Fischer11e PPT Ch04

FISCHER | TAYLOR | CHENG

Intercompany Transactions: Merchandise, Plant Assets,

and Notes

COPYRIGHT © 2012 South-Western/Cengage Learning 2

Learning Objectives (1 of 2)

1. Explain why transactions between members of a consolidated firm should not be reflected in the consolidated financial statements.

2. Defer intercompany profits on merchandise sales when appropriate and eliminate the double counting of sales between affiliates.

3. 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.


Learning Objectives (2 of 2)

4. Demonstrate an understanding of the profit deferral issues for intercompany sales of assets under long-term construction contracts.

5. Eliminate intercompany loans and notes.

6. Discuss the complications intercompany profits create for the use of the sophisticated equity method.

7. (Appendix) Apply intercompany profit eliminations on a vertical worksheet.


Typical Intercompany Transactions

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


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


Combined Inc Stmtwithout eliminations

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

Example of an intercompany sale

Co. P Co. S Outside$1,000

sells to S $1,200sells to outside $1,500

Consolidated Inc Stmt inter-company transaction eliminatedSales $1,500Cost of Goods Sold 1,000Gross Profit 500Gross profit pctg 33.3%

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


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.


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%


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

• P’s inventory of intercompany goods– Beginning: $10,000– Ending: $15,000

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


Consolidation Procedures Needed

IS Eliminate sale from subsidiary to parent

BI Reduce cost of goods sold for profit in beginning inventory and correct beginning retained earnings (allocated 20/80 because sale was by subsidiary)

EI Reduce ending inventory and increase cost of goods sold (ending inventory value contains intercompany profit)

IA Eliminate intercompany trade balance


Worksheet Eliminations

Partial Worksheet Trial Balances Eliminations Co. P Co. S Dr Cr

Ending inventory 15,000 EI 3,000

Accounts receivable 8,000 IA 8,000

Accounts payable 8,000 IA 8,000

RE – Co. S 50,000 BI 400

RE – Co. P 120,000 BI 1,600 Sales 130,000 100,000 IS 100,000

Cost of goods sold 95,000 80,000 EI 3,000 IS 100,000 BI 2,000


Adjustments on the IDS

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

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

Subsidiary

Parent


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

parent’s RE

• Seller’s profit is adjusted through IDS – In this case, the adjustments went to the sub (seller) – They would go to parent if parent was seller


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


Intercompany Sale: Nondepreciable Asset

Year of sale:LA Gain on sale 20,000Land 20,000

Run adjustment through seller’s IDS

Gain is deferred until asset (land) is sold to outside party

Later years: LA RE (split?) 20,000Land 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 20,000Seller may finally recognize gain; credit to seller’s IDS


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 (straight-line for this example)

Year of sale:F1 Gain (seller) 10,000 defer gain on sale

Machine 10,000 return asset to cost

F2 Accum. Depr. 2,000 reduce to depr. on cost

Depr. Expense 2,000 recognize 1/5 profit

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


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 year’s 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 reduce to depr on cost Depr. Expense 2,000 recognize 1/5 profit

IDS: Seller gets profit equal to depreciation adjustment


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


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


Long-Term Construction Contracts

Completed – Like any other fixed asset sale

Not Complete using Completed Contract Method:– Eliminate seller’s Billings and Cost of Construction in

Progress; adjust buyer’s 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


Intercompany Debt

• Typically Parent lends to Sub• Eliminations

– LN1 Intercompany payables and receivables– LN2 Interest expense and revenue

• Income distribution schedule– Sub’s internally generated net income is not adjusted

for incurred intercompany interest expense


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– Parent’s beginning RE does not include– Sub’s beginning RE does include– Adj replaces BI to remove intercompany profit from

Sub’s beginning RE and Parents’s beginning inv

Documents

Fischer11e PPT Ch04