Ch 5 AA Consolidated Financial Statements—Intra-Entity Asset Transactions: Questions

1. Intra-entity transfers between the component companies of a business combination are quite common. Why do these intra-entity transactions occur so frequently?

1. One reason for the significant volume and frequency of intra-entity transfers is that many business combinations are specifically organized so that the companies can provide products for each other. This design is intended to benefit the business combination as a whole because of the economies provided by vertical integration. In effect, more profit can often be generated by the combination if one member is able to buy from another rather than from an outside party.

12. Why does an intra-entity sale of a depreciable asset (such as equipment or a building) require subsequent adjustments to depreciation expense within the consolidation process?

12. Depreciable assets are often transferred between the members of a business combination at amounts in excess of book value. The buyer will then compute depreciation expense based on this inflated transfer price rather than on an historical cost basis. From the perspective of the business combination, depreciation should be calculated solely on historical cost figures. Thus, within the consolidation process for each period, adjustment of the depreciation (that is recorded by the buyer) is necessary to reduce the expense to a cost based figure.

3. Padlock Corp. owns 90 percent of Safeco, Inc. During the year, Padlock sold 3,000 locking mechanisms to Safeco for $900,000. By the end of the year, Safeco had sold all but 500 of the locking mechanisms to outside parties. Padlock marks up the cost of its locking mechanisms by 60 percent in computing its sales price to affiliated and nonaffiliated customers. How much intra-entity profit remains in Safeco's inventory at year-end?

3. Sales price per unit ($900,000 ÷ 3,000 units) $ 300 Number of units in Safeco's ending inventory × 500 Intra-entity inventory at transfer price $150,000 Gross profit rate (0.6 ÷ 1.6) .375 Intra-entity profit in ending inventory $ 56,250

10. The consolidation process applicable when intra-entity land transfers have occurred differs somewhat from that used for intra-entity inventory sales. What differences should be noted?

10. Several differences can be cited that exist between the consolidated process applicable to inventory transfers and that which is appropriate for land transfers. The total intra-entity Sales balance is offset against Purchases (Inventory) when inventory is transferred but no corresponding entry is needed when land is involved. Furthermore, in the year of the sale, ending unrealized inventory gross profits are deferred through an adjustment to cost of goods sold, but a specific gross profit account exists (and must be removed) when land has been sold. Finally, unrealized inventory gross profits are usually expected to be realized in the year following the transfer. This effect is mirrored in that period by reduction of the beginning inventory figure (within cost of goods sold). For land transfers, however, the unrealized gain must be repeatedly deferred in each fiscal period for as long as the land continues to be held within the business combination.

11. A subsidiary sells land to the parent company at a significant gain. The parent holds the land for two years and then sells it to an outside party, also for a gain. How does the business combination account for these events?

11. As long as the land is held by the parent, its recorded value must be reduced to historical cost within each consolidated set of financial statements. In the year of the original transfer, the asset reduction is offset against the subsidiary's recorded gain. For all subsequent years in which the property is held, the credit to the Land account is made against the beginning retained earnings balance of the subsidiary (since the unrealized gain will have been closed into that account). According to this question, the land is eventually sold to an outside party. The intra-entity gain (which has been deferred in each of the previous years) is realized by the sale and should be recognized in the consolidated statements of this later period. Because the transfer was upstream from subsidiary to parent, the above consolidated entries will also affect any noncontrolling interest balances being reported. Because of the deferral of the intra-entity gross profit, the realized net income balances applicable to the subsidiary will be less than the reported values. In the year of resale, however, the realized net income for consolidation purposes is higher than reported. All noncontrolling interest totals are computed on the realized balances rather than the reported figures.

13. If a seller makes an intra-entity sale of a depreciable asset at a price above book value, the seller's beginning Retained Earnings is reduced when preparing each subsequent consolidation. Why does the amount of the adjustment change from year to year?

13. From the viewpoint of the business combination, an unrealized gain has been created by the intra-entity transfer and must be deferred in the preparation of consolidated financial statements. This unrealized gain is closed by the seller into retained earnings necessitating subsequent reductions to that account. In the individual financial records, however, another income effect is created which gradually reduces the overstatement of retained earnings each period. The asset will be depreciated by the buyer based on the inflated transfer price. The resulting expense will be higher than the amount appropriate to the historical cost of the item. Because this excess depreciation is closed into retained earnings annually, the overstatement of the equity account is gradually reduced to a zero balance over the remaining life of the asset.

2. Barker Company owns 80 percent of the outstanding voting stock of Walden Company. During the current year, intra-entity sales amount to $100,000. These transactions were made with a gross profit rate of 40 percent of the transfer price. In consolidating the two companies, what amount of these sales would be eliminated?

2. The sales between Barker and Walden totaled $100,000. Regardless of the ownership percentage or the gross profit rate, the $100,000 was simply an intra-entity asset transfer. Thus, within the consolidation process, the entire $100,000 should be eliminated from both the Sales and the Purchases (Inventory) accounts.

4. Page 236 How are unrealized inventory gross profits created, and what consolidation entries does the presence of these gains necessitate?

4. In intra-entity transactions, a transfer price is often established that exceeds the cost of the inventory. Hence, the seller is recording a gross profit on its books that, from the perspective of the business combination as a whole, remains unrealized until the asset is consumed or sold to an outside party. Any unrealized gross profit on merchandise still held by the buyer must be deferred whenever consolidated financial statements are prepared. For the year of transfer, this consolidation procedure is carried out by removing the unrealized gross profit from the inventory account on the balance sheet and from the ending inventory balance within cost of goods sold. In the year following the transfer (if the goods are resold or consumed), the realized gross profit must be recognized within the consolidation process. Reductions are made on the worksheet to the beginning inventory component of cost of goods sold and to the beginning retained earnings balance of the original seller. The gross profit is thus taken out of last year's earnings (retained earnings) and recognized in the current year through the reduction of cost of goods sold. If the transfer was downstream in direction and the parent company has applied the equity method, the adjustment in the subsequent year is made to the Investment in Subsidiary account rather than to retained earnings.

5. James, Inc., sells inventory to Matthews Company, a related party, at James's standard gross profit rate. At the current fiscal year-end, Matthews still holds some portion of this inventory. If consolidated financial statements are prepared, why are worksheet entries required in two different fiscal periods?

5. On the individual financial records of James, Inc., a gross profit is recorded in the year of transfer. From the viewpoint of the business combination, this gross profit is actually earned in the period in which the products are sold or consumed by Matthews Co. An initial consolidation entry must be made in the year of transfer to defer any gross profit that remains unrealized. A second entry must be made in the following time period to allow the gross profit to be recognized in the year of its ultimate realization.

6. How do intra-entity profits present in any year affect the noncontrolling interest calculations?

6. Currently accounting pronouncement allow discretion regarding the effect of unrealized intra-entity profits and noncontrolling interest values. This textbook reasons that unrealized profits relate to the seller and to the computation of the seller's income. Therefore, any unrealized profits created by upstream transfers (from subsidiary to parent) are attributed to the subsidiary. The effects resulting from the deferral and eventual recognition of these intra-entity profits are considered in the calculation of noncontrolling interest balances. In contrast, unrealized profits from downstream transfers are viewed as relating solely to the parent (as the seller) and, thus, have no effect on the noncontrolling interest.

7. A worksheet is being developed to consolidate Allegan, Incorporated, and Stark Company. These two organizations have made considerable intra-entity transactions. How would the consolidation process be affected if these transfers were downstream? How would consolidated financial statements be affected if these transfers were upstream?

7. Consolidated financial statements are largely unchanged across downstream versus upstream transfers. Sales and purchases (Inventory) balances created by the transactions are eliminated in total. Any unrealized gross profits remaining at the end of a fiscal period get deferred until ultimately earned through sale or consumption of the assets. The direction of intra-entity transfers (upstream versus downstream) does have one effect on consolidated financial statements. In computing noncontrolling interest balances (if present), the deferral of unrealized gross profits on upstream sales is taken into account. Downstream sales, however, are attributed to the parent and are viewed as having no impact on the outside interest.

8. King Company owns a 90 percent interest in the outstanding voting shares of Pawn Company. No excess fair-value amortization resulted from the acquisition. Pawn reports a net income of $110,000 for the current year. Intra-entity sales occur at regular intervals between the two companies. Unrealized gross profits of $30,000 were present in the beginning inventory balances, whereas $60,000 in similar gross profits were recorded at year-end. What is the noncontrolling interest's share of consolidated net income?

8. The computation of this noncontrolling interest balance depends on the direction of the intra-entity transfers which is not indicated in the question. If the unrealized gross profits were created by downstream sales from King to Pawn, they relate only to King. The net income attributable to the noncontrolling interest is not affected and would be $11,000 ($110,000 × 10%). In contrast, if the transfers were upstream from Pawn to King, the deferral and recognition of the profits are attributed to Pawn. Pawn's "realized" net income would be $80,000 and the noncontrolling interest's share of consolidated net income is reported as $8,000: Pawn's reported net income $110,000 Recognition of prior year unrealized gross profit 30,000 Deferral of current year unrealized gross profit (60,000) Pawn's realized net income $ 80,000 Outside ownership percentage 10% Net income attributable to noncontrolling interest $ 8,000

9. When a subsidiary sells inventory to a parent, the intra-entity profit is removed from the subsidiary's net income for consolidation and reduces the income allocation to the noncontrolling interest. Is the profit permanently eliminated from the noncontrolling interest, or is it merely shifted from one period to the next? Explain.

9. The deferral and subsequent recognition of intra-entity profits are allocated to the noncontrolling interest in the same periods as the parent. When one affiliate sells to another affiliate, ownership does not change and therefore the underlying profit is deferred. When the purchasing affiliate subsequently sells the inventory to an entity outside the affiliated group, ownership changes, and the profit may be recognized. Intra-entity profits are not really eliminated, but simply deferred until a sale to an outsider takes place.