Chapter Seven

Consolidated Financial Statements Ownership Patterns and Income Taxes

McGraw-Hill/Irwin Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Indirect Subsidiary Control

When a parent controls a subsidiary which in turn controls other firms, a pyramid or father-songrandson relationship exists
Father
75 % Ownership

Son 80 % ownership
Grandsons

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Consolidation Where Indirect Control is Present

Start from the bottom of the pyramid and work upwards Recognize realized income of the grandson(s) Use this to consolidate the son and grandson(s) financial information, taking care to calculate any noncontrolling interest Finally, consolidate the son(s) and parent in the same manner

Note: In practice this can become quite complicated

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Indirect Control Example

Determine consolidated income for the business combination by: Combining Midway and Bottom to determine Midways realized income. Combining Top with the realized income from Midway. Top Co. 70% Ownership 60% Ownership Midway Co.

Bottom Co.

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Indirect Control Example

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Indirect Control Example

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Indirect Control Example

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Indirect Control Example

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Consolidation Process Indirect Control

Using the consolidation entries previously described is sufficient to complete the fatherson-grandson combination. Essentially, the entries are duplicated for each relationship.

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Indirect Subsidiary Control Connecting Affiliation

The combination of the parents DIRECT ownership and INDIRECT ownership can result in control of a subsidiary.

High Company

70% owned

30% owned

Side Company

45% owned

Low Company

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Indirect Subsidiary Control Connecting Affiliation

In this case, High controls Side directly with 70% 70% owned ownership, and Low indirectly with 61.5% effective ownership.
( 30% + [ 70% x 45% ])

High Company

30% owned

Side Company

45% owned

Low Company

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Indirect Subsidiary Control Connecting Affiliation

Basic Consolidation Rules Still Hold:

In this case, High controls Side directly with 70% ownership, and Low indirectly with 61.5% effective ownership.
( 30% + [ 70% x 45% ])

Eliminate effects of intercompany transfers. Eliminate subs beginning equity balances. Adjust for unamortized FV adjustments. Record amortization Expense. Remove intercompany income and dividends. Compute and record noncontrolling interest in subsidiaries net income.

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Mutual Ownership

Up Company 90% owned 20% owned

Occurs when the subsidiary owns shares of the parent. SFAS 160 requires the treasury stock approach to account for mutual ownership.

Down Company

Mutual Ownership
SFAS 160, Noncontrolling Interests in Consolidated Financial Statements. Shares of the parent held by a subsidiary shall not be treated as outstanding shares in the consolidated statement of financial position and, therefore, shall be eliminated in the consolidated financial statements and reflected as treasury shares. (paragraph 13)

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Mutual Ownership Treasury Stock Approach

Focuses on the parents control over the subsidiary The cost of the parent shares held by the subsidiary is reclassified on the worksheet into Treasury Stock. Intercompany dividends on shares of the parent owned by the subsidiary are eliminated as an intercompany cash transfer. Currently predominates in practice.

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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 composing an affiliated group. The affiliated group will likely exclude some members of the business combination.

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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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Benefits of Using an Affiliated Group

Intercompany profits are not taxed until realized. Intercompany dividends are nontaxable. Losses of one affiliated group member can be used to offset taxable income earned by another group member.

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Income Tax Accounting Deferred Income Taxes

The tax consequences are often dependent on whether separate or consolidated returns are filed. Transactions affected: Unrealized Intercompany Gains Goodwill Intercompany Dividends

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Income Tax Accounting Deferred Income Taxes

Intercompany Dividends For accounting purposes, all intercompany dividends are eliminated. For tax purposes, dividends are NOT eliminated if ownership is < 80%. (They are currently taxed at a rate of 20 percent.) A deferred tax liability is created based on the difference.

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Income Tax Accounting Deferred Income Taxes

Amortization of Goodwill The Revenue Reconciliation Act of 1993 allowed amortization of Goodwill over 15 years for tax purposes. SFAS No. 142 eliminated amortization of Goodwill for financial reporting purposes. However, goodwill can be written off if it is impaired or if there is disposal of the related business A deferred tax liability must therefore be recognized.

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Income Tax Accounting Deferred Income Taxes

Unrealized Intercompany Gains 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.

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SFAS 109, Accounting for Income Taxes

Paragraph 11(h) of SFAS 109 as amended by SFAS 141R:
Business combinations. There may be differences between the tax bases and the recognized values of assets acquired and liabilities assumed in a business combination. Those differences will result in taxable or deductible amounts when the reported amounts of the assets or liabilities are recovered or settled, respectively.

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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 20 Because some acquisitions were designed in part 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.)

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Business Combinations and Operating Loss Carryforwards

SFAS 109 requires deferred tax assets to be recorded for any net operating loss carryforwards Valuation allowances must be recognized if it is more likely than not (based on available evidence) that some portion or all of the deferred tax asset will not be realized. (The valuation
allowance should be sufficient to reduce the deferred tax asset to the amount that is more likely than not to be realized.)

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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 As a basis for calculating noncontrolling interests share of consolidated income

Several techniques available:

Percentage allocation Separate return method

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Assigning Income Tax Expense

Two Methods
Percentage Allocation Method Separate Return Method

Assign Tax Expense based on relative net incomes of the companies.

Allocation based on relative tax expense IF they had filed separate returns.

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Summary

Control may be indirect Consolidation of pyramid structures is conceptually identical to that for direct ownership, but requires a systematic bottom-to-top approach Mutual affiliation occurs when a subsidiary owns shares of the parent. Beginning in 2009, the treasury stock approach must be used to produce consolidated information for this situation. The treasury stock approach also dominated past practice. Affiliated groups, which may differ from the consolidated entity due to IRS restrictions, are permitted to file consolidated returns

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Possible Criticisms

Affiliated groups are often different from the consolidated entity due to IRS restrictions. This can create a variety of differences in reporting financial statement income versus taxable income for the combination. Some critics contend that indirect ownership creates a different control environment than direct ownership, and that this difference should be disclosed.

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