FISCHER | TAYLOR | CHENG Intercompany Transactions: Merchandise, Plant Assets, and Notes

Learning Objectives (1 of 2) 1.Explain why transactions between members of a consolidated firm should not be reflected in the consolidated financial statements. 2.Defer intercompany profits on merchandise sales when appropriate and eliminate the double counting of sales between affiliates. 3.Defer profits on intercompany sales of long-term assets and realize the profits over the period of use and/or at the time of sale to a firm outside the consolidated group. COPYRIGHT © 2012 South-Western/Cengage Learning 2

Learning Objectives (2 of 2) 4.Demonstrate an understanding of the profit deferral issues for intercompany sales of assets under long-term construction contracts. 5.Eliminate intercompany loans and notes. 6.Discuss the complications intercompany profits create for the use of the sophisticated equity method. 7.(Appendix) Apply intercompany profit eliminations on a vertical worksheet. COPYRIGHT © 2012 South-Western/Cengage Learning 3

Typical Intercompany Transactions Merchandise for resale Land Fixed assets Long-term construction contracts Notes receivable/payable COPYRIGHT © 2012 South-Western/Cengage Learning 4

Intercompany merchandise sales Sales between affiliated companies are recorded in the normal manner on the books of the separate companies. For the consolidated financial statements –Do not involve parties outside the consolidated group –Cannot be acknowledged in consolidated statements Procedures for consolidating affiliated companies with intercompany merchandise sales 1.Eliminate the intercompany sale 2.Eliminate related intercompany (i.e., internal) debt/receivable 3.Profit is realized when the goods are sold to an outside party COPYRIGHT © 2012 South-Western/Cengage Learning 5

Combined Inc Stmt without eliminations Sales ($1,200 + $1,500) $2,700 C of GS ($1,000 + $1,200) 2,200 Gross Profit500 Gross profit pctg18.5% Example of an intercompany sale COPYRIGHT © 2012 South-Western/Cengage Learning 6 Co. PCo. SOutside $1,000 sells to S  $1,200 sells to outside  $1,500 Consolidated Inc Stmt inter-company transaction eliminated Sales$1,500 Cost of Goods Sold1,000 Gross Profit500 Gross profit pctg33.3% The “intercompany sale” of $1,200 is eliminated on the worksheet

Intercompany Price Does the intercompany price matter? Yes, if there is an NCI the reported net income of the subsidiary reflects the intercompany sales price the subsidiary's separate income statement becomes the base from which the noncontrolling share of income is calculated. if Company S is an 80%-owned subsidiary, the NCI will receive 20% of the $300 ($1,500 - $1,200) profit made on the final sale by Company S, or $60. COPYRIGHT © 2012 South-Western/Cengage Learning 7

Mark-up Confusion COPYRIGHT © 2012 South-Western/Cengage Learning 8 Mark-up on cost ≠ gross profit! Marking a $10 cost unit up 25% $10.00  125% =$12.50 Provides a gross profit of 20% $2.50  $12.50 =20%

Merchandise: Example S (P owns 80%) buys goods for $80,000 and sells them to P for $100,000; all sales are at 20% gross profit P’s inventory of intercompany goods –Beginning: $10,000 –Ending: $15,000 P owes S $8,000 for intercompany goods at year end COPYRIGHT © 2012 South-Western/Cengage Learning 9

Consolidation Procedures Needed ISEliminate sale from subsidiary to parent BIReduce cost of goods sold for profit in beginning inventory and correct beginning retained earnings (allocated 20/80 because sale was by subsidiary) EIReduce ending inventory and increase cost of goods sold (ending inventory value contains intercompany profit) IAEliminate intercompany trade balance COPYRIGHT © 2012 South-Western/Cengage Learning 10

Worksheet Eliminations COPYRIGHT © 2012 South-Western/Cengage Learning 11

Adjustments on the IDS COPYRIGHT © 2012 South-Western/Cengage Learning 12

Worksheet 4-3 The 4 eliminations are IS, IA, BI, EI In elimination BI, adjustment to RE is split because partially-owned sub was the seller. –If parent or wholly-owned sub is seller, adjust only to parent’s RE Seller’s profit is adjusted through IDS –In this case, the adjustments went to the sub (seller) –They would go to parent if parent was seller COPYRIGHT © 2012 South-Western/Cengage Learning 13

Worksheet 4-3 (continued) If there is an LCM adjustment, only the remaining profit is eliminated Losses (sales below market value) are also eliminated Worksheet 4-4 shows the same adjustments for a periodic inventory COPYRIGHT © 2012 South-Western/Cengage Learning 14

Intercompany Sale: Nondepreciable Asset COPYRIGHT © 2012 South-Western/Cengage Learning 15 Year of sale:LAGain on sale20,000 Land20,000 Run adjustment through seller’s IDS Gain is deferred until asset (land) is sold to outside party Later years:LARE (split?)20,000 Land20,000 Adjustment is split if seller was partially-owned Sub Year of sale to outside party: LARE (split?)20,000 Gain on sale20,000 Seller may finally recognize gain; credit to seller’s IDS

Intercompany Depreciable Asset Sale: Year of Sale COPYRIGHT © 2012 South-Western/Cengage Learning 16 Sell 5-year machine, NBV $20,000, for $30,000 on 1/1/2011 Theory: Defer gain and earn it back over period of use. The allocation method matches the depreciation method (straight- line for this example) Year of sale: F1Gain (seller)10,000 defer gain on sale Machine10,000 return asset to cost F2Accum. Depr.2,000 reduce to depr. on cost Depr. Expense2,000 recognize 1/5 profit IDS: Deduct original profit from seller and add profit equal to depreciation adjustment

Intercompany Depreciable Asset Sale: Year Subsequent to Intercompany Sale COPYRIGHT © 2012 South-Western/Cengage Learning 17 End of second year: Adjust asset at start of year F1RE (split?)8,000deferred gain on 1/1/12 Accum. Depr.2,000adjust prior year’s depr. Machine10,000return asset to cost RE adjustment is split when partially-owned sub is seller Adjust current year depreciation F2Accum. Depr.2,000reduce to depr on cost Depr. Expense2,000recognize 1/5 profit IDS: Seller gets profit equal to depreciation adjustment

Fixed Asset Worksheets WS 4-5 (year of sale) F1 eliminate $10,000 gain; reduce machine to book value F2 adjusts current depreciation and realizes $2,000 gain IDS of seller: defer $10,000 gain; realize $2,000 WS 4-6 (end of second period after sale) F1 removes profit from machine value; eliminates gain unrealized as of beginning of year from RE of seller; adjusts Accum Dep for profit realized in prior year(s) F2 adjusts current depreciation and realizes $2,000 gain IDS of seller: realize another $2,000 of the gain COPYRIGHT © 2012 South-Western/Cengage Learning 18

Fixed Asset Worksheets (continued) WS 4-7 (Asset sold to outside party at end of second year) Machinery and accumulated depreciation are not there to adjust The $6,000 remaining gain at the start of the year is now earned (sale to outside occurred) F3 Combining the $6,000 deferred gain ($10,000 original less $4,000 recognized - $2,000 in 2011 and 2012) and the recorded $4,000 loss on sale to outside party creates a gain on the consolidated statement of $2,000 COPYRIGHT © 2012 South-Western/Cengage Learning 19

Long-Term Construction Contracts Completed – Like any other fixed asset sale Not Complete using Completed Contract Method: –Eliminate seller’s Billings and Cost of Construction in Progress; adjust buyer’s Asset Under Construction for unbilled costs incurred by seller –Eliminate intercompany debt balance Not Complete using Percentage of Completion: –Key is to defer profit recorded by builder and restore asset under construction to cost –Eliminate intercompany debt balance COPYRIGHT © 2012 South-Western/Cengage Learning 20

Intercompany Debt Typically Parent lends to Sub Eliminations –LN1 Intercompany payables and receivables –LN2 Interest expense and revenue Income distribution schedule –Sub’s internally generated net income is not adjusted for incurred intercompany interest expense COPYRIGHT © 2012 South-Western/Cengage Learning 21

Sophisticated Equity Method: Intercompany Transactions Sophisticated equity method records subsidiary income net of all intercompany profits Parent prepares an IDS-Subsidiary to determine and record its share of subsidiary income Unrealized profits of prior periods –Parent’s beginning RE does not include –Sub’s beginning RE does include –Adj replaces BI to remove intercompany profit from Sub’s beginning RE and Parents’s beginning inv COPYRIGHT © 2012 South-Western/Cengage Learning 22