2. Chapter 9 Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions ACCT 501 (All examples are from the textbook by Larsen)

3. Income Taxes and Cash Flows 2 Objectives of the Chapter 1. To learn the accounting treatment of income taxes for a purchase-type business combination. 2. To learn the preparation of consolidated statement of cash flows. 3. To study the accounting for installment acquisitions of a subsidiary in a purchase-type business combination.

4. Income Taxes and Cash Flows 3 Income Taxes in Business Combinations and Consolidations T he discussion of the accounting for income taxes in business combinations and consolidated financial statements are subdivided in three sections: a. Income taxes attributable to current fair values excess of purchased identifiable net assets; b. Income taxes attributable to undistributed earnings of subsidiaries; c. Income taxes attributable to unrealized and realized intercompany profits (gains).

5. Income Taxes and Cash Flows 4 Income Taxes Attributable to Current Fair Values of Purchased Identifiable Net Assets n When a purchase-type business combination is qualified as a "tax-free corporate reorganization" under the IRC, a new income tax basis (i.e., based on the current fair value)is Not required for the combinee's net assets. n In this situation, a temporary difference may result between provisions for deprecation and amortization in the combinee's financial statements and income tax returns.

6. Income Taxes and Cash Flows 5 Income Taxes Attributable to Current Fair Values of Purchased Identifiable Net Assets (contd.) n The other situation which can also result in temporary difference is in the pooling-type business combination, in which there is no revaluation of combinee's net assets. n When the pooling-type business combination is not qualified as a "tax free corporation reorganization" under the IRC, the income tax basis of the combinee's net assets may be changed.

7. Income Taxes and Cash Flows 6 Income Taxes Attributable to Current Fair Values of Purchased Identifiable Net Assets (contd.) n In recognition of this problem, the FASB requires the following: a deferred tax liability or asset be recognized in accordance with the requirements for differences between the assigned value (i.e., the current value at the business combination) and the tax bases (I.e., the carrying amount) of the assets and liabilities.

8. Income Taxes and Cash Flows 7 Income Taxes Attributable to Current Fair Values of Purchased Identifiable Net Assets (contd.) n Example: assume that the purchase- type business combination of Regal Corp. and the combinee,Thorne Company, completed on 6/1/1999, met the requirements for a "tax-free corporation reorganization" for income tax purposes. Regal paid $800,000 for all of Thornes' identifiable net assets except cash.

9. Income Taxes and Cash Flows 8 Income Taxes Attributable to Current Fair Values of Purchased Identifiable Net Assets (contd.) The current fair values of Thorne's identifiable net assets were equal to their carrying amounts, except for the following assets:

10. Income Taxes and Cash Flows 9 Income Taxes Attributable to Current Fair Values of Purchased Identifiable Net Assets (contd.) Assets Current Fair Values Tax/ Bases Carrying Amounts Current Fair Values Excess Economic Life Inventories$ 100,000$ 80,000$ 20,000 Land250,000220,00030,000 Building640,000500,000140,00020 years Machinery120,000100,00020,0005 years Totals$1,110,000$900,000$210,000

11. Income Taxes and Cash Flows 10 Income Taxes Attributable to Current Fair Values of Purchased Identifiable Net Assets (contd.) If the carrying amounts (equal to current fair values) of Thorne's other identifiable assets and liabilities were $390,000 and $650,000, respectively, and the income tax rate is 40%, Regal's journal entry to record the business combination with Thorne Company on 6/1/1999, would be as follows:

12. Income Taxes and Cash Flows 11 Income Taxes Attributable to Current Fair Values of Purchased Identifiable Net Assets (contd.) Investment in Net Assets a 800,000 Cash800,000 Inventories b 100,000 Land250,000 Building640,000 Machinery 120,000 Other Identifiable Assets390,000 Goodwill 34,000 Deferred Income Tax Lia. 84,000 c Other Liability650,000 Investment in Net Assets 800,000

13. Income Taxes and Cash Flows 12 Income Taxes Attributable to Current Fair Values of Purchased Identifiable Net Assets (contd.) Notes for the above journal entries: a. To record acquisition of net assets of Thorne Company except cash. b. To allocate cost of Thorne's net assets to identifiable net assets; to establish liability for deferred income tax attributable to differences between current fair values and tax bases of assets; and to allocate remainder of cost to goodwill. c. Current fair value excess of assets *tax rate = $210,000 *40% = $84,000

14. Income Taxes and Cash Flows 13 Income Taxes Attributable to Current Fair Values of Purchased Identifiable Net Assets (contd.) n The deferred income liability ($84,000) will be extinguished when the temporary differences reverse through sale or deprecation. Example: assume that the inventories were sold during the year ended 5/31/2000, the deferred tax liability would be reduced by $12,400, computed as follows:

15. Income Taxes and Cash Flows 14 Income Taxes Attributable to Current Fair Values of Purchased Identifiable Net Assets (contd.) Cost of goods sold (inventories current fair value excess $20,000 Building depreciation attributable to current fair value excess (140,000 / 20) 7,000 Machinery depreciation attributable to current fair value excess ($20,000 / 5) 4,000 Total reversing temporary differences $31,000 Income tax effect ($31,000 X 0.40) $12,400

16. Income Taxes and Cash Flows 15 Income Taxes Attributable to Current Fair Values of Purchased Identifiable Net Assets (contd.) Assuming Regal Corp. had pre-tax financial income of $420,000 (net of tax-deductible goodwill amortization of $2,267) for the year ended May 31, 2000, and there were no temporary difference between pre-tax financial income and taxable income other than those resulting from the business combination with Thorne Company, Regal's journal entry for income taxes on May 31, 2000, is as follows:

17. Income Taxes and Cash Flows 16 Income Taxes Attributable to Undistributed Earnings of Subsidiaries  The FASB requires that a deferred income tax liability be recognized for an excess of the reported investment income in a subsidiary over its tax basis(i.e., cash dividends received from the subsidiary) if this excess is temporary and will be reverted in the future. a

18. Income Taxes and Cash Flows 17 Income Taxes Attributable to Current Fair Values of Purchased Identifiable Net Assets (contd.) Income Taxes Expense c 168,000 Deferred Income Tax Liability 12,400 Income Taxes Payable b 180,400 a. Income tax effect of the temporary difference reversion = > $31,000 X 0.40 = $12,400. b.Taxable income x 40% = >($420,000 + $31,000) X 40% c. $180,400 – $12,400 = $168,000 d. The tax-deductible goodwill amortization expense of $2,267 is included in the measurement of both pre-tax financial income and taxable income. It is based on the 15-year amortization period.  If the excess is permanent in duration, no deferred income tax liability is recognized for the excess. a. Applies to the excess arose in fiscal years beginning after 12/15/1992.

19. Income Taxes and Cash Flows 18 Income Taxes Attributable to Undistributed Earnings of Subsidiaries (contd.) n Example: n Pinkley Corp. owns 75% of the outstanding common stock of Seabright Company, which it acquired for cash on 4/1/1999. Goodwill acquired by Pinkley in the purchase-type business combination was $30,000 and was to be amortized over 15 years. n Seabright's identifiable net assets were fairly priced at their carrying amounts.

20. Income Taxes and Cash Flows 19 Income Taxes Attributable to Undistributed Earnings of Subsidiaries (contd.) n For the year ended 3/1/2000, Pinkley had pre-tax financial income, exclusive of goodwill amortization and intercompany investment income under the equity method, of $100,000. n Seabright's pre-tax financial income was $50,000, and dividends declared and paid by Seabright during fiscal year 2000 totaled $10,000. n The income tax rate for both companies is 40%.

21. Income Taxes and Cash Flows 20 Income Taxes Attributable to Undistributed Earnings of Subsidiaries (contd.) n Income tax laws provide for a dividend- received deduction rate of 80% on dividends from less-than-80%-owned domestic corporations. n Neither Pinkley nor Seabright had an temporary differences. n Neither had any income subject to preference income tax rates. n There were no intercompany profits resulting from transactions between Pinkley and Seabright.

22. Income Taxes and Cash Flows 21 Income Taxes Attributable to Undistributed Earnings of Subsidiaries (contd.) n Seabright's journal entry to accrue income taxes on 3/31/2000 is as follows: Income Taxes Expense 20,000 Income Taxes Payable 20,000 To record income taxes expense for Fiscal Year 2000 => $50,000 X 40%. On 3/31, 2000, Pinkley Corp. prepares the following journal entries for income taxes payable, the subsidiary's operating results, and deferred income tax liability:

23. Income Taxes and Cash Flows 22 Income Taxes Attributable to Undistributed Earnings of Subsidiaries (contd.) Amortization Expense 2,000 Investment in Seabright Cop. 2,000 To record amortization of goodwill for Fiscal Year 2000 ($30,000 / 15 = $2,000) I ncome Taxes Expense39,200 Income Taxes Payable 39,200 To record income taxes expense for Fiscal Year 2000 on income exclusive of intercompary investment income = > ($100,000 - $2,000) X 40% = $39,200.

24. Income Taxes and Cash Flows 23 Income Taxes Attributable to Undistributed Earnings of Subsidiaries (contd.) Cash 7,500 Investment in Seabright 7,500 To record div. declared and paid by sub.$10,000 X 0.75 = $7,500 Investment in Seabright 22,500 Intercompany Investment Income 22,500 To accrue share of subsidiary’s net income for Fiscal Year 2000 ($30,000* X 0.75 = $22,500) *$50,000 - $20,000 = $30,000

25. Income Taxes and Cash Flows 24 Income Taxes Attributable to Undistributed Earnings of Subsidiaries (contd.) Income Taxes Expense 1,800 Income Taxes Payable 600 Deferred Income Tax Liability 1,200  To provide for income taxes on intercompany investment income from subsidiary as follows:

26. Income Taxes and Cash Flows 25 Income Taxes Attributable to Undistributed Earnings of Subsidiaries (contd.) Net income of subsidiary $ 30,000 Less: Depre. and amor. attributable to differences between current fair values and carrying amounts of subsidiary’s net assets 0 Income of subsidiary subject to income taxes $30,000 Parent company’s share ($30,000 X 0.75) $22,500 Less: Dividend-received deduction ($22,500 X 0.80) $18,000 Amount subject to income taxes $ 4,500 Income taxes expense ($4,500 X 0.40) $ 1,800

27. Income Taxes and Cash Flows 26 Income Taxes Attributable to Undistributed Earnings of Subsidiaries (contd.) Taxes currently payable based on dividend received ($7,500 X 0.20 X 0.40 ) $ 600 Taxes deferred until earnings remitted by subsidiary $ 1,200 Income Taxes expense $ 1,800

28. Income Taxes and Cash Flows 27 Income Taxes Attributable to Intercompany Profits (Gains)  The IRC permits an affiliated group a of corporation to file a consolidated income tax return rather than separate returns.  Intercompany profits and losses are eliminated in a consolidated income tax return just as they are in consolidated financial statements.

29. Income Taxes and Cash Flows 28 Income Taxes Attributable to Intercompany Profits (Gains) (contd.)  Note a:  An "affiliated group" for tax purposes is defined as a group of corporations connected through stock ownership with a common parent corp. which owns directly at least 80% of the voting power of all subsidiaries and at least 80% of each class of the nonvoting stock of at least one of the other affiliates.

30. Income Taxes and Cash Flows 29 Income Taxes Attributable to Intercompany Profits (Gains) (contd.)  If a parent company and its subsidiaries do not qualify for the "affiliated group" status, or if they elect to file separate tax returns, the provisions of SFAS No. 109, "Accounting for Income Taxes" for the recognition of deferred tax assets and liabilities will be applied.

31. Income Taxes and Cash Flows 30 Income Taxes Attributable to Intercompany Profits in Inventory For unrealized intercompany profits in inventory at the end of the first year for an affiliated group's operation, return to the working paper elimination on page 354 of the textbook for Post Corp. and Sage Company (a 95% partially owned subsidiary of Post) on 12/31/2001, which is as follows:

32. Income Taxes and Cash Flows 31 Income Taxes Attributable to Intercompany Profits in Inventory (contd.) Intercomany Sales—Sage120,000 Intercompany CGS—Sage 96,000 CGS—Post 16,000 Inventories—Post 8,000 To eliminate intercompany sales, cost of goods sold (CGS), and unrealized intercomany profit in inventories

33. Income Taxes and Cash Flows 32 Income Taxes Attributable to Intercompany Profits in Inventory (contd.) If Post and Sage file separate income tax returns for year 2001, the following additional working paper elimination is required on 12/31/2001: Deferred Income Tax Asset—Sage 3,200 Income Taxes Expense—Sage 3,200 To defer income taxes provided on separate income tax returns of subsidiary applicable to unrealized intercompany profits in parent company’s inventories on Dec. 31, 2001 ($8,000 X 0.40 = $3,200)

34. Income Taxes and Cash Flows 33 Income Taxes Attributable to Intercompany Profits in Inventory (contd.)  Note: the $3,200 reduction in income tax expense should be considered in the computation for the minority interest in net income of the subsidiary for the year ended 12/31/2001.  For the unrealized intercompany profits in beginning and ending inventories, return to the working paper elimination on p356 of the textbook for the year ended 12/31/2002, which follows:

35. Income Taxes and Cash Flows 34 Income Taxes Attributable to Intercompany Profits in Inventory (contd.) Retained Earnings—Sage a 7,600 Minority Interest in NA of Sub. 400 Intercompary Sales—Sage 150,000 Intercompany CGS—Sage 120,000 CGS—Post 26,000 Inventories—Post 12,000 a. $8,000X0.95 To eliminate intercompany sales, cost of goods sold, and unrealized intercompany profit in inventories.

36. Income Taxes and Cash Flows 35 Income Taxes Attributable to Intercompany Profits in Inventory (contd.) If the affiliated group file income separately, the following additional working paper eliminations are required on 12/31/2002: Deferred Income Tax Asset—Sage 4,800 Income Taxes Expense—Sage 4,800 To defer income taxes provided on separate income tax returns of subsidiary applicable to unrealized intercompany profits in parent company’s inventories on Dec. 31, 2002 ($12,000X0.40=$4,800).

37. Income Taxes and Cash Flows 36 Income Taxes Attributable to Intercompany Profits in Inventory (contd.) Income Taxes Expense—Sage 3,200 Retained Earning—Sage a 3,040 Minority Interest in Net Assets b&c 160 To provide for income taxes attributable to realized intercompany profits in parent company’s inventories on Dec. 31, 2001. ($8,000X0.40=$3,200) a. $3,200X0.95; or $7,600X0.40. b. $3,200X0.05; or $400X0.40. c. This elimination reflects the income tax effects of the realization by the consolidated group, on a FIFO basis,of the intercompnay profits in the parent company's beginning inventories.

38. Income Taxes and Cash Flows 37 Income Taxes Attributable to Intercompany Profits in Inventory (contd.)  Note to the working paper elimination of year 2002: The decrease on the subsidiary's I/T expense of $4,800 and the increase on subsidiary's the I/T expense of $3,200 are included in the computation of the minority interest in subsidiary's net income.

39. Income Taxes and Cash Flows 38 Income Taxes Attributable to Unrealized Intercompany Gain in Land Return to the working paper elimination on p65 of chapter 8 notes for the intercompany gain resulting from an intercompany sale of land by the parent company on 12/31/2001(Post): Intercompany Gain on Saleof Land—Post 50,000 Land—Sage 50,000 To eliminate unrealized intercompany gain on sale of land.

40. Income Taxes and Cash Flows 39 Income Taxes Attributable to Unrealized Intercompany Gain in Land(contd.) Assuming a 40% income tax, the following working paper elimination is needed if Post and Sage filed separate income tax returns for year the year ended 12/31/2001: Deferred Income Tax Asset—Post 20,000 Income Taxes Expense—Post a 20,000 a. This decrease in the expense has no impact on the minority interest in subsidiary's net income.

41. Income Taxes and Cash Flows 40 Income Taxes Attributable to Unrealized Intercompany Gain in Land(contd.) The purposes of the working paper elimination on 12/31/01:  To defer income taxes provided on separate income tax returns of parent company applicable to unrealized intercompany gain in subsidiary's land on Dec. 31, 2001 ($50,000X0.04=$20,000).

42. Income Taxes and Cash Flows 41 Income Taxes Attributable to Unrealized Intercompany Gain in Land(contd.) n The following working paper elimination applies to all subsequent years for this intercompany sale of land as long as Sage does not sell the land to an outsider: Retained Earnings—Post50,000 Land—Sage50,000 To eliminate unrealized intercompany gain in land.

43. Income Taxes and Cash Flows 42 Income Taxes Attributable to Unrealized Intercompany Gain in Land(contd.)  In years subsequent to year 2001, as long as the subsidiary owns the land, the following tax related working paper elimination is also required at the end of the year: Deferred Income Tax Asset—Post 20,000 Retained Earnings—post 20,000 To defer income taxes attributable to unrealized intercompany gain in subsidiary’s land ($50,000x 40%).  This elimination has no impact on the minority interest in subsidiary's net income.

44. Income Taxes and Cash Flows 43 Income Taxes Attributable to Unrealized Intercompany Gain in Land(contd.) When Sage sold the land, the following elimination would be prepared a : Income Tax Expense-Post b 20,000 Retained Earnings- Post 20,000 a. This is due to the intercompany gain is realized by Sage on behave of Post b. No impact on the minority interest in subsidiary's net income

45. Income Taxes and Cash Flows 44 Income Taxes Attributable to Unrealized Intercompany Gain in a Depreciable Plant Assets  Return to the working paper elimination on p76 of chapter 8 note for illustration: 12/31/2001 Intercompany Gain on Sale of Machinery—Sage 23,800 Machinery—Post 23,800 To eliminate unrealized intercompany gain of $23,800 on sale of Post's machinery to Sage on 12/31/3001.  This intercompany gain will be realized through the periodic depreciation of the asset.

46. Income Taxes and Cash Flows 45 Income Taxes Attributable to Unrealized Intercompany Gain in a Depreciable Plant Assets (contd.)  Assuming separate income tax (I/T) returns and an I/T tax rate of 40%, the following additional working paper elimination is required on 12/31/2001:  Deferred I/T Asset—Sage 9,520 I/T Expense—Sage a 9,520 To defer income taxes provided on separate income tax returns of subsidiary applicable to unrealized intercompany gain in parent company’s machinery on Dec. 31, 2001 (23,800X0.40=$9,520).

47. Income Taxes and Cash Flows 46 Income Taxes Attributable to Unrealized Intercompany Gain in a Depreciable Plant Assets (contd.) a. The $9,520 increase in the Sage's net income should be included in the computation of minority interest in the subsidiary's net income for year 2001.  For the year ended 12/31/2002, the working paper elimination of the intercompany gain is as follows:

48. Income Taxes and Cash Flows 47 Income Taxes Attributable to Unrealized Intercompany Gain in a Depreciable Plant Assets (contd.) 12/31/2002 Retained Earning—Sage a 22,610 Minority Interest in Net Assets of Subsidiary b 1,190 Accu. Depre.—Post 4,760 Machinery—Post 23,800 Depre. Expense—Post 4,760 a. $23,800X0.95 b.$23,800X0.05 To eliminate unrealized intercompary gain in machinery and in related depreciation. Gain element in depreciation company is 23,800X0.20=$4,760 based on five-year economic life.

49. Income Taxes and Cash Flows 48 Income Taxes Attributable to Unrealized Intercompany Gain in a Depreciable Plant Assets (contd.)  The elimination for income taxes attributable to the intercompany gain for the year ended 12/31/2002 is as follows: I/T Expense—Sage a 1,904 Deferred I/T Asset—Sage b 7,616 Retained Earning—Sage c 9,044 Minority Interest in NA of Sub. d 476 a.$4,760 x 40% b. 9,520-$1,904 c.$9,520X0.95; or $22,610X40% d. $9,520X0.05; or $1,190X40%

50. Income Taxes and Cash Flows 49 Income Taxes Attributable to Unrealized Intercompany Gain in a Depreciable Plant Assets (contd.)  The purposes of the above working paper elimination are: 1.To provide income taxes expense on intercompany gain realized through parent company’s depreciation ( 4,760X0.40=$1,904) ; 2.To defer income taxes attributable to the remainder of unrealized gain.

51. Income Taxes and Cash Flows 50 Income Taxes Attributable to Unrealized Intercompany Gain in a Depreciable Plant Assets (contd.)  Comments to the above working paper elimination: 1.The decrease in the subsidiary's net income is included in the computation of the minority interest in the subsidiary's net income for year 2002. 2.Comparable working paper eliminations to the above elimination are necessary on December 31, years 2003, 2004,2005 and 2006.

52. Income Taxes and Cash Flows 51 Income Taxes Attributable to Intercompany Gain on Extinguishment of Bonds Return to the 12/31/2001 working paper elimination on p131 of Chapter 8 notes for illustration: Intercompany Bonds Payable— Sage 300,000 Discount on Intercompany Bonds Payable-Sage18,224 Investment in Sage Company Bonds-Post257,175 Gain on Extinguishment of Bonds-Sage24,601 To eliminate subsidiary’s bonds acquired by parent and to recognize gain on the extinguishment of the bonds.(Income tax effects are disregarded.)

53. Income Taxes and Cash Flows 52 Income Taxes Attributable to Intercompany Gain on Extinguishment of Bonds (contd.)  The following working paper elimination is required on 12/31/2001 to accompany the above working paper elimination assuming a separate income tax return filing, a 40% income tax rate and the gain on extinguishment of debt is not material: Income Taxes Expense –Sage a 9,840 Deferred Income Tax Lia.-Sage 9,840 To provide for income taxes attributable to subsidiary's realized gain on parent company's acquisition of the subsidiary's bonds ($24,601*40%)

54. Income Taxes and Cash Flows 53 Income Taxes Attributable to Intercompany Gain on Extinguishment of Bonds (contd.)  The purpose of the elimination on 12/31/2001: To provide for income taxes attributable to subsidiary's realized gain on parent company's acquisition of the subsidiary's bonds ($24,601*40%).

55. Income Taxes and Cash Flows 54 Income Taxes Attributable to Intercompany Gain on Extinguishment of Bonds (contd.) n Note to the elimination on 12/31/2001: The increase in expense of the subsidiary ($9,840) in the above elimination should be included in the computation of the minority interest in net income of the subsidiary for year 2001.

56. Income Taxes and Cash Flows 55 Income Taxes Attributable to Intercompany Gain on Extinguishment of Bonds (contd.) n The working paper elimination for the bonds and interest on 12/31/2002 is as follows: Intercompany Interest Revenue-Post38,576 Intercompany Bonds Payable-Sage300,000 Discount on Intercompany Bonds Payable- Sage14,411 Investment in Sage Company Bonds- Post265,751 Intercompany Interest Expense-Sage33,813 Retained Earnings-Sage ($24,601 x 0.95) 23,371 Minority Interest in Net Assets of Subsidiary 1,230 To eliminate subsidiary’s bonds owned by parent company, and related interest revenue and expense; and to increase subsidiary’s beginning retained earnings by amount of unamortized realized gain on the extinguishments of the bonds.

57. Income Taxes and Cash Flows 56 Income Taxes Attributable to Intercompany Gain on Extinguishment of Bonds (contd.)  The following I/T related working paper elimination is necessary to accompany the above elimination:  12/31/02 Retained Earnings – Sage a 9,348 Minority Interest in NA of Sub. b 492 I/T Expense – Sage c 1,905 Deferred I/T Lia. d 7,935 a. $9,840x 0.95 or $23,371 x 40% b. $9,840x 0.05 c. $38,576-$33,813) x 40% d. $9,840-$1,905

58. Income Taxes and Cash Flows 57 Income Taxes Attributable to Intercompany Gain on Extinguishment of Bonds (contd.) The purposes of the I/T related working paper elimination prepared on 12/31/02: 1.To reduce the subsidiary’s income taxes expense for amount attributable to recorded intercompany gain (for consolidation purposes) on subsidiary’s bond; 2.To provide for remaining deferred income taxes on unrecorded portion of gain.

59. Income Taxes and Cash Flows 58 Income Taxes Attributable to Intercompany Gain on Extinguishment of Bonds (contd.)  Note to the I/T related working paper elimination on 12/31/2002:  The $1,905 decrease in expense (increase in the subsidiary's net income is included in the computation of the minority interest in the subsidiary's net income for the year ended 12/31/2002

60. Income Taxes and Cash Flows 59 Summary: Income Taxes Attributable to Intercompany Profits (Gains) n The unrealized intercompany profits (gains) resulting from intercompany transactions of affiliated companies required interperiod tax allocation when the affiliated companies file separate income tax returns. n The elimination of unrealized intercompany profits causes a temporary difference.

61. Income Taxes and Cash Flows 60 Summary: Income Taxes Attributable to Intercompany Profits (Gains)-contd. n The elimination of unrealized intercompany gains for consolidation purposes will result in a taxable income exceeding a pre-tax financial income. n Thus, a deferred income tax assets must be accounted for in the working paper eliminations that accompany the profit (gain) eliminations.

62. Income Taxes and Cash Flows 61 Summary: Income Taxes Attributable to Intercompany Profits (Gains)- contd. n In the case of intercompany bonds, pre-tax financial income exceeds taxable income of the accounting period of the realized gain. n Thus, a deferred income tax liability must be provided in a working paper elimination.

63. Income Taxes and Cash Flows 62 Summary: Income Taxes Attributable to Intercompany Profits (Gains) – contd. n The following pages summarize the working paper eliminations for the intercompany transactions on inventory, land, depreciable plant assets and extinguishment of bonds for the year ended 12/31/2002.

64. Income Taxes and Cash Flows 63 Summary: Income Taxes Attributable to Intercompany Profits (Gains) – Inventory b) Retained Earnings—Sage 7,600 Minority Interest in NA of Sub.400 Intercompany Sale—Sage150,000 Intercompany CGS-Sage120,000 CGS—Post26,000 Inventories—Post12,000 POST CORPORATION AND SUBSIDIARY Partial Working Paper Eliminations December 31, 2002 To eliminate intercompany sales, cost of goods, and unrealized intercompany profits in inventories.

65. Income Taxes and Cash Flows 64 Summary: Income Taxes Attributable to Intercompany Profits (Gains) –Inventory c) Deferred Income Tax Asset-- Sage 4,800 Income Taxes Expense-- Sage 4,800 To defer income taxes provided on separate income tax returns of subsidiary applicable to unrealized intercompany profits in parent company’s inventories on Dec. 31, 2002 ($12,000X0.40=$4,800).

66. Income Taxes and Cash Flows 65 Summary: Income Taxes Attributable to Intercompany Profits (Gains)-Inventory c) Income Taxes Expense—Sage 3,200 Retained Earnings—Sage ($3,200X0.95; or $7,600X0.40) 4,800 Minority interest in Net Assets of Subsidiary($3,200X0.05; or $400X0.40) 160 To provide for income taxes attributable to realized intercompany profits parent company’s inventories on Dec. 31, 2001($8,000X0.40=$3,200).

67. Income Taxes and Cash Flows 66 Summary: Income Taxes Attributable to Intercompany Profits (Gains)-Land d) Retained Earning—Post 500,000 Land--Sage500,000 To eliminate unrealized intercompany in land. e) Deferred Income Tax Asset– Post 20,000 Retained Earnings--post20,000 To defer income taxes attributable to unrealized intercompany gain in subsidiary’s land ($50,000X0.40=$20,000).

68. Income Taxes and Cash Flows 67 Summary: Income Taxes Attributable to Intercompany Profits (Gains)-Plant Assets f)Retained Earning—Sage ($23,800X0.95) 22,610 Minority Interest in Net Assets of Subsidiary ($23,800X0.05) 1,190 Accumulated Depreciation— Post 4,760 Machinery—Post23,800 Depreciation Expense—Post4,760 To eliminate unrealized intercompany gain in machinery and in related depreciation. Gain element in depreciation computed as $23,800X0.20=$4,760, based on five-year economic life.

69. Income Taxes and Cash Flows 68 Summary: Income Taxes Attributable to Intercompany Profits (Gains)-Plant Assets g) Income Taxes Expense--Sage 1,904 Deferred Income Tax Asset— Sage ($9,520-$1,904) 7,616 Retained Earnings—Sage ($9,520X0.95; or $22,610X0.40) 9,044 Minority Interest in Net Assets of Subsidiary ($9,520X0.05; or $1,190X0.40) 476 To provide for income taxes expense on intercompany gain realized through parent company’s depreciation ($4,760X0.40=$1,904); and to defer income taxes attributable to remainder of unrealized gain.

70. Income Taxes and Cash Flows 69 Summary: Income Taxes Attributable to Intercompany Profits (Gains)-Bonds h) Intercompany Interest Revenue—Post 38,576 Intercompany Bond Payable—Sage300,000 Discount on Intercompany B/P-Sage14,411 Invest. in Sage Company -Post265,751 Intercompany Interest Expense--Sage33,813 Retained Earnings—Sage ($24,601X0.95)23,371 Minority Interest in NA of Sub.1,230 To eliminate subsidiary’s bonds owned by parent company, and related interest revenue and expense; and to increase subsidiary’s beginning retained earning by amount of unamortized realized gain on the extinguishment of the bond.

71. Income Taxes and Cash Flows 70 Summary: Income Taxes Attributable to Intercompany Profits (Gains)-Bonds i)Retained Earning—Sage ($9,840X0.95; or $23,371X0.40) 9,348 Minority interest in Net Assets of Subsidiary ($9,840X0.05; or $1,230X0.40) 492 Income Taxes Expense—Sage [($38,576-$33,813)X0.40] 1,905 Deferred Income Tax Liability– Sage ($9,840-$1,905) 7,935 To reduce the subsidiary’s income taxes expense for amount attributable to recorded intercompany gain (for consolidation purposes) on subsidiary’s bonds; and to provide for remaining deferred income taxes on unrecorded portion of gain

72. Income Taxes and Cash Flows 71 Summary: Income Taxes Attributable to Intercompany Profits (Gains)-Comments n All the forgoing eliminations except (d) and (e) affect the net income of Sage Company. n The corresponding amount of those eliminations are included in the computation of minority interest in net income of subsidiary for year 2002

73. Income Taxes and Cash Flows 72 Consolidated Statement of Cash Flows – General Comments The consolidated statement of cash flows is prepared as described in intermediate accounting textbooks with a few points deserves special attention: n The depreciation and amortization expense added (when using the indirect method) to total consolidated income is the consolidated deprecation and amortization expense.

74. Income Taxes and Cash Flows 73 Consolidated Statement of Cash Flows-General Comments (contd.) n The minority interest in net income of subsidiary (an expense on the consolidated income statement) should also be added to the consolidated net income in preparing the net cash flows of the operating activities. n Only cash dividends paid by the parent company and cash dividends paid by partially owned subsidiary to minority stockholders are reported as cash flows from financing activities.

75. Income Taxes and Cash Flows 74 Consolidated Statement of Cash Flows – General Comments(contd.) n A cash acquisition by the parent company of additional shares of common directly from a subsidiary has no impact on the consolidated cash flows and is not reported in a consolidated statement of cash flows. n A cash acquisition by the parent company of additional shares of common directly from minority stockholders reduces consolidated cash and is reported in a consolidated statement of cash flows as an investing activity.

76. Income Taxes and Cash Flows 75 Consolidated Statement of Cash Flows – General Comments(contd.) n A cash acquisition by the parent company of additional shares of common directly from a subsidiary has no impact on the consolidated cash flows and is not reported in a consolidated statement of cash flows. n A cash acquisition by the parent company of additional shares of common directly from minority stockholders reduces consolidated cash and is reported in a consolidated statement of cash flows as an investing activity.

77. Income Taxes and Cash Flows 76 Illustration of Consolidated Statement of Cash Flows n Example: n Parent Corp. owned 100% of Sub Company for a few years through a purchase-type business combination. Sub has one class of common stock and its total stockholder's equity on 12/31/99 was $500,000. n On 1/2/2000, parent sold 30% of its investment in Sub's common stock to outsiders for $205,000, which was $55,000 more than the carrying amount of the investment in Parent's records.

78. Income Taxes and Cash Flows 77 Illustration of Consolidated Statement of Cash Flows (contd.) n Sub had a net income of $100,000 for Year 2000 and paid cash dividends of $60,000 during Year 2000. n During Year 2000, Parent issued additional common stock and cash of $290,000 for plant assets which a current fair value of $490,000. n The consolidated entity had additional long-term borrowings of $93,000 during Year 2000, and interest payments totaled $62,000 (none was capitalized). Income tax payments totaled $234,000.

79. Income Taxes and Cash Flows 78 Illustration of Consolidated Statement of Cash Flows (contd.) n The followings are the consolidated income statement for Year 2000, the consolidated statement of stockholder's equity for Year 2000, and the comparative consolidated balance sheets on December 31, 1999 and 2000:

80. Income Taxes and Cash Flows 79 Consolidated Income statement for the Year ended 12/31/2000 Sales and other revenue (including gain of $55,000 on sale of investment in Sub Company common stock) $2,450,000 Costs and expenses: Costs of goods sold1,500,000 Depreciation and amortization expense210,000 Other operating expenses190,000 Income before income taxes$550,000 Income taxes expense250,000 Total consolidated income$300,000 Less: Minority interest in net income of subsidiary 30,000 Net income$270,000 Basic earnings per share of common stock$5.14

81. Income Taxes and Cash Flows 80 Consolidated Statement of Stockholders' Equity For Year Ended 12/31/2000 Common Stock, $10 Par Additional Paid-in Capital Retained Earnings Total Balances, beginning of year $500,000$ 300,00$ 670,000$1,470,000 Issuance of 5,000 shares of common stock for plant assets Net income 50,000150,000 270,000 200,000 270,000 Cash dividends declared and paid($2.91 a share) (160,000) Balances, end of year$ 550,000$ 450,000$ 780,000$ 1,780,000

82. Income Taxes and Cash Flows 81 Consolidated Balance Sheets December 31, 2000 1999 Assets Cash$ 300,000$ 240,000 Other current assets Plant assets Less: Accumulated depreciation of plant asset 900,000 3,000,000 (1,300,000) 660,000 2,510,000 (1,100,000) Intangible assets (net)240,000250,000 Total assets$3,140,000$2,560,000

83. Income Taxes and Cash Flows 82 Consolidated Balance Sheets(contd.) December 31, 2000 1999 Liabilities & Stockholder’s Equity Current liabilities Long-term debt Minority interest in net assets of subsidiary 505,000 693,000 162,000 490,000 600,000 Common stock, $10 per Additional paid-in capital Retained Earnings Total Lia. & stockholders' equity 550,000 450,000 780,000 $3,140,000 500,000 300,000 670,000 $2,560,000

84. Income Taxes and Cash Flows 83 Working Paper for Consolidated Statement of Cash Flows for Year Ended 12/31/2000 (indirect Method) Balances 12/31/99 Balances 12/31/00 DebitCredit Cash240,000(x) 60,000300,000 Other current assets less current liabilities 170,000(5) 225,000395,000 Plant assets2,510,000(6) 290,000 (9) 200,000 3,000,000 Intangible assets (net)250,000(2) 10,000240,000 Totals3,170,0003,935,000 Transactions for Year 2000

85. Income Taxes and Cash Flows 84 Working Paper for Consolidated Statement of Cash Flows for Year Ended 12/31/2000 (indirect Method) (contd.) Balances 12/31/99 Balances 12/31/00 DebitCredit Accumulated depreciation1,100,000(2)200,0001,300,000 Long-term debt600,000(7) 93,000693,000 Minority interest in net assets of subsidiary (8) 18,000(3) 30,000 (4)150,000 162,000 Common stock, $10 par500,000(9) 50,000550,000 Additional paid-in capital300,000(9)150,000450,000 Retained earnings670,000(8)160,000(1)270,000780,000 Totals3,170,000953,000 3,935,000 Transactions for Year 2000

86. Income Taxes and Cash Flows 85 Working Paper for Consolidated Statement of Cash Flows for Year Ended 12/31/2000 (indirect Method) (contd.) Balances 12/31/99 Balances 12/31/00 Operating Activities DebitCredit Net Income Add: Depreciation and amortization expense Minority interest in net income of subsidiary Less: Gain on sale of investment in Sub Company common stock Net increase in net current assets (1)270,000 (2)210,000 (3) 30,000 (4) 55,000 (5)225,000 From operating activities $230,000 Transactions for Year 2000

87. Income Taxes and Cash Flows 86 Working Paper for Consolidated Statement of Cash Flows for Year Ended 12/31/2000 (indirect Method) (contd.) Balances 12/31/99 Balances 12/31/00 Investing Activities DebitCredit Sale of investment in Sub Company common Acquisition of plant assets (4)205,000 (6)290,000 From investing activities ($85,000) Transactions for Year 2000

88. Income Taxes and Cash Flows 87 Working Paper for Consolidated Statement of Cash Flows for Year Ended 12/31/2000 (indirect Method) (contd.) Balances 12/31/99 Balances 12/31/00 Financing Activities DebitCredit Long-term borrowings Payable of dividends, including $18,000 to minority stockholders of Sub company (7) 93,000 (8)178,000 From financing activities ($85,000) Subtotals808,000748,000 Increase in cash(x) 60,000 Totals808,000 Transactions for Year 2000

89. Income Taxes and Cash Flows 88 Consolidated Statement of Cash Flows for Year Ended 12/31/2000 Net cash provided by operating activities (Exhibit 1)$230,000 Cash Flows from Investing Activities: Disposal of investment in Sub Company common stock $205,000 Acquisition of plant assets(290,000) Net cash used in investing activities(85,000) Cash Flows from Financing Activities: Long-term borrowings$ 93,000 Dividends paid including $18,000 to minority stockholders of Sub Company (178,000) Net cash used in financing activities Net increase in cash Cash, Beginning of year Cash, end of year (85,000) $60,000 240,000 $300,000

90. Income Taxes and Cash Flows 89 Consolidated Statement of Cash Flows for Year Ended 12/31/2000 (contd.) EXHIBIT 1 Cash flows from operating activities: Net income$270,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization expense210,000 Minority interest in net income of subsidiary30,000 Gain on disposal of investment in Sub Company common stock (55,000) Net increase in net current assets (240,000-15,000)(225,000)* Net cash provided by operating activities$230,000

91. Income Taxes and Cash Flows 90 Consolidated Statement of Cash Flows for Year Ended 12/31/2000 (contd.) EXHIBIT 2 Supplemental disclosure of cash flow information: Cash paid during the year for: Interest (none capitalized)$ 62,000 Income taxes234,000 EXHIBIT 3 Noncash investing and financing activities: Common stock issues for plant assets $200,000

92. Income Taxes and Cash Flows 91 Notes to the Above Consolidated Statement of Cash Flows 1.Net cash provided by operating activities includes the minority interest in net income of Sub Company. 2.Net cash provided by operating activities excludes the gain of $55,000 from sale of the 30% of investment in Sub company. The proceeds received, $205,000, are reported as as a component of investing activity.

93. Income Taxes and Cash Flows 92 Notes to the Above Consolidated Statement of Cash Flows 3.Only the dividends paid to stockholders of the Parent Corp ($160,000) and to minority stockholders of Sub Company ($18,000, Not, $60,000) are reported as cash flows from financing activities. 4.The issuance of common stock by Parent to acquire plant assets is a noncash transaction (a direct exchange).