Chapter Seven
Consolidated
Financial
Statements –
Ownership
Patterns and
Income Taxes
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Indirect Subsidiary Control
Learning Objective 7-1:
Demonstrate the consolidation process when indirect control is
present in a grandfather-father-son ownership configuration.
The presence of an indirect ownership does not change most
consolidation procedures; however, a calculation of each
subsidiary’s accrual-based income does pose some difficulty.
Appropriate income determination is essential for calculating
(1) equity income accruals and
(2) noncontrolling interest’s share of consolidated net
income.
7-2
Indirect Subsidiary Control
Assume three companies form a business combination: Top
Company owns 70% of Midway Company, which owns 60% of
Bottom Company. Top controls both subsidiaries, although the
parent’s relationship with Bottom is only of an indirect nature.
This data is from the company financial records.
7-3
Indirect Control Calculations
First, determine Midway’s realized income.
Next, combine Top Company’s income with Midway’s
realized income.
Using the income from the previous calculations, determine
noncontrolling interest. (Bottom and Midway’s individual
incomes as calculated).
If appropriate equity accruals are recognized, the sum of
the parent’s accrual-based income and the noncontrolling
interest income share serves as a “proof figure” for the
consolidated total.
7-4
Indirect Subsidiary Control –
Connecting Affiliation
Learning Objective 7-2:
Demonstrate the consolidation process when a corporate
ownership structure is characterized by a connecting affiliation.
A connecting affiliation exists when two or more companies
within a business combination own an interest in another
member of the organization.
7-5
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.
 The combination of the parent’s DIRECT ownership and
INDIRECT ownership results in control of the subsidiary.
7-6
Mutual Ownership
Learning Objective 7-3: Demonstrate the consolidation process
when a corporate ownership structure is characterized by
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.
7-7
Mutual Ownership
The Treasury Stock Approach is used to account for the
mutually owned shares.
No accounting distinction is made 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.
7-8
Income Tax Accounting
for a Business Combination
Learning Objective 7-4:
List the criteria for being a member of an affiliated group for
income tax filing purposes.
Business combinations may elect to file a consolidated federal
tax return for all companies of an affiliated group.
An affiliated group will likely exclude some members of the
business combination. It will include the parent company, any
domestic subsidiary in which the parent owns 80% or more of
the voting stock AND 80% of each class of nonvoting stock
(direct or indirect ownership).
All others must file separately (including any foreign
subsidiaries.)
7-9
Income Tax Accounting
for a Business Combination
There is a difference in a business combination as identified
for financial reporting and an affiliated group as defined for
tax purposes.
A business combination comprises all subsidiaries controlled
by a parent company unless control is only temporary.
The IRS’s 80 percent rule creates a smaller circle of
companies qualifying for inclusion in an affiliated group.
 Intra-entity profits are not taxed until realized.
 Losses of one affiliated group member can be used to
offset taxable income earned by another group member.
7-10
Income Tax Accounting –
Deferred Income Taxes
Learning Objective 7-5:
Compute taxable income and deferred tax amounts for an
affiliated group based on information presented in a
consolidated set of financial statements.
Tax consequences are often dependent on whether separate or
consolidated returns are filed.
Transactions affected:

Intra-entity Dividends

Unrealized Intra-entity Gains
Goodwill

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. Consolidated tax returns require
allocation of tax expense between the parties.

Important for the subsidiary if separate financial
statements are needed for loans or equity issues.
 Used as a basis for calculating noncontrolling interest’s
share of consolidated income.
7-14
Filing Separate Tax Returns
Learning Objective 7-6:
Compute taxable income and deferred tax amounts to
be recognized when separate tax returns are filed by any
of the affiliates of a business combination.
Separate returns are mandatory for foreign subsidiaries and
for domestic corporations not meeting the 80 percent
ownership rule. Canadian and Mexican subsidiaries can
qualify for treatment as domestic companies for purposes of
filing a consolidated return.
A company may still elect to file separately even if it meets
the conditions for inclusion within an affiliated group.
7-15
Filing Separate Tax Returns
If all companies are profitable and few intra-entity transactions
occur, they may prefer separate returns to give the companies
more flexibility in choice of accounting methods and fiscal tax
years.
Tax laws do not allow a company to switch back and forth
between consolidated and separate returns. Obtaining Internal
Revenue Service permission to file separately can be difficult
after electing to file a consolidated return.
When members of a business combination file separate tax
returns, temporary differences often emerge for income
recognized for consolidated financial reporting and for income
tax reporting.
7-16
Filing Separate Tax Returns
Differences in the timing of income recognition across
consolidated reporting and income tax purposes create
deferred tax assets and/or liabilities.
These temporary differences may occur due to
(1) the immediate taxation of unrealized intra-entity
gains (and losses) and
(2) possible future tax effects of subsidiary income in
excess of dividend payments.
7-17
Temporary Differences Generated by
Business Combinations
Learning Objective 7-7:
Determine the deferred tax consequences for temporary
differences generated when a business combination is created.
A business combination can create temporary differences due to
differences in tax bases and book value stemming from the
takeover.
Resulting book values of acquired company’s assets and
liabilities may differ from their tax bases because the
subsidiary’s cost is retained for tax purposes (in tax-free
exchanges). Allocations for tax purposes may vary from those
used for financial reporting (taxable transactions).
7-18
Business Combinations and
Operating Loss Carryforwards
Learning Objective 7-8:
Explain the impact that a net operating loss of an acquired
affiliate has on consolidated figures.
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.)
7-19
IFRS and U.S. GAAP Differences
U.S. GAAP prohibits the
recognition of unrealized
intra-entity profits on
asset transfers; therefore,
the selling firm defers any
related current tax effects
until the asset is sold to a
third party.
International Accounting
Standard (IAS) 12 requires
taxes paid by a selling firm
on intra-entity profits to be
recognized as incurred and
allows tax deferral on
differences between the tax
bases of assets transferred
across entities that remain
within the group.
7-20