CHAPTER
8
INTRODUCTION
TO
INTERCOMPANY
TRANSACTIONS
FOCUS OF CHAPTER 8
• Intercompany Transactions:
– Operational Importance
– Nature and Variety
– The Importance of Using
Supportable (fair) Transfer Prices
– Basic Conceptual Issues
• Minimizing the Consolidation Effort
• Realized and Unrealized Profit
Situations
Operational Importance of
Intercompany Transactions
• Extent of Vertical Integration:
– Nearly 40% of world trade constitutes
intercompany transactions.
Operational Importance of
Intercompany Transactions
• Assessing Performance for Each
Entity Within the Consolidated Group:
– Meaningful assessment would be
impossible without intercompany
transactions.
Arm’s-Length Transactions:
A Short Explanation
• Defined:
– “Transactions that take place between
completely independent parties.”
Categories of
Transactions
• Arm’s Length Transactions:
– Are the ONLY transactions that can be
reported in the consolidated statements.
• Non-Arm’s Length Transactions:
– Are usually referred to as “related party
transactions.”
– Include ALL intercompany
transactions.
Types of Related Party
Transactions
• Involving only Individuals:
– Transactions among family members.
• Involving Corporations:
– With management and other employees.
– With directors and stockholders.
– With affiliates (controlled entities).
• Probably constitutes at least 99% of
all corporate related-party
transactions.
Necessity of Eliminating
Intercompany Transactions
• Eliminate ALL intercompany transactions
in consolidation:
Because they are internal
transactions from a consolidated
perspective.
– Not because they are related-party
transactions.
– Only transactions with outside unrelated
parties can be reported in the
consolidated statements.
–
Intercompany Transactions:
Additional Opportunities for Fraud
• Intercompany transactions sometimes
occur to:
– Conceal embezzlements.
–
Overstate reported profits.
2 + 2 = 5
Nature and Variety
of Intercompany Transactions
• Type 1—Dividend payments:
– Parents often need cash from
subsidiaries:
• To pay dividends.
• To pay their own expenses.
– Reasons why parents cannot get cash
from subsidiaries (a “blocked funds”
problem):
• Regulatory restrictions.
• Governmental restrictions.
Nature and Variety
of Intercompany Transactions
• Type 2—Loans:
– Parents often centralize treasury
functions at the parent level. Thus:
• Subsidiaries are unable to borrow from
outside lenders.
• Subsidiaries usually borrow from their
parents.
–Interest may or may not be
charged.
Nature and Variety
of Intercompany Transactions
• Type 3—Reimbursements for Directly
Traceable Costs:
–
Parents often arrange and pay for
external services that benefit a
subsidiary ONLY.
– Charging the subsidiary merely results
in recording expenses in the proper
income statement.
Nature and Variety
of Intercompany Transactions
• Type 4—Corporate Headquarters Services
and Expense Allocations:
– Handle one or two ways:
• BILLING from a profit center:
–Parent credits a Revenues account.
• ALLOCATION from a cost center :
–Parent credits an O/H Allocation acct.
–Use either incremental or
proportional allocation methods.
Nature and Variety
of Intercompany Transactions
• Type 5—Income Tax Expense
Allocations:
– Occurs ONLY when a parent & subsidiary
file a consolidated tax return:
• Use method consistent with FAS 109
“Accounting for Income Taxes”:
–Pro forma separate return method
complies.
–Formula driven allocation method
may or may not comply.
Nature and Variety
of Intercompany Transactions
• Type 6—Intangibles:
– Parents often transfer technology and
other intangibles to subsidiaries: Two
ways to do so are:
• Sell It: The transfer of a “right to”
an item. (Recorded as a sale.)
• Grant a License: The transfer of a
“right to use” an item. (Recorded
as license income.)
Nature and Variety
of Intercompany Transaction
• Type 7—Inventory Transfers:
– Virtually all occur in vertically integrated
entities.
– Classified as:
• Downstream sales (parent to
subsidiary)
• Upstream sales (subsidiary to parent)
• Lateral sales (subsidiary to subsidiary)
Nature and Variety
of Intercompany Transactions
• Type 8—Fixed Asset Transfers:
– Far less common than inventory
transfers.
– Most likely to occur when one entity
has surplus machinery or surplus
office equipment.
Nature and Variety
of Intercompany Transactions
• Type 9—Investments in Bonds of a
Member of the Consolidated Group:
– Found infrequently in practice.
– Much more involved to account for
than intercompany loans because of
premiums and discounts.
Importance of Using Supportable
(Fair) Transfer Prices
• Transfer prices may be:
– Negotiated between the entities.
– Set by the parent company.
Importance of Using Supportable
(Fair) Transfer Prices
• Actual transfer prices used are:
– Relevant ONLY from each individual
entity’s perspective—impacts each
entity’s reported net income.
– Irrelevant from a consolidated
perspective
• Because they are undone in
consolidation—exactly as if the
transactions had NEVER occurred.
Importance of Using Supportable
(Fair) Transfer Prices: Tax Rules
• From An Income Tax Reporting
Perspective:
– Transfer prices used have enormous
implications.
– Because of the potential to arbitrarily
shift profits between entities.
– And thereby lower the consolidated
income tax expense.
– Especially on an international scale.
Importance of Using Supportable
(Fair) Transfer Prices: Tax Rules
• Tax Rules Concerning Transfer Prices:
– Section 482 of Internal Revenue Code
requires that:
• Transfer prices be at an arm’s length
basis.
Thus:
–Must charge a related party the
same price as an unrelated party.
Importance of Using Supportable
(Fair) Transfer Prices: Tax Rules
• Section 482 applies to ALL transfers:
– Inventory.
– Fixed assets.
– Services.
– Technology, patents, trademarks, and
other intangibles (whether by sale or
granting of a license).
– Interest rates on loans & prices on
leases.
Importance of Using Supportable
(Fair) Transfer Prices: Tax Rules
• Consequences of Insupportable Transfer
Prices:
– Substantial tax penalties and fines.
– Adjustment to financial statements for
underreporting of consolidated income
tax expense and payable.
• Transfer prices are irrelevant for tax
purposes:
– When a worldwide reporting system is
used (as used by six states).
A Billion Here, A Billion There!
Pretty Soon We’re Talking “Real Money”
• BAD NEWS:
– The IRS loses between $20-$40
billion of tax revenues each year
because of transfer pricing
shenanigans.
The Complexity of Determining
Supportable Transfer Prices: Winners
• GOOD NEWS:
– Tax accountant advisors to the
multinational firms earn big fees (as
high as $500 per hour) giving advice
on how to “MINIMIZE” consolidated
income taxes.
GAAP Requirements Concerning
Intercompany Transactions
• GAAP requires the following to be
eliminated for consolidated reporting:
– All intercompany revenues, expenses,
gains, and losses.
– All open account balances
(intercompany receivables and
payables).
– All unrealized intercompany profits
and losses.
• Use GROSS PROFIT OR LOSS.
The Consolidation Effort:
Keep It Simple
• Use SEPARATE intercompany accounts
in the income statement (for each
transaction type).
• Use a single Intercompany Receivable/
Payable account on each set of books.
• Reconcile ALL intercompany accounts
prior to consolidation.
• Use the “elimination by rearrangement”
technique on the consolidation worksheet.
What’s Unrealized and
What’s NOT?
• The unrealized profit issue does not occur
when:
– Transfers are made at cost.
– Transfers are made at above cost AND
• The profit reported by the one entity
is FULLY OFFSET by additional
costs and expenses reported in the
income statement by the other
entity.
Issuing Parent-Company-Only
(PCO) Statements
• Ye All Shall Know This:
– A parent company’s PCO statements
must report the same net income
and retained earnings amounts as
appear in the consolidated
statements.
Review Question #1
Intercompany income statement accounts
are eliminated in consolidation because
they are deemed as being:
A.
B.
C.
D.
Artificial transactions.
Potentially manipulative transactions.
Internal transactions.
At amounts that are not determined on
arms-length basis.
E. None of the above.
Review Question #1
With Answer
Intercompany income statement accounts are
eliminated in consolidation because they are
deemed as being:
A.
B.
C.
D.
Artificial transactions.
Potentially manipulative transactions.
Internal transactions.
At amounts that are not determined on
arms-length basis.
E. None of the above.
Review Question #2
Which of the following account types need
not be eliminated in consolidation?
A. Intercompany assets & intercompany
liabilities.
B. Intercompany revenues & intercompany
expenses.
C. Intercompany overhead allocations.
D. Long-term intercompany receivables.
E. None of the above.
Review Question #2
With Answer
Which of the following account types need
not be eliminated in consolidation?
A. Intercompany assets & intercompany
liabilities.
B. Intercompany revenues & intercompany
expenses.
C. Intercompany overhead allocation amounts.
D. Long-term intercompany receivables.
E. None of the above.
Review Question #3
An intercompany account balance that
would not need to be reconciled prior to
consolidation is Intercompany:
A. Dividends Payable.
B. Interest Receivable.
C. Management Fees Payable.
D. Overhead Allocation Receivable.
E. None of the above.
Review Question #3
With Answer
An intercompany account balance that
would not need to be reconciled prior to
consolidation is Intercompany:
A. Dividends Payable.
B. Interest Receivable.
C. Management Fees Payable.
D. Overhead Allocation Receivable.
E. None of the above.
Review Question #4
An account balance that would not need
to be reconciled prior to consolidation is:
A. Intercompany Sales.
B. Intercompany Interest Expense.
C. Intercompany Management Fee Income.
D. Intercompany Overhead Allocation Out.
E. None of the above.
Review Question #4
With Answer
An account balance that would not need to
be reconciled prior to consolidation is:
A. Intercompany Sales.
B. Intercompany Interest Expense.
C. Intercompany Management Fee Income.
D. Intercompany Overhead Allocation Out.
E. None of the above.
Review Question #5
In 2006, Saxco incurred $75,000 of intercompany interest charges. Of this amount,
Saxco paid $50,000 cash to its parent and
capitalized $30,000 to a discrete construction
project. The unrealized intercompany profit at
12/31/06 is:
A. $ -0B. $5,000
C. $20,000
D. $25,000
E. $30,000
Review Question #5
With Answer
In 2006, Saxco incurred $75,000 of intercompany interest charges. Of this amount,
Saxco paid $50,000 cash to its parent and
capitalized $30,000 to a discrete construction
project. The unrealized intercompany profit at
12/31/06 is:
A. $ -0B. $5,000
C. $20,000
D. $25,000
E. $30,000
End of Chapter 8
• Time to Clear Things Up—Any
Questions?