A consolidation means that you combine the financial results of a parent company with a subsidiary company. A parent company buys a percentage of a subsidiary’s equity. At the end of a month or year, all parties would like to see the combined results of the parent and the “sub”.
To prevent double-counting, you need to eliminate the financial impact of transactions between a parent and a sub. Important: Most of the transactions are treated in the same way, whether they are upstream or downstream transactions. Consider a sale of machinery between a parent and a sub.
Sale of machinery for a gain
Assume that Sturdy Denim sells a $1,000 piece of machinery to Parent Jeans. The book value of the machinery on Sturdy’s books is $800. So, here’s Sturdy’s profit:
Sale proceeds $1,000
Less: Book value $800
Gain on sale $200
Finally, assume that Sturdy’s annual depreciation was $100/year. Consider what needs to be eliminated if you consolidate the financials of Sturdy Denim and Parent Jeans.
Sturdy’s gain on sale
In consolidation, Sturdy and Parent are considered the same company. So, you would want to eliminate any profit on transactions between the two companies. Said another way, you want to include only the transactions with third parties.
In this case, Sturdy’s profit is overstated by $200 (due to the sale to Parent). There’s another issue: Parent’s machinery is overstated by $200. In other words, the value of the machinery on Parent’s books is $200 too high. Here’s the journal entry to eliminate these two issues in consolidation:
Net Income (Sturdy- Sub) $200
Machinery (Parent) $200
(To eliminate the intercompany sale of machinery)
Upstream vs. downstream
If the sale of machinery went from Sturdy (the sub) to the parent, the elimination entry would be the same. By that I mean the you would debit net income (to eliminate the profit) and credit machinery (to eliminate the higher machinery cost).
Differences in depreciation
There’s another issue when the intercompany transaction involves machinery You just saw above that the asset on the Parent’s books was overstated. If the asset is overstated, then the depreciation is overstated.
In this case, the Parent was depreciating the asset based on their cost ($1,000). Sturdy’s book value at the time of the sale is $800. The amount of depreiciation depends on the depreciation method used (ie- straight line, accelerated method, etc.). To keep it simple, assume that the Parent’s depreciation for the year is $50 higher than the subsidiary:
Accumulated Depreciation $50
Depreciation Expense $50
(To eliminate the machinery’s excess depreciation)
This entry adjusts the depreciation to the amount recognized by Sturdy (the sub). You have removed any impact of the sale of machinery from the sub to the parent. You eliminated three things:
1. Sturdy’s gain of $200
2. Parent’s excess cost in machinery $200
3. Parent’s excess depreciation $50
This video will also help:
Your comments are welcome! Visit my website for online classes on the toughest accounting topics.
St. Louis Test Preparation
(cell) (314) 913-6529
(you tube channel) kenboydstl
Author/ Cost Accounting for Dummies (John Wiley and Sons) March 2013