Chapter Five

Consolidated Financial Statements Intra-Entity Asset Transactions

McGraw-Hill/Irwin Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Main topic chapter 5

Many companies are affiliated in a vertical integrated chain of organizations. Inter-entity asset transactions take place: sale and purchase of inventory or long-term assets. The elimination of the accounting effects created by these intra-entity transactions is one of the most significant problems in the consolidation process. To defer unrealized gains to establish within the consolidated statements both: historical cost balances and recognize appropriate income
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Learning objectives chapter 5

After studying this chapter, you should be able to: 1. Understand why intra-entity asset transactions create accounting effects within the financial records of affiliated companies that must be eliminated or adjusted in preparing consolidated financial statements. 2. Understand that when companies affiliated through common control engage in intra-entity inventory transfers, consolidation procedures are acquired to eliminate sales and purchase balances. 3. Understand why consolidated entities defer intraentity gross profit in ending inventory and the consolidation procedures required to recognize profits when actually earned.
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Learning objectives chapter 5

4. Understand that the consolidation process for inventory transfers is designed to defer the unrealized portion of an intra-entity gross profit from the year of transfer into the year of disposal or consumption. 5. Understand the difference between upstream and downstream intra-entity transfers and how each affects the computation of noncontrolling interest balances. 6. Prepare the consolidation entry to remove any unrealized gain created by the intra-entity transfer of land from the accounting records of the year of transfer and subsequent years. 7. Prepare the consolidation entries to remove the effects of upstream and downstream intra-entity fixed assets transfers across affiliated entities.

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LO 1

Intra-entity Transactions
When companies affiliated through common control engage in intra-entity inventory transfers, consolidation procedures are required to eliminate sales and purchases balances. Transactions between a parent and subsidiary are considered internal transactions of a single entity. Effects of intra-entity transactions should be eliminated from the consolidated financial statements.

Consolidated statements must reflect only transactions with outside parties.

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Remember
Parent
Downstream Sales

Parent
Upstream Sales

Sub

Sub

Parent and sub operate separately and maintain their own record-keeping: they record sale and purchase in the regular way: consolidation is ones a year. Parent and sub charge a transfer price: market price, cost + margin, or negotiated.
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LO 2

Sales and PurchasesIntra-entity

Exhibit page 200 Arlington Company owns Zirkin Company. Arlington acquired inventory at cost of $50,000 and sells this goods to Zirkin for $80,000. Both affiliated entities record the transfer of Arlington to Zirkin as a normal sale / purchase: Arlington: Accounts Receivable Sales GOCS Inventory Zirkin: Inventory Accounts Payable 80,000 80,000 50,000 50,000

80,000 80,000
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Sales and PurchasesIntra-entity

ENTRY TI (Transferred Inventory) Eliminate all intra-entity sales/purchases of inventory by eliminating the sales price of the transfer which one company records as sales, and the other records as cost of goods sold.
Consolidation Record Sales Cost of Goods Sold ENTRY TI eliminates transferred inventory Page 80,000 80,000 ##

The total recorded amounts are deleted.

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Sales and PurchasesIntra-entity

New consolidated balances: Sales GOCS Inventory 0 30,000 30,000

credit debit

GOCS to low, thus profits to high

Contains Unrealized Gross Profit

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LO 3

Unrealized Gross Profit Intra-entity

ENTRY G (Gross Profit)
Despite Entry TI, ending inventory may still be overstated due to the transfer price exceeding historical cost. Intra-entity profits that remain unrealized at year-end must be removed in arriving at consolidated figures. Unrealized gain is eliminated as follows in Year 1: Consolidation Record Page ##

Cost of Goods Sold (ending Inventory component) 30,000 Inventory (Balance Sheet account)

30,000

ENTRY G removes unrealized gross profit created by intra-entity sale.

Note: The consolidated company has earned the profit on any portion of the intra-entity transaction that was sold to unrelated parties and does not need to make an adjustment for the sold items for consolidation purposes.
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Exercises LO 1+2+3
Problems: 1, 2, 4, 5, 10, 11, 12, 15.

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LO 4

Unrealized Gross Profit Intra-entity

At the beginning of the second year, the figures in the recording system of both affiliated parties still includes:

Arlington: Retained Earnings: a profit of $30,000 Zirkin: Inventory: $80,000. When Zirkin sells these products to outside parties, GOCS is $30,000 to high.
The profit will be realized in the second year. The balances must be removed with reverence to the consolidation at the end of the second year.

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Unrealized Gross Profit Intra-entity

ENTRY *G From a consolidated view, the buyer s Cost of Goods Sold (the beginning inventory component) and the seller s Retained Earnings accounts as of the beginning of Year 2 contain the unrealized profit, and must both be reduced in Entry *G in Year 2.
Consolidation Record Page ##

Retained Earnings (beginning balance of seller) 30,000 COGS (beginning Inventory component of buyer)

30,000

ENTRY *G removes unrealized gross profit from beginning figures so that it is recognized in the consolidated income in the period in which it is earned.

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Unrealized Inventory Gain Downstream Transfers

Worksheet Entry TI: Sales xxx GOCS xxx and Entry G: COGS xxx Inventory xxx are standard, regardless of the circumstances of the consolidation.

But Entry *G differs from just presented IF: 1. the original transfer is downstream (parents) and 2. the parent applies the Equity Method for internal accounting purposes. Because by Entry I: Investment income xxx Investment in Sub xxx unrealized gross profits are already deferred.
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Intra-entity Transactions Downstream Transfers

ENTRY *G If the transfer of inventory is downstream AND the parent uses the Equity Method, the following new version of Entry *G is applied:
Consolidation Record Investment in Subsidiary COGS (beginning Inventory component)
ENTRY *G

Page 30,000

## 30,000

Investment in Subsidiary account replaces the Retained Earnings account used for upstream sales. This compensates the credit balance of the Investment account by Entry I.
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Unrealized Inventory Gain Downstream Transfers

For intra-entity beginning inventory profits resulting from downstream transfers when the parent applies the Equity Method: 1. Parents Retained Earnings are appropriately stated due to intra-entity profit deferrals and recognition. 2. The subsidiary Retained Earnings reflect none of the intra-entity profit and require no adjustment. 3. The parents Investment account at beginning of Year 2 contains a credit from the deferral of Year 1 downstream profits. 4. Worksheet Entry *G transfers the Year 1 Investment account credit to a Year 2 earnings credit via COGS to recognize the profit in the year of sale to outsiders.
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Exercises LO 4
Problem: 28.

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LO 5

Unrealized Gross Profits Effect on Noncontrolling Interest

Accounts affected by intra-entity transactions: Revenues Cost of Goods Sold Expenses Noncontrolling Interest in Subsidiary s Net Income

Retained Earnings at the Beginning of the Year

Inventory Land, Buildings, and Equipment

Noncontrolling Interest in Subsidiary at End of Year.

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Unrealized Gross Profits Effect on Noncontrolling Interest

The complete elimination of the intra-entity profit or loss is consistent with the underlying assumption that consolidated financial statements represent the financial position and operating results of a single economic entity.

According to FASB ASC paragraph 810-10-45-6: The amount of intra-entity profit or loss to be eliminated is not affected by the existence of a noncontrolling interest. The elimination of the intra-entity profit or loss may be allocated proportionately between the parent and noncontrolling interest.

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Intra-Entity Inventory Downstream Transfer - Example

Top Company acquires 80 percent of the voting stock of Bottom Company on January 1, 2012. Top pays $400,000. Acquisition-date fair value of noncontrolling interest is $100,000. Top allocates the entire $50,000 excess fair value over book value to adjust a database owned by Bottom to fair value. The database has an estimated remaining life of 20 years.

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Intra-Entity Inventory Downstream Transfer - Example

The subsidiary reports net income of $30,000 in 2012 and $70,000 in 2013, the current year. Dividend payments are $20,000 in the first year and $50,000 in the second. A $10,000 intra-entity debt exists as of December 31, 2013. Intra-entity inventory transfers between the two companies: 2012 2013 Transfer prices . . . . . . . . . . . . . . . . . . . . . . . . $80,000 $100,000 Historical cost . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 70,000 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,000 $ 30,000 Year-end Inventory balance (transfer price) $16,000 $ 20,000 Gross profit percentage . . . . . . . . . . . . . . . . . . X 25% X30% Gross profit remaining in year-end inventory $ 4,000 $ 6,000

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Intra-Entity Inventory Transfers Example

Three entries require attention in the calculation of noncontrolling interest in the subs Net Income December 31, 2013.

Entry *G removes unrealized gross profits (25% rate) carried over from the previous period intra-entity downstream sales.
Entry *G reduces Cost of Goods Sold (or beginning inventory component) which creates an increase in current year income. Gross profit is correctly recognized in 2013 when inventory is sold to an outside party. The debit to the Investment in Bottom account brings that account to a zero balance in consolidation.
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Intra-Entity Inventory Downstream Transfer - Example

Entry TI eliminates the intra-entity sales/purchases for 2013.

Entry G defers the unrealized gross profit (30% rate) of $6,000 remaining at the end of 2013.

Entry G eliminates the overstatement of Inventory as well as the ending component of Cost of Goods Sold which decreases consolidated income.
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Intra-entity Transactions Upstream Inventory Transfer

A different set of consolidation procedures is necessary if the intra-entity transfers are upstream. Upstream gross profits are attributed to the subsidiary, Bottom, not the parent, Top: Because inventory transfers are upstream from Bottom to Top, only 80% of the profit deferral and subsequent recognition is allocated to the parents Equity Earnings and Investment account. Intra-entity profit reallocation across time affects both the subsidiary s reported income and the noncontrolling interest.
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Intra-entity Transactions Upstream Inventory Transfer

The records of the two companies change to reflect the parents application of the Equity Method for upstream sales. Entry *G reduces Bottoms beginning 2013 Retained Earnings balance, and decreases Cost of Goods Sold which increases consolidated Net Income to recognize profit earned in 2013 by sales to outsiders.

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Intra-entity Transactions Upstream Inventory Transfer

As of January 1, 2013, $16,000 of transfers remain in Tops inventory, and $4,000 of gross profit (25%) is unearned from a consolidated perspective. Also, Bottoms beginning Retained Earnings are overstated by $4,000, the gross profit from 2012 intra-entity transfers.

A credit to Cost of Goods Sold increases consolidated net income to recognize that the profit has been earned in 2013 by sales to outsiders.

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Intra-entity Transactions Upstream vs. Downstream transfers

Compare the Entry *G for the downstream and upstream transfers to see the difference in the transactions.

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Intra-entity Transactions Upstream Inventory Transfer

Entry S eliminates a portion of the parents investment account and provides the initial noncontrolling interest balance. The entry also removes stockholders equity accounts of the subsidiary as of the beginning of the current year.
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Intra-entity Transactions Upstream vs. Downstream transfers

To better understand how the Entry S differs, compare the entries for the downstream and upstream transfers.

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Exercises LO 5
Problems: 3, 6, 7, 13, 17, 19, 21, 27, 29, 31, 32.

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LO 6

Intra-entity Transactions Land Transfer

If land is transferred between the parent and sub at a gain, the gain is considered unrealized and must be eliminated until the moment of selling to an outside party. Two differences compared with intra-entity inventory transfers: No use of sales/purchases accounts, Buyer often holds land for years if not permanently: realizing profit takes a long time.

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Intra-entity Transactions Land Transfer

Exhibit page 220-222 Hastings Company owns Patrick Company. July 1, 2013 Hastings sells land to Patrick at transfer price: $100,000, historical cost: $60,000. Both affiliated entities record the transfer : Hastings: Cash Land Gain on Sale of Land Patrick: Land Cash

100,000
60,000 40,000

100,000
100,000

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Intra-entity Transactions Land Transfer

New consolidated balances: Land Gain on Sale of Land 40,000 40,000 debit credit

Capitalization of inflated transfer price in financial records of buyer

Unrealized Gross Profit in financial records of seller

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Intra-entity Transactions Land Transfer

ENTRY TL For consolidated purpose the unrealized gain is must be eliminated.
Consolidation Record Gain on Sale of Land Land Page 40,000 ##
40,000

ENTRY TL eliminates effects of intra-entity transfer of land in year of transfer.

Note: By crediting land for the same amount, this effectively returns the land to its carrying value on the date of transfer (historical cost).
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Intra-entity Transactions Land Transfer

ENTRY *GL As long as the land remains on the books of the buyer, the unrealized gain must be eliminated at the end of each fiscal period.
Consolidation Record Retained Earnings (beginning balance of seller) Land Page 40,000 ##
40,000

Or Investment account, if downstream and Equity method

ENTRY *GL eliminates effects of intra-entity transfer of land in subsequent years.

Note: The original gain was closed to Retained Earnings at the end of each period. When we eliminate the gain in subsequent years, it must come from Retained Earnings.
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Intra-entity Land Transfers Eliminating Unrealized Gains

If Patrick sells the land to a third party for $115,000, the unrealized gain must be recognized as a REALIZED gain in the current periods consolidated financial statements. Patrick records the transfer :
Cash Land Gain on Sale of Land 115,000

100,000 15,000

Patrick recognizes only a $15,000 gain, but from the viewpoint of the business combination the gain is $55,000.
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Intra-entity Land Transfers Eliminating Unrealized Gains

ENTRY *GL (Year of sale to outside party) In the period the land is sold to a third party, the unrealized gain must be eliminated one more time, and also finally recognized as a REALIZED gain in the current periods consolidated financial statements.
Consolidation Record Retained Earnings (Hastings) Gain on Sale of Land Page 40,000 ## 40,000

To remove intra-entity gain from year of transfer so that total profit can be recognized in current period when land is sold to an outside party.

Note: Modify the entry to credit the Gain account instead of Land.
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The Effect of Land Transfers on Noncontrolling Interests

DOWNSTREAM transfers have no effect on noncontrolling interest.

UPSTREAM transfers have a gain on the SUBSIDIARY books! All noncontrolling interest balances are based on the subs net income EXCLUDING the intra-entity gain.

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Exercises LO 6
Problem: 36.

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LO 7

Intra-entity Transactions Depreciable Asset Transfers

Example Able Co. and Baker Co. are related parties. Able purchased equipment for $100,000 several years ago, and has recorded $40,000 of depreciation since that time. Baker buys the equipment from Able for $90,000 on 1/1/12. The equipment has a remaining useful life of 10 years.

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Intra-entity Transactions Depreciable Asset Transfers

On the Seller s Books: Cash . . . . . . . . . . . . . . . . . . . . . . . . . . $90,000 Accumulated Depreciation . . . . . . . . . 40,000 Equipment . . . . . . . . . . . . . . . . . . . . $100,000 Gain on Sale of Equipment . . . . . . . . . 30,000
NOTE: The seller WOULD record depreciation expense at $6,000 per year year if they had not sold the equipment ($60,000 / 10).

On the Buyer s Books: Equipment. . . . . . . . . . . . . . . . . . . . . $90,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . $90,000

NOTE: The buyer WILL record $9,000 per year in depreciation based on the remaining life ($90,000 / 10).
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Intra-entity Transactions Depreciable Asset Transfers

New consolidated balances:
Accumulated Depreciation Equipment Gain on Sale of Equipment 40,000 10,000 30,000 debit credit credit

Transfer price $90,000, although book value is $60,000

Unrealized Gross Profit in financial records of seller

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Intra-entity Transactions Depreciable Asset Transfers

ENTRY TA In the year of transfer, the unrealized gain must be eliminated and the assets restated to original historical cost.

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Intra-entity Transactions Depreciable Asset Transfers

ENTRY ED In addition, the buyer s depreciation is based on the inflated transfer price. The excess depreciation expense must be eliminated.

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Intra-entity Transactions Depreciable Asset Transfers

In Years Following the Year of Transfer Equipment is carried on the individual books at a different amount than on the consolidated books. The amounts change each year as depreciation is computed. To get the worksheet adjustments, compare the individual records to the consolidated records.

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Intra-entity Transactions Depreciable Asset Transfers

Two years after transfer:

The 1/1/13 Retained Earnings effect = the original gain of $30,000 on Ables (sellers) books less $9,000, one year of depreciation.
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Intra-entity Transactions Depreciable Asset Transfers

ENTRY *TA (Subsequent Years) The adjustment to fixed assets and depreciation expense must be made in each succeeding period. The entry for Consolidation is:

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Intra-entity Transactions Depreciable Asset Transfers

ENTRY ED (Subsequent Years) In addition, the Depreciation Expense and Accumulated Depreciation accounts must be adjusted.

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Intra-entity Transactions Depreciable Asset Transfers

If the transfer is downstream and the parent uses the Equity Method, then their Retained Earnings balance has already been reduced for the gain, and we adjust the Investment account instead.

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Summary
Transfers of assets among related parties are common.

Inventory transfers are the most prevalent form of intraentity asset transaction. Despite being only a transfer, one company records a sale while the other reports a purchase. These balances are reciprocals that must be offset on the worksheet in the process of producing consolidated figures.
Transfers of depreciable assets create the additional accounting issue of differing depreciation expense. This effect is eliminated on the consolidation worksheets. In consolidated financial statements, the effects of these transfers must be removed.
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Summary
Investment in sub EM Investment in sub account EM Equity income account PEM Investment in sub account PEM Equity income account IVM Investment in sub account Dividend of sub Income of sub Amortization excess FV Intra-entity inventory transactions Intra-entity land transactions Intra-entity depreciable assets transactions

+ +

+/+/-

+/+/-

+/+/-

+
+ +

+ +

+
+

+/+/+/+/-

+/+/+/+/-

+/+/+/+/-

IVM Equity income account

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Exercises LO 7
Problems: 8, 9, 18, 20, 22, 23, 24, 25, 26, 30, 33, 34, 35.

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