©The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin

Chapter 8

Consolidated Financial Statements:

Intercompany Transactions

2

Scope of Chapter

Accounting and working paper eliminations for related party transactions between a parent company and its subsidiaries can be grouped in two broad classes:

•Does not include inter company profits/losses.

•Includes inter company profits/losses.

3

Accounting Techniques

Ensure that consolidated financial statements include only those balances and transactions resulting from the consolidated group’s dealings with outsiders.

Separate ledger accounts established for all intercompany assets, liabilities, revenues and expenses.

4

Accounting for Inter company transactions not involving profit/loss

Loans on notes or open accounts

Leases of property under operating leases

Rendering of services

5

Loans on Notes or Open Accounts

Parent companies often make loans to their subsidiaries because of the following reasons:More extensive financial resources or bank lines of credit.Favorable interest rates to the parent company.

6

Accounting for Loans on Notes or Open Accounts

Lending rate of these loans generally exceeds the parent company’s borrowing rate.

Any interest earned by the parent company as a result of such loans must be eliminated

Interest income/expense parent is offset against interest expense/income subsidiary

7

Discounting of intercompany notes

If an intercompany note is discounted at a bank by the payee has following consequences:

The note is not payable to an outsider – the bank.

Discounted intercompany notes are not eliminated in a working paper for consolidated financial statements.

8

Leases of Property under operating Leases

Both the parent and the subsidiary should use the same accounting principle for lease.

Operating Lease

Capital Lease

Lessor:Receipts : Intercompany rent revenue

Sale of Property

Lessee: Payments : Intercompany rent expense

Acquisition of Property

9

Rendering of Services

Services may be rendered by a parent company to a subsidiary or vice versa.

Both the companies should record the transaction in the same accounting period.

Example: Management Fee charged to a subsidiary by a parent company.

10

Income Taxes Applicable to Intercompany Transactions

Intercompany revenue and expense transactions do not include an element of profit or loss for the consolidated entity as expense for one is offset by income for another.

Therefore, no income tax effects are associated with these transactions.

Note: This holds true even if the parent and the subsidiary companies file separate tax returns.

11

Accounting for Intercompany Transactions Involving Profit/Loss

Intercompany sales of merchandise. Intercompany sales of plant assets. Intercompany leases of property under

capital/sales type leases. Intercompany sales of intangible assets. Acquisition of affiliate’s bonds.

12

Importance of Eliminating or Including Intercompany Profits/Losses

While preparing the consolidated financial statements it is important to:

Eliminate unrealized profits/losses relating to:1. Transactions within the affiliated group.

2. Transactions with outsiders.

Recognize realized profits/losses.

13

Intercompany Sales of Merchandise

Intercompany sales of merchandise are a natural outgrowth of business combinations:

Vertical business combinations:1. Downstream: Sales of merchandise from a parent

company to its subsidiaries.2. Upstream: Sales of merchandise from

subsidiaries to the parent company. Lateral: Sales of merchandise between two

subsidiaries.

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Accounting for Intercompany Sales of Merchandise

Sale of merchandise may be made at: Sales price not involving any gross profit

margin. Sales price involving a gross profit margin.

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Intercompany Sales of Merchandise at cost

This has the following effect in the preparation of consolidated financial statements:

The cost of goods sold remains unaffected by the transaction.

The closing inventories do not require any adjustment for price.

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Intercompany Sales of Merchandise at profit

Gross profit margin in these transactions may be equal to, more than or less than the margin on sales to outsiders. It has to be accounted using FIFO method as follows:

• Sales made by the purchasing company – the selling company’s profit is realized and so not adjustment is required.

• Closing Inventories – The selling company’s unrealized gross profit has to be eliminated while preparing the financial statements.

17

Intercompany Profit in Inventories and Amount of Minority Interest

Two approaches have been suggested for intercompany sales/purchases transactions of partially owned subsidiaries:

• Parent Company Concept: Elimination of intercompany profit only to the extent of the parent company’s ownership interest.

• Economic Unit Concept: Elimination of all the intercompany profit.

Note: The FASB has expressed a preference for the second approach.

18

Intercompany Sales of Plant Assets versus Sales of Merchandise

Sales of plant assets are rare as compared to sales of merchandise.

Sales of plant assets pass through many accounting periods before profit/loss are realized as compared to sales of merchandise where profit/loss are usually realized in the ensuing accounting period

19

Intercompany Sales of Land

Valued at historical cost. Intercompany gain eliminated while preparing

consolidated financial statements.

20

Intercompany Sales of Depreciable plant assets

Valued at book value of the selling company while preparing consolidated financial statements.

Intercompany gain element must be eliminated from the depreciation expense.

In case of minority interest, intercompany gain in depreciation should be eliminated to the extent of the parent company’s ownership interest.

Intercompany gain in later years must reflect that the gain element in the acquiring affiliate’s annual depreciation represents a realization of a portion of total gain by the selling affiliate.

21

Intercompany Lease of Property under Capital/Sales type Leases

The assets are a sales-type lease to the lessor and a capital lease to the lessee.

Appropriate ledger accounts must be established by the lessor and the lessee to account for the lease.

22

Intercompany Sales of Intangible Assets

This is similar to gains in depreciable plant assets, but no accumulated amortization ledger account may be involved.

The unrealized gain of the seller is realized via periodic amortization expense recognition by the acquiring company.

23

Acquisition of Affiliate’s Bonds

Intercompany profits/losses can be realized by a consolidate entity when that entity acquires the bonds of the affiliate in the open market.

The profit or loss of acquiring the bonds are imputed because the transaction in not consummated between the two affiliates.

If however, the transaction were to result from a direct acquisition, the profit/loss would have to be eliminated.

In case the acquiring company sells the bonds to outsiders before they mature, the transaction profit/loss is not realized by the the consolidated entity, hence eliminated.