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Intercompany Transactions in Consolidated Financial Statements

This chapter discusses the accounting and elimination of intercompany transactions in the preparation of consolidated financial statements, including transactions involving loans, leases, and rendering of services.

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Intercompany Transactions in Consolidated Financial Statements

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  1. Chapter 8 Consolidated Financial statements: Intercompany Transactions

  2. Objectives of the Chapter • To discuss the accounting and working paper eliminations for related party transactions between a parent company and its subsidiaries for: •   I. intercompany transactions not involving profit or loss such as loans on promissory notes, leases of property under operating leases and rendering of services; Consolidated FS-Intercompany Transactions

  3. Objectives of the Chapter (Contd.) • II.intercompany transactions involving profit or loss such as intercompany sale of merchandise, plant assets, intangible assets and leases of property (under capital/sales-type leases). Consolidated FS-Intercompany Transactions

  4. Principle to follow to account for the intercompany transactions for the consolidated financial statements: • The consolidated financial statements should include only transactions resulting from the consolidated group’s dealings with outsiders. Consolidated FS-Intercompany Transactions

  5. Principle to follow to account for the intercompany transactions for the consolidated financial statements: (Contd.) • Separate ledger accounts are established for all intercompany assets, liabilities, revenue and expenses. • These separate accounts clearly identify the intercompany items that should be eliminated in the preparation of consolidated financial statements. Consolidated FS-Intercompany Transactions

  6. I. Accounting for Intercompany Transactions Not Involving Profit (Gain) or Loss • loans on Notes or Open Accounts • The parent company may make loans to its subsidiaries. • The interest rate charged by the parent company usually exceeds the parent company’s borrowing rate. Consolidated FS-Intercompany Transactions

  7. I. Accounting for Intercompany Transactions Not Involving Profit (Gain) or Loss (Contd.) • Intercompany ledger accounts are used by the parent and the subsidiary to account for these intercompany transactions in order to differentiate intercompany loans and loans with outsiders. Consolidated FS-Intercompany Transactions

  8. Example 8.1: Intercompany Loans from Palm (the parent company) to Starr (the subsidiary) • Assume that Palm Corp. made the following cash loans to its wholly owned subsidiary, Starr Company, on promissory notes: Consolidated FS-Intercompany Transactions

  9. Example 8.1: Intercompany Loans from Palm (the parent company) to Starr (the subsidiary) (Contd.) • Palm Corp. and Starr Company will use the following ledger accounts to record the foregoing transactions (assuming all notes were paid by Starr when due): Consolidated FS-Intercompany Transactions

  10. Example 8.1: Intercompany Loans from Palm (the parent company) to Starr (the subsidiary) (Contd.) Consolidated FS-Intercompany Transactions

  11. Example 8.1: Intercompany Loans from Palm (the parent company) to Starr (the subsidiary) (Contd.) • In the working paper for consolidated financial statements for Palm and subsidiary for the year ended 12/31/2001, the foregoing ledger accounts appear as shown below: Consolidated FS-Intercompany Transactions

  12. Example 8.1: Intercompany Loans from Palm (the parent company) to Starr (the subsidiary) (Contd.) • PALM CORPORATION AND SUBSIDIARY • Partial Working Paper for Consolidated Financial Statements • For Year Ended December 31, 2001 *45,000 + $1,100 = $46,100 Consolidated FS-Intercompany Transactions

  13. Discounting of Intercompany Notes • If an intercompany note receivable is discounted at a bank (by the payee, i.e., Palm in example 8.1), the note becomes payable to an outsider – the bank. • Therefore, discounted intercompany notes are not eliminated in the working paper. Consolidated FS-Intercompany Transactions

  14. Example 8.2: Discounting of Intercompany Notes • Continued with Example 8.1 and Assumed that on 12/1/2001, Palm had discounted at a 12% discount rate the $24,000 note receivable from Starr. Palm would record the following entry: • Cash 23,940 • Interest Expense • ($1,260 discount – 1,000*) 260 • Intercompany Notes Receivable 24,000 • Intercompany Interest Revenue 200 • ($24,000 x 0.10 x 1/12) Consolidated FS-Intercompany Transactions

  15. Example 8.2: Discounting of Intercompany Notes (Contd.) *Interest on note that accrues to discounting bank during discounting period. Consolidated FS-Intercompany Transactions

  16. Example 8.2: Discounting of Intercompany Notes (Contd.) • Palm should inform Starr of the discounting. Starr would prepare the following journal entry on 12/1/2001: Consolidated FS-Intercompany Transactions

  17. Example 8.2: Discounting of Intercompany Notes (Contd.) • Under the note discounting assumption, the ledger accounts related to the intercompany notes would appear in the 12/31/2001 working paper for consolidated financial statements as follows: Consolidated FS-Intercompany Transactions

  18. Example 8.2: Discounting of Intercompany Notes (Contd.) • PALM CORPORATION AND SUBSIDIARY • Partial Working Paper for Consolidated Financial Statements • For Year Ended December 31, 2001 *$200 less than in illustration on page 348 because $24,000 discounted note earned interest for one month rather than two months. † $21,000 note dated Sept. 1, 2001, plus $700 accrued interest. Consolidated FS-Intercompany Transactions

  19. Leases of Property under Operating Leases • When both the parent and subsidiary account the lease as an operating lease, the lessee will record the lease payment as intercompany rent expense, while the lessor will record the lease payment received as intercompany rent revenue. Consolidated FS-Intercompany Transactions

  20. Leases of Property under Operating Leases (Contd.) • For an intercompany operating lease, there is no profit or loss involved. • The inercompany rent revenue would be offset against intercompany rent expense in the manner similar to the offset of intercompany interest revenue and expense illustrated earlier. Consolidated FS-Intercompany Transactions

  21. Rendering of Services • One affiliate may render services to another and result in intercompany fee revenue and expense (i.e., management fee charged to subsidiaries by a parent company). Consolidated FS-Intercompany Transactions

  22. Rendering of Services (Contd.) • The intercompany fee revenue and expense are offset in the working paper. • Both the parent company and the subsidiary should record the fee billing in the same accounting period. Consolidated FS-Intercompany Transactions

  23. Income Texas Applicable to Intercompany Transactions • No income tax effects associated with the elimination of the intercompany revenue or expenses since no profit or loss involved in these intercompany transactions. • It does not matter whether the parent company and its subsidiaries file separate income tax returns or a consolidated tax return. Consolidated FS-Intercompany Transactions

  24. II. Accounting for Intercompany Transactions Involving Profit (Gain) or Loss • For intercompany transactions involving profit or loss, the unrealized profits or losses must be eliminated in the preparation of consolidated financial statements until they are realized. Consolidated FS-Intercompany Transactions

  25. The Importance of Eliminating or Including Intercompany Profits (Gains) and Losses • Failure to eliminate unrealized profits and losses would result in consolidated income statements that report not only results of transactions with outsiders but also the results of related party activities within the affiliated group. Consolidated FS-Intercompany Transactions

  26. The Importance of Eliminating or Including Intercompany Profits (Gains) and Losses (Contd.) • Similarly, no recognition of realized gains (losses) would misstate the consolidated net income. • The management can manipulate consolidated net income if unrealized intercompany profits and losses were not eliminated. Consolidated FS-Intercompany Transactions

  27. Intercompany Sales of Merchandise • Types of Sales • Downstream intercompany sales • Upstream intercompany sales • Lateral intercompany sales Consolidated FS-Intercompany Transactions

  28. Intercompany Sales of Merchandise (Contd.) • a. Intercompany Sales at Cost • Example 8.3: Intercompany sale at cost • Assume that Palm sold merchandise costing $150,000 to Starr during the year ended 12/31/2001 at a selling price equals to Palm’s cost. • The ending inventories of Starr on 12/31/2001 included $25,000 of merchandise obtained form Palm. Consolidated FS-Intercompany Transactions

  29. Intercompany Sales of Merchandise (Contd.)Example 8.3 : (Contd.) • By 12/31/2001, Starr still owed Palm $15,000 for merchandise purchased during 12/31/2001. • Assuming perpetual inventory system for both companies, the following aggregate entries would be prepared by both companies for the foregoing transactions: Consolidated FS-Intercompany Transactions

  30. Intercompany Sales of Merchandise (Contd.)Example 8.3 : (Contd.) • PalmCorporation Journal Entries Consolidated FS-Intercompany Transactions

  31. Intercompany Sales of Merchandise (Contd.)Example 8.3 : (Contd.) • StarrCompany Journal Entries Consolidated FS-Intercompany Transactions

  32. Intercompany Sales of Merchandise (Contd.)Example 8.3 : (Contd.) • The following is a partial working paper for consolidated financial statements of Palm and subsidiary (include only the data related to this intercompany sale of merchandise at cost): Consolidated FS-Intercompany Transactions

  33. Intercompany Sales of Merchandise (Contd.)Example 8.3 : (Contd.) • PALM CORPORATION AND SUBSIDIARY • Partial Working Paper for Consolidated Financial Statements • For Year Ended December 31, 2001 *Palm Corporation’s $15,000 intercompany sales and intercompany cost of goods sold are offset in Palm’s separate income statement in the working paper. Consolidated FS-Intercompany Transactions

  34. Intercompany Sales of Merchandise (Contd.)Example 8.3 : (Contd.) • Note: • Starr Company’s cost of goods sold and inventories are not affected by working paper eliminations. Both Starr’s cost of goods sold and inventories are stated at cost. Consolidated FS-Intercompany Transactions

  35. Intercompany Sales of Merchandise (Contd.) • b.Intercompany Sales with Unrealized Intercompany Profit in Ending Inventories • Without the working paper elimination, the consolidated ending inventory and cost of goods sold are both overstated. Consolidated FS-Intercompany Transactions

  36. Intercompany Sales of Merchandise (Contd.) • The ending inventory is overstated for the mark up of the unsold ending inventory (the unrealized gain). • The cost of goods sold is overstated for the mark up of the cost of goods sold (the realized gain). Consolidated FS-Intercompany Transactions

  37. Intercompany Sales of Merchandise (Contd.)Example 8.4:Intercompany sales at a mark up • During 2001, Sage company (the 95%-owned subsidiary) sold merchandize to Post at a gross profit margin of 20% on sales price. • Sales by Sage to Post totaled $120,000 in year 2001, of which $40,000 remained unsold by Post on 12/31/2001. Consolidated FS-Intercompany Transactions

  38. Intercompany Sales of Merchandise (Contd.)Example 8.4: (Contd.) • On 12/31/2001, Post still owed $30,000 to Sage for merchandise. Both companies use the perpetual inventory system. • The foregoing transactions are recorded in summary form by the two companies as follows: Consolidated FS-Intercompany Transactions

  39. Intercompany Sales of Merchandise (Contd.)Example 8.4 : (Contd.) • Post Company Journal Entries Consolidated FS-Intercompany Transactions

  40. Intercompany Sales of Merchandise (Contd.)Example 8.4 : (Contd.) • SageCorporation Journal Entries Consolidated FS-Intercompany Transactions

  41. Intercompany Sales of Merchandise (Contd.)Example 8.4 : (Contd.) • The intercompany gross profit in Sage’s sale to Post in year 2001 is analyzed as follows: Consolidated FS-Intercompany Transactions

  42. Intercompany Sales of Merchandise (Contd.)Example 8.4 : (Contd.) • The following working paper elimination is required for Sage’s intercompany’s sales of merchandise to Post for the year ended 12/31/2001: Consolidated FS-Intercompany Transactions

  43. Intercompany Sales of Merchandise (Contd.)Example 8.4 : (Contd.) • Entering the preceding eliminations in the working paper for consolidated financial statements results in the consolidated amounts shown below (amounts for total sales to outsiders and cost of goods sold are assumed): Consolidated FS-Intercompany Transactions

  44. Intercompany Sales of Merchandise (Contd.)Example 8.4 : (Contd.) POST CORPORATION AND SUBSIDIARY Partial Working Paper for Consolidated Financial Statements For Year Ended December 31, 2001 Consolidated FS-Intercompany Transactions

  45. Intercompany Sales of Merchandise (Contd.)Example 8.4 : (Contd.) • Contd. Consolidated FS-Intercompany Transactions

  46. Notes to the Intercompany Sales of Merchandise at a Mark Up by a Partially Own Subsidiary • 1.The $8,000 unrealized intercompany profit is attributable to Sage (the seller, a partially-owned subsidiary). • This unrealized intercompany profit should be taken into account in the computation of the minority interest in Sage’s net income for year 2001 (would be illustrated in Example 8.9). Consolidated FS-Intercompany Transactions

  47. Notes to the Intercompany Sales of Merchandise at a Mark Up by a Partially Own Subsidiary (Contd.) • 2.Also, this $8,000 would be entered into the Sage’s portion of consolidated retained earnings on 12/31/2001. • 3.If the intercompany sales of merchandise are made by a parent company or by a wholly owned subsidiary, the unrealized intercompany profit will not have any effect on any minority interest in net income. • This is because the selling agent does not have minority stockholders. Consolidated FS-Intercompany Transactions

  48. Intercompany (Unrealized) Profit in Beginning and Ending Inventories • It is assumed that, on a FIFO basis, the intercompany profit in the purchaser’s beginning inventories is realized through sales of the merchandise to outsiders during the following accounting period. Consolidated FS-Intercompany Transactions

  49. Intercompany (Unrealized) Profit in Beginning and Ending Inventories(contd.) • Only the intercompany profit in ending inventories remains unrealized at the end of the period. • Continuing with Example 8.4, assume that Sage’s intercompany sales of merchandise to Post Corporation during the year ended 12/31/2002, are analyzed as follows: Consolidated FS-Intercompany Transactions

  50. Intercompany (Unrealized) Profit in Beginning and Ending Inventories(contd.) • Analysis of Gross Profit Consolidated FS-Intercompany Transactions

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