Intercompany Inventory and Land Profits

1. Chapter 7 1 Chapter 7 Intercompany Inventory and Land Profits

2. Chapter 7 2 Learning Objectives This chapter summarizes all consolidation issues Unrealized profits in Intercompany sales (Cost Method) How to deal with them in year of sale How to deal with them in future years Unrealized profits in intercompany sales (Equity method)

3. Chapter 7 3 Intercompany sales / purchases Get recorded in the books of the separate legal entities Need to be eliminated (ie. removed) when consolidating parent and sub

4. Chapter 7 4 Examples of Intercompany Revenue and Expenses Purchase of inventory Sale of assets Intercompany management fees Intercompany rentals All intercompany revenues and expenses These items are eliminated to ensure that revenue is only recognized when it is earned with a party outside of the consolidated entity and to stop the double-counting of revenues and expenses

5. Chapter 7 5 Intercompany Profits in Inventory Inventory is often transferred from one company to another within a consolidated group Any inventory sold within the group but not subsequently sold outside might have unrealized profits We have to �eliminate� any unrealized profit for consolidation purposes We also must make an adjustment for the income taxes and non-controlling interest relating to that profit

6. Chapter 7 6 Consolidation process � year 1 Changes from previous chapter: 1) Sales and COGS is reduced by the amount sold 2) Unrealized profit in Ending inventory is removed from inventory 3) Unrealized profit in Ending Inventory is added to COGS 4) Income tax on unrealized profit is removed from income tax expense and added to Deferred Charge, Future Income taxes (B/S) Why is unrealized profit in Ending Inventory added to COGS? COGS = BI + Purchases � Ending inventory If ending inventory is reduced, then COGS will increaseWhy is unrealized profit in Ending Inventory added to COGS? COGS = BI + Purchases � Ending inventory If ending inventory is reduced, then COGS will increase

7. Chapter 7 7 Consolidation process � year 2 The unrealized profit is now realized and the adjustments made in year 1 are reversed on the I/S. Subtract the unrealized profit from COGS Add the income tax expense associated with the unrealized profit Note: No adjustments for inventory or deferred tax is needed on the B/S.

8. Chapter 7 8 example On Jan 1, yr 1, P acquires 90% of the common stock of S for $11,250. On that day, Sub had common stock of $8000 and Retained Earnings of $4500 and there were no differences between the FV and BV of its identifiable net assets. Assume that during year 1, S sells inventory to P for $5000 at a gross profit rate of 30%. At the end of the year, P has $2000 of these items in inventory. S�s tax rate is 40%.

9. Chapter 7 9 Notes: unrealized intercompany profits Adjustments to be made in year of sale: Remove interco sales/COGS Remove unrealized profit in Ending inventory Add unrealized profit to COGS Reduce income tax expense Increase Deferred charge �income tax

10. Chapter 7 10 example In year 2, assume the inventory is sold. Statements are in Ex. 7.4. Notes: Reverse adjustments from year 1 on I/S

11. Chapter 7 11 If sales are downstream Ie. Parent sells to sub The only difference is that you don�t need to make adjustments to Non-controlling interest since it is only the parent who is affected. The rest of the concepts are the same. Example: same as before but assume that the parent is selling to sub: P sells inventory to S for $5000 at a gross profit rate of 30%. At the end of the year, S has $2000 of these items in inventory. P�s tax rate is 40%.

12. Intercompany Profits in Inventory Year of Sale The entry to eliminate unrealized gross profit in ending inventory takes this general form: Cost of goods sold xxx Ending Inventory xxx The tax effect is also recognized Future income tax asset xxx (Deferred taxes) Tax expense xxx Note that profit has been reduced, so associated tax expense has also been reduced. The tax has already been paid so there is a future tax asset.

13. Chapter 7 13 Intercompany Profits in Inventory Adjust non-controlling interest (year of sale): Non-controlling interest (B/S) xxx Non-controlling interest (I/S) xxx (for a unrealized profit)

14. Chapter 7 14 Intercompany Profits in Inventory The year inventory is sold: Entries are reversed since the profit is now realized: Retained earnings xxx Cost of goods sold xxx Tax expense xxx Retained earnings xxx

15. Chapter 7 15 Intercompany Profits in Inventory Adjust non-controlling interest in year of sale: Non-controlling interest (I/S) xxx Non-controlling interest (B/S) xxx (for a unrealized profit which is now realized)

16. Chapter 7 16 Intercompany Profits in Inventory In the first year: Cost of goods sold is increased as ending inventory is written down

17. Chapter 7 17 Intercompany Profits in Inventory In the first year: Cost of goods sold is increased as ending inventory is written down In subsequent year: Cost of goods sold is decreased as beginning inventory is written down

18. Chapter 7 18 Intercompany Profits in Inventory In the first year: Cost of goods sold is increased as ending inventory is written down The profit is held back until realized through external sale In subsequent year Cost of goods sold is decreased as beginning inventory is written down

19. Chapter 7 19 Intercompany Profits in Inventory In the first year: Cost of goods sold is increased as ending inventory is written down The profit is held back until realized through external sale In subsequent year Cost of goods sold is decreased as beginning inventory is written down The profit is now realized in the financial statements

20. Chapter 7 20 Intercompany Profits in Inventory In the first year: Cost of goods sold is increased as ending inventory is written down The profit is held back until realized through external sale The tax effect is established In subsequent year Cost of goods sold is decreased as beginning inventory is written down The profit is now realized in the financial statements

21. Chapter 7 21 Intercompany Profits in Inventory In the first year: Cost of goods sold is increased as ending inventory is written down The profit is held back until realized through external sale The tax effect is established In subsequent year Cost of goods sold is decreased as beginning inventory is written down The profit is now realized in the financial statements The tax effect is now reversed

22. Chapter 7 22 Intercompany Profits in Inventory What is the net effect of these eliminations? The financial statements are shown as if the transaction had never occurred, until it is eventually realized

23. Chapter 7 23 Intercompany land and other asset sales

24. Chapter 7 24 Intercompany Land Profit Holdback Same idea: unrealized gains/losses for the combined entity must be removed and taxes adjusted accordingly The selling company will normally recognize a gain or loss on the sale, and the buying company will record the assets at its cost This cost may be higher or lower than the cost to the company as a whole The company must track the original cost and the intercompany gain or loss

25. Chapter 7 25 Intercompany Land Profit Holdback The gain or loss on these intercompany sales is always unrealized to the group until and unless the asset sold intercompany is sold to a buyer outside the group The unrealized 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 group

26. Chapter 7 26 Intercompany Land Profit Holdback Implications of intercompany transactions: The �intercompany� gain is 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 until the asset is sold Retained earnings is adjusted for the effect of the elimination and change in asset value This adjustment is repeated every year until (and unless) the asset is sold outside the corporate group

27. Chapter 7 27 Intercompany Land Profit Holdback The necessary elimination entry takes this general form: Gain xxx Asset xxx Future tax asset xxx Income tax expense xxx

28. Chapter 7 28 Intercompany Land Profit Holdback Adjust non-controlling interest: Non-controlling interest (B/S) xxx Non-controlling interest (I/S) xxx (for a gain)

29. Chapter 7 29 Intercompany Land Profit Holdback The entry is repeated in years subsequent to the intercompany transfer, through an adjustment to retained earnings: Retained Earnings xxx Asset xxx Future income tax asset xxx Retained earnings xxx

30. Chapter 7 30 Example Suppose S sells land to P for 2600 for which a before tax profit of $600 is recorded and taxes are accrued at $240. Tax rate is 40%.

31. Chapter 7 31 Summary: steps in consolidation See specific guidelines for consolidation (notes on the blackboard) Problems

32. Chapter 7 32 EQUITY METHOD Unrealized profits: Investment in sub xx Investment income xx (for parent�s share of sub�s profits) Investment income xx Investment in sub xx (remove after-tax unrealized profit in year 1) (this entry would reverse when the profit is realized)

33. Chapter 7 33 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)

34. Chapter 7 34 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

35. Chapter 7 35 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

36. Chapter 7 36 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

37. Chapter 7 37 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

38. Chapter 7 38 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 [1600.30] Where there is an unrealized intecompany 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 [1600.32]

39. Chapter 7 39 International view Under International Accounting Standards and the accounting rules and practices of most countries, eliminations of intercompany revenues, expenses, and profits are performed in order that the consolidated financial statements include only the results of completed transactions with non-related companies However, differences in underlying definitions and concepts are such that this area must be treated with caution in investment analysis