Chapter Seven Consolidated Financial Statements Ownership Patterns and

Chapter Seven Consolidated Financial Statements – Ownership Patterns and Income Taxes Copyright © 2015 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

Learning Objective 7 -1 Demonstrate the consolidation process when indirect control is present in a grandfather-son ownership configuration. 7 -2

Indirect Subsidiary Control The presence of an indirect ownership does not change most consolidation procedures; however, a calculation of each subsidiary’s accrual-based income does pose some difficulty. Appropriate income determination is essential for calculating (1) equity income accruals and (2) the noncontrolling interest’s share of consolidated net income. 7 -3

Indirect Subsidiary Control Assume three companies form a business combination: Top Company owns 70% of Midway Company, which owns 60% of Bottom Company. Top controls both subsidiaries, although the parent’s relationship with Bottom is only of an indirect nature. 7 -4

Indirect Control -Example The following data is from the individual company financial records: 7 -5

Indirect Control – Example Following the consolidation steps to determine Midway’s realized income: 7 -6

Indirect Control - Example Then combine Top Company’s income with Midway’s realized income: Midway’s realized income as previously calculated. 7 -7

Indirect Control - Example Using the income from the previous calculations, determine noncontrolling interest. (Bottom and Midway’s individual incomes as calculated). Use the standard consolidation entries to complete the fatherson-grandson combination. The entries are essentially duplicated for each relationship. 7 -8

Indirect Control - Example If appropriate equity accruals are recognized, the sum of the parent’s accrual-based income and the noncontrolling interest income share serves as a “proof figure” for the consolidated total. Thus, if the consolidation process is performed correctly, the earnings this entire organization reports should equal $735, 000. 7 -9

Learning Objective 7 -2 Demonstrate the consolidation process when a corporate ownership structure is characterized by a connecting affiliation. 7 -10

Indirect Subsidiary Control – Connecting Affiliation A connecting affiliation exists when two or more companies within a business combination own an interest in another member of the organization. 7 -11

Indirect Subsidiary Control – Connecting Affiliation Both High company and Side Company own Low Company’s stock, a connecting affiliation. Neither owns enough stock to establish direct control over Low’s operations, but they hold a total of 75% of the outstanding shares. Control lies within the single consolidated entity and Low’s financial information must be included in the consolidated statements. Assume High, Side, and Low have separate internal operating incomes of $300, 000, $200, 000, and $100, 000, respectively. Each has a $30, 000 net intra-entity gain in its current income. Annual amortization expense is $10, 000 for acquisition-date excess fair value over book value for each subsidiary. 7 -12

Indirect Subsidiary Control – Connecting Affiliation Basic Consolidation Rules Still Hold: Ø Ø Ø Ø 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. 7 -13

Indirect Subsidiary Control – Connecting Affiliation In the same manner as a father-son-grandson organization, determining accrual-based earnings begins with any companies solely in a subsidiary position (Low). Next companies that are both parents and subsidiaries (Side) compute their accrual- based income. Finally, this same calculation is made for the one company (High) that has ultimate control over the entire combination. The combination of the parent’s DIRECT ownership and INDIRECT ownership results in control of the subsidiary. Accrual-based income figures for the three companies in this combination are derived as seen on the following slide. 7 -14

Indirect Subsidiary Control – Connecting Affiliation 7 -15

Learning Objective 7 -3 Demonstrate the consolidation process when a corporate ownership structure is characterized by mutual ownership. 7 -16

Mutual Ownership Mutual ownership occurs when two companies within a business combination hold an equity interest in each other. GAAP recommends that “shares of the parent held by the subsidiary should be eliminated in consolidated financial statements. ” The shares are not “outstanding” because they are not held by parties outside the combination. The Treasury Stock Approach is used to account for the mutually owned shares. 7 -17

Mutual Ownership There is no accounting distinction between a parent owning stock of a subsidiary, or a subsidiary owning stock of a parent; they are both intra-entity stock ownership. 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. 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 declares dividends of $8, 000 to Sun, and Sun records dividend income. 7 -18

Mutual Ownership – Treasury Stock Approach Example The following entries are recorded in the consolidation worksheet: (*C) Conversion of initial value method to equity method. Recognizes 70% of increase in Sun Company’s book value less previous year’s amortization expense [70% ($25, 000 - $3, 000)]. (S) Elimination of subsidiary’s stockholders’ equity and recognition of January 1, noncontrolling interest. (TS) Reclassification of Sun’s ownership in Pop into a treasury stock account. (A) Allocation to franchises, unamortized balance recognized as of January 1. (I) Elimination of intra-entity dividend income for the period. (E) Recognition of amortization expense for the current year. (Note: Parentheses indicate a credit balance. ) 7 -19

Mutual Ownership – Treasury Stock Approach Example 7 -20

Learning Objective 7 -4 List the criteria for being a member of an affiliated group for income tax filing purposes. 7 -21

Income Tax Accounting for a Business Combination Business combinations may elect to file a consolidated federal tax return for all companies of an affiliated group. The affiliated group (as defined by the IRS) will likely exclude some members of the business combination. 7 -22

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 (direct or indirect ownership). Ø All others must file separately (including any foreign subsidiaries. ) 7 -23

Income Tax Accounting for a Business Combination There is a distinction between business combinations as identified for financial reporting and affiliated groups as defined for tax purposes. A business combination comprises all subsidiaries controlled by a parent company unless control is only temporary. The IRS’s 80 percent rule creates a smaller circle of companies qualifying for inclusion in an affiliated group. 7 -24

Income Tax Accounting for a Business Combination A parent company is not required to file a consolidated return, but there are benefits for doing so. Ø Intra-entity profits are not taxed until realized. Ø Losses of one affiliated group member can be used to offset taxable income earned by another group member. 7 -25

Learning Objective 7 -5 Compute taxable income and deferred tax amounts for an affiliated group based on information presented in a consolidated set of financial statements. 7 -26

Income Tax Accounting – Deferred Income Taxes Tax consequences are often dependent on whether separate or consolidated returns are filed. Transactions affected: Goodwill Intra-entity Dividends Unrealized Intra-entity Gains 7 -27

Income Tax Accounting – Deferred Income Taxes Intra-entity Dividends For accounting purposes, all intra-entity dividends are eliminated. For tax purposes, dividends are removed from income if at least 80 percent of the subsidiary’s stock is held. (20% is taxable. ) If less than 80 percent of a subsidiary’s stock is held, tax recognition is necessary. A deferred tax liability is created for any of sub’s income not paid currently as a dividend. 7 -28

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. Timing differences between the amortization and writeoff creates a temporary difference that results in deferred income taxes. 7 -29

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. 7 -30

Assigning Income Tax Expense – Consolidated Return Consolidated tax returns require allocation of tax expense between the parties. Ø Important for the subsidiary if separate financial statements are needed for loans or equity issues. Ø Used as a basis for calculating noncontrolling interest’s share of consolidated income. 7 -31

Assigning Income Tax Expense Methods The Percentage Allocation Method attributes the GAAP tax expense based on the relative contribution of each affiliate to taxable income. The Separate Return Method, an alternative technique, uses the taxable income that results from filing separate tax returns. 7 -32

Learning Objective 7 -6 Compute taxable income and deferred tax amounts to be recognized when separate tax returns are filed by any of the affiliates of a business combination. 7 -33

Filing Separate Tax Returns Separate returns are mandatory foreign subsidiaries and for domestic corporations not meeting the 80 percent ownership rule. Canadian and Mexican subsidiaries can qualify for treatment as domestic companies for purposes of filing a consolidated return. A company may still elect to file separately even if it meets the conditions for inclusion within an affiliated group. If all companies in an affiliated group are profitable and few intra-entity transactions occur, they may prefer separate returns to give the companies more flexibility in their choice of accounting methods and fiscal tax years. 7 -34

Filing Separate Tax Returns Tax laws do not allow a company to switch back and forth between consolidated and separate returns. Obtaining Internal Revenue Service permission to file separately can be difficult once consolidation is selected. When members of a business combination file separate tax returns, temporary differences often emerge for income recognized for consolidated financial reporting and for income tax reporting. 7 -35

Filing Separate Tax Returns Differences in the timing of income recognition across consolidated reporting and income tax purposes create deferred tax assets and/or liabilities. These temporary differences may occur due to (1) the immediate taxation of unrealized intra-entity gains (and losses) and (2) possible future tax effects of subsidiary income in excess of dividend payments. 7 -36

Learning Objective 7 -7 Determine the deferred tax consequences for temporary differences generated when a business combination is created. 7 -37

Temporary Differences Generated by Business Combinations A business combination can create temporary differences due to differences in tax bases and book value stemming from the takeover. In most purchases, resulting book values of acquired company’s assets and liabilities differ from their tax bases because: Subsidiary’s cost is retained for tax purposes (in tax-free exchanges). Allocations for tax purposes vary from those used for financial reporting (found in taxable transactions). 7 -38

Learning Objective 7 -8 Explain the impact that a net operating loss of an acquired affiliate has on consolidated figures. 7 -39

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 done 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. ) 7 -40

Business Combinations and Operating Loss Carryforwards FASB ASC Topic 740, Income Taxes, requires an acquiring firm to recognize a deferred income tax asset for any NOL carryforward. However, a valuation allowance also must be recognized if it is more likely than not (based on available evidence) that some or all of the deferred tax asset will not be realized. 7 -41

Operating Loss Carryforwards - Example Assume a parent purchased a company (sub) for $640, 000. The sub has one asset, a building, worth $500, 000. Due to recent losses, the sub has a $200, 000 NOL carryforward. The assumed tax rate is 30 % so the parent can derive $60, 000 in future tax savings if it earns future income. The parent anticipates the sub will utilize some or all of the NOL carryforward. 7 -42

Operating Loss Carryforwards - Example If it is more likely than not that the benefit will be realized, goodwill of $80, 000 results. If chances are 50% or less that the sub will use the NOL carryforward, the parent records a valuation allowance and $140, 000 of consolidated goodwill. 7 -43

IFRS and U. S. GAAP Differences U. S. GAAP prohibits the recognition of unrealized intra-entity profits on asset transfers; therefore, the selling firm defers any related current tax effects until the asset is sold to a third party. International Accounting Standard (IAS) 12 requires taxes paid by a selling firm on intra-entity profits to be recognized as incurred and allows tax deferral on differences between the tax bases of assets transferred across entities that remain within the consolidated group. 7 -44