NON-PROFIT ACCOUNTING HW

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Chapter Five

Consolidated Financial Statements—Intra-Entity Asset Transactions

Learning Objective 5-1

Understand why intra-entity asset transfers create accounting effects within the financial records of affiliated companies that must be eliminated or adjusted in preparing consolidated financial statements.

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LO 5-1: Understand why intra-entity asset transfers create accounting effects within the financial records of affiliated companies that must be eliminated or adjusted in preparing consolidated financial statements.

Intra-Entity Transactions

Companies that make up a business combination frequently retain their legal identities as separate operating centers and maintain their own record-keeping.

Inventory sales between the companies must be recorded. The seller records revenue, and the buyer enters the purchase into its accounts.

For internal reporting purposes, recording an inventory transfer as a sale/purchase provides vital data to help measure the operational efficiency of each enterprise.

5-3

Companies that make up a business combination frequently retain their legal identities as separate operating centers and maintain their own record-keeping. Thus, inventory sales between these companies trigger the independent accounting systems of both parties. The seller duly records revenue, and the buyer simultaneously enters the purchase into its accounts. For internal reporting purposes, recording an inventory transfer as a sale/purchase provides vital data to help measure the operational efficiency of each enterprise.

Intra-Entity Transactions (continued)

From a consolidated perspective, an intra-entity transfer is the internal movement of inventory that creates no net change in the financial position of the business combination taken as a whole.

In producing consolidated financial statements, transfers are eliminated.

Consolidated statements reflect only transactions with outside parties.

The entire impact of the intra-entity transfer must be identified and then removed.

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From a consolidated perspective, neither a sale nor a purchase has occurred. An intra-entity transfer is merely the internal movement of inventory, an event that creates no net change in the financial position of the business combination taken as a whole. Thus, in producing consolidated financial statements, the recorded effects of these transfers are eliminated so that consolidated statements reflect only transactions (and thus profits) with outside parties. Worksheet entries serve this purpose; they adapt the financial information reported by the separate companies to the perspective of the consolidated enterprise. The entire impact of the intra-entity transfer must be identified and then removed. Deleting the effects of the actual transfer is described here first.

Learning Objective 5-2

Demonstrate the consolidation procedures to eliminate intra-entity sales and purchases balances.

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LO-2: Demonstrate the consolidation procedures to eliminate intra-entity sales and purchases balances.

Sales and Purchases—Intra-Entity Example

Arlington Company makes an $80,000 inventory sale to Zirkin Company, an affiliated party within a business combination.

Both parties record the transfer in their internal records as a normal sale/purchase.

In the consolidated financial statements, all intra-entity inventory transfers must be eliminated.

A consolidation worksheet entry, TI, will remove the resulting balances from the externally reported figures.

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To account for related companies as a single economic entity requires eliminating all intra-entity sales/purchases balances. For example, if Arlington Company makes an $80,000 inventory sale to Zirkin Company, an affiliated party within a business combination, both parties record the transfer in their internal records as a normal sale/purchase.

In the preparation of consolidated financial statements, the preceding elimination must be made for all intra-entity inventory transfers. A consolidation worksheet entry, TI, is then necessary to remove the resulting balances from the externally reported figures.

Sales and Purchases—Intra-Entity Entry TI

Cost of Goods Sold is reduced under the assumption that the Purchases account usually is closed out prior to the consolidation process.

Total recorded (intra-entity) sales is deleted regardless of whether the transfer was downstream (from parent to subsidiary) or upstream (from subsidiary to parent).

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Cost of Goods Sold is reduced here under the assumption that the Purchases account usually is closed out prior to the consolidation process.

The total recorded (intra-entity) sales figure is deleted regardless of whether the transfer was downstream (from parent to subsidiary) or upstream (from subsidiary to parent). Furthermore, any gross profit included in the transfer price does not affect this sales/purchases elimination. Because the entire amount of the transfer occurred between related parties, the total effect must be removed in preparing the consolidated statements.

Learning Objective 5-3

Explain why consolidated entities defer intra-entity gross profit in ending inventory and the consolidation procedures required to subsequently recognize profits.

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LO 5-3: Explain why consolidated entities defer intra-entity gross profit in ending inventory and the consolidation procedures required subsequently to recognize profits.

Intra-Entity Gross Profit

Removal of the sale/purchase is often just the first in a series of consolidation entries necessitated by inventory transfers.

Assume that Arlington acquired or produced this inventory at a cost of $50,000 and sold it to Zirkin at the indicated $80,000 price.

From a consolidated perspective, the inventory still has a historical cost of only $50,000.

Zirkin’s records reflect the inventory at the $80,000 transfer price.

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Removal of the sale/purchase is often just the first in a series of consolidation entries necessitated by inventory transfers. Despite the previous elimination, gross profits in ending inventory created by such sales can still exist in the accounting records at year-end. These profits initially result when the merchandise is priced at more than historical cost. Actual transfer prices are established in several ways, including the normal sales price of the inventory, sales price less a specified discount, or at a predetermined markup above cost.

In the preceding example, assume that Arlington acquired or produced this inventory at a cost of $50,000 and then sold it to Zirkin, an affiliated party, at the indicated $80,000 price. From a consolidated perspective, the inventory still has a historical cost of only $50,000. However, Zirkin’s records now reflect the inventory at the $80,000 transfer price.

Intra-Entity Gross Profit (continued)

Because of the markup, Arlington’s records show a $30,000 gross profit from the intra-entity sale.

Because the transaction did not occur with an outside party, recognition of profit is not appropriate for the combination as a whole.

Despite Entry TI, ending inventory is inflated by $30,000, causing Cost of Goods Sold to be too low and profits to be too high.

For consolidation purposes, the expense is increased by this amount through a worksheet adjustment that properly removes the unrealized gross profit from consolidated net income.

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In addition, because of the markup, Arlington’s records show a $30,000 gross profit from this intra-entity sale. However, because the transaction did not occur with an outside party, recognition of this profit is not appropriate for the combination as a whole.

Correcting the ending inventory requires only reducing the asset. However, correcting gross profit requires a careful analysis of the effect of the intra-entity transfer on the Cost of Goods Sold account. In the Arlington/Zirkin example, despite Entry TI, the inflated ending inventory figure causes Cost of Goods Sold to be too low and, thus, profits to be too high by $30,000. For consolidation purposes, the expense is increased by this amount through a worksheet adjustment that properly removes the unrealized gross profit from consolidated net income.

Intra-Entity Gross Profit—Entry G All Inventory Remains at Year-End

If all transferred inventory is retained by the business combination at year-end, Entry G eliminates the effects of the seller’s gross profit that is unrealized in the buyer’s ending inventory in Year 1.

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Consequently, if all of the transferred inventory is retained by the business combination at the end of the year, the worksheet entry labeled G also must be included to eliminate the effects of the seller’s gross profit ($30,000) that remains unrealized within the buyer’s ending inventory in Year 1.

Intra-Entity Gross Profit—Entry G Portion of Inventory Remains

Transferred inventory held at year-end is recorded in separate statements at more than historical cost.

With a gross profit rate of 371⁄2 percent ($30,000 gross profit/$80,000 transfer price), retained inventory is stated at $7,500 ($20,000 × 371⁄2%) more than its original cost.

Ending inventory intra-entity gross profit elimination (Entry G) is based on the amount of transferred merchandise retained by the business at year-end.

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Only the transferred inventory still held at year-end continues to be recorded in the separate statements at a value more than the historical cost. For this reason, the ending inventory intra-entity gross profit elimination (Entry G) is based not on total intra-entity sales but only on the amount of transferred merchandise retained within the business at the end of the year.

Because the gross profit rate was 371⁄2 percent ($30,000 gross profit/$80,000 transfer price), this retained inventory is stated at a value $7,500 more than its original cost ($20,000 × 371⁄2%). The required reduction (Entry G) is not the entire $30,000 shown previously but only the $7,500 intra-entity gross profit that remains in ending inventory.

Learning Objective 5-4

Understand that the consolidation process for inventory transfers is designed to defer the intra-entity gross profit remaining in ending inventory from the year of transfer into the year of disposal or consumption.

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LO 5-4: Understand that the consolidation process for inventory transfers is designed to defer the intra-entity gross profit remaining in ending inventory from the year of transfer into the year of disposal or consumption.

Intra-Entity Gross Profit—Year Following Transfer (Year 2)

After Entry G, a $7,500 overstatement remains in the separate financial records of the buyer and seller.

The ending inventory portion of intra-entity gross profit must be adjusted in two successive years:

From ending inventory in the year of transfer.

From beginning inventory of the next period.

In the example of Arlington’s sale of inventory to Zirkin, the $7,500 intra-entity gross profit is still in Zirkin’s Inventory account at the start of the subsequent year.

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Whenever intra-entity profit is present in ending inventory, one further consolidation entry is eventually required. Although Entry G removes the gross profit from the consolidated inventory balances in the year of transfer, the $7,500 overstatement remains within the separate financial records of the buyer and seller. Although Entry G removes the gross profit from the consolidated inventory balances in the year of transfer, the $7,500 overstatement remains within the separate financial records of the buyer and seller. The effects of this deferred gross profit are carried into their beginning balances in the subsequent year. Hence, a worksheet adjustment is necessary in the period following the transfer. For consolidation purposes, the ending inventory portion of intra-entity gross profit must be adjusted in two successive years (from ending inventory in the year of transfer and from beginning inventory of the next period).

Referring again to Arlington’s sale of inventory to Zirkin, the $7,500 intra-entity gross profit is still in Zirkin’s Inventory account at the start of the subsequent year.

Intra-Entity Gross Profit—Entry *G

The overstatement is removed from beginning inventory in the financial statements with Entry *G. The asterisk indicates that a previous year transfer created the intra-entity gross profits.

Buyer’s Cost of Goods Sold and the seller’s Retained Earnings accounts as of the beginning of Year 2 contain intra-entity profit and must both be reduced in Entry *G.

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Once again, the overstatement is removed within the consolidation process but this time from the beginning inventory balance (which appears in the financial statements only as a positive component of cost of goods sold). This elimination is termed Entry *G. The asterisk indicates that a previous year transfer created the intra-entity gross profits.

From a consolidated view, the buyer’s Cost of Goods Sold (through the beginning inventory component) and the seller’s Retained Earnings accounts as of the beginning of Year 2 contain the intra-entity profit and must both be reduced in Entry *G.

Intra-Entity Gross Profit—Entry *G (continued)

Entry *G removes the:

$7,500 from beginning inventory (within Cost of Goods Sold) and increases current net income.

Intra-entity gross profit in ending inventory (recognized by the seller in the year of transfer) so that the profit is reported in the period when a sale to an outside party takes place.

After Year 1 consolidation, the $7,500 gross profit remained on this company’s separate books and was closed to Retained Earnings at the end of the period.

5-16

In Entry *G, removal of the $7,500 from beginning inventory (within Cost of Goods Sold) appropriately increases current net income and should not pose a significant conceptual problem. However, the rationale for decreasing the seller’s beginning Retained Earnings deserves further explanation. This reduction removes the intra-entity gross profit in ending inventory (recognized by the seller in the year of transfer) so that the profit is reported in the period when a sale to an outside party takes place. Despite the consolidation entries in Year 1, the $7,500 gross profit remained on this company’s separate books and was closed to Retained Earnings at the end of the period. Recall that consolidation entries are never posted to the individual affiliate’s books.

Intra-Entity Beginning Inventory Profit Adjustment—Downstream Sales When Parent Uses Equity Method

Worksheet Entry TI and Entry G are standard, regardless of the circumstances of the consolidation, but Entry *G differs.

IF:

The original transfer is downstream (parent’s)

AND

2) The parent applies the equity method for internal accounting purposes

THEN:

Investment in Subsidiary account replaces parent’s beginning Retained Earnings in consolidation entry *G.

5-17

The worksheet eliminations for intra-entity sales/purchases (Entry TI) and intra-entity gross profit in ending inventory (Entry G) are both standard, regardless of the circumstances of the consolidation. In contrast, for one specific situation, the consolidation entry to recognize intra-entity beginning inventory gross profit differs from the Entry *G just presented. If (1) the original transfer is downstream (intra-entity sales made by the parent) and (2) the parent applies the equity method for internal accounting purposes, then the Investment in Subsidiary account replaces the parent’s beginning Retained Earnings in consolidation entry *G as shown on the next slide.

Intra-Entity Beginning Inventory Profit Adjustment—Downstream Transfers (Entry *G)

Using the equity method for internal reporting, the parent:

Recognizes beginning inventory gross profits.

Defers intra-entity ending inventory gross profits.

Debiting the Investment account allows parent’s net income and retained earnings to appropriately reflect consolidated balances.

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Why debit the Investment in Subsidiary (and not the parent’s beginning Retained Earnings) account in this situation? When the parent uses the equity method in its internal records, it recognizes beginning inventory gross profits on its books (and defers intra-entity ending inventory gross profits) as part of its equity income accruals. Therefore, both the parent’s net income and retained earnings appropriately reflect consolidated balances.

Consolidation entry I, however, removes the current year equity income accruals from the Investment in Subsidiary account as part of the investment account elimination sequence. With the equity income removed, the beginning inventory intra-entity profit reappears as a credit to the Investment in Subsidiary account’s beginning of the year balance. Following our example, consolidation entry *G is thus needed to transfer the original $7,500 Year 1 Investment in Subsidiary account credit to a Year 2 earnings credit (through Cost of Goods Sold). Consolidation entry *G also ensures that the Investment in Subsidiary account is brought to a zero balance on the worksheet.

Learning Objective 5-5

Explain the difference between upstream and downstream intra-entity transfers and how each affects the computation of noncontrolling interest balances.

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LO 5-5: Explain the difference between upstream and downstream intra-entity transfers and how each affects the computation of noncontrolling interest balances.

Unrealized Gross Profit—Effect on Noncontrolling Interest

According to FASB ASC paragraph 810-10-45-6:

Amount of intra-entity profit or loss to be eliminated is not affected by the existence of a noncontrolling interest.

Complete elimination of the intra-entity profit or loss is consistent with the underlying assumption that consolidated financial statements represent the financial position and operating results of a single economic entity.

Elimination of the intra-entity profit or loss may be allocated proportionately between the parent and noncontrolling interests.

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Paragraph 810-10-45-18 of the FASB ASC states,

The amount of intra-entity profit or loss to be eliminated in accordance with paragraph 810-10-45-1 is not affected by the existence of a noncontrolling interest. The complete elimination of the intra-entity income or loss is consistent with the underlying assumption that consolidated financial statements represent the financial position and operating results of a single economic entity. The elimination of the intra-entity income or loss may be allocated between the parent and noncontrolling interests.

The last sentence indicates that alternative approaches are available in computing the noncontrolling interest’s share of a subsidiary’s net income. According to this pronouncement, gross profits in inventory resulting from intra-entity transfers may or may not affect recognition of outside ownership. Because the amount attributed to a noncontrolling interest reduces consolidated net income, the handling of this issue can affect the reported profitability of a business combination.

Consolidated Accounts Affected by Intra-Entity Inventory Transfers

Accounts affected by intra-entity transactions:

Revenues

Cost of Goods Sold

Net Income Attributable to the Noncontrolling Interest

Retained Earnings at the Beginning of the Year

Inventory

Noncontrolling Interest in Subsidiary at End of Year

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A summary of the effects of intra-entity inventory transfers on consolidated accounts follows:

Revenues. Parent and subsidiary balances are combined, but all intra-entity transfers are then removed.

Cost of Goods Sold. Parent and subsidiary balances are combined, but all intra-entity transfers are removed. The resulting total is decreased by any intra-entity gross profit in beginning inventory (thus raising net income) and increased by any intra-entity gross profit in ending inventory (reducing net income).

Net Income Attributable to the Noncontrolling Interest. The subsidiary’s reported net income is adjusted for any excess acquisition-date fair-value amortizations and the effects of intra-entity gross profits in inventory from upstream transfers (but not downstream transfers) and then multiplied by the percentage of outside ownership.

Retained Earnings at the Beginning of the Year. As discussed in previous chapters, if the equity method is applied, the parent’s balance mirrors the consolidated total. When any other method is used, the parent’s beginning Retained Earnings must be converted to the equity method by Entry *C. Accruals for this purpose must recognize (1) the effects on reported subsidiary net income of intra-entity gross profits in beginning inventory that arose from upstream sales in the prior year and (2) prior years’ excess acquisition-date fair-value amortizations.

Inventory. Parent and subsidiary balances are combined. Any intra-entity gross profit remaining at the end of the current year is removed to adjust the reported balance to historical cost.

Noncontrolling Interest in Subsidiary at End of Year. The final total begins with the noncontrolling interest at the beginning of the year. This figure is based on the subsidiary’s book value on that date plus its share of any unamortized acquisition-date excess fair value less its share of gross profits in beginning inventory that arose from upstream sales in the prior year. The beginning balance is updated by adding the portion of the subsidiary’s net income assigned to these outside owners (as described above) and subtracting the noncontrolling interest’s share of subsidiary dividends.

Intra-Entity Inventory Transfers—Equity Method Example

Top pays $400,000 for 80 percent of the voting stock of Bottom Company on January 1, 2017.

Acquisition-date fair value of noncontrolling interest is $100,000.

Top allocates the entire $50,000 excess fair value over book value to adjust a database owned by Bottom to fair value.

The database has an estimated remaining life of 20 years.

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Assume that Top Company acquires 80 percent of the voting stock of Bottom Company on January 1, 2017. The parent pays $400,000 and the acquisition-date fair value of the noncontrolling interest is $100,000. Top allocates the entire $50,000 excess fair value over book value to adjust a database owned by Bottom to fair value. The database has an estimated remaining life of 20 years.

Intra-Entity Inventory Transfers—Equity Method Example (continued)

The subsidiary reports net income of $30,000 in 2017 and $70,000 in 2018, the current year.

Dividends declared are $20,000 in the first year and $50,000 in the second.

A $10,000 intra-entity receivable and payable exists as of December 31, 2018.

EXHIBIT 5.2 Intra-Entity Transfers

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Top Company applies the equity method to its investment in Bottom. The subsidiary reports net income of $30,000 in 2017 and $70,000 in 2018, the current year. The subsidiary declares dividends of $20,000 in the first year and $50,000 in the second. After the takeover, intra-entity inventory transfers between the two companies occurred as shown in Exhibit 5.2. A $10,000 intra-entity receivable and payable also exists as of December 31, 2018.

Intra-entity inventory transfers between the two companies:

2017 2018

Transfer prices . . . . . . . . . . . . . . . . . . . . . . . . $80,000 $ 100,000

Historical cost . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 70,000

Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . $20,000 $ 30,000

Inventory remaining at year-end (at transfer price) . . . $16,000 $ 20,000

Gross profit percentage . . . . . . . . . . . . . . . . . × 25% × 30%

Gross profit remaining in year-end inventory $ 4,000 $ 6,000

Intra-Entity Inventory Transfers—Entry *G Example

Entry *G:

Recognizes gross profit in 2018.

Reduces Cost of Goods Sold (or beginning inventory component).

Reduction in Cost of Goods Sold increases current year net income by $4,000 (25 percent of the remaining $16,000 in inventory).

Gross profit is correctly recognized in 2018 when the inventory is sold to an outside party.

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We examine only three of these entries in detail along with the computation of the net income attributable to the noncontrolling interest.

First, consolidation entry *G adjusts for the intra-entity gross profit carried over in the beginning inventory from the 2017 intra-entity downstream transfers. The gross profit rate (Exhibit 5.2) on these items was 25 percent ($20,000 gross profit/$80,000 transfer price), indicating an intra-entity profit of $4,000 (25 percent of the remaining $16,000 in inventory). To recognize this gross profit in 2018, Entry *G reduces Cost of Goods Sold (or the beginning inventory component of that expense) by that amount. The reduction in Cost of Goods Sold creates an increase in current year net income. From a consolidation perspective, the gross profit is correctly recognized in 2018 when the inventory is sold to an outside party. The debit to the Investment in Bottom account becomes part of the sequence of adjustments to bring that account to a zero balance in consolidation.

Intra-Entity Inventory Downstream Transfer—Entry TI and Entry G

Entry TI eliminates the intra-entity sales/purchases for 2018.

Entry G defers unrealized gross profit remaining at the end of 2018.

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Entry TI eliminates the intra-entity sales/purchases for 2018. The entire $100,000 transfer recorded by the two parties during the current period is removed to arrive at consolidated figures for the business combination.

Entry G defers the intra-entity gross profit remaining in ending inventory at the end of 2018. The $20,000 in transferred merchandise (Exhibit 5.2) that Bottom has not yet sold has a gross profit rate of 30 percent ($30,000 gross profit/$100,000 transfer price); thus, the intra-entity gross profit amounts to $6,000. On the worksheet, Entry G eliminates this overstatement in the Inventory asset balance as well as the ending inventory (credit) component of Cost of Goods Sold. Because the gross profit must be deferred, the increase in this expense appropriately decreases consolidated net income.

Net Income Attributable to the Noncontrolling Interest

When intra-entity transfers are downstream, deferred intra-entity gross profits relate solely to the parent company and have no effect on the subsidiary or outside ownership.

The noncontrolling interest’s share of consolidated net income is unaffected by the downstream intra-entity profit deferral and subsequent recognition.

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In this first illustration, the intra-entity transfers are downstream. Thus, the deferred intra-entity gross profits are considered to relate solely to the parent company, creating no effect on the subsidiary or the outside ownership. For this reason, the noncontrolling interest’s share of consolidated net income is unaffected by the downstream intra-entity profit deferral and subsequent recognition. Therefore, Top allocates $13,500 of Bottom’s net income to the noncontrolling interest computed as 20 percent of $67,500 ($70,000 reported net income less $2,500 current year database excess fair-value amortization).

By including these entries along with the other routine worksheet eliminations and adjustments, the accounting information generated by Top and Bottom is brought together into a single set of consolidated financial statements. However, this process does more than simply delete intra-entity transfers; it also affects reported net income. A $4,000 gross profit is removed on the worksheet from 2017 figures and subsequently recognized in 2018 (Entry *G). A $6,000 gross profit is deferred in a similar fashion from 2018 (Entry G) and subsequently recognized in 2019. However, these changes do not affect the noncontrolling interest because the transfers were downstream.

Intra-Entity Transactions—Upstream Inventory Transfers

A different set of consolidation procedures is necessary if the intra-entity transfers are upstream.

Upstream gross profits are attributed to the subsidiary (Bottom) not the parent (Top).

Because the intra-entity sales are upstream, the $4,000 beginning intra-entity gross profit (Entry *G) deferral no longer involves a debit to the parent’s Investment in Bottom account.

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A different set of consolidation procedures is necessary if the intra-entity transfers are upstream from Bottom to Top. As previously discussed, upstream gross profits are attributed to the subsidiary rather than to the parent company. Therefore, had these transfers been upstream, both the $4,000 beginning inventory gross profit recognition (Entry *G) and the $6,000 intra-entity gross profit deferral (Entry G) would be considered adjustments to Bottom’s reported totals.

Because the intra-entity sales are upstream, the $4,000 beginning intra-entity gross profit (Entry *G) deferral no longer involves a debit to the parent’s Investment in Bottom account.

As of January 1, 2018, $16,000 of transfers remain in Top’s inventory, and $4,000 of gross profit is unearned. Bottom’s beginning Retained Earnings are overstated by $4,000, the gross profit from 2017 intra-entity transfers.

A credit to Cost of Goods Sold increases consolidated net income to recognize the profit in 2018 from sales to outsiders as follows:

Intra-Entity Transactions—Upstream Inventory Transfers (Entry *G)

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Recall that Top and Bottom, as separate legal entities, maintain independent accounting information systems. Thus, when it transferred inventory to Top in 2017, Bottom recorded the transfer as a regular sale even though the counterparty (Top) is a member of the consolidated group. Because $16,000 of these transfers remain in Top’s inventory, $4,000 of gross profit (25 percent) is deferred from a consolidated perspective as of January 1, 2018. Also from a consolidated standpoint, Bottom’s January 1, 2018, Retained Earnings are overstated by the $4,000 gross profit from the 2017 intra-entity transfers. Thus, Exhibit 5.6 shows a worksheet adjustment that reduces Bottom’s January 1, 2018, Retained Earnings balance. Similar to Exhibit 5.4, the credit to Cost of Goods Sold increases consolidated net income to recognize the profit in 2018 from sales to outsiders as shown.

Intra-Entity Transactions—Upstream Inventory Transfers (Entry S)

Entry S eliminates a portion of the parent’s investment account and provides the initial noncontrolling interest balance.

The entry removes stockholders’ equity accounts of the subsidiary as of the beginning of the current year.

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Consolidation entry S eliminates a portion of the parent’s investment account and provides the initial noncontrolling interest balance. This worksheet entry also removes the stockholders’ equity accounts of the subsidiary as of the beginning of the current year. Thus, the above $4,000 reduction in Bottom’s January 1, 2018, Retained Earnings to defer the intra-entity gross profit affects Entry S. After posting Entry *G, only $306,000 remains as the subsidiary’s January 1, 2018, Retained Earnings, which along with Bottom’s common stock is eliminated as shown.

Consolidations—Downstream versus Upstream Transfers (Entry *G)

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To help clarify the effect of downstream and upstream transfers when the parent uses the equity method, we compare two of the worksheet entries in more detail.

Consolidations—Downstream versus Upstream Transfers (Entry S)

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To help clarify the effect of downstream and upstream transfers when the parent uses the equity method, we compare two of the worksheet entries in more detail.

Effects of Alternative Investment Methods on Consolidation

If the parent uses either the initial value or the partial equity method, many of the consolidation procedures are identical to those used in the equity method except for two.

Consolidation entry *C is required in periods subsequent to acquisition to convert the parent’s beginning Retained Earnings to a full-accrual consolidated total.

Consolidation entry *G corrects the overstatement in the subsidiary’s beginning Retained Earnings and appropriately recognizes the profit in the current year.

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When the parent uses either the initial value or the partial equity method, consolidation procedures normally continue to follow the same patterns analyzed in the previous chapters of this textbook. However, these alternative methods lack the full accrual properties of the equity method. Therefore, an additional worksheet adjustment (*C) is needed to ensure the consolidated financial statements reflect a full accrual GAAP basis. As was the case previously, the worksheet adjustments depend on whether the intra-entity inventories result from downstream or upstream sales.

Using the same example, we now assume the parent applies the initial value method. Given that the subsidiary declares and pays dividends of $20,000 in 2017 and $50,000 in 2018, Top records dividend income of $16,000 ($20,000 × 80%) and $40,000 ($50,000 × 80%) during these two years.

Exhibits 5.7 and 5.8 present the worksheets to consolidate these two companies for the year ending December 31, 2018. As in the previous examples, most of the worksheet entries found in Exhibits 5.7 and 5.8 are described and analyzed in previous chapters of this textbook. Additionally, many of the worksheet entries required by intra-entity sales are identical to those used when the parent applies the equity method. Thus, only Consolidation Entries *C and *G are examined in detail separately for downstream intra-entity sales (Exhibit 5.7) and upstream intra-entity sales (Exhibit 5.8).

Consolidation entry *C is required in periods subsequent to acquisition whenever the parent does not apply the equity method. This adjustment converts the parent’s beginning Retained Earnings to a full-accrual consolidated total.

If the parent had applied the partial equity method in its internal records, little would change in the consolidation processes previously described for the equity method. The primary change would involve inclusion of a consolidation entry *C. Because the parent would have recorded changes in reported subsidiary book value, the *C adjustment would be computed only for (1) previous years’ excess fair over book value amortizations and (2) the immediate past year’s intra-entity profit deferral.

Because in this case the sales are upstream, the subsidiary’s January 1, 2018, Retained Earnings will be overstated from a consolidated view by the intra-entity gross profit in beginning inventory. Consolidation entry *G corrects this overstatement and appropriately recognizes the profit in the current year.

Learning Objective 5-6

Prepare the consolidation entry to defer any gain created by the intra-entity transfer of land from the accounting records of the year of transfer and subsequent years.

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LO 5-6: Prepare the consolidation entry to defer any gain created by an intra-entity transfer of land from the accounting records of the year of transfer and subsequent years.

Intra-Entity Transactions—Land Transfers

Consolidation procedures for intra-entity land transfers partially parallel those for the events occurring in an intra-entity inventory transfer. The worksheet process must adjust the account balances as a single economic entity.

The sequence of events in an intra-entity land sale:

1) The original seller of the land reports a gain, even though the transaction occurred between related parties. The acquiring company capitalizes the inflated transfer price.

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The consolidation procedures necessitated by intra-entity land transfers partially parallel those for intra-entity inventory. As with inventory, the sale of land creates a series of effects on the individual records of the two companies. The worksheet process must then adjust the account balances to reflect the perspective of a single economic entity.

By reviewing the sequence of events occurring in an intra-entity land sale, the similarities to inventory transfers can be ascertained as well as the unique features of this transaction.

The original seller of the land reports a gain (losses are rare in intra-entity asset transfers), even though the transaction occurred between related parties. At the same time, the acquiring company capitalizes the inflated transfer price rather than the land’s historical cost to the business combination.

Intra-Entity Transactions—Land Transfers (continued)

The gain recorded by the seller is closed into Retained Earnings at the end of the year. As a consolidated entity, the account is artificially increased by a related party. The buyer’s Land account and the seller’s Retained Earnings account continue to contain the intra-entity gain.

The gain on the original transfer is recognized in consolidated net income only when the land is subsequently disposed of to an outside party. Appropriate consolidation techniques must eliminate the intra-entity gain each period until the time of resale.

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The gain the seller recorded is closed into Retained Earnings at the end of the year. From a consolidated perspective, this account has been artificially increased by a related party. Thus, both the buyer’s Land account and the seller’s Retained Earnings account continue to contain the intra-entity gain.

The gain on the original transfer is recognized in consolidated net income only when the land is subsequently disposed of to an outside party. Therefore, appropriate consolidation techniques must be designed to eliminate the intra-entity gain each period until the time of resale.

Eliminating Intra-Entity Gains—Land Transfers (Entry TL)

Assume that on July 1, 2018, Hastings sold land that originally cost $60,000 to Patrick, a related party, at a $100,000 transfer price.

The seller reports a $40,000 gain.

The buyer records the land at the $100,000 acquisition price.

At the end of this fiscal period, the intra-entity effect of this transaction must be eliminated for consolidation purposes.

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Assume that Hastings Company and Patrick Company are related parties. On July 1, 2018, Hastings sold land that originally cost $60,000 to Patrick at a $100,000 transfer price. The seller reports a $40,000 gain; the buyer records the land at the $100,000 acquisition price. At the end of this fiscal period, the intra-entity effect of this transaction must be eliminated for consolidation purposes.

Intra-Entity Transactions—Land Transfers (Entry *GL)

The effects of the original transaction remain in the financial records of the individual companies for as long as the property is held.

The gain recorded by Hastings carries through to Retained Earnings while Patrick’s Land account retains the inflated transfer price.

For every subsequent consolidation until the land is eventually sold, the elimination process must be repeated.

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This worksheet entry eliminates the intra-entity gain from the 2018 consolidated statements and returns the land to its recorded value at date of transfer, for consolidated purposes. However, as with the transfer of inventory, the effects created by the original transaction remain in the financial records of the individual companies for as long as the property is held. The gain recorded by Hastings carries through to Retained Earnings while Patrick’s Land account retains the inflated transfer price. Therefore, for every subsequent consolidation until the land is eventually sold, the elimination process must be repeated. Including the entry as shown on each subsequent worksheet removes the intra-entity gain from the asset and from the earnings reported by the combination.

Eliminating Intra-Entity Gains—Land Transfers Downstream and Upstream

The reduction in Retained Earnings is changed to an increase in the Investment in Subsidiary account when the original sale is downstream and the parent has applied the equity method.

In that situation, equity method adjustments have already corrected the timing of the parent’s intra-entity gain, which has created a reduction in the Investment account that is appropriately allocated to the subsidiary’s Land account on the worksheet.

Conversely, if sales were upstream, the Retained Earnings of the seller (the subsidiary) continue to be overstated even if the parent applies the equity method.

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Note that the reduction in Retained Earnings is changed to an increase in the Investment in Subsidiary account when the original sale is downstream and the parent has applied the equity method. In that specific situation, equity method adjustments have already corrected the timing of the parent’s intra-entity gain. Removing the gain has created a reduction in the Investment account that is appropriately allocated to the subsidiary’s Land account on the worksheet. Conversely, if sales were upstream, the Retained Earnings of the seller (the subsidiary) continue to be overstated even if the parent applies the equity method.

Eliminating Intra-Entity Gains—Land Transfers (Entry *GL Sale to Outside Party)

When the company eventually sells the land to an outsider, it must recognize the gain deferred at the time of the original transfer.

On the worksheet, the gain is removed one last time from beginning Retained Earnings (or the investment account, if applicable). In this instance, though, the worksheet entry reclassifies the amount as a recognized gain.

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The gain or loss being recognized is incorrect for consolidation purposes; it has not been computed by comparison to the land’s historical cost. Again, the separate financial records fail to reflect the transaction from the perspective of the single economic entity.

Therefore, if the company eventually sells the land, it must recognize the gain deferred at the time of the original transfer. Gain recognition is appropriate once the property is sold to outsiders. On the worksheet, the gain is removed one last time from beginning Retained Earnings (or the investment account, if applicable). In this instance, though, the worksheet entry reclassifies the amount as a recognized gain. Thus, the gain recognition is reallocated from the year of transfer into the fiscal period in which the land is sold to the unrelated party.

Recognizing the Effect on Noncontrolling Interest—Land Transfers

If the original sale was a DOWNSTREAM transaction, it has no effect on the noncontrolling interest.

If the transfer is made UPSTREAM, it is attributed to the subsidiary and the noncontrolling interest.

All noncontrolling interest balances are computed on the reported earnings of the subsidiary after adjustment for any upstream transfers.

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If the original sale was a downstream transaction, neither the annual deferral nor the eventual recognition of the intra-entity gain has any effect on the noncontrolling interest. The rationale for this treatment, as previously indicated, is that profits from downstream transfers relate solely to the parent company.

Conversely, if the transfer is made upstream, deferral and recognition of gains are attributed to the subsidiary and, hence, to the noncontrolling interest. As with inventory, all noncontrolling interest balances are computed on the reported earnings of the subsidiary after adjustment for any upstream transfers.

Learning Objective 5-7

Prepare the consolidation entries to remove the effects of upstream and downstream intra-entity fixed asset transfers across affiliated entities.

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LO 5-7: Prepare the consolidation entries to remove the effects of upstream and downstream intra-entity fixed asset transfers across affiliated entities.

Financial reporting objectives remain unchanged for intra-entity sales of depreciable assets:

Defer intra-entity gains.

Re-establish historical cost balances.

Recognize appropriate income within the consolidated financial statements.

Defer gains created by intra-entity transfers until the subsequent use or resale of the asset consummates the original transaction.

Deferral and Subsequent Recognition of Intra-Entity Gains

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For intra-entity sales of depreciable assets, financial reporting objectives remain unchanged: defer intra-entity gains, re-establish historical cost balances, and recognize appropriate income within the consolidated financial statements. More specifically, we defer gains created by intra-entity transfers until such time as the subsequent use or resale of the asset consummates the original transaction.

Assume that Able Company sells equipment to Baker Company on January 1, 2017.

Able originally acquired the equipment for $100,000.

The equipment had a:

Current market value of $90,000.

Recorded accumulated depreciation of $40,000.

Remaining life of 10 years.

Depreciable Asset Intra-Entity Transfers Illustrated

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To examine the consolidation procedures required by the intra-entity transfer of a depreciable asset, assume that Able Company sells equipment to Baker Company at the current market value of $90,000. Able originally acquired the equipment for $100,000 several years ago; since that time, it has recorded $40,000 in accumulated depreciation. The transfer is made on January 1, 2017, when the equipment has a 10-year remaining life.

The 2017 effects on the separate financial accounts of the two companies:

Baker (buyer) enters the equipment into its records at the $90,000 transfer price. From a consolidated view, the asset has not been sold, and the $60,000 book value ($100,000 cost less $40,000 accumulated depreciation) remains appropriate.

Able (seller) reports a $30,000 gain, which is closed to Retained Earnings.

Depreciable Asset Intra-Entity Transfers Illustrated (continued)

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The 2017 effects on the separate financial accounts of the two companies can be quickly enumerated:

Baker, as the buyer, enters the equipment into its records at the $90,000 transfer price. However, from a consolidated view, the asset has not been sold, and therefore the $60,000 book value ($100,000 cost less $40,000 accumulated depreciation) remains appropriate.

Able, as the seller, reports a $30,000 gain, although the consolidated entity has not yet sold the asset to outsiders. After preparation of the 12/31/17 consolidated financial statements, Able then closes this gain to its Retained Earnings account.

Depreciable Asset Intra-Entity Transfers Illustrated (concluded)

At 2017 year-end, Baker records expense of $9,000 ($90,000 transfer price/10 years) assuming straight-line depreciation.

Proper depreciation expense for consolidation is based on the asset’s carrying amount to the consolidated entity at the date of the intra-entity transfer.

Consolidated depreciation expenses would be $6,000 ($60,000 carrying amount/10 remaining years).

A $3,000 consolidated worksheet adjustment to depreciation expense is necessary.

A consolidated worksheet entry must return the asset to its pre-transfer historical cost.

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Assuming application of the straight-line depreciation method with no salvage value, Baker records expense of $9,000 at the end of 2017 ($90,000 transfer price/10 years). The proper depreciation expense for consolidation, however, is based on the asset’s carrying amount to the consolidated entity at the date of the intra-entity transfer. Consolidated depreciation expense for this asset would thus be $6,000 ($60,000 carrying amount/10 remaining years). This requires a $3,000 consolidated worksheet adjustment to depreciation expense.

To report these events as seen by the consolidated entity, we first acknowledge that an asset write up cannot be recognized based on an intra-entity transfer. A consolidated worksheet entry must therefore return the asset to its pre-transfer carrying amount based on historical cost. Moreover, both the $30,000 intra-entity gain and the $3,000 overstatement in depreciation expense must be eliminated on the worksheet. The two consolidation entries for 2017 are shown on the following slides.

Depreciable Asset Transfers—Year of Transfer (Entry TA)

The $30,000 intra-entity gain and $3,000 overstated depreciation expense must be eliminated.

In the year of transfer, consolidation entries TA and ED are applicable with both upstream and downstream transfers.

Entry TA removes intra-entity gain and returns equipment accounts to balances based on original historical cost.

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The $30,000 intra-entity gain and $3,000 overstated depreciation expense must be eliminated. In the year of the intra-entity depreciable asset transfer, the preceding consolidation entries TA and ED are applicable regardless of whether the transfer was upstream or downstream. Entry TA removes intra-entity gain and returns equipment accounts to balances based on original historical cost. It is labeled “TA” in reference to the transferred asset.

Intra-Entity Transactions—Depreciable Asset Transfers (Entry ED)

Deferred intra-entity profits on depreciable asset transfers are achieved on the consolidated worksheet through a credit to depreciation expense.

Entry ED eliminates overstatement of depreciation expense caused by the inflated price.

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Deferred intra-entity profits on depreciable asset transfers are achieved on the consolidated worksheet through a credit to depreciation expense. Entry ED eliminates the overstatement of depreciation expense caused by the inflated transfer price. It is labeled “ED” in reference to excess depreciation.

Intra-Entity Transactions—Depreciable Asset Transfers in the Years Following the Transfer

The intra-entity gain and excess depreciation expense remain on the separate books and are closed into Retained Earnings of the respective companies at year-end.

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. For every subsequent period, separately reported figures must be adjusted on the worksheet to present the consolidated totals from a single entity’s perspective.

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Both the intra-entity gain and the excess depreciation expense remain on the separate books and are closed into Retained Earnings of the respective companies at year-end. Similarly, the Equipment account with the related Accumulated Depreciation continues to hold balances based on the transfer price, not historical cost. Thus, for every subsequent period, the separately reported figures must be adjusted on the worksheet to present the consolidated totals from a single entity’s perspective.

To derive worksheet entries at any future point, the balances in the accounts of the individual companies must be ascertained and compared to the figures appropriate for the consolidated entity.

Intra-Entity Transactions—Depreciable Asset Transfers and Separate Records

The separate records of Able and Baker two years after the transfer (December 31, 2018) follow.

Consolidated totals are calculated based on the original historical cost of $100,000 and accumulated depreciation of $40,000.

Note: Parentheses indicate a credit balance.

*Accumulated depreciation before transfer $(40,000) plus 2 years × $(6,000). †Intra-entity transfer gain $(30,000) less one year’s depreciation of $9,000.

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As an illustration, the separate records of Able and Baker two years after the transfer (December 31, 2018) are shown. Consolidated totals are calculated based on the original historical cost of $100,000 and accumulated depreciation of $40,000.

Note: Parentheses indicate a credit balance.

*Accumulated depreciation before transfer $(40,000) plus 2 years × $(6,000). †Intra-entity transfer gain $(30,000) less one year’s depreciation of $9,000.

Intra-Entity Transactions—Depreciable Asset Transfers the Following Year (Entries *TA and ED)

The 2018 worksheet includes these entries the year after transfer:

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Because the intra-entity transfer’s effects remain in the separate financial records, the various accounts must be adjusted in each subsequent consolidation. Moreover, the amounts involved must be updated every period because of the continual impact of depreciation recorded by the buyer. Continuing our example, to adjust the individual figures to the consolidated totals derived above, the 2018 worksheet includes the entries shown on the slide.

Consolidation entry *TA removes $27,000 of the original intra-entity gain on sale from Retained Earnings. Then, in consolidation entry ED, the $3,000 credit to Depreciation Expense serves to increase consolidated net income by $3,000. Essentially, the remaining intra-entity gain as of the beginning of the year is removed from Retained Earnings and partially recognized as a current year increase in consolidated net income (via the decrease in depreciation expense).

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.

The following worksheet consolidation entries would be made for a downstream sale assuming that:

Able is the parent.

Able has applied the equity method to account for its investment in Baker.

Years Following Downstream Intra-Entity Depreciable Asset Transfers

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Consolidation entry *TA requires a slight modification when the intra-entity depreciable asset transfer is downstream and the parent uses the equity method. In applying the equity method, the parent adjusts its book income for both the original transfer gain and periodic depreciation expense adjustments. Thus, in downstream intra-entity transfers when the equity method is used, from a consolidated view, the parent’s Retained Earnings balance has been already reduced for the gain. Therefore, continuing with the previous example, the following worksheet consolidation entries would be made for a downstream sale assuming that (1) Able is the parent and (2) Able has applied the equity method to account for its investment in Baker.

For a downstream transfer, Entry *TA replaces the parent’s Retained Earnings with the Investment in Baker account.

Entry ED is not changed.

Downstream Intra-Entity Depreciable Asset Transfers—Parent Uses Equity Method (Entries *TA and ED)

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In Entry *TA, note that the Investment in Baker account replaces the parent’s Retained Earnings. This temporary increase to the Investment account then effectively allocates the adjustments necessitated by the intra-entity transfer to the appropriate subsidiary Equipment and Accumulated Depreciation accounts.

Downstream sales are assumed to have no effect on any noncontrolling interest values. The parent rather than the subsidiary made the sale.

The impact on net income created by upstream sales must be considered in computing the balances attributed to these outside owners.

Many acceptable alternatives exist for assignment of income created within a consolidation process. The authors chose to assign all income to the original seller.

Depreciable Asset Transfers—Additional Issues

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Because of the lack of official guidance, no easy answer exists as to the assignment of any income effects created within the consolidation process. All income is assigned here to the original seller. In Entry *TA, for example, the beginning Retained Earnings account of Able (the seller) is reduced. Both the intra-entity gain on the transfer and the excess depreciation expense subsequently recognized are assigned to that party.

Thus, again, downstream sales are assumed to have no effect on any noncontrolling interest values. The parent rather than the subsidiary made the sale. Conversely, the impact on net income created by upstream sales must be considered in computing the balances attributed to these outside owners. Currently, this approach is one of many acceptable alternatives. However, in its future deliberations on consolidation policies and procedures, the FASB could mandate a specific allocation pattern.