Subsidiary Preferred Stock, Consolidated Earnings per Share, and Consolidated Income Taxation
1. Sam Corporation has 100,000 outstanding shares of $10 par common stock and 5,000 outstanding shares of $100 par, cumulative, 10 percent preferred stock. Sam's net income for the year is $300,000, and its stockholders' equity at year-end is as follows (in thousands):
10% cumulative preferred stock, $100 par $ 500
Common stock, $10 par 1,000
Additional paid-in capital 600
Retained earnings 400
Total Stockholders'Equity $2,500
Par Corporation owns 60 percent of the outstanding common stock of Sam, acquired at a fair value equal to book value several years ago. Compute Par's investment income for the year and the balance of its Investment in Sam account at the end of the year.
Par's investment income
Sam’s net income $ 300,000
Less: Preferred income ($500,000 * 10%) (50,000)
Income to common stockholders 250,000
Par's percentage owned 60%
Investment income $ 150,000
Par's investment account balance (equal to book value):
Sam’s stockholders’ equity $2,500,000
Less: Preferred equity (no arrearages or call premiums) (500,000)
Common equity 2,000,000
Par's percentage ownership 60%
Investment account balance $1,200,000
2. Refer to the information in question 1. Assume that Sam pays two years’ preferred dividend requirements during the current year. Would this affect your computation of Par's investment income for the current year? If so, recompute Par's investment income.
The payment of two years preferred dividend requirements would not have affected Par’s investment income. Since the preferred stock is cumulative, the preferred dividend requirements are deducted from net income each year regardless of whether preferred dividends are declared.
3. How should preferred stock of a subsidiary be shown in a consolidated balance sheet in each case?
a If it is held 100 percent by the parent
b If it is held 50 percent by the parent and 50 percent by outside interests
c If it is held 100 percent by outside interests
The preferred stock of a subsidiary does not appear in a consolidated balance sheet. If there is a noncontrolling interest in the preferred stock, it is reported as a noncontrolling interest in the consolidated balance sheet. In part a, the investment in preferred is eliminated against the preferred equity and there is no noncontrolling interest in preferred. When 50 percent of the stock is held by the parent (part b), the investment in preferred is eliminated against 50 percent of the preferred equity and the other 50 percent is reported as a noncontrolling interest. In part c, all of the preferred stock is reported as a noncontrolling interest.
4. Describe the computation of noncontrolling interest share for an 80 percent-owned subsidiary with both preferred and common stock outstanding.
Assuming that the parent does not hold any of the subsidiary’s preferred stock, the computation of noncontrolling interest share for an 80 percent owned subsidiary is 100 percent of the income allocated to preferred plus 20 percent of the income allocated to common.
5. How does controlling share of consolidated earnings per share differ from parent earnings per share?
There is no difference between the controlling share of consolidated EPS and parent company EPS.
6. Do investments in nonconsolidated subsidiaries and 20 to 50 percent-owned investees affect the nature of the investor's EPS calculations?
An investor company’s EPS computations must reflect the potential dilution of an equity investee’s common stock equivalents and other potentially dilutive securities if the effect is material.
7. Under what conditions will the procedures used in computing a parent’s EPS be the same as those for a company without equity investments?
Procedures applied in computing a parent company’s EPS computations are the same as those for a corporation without equity investments except when the subsidiary has outstanding common stock equivalents or other potentially dilutive securities.
8. It may be necessary to compute the earnings per share for subsidiaries and equity investees before parent (and consolidated) earnings per share can be determined. When are the subsidiary EPS computations used in calculating parent earnings per share?
Subsidiary EPS computations are only needed when computing diluted EPS, never for basic EPS, and then it is only needed when the subsidiary has potentially dilutive securities convertible into subsidiary common stock.
9. Potentially dilutive securities of a subsidiary may be converted into parent common stock or subsidiary common stock. Describe how these situations affect the parent's EPS procedures.
Subsidiary EPS computations are only needed when computing diluted EPS, never for basic EPS, and then it is only needed when the subsidiary has potentially dilutive securities convertible into subsidiary common stock.
10. In computing diluted earnings for a parent, it may be necessary to replace the parent's equity in subsidiary's realized income with the parent's equity in the subsidiary’s diluted earnings. Does this replacement calculation involve unrealized profits that are included in the parent's income from subsidiary?
The replacement computation does not involve unrealized profits from downstream sales because these items relate solely to parent operations and do not affect the noncontrolling interest. In the case of unrealized profits from upstream sales, however, unrealized profits are deducted in the replacement computation which involves subtracting the parent’s equity in subsidiary realized income and adding back the parent’s equity in subsidiary diluted EPS (also based on subsidiary realized income).
11. Are consolidated income tax returns required for all consolidated entities? Discuss.
Consolidated tax returns are not required for a consolidated entity, but a consolidated entity that qualifies as an “affiliated group” may elect to file consolidated tax returns. Once consolidated returns are elected, it may be difficult to obtain IRS permission to file separate returns.
12. Can a consolidated entity that is classified as an “affiliated group” under the IRS code elect to file separate tax returns for each affiliate?
Yes. Consolidated entities that meet the requirements of an affiliated group can and often do elect to file separate income tax returns.
13. What are the primary advantages of filing a consolidated tax return?
The primary advantages of filing consolidated tax returns are (1) losses of affiliates are offset against gains of other members of the affiliated group, (2) intercompany profits between group members are eliminated from taxable income until realized, and (3) intercorporate dividends are fully excluded from taxable income. (But note that 3 is not a unique advantage of filing a consolidated return.)
14. Some or all of the dividends received by a corporation from domestic affiliates may be excluded from federal income taxation. When are all of the dividends excluded?
Dividends received by a member of an affiliated group from other group members are excluded from federal income taxation regardless of whether the affiliated group elects to file consolidated tax returns.
15. Describe the nature of the tax effect of temporary differences that arise from use of the equity method of accounting.
Temporary differences result because investors that are not members of an affiliated group record income from equity investments as it is earned, but pay taxes only when dividends are actually received.
16. Does a parent/investor provide for income taxes on the undistributed earnings of a subsidiary by adjusting investment and investment income accounts? Explain.
In providing for income taxes on undistributed earnings of equity investees, the parent/investor debits income tax expense and credits deferred tax liability as part of the determination of all income taxes for the period. The investment and investment income accounts are not affected.
17. When do unrealized and constructive gains and losses create temporary differences for a consolidated entity?
Unrealized and constructive gains and losses give rise to temporary differences unless the consolidated entity is a member of an affiliated group and elects to file consolidated tax returns.
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