INTRODUCTION TO INTERCOMPANY TRANSACTIONS

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CHAPTER 8

• INTRODUCTION TO INTERCOMPANY TRANSACTIONS

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FOCUS OF CHAPTER 8

• Intercompany Transactions
• Operational Importance
• Nature and Variety
• The Importance of Using Supportable (fair)
  Transfer Prices
• Basic Conceptual Issues
• Minimizing the Consolidation Effort
• Realized and Unrealized Profit Situations

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Operational Importance of Intercompany
Transactions

• Extent of Vertical Integration
• Nearly 40 of world trade constitutes
  intercompany transactions.

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Operational Importance of Intercompany
Transactions

• Assessing Performance for Each Entity Within the
  Consolidated Group
• Meaningful assessment would be impossible without
  intercompany transactions.

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Arms-Length Transactions A Short Explanation

• Defined
• Transactions that take place between completely
  independent parties.

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Categories of Transactions

• Arms Length Transactions
• Are the ONLY transactions that can be reported in
  the consolidated statements.
• Non-Arms Length Transactions
• Are usually referred to as related party
  transactions.
• Include ALL intercompany transactions.

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Types of Related Party Transactions

• Involving only Individuals
• Transactions among family members.
• Involving Corporations
• With management and other employees.
• With directors and stockholders.
• With affiliates (controlled entities).
• Probably constitutes at least 99 of all
  corporate related-party transactions.

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Necessity of Eliminating Intercompany Transactions

• Eliminate ALL intercompany transactionsin
  consolidation
• Because they are internal transactions from a
  consolidated perspective.
• Not because they are related-party transactions.
• Only transactions with outside unrelated parties
  can be reported in the consolidated statements.

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Intercompany TransactionsAdditional
Opportunities for Fraud

• Intercompany transactions sometimesoccur to
• Conceal embezzlements.
• Overstate reported profits.

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Nature and Varietyof Intercompany Transactions

• Type 1Dividend payments
• Parents often need cash from subsidiaries
• To pay dividends.
• To pay their own expenses.
• Reasons why parents cannot get cash from
  subsidiaries (a blocked funds problem)
• Regulatory restrictions.
• Governmental restrictions.

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Nature and Varietyof Intercompany Transactions

• Type 2Loans
• Parents often centralize treasury functions at
  the parent level. Thus
• Subsidiaries are unable to borrow from outside
  lenders.
• Subsidiaries usually borrow from their parents.
• Interest may or may not be charged.

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Nature and Varietyof Intercompany Transactions

• Type 3Reimbursements for Directly Traceable
  Costs
• Parents often arrange and pay for external
  services that benefit a subsidiary ONLY.
• Charging the subsidiary merely results in
  recording expenses in the proper income statement.

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Nature and Varietyof Intercompany Transactions

• Type 4Corporate Headquarters Services and
  Expense Allocations
• Handle one or two ways
• BILLING from a profit center
• Parent credits a Revenues account.
• ALLOCATION from a cost center
• Parent credits an O/H Allocation acct.
• Use either incremental or proportional allocation
  methods.

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Nature and Varietyof Intercompany Transactions

• Type 5Income Tax Expense Allocations
• Occurs ONLY when a parent subsidiary file a
  consolidated tax return
• Use method consistent with FAS 109 Accounting
  for Income Taxes
• Pro forma separate return method complies.
• Formula driven allocation method may or may not
  comply.

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Nature and Varietyof Intercompany Transactions

• Type 6Intangibles
• Parents often transfer technology and other
  intangibles to subsidiaries Two ways to do so
  are
• Sell It The transfer of a right to an item.
  (Recorded as a sale.)
• Grant a License The transfer of a right to
  use an item. (Recorded as license income.)

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Nature and Varietyof Intercompany Transaction

• Type 7Inventory Transfers
• Virtually all occur in vertically integrated
  entities.
• Classified as
• Downstream sales (parent to subsidiary)
• Upstream sales (subsidiary to parent)
• Lateral sales (subsidiary to subsidiary)

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Nature and Varietyof Intercompany Transactions

• Type 8Fixed Asset Transfers
• Far less common than inventory transfers.
• Most likely to occur when one entity has surplus
  machinery or surplus office equipment.

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Nature and Varietyof Intercompany Transactions

• Type 9Investments in Bonds of a Member of the
  Consolidated Group
• Found infrequently in practice.
• Much more involved to account for than
  intercompany loans because of premiums and
  discounts.

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Importance of Using Supportable (Fair) Transfer
Prices

• Transfer prices may be
• Negotiated between the entities.
• Set by the parent company.

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Importance of Using Supportable (Fair) Transfer
Prices

• Actual transfer prices used are
• Relevant ONLY from each individual entitys
  perspectiveimpacts each entitys reported net
  income.
• Irrelevant from a consolidated perspective
• Because they are undone in consolidationexactly
  as if the transactions had NEVER occurred.

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Importance of Using Supportable (Fair) Transfer
Prices Tax Rules

• From An Income Tax Reporting Perspective
• Transfer prices used have enormous implications.
• Because of the potential to arbitrarily shift
  profits between entities.
• And thereby lower the consolidated income tax
  expense.
• Especially on an international scale.

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Importance of Using Supportable (Fair) Transfer
Prices Tax Rules

• Tax Rules Concerning Transfer Prices
• Section 482 of Internal Revenue Code requires
  that
• Transfer prices be at an arms length basis.
  Thus
• Must charge a related party the same price as an
  unrelated party.

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Importance of Using Supportable(Fair) Transfer
Prices Tax Rules

• Section 482 applies to ALL transfers
• Inventory.
• Fixed assets.
• Services.
• Technology, patents, trademarks, and other
  intangibles (whether by sale or granting of a
  license).
• Interest rates on loans prices on leases.

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Importance of Using Supportable(Fair) Transfer
Prices Tax Rules

• Consequences of Insupportable Transfer Prices
• Substantial tax penalties and fines.
• Adjustment to financial statements for
  underreporting of consolidated income tax
  expense and payable.
• Transfer prices are irrelevant for tax purposes
• When a worldwide reporting system is used (as
  used by six states).

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A Billion Here, A Billion There!Pretty Soon
Were Talking Real Money

• BAD NEWS
• The IRS loses between 20-40 billion of tax
  revenues each year because of transfer pricing
  shenanigans.

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The Complexity of Determining Supportable
Transfer Prices Winners

• GOOD NEWS
• Tax accountant advisors to the multinational
  firms earn big fees (as high as 500 per hour)
  giving advice on how to MINIMIZE consolidated
  income taxes.

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GAAP Requirements Concerning Intercompany
Transactions

• GAAP requires the following to be eliminated for
  consolidated reporting
• All intercompany revenues, expenses, gains, and
  losses.
• All open account balances (intercompany
  receivables and payables).
• All unrealized intercompany profits and losses.
• Use GROSS PROFIT OR LOSS.

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The Consolidation EffortKeep It Simple

• Use SEPARATE intercompany accountsin the income
  statement (for each transaction type).
• Use a single Intercompany Receivable/ Payable
  account on each set of books.
• Reconcile ALL intercompany accounts prior to
  consolidation.
• Use the elimination by rearrangement technique
  on the consolidation worksheet.

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Whats Unrealized and Whats NOT?

• The unrealized profit issue does not occur when
• Transfers are made at cost.
• Transfers are made at above cost AND
• The profit reported by the one entity is FULLY
  OFFSET by additional costs and expenses reported
  in the income statement by the other entity.

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Issuing Parent-Company-Only (PCO) Statements

• Ye All Shall Know This
• A parent companys PCO statements must report
  the same net income and retained earnings
  amounts as appear in the consolidated statements.

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Review Question 1

• Intercompany income statement accounts are
  eliminated in consolidation because they are
  deemed as beingA. Artificial transactions.
  B. Potentially manipulative transactions. C.
  Internal transactions. D. At amounts that are
  not determined on arms-length basis. E.
  None of the above.

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Review Question 1With Answer

• Intercompany income statement accounts are
  eliminated in consolidation because they are
  deemed as beingA. Artificial transactions.
  B. Potentially manipulative transactions. C.
  Internal transactions. D. At amounts that are
  not determined on arms-length basis. E.
  None of the above.

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Review Question 2

• Which of the following account types need not be
  eliminated in consolidation? A. Intercompany
  assets intercompany liabilities. B.
  Intercompany revenues intercompany
  expenses. C. Intercompany overhead
  allocations.D. Long-term intercompany
  receivables.E. None of the above.

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Review Question 2With Answer

• Which of the following account types need not be
  eliminated in consolidation? A. Intercompany
  assets intercompany liabilities. B.
  Intercompany revenues intercompany
  expenses. C. Intercompany overhead allocation
  amounts.D. Long-term intercompany
  receivables.E. None of the above.

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Review Question 3

• An intercompany account balance that would not
  need to be reconciled prior to consolidation is
  IntercompanyA. Dividends Payable.B. Interest
  Receivable.C. Management Fees Payable.D.
  Overhead Allocation Receivable.E. None of the
  above.

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Review Question 3With Answer

• An intercompany account balance that would not
  need to be reconciled prior to consolidation is
  IntercompanyA. Dividends Payable.B. Interest
  Receivable.C. Management Fees Payable.D.
  Overhead Allocation Receivable.E. None of the
  above.

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Review Question 4

• An account balance that would not need to be
  reconciled prior to consolidation isA.
  Intercompany Sales.B. Intercompany Interest
  Expense.C. Intercompany Management Fee
  Income.D. Intercompany Overhead Allocation
  Out.E. None of the above.

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Review Question 4With Answer

• An account balance that would not need to be
  reconciled prior to consolidation isA.
  Intercompany Sales.B. Intercompany Interest
  Expense.C. Intercompany Management Fee
  Income.D. Intercompany Overhead Allocation
  Out.E. None of the above.

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Review Question 5

• In 2006, Saxco incurred 75,000 of inter-company
  interest charges. Of this amount, Saxco paid
  50,000 cash to its parent and capitalized
  30,000 to a discrete construction project. The
  unrealized intercompany profit at 12/31/06 is
  A. -0- B. 5,000C. 20,000D. 25,000E.
  30,000

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Review Question 5With Answer

• In 2006, Saxco incurred 75,000 of inter-company
  interest charges. Of this amount, Saxco paid
  50,000 cash to its parent and capitalized
  30,000 to a discrete construction project. The
  unrealized intercompany profit at 12/31/06 is
  A. -0- B. 5,000C. 20,000D. 25,000E.
  30,000

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End of Chapter 8

• Time to Clear Things UpAny Questions?