Advanced Financial Accounting: Chapter 4 Group Reporting III: Consolidation under IAS 27 Tan & Lee...

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Advanced Financial Accounting: Chapter 4

Group Reporting III:

Consolidation under IAS 27

Tan & Lee Chapter 4 © 2009

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Learning Objectives

1. Understand the principles underlying elimination of intragroup

balances and transactions;

2. Understand the rationale for consolidation adjustments to opening

retained earnings (RE);

3. Appreciate the significance of upstream vs downstream sales &

the impact on non-controlling interests (NCI); and

4. Pass the appropriate consolidation adjustments to eliminate

unrealized profit or loss from transfers of fixed assets and

inventory.


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Content


1. Elimination of intragroup transactions and balances

2. Elimination of realized intragroup transactions

3. Elimination of intragroup balances

4. Adjustment of unrealized profit or loss arising from intercompany

transfers

5. Impact on non-controlling interests arising from adjustments of

unrealized profit or loss

6. Special considerations for intercompany transfers of fixed assets

7. Special accounting considerations when intragroup transfers are

made at a loss


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Elimination of Intragroup Transactionsand Balances

• Operational and financial interdependencies within the group entities– Lead to intragroup transactions and balances

• Intragroup transactions include:– Buying or selling of inventory; – Transferring of long lived assets; – Rendering or procuring of services; and– Providing financing among the companies within the group

• Transfer of assets within the group usually includes a profit margin:– Risks and rewards of ownership of assets remain in the group– Profit is unrealized until the asset is sold to a 3rd party– The time lag between purchase and resale of assets results in

overstatement/understatement of group profit/loss and assets


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Elimination of Intragroup Transactionsand Balances

• Intragroup balances arise from unsettled balances of intragroup transactions– E.g. Loan receivable/ payable to or from group companies , Dividend

receivable/payable, Accounts receivable/payable to or from group companies

• From an economic perspective, an entity is not able to transact with itself– All intra-group transactions and balances are to be eliminated during

consolidation– Elimination adjustments are made in relation to the original entries

passed in the separate financial statements


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Principles Governing Elimination

• Outstanding balances due to or from companies within a group are

eliminated

• Transactions in the income statement between the group

companies are eliminated

• Unrealized profit or loss included in assets are eliminated in full

(both parent’s & NCI’s share)

• Tax effects on unrealized profit or loss included in assets should be

adjusted according to IAS 12 Income Taxes

• Balances with associates (“significant influence”) are not eliminated

– Associates are not part of the group


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Content






transfers





made at a loss


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Elimination of Realized Intragroup Transactions

• “Offsetting” effect on the group’s net profit from realized transactions– Profit recorded by the selling company offsets the expense recorded by

the buying company– However, elimination is still required to avoid overstatement of individual

line items

Examples:

1. Transactions relating to interest:– No time lag in the recognizing of interest by borrower and lender– Interest income exactly offsets the interest expense– Elimination entry:


Dr Interest Income

Cr Interest Expense

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Elimination of Realized Intragroup Transactions

2. Transactions relating to services provided– Provision and consumption of services are simultaneous– Transactions are recorded in the same period by both parties– Elimination entry:

3. Transfers of inventories that are resold to 3rd party in the same period– Profit recorded by selling company offsets the higher cost of sale

recorded by buying company– Elimination entry:


Dr Service Income

Cr Service Expense

Dr Sales

Cr Cost of Sales

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Content






transfers





made at a loss


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Prior to Elimination

• Reconciliation is carried out when the balances recorded in both companies differ

• Usually, reconciling items are due to:


Problems Reconciliation adjustments

In-transit items (recorded by only one company)

Either adjusted out or recognized in a

manner consistent with the other party’s

treatment

Errors and omissions Correct the error or pass entry to record

the omitted entry

Dispute on the transaction

Either recognized by the disputing party

or adjusted out by the party that recorded

the items in books

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Reconciliation


Reconciliation of balances between Sub A and Sub B

$

Amount owing by B in A’s book as at 31 December 20X5 40,000

Less: Items in A’s book but not in B’s books:

Disputed (note 1) (1,500)

Goods received on 29 December 20X5 (note 2) (3,200)

Repair for goods not under warranty (note 3) (300)

Less: payment made in December 20X5 by B not recorded by A (note 4) (17,000)

Amount owing to A in B’s book as at 31 December 20X5 18,000

Reconciliation of intercompany balances

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Reconciliation

Note 1: Either Sub A had to reverse the sale or Sub B had to accrue for the invoice

Note 2: Since goods were received before the year end, Sub B had to record the inventory

Note 3: Since repairs were not covered under warranty, Sub B had to record the repair costs

Note 4: Follow –up action is necessary to ascertain the reason for the non-clearance. If the cheque is lost, Sub B is required to reverse the

payment entry

Dr Inventory 3,200

Cr Payable to A 3,200

Dr Repair costs 300

Cr Payable to A 300

Dr Bank 17,000

Cr Payable to A 17,000Tan & Lee Chapter 4 © 2009

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Content






transfers





made at a loss


transfers

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Intragroup Transfers of Inventory and Fixed Assets

• Unrealized profit and loss in asset (arising from intragroup transaction) should be eliminated in full

• If the transferred asset is an inventory:– It should be carried at original cost and not the transferred price– Adjustments are made to:

Eliminate the profit element Recognize profit only when the inventory is sold to 3rd party

• If the transferred asset is a fixed asset:– The asset should be carried at original cost less accumulated

depreciation – Subsequent depreciation is based on original cost and not the

transferred price


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Adjustment to Opening Retained Earnings (RE)

• When a transaction is recognized by a legal entity in one period and by the economic entity in another period– Consolidation adjustments are passed through opening RE– Consolidated opening RE should be the same as the consolidated

closing RE of the previous period

• The summation of the opening RE of the legal entities in the group will not be equal to the consolidated Opening RE– Consolidated adjustments that have a “one-sided effect” on RE (i.e.

elimination adjustments are not fully offsetting) must be re-enacted to opening RE of the next period

– E.g. Unrealized profit from intragroup balances in the previous year are adjusted against opening RE in the subsequent year


Adjustments to Eliminate Unrealized Profit

Tan & Lee Chapter 4 © 2009 17

In the current period:

Dr Sales

Cr Cost of sales

Cr Inventory

In the following period (if unsold):

Dr Opening RE

Cr Inventory

In the following period (if sold):

Dr Opening RE

Cr Cost of sales

Inter-company sales is reversed

(1) Eliminate realized cost of sales

(2) Reverse unrealized cost of sales

Unsold % x Unrealized profit

Remove unrealized profit in inventory

Adjust cost of sales from transfer price to original cost

Assuming no NCI effect

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Tax Effects on Adjustments to Eliminate Unrealized Profit (Loss)

• Consolidated tax expense must reflect the tax effects of the consolidated profit before tax (assuming no NCI)

• When unrealized profit is eliminated:– Profit is taxable for the legal entity but not the economic entity– A deferred tax asset arises (i.e. in the form of a prepaid tax)– Consolidation adjustment:

– The tax expense is recognized when the asset is sold to 3rd party


In the current period:

Dr Deferred tax asset

Cr Tax expense

In the following period (if unsold):

Dr Deferred tax asset

Cr Opening RE

In the following period (if sold):

Dr Opening RE

Cr Tax expense

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Illustration 1:Upstream Sale • S is a wholly owned subsidiary of P• On 1 April 20X1, S sold inventory costing $7,000 to its P for $10,000• On 5 Jan 20X2, P sold the inventory to external party for $15,000• Tax rate was 20% . Year-end is 31 Dec 20X1

Q1 What are the consolidation journal entries as at YE 31 Dec 20X1 ?

Dr Sales (S’s I/S) 10,000

Cr Cost of sales (S’s I/S) 7,000

Cr Inventory (P’s B/S) 3,000

This entry is to reduce current year profits and overstatement of inventory for the unrealized profit of $3,000

Dr Deferred tax asset (Group B/s) 600 (3,000 * 20%)

Cr Tax expense (S’s I/S) 600

Tax effects of profit adjustmentTan & Lee Chapter 4 © 2009

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Illustration 1:Upstream SaleQ2: What are the consolidation entries as at 31 Dec 20X2?

Dr Opening RE (S’s B/S) 3,000

Cr Cost of sales (P’s B/S) 3,000

This entry is to reduce previous year profit through opening RE and recognize profit in the current year when the inventory is sold to a 3rd party

Dr Tax expense (group’s I/S) 600

Cr Opening RE 600

Since the profit is realized in this year, the tax expense should be recognized in the group’s income statement in the current year

OrDr Deferred tax asset 600

Cr Opening RE 600

Dr Tax expense 600

Cr Deferred tax asset 600Tan & Lee Chapter 4 © 2009

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Content






transfers





made at a loss



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Downstream Sale


Parent

Subsidiary

90 % owned

Sales were made from parent to subsidiary

Unrealized profit resides in Parent’s book

In downstream sale, NCI’s share of profit of the subsidiary is not affected because the adjustment affects the parent’s profit not the subsidiary

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Upstream Sale


Parent

Subsidiary

90 % owned

Sales were made from subsidiary to parent

Unrealized profit resides in Subsidiary’s book

In upstream sale, the unrealized profit resides in the subsidiary. Thus, NCI’s share of the unrealized profit or loss needs to be adjusted from the carrying amount of the asset (IAS 27 Para 21)

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Illustration 2:Upstream and Downstream Sales

• P invested in 70% of shares of S• Intercompany transfers of inventory are as follows:

• Tax rate: 20%• Net profit after tax of S: $800,000 (31 Dec 20X3)

$900,000 (31 Dec 20X4)


20X3 20X4

Sale of inventory from P to SOriginal cost of inventoryGross profitPercentage unsold to 3rd party at year end

$60,000$(50,000)$10,000

10% 4%

Sale of inventory from S to POriginal cost of inventoryGross profitPercentage unsold to 3rd party at year end

$200,000$(170,000)

$30,00030% 0%

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31 Dec 20X3

1) Eliminate intercompany sales and adjust unrealized profit in inventory


Dr Sales 60,000

Cr Cost of sales 59,000

Cr Inventory 1,000

(Elimination of intercompany sales and adjustment of unrealized profit from downstream sale)

Unrealized profit x percentage unsold

Dr Sales 200,000


Cr Inventory 9,000

(Elimination of intercompany sales and adjustment of unrealized profit from upstream sale)

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2) Adjust the tax effects on unrealized profit


Dr Deferred tax asset 200

Cr Tax expense 200

(Elimination of intercompany sales and adjustment of unrealized profit from downstream sale)

Unrealized profit from unsold inventory x 20%

Dr Deferred tax asset 1,800

Cr Tax expense 1,800

(Adjustment for tax effects on unrealized profit in inventory from upstream sale)

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3) Allocate share of current profit and RE to NCI


* Note: No adjustment is required for the unrealized profit from downstream sale as profit resides in parent income

Dr Income to NCI 237,840

Cr NCI 237,840

Net profit after tax of S * 800,000

Less: Unrealized profit from upstream sale (9,000)

Add: Tax on unrealized profit 1,800

Adjusted profit 792,800

NCI’s share (30%) 237,840

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31 Dec 20X4

1) Adjust opening RE and adjust unrealized profit in inventory


Dr Opening RE 1,000

Cr Cost of sales 600

Cr Inventory 400

(Adjustment of unrealized profit in RE from downstream sale in 31 Dec 20X3)

Dr Opening RE 6,300

Dr NCI 2,700


(Adjustment of unrealized profit in RE from upstream sale in 31 Dec 20X3)

Need to adjust NCI’s share of unrealized profit from upstream sale

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2) Adjust the tax effect


Dr Tax expense 120

Dr Deferred tax asset 80

Cr Opening RE 200

(Adjustment for tax effects on unrealized profit from downstream sale in RE)

Dr Tax expense 1,800

Cr Opening RE 1,260

Cr NCI 540

(Adjustment for tax effects on unrealized profit in inventory from upstream sale)

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3) Allocate share of current profit and RE to NCI


Cr NCI 272,160

Net profit after tax of S * 900,000

Add: Unrealized profit from upstream sale 9,000

Less: Tax on unrealized profit (1,800)

Adjusted profit 907,200

NCI share (30%) 272,160

* Note: Adjustments to current year profit:

1) Realized profit & tax from prior years is added back

2) Unrealized profit & tax from unsold inventory in current year is deducted (none in this year)

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transfers





made at a loss


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Transfers of Fixed Assets

• When fixed assets (FA) are transferred at a marked-up price– The unrealized profit must be eliminated from the carrying amount of FA– It is as though the transfer did not take place from the group’s

perspective


Acc. Dep.

NBV

Original cost

Before Transfer After Transfer

Transfer price

Mark up

$40,000+Acc. Dep.

NBV

Profit on sale

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Adjustments of Transfers of Fixed Assets


1. Restate the FA carrying amount to the NBV at the point of transfer

2. Profit on sale of FA is adjusted out of:

Consolidated income statement if sale occurred in the same period

Opening RE if sale occurred in the previous period

3. Subsequent depreciation is based on original cost of asset &

estimated useful life (including revision of estimate)

The difference between the old and new depreciation is adjusted to:

Consolidated income statement for current year

Opening RE for prior year accumulated depreciation

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Adjustments of Transfers of Fixed Assets


4. The profit or loss on transfer of FA is realized through the higher or lower

depreciation charge subsequently

5. Tax effect must be adjusted on the unrealized profit and subsequent

corrections of depreciation

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Impact on NCI When an Unrealized Profit Arises from an Intragroup Transfer of FA

• Downstream sales:– No impact on NCI

• Upstream sales:– NCI is adjusted for:

Unrealized profit on sale of FACorrection of over/under-depreciationTax effect on unrealized profitTax effect on correction of over/under-depreciation


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Illustration 3:Downstream Transfer of Fixed Assets

• 1 Jan 20X2: P sold equipment to S for $360,000• The original cost of the equipment was $400,000• The remaining useful life was 10 years from the original purchase

date• The remaining useful life is 8 years from the date of transfer• Assume a tax rate of 20%


Status Quo With sale Amount to be

restored/adjusted

Cost of assetAcc. DepCurrent DepProfit on sale

$400,000$120,000

40,000-

$360,000$45,000

45,000$40,000

$40,000$75,000

5,000$40,000

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CJE 1: Adjustment of unrealized profit

Dr Equipment (S) 40,000

Dr Profit on Sale (P) 40,000

Cr Accumulated depreciation (S) 80,000

31 Dec 20X2

Reversal of these entries:

In P’s Books

Dr Cash 360,000

Dr Acc. dep 80,000

Cr Equipment 400,000

Cr Profit on sale 40,000

In S’s Books

Dr Equipment 360,000

Cr Cash 360,000

Dr Dep 45,000

Cr Acc. Dep 45,000

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CJE 2: Reverse tax on profit on sale

Dr Deferred tax asset (group’s BS) 8,000

Cr Tax expense (P) 8,000

$40,000

$20,000$60,000

Acc. Dep.

$40,000

NBV: $315,000

NBV: $280,000

Depreciation

Depreciation

$360,000

$320,000

8 yrs

8 yrs

Transfer

No Transfer

Dep exp: $45,000

Dep Exp: $40,000

Excess5K

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CJE 3: Correct the over-depreciation on unrealized profit included in equipment

Dr Accumulated depreciation (S) 5,000

Cr Depreciation (S) 5,000

Old depreciation 40,000

New depreciation 45,000

Over-depreciation 5,000

CJE 4: Increase in tax arising from correction of over-depreciation

Dr Tax expense (S) 1,000

Cr Deferred tax asset (group’s BS) 1,000

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When the equipment is fully depreciated:

CJE 5: Reinstate to original cost, accumulated depreciation and reverse profit


Dr Opening RE (P) 40,000


CJE 6 : Correction of past excess depreciation

Dr Accumulated depreciation (S) 40,000

Cr Opening RE (S) 40,000

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CJE 7: Tax effects on unrealized profit on sale of fixed assets

Dr Deferred tax asset 8,000

Cr Opening RE (P) 8,000

CJE 8: Tax effects on unrealized profit on sale of fixed assets

Dr Opening RE (S) 8,000

Cr Deferred tax asset 8,000

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Illustration 4:Upstream Transfer of Fixed Assets

• Assume illustration 3, except that S transfers to P• 1 Jan 20X2 S sold equipment to P for $360,000• The original cost of equipment was $400,000• The remaining useful life is 8 years from date of transfer• Net profit after tax of S for YE 31 Dec 20X2 : 500,000

YE 31 Dec 20X3 : 800,000• Assume a tax rate of 20%

Original cost

$400,000

Before Transfer After Transfer

Transfer price$360,000

40,000

Profit on sale


Acc Dep. = $80,000

Net book value = $320,000

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CJE 1: Adjustment of unrealized profit


Dr Profit on Sale (P) 40,000


31 Dec 20X2

CJE 2: Reverse of tax on profit on sale

Dr Deferred tax asset (group’s BS)

8,000

Cr Tax expense (S) 8,000

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CJE 3: Correct the over-depreciation on unrealized profit included in equipment

Dr Accumulated depreciation (P) 5,000

Cr Depreciation (P) 5,000

Old depreciation 40,000

New depreciation 45,000

Over-depreciation 5,000

CJE 4: Increase in tax arising from correction of over-depreciation

Dr Tax expense (P) 1,000


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CJE 5: Allocation of current year profit


Cr NCI 47,200

Net profit after tax of S 500,000

Less: Unrealized profit on sale (after-tax) (32,000)

Add: Over-depreciation (after-tax) 4,000

Adjusted net profit 472,000

NCI’s share (10%) 47,200

* Note: Upstream sale of FA will affect NCI’s share of profit as unrealized profit resides in S

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31 Dec 20X3

CJE 1: Adjustment of unrealized profit in prior year

Dr Equipment (P) 40,000

Dr Opening RE (S) 36,000

Dr NCI 4,000

Cr Accumulated depreciation (P) 80,000

CJE 2: Reversal of tax on profit on sale in prior year

Dr Deferred tax asset (group’s BS) 8,000

Cr Opening RE (S) 7,200

Cr NCI 800

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CJE 3: Correct the over-depreciation for prior and current year

Dr Accumulated depreciation (P) 10,000

Cr Depreciation (P) 5,000

Cr Opening RE (P) 4,500

Cr NCI 500

CJE 4: Increase in tax arising from correction of over-depreciation in prior and current year

Dr Tax expense (P) 1,000

Cr Opening RE (P) 900

Cr NCI 100


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CJE 5: Allocation of current year profit to NCI


Cr NCI 80,400

Net profit after tax of S 800,000

Add: Over-depreciation (after-tax) 4,000

Adjusted net profit 804,000

NCI’s share (10%) 80,400

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transfers





made at a loss


made at a loss

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Transfers of Assets at a Loss

• Need to reassess whether the loss is indicative of impairment loss

• If it is indicative of impairment loss:– Unrealized loss is not adjusted out of the carrying amount of asset– Only reverse the sales and cost of sale (to the extent of the sales) for

inventory– Only reverse the excess over cost and accumulated depreciation (to the

extent of the sales) for FA

• If it is not indicative of impairment loss:– Same treatment as with unrealized profit– Unrealized loss is adjusted out of the carrying amount of asset– Realized only when the inventory is sold to 3rd party or under/over-

depreciation of FA is corrected


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Illustration 5:Unrealized Loss Arising From Intragroup Transfers

• Parent transferred inventory to subsidiary during the year ended 31 Dec 20X6

• The loss on transfer indicated an impairment loss on the inventory

What is the consolidation journal entry?


Transfer price $60,000

Original Cost $80,000

Gross loss ($20,000)

Dr Sales 60,000

Cr Cost of Sales 60,000

Eliminate the transfer of Inventory – no adjustment is made to remove the unrealized loss

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Illustration 5:Unrealized Loss Arising From Intragroup Transfers

• Parent transferred fixed asset to subsidiary during the year ended 31 Dec 20X6

Transfer price $120,000Original Cost $200,000Acc. Dep ($ 50,000)NBV $150,000Loss on transfer $ (30,000)

• The loss on transfer indicated an impairment loss on the fixed asset

What is the consolidation journal entry?

Dr Fixed assets 80,000

Cr Accumulated depreciation 80,000

Eliminate the transfer of fixed asset – loss of $30,000 is not eliminated

Subsequent depreciation will take into account any revision in useful life of the impairment in value


Conclusions

• Only transactions with 3rd parties should be shown in consolidated financial statements

• Intra-group transactions and balances must be eliminated after reconciliation of balances

• Unrealized profit or loss in inventory or fixed assets must be adjusted

• Upstream transfers will impact NCI• Tax effects on profit adjustments must be made• Special considerations for transfers at a loss

Advanced Financial Accounting: Chapter 4 Group Reporting III: Consolidation under IAS 27 Tan & Lee...

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