FA4 Module 5 Intercompany Transactions

FA4 Module 5 Intercompany Transactions After you have calculated goodwill, and figured out the AD amortization, then you need to analyze all intercompany transactions. If the Subsidiary sells merchandise to the Parent company the sale, related COGS and tax effect must be reversed out because from a single entity view point a sale has not occurred. When the Sub sells to the Parent it is called an upstream transaction. If the Parent sells merchandise to the Sub the sale, COGS and tax effects must be reversed for the same reasons as stated above, you cannot sell an item to yourself. When the Parent sells to the Sub it is called a downstream transaction. Basically any transaction that occurs between the Parent and Sub must be reversed out. Only when the items are sold to persons outside the entity can the transaction be recognized (included in the consolidated financial statements). eg. Assume S Co. sold $1,500 of merchandise to P Co. The cost of the merchandise was $1,000. If P Co. had not sold the inventory to third parties i.e. the inventory was still on the books of P Co. Each company would have recorded its own transactions. S Co. would have made the following journal entries on their books to record the sale: Cash 1,500 Sales 1,500 COGS 1,000 Inventory 1,000 and P Co. would have made the following journal entry to record the receipt of the inventory: Inventory (purchases) 1,500 Cash 1,500 To correct the above entries to represent the consolidated view, the following eliminating/adjustments entry would have to be done: Sales 1,500 to reverse the sale on S's books Inventory 1,000 to reverse the reduction of inventory on S's books COGS 1,000 to reverse the COGS on S's books Inventory 1,500 to reverse the receipt of inventory on P's books The above eliminating entry reverses the effect of these bookkeeping entries. Alternatively, think of it this way S Co. made $500 on the sale of inventory to P Co. However, since the inventory has not been sold to a third party, this profit must be held back (ie not realized) by the consolidated entity. Thus, you could simply reverse the ACCTG FA4 Module 5 Intercompany Transactions page 1

effects of the $500 intercompany profit by eliminating $500 from the consolidated inventory account and COGS account and $1,500 from the consolidated sales account and purchases account (effects COGS; remember COGS = BI + purchases EI). DR Sales $1,500 CR COGS (purchases) $1,500 DR COGS $500 CR Inventory (EI) $500 This is the way the textbook approaches intercompany sale of inventory. This method works well for the direct method ie when not making working journal entries. Assume P Co. has sold the entire inventory received by S Co. for $3,000, the following analysis will lead us to the eliminating entry. S Co. would have made the following journal entries on their books to record the sale to P Co.: Cash 1,500 Sales 1,500 COGS 1,000 Inventory 1,000 and P Co. would have made the following journal entry to record the receipt of the inventory: Inventory 1,500 Cash 1,500 Then P Co. would have made the following entry to record the sale of the merchandise to outside persons: Cash 3,000 COGS 1,500 Sales 3,000 Inventory 1,500 From a single entity view point the total sales for the period should be $3,000 and the COGS should be $1,000. Thus, we need to eliminate the sale proceeds recorded by S Co. for $1,500 and the COGS amount recorded by P Co. for $1,500. The eliminating entry would be: Sales 1,500 COGS (purchases) 1,500 Assume P Co. only sold 60% of the merchandise to outside persons for $1,800. This means the total sales for the company are $1,800 and the total COGS should be 600 (1,000x.60). The elimination entry would be: Sales 1,500 to eliminate S's sales entry COGS 1,500 to eliminate P's $1,500 purchases entry COGS 200 Inventory 200 to reduce P's inventory to $400 from $600 after the sale and adjust EI valuation on COGS ACCTG FA4 Module 5 Intercompany Transactions page 2

Note, P's single entity entry for the sale was: Cash 1,800 COGS (1,500 x.60) 900 Sales 1,800 Inventory 900 Another way to look at the above eliminating entry is through unrealized profit. Since S sold to P and P only sold 60% of that merchandise 40% of the profit S realized on the sale to P is included in P's inventory. S realized 1,500-1,000 = 500 profit on the sale but since P only sold 60% the single entity only made 500 x 60% = 300 profit. Thus the other $200 profit is included in P's inventory, thus if we credit inventory for 200 we eliminate the unearned profit from the entity as a whole. NOTE IN THE ABOVE ELIMINATION ENTRIES WE HAVE ASSUMED P OWNS 100% OF S. Anytime there is an upstream sale of inventory and there is non controlling interest shareholders (i.e. the Parent does not own 100% of the Subsidiary) we need to make another elimination entry to recognize the fact that the non controlling interest should be adjusted for their share of the intercompany transactions. Assume in the above upstream sale example that P owned 75% of S and only 60% of the merchandise has been sold. Recall we made the following elimination entry: Sales 1,500 COGS (purchases) 1,500 COGS 200 Inventory (EI) 200 Assume that S Co. made 5,000 in profit this year. The NCI calculation of this share of the NI has to be adjusted for the profit in ending inventory because the non controlling interest shareholders only receive the profits generated by outside sales. (the intercompany sales do not exist, thus NCI does not have a claim on these amounts). NCI is only a consolidation phenomena it does not exist outside the consolidated entity. NCI calculation: NI of S 5,000 Less profit in EI 200 4,800 NCI % 25% 1,200 The profit in EI is not realized by the consolidated entity thus it is subtracted from the NI of S because S would have recorded the full $500 as profit (Sales of $1,500 less $1,000 COGS) in their separate entity income statement (ie net income). NCI I/S 1,200 NCI B/S 1,200 ACCTG FA4 Module 5 Intercompany Transactions page 3

Note how the NCI on the B/S is increased by the amount of net income the subsidiary contributed to the consolidated entity (adjusted for intercompany transactions). Recall that NCI represents the non-controlling shareholder s share of the net fair value at time of acquisition plus their share of the subsidiary s adjusted R/E since acquisition. Net income increases net book value of a company (net income flows to retained earnings!!!). It would then stand to reason that any dividends paid by the subsidiary would decrease NCI B/S as this transaction decreases the net book value of the subsidiary however, NCI I/S is not affected by dividends only by net income (adjusted for intercompany transactions). Note: All the above elimination entries are meant as thinking tools to aid the analysis required to determine adjustments required to accounts using the direct method. These entries do not represent the working paper elimination entries demonstrated in the textbook. Downstream sales of amortizable assets: When a parent company sells its amortizable asset it would record the following journal entry: Cash (A/R) Accumulated Amortization Gain on Sale Capital Asset x x x x OR Cash (A/R) Accumulated Amortization Loss on Sale Capital Asset x x x x Once the asset is sold no further amortization would be taken. When a subsidiary company buys an asset the following journal entry is made: Asset Cash (A/P) x x Amortization expense would then be calculated on the asset value over its useful life. When consolidation of the parent and subsidiary is to take place and a sale of amortizable assets has occurred between the parent and the subsidiary, we need to eliminate the gain (loss) on sale of the asset recorded by the parent. From the single entity view point no sale has occurred and no gain (loss) has resulted. Also, note from the single entity view point the amount of amortization to be taken each year should be based on the original cost of the asset, not the sale price of the asset to the subsidiary. Also, note the subsidiary would be amortizing the asset based on the sale/purchase price not on the original cost to ACCTG FA4 Module 5 Intercompany Transactions page 4

the single entity. Thus, in the consolidation process we need to eliminate the extra (or add extra) amortization expense the subsidiary has recorded. After the first year, the gain (loss) on the parent's books is now included in the parent opening retained earnings, and the amortization expenses on the sub's books in now included in the subsidiary's opening retained earnings. However, from a single entity view point we need to eliminate the gain (loss) and some of the amortization expense from the retained earnings of the consolidated subsidiary. After the asset has been fully amortized and is still on the subsidiary's books at its salvage value, the resulting eliminating entry would be needed: Accumulated Amortization Asset x x Note the retained earnings does not need to be adjusted because the difference between the "inflated" amortization expensed recorded by the subsidiary and the gain recorded by the parent have now netted themselves out. Example: P acquired 80% of S in 20X1. It is now 20X5. P sold a capital asset with an original cost of $100,000 and accumulated amortization of $30,000 to S for $60,000. The asset will be useful for another 5 years with a residual value of $5,000. The straight line method of amortization is used. The tax rate is 40% for intercompany adjustments. REQUIRED: Give the eliminating journal entries for 20X5 and 20X6. Also, give the consolidated balances for 20X5 and 20X6 for the capital asset and accumulated amortization. 20X5 eliminating entries: 1 Capital Asset 10,000 Income tax expense 4,000 Loss on Sale 10,000 Deferred income tax 4,000 P company would have recorded a loss of 10,000 on the transaction, but from the single entity view point no sale has occurred and thus we need to cr the loss on sale account. S company would have recorded the asset at 60,000 but from the single entity view point the asset should be on the books at 70,000, thus we have to dr the asset for 10,000. The tax effects of the sale also need to be eliminated. P company would have had tax savings due to the loss in the amount of (10,000 x.40) = 4,000. Thus, we need to dr income tax expense to reverse the effect of the tax savings. Deferred income tax is cr for 4,000 because as time passes the single entity as a whole will realized the 4,000 as tax savings, through the "bump" amount of the amortization for the asset. ACCTG FA4 Module 5 Intercompany Transactions page 5

2 Amortization Expense 2,000 Deferred income tax 800 Accumulated Amortization 2,000 Income tax expense 800 For each year the asset is to be amortized, S records (60,000-5,000)/5 = 11,000 of amortization expense. However, from a single entity view point amortization expense should be (100,000-30,000-5,000)/5 = 13,000. Thus, we need to "bump" amortization up by 2,000 and accumulated amortization up for 2,000. This also means that the consolidated tax expense is too high because S's tax expense is based on the subtraction of 11,000 for amortization expense not 13,000. Thus, we need to cr income tax expense for the difference (11,000-13,000).40 = 800. Consolidated Balances for 20X5 - effect of sale of asset only presented: B/S Assets: Asset 100,000 A/A (30,000 + 11,000 +2,000) 43,000 Liabilities: Deferred income taxes (4,000-800) 3,200 20X6 elimination entries: 1 Capital Asset 10,000 Retained Earnings 6,000 Deferred income tax 4,000 This entry eliminates the loss, net of tax, amount from the opening retained earnings of the consolidated entity, and sets up the Deferred income tax account resulting from the sale. Remember, the elimination entries need to be repeated each year (provided the asset was not sold to a third party) because the entries are not recorded in the "books" of either company. 2 Retained Earnings 1,200 Deferred income tax 800 Accumulated Amortization 2,000 This entry eliminates the effects of last years amortization adjustment. S company recorded only 11,000 of amortization and the consolidated entity should have had 13,000, thus the 2,000 net of 800 taxes, ended up in S's retained earnings, hence the dr to retained earnings for 1,200. 3 Amortization Expense 2,000 Deferred income tax 800 Accumulated Amortization 2,000 Income tax expense 800 ACCTG FA4 Module 5 Intercompany Transactions page 6

This entry updates the amortization expense, A/A and taxes for the current year. Again, S company expensed 11,000, the consolidated entity should expense 13,000, thus the 2,000 difference needs to be entered as amortization expense. Consolidated Balances for 20X6 - effect of sale of asset only presented: B/S Assets: Asset 100,000 A/A (30,000+11,000+2,000+11,000+2,000) 56,000 Liabilities: Deferred income taxes (4,000-800-800) 2,400 The following chart shows the effects of the intercompany sale from 20X5-20X0: Original Sale 20X5 20X6 20X7 20X8 20X9 20X0 Amortization Expense adjustment (11,000-13,000) 2,000 2,000 2,000 2,000 2,000 0 Loss on Sale 10,000 tax effect (2,000 x.40) net income effect (2,000-800) retained earnings effect (opening) 4,000 800 800 800 800 800 0 6,000 1,200 1,200 1,200 1,200 1,200 0 0 0 4,800 3,600 2,400 1,200 0 Note that in 20X0, the asset is fully amortized, thus there is no amortization difference to be accounted for. Also, note that by 20X0, the affect on opening retained earnings has been reduced to zero. The original sale caused a 6,000 net income effect (retained earnings), however, for each of the next 5 years this effect was reversed by the amortization of the asset. Once the asset was fully amortized the retained earnings effect was nil. In the text they talk about the amount of the unrealized gain (loss) (in our example the amount would be a 6,000 unrealized loss) decreasing as the asset is amortized, this is the result the above chart demonstrates. Thus, in our example in year 20X8 (beginning) 3/5 of the loss has been realized and 1/5 will be realized in 20X8. The eliminating entries would be calculated as follows: Retained Earnings (10,000 x 3/5).6 3,600 Deferred income tax (4,000x3/5) 2,400 ACCTG FA4 Module 5 Intercompany Transactions page 7

Accumulated Amortization (10,000 x 3/5) 6,000 Amortization Expense (10,000 x 1/5) 2,000 Deferred income tax 800 Accumulated Amortization 2,000 Income tax expense 800 IMPORTANT: the textbook calculates the unrealized profit on the sale and makes one working entry for this amount. The above journal entries are intended to be used as thinking tools, and do not represent the working paper elimination entries demonstrated in the textbook. Upstream Sale of Amortizable Assets: If the subsidiary is wholly owned by the parent the elimination entries would be exactly the same as the above elimination entries. If the subsidiary is less than 100% owned by the parent, the sale of asset is complicated by non controlling interest. If the Subsidiary is the one selling the asset, the journal entry made by the Subsidiary to record the sale would be: Cash (A/R) Accumulated Amortization Gain on Sale Capital Asset x x x x OR Cash (A/R) Accumulated Amortization Loss on Sale Capital Asset x x x x Once the asset is sold no further amortization would be taken. When a parent company buys an asset the following journal entry is made: Asset Cash (A/P) x x Amortization expense would then be calculated on the asset value over its useful life. From the single entity view point no sale has occurred, and thus we need to eliminate any gain (loss) on the sale recorded by the Subsidiary. However, if non controlling interest is present we must adjust the non controlling interest accounts (I/S + B/S) for the amount of gain (loss) that "belongs" to the minority shareholders. ACCTG FA4 Module 5 Intercompany Transactions page 8

The amortization expense that would be recorded by the parent would be based on the assets sale price not the original cost to the single entity, and thus we need to adjust for the difference. However, non controlling interest comes into play again because through the amortization update process we are realizing the gain (loss) on sale and part of this gain (loss) "belongs" to the minority shareholders. In years subsequent to the sale, retained earnings will be affected for the initial gain (loss) on sale and for the amortization update difference. Example: P acquired 80% of S in 20X1. It is now 20X5. S sold a capital asset with an original cost of $100,000 and accumulated amortization of $30,000 to P for $60,000. The asset will be useful for another 5 years with a residual value of $5,000. The straight line method of amortization is used. The tax rate is 40% for intercompany adjustments. REQUIRED: Give the eliminating journal entries for 20X5 and 20X6. Also, give the consolidated balances for 20X5 and 20X6 for the capital asset and accumulated amortization. 20X5 eliminating entries: 1 Capital Asset 10,000 Income tax expense 4,000 Loss on Sale 10,000 Deferred income tax 4,000 Non Controlling Interest in Earnings 1,200 Non Controlling Interest (B/S) 1,200 (loss - tax) x % non ownership = (10,000-4,000) x 0.20 NOTE THIS ENTRY ASSUMES WE WILL DO AN ENTRY FOR THE NCI SHARE OF TOTAL NI OF THE SUB. THUS IF THE SUB HAD NI OF 10,000 WE WOULD DR NCI I/S FOR 2,000 AND CR NCI B/S 2,000. S company would have recorded a loss of 10,000 on the transaction, but from the single entity view point no sale has occurred and thus we need to cr the loss on sale account. P company would have recorded the asset at 60,000 but from the single entity view point the asset should be on the books at 70,000, thus we have to dr the asset for 10,000. The tax effects of the sale also need to be eliminated. S company would have had tax savings due to the loss in the amount of (10,000 x.40) = 4,000. Thus, we need to dr income tax expense to reverse the effect of the tax savings. Deferred income tax is cr for 4,000 because as time passes the single entity as a whole will realized the 4,000 as tax savings, through the "bump" amount of the amortization for the asset. Non controlling interest is affected by this upstream transaction. As a consolidated entity we have eliminated the entire amount of the loss on the sale and adjusted the asset account by the loss amount. However, we do not own 100% of S and must reflect this fact on the consolidated statements. Thus, by dr the non controlling interest in earnings ACCTG FA4 Module 5 Intercompany Transactions page 9

account (which shows up on the income statement) the net affect will be to report only our share, 80%, of the loss (after tax) amount in the consolidated net income. Another way to look at it is the fact that non controlling interest relates to S's net income and balance sheet figures as calculated by the separate entity. Thus, of the after tax net loss, 6,000, 20% should remain with the non controlling interest. The non controlling interest amount also enters into the balance sheet. 2 Amortization Expense 2,000 Deferred income tax 800 Accumulated Amortization 2,000 Income tax expense 800 Non Controlling Interest (B/S) 240 Non Controlling Interest in Earnings 240 (amortization expense - tax) x % non ownership = (2,000-800)x0.20 For each year the asset is to be amortized, P records (60,000-5,000)/5 = 11,000 of amortization expense. However, from a single entity view point amortization expense should be (100,000-30,000-5,000)/5 = 13,000. Thus, we need to "bump" amortization up by 2,000 and accumulated amortization up for 2,000. This also means that the consolidated tax expense is too high because P's tax expense is based on the subtraction of 11,000 for amortization expense not 13,000. Thus, we need to cr income tax expense for the difference (11,000-13,000).40 = 800. Non controlling interest is affected by this elimination entry because, as a consolidated entity we have recognized part of the unrealized loss (2,000-800), of which 20% "belongs" to the minority shareholders. Consolidated Balances for 20X5 effect of sale of asset only presented: B/S Assets: Asset 100,000 A/A (30,000 + 11,000 +2,000) 43,000 Liabilities: Deferred income tax (4,000-800) 3,200 Non Controlling Interest (1,200-240) 960 ACCTG FA4 Module 5 Intercompany Transactions page 10

20X6 eliminating entries: 1 Capital Asset 10,000 Retained Earnings 6,000 Deferred income tax 4,000 Retained Earnings 1,200 Non Controlling Interest 1,200 This entry eliminates the loss, net of tax, amount from the opening retained earnings of S company, and sets up the Deferred income tax account resulting from the sale. Remember, the elimination entries need to be repeated each year (provided the asset was not sold to a third party) because the entries are not recorded in the "books" of either company. Non controlling interest is cr for its portion of the loss net of tax. Also note, that retained earnings is affected by the amount of loss net of tax that "belongs" to the non controlling shareholders. Remember in the eliminating entry above the cr of 6,000 to retained earnings eliminated 100% of the loss net of tax, thus by dr the retained earnings for 1,200 we have effectively reversed out 80% of the loss net of tax from S's opening retained earnings. 2 Retained Earnings 1,200 Deferred income tax 800 Accumulated Amortization 2,000 Non Controlling Interest 240 Retained Earnings 240 This entry eliminates the effects of last years amortization adjustment. P company recorded only 11,000 of amortization and the consolidated entity should have had 13,000, thus the 2,000 net of 800 taxes, ended up in P's retained earnings, hence the dr to retained earnings for 1,200. The non controlling interest also needs to be adjusted to reflect the amount of loss that was realized last year by the non controlling shareholders. 3 Amortization Expense 2,000 Deferred income tax 800 Accumulated Amortization 2,000 Income tax expense 800 Non Controlling Interest (B/S) 240 Non Controlling Interest in Earnings 240 (amortization expense - tax) x % non ownership = (2,000-800)x0.20 This entry updates the amortization expense, A/A and taxes for the current year. Again, P company expensed 11,000, the consolidated entity should expense 13,000, thus the 2,000 difference needs to be entered as amortization expense. The non controlling shareholders have also now realized another portion of the loss net of tax. ACCTG FA4 Module 5 Intercompany Transactions page 11

Consolidated Balances for 20X6 effect of assets sale only presented: B/S Assets: Asset 100,000 A/A (30,000+11,000+2,000+11,000+2,000) 56,000 Liabilities: Deferred income taxes (4,000-800-800) 2,400 Non Controlling Interest (1,200-240-240) 720 The following chart shows the effects of the intercompany sale from 20X5-20X0: Original Sale 20X5 20X6 20X7 20X8 20X9 20X0 Amortization Expense adjustment (11,000-13,000) 2,000 2,000 2,000 2,000 2,000 0 Loss on Sale 10,000 tax effect (2,000 x.40) net income effect (2,000-800) non controlling interest 20% retained earnings effect (opening) 4,000 800 800 800 800 800 0 6,000 1,200 1,200 1,200 1,200 1,200 0 1,200 240 240 240 240 240 0 0 0 3,840 2,880 1,920 960 0 Note that in 20X0, the asset is fully amortized, thus there is no amortization difference to be accounted for. Also, note that by 20X0, the affect on opening retained earnings has been reduced to zero. The original sale caused a 6,000 net income effect (retained earnings) and a 1,200 effect on non controlling interest, however, for each of the next 5 years this effect was reversed by the amortization of the asset. Once the asset was fully amortized the retained earnings effect was nil. IMPORTANT: The text book uses an aggregate approach to adjust prior year s intercompany/fvi adjustments/retained Earnings/NCI. So the text uses two entries to update the account balance to the current date, one to adjust the retained earnings for all prior year s equity earnings and another to update the AD to current balances. The above elimination entries have been done on a transaction by transaction approach for demonstration purposes (to show the individual transaction consequences on each affected account). ACCTG FA4 Module 5 Intercompany Transactions page 12

Concluding Thoughts and Tips Think about how the intercompany transactions were recorded for each individual company, note the affected accounts for a transaction this will determine which accounts need to be adjusted from a consolidated basis. If you are calculating a figure, such as consolidated net income or opening consolidated retained earnings, think about how the intercompany transactions have affected this item from an individual company perspective and then reverse the effects. 1. Calculation of opening consolidated retained earnings assuming parent used the cost method: P s opening R/E (includes all of P s individual NI and Dividends) Downstream Transactions: Less BI profit, net of tax (need to subtract BI profit because this was EI profit of last year and P s R/E would include this profit) Add BI loss, net of tax (need to add BI loss because this was EI Loss of last year and P s R/E would included this loss) Less Unrealized gain on sale of land or amortizable assets, net of tax (again P s R/E would have included the full amount of the gain from its recording of the original transaction) Add Unrealized loss on sale of land or amortizable assets, net of tax (P s R/E would have included the full amount of the loss from its original transaction) Adjusted open R/E of P Add increase in S s retained earnings since acquisition (the consolidated entity only gets to include the value S has contributed to the consolidated entity since acquisition) Upstream transactions: Less/Add BI profit/loss, net of tax (need to subtract/add BI profit/loss because this was EI profit/loss of last year and S s R/E would include this profit/loss) Less/Add Unrealized gain/loss on sale of land or amortizable assets, net of tax (again S s R/E would have included the full amount of the gain/loss from its recording of the original transaction) Adjusted open R/E AD amortization to Jan 1 of current year % ownership % Consolidated open R/E XX ACCTG FA4 Module 5 Intercompany Transactions page 13

2. If you are calculated consolidated NI, assuming the cost method was used: P s NI Less: dividends received from S (P would have recorded this amount As dividend revenue under the cost method, so we need to Reverse this out) Downstream Transactions: Add/Less: BI profit/loss (P would have recognized the profit/loss last year, but the consolidated entity should recognize it now) Less/add: EI profit/loss (P would have recognized the profit/loss this year, but the consolidated entity should defer recognizing it until next year) Add/less: Realized gain/loss on sale of amortizable assets (this adjusts for The difference in amortization expense between P and S resulting From prior year s intercompany sale of assets) Less/add: Gain/loss on sale of land or amortizable assets if sale occurred in the current year (P would have included this full amount in its NI, but the consolidated entity should show no gain) Adjusted NI of P S s NI Upstream Transactions: Add/less: BI profit/loss (S would have recognized the profit/loss last year but the consolidated entity should recognize it now) Less/add: EI profit/loss (S would have recognized the profit/loss this year but the consolidated entity should defer recognizing it until next year) Add/less: Realized gain/loss on sale of amortizable assets (this adjusts for the difference in amortization expense between P and S resulting from prior year s intercompany sale of assets) Less/add: Gain/loss on sale of land or amortizable assets if sale Occurred in the current year (S would have included this full amount in its NI, but the consolidated entity should show no gain) Adjusted NI of S AD amortization for current year Adjusted NI after AD % ownership % Consolidated NI attributable to P XX NI Attributed to: NCI I/S = adjusted NI of S after AD* x % XX ACCTG FA4 Module 5 Intercompany Transactions page 14

*Will be impacted by FVE or INA methods of NCI recognition. Exclude goodwill items if INA method is used. 3. If you are calculating consolidated line items, like COGS, think about what each individual company would have recorded in these accounts. Example: Assume the following intercompany transaction amounts, all downstream. BI profit = $400 before tax Sales = $5,000 EI profit = $200 before tax Assume P and S reported $10,000 and $6,000 in COGS respectively. Consolidated COGS would be: (remember COGS = BI + purchases EI) P s 10,000 S s 6,000 Less BI profit (S would have included in its calculation of COGS, A BI value that is too high, thus we need to subtract) 400 Less sales amount of $5,000 S would have recorded this Amount as purchases, thereby inflating their COGS) 5,000 Add EI profit (S would have subtracted in its calculation of COGS, An EI value that is too high, thus we need to add) 200 Consolidated COGS 10,800 Note how you are subtracting BI profits, before tax in the COGS calculation, but you would add BI profits, after tax, in calculating consolidated NI. Why??? ACCTG FA4 Module 5 Intercompany Transactions page 15

Textbook Chp 7 Problem 13 (in 000s) Calculation and allocation of acquisition differential Cost of 60% investment in ENS $ 780 Implied value of 100% investment in ENS 1,300 Carrying amount of ENS: Common shares $500 Retained earnings 120 Total shareholders equity 620 Acquisition differential 680 Allocated: (FV CA) Equipment - 30 Internet domain names 100 Land 120 190 Balance goodwill $ 490 Acquisition differential amortization and goodwill impairment schedule (in 000s) Balance Amortization/Impairment Balance Dec. 31, Yr1 Yr2- Yr4 Yr5 Dec. 31, Yr5 Equipment (6 years) $ (30) $ (15) $ (5) $ (10) (a) Internet domain names 100 - - 100 Land 120 - - 120 (b) Goodwill 490 390 25 75 (c) Total $ 680 $ 375 $ 20 $ 285 (d) Intercompany sales and cost of sales Intercompany other revenues and other expenses ($5 x 12) $600 (e) $60 (f) Intercompany inventory profits ENS selling ENS s gross margin % = (3,010 2,107) / 3,010 = 30% ACCTG FA4 Module 5 Intercompany Transactions page 16

Before tax 40% tax After tax Closing inventory (30% x $200) $ 60 $ 24 $ 36 (g) Beginning inventory (30% x $250) $ 75 $ 30 $ 45 (h) Intercompany receivables and payables 150 (i) Intercompany depreciable assets profits RAV selling Before tax 40% tax After tax Proceeds on sale $750 Carrying amount 600 Gain on sale of building, July 1, 2002 150 $60 $90 Realized gain per year (15 years remaining) 10 4 6 (j) Realized gains to December 31, 2005 (3.5 years) 35 14 21 (k) Unrealized gains, December 31, 2005 $ 115 $46 $69 (l) ENS s income ($3,010 $2,107 $120 $432) = $351 (m) (a) Sales (4,220 + 3,010 (e) 600) 6,630 Other revenues (80 + 0 (f) 60) 20 Total revenues 6,650 Cost of goods purchased (2,340 + 2,137 (e) 600) 3,877 Change in inventory (60 30 + (g) 60 (h) 75) 15 Amortization expense (240 + 120 (a) 5 (j) 10) 345 Goodwill impairment (0 + 0 + (c) 25) 25 Income tax and other expenses (960 + 432 (g) 24 + (h) 30 + (j) 4 (f) 60) 1,342 Total expenses 5,604 Consolidated net income $1,046 Attributable to: Shareholders of RAV 910 Non-controlling interest (40% x [(m) 351 (g) 36 + (h) 45 (d) 20]) 136 1,046 ACCTG FA4 Module 5 Intercompany Transactions page 17

(b) Current assets Cash (150 + 75) 225 Accounts receivable (275 + 226 (i) 150) 351 Inventory (594 + 257 (g) 60) 791 Property, plant & equipment Land (600 + 170 + (b) 120) 890 Building net (710 + 585 (l) 115) 1,180 Equipment net (690 + 349 (a) 10) 1,029 Intangible assets Internet domain names 100 Goodwill 75 (c) Subsidiary s retained earnings, beginning of year $279 Unrealized after-tax profit in beginning inventory (h) (45) 234 Subsidiary s common shares 500 734 Unamortized acquisition differential (d) (285 + 20) 305 1,039 NCI s share (40%) $415.6 (d) i) RAV s separate entity income would decrease because it would report dividend income from ENS of $182.4 (60% x $304) instead of investment income of $210. ii) Consolidated net income would remain the same because intercompany dividends and other intercompany transactions are eliminated and only income from outsiders is reported. Income from outsiders remains the same. ACCTG FA4 Module 5 Intercompany Transactions page 18

Textbook Chp 7 Problem 15 Calculation, allocation, and amortization of acquisition differential Champlain NCI (80%) (20%) Cost of 80% investment in Samuel 129,200 Fair value of NCI s Interest in Samuel (14 x 2,000) 28,000 Carrying amounts of Samuel's net assets: Ordinary shares 50,000 Retained earnings 12,000 Total shareholders' equity 62,000 49,600 12,400 Acquisition differential, Jan. 1, Year 1 79,600 15,600 Allocation: FV CA Inventories -18,000-14,400-3,600 Patent 14,000 11,200 2,800 Balance Goodwill 82,800 16,400 Balance Amortization Balance Jan. 1/1 Years 1 to 4 Year 5 Dec. 31/5 Inventories -18,000-18,000 - - Patent 14,000 7,000 1,750 5,250 (a) Subtotal -4,000-11,000 1,750 5,250 Goodwill Champlain s purchase 82,800 34,800 19,200 28,800 (b) - NCI s share 16,400 6,600 3,600 6,200 (c) 95,200 30,400 24,550 40,250 Champlain s share (80% x subtotal + Goodwill) 79,600 26,000 20,600 33,000 (d) NCI s share (20% x subtotal + Goodwill) 15,600 4,400 3,950 7,250 (e) ACCTG FA4 Module 5 Intercompany Transactions page 19

Intercompany profits Before tax 40% tax After tax Opening inventory Samuel selling 1,900 760 1,140 (f) Closing inventory Samuel selling 3,300 1,320 1,980 (g) Equipment Jan. 1/3 Samuel selling 21,000 (h) Depreciation to Dec. 31, Year 4 ([21,000 / 6] 2) 7,000 Balance, Dec. 31, Year 4 14,000 5,600 8,400 (i) Depreciation Year 5 (21,000 6) 3,500 1,400 2,100 (j) Balance, Dec. 31, Year 5 10,500 4,200 6,300 (k) Land Champlain selling 7,000 2,800 4,200 (l) Intercompany revenues and expenses, receivables and payables Sales and purchases 92,000 (m) Receivables and payables 21,000 (n) Dividends receivable and payable (5,500 80%) 4,400 (o) Samuel s accumulated depreciation, date of acquisition 17,000 (p) Deferred income taxes (Dec. 31, Year 5) Inventory (g) 1,320 Equipment (k) 4,200 Land (l) 2,800 8,320 (q) Calculation of consolidated profit Year 5 Profit of Champlain 42,800 Less: Dividends from Samuel (11,000 80%) 8,800 (r) Adjusted profit 34,000 Profit of Samuel 13,000 Add: Opening inventory profit (f) 1,140 Equipment gain realized (j) 2,100 3,240 16,240 Less: Closing inventory profit (g) 1,980 14,260 (s) Less: Amortization of acquisition differential - Champlain s share (d) 20,600 - NCI s share (e) 3,950 24,550 Adjusted profit (10,290) Profit 23,710 ACCTG FA4 Module 5 Intercompany Transactions page 20

Attributable to: Shareholders of Champlain 24,808 NCI (20% x (r) 14,260 (e) 3,950) - 1,098 23,710 (a) (i) Champlain Ltd. Consolidated Income Statement Year 5 Sales (535,400 + 270,000 (m) 92,000) 713,400 Miscellaneous revenue (9,900 (r) 8,800) 1,100 Total revenues 714,500 Cost of sales (364,000 + 206,000 (m) 92,000 + (g) 3,300 (f) 1,900) 479,400 Selling expense (78,400 + 24,100) 102,500 Admin. exp. (including depreciation & goodwill impairment loss) (46,300 + 20,700 + (a) 1,750 + (b) 19,200 + (c) 3,600 (j) 3,500) 88,050 Income taxes (13,800 + 6,200 + (f) 760 (g) 1,320 + (j) 1,400) 20,840 Total expenses 690,790 Profit 23,710 Attributable to: Shareholders of Champlain 24,808 NCI (20% x (s) 14,260 (e) 3,950) - 1,098 23,710 ACCTG FA4 Module 5 Intercompany Transactions page 21

Calculation of consolidated retained earnings Jan. 1, Year 5 Retained earnings of Champlain, Jan. 1/5 45,500 Less: Land profit (l) 4,200 Adjusted retained earnings 41,300 Retained earnings of Samuel, Jan. 1/5 68,000 At acquisition 12,000 Increase 56,000 Less: Inventory profit (f) 1,140 Equipment gain (net) (i) 8,400 9,540 Adjusted increase 46,460 Champlain's ownership % 80% 37,168 Less: Champlain s share of amort. of acquisition differential. (d) (26,000) Consolidated retained earnings, Jan. 1, Year 5 52,468 (a) (ii) Champlain Ltd. Consolidated Retained Earnings Statement Year 5 Retained earnings, Jan. 1, Year 5 52,468 Add: profit 24,808 77,276 Less: dividends 20,000 Retained earnings, Dec. 31, Year 5 57,276 Calculation of non-controlling interest Dec. 31, Year 5 Ordinary shares 50,000 Retained earnings (68,000 + 13,000 11,000) 70,000 Total shareholders' equity, Dec. 31, Year 5 120,000 Less: Inventory profit (g) 1,980 Equipment gain (k) 6,300 8,280 Adjusted shareholders' equity 117,720 Non-controlling interest s share 20% 22,344 Add: NCI s share of unamortized acquisition differential (e) 7,250 Non-controlling interest, Dec. 31, Year 5 29,594 ACCTG FA4 Module 5 Intercompany Transactions page 22

(a) (iii) Champlain Ltd. Consolidated Statement of Financial Position December 31, Year 5 Property, plant, and equipment (198,000+104,000 (l) 7,000 (h) 21,000 (p) 17,000) 257,000) Accumulated depreciation (86,000 + 30,000 10,500* (p) 17,000) (88,500) Patent (a) 5,250) Goodwill (b & c) 35,000) Deferred income taxes (q) 8,320) Inventories (35,000 + 46,000 (g) 3,300) 77,700) Accounts receivable (60,000 + 55,000 (n) 21,000 (o) 4,400) 89,600) Cash (18,100 + 20,600) 38,700) Total assets 423,070) Ordinary shares 225,000) Retained earnings 57,276) Non-controlling interest 29,594) Dividends payable (5,000 + 5,500 (o) 4,400) 6,100) Accounts payable (56,000 + 70,100 (n) 21,000) 105,100) Total liabilities and shareholders equity 423,070) * 7,000 + (j) 3,500 = 10,500 (b)when the gain on the sale of the equipment is eliminated on consolidation, the equipment is restated to its carrying value on Champlain s books prior to the intercompany sale. The carrying value represents Champlain s original cost less accumulated amortization based on the historical cost. After the consolidation adjustment, the equipment is reported at the historical cost to the consolidated entity net of accumulated amortization. (c) The return on equity attributable to the shareholders of Samuel would not change because the parent company extension theory only affects values used for non-controlling interests. (d) Goodwill under entity theory 35,000 Less: NCI s share 6,200 Goodwill under parent company extension theory 28,800 NCI on statement of financial position under entity theory 29,594 Less: NCI s share of goodwill (20%) 6,200 NCI on statement of financial position under parent company extension theory 23,394 ACCTG FA4 Module 5 Intercompany Transactions page 23

Chapter 7 Problem 17 Calculation, allocation, and amortization of acquisition differential Cost of 70% investment in Dandy 7,000 Implied value of 100% 10,000 Carrying amounts of Dandy s net assets: Common shares 250 Retained earnings 4,500 Total shareholders' equity 4,750 Acquisition differential, Jan. 1, Year 1 5,250 Allocation: FV CA Inventory 100 Equipment 500 600 Balance Goodwill 4,650 Amortization Balance Balance Jan. 1/1 Years 1 to 5 Year 6 Dec. 31/6 Inventory 100 100 - - Equipment (10 year life) 500 250 50 200 (a) Goodwill 4,650 3,550 70 1,030 (b) 5,250 3,900 120 1,230 (c) Intercompany profits Before tax 40% tax After tax Opening inventory Dandy selling (2,000 x 40%) 800 320 480 (d) Closing inventory Dandy selling (2,500 x 40%) 1,000 400 600(e) Equipment Jan. 1/2 Handy selling 200 (f) Depreciation to Dec. 31, Year 5 ([200 / 8] 4) 100 Balance, Dec. 31, Year 5 100 40 60(g) Depreciation Year 6 (200 8) 25 10 15(h) Balance, Dec. 31, Year 6 75 30 45(i) ACCTG FA4 Module 5 Intercompany Transactions page 24

Intercompany revenues and expenses, receivables and payables Sales and purchases Consulting revenues and expenses (50 x 12) 5,000(j) 600(k) Deferred income taxes (Dec. 31, Year 6) Inventory (e) 400 Equipment (i) 30 430(l) Calculation of consolidated net income Year 6 Income of Handy 1,760 Less: Dividends from Dandy (800 70%) (m) 560 1,200 Add: Realized gain on equipment (h) 15 Adjusted net income 1,215 Income of Dandy 1,020 Add: Opening inventory profit (d) 480 Less: Amortization of acquisition differential (c) (120) Closing inventory profit (e) (600) Adjusted net income 780 Consolidated net income 1,995 Attributable to: Shareholders of Handy 1,761 NCI (30% x 780) 234 1,995 ACCTG FA4 Module 5 Intercompany Transactions page 25

(a) Handy Company Consolidated Income Statement Year 6 Sales (21,900 + 7,440 (j) 5,000) 24,340 Cost of sales (14,800 + 3,280 (j) 5,000 + (e) 1,000 (d) 800) 13,280 Gross profit 11,060 Other revenue (1,620 + 0 (m) 560 (k) 600) 460 Selling & admin expense (840 + 420 + (a) 50 (h) 25) (1,285) Other expenses (5,320 + 2,040 + (b) 70 (k) 600) (6,830) Income before income taxes 3,405 Income tax expense (800 + 680 + (d) 320 (e) 400 + (h) 10) 1,410 Net income 1,995 Attributable to: Shareholders of Handy 1,761 NCI (30% x 780) 234 (b) Calculation of consolidated retained earnings Jan. 1, Year 6 Handy s retained earnings 10,420 Unrealized gain on sale of equipment net of tax (g) (60) Subtotal 10,360 Dandy s retained earnings, beginning of Year 6 $5,180 Dandy s retained earnings, at acquisition 4,500 Change in retained earnings since acquisition 680 Cumulative differential amortization and impairment (c)(3,900) Profit in beginning inventory net of tax (d) (480) -3,700 Handy s share @ 70% - 2,590 Consolidated retained earnings 7,770 1,995 ACCTG FA4 Module 5 Intercompany Transactions page 26

Handy Company Consolidated Statement of Retained Earnings For the year ended December 31, Year 6 Retained earnings, beginning of year 7,770 Net income 1,761 9,531 Dividends paid (1,600) Retained earnings, end of year 7,931 (c) When unrealized profit is eliminated from the carrying value of the equipment, the equipment ends up being reported at the original cost of the equipment less accumulated amortization based on the original cost, as if the intercompany transaction had never taken place. So, in effect, the equipment is reported at its historical cost. (d) Goodwill impairment loss under entity theory 70 Less: NCI s share (30%) 21 Goodwill impairment loss under parent company extension theory 49 NCI on income statement under entity theory 234 Add: NCI s share of goodwill impairment (30%) 21 NCI on income statement under parent company extension theory 255 ACCTG FA4 Module 5 Intercompany Transactions page 27