Consolidated Financial Statements – Intra-Entity Asset Transactions

Consolidated Financial Statements – Intra-Entity Asset Transactions
Chapter Five Consolidated Financial Statements – Intra-Entity Asset Transactions Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Understand why intra-entity asset transfers create accounting
Learning Objective 5-1 Understand why intra-entity asset transfers create accounting effects within the financial records of affiliated companies that must be eliminated or adjusted in preparing consolidated financial statements. Understand why intra-entity asset transfers create accounting effects within the financial records of affiliated companies that must be eliminated or adjusted in preparing consolidated financial statements.

Intra-entity Transactions
Companies that make up a business combination frequently retain their legal identities as separate operating centers and maintain their own recordkeeping. Inventory sales between the companies must be recorded. The seller records revenue, and the buyer enters the purchase into its accounts. For internal reporting purposes, recording an inventory transfer as a sale/purchase provides vital data to help measure the operational efficiency of each enterprise. companies that make up a business combination frequently retain their legal identities as separate operating centers and maintain their own recordkeeping. Thus, inventory sales between these companies trigger the independent accounting systems of both parties. The seller duly records revenue, and the buyer simultaneously enters the purchase into its accounts. For internal reporting purposes, recording an inventory transfer as a sale/purchase provides vital data to help measure the operational efficiency of each enterprise. 2

Intra-entity Transactions
From a consolidated perspective neither a sale nor a purchase has occurred. An intra-entity transfer is merely the internal movement of inventory that creates no net change in the financial position of the business combination taken as a whole. In the consolidated financial statements, the transfers are eliminated. The consolidated statements reflect only transactions with outside parties. Worksheet entries report the perspective of the consolidated enterprise. From a consolidated perspective neither a sale nor a purchase has occurred. An intra-entity transfer is merely the internal movement of inventory, an event that creates no net change in the financial position of the business combination taken as a whole. When producing consolidated financial statements, the recorded effects of these transfers are eliminated so that consolidated statements reflect only transactions with outside parties. Worksheet entries serve this purpose; they adapt the financial information reported by the separate companies to the perspective of the consolidated enterprise. The entire impact of the intra-entity transactions must be identified and then removed. Deleting the effects of the actual transfer is described here first. 2

Demonstrate the consolidation procedures to eliminate intra-entity
Learning Objective 5-2 Demonstrate the consolidation procedures to eliminate intra-entity sales and purchases balances. Demonstrate the consolidation procedures to eliminate intra-entity sales and purchases balances.

Sales and Purchases- Intra-entity
ENTRY TI (Transferred Inventory) In a business combination, both parties record the transfer in their internal records as a normal sale/purchase. This consolidation worksheet entry is necessary to remove the resulting balances from the externally reported figures. Cost of Goods Sold is reduced here under the assumption that the Purchases account usually is closed out prior to the consolidation process. Sales and Purchases-Intra-entity ENTRY TI (Transferred Inventory) In a business combination, both parties record the transfer in their internal records as a normal sale/purchase. This consolidation worksheet entry is necessary to remove the resulting balances from the externally reported figures. Cost of Goods Sold is reduced here under the assumption that the Purchases account usually is closed out prior to the consolidation process. 3

Explain why consolidated entities defer intra-entity gross
Learning Objective 5-3 Explain why consolidated entities defer intra-entity gross profit in ending inventory and the consolidation procedures required to recognize profits when actually earned. Explain why consolidated entities defer intra-entity gross profit in ending inventory and the consolidation procedures required to recognize profits when actually earned.

Unrealized Gross Profit – Intra-entity
Despite Entry TI, the inflated ending inventory figure causes cost of goods sold to be too low and profits to be too high . For consolidation purposes, the expense is increased by this amount through a worksheet adjustment that properly removes the unrealized gross profit from consolidated net income. Unrealized Gross Profit – Intra-entity ENTRY G (Gross Profit) Despite Entry TI, the inflated ending inventory figure causes cost of goods sold to be too low and, thus, profits to be too high by $30,000. For consolidation purposes, the expense is increased by this amount through a worksheet adjustment that properly removes the unrealized gross profit from consolidated net income. Consequently, if all of the transferred inventory is retained by the business combination at the end of the year, the following worksheet entry also must be included to eliminate the effects of the seller’s gross profit that remains unrealized within the buyer’s ending inventory in year 1. If all of the transferred inventory is retained by the business combination at the end of the year, entry G eliminates the effects of the seller’s gross profit that remains unrealized within the buyer’s ending inventory in year 1. 4

Consoliation ENTRY G Year of Transfer (Year 1) Because the gross profit rate was 37½ percent ($30,000 gross profit/$80,000 transfer price), this retained inventory is stated at a value $7,500 more than its original cost ($20,000 X 37½%). The required reduction (Entry G ) is not the entire $30,000 shown previously but only the $7,500 unrealized gross profit that remains in ending inventory. Because the gross profit rate was 37½ percent ($30,000 gross profit/$80,000 transfer price), this retained inventory is stated at a value $7,500 more than its original cost ($20, ½%). The required reduction (Entry G ) is not the entire $30,000 shown previously but only the $7,500 unrealized gross profit that remains in ending inventory. 4

Understand that the consolidation
Learning Objective 5-4 Understand that the consolidation process for inventory transfers is designed to defer the unrealized portion of an intra- entity gross profit from the year of transfer into the year of disposal or consumption. Understand that the consolidation process for inventory transfers is designed to defer the unrealized portion of an intra- entity gross profit from the year of transfer into the year of disposal or consumption.

In year 2, the overstatement is removed within the consolidation process but this time from the beginning inventory balance (which appears in the financial statements only as a positive component of cost of goods sold). This elimination is termed Entry *G. The asterisk indicates that a previous year transfer created the intra-entity gross profits. Unrealized Gross Profit – Intra-entity ENTRY *G In year 2, the overstatement is removed within the consolidation process but this time from the beginning inventory balance (which appears in the financial statements only as a positive component of cost of goods sold). This elimination is termed Entry *G. The asterisk indicates that a previous year transfer created the intra-entity gross profits. Entry *G removes unrealized gross profit from beginning figures so that it is recognized in the consolidated income in the period in which it is earned. Entry *G removes unrealized gross profit from beginning figures so that it is recognized in the consolidated income in the period in which it is earned. 5

Intra-entity Transactions – Downstream Transfers
Entry *G if the transfer of inventory is downstream AND the parent uses the equity method, the following entry is used to recognize the remaining unrealized profit left at the end of the previous year. Intra-entity Transactions – Downstream Transfers ENTRY *G If the transfer of inventory is downstream AND the parent uses the equity method, the following entry is used to recognize the remaining unrealized profit left at the end of the previous year. Investment in Subsidiary account replaces the Retained Earnings account used for upstream sales. Investment in Subsidiary account replaces the Retained Earnings account used for upstream sales. 6

Unrealized Inventory Gain – Downstream Transfers
Worksheet entries to eliminate sales/purchases balances (Entry TI) and to remove unrealized gross profit from ending Inventory in Year 1 (Entry G) are standard, regardless of the circumstances of the consolidation. BUT the procedure to eliminate intra-entity gross profit from Year 2’s beginning account balances differs from the Entry *G just presented IF: (1) the original transfer is downstream (parent’s) and (2) the parent applies the equity method for internal accounting purposes. Unrealized Inventory Gain – Downstream Transfers Worksheet entries to eliminate sales/purchases balances (Entry TI) and to remove unrealized gross profit from ending Inventory in Year 1 (Entry G) are standard, regardless of the circumstances of the consolidation. BUT the procedure to eliminate intra-entity gross profit from Year 2’s beginning account balances differs from the Entry *G just presented IF: (1) the original transfer is downstream (parent’s) and (2) the parent applies the equity method for internal accounting purposes.

Unrealized Inventory Gain - Downstream Transfers
For intra-entity beginning inventory profits resulting from downstream transfers when the parent applies the equity method: Parent’s retained earnings are appropriately stated due to intra-entity profit deferrals and recognition. The subsidiary retained earnings reflect none of the intra-entity profit and require no adjustment. The parent’s investment account at beginning of Year 2 contains a credit from the deferral of Year 1 downstream profits. Worksheet Entry *G transfers the Year 1 Investment account credit to a Year 2 earnings credit via COGS to recognize the profit in the year of sale to outsiders. Unrealized Inventory Gain - Downstream Transfers For intra-entity beginning inventory profits resulting from downstream transfers when the parent applies the equity method: Parent’s retained earnings are appropriately stated due to intra-entity profit deferrals and recognition. The subsidiary retained earnings reflect none of the intra-entity profit and require no adjustment. The parent’s investment account at beginning of Year 2 contains a credit from the deferral of Year 1 downstream profits. Worksheet Entry *G transfers the Year 1 Investment account credit to a Year 2 earnings credit via COGS to recognize the profit in the year of sale to outsiders. 9

Explain the difference between upstream and downstream
Learning Objective 5-5 Explain the difference between upstream and downstream intra-entity transfers and how each affects the computation of noncontrolling interest balances. Explain the difference between upstream and downstream intra-entity transfers and how each affects the computation of noncontrolling interest balances.

Unrealized Gross Profits – Effect on Noncontrolling Interest
According to FASB ASC paragraph : The amount of intra-entity profit or loss to be eliminated is not affected by the existence of a noncontrolling interest. The complete elimination of the intra-entity profit or loss is consistent with the underlying assumption that consolidated financial statements represent the financial position and operating results of a single economic entity. The elimination of the intra-entity profit or loss may be allocated proportionately between the parent and noncontrolling interest. Unrealized Gross Profits – Effect on Noncontrolling Interest According to FASB ASC paragraph : The amount of intra-entity profit or loss to be eliminated is not affected by the existence of a noncontrolling interest. The complete elimination of the intra-entity profit or loss is consistent with the underlying assumption that consolidated financial statements represent the financial position and operating results of a single economic entity. The elimination of the intra-entity profit or loss may be allocated proportionately between the parent and noncontrolling interest.

Unrealized Gross Profits – Effect on Noncontrolling Interest
Accounts affected by intra-entity transactions: Revenues Cost of Goods Sold Expenses Noncontrolling Interest in Subsidiary’s Net Income Retained Earnings at the Beginning of the Year Inventory Land, Buildings, and Equipment Noncontrolling Interest in Subsidiary at End of Year. Unrealized Gross Profits – Effect on Noncontrolling Interest Accounts affected by intra-entity transactions: Revenues Cost of Goods Sold Expenses Noncontrolling Interest in Subsidiary’s Net Income Retained Earnings at the Beginning of the Year Inventory Land, Buildings, and Equipment Noncontrolling Interest in Subsidiary at End of Year.

Intra-Entity Inventory Downstream Transfer - Example
Top Company acquires 80 percent of the voting stock of Bottom Company on January 1, Top pays $400,000. Acquisition-date fair value of noncontrolling interest is $100,000. Top allocates the entire $50,000 excess fair value over book value to adjust a database owned by Bottom to fair value. The database has an estimated remaining life of 20 years. Intra-Entity Inventory Downstream Transfer - Example Top Company acquires 80 percent of the voting stock of Bottom Company on January 1, 2012. Top pays $400,000. Acquisition-date fair value of noncontrolling interest is $100,000. Top allocates the entire $50,000 excess fair value over book value to adjust a database owned by Bottom to fair value. The database has an estimated remaining life of 20 years.

The subsidiary reports net income of $30,000 in 2014 and $70,000 in 2015, the current year. Dividends declared are $20,000 in the first year and $50,000 in the second. A $10,000 intra-entity receivable and payable exists as of December 31, Intra-entity inventory transfers between the two companies: Transfer prices $80,000 $100,000 Historical cost ,000 70,000 Gross profit $20,000 $ 30,000 Year-end Inventory balance (transfer price) $16,000 $ 20,000 Gross profit percentage X 25% X30% Gross profit remaining in year-end inventory$ 4,000 $ 6,000 Intra-Entity Inventory Downstream Transfer - Example The subsidiary reports net income of $30,000 in 2014 and $70,000 in 2015, the current year. Dividends declared are $20,000 in the first year and $50,000 in the second. A $10,000 intra-entity debt exists as of December 31, 2015. Intra-entity inventory transfers between the two companies: Transfer prices $80, $100,000 Historical cost , ,000 Gross profit $20, $ 30,000 Year-end Inventory balance (transfer price) $16, $ 20,000 Gross profit percentage X 25% X30% Gross profit remaining in year-end inventory $ 4, $ 6,000

Intra-Entity Inventory Transfers Example
Three entries require attention in the calculation of noncontrolling interest in the sub’s net income December 31, Entry *G removes unrealized gross profits (25% rate) carried over from the previous period intra-entity downstream sales. Entry *G reduces Cost of Goods Sold (or beginning inventory component) which creates an increase in current year income. Gross profit is correctly recognized in 2015 when inventory is sold to an outside party. The debit to the Investment in Bottom account brings that account to a zero balance in consolidation. Intra-Entity Inventory Transfers Example Three entries require attention in the calculation of noncontrolling interest in the sub’s net income December 31, 2015. Entry *G removes unrealized gross profits (25% rate) carried over from the previous period intra-entity downstream sales. Entry *G reduces Cost of Goods Sold (or beginning inventory component) which creates an increase in current year income. Gross profit is correctly recognized in 2015 when inventory is sold to an outside party. The debit to the Investment in Bottom account brings that account to a zero balance in consolidation.

Entry TI eliminates the intra-entity sales/purchases for 2015. Entry G defers the unrealized gross profit (30% rate) of $6,000remaining at the end of 2015. Entry G eliminates the overstatement of Inventory as well as the ending component of Cost of Goods Sold which decreases consolidated income. Entry TI eliminates the intra-entity sales/purchases for 2015. Entry G defers the unrealized gross profit (30% rate) of $6,000remaining at the end of 2015. Entry G eliminates the overstatement of Inventory as well as the ending component of Cost of Goods Sold which decreases consolidated income.

Intra-entity Transactions – Upstream Inventory Transfer
A different set of consolidation procedures is necessary if the intra-entity transfers are upstream. Upstream gross profits are attributed to the subsidiary, Bottom, not the parent, Top. Because inventory transfers are upstream from Bottom to Top, only 80% of the profit deferral and subsequent recognition is allocated to the parent’s equity earnings and investment account. Intra-entity profit reallocation across time affects both the subsidiary’s reported income and the noncontrolling interest. A different set of consolidation procedures is necessary if the intra-entity transfers are upstream. Upstream gross profits are attributed to the subsidiary, Bottom, not the parent, Top. Because inventory transfers are upstream from Bottom to Top, only 80% of the profit deferral and subsequent recognition is allocated to the parent’s equity earnings and investment account. Intra-entity profit reallocation across time affects both the subsidiary’s reported income and the noncontrolling interest. 8

The records of the two companies change to reflect the parent’s application of the equity method for upstream sales. (Entry *G) reduces Bottom’s beginning 2015 Retained Earnings balance, and decreases Cost of Goods Sold which increases consolidated net income to recognize profit earned in 2015 by sales to outsiders. The records of the two companies change to reflect the parent’s application of the equity method for upstream sales. (Entry *G) reduces Bottom’s beginning 2015 Retained Earnings balance, and decreases Cost of Goods Sold which increases consolidated net income to recognize profit earned in 2015 by sales to outsiders. 8

As of January 1, 2015, $16,000 of transfers remain in Top’s inventory, and $4,000 of gross profit (25%) is unearned from a consolidated perspective. Also, Bottom’s beginning Retained Earnings are overstated by $4,000, the gross profit from 2014 intra-entity transfers. A credit to Cost of Goods Sold increases consolidated net income to recognize that the profit has been earned in 2015 by sales to outsiders. As of January 1, 2015, $16,000 of transfers remain in Top’s inventory, and $4,000 of gross profit (25%) is unearned from a consolidated perspective. Also, Bottom’s beginning Retained Earnings are overstated by $4,000, the gross profit from 2014 intra-entity transfers. A credit to Cost of Goods Sold increases consolidated net income to recognize that the profit has been earned in 2015 by sales to outsiders.

Entry S eliminates a portion of the parent’s investment account and provides the initial noncontrolling interest balance. The entry also removes stockholders’ equity accounts of the subsidiary as of the beginning of the current year. Entry S eliminates a portion of the parent’s investment account and provides the initial noncontrolling interest balance. The entry also removes stockholders’ equity accounts of the subsidiary as of the beginning of the current year. 8

Intra-entity Transactions – Upstream vs. Downstream transfers
Compare the Entry *G for the downstream and upstream transfers to see the difference in the transactions. Compare the Entry *G for the downstream and upstream transfers to see the difference in the transactions. The effect of downstream and upstream transfers when the parent uses the equity method are compared in more detail.

Intra-entity Transactions – Upstream vs. Downstream transfers
To better understand how the Entry S differs, compare the entries for the downstream and upstream transfers. 8

Prepare the consolidation entry to remove any unrealized
Learning Objective 5-6 Prepare the consolidation entry to remove any unrealized gain created by the intra-entity transfer of land from the accounting records of the year of transfer and subsequent years. Prepare the consolidation entry to remove any unrealized gain created by the intra-entity transfer of land from the accounting records of the year of transfer and subsequent years.

Intra-entity Transactions – Land Transfer
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 ENTRY TL If land is transferred between the parent and sub at a gain, the gain is considered unrealized and must be eliminated. Note: By crediting land for the same amount, this effectively returns the land to its carrying value on the date of transfer. By crediting land for the same amount, this effectively returns the land to its carrying value on the date of transfer. 10

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. 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. The original gain was closed to R/E at the end of that period. To eliminate the gain in subsequent years, it must come from R/E. 11

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. 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. 12

The Effect of Land Transfers on Noncontrolling Interests
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. DOWNSTREAM transfers have no effect on noncontrolling interest. 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.

Prepare the consolidation entries to remove the effects
Learning Objective 5-7 Prepare the consolidation entries to remove the effects of upstream and downstream intra-entity fixed asset transfers across affiliated entities. Prepare the consolidation entries to remove the effects of upstream and downstream intra-entity fixed asset transfers across affiliated entities.

Intra-entity Transactions -- Depreciable Asset Transfers
Example Able Co and Baker Co are related parties. Able purchased equipment for $100,000 several years ago, and has recorded $40,000 of depreciation since that time. Baker buys the equipment from Able for $90,000 on 1/1/14. Equipment has a remaining useful life of 10 years. Example Able Co and Baker Co are related parties. Able purchased equipment for $100,000 several years ago, and has recorded $40,000 of depreciation since that time. Baker buys the equipment from Able for $90,000 on 1/1/14. The equipment has a remaining useful life of 10 years.

On the Buyer’s (Baker) Books: Equipment $90,000 Cash $90,000 NOTE: The buyer WILL record $9,000 per year in depreciation based on the remaining life. On the Seller’s (Able) Books: Cash $90,000 Accumulated Depreciation ,000 Equipment $100,000 Gain on Sale of Equipment ,000 NOTE: The seller WOULD record depreciation expense at $6,000 / year if they had not sold the equipment. 1. Baker, as the buyer, enters the equipment into its records at the $90,000 transfer price. However, from a consolidated view, the $60,000 book value ($100,000 cost less $40,000 accumulated depreciation) is still appropriate. 2. Able, as the seller, reports a $30,000 profit, although the combination has not yet earned anything. Able then closes this gain into its Retained Earnings account at the end of 2014. 3. Assuming application of the straight-line depreciation method with no salvage value, Baker records expense of $9,000 at the end of 2014 ($90,000/10 years). The buyer recognizes this amount rather than the $6,000 depreciation figure applicable to the consolidated entity ($60,000/10 years).

ENTRY TA In the year of transfer, the unrealized gain must be eliminated and the assets restated to original historical cost. Intra-entity Transactions -- Depreciable Asset Transfers ENTRY TA In the year of transfer, the unrealized gain must be eliminated and the assets restated to original historical cost. 15

ENTRY ED In addition, the buyer’s depreciation is based on the inflated transfer price. The excess depreciation expense must be eliminated. Intra-entity Transactions -- Depreciable Asset Transfers ENTRY ED In addition, the buyer’s depreciation is based on the inflated transfer price. The excess depreciation expense must be eliminated. 16

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. 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. For every subsequent period, the separately reported figures must be adjusted on the worksheet to present the consolidated totals from a single entity’s perspective. For every subsequent period, the separately reported figures must be adjusted on the worksheet to present the consolidated totals from a single entity’s perspective. 17

On Baker’s (buyer’s) books, the annual depreciation = $90,000 ÷ 10 yrs. = $9,000 per year. The 1/1/15 R/E effect = the original gain of $30,000 on Able’s (seller’s) books less $9,000, one year of depreciation. On Baker’s (buyer’s) books, the annual depreciation = $90,000 ÷ 10 yrs. = $9,000 per year. The 1/1/15 R/E effect = the original gain of $30,000 on Able’s (seller’s) books less $9,000, one year of depreciation. 17

ENTRY *TA (Subsequent Years) The adjustment to fixed assets and depreciation expense must be made in each succeeding period. The entry for Consolidation is: Intra-entity Transactions -- Depreciable Asset Transfers ENTRY *TA (Subsequent Years) The adjustment to fixed assets and depreciation expense must be made in each succeeding period 17

ENTRY ED (Subsequent Years) In addition, the Depreciation Expense and Accumulated Depreciation accounts must be adjusted. Intra-entity Transactions -- Depreciable Asset Transfers ENTRY ED (Subsequent Years) In addition, the Depreciation Expense and Accumulated Depreciation accounts must be adjusted. The ED entry removes excess depreciation expense on the intra-entity transfer price and adjust Accumulated Depreciation to its correct 12/31/13 balance. The $34,000 increase in 12/31/13 consolidated Accumulated Depreciation is accomplished by a $37,000 credit in Entry *TA and a $3,000 debit in Entry ED. 16

If the transfer is downstream and the parent uses the equity method, then their Retained Earnings balance has already been reduced for the gain, and we adjust the Investment account instead. If the transfer is downstream and the parent uses the equity method, then their Retained Earnings balance has already been reduced for the gain, and we adjust the Investment account instead.

Consolidated Financial Statements – Intra-Entity Asset Transactions

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Consolidated Financial Statements – Intra-Entity Asset Transactions

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