After studying this chapter, you should be able to do the following:

1. Describe the effect on consolidated profit of the elimination of both intercompany revenues (and expenses) and intercompany asset profits.
2. Prepare consolidated financial statements that reflect the elimination of upstream and downstream intercompany profits in inventory and land.
3. Explain how the cost, revenue recognition, and matching principles are used to support adjustments for intercompany transactions when preparing consolidated financial statements.
4. Prepare consolidated financial statements that reflect the realization of upstream and downstream intercompany profits in inventory and land that were held back in previous periods.
5. Prepare the journal entries under the equity method to reflect the elimination and subsequent realization of intercompany profits in inventory and land.
6. Analyze and interpret financial statements involving intercompany transactions.
7. Identify some of the differences between IFRSs and ASPE involving intercompany transactions.

Intercompany Revenue and Expenses – To ensure that consolidated financial statements reflect only transactions between the single entity and those outside the entity, all intercompany transactions are eliminated. The elimination of intercompany revenues and expenses does not affect the net income of this entity (since we eliminate an equal amount from revenue and expense); therefore, it cannot affect the amounts allocated to the two equities in the balance sheet.

Intercompany Profits in Assets – Intercompany profits in assets are not recognized in the consolidated financial statements until the assets have been sold outside the group or consumed. (The concept of realization as a result of consumption is discussed in the next chapter.) A transaction with an outside entity that is not associated with the consolidated group is referred to as an arm’s-length transaction. Revenue is recognized when it is earned in a transaction with an outsider in accordance with the revenue recognition principle. The cost of sales is expensed in the same period as the revenue in accordance with the matching principle. If the intercompany sales transactions are not eliminated, then sales and cost of sales would be overstated for the consolidated entity. The elimination entries are recorded on the consolidated working papers and not in the separate-entity books of the parent and the subsidiary.

Three types of unrealized intercompany profits (losses) in assets are eliminated:

• Profits in inventory;
• Profits in non-depreciable assets; and
• Profits in depreciable assets.

The first two of these will be discussed in this chapter; the last one will be discussed in Chapter 7.

Downstream and upstream are defined by who the seller is. When the parent sells to the subsidiary, the transaction is referred to as a downstream transaction. When the subsidiary sells to the parent or another subsidiary, the transaction is referred to as an upstream transaction.

Holdback of Intercompany Inventory and Land Profits – The elimination of unrealized intercompany profits in assets reduces the net income of the consolidated entity. Also, it will affect the amount allocated to non-controlling interest only if the subsidiary was the selling company. Non-controlling interest is not affected by intercompany profits made on downstream transactions. Non-controlling interest is affected and will share in intercompany profits made on upstream transactions. Non-controlling interest is based on subsidiary’s shareholders’ equity after it has been adjusted for unrealized profit on upstream transactions. The income tax recorded on the unrealized profit is also removed from the consolidated income statement and is shown as deferred income taxes until a sale to outsiders takes place.

The unrealized profit is always deducted from the selling company’s income (for instance, unrealized profits on downstream transactions are deducted from the parent’s separate-entity income, whereas unrealized profits on upstream transactions are deducted from the subsidiary’s separate-entity income). The unrealized profits are eliminated on the consolidated financial statements, and thus, by eliminating the unrealized profit, the asset (inventory, land, etc) is now stated at cost to the consolidated entity. However, note that the unrealized profits are not eliminated on the separate-entity financial statements. The unrealized profits will be eliminated from retained earnings of the selling company on the consolidated working papers each year until the land is sold to outsiders.

Realization of Intercompany Inventory and Land Profits – When the assets that contain the intercompany profit are sold outside (or consumed), the profit is considered realized and is reflected in the consolidated income statement. When the profits are realized, they are credited to the income of the original seller. The appropriate income tax is removed from the consolidated balance sheet and reflected as an expense in the income statement. The adjustments for income tax ensure that income tax expense is properly matched to income recognized on the consolidated income statement. Income tax should be expensed in the same period as revenue.

Unrealized Profits with Associates – When the investor only has significant influence in an associate, it cannot control the decisions made by the associate. As such, transactions with the associate are similar to transactions with outsiders. Therefore, the accounting for unrealized profits on downstream transactions is a bit different for an investment in an associate. Rather than eliminating all of the profit, only the investor’s percentage ownership of the associate times the profit earned on the transaction with the associate is eliminated.

Equity Method Journal Entries – The equity method captures the net effect of all consolidation entries including the adjustments for unrealized and realized profits on intercompany transactions. The parent’s income under the equity method should be equal to consolidated net income. This is why the equity method is referred to as the one-line consolidation.

Losses on Intercompany Transactions – When one affiliated company sells inventory to another affiliated company at a loss, the intercompany transaction and any unrealized losses should be eliminated on consolidation in a similar fashion to the previous discussion for unrealized profits. However, selling inventory at a loss raises a red flag that it may be impaired. If the inventory is impaired, it should be written down to its net realizable value. Ideally, the impairment should be reported on the separate-entity statements. If not, the impairment will have to be reported on the consolidated statements. Impairment tests for inventory are usually performed at the end of the fiscal period. When intercompany losses are eliminated, the inventory is brought back to the original cost to the selling entity. Inventory on the consolidated balance sheet should be reported at the lower of cost and net realizable value. Intercompany transactions are not always consummated at market value, which means that artificial gains and losses may be recognized in the separate-entity financial statements as a result of the related-party transactions.

Intercompany Transfer Pricing – From a financial reporting point of view we are not concerned with the amount of profit earned by each company, but only with eliminating intercompany transactions and profits that are unrealized because they have not been sold outside the consolidated “single entity.” From a Canadian taxation point of view, the consolidated entity is not subject to tax; rather each company pays tax on its taxable income. It should seem obvious that the management of the parent company would be interested in maximizing the after-tax profit of this single entity if possible. Intercompany transactions are sometimes undertaken to transfer profit from high-tax to low-tax jurisdictions. This will often bring companies into conflict with the governments of the high-tax-rate jurisdictions.

ASPE Differences

• As mentioned in Chapter 3, private companies can either consolidate their subsidiaries or report their investments in subsidiaries under the cost method, equity method, or at fair value.
• When eliminating unrealized profits on downstream transactions between an investor and its associate, the entire profit is eliminated under ASPE, whereas only the investor’s proportionate interest is eliminated under IFRSs.