© 2009 Pearson Education, Inc. publishing as Prentice Hall10-1 Chapter 10: Subsidiary Preferred Stock, Consolidated Earnings Per Share, and Consolidated Income Taxation by Jeanne M. David, Ph.D., Univ. of Detroit Mercy to accompany Advanced Accounting, 10 th edition by Floyd A. Beams, Robin P. Clement, Joseph H. Anthony, and Suzanne Lowensohn

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-2 Preferred Stock, EPS, and Taxes: Objectives 1.Modify consolidation procedures for subsidiary companies with preferred stock in their capital structure. 2.Calculate basic and diluted earnings per share for a consolidated reporting entity. 3.Understand the complexities of accounting for income taxes by consolidated entities.

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-3 1: Preferred Stock Subsidiary Preferred Stock, Consolidated Earnings Per Share, and Consolidated Income Taxation

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-4 Subsidiary Preferred Stock Subsidiary preferred stock –Doesn't change consolidation in principle –Does impact calculations Common stockholders' equity = total equity less preferred stock at book value Income of subsidiary is first allocated to preferred shareholders, then CI and NCI Subsidiary dividend payments must consider payments to preferred shareholders before common shareholders

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-5 Who Holds Preferred Stock? Preferred stock is held by outsiders Preferred stock is a noncontrolling interest Preferred stock is held by parent May choose between –Constructive retirement –Cost basis

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-6 Review of Preferred Stock Characteristics Callable, redeemable Cumulative or noncumulative Participative or non- participative Limited voting rights Most is cumulative and nonparticipating Book Value of PS is: Call or redemption price (par value if neither) Plus Dividends in arrears (if cumulative) Income allocated to PS is: Current period dividend Irrespective of amount declared, if cumulative Declared amount if noncumulative Potentially more if participative Preferred stock dividend is: Face value x dividend rate Also consider: Arrearage Participation

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-7 Example: PS Held by Outsiders Poe buys 90% of Sol for $396 when Sol's equity consists of $100 preferred stock, $200 common stock, $40 other paid in capital and $160 retained earnings. The preferred stock is cumulative, nonparticipating, carries a 10% dividend and is callable at 105% of par value. There is no arrearage. During the year, Sol earns $50 and pays $30 in dividends.

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-8 Calculations for Preferred Stock The book value of preferred is its call price (no arrearage), 105%($100 par value). Dividends are cumulative, so the current dividend is $10 = 10%($100 par value). Cost of 90% of Sol $396 Implied value of Sol $440 Sol's total equity$500 Less book value of preferred stock(105) Book value of common 395 Excess, goodwill $45

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-9 Allocations Income allocation: Sol's net income50 Amortizations0 Income to allocate50 Allocated to preferred(10) Allocated to common40 Dividends30 Allocated to preferred(10) Allocated to common20 NCI share – Preferred $10 income $10 dividend NCI share (10% common) $4 income $2 dividend CI share (90%) $36 income $18 dividend

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-10 Income from Sol36 Dividends 18 Investment in Sol 18 Noncontrolling interest share, CS4 Dividends 2 Noncontrolling interest, CS 2 Noncontrolling interest share, PS10 Dividends 10 Preferred stock100 Common stock200 Other paid in capital40 Retained earnings160 Goodwill45 Investment in Sol 396 Noncontrolling interest, CS 44 Noncontrolling interest, PS 105 Worksheet Entries with Preferred Stock Held by Outsiders There is an entry for NCI share, PS that parallels the entry for NCI share, CS. Preferred Stock is eliminated.

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-11 Parent Uses Constructive Retirement Parent acquires subsidiary's preferred stock –Investment in subsidiary, PS is recorded at its book value –Any difference between book value and cost of the stock is an adjustment of other paid in capital –This is an owner transaction; no gain or loss is recorded Investment is carried at PS book value –Increase for dividends in arrears –Decrease later when declared

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-12 Parent Uses Cost Basis Parent acquires subsidiary's preferred stock –Use cost method –Investment in subsidiary, PS is at cost –Dividends are recorded as income In the consolidation process –Preferred stock is eliminated at its book value –Noncontrolling interest, PS is recorded at book value of the preferred stock held by others –Investment is removed at its cost and any difference from book value is charged or credited to other paid in capital

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-13 Example: Parent Acquires PS Plato owns 80% of Shem acquired at fair value plus implied goodwill of $100. On 1/1/09 Plato acquires 70% of Shem's outstanding preferred stock at $950. Shem's equity at 1/1/09: $3 Preferred stock, $50 par, callable at $52, cumulative, no arrearage1,500 Common stock $1 par300 Other paid in capital1,200 Retained earnings2,300 Total equity5,300

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-14 Calculations Book value of preferred stock $52 x ($1,500 / $50par) = $1,560 Book value of Shem's common stock $5,300 total equity – $1,560 = $3,740 Shem's total value with goodwill $3,740 + $100 = $3,840 Investment in Shem, CS (80%) = $3,072 Noncontrolling interest, CS (20%) = $768 Noncontrolling interest, PS (30%) = $468 Parent acquired 70% of Shem's PS for $950 Investment in Shem, PS (70%, book) = $1,092 Or Investment in Shem, PS (70%, cost) = $950 The difference, $142 = , increases the parent's other paid in capital

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-15 Constructive Retirement Entries Parent's acquisition entry: Investment in Shem, PS (70%)1,092 Cash 950 Other paid in capital (Plato) 142 Worksheet entry: Preferred stock1,500 Common stock300 Other paid in capital1,200 Retained earnings2,300 Goodwill100 Investment in Shem, CS (80%) 3,072 Investment in Shem, PS (70%) 1,092 Noncontrolling interest, CS (20%) 768 Noncontrolling interest, PS (30%) 468

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-16 Cost Basis Entries Parent's acquisition entry: Investment in Shem, PS (70%)950 Cash 950 Worksheet entry Preferred stock1,500 Common stock300 Other paid in capital1,200 Retained earnings2,300 Goodwill100 Investment in Shem, CS (80%) 3,072 Investment in Shem, PS (70%) 950 Noncontrolling interest, CS (20%) 768 Noncontrolling interest, PS (30%) 468 Other paid in capital (Plato's) 142

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-17 Comparison of Methods Both result in the same consolidated amounts Constructive retirement Records the Other paid in capital (parent's) at acquisition Investment is at book value Simplifies consolidation process! Cost basis Records the Other paid in capital (parent's) as part of the consolidation process Investment is at cost

© 2009 Pearson Education, Inc. publishing as Prentice Hall : Earnings Per Share Subsidiary Preferred Stock, Consolidated Earnings Per Share, and Consolidated Income Taxation

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-19 EPS Requirements GAAP requires firms report basic and diluted (where applicable) EPS EPS is disclosed on a consolidated basis Main issue: Subsidiary's capital structure Subsidiary potentially dilutive securities convertible into subsidiary common stock Subsidiary potentially dilutive securities convertible into parent common stock

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-20 Review Basic EPS Numerator: Net income – preferred stock dividends* * current dividends if cumulative, otherwise declared dividends Denominator: Weighted average shares of common stock

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-21 Review Diluted EPS Numerator: (Net income – PS dividends) + adjustments for dilutive securities Denominator: Weighted average shares outstanding + shares represented by dilutive securities Dilution: Dilutive securities reduce EPS. Non-dilutive securities are excluded

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-22 Review Dilutive Securities Convertible bonds –Numerator: after tax interest expense –Denominator: common shares bonds represent Convertible preferred stock –Numerator: preferred stock dividend –Denominator: common shares the preferred shares represent Convertible preferred stock –Numerator: none –Denominator: "treasury stock method" to compute shares (if positive) # shares – (# shares x option price / market price)

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-23 Subsidiary Securities Convertible into Subsidiary Common Stock Compare Parent's equity –Realized earnings of subsidiary –Diluted earnings of subsidiary If diluted is higher, skip  Non-dilutive Realized earnings: –Subsidiary's net income adjusted for intercompany profits/losses Does not include amortizations of valuation differentials Diluted earnings: –Subsidiary's diluted EPS x number of shares Parent's diluted EPS –Numerator: Reduce by difference –Denominator: No effect – no parent shares!

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-24 Subsidiary PS Convertible into Subsidiary CS Seed has $50 net income and 20 weighted average shares of common stock. Its preferred stock has a $10 dividend and is convertible into 12 shares of Seed common stock. Seed's basic EPS: ($50 - $10) / 20 = $2.00 Seed's diluted EPS: ($50 - $10) + $10 = $

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-25 Parent's Basic EPS Seed is 90% owned by Plant. Plant's net income is $186, 200 shares of common are outstanding all year, and Plant has no dilutive securities. Plant's basic EPS: $186 / 200 = $0.93

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-26 Parent's Diluted EPS Plant's realized income from Seed 90% x $40 = $36 Plant's share of Seed's diluted earnings: 90% x 20 shares x $ = $ Since the share of diluted earnings is lower, we will reduce the numerator by the difference. Plant's diluted EPS: $186 – = $

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-27 Subsidiary Securities Convertible into Parent Common Stock Parent's diluted EPS calculation: –Numerator: Add adjustments for subsidiary securities convertible into parent common stock –Denominator: Add parent common shares represented by subsidiary's dilutive securities

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-28 Subsidiary Options and Bonds Convertible into Parent CS Syd's net income is $450 and it has 400 shares of common outstanding all year. Options: Syd has options that convert into 60 shares of its parent's (Paddy) common stock at $10 per share. The average market price is $15. Convertible bonds: Syd has $1,000 par bonds convertible into 80 shares of Paddy's common stock. The bonds were issued at par to yield 7%. The effective tax rate is 34%.

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-29 Parent's Data and Basic EPS Paddy has $1,800 income and 1,000 shares of common stock outstanding all year. It has no preferred stock or dilutive securities. Paddy's basic EPS: $1,800 / 1,000 shares = $1.80

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-30 Parent's Diluted EPS Impact of Syd's options for Paddy common: Numerator: none Denominator: 60 + (60 x $10/$15) = 20 shares Impact of Syd's bonds convertible to Paddy common: Numerator: 7% x $1,000 x (1-34%) = $46.2 Denominator: 80 shares Paddy's diluted EPS: $1, $46.2 = $1.76 1,

© 2009 Pearson Education, Inc. publishing as Prentice Hall : Income Taxes Subsidiary Preferred Stock, Consolidated Earnings Per Share, and Consolidated Income Taxation

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-32 Consolidated Tax Return Advantages –Offset affiliate losses (excluding preacquisition loss carry forwards) –Exclude intercompany dividends –Defer intercompany profits until realized (losses are also deferred) Disadvantages –Loss of flexibility –Difficult to switch back to unconsolidated Cannot file as consolidated again for 5 years

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-33 Income Tax Allocation Permanent differences –Dividends from affiliates are excluded from taxable income –Dividends from affiliates that are not members of the affiliated group are allowed an 80% dividends received deduction Temporary difference –Undistributed income from domestic affiliates (FASB Statement No. 109) –Undistributed income from foreign affiliates and from domestic affiliated earnings preceding FASB Statement No. 109 may be permanent.

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-34 Undistributed Earnings Parson owns 30% of Seaton's common stock. Seaton's income, $600 Seaton's dividends, $200 Parson's applicable tax rate = 34% Parson's deferred tax liability = [30%($600 - $200)] x 20% x 34% = $8.16 Seaton's earnings are allowed the 80% deduction, so only 20% is subject to tax. If Seaton was a consolidated subsidiary, its earnings would be excluded and Parson would have no deferred tax liability.

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-35 Unrealized Profits and Losses Separate tax returns –Unrealized gains (losses) are taxed (deducted) in the separate returns –Consolidation procedures Remove the unrealized gain (loss) Record a deferred tax asset (liability) Tax effect impacts the income tax expense of the selling affiliate Consolidated tax return –Unrealized gains (losses) are excluded

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-36 Example Pool owns 90% of Sal. The tax rate is 34%. Pretax operating income of Pool and Sal are $150 and $50. Sal paid dividends of $20 and Sal's dividends are subject to the 100% exclusion. During the year, intercompany sales were $50 and there remains $10 in unrealized profits in ending inventory.

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-37 Consolidated Tax Return Downstream sales Pool's income $150 - $10 = $140 Sal's income $50 Consolidated taxes ($140 + $50) x 34% = $64.6 –Allocate (140/(140+50)) x $64.6 = $47.6 to Pool (50/(140+50)) x $64.6 = $17.0 to Sal Upstream sales Pool's income $150 Sal's income $50 - $10 = $40 Consolidated taxes ($150 + $40) x 34% = $64.6 –Allocate (150/(150+40)) x $64.6 = $51.0 to Pool (40/(150+40)) x $64.6 = $13.6 to Sal

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-38 Entries with Consolidated Return Pool and Sal would each record their own share of the income tax expense and income tax payable. The unrealized profit does not give rise to any temporary differences –Deferred for consolidation purposes –Deferred for tax purposes –That is, it is not income now and it is not taxed now! No special considerations for consolidation worksheet.

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-39 Separate Tax Returns Downstream sales Pool's accounting income $150 - $10 = $140 –Pool's taxes payable $150 x 34% = $51.0 –Pool's deferred taxes $10 x 34% = $3.4 –Income tax expense $47.6 Sal's income $50 –Sal's taxes $50 x 34% = $17.0 Upstream sales Pool's income $150 –Pool's taxes $150 x 34% = $51.0 Sal's income $50 - $10 = $40 –Sal's taxes payable $50 x 34% = $17.0 –Sal's deferred taxes $10 x 34% = $3.4 –Sal's income tax expense $13.6

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-40 Business Combinations Tax free combinations –Mergers or consolidations –Exchange of voting stock for another corporation's stock –Exchange of voting stock for another corporation's assets Purchase acquisitions may be either –Tax free –Taxable

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-41 Tax Free Business Combinations Tax free business combinations give rise to differences between book values and tax values At acquisition –Assign assets value based on gross fair value –Except Goodwill, bargain purchase, deferred taxes, pension assets, leveraged leases –Tax bases carry forward from predecessor –Record deferred tax asset/liability for temporary differences

© 2009 Pearson Education, Inc. publishing as Prentice Hall10-42 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.