Chapter Seven Consolidated Financial Statements – Ownership Patterns and Income Taxes Consolidated Financial Statements – Ownership Patterns and Income Taxes Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Indirect Subsidiary Control Learning Objective 7-1: Demonstrate the consolidation process when indirect control is present in a grandfather-father-son ownership configuration. The presence of an indirect ownership does not change most consolidation procedures; however, a calculation of each subsidiary’s accrual-based income does pose some difficulty. Appropriate income determination is essential for calculating (1) equity income accruals and (2) noncontrolling interest’s share of consolidated net income. Although the presence of an indirect ownership does not change most consolidation procedures, a calculation of each subsidiary’s accrual-based income does pose some difficulty. Appropriate income determination is essential for calculating (1) equity income accruals and (2) the noncontrolling interest’s share of consolidated net income.

Indirect Subsidiary Control Assume three companies form a business combination: Top Company owns 70% of Midway Company, which owns 60% of Bottom Company. Top controls both subsidiaries, although the parent’s relationship with Bottom is only of an indirect nature. This data is from the company financial records. Assume three companies form a business combination: Top Company owns 70% of Midway Company, which owns 60% of Bottom Company. Top controls both subsidiaries, although the parent’s Relationship with Bottom is only of an indirect nature.

Indirect Control Calculations First, determine Midway’s realized income. Next, combine Top Company’s income with Midway’s realized income. Using the income from the previous calculations, determine noncontrolling interest. (Bottom and Midway’s individual incomes as calculated). From the perspective of the business combination, Bottom’s income for the period is only $55,000 after deferring the $20,000 in net intra-entity gains and recognizing the $25,000 excess amortization associated with the acquisition by Midway. Thus, $55,000 is the basis for the equity accrual by its parent and noncontrolling interest recognition. Once the grandson’s income has been derived, this figure then is used to compute the accrual-based earnings of the son, Midway If appropriate equity accruals are recognized, the sum of the parent’s accrual-based income and the noncontrolling interest income share serves as a “proof figure” for the consolidated total.

Indirect Subsidiary Control – Connecting Affiliation Learning Objective 7-2: Demonstrate the consolidation process when a corporate ownership structure is characterized by a connecting affiliation. A connecting affiliation exists when two or more companies within a business combination own an interest in another member of the organization. A connecting affiliation exists when two or more companies within a business combination own an interest in another member of the organization.

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. The combination of the parent’s DIRECT ownership and INDIRECT ownership results in control of the subsidiary. 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 Learning Objective 7-3: Demonstrate the consolidation process when a corporate ownership structure is characterized by mutual ownership. Mutual ownership occurs when two companies within a business combination hold an equity interest in each other. GAAP recommends that “shares of the parent held by the subsidiary should be eliminated in consolidated financial statements.” The shares are not “outstanding” because they are not held by parties outside the combination. Mutual ownership occurs when two companies within a business combination hold an equity interest in each other. GAAP recommends that “shares of the parent held by the subsidiary should be eliminated in consolidated financial statements.” The shares are not “outstanding” because they are not held by parties outside the combination. The Treasury Stock Approach is used to account for the mutually owned shares.

Mutual Ownership The Treasury Stock Approach is used to account for the mutually owned shares. No accounting distinction is made between a parent owning stock of a subsidiary, or a subsidiary owning stock of a parent – they are both intra-entity stock ownership. 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. There is no accounting distinction between a parent owning stock of a subsidiary, or a subsidiary owning stock of a parent – they are both intra-entity stock ownership. 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.

Income Tax Accounting for a Business Combination Learning Objective 7-4: List the criteria for being a member of an affiliated group for income tax filing purposes. Business combinations may elect to file a consolidated federal tax return for all companies of an affiliated group. An affiliated group will likely exclude some members of the business combination. It will include the parent company, any domestic subsidiary in which the parent owns 80% or more of the voting stock AND 80% of each class of nonvoting stock (direct or indirect ownership). All others must file separately (including any foreign subsidiaries.) Business combinations may elect to file a consolidated federal tax return for all companies of 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 There is a difference in a business combination as identified for financial reporting and an affiliated group as defined for tax purposes. A business combination comprises all subsidiaries controlled by a parent company unless control is only temporary. The IRS’s 80 percent rule creates a smaller circle of companies qualifying for inclusion in an affiliated group. Intra-entity profits are not taxed until realized. Losses of one affiliated group member can be used to offset taxable income earned by another group member. There is a distinction between business combinations as identified for financial reporting and affiliated groups as defined for tax purposes. A business combination comprises all subsidiaries controlled by a parent company unless control is only temporary. The IRC’s 80 percent rule creates a smaller circle of companies qualifying for inclusion in an affiliated group.

Income Tax Accounting – Deferred Income Taxes Learning Objective 7-5: Compute taxable income and deferred tax amounts for an affiliated group based on information presented in a consolidated set of financial statements. Tax consequences are often dependent on whether separate or consolidated returns are filed. Transactions affected: Tax consequences are often dependent on whether separate or consolidated returns are filed. Transactions affected include intra-entity dividends, goodwill, and unrealized intra-entity gains. Intra-entity Dividends Unrealized Intra-entity Gains Goodwill

Income Tax Accounting – Deferred Income Taxes Intra-entity Dividends For accounting purposes, all intra-entity dividends are eliminated. For tax purposes, dividends are removed from income if at least 80 percent of the subsidiary’s stock is held. (20% is taxable.) If less than 80 percent of a subsidiary’s stock is held, tax recognition is necessary. A deferred tax liability is created for any of sub’s income not paid currently as a dividend. Intra-entity Dividends For accounting purposes, all intra-entity dividends are eliminated. For tax purposes, dividends are removed from income if at least 80 percent of the subsidiary’s stock is held. (20% is taxable.) If less than 80 percent of a subsidiary’s stock is held, tax recognition is necessary. A deferred tax liability is created for any of sub’s income not paid currently as a dividend.

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. Timing differences between the amortization and write-off creates a temporary difference that results in 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. Timing differences between the amortization and write-off creates a temporary difference that results in deferred income taxes.

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. 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. Used as a basis for calculating noncontrolling interest’s share of consolidated income. 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.

Filing Separate Tax Returns Learning Objective 7-6: Compute taxable income and deferred tax amounts to be recognized when separate tax returns are filed by any of the affiliates of a business combination. Separate returns are mandatory for foreign subsidiaries and for domestic corporations not meeting the 80 percent ownership rule. Canadian and Mexican subsidiaries can qualify for treatment as domestic companies for purposes of filing a consolidated return. A company may still elect to file separately even if it meets the conditions for inclusion within an affiliated group. Separate returns are mandatory for foreign subsidiaries and for domestic corporations not meeting the 80 percent ownership rule. Canadian and Mexican subsidiaries can qualify for treatment as domestic companies for purposes of filing a consolidated return. A company may still elect to file separately even if it meets the conditions for inclusion within an affiliated group. If all companies in an affiliated group are profitable and few intra-entity transactions occur, they may prefer separate returns to give the companies more flexibility in their choice of accounting methods and fiscal tax years.

Filing Separate Tax Returns If all companies are profitable and few intra-entity transactions occur, they may prefer separate returns to give the companies more flexibility in choice of accounting methods and fiscal tax years. Tax laws do not allow a company to switch back and forth between consolidated and separate returns. Obtaining Internal Revenue Service permission to file separately can be difficult after electing to file a consolidated return. When members of a business combination file separate tax returns, temporary differences often emerge for income recognized for consolidated financial reporting and for income tax reporting. Separate returns are mandatory for foreign subsidiaries and for domestic corporations not meeting the 80 percent ownership rule. Canadian and Mexican subsidiaries can qualify for treatment as domestic companies for purposes of filing a consolidated return. A company may still elect to file separately even if it meets the conditions for inclusion within an affiliated group. If all companies in an affiliated group are profitable and few intra-entity transactions occur, they may prefer separate returns to give the companies more flexibility in their choice of accounting methods and fiscal tax years.

Filing Separate Tax Returns Differences in the timing of income recognition across consolidated reporting and income tax purposes create deferred tax assets and/or liabilities. These temporary differences may occur due to (1) the immediate taxation of unrealized intra-entity gains (and losses) and (2) possible future tax effects of subsidiary income in excess of dividend payments. Differences in the timing of income recognition across consolidated reporting and income tax purposes create deferred tax assets and/or liabilities. These temporary differences may occur due to (1) the immediate taxation of unrealized intra-entity gains (and losses) and (2) possible future tax effects of subsidiary income in excess of dividend payments.

Temporary Differences Generated by Business Combinations Learning Objective 7-7: Determine the deferred tax consequences for temporary differences generated when a business combination is created. A business combination can create temporary differences due to differences in tax bases and book value stemming from the takeover. Resulting book values of acquired company’s assets and liabilities may differ from their tax bases because the subsidiary’s cost is retained for tax purposes (in tax-free exchanges). Allocations for tax purposes may vary from those used for financial reporting (taxable transactions). A business combination can create temporary differences due to differences in tax bases and book value stemming from the takeover. In most purchases, resulting book values of acquired company’s assets and liabilities differ from their tax bases because: Subsidiary’s cost is retained for tax purposes (in tax-free exchanges) Allocations for tax purposes vary from those used for financial reporting (found in taxable transactions).

Business Combinations and Operating Loss Carryforwards Learning Objective 7-8: Explain the impact that a net operating loss of an acquired affiliate has on consolidated figures. Net operating losses for companies may be carried back for two years and/or forward for twenty years. Because some acquisitions appeared to be done 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.) Net operating losses for companies may be carried back for two years and/or forward for twenty years Because some acquisitions appeared to be done 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.)

IFRS and U.S. GAAP Differences U.S. GAAP prohibits the recognition of unrealized intra-entity profits on asset transfers; therefore, the selling firm defers any related current tax effects until the asset is sold to a third party. International Accounting Standard (IAS) 12 requires taxes paid by a selling firm on intra-entity profits to be recognized as incurred and allows tax deferral on differences between the tax bases of assets transferred across entities that remain within the group. U.S. GAAP prohibits the recognition of unrealized intra-entity profits; therefore, the selling firm defers any related current tax effects until the asset is sold to a third party. International Accounting Standard (IAS) 12 requires taxes paid by a selling firm on intra-entity profits to be recognized as incurred and allows tax deferral on differences between the tax bases of assets transferred across entities that remain within the consolidated group.