Buscom Inco.docx

Most economic transactions involve two unrelated entities, although transactions may occur between units of one entity (intercompany transactions). Intercompany transactions may involve such items as the declaration and payment of dividends, the purchase and sale of assets such as inventory or plant assets, and borrowing and lending. Regardless of the type of transaction, the occurrence of an intercompany transaction, if not removed (eliminated) from the consolidated financial statements, will often result in a misrepresentation of the consolidated entity’s financial position. This chapter presents a framework for evaluating intercompany transactions. The next section presents a theoretical discussion of intercompany transactions. The subsequent section presents a framework for interpreting such transactions, including two-year examples of downstream (parent-to-subsidiary) transactions to assist in applying the framework to specific situations. The examples in this section are simplified in that each intercompany transaction occurs at, or near, year-end. This is followed by examples where the simplifying assumption is relaxed. The chapter then presents how upstream (subsidiary-to-parent) intercompany transactions differ from downstream transactions. BASIC CONCEPTS An intercompany transaction occurs when one unit of an entity is involved in a transaction with another unit of the same entity. While these transactions can occur for a variety of reasons, they often occur as a result of the normal business relationships that exist between the units of the entity. These units may be the parent and a subsidiary, two 139 INTERCOMPANY TRANSACTIONS CHAPTER4 Intercompany transaction: a transaction that occurs between two units of the same entity 139-210.ch04rev.qxd 12/2/03 2:57 PM Page 139 subsidiaries, two divisions, or two departments of one entity. It is common for vertically integrated organizations to transfer inventory among the units of the consolidated entity. On the other hand, a plant asset may be transferred between organizational units to take advantage of changes in demand across product lines. An intercompany transaction is recognized in the financial records of both units of the entity as if it were an arm’s-length transaction with an unrelated party. From the consolidated entity’s perspective, the transaction is initially unrealized because unrelated parties are not involved; therefore, the intercompany transaction needs to be interpreted differently than it was by either of the participating units. The difference in interpretation generally results in the elimination of certain account balances from the consolidated financial statements. Transactions between units of an entity can take several forms and can occur between any units of the entity. Figure 4-1 illustrates possible directions of intercompany transactions. Transactions flowing from the parent to the subsidiary are commonly called downstream transactions, transactions from the subsidiary to the parent are commonly called upstream transactions,and transactions between subsidiaries are commonly called lateral transactions. The volume of intercompany transactions eliminated from the financial records of many large conglomerate organizations is significant. For example, Exxon Mobil Corporation reported the elimination of intercompany revenue of $98.1 billion, $113.4 billion, and $136.6 billion for 2000, 2001, and 2002, respectively.1 These amounts represented 29.7 percent, 34.8 percent, and 40.0 percent of the entity’s total sales and other revenue before eliminating intercompany transactions for the three years,

respectively. The views developed in ARB No. 51 have long served as the basic philosophy of the accounting profession toward consolidations and intercompany transactions. In stating the purpose of consolidated financial statements, ARB No. 51 provides a justification for the elimination of intercompany transactions. Regardless of the direction, the intercompany transaction must be removed when preparing the consolidated entity’s financial statements because, as discussed in ARB No. 51: The purpose of consolidated statements is to present, primarily for the benefit of the shareholders and creditors of the parent company, the results of operations and the financial position of a parent company and its subsidiaries essentially as if the group were a single company with one or more branches or divisions.2 140 CHAPTER 4 INTERCOMPANY TRANSACTION Downstream transaction: an intercompany transaction flowing from the parent to the subsidiary Upstream transaction: an intercompany transaction flowing from the subsidiary to theparent Lateral transaction: an intercompany transaction flowing from one subsidiary to another subsidiary FIGURE 4-1 Directions of Intercompany Transaction Parent Company Downstream Lateral Subsidiary BSubsidiary A UpstreamUpstream 1 Exxon Mobil Corporation, 2002 10-K. 2 Accounting Research Bulletin, No. 51, “Consolidated Financial Statements” (New York:American Institute