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Single Economic Entity

Single Economic Entity. Consolidated statements present financial performance and status of consolidated companies as a single economic entity Intercompany transactions must be removed Two types of intercompany sales/transfers Downstream sale/transfer

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Single Economic Entity

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  1. Single Economic Entity • Consolidated statements present financial performance and status of consolidated companies as a single economic entity • Intercompany transactions must be removed • Two types of intercompany sales/transfers • Downstream sale/transfer • Occurs when the parent sells to a subsidiary • Upstream sale/transfer • Occurs when a subsidiary sells to a parent Often used to enhance supply chain efficiencies

  2. Eliminating Intercompany Transactions • Why eliminate intercompany revenues and expenses? • Do not arise out of transactions with outside parties • Must avoid overstatement of consolidated revenues and expenses • Also eliminate related intercompany receivables and payables • Eliminate gains and losses on intercompany asset transfers • Since gains and losses are not ‘confirmed’ by outside party transactions, assets held at end of period must be adjusted

  3. Eliminating Entries C Eliminate current year’s equity method entries I Eliminate the effects of upstream and downstream intercompany transactions E Eliminate subsidiary’s beginning-of-year stockholders’ equity account balances R Revalue the subsidiary’s assets and liabilities as of the beginning of the year O Recognize current year write-offs of the subsidiary’s asset and liability revaluations N Recognize the noncontrolling interest in net income

  4. Intercompany Service & Financing Transactions • Providing services such as design, maintenance, accounting, payroll, etc. • Eliminate revenue on the provider’s books • Eliminate expense on the recipient’s books • Loans between parent and subsidiary • Eliminate loan receivable on lender’s books • Eliminate loan payable on borrower’s books • Eliminate interest revenue on lender’s books • Eliminate interest expense on borrower’s books

  5. Eliminating Intercompany Service Transactions Example Parrish Shoe Factory is a subsidiary of Jordan Athleticwear. In 2010, Jordan provides design services costing $650,000 to Parrish and bills Parrish $900,000. At year-end, Parrish still owes Jordan $100,000. Balances at December 31, 2010: To eliminate the intercompany receivable/payable: To eliminate the intercompany service revenue/expense:

  6. Eliminating Intercompany Loan Transactions Example Parrish Shoe Factory is a subsidiary of Jordan Athleticwear. In 2010, Jordan loans $1,000,000 to Parrish. Interest on the loan totals $50,000, and is accrued and paid. Balances at December 31, 2010: To eliminate the intercompany loan principal: To eliminate the intercompany interest revenue/expense:

  7. Intercompany Profits • Result from transferred assets from one affiliate to the other • Per ARB 51, profits not yet confirmed by further sale to outside parties must be eliminated • Both upstream and downstream transactions • i.e., not considered to be arm’s-length transactions • Confirmed profits require no elimination

  8. Eliminating Intercompany Profits Example Parrish Shoe Factory is a subsidiary of Jordan Athleticwear. In 2010, Jordan sells land to Parrish for $1,400,000 that had an original cost of $1,000,000. Prior to consolidation, Jordan shows a gain of $400,000 on its books while Parrish carries the land at $1,400,000. To eliminate the unconfirmed intercompany profit and reduce the land to original acquisition cost: • Land in consolidated balance sheet will be $1,000,000 • Gain of $400,000 remains in Jordan’s retained earnings • Land remains at $1,400,000 on Parrish’s books

  9. If Subsidiary Has Noncontrolling Interest • Elimination of intercompany profits arising in downstream sales must be made • Affects only the controlling interest in consolidated income • No effect on subsidiary’s income • No effect on any noncontrolling interest in income • Elimination of intercompany profits arising in upstream sales must be made • Affects both controlling and noncontrolling interests in consolidated net income • Elimination of profit shared between controlling and noncontrolling interests

  10. Equity Method Income Effects • Affects equity method income accrual • Due to unconfirmed intercompany gains and losses on upstream and downstream sales • Parent’s share of unconfirmed intercompany gains (losses) is deducted (added) to its share of subsidiary’s reported net income • Because unconfirmed profits are eliminated in consolidation

  11. Equity Method Effects of Unconfirmed Intercompany Profits

  12. Equity Method Example Jordan Athleticwear acquires 80% of Parrish Shoe Factory on January 1, 2010. During 2010, Jordan sells merchandise costing $380,000 to Parrish for $400,000, which Parrish still holds at year-end. $20,000 profit unconfirmed until Parrish sells to an outside customer Equity in Income of Parrish Deduct $20,000 to remove downstream intercompany profit Suppose Parrish sells the merchandise to Jordan, and Jordan holds the merchandise at year-end. $20,000 profit unconfirmed until Jordan sells to an outside customer Jordan’s Equity in Income Deduct Jordan’s 80% share of unconfirmed profit ($16,000 )to remove upstream intercompany profit Noncontrolling Interest in Net Income Deduct noncontrolling interest’s 20% share of unconfirmed profit ($4,000)

  13. Intercompany Transfers of Land Eliminations in Year of Transfer If sale is downstream • Unconfirmed gains are deducted from the equity accrual • Creates an offset of the gain in the parent’s separate income statement • If sale is upstream • Parent’s share of the subsidiary’s unconfirmed gain is deducted from the equity accrual • Offsets the parent’s share of the gain in the subsidiary’s separate income statement

  14. Intercompany Transfers of Land –Year of Transfer Example In 2010, one affiliate sells land costing $2,000,000 to the other affiliate for $2,300,000. The buying affiliate holds the land at year-end. Consolidation eliminating entry, year of transfer To eliminate the unconfirmed intercompany profit and reduce the land to original acquisition cost (same entry, downstream or upstream):

  15. Intercompany Transfers of Land –Subsequent Years Sold Upstream in a Prior Period • Must eliminate the unconfirmed gain from subsidiary’s beginning retained earnings • Facilitates elimination of the investment account against the parent’s share of the subsidiary’s stockholders’ equity Sold Downstream • In subsequent years, must add back the unconfirmed gain to the investment account • No adjustment to retained earnings because downstream transfers have no effect on subsidiary’s income

  16. Intercompany Transfers of Land –Subsequent Year Upstream Example Parrish Shoe is a subsidiary of Jordan Athleticwear. In 2010, Parrish sells land costing $2,000,000 to Jordan for $2,300,000. Jordan still holds the land at the end of 2011. December 31, 2011 Consolidation eliminating entry: To eliminate the unconfirmed upstream intercompany profit from a previous year and reduce the land to the original acquisition cost: The gain was originally included in Parrish’s 2010 net income.

  17. Intercompany Transfers of Land –Subsequent Year Downstream Example Parrish Shoe is a subsidiary of Jordan Athleticwear. In 2010, Jordan sells land costing $2,000,000 to Parrish for $2,300,000. Parrish still holds the land at the end of 2011. December 31, 2011 Consolidation eliminating entry: To eliminate the unconfirmed downstream intercompany profit from a previous year and reduce the land to the original acquisition cost: The gain was originally subtracted from the investment account.

  18. Intercompany Transfers of Land –Year of Sale to Outside Party • Requires that the original intercompany gain be recognized in consolidated net income in the year of sale to outside party • Upstream • Entry transfers the original gain out of the subsidiary’s retained earnings and into current income • Downstream • Entry adds the gain back to the investment account from which it was previously deducted via the equity method income accrual and recognizes it as current income

  19. Intercompany Transfers of Land –Year of Sale to Outside Party Example Assume the land was sold in 2012 for $3 million. The original cost to the consolidated entity was $2 million, requiring a consolidated gain of $1 million to be reported. The selling entity carries the land at $2,300,000, and reports a gain of $700,000. Upstream - To include in current consolidated net income the previously recorded upstream gain now confirmed through external sale: Downstream - To include in current consolidated net income the previously recorded downstream gain now confirmed through external sale:

  20. Intercompany Transfers of Land –Year of Sale to Outside Party Example Assume the land was sold in 2012 for $3 million. The original cost to the consolidated entity was $2 million, requiring a consolidated gain of $1 million to be reported. The selling entity carries the land at $2,300,000, and reports a gain of $700,000.

  21. Intercompany Transfers of Inventory • Elimination of intercompany revenues and expenses required • Unconfirmed gains or losses may exist • If intercompany transfer price differs from cost, and • Goods remain in the affiliated entity at year-end • Unconfirmed gain is part of ending or beginning inventory balance • Eliminated by adjusting cost of goods sold Eliminating intercompany profit in ending inventory Eliminating intercompany profit in beginning inventory Increases cost of goods sold Decreases cost of goods sold

  22. Intercompany Transfers of Inventory Example During 2010, Jordan sells merchandise costing $1 million to Parrish for $1.5 million. Parrish holds all the inventory in its year-end inventory at December 31, 2010. Balances at December 31, 2010: To eliminate intercompany merchandise sales and purchases: To eliminate unconfirmed profit from Parrish's ending inventory:

  23. Intercompany Transfers of Inventory Example During 2010, Jordan sells merchandise costing $1 million to Parrish for $1.5 million. Parrish sells all the inventory for $1.8 million during 2010. Balances at December 31, 2010: To eliminate intercompany merchandise sales and purchases: The profit is confirmed, so no other elimination is needed.

  24. Unconfirmed Profit in Ending Inventory • Same whether upstream or downstream • i.e., whether the parent or subsidiary holds the inventory • Adjustments required for parent’s equity income accrual and noncontrolling interest in net income Eliminating intercompany profit in ending inventory Increases cost of goods sold

  25. Unconfirmed Profit in Ending Inventory Example Assume merchandise priced at $5 million is sold to an affiliate during 2010. The buyer’s ending inventory includes $840,000 purchased from the seller. The seller’s markup is 20% of cost. Eliminations are the same whether upstream or downstream. To eliminate intercompany merchandise sales and purchases. To eliminate unconfirmed profit from the buyer’s ending inventory: $840,000 – ($840,000 ÷ 1.2) = $140,000

  26. Unconfirmed Profit in Ending Inventory Example Assume merchandise priced at $5 million is sold to an affiliate during 2010. The buyer’s ending inventory includes $840,000 purchased from the seller. The seller’s markup is 20% of cost. Effect of $140,000 unconfirmed profit in ending inventory: 20% × $140,000 = $28,000

  27. Unconfirmed Profit in Beginning Inventory • Consolidated cost of goods sold is overstated by the previous year’s unconfirmed profits • Must eliminate these gains by transferring into current year income and reduce cost of goods sold • Adjustments required for parent’s equity income accrual and noncontrolling interest in net income Eliminating intercompany profit in beginning inventory Decreases cost of goods sold

  28. Unconfirmed Profit in Beginning Inventory Example Assume merchandise priced at $5 million is sold to an affiliate during 2010. The buyer’s ending inventory includes $840,000 purchased from the seller. The seller’s markup is 20% of cost. Downstream: Parrish’s beginning inventory includes $840,000 purchased from Jordan. To eliminate intercompany merchandise sales and purchases: Upstream: Jordan’s beginning inventory includes $840,000 purchased from Parrish. To eliminate unconfirmed profit from beginning inventory:

  29. Unconfirmed Profit in Beginning Inventory Example Assume merchandise priced at $5 million is sold to an affiliate during 2010. The buyer’s ending inventory includes $840,000 purchased from the seller. The seller’s markup is 20% of cost. Effect of $140,000 unconfirmed profit in ending inventory: 20% × $140,000 = $28,000

  30. Intercompany Profits and Inventory Cost Flow Assumptions • Eliminating entries apply to any cost flow assumption • Elimination of profit from beginning inventory assumes beginning inventory is sold and profit confirmed • But if beginning inventory is not sold, it appears in ending inventory and elimination of profit from ending inventory corrects that assumption

  31. Intercompany Transfers of Depreciable Assets • Intercompany gains and losses are confirmed when • Asset is sold to an outside party or • Asset depreciates • Portion of gain equal to excess depreciation is ‘confirmed’ • Objectives of eliminations • Eliminate the unconfirmed intercompany gain or loss • Eliminate the difference between depreciation expense recorded by purchasing entity and the amount based on original acquisition cost, i.e. excess depreciation • Restate the asset and accumulated depreciation accounts so that they are based on cost

  32. Eliminations in Year of Transfer for Depreciable Assets Example On January 2, 2010, Jordan sells equipment with a 10-year remaining life and an original cost of $5 million to Parrish for $4,500,000. Accumulated depreciation on the transfer date was $2 million. Balances on 2010 statements: Jordan’s gain = $4,500,000 – ($5,000,000 – $2,000,000) = $1,500,000 Parrish’s depreciation = $4,500,000/10 = $450,000

  33. Eliminations in Year of Transfer for Depreciable Assets Example continued December 31, 2010 consolidation eliminating entries: To eliminate unconfirmed gain on intercompany transfer of equipment: To eliminate the excess annual depreciation expense recorded by the purchasing affiliate: $1,500,000 ÷ 10 = $150,000 To restate the assets and accumulated depreciation accounts to their original acquisition cost basis. The amount of adjustment is equal to the accumulated depreciation at the date of transfer:

  34. Effects in Year of Transfer for Depreciable Assets Effect of $1,500,000 unconfirmed gain on intercompany transfer of depreciable assets in year of transfer: The $1,500,000 unconfirmed gain as of the date of transfer is confirmed by reducing depreciation expense by $150,000 in each of the asset’s 10 years of remaining life.

  35. Eliminations in Subsequent Years for Depreciable Assets Downstream Example December 31, 2011 downstream consolidation eliminating entries: To eliminate unconfirmed gain on intercompany transfer of equipment: To eliminate the excess annual depreciation expense recorded by the purchasing affiliate: $1,500,000 ÷ 10 = $150,000 To restate the assets and accumulated depreciation accounts to their original acquisition cost basis.

  36. Eliminations in Subsequent Years for Depreciable Assets Upstream Example December 31, 2011 upstream consolidation eliminating entries: To eliminate unconfirmed gain on intercompany transfer of equipment: To eliminate the excess annual depreciation expense recorded by the purchasing affiliate: $1,500,000 ÷ 10 = $150,000 To restate the assets and accumulated depreciation accounts to their original acquisition cost basis.

  37. Effects in Subsequent Years for Depreciable Assets Effect of $1,500,000 unconfirmed gain on intercompany transfer of depreciable assets during the subsequent year, 2011: The $1,500,000 unconfirmed gain as of the date of transfer is confirmed by reducing depreciation expense by $150,000 in each of the asset’s 10 years of remaining life.

  38. Comprehensive Illustration Adonis Corp. acquired 90% of the voting stock of Reelok Company, on January 2, 2007 at a cost of $27,830,000. Other data: Calculation of goodwill:

  39. Comprehensive Illustration continued Adonis Corp. acquired 90% of the voting stock of Reelok Company, on January 2, 2007 at a cost of $27,830,000. Total calculated goodwill is $16,600,000. The total fair value of Reelok’s identifiable net assets is $13,400,000. Goodwill to controlling interest: Goodwill to noncontrolling interest:

  40. Comprehensive Illustration continued Adonis Corp.’s intercompany transactions during 2010: • Sale of land in 2008 costing $5 million by Reelock to Adonis for $5.5 million; Sale in 2010 by Adonis to outside firm for $6.5 million • Reelock sells merchandise to Adonis at a 20% markup on sales. Adonis’ January 1, 2010 inventory balance includes $400,000 of merchandise purchased from Reelock, and its December 31, 2010 inventory includes $450,000 purchased from Reelock. Equity in net income $450,000 $72,000 ($81,000) Noncontrolling interest in net income $50,000 $8,000 ($9,000) Upstream

  41. Comprehensive Illustration continued Adonis Corp.’s intercompany transactions during 2010: • Adonis sells merchandise to Reelock at a 20% markup on cost. Reelock’s January 1, 2010 inventory balance includes $300,000 of merchandise purchased from Adonis, and its December 31, 2010 inventory includes $240,000 purchased from Adonis. • On January 2, 2007, Adonis sold equipment costing $5 million with $3 million of accumulated depreciation and a 10-year remaining life to Reelock for $3.5 million. Reelock holds the equipment at year-end. Equity in net income $50,000 $(40,000) $150,000 Noncontrolling interest in net income $0 $0 Downstream

  42. Comprehensive Illustration continued Adonis Corp. acquired 90% of the voting stock of Reelok Company, on January 2, 2007 at a cost of $27,830,000. Total calculated goodwill is $16,600,000. Reelock’s reported income for 2010 is $2,000,000. 2010 Equity in net income and noncontrolling interest in income:

  43. Comprehensive Illustration continuedElimination C The equity in net income of Reelock, reported on Adonis’ books, totals $951,000. Reelock declared and paid no dividends in 2010. To eliminate equity in net income on the parent's books and restore the investment account to its beginning-of-year value:

  44. Comprehensive Illustration continuedAdjustments for Intercompany Transactions In 2008, Reelock sold land costing $5 million to Adonis for $5.5 million. In 2010, Adonis sold the land to a real estate investment firm for $6.5 million. To recognize the confirmed gain on the upstream land sales.

  45. Comprehensive Illustration continuedAdjustments for Intercompany Transactions Total 2010 retail sales by Reelock to Adonis were $3 million. Adonis’ January 1, 2010 inventory balance includes $400,000 in merchandise purchased from Reelock. Total 2010 retail sales by Adonis to Reelock were $2 million. Reelock sells to Adonis at a 20% markup on sales. To eliminate intercompany sales and purchases: $3,000,000 + $2,000,000 = $5,000,000 To recognize the confirmed upstream profit in beginning inventory: $400,000 × 20% = $80,000

  46. Comprehensive Illustration continuedAdjustments for Intercompany Transactions Adonis sells to Reelock at a 20% markup on cost. Reelock’s January 1, 2010 inventory includes $300,000 in merchandise purchased from Adonis. To recognize the confirmed downstream profit in beginning inventory: $300,000 – ($300,000 ÷ 1.2) = $50,000 Reelock’s December 31, 2010 inventory includes $240,000 purchased from Adonis (20% markup on cost). Adonis’ December 31, 2010 inventory includes $450,000 purchased from Reelock (20% markup on sales). To eliminate the unconfirmed upstream and downstream profit in ending inventory: ($450,000 × 20%) + ($240,000 – ($240,000/1.2)) = $130,000

  47. Comprehensive Illustration continuedAdjustments for Intercompany Transactions On January 2, 2007, Adonis sold equipment costing $5 million with $3 million accumulated depreciation, and a 10-year remaining life, straight-line, to Reelock for $3.5 million. Reelock still holds the equipment at year-end. To remove the unconfirmed beginning-of-year profit on downstream sale of equipment: Total gain = $3,500,000 – ($5,000,000 - $3,000,000) = $1,500,000 Unconfirmed gain = $1,500,000 – [($1,500,000 ÷ 10) × 3 years] = $1,050,000

  48. Comprehensive Illustration continuedAdjustments for Intercompany Transactions On January 2, 2007, Adonis sold equipment costing $5 million with $3 million accumulated depreciation, and a 10-year remaining life, straight-line, to Reelock for $3.5 million. Reelock still holds the equipment at year-end. To recognize the confirmed profit (excess depreciation) on downstream sale of equipment: $1,500,000 ÷ 10 = $150,000 To restate the asset and accumulated depreciation accounts to their original acquisition cost basis:

  49. Comprehensive Illustration continuedAdjustments for Intercompany Transactions In 2010, Adonis charged Reelock $500,000 for marketing services costing $400,000. At year-end, Reelock owes Adonis $25,000 related to marketing services. At year-end, Adonis owes Reelock $100,000 related to merchandise sales, and Reelock owes Adonis $85,000 related to merchandise sales. To eliminate the intercompany sale of marketing services: To eliminate intercompany receivables/payables: $100,000 + $85,000 + $25,000 = $210,000

  50. Comprehensive Illustration continuedElimination E Reelock’s January 1, 2010 capital stock balance was $1,400,000 and its retained earnings was $8,600,000. Entry I-1 reduced Reelock’s retained earnings by $500,000 and entry I-3 reduced it by $80,000. To eliminate the subsidiary's beginning-of-year capital stock account and the remainder of its beginning retained earnings account against the beginning-of-year book value portion of the investment account, and recognize the beginning-of-year book value of the noncontrolling interest: $8,600,000 – $500,000 – $80,000 = $8,020,000

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