Further consolidation issues I: Accounting for intragroup transactions Chapter 29 Further consolidation issues I: Accounting for intragroup transactions Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 1

Objectives of this lecture Understand the nature of intragroup transactions Understand how and why to eliminate intragroup dividends on consolidation Understand how to account for intragroup sales of inventory inclusive of the related tax expense effects Understand how to account for intragroup sales of non-current assets inclusive of the related tax expense effects Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 2

Introduction to accounting for consolidation issues Overview During a financial period it is common for separate legal entities within an economic entity to transact with each other In preparing consolidated financial statements, the effects of all transactions between entities within the economic entity are eliminated in full, even where the parent entity holds only a fraction of the issued equity. Specifically, paragraph 20 of AASB 127 states in relation to the consolidation process that: Intragroup balances, transactions, income and expenses shall be eliminated in full Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 3

Introduction to accounting for consolidation issues (cont.) Examples of intragroup transactions Payment of dividends to group members Payment of management fees to a group member Intragroup sales of inventory Intragroup sales of non-current assets Intragroup loans Consolidation adjustments for intragroup transactions Typically eliminate these transactions by reversing the original accounting entries made to recognise the transactions in the separate legal entities Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 4

Dividend payments from pre- and post-acquisition earnings In the consolidation process it is necessary to eliminate: all dividends paid/payable to other entities within the group all dividends received/receivable from other entities within the group Only dividends paid externally should be shown in the consolidated financial statements AASB 127 requires that: on consolidation of intragroup balances, transactions, income and expenses are all to be eliminated in full Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 5

Dividend payments pre- and post-acquisition (cont.) Dividends paid from post-acquisition profits Only dividends paid externally should be shown in the consolidated financial statements Journal entry to eliminate dividends payable (in consolidation journal) Dr Dividends payable (statement of financial position) Cr Dividends declared (statement of changes in equity) Journal entry to eliminate dividends receivable (in consolidation journal) Dr Dividend income (statement of comprehensive income) Cr Dividend receivable (statement of financial position) Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 6

Dividend payments pre- and post-acquisition (cont.) Note Consolidation journal entries are not written in the journals of either company but are entered in a separate consolidation journal Refer to Worked Example 29.1 on pp. 900-902—Dividend payments to a subsidiary out of post-acquisition earnings Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 6

Worked Example 29.2—Dividend payments to a subsidiary out of post-acquisition earnings Company A acquired all the issued capital of Company B on 1 July 2011 for a cost of $800 000. The share capital and reserves of Company B on the date of acquisition are: Share capital $500 000 Retained earnings $300 000 $800 000 Dividends of $50 000 paid by Company B come from profits earned since 1 July 2011 It is considered that the assets of Company B are fairly stated at the date that Company A acquires its shares Company A recognises dividend income when it is declared by the investee The financial statements of Company A and Company B as at 30 June 2012 (one year later) reveal the following: Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e

Worked Example 29.2—Dividend payments to a subsidiary out of post-acquisition earnings (cont.) Company A Company B ($000) ($000) Reconciliation of opening and closing retained earnings Profit before tax 200 100 Tax expense 50 40 Profit after tax 150 60 Opening retained earnings—1 July 2011 400 300 550 360 less Dividends declared 70 50 Closing retained earnings—30 June 2012 480 310 Statement of financial position Shareholders’ funds Retained earnings 480 310 Share capital 500 500 Liabilities Accounts payable 1 000 100 Dividends payable 70 50 2 050 960 Assets Cash 100 70 Accounts receivable 50 130 Dividends receivable 50 – Inventory 200 160 Plant and equipment 850 600 Investment in Company B 800 – Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e

Worked Example 29.2—Solution In relation to recognising the dividends, the entry in Company B’s own journal would be: Dr Dividend declared (statement of changes in equity) 50 000 Cr Dividend payable (statement of financial position) 50 000 As Company A recognises dividend income when the dividend is declared by the investee, it would have the following entry in its own journal: Dr Dividend receivable (statement of financial position) 50 000 Cr Dividend income (statement of comprehensive income) 50 000 We need to know the entries the individual entities made (above) so that we can reverse them on consolidation Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e

Worked Example 29.2—Solution (cont.) Elimination entry for dividends declared by Company B Dr Dividend payable (statement of financial position) 50 000 Cr Dividend declared (statement of changes in equity) 50 000 Elimination entry for dividends receivable by Company A Dr Dividend income (statement of comprehensive income) 50 000 Cr Dividend receivable (statement of financial position) 50 000 Consolidation entry to eliminate investment in Company B Dr Share capital 500 000 Dr Retained earnings 300 000 Cr Investment in Company B 800 000 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e

Worked Example 29.2—Solution (cont.) Company A Company B Dr Cr Consolidated ($000) ($000) ($000) ($000) ($000) Reconciliation of opening and closing retained earnings Profit before tax 200 100 50(b) 250 Tax expense 50 40 90 Profit after tax 150 60 160 Opening retained earnings 400 300 300(c) 400 550 360 560 less Dividends declared 70 50 50(a) 70 Closing retained earnings 480 310 490 Statement of financial position Shareholders’ funds Retained earnings 480 310 490 Share capital 500 500 500(c) 500 Liabilities Accounts payable 1 000 100 1 100 Dividends payable 70 50 50(a) 70 2 050 960 2 160 Assets Cash 100 70 170 Accounts receivable 50 130 180 Dividends receivable 50 – 50(b) – Inventory 200 160 360 Plant and equipment 850 600 1 450 Investment in Company B 800 – 800(c) – 2 050 960 900 900 2 160 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e

Dividend payments pre- and post-acquisition (cont.) Dividends out of pre-acquisition profits If an entity pays dividends out of profits earned before acquisition, it is effectively returning part of the net assets originally acquired (return of part of investment in subsidiary) The traditional treatment was for the pre-acquisition dividends not to be treated as revenue, but rather as a return of part of the initial investment (this seemed logical) Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 7

Dividend payments pre- and post-acquisition (cont.) Dividends out of pre-acquisition profits (cont.) In 2008 the above treatment was changed and now dividends paid by a subsidiary are to be recorded as dividend revenue in the parent entity’s accounts, regardless of whether they are paid out of: (a) pre-acquisition profits/equity (that is, paid out of profits earned by the subsidiary prior to the purchase by the parent of the interest in the subsidiary), or (b) post-acquisition profits/equity (that is, paid out of profits earned by the subsidiary after the purchase by the parent entity of the interest in the subsidiary) Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e

Dividend payments pre- and post-acquisition (cont.) AASB 127 now states: An entity shall recognise a dividend from a subsidiary, jointly controlled entity or associate in profit or loss in its separate financial statements when its right to receive the dividend is established Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e

Intragroup sale of inventory From the group’s perspective, revenue should not be recognised until inventory is sold to parties outside the group We will need to eliminate any unrealised profits from the consolidated financial statements Unrealised profits result from inventory, which is sold within the group for a profit, remaining on hand within the group at the end of the period AASB 127 (par. 21) Intragroup balances and transactions, including income, expenses and dividends, are eliminated in full. Profits and losses resulting from intragroup transactions that are recognised in assets, such as inventory and fixed assets, are eliminated in full Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 10

Illustration of intragroup sale of inventory Let us assume that Company A controls Company B and: Company A sells $200 000 of inventory to Company B (see diagram next page) Company B in turn sells the inventory to an external organisation, Company C, for $350 000 What total amount of sales should be recorded in the consolidated financial statements? (Hint: What amount of sales was actually made to parties external to the group?) Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e

Company A Economic entity $200 000 $350 000 Company B Company B Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e

Intragroup sale of inventory (cont.) Each member of a group is typically taxed individually on its income, not the group collectively If tax has been paid by one member of the group, from the group’s perspective this represents a prepayment of tax (deferred tax asset) to the extent that the inventory remains within the group (meaning that the related profit is unrealised from the perspective of the economic entity) This income will not be earned by the economic entity until the inventory is sold outside the group Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 11

Intragroup sale of inventory (cont.) Journal entry to eliminate inter-company sales To eliminate total intragroup sales as no sales have occurred from perspective of group Dr Sales Cr Cost of goods sold (perpetual) or purchases (periodic) Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 12

Intragroup sale of inventory (cont.) Journal entry to eliminate unrealised profit in closing stock Accounting Standards require that inventory must be valued at the lower of cost and net realisable value. Therefore, on consolidation we must reduce the value of closing inventory to its cost to the economic entity Dr Cost of goods sold (perpetual) or closing inventory—(periodic) Cr Inventory Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 13

Intragroup sale of inventory (cont.) Consideration of tax paid on intragroup sale of inventory Any tax paid by members of the group related to intragroup sales where full amount of revenue has not been earned from the group’s perspective, effectively represents a prepayment of tax. The adjusting consolidation entry would be: Dr Deferred tax asset Cr Income tax expense Refer to Worked Example 29.3 on p. 908—Unrealised profit in closing inventory Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 14

Worked Example 29.3—Unrealised profit in closing inventory Big Ltd owns 100% of the shares of Little Ltd These shares are acquired on 1 July 2011 During the 2012 financial year, Little Ltd sells inventory to Big Ltd at a sales price of $200 000. The inventory cost Little Ltd $120 000 to produce At 30 June 2012 half of the stock is still on hand with Big Ltd. The tax rate is assumed to be 33% Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e

Worked Example 29.3—Unrealised profit in closing inventory—Consolidation entries Elimination of intragroup sales We need to eliminate the intragroup sales because, from the perspective of the economic entity, no sales have in fact occurred. This will ensure that we do not overstate the turnover of the economic entity Dr Sales 200 000 Cr Cost of goods sold 200 000 Elimination of unrealised profit in closing inventory The total profit earned by Little Ltd on the sale of the inventory is $80 000 Since some of this inventory remains in the economic entity, this amount has not been fully earned from the perspective of the group. In this case, half of the inventory is still on hand, so unrealised profit amounts to $40 000. In accordance with AASB 102 Inventories, we must value the inventory at the lower of cost and net realisable value Dr Cost of goods sold 40 000 Cr Inventory 40 000 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e

Worked Example 29.3—Unrealised profit in closing inventory—Consolidation entries (cont.) Consideration of the tax paid on the sale of inventory that is still held within the group From the group’s perspective, $40 000 has not been earned. However, from Little Ltd’s individual perspective (as a separate legal entity), the full amount of the sale has been earned This will attract a tax liability in Little Ltd’s accounts of $26 400 (33% of $80 000) However, from the group’s perspective, some of this will represent a prepayment of tax as the full amount has not been earned by the group even if Little Ltd is obliged to pay the tax Dr Deferred tax asset 13 200 Cr Income tax expense 13 200 ($40000 × 33%) Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e

Intragroup sale of inventory (cont.) Unrealised profit in opening inventory If there have been intragroup sales in the previous period, and some of the inventory is still on hand at the previous year end, then the cost of opening inventory held by one of the entities within the group will be overstated from the group’s perspective In the consolidation journal entries we need to shift income from the previous period, in which inventory was still on hand, to the period in which the inventory is ultimately sold to external parties Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 15

Intragroup sale of inventory (cont.) Unrealised profit in opening inventory (cont.) Consolidation entries: Unrealised profits in opening inventory Reducing opening inventory reduces cost of goods sold Dr Opening retained earnings Cr Cost of goods sold Higher profits lead to higher tax expense Dr Income tax expense Cr Opening retained earnings Consider Worked Example 29.4 (pp. 914–16)—Unrealised profit in opening inventory Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 16

Worked Example 29.4—Unrealised profit in opening inventory This worked example is a continuation of Worked Example 29.3. Eliminating unrealised profit in opening inventory From the previous example we know that there were unrealised profits in closing inventory in the previous financial period Therefore, in the consolidation adjustments of the current period we need to shift the income from the previous period, in which the inventory was still on hand, to the period in which the inventory will ultimately be sold to parties external to the economic entity The effect of reducing cost of goods sold is to increase consolidated profits in the current year Dr Opening retained earnings—1 July 2012 40 000 Cr Cost of goods sold 40 000 Consideration of the tax on the sale of inventory held within the group at the beginning of the reporting period Reducing the value of opening inventory will reduce the cost of goods sold. This entry will effectively shift the income from 2012 to 2013 Higher profits will lead to a higher tax expense, which is based upon accounting profits Dr Income tax expense 13 200 Cr Retained earnings—1 July 2012 13 200 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e

Sale of non-current assets within the group Assets of the group need to be valued as if the intragroup sale had not occurred Need to reinstate the non-current asset to the original cost or revalued amount Eliminate any unrealised profits on sale Adjust depreciation There may be tax on profit of sale, which will represent a temporary difference in the consolidated financial statements Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 17

Sale of non-current assets within the group (cont.) Consolidation journal entries to eliminate sale of non-current asset Reversing gain and reinstating accumulated depreciation Dr Gain on sale Dr Asset Cr Accumulated depreciation Recognising deferred tax asset Dr Deferred tax asset Cr Income tax expense Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 18

Sale of non-current assets within the group (cont.) Consolidation journal entries to eliminate sale of non-current asset (cont.) Adjusting depreciation to reflect correct amount Dr Accumulated depreciation Cr Depreciation expense Partially reversing deferred tax asset to reflect depreciation adjustment Dr Income tax expense Cr Deferred tax asset Refer to Worked Example 29.5 on pp. 917–20 —Intragroup sale of a non-current asset Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 19

Worked Example 29.5—Intragroup sale of a non-current asset On 1 July 2011 Eddie Ltd acquired a 100% interest in Sandy Ltd On 1 July 2011 Eddie Ltd sells an item of plant to Sandy Ltd for $780 000 This plant cost Eddie Ltd $1 million, is four years old and has accumulated depreciation of $400 000 at the date of the sale The remaining useful life of the plant is assessed as six years The tax rate is 30% Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e

Worked Example 29.5—Solution The result of the sale of the item of plant to Sandy Ltd is that the gain of $180 000—the difference between the sales proceeds of $780 000 and the carrying amount of $600 000—will be shown in Eddie Ltd’s financial statements However, from the economic entity’s perspective there has been no ‘sale’ and therefore no ‘gain on sale’ given that there has been no transaction with a party external to the group The following entry is necessary so that the financial statements will reflect the balances that would have applied had the intragroup sale not occurred Dr Gain on sale of plant 180 000 Dr Plant 220 000 Cr Accumulated depreciation 400 000 The result of this entry is that the intragroup gain is removed and the asset and accumulated depreciation accounts revert to reflecting the situation had no sales transaction occurred Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e

Worked Example 29.5—Solution (cont.) Impact of tax on gain on sale of item of plant From Eddie Ltd’s individual perspective it would have made a gain of $180 000 on the sale of the plant and this gain would have been taxable At a tax rate of 30%, $54 000 would be payable in tax by Eddie Ltd and $54 000 would similarly have been included in the income tax expense account However, from the economic entity’s perspective, no gain has been made, which means that the related ‘tax expense’ must be reversed and a related deferred tax benefit recognised Dr Deferred tax asset 54 000 Cr Income tax expense 54 000 Reinstating accumulated depreciation in the statement of financial position Sandy Ltd would be depreciating the asset on the basis of the cost it incurred to acquire the asset. Its depreciation charge would be $780 000 ÷ 6 = $130 000 From the economic entity’s perspective, the asset had a carrying value of $600 000, which was to be allocated over the next six years, giving a depreciation charge of $600 000 ÷ 6 = $100 000. An adjustment of 30 000 is therefore required Dr Accumulated depreciation 30 000 Cr Depreciation expense 30 000 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e

Worked Example 29.5—Solution (cont.) Consideration of the tax effect of the reduction in depreciation expense The increase in the tax expense from the perspective of the economic entity is due to the reduction in the depreciation expense The additional tax expense is $9000, which is $30 000 × 30% This entry represents a partial reversal of the deferred tax asset of $54 000 recognised in the earlier entry. After six years the balance of the deferred tax asset relating to the sale of the item of plant will be $nil Dr Income tax expense 9 000 Cr Deferred tax asset 9 000 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e

Summary The lecture considered the consolidation process and, in particular, how to account for intragroup transactions (e.g. dividend payments, sales of inventory, sales of non-current assets) Only dividends paid externally should be shown in the consolidated financial statements—intragroup dividends paid by one entity within the group are to be offset against the dividend revenue recorded in other entity Within the consolidation worksheet, the liability associated with dividends payable is to be offset against dividend receivable (as recorded by other entities within the group) Where intragroup sales of inventory have taken place and inventory remains on hand at year end, consolidation adjustments are required to reduce the consolidated balance of closing inventory (inventory is to be valued at lower of cost and net realisable value from the group’s perspective) Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 21

Summary Where there is sale of non-current assets within the group, consolidation adjustments are required to eliminate any intragroup profit on sale and to adjust the cost of the asset to reflect the cost of the asset to the economic entity—this may also require adjustments to depreciation expense If there are non-controlling interests, the effect of intragroup transactions will be still eliminated in full even though the parent entity might hold only a proportion of the capital of the respective subsidiaries Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 21