preferred stock, eps, and taxes

© 2009 Pearson Education, Inc. publishing as Prentice Hall 10-1

Chapter 10: Subsidiary Preferred Stock, Consolidated Earnings Per Share, and

Consolidated Income Taxationby Jeanne M. David, Ph.D., Univ. of Detroit Mercy

to accompanyAdvanced Accounting, 10th editionby Floyd A. Beams, Robin P. Clement,

Joseph H. Anthony, and Suzanne Lowensohn


Preferred Stock, EPS, and Taxes: Objectives1. Modify consolidation procedures for subsidiary

companies with preferred stock in their capital structure.

2. Calculate basic and diluted earnings per share for a consolidated reporting entity.

3. Understand the complexities of accounting for income taxes by consolidated entities.


1: Preferred Stock1: Preferred Stock

Subsidiary Preferred Stock, Consolidated Earnings Per Share, and Consolidated Income Taxation


Subsidiary Preferred StockSubsidiary preferred stock

– Doesn't change consolidation in principle– Does impact calculations

• Common stockholders' equity = total equity less preferred stock at book value

• Income of subsidiary is first allocated to preferred shareholders, then CI and NCI

• Subsidiary dividend payments must consider payments to preferred shareholders before common shareholders


Who Holds Preferred Stock?Preferred stock is held by outsiders• Preferred stock is a noncontrolling interest

Preferred stock is held by parent• May choose between

– Constructive retirement– Cost basis


Review of Preferred StockCharacteristics• Callable, redeemable• Cumulative or noncumulative• Participative or non-

participative• Limited voting rightsMost is cumulative and

nonparticipating

Book Value of PS is:Call or redemption price (par

value if neither)Plus Dividends in arrears (if

cumulative)

Income allocated to PS is:Current period dividend• Irrespective of amount

declared, if cumulative• Declared amount if

noncumulative• Potentially more if

participative

Preferred stock dividend is:Face value x dividend rate• Also consider:• Arrearage• Participation


Example: PS Held by OutsidersPoe buys 90% of Sol for $396 when Sol's equity

consists of $100 preferred stock, $200 common stock, $40 other paid in capital and $160 retained earnings.

The preferred stock is cumulative, nonparticipating, carries a 10% dividend and is callable at 105% of par value. There is no arrearage.

During the year, Sol earns $50 and pays $30 in dividends.


Calculations for Preferred Stock

The book value of preferred is its call price (no arrearage), 105%($100 par value).

Dividends are cumulative, so the current dividend is $10 = 10%($100 par value).

Cost of 90% of Sol $396 Implied value of Sol $440 Sol's total equity $500 Less book value of preferred stock (105) Book value of common 395 Excess, goodwill $45


Allocations

Income allocation: Sol's net income 50 Amortizations 0 Income to allocate 50 Allocated to preferred (10)Allocated to common 40 Dividends 30 Allocated to preferred (10)Allocated to common 20

NCI share – Preferred

$10 income

$10 dividend

NCI share (10%

common)

$4 income

$2 dividendCI share (90%)

$36 income

$18 dividend


Income from Sol 36 Dividends 18 Investment in Sol 18

Noncontrolling interest share, CS 4 Dividends 2 Noncontrolling interest, CS 2

Noncontrolling interest share, PS 10 Dividends 10

Preferred stock 100 Common stock 200 Other paid in capital 40 Retained earnings 160 Goodwill 45

Investment in Sol 396 Noncontrolling interest, CS 44 Noncontrolling interest, PS 105

Worksheet Entries with Preferred Stock Held by Outsiders

There is an entry for NCI share, PS that parallels the entry for NCI share, CS. Preferred Stock is eliminated.


Parent Uses Constructive RetirementParent acquires subsidiary's preferred stock

– Investment in subsidiary, PS is recorded at its book value

– Any difference between book value and cost of the stock is an adjustment of other paid in capital

– This is an owner transaction; no gain or loss is recorded

Investment is carried at PS book value– Increase for dividends in arrears– Decrease later when declared


Parent Uses Cost BasisParent acquires subsidiary's preferred stock

– Use cost method– Investment in subsidiary, PS is at cost– Dividends are recorded as income

In the consolidation process– Preferred stock is eliminated at its book value– Noncontrolling interest, PS is recorded at book

value of the preferred stock held by others– Investment is removed at its cost and any

difference from book value is charged or credited to other paid in capital


Example: Parent Acquires PSPlato owns 80% of Shem acquired at fair value

plus implied goodwill of $100. On 1/1/09 Plato acquires 70% of Shem's

outstanding preferred stock at $950.Shem's equity at 1/1/09:

$3 Preferred stock, $50 par, callable at $52, cumulative, no arrearage 1,500 Common stock $1 par 300 Other paid in capital 1,200 Retained earnings 2,300 Total equity 5,300


CalculationsBook value of preferred stock

$52 x ($1,500 / $50par) = $1,560 Book value of Shem's common stock

$5,300 total equity – $1,560 = $3,740Shem's total value with goodwill

$3,740 + $100 = $3,840Investment in Shem, CS (80%) = $3,072Noncontrolling interest, CS (20%) = $768Noncontrolling interest, PS (30%) = $468

Parent acquired 70% of Shem's PS for $950Investment in Shem, PS (70%, book) = $1,092

OrInvestment in Shem, PS (70%, cost) = $950

The difference, $142 = 1092-950, increases the parent's other paid in capital


Constructive Retirement Entries Parent's acquisition entry: Investment in Shem, PS (70%) 1,092

Cash 950 Other paid in capital (Plato) 142

Worksheet entry: Preferred stock 1,500 Common stock 300 Other paid in capital 1,200 Retained earnings 2,300 Goodwill 100

Investment in Shem, CS (80%) 3,072 Investment in Shem, PS (70%) 1,092 Noncontrolling interest, CS (20%) 768 Noncontrolling interest, PS (30%) 468


Cost Basis Entries Parent's acquisition entry: Investment in Shem, PS (70%) 950

Cash 950 Worksheet entry Preferred stock 1,500 Common stock 300 Other paid in capital 1,200 Retained earnings 2,300 Goodwill 100

Investment in Shem, CS (80%) 3,072 Investment in Shem, PS (70%) 950 Noncontrolling interest, CS (20%) 768 Noncontrolling interest, PS (30%) 468 Other paid in capital (Plato's) 142


Comparison of MethodsBoth result in the same consolidated amountsConstructive retirement• Records the Other paid in capital (parent's) at

acquisition • Investment is at book value• Simplifies consolidation process!Cost basis• Records the Other paid in capital (parent's) as part of

the consolidation process• Investment is at cost


2: Earnings Per Share2: Earnings Per Share



EPS RequirementsGAAP requires firms report basic and diluted

(where applicable) EPSEPS is disclosed on a consolidated basis

Main issue: Subsidiary's capital structure• Subsidiary potentially dilutive securities

convertible into subsidiary common stock• Subsidiary potentially dilutive securities

convertible into parent common stock


Review Basic EPSNumerator:

Net income – preferred stock dividends* * current dividends if cumulative, otherwise

declared dividendsDenominator:

Weighted average shares of common stock


Review Diluted EPSNumerator:

(Net income – PS dividends) + adjustments for dilutive securities

Denominator:Weighted average shares outstanding

+ shares represented by dilutive securitiesDilution:• Dilutive securities reduce EPS. • Non-dilutive securities are excluded


Review Dilutive SecuritiesConvertible bonds

– Numerator: after tax interest expense– Denominator: common shares bonds represent

Convertible preferred stock– Numerator: preferred stock dividend– Denominator: common shares the preferred

shares representConvertible preferred stock

– Numerator: none– Denominator: "treasury stock method" to

compute shares (if positive)# shares – (# shares x option price / market price)


Subsidiary Securities Convertible into Subsidiary Common Stock• Compare Parent's equity

– Realized earnings of subsidiary– Diluted earnings of subsidiary

• If diluted is higher, skip Non-dilutive• Realized earnings:

– Subsidiary's net income adjusted for intercompany profits/losses

• Does not include amortizations of valuation differentials• Diluted earnings:

– Subsidiary's diluted EPS x number of shares• Parent's diluted EPS

– Numerator: Reduce by difference– Denominator: No effect – no parent shares!


Subsidiary PS Convertible into Subsidiary CSSeed has $50 net income and 20 weighted average

shares of common stock. Its preferred stock has a $10 dividend and is convertible into 12 shares of Seed common stock.

Seed's basic EPS:($50 - $10) / 20 = $2.00

Seed's diluted EPS:($50 - $10) + $10 = $1.5625

20 + 12 .


Parent's Basic EPSSeed is 90% owned by Plant. Plant's net income is

$186, 200 shares of common are outstanding all year, and Plant has no dilutive securities.

Plant's basic EPS:$186 / 200 = $0.93


Parent's Diluted EPSPlant's realized income from Seed

90% x $40 = $36Plant's share of Seed's diluted earnings:

90% x 20 shares x $1.5625 = $28.125Since the share of diluted earnings is lower, we will

reduce the numerator by the difference.Plant's diluted EPS:

$186 – 36 + 28.125 = $0.89200 .


Subsidiary Securities Convertible into Parent Common StockParent's diluted EPS calculation:

– Numerator: Add adjustments for subsidiary securities convertible into parent common stock

– Denominator: Add parent common shares represented by subsidiary's dilutive securities


Subsidiary Options and Bonds Convertible into Parent CSSyd's net income is $450 and it has 400 shares of

common outstanding all year. Options: Syd has options that convert into 60

shares of its parent's (Paddy) common stock at $10 per share. The average market price is $15.

Convertible bonds: Syd has $1,000 par bonds convertible into 80 shares of Paddy's common stock. The bonds were issued at par to yield 7%. The effective tax rate is 34%.


Parent's Data and Basic EPSPaddy has $1,800 income and 1,000 shares of

common stock outstanding all year. It has no preferred stock or dilutive securities.

Paddy's basic EPS:$1,800 / 1,000 shares = $1.80


Parent's Diluted EPSImpact of Syd's options for Paddy common:• Numerator: none• Denominator: 60 + (60 x $10/$15) = 20 sharesImpact of Syd's bonds convertible to Paddy common:• Numerator: 7% x $1,000 x (1-34%) = $46.2• Denominator: 80 sharesPaddy's diluted EPS:

$1,800 + 0 + $46.2 = $1.761,000 + 20 + 80 .


3: Income Taxes3: Income Taxes



Consolidated Tax Return• Advantages

– Offset affiliate losses (excluding preacquisition loss carry forwards)

– Exclude intercompany dividends– Defer intercompany profits until realized

(losses are also deferred)• Disadvantages

– Loss of flexibility– Difficult to switch back to unconsolidated

• Cannot file as consolidated again for 5 years


Income Tax Allocation• Permanent differences

– Dividends from affiliates are excluded from taxable income

– Dividends from affiliates that are not members of the affiliated group are allowed an 80% dividends received deduction

• Temporary difference– Undistributed income from domestic affiliates

(FASB Statement No. 109)– Undistributed income from foreign affiliates and

from domestic affiliated earnings preceding FASB Statement No. 109 may be permanent.


Undistributed EarningsParson owns 30% of Seaton's common stock.• Seaton's income, $600• Seaton's dividends, $200• Parson's applicable tax rate = 34%Parson's deferred tax liability

= [30%($600 - $200)] x 20% x 34% = $8.16Seaton's earnings are allowed the 80% deduction,

so only 20% is subject to tax.If Seaton was a consolidated subsidiary, its

earnings would be excluded and Parson would have no deferred tax liability.


Unrealized Profits and Losses• Separate tax returns

– Unrealized gains (losses) are taxed (deducted) in the separate returns

– Consolidation procedures• Remove the unrealized gain (loss)• Record a deferred tax asset (liability)• Tax effect impacts the income tax expense of the

selling affiliate• Consolidated tax return

– Unrealized gains (losses) are excluded


ExamplePool owns 90% of Sal. The tax rate is 34%. Pretax

operating income of Pool and Sal are $150 and $50. Sal paid dividends of $20 and Sal's dividends are subject to the 100% exclusion.

During the year, intercompany sales were $50 and there remains $10 in unrealized profits in ending inventory.


Consolidated Tax ReturnDownstream sales• Pool's income $150 - $10 = $140• Sal's income $50• Consolidated taxes ($140 + $50) x 34% = $64.6

– Allocate (140/(140+50)) x $64.6 = $47.6 to Pool

(50/(140+50)) x $64.6 = $17.0 to Sal

Upstream sales• Pool's income $150• Sal's income $50 - $10 = $40• Consolidated taxes ($150 + $40) x 34% = $64.6

– Allocate(150/(150+40)) x $64.6 = $51.0 to Pool

(40/(150+40)) x $64.6 = $13.6 to Sal


Entries with Consolidated ReturnPool and Sal would each record their own share of the

income tax expense and income tax payable.The unrealized profit does not give rise to any

temporary differences– Deferred for consolidation purposes– Deferred for tax purposes– That is, it is not income now and it is not taxed now!

No special considerations for consolidation worksheet.


Separate Tax ReturnsDownstream sales• Pool's accounting income $150 - $10 = $140

– Pool's taxes payable $150 x 34% = $51.0– Pool's deferred taxes $10 x 34% = $3.4– Income tax expense $47.6

• Sal's income $50– Sal's taxes $50 x 34% = $17.0

Upstream sales• Pool's income $150

– Pool's taxes $150 x 34% = $51.0• Sal's income $50 - $10 = $40

– Sal's taxes payable $50 x 34% = $17.0– Sal's deferred taxes $10 x 34% = $3.4– Sal's income tax expense $13.6


Business CombinationsTax free combinations

– Mergers or consolidations– Exchange of voting stock for another

corporation's stock– Exchange of voting stock for another

corporation's assetsPurchase acquisitions may be either

– Tax free– Taxable


Tax Free Business CombinationsTax free business combinations give rise to differences

between book values and tax valuesAt acquisition

– Assign assets value based on gross fair value– Except

• Goodwill, bargain purchase, deferred taxes, pension assets, leveraged leases

– Tax bases carry forward from predecessor– Record deferred tax asset/liability for temporary

differences


Copyright © 2009 Pearson Education, Inc. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice HallPublishing as Prentice Hall

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any

means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher.

Printed in the United States of America.

preferred stock, eps, and taxes

Documents