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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.
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 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).
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
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
3. Able—100% of income accrues to the consolidated entity (as parent company).
Baker—70% (percentage of stock 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
that company's parent.
5. In a connecting affiliation, two (or more) companies within a business combination own shares
6. In accounting for a mutual ownership, U.S. GAAP requires the treasury stock approach. The
treasury stock approach presumes that the cost of the parent shares should be reclassified as
7. According to present tax laws, an affiliated group can be comprised of all domestic
8. 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
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
9. 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
10. 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
11. 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.
12. 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
13. 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,
Answers to Problems
7. D Sapphire's accrual-based income:
Operating income ....................................................................... $210,000
Defer unrealized gain ................................................................. (50 ,000)
Sapphire's accrual-based income ....................................... $160,000
8. C Cherry's accrual-based income:
Operating income ....................................................................... $280,000
Defer unrealized gain ................................................................. (50 ,000)
Cherry's accrual-based income ........................................... $230,000
Beech's accrual-based income:
Operating income ....................................................................... $315,000
Defer unrealized gain ................................................................. (19,000)
Investment income (80% of Cherry's accrual-based income) ..... 184,000
($46,000 + $96,000) = $142,000
9. A Stark's operating income................................................................. $78,000
Dividend income from Arryn............................................................ 18,000
Noncontrolling interest .................................................................... $ 4,800
10. B Equity income (75% of $415,000) ................................................... $311,250
Dividend income (75% of $110,000) ............................................... 82 ,500
Tax difference .............................................................................. $228,750
11.C Unrealized Gross Profit:
Total gross profit .......................................................................... $30,000
Portion still held ........................................................................... 20%
12.A Recognition of this gross profit is not required on a consolidated tax return.
13.A Because fair value of the subsidiary's assets exceeds the tax basis by
$144,000, a deferred tax liability of $57,600 (40%) must be recorded. Goodwill
is then computed as follows:
Consideration transferred ........................................ $450,000
Fair value ................................................................. $454,000
14.(30 Minutes) (Series of reporting and consolidation questions pertaining to a
father-son-grandson combination. Includes unrealized inventory gains)
a. Consideration transferred (by Aspen) ........................... $288,000
Birch’s business fair value.............................................. 360,000
Book value ................................................................. (300 ,000)
14. (continued)
Consideration transferred for Cedar (by Birch) ........... $104,000
Noncontrolling interest fair value .................................. 26 ,000
Annual amortization ........................................................ $ 1 ,000
Investment in Birch $288,000
Birch's reported income-2012 $40,000
Amortization expense (2 ,000)
Accrual-based income $38,000
Birch’s percentage ownership 80 %
Birch’s percentage ownership 80 %
Equity accrual-2013 $52,160
Dividends received from Birch 2013 (16 ,000)
Investment in Birch 12-31-13 $346 ,560
Note: Dividends declared by Cedar to Birch do not affect Aspen’s Investment
account.
b. Consolidated sales (total for the companies) $1,298,000
c. Noncontrolling interest in income of Cedar
Revenues less expenses $30,000
Excess amortization (1 ,000)
Accrual-based income $29,000
Noncontrolling interest percentage 20 %
Noncontrolling interest in income of Cedar $5,800
Outside ownership 20 % $17 ,240
NCI share of 2014 consolidated income $23 ,040
14. (continued)
d. 2013 Realized net income of Birch (prior to accounting
for unrealized gross profit) (see a) $65,200
2012 Transfer-gross profit recognized in 2013 10,000
15.(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
Amortization expense (above) ....................................... (2 ,500)
Accrual-based income..................................................... 47,500
Uncle's ownership percentage ....................................... 80%
Net income of subsidiary recognized by Uncle ............ $38 ,000
b. To the outside owners, the $6,000 intra-entity dividends ($20,000 × 30%)
declared by Uncle are viewed as income because the book value of Nephew
increases. Thus, the noncontrolling interest's share of income is computed as
follows:
Nephew’s accrual-based income (above) $47,500
Dividends declared by Uncle to Nephew 6,000
Income to outside owners $53,500
Noncontrolling interest percentage 20%
Noncontrolling interest share of Nephew’s net income $10,700
16. (35 Minutes) (Consolidated net income for a father-son-grandson combination.)
a. Mesa's operating income $250,000
Butte's operating income 98,000
Consolidated net income $457 ,500
b. Valley's operating income $140,000
Amortization expense (on Butte's investment) (8 ,000)
Valley's accrual-based net income $132,000
Outside ownership 45 %
Noncontrolling interest in Valley's income $59,400
Noncontrolling interest in Butte's net income $29 ,620
Total net income attributable to noncontrolling interests $89 ,020
Reconciliation:
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
