Consolidated Financial Statements:: Inter Company Transactions

Consolidated Financial
Statements:
Inter Company
Transactions
2003 The McGraw-Hill Companies, In
Scope
Accounting and working paper eliminations for
related party transactions between a parent
company and its subsidiaries can be grouped in
two broad classes:
Does
not include inter company profits/losses.
Includes
inter company profits/losses.
Accounting Techniques
Ensure
that consolidated financial statements

include only those balances and transactions
resulting from the consolidated groups
dealings with outsiders.
Separate ledger accounts established for all
intercompany assets, liabilities, revenues and
expenses.
Accounting for Inter company

transactions not involving profit/loss
Loans
on notes or open accounts
Leases
of property under operating leases
Rendering
of services
Loans on Notes or Open Accounts

Parent companies often make loans to their
subsidiaries because of the following reasons:
More extensive financial resources or bank
lines of credit.
Favorable interest rates to the parent company.
Accounting for Loans on Notes or Open

Accounts
Lending
rate of these loans generally exceeds

the parent companys borrowing rate.
Any interest earned by the parent company as
a result of such loans must be eliminated while
preparing
the
consolidated
financial
statements.
Discounting of intercompany notes

If an intercompany note is discounted at a bank
by the payee has following consequences:
The note is not payable to an outsider the
bank.
Discounted
intercompany notes are not
eliminated in a working paper for consolidated
financial statements.
7
Leases of Property under operating

Leases
Both the parent and the subsidiary should use
the same accounting principle for lease.
Lessor:
Lessee:
8
Operating
Lease
Capital
Lease
Receipts :
Intercompany
rent revenue
Sale of
Property
Payments :
Intercompany
rent expense
Acquisition of
Property
Rendering of Services
Services
may be rendered by a parent

company to a subsidiary or vice versa.
Both the companies should record the
transaction in the same accounting period.
Example: Management Fee charged
subsidiary by a parent company.
9
to
Income
Taxes
Applicable
Intercompany Transactions
Intercompany
to
revenue
and
expense
transactions do not include an element of profit
or loss for the consolidated entity as expense
for one is offset by income for another.
Therefore,
no income tax effects are
associated with these transactions.
Note: This holds true even if the parent and the
subsidiary companies file separate tax returns.
10
Accounting
for
Intercompany
Transactions Involving Profit/Loss
Intercompany
sales of merchandise.
Intercompany sales of plant assets.
Intercompany leases of property under
capital/sales type leases.
Intercompany sales of intangible assets.
Acquisition of affiliates bonds.
11
Importance of Eliminating or Including

Intercompany Profits/Losses
While preparing the consolidated financial
statements it is important to:
Eliminate unrealized profits/losses relating to:
1.
2.
12
Transactions within the affiliated group.

Transactions with outsiders.
Recognize realized profits/losses.
Intercompany Sales of Merchandise

Intercompany sales of merchandise are a natural
outgrowth of business combinations:
Vertical business combinations:
1.
2.
13
Downstream: Sales of merchandise from a parent

company to its subsidiaries.
Upstream:
Sales
of
merchandise
from
subsidiaries to the parent company.
Lateral: Sales of merchandise between two

subsidiaries.
Accounting for Intercompany Sales of

Merchandise
Sale of merchandise may be made at:
Sales price not involving any gross profit
margin.
Sales price involving a gross profit margin.
14
Intercompany Sales of Merchandise at

cost
This has the following effect in the preparation of
consolidated financial statements:
The cost of goods sold remains unaffected by
the transaction.
The closing inventories do not require any
adjustment for price.
15
Intercompany Sales of Merchandise at

profit
16
The gross profit margin in these transactions may

be equal to, more than or less than the margin
on sales to outsiders. It has to be accounted
using FIFO method as follows:
Sales made by the purchasing company the
selling companys profit is realized and so not
adjustment is required.
Closing Inventories The selling companys
unrealized gross profit has to be eliminated
while preparing the financial statements.
Intercompany Profit in Inventories and

Amount of Minority Interest
17
Two approaches have been suggested for

intercompany sales/purchases transactions of
partially owned subsidiaries:
Parent Company Concept: Elimination of
intercompany profit only to the extent of the
parent companys ownership interest.
Economic Unit Concept: Elimination of all the
intercompany profit.
Note: The FASB has expressed a preference for
the second approach.
Intercompany Sales of Plant Assets

versus Sales of Merchandise
Sales
of plant assets are rare as compared to

sales of merchandise.
Sales of plant assets pass through many
accounting periods before profit/loss are
realized as compared to sales of merchandise
where profit/loss are usually realized in the
ensuing accounting period.
18
Intercompany Sales of Land
19
Valued at historical cost.

Intercompany gain eliminated while preparing
consolidated financial statements.
Intercompany
plant assets
20
Sales
of
Depreciable
Valued at book value of the selling company while

preparing consolidated financial statements.
Intercompany gain element must be eliminated from
the depreciation expense.
In case of minority interest, intercompany gain in
depreciation should be eliminated to the extent of the
parent companys ownership interest.
Intercompany gain in later years must reflect that the
gain element in the acquiring affiliates annual
depreciation represents a realization of a portion of
total gain by the selling affiliate.
Intercompany Lease of Property under

Capital/Sales type Leases
The
assets are a sales-type lease to the lessor

and a capital lease to the lessee.
Appropriate
ledger accounts must be
established by the lessor and the lessee to
account for the lease.
21
Intercompany Sales of Intangible Assets

This
is similar to gains in depreciable plant

assets, but no accumulated amortization ledger
account may be involved.
The unrealized gain of the seller is realized via
periodic amortization expense recognition by
the acquiring company.
22
Acquisition of Affiliates Bonds
23
Intercompany profits/losses can be realized by a

consolidate entity when that entity acquires the bonds of the
affiliate in the open market.
The profit or loss of acquiring the bonds are imputed
because the transaction in not consummated between the
two affiliates.
If however, the transaction were to result from a direct
acquisition, the profit/loss would have to be eliminated.
In case the acquiring company sells the bonds to outsiders
before they mature, the transaction profit/loss is not realized
by the the consolidated entity, hence eliminated.

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Consolidated Financial

2003 The McGraw-Hill Companies, In

not include inter company profits/losses.

inter company profits/losses.

that consolidated financial statements

Accounting for Inter company

on notes or open accounts

of property under operating leases

Loans on Notes or Open Accounts

Accounting for Loans on Notes or Open

rate of these loans generally exceeds

Discounting of intercompany notes

Leases of Property under operating

may be rendered by a parent

Importance of Eliminating or Including

Transactions within the affiliated group.

Recognize realized profits/losses.

Intercompany Sales of Merchandise

Downstream: Sales of merchandise from a parent

Lateral: Sales of merchandise between two

Accounting for Intercompany Sales of

Intercompany Sales of Merchandise at

Intercompany Sales of Merchandise at

The gross profit margin in these transactions may

Intercompany Profit in Inventories and

Two approaches have been suggested for

Intercompany Sales of Plant Assets

of plant assets are rare as compared to

Intercompany Sales of Land

Valued at historical cost.

Valued at book value of the selling company while

Intercompany Lease of Property under

assets are a sales-type lease to the lessor

Intercompany Sales of Intangible Assets

is similar to gains in depreciable plant

Acquisition of Affiliates Bonds

Intercompany profits/losses can be realized by a

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