Intercompany Transactions: Merchandise, Plant Assets, and Notes

FISCHER | TAYLOR | CHENG

Learning Objectives (1 of 2)
1. 2. Explain why transactions between members of a consolidated firm should not be reflected in the consolidated financial statements. Defer intercompany profits on merchandise sales when appropriate and eliminate the double counting of sales between affiliates. Defer profits on intercompany sales of long-term assets and realize the profits over the period of use and/or at the time of sale to a firm outside the consolidated group.

3.

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Learning Objectives (2 of 2)
4. Demonstrate an understanding of the profit deferral issues for intercompany sales of assets under long-term construction contracts. Eliminate intercompany loans and notes. Discuss the complications intercompany profits create for the use of the sophisticated equity method. (Appendix) Apply intercompany profit eliminations on a vertical worksheet.

5. 6. 7.

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Typical Intercompany Transactions

Merchandise for resale Land Fixed assets Long-term construction contracts Notes receivable/payable

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Intercompany merchandise sales

Sales between affiliated companies are recorded in the normal manner on the books of the separate companies. For the consolidated financial statements
Do not involve parties outside the consolidated group Cannot be acknowledged in consolidated statements

Procedures for consolidating affiliated companies with intercompany merchandise sales

1. Eliminate the intercompany sale 2. Eliminate related intercompany (i.e., internal) debt/receivable 3. Profit is realized when the goods are sold to an outside party

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Example of an intercompany sale

Co. P Co. S Outside $1,000 sells to S $1,200 sells to outside $1,500
Combined Inc Stmt
without eliminations

Consolidated Inc Stmt

inter-company transaction eliminated

Sales ($1,200 + $1,500) $2,700 C of GS ($1,000 + $1,200) 2,200 Gross Profit 500 Gross profit pctg 18.5%

Sales Cost of Goods Sold Gross Profit Gross profit pctg

$1,500 1,000 500 33.3%

The intercompany sale of $1,200 is eliminated on the worksheet

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Intercompany Price
Does the intercompany price matter? Yes, if there is an NCI the reported net income of the subsidiary reflects the intercompany sales price the subsidiary's separate income statement becomes the base from which the noncontrolling share of income is calculated. if Company S is an 80%-owned subsidiary, the NCI will receive 20% of the $300 ($1,500 - $1,200) profit made on the final sale by Company S, or $60.

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Mark-up Confusion
Mark-up on cost gross profit! Marking a $10 cost unit up 25%
$10.00 125% = $12.50

Provides a gross profit of 20%

$2.50 $12.50 = 20%

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Merchandise: Example
S (P owns 80%) buys goods for $80,000 and sells them to P for $100,000; all sales are at 20% gross profit Ps inventory of intercompany goods
Beginning: $10,000 Ending: $15,000

P owes S $8,000 for intercompany goods at year end

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Consolidation Procedures Needed

IS BI Eliminate sale from subsidiary to parent Reduce cost of goods sold for profit in beginning inventory and correct beginning retained earnings (allocated 20/80 because sale was by subsidiary) Reduce ending inventory and increase cost of goods sold (ending inventory value contains intercompany profit)

EI

IA

Eliminate intercompany trade balance

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Worksheet Eliminations
Partial Worksheet Trial Balances Co. P Co. S Ending inventory 15,000 Accounts receivable 8,000 Accounts payable 8,000 RE Co. S 50,000 RE Co. P 120,000 Sales 130,000 100,000 Cost of goods sold 95,000 80,000 Eliminations Dr Cr EI 3,000 IA 8,000 8,000 400 1,600 100,000 3,000 IS 100,000 BI 2,000

IA BI BI IS EI

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Adjustments on the IDS

Subsidiary
End inv profit (EI) $ 3,000 Int generated inc Beg inv profit (BI) Adjusted inc NCI % NCI $ 20,000 2,000 $ 19,000 20% $ 3,800

Parent
Int generated inc $ 35,000 80% of Sub's adjusted income 15,200 Controlling interest $ 50,200

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Worksheet 4-3
The 4 eliminations are IS, IA, BI, EI

In elimination BI, adjustment to RE is split because partially-owned sub was the seller.
If parent or wholly-owned sub is seller, adjust only to parents RE

Sellers profit is adjusted through IDS

In this case, the adjustments went to the sub (seller) They would go to parent if parent was seller

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Worksheet 4-3 (continued)

If there is an LCM adjustment, only the remaining profit is eliminated Losses (sales below market value) are also eliminated Worksheet 4-4 shows the same adjustments for a periodic inventory

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Intercompany Sale: Nondepreciable Asset

Gain is deferred until asset (land) is sold to outside party Year of sale: LA Gain on sale Land Run adjustment through sellers IDS 20,000 20,000

Later years: LA

RE (split?) 20,000 Land 20,000 Adjustment is split if seller was partially-owned Sub Year of sale to outside party: LA RE (split?) 20,000 Gain on sale 20,000 Seller may finally recognize gain; credit to sellers IDS
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Intercompany Depreciable Asset Sale: Year of Sale

Sell 5-year machine, NBV $20,000, for $30,000 on 1/1/2011

Theory: Defer gain and earn it back over period of use.

The allocation method matches the depreciation method (straightline for this example)

Year of sale:
F1 Gain (seller) Machine 10,000 10,000 2,000 defer gain on sale return asset to cost reduce to depr. on cost recognize 1/5 profit

F2 Accum. Depr. 2,000 Depr. Expense

IDS: Deduct original profit from seller and add profit equal to depreciation adjustment

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Intercompany Depreciable Asset Sale: Year Subsequent to Intercompany Sale

End of second year:
Adjust asset at start of year F1 RE (split?) 8,000 deferred gain on 1/1/12 Accum. Depr. 2,000 adjust prior years depr. Machine 10,000 return asset to cost RE adjustment is split when partially-owned sub is seller
Adjust current year depreciation F2 Accum. Depr. 2,000 Depr. Expense 2,000

reduce to depr on cost recognize 1/5 profit

IDS: Seller gets profit equal to depreciation adjustment

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Fixed Asset Worksheets

WS 4-5 (year of sale)

F1 eliminate $10,000 gain; reduce machine to book value

F2 adjusts current depreciation and realizes $2,000 gain IDS of seller: defer $10,000 gain; realize $2,000 WS 4-6 (end of second period after sale) F1 removes profit from machine value; eliminates gain unrealized as of beginning of year from RE of seller; adjusts Accum Dep for profit realized in prior year(s) F2 adjusts current depreciation and realizes $2,000 gain IDS of seller: realize another $2,000 of the gain

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Fixed Asset Worksheets (continued)

WS 4-7 (Asset sold to outside party at end of second year)

Machinery and accumulated depreciation are not there to adjust

The $6,000 remaining gain at the start of the year is now earned (sale to outside occurred) F3 Combining the $6,000 deferred gain ($10,000 original less $4,000 recognized - $2,000 in 2011 and 2012) and the recorded $4,000 loss on sale to outside party creates a gain on the consolidated statement of $2,000

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Long-Term Construction Contracts

Completed Like any other fixed asset sale Not Complete using Completed Contract Method:
Eliminate sellers Billings and Cost of Construction in Progress; adjust buyers Asset Under Construction for unbilled costs incurred by seller Eliminate intercompany debt balance

Not Complete using Percentage of Completion:

Key is to defer profit recorded by builder and restore asset under construction to cost Eliminate intercompany debt balance
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Intercompany Debt
Typically Parent lends to Sub Eliminations
LN1 Intercompany payables and receivables LN2 Interest expense and revenue

Income distribution schedule

Subs internally generated net income is not adjusted for incurred intercompany interest expense

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Sophisticated Equity Method: Intercompany Transactions

Sophisticated equity method records subsidiary income net of all intercompany profits Parent prepares an IDS-Subsidiary to determine and record its share of subsidiary income Unrealized profits of prior periods
Parents beginning RE does not include Subs beginning RE does include Adj replaces BI to remove intercompany profit from Subs beginning RE and Parentss beginning inv

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