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Chapter Seven

Consolidated

Financial

Statements -

Ownership

Patterns andIncome Taxes

Copyri ght 2013 by The McGraw-H il l Companies, In c. All ri ghts reserved.McGraw-Hill/Irwin

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Indirect Subsidiary ControlLO 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 parents

Relationship with

Bottom is only of

an indirect nature.

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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 workupwards.

1. Recognize realized income of grandson(s)

2. Use this to consolidate the son and

grandson(s) financial information (take careto calculate any noncontrolling interest)

3. Finally, consolidate the son(s) and parent in

the same manner.

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Indirect Subsidiary Control

Connecting Affiliation

A connecting aff i l iationexists 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

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Indirect Subsidiary Control

Connecting Affiliation

Basic Consolidation Rules Still Hold:

Eliminate effects of intra-entity transfers.

Adjust parents beginning R/E to recognize

prior period ownership.Eliminate subs beginning equity balances.

Adjust for unamortized FV adjustments.

Record Amortization Expense.

Remove intra-entity income and dividends.

Compute and record noncontrolling interestin subsidiaries net income.

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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 parentheld 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

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Mutual Ownership

There is no accounting distinction between a

parent owning stock of a subsidiary, or a

subsidiary owning stock of a parentthey are

both intra-entity stock ownership.

The cost of the parent shares held by the

subsidiary is reclassifiedon 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.

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Income Tax Accounting

for a Business Combination

Business combinations may elect to file

a consolidated federal tax return for

all companies of an aff i l iated group.

The affiliated group (as defined by the

IRS) will likely exclude some members

of the business combination.

LO 4

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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.)

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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 membercan be used to offset taxable income

earned by another group member.

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Income Tax Accounting

Deferred Income Taxes

Tax consequences are often dependent onwhether separate or consolidated returns are

filed.

Transactions affected:

Intra-entity

DividendsGoodwill

Unrealized

Intra-entity

Gains

LO 5

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Income Tax Accounting

Deferred Income Taxes

Intra-entity Dividends

For accounting purposes, all intra-entity

dividends are eliminated.

For tax purposes, dividends are removed fromincome if at least 80 percent of the subsidiarys

stock is held. (20% is taxable.)

If less than 80 percent of a subsidiarys stock is

held, tax recognition is necessary.

A deferred tax liability is created for any of subs

income not paid currently as a dividend.

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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 andwrite-off creates a temporary difference that

results in deferred income taxes.

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Income Tax Accounting

Deferred Income Taxes

Unrealized Intra-Entity Gains

If consolidated returns are filed, intra-entitygains are deferred until realized and notiming difference is created.

If separate returns are filed, taxable gainsmust be reported in the period of transfer.

The prepayment of taxes on the unrealizedgains creates a deferred income tax asset.

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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 acquiredcompanys assets and liabilities differ from their tax

bases because:

Subsidiarys 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 7

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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 beused only by the company incurring the loss

(in most situations.)

LO 8

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