© The McGraw-Hill Companies, Inc., 2004 Slide 5-1 McGraw-Hill/Irwin Chapter Five Consolidated Financial Statements – Intercompany Asset Transactions

© The McGraw-Hill Companies, Inc., 2004 Slide 5-2 McGraw-Hill/Irwin Intercompany Inventory Transactions Transactions between the parent and subsidiary are viewed as “internal” transactions of a single economic entity. The effects of those transactions should be “eliminated” from the consolidated financial statements.

© The McGraw-Hill Companies, Inc., 2004 Slide 5-3 McGraw-Hill/Irwin Purchases component of COGS. Intercompany Inventory Transactions ENTRY TI ALL 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.

© The McGraw-Hill Companies, Inc., 2004 Slide 5-4 McGraw-Hill/Irwin Ending Inventory component of COGS. Unrealized Inventory Gains Year of Transfer 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:

© The McGraw-Hill Companies, Inc., 2004 Slide 5-5 McGraw-Hill/Irwin Unrealized Inventory Gains Year Following Year of Transfer ENTRY *G If the inventory was sold during the year, the gain is now in Retained Earnings and must be moved back to Income. ENTRY *G If the inventory was sold during the year, the gain is now in Retained Earnings and must be moved back to Income.

© The McGraw-Hill Companies, Inc., 2004 Slide 5-6 McGraw-Hill/Irwin Unrealized Inventory Gains Year Following Year of Transfer 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.

© The McGraw-Hill Companies, Inc., 2004 Slide 5-7 McGraw-Hill/Irwin Inventory Transfers Example On April 5, 2005 World Co (parent) buys 1,000 widgets from Sub, Inc. for $500,000. The widgets originally cost Sub, Inc. $400,000. At year-end on December 31, 2005, World Co. still had 250 of the units on hand. Record the consolidation entries on 12/31/05 to eliminate the unrealized gain. On April 5, 2005 World Co (parent) buys 1,000 widgets from Sub, Inc. for $500,000. The widgets originally cost Sub, Inc. $400,000. At year-end on December 31, 2005, World Co. still had 250 of the units on hand. Record the consolidation entries on 12/31/05 to eliminate the unrealized gain.

© The McGraw-Hill Companies, Inc., 2004 Slide 5-8 McGraw-Hill/Irwin Inventory Transfers Example First, the entire intercompany transfer must be eliminated. {

© The McGraw-Hill Companies, Inc., 2004 Slide 5-9 McGraw-Hill/Irwin Inventory Transfers Example

© The McGraw-Hill Companies, Inc., 2004 Slide 5-10 McGraw-Hill/Irwin Unrealized Inventory Gains Effect on Noncontrolling Interest 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. 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.

© The McGraw-Hill Companies, Inc., 2004 Slide 5-11 McGraw-Hill/Irwin Noncontrolling Interest in Sub Net Income = the noncontrolling % of the sub’s net income, AFTER eliminating UPSTREAM unrealized intercompany profit. Unrealized Inventory Gains Effect on Noncontrolling Interest

© The McGraw-Hill Companies, Inc., 2004 Slide 5-12 McGraw-Hill/Irwin Intercompany Land Transfers Eliminating Unrealized Gains 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.

© The McGraw-Hill Companies, Inc., 2004 Slide 5-13 McGraw-Hill/Irwin Intercompany Land Transfers Eliminating Unrealized Gains 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. 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.

© The McGraw-Hill Companies, Inc., 2004 Slide 5-14 McGraw-Hill/Irwin Intercompany Land Transfers Eliminating Unrealized Gains 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. 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.

© The McGraw-Hill Companies, Inc., 2004 Slide 5-15 McGraw-Hill/Irwin Land Transfers Example On June 25, 2004 World Co. (parent) sells a 30 acre tract of land originally costing $600,000 to Sub, Inc. for $750,000. At year-end on December 31, 2006 Sub Inc. still owns the land. Record the appropriate consolidation entry on 12/31/06. On June 25, 2004 World Co. (parent) sells a 30 acre tract of land originally costing $600,000 to Sub, Inc. for $750,000. At year-end on December 31, 2006 Sub Inc. still owns the land. Record the appropriate consolidation entry on 12/31/06.

© The McGraw-Hill Companies, Inc., 2004 Slide 5-16 McGraw-Hill/Irwin This entry must be made at the end of each year as long as the land is still on the books. Land Transfers Example

© The McGraw-Hill Companies, Inc., 2004 Slide 5-17 McGraw-Hill/Irwin What if the land transfer is UPSTREAM? The Effect of Land Transfers on Noncontrolling Interests If the transfer is DOWNSTREAM, there is no effect on noncontrolling interest. 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 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

© The McGraw-Hill Companies, Inc., 2004 Slide 5-18 McGraw-Hill/Irwin Intercompany Transfer of Depreciable Assets ENTRY TA In the year of transfer, the unrealized gain must be eliminated and the assets restated to original historical cost. ENTRY TA In the year of transfer, the unrealized gain must be eliminated and the assets restated to original historical cost.

© The McGraw-Hill Companies, Inc., 2004 Slide 5-19 McGraw-Hill/Irwin Intercompany Transfer of Depreciable Assets ENTRY ED In addition, the buyer’s depreciation is based on the inflated transfer price. The excess depreciation expense must be eliminated. ENTRY ED In addition, the buyer’s depreciation is based on the inflated transfer price. The excess depreciation expense must be eliminated.

© The McGraw-Hill Companies, Inc., 2004 Slide 5-20 McGraw-Hill/Irwin Intercompany Transfer of Depreciable Assets 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. 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.

© The McGraw-Hill Companies, Inc., 2004 Slide 5-21 McGraw-Hill/Irwin Intercompany Transfer of Depreciable Assets Big Wheel Trucking (BWT) owns 80% of Quick Delivery, Inc. On 1/1/04, Quick Delivery has a truck on the books with an original cost of $100,000, and accumulated depreciation of $60,000 (4 year remaining useful life, $0 salvage value, straight-line). Quick Delivery sells the truck to BWT for $80,000. Analyze the information in preparation for making entries on 12/31/05. Big Wheel Trucking (BWT) owns 80% of Quick Delivery, Inc. On 1/1/04, Quick Delivery has a truck on the books with an original cost of $100,000, and accumulated depreciation of $60,000 (4 year remaining useful life, $0 salvage value, straight-line). Quick Delivery sells the truck to BWT for $80,000. Analyze the information in preparation for making entries on 12/31/05.

© The McGraw-Hill Companies, Inc., 2004 Slide 5-22 McGraw-Hill/Irwin Intercompany Transfer of Depreciable Assets On BWT’s books, the annual depreciation = $80,000 ÷ 4 yrs. = $20,000 per year. The 1/1/05 R/E effect = the original gain of $40,000 on Quick Delivery’s books less 1 year of depreciation.

© The McGraw-Hill Companies, Inc., 2004 Slide 5-23 McGraw-Hill/Irwin Intercompany Transfer of Depreciable Assets For the consolidated entity, the annual depreciation = $40,000 remaining BV ÷ 4 yrs. = $10,000 per year. The Acc. Depr. At 12/31/05 = $60,000 accumulated depreciation at 1/1/ years of depreciation.

© The McGraw-Hill Companies, Inc., 2004 Slide 5-24 McGraw-Hill/Irwin Intercompany Transfer of Depreciable Assets The consolidation worksheet adjustments appear in the last column.

© The McGraw-Hill Companies, Inc., 2004 Slide 5-25 McGraw-Hill/Irwin Intercompany Transfer of Depreciable Assets ENTRY *TA (Subsequent Years) The adjustment to fixed assets and depreciation expense must be made in each succeeding period. The entry for the BWT/Quick Delivery Consolidation is:

© The McGraw-Hill Companies, Inc., 2004 Slide 5-26 McGraw-Hill/Irwin Intercompany Transfer of Depreciable Assets 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: 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:

© The McGraw-Hill Companies, Inc., 2004 Slide 5-27 McGraw-Hill/Irwin Hey, Chester, ol’ buddy! I’m thinkin’ we need to switch desks in a little “intercompany” transfer. End of Chapter 5