Chapter 6

• Cash Flows

• EPS

• Taxation

• Unconsolidated Investments

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Special issues

Cash flow for the consolidated company Consolidated earnings per share Taxation

– using a consolidated tax return– using separate tax returns for each affiliate

Equity method for influential investments

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Consolidated cash flow:The issues

Impact of the purchase– cash purchase is investing– stock issue is non-cash transaction

Amortizations are non-cash adjustment to operations

Transactions between firms are eliminated on the income statement and balance sheet we use for the analysis

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Cash purchase is “Investing.” There is usually also a non-cash portion (liabilities assumed and non-controlling interest).

Cash paid is recorded net of sub’s cash received. Stock issue usually results in cash inflow (for the

sub’s cash) and disclosure of the “non-cash” transaction

Pooling was a non-event because prior balance sheet was retroactively consolidated

Consolidated cash flow:Impact of the purchase

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Start with consolidated net income (includes the NCI share). If you start with only controlling interest, the NCI must be added back to income.

Add back amortizations from D&D to income; they are non-cash expensesOperations (+)

Consolidated cash flow:Adjustments

continued . . .

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Purchase of additional sub shares is the purchase of treasury shares for the consolidated entityFinancing (-)

All parent dividends and dividends paid to NCI cashFinancing (-)

Buying sub bonds is retirement for consolidated entityFinancing (-)

Consolidated cash flow:Adjustments (continued)

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Example:Cash purchase

Balance Sheet of Company Acquired

Cash 10,000 Liabilities 30,000

Fixed assets 80,000 Equity 60,000

D&D SchedulePrice Paid 100,000Interest (80% $60,000) 48,000Excess 52,000Allocate to building (80% 50,000) 40,000 20 yearGoodwill 12,000

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To see cash flow impact, consider additions to parent balance sheet on purchase date:

Fixed asset (increased 40,000) 120,000Goodwill 12,000Liabilities 30,000Cash (100,000 - 10,000 sub cash) 90,000NCI (20% 60,000) 12,000

Non-cash “investing” is $30,000 liability & $12,000 NCI

Cash Operations is +$2,000 depreciation adjustment

Example:Cash purchase (continued)

Dr Cr

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Example:Stock issued for sub

Balance Sheet of Company Acquired

Cash 10,000 Liabilities 30,000

Fixed assets 80,000 Equity 60,000

D&D SchedulePrice Paid (10,000 par $10 shares) 100,000Interest (80% $60,000) 48,000Excess 52,000Allocate to building (80% 50,000) 40,000 20 yearGoodwill 12,000

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To see cash flow impact, consider additions to parent balance sheet on purchase date:

Cash (from Sub) 10,000Fixed asset (increased 40,000)120,000Goodwill 12,000Liabilities 30,000NCI (20% 60,000) 12,000Common stock, $10 par 100,000

Non-cash “investing” is $30,000 liability is + $12,000 NCI + $100,000 stock issue

Cash Operations is + $2,000 depreciation adjustment

Example:Stock issued for sub (continued)

Dr Cr

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Consolidated EPS

Consolidated Basic EPS

Consolidated net income [controlling

interest only]

Parent common shares

=

Consolidated Diluted EPS

P’s internally gen adj inc + Parent DEPS inc adj + (P’s owned Sub Equity Shares Sub

DEPS)

Parent common shares

=

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Taxation of the consolidated entity

Consolidated Return Requires 80% plus IRS

rules No tax on separate books Tax based on “consolidated

net income” from consol WS

Inter-co profits have been eliminated - not taxed

Allocate tax back to Parent & Sub books

Separate Taxation Each firm paid tax on their

reported income Parent may pay (and /or

accrue) “secondary tax” on share of sub income

Intercompany profits have been taxed - requires deferral

Tax allocation techniques are employed

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Base example for taxation

Parent Sub Sales 300,000 120,000 Cost of Goods Sold (200,000) (90,000)Gross profit 100,000 30,000 Expenses (40,000) (20,000)Gain on sale of machine 5,000 _______Net Income 65,000 10,000

Parent owns 80% interest Tax rate is 30% Gain on machine is 5 year asset sold to S by P (downstream) S sells inventory to P at 20% GP, $50,000 sales during year,

$20,000 in beg inv, $6,000 in end inv

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Consolidated taxation:Adjustments

Partial worksheet Trial Balances Eliminations Inc Stmt. Sales (300,000) (120,000) IS 50,000 (370,000) Cost of Goods Sold 200,000 90,000 EI 1,200 IS 50,000

BI 4,000

237,200 Gain on Mach. (5,000) F1 5,000 Subsidiary inc. (8,000) CY 8,000 Expenses 40,000 20,000 F2 1,000 59,000 Net income (73,800) Tax (30%) T 22,140 22,140 Net income 51,660 To NCI (see IDS) 1,792 To controlling interest (see IDS) 49,868 IS Inter-co sales EI end inv profit BI beg inv profit

F1 Inter-co gain F2 reduce depr (gain) T tax provision

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Consolidated taxation:Sub IDS

Sub

End inv profit (EI) 1,200 Internal gen NI 10,000

Beg inv profit (BI) 4,000

Adjusted net 12,800 Tax (3,840)

Net income 8,960

20% NCI 1,792

Sub must record tax provision on its books

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Parent

Gain on mach (F1) 5,000 Intern gen NI before tax 65,000

Realized gain (F2) 1,000

Adjusted net income 61,000 Tax (18,300)

Net income 42,700

80% of S’s NI after tax + 7,168

Controlling Interest 49,868

Consolidated taxation:Parent IDS

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Consolidated tax: WorksheetIn Worksheet 6-1: Neither P or S has tax provision on books; if there were

one, we would reverse it out. Eliminations, prior to tax entry, do not change from prior

chapters Provision T for tax based on consolidated income Take care on parent IDS to avoid taxing Sub income

again Tax provision on IDS must be recorded on books of P

and S

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Separate tax:Worksheet

In Worksheet 6-2: Confirm the tax provision on P’s and S’s incomes,

P’s provision includes secondary tax on 75% of sub income.

Confirm P’s deferred tax liability for the undistributed share of sub income (current and prior years).

Eliminations prior to tax do not change from prior chapters

continued . . .

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Separate tax: Worksheet (continued) Entry T1 adjusts for tax impact on RE adjustments Entry T2 adjusts for tax impact of current year

adjustments All IDS adjustments are net of tax, including double

tax on P’s share of S income.

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Separate taxation example:Adjustments for current year

Partial worksheet Trial Balances Eliminations Inc Stmt. Sales (300,000) (120,000) IS 50,000 (370,000) Cost of Goods Sold 200,000 90,000 BE 1,200 IS 50,000

BI 4,000

237,200 Gain on Mach. (5,000) F1 5,000 Expenses 40,000 20,000 F2 1,000 59,000 Subsidiary inc. (5,600) CY 5,600 Provision for tax *19,836 3,000 T2 266 22,570 Net income (51,230) To NCI (see IDS) 1,792 To controlling interest (see IDS) 49,438

* P’s tax = (65,000 .3) + ([5,600 .2] .3)

IS inter co sales BE end inv profit BI beg inv profit

F1 inter co gain F2 reduce depr (gain) CY elim sub income

T2 tax adjustment (see next slide)

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Separate taxation:Tax adjustmentTax adjustment schedule: Deferred Tax Asset increase (decrease)

Item Total 80% Par 20% NCIMach gain deferred ($5,000 .3) 1,500 1,500 Mach gain realized ($1,000 .3) (300) (300)Beg Inv realized ($4,000 .3) (1,200) (960) (240) secondary tax ($2,800 .8 .2 .3) (134) (134)End Inv deferred ($1,200 .3) 360 288 72 secondary tax ($840 .8 .2 .3) 40 40 _____Total 266 434 (168)

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Separate taxation:Sub IDS

Sub

End inv profit (EI) 1,200 Int gen NI before tax 10,000

Beg inv profit (BI) 4,000

Adjusted inc before tax 12,800

30% tax (3,840)

Adj inc net of tax 8,960

Minority share (20%) 1,792

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Separate taxation:Parent IDS

ParentGain on mach. (F1) 5,000 Int gen NI before tax

65,000 Realized gain (F2)

1,000 Adj. inc. before tax

61,000 30% tax

(18,300)Net income

42,700 80% Sub Adj Net Inc

+ 7,168 Secondary tax on $7,168*

(430)Adjusted net inc

49,438

* $7,168 20% included 30% tax rate

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Influential investments:Equity Method D&D is still used to determine excess and schedule

amortizations– amortizations now come out of the investment account

– there is no amortization of goodwill component of excess

Investee profits are adjusted via the IDS. Only the investor’s share of profits is deferred

Double tax applies (20%) Tax allocation applies to only the double tax

– investor must accrue tax on undistributed investee income

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Influential investment:Example

D&D of Excess Schedule

Price paid $80,000Equity (30% $250,000) 75,000Excess: patents with 5 year amortization 5,000

Investor sells inventory to investee: 30% GP, $10,000 goods in beg inv, $40,000 goods in end inv

At beginning of year, investee sold machine (5 years life) to investor at $10,000 profit

Investee reports income of $60,000 (before tax) 30% tax rate; 80% income exclusion

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Influential investment:IDS to calculate investment income

IDS for Investee

Mach gain 10,000 Int generated income 60,000

no inventory adj. here! Realized mach gain 2,000

Adjusted Inc 52,000

Tax at 30% 15,600

Net Inc 36,400

30% interest 10,920

Less patent amort (1,000)

Equity income 9,920

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Influential investment:Entries to record incomeInvestment in Investee 9,920

Investment income 9,920Provision for Tax* 655

DTL 655* ([9,920 + 1,000] 20% included 30% tax rate). Amort of excess is not tax deductible.

Deferred gross profit (beginning inv) 900Sales rev (10,000 30% GP 30% interest) 900

Sales Rev (4,000 30% GP 30% interest) 3,600Deferred gross profit (ending inv) 3,600

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Provision for tax (900 30% ) 270DTA (on beginning inventory) 270

DTA (on ending inventory) 1,080 Provision for tax (3,600 30% ) 1,080

Influential investment:Entries to record income (cont’d)

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Influential investment:Special issues

You can’t equity adjust below “zero.”– memo entries to track unrecorded losses

– future income not recognized until it exceeds unrecorded losses

Investor defers profit on own interest on own books. Achieve influence with subsequent purchases

– retroactive conversion to sophisticated equity

Loose influence – stop using sophisticated equity; no retroactive adjustment