Chapter 10

Chapter 10: Subsidiary Preferred Stock,
Consolidated Earnings Per Share, and
Consolidated Income Taxation
by Jeanne M. David, Ph.D., Univ. of Detroit Mercy
to accompany
Advanced Accounting, 10th edition
by Floyd A. Beams, Robin P. Clement,
Joseph H. Anthony, and Suzanne Lowensohn
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10-1
Preferred Stock, EPS, and Taxes:
Objectives
1. Modify consolidation procedures for subsidiary
companies with preferred stock in their capital
structure.
2. Calculate basic and diluted earnings per share
for a consolidated reporting entity.
3. Understand the complexities of accounting for
income taxes by consolidated entities.
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10-2
Subsidiary Preferred Stock, Consolidated Earnings Per
Share, and Consolidated Income Taxation
1: Preferred Stock
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10-3
Subsidiary Preferred Stock
Subsidiary preferred stock
– Doesn't change consolidation in principle
– Does impact calculations
• Common stockholders' equity = total equity
less preferred stock at book value
• Income of subsidiary is first allocated to
preferred shareholders, then CI and NCI
• Subsidiary dividend payments must consider
payments to preferred shareholders before
common shareholders
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10-4
Who Holds Preferred Stock?
Preferred stock is held by outsiders
• Preferred stock is a noncontrolling interest
Preferred stock is held by parent
• May choose between
– Constructive retirement
– Cost basis
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10-5
Review of Preferred Stock
Characteristics
• Callable, redeemable
• Cumulative or
noncumulative
• Participative or nonparticipative
• Limited voting rights
Most is cumulative and
nonparticipating
Book Value of PS is:
Call or redemption price
(par value if neither)
Plus Dividends in arrears
(if cumulative)
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Income allocated to PS is:
Current period dividend
• Irrespective of amount
declared, if cumulative
• Declared amount if
noncumulative
• Potentially more if
participative
Preferred stock dividend is:
Face value x dividend rate
• Also consider:
• Arrearage
• Participation
10-6
Example: PS Held by Outsiders
Poe buys 90% of Sol for $396 when Sol's equity
consists of $100 preferred stock, $200 common
stock, $40 other paid in capital and $160
retained earnings.
The preferred stock is cumulative,
nonparticipating, carries a 10% dividend and is
callable at 105% of par value. There is no
arrearage.
During the year, Sol earns $50 and pays $30 in
dividends.
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10-7
Calculations for Preferred Stock
Cost of 90% of Sol
$396
Implied value of Sol
Sol's total equity
$440
$500
Less book value of preferred stock
(105)
Book value of common
395
Excess, goodwill
$45
The book value of preferred is its call price (no
arrearage), 105%($100 par value).
Dividends are cumulative, so the current dividend
is $10 = 10%($100 par value).
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10-8
Allocations
Income allocation:
Sol's net income
Amortizations
Income to allocate
Allocated to preferred
Allocated to common
50
0
50
(10)
40
Dividends
Allocated to preferred
Allocated to common
30
(10)
20
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NCI share –
Preferred
$10 income
$10 dividend
CI share
(90%)
NCI share
(10%
common)
$4 income
$2 dividend
$36 income
$18 dividend
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Worksheet
Entries
with
Preferred
Stock Held
by
Outsiders
There is an
entry for NCI
share, PS that
parallels the
entry for NCI
share, CS.
Preferred Stock
is eliminated.
Income from Sol
Dividends
Investment in Sol
Noncontrolling interest share, CS
Dividends
Noncontrolling interest, CS
Noncontrolling interest share, PS
Dividends
Preferred stock
Common stock
Other paid in capital
Retained earnings
Goodwill
Investment in Sol
Noncontrolling interest, CS
Noncontrolling interest, PS
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36
18
18
4
2
2
10
10
100
200
40
160
45
396
44
105
10-10
Parent Uses Constructive Retirement
Parent acquires subsidiary's preferred stock
– Investment in subsidiary, PS is recorded at
its book value
– Any difference between book value and cost
of the stock is an adjustment of other paid in
capital
– This is an owner transaction; no gain or loss
is recorded
Investment is carried at PS book value
– Increase for dividends in arrears
– Decrease later when declared
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10-11
Parent Uses Cost Basis
Parent acquires subsidiary's preferred stock
– Use cost method
– Investment in subsidiary, PS is at cost
– Dividends are recorded as income
In the consolidation process
– Preferred stock is eliminated at its book
value
– Noncontrolling interest, PS is recorded at
book value of the preferred stock held by
others
– Investment is removed at its cost and any
difference from book value is charged or
credited to other paid in capital
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10-12
Example: Parent Acquires PS
Plato owns 80% of Shem acquired at fair value
plus implied goodwill of $100.
On 1/1/09 Plato acquires 70% of Shem's
outstanding preferred stock at $950.
Shem's equity at 1/1/09:
$3 Preferred stock, $50 par, callable at
$52, cumulative, no arrearage
Common stock $1 par
Other paid in capital
Retained earnings
Total equity
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1,500
300
1,200
2,300
5,300
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Calculations
Book value of preferred stock
$52 x ($1,500 / $50par) = $1,560
Book value of Shem's common stock
$5,300 total equity – $1,560 = $3,740
Shem's total value with goodwill
$3,740 + $100 = $3,840
Investment in Shem, CS (80%) = $3,072
Noncontrolling interest, CS (20%) = $768
Noncontrolling interest, PS (30%) = $468
Parent acquired 70% of Shem's PS for $950
Investment in Shem, PS (70%, book) = $1,092
Or
Investment in Shem, PS (70%, cost) = $950
The difference, $142 = 1092-950, increases the parent's other
paid in capital
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10-14
Constructive Retirement Entries
Parent's acquisition entry:
Investment in Shem, PS (70%)
Cash
Other paid in capital (Plato)
1,092
950
142
Worksheet entry:
Preferred stock
Common stock
Other paid in capital
Retained earnings
Goodwill
Investment in Shem, CS (80%)
Investment in Shem, PS (70%)
Noncontrolling interest, CS (20%)
Noncontrolling interest, PS (30%)
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1,500
300
1,200
2,300
100
3,072
1,092
768
468
10-15
Cost Basis Entries
Parent's acquisition entry:
Investment in Shem, PS (70%)
Cash
950
950
Worksheet entry
Preferred stock
Common stock
Other paid in capital
Retained earnings
Goodwill
Investment in Shem, CS (80%)
Investment in Shem, PS (70%)
Noncontrolling interest, CS (20%)
Noncontrolling interest, PS (30%)
Other paid in capital (Plato's)
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1,500
300
1,200
2,300
100
3,072
950
768
468
142
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Comparison of Methods
Both result in the same consolidated amounts
Constructive retirement
• Records the Other paid in capital (parent's) at
acquisition
• Investment is at book value
• Simplifies consolidation process!
Cost basis
• Records the Other paid in capital (parent's) as
part of the consolidation process
• Investment is at cost
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10-17
Subsidiary Preferred Stock, Consolidated Earnings Per
Share, and Consolidated Income Taxation
2: Earnings Per Share
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10-18
EPS Requirements
GAAP requires firms report basic and diluted
(where applicable) EPS
EPS is disclosed on a consolidated basis
Main issue: Subsidiary's capital structure
• Subsidiary potentially dilutive securities
convertible into subsidiary common stock
• Subsidiary potentially dilutive securities
convertible into parent common stock
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10-19
Review Basic EPS
Numerator:
Net income – preferred stock dividends*
* current dividends if cumulative, otherwise
declared dividends
Denominator:
Weighted average shares of common stock
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10-20
Review Diluted EPS
Numerator:
(Net income – PS dividends)
+ adjustments for dilutive securities
Denominator:
Weighted average shares outstanding
+ shares represented by dilutive securities
Dilution:
• Dilutive securities reduce EPS.
• Non-dilutive securities are excluded
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10-21
Review Dilutive Securities
Convertible bonds
– Numerator: after tax interest expense
– Denominator: common shares bonds
represent
Convertible preferred stock
– Numerator: preferred stock dividend
– Denominator: common shares the preferred
shares represent
Convertible preferred stock
– Numerator: none
– Denominator: "treasury stock method" to
compute shares (if positive)
# shares – (# shares x option price / market price)
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10-22
Subsidiary Securities Convertible
into Subsidiary Common Stock
• Compare Parent's equity
– Realized earnings of subsidiary
– Diluted earnings of subsidiary
• If diluted is higher, skip  Non-dilutive
• Realized earnings:
– Subsidiary's net income adjusted for
intercompany profits/losses
• Does not include amortizations of valuation
differentials
• Diluted earnings:
– Subsidiary's diluted EPS x number of shares
• Parent's diluted EPS
– Numerator: Reduce by difference
– Denominator: No effect – no parent shares!
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10-23
Subsidiary PS Convertible into
Subsidiary CS
Seed has $50 net income and 20 weighted average
shares of common stock. Its preferred stock has
a $10 dividend and is convertible into 12 shares
of Seed common stock.
Seed's basic EPS:
($50 - $10) / 20 = $2.00
Seed's diluted EPS:
($50 - $10) + $10 = $1.5625
20 + 12
.
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10-24
Parent's Basic EPS
Seed is 90% owned by Plant. Plant's net income is
$186, 200 shares of common are outstanding all
year, and Plant has no dilutive securities.
Plant's basic EPS:
$186 / 200 = $0.93
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Parent's Diluted EPS
Plant's realized income from Seed
90% x $40 = $36
Plant's share of Seed's diluted earnings:
90% x 20 shares x $1.5625 = $28.125
Since the share of diluted earnings is lower, we
will reduce the numerator by the difference.
Plant's diluted EPS:
$186 – 36 + 28.125 = $0.89
200
.
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10-26
Subsidiary Securities Convertible
into Parent Common Stock
Parent's diluted EPS calculation:
– Numerator: Add adjustments for subsidiary
securities convertible into parent common
stock
– Denominator: Add parent common shares
represented by subsidiary's dilutive securities
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10-27
Subsidiary Options and Bonds
Convertible into Parent CS
Syd's net income is $450 and it has 400 shares of
common outstanding all year.
Options: Syd has options that convert into 60
shares of its parent's (Paddy) common stock at
$10 per share. The average market price is $15.
Convertible bonds: Syd has $1,000 par bonds
convertible into 80 shares of Paddy's common
stock. The bonds were issued at par to yield
7%. The effective tax rate is 34%.
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10-28
Parent's Data and Basic EPS
Paddy has $1,800 income and 1,000 shares of
common stock outstanding all year. It has no
preferred stock or dilutive securities.
Paddy's basic EPS:
$1,800 / 1,000 shares = $1.80
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10-29
Parent's Diluted EPS
Impact of Syd's options for Paddy common:
• Numerator: none
• Denominator: 60 + (60 x $10/$15) = 20 shares
Impact of Syd's bonds convertible to Paddy
common:
• Numerator: 7% x $1,000 x (1-34%) = $46.2
• Denominator: 80 shares
Paddy's diluted EPS:
$1,800 + 0 + $46.2 = $1.76
1,000 + 20 + 80
.
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10-30
Subsidiary Preferred Stock, Consolidated Earnings Per
Share, and Consolidated Income Taxation
3: Income Taxes
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Consolidated Tax Return
• Advantages
– Offset affiliate losses (excluding preacquisition
loss carry forwards)
– Exclude intercompany dividends
– Defer intercompany profits until realized
(losses are also deferred)
• Disadvantages
– Loss of flexibility
– Difficult to switch back to unconsolidated
• Cannot file as consolidated again for 5
years
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Income Tax Allocation
• Permanent differences
– Dividends from affiliates are excluded from
taxable income
– Dividends from affiliates that are not
members of the affiliated group are allowed
an 80% dividends received deduction
• Temporary difference
– Undistributed income from domestic
affiliates (FASB Statement No. 109)
– Undistributed income from foreign affiliates and
from domestic affiliated earnings preceding
FASB Statement No. 109 may be permanent.
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10-33
Undistributed Earnings
Parson owns 30% of Seaton's common stock.
• Seaton's income, $600
• Seaton's dividends, $200
• Parson's applicable tax rate = 34%
Parson's deferred tax liability
= [30%($600 - $200)] x 20% x 34% = $8.16
Seaton's earnings are allowed the 80% deduction,
so only 20% is subject to tax.
If Seaton was a consolidated subsidiary, its
earnings would be excluded and Parson would
have no deferred tax liability.
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Unrealized Profits and Losses
• Separate tax returns
– Unrealized gains (losses) are taxed
(deducted) in the separate returns
– Consolidation procedures
• Remove the unrealized gain (loss)
• Record a deferred tax asset (liability)
• Tax effect impacts the income tax expense
of the selling affiliate
• Consolidated tax return
– Unrealized gains (losses) are excluded
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Example
Pool owns 90% of Sal. The tax rate is 34%. Pretax
operating income of Pool and Sal are $150 and $50. Sal
paid dividends of $20 and Sal's dividends are subject to
the 100% exclusion.
During the year, intercompany sales were $50 and there
remains $10 in unrealized profits in ending inventory.
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Consolidated Tax Return
Downstream sales
• Pool's income $150 - $10 = $140
• Sal's income $50
• Consolidated taxes ($140 + $50) x 34% = $64.6
– Allocate
(140/(140+50)) x $64.6 = $47.6 to Pool
(50/(140+50)) x $64.6 = $17.0 to Sal
Upstream sales
• Pool's income $150
• Sal's income $50 - $10 = $40
• Consolidated taxes ($150 + $40) x 34% = $64.6
– Allocate
(150/(150+40)) x $64.6 = $51.0 to Pool
(40/(150+40)) x $64.6 = $13.6 to Sal
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Entries with Consolidated Return
Pool and Sal would each record their own share of
the income tax expense and income tax payable.
The unrealized profit does not give rise to any
temporary differences
– Deferred for consolidation purposes
– Deferred for tax purposes
– That is, it is not income now and it is not taxed
now!
No special considerations for consolidation
worksheet.
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10-38
Separate Tax Returns
Downstream sales
• Pool's accounting income $150 - $10 = $140
– Pool's taxes payable $150 x 34% = $51.0
– Pool's deferred taxes $10 x 34% = $3.4
– Income tax expense $47.6
• Sal's income $50
– Sal's taxes $50 x 34% = $17.0
Upstream sales
• Pool's income $150
– Pool's taxes $150 x 34% = $51.0
• Sal's income $50 - $10 = $40
– Sal's taxes payable $50 x 34% = $17.0
– Sal's deferred taxes $10 x 34% = $3.4
– Sal's income tax expense $13.6
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Business Combinations
Tax free combinations
– Mergers or consolidations
– Exchange of voting stock for another
corporation's stock
– Exchange of voting stock for another
corporation's assets
Purchase acquisitions may be either
– Tax free
– Taxable
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10-40
Tax Free Business Combinations
Tax free business combinations give rise to
differences between book values and tax values
At acquisition
– Assign assets value based on gross fair value
– Except
• Goodwill, bargain purchase, deferred taxes,
pension assets, leveraged leases
– Tax bases carry forward from predecessor
– Record deferred tax asset/liability for
temporary differences
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10-41
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Publishing as Prentice Hall
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10-42