CHAPTER 8 CONSOLIDATED FINANCIAL STATEMENTS: INTERCOMPANY TRANSACTIONS The title of each problem is followed by the estimated time in minutes required for completion and by a difficulty rating. The time estimates are applicable for students using the partially filled-in working papers. Pr. 8–1 Prentiss Corporation (30 minutes, easy) Journal entries for intercompany promissory note, including discounting of the note with a bank, for both parent corporation and subsidiary. Pr. 8–2 Pillsbury Corporation (30 minutes, medium) Journal entries for both parent company and subsidiary to record intercompany promissory note transactions, including discounting of a note. Pr. 8–3 Pittsburgh Corporation (50 minutes, medium) Correcting entries for improperly recorded intercompany transactions and balances. Partial working paper for consolidated financial statements to show presentation of intercompany transactions and balances. Pr. 8–4 Parley Corporation (30 minutes, medium) Working paper eliminations (in journal entry format) for partially owned subsidiary’s sale of leasehold improvement to parent company and for parent company’s acquisition of subsidiary’s bonds in the open market. Pr. 8–5 Peke Corporation (30 minutes, medium) Working paper eliminations (in journal entry format) for downstream and upstream intercompany sales of merchandise. Partially owned subsidiary is involved. Pr. 8–6 Pandua Corporation (45 minutes, medium) Working paper eliminations (in journal entry format) for intercompany sales of merchandise and machinery, for parent company’s open-market acquisition of subsidiary’s bonds, and for minority interest in net income of partially owned subsidiary. Pr. 8–7 Pacific Corporation (50 minutes, medium) Journal entries and working paper eliminations (in journal entry format) for intercompany sale of machinery and for The McGraw-Hill Companies, Inc., 2006 Solutions Manual, Chapter 8 263
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CHAPTER 8CONSOLIDATED FINANCIAL STATEMENTS:
INTERCOMPANY TRANSACTIONS
The title of each problem is followed by the estimated time in minutes required for completion and by a difficulty rating. The time estimates are applicable for students using the partially filled-in working papers.
Pr. 8–1 Prentiss Corporation (30 minutes, easy)
Journal entries for intercompany promissory note, including discounting of the note with a bank, for both parent corporation and subsidiary.
Pr. 8–2 Pillsbury Corporation (30 minutes, medium)
Journal entries for both parent company and subsidiary to record intercompany promissory note transactions, including discounting of a note.
Pr. 8–3 Pittsburgh Corporation (50 minutes, medium)
Correcting entries for improperly recorded intercompany transactions and balances. Partial working paper for consolidated financial statements to show presentation of intercompany transactions and balances.
Pr. 8–4 Parley Corporation (30 minutes, medium)
Working paper eliminations (in journal entry format) for partially owned subsidiary’s sale of leasehold improvement to parent company and for parent company’s acquisition of subsidiary’s bonds in the open market.
Pr. 8–5 Peke Corporation (30 minutes, medium)
Working paper eliminations (in journal entry format) for downstream and upstream intercompany sales of merchandise. Partially owned subsidiary is involved.
Pr. 8–6 Pandua Corporation (45 minutes, medium)
Working paper eliminations (in journal entry format) for intercompany sales of merchandise and machinery, for parent company’s open-market acquisition of subsidiary’s bonds, and for minority interest in net income of partially owned subsidiary.
Pr. 8–7 Pacific Corporation (50 minutes, medium)
Journal entries and working paper eliminations (in journal entry format) for intercompany sale of machinery and for parent company’s acquisition of wholly owned subsidiary’s bonds in the open market.
Pr. 8–8 Pollard Corporation (50 minutes, medium)
Preparation of three-column ledger accounts for accounts affected by parent company’s open-market acquisition of wholly owned subsidiary’s bonds. Working paper eliminations (in journal entry format) for two years.
Pr. 8–9 Procus Corporation (60 minutes, medium)
Preparation of three-column ledger accounts for accounts affected by intercompany sales-type/capital lease. Working paper eliminations (in journal entry format) for two years.
Pr. 8–10 Patrick Corporation (60 minutes, medium)
Working paper for consolidated balance sheet and related working paper eliminations (in journal entry format) for parent corporation and wholly owned subsidiary having merchandising transactions prior to the business combination.
The McGraw-Hill Companies, Inc., 2006Solutions Manual, Chapter 8 263
Pr. 8–11 Power Corporation (65 minutes, strong)
Working paper for consolidated financial statements and related working paper eliminations (in journal entry format) of parent company and partially owned subsidiary having intercompany transactions for merchandise and equipment.
Pr. 8–12 Pritchard Corporation (65 minutes, strong)
Adjusting entries, working paper eliminations (in journal entry format), and working paper for consolidated financial statements of parent company and wholly owned subsidiary having intercompany transactions for notes, merchandise, and equipment.
ANSWERS TO REVIEW QUESTIONS
1. To assure correct elimination of intercompany transactions and balances in consolidated financial statements, a parent company and subsidiary should set up clearly identified separate ledger accounts to record the intercompany items.
2. Common intercompany transactions between a parent company and its subsidiary include the following (only five are required):
(1) Sales of merchandise
(2) Sales of land or depreciable plant assets
(3) Sales of intangible assets
(4) Leases of property under sales-type/capital leases
(5) Loans on promissory notes or open accounts
(6) Leases of property under operating leases
(7) Rendering of services
3. There are no income tax effects associated with the elimination of intercompany rent revenue and expense under an operating lease. Because the revenue of one affiliate exactly offsets the expense of the other affiliate, there is no intercompany profit (gain) or loss associated with the operating lease in a consolidated income statement.
4. A discounted intercompany note receivable is not eliminated in the preparation of a consolidated balance sheet. Discounting the note in effect makes it payable to an outsiderthe bank that discounted the note.
5. If unrealized intercompany profits (gains) resulting from transactions between parent company and subsidiaries are not eliminated, consolidated financial statements will reflect the results of related party activities within the group, as well as results of transactions with those outside the consolidated entity. In these circumstances, consolidated net income would be subject to manipulation by management of the parent company.
6. The following consolidated financial statement categories are affected by intercompany sales of merchandise at a profit:
Net sales
Cost of goods sold
Net income to parent
Inventories
Total current assets
Total assets
Total stockholders’ equity
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7. The unrealized intercompany profit in a subsidiary’s beginning inventories resulting from the parent company’s sales of merchandise to the subsidiary is eliminated from the parent’s beginning retained earnings. This technique is required because the parent had closed the gross profit on its sales to the subsidiaryincluding the profit attributable to the subsidiary’s ending inventories of the preceding accounting periodto its Retained Earnings ledger account.
8. The minority interest in net income of a partially owned subsidiary is affected by working paper eliminations that involve intercompany profits (gains) attributable to that subsidiary. Examples are intercompany profits (gains) on upstream or lateral sales of merchandise, plant assets, or intangible assets, and gains on the open-market acquisition of a partially owned subsidiary’s bonds by the parent company or by another subsidiary.
9. Eliminations of intercompany profit in the parent company’s inventories only to the extent of the parent company’s ownership interest in the selling subsidiary results in a portion of intercompany profit remaining in consolidated net income. This is an undesirable result if the consolidated financial statements are to present the results of transactions with those outside the consolidated entity. The minority stockholders of the subsidiary, although they are considered co-owners of the consolidated entity under the economic unit concept of consolidated financial statements, play no part whatsoever in the negotiation of intercompany sales. Therefore, all the intercompany profit in the parent company’s ending inventories should be eliminated in the preparation of consolidated financial statements.
10. Intercompany sales of plant assets and intangible assets differ from intercompany sales of merchandise in two respects. First, intercompany sales of plant assets and intangible assets are infrequent in occurrence, but intercompany sales of merchandise are recurring transactions once a program for intercompany sales has begun. Second, realization of intercompany gain on sales of plant assets or intangible assets requires the passage of many accounting periods; intercompany profits on sales of merchandise generally are realized rapidly, depending on the frequency of inventories turnover.
11. An intercompany gain on the sale of land is realized only when the land is resold to an outsider. The gain on sale of land between affiliated companies is unrealized from a consolidated point of view.
12. The intercompany gain element of Partin Corporation’s annual depreciation expense is $500 ($2,000 x 1/4 = $500). In the working paper for consolidated financial statements, depreciation expense is reduced by the $500 intercompany gain element. The $500 is considered to be an increase in Sayles Company’s net income, for the computation of the minority interest in net income of subsidiary.
13. Working paper eliminations (in journal entry format) for intercompany leases of property under capital/sales-type leases include eliminations of both intercompany sales and cost of goods sold and the intercompany profit in depreciation expense. Thus, such eliminations have features of both eliminations for intercompany sales of merchandise and eliminations for intercompany sales of plant assets.
14. The quoted statement is unsupportable because it implies that intercompany gain or loss results only from transactions between affiliated companies. When one affiliate acquires another affiliate’s bonds in the open market, a realized gain or loss is recognized on the transaction. Although in form no transaction has taken place between the affiliates, in substance the acquiring affiliate acts as an agent for the issuer of the bonds in the open-market transaction. Thus, the realized gain or loss is recognized in the consolidated income statement and is attributed to the issuer of the bonds.
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15. A subsidiary’s reissuance of parent company bonds acquired in the open market by the subsidiary interrupts the orderly amortization of the realized gain or loss on the acquisition of the bonds. A transaction gain or loss on the subsidiary’s reissuance of the parent company’s bonds is not realized by the consolidated entity. Logically, the transaction gain or loss should be treated in consolidation as premium or discount on the reissued bonds.
16. The elimination or recognition of intercompany profits (gains) or losses in inventories, plant assets, intangible assets, or bonds is recorded only in the working paper for consolidated financial statements. Because the parent company generally does not reflect intercompany profit (gain) or loss eliminations in its equity-method recording of the subsidiary’s operating results, the parent company’s net income will differ from consolidated net income.
SOLUTIONS TO EXERCISES
Ex. 8–1 1. b ($51,000 – $850 = $50,150) 8. c2. a 9. d ($120,000 0.60 = $200,000)3. b 10. a4. b 11. b ($84,115 x 0.07 = $5,888)5. c 12. b6. b 13. a7. b 14. b [$60,000 – ($12,000 x 2) = $36,000]
Ex. 8–2 Computation of Parker Corporation’s debit to Cash, Apr. 12, 2006:
Maturity value of note [$100,000 + ($100,000 x 0.08 x 90/360)] $102,000Less: Discount ($102,000 x 0.10 x 60/360) 1,700 Debit to Cash $100,300
Ex. 8–3 Payton Corporation’s journal entry, Mar. 31, 2006:
Intercompany Notes Receivable 10,000Intercompany Interest Revenue ($10,000 x 0.07 x 30/360) 58
To record discounting of 7%, 90-day note receivable from Slagle Company dated Mar. 1, 2006, at a discount rate of 9%. Cash proceeds computed as $10,175 maturity value of note, less $153 discount ($10,175 x 0.09 x 60/360 = $153).*$10,000 x 0.07 x 60/360 = $117
Ex. 8–4 Planke Corporation’s journal entry to record discounting of Scully Company note, Mar. 31, 2006:
To record discounting of 9%, 60-day note receivable from Scully Company dated Mar. 1, 2006, at a discount rate of 10%. Cash proceeds computed as follows:Maturity value of note [$18,000 + ($18,000 x 0.09 x 60/360)] $18,270Discount ($18,270 x 0.10 x 30/360) 152Proceeds $18,118
*$18,000 x 0.09 x 30/360 = $135
The McGraw-Hill Companies, Inc., 2006266 Modern Advanced Accounting, 10/e
Intercompany Cost of Goods SoldPatter 600,000Cost of Goods SoldSmatter 187,500InventoriesSmatter 37,500
Ex. 8–8 Working paper elimination for Pele Corporation and subsidiary, July 31, 2006:
Intercompany SalesPele 120,000Intercompany Cost of Goods SoldPele ($120,000 x 0.83 1/3) 100,000Cost of Goods SoldShad ($84,000 x 0.16 2/3) 14,000InventoriesShad ($36,000 x 0.16 2/3) 6,000
To eliminate intercompany sales and cost of goods sold, and unrealized intercompany profit in inventories. (Income tax effects are disregarded.)
Ex. 8–9 Working paper elimination for Polydom Corporation and subsidiary, Dec. 31, 2006:
Retained EarningsSpring ($160,000 x 0.25 x 0.75) 30,000
The McGraw-Hill Companies, Inc., 2006Solutions Manual, Chapter 8 267
Minority Interest in Net Assets of Spring Company ($160,000 x 0.25 x 0.25) 10,000
Intercompany SalesSpring ($600,000 x 1.33 1/3) 800,000Intercompany Cost of Goods SoldSpring 600,000InventoriesSolano ($200,000 x 0.25) 50,000Cost of Goods SoldSolano ($760,000 x 0.25) 190,000
To eliminate intercompany sales and cost of goods sold and unrealized intercompany profit in inventories. (Income tax effects are disregarded.)
Ex. 8–10 Working paper eliminations for Polar Corporation and subsidiaries, Sept. 30, 2006:
Intercompany SalesSolar ($120,000 x 1.25) 150,000Intercompany Cost of Goods SoldSolar 120,000Cost of Goods SoldStellar ($110,000 x 0.20) 22,000InventoriesStellar ($40,000 x 0.20) 8,000
Intercompany SalesStellar ($180,000 x 1.33 1/3) 240,000Intercompany Cost of Goods SoldStellar 180,000Cost of Goods SoldSolar ($180,000 x 0.25) 45,000InventoriesSolar ($60,000 x 0.25) 15,000
Ex. 8–11 a. To eliminate unrealized intercompany gain in machinery and in related depreciation. (Income tax effects are disregarded.)
b. Two years. ($12,500 $6,250 = 2)
c. The credit to Depreciation ExpenseParke in effect represents the realization of a portion of the intercompany gain on Selma’s sale of machinery to Parke two years ago. Thus, $6,250 is added to Selma’s net income for the year ended December 31, 2006, to compute the minority interest in net income of Selma. The consolidated net income of Parke Corporation and subsidiary for the year ended December 31, 2006, is net of the minority interest in net income of Selma.
Ex. 8–12 Working paper elimination for Patria Corporation and subsidiary, Sept. 30, 2008:
Retained EarningsSelena ($4,500* x 0.90) 4,050Minority Interest in Net Assets of Subsidiary ($4,500 x 0.10) 450Accumulated DepreciationPatria [$5,500 x (10/55 + 9/55)] 1,900
EquipmentPatria ($14,500 – $9,000) 5,500Depreciation ExpensePatria ($5,500 x 9/55) 900
To eliminate unrealized intercompany gain in equipment and in related depreciation. (Income tax effects are disregarded.)*$5,500 – ($1,900 – $900) = $4,500
Ex. 8–13 Computation of missing amounts in working paper eliminations for Paulo Corporation and subsidiary:
(1) $480 ($2,400 x 0.20)
(2) $1,920 ($2,400 x 0.80)
(3) $2,400 ($800 x 3)
(4) $160 ($800 x 0.20)
(5) $640 ($800 x 0.80)
(6) $4,000 ($800 x 5)
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Ex. 8–14 Working paper elimination for Pelion Corporation and subsidiary, Dec. 31, 2007:
Intercompany Liability under Capital LeaseStyron ($15,849 – $5,000 + $1,585) 12,434
To eliminate intercompany accounts associated with intercompany lease and to defer unrealized portion of intercompany gross profit on sales-type lease. (Income tax effects are disregarded.)
Note to Instructor: Pelion’s intercompany interest revenue [($20,000 – $4,151) x 0.10 = $1,585] is offset against Styron’s intercompany interest expense ($15,849 x 0.10 = $1,585) on the same line in the income statement section of the working paper for consolidated financial statements.
Ex. 8–15 Working paper elimination for Pawley Corporation and subsidiary, Feb. 28, 2007:Intercompany Gain on Sale of PatentSmart ($80,000 –
Ex. 8–16 Computation of amount of cash paid by Polka Corporation, Apr. 30, 2007:
Present value of $40,000 due in four years at 12%, with interest paid annually ($40,000 x 0.635518) $25,421
Add: Present value of $4,000 due each year for four years at 12% ($4,000 x 3.037349) 12,149
Cost of $40,000 face amount of bonds $37,570Add: Accrued interest purchased ($40,000 x 0.10) 4,000Amount of cash paid by Polka Corporation $41,570
Computation of gain on extinguishment of bonds:
Carrying amounts of bonds acquired: $100,000 x 0.40 $40,000Less: Cost of bonds to Polka Corporation (see above) 37,570Gain on extinguishment of bonds $ 2,430
Ex. 8–17 Computation of missing amounts in working paper elimination:
(1) Intercompany interest revenue: $58,098 x 0.10 $ 5,810
Amortization for year ended Oct. 31, 2008: $5,400 – ($61,987 x 0.08) 441
Premium, Oct. 31, 2008 $ 1,546
(3) Investment in Sinn Company bonds: $58,098 + ($5,810 – $5,400) $58,508
(4) Intercompany interest expense: $61,987 x 0.08 $ 4,959
(5) Retained earnings: $3,889 x 0.90, or $3,889 – $389 $ 3,500
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Ex. 8–18 Computation of minority interest in Sokal Company’s net income:Year 2006 Year 2007
Net income of subsidiary $80,000 $90,000Intercompany profit in parent company’s inventories, unrealized
in Year 2006, realized in Year 2007 (2,000 ) 2,000 Adjusted net income of subsidiary $78,000 $92,000 Minority interest (30%) $23,400 $27,600
CASES
Case 8–1 The journal entries of Seeley Company to record the acquisition and depreciation of machinery are adequate and need not be changed. However, the journal entries of Powell Corporation are incorrect for two reasons:
(1) Idle machinery is accounted for as though it were merchandise. A Sales ledger account is inappropriate for any asset except merchandise sold to customers.
(2) The first journal entry does not identify the transaction as an intercompany transaction. Failure to identify intercompany transactions leads to the risk that such transactions, profits (gains) or losses, and balances will not be eliminated in the preparation of consolidated financial statements.
The working paper elimination prepared by Powell’s accountant does not remove the intercompany gain element from the consolidated income statement. In effect, the elimination accounts for the intercompany gain as though it were a prior period adjustment. This treatment has no justification.
Powell’s journal entry for the intercompany sale of idle machinery should have been as follows:
Cash 50,000
Idle Machinery 40,000
Intercompany Gain on Sale of Idle Machinery 10,000
To record sales of idle equipment to Seeley Company. (Income tax effects are disregarded.)
The correct December 31, 2006, working paper elimination (in journal entry format) is as follows:
Intercompany Gain on Sale of Idle MachineryPowell 10,000
Accumulated Depreciation of MachinerySeeley 1,000
MachinerySeeley 10,000
Depreciation ExpenseSeeley 1,000
To eliminate unrealized intercompany gain in machinery and in related depreciation. (Income tax effects are disregarded.)
Case 8–2 Shelton Company’s $10,000 debit to a deferred charge ledger account for the excess paid by Shelton for the trade accounts receivable acquired from Sawhill Company is inappropriate. A deferred charge is an account established for long-term prepayments for goods or services to be received in the future. The $10,000 excess payment for the trade accounts receivable does not fit the concept of a deferred charge. Further, the nature of the expense account debited by Shelton for the amortization of the deferred charge is not clear. The $10,000 should have been debited to a loss ledger account, because it represents an outlay by Shelton to a liquidating affiliated company for which no benefits were received. The $10,000 loss in Shelton’s accounting records, as recommended above, should be eliminated in the
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preparation of consolidated financial statements for Peasley Corporation and subsidiaries for the year ended October 31, 2006. The following working paper elimination (in journal entry format) is required:
Investment Income of Sawhill CompanyPeasley 10,000
Loss on Acquisition of ReceivablesShelton 10,000
To eliminate loss on Shelton Company’s acquisition of trade accounts receivable from Sawhill Company, an unconsolidated subsidiary in liquidation.
The fact that Sawhill is in liquidation and is not consolidated does not change the need for eliminating all intercompany transactions, balances, and profits (gains) or losses from the consolidated financial statements.
Case 8–3 Given that both Winston Corporation and Cranston Company use the periodic inventory system and that markups on Winston’s sales of products to Cranston had varied, it is probably impossible for the newly hired controller of Winston to prepare any consolidated financial statements other than a consolidated balance sheet at the end of the first fiscal year of the controllership. The local CPA firm had prepared separate income tax returns for both Winston and Cranston; thus, it is unlikely that the CPA firm had any records of intercompany profits in Winston’s sales to Cranston and in Cranston’s ending inventories.
If the controller is able to obtain accurate quantities and billed prices of Winston-produced products in Cranston’s ending inventory, and if Winston’s costs of those products are obtainable from Winston’s production records, the amount of the unrealized intercompany profit in Cranston’s ending inventory can be determined, thus facilitating preparation of a consolidated balance sheet. Establishment of appropriate intercompany sales and intercompany cost of goods sold accounting records for Winston for the following fiscal year (which would entail Winston’s adoption of the perpetual inventory system) would enable the controller to prepare consolidated statements of income, retained earnings, and cash flows, as well as consolidated balance sheets, for future fiscal years.
Case 8–4 The accountant’s position is not supported by accounting theory for consolidated financial statements. Under that theory, consolidated financial statements should display amounts resulting from transactions with those outside the consolidated group. Consolidated financial statements should not be distorted by intercompany transactions, which are not the result of arm’s-length bargaining between parties with opposing interests. Despite the fact that Aqua Well Company’s charges for transmission of water to Aqua Water Corporation were at the customary rate approved by the state’s Public Utilities Commission, these charges in the aggregate are dependent on the volume of water ordered from the subsidiary by the parent company. Thus, Aqua Well’s transmission revenue amount must be offset against Aqua Water’s transmission expense amount if the consolidated income statement for the two companies is to comply with generally accepted accounting principles for consolidated financial statements.
Case 8–5 The Audit Committee of the Board of DirectorsPadgett Corporation
At your request, I have found the following misstatements in the condensed consolidated financial statements of Padgett Corporation and subsidiary, Seacoast Company, for the year ended December 31, 2006:
The McGraw-Hill Companies, Inc., 2006Solutions Manual, Chapter 8 271
1. The failure to eliminate the intercompany “gain” (actually, because of implicit interest, a $119,417 loss; the present value of $680,583, at an interest rate of 8%, compared with Padgett’s $800,000 cost of the land) on the sale of land to Seacoast by Padgett. Elimination of the “gain” reduces pre-tax consolidated income and consolidated property, plant, and equipment by $200,000.
2. The failure to eliminate the December 31, 2006, intercompany sale, $650,000, and cost of goods sold, $500,000, resulting from a shipment by Padgett to Seacoast. Elimination of the $150,000 intercompany gross margin reduces pre-tax income by that amount.
The net effect of the foregoing errors on the subject consolidated financial statements is as follows:
Balance sheet:
Current assets (inventories) overstated $150,000
Property, plant, and equipment overstated $200,000
Total assets overstated $350,000
Current liabilities (income taxes payable) overstated $119,000 (see below)
Stockholders’ equity overstated $231,000
Income statement:
Net sales overstated $650,000
Cost of goods sold overstated $500,000
Gain on sale of land overstated $200,000
Pre-tax income overstated $350,000
Income tax expense overstated $119,000 ($350,000 x 0.34)