ELIMINATION OF UNREALIZED GAINS OR LOSSES ON INTERCOMPANY SALES OF PROPERTY AND

EQUIPMENT

Realization Through Usage

A firm may sell property or equipment to an affiliate for a price that differs from its book value. In the year of the sale,
the amount of intercompany gain (loss) recorded by the selling affiliate must be eliminated in consolidation. After the
sale, the purchasing affiliate will calculate depreciation on the basis of its cost, which is the intercompany selling price.
The depreciation recorded by the purchasing affiliate will, therefore, be excessive (deficient) from a consolidated point
of view and will also require adjustment.

From the point of view of the consolidated entity, the intercompany gain (loss) is considered to be realized from the use
of the property or equipment in the generation of revenue. Because such use is measured by depreciation, the
recognition of the realization of intercompany profit (loss) is accomplished through depreciation adjustments.

When there have been intercompany sales of depreciable property, workpaper entries on necessary to accomplish the
following financial reporting objectives in the consolidated financial statements:
 To report as gains or losses in the consolidated income statement only those that result from the sale of
depreciable property to parties outside the affiliated group.
 To present property in the consolidated balance sheet at its cost to the affiliated group.
 To present accumulated depreciation in the consolidated balance sheet based on the cost to the affiliated
group of the related assets.
 To present depreciation expense in the consolidated income statement based on the cost to the affiliated group
of the related assets.

Change in Estimated Life of Asset upon Transfer

When a depreciable asset is transferred between companies, a change in the remaining estimated economic life may
be appropriate. When a change in estimated life of a depreciable asset occurs at the time of an intercorporate transfer,
the treatment is no different than if the change had occurred while the asset remained in the books of the transferring
affiliate. The new remaining useful life is used as a basis for depreciation both by the purchasing affiliate and for
purposes of preparing consolidated financial statements.

Asses Transfer before year-end

In cases in which an intercorporate asset transfer occurs during a period rather than at the end (wherein there is no
intercompany realized gain or loss), a portion of the intercompany gain or loss is considered realized in the period of
the transfer. Then this occurs, the worksheet eliminating entries at the end of the year must include an adjustment of
depreciation expense and accumulated depreciation. The amount of this adjustment is equal to the difference between
the depreciation recorded by the purchaser and that which would have been recorded by the seller during the portion of
the year elapsing after the intercorporate sale.
DOWNSTREAM / UPSTREAM Intercompany SALE

Parent’s adjustment on unrealized gain for downstream sale (Parent is the seller) is recorded at 100% and only at
its percent of ownership if an upstream sale (Subsidiary is the seller).

Illustration 1 – Downstream

On January 1, 2002, Arman Co. acquired for P400,000, 80% interest from Romy Co. when its stockholders’ equity
amounted to P500,000. On July 1, 2002, Romy Co. purchased one Arman Co.’s machine for P35,000. The
machine has an original cost of P60,000 and was already 50% depreciated. Its remaining life at the date of sale was
3 years. The following additional data were given:
Arman Co. Romy Co.
Capital Stock, Jan. 1, 2002 1,000,000 300,000
Retained Earnings Jan. 1, 2002 1,000,000 200,000
Net Income from Operation 250,000 75,000
Gain from Sale of Machine 5,000
Dividends 500,000 150,000

Arman Co.’s Books:

1. Investment in Romy Co. 400,000

Cash 400,000

2. Cash 120,000
Dividend Revenue from Subsidiary 120,000
(150,000 x 80%)

Arman Co.’s Working Paper: (Adjustment and elimination entries)

1. Dividend Revenue from Subsidiary 120,000

Non-controlling Interest 30,000
Dividend, Romy Co. 150,000

2. Machinery 25,000
Gain on Sale (35T-(60Tx50%)) 5,000
Accum. Depr. 29,167
Depreciation Expense 833

3. Capital Stock, Romy Co. 300,000

Retained Earnings, Romy Co. 200,000
Investment in Romy Co. 400,000
Non-controlling Interest 100,000

4. NCI profit P15,000

Non-controlling interest P15,000
(75,000 x 20%)

In 2003 Romy Co. reported the same amount of income and dividends for 2003

Arman Co.’s Books:

1. Cash 120,000
Dividend Revenue from Subsidiary 120,000

Arman Co.’s Working Paper: (Adjustment and elimination entries)

1. Retained Earnings, P Co. 75,000

Investment in S Co. 75,000
#
2. Dividend Revenue from Subsidiary 120,000
Non-controlling Interest 30,000
Dividend, Romy Co. 150,000
#
3. Machinery 25,000
Retained earnings (5T-833) 4,167
Accum. Depr. 27,500
Depreciation Expense 1,667
#
4. Capital Stock, Romy Co. 300,000
Retained Earnings, Romy Co. 125,000
Investment in Romy Co. 340,000
Non-controlling Interest 85,000
#
1. NCI profit P15,000
Non-controlling interest P15,000
(75,000 x 20%)
UPSTREAM SALE (SUBSIDIARY AS INTERCOMPANY SELLER)

The treatment of unrealized gain (loss) arising from the intercompany sales is identical to that of the downstream sles
except that the unrealized gain (loss), and subsequent realization, must be allocated between the controlling and non-
controlling interests.

Illustration – Upstream

On December 31, 2002, P Company purchased for P500,000, 80% controlling interest from S. Co. whose net assets
at the fair value were equal to the investment cost. The following is S Co.’s stockholders’ equity on this date.

Capital Stock P500,000

APIC 25,000
Retained Earnings 100,000
Total P625,000

P Company Books: Acquisition of 80% of S Co. voting stocks

Investment in stock of S Co. P500,000

Cash P500,000

On July 1, 2003, S Co. sold merchandise to P Co. costing P80,000 but billed at 120%. One fourth of the
merchandise purchased from S Co. remained on hand on December 31, 2003. P Co.’s gross profit rate is 25% above
cost. Assuming these are the only transactions of P Co. and S Co. for the year and that they incurred expenses of
P6,000 and P5,000 respectively.

P Company Working Paper Adjustments and Elimination Entries:

1. Sales 96,000*
Cost of Sales 92,000**
Merchandise 4,000***

*96T sale of S Co. is not a sale under consolidated

FS As a result:
**92T overstatement of COS ((80T-S Co + (96T x ¾)-P Co.) – (80T x ¾)-CoS for Conso FS)
***4T overstatement of Invty-End ((96T x ¼)-per books – (80T x ¼) for Conso FS)
 2. Capital Stock, S Co. 500,000
APIC, S Co. 25,000
Retained Earnings, S Co. 100,000
Investment in stock of S Co. 500,000
Non-controlling interest 125,000

3. NCI Profit 1,400

Non-controlling interest 1,400

Upstream Adj
(11,000 – (96T-92T)) x 20%

P Co. sold the remaining merchandise bought from S Co. last year. S Co. reported a net income of P18,000. Assume
no other transaction for the year.

P Company Working Paper Adjustments and Elimination Entries:

1. Investment in stock of S Co. 8,800

Retained Earnings, P Co. 8,800

2. Retained Earnings, P Co. 3,200

Non-controlling Interest 800
Cost of Sales 4,000

3. Capital Stock, S Co. 500,000

APIC, S Co. 25,000
Retained Earnings, S Co. 111,000
(100T+96T-80T-5T)
Investment in stock of S Co. 508,800
Non-controlling interest 127,200

4. NCI Profit 4,400

Non-controlling interest 4,400

Upstream Adj
(18T + 4,000) x 20%