AU: Consolidation: Intragroup Transactions

Consolidation: Intragroup Transactions

1. Why is it necessary to make adjustments for intragroup transactions?

The consolidated financial statements are the statements of the group, i.e. an economic entity consisting of a parent and its subsidiaries. These consolidated financial statements then can only contain revenues, expenses, profits, assets and liabilities that relate to parties external to the group.

Adjustments must be made for intragroup transactions as these are internal to the economic entity, and do not reflect the effects of transactions with external parties. This is consistent with the entity concept of consolidation, which defines the group as the net assets of the parent, together with the net assets of the subsidiaries. Transactions between these parties internal to the group must be adjusted in full.

2. Why is it important to identify intragroup transactions as current or previous period transactions?

Current period intragroup transactions affect different accounts than prior period transactions. For example, current period intragroup sales of inventories affect sales and cost of sales accounts, whereas prior period sales of inventories affect retained earnings (opening balance) and, to the extent that inventories are sold externally during the current period, the cost of sales account. If the transactions are not correctly placed into a time context, then the adjustments posted in the consolidation worksheet to eliminate the effects of the intragroup transactions may be inappropriate.

3. In making consolidation worksheet adjustments, sometimes tax-effect entries are made. Why?

Obviously, not all adjustments have tax consequences. The only adjustment entries that have tax consequences are those where profits or losses are eliminated and carrying amounts of assets or liabilities are adjusted.

Accounting for tax is governed by AASB 112/IAS 12 Income Taxes. Deferred tax accounts are raised when a temporary difference arises because the tax base of an asset or liability differs from the carrying amount. Some consolidation adjustments result in changing the carrying amounts of assets and liabilities. Where this occurs, a temporary difference arises as there is no change to the tax base. In these situations, tax-effect entries requiring the recognition of deferred tax assets and liabilities are necessary.

Consider an example of an item of inventories carried at cost of $10 000 being sold by a parent to a subsidiary for $12 000, with the item still being on hand at the end of the period. The tax rate is 30%.

In the consolidation worksheet, the adjustment entry necessary to eliminate the unrealised profit of the intragroup transaction includes a credit adjustment to inventories of $2000 as the cost to the economic entity for that item differs from that to the subsidiary. In the subsidiary’s accounts, the inventories are carried at $12 000 and has a tax base of $12 000, giving rise to no temporary differences. However, from the group’s point of view, the asset has a carrying amount of $10 000, and, combined with a tax base of $12 000, gives a deductible temporary difference of $2000 (the expected future deduction is greater than the future assessable amount). As a result, a deferred tax asset exists for the group and should be recognised in a tax-effect entry. This has no effect on the amount of tax payable in the current period, but will decrease the Income Tax Expense from the perspective of the group.

Another explanation for the tax effect of the consolidation worksheet entry to eliminate the unrealised profit of the intragroup transaction can be provided as follows: as profit of $2000 is eliminated (by crediting Cost of Sales by $10 000 and debiting Sales Revenue by $12 000), the group’s profit is decreased and therefore, the Income Tax Expense (which is normally calculated as 30% of the profit) should decrease as well by 30% of $2000. Also, the entity that made the intragroup sale and recorded the profit would have paid tax on that profit; from the perspective of the group, that tax should not have been paid yet and represents a prepayment of tax in advance of the actual profit being realised by the group; this prepayment is going to be recognised by the group as a future tax benefit, a Deferred Tax Asset.

4. What are the key questions to consider when preparing consolidation worksheet adjustments for intragroup transactions?

The five key questions to consider when preparing consolidation worksheet adjustments for intragroup transactions are as follows.

1. Is this a prior period or a current period transaction?
2. What has been recorded by the legal entities?
3. What should be reported by the group?
4. What adjustments are necessary to get from the legal entities’ amounts to the group amounts?
5. What is the tax effect of the adjustments made?

1. Is this a prior period or a current period transaction?
If it is a current period transaction, its effects will be eliminated against the respective accounts. If it is a prior period transaction, the effects on prior period income and expenses accounts will be eliminated against the retained earnings account (opening balance), while its effects on current period accounts will be eliminated against the respective accounts.

2. What has been recorded by the legal entities?
That is, what accounts on the left-hand side of the worksheet contain amounts arising from, or affected by, the intragroup transaction and what are the amounts recorded in those accounts?

3. What should be reported by the group?
That is, what amounts should the group report on the right-hand side of the worksheet for the individual accounts affected by the intragroup transaction?

4. What adjustments are necessary to get from the legal entities’ amounts to the group amounts?
That is, the adjustments are determined by comparing what has been recorded by the legal entities to what the group needs to report.

5. What is the tax effect of the adjustments made?
Having determined the consolidation adjustment for the intragroup transaction, the tax-effect consequences need to be considered. Obviously, not all adjustments have tax consequences. The only adjustment entries that have tax consequences are those where profits or losses are eliminated (current tax effect) and carrying amounts of assets or liabilities are adjusted (deferred tax effect).

5. What is meant by 'realisation of intragroup profits or losses'?

Profits/losses are realised when an economic entity transacts with another external entity. For a group, this is consistent with the concept that the consolidated financial statements show only the results of transactions with external entities. The consolidated statement of profit or loss and other comprehensive income will thus show only realised profits and realised losses. Profits/losses recognised by group members on sale of assets within the group are unrealised profits/losses to the extent that the assets are still within the group. Realisation of profits/losses on intragroup transactions involving assets normally occurs when an external party gets involved.

With intragroup sales of inventories, involvement of an external party, or realisation, occurs when the inventories are on-sold to an external entity.

With intragroup sales of depreciable assets, realisation occurs as the asset is used up, as the benefits are received by the group as a result of use of the asset. The proportion of profits/losses realised in any one period is measured by reference to the depreciation charged on the transferred depreciable asset.

6. With regards to intragroup transfers of inventories, are adjustments for current period transfers different from adjustments for such transfers happening in a previous period? Explain.

In preparing the adjustment entries for inventories sold intragroup for a profit within the current period, note the following.

• In all cases, regardless of the amount of inventories on-sold, the adjustment to sales is always a decrease by the amount of the sales within the group as those should not be recognised by the group.
• The adjustment to inventories is always equal to the percentage (%) of inventories still on hand within the group multiplied by the profit on the sale within the group (i.e. the unrealised profit = % of inventories still on hand × (transfer price − original cost)). Without this adjustment, the inventories on hand would be overstated from the perspective of the group – this adjustment manes sure that the inventory on hand are recognised in the consolidated financial statements based on the original cost to the group.
• The adjustment to cost of sales can be determined as a balancing item once the adjustments to sales and inventories have been determined (as the difference between the adjustment to sales and the adjustment to inventories). However, the reason for this adjustment is the need to eliminate the cost of sale recognised on the intragroup transaction and adjust the cost of sales on the external transaction to the original cost to the group of the inventory sold externally.
• The tax effect adjustment is always equal to the tax rate multiplied by the unrealised profit and is posted as a debit to deferred tax asset and a credit to income tax expense. That is needed to reflect that the tax paid on the unrealised profit from the intragroup transaction is a pre-payment of tax, i.e. a tax benefit.

In preparing the consolidation adjustment entry for inventories transferred intragroup in a previous period for the profit remaining in inventories on hand at the beginning of the current period, to the extent that the inventories are on-sold to external entities by the end of the current period, note the following.

• The adjustment to retained earnings (opening balance) is the after-tax profit on transferred inventories remaining on hand at the beginning of the period (also known as after-tax unrealised profit in beginning inventories). That is done in order to eliminate the unrealised profit from the previous period from retained earnings.
• The adjustment to cost of sales is the before-tax profit on inventories on hand at the beginning of the period (also known as before-tax unrealised profit in beginning inventories). This adjustment is needed to adjust the cost of sales recorded on the external sale based on the price paid intragroup to the original cost of the inventory sold externally in the current period.
• The adjustment to income tax expense is the tax rate times the adjustment to cost of sales. That is needed to reflect the current tax effect given by the realisation of the profit.

7. When are profits realised in relation to inventories transfers within the group?

Realisation occurs on involvement of an external entity, namely when the inventories are on-sold to an entity that is not a member of the group. If only a part of the inventories initially transferred intragroup is on-sold to external parties by the end of a period, only the part of the intragroup profit related to the inventories on-sold is realised. It should be noted that, as inventories are current assets which should be eventually sold to external parties, it is normally assumed, unless otherwise specified, that inventories transferred intragroup that are not sold to external parties by the end of a period are sold to external parties by the end of the next period and therefore any unrealised profit in opening inventories in one period is considered realised by the end of that period.

8. Where a current period intragroup transaction involves a depreciable asset, why is depreciation expense adjusted?

9. Where a previous period intragroup transaction involves a depreciable asset, why is retained earnings adjusted?

The cost of the depreciable asset to the group is different from that recorded by the acquirer of the depreciable asset within an intragroup transaction if the intragroup transaction generated a profit or loss. The acquirer of the asset (i.e. the new owner) records depreciation in each period after the intragroup transaction based on the price paid for the asset intragroup while in the consolidated financial statements, the group wants to show depreciation calculated based on cost to the group (i.e. the carrying amount of the asset prior to the intragroup transaction). Hence an adjustment is necessary for the depreciation recorded in each period after the intragroup transaction.

If a profit is made on a previous period intragroup sale of a depreciable asset, then the cost of the asset to the group is less than the cost recorded by the acquirer of the asset (i.e. the new owner) and therefore the depreciation expenses that should be recognised by the group each period are less than the depreciation expenses recorded by the new owner of the asset. Hence an adjustment is necessary to reduce the depreciation expenses (from the current period, but also from the previous periods) and accumulated depreciation recorded by the new owner of the asset in relation to the asset. However, the depreciation expenses from the previous periods are in the retained earnings (together with all the other income and expenses from previous periods, including income tax expense) and therefore in order to reduce those, we need to increase retained earnings. The current depreciation expense will be adjusted against the depreciation expense account.

If a loss is made on a previous period intragroup sale of a depreciable asset, then the cost of the asset to the group is more than the cost recorded by the acquirer of the asset (i.e. the new owner) and therefore the depreciation expenses that should be recognised by the group are more than the depreciation expenses recorded by the new owner of the asset. Hence an adjustment is necessary to increase the depreciation expenses (from the current period, but also from the previous periods) and accumulated depreciation recorded by the new owner of the asset in relation to the asset. However, as mentioned above, the depreciation expenses from the previous periods are in the retained earnings (together with all the other income and expenses from previous periods, including income tax expense) and therefore in order to increase those, we need to decrease retained earnings. The current depreciation expense will be adjusted against the depreciation expense account.

Please note that if the intragroup transaction took place in a previous period, the adjustment to retained earnings is calculated based on the time passed since the intragroup transaction until the beginning of the current period as that will capture all the previous periods’ depreciation expenses. For example, if the intragroup transaction took place on 1 July 2010, on 30 June 2016 we will need to adjust retained earnings for 5 years’ worth of annual depreciation expense adjustments (for the period from 1 July 2010 to 1 July 2015), together with an adjustment to the current depreciation expense for 1 year worth of annual depreciation expense adjustments.

10. When are profits realised on transfers of depreciable assets within the group?

As a depreciable asset may never be on-sold by a member of the group to external parties, remaining instead within the group and being consumed by use, the point of realisation may not be directly and exclusively determined by reference to involvement of an external entity. Realisation is then indirectly determined by usage of the asset within the group, that is, in proportion to the consumption of the benefits from the asset within the group. Realisation of the profit/loss on sale within the group is then measured in the same proportion to the depreciation of the asset recorded by the entity that uses it. For example, if the transferred asset is being depreciated on a straight line basis over a 10-year period, that is, at 10% per annum, then the profit on sale is realised at 10% per annum. As such, if the asset is used in the group up to the end of its useful life, the profit will be realised in full only at the end of the useful life. However, the depreciable asset may be on-sold to external parties before the end of the useful life, in which case, the profit is realised in full at the moment of external sale, with a part of it being realised through depreciation (based on the period of time since the intragroup transfer up to the moment of external sale) and the rest through the external sale.

11. Are tax effect-entries required when adjusting for intragroup services or intragroup borrowings? Explain.

The consolidation worksheet adjustment entry to eliminate the effects of intragroup services or intragroup borrowings does not affect the carrying amount of any asset or liability that are taxable or the overall profit. Therefore, there is no deferred or current tax-effect adjustment.

12. Are adjustments for post-acquisition intragroup dividends different from those for pre-acquisition intragroup dividends? Explain.

All dividends are accounted for as post-acquisition dividends. This treatment is hard to justify conceptually and this decision was made by the standard-setters on pragmatic grounds. Refer to AASB 127/IAS27 and AASB 9/IFRS 9 (paragraph 5.7.6). As a consequence, there is no difference between the form of the main adjustments posted on consolidation for pre- and post-acquisition dividends:
• For interim dividends paid: the consolidation adjustment entry will eliminate dividend revenue recorded by the parent and dividends paid recorded by the subsidiary.
• For final dividends declared: the consolidation adjustment entry will eliminate dividend revenue recorded by the parent and dividends declared recorded by the subsidiary and also the dividend receivable recorded by the parent and dividends payable recorded by the subsidiary.

However, there are two subtle differences in the adjustments posted for pre-acquisition or post-acquisition dividends:

• Adjustments for pre-acquisition dividends are normally posted under the pre-acquisition entries, while adjustments for post-acquisition dividends are posted in the elimination entries for intragroup transactions.
• If the pre-acquisition dividends cause an impairment of the investment account recognised by the parent, then the pre-acquisition entries will include an additional entry to reverse the effect of that impairment.

US-CN Companies & Securities Law Assignment

Search This Blog