1. Chapter Seven
Consolidated Financial Statements – Ownership Patterns and Income Taxes
Consolidated Financial Statements – Ownership Patterns and Income Taxes
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2. ownership configuration.
Learning Objective 7-1
Demonstrate the consolidation process when indirect control is present in a grandfather-father-son
ownership configuration.
Demonstrate the consolidation process when indirect control is present in a grandfather-father-son
ownership configuration.

3. Indirect Subsidiary Control
The presence of an indirect ownership does not change most consolidation procedures; however, a calculation of each subsidiary’s accrual-based income does pose some difficulty.
Appropriate income determination is essential for calculating (1) equity income accruals and
(2) the noncontrolling interest’s share of consolidated net income.
Although the presence of an indirect ownership does not change most consolidation
procedures, a calculation of each subsidiary’s accrual-based income does pose some difficulty.
Appropriate income determination is essential for calculating (1) equity income
accruals and (2) the noncontrolling interest’s share of consolidated net income.

4. Indirect Subsidiary Control
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.
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.

5. Indirect Control -Example
The following data is from the individual company financial records:

6. Indirect Control – Example
Following the consolidation steps to determine Midway’s realized income:
From the perspective of the business combination, Bottom’s income for the period is only $55,000 after deferring the $20,000 in net intra-entity gains and recognizing the $25,000 excess amortization associated with the acquisition by Midway. Thus, $55,000 is the basis for the equity accrual by its parent and noncontrolling interest recognition. Once the grandson’s income has been derived, this
figure then is used to compute the accrual-based earnings of the son, Midway

7. Indirect Control - Example
Then combine Top Company’s income with Midway’s realized income:
Midway’s $223,000 accrual-based income differs from its internally calculated profit of
$350,000. The difference reflects a consolidated perspective for the entire ownership
structure including excess amortization and intra-entity transfers. Continuing with the
successive derivation of each company’s earnings, we now can determine Top’s income.
After computing the son’s earnings, the father’s earnings are calculated.
Midway’s realized income as previously calculated.

8. Indirect Control - Example
Using the income from the previous calculations, determine noncontrolling interest. (Bottom and Midway’s individual incomes as calculated).
The income statement for Top Company and its consolidated subsidiaries
discloses an $88,900 balance as the “noncontrolling interests’ share of subsidiary income.
Use the standard consolidation entries to complete the father-son-grandson combination. The entries are essentially duplicated for each relationship.

9. Indirect Control - Example
If appropriate equity accruals are recognized, the sum of the parent’s accrual-based income and the noncontrolling interest income share serves as a “proof figure” for the consolidated total. Thus, if the consolidation process is performed correctly, the earnings this entire organization reports should equal $735,000.
If appropriate equity accruals are recognized, the sum of the parent’s accrual-based income and the noncontrolling interest income share serves as a “proof figure” for the consolidated total. Thus, if the consolidation process is performed correctly, the earnings this entire organization reports should equal $735,000.

10. Learning Objective 7-2
Demonstrate the consolidation process when a corporate ownership structure is characterized by a connecting affiliation.
Demonstrate the consolidation process when a corporate ownership structure is characterized by a connecting affiliation.

11. 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.
A connecting affiliation exists when two or more companies within a business combination own an interest in another member of the organization.

12. Indirect Subsidiary Control – Connecting Affiliation
Both High company and Side Company own Low Company’s stock, a connecting affiliation. Neither owns enough stock to establish direct control over Low’s operations, but they hold a total of 75% of the outstanding shares. Control lies within the single consolidated entity and Low’s financial information must be included in the consolidated statements.
Assume High, Side, and Low have separate internal operating incomes of $300,000, $200,000, and $100,000, respectively. Each has a $30,000 net intra-entity gain in its current income. Annual amortization expense is $10,000 for acquisition-date excess fair value over book value for each subsidiary.
Both High company and Side Company own Low Company’s stock, a connecting affiliation. Neither owns enough stock to establish direct control over Low’s operations, but they hold a total of 75% of the outstanding shares. Control lies within the single consolidated entity and Low’s financial information must be included in the consolidated statements. Assume High, Side, and Low have separate internal operating incomes of $300,000, $200,000, and $100,000, respectively. Each has a $30,000 net intra-entity gain in its current income. Annual amortization expense is $10,000 for acquisition-date excess fair value over book value for each subsidiary.

13. 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.
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.

14. Indirect Subsidiary Control – Connecting Affiliation
In the same manner as a father-son-grandson organization, determining accrual-based earnings begins with any companies solely in a subsidiary position (Low). Next companies that are both parents and subsidiaries (Side) compute their accrual- based income. Finally, this same calculation is made for the one company (High) that has ultimate control over the entire combination.
The combination of the parent’s DIRECT ownership and INDIRECT ownership results in control of the subsidiary.
Accrual-based income figures for the three companies in this combination are derived as seen on the following slide.
In the same manner as a father-son-grandson organization, determining accrual-based earnings begins with any companies solely in a subsidiary position (Low, in this case). Next companies that are both parents and subsidiaries (Side) compute their accrual- based income. Finally, this same calculation is made for the one company (High) that has ultimate control over the entire combination.
The combination of the parent’s DIRECT ownership and INDIRECT ownership results in control of the subsidiary.
Although neither of the individual companies possesses enough voting stock to establish direct control over Low’s operations, the combination’s members hold a total of 75 percent of the outstanding shares.
Accrual-based income figures for the three companies in this combination are derived as seen on the following slide.

15. Indirect Subsidiary Control – Connecting Affiliation

16. Learning Objective 7-3
Demonstrate the consolidation process when a corporate ownership structure is characterized by mutual ownership.
Demonstrate the consolidation process when a corporate ownership structure is characterized by mutual ownership.

17. 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.
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.

18. 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. Example: Pop Co owns 70% of Sun Co. Sun owns 10% of Pop Co, purchased for $120,000, and records the investment under the Fair Value Method. Pop declares dividends of $8,000 to Sun, and Sun records dividend income.
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.
Example: Pop Co owns 70% of Sun Co. Sun owns 10% of Pop Co, purchased for $120,000, and records the investment under the Fair Value Method. Pop declares dividends of $8,000 to Sun, and Sun records dividend income.

19. Treasury Stock Approach Example
Mutual Ownership –
Treasury Stock Approach Example
The following entries are recorded in the consolidation worksheet:
(*C) Conversion of initial value method to equity method. Recognizes
70% of increase in Sun Company’s book value less previous year’s
amortization expense [70% ($25,000  -  $3,000)].
(S) Elimination of subsidiary’s stockholders’ equity and recognition of
January 1, noncontrolling interest.
(TS) Reclassification of Sun’s ownership in Pop into a treasury stock account.
(A) Allocation to franchises, unamortized balance recognized as of January 1.
(I) Elimination of intra-entity dividend income for the period.
(E) Recognition of amortization expense for the current year.
(Note: Parentheses indicate a credit balance.)
Note: Parentheses indicate a credit balance.
Consolidation entries:
(*C) Conversion of initial value method to equity method. This entry recognizes 70 percent of the increase in Sun Company’s book value less amortization expense applicable to the previous year [70% ($25,000  2  $3,000)].
(S) Elimination of subsidiary’s stockholders’ equity accounts along with recognition of January 1, noncontrolling interest.
(TS) Reclassification of Sun Company’s ownership in Pop Company into a treasury stock account.
Allocation to franchises, unamortized balance recognized as of January 1.
(I) Elimination of intra-entity dividend income for the period.
(E) Recognition of amortization expense for the current year.

20. Treasury Stock Approach Example
Mutual Ownership –
Treasury Stock Approach Example
Consolidation Worksheet

21. List the criteria for being a member of an affiliated group
Learning Objective 7-4
List the criteria for being a
member of an affiliated group
for income tax filing purposes.
List the criteria for being a member of an affiliated group for income tax filing purposes.

22. 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.
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.

23. 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 (direct or indirect ownership).
All others must file separately (including any foreign subsidiaries.)
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.)

24. Income Tax Accounting for a Business Combination
There is a distinction between business combinations as identified for financial reporting and affiliated groups as defined for tax purposes. A business combination comprises all subsidiaries controlled by a parent company unless control is only temporary. The IRS’s 80 percent rule creates a smaller circle of companies qualifying for inclusion in an affiliated group.
There is a distinction between business combinations as identified for financial reporting and affiliated groups as defined for tax purposes.
A business combination comprises all subsidiaries controlled by a parent company unless control is only temporary.
The IRS’s 80 percent rule creates a smaller circle of companies qualifying for inclusion in an affiliated group.

25. Income Tax Accounting for a Business Combination
A parent company is not required to file a consolidated return, but there are benefits for doing so.
Intra-entity profits are not taxed until realized.
Losses of one affiliated group member can be used to offset taxable income earned by another group member.
A parent company is not required to file a consolidated return, but there are benefits for doing so.
Intra-entity profits are not taxed until realized.
Losses of one affiliated group member can be used to offset taxable income earned by another group member.

26. Compute taxable income and deferred tax amounts for
Learning Objective 7-5
Compute taxable income
and deferred tax amounts for
an affiliated group based on
information presented in a
consolidated set of financial
statements.
Compute taxable income and deferred tax amounts for an affiliated group based on information presented in a
consolidated set of financial statements.

27. Income Tax Accounting – Deferred Income Taxes
Tax consequences are often dependent on whether separate or consolidated returns are filed. Transactions affected:
Goodwill
Intra-entity Dividends
Tax consequences are often dependent on whether separate or consolidated returns are filed. Transactions affected include intra-entity dividends, goodwill, and unrealized intra-entity gains.
Unrealized Intra-entity Gains

28. 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.
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.

29. 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.
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.

30. 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.
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.

31. Assigning Income Tax Expense – Consolidated Return
Consolidated tax returns require allocation of tax expense between the parties.
Important for the subsidiary if separate financial statements are needed for loans or equity issues.
Used as a basis for calculating noncontrolling interest’s share of consolidated income.
Consolidated tax returns require allocation of tax expense between the parties.
Important for the subsidiary if separate financial statements are needed for loans or equity issues.
Used as a basis for calculating noncontrolling interest’s share of consolidated income.

32. Assigning Income Tax Expense Methods
The Percentage Allocation Method attributes the GAAP tax expense based on the relative contribution of each affiliate to taxable income.
The Separate Return Method, an alternative technique, uses the taxable income that results from filing separate tax returns.
The Percentage Allocation Method attributes the GAAP tax expense based on the relative contribution of each affiliate to taxable income.
The Separate Return Method, an alternative technique, uses the taxable income that results from filing separate tax returns.

33. Compute taxable income and deferred tax amounts to
Learning Objective 7-6
Compute taxable income
and deferred tax amounts to
be recognized when separate
tax returns are filed by any
of the affiliates of a business
combination.
Compute taxable income and deferred tax amounts to be recognized when separate tax returns are filed by any of the affiliates of a business combination.

34. Filing Separate Tax Returns
Separate returns are mandatory for foreign subsidiaries and for domestic corporations not meeting the 80 percent ownership rule. Canadian and Mexican subsidiaries can qualify for treatment as domestic companies for purposes of filing a consolidated return. A company may still elect to file separately even if it meets the conditions for inclusion within an affiliated group. If all companies in an affiliated group are profitable and few intra-entity transactions occur, they may prefer separate returns to give the companies more flexibility in their choice of accounting methods and fiscal tax years.
Separate returns are mandatory for foreign subsidiaries and for domestic corporations not meeting the 80 percent ownership rule. Canadian and Mexican subsidiaries can qualify for treatment as domestic companies for purposes of filing a consolidated return. A company may still elect to file separately even if it meets the conditions for inclusion within an affiliated group.
If all companies in an affiliated group are profitable and few intra-entity transactions occur, they may prefer separate returns to give the companies more flexibility in their choice of accounting methods and fiscal tax years.

35. Filing Separate Tax Returns
Tax laws do not allow a company to switch back and forth between consolidated and separate returns. Obtaining Internal Revenue Service permission to file separately can be difficult once consolidation is selected. When members of a business combination file separate tax returns, temporary differences often emerge for income recognized for consolidated financial reporting and for income tax reporting.
Tax laws do not allow a company to switch back and forth between consolidated and separate returns. Obtaining Internal Revenue Service permission to file separately can be difficult.
When members of a business combination file separate tax returns, temporary differences often emerge for income recognized for consolidated financial reporting and for income tax reporting.

36. Filing Separate Tax Returns
Differences in the timing of income recognition across consolidated reporting and income tax purposes create deferred tax assets and/or liabilities. These temporary differences may occur due to (1) the immediate taxation of unrealized intra-entity gains (and losses) and (2) possible future tax effects of subsidiary income in excess of dividend payments.
Differences in the timing of income recognition across consolidated reporting and income tax purposes create deferred tax assets and/or liabilities.
These temporary differences may occur due to
(1) the immediate taxation of unrealized intra-entity gains (and losses) and
(2) possible future tax effects of subsidiary income in excess of dividend payments.

37. Determine the deferred tax consequences for temporary
Learning Objective 7-7
Determine the deferred tax
consequences for temporary
differences generated when a
business combination is
created.
Determine the deferred tax consequences for temporary differences generated when a business combination is
created.

38. 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).
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).

39. Explain the impact that a net operating loss of an acquired
Learning Objective 7-8
Explain the impact that a net
operating loss of an acquired
affiliate has on consolidated
figures.
Explain the impact that a net operating loss of an acquired affiliate has on consolidated
figures.

40. 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.)
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.)

41. Business Combinations and Operating Loss Carryforwards
FASB ASC Topic 740, Income Taxes, requires an acquiring firm to recognize a deferred income tax asset for any NOL carryforward. However, a valuation allowance also must be recognized if it is more likely than not (based on available evidence) that some or all of the deferred tax asset will not be realized.
FASB ASC Topic 740, Income Taxes, requires an acquiring firm to recognize a deferred income tax asset for any NOL carryforward. However, a valuation allowance also must be recognized.
Valuation allowances are recorded if it is more likely than not (based on available evidence) that some or all of the deferred tax asset will not be realized.

42. Operating Loss Carryforwards - Example
Assume a parent purchased a company (sub) for $640,000. The sub has one asset, a building, worth $500,000. Due to recent losses, the sub has a $200,000 NOL carryforward. The assumed tax rate is 30 % so the parent can derive $60,000 in future tax savings if it earns future income. The parent anticipates the sub will utilize some or all of the NOL carryforward.
Assume a parent purchased a company (sub) for $640,000. The sub has one asset, a building, worth $500,000.
Due to recent losses, the sub has a $200,000 NOL carryforward. The assumed tax rate is 30 % so the parent can derive a $60,000 benefit if it earns future income.
The parent anticipates the sub will utilize some or all of the NOL carryforward.

43. Operating Loss Carryforwards - Example
If it is more likely than not that the benefit will be realized, goodwill of $80,000 results.
If chances are 50% or less that the sub will use the NOL carryforward, the parent records a valuation allowance and $140,000 of consolidated goodwill.
If it is more likely than not that the benefit will be realized, goodwill of $80,000 results.
If chances are 50% or less that the sub will use the NOL carryforward, the parent records a valuation allowance and $140,000 of consolidated goodwill.

44. IFRS and U.S. GAAP Differences
U.S. GAAP prohibits the recognition of unrealized
intra-entity profits on asset transfers; therefore, the selling firm defers any related current tax effects until the asset is sold to a third party.
International Accounting Standard (IAS) 12 requires taxes paid by a selling firm on intra-entity profits to be recognized as incurred and allows tax deferral on differences between the tax bases of assets transferred across entities that remain within the consolidated group.
U.S. GAAP prohibits the recognition of unrealized intra-entity profits; therefore, the selling firm defers any related current tax effects until the asset is sold to a third party.
International Accounting Standard (IAS) 12 requires taxes paid by a selling firm on intra-entity profits to be recognized as incurred and allows tax deferral on differences between the tax bases of assets transferred across entities that remain within the consolidated group.