1. Further consolidation issues I: Accounting for intragroup transactions
Chapter 29
Further consolidation issues I: Accounting for intragroup transactions
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2. 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
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3. 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
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4. 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
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5. 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
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6. 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)
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7. 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 —Dividend payments to a subsidiary out of post-acquisition earnings
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8. 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 $ The share capital and reserves of Company B on the date of acquisition are:
Share capital $
Retained earnings $ $
Dividends of $ 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:
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9. 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
Tax expense
Profit after tax
Opening retained earnings—1 July
less Dividends declared
Closing retained earnings—30 June
Statement of financial position
Shareholders’ funds
Retained earnings
Share capital
Liabilities
Accounts payable
Dividends payable
Assets
Cash
Accounts receivable
Dividends receivable 50 –
Inventory
Plant and equipment
Investment in Company B –
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10. 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)
Cr Dividend payable (statement of financial position)
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)
Cr Dividend income (statement of comprehensive income)
We need to know the entries the individual entities made (above) so that we can reverse them on consolidation
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11. Worked Example 29.2—Solution (cont.)
Elimination entry for dividends declared by Company B
Dr Dividend payable (statement of financial position)
Cr Dividend declared (statement of changes in equity)
Elimination entry for dividends receivable by Company A
Dr Dividend income (statement of comprehensive
income)
Cr Dividend receivable (statement of financial position)
Consolidation entry to eliminate investment in Company B
Dr Share capital
Dr Retained earnings
Cr Investment in Company B
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12. 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 (b) 250
Tax expense
Profit after tax
Opening retained earnings (c) 400
less Dividends declared (a) 70
Closing retained earnings
Statement of financial position
Shareholders’ funds
Retained earnings
Share capital (c) 500
Liabilities
Accounts payable
Dividends payable (a) 70
Assets
Cash
Accounts receivable
Dividends receivable 50 – 50(b) –
Inventory
Plant and equipment
Investment in Company B – 800(c) –
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13. 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)
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14. 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)
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15. 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
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16. 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
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17. Illustration of intragroup sale of inventory
Let us assume that Company A controls Company B and:
Company A sells $ of inventory to Company B (see diagram next page)
Company B in turn sells the inventory to an external organisation, Company C, for $
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?)
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18. Company A Economic entity $200 000 $350 000 Company B Company B
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19. 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
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20. 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)
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21. 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
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22. 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
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23. 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 $ The inventory cost Little Ltd $ 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%
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24. 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
Cr Cost of goods sold
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 $ 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
Cr Inventory
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25. 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, $ 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 $ (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
Cr Income tax expense
($40000 × 33%)
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26. 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
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27. 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
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28. 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
Cr Cost of goods sold
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
Cr Retained earnings—1 July
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29. 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
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30. 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
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31. 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
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32. 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 $
This plant cost Eddie Ltd $1 million, is four years old and has accumulated depreciation of $ at the date of the sale
The remaining useful life of the plant is assessed as six years
The tax rate is 30%
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33. Worked Example 29.5—Solution
The result of the sale of the item of plant to Sandy Ltd is that the gain of $ —the difference between the sales proceeds of $ and the carrying amount of $ —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
Dr Plant
Cr Accumulated depreciation
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
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34. 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 $ on the sale of the plant and this gain would have been taxable
At a tax rate of 30%, $ would be payable in tax by Eddie Ltd and $ 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
Cr Income tax expense
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 $ ÷ 6 = $
From the economic entity’s perspective, the asset had a carrying value of $ , which was to be allocated over the next six years, giving a depreciation charge of $ ÷ 6 = $ An adjustment of is therefore required
Dr Accumulated depreciation
Cr Depreciation expense
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35. 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%
This entry represents a partial reversal of the deferred tax asset of $ 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
Cr Deferred tax asset
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36. 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)
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37. 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
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