Professional Documents
Culture Documents
CHAPTER 5
CONSOLIDATED FINANCIAL STATEMENTS - INTRA-ENTITY ASSET
TRANSACTIONS
Answers to Questions
1.
2.
3.
4.
5.
6.
One reason for the significant volume and frequency of intra-entity 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.
The sales between Barker and Walden totaled $100,000. Regardless of the ownership
percentage or the gross profit rate, the $100,000 was simply an intra-entity asset transfer. Thus,
within the consolidation process, the entire $100,000 should be eliminated from both the Sales
and the Purchases (Inventory) accounts.
Sales price per unit ($900,000 3,000 units)
$ 300
Number of units in Safecos ending inventory
500
Intra-entity inventory at transfer price
$150,000
Gross profit rate (0.6 1.6)
.375
Intra-entity profit in ending inventory
$56,250
In intra-entity transactions, a transfer price is often established that exceeds the cost of the
inventory. Hence, the seller is recording a gross profit 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 gross profit on merchandise still held by the buyer must be
deferred whenever consolidated financial statements are prepared. For the year of transfer, this
consolidation procedure is carried out by removing the unrealized gross profit 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 realized
gross profit must be recognized within the consolidation process. Reductions are made on the
worksheet to the beginning inventory component of cost of goods sold and to the beginning
retained earnings balance of the original seller. The gross profit is thus taken out of last years
earnings (retained earnings) and recognized in the current year through the reduction of cost of
goods sold. If the transfer was downstream in direction and the parent company has applied the
equity method, the adjustment in the subsequent year is made to the Investment in Subsidiary
account rather than to retained earnings.
On the individual financial records of James, Inc., a gross profit is recorded in the year of
transfer. From the viewpoint of the business combination, this gross profit 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 gross profit that remains unrealized. A
second entry must be made in the following time period to allow the gross profit to be
recognized in the year of its ultimate realization.
GAAP allows discretion regarding the effect of unrealized intra-entity profits and noncontrolling
interest values. This textbook reasons that unrealized profits relate to the seller and to the
computation of the seller's income. Therefore, any unrealized profits created by upstream
5-1
7.
8.
9.
10.
11.
transfers (from subsidiary to parent) are attributed to the subsidiary. The effects resulting from
the deferral and eventual recognition of these intra-entity profits are considered in the
calculation of noncontrolling interest balances. In contrast, unrealized profits from downstream
transfers are viewed as relating solely to the parent (as the seller) and, thus, have no effect on
the noncontrolling interest.
Consolidated financial statements are largely unchanged across downstream versus upstream
transfers. Sales and purchases (Inventory) balances created by the transactions are eliminated
in total. Any unrealized gross profits remaining at the end of a fiscal period get deferred until
ultimately earned through sale or consumption of the assets.
The direction of intra-entity transfers (upstream versus downstream) does have one effect on
consolidated financial statements. In computing noncontrolling interest balances (if present), the
deferral of unrealized gross profits 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.
The computation of this noncontrolling interest balance is dependent on the direction of the
intra-entity transactions that is not indicated in this question. If the unrealized gross profits 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 profits 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 gross profit ..........
30,000
Deferral of current year unrealized gross profit ............
(60,000)
Pawn's realized income ................................................
$80,000
Outside ownership percentage .....................................
10%
Noncontrolling interest in subsidiary's income..............
$ 8,000
The deferral and subsequent recognition of intra-entity 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. Intra-entity profits are not really
eliminated, but simply deferred until a sale to an outsider takes place.
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 intra-entity 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 gross profits are deferred through an adjustment to cost of goods
sold, but a specific gain or loss account exists (and must be removed) when land has been
sold. Finally, unrealized inventory gross profits 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 or
loss must be repeatedly deferred in each fiscal period, through retained earnings, for as long as
the land continues to be held within the business combination.
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).
5-2
12.
13.
According to this question, the land is eventually sold to an outside party. The intra-entity 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 intra-entity 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.
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 (that is
recorded by the buyer) is necessary to reduce the expense to a cost-based figure.
From the viewpoint of the business combination, an unrealized gain has been created by the
intra-entity transfer and must be deferred in the preparation of consolidated financial
statements. This unrealized gain is closed by the seller into retained earnings necessitating
subsequent reductions 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 initial
overstatement due to the gain is offset by the acculmulating overstatement ofdepreciation
expense. Therefore, the overstatement of the equity account is gradually reduced to a zero
balance over the life of the asset.
5-3
Answers to Problems
10. D Add the two book values and remove $100,000 intra-entity transfers.
11. C Intra-entity gross profit ($100,000 - $80,000) ................................
Inventory remaining at year's end ..................................................
Unrealized intra-entity gross profit ................................................
CONSOLIDATED COST OF GOODS SOLD
Parent balance ............................................................................
Subsidiary balance .....................................................................
Remove intra-entity transfer ......................................................
Defer unrealized gross profit (above) ......................................
Cost of goods sold ..........................................................................
12. C Consideration transferred .............................
Noncontrolling interest fair value...................
Suarez total fair value......................................
Book value of net assets.................................
Excess fair over book value
$20,000
60%
$12,000
$140,000
80,000
(100,000)
12,000
$132,000
$260,000
65,000
$325,000
(250,000)
$75,000
Annual Excess
Life Amortizations
25,000 5 years
$5,000
$50,000 20 years
2,500
-0$7,500
Consolidated expenses = $37,500 (add the two book values and include current
year amortization expense)
5-4
$50,000
15,000
20,500
$85,500
14. C Add the two book values plus the $25,000 original allocation less one year of
excess amortization expense ($5,000).
15. B Add the two book values less the ending unrealized gross profit of $12,000.
Combined pre-consolidation inventory balances......................... $260,000
Intra-entity gross profit ($100,000 $80,000) ................... $20,000
Inventory remaining at year's end ......................................
60%
Unrealized intra-entity gross profit, 12/31 .....................................
12,000
Consolidated total for inventory.....................................................
$248,000
16.
$40,000
20%
$8,000
CONSOLIDATED TOTALS
Inventory = $592,000 (add the two book values and subtract the ending
unrealized gross profit of $8,000)
Sales = $1,240,000 (add the two book values and subtract the $160,000 intraentity transfer)
Cost of goods sold = $548,000 (add the two book values and subtract the intraentity transfer and add [to defer] ending unrealized gross profit)
Operating expenses = $443,000 (add the two book values and the amortization
expense for the period)
5-5
18.
$300,000
110,000
(5,000)
7,200
(16,200)
$396,000
$36,000
20%
$ 7,200
$54,000
30%
$16,200
$300,000
76,800
$376,800
$105,000
20%
$21,000
$300,000
84,000
7,200
(16,200)
$375,000
18. (continued)
5-6
$140,000
90,000
(16,200)
$213,800
$600,000
200,000
(20,000)
$780,000
f. The intra-entity transfer was upstream from Scenic to Placid Lake. Because the
transfer occurred in 2012, beginning retained earnings of the seller for 2013
contains the remaining portion of the unrealized gain.
Transfer pricing figures:
2012
Equipment
Gain
Depreciation expense
Income effect
Accumulated depreciation
=
=
=
=
=
$80,000
$20,000 ($80,000 $60,000)
$16,000 ($80,000 5)
$4,000 ($20,000 $16,000)
$16,000
2013
Depreciation expense
Accumulated depreciation
=
=
$16,000
$32,000
Equipment
Depreciation expense
Accumulated depreciation
=
=
=
$100,000
$12,000 ($60,000 5 years)
$52,000 ($40,000 + $12,000)
2013
Depreciation expense
Accumulated depreciation
=
=
$12,000
$64,000
16,000
20,000
36,000
5-7
18. (continued)
ENTRY ED
Accumulated Depreciation ........................................
4,000
Depreciation Expense ..........................................
4,000
To reduce depreciation from transfer price ($16,000) to historical cost of $12,000.
This intra-entity transfer was upstream from Scenic to Placid Lake. Thus, income
effects are assumed to relate to the original seller (Scenic). Because the sale
occurred in 2012, the only effect in 2013 relates to depreciation expense. The
expense based on the transfer price is $4,000 higher than the amount based on
the historical cost. As an upstream transfer, this adjustment affects Scenic and the
noncontrolling interest computations.
Transfer price depreciation: $80,000 5 yrs. = $16,000
Historical cost depreciation (based on book value): $60,000 5 yrs. = $12,000
Noncontrolling Interest in Scenic's Net Income
Scenic's reported net income less excess amortization .........
Reduction of depreciation expense to historical cost figure.
Scenic's realized income .............................................................
Outside ownership percentage ..................................................
Noncontrolling interest in Scenics net income ..................
5-8
$105,000
4,000
$109,000
20%
$21,800
20.
$290,000
197,000
(110,000)
(8,000)
12,000
$381,000
$346,000
110,000
(12,000)
$444,000
5-9
$290,000
197,000
(80,000)
(6,000)
10,000
$411,000
20. b. (continued)
Consolidated inventory
Penguin book value ....................................................................
Snow book value ........................................................................
Defer ending unrealized gross profit (see above) ..................
Consolidated inventory ........................................................
$346,000
110,000
(10,000)
$446,000
$58,000
6,000
(10,000)
$54,000
20%
$10,800
$358,000
157,000
$(30,000)
12,000
(18,000)
$497,000
Consolidated expenses
Penguins book value ..............................................
Snow's book value ..................................................
Remove excess depreciation on transferred building
($30,000) unrealized gain 5 years) .................
Consolidated expenses ..........................................
$150,000
105,000
(6,000)
$249,000
5-10
25.
(35 minutes) (Compute consolidated totals with transfers of both inventory and a building.)
$21,000
30%
$30,000
30%
$9,000
$50,000
50%
$40,000
50%
$20,000
5-11
$50,000
20,000
10,000
10,000
10,000
20,000
$70,000
6,000
46,000
6,000
52,000
25. (continued)
CONSOLIDATED BALANCES
Sales = $1,000,000 (add the two book values and subtract $100,000 in intra-entity
transfers)
Cost of Goods Sold = $571,000 (add the two book values and subtract $100,000 in
intra-entity purchases. Subtract $9,000 because of the previous year unrealized gross
profit and add $20,000 to defer the current year unrealized gross profit.)
Operating Expenses = $206,000 (add the two book values and include the $10,000
excess amortization expenses but remove the $4,000 in excess depreciation expense
[$10,000 $6,000] created by building transfer)
Inventory = $280,000 (add the two book values and subtract the $20,000 ending
unrealized gross profit)
Equipment (net) = $292,000 (add the two book values and include the $60,000
allocation from the acquisition-date fair value less three years of excess
amortizations)
Buildings (net) = $528,000 (add the two book values and subtract the $20,000
unrealized gain on the transfer after two years of excess depreciation [$4,000 per
year])
5-12
27.
$342,000
38,000
380,000
(326,000)
$54,000
18,000
36,000
-0-
Life
9 yrs.
6 yrs.
Annual Excess
Amortizations
$2,000
6,000
$8,000
$54,000
40%
$37,500
40%
$15,000
$67,200
42%
$50,000
42%
$21,000
27. (continued)
e. Petino is applying the equity method because the $68,400 equals neither 90% of
Brey's reported Income nor 90% of the dividends paid by Brey.
Breys reported net income .......................................................
Excess fair value amortization...................................................
Realized gross profit .................................................................
Deferred gross profit...................................................................
Adjusted subsidiary income.......................................................
Ownership ...................................................................................
Investment incomeBrey ..........................................................
$90,000
(8,000)
15,000
(21,000)
$76,000
90%
$68,400
$76,000
10%
$7,600
$342,000
5-13
$64,000
80,000
90,000
234,000
(21,000)
213,000
90%
$19,000
23,000
27,000
69,000
90%
h. Entry S
Common Stock (Brey) ...............................
Retained Earnings, 1/1/13 (Brey) (reduced by
1/1/13 unrealized gross profit) ..................
Investment in Brey (90%) .....................
Noncontrolling interest in Brey (10%)
5-14
191,700
(21,600)
(62,100)
$450,000
150,000
263,000
371,700
41,300
Cost of Goods Sold = $570,000 (add book values less $160,000 in intra-entity
purchases. Also, adjust for 2012 unrealized gross profit [subtract $15,000] and
2013 unrealized gross profit [add $21,000])
Expenses = $260,400 (add book values with $8,000 amortization for excess fair
value allocations)
Land, Buildings, and Equipment = $1,304,000 (add book values and include a
$12,000 net allocation after 3 years of amortization)
5-15
30.
$657,000
73,000
730,000
(620,000)
$110,000
20,000
40,000
50,000
-0-
Annual Excess
Life
Amortizations
4 yrs.
$5,000
5 yrs.
8,000
10 yrs.
5,000
$18,000
$700,000
(80,000)
-0$620,000
$43,500
20%
$ 8,700
$64,000
20%
$12,800
$25,000
10,000
$15,000
5-16
$2,000
5,000
$3,000
30. (continued)
Adjustment to buildings to return to historical cost at 1/1/13
Transfer Price Historical Cost
Buildings
$25,000
$100,000
Accumulated depreciation
(1/1/12 balance after 1
more year of depreciation) 5,000
92,000
Consolidation
Adjustment
$75,000
87,000
Consolidated Totals
Sales and other Income = $1,240,000 (add the two book values and eliminate
the intra-entity transfers)
$500,000
400,000
(160,000)
(8,700)
12,800
$744,100
Operating and interest expenses = $275,000 (add the two book values and
include $18,000 amortization for current year but eliminate $3,000 excess
depreciation from asset transfer)
$40,000
8,700
(12,800)
$35,900
(18,000)
17,900
10%
$ 1,790
5-17
30. (continued)
Retained earnings, 1/1/13 = $1,025,970 (because the parent uses the initial
value method, its retained earnings must be adjusted for changes in
subsidiary's book value, excess amortizations, and the impact of unrealized
gross profits in previous years)
$990,000
(12,000)
$80,000
(18,000)
(8,700)
53,300
90%
47,970
$1,025,970
5-18
30. (continued)
NCI 12/31/13 = $80,120 (10 percent of $691,300 adjusted beginning book value
[$700,000 less $8,700 deferral of unrealized gross profit] plus $9,200 share of
beginning unamortized excess fair value allocations plus $1,790 net income share)
Common Stock = $600,000 (parent balance only)
Retained Earnings, 12/31/13 = $1,115,080 (computed above)
Total Liabilities and Equities = $3,479,200 (summation of consolidated balances).
The same consolidation balances can be derived using a worksheet and the
following adjusting and eliminating entries:
CONSOLIDATION ENTRIES
Entry *G
Retained Earnings, 1/1/13 (Kirby) .......................
8,700
Cost of Goods Sold .........................................
(To recognize 2012 deferred gross profit as income in 2013)
Entry *TA
Building...................................................................
Retained Earnings, 1/1/13 (Moore) ......................
Accumulated Depreciation .............................
(To adjust 1/1/13 balance to historical cost figures)
8,700
75,000
12,000
87,000
Entry *C
Investment in Kirby ...............................................
47,970
Retained Earnings, 1/1/13 (Moore) ................
47,970
(To convert from initial value to equity method based on the following
computation)
Increase in subsidiary's book value during prior year
(net income of $80,000)..................................
Excess amortization for 2012...............................
Deferral of 12/31/12 unrealized gross profit.......
Realized increase in subsidiary's book value....
Ownership ..............................................................
Conversion to equity method adjustment...........
$80,000
(18,000)
(8,700)
$53,300
90%
$47,970
5-19
30. (continued)
A Liabilities ...............................................................
32,000
Equipment ..............................................................
15,000
Brand Names .........................................................
45,000
Investment in Kirby .........................................
82,800
Noncontrolling Interest in Kirby (10%) ..........
9,200
(To recognize unamortized balance of excess allocations as of 1/1/13. Figures
have been reduced by one year of amortization)
Entry I (the subsidiary paid no dividends so no adjustment needed)
E Operating and Interest Expense..........................
18,000
Liabilities ..........................................................
Equipment.........................................................
Brand Names ...................................................
(To recognize excess amortization expenses for current year)
Tl Sales .......................................................................
Cost of Goods Sold .........................................
(To eliminate intra-entity transfers for 2013)
G Cost of Goods Sold ..............................................
Inventory ...........................................................
(To defer ending unrealized inventory gross profit)
8,000
5,000
5,000
160,000
160,000
12,800
12,800
5-20
Moore
Kirby
NCI
(800,000)
(600,000)
(TI) 160,000
500,000
400,000
(G) 12,800
Consolidated
(1,240,000)
(G*)
8,700
744,100
(TI)160,000
Op. and interest expenses
100,000
160,000
(200,000)
(40,000)
(E) 18,000
(ED)
3,000
275,000
(220,900)
to noncontrolling interest
(1,790)
to controlling interest
Retained earnings, 1/1
(219,110)
(990,000)
(TA*) 12,000
(550,000)
(*C) 47,970
(1,025,970)
(S) 541,300
(G*)
Net income
1,790
8,700
(200,000)
(40,000)
(219,110)
130,000
130,000
(1,060,000)
(590,000)
(1,115,080)
217,000
180,000
397,000
Inventory
224,000
160,000
Investment in Kirby
657,000
Dividends paid
Retained earnings, 12/31
(*C) 47,970
(G) 12,800
371,200
(S) 622,170
(A) 82,800
Equipment (net)
600,000
420,000
(A) 15,000
1,000,000
650,000
(TA*) 75,000
(100,000)
(200,000)
(ED) 3,000
(TA*) 87,000
(384,000)
Brand names
(A) 45,000
(E) 5,000
40,000
Other assets
200,000
100,000
300,000
2,798,000
1,310,000
3,479,200
(1,138,000)
(570,000)
(A) 32,000
(600,000)
(150,000)
(S)150,000
Buildings
Acc. depreciationbuildings
Total assets
Liabilities
Common stock
Noncontrolling interest , 1/1
(E) 5,000
1,030,000
1,725,000
(E) 8,000
(1,684,000)
(600,000)
(S) 69,130
(A) 9,200
Noncontrolling
interest,12/31
(78,330)
80,120
(1,060,000)
(590,000)
(2,798,000)
(1,310,000)
(80,120)
(1,115,080)
1,120,770
5-21
1,120,770
(3,479,200)