Chapter 10

Subsidiary
Preferred Stock,
Consolidated
Earnings Per
Share, and
Consolidated
Income Taxation
Preferred Stock, EPS, and Taxes:
Objectives

1. Modify consolidation procedures for

subsidiary companies with outstanding
preferred stock.
2. Calculate basic and diluted earnings per
share for a consolidated entity.
3. Understand the complexities of accounting
for income taxes by consolidated entities.

© Pearson Education Limited 2015 10-2

 Subsidiary Preferred Stock, Consolidated Earnings Per
Share, and Consolidated Income Taxation

1: PREFERRED STOCK

© Pearson Education Limited 2015 10-3

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

© Pearson Education Limited 2015 10-4

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

© Pearson Education Limited 2015 10-5

Review of Preferred Stock
Characteristics
• Callable, redeemable
• Cumulative or noncumulative
• Participative or non-participative
• Limited voting rights
Most is cumulative and
nonparticipating
Book Value of PS is:
Call or redemption price (par value
if neither)
Plus Dividends in arrears (if
cumulative)
© Pearson Education Limited 2015
Income allocated to PS is:
Current period dividend
irrespective of amount declared,
if cumulative
• Declared amount if
noncumulative
• Potentially more if participative
Preferred stock dividend is:
Face value x dividend rate
Also consider:
• Arrearage
• Participation
10-6
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.
© Pearson Education Limited 2015 10-7
 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% x $100 PS par value.
Dividends are cumulative, so the current dividend is
$10 = 10% x $100 PS par value.

© Pearson Education Limited 2015 10-8

 Allocations
Income allocation:  
Sol's net income $50
NCI share –
Amortizations 0 (preferred)
NCI share
Income to allocate 50 $10 income (10%
Allocated to preferred (10) common)
$10 dividend
Allocated to $4 income
common $40
$2 dividend
   
Dividends $30
CI share (90%)
Allocated to preferred (10)
$36 income
Allocated to
common $20 $18 dividend

© Pearson Education Limited 2015 10-9

 Income from Sol (-R, -SE) 36  
Worksheet Dividends (+SE)   18
Entries with Investment in Sol (-A)   18
Preferred Noncontrolling interest share, CS (-SE) 4  
Dividends (+SE)   2
Stock Held
Noncontrolling interest, CS (+SE)   2
by Outsiders Noncontrolling interest share, PS (-SE) 10  
Dividends (+SE)   10
Preferred Stock (-SE) 100
There is an
Retained earnings (-SE) 5
entry for NCI
share, PS that Noncontrolling interests, PS (+SE) 105
parallels the Common stock (-SE) 200  
entry for NCI Other paid in capital (-SE) 40  
share, CS. Retained earnings (-SE) 155  
Preferred
Goodwill (+A) 45  
Stock is
eliminated. Investment in Sol (-A)   396
Noncontrolling interest, CS (+SE)   44

© Pearson Education Limited 2015 10-10

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 the book value of the PS
– Increase for dividends in arrears
– Decrease later when declared

© Pearson Education Limited 2015 10-11

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

© Pearson Education Limited 2015 10-12

Example: Parent Acquires PS

Poe owns 90% of Sol acquired at fair value plus

implied goodwill of $45.
On 1/1/14 Poe acquires 80% of Sol's outstanding
preferred stock for $80.

Sol's equity at 1/1/14:

$10 Preferred stock, $100 par, callable

at $105, cumulative, 1 year in arrears $100
Common stock $10 par 200
Other paid-in capital 40
Retained earnings 140
Total equity $480

© Pearson Education Limited 2015 10-13

Calculations at 1/1/14

Book value of preferred stock

($105 call price + $10 arrearage) x
($100 total PS / $100 par) shares
= $115
Book value of Sol's common stock
$480 total equity – $115 = $365

Sol's total value with goodwill

$480 total equity + $45 goodwill = $525

Investment in Sol, CS (90%) = $369

Noncontrolling interest, CS (10%) = $41
Noncontrolling interest, PS (20%) = $115

© Pearson Education Limited 2015 10-14

Acquisition of PS by Poe

Poe acquires 80% of Sol's PS for $80 on 1/1/14

Poe may use the constructive retirement or cost basis

Investment in Sol, PS (at book value)

80% x 115 = $92
Or
Investment in Sol, PS (at cost)
= $80

The difference, $12 = $92 - $80, increases the parent's other paid-in
capital for the constructive retirement method.

© Pearson Education Limited 2015 10-15

Sol’s 2014 Income and Dividends

For 2014, Sol had $20 in income and paid no

dividends.

Totals CI NCI
Sol’s net income $20
Allocated to preferred
(10) $8 $2
shareholders
To common
$10 $9 $1
shareholders

© Pearson Education Limited 2015 10-16

Constructive Retirement Entries
 POE'S ACQUISITION ENTRY 1/1/14: 
Investment in Sol, preferred (+A) 92  
Cash (-A)   80
Other paid-in capital (+SE)   12
 CONSOLIDATION WORKSHEET ENTRY 12/31/14:
Income from Sol, preferred (-R, -SE) 8  
Investment in Sol, preferred (+SE) 8
NCI share, preferred (-SE) 2
NCI, preferred (+SE) 2
Income from Sol, common (-R, -SE) 9
Investment in Sol, common 9

© Pearson Education Limited 2015 10-17

Constructive Retirement Entries
(cont.)
NCI share, common (-SE) 1
NCI, common (+SE) 1
Preferred stock (-SE) 100
Retained earnings (-SE) 15
Investment in Sol, preferred (+SE) 92
NCI, preferred (+SE) (20% x 115) 23
Common stock (-SE) 200  
Other paid in capital (-SE) 40  
Retained earnings (-SE) 125  
Goodwill (+A) 45  
Investment in Sol, common (-A)   369
Noncontrolling interest, common (20%)   41

© Pearson Education Limited 2015 10-18

Cost Basis Entries

 PARENT'S ACQUISITION ENTRY 1/1/14:

Investment in Sol, preferred (+A) 80  
Cash (-A)   80
CONSOLIDATION WORKSHEET ENTRIES 12/31/14: 
Income from Sol, preferred (-R, -SE) 8
Investment in Sol, preferred (-A) 8
NCI share, preferred (-SE) 2
NCI, preferred (+SE) 2
Income from Sol, common (-R, -SE) 9
Investment in Sol, common (-A) 9
NCI share, common (-SE) 1
NCI, common (+SE) 1

© Pearson Education Limited 2015 10-19

Cost Basis Entries (cont.)

Preferred stock (-SE) 100  

Retained earnings (-SE) 15
Investment in Sol, preferred (-A) 80
Other paid-in capital (+SE) 12
NCI, preferred (+SE) 23
Common stock (-SE) 200  
Other paid in capital (-SE) 40  
Retained earnings (-SE) 125  
Goodwill 45  
Investment in Sol, common (-A)   369
Noncontrolling interest, common (+SE)   41

© Pearson Education Limited 2015 10-20

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
© Pearson Education Limited 2015 10-21
 Subsidiary Preferred Stock, Consolidated Earnings Per
Share, and Consolidated Income Taxation

2: EARNINGS PER SHARE

© Pearson Education Limited 2015 10-22

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

© Pearson Education Limited 2015 10-23

Review Basic EPS

Numerator:
Net income – preferred stock dividends*
* current dividends if cumulative, otherwise
declared dividends
Denominator:
Weighted average shares of common stock

© Pearson Education Limited 2015 10-24

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

© Pearson Education Limited 2015 10-25

Effect of Dilutive Securities on EPS

Bonds payable convertible into common

– Numerator: after-tax interest expense
– Denominator: common shares bonds represent
Preferred stock convertible into common
– Numerator: preferred stock dividend
– Denominator: common shares the preferred shares
represent
Options or warrants for common stock
– Numerator: none
– Denominator: "treasury stock method" to compute shares
(only if positive, i.e., dilutive)

# shares – (# shares x option price / average market price)

© Pearson Education Limited 2015 10-26

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:
– Parent’s share of subsidiary's net income adjusted for
intercompany profits/losses and constructive gains/losses
• Does not include amortizations of valuation differentials
Diluted earnings:
– Subsidiary's diluted EPS x shares held by parent
Parent's diluted EPS
– Numerator: Reduce by difference
– Denominator: No effect – no parent shares!

© Pearson Education Limited 2015 10-27

Subsidiary PS Convertible into
Subsidiary CS
Sad 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 Sad
common stock.
Sad's basic EPS:

($50 - $10) / 20 = $2.00

Sad's diluted EPS:

($50 - $10) + $10 = $1.5625

20 + 12 .
© Pearson Education Limited 2015 10-28
Parent's Basic EPS

Sad is 90% owned by Pan. Pan's separate income is

$150. Pan has 200 shares of common outstanding
all year and no dilutive securities.
Pan’s net income
– Separate income $150
– Income from Sad 90% (50-10) 36
– Pan’s net income $186

Pan's basic EPS:

$186 / 200 = $0.93

© Pearson Education Limited 2015 10-29

Parent's Diluted EPS

Pan's realized income from Sad

90% x $40 = $36
Pan's share of Sad'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.

Pan's diluted EPS:

$186 – 36 + 28.125 = $0.89
200 .

© Pearson Education Limited 2015 10-30

Subsidiary Securities Convertible
into Parent Common Stock
Parent's diluted EPS calculation:
– Numerator: Add adjustments for subsidiary securities
convertible into parent common stock
• Preferred stock dividends for shares assumed converted
• After-tax interest on bonds assumed converted
– Denominator: Add parent common shares represented by
subsidiary's dilutive securities
• Parent common shares to be issued for subsidiary
preferred stock or bonds
• Parent common shares assumed issued for options or
warrants (treasury stock method)

© Pearson Education Limited 2015 10-31

Parent's Diluted EPS

Use the same assumptions and data as before, except

that Sad’s preferred stock is convertible into 24
shares of Pan’s common stock.

Sad’s preferred stock dividends on shares assumed to

be converted by Pan is (90% x $10 preferred stock
dividend) = $9

Pan's diluted EPS:

$186 + 9 = $0.87
200 + 24 .

© Pearson Education Limited 2015 10-32

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 issued options for 60 shares of its

parent's (Pad) 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 Pad's common stock.
The bonds were issued at par to yield 7%. The
effective tax rate is 34%.

© Pearson Education Limited 2015 10-33

Parent's Data and Basic EPS

Pad has $1,800 income (including $300 from Syd)

and 1,000 shares of common stock outstanding all
year. It has no preferred stock or dilutive securities.

Pad's basic EPS:

$1,800 / 1,000 shares = $1.80

© Pearson Education Limited 2015 10-34

Parent's Diluted EPS

Impact of Syd's options for Pad common:

– Numerator: none
– Denominator: 60 - (60 x $10/$15) = 20 shares
Impact of Syd's bonds convertible to Pad common:
– Numerator: 7% x $1,000 x (1-34%) = $46.2
– Denominator: 80 shares
Pad's diluted EPS:
$1,800 + 0 + $46.2 = $1.68
1,000 + 20 + 80 .

© Pearson Education Limited 2015 10-35

 Subsidiary Preferred Stock, Consolidated Earnings Per
Share, and Consolidated Income Taxation

3: INCOME TAXES

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Consolidated Tax Return

Advantages
– Offset affiliate losses (excluding preacquisition
loss carry forwards)
– Exclude 100% of intercompany dividends
– Defer intercompany profits until realized (losses
are also deferred)
Disadvantages
– Loss of flexibility from filing separate returns
– Difficult to switch back to unconsolidated
• Cannot file as consolidated again for 5 years

© Pearson Education Limited 2015 10-37

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 ASC 740-10-05]
– Exception for undistributed earnings of foreign
subsidiaries and foreign joint ventures

© Pearson Education Limited 2015 10-38

Undistributed Earnings

Par owns 30% of Sea's common stock.

– Sea's income, $600
– Sea's dividends, $200
– Par's applicable tax rate = 34%
Filing separate returns, Par's deferred tax liability =
[30%($600 - $200)] x 20% x 34% = $8.16
Sea's earnings are allowed the 80% deduction, so only 20%
is subject to tax.
Filing a consolidated return, Sea’s earnings would be
excluded and Par would have no deferred tax liability.

© Pearson Education Limited 2015 10-39

Unrealized Gains 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

© Pearson Education Limited 2015 10-40

Example

Pal owns 90% of Sal. The tax rate is 34%. Pretax

operating income of Pal 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 $40 and

there remains $10 in unrealized profits in ending
inventory.

© Pearson Education Limited 2015 10-41

Consolidated Tax Return

Downstream sales
• Pal's income $150 - $10 unrealized gain = $140
• Sal's income $50
• Consolidated taxes ($140 + $50) x 34% = $64.6
– Allocate
(140/(140+50)) x $64.6 = $47.6 to Pal
(50/(140+50)) x $64.6 = $17.0 to Sal

Upstream sales
• Pal'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 Pal
(40/(150+40)) x $64.6 = $13.6 to Sal

© Pearson Education Limited 2015 10-42

Entries with Consolidated Return

Pal 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

No special considerations for consolidation

worksheet.

© Pearson Education Limited 2015 10-43

Separate Tax Returns

Downstream sales
Pal's accounting income $150 - $10 = $140
– Pal's taxes payable $150 x 34% = $51.0
– Pal's deferred tax asset $10 x 34% = $3.4
– Income tax expense $47.6
Sal's income $50
– Sal's taxes $50 x 34% = $17.0

Upstream sales
Pal's income $150
– Pal'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 tax asset $10 x 34% = $3.4
– Sal's income tax expense $13.6

© Pearson Education Limited 2015 10-44

Business Combinations

Tax free reorganizations

– 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

© Pearson Education Limited 2015 10-45

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

© Pearson Education Limited 2015 10-46

Income Tax Disclosures

Deferred tax assets and liabilities

– Separate into current and non-current
– Based on related asset or liability reporting
Income tax expense
– Separated into its components of expense and
benefits related to:
• Continuing operations
• Discontinued operations
• Extraordinary items

Income tax component of prior-period

adjustments

© Pearson Education Limited 2015 10-47