Chapter 6 - Modern Advanced Accounting in Canada PDF

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Textbook summary of Ch.6 Modern Advanced Accounting in Canada...

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CHAPTER 6 INTERCOMPANY INVENTORY AND LAND PROFITS INTERCOMPANY REVENUE AND EXPENSES Intercompany Sales and Purchases - Read textbook example - Elimination of intercompany revenue and expenses does not change the net income of the consolidated entity o The amount allocated to NCI and controlling interest is also not affected Intercompany Loans - Notes receivable/payable eliminated - Interest income/interest expense eliminated Intercompany Management Fees - Parent may charge its subsidiary companies a yearly management fee as a means of allocating head office costs to all the companies within the group o This must be eliminated on the consolidated income statement Intercompany Rentals - Companies may agree on a yearly rental to be charged - These intercompany rental revenues/expenses must be eliminated from the consolidated income statement INTERCOMPANY PROFITS IN ASSETS - If all or a portion of assets have not been sold outside the group, the intercompany profit/loss must be eliminated from the consolidated statements o The intercompany profit/loss will be realized for consolidation purposes during the accounting period in which the particular asset is sold to outsiders - Three types of unrealized intercompany profits (losses) are eliminated: o Profits in inventory o Profits in non-depreciable assets o Profits in depreciable assets Upstream vs. Downstream Transactions - Downstream transaction: parent sells to subsidiary - Upstream transaction: subsidiary sells to parent - Company doing the selling = the company recognizing profit on the sale o Take away profit from the selling company when eliminating profit from intercompany transactions - Lateral transactions from subsidiary to subsidiary are also referred to as upstream transactions Holdback of Inventory Profits

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Parent’s inventory may contain items purchased from the subsidiary which are not yet sold o This means there is an unrealized intercompany profit in inventory, which must be held back from consolidated income, and realized in the period in which it is sold to outsiders o Tax expense relating to this profit should also be held back from the consolidated statement The company that recorded the intercompany profit also paid (or accrued) income taxes on that profit, and the income tax expense on its income statement reflects this o The difference between the buyer’s 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 o From a consolidated perspective, some of the tax paid by the subsidiary was prepaid, since the income was not yet earned Important issue is how to allocate the eliminated amount between controlling and non-controlling interests o Since NCI do not have any interest in the parent company, they should not be affected by the elimination of profit on downstream transactions o NCI is affected and will share in intercompany profits made on upstream transactions

Notes on the Direct Approach to Intercompany Adjustments for Income Statement Consolidation 1. To hold back gross profit from the consolidated entity’s net income, we increase COGS by the amount of gross profit. Reasoning is as follows: a. COGS = opening inventory + purchases – ending inventory b. The ending inventory contains the gross profit c. If we subtract the gross profit from ending inventory on the balance sheet, the ending inventory is now stated at cost to the consolidated entity d. A reduction from ending inventory in the COGS calculation increases COGS e. This increase to COGS reduces the before-tax net income earned by the entity by the amount of gross profit in inventory 2. Because before-tax net income has been reduced, it is necessary to reduce the income tax expense based on unrealized profits 3. A reduction of income tax expense increases the net income of the consolidated entity Notes on the Direct Approach to Intercompany Adjustments for Balance Sheet Consolidation 1. The ending inventory in the COGS calculation is the inventory balance on the consolidated balance sheet, after removing unrealized gross profit; this results in the consolidated inventory being reflected at cost to the entity

2. Income tax will be expensed when the profit is realized; in a consolidated view, the paid (but unrealized) taxes are deferred tax assets Equity Method Journal Entries Investment in Sub Inc. 1,530 Equity Method Income 90% of the net income of Sub Inc. (90% x 1,700)

1,530

Equity Method Income 162 Investment in Sub Inc. 162 To hold back 90% of the after-tax inventory profit recorded by Sub Inc. (90% x 180) Realization of Inventory Profits in Following Year - When remaining inventory is sold to outsiders, beginning inventory gets brought down to original cost, and tax expense increases up to the level required o When the beginning inventory component of cost of sales is decreased, overall cost of sales will decrease, and income will increase - To realize gross profit, decrease COGS by the amount of gross profit. Reasoning as follows: o COGS = opening inventory + purchases – ending inventory o Opening inventory contains the previously unrealized gross profit; after we reduce it, opening inventory is at cost to the entity o A reduction from opening inventory decreases COGS by the amount of previously unrealized gross profit o Decrease in COGS increases before-tax net income earned by the entity - Matching principle: we increase income tax expense to match it with the gross profit being realized o The deferred income tax asset previously recognized becomes an expense on the next year’s income statement Equity Method Journal Entries Investment in Sub Inc. 2,790 Equity Method Income 90% of the net income of Sub Inc. (90% x 3,100)

2,790

Investment in Sub Inc. 162 Equity Method Income 162 To release the after-tax inventory profit held back in previous year (90% x 180) INTERCOMPANY INVENTORY PROFITS: PARENT SELLING (DOWNSTREAM TRANSACTIONS) - Unrealized profits on downstream transactions are deducted from the parent’s separate-entity income - Eliminations on the consolidated income statement for intercompany sales and purchases and for unrealize profit in inventory, and the related adjustment to income tax expense would not change

o However, NCI is not affected by the elimination of unrealized profits on downstream transactions; the entire holdback is allocated to the parent Equity Method Journal Entries Investment in Sub Inc. 1,530 Equity Method Income 90% of the net income of Sub Inc. (90% x 1,700)

1,530

Equity Method Income 180 Investment in Sub Inc. 180 To hold back the after-tax inventory profit recorded by Parent Co. in previous year Unrealized Profits with Associates - Rather than eliminating all of the profit associated with downstream associate transactions, only the investor’s percentage ownership of the associate times the profit earned on the transaction is eliminated - The total profit would be recorded in sales and cost of sales accounts, and the % interest would be eliminated through the investment account Income Statement with Expenses Classified by Nature - COGS is presented as a separate income statement line when: o Expenses are classified according to their function and COGS represented the expenses of the production function o When expenses are classified by nature and the reporting entity is a merchandising company - When a manufacturing company presents expenses according to nature, COGS usually does not exist; instead, they use raw materials consumed, labour costs, depreciation, etc. LOSSES ON INTERCOMPANY TRANSACTIONS - Unrealized losses should be eliminated on consolidation in a similar fashion to unrealized profits - Selling inventory at a loss raises a red flag that it may be impaired and should be written down to NRV - Ideally, impairment should be reported on separate-entity statements o If not, impairment will have to be reported on consolidated statements - Adjustments to be made: o Sales & COGS should be reduced by the amount of the intercompany sale o Unrealized loss in ending inventory (GP/Sales x Ending Inventory) should be eliminated by adding the amount to the value of inventory and subtracting the amount from COGS - Write-down adjustments must be made to the consolidated inventory balance if the inventory is impaired INTERCOMPANY LAND PROFIT HOLDBACK

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Holdback of a gain on sale of land should occur, along with the reduction of income tax expense After eliminating the profit, the land is stated at the original cost to the consolidated entity If the subsidiary is the selling company, the calculation of NCI will have to reflect this fact; if the parent is the selling company, the entire after-tax profit holdback is attributed to the parent company’s shareholders and is reflected in RE shown on balance sheet

Realization of Intercompany Land Profits - At the end of each successive year prior to the sale to outsiders, the preparation of consolidated balance sheet requires the same adjustment as the year of intercompany sale - Consolidated income statements require no further adjustment until sale of land to an outsider - Beginning consolidated RE each year would have to include an adjustment to hold back unrealized land profit, until the land is sold to outsiders - When sold to an outsider, the gain previously held back is realized, and income tax expense is adjusted upwards INTERCOMPANY TRANSFER PRICING - If some of the companies in the corporate structure are in jurisdictions with low rates of corporate income tax, while others are in high-tax-rate jurisdictions, management may try to structure each company’s transfer price so that the majority of profit is earned in low-tax-rate jurisdictions...