INTERCOMPANY PROFITS

IN DEPRECIABLE ASSETS

Seda Oz, PhD

seda.oz@uwaterloo.ca

AFM 491, SAF, University of Waterloo

November 5, 2018 Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 1
  We will not discuss Appendix 7A
 (not your responsibility for exam
purposes)

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 2

 SO FAR
 We have now established the basis for
preparation of consolidated financial
statements, including:
 The allocation of the acquisition price
 The conceptual alternatives
 Consolidation after parent uses cost and
equity method
 Elimination of intercompany sales and
purchases
 Elimination of unrealized intercompany
profits on inventory and land
 Parents and subsidiaries engage in more
complex transactions such as intercompany
transfers of depreciable assets.

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 3

 INTERCOMPANY SALE OF
LONG-TERM ASSETS
 General Rule: Profits not recognized until
realized through sale to party outside the
group.
1. Inventory
 Eliminate the sales/COGS & unrealized
profit still in ending inventory. Assume
realized next year
2. Land
 Eliminate gain every year until sold
outside.
 What about Capital Assets that may never
be resold?

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 4

 DEPRECIABLE ASSETS
 Assume sold, inside the group, at a gain.
 Need to eliminate the gain on seller's books
 Lower the cost on the buyer’s books
 back to historical cost to the entity
 How is it Realized?
 As the asset is used  through depreciation
 Depreciation expense (and acc’m dep’n) will be overstated
on buyer’s books (based on their higher cost).
 Need to lower the expense to the value based on historical
cost to entity.
 Lower expense  partial recognition of gain

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 5

 UPSTREAM
EXAMPLE

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 6

 UPSTREAM

NBV $15,000, Sold for $21,000, 5 yr life

Gain on S’s books $6,000
-eliminate the gain – what is affected?
Depreciation now (P) on $21,000/5 = $4,200
but on cons it should be: $15,000/5 = $3,000
- Decrease expense & acc’m depreciation
- when expense decreased, gain partially recognized.
include tax effects: expense income  income tax

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 COMPARISON CAPITAL
ASSET AFTER 1 YEAR
On P’s F/S On Cons F/S
Cost 21,000 Cost 15,000
Accm Dep’n (4,200) Accm Dep’n (3,000)
NBV 16,800 NBV 12,000
(historical cost to entity)

Difference only 4,800 (6,000 -1,200)

6,000 / 5 × 4 = 4,800
Original Gain less recognition of 1/5

What will the difference be after 2 years? After 5 years?

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 8

 CAPITAL ASSET ADJUSTMENTS
F/S VIEW
P S Adj Cons
PPE (NBV) 21,000 [Was at (6,000) 15,000
15,000] Net effect still unrealized
Less: Acc’m Dep’n (4,200) 1,200 (3,000)
Def Tax Asset 2,000 - 400 1,600

Gain 6,000 (6,000) 0

Dep’n Exp 4,200 (1,200) 3,000
Tax exp 33% ~2,000 (2,000) + 400 400

Have both an unrealized portion (full gain) & a realized

portion (annual amount) in the same year.
In subsequent years just the annual realized portion

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 9

 Realized by paying lower

KEEPING TRACK
Depreciation expense

Before Tax @33% After tax

Tax
Unrealized gain Yr 1 6,000 2,000 4,000
Realized Yr 1 (1,200) (400) (800)
Balance End of Yr 1 4,800 1,600 (3,200)
unrealized
Realized Yr 2 (1,200) (400) (800)
Balance End of Yr 2 3,600 1,200 2,400
unrealized

TIP: Keep track of annual adjustments vs. balance

at end of a year. Keep track of before & after tax

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 10

 SUBSEQUENT YEARS
1. Reduce equipment account by the full gain
 Equipment at historical cost (e.g. S’s books), no gain (within the group)
2. Reduce acc’m dep’n by gain realized so far.
 Update depreciation expense. P records higher dep exp. Why?
 1 & 2: Net effect is to decrease net equipment by unrealized portion.
 Gain (unrealized) + (realized) change in dep exp on cons compared to P
3. Reduce R/E by gain still unrealized.
 Due to changes in net income
4. Reduce depreciation exp by gain realized for that year.
5. Increase tax expense related to the gain recognized
 Lower dep exp  higher tax expense
6. Set up Deferred tax asset on unrealized portion
 Gain not recognized by the group yet

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 11

 REMEMBER NCI FOR
UPSTREAM SALES
 S’s NI = $100,000 per year, t = 33%
 S’s BV @ acquisition = $400,000 (share capital) +
$2,000,000 (ret earn)
 Opening R/E in year of asset sale $2,100,000 (no unrealized
profit in it)

 Eliminate gain - Realize a portion

 NCI (20%) on I/S for year?
 NCI (20%) on B/S at end of year?
 Next year?

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 12

 ADJUSTMENTS
UPSTREAM SALE
Net income (S) $100,000
Less gain (after tax) ________
6,000 × (1-.33) = 4,000

Plus realized portion

1,200 × (1-.33) = 800
(adjustment to dep’n exp after tax) ___________
Adjusted Net income: 96,800
_________

NCI’s 20% = 19,360

P’s 80% = 77,440

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 13

 ADJUSTMENTS
UPSTREAM SALE
Adjustment to change in R/E:
Change in R/E 2,100 + 100 – 2,000 = 200,000
Less unrealized: 4,000 - 800= 3,200
Adjusted R/E: 196,800

80% to P’s Cons R/E

20% added to beg balance of NCI (original amount)

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 14

 SUMMARY
 Summary of implication of intercompany transactions in
depreciable assets:
 The “intercompany” gain must be eliminated and associated
income taxes paid deferred.
 The asset must be adjusted to its historical cost.
 Depreciation is restated so that it is based on original cost,
and associated income taxes are recorded.
 Accumulated depreciation restated so that it is based on
original cost.
 Retained earnings is adjusted for the cumulative after-tax
effect of the unrealized gain or loss (i.e., gain or loss less
incremental depreciation to date).

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 INTANGIBLES

 Definite life – just like Capital Asset

 But no accumulated amortization account to decrease
 Increase the asset directly as realizing gain

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 WHAT IF ASSET LATER
SOLD OUTSIDE THE GROUP

 Can recognize the rest of the unrealized gain

 Added to the gain (loss) from the sale to the outsider
 If after 2 years P sold it for $17,000?
 What is BV of asset at the end of year 2 on Cons B/S?
 Incremental gain
 What should it be if it hadn’t been sold inside the group?
 The rest of unrealized gain

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 17

 WHAT IF SOLD FOR A LOSS?
(UPSTREAM OR DOWNSTREAM)
 Is there really an impairment in value?

 If No – eliminate the loss

 If Yes –eliminate it then test for recoverability and write
down
 Asset should have been written down anyway
 Remember for capital assets don’t normally write them down
if FMV < NBV
 Co would record depreciation exp instead of impairment loss
 unless there has been an impairment of productive value

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 18

 ALLOCATION OF S’S NET
INCOME
S’s reported net income 100
FVI amortizations (acq diff amort sch.) (10)
Current period goodwill impairment (0)
*Realization of Profits from prior period 120 Upstream
Profits
*Unrealized profits at end of period (80) Only
S’s adjusted net income 130
NCI’s % (20%) (26)
P’s % of S’s adjusted NI 104
-unrealized Down
Adjust for downstream profits + realized 4 stream
S’s NI included in P’s NI to shhldrs 108
Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 19
 Or S’s com Shares + S’s R/E –
unrealized profit (upstream) +
NCI ON B/S remaining unamortized FVI if
any from acq diff schedule

S’s Com Shares $ 400

S’s R/E 2,000
- FVI amortizations taken 0
- Unrealized profit (upstream) (80)
- S’s Adjusted Book Value $ 2,320
+ (full) unamortized FVI if any from acq diff schedule

NCI’s % of [Adj. BV + Unamortized FV]

[.20 x (2,320 + 0)] = $464
Note – you don’t add back in REALIZED profits (they are
already in S’s R/E from when S 1st reported them)
Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 20
 NCI ON B/S
 % of Book value

 Continuity
 Opening NCI + PLUS NCI’s share of S’s NI – LESS
ADJUSTMENTS

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 CONSOLIDATION STEPS

 Date of Acquisition
1. Do acquisition transaction, determine FV Increments &
Goodwill
2. Eliminate the investment & S’s common shares & R/E (at
date of acq. only)
3. FVI: add in + goodwill + NCI (B/S)
 Subsequent Years
1. Prepare Acq Diff Amortization schedule – don’t forget
goodwill impairment
2. Identify intercompany transactions – Eliminate Sales/CGS
and offsetting balance sheet amounts (A/R & A/P)
3. Eliminate Unrealized upstream profits (deferred tax asset)
4. Add in Realized profits upstream
5. Calculate NCI’s share of consolidated net income based on
steps 1-4

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 22

 CONSOLIDATION STEPS (CONT)

 Subsequent Years (continued)

6. Eliminate Unrealized downstream profits (deferred taxes)
7. Recognize Realized profits upstream
8. P’s Investment Income (based on steps 1 – 8)
9. Calculate NCI on balance sheet based on S’s adjusted FV
(Book value – unrealized profits upstream only +
Unamortized Acq Diff)
10. If P using cost: Need to calculate opening cons R/E. Change
in S’s R/E since acquisition adjusted for previous expenses
against R/E (acc’m amort of FVI,) and any unrealized
profits (% of upstream, 100% downstream).
11. What if P using equity?

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 23

 INTERCOMPANY
BONDHOLDINGS
Seda Oz, PhD

seda.oz@uwaterloo.ca

AFM 491, SAF, University of Waterloo

November 5, 2018 Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 24
 INTERCOMPANY
BONDHOLDINGS
 Occasionally one affiliate may purchase all or a portion or
the bonds issued by another affiliate

1 cash
Cash Parent 2

Issues bonds
bonds
Sub Open
Issues bonds Market

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 25

 INTERCOMPANY
BONDHOLDINGS
 Must prevent the interco receivable and payable from
appearing on the consolidated B/S.
 As long as the bonds are held within the group, eliminate:
 interco interest expense (to the issuer) and interest revenue (to
the holder)
 amortization of related discount or premium
 When the bonds are retired, the indebtedness and the
investment will both be removed from the books.
 If the retirement occurs prior to the maturity date of the
bonds, a gain or loss may result on the separate company
books.
 Any such gain or loss must also be eliminated upon
consolidation

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 26

 INTERCOMPANY
BONDHOLDINGS
 Separate F/S
 The issuer: interest expense, bonds payable,
discount/amortization on bonds payable
 The buyer: interest revenue, bonds investment (receivable),
discount/amortization on bonds investment (receivable)
 If the transaction happened between these two companies at
the time of issuance, these accounts will have the same
balances.
 Consolidated F/S:
 These accounts will be eliminated against each other

 Nothing special about it.

 similar to asset transactions

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 27

 INDIRECT
ACQUISITIONS OF BONDS
 What if one company within the economic entity buys
bonds in an affiliated company not directly from the issuer,
but rather from an outside holder of the bonds?
 The buying company still ends up holding bonds that were
issued by an affiliated company and that must be eliminated
upon consolidation, but the buying price and the issuer’s
carrying value may not be the same

 An open-market purchase of an affiliate’s bonds is possible

but extremely rare in Canada
 we’ll only discuss it conceptually.

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 28

 INDIRECT
ACQUISITIONS OF BONDS
 Suppose that Sub has a bond issue outstanding that has a
face value of $1,000,000,
 an unamortized premium of $50,000,
 An interest rate of 12%, and
 five years remaining to maturity.
 Non-affiliated investors hold all of the bonds.
 Market rates of interest have risen above the interest rate on
the bonds, and have caused the market price of Sub’s bonds
to fall.
 Sub’s parent, Parent, then buys $100,000 face value of the
Sub bonds on the open market for $90,000.

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 29

 INDIRECT
ACQUISITIONS OF BONDS
 Instead of letting Parent to buy the bonds on an open
market what options do Sub have?
 Sub could have used its own cash to purchase the bonds itself.
 If Sub had done so, it would have recognized a gain on the
retirement of debt of $15,000.
 Sub could have borrowed $90,000 from Parent and used that
cash to buy the bonds.
 Sub still would have recognized a gain of $15,000, and an
intercompany payable (and receivable) for $90,000 would exist—
that payable (and receivable) would be eliminated upon
consolidation.

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 30

 INDIRECT
ACQUISITIONS OF BONDS
 But instead of these two options let’s assume that Parent
proceeds with the transaction
 When consolidated statements are prepared, the
intercompany interest must be eliminated, and the amount of
the bonds held by Parent must be eliminated against the
proportionate part of the indebtedness of Sub.
 On Parent’s books, the bond investment is carried at
$90,000; while on Sub’s books, the bond indebtedness is
carried at $105,000 (10% of the $1,000,000 face value and of
the $50,000 premium).
 The problem is how to dispose of the $15,000 difference in
carrying values.

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 31

 INDIRECT
ACQUISITIONS OF BONDS
 Sub still has a legal liability (to Parent) for the bonds, but
the substance is that, for the consolidated entity, the
indebtedness no longer exists.
 From the consolidated statements, the bonds have been
retired.
 the $15,000 difference between Sub’s carrying value and
Parent’s acquisition cost must be treated as a gain when the
statements are consolidated and the intercompany bond
holdings are eliminated.

 Realistically, this transaction is not likely to happen.

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 32

  You are expected to understand Interco
Bondholdings to the extent I discussed in
class.
 Indirect acquisitions of bonds is discussed
in great detail in your textbook. For exam
purposes it is off limits.
 On the other hand, if you want satisfy
your intellectual hunger  come and see
me

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 33

 COMING UP
 Tuesday, Oct 24th
 Quiz 2
 See next slide
 Comprehensive problem(s) covering chapters 2 to 7
 Time is limited
 Material will be posted Oct 22
 Thursday, Oct 26 & Tuesday, Oct 31
 Chapter 8 (included in the final examination)
 Thursday, Nov 2
 Midterm review (Chapters 1 to 7, inclusively)
 Study materials will be posted on Oct 22
 Friday, Nov 3
 Midterm

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 34

 QUIZ 2
 October 24
 Don’t be late – 1st half of the class
 Chapters 4 to 6
 Consolidation of non wholly owned subsidiaries at the
acquisition time / subsequent to acquisition
 FV amortization adjustments
 Dividend adjustments
 Intercompany inventory and land adjustments
 Study textbook self study problems
 In class exercises (e.g. Mary Poppins)

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 35