Chapter 6 Cash Flows EPS Taxation Unconsolidated Investments

Special issues Cash flow for the consolidated company Consolidated earnings per share Taxation using a consolidated tax return using separate tax returns for each affiliate Equity method for influential investments C6

Consolidated cash flow: The issues Impact of the purchase cash purchase is investing stock issue is non-cash transaction Amortizations are non-cash adjustment to operations Transactions between firms are eliminated on the income statement and balance sheet we use for the analysis C6

Consolidated cash flow: Impact of the purchase Cash purchase is “Investing.” There is usually also a non-cash portion (liabilities assumed and non-controlling interest). Cash paid is recorded net of sub’s cash received. Stock issue usually results in cash inflow (for the sub’s cash) and disclosure of the “non-cash” transaction Pooling was a non-event because prior balance sheet was retroactively consolidated C6

Consolidated cash flow: Adjustments Start with consolidated net income (includes the NCI share). If you start with only controlling interest, the NCI must be added back to income. Add back amortizations from D&D to income; they are non-cash expenses Operations (+) continued . . . C6

Consolidated cash flow: Adjustments (continued) Purchase of additional sub shares is the purchase of treasury shares for the consolidated entity Financing (-) All parent dividends and dividends paid to NCI cash Buying sub bonds is retirement for consolidated entity C6

Example: Cash purchase Balance Sheet of Company Acquired Cash 10,000 Liabilities 30,000 Fixed assets 80,000 Equity 60,000 D&D Schedule Price Paid 100,000 Interest (80%  $60,000) 48,000 Excess 52,000 Allocate to building (80%  50,000) 40,000 20 year Goodwill 12,000 C6

Example: Cash purchase (continued) To see cash flow impact, consider additions to parent balance sheet on purchase date: Fixed asset (increased 40,000) 120,000 Goodwill 12,000 Liabilities 30,000 Cash (100,000 - 10,000 sub cash) 90,000 NCI (20%  60,000) 12,000 Non-cash “investing” is $30,000 liability & $12,000 NCI Cash Operations is +$2,000 depreciation adjustment Dr Cr C6

Balance Sheet of Company Acquired Example: Stock issued for sub Balance Sheet of Company Acquired Cash 10,000 Liabilities 30,000 Fixed assets 80,000 Equity 60,000 D&D Schedule Price Paid (10,000 par $10 shares) 100,000 Interest (80%  $60,000) 48,000 Excess 52,000 Allocate to building (80%  50,000) 40,000 20 year Goodwill 12,000 C6

Stock issued for sub (continued) Example: Stock issued for sub (continued) To see cash flow impact, consider additions to parent balance sheet on purchase date: Cash (from Sub) 10,000 Fixed asset (increased 40,000) 120,000 Goodwill 12,000 Liabilities 30,000 NCI (20%  60,000) 12,000 Common stock, $10 par 100,000 Non-cash “investing” is $30,000 liability is + $12,000 NCI + $100,000 stock issue Cash Operations is + $2,000 depreciation adjustment Dr Cr C6

Consolidated EPS Consolidated net income [controlling interest only] Parent common shares Consolidated Basic EPS =  P’s internally gen adj inc + Parent DEPS inc adj + (P’s owned Sub Equity Shares  Sub DEPS) Parent common shares Consolidated Diluted EPS =  C6

Taxation of the consolidated entity Consolidated Return Requires 80% plus IRS rules No tax on separate books Tax based on “consolidated net income” from consol WS Inter-co profits have been eliminated - not taxed Allocate tax back to Parent & Sub books Separate Taxation Each firm paid tax on their reported income Parent may pay (and /or accrue) “secondary tax” on share of sub income Intercompany profits have been taxed - requires deferral Tax allocation techniques are employed C6

Base example for taxation Parent Sub Sales 300,000 120,000 Cost of Goods Sold (200,000) (90,000) Gross profit 100,000 30,000 Expenses (40,000) (20,000) Gain on sale of machine 5,000 _______ Net Income 65,000 10,000 Parent owns 80% interest Tax rate is 30% Gain on machine is 5 year asset sold to S by P (downstream) S sells inventory to P at 20% GP, $50,000 sales during year, $20,000 in beg inv, $6,000 in end inv C6

Consolidated taxation: Adjustments

Consolidated taxation: Sub IDS End inv profit (EI) 1,200 Internal gen NI 10,000 Beg inv profit (BI) 4,000 Adjusted net 12,800 Tax (3,840) Net income 8,960 20% NCI 1,792 Sub must record tax provision on its books C6

Consolidated taxation: Parent IDS Gain on mach (F1) 5,000 Intern gen NI before tax 65,000 Realized gain (F2) 1,000 Adjusted net income 61,000 Tax (18,300) Net income 42,700 80% of S’s NI after tax + 7,168 Controlling Interest 49,868 C6

Consolidated tax: Worksheet In Worksheet 6-1: Neither P or S has tax provision on books; if there were one, we would reverse it out. Eliminations, prior to tax entry, do not change from prior chapters Provision T for tax based on consolidated income Take care on parent IDS to avoid taxing Sub income again Tax provision on IDS must be recorded on books of P and S C6

Separate tax: Worksheet In Worksheet 6-2: Confirm the tax provision on P’s and S’s incomes, P’s provision includes secondary tax on 75% of sub income. Confirm P’s deferred tax liability for the undistributed share of sub income (current and prior years). Eliminations prior to tax do not change from prior chapters continued . . . C6

Worksheet (continued) Separate tax: Worksheet (continued) Entry T1 adjusts for tax impact on RE adjustments Entry T2 adjusts for tax impact of current year adjustments All IDS adjustments are net of tax, including double tax on P’s share of S income. C6

Separate taxation example: Adjustments for current year

Separate taxation: Tax adjustment Tax adjustment schedule: Deferred Tax Asset increase (decrease) Item Total 80% Par 20% NCI Mach gain deferred ($5,000  .3) 1,500 1,500 Mach gain realized ($1,000  .3) (300) (300) Beg Inv realized ($4,000  .3) (1,200) (960) (240) secondary tax ($2,800 .8 .2 .3) (134) (134) End Inv deferred ($1,200  .3) 360 288 72 secondary tax ($840 .8 .2 .3) 40 40 _____ Total 266 434 (168) C6

Separate taxation: Sub IDS Sub End inv profit (EI) 1,200 Int gen NI before tax 10,000 Beg inv profit (BI) 4,000 Adjusted inc before tax 12,800 30% tax (3,840) Adj inc net of tax 8,960 Minority share (20%) 1,792 C6

Separate taxation: Parent IDS Parent Gain on mach. (F1) 5,000 Int gen NI before tax 65,000 Realized gain (F2) 1,000 Adj. inc. before tax 61,000 30% tax (18,300) Net income 42,700 80% Sub Adj Net Inc + 7,168 Secondary tax on $7,168* (430) Adjusted net inc 49,438 * $7,168  20% included  30% tax rate C6

Influential investments: Equity Method D&D is still used to determine excess and schedule amortizations amortizations now come out of the investment account there is no amortization of goodwill component of excess Investee profits are adjusted via the IDS. Only the investor’s share of profits is deferred Double tax applies (20%) Tax allocation applies to only the double tax investor must accrue tax on undistributed investee income C6

Influential investment: Example D&D of Excess Schedule Price paid $80,000 Equity (30%  $250,000) 75,000 Excess: patents with 5 year amortization 5,000 Investor sells inventory to investee: 30% GP, $10,000 goods in beg inv, $40,000 goods in end inv At beginning of year, investee sold machine (5 years life) to investor at $10,000 profit Investee reports income of $60,000 (before tax) 30% tax rate; 80% income exclusion C6

Influential investment: IDS to calculate investment income IDS for Investee Mach gain 10,000 Int generated income 60,000 no inventory adj. here! Realized mach gain 2,000 Adjusted Inc 52,000 Tax at 30% 15,600 Net Inc 36,400 30% interest 10,920 Less patent amort (1,000) Equity income 9,920 C6

Influential investment: Entries to record income Investment in Investee 9,920 Investment income 9,920 Provision for Tax* 655 DTL 655 * ([9,920 + 1,000]  20% included  30% tax rate).  Amort of excess is not tax deductible. Deferred gross profit (beginning inv) 900 Sales rev (10,000  30% GP  30% interest) 900 Sales Rev (4,000  30% GP  30% interest) 3,600 Deferred gross profit (ending inv) 3,600 C6

Influential investment: Entries to record income (cont’d) Provision for tax (900  30% ) 270 DTA (on beginning inventory) 270 DTA (on ending inventory) 1,080 Provision for tax (3,600  30% ) 1,080 C6

Influential investment: Special issues You can’t equity adjust below “zero.” memo entries to track unrecorded losses future income not recognized until it exceeds unrecorded losses Investor defers profit on own interest on own books. Achieve influence with subsequent purchases retroactive conversion to sophisticated equity Loose influence stop using sophisticated equity; no retroactive adjustment C6