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Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions

Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions ACCT 501 (All examples are from the textbook by Larsen) . Objectives of the Chapter. 1. To learn the accounting treatment of income taxes for a purchase-type business combination.

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Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions

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  1. Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions ACCT 501 (All examples are from the textbook by Larsen)

  2. Objectives of the Chapter • 1. To learn the accounting treatment of income taxes for a purchase-type business combination. • 2. To learn the preparation of consolidated statement of cash flows. • 3. To study the accounting for installment acquisitions of a subsidiary in a purchase-type business combination. Income Taxes and Cash Flows

  3. Income Taxes in Business Combinations and Consolidations • The discussion of the accounting for income taxes in business combinations and consolidated financial statements are subdivided in three sections: • a. Income taxes attributable to current fair values excess of purchased identifiable net assets; • b. Income taxes attributable to undistributed earnings of subsidiaries; • c. Income taxes attributable to unrealized and realized intercompany profits (gains). Income Taxes and Cash Flows

  4. Income Taxes Attributable to Current Fair Values of Purchased Identifiable Net Assets • When a purchase-type business combination is qualified as a "tax-free corporate reorganization" under the IRC, a new income tax basis (i.e., based on the current fair value)is Not required for the combinee's net assets. • In this situation, a temporary difference mayresult between provisions for deprecation and amortization in the combinee's financial statements and income tax returns. Income Taxes and Cash Flows

  5. Income Taxes Attributable to Current Fair Values of Purchased Identifiable Net Assets (contd.) • The other situation which can also result in temporary difference is in the pooling-type business combination, in which there is no revaluation of combinee's net assets. • When the pooling-type business combination is not qualified as a "tax free corporation reorganization" under the IRC, the income tax basis of the combinee's net assets may be changed. Income Taxes and Cash Flows

  6. Income Taxes Attributable to Current Fair Values of Purchased Identifiable Net Assets (contd.) • In recognition of this problem, the FASB requires the following: • a deferred tax liability or asset be recognized in accordance with the requirements for differences between the assigned value (i.e., the current value at the business combination) and the tax bases (I.e., the carrying amount) of the assets and liabilities. Income Taxes and Cash Flows

  7. Income Taxes Attributable to Current Fair Values of Purchased Identifiable Net Assets (contd.) • Example: assume that the purchase-type business combination of Regal Corp. and the combinee,Thorne Company, completed on 6/1/1999, met the requirements for a "tax-free corporation reorganization" for income tax purposes. • Regal paid $800,000 for all of Thornes' identifiable net assets except cash. Income Taxes and Cash Flows

  8. Income Taxes Attributable to Current Fair Values of Purchased Identifiable Net Assets (contd.) • The current fair values of Thorne's identifiable net assets were equal to their carrying amounts, except for the following assets: Income Taxes and Cash Flows

  9. Income Taxes Attributable to Current Fair Values of Purchased Identifiable Net Assets (contd.) Income Taxes and Cash Flows

  10. Income Taxes Attributable to Current Fair Values of Purchased Identifiable Net Assets (contd.) • If the carrying amounts (equal to current fair values) of Thorne's other identifiable assets and liabilities were $390,000 and $650,000, respectively, and the income tax rate is 40%, Regal's journal entry to record the business combination with Thorne Company on 6/1/1999, would be as follows: Income Taxes and Cash Flows

  11. Income Taxes Attributable to Current Fair Values of Purchased Identifiable Net Assets (contd.) • Investment in Net Assetsa 800,000 Cash 800,000 • Inventoriesb 100,000 Land 250,000 Building 640,000 Machinery 120,000 Other Identifiable Assets 390,000 Goodwill 34,000 • Deferred Income Tax Lia.84,000c Other Liability 650,000 Investment in Net Assets 800,000 Income Taxes and Cash Flows

  12. Income Taxes Attributable to Current Fair Values of Purchased Identifiable Net Assets (contd.) • Notes for the above journal entries: • a. To record acquisition of net assets of Thorne Company except cash. • b. To allocate cost of Thorne's net assets to identifiable net assets; to establish liability for deferred income tax attributable to differences between current fair values and tax bases of assets; and to allocate remainder of cost to goodwill. • c. Current fair value excess of assets *tax rate = $210,000 *40% = $84,000 Income Taxes and Cash Flows

  13. Income Taxes Attributable to Current Fair Values of Purchased Identifiable Net Assets (contd.) • The deferred income liability ($84,000) will be extinguished when the temporary differences reverse through sale or deprecation. • Example: assume that the inventories were sold during the year ended 5/31/2000, the deferred tax liability would be reduced by $12,400, computed as follows: Income Taxes and Cash Flows

  14. Income Taxes Attributable to Current Fair Values of Purchased Identifiable Net Assets (contd.) Cost of goods sold (inventories current fair value excess $20,000 Building depreciation attributable to current fair value excess (140,000 / 20) 7,000 Machinery depreciation attributable to current fair value excess ($20,000 / 5) 4,000 Total reversing temporary differences $31,000 Income tax effect ($31,000 X 0.40) $12,400 Income Taxes and Cash Flows

  15. Income Taxes Attributable to Current Fair Values of Purchased Identifiable Net Assets (contd.) Assuming Regal Corp. had pre-tax financial income of $420,000 (net of tax-deductible goodwill amortization of $2,267) for the year ended May 31, 2000, and there were no temporary difference between pre-tax financial income and taxable income other than those resulting from the business combination with Thorne Company, Regal's journal entry for income taxes on May 31, 2000, is as follows: Income Taxes and Cash Flows

  16. Income Taxes Attributable to Undistributed Earnings of Subsidiaries • The FASB requires that a deferred income tax liability be recognized for an excess of the reported investment income in a subsidiary over its tax basis(i.e., cash dividends received from the subsidiary) if this excess is temporary and will be reverted in the future.a Income Taxes and Cash Flows

  17. Income Taxes Attributable to Current Fair Values of Purchased Identifiable Net Assets (contd.) Income Taxes Expensec 168,000 Deferred Income Tax Liability 12,400 Income Taxes Payable b 180,400 a. Income tax effect of the temporary difference reversion = > $31,000 X 0.40 = $12,400. b.Taxable income x 40% = >($420,000 + $31,000) X 40% c. $180,400 – $12,400 = $168,000 d. The tax-deductible goodwill amortization expense of $2,267 is included in the measurement of both pre-tax financial income and taxable income. It is based on the 15-year amortization period. • If the excess is permanent in duration, no deferred income tax liability is recognized for the excess. a. Applies to the excess arose in fiscal years beginning after 12/15/1992. Income Taxes and Cash Flows

  18. Income Taxes Attributable to Undistributed Earnings of Subsidiaries (contd.) • Example: • Pinkley Corp. owns 75% of the outstanding common stock of Seabright Company, which it acquired for cash on 4/1/1999. Goodwill acquired by Pinkley in the purchase-type business combination was $30,000 and was to be amortized over 15 years. • Seabright's identifiable net assets were fairly priced at their carrying amounts. Income Taxes and Cash Flows

  19. Income Taxes Attributable to Undistributed Earnings of Subsidiaries (contd.) • For the year ended 3/1/2000, Pinkley had pre-tax financial income, exclusive of goodwill amortization and intercompany investment income under the equity method, of $100,000. • Seabright's pre-tax financial income was $50,000, and dividends declared and paid by Seabright during fiscal year 2000 totaled $10,000. • The income tax rate for both companies is 40%. Income Taxes and Cash Flows

  20. Income Taxes Attributable to Undistributed Earnings of Subsidiaries (contd.) • Income tax laws provide for a dividend-received deduction rate of 80% on dividends from less-than-80%-owned domestic corporations. • Neither Pinkley nor Seabright had an temporary differences. • Neither had any income subject to preference income tax rates. • There were no intercompany profits resulting from transactions between Pinkley and Seabright. Income Taxes and Cash Flows

  21. Income Taxes Attributable to Undistributed Earnings of Subsidiaries (contd.) • Seabright's journal entry to accrue income taxes on 3/31/2000 is as follows: Income Taxes Expense 20,000 Income Taxes Payable 20,000 To record income taxes expense for Fiscal Year 2000 => $50,000 X 40%. •On 3/31, 2000, Pinkley Corp. prepares the following journal entries for income taxes payable, the subsidiary's operating results, and deferred income tax liability: Income Taxes and Cash Flows

  22. Income Taxes Attributable to Undistributed Earnings of Subsidiaries (contd.) Amortization Expense 2,000 Investment in Seabright Cop. 2,000 To record amortization of goodwill for Fiscal Year 2000 ($30,000 / 15 = $2,000) Income Taxes Expense 39,200 Income Taxes Payable 39,200 To record income taxes expense for Fiscal Year 2000 on income exclusive of intercompary investment income = > ($100,000 - $2,000) X 40% = $39,200. Income Taxes and Cash Flows

  23. Income Taxes Attributable to Undistributed Earnings of Subsidiaries (contd.) Cash 7,500 Investment in Seabright 7,500 To record div. declared and paid by sub.$10,000 X 0.75 = $7,500 Investment in Seabright 22,500 Intercompany Investment Income 22,500 To accrue share of subsidiary’s net income for Fiscal Year 2000 ($30,000* X 0.75 = $22,500) *$50,000 - $20,000 = $30,000 Income Taxes and Cash Flows

  24. Income Taxes Attributable to Undistributed Earnings of Subsidiaries (contd.) Income Taxes Expense 1,800 Income Taxes Payable 600 Deferred Income Tax Liability 1,200 • To provide for income taxes on intercompany investment income from subsidiary as follows: Income Taxes and Cash Flows

  25. Income Taxes Attributable to Undistributed Earnings of Subsidiaries (contd.) Net income of subsidiary $ 30,000 Less: Depre. and amor. attributable to differences between current fair values and carrying amounts of subsidiary’s net assets 0 Income of subsidiary subject to income taxes $30,000 Parent company’s share ($30,000 X 0.75) $22,500 Less: Dividend-received deduction ($22,500 X 0.80) $18,000 Amount subject to income taxes $ 4,500 Income taxes expense ($4,500 X 0.40) $ 1,800 Income Taxes and Cash Flows

  26. Income Taxes Attributable to Undistributed Earnings of Subsidiaries (contd.) Taxes currently payable based on dividend received ($7,500 X 0.20 X 0.40 ) $ 600 Taxes deferred until earnings remitted by subsidiary $ 1,200 Income Taxes expense $ 1,800 Income Taxes and Cash Flows

  27. Income Taxes Attributable to Intercompany Profits (Gains) • The IRC permits an affiliated groupa of corporation to file a consolidated income tax return rather than separate returns. • Intercompany profits and losses are eliminated in a consolidated income tax return just as they are in consolidated financial statements. Income Taxes and Cash Flows

  28. Income Taxes Attributable to Intercompany Profits (Gains) (contd.) • Note a: • An "affiliated group" for tax purposes is defined as a group of corporations connected through stock ownership with a common parent corp. which owns directly at least 80% of the voting power of all subsidiaries and at least 80% of each class of the nonvoting stock of at least one of the other affiliates. Income Taxes and Cash Flows

  29. Income Taxes Attributable to Intercompany Profits (Gains) (contd.) • If a parent company and its subsidiaries do not qualify for the "affiliated group" status, or if they elect to file separate tax returns, the provisions of SFAS No. 109, "Accounting for Income Taxes" for the recognition of deferred tax assets and liabilities will be applied. Income Taxes and Cash Flows

  30. Income Taxes Attributable to Intercompany Profits in Inventory • For unrealized intercompany profits in inventory at the end of the first year for an affiliated group's operation, return to the working paper elimination on page 354 of the textbook for Post Corp. and Sage Company (a 95% partially owned subsidiary of Post) on 12/31/2001, which is as follows: Income Taxes and Cash Flows

  31. Income Taxes Attributable to Intercompany Profits in Inventory (contd.) Intercomany Sales—Sage 120,000 Intercompany CGS—Sage 96,000 CGS—Post 16,000 Inventories—Post 8,000 To eliminate intercompany sales, cost of goods sold (CGS), and unrealized intercomany profit in inventories Income Taxes and Cash Flows

  32. Income Taxes Attributable to Intercompany Profits in Inventory (contd.) If Post and Sage file separate income taxreturns for year 2001, the following additional working paper elimination is required on 12/31/2001: Deferred Income Tax Asset—Sage 3,200 Income Taxes Expense—Sage 3,200 To defer income taxes provided on separate income tax returns of subsidiary applicable to unrealized intercompany profits in parent company’s inventories on Dec. 31, 2001 ($8,000 X 0.40 = $3,200) Income Taxes and Cash Flows

  33. Income Taxes Attributable to Intercompany Profits in Inventory (contd.) • Note: the $3,200 reduction in income tax expense should be considered in the computation for the minority interest in net income of the subsidiary for the year ended 12/31/2001. • For the unrealized intercompany profits in beginning and ending inventories, return to the working paper elimination on p356 of the textbook for the year ended 12/31/2002, which follows: Income Taxes and Cash Flows

  34. Income Taxes Attributable to Intercompany Profits in Inventory (contd.) Retained Earnings—Sagea 7,600 Minority Interest in NA of Sub. 400 Intercompary Sales—Sage 150,000 Intercompany CGS—Sage 120,000 CGS—Post 26,000 Inventories—Post 12,000 a. $8,000X0.95 To eliminate intercompany sales, cost of goods sold, and unrealized intercompany profit in inventories. Income Taxes and Cash Flows

  35. Income Taxes Attributable to Intercompany Profits in Inventory (contd.) If the affiliated group file income separately, the following additional working paper eliminations are required on 12/31/2002: Deferred Income Tax Asset—Sage 4,800 Income Taxes Expense—Sage 4,800 To defer income taxes provided on separate income tax returns of subsidiary applicable to unrealized intercompany profits in parent company’s inventories on Dec. 31, 2002 ($12,000X0.40=$4,800). Income Taxes and Cash Flows

  36. Income Taxes Attributable to Intercompany Profits in Inventory (contd.) Income Taxes Expense—Sage 3,200 Retained Earning—Sage a 3,040 Minority Interest in Net Assetsb&c 160 To provide for income taxes attributable to realized intercompany profits in parent company’s inventories on Dec. 31, 2001. ($8,000X0.40=$3,200) a. $3,200X0.95; or $7,600X0.40. b. $3,200X0.05; or $400X0.40. c. This elimination reflects the income tax effects of the realization by the consolidated group, on a FIFO basis,of the intercompnay profits in the parent company's beginning inventories. Income Taxes and Cash Flows

  37. Income Taxes Attributable to Intercompany Profits in Inventory (contd.) • Note to the working paper elimination of year 2002: The decrease on the subsidiary's I/T expense of $4,800 and the increase on subsidiary's the I/T expense of $3,200 are included in the computation of the minority interest in subsidiary's net income. Income Taxes and Cash Flows

  38. Income Taxes Attributable to Unrealized Intercompany Gain in Land Return to the working paper elimination on p65 of chapter 8 notes for the intercompany gain resulting from an intercompany sale of land by the parent company on 12/31/2001(Post): Intercompany Gain on Sale of Land—Post 50,000 Land—Sage 50,000 To eliminate unrealized intercompany gain on sale of land. Income Taxes and Cash Flows

  39. Income Taxes Attributable to Unrealized Intercompany Gain in Land(contd.) Assuming a 40% income tax, the following working paper elimination is needed if Post and Sage filed separate income tax returns for year the year ended 12/31/2001: Deferred Income Tax Asset—Post 20,000 Income Taxes Expense—Posta 20,000 a. This decrease in the expense has no impact on the minority interest in subsidiary's net income. Income Taxes and Cash Flows

  40. Income Taxes Attributable to Unrealized Intercompany Gain in Land(contd.) The purposes of the working paper elimination on 12/31/01: • To defer income taxes provided on separate income tax returns of parent company applicable to unrealized intercompany gain in subsidiary's land on Dec. 31, 2001 ($50,000X0.04=$20,000). Income Taxes and Cash Flows

  41. Income Taxes Attributable to Unrealized Intercompany Gain in Land(contd.) • The following working paper elimination applies to all subsequent years for this intercompany sale of land as long as Sage does not sell the land to an outsider: Income Taxes and Cash Flows

  42. Income Taxes Attributable to Unrealized Intercompany Gain in Land(contd.) • In years subsequent to year 2001, as long as the subsidiary owns the land, the following tax related working paper elimination is also required at the end of the year: Deferred Income Tax Asset—Post 20,000 Retained Earnings—post 20,000 To defer income taxes attributable to unrealized intercompany gain in subsidiary’s land ($50,000x 40%). • This elimination has no impact on the minority interest in subsidiary's net income. Income Taxes and Cash Flows

  43. Income Taxes Attributable to Unrealized Intercompany Gain in Land(contd.) When Sage sold the land, the following elimination would be prepareda: Income Tax Expense-Postb 20,000 Retained Earnings- Post 20,000 a. This is due to the intercompany gain is realized by Sage on behave of Post b. No impact on the minority interest in subsidiary's net income Income Taxes and Cash Flows

  44. Income Taxes Attributable to Unrealized Intercompany Gain in a Depreciable Plant Assets • Return to the working paper elimination on p76 of chapter 8 note for illustration: 12/31/2001 Intercompany Gain on Sale of Machinery—Sage 23,800 Machinery—Post 23,800 To eliminate unrealized intercompany gain of $23,800 on sale of Post's machinery to Sage on 12/31/3001. • This intercompany gain will be realized through the periodic depreciation of the asset. Income Taxes and Cash Flows

  45. Income Taxes Attributable to Unrealized Intercompany Gain in a Depreciable Plant Assets (contd.) • Assuming separate income tax (I/T) returns and an I/T tax rate of 40%, the following additional working paper elimination is required on 12/31/2001: • Deferred I/T Asset—Sage 9,520 I/T Expense—Sage a 9,520 To defer income taxes provided on separate income tax returns of subsidiary applicable to unrealized intercompany gain in parent company’s machinery on Dec. 31, 2001 (23,800X0.40=$9,520). Income Taxes and Cash Flows

  46. Income Taxes Attributable to Unrealized Intercompany Gain in a Depreciable Plant Assets (contd.) a. The $9,520 increase in the Sage's net income should be included in the computation of minority interest in the subsidiary's net income for year 2001. • For the year ended 12/31/2002, the working paper elimination of the intercompany gain is as follows: Income Taxes and Cash Flows

  47. Income Taxes Attributable to Unrealized Intercompany Gain in a Depreciable Plant Assets (contd.) 12/31/2002 Retained Earning—Sagea 22,610 Minority Interest in Net Assets of Subsidiaryb 1,190 Accu. Depre.—Post 4,760 Machinery—Post 23,800 Depre. Expense—Post 4,760 a. $23,800X0.95 b.$23,800X0.05 To eliminate unrealized intercompary gain in machinery and in related depreciation. Gain element in depreciation company is 23,800X0.20=$4,760 based on five-year economic life. Income Taxes and Cash Flows

  48. Income Taxes Attributable to Unrealized Intercompany Gain in a Depreciable Plant Assets (contd.) • The elimination for income taxes attributable to the intercompany gain for the year ended 12/31/2002 is as follows: I/T Expense—Sagea 1,904 Deferred I/T Asset—Sageb 7,616 Retained Earning—Sagec 9,044 Minority Interest in NA of Sub.d 476 a.$4,760 x 40% b. 9,520-$1,904 c.$9,520X0.95; or $22,610X40% d. $9,520X0.05; or $1,190X40% Income Taxes and Cash Flows

  49. Income Taxes Attributable to Unrealized Intercompany Gain in a Depreciable Plant Assets (contd.) • The purposes of the above working paper elimination are: • To provide income taxes expense on intercompany gain realized through parent company’s depreciation (4,760X0.40=$1,904); • To defer income taxes attributable to the remainder of unrealized gain. Income Taxes and Cash Flows

  50. Income Taxes Attributable to Unrealized Intercompany Gain in a Depreciable Plant Assets (contd.) • Comments to the above working paper elimination: • The decrease in the subsidiary's net income is included in the computation of the minority interest in the subsidiary's net income for year 2002. • Comparable working paper eliminations to the above elimination are necessary on December 31, years 2003, 2004,2005 and 2006. Income Taxes and Cash Flows

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