Just as related parties can transfer land, the intra-entity sale of a host of other assets is possi- ble. Equipment, patents, franchises, buildings, and other long-lived assets can be involved.
Accounting for these transactions resembles that demonstrated for land sales. However, the subsequent calculation of depreciation or amortization provides an added challenge in the development of consolidated statements.10
Deferral of Unrealized Gains
When faced with intra-entity sales of depreciable assets, the accountant’s basic objective remains unchanged: to defer unrealized gains to establish both historical cost balances and rec- ognize appropriate income within the consolidated statements.More specifically, accountants defer gains created by these transfers until such time as the subsequent use or resale of the as- set consummates the original transaction. For inventory sales, the culminating disposal nor- mally occurs currently or in the year following the transfer. In contrast, transferred land is quite often never resold, thus permanently deferring the recognition of the intra-entity profit.
For depreciable asset transfers, the ultimate realization of the gain normally occurs in a dif- ferent manner; the property’s use within the buyer’s operations is reflected through deprecia- tion. Recognition of this expense reduces the asset’s book value every year and, hence, the overvaluation within that balance.
The depreciation systematically eliminates the unrealized gain not only from the asset account but also from Retained Earnings. For the buyer, excess expense results each year because the computation is based on the inflated transfer cost. This depreciation is then closed annually into Retained Earnings. From a consolidated perspective, the extra expense gradually
216 Chapter 5
10To avoid redundancy within this analysis, all further references are made to depreciation expense alone, although this discussion is equally applicable to the amortization of intangible assets and the depletion of wasting assets.
LO7
Prepare the consolidation entries to remove the effects of upstream and downstream intra-entity fixed asset transfers across affiliated entities.
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Consolidated Financial Statements—Intra-Entity Asset Transactions 217
11If the worksheet uses only one account for a net depreciated asset, this entry would have been
Gain on sale 30,000
Equipment (net) 30,000
To reduce the 90,000 to original 60,000 book value at date of transfer rather than reinstating original balances.
offsets the unrealized gain within this equity account. In fact, over the life of the asset, the depreciation process eliminates all effects of the transfer from both the asset balance and the Retained Earnings account.
Depreciable Asset Transfers Illustrated
To examine the consolidation procedures required by the intra-entity transfer of a depreciable asset, assume that Able Company sells equipment to Baker Company at the current market value of $90,000. Able originally acquired the equipment for $100,000 several years ago;
since that time, it has recorded $40,000 in accumulated depreciation. The transfer is made on January 1, 2010, when the equipment has a 10-year remaining life.
Year of Transfer
The 2010 effects on the separate financial accounts of the two companies can be quickly enumerated:
1. Baker, as the buyer, enters the equipment into its records at the $90,000 transfer price.
However, from a consolidated view, the $60,000 book value ($100,000 cost less $40,000 accumulated depreciation) is still appropriate.
2. Able, as the seller, reports a $30,000 profit, although the combination has not yet earned anything. Able then closes this gain into its Retained Earnings account at the end of 2010.
3. Assuming application of the straight-line depreciation method with no salvage value, Baker records expense of $9,000 at the end of 2010 ($90,000 transfer price/10 years). The buyer recognizes this amount rather than the $6,000 depreciation figure applicable to the consol- idated entity ($60,000 book value/10 years).
To report these events as seen by the business combination, both the $30,000 unrealized gain and the $3,000 overstatement in depreciation expense must be eliminated on the work- sheet. For clarification purposes, two separate consolidation entries for 2010 follow. However, they can be combined into a single adjustment:
Consolidation Entry TA (year of transfer)
Gain on Sale of Equipment . . . . 30,000 Equipment . . . . 10,000
Accumulated Depreciation . . . . 40,000 To remove unrealized gain and return equipment accounts to
balances based on original historical cost. (Labeled “TA”in reference to transferred asset.)
Consolidation Entry ED (year of transfer)
Accumulated Depreciation . . . . 3,000
Depreciation Expense . . . . 3,000 To eliminate overstatement of depreciation expense caused by inflated
transfer price. (Labeled “ED”in reference to excess depreciation.) Entry must be repeated for all 10 years of the equipment’s life.
From the viewpoint of a single entity, these entries accomplish several objectives:11
• Reinstate the asset’s historical cost of $100,000.
• Return the January 1, 2010, book value to the appropriate $60,000 figure by recognizing accumulated depreciation of $40,000.
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• Eliminate the $30,000 unrealized gain recorded by Able so that this intra-entity profit does not appear in the consolidated income statement.
• Reduce depreciation for the year from $9,000 to $6,000, the appropriate expense based on historical cost.
In the year of the intra-entity depreciable asset transfer, the preceding consolidation entries TAand EDare applicable regardless of whether the transfer was upstream or downstream.
They are likewise applicable regardless of whether the parent applies the equity method, ini- tial value method, or partial equity method of accounting for its investment. As discussed sub- sequently, however, in the years following the intra-entity transfer, a slight modification must be made to the consolidation entry *TAwhen the equity method is applied and the transfer is downstream.
Years Following Transfer
Again, the preceding worksheet entries do not actually remove the effects of the intra- entity transfer from the individual records of these two organizations. Both the unrealized gain and the excess depreciation expense remain on the separate books and are closed into Retained Earnings of the respective companies at year-end. Similarly, the Equipment account with the related accumulated depreciation continues to hold balances based on the transfer price, not historical cost. Thus, for every subsequent period, the separately re- ported figures must be adjusted on the worksheet to present the consolidated totals from a single entity’s perspective.
To derive worksheet entries at any future point, the balances in the accounts of the individ- ual companies must be ascertained and compared to the figures appropriate for the business combination. As an illustration, the separate records of Able and Baker two years after the transfer (December 31, 2011) follow. Consolidated totals are calculated based on the original historical cost of $100,000 and accumulated depreciation of $40,000.
Individual Consolidated Worksheet
Account Records Perspective Adjustments
Equipment 12/31/11 $90,000 $100,000 $10,000
Accumulated Depreciation 12/31/11 (18,000) (52,000)* (34,000)
Depreciation Expense 12/31/11 9,000 6,000 (3,000)
1/1/11 Retained Earnings effect (21,000)† 6,000 27,000
Note: Parentheses indicate a credit.
*Accumulated depreciation before transfer $(40,000) plus 2 years $(6,000).
† Intra-entity transfer gain $(30,000) less one year’s depreciation of $9,000.
Because the transfer’s effects continue to exist in the separate financial records, the various accounts must be corrected in each succeeding consolidation. However, the amounts involved must be updated every period because of the continual impact that depreciation has on these balances. As an example, to adjust the individual figures to the consolidated totals derived ear- lier, the 2011 worksheet must include the following entries:
Consolidation Entry *TA (year following transfer)
Equipment . . . . 10,000 Retained Earnings, 1/1/11 (Able) . . . . 27,000
Accumulated Depreciation . . . . 37,000 To return the Equipment account to original historical cost and
correct the 1/1/11 balances of Retained Earnings and Accumulated Depreciation.
218 Chapter 5
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Consolidated Financial Statements—Intra-Entity Asset Transactions 219
Consolidation Entry ED (year following transfer)
Accumulated Depreciation . . . . 3,000
Depreciation Expense . . . . 3,000 To remove excess depreciation expense on the intra-entity transfer price
and adjust Accumulated Depreciation to its correct 12/31/11 balance.
Note that the $34,000 increase in 12/31/11 consolidated Accumulated Depreciation is accomplished by a $37,000 credit in Entry *TAand a
$3,000 debit in Entry ED.
Although adjustments of the asset and depreciation expense remain constant, the change in beginning Retained Earnings and Accumulated Depreciation varies with each succeeding con- solidation. At December 31, 2010, the individual companies closed out both the unrealized gain of $30,000 and the initial $3,000 overstatement of depreciation expense. Therefore, as re- flected in Entry *TA,the beginning Retained Earnings account for 2011 is overvalued by a net amount of only $27,000 rather than $30,000. Over the life of the asset, the unrealized gain in retained earnings will be systematically reduced to zero as excess depreciation expense ($3,000) is closed out each year.Hence, on subsequent consolidation worksheets, the begin- ning Retained Earnings account decreases by this amount: $27,000 in 2011, $24,000 in 2012, and $21,000 in the following period. This reduction continues until the effect of the unrealized gain no longer exists at the end of 10 years.
If this equipment is ever resold to an outside party, the remaining portion of the gain is considered earned. As in the previous discussion of land, the intra-entity profit that exists at that date must be recognized on the consolidated income statement to arrive at the appropriate amount of gain or loss on the sale.
Depreciable Intra-Entity Asset Transfers—Downstream Transfers When the Parent Uses the Equity Method
A slight modification to consolidation entry *TAis required when the intra-entity depreciable asset transfer is downstream and the parent uses the equity method. In applying the equity method, the parent adjusts its book income for both the original transfer gain and periodic de- preciation expense adjustments. Thus, in downstream intra-entity transfers when the equity method is used, from a consolidated view, the book value of the parent’s Retained Earnings balance has been already reduced for the gain. Therefore, continuing with the previous exam- ple, the following worksheet consolidation entries would be made for a downstream sale assuming that (1) Able is the parent and (2) Able has applied the equity method to account for its investment in Baker.
Consolidation Entry *TA (year following transfer)
Equipment . . . . 10,000 Investment in Baker . . . . 27,000
Accumulated Depreciation . . . . 37,000
Consolidation Entry ED (year following transfer)
Accumulated Depreciation . . . . 3,000
Depreciation Expense . . . . 3,000
In Entry *TA,note that the Investment in Baker account replaces the parent’s Retained Earn- ings. The debit to the investment account effectively allocates the write-down necessitated by the intra-entity transfer to the appropriate subsidiary equipment and accumulated depreci- ation accounts.
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Effect on Noncontrolling Interest Valuation—
Depreciable Asset Transfers
Because of the lack of official guidance, no easy answer exists as to the assignment of any income effects created within the consolidation process. Consistent with the previous sections of this chapter, all income is assigned here to the original seller. In Entry *TA,for example, the beginning Retained Earnings account of Able (the seller) is reduced. Both the unrealized gain on the transfer and the excess depreciation expense subsequently recognized are assigned to that party.
Thus, again, downstream sales are assumed to have no effect on any noncontrolling inter- est values. The parent rather than the subsidiary made the sale. Conversely, the impact on income created by upstream sales must be considered in computing the balances attributed to these outside owners. Currently, this approach is one of many acceptable alternatives. How- ever, in its future deliberations on consolidation policies and procedures, the FASB could man- date a specific allocation pattern.
Summary 1. The transfer of assets, especially inventory, between the members of a business combination is a com- mon practice. In producing consolidated financial statements, any effects on the separate accounting records created by such transfers must be removed because the transactions did not occur with an outside, unrelated party.
2. Inventory transfers are the most prevalent form of intra-entity asset transaction. Despite being only a transfer, one company records a sale while the other reports a purchase. These balances are recipro- cals that must be offset on the worksheet in the process of producing consolidated figures.
3. Additional accounting problems result if inventory is transferred at a markup. Any portion of the merchandise still held at year-end is valued at more than historical cost because of the inflation in price. Furthermore, the gross profit that the seller reports on these goods is unrealized from a con- solidation perspective. Thus, this gross profit must be removed from the ending Inventory account, a figure that appears as an asset on the balance sheet and as a negative component within cost of goods sold.
4. Unrealized inventory gross profits also create a consolidation problem in the year following the trans- fer. Within the separate accounting systems, the seller closes the gross profit to Retained Earnings.
The buyer’s ending Inventory balance becomes the next period’s beginning balance (within Cost of Goods Sold). Therefore, the inflation must be removed again but this time in the subsequent year. The seller’s beginning Retained Earnings is decreased to eliminate the unrealized gross profit while Cost of Goods Sold is reduced to remove the overstatement from the beginning inventory component.
Through this process, the intra-entity profit is deferred from the year of transfer so that recognition can be made at the point of disposal or consumption.
5. The deferral and subsequent realization of intra-entity gross profits raise a question concerning the valuation of noncontrolling interest balances: Does the change in the period of recognition alter these calculations? Although the issue is currently under debate, no formal answer to this question is yet found in official accounting pronouncements. In this textbook, the deferral of profits from upstream transfers (from subsidiary to parent) is assumed to affect the noncontrolling interest whereas down- stream transactions (from parent to subsidiary) do not. When upstream transfers are involved, non- controlling interest values are based on the earned figures remaining after adjustment for any unrealized profits.
6. Inventory is not the only asset that can be sold between the members of a business combination. For example, transfers of land sometimes occur. Again, if the price exceeds original cost, the buyer’s records state the asset at an inflated value while the seller recognizes an unrealized gain. As with in- ventory, the consolidation process must return the asset’s recorded balance to cost while deferring the gain. Repetition of this procedure is necessary in every consolidation for as long as the land remains within the business combination.
7. The consolidation process required by the intra-entity transfer of depreciable assets differs somewhat from that demonstrated for inventory and land. Unrealized gain created by the transaction must still be eliminated along with the asset’s overstatement. However, because of subsequent depreciation, these adjustments systematically change from period to period. Following the transfer, the buyer com- putes depreciation based on the new inflated transfer price. Thus, an expense that reduces the carry- ing value of the asset at a rate in excess of appropriate depreciation is recorded; the book value moves closer to the historical cost figure each time that depreciation is recorded. Additionally, because the 220 Chapter 5
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Consolidated Financial Statements—Intra-Entity Asset Transactions 221
(Estimated Time: 45 to 65 Minutes) On January 1, 2009, Daisy Company acquired 80 percent of Rose Company for $594,000 in cash. Rose’s total book value on that date was $610,000 and the fair value of the noncontrolling interest was $148,500. The newly acquired subsidiary possessed a trademark (10-year remaining life) that, although unrecorded on Rose’s accounting records, had a fair value of $75,000. Any remaining excess acquisition-date fair value was attributed to goodwill.
Daisy decided to acquire Rose so that the subsidiary could furnish component parts for the parent’s production process. During the ensuing years, Rose sold inventory to Daisy as follows:
Cost to Gross Transferred Inventory
Rose Transfer Profit Still Held at End of Year Company Price Rate Year (at transfer price)
2009 $100,000 $140,000 28.6% $20,000
2010 100,000 150,000 33.3 30,000
2011 120,000 160,000 25.0 68,000
Any transferred merchandise that Daisy retained at a year-end was always put into production during the following period.
On January 1, 2010, Daisy sold Rose several pieces of equipment that had a 10-year remaining life and were being depreciated on the straight-line method with no salvage value. This equipment was trans- ferred at an $80,000 price, although it had an original $100,000 cost to Daisy and a $44,000 book value at the date of exchange.
On January 1, 2011, Daisy sold land to Rose for $50,000, its fair value at that date. The original cost had been only $22,000. By the end of 2011, Rose had made no payment for the land.
The following separate financial statements are for Daisy and Rose as of December 31, 2011. Daisy has applied the equity method to account for this investment.
Daisy Company Rose Company Sales . . . $ (900,000) $ (500,000) Cost of goods sold . . . 598,000 300,000 Operating expenses . . . 210,000 80,000 Gain on sale of land . . . (28,000) –0–
Income of Rose Company . . . (60,000) –0–
Net income . . . $ (180,000) $ (120,000) Retained earnings, 1/1/11 . . . $ (620,000) $ (430,000) Net income . . . (180,000) (120,000) Dividends paid . . . 55,000 50,000
Retained earnings, 12/31/11 . . . $ (745,000) $ (500,000) Cash and accounts receivable . . . $ 348,000 $ 410,000 Inventory . . . 430,400 190,000
Investment in Rose Company . . . 737,600 –0–
Land . . . 454,000 280,000 Equipment . . . 270,000 190,000 Accumulated depreciation . . . (180,000) (50,000)
Total assets . . . $ 2,060,000 $ 1,020,000 Liabilities . . . (715,000) (120,000) Common stock . . . (600,000) (400,000) Retained earnings, 12/31/11 . . . (745,000) (500,000) Total liabilities and equities . . . $(2,060,000) $(1,020,000)
Comprehensive Illustration PROBLEM
excess depreciation is closed annually to Retained Earnings, the overstatement of the equity account resulting from the unrealized gain is constantly reduced. To produce consolidated figures at any point in time, the remaining inflation in these figures (as well as in the current depreciation expense) must be determined and removed.
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222 Chapter 5
Required
Answer the following questions:
a. By how much did Rose’s book value increase during the period from January 1, 2009, through December 31, 2010?
b. During the initial years after the takeover, what annual amortization expense was recognized in con- nection with the acquisition-date excess of fair value over book value?
c. What amount of unrealized gross profit exists within the parent’s inventory figures at the beginning and at the end of 2011?
d. Equipment has been transferred between the companies. What amount of additional depreciation is recognized in 2011 because of this transfer?
e. The parent reports Income of Rose Company of $60,000 for 2011. How was this figure calculated?
f. Without using a worksheet, determine consolidated totals.
g. Prepare the worksheet entries required at December 31, 2011, by the transfers of inventory, land, and equipment.
SOLUTION
a. The subsidiary’s book value on the date of purchase was given as $610,000. At the beginning of 2011, the company’s common stock and retained earnings total is $830,000 ($400,000 and $430,000, respectively). In the previous years, Rose’s book value has apparently increased by $220,000 ($830,000
$610,000).
b. To determine amortization, an allocation of Daisy’s acquisition-date fair value must first be made.
The $75,000 allocation needed to show Daisy’s equipment at fair value leads to additional annual expense of $7,500 for the initial years of the combination. The $57,500 assigned to goodwill is not subject to amortization.
Acquisition-Date Fair-Value Allocation and Excess Amortization Schedule Consideration paid by Daisy for 80% of Rose . . . $ 594,000 Noncontrolling interest (20%) fair value . . . 148,500 Rose’s fair value at acquisition date . . . $ 742,500 Book value of Rose Company . . . (610,000) Excess fair value over book value . . . $ 132,500
Annual Excess Unamortized Life Excess Amortizations Value, (Years) Amortizations 2009–2011 12/31/11
Trademark . . . $ 75,000 10 $7,500 $22,500 $52,500
Goodwill . . . 57,500 –0– –0– 57,500
Totals . . . $132,500 $7,500 $22,500
c. Of the inventory transferred to Daisy during 2010, $30,000 is still held at the beginning of 2011. This merchandise contains an unrealized gross profit of $10,000 ($30,000 33.3% gross profit rate for that year). At year-end, $17,000 ($68,000 remaining inventory 25% gross profit rate) is viewed as an unrealized gross profit.
d. Additional depreciation for the net addition of 2011 is $3,600. Equipment with a book value of $44,000 was transferred at a price of $80,000. The net of $36,000 to this asset’s account bal- ances would be written off over 10 years for an extra $3,600 per year during the consolidation process.
e. According to the separate statements given, the subsidiary reports net income of $120,000. However, in determining the income allocation between the parent and the noncontrolling interest, this reported figure must be adjusted for the effects of any upstream transfers.Because Rose sold the inventory upstream to Daisy, the $10,000 net profit deferred in requirement (c) from 2010 into the current period hoy36628_ch05_195-240.qxd 12/28/09 7:37 AM Page 222
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