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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 combinationconsolidated 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 expenseeffect 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 combinationseparate 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.

Learning Objectives
Having completed Chapter 7, "Ownership Patterns and Income TaxesConsolidated Financial
Statements," students should be able to fulfill each of the following learning objectives:
1. Differentiate between a father-son-grandson ownership configuration and a connecting
affiliation.
2. Calculate realized income figures for all companies in a business combination when either a
father-son-grandson or connecting affiliation is in existence.
3. Prepare a consolidation worksheet for both a father-son-grandson ownership pattern and a
connecting affiliation.
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. Able100% of income accrues to the consolidated entity (as parent company).


Baker70% (percentage of stock owned by Able).
Carter56% (80% of stock owned by Baker multiplied by the 70% of Baker controlled by
Able).
Dexter33.6% (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 subsidiarys 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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Answers to Problems

1. D

2. B

3. D

4. C

5. C

6. C

7. A Damson's accrual-based income:


Operational income ................................................................. $200,000
Defer unrealized gain ............................................................... (40,000)
Damson's accrual-based income ....................................... $160,000

Crimson's accrual-based income:


Operational income ................................................................. $200,000
Investment Income (90% of Damsons 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
Limbs 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
Leafs business fair value ............................................. $130,000
Book value ............................................................... (100,000)
Trade name ..................................................................... $30,000
Life ................................................................................. 30 years
Annual amortization ...................................................... $1,000

a. Investment in Limb $252,000


Limb's reported income-2009 $40,000
Amortization expense (2,000)
Accrual-based income $38,000
Limbs percentage ownership 70%
Equity accrual-2009 $26,600
Dividends received 2009 (7,000)
Limb's reported income-2010 $60,000
Amortization expense (2,000)
Income from Leaf 6,300
Accrual-based income $64,300
Limbs percentage ownership 70%
Equity accrual-2010 $45,010
Dividends received 2010 (14,000)
Investment in Limb 12-31-10 $302,610

b. Leaf2010 income (revenues minus expenses) $10,000


Amortization (1,000)
Accrual-based income $9,000
Limb's ownership percentage 70%
Equity Income accrual $6,300
Income recognized ($2,000 dividends 70%) (1,400)
Retained earnings increase (Limb), 1/1/11 $4,900

Limb2009 operating income $40,000


Limb2010 operating income 60,000
Amortization (2 years at $2,000 per year) (4,000)
Equity income from ownership of Leaf (above) 6,300
Total income for previous periods 102,300
Tree's ownership percentage 70%
Equity Income accrual 71,610
Income recognized ($10,000 [2009] + $20,000 [2010]
dividends 70% ownership) (21,000)
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)
Consolidated net income for 2011 $232,000

d. Noncontrolling interest in income of Leaf


Revenues less expenses $30,000
Excess amortization (1,000)
Accrual-based income $29,000
Noncontrolling interest percentage 30%
Noncontrolling interest in income of Leaf $8,700

Noncontrolling interest in income of Limb:


Revenues less expenses $65,000
Excess amortization (2,000)
Equity in Leaf income [(30,000-1,000) 70%] 20,300
Realized income of Limb2011 $83,300
Outside ownership 30% $24,990
NCI share of consolidated income $33,690

e. 2010 Realized income of Limb (prior to accounting


for unrealized gains) (see a) $64,300
2009 Transfer-gain recognized in 2010 10,000
2010 Transfer-gain to be recognized in 2011 (16,000)
2010 Realized income Limb $58,300

2011 Realized Income of Limb (prior to accounting


for unrealized gains) (see d.) $83,300
2010 Transfer-gain recognized in 2011 16,000
2011 Transfer-gain to be recognized in 2012 (25,000)
2011 Realized incomeLimb $74,300

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. Limbs 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
Nephews business fair value ....................................... $625,000
Book value ..................................................................... 600,000
Intangible Assets ........................................................... $25,000
Life ................................................................................. 10 years
Amortization expense (annual) ..................................... $2,500

Income reported by Nephew2011 .............................. $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.)

a. Mesa's operating income $250,000


Butte's operating income 98,000
Valley's operating income 140,000
Amortization expenseMesa's investment in Butte (22,500)
Amortization expenseButte's investment in Valley (8,000)
Consolidated net income $457,500

b. Valley's operating income $140,000


Amortization expense (on Butte's investment) (8,000)
Valley's accrual-based income $132,000
Outside ownership 45%
Noncontrolling interest in Valley's income $59,400
Butte's operating income $ 98,000
Amortization expense (on Mesa's investment) (22,500)
Equity accrual from ownership of Valley
($132,000 55%) 72,600
Butte's accrual-based income $148,100
Outside ownership 20%
Noncontrolling interest in Butte's income $29,620
Total noncontrolling interest in income of subsidiaries $89,020

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16. (Continued)

Mesas operating income $250,000


Mesas share of Buttes operating income (80% $98,000) 78,400
Mesas share of Valleys operating income (80% 55% $140,000) 61,600
Mesas share of Buttes excess amortization (80% $22,500) (18,000)
Mesas share of Valleys excess amortization (80% 55% $8,000) (3,520)
Controlling interest in consolidated net income $368,480
Noncontrolling interest in consolidated net income 89,020
Consolidated net income $457,500

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

NONCONTROLLING INTERESTS:
CLEVELAND:
Operational income (sales minus cost of goods sold and
expenses) ................................................................. $60,000
Defer unrealized gain (above) ....................................... (3,000)
Realized incomeCleveland ................................... $57,000
Outside ownership ........................................................ 20%
Noncontrolling interest in Cleveland's income ...... $11,400

WISCONSIN:
Operational income (sales minus cost of goods sold and
expenses) ................................................................. $110,000
Defer unrealized gain (above) ....................................... (12,000)
Investment income (60% of Cleveland's realized income of
$57,000) .................................................................... 34,200
Realized incomeWisconsin .................................. $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 intercompany
transfers of $40,000 and $100,000)
Cost of Goods Sold = $1,015,000 (add the three book values, eliminate
intercompany transfers of $40,000 and $100,000, and defer [add] unrealized
gains of $3,000 and $12,000)

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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.)

a. CONSOLIDATED TOTALS
Sales = $790,000 (add the two book values and eliminate the $110,000
intercompany transfer)
Cost of Goods Sold = $340,000 (add the book values, eliminate intercompany
transfers of $110,000, recognize [subtract] $30,000 deferred gain from 2010,
and defer [add] $40,000 intercompany gain deferred into 2011)
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)


UP:
Income (without dividend income) ............................... $126,000
Tax rate ......................................................................... 30%
Currently payable to government ............................ $37,800

DOWN:
Reported income ........................................................... $100,000
Tax rate ......................................................................... 30%
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.

d. $268,064
Rogers would record income tax expense of $96,000 or 40% of its $240,000
operating income.

Clarke must record its expense based on the revenue recognized during the
period. Thus, the tax expense is based on operating income of $410,000 (the net
unrealized gain is not being recognized in this period) plus equity income
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 expenseequity income (Clarke) ............. $8,064
Income tax expenseoperating income (Clarke)
(above) ...................................................................... 164,000 $172,064
Income tax expenseoperating 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.)

a. Consolidated Return2010

Piranto income 2010 (sales less expenses) ...................................... $300,000


Slinton income 2010 (sales less expenses) ...................................... 100,000
2009 gain realized in 2010 ................................................................... 120,000
2010 deferred gain ............................................................................... (150,000)
Taxable income ............................................................................. $370,000
Tax rate .............................................................................................. 40%
Income tax payablecurrent ........................................................ $148,000

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.

b. Separate Returns2010
On its separate tax return, Piranto will report taxable income of $300,000the
unrealized gains cannot be deferred. The dividends would not be taxable
because Slinton still meets the criteria to be a member of an affiliated group. A
consolidated return is not a requirement for these dividends to be excluded.
Thus, income taxes payable by Piranto would be $120,000 ($300,000 40%).

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 payableLake ............................................ $120,480
Income tax payableBoxwood (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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23. (continued)

Garrison records its expense based on the revenue recognized during the
period. Thus, the expense is computed on an operating income of $250,000 (the
net unrealized gain is not recognized in this period) along with equity income
from Robertson of $84,000 (70% of that company's $120,000 after-tax income).
Garrison will record an income tax expense of $100,000 in connection with the
operating income ($250,000 40%) and $6,720 resulting from its equity income
($84,000 20% 40%). Total expense to be reported amounts to $186,720 for
Garrison and Robertson ($80,000 + $100,000 + $6,720).

d. Garrison will pay $120,000 in connection with its operating income ($300,000
40%) and $2,400 because of the dividends received from Robertson. Garrison
will receive $30,000 in dividends based on its 60% ownership. Of this total, only
$6,000 (20%) is taxable. Thus, at a 40% rate, the tax on the dividends would
amount to $2,400 ($6,000 40%). The total income taxes payable by Garrison is
$122,400 ($120,000 + $2,400).

24. (10 Minutes) (Impact on goodwill of assets with a different tax vs. book value.)

The assets and liabilities of Kew (the subsidiary) will be consolidated at their
individual fair values (netting to $500,000). However, both the buildings and
equipment have a tax basis that is lower than fair value. Thus, for tax purposes,
future depreciation expense will be lower on the tax return so that taxable
income will exceed book income. The higher taxable income (anticipated in the
future) creates a deferred tax liability at the time the combination is created.

Tax Fair Temporary


Basis Value Difference
Buildings ........................................ $140,000 $180,000 $40,000
Equipment ...................................... 150,000 200,000 50,000
Total temporary difference ...... $90,000
Tax rate ..................................... 30%
Deferred tax liability ................. $27,000

Consequently, Kew's accounts will be consolidated as follows: (parentheses


indicate a credit balance)

Accounts receivable ...................................................... $110,000


Inventory ........................................................................ 130,000
Land .............................................................................. 100,000
Buildings ........................................................................ 180,000
Equipment ....................................................................... 200,000

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24. (continued)

Liabilities ......................................................................... (220,000)


Deferred tax liability ...................................................... (27,000)
Assigned to specific accounts ..................................... 473,000
Purchase price ............................................................... 650,000
Excess assigned to goodwill ........................................ $177,000

25. (55 Minutes) (Consolidation worksheet for a father-son-grandson combination.


Includes intercompany inventory transfers.)

The following computations are needed before the consolidation worksheet is


prepared: calculation of the deferred gains in beginning and ending inventory.

Beginning Unrealized Gain (Wilson)


(January 1, 2011 Inventory Transfer Price (goods remaining) =
Balance) Cost + .25 Cost
$60,000 = 1.25 Cost
$48,000 = Cost
$12,000 is Unrealized Gain
Ending Unrealized Gain (Wilson)
(December 31, 2011 Inventory Transfer Price (goods remaining) =
Balance) Cost + .25 Cost
$90,000 = 1.25 Cost
$72,000 = Cost
$18,000 is Unrealized Gain
CONSOLIDATION ENTRIES
Entry *G
Retained Earnings, 1/1/11 (Wilson) ......................... 12,000
Cost of Goods Sold ............................................ 12,000
(To recognize income on intercompany inventory transfers made in previous
year but not resold until current year as per above computation.)

Entry *C
Retained Earnings, 1/1/11 (House) ............................... 11,200
Investment in Wilson Company ......................... 11,200
(To convert investment account from partial equity method to equity method.
Unrealized gain shown in Entry *G is not properly reflected by parent under
partial equity method [12,000 70% = $8,400 income decrease] nor would the
$2,800 in amortization expense for 20092010. Thus, a reduction of $11,200 is
required. Because Cuddy is a current year acquisition, no prior conversion to
equity method is required for the investment.)

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25. (continued)

Entry S1
Common Stock (Cuddy) ................................................ 150,000
Retained Earnings, 1/1/11 (Cuddy) ............................... 150,000
Investment in Cuddy Company (80%) ...................... 240,000
Noncontrolling Interest in Cuddy Common Stock (20%) 60,000
(To eliminate Cuddy's stockholders' equity against the corresponding
investment balance and to recognize noncontrolling interest on common stock.)

Entry S2
Common Stock (Wilson) ............................................... 310,000
Retained Earnings, 1/1/11 (Wilson)
(adjusted by Entry *G) .............................................. 578,000
Investment in Wilson Company (70%) ............... 621,600
Noncontrolling Interest in Wilson (30%) ........... 266,400
(To eliminate Wilson's stockholders' equity against corresponding investment
balance and to recognize noncontrolling interest.)

Entry A
Buildings ......................................................................... 54,000
Franchise Contracts ...................................................... 32,000
Goodwill .......................................................................... 140,000
Equipment ................................................................ 10,000
Investment in Wilson Company .............................. 151,200
Noncontrolling interest in Wilson Company ........... 64,800
(To allocate excess payment made in connection with purchase of Wilson
shown above. Amortization for 2009 and 2010 has been taken into account in
determining the January 1, 2011 value for each account.)

Entry I1
Income of Cuddy Company ..................................... 56,000
Investment in Cuddy Company .......................... 56,000
(To eliminate intercompany income accrued by both House and Wilson
during the year.)

Entry I2
Income of Wilson Company .................................... 91,000
Investment in Wilson Company ......................... 91,000
(To eliminate intercompany income accrued by House during the year.)

Entry D1
Investment in Cuddy Company ............................... 40,000
Dividends Paid (80%) (Cuddy) ............................ 40,000
(To eliminate effects of intercompany dividend payments.)

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25. (continued)

Entry D2
Investment in Wilson Company .............................. 67,200
Dividends Paid (70%) (Wilson) ........................... 67,200
(To eliminate effects of intercompany dividend payments.)

Entry E
Operating Expenses ................................................. 2,000
Equipment ............................................................... 5,000
Franchise Contracts ........................................... 4,000
Buildings .............................................................. 3,000
(To record 2011 amortization on excess payment made in connection with
acquisition of Wilson Company.)

Entry TI
Sales and Other Revenues ...................................... 200,000
Cost of Goods Sold ............................................ 200,000
(To eliminate intercompany inventory sales for the current year.)

Entry G
Cost of Goods Sold .................................................. 18,000
Inventory...............................................................
18,000
(To defer unrealized gain in ending inventory.)

Noncontrolling Interest in Net Income of Cuddy

Reported net income $70,000


Outside ownership 20%
Noncontrolling interest in Cuddy incomecommon $14,000

Noncontrolling Interest in Net Income of Wilson*

Reported operational income $130,000


Equity income of Cuddy ($70,000 40%) 28,000
Excess amortization ..................................................................... (2,000)
Recognition of 2010 gain (Entry *G) 12,000
Deferral of 2011 unrealized gain (Entry G) (18,000)
Realized income $150,000
Outside ownership 30%
Noncontrolling interest in net income of Wilson $45,000

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25. (continued)
HOUSE CORPORATION AND CONSOLIDATED SUBSIDIARIES
Consolidation Worksheet
December 31, 2011

Accounts House Wilson Cuddy Consolidation EntriesNoncontrollingConsolidated


Corp. Company Company Debit Credit Interest Balance
Sales and other revenue (900,000) (700,000) (300,000) (TI) 200,000 (1,700,000)

Cost of goods sold 551,000 300,000 140,000 (G) 18,000 (*G) 12,000 797,000
(TI) 200,000
Operating expenses 219,000 270,000 90,000 (E) 2,000 581,000
Income of Wilson Company (91,000) (I2) 91,000 -0-
Income of Cuddy Company (28,000) (28,000) (I1) 56,000 -0-
Net Income (249,000) (158,000) (70,000)
Consolidated net income (322,000)
Noncontrolling interest in
Wilson net income (45,000) 45,000
Noncontrolling interest in
Cuddy net income (14,000) 14,000
To House Corporation (263,000)
Retained earnings, 1/1/11:
House Corporation (820,000) (*C) 11,200 (808,800)
Wilson Company (590,000) (*G) 12,000 -0-
(S2)578,000
Cuddy Company (150,000) (S1)150,000 -0-
Net Income (249,000) (158,000) (70,000) (263,000)
Dividends paid
House Corporation 100,000 100,000
Wilson Company 96,000 (D2) 67,200 28,800 -0-
Cuddy Company 50,000 (D1) 40,000 10,000 -0-
Retained earnings, 12/31/11 (969,000) (652,000) (170,000) (971,800)

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25. (continued)

Accounts House Wilson Cuddy Consolidation EntriesNoncontrollingConsolidated


Corp. Company Company Debit Credit Interest Balance
Cash and receivables 220,000 334,000 67,000 621,000
Inventory 390,200 320,000 103,000 (G) 18,000 795,200
Investment in Wilson Company 807,800 (D2) 67,200 (*C) 11,200 -0-
(S2) 621,600
(I2) 91,000
(A) 151,200
Investment in Cuddy Company 128,000 128,000 (D1) 40,000 (S1) 240,000 -0-
(I1) 56,000
Buildings 385,000 320,000 144,000 (A) 54,000 (E) 3,000 900,000
Equipment 310,000 130,000 88,000 (E) 5,000 (A) 10,000 523,000
Land 180,000 300,000 16,000 496,000
Goodwill (A) 140,000 140,000
Franchise Contracts (A) 32,000 (E) 4,000 28,000
Total assets 2,421,000 1,532,000 418,000 3,503,200

Liabilities (632,000) (570,000) (98,000) (1,300,000)


Noncontrolling interest in Cuddy (S1) 60,000 (60,000)
Noncontrolling interest in Wilson (S2) 266,400
Noncontrolling interest in (A) 64,800 (331,200)
subsidiary companies 411,400 (411,400)
Common stock (820,000) (310,000) (150,000) (S1) 150,000 (820,000)
(S2) 310,000
Retained earnings (above) (969,000) (652,000) (170,000) (971,800)
Total liabilities and equities (2,421,000) (1,532,000) (418,000) 1,916,400 1,916,400 (3,503,200)

Parentheses indicate a credit balance.

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26. (20 Minutes) (Consolidation entries for a mutual holding business combination)

a. Acquisition Price Allocation and Amortization Mighty's Purchase of Lowly


Consideration transferred ............................................ $420,000
Noncontrolling interest fair value ................................. 280,000
Lowlys business fair value ........................................... 700,000
Book value acquired....................................................... (600,000)
Trademarks ..................................................................... $100,000
Annual amortization (20-year life).................................. $5,000

CONSOLIDATION ENTRIES
Entry *C
Investment in Lowly ................................................. 117,000
Retained Earnings, 1/1/10 (Mighty) .................... 117,000
(To record $180,000 income accruing to parent during the previous years as
measured by increase in book value [$200,000 60%] and amortization
expense of $3,000 [$5,000 60%] for the previous year.)

Entry S1
Common Stock (Lowly) ........................................... 300,000
Retained Earnings, 1/1/10 (Lowly) ........................... 500,000
Investment in Lowly (60%) ................................. 480,000
Noncontrolling Interest in Lowly 1/1/10 (40%) .. 320,000
(To eliminate subsidiary stockholders' equity accounts against investment
account and to recognize noncontrolling interest ownership.)

Entry S2
Treasury Stock ......................................................... 240,000
Investment in Mighty .......................................... 240,000
(To reclassify cost of parent shares as treasury stock.)

Entry A
Trademarks ............................................................... 95,000
Investment in Lowly ............................................ 57,000
Noncontrolling Interest in Lowly 1/1/10 (40%) .. 38,000
(To recognize unamortized portion of acquisition-date excess fair value.)

Entry E
Amortization Expense .............................................. 5,000
Trademarks .......................................................... 5,000
(To record trademarks amortization expense for 2010.)

Noncontrolling interest in subsidiary income = 40% ($40,000 - $5,000) = $14,000

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27. (80 Minutes) (Prepare consolidation worksheet for a father-son-grandson


combination. Also asks about income taxes paid on both a separate and a
consolidated return)

a. Acquisition-Date Allocation and Amortization


The January 1, 2009 book values are determined by removing the 2009 income
from the January 1, 2010 book values (based on equity accounts).

Consideration transferred for Stookey ......................... $344,000


Noncontrolling interest fair value ................................. 86,000
Stookey business fair value .......................................... $430,000
Stookey book value ....................................................... (380,000)
Customer List ................................................................. $50,000
Life .................................................................................. 10 Years
Annual amortization ...................................................... $5,000

Consideration transferred for Yarrow ........................... $720,000


Noncontrolling interest fair value ................................. 80,000
Yarrow business fair value ........................................... $800,000
Yarrow book value.......................................................... 740,000
Copyright ....................................................................... $60,000
Life .................................................................................. 15 Years
Annual amortization ...................................................... $4,000

CONSOLIDATION ENTRIES

Entry *G
Retained Earnings, 1/1/10 (Stookey) ....................... 7,680
Cost of Goods Sold ............................................ 7,680
(To give effect to unrealized gain from 2009. Amount is calculated based on
normal 48% markup [found from Income Statement] multiplied by $16,000
retained inventory [20% of $80,000])

Entry *C1
Investment in Stookey ............................................. 85,856
Retained Earnings, 1/1/10 (Yarrow) ................... 85,856
(To recognize equity income accruing from Yarrow's investment in Stookey
during 2009. Because the initial value method is applied and no dividends
paid, no income has been recognized in connection with the 2009 ownership
of Stookey. Reported income of $120,000 [2009] less unrealized gain of
$7,680 deferred above indicates income of $112,320. Based on 80%
ownership, an $89,856 accrual is needed, which is reduced by the $4,000
amortization (80% $5,000) for that year.

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27. (continued)

Entry *C2
Investment in Yarrow ............................................... 217,670
Retained Earnings, 1/1/10 (Travers) ................... 217,670
(To recognize equity income accruing from Travers' investment in Yarrow
during 2009. Because the initial method is applied and no dividends paid,
income has not been recognized in connection with the 2009 ownership of
Yarrow. Income of $245,856 is calculated based on reported income of
$160,000 [2009] plus the $85,856 accrual recognized in Entry *C1. Ownership
of 90% dictates a $221,270 accrual that is then reduced to $217,670 by the
$3,600 [90% $4,000] amortization applicable to 2009.)

Entry S1
Common Stock (Stookey) ........................................ 200,000
Retained Earnings, 1/1/10 (Stookey, as adjusted
by Entry *G) ......................................................... 292,320
Investment in Stookey (80%) ......................... 393,856
Noncontrolling Interest in Stookey (20%) .... 98,464
(To eliminate stockholders' equity accounts of subsidiary [Stookey] against
corresponding balance in investment account and to recognize
noncontrolling interest ownership.)

Entry S2
Common Stock (Yarrow) ......................................... 300,000
Retained Earnings, 1/1/10 (Yarrow, as adjusted
by Entry *C1) ....................................................... 685,856
Investment in Yarrow (90%) .......................... 887,270
Noncontrolling Interest in Yarrow (10%) ...... 98,586
(To eliminate stockholders equity accounts of subsidiary Yarrow against
corresponding balance in investment account and to recognize
noncontrolling interest ownership.)

Entry A1
Customer List ............................................................ 45,000
Investment in Stookey ........................................ 36,000
Noncontrolling Interest in Stookey (20%) ......... 9,000

(To recognize January 1, 2010 unamortized portion of acquisition price


assigned to Stookeys customer list.)

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27. (continued)

Entry A2
Copyright ................................................................... 56,000
Investment in Yarrow . ......................................... 50,400
Noncontrolling interest in Yarrow ...................... 5,600
(To recognize January 1, 2010 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 2010$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 ............................................ 100,000
(To eliminate intercompany inventory transfers made during 2010.)

Entry G
Cost of Goods Sold .................................................. 9,600
Inventory (current assets) .................................. 9,600
(To defer unrealized gain on ending inventory$20,000 48% markup.)

Noncontrolling Interest in Stookey's Net Income


2010 Reported net income ............................................ $100,000
Customer list amortization ............................................ (5,000)
Realization of 2009 deferred income (*G) .................... 7,680
Deferral of 2010 unrealized gain (G) ............................. (9,600)
Realized income 2010 .................................................... $93,080
Outside ownership ........................................................ 20%
Noncontrolling interest in Stookey's net income ........ $18,616

Noncontrolling Interest in Yarrow's Net Income


2010 Reported net income ............................................ $200,000
Copyright amortization ................................................. (4,000)
Accrual of Stookey's income (80% of $93,080
realized income [computed above]) ........................ 74,464
Realized Income2010 ................................................. $270,464
Outside ownership ........................................................ 10%
Noncontrolling interest in Yarrow's net income ......... $27,046

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27. (continued) TRAVERS COMPANY AND CONSOLIDATED SUBSIDIARIES


Consolidation Worksheet
December 31, 2010
Travers Yarrow Stookey Consolidation EntriesNoncontrollingConsolidated
Accounts Company Company Company Debit Credit Interest Balances
Sales and other revenues (900,000) (600,000) (500,000) (Tl) 100,000 (1,900,000)
Cost of goods sold 480,000 320,000 260,000 (G) 9,600 (*G) 7,680 961,920
(TI) 100,000
Operating expenses 100,000 80,000 140,000 (E) 9,000 329,000
Separate company net income (320,000) (200,000) (100,000)
Consolidated net income (609,080)
NCI in Yarrow's net income (27,046) 27,046
NCI in Stookey's net income (18,616) 18,616
To controlling interest (563,418)
Retained earnings, 1/1/10:
Travers Company (700,000) (*C2) 217,670 (917,670)
Yarrow Company (600,000) (S2) 685,856 (*C1) 85,856 -0-
Stookey Company (300,000) (*G) 7,680 -0-
(S1) 292,320
Net Income (above) (320,000) (200,000) (100,000) (563,418)
Dividends paid 128,000 128,000
Retained earnings, 12/31/10 (892,000) (800,000) (400,000) (1,353,088)

Current assets 444,000 380,000 280,000 (G) 9,600 1,094,400


Investment in Yarrow Company 720,000 (*C2) 217,670 (S2) 887,270 -0-
(A2) 50,400
Investment in Stookey Company 344,000 (*C1) 85,856 (S1) 393,856 -0-
(A1) 36,000
Land, buildings, & equipment (net) 949,000 836,000 520,000 2,305,000
Customer List (A1) 45,000 (E) 5,000 40,000
Copyright (A2) 56,000 (E) 4,000 52,000
Total assets 2,113,000 1,560,000 800,000 3,491,400

Liabilities (721,000) (460,000) (200,000) (1,381,000)


Common stock (500,000) (300,000) (200,000) (S1) 200,000
(S2) 300,000 (500,000)
Retained earnings, 12/31/10 (above) (892,000) (800,000) (400,000) (S1) 98,464 (1,353,088)
NCI interest in Stookey, 1/1/10 (A1) 9,000 (107,464)
(S2) 98,586
Noncontrolling interest in Yarrow, 1/1/10 (A2) 5,600 (104,186)
Noncontrolling interests in subsidiaries (257,312) (257,312)
Total liabilities and equities (2,113,000) (1,560,000) (800,000) 2,008,982 2,008,982 (3,491,400)

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27. (continued)

b. Travers' reported income ................................................................... $320,000


Yarrow's reported income .................................................................. 200,000
Dividend income (none collected) ..................................................... -0-
Intercompany gains (no transfers) .................................................... -0-
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 ............................................................................. $45,000

d. (1) Because 80% of Stookey's stock is owned by Yarrow, intercompany


dividends would be nontaxable. Consequently, 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. A
temporary difference is created. The net effect is an increase in taxable
income by $1,920 over reported income:

2010 Unrealized gain taxed in 2010 .................................................... $9,600


2009 Unrealized gain taxed previously in 2009 ................................. (7,680)
Increase in taxable income ................................................................ $1,920
Tax rate ................................................................................................ 45%
Deterred income tax asset ................................................................. $864

Income Tax Expense:


Travers and Yarrowpayable (part b) ......................................... $229,950
Stookeypayable (part c) ............................................................. 45,000
Total taxes to be paid2010 ......................................................... $274,950
Prepayment (Asset) (above) ......................................................... (864)
Income tax expense 2010............................................................... $274,086

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27. d. (continued)

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 ExpenseCurrent ..................................... 274,086


Deferred Income TaxAsset ........................................ 864
Income Tax Payable ................................................. 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.

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 gains. 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 intercompany sales. The increase of $12,000 created by the
ending unrealized gain (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 gain must have been deferred from the previous year.

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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 gain from the prior year (see part g.) is recognized.

Amortization expenseprior years 80% .................... $2,000


Unrealized gainupstream effect on
parent's retained earnings is $8,000 80% ............. 6,400
Adjustment to parents beginning retained earnings .. $8,400

i. This figure is computed as follows:


Book value of subsidiary1/1 ...................................... $370,000
Unrealized gain in beginning inventory (see above) ... (8,000)
Realized book value .................................................... $362,000
Excess allocation .................................................... 35,000
Total to noncontrolling interest .................................... 397,000
Outside ownership ........................................................ 20% $79,400
Noncontrolling interest in Soludan's income
(as reported) ............................................................. 18,700
Noncontrolling interest in Soludan's dividends
($20,000 20%) ......................................................... (4,000)
Ending noncontrolling interest .................................... $94,100

j. For a consolidated return, unrealized gains are deferred as in the consolidated


statements. At a 40% rate, both the expense and payable would be $117,400.

Income Tax Expense ..................................................... 117,400


Income Tax Payable ................................................. 117,400

Consolidated Taxable Income:


Sales ............................................................................................. $1,280,000
Cost of goods sold ....................................................................... (784,000)
Operating expenses ..................................................................... (202,500)
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, intercompany dividend (or investment) income is omitted.

Income Tax Expense ..................................................... 80,000


Income Tax Payable ................................................. 80,000

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28. k. (continued)

On a separate return, Soludan would report $100,000 operating income for a


payable of $40,000. The unrealized gains are accounted for in different time
periods in the financial statements, thus, a temporary difference is created. The
beginning gain of $8,000 was taxed in the previous year rather than currently.
The current gain 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 ..................................................... 38,400


Deferred Income Tax - Asset ......................................... 1,600
Income Tax Payable ................................................. 40,000

Soludan's entry can also be computed as follows:


Reported Income ........................................................................... $100,000
Unrealized gain from previous period realized currently ........... 8,000
Deferral of current unrealized gain .............................................. (12,000)
Realized Income ............................................................................ $96,000
Tax rate .................................................................................... 40%
Income tax expense ...................................................................... $38,400
Taxes payable ................................................................................. 40,000
Deferred tax asset ............................................................................... $1,600

29. (45 Minutes) Develop worksheet entries that were used to consolidate the
financial statements of a father-son-grandson combination.

Entry *G
Retained Earnings, 1/1/11 (Delta) ............................ 15,000
Cost of Goods Sold ............................................ 15,000
(To recognize gain that was unrealized in 2010 [amount provided].)

Entry *C1
Retained Earnings, 1/1/11 (Delta) ............................ 7,000
Investment in Omega Company ......................... 7,000
(To recognize amortization expense from Deltas acquisition for 2010.)

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29. (continued)

Entry *C2
Retained Earnings, 1/1/11 (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 2 years) ........................................ $10,000
Deltas share of excess amortization from Omega acquisition
(80% [70% $10,000] 1 year) .......................... 5,600
Inventory profit deferral at 1/1/11 (80% $15,000) .. (12,000)
*C2 adjustment .......................................................... $27,600

Entry S1
Common Stock (Omega) .......................................... 100,000
Retained Earnings, 1/1/11 (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, 1/1/11 (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 ............................................. 90,000
Investment in Omega .......................................... 77,000
Noncontrolling interest in Delta .......................... 22,500
Noncontrolling interest in Omega ...................... 33,000
(To recognize January 1, 2011 unamortized copyrights, 2 years amortization
recorded on first investment but only one year for second.)

Entry I1
Income of Subsidiary ............................................... 144,000
Investment in Delta ............................................. 144,000
(To eliminate intercompany income accrual found on Alpha's records.)

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29. (continued)

Entry I2
Income of Subsidiary ............................................... 49,000
Investment in Omega .......................................... 49,000
(To eliminate intercompany income accrual found on Delta's records.)

Entry D1
Investment in Delta .................................................. 32,000
Dividends Paid (Delta) ........................................ 32,000
(To eliminate intercompany dividend payments, 80% of Delta's payment.)

Entry D2
Investment in Omega ............................................... 35,000
Dividends Paid (Omega) ..................................... 35,000
(To eliminate intercompany dividend payments, 70% of Omega's payment.)

Entry E
Operating Expenses ................................................. 16,250
Copyrights ........................................................... 16,250
(Current year amortization, $6,250 on first acquisition and $10,000 on
second.)

Entry Tl
Sales ......................................................................... 200,000
Cost of Goods Sold ............................................ 200,000
(To eliminate intercompany inventory transfer.)

Entry G
Cost of Goods Sold .................................................. 22,000
Inventory............................................................... 22,000
(To defer ending unrealized gain on intercompany transfers.)

Noncontrolling Interest in Omega's Income:


Reported income ........................................................... $70,000
Excess fair value amortization ...................................... (10,000)
Accrual-based income.................................................... 60,000
Outside ownership ........................................................ 30%
Noncontrolling interest in Omegas income ................ $18,000

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29. (continued)

Noncontrolling Interest in Delta's Income:


Reported operating income .......................................... $131,000
Equity income investment in Omega (70% $60,000) 42,000
Amortization expense .................................................... (6,250)
2010 Unrealized income realized in 2011 ...................... 15,000
2011 Unrealized income realized in 2011 ..................... (22,000)
Accrual-based incomeDelta (2011) ........................... $159,750
Outside ownership ........................................................ 20%
Noncontrolling interest in Delta's income (2011) ........ $31,950

Noncontrolling interest in Delta Company ...................


Noncontrolling interest, 1/01/11 (Entry S2).............. $99,600
Noncontrolling interest, 1/01/11 (Entry A) ............... 22,500
Noncontrolling interest in Deltas income (above) . 31,950
Dividends paid to noncontrolling interest
($40,000 20%) ....................................................... (8,000)
Noncontrolling interest in Delta, 12/31/11 .......... $146,050

Noncontrolling interest in Omega Company ................


Noncontrolling interest, 1/01/11 (Entry S1).............. $60,000
Noncontrolling interest in Omegas income (above) 18,000
Noncontrolling interest, 1/01/11 (Entry A) ............... 33,000
Dividends paid to noncontrolling interest ($50,000 30%) (15,000)
Noncontrolling interest in Omega, 12/31/11 ....... $96,000

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Chapter 7 Excel Case Solution

Operating Dividends Excess


income paid amortizations
Summit $345,000 $150,000
Treeline $280,000 $100,000 $20,000
Basecamp $175,000 $40,000 $25,000

Ownership percentages
Summit-->Treeline 90%
Treeline-->Basecamp 70%

Treeline's share of Basecamp income:


Basecamp operating income $175,000
Excess amortization (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
Equity earnings in Treeline and Basecamp 328,500
Summits net income $673,500

Comparison
Consolidated net income (operating incomes less
amortizations) $755,000
Noncontrolling interest in consolidated net income
(30% $150,000 plus 10% $365,000) $81,500
Controlling interest in consolidated net income $673,500

Difference between Summits net income and controlling interest in


consolidated net income = -0-

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RESEARCH CASE: CONSOLIDATED TAX EXPENSE

At www.thecoca-colacompany.com the annual financial statements and 10-K


provide an excellent set of statements and footnotes to review disclosures for
consolidated income tax issues.

In particular Note 17 provides details of the consolidated tax expense in Coca-


Colas 2006 annual report. The excerpt below shows the portion of the
footnote relating to components of deferred tax assets and liabilities and
carryforwards.

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