FISCHER | TAYLOR | CHENG Cash Flows, EPS and Taxation

Learning Objectives 1.Demonstrate an understanding of the effect of a business combination on cash flow in and subsequent to the period of the purchase. 2.Compute earnings per share for a consolidated firm. 3.Calculate and prepare a consolidated worksheet where the consolidated firm is an "affiliated group" and pays a single consolidated tax. 4.Prepare a consolidated worksheet where the parent and subsidiary are separately taxed by employing tax allocation procedures. COPYRIGHT © 2012 South-Western/Cengage Learning 2

Consolidated Cash Flow: Cash Acquisition Reported as –An Investing Activity outflow –Noncash financing and investment activity for the changes in consolidated assets and addition of the NCI COPYRIGHT © 2012 South-Western/Cengage Learning 3

Consolidated Statement of Cash Flows: Cash Acquisition of Controlling Interest COPYRIGHT © 2012 South-Western/Cengage Learning 4 FV: $250,000 FV: $425,000

Consolidated Statement of Cash Flows: Cash Acquisition of Controlling Interest COPYRIGHT © 2012 South-Western/Cengage Learning 5 Cash flows from investing activities: Payment for purchase of Company S, net of cash acquired $(490,000)

Consolidated Statement of Cash Flows: Cash Acquisition of Controlling Interest COPYRIGHT © 2012 South-Western/Cengage Learning 6 Noncash financing and investing activities: Purchased 80% of Company S stock for $540,000; liabilities assumed and NCI created: Assets acquired$825,000 Cash paid(540,000) Noncash$285,000 Liabilities assumed$150,000 NCI$135,000

Consolidated Statement of Cash Flows: Noncash Acquisition of Controlling Interest COPYRIGHT © 2012 South-Western/Cengage Learning 7 Cash flows from investing activities: Cash acquired in purchase of Company S$50,000

Consolidated Statement of Cash Flows: Noncash Acquisition of Controlling Interest COPYRIGHT © 2012 South-Western/Cengage Learning 8 Noncash financing and investing activities: Acquire 80% of Company S stock with issuance of Company P stock valued at $540,000; liabilities assumed and NCI created: Assets acquired$825,000 Common stock issued$540,000 Liabilities assumed$150,000 NCI$135,000

Consolidated Cash Flow: Adjustments Resulting from Business Combinations Noncash expenses –Add back depreciation based on the fair values assigned to the assets on the acquisition date –Add back depreciation of book value recorded by the parent company Purchase additional shares from NCI owners –Financing activity outflow Subsidiary dividend –Dividends paid to NCI are financing activity outflow COPYRIGHT © 2012 South-Western/Cengage Learning 9 Continued…

Consolidated Cash Flow: Adjustments Resulting from Business Combinations Purchase of intercompany bonds –Financing activity outflow COPYRIGHT © 2012 South-Western/Cengage Learning 10

Start with consolidated net income 11 COPYRIGHT © 2012 South- Western/Cengage Learning

Add back depreciation and amortization of excess cost from D&D schedule 12 COPYRIGHT © 2012 South- Western/Cengage Learning

Adjust for changes in current assets and current liabilities 13 COPYRIGHT © 2012 South- Western/Cengage Learning

Subtract excess of equity-method income over dividends received 14 COPYRIGHT © 2012 South- Western/Cengage Learning

Parent’s purchase of equipment for cash 15 COPYRIGHT © 2012 South- Western/Cengage Learning

Parent’s payment of dividends and Dividends paid by Sub to nonaffiliated owners 16 COPYRIGHT © 2012 South- Western/Cengage Learning

Consolidated Earnings Per Share COPYRIGHT © 2012 South-Western/Cengage Learning 17 First, calculate Sub’s EPS (basic and diluted) The parent’s numerator for EPS includes its own internally generated net income plus its share of subsidiary EPS. The parent also adjusts its numerator and denominator for dilutive parent company securities and subsidiary securities that are satisfied by issuing parent company shares.

Basic Earnings Per Share COPYRIGHT © 2012 South-Western/Cengage Learning 18

Diluted Earnings Per Share COPYRIGHT © 2012 South-Western/Cengage Learning 19

Diluted Earnings Per Share COPYRIGHT © 2012 South-Western/Cengage Learning 20 If dilutive subsidiary securities enable the holder to acquire common stock of the parent, these securities are not included in the computation of subsidiary DEPS. However, these securities must be included in the parent's share adjustment in computing consolidated DEPS:

Taxation of the Consolidated Entity Consolidated Return Requires 80% interest plus other IRS criteria No tax on separate books Tax based on “consolidated net income” from consol worksheet Inter-co profits have been eliminated – not taxed Allocate tax back to Parent & Sub books Separate Tax Returns Each firm paid tax on their reported income Parent must pay (and /or accrue) “secondary tax” on share of sub income Intercompany profits have been taxed – requires deferral Interperiod tax allocation techniques are employed COPYRIGHT © 2012 South-Western/Cengage Learning 21

Consolidated Tax Return Neither P nor S has tax provision on books; if there were one, it would be reversed out Consolidating eliminations, prior to tax entry, do not change from prior chapters Take care on parent IDS to avoid taxing sub income again Provision T for tax based on consolidated income –Tax provision on IDS must be recorded on books of P and S COPYRIGHT © 2012 South-Western/Cengage Learning 22

Consolidated Tax Return Scenario: Data 1/1/2011 acquisition 23 COPYRIGHT © 2012 South-Western/Cengage Learning Fiscal Year 2013 Income Statements

Consolidated Tax Return Scenario: Consolidated Tax Provision The portion of excess amortization applicable to the NCI is not deductible Annual amortization $6,250 × 20% = $1,250 NCI portion COPYRIGHT © 2012 South-Western/Cengage Learning 24

Consolidated Tax Return Scenario: Adjustment The nondeductible nature of the NCI share of excess amortizations requires measurement of tax applicable to distributable portions of subsidiary income: COPYRIGHT © 2012 South-Western/Cengage Learning 25

Consolidated Tax Return Scenario: Income Distribution Schedules COPYRIGHT © 2012 South-Western/Cengage Learning 26

Consolidated Tax Return Scenario: Partial Worksheet COPYRIGHT © 2012 South-Western/Cengage Learning 27

Separate Tax Returns Each member of the consolidated group bases its provision for tax on its own reported income Parent’s taxable income may include dividends (income) received from other corporations: DegreeCurrent treatment of of ownershipincome received Greater than 80%exclude 100% 20% to 80%exclude 80% Less than 20%exclude 70% Consolidation process creates timing differences that give rise to DTAs and DTLs COPYRIGHT © 2012 South-Western/Cengage Learning 28 Continued…

Separate Tax Returns T1: Adjust beginning retained earnings and create a deferred tax asset on consolidated prior-period adjustments T2: Adjust current-year tax provision and deferred tax asset for the effects of current-year income adjustments COPYRIGHT © 2012 South-Western/Cengage Learning 29

Separate Tax Returns Scenario: Data 30 1/1/2011 acquisition COPYRIGHT © 2012 South- Western/Cengage Learning Fiscal year 2014 income statements

Separate Tax Returns Scenario: Individual Entity Tax Provisions COPYRIGHT © 2012 South-Western/Cengage Learning 31 Parent income$80,000 Tax rate× 30% Tax on internally generated net income$24,000 Secondary tax on sub net income: Sub NetControllingTaxableTax IncomeInterestPortionRate $42,000 × 75% × 20% × 30%1,890 $25,890 Sub’s tax provision: Operating income$60,000 30% tax rate(18,000) Net income$42,000 Parent’s tax provision: The sum of: Tax on internally generated income Tax on 20% of share of sub’s net income

Separate Tax Returns Scenario: Individual Entity Tax Provisions COPYRIGHT © 2012 South-Western/Cengage Learning 32 Parent’s tax provision: Parent income$80,000 Tax rate× 30% Tax on IGNI$24,000 Secondary tax 1,890 $25,890 Sub’s tax provision: Operating income$60,000 30% tax rate(18,000) Net income$42,000 Provision for Inc Tax18,000 Inc Tax Payable18,000 Provision for Inc Tax25,890 Inc Tax Payable24,000 Deferred Tax Liability1,890

Separate Tax Returns Scenario: T1 : Adjustment to Beginning R/E for Taxes Paid in Prior Periods COPYRIGHT © 2012 South-Western/Cengage Learning 33 T1: Deferred Tax Liabil16,695 Retained Earnings-Par14,895 Retained Earnings-Sub1,800

Separate Tax Returns Scenario: T2 : Tax Effect of Adjustments Made to Current-Year Income COPYRIGHT © 2012 South-Western/Cengage Learning 34 T2: Provision for Inc Taxes4,539 Deferred Tax Liability 4,539

Separate Tax Returns Scenario: Subsidiary Tax & Income Distribution Schedules COPYRIGHT © 2012 South-Western/Cengage Learning 35 $34,650 × 20% × 30%