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Chap007 Chap007 Presentation Transcript

  • Chapter Seven Consolidated Financial Statements – Ownership Patterns and Income Taxes McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
  • Indirect Subsidiary Control When a parent controls a subsidiary which in turn controls other firms, a “pyramid” or “father-son-grandson” relationship exists “ Father ” 75 % Ownership “ Son ” 80 % ownership “ Grandsons” 7-
  • Consolidation When Indirect Control is Present
    • Start from the bottom of the “pyramid” and work upwards
    • Recognize realized income of the “grandson(s)”
    • Use this to consolidate the “son” and “grandson(s)” financial information, taking care to calculate any noncontrolling interest
    • Finally, consolidate the “son(s)” and parent in the same manner
    7- Note: In practice this can become quite complicated
  • 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.
    70% Ownership 60% Ownership 7- Top Co. Midway Co. Bottom Co.
  • Indirect Control -- Example 7- The following data is from the individual company financial records:
  • Indirect Control – Example 7- Following the consolidation steps to determine Midway’s realized income:
  • Indirect Control -- Example 7- Then combine Top Company’s income with Midway’s realized income: Midway’s realized income as calculated in the last step.
  • Indirect Control -- Example 7- 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.
  • Consolidation Process -- Indirect Control
    • Use the standard consolidation entries to complete the father-son-grandson combination.
    • Essentially, the entries are duplicated for each relationship.
  • Indirect Subsidiary Control - Connecting Affiliation Side Company 45% owned The combination of the parent’s DIRECT ownership and INDIRECT ownership can result in control of a subsidiary. 7- Low Company 70% owned 30% owned High Company
  • Indirect Subsidiary Control - Connecting Affiliation In this case, High controls Side directly with 70% ownership, and controls Low indirectly with 61.5% effective ownership. 30% +(70% x 45%) 7- 45% owned Low Company Side Company 70% owned 30% owned High Company
  • 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.
  • 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
    7- Up Company Down Company 90% owned 20% owned
  • 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.
  • 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.
  • 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 :
    7- Treasury Stock . . . . . . . . . . . . . . . . . . $120,000 Investment . . . . . . . . . . . . . . . . . . . . . . . . $120,000 Dividends Paid . . . . . . . . . . . . . . . . . . . .$8,000 Dividends Income . . . . . . . . . . . . . . . . . . . . .$8,000
  • IFRS and Indirect Control Under GAAP , the consolidation process begins at the lowest level in the ownership structure and works its way up . Under IFRS , firms may apply a direct method that consolidates each controlled subsidiary without regard to an intermediate controlling affiliate. 7-
  • 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.
  • 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.)
  • 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.
  • 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 7-
  • 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% . (They are currently taxed at a rate of 20%.)
    • A deferred tax liability is created based on the difference.
  • 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.
  • 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 .
  • 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
  • Assigning Income Tax Expense 7-
    • 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.
  • 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.)
  • 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.
  • 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 .
  • 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.