1. Electronic Presentations in Microsoft ® PowerPoint ® Prepared by James Myers, C.A. University of Toronto © 2010 McGraw-Hill Ryerson Limited Chapter 6, Slide 1 © 2010 McGraw-Hill Ryerson Limited

2. Chapter 6 Intercompany Inventory and Land Profits Chapter 6, Slide 2 © 2010 McGraw-Hill Ryerson Limited

3. Learning Objectives 1. Describe the effect on consolidated net income of the elimination of both intercompany revenues (and expenses) and intercompany asset profits 2. Prepare consolidated financial statements that reflect the elimination of upstream and downstream intercompany profits in inventory and land 3. Prepare consolidated financial statements that reflect the realization of upstream and downstream intercompany profits in inventory and land that were held back in previous periods Chapter 6, Slide 3 © 2010 McGraw-Hill Ryerson Limited

4. Learning Objectives 4. Explain how the revenue recognition and matching principles are used to support adjustments for intercompany transactions when preparing consolidated financial statements 5. Prepare the journal entries under the equity method to reflect the elimination and subsequent realization of intercompany profits in inventory and land Chapter 6, Slide 4 © 2010 McGraw-Hill Ryerson Limited

5. Intercompany Revenue & Expenses Parents and subsidiaries frequently have sales and purchases transactions between each other, or other transactions such as intercompany rent, management fees, and interest  While not paid, these transactions can give rise to intercompany balances such as receivables and payables Intercompany transactions are recorded in the books of each of the individual legal entities  These amounts would be included in separate entity financial statements, and reported on separate entity income tax returns LO 1 Chapter 6, Slide 5 © 2010 McGraw-Hill Ryerson Limited

6. Intercompany Revenue & Expenses However, in the consolidated financial statements:  All intercompany sales or other intercompany income must be eliminated against the related purchase or intercompany expense  All intercompany balances (including receivables and payables) are eliminated against each other  Income should be recognized only when it is earned in a transaction with an outsider Companies must have systems in place that can capture full information regarding both internal and external sales and purchases, in order that the appropriate eliminations may be identified and made in the consolidated financial statements LO 1 Chapter 6, Slide 6 © 2010 McGraw-Hill Ryerson Limited

7. Intercompany Revenue & Expenses The selling company will generally have recorded a profit on the intercompany sales  These profits are “unrealized” because they are only within the combined entity, they are not objectively measurable, and are not with an arm’s-length outsider  Intercompany sales are like moving a coin from one pocket in a pair of pants to the other pocket: the pants still contain the same coin and no income has been earned  Intercompany sales do not reflect the culmination of the earnings process  These unrealized profits must be eliminated net of related income taxes paid LO 1 Chapter 6, Slide 7 © 2010 McGraw-Hill Ryerson Limited

8. Examples of Intercompany Revenue and Expenses Intercompany management fees - often the parent will charge its subsidiary companies a management fee as means of allocating head office cost to all the companies within the group Intercompany rentals – occasionally, buildings or equipment owned by one company are used by another company within the group with a corresponding rental charge LO 1 Chapter 6, Slide 8 © 2010 McGraw-Hill Ryerson Limited

9. Examples of Intercompany Revenue and Expenses Intercompany interest revenue and expense – one company may record interest income on a loan to another company which records a corresponding interest expense Intercompany revenues and expenses must be eliminated against each other on the consolidated income statement  Since equal amounts of income and expense are being eliminated, there is no net effect on consolidated income  Only revenues and expenses incurred with outside parties should be reflected on the consolidated income statement LO 1 Chapter 6, Slide 9 © 2010 McGraw-Hill Ryerson Limited

10. Intercompany Profits in Inventory Inventory is often sold from one company to another within a consolidated group. There are two types of intercompany profits to consider:  Those resulting from downstream sales (i.e., where the parent sells to its subsidiary)  Those resulting from upstream sales (i.e., where a subsidiary sells to the parent) Any inventory sold within the group but not subsequently sold outside must be shown at its original cost with the unrealized profit eliminated net of the associated income tax We have to “hold back” any unrealized net-of-tax profit for consolidation purposes LO 1 Chapter 6, Slide 10 © 2010 McGraw-Hill Ryerson Limited

11. Intercompany Profits in Inventory The matching of expenses with revenues is a basic accounting concept; the adjustment made for income taxes is a perfect example of this matching process Income tax should be expensed in the same period as revenue is recorded  The timing difference between the buyer’s tax basis in the asset purchase and the cost of the transferred asset meets the definition of a temporary difference and will give rise to deferred income taxes LO 4 Chapter 6, Slide 11 © 2010 McGraw-Hill Ryerson Limited

12. Intercompany Profits in Inventory The consolidation worksheet entry to eliminate unrealized gross profit in ending inventory takes this general form: Cost of goods soldxxx Ending Inventoryxxx [Inventory is hereby restored to its historical cost] The tax prepaid by the seller on the profit that is not yet recognized is deferred as an asset on the consolidation worksheet: Deferred income taxxxx Tax expensexxx  Note that tax expense has been reduced to match the reduced income. LO 2 Chapter 6, Slide 12 © 2010 McGraw-Hill Ryerson Limited

13. Intercompany Profits in Inventory Equity method journal entries If the parent uses the equity method to account for its subsidiaries it would record the following entries in its own books: Investment incomexxx Investmentxxx To record elimination of unrealized gross profit Investment xxx Investment incomexxx To defer prepaid income tax LO 5 Chapter 6, Slide 13 © 2010 McGraw-Hill Ryerson Limited

14. Intercompany Profits in Inventory The elimination of unrealized profits from intercompany inventory sales in one year has the opposite effect in the following year. Cost of Sales = Opening Inventory + Purchases – Ending Inventory In the year following the intercompany sale, opening inventory is inflated by the unrealized profit, therefore cost of sales is inflated. Therefore, reduce cost of sales in the following year, thus “realizing” the profit. Corresponding income tax expense is then recorded. LO 2 Chapter 6, Slide 14 © 2010 McGraw-Hill Ryerson Limited

15. Intercompany Profits in Inventory In the first year:  Cost of goods sold is increased as ending inventory is decreased to its original cost  The profit is held back until realized through sale to outsider  A deferred tax asset is established In subsequent year  Cost of goods sold is decreased as beginning inventory is decreased to original cost  The profit is now realized in the financial statements Income tax expense is increased LO 1, 3, 4 Chapter 6, Slide 15 © 2010 McGraw-Hill Ryerson Limited

16. Intercompany Profits in Inventory The consolidation worksheet entry to recognize unrealized gross profit held back from the prior year takes this general form: Retained earningsxxx Cost of goods soldxxx The tax effect is also recognized Retained earnings xxx Deferred income taxxxx  Note that profit has now been increased, so associated tax expense also must be increased LO 3 Chapter 6, Slide 16 © 2010 McGraw-Hill Ryerson Limited

17. Intercompany Profits in Inventory When profit is recorded by the subsidiary on inventory sold to the parent (an “upstream” sale) then a portion of the after-tax unrealized profit elimination is assigned to non-controlling interest. Example: $360 after-tax profit in ending inventory sold by 90% subsidiary to parent  Effect on NCI is 10% x $360 = $36  Reflect on consolidation worksheet with the following entry: NCI (balance sheet)$36 NCI (income statement)$36 LO 2 Chapter 6, Slide 17 © 2010 McGraw-Hill Ryerson Limited

18. Intercompany Profits in Inventory What is the net effect of these eliminations?  The profit is deferred (“held back”) until realized in an arms’ length transaction with an unrelated party  The financial statements are shown as if the transaction had never occurred, until it is eventually realized The elimination of unrealized profits is an essential element of the fair presentation of consolidated financial statements. Without these eliminations, profit could readily be manipulated. LO 1 Chapter 6, Slide 18 © 2010 McGraw-Hill Ryerson Limited

19. Intercompany Profits in Inventory The examples in the next two slides - from Exhibits 6.5 and 6.6, illustrate how the elimination of unrealized upstream intercompany profits net of income tax is reflected in:  The calculation of consolidated net income  The calculation of consolidated retained earnings  The calculation of non-controlling interest  The consolidated income statement  The consolidated balance sheet LO 2 Chapter 6, Slide 19 © 2010 McGraw-Hill Ryerson Limited

20. Intercompany Profits in Inventory LO 2 Chapter 6, Slide 20 © 2010 McGraw-Hill Ryerson Limited

21. Intercompany Profits in Inventory LO 2 Chapter 6, Slide 21 © 2010 McGraw-Hill Ryerson Limited

22. Intercompany Land Profit Holdback Companies often redistribute assets among various corporate divisions within a group  land and other non-depreciable assets may be sold intercompany The selling company will normally recognize a gain or loss on the sale, and the buying company will record the assets at the price charged by the seller. This cost may be higher or lower than the cost to the selling company  The company must track the original cost and the intercompany unrealized gain or loss LO 1 Chapter 6, Slide 22 © 2010 McGraw-Hill Ryerson Limited

23. Intercompany Land Profit Holdback The gain or loss on these intercompany sales is always unrealized to the group until and unless the asset is subsequently sold to a buyer outside the group  The unrealized intercompany gain must be eliminated All adjustments are made with the objective of presenting the statements of the group to report as if the transaction between the companies had never taken place  The asset is restated to its original cost to the seller LO 1 Chapter 6, Slide 23 © 2010 McGraw-Hill Ryerson Limited

24. Intercompany Land Profit Holdback Implications of intercompany transactions:  The intercompany gain and associated income taxes are eliminated on the income statement in the year of the sale  The asset is restated to its original cost on any balance sheet prepared after the intercompany sale This is repeated each period until the asset is sold to an outside party.  Retained earnings is adjusted for the effect of the elimination and change in asset value This adjustment is repeated every period until (and unless) the asset is sold outside the corporate group. LO 1 Chapter 6, Slide 24 © 2010 McGraw-Hill Ryerson Limited

25. Intercompany Land Profit Holdback The necessary consolidation elimination entry takes this general form: Gainxxx Assetxxx [The asset is hereby restored to historical cost] The entry is repeated in periods subsequent to the intercompany transfer until the land is sold to outsiders, through a consolidation worksheet adjustment to retained earnings: Retained Earningsxxx Assetxxx LO 2 Chapter 6, Slide 25 © 2010 McGraw-Hill Ryerson Limited

26. Intercompany Land Profit Holdback The tax effect of the elimination entry takes this general form on the consolidation worksheet: Deferred income taxxxx Tax expensexxx The entry is repeated in years subsequent to the intercompany sale until the land is sold to outsiders, through a consolidation worksheet adjustment to retained earnings: Deferred income taxxxx Retained earningsxxx The direct approach requires calculations of the unrealized gains and their tax effects LO 2 Chapter 6, Slide 26 © 2010 McGraw-Hill Ryerson Limited

27. Intercompany Land Profit Holdback Equity method journal entries If the parent uses the equity method to account for its subsidiaries it would record the following entries in its own books: Investment incomexxx Investmentxxx To record elimination of unrealized land gain Investment xxx Investment incomexxx To defer prepaid income tax LO 5 Chapter 6, Slide 27 © 2010 McGraw-Hill Ryerson Limited

28. Intercompany Land Profit Holdback Non-controlling interest on upstream land sales:  Non-controlling interest must be adjusted to eliminate all upstream gains and losses net of income taxes.  Example: Subsidiary 90% owned by parent sells land to parent for a gain of $1,300 after-tax Effect on NCI is 10% x $1,300 = $130 Reflect on consolidation worksheet with the following entry: NCI (balance sheet)$130 NCI (income statement)$130 LO 1, 2 Chapter 6, Slide 28 © 2010 McGraw-Hill Ryerson Limited

29. Losses on Intercompany Transactions Selling an asset at a loss raises the question of whether the loss reflects fair value and an impairment  If impairment is present the asset should be written down to its net realizable value  If impairment is not present and the loss does not reflect fair value, the loss should be eliminated LO 1 Chapter 6, Slide 29 © 2010 McGraw-Hill Ryerson Limited