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

Subsidiary Preferred Stock, Consolidated Earnings per Share, and Consolidated Income Taxation. Chapter 10. Learning Objective 1. Modify consolidation procedures for subsidiary companies with preferred stock in their capital structure. Subsidiaries with Preferred Stock Outstanding.

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

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  1. Subsidiary Preferred Stock,Consolidated Earnings per Share,and Consolidated Income Taxation Chapter 10

  2. Learning Objective 1 Modify consolidation procedures for subsidiary companies with preferred stock in their capital structure.

  3. Subsidiaries with PreferredStock Outstanding When preferred stock has a call or redemption price, this amount is used in allocating the investee’s equity to preferred stockholders.

  4. 2 Any dividends in arrears on cumulative preferred stock is allocated to the preferred stockholders. Subsidiaries with PreferredStock Outstanding 1 If there is no redemption provision, the equity is allocated on the basis of par value plus any liquidation premium.

  5. Subsidiary With Preferred StockNot Held by Parent Poe acquired a 90% interest in Sol on January 1, 2004, for $395,500. There were no preferred dividends in arrears as of January 1, 2004. During 2004, Sol had income of $50,000 and paid $30,000 dividends. Dividends were $20,000 on common stock and $10,000 on preferred stock.

  6. Subsidiary With Preferred StockNot Held by Parent Sol’s stockholders’ equity December 31, 2003 $10 preferred stock, $100 par, cumulative, nonparticipating, callable at $105 per share $100,000 Common stock, $10 par 200,000 Other paid-in capital 40,000 Retained earnings 160,000 Total stockholders’ equity $500,000

  7. Subsidiary With Preferred StockNot Held by Parent Total Sol stockholders’ equity $500,000 Less: Preferred stockholders’ equity (1,000 × $105) –105,000 Common stockholders’ equity $395,000 Price paid for 90% interest $395,500 Less: Book and fair value acquired ($395,000 × 90%) –355,500 Goodwill $ 40,000

  8. Subsidiary With Preferred StockNot Held by Parent Sol’s stockholders’ equity December 31, 2004 Total stockholders’ equity $520,000 Less: Preferred stockholders’ equity (1,000 × $105) –105,000 Common stockholders’ equity $415,000

  9. Minority interest in Sol at December 31, 2004 $105,000 × 100% of preferred equity $105,000 $415,000 × 10% of common equity 41,500 Total $146,500 Minority Interest inPreferred Stock

  10. Subsidiary Preferred StockAcquired by Parent A parent company’s purchase of the outstanding preferred stock of a subsidiary results in a retirement of the stock purchased from the viewpoint of the consolidated entity.

  11. Subsidiary Preferred StockAcquired by Parent Sol Corporation experienced a loss of $40,000 in 2005. No dividends were paid. What is Sol’s stockholders’ equity at 12/31/2005? $520,000 – $40,000 = $480,000

  12. Subsidiary Preferred StockAcquired by Parent What is Poe’s share of this loss? ($40,000 + $10,000 income to preferred) × 90% $45,000 What is Poe’s investment in Sol on 12/31/2005?

  13. Subsidiary Preferred StockAcquired by Parent Poe’s Investment Dividends 1/1/2004 395,500 12/31/2004 36,000 1/1/2005 413,500 368,500 18,000 45,000 loss 12/31/2005

  14. Constructive Retirement ofSubsidiary Preferred Stock On January 1, 2006, Poe purchased 800 of Sol’s preferred shares (80% interest) at $100 per share. Sol reports net income of $20,000 for 2006. $115,000 × 80% = $92,000 book value $92,000 – $80,000 = $12,000

  15. Constructive Retirement ofSubsidiary Preferred Stock Investment in Sol Preferred 80,000 Cash 80,000 To record purchase of stock Investment in Sol Preferred 12,000 Other Paid-in Capital 12,000 To adjust other paid-in capital to reflect constructive retirement

  16. Constructive Retirement ofSubsidiary Preferred Stock Poe’s Investment Dividends 1/1/2004 395,500 12/31/2004 36,000 1/1/2005 413,500 368,500 9,000 377,500 18,000 45,000 loss Income 12/31/2006

  17. Learning Objective 2 Calculated basic and diluted earnings per share for a consolidated reporting entity.

  18. Parent Company and ConsolidatedEarnings Per Share GAAP requires that all firms calculate and report basic and diluted (where applicable) earnings per share (EPS). Consolidated entities disclose (EPS) on a consolidated basis.

  19. Parent Company and ConsolidatedEarnings Per Share A parent company’s net income and EPS under the equity method are equal to consolidated net income and consolidated EPS. Parent Company procedures for computing EPS depend on the subsidiary’s capital structure.

  20. General Format for EPS Calculations Numerator in Dollars ($) A Income to parent’s common stockholders $$$ Add: Adjustments for parent’s dilutive securities + $ Add: Adjustments for subsidiary’s potentially dilutive securities convertible into parent company stock N/A Replacement calculation Deduct: Parent’s equity in subsidiary’s diluted earnings N/A Add: Parent’s equity in subsidiary’s diluted earnings N/A Parent's diluted earnings = a $$$ A: Subsidiary does not have potentially dilutive securities outstanding

  21. General Format for EPS Calculations Numerator in Dollars ($) B Income to parent’s common stockholders $$$ Add: Adjustments for parent’s dilutive securities + $ Add: Adjustments for subsidiary’s potentially dilutive securities convertible into parent company stock N/A Replacement calculation Deduct: Parent’s equity in subsidiary’s diluted earnings – $ Add: Parent’s equity in subsidiary’s diluted earnings + $ Parent's diluted earnings = a $$$ B: Subsidiary has potentially dilutive securities convertible into subsidiary common stock

  22. General Format for EPS Calculations Numerator in Dollars ($) C Income to parent’s common stockholders $$$ Add: Adjustments for parent’s dilutive securities + $ Add: Adjustments for subsidiary’s potentially dilutive securities convertible into parent company stock + $ Replacement calculation Deduct: Parent’s equity in subsidiary’s diluted earnings N/A Add: Parent’s equity in subsidiary’s diluted earnings N/A Parent's diluted earnings = a $$$ C: Subsidiary has potentially dilutive securities convertible into parent company common stock

  23. General Format for EPS Calculations Denominator in Shares (Y) A Parent’s common shares outstanding YYY Add: Shares represented by parent’s potentially dilutive securities + Y Add: Shares represented by subsidiary’s potentially dilutive securities convertible into parent company common shares N/A Parent’s common shares and common share equivalents = b YYY Parent Company and Consolidated Diluted EPS a ÷ b A: Subsidiary does not have potentially dilutive securities outstanding

  24. General Format for EPS Calculations Denominator in Shares (Y) B Parent’s common shares outstanding YYY Add: Shares represented by parent’s potentially dilutive securities + Y Add: Shares represented by subsidiary’s potentially dilutive securities convertible into parent company common shares N/A Parent’s common shares and common share equivalents = b YYY Parent Company and Consolidated Diluted EPS a ÷ b B: Subsidiary has potentially dilutive securities convertible into subsidiary common stock

  25. General Format for EPS Calculations Denominator in Shares (Y) C Parent’s common shares outstanding YYY Add: Shares represented by parent’s potentially dilutive securities + Y Add: Shares represented by subsidiary’s potentially dilutive securities convertible into parent company common shares + Y Parent’s common shares and common share equivalents = b YYY Parent Company and Consolidated Diluted EPS a ÷ b C: Subsidiary has potentially dilutive securities convertible into parent company common stock

  26. Dilutive Securities of SubsidiaryConvertible into Subsidiary Shares Diluted earnings of the parent company are adjusted by excluding the parent’s equity in subsidiary realized income and replacing that equity with the parent’s share of diluted earnings of the subsidiary.

  27. Subsidiary With ConvertiblePreferred Stock Plant Corporation purchased 90% of Seed Corporation’s outstanding voting common stock for $328,000 on January 1, 2003. During 2003, Seed reports $50,000 net income and pays $25,000 dividends, $10,000 to preferred and $15,000 to common.

  28. Subsidiary With ConvertiblePreferred Stock January 1, 2003 Plant Seed Common stock, $5 par, 200,000 shares issued and outstanding $1,000,000 Common stock, $10 par, 20,000 shares outstanding $200,000 10% cumulative, convertible preferred stock, $100 par, 1,000 shares outstanding 100,000 Retained earnings 500,000 120,000 Total stockholders’ equity $1,500,000 $420,000

  29. Subsidiary With ConvertiblePreferred Stock Plant’s Income for 2003 Income from Plant’s operations $150,000 Income from Seed ($50,000 – $10,000 preferred income) × 90% 36,000 Plant net income $186,000

  30. Subsidiary Preferred StockConvertible into Subsidiary Common Seed’s preferred stock is convertible into 12,000 shares of Seed’s common stock. Neither Plant nor Seed has any other potentially dilutive securities outstanding. Seed’s diluted EPS: $50,000 ÷ (20,000 + 12,000) = $1.5625

  31. Subsidiary Preferred StockConvertible into Subsidiary Common Plant’s Diluted EPS Net income of Plant $186,000 Replacement of Plant’s equity in Seed’s realized income ($40,000 × 90%) – 36,000 with Plant’s equity in Seed’s diluted earnings (18,000 × $1.5625) 28,125 Plant’s diluted earnings = a $178,125 Plant’s outstanding shares = b 200,000 Plant’s diluted EPS = a ÷ b $ 0.89

  32. Subsidiary Preferred Convertibleinto Parent Company Common Seed’s preferred stock is convertible into 24,000 shares of Plant’s common stock. Neither Plant nor Seed had other potentially dilutive securities outstanding. Seed’s diluted EPS is $2 ($40,000 income to common ÷ 20,000 common shares). What is Plant’s diluted EPS?

  33. Subsidiary Preferred Convertibleinto Parent Company Common Net income of Plant $186,000 Add: Income to preferred stockholders of Seed assumed to be converted 10,000 Plant’s diluted earnings = a $196,000 Plant’s outstanding shares 200,000 Add: Seed’s preferred shares assumed converted 24,000 Plant common shares and common stock equivalents = b 224,000 Plant’s diluted EPS = a ÷ b $ 0.88

  34. Paddy’s income 2003 Own operations $1,500,000 Syd’s operations $ 300,000 Subsidiary With Optionsand Convertible Bonds Syd is 80% owned by Paddy. 80% × $450,000 Syd net income $360,000 80% × $50,000 unrealized profit – 40,000 Amortization – 20,000 Income from Syd $300,000

  35. Subsidiary With Optionsand Convertible Bonds Paddy: Common stock, 1,000,000 shares Syd: Common stock, 400,000 shares Options to purchase 60,000 shares of stock at $10 per share (average market price is $15 per share) 7% convertible bonds, $1,000,000 par outstanding, convertible into 80,000 shares of common stock

  36. Options and Bonds Convertibleinto Subsidiary Common Stock Syd’s income to common stockholders $450,000 Less: Unrealized profit on sale of land – 50,000 Add: Net-of-tax interest expense assuming bonds converted into subsidiary shares ($1,000,000 × 7% × 66% net of tax) 46,200 Subsidiary adjusted earnings = a $446,200

  37. Options and Bonds Convertibleinto Subsidiary Common Stock Syd’s common shares outstanding 400,000 Incremental shares 60,000 – ($600,000 ÷ $15) 20,000 Additional shares assuming bonds converted into subsidiary shares 80,000 Syd’s adjusted shares = b 500,000 Syd’s diluted EPS = a ÷ b ($446,200 ÷ 500,000) $ 0.89

  38. Options and Bonds Convertibleinto Subsidiary Common Stock Paddy’s income to common stockholders $1,800,000 Replacement of Paddy’s equity in Syd’s realized income ($400,000 × 80%) – 320,000 with Paddy’s equity in Syd’s diluted EPS (320,000 × $0.89) 284,800 Paddy adjusted earnings = a $1,764,800 Paddy outstanding shares = b 1,000,000 Paddy’s diluted EPS = a ÷ b $ 1.76

  39. Options and Bonds Convertibleinto Parent’s Common Stock Paddy’s income to common stockholders $1,800,000 Add: Net-of-tax interest expense assuming bonds were converted into shares ($1,000,000 × 7% × 66% net-of-tax effect) 46,200 Paddy’s adjusted earnings = a $1,846,200

  40. Options and Bonds Convertibleinto Parent’s Common Stock Paddy’s common shares outstanding 1,000,000 Incremental shares 60,000 – ($600,000 ÷ $15) 20,000 Additional shares assuming bonds are converted into parent shares 80,000 Paddy’s adjusted shares = b 1,100,000 Paddy’s diluted EPS = a ÷ b ($1,846,200 ÷ 1,100,000) $ 1.68

  41. Learning Objective 3 Understand the complexities of accounting for income taxes by consolidated entities.

  42. Accounting for Income Taxesof Consolidated Entities An affiliated group exists when a common parent corporation owns at least 80% of the voting power of all classes of stock and 80% or more of the total value of all outstanding stock of each of the includable corporations.

  43. Accounting for Income Taxesof Consolidated Entities A consolidated entity that is an affiliated group may elect to file consolidated income tax returns. All other consolidated entities must file separate income tax returns for each affiliated company.

  44. 1 Losses are offset against income between members. 2 Intercorporate dividends are excluded from taxable income. 3 Intercompany profits are deferred from income until realized. Advantages of FilingConsolidated Returns

  45. 1 Decrease in flexibility. 2 Commitment to consolidated returns year after year. 3 Deconsolidated corporations cannot rejoin the group for 5 years. Disadvantages of FilingConsolidated Returns

  46. Income Tax Allocation FASB Statement No. 109, “Accounting for Income Taxes,” is the primary source of GAAP for accounting for income taxes. Events that have future tax consequences are designated temporary differences.

  47. Income Tax Allocation The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and to recognize deferred tax liabilities and assets for the tax consequences of events that have been recognized in the financial statements or tax returns.

  48. Accounting for Distributedand Undistributed Income Parson owns a 30% interest in Seaton Corporation, a domestic corporation. Seaton reports $600,000 net income and pays dividends of $200,000. The income tax rate is 34%. What is Parson’s share of Seaton’s income?

  49. Accounting for Distributedand Undistributed Income Share of distributed earnings (dividends) ($200,000 × 30%) $ 60,000 Share of undistributed earnings (retained earnings increase) ($400,000 × 30%) 120,000 Equity in Seaton’s earnings $180,000

  50. Accounting for Distributedand Undistributed Income The income tax expense equals income tax liability for the dividends received. $60,000 × 20% taxable × 34% tax rate = $4,080 December 31, 2003 Income Tax Expense 8,160 Deferred Income Taxes 8,160 To provide for taxes on undistributed earnings ($120,000 × 20% × 34% = $8,160)

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