© The McGraw-Hill Companies, Inc., 2004 Slide 7-1 McGraw-Hill/Irwin Chapter Seven Consolidated Financial Statements – Ownership Patterns and Income Taxes 1. Indirect Subsidiary Control 2. Mutual Ownership 3. Income Tax Accounting for a Business Combination

© The McGraw-Hill Companies, Inc., 2004 Slide 7-2 McGraw-Hill/Irwin 1. Indirect Subsidiary Control 80% Ownership Father Son Grandson 70% Ownership Father-Son- Grandson relationships occur when the parent controls a subsidiary that controls other subsidiaries.

© The McGraw-Hill Companies, Inc., 2004 Slide 7-3 McGraw-Hill/Irwin In effect, the Father company indirectly controls ALL of the subsidiaries in the chain. Indirect Subsidiary Control 80% Ownership Father Son Grandson 70% Ownership

© The McGraw-Hill Companies, Inc., 2004 Slide 7-4 McGraw-Hill/Irwin Be sure to always start from the bottom and work up to the parent company. Consolidation When Indirect Control Is Present  Compute realized income for the “grandson”.  Compute consolidated income for the “son” and “grandson”.  Compute consolidated income for the “father” and the “son”.

© The McGraw-Hill Companies, Inc., 2004 Slide 7-5 McGraw-Hill/Irwin Be sure to always start from the bottom and work up to the parent company. Consolidation When Indirect Control Is Present  Compute realized income for the “grandson”.  Compute consolidated income for the “son” and “grandson”.  Compute consolidated income for the “father” and the “son”. Let’s look at an example from your text.

© The McGraw-Hill Companies, Inc., 2004 Slide 7-6 McGraw-Hill/Irwin Indirect Control Example Determine consolidated income for the business combination by: Combining Midway and Bottom to determine Midway’s realized income. Combining Top with the realized income from Midway. Determine consolidated income for the business combination by: Combining Midway and Bottom to determine Midway’s realized income. Combining Top with the realized income from Midway. 70% Ownership Top Co. Midway Co. Bottom Co. 60% Ownership

© The McGraw-Hill Companies, Inc., 2004 Slide 7-7 McGraw-Hill/Irwin 2004 Income Figures For Each Company Indirect Control Example

© The McGraw-Hill Companies, Inc., 2004 Slide 7-8 McGraw-Hill/Irwin 2004 Income Figures For Each Company Indirect Control Example After adjusting for intercompany income, Bottom Co.’s realized income is $80,000. Midway gets 60% of $80,000. After adjusting for intercompany income, Bottom Co.’s realized income is $80,000. Midway gets 60% of $80,000.

© The McGraw-Hill Companies, Inc., 2004 Slide 7-9 McGraw-Hill/Irwin 2004 Income Figures For Each Company Indirect Control Example

© The McGraw-Hill Companies, Inc., 2004 Slide 7-10 McGraw-Hill/Irwin 2004 Income Figures For Each Company Indirect Control Example

© The McGraw-Hill Companies, Inc., 2004 Slide 7-11 McGraw-Hill/Irwin 2004 Income Figures For Each Company Indirect Control Example

© The McGraw-Hill Companies, Inc., 2004 Slide 7-12 McGraw-Hill/Irwin Consolidation Process Indirect Control The consolidation process requires making the consolidation entries for: Each son/grandson relationship, and then Each father/son relationship.

© The McGraw-Hill Companies, Inc., 2004 Slide 7-13 McGraw-Hill/Irwin Consolidation Process Indirect Control Using the consolidation entries previously described is sufficient to complete the father- son-grandson combination. Essentially, the entries are duplicated for each relationship.

© The McGraw-Hill Companies, Inc., 2004 Slide 7-14 McGraw-Hill/Irwin Consolidation Process Indirect Control Requires a separate computation for the “son” and the “grandson.” Compute realized income for each company, starting with the “grandson.” Requires a separate computation for the “son” and the “grandson.” Compute realized income for each company, starting with the “grandson.” Consolidation entries to the retained earnings account of son always updates son’s retained earnings. This is obvious but it is very important when a method other full equity method is being used. That is, the effect of the “C” entry must be taken into account See exercise 30, page 360 (Part a only)

© The McGraw-Hill Companies, Inc., 2004 Slide 7-15 McGraw-Hill/Irwin Indirect Subsidiary Control Connecting Affiliation Low Company Side Company 70% owned 30% owned 45% owned The combination of the parent’s DIRECT ownership and INDIRECT ownership can result in control of a subsidiary. High Company In this case, High controls Side directly with 70% ownership, and Low indirectly with 61.5% effective ownership. ( 30% + [ 70% x 45% ]) In this case, High controls Side directly with 70% ownership, and Low indirectly with 61.5% effective ownership. ( 30% + [ 70% x 45% ])

© The McGraw-Hill Companies, Inc., 2004 Slide 7-16 McGraw-Hill/Irwin Indirect Subsidiary Control Connecting Affiliation Basic Consolidation Rules Still Hold: Eliminate effects of intercompany transfers. Eliminate sub’s beginning equity balances. Adjust for unamortized FMV adjustments. Record Amortization Expense. Remove intercompany income and dividends. Compute and record noncontrolling interest in subsidiaries’ net income. The sequence of consolidation process is as follows: Consolidate direct subsidiary chain first (starting with “Grandson”) then Consolidate “father” indirect interest in “grandson” E.g. in this case, consolidate:  Son-grandson (Side-Low)  Father-son (High-Side)  Father-grandson (High-Low)

© The McGraw-Hill Companies, Inc., 2004 Slide 7-17 McGraw-Hill/Irwin Up Company Down Company 90% owned 20% owned 2.Mutual Ownership Occurs when the subsidiary owns shares of the parent. Two methods can be used to account for the mutually owned shares: a) Treasury Stock Approach b) Conventional Approach

© The McGraw-Hill Companies, Inc., 2004 Slide 7-18 McGraw-Hill/Irwin Mutual Ownership a) Treasury Stock Approach The predominant approach in practice. (simpler) The cost of the parent shares held by the subsidiary are reclassified on the worksheet to Treasury Stock. Intercompany dividends on shares of the parent that are owned by the subsidiary are eliminated as an intercompany cash transfer.

© The McGraw-Hill Companies, Inc., 2004 Slide 7-19 McGraw-Hill/Irwin Mutual Ownership b) Conventional Approach Treats each investment independently. Both investments must be treated the same. Requires the use of simultaneous equations to compute realized* income for the parent and the subsidiary. A “Parent’s” Realized income = “Parent’s” own operating income (adjusted for amortization) + Equity Income Accrual of “Sub”

© The McGraw-Hill Companies, Inc., 2004 Slide 7-20 McGraw-Hill/Irwin Mutual Ownership b) Conventional Approach (Cont’d) Under this approach, the computation of realized income for the parent (PRI) and the subsidiary (SRI) requires the use of simultaneous equations: SRI = Sub’s Operating NI + Sub’s % of PRI PRI = Parent’s Operating NI + Parent’s % of SRI Under this approach, the computation of realized income for the parent (PRI) and the subsidiary (SRI) requires the use of simultaneous equations: SRI = Sub’s Operating NI + Sub’s % of PRI PRI = Parent’s Operating NI + Parent’s % of SRI Noncontrolling Interest in Subsidiary NI is based on the Parent’s % of SRI.

© The McGraw-Hill Companies, Inc., 2004 Slide 7-21 McGraw-Hill/Irwin b) Conventional Approach - Example Brother Inc. owns 80% of Cousin. In 2005, Brother has net operating income of $400,000. There is also $4,000 of amortization expenses related to Brother’s acquisition of Cousin. Cousin owns 20% of Brother, Inc. In 2005, Cousin has net operating income of $120,000. Compute each company’s realized income? Brother Inc. owns 80% of Cousin. In 2005, Brother has net operating income of $400,000. There is also $4,000 of amortization expenses related to Brother’s acquisition of Cousin. Cousin owns 20% of Brother, Inc. In 2005, Cousin has net operating income of $120,000. Compute each company’s realized income? Continue

© The McGraw-Hill Companies, Inc., 2004 Slide 7-22 McGraw-Hill/Irwin b) Conventional Approach - Example Substitute the PRI equation into the SRI equation.

© The McGraw-Hill Companies, Inc., 2004 Slide 7-23 McGraw-Hill/Irwin b) Conventional Approach - Example Substitute the PRI equation into the SRI equation.

© The McGraw-Hill Companies, Inc., 2004 Slide 7-24 McGraw-Hill/Irwin b) Conventional Approach - Example Substitute the PRI equation into the SRI equation. See exercise 31, page 361

© The McGraw-Hill Companies, Inc., 2004 Slide 7-25 McGraw-Hill/Irwin 3. Income Tax Accounting for a Business Combination Business combinations may elect to file a consolidated federal tax return for all companies composing an affiliated group. The affiliated group will likely exclude some members of the business combination. Business combinations may elect to file a consolidated federal tax return for all companies composing an affiliated group. The affiliated group will likely exclude some members of the business combination.

© The McGraw-Hill Companies, Inc., 2004 Slide 7-26 McGraw-Hill/Irwin Income Tax Accounting for a Business Combination Affiliated Group = The parent company + Any (domestic) subsidiary where the parent owns 80% of the voting stock AND 80% of each class of nonvoting stock. All others must file separately. Affiliated Group = The parent company + Any (domestic) subsidiary where the parent owns 80% of the voting stock AND 80% of each class of nonvoting stock. All others must file separately.

© The McGraw-Hill Companies, Inc., 2004 Slide 7-27 McGraw-Hill/Irwin Benefits of Using an Affiliated Group Intercompany profits are not taxed until realized. Intercompany dividends are non-taxable. Losses of one affiliated group member can be used to offset income earned by another group member. Intercompany profits are not taxed until realized. Intercompany dividends are non-taxable. Losses of one affiliated group member can be used to offset income earned by another group member.

© The McGraw-Hill Companies, Inc., 2004 Slide 7-28 McGraw-Hill/Irwin Income Tax Accounting: Deferred Income Taxes The tax consequences are often dependent on whether separate or consolidated returns are filed. Transactions affected: 1. Intercompany Dividends 2. Goodwill 3. Unrealized Intercompany Gains

© The McGraw-Hill Companies, Inc., 2004 Slide 7-29 McGraw-Hill/Irwin 1. Intercompany Dividends a) For accounting purposes, all intercompany dividends are eliminated. b) For tax purposes, dividends are NOT eliminated if ownership is < 80%. c) In such a case, a tax liability (on 20% of the dividend) is immediately created for the recipient. d) A deferred tax liability is also required for the parent’s share of any of the subsidiary’s income not paid currently as dividend i.e. the retained portion. (even if reversal is not apparent) e) An exception to d): If the subsidiary is foreign, a deferred tax liability should not be created unless its reversal is apparent Income Tax Accounting: Deferred Income Taxes

© The McGraw-Hill Companies, Inc., 2004 Slide 7-30 McGraw-Hill/Irwin 2. Amortization of Goodwill a) The Revenue Reconciliation Act of 1993 allows amortization of Goodwill over 15 years for tax purposes. b) SFAS No. 142 prohibits amortization of Goodwill for financial reporting purposes, but an impairment test could result in reduced goodwill, therefore c) A deferred tax liability must be recognized. 2. Amortization of Goodwill a) The Revenue Reconciliation Act of 1993 allows amortization of Goodwill over 15 years for tax purposes. b) SFAS No. 142 prohibits amortization of Goodwill for financial reporting purposes, but an impairment test could result in reduced goodwill, therefore c) A deferred tax liability must be recognized. Income Tax Accounting: Deferred Income Taxes

© The McGraw-Hill Companies, Inc., 2004 Slide 7-31 McGraw-Hill/Irwin 3. Unrealized Intercompany Gains a) If consolidated returns are filed, the gains are also removed, until realized. b) If separate returns are filed, the gains must be reported in the period of transfer. c) This “prepayment” of taxes on the unrealized gains in b) above creates a deferred income tax asset. 3. Unrealized Intercompany Gains a) If consolidated returns are filed, the gains are also removed, until realized. b) If separate returns are filed, the gains must be reported in the period of transfer. c) This “prepayment” of taxes on the unrealized gains in b) above creates a deferred income tax asset. Income Tax Accounting: Deferred Income Taxes

© The McGraw-Hill Companies, Inc., 2004 Slide 7-32 McGraw-Hill/Irwin Assigning Income Tax Expense

© The McGraw-Hill Companies, Inc., 2004 Slide 7-33 McGraw-Hill/Irwin Assigning Income Tax Expense Taxable Income See exercise 30, page 360 (Parts b -d)

© The McGraw-Hill Companies, Inc., 2004 Slide 7-34 McGraw-Hill/Irwin A liability (DTL) or asset (DTA) should be recognised for the deferred tax consequences of the differences between the assigned values (FMV) and the tax bases (e.g. BV) of the assets and liabilities recognised in a purchase combinations. If the FMV exceeds the tax base, then a DTL is required. This DTL will reduce the BV of the acquired company, hence increase the Goodwill (if any) Income Tax Accounting: Temporary differences generated by business combinations

© The McGraw-Hill Companies, Inc., 2004 Slide 7-35 McGraw-Hill/Irwin Previously, the NOL of an acquired subsidiary could be (and was) used to offset the profits of a parent company. However, US Laws have now been changed so that virtually all of a NOL carryfoward can be used only by the company that reported the loss. A valuation allowance to this DTA (created by the NOL) is required if future profits are 50% or less likely to occur.  If future taxes are successfully reduced by this NOL, SFAS109 requires that these subsequent benefits be recorded as a reduction to goodwill. If Goodwill becomes zero, then and only then, may income tax expense may be reduced e.g. Dr. Valuation Allowance & Cr. Goodwill or –Dr. Valuation Allowance & Cr. Income Tax Expense Income Tax Accounting: Business combinations & NOL

© The McGraw-Hill Companies, Inc., 2004 Slide 7-36 McGraw-Hill/Irwin Our grandson is so good to send us dividends on our share of his company each year! End of Chapter 7