C4 SÁCH

Elimination of Intragroup Transactions and Balances

A group operates as one unit to gain economic benefits, leading to operational and financial interdependencies, resulting in intragroup transactions and balances.
Intragroup transactions include:
1. Selling/buying inventory to/from a group company.
2. Transferring long-lived assets (fixed assets/investments).
3. Rendering/procuring services from other group companies.
4. Providing financing for working capital or long-term financing needs.
Intragroup asset transfers are often at fair value, including a profit margin, rather than at carrying amounts.
From a group perspective, profit or loss is unrealized until the asset is sold to a third party.
The buying company recognizes inventory at a marked-up price. While IFRS 15 recognizes profit from a legal entity perspective, the group perspective overstates both the selling company's profit and the buying company's inventory.
The unrealized profit must be eliminated, and inventory restated to the lower of original cost (as transacted with third parties) and net realizable value.
The group recognizes profit only when control of the asset is transferred to third parties, or the asset is used, consumed, or expensed off.
Intragroup balances arise from intragroup transactions (e.g., asset transfers, financing).
Examples of intragroup balances:
1. Amounts receivable/payable from/to group companies.
2. Loans receivable/payable from/to group companies.
3. Dividends receivable from subsidiaries/payable to the parent company.
From an economic view, an entity cannot transact with itself. Consolidated financial statements treat the group as a single economic entity; therefore, intragroup transactions and balances must be eliminated fully.
IFRS 10 Appendix B paragraph B86(c) states that consolidated financial statements eliminate in full intragroup assets and liabilities, equity, income, expenses and cash flows relating to transactions between entities of the group. Profits and losses resulting from intragroup transactions that are recognized in assets, such as inventory and fixed assets, are eliminated in full. Intragroup losses may indicate an impairment that requires recognition in the consolidated financial statements. IAS 12 Income Taxes applies to temporary differences that arise from the elimination of profits and losses resulting from intragroup transactions.
Consolidation adjustments eliminate, correct, or reverse original entries to reflect transactions/balances with external parties.
Understanding consolidation adjustments requires understanding the original entries in the individual group companies' financial statements.
Consolidation involves three steps:
1. Preparing consolidation adjusting entries for transactions with external third parties.
2. Preparing consolidation worksheets combining legal entities' financial statements and consolidation adjusting entries.
3. Analyzing final consolidated totals to verify reported numbers.
Compilation of consolidation worksheets is now often done using computerized software.
Understanding the preparation of consolidation adjusting entries and analyzing the consolidated totals is most critical, as these reflect the application of accounting principles at the economic entity level.
The focus is on preparing consolidation adjusting entries and analyzing consolidated totals, while the compilation of the consolidation worksheet and the preparing of consolidated financial statements is a mechanistic process.

Principles Governing Elimination

The principles governing elimination are as follows:

Outstanding balances due to, and from, companies within a group are eliminated.
Transactions in the income statement between one group company and another are eliminated.
Profit or loss resulting from intragroup transactions that are included in the carrying amount of an asset at year-end must be eliminated in full. Elimination in full implies that the non-controlling interests' share of the profit or loss is eliminated as well. The consistent treatment between controlling and non-controlling interests with respect to elimination of unrealized profit or loss is in line with the entity theory of consolidation.
Tax effects on unrealized profit or loss included in the carrying amount of an asset such as inventory or fixed assets should also be adjusted in accordance with IAS 12 Income Taxes.
Associates are not included in the definition of "group". Thus, balances with associates are not eliminated. Unrealized profit or loss from transactions between an investor and its associates are eliminated to the extent of the investor's interest. The principles and processes relating to accounting for associates are elaborated in Chapter 6.

Elimination of Realized Intragroup Transactions

When profit and loss effects are offsetting for the buying and selling company, eliminate reciprocal account items. Eliminate individual items to avoid overstating disclosed line items in the consolidated income statement, despite a "natural" offsetting effect on net profit.

Transactions Relating to Interest

General Rule: Interest expense should offset interest income exactly.
Example: Parent lends 2,000,000 to a subsidiary at 5% per annum. The elimination entry is:
- Dr Interest income (Parent) 100,000
- Cr Interest expense (Subsidiary) 100,000
Exception: When one group company lends to another to develop/construct a long-lived asset, IAS 23 requires capitalizing interest during the construction period.
Example: Parent Co borrows 1,000,000 from a bank at 5% and lends it to Subsidiary Co at 6% to construct a warehouse (completed on Dec 31, 20x1, useful life 20 years from Jan 1, 20x2). Interest is paid on Dec 31.
During 20x1, Parent Co records:
- Dr Cash 1,000,000
- Cr Loan payable to bank 1,000,000
- Dr Loan receivable from Subsidiary Co 1,000,000
- Cr Cash 1,000,000
- Dr Interest expense 50,000
- Cr Cash 50,000
- Dr Cash 60,000
- Cr Interest income 60,000
Subsidiary Co records:
- Dr Cash 1,000,000
- Cr Loan payable to Parent Co 1,000,000
- Dr Fixed assets in progress 60,000
- Cr Cash 60,000
At the economic entity level, internal interest "income" does not exist; only the external bank borrowing matters. Eliminate internal interest and capitalize external interest per IAS 23.
Consolidation adjusting entries at Dec 31, 20x1:
- Dr Interest income 60,000
- Cr Fixed assets in progress 60,000 (Eliminate interest income and internal interest capitalized in fixed assets)
- Dr Fixed assets in progress 50,000
- Cr Interest expense 50,000 (Capitalize external interest in self-constructed fixed assets)
- Dr Loan payable to Parent Co 1,000,000
- Cr Loan receivable from Subsidiary Co 1,000,000 (Eliminate intercompany loan balances)
In 20x2, the warehouse is depreciated. The consolidated income statement reflects depreciation of the capitalized external interest, not the internal loan interest.
- Depreciation from the group's perspective (50,000/20) = 2,500
- Depreciation from the legal entity's perspective (60,000/20) = 3,000
- Excess depreciation to adjust on consolidation = 500
Consolidation adjusting entries for 20x2:
- Dr Interest income 60,000
- Cr Interest expense 60,000 (Elimination of internal interest transaction)
- Dr Accumulated depreciation 500
- Cr Depreciation expense 500 (Adjustment of excess depreciation)
An entry is also needed to "correct" the overstatement of opening retained earnings of Parent Co and the overcapitalization of interest in fixed assets as at January 1, 20x2, re-enacting previous year's consolidation adjustments.
- Dr Opening retained earnings 10,000
- Cr Fixed assets 10,000 (Adjustment of opening retained earnings and overstated fixed assets as at beginning of the year)

Transactions Relating to Services Provided

The provision and enjoyment of services are simultaneous. Both parties record the transaction when the services are rendered.
Example: Subsidiary A rents its warehouse to Subsidiary B for 200,000 a year. The elimination entry is:
- Dr Rental income (Subsidiary A) 200,000
- Cr Rental expense (Subsidiary B) 200,000
When a customer capitalizes service costs in an asset, service transactions may be recognized in different periods.
Example: Parent Co provides architectural services to Subsidiary Co in 20x1 for 500,000, with directly attributable costs of 300,000 expensed by Parent Co. Fees are capitalized into the building cost of Subsidiary Co. Depreciation starts Jan 1, 20x2, over 20 years.
In 20x1, the consolidation adjustment will eliminate the fee income against the fixed assets in progress:
- Dr Fee income 500,000
- Cr Fixed assets in progress 200,000
- Cr Architectural expense 300,000 (To eliminate fee income and profit in fixed assets and to capitalize directly attributable costs)
In 20x2, consolidation adjustments re-enact CJE1 to correct opening retained earnings of Parent Co and overstatement of fixed assets:
- Dr Opening retained earnings 200,000
- Cr Fixed assets 200,000 (To eliminate fee income and capitalized cost in fixed assets as at 1 January 20x2)
In 20x2, consolidation adjustments also correct the excess depreciation of 10,000 (200,000 divided by 20 years) from the internal fee capitalized in fixed assets:
- Dr Accumulated depreciation 10,000
- Cr Depreciation expense 10,000 (To adjust excess depreciation on internal fee capitalized in fixed assets)

Transfer of Inventories that are Resold to Third Parties Within the Same Financial Year

Intercompany sales offset intercompany cost of sales. Profit (or loss) of the selling company offsets higher (or lower) cost of sales of the buying company. Eliminate sales and cost of sale via consolidation adjustment, even with no net impact on consolidated net income, to avoid including intragroup transactions in consolidated financials.
Example: Subsidiary C sells 500,000 of inventory to Subsidiary D (profit of 100,000), which resells it to third parties within the year. The elimination entry is:
- Dr Sales (Subsidiary C) 500,000
- Cr Cost of sales (Subsidiary D) 500,000
Adjusting entry ensures that financial statements show only sales to third parties and the original cost of purchasing the inventory from third parties.

Dividend Transactions

A parent records dividend income when the receipt right is established (IFRS 9 paragraph 5.7.1). Do not recognize proposed dividends not yet declared.
A consolidation entry eliminates proposed dividends. Declared dividends and dividend income are eliminated in Chapter 4.

Elimination of Intragroup Balances

Reconcile reciprocal balances between group companies before eliminating intragroup balances.
Reconciling items:
1. In-transit items recorded by one company but not the other.
2. Errors and omissions.
3. Disputes on the transaction.
Resolve all reconciling items:
1. Adjust in-transit items consistently with the other party's treatment and sound accounting principles.
2. Correct errors and omissions.
3. Disputed items should be recognized by the disputing party or adjusted out by the party that recorded them.
Table 5.1 shows an example of a reconciliation between two fellow subsidiaries, Subsidiaries A and B:
- Amount owing by B in A's books as at 31 December 20x5: 40,000
- Items in A's books but not in B's books:
  - Invoice #1278 (5/11/05) Disputed (Note 1): (1,500)
  - Invoice #1309 (26/12/05) Goods received on 29 December 20x5 (Note 2): (3,200)
  - Invoice #2730 (31/12/05) Goods received on 3 January 20x6 (Note 3): (2,500)
  - Debit note #21 (31/12/05) Repair for goods not under warranty (Note 4): (300)
- Payment made in December 20x5 by B but not recorded by A:
  - Cheque No. 1024 paid on 31 December 20x5 and uncleared as of 31 January 20x6 (Note 5): (17,000)
- Items recorded by B but not by A:
  - Defective goods returned on 1 December 20x5 by B but for which no credit note has been received (Note 6): (2,000)
- Amount owing to A in B's books as at 31 December 20x5: 13,500
Note 1: Either Subsidiary A reverses the sales or Subsidiary B accrues the invoice. Both may reserve rights to resolve the dispute.
Note 2: Subsidiary B records the following adjusting entry:
- Dr Inventory 3,200
- Cr Payable to A 3,200
Note 3: If shipment was made before the year-end, Subsidiary B records:
- Dr Goods-in-transit 2,500
- Cr Payable to A 2,500
Note 4: Subsidiary B makes the following adjustment:
- Dr Repair costs 300
- Cr Payable to A 300
Note 5: Follow-up on non-clearance of the cheque. If lost, cancel and reissue; Subsidiary B adjusts:
- Dr Bank 17,000
- Cr Payable to A 17,000
Note 6: Adjusting entry by either Subsidiary A or B is necessary, pending resolution.
After reconciliation and adjustments, the elimination entries are simple when balances agree:
- Dr Intercompany payable (SFP)
- Cr Intercompany receivable (SFP)
- Dr Dividend payable to parent (SFP)
- Cr Dividend receivable from subsidiary (SFP)
- Dr Loan payable to parent (SFP)
- Cr Loan receivable from subsidiary (SFP)

Adjustment of Unrealized Profit or Loss Arising from Intercompany Transfers

Profits and losses from intragroup transactions recognized in assets (inventory, fixed assets) are eliminated fully (IFRS 10 App B: B86(c)). Carrying amounts of assets should exclude unrealized profit/loss unless the loss is an impairment.

Intragroup Transfers of Inventory and Fixed Assets

Inventory is carried at the lower of cost and net realizable value. Cost is the original purchase price with an external party. IAS 2 paragraph 9 applies to both the group and legal entity.
From the group's view, the original cost is the price when goods were bought from a third party originally. From a legal view, the original cost is the exchange price of the goods purchased from another group company.
A consolidation adjustment eliminates the profit element in inventory carrying amount. The cost of sales in consolidated financials should be the original cost from unrelated third parties.
Figure 5.1 shows unrealized profit in inventory:
- Transfer price (TP)
- Original cost (OC)
- Inventory amount in the buying company's books
- (TP-OC) in remaining inventory should be eliminated
- Inventory amount on consolidation
Fixed assets should be stated at original purchase cost less accumulated depreciation from the original purchase date to the current period.
From a group's perspective, transferred fixed asset depreciation must be based on the original cost, not the transfer price.

Adjustment to Opening Retained Earnings

When a transaction is recognized by a legal entity in one period, but by the economic entity in another, consolidation adjustments are passed to opening retained earnings.
Example: Subsidiary sells inventory to Parent with a 20,000 profit in 20x1. Parent resells 10% in 20x1. Only 10% of the profit is earned by the group in 20x1. Subsidiary Company's opening retained earnings in 20x2 include 18,000 of "unrealized" profit.
Opening retained earnings are disclosed as a separate line item in the consolidated statement of changes in equity.
The sum of the opening retained earnings of the legal entities is not equal to the consolidated opening retained earnings because of timing differences in income recognition between the legal and economic entity. Hence, consolidation adjustments must be passed through again in the current year to ensure that the consolidated opening retained earnings is equal to the consolidated retained earnings at the previous year-end.
Unrealized profit from an intragroup transaction adjusted in one period is adjusted against opening retained earnings in the next. Re-enactment continues while unrealized profit remains in retained earnings. The amount in the re-enacted entry will be pro-rated accordingly if part of the inventory is resold to third parties.

Tax Effects on Adjustments to Eliminate Profit or Loss in Carrying Amounts of Assets

Taxes on unrealized profits/losses are adjusted to align consolidated tax expense with consolidated profit/loss.
When unrealized profits are eliminated from consolidated profit, but are included in legal entity's taxable income, a deferred tax asset arises. IAS 12 describes the unrealized profit as a “deductible temporary difference"
The tax expense relates to a future period and is deemed a deferred tax asset.
The consolidation adjustment in the year of transfer is as follows:
- Dr Deferred tax asset
- Cr Tax expense
In the reselling year:
- Dr Tax expense
- Cr Opening retained earnings
When unrealized losses from intragroup transactions are deducted for tax, a deferred tax liability is recognized.
The consolidation adjustment in the year of transfer is as follows:
- Dr Tax expense
- Cr Deferred tax liability
Illustration 5.1 shows consolidation adjustments and their impact when a subsidiary sells inventory to its parent.

ILLUSTRATION 5.1 Upstream sale

During the financial year ended 31 December 20x1, the following sale was made to the parent company, P, by its 100% owned subsidiary, S. Assume a tax rate of 20%. For simplicity, assume that this was the only transaction that transpired over the two years for both companies.
- 1 March 20x1: S purchased inventory of 7,000
- 1 April 20x1: S sold to P at a price of 10,000
- 31 December 20x1: Gross profit in S's books of 3,000 and tax expense of 600. P's inventory includes the unrealized profit of 3,000
- 5 January 20x2: P sold to third party for 15,000
Consolidation adjustments at 31 December 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 (The gross profit of 3,000 is not yet realized from the group's perspective).
- Dr Deferred tax asset (Group SFP) 600
- Cr Tax expense (S's I/S) 600 (Tax on profit is not recognized in 20x1; instead, the tax expense in S's books is considered as prepaid)
Consolidation adjustments at 31 December 20x2:
- Dr Opening retained earnings (S's SFP) 3,000
- Cr Cost of sales (P's I/S) 3,000 (Shift profits from the prior year's retained earnings to the current year's income when a sale to a third party is made.)
- Dr Tax expense (Group's P/L) 600
- Cr Opening retained earnings (S's SFP) 600 (Tax expense should be recognized in the group income statement)
What if the sale to an external party is made only in 20x3?
- Dr Opening retained earnings (S's SFP) 3,000
- Cr Inventory (P's SFP) 3,000
- Dr Deferred tax asset (Group's SFP) 600
- Cr Opening retained earnings (S's SFP) 600
Consolidation worksheet for 20x1:
- Consolidated Income Statement for the Year Ended 31 December 20x1:
  - Sales: Combined P and S = 10,000, Dr =, Cr 10,000, Consolidated =
  - Cost of sales: Combined P and S = (7,000), Dr =, Cr (7,000), Consolidated =
  - Gross profit: Combined P and S = 3,000, Dr =, Cr =, Consolidated =
  - Tax expense: Combined P and S = (600), Dr =, Cr 600, Consolidated =
  - Profit after tax: Combined P and S = 2,400, Dr =, Cr =, Consolidated =
- Consolidated Statement of Financial Position As at 31 December 20x1:
  - Cash: Combined P and S = 2,400, Dr =, Cr =, Consolidated = 2,400
  - Inventory: Combined P and S = 10,000, Dr =, Cr 3,000, Consolidated = 7,000
  - Deferred tax asset: Combined P and S = , Dr 600, Cr =, Consolidated = 600
  - Bank overdraft: Combined P and S = (10,000), Dr =, Cr =, Consolidated = (10,000)
  - Retained earnings: Combined P and S = (7,600), Dr =, Cr =, Consolidated = (7,600)
  - Total adjustments: Dr 600, Cr 3,000
Consolidation worksheet for 20x2:
- Consolidated Income Statement for the Year Ended 31 December 20x2:
  - Sales: Combined P and S = 15,000, Dr =, Cr =, Consolidated = 15,000
  - Cost of sales: Combined P and S = (10,000), Dr 3,000, Cr =, Consolidated = (7,000)
  - Gross profit: Combined P and S = 5,000, Dr =, Cr =, Consolidated = 8,000
  - Tax expense: Combined P and S = (1,000), Dr =, Cr 600, Consolidated = (600)
  - Profit after tax: Combined P and S = 4,000, Dr =, Cr =, Consolidated = 6,400
  - Retained earnings, 1 January 20x2: Combined P and S = 2,400, Dr 3,000, Cr 600, Consolidated =
  - Retained earnings, 31 December 20x2: Combined P and S = 6,400, Dr =, Cr =, Consolidated =3,600
- Consolidated Statement of Financial Position As at 31 December 20x2:
  - Cash: Combined P and S = 6,400, Dr =, Cr =, Consolidated =
  - Retained earnings: Combined P and S = 3,600, Dr =, Cr =, Consolidated =

Impact on Non-Controlling Interests Arising from Adjustments of Unrealized Profit or Loss

In subsidiaries partially owned, the direction of sale determines non-controlling interests' share of profits.

Situation 1: "Downstream Sale"

When a parent sells to a subsidiary, the unrealized profit resides in the parent's books, and the marked-up inventory remains on the subsidiary's statement of financial position. Non-controlling interests' profit share of the subsidiary is unaffected as the adjustment impacts the parent's profits only.

Situation 2: "Upstream Sale"

If a subsidiary sells to a parent, the profit in the subsidiary's books is "unrealized" for both the parent and non-controlling interests. Non-controlling shareholders assume the same perspective as the group.
The non-controlling interests' share of unrealized profit/loss should be adjusted from the asset's carrying amount.
The consistent treatment of unrealized profit/loss for both parent and non-controlling interests applies if one subsidiary sells to another.
Illustration 5.2 explains the consolidation adjustments that have to be passed for upstream and downstream sales of inventory in a two-year setting.

ILLUSTRATION 5.2 Multi-period effects of "upstream" and "downstream" sales

P invested in 70% of the shares of S at its incorporation on 1 January 20x3. The table below provides information on intercompany transfers of inventory. Assume a tax rate of 20%. Net profit after tax of S was 800,000 for the year ended 31 December 20x3 and 900,000 for the year ended 31 December 20x4. No dividends were declared in 20x3 and 20x4. The transfers of inventory between P and S are shown below:
- 20x3.
  - Sales of inventory from P to S: 60,000
  - Original cost of inventory: (50,000)
  - Gross profit: 10,000
  - Percentage unsold to third parties at year-end: 10%
  - Sales of inventory from S to P:
  - Original cost of inventory:
  - Gross profit:
  - Percentage unsold to third parties at year-end:
- 20x4.
  - Sales of inventory from P to S:
  - Original cost of inventory:
  - Gross profit:
  - Percentage unsold to third parties at year-end: 4%
  - Sales of inventory from S to P: 200,000
  - Original cost of inventory: (170,000)
  - Gross profit: 30,000
  - Percentage unsold to third parties at year-end: 30%
Consolidation adjustments at 31 December 20x3:
- CJE1: Elimination of intercompany sales and adjustment of unrealized profit from downstream sale
  - Dr Sales 60,000
  - r Cost of sales 59,000
  - r Inventory 1,000 (10% 10,000)
- Cost of sales (as reported in P's I/S):
- Cost of sales (as reported in S's I/S): 54,000 (90% of 60,000)
- Combined cost of sales:
- Cost of sales (from the group's perspective): (45,000)
- Amount to be eliminated: 59,000
- CJE1(a) eliminates the sales of P against the cost of sales of S for the proportion of inventory that was resold to third parties during 20x3.
  - Dr Sales (P) 54,000
  - Cr Cost of sales (S) 54,000
- CJE1(b) reverses the sales, cost of sales and profit in inventory for the proportion of inventory that remained unsold as at 31 December 20x3.
  - Dr Sales (P) 6,000 (10% 60,000)
  - Cr Cost of sales (P) 5,000 (10% 50,000)
  - Cr Inventory (S) 1,000
- CJE2: Adjustment for the tax effects on unrealized profit in inventory from downstream sale
  - Dr Deferred tax asset 200
  - Cr Tax expense 200 (20% 1,000)
- CJE3: Elimination of intercompany sales and adjustment of unrealized profit from upstream sale
  - Dr Sales 200,000
  - Cr Cost of sales 191,000
  - Cr Inventory 9,000 (30% x 30,000)
- Cost of sales (as reported in S's I/S)
- Cost of sales (as reported in P's I/S) 140,000 (70% of 200,000)
- Combined cost of sales
- Cost of sales (from the group's perspective) (119,000)
- Amount to be eliminated
- Cost of sales of the resold portion: Cost of sales eliminated = Percentage resold to third parties × Transfer price: 140,000 (70% × 200,000)
- Cost of sales of the unsold portion: Cost of sales reversed = Percentage unsold Original cost: 51,000 (30% x 170,000)
- CJE4: Adjustment for the tax effects on unrealized profit in inventory from upstream sale
  - Dr Deferred tax asset 1,800
  - Cr Tax expense 1,800 (20% x 9,000)
- CJE5: Allocation of current profit after tax to non-controlling interests
  - Dr Income to non-controlling interests (I/S) 237,840
  - Cr Non-controlling interests (SFP) 237,840
  - Less unrealized profit from upstream sale (CJE3): (9,000)
  - Add tax expense on unrealized profit from upstream sale (CJE4): 1,800
  - Adjusted net profit after tax of S for 20x3: 792,800
  - Non-controlling interests' share of profit after tax for 20x3 at 30%: 237,840
Consolidation adjustments at 31 December 20x4
- CJE1: Adjustment of unrealized profit from downstream sale in retained earnings as at 1 January 20x4
  - Dr Opening retained earnings 1,000 (10% 10,000)
  - Cr Cost of sales 600 (6% 10,000)
  - Cr Inventory 400 (4% 10,000)
- CJE2: Adjustment of tax on unrealized profit from downstream sale in retained earnings as at 1 January 20x4
  - Dr Tax expense 120
  - Dr Deferred tax asset 80
  - Cr Opening retained earnings 200
- CJE3: Allocation of post-acquisition retained earnings as at 1 January 20x4
  - Dr Opening retained earnings 240,000
  - Cr Non-controlling interests 240,000
- CJE4: Adjustment of unrealized profit from upstream sale in retained earnings as at 1 January 20x4
  - Dr Opening retained earnings 6,300 (70% 30% x 30,000)
  - Dr Non-controlling interests 2,700 (30% 30% × 30,000)
  - Cr Cost of sales 9,000 (30% 30,000)
- CJE5: Adjustment of tax on unrealized profit from upstream sale as at 1 January 20x4
  - Dr Tax expense 1,800
  - Cr Opening retained earnings 1,260
  - Cr Non-controlling interests 540
- CJE6: Allocation of current profit after tax to non-controlling interests
  - Dr Income to non-controlling interests (I/S) 272,160
  - Cr Non-controlling interests (SFP) 272,160
  - Net profit after tax of S for 20x4: