Chap005

Chapter Five

Consolidated Consolidated Financial Financial

Statements–Statements–Intra-Entity Intra-Entity

Asset Asset TransactionsTransactions

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Intra-entity Transactions

Transactions between the parent and subsidiary are considered “internal” transactions of a single economic entity.

The effects of these intra-entity transactions should be eliminated from the consolidated financial statements.

Thus, consolidated statements only reflect transactions with outside parties.

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Note: Assuming inventory has been re-sold to a third-party, both companies have debited COGS

and credited Sales for the same inventory.

Intra-entity Transactions – Inventory Transfers

ENTRY TIEliminate all intra-entity sales/purchases of inventory, by eliminating the sales price of the

transfer – which one company recorded as sales, and the other recorded as cost of goods sold.

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Note: Any inventory that was ‘marked-up’ in an I/C transfer must be returned to it’s original

cost if it has not been sold to an outside party.


ENTRY G

Despite Entry TI, ending inventory is still overstated by the amount of gain on any

inventory that remains unsold at year end.

We must eliminate the unrealized gain as follows:

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ENTRY *G

In the year that the inventory is subsequently sold to a third party, the I/C gain is in beginning

Retained Earnings on the seller’s books, and must be moved to Consolidated Income.

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Note: The separate records of each company still contain the I/C transactions, including any gain that was recorded at the time they occurred.

Unrealized Inventory Gain - Other issues

If it’s DOWNSTREAM, then any unrealized gain belongs to the parent.

If it’s UPSTREAM, then any unrealized gain belongs to the subsidiary. We will reduce the Sub’s net income by the

unrealized gain prior to calculating the noncontrolling interest’s share.

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Does it matter if the sale is Upstream or Downstream?

YES!!


ENTRY *GIf the transfer of inventory is downstream AND

the parent uses the equity method, then the following entry is used to recognize the

remaining unrealized profit left at the end of the previous year.

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Note: This properly eliminates the gain from the Equity in Sub Income account and moves it to the Parent’s operating income accounts.

Intra-entity Transactions – Upstream Inventory Transfer

Large Company owns 100% of the voting stock of Small Company.

During 2010, Large buys 800 widgets from Small for $80,000. The widgets originally cost Small $50,000.

At year-end on December 31, 2010, Large still had 200 of the units on hand.

Prepare the consolidation entries on 12/31/10 to eliminate the unrealized gain.

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First, the entire intra-entity transfer must be

eliminated.

{

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Next, eliminate the unrealized gain:

Original Gain x % Unsold = Unrealized Gain $30,000 x (200/800) = $7,500


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And in a subsequent year when the inventory is sold to a third party, we will reverse Entry G to realize the gain.

Intra-entity Transactions –Inventory Transfer

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And the exception is…

If the transfer is downstream and the parent uses the equity method, then their Retained Earnings balance has already been adjusted for the gain,

and we adjust the Equity in Subsidiary Earnings account instead.

ENTRY TLIf land is transferred between the parent and

sub at a gain, the gain is considered unrealized and must be eliminated.

5-13 Intra-entity Transactions – Land Transfer

Note: By crediting land for the same amount, this effectively returns the land to its carrying value on the date of transfer.

Intra-entity Transactions --Land Transfer

ENTRY *GLAs long as the land remains on the books of

the buyer, the unrealized gain must be eliminated at the end of each fiscal period.

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Note: The original gain was closed to R/E at the end of that period. When we eliminate the gain

in subsequent years, it must come from R/E.

Intra-entity Land TransfersEliminating Unrealized Gains

ENTRY *GL (Year of sale)In the period the land is sold to a third party,

the unrealized gain must be eliminated one more time, and also finally recognized as a

REALIZED gain in the current period’s consolidated financial statements.

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Note: Modify the entry to credit the Gain account instead of Land.

The Effect of Land Transfers on Noncontrolling Interests

DOWNSTREAM transfers have

no effect on noncontrolling

interest.

UPSTREAM transfers have a gain on the

SUBSIDIARY books!All noncontrolling

interest balances are based on the sub’s

net income EXCLUDING the intra-entity gain

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Intra-entity Transactions -- Depreciable Asset Transfers

Example Able Co and Baker Co are related parties. Able purchased equipment for $100,000

several years ago, and has recorded $40,000 of depreciation since that time.

Baker buys the equipment from Able for $90,000 on 1/1/10.

The equipment has a remaining useful life of 10 years.

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On the Seller’s Books:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . $90,000

Accumulated Depreciation . . . . . . . . .40,000

Equipment . . . . . . . . . . . . . . . . . . . . . $100,000

Gain on Sale of Equipment . . . . . . . . . . 30,000

NOTE: The seller WOULD record depreciation expense at $6,000 / year if they had not sold the equipment.

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On the Buyer’s Books:

Equipment. . . . . . . . . . . . . . . . . . . . . $90,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . $90,000

NOTE: The buyer WILL record $9,000 per year in depreciation based on the remaining life


ENTRY TA

In the year of transfer, the unrealized gain must be eliminated and the assets restated to

original historical cost.

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ENTRY ED

In addition, the buyer’s depreciation is based on the inflated transfer price. The excess depreciation expense must be eliminated.

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In Years Following the Year of Transfer

Equipment is carried on the individual books at a different amount than on the

consolidated books.

The amounts change each year as depreciation is computed.

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To get the worksheet adjustments, compare the individual records to the consolidated records.


On Baker’s (buyer’s) books, the annual depreciation = $90,000 ÷ 10 yrs. =

$9,000 per year.The 1/1/11 R/E effect = the original gain

of $30,000 on Able’s (seller’s) books less one year of depreciation.

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For the consolidated entity, the annual depreciation = $48,000 remaining BV ÷ 8

yrs. = $6,000 per year.The Accumulated Depreciation at 12/31/11 =

$40,000 accumulated depreciation at 12/31/09 + two years of depreciation.

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The consolidation worksheet adjustments appear in the

last column.

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ENTRY *TA (Subsequent Years)The adjustment to fixed assets and

depreciation expense must be made in each succeeding period. The entry for the Mor/Beag Delivery Consolidation is:

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ENTRY ED (Subsequent Years)

In addition, we must adjust for the difference in Depreciation Expense on the two

income statements. The entry for our example is:

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And the exception is…

If the transfer is downstream and the parent uses the equity method, then

their Retained Earnings balance has already been reduced for the

gain, and we adjust the Investment account instead.

Summary

Transfers of assets among related parties are common.

In consolidated financial statements, the effects of these transfers must be removed.

Transfers of depreciable assets create the additional accounting issue of differing depreciation expense. This effect is eliminated on the consolidation worksheets.

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Possible Criticisms

No formal accounting pronouncements address valuation of noncontrolling interests in intra-entity gains. Traditionally, the deferral of gains from upstream sales is presumed to affect the noncontrolling interest, whereas downstream sales do not.

WHAT DO YOU THINK???

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Business

Chap005