1. Beams, Advanced Accounting 10e, Ch. 10
2/22/2019
Chapter 10: Subsidiary Preferred Stock, Consolidated Earnings Per Share, and Consolidated Income Taxation
by Jeanne M. David, Ph.D., Univ. of Detroit Mercy
to accompany Advanced Accounting, 10th edition
by Floyd A. Beams, Robin P. Clement,
Joseph H. Anthony, and Suzanne Lowensohn
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2. Preferred Stock, EPS, and Taxes: Objectives
Modify consolidation procedures for subsidiary companies with preferred stock in their capital structure.
Calculate basic and diluted earnings per share for a consolidated reporting entity.
Understand the complexities of accounting for income taxes by consolidated entities.
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3. Subsidiary Preferred Stock, Consolidated Earnings Per Share, and Consolidated Income Taxation
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4. Subsidiary Preferred Stock
Doesn't change consolidation in principle
Does impact calculations
Common stockholders' equity = total equity less preferred stock at book value
Income of subsidiary is first allocated to preferred shareholders, then CI and NCI
Subsidiary dividend payments must consider payments to preferred shareholders before common shareholders
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5. Who Holds Preferred Stock?
Preferred stock is held by outsiders
Preferred stock is a noncontrolling interest
Preferred stock is held by parent
May choose between
Constructive retirement
Cost basis
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6. Review of Preferred Stock
Characteristics
Callable, redeemable
Cumulative or noncumulative
Participative or non-participative
Limited voting rights
Most is cumulative and nonparticipating
Book Value of PS is:
Call or redemption price (par value if neither)
Plus Dividends in arrears (if cumulative)
Income allocated to PS is:
Current period dividend
Irrespective of amount declared, if cumulative
Declared amount if noncumulative
Potentially more if participative
Preferred stock dividend is:
Face value x dividend rate
Also consider:
Arrearage
Participation
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7. Example: PS Held by Outsiders
Poe buys 90% of Sol for $396 when Sol's equity consists of $100 preferred stock, $200 common stock, $40 other paid in capital and $160 retained earnings.
The preferred stock is cumulative, nonparticipating, carries a 10% dividend and is callable at 105% of par value. There is no arrearage.
During the year, Sol earns $50 and pays $30 in dividends.
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8. Calculations for Preferred Stock
Cost of 90% of Sol
$396
Implied value of Sol
$440
Sol's total equity
$500
Less book value of preferred stock
(105)
Book value of common
395
Excess, goodwill
$45
The book value of preferred is its call price (no arrearage), 105%($100 par value).
Dividends are cumulative, so the current dividend is $10 = 10%($100 par value).
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9. Allocations Income allocation: Sol's net income 50 Amortizations
NCI share – Preferred
$10 income
$10 dividend
Income allocation:
Sol's net income 50
Amortizations
Income to allocate
Allocated to preferred
(10)
Allocated to common 40
Dividends 30 20
NCI share (10% common)
$4 income
$2 dividend
CI share (90%)
$36 income
$18 dividend
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10. Worksheet Entries with Preferred Stock Held by Outsiders
Income from Sol 36
Dividends 18
Investment in Sol
Noncontrolling interest share, CS 4 2
Noncontrolling interest, CS
Noncontrolling interest share, PS 10
Preferred stock
100
Common stock
200
Other paid in capital 40
Retained earnings
160
Goodwill 45
396 44
Noncontrolling interest, PS
105
There is an entry for NCI share, PS that parallels the entry for NCI share, CS. Preferred Stock is eliminated.
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11. Parent Uses Constructive Retirement
Parent acquires subsidiary's preferred stock
Investment in subsidiary, PS is recorded at its book value
Any difference between book value and cost of the stock is an adjustment of other paid in capital
This is an owner transaction; no gain or loss is recorded
Investment is carried at PS book value
Increase for dividends in arrears
Decrease later when declared
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12. Parent Uses Cost Basis Parent acquires subsidiary's preferred stock
Use cost method
Investment in subsidiary, PS is at cost
Dividends are recorded as income
In the consolidation process
Preferred stock is eliminated at its book value
Noncontrolling interest, PS is recorded at book value of the preferred stock held by others
Investment is removed at its cost and any difference from book value is charged or credited to other paid in capital
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13. Example: Parent Acquires PS
Plato owns 80% of Shem acquired at fair value plus implied goodwill of $100.
On 1/1/09 Plato acquires 70% of Shem's outstanding preferred stock at $950.
Shem's equity at 1/1/09:
$3 Preferred stock, $50 par, callable at $52, cumulative, no arrearage
1,500
Common stock $1 par
300
Other paid in capital
1,200
Retained earnings
2,300
Total equity
5,300
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14. Calculations Book value of preferred stock
$52 x ($1,500 / $50par) = $1,560
Book value of Shem's common stock
$5,300 total equity – $1,560 = $3,740
Shem's total value with goodwill
$3,740 + $100 = $3,840
Investment in Shem, CS (80%) = $3,072
Noncontrolling interest, CS (20%) = $768
Noncontrolling interest, PS (30%) = $468
Parent acquired 70% of Shem's PS for $950
Investment in Shem, PS (70%, book) = $1,092 Or
Investment in Shem, PS (70%, cost) = $950
The difference, $142 = , increases the parent's other paid in capital
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15. Constructive Retirement Entries
 Parent's acquisition entry:
Investment in Shem, PS (70%)
1,092
Cash
950
Other paid in capital (Plato)
142
 Worksheet entry:
Preferred stock
1,500
Common stock
300
Other paid in capital
1,200
Retained earnings
2,300
Goodwill
100
Investment in Shem, CS (80%)
3,072
Noncontrolling interest, CS (20%)
768
Noncontrolling interest, PS (30%)
468
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16. Cost Basis Entries Investment in Shem, PS (70%) 950 Cash
 Parent's acquisition entry:
Investment in Shem, PS (70%)
950
Cash
Worksheet entry 
Preferred stock
1,500
Common stock
300
Other paid in capital
1,200
Retained earnings
2,300
Goodwill
100
Investment in Shem, CS (80%)
3,072
Noncontrolling interest, CS (20%)
768
Noncontrolling interest, PS (30%)
468
Other paid in capital (Plato's)
142
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17. Comparison of Methods Both result in the same consolidated amounts
Constructive retirement
Records the Other paid in capital (parent's) at acquisition
Investment is at book value
Simplifies consolidation process!
Cost basis
Records the Other paid in capital (parent's) as part of the consolidation process
Investment is at cost
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18. Subsidiary Preferred Stock, Consolidated Earnings Per Share, and Consolidated Income Taxation
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19. EPS Requirements
GAAP requires firms report basic and diluted (where applicable) EPS
EPS is disclosed on a consolidated basis
Main issue: Subsidiary's capital structure
Subsidiary potentially dilutive securities convertible into subsidiary common stock
Subsidiary potentially dilutive securities convertible into parent common stock
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20. Review Basic EPS Numerator: Net income – preferred stock dividends*
* current dividends if cumulative, otherwise declared dividends
Denominator:
Weighted average shares of common stock
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21. Review Diluted EPS Numerator: (Net income – PS dividends)
+ adjustments for dilutive securities
Denominator:
Weighted average shares outstanding
+ shares represented by dilutive securities
Dilution:
Dilutive securities reduce EPS.
Non-dilutive securities are excluded
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22. Review Dilutive Securities
Convertible bonds
Numerator: after tax interest expense
Denominator: common shares bonds represent
Convertible preferred stock
Numerator: preferred stock dividend
Denominator: common shares the preferred shares represent
Numerator: none
Denominator: "treasury stock method" to compute shares (if positive)
# shares – (# shares x option price / market price)
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23. Subsidiary Securities Convertible into Subsidiary Common Stock
Compare Parent's equity
Realized earnings of subsidiary
Diluted earnings of subsidiary
If diluted is higher, skip  Non-dilutive
Realized earnings:
Subsidiary's net income adjusted for intercompany profits/losses
Does not include amortizations of valuation differentials
Diluted earnings:
Subsidiary's diluted EPS x number of shares
Parent's diluted EPS
Numerator: Reduce by difference
Denominator: No effect – no parent shares!
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24. Subsidiary PS Convertible into Subsidiary CS
Seed has $50 net income and 20 weighted average shares of common stock. Its preferred stock has a $10 dividend and is convertible into 12 shares of Seed common stock.
Seed's basic EPS:
($50 - $10) / 20 = $2.00
Seed's diluted EPS:
($50 - $10) + $10 = $1.5625
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25. Parent's Basic EPS
Seed is 90% owned by Plant. Plant's net income is $186, 200 shares of common are outstanding all year, and Plant has no dilutive securities.
Plant's basic EPS:
$186 / 200 = $0.93
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26. Parent's Diluted EPS Plant's realized income from Seed 90% x $40 = $36
Plant's share of Seed's diluted earnings:
90% x 20 shares x $ = $28.125
Since the share of diluted earnings is lower, we will reduce the numerator by the difference.
Plant's diluted EPS:
$186 – = $0.89
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27. Subsidiary Securities Convertible into Parent Common Stock
Parent's diluted EPS calculation:
Numerator: Add adjustments for subsidiary securities convertible into parent common stock
Denominator: Add parent common shares represented by subsidiary's dilutive securities
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28. Subsidiary Options and Bonds Convertible into Parent CS
Syd's net income is $450 and it has 400 shares of common outstanding all year.
Options: Syd has options that convert into 60 shares of its parent's (Paddy) common stock at $10 per share. The average market price is $15.
Convertible bonds: Syd has $1,000 par bonds convertible into 80 shares of Paddy's common stock. The bonds were issued at par to yield 7%. The effective tax rate is 34%.
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29. Parent's Data and Basic EPS
Paddy has $1,800 income and 1,000 shares of common stock outstanding all year. It has no preferred stock or dilutive securities.
Paddy's basic EPS:
$1,800 / 1,000 shares = $1.80
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30. Parent's Diluted EPS Impact of Syd's options for Paddy common:
Numerator: none
Denominator: 60 + (60 x $10/$15) = 20 shares
Impact of Syd's bonds convertible to Paddy common:
Numerator: 7% x $1,000 x (1-34%) = $46.2
Denominator: 80 shares
Paddy's diluted EPS:
$1, $ = $1.76 1,
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31. Subsidiary Preferred Stock, Consolidated Earnings Per Share, and Consolidated Income Taxation
3: Income Taxes
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32. Consolidated Tax Return
Advantages
Offset affiliate losses (excluding preacquisition loss carry forwards)
Exclude intercompany dividends
Defer intercompany profits until realized (losses are also deferred)
Disadvantages
Loss of flexibility
Difficult to switch back to unconsolidated
Cannot file as consolidated again for 5 years
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33. Income Tax Allocation Permanent differences
Dividends from affiliates are excluded from taxable income
Dividends from affiliates that are not members of the affiliated group are allowed an 80% dividends received deduction
Temporary difference
Undistributed income from domestic affiliates (FASB Statement No. 109)
Undistributed income from foreign affiliates and from domestic affiliated earnings preceding FASB Statement No. 109 may be permanent.
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34. Undistributed Earnings
Parson owns 30% of Seaton's common stock.
Seaton's income, $600
Seaton's dividends, $200
Parson's applicable tax rate = 34%
Parson's deferred tax liability
= [30%($600 - $200)] x 20% x 34% = $8.16
Seaton's earnings are allowed the 80% deduction, so only 20% is subject to tax.
If Seaton was a consolidated subsidiary, its earnings would be excluded and Parson would have no deferred tax liability.
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35. Unrealized Profits and Losses
Separate tax returns
Unrealized gains (losses) are taxed (deducted) in the separate returns
Consolidation procedures
Remove the unrealized gain (loss)
Record a deferred tax asset (liability)
Tax effect impacts the income tax expense of the selling affiliate
Consolidated tax return
Unrealized gains (losses) are excluded
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36. Example
Pool owns 90% of Sal. The tax rate is 34%. Pretax operating income of Pool and Sal are $150 and $50. Sal paid dividends of $20 and Sal's dividends are subject to the 100% exclusion.
During the year, intercompany sales were $50 and there remains $10 in unrealized profits in ending inventory.
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37. Consolidated Tax Return
Downstream sales
Pool's income $150 - $10 = $140
Sal's income $50
Consolidated taxes ($140 + $50) x 34% = $64.6
Allocate
(140/(140+50)) x $64.6 = $47.6 to Pool
(50/(140+50)) x $64.6 = $17.0 to Sal
Upstream sales
Pool's income $150
Sal's income $50 - $10 = $40
Consolidated taxes ($150 + $40) x 34% = $64.6
(150/(150+40)) x $64.6 = $51.0 to Pool
(40/(150+40)) x $64.6 = $13.6 to Sal
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38. Entries with Consolidated Return
Pool and Sal would each record their own share of the income tax expense and income tax payable.
The unrealized profit does not give rise to any temporary differences
Deferred for consolidation purposes
Deferred for tax purposes
That is, it is not income now and it is not taxed now!
No special considerations for consolidation worksheet.
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39. Separate Tax Returns Downstream sales
Pool's accounting income $150 - $10 = $140
Pool's taxes payable $150 x 34% = $51.0
Pool's deferred taxes $10 x 34% = $3.4
Income tax expense $47.6
Sal's income $50
Sal's taxes $50 x 34% = $17.0
Upstream sales
Pool's income $150
Pool's taxes $150 x 34% = $51.0
Sal's income $50 - $10 = $40
Sal's taxes payable $50 x 34% = $17.0
Sal's deferred taxes $10 x 34% = $3.4
Sal's income tax expense $13.6
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40. Business Combinations
Tax free combinations
Mergers or consolidations
Exchange of voting stock for another corporation's stock
Exchange of voting stock for another corporation's assets
Purchase acquisitions may be either
Tax free
Taxable
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41. Tax Free Business Combinations
Tax free business combinations give rise to differences between book values and tax values
At acquisition
Assign assets value based on gross fair value
Except
Goodwill, bargain purchase, deferred taxes, pension assets, leveraged leases
Tax bases carry forward from predecessor
Record deferred tax asset/liability for temporary differences
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