Intercompany Profit Transactions Fixed Assets
Intercompany sales of fixed assets differ from intercompany sales of
merchandise in two aspects. First, intercompany sales of fixed assets
between affiliated companies are unusual transactions while intercompany
sales of merchandise occur frequently, Second, the relatively long useful
lives of fixed assets require the passage of many accounting periods before
intercompany gains or losses on sales of these assets are realized in
transactions with outsiders. In contrast, intercompany profits in inventories at
the end of one accounting period usually are realized through sale of the
merchandise to outsiders during the following period.
Intercompany gains and losses resulting from intercompany sales of fixed
assets are to be eliminated (deferred) in preparing consolidated financial
statements. The working paper elimination entries to eliminate the effects of
intercompany gains on fixed assets are similar to, but not identical with, those
for unrealized inventory profits. Unrealized profit in inventories are selfcorrecting over any two accounting periods, while unrealized gains or losses
on fixed assets affect the financial statements until the related fixed assets are
sold to outsiders or are exhausted through use by the purchasing affiliate.
This chapter illustrates the procedures involved in eliminating the effect of
intercompany gains or losses on sales of fixed assets.
INTERCOMPANY GAIN ON SALE OF NON-DEPRECIABLE FIXED
ASSETS
When intercompany sale of non-depreciable fixed assets occur, elimination
often are needed in the preparation of consolidated financial statements for as
long as the assets are held by the acquiring company. The simplest example
is the intercompany sale of land.
Overview of Profit Elimination Process
When land is sold between affiliated companies at book value, no special
adjustments or eliminations are needed in preparing the consolidated
statements. If, for example, a company sells to a subsidiary land costing
P100, 000 for also P100,000, the land continues to be valued at the P100,000
original cost to the consolidated entity:
Parent
Subsidiary
Cash
100,000
Land
Land
100,000
100,000
Cash
100,000
Since the seller records no gain/loss, both the income and assets are stated
correctly from a consolidated viewpoint.
Intercompany sale of land at a gain requires adjustments or eliminations in the
consolidation process. The selling entity’s gain must be eliminated because
the land is still held by the consolidated entity, and no gain may be reported in
the consolidated financial statements until the land is sold to outsiders. Also,
the land must be reported at its original cost in the consolidated financial
statements as long as it is held within the consolidated entity, regardless of
which affiliate holds the land.
Exercise
1. Assume that on July 1, 2013 Pete Corporation sold land costing P100, 000
to its subsidiary, Sake Company for P175, 000. Provide the entry to
record the sale of land on the books of Pete.
Assignment of Unrealized Profit Elimination
A gain or loss on an intercompany sale is recognized by the selling affiliate
and ultimately accrues to the stockholders of that affiliate. When a sale is from
a parent to a subsidiary, referred to as downstream sale, any gain or loss on
the sale accrues to the parent company’s stockholders. When the sale is from
a subsidiary to its parent, an upstream sale, any gain or loss accrues to the
subsidiary’s stockholders. If the subsidiary is wholly owned, all gain or loss
ultimately accrues to the parent company as the sole stockholders, If,
however, the selling affiliate is not wholly owned, the gain or loss on the
upstream sale is apportioned between the parent company and the noncontrolling shareholders.
Generally, gains and losses are not considered realized by the consolidated
entity until sale is made to outsiders. Unrealized gains and losses are
eliminated in preparing consolidated financial statements against the interests
of those shareholders who recognized the gains and losses in the first place:
the shareholders of the selling affiliate. Therefore, the direction of the sale
determines which shareholders group absorbs the elimination of unrealized
intercompany gains and losses. Specifically, unrealized intercompany gains
and losses are eliminated in the following:
Sale
Elimination
Downstream
Against controlling interest
Upstream:
Wholly owned subsidiary
Against controlling interest
Partially owned subsidiary
Proportionately against controlling
and
non-controlling
interests.
Exercise
Assume that Pop Corporation owns 80 percent of the common stock of Son
Company. The companies report the following comprehensive income (CI)
from their own operations:
Pop Corporation
P500,000
Son Company
300,000
Included in the CI of the selling affiliate is an unrealized gain of P50,000 on
the intercompany sale of a non-current asset. If the sale is a downstream sale,
all unrealized profit is eliminated from the controlling interest’s share of
income when consolidated statements are prepared.
1. Compute and allocate the consolidated CI.
2. If, instead, the intercompany sale is from subsidiary to parent, the
unrealized profit on the upstream sale is eliminated proportionately from
the interests of the controlling and non-controlling shareholders. Compute
and allocate the consolidated CI.
Note that the unrealized intercompany gains and losses are
always fully eliminated in preparing consolidated financial statements. The
existence of a NCI in a selling subsidiary affects only the allocation of the
eliminated unrealized gain or loss and not the amount eliminated.
NCI in Comprehensive Income of Subsidiary
The income assigned to the NCI is the non-controlling interest’s proportionate
share of the subsidiary income realized in transactions with outsiders. Income
assigned to the NCI in the downstream and upstream sale is computed as:
Subsequent Disposition of Asset
Unrealized intercompany gain on sale of assets in viewed as being realized at
the time the assets are resold to outsiders. For consolidation purposes, the
gain or loss recognized by the affiliate t outsiders must be adjusted for the
previously unrealized intercompany gain or loss. While the seller’s reported
profit on the sale to outsiders is based on that affiliate cost, the gain reported
by the consolidated entity is based on the cost of the asset to consolidated
entity, which is the cost of the selling affiliate that purchased the asset
originally from outsiders.
When previously unrealized intercompany gain are realized, the effects of the
profit elimination process must be reversed. At the time of realization, the full
amount of the unrealized intercompany gain is added back to the consolidated
income computation and assigned to the shareholder interest from which it
originally was eliminated.
Illustration
Continuing the case of Pete Corporation and Sake Company, assume that
Sake Company sold the land that it purchased from Pete to outsiders for
P225,000 on March 1, 2013.
Sake Company, recognizes a gain on the sale to outsiders of P50,000
(P225,000-P175,000). From a consolidated viewpoint, however the gain is
P125,000, the difference between the price at which the land left the
consolidated entity (P225,000) and the price at which the land entered the
consolidated entity (P100,000) when purchased originally by Pete.
In the consolidation working paper, the land no longer needs to be reduced by
the unrealized gain because the gain now is realized and the consolidated
entity no longer holds the land. Instead the P50,000 gain recognized by Sake
Company on the sale of the land to outsiders must be adjusted to reflect a
total gain for the consolidated entity of P125,000. Thus, the following
elimination entity is made in the consolidated working paper on December 31,
2013:
(E4) Retained earnings, January 1
75,000
Gain on sale of land
75,000
To adjust previously unrealized gain on sale of
land
If the sale to the outsiders had been made by Pete following an upstream sale
from Sake, the working paper treatment would be the same as in the case of
downstream sale except that the debt of elimination E(4) would be prorate
between beginning retained earnings (P60,000) and NCI (P15,000) based on
the relative ownership interests. In addition, the income assigned to NCI in the
work paper would be based on the subsidiary’s realized net income. Because
the P75,000 intercompany gain becomes realized during the year through
sale to outsiders, the subsidiary’s realized CI includes the subsidiary’s CI plus
the intercompany gain.
INTERCOMPANY SALE INVOLVING DEPRECIABLE ASSETS
Unrealized intercompany gains on a depreciable asset are viewed as being
realized gradually over the remaining life of the asset as it is used by the
purchasing affiliate. In effect, a portion of the unrealized gain is realized each
period as benefits are derived from the asset.
The amount of depreciation recognized each period on an asset purchased
from an affiliate is based on the intercompany selling price. From a
consolidated viewpoint, however, depreciation must be based on the cost of
the asset to the consolidated entity. Eliminating entries are needed to restate
the asset, the related accumulated depreciation, and depreciation expense to
the amount that would appear in the consolidated financial statements if there
had been no intercompany sale. Consolidated statements must appear as if
the intercompany sale had never occurred.
DOWNSTEAM SALE
The case of Pete Corporation and Sake Company is modified to illustrate the
downstream sale of a depreciable asset. Assume that Pete sells equipment to
Sake on December 31, 2012, for P70,000. The equipment originally cost Pete
P90,000 when purchased three years before December 31, 2012, and is
being depreciated over a total life of 10 years using the straight-line method
with no residual value.
1. Compute for the book value of the equipment immediately before the sale
by Pete.
2. Sake does not depreciate the equipment during 2012 because the
equipment is purchased at the very end of 2012. Record the depreciation
for 2012 (because it held the asset until the end of the year).
3. In addition, record the normal cost-method entry in recognizing the share
of Pete on Sake’s dividends for 2012.
Consolidation Working Paper
The working paper to prepare consolidated financial statements on December
31, 2012 is presented in Illustration 18-1. The first three elimination entries are
the normal entries to (1) eliminate intercompany dividends and NCI in the
dividends paid by Sake (2) assign income to the NCI, and (3) eliminate the
stockholders’ equity accounts of Sake and the investment account as of the
date of acquisition. No allocation of the excess exists in this example.
E(9) Dividend income
NCI
24,000
6,000
Dividends declared – Sake Company
30,000
To eliminate dividends income and NCI
share in
the dividends declared by Sake.
E(10) NCI in CI of subsidiary
10,000
NCI
To assign Sake income to NCI (50,000 x
10,000
20%).
E(11) Common stock – Sake
Retained earnings, Jan. 1 – Sake
200,000
100,000
Investment in Sake Company stock
NCI
To eliminate Sake’s equity accounts
and
investment cost on the date of
acquisition and
recognize NCI in net
assets of subsidiary.
240,000
60,000
An additional elimination entry is needed to eliminate the unrealized
intercompany gain on the sale of the equipment from consolidated CI and to
restate the equipment to the amounts that would appear in the consolidated
statements if there had been no intercompany sale. The amounts in the trial
balances of the parent and subsidiary include the effects of intercompany sale
and need to be adjusted in the consolidated working paper to the balances
immediately before the sale.
CONSOLIDATION IN SUBSEQUENT YEARS
The elimination procedure in subsequent years are basically similar to those
in 2013. As long as Sake continues to hold and depreciate the equipment ,
elimination procedures must include:
1. Restating the equipment and accumulated depreciation balances.
2. Eliminating the excess depreciation for the year.
3. Reducing beginning retained earnings by the amount of the unrealized
intercompany gain at the beginning of the year.
Change in Estimated Life of Asset upon Intercompany Sale
When a change in the estimated life of depreciable asset occurs at the time of
an intercompany sale, the treatment is no different than if the change occurred
while the asset remained on the books of the selling affiliate. The new
remaining useful life is used as a basis for depreciation both by the
purchasing affiliate and for purposes of preparing consolidated financial
statements.
UPSTREAM SALE
The treatment of unrealized profits arising from intercompany sales is the
same to that of downstream sale except that the unrealized gain, and
subsequent realization, must be allocated between the parent and NCI.
Exercise
Using the same example in the downstream sale, assume that Sake
Company sells equipment to Pete Corporation for P70,000 on December 31,
2012. Compute for the book value of the equipment at the time of sale
(P63,000).
Separate Company Entries – 2012
Books of Sake Company. Create entry to record depreciation on the
equipment for the year and the sale of the equipment to Pete on December
31, 2012.
Books of Pete Corporation. Create entry to record the purchase of the
equipment from Sake Company.
Consolidation Working Paper – 2012
It is basically the same to that presented in Illustration 18-1 with a slight
modification to reflect the upstream sale of the equipment. Create the
elimination entries to appear in the consolidation working paper.
Consolidated CI – 2012
Create entry for consolidated CI of P190 000 and its allocation in the
consolidation working paper on December 31, 2012.
Consolidated Retained Earnings – 2012
Create entry for consolidated retained earnings of P420,000 in the
consolidated working paper on December 31, 2012.
Non-controlling Interest (NCI)
Compute for the NCI of P64,000 in the working paper.
Separate Company Entries – 2013
Books of Pete Corporation. Create entry on the depreciation of equipment
purchased from Sake for the year 2013.