2. ©The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin Chapter 9 Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions

3. 2 Income Taxes in Business Combinations and Consolidations Accounting for income taxes in consolidated financial statements may be subdivided into the following three sections: Income taxes attributable to current fair values of a combinees identifiable net assets. Income taxes attributable to undistributed earnings of subsidiaries. Income taxes attributable to unrealized and realized intercompany profits.

4. 3 Income Taxes Attributable to Current Fair Values of a Combinees Identifiable Net Assets A business combination requiring a revaluation of the combinees identifiable assets under financial accounting may result in the following: Meet the requirements for a tax-free corporate reorganization under the Internal Revenue Code. A new income tax basis may not be required. A temporary difference may result between provisions for depreciation and amortization in the financial statements and income tax returns.

5. 4 Income Taxes Attributable to Undistributed Earnings of Subsidiaries Prior Accounting Standards for income taxes attributable to undistributed earnings of subsidiaries relating to deferred income tax liability were revised in 1992 as under: To be recognized for an excess of the financial reporting carrying amount of an investment in a domestic subsidiary over its tax basis if the excess arose in fiscal years beginning December 15, 1992. Need not be recognized for an excess of the financial reporting carrying amount over the tax basis of an investment in a foreign subsidiary if the excess essentially permanent in duration.

6. 5 Income Taxes Attributable to Intercompany Profits Federal income tax laws permit an affiliated group of corporations to file consolidated tax return. Intercompany profits and losses are eliminated. Note: If a parent company and its subsidiaries do not qualify for the affiliated group status or elect to file separate tax returns, the provisions of FASB Statement No. 109, Accounting for Income Taxes for the recognition of deferred tax asses and liabilities apply.

7. 6 Affiliated Group for Federal Income Tax Affiliated group for federal Income tax means one or more chains of includible corporation connected through stock ownership with a common parent corporation if: Stock possessing at least 80 percent of both, voting power of all classes of stock and each class of nonvoting stock of each of the including corporations (except the common parent corporation) is owned directly by one or more of the other includible corporations. The common parent corporation owns directly stock possessing at least 80 percent of the voting power of all classes of stock and at least 80 percent of each class of the nonvoting stock of at least one of the other includible corporations.

8. 7 Illustration ABC Corp sold goods worth $12000 to its subsidiary Sub Corp at a gross profit of 20% of sales. The following journal entry will be passed for elimination of working paper: Intercompany Sales – ABC12000 Intercompany Cost of Goods sold - ABC9600 Cost of Goods Sold – Sub1600 Inventories – Sub 800

9. 8 Consolidated Statement of Cash Flows Consolidated financial statement issued by publicly owned companies include a statement of cash flows which may present the following problems: Depreciation and amortization expense. Cash dividends. Cash acquisition. Cash Sale of part of Investment in subsidiary.

10. 9 Cash Flow Difficulties Relating to Depreciation and Amortization Expense While preparing consolidated statement of cash flows: Depreciation and amortization expense, based on current fair values of assets including any goodwill of subsidiaries on the date of business combination is added to consolidated income. Net income applicable to minority interest is included in the computation of net cash provided by operating activities as 100% of the cash of all subsidiaries is included in a consolidated balance sheet.

11. 10 Cash Flow Difficulties Relating to Cash Dividends Reported cash flows from financing activities include cash dividends paid by parent company and partially owned subsidiary companies to minority stockholders. Cash dividend paid by subsidiaries to the parent company have no effect on the consolidated statement of cash flows. Note: Dividend paid to minority stockholders that are material in amount may be disclosed separately in the consolidated statement of cash flows.

12. 11 Cash Flow Difficulties Relating to Cash Acquisition Cash acquisition of additional shares of common stock by the parent company has the following effects: Acquisition directly from the subsidiary: No change in the amount of consolidated cash, hence not reported. Acquisition from Minority Stockholders: Reduces consolidated cash, hence reported in the cash flows from investing activities section.

13. 12 Cash Flow Difficulties Relating to Cash Sale of part of Investment in subsidiary A cash sale of a portion of an investment in the subsidiary company increases consolidated cash flow and is required to be reported in the cash flows from investing activities section. A gain/loss from such a sale is represented as an adjustment of consolidated net income of the parent company and its subsidiaries and is reflected in the net cash flow from operating activities.

14. 13 Installment Acquisition of Subsidiary A parent company may obtain control of a subsidiary in: –A series of installment acquisitions of the subsidiarys common stock. –In a single transaction constituting a business combination. Installment acquisitions require application of accounting standards applicable to influenced investees and controlled subsidiaries.

15. 14 Installment Acquisition of Subsidiary During the installment acquisition process the fair value of the subsidiarys identifiable net asset is determined: On the day the parent company attains control of the subsidiary. By the equity method of accounting enabling the investor to influence the operating and financial policies of the investee in accordance with the generally accepted accounting principles. Note: Generally, the presumed common stock investment for exercising significant operating and financial influence over the investee is 20%.