CHAPTER 8 INTRODUCTION TO INTERCOMPANY TRANSACTIONS

FOCUS OF CHAPTER 8 Intercompany Transactions: – Operational Importance – Nature and Variety – The Importance of Using Supportable (fair) Transfer Prices – Basic Conceptual Issues Minimizing the Consolidation Effort Realized and Unrealized Profit Situations

Operational Importance of Intercompany Transactions Extent of Vertical Integration: – Nearly 40% of world trade constitutes intercompany transactions.

Operational Importance of Intercompany Transactions Assessing Performance for Each Entity Within the Consolidated Group: – Meaningful assessment would be impossible without intercompany transactions.

Arm’s-Length Transactions: A Short Explanation Defined: – “Transactions that take place between completely independent parties.”

Categories of Transactions Arm’s Length Transactions: – Are the ONLY transactions that can be reported in the consolidated statements. Non-Arm’s Length Transactions: – Are usually referred to as “related party transactions.” – Include ALL intercompany transactions.

Types of Related Party Transactions Involving only Individuals: – Transactions among family members. Involving Corporations: – With management and other employees. – With directors and stockholders. – With affiliates (controlled entities). Probably constitutes at least 99% of all corporate related-party transactions.

Necessity of Eliminating Intercompany Transactions Eliminate ALL intercompany transactions in consolidation: – Because they are internal transactions from a consolidated perspective. – Not because they are related-party transactions. – Only transactions with outside unrelated parties can be reported in the consolidated statements.

Intercompany Transactions: Additional Opportunities for Fraud Intercompany transactions sometimes occur to: – Conceal embezzlements. – Overstate reported profits = 5

Nature and Variety of Intercompany Transactions Type 1—Dividend payments: – Parents often need cash from subsidiaries: To pay dividends. To pay their own expenses. – Reasons why parents cannot get cash from subsidiaries (a “blocked funds” problem): Regulatory restrictions. Governmental restrictions.

Nature and Variety of Intercompany Transactions Type 2—Loans: – Parents often centralize treasury functions at the parent level. Thus: Subsidiaries are unable to borrow from outside lenders. Subsidiaries usually borrow from their parents. –Interest may or may not be charged.

Nature and Variety of Intercompany Transactions Type 3—Reimbursements for Directly Traceable Costs: – Parents often arrange and pay for external services that benefit a subsidiary ONLY. – Charging the subsidiary merely results in recording expenses in the proper income statement.

Nature and Variety of Intercompany Transactions Type 4—Corporate Headquarters Services and Expense Allocations: – Handle one or two ways: BILLING from a profit center: –Parent credits a Revenues account. ALLOCATION from a cost center : –Parent credits an O/H Allocation acct. –Use either incremental or proportional allocation methods.

Nature and Variety of Intercompany Transactions Type 5—Income Tax Expense Allocations: – Occurs ONLY when a parent & subsidiary file a consolidated tax return: Use method consistent with FAS 109 “Accounting for Income Taxes”: –Pro forma separate return method complies. –Formula driven allocation method may or may not comply.

Nature and Variety of Intercompany Transactions Type 6—Intangibles: – Parents often transfer technology and other intangibles to subsidiaries: Two ways to do so are: Sell It: The transfer of a “right to” an item. (Recorded as a sale.) Grant a License: The transfer of a “right to use” an item. (Recorded as license income.)

Nature and Variety of Intercompany Transaction Type 7—Inventory Transfers: – Virtually all occur in vertically integrated entities. – Classified as: Downstream sales (parent to subsidiary) Upstream sales (subsidiary to parent) Lateral sales (subsidiary to subsidiary)

Nature and Variety of Intercompany Transactions Type 8—Fixed Asset Transfers: – Far less common than inventory transfers. – Most likely to occur when one entity has surplus machinery or surplus office equipment.

Nature and Variety of Intercompany Transactions Type 9—Investments in Bonds of a Member of the Consolidated Group: – Found infrequently in practice. – Much more involved to account for than intercompany loans because of premiums and discounts.

Importance of Using Supportable (Fair) Transfer Prices Transfer prices may be: – Negotiated between the entities. – Set by the parent company.

Importance of Using Supportable (Fair) Transfer Prices Actual transfer prices used are: – Relevant ONLY from each individual entity’s perspective—impacts each entity’s reported net income. – Irrelevant from a consolidated perspective Because they are undone in consolidation—exactly as if the transactions had NEVER occurred.

Importance of Using Supportable (Fair) Transfer Prices: Tax Rules From An Income Tax Reporting Perspective: – Transfer prices used have enormous implications. – Because of the potential to arbitrarily shift profits between entities. – And thereby lower the consolidated income tax expense. – Especially on an international scale.

Importance of Using Supportable (Fair) Transfer Prices: Tax Rules Tax Rules Concerning Transfer Prices: – Section 482 of Internal Revenue Code requires that: Transfer prices be at an arm’s length basis. Thus: –Must charge a related party the same price as an unrelated party.

Importance of Using Supportable (Fair) Transfer Prices: Tax Rules Section 482 applies to ALL transfers: – Inventory. – Fixed assets. – Services. – Technology, patents, trademarks, and other intangibles (whether by sale or granting of a license). – Interest rates on loans & prices on leases.

Importance of Using Supportable (Fair) Transfer Prices: Tax Rules Consequences of Insupportable Transfer Prices: – Substantial tax penalties and fines. – Adjustment to financial statements for underreporting of consolidated income tax expense and payable. Transfer prices are irrelevant for tax purposes: – When a worldwide reporting system is used (as used by six states).

A Billion Here, A Billion There! Pretty Soon We’re Talking “Real Money” BAD NEWS: – The IRS loses between $20-$40 billion of tax revenues each year because of transfer pricing shenanigans.

The Complexity of Determining Supportable Transfer Prices: Winners GOOD NEWS: – Tax accountant advisors to the multinational firms earn big fees (as high as $500 per hour) giving advice on how to “MINIMIZE” consolidated income taxes.

GAAP Requirements Concerning Intercompany Transactions GAAP requires the following to be eliminated for consolidated reporting: – All intercompany revenues, expenses, gains, and losses. – All open account balances (intercompany receivables and payables). – All unrealized intercompany profits and losses. Use GROSS PROFIT OR LOSS.

The Consolidation Effort: Keep It Simple Use SEPARATE intercompany accounts in the income statement ( for each transaction type). Use a single Intercompany Receivable/ Payable account on each set of books. Reconcile ALL intercompany accounts prior to consolidation. Use the “elimination by rearrangement” technique on the consolidation worksheet.

What’s Unrealized and What’s NOT? The unrealized profit issue does not occur when: – Transfers are made at cost. – Transfers are made at above cost AND The profit reported by the one entity is FULLY OFFSET by additional costs and expenses reported in the income statement by the other entity.

Issuing Parent-Company-Only (PCO) Statements Ye All Shall Know This: – A parent company’s PCO statements must report the same net income and retained earnings amounts as appear in the consolidated statements.

Review Question #1 Intercompany income statement accounts are eliminated in consolidation because they are deemed as being: A. Artificial transactions. B. Potentially manipulative transactions. C. Internal transactions. D. At amounts that are not determined on arms-length basis. E. None of the above.

Review Question #1 With Answer Intercompany income statement accounts are eliminated in consolidation because they are deemed as being: A. Artificial transactions. B. Potentially manipulative transactions. C. Internal transactions. D. At amounts that are not determined on arms-length basis. E. None of the above.

Review Question #2 Which of the following account types need not be eliminated in consolidation? A. Intercompany assets & intercompany liabilities. B. Intercompany revenues & intercompany expenses. C. Intercompany overhead allocations. D. Long-term intercompany receivables. E. None of the above.

Review Question #2 With Answer Which of the following account types need not be eliminated in consolidation? A. Intercompany assets & intercompany liabilities. B. Intercompany revenues & intercompany expenses. C. Intercompany overhead allocation amounts. D. Long-term intercompany receivables. E. None of the above.

Review Question #3 An intercompany account balance that would not need to be reconciled prior to consolidation is Intercompany: A. Dividends Payable. B. Interest Receivable. C. Management Fees Payable. D. Overhead Allocation Receivable. E. None of the above.

Review Question #3 With Answer An intercompany account balance that would not need to be reconciled prior to consolidation is Intercompany: A. Dividends Payable. B. Interest Receivable. C. Management Fees Payable. D. Overhead Allocation Receivable. E. None of the above.

Review Question #4 An account balance that would not need to be reconciled prior to consolidation is: A. Intercompany Sales. B. Intercompany Interest Expense. C. Intercompany Management Fee Income. D. Intercompany Overhead Allocation Out. E. None of the above.

Review Question #4 With Answer An account balance that would not need to be reconciled prior to consolidation is: A. Intercompany Sales. B. Intercompany Interest Expense. C. Intercompany Management Fee Income. D. Intercompany Overhead Allocation Out. E. None of the above.

Review Question #5 In 2006, Saxco incurred $75,000 of inter- company interest charges. Of this amount, Saxco paid $50,000 cash to its parent and capitalized $30,000 to a discrete construction project. The unrealized intercompany profit at 12/31/06 is: A. $ -0- B. $5,000 C. $20,000 D. $25,000 E. $30,000

Review Question #5 With Answer In 2006, Saxco incurred $75,000 of inter- company interest charges. Of this amount, Saxco paid $50,000 cash to its parent and capitalized $30,000 to a discrete construction project. The unrealized intercompany profit at 12/31/06 is: A. $ -0- B. $5,000 C. $20,000 D. $25,000 E. $30,000

End of Chapter 8 Time to Clear Things Up — Any Questions?