Deferred Profit on Intercompany Asset Sales

Intercompany transactions between subsidiaries of the same parent company are common in consolidated financial reporting. One type of intercompany transaction that can impact financial statements is intercompany asset sales. When one subsidiary sells an asset to another subsidiary of the same parent company, there are specific accounting rules that must be followed to properly report the transaction.

What is an Intercompany Sale?

An intercompany sale refers to a transaction where one affiliated company sells assets, products, or services to another affiliated company under the same parent corporation. For example, Subsidiary A sells inventory to Subsidiary B. Both Subsidiary A and Subsidiary B are owned by Parent Company P. This would be considered an intercompany sale.

Why Deferred Profit is Used

When an intercompany sale occurs, the profit from the sale is deferred. Deferred profit means the selling company cannot recognize the profit or loss from the sale right away. Instead, the profit is deferred until the asset is sold to an outside third party. This is done to avoid artificially inflating revenues and profits within the consolidated financial statements.

Consolidated Financial Statements

Consolidated financial statements report the financial results of a parent company and its subsidiaries as a single economic entity. Intercompany transactions must be eliminated to avoid double-counting revenues and expenses. By deferring intercompany profits, the consolidated statements accurately reflect profits as if the sales were made to third parties.

How to Calculate Deferred Profit

Deferred profit on intercompany sales is calculated as follows:

Deferred Profit = Selling Company’s Gross Profit – Unrealized Gain/Loss

Where:

• Selling Company’s Gross Profit = Sales Price – Carrying Value of Asset Sold
• Unrealized Gain/Loss = Fair Market Value – Carrying Value of Asset Sold

The unrealized gain or loss accounts for the difference between the asset’s book value and market value.

Example

Subsidiary A sells machinery to Subsidiary B for $20,000. The machinery originally cost Subsidiary A $12,000. The current fair market value of the machinery is $15,000.

Subsidiary A’s Gross Profit is $20,000 (Sales Price) – $12,000 (Carrying Value) = $8,000

The Unrealized Gain is $15,000 (FMV) – $12,000 (Carrying Value) = $3,000

Therefore, the Deferred Profit is $8,000 – $3,000 = $5,000

Subsidiary A defers $5,000 of the $8,000 intercompany profit.

When is Deferred Profit Recognized?

The deferred profit is not recognized until the asset is sold to an independent third party. At that point, the entity that originally sold the asset can recognize the deferred intercompany profit.

For example, if Subsidiary B later sold the machinery to an outsider for $30,000. Subsidiary A would then recognize the $5,000 in deferred profit from the original sale.

The key is that true profit or loss is only reported when the asset leaves the consolidated group.

Impact on Financial Statements

Deferred profit impacts the following financial statement accounts:

• Balance Sheet – Deferred profit on the sale of an asset is reported as a deferred credit. It appears as a long-term liability.
• Income Statement – Only the realized profit or loss from selling to a third party is recognized on the income statement.
• Cash Flow Statement – While cash is received at the time of the intercompany sale, the deferred profit means revenue is not recognized. Cash flow is treated as an investing activity.

complicated Accounting

Accounting for intercompany transactions can be complex. There are specific GAAP rules for properly recording transfers of assets between affiliated entities. Care must be taken to eliminate intercompany profits and accurately reflect consolidated activities.

Maintaining Separate Books

Even with intercompany eliminations, each subsidiary still maintains its accounting records. The deferred profit is only an eliminating entry for consolidated reporting purposes. It does not impact each entity’s books.

Assessing Profitability

Deferred intercompany profits can make it more difficult to assess performance. Management should track both separate entity and consolidated results to obtain a full profitability picture.

Monitoring Transfer Pricing

There is also a concern that intercompany transfer pricing could be manipulated to shift profits between entities. Companies should monitor pricing policies to ensure transactions are recorded at fair market values.

Consulting Accounting Experts

When intercompany activities become extensive, it can be prudent to consult outside accounting experts. They can ensure proper deferred profit reporting and advise on appropriate transfer pricing mechanisms.

Conclusion

Deferred profit accounting is an important concept for intercompany asset sales between affiliated subsidiaries. By deferring the profit from internal transfers, companies avoid premature revenue recognition in their consolidated financial statements. While complex, proper accounting for deferred profits provides investors and management with an accurate depiction of group financial performance. With the help of accounting experts, companies can navigate this technical area and meet financial reporting objectives.

FAQs

Q: When does deferred profit get recognized?

A: The deferred profit is recognized when the purchasing subsidiary resells the asset to an independent third party outside the consolidated group.

Q: Where does deferred profit appear on the balance sheet?

A: Deferred profit on intercompany sales is presented as a deferred credit and classified as a long-term liability on the consolidated balance sheet.

Q: Can subsidiaries eliminate deferred profit in consolidation?

A: No, the selling subsidiary must continue to defer the intercompany profit. It cannot be eliminated until the asset is sold externally.

Q: How does deferred profit impact cash flows?

A: It is treated as an investing cash inflow at the time of the intercompany sale since the profit recognition is deferred.

Q: Does deferred profit apply to intercompany services?

A: No, deferred profit accounting applies only to intercompany sales of tangible assets, not services.