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CHAPTER 7:
(A)
Intercompany
Profits in
Depreciable
Assets (B)
Intercompany
Bondholdings
Prepared by
Shannon Butler, CPA,
Carleton University
Learning Objectives
LO1 Prepare consolidated financial statements that reflect the
elimination and subsequent realization of upstream and
downstream intercompany profits in depreciable assets.
LO2 Explain how the historical cost principle supports the
elimination of unrealized profits resulting from
intercompany
transactions when preparing consolidated
financial
statements.
LO3 Prepare the journal entries under the equity method to
reflect the elimination and subsequent realization of the
intercompany profits in depreciable assets.
LO4 Analyze and interpret financial statements with
intercompany transactions involving depreciable assets.
2
Learning Objectives
LO5 Calculate the gain or loss that results from the
elimination of intercompany bondholdings and the
allocation of such gain or loss to the equities of the
controlling and non-controlling interests.
LO6 Explain how recognition of gains on the elimination of
intercompany bondholdings is consistent with the
principle of recording gains only when they are realized.
LO7 Prepare consolidated financial statements that reflect
the gains or losses that are the result of intercompany
bondholdings.
LO8 (Appendix 7A) Prepare consolidated financial
statements when depreciable assets are remeasured to fair
value each period.
3
Intercompany Profits in
Depreciable Assets
LO1
Intercompany Profits in
Depreciable Assets
LO1, LO2
Intercompany Profits in
Depreciable Assets
LO1, LO2
Intercompany Profits in
Depreciable Assets
LO1, LO2
Intercompany Profits in
Depreciable Assets
LO2
Intercompany Profits in
Depreciable Assets
LO2
Intercompany Profits in
Depreciable Assets
LO1, LO2
Income tax
All intercompany unrealized gains or losses affect net
earnings net of tax
Deferred income tax (on the balance sheet) is computed on
the outstanding balance of the unrealized gain or loss at
the
balance sheet date.
Example of Depreciable
Asset Transfer
LO1, LO3
Example:
Parent purchased equipment from an unrelated party for a
cost of $1,000
Parent pays income tax for $200 (40%) on the $500 gain
that is unrealized for consolidated financial statement
purposes
11
Example of Depreciable
Asset Transfer
LO1, LO3
Description
Cash
Income tax expense
Debit
Credit
1,500
200
Income Tax
Payable
200
Equipment
1,000
Gain
500
12
Example of Depreciable
Asset Transfer
LO1, LO3
200
200
$300
13
Example of Depreciable
Asset Transfer
LO1, LO3
Description
Debit
Credit
Equipment
1,500
Cash
1,500
31-Dec
Depreciation Expense
150
Accumulated Depreciation
150
14
Example of Depreciable
Asset Transfer
15
Example of Depreciable
Asset Transfer
LO1, LO3
$20
16
Example of Depreciable
Asset Transfer
LO1, LO3
In each of the following years, until either the equipment is fully depreciated or
the subsidiary sells it, two consolidation elimination entries are required on the
consolidation worksheet
The first entry records the cumulative effect of adjustments made in prior
years as follows:
Accumulated Depreciation $xxx
Deferred income tax
xxx
Retained earnings
xxx
Equipment $500
The second entry adjusts for the excess depreciation for that particular year as
follows:
Accumulated Depreciation $50
Income tax expense
20
Depreciation expense 50
Deferred income tax
20
If the parent uses the equity method account for the subsidiary, the following
journal entry would be recorded in the parents general ledger each year:
Investment in Subsidiary $30
Investment Income
$30
17
Example of Depreciable
Asset Transfer
LO1, LO3
18
Example of Depreciable
Asset Transfer
LO1, LO2
associated
income taxes paid deferred
The asset must be adjusted to its historical cost
Depreciation is restated so that it is based on original cost,
and associated income taxes are recorded
Accumulated depreciation restated so that it is based on
original cost
Retained earnings is adjusted for the cumulative after-tax
effect of the unrealized gain or loss (i.e. gain or loss less
incremental depreciation to date)
19
Intercompany Profits in
Depreciation Assets
LO3
20
Intercompany Profits in
Depreciation Assets
LO3
Investment in Subsidiary
Original Cost
Income Earned
Dividends Received
A.D. Amortization
Accumulated
Depreciation
Unrealized Gains
Balance
21
Intercompany Profits in
Depreciation Assets
LO3
Accumulated
Balance
22
LO4
23
LO5
Intercompany Bondholdings
When we discuss intercompany profits, we are generally
concerned with eliminating profits recorded by individual
companies, but unrealized by the group
24
LO5
Intercompany Bondholdings
In the typical case, bonds are issued by a company into the
open market, or are placed privately with an unrelated entity
such as an insurance company or pension plan
25
LO5
Intercompany Bondholdings
When this occurs, the company which has purchased the
bond reports investment in bonds as an asset on it separateentity balance sheet.
LO5, LO6
Intercompany Bondholdings
The gain or loss on the effective retirement of bonds must
be
recognized in the consolidated statements, not on the
simple-entity statements
LO6
Intercompany Bondholdings
A difference arises with the elimination of the premium/
discount amortization when the bond was purchased by the
related company in the open market at a value different from
the original issue price
Amortization can be straight-line, or based on the effectiveyield method by calculating the present value of future cash
flows using the current market discount rate.
28
LO6
Intercompany Bondholdings
- Example
Example: Parent owns 100% of subsidiary. On January 1,
subsidiary pay $9,800 on the open market to purchase
$10,000 of bonds that were originally issued by Parent for
$10,000 (i.e. no issuing premium/discount). Bonds pay
interest at 10% annually and mature in 4 years.
29
LO6
Intercompany Bondholdings
- Example
The following adjustments are required on the
consolidation worksheet to:
(i) eliminate the intercompany bonds and record the gain
on retirement;
(ii) match the gain recognized to related income tax
expense; and
(iii) eliminate the intercompany interest net of income tax.
$80
$80
30
LO6
Intercompany Bondholdings
- Example
Consolidation adjusting entries December 31:
Parent has recorded $1,000 interest expense and
subsidiary has recorded $1,000 interest income + $50
discount amortization.
Net pre-tax income = $1,050 - $1,000 = $50 x 40% tax
rate = $20 income tax paid.
Subsidiarys books reflect bond investment as $9,800
paid + $50 amortization = $9,850 of which $ 9,800 was
eliminated on January 1, see consolidation adjusting
entry:
Interest Income $1,050
Deferred income tax
Interest expense $1,000
Income tax expense
20
Investment in bonds
50
20
31
LO7
LO7
33
Effective-Yield Method of
Amortization
LO5
34
Effective-Yield Method of
Amortization
Period
Year
Year
Year
Year
Year
Year
1
3
0
1
2
3
4
5
Interest
paid
$10,0001
10,000
10,000
10,000
10,000
Amortization
Interest
of bond
expense
premium
$11,1352
11,271
11,424
11,594
11,785
$ 92,791
$1,1353
1,271
1,424
1,594
1,785
2
LO5
Amortized
cost of
bonds
$ 93,9264
$ 95,197
96,621
98,215
100,000
35
Effective-Yield Method of
Amortization
LO5
36
Effective-Yield Method of
Amortization
LO5
Interest
received
Amortization
Amortized
Interest
of bond
cost of
revenue
premium
bonds
Year
Year
Year
Year
1
3
2
3
4
5
$105,154
1,5883
1,715
1,851
$10,0001
$8,4122
10,000
8,285
10,000
8,149
103,5664
101,851
100,000
$105,154 x 8% = $8,412
4 $105,154 - $1,588 = $103,566
2
37
Effective-Yield Method of
Amortization
LO5
38
LO8