1. Chapter Five Consolidated Financial Statements – Intra-Entity Asset Transactions McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Intra-entity Transactions  Transactions between the parent and subsidiary are considered “internal” transactions of a single economic entity.  The effects of these intra-entity transactions should be eliminated from the consolidated financial statements.  Thus, consolidated statements only reflect transactions with outside parties. 5-2

3. Note: Assuming inventory has been re-sold to a third-party, both companies have debited COGS and credited Sales for the same inventory. Intra-entity Transactions – Inventory Transfers ENTRY TI Eliminate all intra-entity sales/purchases of inventory, by eliminating the sales price of the transfer – which one company recorded as sales, and the other recorded as cost of goods sold. 5-3

4. Note: Any inventory that was ‘marked-up’ in an I/C transfer must be returned to it’s original cost if it has not been sold to an outside party. Intra-entity Transactions – Inventory Transfers ENTRY G Despite Entry TI, ending inventory is still overstated by the amount of gain on any inventory that remains unsold at year end. We must eliminate the unrealized gain as follows: 5-4

5. Intra-entity Transactions – Inventory Transfers ENTRY *G In the year that the inventory is subsequently sold to a third party, the I/C gain is in beginning Retained Earnings on the seller’s books, and must be moved to Consolidated Income. Note: The separate records of each company still contain the I/C transactions, including any gain that was recorded at the time it occurred. 5-5

6. Unrealized Inventory Gain - Other issues  If it’s DOWNSTREAM, then any unrealized gain belongs to the parent.  If it’s UPSTREAM, then any unrealized gain belongs to the subsidiary.  We will reduce the Sub’s net income by the unrealized gain prior to calculating the noncontrolling interest’s share. Does it matter if the sale is Upstream or Downstream? YES!! 5-6

7. Intra-entity Transactions – Inventory Transfers ENTRY *G If the transfer of inventory is downstream AND the parent uses the equity method, then the following entry is used to recognize the remaining unrealized profit left at the end of the previous year. Note: This properly eliminates the gain from the Equity in Sub Income account and moves it to the Parent’s operating income accounts. 5-7

8. ENTRY TL If land is transferred between the parent and sub at a gain, the gain is considered unrealized and must be eliminated. Intra-entity Transactions – Land Transfer Note: By crediting land for the same amount, this effectively returns the land to its carrying value on the date of transfer. 5-8

9. Intra-entity Transactions -- Land Transfer ENTRY *GL As long as the land remains on the books of the buyer, the unrealized gain must be eliminated at the end of each fiscal period. Note: The original gain was closed to R/E at the end of that period. When we eliminate the gain in subsequent years, it must come from R/E. 5-9

10. Intra-entity Land Transfers Eliminating Unrealized Gains ENTRY *GL (Year of sale) In the period the land is sold to a third party, the unrealized gain must be eliminated one more time, and also finally recognized as a REALIZED gain in the current period’s consolidated financial statements. Note: Modify the entry to credit the Gain account instead of Land. 5-10

11. The Effect of Land Transfers on Noncontrolling Interests DOWNSTREAM transfers have no effect on noncontrolling interest. UPSTREAM transfers have a gain on the SUBSIDIARY books! All noncontrolling interest balances are based on the sub’s net income EXCLUDING the intra-entity gain 5-11

12. Intra-entity Transactions -- Depreciable Asset Transfers In Years Following the Year of Transfer Equipment is carried on the individual books at a different amount than on the consolidated books. The amounts change each year as depreciation is computed. To get the worksheet adjustments, compare the individual records to the consolidated records. 5-12

13. Intra-entity Transactions -- Depreciable Asset Transfers On Baker’s (buyer’s) books, the annual depreciation = $90,000 ÷ 10 yrs. = $9,000 per year. The 1/1/11 R/E effect = the original gain of $30,000 on Able’s (seller’s) books less one year of depreciation. 5-13

14. Intra-entity Transactions -- Depreciable Asset Transfers For the consolidated entity, the annual depreciation = $48,000 remaining BV ÷ 8 yrs. = $6,000 per year. The Accumulated Depreciation at 12/31/11 = $40,000 accumulated depreciation at 12/31/09 + two years of depreciation. 5-14

15. Intra-entity Transactions -- Depreciable Asset Transfers The consolidation worksheet adjustments appear in the last column. 5-15