1. Electronic Presentations in Microsoft® PowerPoint®
Prepared by
James Myers, C.A.
University of Toronto
© 2008 McGraw-Hill Ryerson Limited
Chapter 7

2. Inventory and Land Profits
Chapter 7
Intercompany
Inventory and Land Profits
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

3. © 2008 McGraw-Hill Ryerson Limited
Learning Objectives
Describe the effect on consolidated net income of the elimination of both intercompany revenues (and expenses) and intercompany asset profits
Prepare consolidated financial statements that reflect the elimination of upstream and downstream intercompany profits in inventory and land
Prepare consolidated financial statements that reflect the realization of upstream and downstream intercompany profits in inventory and land that were held back in previous periods
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

4. © 2008 McGraw-Hill Ryerson Limited
Learning Objectives
Explain how the revenue recognition and matching principles are used to support adjustments for intercompany transactions when preparing consolidated financial statements
Prepare the journal entries under the equity method to reflect the elimination and subsequent realization of intercompany profits in inventory and land
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

5. Intercompany Revenue & Expenses
Parents and subsidiaries frequently have sales and purchases transactions between each other, or other transactions such as intercompany rent, management fees, and interest.
Intercompany transactions are recorded in the books of each of the individual legal entities.
These amounts would be included in separate company statements, and reported on separate company income tax returns which are based on the separate company financial statements, not on the consolidated financial statements.
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

6. Intercompany Revenue & Expenses
However, in the consolidated financial statements:
All intercompany sales or other intercompany income must be eliminated against the related purchase or intercompany expense.
All intercompany balances (including receivables and payables) are eliminated against each other
Companies must have systems in place that can capture full information regarding both internal and external sales and purchases, in order that the appropriate eliminations may be identified and made in the consolidated financial statements
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

7. Intercompany Revenue & Expenses
The selling company will generally have recorded a profit on the intercompany sales
These profits are “unrealized” because they are only within the combined entity, they are not objectively measurable, and are not with an arm’s-length outsider.
Intercompany sales are like moving a coin from one pocket in a pair of pants to the other pocket: the pants still contain the same coin and no income has been earned.
Intercompany sales do not reflect the culmination of the earnings process.
These unrealized profits must be eliminated net of related income taxes paid.
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

8. Examples of Intercompany Revenue and Expenses
Intercompany management fees - often the parent will charge its subsidiary companies a management fee as means of allocating head office cost to all the companies within the group.
Intercompany rentals - occasionally buildings or equipment owned by one company are used by another company within the group with a corresponding rental charge.
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

9. Examples of Intercompany Revenue and Expenses
Intercompany interest revenue and expense – one company may record interest income on a loan to another company which records a corresponding interest expense.
Intercompany revenues and expenses must be eliminated against each other on the consolidated income statement.
Since equal amounts of income and expense are being eliminated, there is no net effect on consolidated income.
Only revenues and expenses incurred with outside parties should be reflected on the consolidated income statement.
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

10. Intercompany Profits in Inventory
Inventory is often sold from one company to another within a consolidated group.
Any inventory sold within the group but not subsequently sold outside must be shown at its original cost with the unrealized profit eliminated net of the associated income tax.
We have to “hold back” any unrealized net-of-tax profit for consolidation purposes.
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

11. Intercompany Profits in Inventory
The matching of expenses with revenues is a basic accounting concept; the adjustment made for income taxes is a perfect example of this matching process.
Income tax should be expensed in the same period as revenue is recorded.
Section 1000 of the Handbook reinforces this concept as follows:
Expenses that are linked to revenue-generating activities in a cause-and-effect relationship are normally matched with revenue in the accounting period in which the revenue is recognized [ ]
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

12. Intercompany Profits in Inventory
Income taxes paid by the seller on the profits technically meet the definition of a temporary difference and would normally give rise to future income taxes.
However, Handbook Section 3465 explicitly states:
A future income tax liability or asset should not be recognized in the consolidated financial statements for a temporary difference arising between the tax basis of the asset in the buyer’s tax jurisdiction and its cost as reported in the consolidated financial statements. Any taxes paid or recovered by the transferor as a result of the transfer should be recorded as an asset or liability in the consolidated financial statements until the gain or loss is recognized by the consolidated entity [ ]
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

13. Intercompany Profits in Inventory
The entry to eliminate unrealized gross profit in ending inventory takes this general form:
Cost of goods sold xxx
Ending Inventory xxx
The tax paid by the seller on the profit is deferred as an asset:
Deferred charge – income tax xxx
Tax expense xxx
Note that tax expense has been reduced to match the reduced income.
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

14. Intercompany Profits in Inventory
The elimination of unrealized profits from intercompany inventory sales in one year has the opposite effect in the following year.
Cost of Sales = Opening Inventory + Purchases – Ending Inventory
In the year following the intercompany sale, opening inventory is inflated by the unrealized profit, therefore cost of sales is inflated.
Therefore, reduce cost of sales in the following year, thus “realizing” the profit.
Corresponding income tax expense is then recorded.
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

15. Intercompany Profits in Inventory
In the first year:
Cost of goods sold is increased as ending inventory is decreased to its original cost
The profit is held back until realized through sale to outsider
The tax effect is established
In subsequent year
Cost of goods sold is decreased as beginning inventory is decreased to original cost
The profit is now realized in the financial statements
The tax effect is now reversed
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

16. Intercompany Profits in Inventory
The entry to recognize unrealized gross profit held back from the prior year takes this general form:
Retained earnings xxx
Cost of goods sold xxx
The tax effect is also recognized
Tax expense xxx
Deferred charge-income tax xxx
Note that profit has now been increased, so associated tax expense also must be increased
The deferred tax balance is now zero as the tax expense has now been recorded.
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

17. Intercompany Profits in Inventory
When profit is recorded by the subsidiary on inventory sold to the parent (an “upstream” sale) then a portion of the after-tax unrealized profit elimination is assigned to noncontrolling interest.
Example: $360 after-tax profit in ending inventory sold by 90% subsidiary to parent
Effect on NCI is 10% x $360 = $36
Reflect on consolidated financial statements with the following entry:
NCI (balance sheet) $36
NCI (income statement) $36
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

18. Intercompany Profits in Inventory
What is the net effect of these eliminations?
The profit is deferred (“held back”) until realized in an arms’ length transaction with an unrelated party
The financial statements are shown as if the transaction had never occurred, until it is eventually realized
The elimination of unrealized profits is an essential element of the fair presentation of consolidated financial statements.
Without these eliminations, profit could readily be manipulated.
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

19. Intercompany Land Profit Holdback
Companies often redistribute assets among various corporate divisions within a group
land and other non-depreciable assets may be sold intercompany
The selling company will normally recognize a gain or loss on the sale, and the buying company will record the assets at the price charged by the seller.
This cost may be higher or lower than the cost to the selling company
The company must track the original cost and the intercompany unrealized gain or loss
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

20. Intercompany Land Profit Holdback
The gain or loss on these intercompany sales is always unrealized to the group until and unless the asset is subsequently sold to a buyer outside the group
The unrealized intercompany gain must be eliminated
All adjustments are made with the objective of presenting the statements of the group to report as if the transaction between the companies had never taken place
The asset is restated to its original cost to the seller
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

21. Intercompany Land Profit Holdback
Implications of intercompany transactions:
The intercompany gain and associated income taxes are eliminated on the income statement in the year of the sale
The asset is restated to its original cost on any balance sheet prepared after the intercompany sale
This is repeated each period until the asset is sold to an outside party.
Retained earnings is adjusted for the effect of the elimination and change in asset value
This adjustment is repeated every period until (and unless) the asset is sold outside the corporate group.
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

22. Intercompany Land Profit Holdback
The necessary elimination entry takes this general form:
Gain xxx
Asset xxx
The entry is repeated in periods subsequent to the intercompany transfer, through an adjustment to retained earnings:
Retained Earnings xxx
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

23. Intercompany Land Profit Holdback
The tax effect of the elimination entry takes this general form:
Deferred charge – income tax xxx
Tax expense xxx
The entry is repeated in years subsequent to the intercompany sale, through an adjustment to retained earnings:
Retained earnings xxx
The direct approach requires calculations of the unrealized gains and their tax effects
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

24. Intercompany Land Profit Holdback
Further implication:
Non-controlling interest must be adjusted to eliminate all upstream gains and losses net of income taxes.
Example: Subsidiary 90% owned by parent sells land to parent for a gain of $1,300 after-tax
Effect on NCI is 10% x $1,300 = $130
Reflect on consolidated financial statements with the following entry:
NCI (balance sheet) $130
NCI (income statement) $130
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

25. Consolidated Theories and Intercompany Profits
We will return to the three theories of consolidation and examine what they have to say regarding the elimination of intercompany profits
There are two types of intercompany profits to consider:
Those resulting from downstream sales (i.e., where the parent sells to its subsidiaries)
Those resulting from upstream sales (i.e., where a subsidiary sells to the parent)
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

26. Consolidated Theories and Intercompany Profits
Proprietary Theory views the entity from the perspective of the shareholders of the parent company and does not acknowledge the existence of a noncontrolling interest in the consolidated financial statements
Profits resulting from sales to or purchases from its group are consider to be partially realized
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

27. Consolidated Theories and Intercompany Profits
Only the parent company’s share of intercompany profits from upstream and downstream transactions is eliminated when preparing consolidated statements
This is known as the fractional elimination of intercompany profits
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

28. Consolidated Theories and Intercompany Profits
Parent Theory views the entity from the perspective of the shareholders of the parent company; however it does acknowledge the existence of a noncontrolling interest by showing it as a liability
Since this noncontrolling interest is considered to be an outside group, the fractional elimination of intercompany profits resulting from upstream and downstream transactions is seen as appropriate
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

29. Consolidated Theories and Intercompany Profits
Entity theory views the consolidated entity as having two distinct groups of shareholders - the controlling shareholders and the noncontrolling interest
All intercompany profits, upstream and downstream, are eliminated
The profit eliminated as a result of an upstream transaction is allocated to both the controlling and the noncontrolling interest
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

30. Consolidated Theories and Intercompany Profits
The relevance statement from the CICA Handbook regarding the elimination of intercompany profits (losses) as follows:
Unrealized intercompany gains and losses arising subsequent to the date of an acquisition on assets remaining within the consolidated group should be eliminated. The amount of elimination from assets should not be affected by the existence of a non-controlling interest [ ]
Where there is an unrealized intercompany gain or loss recognized by a subsidiary company in which there is a non-controlling interest, such gain or loss should be eliminated proportionately between the parent and non-controlling interest in that company’s income [ ]
Chapter 7
© 2008 McGraw-Hill Ryerson Limited

31. © 2008 McGraw-Hill Ryerson Limited
International view
Elimination of unrealized intercompany profits is such an integral part of the consolidation process that most countries follow this practice.
IASB and FASB require elimination of unrealized profits.
IAS 16 permits the revaluation of land to fair value where Canadian GAAP requires it to be carried at cost.
Chapter 7
© 2008 McGraw-Hill Ryerson Limited