Chapter 8

Consolidated
Financial Statements:
Intercompany
Transactions

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc. 2006

 Scope of Chapter

Accounting and working paper eliminations for

related party transactions between a parent
company and its subsidiaries can be grouped in
two broad classes:
•Does not include inter company profits/losses.
•Includes inter company profits/losses.

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 Accounting Techniques

 Ensure that consolidated financial statements

include only those balances and transactions
resulting from the consolidated group’s
dealings with outsiders.
 Separate ledger accounts established for all
intercompany assets, liabilities, revenues and
expenses.

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 Accounting for Inter company
transactions not involving profit/loss

 Loans on notes or open accounts

 Leases of property under operating leases

 Rendering of services

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 Loans on Notes or Open Accounts

Parent companies often make loans to their

subsidiaries because of the following reasons:
More extensive financial resources or bank lines
of credit.
Favorable interest rates to the parent company.

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 Accounting for Loans on Notes or Open
Accounts

 Lending rate of these loans generally exceeds

the parent company’s borrowing rate.
 Any interest earned by the parent company as
a result of such loans must be eliminated
 Interest income/expense parent is offset
against interest expense/income subsidiary

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 Discounting of intercompany notes

If an intercompany note is discounted at a bank

by the payee has following consequences:
 The note is not payable to an outsider – the
bank.
 Discounted intercompany notes are not
eliminated in a working paper for consolidated
financial statements.

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 Leases of Property under operating
Leases

Both the parent and the subsidiary should use

the same accounting principle for lease.
Operating Capital
Lease Lease
Receipts : Sale of
Lessor: Intercompany Property
rent revenue
Lessee: Payments : Acquisition of
Intercompany Property
8 rent expense
 Rendering of Services

 Services may be rendered by a parent

company to a subsidiary or vice versa.
 Both the companies should record the
transaction in the same accounting period.

Example: Management Fee charged to a

subsidiary by a parent company.

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 Income Taxes Applicable to
Intercompany Transactions

 Intercompany revenue and expense

transactions do not include an element of profit
or loss for the consolidated entity as expense
for one is offset by income for another.
 Therefore, no income tax effects are
associated with these transactions.
Note: This holds true even if the parent and the
subsidiary companies file separate tax returns.

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 Accounting for Intercompany
Transactions Involving Profit/Loss

 Intercompany sales of merchandise.

 Intercompany sales of plant assets.
 Intercompany leases of property under
capital/sales type leases.
 Intercompany sales of intangible assets.
 Acquisition of affiliate’s bonds.

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 Importance of Eliminating or Including
Intercompany Profits/Losses

While preparing the consolidated financial

statements it is important to:
 Eliminate unrealized profits/losses relating to:
1. Transactions within the affiliated group.
2. Transactions with outsiders.
 Recognize realized profits/losses.

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 Intercompany Sales of Merchandise

Intercompany sales of merchandise are a natural

outgrowth of business combinations:
 Vertical business combinations:
1. Downstream: Sales of merchandise from a parent
company to its subsidiaries.
2. Upstream: Sales of merchandise from
subsidiaries to the parent company.
 Lateral: Sales of merchandise between two
subsidiaries.

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 Accounting for Intercompany Sales of
Merchandise

Sale of merchandise may be made at:

 Sales price not involving any gross profit
margin.
 Sales price involving a gross profit margin.

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 Intercompany Sales of Merchandise at
cost

This has the following effect in the preparation of

consolidated financial statements:
 The cost of goods sold remains unaffected by
the transaction.
 The closing inventories do not require any
adjustment for price.

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 Intercompany Sales of Merchandise at
profit

Gross profit margin in these transactions may be

equal to, more than or less than the margin on
sales to outsiders. It has to be accounted using
FIFO method as follows:
• Sales made by the purchasing company – the
selling company’s profit is realized and so not
adjustment is required.
• Closing Inventories – The selling company’s
unrealized gross profit has to be eliminated
while preparing the financial statements.
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 Intercompany Profit in Inventories and
Amount of Minority Interest

Two approaches have been suggested for

intercompany sales/purchases transactions of
partially owned subsidiaries:
• Parent Company Concept: Elimination of
intercompany profit only to the extent of the
parent company’s ownership interest.
• Economic Unit Concept: Elimination of all the
intercompany profit.
Note: The FASB has expressed a preference for
the second approach.
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 Intercompany Sales of Plant Assets
versus Sales of Merchandise

 Sales of plant assets are rare as compared to

sales of merchandise.

 Sales of plant assets pass through many

accounting periods before profit/loss are
realized as compared to sales of merchandise
where profit/loss are usually realized in the
ensuing accounting period

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 Intercompany Sales of Land

 Valued at historical cost.

 Intercompany gain eliminated while preparing
consolidated financial statements.

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 Intercompany Sales of Depreciable
plant assets

 Valued at book value of the selling company while

preparing consolidated financial statements.
 Intercompany gain element must be eliminated from the
depreciation expense.
 In case of minority interest, intercompany gain in
depreciation should be eliminated to the extent of the
parent company’s ownership interest.
 Intercompany gain in later years must reflect that the
gain element in the acquiring affiliate’s annual
depreciation represents a realization of a portion of total
gain by the selling affiliate.
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 Intercompany Lease of Property under
Capital/Sales type Leases

 The assets are a sales-type lease to the lessor

and a capital lease to the lessee.
 Appropriate ledger accounts must be
established by the lessor and the lessee to
account for the lease.

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 Intercompany Sales of Intangible Assets

 This is similar to gains in depreciable plant

assets, but no accumulated amortization ledger
account may be involved.
 The unrealized gain of the seller is realized via
periodic amortization expense recognition by
the acquiring company.

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 Acquisition of Affiliate’s Bonds

 Intercompany profits/losses can be realized by a

consolidate entity when that entity acquires the bonds of
the affiliate in the open market.
 The profit or loss of acquiring the bonds are imputed
because the transaction in not consummated between the
two affiliates.
 If however, the transaction were to result from a direct
acquisition, the profit/loss would have to be eliminated.
 In case the acquiring company sells the bonds to outsiders
before they mature, the transaction profit/loss is not
realized by the the consolidated entity, hence eliminated.

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