Consolidated Financial Statements: Intercompany Transactions Chapter 8 Consolidated Financial Statements: Intercompany Transactions

Scope of Chapter Accounting and working paper eliminations for related party transactions between a parent company and its subsidiaries can be grouped in two broad classes: Does not include inter company profits/losses. Includes inter company profits/losses.

Accounting Techniques Ensure that consolidated financial statements include only those balances and transactions resulting from the consolidated group’s dealings with outsiders. Separate ledger accounts established for all intercompany assets, liabilities, revenues and expenses.

Accounting for Inter company transactions not involving profit/loss Loans on notes or open accounts Leases of property under operating leases Rendering of services

Loans on Notes or Open Accounts Parent companies often make loans to their subsidiaries because of the following reasons: More extensive financial resources or bank lines of credit. Favorable interest rates to the parent company.

Accounting for Loans on Notes or Open Accounts Lending rate of these loans generally exceeds the parent company’s borrowing rate. Any interest earned by the parent company as a result of such loans must be eliminated Interest income/expense parent is offset against interest expense/income subsidiary

Discounting of intercompany notes If an intercompany note is discounted at a bank by the payee has following consequences: The note is not payable to an outsider – the bank. Discounted intercompany notes are not eliminated in a working paper for consolidated financial statements.

Leases of Property under operating Leases Both the parent and the subsidiary should use the same accounting principle for lease. Operating Lease Capital Lease Lessor: Receipts : Intercompany rent revenue Sale of Property Lessee: Payments : Intercompany rent expense Acquisition of Property

Rendering of Services Services may be rendered by a parent company to a subsidiary or vice versa. Both the companies should record the transaction in the same accounting period. Example: Management Fee charged to a subsidiary by a parent company.

Income Taxes Applicable to Intercompany Transactions Intercompany revenue and expense transactions do not include an element of profit or loss for the consolidated entity as expense for one is offset by income for another. Therefore, no income tax effects are associated with these transactions. Note: This holds true even if the parent and the subsidiary companies file separate tax returns.

Accounting for Intercompany Transactions Involving Profit/Loss Intercompany sales of merchandise. Intercompany sales of plant assets. Intercompany leases of property under capital/sales type leases. Intercompany sales of intangible assets. Acquisition of affiliate’s bonds.

Importance of Eliminating or Including Intercompany Profits/Losses While preparing the consolidated financial statements it is important to: Eliminate unrealized profits/losses relating to: Transactions within the affiliated group. Transactions with outsiders. Recognize realized profits/losses.

Intercompany Sales of Merchandise Intercompany sales of merchandise are a natural outgrowth of business combinations: Vertical business combinations: Downstream: Sales of merchandise from a parent company to its subsidiaries. Upstream: Sales of merchandise from subsidiaries to the parent company. Lateral: Sales of merchandise between two subsidiaries.

Accounting for Intercompany Sales of Merchandise Sale of merchandise may be made at: Sales price not involving any gross profit margin. Sales price involving a gross profit margin.

Intercompany Sales of Merchandise at cost This has the following effect in the preparation of consolidated financial statements: The cost of goods sold remains unaffected by the transaction. The closing inventories do not require any adjustment for price.

Intercompany Sales of Merchandise at profit Gross profit margin in these transactions may be equal to, more than or less than the margin on sales to outsiders. It has to be accounted using FIFO method as follows: Sales made by the purchasing company – the selling company’s profit is realized and so not adjustment is required. Closing Inventories – The selling company’s unrealized gross profit has to be eliminated while preparing the financial statements.

Intercompany Profit in Inventories and Amount of Minority Interest Two approaches have been suggested for intercompany sales/purchases transactions of partially owned subsidiaries: Parent Company Concept: Elimination of intercompany profit only to the extent of the parent company’s ownership interest. Economic Unit Concept: Elimination of all the intercompany profit. Note: The FASB has expressed a preference for the second approach.

Intercompany Sales of Plant Assets versus Sales of Merchandise Sales of plant assets are rare as compared to sales of merchandise. Sales of plant assets pass through many accounting periods before profit/loss are realized as compared to sales of merchandise where profit/loss are usually realized in the ensuing accounting period

Intercompany Sales of Land Valued at historical cost. Intercompany gain eliminated while preparing consolidated financial statements.

Intercompany Sales of Depreciable plant assets Valued at book value of the selling company while preparing consolidated financial statements. Intercompany gain element must be eliminated from the depreciation expense. In case of minority interest, intercompany gain in depreciation should be eliminated to the extent of the parent company’s ownership interest. Intercompany gain in later years must reflect that the gain element in the acquiring affiliate’s annual depreciation represents a realization of a portion of total gain by the selling affiliate.

Intercompany Lease of Property under Capital/Sales type Leases The assets are a sales-type lease to the lessor and a capital lease to the lessee. Appropriate ledger accounts must be established by the lessor and the lessee to account for the lease.

Intercompany Sales of Intangible Assets This is similar to gains in depreciable plant assets, but no accumulated amortization ledger account may be involved. The unrealized gain of the seller is realized via periodic amortization expense recognition by the acquiring company.

Acquisition of Affiliate’s Bonds Intercompany profits/losses can be realized by a consolidate entity when that entity acquires the bonds of the affiliate in the open market. The profit or loss of acquiring the bonds are imputed because the transaction in not consummated between the two affiliates. If however, the transaction were to result from a direct acquisition, the profit/loss would have to be eliminated. In case the acquiring company sells the bonds to outsiders before they mature, the transaction profit/loss is not realized by the the consolidated entity, hence eliminated.