Advanced Accounting, Fourth Edition

Advanced Accounting, Fourth Edition
7 Elimination of Unrealized Gains or Losses on Intercompany Sales of Property and Equipment Advanced Accounting, Fourth Edition

Learning Objectives Understand the financial reporting objectives in accounting for intercompany sales of nondepreciable assets on the consolidated financial statements. Explain the additional financial reporting objectives in accounting for intercompany sales of depreciable assets on the consolidated financial statements. Explain when gains or losses on intercompany sales of depreciable assets should be recognized on a consolidated basis. Explain the term “realized through usage.” Describe the differences between upstream and downstream sales in determining consolidated net income and the controlling and noncontrolling interests in consolidated income.

Learning Objectives Compare the eliminating entries when the selling affiliate is a subsidiary (less than wholly owned) versus when the selling affiliate is the parent company. Compute the noncontrolling interest in consolidated net income when the selling affiliate is a subsidiary. Compute consolidated net income considering the effects of intercompany sales of depreciable assets. Describe the eliminating entry needed to adjust the consolidated financial statements when the purchasing affiliate sells a depreciable asset that was acquired from another affiliate. Explain the basic principles used to record or eliminate intercompany interest, rent, and service fees.

Intercompany Sales of Nondepreciable Property
When there have been intercompany sales of nondepreciable property, workpaper entries are necessary to: Include gains or losses on the sale in consolidated net income only at the time such property is sold to parties outside the affiliated group and in an amount equal to the difference between the cost of the property to the affiliated group and the proceeds received from outsiders. Present nondepreciable property in the consolidated balance sheet at its cost to the affiliated group. LO 1 Financial reporting objectives nondepreciable property.

Upstream Sale E7-4 (variation): Procter Company owns 90% of the outstanding stock of Silex Company. On January 1, 2011, Silex Company sold land to Procter Company for $350,000. Silex had originally purchased the land on June 30, 2007, for $200,000. Procter Company plans to construct a building on the land bought from Silex in which it will house new production machinery. The estimated useful life of the building and the new machinery is 15 years. LO 1 Financial reporting objectives nondepreciable property.

E7-4 (variation): Entries made on the books of each affiliate to record this intercompany sale in 2011. Entry on Books of Silex Cash 350,000 Land 200,000 Gain on sale 150,000 Entry on Books of Procter Land 350,000 Cash 350,000 Additional Entry for Complete Equity Method: Proctor Only Equity in income 135,000 Investment in Silex 135,000 To reduce its income from subsidiary by its share of the intercompany gain ($150,000 x 90%). Note: No further entries are recorded on the books of Procter until the land is sold to outsiders. LO 1 Financial reporting objectives nondepreciable property.

E7-4: B(1). Prepare the workpaper entries necessary because of the intercompany sale of land for the year ended December 31, 2011. Gain on Sale of Land 150,000 Land ($350,000 - $200,000) 150,000 To eliminate the $150,000 gain reported by Silex Company and to reduce the land balance from the $350,000 recorded on the books of Procter to its $200,000 cost to the affiliated group. LO 1 Financial reporting objectives nondepreciable property.

E7-4: B(2). Prepare the workpaper entries for the year ended December 31, 2012. Upstream Sale Cost Method and Partial Equity Method Beg. Retained Earnings – Procter (90%) 135,000 Noncontrolling Interest (10%) 15,000 Land 150,000 Complete Equity Method Investment in Silex Company (90%) 135,000 Noncontrolling Interest (10%) 15,000 Land 150,000 LO 1 Financial reporting objectives nondepreciable property.

E7-4: Summary Points Proctor (parent) continues to report the land on their statements at the intercompany selling price of $350,000. However, in the consolidated balance sheet, the land is reported at its cost to the affiliated group of $200,000. If the intercompany seller had been the parent (downstream sale), the entire $150,000 would go to the controlling interest, resulting in a $150,000 debit to the beginning retained earnings of the parent company. LO 1 Financial reporting objectives nondepreciable property.

Sales to Outsiders E7-6: P Company owns 90% of the outstanding common stock of S Company. On January 1, 2011, S Company sold land to P Company for $600,000. S Company originally purchased the land for $400,000. On January 1, 2012, P Company sold the land purchased from S Company to a company outside the affiliated group for $700,000. Required: A. Calculate the amount of gain on the sale of the land that is recognized on the books of P Company in 2012. LO 1 Financial reporting objectives nondepreciable property.

E7-6: A. Calculate the gain on the sale of the land that is recognized on the books of P Company in 2012. Selling price to third party $ 700,000 Cost of land to P Company 600,000 Gain recognized by P Company $ 100,000 B. Calculate the gain that should be recognized in the consolidated statements in 2012. Selling price to third party $ 700,000 Cost of land to affiliate group 400,000 Gain recognized in consolidation $ 300,000 LO 1 Financial reporting objectives nondepreciable property.

E7-6: C. Prepare the workpaper entries for the year ended December 31, 2012. Cost Method and Partial Equity Method Beg. Retained Earnings – Procter (90%) 180,000 Noncontrolling Interest (10%) 20,000 Gain on Sale of Land 200,000 * Complete Equity Method Investment in Silex Company (90%) 180,000 Noncontrolling Interest (10%) 20,000 Gain on Sale of Land ,000 * * Gain recognized in consolidation less gain recognized by P Company ($300,000 - $100,000 = $200,000). LO 1 Financial reporting objectives nondepreciable property.

Intercompany Sales of Depreciable Property (Machinery, Equipment, and Buildings)
Realization through Usage A firm may sell property or equipment to an affiliate for a price that differs from its book value. From the view of the consolidated entity, the intercompany gain (loss) is considered to be realized from the use of the property or equipment in the generation of revenue. The use is measured by depreciation adjustments. LO 4 Intercompany gain realized through usage.

When there have been intercompany sales of depreciable property, workpaper entries are necessary: To report only those gains or losses that result from the sale of depreciable property to outside parties. To present property in the consolidated balance sheet at its cost to the affiliated group. To present accumulated depreciation in the consolidated balance sheet based on the cost to the affiliated group. To present depreciation expense in the consolidated income statement based on the cost to the affiliated group. LO 2 Financial reporting objectives— depreciable property.

Workpaper Elimination Entries A firm may sell property or equipment to an affiliate for a price that differs from its book value. From the view of the consolidated entity, the intercompany gain (loss) is considered to be realized from the use of the property or equipment in the generation of revenue. LO 2 Financial reporting objectives— depreciable property.

Intercompany Sales of Depreciable Property
Upstream Sale P7-1 (Cost or Partial Equity): Powell Company owns 80% of the outstanding common stock of Sullivan Company. On June 30, 2011, Sullivan Company sold equipment to Powell Company for $500,000. The equipment cost Sullivan Company $780,000 and had accumulated depreciation of $400,000 on the date of the sale. The management of Powell Company estimated that the equipment had a remaining useful life of four years from June 30, In 2012, Powell Company reported $300,000 and Sullivan Company reported $200,000 in net income from their independent operations (including sales to affiliates but excluding dividend or equity income from subsidiary). LO 6 Subsidiary vs. parent as the seller.

P7-1: Entries on the books of Powell and Sullivan to record the intercompany sale are: Powell Company Equipment 500,000 Cash 500,000 Sullivan Company Cash 500,000 Accumulated Depreciation 400,000 Equipment 780,000 Gain on Sale of Equipment 120,000 LO 6 Subsidiary vs. parent as the seller.

P7-1: A. Prepare the workpaper entries necessary because of the sale of equipment for the year ended December 31, 2011. 2011 Equipment 280,000 Gain on Sale of Equipment 120,000 Accumulated Depreciation 400,000 To eliminate the intercompany gain and restore equipment to its original cost to the consolidated entity. LO 6 Subsidiary vs. parent as the seller.

P7-1: A. Prepare the workpaper entries necessary because of the sale of equipment for the year ended December 31, 2011. 2011 Accumulated Depreciation - Equipment 15,000 Depreciation Expense ($30,000/2) 15,000 To adjust depreciation expense to the correct amount to the consolidated entity, thus realizing a portion of the gain through usage. LO 6 Subsidiary vs. parent as the seller.

P7-1: A. Prepare the workpaper entries necessary because of the sale of equipment for the year ended December 31, 2012. 2012 Equipment (to original cost) 280,000 Beg. Retained Earnings - Powell ($120,000 x 80%) 96,000 Noncontrolling Interest ($120,000 x 20%) 24,000 Accumulated Depreciation - Equipment 400,000 To eliminate prior period intercompany gain and restore equipment to its original cost to the consolidated entity. LO 7 Computing the noncontrolling interest.

P7-1: A. Prepare the workpaper entries necessary because of the sale of equipment for the year ended December 31, 2012. 2012 Accumulated Depreciation - Equipment 45,000 Depreciation Expense ($120,000/4) 30,000 Beg. Retained Earnings – Powell ($15,000 x 80%) 12,000 Noncontrolling Interest ($15,000 x 20%) 3,000 To adjust depreciation for the current and prior year on equipment sold to affiliate. LO 7 Computing the noncontrolling interest.

P7-1 (variation): For the Compete Equity Method, the 2012 workpaper entries would have changed as follows: Equipment (to original cost) 280,000 Investment in Sullivan ($120,000 x 80%) 96,000 Noncontrolling Interest ($120,000 x 20%) 24,000 Accumulated Depreciation - Equipment 400,000 Accumulated Depreciation - Equipment 45,000 Depreciation Expense ($120,000/4) 30,000 Investment in Sullivan ($15,000 x 80%) 12,000 Noncontrolling Interest ($15,000 x 20%) 3,000 LO 7 Computing the noncontrolling interest.

P7-1 (variation): If this had been a Downstream sale, the 2012 entries would have changed as follows: Cost or Partial Equity Noncontrolling interest of 20% would be included in Beginning Retained Earnings of Powell Company. Complete Equity Method Noncontrolling interest of 20% would be included in Investment in Sullivan. There is no differentiation between Controlling interest and Noncontrolling interest with Downstream Intercompany Sales. LO 7 Computing the noncontrolling interest.

Year Subsequent to Intercompany Sale Upstream Sale P7-6 (Cost Method): Pitts Company owns 80% of the common stock of Shannon Company. The stock was purchased for $960,000 on January 1, 2009, when Shannon Company’s retained earnings were $675,000. On January 1, 2011, Shannon Company sold fixed assets to Pitts Company for $960,000; Shannon Company had purchased these assets for $1,350,000 on January 1, 2001, at which time their estimated useful life was 25 years. The estimated remaining useful life to Pitts Company on 1/1/11 is 10 years. Both companies employ the straight-line method of depreciation. Required: A. Prepare a consolidated statements workpaper for the year ended December 31, 2012. LO 6 Workpaper entries-upstream sales.

P7-6 (Cost Method): (4) (3) (2) (1) (3) (5) (4) NCI in Consolidated Income = 20% x ($300,000 + $15,000) = $63,000 LO 6 Workpaper entries-upstream sales.

P7-6 (Cost Method): (1) (5) (2) (3) (2) (5) (2) (5) (3) LO 6 Workpaper entries-upstream sales.

P7-6: Prepare the worksheet entries for Dec. 31, 2012. Acquisition date retained earnings - Shannon $ 675,000 Retained earnings 1/1/12 - Shannon 1,038,000 Increase 363,000 Ownership percentage 80% $ 290,400 1. Investment in Shannon Company 290,400 Retained Earnings – Pitts 290,400 To establish reciprocity/convert to equity LO 6 Workpaper entries-upstream sales.

P7-6: Prepare the worksheet entries for Dec. 31, 2012. 2. Plant and Equipment 390,000 Retained Earnings – Pitts ($150,000 x 80%) 120,000 Noncontrolling Interest ($150,000 x 20%) 30,000 Accumulated Depreciation 540,000 To reduce controlling and noncontrolling interests for their shares of unrealized intercompany profit at beg. of year, to restore fixed assets to its book value to the selling affiliate on the date of the intercompany sale LO 6 Workpaper entries-upstream sales.

P7-6: Prepare the worksheet entries for Dec. 31, 2012. 3. Accumulated Depreciation 30,000 Other Expenses (Depreciation Expense) 15,000 Retained Earnings – Pitts ($15,000 x 80%) 12,000 Noncontrolling Interest ($15,000 x 20%) 3,000 To reverse amount of excess depreciation recorded during year and to recognize an equivalent amount of intercompany profit as realized LO 6 Workpaper entries-upstream sales.

P7-6: Prepare the worksheet entries for Dec. 31, 2012. 4. Dividend Income 60,000 Dividends Declared 60,000 To eliminate intercompany dividends 5. Beg. Retained Earnings - Shannon 1,038,000 Common Stock - Shannon 525,000 Investment in Shannon 1,250,400 Noncontrolling Interest 312,600 To eliminate investment account and create NCI account LO 6 Workpaper entries-upstream sales.

Year Subsequent to Intercompany Sale Upstream Sale P7-12 (Partial Equity Method): Prather Company owns 80% of the common stock of Stone Company. The stock was purchased for $960,000 on January 1, 2009, when Stone Company’s retained earnings were $675,000. On January 1, 2011, Stone Company sold fixed assets to Prather Company for $960,000; Stone Company had purchased these assets for $1,350,000 on January 1, 2001, at which time their estimated useful life was 25 years. The estimated remaining useful life to Prather Company on 1/1/11 is 10 years. Both companies employ the straight-line method of depreciation. Required: A. Prepare a consolidated statements workpaper for the year ended December 31, 2012. LO 6 Workpaper entries-upstream sales.

P7-12 (Partial Equity Method): (1) (3) (2) (3) (4) (1) NCI in Consolidated Income = 20% x ($300,000 + $15,000) = $63,000 LO 6 Workpaper entries-upstream sales.

P7-12 (Partial Equity Method): (4) (1) (2) (3) (2) (4) (2) (4) (3) LO 6 Workpaper entries-upstream sales.

P7-12: Prepare the worksheet entries for Dec. 31, 2012. 1. Equity In Subsidiary Income 240,000 Dividends Declared ($75,000 x 80%) 60,000 Investment in Stone Company 180,000 To reverse the effect of parent company entries during the year for subsidiary dividends and income LO 6 Workpaper entries-upstream sales.

P7-12: Prepare the worksheet entries for Dec. 31, 2012. 2. Plant and Equipment 390,000 Retained Earnings – Prather ($150,000 x 80%) 120,000 Noncontrolling Interest ($150,000 x 20%) 30,000 Accumulated Depreciation 540,000 To reduce controlling and noncontrolling interests for their shares of unrealized intercompany profit at beg. of year, to restore fixed assets to its book value to the selling affiliate on the date of the intercompany sale LO 6 Workpaper entries-upstream sales.

P7-12: Prepare the worksheet entries for Dec. 31, 2012. 3. Accumulated Depreciation 30,000 Other Expenses (Depreciation Expense) 15,000 Retained Earnings – Prather ($15,000 x 80%) 12,000 Noncontrolling Interest ($15,000 x 20%) 3,000 To reverse amount of excess depreciation recorded during year and to recognize an equivalent amount of intercompany profit as realized LO 6 Workpaper entries-upstream sales.

P7-12: Prepare the worksheet entries for Dec. 31, 2012. 4. Beg. Retained Earnings - Stone 1,038,000 Common Stock - Stone 525,000 Investment in Stone 1,250,400 * Noncontrolling Interest 312,600 ** To eliminate investment account and create NCI account * (($1,263,000 - $675,000) x 80%) - $180,000 = $290,400 + $960,000 = $1,250,400 ** [$240,000 + ($1,038,000 - $675,000) x 20%] = $312,600 LO 6 Workpaper entries-upstream sales.

Year Subsequent to Intercompany Sale Upstream Sale P7-16 (Complete Equity Method): Prather Company owns 80% of the common stock of Stone Company. The stock was purchased for $960,000 on January 1, 2009, when Stone Company’s retained earnings were $675,000. On January 1, 2011, Stone Company sold fixed assets to Prather Company for $960,000; Stone Company had purchased these assets for $1,350,000 on January 1, 2001, at which time their estimated useful life was 25 years. The estimated remaining useful life to Prather Company on 1/1/11 is 10 years. Both companies employ the straight-line method of depreciation. Required: A. Prepare a consolidated statements workpaper for the year ended December 31, 2012. LO 6 Upstream sales- complete equity method.

P7-16 (Complete Equity Method): (1) (3) (5) (1) NCI in Consolidated Income = 20% x ($300,000 + $15,000) = $63,000 LO 6 Upstream sales- complete equity method.

P7-16 (Complete Equity Method): (2) (1) (3) (4) (2) (3) (2) (4) (2) (5) (3) LO 6 Upstream sales- complete equity method.

P7-16: Prepare the worksheet entries for Dec. 31, 2012. 1. Equity in Subsidiary Income 252,000 Dividends Declared ($75,000 x 80%) 60,000 Investment in Stone Company 192,000 To reverse the effect of parent company entries during the year for subsidiary dividends and income LO 6 Upstream sales- complete equity method.

P7-16: Prepare the worksheet entries for Dec. 31, 2012. 2. Plant and Equipment 390,000 Investment in Stone ($150,000 x 80%) 120,000 Noncontrolling Interest ($150,000 x 20%) 30,000 Accumulated Depreciation 540,000 To reduce controlling and noncontrolling interests for their shares of unrealized intercompany profit at beg. of year, to restore the carrying value of equipment to its book value on the date of the intercompany sale LO 6 Upstream sales- complete equity method.

P7-16: Prepare the worksheet entries for Dec. 31, 2012. 3. Accumulated Depreciation 30,000 Other Expenses (Depreciation Expense) 15,000 Investment in Stone Company ($15,000 x 80%) 12,000 Noncontrolling Interest ($15,000 x 20%) 3,000 To reverse amount of excess depreciation recorded during year and to recognize an equivalent amount of intercompany profit as realized LO 6 Upstream sales- complete equity method.

P7-16: Prepare the worksheet entries for Dec. 31, 2012. 4. Beg. Retained Earnings - Stone 1,038,000 Common Stock - Stone 525,000 Investment in Stone 1,250,400 * Noncontrolling Interest ,600 ** To eliminate investment account and create NCI account * (($1,263,000 - $675,000) x 8)%) - $180,000 = $290,400 + $960,000 = $1,250,400 ** [$240,000 + ($1,038,000 - $675,000) x 20%] = $312,600 LO 6 Upstream sales- complete equity method.

Calculation And Allocation Of Consolidated Net Income; Consolidated Retained Earnings: Complete Equity Method Under the Complete Equity Method: Consolidated net income equals the parent company’s recorded income. Consolidated retained earnings equals the parent company’s recorded retained earnings. LO 8 Consolidated net income – complete equity method.

Intercompany Interest, Rents, and Service Fees
Income and expenses relating to interest, fees, and rents should be reported in consolidation only when they arise from transactions with parties outside the affiliated group. Workpaper entry to eliminate intercompany interest: Interest Income XXX Interest Expense XXX Workpaper entry to eliminate intercompany payables and receivables: Notes Payable XXX Notes Receivable XXX Interest Payable XXX Interest Receivable XXX LO 10 Intercompany interest, rents, service fees.

Workpaper entry to eliminate intercompany rent: Rent Income XXX Rent Expense XXX Intercompany Service Fees When one affiliate charges fees to another, the form of the eliminating entry is determined by how the transaction is recorded by the affiliates. LO 10 Intercompany interest, rents, service fees.

Eliminating entries relating to intercompany transactions depend on how these transactions are recorded on the books of the affiliates. In all cases the financial reporting objectives are: To include in revenue only the amounts that result from transactions with parties outside the affiliated group. To present property in the consolidated balance sheet at its cost to the affiliated group. To present accumulated depreciation in the consolidated balance sheet based on the cost to the affiliated group. To present depreciation expense in the consolidated income statement based on the cost to the affiliated group. LO 10 Intercompany interest, rents, service fees.

APPENDIX - Deferred Tax Consequences Related to Intercompany Sales of Equipment
Illustration: P Company owns a 70% interest in S Company and that on January 1, 2008, S Company sells P Company equipment with a book value of $500,000 (original cost of $800,000 and accumulated depreciation of $300,000) for $600,000. On January 1, 2008, the equipment has a remaining useful life of five years and is depreciated using the straight-line method. The marginal income tax rates for both companies are 40% and separate income tax returns are filed. S Company will record a gain of $100,000 on the sale of the equipment and each year P Company will record depreciation that is $20,000 greater than depreciation based on the cost of the equipment to the selling affiliate. Workpaper eliminating entries in the December 31, 2008, and December 31, 2009, consolidated

Illustration: Workpaper eliminating entries in the December 31, 2008, and December 31, 2009, consolidated statements workpapers relating to the unrealized profit on the intercompany sale of the equipment are illustrated below:

Since the selling affiliate is a partially owned subsidiary (upstream sale), the calculation of the noncontrolling interest in consolidated income requires that the after-tax amount of gain recorded by the subsidiary (.60 x $100,000 = $60,000) be subtracted from the reported net income of the subsidiary and that the after-tax amount of the gain realized through depreciation (.6 x $20,000 = $12,000) be added to the reported net income of the subsidiary before multiplying by the noncontrolling interest percentage. Assuming that S Company reported net income of $144,000 in 2008, the noncontrolling interest in consolidated income is $28,800 [.30 x ($144,000 - $60,000 + $12,000)].

If the sale of equipment is downstream, no adjustments to the reported net income of the subsidiary are necessary in the calculation of the noncontrolling interest in consolidated income.

APPENDIX - Impact of Unrealized Intercompany Profit on the Calculation of Deferred Tax Consequences Related To Undistributed Subsidiary Income Before calculating the deferred tax consequences relating lo undistributed subsidiary income, the amount of undistributed income must be adjusted for the after-tax amount of unrealized intercompany profit recorded by the subsidiary that has been recognized in the determination of consolidated income.

APPENDIX – Calculations (and Allocations) of Consolidated net Income and Consolidated Retained Earnings. When the affiliated companies file separate income tax returns, the calculations of consolidated net income and consolidated retained earnings must be modified to incorporate income tax consequences. Adjustments must now be made for the after-tax amounts of unrealized intercompany profit. Consolidated net income is reduced by the income tax consequence of undistributed income for the current year. Consolidated retained earnings is reduced by the income tax consequence of undistributed income from the date of acquisition to the date of the calculation.

Copyright Copyright © 2011 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

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