INTERCOMPANY TRANSACTIONS - Wiley

1 LEARNING OBJECTIVESA fter reading this chapter, you should be able to: Understand the different types of INTERCOMPANY TRANSACTIONS that can occur. Understand why INTERCOMPANY TRANSACTIONS are addressed when preparingconsolidated financial statements. Prepare the worksheet eliminations necessary for INTERCOMPANY TRANSACTIONS inthe period of the transaction. Prepare the worksheet eliminations necessary for INTERCOMPANY TRANSACTIONS inperiods subsequent to the transaction. Differentiate between upstream and downstream INTERCOMPANY economictransactions involve two unrelated entities, althoughtransactions may occur between units of one entity ( INTERCOMPANY TRANSACTIONS ). INTERCOMPANY TRANSACTIONS may involve such items as the declaration and payment ofdividends, the purchase and sale of assets such as inventory or plant assets, and borrowingand lending. Regardless of the type of transaction, the occurrence of an intercompanytransaction, if not removed (eliminated) from the consolidated financial statements, willoften result in a misrepresentation of the consolidated entity s financial chapter presents a framework for evaluating INTERCOMPANY TRANSACTIONS .

2 Thenext section presents a theoretical discussion of INTERCOMPANY TRANSACTIONS . The subsequentsection presents a framework for interpreting such TRANSACTIONS , including two-yearexamples of downstream (parent-to-subsidiary) TRANSACTIONS to assist in applying theframework to specific situations. The examples in this section are simplified in that eachintercompany transaction occurs at, or near, year-end. This is followed by exampleswhere the simplifying assumption is relaxed. The chapter then presents how upstream(subsidiary-to-parent) INTERCOMPANY TRANSACTIONS differ from downstream CONCEPTSAn INTERCOMPANY transactionoccurs when one unit of an entity is involved in a transactionwith another unit of the same entity. While these TRANSACTIONS can occur for a variety ofreasons, they often occur as a result of the normal business relationships that existbetween the units of the entity.

3 These units may be the parent and a subsidiary, two139 INTERCOMPANY TRANSACTIONSCHAPTER4 Intercompanytransaction: atransaction that occursbetween two units of thesame 12/2/03 2:57 PM Page 139subsidiaries, two divisions, or two departments of one entity. It is common for verticallyintegrated organizations to transfer inventory among the units of the consolidated the other hand, a plant asset may be transferred between organizational units to takeadvantage of changes in demand across product INTERCOMPANY transaction is recognized in the financial records of both units ofthe entity as if it were an arm s-length transaction with an unrelated party. From theconsolidated entity s perspective, the transaction is initially unrealized because unrelatedparties are not involved; therefore, the INTERCOMPANY transaction needs to be interpreteddifferently than it was by either of the participating units.

4 The difference in interpretationgenerally results in the elimination of certain account balances from the consolidatedfinancial between units of an entity can take several forms and can occurbetween any units of the entity. Figure 4-1 illustrates possible directions of intercompanytransactions. TRANSACTIONS flowing from the parent to the subsidiary are commonly calleddownstream TRANSACTIONS , TRANSACTIONS from the subsidiary to the parent are commonlycalled upstream TRANSACTIONS , and TRANSACTIONS between subsidiaries are commonly calledlateral volume of INTERCOMPANY TRANSACTIONS eliminated from the financial records of many large conglomerate organizations is significant. For example, Exxon MobilCorporation reported the elimination of INTERCOMPANY revenue of $ billion, $ billion, and $ billion for 2000, 2001, and 2002, amounts repre-sented percent, percent, and percent of the entity s total sales and other revenue before eliminating INTERCOMPANY TRANSACTIONS for the three years, views developed in ARB No.

5 51 have long served as the basic philosophy of the accounting profession toward consolidations and INTERCOMPANY TRANSACTIONS . In statingthe purpose of consolidated financial statements, ARB No. 51 provides a justification forthe elimination of INTERCOMPANY TRANSACTIONS . Regardless of the direction, the intercom-pany transaction must be removed when preparing the consolidated entity s financial statements because, as discussed in ARB No. 51:The purpose of consolidated statements is to present, primarily for the benefit of theshareholders and creditors of the parent company, the results of operations and thefinancial position of a parent company and its subsidiaries essentially as if the groupwere a single company with one or more branches or 4 INTERCOMPANY TRANSACTIOND ownstreamtransaction:anintercompanytrans action flowing fromthe parent to thesubsidiaryUpstream transaction:an intercompanytransaction flowing fromthe subsidiary totheparentLateral transaction: anintercompanytransaction flowing fromone subsidiary toanother subsidiaryFIGURE 4-1 Directions of INTERCOMPANY TransactionParent CompanyDownstreamLateralSubsidiary BSubsidiary AUpstreamUpstream1 Exxon Mobil Corporation, 2002 Research Bulletin, No.

6 51, Consolidated Financial Statements (New York: American Instituteof Certified Public Accountants, 1959), par. 12/2/03 2:57 PM Page 140In addition, ARB No. 51 also states that .. any INTERCOMPANY profit or loss on assetsremaining within the group should be eliminated; the concept usually applied for thispurpose is gross profit or loss (par. 6). Addressing profit or loss on assets transferred as aresult of INTERCOMPANY TRANSACTIONS is important because many organizations, such asExxon Mobil, record INTERCOMPANY inventory TRANSACTIONS (typically the largest dollaramount of INTERCOMPANY TRANSACTIONS ) on a market value basis. For example, failure toeliminate INTERCOMPANY inventory TRANSACTIONS recorded at market value would result in anoverstatement of Sales, Cost of Goods Sold,and if the intercompanyinventory transaction is recorded at cost, the Salesand Cost of Goods Soldaccountswould be overstated if they are not eliminated when preparing the consolidated percentage ownership interest by the parent in the subsidiary does not alter therequirement to eliminate INTERCOMPANY TRANSACTIONS .

7 ARB No. 51 states:The amount of INTERCOMPANY profit or loss to be eliminated in accordance withparagraph 6 is not affected by the existence of a minority interest. The completeelimination of the INTERCOMPANY profit or loss is consistent with the underlyingassumption that consolidated statements represent the financial position andoperating results of a single business enterprise. The elimination of the intercompanyprofit or loss may be allocated proportionately between the majority and 14 states that INTERCOMPANY profit or loss maybe allocated between majority(controlling interest) and minority (noncontrolling) interest. In a downstream transaction,all profit or loss accrues to the parent company because the parent company records thesale. None of the gain or loss is recognized on the subsidiary s books. As a result, the profitor loss is not shared between the parent company stockholders and the noncontrollinginterest; that is, all the profit or loss accrues to the parent company chapter takes the position that the allocation of profit or loss to parent companystockholders and the noncontrolling interest is theoretically preferable in upstream andlateral TRANSACTIONS .

8 The gain or loss is divided between the parent stockholders and thenoncontrolling interest in an upstream or a lateral transaction because the subsidiaryrecords the sale and, therefore, records the gain or loss on the sale. Because the parent andnoncontrolling stockholders share ownership interest in the subsidiary, the gain or loss isallocated proportionately to the two OF INTERCOMPANY TRANSACTIONSON FINANCIAL STATEMENTSI nterpreting the impact of INTERCOMPANY TRANSACTIONS on the financial records of the unitsinvolved begins with understanding how the TRANSACTIONS are initially recognized on eachunit s financial records. It is also important to understand how each INTERCOMPANY transactionimpacts the income statement and balance sheet of the units involved in the period of theintercompany transaction as well as in subsequent periods.

9 From this understanding it ispossible to determine how to adjust the consolidated financial statements for intercompanytransactions using worksheet section presents the journal entries that would be recorded by each entity whenselected INTERCOMPANY TRANSACTIONS occur. Accompanying the journal entries are the worksheetIMPACT OF INTERCOMPANY TRANSACTIONS ON FINANCIAL STATEMENTS1413 Ibid., par. 12/2/03 2:57 PM Page 141eliminations that are necessary to prepare the consolidated financial statements. Theremainder of the chapter examines INTERCOMPANY TRANSACTIONS in the order outlined below: DownstreamIntercompany TRANSACTIONS initiated at year-end Elimination in year of transaction Second-year eliminationIntercompany TRANSACTIONS initiated during the year Elimination in year of transaction Second-year elimination Upstream INTERCOMPANY TRANSACTIONS initiated during the yearIntercompany TRANSACTIONS initiated during the year Elimination in year of transaction Second-year eliminationPeriod of INTERCOMPANY Transaction Downstream(at or near Year-End)To adjust for the effects of INTERCOMPANY TRANSACTIONS , additional worksheet eliminations,labeled (5), are required.

10 The purpose of such worksheet eliminations is to adjust the financialinformation so that it is presented from the perspective of the consolidated entity ratherthan from the perspective of either the parent or the subsidiary. These adjustments restatethe consolidated financial statements to recognize that the effect of INTERCOMPANY transactionson the consolidated entity is different from the effect recognized on the financial recordsof either the parent or the subsidiary. The following examples (machine, inventory, anddebt) analyze three downstream INTERCOMPANY TRANSACTIONS . The presentation includes thejournal entries recorded by both Pratt and Sterling as well as the worksheet eliminationsnecessary to prepare the consolidated financial Asset Transaction at the End of the PeriodThe following data pertain to the sale of a machine from Pratt to a machine was purchased by Pratt on January 1, 2001, for $9,000.