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

1. Prepare consolidated financial statements that reflect the elimination and subsequent realization of upstream and downstream intercompany profits in depreciable assets.
2. Explain how the historical cost principle supports the elimination of unrealized profits resulting from intercompany transactions when preparing consolidated financial statements.
3. Prepare the journal entries under the equity method to reflect the elimination and subsequent realization of intercompany profits in depreciable assets.
4. Analyze and interpret financial statements with intercompany transactions involving depreciable assets.
5. Calculate the gain or loss that results from the elimination of intercompany bondholdings and the allocation of such gain or loss to the equities of the controlling and non-controlling interests.
6. Explain how the recognition of gains on the elimination of intercompany bondholdings is consistent with the principle of recording gains only when they are realized.
7. Prepare consolidated financial statements that reflect the gains or losses that are the result of intercompany bondholdings.
8. Identify some of the differences between IFRSs and ASPE involving intercompany transactions.
9. Prepare consolidated financial statements when depreciable assets are remeasured to fair value each period.

Part (A) looks at the elimination and realization of intercompany profits (losses) in depreciable assets. The concepts involved in the holdback of profits (losses) are similar to those examined previously with regard to intercompany land profits (losses), but the realization concepts are different because they are based on consumption rather than a sale. This chapter completed the illustrations of the holdback and realization of intercompany profits and gains in assets by examining the consolidation procedures involved when the profit is in an asset subject to amortization. The gain is held back in order to state the depreciable asset at its undepreciated historical cost from a consolidated perspective. The intercompany profit is subsequently realized as the assets are used or consumed in generating revenues over the remaining life of the assets. Because there are differences between the periods in which the tax is paid and the periods in which the gains are realized in the consolidated statements, income tax must be allocated.

Some general tips to remember when consolidating intercompany profits in depreciable assets:

• Recall that profit is recognized when the goods are sold to outsiders when accounting for intercompany profits in inventory and land.



• When accounting for intercompany exchanges in depreciable assets, the purchasing entity’s depreciation expense is based on the parent’s cost.



• The gain (loss) on sale is recorded on the separate-entity books of the selling entity at the time of the sale.



• On consolidation, the depreciation expense is adjusted to what the depreciation would have been if the intercompany exchange had not taken place and an intercompany gain (loss) had not arisen on the separate-entity financial statement of the seller.



• For intercompany profits in depreciable assets, the entity purchasing the depreciable asset uses the depreciable asset to carry out its business of selling goods or providing services to its customers. Even though the depreciable asset is not sold to outsiders, the products or services are sold to outsiders. Therefore, the gain from the intercompany sale of the depreciable asset is realized over the life of the depreciable asset as the purchasing entity uses the depreciable asset to produce goods or provide services for outsiders. This concept bases the realization of the gain on the consumption (by depreciation) of the asset that contains the unrealized gain.



• When the subsidiary is the selling company, increase or reduction in net income (to adjust for (1) the unrealized gain or loss, and (2) the realization of the gain or loss through depreciation) is allocated to both the non-controlling and controlling interests in the same manner as was illustrated in Chapter 6. When the parent is the selling company, there is no need to allocate between the non-controlling and controlling interests.



• Non-controlling interest is affected by unrealized profits on upstream transactions.



• The tax paid on the unrealized profits represents a prepayment from a consolidated viewpoint. Income tax expense is matched to the income of the consolidated entity.



• Accumulated depreciation is based on the original cost to the consolidated entity.



• As with chapter 6, when the parent uses the equity method to account for it investment in the subsidiary, the equity method captures the net effect of all consolidation entries. The investment account is a balance sheet account at the end of the year, whereas investment income is an income statement account for one period of time. The parent’s income under the equity method should be equal to consolidated net income attributable to the parent.



• The above assumes that the depreciable asset exchanged had not yet been used and depreciated. When there is an intercompany sale of a used depreciable asset, both the depreciable asset cost account and accumulated depreciation need to be grossed up to the original cost to the consolidated entity. This entry does not change the net book value of the equipment but does change the cost and accumulated depreciation on the consolidated balance sheet.



• The intercompany profits are eventually realized from a consolidated viewpoint; it is just a matter of timing differences between the separate-entity financial statements (where the gain or loss is recognized at the time of sale) and the consolidated entity financial statements (where the intercompany profits on depreciable assets are realized as the assets are used over their useful lives).



• As with inventory and land profits, adjustments for unrealized and realized profits from intercompany transactions are always charged/credited to the original seller when measuring the consolidated entity’s net income.

Part (B) examines the gains (losses) that are created in the consolidated financial statements when intercompany bondholdings are eliminated. The second part of the chapter examined the gains and losses that are created in the consolidated statements by the elimination of intercompany bondholdings. When the investing company purchases the bonds from outsiders, the bonds are effectively retired from a consolidated perspective. The difference between the price paid to retire the bonds and the book value of the bonds is a gain or a loss. These gains and losses can occur only if there were premiums or discounts involved in the issue or purchase of these bonds. In the case of intercompany bondholdings, the gains or losses are recognized in the consolidated statements before they are recorded by the affiliated companies, whereas intercompany asset gains are recorded by the affiliated companies before they are recognized in the consolidated statements.

Some general tips to remember when consolidating intercompany bondholdings:

• The gain (losses) resulting from intercompany sale of inventory, land, and depreciable assets are realized in the consolidated financial statements subsequent to the recording of the gain (loss) in the selling affiliate. The gains (losses) arising because of the elimination of intercompany bondholding accounts in the consolidated financial statements are realized prior to the recording of these gains (losses) by the affiliates on their separate-entity statements.



• From the consolidated perspective, the issuing company’s bonds have been retired; the issuing company no longer has a bond payable to outsiders.



• When there are intercompany bondholdings with no gain or loss, the consolidation is very simple. The asset and liability appear on the separate-entity financial statements. An entry is made on the consolidation working papers to eliminate the investment in affiliate bonds (asset account) and the bonds payable (liability account). Since there is no gain or loss, then both the asset and liability that are eliminated are equal, thus there is no effect on equity (and no effect on the non-controlling or controlling interests). In addition, the interest revenue and the interest expense are also eliminated on consolidation, and once again, they are equal, thus the entry does not change the net income of the consolidated entity.



• When there are intercompany bondholdings with a gain or a loss, the consolidation is more complex. This happens when bonds are issued at a premium or discount, or when the purchasing affiliate acquires the bonds at a premium or discount. It is the market price differential on the date of an intercompany purchase, combined with any unamortized issue discount or premium, that causes the consolidated gains or losses that result from the elimination of intercompany bondholdings. The gain or loss is reported on the consolidated statements, not on the single-entity statements. Income tax expense is reported on the consolidated statements in accordance with the matching principle.



• There are various approaches to allocate the gain or loss between the two companies as described in the text section “Intercompany Bondholdings—With Gain or Loss” (on page 365 of the text). IFRS is silent regarding the approach to be taken. The text takes the approach to allocate the gain between the issuing and purchasing companies, because each will record its portion of the gain in future periods (approach 4 in the text). This approach is taken because it reflects how each company will actually record the transaction in future years by the separate entities. The investment in bonds and bonds payable are reported on the separate-entity balance sheets, they are just eliminated on the consolidated financial statements. Income tax is accrued on the consolidated financial statements to match the gain on bond retirement. The after-tax gain is allocated to non-controlling and controlling interests.



• Accounting for Gain in Subsequent Years – The income being reported by the separate entities has already been reported on the consolidated financial statements. The difference between interest revenue and interest expense is due to the difference in amortization of the bond premium and discount. The intercompany interest must be eliminated on consolidation to avoid doublecounting of the gain on bond retirement. Income tax expense must be eliminated on consolidation to match with the elimination of the interest revenue and interest expense.



• The realization of a gain on bond retirement on the consolidated income statement in the year of acquisition of intercompany bonds will always result in an “interest elimination loss” affecting the entity’s before-tax net income in all subsequent consolidated income statements until the bonds mature. This “interest elimination loss” does not appear as such in the consolidated income statement because it results from eliminating an amount of intercompany interest revenue that is larger than the amount of intercompany interest expense eliminated. The interest elimination loss for each year is equal to the amortization of the bond premium and bond discount on the separate-entity books. The interest elimination loss is allocated to the parent and the subsidiary. Conversely, the realization of a loss on bond retirement in the year of acquisition of intercompany bonds will always result in an “interest elimination gain” in all subsequent consolidated income statements because the amount of interest expense eliminated will always be larger than the amount of interest revenue eliminated.



• Only the portion of the gain on bond retirement allocated to Sub affects non-controlling interest.



• Less Than 100% Purchase of Affiliate’s Bonds – A gain on bond retirement is recognized only on the portion of the bonds being retired from a consolidated perspective.



• Intercompany Purchases during the Fiscal Year – If the purchase took place during the fiscal year, the Year 1 consolidated income statement contains both the gain on bond retirement and the hidden loss resulting from the elimination of intercompany interest revenue earned and expense incurred for the period subsequent to the acquisition.



• Effective-Yield Method of Amortization – The straight-line method leads to fairly easy calculations because the yearly amortizations are equal (the text assumes straight-line unless otherwise noted). If one or both companies use the effective-interest method of amortization, the calculations become more complex, but the concepts remain the same.

• As mentioned in Chapter 3, private companies can either consolidate their subsidiaries or report their investments in subsidiaries under the cost method or the equity method.
• Whereas public companies can adopt the revaluation model or the cost model to value property, plant, and equipment, private companies using ASPE, must use the cost model.
• Whereas impairment losses for property, plant, and equipment and intangible assets other than goodwill can be reversed under IFRSs, they cannot be reversed under ASPE.

When the parent company uses the revaluation model to revalue its property, plant, and equipment under IAS 16, the consolidated financial statements should reflect the fair value of these assets less accumulated depreciation based on fair value. When intercompany transactions occur, the gain or loss on the intercompany transaction must be eliminated and the values reinstated as if the intercompany transaction had not occurred.