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Follow the conditions in the file

Chapter 06
Intercompany
Inventory
Transactions
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objective 1
Understand and explain
intercompany transfers and
why they must be
eliminated.
6-2
Road Map: Intercompany Transactions
 Typical intercompany transactions
◼
Intercompany reciprocal accounts (Chapter 4)
◼
Inventory transfers (Chapter 6)
◼
Fixed asset transfers (Chapter 7)
◼
Intercompany Indebtedness (Chapter 8)
6-3
Arm’s-Length Transactions
Q:
What are “Arm’s-length” Transactions?
A:
“Transactions that take place between
completely independent parties.”
6-4
Categories of Transactions
 Arm’s Length Transactions
◼ The only transactions that can be reported in the
consolidated statements.
◼ We want to report the results of our interactions
with outside parties!
 Non-Arm’s Length Transactions
◼ Usually referred to as “related party
transactions.”
◼ Include all intercompany transactions.
6-5
Types of “Related Party” Transactions
 Involving only Individuals
◼ Transactions among family members
 Involving Corporations
◼ With management and other employees
◼ With directors and stockholders
◼ With affiliates (controlled entities)
⚫ Probably constitutes at least 99% of all corporate
related-party transactions
6-6
Necessity of Eliminating Intercompany Transactions
 Eliminate all intercompany transactions in
consolidation:
◼ Because they are internal transactions from a
consolidated perspective.
◼ Not because they are related-party transactions.
◼ Only transactions with outside unrelated parties
can be reported in the consolidated statements.
6-7
Intercompany Transactions: Additional
Opportunities for Fraud
 Intercompany transactions sometimes
occur to
◼ conceal embezzlements.
◼ overstate reported profits.
2 + 2 = 5
6-8
Example 1: Intercompany Loan
 A 12-year old girl lends $5 to her 17-year-old
brother.
 From the standpoint of individuals, this
represents a receivable and a payable.
 If the family prepares a “consolidated balance
sheet”, what is the effect?
◼
No net change to the family’s wealth.
◼
Not a transaction with a non-family person.
6-9
Example 2:
Sale from Parent to Sub to Outsider
 Parent has 19 subsidiaries.
 Parent has received a $1 order from an
outsider.
 Parent sells inventory to Sub 1 for $1.
Sub 1 sells the inventory to Sub 2 for $1.
◼ Sub 2 sells the inventory to Sub 3 for $1.
◼ The inventory is sold from one sub to another until Sub 19
sells it to the outsider for $1.
◼
 The parent and each sub reports sales of $1.
 From a consolidated standpoint, what is the
total amount of sales?
6-10
Example 3: Sale from Parent to Sub, But Not Yet to
an Outsider
 Sleazy Parent Company has one sub.
 Sleazy Parent is preparing for an IPO.
 Sleazy Parent owns lots of obsolete inventory
which it cannot sell.
 Sleazy Parent sells the obsolete inventory (costing
$1,000) to its sub for $100,000.
 Sleazy Sub now holds the inventory.
 Without any adjustment, what items in Sleazy’s
consolidated financial statements will be
misstated?
6-11
Correcting Entries
 Conceptually, how would you correct each of these three
problems?
Easy! To eliminate intercompany loans:
Just
Loan Payable
Loan Receivable
reverse
More
difficult
xxx
To eliminate sale from Parent to Sub to Outsider:
Sales
xxx
Cost of Goods Sold
xxx
xxx
Easy! To eliminate sale from Parent to Sub, not yet to Outsider:
Sales
xxx
Just
Cost of Goods Sold
xxx
reverse
Inventory
Unrealized GP
6-12
Let’s work through an example:
 Assume Parent Co. owns 100% of Sub Co.
 The following intercompany transactions occurred during
the year:
◼
◼
◼
Parent loaned $500 to Sub. To keep things simple, assume that
there is no interest revenue or interest expense associated with this
loan.
Parent made a sale to Sub for $400 cash. The inventory had
originally cost Parent $250. Sub then sold that same inventory to an
outsider for $500.
Parent made a sale to Sub for $300 cash. The inventory had
originally cost Parent $200. Sub has not yet sold that same
inventory to an outsider.
 What consolidation worksheet entries would you make?
6-13
(a) Loan from Parent to Sub
Does this transaction include outsiders?
Parent $500
Sub
Reverse the entries made by
the parent and the sub.
To eliminate intercompany loans:
Loan Payable
Loan Receivable
Parent:
Receivable
Cash
Sub:
Cash
500
500
500
Payable
500
500
500
6-14
(b) Sale from Parent to Sub to Outsider
Arm’s
Length
Keep Parent’s COGS
Keep Sub’s Sale
Are these legitimate transactions?
$250
Keep
This
Purchase
Parent $400
Eliminate effect
of this internal
Transaction
Get rid of Parent’s Sale
Sub
$500
Keep
This
Sale
Get rid of Sub’s COGS
Internal (fake)
6-15
(b) Sale from Parent to Sub to Outsider
Which transactions are legitimate?
Parent’s sale to Sub:
Sub’s sale to Outsider:
Parent:
Cash
Sales
COGS
Inventory
Sub:
Inventory
Cash
Sub:
Cash
500
Sales
500
COGS
400
Inventory
400
400
400
250
250
400
400
Reverse the rest!
To eliminate sale from Parent to Sub to Outsider:
Sales (parent to sub)
400
Cost of Goods Sold (to outsider)
400
6-16
(c) Sale From Parent to Sub (Not Outside)
Is this a legitimate arm’s length transaction?
$200
Keep
this
purchase
Parent $300
Sub
Eliminate effect
of this internal
transaction
Parent:
Cash
300
Sales
300
COGS
200
Inventory
200
Sub:
Inventory 300
Cash
300
Summary of the Transaction:
▪ Parent purchased inventory for $200.
▪ Parent sold the inventory to a Sub for $300.
Reverse the entries made by the parent and sub.
6-17
(c) Sale From Parent to Sub (Not Outside)
Reverse the entries made by the parent and sub.
Parent:
Cash
300
Sales
300
COGS
200
Inventory
200
Sub:
Inventory
Cash
Parent $300
Sub
300
300
To eliminate sale from Parent to Sub, not yet to Outsider:
Sales
300
Cost of Goods Sold
200
Inventory (net)
100
6-18
Summary of Consolidation Entries:
To eliminate intercompany loans:
Loan Payable
Loan Receivable
500
To eliminate sale from Parent to Sub to Outsider:
Sales
400
Cost of Goods Sold
500
400
To eliminate sale from Parent to Sub, not yet to Outsider:
Sales
300
Cost of Goods Sold
200
Inventory
100
6-19
Fully-adjusted Equity Method Adjustment
 Parent companies have to adjust their equity
method investment accounts for certain
transactions.
 At this point, let’s just consider one:
◼
◼
Sale from parent to sub, but not yet sold to an outsider.
It represents “fake profit” that hasn’t really been realized
in an arm’s-length transaction.
 Both the balance sheet and income statement
accounts need to be adjusted.
 This is a REAL journal entry, not a consolidation
worksheet entry!
6-20
Equity Method Adjustment Example
$500
Parent $600
Sub
Sales
COGS
GP
$ 600
500
$ 100
Summary of the Transaction:
▪ Parent purchased inventory for $500.
▪ Parent sold the inventory to a Sub for $600.
Equity Method Entry:
Income from Sub
Investment in Sub
100
100
 The Parent recognized $100 of “fake gross profit!
 The Parent should have transferred the inventory at cost.
 This profit is not from a transaction with an arm’s length
independent party.
6-21
Group Practice
 Assume Parent Co. owns 100% of Sub Co.
 The following intercompany transactions occurred during
the year:
◼
◼
◼
Parent loaned $100 to Sub. To keep things simple, assume that there
is no interest revenue or interest expense associated with this loan.
Parent made a sale to Sub for $200 cash. The inventory had originally
cost Parent $120. Sub then sold that same inventory to an outsider for
$300.
Parent made a sale to Sub for $300 cash. The inventory had originally
cost Parent $180. Sub has not yet sold that same inventory to an
outsider. (Don’t forget equity method entry!)
 Based on our “conceptual discussion,” what consolidation
worksheet entries would you make?
6-22
Consolidation Entries
To eliminate intercompany loans:
Loan Payable
Loan Receivable
100
100
To eliminate sale from Parent to Sub to Outsider:
Sales
200
Cost of Goods Sold
200
To eliminate sale from Parent to Sub, not yet to Outsider:
Sales
300
Cost of Goods Sold
180
Inventory
120
To correct inventory value
Equity Method Entry:
Income from Sub
Investment in Sub
120
120
6-23
Practice Quiz Question #1
Why must intercompany transactions
be eliminated?
a. They portray the consolidated
company’s results too
conservatively.
b. They understate the results of the
consolidated group.
c. They are arm’s length
transactions.
d. They are not arm’s length
transactions.
6-24
Practice Quiz Question #1 Solution
Why must intercompany transactions
be eliminated?
a. They portray the consolidated
company’s results too
conservatively.
b. They understate the results of the
consolidated group.
c. They are arm’s length
transactions.
d. They are not arm’s length
transactions.
6-25
Learning Objective 2
Understand and explain
concepts associated with
inventory transfers and
transfer pricing.
6-26
Issue #1: Eliminate Intercompany Transfers?
 Whether to Eliminate Intercompany
Transactions in Consolidation:
◼ No controversy—they must be eliminated.
◼ Not eliminating them would cause two problems:
⚫ Meaningless double-counting of
1.
2.
sales, and
expenses
⚫ Potential to manipulate income.
6-27
The Substance of Inventory Transfers
 The CONSOLIDATED Perspective:
◼ Merely the physical movement of inventory
from one location to another location.
◼ Similar to the movement of inventory from one
division to another division.
◼ Not a bona fide transaction.
6-28
Issue #2: Which Measure of Profit To Use?
 Possible theoretical profit measures:
◼
Gross profit
◼
Operating profit
◼
Net income
 Profit measure required under GAAP:
◼
Gross profit (of the selling entity):
Sales
Cost of sales
Gross profit
$1,000
600
$ 400
6-29
Issue #3: Eliminate Income Tax Effects?
 Income taxes play a major role in
intercompany sales and transfer pricing
decisions.
 Income taxes on the selling entity’s unrealized
gross profit must also be eliminated.
 In this chapter :
◼
◼
No income tax entries are required.
Because we assume that the tax effects have
already been recorded in the parent’s or the
subsidiary’s general ledger.
6-30
Issue #4: Whether To Eliminate All or Some?
 Downstream sales to a
partially-owned subsidiary:
◼
◼
Eliminate 100% of unrealized
profit.
Fractional elimination is
prohibited.
 Upstream sales from a
partially-owned subsidiary:
◼
◼
Eliminate 100% of unrealized
profit.
Fractional elimination is
prohibited.
6-31
Issue #4: Whether To Eliminate All or Some?
 Downstream sales to a partiallyowned subsidiary:
◼ Entire profit accrues to the parent;
thus, sharing is not appropriate.
NCI
P
 Upstream sales from a partiallyowned subsidiary:
◼ Must share deferral with the NCI
shareholders (if amount is material).
◼ Because S profits are shared with the
S
NCI shareholders.
6-32
Inventory Transfers: What is “Realization”?
 Realization for consolidated reporting
purposes:
◼ Does not focus on whether the seller has
⚫ delivered the product,
⚫ collected on the sale, or
⚫ reduced to an acceptable level the
uncertainty about the net cash flow effect
of an earnings activity.
6-33
Inventory Transfers: What is “Realization”?
 Realization for consolidated reporting
purposes:
◼
Depends on whether the BUYER has resold the
inventory to an outside unaffiliated customer.
Parent
Sub
6-34
Review: Two Types of Transfers
◼ Parent-to-sub-to-outsider
$750 Parent $1,000
Sub For $1,200
◼ Parent-to-sub-not-yet-to-outsider
$300 Parent $400
Sub
Assume both
transactions
took place
during the
same year.
6-35
Understanding Inventory Transfers: Map it out
Ending Inventory = $400
Resold = $1,000
$1,400
Split
$1,050
Parent $1,400
Sub
Unknown
What happened to it?
Total Interco Sales
Resold
On hand
Sales
1,400
1,000
400
− COGS
1,050
750
300
Gross Profit
350
250
100
Gross Profit %
25%
Splits out parent’s numbers.
6-36
Calculating Unrealized Gross Profit
 Amounts that will always be known (given):
Total
Sales (NEW basis)
1,000
− Cost of sales (OLD basis)
600
Gross Profit
400
Gross Profit %
40%
Resold
On hand
200
CRITICAL ASSUMPTION:
 The gross profit percentage derivable from the total column
applies to both (1) the inventory that has been resold AND
(2) the inventory that is still on hand.
6-37
Calculating Unrealized Gross Profit
 Completed Analysis:
Total
Resold
On hand
Sales (NEW basis)
1,000
800
200
− Cost of sales (OLD basis)
600
480
120
Gross Profit
400
320
80
Gross Profit %
40%
Realized
Unrealized
 The Inventory/COGS Change in Basis Elimination Entry
is derived from this analysis.
 Unrealized profit = Inventory on hand x GP%
= $200 x 40% = $80
6-38
Inventory Transfers: Terminology
What happened to it?
Total Interco
Sales
Resold
On hand
Transfer Price
Sales
1,400
1,000
400
Cost
− COGS
1,050
750
300
Markup
Gross Profit
350
250
100
Markup on
Transfer Price
Gross Profit %
25%
Watch out for terminology like
“mark-up based on cost”!
6-39
Practice Quiz Question #2
For 20X8, Pete reported intercompany
cost of sales of $800,000 (markup is 20%
of transfer price) to Sampras, which
reported $300,000 of intercompany
acquired inventory at 12/31/X8. The
unrealized profit at 12/31/X8 is:
a. $40,000
b. $48,000
c. $60,000
d. $75,000
e. None of the above
6-40
Practice Quiz Question #2 Solution
For 20X8, Pete reported intercompany
cost of sales of $800,000 (markup is 20%
of transfer price) to Sampras, which
reported $300,000 of intercompany
acquired inventory at 12/31/X8. The
unrealized profit at 12/31/X8 is:
a. $40,000
b. $48,000
c. $60,000 ($300,000 EI x 0.20 GP%)
d. $75,000
e. None of the above
6-41
Practice Quiz Question #2 Solution
Ending Inventory = $300,000
$800,000
Parent
?
Sub
?
What happened to it?
Total Interco Sales
Sales
− COGS
On hand
300,000
800,000
Gross Profit
Gross Profit %
Resold
?
20%
6-42
Practice Quiz Question #2 Solution
Ending Inventory = $300,000
$800,000
Parent
?
Sub
?
What happened to it?
Total Interco Sales
Sales
− COGS
On hand
300,000
800,000
Gross Profit
Gross Profit %
Resold
60,000
20%
6-43
Practice Quiz Question #2 Solution
Ending Inventory = $300,000
$800,000
Parent
?
Sub
?
What happened to it?
Total Interco Sales
Sales
− COGS
S
Resold
On hand
300,000
800,000
Gross Profit
.2 S
Gross Profit %
20%
60,000
6-44
Practice Quiz Question #2 Solution
Ending Inventory = $300,000
$800,000
Parent
?
Sub
?
S − 800,000 = .2 S
.8 S = 800,000
S = 800,000 / .8 = 1,000,000
6-45
Practice Quiz Question #2 Solution
Ending Inventory = $300,000
$800,000
Parent
?
Sub
?
What happened to it?
Total Interco Sales
Sales
1,000,000
− COGS
800,000
Gross Profit
200,000
Gross Profit %
Resold
On hand
300,000
60,000
20%
6-46
Practice Quiz Question #2 Solution
Ending Inventory = $300,000
Resold = $700,000
$1,000,000
Split
$800,000
Parent 1,000,000
Sub
Unknown
What happened to it?
Total Interco Sales
Resold
On hand
Sales
1,000,000
700,000
300,000
− COGS
800,000
560,000
240,000
Gross Profit
200,000
140,000
60,000
Gross Profit %
20%
6-47
Practice Quiz Question #3
For 20X8, Post reported $90,000 of
intercompany sales (25% markup on cost
and fully paid for by year end) to Script,
which reported $30,000 of intercompany
acquired inventory at 12/31/X8. The
unrealized profit at 12/31/X8 is:
a. $0
b. $6,000
c. $7,500
d. $30,000
e. None of the above
6-48
Practice Quiz Question #3 Solution
For 20X8, Post reported $90,000 of
intercompany sales (25% markup on cost
and fully paid for by year end) to Script,
which reported $30,000 of intercompany
acquired inventory at 12/31/X8. The
unrealized profit at 12/31/X8 is:
a. $0
b. $6,000 ($30,000 EI x 0.20 GP%)
c. $7,500
d. $30,000
e. None of the above
6-49
Practice Quiz Question #3 Solution
Ending Inventory = $30,000
$90,000
Split
?
Parent
90,000
Sub
?
What happened to it?
Total Interco Sales
Sales
− COGS
90,000
Resold
On hand
30,000
C
Gross Profit
0.25 C
Gross Profit %
?
?
6-50
Practice Quiz Question #3 Solution
Ending Inventory = $30,000
$90,000
Split
?
Parent
90,000
Sub
?
90,000 − C = 0.25 C
1.25 C = 90,000
C = 90,000 / 1.25 = 72,000
6-51
Practice Quiz Question #3 Solution
Ending Inventory = $30,000
$90,000
Split
72,000
Parent
90,000
Sub
?
What happened to it?
Total Interco Sales
Sales
90,000
− COGS
72,000
Gross Profit
18,000
Gross Profit %
Resold
On hand
30,000
6,000
20%
6-52
Practice Quiz Question #3 Solution
Ending Inventory = $30,000
Resold = $60,000
$90,000
Split
72,000
Parent
90,000
Sub
Unknown
What happened to it?
Total Interco Sales
Resold
On hand
Sales
90,000
60,000
30,000
− COGS
72,000
48,000
24,000
Gross Profit
18,000
12,000
6,000
Gross Profit %
20%
6-53
Practice Quiz Question #4
For 20X8, Sempre (80% owned by Para)
reported $1,600,000 of intercompany
sales (1/3 markup on cost) to Para, which
resold $1,400,000 of this inventory by
12/31/X8. The unrealized profit at
12/31/X8 is:
a. $40,000
b. $50,000
c. $53,333
d. $66,667
e. None of the above
6-54
Practice Quiz Question #4 Solution
For 20X8, Sempre (80% owned by Para)
reported $1,600,000 of intercompany
sales (1/3 markup on cost) to Para, which
resold $1,400,000 of this inventory by
12/31/X8. The unrealized profit at
12/31/X8 is:
a. $40,000
b. $50,000 ($200,000 EI x 0.25 GP%)
c. $53,333
d. $66,667
e. None of the above
6-55
Practice Quiz Question #4 Solution
Ending Inventory = 200,000
Resold = $1,400,000
$1,600,000
Split
?
Parent 1,600,000
Sub
unknown
What happened to it?
Total Interco Sales
Sales
Resold
On hand
1,600,000 1,400,000
− COGS
Gross Profit
Gross Profit %
?
?
6-56
Practice Quiz Question #4 Solution
Ending Inventory = 200,000
Resold = $1,400,000
$1,600,000
Split
?
Parent 1,600,000
Sub
unknown
What happened to it?
Total Interco Sales
Sales
− COGS
Resold
On hand
1,600,000 1,400,000
C
Gross Profit
1/3 C
Gross Profit %
?
?
6-57
Practice Quiz Question #4 Solution
Ending Inventory = 200,000
Resold = $1,400,000
$1,600,000
Split
?
Parent 1,600,000
Sub
unknown
1,600,000 − C = 1/3 C
4/3 C = 1,600,000
C = 1,600,000 / (4/3) = 1,200,000
6-58
Practice Quiz Question #4 Solution
Ending Inventory = 200,000
Resold = $1,400,000
$1,600,000
Split
1,200,000
Parent 1,600,000
Sub
unknown
What happened to it?
Total Interco Sales
Sales
On hand
1,600,000 1,400,000
− COGS
1,200,000
Gross Profit
400,000
Gross Profit %
Resold
?
25%
6-59
Practice Quiz Question #4 Solution
Ending Inventory = 200,000
Resold = $1,400,000
$1,600,000
Split
1,200,000
Parent 1,600,000
Sub
unknown
What happened to it?
Total Interco Sales
Resold
On hand
Sales
1,600,000 1,400,000
200,000
− COGS
1,200,000 1,050,000
150,000
Gross Profit
Gross Profit %
400,000
350,000
50,000
25%
6-60
Learning Objective 3
Prepare equity-method journal
entries and elimination entries
for the consolidation
of a subsidiary following
downstream inventory
transfers.
6-61
Agreement between Parent Company and
Consolidated Financial Statements
 Under the fully adjusted equity method,
◼
the parent company’s financial statements should
report the same net income and retained earnings
amounts as appear in the consolidated statements.
 Therefore, we
◼
◼
record and equity method adjustment on the
parent’s books to defer unrealized gross profit,
and
prepare consolidation worksheet elimination
entries to avoid double counting in the income
statement and overstating inventory.
6-62
Big Picture—Elimination entry: Sale From Parent to
Sub to Outsider
To eliminate sale from Parent to Sub to Outsider:
Sales (Parent)
400
Cost of Goods Sold (Sub)
400
Get rid of the non-arm’s-length transaction!
$250
Parent
$400
Sub
$500
6-63
Big Picture—Elimination entry: Sale From Parent to
Sub (not yet sold outside)
Reverse the entire transaction!
To eliminate sale from Parent to Sub, not yet to Outsider:
Sales
400
Cost of Goods Sold
250
Inventory
150
Equity Method Entry:
Income from Sub
Investment in Sub
Sales
Cost of sales
Gross profit
$250
150
150
$400
250
$ 150
Parent’s gross profit is overstated by $150
Parent
$400
Sub’s inventory is overstated by $150
Sub
6-64
What to Look For
 Most problems will contain
◼
◼
Inventory transferred from parent to sub (downstream),
or
Inventory transferred from sub to parent (upstream).
 Often part of the inventory is sold to an
outsider, but part remains in the buyer’s
ending inventory.
 Key: Any problem can be split into two parts
◼
The portion of the inventory that is sold
◼
The portion of the inventory that is still on hand
6-65
A Comprehensive Downstream Example
During 20X8, Parent sold inventory originally costing
$60,000 to its 100% owned Sub for $75,000. Sub sold most
of the inventory purchased from Parent (all but $10,000)
for $70,000 to outsiders during the year.
Income Statements
Parent
Sales
$75,000
Cost of sales
60,000
Gross profit $15,000
Sub
$70,000
65,000
$ 5,000
What happened to it?
Sold
On-hand
$65,000 $10,000 x 20% = $2,000
Unrealized GP
Ending inventory = $10,000
$75,000
Split
60,000
Parent
75,000
Sub
70,000
6-66
One Approach: Split into Two Transactions
 This transaction can be broken into two pieces:
◼
◼
Parent sells Sub inventory with a cost of $52,000 for
$65,000. Sub then sells this inventory to outsiders for
$70,000.
Parent sells Sub inventory with a cost of $8,000 for
$10,000, which remains on hand in Sub’s ending
inventory.
Total
Sold
On hand
Sales
$75,000
$65,000
$10,000
− COGS
60,000
52,000
8,000
Gross Profit
$15,000
$13,000
$ 2,000
6-67
Part 1: Sale from Parent to Sub to Outsider
To eliminate sale from Parent to Sub to Outsider:
Sales (Parent)
65,000
Cost of Goods Sold (Sub)
65,000
Get rid of the non-arm’s-length transaction!
$52,000
Parent $65,000
Sub
$70,000
6-68
Part 2: Sale from Parent to Sub (Not Outside)
Reverse the entire transaction!
To eliminate sale from Parent to Sub, not yet to Outsider:
Sales (Parent)
10,000
Cost of Goods Sold (Parent)
8,000
Inventory (basis correction)
2,000
Sales
Cost of sales
Gross profit
$8,000
$10,000
8,000
$ 2,000
Parent’s gross profit is overstated
by $2,000
Sub’s inventory is overstated by $2,000
Parent $10,000
Sub
6-69
Summary
To eliminate sale from Parent to Sub to Outsider :
Sales (Parent)
65,000
Cost of Goods Sold (Sub)
65,000
To eliminate sale from Parent to Sub, not yet to Outsider:
Sales (Parent)
10,000
Cost of Goods Sold (Parent)
8,000
Inventory (basis correction)
2,000
Can combine the two entries:
Sales
Cost of Goods Sold
Inventory
75,000
73,000
2,000
6-70
Partial Consolidated Worksheet
Parent
Income Statement
Sales
75,000
COGS
Gross Profit
Balance Sheet
Inventory
60,000
15,000
0
CR
Consolidated
70,000 75,000
65,000
5,000 75,000
73,000
73,000
70,000
52,000
18,000
10,000
2,000
8,000
Sub
DR
6-71
Second Approach: Short Cut Method
Total
Sold
On hand
Sales
$75,000
$65,000
$10,000
− COGS
60,000
52,000
8,000
Gross Profit
$15,000
$13,000
$ 2,000
COGS Credit = $65,000 + $8,000
The numbers come right off the chart!
Sales
Cost of Goods Sold
Inventory
75,000
73,000
2,000
6-72
Fully-adjusted Equity Method Adjustment
 Don’t forget that one of the desirable properties
of using the equity method is that the parent’s
net income should be equal to the consolidated
net income.
 If you only adjust for unrealized deferred profit
in the consolidation, the consolidated net income
will be different from the parent’s income!
6-73
Partial Consolidated Worksheet
Parent
Income Statement
Sales
75,000
COGS
Inc from Sub
Net Income
60,000
5,000
20,000
Sub
0
73,000
70,000
52,000
73,000
18,000
Not the same!
2,000
8,000
DR
70,000 75,000
65,000
5,000
5,000 80,000
Balance Sheet
Inventory
CR
Consolidated
10,000
6-74
Fully-adjusted Equity Method Adjustment
 Don’t forget that one of the desirable properties
of using the equity method is that the parent’s
net income should be equal to the consolidated
net income.
 If you only adjust for unrealized deferred profit
in the consolidation, the consolidated net income
will be different from the parent’s income!
 Thus, an actual adjustment on the parent’s books
in addition to the worksheet entries above.
 Like we did for the excess fair value amortization.
6-75
Fully-adjusted Equity Method Adjustment
 After calculating the unrealized
deferred profit, simply make an extra
adjustment to back it out.
 Do this at the same time you record
the parent’s share of the sub’s
income.
Investment in Sub
Parent NI =
Consolidated NI
Sales
$75,000
COGS
60,000
Gross profit
$15,000
Inc. from Sub
3,000
NI
$18,000
Income from Sub
NI 5,000
5,000 NI
2,000
Unreal GP
2,000
3,000
Reverse next year when this inventory is sold!
6-76
Partial Consolidated Worksheet
Parent
Income Statement
Sales
75,000
COGS
Inc from Sub
Net Income
60,000
3,000
18,000
Balance Sheet
Inventory
0
Sub
DR
70,000 75,000
65,000
3,000
5,000 78,000
CR
Consolidated
73,000
70,000
52,000
73,000
18,000
Now they’re the same!
10,000
2,000
8,000
6-77
Practice Quiz Question #5
Under the fully adjusted equity method,
what is one benefit of making an equity
method adjustment to defer unrealized
gross profit on inventory transfers?
a. Consolidated net income always
increases.
b. Parent company net income always
increases.
c. Parent company net income is not equal
to consolidated net income.
d. Parent company net income equals
consolidated net income.
6-78
Practice Quiz Question #5 Solution
Under the fully adjusted equity method,
what is one benefit of making an equity
method adjustment to defer unrealized
gross profit on inventory transfers?
a. Consolidated net income always
increases.
b. Parent company net income always
increases.
c. Parent company net income is not equal
to consolidated net income.
d. Parent company net income equals
consolidated net income.
6-79
Review Exercise Part 1: Downstream
 Para sold inventory costing $100,000 to its
75%-owned subsidiary, Shute, for $125,000
in 20X8.
NCI
 Shute resold most of this inventory for
25%
$230,000 in 20X8.
 At 12/31/X8, Shute’s balance sheet showed
intercompany-acquired inventory on hand of
$20,000.
P
75%
S
Required:
 Prepare the consolidation entry and/or entries required
at 12/31/X8 under the equity method.
 Since this is a DOWNSTREAM transaction, we don’t
share the GP deferral with the NCI.
6-80
Review Exercise Part 1: Big Picture
Total
Sales
125,000
− COGS
100,000
Gross Profit
25,000
Sold
On hand
20,000
Gross Profit %
Ending Inventory = 20,000
Resold = $105,000
$125,000
split
$100,000
Parent $125,000
Sub
$230,000
6-81
Review Exercise Part 1: Big Picture
Total
Sales
125,000
− COGS
100,000
Gross Profit
25,000
Sold
On hand
20,000
Gross Profit % = 25,000 ÷ 125,000 = 20%
Ending Inventory = 20,000
Resold = $105,000
$125,000
split
$100,000
Parent $125,000
Sub
$230,000
6-82
Review Exercise Part 1: Big Picture
Total
Sold
On hand
Sales
125,000
105,000
20,000
− COGS
100,000
84,000
16,000
Gross Profit
25,000
21,000
4,000
Gross Profit % = 25,000 ÷ 125,000 = 20%
Unrealized GP
Ending Inventory = 20,000
Resold = $105,000
$125,000
split
$100,000
Parent $125,000
Sub
$230,000
6-83
Review Exercise 1: Sale from Parent to Sub to
Outsider
To eliminate sale from Parent to Sub to Outsider:
Sales (Parent)
105,000
Cost of Goods Sold (Sub)
105,000
Get rid of the internal non-arm’s-length transaction!
$84,000
Parent $105,000
Sub
$230,000
6-84
Review Exercise 1: Sale from Parent to Sub (Not Yet
Outside)
Reverse the entire transaction!
To eliminate sale from Parent to Sub, not yet to Outsider:
Sales (Parent)
20,000
Cost of Goods Sold (Parent)
16,000
Inventory (basis correction)
4,000
Sales
Cost of sales
Gross profit
$16,000
$20,000
16,000
Parent’s gross profit is overstated by $4,000
$ 4,000
Sub’s inventory is overstated by $4,000
Parent $20,000
Sub
6-85
Review Exercise 1: Summary
To eliminate sale from Parent to Sub to Outsider:
Sales (Parent)
105,000
Cost of Goods Sold (Sub)
105,000
To eliminate sale from Parent to Sub, not yet to Outsider:
Sales (Parent)
20,000
Cost of Goods Sold (Parent)
16,000
Inventory (basis correction)
4,000
Combine both entries:
Sales
Cost of Goods Sold
Inventory
125,000
121,000
4,000
Fully-adjusted Equity Method Entry on Parent’s books:
Income from Sub
Investment in Sub
4,000
4,000
6-86
Review Exercise Part 1: Short Cut
Total
Sold
On hand
Sales
125,000
105,000
20,000
− COGS
100,000
84,000
16,000
Gross Profit
25,000
21,000
4,000
COGS Credit = 105,000 + 16,000 = 121,000
Unrealized GP
Worksheet Elimination Entry:
Sales
Cost of Goods Sold
Inventory
125,000
121,000
4,000
6-87
Review Exercise Part 1
Worksheet Elimination Entry in Year 1:
Sales
Cost of Goods Sold
Inventory
125,000
121,000
4,000
FYI, this year’s deferral is REVERSED next year to recognize
when sold!
Worksheet Elimination Entry in Year 2:
Investment in Sub
Cost of Goods Sold
4,000
4,000
INCREASES income!
6-88
Review Exercise 1: Equity Method Entry
Investment in Sub
Income from Sub
93,750 75% NI
75% NI 93,750
4,000
Low 4,000
Defer GP
4,000
89,750
Downstream, so don’t split
the deferral with the NCI.
6-89
Review Exercise 1: Partial Consolidated Worksheet
Parent
Sub
DR
125,000
CR
Consolidated
Income Statement
Sales
125,000
230,000
COGS
100,000
105,000
Inc from Sub
89,750
Gross Profit
114,750
114,750
121,000
84,000)
89,750 Basic
125,000
NCI in NI
CI in NI
230,000)
125,000
214,750
121,000
146,000)
31,250 Basic
(31,250)
246,000
121,000
114,750)
4,000
16,000)
Balance Sheet
Inventory
20,000
6-90
Review Exercise 1: Equity Method Reversal Next
Year
Equity Method Adjustment on Parent’s books in 20X7:
Income from Sub
Investment in Sub
4,000
4,000
Reversal of 20X7 Deferral on Parent’s books in 20X8:
Investment in Sub
Income from Sub
4,000
4,000
6-91
Learning Objective 4
Prepare equity-method journal
entries and elimination entries
for the consolidation
of a subsidiary following
upstream inventory transfers.
6-92
Partially Owned Upstream Sales
 Must share deferral with the NCI shareholders.
 Simply split up the adjustment for unrealized
gross profit proportionately.
Equity Method
Adjustments
Investment in Sub
Income from Sub
NI 4,500
NCI
10%
P
90%
4,500 NI
1,800 Defer GP
1,800
2,700
NCI in NA of Sub
Unreal GP
200
S
Worksheet
Entry Only
6-93
Review Exercise Part 2
 In 20X7, Sensei, a 90%-owned subsidiary of Padawan,
sold inventory to Padawan for $600,000, which includes a
markup of 25% on Sensei’s cost.
NCI
 Padawan resold most of this inventory in 20X7 for
$588,000.
10%
 At 12/31/X7, Padawan reported $110,000 of this
inventory in its balance sheet. (This ending inventory was
resold in 20X8 by Padawan.)
 In 20X8, Sensei sold Padawan inventory for $900,000 that
had a cost of $675,000, of which Padawan resold $700,000
by12/31/X8 for $840,000.
P
90%
S
Required:
 Prepare the consolidation entry and/or entries required
at 12/31/X8 under the equity method.
 Since this is an UPSTREAM transaction, we do share the
GP deferral with the NCI.
6-94
Review Exercise Part 2: The Big Picture—20X7
Total
Sold
On hand
Sales
600,000
490,000 110,000
− COGS
480,000
392,000
88,000
Gross Profit
120,000
98,000
22,000
Gross Profit % = 120,000 ÷ 600,000 = 20%
$600,000 – C = 0.25C
C = $600,000/1.25
= $480,000
?
Sub
Unrealized GP
Ending Inventory = $110,000
$600,000
Parent
?
6-95
20X7 Upstream Sales: Elimination Entries—20X7 &
20X8
20X7 Worksheet Elimination Entry:
Sales
Cost of Goods Sold
Inventory
600,000
578,000
22,000
Deferred GP this year “reversed”
to recognize in the financial
statements next year when sold.
NCI
10%
P
90%
20X8 Worksheet Elimination Entry:
Investment in Sub
19,800
NCI in NA of Sub
Cost of Goods Sold
2,200
22,000
S
6-96
20X7 Upstream Sales: Equity Method Adjustments
— 20X7 & 20X8
20X7 Equity Method Adjustment on Parent’s books:
Income from Sub
Investment in Sub
19,800
19,800
Deferral of GP in 20X7
because not yet sold this year.
NCI
10%
20X8 Equity Method Reversal of 20X7 Deferral (on
Parent’s books):
Investment in Sub
Income from Sub
19,800
19,800
P
90%
S
6-97
20X7 Upstream Sales: 20X7 Equity Accounts
Investment in Sub
Income from Sub
108,000 90% NI
90% NI 108,000
19,800
Low 19,800
X7 Deferral
19,800
88,200
6-98
20X7 Upstream Sales: 20X7 Partial Worksheet
Parent
Sub
DR
600,000
CR
Consolidated
Income Statement
Sales
588,000
600,000
COGS
490,000
480,000
Inc from Sub
88,200
Gross Profit
186,200
578,000
120,000
688,200
578,000
9,800 Basic
186,200
392,000)
88,200 Basic
NCI in NI
CI in NI
588,000)
120,000
698,000
196,000)
(9,800)
578,000
186,200)
22,000
88,000)
Balance Sheet
Inventory
110,000
6-99
Review Exercise Part 2
 In 20X7, Sensei, a 90%-owned subsidiary of Padawan,
sold inventory to Padawan for $600,000, which includes a
markup of 25% on Sensei’s cost.
NCI
 Padawan resold most of this inventory in 20X7 for
$588,000.
10%
 At 12/31/X7, Padawan reported $110,000 of this
inventory in its balance sheet. (This ending inventory was
resold in 20X8 by Padawan.)
 In 20X8, Sensei sold Padawan inventory for $900,000 that
had a cost of $675,000, of which Padawan resold $700,000
by12/31/X8 for $840,000.
P
90%
S
Required:
 Prepare the consolidation entry and/or entries required
at 12/31/X8 under the equity method.
 Since this is an UPSTREAM transaction, we do share the
GP deferral with the NCI.
6-100
Review Exercise Part 2: The Big Picture—20X8
Total
Sold
On hand
Sales
900,000
700,000 200,000
− COGS
675,000
525,000 150,000
Gross Profit
225,000
175,000
50,000
Gross Profit % = 225,000 ÷ 900,000 = 25%
Unrealized GP
Ending Inventory = $200,000
675,000
Sub
$900,000
Parent
?
6-101
Review Exercise 2: Summary
To eliminate sale from Sub to Parent to Outsider:
Sales (Sub)
700,000
Cost of Goods Sold (Parent)
700,000
To eliminate sale from Sub to Parent, not yet to Outsider:
Sales (Sub)
200,000
Cost of Goods Sold (Sub)
150,000
Inventory (basis correction)
50,000
Combine both entries:
Sales
Cost of Goods Sold
Inventory
900,000
850,000
50,000
Fully-adjusted Equity Method Entry on Parent’s books:
Income from Sub
Investment in Sub
45,000
45,000
6-102
Review Exercise 2: Short Cut
Total
Sold
On hand
Sales
900,000
700,000
200,000
− COGS
675,000
525,000
150,000
Gross Profit
200,000
175,000
50,000
COGS CR = 700,000 + 150,000 = 850,000
The Elimination Entry:
Sales
Cost of Goods Sold
Inventory
900,000
850,000
50,000
6-103
20X8 Upstream Sales: 20X8 Equity Accounts
Investment in Sub
Income from Sub
19,800 Low
19,800
X7 Reversal
19,800
90% NI 202,500
202,500 90% NI
45,000
X8 Deferral
45,000 Low
45,000
177,300
6-104
20X7 & 20X8 Upstream Sales: 20X8 Partial
Worksheet
Parent
Sub
DR
Sales
840,000
900,000
900,000
COGS
700,000
675,000
CR
Consolidated
Income Statement
840,000)
850,000
503,000)
22,000
Income from Sub
177,300
Gross Profit
317,300
177,300 Basic
225,000
NCI in NI
CI in NI
1,077,300
872,000
19,700 Basic
317,300
225,000
1,097,000
337,000)
(19,700)
872,000
317,300
50,000
150,000)
Balance Sheet
Inventory
200,000
Investment in Sub
Low by
45,000
NCI in NA of Sub
19,800
2,200
Basic X
2,200
6-105
Learning Objective 5
Understand and explain
additional considerations
associated with consolidation.
6-106
Additional Considerations
 Sale from one subsidiary to another
◼
◼
◼
Transfers of inventory often occur between
companies that are under common control or
ownership.
The eliminating entries are identical to those
presented earlier for sales from a subsidiary to its
parent.
The full amount of any unrealized intercompany
profit is eliminated, with the profit elimination
allocated proportionately against the ownership
interests of the selling subsidiary.
6-107
Additional Considerations
 Costs associated with transfers
◼
◼
When one affiliate transfers inventory to
another, some additional cost is often
incurred.
Such costs should be treated in the same
way as if the affiliates were operating
divisions of a single company.
6-108
Additional Considerations
 Lower-of-cost-or-market
◼
A company might write down inventory
purchased from an affiliate under this rule
if the market value at the end of the period
is less than the intercompany transfer
price.
6-109
Lower-of-Cost-or-Market Example
Assume that a parent company purchases inventory for $20,000 and
sells it to its subsidiary for $35,000. The subsidiary still holds the
inventory at year-end and determines that its market value
(replacement cost) is $25,000 at that time. The subsidiary writes the
inventory down from $35,000 to its lower market value of $25,000 at
the end of the year and records the following entry:
Write-down Inventory to Market Value:
Loss on Decline in Value of Inventory
Inventory
10,000
10,000
Make the following worksheet eliminating entry:
Sales
Cost of Goods sold
Inventory
Loss on Decline in Value of Inventory
35,000
20,000
5,000
10,000
6-110
Additional Considerations
 Sales and purchases before affiliation
◼
◼
The consolidation treatment of profits on
inventory transfers that occurred before the
business combination depends on whether the
companies were at that time independent and the
sale transaction was the result of arm’s-length
bargaining.
As a general rule, the effects of transactions that
are not the result of arm’s-length bargaining must
be eliminated.
6-111
Additional Considerations
 In the absence of evidence to the contrary,
companies that have joined together in a business
combination are viewed as having been separate
and independent prior to the combination.
◼
◼
If the prior sales were the result of arm’s-length
bargaining, they are viewed as transactions between
unrelated parties.
No elimination or adjustment is needed in preparing
consolidated statements subsequent to the combination,
even if an affiliate still holds the inventory.
6-112
Practice Quiz Question #6
Peanut Co. regularly purchased inventory
from Snack Inc. in 20X3 when Peanut did
not own any Snack stock. On March 31,
20X4, Peanut purchased 90% of Snack
Inc.’s outstanding common stock.
a. Peanut should eliminate 90% of Snack’s
first quarter 20X4 gross profit.
b. Peanut should eliminate 100% of
Snack’s first quarter 20X4 gross profit.
c. Peanut should not eliminate any of
Snack’s first quarter 20X4 gross profit.
d. Peanut should eliminate 100% of
Snack’s 20X4 gross profit.
6-113
Practice Quiz Question #6 Solution
Peanut Co. regularly purchased inventory
from Snack Inc. in 20X3 when Peanut did
not own any Snack stock. On March 31,
20X4, Peanut purchased 90% of Snack
Inc.’s outstanding common stock.
a. Peanut should eliminate 90% of Snack’s
first quarter 20X4 gross profit.
b. Peanut should eliminate 100% of
Snack’s first quarter 20X4 gross profit.
c. Peanut should not eliminate any of
Snack’s first quarter 20X4 gross profit.
d. Peanut should eliminate 100% of
Snack’s 20X4 gross profit.
6-114
Conclusion
The End
Chapter 07
Intercompany Transfers
of Services and
Noncurrent Assets
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objective 1
Understand and explain
concepts associated with
transfers of long-term assets
and services.
7-2
Summary of GAAP Requirements for Preparing
Consolidated Statements
 All intercompany transactions must be
eliminated in consolidation.
 The full amount of unrealized intercompany
profit or gain must be eliminated.
◼
The deferral is shared with NCI shareholders in
upstream transactions.
7-3
Big Picture: The Consolidated Perspective
 From a consolidated viewpoint,
the reported amount for a fixed
asset cannot change merely
because the asset has been
moved to a different location
within the consolidated group.
 Objective:
◼
◼
Undo the transfer.
Make it appear as if we only
changed the estimated useful
life of asset.
P
Long-term
Asset
S
7-4
Different Asset Types
 Non-depreciable Assets
The transfer of non-depreciable assets is very
similar to the transfer of inventory
◼ Eliminate gains like unrealized gross profit
◼
 Depreciable Assets
Eliminate the seller’s gain
◼ Adjust transferred asset back to old basis
◼ Adjust depreciation back to what it would have
otherwise been if the original owner had
depreciated the asset based on the revised
estimate of useful life
◼
7-5
Intercompany Transfers of Services
 When one company purchases services from a
related company, the purchaser typically records an
expense and the seller records a revenue.
◼
◼
◼
In the consolidation worksheet, an eliminating entry
would be needed to reduce both revenue (debit) and
expense (credit).
Because the revenue and expense are equal and both
are eliminated, income is unaffected by the
elimination.
The elimination is still important because otherwise
both revenues and expenses are overstated.
7-6
Practice Quiz Question #1
The goal in preparing eliminating entries
related to asset transfers among affiliated
companies is to:
a. Emphasize gains and losses in the
consolidated financial statements.
b. Eliminate gains and losses and re-adjust
the basis of the transferred asset to what
it would have been on the original
owner’s books.
c. Augment consolidated income.
d. Decrease consolidated income.
7-7
Practice Quiz Question #1 Solution
The goal in preparing eliminating entries
related to asset transfers among affiliated
companies is to:
a. Emphasize gains and losses in the
consolidated financial statements.
b. Eliminate gains and losses and re-adjust
the basis of the transferred asset to what
it would have been on the original
owner’s books.
c. Augment consolidated income.
d. Decrease consolidated income.
7-8
Learning Objective 2
Prepare equity-method
journal entries and
elimination entries for the
consolidation of a subsidiary
following an intercompany
land transfer.
7-9
Example 1: 100% Ownership Land Transfer (NonDepreciable)
 On 3/31/X5, Parker Inc. sold land costing $40,000 to its
100% owned subsidiary, Stubben Inc., for $100,000.
 In this example, we’ll do consolidation worksheet entries
without adjusting the equity method accounts.
 This is the modified equity method.
 This is meant to be a conceptual exercise only. (We will
switch to the fully adjusted equity method next.)
Required:
1. Prepare the consolidation entry(ies) as of 12/31/X5 and
12/31/X6.
2. Prepare the consolidation entry at 12/31/X7, assuming that
Stubben sold the land in 20X7 for $120,000.
7-10
Example 1: 100% Ownership Land Transfer (NonDepreciable)
On 3/31/X5, Parker Inc. sold land costing $40,000 to its
100% owned subsidiary, Stubben Inc., for $100,000.
In 20X7
$40
Parker $100 Stubben $120
“Fake” Gain = $60
Gain = $20
Total Gain = $80
7-11
Example 1: Consolidation Entry at 12/31/X5
Requirement 1:
Parker
Stubben
Assets = Liabilities + Equity
Assets = Liabilities + Equity
Gain +60
Land +60
Consolidation Entry at 12/31/X5
Gain on Sale of Land
Land
60,000
60,000
What happens to the gain?
RE +60
Land +60
7-12
Example 1: Consolidation Entry at 12/31/X6
Requirement 1:
Parker
Stubben
Assets = Liabilities + Equity
Assets = Liabilities + Equity
RE +60
Land +60
Consolidation Entry at 12/31/X6 (and all years until land is sold)
Retained Earnings
Land
60,000
60,000
7-13
Example 1: Consolidation Entry at 12/31/X7
Requirement 2:
Parker
Stubben
Assets = Liabilities + Equity
Assets = Liabilities + Equity
RE +60
Gain +20
What gain should Stubben report in 20X7 when the land is sold?
Consolidation Entry at 12/31/X7 (Stubben resold the land in 20X7)
Retained Earnings
Gain on Sale
60,000
60,000
• Thus, the consolidated gain is $80,000!
• What’s the only problem with the partial equity method?
• THE PARENT’S FINANCIAL STATEMENTS ARE NOT CORRECT!
7-14
Solution: Parker Company Equity Method Journal
Entries
Requirement 1
Consolidation Entry at 12/31/X5
Gain on Sale of Land
Land
60,000
60,000
Consolidation Entry at 12/31/X6
Retained Earnings
Land
60,000
60,000
Requirement 2
Consolidation Entry at 12/31/X7 (Stubben resold the land in 20X7)
Retained Earnings
Gain on Sale of Land
60,000
60,000
7-15
Equity Method Adjustment
 After calculating the unrealized gain, simply make an
extra adjustment to back it out.
 Do this at the same time you record the parent’s
share of the sub’s income.
Investment in Sub
NI
Income from Sub
XXX
XXX
NI
60,000 Unreal. Gain 60,000
Reverse later when the
asset is sold!
This ensures that
the parent income
is equal to the
consolidated
income.
7-16
Example 2: 100% Ownership Land Transfer
 On 3/31/X5, Parker Inc. sold land costing $40,000 to its
100% owned subsidiary, Stubben Inc., for $100,000.
 Now assume Parker adjusts for this transaction in the
equity accounts.
 This is the fully adjusted equity method!
 How would your answers change?
Required:
1. Prepare the consolidation entry(ies) as of 12/31/X5 and
12/31/X6.
2. Prepare the consolidation entry at 12/31/X7, assuming that
Stubben sold the land in 20X7 for $120,000.
7-17
Example 2: 100% Ownership Land Transfer
On 3/31/X5, Parker Inc. sold land costing $40,000 to its
100% owned subsidiary, Stubben Inc., for $100,000.
In 20X7
$40
Parker $100 Stubben $120
“Fake” Gain = $60
Gain = $20
Total Gain = $80
7-18
ONE EXTRA STEP! Equity Method Adjustment
Investment in Sub
Income from Sub
NI XXX
XXX NI
60,000 Unreal. 60,000
Gain
This defers the
gain until later
7-19
Example 2: Consolidation Entry at 12/31/X5
Requirement 1:
Parker
Stubben
Assets = Liabilities + Equity
Invest −60
Gain +60
Income from Sub −60
Assets = Liabilities + Equity
Land +60
• The equity method adjustment “fixes” parent’s books!
What happens to the equity method accounts?
• Eliminated in the consolidation. But we still need to fix the problem!
Consolidation Entry at 12/31/X5
Gain on Sale of Land
Land
60,000
Same!
60,000
What happens to the gain AND Income from Sub?
Invest −60
RE correct
Land +60
They cancel out!
7-20
Example 2: Consolidation Entry at 12/31/X6
Requirement 1:
Parker
Stubben
Assets = Liabilities + Equity
Invest −60
Assets = Liabilities + Equity
Land +60
• The normal basic elimination entry will still eliminate BV of equity.
• The investment account will be “over eliminated” and left with a 60,000
credit!
• We can’t leave a “balance” in that account in the consolidated B/S!
Consolidation Entry at 12/31/X6 (and all years until land is sold)
Investment
Land
60,000
60,000
• This entry eliminates the investment account and fixes the land balance.
7-21
Example 2: Consolidation Entry at 12/31/X7
Requirement 1:
Parker
Stubben
Assets = Liabilities + Equity
Invest −60
Assets = Liabilities + Equity
Gain +20
What gain should Stubben report in 20X7 when the land is resold?
Consolidation Entry at 12/31/X7 (Stubben resold the land in 20X7)
Investment
Gain on Sale
60,000
60,000
• Thus, the consolidated gain is $80,000!
• We also reverse out the equity method deferral this year.
• THE PARENT’S FINANCIAL STATEMENTS ARE ALWAYS CORRECT!
7-22
Example 2: Solution Summary
Requirement 1
Consolidation Entry at 12/31/X5
Gain on Sale of Land
Land
60,000
60,000
Consolidation Entry at 12/31/X6
Investment in Stubben
Land
60,000
60,000
Requirement 2
Consolidation Entry at 12/31/X7 (Stubben resold the land in 20X7)
Investment in Stubben
Gain on Sale of Land
60,000
60,000
7-23
Consolidation Worksheet—20X5
Adjustments
Parent
Sub
DR
CR
Consolidated
Income Statement
Gain
Income from Sub
60,000
60,000
(60,000)
Lower
Basic
0
0
Balance Sheet
Investment in Sub
Land
(60,000)
Lower
Basic
100,000
60,000
0
40,000
7-24
Consolidation Worksheet—20X6
Adjustments
Parent
Sub
DR
CR
Consolidated
Income Statement
Balance Sheet
Investment in Sub
Land
(60,000)
Lower
60,000
Basic
100,000
60,000
0
40,000
7-25
Consolidation Worksheet—20X7
Adjustments
Parent
Sub
DR
CR
Consolidated
60,000
80,000
Income Statement
Gain
20,000
Balance Sheet
Investment in Sub
Land
(60,000)
Lower
60,000
Basic
0
0
0
7-26
Practice Quiz Question #2
The major difference between the modified
and fully adjusted equity methods of
accounting for fixed asset transfers is:
a. The parent’s income is always lower under
the modified equity method.
b. The parent’s income is always higher
under the modified equity method.
c. The parent’s income equals consolidated
income under both methods.
d. The parent’s income equals consolidated
income under the fully adjusted method.
7-27
Practice Quiz Question #2 Solution
The major difference between the modified
and fully adjusted equity methods of
accounting for fixed asset transfers is:
a. The parent’s income is always lower under
the modified equity method.
b. The parent’s income is always higher
under the modified equity method.
c. The parent’s income equals consolidated
income under both methods.
d. The parent’s income equals consolidated
income under the fully adjusted method.
7-28
Learning Objective 3
Prepare equity-method journal
entries and elimination entries
for the consolidation of a
subsidiary following a
downstream land transfer.
7-29
Group Exercise 1: Partial Ownership Land Transfer
 Stubben Corporation is a 90%-owned subsidiary of Parker
Corporation, acquired for $270,000 on 1/1/X5.
 Investment cost was equal to book value and fair value.
 Stubben’s net income in 20X5 was $70,000, and Parker’s
income, excluding its income from Stubben, was $90,000.
 Parker’s income includes a $10,000 unrealized gain on
NCI
land that cost $40,000 and was sold to Stubben for
90%
$50,000.
 Assume that Stubben sold the land in 20X7 for $65,000.
10%
Assume Parker adjusts for this transaction in the equity
accounts.
NOTE: This is a downstream transaction.
P
S
Required:
1. What entry(ies) would Parker make in 20X5 and 20X7?
2. Prepare the consolidation entries at 12/31/X5,
12/31/X6, and 12/31/X7.
7-30
Group Exercise 1: Solution
Requirement 1
20X5 Equity Method Entries
Investment in Stubben
Income from Stubben
63,000
Income from Stubben
Investment in Stubben
10,000
63,000
10,000
20X7 Equity Method Entry (after Stubben resold the land)
Investment in Stubben
Income from Stubben
10,000
10,000
7-31
Group Exercise 1: Solution
Requirement 2
Consolidation Entry at 12/31/X5
Gain on Sale of Land
Land
10,000
10,000
Consolidation Entry at 12/31/X6
Investment in Stubben
Land
10,000
10,000
Consolidation Entry at 12/31/X7 (Stubben resold the land in 20X7)
Investment in Stubben
Gain on Sale of Land
10,000
10,000
7-32
Consolidation Worksheet—20X5
Adjustments
Parent
Sub
DR
CR
Consolidated
Income Statement
Gain
Income from Sub
10,000
10,000
0
53,000
53,000
Basic
0
Balance Sheet
Investment in Sub
Land
323,000
50,000
323,000
Basic
0
10,000
40,000
7-33
Consolidation Worksheet—20X6
Adjustments
Parent
Sub
DR
CR
Consolidated
Income Statement
Balance Sheet
Investment in Sub
Land
(10,000)
Lower
10,000
50,000
Basic
10,000
0
40,000
7-34
Consolidation Worksheet—20X7
Adjustments
Parent
Sub
DR
CR
Consolidated
10,000
25,000
Income Statement
15,000
Balance Sheet
Investment in Sub
Land
(10,000)
Lower
10,000
0
Basic
0
0
7-35
Learning Objective 4
Prepare equity-method journal
entries and elimination entries
for the consolidation of a
subsidiary following an
upstream land transfer.
7-36
Group Exercise 2: Partial Ownership Land Transfer
 Stubben Corporation is a 90%-owned subsidiary of Parker
Corporation, acquired for $270,000 on 1/1/X5.
 Investment cost was equal to book value and fair value.
 Stubben’s net income in 20X5 was $70,000, and Parker’s
income, excluding its income from Stubben, was $90,000.
NCI
 Stubben’s income includes a $10,000 unrealized gain on
90%
land that cost $40,000 and was sold to Parker for $50,000.
 Assume that Parker sold the land in 20X7 for $65,000.
10%
 Assume Parker adjusts for this transaction in the equity
accounts.
 Assume that Stubben sold the land in 20X7 for $65,000.
 Assume Parker adjusts for this transaction in the equity
accounts.
Required:
1. What entry(ies) would Parker make in 20X5 and 20X7?
2. Prepare the consolidation entries at 12/31/X5, 12/31/X6,
and 12/31/X7.
P
S
7-37
Partially Owned Upstream Sales Equity Method Adjustment
 Similar to what we did with inventory transfers:
we must share deferral with the NCI shareholders
 Simply split up the adjustment for unrealized
gains proportionately.
Investment in
Stubben
NI 63,000
9,000
Equity
Method
Adjustments
Unreal. Gain
NCI
P
90%
Income from
Stubben
9,000
63,000 NI
10%
S
54,000
Unreal. 1,000 Gain
To NCI Shareholders
7-38
Solution: Parker Company Equity Method Journal Entries
Requirement 1
20X5 Equity Method Entries
Investment in Stubben
Income from Stubben
63,000
Income from Stubben
Investment in Stubben
9,000
63,000
9000
20X7 Equity Method Entry (after Stubben resold the land)
Investment in Stubben
Income from Stubben
9,000
9,000
7-39
Solution: Parker Company Equity Method Journal Entries
Requirement 2
Consolidation Entry at 12/31/X5
Gain on Sale of Land
Land
10,000
10,000
Consolidation Entry at 12/31/X6
Investment in Stubben
NCI in NA of Stubben
Land
9,000
1,000
10,000
Requirement 3
Consolidation Entry at 12/31/X7 (Stubben resold the land in 20X7)
Investment in Stubben
NCI in NA of Stubben
Gain on Sale of Land
9,000
1,000
10,000
7-40
Consolidation Worksheet—20X5
Adjustments
Parent
CR
Consolidated
Sub
DR
10,000
10,000
0
54,000
Basic
0
Income Statement
Gain
Income from Sub
54,000
Balance Sheet
Investment in Sub
Land
324,000
324,000
Basic
0
50,000
10,000
40,000
7-41
Consolidation Worksheet—20X6
Adjustments
Parent
Sub
DR
CR
Consolidated
Income Statement
Income from Sub
Basic
0
Balance Sheet
Investment in Sub
(9,000)
Lower
Basic
1,000
NCI in NA
Land
9,000
50,000
0
1,000
Lower
10,000
40,000
7-42
Consolidation Worksheet—20X7
Adjustments
Parent
Sub
DR
CR
Consolidated
10,000
25,000
Income Statement
15,000
Income from Sub
Basic
0
Balance Sheet
Investment in Sub
(9,000)
Lower
Basic
1,000
NCI in NA
Land
9,000
0
1,000
Lower
0
7-43
Learning Objective 5
Prepare equity-method journal
entries and elimination entries
for the consolidation of a
subsidiary following a
downstream depreciable asset
transfer.
7-44
Transfers of Depreciable Assets
 What is the major difference between depreciable and
non-depreciable assets?
◼
◼
Depreciation—DUH!
Adds complexity because you have a “moving target” instead of a
stationary target. However, the concepts are the same!
 Adjust for:
◼
Unrealized gain (same as with land)
◼
Differences in depreciation expense
 The goal is to get back to the asset’s old basis “as if ” it were
still on the books of the original owner.
◼
◼
One difference—depreciated going forward based on the new
estimated new life.
Same as a change of depreciation estimates on any company’s books
7-45
Developing Fixed Asset Elimination Entries
 Compare “Actual” with “As if ”
◼
◼
“Actual”
= How the transferred asset and
related accounts actually appear on the
companies’ books
“ As if ”
= How the transferred asset and
related accounts would have appeared if the
asset had stayed on the original owner’s books
 The difference between the two gives
the elimination entry or entries.
7-46
Choosing the Right Depreciable Life
 What’s not relevant?
◼
The original owner’s remaining useful life
at the transfer date.
 What’s relevant?
◼
The acquirer’s estimated remaining useful
life (if different from the original remaining
life).
7-47
Example 3—End of Year Transfer
Assume Padre Corp. purchased a machine on 1/1/20X1 for
$100,000 and estimated that the machine would have a useful
life of 10 years with no salvage value. After two years, on
12/31/20X2, Padre Corp. sold the machine to its 100% owned
subsidiary, Sonny Co., for $90,000. Sonny Co. estimated that the
asset had a remaining useful life of five years.
What is the amount of the gain or loss recorded by Padre at
the time of the fixed asset transfer?
Machine
Accumulated
Depreciation
100,000
20,000
Book Value = 80,000
Sale:
Proceeds
$90,000
− Book Value 80,000
Gain
$ 10,000
7-48
Example 3—End of Year Transfer
Assume Padre Corp. purchased a machine on 1/1/20X1 for
$100,000 and estimated that the machine would have a useful
life of 10 years with no salvage value. After two years, on
12/31/20X2, Padre Corp. sold the machine to its 100% owned
subsidiary, Sonny Co., for $90,000. Sonny Co. estimated that the
asset had a remaining useful life of five years.
What accounts and balances actually exist after the fixed
asset transfer?
Machine
100,000
Accumulated
Depreciation
20,000
Gain on Sale
10,000
7-49
Example 3—End of Year Transfer
Assume Padre Corp. purchased a machine on 1/1/20X1 for
$100,000 and estimated that the machine would have a useful
life of 10 years with no salvage value. After two years, on
12/31/20X2, Padre Corp. sold the machine to its 100% owned
subsidiary, Sonny Co., for $90,000. Sonny Co. estimated that the
asset had a remaining useful life of five years.
What balances would have existed if the transfer had not
taken place?
Accumulated
Depreciation
Machine
Gain on Sale
90,000
“Actual”
0
10,000
100,000
“As if”
20,000
0
7-50
Example 3—End of Year Transfer
The worksheet entry on 12/31/X2 to eliminate the asset
transfer is simply the “adjustment” to change from “actual”
to “as if” the asset hadn’t been transferred.
Gain on Sale
Machine
Accumulated Depreciation
“Actual”
10,000
100,000
20,000
Accumulated
Depreciation
Machine
90,000
10,000
10,000
Gain on Sale
0
20,000
“As if”
20,000
10,000
10,000
0
7-51
Example 4: Beginning of Year Transfer
Assume Padre Corp. purchased a machine on 1/1/20X1 for
$100,000 and estimated that the machine would have a useful
life of 10 years with no salvage value. After two years, on
1/1/20X3, Padre Corp. sold the machine to its 100% owned
subsidiary, Sonny Co., for $90,000. Sonny Co. estimated that the
asset had a remaining useful life of five years.
How much depreciation expense will Sonny record in 20X3?
Depreciation Expense = (C – SV) / # years
= (90,000 – 0) / 5 years = $18,000
How much depreciation expense would Padre have recorded in 20X3
if it had retained the machine and simply changed the estimated life to
five years?
Depreciation Expense = (BV – SV) / # years left
= (80,000 – 0) / 5 years = $16,000
7-52
Example 4: Beginning of Year Transfer
Assume Padre Corp. purchased a machine on 1/1/20X1 for
$100,000 and estimated that the machine would have a useful
life of 10 years with no salvage value. After two years, on
1/1/20X3, Padre Corp. sold the machine to its 100% owned
subsidiary, Sonny Co., for $90,000. Sonny Co. estimated that the
asset had a remaining useful life of five years.
Sonny’s 20X3 expense can be separated into two parts:
◼
◼
The portion associated with the original book value from Padre’s books.
The portion associated with the extra amount paid above Padre’s book
value (the gain).
Gain = 10,000  5 =
2,000
Extra Depreciation
Book Value = 80,000  5 =
16,000
Padre Depreciation
18,000
Total Sonny Depreciation
7-53
Example 4: Beginning of Year Transfer
Assume Padre Corp. purchased a machine on 1/1/20X1 for
$100,000 and estimated that the machine would have a useful
life of 10 years with no salvage value. After two years, on
1/1/20X3, Padre Corp. sold the machine to its 100% owned
subsidiary, Sonny Co., for $90,000. Sonny Co. estimated that the
asset had a remaining useful life of five years.
How do we “fix” the depreciation expense so that it will
appear “as if” the asset had not been transferred?
In other words, how do eliminate the “extra” depreciation
expense?
Gain = 10,000  5 =
2,000
Extra Depreciation
Book Value = 80,000  5 =
16,000
Padre Depreciation
18,000
Total Sonny Depreciation
7-54
Example 4: Beginning of Year Transfer
Assume Padre Corp. purchased a machine on 1/1/20X1 for
$100,000 and estimated that the machine would have a useful
life of 10 years with no salvage value. After two years, on
1/1/20X3, Padre Corp. sold the machine to its 100% owned
subsidiary, Sonny Co., for $90,000. Sonny Co. estimated that the
asset had a remaining useful life of five years.
Depreciation
Expense
Accumulated
Depreciation
18,000
“Actual”
18,000
16,000
“As if”
16,000
Gain = 10,000  5 =
2,000
Extra Depreciation
Book Value = 80,000  5 =
16,000
Padre Depreciation
18,000
Total Sonny Depreciation
7-55
Example 4: Beginning of Year Transfer
Assume Padre Corp. purchased a machine on 1/1/20X1 for
$100,000 and estimated that the machine would have a useful
life of 10 years with no salvage value. After two years, on
1/1/20X3, Padre Corp. sold the machine to its 100% owned
subsidiary, Sonny Co., for $90,000. Sonny Co. estimated that the
asset had a remaining useful life of five years.
Depreciation
Expense
18,000
Accumulated
Depreciation
“Actual”
2,000
16,000
18,000
2,000
“As if”
Accumulated Depreciation
Depreciation Expense
16,000
2,000
2,000
7-56
Example 4: Beginning of Year Transfer
Assume Padre Corp. purchased a machine on 1/1/20X1 for
$100,000 and estimated that the machine would have a useful
life of 10 years with no salvage value. After two years, on
1/1/20X3, Padre Corp. sold the machine to its 100% owned
subsidiary, Sonny Co., for $90,000. Sonny Co. estimated that the
asset had a remaining useful life of five years.
In addition to the depreciation adjustment, the asset’s basis needs to be
adjusted and the gain eliminated. What accounts and balances actually
exist after the fixed asset transfer?
Accumulated
Depreciation
Machine
Gain on Sale
90,000
“Actual”
18,000
10,000
7-57
Example 4: Beginning of Year Transfer
Assume Padre Corp. purchased a machine on 1/1/20X1 for
$100,000 and estimated that the machine would have a useful
life of 10 years with no salvage value. After two years, on
1/1/20X3, Padre Corp. sold the machine to its 100% owned
subsidiary, Sonny Co., for $90,000. Sonny Co. estimated that the
asset had a remaining useful life of five years.
What balances would have existed if the transfer hadn’t taken
place?
Accumulated
Depreciation
Machine
Gain on Sale
90,000
“Actual”
18,000
10,000
100,000
“As if”
36,000
0
7-58
Example 4: Beginning of Year Transfer
There are two worksheet entries on 12/31/X3 to compare
“actual” to “as if” to make it appear like the asset hadn’t been
transferred. What is the second elimination entry?
Accumulated Depreciation
Depreciation Expense
2,000
Gain on Sale
Equipment
Accumulated Depreciation
10,000
10,000
“Actual”
10,000
100,000
20,000
Accumulated
Depreciation
Machine
90,000
2,000
18,000
2,000
“As if”
Gain on Sale
20,000
36,000
10,000
10,000
0
7-59
Practice Quiz Question #2
On 7/1/X8, Pale, Inc. reported a $30,000
gain on equipment sold to Sunny, Inc.
(100% owned), which extended the then
remaining life of 3 yrs. to 5 yrs. The
adjustment to depreciation expense in
consolidation at 12/31/X8 is :
a. $3,000.
b. $5,000.
c. $6,000.
d. $10,000.
e. None of the above.
7-60
Practice Quiz Question #2 Solution
On 7/1/X8, Pale, Inc. reported a $30,000
gain on equipment sold to Sunny, Inc.
(100% owned), which extended the then
remaining life of 3 yrs. to 5 yrs. The
adjustment to depreciation expense in
consolidation at 12/31/X8 is :
a. $3,000. ($30,000 / 5) x ½ year
b. $5,000.
c. $6,000.
d. $10,000.
e. None of the above.
7-61
Practice Quiz Question #3
On 5/1/X8, Pastor, Inc. had a $30,000 gain
on equipment sold to Sermon, Inc. (100%
owned) for $150,000. Sermon extended the
then remaining life of 2 yr. (original life was
10 yrs.) to 4 yrs. What is the consolidated
accumulated depreciation at 12/31/X8?
a. $500,000.
b. $505,000.
c. $510,000.
d. $520,000.
e. $540,000.
7-62
Practice Quiz Question #3 Solution
On 5/1/X8, Pastor, Inc. had a $30,000 gain
on equipment sold to Sermon, Inc. (100%
owned) for $150,000. Sermon extended the
then remaining life of 2 yr. (original life was
10 yrs.) to 4 yrs. What is the consolidated
accumulated depreciation at 12/31/X8?
a. $500,000. ($480,000 + [$120,000/4 x 2/3 yr.])
b. $505,000.
c. $510,000.
d. $520,000.
e. $540,000.
This is a difficult question! Solve it in several steps.
7-63
Example 5: Partial Ownership Depreciable Asset
Transfer at the End of the Year
On Pericles Corporation sells machinery to its 80%-owned
subsidiary, Sophocles Corporation, on 12/31/20X4. The
machinery has a book value of $60,000 on this date (cost
$120,000 and accumulated depreciation $60,000), and it is
sold to Sophocles for $90,000. Thus, this transaction
produces an unrealized gain of $30,000. Assume that
Pericles adjusts its equity method accounts accordingly.
Note: Transfer is on last day of the year.
Required:
1. What journal entry would Pericles make on its
books to adjust for the unrealized gain from this
transaction?
2. What worksheet entry would Pericles make to
consolidate on this date?
NCI
P
80%
20%
S
7-64
Example 5: Partial Ownership Depreciable Asset
Transfer at the End of the Year
Equipment
Accumulated
Depreciation
120,000
60,000
Book Value = 60,000
Proceeds
− Book Value
Unrealized Gain
$90,000
60,000
$ 30,000
Income from
Sub
Investment in Sub
30,000
Sale:
Defer Gain
30,000
Requirement 1: Equity Method
Income from Sub
Investment in Sub
30,000
30,000
7-65
Example 5: Partial Ownership Depreciable Asset
Transfer at the End of the Year
Accumulated
Depreciation
Equipment
Sub
90,000
30,000
“Actual”
0
60,000
Parent 120,000
“As if”
60,000
Requirement 2: Worksheet Entry
Gain on Sale
Equipment
Accumulated Depreciation
30,000
30,000
60,000
7-66
Example 6: Depreciable Asset Transfer at Beginning
of Year
Given all other information from the previous example,
assume that the transfer takes place on 1/1/20X4. Also,
assume that as of the date of transfer, the machinery has a
five-year remaining useful life (with no residual value) and
that Sophocles uses straight-line depreciation. In addition to
the journal entries to record the transfer of the asset,
Sophocles also records depreciation expense of $18,000 for
20X4 ($90,000 / 5 years).
Note: Transfer is on first day of the year.
Required:
1. What journal entry(ies) would Pericles make on its books
to adjust for the unrealized gain from this transaction?
2. What worksheet entry(ies) would Pericles make to
consolidate on this date?
7-67
Example 6: Depreciable Asset Transfer at Beginning
of Year
Gain = 30,000  5 =
6,000
Extra Depreciation
Book Value = 60,000  5 = 12,000 Parent Depreciation
18,000
Total Depreciation
Requirement 1:
Of the $18,000 of depreciation recorded, $12,000 is based
on the BV at the time of transfer and $6,000 is based on the
unrealized gain component. We can think of the $6,000 as
the cancelation of 1/5 of the unrealized gain.
7-68
Example 6: Depreciable Asset Transfer at Beginning
of Year
Investment in Sub
30,000
6,000
Income from Sub
Defer Gain
Extra Depreciation
30,000
6,000
Income from Sub
Investment in Sub
30,000
Investment in Sub
Income from Sub
6,000
30,000
6,000
7-69
Example 6: Depreciable Asset Transfer at Beginning
of Year
Accumulated
Depreciation
Equipment
Sub
90,000
30,000
“Actual”
Parent 120,000
“As if”
6,000
18,000
60,000
72,000
Requirement 2: Worksheet Entries
Gain on Sale
Equipment
Accumulated Depreciation
30,000
30,000
Accumulated Depreciation
Depreciation Expense
6,000
60,000
6,000
7-70
Consolidation Worksheet—20X4
Adjustments
Parent
Sub
DR
CR
Consolidated
Income Statement
Gain
Depreciation Expense
30,000
30,000
18,000
0
6,000
12,000
Balance Sheet
Equipment
90,000
30,000
Accumulated
Depreciation
18,000
6,000
120,000
60,000
72,000
7-71
Example 6: Subsequent Years
Given all other information from the previous examples,
consider what happens in the last 5 years of the asset’s
useful life. Think about both the equity method entry
Pericles would have to make each year and what
elimination entry would be made each year.
Note: Transfer is on first day of the year.
Required:
1. What journal entry would Pericles make on its books to
adjust for the unrealized gain from this transaction on
12/31/X5?
2. What worksheet entry(ies) would Pericles make to
consolidate on this date on 12/31/X5?
7-72
Solution 6: Subsequent Years
Requirement 1:
Pericles will continue to extinguish $6,000 (1/5) of
the unrealized gain each year to its equity accounts.
Equity Method Entry for all Subsequent Years:
Investment in Sub
Income from Sub
6,000
6,000
7-73
Solution 6: Subsequent Years
Accumulated
Depreciation
Equipment
Sub
90,000
30,000
“Actual”
Parent 120,000
“As if”
6,000
36,000
54,000
84,000
20X5 Worksheet Entries:
Investment in Sub
Equipment
Accumulated Depreciation
24,000
30,000
Accumulated Depreciation
Depreciation Expense
6,000
54,000
6,000
7-74
Consolidation Worksheet—20X5
Adjustments
Parent
Sub
DR
CR
Consolidated
6,000
12,000
Income Statement
Depreciation Expense
18,000
Balance Sheet
Equipment
90,000
30,000
Accumulated
Depreciation
36,000
6,000
54,000
84,000
24,000
Basic
0
Investment in Sub
XXX
120,000
7-75
Solution 6: Subsequent Years
20X6 Worksheet Entries:
Accumulated
Depreciation
Equipment
Investment in Sub
Equipment
Accumulated Depreciation
18,000
30,000
Accumulated Depreciation
Depreciation Expense
6,000
Sub
48,000
6,000
90,000
“Actual”
30,000
Parent 120,000
20X7 Worksheet Entries:
6,000
“As if”
12,000
30,000
Accumulated Depreciation
Depreciation Expense
6,000
Sub
42,000
30,000
6,000
Parent 120,000
20X8 Worksheet Entries:
Investment in Sub
Equipment
Accumulated Depreciation
6,000
30,000
Accumulated Depreciation
Depreciation Expense
6,000
90,000
36,000
6,000
90,000
72,000
6,000
“As if”
42,000
108,000
Accumulated
Depreciation
“Actual”
30,000
Parent 120,000
96,000
“Actual”
Equipment
Sub
48,000
Accumulated
Depreciation
Equipment
Investment in Sub
Equipment
Accumulated Depreciation
54,000
90,000
6,000
“As if”
36,000
120,000
7-76
Consolidation Worksheet—20X6
Adjustments
Parent
Sub
DR
CR
Consolidated
6,000
12,000
Income Statement
Depreciation Expense
18,000
Balance Sheet
Equipment
90,000
30,000
Accumulated
Depreciation
54,000
6,000
48,000
96,000
24,000
Basic
0
Investment in Sub
XXX
120,000
7-77
Consolidation Worksheet—20X7
Adjustments
Parent
Sub
DR
CR
Consolidated
6,000
12,000
Income Statement
Depreciation Expense
18,000
Balance Sheet
Equipment
90,000
30,000
Accumulated
Depreciation
72,000
6,000
42,000
108,000
24,000
Basic
0
Investment in Sub
XXX
120,000
7-78
Consolidation Worksheet—20X8
Adjustments
Parent
Sub
DR
CR
Consolidated
6,000
12,000
Income Statement
Depreciation Expense
18,000
Balance Sheet
Equipment
90,000
30,000
Accumulated
Depreciation
90,000
6,000
36,000
120,000
24,000
Basic
0
Investment in Sub
XXX
120,000
7-79
Learning Objective 6
Prepare equity-method journal
entries and elimination entries
for the consolidation of a
subsidiary following an
upstream depreciable asset
transfer.
7-80
Example 7: Upstream with Partial Ownership
Depreciable Asset Transfer
On 1/3/X6, Snoopy (an 85%-owned subsidiary of Peanut)
sold equipment costing $150,000 to Peanut for $90,000. At
the time of the sale, the equipment had accumulated
depreciation of $110,000. Peanut continued depreciating
the equipment using the straight-line method and
assigned a remaining useful life of five years.
Note: Transfer is on first day of the year.
P
Required:
NCI
85%
1. What journal entry would Peanut make on its
books each year to adjust for the unrealized
15%
gain from this transaction?
2. What worksheet entry would Peanut make each
year to consolidate on this date?
S
7-81
Example 5 Computations
Equipment
Accumulated Depreciation
150,000
110,000
Book Value = 40,000
Sale:
Proceeds
− Book Value
Unrealized Gain
$90,000
40,000
$ 50,000
7-82
Example 7 Computations
Peanut
Sale:
Proceeds
− Book Value
Unrealized Gain
NCI
$90,000
40,000
$ 50,000
Gain = 50,000  5 = 10,000
Book Value = 40,000  5 =
15%
85%
Snoopy
Extra Depreciation
8,000
Sub Depreciation
18,000
Total Depreciation
7-83
Solution: Peanut Company Equity Method Journal
Entries
Investment in Snoopy
85%
Year 1
Income from Snoopy
42,500 Defer Gain
8,500
42,500
Extra Depr.
8,500
Income from Snoopy
Investment in Snoopy
42,500
Investment in Snoopy
Income from Snoopy
8,500
42,500
8,500
7-84
Solution: Peanut Company Equity Method Journal
Entries
Year 2
Investment in Snoopy
Income from Snoopy
8,500
Year 3
Investment in Snoopy
Income from Snoopy
8,500
Year 4
Investment in Snoopy
Income from Snoopy
8,500
Year 5
Investment in Snoopy
Income from Snoopy
8,500
8,500
8,500
8,500
8,500
7-85
Worksheet Entries
Year 1
Gain on Sale
Equipment
Accumulated Depreciation
50,000
60,000
Accumulated Depreciation
Depreciation Expense
10,000
Equipment
Peanut
90,000
60,000
Snoopy 150,000
110,000
10,000
Accumulated Depreciation
“Actual”
10,000
“As if”
18,000
110,000
118,000
7-86
Worksheet Entries
Year 2
Investment in Snoopy
NCI in NA of Snoopy
Equipment
Accumulated Depreciation
34,000
6,000
60,000
Accumulated Depreciation
Depreciation Expense
10,000
Equipment
Peanut
90,000
60,000
Snoopy 150,000
100,000
10,000
Accumulated Depreciation
“Actual”
10,000
“As if”
36,000
100,000
126,000
7-87
Worksheet Entries
Year 3
Investment in Snoopy
NCI in NA of Snoopy
Equipment
Accumulated Depreciation
25,500
4,500
60,000
Accumulated Depreciation
Depreciation Expense
10,000
Equipment
Peanut
90,000
60,000
Snoopy 150,000
90,000
10,000
Accumulated Depreciation
“Actual”
10,000
“As if”
54,000
90,000
134,000
7-88
Worksheet Entries
Year 4
Investment in Snoopy
NCI in NA of Snoopy
Equipment
Accumulated Depreciation
17,000
3,000
60,000
Accumulated Depreciation
Depreciation Expense
10,000
Equipment
Peanut
90,000
60,000
Snoopy 150,000
80,000
10,000
Accumulated Depreciation
“Actual”
10,000
“As if”
72,000
80,000
142,000
7-89
Worksheet Entries
Year 5
Investment in Snoopy
NCI in NA of Snoopy
Equipment
Accumulated Depreciation
8,500
1,500
60,000
Accumulated Depreciation
Depreciation Expense
10,000
Equipment
Peanut
90,000
60,000
Snoopy 150,000
70,000
10,000
Accumulated Depreciation
“Actual”
10,000
“As if”
90,000
70,000
150,000
7-90
Consolidation Worksheet—Year 1
Adjustments
Parent
Sub
DR
50,000
50,000
CR
Consolidated
Income Statement
Gain
Depreciation Expense
18,000
0
10,000
8,000
Balance Sheet
Equipment
90,000
60,000
Accumulated
Depreciation
18,000
10,000
150,000
110,000
118,000
7-91
Consolidation Worksheet—Year 2
Adjustments
Parent
Sub
DR
CR
Consolidated
Income Statement
Depreciation Expense
18,000
10,000
8,000
Balance Sheet
Equipment
90,000
60,000
Accumulated
Depreciation
36,000
10,000
100,000
126,000
XXX
34,000
Basic
0
Investment in Snoopy
NCI in NA of Snoopy
6,000
150,000
XXX
7-92
Consolidation Worksheet—Year 3
Adjustments
Parent
Sub
DR
CR
Consolidated
Income Statement
Depreciation Expense
18,000
10,000
8,000
Balance Sheet
Equipment
90,000
60,000
Accumulated
Depreciation
54,000
10,000
90,000
134,000
XXX
25,500
Basic
0
Investment in Snoopy
NCI in NA of Snoopy
4,500
150,000
XXX
7-93
Consolidation Worksheet—Year 4
Adjustments
Parent
Sub
DR
CR
Consolidated
Income Statement
Depreciation Expense
18,000
10,000
8,000
Balance Sheet
Equipment
90,000
60,000
Accumulated
Depreciation
72,000
10,000
80,000
142,000
XXX
17,000
Basic
0
Investment in Snoopy
NCI in NA of Snoopy
3,000
150,000
XXX
7-94
Consolidation Worksheet—Year 5
Adjustments
Parent
Sub
DR
CR
Consolidated
Income Statement
Depreciation Expense
18,000
10,000
8,000
Balance Sheet
Equipment
90,000
60,000
Accumulated
Depreciation
90,000
10,000
70,000
150,000
XXX
8,500
Basic
0
Investment in Snoopy
NCI in NA of Snoopy
1,500
150,000
XXX
7-95
Intercompany Transfers of Amortizable Assets
 Accounting for intangible assets usually differs
from accounting for tangible assets in that
amortizable intangibles normally are reported
at the remaining unamortized balance without
the use of a contra account.
 Other than netting the accumulated
amortization on an intangible asset against the
asset cost, the intercompany sale of intangibles
is treated the same in consolidation as the
intercompany sale of tangible assets.
7-96
Conclusion
The End
Chapter 08
Multinational
Accounting:
Foreign Currency
Transactions and
Financial Instruments
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objective 1
Understand how to make
calculations using foreign
currency exchange rates.
8-2
The Accounting Issues
 Foreign currency transactions of a U.S.
company denominated in other
currencies must be restated to their U.S.
dollar equivalents before they can be
recorded in the U.S. company’s books and
included in its financial statements.
◼
Translation: The process of restating foreign
currency transactions to their U.S. dollar
equivalent values
8-3
The Accounting Issues
 Many U.S. corporations have
multinational operations
◼
◼
The foreign subsidiaries prepare their financial
statements in the currency of their countries.
The foreign currency amounts in these financial
statements have to be translated into their U.S.
dollar equivalents before they can be
consolidated with the U.S. parent’s financial
statements.
8-4
Foreign Currency Exchange Rates
 Foreign currency exchange rates between
currencies are established daily by
foreign exchange brokers who serve as
agents for individuals or countries
wishing to deal in foreign currencies.
◼
Some countries maintain an official fixed rate of
currency exchange
8-5
Foreign Currency Exchange Rates
 Determination of exchange rates
◼
◼
Exchange rates change because of a number of
economic factors affecting the supply of and
demand for a nation’s currency.
Factors causing fluctuations are a nation’s
⚫
Level of inflation
⚫
Balance of payments
⚫
Changes in a country’s interest rate
⚫
Investment levels
⚫
Stability and process of governance
8-6
Foreign Currency Exchange Rates
 Direct Exchange Rate (DER) is the number
of local currency units (LCUs) needed to
acquire one foreign currency unit (FCU)
◼
From the viewpoint of a U.S. entity:
U.S. dollar – equivalent value
DER =
1 FCU
8-7
Foreign Currency Exchange Rates
 Indirect Exchange Rate (IER) is the
reciprocal of the direct exchange rate
◼
From the viewpoint of a U.S. entity:
1 FCU
IER =
U.S. dollar – equivalent value
8-8
Foreign Currency Exchange Rates
 DER is identified as American terms
◼
To indicate that it is U.S. dollar–based and
represents an exchange rate quote from the
perspective of a person in the United States
 IER is identified as European terms
◼
To indicate the direct exchange rate from the
perspective of a person in Europe, which means
the exchange rate shows the number of units of
the European’s local currency units per one U.S.
dollar
8-9
Foreign Currency Exchange Rates
 Changes in exchange rates
◼
◼
Strengthening of the U.S. dollar—direct
exchange rate decreases, implies:
⚫
Taking less U.S. currency to acquire one FCU
⚫
One U.S. dollar acquiring more FCUs
Weakening of the U.S. dollar—direct exchange
rate increases, implies:
⚫
Taking more U.S. currency to acquire one FCU
⚫
One U.S. dollar acquiring fewer FCUs
8-10
Relationships between Currencies and Exchange
Rates
8-11
Foreign Currency Exchange Rates
 Spot Rates versus Current Rates
◼
◼
The spot rate is the exchange rate for immediate
delivery of currencies.
The current rate is defined simply as the spot
rate on the entity’s balance sheet date.
8-12
Foreign Currency Exchange Rates
 Forward Exchange Rates
◼
◼
◼
The forward rate on a given date is not the same
as the spot rate on the same date.
Expectations about the relative value of
currencies are built into the forward rate.
The Spread:
⚫
⚫
The difference between the forward rate and the spot
rate on a given date.
Gives information about the perceived strengths or
weaknesses of currencies
8-13
Practice Quiz Question #1
Which of the following statements is false?
a. Most currency exchange rates are
determined by brokers on a daily basis.
b. Economic factors rarely affect exchange
rates.
c. Some countries maintain control over
their exchange rates.
d. When the U.S. dollar strengthens, it has
greater buying power overseas and can
buy more units of foreign currencies.
e. A spot rate is the exchange rate for
immediate delivery of a currency.
8-14
Practice Quiz Question #2 Solution
Which of the following statements is false?
a. Most currency exchange rates are
determined by brokers on a daily basis.
b. Economic factors rarely affect exchange
rates.
c. Some countries maintain control over
their exchange rates.
d. When the U.S. dollar strengthens, it has
greater buying power overseas and can
buy more units of foreign currencies.
e. A spot rate is the exchange rate for
immediate delivery of a currency.
8-15
Learning Objective 2
Understand the accounting
implications of and be able
to make calculations related
to foreign currency
transactions.
8-16
Foreign Currency Transactions
 Foreign currency transactions are
economic activities denominated in a
currency other than the entity’s recording
currency.
 These include:
1. Purchases or sales of goods or services (imports or
exports), the prices of which are stated in a foreign
currency
2. Loans payable or receivable in a foreign currency
3. Purchase or sale of foreign currency forward exchange
contracts
4. Purchase or sale of foreign currency units
8-17
Foreign Currency Transactions
 For financial statement purposes, transactions
denominated in a foreign currency must be
translated into the currency the reporting
company uses
 At each balance sheet date, account balances
denominated in a currency other than the
entity’s reporting currency must be adjusted to
reflect changes in exchange rates during the
period
◼
The adjustment in equivalent U.S . dollar values is a
foreign currency transaction gain or loss for the entity
when exchange rates have changed
8-18
Example: Foreign Currency Transactions
Assume that a U.S. company acquires €5,000 from its bank on
January 1, 20X1, for use in future purchases from German
companies. The direct exchange rate is $1.20 = €1; thus, the company
pays the bank $6,000 for €5,000, as follows:
U.S. dollar equivalent value = Foreign currency units x Direct exchange rate
$6,000
=
€5,000
x
$1.20
The following entry records this exchange of currencies:
January 1, 20X1
Foreign Currency Units (€ )
Cash
6,000
6,000
On July 2, 20X1, the exchange rate is $1.100 = €1. The following adjusting
entry is required in preparing financial statements on July 1:
July 1, 20X1
Foreign Currency Transaction Loss
Foreign Currency Units (€ )
500
500
8-19
Foreign Currency Transactions
 Foreign currency import and export
transactions – Required accounting
overview (assuming the company does
not use forward contracts)
◼
Transaction date:
⚫
Record the purchase or sale transaction at the U.S.
dollar–equivalent value using the spot direct
exchange rate on this date
8-20
Foreign Currency Transactions
 Foreign currency import and export
transactions – Required accounting
overview (assuming the company does
not use forward contracts)
◼
Balance sheet date:
⚫
⚫
Adjust the payable or receivable to its U.S. dollar–
equivalent, end-of-period value using the current
direct exchange rate
Recognize any exchange gain or loss for the change in
rates between the transaction and balance sheet
dates
8-21
Foreign Currency Transactions
 Foreign currency import and export
transactions – Required accounting
overview (assuming the company does
not use forward contracts)
◼
Settlement date:
⚫
⚫
Adjust the foreign currency payable or receivable for
any changes in the exchange rate between the
balance sheet date (or transaction date) and the
settlement date, recording any exchange gain or loss
as required.
Record the settlement of the foreign currency
payable or receivable
8-22
Foreign Currency Transactions
 The two-transaction approach
◼
◼
Views the purchase or sale of an item as a
separate transaction from the foreign currency
commitment.
The FASB established that foreign currency
exchange gains or losses resulting from the
revaluation of assets or liabilities denominated
in a foreign currency must be recognized
currently in the income statement of the period
in which the exchange rate changes.
8-23
Comparative U.S. Company Journal Entries for Foreign Purchase
Transaction Denominated in Dollars versus Foreign Currency Units
8-24
Practice Quiz Question #2
Which of the following statements is true?
a. Foreign currency transactions of a U.S.
Firm involve the exchange of goods from a
foreign country denominated in $ U.S.
b. The purchase or sale of an item is a
separate transaction from the foreign
currency commitment under the two
transaction approach.
c. Foreign currency exchange gains or losses
from the revaluation of assets or liabilities
denominated in a foreign currency must
be recognized in the period when the
exchange rate changes
8-25
Practice Quiz Question #2 Solution
Which of the following statements is true?
a. Foreign currency transactions of a U.S.
Firm involve the exchange of goods from a
foreign country denominated in $ U.S.
b. The purchase or sale of an item is a
separate transaction from the foreign
currency commitment under the two
transaction approach.
c. Foreign currency exchange gains or losses
from the revaluation of assets or liabilities
denominated in a foreign currency must
be recognized in the period when the
exchange rate changes
8-26
Learning Objective 3
Understand how to hedge
international currency risk
using foreign currency
forward exchange financial
instruments.
8-27
Managing International Currency Risk with Foreign Currency
Forward Exchange Financial Instruments
 The accounting for derivatives and
hedging activities is guided by three
standards:
133
Defined derivatives and
established the general rule of
recognizing all derivatives as
either assets or liabilities in the
balance sheet and measuring
those financial instruments at
fair value
FASB Statement No.
138
Amendments of importance to
multinational entities
149
Specific implementation
issues
8-28
Managing International Currency Risk with Foreign Currency
Forward Exchange Financial Instruments
 A financial instrument is cash, evidence of
ownership, or a contract that both:
1. imposes on one entity a contractual obligation to
deliver cash or another instrument, and
2. conveys to the second entity that contractual
right to receive cash or another financial
instrument.
 A derivative is a financial instrument or
other contract whose value is “derived
from” some other item that has a variable
value over time.
8-29
Managing International Currency Risk with Foreign Currency
Forward Exchange Financial Instruments
 Characteristics of derivatives:
◼
◼
The financial instrument must contain one or
more underlyings and one or more notional
amounts, which specify the terms of the financial
instrument.
The financial instrument/ contract requires no
initial net investment or an initial net investment
that is smaller than required for other types of
contracts expected to have a similar response to
changes in market factors.
8-30
Managing International Currency Risk with Foreign Currency
Forward Exchange Financial Instruments
 Characteristics of derivatives:
◼
The contract terms:
⚫
⚫
⚫
Require or permit net settlement
Provide for the delivery of an asset that puts the
recipient in an economic position not
substantially different from net settlement, or
Allow for the contract to be readily settled net by
a market or other mechanism outside the
contract
8-31
Derivatives Designated as Hedges
 Two criteria to be met for a derivative
instrument to qualify as a hedging
instrument:
1. Sufficient documentation must be provided at
the beginning of the hedge term to identify the
objective and strategy of the hedge, the hedging
instrument and the hedged item, and how the
hedge’s effectiveness will be assessed on an
ongoing basis.
8-32
Derivatives Designated as Hedges
 Two criteria to be met for a derivative
instrument to qualify as a hedging
instrument:
2. The hedge must be highly effective throughout
its term
⚫
Effectiveness is measured by evaluating the
hedging instrument’s ability to generate changes
in fair value that offset the changes in value of the
hedged item.
8-33
Derivatives Designated as Hedges
 Fair value hedges are designated to hedge
the exposure to potential changes in the
fair value of:
a) a recognized asset or liability such as availablefor-sale investments, or
b) an unrecognized firm commitment for which a
binding agreement exists.
 The net gains and losses on the hedged
asset or liability and the hedging
instrument are recognized in current
earnings on the statement of income.
8-34
Derivatives Designated as Hedges
 Cash flow hedges
◼
Designated to hedge the exposure to potential
changes in the anticipated cash flows, either into
or out of the company, for
⚫
⚫
a recognized asset or liability such as future
interest payments on variable-interest debt, or
a forecasted cash transaction such as a forecasted
purchase or sale.
8-35
Derivatives Designated as Hedges
 Cash flow hedges
◼
Changes in the fair market value are separated
into an effective portion and an ineffective
portion
⚫
⚫
The net gain or loss on the effective portion of the
hedging instrument should be reported in other
comprehensive income
The gain or loss on the ineffective portion is
reported in current earnings on the statement of
income.
8-36
Derivatives Designated as Hedges
 Foreign currency hedges are hedges in
which the hedged item is denominated in
a foreign currency
◼
◼
◼
A fair value hedge of a firm commitment to enter
into a foreign currency transaction
A cash flow hedge of a forecasted foreign
currency transaction
A hedge of a net investment in a foreign
operation.
8-37
Forward Exchange Contracts
 Forward Exchange Contracts
◼
◼
◼
◼
Contracted through a dealer, usually a bank
Possibly customized to meet contracting
company’s terms and needs
Typically no margin deposit required
Must be completed either with the underlying’s
future delivery or net cash settlement
8-38
Forward Exchange Contracts
 FASB 133 establishes a basic rule of fair
value for accounting for forward
exchange contracts
◼
◼
Changes in the fair value are recognized in the
accounts, but the specific accounting for the
change depends on the purpose of the hedge
For forward exchange contracts, the basic rule is
to use the forward exchange rate to value the
forward contract
8-39
Case 1: Forward Exchange Contracts
Managing an Exposed Foreign Currency Net Asset or
Liability Position: Not a Designated Hedging Instrument
 This case presents the most common use of foreign
currency forward contracts, which is to manage a part of
the foreign currency exposure from accounts payable or
accounts receivable denominated in a foreign currency.
 Note that the company has entered into a foreign
currency forward contract but that the contract does not
qualify for or the company does not designate the forward
contract as a hedging instrument.
8-40
Case 2: Forward Exchange Contracts
Hedging an Unrecognized Foreign Currency Firm
Commitment: A Foreign Currency Fair Value Hedge
 This case presents the accounting for an unrecognized
firm commitment to enter into a foreign currency
transaction, which is accounted for as a fair value hedge.
 A firm commitment exists because of a binding agreement
for the future transaction that meets all requirements for
a firm commitment.
 The hedge is against the possible changes in fair value of
the firm commitment from changes in the foreign
currency exchange rates.
8-41
Case 3: Forward Exchange Contracts
Hedging a Forecasted Foreign Currency Transaction: A
Foreign Currency Cash Flow Hedge
 This case presents the accounting for a forecasted foreign
currency-denominated transaction, which is accounted
for as a cash flow hedge of the possible changes in future
cash flows.
 The forecasted transaction is probable but not a firm
commitment. Thus, the transaction has not yet occurred
nor is it assured; the company is anticipating a possible
future foreign currency transaction.
 Because the foreign currency hedge is against the impact
of changes in the foreign currency exchange rates used to
predict the possible future foreign currency-denominated
cash flows, it is accounted for as a cash flow hedge.
8-42
Case 4: Forward Exchange Contracts
Speculation in Foreign Currency Markets
 This case presents the accounting for foreign currency
forward contracts used to speculate in foreign currency
markets. These transactions are not hedging transactions.
 The foreign currency forward contract is revalued
periodically to its fair value using the forward exchange
rate for the remainder of the contract term.
 The gain or loss on the revaluation is recognized currently
in earnings on the statement of income.
8-43
Practice Quiz Question #3
Which of the following is NOT one of the
criteria for a hedge to be considered
effective?
a. The hedge is based on an effective
interest rate.
b. Documentation of the objective, strategy,
and effectiveness of the hedge.
c. The hedge must be highly effective
through its term.
d. The effectiveness of the hedge is
assessed on an ongoing basis
8-44
Practice Quiz Question #3 Solution
Which of the following is NOT one of the
criteria for a hedge to be considered
effective?
a. The hedge is based on an effective
interest rate.
b. Documentation of the objective, strategy,
and effectiveness of the hedge.
c. The hedge must be highly effective
through its term.
d. The effectiveness of the hedge is
assessed on an ongoing basis
8-45
Learning Objective 4
Understand how to measure
hedge effectiveness, make
interperiod tax allocations for
foreign currency transactions,
and hedge net investments in
a foreign entity.
8-46
Additional Considerations
 Measuring hedge effectiveness
◼
◼
◼
Effectiveness: There will be an approximate
offset, within the range of 80 to 125 percent, of
the changes in the fair value of the cash flows or
changes in fair value to the risk being hedged
Must be assessed at least every three months
and when the company reports financial
statements or earnings
Intrinsic value and Time value
8-47
Additional Considerations
 Interperiod tax allocation for foreign
currency gains (losses)
◼
◼
Temporary differences in the recognition of
foreign currency gains or losses between tax
accounting and GAAP accounting require
interperiod tax allocation
The temporary difference is recognized in
accordance with FASB Statement No. 109
8-48
Additional Considerations
 Hedges of a net investment in a foreign entity
◼
◼
A number of balance sheet management tools
are available for a U.S. company to hedge its net
investment in a foreign affiliate.
FASB 133 specifies that for derivative financial
instruments designated as a hedge of the foreign
currency exposure of a net investment in a
foreign operation, the portion of the change in
fair value equivalent to a foreign currency
transaction gain or loss should be reported in
other comprehensive income.
8-49
Practice Quiz Question #4
Which of the following is the appropriate test
of hedge effectiveness?
a. The hedge offsets between 80-100% of
the cash flows or risk of the item hedged.
b. The hedge offsets between 100-125% of
the cash flows or risk of the item hedged.
c. The hedge offsets between 80-125% of
the cash flows or risk of the item hedged.
d. The hedge offsets between 80-150% of
the cash flows or risk of the item hedged.
8-50
Practice Quiz Question #4 Solution
Which of the following is the appropriate test
of hedge effectiveness?
a. The hedge offsets between 80-100% of
the cash flows or risk of the item hedged.
b. The hedge offsets between 100-125% of
the cash flows or risk of the item hedged.
c. The hedge offsets between 80-125% of
the cash flows or risk of the item hedged.
d. The hedge offsets between 80-150% of
the cash flows or risk of the item hedged.
8-51
Conclusion
The End
Chapter 09
Multinational
Accounting:
Issues in Financial
Reporting and
Translation of Foreign
Entity Statements
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objective 1
Understand and explain
differences between U.S.
GAAP and international
financial reporting
standards (IFRS) and the
expected timeline to global
convergence.
9-2
General Overview
 Accountants preparing financial
statements for multinationals must
consider:
◼
◼
Differences in accounting standards across
countries and jurisdictions
Differences in currencies used to measure the
foreign entity’s operations
9-3
Differences in Accounting Principles
 Methods used to measure economic
activity differ around the world
 Benefits of adoption of a single set of
globally accepted accounting standards
◼
◼
◼
◼
Expansion of capital markets across borders
Help investors to better evaluate opportunities
across borders
Reduce reporting costs for companies accessing
capital in other countries
Increased confidence for users
9-4
Differences in Accounting Principles
 International Financial Reporting
Standards (IFRS)
◼
Standards published by the International
Accounting Standards Board (IASB)
◼
Widely accepted
◼
Mandated or permitted in over 100 countries
◼
FASB is working with the IASB to improve the
quality of standards and to “converge” their two
sets of standards
9-5
Differences in Accounting Principles
 New SEC rules
◼
Allow foreign private issuers to file statements
prepared in accordance with IFRS as issued by
the IASB without reconciliation to U.S. GAAP
(January 4, 2008)
 Next steps:
◼
◼
Allow U.S. issuers to choose between IFRS and
U.S. GAAP
Require U….