Income tax accounting requirements for business combinations often differ from generally accepted accounting principles. Consequently, the current fair values assigned to identifiable net assets of a combinee in a business combination often include deferred income tax liabilities or assets attributable to differences between financial accounting and income tax accounting for the combination.
Generally, income tax allocation accounting is appropriate in the parent company's accounting records for undistributed earnings of subsidiaries. Income taxes attributed to domestic subsidiaries' undistributed earnings are computed under the assumption that the undistributed earnings had been distributed as dividends and the parent company had availed itself of all possible tax planning alternatives, credits, and deductions. The resultant parent company journal entry generally is in the following form:
Income Taxes Expense
XXX
Income Taxes Payable
XXX
Deferred Income Tax Liability
XXX
To provide for income taxes on intercompany investment income from subsidiary.
The amount credited to Income Taxes Payable in the journal entry illustrated in paragraph 2 is for income taxes attributable to dividends received by the parent company from the subsidiary during the accounting period. The credit to the Deferred Income Tax Liability ledger account is for the amount of income taxes attributable to undistributed earnings of the subsidiary.
Under current federal income tax laws, an affiliated group of corporations may file a consolidated income tax return, with intercompany profits (gains) and losses eliminated from consolidated taxable income. If the parent and subsidiary companies do not qualify for, or do not choose to file, consolidat-ed income tax returns, income taxes accrued or paid on intercompany profits (gains) must be deferred (assuming the criteria for recognizing deferred tax assets without a valuation allowance are met).
To illustrate the deferral of income taxes attributable to intercompany profits, assume that intercompany profits of $15,000 and $20,000, respectively, were attributable to the beginning and ending inventories of Sprackle Company resulting from merchandise purchases from its parent company, Prangle Corporation. If the income tax rate is 40%, the following working paper eliminations (in journal entry format) are appropriate for Prangle Corporation and subsidiary at the end of the year:
Deferred Income Tax Asset — Prangle
8,000
Income Taxes Expense — Prangle
8,000
To defer income taxes provided on separate income tax returns of parent applicable to unrealized intercompany profits in subsidiary's inventories at end of year ($20,000 x 0.40 = $8,000).
Income Taxes Expense — Prangle
6,000
Retained Earnings — Prangle
6,000
To provide for income taxes attributable to realized intercompany profits in subsidiary's inventories at beginning of year ($15,000 x 0.40 = $6,000)
The deferral of income taxes attributable to an intercompany gain on sale of land is accomplished with a working paper elimination (in journal entry format) at the end of the accounting period of the sale, such as the following:
Deferred Income Tax Asset — Parent
XXX
Income Taxes Expense — Parent
XXX
To defer income taxes provided on separate income tax returns of parent company applicable to unrealized intercompany gain in subsidiary's land at end of period.
In years subsequent to the intercompany sale of land, as long as the acquiring affiliate owns the land, a working paper elimination similar to the one illustrated in paragraph 6 is appropriate except that the credit is to the retained earnings of the selling affiliate.
The deferral of income taxes attributed to an intercompany gain on sale of a depreciable plant asset at the end of an accounting period is accomplished by a working paper elimination identical in format to the one illustrated in paragraph 6. In working paper eliminations of subsequent years of the economic life of the depreciable plant asset, a portion of the deferred income taxes attributable to the intercompany gain element of the acquiring affiliate's depreciation expense is allocated to the income taxes expense of the selling affiliate.
A working paper elimination should be used to provide for income taxes attributable to the realized gain or loss on one affiliate's open-market acquisition of another affiliate's outstanding bonds at the end of an accounting period. The working paper elimination (in journal entry format) would be as follows:
Income Taxes Expense — Subsidiary
XXX
Deferred Income Tax Liability — Subsidiary
XXX
To provide for income taxes attributable to subsidiary's realized gain on parent company's acquisition of the subsidiary bonds.
In accounting periods subsequent to the acquisition of the bonds, the actual income tax effects of the difference between intercompany interest revenue and expense would represent the reversal of the deferred income tax liability illustrated in paragraph 9.
In the preparation of a consolidated statement of cash flows, special problems arise with respect to the minority interest in net income of subsidiary, cash dividends applicable to minority stockholders, and changes in the parent company's ownership of common stock of the subsidiary.
A parent company may obtain control of a subsidiary company in a series of common stock acquisitions, rather than in a single transaction constituting a business combination. If so, the parent company logically should determine the current fair value of the subsidiary's identifiable net assets on the date the parent attains a controlling interest in the subsidiary. Prior to attaining a controlling interest, the investor company begins applying the equity method of accounting at the time when the investment is sufficient to enable the investor to exercise significant operating and financial influence over the investee.
Application of the equity method of accounting in conjunction with the installment acquisition of a subsidiary's outstanding common stock may lead to the piecemeal recognition of goodwill. For example, assume that Pogue Corporation acquired outstanding common stock of Stigue Company as follows:
July 1, 2003
30%
July 1, 2004
15%
July 1, 2005
35%
Under generally accepted accounting principles, Pogue begins applying the equity method for its investment in Stigue's common stock during the year beginning July 1, 2003. Any goodwill is computed separately on that date, on July 1, 2004, and on July 1, 2005. A business combination is considered to have taken place on July 1, 2005, when a controlling interest of 80% was achieved.
