Intercompany

1
Chapter 7

• Intercompany
• Inventory and Land Profits

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
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
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
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
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)

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
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. Ss tax rate is 40.

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

A-f
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

G-L
11
If sales are downstream

• Ie. Parent sells to sub
• The only difference is that you dont 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. Ps tax rate is 40.

M-O
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
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
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
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
Intercompany Profits in Inventory

• In the first year
• Cost of goods sold is increased as ending
  inventory is written down

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
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
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
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
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
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
Intercompany land and other asset sales
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
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
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
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
Intercompany Land Profit Holdback

• Adjust non-controlling interest
• Non-controlling interest (B/S) xxx
• Non-controlling interest (I/S) xxx
• (for a gain)

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
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.

P
31
Summary steps in consolidation

• See specific guidelines for consolidation (notes
  on the blackboard)
• Problems

32
EQUITY METHOD

• Unrealized profits
• Investment in sub xx
• Investment income xx
• (for parents share of subs 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
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
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
Consolidated Theories and Intercompany Profits

• Only the parent companys 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
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
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
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 companys income 1600.32

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