Chapter Seven

Consolidated Financial Statements – Ownership

Patterns and Income Taxes

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Indirect Subsidiary Control7-2

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Father Company

75 % Ownership

80 % ownership

Son Company

Grandson Company

When a parent controls a subsidiary which in turn controls other firms, a “pyramid” or “father-son-grandson” relationship exists

Consolidation When Indirect Control is Present

Start from the bottom of the “pyramid” and work upwards

Recognize realized income of the “grandson(s)”

Consolidate the “son” and “grandson(s)” financial information, and calculate any noncontrolling interest

Finally, consolidate the “son(s)” and parent in the same manner

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Note: In practice this can become quite complicated

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Indirect Control -- Example

Determine consolidated income for the entire combination by:

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

Combining Top with the realized income from Midway.

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Top Company

70 % Ownership

60 % ownership

Midway Company

Bottom Company

Indirect Control -- Example

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The following data is from the individual company financial records:

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Indirect Control – Example

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Following the consolidation steps to determine Midway’s realized income:

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Indirect Control -- Example

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Then combine Top Company’s income with Midway’s realized income:

Midway’s realized income as calculated in the last step.

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Indirect Control -- Example

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Lastly, using the calculation of income from the previous calculations, determine the noncontrolling interest:

Bottom and Midway’s individual incomes as calculated in the first step.

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Consolidation Process --Indirect Control

Use the standard consolidation entries to complete the father-son-grandson combination.

Essentially, the entries are duplicated for each relationship.

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Indirect Subsidiary Control -Connecting Affiliation

Low Company

Side Company

70% ownership

30% ownership

45% ownership

The combination of the parent’s DIRECT ownership and INDIRECT ownership can result in control of a subsidiary.

High Company

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The process of consolidating a connecting affiliation is essentially the same as for a father-son-grandson organization.

Indirect Subsidiary Control -Connecting Affiliation

Basic Consolidation Rules Still Hold: Eliminate effects of intra-entity transfers.

Adjust parent’s beginning R/E to recognize prior period ownership.

Eliminate sub’s beginning equity balances.

Adjust for unamortized FV adjustments.

Record Amortization Expense.

Remove intra-entity income and dividends.

Compute and record noncontrolling interest in subsidiaries’ net income.

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Up Company

Down Company

90% owned

20% owned

Mutual Ownership

Occurs when the sub owns shares of the parent.

The primary method used to account for the mutually owned shares is the Treasury Stock Approach

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Mutual Ownership23

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Mutual Ownership

GAAP recommends that “shares of the parent held by the subsidiary should be eliminated in consolidated financial statements”

Theoretically, these shares are not “outstanding” because they are not held by parties outside the combination

There is no legitimate accounting distinction between the parent owning stock of a subsidiary, or a subsidiary owning stock of a parent – they are both intra-entity stock ownership.

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Mutual Ownership -- Treasury Stock Approach

The cost of the parent shares held by the subsidiary is reclassified on the worksheet into Treasury Stock.

Intra-entity dividends on shares of the parent owned by the subsidiary are eliminated as an intra-entity cash transfer.

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Mutual Ownership -- Treasury Stock Approach Example

Pop Co owns 70% of Sun Co. Sun owns 10% of Pop Co, purchased for $120,000, and

records the investment under the Fair Value Method. Pop pays dividends of $8,000 to Sun, who records

dividend income. The following entries are recorded in consolidation:

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Treasury Stock . . . . . . . . . . . . . . . . . . $120,000 Investment . . . . . . . . . . . . . . . . . . . . . . . . $120,000Dividends Income . . . . . . . . . . . . . . . . . .$8,000 Dividends Paid . . . . . . . . . . . . . . . . . . . . . . .$8,000

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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 (as defined by the IRS) 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% or more of the voting stock AND 80% of each class of nonvoting stock.

All others must file separately (including any foreign subsidiaries.)

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Benefits of Using an Affiliated Group

Intra-entity profits are not taxed until realized.

Intra-entity dividends are nontaxable (regardless of filing a consolidated return).

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

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Income Tax Accounting -- Deferred Income Taxes

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

Transactions affected:

Intra-entity Dividends

Goodwill

Unrealized Intra-entity

Gains

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Income Tax Accounting – Deferred Income Taxes

Intra-entity Dividends

For accounting purposes, all intra-entity dividends are eliminated. For tax purposes, dividends are NOT eliminated if ownership is less than

80%, but there is a 80% (for ownership of 20% to 80%) or 70% (for ownership of less than 20%) deduction.

If less than 80 percent of a subsidiary’s stock is held, tax recognition becomes necessary.

An income tax liability is immediately created for the recipient. In addition, deferred income taxes are required for any of the

subsidiary’s income not paid currently as a dividend. A temporary difference is created because tax payments will occur in

future years when the subsidiary’s earnings eventually are distributed to the parent.

Hence, a current tax liability is recorded based on the dividends collected, and a deferred tax liability is recorded for the taxable portion of any income not paid to the parent during the year.

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Income Tax Accounting --Deferred Income Taxes

Amortization of Goodwill

Current tax law permits the amortization of Goodwill and other purchased Intangible Assets over 15 years.

GAAP does not systematically amortize Goodwill for financial reporting purposes, but instead reviews it annually for impairment.

A deferred tax liability results from the timing differences between the amortization and write-off.

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Income Tax Accounting -- Deferred Income Taxes

Unrealized Intra-Entity Gains

If consolidated returns are filed, intra-entity gains are deferred until realized and no timing difference is created.

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

The “prepayment” of taxes on the unrealized gains creates a deferred income tax asset.

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Assigning Income Tax Expense – Consolidated Return

Consolidated tax returns require allocation of tax expense between the parties

Important for the subsidiary: If separate financial statements are needed for

loans or equity issues As a basis for calculating noncontrolling interest’s

share of consolidated income

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Assigning Income Tax Expense7-35

Two Methods may be used to allocate Income Tax Expense:

Percentage Allocation Method – Tax Expense is assigned based on relative net incomes of the companies.

Separate Return Method – Tax Expense is assigned based on relative tax expense IF they had filed separate returns.

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Temporary Differences Generated by Business Combinations

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Based on the transaction’s nature, the tax laws deem some purchase combinations to be tax-free ( to the seller) but others to be taxable.

In most tax- free purchases and in a few taxable purchases, the resulting book values of the acquired company’s assets and liabilities differ from their tax bases.

Such differences result because the subsidiary’s cost is retained for tax purposes or because the allocations for tax purposes vary from those used for financial reporting (a situation found in some taxable transactions).

Thus, formation of a business combination can create temporary differences (e.g. different basis for depriciable assets).

The question here concerns differences in book value and tax basis that stem from the takeover.

See question 11

Business Combinations and Operating Loss Carryforwards

Net operating losses for companies may be carried back for two years and/or forward for twenty years

Because some acquisitions appeared to be primarily to take advantage of this situation, US law has been changed to require operating loss carryforwards to be used only by the company incurring the loss (in most situations.)

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Business Combinations and Operating Loss Carryforwards

FASB ASC Topic 740 requires deferred tax assets to be recorded for any net operating loss carryforwards

Valuation allowances are recorded if it is more likely than not (based on available evidence) that some or all of the deferred tax asset will not be realized.

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Summary

Control may be indirect.

Consolidation of pyramid structures requires a systematic bottom-to-top approach.

Mutual affiliation occurs when a subsidiary owns shares of the parent, and either the treasury stock or conventional approaches may be used to produce consolidated information.

Affiliated groups, which may differ from the consolidated entity due to IRS restrictions, are permitted to file consolidated returns.

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Possible Criticisms

Due to IRS regulations, the affiliated groups filing a tax return are often different from the consolidated entity, creating differences in financial statement income versus taxable income for the combination.

Indirect ownership creates a different “control environment” than direct ownership, but this difference is not disclosed.

WHAT DO YOU THINK????

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Problem 7-23:

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Problem 7-26:

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Problem 7-17:

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