Electronic Presentations in Microsoft® PowerPoint® Prepared by James Myers, C.A. University of Toronto © 2010 McGraw-Hill Ryerson Limited

(A) Intercompany Profits in Depreciable Assets Chapter 7 (A) Intercompany Profits in Depreciable Assets (B) Intercompany Bondholdings

Learning Objectives Prepare consolidated financial statements that reflect the elimination and subsequent realization of upstream and downstream intercompany profits in depreciable assets Explain how the historical cost principle supports the elimination of unrealized profits resulting from intercompany transactions when preparing consolidated financial statements Prepare the journal entries under the equity method to reflect the elimination and subsequent realization of intercompany profits in depreciable assets

Learning Objectives Calculate the gain or loss that results from the elimination of intercompany bondholdings and the allocation of such gain or loss to the equities of the controlling and non-controlling interests Explain how the recognition of gains on the elimination of intercompany bondholdings is consistent with the principle of recording gains only when they are realized Prepare consolidated financial statements that reflect the gains or losses that are the result of intercompany bondholdings

Intercompany Profits in Depreciable Assets We have now established the basis for preparation of consolidated financial statements, including: The allocation of the acquisition price The conceptual alternatives Consolidation after parent uses cost method or equity method Elimination of intercompany sales and purchases Elimination of unrealized intercompany profits on inventory and land Parents and subsidiaries engage in more complex transactions such as intercompany transfers of depreciable assets LO 1

Intercompany Profits in Depreciable Assets Parents and subsidiaries often redistribute depreciable and non-depreciable assets among themselves, for a variety of reasons including management, income tax, and corporate restructuring Such transactions usually are recorded at the market value of the assets transferred: The selling company will record a gain (or loss) on the sale, and the buying company will record the assets at the price it paid, often higher than the original cost of the asset to the combined entity LO 1, 2

Intercompany Profits in Depreciable Assets The gain or loss on intercompany asset sales is unrealized to the group until the asset is subsequently sold to a buyer outside the group or used in producing a product or service that is sold The effect of the gain or loss is eliminated in the consolidated financial statements The objective of the elimination is to report “as if” the transaction between the companies had never taken place If the intercompany transaction involves depreciable assets, there are further adjustments to be considered in later periods, including depreciation LO 1, 2

Intercompany Profits in Depreciable Assets The intercompany sale of depreciable assets at a profit or loss results in depreciation being recorded by the buying company at an amount that is different than what the selling company would have recorded on the historical cost basis if the transaction had not occurred The buying company has a different (higher or lower) cost basis than the original cost paid by the seller Therefore, the amount of depreciation recorded in the buyer’s books will be greater (or lesser) than the depreciation that would have been recorded based on the historical cost to the consolidated entity LO 1, 2

Intercompany Profits in Depreciable Assets The incremental depreciation, which is the portion that is not based on historical cost to the group, must be eliminated This incremental depreciation in later periods may also be thought of as the realization of the intercompany gain or loss through the process of consumption of the value of the asset As the value of the asset is depreciated by the buying company, a portion of the intercompany gain or loss is “realized” in the sense that it no longer has to be eliminated in the preparation of the consolidated financial statements LO 2

Intercompany Profits in Depreciable Assets The depreciation expense which remains on the consolidated financial statements after eliminating the incremental depreciation is the amount that would have been recorded by the seller, based on the original cost of the asset to the group, if the intercompany sale had not occurred LO 2

Intercompany Profits in Depreciable Assets Income taxes All intercompany unrealized gains and losses affect net earnings “net of tax” Deferred income tax (on the balance sheet) is computed on the outstanding balance of the unrealized gain or loss at the balance sheet date Upstream gains and losses Allocate portion of unrealized upstream gain/loss net of depreciation and tax to income statement non-controlling interest To compute balance sheet non-controlling interest, adjust shareholders’ equity of subsidiary for unrealized upstream gain/loss net of depreciation and tax LO 1 Chapter 7, Slide 11 © 2010 McGraw-Hill Ryerson Limited

Example of Depreciable Asset Transfer Parent purchased equipment from an unrelated party for a cost of $1,000 The equipment has a 10-year life and is depreciated on the straight-line basis Parent immediately sells the equipment to Subsidiary for $1,500 Parent pays income tax of $200 (40%) on the $500 gain that is unrealized for consolidated financial statement purposes LO 1,3

Example of Depreciable Asset Transfer The parent records the following entry on its books to reflect the sale of the equipment to the subsidiary and payment of the resulting income taxes LO 1,3 Chapter 7, Slide 13 © 2010 McGraw-Hill Ryerson Limited

Example of Depreciable Asset Transfer To eliminate the unrealized gain on the parent’s books, restore equipment to its original cost, and defer the $200 tax paid, the following elimination entry is required on the consolidation worksheet: Gain $500 Deferred income tax $200 Equipment $500 Income tax expense $200 If the parent uses the equity method to account for the subsidiary, the following journal entry would be recorded in the parent’s general ledger: Investment income $300 Investment in subsidiary $300 LO 1, 3 Chapter 7, Slide 14 © 2010 McGraw-Hill Ryerson Limited

Example of Depreciable Asset Transfer The subsidiary records the following entries on its books to reflect the purchase of the equipment and its depreciation during the following year LO 1,3 Chapter 7, Slide 15 © 2010 McGraw-Hill Ryerson Limited

Example of Depreciable Asset Transfer If the parent had not sold the equipment, it would have recorded depreciation of $1,000 / 10 years = $100 Since the subsidiary is depreciating at a cost of $1,500 and not $1,000, $150 of depreciation has been recorded To adjust the consolidated financial statements to reduce depreciation to what it would have been if the transfer had not occurred (or to “realize” the gain over time as the asset is consumed), depreciation expense must be reduced with the following consolidation elimination entry: Accumulated depreciation $50 Depreciation expense $50 LO 1, 2, 3

Example of Depreciable Asset Transfer To match the decrease in depreciation expense to related income taxes at the parent’s 40% tax rate the following adjustment is also reflected in the Year 1 consolidated financial statements: Income tax expense $20 Deferred income tax $20 LO 1, 3 Chapter 7, Slide 17 © 2010 McGraw-Hill Ryerson Limited

Example of Depreciable Asset Transfer In each of the following years, until either the equipment is fully depreciated or the subsidiary sells it, two consolidation elimination entries are required on the consolidation worksheet The first entry records the cumulative effect of adjustments made in prior years as follows: Accumulated depreciation $xxx Deferred income tax $xxx Retained earnings $xxx Equipment $500 The second entry adjusts for the excess depreciation for that particular year as follows: Accumulated depreciation $50 Income tax expense $20 Depreciation expense $50 Deferred income tax $20 If the parent uses the equity method to account for the subsidiary, the following journal entry would be recorded in the parent’s general ledger each year: Investment in subsidiary $30 Investment income $30 LO 1, 3 Chapter 7, Slide 18 © 2010 McGraw-Hill Ryerson Limited

Example of Depreciable Asset Transfer The foregoing is an example of a downstream intercompany transaction. If the equipment had instead been sold upstream, by subsidiary to parent, then a further consolidation adjustment would be required to allocate a portion of the net-of-tax eliminations to non-controlling interest LO 1, 3 Chapter 7, Slide 19 © 2010 McGraw-Hill Ryerson Limited

Intercompany Profits in Depreciable Assets Summary of implications of intercompany transactions in depreciable assets: The “intercompany” gain must be eliminated and associated income taxes paid deferred The asset must be adjusted to its historical cost Depreciation is restated so that it is based on original cost, and associated income taxes are recorded Accumulated depreciation restated so that it is based on original cost Retained earnings is adjusted for the cumulative after-tax effect of the unrealized gain or loss (i.e. gain or loss less incremental depreciation to date) LO 1, 2

Intercompany Profits in Depreciable Assets The following two slides summarize the effects of net-of-tax adjustments for unrealized gains and associated depreciation on the balances of investment in subsidiary and retained earnings, if the equity method of accounting has been used by the parent LO 3

Intercompany Profits in Depreciable Assets Investment in Subsidiary Original Cost Income earned Dividends received A.D. Amortization Unrealized Gains Accumulated Depreciation Balance LO 3

Intercompany Profits in Depreciable Assets Consolidated Retained Earnings Parent retained earnings Parent’s share of change in Sub RE since acquisition A.D. Amortization Unrealized gains Accumulated depreciation Balance LO 3

Intercompany Bondholdings When we discuss intercompany profits, we are generally concerned with eliminating profits recorded by individual companies, but unrealized by the group When purchased on the open market, intercompany bondholdings present the opposite situation: Profits associated with these bonds are unrealized at the individual company level, but realized by the group as a whole since they occurred with outside parties and arose as a result of changes in prevailing market interest rates since the bonds were originally issued The process of accounting for intercompany bonds involves the recognition of these gains and losses in the consolidated financial statements before they are recognized in the separate-entity financial statements LO 5

Intercompany Bondholdings In the typical case, bonds are issued by a company into the open market, or are placed privately with an unrelated entity such as an insurance company or pension plan If related companies provide financing, the financing conditions are generally simpler than the relatively complex and restrictive requirements of bonds As a result, it is fairly common for a company to buy on the open market the outstanding bonds of a parent or subsidiary company The market value paid by the related company will be different from the issuing company’s book value if the prevailing market interest rates have changed since the bonds were issued LO 4, 5

Intercompany Bondholdings When this occurs, the company which has purchased the bond reports investment in bonds as an asset on its separate-entity balance sheet The issuing company reflects the bond liability and records interest expense and any related amortization of premium/discount on its separate-entity statements However, from the perspective of the combined group, the intercompany bonds have been retired at the time they were purchased on the open market and the bond investment is eliminated against the bond liability The difference, if any, between acquisition cost and book value of the bonds is recognized as a gain or loss LO 4, 5

Intercompany Bondholdings The gain or loss on the effective retirement of bonds must be recognized in the consolidated statements However, since the bond is still in fact an outstanding liability to the individual company issuer: interest payments continue to be made and amortization of any premium or discount received continues to be recorded on the issuer’s books the individual company purchaser records the revenue received, and records amortization of any premium or discount paid, over the bond’s term to maturity This intercompany interest revenue received and interest expense paid must be eliminated in the consolidated financial statements LO 4, 5, 6

Intercompany Bondholdings A difference arises with the elimination of the premium/discount amortization when the bond was purchased by the related company in the open market at a value different from the original issue price the amortization recorded by the issuer, based on original issue price, will be different from the amortization recorded by the purchaser based on market value paid to purchase the bond This difference, over the remaining term of the bond, is eliminated since it is equal to the gain or loss recognized on the open market purchase and retirement of the bond Amortization can be straight-line, or based on the effective-yield method by calculating the present value of future cash flows using the current market discount rate LO 6

Intercompany Bondholdings - Example Example: Parent owns 100% of Subsidiary. On January 1, Subsidiary pays $9,800 on the open market to purchase $10,000 of bonds that were originally issued by Parent for $10,000 (i.e. no issuing premium/discount). Bonds pay interest at 10% annually and mature in 4 years Gain on retirement of bonds = $10,000-$9,800 = $200 Income tax on gain (assume 40% rate) = $200 x 40% = $80 Annual intercompany interest = $10,000 x 10% = $100 (Parent books reflect expense, Subsidiary books reflect income) Each year, Subsidiary amortizes discount $200 / 4 = $50 to income (entry is Dr bond investment, Cr interest income) LO 4, 6 Chapter 7, Slide 29 © 2010 McGraw-Hill Ryerson Limited

Intercompany Bondholdings - Example The following adjustments are required on the consolidation worksheet to (i) eliminate the intercompany bonds and record the gain on retirement; (ii) match the gain recognized to related income tax expense; and (iii) eliminate the intercompany interest net of income tax Consolidation adjusting entries – January 1: (i) Bonds payable (Parent) $10,000 Investment in bonds (Sub) $9,800 Gain on bond retirement $200 (ii) Income tax expense $80 Deferred income tax $80 LO 4, 6 Chapter 7, Slide 30 © 2010 McGraw-Hill Ryerson Limited

Intercompany Bondholdings - Example Consolidation adjusting entry – December 31: Parent has recorded $1,000 interest expense and Subsidiary has recorded $1,000 interest income + $50 discount amortization. Net pre-tax income = $1,050 - $1,000 = $50 x 40% tax rate = $20 income tax paid. Subsidiary’s books reflect bond investment as $9,800 paid + $50 amortization = $9,850 of which $9,800 was eliminated on January 1 (see consolidation adjusting entry (i)) (iii) Interest income $1,050 Deferred income tax $20 Interest expense $1,000 Income tax expense $20 Investment in bonds $50 LO 6 Chapter 7, Slide 31 © 2010 McGraw-Hill Ryerson Limited

Intercompany Bondholdings Non-controlling interest: When a subsidiary is less than 100% owned, gains and losses on intercompany bondholdings are allocated, net of tax, based on 1 of 4 possible methods permitted by IFRS We will allocate the gain or loss between the issuing and purchasing companies based on the relative premium or discount arising from the bonds that is reflected on the books of each company, in order to mirror the manner in which each company amortizes the premium or discount In our example above 100% of the discount is reflected on the books of the subsidiary and 0% is reflected on the books of the parent, therefore the gain would be allocated to the subsidiary The gain or loss allocated in this manner to the subsidiary would therefore affect non-controlling interest if the subsidiary is less than 100% owned by the parent LO 4