Chapter 5
Consolidated Financial Statements
Intercompany Asset Transactions
Answers to Questions
1. One reason for the significant volume and frequency of intercompany transfers is that many business combinations are specifically organized so that the companies can provide products for each other. This design is intended to benefit the business combination as a whole because of the economies provided by vertical integration. In effect, more profit can often be generated by the combination if one member is able to buy from another rather than from an outside party.
2. The sales between Barker and Walden totaled $100,000. Regardless of the ownership percentage or the markup, the $100,000 was simply an intercompany asset transfer. Thus, within the consolidation process, the entire $100,000 should be eliminated from both the Sales and the Purchases (Inventory) accounts.
3. Sales price per unit ($900,000 ÷ 3,000 units) $ 300
Number of units in Safeco’s ending inventory × 500
Intercompany inventory at transfer price $150,000
Gross profit rate (.6 ÷ 1.6) .375
Intercompany profit in ending inventory $56,250
4. In intercompany transactions, a transfer price is often established that exceeds the cost of the inventory. Hence, the seller is recording a gain on its books that, from the perspective of the business combination as a whole, remains unrealized until the asset is consumed or sold to an outside party. Any unrealized gain on merchandise still being held by the buyer must be eliminated whenever consolidated financial statements are produced. For the year of transfer, this consolidation procedure is carried out by removing the unrealized gain from the inventory account on the balance sheet and from the ending inventory balance within cost of goods sold. In the year following the transfer (if the goods are resold or consumed), the unrealized gain must again be eliminated within the consolidation process. This second reduction is made on the worksheet to the beginning inventory component of cost of goods sold as well as to the beginning retained earnings balance of the original seller. The gain is being moved into the year of realization. If the transfer was downstream in direction and the parent company has applied the equity method, the adjustment in the subsequent year must be made to the equity in subsidiary earnings account rather than to retained earnings.
5. On the individual financial records of James, Inc., a gain is being recorded in the year of transfer. From the viewpoint of the business combination, this gain is actually earned in the period in which the products are sold or consumed by Matthews Co. An initial consolidation entry must be made in the year of transfer to defer any gain that remains unrealized. A second entry must be made in the following time period to allow the gain to be recognized in the year of its ultimate realization.
6. Currently, no official accounting pronouncement answers the question as to the relationship between unrealized intercompany gains and noncontrolling interest values, although the issue has been under study by the FASB. This textbook reasons that unrealized gains relate to the seller and to the computation of the seller's income. Therefore, any unrealized gains created by upstream transfers (from subsidiary to parent) are attributed to the subsidiary. The effects resulting from the deferral and eventual recognition of these intercompany gains are considered to have an impact on the calculation of noncontrolling interest balances. In contrast, unrealized gains from downstream transfers are viewed as relating solely to the parent (as the seller) and, thus, have no effect on the noncontrolling interest.
7. The basic consolidation process does not differ between downstream and upstream transfers. Sales and purchases (Inventory) balances created by the transactions must be eliminated in total. Any unrealized gains remaining at the end of a fiscal period are deferred until ultimately earned through sale or consumption of the assets.
The direction of intercompany transfers (upstream versus downstream) does have one effect on consolidated financial statements. In computing noncontrolling interest balances (if present), the deferral of unrealized gains on upstream sales is taken into account. Downstream sales, however, are attributed to the parent and are viewed as having no impact on the outside interest.
8. The computation of this noncontrolling interest balance is dependent on the direction of the intercompany transactions that is not indicated in this question. If the unrealized gains were created by downstream sales from King to Pawn, they relate only to King. The noncontrolling interest in the subsidiary's net income is not affected and would be $11,000 ($110,000 × 10%). In contrast, if the transfers were upstream from Pawn to King, the deferral and recognition of the gains are attributed to Pawn. Pawn's "realized" income would be $80,000 and the noncontrolling interest's share of the subsidiary's income is reported as $8,000:
Pawn's reported income $110,000
Recognition of prior year unrealized gain 30,000
Deferral of current year unrealized gain (60,000)
Pawn's realized income $80,000
Outside ownership percentage 10%
Noncontrolling interest in subsidiary's income $ 8,000
9. The deferral and subsequent recognition of intercompany profits are allocated to the noncontrolling interest in the same periods as the parent. When one affiliate sells to another affiliate, ownership does not change and therefore the underlying profit is deferred. When the purchasing affiliate subsequently sells the inventory to an entity outside the affiliated group, ownership changes, and the profit may be recognized. Intercompany profits are not really eliminated, but simply deferred until a sale to an outsider takes place.
10. Several differences can be cited that exist between the consolidated process applicable to inventory transfers and that which is appropriate for land transfers. The total intercompany Sales balance is offset against Purchases (Inventory) when inventory is transferred but no corresponding entry is needed when land is involved. Furthermore, in the year of the sale, ending unrealized inventory gains are eliminated through an adjustment to cost of goods sold but a specific gain account exists (and must be removed) when land has been sold. Finally, unrealized inventory gains are usually expected to be realized in the year following the transfer. This effect is mirrored in that period by reduction of the beginning inventory figure (within cost of goods sold). For land transfers, however, the unrealized gain must be repeatedly deferred in each fiscal period for as long as the land continues to be held within the business combination.
11. As long as the land is held by the parent, its recorded value must be reduced to historical cost within each consolidated set of financial statements. In the year of the original transfer, the asset reduction is offset against the subsidiary's recorded gain. For all subsequent years in which the property is held, the credit to the Land account is made against the beginning retained earnings balance of the subsidiary (since the unrealized gain will have been closed into that account).
According to this question, the land is eventually sold to an outside party. The intercompany gain (which has been deferred in each of the previous years) is realized by the sale and should be recognized in the consolidated statements of this later period.
Because the transfer was upstream from subsidiary to parent, the above consolidated entries will also affect any noncontrolling interest balances being reported. Because of the deferral of the intercompany gain, the realized income balances applicable to the subsidiary will be less than the reported values. In the year of resale, however, the realized income for consolidation purposes is higher than reported. All noncontrolling interest totals are computed on the realized balances rather than the reported figures.
12. Depreciable assets are often transferred between the members of a business combination at amounts in excess of book value. The buyer will then compute depreciation expense based on this inflated transfer price rather than on an historical cost basis. From the perspective of the business combination, depreciation should be calculated solely on historical cost figures. Thus, within the consolidation process for each period, adjustment of the depreciation (being recorded by the buyer) is necessary to reduce the expense to a cost‑based figure.
13. From the viewpoint of the business combination, an unrealized gain has been created by the intercompany transfer and must be eliminated whenever consolidated financial statements are produced. This unrealized gain is closed by the seller into retained earnings necessitating that subsequent reductions be made to that account. In the individual financial records, however, another income effect is created which gradually reduces the overstatement of retained earnings each period. The asset will be depreciated by the buyer based on the inflated transfer price. The resulting expense will be higher than the amount appropriate to the historical cost of the item. Because this excess depreciation is closed into retained earnings annually, the overstatement of the equity account is gradually reduced to a zero balance over the life of the asset.
Answers to Problems
1. C
2. B Inventory remaining $100,000 × 50% = $50,000 Unrealized gain (based on Lee's markup as the seller) $50,000 × 40% = $20,000. The ownership percentage has no impact on this computation.
3. A
4. C UNREALIZED GAIN, 12/31/06
Intercompany Gain ($100,000 – $75,000) $25,000
Inventory Remaining at Year's End 16%
Unrealized Intercompany Gain, 12/31/06 $4,000
UNREALIZED GAIN, 12/31/07
Intercompany Gain ($120,000 – $96,000) $24,000
Inventory Remaining at Year's End 35%
Unrealized Intercompany Gain, 12/31/07 $8,400
CONSOLIDATED COST OF GOODS SOLD
Parent balance $380,000
Subsidiary Balance 210,000
Remove Intercompany Transfer (120,000)
Recognize 2006 Deferred Gain (4,000)
Defer 2007 Unrealized Gain 8,400
Cost of Goods Sold $474,400
5. A Intercompany sales and purchases of $100,000 must be eliminated. Additionally, an unrealized gain of $10,000 must be removed from ending inventory based on a markup of 25 percent ($200,000 gross profit/$800,000 sales) which is multiplied by the $40,000 ending balance. This deferral increases cost of goods sold because ending inventory is a negative component of that computation. Thus, cost of goods sold for consolidation purposes is $690,000 ($600,000 + $180,000 – $100,000 + $10,000).
6. C The only change here from Problem 5 is the markup percentage which would now be 40 percent ($120,000 gross profit ¸ $300,000 sales). Thus, the unrealized gain to be deferred is $16,000 ($40,000 × 40%). Consequently, consolidated cost of goods sold is $696,000 ($600,000 + $180,000 – $100,000 + $16,000).
7. B UNREALIZED GAIN, 12/31/05
Ending Inventory $40,000
Markup ($33,000/$110,000) 30%
Unrealized Intercompany Gain, 12/31/05 $12,000
UNREALIZED GAIN, 12/31/06
Ending Inventory $50,000
Markup ($48,000/$120,000) 40%
Unrealized Intercompany Gain, 12/31/06 $20,000
NONCONTROLLING INTEREST IN SUBSIDIARY'S INCOME
Reported Income for 2006 $90,000
Realized Gain Deferred In 2005 12,000
Deferral of 2006 Unrealized Gain (20,000)
Realized Income of Subsidiary $82,000
Outside Ownership 10%
Noncontrolling Interest $8,200
8. A Individual Records after Transfer
12/31/06
Machinery—$40,000
Gain—$10,000
Depreciation expense $8,000 ($40,000/5 years)
Income effect net—$2,000 ($10,000 – $8,000)
12/31/07
Depreciation expense—$8,000
Consolidated Figures—Historical Cost
12/31/06
Machinery—$30,000
Depreciation expense—$6,000 ($30,000/5 years)
12/31/07
Depreciation expense--$6,000
Adjustments for Consolidation Purposes:
2006: $2,000 income is reduced to a $6,000 expense (income is reduced
by $8,000)
2007: $8,000 expense is reduced to a $6,000 expense (income is increased
by $2,000)
9. B UNREALIZED GAIN
Transfer Price $280,000
Book Value (cost after two years of depreciation) 240,000
Unrealized Gain $40,000
EXCESS DEPRECIATION
Annual Depreciation Based on Cost ($300,000/10 years) $30,000
Annual Depreciation Based on Transfer Price
($280,000/8 years) 35,000
Excess Depreciation $5,000
ADJUSTMENTS TO CONSOLIDATED NET INCOME
Defer Unrealized Gain $(40,000)
Remove Excess Depreciation 5,000
Decrease to Consolidated Net Income $(35,000)
10. D Add the two book values and remove $100,000 intercompany transfers.
11. B Purchase Price $260,000
Book Value of Net Assets
($250,000 × 80%) (200,000)
Purchase Price in Excess of Annual Excess
Book Value $60,000 Life Amortizations
Excess Purchase Price Assigned
Based on Market Value:
—Equipment ($25,000 × 80%) 20,000 5 years $4,000
Secret Formulas $40,000 20 years 2,000
Total $6,000
Consolidated Expenses = $36,000 (add the two book values and include
amortization expense for the current year)
12. C Intercompany Gain ($100,000 ‑ $80,000) $20,000
Inventory Remaining at Year's End 60%
Unrealized Intercompany Gain, 12/31/06 $12,000
CONSOLIDATED COST OF GOODS SOLD
Parent Balance $140,000
Subsidiary Balance 80,000
Remove Intercompany Transfer (100,000)
Defer Unrealized Gain (above) 12,000
Cost of Goods Sold $132,000
13. A 20% of the ending book value of the subsidiary. Because transfers were downstream, they do not affect this computation. As an alternative, add 20% of subsidiary's Income to 20% of beginning book value and subtract 20% of dividends.
14. B Add the two book values plus the original allocation ($20,000) less one year of excess amortization expense ($4,000).
15. B Add the two book values less the ending unrealized gain of $12,000.
Intercompany Gain ($100,000 – $80,000) $20,000
Inventory Remaining at Year's End 60%
Unrealized Intercompany Gain, 12/31/06 $12,000
16. (15 Minutes) (Determine selected consolidated balances; includes inventory transfers and an outside ownership.)
Intangible asset amortization = $180,000/20 years = $9,000 per year
Intercompany Gain ($150,000 – $100,000) $50,000
Inventory Remaining at Year's End 10%
Unrealized Intercompany Gain, 12/31/06 $5,000
CONSOLIDATED TOTALS
§ Inventory = $395,000 (add the two book values and subtract the ending unrealized gain of $5,000)
§ Sales = $1,050,000 (add the two book values and subtract the $150,000 intercompany transfer)
§ Cost of Goods Sold = $355,000 (add the two book values and subtract the intercompany transfer and add [to defer] ending unrealized gain)
§ Operating Expenses = $409,000 (add the two book values and the amortization expense for the period)
§ Noncontrolling Interest in Subsidiary's Net Income = $19,000 (20 percent of the reported income after deferring $5,000 ending unrealized gain. Gain is included in this computation because the transfer was upstream from Sam to Pop)
17. (60 minutes) (Downstream intercompany profit adjustments when parent uses equity method and a noncontrolling interest is present)
Purchase price $980,000
Book value of subsidiary $950,000
Portion acquired 80% 760,000
Excess assigned to covenants $220,000
Useful life in years ÷ 20
Annual amortization $11,000
2005 Ending Inventory Profit Deferral
§ Cost = $100,000/1.6 or $62,500
§ Intercompany Gain = $100,000 – $62,500 or $37,500