Chapter 5: Intra-Entity Assets Transactions (Equity Method)

*Elimination* of Intra-Entity Inventory Transfers in the *consolidation process*

1) *Year of transfer*: The *sales (revenue)* and *purchases (expense)* balances created by the transfer must be eliminated (Entry T1). *Unrealized gross profit/losses* may exist if intra-entity transfer price differs from cost and goods remain in the affiliated entity at year-end. For consolidation purposes, this intra-entity gross profit/losses must be *deferred* (Entry G). (Entry T1): Dr: Sales Cr: COGS Entry (G) - We have a gross profit: Dr: COGS Cr: Inventory 2) For *each subsequent consolidation* if the inventory is not yet sold to an outsider, the recorded value of the inventory account must be adjusted to *original cost*. Because the effects of the transfer carry over into the subsequent fiscal period, the effect of the unrealized *gross profit/losses* must also be removed a second time (Entry *G): Entry *G (Upstream): Dr: Beg. R/E - Subsidiary Cr: COGS Entry *G (Downstream): Dr: Investment in Subsidiary Cr: Inventory 3) *If the inventory is ever sold to an outside party*, the intra-entity gross profit/losses is realized and has to be recognized within that time period. Entry *G(Upstream): Dr: R/E - Subsidiary Cr: COGS Entry *G(Downstream): Investment in Subsidiary Cr: COGS - The consolidation process is designed to *shift the profit/losses* from the period of transfer into the time period in which the goods are actually sold to unrelated parties or consumed.

Intra-Entity *Land* Transfers

1) *Year of transfer*: an actual gain or loss account exists within the accounting records of the seller. This gain or loss created by intra-entity land transfers is *unrealized* if the land is not sold to an outside party at the end of the transfer year. Dr: Gain on Sale of Land Cr: Land 2) For *each subsequent consolidation* if the land is not yet sold to an outsider, the recorded value of the land account must be adjusted to *original cost*. The unrealized gain/loss recorded by the seller must also be *removed and deferred*. (Upstream - gain): Dr: R/E - Subsidiary Cr: Land (Downstream - gain): Dr: Investment in Subsidiary Cr: Land 3) *If the land is ever sold to an outside party*, the *intra-entity gain/loss* is realized and has to be recognized within that time period. (Upstream - gain): Dr: Beg. R/E - Subsidiary Cr: Gain on Sale of Land (Downstream - gain) Dr: Investment in Subsidiary Cr: Gain on Sale of Land

Intra-Entity transfer *of depreciable assets*

1) In the *year of transfer*, any unrealized *gains/losses* must be deferred for consolidation purposes to establish appropriate historical cost balances. e.g., *Gains* Dr: Gain on sale of Equipment Dr: Equipment Cr: A/D Dr: A/D Cr: Depreciation Expense 2) For *each subsequent period* if the asset is not yet sold to an outsider: the difference between the transfer - based accounting value and the historical cost of the asset will change each year because of the effects of *depreciation*. The amount of unrealized gains within retained earnings will also be reduced annually since excess expense is recognized (and closed into retained earnings) based on the inflated transfer price. Consequently, elimination of the unrealized gain (within retained earnings) and the reduction of the asset value to historical cost will differ from year to year. Also within the consolidation process, the recorded depreciation expense must be decreased every period to an amount appropriately based on the asset's original acquisition price. (Upstream - gain) Dr: Beg. R/E - Subsidiary Dr: Equipment Cr: A/D Dr: A/D Cr: Depreciation Expense (Downstream - gain) Dr: Investment in Subsidiary Dr: Equipment Cr: A/D Dr: A/D Cr: Depreciation Expense 3) *If the asset is ever sold to an outsider or consumed*, the intra-entity gains/losses realized has to be recognized within that time period. (Upstream - gain) Dr: Beg. R/E - Subsidiary Cr: Gain on Sale of Equipment (Downstream - gain) Dr: Investment in Subsidiary Cr; Gain on Sale of Equipment

Effect of deferral process on the valuation of a noncontrolling interest

1) Official accounting pronouncements permit but do not require deferral of unrealized gains/losses on the valuation of noncontrolling interest balances. 2) This textbook adjusts the noncontrolling interest balances but only if the sale was made upstream from subsidiary to parent. Downstream sales are made by the parent and, thus, are viewed as having no effect on the outside interest.

Effect of deferral process on the valuation of a noncontrolling interest

1) Official accounting pronouncements permit but not require deferral of unrealized profits/losses on the valuation of noncontrolling interest balances 2) This textbook adjusts the noncontrolling interest balances but only if the sale was made upstream from subsidiary to parent. Downstream sales are made by the parent and, thus, are viewed as having no effect on the outside interest.

Single Economic Entity

1) Transactions between the parent and subsidiary are considered "internal" transactions of a *single economic entity*. 2) Consolidated statements present financial performance and status of consolidated companies as a *single economic entity* - Intra-entity transactions must be *removed*.

Review in Chapter 1: Intra-Entity Asset Transaction

1) Two types of intra-entity sales/transfers. 2) Accounting for intra-entity transfers.

Accounting for intra-entity transfer:

A. *At the time of intra-entity sale/transfer*: The *individual* accounting systems of the two companies will record the transfer as a sale by one party and as a purchase by the other. B. At the end of the fiscal year: when a portion of the goods are not consumed or resold to unrelated parties: This portion of intra-entity profits/gains/losses should be *deferred*. C. When the goods are subsequently consumed or resold to unrelated parties: The deferred profits/gains/losses should be *recognized* in the same period.

Two types of intra-entity sales/transfers

A. *Downstream* sale/transfer: Occurs when the investor sells to the investee. B. *Upstream* sale/transfer: Occurs when the investee sells to the investor.