CHAPTER 5
CONSOLIDATED FINANCIAL STATEMENTS—
INTRA-ENTITY ASSET TRANSACTIONS
Chapter Outline
I. The transfer of assets between the companies forming a business combination is a
common practice. The opportunity for such direct acquisition (especially of inventory) is
often the underlying motive for the creation of the combination.
II. Intra-entity inventory transfers
A. The individual accounting systems of the two companies will record the transfer as a
sale by one party and as a purchase by the other
B. Because the transaction was not made with an outside, unrelated party, the sales
and purchases balances created by the transfer are eliminated in consolidation
(Entry Tl)
C. Any transferred inventory retained at the end of the year is recorded at its transfer
price which in (many cases) will include an unrealized gross profit
1. For consolidation purposes, this intra-entity gross profit must be deferred by
eliminating the amount from the inventory account on the balance sheet and from
the ending inventory figure within cost of goods sold (Entry G).
2. Because transfer effects carry over to the subsequent fiscal period, the
unrealized gross profit must also be removed a second time: from the beginning
inventory component of cost of goods sold and from the beginning retained
earnings balance (Entry *G).
a. The retained earnings figure being adjusted is that of the original seller.
b. If the equity method has been applied and the transfer was made
downstream (by the parent), the beginning retained earnings account will be
correct; therefore, in this one case, the adjustment is to the Investment in
Subsidiary account.
3. The consolidation process is designed to shift the profit from the period of
transfer into the time period in which the goods are actually sold to unrelated
parties or consumed
D. Effect of deferral process on the valuation of a noncontrolling interest
1. Official accounting pronouncements permit but do not require deferral of
unrealized profits on the valuation of noncontrolling interest balances
2. This textbook adjusts the noncontrolling interest balances but only if the sale was
made upstream from subsidiary to parent. Downstream sales are made by the
parent and, thus, are viewed as having no effect on the outside interest.
III. Intra-entity land transfers
A. Any gain created by intra-entity land transfers is unrealized and will remain so until
the land is sold to an outside party
B. For each subsequent consolidation, the recorded value of the land account is
reduced to original cost. The unrealized gain recorded by the seller must also be
removed and deferred until the land is sold to an outsider.
1. In the year of transfer, an actual gain account exists within the accounting
records of the seller and must be removed.
2. In all later time periods, since the unrealized gain has become an element of the
seller’s beginning retained earnings balance, the reduction is made to this equity
account.
3. If the land is ever sold to an outside party, the intra-entity gain is realized and has
to be recognized within that time period.
IV. Intra-entity transfer of depreciable assets
A. As with other intra-entity transfers, any unrealized gross profit must be deferred for
consolidation purposes to establish appropriate historical cost balances.
B. However, the difference between the transfer-based accounting value and the
historical cost of the asset will change each year because of the effects of
depreciation. The amount of unrealized gain within retained earnings will also be
reduced annually since excess depreciation expense is recognized (and closed into
retained earnings) based on the inflated transfer price.
C. Consequently, elimination of the unrealized gain (within retained earnings) and the
reduction of the asset value to historical cost will differ from year to year.
D. Also within the consolidation process, the recorded depreciation expense must be
decreased every period to an amount appropriately based on the asset’s original
acquisition price.
Answers to Discussion Questions
Earnings Management: By selling goods to special purpose entities that it controlled but did
not consolidate, did Enron overstate its earnings?
According to the Power’s Report (Report of Investigation by the Special Investigative
Committee of the Board of Directors of Enron Corp.—February 1, 2004)
These partnerships—Chewco, LJM1, and LJM2—were used by Enron
Management to enter into transactions that it could not, or would not, do with
What effect does consolidation have on the financial reporting for transactions with controlled
entities?
In consolidation, all intra-entity profit would have been deferred until the goods were sold to an
outside party. Also the intra-entity note receivable and payable would have been eliminated in
consolidation.
As noted by Bala Dahran in his February 6, Congressional Testimony
FASB Activity on Variable Interest Entities (VIEs)
Fortunately the FASB’s ASC Topic 810 explains how to identify an SPE (a type of entity that is
What Price Should We Charge Ourselves?
Transfer pricing is actually a topic for a managerial accounting discussion. Students, though,
need to be aware that managerial and financial accounting do overlap at times. In this
Since Slagle owns 100 percent of Harrison’s common stock, consolidated net income will not be
altered by the transfer pricing decision. All intra-entity transactions as well as unrealized profits
To the accountant, the easiest approach is to set the transfer price at the seller’s cost ($70.00 in
this case). No intra-entity profits are created and the consolidation process is less complicated.
However, as indicated in the narrative, that price may penalize the seller since no profits are
Answers to Questions
1. One reason for the significant volume and frequency of intra-entity transfers is that many
business combinations are specifically organized so that the companies can provide
2. The sales between Barker and Walden totaled $100,000. Regardless of the ownership
percentage or the gross profit rate, the $100,000 was simply an intra-entity asset
3. Sales price per unit ($900,000 ÷ 3,000 units) $ 300
Number of units in Safeco’s ending inventory × 500
4. In intra-entity transactions, a transfer price is often established that exceeds the cost of
the inventory. Hence, the seller is recording a gross profit on its books that, from the
perspective of the business combination as a whole, remains unrealized until the asset
is consumed or sold to an outside party. Any unrealized gross profit on merchandise still
held by the buyer must be deferred whenever consolidated financial statements are
5. On the individual financial records of James, Inc., a gross profit is recorded in the year of
transfer. From the viewpoint of the business combination, this gross profit is actually
6. Currently accounting pronouncement allow discretion regarding the effect of unrealized
intra-entity profits and noncontrolling interest values. This textbook reasons that
unrealized profits relate to the seller and to the computation of the seller’s income.
7. Consolidated financial statements are largely unchanged across downstream versus
upstream transfers. Sales and purchases (Inventory) balances created by the
transactions are eliminated in total. Any unrealized gross profits remaining at the end of
having no impact on the outside interest.
8. The computation of this noncontrolling interest balance depends on the direction of the
intra-entity transfers which is not indicated in the question. If the unrealized gross profits
were created by downstream sales from King to Pawn, they relate only to King. The net
income would be $80,000 and the noncontrolling interest’s share of consolidated net
income is reported as $8,000:
Pawn’s reported net income …..……………..……..…....….. $110,000
Recognition of prior year unrealized gross profit ........... 30,000
9. The deferral and subsequent recognition of intra-entity profits are allocated to the
noncontrolling interest in the same periods as the parent. When one affiliate sells to
10. Several differences can be cited that exist between the consolidated process applicable
to inventory transfers and that which is appropriate for land transfers. The total intra-
entity Sales balance is offset against Purchases (Inventory) when inventory is
transferred but no corresponding entry is needed when land is involved. Furthermore, in
11. As long as the land is held by the parent, its recorded value must be reduced to
historical cost within each consolidated set of financial statements. In the year of the
original transfer, the asset reduction is offset against the subsidiary’s recorded gain. For
all subsequent years in which the property is held, the credit to the Land account is
made against the beginning retained earnings balance of the subsidiary (since the
unrealized gain will have been closed into that account).
12. Depreciable assets are often transferred between the members of a business
combination at amounts in excess of book value. The buyer will then compute
depreciation expense based on this inflated transfer price rather than on an historical
13. From the viewpoint of the business combination, an unrealized gain has been created by
the intra-entity transfer and must be deferred in the preparation of consolidated financial
statements. This unrealized gain is closed by the seller into retained earnings
necessitating subsequent reductions to that account. In the individual financial records,
Answers to Problems
1. D
2. B Merchandise remaining in James’s inventory $250,000 × 40% = $100,000.
4. D UNREALIZED GROSS PROFIT, 12/31/14
Intra-entity gross profit ($200,000 – $160,000) ……………………..…. $40,000
UNREALIZED GROSS PROFIT, 12/31/15
Intra-entity gross profit ($350,000 – $297,500) ……………….…..…… $52,500
Inventory remaining at year’s end ……………..…………………………… 30%
Unrealized intra-entity gross profit, 12/31/15 ………………….………. $15 ,750
CONSOLIDATED COST OF GOODS SOLD
Parent balance ……….……………………………………….……………….. $607,500
Subsidiary balance …………….………………………………….…………. 450,000
5. A Intra-entity sales and purchases of $100,000 must be eliminated.
Additionally, an unrealized gross profit of $10,000 must be removed from
ending inventory based on a gross profit rate of 25 percent ($200,000 gross
$10,000).
6. C The only change here from Problem 5 is the gross profit rate which would
now be 40 percent ($120,000 gross profit $300,000 sales). Thus, the
7. B UNREALIZED GROSS PROFIT, 12/31/14
Ending inventory ……………………………………………………………… $40,000
Gross profit rate ($33,000 ÷ $110,000) …………….……………..….. 30%
Unrealized intra-entity gross profit, 12/31/14 ………………..……. $12 ,000
UNREALIZED GROSS PROFIT, 12/31/15
NET INCOME ATTRIBUTABLE TO NONCONTROLLING INTEREST
Reported net income for 2015 …………….…………………….………. $90,000
Realized gross profit deferred in 2014 ……………..……………….. 12,000
8. A Individual records after transfer:
12/31/14
Machinery = $40,000
Gain = $10,000
Depreciation expense $8,000 ($40,000 ÷ 5 years)
Net effect on income = $2,000 ($10,000 – $8,000)
12/31/15
Depreciation expense = $6,000
Adjustments for consolidation purposes:
2014: $2,000 income is reduced to a $6,000 expense (net income is reduced
by $8,000)
9. D UNREALIZED GAIN
Transfer price …………..………………………………………………………. $430,400
Book value (original cost less two years depreciation) ......... 368 ,000
Unrealized gain………..……………………………………..………………… $ 62 ,400
EXCESS DEPRECIATION
Remove excess depreciation ………….………………..………………. 7 ,800
Net reduction in consolidated net income …….…………………… $(54 ,600)
10.D Add the two book values and remove $100,000 intra-entity transfers.
11.C Intra-entity gross profit ($100,000 – $80,000) ..…………………………. $20,000
Inventory remaining at year’s end ……………..…………………………… 60%
Unrealized intra-entity gross profit ……………..…………….…………… $12 ,000
CONSOLIDATED COST OF GOODS SOLD
Parent balance ……….……………………………………….……………….. $140,000
Cost of goods sold ……………..…………………………………………………. $132 ,000
12.C Consideration transferred ……….………………. $260,000
Noncontrolling interest fair value………………. 65 ,000
Excess fair over book value $ 75,000
Remaining Annual Excess
Excess fair value to undervalued assets: Life Amortizations
Equipment……….…………………………………… $25,000
5 years……………………………………..…$5,000
Secret Formulas ………………………………….. 50 ,000
20 years……….………………………….… 2,500
Total ………..…………………………………….……….. -0- $7 ,500
Consolidated expenses = $37,500 (add the two book values and include
current year amortization expense)
13. A 20% of the beginning book value $50,000
Excess fair value allocation (20%× $75,000) 15,000
20% share of Suarez net income
14. C Add the two book values plus the $25,000 original allocation less one year
of excess amortization expense ($5,000).
15. B Add the two book values less the ending unrealized gross profit of $12,000.
Combined pre-consolidation inventory balances………………….… $260,000
Intra-entity gross profit ($100,000 – $80,000) ……………….. $20,000
16. (15 Minutes) (Determine selected consolidated balances; includes
inventory transfers and an outside ownership.)
Customer list amortization = $78,000 ÷ 4 years = $19,500 per year
CONSOLIDATED TOTALS
Inventory = $795,000 (add the two book values and subtract the ending
unrealized gross profit of $5,000)
Sales = $1,620,000 (add the two book values and subtract the $180,000
intra-entity transfer)
Intra-entity gross profit deferral……………………………..……. (5,000)
Excess fair value amortization…………..…………..……………. (19 ,500)
Gross profit deferral is allocated to the noncontrolling interest because
the transfer was upstream from Barone to Allister.
17. (60 minutes) (Downstream intra-entity profit adjustments when parent uses
equity method and a noncontrolling interest is present)
Consideration transferred by Corgan $980,000
Noncontrolling interest fair value 245 ,000
Smashing’s acquisition-date fair value 1,225,000
Book value of subsidiary 950 ,000
2014 Ending Inventory Profit Deferral
Cost = $100,000 ÷ 1.6 = $62,500
2015 Ending Inventory Profit Deferral
Cost = $120,000 ÷ 1.6 = $75,000
a. Investment account:
Consideration transferred, January 1, 2014 $980,000
Smashing’s 2014 net income × 80% $120,000
Covenant amortization (13,750 × 80%) (11,000)
Ending inventory profit deferral (100%) (15 ,000)
Equity in Smashing’s earnings 94,000
2014 dividends (28 ,000)
17. (continued)
b. 12/31/15 Worksheet Adjustments
*G Investment in Smashing 15,000
Cost of goods sold 15,000
S Common stock—Smashing 700,000
Retained earnings—Smashing 365,000
I Equity in earnings of Smashing 90,000
Investment in Smashing 90,000
D Investment in Smashing 36,000
Dividends declared 36,000
E Amortization expense 13,750