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Chapter 7 - Consolidated Financial Statements - Ownership Patterns And Income Taxes

CHAPTER 7
CONSOLIDATED FINANCIAL STATEMENTS - OWNERSHIP
PATTERNS AND INCOME TAXES

Chapter Outline
I. Indirect subsidiary control
A. Control of subsidiary companies within a business combination is often of an indirect
nature; one subsidiary possesses the stock of another rather than the parent having
direct ownership.
1. These ownership patterns may be developed specifically to enhance control or for
organizational purposes.
2. Such ownership patterns may also result from the parent company's acquisition of a
company that already possesses subsidiaries.
B. One of the most common corporate structures is the father-son-grandson configuration
where each subsidiary in turn owns one or more subsidiaries.
C. The consolidation process is altered somewhat when indirect control is present.
1. The worksheet entries are effectively doubled by each corporate ownership layer but
the concepts underlying the consolidation process are not changed.
2. Calculation of the accrual-based income of a subsidiary recognizing the consolidated
relationships is an important step in an indirect ownership structure.
a. The determination of accrual-based income figures is needed for equity income
accruals as well as for the computation of noncontrolling interest balances.
b. Any company within the business combination that is in both a parent and a
subsidiary position must recognize the equity income accruing from its subsidiary
before computing its own income.

II. Indirect subsidiary control-connecting affiliation

A. A connecting affiliation exists whenever two or more companies within a business
combination hold an equity interest in another member of that organization.
B. Despite this variation in the standard ownership pattern, the consolidation process is
essentially the same for a connecting affiliation as for a father-son-grandson
organization.
C. Once again, any company in both a parent and a subsidiary position must recognize an
appropriate equity accrual in computing its own income.

III. Mutual ownership

A. A mutual affiliation exists whenever a subsidiary owns shares of its parent company.
B. Parent shares being held by a subsidiary are accounted for by the treasury stock
approach.
1. The cost paid to acquire the parent's stock is reclassified within the consolidation
process to a treasury stock account and no income is accrued.

7-1
Chapter 7 - Consolidated Financial Statements - Ownership Patterns And Income Taxes

2. The treasury stock approach is popular in practice because of its simplicity and is now
required by the FASB Codification.

IV. Income tax accounting for a business combination—consolidated tax returns

A. A consolidated tax return can be prepared for all companies comprising an affiliated group.
Any other companies within the business combination file separate tax returns.
B. A domestic corporation may be included in an affiliated group if the parent company (either
directly or indirectly) owns at least 80 percent of the voting stock of the subsidiary as well
as 80 percent of each class of its nonvoting stock.
C. The filing of a consolidated tax return provides several potential advantages to the
members of an affiliated group.
1. Intra-entity profits are not taxed until realized.
2. Intra-entity dividends are not taxed (although these distributions are nontaxable for all
members of an affiliated group whether a consolidated return or a separate return is
filed).
3. Losses of one affiliate can be used to reduce the taxable income earned by other
members of the group.
D. Income tax expense—effect on noncontrolling interest valuation
1. If a consolidated tax return is filed, an allocation of the total expense must be made to
each of the component companies to arrive at the realized income figures that serve
as a basis for noncontrolling interest computations.
2. Income tax expense is frequently assigned to each subsidiary based on the amounts
that would have been paid on separate returns.

V. Income tax accounting for a business combination—separate tax returns

A. Members of a business combination that are foreign companies or that do not meet the 80
percent ownership rule (as described above) must file separate income tax returns.
B. Companies in an affiliated group can elect to file separate tax returns. Deferred income
taxes are often recognized when separate returns are filed due to temporary differences
stemming from unrealized gains and losses as well as intra-entity dividends.

VI. Temporary tax differences can stem from the creation of a business combination
A. The tax basis of a subsidiary's assets and liabilities may differ from their consolidated
values (which is based on the fair market value on the date the combination is created).
B. If additional taxes will result in future years (for example, it the tax basis of an asset is
lower than its consolidated value so that future depreciation expense for tax purposes will
be less), a deferred tax liability is created by a combination.
C. The deferred tax liability is then written off (creating a reduction in tax expense) in future
years so that the net expense recognized (a lower number) matches the combination's
book income (a lower number due to the extra depreciation of the consolidated value).

Vll. Operating loss carryforwards

A. Net operating losses recognized by a company can be used to reduce taxable income
from the previous two years (a carryback) or for the future 20 years (a carryforward).

7-2
Chapter 7 - Consolidated Financial Statements - Ownership Patterns And Income Taxes

B. If one company in a newly created combination has a tax carryforward, the future tax
benefits are recognized as a deferred income tax asset.

C. However, a valuation allowance must also be recorded to reduce the deferred tax asset to
the amount that is more likely than not to be realized.

Answers to Questions

1. A father-son-grandson relationship is a specific type of ownership configuration often

encountered in business combinations. The parent possesses the stock of one or more
companies. At least one of these subsidiaries holds a majority of the voting stock of its own
subsidiary. Each subsidiary controls other subsidiaries with the chain of ownership going on
indefinitely. The parent actually holds control over all of the companies within the business
combination despite having direct ownership in only its own subsidiaries.

2. In a business combination having an indirect ownership pattern, at least one company is in

both a parent and a subsidiary position. To calculate the accrual-based income earned by that
company, a proper recognition of the equity income accruing from its own subsidiary must
initially be made. Structuring the income calculation in this manner is necessary to ensure that
all earnings are properly included by each company.

3. Able—100% of income accrues to the consolidated entity (as parent company).

Baker—70% (percentage of stock owned by Able).
Carter—56% (80% of stock owned by Baker multiplied by the 70% of Baker controlled by
Able).
Dexter—33.6% (60% of stock owned by Carter multiplied by the 80% of Carter controlled by
Baker multiplied by the 70% of Baker owned by Able).

4. When an indirect ownership is present, the quantity of consolidation entries will increase,
perhaps significantly. An additional set of entries is included on the worksheet for each
separate investment. Furthermore, the determination of realized income figures for each
subsidiary must be computed in a precise manner. For any company in both a parent and a
subsidiary position, equity income accruals are recognized prior to the calculation of that
company's realized income. This realized income total is significant because it serves as the
basis for noncontrolling interest calculations as well as the equity accruals to be recognized by
that company's parent.

5. In a connecting affiliation, two (or more) companies within a business combination own shares
in a third member. A mutual ownership, in contrast, exists whenever a subsidiary possesses
an equity interest in its own parent.

6. In accounting for a mutual ownership, SFAS 160 requires the treasury stock approach. The
treasury stock approach presumes that the cost of the parent shares should be reclassified as
treasury stock within the consolidation process. The subsidiary is being viewed, under this
method, as an agent of the parent. Thus, the shares are accounted for as if the parent had
actually made the acquisition.

7-3
Chapter 7 - Consolidated Financial Statements - Ownership Patterns And Income Taxes

7. According to present tax laws, an affiliated group can be comprised of all domestic
corporations in which a parent holds 80 percent ownership. More specifically, the parent must

8. own (directly or indirectly) 80 percent of the voting stock of the corporation as well as at least
80 percent of each class of nonvoting stock.

9. Several basic advantages are available to combinations that file a consolidated tax return.
First, intra-entity profits are not taxed until realized. For companies with large amounts of intra-
entity transactions, the deferral of unrealized gains causes a delay in the making of significant
tax payments. Second, losses incurred by one company can be used to reduce or offset
taxable income earned by other members of the affiliated group. In addition, intra-entity
dividends are not taxable but that exclusion applies to the members of an affiliated group
regardless of whether a consolidated or separate tax return is filed.

Members of a business combination may be forced to file separate tax returns. Foreign
corporations, for example, must always file separately. Domestic companies that do not meet
the 80 percent ownership rule are also required to file in this manner. Furthermore, companies
that are in an affiliated group may still elect to file separately. If all companies within the
combination are profitable and few intra-entity transactions are carried out, little advantage
may accrue from preparing a consolidated return. With a separate filing, a subsidiary has
more flexibility as to accounting methods as well as its choice of a fiscal year-end.

10. The allocation of income tax expense among the component companies of a business
combination has a direct bearing on realized income totals and, therefore, noncontrolling
interest calculations. Obviously, the more expense that is assigned to a particular company
the less realized income is attributed to that concern. Income tax expense can be allocated
based on the income totals that would have been reported by various companies if separate
tax returns had been filed or on the portion of taxable income derived from each company.

11. In filing a separate tax return (assuming that the two companies do not qualify as members of
an affiliated group), the parent must include as income the dividends received from the
subsidiary. For financial reporting purposes, however, income is accrued based on the
ownership percentage of the realized income of the subsidiary. Because income is frequently
recognized by the parent prior to being received in the form of dividends (when it is subject to
taxation), deferred income taxes must be recognized.

Either the parent or the subsidiary might also have to record deferred income taxes in
connection with any unrealized intra-entity gain. On a separate tax return, such gains are
reported at the time of transfer while for financial reporting purposes they are appropriately
deferred until realized. Once again, a temporary difference is created which necessitates the
recognition of deferred income taxes.

12. If the consolidated value of a subsidiary’s assets exceeds their tax basis, depreciation
expense in the future will be less on the tax return than is shown for external reporting
purposes. The reduced expense creates higher taxable income and, thus, increases taxes.
Therefore, the difference in values dictates an anticipated increase in future tax payments.
This deferred liability is recognized at the time the combination is created. Subsequently,

7-4
Chapter 7 - Consolidated Financial Statements - Ownership Patterns And Income Taxes

when actual tax payments do arise, the deferred liability is written off rather than recognizing
expense based solely on the current liability. In this manner, the expense is shown at a lower
figure, one that is matched with reported income (which is also a lower balance because of
the extra depreciation).

Recognition of this deferred liability at date of acquisition also reduces the net amount
attributed to the subsidiary's assets and liabilities in the initial allocation process. Therefore,
the residual asset (goodwill) is increased by the amount of any liability that must be
recognized.

13. A net operating loss carryforward allows the company to reduce taxable income for up to 20
years into the future. Thus, a benefit may possibly be derived from the carryforward but that
benefit is based on Wilson (the subsidiary) being able to generate taxable income to be
decreased by the carryforward. To reflect the potential tax reduction, a deferred income tax
asset is recorded for the total amount of anticipated benefit. However, because of the
uncertainty, unless the receipt of this benefit is more likely than not to be received, a valuation
allowance must also be recorded as a contra account to the asset. The valuation allowance
may be for the entire amount or just for a portion of the asset.

14. At the date of acquisition, the valuation allowance was $150,000. As a contra asset account,
recognition of this amount reduced the net assets attributed to the subsidiary and, hence,
increased the recording of goodwill (assuming that the price did not indicate a bargain
purchase). If the valuation allowance is subsequently reduced to $110,000, the net assets
have increased by $40,000. This change is reflected by a decrease in income tax expense.

Answers to Problems
1. D

2. B

3. D

4. C

5. C

6. C

7. A Damson's accrual-based income:

Operational income ................................................................... $200,000
Defer unrealized gain ................................................................ (40,000)
Damson's accrual-based income ....................................... $160,000

Crimson's accrual-based income:

Operational income ................................................................... $200,000
Investment Income (90% of Damson’s realized income) ....... 144,000
Crimson's accrual-based income ....................................... $344,000

7-5
Chapter 7 - Consolidated Financial Statements - Ownership Patterns And Income Taxes

Bassett's accrual-based income:

Operational income ................................................................... $300,000
Investment income (80% of Crimson's realized income) ....... 275,200
Bassett's accrual-based income ........................................ $575,200

8. C Icede's accrual-based income:

Operational income ................................................................... $220,000
Defer unrealized gain ................................................................ (60,000)
Icede's accrual-based income ............................................ $160,000
Outside ownership .................................................................... 20%
Noncontrolling interest ....................................................... $32,000

Healthstone's accrual-based income:

Operational income ................................................................... $300,000
Defer unrealized gain ................................................................ (30,000)
Investment income (80% of Icede's accrual-based income) . 128,000
Healthstone's accrual-based income ................................. $398,000
Outside ownership .................................................................... 20%
Noncontrolling interest ....................................................... $79,600

Total noncontrolling interest = ($32,000 + $79,600) = $111,600

9. D Juvyn's operational income .......................................................... $50,000

Dividend income ............................................................................. 14,000
Juvyn's income ............................................................................... $64,000
Outside ownership ......................................................................... 10%
Noncontrolling interest .................................................................. $6,400

10. A Equity income (60% of $200,000) .................................................. $120,000

Dividend income (60% of $40,000) ................................................ 24,000
Tax difference ............................................................................ $96,000
Dividend deduction upon eventual distribution (80%) ................ (76,800)
Temporary portion of tax difference ........................................ $19,200
Tax rate .......................................................................................... 30%
Deferred income tax liability .................................................... $5,760

11. C Unrealized Gain:

Total gain ..................................................................................... $30,000
Portion still held .......................................................................... 20%
Unrealized gain .......................................................................... $6,000
Tax rate .......................................................................................... 25%
Deferred tax asset ....................................................................... $1,500

7-6
Chapter 7 - Consolidated Financial Statements - Ownership Patterns And Income Taxes

12. A Recognition of this gain is not required on a consolidated tax return.

13. C Because fair value of the subsidiary's assets exceeds the tax basis by
$100,000 a deferred tax liability of $30,000 (30%) must be recorded. Goodwill
is then computed as follows:

Consideration transferred ....................................... $420,000

Fair value ............................................................... $400,000
Deferred tax liability ................................................. (30,000) 370,000
Goodwill .................................................................... $50,000

14. (35 Minutes) (Series of reporting and consolidation questions pertaining to a

father-son-grandson combination. Includes unrealized inventory gains)
a. Consideration transferred (by Tree) ............................. $252,000
Noncontrolling interest fair value ................................. 108,000
Limb’s business fair value ............................................. 360,000
Book value ............................................................... (300,000)
Trade name ...................................................................... $60,000
Life .................................................................................. 30 years
Annual amortization ...................................................... $2,000

14. (continued)
Consideration transferred for Leaf (by Limb) .............. $91,000
Noncontrolling interest fair value ................................. 39,000
Leaf’s business fair value ............................................. $130,000
Book value ............................................................... (100,000)
Trade name ...................................................................... $30,000
Life .................................................................................. 30 years
Annual amortization ...................................................... $1,000

a. Investment in Limb $252,000

Limb's reported income-2009 $40,000
Amortization expense (2,000)
Accrual-based income $38,000
Limb’s percentage ownership 70%
Equity accrual-2009 $26,600
Dividends received 2009 (7,000)
Limb's reported income-2010 $60,000
Amortization expense (2,000)
Income from Leaf 6,300
Accrual-based income $64,300
Limb’s percentage ownership 70%
Equity accrual-2010 $45,010

7-7
Chapter 7 - Consolidated Financial Statements - Ownership Patterns And Income Taxes

Dividends received 2010 (14,000)

Investment in Limb 12-31-10 $302,610

b. Leaf—2010 income (revenues minus expenses) $10,000

Amortization (1,000)
Accrual-based income $9,000
Limb's ownership percentage 70%
Equity income accrual $6,300
Income recognized ($2,000 dividends × 70%) (1,400)
Retained earnings increase (Limb), 1/1/11 $4,900

Limb—2009 operating income $40,000

Limb—2010 operating income 60,000
Amortization (2 years at $2,000 per year) (4,000)
Equity income from ownership of Leaf (above) 6,300
Total income for previous periods 102,300
Tree's ownership percentage 70%
Equity income accrual 71,610
Income recognized ($10,000 [2009] + $20,000 [2010]
dividends × 70% ownership) (21,000)
Retained earnings increase (Tree), 1/1/11 $50,610

15. (continued)

c. Consolidated sales (total for the companies) $1,260,000

Consolidated expenses (total for the companies) (1,025,000)
Total amortization expense (see a.) (3,000)
Consolidated net income for 2011 $232,000

d. Noncontrolling interest in income of Leaf

Revenues less expenses $30,000
Excess amortization (1,000)
Accrual-based income $29,000
Noncontrolling interest percentage 30%
Noncontrolling interest in income of Leaf $8,700

Noncontrolling interest in income of Limb:

Revenues less expenses $65,000
Excess amortization (2,000)
Equity in Leaf income [(30,000-1,000) × 70%] 20,300
Realized income of Limb—2011 $83,300
Outside ownership 30% $24,990
NCI share of consolidated income $33,690

7-8
Chapter 7 - Consolidated Financial Statements - Ownership Patterns And Income Taxes

e. 2010 Realized income of Limb (prior to accounting

for unrealized gains) (see a) $64,300
2009 Transfer-gain recognized in 2010 10,000
2010 Transfer-gain to be recognized in 2011 (16,000)
2010 Realized income Limb $58,300

2011 Realized income of Limb (prior to accounting

for unrealized gains) (see d.) $83,300
2010 Transfer-gain recognized in 2011 16,000
2011 Transfer-gain to be recognized in 2012 (25,000)
2011 Realized income—Limb $74,300

f. In b., an adjustment of $50,610 was made to the beginning 2011 retained

earnings. Question e. takes this same question and alters it by including
unrealized gains. The $10,000 gain does not affect the answer because the 2010
and 2011 effects cancel each other.

Thus, only the $16,000 gain must be taken into consideration on January 1,
2011. Limb’s realized income in 2010 is reduced by $16,000 because of the
deferred gain. The parent's equity accrual would be reduced by $11,200 or 70%
of that figure. The adjustment as of January 1, 2011 is $39,410 ($50,610 –
$11,200).
16. (15 minutes) (Income and noncontrolling interest with mutual ownership.)

a. Consideration transferred by Uncle ............................. $500,000

Noncontrolling interest fair value ................................. 125,000
Nephew’s business fair value ....................................... $625,000
Book value ...................................................................... 600,000
Intangible assets ............................................................ $25,000
Life .................................................................................. 10 years
Amortization expense (annual) ..................................... $2,500

Income reported by Nephew—2011 .............................. $50,000

Amortization expense (above) ...................................... (2,500)
Accrual-based income.................................................... 47,500
Uncle's ownership percentage ..................................... 80%
Income of subsidiary recognized by Uncle ................. $38,000

b. To the outside owners, the $6,000 intra-entity dividends ($20,000 × 30%) paid by
Uncle are viewed as income because the book value of Nephew is increasing.
Thus, the noncontrolling interest's share of income is $10,700 or 20% of
[$47,500 income ($50,000 operational income less $2,500 excess amortization)

7-9
Chapter 7 - Consolidated Financial Statements - Ownership Patterns And Income Taxes

plus the $6,000 in dividends].

17. (35 Minutes) (Consolidated income for a father-son-grandson combination.)

a. Mesa's operating income $250,000

Butte's operating income 98,000
Valley's operating income 140,000
Amortization expense–Mesa's investment in Butte (22,500)
Amortization expense–Butte's investment in Valley (8,000)
Consolidated net income $457,500

b. Valley's operating income $140,000

Amortization expense (on Butte's investment) (8,000)
Valley's accrual-based income $132,000
Outside ownership 45%
Noncontrolling interest in Valley's income $59,400
Butte's operating income $ 98,000
Amortization expense (on Mesa's investment) (22,500)
Equity accrual from ownership of Valley
($132,000 × 55%) 72,600
Butte's accrual-based income $148,100
Outside ownership 20%
Noncontrolling interest in Butte's income $29,620
Total noncontrolling interest in income of subsidiaries $89,020

16. (Continued)

Mesa’s operating income $250,000

Mesa’s share of Butte’s operating income (80% × $98,000) 78,400
Mesa’s share of Valley’s operating income (80% × 55% × $140,000) 61,600
Mesa’s share of Butte’s excess amortization (80% × $22,500) (18,000)
Mesa’s share of Valley’s excess amortization (80% × 55% × $8,000) (3,520)
Controlling interest in consolidated net income $368,480
Noncontrolling interest in consolidated net income 89,020
Consolidated net income $457,500

17. (30 Minutes) (Consolidated income figures for a connecting affiliation)

UNREALIZED GAINS:
Cleveland ($12,000 remaining inventory × 25% markup) = $3,000
Wisconsin ($40,000 remaining inventory × 30% markup) = $12,000

NONCONTROLLING INTERESTS:
CLEVELAND:

7-10
Chapter 7 - Consolidated Financial Statements - Ownership Patterns And Income Taxes

Operational income (sales minus cost of goods sold and

expenses) .................................................................. $60,000
Defer unrealized gain (above) ....................................... (3,000)
Realized income—Cleveland ................................... $57,000
Outside ownership ......................................................... 20%
Noncontrolling interest in Cleveland's income ...... $11,400

WISCONSIN:
Operational income (sales minus cost of goods sold and
expenses) .................................................................. $110,000
Defer unrealized gain (above) ....................................... (12,000)
Investment income (60% of Cleveland's realized income of
$57,000) .................................................................... 34,200
Realized income—Wisconsin .................................. $132,200
Outside ownership ......................................................... 10%
Noncontrolling interest in Wisconsin's income ..... $13,220

TOTAL NONCONTROLLING INTERESTS: $24,620 ($11,400 + $13,220)

CONSOLIDATION TOTALS
▪ Sales = $1,590,000 (add the three book values and eliminate intra-entity
transfers of $40,000 and $100,000)
▪ Cost of goods sold = $1,015,000 (add the three book values, eliminate intra-
entity transfers of $40,000 and $100,000, and defer [add] unrealized gains of
$3,000 and $12,000)

17. (continued)
▪ Expenses = $200,000 (add the three book values)
▪ Dividend income = -0- (eliminated for consolidation purposes)
▪ Consolidated net income = $375,000 (consolidated revenues less
consolidated cost of goods sold and expenses)
▪ Noncontrolling interests in subsidiaries' income = $24,620 (computed above)
▪ Controlling interest in consolidated net income = $350,380 (consolidated net
income less noncontrolling interest share)

18. (12 Minutes) (Acquisition accounting for a subsidiary’s operating loss

carryforward)

a. Consideration transferred 1/1/11 $900,000

Fair value of identifiable assets acquired:

7-11
Chapter 7 - Consolidated Financial Statements - Ownership Patterns And Income Taxes

Software licensing agreements $750,000

Deferred tax asset from NOL (.35 × $120,000) 42,000
Fair value of net identifiable assets acquired 792,000
Goodwill $108,000

b. Consideration transferred 1/1/11 $900,000

Fair value of identifiable assets acquired:
Software licensing agreements $750,000
Deferred tax asset from NOL (.35 × $120,000) 42,000
Valuation allowance for NOL (42,000)
Fair value of net identifiable assets acquired 750,000
Goodwill $150,000

19. (25 Minutes) (Tax expense with separate tax returns for a combination.)

a. CONSOLIDATED TOTALS
▪ Sales = $790,000 (add the two book values and eliminate the $110,000 intra-
entity transfer)
▪ Cost of goods sold = $340,000 (add the book values, eliminate intra-entity
transfers of $110,000, recognize [subtract] $30,000 deferred gain from 2011,
and defer [add] $40,000 intra-entity gain into 2012)
▪ Operating expenses = $234,000 (add the two book values)
▪ Dividend income = -0- (eliminated for consolidation purposes)
▪ Consolidated net income = $216,000 (Revenues less expenses)
▪ Noncontrolling interest in Down's Income = $18,000 (20 percent of reported
Income of $100,000 plus $30,000 gain deferred from 2011 less $40,000 gain
deferred into 2012)
▪ Controlling interest in consolidated net income = $198,000

19. (continued)

b. On separate returns, the unrealized gains are reported as taxable income.

Because Up owns 80 percent of Down's stock, the dividends are tax- free and no
deferred tax liability is necessary on the undistributed income.

DUE TO GOVERNMENT: (separate returns)

UP:
Income (without dividend income) ............................... $126,000
Tax rate .......................................................................... 30%
Currently payable to government ........................... $37,800

DOWN:
Reported income ............................................................ $100,000
Tax rate .......................................................................... 30%

7-12
Chapter 7 - Consolidated Financial Statements - Ownership Patterns And Income Taxes

Currently payable to government ........................... $30,000

Total income tax payable: Current = $67,800 ($37,800 + $30,000)

CURRENT EXPENSE:
Consolidated net income (part a.) ........................... $198,000
Eliminate noncontrolling interest ............................ +18,000
Income to be taxed .............................................. $216,000
Tax rate .................................................................. 30%
Income tax expense ................................................. $64,800

The $3,000 difference between the liability and the expense is an increase in the
Deferred Income Tax Asset account. It is created by the tax effect (30%) on the
net unrealized gain for the period ($10,000 or $40,000 – $30,000).

20. (45 Minutes) (Series of questions requires computation of income tax expense
and the related payable balance)

a. $260,000 ($650,000 × 40%)

The affiliated group would be taxed on its operating income of $650,000 (the
net unrealized gain is deferred on a consolidated return). The intra-entity
income and dividends are not relevant since a consolidated return is filed.

b. $260,000 ($650,000 × 40%)

The affiliated group would be taxed on its operating income of $650,000 (the
net unrealized gain is deferred on a consolidated return). The intra-entity
income and dividends are not relevant because a consolidated return is filed.
The percentage ownership does not affect the figures on a consolidated
return.

20. (continued)

c. $296,000 ($96,000 + $200,000)

Rogers would pay $96,000 or 40% of its $240,000 operating income. Clarke
would pay $200,000 or 40% of its $500,000 operating income. The unrealized
gain is not deferred when separate returns are filed. Intra-entity dividends are
not taxable because the parties qualify as an affiliated group even though
separate returns are being filed. Answer (c.) differs from (a.) and (b.) because
tax on the $90,000 unrealized gain (40% or $36,000) is paid immediately.

d. $268,064
Rogers would record income tax expense of $96,000 or 40% of its $240,000
operating income.

7-13
Chapter 7 - Consolidated Financial Statements - Ownership Patterns And Income Taxes

Clarke must record its expense based on the revenue recognized during the
period. Thus, the tax expense is based on operating income of $410,000 (the net
unrealized gain is not being recognized in this period) plus equity income
accruing from Rogers of $100,800 (70% of that company's after-tax income).
Clarke will record an income tax expense of $164,000 in connection with the
operating income ($410,000 × 40%). The expense recognized in connection with
the equity accrual is affected by the dividends-received deduction:

Equity income of subsidiary .......................................... $100,800

Dividends-received deduction (when received) (80%) 80,640
Income subject to taxation ............................................ $20,160
Tax rate .......................................................................... 40%
Income tax expense—equity income (Clarke) ............. $8,064
Income tax expense—operating income (Clarke)
(above) ....................................................................... 164,000 $172,064
Income tax expense—operating income (Rogers)
(above) ....................................................................... 96,000
Income tax expense ....................................................... $268,064

e. $204,480
Clarke will pay $200,000 in connection with its operating income ($500,000 ×
40%) because the unrealized gain cannot be deferred. Clarke also receives
$56,000 in dividends from Rogers ($80,000 × 70%). Tax payment on these
dividends is $4,480 ($56,000 × 20% × 40%). The difference between the payment
by Clarke ($204,480) and the company's expense in (d.) ($172,064) is created by
the premature payment of the tax (a deferred tax asset) on the unrealized gain
($90,000) less the deferred tax liability on the parent's equity accrual ($100,800)
in excess of dividends received ($56,000).

21. (20 Minutes) (Comparison of income tax expense and payable on separate and
consolidated tax returns.)

a. Consolidated Return—2011

Piranto income 2011 (sales less expenses) ...................................... $300,000

Slinton income 2011 (sales less expenses) ....................................... 100,000
2010 gain realized in 2011 .................................................................... 120,000
2011 deferred gain ................................................................................ (150,000)
Taxable income ............................................................................... $370,000
Tax rate ................................................................................................ 40%
Income tax payable—current ......................................................... $148,000

7-14
Chapter 7 - Consolidated Financial Statements - Ownership Patterns And Income Taxes

Because no temporary differences exist in this problem, the income tax expense
would also be $148,000. The unrealized gain is not taxed until realized. Dividend
income is not important because a consolidated return is being filed.

b. Separate Returns—2011
On its separate tax return, Piranto will report taxable income of $300,000—the
unrealized gains cannot be deferred. The dividends would not be taxable
because Slinton still meets the criteria to be a member of an affiliated group. A
consolidated return is not a requirement for these dividends to be excluded.
Thus, income taxes payable by Piranto would be $120,000 ($300,000 × 40%).

To determine the income tax expense for Piranto, the two temporary differences
must be taken into account:

Taxable income .............................................................. $300,000

Gain taxed in 2010 although realized
in 2011 ....................................................................... 120,000
Gain taxed in 2011 although not yet realized ............... (150,000)
2011 realized income subject to taxation .................... $270,000
Tax rate ........................................................................... 40%
Income tax expense ....................................................... $108,000

The $12,000 difference between the expense and the payable is the tax effect on
the net unrealized gain ($30,000 × 40%).

Slinton will have an expense and payable of $40,000 ($100,000 × 40%).

22. (45 Minutes) (Comparison of income tax expense and payable on separate and
consolidated tax returns. Includes question on mutual ownership and the
conventional approach.)

a. Total income tax expense is $156,877. Because of the level of ownership,

separate returns must be filed. Unrealized gains are taxed immediately as are
intra-entity dividends.

Because the unrealized gains are deferred on the consolidated financial

statements, Boxwood's expense would be $34,400 or 40% of $86,000 in realized
income ($100,000 + $18,000 – $32,000).

Lake's income subject to taxation includes its $300,000 in operating income

plus $30,960 in income accruing from its investment in Boxwood (60% of the
after-tax income of $51,600 [$86,000 – $34,400]). Income tax expense for Lake is
computed as follows:

7-15
Chapter 7 - Consolidated Financial Statements - Ownership Patterns And Income Taxes

Operating income .......................................................... $300,000

Equity income ................................................................ $30,960
Taxable portion .............................................................. 20% 6,192
Income eventually subject to taxation ......................... $306,192
Tax rate ............................................................................ 40%
Income tax expense Lake (rounded) ............................. $122,477
Income tax expense Boxwood (above) ......................... 34,400
Total income tax expense ............................................. $156,877

b. Boxwood will pay $40,000 ($100,000 × 40%) because separate returns are filed.
Lake, however, will pay its taxes based on dividends received rather than on the
equity accrual. A deferred income tax liability would be established for the
difference. Lake's payment for the current year is computed as follows:

Operating income ........................................................... $300,000

Dividend income (60% × $10,000) ................................. $6,000
Taxable portion .............................................................. 20% 1,200
Income currently taxable ............................................... $301,200
Tax rate .......................................................................... 40%
Income tax payable—Lake ............................................ $120,480
Income tax payable—Boxwood (above) ...................... 40,000
Total income tax payable current ................................. $160,480

22. (continued)

The $3,603 difference between the expense in a. and the payable in b. is created
by the following two effects:

Deferred income tax liability on equity income accrual not yet taxed
($30,960 – $6,000 = $24,960 × 20% × 40%) .................................. $1,997
Deferred income tax asset on net unrealized gain
($32,000 – $18,000 = $14,000 × 40%) ........................................... 5,600
Net decrease in expense ................................................................... $3,603

c. Because a consolidated tax return is filed, unrealized gains are deferred in the
same manner as for external reporting purposes. Dividend income is not
taxable.

Lake's operating income ............................................... $300,000

Boxwood's operating income ....................................... $100,000
Prior year unrealized gain ............................................. 18,000
Current year unrealized gain ......................................... (32,000) 86,000
Income subject to taxation (and currently taxable) ..... $386,000
Tax rate ........................................................................... 40%

7-16
Chapter 7 - Consolidated Financial Statements - Ownership Patterns And Income Taxes

Income tax expense ....................................................... $154,400

23. (30 Minutes) (Computation of income tax expense and income tax payable on
consolidated and separate tax returns.)

a. Operating income .......................................................... $450,000

Tax rate .......................................................................... 40%
Taxes to be paid ............................................................. $180,000

The affiliated group would be taxed on its operating income of $450,000 (the
$50,000 unrealized gain is deferred). Intra-entity income and dividends are not
relevant because a consolidated return is filed.

b. Total taxes to be paid are $200,000. Robertson would have to pay $80,000 or
40% of its $200,000 operating income. Garrison would pay $120,000 or 40% of
its $300,000 operating income. The unrealized gain is not deferred because
separate returns are being filed. Intra-entity dividends are not taxable because
the parties still qualify as an affiliated group even though separate returns are
being filed.

c. Robertson must report an income tax expense of $80,000 or 40% of its $200,000
operating income.

23. (continued)

Garrison records its expense based on the revenue recognized during the
period. Thus, the expense is computed on an operating income of $250,000 (the
net unrealized gain is not recognized in this period) along with equity income
from Robertson of $84,000 (70% of that company's $120,000 after-tax income).
Garrison will record an income tax expense of $100,000 in connection with the
operating income ($250,000 × 40%) and $6,720 resulting from its equity income
($84,000 × 20% × 40%). Total expense to be reported amounts to $186,720 for
Garrison and Robertson ($80,000 + $100,000 + $6,720).

d. Garrison will pay $120,000 in connection with its operating income ($300,000 ×
40%) and $2,400 because of the dividends received from Robertson. Garrison
will receive $30,000 in dividends based on its 60% ownership. Of this total, only
$6,000 (20%) is taxable. Thus, at a 40% rate, the tax on the dividends would
amount to $2,400 ($6,000 × 40%). The total income taxes payable by Garrison is
$122,400 ($120,000 + $2,400).

24. (10 Minutes) (Impact on goodwill of assets with a different tax vs. book value.)

7-17
Chapter 7 - Consolidated Financial Statements - Ownership Patterns And Income Taxes

The assets and liabilities of Kew (the subsidiary) will be consolidated at their
individual fair values (netting to $500,000). However, both the buildings and
equipment have a tax basis that is lower than fair value. Thus, for tax purposes,
future depreciation expense will be lower on the tax return so that taxable
income will exceed book income. The higher taxable income (anticipated in the
future) creates a deferred tax liability at the time the combination is created.

Tax Fair Temporary

Basis Value Difference
Buildings ........................................ $140,000 $180,000 $40,000
Equipment ...................................... 150,000 200,000 50,000
Total temporary difference ...... $90,000
Tax rate ...................................... 30%
Deferred tax liability ................. $27,000

Consequently, Kew's accounts will be consolidated as follows: (parentheses

indicate a credit balance)

Accounts receivable ...................................................... $110,000

Inventory ......................................................................... 130,000
Land ............................................................................... 100,000
Buildings ........................................................................ 180,000
Equipment ....................................................................... 200,000

24. (continued)

Liabilities ......................................................................... (220,000)

Deferred tax liability ....................................................... (27,000)
Assigned to specific accounts ..................................... 473,000
Purchase price ............................................................... 650,000
Excess assigned to goodwill ........................................ $177,000

25. (55 Minutes) (Consolidation worksheet for a father-son-grandson combination.

Includes intra-entity inventory transfers.)

The following computations are needed before the consolidation worksheet is

prepared: calculation of the deferred gains in beginning and ending inventory.

Beginning Unrealized Gain (Wilson)

(January 1, 2011 Inventory Transfer Price (goods remaining) =
Balance) Cost + .25 Cost
$60,000 = 1.25 Cost
$48,000 = Cost

7-18
Chapter 7 - Consolidated Financial Statements - Ownership Patterns And Income Taxes

$12,000 is Unrealized gain

Ending Unrealized Gain (Wilson)
(December 31, 2011 Inventory Transfer Price (goods remaining) =
Balance) Cost + .25 Cost
$90,000 = 1.25 Cost
$72,000 = Cost
$18,000 is Unrealized gain
CONSOLIDATION ENTRIES
Entry *G
Retained earnings, 1/1/11 (Wilson) ......................... 12,000
Cost of goods sold .............................................. 12,000
(To recognize income on intra-entity inventory transfers made in previous
year but not resold until current year as per above computation.)

Entry *C
Retained earnings, 1/1/11 (House) ................................ 11,200
Investment in Wilson .......................................... 11,200
(To convert investment account from partial equity method to equity method.
Unrealized gain shown in Entry *G is not properly reflected by parent under
partial equity method [12,000 × 70% = $8,400 income decrease] nor would the
$2,800 in amortization expense for 2009–2010. Thus, a reduction of $11,200 is
required. Because Cuddy is a current year acquisition, no prior conversion to
equity method is required for the investment.)

25. (continued)
Entry S1
Common stock (Cuddy) ................................................ 150,000
Retained earnings, 1/1/11 (Cuddy) ............................... 150,000
Investment in Cuddy (80%) ....................................... 240,000
Noncontrolling interest in Cuddy common stock (20%) 60,000
(To eliminate Cuddy's stockholders' equity against the corresponding
investment balance and to recognize noncontrolling interest on common stock.)

Entry S2
Common stock (Wilson) ................................................ 310,000
Retained earnings, 1/1/11 (Wilson)
(adjusted by Entry *G) .............................................. 578,000
Investment in Wilson (70%) ................................ 621,600
Noncontrolling interest in Wilson (30%) ........... 266,400
(To eliminate Wilson's stockholders' equity against corresponding investment
balance and to recognize noncontrolling interest.)

Entry A
Buildings ......................................................................... 54,000

7-19
Chapter 7 - Consolidated Financial Statements - Ownership Patterns And Income Taxes

Franchise contracts ....................................................... 32,000

Goodwill ........................................................................... 140,000
Equipment ................................................................. 10,000
Investment in Wilson ................................................ 151,200
Noncontrolling interest in Wilson ............................ 64,800
(To allocate excess payment made in connection with purchase of Wilson
shown above. Amortization for 2009 and 2010 has been taken into account in
determining the January 1, 2011 value for each account.)

Entry I1
Income of Cuddy ...................................................... 56,000
Investment in Cuddy ........................................... 56,000
(To eliminate intra-entity income accrued by both House and Wilson during
the year.)

Entry I2
Income of Wilson ...................................................... 91,000
Investment in Wilson .......................................... 91,000
(To eliminate intra-entity income accrued by House during the year.)

Entry D1
Investment in Cuddy ............................................... 40,000
Dividends paid (80%) (Cuddy) ............................ 40,000
(To eliminate effects of intra-entity dividend payments.)

25. (continued)

Entry D2
Investment in Wilson ............................................... 67,200
Dividends paid (70%) (Wilson) ........................... 67,200
(To eliminate effects of intra-entity dividend payments.)

Entry E
Operating expenses ................................................. 2,000
Equipment ............................................................... 5,000
Franchise contracts ............................................ 4,000
Buildings ............................................................... 3,000
(To record 2011 amortization on excess payment made in connection with
acquisition of Wilson Company.)

Entry TI
Sales and other revenues ........................................ 200,000
Cost of goods sold .............................................. 200,000
(To eliminate intra-entity inventory sales for the current year.)

7-20
Chapter 7 - Consolidated Financial Statements - Ownership Patterns And Income Taxes

Entry G
Cost of goods sold ................................................... 18,000
Inventory ...............................................................
18,000
(To defer unrealized gain in ending inventory.)

Noncontrolling Interest in Net Income of Cuddy:

Reported net income $70,000

Outside ownership 20%
Noncontrolling interest in Cuddy income—common ............... $14,000

Noncontrolling Interest in net income of Wilson:

Reported operational income $130,000

Equity income of Cuddy ($70,000 × 40%) ................................... 28,000
Excess amortization ..................................................................... (2,000)
Recognition of 2010 gain (Entry *G) 12,000
Deferral of 2011 unrealized gain (Entry G) (18,000)
Realized income $150,000
Outside ownership 30%
Noncontrolling interest in net income of Wilson $ 45,000

7-21
Chapter 7 - Consolidated Financial Statements - Ownership Patterns And Income Taxes

25. (continued)
HOUSE CORPORATION AND CONSOLIDATED SUBSIDIARIES
Consolidation Worksheet
December 31, 2011

Accounts House Wilson Cuddy Consolidation EntriesNoncontrollingConsolidated

Corp. Company Company Debit Credit Interest Balance
Sales and other revenue (900,000) (700,000) (300,000) (TI) 200,000 (1,700,000)

Cost of goods sold 551,000 300,000 140,000 (G) 18,000 (*G) 12,000 797,000
(TI) 200,000
Operating expenses 219,000 270,000 90,000 (E) 2,000 581,000
Income of Wilson Company (91,000) (I2) 91,000 -0-
Income of Cuddy Company (28,000) (28,000) (I1) 56,000 -0-
Net income (249,000) (158,000) (70,000)
Consolidated net income (322,000)
Noncontrolling interest in
Wilson net income (45,000) 45,000
Noncontrolling interest in
Cuddy net income (14,000) 14,000
To House Corporation (263,000)
Retained earnings, 1/1/11:
—House Corporation (820,000) (*C) 11,200 (808,800)
—Wilson Company (590,000) (*G) 12,000 -0-
(S2)578,000
—Cuddy Company (150,000) (S1)150,000 -0-
Net Income (249,000) (158,000) (70,000) (263,000)
Dividends paid
—House Corporation 100,000 100,000
—Wilson Company 96,000 (D2) 67,200 28,800 -0-
—Cuddy Company 50,000 (D1) 40,000 10,000 -0-
Retained earnings, 12/31/11 (969,000) (652,000) (170,000) (971,800)

7-22
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