© The McGraw-Hill Companies, Inc., 2001 Slide 7-1 McGraw-Hill/Irwin 7 C H A P T E R Ownership Patterns and Income Taxes Updated Sixth Edition

© The McGraw-Hill Companies, Inc., 2001 Slide 7-2 McGraw-Hill/Irwin Indirect Subsidiary Control Father-Son-Grandson relationships occur when the parent controls a subsidiary that controls other subsidiaries. 80% Ownership Father Son Grandson 70% Ownership

© The McGraw-Hill Companies, Inc., 2001 Slide 7-3 McGraw-Hill/Irwin Indirect Subsidiary Control In effect, the Father company indirectly controls ALL of the subsidiaries in the chain. 80% Ownership Father Son Grandson 70% Ownership

© The McGraw-Hill Companies, Inc., 2001 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”. Let’s look at an example from your text.

© The McGraw-Hill Companies, Inc., 2001 Slide 7-5 McGraw-Hill/Irwin Determine consolidated income for the business combination by: Ê Combining Midway and Bottom to determine Midway’s realized income. Ë Combining Top with the realized income from Midway. Determine consolidated income for the business combination by: Ê Combining Midway and Bottom to determine Midway’s realized income. Ë Combining Top with the realized income from Midway. Indirect Control Example 70% Ownership Top Co. Midway Co. Bottom Co. 60% Ownership

© The McGraw-Hill Companies, Inc., 2001 Slide 7-6 McGraw-Hill/Irwin 2000 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., 2001 Slide 7-7 McGraw-Hill/Irwin 2000 Income Figures For Each Company Indirect Control Example

© The McGraw-Hill Companies, Inc., 2001 Slide 7-8 McGraw-Hill/Irwin 2000 Income Figures For Each Company Indirect Control Example

© The McGraw-Hill Companies, Inc., 2001 Slide 7-9 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., 2001 Slide 7-10 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., 2001 Slide 7-11 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

© The McGraw-Hill Companies, Inc., 2001 Slide 7-12 McGraw-Hill/Irwin Indirect Subsidiary Control Connecting Affiliation In this case, High controls Side directly with 70% ownership, and Low indirectly with 61.5% effective ownership. Low Company Side Company 70% owned 30% owned 45% owned High Company

© The McGraw-Hill Companies, Inc., 2001 Slide 7-13 McGraw-Hill/Irwin In this case, High controls Side directly with 70% ownership, and Low indirectly with 61.5% effective ownership. 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. Record noncontrolling interest.

© The McGraw-Hill Companies, Inc., 2001 Slide 7-14 McGraw-Hill/Irwin Up Company Down Company 90% owned 20% owned Mutual Ownership Occurs when the subsidiary owns shares of the parent. Two methods can be used to account for the mutually owned shares:  Treasury Stock Approach  Conventional Approach

© The McGraw-Hill Companies, Inc., 2001 Slide 7-15 McGraw-Hill/Irwin Mutual Ownership Treasury Stock Approach The predominant approach in practice. The cost of the parent shares held by the subsidiary are reclassified on the worksheet to Treasury Stock.

© The McGraw-Hill Companies, Inc., 2001 Slide 7-16 McGraw-Hill/Irwin Mutual Ownership Conventional Approach Treats each investment independently. Applies the equity accounting rules. Requires the use of simultaneous equations to compute realized income for the parent and the sub.

© The McGraw-Hill Companies, Inc., 2001 Slide 7-17 McGraw-Hill/Irwin 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., 2001 Slide 7-18 McGraw-Hill/Irwin Income Tax Accounting for a Business Combination Affiliated Group = The parent company + Any 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 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., 2001 Slide 7-19 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., 2001 Slide 7-20 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: Intercompany Dividends Goodwill Unrealized Intercompany Gains

© The McGraw-Hill Companies, Inc., 2001 Slide 7-21 McGraw-Hill/Irwin Income Tax Accounting Deferred Income Taxes Intercompany Dividends For accounting purposes, all intercompany dividends are eliminated. For tax purposes, dividends are NOT eliminated if ownership is < 80%. A deferred tax liability is created based on the uneliminated difference.

© The McGraw-Hill Companies, Inc., 2001 Slide 7-22 McGraw-Hill/Irwin Income Tax Accounting Deferred Income Taxes Amortization of Goodwill The Revenue Reconciliation Act of 1993 allows amortization of Goodwill over 15 years for tax purposes. SFAS No. 142 prohibits amortization of Goodwill for financial reporting purposes. A permanent deferred tax liability must be recognized. Amortization of Goodwill The Revenue Reconciliation Act of 1993 allows amortization of Goodwill over 15 years for tax purposes. SFAS No. 142 prohibits amortization of Goodwill for financial reporting purposes. A permanent deferred tax liability must be recognized.

© The McGraw-Hill Companies, Inc., 2001 Slide 7-23 McGraw-Hill/Irwin Income Tax Accounting Deferred Income Taxes Unrealized Intercompany Gains If separate returns are filed, the gains must be reported in the period of transfer. The “prepayment” of taxes on the unrealized gains creates a deferred income tax asset. Unrealized Intercompany Gains If separate returns are filed, the gains must be reported in the period of transfer. The “prepayment” of taxes on the unrealized gains creates a deferred income tax asset.

© The McGraw-Hill Companies, Inc., 2001 Slide 7-24 McGraw-Hill/Irwin Assigning Income Tax Expense

© The McGraw-Hill Companies, Inc., 2001 Slide 7-25 McGraw-Hill/Irwin Assigning Income Tax Expense

© The McGraw-Hill Companies, Inc., 2001 Slide 7-26 McGraw-Hill/Irwin Our grandson is so good to send us dividends on our share of his company each year! End of Chapter 7