Dr. M.D. Chase Advanced Accounting 710-51CB Long Beach State University Special Issues: Intercompany Preferred Stock Page 1 I. Subsidiary Preferred Stock: A. The accounting issue: The existence of subsidiary preferred stock may complicate consolidation procedures in one of two ways: 1. if preferred stock has any claim to subsidiary retained earnings; 2. if preferred stock is purchased by the parent. B. Preferred stock with a claim on subsidiary retained earnings: 1. preferred stock with a claim on "S" retained earnings causes problems by its mere existence; whether any of it is owned by "P" or not is moot. 2. preferred stock typically gets a claim on "S" retained earnings in one of three ways: a. liquidation value in excess of par value. b. cumulative dividend rights; c. participation rights with common stock; 3. The retained earnings available to the common stockholders must be reduced by the preferred stock claims; --This can be done by WORKING PAPER entry or by schedule --If done by WORKING PAPER a special R/E-P/S account is created to keep the preferred stock claims separate from common; R/E..................xxxx R/E-P/S......... xxxx 4. In "analyzing the investment" in common stock, only the R/E allocable to the common stock must be considered; therefor, adjust retained earnings balances prior to analyzing the investment. 5. To determine P/S claim on R/E, an order of preference must be followed: a. Presence of liquidation preference > par --R/E is reduced by total liquidation bonus b. Cumulative dividends in arrears; c. Participation rights are allocated EXAMPLE 1: Subsidiary Common Stock --"P" purchases 70% of "S" on 1/1/x1 for $150,000 --at the time of purchase, "S" SHE was: "S" preferred stock, $100 par, 6% cumulative, fully participating.. "S" common stock, $10 par........................................... "S" retained earnings............................................... Total SHE................................................... $ $ 100,000 150,000 50,000 300,000 --The preferred stock has a $5 liquidation preference in excess of par --the preferred stock is two years in arrears at the date of purchase Analyze the investment (of the common stock investment): Cost...................................................................... Purchased BV: Common stock: (15,000 x $10)......................................... $ Retained earnings 12/31/x0........................................... less: Liquidation preference ($5 x 1,000)............................ cumulative dividends in arrears................................ right to participate in future dividends (100/250 x (50 - 17).. Total equity interest attributable to common stock................. ownership interest ................................................ Excess of cost over book value (to goodwill)...................... $ 150,000 50,000 [5,000] [12,000] [13,200] $ 150,000 19,800 169,800 70% 118,860 31,400 Note: The participation feature of the preferred stock is applicable only to that portion of retained earnings remaining after the cumulative and liquidating preferences have been applied. C. Intercompany preferred stock acquisitions: 1. Intercompany investments in P/S are considered a retirement of P/S or an investment in treasury shares from the consolidated view. Treating intercompany purchases of P/S as treasury acquisitions involves only those adjustments necessary to convert outstanding P/S to treasury stock on the consolidated working papers. Dr. M.D. Chase Advanced Accounting 710-51CB Long Beach State University Special Issues: Intercompany Preferred Stock Page 2 2. Procedures to constructively retire intercompany P/S: a: compare the cost basis of the P/S to the underlying bookvalue of the stock (including all P/S claims to R/E or income; differences are accounted for as "gains" or "losses" on retirement of P/S. NOTE: recall that there are never "gains" or "losses" on a company’s own stock transactions; therefore: --"gains": (excess of BV over cost) are credited to "P" PIC assuming "P" is investor in P/S; --"losses": (excess of cost over BV) are: 1. offset against "P" PIC from retirement of P/S (to the extent available) 2. offset against "P" retained earnings after "P" PIC from retirement of P/S is exhausted; (this amounts to a "retirement dividend". NOTE: this is not PIC in excess of par, it is a special PIC created from prior retirements) EXAMPLE 2: "P" purchases subsidiary preferred stock: --assume the same facts as example 1 above except that "P" purchases 75% (750 shares) of "S" P/S on 1/1/x3; --"S" R/E on 1/1/x3, x4 and x5 is $130,000; $138,000 and $145,000 respectively; --no dividends are paid in years 1 through 5; --Required: 1. Situation One: Calculate the gain or loss on retirement of P/S if "P" paid $128,000 for the P/S; 2. Situation Two: Calculate the gain or loss on retirement of P/S if "P" paid $148,000 for the P/S 3. Situation Three: Calculate the gain or loss on retirement of P/S if "P" paid $120,000 for the P/S; 3. Compute the value of the investment in "S" P/S account at 12/31/x3; x4 and x5 respectively for situation one and two; 4. Present any necessary elimination/adjustment entries required for requirements 1 and 2 above for years ending 12/31/x3; 12/31/x4 and 12/31/x5. Show all computations below in good form: Solutions: (5k+24k=29k) Requirements 1 2 and 3: Cost....................................... Book value: Par (1,000 x $100).... Liq. Pref....................... Div in Arrears (6,000 x 4)...... Participation (100/250 x 130-29) Total value of P/S: ownership interest .75 (gain) or loss on retirement: $ 100,000 5,000 24,000 40,400 $ 169,400 $ Date of Purchase 1/1/x3: Situation Situation Situation One Two Three 128,000 $148,000 $120,000 $ 127,050 950 127,050 $ 20,950 127,050 ($ 7,050) Requirement 3: Compute the value of the investment in "S" P/S account at 12/31/x3;x4 and x5 respectively for situations one and two; Situation One: Beginning Balance (Cost plus claims on RE). add: 75% cum div in arrears (for crnt yr).. 75% of 100/250 change in BOY RE....... Ending balance............................. 12/31/x3 $ 128,000 $ 4,500 0* $ 132,500 $ $5,100 12/31/x4 132,500 4,500 600 ** 137,600 12/31/x5 $ 137,600 4,500 300 *** $ 142,400 $4,800 * No change in RE balance in first year (P/S was purchased at BOY) ** see summary of changes in RE below *** see summary of changes in RE below Situation Two: Beginning Balance ........... add: 75% cum div in arrears.. 75% of 100/250 change in RE................. Ending balance............... 12/31/x3 $ 148,000 4,500 0* $ 152,500 12/31/x4 152,500 4,500 600** $ 157,600 $ 12/31/x5 $ 157,600 4,500 300*** $ 162,400 The cumulative feature of P/S is unique in that it places a claim on current net income; cumulative dividends in arrears will be paid prior to any dividend being distributed to C/S; they represent a claim on retained earnings that will never be available for distribution to the common shareholders. The participation feature does not affect current income but must be recognized as a claim against retained earnings available to the common stockholders. Dr. M.D. Chase Advanced Accounting 710-51CB Long Beach State University Special Issues: Intercompany Preferred Stock Page 3 Requirement 4 (situation one): a. Retire the P/S "S" P/S (7,500 x $100)........ "P" PIC-retirement of P/S Investment in "S" P/S.... b. Adjust BOY R/E allocable to P/S "S" RE P/S (81,000 .75).... Investment in "S" P/S........ 12/31/x3 75,000 950 52,050 c. Eliminate current yr. income claim of cumulative P/S Investment in "S" P/S... --"S" income-P/S (6,000 x .75). Computations: Liquidation preference ($5 x 1000 shares).. Dividends in arrears (4 years x $6,000).... Participation (100/250)(130; 138; 145)..... Total claim on "S" RE................. Percentage of "S" P/S owned........... Intercompany claim on "S" RE.......... Requirement 4 (situation two): a. Retire the P/S "S" P/S (7,500 x $100)........ "P" RE........................ Investment in "S" P/S.... b. Adjust BOY R/E allocable to P/S "S" RE P/S (81,000 .75).... Investment in "S" P/S........ c. Eliminate current yr. income claim of cumulative P/S Investment in "S" P/S... "S" income-P/S (6,000 x .75). Summary of Changes in RE: RE-CS 1/1/x1 RE-CS 1/1/x2 RE-CS 1/1/x3 130 138 145 5 5 5 24 30 36 101 103 104 40.4 41.2 41.6 60.6 61.8 62.4 800 400 x .75 x .75 600** 300*** RE-PS 1/1/x1 RE-PS 1/1/x2 RE-PS 1/1/x3 5 5 5 24 30 36 40.4 41.2 41.6 69.4 76.2 82.6 x .75 x .75 x .75 52,050 57,150 61,950 5,100 4800 9,900 75,950 52,050 --- 12/31/x4 75,000 950 57,150 600 75,950 57,150 600 12/31/x5 75,000 950 61,950 300 75,950 61,950 300 12/31/x3 $ 5,000 24,000 40,400 $ 81,000 75% $ 52,050* 12/31/x4 $ 5,000 30,000 41,200 $ 76,200 75% $ 57,150** 12/31/x5 $ 5,000 36,000 41,600 $ 82,600 75% $ 61,950*** 12/31/x3 12/31/x4 12/31/x5 75,000 20,950 52,050 --- 95,950 52,050 --- 75,000 20,950 57,150 600 95,950 57,150 600 75,000 20,950 61,950 300 95,950 61,950 300 128,000 132,500 137,600