U.S. GAAP on accounting for income taxes and International Accounting Standard (IAS) 12 each requires business combinations to recognize both current tax effects and anticipated future tax consequences using deferred tax assets and liabilities. For many financial reporting tax is- sues that arise from business combinations, the standards are the same.
One area, however, where a difference remains concerns taxes on intra-entity asset trans- fers that remain within the consolidated group. U.S. GAAP prohibits the recognition of un- realized intra-entity profits and therefore the selling firm defers any related current tax effects until the asset is sold to a third party. In contrast, IFRS requires the taxes paid by the selling firm on intra-entity profits to be recognized as incurred. Further, although prohibited by U.S.
GAAP, IFRS allows tax deferral on differences between the tax bases of assets transferred across entities (and tax jurisdictions) that remain within the consolidated group.9
8However, once goodwill is reduced to zero, an acquirer recognizes any additional decrease in the valuation allowance as a bargain purchase.
9Ernst & Young LLP, US GAAP vs. IFRS: The Basics,January 2009.
Summary 1. For consolidation purposes, a parent need not possess majority ownership of each of the component companies constituting a business combination. Often control is indirect: One subsidiary owns a ma- jority of an affiliated subsidiary’s shares. Although the parent might own stock in only one of these companies, control has been established over both. Such an arrangement often is referred to as a father-son-grandson configuration.
2. The consolidation of financial information for a father-son-grandson business combination does not differ conceptually from a consolidation involving only direct ownership. All intra-entity, reciprocal balances are eliminated. Goodwill, other allocations, and amortization usually must be recognized if an acquisition has taken place. Because more than one investment is involved, the number of work- sheet entries increases, but that is more of a mechanical inconvenience than a conceptual concern.
3. One aspect of a father-son-grandson consolidation that warrants attention is determining accrual- based income figures for each subsidiary. Any company within a business combination that holds both a parent and subsidiary position must determine the income accruing from ownership of its sub- sidiary before computing its own earnings. This procedure is important because income is the basis for each parent’s equity accruals and noncontrolling interest allocations.
4. If a subsidiary possesses shares of its parent, a mutual affiliation exists. This investment is intra- entity in nature and must be eliminated for consolidation purposes. The treasury stock approach simply reclassifies the cost of these shares as treasury stock with no equity accrual recorded.
5. Under present tax laws, an affiliated group of only domestic corporations can file a single consoli- dated income tax return. The parent must control 80 percent of the voting stock as well as 80 percent of the nonvoting stock (either directly or indirectly). A consolidated return allows the companies to defer recognition of intra-entity gains until realized. Furthermore, losses incurred by one member of the group reduce taxable income earned by the others. Intra-entity dividends are also nontaxable on a consolidated return, although such distributions are never taxable when paid between companies within an affiliated group.
6. Separate tax returns apply to some members of a business combination. Foreign corporations and any company not meeting the 80 percent ownership rule, as examples, must report in this manner. In ad- dition, a company might simply elect to file in this manner if a consolidated return provides no ad- vantages. For financial reporting purposes, a separate return often necessitates recognition of deferred income taxes because temporary differences can result from unrealized transfer gains as well as intra-entity dividends (if 80 percent ownership is not held).
7. When a business combination is created, the subsidiary’s assets and liabilities sometimes have a tax basis that differs from their assigned values. In such cases, the company must recognize a deferred tax asset or liability at the time of acquisition to reflect the tax impact of these differences.
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318 Chapter 7
(Estimated Time: 60 to 75 Minutes) On January 1, 2009, Gold Company acquired 90 percent of Silver Company. Details of the acquisition are as follows:
Consideration transferred by Gold . . . $576,000 Noncontrolling interest acquisition-date fair value . . . 64,000 Silver total fair value . . . $640,000 Silver book value . . . 600,000 Excess fair value over book value assigned to brand name (20-year life) . . $ 40,000 Subsequently, on January 1, 2010, Silver purchased 10 percent of Gold for $150,000. This price equaled the book value of Gold’s underlying net assets and no allocation was made to either goodwill or any spe- cific accounts.
On January 1, 2011, Gold and Silver each acquired 30 percent of the outstanding shares of Bronze for $105,000 apiece, which resulted in Gold obtaining control over Bronze. Details of this acquisition are as follows:
Consideration transferred by Gold and Silver ($105,000 each) . . . $210,000 Noncontrolling interest acquisition-date fair value . . . 140,000 Bronze total fair value . . . $350,000 Bronze book value . . . 300,000 Excess fair value over book value assigned to copyright (10-year life) . . . . $ 50,000 After the formation of this business combination. Silver made significant intra-entity inventory sales to Gold. The volume of these transfers follows:
Transfer Price to Markup on Inventory Retained at Year Gold Company Transfer Price Year-End (at transfer price)
2009 $100,000 30% $ 60,000
2010 160,000 25 90,000
2011 200,000 28 120,000
In addition, on July 1, 2011, Gold sold Bronze a tract of land for $25,000. This property cost $12,000 when the parent acquired it several years ago.
The initial value method is used to account for all investments. The individual firms recognize in- come from the investments when dividends are received. Because consolidated statements are prepared for the business combination, accounting for the investments affects internal reporting only. During 2009 and 2010, Gold and Silver individually reported the following information:
Gold Silver Company Company
2009:
Operational income . . . $180,000 $120,000 Dividend income—Silver Company (90%) . . . 36,000 –0–
Dividends paid . . . 80,000 40,000 2010:
Operational income . . . 240,000 150,000 Dividend income—Gold Company (10%) . . . –0– 9,000 Dividend income—Silver Company (90%) . . . 27,000 –0–
Dividends paid . . . 90,000 30,000 The 2011 financial statements for each of the three companies comprising this business combination are presented in Exhibit 7.3. These figures ignore income tax effects.
Required
a. Prepare worksheet entries to consolidate the 2011 financial statements for this combination. Assume that the mutual ownership between Gold and Silver is accounted for by means of the treasury stock approach. Compute the noncontrolling interests in Bronze’s income and in Silver’s income.
Comprehensive Illustration PROBLEM
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Consolidated Financial Statements—Ownership Patterns and Income Taxes 319
b. Assume that consolidated net income (before deducting any balance for the noncontrolling interests) amounts to $498,900. Assume also that the effective tax rate is 40 percent and that Gold and Silver file a consolidated tax return but Bronze files separately. Calculate the income tax expense recog- nized within the consolidated income statement for 2011.
SOLUTION
a. The 2011 consolidation entries for Gold, Silver, and Bronze follow.
Entry *G
The consolidation process begins with Entry *G,which recognizes the intra-entity gain (on transfers from Silver to Gold) created in the previous period. The unrealized gain within ending inventory is de- ferred from the previous period into the current period.
Consolidation Entry *G
Retained earnings, 1/1/11 (Silver Company) . . . . 22,500
Cost of goods sold . . . . 22,500 To recognize gains on intra-entity sales made from Silver to Gold
during the preceding year (25% markup $90,000).
Consolidation Entry *C (Gold)
Investment in Silver Company . . . . 164,250
Retained Earnings, 1/1/11 (Gold Company) . . . . 164,250 To convert Gold’s investment income figures for the two preceding
years to equity income accruals computed as follows:
EXHIBIT 7.3 Individual Financial Statements—2011
Gold Silver Bronze
Company Company Company Sales . . . $ (800,000) $ (600,000) $ (300,000) Cost of goods sold . . . 380,000 300,000 120,000 Operating expenses . . . 193,000 100,000 90,000 Gain on sale of land . . . (13,000) –0– –0–
Dividend income from
Gold Company . . . –0– (10,000) –0–
Dividend income from
Silver Company . . . (36,000) –0– –0–
Dividend income from
Bronze Company . . . (6,000) (6,000) –0–
Net income . . . $ (282,000) $ (216,000) $ (90,000) Retained earnings, 1/1/11 . . . $ (923,200) $ (609,000) $ (200,000) Net income (above) . . . (282,000) (216,000) (90,000) Dividends paid . . . 100,000 40,000 20,000
Retained earnings, 12/31/11 . . . $(1,105,200) $ (785,000) $ (270,000) Cash and receivables . . . $ 295,000 $ 190,000 $ 130,000 Inventory . . . 459,000 410,000 110,000
Investment in Silver Company . . . 570,000 –0– –0–
Investment in Gold Company . . . –0– 150,000 –0–
Investment in Bronze Company . . . 105,000 105,000 –0–
Land, buildings, and equipment (net) . . . 980,000 670,000 380,000 Total assets . . . $ 2,409,000 $ 1,525,000 $ 620,000 Liabilities . . . $ (603,800) $ (540,000) $ (250,000) Common stock . . . (700,000) (200,000) (100,000) Retained earnings, 12/31/11 . . . (1,105,200) (785,000) (270,000) Total liabilities and equities . . . $(2,409,000) $(1,525,000) $ (620,000) hoy36628_ch07_293-334.qxd 1/6/10 8:04 AM Page 319
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320 Chapter 7
Increase in Silver’s book value from 1/1/09 to 1/1/11
($809,000 600,000) . . . . $209,000 Excess fair-value amortization ($2,000 2 years) . . . . (4,000) Deferral of 12/31/10 intra-entity profit (25% $90,000) . . . . (22,500) Silver’s increase in book value adjusted for accruals recognized
in combination . . . . $182,500 Gold’s ownership percentage . . . . 90%
Conversion from initial value method to equity method . . . . $164,250
Consolidation Entry S1
Common Stock (Silver Company) . . . . 200,000 Retained Earnings, 1/1/11 (Silver Company) . . . . 586,500
Investment in Silver Company (90%) . . . . 707,850 Noncontrolling Interest in Silver Company, 1/1/11 (10%) . . . . 78,650 To eliminate the beginning stockholders’ equity accounts of Silver and
to recognize a 10 percent noncontrolling interest in the subsidiary.
Retained Earnings has been adjusted for Entry *G.
Consolidation Entry S2
Common Stock (Bronze Company) . . . . 100,000 Retained Earnings, 1/1/11 (Bronze Company) . . . . 200,000
Investment in Bronze Company (60%) . . . . 180,000 Noncontrolling Interest in Bronze Company, 1/1/11 (40%) . . . . 120,000 To eliminate Bronze’s beginning stockholders’ equity accounts and to
recognize outside ownership of the company’s remaining shares. The investments of both Gold and Silver are accounted for concurrently through this one entry.
Consolidation Entry TS
Treasury Stock . . . . 150,000
Investment in Gold . . . . 150,000 To reclassify Silver’s investment in Gold as treasury stock.
Consolidation Entry A
Brand Name . . . . 36,000 Copyright . . . . 50,000
Investment in Silver . . . . 32,400 Noncontrolling Interest in Silver . . . . 3,600 Investment in Bronze . . . . 30,000 Noncontrolling Interest in Bronze . . . . 20,000 To recognize unamortized beginning-of-the-year balances from the
excess fair value over book value acquisition-date allocations.
Consolidation Entry I
Dividend Income from Gold Company . . . . 10,000 Dividend Income from Silver Company . . . . 36,000 Dividend Income from Bronze Company . . . . 12,000
Dividends Paid (Gold Company) . . . . 10,000 Dividends Paid (Silver Company) . . . . 36,000 Dividends Paid (Bronze Company) . . . . 12,000 To eliminate dividend payments made between the companies and
recorded as income based on application of the initial value method.
Consolidation Entry E
Amortization Expense . . . . 7,000
Brand Name . . . . 2,000 Copyright . . . . 5,000 To recognize current year amortizations of the acquisition-date excess
fair-value allocations.
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Consolidated Financial Statements—Ownership Patterns and Income Taxes 321
Consolidation Entry TI
Sales . . . . 200,000
Cost of Goods Sold . . . . 200,000 To eliminate the intra-entity transfer of inventory made in 2011
by Silver.
Consolidation Entry G
Cost of Goods Sold . . . . 33,600
Inventory . . . . 33,600 To eliminate intra-entity gains remaining in Gold’s December 31, 2011,
inventory (28 percent gross profit rate ⫻the parent’s $120,000 ending inventory balance).
Consolidation Entry GL
Gain on Sale of Land . . . . 13,000
Land . . . . 13,000 To eliminate gain on intra-entity transfer of land from Gold to Bronze
during the year.
Noncontrolling Interest in Bronze Company’s Income
As in all previous examples, the noncontrolling interest calculates its claim to a portion of consolidated income based on the subsidiary’s income after amortizations and intra-entity profit deferrals and recog- nitions. Because this subsidiary has no unrealized intra-entity gains, the $90,000 income figure reported in Exhibit 7.3 is applicable and is adjusted only for the $5,000 excess fair-value amortization. Thus, the noncontrolling interest in Bronze’s income is $34,000 [40% ⫻($90,000 ⫺$5,000)].
Noncontrolling Interest in Silver Company’s Income
Again, the noncontrolling interest calculates its claim to a portion of consolidated income based on the subsidiary’s income after amortizations and intra-entity profit deferrals and recognitions. For Silver Company the adjustments are as follows:
Silver’s internally computed net income . . . $210,000 Excess fair-value amortization . . . (2,000) Equity in earnings of Bronze (30%) . . . 27,000 Beginning intra-entity profit recognized . . . 22,500 Ending intra-entity profit deferral . . . (33,600) Silver’s income adjusted for combination accruals . . . $223,900 Noncontrolling interest percentage . . . 10%
Noncontrolling interest in Silver’s net income . . . $ 22,390 b. No differences exist between Bronze’s book values and tax basis. No computation of deferred income
taxes is required; thus, this company’s separate tax return is relatively straightforward. The $90,000 income figure creates a current tax liability of $36,000 (using the 40 percent tax rate).
In contrast, the consolidated tax return filed for Gold and Silver must include the following financial information. When applicable, figures reported in Exhibit 7.3 have been combined for the two companies.
Tax Return Information—Consolidated Return
Sales . . . $1,400,000
Less: Intra-entity sales (2011) . . . (200,000) $1,200,000 Cost of goods sold . . . $ 680,000
Less: 2011 intra-entity purchases . . . (200,000) Less: 2010 intra-entity gains recognized in 2011
(90,000 ⫻25%) . . . (22,500) Add: 2011 unrealized intra-entity gains
(120,000 ⫻28%) . . . 33,600 491,100 Gross profit . . . $ 708,900 Operating expenses (including amortization) . . . 300,000
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322 Chapter 7
Operating income . . . $ 408,900 Other income (since Bronze is not part of affiliated group):
Gain on sale of land . . . 13,000 Dividend income—Bronze Company . . . $ 12,000
Less: 80% dividends received deduction . . . (9,600) 2,400 Taxable income . . . $ 424,300 Tax rate . . . 40%
Income tax payable by Gold Company
and Silver Company for 2011 . . . $ 169,720 Members of this business combination must pay a total of $205,720 to the government in 2011 ($36,000 for Bronze and $169,720 in connection with the consolidated return of Gold and Silver). Any temporary differences that originate or reverse during the year necessitate accounting for deferred in- come tax assets and/or liabilities. In this illustration, only the dividend payments from Bronze and the un- realized gain on the sale of land to Bronze actually create such differences. For example, amortization of the intangible assets is the same for book and tax purposes. Other items encountered do not lead to de- ferred income taxes:
• Because Gold and Silver file a consolidated return, they defer the unrealized inventory gains for both tax purposes and financial reporting so that no difference is created.
• The dividends that Silver paid to Gold are not subject to taxation because these distributions were made between members of an affiliated group.
However, recognition of a deferred tax liability is required because Bronze’s realized income ($54,000 after income tax expense of $36,000) is higher than its $20,000 dividend distribution. Gold and Silver own 60 percent of Bronze, indicating that the consolidated income statement includes $32,400 ($54,000 60%) of its income. Because this figure is $20,400 more than the amount of dividends it paid Gold and Silver ($12,000, or 60% of $20,000), a deferred tax liability is required. The temporary differ- ence is actually $4,080 (20% of $20,400) because of the 80 percent dividends received deduction. The future tax effect on this difference is $1,632 based on the 40 percent tax rate applied.
A deferred tax asset also is needed in connection with Gold’s intra-entity sale of land to Bronze.
These companies file separate returns. Thus, the gain is taxed immediately, although this $13,000 is not realized for reporting purposes until a future resale occurs. From an accounting perspective, the tax of
$5,200 ($13,000 40%) is being prepaid in 2011.
Recognition of the current payable as well as the two deferrals leads to an income tax expense of
$202,152:
Income Tax Expense . . . . 202,152 Deferred Income Tax—Asset . . . . 5,200
Income Taxes Payable—Current . . . . 205,720 Deferred Income Tax—Liability . . . . 1,632
Questions 1. What is a father-son-grandson relationship?
2. When an indirect ownership is present, why is a specific ordering necessary for determining the incomes of the component corporations?
3. Able Company owns 70 percent of the outstanding voting stock of Baker Company, which, in turn, holds 80 percent of Carter Company. Carter possesses 60 percent of Dexter Company’s capital stock.
How much income actually accrues to the consolidated entity from each of these companies after considering the various noncontrolling interests?
4. How does the presence of an indirect ownership (such as a father-son-grandson relationship) affect the mechanical aspects of the consolidation process?
5. What is the difference between a connecting affiliation and a mutual ownership?
6. In accounting for mutual ownerships, what is the treasury stock approach?
7. For income tax purposes, how is affiliated groupdefined?
8. What are the advantages to a business combination filing a consolidated tax return? Considering these advantages, why do some members of a business combination file separate tax returns?
9. Why is the allocation of the income tax expense figure between the members of a business combi- nation important? By what methods can this allocation be made?
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Consolidated Financial Statements—Ownership Patterns and Income Taxes 323 10. If a parent and its subsidiary file separate income tax returns, why will the parent frequently have to recognize deferred income taxes? Why might the subsidiary have to recognize deferred income taxes?
11. In a recent acquisition, the consolidated value of a subsidiary’s assets exceeded the basis appropri- ate for tax purposes. How does this difference affect the consolidated balance sheet?
12. Jones acquires Wilson, in part because the new subsidiary has an unused net operating loss carry- forward for tax purposes. How does this carryforward affect the consolidated figures at the acquisi- tion date?
13. A subsidiary that has a net operating loss carryforward is acquired. The related deferred income tax asset is $230,000. Because the parent believes that a portion of this carryforward likely will never be used, it also recognizes a valuation allowance of $150,000. At the end of the first year of owner- ship, the parent reassesses the situation and determines that the valuation allowance should be re- duced to $110,000. What effect does this change have on the business combination’s reporting?
Problems 1. In a father-son-grandson business combination, which of the following is true?
a. The father company always must have its realized income computed first.
b. The computation of a company’s realized income has no effect on the realized income of other companies within a business combination.
c. A father-son-grandson configuration does not require consolidation unless one company owns shares in all of the other companies.
d. All companies solely in subsidiary positions must have their realized income computed first within the consolidation process.
2. A subsidiary owns shares of its parent company. Which of the following is true concerning the trea- sury stock approach?
a. It is one of several options to account for mutual holdings available under current accounting standards.
b. The original cost of the subsidiary’s investment is a reduction in consolidated stockholders’ equity.
c. The subsidiary accrues income on its investment by using the equity method.
d. The treasury stock approach eliminates these shares entirely within the consolidation process.
3. On January 1, a subsidiary buys 10 percent of the outstanding shares of its parent company. Although the total book value and fair value of the parent’s net assets were $4 million, the price paid for these shares was $420,000. An intangible asset is amortized in this business combination over a 40-year pe- riod. During the year, the parent reported $510,000 of operational income (no investment income was included) and paid dividends of $140,000. How are these shares reported at December 31?
a. The investment is recorded as $457,000 and then eliminated for consolidation purposes.
b. Consolidated stockholders’ equity is reduced by $457,000.
c. The investment is recorded as $456,500 and then eliminated for consolidation purposes.
d. Consolidated stockholders’ equity is reduced by $420,000.
4. Which of the following is correct for two companies that want to file a consolidated tax return as an affiliated group?
a. One company must hold at least 51 percent of the other company’s voting stock.
b. One company must hold at least 65 percent of the other company’s voting stock.
c. One company must hold at least 80 percent of the other company’s voting stock.
d. They cannot file one unless one company owns 100 percent of the other’s voting stock.
5. How does the amortization of tax-deductible goodwill affect the computation of a parent company’s income taxes?
a. It is a deductible expense only if the parent owns at least 80 percent of subsidiary’s voting stock.
b. It is deductible only as impairments are recognized.
c. It is a deductible item over a 15-year period.
d. It is deductible only if a consolidated tax return is filed.
6. Which of the following is nota reason for two companies to file separate tax returns?
a. The parent owns 68 percent of the subsidiary.
b. They have no intra-entity transactions.
c. Intra-entity dividends are tax free only on separate returns.
d. Neither company historically has had an operating tax loss.
LO1
LO3
LO3
LO4
LO5
LO4
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