CHP 10

Subsidiary Preferred Stock, Consolidated Earnings per Share, and Consolidated Income Taxation Chapter 10
2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn
10 - 1
Learning Objective 1 Modify consolidation procedures for subsidiary companies with preferred stock in their capital structure.
10 - 2
Subsidiaries with Preferred Stock Outstanding
When preferred stock has a call or redemption price, this amount is used in allocating the investees equity to preferred stockholders.
10 - 3
Subsidiaries with Preferred Stock Outstanding

1 If there is no redemption provision, the equity is allocated on the basis of par value plus any liquidation premium. Any dividends in arrears on cumulative preferred stock is allocated to the preferred stockholders.
10 - 4
Subsidiary With Preferred Stock Not Held by Parent

Poe acquired a 90% interest in Sol on 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 common stock and $10,000 on preferred stock.
10 - 5

Sols stockholders equity December 31, 2003 $10 preferred stock, $100 par, cumulative, nonparticipating, callable at $105 per share $100,000 Common stock, $10 par 200,000 Other paid-in capital 40,000 Retained earnings 160,000 Total stockholders equity $500,000
10 - 6

Total Sol stockholders equity Less: Preferred stockholders equity (1,000 $105) Common stockholders equity Price paid for 90% interest Less: Book and fair value acquired ($395,000 90%) Goodwill $500,000 105,000 $395,000 $395,500 355,500 $ 40,000
10 - 7

Sols stockholders equity December 31, 2004 Total stockholders equity Less: Preferred stockholders equity (1,000 $105) Common stockholders equity $520,000 105,000 $415,000
10 - 8
Minority Interest in Preferred Stock

Minority interest in Sol at December 31, 2004 $105,000 100% of preferred equity $105,000 $415,000 10% of common equity 41,500 Total $146,500
10 - 9
Subsidiary Preferred Stock Acquired by Parent
A parent companys purchase of the outstanding preferred stock of a subsidiary results in a retirement of the stock purchased from the viewpoint of the consolidated entity.
2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 10 - 10

Sol Corporation experienced a loss of $40,000 in 2005. No dividends were paid. What is Sols stockholders equity at 12/31/2005? $520,000 $40,000 = $480,000

What is Poes share of this loss? ($40,000 + $10,000 income to preferred) 90%
What is Poes investment in Sol on 12/31/2005?


1/1/2004 12/31/2004 1/1/2005 Poes Investment 395,500 18,000 36,000 413,500 45,000 loss 368,500 12/31/2005 Dividends
Constructive Retirement of Subsidiary Preferred Stock

On January 1, 2006, Poe purchased 800 of Sols preferred shares (80% interest) at $100 per share. Sol reports net income of $20,000 for 2006. $115,000 80% = $92,000 book value $92,000 $80,000 = $12,000

Investment in Sol Preferred Cash To record purchase of stock 80,000 80,000
Investment in Sol Preferred 12,000 Other Paid-in Capital 12,000 To adjust other paid-in capital to reflect constructive retirement

1/1/2004 12/31/2004 1/1/2005 Income Poes Investment 395,500 18,000 36,000 413,500 45,000 loss 368,500 9,000 377,500 12/31/2006
Dividends
Learning Objective 2 Calculated basic and diluted earnings per share for a consolidated reporting entity.
Parent Company and Consolidated Earnings Per Share

GAAP requires that all firms calculate and report basic and diluted (where applicable) earnings per share (EPS). Consolidated entities disclose (EPS) on a consolidated basis.
Parent Company and Consolidated Earnings Per Share

A parent companys net income and EPS under the equity method are equal to consolidated net income and consolidated EPS. Parent Company procedures for computing EPS depend on the subsidiarys capital structure.
General Format for EPS Calculations

Numerator in Dollars ($) Income to parents common stockholders Add: Adjustments for parents dilutive securities Add: Adjustments for subsidiarys potentially dilutive securities convertible into parent company stock Replacement calculation Deduct: Parents equity in subsidiarys diluted earnings Add: Parents equity in subsidiarys diluted earnings Parent's diluted earnings = a A $$$ +$ N/A N/A N/A $$$
A: Subsidiary does not have potentially dilutive securities outstanding


Numerator in Dollars ($) Income to parents common stockholders Add: Adjustments for parents dilutive securities Add: Adjustments for subsidiarys potentially dilutive securities convertible into parent company stock Replacement calculation Deduct: Parents equity in subsidiarys diluted earnings Add: Parents equity in subsidiarys diluted earnings Parent's diluted earnings = a
B: Subsidiary has potentially dilutive securities convertible into subsidiary common stock
B $$$ +$ N/A $ +$ $$$

Numerator in Dollars ($) Income to parents common stockholders Add: Adjustments for parents dilutive securities Add: Adjustments for subsidiarys potentially dilutive securities convertible into parent company stock Replacement calculation Deduct: Parents equity in subsidiarys diluted earnings Add: Parents equity in subsidiarys diluted earnings Parent's diluted earnings = a
C: Subsidiary has potentially dilutive securities convertible into parent company common stock
C $$$ +$ +$ N/A N/A $$$

Denominator in Shares (Y) Parents common shares outstanding Add: Shares represented by parents potentially dilutive securities Add: Shares represented by subsidiarys potentially dilutive securities convertible into parent company common shares Parents common shares and common share equivalents = b Parent Company and Consolidated Diluted EPS A YYY +Y N/A YYY ab
A: Subsidiary does not have potentially dilutive securities outstanding


Denominator in Shares (Y) Parents common shares outstanding Add: Shares represented by parents potentially dilutive securities Add: Shares represented by subsidiarys potentially dilutive securities convertible into parent company common shares Parents common shares and common share equivalents = b Parent Company and Consolidated Diluted EPS
B: Subsidiary has potentially dilutive securities convertible into subsidiary common stock
B YYY +Y N/A YYY ab

Denominator in Shares (Y) Parents common shares outstanding Add: Shares represented by parents potentially dilutive securities Add: Shares represented by subsidiarys potentially dilutive securities convertible into parent company common shares Parents common shares and common share equivalents = b Parent Company and Consolidated Diluted EPS
C: Subsidiary has potentially dilutive securities convertible into parent company common stock
C YYY +Y +Y YYY ab
Dilutive Securities of Subsidiary Convertible into Subsidiary Shares

Diluted earnings of the parent company are adjusted by excluding the parents equity in subsidiary realized income and replacing that equity with the parents share of diluted earnings of the subsidiary.
Subsidiary With Convertible Preferred Stock

Plant Corporation purchased 90% of Seed Corporations outstanding voting common stock for $328,000 on January 1, 2003. During 2003, Seed reports $50,000 net income and pays $25,000 dividends, $10,000 to preferred and $15,000 to common.

January 1, 2003
Common stock, $5 par, 200,000 shares issued and outstanding Common stock, $10 par, 20,000 shares outstanding 10% cumulative, convertible preferred stock, $100 par, 1,000 shares outstanding Retained earnings Total stockholders equity
Plant
$1,000,000
Seed
$200,000
500,000 $1,500,000
100,000 120,000 $420,000

Plants Income for 2003 Income from Plants operations Income from Seed ($50,000 $10,000 preferred income) 90% Plant net income
$150,000 36,000 $186,000
Subsidiary Preferred Stock Convertible into Subsidiary Common

Seeds preferred stock is convertible into 12,000 shares of Seeds common stock. Neither Plant nor Seed has any other potentially dilutive securities outstanding. Seeds diluted EPS: $50,000 (20,000 + 12,000) = $1.5625
Subsidiary Preferred Stock Convertible into Subsidiary Common

Plants Diluted EPS Net income of Plant Replacement of Plants equity in Seeds realized income ($40,000 90%) with Plants equity in Seeds diluted earnings (18,000 $1.5625) Plants diluted earnings = a Plants outstanding shares = b Plants diluted EPS = a b $186,000 36,000 28,125 $178,125 200,000 $ 0.89
Subsidiary Preferred Convertible into Parent Company Common

Seeds preferred stock is convertible into 24,000 shares of Plants common stock. Neither Plant nor Seed had other potentially dilutive securities outstanding. Seeds diluted EPS is $2 ($40,000 income to common 20,000 common shares). What is Plants diluted EPS?
Subsidiary Preferred Convertible into Parent Company Common

Net income of Plant Add: Income to preferred stockholders of Seed assumed to be converted Plants diluted earnings = a Plants outstanding shares Add: Seeds preferred shares assumed converted Plant common shares and common stock equivalents = b Plants diluted EPS = a b $186,000 10,000 $196,000 200,000 24,000 224,000 $ 0.88
Subsidiary With Options and Convertible Bonds

Paddys income 2003 Own operations Syds operations $1,500,000 $ 300,000 $360,000 40,000 20,000 $300,000
Syd is 80% owned by Paddy. 80% $450,000 Syd net income 80% $50,000 unrealized profit Amortization Income from Syd
Subsidiary With Options and Convertible Bonds

Paddy: Common stock, 1,000,000 shares Syd: 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 Convertible into Subsidiary Common Stock

Syds income to common stockholders Less: Unrealized profit on sale of land Add: Net-of-tax interest expense assuming bonds converted into subsidiary shares ($1,000,000 7% 66% net of tax) Subsidiary adjusted earnings = a $450,000 50,000
46,200 $446,200

Syds common shares outstanding Incremental shares 60,000 ($600,000 $15) Additional shares assuming bonds converted into subsidiary shares Syds adjusted shares = b Syds diluted EPS = a b ($446,200 500,000) 400,000 20,000 80,000 500,000 $ 0.89

Paddys income to common stockholders Replacement of Paddys equity in Syds realized income ($400,000 80%) with Paddys equity in Syds diluted EPS (320,000 $0.89) Paddy adjusted earnings = a Paddy outstanding shares = b Paddys diluted EPS = a b $1,800,000 320,000 284,800 $1,764,800 1,000,000 $ 1.76
Options and Bonds Convertible into Parents Common Stock
Paddys income to common stockholders Add: Net-of-tax interest expense assuming bonds were converted into shares ($1,000,000 7% 66% net-of-tax effect) Paddys adjusted earnings = a
$1,800,000
46,200 $1,846,200
Options and Bonds Convertible into Parents Common Stock

Paddys common shares outstanding Incremental shares 60,000 ($600,000 $15) Additional shares assuming bonds are converted into parent shares Paddys adjusted shares = b Paddys diluted EPS = a b ($1,846,200 1,100,000) 1,000,000 20,000 80,000 1,100,000 $ 1.68
Learning Objective 3 Understand the complexities of accounting for income taxes by consolidated entities.
Accounting for Income Taxes of Consolidated Entities

An affiliated group exists when a common parent corporation owns at least 80% of the voting power of all classes of stock and 80% or more of the total value of all outstanding stock of each of the includable corporations.
Accounting for Income Taxes of Consolidated Entities

A consolidated entity that is an affiliated group may elect to file consolidated income tax returns. All other consolidated entities must file separate income tax returns for each affiliated company.
Advantages of Filing Consolidated Returns

1 Losses are offset against income between members. Intercorporate dividends are excluded from taxable income. Intercompany profits are deferred from income until realized.
Disadvantages of Filing Consolidated Returns

1 Decrease in flexibility. Commitment to consolidated returns year after year. Deconsolidated corporations cannot rejoin the group for 5 years.
Income Tax Allocation
FASB Statement No. 109, Accounting for Income Taxes, is the primary source of GAAP for accounting for income taxes. Events that have future tax consequences are designated temporary differences.
Income Tax Allocation
The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and to recognize deferred tax liabilities and assets for the tax consequences of events that have been recognized in the financial statements or tax returns.
Accounting for Distributed and Undistributed Income

Parson owns a 30% interest in Seaton Corporation, a domestic corporation. Seaton reports $600,000 net income and pays dividends of $200,000. The income tax rate is 34%. What is Parsons share of Seatons income?

Share of distributed earnings (dividends) ($200,000 30%) Share of undistributed earnings (retained earnings increase) ($400,000 30%) Equity in Seatons earnings
$ 60,000
120,000 $180,000

The income tax expense equals income tax liability for the dividends received. $60,000 20% taxable 34% tax rate = $4,080 December 31, 2003 Income Tax Expense 8,160 Deferred Income Taxes 8,160 To provide for taxes on undistributed earnings ($120,000 20% 34% = $8,160)
Unrealized Gains and Losses from Intercompany Transactions

Unrealized and constructive gains and losses create temporary differences that may affect deferred tax calculations when filing separate income tax returns. This is not the case when filing consolidated returns.
Separate Company Tax Returns with Intercompany Gain

Paco Corporation paid $375,000 for a 75% interest in Step on January 1, 2003.
Steps equity consisted of $300,000 capital stock and $200,000 retained earnings.

Paco had a deferred tax liability of $10,200, consisting of $30,000 tax/book depreciation differences that reverse in equal ($7,500) amounts over the years. On January 8, 2003, Paco sold equipment to Step at a gain of $20,000. Step is depreciating the equipment over five years (S/L).

12/31/2003 Sales Gain on equipment sale Income from Step Cost of sales Operating expenses Income tax expense Net income Add: Beginning retained earnings Deduct: Dividends (December) Retained earnings 12/31/2003 Paco $380,000 20,000 23,600 200,000 100,000 31,253 $ 92,347 357,653 50,000 $400,000 Step $300,000 180,000 40,000 27,200 $ 52,800 200,000 28,000 $224,800
One-Line Consolidation
January 1, 2003 Investment in Step 375,000 Cash 375,000 To record purchase of 75% interest December 2003 Cash 21,000 Investment in Step To record dividends received
21,000
One-Line Consolidation
December 31, 2003 Investment in Step 23,600 Income from Step 23,600 To record income from Step Pacos share of Step net income ($52,800 75%) $39,600 Less: Unrealized profit 20,000 Add: Piecemeal recognition of gain 4,000 Income from Step $23,600
Schedule of Deferred Income Tax Liability

Temporary Difference 2003 Depreciation Gain on equipment $20,000 Piecemeal recognition 4,000 Future dividends 3,720 Taxable in future years Enacted tax rate Deferred tax liability 2004-7 $ 7,500 Future Years
4,000 $3,720 $ 3,500 $3,720 34% 34% $ 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 liabilities acquired at gross fair values, and a deferred tax asset or liability is recorded for the related tax effect.
Financial Statement Disclosures for Income Taxes
GAPP divides deferred assets or liabilities.
Current
Noncurrent
Financial Statement Disclosures for Income Taxes

GAPP requires disclosure for income tax expense and benefits allocated to: Continuing operations Discontinued operations Extraordinary items Cumulate effect type Prior period adjustments
End of Chapter 10

CHP 10

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Subsidiary Preferred Stock, Consolidated Earnings per Share, and Consolidated Income Taxation Chapter 10

2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn

Subsidiaries with Preferred Stock Outstanding

2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn

Subsidiaries with Preferred Stock Outstanding

2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn

Subsidiary With Preferred Stock Not Held by Parent

Subsidiary With Preferred Stock Not Held by Parent

Subsidiary With Preferred Stock Not Held by Parent

2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn

Subsidiary With Preferred Stock Not Held by Parent

2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn

Minority Interest in Preferred Stock

2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn

Subsidiary Preferred Stock Acquired by Parent

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

Subsidiary Preferred Stock Acquired by Parent

Subsidiary Preferred Stock Acquired by Parent

What is Poes investment in Sol on 12/31/2005?

Subsidiary Preferred Stock Acquired by Parent

2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 10 - 13

Constructive Retirement of Subsidiary Preferred Stock

2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 10 - 14

Constructive Retirement of Subsidiary Preferred Stock

Constructive Retirement of Subsidiary Preferred Stock

2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 10 - 17

Parent Company and Consolidated Earnings Per Share

Parent Company and Consolidated Earnings Per Share

General Format for EPS Calculations

A: Subsidiary does not have potentially dilutive securities outstanding

General Format for EPS Calculations

B $$$ +$ N/A $ +$ $$$

General Format for EPS Calculations

C $$$ +$ +$ N/A N/A $$$

General Format for EPS Calculations

A: Subsidiary does not have potentially dilutive securities outstanding

General Format for EPS Calculations

B YYY +Y N/A YYY ab

General Format for EPS Calculations

Dilutive Securities of Subsidiary Convertible into Subsidiary Shares

2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 10 - 26

Subsidiary With Convertible Preferred Stock

2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 10 - 27

Subsidiary With Convertible Preferred Stock

100,000 120,000 $420,000

2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 10 - 28

Subsidiary With Convertible Preferred Stock

$150,000 36,000 $186,000

2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 10 - 29

Subsidiary Preferred Stock Convertible into Subsidiary Common

Subsidiary Preferred Stock Convertible into Subsidiary Common

2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 10 - 31

Subsidiary Preferred Convertible into Parent Company Common

Subsidiary Preferred Convertible into Parent Company Common

2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 10 - 33

Subsidiary With Options and Convertible Bonds

2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 10 - 34

Subsidiary With Options and Convertible Bonds

2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 10 - 35

Options and Bonds Convertible into Subsidiary Common Stock

2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 10 - 36

Options and Bonds Convertible into Subsidiary Common Stock