Intercompany transfers of services and noncurrent assets part 1

Intercompany Transfers

of Services and Noncurrent Assets

(Part 1)

Source:

BAKER CHRISTENSEN COTTLRELLAdvanced Financial Accounting

Ninth Edition

McGRAW HILL INTERNATIONAL EDITION

Learning Objective 1

Understand and explain concepts associated with

transfers of long-term assetsand services.

Summary of GAAP Requirements for Preparing Consolidated StatementsAll intercompany transactions must be eliminated in consolidation.

The full amount of unrealized intercompany profit or gain must be eliminated.

The deferral is shared with NCI shareholders in upstream transactions.

Big Picture: The Consolidated Perspective

From a consolidated viewpoint, the reported amount for a fixed asset cannot change merely because the asset has been moved to a different location within the consolidated group.

Objective: Undo the transfer.

Make it appear as if we only changed the estimated useful life of asset.

P

S

Long-termAsset

Different Asset Types1. Non-depreciable Assets• The transfer of non-depreciable assets is very similar

to the transfer of inventory• Eliminate gains like unrealized gross profit

2. Depreciable Assets• Eliminate the seller’s gain• Adjust transferred asset back to old basis• Adjust depreciation back to what it would have

otherwise been if the original owner had depreciated the asset based on the revised estimate of useful life

Intercompany Transfers of Services

When one company purchases services from a related company, the purchaser typically records an expense and the seller records a revenue. • In the consolidation worksheet, an eliminating

entry would be needed to reduce both revenue (debit) and expense (credit).• Because the revenue and expense are equal and

both are eliminated, income is unaffected by the elimination.• The elimination is still important because

otherwise both revenues and expenses are overstated.

Illustration (Baker et al. 2011, p. 307-309)• Intercompany sale process of land.• A series of transaction: (1) land purchased by Parent company

from an unrelated party, (2) land sold to a subsidiary of Parent Company, and (3) land sold by subsidiary to an unrelated party:• Details of transactions:T1 – purchase by Parent Company from an outsider for $10,000T2 – Sale from Parent Company to Subsidiary for $15,000T3 – Sale from Subsidiary to an outsider for $25,000• The amount of gain reported by each company and by the

consolidated entity in a periods depends on the transactions occur during a period.

Illustration (continue)Case AAll three transactions are completed in the same accounting period.

Case BOnly transaction T1 is completed during the current period.

Parent Company $ 5,000 ($15,000 - $10,000)

Subsidiary Corporation 10,000 (25,000 - $15,000)

Consolidated Entity 15,000 ($25,000 - $10,000)

Parent Company $ 0

Subsidiary Corporation 0

Consolidated Entity 0

Illustration (continue)Case CTransaction T1 and T2 are completed during the current period.

Case DOnly transaction T3 is completed during the current period, T1 and T2 occurred in a prior period.

Parent Company $ 5,000 ($15,000 - $10,000)

Subsidiary Corporation 0

Consolidated Entity 0

Parent Company $ 0

Subsidiary Corporation 10,000 (25,000 - $15,000)

Consolidated Entity 15,000 ($25,000 - $10,000)


Prepare equity-method journal entries and

elimination entries for theconsolidation of a subsidiary following an intercompany

land transfer.

Intercompany Land Transfers• If land is transferred between related companies at book

value – no adjustment or elimination needed in consolidating financial statements.• Because there is no gain or loss, both income and assets

are stated correctly in the consolidation.• Special treatment is needed if land transfer is more or

less then book value – elimination of gain or loss.• There should be no gain or loss from related companies

reported in the consolidated financial statements – until land is sold to other party.

Illustration (p. 310 - 311)Peerless Products Corporation acquires land for $20,000 on January 1, 20X1, and sells the land to its subsidiary, Special Food Incorporated, on July 1, 20X1, for $35,000

Peerless Product

SpecialFoods$20 $35

Jan 1, 20X1 Jul 1, 20X1

Purchase land

Inter-corporate transfer of

land

Consolidated Entity

Illustration (continues)• Peerless records

January 1, 20X1

(1) Land 20,000

Cash 20,000

Record land purchase

July 1, 20X1

(2) Cash 35,000

Land 35,000

Record on Sale of land to Special Food

Illustration (continues)• Special Foods records

• Eliminating entry

July 1, 20X1

(3) Land 35,000

Cash 35,000

Record land purchase

July 1, 20X1

(4) Income from Special Foods 15,000

Investment in Special Food 15,000

Defer gain on intercompany land sale to Special Foods

Gain on Sale of Land 15,000

Land 15,000

Assignment of Unrealized Profit Elimination

Unrealized intercompany gains and losses must be eliminated in consolidating financial statements – regardless parent’s ownership of a subsidiary.

Sale EliminationDownstream (parent to subsidiary) Against controlling interestUpstream (subsidiary to parent) Wholly owned subsidiary Against controlling interest Majority-owned subsidiary Proportionately against controlling

and noncontrolling interests

Illustration

• Purity Company owns 75% of the common stock of Southern Corp.• Purity reports operating income (excluding any

investment income from Southern) of $100,000• Southern reports net income of $60,000, included the

income of selling affiliate is an unrealized gain of $10,000 from the intercompany transfer of asset.

Illustration (continues)

• If the sale is a downstream transfer, all unrealized profit is to be eliminated from the controlling interest.• Consolidated net income (computed and allocated):

Purity’s separate income $100,000

Less: Unrealized intercompany gain on downstream asset sale (10,000)

Purity’s separate realized income $90,000

Southern’s net income 60,000

Consolidated net income $150,000

Income to noncontrolling interest ($60,000 x 0.25) (15,000)

Income to controlling interest $135,000

Illustration (continues)• In the intercompany transfer is from subsidiary to

parent, the unrealized profit on the upstream sale is eliminated proportionately from both the controlling and noncontrolling shareholders.• Consolidated net income (computed and allocated):

Purity’s separate income $100,000

Southern’s net income $60,000

Less: Unrealized intercompany gain on downstream asset sale (10,000)

Southern’s realized net income 50,000

Consolidated net income $150,000

Income to noncontrolling interest ($50,000 x 0.25) (12,500)

Income to controlling interest $137,500

Example 1: 100% Ownership Land Transfer (Non-Depreciable) • On 3/31/X5, Parker Inc. sold land costing $40,000 to its

100% owned subsidiary, Stubben Inc., for $100,000.• In this example, we’ll do consolidation worksheet entries

without adjusting the equity method accounts.• This is the modified equity method. • This is meant to be a conceptual exercise only. (We will

switch to the fully adjusted equity method next.)

Required:1. Prepare the consolidation entry(ies) as of 12/31/X5 and

12/31/X6.2. Prepare the consolidation entry at 12/31/X7, assuming

that Stubben sold the land in 20X7 for $120,000.

Example 1: 100% Ownership Land Transfer (Non-Depreciable)

Parker Stubben$40 $120$100

On 3/31/X5, Parker Inc. sold land costing $40,000 to its 100% owned subsidiary, Stubben Inc., for $100,000.

“Fake” Gain = $60 Gain = $20

Total Gain = $80

In 20X7

Gain +60

Gain on Sale of Land 60,000Land 60,000

Example 1: Consolidation Entry at 12/31/X5Requirement 1 – consolidation entry:

Parker Stubben

Assets = Liabilities + Equity Assets = Liabilities + Equity

Consolidation Entry at 12/31/X5

Land +60

What happens to the gain?

RE +60 Land +60

RE +60

Retained Earnings 60,000Land 60,000

Example 1: Consolidation Entry at 12/31/X6Requirement 1 – consolidation entry:

Parker Stubben


Consolidation Entry at 12/31/X6 (and all years until land is sold)

Land +60

RE +60

Retained Earnings 60,000Gain on Sale 60,000

Example 1: Consolidation Entry at 12/31/X7Requirement 2 – consolidation entry after land sold:

Parker Stubben


Consolidation Entry at 12/31/X7 (Stubben resold the land in 20X7)

Gain +20

What gain should Stubben report in 20X7 when the land is sold?

• Thus, the consolidated gain is $80,000!• What’s the only problem with the partial equity method?

• THE PARENT’S FINANCIAL STATEMENTS ARE NOT CORRECT!

Solution: Parker Company Equity Method Journal Entries



Retained Earnings 60,000Land 60,000


Retained Earnings 60,000Gain on Sale of Land 60,000

Requirement 1

Requirement 2Consolidation Entry at 12/31/X7 (Stubben resold the land in 20X7)

Equity Method Adjustment

NI XXX

Income from SubXXX NI

60,000 Unreal. Gain 60,000

After calculating the unrealized gain, simply make an extra adjustment to back it out.

Do this at the same time you record the parent’s share of the sub’s income.

This ensures that the parent income is

equal to the consolidated

income.

Investment in Sub

Reverse later when the asset is sold!

Example 2: 100% Ownership Land Transfer• On 3/31/X5, Parker Inc. sold land costing $40,000 to its

100% owned subsidiary, Stubben Inc., for $100,000.• Now assume Parker adjusts for this transaction in the

equity accounts.• This is the fully adjusted equity method!• How would your answers change?

Required:1. Prepare the consolidation entry(ies) as of 12/31/X5

and 12/31/X6.2. Prepare the consolidation entry at 12/31/X7,

assuming that Stubben sold the land in 20X7 for $120,000.

Example 2: 100% Ownership Land Transfer

Parker Stubben$40 $120$100

On 3/31/X5, Parker Inc. sold land costing $40,000 to its 100% owned subsidiary, Stubben Inc., for $100,000.

“Fake” Gain = $60 Gain = $20

Total Gain = $80

In 20X7

Investment in Sub Income from Sub

NI XXX XXX NI 60,000 Unreal. 60,000

Gain

This defers the gain until later

ONE EXTRA STEP! Equity Method Adjustment

Gain +60


Example 2: Consolidation Entry at 12/31/X5Requirement 1:

Parker Stubben



Land +60

RE correct

Invest 60Income from Sub 60

• The equity method adjustment “fixes” parent’s books!

Same!

What happens to the gain AND Income from Sub?

They cancel out!Invest 60 Land +60

What happens to the equity method accounts?• Eliminated in the consolidation. But we still need to fix the problem!

Investment 60,000Land 60,000


Parker Stubben


Consolidation Entry at 12/31/X6 (and all years until land is sold)

Land +60Invest 60

• The normal basic elimination entry will still eliminate BV of equity.• The investment account will be “over eliminated” and left with a 60,000

credit!• We can’t leave a “balance” in that account in the consolidated B/S!

• This entry eliminates the investment account and fixes the land balance.

Investment 60,000Gain on Sale 60,000


Parker Stubben



Invest 60

What gain should Stubben report in 20X7 when the land is resold?

• Thus, the consolidated gain is $80,000!• We also reverse out the equity method deferral this year.• THE PARENT’S FINANCIAL STATEMENTS ARE ALWAYS CORRECT!

Gain +20

Example 2: Solution Summary



Investment in Stubben 60,000Land 60,000


Investment in Stubben 60,000Gain on Sale of Land 60,000

Requirement 1


Consolidation Worksheet—20X5

Adjustments

Parent Sub DR CRConsol-idated

Income Statement Gain on Sale 60,000 60,000 0

Income from Sub (60,000)Lower Basic 0

Balance Sheet

Investment in Sub (60,000)Lower Basic 0

Land 100,000 60,000 40,000


Adjustments


Income Statement

Balance Sheet

Investment in Sub (60,000)Lower

60,000Basic 0

Land 100,000 60,000 40,000


Adjustments


Income Statement Gain on Sale 20,000 60,000 80,000

Balance Sheet


60,000Basic 0

Land 0 0


Prepare equity-method journal entries and elimination entries for the consolidation of a subsidiary

following a downstream land transfer.

Downstream Sale of Land

• Peerless Products purchases 80% of the common stock of Special Foods on Dec 31, 20X0, on its book value of $240,000. The fair value of Special Foods NCI is equal to its nook value of $60,000.• During 20X1, Peerless reports separate income of

$140,000 and declares dividends of $60,000.• Special Foods reports net income of $50,000 and

declares dividend of $30,000.• July 1, 20X1, Peerless sells land to Special Foods for

$35,000, which was purchased on Jan 1, 20X1, for $20,000, resulting an unrealized gain of $15,000. • Special Foods holds the land until the following

years.

P

S

NCI

20%

80%

Fully adjusted equity-method entries – 20X1• 20X1 Peerless records its share of Special Foods’ income and

dividend.

(5) Investment in Special Foods 40,000

Income from Special Foods 40,000

Record Peerless’ 80% share of Special Foods’ 20X1 income

(6) Cash 24,000

Investment in Special Foods 24,000

Record Peerless’ 80% share of Special Foods’ 20X1 dividend

• Under the fully adjusted equity method, Peerless defers the entire $15,000 using the following entry:

• Objectives: (1) Peerless income is overstated by $15,000, the adjustment

to Income from Special Foods offsets this overstatement – Peerless net income is now correct, and

(2) Special Foods’ land account is currently overstated by $15,000 (was recorded for $20,000 but purchased for $35,000), reduction on the investment account offsets the overstatement and defer the unrealized gain.

(7) Income from Special Foods 15,000


Defer gain on intercompany land sale to Special Foods

Fully adjusted equity-method entries – 20X1

Basic investment account elimination entry:

Common stock 200,000Retained earnings 100,000Income from Special Foods 25,000NCI in NI of Special Foods 10,000 Dividend declared 30,000 Investment in Special Foods 241,000 NCI in NA of Special Foods 64,000


Adjustments


Income Statement Gain on Sale 15,000 15,000 0 Income from Sub 25,000 25,000

Basic 0

Balance Sheet Investment in Sub 241,000 241,000

Basic 0

Land 155,000 75,000 15,000 215,000

Group Exercise 1: Partial Ownership Land Transfer

• Stubben Corporation is a 90%-owned subsidiary of Parker Corporation, acquired for $270,000 on 1/1/X5.

• Investment cost was equal to book value and fair value.• Stubben’s net income in 20X5 was $70,000, and Parker’s

income, excluding its income from Stubben, was $90,000.• Parker’s income includes a $10,000 unrealized gain on land

that cost $40,000 and was sold to Stubben for $50,000. • Assume that Stubben sold the land in 20X7 for $65,000.

Assume Parker adjusts for this transaction in the equity accounts.NOTE: This is a downstream transaction.

Required: 1. What entry(ies) would Parker make in 20X5 and 20X7?2. Prepare the consolidation entries at 12/31/X5, 12/31/X6,

and 12/31/X7.

P

S

NCI

10%

90%

Group Exercise 1: Solution

20X5 Equity Method Entries

Requirement 1

20X7 Equity Method Entry (after Stubben resold the land)

Group Exercise 1: Solution


Requirement 2




Adjustments



Income from Sub 53,000 53,000Basic 0

Balance Sheet

Investment in Sub 323,000 323,000Basic 0

Land 50,000 10,000 40,000


Adjustments


Income Statement

Balance Sheet

Investment in Sub (10,000)Lower 10,000 Basic 0

Land 50,000 10,000 40,000


Prepare equity-method journal entries and elimination entries for the consolidation of a subsidiary

following an upstream land transfer.

Illustration (p. 318 - 321)Peerless Products Corporation acquires land for $20,000 on January 1, 20X1, and sells the land to its subsidiary, Special Food Incorporated, on July 1, 20X1, for $35,000

Peerless Product

SpecialFoods

Jan 1, 20X1Jul 1, 20X1

Purchase land

Inter-corporate transfer of

land

Consolidated Entity

$35 $20

Upstream Sale of Land• Peerless Products purchases 80% of the common

stock of Special Foods on Dec 31, 20X0, on its book value of $240,000. The fair value of Special Foods NCI is equal to its nook value of $60,000.• During 20X1, Peerless reports separate income of

$140,000 and declares dividends of $60,000.• Special Foods reports net income of $50,000 and

declares dividend of $30,000.• July 1, 20X1, Special Foods sells land to Peerless for

$35,000, which was purchased on Jan 1, 20X1, for $20,000, resulting an unrealized gain of $15,000. • Special Foods holds the land until the following

years.

P

S

NCI

20%

80%

• 20X1 Peerless records its share of Special Foods’ income and dividend under the fully adjusted method:

(8) Investment in Special Foods 40,000

Income from Special Foods 40,000

Record Peerless’ 80% share of Special Foods’ 20X1 income

(9) Cash 24,000


Record Peerless’ 80% share of Special Foods’ 20X1 dividend

Fully adjusted equity-method entries – 20X1• Under the fully adjusted equity method, Peerless Inc. defers

relative share of the unrealized gross profit is $12,000 (15,000 X 0.80)

Until resold to external party by Special Food, the carrying value of land must be reduces each time consolidated statements are prepared

(10) Income from special Foods 12,000


Defer gain on intercompany land sale to Special Foods.

Basic investment account elimination entry:

Common stock 200,000Retained earnings 100,000Income from Special Foods 40,000NCI in NI of Special Foods 10,000 Dividend declared 30,000 Investment in Special Foods 256,000 NCI in NA of Special Foods 64,000

Partially Owned Upstream Sales Equity Method Adjustment• Similar to what we did with inventory

transfers: we must share deferral with the NCI shareholders• Simply split up the adjustment for unrealized

gains proportionately.

Unreal. 3,000 Gain To NCI Shareholders

P

S

NCI

20%

80%Equity MethodAdjustments

Investment in Special Foods

12,000

Income from Special Foods

12,000Unreal. GainNI 52,000 52,000 NI

40,000

Group Exercise 2: Partial Ownership Land Transfer• Stubben Corporation is a 90%-owned subsidiary of Parker

Corporation, acquired for $270,000 on 1/1/X5.• Investment cost was equal to book value and fair value.• Stubben’s net income in 20X5 was $70,000, and Parker’s

income, excluding its income from Stubben, was $90,000.• Stubben’s income includes a $10,000 unrealized gain on land

that cost $40,000 and was sold to Parker for $50,000.• Assume that Parker sold the land in 20X7 for $65,000.• Assume Parker adjusts for this transaction in the equity

accounts.• Assume that Stubben sold the land in 20X7 for $65,000.• Assume Parker adjusts for this transaction in the equity

accounts.Required: 1. What entry(ies) would Parker make in 20X5 and 20X7?2. Prepare the consolidation entries at 12/31/X5, 12/31/X6,

and 12/31/X7.

P

S

NCI

10%

90%

Partially Owned Upstream Sales Equity Method Adjustment• Similar to what we did with inventory

transfers: we must share deferral with the NCI shareholders• Simply split up the adjustment for unrealized

gains proportionately.

Unreal. 1,000 Gain To NCI Shareholders

P

S

NCI

10%

90%Equity MethodAdjustments

Investment in Stubben

9,000

Income from Stubben

9,000Unreal. GainNI 63,000 63,000 NI

54,000


20X5 Equity Method Entries

Requirement 1

20X7 Equity Method Entry (after Stubben resold the land)




Requirement 2



Adjustments



Income from Sub 54,000 54,000Basic 0

Balance Sheet

Investment in Sub 324,000 324,000Basic 0

Land 50,000 10,000 40,000


Adjustments


Income Statement Income from Sub Basic 0Balance Sheet


9,000Basic 0

NCI in NA 1,000 1,000Lower

Land 50,000 10,000 40,000


Adjustments


Income Statement Gain on Sale 15,000 10,000 25,000 Income from Sub Basic 0Balance Sheet


9,000Basic 0

NCI in NA 1,000 1,000Lower

Land 0

Intercompany transfers of services and noncurrent assets part 1

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Transcript of Intercompany transfers of services and noncurrent assets part 1