ADVANCED FINANCIAL

ACCOUNTING STUDIES

Lecture 6
Group Reporting IV

Angie Wang
School of Accountancy
Elimination of intragroup transactions and
balances
➢Operational and financial interdependencies within the group entities
– Lead to intragroup transactions and balances

➢Intragroup transactions include for example:

– Buying or selling of inventory
– Transferring of long lived assets
– Rendering or procuring of services
– Providing financing among the companies within the group
 Elimination of intragroup transactions and
balances
➢Intragroup transactions give rise to intragroup balances.
– E.g., Loan receivable/payable to or from group companies, Dividend receivable,
Accounts payable/receivable to or from group companies

➢From an economic perspective, an entity is not able to transact with itself.

– Intragroup assets and liabilities, equity, income, expenses and cash flows relating to
transactions between entities of the group are to be eliminated in full during
consolidation.
Elimination of intragroup transactions and
balances
➢Principles Governing Elimination

―Outstanding balances due to or from companies within a group are eliminated;

―Transactions in the income statement between the group companies are eliminated;
―Profit or loss resulting from intragroup transactions that are included in the asset are
eliminated in full (both parent’s & NCI’s share);
―Tax effects on unrealized profit or loss included in the asset should be adjusted
according to IAS 12 Income Taxes.
Elimination of intragroup transactions and
balances
➢Principles Governing Elimination

―Associates (“significant influence) are not part of the group:

√ Balances with associates are not eliminated;
√ Unrealized profit or loss from transactions between an investor and its associates
are eliminated to the extent of investor’s interests.
Elimination of realized intragroup transactions
➢“Offsetting” effect on the group net profit from realized transactions:

―Profit recorded by the selling company offsets the expense recorded by buying
company.

―Elimination is still required to avoid overstatement of individual line items.

Elimination of realized intragroup transactions
Examples:
1. Transactions relating to interest:
―Usually, no time lag in the recognizing of interest by borrower and lender i.e.,
interest income exactly offsets the interest expense.
―Elimination entry:
Dr Interest Income (lender)
Cr Interest Expense (borrower)

―Exception: borrower capitalizes interest on borrowed money into the cost of

construction of a long-lived asset
Dr Interest Income
Cr Fixed assets in progress
Elimination of realized intragroup transactions
2. Transactions relating to services provided:
―Provision and consumption of services are simultaneous
―Elimination entry:
Dr Service Income
Cr Service Expense

―Exception: service receiver capitalizes service fee when the service provided
creates or enhances an asset or extends its useful life

Dr Service Income
Cr Machinery
(enhancing service)
 Elimination of intragroup balances
Prior to Elimination
➢Reconciliation is carried out when the balances recorded in both companies differ.

➢Usually, reconciling items are due to:

Problems Reconciliation adjustments
✓ Either adjusted out or recognized in a manner
In-transit items (recorded only by one company) consistent with the other party’s treatment
✓ Correct the error account or pass entry to
Errors and omissions record the omitted entry
✓ Either recognized by the disputing party or
adjusted out by the party that recorded the items
Dispute on the transaction in books
Elimination of intragroup balances
Prior to Elimination
Example of a reconciliation of intercompany balances
Reconciliation of balances between Sub A and Sub B $
(This example is showing why A and B don’t have the same balance, so
reconciliation is needed.)
Amount owing by B in A’s book as at 31 December 20X5 40,000

Items in A’s book but not in B’s books:

Disputed sales invoice (note 1) (1,500)
Goods received by B on 29 December 20X5 (note 2) (3,200)
Repair for goods not under warranty (note 3) (300)

Payment made in December 20X5 by B not recorded by A (note 4)

(17,000)
Amount owing to A in B’s book as at 31 December 20X5 18,000
Elimination of intragroup balances
Prior to Elimination
Note 1: Either Sub A had to reverse the sale or Sub B had to accrue for the invoice.

Note 2: Since goods were received before the year ended, Sub B had to record the inventory.
Dr Inventory 3,200
Cr Payable to A 3,200

Note 3: Since repairs were not covered under warranty, Sub B had to record the repair cost.
Dr Repair costs 300
Cr Payable to A 300

Note 4: Follow –up action is necessary to ascertain the reason for the non-clearance. If the cheque is lost,
Sub B is required to reverse the payment entry.
Dr Bank 17,000
Cr Payable to A 17,000
Adjustment of unrealized profit or loss
arising from intercompany transfers
- Intragroup transfers of inventory and fixed assets
➢Unrealized profit in inventory
― Unrealized profit and loss in asset (arising from intragroup transaction) should be
eliminated in full unless loss is impairment loss.

Transfer
price (TP) Unrealized profit
Original
cost (OC) Inventory amount in
Inventory amount on buying company’s
consolidation books

➢TP - OC (unrealized profit arising from intragroup transaction) in remaining

inventory should be eliminated.
Adjustment of unrealized profit or loss
arising from intercompany transfers
- Intragroup transfers of inventory and fixed assets
➢If the transferred asset is inventory:

―It should be carried at lower of cost and net realizable value.

―Cost is the exchange price when the goods were originally purchased from a third party.
―Adjustments are made to eliminate the profit element in the carrying amount of the
inventory arising from intragroup transaction.
―Recognize profit only when the inventory is sold to 3rd party.
✓Cost of sales in the consolidated financial statements should be the original cost as
transacted with unrelated third parties and not the transfer price invoiced by one
group company to another.
Adjustment of unrealized profit or loss
arising from intercompany transfers
- Intragroup transfers of inventory and fixed assets
➢If the transferred asset is a fixed asset:

―Asset should be carried at original cost less accumulated depreciation from

date of original purchase to current period.
―Subsequent depreciation is based on original cost and not the transferred
price.
―If there is a change in useful life or estimates, the changes for the group
should be made with reference to the carrying amount based on original
cost and not the transfer price.
Adjustment of unrealized profit or loss
arising from intercompany transfers
- Adjustment to opening retained earnings (RE)
➢When a transaction is recognized by a legal entity in one period and by the economic entity
in another period:

―Consolidation adjustments are passed through opening RE.

―Consolidated opening RE should be the same as the consolidated closing RE of the
previous period (e.g., Unrealized profit from intragroup balances in the previous year are
adjusted against opening RE in the subsequent year)
Adjustment of unrealized profit or loss
arising from intercompany transfers
- Adjustment to opening retained earnings (RE)
Example:
Subsidiary Co sells inventory to Parent Co and makes a profit of $20,000 in 20x1.
Parent Co resells 10% of the inventory to third parties in 20x1 and 90% in 20x2. Only
10% of the profit is earned by the group in 20x1.

―Opening RE of Subsidiary Co in 20x2 includes “unrealized” profit of $18,000.

―Consolidated RE at the end of 20x1 and beginning of 20x2 should only include
profit of $2,000 and not $20,000.
―Re-enactment continue for as long as the asset remains in the group.
Adjustment of unrealized profit or loss
arising from intercompany transfers
- Tax effects on adjustments to eliminate unrealized profit (Loss)
➢Consolidated tax expense must reflect the tax effects of the consolidated profit
before tax.
―Tax expense should be aligned with income recognition.

➢When unrealized profit is eliminated:

―Profit is taxable for the legal entity but not the economic entity.
―A deferred tax asset arises (i.e., in the form of a prepaid tax).
Adjustment of unrealized profit or loss
arising from intercompany transfers
- Tax effects on adjustments to eliminate unrealized profit (Loss)
➢Consolidation adjustment:
In the current period: In the following period:
Dr Deferred tax asset Dr Deferred tax asset
Cr Tax expense Cr Opening RE

―The tax expense is recognized when the asset is sold to 3rd party.
Sold in any period: Sold in the following period (combined):
Dr Tax expense Dr Tax expense
Cr Deferred tax asset Cr Opening RE
Illustration 1: Upstream sale
― S is a wholly owned subsidiary of P.
― On 1 April 20X1, S sold inventory costing $7,000 to its P for $10,000.
― On 5 Jan 20X2, P sold the inventory to external party for $15,000.
― Assumed tax rate of 20% . Year-end is 31 Dec 20X1.

Journal entries for the legal entities as at YE 31 Dec 20X1

In S’s book
Dr Account receivable/Cash 10,000
Cr Sales 10,000 S’s NI (overstated) →
20X1 YE RE →
Dr Cost of sales/COGS 7,000 20X2 Opening RE
Cr Inventory 7,000

In P’s book
Dr Inventory 10,000
Cr Account payable/Cash 10,000
Illustration 1: Upstream sale
― S is a wholly owned subsidiary of P.
― On 1 April 20X1, S sold inventory costing $7,000 to its P for $10,000.
― On 5 Jan 20X2, P sold the inventory to external party for $15,000.
― Assumed tax rate of 20% . Year-end is 31 Dec 20X1.

Q1 What are the consolidation journal entries as at YE 31 Dec 20X1 ?

Dr Sales (S’s I/S) 10,000
Cr Cost of sales (S’s I/S) 7,000
Cr Inventory (P’s SFP) 3,000
This entry is to reduce current year profits and overstatement of inventory
from the unrealized profit of $3,000
Dr Deferred tax asset (Group SFP) 600 (3,000 * 20%)
Cr Tax expense (S’s I/S) 600
This entry is to reduce current year profits and overstatement of inventory
from the unrealized profit of $3,000
Illustration 1: Upstream sale
Q2: What are the consolidation entries as at 31 Dec 20X2?
(1) Dr Opening RE (S’s SFP) 3,000
Cr Cost of Sale (P’s I/S) 3,000
This entry is to reduce previous year profit through opening RE and
recognize profit in the current year when the inventory is sold to a 3rd party
(2)
Dr Tax expense (Group’s P/L) 600
Cr Opening RE (S’s SFP) 600
Since the profit is realized in this year, the tax expense should be
recognized in the group’s income statement in the current year
Or
Dr Deferred tax asset 600
Cr Opening RE 600
Dr Tax expense 600
Cr Deferred tax asset 600
Illustration 1: Upstream sale
If sale to an external party is only made in 20x3:
(1) Dr Opening RE (S’s SFP) 3,000
Cr Inventory (P’s SFP) 3,000
This entry is to reduce previous year profit through opening RE and
eliminate “unrealized” profit in the current year when the inventory
remains unsold to external 3rd party
(2)
Dr Deferred tax asset (Group’s SFP) 600
Cr Opening RE (S’s SFP) 600
This entry reinstates the prepaid tax and implicitly shifts the tax expense
from the past period to the future period
Any questions?
For next time…
• Read McGraw Hill Ch5, Wiley Ch22