©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Subsidiary Preferred Stock, Consolidated Earnings per Share, and Consolidated Income Taxation Chapter 10

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Learning Objective 1 Modify consolidation procedures for subsidiary companies with preferred stock in their capital structure.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Subsidiaries with Preferred Stock Outstanding When preferred stock has a call or redemption price, this amount is used in allocating the investee’s equity to preferred stockholders. When preferred stock has a call or redemption price, this amount is used in allocating the investee’s equity to preferred stockholders.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Subsidiaries with Preferred Stock Outstanding If there is no redemption provision, the equity is allocated on the basis of par value plus any liquidation premium. If there is no redemption provision, the equity is allocated on the basis of par value plus any liquidation premium. 1 Any dividends in arrears on cumulative preferred stock is allocated to the preferred stockholders. Any dividends in arrears on cumulative preferred stock is allocated to the preferred stockholders. 2

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Subsidiary With Preferred Stock Not Held by Parent Poe acquired a 90% interest in Sol on January 1, 2004, for $395,500. There were no preferred dividends in arrears as of January 1, During 2004, Sol had income of $50,000 and paid $30,000 dividends. Dividends were $20,000 on common stock and $10,000 on preferred stock.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Subsidiary With Preferred Stock Not Held by Parent $10 preferred stock, $100 par, cumulative, nonparticipating, callable at $105 per share$100,000 Common stock, $10 par 200,000 Other paid-in capital 40,000 Retained earnings 160,000 Total stockholders’ equity$500,000 Sol’s stockholders’ equity December 31, 2003

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Subsidiary With Preferred Stock Not Held by Parent Total Sol stockholders’ equity$500,000 Less: Preferred stockholders’ equity (1,000 × $105)–105,000 Common stockholders’ equity$395,000 Price paid for 90% interest$395,500 Less: Book and fair value acquired ($395,000 × 90%)–355,500 Goodwill$ 40,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Subsidiary With Preferred Stock Not Held by Parent Total stockholders’ equity$520,000 Less: Preferred stockholders’ equity (1,000 × $105)–105,000 Common stockholders’ equity$415,000 Sol’s stockholders’ equity December 31, 2004

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Minority Interest in Preferred Stock $105,000 × 100% of preferred equity$105,000 $415,000 × 10% of common equity 41,500 Total$146,500 Minority interest in Sol at December 31, 2004

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Subsidiary Preferred Stock Acquired by Parent A parent company’s purchase of the outstanding preferred stock of a subsidiary results in a retirement of the stock purchased from the viewpoint of the consolidated entity.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Subsidiary Preferred Stock Acquired by Parent Sol Corporation experienced a loss of $40,000 in What is Sol’s stockholders’ equity at 12/31/2005? $520,000 – $40,000 = $480,000 No dividends were paid.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Subsidiary Preferred Stock Acquired by Parent What is Poe’s share of this loss? ($40,000 + $10,000 income to preferred) × 90% What is Poe’s investment in Sol on 12/31/2005?

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Subsidiary Preferred Stock Acquired by Parent Poe’s Investment 1/1/ ,500 12/31/ ,000 1/1/ , ,500 18,000 45,000 loss Dividends 12/31/2005

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Constructive Retirement of Subsidiary Preferred Stock On January 1, 2006, Poe purchased 800 of Sol’s preferred shares (80% interest) at $100 per share. $115,000 × 80% = $92,000 book value $92,000 – $80,000 = $12,000 Sol reports net income of $20,000 for 2006.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Constructive Retirement of Subsidiary Preferred Stock Investment in Sol Preferred80,000 Cash80,000 To record purchase of stock Investment in Sol Preferred12,000 Other Paid-in Capital12,000 To adjust other paid-in capital to reflect constructive retirement

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Constructive Retirement of Subsidiary Preferred Stock Poe’s Investment 1/1/ ,500 12/31/ ,000 1/1/ , ,500 9, ,500 18,000 45,000 loss Dividends 12/31/2006 Income

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Learning Objective 2 Calculated basic and diluted earnings per share for a consolidated reporting entity.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Parent Company and Consolidated Earnings Per Share GAAP requires that all firms calculate and report basic and diluted (where applicable) earnings per share (EPS). Consolidated entities disclose (EPS) on a consolidated basis.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Parent Company and Consolidated Earnings Per Share A parent company’s net income and EPS under the equity method are equal to consolidated net income and consolidated EPS. Parent Company procedures for computing EPS depend on the subsidiary’s capital structure.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn General Format for EPS Calculations Numerator in Dollars ($) A Income to parent’s common stockholders$$$ Add: Adjustments for parent’sdilutive securities + $ Add: Adjustments for subsidiary’spotentially dilutive securities convertible into parent company stockN/A Replacement calculation Deduct: Parent’s equity in subsidiary’s diluted earningsN/A Add: Parent’s equity in subsidiary’s diluted earningsN/A Parent's diluted earnings = a$$$ A: Subsidiary does not have potentially dilutive securities outstanding

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn General Format for EPS Calculations Numerator in Dollars ($) B Income to parent’s common stockholders$$$ Add: Adjustments for parent’sdilutive securities + $ Add: Adjustments for subsidiary’spotentially dilutive securities convertible into parent company stockN/A Replacement calculation Deduct: Parent’s equity in subsidiary’s diluted earnings – $ Add: Parent’s equity in subsidiary’s diluted earnings + $ Parent's diluted earnings = a$$$ B: Subsidiary has potentially dilutive securities convertible into subsidiary common stock

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn General Format for EPS Calculations Numerator in Dollars ($) C Income to parent’s common stockholders$$$ Add: Adjustments for parent’sdilutive securities + $ Add: Adjustments for subsidiary’spotentially dilutive securities convertible into parent company stock + $ Replacement calculation Deduct: Parent’s equity in subsidiary’s diluted earningsN/A Add: Parent’s equity in subsidiary’s diluted earningsN/A Parent's diluted earnings = a$$$ C: Subsidiary has potentially dilutive securities convertible into parent company common stock

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn General Format for EPS Calculations Denominator in Shares (Y) A Parent’s common shares outstandingYYY Add: Shares represented by parent’s potentially dilutive securities + Y Add: Shares represented by subsidiary’s potentially dilutive securities convertible into parent company common sharesN/A Parent’s common shares and common share equivalents = bYYY Parent Company and Consolidated Diluted EPSa ÷ b A: Subsidiary does not have potentially dilutive securities outstanding

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn General Format for EPS Calculations Denominator in Shares (Y) B Parent’s common shares outstandingYYY Add: Shares represented by parent’s potentially dilutive securities + Y Add: Shares represented by subsidiary’s potentially dilutive securities convertible into parent company common sharesN/A Parent’s common shares and common share equivalents = bYYY Parent Company and Consolidated Diluted EPSa ÷ b B: Subsidiary has potentially dilutive securities convertible into subsidiary common stock

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn General Format for EPS Calculations Denominator in Shares (Y) C Parent’s common shares outstandingYYY Add: Shares represented by parent’s potentially dilutive securities + Y Add: Shares represented by subsidiary’s potentially dilutive securities convertible into parent company common shares + Y Parent’s common shares and common share equivalents = bYYY Parent Company and Consolidated Diluted EPSa ÷ b C: Subsidiary has potentially dilutive securities convertible into parent company common stock

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Dilutive Securities of Subsidiary Convertible into Subsidiary Shares Diluted earnings of the parent company are adjusted by excluding the parent’s equity in subsidiary realized income and replacing that equity with the parent’s share of diluted earnings of the subsidiary.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Subsidiary With Convertible Preferred Stock Plant Corporation purchased 90% of Seed Corporation’s outstanding voting common stock for $328,000 on January 1, During 2003, Seed reports $50,000 net income and pays $25,000 dividends, $10,000 to preferred and $15,000 to common.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Subsidiary With Convertible Preferred Stock Common stock, $5 par, 200,000 shares issued and outstanding$1,000,000 Common stock, $10 par, 20,000 shares outstanding$200,000 10% cumulative, convertible preferred stock, $100 par, 1,000 shares outstanding 100,000 Retained earnings 500, ,000 Total stockholders’ equity$1,500,000$420,000 January 1, 2003 Plant Seed

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Subsidiary With Convertible Preferred Stock Income from Plant’s operations$150,000 Income from Seed ($50,000 – $10,000 preferred income) × 90% 36,000 Plant net income$186,000 Plant’s Income for 2003

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Subsidiary Preferred Stock Convertible into Subsidiary Common Seed’s preferred stock is convertible into 12,000 shares of Seed’s common stock. Neither Plant nor Seed has any other potentially dilutive securities outstanding. Seed’s diluted EPS: $50,000 ÷ (20, ,000) = $1.5625

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Subsidiary Preferred Stock Convertible into Subsidiary Common Net income of Plant$186,000 Replacement of Plant’s equity in Seed’s realized income ($40,000 × 90%) – 36,000 with Plant’s equity in Seed’s diluted earnings (18,000 × $1.5625) 28,125 Plant’s diluted earnings = a$178,125 Plant’s outstanding shares = b 200,000 Plant’s diluted EPS = a ÷ b$ 0.89 Plant’s Diluted EPS

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Subsidiary Preferred Convertible into Parent Company Common Seed’s preferred stock is convertible into 24,000 shares of Plant’s common stock. Neither Plant nor Seed had other potentially dilutive securities outstanding. Seed’s diluted EPS is $2 ($40,000 income to common ÷ 20,000 common shares). What is Plant’s diluted EPS?

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Subsidiary Preferred Convertible into Parent Company Common Net income of Plant$186,000 Add: Income to preferred stockholders of Seed assumed to be converted 10,000 Plant’s diluted earnings = a$196,000 Plant’s outstanding shares 200,000 Add: Seed’s preferred shares assumed converted 24,000 Plant common shares and common stock equivalents = b 224,000 Plant’s diluted EPS = a ÷ b$ 0.88

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Subsidiary With Options and Convertible Bonds Own operations$1,500,000 Syd’s operations$ 300,000 Paddy’s income 2003 Syd is 80% owned by Paddy. 80% × $450,000 Syd net income$360,000 80% × $50,000 unrealized profit – 40,000 Amortization – 20,000 Income from Syd$300,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Subsidiary With Options and Convertible Bonds Paddy: Common stock, 1,000,000 shares Syd: Common stock, 400,000 shares Options to purchase 60,000 shares of stock at $10 per share (average market price is $15 per share) 7% convertible bonds, $1,000,000 par outstanding, convertible into 80,000 shares of common stock

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Options and Bonds Convertible into Subsidiary Common Stock Syd’s income to common stockholders$450,000 Less: Unrealized profit on sale of land – 50,000 Add: Net-of-tax interest expense assuming bonds converted into subsidiary shares ($1,000,000 × 7% × 66% net of tax) 46,200 Subsidiary adjusted earnings = a$446,200

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Options and Bonds Convertible into Subsidiary Common Stock Syd’s common shares outstanding 400,000 Incremental shares 60,000 – ($600,000 ÷ $15) 20,000 Additional shares assuming bonds converted into subsidiary shares 80,000 Syd’s adjusted shares = b 500,000 Syd’s diluted EPS = a ÷ b ($446,200 ÷ 500,000)$ 0.89

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Options and Bonds Convertible into Subsidiary Common Stock Paddy’s income to common stockholders$1,800,000 Replacement of Paddy’s equity in Syd’s realized income ($400,000 × 80%) – 320,000 with Paddy’s equity in Syd’s diluted EPS (320,000 × $0.89) 284,800 Paddy adjusted earnings = a$1,764,800 Paddy outstanding shares = b 1,000,000 Paddy’s diluted EPS = a ÷ b$ 1.76

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Options and Bonds Convertible into Parent’s Common Stock Paddy’s income to common stockholders$1,800,000 Add: Net-of-tax interest expense assuming bonds were converted into shares ($1,000,000 × 7% × 66% net-of-tax effect) 46,200 Paddy’s adjusted earnings = a$1,846,200

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Options and Bonds Convertible into Parent’s Common Stock Paddy’s common shares outstanding 1,000,000 Incremental shares 60,000 – ($600,000 ÷ $15) 20,000 Additional shares assuming bonds are converted into parent shares 80,000 Paddy’s adjusted shares = b 1,100,000 Paddy’s diluted EPS = a ÷ b ($1,846,200 ÷ 1,100,000)$ 1.68

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Learning Objective 3 Understand the complexities of accounting for income taxes by consolidated entities.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Accounting for Income Taxes of Consolidated Entities An affiliated group exists when a common parent corporation owns at least 80% of the voting power of all classes of stock and 80% or more of the total value of all outstanding stock of each of the includable corporations. An affiliated group exists when a common parent corporation owns at least 80% of the voting power of all classes of stock and 80% or more of the total value of all outstanding stock of each of the includable corporations.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Accounting for Income Taxes of Consolidated Entities A consolidated entity that is an affiliated group may elect to file consolidated income tax returns. A consolidated entity that is an affiliated group may elect to file consolidated income tax returns. All other consolidated entities must file separate income tax returns for each affiliated company. All other consolidated entities must file separate income tax returns for each affiliated company.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Advantages of Filing Consolidated Returns 1 Losses are offset against income between members. Losses are offset against income between members. 2 Intercorporate dividends are excluded from taxable income. Intercorporate dividends are excluded from taxable income. 3 Intercompany profits are deferred from income until realized. Intercompany profits are deferred from income until realized.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Disadvantages of Filing Consolidated Returns 1 Decrease in flexibility. 2 Commitment to consolidated returns year after year. Commitment to consolidated returns year after year. 3 Deconsolidated corporations cannot rejoin the group for 5 years. Deconsolidated corporations cannot rejoin the group for 5 years.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Income Tax Allocation FASB Statement No. 109, “Accounting for Income Taxes,” is the primary source of GAAP for accounting for income taxes. Events that have future tax consequences are designated temporary differences.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Income Tax Allocation The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and to recognize deferred tax liabilities and assets for the tax consequences of events that have been recognized in the financial statements or tax returns.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Accounting for Distributed and Undistributed Income Parson owns a 30% interest in Seaton Corporation, a domestic corporation. Seaton reports $600,000 net income and pays dividends of $200,000. The income tax rate is 34%. What is Parson’s share of Seaton’s income?

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Accounting for Distributed and Undistributed Income Share of distributed earnings (dividends) ($200,000 × 30%)$ 60,000 Share of undistributed earnings (retained earnings increase) ($400,000 × 30%) 120,000 Equity in Seaton’s earnings$180,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Accounting for Distributed and Undistributed Income The income tax expense equals income tax liability for the dividends received. $60,000 × 20% taxable × 34% tax rate = $4,080 December 31, 2003 Income Tax Expense8,160 Deferred Income Taxes8,160 To provide for taxes on undistributed earnings ($120,000 × 20% × 34% = $8,160)

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Unrealized Gains and Losses from Intercompany Transactions Unrealized and constructive gains and losses create temporary differences that may affect deferred tax calculations when filing separate income tax returns. This is not the case when filing consolidated returns.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Separate Company Tax Returns with Intercompany Gain Paco Corporation paid $375,000 for a 75% interest in Step on January 1, Step’s equity consisted of $300,000 capital stock and $200,000 retained earnings.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Separate Company Tax Returns with Intercompany Gain Paco had a deferred tax liability of $10,200, consisting of $30,000 tax/book depreciation differences that reverse in equal ($7,500) amounts over the years. On January 8, 2003, Paco sold equipment to Step at a gain of $20,000. Step is depreciating the equipment over five years (S/L).

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Separate Company Tax Returns with Intercompany Gain Sales$380,000$300,000 Gain on equipment sale 20,000 – Income from Step 23,600 – Cost of sales–200,000–180,000 Operating expenses–100,000 – 40,000 Income tax expense – 31,253 – 27,200 Net income$ 92,347$ 52,800 Add: Beginning retained earnings 357, ,000 Deduct: Dividends (December) – 50,000 – 28,000 Retained earnings 12/31/2003$400,000$224,800 12/31/2003 Paco Step

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn One-Line Consolidation January 1, 2003 Investment in Step375,000 Cash375,000 To record purchase of 75% interest December 2003 Cash 21,000 Investment in Step 21,000 To record dividends received

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn One-Line Consolidation December 31, 2003 Investment in Step 23,600 Income from Step 23,600 To record income from Step Paco’s share of Step net income ($52,800 × 75%)$39,600 Less: Unrealized profit–20,000 Add: Piecemeal recognition of gain 4,000 Income from Step$23,600

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Schedule of Deferred Income Tax Liability Temporary Future Difference Years Depreciation$ 7,500 Gain on equipment$20,000 Piecemeal recognition – 4,000– 4,000 Future dividends – 3,720 – $3,720 Taxable in future years$ 3,500 $3,720 Enacted tax rate 34% 34% Deferred tax liability$ 1,190 $1,265

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Business Combination Taxable combination Tax-free reorganization

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Business Combination In a purchase business combination, the cost/book value differential is allocated to the assets and liabilities acquired at gross fair values, and a deferred tax asset or liability is recorded for the related tax effect.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Financial Statement Disclosures for Income Taxes GAPP divides deferred assets or liabilities. CurrentNoncurrent

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Financial Statement Disclosures for Income Taxes GAPP requires disclosure for income tax expense and benefits allocated to: Continuing operations Discontinued operations Extraordinary items Cumulate effect type Prior period adjustments

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn End of Chapter 10