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CHAPTER 8

CHAPTER 8. INTRODUCTION TO INTERCOMPANY TRANSACTIONS. FOCUS OF CHAPTER 8. Intercompany Transactions: Operational Importance Nature and Variety The Importance of Using Supportable (fair) Transfer Prices Basic Conceptual Issues Minimizing the Consolidation Effort

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CHAPTER 8

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  1. CHAPTER 8 INTRODUCTION TO INTERCOMPANY TRANSACTIONS

  2. FOCUS OF CHAPTER 8 • Intercompany Transactions: • Operational Importance • Nature and Variety • The Importance of Using Supportable (fair) Transfer Prices • Basic Conceptual Issues • Minimizing the Consolidation Effort • Realized and Unrealized Profit Situations

  3. Operational Importance of Intercompany Transactions • Extent of Vertical Integration: • Nearly 40% of world trade constitutes intercompany transactions.

  4. Operational Importance of Intercompany Transactions • Assessing Performance for Each Entity Within the Consolidated Group: • Meaningful assessment would be impossible without intercompany transactions.

  5. Arm’s-Length Transactions: A Short Explanation • Defined: • “Transactions that take place between completely independent parties.”

  6. Categories of Transactions • Arm’s Length Transactions: • Are the ONLY transactions that can be reported in the consolidated statements. • Non-Arm’s Length Transactions: • Are usually referred to as “related party transactions.” • Include ALL intercompany transactions.

  7. Types of Related Party Transactions • Involving only Individuals: • Transactions among family members. • Involving Corporations: • With management and other employees. • With directors and stockholders. • With affiliates (controlled entities). • Probably constitutes at least 99% of all corporate related-party transactions.

  8. Necessity of Eliminating Intercompany Transactions • Eliminate ALL intercompany transactionsin consolidation: • Because they are internal transactions from a consolidated perspective. • Not because they are related-party transactions. • Only transactions with outside unrelated parties can be reported in the consolidated statements.

  9. Intercompany Transactions:Additional Opportunities for Fraud • Intercompany transactions sometimesoccur to: • Conceal embezzlements. • Overstate reported profits. 2 + 2 = 5

  10. Nature and Varietyof Intercompany Transactions • Type 1—Dividend payments: • Parents often need cash from subsidiaries: • To pay dividends. • To pay their own expenses. • Reasons why parents cannot get cash from subsidiaries (a “blocked funds” problem): • Regulatory restrictions. • Governmental restrictions.

  11. Nature and Varietyof Intercompany Transactions • Type 2—Loans: • Parents often centralize treasury functions at the parent level. Thus: • Subsidiaries are unable to borrow from outside lenders. • Subsidiaries usually borrow from their parents. • Interest may or may not be charged.

  12. Nature and Varietyof Intercompany Transactions • Type 3—Reimbursements for Directly Traceable Costs: • Parents often arrange and pay for external services that benefit a subsidiaryONLY. • Charging the subsidiary merely results in recording expenses in the proper income statement.

  13. Nature and Varietyof Intercompany Transactions • Type 4—Corporate Headquarters Services and Expense Allocations: • Handle one or two ways: • BILLING from a profit center: • Parent credits a Revenues account. • ALLOCATION from a cost center : • Parent credits an O/H Allocation acct. • Use either incremental or proportional allocation methods.

  14. Nature and Varietyof Intercompany Transactions • Type 5—Income Tax Expense Allocations: • Occurs ONLY when a parent & subsidiary file a consolidated tax return: • Use method consistent with FAS 109 “Accounting for Income Taxes”: • Pro forma separate return method complies. • Formula driven allocation method may or may not comply.

  15. Nature and Varietyof Intercompany Transactions • Type 6—Intangibles: • Parents often transfer technology and other intangibles to subsidiaries: Two ways to do so are: • Sell It: The transfer of a “right to” an item. (Recorded as a sale.) • Grant a License: The transfer of a “right to use” an item. (Recorded as licenseincome.)

  16. Nature and Varietyof Intercompany Transaction • Type 7—Inventory Transfers: • Virtually all occur in vertically integrated entities. • Classified as: • Downstream sales (parent to subsidiary) • Upstream sales (subsidiary to parent) • Lateral sales (subsidiary to subsidiary)

  17. Nature and Varietyof Intercompany Transactions • Type 8—Fixed Asset Transfers: • Far less common than inventory transfers. • Most likely to occur when one entity has surplus machinery or surplus office equipment.

  18. Nature and Varietyof Intercompany Transactions • Type 9—Investments in Bonds of a Member of the Consolidated Group: • Found infrequently in practice. • Much more involved to account for than intercompany loans because of premiums and discounts.

  19. Importance of Using Supportable (Fair) Transfer Prices • Transfer prices may be: • Negotiated between the entities. • Set by the parent company.

  20. Importance of Using Supportable (Fair) Transfer Prices • Actual transfer prices used are: • RelevantONLY from each individual entity’s perspective—impacts each entity’s reported net income. • Irrelevant from a consolidated perspective • Because they are undone in consolidation—exactly as if the transactions had NEVER occurred.

  21. Importance of Using Supportable (Fair) Transfer Prices: Tax Rules • From An Income Tax Reporting Perspective: • Transfer prices used have enormous implications. • Because of the potential to arbitrarily shift profits between entities. • And thereby lower the consolidated income tax expense. • Especially on an international scale.

  22. Importance of Using Supportable (Fair) Transfer Prices:Tax Rules • Tax Rules Concerning Transfer Prices: • Section 482 of Internal Revenue Code requires that: • Transfer prices be at an arm’s length basis. Thus: • Must charge a related party the same price as an unrelated party.

  23. Importance of Using Supportable(Fair) Transfer Prices: Tax Rules • Section 482 applies to ALL transfers: • Inventory. • Fixed assets. • Services. • Technology, patents, trademarks, and other intangibles (whether by sale or granting of a license). • Interest rates on loans & prices on leases.

  24. Importance of Using Supportable(Fair) Transfer Prices: Tax Rules • Consequences of Insupportable Transfer Prices: • Substantial tax penalties and fines. • Adjustment to financial statements for underreporting of consolidated income tax expense and payable. • Transfer prices are irrelevant for tax purposes: • When a worldwide reporting system is used (as used by six states).

  25. A Billion Here, A Billion There!Pretty Soon We’re Talking “Real Money” • BAD NEWS: • The IRS loses between $20-$40 billion of tax revenues each year because of transfer pricing shenanigans.

  26. The Complexity of Determining Supportable Transfer Prices: Winners • GOOD NEWS: • Tax accountant advisors to the multinational firms earn big fees (as high as $500 per hour) giving advice on how to “MINIMIZE” consolidated income taxes.

  27. GAAP Requirements Concerning Intercompany Transactions • GAAP requires the following to be eliminated for consolidated reporting: • All intercompany revenues, expenses, gains, and losses. • All open account balances (intercompany receivables and payables). • All unrealized intercompany profits and losses. • Use GROSS PROFIT OR LOSS.

  28. The Consolidation Effort:Keep It Simple • Use SEPARATE intercompany accountsin the income statement (for eachtransaction type). • Use a single Intercompany Receivable/ Payable account on each set of books. • Reconcile ALLintercompany accounts prior to consolidation. • Use the “elimination by rearrangement” technique on the consolidation worksheet.

  29. What’s Unrealized and What’s NOT? • The unrealized profit issue does not occur when: • Transfers are made at cost. • Transfers are made at above cost AND • The profit reported by the one entity is FULLY OFFSET by additional costs and expenses reported in the income statement by the other entity.

  30. Issuing Parent-Company-Only (PCO) Statements • Ye All Shall Know This: • A parent company’s PCO statementsmust report the samenet income and retained earnings amounts as appear in the consolidated statements.

  31. Review Question #1 Intercompany income statement accounts are eliminated in consolidation because they are deemed as being:A. Artificial transactions. B. Potentially manipulative transactions. C. Internal transactions. D. At amounts that are not determined onarms-length basis. E. None of the above.

  32. Review Question #1With Answer Intercompany income statement accounts are eliminated in consolidation because they are deemed as being:A. Artificial transactions. B. Potentially manipulative transactions. C. Internal transactions. D. At amounts that are not determined onarms-length basis. E. None of the above.

  33. Review Question #2 Which of the following account types need not be eliminated in consolidation? A. Intercompany assets & intercompany liabilities. B. Intercompany revenues & intercompany expenses. C. Intercompany overhead allocations.D. Long-term intercompany receivables.E. None of the above.

  34. Review Question #2With Answer Which of the following account types need not be eliminated in consolidation? A. Intercompany assets & intercompany liabilities. B. Intercompany revenues & intercompany expenses. C. Intercompany overhead allocation amounts.D. Long-term intercompany receivables.E. None of the above.

  35. Review Question #3 An intercompany account balance that would not need to be reconciled prior to consolidation is Intercompany:A. Dividends Payable.B. Interest Receivable.C. Management Fees Payable.D. Overhead Allocation Receivable.E. None of the above.

  36. Review Question #3With Answer An intercompany account balance that would not need to be reconciled prior to consolidation is Intercompany:A. Dividends Payable.B. Interest Receivable.C. Management Fees Payable.D. Overhead Allocation Receivable.E. None of the above.

  37. Review Question #4 An account balance that would not need to be reconciled prior to consolidation is:A. Intercompany Sales.B. Intercompany Interest Expense.C. Intercompany Management Fee Income.D. Intercompany Overhead Allocation Out.E. None of the above.

  38. Review Question #4With Answer An account balance that would not need to be reconciled prior to consolidation is:A. Intercompany Sales.B. Intercompany Interest Expense.C. Intercompany Management Fee Income.D. Intercompany Overhead Allocation Out.E. None of the above.

  39. Review Question #5 In 2006, Saxco incurred $75,000 of inter-company interest charges. Of this amount, Saxco paid $50,000 cash to its parent and capitalized $30,000 to a discrete construction project. The unrealized intercompany profit at 12/31/06 is: A. $ -0- B. $5,000C. $20,000D. $25,000E. $30,000

  40. Review Question #5With Answer In 2006, Saxco incurred $75,000 of inter-company interest charges. Of this amount, Saxco paid $50,000 cash to its parent and capitalized $30,000 to a discrete construction project. The unrealized intercompany profit at 12/31/06 is: A. $ -0- B. $5,000C. $20,000D. $25,000E. $30,000

  41. End of Chapter 8 • Time to Clear Things Up—Any Questions?

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