When intercompany transfer of noncurrent assets occur, adjustments often are needed in the preparation of consolidated financial statements for as long as the acquiring company holds the assets. The simplest example of an intercompany asset transfer is the intercompany sale of land.
Overview of the Profit Elimination Process
When related companies transfer land at book value, no special adjustments or eliminations are needed in preparing the consolidated statements. If for example, a company purchases land for $10,000 and sells it to its subsidiary for $10,000, the asset continues to be valued at the $10,000 original cost to the consolidated entity:
Because the seller records no gain or loss, both income and assets are stated correctly from a consolidated viewpoint.
Land transfers at more or less than book value do require special treatment. Under the fully adjusted equity method, the parent company must defer any unrealized gains or losses until it eventually sells the assets to unrelated parties. Moreover, in the consolidation process, the selling entity’s gain or loss must be eliminated because the consolidated entity still holds the land, and no gain or loss may be reported in the consolidated financial statements until the land is sold to a party outside the consolidated entity. Likewise, the land must be reported at its original cost in the consolidated financial statements as long as it is held within the consolidated entity, regardless of which affiliate holds the land.
As an illustration, assume that Peerless Products Corporation acquires land for $20,000 on January 1, 20X1, and sells the land to its subsidiary, Special Foods Incorporated, on July 1, 20X1, for $35,000, as follows:
Peerless records the purchase of the land and its sale to Special Foods with the following entries:
The intercompany transfer leads to a $15,000 gain on Peerless’ books, and the carrying value of the land increases by the same amount on Special Foods’ books. Neither of these amounts may be reported in the consolidated financial statements because the $15,000 intercompany gain is unrealized from a consolidated viewpoint. The land has not been sold to a party outside the consolidated entity but only transferred within it; consequently, the land must still be reported in consolidated financial statements at its original cost to the consolidated entity.
When intercompany gains or losses on asset transfers are incurred, the parent company can choose to use the fully adjusted equity method, which requires it to adjust its investment and income from subsidiary accounts to remove the unrealized gain.
This equity-method entry ensures that the parent company’s income is exactly equal to the controlling interest in consolidated income on the consolidated financial statements.
The deferral of gain on an intercompany asset transfer is reversed in the period in which the asset is sold to an outsider. We use the fully adjusted equity method in all subsequent examples in the chapter. Another option is to ignore this unrealized gain on the parent company’s books and adjust for it in the consolidation worksheet only under the modified equity method.
In the consolidation process, the gain should be eliminated and the land restated from the $35,000 recorded on Special Foods’ books to its original cost of $20,000. This is accomplished with the following elimination entry in the consolidation worksheet prepared at the end of 20X1: