Advanced Financial Accounting I
ADMS 4520 – Winter 2012 – Patrice Gelinas
Lecture 6 – Intercompany Inventory and Land Profits – Feb 10
Intercompany Revenue & Expenses
- Parents and subsidiaries frequently have sales and purchases transactions between
each other, or other transactions such as intercompany rent, management fees, and
interest
o While not paid, these transactions can give rise to intercompany balances
such as receivables and payables
- Intercompany transactions are recorded in the books of each of the individual legal
entities
o These amounts would be included in separate entity financial statements,
and reported on separate entity income tax returns
- However, in the consolidated financial statements:
o All intercompany sales or other intercompany income must be eliminated
against the related purchase or intercompany expense
o All intercompany balances (including receivables and payables) are
eliminated against each other
o Income should be recognized only when it is earned in a transaction with an
outsider
- Companies must have systems in place that can capture full information regarding
both internal and external sales and purchases, in order that the appropriate
eliminations may be identified and made in the consolidated financial statements
- The selling company will generally have recorded a profit on the intercompany sales
o These profits are “unrealized” because they are only within the combined
entity, they are not objectively measurable, and are not with an arm’s-length
outsider
o Intercompany sales are like moving a coin from one pocket in a pair of pants
to the other pocket: the pants still contain the same coin and no income has
been earned
o Intercompany sales do not reflect the culmination of the earnings process
o These unrealized profits must be eliminated net of related income taxes paid
Examples of Intercompany Revenue and Expenses
- Intercompany management fees - often the parent will charge its subsidiary
companies a management fee as means of allocating head office cost to all the
companies within the group
- Intercompany rentals – ooccasionally, buildings or equipment owned by one
company are used by another company within the group with a corresponding
rental charge
- Intercompany interest revenue and expense – one company may record interest
income on a loan to another company which records a corresponding interest
expense
-
Intercompany revenues and expenses must be eliminated against each other on the
consolidated income statement
o Since equal amounts of income and expense are being eliminated, there is no
net effect on consolidated income
o Only revenues and expenses incurred with outside parties should be
reflected on the consolidated income statement
Intercompany Profits in Inventory
- Inventory is often sold from one company to another within a consolidated group.
- There are two types of intercompany profits to consider:
o Those resulting from downstream sales (i.e., where the parent sells to its
subsidiary)
o Those resulting from upstream sales (i.e., where a subsidiary sells to the
parent)
- Any inventory sold within the group but not subsequently sold outside must be
shown at its original cost with the unrealized profit eliminated net of the associated
income tax
- We have to “hold back” any unrealized net-of-tax profit for consolidation purposes
- The matching of expenses with revenues is a basic accounting concept; the
adjustment made for income taxes is a perfect example of this matching process
- Income tax should be expensed in the same period as revenue is recorded
o The timing difference between the buyer’s tax basis in the asset purchase and
the cost of the transferred asset meets the definition of a temporary
difference and will give rise to deferred income taxes
- The consolidation worksheet entry to eliminate unrealized gross profit in ending
inventory takes this general form:
o Cost of goods sold
xxx
o Ending Inventory
xxx
o [Inventory is hereby restored to its historical cost]
- The tax prepaid by the seller on the profit that is not yet recognized is deferred as an
asset on the consolidation worksheet:
o Deferred income tax
xxx
o Tax expense
xxx
Equity Method Journal Entries
- If the parent uses the equity method to account for its subsidiaries it would record
the following entries in its own books:
o Investment income
xxx
o Investment
xxx
o To record elimination of unrealized gross profit
o Investment
xxx
o Investment income
xxx
o To defer prepaid income tax
- The elimination of unrealized profits from intercompany inventory sales in one year
has the opposite effect in the following year.
o Cost of Sales = Opening Inventory + Purchases – Ending Inventory
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In the year following the intercompany sale, opening inventory is inflated by the
unrealized profit, therefore cost of sales is inflated.
Therefore, reduce cost of sales in the following year, thus “realizing” the profit.
Corresponding income tax expense is then recorded.
In the first year:
o Cost of goods sold is increased as ending inventory is decreased to its
original cost
o The profit is held back until realized through sale to outsider
o A deferred tax asset is established
In subsequent year
o Cost of goods sold is decreased as beginning inventory is decreased to
original cost
o The profit is now realized in the financial statements
o Income tax expense is increased
The consolidation worksheet entry to recognize unrealized gross profit held back
from the prior year takes this general form:
o Retained earnings
xxx
o Cost of goods sold
xxx
The tax effect is also recognized
o Retained earnings
xxx
o Deferred income tax
xxx
When profit is recorded by the subsidiary on inventory sold to the parent (an
“upstream” sale) then a portion of the after-tax unrealized profit elimination is
assigned to non-controlling interest.
Example: $360 after-tax profit in ending inventory sold by 90% subsidiary to parent
o Effect on NCI is 10% x $360 = $36
o Reflect on consolidation worksheet with the following entry:
 NCI (balance sheet)
$36
 NCI (income statement)
$36
What is the net effect of these eliminations?
o The profit is deferred (“held back”) until realized in an arms’ length
transaction with an unrelated party
o The financial statements are shown as if the transaction had never occurred,
until it is eventually realized
The elimination of unrealized profits is an essential element of the fair presentation
of consolidated financial statements.
Without these eliminations, profit could readily be manipulated.
Intercompany Land Profit Holdback
- Companies often redistribute assets among various corporate divisions within a
group
o land and other non-depreciable assets may be sold intercompany
- The selling company will normally recognize a gain or loss on the sale, and the
buying company will record the assets at the price charged by the seller.
- This cost may be higher or lower than the cost to the selling company
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o The company must track the original cost and the intercompany unrealized
gain or loss
The gain or loss on these intercompany sales is always unrealized to the group until
and unless the asset is subsequently sold to a buyer outside the group
o The unrealized intercompany gain must be eliminated
All adjustments are made with the objective of presenting the statements of the
group to report as if the transaction between the companies had never taken place
o The asset is restated to its original cost to the seller
Implications of intercompany transactions:
o The intercompany gain and associated income taxes are eliminated on the
income statement in the year of the sale
o The asset is restated to its original cost on any balance sheet prepared after
the intercompany sale
 This is repeated each period until the asset is sold to an outside party.
o Retained earnings is adjusted for the effect of the elimination and change in
asset value
 This adjustment is repeated every period until (and unless) the asset
is sold outside the corporate group.
The necessary consolidation elimination entry takes this general form:
o Gain
xxx
o Asset
xxx
o [The asset is hereby restored to historical cost]
The entry is repeated in periods subsequent to the intercompany transfer until the
land is sold to outsiders, through a consolidation worksheet adjustment to retained
earnings:
o Retained Earnings
xxx
o Asset
xxx
The tax effect of the elimination entry takes this general form on the consolidation
worksheet:
o Deferred income tax xxx
o Tax expense
xxx
The entry is repeated in years subsequent to the intercompany sale until the land is
sold to outsiders, through a consolidation worksheet adjustment to retained
earnings:
o Deferred income tax xxx
o Retained earnings
xxx
The direct approach requires calculations of the unrealized gains and their tax
effects
Equity Method Journal Entries
- If the parent uses the equity method to account for its subsidiaries it would record
the following entries in its own books:
o Investment income
xxx
o Investment
xxx
- To record elimination of unrealized land gain
o Investment
xxx
-
o Investment income
xxx
o To defer prepaid income tax
Non-controlling interest on upstream land sales:
o Non-controlling interest must be adjusted to eliminate all upstream gains
and losses net of income taxes.
o Example: Subsidiary 90% owned by parent sells land to parent for a gain of
$1,300 after-tax
 Effect on NCI is 10% x $1,300 = $130
 Reflect on consolidation worksheet with the following entry:
 NCI (balance sheet)
$130
 NCI (income statement)
$130
Losses on Intercompany Transactions
- Selling an asset at a loss raises the question of whether the loss reflects fair value
and an impairment
o If impairment is present the asset should be written down to its net
realizable value
o If impairment is not present and the loss does not reflect fair value, the loss
should be eliminated