Question

Ocean Ltd is a wholly-owned subsidiary of Breeze Ltd. The rate of company income tax is 30%. During the year ended 30 June 2017 the accounts revealed:

i               Ocean Ltd paid management fees of $15,000 to Breeze Ltd.
ii              Breeze Ltd sold inventory for $17,500 to parties external to the group. Ocean Ltd had previously sold this inventory to Breeze Ltd for $15,000. The inventory had cost Ocean Ltd $10,000.
iii             Breeze Ltd sold inventory to Ocean Ltd for $40,000. This inventory had cost Breeze Ltd $20,000. Ocean Ltd sold three-quarters of this inventory to parties external to the group.
iv             On 1 July 2016, Ocean Ltd sold machinery to Breeze Ltd for $150,000. The machinery was originally purchased by Ocean Ltd on 1 July 2012. The carrying amount of the machinery at the time of sale was $120,000 (cost $200,000, accumulated depreciation $80,000). The machinery is assessed as having a remaining useful life of 5 years from the date of sale. Straight-line depreciation is used.

Required
B) Explain why the adjustments for ii) and iv) are required (Explain in your own words).

Question 12 options:

Answer 1

In this question Ocean Ltd is a Wholly-owned subsidiary of Breeze Ltd. Hence Breeze Ltd is Parent and Ocean Ltd is subsidiary company. In this question IFRS 3(Consolidated Financial Statment) will be applicable and answer will be given accordingly. All the four questions are discussed as follows.

i) First transaction of inter company services would not required any adjustment as services are consumed as and when received hence they will not be outstanding on balance sheet date hence does not required any adjustments in Consolidated balance sheet. In Consolidated statment of comprehensive income such transaction will be off-setted.

ii) Second Transaction is inter company sales of inventory. However such inventory is sold to third party i.e outside the group during the year and is not held in inventory of Group as on Balance sheet date. So profit on such sales is realised and hence do not required any adjustment in Consolidated Balance sheet. However such Purchase and sales of inventory(Only Inter comapny sales and purchase, not outside the group sales) will be off-setted in Consolidated statment of comprehensive income.

iii) In third Transaction again there is inter company sales of inventory. However in this case three-quarter of such inventory is sold outside the group hence only one-quarter of inventory is only held as on balance sheet date. Calculation of unrealied profit on such inventory is explained in below table.

From above table we can see that inventory held in Ocean ltd contains unrealised profit of $ 5000 which needs to be elemenated from Conslolidated Statment of Comprehensive income as well as from Group inventory in Consolidated Balance sheet. Also Tax Expense related to Unrealised profit $5000 * 30% = $1500 needs to be reversed. Hence Tax expense will be reduced by $ 1500. Journal ENtry of above transaction can be as follows.

Consolidated Profit or Loss Dr $ 3500

Deffered Tax Expense Dr $ 1500

To Inventory or Inventory Reserve for Unrealised Profit $ 5000

Also inter company Sales and purchase of Inventory (Only Inter comapny sales and purchase, not outside the group sales) will be eleminated from Conslolidated Statment of Comprehensive income.

Sales Dr $ 40000

To Purchase $ 4000

iv) Fourth tranasaction is a tricky one in which a machinery is sold by Ocean Ltd. to Breeze Ltd. In case of asset unrealised profit will only included in thw value of asset not depreciated i,e carrying amont as on Balance sheet date. On date of acquisiton of machinery by Breeze Ltd. machinery has remaining useful life of 5 years and depreciation is charged on straight line basis. Following is the calculation of unrealised profit.

Hence from above table we can see that there is a unrealised profit of $ 24000 which needes to be elemenated from Conslolidated Statment of Comprehensive income as well from Group Carrying amount of Machinery in Consolidated Balance sheet. Also Tax Expense on Unrealised profit needs to be reversed which is $ 24000 * 30% = $ 7200.

Consolidated Profit or Loss Dr $ 16800

Deffered Tax Expense Dr $ 7200

To Machinery A/c $ 24000

No adjustment is required in Conslolidated Statment of Comprehensive income as sale and purchase of Mahinery has no impact on it.

Note: Even though in question it has asked for adjustment in only ii) and iv) point i considered it necessary to explain all points to clear this concepts. Also journal entries is not asked but i have included them wherever necessary to clear understanding of transaction. We have given this treatment according to IFRS 3(Consolidated FInancial Statments) which is globally accepted Accounting Staandard.