2016 McGraw-Hill Education

CHAPTER 7:
(A)
Intercompany
Profits in
Depreciable
Assets (B)
Intercompany
Bondholdings

Prepared by
Shannon Butler, CPA,
Carleton University

Learning Objectives
LO1 Prepare consolidated financial statements that reflect the
elimination and subsequent realization of upstream and
downstream intercompany profits in depreciable assets.
LO2 Explain how the historical cost principle supports the
elimination of unrealized profits resulting from
intercompany
transactions when preparing consolidated
financial
statements.
LO3 Prepare the journal entries under the equity method to
reflect the elimination and subsequent realization of the
intercompany profits in depreciable assets.
LO4 Analyze and interpret financial statements with
intercompany transactions involving depreciable assets.
2

Learning Objectives
LO5 Calculate the gain or loss that results from the
elimination of intercompany bondholdings and the
allocation of such gain or loss to the equities of the
controlling and non-controlling interests.
LO6 Explain how recognition of gains on the elimination of
intercompany bondholdings is consistent with the
principle of recording gains only when they are realized.
LO7 Prepare consolidated financial statements that reflect
the gains or losses that are the result of intercompany
bondholdings.
LO8 (Appendix 7A) Prepare consolidated financial
statements when depreciable assets are remeasured to fair
value each period.
3

Intercompany Profits in
Depreciable Assets

LO1

We have now established the basis for preparation of

consolidated financial statements, including:

The allocation of the acquisition price

The conceptual alternatives
Consolidation after parent uses cost and equity
method
Elimination of intercompany sales and purchases
Elimination of unrealized intercompany profits on
inventory
and land

Parents and subsidiaries engage in more complex

transactions such as intercompany transfers of
depreciable
assets.

Intercompany Profits in
Depreciable Assets

LO1, LO2

Parents and subsidiaries often redistribute

depreciable and non-depreciable assets among
themselves, for a variety of reasons including
management, income tax, and corporate
restructuring.

Such transactions usually are recorded at the

market value of the assets transferred.

The selling company will record a gain (or loss) on

the sale, and the buying company will record the
assets at the price it paid, often higher than the
original cost of the assets to the combined entity.
5

Intercompany Profits in
Depreciable Assets

LO1, LO2

The gain or loss on intercompany asset sales is unrealized to

the group until the asset is subsequently sold to a buyer
outside the group or used in producing a product or service
that is sold.

The effect of the gain or loss is eliminated in the consolidated

financial statements

The objective of the elimination is to report as if the

transaction between the companies had never taken place.

If the intercompany transaction involves depreciable assets,

there are further adjustments to be considered in later periods,
including depreciation.

Intercompany Profits in
Depreciable Assets

LO1, LO2

The intercompany sales of depreciable assets at a profit or

loss results in depreciation being recorded by the buying
company at an amount that is different than what the selling
company would have recorded on the historical cost basis
if the transaction had not occurred.

The buying company has a different (higher or lower) cost

basis than the original cost paid by the seller.

Therefore, the amount of depreciation recorded in the

buyers books will be greater (lesser) than the depreciation
that would have been recorded based on the historical
cost to the consolidated entity.

Intercompany Profits in
Depreciable Assets

LO2

The incremental depreciation, which is the portion that is

not based on historical cost to the group, must be
eliminated.

This incremental depreciation in later periods may also be

thought of as the realization of the intercompany gain or
loss through the process of consumption of the value of the
asset.

As the value of the asset is depreciated by the buying

company, a portion of the intercompany gain or loss is
realized in the sense that it no longer has to be eliminated in
the preparation of the consolidated financial statements.

Intercompany Profits in
Depreciable Assets

LO2

The depreciation expense which remains on the

consolidated financial statements after eliminating
the
incremental depreciation is the amount that would
have
been recorded by the seller, based on the original
cost
of the asset to the group, as if the intercompany sale
had not occurred.

Intercompany Profits in
Depreciable Assets

LO1, LO2

Income tax
All intercompany unrealized gains or losses affect net
earnings net of tax
Deferred income tax (on the balance sheet) is computed on
the outstanding balance of the unrealized gain or loss at
the
balance sheet date.

Upstream gains and losses

Allocate portion of the unrealized upstream gain/loss of
depreciation and tax to income statement non-controlling
interest
To compute balance sheet non-controlling interest, adjust
shareholders equity of subsidiary for unrealized upstream
gain/loss net of depreciation and tax
10

Example of Depreciable
Asset Transfer

LO1, LO3

Example:
Parent purchased equipment from an unrelated party for a
cost of $1,000

The equipment has a 10 year life and is depreciated on the

straight-line basis

Parent immediately sells the equipment to Subsidiary for

$1,500

Parent pays income tax for $200 (40%) on the $500 gain
that is unrealized for consolidated financial statement
purposes

11

Example of Depreciable
Asset Transfer

LO1, LO3

The parent records the following entry on its books

to reflect the sale of the equipment to the subsidiary
and payment of the resulting income taxes.
Date
1-Jan

Description
Cash
Income tax expense

Debit

Credit

1,500
200

Income Tax
Payable

200

Equipment

1,000

Gain

500

To record gain on equipment

sale

12

Example of Depreciable
Asset Transfer

LO1, LO3

To eliminate the unrealized gain on the parents books,

restore equipment to its original cost, and defer the
$200 tax paid, the following elimination entry is required
on the consolidated worksheet:
Gain
$500
Deferred income tax
Equipment $500
Income tax expense

200
200

If the parent, uses the equity method to account for the

subsidiary, the following journal entry would be recorded
in the parents general ledger:
Investment income $300
Investment in Subsidiary

$300
13

Example of Depreciable
Asset Transfer

LO1, LO3

The subsidiary records the following entry on its

books to reflect the purchase of the equipment and
its depreciation during the following year:
Date

Description

Debit

Credit

SUBSIDIARY GENERAL JOURNAL

1-Jan

Equipment

1,500

Cash

1,500

To record equipment Purchase

31-Dec

Depreciation Expense

150

Accumulated Depreciation

150

To depreciate equipment $1,500/10 years

14

LO1, LO2, LO3

Example of Depreciable
Asset Transfer

If the parent had not sold the equipment, it would have

recorded depreciation of $1,000/10 years = $100
Since the subsidiary is depreciating at a cost of $1,500 and
not $100, $150 of depreciation has been recorded

To adjust the consolidated financial statements to reduce

depreciation to what it would have been if the transfer had
not occurred (or to realize the gain over time as the asset
is consumed), depreciation expense must be reduced with
the following consolidated elimination entry:
Accumulated Depreciation $50
Depreciation Expense
$50

15

Example of Depreciable
Asset Transfer

LO1, LO3

To match the decrease in depreciation expense to

related income taxes at the parents 40% tax rate
the following adjustment is also reflected in the Year
1 consolidated financial statements:
Income Tax Expense
$20
Deferred Income Tax

$20

16

Example of Depreciable
Asset Transfer

LO1, LO3

In each of the following years, until either the equipment is fully depreciated or
the subsidiary sells it, two consolidation elimination entries are required on the
consolidation worksheet

The first entry records the cumulative effect of adjustments made in prior
years as follows:
Accumulated Depreciation $xxx
Deferred income tax
xxx
Retained earnings
xxx
Equipment $500

The second entry adjusts for the excess depreciation for that particular year as
follows:
Accumulated Depreciation $50
Income tax expense
20
Depreciation expense 50
Deferred income tax
20

If the parent uses the equity method account for the subsidiary, the following
journal entry would be recorded in the parents general ledger each year:
Investment in Subsidiary $30

Investment Income

$30
17

Example of Depreciable
Asset Transfer

LO1, LO3

The foregoing is an example of a downstream

intercompany transaction. If the equipment had
instead been sold upstream, by subsidiary to
parent, then a further consolidation adjustment
would be required to allocate a portion of the
net-of-tax eliminations to non-controlling
interest.

See text example and Exhibits 7.1 and 7.2

18

Example of Depreciable
Asset Transfer

LO1, LO2

Summary of implication of intercompany transactions in

depreciable assets:

The intercompany gain must be eliminated and

associated
income taxes paid deferred
The asset must be adjusted to its historical cost
Depreciation is restated so that it is based on original cost,
and associated income taxes are recorded
Accumulated depreciation restated so that it is based on
original cost
Retained earnings is adjusted for the cumulative after-tax
effect of the unrealized gain or loss (i.e. gain or loss less
incremental depreciation to date)

19

Intercompany Profits in
Depreciation Assets

LO3

The following two slides summarize the effect of

the net-of-tax adjustments for unrealized gains
and
associated depreciation of the balances of
investment in subsidiary and retained earnings,
if the equity method of accounting has been
used by the parent.

20

Intercompany Profits in
Depreciation Assets

LO3

Investment in Subsidiary
Original Cost
Income Earned
Dividends Received
A.D. Amortization
Accumulated
Depreciation
Unrealized Gains
Balance

21

Intercompany Profits in
Depreciation Assets

LO3

Consolidated Retained Earnings

Parent retained earnings
Parents shares of change
in Sub RE since acquisition
A.D. Amortization
Unrealized Gains
Depreciation

Accumulated

Balance

22

LO4

Analysis and Interpretation

of Financial Statements
Exhibit 7.4 presents selected accounts from the
Year 4 separate entity and consolidated
financial
statements that show intercompany
transactions
involving equipment as well as debt-to-equity
and return-on-equity ratios.

23

LO5

Intercompany Bondholdings
When we discuss intercompany profits, we are generally
concerned with eliminating profits recorded by individual
companies, but unrealized by the group

When purchased on the open market, intercompany

bondholdings present the opposite situation:
Profits associated with these bonds are unrealized at the
individual company level, but realized by the group as a
whole since they occurred with outside parties and arose as
a result of changes in prevailing market interest rates since
the bonds were originally issued.
The process of accounting for intercompany bonds involves
the recognition of these gains and losses in the consolidated
financial statements prior to recording them in the
separate-entity financial statements.

24

LO5

Intercompany Bondholdings
In the typical case, bonds are issued by a company into the
open market, or are placed privately with an unrelated entity
such as an insurance company or pension plan

If related companies provide financing, the financing

conditions are generally simpler than the relatively complex
and restrictive requirements of bonds.
As a result, it is fairly common for a company to buy on the
open market the outstanding bonds of a parent or subsidiary
company.

The market value paid by the related company will be different

from the issuing companys book value if the prevailing market
interest rates have changed since the bonds were issued.

25

LO5

Intercompany Bondholdings
When this occurs, the company which has purchased the
bond reports investment in bonds as an asset on it separateentity balance sheet.

The issuing company reflects the bond liability and records

interest expense and any related amortization of premium/
discount on its separate-entity statements.

However from the consolidated perspective, the

intercompany bonds have been retired at the time they
were
purchased on the open market and the bond investment is
eliminated against the bond liability.

The difference, if any, between acquisition cost and book

value of the bonds is recognized as a gain or loss.
26

LO5, LO6

Intercompany Bondholdings
The gain or loss on the effective retirement of bonds must
be
recognized in the consolidated statements, not on the
simple-entity statements

However, since the bond is still in fact an outstanding

liability to the individual company issuer:
Interest payments continue to be made and amortization of any
premium or discount received continues to be recorded on the
issuers books.
the individual company purchaser records the revenue
received, and records amortization of any premium or discount
paid, over the bonds term to maturity.

This intercompany interest revenue received and interest

expense paid must be eliminated in the consolidated
financial statements.
27

LO6

Intercompany Bondholdings
A difference arises with the elimination of the premium/
discount amortization when the bond was purchased by the
related company in the open market at a value different from
the original issue price

The amortization recorded by the issuer, based on the

original issue price, will be different from the amortization
recorded by the purchaser based on the market value paid
to purchase the bond.

This difference, over the remaining term of the bond, is

eliminated since it is equal to the gain or loss recognized
on the open market purchase and retirement of the bond

Amortization can be straight-line, or based on the effectiveyield method by calculating the present value of future cash
flows using the current market discount rate.
28

LO6

Intercompany Bondholdings
- Example
Example: Parent owns 100% of subsidiary. On January 1,
subsidiary pay $9,800 on the open market to purchase
$10,000 of bonds that were originally issued by Parent for
$10,000 (i.e. no issuing premium/discount). Bonds pay
interest at 10% annually and mature in 4 years.

Gain on retirement of bonds = $10,000 - $9,800 = $200

Income tax on gain (assume 40% rate) = $200 x 40% = $80
Annual intercompany interest = $10,000 x 10% = $100
(Parent books reflects expense, Subsidiary books reflect
income)

Each year, Subsidiary amortizes discount $200 / 4 = $50 to

income (entry is Dr bond investment, Cr interest income)

29

LO6

Intercompany Bondholdings
- Example
The following adjustments are required on the
consolidation worksheet to:
(i) eliminate the intercompany bonds and record the gain
on retirement;
(ii) match the gain recognized to related income tax
expense; and
(iii) eliminate the intercompany interest net of income tax.

Consolidation adjusting entries January 1:

(i) Bonds payable (Parent) $10,000
Investment in bonds(Sub)
$9,800
Gain on bond retirement
200
(ii) Income tax expense
Deferred income tax

$80
$80
30

LO6

Intercompany Bondholdings
- Example
Consolidation adjusting entries December 31:
Parent has recorded $1,000 interest expense and
subsidiary has recorded $1,000 interest income + $50
discount amortization.
Net pre-tax income = $1,050 - $1,000 = $50 x 40% tax
rate = $20 income tax paid.
Subsidiarys books reflect bond investment as $9,800
paid + $50 amortization = $9,850 of which $ 9,800 was
eliminated on January 1, see consolidation adjusting
entry:
Interest Income $1,050
Deferred income tax
Interest expense $1,000
Income tax expense
20
Investment in bonds
50

20

31

Gain Allocated to the

Affiliates

LO7

From the purchasing affiliate, the cost of the

acquisition is compared with the par value of
the bonds acquired, the difference being a gain
or loss.

From the issuing affiliate, the cost to retire the

bonds is compared with the par value of the
bonds; the difference between the par value
and the carrying amount is the gain or loss.

The gain is allocated to the affiliates based on

the premium or discount on their separateentity books.
32

Less Than 100% Purchase

of Affiliates Bonds

LO7

If a subsidiary purchased only 40% of the

parents bonds then the gain on bond
retirement is recognized only on the portion of
the bonds being retired from a consolidated
perspective.

33

Effective-Yield Method of
Amortization

LO5

Previous examples have assumed that both companies use the

straight-line method to amortize the premiums and discounts

Example: Pubco owns 100% of Subco. on December 31, Year 0,

Subco issued $100,000 face value bonds for a price of
$92,791
Coupon rate 10%, mature December 31, Year 5
Market rate 12%, December 31, Year 0

The bond discount is amortized on Subcos separate-entity

books over the remaining term of the bonds at a 12%
discount
rate
See the next slide for the bond amortization schedule

34

Effective-Yield Method of
Amortization
Period
Year
Year
Year
Year
Year
Year
1
3

0
1
2
3
4
5

Interest
paid
$10,0001
10,000
10,000
10,000
10,000

Amortization
Interest
of bond
expense
premium

$11,1352
11,271
11,424
11,594
11,785

$100,000 x 10% = $10,000

$10,000 - $11,135 = - $1,135

$ 92,791
$1,1353
1,271
1,424
1,594
1,785
2

LO5

Amortized
cost of
bonds

$ 93,9264
$ 95,197
96,621
98,215
100,000

$92,791 x 12% = $11,135

4 $92,791 + $1,135 = $93,926

35

Effective-Yield Method of
Amortization

LO5

The market rate for these bonds decreased from

12% to 8%, and these bonds were trading for
$105,154 on December 31, Year 2

Pubco. purchased Subcos bonds in the open

market December 31, Year 2 for $105,154

From a consolidated perspective, the bonds were

redeemed at a loss of $9,957 (105,154 95,197)

36

Effective-Yield Method of
Amortization

LO5

The following schedule shows the amortization

of this Premium by Pubco using the effective
interest method.
Period

Interest
received

Amortization
Amortized
Interest
of bond
cost of
revenue
premium

bonds
Year
Year
Year
Year
1
3

2
3
4
5

$105,154
1,5883
1,715
1,851

$10,0001
$8,4122
10,000
8,285
10,000
8,149

$100,000 x 10% = $10,000

$10,000 - $8,412 = $1,588

103,5664
101,851
100,000

$105,154 x 8% = $8,412
4 $105,154 - $1,588 = $103,566
2

37

Effective-Yield Method of
Amortization

LO5

From the separate-entity perspective, Pubco and Subco

continue to amortize the bond discount or premium using
their effective rates.

The loss on bond redemption and elimination of bond

amortization is allocated to Pubco and Subco each year
over the remaining life of the bonds.

The loss on bond redemption was recognized in Year 2 from

a
consolidated perspective and over or three-year period
ending in
Year 5 from a single-entity perspective.

38

Depreciable Assets under

Revaluation Model
Appendix 7A

LO8

An entity can choose to revalue its property,

plant, and equipment to fair value on an annual
basis.

The revaluation surplus is reported through other

comprehensive income.

The revaluation surplus is transferred to retained

earnings when the property is sold.

The consolidated statements should report

amounts that would have existed had the
intercompany transaction not occurred.
39