Chapter 4 Consolidation: Intragroup Transactions © 2013 Advanced Accounting, Canadian Edition by G. Fayerman

The Consolidation Process Two major adjustments are necessary to effect the consolidation: 1. Adjustments must be made involving equity at the acquisition date, namely the fair value adjustments (if any) and the pre-acquisition adjustment, that eliminate the investment account in the parent’s financial statements against the pre-acquisition equity of the subsidiary (see Chapter 3). 2. Adjustments must be made to eliminate intragroup balances and the effects of transactions whereby profits or losses are made by different members of the group through trading with each other (see Chapter 4). acquisition date fair value adjustments eliminate intragroup balances and transactions arising when members of the group trade with each other LO 1 2

Rationale for Adjusting for Intragroup Transactions Intragroup transactions: transactions that occur between entities in the group. They must be eliminated on consolidation because, from a group viewpoint, they are not dealings with external parties IFRS 10 requires intragroup balances (assets, liabilities, and equity), transactions, revenues, and expenses to be eliminated in full IFRS 10 and IAS 12 also require tax effect accounting to be applied where temporary differences arise due to the elimination of profits and losses LO 1 3

Transfers of Inventory Example 4.2 The broad effect of intragroup sales and purchases of inventory can be illustrated by reference to the diagram below S sells inventory to P for $10,000 on Jan 1, 2013 Parent S purchases inventory for $8,000 on Dec 31, 2012 All inventory still held by the parent at Dec 31, 2012 Subsidiary LO 2 4

Unrealized Profit in Ending Inventory Example 4.2 The subsidiary would record sales of $10,000 and COGS of $8,000 – recognizing a profit of $2,000 The parent would record inventory of $10,000 The $2,000 profit made by the subsidiary is considered to be unrealized at December 31, 2013, as the inventory is yet to be sold to an external party To determine how to eliminate the effects of this transaction it is helpful to consider the journal entries that would have been recorded in the subsidiary and parent’s books respectively LO 2 5

Unrealized Profit in Ending Inventory Example 4.2 Subsidiary Parent Dec 31, 2012 Dr Inventory 8,000 Cr A/P 8,000 January 1, 2013 Dr Cash 10,000 Dr Inventory 10,000 Cr Sales 10,000 Cr Cash 10,000 Dr COGS 8,000 Cr Inventory 8,000 Dr Inc. Tax Exp 600 Cr Curr. Tax Liab. 600 LO 2 6

Unrealized Profit in Ending Inventory Example 4.2 Consolidation journal adjustments are required at Dec 31, 2013 for the following: Note: Transactions (i) and (ii) can be combined into a single entry as follows: Sales revenue 10,000 ↓ Cost of sales 10,000 ↓ – 2,000 ↑ = 8,000 ↓ Ending inventory 2,000 ↓ (i) Eliminate intragroup sale Sales revenue 10,000 ↓ Cost of sales 10,000 ↓ (ii) Eliminate unrealized profit and adjust overstated inventory Cost of sales 2,000 ↑ Ending inventory 2,000 ↓ From a consolidated viewpoint, there is NO sale, NO COS (and therefore no profit). In addition, inventory must be shown at the cost to the group (i.e., $8,000 not $10,000). (iii) Recognize tax effect of profit elimination Deferred tax asset 600 ↑ Income tax expense 600 ↓ No profit and therefore no tax expense, from group viewpoint. In future, when inventory sold by parent the group will recognize the tax expense. LO 2 7

Unrealized Profit in Ending Inventory Example 4.2 Notes: 1. Inventory is now recorded at the original $8,000 cost to the group. 2. All impacts on the Profit and Loss resulting from the inter-entity sale have been removed. LO 2 8

Unrealized Profit in Ending Inventory Example 4.3 What if the purchaser (i.e., the parent), subsequently sells some of the inventory to external parties before the end of the year? S sells inventory to P for $10,000 on Jan 1, 2013 Parent P sells 75% of the inventory to external entities for $14,000 on Dec 31, 2013 S purchases inventory for $8,000 on Dec 31, 2012 Subsidiary The journal entries processed by each entity and the consolidation journal adjustments required are shown on the following slides. LO 2 9

Unrealized Profit in Ending Inventory Example 4.3 Subsidiary Parent Dec 31, 2012 Dr Inventory 8,000 Cr A/P 8,000 January 1, 2013 Dr Cash 10,000 Dr Inventory 10,000 Cr Sales 10,000 Cr Cash 10,000 Dr COS 8,000 Cr Inventory 8,000 Dr Inc. Tax Exp. 600 Cr Curr. Tax Liab. 600 December 31, 2013 Dr A/R 14,000 Cr Sales 14,000 Dr COS 7,500 Cr Inventory 7,500 Dr Income Tax Exp. 1,950 Cr Curr. Tax Liab. 1,950 COS calculated as 75% of the inventory purchased (i.e., 75% of $10,000) = $7,500 LO 2 10

Unrealized Profit in Ending Inventory Consolidation adjustments are required at Dec 31, 2013 for the following: Example 4.3 (i) Eliminate intragroup sale Sales revenue 10,000 ↓ Cost of sales 10,000 ↓ The WHOLE amount of the sale is eliminated regardless of the amount subsequently disposed of by the parent. (ii) Eliminate unrealized profit and adjust overstated inventory Cost of sales 500 ↑ Ending inventory 500 ↓ From a consolidated viewpoint, the UNREALIZED portion (i.e., 25% × $2,000) of the profit needs to be eliminated. (iii) Recognize tax effect of profit elimination Deferred tax asset 150 ↑ Income tax expense 150 ↓ Note that the increase (debit) is recorded against the Deferred Tax Asset, not the Current Tax Liability (as was done in the sub’s books) { = $500 unrealized profit × 30% tax rate } As with the previous example, adjustments (i) and (ii) can be combined if desired LO 2 11

Unrealized Profit in Beginning Inventory If inventory is sold between entities within the group one year and not sold by the end of the year, then we need to consider how this affects the following year’s consolidated accounts. The profit will become realized when the inventory is sold to an external party (in the next financial year). As inventory is a current asset you should assume (unless specifically told otherwise) that it is sold to external parties within 12 months of being acquired by the group. LO 2 12

Unrealized Profit in Beginning Inventory Example 4.5 Go back to our original example (where all inventory was still held by the parent at December 31, 2013) S sells inventory to P for $10,000 on Jan 1, 2013 S purchases inventory for $8,000 on Dec 31, 2012 Parent P sells 100% of the inventory to external entities for $18,000 on Dec 31, 2013 Subsidiary LO 2 13

Unrealized Profit in Beginning Inventory Example 4.5 To carry forward the net effect of last year’s consolidation journals the following entry would be required on January 1, 2013 (refer back to slide 7): Sales revenue 10,000 ↓ Cost of sales 10,000 ↓ – 2,000 ↑ = 8,000 ↓ Ending inventory 2,000 ↓ Once the inventory is sold to an external third party (and the profit therefore realized) the above entry must be amended to reflect the following for the remainder of the 2013 financial year: Retained earnings (1/1/2013) 2,500 ↓ – 750 ↑ = 1,750 ↓ Income tax expense 750 ↑ Cost of sales 2,500 ↓ Sales, COGS, ITE adjustments closed to R/E No entry required in future years as the profit has been “realized”. (All accounts will close to retained earnings). LO 2 14

Transfers of Property, Plant, & Equipment Example 4.7 Consider the following example Parent P purchases plant for $20,000 – the plant has a useful life of 10 years, P uses straight-line depreciation with no residual value Subsidiary S purchases plant from Parent P for $18,500 on Jan 1, 2013 The tax rate is 30% The journal entries processed by each entity and the consolidation journal adjustments required are shown on the following slides LO 3 15

Intragroup Sale of Depreciable Assets Example 4.7 Parent Subsidiary January 1, 2012 Dr Plant 20,000 Cr Cash 20,000 December 31, 2012 Dr Deprec. Exp. 2,000 Cr Accum. Depr. 2,000 January 1, 2013 Dr Cash 18,500 Dr Machine 18,500 Dr Accum. Depr. 2,000 Cr Cash 18,500 Cr Plant 20,000 Cr Gain on sale 500 Dr Income Tax Exp. 150 Cr Curr. Tax Liability 150 LO 3 16

Intragroup Sale of Depreciable Assets Example 4.7 Consolidation journal adjustments are required at Dec 31, 2013 for the following: (i) Eliminate unrealized profit and reduce asset to group WDV Gain on sale of plant ↓ 500 Cost of sales ↓ 500 (ii) Recognize tax effect of profit elimination Deferred tax asset ↑ 150 (30% × $500) Income tax expense ↓ 150 Note that the increase (debit) is recorded against the Deferred Tax Asset, not the Current Tax Liability (as was done in the sub’s books) LO 3 17

Intragroup Services Example 4.8 Quite often in a group, one entity (normally the parent) provides services (such as accounting, HR, IT) to the other entities (normally the subsidiaries) to reduce duplication. Example: During 2013, P offered the services of a specialist employee to S for two months, in return for which S paid $30,000 to P. The journal entries in the records of P and S in relation to this transaction are: be eliminated on consolidation as follows: Company P DR Cash 30,000 CR Service revenue 30,000 Company S DR Service expense 30,000 CR Cash 30,000 LO 4 18

Intragroup Services Example 4.8 From the group’s perspective there has been no service revenue received or service revenue expense made to entities external to the group. Hence, to adjust to adjust from what has been recorded by the legal entities to the group’s perspective, the consolidation adjustment is: Service revenue ↓ 30,000 Service expense ↓ 30,000 If payable/receivable balances also exist, these balances must be eliminated on consolidation. LO 4 19

Intragroup Dividends Assumptions: All dividends received by the parent from the subsidiary are accounted for as revenue by the parent since the parent has been recording its investment using the cost method on its own non-consolidated financial statements. It is assumed that the company expecting to receive the dividend recognizes revenue when the dividend is declared. LO 5 20

Intragroup Services Dividends Declared in the Current Period but Not Paid Example: Assume that, on December 31, 2013, S declares a dividend of $4,000. At the end of the period, the dividend is unpaid. The journal entries recorded by the legal entities are: Journal Entry in S Journal Entry in P DR Dividend Declared 4,000 DR Dividend Receivable 4,000 CR Dividend Payable 4,000 CR Dividend Revenue 4,000 The consolidation adjustments are: Dividend payable ↓ 4,000 Dividend declared ↓ 4,000 (To adjust for the effects of the adjustment made by S) Dividend revenue ↓ 4,000 Dividend receivable ↓ 4,000 (To adjust for the effects of the adjustment made by P) From the group’s perspective, there is no reduction in equity and the group has no obligation to pay dividends outside the group. Similarly, the group expects no dividends to be received from entities outside the group. LO 5 21

Intragroup Services Dividends Declared and Paid in the Current Period Example: Assume S declares and pays an interim dividend of $4,000 in the current period. Entries by the legal entities are: Journal Entry in S Journal Entry in P DR Dividend Paid 4,000 DR Cash 4,000 CR Cash 4,000 CR Dividend Revenue 4,000 The consolidation adjustments are: Dividend revenue ↓ 4,000 Dividend declared and paid ↓ 4,000 From the group’s perspective, no dividends have been paid and no dividend revenue has been received. LO 5 22

Intragroup Borrowings Members of a group often borrow and lend money among themselves and charge interest on the money borrowed. Consolidation adjustments are necessary in relation to these intragroup borrowings and interest thereon because, from the stance of the group, these transactions create assets and liabilities and revenues and expenses that do not exist in terms of the group’s relationship with external entities. LO 6 23

Intragroup Borrowings Intragroup Advances with Interest Example: P lends $100,000 to S, with S paying $15,000 interest to P. The relevant journal entries in each of the legal entities are: Journal Entry in P Journal Entry in S DR Advance to S 100,000 DR Cash 100,000 CR Cash 100,000 CR Advance from P 100,000 DR Cash 15,000 DR Interest Expense 15,000 CR Interest Revenue 15,000 CR Cash 15,000 The consolidation adjustments are: Advances from P ↓ 100,000 Advances to S ↓ 100,000 Interest revenue ↓ 15,000 Interest expense ↓ 15,000 From the group’s perspective, The adjustment to the asset and liability is necessary as long as the intragroup loan exists. In relation to any past period’s payments and receipt of interest, no ongoing adjustment to accumulated profits (opening balance) is necessary as the net effect of the consolidation adjustment is zero on that item. There are no tax effects since the effect on consolidated net assets is zero. LO 6 24

Intragroup Borrowings Intragroup Bonds Acquired at Date of Issue Example: On July 1, 2013, P issues 1,000 $100 bonds with an interest rate of 5% p.a. payable on July 1 of each year. S, a wholly owned subsidiary of P, acquires half the bonds issued. Journal Entry in P Journal Entry in S DR Cash 100,000 DR Bonds in P 50,000 CR Bonds 100,000 CR Cash 50,000 DR Interest Expense 2,500 DR Interest Receivable 1,250 CR Interest Payable 2,500 CR Interest Revenue 1,250 The consolidation adjustments are: Bonds ↓ 50,000 Bond investment ↓ 100,000 Interest receivable ↓ 1,250 Interest payable ↓ 1,250 Interest revenue ↓ 1,250 Interest expense ↓ 1,250 From the group’s perspective, the group has now retired the portion of the bonds that are part of the intragroup borrowings. There are no tax effects since the effect on consolidated net assets is zero. LO 6 25

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