Electronic
Presentations
in Microsoft®
PowerPoint®
Prepared by
James Myers,
C.A.
University of
Toronto
© 2010 McGraw-Hill
Ryerson Limited
Chapter 7, Slide 1
© 2010 McGraw-Hill Ryerson Limited
Chapter 7
(A) Intercompany Profits
in Depreciable Assets
(B) Intercompany Bondholdings
Chapter 7, Slide 2
© 2010 McGraw-Hill Ryerson Limited
Learning Objectives
1.
2.
3.
Prepare consolidated financial statements that reflect
the elimination and subsequent realization of
upstream and downstream intercompany profits in
depreciable assets
Explain how the historical cost principle supports the
elimination of unrealized profits resulting from
intercompany transactions when preparing
consolidated financial statements
Prepare the journal entries under the equity method
to reflect the elimination and subsequent realization
of intercompany profits in depreciable assets
Chapter 7, Slide 3
© 2010 McGraw-Hill Ryerson Limited
Learning Objectives
4.
5.
6.
Calculate the gain or loss that results from the
elimination of intercompany bondholdings and the
allocation of such gain or loss to the equities of the
controlling and non-controlling interests
Explain how the recognition of gains on the
elimination of intercompany bondholdings is
consistent with the principle of recording gains only
when they are realized
Prepare consolidated financial statements that reflect
the gains or losses that are the result of
intercompany bondholdings
Chapter 7, Slide 4
© 2010 McGraw-Hill Ryerson Limited
Intercompany Profits in Depreciable Assets

We have now established the basis for preparation of
consolidated financial statements, including:






The allocation of the acquisition price
The conceptual alternatives
Consolidation after parent uses cost method or equity method
Elimination of intercompany sales and purchases
Elimination of unrealized intercompany profits on inventory and
land
Parents and subsidiaries engage in more complex
transactions such as intercompany transfers of
depreciable assets
LO 1
Chapter 7, Slide 5
© 2010 McGraw-Hill Ryerson Limited
Intercompany Profits in Depreciable Assets


Parents and subsidiaries often redistribute depreciable
and non-depreciable assets among themselves, for a
variety of reasons including management, income tax,
and corporate restructuring
Such transactions usually are recorded at the market
value of the assets transferred:

The selling company will record a gain (or loss) on the sale, and
the buying company will record the assets at the price it paid,
often higher than the original cost of the asset to the combined
entity
LO 1, 2
Chapter 7, Slide 6
© 2010 McGraw-Hill Ryerson Limited
Intercompany Profits in Depreciable Assets

The gain or loss on intercompany asset sales is
unrealized to the group until the asset is subsequently
sold to a buyer outside the group or used in producing a
product or service that is sold



The effect of the gain or loss is eliminated in the consolidated
financial statements
The objective of the elimination is to report “as if” the transaction
between the companies had never taken place
If the intercompany transaction involves depreciable
assets, there are further adjustments to be considered in
later periods, including depreciation
LO 1, 2
Chapter 7, Slide 7
© 2010 McGraw-Hill Ryerson Limited
Intercompany Profits in Depreciable Assets

The intercompany sale of depreciable assets at a profit
or loss results in depreciation being recorded by the
buying company at an amount that is different than what
the selling company would have recorded on the
historical cost basis if the transaction had not occurred


The buying company has a different (higher or lower) cost basis
than the original cost paid by the seller
Therefore, the amount of depreciation recorded in the buyer’s
books will be greater (or lesser) than the depreciation that would
have been recorded based on the historical cost to the
consolidated entity
LO 1, 2
Chapter 7, Slide 8
© 2010 McGraw-Hill Ryerson Limited
Intercompany Profits in Depreciable Assets

The incremental depreciation, which is the portion that is
not based on historical cost to the group, must be
eliminated


LO 2
This incremental depreciation in later periods may also be
thought of as the realization of the intercompany gain or loss
through the process of consumption of the value of the asset
As the value of the asset is depreciated by the buying company,
a portion of the intercompany gain or loss is “realized” in the
sense that it no longer has to be eliminated in the preparation of
the consolidated financial statements
Chapter 7, Slide 9
© 2010 McGraw-Hill Ryerson Limited
Intercompany Profits in Depreciable Assets

The depreciation expense which remains on the
consolidated financial statements after eliminating the
incremental depreciation is the amount that would have
been recorded by the seller, based on the original cost of
the asset to the group, if the intercompany sale had not
occurred
LO 2
Chapter 7, Slide 10
© 2010 McGraw-Hill Ryerson Limited
Intercompany Profits in Depreciable Assets

Income taxes



All intercompany unrealized gains and losses affect net earnings
“net of tax”
Deferred income tax (on the balance sheet) is computed on the
outstanding balance of the unrealized gain or loss at the balance
sheet date
Upstream gains and losses


LO 1
Allocate portion of unrealized upstream gain/loss net of
depreciation and tax to income statement non-controlling interest
To compute balance sheet non-controlling interest, adjust
shareholders’ equity of subsidiary for unrealized upstream
gain/loss net of depreciation and tax
Chapter 7, Slide 11
© 2010 McGraw-Hill Ryerson Limited
Example of Depreciable Asset Transfer

Example:




Parent purchased equipment from an unrelated party for a cost of
$1,000
The equipment has a 10-year life and is depreciated on the
straight-line basis
Parent immediately sells the equipment to Subsidiary for $1,500
Parent pays income tax of $200 (40%) on the $500 gain that is
unrealized for consolidated financial statement purposes
LO 1,3
Chapter 7, Slide 12
© 2010 McGraw-Hill Ryerson Limited
Example of Depreciable Asset Transfer

The parent records the following entry on its books to
reflect the sale of the equipment to the subsidiary and
payment of the resulting income taxes
Date
Description
1-Jan. Cash
$
Income tax expense
$
Income tax payable
Equipment
Gain
to record gain on equipment sale
LO 1,3
Debit
Credit
1,500
200
$
$
$
200
1,000
500
Chapter 7, Slide 13
© 2010 McGraw-Hill Ryerson Limited
Example of Depreciable Asset Transfer

To eliminate the unrealized gain on the parent’s books,
restore equipment to its original cost, and defer the $200
tax paid, the following elimination entry is required on the
consolidation worksheet:
Gain
Deferred income tax
Equipment
Income tax expense

$500
$200
$500
$200
If the parent uses the equity method to account for the
subsidiary, the following journal entry would be recorded
in the parent’s general ledger:
Investment income
Investment in subsidiary
LO 1, 3
$300
$300
Chapter 7, Slide 14
© 2010 McGraw-Hill Ryerson Limited
Example of Depreciable Asset Transfer

The subsidiary records the following entries on its books
to reflect the purchase of the equipment and its
depreciation during the following year
SUBSIDIARY GENERAL JOURNAL
Page
1
Date
Debit
Credit
Description
1-Jan. Equipment
Cash
to record equipment purchase
$
1,500
$
SUBSIDIARY GENERAL JOURNAL
Page
1
Date
Debit
Credit
Description
31-Dec. Depreciation Expense
$
150
Accumulated depreciation
to depreciate equipment $1,500/10 years
LO 1,3
1,500
$
150
Chapter 7, Slide 15
© 2010 McGraw-Hill Ryerson Limited
Example of Depreciable Asset Transfer

If the parent had not sold the equipment, it would have
recorded depreciation of $1,000 / 10 years = $100


Since the subsidiary is depreciating at a cost of $1,500 and not
$1,000, $150 of depreciation has been recorded
To adjust the consolidated financial statements to reduce
depreciation to what it would have been if the transfer
had not occurred (or to “realize” the gain over time as the
asset is consumed), depreciation expense must be
reduced with the following consolidation elimination
entry:
Accumulated depreciation
Depreciation expense
LO 1, 2, 3
$50
$50
Chapter 7, Slide 16
© 2010 McGraw-Hill Ryerson Limited
Example of Depreciable Asset Transfer

To match the decrease in depreciation expense to
related income taxes at the parent’s 40% tax rate the
following adjustment is also reflected in the Year 1
consolidated financial statements:
Income tax expense
Deferred income tax
LO 1, 3
$20
$20
Chapter 7, Slide 17
© 2010 McGraw-Hill Ryerson Limited
Example of Depreciable Asset Transfer


In each of the following years, until either the equipment is fully depreciated
or the subsidiary sells it, two consolidation elimination entries are required
on the consolidation worksheet
The first entry records the cumulative effect of adjustments made in prior
years as follows:
Accumulated depreciation
Deferred income tax
Retained earnings
Equipment

$500
The second entry adjusts for the excess depreciation for that particular year
as follows:
Accumulated depreciation
Income tax expense
Depreciation expense
Deferred income tax

$xxx
$xxx
$xxx
$50
$20
$50
$20
If the parent uses the equity method to account for the subsidiary, the
following journal entry would be recorded in the parent’s general ledger
each year:
Investment in subsidiary
Investment income
LO 1, 3
$30
$30
Chapter 7, Slide 18
© 2010 McGraw-Hill Ryerson Limited
Example of Depreciable Asset Transfer
 The foregoing is an example of a downstream
intercompany transaction. If the equipment had instead
been sold upstream, by subsidiary to parent, then a
further consolidation adjustment would be required to
allocate a portion of the net-of-tax eliminations to noncontrolling interest
LO 1, 3
Chapter 7, Slide 19
© 2010 McGraw-Hill Ryerson Limited
Intercompany Profits in Depreciable Assets

Summary of implications of intercompany
transactions in depreciable assets:





The “intercompany” gain must be eliminated and
associated income taxes paid deferred
The asset must be adjusted to its historical cost
Depreciation is restated so that it is based on original cost,
and associated income taxes are recorded
Accumulated depreciation restated so that it is based on
original cost
Retained earnings is adjusted for the cumulative after-tax
effect of the unrealized gain or loss (i.e. gain or loss less
incremental depreciation to date)
LO 1, 2
Chapter 7, Slide 20
© 2010 McGraw-Hill Ryerson Limited
Intercompany Profits in Depreciable Assets

The following two slides summarize the effects of net-oftax adjustments for unrealized gains and associated
depreciation on the balances of investment in subsidiary
and retained earnings, if the equity method of accounting
has been used by the parent
LO 3
Chapter 7, Slide 21
© 2010 McGraw-Hill Ryerson Limited
Intercompany Profits in Depreciable Assets
Investment in Subsidiary
Original Cost
Income earned
Dividends received
A.D. Amortization
Accumulated Depreciation
Unrealized Gains
Balance
LO 3
Chapter 7, Slide 22
© 2010 McGraw-Hill Ryerson Limited
Intercompany Profits in Depreciable Assets
Consolidated Retained Earnings
Parent retained earnings
Parent’s share of change in
Sub RE since acquisition
A.D. Amortization
Unrealized gains
Accumulated depreciation
Balance
LO 3
Chapter 7, Slide 23
© 2010 McGraw-Hill Ryerson Limited
Intercompany Bondholdings


When we discuss intercompany profits, we are generally
concerned with eliminating profits recorded by individual
companies, but unrealized by the group
When purchased on the open market, intercompany
bondholdings present the opposite situation:


LO 5
Profits associated with these bonds are unrealized at the
individual company level, but realized by the group as a whole
since they occurred with outside parties and arose as a result of
changes in prevailing market interest rates since the bonds were
originally issued
The process of accounting for intercompany bonds involves the
recognition of these gains and losses in the consolidated financial
statements before they are recognized in the separate-entity
financial statements
Chapter 7, Slide 24
© 2010 McGraw-Hill Ryerson Limited
Intercompany Bondholdings


In the typical case, bonds are issued by a company into
the open market, or are placed privately with an
unrelated entity such as an insurance company or
pension plan
If related companies provide financing, the financing
conditions are generally simpler than the relatively
complex and restrictive requirements of bonds


As a result, it is fairly common for a company to buy on the open
market the outstanding bonds of a parent or subsidiary company
The market value paid by the related company will be different
from the issuing company’s book value if the prevailing market
interest rates have changed since the bonds were issued
LO 4, 5
Chapter 7, Slide 25
© 2010 McGraw-Hill Ryerson Limited
Intercompany Bondholdings




When this occurs, the company which has purchased
the bond reports investment in bonds as an asset on its
separate-entity balance sheet
The issuing company reflects the bond liability and
records interest expense and any related amortization of
premium/discount on its separate-entity statements
However, from the perspective of the combined group,
the intercompany bonds have been retired at the time
they were purchased on the open market and the bond
investment is eliminated against the bond liability
The difference, if any, between acquisition cost and book
value of the bonds is recognized as a gain or loss
LO 4, 5
Chapter 7, Slide 26
© 2010 McGraw-Hill Ryerson Limited
Intercompany Bondholdings


The gain or loss on the effective retirement of bonds
must be recognized in the consolidated statements
However, since the bond is still in fact an outstanding
liability to the individual company issuer:



interest payments continue to be made and amortization of any
premium or discount received continues to be recorded on the
issuer’s books
the individual company purchaser records the revenue received,
and records amortization of any premium or discount paid, over
the bond’s term to maturity
This intercompany interest revenue received and interest
expense paid must be eliminated in the consolidated
financial statements
LO 4, 5, 6
Chapter 7, Slide 27
© 2010 McGraw-Hill Ryerson Limited
Intercompany Bondholdings

A difference arises with the elimination of the
premium/discount amortization when the bond was
purchased by the related company in the open market at
a value different from the original issue price



the amortization recorded by the issuer, based on original issue
price, will be different from the amortization recorded by the
purchaser based on market value paid to purchase the bond
This difference, over the remaining term of the bond, is
eliminated since it is equal to the gain or loss recognized
on the open market purchase and retirement of the bond
Amortization can be straight-line, or based on the
effective-yield method by calculating the present value of
future cash flows using the current market discount rate
LO 6
Chapter 7, Slide 28
© 2010 McGraw-Hill Ryerson Limited
Intercompany Bondholdings - Example

Example: Parent owns 100% of Subsidiary. On January
1, Subsidiary pays $9,800 on the open market to
purchase $10,000 of bonds that were originally issued by
Parent for $10,000 (i.e. no issuing premium/discount).
Bonds pay interest at 10% annually and mature in 4
years




Gain on retirement of bonds = $10,000-$9,800 = $200
Income tax on gain (assume 40% rate) = $200 x 40% = $80
Annual intercompany interest = $10,000 x 10% = $100 (Parent
books reflect expense, Subsidiary books reflect income)
Each year, Subsidiary amortizes discount $200 / 4 = $50 to
income (entry is Dr bond investment, Cr interest income)
LO 4, 6
Chapter 7, Slide 29
© 2010 McGraw-Hill Ryerson Limited
Intercompany Bondholdings - Example


The following adjustments are required on the
consolidation worksheet to (i) eliminate the intercompany
bonds and record the gain on retirement; (ii) match the
gain recognized to related income tax expense; and (iii)
eliminate the intercompany interest net of income tax
Consolidation adjusting entries – January 1:
(i)
Bonds payable (Parent)
Investment in bonds (Sub)
Gain on bond retirement
$10,000
$9,800
$200
(ii)
Income tax expense
$80
Deferred income tax
LO 4, 6
$80
Chapter 7, Slide 30
© 2010 McGraw-Hill Ryerson Limited
Intercompany Bondholdings - Example

Consolidation adjusting entry – December 31: Parent
has recorded $1,000 interest expense and Subsidiary
has recorded $1,000 interest income + $50 discount
amortization. Net pre-tax income = $1,050 - $1,000 =
$50 x 40% tax rate = $20 income tax paid. Subsidiary’s
books reflect bond investment as $9,800 paid + $50
amortization = $9,850 of which $9,800 was eliminated on
January 1 (see consolidation adjusting entry (i))
(iii) Interest income
Deferred income tax
Interest expense
Income tax expense
Investment in bonds
LO 6
$1,050
$20
$1,000
$20
$50
Chapter 7, Slide 31
© 2010 McGraw-Hill Ryerson Limited
Intercompany Bondholdings

Non-controlling interest:

When a subsidiary is less than 100% owned, gains and losses
on intercompany bondholdings are allocated, net of tax, based
on 1 of 4 possible methods permitted by IFRS



LO 4
We will allocate the gain or loss between the issuing and purchasing
companies based on the relative premium or discount arising from
the bonds that is reflected on the books of each company, in order
to mirror the manner in which each company amortizes the premium
or discount
In our example above 100% of the discount is reflected on the
books of the subsidiary and 0% is reflected on the books of the
parent, therefore the gain would be allocated to the subsidiary
The gain or loss allocated in this manner to the subsidiary would
therefore affect non-controlling interest if the subsidiary is less
than 100% owned by the parent
Chapter 7, Slide 32
© 2010 McGraw-Hill Ryerson Limited