Although not as prevalent as inventory transactions, intercompany sales of other assets occur occasionally.
Accounting for Land Transactions:
The consolidation procedures necessitated by intercompany land transfers partially parallel those for intercompany inventory. As with inventory, the sale of land creates a series of effects on the individual records of the two companies. The worksheet process must then adjust the account balances to present all transactions from the perspective of a single economic entity.
By reviewing the sequence of events occurring in an intercompany land sale, the similarities to inventory transfers can be ascertained as well as the unique features of this transaction.
1. The original seller of the land reports a gain (losses are rare in intercompany asset transfers), even though the transaction occurred between related parties. At the same time, the acquiring company capitalizes the inflated transfer price rather than the land’s historical cost to the business combination.
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2. The gain the seller recorded is closed into Retained Earnings at the end of the year. From a consolidated perspective, this account has been artificially increased by a related party. Thus, both the buyer’s Land account and the seller’s Retained Earnings account continue to contain the unrealized profit.
3. The gain on the original transfer is actually earned only when the land is subsequently disposed of to an outside party. Therefore, appropriate consolidation techniques must be designed to eliminate the intercompany gain each period until the time of resale.
Clearly, two characteristics encountered in inventory transfers also exist in intercompany land transactions: inflated book values and unrealized gains subsequently culminated through sales to outside parties. Despite these similarities, significant differences exist. Because of the nature of the transaction, the individual companies do not use sales/purchases accounts when land is transferred.
Instead, the seller establishes a separate gain account when it removes the land from its books. Because this gain is unearned, the balance has to be eliminated when preparing consolidated statements.
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In addition, the subsequent resale of land to an outside party does not always occur in the year immediately following the transfer. Although inventory is normally disposed of within a relatively short time, the buyer often holds land for years if not permanently. Thus, the overvalued Land account can remain on the acquiring company’s books indefinitely.
As long as the land is retained, elimination of the effects of the unrealized gain (the equivalent of Entry *G in inventory transfers) must be made for each subsequent consolidation. By repeating this worksheet entry every year, the consolidated financial statements properly state both the Land and the Retained Earnings accounts.
Eliminating Unrealized Gains—Land Transfers:
To illustrate these worksheet procedures, assume that Hastings Company and Patrick Company are related parties. On July 1, 2009, Hastings sold land that originally cost $60,000 to Patrick at a $100,000 transfer price. The seller reports a $40,000 gain; the buyer records the land at the $100,000 acquisition price.
At the end of this fiscal period, the intercompany effect of this transaction must be eliminated for consolidation purposes:
This worksheet entry eliminates the unrealized gain from the 2009 consolidated statements and returns the land to its recorded value of date of transfer, for consolidated purposes. However, as with the transfer of inventory, the effects created by the original transaction remain in the financial records of the individual companies for as long as the property is held.
The gain recorded by Hastings carries through to Retained Earnings while Patrick’s Land account retains the inflated transfer price. Therefore, for every subsequent consolidation until the land is eventually sold, the elimination process must be repeated.
Including the following entry on each subsequent worksheet removes the unrealized gain from the asset and from the earnings reported by the combination:
Note that the reduction in Retained Earnings is changed to an increase in the investment account when the original sale is downstream and the parent has applied the equity method. In that specific situation, equity method adjustments have already corrected the timing of the parent’s unrealized gain.
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Removing the gain has created a reduction in the investment account that is appropriately allocated to the subsidiary’s Land account on the worksheet. Conversely, if sales were upstream, the Retained Earnings of the seller (the subsidiary) continue to be overstated even if the parent applies the equity method.
One final consolidation concern exists in accounting for intercompany transfers of land. If the property is ever sold to an outside party, the company making the sale records a gain or loss based on its recorded book value. However, this cost figure is actually the internal transfer price. The gain or loss being recognized is incorrect for consolidation purposes; it has not been computed by comparison to the land’s historical cost. Again, the separate financial records fail to reflect the transaction from the perspective of the single economic entity.
Therefore, if the company eventually sells the land, it must recognize the gain deferred at the time of the original transfer. It has finally earned this profit by selling the property to outsiders. On the worksheet, the gain is removed one last time from beginning Retained Earnings (or the investment account, if applicable). In this instance, though, the entry is completed by reclassifying the amount as a realized gain. The timing of income recognition has been switched from the year of transfer into the fiscal period in which the land is sold to the unrelated party.
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Returning to the previous illustration, Hastings acquired land for $60,000 and sold it to Patrick, a related party, for $100,000. Consequently, the $40,000 unrealized gain was eliminated on the consolidation worksheet in the year of transfer as well as in each succeeding period. However, if this land is subsequently sold to an outside party for $115,000, Patrick recognizes only a $15,000 gain.
From the viewpoint of the business combination, the land (having been bought for $60,000) was actually sold at a $55,000 gain. To correct the reporting, the following consolidation entry must be made in the year that the property is sold to the unrelated party.
This adjustment increases the $15,000 gain recorded by Patrick to the consolidated balance of $55,000:
As in the accounting for inventory transfers, the entire consolidation process demonstrated here accomplishes two major objectives:
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1. Reports historical cost for the transferred land for as long as it remains within the business combination.
2. Defers income recognition until the land is sold to outside parties.
Recognizing the Effect on Non-Controlling Interest Valuation—Land Transfers:
The preceding discussion of intercompany land transfers has ignores the possible presence of a noncontrolling interest. In constructing financial statements for an economic entity that includes outside ownership, the guidelines already established for inventory transfers remain applicable.
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If the original sale was a downstream transaction, neither the annual deferral nor the eventual recognition of the unrealized gain has any effect on the noncontrolling interest. The rationale for this treatment, as previously indicated, is that profits from downstream transfers relate solely to the parent company.
Conversely, if the transfer is made upstream, deferral and recognition of gains are attributed to the subsidiary and hence, to the valuation of the noncontrolling interest. As with inventory, all noncontrolling interest balances are computed on the reported earnings of the subsidiary after adjustment for any upstream transfers.
To reiterate, the accounting consequences stemming from land transfers are these:
1. In the year of transfer, any unrealized gain is deferred and the Land account is reduced to historical cost. When an upstream sale creates the gain, the amount also is excluded in calculating the noncontrolling interest’s share of the subsidiary’s net income for that year.
2. Each year thereafter, the unrealized gain will be removed from the seller’s beginning Retained Earnings. If the transfer was upstream, eliminating this earlier gain directly affects the balances recorded within both Entry *C (if conversion to the equity method is required) and Entry S. The additional equity accrual (Entry *C, if needed) as well as the elimination of beginning Stockholders’ Equity (Entry S) must be based on the newly adjusted balance in the subsidiary’s Retained Earnings. This deferral process also has an impact on the noncontrolling interest’s share of the subsidiary’s income, but only in the year of transfer and the eventual year of sale.
3. If the land is ever sold to an outside party, the original gain is earned and must be reported by the consolidated entity.
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