A parent company and its subsidiaries may enter into a number of business transactions with each other subsequent to the date of the business combination. Both the parent company and the subsidiary should account for these related party intercompany transactions in a manner that facilitates the consolidation process.
Among the transactions (other than dividends) between a parent company and its subsidiaries are loans on promissory notes or open account, operating leases of property, and rendering of services. None of these transactions involves an element of intercompany profit or loss, because the balances of the ledger accounts used to record these intercompany transactions are offset in the preparation of consolidated financial statements.
A parent company often carries out all of an affiliated group's borrowings from financial institutions. The parent company then makes loans to its subsidiaries for their working capital or other needs at an interest rate exceeding the parent's borrowing rate. These loans and related interest revenue or expense and interest receivable or payable should be recorded in intercompany ledger accounts by each of the affiliated companies.
If the parent company discounts at a bank a promissory note receivable from a subsidiary, the subsidiary transfers the note payable and related accrued interest from the intercompany ledger accounts to accounts for liabilities payable to outsiders.
Intercompany rent revenue and expense and intercompany management fee revenue and expense also are accounted for in clearly designated intercompany ledger accounts in the accounting records of both the parent company and the subsidiary. Accounts for intercompany assets and liabilities and revenue and expenses from loans, rent, and management fees are placed on the same line in the working paper for consolidated financial statements so that they are eliminated without a working paper elimination.
To illustrate the technique described in paragraph 5, assume that management fees for services rendered by Plato Corporation to Socrates Company during the fiscal year ended July 31, 2006, totaled $146,800, of which $15,200 remained unpaid on July 31, 2006. These amounts would be presented as shown below in the working paper for consolidated financial statements of Plato Corporation and subsidiary for the year ended July 31, 2006.
Plato Corporation
Socrates Company
Eliminations increase (decrease)
Consolidated
Income Statement
Revenue:
Intercompany revenue (expenses)
$146,800
$(146,800)
Balance Sheet
Assets:
Intercompany receivables (payables)
$ 15,200
$ (15,200)
Because there is no element of intercompany profit or loss in the interest, rent, or management fee transactions, there are no income tax effects associated with the elimination of the intercompany revenue and expenses.
Transactions between a parent company and its subsidiaries that may involve an element of profit (gain) or loss include intercompany sales of merchandise, plant assets, or intangible assets, and intercompany leases of property under sales-type/capital leases. Such intercompany profits and losses are unrealized until the related assets or their products are sold to outsiders. In addition, a realized intercompany gain or loss may result from a parent or subsidiary company's acquisition of its affiliate's bonds in the open market.
Elimination of unrealized intercompany profits (gains) or losses, and inclusion of realized gains and losses, for consolidated financial statements are essential to prevent a parent company's management from manipulating consolidated net income.
Intercompany sales of merchandise may be made at a price equal to the selling affiliate's cost. If so, the selling affiliate offsets intercompany cost of goods sold against intercompany sales in its separate income statement; no working paper elimination is required for consolidated financial statements. Any resultant intercompany receivables and payables are offset in the usual fashion in the working paper for consolidated financial statements.
Intercompany sales of merchandise typically are made at a gross profit, which may be equal to, larger than, or less than the gross profit margin on sales to outsiders. The intercompany profit is realized through the purchasing affiliate's sales of the merchandise to outsiders. Consequently, the unrealized intercompany profit in the purchasing affiliate's inventories on the date of a consolidated balance sheet must be eliminated through an appropriate working paper elimination.
The intercompany profit in beginning inventories is considered to be realized on a first-in, first-out basis through the purchasing affiliate's sales of the merchandise to outsiders during the ensuing year. Because the selling affiliate in essence closed its Intercompany Sales and Intercompany Cost of Goods Sold ledger accounts of the prior accounting period to its Retained Earnings account, the selling affiliate's beginning retained earnings balance is overstated, from a consolidated viewpoint, by the amount of the unrealized intercompany profit in the purchasing affiliate's beginning inventories.
To illustrate the issues of intercompany sales of merchandise set forth in paragraphs 11 and 12, assume that Peters Corporation's sales of merchandise to its 80%-owned subsidiary, Styles Company, during the fiscal year ended December 31, 2006, were summarized as follows:
Selling price
Cost
Gross profit (25%)
Beginning inventories
$ 60,000
$ 45,000
$ 15,000
Sales
360,000
270,000
90,000
Totals
$420,000
$315,000
$105,000
Less: Ending Inventories
80,000
60,000
20,000
Cost of goods sold
$340,000
$255,000
$ 85,000
The December 31, 2006, working paper elimination (in journal entry format) for Peters Corporation and subsidiary, disregarding income tax effects, is as follows:
Retained Earnings−
Peters
15,000
Intercompany Sales−
Peters
360,000
Intercompany Cost of Goods Sold−
Peters
270,000
Cost of Goods Sold−
Styles
85,000
Inventories−
Styles
20,000
To eliminate intercompany sales, cost of goods sold, and unrealized profit in inventories. (Income tax effects are disregarded.)
If intercompany sales are made by a partially owned subsidiary to its parent company or to another subsidiary, the resultant intercompany profits or losses must be taken into consideration in the computation of minority interest in the selling subsidiary's beginning retained earnings and its net income or net loss for the accounting period.
Intercompany sales of plant assets or intangible assets are rare transactions. The intercompany gain or loss on such sales is realized in transactions with outsiders after the passage of many accounting periods, in contrast to the typical realization of intercompany profit in inventories during the accounting period immediately following the period of the intercompany sales transactions.
If Stebbins Company, a 90%-owned subsidiary of Pippin Corporation, sold land with a cost of $100,000 to its parent company for $175,000, the $75,000 intercompany gain is accounted for as follows, in a working paper elimination (in journal entry format) at the end of the accounting period in which the intercompany sale took place:
Intercompany Gain on Sale of Land−
Stebbins
75,000
Land−Pippin
75,000
To eliminate unrealized intercompany gain on sale of land. (Income tax effects are disregarded.)
For accounting periods subsequent to the period of Stebbins Company's sale of land to Pippin Corporation, as long as Pippin continued to own the land, the working paper elimination (in journal entry format) is as follows (disregarding income tax effects):
Retained Earnings−Stebbins ($75,000 x 0.90)
67,500
Minority Interest in Net Assets of Subsidiary ($75,000 x 0.10)
7,500
Land−Pippin
75,000
To eliminate unrealized intercompany gain in land. (Income tax effects are disregarded.)
The eliminated intercompany gain illustrated in paragraphs 16 and 17 is taken into account in the computation of (a) the minority interest in Stebbins Company's net income in the year of sale and (b) the minority interest in Stebbin's beginning retained earnings for subsequent periods during which Pippin Corporation continued to own the land.
The working paper elimination, on the date of sale, for an intercompany gain on the sale of a depreciable plant asset or an intangible asset is identical to the comparable date-of-sale elimination for land as illustrated in paragraph 16. For example, if on April 30, 2006, the end of a fiscal year, Pasteur Corporation sold to its partially owned subsidiary, Salk Company, for $50,000 a machine with a carrying amount of $40,000, the April 30, 2006, working paper elimination (in journal entry format) for Pasteur Corporation and subsidiary is as follows (disregarding income tax effects):
Intercompany Gain on Sale of Machinery−Pasteur
10,000
Machinery−Salk
10,000
To eliminate unrealized intercompany gain on sale of machinery. (Income tax effects are disregarded.)
In subsequent years, the intercompany profit element in Salk Company's depreciation expense also must be eliminated for consolidated financial statements. If Salk assigned to the machine acquired from Pasteur Corporation an economic life of five years, the straight-line method of depreciation, and no residual value, the working paper elimination (in journal entry format) for Pasteur Corporation and subsidiary on April 30, 2007, is as follows (disregarding income tax effects):
Retained Earnings−Pasteur
10,000
Accumulated Depreciation−Salk ($10,000 ÷ 5)
2,000
Machinery−Salk
10,000
Depreciation Expense−Salk
2,000
To eliminate unrealized intercompany gain in machinery and related depreciation. (Income tax effects are disregarded.)
The $2,000 credit to Salk Company's depreciation expense in the working paper elimination in paragraph 20 represents a realization of a portion of Pasteur's intercompany gain on the sale of the machinery. Thus, the $2,000 is treated as an increase in Pasteur Corporation's net income, and it does not enter into the computation of the minority interest in net income of Salk.
At the end of each of the four remaining years of the economic life of Salk Company's machine, the credit amounts of the working paper elimination for intercompany gain are the same as the amounts shown in paragraph 20. However, the unrealized portion of the intercompany gain decreases in each succeeding year, as indicated by the following summary of the debit amounts of the working paper eliminations (in journal entry format) for April 30, 2008 and 2009:
Year Ended April 30,
2008
2009
Retained Earnings−
Pasteur
$8,000
$6,000
Accumulated Depreciation−
Salk
4,000
6,000
An intercompany lease of property under a sales-type/capital lease requires working paper eliminations with features that resemble eliminations for both intercompany sales of merchandise and intercompany sales of plant assets. For example, if on June 30, 2005, the end of a fiscal year, Planck Corporation leased a machine carried in its inventories at $6,000 to its 80%-owned subsidiary, Sunder Company, on a three-year sales-type lease requiring Sunder to pay $3,000 to Planck on June 30, 2005, 2006, and 2007, the present value of the minimum lease payments at Planck's 10% interest rate implicit in the lease (known to Sunder and less than Sunder's incremental borrowing rate) is $8,207 ($3,000 x 2.735537 = $8,207). Assuming that Sunder uses straight-line depreciation, a five-year economic life, and no residual value for the machine, working paper eliminations (in journal entry format, explanations omitted, and income taxes disregarded) on June 30, 2005 and 2006, are as follows:
June 30, 2005
Intercompany Liability under Capital Lease − Sunder ($8,207 − $3,000)
Leased Equipment − Capital Lease − Sunder ($2,207 − $441)
1,766
Depreciation Expense − Sunder ($2,207 ÷
5)
441
In the June 30, 2006, working paper for consolidated financial statements of Planck Corporation and subsidiary, Planck's intercompany interest revenue, $521 ($5,207 x 0.10 = $521) is offset against Sunder's intercompany interest expense of $521 on the same line of the income statement section.
Working paper eliminations for intercompany gains or losses on intercompany sales of intangible assets resemble the eliminations for depreciable plant assets illustrated in paragraphs 19 and 20, except that there typically is no separate ledger account for accumulated amortization.
No intercompany gain or loss results from the direct acquisition of one affiliate's bonds by another affiliate because the cost of the investment to the acquirer exactly offsets the issuance proceeds of the debt. However, intercompany gains or losses may be realized when one affiliate acquires in the open market the outstanding bonds of another affiliate.
To illustrate the realized gain or loss when one affiliate acquires another affiliate's outstanding bonds in the open market, assume that on March 31, 2005, the end of a fiscal year, Peale Corporation acquired in the open market for $442,919 (a 15% yield), $500,000 face amount of the $750,000 total outstanding 10%, five-year bonds payable of Stole Company, Peale's wholly owned subsidiary. The bonds had been issued by Stole on March 31, 2003, for $695,928 (a 12% yield), with interest payable annually each March 31. On March 31, 2005, the balance of Stole's Discount on 10% Bonds Payable ledger account was $36,028.
Based on the facts in paragraph 29, the appropriate working paper elimination (in journal entry format) for Peale Corporation and subsidiary on March 31, 2005, is as follows (disregarding income tax effects):
Intercompany 10% Bonds Payable − Stole
500,000
Discount on Intercompany 10% Bonds Payable − Stole [$36,028 x ($500,000 ÷ $750,000)]
24,019
Investment in Stole Company Bonds − Peale
442,919
Gain on Extinguishment of Bonds − Stole [($500,000 − $24,019) − $442,919]
33,062
To eliminate subsidiary's bonds acquired by parent, and to recognize gain on the extinguishment of the bonds. (Income tax effects are disregarded).
In the working paper elimination illustrated in paragraph 30, the gain resulting from the parent company's acquisition of the subsidiary's bonds is attributed to the subsidiary. The parent company is considered to have acted as agent for the subsidiary in the acquisition of the bonds.
In the three years subsequent to Peale Corporation's acquisition of Stole Company's bonds, the $33,062 realized gain on the acquisition will be recorded through the differences in the discount amortization (by the interest method) of the two affiliates. This is illustrated by the following working paper elimination (in journal entry format) for Peale Corporation and subsidiary on March 31, 2006:
Intercompany Interest Revenue − Peale ($442,919 x 0.15)
Investment in Stole Company Bonds − Peale [$442,919 + ($66,438 − $50,000)]
459,357
Intercompany Interest Expense − Stole [($500,000 − $24,019) x 0.12]
57,118
Retained Earnings − Stole
33,062
To eliminate subsidiary's bonds owned by parent, and related interest revenue and expense; and to increase subsidiary's beginning retained earnings by amount of unamortized gain on the extinguishment of the bonds. (Income tax effects are disregarded).
The $9,320 difference between Peale's intercompany interest revenue ($66,438) and Stole Company's intercompany interest expense ($57,118) represents a portion of the $33,062 realized gain that was recorded during the fiscal year ended March 31, 2005. However, because the entire $33,062 gain was recognized in the consolidated income statement of Peale Corporation and subsidiary for the year ended March 31, 2005, the working paper elimination in paragraph 32 effectively eliminates the $9,320 difference.
Working paper eliminations for intercompany profits (gains) and losses must be analyzed carefully for the computation of minority interest in net income of a partially owned subsidiary.
