Chapter Seven
Consolidated
Financial
Statements Ownership
Patterns and
Income Taxes
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
LO 1
Indirect Subsidiary Control
Assume three companies form
a business combination: Top
Top
Company owns 70% of
Company
Midway Company, which
70%
owns 60% of Bottom
Company. Top controls
Midway
both subsidiaries,
Company
although the parent’s
Relationship with
60%
Bottom is only of
Bottom Company
an indirect nature.
7-2
Consolidation When Indirect
Control is Present
When a parent controls a subsidiary which in turn
controls other firms, a “pyramid” or “father-songrandson” relationship exists. To consolidate:
start from the bottom of the “pyramid” and work
upwards.
1. Recognize realized income of “grandson(s)”
2. Use this to consolidate the “son” and
“grandson(s)” financial information (take care
to calculate any noncontrolling interest)
3. Finally, consolidate the “son(s)” and parent in
the same manner.
7-3
LO 2
Indirect Subsidiary Control –
Connecting Affiliation
A connecting affiliation exists when two or more
companies within a business combination own an
interest in another member of the organization.
High
Company
70%
ownership
Side
Company
30%
ownership
45%
ownership
Low
Company
7-4
Indirect Subsidiary Control –
Connecting Affiliation
Basic Consolidation Rules Still Hold:
 Eliminate effects of intra-entity transfers.
 Adjust parent’s beginning R/E to recognize
prior period ownership.
 Eliminate sub’s beginning equity balances.
 Adjust for unamortized FV adjustments.
 Record Amortization Expense.
 Remove intra-entity income and dividends.
 Compute and record noncontrolling interest
in subsidiaries’ net income.
7-5
LO 3
Mutual Ownership
Mutual ownership occurs when two companies
within a business combination hold an equity
interest in each other.
GAAP recommends that “shares of the parent
held by the subsidiary should be eliminated in
consolidated financial statements.”
The shares are not “outstanding” because they
are not held by parties outside the combination.
The Treasury Stock Approach is used to account
for the mutually owned shares.
7-6
Mutual Ownership
There is no accounting distinction between a
parent owning stock of a subsidiary, or a
subsidiary owning stock of a parent – they are
both intra-entity stock ownership.
The cost of the parent shares held by the
subsidiary is reclassified on the worksheet into
Treasury Stock.
Intra-entity dividends on shares of the parent
owned by the subsidiary are eliminated as an
intra- entity cash transfer.
7-7
LO 4
Income Tax Accounting
for a Business Combination
Business combinations may elect to file
a consolidated federal tax return for
all companies of an affiliated group.
The affiliated group (as defined by the
IRS) will likely exclude some members
of the business combination.
7-8
Income Tax Accounting
for a Business Combination
Affiliated Group
= The parent company
+ Any domestic subsidiary where the
parent owns 80% or more of the voting
stock AND 80% of each class of
nonvoting stock.
 All others must file separately
(including any foreign subsidiaries.)
7-9
Income Tax Accounting
for a Business Combination
Intra-entity profits are not taxed until
realized.
Intra-entity dividends are nontaxable
(regardless of filing a consolidated
return).
Losses of one affiliated group member
can be used to offset taxable income
earned by another group member.
7-10
LO 5
Income Tax Accounting –
Deferred Income Taxes
Tax consequences are often dependent on
whether separate or consolidated returns are
filed.
Transactions affected:
Intra-entity
Dividends
Goodwill
Unrealized
Intra-entity
Gains
7-11
Income Tax Accounting –
Deferred Income Taxes
Intra-entity Dividends
For accounting purposes, all intra-entity
dividends are eliminated.
For tax purposes, dividends are removed from
income if at least 80 percent of the subsidiary’s
stock is held. (20% is taxable.)
If less than 80 percent of a subsidiary’s stock is
held, tax recognition is necessary.
A deferred tax liability is created for any of sub’s
income not paid currently as a dividend.
7-12
Income Tax Accounting –
Deferred Income Taxes
Amortization of Goodwill
Current tax law permits the amortization of
Goodwill and other purchased Intangible Assets
over 15 years.
GAAP does not systematically amortize Goodwill
for financial reporting purposes, but instead
reviews it annually for impairment.
Timing differences between the amortization and
write-off creates a temporary difference that
results in deferred income taxes.
7-13
Income Tax Accounting –
Deferred Income Taxes
Unrealized Intra-Entity Gains
If consolidated returns are filed, intra-entity
gains are deferred until realized and no
timing difference is created.
If separate returns are filed, taxable gains
must be reported in the period of transfer.
The “prepayment” of taxes on the unrealized
gains creates a deferred income tax asset.
7-14
LO 7
Temporary Differences Generated
by Business Combinations
A business combination can create temporary
differences due to differences in tax bases and book
value stemming from the takeover.
In most purchases, resulting book values of acquired
company’s assets and liabilities differ from their tax
bases because:
Subsidiary’s cost is retained for tax purposes (in taxfree exchanges)
Allocations for tax purposes vary from those used for
financial reporting (found in taxable transactions).
7-15
LO 8
Business Combinations and
Operating Loss Carryforwards
Net operating losses for companies may be
carried back for two years and/or forward
for twenty years
Because some acquisitions appeared to be
done primarily to take advantage of this
situation, US law has been changed to
require operating loss carryforwards to be
used only by the company incurring the loss
(in most situations.)
7-16