1398450121-433617

Chapter 07 - Intercompany Transfers of Services and Noncurrent Assets

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CHAPTER 7

INTERCOMPANY TRANSFERS OF SERVICES AND NONCURRENT ASSETS

ANSWERS TO QUESTIONS

Q7-1 Profits on intercorporate sales generally are considered to be realized when the affiliate that has purchased the item sells it to a nonaffiliate. For depreciable or amortizable items that are used by the affiliate in its operations, profits are considered to be realized as the purchaser depreciates or amortizes the asset.

Q7-2 An upstream sale occurs when a subsidiary sells an item to the parent company. If the asset is not resold before the end of the period, the parent is the company holding the asset and any unrealized profits are recorded on the books of the subsidiary.

Q7-3 If the purchaser records the services received as an expense, both revenues and expenses will be overstated in the consolidated income statement in the period in which the intercorporate services are provided. In the event the services are capitalized by the purchaser, the cost of the asset will be overstated, depreciation expense and accumulated depreciation will be overstated if the services are assigned to a depreciable asset, and service revenue will be overstated.

Q7-4 (a) Unrealized profit on an intercorporate sale generally is included in the reported net income of the seller.

(b) All unrealized profit on current-period intercorporate sales must be excluded from consolidated net income until realized through resale to a nonaffiliate.

Q7-5 Profits on intercompany sales are included in consolidated net income in the period in which the items are sold to a nonaffiliate. If there are unrealized profits on the books of one of the companies at the start of the period and the item is sold to a nonaffiliate during the current period, the intercompany profit is included in the computation of consolidated net income for the current period.

Q7-6 The profits continue to be unrealized in this case and therefore must be eliminated from both the beginning and ending asset and retained earnings balances when consolidated statements are prepared. There should be no income statement effect for the current period.

Q7-7 A downstream sale is a sale from the parent to one of its subsidiaries. If the asset is not resold before the end of the period, the subsidiary is the company holding the asset at year-end and any unrealized profits are recorded on the books of the parent company.

Q7-8 The entire balance of unrealized profits is eliminated in all cases. While the direction of the sale will affect the allocation of unrealized profits between companies, it does not change the total amount of profit eliminated.

Q7-9 Consolidated net income is reduced by the amount of unrealized profits assigned to the shareholders of the parent company. When a downstream sale occurs, all the profit is on the parent's books and consolidated net income is reduced by the full amount of any unrealized profit. On the other hand, when an upstream sale occurs, all the intercorporate profit is recorded on the books of the subsidiary and the amount of income assigned to both the parent company shareholders and the noncontrolling shareholders is reduced by a proportionate amount of any unrealized profit.


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Q7-10 The amount of intercorporate profit realized in the current period from prior years' sales to the parent is added to the reported net income of the subsidiary in computing income assigned to the noncontrolling interest.

Q7-11 Income assigned to noncontrolling interest for the current period will be less than a proportionate share of the reported net income of the subsidiary. In determining the amount of income to be assigned to the noncontrolling interest in the consolidated income statement, the net income reported by the subsidiary must be adjusted to exclude any unrealized gain recorded during the period on the sale of depreciable assets to the parent. On the other hand, if an unrealized loss had been recorded, the basis used in assigning income to the noncontrolling interest would be greater than the reported net income of the subsidiary. Such adjustments must be made to assure that the income assigned to noncontrolling interest is based on the contribution of the subsidiary to consolidated net income rather than the amount the subsidiary may have reported as net income.

Q7-12 All other factors being equal, the income assigned to noncontrolling interest will be larger if the sale occurs at the start of the current period. Some part of the gain will be considered realized in the current period as the parent depreciates the asset if the sale occurs before year-end. None of the gain will be considered realized in the period of transfer if the sale occurs at year-end.

Q7-13 As in all other cases, income from the subsidiary recorded on the parent's books must be eliminated in preparing the consolidated income statement and an appropriate amount of subsidiary net income must be assigned to the noncontrolling interest if the parent owns less than 100 percent of the subsidiary's stock. The gain recorded on the parent's books also must be eliminated.

Q7-14 Depreciation expense recorded by the subsidiary is overstated from the viewpoint of the consolidated entity when the subsidiary pays the parent more than book value for the asset at the start of the period. As a result, an eliminating entry is needed to reduce depreciation expense and accumulated depreciation by the amount of excess depreciation recorded during 20X3.

Q7-15 Following an intercorporate sale of a depreciable asset, the eliminating entries should adjust the balance in the asset account to reflect the original purchase price to the first owner and accumulated depreciation should be adjusted to reflect the balance that would be reported if the asset were still held by the first owner. In the case of an intercorporate sale of an intangible asset, only the unamortized balance normally is reported and an eliminating entry is needed to adjust the carrying value to that which would be reported if the asset were still held by the first owner.

Q7-16 Profit on an intercorporate sale of land is considered realized at the time the purchaser sells the land to a nonaffiliate. Profit on equipment normally is considered realized as the asset is used and depreciated on the books of the purchaser. Equipment typically is considered to be used up in the production process and therefore is charged to expense over its remaining economic life, while land is not.

Q7-17 A portion of the profit is considered realized each period as the asset is depreciated by the purchaser. Thus, the net amount considered unrealized decreases each period and a smaller debit to beginning retained earnings is needed.


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Q7-18A The balance in the investment account will depend on which method the parent uses to account for its investment in the subsidiary. If the parent uses (a) the cost method or (b) the modified equity method, no adjustments are made on the parent company's books for unrealized intercompany profits and the balance in the investment account will be the same as if there were no unrealized profits. If the parent uses (c) the fully-adjusted equity method, the balance in the investment account will be reduced by the full amount of the unrealized profit when the profit is on the parent's books and by a proportionate share of the unrealized profit when it is on the subsidiary's books.

SOLUTIONS TO CASES

C7-1 Correction of Elimination Procedures

MEMO

To: Controller Plug Corporation

From: , CPA

Re: Elimination of Intercompany Profit on Equipment

This memo is in response to our review of the elimination procedures used in preparing the consolidated statements for Plug Corporation at December 31, 20X2. You have correctly identified the need to eliminate the effects of the intercorporate sale of equipment. In preparing your consolidated statements, all intercompany balances and transactions should be eliminated. [ARB 51, Par. 6; ASC 810]

Your eliminating entry recorded at December 31, 20X2, was:

Equipment 150,000

Loss on Sale of Equipment

150,000

This entry correctly eliminates the $150,000 loss recorded by Coy January 1, 20X2, on the sale of equipment to Plug and adds $150,000 to the equipment account. By adding back $150,000 to equipment, the balance is adjusted to $1,000,000 ($850,000 + $150,000). This represents the carrying value of the equipment on Coys books at the time of sale but does not reflect the purchase price paid by Coy ($1,200,000) or the accumulated depreciation at the time of sale ($200,000). Moreover, the eliminating entry above understates depreciation expense for the year. The correct eliminating entry at December 31, 20X2, is:

Equipment 350,000

Depreciation Expense 15,000

Accumulated Depreciation

215,000

Loss on Sale of Equipment

150,000

A debit of $350,000 to equipment is required to raise the balance from $850,000 recorded by Plug to $1,200,000, the initial purchase price to the consolidated entity. Depreciation expense must be increased by $15,000 from $85,000 ($850,000/10 years) recorded by Plug to $100,000 ($1,200,000/12 years) based on the initial purchase price. Accumulated depreciation must be credited by $215,000 to adjust from the $85,000 [($85,000/10 years) x 1 year] reported by Plug to $300,000 [($1,200,000/12 years) x 3 years]. As previously noted, the $150,000 loss recorded


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by Coy must be eliminated. If the amounts included in second eliminating entry are omitted, consolidated net income for 20X2 and the retained earnings balance at December 31, 20X2, will be overstated and the balances for equipment and accumulated depreciation will be understated.

Primary citation: ARB 51, Par. 6; ASC 810

C7-2 Elimination of Intercorporate Services

MEMO

To: Chief Accountant Dream Corporation

From: , CPA

Re: Elimination of Legal Services Provided by Parent Company

This memo is in response to our discussion regarding the elimination of intercompany services in preparing consolidated financial statements for Dream Corporation. It is my understanding that at present Dream Corporation does not eliminate such services. In preparing consolidated financial statements all intercompany balances and transactions should be eliminated. [ARB 51, Par. 6; ASC 810]

The legal services provided by Dream Corporation to Classic Company and Plain Company are intercompany transactions that should be eliminated. If the revenues recorded by the parent are equal to the expenses recorded by the subsidiaries and both are properly recorded, elimination of these transactions will have no impact on reported net income but will reduce consolidated revenues and expenses by equal amounts. Financial statement readers will receive a more accurate picture of operations of the consolidated entity if the appropriate amounts are reported. The legal services provided to Classic Company in 20X3 should be eliminated with the following entry:

Legal Services Revenue 80,000

Legal Services Expense

80,000

The information on intercorporate services provided to Plain Company indicates that an additional adjustment is needed in the consolidation process. Although Plain Company recorded its $150,000 payment to the parent as a legal expense, it should have been recorded as an investment in land to be used in future development of its strip mine. This error should be corrected on the books of Plain Company. If it is not, the eliminating entry prepared at December 31, 20X3, should include an adjustment to reflect the appropriate investment in land and would be recorded as:


Land 100,000

Legal Services Expense

150,000

Wage and Salary Expense

100,000


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Care must be taken to capitalize only the cost of legal services in this case. The eliminating entry should contain a debit of $100,000 ($150,000/1.50) to land since Dream Corporation bills its services to the subsidiaries at 150 percent of the cost of services provided. Had Plain Company debited land for its $150,000 payment to Dream, the eliminating entry at December 31, 20X3, would have been:


Land

50,000

Wage and Salary Expense

100,000

C7-2 (continued)

No eliminating entry would be required at December 31, 20X4, on the legal services provided to Classic Company in 20X3. The conditions of the intercorporate transfer of services to Plain Company require an eliminating entry at December 31, 20X4, and in following years, as long as Plain Company owns the strip mine. The entry at December 31, 20X4, would be:

Land 100,000

Investment in Plain

100,000

Had Plain Company debited land for its $150,000 payment to Dream in 20X3, the eliminating entry at December 31, 20X4, would require a $50,000 debit to Investment in Plain and a $50,000 credit to land.

Primary citation: ARB 51, Par. 6; ASC 810

C7-3 Noncontrolling Interest

a. When there are no unrealized profits on the subsidiary's books, a pro rata portion of the reported net income of the subsidiary is assigned to the noncontrolling interest, adjusted for the noncontrolling interests share of any amortization or write-off of differential.

b. When there are no unrealized profits on the subsidiary's books, the noncontrolling interest is reported in the consolidated balance sheet at an amount equal to a pro rata portion of the book value of the net assets of the subsidiary plus the noncontrolling interests share of any remaining differential.

c. The effect of unrealized intercompany profits depends on which company has recorded the profits. Those recorded on the books of the parent do not affect the income assigned to the noncontrolling interest. When subsidiary net income includes unrealized intercompany profits, the portion of consolidated net income assigned to the noncontrolling interest is reduced by its portion of the unrealized profit in the period of the intercorporate sale.

(1) On a sale of land, the intercompany profit remains unrealized until the land is sold to a nonaffiliate. When the land is resold, the profit is added to the reported net income of the subsidiary in computing the portion of consolidated net income assigned to the noncontrolling interest.

(2) On an intercorporate sale of a depreciable asset, a portion of the intercompany profit is


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considered realized each period as the purchaser depreciates the asset. Thus, in the period of the intercorporate sale, the adjustment to subsidiary net income for unrealized profits is based on the gain or loss less any portion considered realized before the end of the period. Each period thereafter, a portion of the profit or loss is considered realized and treated as an adjustment to subsidiary income in determining the portion of consolidated net income assigned to the noncontrolling interest.

d. Noncontrolling shareholders of a subsidiary generally will not gain a great deal of useful information from the consolidated financial statements. Their primary focus must continue to be on the income, assets, and liabilities of the subsidiary in which they hold direct ownership. In the event there are a number of transactions with the parent or other affiliates, the success of the operations of the entire economic entity may provide information useful to the noncontrolling shareholders. Debt guarantees or other assurances by the parent may also lead to an examination of the parent company and consolidated statements.

C7-4 Intercompany Sale of Services

a. When preparing consolidated financial statements, Schwartz's revenue from the sale of services to Diamond and Diamond's expenses associated with the services acquired from Schwartz must be eliminated. The expenses related to the janitorial and maintenance activities that will be reported in the consolidated income statement will be the actual salary and associated costs incurred by Schwartz to provide the services to Diamond. The eliminations have no effect on consolidated net income because revenues and expenses of equal amount are eliminated in the preparation of the consolidated financial statements.

b. Intercompany profits from the sale of services to an affiliate normally are considered realized at the time the services are provided. Realization of intercompany profits on services normally is considered to occur as the services are consumed, and services such as maintenance and repair services normally are considered to be consumed by the purchasing affiliate at the time received.

C7-5 Intercompany Profits

Answers can be found in the companies' 10-K filings with the SEC and in their annual reports. Note that financial statements are often included in the Form 10-K by reference to the companys annual report. In such cases, the financial statements are often shown in a separate exhibit rather than in Item 8 of the Form 10-K.

a. Verizon (www.verizon.com) eliminates all intercompany profits. It discontinued the use of regulatory accounting as provided by FASB 71 in 1994 and now no longer applies the provisions of FASB 71.

b. All of Harley-Davidsons (www.harleydavidson.com) intercompany transactions are eliminated except some occurring between the Motorcycles and Financial Services segments. Some interest and fees recognized as income by Financial Services and expense by Motorcycles are not eliminated. This leads to higher finance income and higher expenses, but net income is unaffected.
http://www.verizon.comhttp://www.harleydavidson.com


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SOLUTIONS TO EXERCISES

E7-1 Multiple-Choice Questions on Intercompany Transfers [AICPA Adapted]

1. c

2. d

3. b

4. a

5. b Depreciation expense recorded by Pirn $40,000

Depreciation expense recorded by Scroll 10,000

Total depreciation reported $50,000

Adjustment for excess depreciation charged

by Scroll as a result of increase in

carrying value of equipment due to gain

on intercompany sale ($12,000 / 4 years) (3,000)

Depreciation for consolidated statements $47,000

E7-2 Multiple-Choice Questions on Intercompany Transactions

1. d When only retained earnings is debited, and not the noncontrolling interest, a gain has been recorded in a prior period on the parent's books.

2. a The costs incurred by Bottom to develop the equipment are research and development costs and must be expensed as they are incurred (FASB Statement No. 2, par. 12; ASC 730-10-25-1). Transfer to another legal entity does not cause a change in accounting treatment within the economic entity.

3. b The $39,000 paid to Gold Company will be charged to depreciation expense by Top Corporation over the remaining 3 years of ownership. As a result, Top Corporation will debit depreciation expense for $13,000 each year. Gold Company had charged $16,000 to accumulated depreciation in 2 years, for an annual rate of $8,000. Depreciation expense therefore must be reduced by $5,000 ($13,000 - $8,000) in preparing the consolidated statements.

4. a TLK Corporation will record the purchase at $39,000, the amount it paid. Gold Company had the equipment recorded at $40,000; thus, a debit of $1,000 will raise the equipment balance back to its original cost from the viewpoint of the consolidated entity.


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E7-2 (continued)

5. b Reported net income of Gold Company

$ 45,000

Reported gain on sale of equipment $15,000

Intercompany profit realized in 20X6 (5,000)

(10,000)

Realized net income of Gold Company

$ 35,000

Proportion of stock held by

noncontrolling interest

x .40

Income assigned to noncontrolling interests $ 14,000

6. c Operating income reported by Top Corporation $ 85,000

Net income reported by Gold Company 45,000

$130,000

Less: Unrealized gain on sale of equipment

($15,000 - $5,000) (10,000)

Consolidated net income $120,000

E7-3 Elimination Entries for Land Transfer

a. Eliminating entry, December 31, 20X4:

Gain on Sale of Land 10,000

Land

10,000

Eliminating entry, December 31, 20X5:

Investment in Lowly 10,000

Land

10,000

b. Eliminating entry, December 31, 20X4:


Land

10,000


Investment in Lowly 6,000

NCI in NA of Lowly 4,000

Land

10,000


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E7-4 Intercompany Services

a. Consolidated net income will not change.

b. One hundred percent of the intercompany services must always be eliminated. Thus, a change in the level of ownership of the subsidiary will not have an impact on the amount eliminated or on consolidated net income.

c. $38,000 = $70,000 - $32,000

E7-5 Elimination Entries for Intercompany Services

Two eliminating entries are required:

Delivery Service Revenue 76,000

Delivery Service Expense

76,000

Accounts Payable 18,000

Accounts Receivable

18,000

E7-6 Elimination Entries for Depreciable Asset Transfer: Year-End Sale a.

Accumulated Truck

Depreciation Northern

40,000

Actual

0

5,000

15,000

Pam

45,000

"As If" 15,000

Eliminate the gain on Truck & correct asset's basis: Gain on sale

10,000

Truck

5,000


15,000

b. Accumulated

Truck

Depreciation Northern

40,000

Actual

4,000

5,000

1,000

15,000

Pam

45,000

"As If"

18,000

Eliminate the gain on Truck & correct asset's basis:

Investment in Northern

10,000

Truck

5,000


15,000


1,000

Depreciation Expense

1,000


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E7-7 Transfer of Land

a. Eliminating entry, December 31, 20X2:


Land

45,000


Investment in Roan 31,500

NCI in NA of Roan 13,500

Land

45,000

b. Eliminating entries, December 31, 20X3 and 20X4:

Investment in Roan 30,000

Land

30,000

E7-8 Transfer of Depreciable Asset at Year-End a.

Truck


Minnow Corp.

210,000

Actual

0

90,000

120,000

Frazer Corp.

300,000

"As If"

120,000

Eliminate the gain on Truck & correct asset's basis: Gain on sale

30,000

Truck

90,000


120,000

Computation of gain on sale of truck:

Price paid by Minnow $210,000

Cost of truck to Frazer $300,000

Accumulated depreciation

($300,000 / 10 years) x 4 years (120,000) (180,000)

Gain on sale of truck $ 30,000


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E7-8 (continued)

b.

Truck


Minnow Corp.

210,000

Actual

35,000

90,000

5,000

120,000

Frazer Corp.

300,000

"As If"

150,000

Eliminate the gain on Truck & correct asset's basis: Investment in Minnow Corp.

30,000

Truck

90,000


120,000


5,000


5,000

E7-9 Transfer of Depreciable Asset at Beginning of Year

a.

Truck


Minnow Corp.

245,000

Actual

35,000

55,000

5,000

90,000

Frazer Corp.

300,000

"As If"

120,000


Gain on Sale

35,000

Truck

55,000


90,000


5,000


5,000

Computation of gain on sale of truck:

Price paid by Minnow $245,000

Cost of truck to Frazer $300,000

Accumulated depreciation

($300,000 / 10 years) x 3 years ( 90,000) (210,000)

Gain on sale of truck $ 35,000


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E7-9 (continued) b.

Truck


Minnow Corp.

245,000

Actual

70,000

55,000

5,000

85,000

Frazer Corp.

300,000

"As If"

150,000


Investment in Minnow Corp.

30,000

Truck

55,000


85,000


5,000


5,000

E7-10 Sale of Equipment to Subsidiary in Current Period

a. Cash

84,000


80,000

Equipment

150,000

Gain on sale of Equipment

14,000

Record gain on Equipment

b.

Equipment 84,000

Cash

84,000

Journal entry to record purchase

Depreciation Expense 12,000


12,000

Journal entry to record depreciation expense


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E7-10 (continued) c.

Equipment


Lance Corp.

84,000

Actual

12,000

66,000

2,000

80,000

Wainwrite Corp.

150,000

"As If"

90,000

Eliminate the gain on Equipment & correct asset's basis: Gain on sale

14,000

Equipment

66,000


80,000


2,000


2,000

d. Eliminating entry at January 1, 20X8, to eliminate intercompany sale of equipment and prepare a consolidated balance sheet only:

Eliminate the gain on Equipment & correct asset's basis: Investment in Lance Corp.

12,000

Equipment

66,000


78,000

E7-11 Upstream Sale of Equipment in Prior Period

a. Consolidated net income for 20X8:

Operating income reported by Baywatch

$100,000

Net income reported by Tubberware $40,000

Amount of gain realized in 20X8

($30,000 / 12 years) 2,500

Realized net income of Tubberware

42,500

Consolidated net income

$142,500

b. Consolidated net income for 20X8 would be unchanged.


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E7-11 (continued) c.

Equipment


Baywatch

270,000

Actual

67,500

30,000

2,500

55,000

Tubberware

300,000

"As If"

120,000

Eliminate the gain on Equipment & correct asset's basis: Investment in Tubberware

20,000

NCI in NA of Tubberware

5,000

Equipment

30,000


55,000


2,500


2,500

E7-12 Elimination Entries for Midyear Depreciable Asset Transfer a.

Equipment


Andrews Co.

28,000

Actual

4,000

2,000

1,500

12,500

Kline Corp.

30,000

"As If"

15,000

Eliminate the gain on Equipment & correct asset's basis: Investment in Andrews Co.

10,500

Equipment

2,000


12,500


1,500


1,500

b.

Equipment


Andrews Co.

28,000

Actual

12,000

2,000

3,000

11,000

Kline Corp.

30,000

"As If"

20,000

Eliminate the gain on Equipment & correct asset's basis: Investment in Andrews Co.

9,000

Equipment

2,000


11,000


3,000


3,000

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