Chapter Seven Consolidated Financial Statements - Ownership Patterns and Income Taxes Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Indirect Subsidiary Control LO 1 Bottom Company Midway Company Top Company 70% 60% Assume three companies form a business combination: Top Company owns 70% of Midway Company, which owns 60% of Bottom Company. Top controls both subsidiaries, although the parent’s Relationship with Bottom is only of an indirect nature. 7-2

Consolidation When Indirect Control is Present When a parent controls a subsidiary which in turn controls other firms, a “pyramid” or “father-son- grandson” relationship exists. To consolidate: start from the bottom of the “pyramid” and work upwards. 1. Recognize realized income of “grandson(s)” 2. Use this to consolidate the “son” and “grandson(s)” financial information (take care to calculate any noncontrolling interest) 3. Finally, consolidate the “son(s)” and parent in the same manner. 7-3

Indirect Subsidiary Control – Connecting Affiliation A connecting affiliation exists when two or more companies within a business combination own an interest in another member of the organization. High Company 70% 30% ownership ownership Side Low Company 45% Company ownership LO 2 7-4

Indirect Subsidiary Control – Connecting Affiliation Basic Consolidation Rules Still Hold:  Eliminate effects of intra-entity transfers.  Adjust parent’s beginning R/E to recognize prior period ownership.  Eliminate sub’s beginning equity balances.  Adjust for unamortized FV adjustments.  Record Amortization Expense.  Remove intra-entity income and dividends.  Compute and record noncontrolling interest in subsidiaries’ net income. 7-5

Mutual Ownership Mutual ownership occurs when two companies within a business combination hold an equity interest in each other. GAAP recommends that “shares of the parent held by the subsidiary should be eliminated in consolidated financial statements.” The shares are not “outstanding” because they are not held by parties outside the combination. The Treasury Stock Approach is used to account for the mutually owned shares. LO 3 7-6

Mutual Ownership There is no accounting distinction between a parent owning stock of a subsidiary, or a subsidiary owning stock of a parent – they are both intra-entity stock ownership. The cost of the parent shares held by the subsidiary is reclassified on the worksheet into Treasury Stock. Intra-entity dividends on shares of the parent owned by the subsidiary are eliminated as an intra- entity cash transfer. 7-7

Income Tax Accounting for a Business Combination Business combinations may elect to file a consolidated federal tax return for all companies of an affiliated group. The affiliated group (as defined by the IRS) will likely exclude some members of the business combination. LO 4 7-8

Income Tax Accounting for a Business Combination Affiliated Group = The parent company + Any domestic subsidiary where the parent owns 80% or more of the voting stock AND 80% of each class of nonvoting stock.  All others must file separately (including any foreign subsidiaries.) 7-9

Income Tax Accounting for a Business Combination Intra-entity profits are not taxed until realized. Intra-entity dividends are nontaxable (regardless of filing a consolidated return). Losses of one affiliated group member can be used to offset taxable income earned by another group member. 7-10

Income Tax Accounting – Deferred Income Taxes Tax consequences are often dependent on whether separate or consolidated returns are filed. Transactions affected: Intra-entity Dividends Goodwill Unrealized Intra-entity Gains LO

Income Tax Accounting – Deferred Income Taxes Intra-entity Dividends For accounting purposes, all intra-entity dividends are eliminated. For tax purposes, dividends are removed from income if at least 80 percent of the subsidiary’s stock is held. (20% is taxable.) If less than 80 percent of a subsidiary’s stock is held, tax recognition is necessary. A deferred tax liability is created for any of sub’s income not paid currently as a dividend. 7-12

Income Tax Accounting – Deferred Income Taxes Amortization of Goodwill Current tax law permits the amortization of Goodwill and other purchased Intangible Assets over 15 years. GAAP does not systematically amortize Goodwill for financial reporting purposes, but instead reviews it annually for impairment. Timing differences between the amortization and write-off creates a temporary difference that results in deferred income taxes. 7-13

Income Tax Accounting – Deferred Income Taxes Unrealized Intra-Entity Gains If consolidated returns are filed, intra-entity gains are deferred until realized and no timing difference is created. If separate returns are filed, taxable gains must be reported in the period of transfer. The “prepayment” of taxes on the unrealized gains creates a deferred income tax asset. 7-14

Temporary Differences Generated by Business Combinations A business combination can create temporary differences due to differences in tax bases and book value stemming from the takeover. In most purchases, resulting book values of acquired company’s assets and liabilities differ from their tax bases because: Subsidiary’s cost is retained for tax purposes (in tax- free exchanges) Allocations for tax purposes vary from those used for financial reporting (found in taxable transactions). LO

Business Combinations and Operating Loss Carryforwards Net operating losses for companies may be carried back for two years and/or forward for twenty years Because some acquisitions appeared to be done primarily to take advantage of this situation, US law has been changed to require operating loss carryforwards to be used only by the company incurring the loss (in most situations.) LO