Chapter Five

1. Chapter Five Consolidated Financial Statements – Intercompany Asset Transactions

2. 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.

3. Intercompany Inventory Transactions ENTRY TI 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. Purchases component of COGS.

4. Unrealized Inventory GainsYear 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: Ending Inventory component of COGS.

5. Unrealized Inventory GainsYear 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. Subsidiary (In case of an upstream) Note – this part of the entry serves to increase the income for the current year (very important for upstream!)

6. Unrealized Inventory GainsYear 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. (see explanation on next slide)

7. Unrealized Inventory GainsYear Following Year of Transfer Recall from chapter 1, that the Equity Method, treats upstream sales the same way as downstream sales and that the following deferred (original) entry is made (which is reversed in the following year, when the inventory item is sold) (see page 18)

8. Unrealized Inventory GainsYear Following Year of Transfer A “C” Conversion entry may be required if a method other than the equity method were being used. In such a case, the deferral of unrealised gains’ impact on the subsidiary’s net income (and ultimately, the parent company’s income accrual) are ignored for downstream sales, but are adjusted for on upstream sales (because they affect the subsidiary’s net income)

9. Inventory TransfersExample 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.

10. Inventory TransfersExample { First, the entire intercompany transfer must be eliminated.

11. Inventory TransfersExample

12. Unrealized Inventory GainsEffect on Noncontrolling Interest • If the transfer is DOWNSTREAM, then any resulting unrealized gain belongs to the parent. • No effect on Noncontrolling Interest i.e. NCI’s share of income = NCI % x Sub Net Income • If the transfer is UPSTREAM, then any resulting unrealized gain belongs to the subsidiary. • Noncontrolling Interest must be adjusted for the unrealized gain. (see next slide)

13. Unrealized Inventory GainsEffect on Noncontrolling Interest Noncontrolling Interest in Sub Net Income = the noncontrolling % of the sub’s net income, AFTER eliminating both UPSTREAM unrealized intercompany profits (i.e. those reversed from prior year and those deferred from current year

14. Intercompany Land TransfersEliminating 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.

15. Intercompany Land TransfersEliminating 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. If it were a downstream sale and the equity method were being used by the parent, the Investment account would have been debited. (See page 227)

16. Intercompany Land TransfersEliminating 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.

17. Land TransfersExample 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.

18. Land TransfersExample This entry must be made at the end of each year as long as the land is still on the books.

19. The Effect of Land Transfers on Noncontrolling Interests What if the land transfer is UPSTREAM? If the transfer is DOWNSTREAM, there is no effect on noncontrolling interest.

20. The Effect of Land Transfers on Noncontrolling Interests 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 (as before) If the transfer is DOWNSTREAM, there is no effect on noncontrolling interest.

21. 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.

22. 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.

23. 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.

24. 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.

25. 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.

26. 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 1/1/04 + 2 years of depreciation.

27. Intercompany Transfer of Depreciable Assets The consolidation worksheet adjustments appear in the last column.

28. 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: As with land, if it were a downstream sale and the equity method were being used by the parent, the Investment account would have been debited. (See page 231)

29. 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:

30. End of Chapter 5 Hey, Chester, ol’ buddy! I’m thinkin’ we need to switch desks in a little “intercompany” transfer.