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Solution manual advanced accounting 9e by hoyle ch07

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Intercompany 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.. If a

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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

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2 The treasury stock approach is popular in practice because of its simplicity and is now

required by SFAS 160

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 Intercompany profits are not taxed until realized

2 Intercompany 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 intercompany 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 market 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)

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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

4 Eliminate a subsidiary's ownership interest in its parent using the treasury stock approach

5 Explain the rationale underlying the treasury stock approach to a mutual ownership

6 List the criteria for being a member of an affiliated group for income tax filing purposes

7 Discuss the advantages to a business combination of filing a consolidated tax return

8 Allocate the income tax expense computed on a consolidated tax return to the various members of a business combination according to their separate taxable incomes

9 Compute taxable income for an affiliated group based on information presented in a consolidated set of financial statements

10 Compute the deferred income tax expense to be recognized when separate tax returns are filed by any of the members of a business combination

11 Determine the deferred tax liability that is created when the tax bases of a subsidiary's assets and liabilities are below consolidated values

12 Explain the impact that a net operating loss of an acquired affiliate has on consolidated figures

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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 companies At least one of these subsidiaries holds a majority of the voting stock of its own subsidiary Each subsidiary controls other subsidiaries with the chain of ownership going on indefinitely The parent actually holds control over all of the companies within the business combination despite having direct ownership in only its own subsidiaries

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 company, a proper recognition of the equity income accruing from its own subsidiary must initially be made Structuring the income calculation in this manner is necessary to ensure that all earnings are properly included by each company

3 Able—100% of income accrues to the consolidated entity (as parent company)

Baker—70% (percentage of stock owned by Able)

Carter—56% (80% of stock owned by Baker multiplied by the 70% of Baker controlled by Able)

Dexter—33.6% (60% of stock owned by Carter multiplied by the 80% of Carter controlled by Baker multiplied by the 70% of Baker 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 subsidiary must be computed in a precise manner For any company in both a parent and a subsidiary position, equity income accruals are recognized prior to the calculation of that company's realized income This realized income total is significant because it serves as the basis for noncontrolling interest calculations as well as the equity accruals to be recognized by that company's parent

5 In a connecting affiliation, two (or more) companies within a business combination own shares

in a third member A mutual ownership, in contrast, exists whenever a subsidiary possesses

an equity interest in its own parent

6 In accounting for a mutual ownership, SFAS 160 requires the treasury stock approach The treasury stock approach presumes that the cost of the parent shares should be reclassified as treasury stock within the consolidation process The subsidiary is being viewed, under this method, as an agent of the parent Thus, the shares are accounted for as if the parent had actually made the acquisition

7 According to present tax laws, an affiliated group can be comprised of all domestic corporations in which a parent holds 80 percent ownership More specifically, the parent must own (directly or indirectly) 80 percent of the voting stock of the corporation as well as at least

80 percent of each class of nonvoting stock

8 Several basic advantages are available to combinations that file a consolidated tax return First, intercompany profits are not taxed until realized For companies with large amounts of

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intercompany transactions, the deferral of unrealized gains causes a delay in the making of significant tax payments Second, losses incurred by one company can be used to reduce or offset taxable income earned by other members of the affiliated group In addition, intercompany dividends are not taxable but that exclusion applies to the members of an affiliated group regardless of whether a consolidated or separate tax return is filed

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 that are in an affiliated group may still elect to file separately If all companies within the combination are profitable and few intercompany transactions are carried out, little advantage may accrue from preparing a consolidated return With a separate filing, a subsidiary has more flexibility as to accounting methods as well as its choice of a fiscal year-end

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 interest calculations Obviously, the more expense that is assigned to a particular company the less realized income is attributed to that concern Income tax expense can be allocated based on the income totals that would have been reported by various companies if separate tax returns had been filed or on the portion of taxable income derived from each company

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 recognized by the parent prior to being received in the form of dividends (when it is subject to taxation), deferred income taxes must be recognized

Either the parent or the subsidiary might also have to record deferred income taxes in connection with any unrealized intercompany gain On a separate tax return, such gains are reported at the time of transfer while for financial reporting purposes they are appropriately deferred until realized Once again, a temporary difference is created which necessitates the recognition of deferred income taxes

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 This deferred liability is recognized at the time the combination is created Subsequently, when actual tax payments do arise, the deferred liability is written off rather than recognizing expense based solely on the current liability In this manner, the expense is shown at a lower figure, one that is matched with reported income (which is also a lower balance because of the extra depreciation)

Recognition of this deferred liability at date of acquisition also reduces the net amount attributed to the subsidiary's assets and liabilities in the initial allocation process Therefore, the residual asset (goodwill) is increased by the amount of any liability that must be recognized

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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 decreased by the carryforward To reflect the potential tax reduction, a deferred income tax asset is recorded for the total amount of anticipated benefit However, because of the uncertainty, unless the receipt of this benefit is more likely than not to be received, a valuation allowance must also be recorded as a contra account to the asset The valuation allowance may be for the entire amount or just for a portion of the asset

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, increased the recording of goodwill (assuming that the price did not indicate a bargain purchase) If the valuation allowance is subsequently reduced to $110,000, the net assets have increased by $40,000 This change is reflected by a decrease in income tax expense

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Crimson's accrual-based income:

Operational income $200,000 Investment Income (90% of Damson’s realized income) 144,000 Crimson's accrual-based income $344,000

Bassett's accrual-based income:

Operational income $300,000 Investment income (80% of Crimson's realized income) 275,200 Bassett's accrual-based income $575,200

8 C Icede's accrual-based income:

Operational income $220,000 Defer unrealized gain (60,000) Icede's accrual-based income $160,000 Outside ownership 20% Noncontrolling interest $32,000

Healthstone's accrual-based income:

Operational income $300,000 Defer unrealized gain (30,000) Investment income (80% of Icede's accrual-based income) 128,000 Healthstone's accrual-based income $398,000 Outside ownership 20% Noncontrolling interest $79,600 Total noncontrolling interest = $111,600 ($32,000 + $79,600)

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9 D Juvyn's Operational Income $50,000 Dividend Income 14,000 Juvyn's Income $64,000 Outside Ownership 10% Noncontrolling Interest $6,400

10 A Equity Income (60% of $200,000) $120,000

Dividend Income (60% of $40,000) 24,000 Tax Difference $96,000 Dividend Deduction upon Eventual Distribution (80%) (76,800) Temporary Portion of Tax Difference $19,200 Tax Rate 30% Deferred Income Tax Liability $5,760

11 C Unrealized Gain:

Total Gain $30,000 Portion Still Held 20% Unrealized Gain $6,000 Tax Rate 25% Deferred Tax Asset $1,500

12 A Recognition of this gain is not required on a consolidated tax return

13 C Because fair value of the subsidiary's assets exceeds the tax basis by

$100,000 a deferred tax liability of $30,000 (30%) must be recorded Goodwill

is then computed as follows:

Consideration transferred $420,000 Fair Value $400,000

Deferred Tax Liability (30,000) 370,000 Goodwill $50,000

14 (35 Minutes) (Series of reporting and consolidation questions pertaining to a father-son-grandson combination Includes unrealized inventory gains)

a Consideration transferred (by Tree) $252,000

Noncontrolling interest fair value 108,000

Limb’s business fair value 360,000

Book value (300,000)

Trade name $60,000

Life 30 years

Annual amortization $2,000

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14 (continued)

Consideration transferred for Leaf (by Limb) $91,000

Noncontrolling interest fair value 39,000

Leaf’s business fair value $130,000

Income recognized ($2,000 dividends × 70%) (1,400)

Retained earnings increase (Limb), 1/1/11 $4,900

Amortization (2 years at $2,000 per year) (4,000)

Equity income from ownership of Leaf (above) 6,300

Income recognized ($10,000 [2009] + $20,000 [2010]

Retained earnings Increase (Tree), 1/1/11 $50,610

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14 (continued)

c Consolidated sales (total for the companies) $1,260,000

Consolidated expenses (total for the companies) (1,025,000)

Total amortization expense (see a.) (3,000)

d Noncontrolling interest in income of Leaf

Noncontrolling interest in income of Leaf $8,700

Noncontrolling interest in income of Limb:

Equity in Leaf income [(30,000-1,000) × 70%] 20,300

e 2010 Realized income of Limb (prior to accounting

2009 Transfer-gain recognized in 2010 10,000

2010 Transfer-gain to be recognized in 2011 (16,000)

2011 Realized Income of Limb (prior to accounting

2010 Transfer-gain recognized in 2011 16,000

2011 Transfer-gain to be recognized in 2012 (25,000)

f In b., an adjustment of $50,610 was made to the beginning 2011 retained

earnings Question e takes this same question and alters it by including

unrealized gains The $10,000 gain does not affect the answer because the 2010 and 2011 effects cancel each other

Thus, only the $16,000 gain must be taken into consideration on January 1,

2011 Limb’s realized income in 2010 is reduced by $16,000 because of the deferred gain The parent's equity accrual would be reduced by $11,200 or 70%

of that figure The adjustment as of January 1, 2011 is $39,410 ($50,610 –

$11,200)

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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

Intangible Assets $25,000

Life 10 years

Amortization expense (annual) $2,500

Income reported by Nephew—2011 $50,000

Amortization expense (above) (2,500)

Accrual-based income 47,500

Uncle's ownership percentage 80%

Income of subsidiary recognized by Uncle $38,000

b To the outside owners, the $6,000 intercompany dividends ($20,000 × 30%) paid

by Uncle are viewed as income because the book value of Nephew is

increasing Thus, the noncontrolling interest's share of income is $10,700 or 20% of [$47,500 income ($50,000 operational income less $2,500 excess

amortization) plus the $6,000 in dividends]

16 (35 Minutes) (Consolidated income for a father-son-grandson combination.)

Amortization expense (on Butte's investment) (8,000)

Amortization expense (on Mesa's investment) (22,500)

Equity accrual from ownership of Valley

Total noncontrolling interest in income of subsidiaries $89,020

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16 (Continued)

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 Mesa’s share of Butte’s excess amortization (80% × $22,500) (18,000) Mesa’s share of Valley’s excess amortization (80% × 55% × $8,000) (3,520)

Noncontrolling interest in consolidated net income 89,020

17 (30 Minutes) (Consolidated income figures for a connecting affiliation)

UNREALIZED GAINS:

Cleveland ($12,000 remaining inventory × 25% markup) = $3,000

Wisconsin ($40,000 remaining inventory × 30% markup) = $12,000

Defer unrealized gain (above) (12,000)

Investment income (60% of Cleveland's realized income of

$57,000) 34,200

Realized income—Wisconsin $132,200

Outside ownership 10%

Noncontrolling interest in Wisconsin's income $13,220

TOTAL NONCONTROLLING INTERESTS: $24,620 ($11,400 + $13,220)

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17 (continued)

 Expenses = $200,000 (add the three book values)

 Dividend Income = -0- (eliminated for consolidation purposes)

 Consolidated net income = $375,000 (consolidated revenues less

consolidated cost of goods sold and expenses)

 Noncontrolling Interests in subsidiaries' income = $24,620 (computed above)

 Controlling interest in consolidated net income = $350,380 (consolidated net income less noncontrolling interest share)

18 (15 Minutes) (Consolidated income and equity accounts mutual ownership.)

a CONSOLIDATED TOTALS

 Sales = $1,800,000 (add the two book values)

 Cost of goods sold = $1,020,000 (add the two book values)

 Expenses = $352,000 (add the two book values and include the amortization expense of $12,000)

 Dividend income = -0- (eliminated for consolidation purposes)

 Consolidated net income = $428,000 (consolidated revenues less

consolidated cost of goods sold and expenses)

 Noncontrolling interest in Wonderland's income = $11,400 (10 percent of the reported balance less $12,000 excess amortization) Dividend income is included because it increases the book value of the subsidiary and,

therefore, the noncontrolling interest.)

b

 Common Stock = $880,000 (the parent company balance only)

 Treasury Stock = $111,000 (cost paid by subsidiary for the shares of the parent company)

19 (25 Minutes) (Tax expense with separate tax returns for a combination.)

 Operating expenses = $234,000 (add the two book values)

 Dividend Income = -0- (eliminated for consolidation purposes)

 Consolidated net income = $216,000 (Revenues less expenses)

 Noncontrolling interest in Down's Income = $18,000 (20 percent of reported Income of $100,000 plus $30,000 gain deferred from 2010 less $40,000 gain deferred into 2011)

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 Controlling interest in consolidated net income = $198,000

19 (continued)

b On separate returns, the unrealized gains are reported as taxable income

Because Up owns 80 percent of Down's stock, the dividends are tax- free and no deferred tax liability is necessary on the undistributed income

DUE TO GOVERNMENT: (separate returns)

Currently payable to government $30,000

Total Income Tax Payable: Current = $67,800 ($37,800 + $30,000)

CURRENT EXPENSE:

Consolidated net income (part a.) $198,000

Eliminate noncontrolling interest +18,000

Income to be taxed $216,000

Tax rate 30%

Income tax expense $64,800

The $3,000 difference between the liability and the expense is an increase in the Deferred Income Tax Asset account It is created by the tax effect (30%) on the net unrealized gain for the period ($10,000 or $40,000 – $30,000)

20 (45 Minutes) (Series of questions requires computation of income tax expense and the related payable balance)

a $260,000 ($650,000 × 40%)

The affiliated group would be taxed on its operating income of $650,000 (the net unrealized gain is deferred on a consolidated return) The intercompany income and dividends are not relevant since a consolidated return is filed

b $260,000 ($650,000 × 40%)

The affiliated group would be taxed on its operating income of $650,000 (the net unrealized gain is deferred on a consolidated return) The intercompany income and dividends are not relevant because a consolidated return is filed

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The percentage ownership does not affect the figures on a consolidated

return

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20 (continued)

c $296,000 ($96,000 + $200,000)

Rogers would pay $96,000 or 40% of its $240,000 operating income Clarke

would pay $200,000 or 40% of its $500,000 operating income The unrealized gain is not deferred when separate returns are filed Intercompany dividends are not taxable because the parties qualify as an affiliated group even though

separate returns are being filed Answer (c.) differs from (a.) and (b.) because tax on the $90,000 unrealized gain (40% or $36,000) is paid immediately

accruing from Rogers of $100,800 (70% of that company's after-tax income) Clarke will record an income tax expense of $164,000 in connection with the operating income ($410,000 × 40%) The expense recognized in connection with the equity accrual is affected by the dividends-received deduction:

Equity income of subsidiary $100,800

Dividends-received deduction (when received) (80%) 80,640

Income subject to taxation $20,160

Tax rate 40%

Income tax expense—equity income (Clarke) $8,064

Income tax expense—operating income (Clarke)

(above) 164,000 $172,064 Income tax expense—operating income (Rogers)

(above) 96,000 Income tax expense $268,064

e $204,480

Clarke will pay $200,000 in connection with its operating income ($500,000 × 40%) because the unrealized gain cannot be deferred Clarke also receives

$56,000 in dividends from Rogers ($80,000 × 70%) Tax payment on these

dividends is $4,480 ($56,000 × 20% × 40%) The difference between the payment

by Clarke ($204,480) and the company's expense in (d.) ($172,064) is created by the premature payment of the tax (a deferred tax asset) on the unrealized gain ($90,000) less the deferred tax liability on the parent's equity accrual ($100,800)

in excess of dividends received ($56,000)

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21 (20 Minutes) (Comparison of income tax expense and payable on separate and consolidated tax returns.)

Because no temporary differences exist in this problem, the income tax expense would also be $148,000 The unrealized gain is not taxed until realized Dividend income is not important because a consolidated return is being filed

To determine the income tax expense for Piranto, the two temporary differences must be taken into account:

Taxable income $300,000

Gain taxed in 2009 although realized

in 2010 120,000

Gain taxed in 2010 although not yet realized (150,000)

2010 realized income subject to taxation $270,000

Tax rate 40%

Income tax expense $108,000

The $12,000 difference between the expense and the payable is the tax effect on the net unrealized gain ($30,000 × 40%)

Slinton will have an expense and payable of $40,000 ($100,000 × 40%)

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22 (45 Minutes) (Comparison of income tax expense and payable on separate and consolidated tax returns Includes question on mutual ownership and the

conventional approach.)

a Total income tax expense is $156,877 Because of the level of ownership,

separate returns must be filed Unrealized gains are taxed immediately as are intercompany dividends

Because the unrealized gains are deferred on the consolidated financial

statements, Boxwood's expense would be $34,400 or 40% of $86,000 in realized income ($100,000 + $18,000 – $32,000)

Lake's income subject to taxation includes its $300,000 in operating income plus $30,960 in income accruing from its investment in Boxwood (60% of the after-tax Income of $51,600 [$86,000 – $34,400]) Income tax expense for Lake is computed as follows:

Operating income $300,000 Equity income $30,960

Taxable portion 20% 6,192 Income eventually subject to taxation $306,192 Tax rate 40% Income tax expense Lake (rounded) $122,477 Income tax expense Boxwood (above) 34,400 Total income tax expense $156,877

b Boxwood will pay $40,000 ($100,000 × 40%) because separate returns are filed Lake, however, will pay its taxes based on dividends received rather than on the equity accrual A deferred income tax liability would be established for the difference Lake's payment for the current year is computed as follows:

Operating income $300,000 Dividend income (60% × $10,000) $6,000

Taxable portion 20% 1,200 Income currently taxable $301,200 Tax rate 40% Income tax payable—Lake $120,480 Income tax payable—Boxwood (above) 40,000 Total Income tax payable current $160,480

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22 (continued)

The $3,603 difference between the expense in a and the payable in b is created

by the following two effects:

Deferred income tax liability on equity income accrual not yet taxed

($30,960 – $6,000 = $24,960 × 20% × 40%) $1,997 Deferred income tax asset on net unrealized gain

($32,000 – $18,000 = $14,000 × 40%) 5,600 Net decrease in expense $3,603

c Because a consolidated tax return is filed, unrealized gains are deferred in the same manner as for external reporting purposes Dividend income is not

taxable

Lake's operating income $300,000

Boxwood's operating income $100,000

Prior year unrealized gain 18,000

Current year unrealized gain (32,000) 86,000 Income subject to taxation (and currently taxable) $386,000 Tax rate 40% Income tax expense $154,400

23 (30 Minutes) (Computation of income tax expense and income tax payable on

consolidated and separate tax returns.)

a Operating Income $450,000

Tax rate 40%

Taxes to be paid $180,000

The affiliated group would be taxed on its operating income of $450,000 (the

$50,000 unrealized gain is deferred) Intercompany income and dividends are not relevant because a consolidated return is filed

b Total taxes to be paid are $200,000 Robertson would have to pay $80,000 or 40% of its $200,000 operating income Garrison would pay $120,000 or 40% of its

$300,000 operating income The unrealized gain is not deferred because

separate returns are being filed Intercompany dividends are not taxable

because the parties still qualify as an affiliated group even though separate returns are being filed

c Robertson must report an income tax expense of $80,000 or 40% of its $200,000 operating income

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