Solution manual advanced accounting 11th edition joe ben hoyle chap007

Chapter 07 - Consolidated Financial Statements - Ownership Patterns and Income Taxes CHAPTER 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 These ownership patterns may be developed specifically to enhance control or for organizational purposes 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 The worksheet entries are effectively doubled by each corporate ownership layer but the concepts underlying the consolidation process are not changed 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 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 The treasury stock approach is popular in practice because of its simplicity and is now required by the FASB Codification 7-1 Chapter 07 - Consolidated Financial Statements - Ownership Patterns and Income Taxes 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 Intra-entity profits are not taxed until realized 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) 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 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 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 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 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) 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 7-2 Chapter 07 - Consolidated Financial Statements - Ownership Patterns and Income Taxes 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 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 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 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) 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 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 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 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 7-3 Chapter 07 - Consolidated Financial Statements - Ownership Patterns and Income Taxes 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 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 intraentity 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, intra-entity 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 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 intra-entity 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 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 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 intra-entity 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 arise, the deferred liability is written off rather than recognizing expense based 7-4 Chapter 07 - Consolidated Financial Statements - Ownership Patterns and Income Taxes 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 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 Answers to Problems D B D C C C A Damson's accrual-based income: Operating income Defer unrealized gain Damson's accrual-based income Crimson's accrual-based income: Operating income Investment Income (90% of Damson’s realized income) Crimson's accrual-based income 7-5 $200,000 (40,000) $160,000 $200,000 144,000 $344,000 Chapter 07 - Consolidated Financial Statements - Ownership Patterns and Income Taxes Bassett's accrual-based income: Operating income Investment income (80% of Crimson's realized income) Bassett's accrual-based income $300,000 275,200 $575,200 C Cherry's accrual-based income: Operating income Defer unrealized gain Cherry's accrual-based income Outside ownership Noncontrolling interest $280,000 (50,000) $230,000 20% $46,000 Beech's accrual-based income: Operating income Defer unrealized gain Investment income (80% of Cherry's accrual-based income) Beech's accrual-based income Outside ownership Noncontrolling interest $315,000 (19,000) 184,000 $480,000 20% $96,000 Total noncontrolling interest = ($46,000 + $96,000) = $142,000 C Satellite's operating income Dividend income Satellite 's income Outside ownership Noncontrolling interest $50,000 14,000 $64,000 15% $9,600 10 A Equity income (60% of $200,000) Dividend income (60% of $40,000) Tax difference Dividends received deduction upon eventual distribution (80%) Temporary portion of tax difference Tax rate Deferred income tax liability $120,000 24,000 $96,000 (76,800) $19,200 30% $5,760 11 C Unrealized Gross Profit: Total gross profit Portion still held Unrealized gross profit Tax rate Deferred tax asset $30,000 20% $6,000 25% $1,500 7-6 Chapter 07 - Consolidated Financial Statements - Ownership Patterns and Income Taxes 12 A Recognition of this gross profit 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 Fair value Deferred tax liability Goodwill $420,000 $400,000 (30,000) 370,000 $50,000 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) Noncontrolling interest fair value Birch’s business fair value Book value Trade name Life Annual amortization $288,000 72,000 360,000 (300,000) $60,000 30 years $2,000 14 (continued) Consideration transferred for Cedar (by Birch) Noncontrolling interest fair value Cedar’s business fair value Book value Trade name Life Annual amortization $104,000 26,000 $130,000 (100,000) $30,000 30 years $1,000 Investment in Birch Birch's reported income-2011 $40,000 Amortization expense (2,000) Accrual-based income $38,000 Birch’s percentage ownership 80% Equity accrual-2011 Dividends received 2011 Birch's reported income-2012 $60,000 Amortization expense (2,000) Income from Cedar [80% x ($10,000 - $1,000)] 7,200 Accrual-based income $65,200 Birch’s percentage ownership 80% $288,000 7-7 $30,400 (8,000) Chapter 07 - Consolidated Financial Statements - Ownership Patterns and Income Taxes Equity accrual-2012 Dividends received from Birch 2012 Investment in Birch 12-31-12 $52,160 (16,000) $346,560 Note: Dividends paid by Cedar to Birch not affect Aspen’s Investment account b Consolidated sales (total for the companies) Consolidated expenses (total for the companies) Total amortization expense (see a.) Consolidated net income for 2013 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 Noncontrolling interest in income of Birch: Revenues less expenses $65,000 Excess amortization (2,000) Equity in Cedar income [(30,000-1,000) × 80%] 23,200 Realized income of Birch—2013 $86,200 Outside ownership 20% NCI share of 2013 consolidated income $1,298,000 (1,025,000) (3,000) $ 270,000 $5,800 $17,240 $23,040 14 (continued) d 2012 Realized income of Birch (prior to accounting for unrealized gross profit) (see a) 2011 Transfer-gross profit recognized in 2012 2012 Transfer-gross profit to be recognized in 2013 2012 Realized income - Birch $65,200 10,000 (16,000) $59,200 2013 Realized income of Birch (prior to accounting for unrealized gross profit) (see c.) 2012 Transfer-gross profit recognized in 2013 2013 Transfer-gross profit to be recognized in 2014 2013 Realized income—Birch $86,200 16,000 (25,000) $77,200 15 (15 minutes) (Income and noncontrolling interest with mutual ownership.) a Consideration transferred by Uncle Noncontrolling interest fair value Nephew’s business fair value Book value 7-8 $500,000 125,000 $625,000 600,000 Chapter 07 - Consolidated Financial Statements - Ownership Patterns and Income Taxes Intangible assets Life Amortization expense (annual) Income reported by Nephew—2013 Amortization expense (above) Accrual-based income Uncle's ownership percentage Income of subsidiary recognized by Uncle $25,000 10 years $2,500 $50,000 (2,500) 47,500 80% $38,000 b To the outside owners, the $6,000 intra-entity 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 computed as follows: Nephew’s accrual-based income (above) $47,500 Dividends paid by Uncle to Nephew 6,000 Income to outside owners $53,500 Noncontrolling interest percentage 20% Noncontrolling interest share of Nephew’s income $10,700 16 (35 Minutes) (Consolidated income for a father-son-grandson combination.) a Mesa's operating income Butte's operating income Valley's operating income Amortization expense–Mesa's investment in Butte Amortization expense–Butte's investment in Valley Consolidated net income b Valley's operating income Amortization expense (on Butte's investment) Valley's accrual-based income Outside ownership Noncontrolling interest in Valley's income Butte's operating income Amortization expense (on Mesa's investment) Equity accrual from ownership of Valley ($132,000 × 55%) Butte's accrual-based income Outside ownership Noncontrolling interest in Butte's income Total noncontrolling interest in income of subsidiaries 7-9 $250,000 98,000 140,000 (22,500) (8,000) $457,500 $140,000 (8,000) $132,000 45% $59,400 $ 98,000 (22,500) 72,600 $148,100 20% $29,620 $89,020 Chapter 07 - Consolidated Financial Statements - Ownership Patterns and Income Taxes Reconciliation: Mesa’s operating income Mesa’s share of Butte’s operating income (80% × $98,000) Mesa’s share of Valley’s operating income (80% × 55% × $140,000) Mesa’s share of Butte’s excess amortization (80% × $22,500) Mesa’s share of Valley’s excess amortization (80% × 55% × $8,000) Controlling interest in consolidated net income Noncontrolling interest in consolidated net income Consolidated net income $250,000 78,400 61,600 (18,000) (3,520) $368,480 89,020 $457,500 17 (30 Minutes) (Consolidated income figures for a connecting affiliation) UNREALIZED GROSS PROFIT: Cleveland ($12,000 remaining inventory × 25% markup) = $3,000 Wisconsin ($40,000 remaining inventory × 30% markup) = $12,000 NONCONTROLLING INTERESTS: CLEVELAND: Operating income (sales minus cost of goods sold and expenses) Defer unrealized gross profit (above) Realized income—Cleveland Outside ownership Noncontrolling interest in Cleveland's income $60,000 (3,000) $57,000 20% $11,400 WISCONSIN: Operating income (sales minus cost of goods sold and expenses) $110,000 Defer unrealized gross profit (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) CONSOLIDATION TOTALS  Sales = $1,590,000 (add the three book values and eliminate intra-entity transfers of $40,000 and $100,000)  Cost of goods sold = $1,015,000 (add the three book values, eliminate intraentity transfers of $40,000 and $100,000, and defer [add] unrealized gains of $3,000 and $12,000) 7-10 Chapter 07 - Consolidated Financial Statements - Ownership Patterns and Income Taxes 27 (continued) Entry A2 Copyright 56,000 Investment in Yarrow 50,400 Noncontrolling Interest in Yarrow 5,600 (To recognize January 1, 2013 unamortized portion of acquisition price assigned to copyright.) Entry E Operating Expenses 9,000 Customer List 5,000 Copyright 4,000 (To recognize amortization expense for 2013—$5,000 in connection with Travers' investment and $3,000 in connection with Yarrow's investment.) Entry Tl Sales 100,000 Cost of Goods Sold (To eliminate intra-entity inventory transfers made during 2013.) Entry G Cost of Goods Sold 9,600 Inventory (current assets) (To defer unrealized gross profit on ending inventory—$20,000 × 48% markup.) Noncontrolling Interest in Stookey's Net Income 2013 Reported net income Customer list amortization Realization of 2012 deferred gross profit (*G) Deferral of 2013 unrealized gross profit (G) Realized income 2013 Outside ownership Noncontrolling interest in Stookey's net income Noncontrolling Interest in Yarrow's Net Income 2013 Reported net income Copyright amortization Accrual of Stookey's income (80% of $93,080 realized income [computed above]) Realized income—2013 Outside ownership Noncontrolling interest in Yarrow's net income 7-28 100,000 9,600 $100,000 (5,000) 7,680 (9,600) $93,080 20% $18,616 $200,000 (4,000) 74,464 $270,464 10% $ 27,046 Chapter 07 - Consolidated Financial Statements - Ownership Patterns and Income Taxes 27 (continued) Accounts TRAVERS COMPANY AND CONSOLIDATED SUBSIDIARIES Consolidation Worksheet December 31, 2013 Travers Yarrow Stookey Consolidation EntriesNoncontrollingConsolidated Company Company Company Debit Credit Interest Balances Sales and other revenues Cost of goods sold (900,000) 480,000 (600,000) 320,000 (500,000) 260,000 (Tl) (G) Operating expenses Separate company net income Consolidated net income NCI in Yarrow's net income NCI in Stookey's net income To controlling interest Retained earnings, 1/1/13: Travers Company Yarrow Company Stookey Company 100,000 (320,000) 80,000 (200,000) 140,000 (100,000) (E) Net Income (above) Dividends paid Retained earnings, 12/31/13 (320,000) 128,000 (892,000) (200,000) 444,000 720,000 380,000 Current assets Investment in Yarrow Company (700,000) (600,000) (300,000) 329,000 (800,000) 2,113,000 280,000 (*C1) (917,670) -0-0- (G) 217,670 (S2) (A2) 85,856 (S1) (A1) 9,600 887,270 50,400 393,856 36,000 1,094,400 -0-0- 520,000 (A2) 800,000 1,560,000 (721,000) (500,000) (460,000) (300,000) (200,000) (200,000) Retained earnings, 12/31/13 (above) NCI interest in Stookey, 1/1/13 (892,000) (800,000) (400,000) (2,113,000) 217,670 85,856 (1,560,000) (800,000) 7-29 (609,080) 27,046 18,616 (563,418) (563,418) 128,000 (1,353,088) (*C2) 836,000 (*C2) 685,856 (*C1) 7,680 292,320 (400,000) 344,000 949,000 (S2) (*G) (S1) (100,000) Liabilities Common stock Noncontrolling interest in Yarrow, 1/1/13 Noncontrolling interests in subsidiaries Total liabilities and equities (1,900,000) 961,920 7,680 100,000 (27,046) (18,616) Investment in Stookey Company Land, buildings, & equipment (net) Customer list Copyright Total assets 100,000 9,600 (*G) (TI) 9,000 (A1) 45,000 56,000 (E) (E) 4,000 2,305,000 40,000 5,000 52,000 3,491,400 (1,381,000) (S1) (S2) 200,000 300,000 (S1) (A1) (S2) (A2) 2,008,982 98,464 9,000 98,586 5,600 2,008,982 (500,000) (1,353,088) (107,464) (104,186) (257,312) (257,312) (3,491,400) Chapter 07 - Consolidated Financial Statements - Ownership Patterns and Income Taxes 27 (continued) b Travers' reported income $320,000 Yarrow's reported income Dividend income (none collected) Intra-entity gains (no transfers) Amortization expense (9,000) Taxable income $511,000 Tax rate 45% Income tax payable $229,950 c Stookey's reported income $100,000 (Unrealized gains are not deferred on a separate tax return.) Tax rate 45% Income tax payable 200,000 $45,000 d (1) Because Yarrow owns 80% of Stookey's stock, intra-entity dividends are nontaxable Thus, no temporary difference is created by Stookey's failure to pay a dividend (2) Stookey's unrealized gains are recognized in one time period for financial reporting purposes and in a different time period for tax purposes This temporary increases taxable income by $1,920 over reported income: 2013 Unrealized gross profit taxed in 2013 $9,600 2012 Unrealized gross profit taxed previously in 2012 (7,680) Increase in taxable income $1,920 Tax rate 45% Deterred income tax asset $ 864 7-30 Chapter 07 - Consolidated Financial Statements - Ownership Patterns and Income Taxes Income Tax Expense: Travers and Yarrow—payable (part b) $229,950 Stookey—payable (part c) 45,000 Total taxes to be paid—2013 $274,950 Prepayment (asset) (above) (864) Income tax expense 2013 $274,086 Because a single rate is used, income tax expense can also be computed by taking consolidated net income (prior to noncontrolling interest reduction) of $609,080 (part a.) and multiplying by the 45% tax rate to obtain $274,086 Income tax expense—current Deferred income tax—asset Income tax payable 274,086 864 274,950 28 (40 Minutes) (Series of questions about a business combination and its income tax reporting) a Partial equity method "Income of Soludan" is 80% of Soludan's reported total b $12,000 Reduction is evidenced by a $338,000 figure reported for consolidated inventory rather than the $350,000 total for the two companies c $37,500 Consolidated operating expenses have increased by $2,500, evidently the annual amortization Because a 15-year life is assumed by the combination, the amount originally allocated to trademarks must have been $37,500 d $120,000 Decrease shown in consolidated sales account 7-31 Chapter 07 - Consolidated Financial Statements - Ownership Patterns and Income Taxes e Upstream "Noncontrolling interest in Soludan Company's income" is $18,700 Because this amount is not equal to 20% of Soludan's reported income less excess amortization ($100,000 – $2,500), realized income must have been adjusted for unrealized gross profits Subsidiary income is only adjusted to show the effects of upstream transfers f $20,000 For both receivables and liabilities, the consolidated total is $20,000 less than the sum of the two companies g $8,000 Consolidated cost of goods sold is decreased by $120,000 (to $780,000) in eliminating intra-entity sales The increase of $12,000 created by the ending unrealized gross profit (see part b.) would then leave a $792,000 balance Because $784,000 is the ending balance reported for consolidated cost of goods sold, an $8,000 unrealized gross profit must have been deferred from the previous year 28 (continued) h Because the trademarks balance now stands at $32,500, amortization expense of $2,500 has been recognized, $2,500 in the previous year In addition, an $8,000 unrealized gross profit from the prior year (see part g.) is recognized Amortization expense—prior year × 80% Unrealized gross profit—upstream effect on parent's retained earnings is $8,000 × 80% Adjustment to parent’s beginning retained earnings $2,000 6,400 $8,400 i This figure is computed as follows: Book value of subsidiary—1/1 $370,000 Unrealized gross profit in beginning inventory (see above) (8,000) Realized book value $362,000 Excess allocation at 1/1 35,000 Subsidiary valuation basis 1/1 397,000 7-32 Chapter 07 - Consolidated Financial Statements - Ownership Patterns and Income Taxes Noncontrolling interest percentage Noncontrolling interest 1/1 Noncontrolling interest in Soludan's income (as reported) Noncontrolling interest in Soludan's dividends ($20,000 × 20%) Ending noncontrolling interest 20% $79,400 18,700 (4,000) $94,100 j For a consolidated return, unrealized gross profit are deferred as in the consolidated statements At a 40% rate, both the expense and payable would be $117,400 Income tax expense Income tax payable 117,400 Consolidated Taxable Income: Sales $1,280,000 Cost of Goods Sold (784,000) Operating expenses (202,500) 7-33 117,400 Chapter 07 - Consolidated Financial Statements - Ownership Patterns and Income Taxes Taxable income 293,500 k On a separate return, Politan would report its operating income of $200,000 leading to a tax expense and payable of $80,000 Because of the level of ownership, intra-entity dividend (or investment) income is omitted Income Tax Expense Income Tax Payable 80,000 80,000 28 k (continued) On a separate return, Soludan would report $100,000 operating income for a payable of $40,000 The unrealized gross profits are accounted for in different time periods in the financial statements, thus, a temporary difference is created The beginning inventory gross profit of $8,000 was taxed in the previous year rather than currently The current unrealized gross profit of $12,000 is taxed now rather than next year; the tax paid this year on the net $4,000 ($1,600) is a prepayment Income Tax Expense Deferred Income Tax Asset Income Tax Payable 38,400 1,600 Soludan's entry can also be computed as follows: Reported income $100,000 Unrealized gross profit from previous period realized currently 40,000 8,000 Deferral of current unrealized gross profit (12,000) Realized income $96,000 Tax rate 40% Income tax expense $38,400 Taxes payable 40,000 Deferred tax asset $ 1,600 7-34 Chapter 07 - Consolidated Financial Statements - Ownership Patterns and Income Taxes 29 (45 Minutes) Develop worksheet entries that were used to consolidate the financial statements of a father-son-grandson combination Entry *G Retained Earnings, 1/1/13 (Delta) 15,000 Cost of Goods Sold (To recognize gross profit that was unrealized in 2012 [amount provided].) 15,000 Entry *C1 Retained Earnings, 1/1/13 (Delta) 7,000 Investment in Omega Company 7,000 (To recognize amortization expense from Delta’s acquisition for 2012.) 29 (continued) Entry *C2 Retained Earnings, 1/1/13 (Alpha) 27,600 Investment in Delta Company 27,600 To recognize accrual adjustments for excess amortization and inventory deferral as follows: Excess amortization from Delta acquisition (80% × $6,250 × years) $10,000 Deltas’ share of excess amortization from Omega acquisition (80% × [70% × $10,000] × year) 5,600 Inventory profit deferral at 1/1/13 (80% × $15,000) 12,000 *C2 adjustment $27,600 7-35 Chapter 07 - Consolidated Financial Statements - Ownership Patterns and Income Taxes Entry S1 Common Stock (Omega) 100,000 Retained Earnings, 1/1/13 (Omega) 100,000 Investment in Omega (70%) 140,000 Noncontrolling Interest in Omega (30%) 60,000 (To eliminate stockholders' equity accounts of Omega against parent's Investment account and to recognize outside ownership.) Entry S2 Common Stock (Delta) 120,000 Retained Earnings, 1/1/13 (Delta, as adjusted) 378,000 Investment in Delta (80%) 398,400 Noncontrolling Interest in Delta (20%) 99,600 (To eliminate stockholders' equity accounts of Delta [as adjusted as Entry *G and Entry *C1] against corresponding balance in Investment account and to recognize outside ownership.) Entry A Copyrights 222,500 Investment in Delta Investment in Omega Noncontrolling Interest in Delta Noncontrolling Interest in Omega (To recognize January 1, 2013 unamortized copyrights, years amortization recorded on first investment but only one year for second.) 7-36 90,000 77,000 22,500 33,000 Chapter 07 - Consolidated Financial Statements - Ownership Patterns and Income Taxes Entry I1 Income of Subsidiary 144,000 Investment in Delta 144,000 (To eliminate intra-entity income accrual found on Alpha's records.) 29 (continued) Entry I2 Income of Subsidiary 49,000 Investment in Omega 49,000 (To eliminate intra-entity income accrual found on Delta's records.) Entry D1 Investment in Delta 32,000 Dividends Paid (Delta) 32,000 (To eliminate intra-entity dividend payments, 80% of Delta's payment.) Entry D2 Investment in Omega 35,000 Dividends Paid (Omega) (To eliminate intra-entity dividend payments, 70% of Omega's payment.) 35,000 Entry E Operating Expenses 16,250 Copyrights 16,250 (Current year amortization, $6,250 on first acquisition and $10,000 on second.) 7-37 Chapter 07 - Consolidated Financial Statements - Ownership Patterns and Income Taxes Entry Tl Sales Cost of Goods Sold (To eliminate intra-entity inventory transfer.) 200,000 200,000 Entry G Cost of Goods Sold 22,000 Inventory 22,000 (To defer ending unrealized gross profit on intra-entity transfers.) Noncontrolling Interest in Omega's Income: Reported income Excess fair value amortization Accrual-based income Outside ownership Noncontrolling interest in Omega’s income $70,000 (10,000) 60,000 30% $18,000 29 (continued) Noncontrolling Interest in Delta's Income: Reported operating income Equity income investment in Omega (70% × $60,000) Amortization expense 2012 Unrealized income realized in 2013 2013 Unrealized income realized in 2013 Accrual-based income—Delta (2013) Outside ownership Noncontrolling interest in Delta's income (2013) Noncontrolling interest in Delta Company Noncontrolling interest, 1/01/13 (Entry S2) Noncontrolling interest, 1/01/13 (Entry A) Noncontrolling interest in Delta’s income (above) Dividends paid to noncontrolling interest ($40,000 × 20%) Noncontrolling interest in Delta, 12/31/13 Noncontrolling interest in Omega Company Noncontrolling interest, 1/01/13 (Entry S1) Noncontrolling interest in Omega’s income (above) Noncontrolling interest, 1/01/13 (Entry A) Dividends paid to noncontrolling interest ($50,000 × 30%) Noncontrolling interest in Omega, 12/31/13 7-38 $131,000 42,000 (6,250) 15,000 (22,000) $159,750 20% $31,950 $99,600 22,500 31,950 (8,000) $146,050 $60,000 18,000 33,000 (15,000) $96,000 Chapter 07 - Consolidated Financial Statements - Ownership Patterns and Income Taxes Chapter Excel Case Solution Summit Treeline Basecamp Operating income $345,000 $280,000 $175,000 Ownership percentages Summit >Treeline Treeline >Basecamp Dividends paid $150,000 $100,000 $40,000 Excess amortizations $20,000 $25,000 90% 70% Treeline's share of Basecamp income: Basecamp operating income Excess amortization $175,000 (25,000) Accrual based income $150,000 Treeline ownership percentage 70% Equity income from Basecamp $105,000 Summit's share of Treeline income: Treeline operating income $280,000 Equity income from Basecamp 105,000 Excess amortization (20,000) Treeline adjusted income $365,000 Summit ownership percentage 90% Summit's share of reported income $328,500 Controlling interest in net income Summit's operating income $345,000 7-39 Chapter 07 - Consolidated Financial Statements - Ownership Patterns and Income Taxes Equity earnings in Treeline and Basecamp Summit’s net income 328,500 $673,500 Comparison Consolidated net income (operating incomes less amortizations) Noncontrolling interest in consolidated net income (30% × $150,000 plus 10% × $365,000) Controlling interest in consolidated net income $755,000 81,500 $673,500 Difference between Summit’s net income and controlling interest in consolidated net income = -0- 7-40 Chapter 07 - Consolidated Financial Statements - Ownership Patterns and Income Taxes RESEARCH CASE: CONSOLIDATED TAX EXPENSE At www.thecoca-colacompany.com the annual 10-K provides financial statements and footnotes to review disclosures for consolidated income tax issues In particular Note 14 provides details of the consolidated tax expense in Coca-Cola’s 2010 annual report The excerpt below shows the portion of the footnote relating to deferred tax assets, liabilities, carryforwards and the partial impact of the CCE acquisition The tax effects of temporary differences and carryforwards that give rise to deferred tax assets and liabilities consist of the following (in millions): December 31, 2010 2009 Property, plant and equipment $ 49 $ 28 Trademarks and other intangible assets 271 72 Equity method investments (including translation adjustment) 304 396 Other liabilities 1,285 404 Benefit plans 2,019 1,106 Net operating/capital loss carryforwards 911 629 Other 6831 241 Deferred tax assets: Gross deferred tax assets 5,522 Valuation allowances Total deferred tax assets2,3 (950) $ 4,572 2,876 (681) $ 2,195 Deferred tax liabilities: Property, plant and equipment $ (2,227) $ (988) Trademarks and other intangible assets (4,284) (1,776) Equity method investments (including translation adjustment) (509) (462) Other liabilities (107) (66) Benefit plans (383) (55) Other (765) (248) Total deferred tax liabilities5 $ (8,275) $ (3,595) Net deferred tax liabilities6 $ (3,703) $ (1,400) Includes $183 million of tax credit carryforwards acquired in conjunction with our acquisition of CCE's North American business 7-41 Chapter 07 - Consolidated Financial Statements - Ownership Patterns and Income Taxes Noncurrent deferred tax assets of $98 million and $96 million were included in the consolidated balance sheets line item other assets as of December 31, 2010 and 2009, respectively Current deferred tax assets of $478 million and $118 million were included in the consolidated balance sheets line item prepaid expenses and other assets as of December 31, 2010 and 2009, respectively The increase is primarily related to deferred tax expense on certain current year undistributed foreign earnings that are not considered to be indefinitely reinvested Current deferred tax liabilities of $18 million and $34 million were included in the consolidated balance sheets line item accounts payable and accrued expenses as of December 31, 2010 and 2009, respectively RESEARCH CASE: CONSOLIDATED TAX EXPENSE (continued) The increase in the net deferred tax liability position in 2010 compared to 2009 was primarily due to the noncurrent deferred tax liabilities related to identifiable intangible assets recognized in connection with our acquisition of CCE's North American business, partially offset by the deferred tax assets acquired in the same transaction Refer to Note As of December 31, 2010 and 2009, we had $445 million and $593 million, respectively, of net deferred tax liabilities located in countries outside the United States As of December 31, 2010, we had $6,685 million of loss carryforwards Approximately $3,580 million of the loss carryforwards were acquired in connection with our acquisition of CCE's North American business and are available to reduce future taxable income in various jurisdictions Loss carryforwards of $408 million must be utilized within the next five years and the remainder can be utilized over a period greater than five years Approximately $183 million of the tax credit carryforwards are available to reduce our federal income tax liability Although the tax credit carryforwards acquired in connection with our acquisition of CCE's North American business are subject to limitations under Internal Revenue Code Section 383, the Company expects to utilize these carryforwards in 2011 7-42 ... 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... 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... 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 7-2 Chapter 07 - Consolidated Financial Statements