2016 McGraw-Hill Education

CHAPTER
6:
Intercompan
y Inventory
and Land
Profits
Prepared by
Shannon Butler, CPA,
Carleton University

Learning Objectives
LO1 Describe the effect on consolidated profit of the
elimination of intercompany revenues and
expenses.
LO2 Prepare consolidated financial statements that
reflect the elimination and subsequent realization
of upstream and downstream intercompany profits
in inventory.
LO3 Explain how the cost, revenue recognition, and
matching principles are used to support
adjustments for intercompany transactions when
preparing consolidated financial statements.
2

Learning Objectives
LO4 Prepare consolidated financial statements that
reflect the elimination and subsequent realization of
upstream and downstream intercompany profits in land.
LO5 Prepare the journal entries under the equity
method to reflect the elimination and subsequent
realization of intercompany profits in inventory and land.
LO6 Analyze and interpret financial statements involving
intercompany transactions.
LO7 (Appendix 6A) Prepare consolidated financial
statements when land is remeasured to fair value each
reporting period.
3

Intercompany Revenue &

Expenses

LO1

Parents and subsidiaries frequently have sales and

purchase transactions between each other, or other
transactions such as intercompany rent, management
fees, and interest.
When not paid, these transactions can give rise to
intercompany balances such as receivables and payables.

Intercompany transactions are recorded in the books of

each of the individual legal entries.
These amounts would be included in separate entity
financial statements, and reported on separate entity
income tax returns.

Intercompany Revenue &

Expenses

LO1

However, in the consolidated financial statements:

All intercompany sales or other intercompany income must
be eliminated against the related purchase or intercompany
expense.
All intercompany balances (including receivables and
payables) are eliminated against each other.
Income should be recognized only when it is earned in a
transaction with an outsider.

Companies must have systems in place that can capture

full information regarding both internal and external sales
and purchases, in order that the appropriate eliminations
may be identified and made in the consolidated financial
statements.
5

Intercompany Revenue &

Expenses

LO1

The selling company will generally have recorded a profit on

the intercompany sales.

These profits are unrealized because they are only within the
combined entity, they are not objectively measurable, and are
not with an arms-length outsider.

Intercompany sales are like moving a coin from one pocket in

a pair of pants to the other pocket; the pants still contain the
same coin and no income has been earned.

Intercompany sales do not reflect the culmination of the

earning process.

These unrealized profits, must be eliminated net of related

income taxes paid.

Examples of Intercompany
Revenue & Expenses

LO1

Intercompany management fees often the

parent
will charge its subsidiary companies a
management
fee as means of allocating head office cost to all
the companies within the group.

Intercompany rentals occasionally, buildings

or
equipment owned by one company are used by
another company within the group with a
corresponding rental charge.
7

Examples of Intercompany
Revenue & Expenses

LO1

Intercompany revenues and expenses must be

eliminated against each other on the consolidated
income statement

Since equal amounts of income and expenses

are being eliminated, there is no net effect on
consolidated income.

Only revenues, and expenses incurred with

outside parties should be reflected on the
consolidated income statement.
8

Intercompany Profits in
Assets

LO1

When one affiliated company sells assets to another

affiliated company, it is possible that the profit or loss
recorded on the transaction has not been realized from the
point of view of the consolidated entity.

If all or a portion of these assets have not been sold

outside the group, we must eliminate the remaining
intercompany profits and may need to eliminate the
intercompany loss from the consolidated statements.

There are three types of unrealized intercompany profits

(losses) that are eliminated:
Profits in inventory
Profits in nondepreciable assets
Profits in depreciable assets
9

Upstream versus
Downstream

LO1

We need to distinguish between downstream and

upstream transactions:
Downstream transactions: when the parent sells to its
subsidiary.
Upstream transactions: when the subsidiary sells to
the parent or another subsidiary of the parent.

Downstream and upstream transactions are defined

by who the seller is.

10

LO1

Intercompany Inventory Profits:

Subsidiary Selling
When the purchases component of cost of sales is
reduced, overall cost of sales will decrease.

When the ending inventory component of cost of sales is

reduced, overall cost of sales will increase and net income
will decrease.

Income tax should be expensed in the same period as

profit.

Non-controlling interest is not affected by intercompany

profits made on downstream transactions.

Non-controlling interest is affected and will share in

intercompany profits made on upstream transactions.
11

LO1

Holdback of Inventory Profits

Unrealized profits for consolidation purposes need
to be held back.

An adjustment for income taxes relating to the

unrealized profits needs to be made.

Since income taxes are calculated at the individual

company level rather than the consolidated-entity
level, the company that recorded the profit also
paid or accrued income taxes on that profit and
therefore the income tax expense on its income
statement would reflect this.
12

LO1

Holdback of Inventory Profits

The difference between the buyers tax basis
and the cost of transferred assets as reported in
the consolidated financial statements meets the
definition of a temporary difference and will give
rise to deferred income taxes.

ISA 27 states that profits and losses resulting

form intragroup transactions should be
eliminated in full, but it does not state how the
elimination should be allocated between the
controlling and non-controlling interest.

13

Consolidated Financial
Statements

LO2, LO4

Exhibit 6.4 in the textbook uses the direct approach to

prepare the Year 4 consolidated statements after
making the consolidation adjustment in exhibit 6.3.

The purpose of the calculation of consolidated net

income is to adjust the parents cost method net income
to what it would have been under the equity method.

The unrealized profit is always deducted from the selling

companys income.

The unrealized profit at the end of Year 4 must be

eliminated when calculating consolidated retained
earnings at the end of Year 4.

Non-controlling interest is affected when there are

unrealized profits on upstream transactions.
14

Consolidated Financial
Statements

LO2, LO4

Exhibit 6.4 on the next slide shows that:

The unrealized profits are eliminated on the
consolidated financial statements.

By eliminating the unrealized profit, inventory is now

stated at cost to the consolidated entity.

When ending inventory is overstated, cost of sales is

understated.

When cost of sales is increased, income decreases and

income tax expense should decrease.

15

Consolidated Financial
Statements

LO2, LO4

Exhibit 6.4

16

Cost, Revenue Recognition

&
Matching Principles

LO3

The adjustments to eliminate the unrealized

profits are needed in order to properly apply the
cost, revenue recognition, and matching
principles.

The unrealized profits are not eliminated on the

separate-entity financial statements.

The unrealized profit is deducted from the

inventory to bring inventory back to its original
cost in accordance with the historical cost
principle.

Income tax will be expensed when the profit is

realized in accordance with the matching

17

Intercompany Profits in
Inventory

LO5

Equity Method Journal Entries

If the parent uses the equity method to account for its

subsidiaries it would record the following entries in its own
books:
Investment in Subsidiary xxx
Equity method income xxx
To record % of the reported income of subsidiary
Investment in Subsidiary xxx
Equity method income xxx
To release the after-tax inventory profit held back in the prior
year.
18

Intercompany Profits in
Inventory

LO5

The parents income under the equity method

should be equal to consolidated net income
attributable to Parents shareholders.

The equity method captures the net effect of all

consolidation entries, including the adjustment for
realized profits.

19

Consolidated Financial
Statements

LO2, LO4

The examples in the next three slides from

Exhibit 6.7and 6.8, illustrate how the elimination
of unrealized upstream intercompany profit net of
income tax is reflected in:

The calculation of consolidated net income

The calculation of consolidated retained earnings
The calculation of non-controlling interest
The consolidated income statement
The consolidated balance sheet

20

Consolidated Financial
Statements

LO2, LO4

Exhibit 6.7

INTERCOMPANY INVENTORY PROFITS -- Year 5

Intercompany inventory profits:
Realized profit in opening inventory Sub selling (upstream)
Income tax (40%)
120 (b)
After-tax profit
$
180 (c)

300 (a)

CALCULATION OF CONSOLIDATED NET INCOME Year 5

Net income Parent Co.
$ 4,050
Net income -- Sub Inc.
$3,100
Add after-tax profit in opening inventory (5c)
Adjusted net income Sub Inc.
3,280
Net income
$ 7,330

180

Attributable to
Shareholders of parent $ 7,002 (d)
Non-controlling interest (10% x 3,280)

328 (e)

CALCULATION OF CONSOLIDATED RETAINED EARNINGS

December 31, Year 5
Retained earnings Parent Co.
$14,950
Retained earnings Sub Inc.
$9,300
Acquisition retained earnings
4,500
Increase since acquisition
4,800
(f)
Parent Co.s share
90%
4,320
Consolidated retained earnings
$19,270 (g)

When the profits are realized they are credited to the income of the original seller.

21

Consolidated Financial
Statements

LO2, LO4

Exhibit 6.7 Continued

CALCULATION OF NON-CONTROLLING INTEREST (METHOD 1)

December 31, Year 5
Common shares Sub Inc.
$ 8,000
Retained earnings Sub Inc.
9,300
17,300
Non-controlling interests share
10%
Non-controlling interest, December 31, Year 5

$ 1,730 (h)

CALCULATION OF NON-CONTROLLING INTEREST (METHOD 2)

Non-controlling interest at date of acquisition (10% x [11,250/.9]) $ 1,250
Subs adjusted increase in retained earnings (g)
4,800
NCIs share @ 10%
480
Non-controlling interest, December 31, Year 5 $ 1,730 (j)
All of subsidiarys shareholders equity is legitimate from a consolidated
perspective
at the end of Year 5.

22

Consolidated Financial
Statements

LO2, LO4

Exhibit 6.8 Direct approach

PARENT COMPANY
CONSOLIDATED INCOME STATEMENT
for the Year Ended December 31, Year 5
Sales (25,000 + 12,000)
$37,000
Cost of sales (16,000 + 5,500 [5a] 300)
21,200
Miscellaneous expenses (2,350 + 1,400)
3,750
Income tax expense (2,600 + 2,000 + [5b] 120)
4,720
29,670
Net Income
$ 7,330
Attributable to
Shareholders of parent (5d)
$ 7,002
Non-controlling interest (5e)
328

The unrealized profits from the end of Year 4 are released into consolidated Income in Year 5.
PARENT COMPANY
CONSOLIDATED BALANCE SHEET
December 31, Year 5
Inventory (9,900 + 7,500)
$17,400
Assets miscellaneous (22,800 + 20,800)
43,600
$61,000
Liabilities (14,000 + 11,000)
Common shares
Retained Earnings (5g)
Non-controlling interest (5h)

$25,000
15,000
19,270
1,700
$61,000

There are no unrealized profits at the end of year 5.

23

Intercompany Inventory
Profits: Parent Selling

LO5

Unrealized profits on downstream transactions are

deducted from the parents separate-entity income.

Non-controlling interest is not affected by the

elimination of unrealized profits on downstream
transactions.

When unrealized profits on downstream transactions

are realized, they are added to the parents
separate-entity income.

The equity method is referred to as the one-line

consolidation.
24

Intercompany Profits in LO1, LO3, LO4

Inventory
In the first year:
Cost of goods sold is
increased as ending
inventory is decreased to
its
original cost

The profit is held back

until
realized through sale to
outsider

A deferred tax asset is

In subsequent year:
Cost of goods sold is
decreased as beginning
inventory is decreased to
original cost

The profit is now realized

in the financial statements

Income tax expense is

increased

established

25

Losses on Intercompany
Transactions

LO5

Selling an asset at a loss raises the question of

whether the loss reflects the fair value and an
impairment

If impairment is present the asset should be

written down to its net realizable value

If impairment is not present and the loss does not

reflect fair value, the loss should be eliminated

26

Intercompany Land Profit

Holdback

LO4

Companies often redistribute assets among various

corporate divisions within a group.
Land and other non-depreciable assets may be sold
intercompany

The selling company will normally recognize a gain or

loss on the sale, and the buying company will record
the assets at the price charged by the seller.

This cost may be higher or lower than the cost to the

selling company.
The company must track the original cost and the
intercompany unrealized gain or loss.
27

Intercompany Land Profit

Holdback

LO4

The gain or loss on these intercompany sales is always

unrealized to the group until and unless the asset is
subsequently sold to a buyer outside the group.
The unrealized intercompany gain must be eliminated

All adjustments are made with the objective of

presenting the statements of the group to report as if
the transaction between the companies had never taken
place.
The asset is restated to its original cost to the seller

28

Intercompany Land Profit

Holdback

LO4

Implications of intercompany transactions:

The intercompany gain and associated income taxes are
eliminated on the income statement in the year of the
sale

The asset is restated to its original cost on any balance

sheet prepared after the intercompany sale
This is repeated each period until the asset is sold to an
outside party.

Retained earnings is adjusted for the effect to the

elimination and change in asset value

This adjustment is repeated every period until (and

unless) the asset is sold outside the corporate group.
29

Analysis and Interpretation of

Financial Statements

LO6

The separate entity statements under the cost

method are the same for upstream and
downstream transactions.

no income effect
The separate-entity statements under the cost
method are the same as the equity method
statements.
Except for the investment account, retained
earnings and investment income

ROE and Solvency ratios are impacted

30

Reporting Land under

LO7
Revaluation Model Appendix
6A
IAS 16, Property, Plant and Equipment allows a
reporting entity the option to periodically revalue its
property, plant, and equipment to fair value on an
annual basis.

The revaluation surplus is transferred to retained

earnings when the property is sold.

The revaluation surplus is reported through other

comprehensive income on an after-tax basis.

The consolidated statements should report amounts

that would have existed had the intercompany
transaction not occurred.
31