Consolidated Financial Statements – Intercompany Asset Transactions Chapter Five Consolidated Financial Statements – Intercompany Asset Transactions McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Intercompany Inventory Transactions 5-2 Transactions between the parent and subsidiary are viewed as “internal” transactions of a single economic entity. The effects of intercompany transactions should be “eliminated” from the consolidated financial statements. 2

Intercompany Inventory Transactions 5-3 ENTRY TI On the consolidation worksheet, eliminate ALL intercompany sales/purchases of inventory. The elimination amount is the amount assigned as the “sales price” of the transfer. Purchases component of COGS. 3

Unrealized Inventory Gains Year of Transfer 5-4 ENTRY G Despite Entry TI, ending inventory is still overstated by the amount of gain on the inventory that is still unsold at year end. We must eliminate the unrealized gain as follows: Ending Inventory component of COGS. 4

Unrealized Inventory Gains Year Following Year of Transfer 5-5 ENTRY *G If the inventory was sold during the year, the gain is now in Retained Earnings and must be moved back to Income. 5

Unrealized Inventory Gains Year Following Year of Transfer 5-6 ENTRY *G If the transfer of inventory is DOWNSTREAM & if the parent uses the Equity Method, then the following entry is used to recognize the remaining unrealized profit left at the end of the previous year. 6

Inventory Transfers Example 5-7 On April 5, 2008, Grut Co (parent) buys 1,000 widgets from Lyts, Inc. for $500,000. The widgets originally cost Lyts, Inc. $400,000. At year-end on December 31, 2008, Grut Co. still had 250 of the units on hand. Record the consolidation entries on 12/31/08 to eliminate the unrealized gain. 7

Inventory Transfers - Example 5-8 { First, the entire intercompany transfer must be eliminated. 8

Inventory Transfers Example 5-9 8

Unrealized Inventory Gains Effect on Noncontrolling Interest 5-10 If the transfer is DOWNSTREAM, then any resulting unrealized gain belongs to the parent. No effect on Noncontrolling Interest If the transfer is UPSTREAM, then any resulting unrealized gain belongs to the subsidiary. Noncontrolling Interest must be adjusted for the unrealized gain. 9

Unrealized Inventory Gains Effect on Noncontrolling Interest 5-11 Noncontrolling Interest in Sub Net Income = the noncontrolling % of the sub’s net income, AFTER eliminating UPSTREAM unrealized intercompany profit.

Intercompany Land Transfers Eliminating Unrealized Gains 5-12 ENTRY TL If land is transferred between the parent and sub at a gain, the gain is considered unrealized and must be eliminated. By crediting land for the same amount, this effectively returns the land to its carrying value on the date of transfer. 10

Intercompany Land Transfers Eliminating Unrealized Gains 5-13 ENTRY *GL As long as the land remains on the books of the buyer, the unrealized gain must be eliminated at the end of each fiscal period. The original gain appeared on last period’s income statement. Now, the gain resides in R/E. Therefore, when we eliminate the gain, it must come from R/E. 11

Intercompany Land Transfers Eliminating Unrealized Gains 5-14 ENTRY *GL (Year of sale) In the year of disposal, modify the entry *GL, so that the unrealized gain must be eliminated one more time, and also recognized as a REALIZED gain in the current period’s consolidated financial statements. 12

Land Transfers Example 5-15 13

Land Transfers Example 5-16 14

The Effect of Land Transfers on Noncontrolling Interests 5-17 If the transfer is UPSTREAM, the gain is attributed to the SUBSIDIARY! All noncontrolling interest balances are to be based on the subsidiary’s net income EXCLUDING the intercompany gain If the transfer is DOWNSTREAM, there is no effect on noncontrolling interest. What if the land transfer is UPSTREAM?

Intercompany Transfer of Depreciable Assets 5-18 ENTRY TA In the year of transfer, the unrealized gain must be eliminated and the assets restated to original historical cost. 15

Intercompany Transfer of Depreciable Assets 5-19 ENTRY ED In addition, the buyer’s depreciation is based on the inflated transfer price. The excess depreciation expense must be eliminated. 16

Intercompany Transfer of Depreciable Assets 5-20 In Years Following the Year of Transfer The equipment is carried on the individual books at a different amount than on the consolidated books. These amounts change each year as depreciation is computed. To get the worksheet adjustments, compare the individual records to the consolidated records. 17

Intercompany Transfer of Depreciable Assets 5-21 Mor Trucking owns 80% of Beag Delivery, Inc. On 1/1/07, Beag Delivery has a truck on the books with an original cost of $100,000, and accumulated depreciation of $60,000 (4 years remaining useful life, $0 salvage value, straight-line depreciation). Beag Delivery sells the truck to Mor for $80,000 on 1/1/07. Analyze the information in preparation for making entries on 12/31/08. 17

Intercompany Transfer of Depreciable Assets 5-22 On Mor’s books, the annual depreciation = $80,000 ÷ 4 yrs. = $20,000 per year. The 1/1/08 R/E effect = the original gain of $40,000 on Quick Delivery’s books less 1 year of depreciation. 17

Intercompany Transfer of Depreciable Assets 5-23 For the consolidated entity, the annual depreciation = $40,000 remaining BV ÷ 4 yrs. = $10,000 per year. The Acc. Depr. At 12/31/08 = $60,000 accumulated depreciation at 1/1/07 + 2 years of depreciation. 17

Intercompany Transfer of Depreciable Assets 5-24 The consolidation worksheet adjustments appear in the last column. 17

Intercompany Transfer of Depreciable Assets 5-25 ENTRY *TA (Subsequent Years) The adjustment to fixed assets and depreciation expense must be made in each succeeding period. The entry for the Mor/Beag Delivery Consolidation is: 17

Intercompany Transfer of Depreciable Assets 5-26 ENTRY ED (Subsequent Years) In addition, we must adjust for the difference in Depreciation Expense on the two income statements. The entry for our example is: 16

Summary 5-27 Transfers of assets between the members of a business combination are common. In producing consolidated financial statements, the effects of these transfers on the separate accounting records must be removed Transfers of depreciable assets create the additional accounting problem of differing depreciation amounts. These effects must be dealt with on the consolidated worksheets

Possible Criticisms 5-28 No formal accounting pronouncements deal with the valuation of noncontrolling interests in the deferral and subsequent realization of intercompany gains. Traditionally, the deferral of gains from upstream sales is presumed to affect the noncontrolling interest, whereas downstream sales do not. WHAT DO YOU THINK?