Advanced accounting 10th by a beams athony ch10

Chapter 10: Subsidiary Preferred Stock,
Consolidated Earnings Per Share, and
Consolidated Income Taxation
by Jeanne M. David, Ph.D., Univ. of Detroit Mercy
to accompany
Advanced Accounting, 10th edition
by Floyd A. Beams, Robin P. Clement,
Joseph H. Anthony, and Suzanne Lowensohn

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10-1


Preferred Stock, EPS, and Taxes:
Objectives
1.
2.
3.

Modify consolidation procedures for subsidiary companies with
preferred stock in their capital structure.
Calculate basic and diluted earnings per share for a consolidated
reporting entity.
Understand the complexities of accounting for income taxes by
consolidated entities.

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10-2

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

1: Preferred Stock

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Subsidiary Preferred Stock
Subsidiary 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

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10-4

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

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10-5


Review of Preferred Stock
Characteristics
• Callable, redeemable
• Cumulative or noncumulative
• Participative or nonparticipative
• Limited voting rights
Most 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

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10-6


Example: PS Held by Outsiders
Poe 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.

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10-7


Calculations for Preferred Stock
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

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).
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10-8


Allocations
Income allocation:
Sol's net income
Amortizations
Income to allocate
Allocated to preferred
Allocated to common
 
Dividends
Allocated to preferred
Allocated to common

 
50
0

50
(10)
40
 
30
(10)
20

NCI share –
Preferred
$10 income
$10 dividend
CI share
(90%)

NCI share
(10%
common)
$4 income
$2 dividend

$36 income
$18 dividend

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10-9


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.

Income from Sol
Dividends
Investment in Sol
Noncontrolling interest share, CS
Dividends
Noncontrolling interest, CS
Noncontrolling interest share, PS
Dividends
Preferred stock
Common stock
Other paid in capital
Retained earnings
Goodwill
Investment in Sol
Noncontrolling interest, CS

Noncontrolling interest, PS

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36  
 
 

18
18
4  

 
 

2
2
10  

 
100
200
40
160
45
 
 
 

10

 
 
 
 
 
396
44
105
10-10


Parent Uses Constructive Retirement
Parent 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

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10-11


Parent Uses Cost Basis
Parent 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

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Example: Parent Acquires PS

Plato 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
Common stock $1 par
Other paid in capital
Retained earnings
Total equity
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1,500
300
1,200
2,300
5,300
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Calculations
Book value of preferred stock
$52 x ($1,500 / $50par) = $1,560
Book value of Shem's common stock
$5,300 total equity – $1,560 = $3,740
Shem's total value with goodwill
$3,740 + $100 = $3,840
Investment in Shem, CS (80%) = $3,072

Noncontrolling interest, CS (20%) = $768
Noncontrolling interest, PS (30%) = $468
Parent acquired 70% of Shem's PS for $950
Investment in Shem, PS (70%, book) = $1,092
Or
Investment in Shem, PS (70%, cost) = $950
The difference, $142 = 1092-950, increases the parent's other
paid in capital
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Constructive Retirement Entries
 Parent's acquisition entry:

 

Investment in Shem, PS (70%)
Cash
Other paid in capital (Plato)

 
 

 Worksheet entry:

 

Preferred stock

Common stock
Other paid in capital
Retained earnings
Goodwill
Investment in Shem, CS (80%)
Investment in Shem, PS (70%)
Noncontrolling interest, CS (20%)
Noncontrolling interest, PS (30%)

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1,092  
950
142
 

1,500
300
1,200
2,300
100
 
 
 
 

 
 

 
 
 
3,072
1,092
768
468

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Cost Basis Entries
 Parent's acquisition entry:

 

Investment in Shem, PS (70%)
Cash

 

Worksheet entry 

 

Preferred stock
Common stock
Other paid in capital
Retained earnings
Goodwill

Investment in Shem, CS (80%)
Investment in Shem, PS (70%)
Noncontrolling interest, CS (20%)
Noncontrolling interest, PS (30%)
Other paid in capital (Plato's)

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950  
950
 

1,500
300
1,200
2,300
100
 
 
 
 
 

 
 
 
 
 

3,072
950
768
468
142

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Comparison of Methods
Both result in the same consolidated amounts
Constructive 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

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

2: Earnings Per Share

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10-18


EPS Requirements
GAAP requires firms report basic and diluted (where applicable) EPS
EPS 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

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10-19


Review Basic EPS
Numerator:
Net income – preferred stock dividends*
* current dividends if cumulative, otherwise declared dividends
Denominator:
Weighted average shares of common stock

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10-20

Review Diluted EPS
Numerator:
(Net income – PS dividends)
+ adjustments for dilutive securities
Denominator:
Weighted average shares outstanding
+ shares represented by dilutive securities
Dilution:
• Dilutive securities reduce EPS.
• Non-dilutive securities are excluded

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10-21


Review Dilutive Securities
Convertible bonds
–
–

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

–
–

Numerator: preferred stock dividend
Denominator: common shares the preferred shares represent

–
–

Numerator: none
Denominator: "treasury stock method" to compute shares (if positive)

Convertible preferred stock
Convertible preferred stock

# shares – (# shares x option price / market price)

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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!

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10-23


Subsidiary PS Convertible into
Subsidiary CS
Seed 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
.

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Parent's Basic EPS
Seed 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

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