Question

On 1 January 2009 Cell Ltd acquired 100% of Android 18 Ltd for $850,000. For the year ending 31 December 213, record any and all consolidation adjustments for the following series of events, and explain the effect on the consolidated group's profit before tax (ignore tax).

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la) Each year Android 18 Ltd pays Cell Ltd a management fee of $20,000.

1b) During the year Android 18 Ltd declared paid a dividend of $75,000.

1c) On 1 January 2010 Cell Ltd sold Android 18 Ltd a 3 year old piece of plant that had a historical cost of $400,000 and an economic life of 10 years for $350,000 (which was paid in cash).

1d) During the year Android 18 Ltd sold Cell Ltd inventory for $630,000, which Android 18 Ltd had bought for $525,000. At the end of the year Cell Ltd had sold 70% of the inventory to external customers for $700,000. Cell Ltd owes Android 18 Ltd 30,000 for the inventory.

Answer 1

On january 1 2009, Cell Ltd has acquired 100% share in Android 18 Ltd. Transactions between the two entities shall hence be considered as Inter company transactions.

Classification of Intercompany transactions

Intercompany transactions can be divided into three main categories:

Downstream transaction: This is a transaction from parent to subsidiary. In a downstream transaction, the parent records the transaction and the profit/loss resulting from it. Thus, profit/loss will be visible to the parent’s shareholders only, and not to the minority interest’s.

Upstream transaction: This is a transaction from subsidiary to parent.

Lateral transaction: This is a transaction between two subsidiaries of the same company. In both lateral and upstream transactions, the subsidiary records the transaction and the profit/loss from it. Thus, the profit/loss can be shared between majority and minority interests, as the parent’s shareholders and minority interest share the ownership of the subsidiary.

1a Android 18 Ltd pays Cell Ltd a management fee of $20,000

Parent charges subsidiary management fee:

• In consolidated income statements, eliminate intercompany revenue and expenses arising from the management fee and recognise management expenses attributable to NCI.
• In the consolidated balance sheet, eliminate income from management fees; management fees attributable to NCI are recognised as income for the parent company

Effect on the consolidated group's profit before tax : Since in the income statement, both intercompany revenue as well as expense on account of management fee is to be eliminated, the effect on profit before tax shall ne nil.

1b During the year Android 18 Ltd declared paid a dividend of $75,000

On consolidation, we ignore any intra-group dividends in the statement of income. But for the consolidated statement of financial position, any PROPOSED dividends are accounted for by deducting from the retained earnings of the paying company and the appropriate part of the subsidiary dividend payable to the parent is included within the parent’s retained earnings

AS far as the impact on profit before tax is concerned, since payment of dividend is an appropriation to profit and not deduction from profit, it would not impact the profit before tax.

1c) On 1 January 2010 Cell Ltd sold Android 18 Ltd a 3 year old piece of plant that had a historical cost of $400,000 and an economic life of 10 years for $350,000 (which was paid in cash)

When an intercompany sale/purchase of a fixed asset occurs, such assets remain within the consolidated group. Intercompany profits on the sale and/or acquisition of fixed assets between affiliates are eliminated in consolidation so as to reflect the carrying value of the fixed assets at cost to the consolidated group.

A similar adjustment for intercompany profit is made for depreciable and nondepreciable long-lived assets.

1d) During the year Android 18 Ltd sold Cell Ltd inventory for $630,000, which Android 18 Ltd had bought for $525,000. At the end of the year Cell Ltd had sold 70% of the inventory to external customers for $700,000. Cell Ltd owes Android 18 Ltd 30,000 for the inventory.:

The parent (P) and their subsidiary (S) may well trade with each other during a financial period, leading to the following potential issues to be dealt with:

• receivables and payables in P and S that effectively cancel each other out
• sales and purchases in P and S that effectively cancel each other out

The effect of intra-group trading must be eliminated from the consolidated
income statement. Such trading will be included in the sales revenue of one group company and the purchases of another.

• Consolidated sales revenue = P's revenue + S's revenue – intra-group sales.
• Consolidated cost of sales = P's COS + S's COS – intra-group purchases

Profits made by members of a group on transactions with other group members are:

• recognised in the accounts of the individual companies concerned, but
• in terms of the group as a whole, such profits are unrealised and must be eliminated from the consolidated accounts

Adjustments for unrealised profit in inventory

(1)Determine the value of closing inventory still held within the group at the reporting date that are the result of intra-group trading. Here out of total intra trading of $630,000, 30% still left unsold i..e. $189,000.

(2)Use either the profit mark-up or margin to calculate how much of that value represents profit earned by the selling company. here the profit markup used by Andoid Ltd is 20% calculated as under:

Sales Value 630,000

Cost of Inventory to Android 18: 525,000

Difference: $ 105,000.

Markup : 105000//525000*100= 20%

Adjustment required:

Dr Subsidiary cost of sales (and therefore their retained earnings in the net asset working)

Cr Group inventory