1. McGraw-Hill/Irwin© 2008 The McGraw-Hill Companies, Inc. All rights reserved. 10 Additional Consolidation Reporting Issues

2. 10-2 Additional Reporting Issues The financial statements of a consolidated entity must be prepared in conformity with generally accepted accounting principles in the same manner as for any individual enterprise. Standards of reporting and presentation are no different for a consolidated entity than for a single-corporate entity.

3. 10-3 Additional Reporting Issues This chapter discusses the following additional consolidation issues : –The consolidated statement of cash flows. –Consolidation following an interim acquisition. –Consolidation tax considerations. –Consolidated earnings per share.

4. 10-4 Statement of Cash Flows Consolidated entities, as with individual companies, must present a statement of cash flows when they issue a complete set of financial statements.

5. 10-5 Statement of Cash Flows A consolidated statement of cash flows is similar to a statement of cash flows prepared for a single-corporate entity and is prepared in basically the same manner.

6. 10-6 Statement of Cash Flows A consolidated statement of cash flows is typically prepared after the consolidated income statement, retained earnings statement, and balance sheet.

7. 10-7 Statement of Cash Flows Rather than being included in the three- part consolidation work paper, the consolidated cash flow statement is prepared from the information in the other three statements.

8. 10-8 Statement of Cash Flows When an indirect approach is used, preparation of a consolidated statement of cash flows requires only a few adjustments.

9. 10-9 Statement of Cash Flows Such as for depreciation and amortization resulting from the write-off of a purchase differential. Beyond those used in preparing a cash flow statement for an individual company.

10. 10-10 Statement of Cash Flows While the sale or purchase of assets is a source or use of cash to an individual company, if such activities occur entirely within the consolidated entity, they should not be included in the statement of cash flows.

11. 10-11 Statement of Cash Flows As in the other consolidated financial statements, all transfers (and the related unrealized profits, if applicable) should be eliminated in preparing the consolidated statement of cash flows.

12. 10-12 Statement of Cash Flows Income assigned to the noncontrolling interest is deducted in computing consolidated net income but does not represent an outflow of cash.

13. 10-13 Statement of Cash Flows Therefore, income assigned to the noncontrolling interest is added back to consolidated net income in the consolidated statement of cash flows to derive the cash flow from operating activities.

14. 10-14 Statement of Cash Flows Receipt from and payments to noncontrolling shareholders usually are included in the consolidated cash flow statement as cash flows related to financing activities (e.g., dividend payments to noncontrolling shareholders normally are included as a use of cash).

15. 10-15 Statement of Cash Flows A sale of additional shares to noncontrolling shareholders or a repurchase of shares from them is considered to be a transaction with a nonaffiliate and is reported as a source or use of cash.

16. 10-16 Interim Acquisition When one company purchases another company’s common stock, the subsidiary is viewed as being part of the consolidated entity only from the time the stock is acquired. Consequently, when a subsidiary is purchased during a fiscal period rather than at the beginning or end, the results of the subsidiary’s operations are included in the consolidated statements only for the portion of the year that the stock is owned by the parent.

17. 10-17 Interim Acquisition When one company purchases another company’s common stock, the subsidiary is viewed as being part of the consolidated entity only from the time the stock is acquired.

18. 10-18 Interim Acquisition Consequently, when a subsidiary is purchased during a fiscal period rather than at the beginning or end, the results of the subsidiary’s operations are included in the consolidated statements only for the portion of the year that the stock is owned by the parent.

19. 10-19 Interim Acquisition ARB 51 expresses a preference for the following method of reporting the results of operations for a subsidiary purchased during the fiscal period. [Continued on next slide]

20. 10-20 Interim Acquisition Include in the consolidated income statement the revenue and expenses of the subsidiary as if it had been acquired at the beginning of the fiscal period, and deduct the parent’s share of the subsidiary’ preacquisition earnings at the bottom of the consolidated income statement.

21. 10-21 Interim Acquisition Another method to report the results of operations for a subsidiary purchased during the fiscal year would be as follows. –Include in the consolidated income statement only the subsidiary’s revenue earned and expenses incurred subsequent to the date of combination.

22. 10-22 Income Tax Issues A parent company and its subsidiaries may file a consolidated tax return, or they may choose to file separate returns. For a subsidiary to be eligible to be included in a consolidated tax return, at least 80 percent of its stock must be held by the parent company or another company included in the consolidated return.

23. 10-23 Income Tax Issues A major advantage of filing a consolidated return is the ability to offset the losses of one company against the profits of another. In addition, dividends and other transfers between the affiliated companies are not taxed.

24. 10-24 Income Tax Issues Thus, tax payments on profits from intercompany transfers can be delayed until the intercompany profits are realized through transactions with nonaffilitates.

25. 10-25 Income Tax Issues When separate returns are filed, the selling company is required to pay tax on intercompany profits it has recognized, whether or not the profits are realized from a consolidated viewpoint.

26. 10-26 Income Tax Issues Filing a consolidated return also may make it possible to avoid limits on the use of certain items such as foreign tax credits and charitable contributions.

27. 10-27 Income Tax Issues An election to file a consolidated income tax return carries with it certain limitations. Once an election is made to include a subsidiary in the consolidated return, the company cannot file separate tax returns in the future unless it receives approval from the Internal Revenue Service.

28. 10-28 Income Tax Issues The subsidiary’s tax year also must be brought into conformity with the parent’s tax year. In addition, preparing a consolidated tax return can become quite difficult when numerous companies are involved and complex ownership arrangements exist between the companies.

29. 10-29 Income Tax Issues Two consolidation financial reporting issues relating to income taxes are discussed in this chapter: Allocation of income tax amounts from a consolidated tax return to the individual companies. The tax effects of unrealized intercompany profit eliminations.

30. 10-30 Allocating Tax Expense A consolidated tax return portrays the companies included in the return as if they actually were a single legal entity. All intercorporate transfers of goods and services and intercompany dividends are eliminated and a single income tax figure is assessed when a consolidated return is prepared.

31. 10-31 Allocating Tax Expense Consolidated companies sometimes need to prepare separate financial statements for noncontrolling shareholders and creditors.

32. 10-32 Allocating Tax Expense Because only a single income tax amount is determined for the consolidated entity when a consolidated tax return is filed, income tax expense must be assigned to the individual companies included in the return in some manner.

33. 10-33 Allocating Tax Expense While no authoritative pronouncements specify the assignment of consolidated income tax expense to the individual companies included in the consolidated tax return.

34. 10-34 Allocating Tax Expense A reasonable approach is to allocate consolidated income tax expense among the companies on the basis of their relative contributions to income before taxes.

35. 10-35 Unrealized Intercompany Profits The income tax effects of unrealized inter- company profit eliminations depend on whether the companies within the consolidated entity file a consolidated tax return or separate tax returns.

36. 10-36 Unrealized Intercompany Profits For consolidating companies filing separate tax returns, income tax expense is recognized in the consolidated income statement when the associated transaction is recognized by the consolidated entity, not necessarily when it is reported by an individual company.

37. 10-37 Unrealized Intercompany Profits If an intercompany gain or loss is included in an individual company’s tax return in a different period from the one in which it is included in the consolidated income statement, deferred income taxes should be recognized on the temporary difference.

38. 10-38 Consolidated Earnings per Share In general, consolidated earnings per share is calculated in the same way as earnings per share for a single corporation.

39. 10-39 Consolidated Earnings per Share Basic consolidated EPS is equal to consolidated net income available to the parent’s common stockholders (i.e., after deducting any preferred dividends of the parent) divided by the weighted average number of the parent’s common shares outstanding during the period.

40. 10-40 Consolidated Earnings per Share The computation of diluted consolidated EPS is more complicated. A subsidiary’s contribution to the diluted EPS number may be different from its contribution to consolidated net income because of different underlying assumptions.

41. 10-41 Consolidated Earnings per Share In the computation of EPS, the parent’s percentage of ownership frequently is changed when a subsidiary’s convertible bonds and preferred stock are treated as common stock and its options and warrants are treated as if they had been exercised.

42. 10-42 Consolidated Earnings per Share In addition, income available to common shareholders of the subsidiary changes when bonds and preferred stock are treated as common stock for purposes of computing EPS.

43. 10-43 Consolidated Earnings per Share Interest expense or preferred dividends, if already deducted, must be added back in computing income available to common shareholders when the securities are considered to be common stock.

44. 10-44 Summary--Cash Flow In addition to an income statement, balance and statement of retained earnings, a full set of consolidated financial statements must include a consolidated statement of cash flows.

45. 10-45 Summary--Cash Flow The consolidated statement of cash flows is prepared from the other three consolidated statements in the same way as the statement of cash flows is prepared for a single company. However, certain additional adjustments are needed (as indicated on the next slide).

46. 10-46 Summary—Cash Flow For example, income assigned to the noncontrolling interest reduces consolidated net income but does not use cash; it therefore must be added back to net income in deriving cash generated from operating activities.

47. 10-47 Summary—Cash Flow Also, dividends to noncontrolling shareholders must be included as a financing use of cash because they do require the use of cash even though they are not viewed as dividends of the consolidated entity.

48. 10-48 Summary—Interim Acquisition When a subsidiary is purchased at an interim date during the year, the consolidation procedures must ensure that income earned by the subsidiary before it was part of the consolidated entity is not included in the basis for calculating consolidated net income.

49. 10-49 Summary—Interim Acquisition The approach used most frequently is to include the subsidiary’s revenues and expenses for the entire year and then deduct its preacquisition earnings.

50. 10-50 Summary—Tax Allocation Two major financial reporting issues related to income taxes arise in consolidation. The first is concerned with how to allocate income tax expense to individual companies included in a consolidated income tax return.

51. 10-51 Summary—Tax Allocation This issue is important because the allocation impacts the separate financial statements and the amounts assigned to the noncontrolling interests in the consolidated statements.

52. 10-52 Summary—Tax Allocation The second tax issue involves intercorporate transactions. For consolidating companies filing separate tax returns, income tax expense is recognized in the consolidated income statement when the associated transaction is recognized by the consolidated entity, Not necessarily when it is reported by an individual company (see next slide).

53. 10-53 Summary—Tax Allocation If an intercompany gain or loss is included in an individual company’s tax return in a different period from the one in which it is included in the consolidated income statement, deferred income taxes should be recognized on the temporary difference.

54. 10-54 Summary--EPS Consolidated earnings per share is calculated largely in the same way as for a single company. The numerator of the basic EPS computation is based on earnings available to the holders of the parent’s common stock, and the denominator is the weighted average number of the parent’s common shares outstanding during the period.

55. 10-55 Summary--EPS Diluted consolidated EPS assumes both the parent’s and subsidiary’s dilutive securities are converted, and special adjustments to consolidated net income may be needed to reflect the effect of the assumed conversion on the amount of subsidiary income to include in the EPS numerator.

56. 10-56 You will Survive This Chapter !!! This is the last chapter specifically addressing consolidation issues !!!

57. McGraw-Hill/Irwin© 2008 The McGraw-Hill Companies, Inc. All rights reserved. 10 Additional Consolidation Reporting Issues End of Chapter