CHAPTER 8 INTRODUCTION TO INTERCOMPANY TRANSACTIONS

CHAPTER 8

INTRODUCTION TO

INTERCOMPANY TRANSACTIONS

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

Operational Importance of Intercompany Transactions

• Extent of Vertical Integration:– Nearly 40% of world trade constitutes

intercompany transactions.

Operational Importance of Intercompany Transactions

• Assessing Performance for Each Entity Within the Consolidated Group:– Meaningful assessment would be

impossible without intercompany transactions.

Arm’s-Length Transactions: A Short Explanation

• Defined:– “Transactions that take place between

completely independent parties.”

Categories of Transactions• Arm’s Length Transactions:

– Are the ONLY transactions that can be reported in the consolidated statements.

• Non-Arm’s Length Transactions:– Are usually referred to as “related party

transactions.”– Include ALL intercompany

transactions.

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.

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.

Intercompany Transactions:Additional Opportunities for Fraud

• Intercompany transactions sometimesoccur to:– Conceal embezzlements.

– Overstate reported profits.

2 + 2 = 5

Nature and Varietyof Intercompany Transactions

• Type 1—Dividend 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.

Nature and Varietyof Intercompany Transactions

• Type 2—Loans:– 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.

Nature and Varietyof Intercompany Transactions

• Type 3—Reimbursements 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.

Nature and Varietyof Intercompany Transactions

• Type 4—Corporate 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.

Nature and Varietyof Intercompany Transactions

• Type 5—Income 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.

Nature and Varietyof Intercompany Transactions

• Type 6—Intangibles:– 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.)

Nature and Varietyof Intercompany Transaction

• Type 7—Inventory 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)

Nature and Varietyof Intercompany Transactions

• Type 8—Fixed Asset Transfers:– Far less common than inventory

transfers.– Most likely to occur when one entity

has surplus machinery or surplus office equipment.

Nature and Varietyof Intercompany Transactions

• Type 9—Investments 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.

Importance of Using Supportable (Fair) Transfer Prices

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

Importance of Using Supportable (Fair) Transfer Prices

• Actual transfer prices used are:– Relevant ONLY from each individual

entity’s perspective—impacts each entity’s reported net income.

– Irrelevant from a consolidated perspective• Because they are undone in

consolidation—exactly as if the transactions had NEVER occurred.

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.

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 arm’s length

basis. Thus:

–Must charge a related party the same price as an unrelated party.

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.

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).

A Billion Here, A Billion There!Pretty Soon We’re Talking “Real Money”

• BAD NEWS:– The IRS loses between $20-$40

billion of tax revenues each year because of transfer pricing shenanigans.

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.

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.

The Consolidation Effort:Keep 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.

What’s Unrealized and What’s 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.

Issuing Parent-Company-Only (PCO) Statements

• Ye All Shall Know This:– A parent company’s PCO statements

must report the same net income and retained earnings amounts as appear in the consolidated statements.

Review Question #1

Intercompany income statement accounts

are eliminated in consolidation because they are deemed as being:

A. 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.

Review Question #1With Answer

Intercompany income statement accounts are eliminated in consolidation because they are deemed as being:

A. 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.

Review Question #2Which 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.

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.

Review Question #3

An intercompany account balance that

would not need to be reconciled prior to consolidation is Intercompany:

A. Dividends Payable.B. Interest Receivable.C. Management Fees Payable.D. Overhead Allocation Receivable.E. None of the above.

Review Question #3With Answer

An intercompany account balance that would not need to be reconciled prior to consolidation is Intercompany:

A. Dividends Payable.B. Interest Receivable.C. Management Fees Payable.D. Overhead Allocation Receivable.E. None of the above.

Review Question #4An account balance that would not need to be reconciled prior to consolidation is:

A. Intercompany Sales.B. Intercompany Interest Expense.C. Intercompany Management Fee Income.D. Intercompany Overhead Allocation Out.E. None of the above.

Review Question #4With Answer

An account balance that would not need to be reconciled prior to consolidation is:

A. Intercompany Sales.B. Intercompany Interest Expense.C. Intercompany Management Fee Income.D. Intercompany Overhead Allocation Out.E. None of the above.

Review Question #5In 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

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

End of Chapter 8

• Time to Clear Things Up—Any Questions?