Chap005

Chapter Five
ConsolidatedConsolidated
FinancialFinancial
Statements–Statements–
Intra-EntityIntra-Entity
AssetAsset
TransactionsTransactions
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Intra-entity Transactions
 Transactions between the parent and
subsidiary are considered “internal”
transactions of a single economic
entity.
 The effects of these intra-entity
transactions should be eliminated
from the consolidated financial
statements.
 Thus, consolidated statements
only reflect transactions with
outside parties.
2

Note: Assuming inventory has been re-sold to a
third-party, both companies have debited COGS
and credited Sales for the same inventory.
Intra-entity Transactions –
Inventory Transfers
ENTRY TI
Eliminate all intra-entity sales/purchases of
inventory, by eliminating the sales price of the
transfer – which one company recorded as sales,
and the other recorded as cost of goods sold.
3

Note: Any inventory that was ‘marked-up’ in an
I/C transfer must be returned to it’s original
cost if it has not been sold to an outside party.
Inventory Transfers
ENTRY G
Despite Entry TI, ending inventory is still
overstated by the amount of gain on any
inventory that remains unsold at year end.
We must eliminate the unrealized gain as follows:
4

Inventory Transfers
ENTRY *G
In the year that the inventory is subsequently sold
to a third party, the I/C gain is in beginning
Retained Earnings on the seller’s books, and
must be moved to Consolidated Income.
5
Note: The separate records of each company still
contain the I/C transactions, including any gain
that was recorded at the time they occurred.

Unrealized Inventory Gain -
Other issues
 If it’s DOWNSTREAM, then any
unrealized gain belongs to the parent.
 If it’s UPSTREAM, then any unrealized
gain belongs to the subsidiary.
 We will reduce the Sub’s net income by the
unrealized gain prior to calculating the
noncontrolling interest’s share.
6
Does it matter if the sale is
Upstream or Downstream?
YES!!

Inventory Transfers
ENTRY *G
If the transfer of inventory is downstream AND
the parent uses the equity method, then the
following entry is used to recognize the
remaining unrealized profit left at the end of
the previous year.
7
Note: This properly eliminates the gain from
the Equity in Sub Income account and moves
it to the Parent’s operating income accounts.

Upstream Inventory Transfer
 Large Company owns 100% of the voting
stock of Small Company.
 During 2010, Large buys 800 widgets from
Small for $80,000.
 The widgets originally cost Small $50,000.
 At year-end on December 31, 2010, Large
still had 200 of the units on hand.
Prepare the consolidation
entries on 12/31/10 to
eliminate the unrealized gain.
8

First, the entire intra-
entity transfer must be
eliminated.
{
9

10
Next, eliminate the unrealized gain:
Original Gain x % Unsold = Unrealized Gain
$30,000 x (200/800) = $7,500

11
And in a subsequent year when the
inventory is sold to a third party, we will
reverse Entry G to realize the gain.

Inventory Transfer
12
And the exception is…
If the transfer is downstream and the
parent uses the equity method, then
their Retained Earnings balance has
already been adjusted for the gain,
and we adjust the Equity in
Subsidiary Earnings account instead.

ENTRY TL
If land is transferred between the parent and
sub at a gain, the gain is considered
unrealized and must be eliminated.
13
Land Transfer
Note: By crediting land for the same amount,
this effectively returns the land to its
carrying value on the date of transfer.

Intra-entity Transactions --
Land Transfer
ENTRY *GL
As long as the land remains on the books of
the buyer, the unrealized gain must be
eliminated at the end of each fiscal period.
14
Note: The original gain was closed to R/E at the
end of that period. When we eliminate the gain
in subsequent years, it must come from R/E.

Intra-entity Land Transfers
Eliminating Unrealized Gains
ENTRY *GL (Year of sale)
In the period the land is sold to a third party,
the unrealized gain must be eliminated one
more time, and also finally recognized as a
REALIZED gain in the current period’s
consolidated financial statements.
15
Note: Modify the entry to credit the Gain
account instead of Land.

The Effect of Land Transfers on
Noncontrolling Interests
DOWNSTREAM
transfers have
no effect on
noncontrolling
interest.
UPSTREAM transfers
have a gain on the
SUBSIDIARY books!
All noncontrolling
interest balances are
based on the sub’s
net income
EXCLUDING the
intra-entity gain
16

Depreciable Asset Transfers
Example
 Able Co and Baker Co are related parties.
 Able purchased equipment for $100,000
several years ago, and has recorded
$40,000 of depreciation since that time.
 Baker buys the equipment from Able for
$90,000 on 1/1/10.
 The equipment has a
remaining useful life
of 10 years.
17

On the Seller’s Books:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . $90,000
Accumulated Depreciation . . . . . . . . .40,000
Equipment . . . . . . . . . . . . . . . . . . . . . $100,000
Gain on Sale of Equipment . . . . . . . . . . 30,000
NOTE: The seller WOULD record depreciation expense at
$6,000 / year if they had not sold the equipment.
5-18
On the Buyer’s Books:
Equipment. . . . . . . . . . . . . . . . . . . . . $90,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . $90,000
NOTE: The buyer WILL record $9,000 per year in
depreciation based on the remaining life

ENTRY TA
In the year of transfer, the unrealized gain must
be eliminated and the assets restated to
original historical cost.
19

ENTRY ED
In addition, the buyer’s depreciation is based
on the inflated transfer price. The excess
depreciation expense must be eliminated.
20

In Years Following the Year of Transfer
Equipment is carried on the individual
books at a different amount than on the
consolidated books.
The amounts change each year as
depreciation is computed.
21
To get the worksheet
adjustments, compare
the individual records
to the consolidated
records.

On Baker’s (buyer’s) books, the
annual depreciation = $90,000 ÷ 10
yrs. = $9,000 per year.
The 1/1/11 R/E effect = the original
gain of $30,000 on Able’s (seller’s)
books less one year of
depreciation.
22

For the consolidated entity, the annual
depreciation = $48,000 remaining BV ÷ 8
yrs. = $6,000 per year.
The Accumulated Depreciation at 12/31/11 =
$40,000 accumulated depreciation at
12/31/09 + two years of depreciation.
23

The consolidation worksheet
adjustments appear in the
last column.
24

ENTRY *TA (Subsequent Years)
The adjustment to fixed assets and
depreciation expense must be made in each
succeeding period. The entry for the
Mor/Beag Delivery Consolidation is:
25

ENTRY ED (Subsequent Years)
In addition, we must adjust for the
difference in Depreciation Expense on
the two income statements. The entry
for our example is:
26

27
And the exception is…
If the transfer is downstream and the
parent uses the equity method, then
their Retained Earnings balance
has already been reduced for the
gain, and we adjust the Investment
account instead.

Summary
 Transfers of assets among
related parties are common.
 In consolidated financial
statements, the effects of these
transfers must be removed.
 Transfers of depreciable assets
create the additional accounting
issue of differing depreciation
expense. This effect is
eliminated on the consolidation
28

Possible Criticisms
 No formal accounting
pronouncements address
valuation of noncontrolling
interests in intra-entity gains.
Traditionally, the deferral of gains
from upstream sales is presumed
to affect the noncontrolling
interest, whereas downstream
sales do not.
WHAT DO YOU THINK???
29

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