredStock Outstanding

When preferred stock has a call orredemption price, this amount is used

in allocating the investee’s equityto preferred stockholders.


Subsidiaries with PreferredStock Outstanding

If there is no redemption provision,the equity is allocated on the basis of

par value plus any liquidation premium.1

Any dividends in arrears on cumulative preferred stock is allocated to the

preferred stockholders.2


Subsidiary With Preferred StockNot Held by Parent

Poe acquired a 90% interest in Solon January 1, 2004, for $395,500.There were no preferred dividends

in arrears as of January 1, 2004.During 2004, Sol had income of

$50,000 and paid $30,000 dividends.Dividends were $20,000 on commonstock and $10,000 on preferred stock.



$10 preferred stock, $100 par, cumulative, nonparticipating, callable at $105 per share $100,000Common stock, $10 par 200,000Other paid-in capital 40,000Retained earnings 160,000Total stockholders’ equity $500,000

Sol’s stockholders’ equity December 31, 2003



Total Sol stockholders’ equity $500,000Less: Preferred stockholders’ equity (1,000 × $105) –105,000Common stockholders’ equity $395,000Price paid for 90% interest $395,500Less: Book and fair value acquired ($395,000 × 90%) –355,500Goodwill $ 40,000



Total stockholders’ equity $520,000Less: Preferred stockholders’

equity (1,000 × $105) –105,000Common stockholders’ equity $415,000

Sol’s stockholders’ equity December 31, 2004


Minority Interest inPreferred Stock

$105,000 × 100% of preferred equity $105,000$415,000 × 10% of common equity 41,500Total $146,500

Minority interest in Sol at December 31, 2004


Subsidiary Preferred StockAcquired by Parent

A parent company’s purchase of theoutstanding preferred stock of a subsidiary

results in a retirement of the stock purchasedfrom the viewpoint of the consolidated entity.



Sol Corporation experienceda loss of $40,000 in 2005.

What is Sol’s stockholders’equity at 12/31/2005?

$520,000 – $40,000 = $480,000

No dividends were paid.



What is Poe’s share of this loss?

($40,000 + $10,000 income to preferred) × 90%

What is Poe’s investment in Sol on 12/31/2005?



Poe’s Investment1/1/2004 395,50012/31/2004 36,0001/1/2005 413,500

368,500

18,000

45,000 loss

Dividends

12/31/2005


Constructive Retirement ofSubsidiary Preferred Stock

On January 1, 2006, Poe purchased 800 of Sol’spreferred shares (80% interest) at $100 per share.

$115,000 × 80% = $92,000 book value$92,000 – $80,000 = $12,000

Sol reports net income of $20,000 for 2006.



Investment in Sol Preferred 80,000Cash 80,000

To record purchase of stock

Investment in Sol Preferred 12,000Other Paid-in Capital 12,000

To adjust other paid-in capital to reflect constructive retirement



Poe’s Investment1/1/2004 395,50012/31/2004 36,0001/1/2005 413,500

368,500 9,000377,500

18,000

45,000 loss

Dividends

12/31/2006

Income



Calculated basic and dilutedearnings per share for a

consolidated reporting entity.


Parent Company and ConsolidatedEarnings Per Share

GAAP requires that all firms calculate andreport basic and diluted (where applicable)

earnings per share (EPS).

Consolidated entities disclose (EPS)on a consolidated basis.


Parent Company and ConsolidatedEarnings Per Share

A parent company’s net income and EPSunder the equity method are equal to

consolidated net income and consolidated EPS.

Parent Company procedures for computing EPSdepend on the subsidiary’s capital structure.


General Format for EPS Calculations

Numerator in Dollars ($) AIncome to parent’s common stockholders $$$Add: Adjustments for parent’s dilutive securities + $Add: Adjustments for subsidiary’s potentially

dilutive securities convertible into parentcompany stock N/A

Replacement calculationDeduct: Parent’s equity in subsidiary’s

diluted earnings N/AAdd: Parent’s equity in subsidiary’s

diluted earnings N/AParent's diluted earnings = a $$$A: Subsidiary does not have potentially dilutive securities outstanding



Numerator in Dollars ($) BIncome to parent’s common stockholders $$$Add: Adjustments for parent’s dilutive securities + $Add: Adjustments for subsidiary’s potentially

dilutive securities convertible into parentcompany stock N/A


diluted earnings – $Add: Parent’s equity in subsidiary’s

diluted earnings + $Parent's diluted earnings = a $$$B: Subsidiary has potentially dilutive securities convertible into subsidiary common stock



Numerator in Dollars ($) CIncome to parent’s common stockholders $$$Add: Adjustments for parent’s dilutive securities + $Add: Adjustments for subsidiary’s potentially

dilutive securities convertible into parentcompany stock + $


diluted earnings N/AAdd: Parent’s equity in subsidiary’s

diluted earnings N/AParent's diluted earnings = a $$$C: Subsidiary has potentially dilutive securities convertible into parent company common stock



Denominator in Shares (Y) AParent’s common shares outstanding YYYAdd: Shares represented by parent’s

potentially dilutive securities + YAdd: Shares represented by subsidiary’s

potentially dilutive securities convertibleinto parent company common shares N/A

Parent’s common shares and commonshare equivalents = b YYY

Parent Company and Consolidated Diluted EPS a ÷ bA: Subsidiary does not have potentially dilutive securities outstanding



Denominator in Shares (Y) BParent’s common shares outstanding YYYAdd: Shares represented by parent’s


potentially dilutive securities convertibleinto parent company common shares N/A


Parent Company and Consolidated Diluted EPS a ÷ bB: Subsidiary has potentially dilutive securities convertible into subsidiary common stock



Denominator in Shares (Y) CParent’s common shares outstanding YYYAdd: Shares represented by parent’s


potentially dilutive securities convertibleinto parent company common shares + Y


Parent Company and Consolidated Diluted EPS a ÷ bC: Subsidiary has potentially dilutive securities convertible into parent company common stock


Dilutive Securities of SubsidiaryConvertible into Subsidiary Shares

Diluted earnings of the parent company areadjusted by excluding the parent’s equity insubsidiary realized income and replacing

that equity with the parent’s share ofdiluted earnings of the subsidiary.


Subsidiary With ConvertiblePreferred Stock

Plant Corporation purchased 90% of SeedCorporation’s outstanding voting common

stock for $328,000 on January 1, 2003.During 2003, Seed reports $50,000 netincome and pays $25,000 dividends,

$10,000 to preferred and $15,000 to common.



Common stock, $5 par, 200,000shares issued and outstanding $1,000,000

Common stock, $10 par,20,000 shares outstanding $200,000

10% cumulative, convertiblepreferred stock, $100 par,1,000 shares outstanding 100,000

Retained earnings 500,000 120,000Total stockholders’ equity $1,500,000 $420,000

January 1, 2003 Plant Seed



Income from Plant’s operations $150,000Income from Seed

($50,000 – $10,000 preferred income) × 90% 36,000Plant net income $186,000

Plant’s Income for 2003


Subsidiary Preferred StockConvertible into Subsidiary

Common

Seed’s preferred stock is convertible into12,000 shares of Seed’s common stock.Neither Plant nor Seed has any other

potentially dilutive securities outstanding.Seed’s diluted EPS:

$50,000 ÷ (20,000 + 12,000) = $1.5625


Subsidiary Preferred StockConvertible into Subsidiary

CommonNet income of Plant $186,000Replacement of Plant’s equity in Seed’s

realized income ($40,000 × 90%) – 36,000with Plant’s equity in Seed’s dilutedearnings (18,000 × $1.5625) 28,125

Plant’s diluted earnings = a $178,125

Plant’s outstanding shares = b 200,000Plant’s diluted EPS = a ÷ b $ 0.89

Plant’s Diluted EPS


Subsidiary Preferred Convertibleinto Parent Company Common

Seed’s preferred stock is convertible into24,000 shares of Plant’s common stock.

Neither Plant nor Seed had otherpotentially dilutive securities outstanding.Seed’s diluted EPS is $2 ($40,000 income

to common ÷ 20,000 common shares). What is Plant’s diluted EPS?


Subsidiary Preferred Convertibleinto Parent Company Common

Net income of Plant $186,000Add: Income to preferred stockholders

of Seed assumed to be converted 10,000Plant’s diluted earnings = a $196,000Plant’s outstanding shares 200,000Add: Seed’s preferred shares

assumed converted 24,000Plant common shares and common

stock equivalents = b 224,000Plant’s diluted EPS = a ÷ b $ 0.88


Subsidiary With Optionsand Convertible Bonds

Own operations $1,500,000Syd’s operations $ 300,000

Paddy’s income 2003

Syd is 80% owned by Paddy.80% × $450,000 Syd net income $360,00080% × $50,000 unrealized profit – 40,000Amortization – 20,000Income from Syd $300,000


Subsidiary With Optionsand Convertible Bonds

Paddy: Common stock, 1,000,000 sharesSyd: Common stock, 400,000 shares

Options to purchase 60,000 shares of stock at $10 per share (average market price is $15 per share) 7% convertible bonds, $1,000,000

par outstanding, convertible into 80,000 shares of common stock


Options and Bonds Convertibleinto Subsidiary Common Stock

Syd’s income to common stockholders $450,000Less: Unrealized profit on sale of land – 50,000Add: Net-of-tax interest expense assuming

bonds converted into subsidiary shares($1,000,000 × 7% × 66% net of tax) 46,200

Subsidiary adjusted earnings = a $446,200



Syd’s common shares outstanding 400,000Incremental shares

60,000 – ($600,000 ÷ $15) 20,000Additional shares assuming bonds

converted into subsidiary shares 80,000Syd’s adjusted shares = b 500,000Syd’s diluted EPS = a ÷ b

($446,200 ÷ 500,000) $ 0.89



Paddy’s income to common stockholders $1,800,000Replacement of Paddy’s equity in

Syd’s realized income ($400,000 × 80%) – 320,000with Paddy’s equity in Syd’sdiluted EPS (320,000 × $0.89) 284,800

Paddy adjusted earnings = a $1,764,800

Paddy outstanding shares = b 1,000,000Paddy’s diluted EPS = a ÷ b $ 1.76


Options and Bonds Convertibleinto Parent’s Common Stock

Paddy’s income to common stockholders $1,800,000Add: Net-of-tax interest expense assuming

bonds were converted into shares($1,000,000 × 7% × 66% net-of-tax effect) 46,200

Paddy’s adjusted earnings = a $1,846,200


Options and Bonds Convertibleinto Parent’s Common Stock

Paddy’s common shares outstanding 1,000,000Incremental shares

60,000 – ($600,000 ÷ $15) 20,000Additional shares assuming bonds

are converted into parent shares 80,000Paddy’s adjusted shares = b 1,100,000Paddy’s diluted EPS = a ÷ b ($1,846,200 ÷ 1,100,000) $ 1.68



Understand the complexities ofaccounting for income taxes

by consolidated entities.


Accounting for Income Taxesof Consolidated Entities

An affiliated group exists when a commonparent corporation owns at least 80% of thevoting power of all classes of stock and 80%or more of the total value of all outstandingstock of each of the includable corporations.


Accounting for Income Taxesof Consolidated Entities

A consolidated entity that is anaffiliated group may elect to fileconsolidated income tax returns.

All other consolidated entities mustfile separate income tax returns for

each affiliated company.


Advantages of FilingConsolidated Returns

1 Losses are offset against incomebetween members.

2 Intercorporate dividends areexcluded from taxable income.

3 Intercompany profits are deferredfrom income until realized.


Disadvantages of FilingConsolidated Returns

1 Decrease in flexibility.

2 Commitment to consolidatedreturns year after year.

3 Deconsolidated corporationscannot rejoin the group for 5 years.


Income Tax Allocation

FASB Statement No. 109, “Accounting forIncome Taxes,” is the primary source ofGAAP for accounting for income taxes.

Events that have future tax consequencesare designated temporary differences.


Income Tax Allocation

The objectives of accounting forincome taxes are to recognize the amount

of taxes payable or refundable for thecurrent year and to recognize deferred tax

liabilities and assets for the tax consequencesof events that have been recognized in the

financial statements or tax returns.


Accounting for Distributedand Undistributed Income

Parson owns a 30% interest in SeatonCorporation, a domestic corporation.Seaton reports $600,000 net income

and pays dividends of $200,000.The income tax rate is 34%.

What is Parson’s shareof Seaton’s income?



Share of distributed earnings (dividends)($200,000 × 30%) $ 60,000

Share of undistributed earnings(retained earnings increase)($400,000 × 30%) 120,000

Equity in Seaton’s earnings $180,000



The income tax expense equals income taxliability for the dividends received.

$60,000 × 20% taxable × 34% tax rate = $4,080December 31, 2003Income Tax Expense 8,160

Deferred Income Taxes 8,160To provide for taxes on undistributed earnings($120,000 × 20% × 34% = $8,160)


Unrealized Gains and Lossesfrom Intercompany Transactions

Unrealized and constructive gains and losses createtemporary differences that may affect deferred taxcalculations when filing separate income tax returns.

This is not the case when filing consolidated returns.


Separate Company Tax Returnswith Intercompany Gain

Paco Corporation paid $375,000 for a 75%interest in Step on January 1, 2003.

Step’s equity consisted of $300,000 capitalstock and $200,000 retained earnings.



Paco had a deferred tax liability of$10,200, consisting of $30,000 tax/bookdepreciation differences that reverse inequal ($7,500) amounts over the years.

On January 8, 2003, Paco sold equipmentto Step at a gain of $20,000.

Step is depreciating the equipmentover five years (S/L).



Sales $380,000 $300,000Gain on equipment sale 20,000 –Income from Step 23,600 –Cost of sales –200,000 –180,000Operating expenses –100,000 – 40,000Income tax expense – 31,253 – 27,200

Net income $ 92,347 $ 52,800Add: Beginning retained earnings 357,653 200,000Deduct: Dividends (December) – 50,000 – 28,000Retained earnings 12/31/2003 $400,000 $224,800

12/31/2003 Paco Step


One-Line Consolidation

January 1, 2003Investment in Step 375,000

Cash 375,000To record purchase of 75% interestDecember 2003Cash 21,000

Investment in Step 21,000To record dividends received


One-Line Consolidation

December 31, 2003Investment in Step 23,600

Income from Step 23,600To record income from StepPaco’s share of Step net income

($52,800 × 75%) $39,600Less: Unrealized profit –20,000Add: Piecemeal recognition of gain 4,000Income from Step $23,600


Schedule of DeferredIncome Tax Liability

Temporary FutureDifference 2003 2004-7 Years

Depreciation $ 7,500Gain on equipment $20,000Piecemeal recognition – 4,000 – 4,000Future dividends – 3,720 – $3,720Taxable in future years $ 3,500 $3,720Enacted tax rate 34% 34%Deferred tax liability $ 1,190 $1,265


Business Combination

Taxable combination

Tax-free reorganization


Business Combination

In a purchase business combination,the cost/book value differential is

allocated to the assets and liabilitiesacquired at gross fair values, anda deferred tax asset or liability is

recorded for the related tax effect.


Financial Statement Disclosuresfor Income Taxes

GAPP divides deferred assets or liabilities.

Current Noncurrent


Financial Statement Disclosuresfor Income Taxes

GAPP requires disclosure for incometax expense and benefits allocated to:

Continuing operationsDiscontinued operations

Extraordinary itemsCumulate effect type

Prior period adjustments


End of Chapter 10

subsidiary preferred stock, consolidated earnings per share, and consolidated income taxation

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