Chapter 10 SUBSIDIARY PREFERRED STOCK, CONSOLIDATED EARNINGS PER SHARE, AND CONSOLIDATED INCOME TAXATION Answers to Questions Flora’s investment income Arom’s net income Less: Preferred income ($500,000 × 10%) Income to common stockholders Flora’s percentage owned Investment income Flora’s investment account balance (equal to book value): Arom’s stockholders’ equity Less: Preferred equity (no arrearages or call premiums) Common equity Flora’s percentage ownership Investment account balance $ $ 300,000 (50,000) 250,000 60% 150,000 $2,500,000 (500,000) 2,000,000 60% $1,200,000 The payment of two years preferred dividend requirements would not have affected Flora’s investment income Since the preferred stock is cumulative, the preferred dividend requirements are deducted from net income each year regardless of whether preferred dividends are declared The preferred stock of a subsidiary does not appear in a consolidated balance sheet If there is a noncontrolling interest in the preferred stock, it is reported as a noncontrolling interest in the consolidated balance sheet In part a, the investment in preferred is eliminated against the preferred equity and there is no noncontrolling interest in preferred When 50 percent of the stock is held by the parent (part b), the investment in preferred is eliminated against 50 percent of the preferred equity and the other 50 percent is reported as a noncontrolling interest In part c, all of the preferred stock is reported as a noncontrolling interest Assuming that the parent does not hold any of the subsidiary’s preferred stock, the computation of noncontrolling interest share for an 80 percent owned subsidiary is 100 percent of the income allocated to preferred plus 20 percent of the income allocated to common There is no difference between the controlling share of consolidated and parent company EPS An investor company’s EPS computations must reflect the potential dilution of an equity investee’s common stock equivalents and other potentially dilutive securities if the effect is material Procedures applied in computing a parent company’s EPS computations are the same as those for a corporation without equity investments except when the subsidiary has outstanding common stock equivalents or other potentially dilutive securities Subsidiary EPS computations are only needed when computing diluted EPS, never for basic EPS, and then it is only needed when the subsidiary has potentially dilutive securities convertible into subsidiary common stock If a subsidiary has dilutive securities convertible into subsidiary common stock, the parent’s diluted earnings are adjusted by replacing the parent’s equity in subsidiary realized income with its equity in subsidiary diluted EPS Alternatively, when subsidiary securities are convertible into the parent’s common stock, the parent’s diluted earnings and common shares are adjusted as if the dilutive securities had been issued by the parent company © 2009 Pearson Education, Inc publishing as Prentice Hall 10-1 10-2 Subsidiary Preferred Stock, Consolidated Earnings per Share, and Consolidated Income Taxation 10 The replacement computation does not involve unrealized profits from downstream sales because these items relate solely to parent company operations and not affect the noncontrolling interest In the case of unrealized profits from upstream sales, however, unrealized profits are deducted in the replacement computation which involves subtracting the parent’s equity in subsidiary realized income and adding back the parent’s equity in subsidiary primary or fully diluted EPS (also based on subsidiary realized income) 11 Consolidated tax returns are not required for a consolidated entity, but a consolidated entity that qualifies as an “affiliated group” may elect to file consolidated tax returns Once consolidated returns are elected, it may be difficult to obtain IRS permission to file separate returns 12 Yes Consolidated entities that meet the requirements of an affiliated group can and often elect to file separate income tax returns 13 The primary advantages of filing consolidated tax returns are (1) losses of affiliates are offset against gains of other members of the affiliated group, (2) intercompany profits between group members are eliminated from taxable income until realized, and (3) intercorporate dividends are fully excluded from taxable income (But note that is not a unique advantage of filing a consolidated return.) 14 Dividends received by a member of an affiliated group from other group members are excluded from federal income taxation regardless of whether the affiliated group elects to file consolidated tax returns 15 Temporary differences result because investors that are not members of an affiliated group record income from equity investments as it is earned, but pay taxes only when dividends are actually received 16 In providing for income taxes on undistributed earnings of equity investees, the parent company/investor debits income tax expense and credits deferred income taxes as part of the determination of all income taxes for the period The investment and investment income accounts are not affected 17 Unrealized and constructive gains and losses give rise to temporary differences unless the consolidated entity is a member of an affiliated group and elects to file consolidated tax returns SOLUTIONS TO EXERCISES Solution E10-1 [AICPA adapted] a Moss income to preferred $ 2,000 $10,000 × 20% owned Moss income to common 40,000 $50,000 × 80% owned Income from Moss $ 42,000 b $180,000 × 20% taxable × 30% tax rate d All dividend income is excluded from a consolidated group d Intercompany profit is deferred in the consolidated tax return until realized through sale to an outside entity © 2009 Pearson Education, Inc publishing as Prentice Hall Chapter 10 10-3 Solution E10-2 [Preferred stock] Cost/fair value differential Total stockholders’ equity January 1, 2010 Less: Preferred equity (10,000 shares × $115) Common equity $8,000,000 1,150,000 $6,850,000 Cost $8,100,000 Implied total fair ($8,100,000 / 90%) Book value of investment Excess fair over book value – Goodwill $9,000,000 6,850,000 $2,150,000 Income from Star for 2010 Star’s net income Less: Preferred dividends for 2010 Income to common Income from Star ($1,100,000 × 90%) $1,200,000 100,000 $1,100,000 $ 990,000 Investment in Star at December 31, 2010 Investment cost January 1, 2010 Add: Income from Star Less: Dividends ($600,000 - $200,000 preferred) × 90% Investment in Star $8,100,000 990,000 (360,000) $8,730,000 Noncontrolling interest for 2010 Beginning stockholders’ equity Add: Net income Less: Dividends Stockholders’ equity December 31, 2010 $8,000,000 1,200,000 (600,000) $8,600,000 Preferred equity ($105 × 10,000) Common noncontroling interest ($8,600,000 + $2,150,000 (Goodwill)-$1,050,000) × 10% Noncontrolling interest December 31, 2010 Solution E10-3 $1,050,000 970,000 $2,020,000 [Preferred stock] Fair value — book value differential Cost of 80% interest $1,536,000 Implied total fair value ($1,536,000 / 80%) Less: Book value ($2,500,000 total equity $630,000 preferred equity) Excess fair value over book value - Goodwill $1,920,000 (1,870,000) $ 50,000 Loss from Sommerfeld — 2009 Sommerfeld’s net loss Add: Income to preferred stockholders Loss to common stockholders Percent owned Loss on investment in Sommerfeld $ $ © 2009 Pearson Education, Inc publishing as Prentice Hall 100,000 72,000 172,000 80% 137,600 10-4 Subsidiary Preferred Stock, Consolidated Earnings per Share, and Consolidated Income Taxation Solution E10-3 (continued) Income from Sommerfeld — 2010 Net income Less: Income to preferred stockholders Income to common stockholders Percent owned Income from investment in Sommerfeld Total stockholders’ equity at December 31, 2010 ($2,500,000 - $100,000 loss in 2009 + $500,000 income in 2010 - $344,000 dividends in 2010) Less: Preferred equity Common equity Percent owned Underlying equity Add: 80% of Unamortized excess Investment in Sommerfeld at December 31, 2010 $2,556,000 (630,000) 1,926,000 80% 1,540,800 40,000 $1,580,800 Check: Cost of investment Loss — 2009 Income — 2010 Dividends 2010 ($344,000 - $144,000) × 80% Investment in Sommerfeld at December 31, 2010 $1,536,000 (137,600) 342,400 (160,000) $1,580,800 [Preferred stock] Investment cost (fair value equals book value) Total stockholders’ equity of Sandalwood Less: Preferred equity 10,000 shares × ($100 + $5 + $12) Common equity Percent owned Investment cost (fair value and book value) $ 500,000 (72,000) 428,000 80% 342,400 Parnell’s investment in Sommerfeld account Solution E10-4 $ $4,000,000 1,170,000 2,830,000 80% $2,264,000 Consolidated net income and noncontrolling interest share Penzance separate income Add: Income from Sandalwood ($500,000 - $120,000) × 80% Consolidated net income $3,000,000 304,000 $3,304,000 Noncontrolling interest share ($380,000 common income × 20%) + $120,000 preferred income $ 196,000 Underlying book value Total stockholders’ equity Less: Preferred equity (10,000 shares × $105 call price) Common equity Percent owned Underlying book value December 31, 2010 $4,200,000 1,050,000 3,150,000 80% $2,520,000 © 2009 Pearson Education, Inc publishing as Prentice Hall Chapter 10 10-5 © 2009 Pearson Education, Inc publishing as Prentice Hall 10-6 Subsidiary Preferred Stock, Consolidated Earnings per Share, and Consolidated Income Taxation Solution E10-5 Preliminary computations Total equity of Shoshone at December 31, 2009 Less: Preferred equity (10,000 shares × $115) Common equity December 31, 2009 $3,500,000 (1,150,000) $2,350,000 Entries to record preferred stock investment 600,000 Investment in Shoshone — preferred Cash 600,000 To record purchase of 50% of Shoshone’s preferred stock Additional paid-in capital 25,000 25,000 Investment in Shoshone — preferred To adjust investment in preferred account to underlying equity: $600,000 cost - ($1,150,000 underlying equity × 50%) = $25,000 Excess of fair value over book value from common stock investment Cost of 80% investment in common stock $2,000,000 Implied total fair value ($2,000,000 / 80%) Book value Excess fair value over book value $2,500,000 (2,350,000) $ 150,000 Pimlico’s income from Shoshone preferred — 2010 $1,000,000 par × 15% × 50% owned $ 75,000 $ 200,000 (12,000) 188,000 Pimlico’s income from Shoshone common — 2010 Equity in Shoshone’s common income ($400,000 income $150,000 preferred dividends) × 80% owned Amortization of excess ($150,000/10 years) × 80% owned Income from Shoshone common $ Noncontrolling interest at December 31, 2010 Total equity at December 31 ($3,500,000 + $400,000 income - $300,000 dividends) Less: Preferred equity Common equity Plus 20% of unamortized differential (20% × $135,000) Common equity plus excess fair value $3,600,000 (1,000,000) $2,600,000 27,000 $2,627,000 Noncontrol Int — preferred ($1,000,000 × 50%) $500,000 Noncontrol interest — common ($2,627,000 × 20%) 525,400 Total noncontrolling interest December 31 $1,025,400 © 2009 Pearson Education, Inc publishing as Prentice Hall Chapter 10 10-7 Solution E10-6 [Preferred stock] Fair value — book value differentials Cost of preferred stock Book value of preferred 60,000 shares × ($100 par + $5 call premium + $10 dividend arrearage) Excess book value of preferred stock over cost $ 6,500,000 Cost of common stock $35,000,000 Implied total fair value ($35,000,000 / 70%) Book value of common ($60,000,000 total equity $11,500,000 preferred equity) Excess fair value over book value of common $50,000,000 (6,900,000) (400,000) $ 48,500,000 $ 1,500,000 The $400,000 negative differential should be treated as an increase in the preferred investment and other paid-in capital accounts on Perry’s books Perry will record its investment in Sketch preferred as follows: Investment in Sketch preferred 6,500,000 Cash To record purchase of 60% of Sketch’s preferred stock 6,500,000 Investment in Sketch preferred 400,000 Other paid-in capital 400,000 To adjust other paid-in capital for the constructive retirement of 60% of Sketch’s preferred shares Solution E10-7 [EPS] d c d Solution E10-8 [EPS] a Solaid’s diluted earnings for consolidated EPS purposes Polar’s equity in Solaid’s income $176,000/.8 $ c Solaid’s outstanding shares Add: Incremental shares 10,000 shares - ($100,000 assumed proceeds/$20 average market price) Solaid’s common shares and common share equivalents 220,000 50,000 shares 5,000 shares 55,000 shares b Polar’s net income Less: Equity in Solaid’s income Add: Equity in Solaid’s diluted earnings (40,000 shares × Solaid’s $4 diluted EPS) Polar’s diluted earnings $ $ 316,000 (176,000) d © 2009 Pearson Education, Inc publishing as Prentice Hall 160,000 300,000 10-8 Subsidiary Preferred Stock, Consolidated Earnings per Share, and Consolidated Income Taxation Polar’s diluted earnings $300,000/300,000 Polar outstanding common shares = $1 © 2009 Pearson Education, Inc publishing as Prentice Hall Chapter 10 10-9 Solution E10-9 [EPS] Sheridan’s basic and diluted EPS Basic Income to common (equal to Sheridan’s net income) = a $18,000 Common shares and common share equivalents: Outstanding shares Additional shares using treasury stock method: 1,000 - (1,000 × $9)/$15 Common shares and common share equivalents = b Sheridan’s EPS = a/b Diluted $18,000 5,000 5,000 5,000 $ 3.60 400 5,400 $ 3.33 $20,000 $20,000 Putman’s basic and diluted EPS Income to common (equal to Putman’s net income) Replacement of Putman’s equity in Sheridan’s realized income with Putman’s equity in Sheridan’s diluted earnings: Equity in Sheridan’s income to common ($18,000 × 80%) Equity in Sheridan’s diluted earnings (4,000 shares × $3.33) Putman’s basic and diluted earnings = a $20,000 Outstanding common shares = b 8,000 Putman’s EPS = a/b $ 2.50 Solution E10-10 (14,400) 13,320 $18,920 8,000 $ 2.37 [EPS] Basic a b Stanley’s earnings per share Net income Stanley’s common shares outstanding Incremental shares from warrants Diluted: 5,000 — ($120,000 assumed proceeds/$30 average price) Common shares and equivalents Earnings per share Prince’s basic and diluted EPS Prince’s income to common ($80,467 - $12,000 to preferred) Replacement computation: Equity in Stanley’s income Equity in Stanley’s EPS 16,000 shares × $1.26 $26,400 20,000 Diluted $26,400 20,000 1,000 20,000 1.32 21,000 1.26 $ $ $68,467 $68,467 (21,120) 20,160 a b Earnings Prince’s common shares outstanding $68,467 10,000 $67,507 10,000 a/b Earnings per share $ $ 6.85 © 2009 Pearson Education, Inc publishing as Prentice Hall 6.75 10-10 Subsidiary Preferred Stock, Consolidated Earnings per Share, and Consolidated Income Taxation Solution E10-11 [EPS] Diluted a Scony’s earnings per share Scony’s earnings: Income to Scony common (equals net income) Scony’s outstanding shares Incremental shares from warrants Diluted: 10,000 — ($240,000 assumed proceeds/$40 average price) b Common and equivalent shares a/b Scony’s earnings per share a Consolidated earnings per share Poway’s income to common (equals net income) Replacement: 80% of Scony’s income Equity in diluted earnings 40,000 shares × $11.67 diluted EPS Poway’s earnings b Poway’s outstanding shares a/b Consolidated earnings per share Solution E10-12 [Tax] c b Solution E10-13 c $630,000 50,000 4,000 54,000 $ 11.67 Basic Diluted $1,480,000 $1,480,000 (504,000) $1,480,000 466,800 $1,442,800 1,000,000 1,000,000 $ 1.48 $ 1.44 b [Tax] c Assigned value of equipment Related deferred tax liability ($6,000,000 - $4,000,000 tax basis) × 34% tax rate $6,000,000 $ 680,000 c Income tax expense = $500,000 investment income × 20% taxable × 34% tax rate c Income taxes currently payable: $30,000 dividends × 20% taxable × 34% tax rate = $2,040 Income tax expense: $60,000 income from Springer × 20% taxable × 34% tax rate = $4,080 Deferred tax liability: $30,000 undistributed earnings × 20% taxable × 34% tax rate = $2,040 © 2009 Pearson Education, Inc publishing as Prentice Hall Chapter 10 10-21 Solution P10-4 (continued) Pari Corporation and Subsidiary Consolidation Working Papers for the year ended December 31, 2009 Pari Income Statement Sales Gain on land Interest income Gain on bonds Income from Sak Cost of sales $ 900,000 10,000 6,500 $ 50,000 600,000* Operating expenses Interest expense Consolidated net income Noncontrolling share Preferred 300,000 140,000* 208,500* Noncontrol Share — common Controlling share of NI Adjustments and Eliminations Sak 80% a e 6,500 f c 50,000 16,000 90,000* 10,000* i i $ 158,000 $ 132,000 60,000 $ 60,000 $ 50,000 Consolidated Statements d 10,000 $1,140,000 20,000 e 9,000 9,000 a b 60,000 12,000 e 5,000 684,000* 298,500* 5,000* 181,500 10,000 13,500 10,000* 13,500* $ 158,000 $ 132,000 Retained Earnings — earnings — Retained earnings Pari Retained Sak Controlling share of NI Dividends Retained earnings December 31 — Investment — 190,000 $ 90,000 $ $ 15,000 20,000 60,000 5,000 30,000 420,000 Sak bonds 5,500 26,000 80,000 100,000 160,000 268,000 92,500 Sak stock 282,000 $1,014,000 $ 550,000 $ $ 15,000 100,000 45,000 200,000 100,000 90,000ü 24,000 100,000 700,000 190,000ü $1,014,000 — interest — Noncontrolling interest 158,000 f i b d h Goodwill Accounts payable 10% bonds payable Other liabilities Capital stock 10% preferred stock Retained earnings 50,000 60,000ü 20,000* $ Balance Sheet Cash Accounts receivable Inventories Other current assets Land Plant and equipment Investment 158,000ü 100,000* h $ 12,000 8,000 75,000 8,000 12,000 j c 5,000 16,000 e 92,500 100,000* $ 190,000 $ 20,500 41,000 124,000 105,000 190,000 688,000 f 42,000 h 260,000 75,000 $1,243,500 j 5,000 e 100,000 $ 34,000 145,000 700,000 h 200,000 g 100,000 190,000 550,000 common (beginning) Noncontrolling preferred (beginning) Noncontrolling interest December 31 d 2,000 h 65,000 g 100,000 i 11,500 174,500 © 2009 Pearson Education, Inc publishing as Prentice Hall 10-22 Subsidiary Preferred Stock, Consolidated Earnings per Share, and Consolidated Income Taxation $1,243,500 © 2009 Pearson Education, Inc publishing as Prentice Hall Chapter 10 10-23 Solution P10-5 [EPS] Requirement Requirement Diluted Diluted Skinner’s EPS Skinner’s net income (equal to income to common stockholders) Add: Net-of-tax interest on convertible bonds Skinner’s earnings = a $ 60,000 6,000 $ 66,000 $ 60,000 NA $ 60,000 Skinner’s outstanding common shares Add: Shares from assumed conversion of bonds Common shares and common share equivalents = b Skinner’s EPS = a/b 50,000 10,000 60,000 $ 1.10 50,000 NA 50,000 $ 1.20 Palace’s EPS Palace’s net income (equal to income to common stockholders) $150,000 Add: Net-of-tax interest on convertible bonds of Skinner Replacement of Palace’s equity in Skinner’s income with Palace’s equity in Skinner’s diluted (42,000) 38,500 EPS (35,000 shares × $1.10) and convertible to Palace securities (35,000 shares × $1.20) Palace’s earnings = a $146,500 Palace’s outstanding common shares Add: Shares from assumed conversion of bonds Common shares and common share equivalents = b Palace’s EPS = a/b a 100,000 100,000 1.47 $ $150,000 6,000 (42,000)a 42,000a $156,000 100,000 10,000 110,000 $ 1.42 When subsidiary securities are convertible into parent company common stock, the replacement calculation is not needed The replacement is included in this solution only to show that it has no effect on the calculation © 2009 Pearson Education, Inc publishing as Prentice Hall 10-24 Subsidiary Preferred Stock, Consolidated Earnings per Share, and Consolidated Income Taxation Solution P10-6 [EPS] Basic a b a b a Sheridan’s earnings per share Income to common Income to preferred assumed converted Earnings Common shares and common share equivalents: Common shares outstanding Add: Common shares issuable on preferred Add: Incremental shares issuable on options 2,000 - [($2,000 × $15)/$30] Common and common equivalent shares EPS a/b Pensacola’s earnings per share Income to common Replacement calculation Equity in Sheridan’s income to common ($45,000 × 80%) Equity in Sheridan’s EPS 8,000 × $4.50 basic EPS 8,000 × $3.93 diluted EPS Earnings Common shares EPS a/b $ 45,000 $ 45,000 Diluted $ 45,000 10,000 $ 55,000 10,000 10,000 3,000 1,000 10,000 14,000 $ 4.50 $ 3.93 $150,000 (36,000)a $150,000 (36,000) 36,000a 31,440 $150,000 $145,440 20,000 20,000 $ 7.50 $ 7.27 A replacement calculation is never needed when calculating basic earnings per share It is only included here to illustrate the point that the replacement will have no impact on the earnings per share calculation © 2009 Pearson Education, Inc publishing as Prentice Hall Chapter 10 10-25 Solution P10-7 [EPS] a b Basic Starch’s earnings per share Income to common $50,000 - $14,000 $36,000 Add: Income to preferred assumed converted Earnings $36,000 Common shares outstanding 6,000 Common shares from conversion of preferred Common and common equivalent shares a b $ Consolidated earnings per share Net income to Protein Replacement calculation for diluted EPS $36,000 × 80% share of realized income $5.00 diluted EPS × 4,800 shares Earnings Outstanding common shares EPS a/b Net income of Protein Add: Income to preferred Earnings Common stock of Protein Common shares from conversion of preferred Common and common share equivalents EPS a/b Solution P10-8 $ 36,000 14,000 $ 50,000 6,000 4,000 6,000 EPS a/b a b Diluted 10,000 6.00 $ 5.00 $93,800 $ 93,800 $93,800 20,000 $ 4.69 (28,800) 24,000 $ 89,000 20,000 $ 4.45 $93,800 $93,800 20,000 $ 93,800 14,000 $107,800 20,000 20,000 $ 4.69 5,000 25,000 $ 4.312 [EPS] Premble’s net income Replacement calculation: Premble’s equity in Smithfield’s realized income ($500,000 - $60,000) × 80% Premble’s equity in Smithfield’s diluted EPS (40,000 shares × $7.44) Consolidated diluted earnings = a Premble’s outstanding common shares = b Consolidated diluted EPS = a/b $1,262,000 $352,000 297,600 54,400 $1,207,600 100,000 $ 12.08 © 2009 Pearson Education, Inc publishing as Prentice Hall 10-26 Subsidiary Preferred Stock, Consolidated Earnings per Share, and Consolidated Income Taxation Solution P10-9 [EPS] Basic a b a b Sim’s earnings per share Income to common Less: Unrealized profit — upstream sale Add: Income to preferred Earnings Common shares outstanding Add: Shares from conversion of preferred Add: Incremental shares from warrants 10,000 - ($150,000/$20) Common and common equivalent shares EPS a/b $200,000 (20,000) $180,000 50,000 50,000 $ 3.60 Consolidated (and Pike’s) earnings per share Pike’s income to common $450,000 Replacement calculation Equity in Sim’s realized income ($200,000 - $20,000) × 80% Equity in Sim’s diluted EPS 40,000 × $3.39 Earnings $450,000 Outstanding common shares 100,000 EPS a/b $ 4.50 Diluted $200,000 (20,000) 100,000 $280,000 50,000 30,000 2,500 82,500 $ 3.3939 $450,000 (144,000) 135,600 $441,600 100,000 $ 4.42 Solution P10-10 [Tax] Pactor Corporation Income Statement for the current year (a) Assuming Separate Tax Returns Sales $1,200,000 Gain on sale of land 50,000 49,000 Income from Shrama Cost of sales (600,000) Operating expenses (350,000) Income before income taxes 349,000 (85,000) Income tax expenseb Net income $ 264,000 (b) Assuming Consolidated Tax Return $1,200,000 50,000 49,000 (600,000) (350,000) 349,000 (85,000) $ 264,000 Supporting computations a b Income from Shram Equity in Shram’s income ($150,000 - $51,000 income taxes) × 100% Less: Unrealized profit Income from Shram Income tax expense Income tax currently payable: Pactor’s $300,000 taxable income × 34% Consolidated taxable income of $400,000 × 34% × $250,000/$400,000 Deferred income taxes: Deferred tax asset ($50,000 × 34%) Income tax expense $ 99,000 (50,000) $ 49,000 $99,000 (50,000) $49,000 $102,000 $85,000 (17,000) $ 85,000 $85,000 © 2009 Pearson Education, Inc publishing as Prentice Hall Chapter 10 10-27 Note: There is no tax on undistributed income because Pactor and Shram are an affiliated group © 2009 Pearson Education, Inc publishing as Prentice Hall 10-28 Subsidiary Preferred Stock, Consolidated Earnings per Share, and Consolidated Income Taxation Solution P10-11 [Tax] Preliminary computations Investment cost $577,500 Implied total fair value of Silky($577,500 / 70%) Less: Book value of Silky Excess fair value over book value = Goodwill $825,000 800,000 $ 25,000 Income tax expense (separate tax returns required) Panama Tax on operating income ($500,000 × 34%) ($200,000 × 34%) Tax on dividends received ($50,000 × 70%) × 20% taxable × 34% tax rate Income taxes currently payable Deferred tax on undistributed income ($49,000* × 70%) × 20% taxable × 34% tax rate Deferred tax asset on unrealized inventory profit ($50,000 × 34%) Income tax expense * Silky $170,000 $ 68,000 2,380 172,380 68,000 2,332 (17,000) $170,048 $ 51,000 Undistributed income (Silky’s operating income of $200,000 - $51,000 tax $50,000 unrealized profit - $50,000 dividends paid) = $49,000 Income from Silky Equity in Silky’s net income ($200,000 - $51,000 tax) × 70% Unrealized inventory profit ($50,000 × 70%) Income from Silky $104,300 (35,000) $ 69,300 Panama Corporation and Subsidiary Consolidated Income Statement for the year ended December 31, 2009 Sales ($5,000,000 - $120,000) Cost of sales ($2,550,000 + $50,000 - $120,000) Gross profit Operating expenses Income before income taxes and noncontrolling interest Less: Income taxes ($170,048 + $51,000) Total consolidated income Less: Noncontrolling interest share ($149,000 net income - $50,000 unrealized) × 30% $4,880,000 2,480,000 2,400,000 1,750,000 650,000 221,048 428,952 Controlling share of NI $ 399,252 Check: Panama’s separate income ($500,000 - $170,048) Income from Silky $ 329,952 69,300 29,700 © 2009 Pearson Education, Inc publishing as Prentice Hall Chapter 10 10-29 Panama’s and Controlling share of NI $ © 2009 Pearson Education, Inc publishing as Prentice Hall 399,252 10-30 Subsidiary Preferred Stock, Consolidated Earnings per Share, and Consolidated Income Taxation Solution P10-12 [Tax] Pulaski Corporation and Subsidiary Partial Consolidation Working Papers for the year ended December 31, 2009 Pulaski Income Statement Sales $500,000 Dividends received from Stewart 28,000 Cost of sales 250,000 * Operating expenses 78,000 * Income tax expense 58,222 * Noncont Share** Control Share - NI $141,778 70% Stewart $300,000 120,000 * 80,000 * 34,000 * Adjustments and Eliminations Noncont Interest a 90,000 c 28,000 b 10,000 Consolidated Statements $ 710,000 $ 290,000 * 158,000 * 92,222 * 19,800 * 149,978 a 90,000 $19,800 $ 66,000 Note: The offsetting credits to entries b and c are to inventory and dividend accounts, respectively * ** Deduct Noncontrolling interest share = $66,000 × 30% Supporting computations Pulaski Income taxes currently payable Taxes on operating income ($172,000 × 34%) ($100,000 × 34%) Tax on dividends received ($40,000 × 70%) × 20% taxable × 34% tax rate Tax on undistributed income ($26,000 × 70%) × 20% taxable × 34% tax rate Less: Deferred tax on inventory profit $10,000 × 34% tax rate Income tax expense Consolidated net income check Stewart’s net income of $66,000 × 70% Less: Unrealized inventory profit Income from Stewart — equity basis Less: Stewart’s income — cost basis Cost — equity method difference Add: Pulaski’s reported net income Controlling share of NI Stewart $58,480 $ 34,000 1,904 60,384 34,000 1,238 (3,400) $58,222 $ 34,000 $ 46,200 (10,000) 36,200 (28,000) 8,200 141,778 $149,978 © 2009 Pearson Education, Inc publishing as Prentice Hall Chapter 10 10-31 Solution P10-13 [Tax] Preliminary computations Investment cost $900,000 Implied total fair value of Soo($900,000 / 90%) Less: Book value of Soo Excess fair value over book value = Goodwill $1,000,000 900,000 $ 100,000 Sales Gain on land sale Income from Soo Cost of sales Expenses Income tax expense Noncontrolling share Controlling share of NI a Pen $800,000 20,000 36,430 (400,000) (150,000) (85,000) a $221,430 Soo $200,000 Adjustments and Eliminations Consolidated $1,000,000 a 20,000 b 36,430 (75,000) (30,000) (32,300) (475,000) (180,000) (117,300) $ 62,700 $ Pen’s income tax expense is calculated: Sales Cost of Sales Expenses Pretax income Tax rate Income tax expense (6,270) 221,430 800,000 (400,000) (150,000) 250,000 34 85,000 Preliminary computations Income from Soo for 2009 Share of Soo’s net income ($62,700 × 90%) Less: Unrealized profit on intercompany sale of land Income from Soo Investment in Soo account December 31, 2009 Cost of 90% interest in Soo January Add: Income from Soo Less: Dividends from Soo Investment December 31 $ 56,430 (20,000) $ 36,430 $900,000 36,430 (45,000) $891,430 a Gain on sale of land 20,000 Land 20,000 To eliminate unrealized intercompany profit from downstream sale of land b Income from Soo 36,430 Investment in Soo 8,570 Dividends from Soo 45,000 To eliminate investment income and dividends and return the investment in Soo account to its beginning of the period balance c Capital stock — Soo Retained earnings — Soo Goodwill Investment in Soo Noncontrolling interest January 500,000 400,000 100,000 900,000 100,000 © 2009 Pearson Education, Inc publishing as Prentice Hall 10-32 Subsidiary Preferred Stock, Consolidated Earnings per Share, and Consolidated Income Taxation To eliminate reciprocal beginning of the period investment and equity balances, establish beginning noncontrolling interest, and enter goodwill © 2009 Pearson Education, Inc publishing as Prentice Hall Chapter 10 10-33 Solution P10-14 [Tax] Allocation schedule Cost of investment = Fair value (100% purchase) Book value Excess fair value over book value Excess allocated Land Buildings — net Equipment — net Goodwill for the remainder Excess fair value over book value $280,000 170,000 $110,000 $ 40,000 30,000 10,000 30,000 $110,000 (10 year life) (2 year life) Note: In a taxable combination transaction there are no deferred tax liabilities since the tax basis and book basis are the same A current tax deduction will affect the future recognized income from Studio Corporation Allocation schedule Cost (fair value) of investment Book value Excess fair value over book value Excess allocated: Land Buildings — net Equipment — net Deferred tax liability ($80,000 × 35%) Goodwill for the remainder Excess fair value over book value a $280,000 170,000 $110,000 $ 40,000 30,000 10,000 (10 year life) (2 year life) (28,000)a 58,000 $110,000 On a tax-free reorganization a deferred tax liability must be set up for all the tax basis/book basis differentials, other than goodwill Since the transaction is recorded at purchase price on the books but has no change in tax basis from the original books, differences in basis occur and are equal to any fair value write-ups of the assets Parson’s income from Studio for 2009 Taxable Studio’s reported income Less: Depreciation on excess allocated to buildings — net ($30,000/10 years) Less: Depreciation on excess allocated to equipment — net ($10,000/2 years) Add: Income tax reductions due to the prior adjustments Income from Studio a $ 50,000 (3,000) (5,000) 2,800a $ 44,800 Since all three items are currently deductible for tax purposes they will reduce the income taxes Parson will have to pay © 2009 Pearson Education, Inc publishing as Prentice Hall 10-34 Subsidiary Preferred Stock, Consolidated Earnings per Share, and Consolidated Income Taxation Solution P10-14 (continued) Tax free Studio’s reported income Less: Depreciation on excess allocated to buildings — net ($30,000/10 years) Add: Amortization of deferred tax liability allocated to buildings ($3,000 × 35) Less: Depreciation on excess allocated to equipment — net ($10,000/2 years) Add: Amortization of deferred tax liability allocated to equipment ($5,000 × 35) Income from Studio $50,000 (3,000) 1,050 (5,000) 1,750 $44,800 Solution P10-15 Income tax expense Pommer Income taxes currently payable: Taxes on operating income $1,400,000 × 34% $800,000 × 34% Tax on dividends received: $280,000 × 20% taxable × 34% tax rate Income taxes currently payable Tax on undistributed income: $128,000 × 70% × 20% taxable × 34% tax rate Less: Deferred tax on gain on equipment $400,000 × 34% tax rate Income tax expense $476,000 $272,000 19,040 495,040 272,000 6,093 (136,000) $365,133 $272,000 Loss from Sooner Income from Sooner on an equity basis Sooner’s net income of $528,000 × 70% Less: Unrealized gain ($500,000 - $100,000) Income from Sooner — equity basis (loss) Sooner $ $ 369,600 (400,000) (30,400) Pommer Corporation and Subsidiary Consolidated Income Statement for the year ended December 31, 2009 Sales Cost of sales Gross profit Other expenses ($2,100,000 + $1,200,000 - $100,000) Income before income taxes Income tax expense ($365,133 + $272,000) Total consolidated income Less: Noncontrolling interest share ($528,000 × 30%) Controlling share of NI $12,000,000 (7,000,000) 5,000,000 (3,200,000) 1,800,000 (637,133) 1,162,867 (158,400) $ 1,004,467 Check: Pommer’s pretax income of $1,400,000 - $30,400 loss from Sooner $365,133 income taxes = $1,004,467 Controlling share of NI © 2009 Pearson Education, Inc publishing as Prentice Hall Chapter 10 10-35 Solution P10-16 [Tax] Selica’s net income Pretax income Less: Income tax expense: Taxes currently payable ($430,000 × 34%) Less: Deferred tax asset — land ($30,000 × 34%) Selica’s net income 430,000 $ (136,000) 294,000 $ 264,600 $ (27,000) (15,000) 222,600 $146,200 (10,200) Phoenix’s income from Selica Share of Selica’s net income ($294,000 × 90%) Less: Unrealized gain on upstream sale of land ($30,000 × 90%) Less: Unrealized inventory profit Income from Selica on an equity basis $ Phoenix’s net income Sales Income from Selica Less: Cost of sales and expenses Income before income taxes Income tax expense ($209,100 currently payable less $5,100a deferred tax asset) Net income a $3,815,000 222,600 (3,200,000) 837,600 (204,000) 633,600 $ The deferred tax asset is $5,100 deferral for the inventory profit © 2009 Pearson Education, Inc publishing as Prentice Hall ... subsidiary Solution E10-14 [Tax] Separate company tax returns Pruit’s income taxes currently payable: Pretax accounting income $300,000 × 34% tax rate = Solo’s income taxes currently payable: Pretax accounting. .. paid-in capital for the constructive retirement of 60% of Sketch’s preferred shares Solution E10-7 [EPS] d c d Solution E10-8 [EPS] a Solaid’s diluted earnings for consolidated EPS purposes Polar’s... Poway’s earnings b Poway’s outstanding shares a/b Consolidated earnings per share Solution E10-12 [Tax] c b Solution E10-13 c $630,000 50,000 4,000 54,000 $ 11.67 Basic Diluted $1,480,000 $1,480,000