Christensen 12e Chap10 SM PDF

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Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent10-CHAPTER 10ADDITIONAL CONSOLIDATION REPORTING ISSUESANSWERS TO QUESTIONSQ10-1 The balance sheet, income statement, and statement of changes in retained earnings are an inte...

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Chapter 10 - Additional Consolidation Reporting Issues

CHAPTER 10 ADDITIONAL CONSOLIDATION REPORTING ISSUES ANSWERS TO QUESTIONS Q10-1 The balance sheet, income statement, and statement of changes in retained earnings are an integrated set and generally need to be completed as a unit. Once completed, these statements can then be used in preparing a consolidated cash flow statement. Because both the beginning and ending consolidated balance sheet totals (with all consolidation entries posted) are needed in determining cash flows for the period, the cash flow statement cannot be easily incorporated into the existing three-part worksheet format. Q10-2 Consolidated retained earnings do not include the earnings assigned to noncontrolling shareholders. As a result, dividends paid to noncontrolling shareholders are not included in the consolidated retained earnings statement. On the other hand, all the cash generated by the subsidiary is included in the consolidated cash flow statement and all uses of cash must also be included, including cash distributed to noncontrolling shareholders in the form of dividends. Q10-3 The indirect method focuses on reconciling between net income and cash flows from operations and does not attempt to report payments to suppliers or other specific uses of cash. It does report the change in inventory and accounts payable which are included in determining payments to suppliers. While adjusting net income for changes in inventory and accounts payable leads to a correct reporting of cash flows from operations, it does not permit explicit reporting of payments to suppliers. Q10-4 Changes in inventory balances are used in computing the amount reported as payments to suppliers and do not need to be separately reported. Q10-5 Sales must be included in the consolidated cash flows worksheet when the direct method is used. They are excluded from the worksheet when the indirect method is used. Q10-6 (a) When the indirect method is used, the changes in inventory are reported as a reconciling item in the operating section of the statement of cash flows. (b) When the direct method is used, changes in inventory are included in the computation of payments to suppliers and not separately disclosed. Q10-7 Only sales subsequent to the date of acquisition are included. The acquired company was not part of the consolidated entity prior to the date of acquisition. Q10-8 Dividends paid by the acquired company to the noncontrolling shareholders following the date of acquisition are included as a cash outflow in the consolidated statement of cash flows. Dividends paid by the acquired company prior to acquisition are excluded. The acquired company was not part of the consolidated entity prior to the acquisition date. However, none of the dividends paid by the subsidiary (before or after the acquisition date) will be reported in the consolidated statement of changes in stockholders’ equity.

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Chapter 10 - Additional Consolidation Reporting Issues

Q10-9 The revenues and expenses of the subsidiary for the full year are included in the consolidated income statement when the acquisition occurs at the beginning of the year. When a mid-year acquisition occurs, the revenues and expenses of the acquired company prior to the date of acquisition were not transactions of the consolidated entity. As a result, an additional consolidation entry is made to close pre-acquisition account balances to retained earnings. Q10-10 When there is a difference between the fair market value and the tax basis of an asset acquired or liability assumed in an acquisition, a deferred tax asset or liability must be recognized as part of the net identifiable assets in an acquisition. This usually occurs in a nontaxable acquisition where the acquiree’s tax bases in the assets and liabilities carry over to the consolidated entity after the acquisition. Q10-11 The only book-tax difference that arises in acquisition that does not require the inclusion of a related deferred tax asset or liability is goodwill. ASC805-740-25-9 states that deferred taxes are not recognized when there is an excess of goodwill for financial reporting over that for tax. Q10-12 An accurate measure of the overall profit contribution from each segment of business operations is often considered desirable in evaluating past operations and in planning future strategy. In some cases the tax impact of operating a particular division is very different from one or more other divisions, and that difference should be recognized in evaluating the segment. Even when such differences do not exist, better knowledge of the approximate after tax return from a particular subsidiary can be very helpful in assessing future investment and operating strategies. Q10-13 When a consolidated tax return is filed, all intercompany transfers are eliminated in computing taxable income and there should be no need to adjust recorded tax expense in preparing consolidated financial statements for the period. When the companies do not file a consolidated return, tax payments and expense accruals recorded by the individual companies presumably will include gains and losses on intercompany transfers. If an unrealized gain or loss is eliminated in consolidation, the amount reported as tax expense also should be adjusted to reflect only the tax expense on those items included in the consolidated income statement. Q10-14 Assuming an unrealized profit has been reported, an additional consolidation entry is needed to reduce tax expense and establish a deferred tax asset in the amount of the excess payment. If a loss is eliminated, additional tax expense and taxes payable must be established in the consolidation process. Q10-15 When one of the companies in the consolidated entity has recorded tax expense on unrealized profit in a preceding period, its retained earnings balance at the start of the period will be overstated by the amount of unrealized profit less the tax expense recorded thereon. In the period in which the item is sold and the profit is considered realized, the consolidation entries must include a debit to the Investment in Subsidiary account for the amount of the net overstatement and a debit to deferred tax expense for the proper amount of expense to be recognized. If the original transfer was upstream, the entry would also include a debit to the NCI in NA of the Subsidiary account. Q10-16 When taxes are not considered, income assigned to noncontrolling shareholders is reduced by a proportionate share of the unrealized profit. When taxes are considered, the reduction is based on a proportionate share of the after tax balance of unrealized profits. Q10-17 Perhaps the most important reason is that the earnings per share data reported by the separate companies may include unrealized profits that must be eliminated in computing the consolidated totals. Even without unrealized profits, simple addition could not be used when the 10-2 Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 10 - Additional Consolidation Reporting Issues

companies do not have an equal number of shares outstanding or when the parent does not hold all the common or preferred shares of the subsidiary. Q10-18 The full amount of dividends paid to unaffiliated preferred shareholders of the parent are deducted from consolidated net income in arriving at consolidated earnings per share. Preferred dividends paid by the subsidiary to noncontrolling shareholders and income assigned to noncontrolling common shareholders are deducted from consolidated revenue and expenses in computing consolidated net income and earnings per share. Subsidiary preferred dividends paid to the parent or other affiliates must be eliminated and are not deducted in computing consolidated earnings per share. Q10-19 A subsidiary's contribution to consolidated earnings per share may be different from its contribution to consolidated net income if the subsidiary has convertible bonds or preferred stock outstanding that are treated as if they had been converted, or if the treasury stock method is used to include the dilutive effects of subsidiary stock rights or stock options outstanding. Q10-20 The net of tax interest savings from the assumed conversion of the bond into common stock is included in the numerator and the additional shares are added to the denominator of the earnings per share computation for the subsidiary. In doing so, earnings per share of the subsidiary will be reduced. Moreover, the additional shares added to the denominator will potentially alter the ownership ratio held by the parent; thus, the amount of subsidiary income included in the consolidated earnings per share computation is likely to be reduced. Q10-21 Those rights, warrants, and options treated as stock outstanding in the denominator of the earnings per share computation of the subsidiary will reduce the amount of subsidiary income included in the consolidated earnings per share computation to the extent that the ownership ratio held by the parent is reduced. The actual shares will not be reported as such, because they are assumed to be either eliminated or assigned to the noncontrolling interest. Q10-22 In the earnings per share computation, the amount of income assigned to noncontrolling interest may change as it is assumed that convertible securities are converted or rights, warrants, and options are exercised. Both the amount of subsidiary income included in the numerator and the proportion of parent company ownership may vary, thereby changing the amount of subsidiary income included in the consolidated earnings per share computation.

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Chapter 10 - Additional Consolidation Reporting Issues

SOLUTIONS TO CASES C10-1 The Effect of Security Type on Earnings per Share a. Until the securities are converted, the interest expense on bonds and the preferred dividends must both be deducted in determining income available to common shareholders when basic earnings per share is computed. Because interest expense is deductible for tax purposes and preferred dividends are not, the increase in earnings available to common shareholders will be less with conversion of the debentures. The decrease in earnings per share will be greater with conversion of the convertible debentures since the two securities convert into an equal number of common shares. b. Interest expense is deducted in computing net income and preferred dividends are not. Thus, conversion of the bonds will increase net income and conversion of the preferred stock will have no effect on the reported net income of Stage Corporation. If Stage Corporation is a parent company, consolidated net income will increase by the full amount of the interest saving (net of tax) if the bonds are converted. In the event Stage Corporation is a subsidiary of another company, consolidated net income again will increase if the bonds are converted, but the amount of the increase depends on the percentage ownership of Stage by the parent. Conversion of the preferred stock will increase consolidated net income because it increases Stage’s income available to common shareholders, of which the parent is one. The increase will be greater than the effect of the bond conversion because the preferred dividends have no tax effect, but the amount of the increase will depend on the parent’s percentage ownership. c. If the preferred shares are those of a parent company, they will be excluded entirely if (1) all the shares are owned by its subsidiaries, or (2) the preferred shares are noncumulative and have had no dividends declared during the period. If the shares are those of a subsidiary, the preferred shares will have an effect on basic earnings per share unless (1) the parent or other affiliates own all the common and preferred shares outstanding, or (2) the preferred shares are noncumulative and have had no dividends declared during the period. d. Interest expense will be deducted in computing Stage's net income. The preferred dividends will then be deducted from net income in computing Stage's income available to common shareholders. Assuming both securities are dilutive, interest expense (net of tax) will be added back to Stage's net income, no preferred dividends will be deducted, and the increased number of shares from the conversion of both securities will be added to the denominator in computing Stage’s diluted earnings per share. These earnings per share amounts will then be used by Prop Company in determining the income from the subsidiary to be included in its consolidated earnings per share computations.

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Chapter 10 - Additional Consolidation Reporting Issues

C10-2 Evaluating Consolidated Statements MEMO To:

Treasurer Cowl Corporation

From: Re:

, Accounting Staff Disclosure of Transfer of Cash from Subsidiary to Parent

The following comments are provided in response to your concern with respect to the transfer of cash from Plum Corporation to the parent company. Intercompany borrowings often offer an opportunity for one company to borrow money from an affiliate at rates favorable to both parties. As a result, transfers of cash between affiliates are very common. These transactions are eliminated in preparing the consolidated statements and the financial statement reader will be unaware of them unless supplemental disclosures are made. In general, the FASB does not require separate disclosure of transactions between consolidated entities when they are eliminated in the preparation of consolidated or combined financial statements. [ASC 850-10-50-4] Nevertheless, the fact that Cowl Company is unable to generate sufficient cash from its separate operations to pay its bills appears to be of sufficient importance that disclosure would be appropriate in both the Management Discussion and Analysis (MD&A) section of Cowl’s annual report and in the notes to the financial statements. The SEC establishes the disclosure requirements for MD&A and requires discussion of currently known trends, demands, commitments, events, or uncertainties that are reasonably expected to have material effects on the registrant’s financial condition or results of operations, or that would cause reported financial information not to be necessarily indicative of future operating results or financial condition. [SEC Regulation S-K, Item 303] The SEC also requires discussion of both short- and long-term liquidity and capital resources. [SEC Financial Reporting Release 36] ASC 230 does not specify those situations in which a discussion of operating cash flows must be included in the notes to the financial statements. However, if the negative cash flow from Cowl Company’s operations significantly affects the operating cash flows of the consolidated entity, one or more notes to the financial statements should be used to provide information to the financial statement readers. One possible form for doing so would be to include supplemental cash flow information if the operations of the parent are identified as a separate reportable segment [ASC 280-10-50-10]. Primary citations: ASC 850-10-50-4 SEC Regulation S-K, Item 303 Secondary citations: ASC 230 ASC 280-10-50-10

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Chapter 10 - Additional Consolidation Reporting Issues

C10-3 Income Tax Expense a. When prior-period intercompany profits are realized through resale to a nonaffiliate in the current period, tax expense reported by the consolidated entity will be greater than actual tax payments made by the separate companies. b. Report the additional amount paid as a deferred tax asset or as prepaid income tax in the consolidated balance sheet. (An alternate approach is to net the overpayment for unrealized profits against deferred income taxes payable, but this was not discussed in the chapter.) c. Whenever separate tax returns are filed and unrealized profits/gains are recorded on intercompany transfers of land, buildings and equipment, or other assets, income tax expense reported in the consolidated income statement in the period of the intercompany transfer will be less than tax payments made. A similar effect occurs when one affiliate purchases the bonds of another affiliate and a constructive loss on bond retirement is reported in the consolidated income statement. d. When unrealized profits from a prior period are realized in the current period, income tax expense recognized in the current period will be greater than the actual tax payment made. Also, when unrealized losses are recorded on intercompany transfers (like land, buildings, equipment or other assets), tax expense reported in the consolidated income statement in the period of the transfer will be greater than the actual tax payment. A constructive gain on bond retirement on a purchase of an affiliate's bonds will also result in an excess of consolidated tax expense over tax payments.

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Chapter 10 - Additional Consolidation Reporting Issues

C10-4 Consolidated Cash Flows a. The factors contributing to the increase in net income over the prior period are key in this case. One possible explanation is that operating earnings of the combined companies actually declined and the increase in net income resulted from a substantial one-time gain on sale of a division or other assets in the current period. Another possibility would be a decrease in noncash charges deducted in computing income. Cash generated by operations often is well above operating earnings as a result of charges such as amortization of intangible assets or depreciation. A decrease in these charges will increase net income but not change cash flows Changes in the net amounts invested in receivables, inventories, and other current assets are included in the computation of cash flows from operations. Increases in these balances can substantially reduce the reported cash flows from operations without affecting net income. b. Both sales and the balance in accounts receivable should increase when less stringent criteria are used in extending credit. Similarly, both should decrease when credit terms are tightened. If the companies have relaxed credit standards during the current period, net income may be greater as a result of increased sales. However, cash flows are likely to increase to a lesser degree as accounts receivable increase. c. An inventory write-off under lower of cost or market and other noncash charges will not reduce cash flows from operations. The amount expensed would be added back to consolidated net income in arriving at cash generated by operating activities. d. Assuming an allowance account is used, this particular write-off will not appear in either the income statement or computation of cash flows from operations. There is no charge in the income statement and no change in the net receivable balance as a result of a simple write-off of an account receivable. e. There are no significant differences between the preparation of a statement of cash flows for a consolidated entity and a single corporate entity. However, for the consolidated entity, dividend payments to the subsidiary’s noncontrolling interest must be included in the financing section because they use cash even though they are not viewed as dividends of the consolidated entity.

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