Electronic
Presentations
in Microsoft®
PowerPoint®
Prepared by
James Myers,
C.A.
University of
Toronto
© 2010 McGraw-Hill
Ryerson Limited
Chapter 6, Slide 1
© 2010 McGraw-Hill Ryerson Limited
Chapter 6
Intercompany
Inventory and Land Profits
Chapter 6, Slide 2
© 2010 McGraw-Hill Ryerson Limited
Learning Objectives
1.
2.
3.
Describe the effect on consolidated net income of
the elimination of both intercompany revenues (and
expenses) and intercompany asset profits
Prepare consolidated financial statements that
reflect the elimination of upstream and downstream
intercompany profits in inventory and land
Prepare consolidated financial statements that
reflect the realization of upstream and downstream
intercompany profits in inventory and land that were
held back in previous periods
Chapter 6, Slide 3
© 2010 McGraw-Hill Ryerson Limited
Learning Objectives
4.
5.
Explain how the revenue recognition and matching
principles are used to support adjustments for
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 inventory and land
Chapter 6, Slide 4
© 2010 McGraw-Hill Ryerson Limited
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


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

LO 1
These amounts would be included in separate entity financial
statements, and reported on separate entity income tax returns
Chapter 6, Slide 5
© 2010 McGraw-Hill Ryerson Limited
Intercompany Revenue & Expenses

However, in the consolidated financial statements:




All intercompany sales or other intercompany income must be
eliminated against the related purchase or intercompany expense
All intercompany balances (including receivables and payables)
are eliminated against each other
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
LO 1
Chapter 6, Slide 6
© 2010 McGraw-Hill Ryerson Limited
Intercompany Revenue & Expenses

The selling company will generally have
recorded a profit on the intercompany sales




LO 1
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
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
Intercompany sales do not reflect the culmination of
the earnings process
These unrealized profits must be eliminated net of
related income taxes paid
Chapter 6, Slide 7
© 2010 McGraw-Hill Ryerson Limited
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 – occasionally, buildings
or equipment owned by one company are used
by another company within the group with a
corresponding rental charge
LO 1
Chapter 6, Slide 8
© 2010 McGraw-Hill Ryerson Limited
Examples of Intercompany Revenue and Expenses


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


LO 1
Since equal amounts of income and expense are being
eliminated, there is no net effect on consolidated income
Only revenues and expenses incurred with outside parties should
be reflected on the consolidated income statement
Chapter 6, Slide 9
© 2010 McGraw-Hill Ryerson Limited
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:




Those resulting from downstream sales (i.e., where the parent
sells to its subsidiary)
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
LO 1
Chapter 6, Slide 10
© 2010 McGraw-Hill Ryerson Limited
Intercompany Profits in Inventory


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

LO 4
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
Chapter 6, Slide 11
© 2010 McGraw-Hill Ryerson Limited
Intercompany Profits in Inventory

The consolidation worksheet entry to eliminate
unrealized gross profit in ending inventory takes this
general form:
Cost of goods sold
Ending Inventory
xxx
xxx
[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:
Deferred income tax
Tax expense

LO 2
xxx
xxx
Note that tax expense has been reduced to match the reduced
income.
Chapter 6, Slide 12
© 2010 McGraw-Hill Ryerson Limited
Intercompany Profits in Inventory
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:
Investment income
xxx
Investment
xxx
To record elimination of unrealized gross profit
Investment
xxx
Investment income
xxx
To defer prepaid income tax
LO 5
Chapter 6, Slide 13
© 2010 McGraw-Hill Ryerson Limited
Intercompany Profits in Inventory

The elimination of unrealized profits from
intercompany inventory sales in one year has
the opposite effect in the following year.
Cost of Sales = Opening Inventory + Purchases – Ending
Inventory



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.
LO 2
Chapter 6, Slide 14
© 2010 McGraw-Hill Ryerson Limited
Intercompany Profits in Inventory

In the first year:

Cost of goods sold is
increased as ending
inventory is decreased
to its original cost

The profit is held back
until realized through
sale to outsider

A deferred tax asset is
established
LO 1, 3, 4

In subsequent year


Cost of goods sold is
decreased as
beginning inventory
is decreased to
original cost
The profit is now
realized in the
financial statements
Income tax expense
is increased
Chapter 6, Slide 15
© 2010 McGraw-Hill Ryerson Limited
Intercompany Profits in Inventory

The consolidation worksheet entry to recognize
unrealized gross profit held back from the prior
year takes this general form:
Retained earnings
Cost of goods sold

xxx
xxx
The tax effect is also recognized
Retained earnings
Deferred income tax

LO 3
xxx
xxx
Note that profit has now been increased, so
associated tax expense also must be increased
Chapter 6, Slide 16
© 2010 McGraw-Hill Ryerson Limited
Intercompany Profits in Inventory


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


Effect on NCI is 10% x $360 = $36
Reflect on consolidation worksheet with the following
entry:
NCI (balance sheet)
NCI (income statement)
LO 2
$36
$36
Chapter 6, Slide 17
© 2010 McGraw-Hill Ryerson Limited
Intercompany Profits in Inventory

What is the net effect of these eliminations?




The profit is deferred (“held back”) until realized in an
arms’ length transaction with an unrelated party
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.
LO 1
Chapter 6, Slide 18
© 2010 McGraw-Hill Ryerson Limited
Intercompany Profits in Inventory

The examples in the next two slides - from
Exhibits 6.5 and 6.6, illustrate how the
elimination of unrealized upstream intercompany
profits net of income tax is reflected in:





LO 2
The calculation of consolidated net income
The calculation of consolidated retained earnings
The calculation of non-controlling interest
The consolidated income statement
The consolidated balance sheet
Chapter 6, Slide 19
© 2010 McGraw-Hill Ryerson Limited
Intercompany Profits in Inventory
LO 2
Chapter 6, Slide 20
© 2010 McGraw-Hill Ryerson Limited
Intercompany Profits in Inventory
LO 2
Chapter 6, Slide 21
© 2010 McGraw-Hill Ryerson Limited
Intercompany Land Profit Holdback

Companies often redistribute assets among
various corporate divisions within a group



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

LO 1
The company must track the original cost and the
intercompany unrealized gain or loss
Chapter 6, Slide 22
© 2010 McGraw-Hill Ryerson Limited
Intercompany Land Profit Holdback

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


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

LO 1
The asset is restated to its original cost to the seller
Chapter 6, Slide 23
© 2010 McGraw-Hill Ryerson Limited
Intercompany Land Profit Holdback

Implications of intercompany transactions:


The intercompany gain and associated income taxes
are eliminated on the income statement in the year of
the sale
The asset is restated to its original cost on any
balance sheet prepared after the intercompany sale


Retained earnings is adjusted for the effect of the
elimination and change in asset value

LO 1
This is repeated each period until the asset is sold to an
outside party.
This adjustment is repeated every period until (and unless) the
asset is sold outside the corporate group.
Chapter 6, Slide 24
© 2010 McGraw-Hill Ryerson Limited
Intercompany Land Profit Holdback

The necessary consolidation elimination entry
takes this general form:
Gain
Asset
xxx
xxx
[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:
Retained Earnings
Asset
LO 2
xxx
xxx
Chapter 6, Slide 25
© 2010 McGraw-Hill Ryerson Limited
Intercompany Land Profit Holdback

The tax effect of the elimination entry takes this general
form on the consolidation worksheet:
Deferred income tax
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:
Deferred income tax
Retained earnings

xxx
xxx
xxx
The direct approach requires calculations of the
unrealized gains and their tax effects
LO 2
Chapter 6, Slide 26
© 2010 McGraw-Hill Ryerson Limited
Intercompany Land Profit Holdback
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:
Investment income
xxx
Investment
xxx
To record elimination of unrealized land gain
Investment
xxx
Investment income
xxx
To defer prepaid income tax
LO 5
Chapter 6, Slide 27
© 2010 McGraw-Hill Ryerson Limited
Intercompany Land Profit Holdback

Non-controlling interest on upstream land sales:


Non-controlling interest must be adjusted to eliminate
all upstream gains and losses net of income taxes.
Example: Subsidiary 90% owned by parent sells land
to parent for a gain of $1,300 after-tax


LO 1, 2
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
Chapter 6, Slide 28
© 2010 McGraw-Hill Ryerson Limited
Losses on Intercompany Transactions

Selling an asset at a loss raises the question of
whether the loss reflects fair value and an
impairment


LO 1
If impairment is present the asset should be written
down to its net realizable value
If impairment is not present and the loss does not
reflect fair value, the loss should be eliminated
Chapter 6, Slide 29
© 2010 McGraw-Hill Ryerson Limited