Advanced Accounting II Chapter 10

ADVANCED
ACCOUNTING II
CHAPTER 10
SUBSIDIARY PREFFERED STOCK, CONSOLIDATED EARNING PER
SHARE, AND CONSOLIDATED INCOME TAXATION
Objectives
1. Modify consolidation procedures for subsidiary companies with
preferred stock in their capital structure.
2. Calculate basic and diluted earnings per share for a consolidated
reporting entity.
3. Understand the complexities of accounting for income taxes by
consolidated entities.
ADVANCED ACCOUNTING II 2
Subsidiary Preferred Stock
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
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
Review of Preferred Stock
Characteristics Income allocated to PS is:
 Callable, redeemable Current period dividend
 Cumulative or noncumulative  Irrespective of amount
 Participative or non- declared, if cumulative
participative  Declared amount if
 Limited voting rights noncumulative
 Potentially more if
Most is cumulative and participative
nonparticipating
Book Value of PS is: Preferred stock dividend is:
 Call or redemption price (par Face value x dividend rate Also
value if neither) consider:
 Arrearage
 Plus Dividends in arrears (if
cumulative)  Participation
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.
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).
Allocations
Income allocation: NCI share –
Preferred
Sol's net income 50 NCI share
Amortizations 0 $10 income (10%
common)
Income to allocate 50 $10 dividend
Allocated to preferred (10) $4 income
Allocated to common 40
$2 dividend
CI share (90%)
Dividends 30
Allocated to preferred (10) $36 income
Allocated to common 20
$18 dividend
Worksheet Entries with Preferred
Stock Held by Outsiders
Income from Sol 36
Dividends 18
Investment in Sol 18
Noncontrolling interest share, CS 4
Dividends 2
Noncontrolling interest, CS 2
Noncontrolling interest share, PS 10
Dividends 10
Preferred stock 100
Common stock 200
Other paid in capital 40
Retained earnings 160
Goodwill 45
Investment in Sol 396
Noncontrolling interest, CS 44
Noncontrolling interest, PS 105
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
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
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
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 = 1092-950, increases the parent's other paid in capital
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
Goodwill 100
Investment in Shem, CS (80%) 3,072
Investment in Shem, PS (70%) 1,092
Noncontrolling interest, CS (20%) 768
Noncontrolling interest, PS (30%) 468
Cost Basis Entries
Parent's acquisition entry:
Investment in Shem, PS (70%) 950
Cash 950
Worksheet entry
Preferred stock 1,500
Common stock 300
Goodwill 100
Investment in Shem, CS (80%) 3,072
Investment in Shem, PS (70%) 950
Noncontrolling interest, CS (20%) 768
Noncontrolling interest, PS (30%) 468
Other paid in capital (Plato's) 142
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
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
Review Basic EPS
 Numerator:
Net income – preferred stock dividends*
* current dividends if cumulative, otherwise declared dividends
 Denominator:
Weighted average shares of common stock
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
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
Convertible preferred stock
 Numerator: none
 Denominator: "treasury stock method" to compute shares (if positive)
# shares – (# shares x option price / market price)
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!
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
20 + 12
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
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 $1.5625 = $28.125
 Since the share of diluted earnings is lower, we will reduce the
numerator by the difference.
Plant's diluted EPS:
$186 – 36 + 28.125 = $0.89
200
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
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%.
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
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:
$1,800 + 0 + $46.2 = $1.76
1,000 + 20 + 80
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
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.
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.
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
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.
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
 Allocate
(150/(150+40)) x $64.6 = $51.0 to Pool
(40/(150+40)) x $64.6 = $13.6 to Sal
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.
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
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
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

Advanced Accounting II Chapter 10

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Advanced Accounting II Chapter 10

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ADVANCED

 Preferred stock is held by parent

Main issue: Subsidiary's capital structure

Seed's diluted EPS:

Paddy's basic EPS:

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