8 INTRODUCTION TO INTERCOMPANY TRANSACTIONS LEVEL OF TIME DIFFICULTY (MINUTES) REVIEW QUESTIONS EXERCISES 8-1 Consolidation entries: Intercompany loan and interest Simple 5 8-2 Consolidation entries: Intercompany computer charges Simple 5 8-3 Consolidation entries: Intercompany operating lease Simple 5 8-4 Consolidation entries: Intercompany inventory transfer at cost Simple 5 8-5 Reconciling intercompany accounts Simple 10 8-6 Tax effects of different transfer prices Simple 10 PROBLEMS 8-1 Recording a variety of intercompany transactions Moderate 30 8-2 Consolidation entries: Intercompany patent license fee Moderate 20 8-3 Consolidation worksheet: Intercompany software use charges Moderate 40 U THINKING CRITICALLY U CASES 8-1 Auditing a subsidiary’s intercompany receivable Simple 15 8-2 Suspicious upstream cash transfers Simple 10 8-3 Making parent-company-only statements articulate Moderate 20 8-4 Accounting theory: Substance of over- and underallocating taxes Simple 10 FINANCIAL ANALYSIS PROBLEMS 8-1 Assessing the newly created subsidiary’s performance (includes a library assignment) Complex 80 CHAPTER ETHICS QUESTIONS Corporate loyalty—Does it require questionable practices? (page 275) Simple 10 Relatives on the payroll—A family matter? (page 296) Simple 10 8-2 • ADVANCED ACCOUNTING: Concepts and Practice ASSIGNMENT MATERIAL Review Questions 1. Intercompany transactions constitute nearly 40% of world trade because of the large number of advantages to conducting operations in overseas countries (cheap labor, tax holidays, fewer environmental and child labor laws, and avoiding the fluctuating exchange rate problem). The desire for vertical integration (whether through vertical business combinations or internal expansion) has also resulted in a high level of intercompany transactions. 2. Intercompany transactions are between legal entities within a consolidated group of companies. Intracompany transactions are between a home office and one of its branches. 3. Ten examples of intercompany transactions are noninterest-bearing loans, interest-bearing loans, management fee charges, inventory transfers, fixed asset transfers, patent technology transfers, bond purchases, dividend payments, expense allocations, and royalty payments. 4. Upstream transfers are from subsidiary to parent. Downstream transfers are from parent to subsidiary. 5. The benefits derived from recording intercompany transactions in separately identifiable accounts is that the amounts generated from intercompany transactions are readily identifiable for elimination in consolidation. 6. Intercompany transactions are eliminated in consolidation because they are internal transactions—not because they are related-party transactions. 7. Transfer prices for related-party transactions must be set at supportable arm’s-length amounts. 8. Inbound transfers are from overseas countries into the United States; outbound transfers are from the United States to overseas countries. 9. Transfer pricing is a hot topic by taxing authorities because of (a) the huge potential for evading income taxes (largely a result of the phenomenal increase in world trade in the past 50 years) and (b) the apparent tax evasion that occurs. 10. Section 482 of the Internal Revenue Code deals with transfer pricing. 11. The IRS penalties for transfer pricing adjustments are a 20% nondeductible penalty if transfer pricing adjustments during a year exceed the lower of (a) $10 million or (b) 10% of the taxpayer’s gross receipts. This penalty increases to 40% if the IRS adjustments exceed $20 million. 12. The consequences to the consolidated financial statements of using unsupportable transfer prices are (a) understating both consolidated income tax expense and consolidated income taxes payable and (b) overstating both consolidated net income and consolidated stockholders’ equity. 13. The primary justification for eliminating intercompany transactions under current GAAP is that they are inconsistent with the presumption of consolidated statements—that is, presenting statements as if a single company with one or more branches or divisions existed. 14. Elimination by rearrangement merely arranges intercompany accounts on the consolidation worksheet so that they automatically cancel out in the Consolidated column without having to use consolidation entries. 15. Yes. A downstream intercompany inventory transfer at cost must still be eliminated in consolidation to prevent overstating consolidated revenues and consolidated cost of sales. Introduction to Intercompany Transactions • 8-3 EXERCISES E 8-1 (Estimated time: 5 minutes) Requirements 1 and 2: Consolidation Entries Ply Inc. Stry Inc. Dr. Cr. Consolidated Income Statement Intercompany interest income 2,000 2,000 (1) -0- Intercompany interest expense (2,000) 2,000 (1) -0- Balance Sheet Intercompany receivable 2,000 2,000 (2) -0- Intercompany payable 2,000 2,000 (2) -0- Intercompany note receivable 100,000 100,000 (3) -0- Intercompany note payable 100,000 100,000 (3) -0- Note: Two months of interest expense is $2,000 (11/1/06 to 12/31/06); $1,000 pertains to 2007. E 8-2 (Estimated time: 5 minutes) Requirements 1 and 2: Consolidation Entries Plo Inc. Stro Inc. Dr. Cr. Consolidated Income Statement Intercompany computer fee income 24,000 24,000 (1) -0- Intercompany computer fee expense (24,000) 24,000 (1) -0- Balance Sheet Intercompany receivable 6,000 6,000 (2) -0- Intercompany payable 6,000 6,000 (2) -0- E 8-3 (Estimated time: 5 minutes) Requirements 1 and 2: Consolidation Entries Prin Inc. Strin Inc. Dr. Cr. Consolidated Income Statement Intercompany lease income 36,000 36,000 (1) -0- Depreciation expense (22,000) (22,000) Intercompany lease expense (36,000) 36,000 (1) -0- Balance Sheet Intercompany receivable 6,000 6,000 (2) -0- Equipment on lease 110,000 110,000 Accumulated depreciation (22,000) (22,000) Intercompany payable 6,000 6,000 (2) -0- E 8-4 (Estimated time: 5 minutes) Requirements 1, 2, and 3: 2006 2007 2008 Intercompany Sales 40,000 (no entry) (no entry) Intercompany Cost of Sales 40,000 8-4 • ADVANCED ACCOUNTING: Concepts and Practice E 8-5 (Estimated time: 10 minutes) Requirement 1: Intercompany Accounts Parent’s Subsidiary’s Books Books Book balances at 6/30/06................................................................. $82,000 Dr. $52,600 Cr. Collection of subsidiary’s customer receivable not reported to subsidiary ....................................................................................... (2,000) Advertising allocation improperly recorded at $600 instead of $6,000 ... 5,400 Inventory return in transit ................................................................. (5,000) Inventory sale in transit .................................................................... 14,000 G&A allocation................................................................................ ______ 7,000 Adjusted Book Balances at 6/30/06 ................................................ $77,000 $77,000 Requirement 2: Entries on Parents Books Sales (or Sales Returns) 5,000 Intercompany Receivable 5,000 Inventory (cost is 60% of the transfer price) 3,000 Cost of Sales 3,000 Entry on Subsidiary’s Books Advertising Expense 5,400 Inventory 14,000 Intercompany Overhead Allocation In 7,000 Accounts Receivable 2,000 Intercompany Payable 24,400 E 8-6 (Estimated time: 10 minutes) Requirement 1: U.K. Total Worldwide U.S. (translated) Income Taxes Selling price .............................................................. $200,000 $300,000 Cost of sales............................................................. (100,000) (200,000) Gross Profit ........................................................... $100,000 $100,000 Income tax rate ........................................................ 40% 50% Income Tax Expense .......................................... $ 40,000 $ 50,000 $90,000 Requirement 2: U.K. Total Worldwide U.S. (translated) Income Taxes Selling price .............................................................. $250,000 $300,000 Cost of sales............................................................. (100,000) (250,000) Gross Profit ........................................................... $150,000 $ 50,000 Income tax rate ........................................................ 40% 50% Income Tax Expense .......................................... $ 60,000 $ 25,000 $85,000 Introduction to Intercompany Transactions • 8-5 PROBLEMS P 8-1 (Estimated time: 30 minutes) Requirement 1: Parr Inc. Intercompany Receivable/Payable Make loan (1) $ 50,000 Management fees (2) 36,000 Sell inventory (3) 160,000 Dividend declaration (4) 25,000 20,000 (5) Dividend receipt Legal fee charges (6) 15,000 Sell inventory (7) 30,000 Overhead allocation (8) 44,000 _________ $340,000 Subb Inc. Intercompany Receivable/Payable $ 50,000 (1) Borrow money 36,000 (2) Management charges 160,000 (3) Buy inventory 25,000 (4) Declare dividends Pay dividends (5) 20,000 15,000 (6) Legal fee charges Sell inventory 30,000 (7) Buy inventory 44,000 (8) Overhead allocation ________ $340,000 Requirement 2: Account Parr Inc. Subb Inc. Income Statement Sales ......................................................................................................... 220,000 Cost of sales.............................................................................................. (145,000) Intercompany sales .................................................................................... 190,000a Intercompany cost of sales ......................................................................... (152,000)b Balance Sheet Intercompany acquired inventory ................................................................ 45,000c a $160,000 + $30,000 = $190,000. b $128,000 + $24,000 = $152,000. c $15,000 + $30,000 = $45,000. 8-6 • ADVANCED ACCOUNTING: Concepts and Practice P 8-1 (continued) Requirement 3: Analysis of Inventory Sold to Subsidiary on 5/1/06 Total Resold On Hand Intercompany sales (new basis) ................................................. $160,000 $145,000 $15,000 Intercompany cost of sales (old basis) (128,000) (116,000) (12,000) Gross Profit (20% of transfer price) $ 32,000 $ 29,000 $ 3,000 Total Intercompany Acquired Inventory on Hand at 12/31/06: Amount from 5/1/06 shipment (per above) $ 15,000 Amount from 12/30/06 shipment 30,000 Total $ 45,000 P 8-2 (Estimated time: 20 minutes) Requirement 1: Total intercompany royalty fee (12,000 units manufactured × $10) $120,000 Intercompany royalty fee expensed on Sota’s books (10,000 units sold × $10) (100,000) Intercompany royalty fee reported in inventory by Sota at 12/31/06 $ 20,000 Requirements 2 and 3: Consolidation Entries Pota Sola Dr. Cr. Consolidated Income Statement Cost of sales (100,000) 100,000 (1) -0- Intercompany patent fee income 120,000 120,000 (1) -0- Balance Sheet Inventory 20,000 20,000 (1) -0- Intercompany receivable 43,000a 43,000 (2) -0- Intercompany payable 43,000a 43,000 (2) -0- a $120,000 – $77,000 = $43,000. P 8-3 (Estimated time: 40 minutes) Requirement 1 For Suda’s $10,000 of 2006 software cost incurred, $7,000 is reported in cost of sales (210/300 × $10,000) and $3,000 is reported in inventory (90/300 × $10,000). Puda’s software costs. For Puda’s $20,000 of 2006 amortization expense, $16,000 is reported in cost of sales (400/500 × $20,000) and $4,000 is reported in inventory (100/500 × $20,000). None of these amounts require adjustment or elimination in consolidation because they are unrelated to the intercompany licensing transaction. y. Introduction to Intercompany Transactions • 8-7 U CASES U C 8-1 (Estimated time: 15 minutes) Requirement 1: A generally accepted auditing procedure is to confirm the balance of receivables with outside parties to establish their validity. Although this should be done here as well, obtaining a confirmation of the balance from the parent does not provide nearly as much value as does a confirmation of an accounts receivable balance from a customer. The critical focus should be on (a) obtaining the business reasons behind the creation of the receivable and (b) determining whether the parent has the wherewithal to pay off the receivable. Thus it probably is necessary to review the parent’s financial statements and the related accompanying audit report. Furthermore, the auditor should be satisfied that the parent’s auditing firm has a reputation for performing quality work. If the parent’s auditors are from a small, relatively unknown firm, consideration should be given to examining their audit working papers. A Real-World Example—ESM Government Securities, Inc. (hereafter ESM-GS). ESM-GS was a 100%- owned subsidiary that incurred nearly $300 million of trading and embezzlement losses, which it concealed by shifting the losses to a sister subsidiary using thousands of intercompany transactions. In turn, the sister subsidiary shifted the losses to the common parent. As a result, ESM-GS had a nearly $300 million intercompany receivable from its parent company. Likewise, the parent had almost as large an intercompany receivable from ESM-GS’s sister subsidiary. Accordingly, the collectibility of ESM-GS’s intercompany receivable depended on the ability of the sister subsidiary (which was insolvent) to repay the parent. In this case, the auditors merely confirmed the intercompany receivable with the parent, a woefully inadequate audit procedure. Requirement 2: The best course of action is to pursue this matter with a more senior audit partner—with the full knowledge of the engagement partner. In an extreme case, you might ask to be removed from the audit so that you are not associated with it should legal problems occur at a later date. Such a request most likely would upset the engagement partner, and you would have to be willing to live with the consequences. In the ESM-GS case, the engagement partner had taken bribes of $200,000 over several years to look the other way regarding the collectibility of the intercompany receivable. He was later convicted and sentenced to a federal prison for eight years. The younger staff auditors often questioned this engagement partner regarding the intercompany receivable, and he always gave them baloney answers. Unfortunately, all of the younger auditors merely (a) accepted the engagement partner’s answers and (b) did not pursue the matter with more senior partners. C 8-2 (Estimated time: 10 minutes) Although these upstream intercompany transfers are undone in consolidation (as though they had never occurred), cash that otherwise would be at the subsidiary level may not actually be at the parent level. Once the cash reached the parent level, it could have been used to pay (1) corporate expenses or (2) dividends to the parent’s stockholders. Thus the consolidated cash balance could be much lower than had the upstream transfer not occurred. Accordingly, the auditor must be satisfied that these transfers are bonafide and not dividends in disguise. The safest course of action is for the auditor to request the client to obtain a written approval of these cash transfers from the regulatory authorities. Without such approval, the auditor has a scope restriction that requires issuing a qualified opinion on the financial statements. 8-8 • ADVANCED ACCOUNTING: Concepts and Practice C 8-3 (Estimated time: 20 minutes) C 8-4 (Estimated time: 10 minutes) Requirement 1: An overallocation of income taxes from a parent to a subsidiary should be acounting for as a dividend from the subsidiary. Requirement 2: An underallocation of income taxes from a parent to a subsidiary should be accounting for as an additional capital investment by the parent. Introduction to Intercompany Transactions • 8-9 U FINANCIAL ANALYSIS PROBLEMS U FAP 8-1 (Estimated time: 120 minutes) Key points. The following are the problem’s key points: 1. Annualizing the subsidiary’s quarterly earnings. To properly compare the subsidiary with the parent, it is necessary to either: a. Annualize the subsidiary’s quarterly earnings for comparing them to the parent’s 2005 annual results; or b. Deannualize the parent’s annual results by dividing by 4. Students often overlook this critical step. If the business is seasonal, it is necessary instead to use the parent’s actual first quarter results. (Some industries, such as the disk drive industry, are so volatile that financial analysts compare the current quarter to the previous quarter rather than to the quarter of the previous year.) 2. Subsidiary’s reported earnings represent an operating income. The subsidiary’s $48,000 reported earnings represent an operating income—not a net income. No amounts for interest expense or income taxes were deducted in arriving at this amount. Accordingly, the $48,000 can be compared only to the parent’s operating income—not to its net income. 3. Required allocations to obtain the subsidiary’s net income. To properly make ROE calculations, net income should be used. For the subsidiary, this requires the allocation of both interest expense and income taxes. 4. Incremental analysis versus proportional analysis. The subsidiary can be evaluated using incremental or proportional analysis. The information given will lead students into incremental analysis, which indicates that the subsidiary is a very worthwhile investment. However, proportional analysis (whereby general corporate expenses, such as the purchasing department, the president’s salary, and annual audit costs, are allocated to the subsidiary based on relative revenues or square footage) may reveal that the subsidiary is not performing as well as the parent. If such expenses are not allocated, the subsidiary will clearly appear to outperform the parent. In the problem, only advertising expenses were allocated proportionally. 5. BEP and ROE percentages for the parent will be distorted if its fixed assets have a current value significantly different from historical cost. If the parent’s cost of land is significantly below its current value, the undervaluation negates a valid comparison with the subsidiary unless this undervaluation is added to the parent’s total assets in the parent’s BEP calculation. (Likewise, the undervaluation also must be added to stockholders’ equity in the parent’s ROE calculation.) The same holds true for depreciable assets. An additional factor for depreciable assets that could make comparison more difficult is the depreciation method used. With the use of the double declining-balance method, the subsidiary—in its first year—is incurring substantially higher de- preciation expense relative to the parent—which has existed for 10 years. 6. Recognizing that more information is needed to perform a meaningful analysis. To make a valid comparison, much more detailed information is needed. This information was excluded to see whether students recognize this. 8-10 • ADVANCED ACCOUNTING: Concepts and Practice FAP 8-1 (continued) Requirement 1 (parent for 2005): a. Basic earning power (BEP) To negate the effect of leverage, management calculates the return on total assets using operating itncome as follows: Before After Income Taxes Income Taxes Operating Income (EBIT) = $160,000 = 16% $96,000 = 9.6% Total Assets (beginning) $1,000,000 $1,000,000 Interest rate on long-term debt 10% 6% Note that leveraging is advantageous because Pola is earning more on the assets than it is paying on the borrowing. b. Return on equity (ROE) The ROE calculation is useful from an investor (stockholder) perspective and is calculated as follows: Net Income = $72,000 = 18% Stockholders’ Equity (beginning) $400,000 Requirement 2 (subsidiary for first quarter of 2006): a. Basic earning power (BEP) QuarterAnnualized Subsidiary Income (EBIT) = $48,000 = 4% 16% Total Assets (beginning) $1,200,000a a See next page for balance sheet that shows how this amount was calculated. For comparative purposes, Pola’s BEP for 2005 was also 16% (as shown in requirement 1, part a). b. Return on equity (ROE) Sola also can be evaluated from the perspective of the parent being an investor (in the same manner that stockholders evaluate a company from their perspective). To do this for Sola, Pola determines its net investment in Sola as follows: Average balance in Investment is Subsidiary account during the quarter .................................. $1,000,000 Less: Long-term debt issued to finance Sola (800,000) Net Investment in Sola $ 200,000 Introduction to Intercompany Transactions • 8-11 FAP 8-1 (continued) Requirement 2: (continued) The preceding calculation assumes that the $800,000 of debt is a borrowing of Sola. Some students will contend that Pola’s investment is $1,000,000—not $200,000—for ROE calculation purposes. This view assumes that the $800,000 of debt is a borrowing of Pola. We believe that the $800,000 is best treated as a borrowing of Sola for ROE calculation purposes. Accordingly, the stockholder’s equity of Sola would have been $200,000 throughout the first quarter of 2006 (exclusive of the increase that occurs because of the reported earnings). If the debt had been recorded on Sola’s books, its balance sheet would appear as follows on 1/1/06): Sola Inc.—Balances on 1/1/06 Current assets (forced out) $ 500,000 Current liabilities (given) $ 200,000 Fixed assets (given) 700,000 Long-Term debt (given) 800,000 ________ Stockholders’ equity (as calculated) 200,000 $1,200,000 $1,200,000 Note: As discussed in Chapter 8, Staff Accounting Bulletin No. 73 (issued in 1987) requires debt incurred by a parent company in connection with the acquisition of the common stock of a company to be ―pushed down‖ to the separate financial statements of the subsidiary if the subsidiary’s assets are pledged as collateral for the debt. In this problem, Sola’s fixed assets are pledged as collateral on the $800,000 loan. This view lends support to the position that the debt should be considered Sola’s for ROE calculation purposes. Also, the fact that Sola’s expected cash flow is the likely source for repaying the debt suggests that the debt should be considered Sola’s. The next step necessary to calculate Sola’s ROE is to allocate interest expense and income taxes to Sola as follows: Sola’s earnings, as reported $48,000 Less: Interest allocable to Sola ($800,000 × 12% × ¼ yr.) (24,000) Income before Income Taxes $24,000 Income tax expense @ 40% (9,600) Net Income $14,400 Sola’s ROE Calculation for 2006 QuarterAnnualized Sola’s Net Income = $14,400 = 7.2% 28.8% Net Investment in Sola (beginning) $200,000 This 28.8% is much higher than the 18% shown in requirement 1, part b for Pola for 2005. The major reason for the large difference is that Sola (which has $800,000 of 12% debt [80% LTD and 20% equity]) is more highly leveraged than Pola (which has $400,000 of 10% debt [50% LTD and 50% equity]). If Sola had only $500,000 of 12% debt (50% LTD and 50% equity—the same ratio as for Pola), its ROE would be 16% (much closer to Pola’s ROE), as shown in the following calculation (which reflects $500,000 of equity capital instead of $200,000): 8-12 • ADVANCED ACCOUNTING: Concepts and Practice FAP 8-1 (continued) Requirement 2: (continued) Pro Forma ROE Calculation for Sola— Assuming $500,000 of Equity Instead of $200,000 [$500,000 LTD instead of $800,000] Quarter ...Annualized Sola’s Net Income = $19,800 (1) = 4% 16% Net Investment in Sola (beginning) $500,000 (3.96% rounded) (1) $48,000 – $15,000 of interest = $33,000; $33,000 – $13,200 of taxes @ 40% = $19,800. Note: The 28.8% annual ROE for Sola would almost double if Pola had issued only $100,000 of common stock and borrowed $900,000: Pro Forma ROE Calculation for Sola— Assuming $100,000 of Equity Instead of $200,000 [$900,000 of LTD instead of $800,000] Quarter ...Annualized Sola’s Net Income = $12,600 (1) = 12.6% 50.4% Net Investment in Sola (beginning) $100,000 (1) $48,000 – $27,000 of interest = $21,000; $21,000 – $8,400 of taxes @ 40% = $12,600. Requirement 3 (the ROTC calculation): The return on total capital (ROTC) calculation is a ―first cousin‖ to the ROE calculation. In general, total capital is the sum of long-term debt and stockholders’ equity. DuPont pioneered this method. Both Forbes (labels it return on capital) and Business Week (labels it return on invested capital) use this calculation (in addition to the ROE calculation) in evaluating the profitability of the largest U.S. companies each year (1,340 by Forbes and 1,000 by Business Week ). The calculations follow: Return on Total Capital (ROTC) for Pola for 2005 Operating ................. Annual Income (EBIT) = $160,000 = 20% (LTD & St. Eq.) Return on Total Capital (ROTC) for Sola Quarter.....Annualized Operating = = 16% Total Capital $800,000 Income (EBIT) = $48,000 = 4.8% 19.2% Total Capital $1,000,000 (LTD & St. Eq.) Note: Some finance books calculate total capital by subtracting current liabilities from total assets. This approach often confuses students because it implies that a variation of the BEP calculation (a return on assets calculation) is being made when instead the perspective is from the providers of capital. (For reasons unknown, not all finance books show the ROTC calculation.) Note: Forbes uses a very broad definition of total capital, which includes common stock, preferred stock, long- term debt, deferred income taxes payable, noncontrolling interest in net assets of subsidiary, and deferred investment tax credits. Introduction to Intercompany Transactions • 8-13 FAP 8-1 (continued) Requirement 4 (the ROA calculation): The Return on Assets (ROA) Calculation for Pola for 2005 Net Income = $72,000 = 7.2% Total Assets (beginning) $1,000,000 This calculation is of limited use because the $72,000 net income depends to a certain extent on the entity’s level of debt, which determines the level of interest expense. Thus the net income would be higher if less debt were used and lower if more debt were used. Accordingly, the 7.2% is useful only for making comparisons with other companies having an identical debt-to-equity structure. To illustrate, let us use (a) Pola’s actual 2006 amounts and (b) the annualized first quarter amounts for Sola, which has a higher debt level and a higher interest rate. This comparison follows: Pola’s....................... Sola’s Actual Amounts ......Annualized Amounts for 2005 ................. for 2006 Operating income $160,000 $192,000 Interest expense: $400,000 × 10% (40,000) (50% LTD/50% EQ.) $800,000 × 12% (80% LTD/20% EQ.) (96,000) Income tax expense -0-a -0-a Net Income $120,000 $ 96,000 a For simplicity, we assume a zero income tax rate. Net Income = $120,000_ = 12% $96,000_ = 8% Total Assets (beginning) $1,000,000 $1,200,000 At first thought, it appears Pola is doing better than Sola. No meaningful conclusion can be drawn, however, regarding each operation’s earning ability in relation to the total assets used to generate income. Only using operating income in the numerator [which is the BEP calculation shown earlier] would reveal whether Pola has utilized its assets better than Sola. If Pola had untilized its assets better than Sola, it would result in either higher sales or lower operating costs and expenses (or a combination of the two). In this problem, the BEP percentages calculated in requirements 1a and 2a for Pola and Sola, respectively, are both 16%. Note: Neither Business Week nor Forbes uses the ROA calculation in its annual ratings of the largest U.S. companies. Requirement 5 (alternative borrowing arrangements): Two other ways in which the $800,000 bank borrowing and cash transfer to Sola could have been recorded or handled are 1. Have Sola borrow the money and Pola guarantee the debt. 2. Have Pola borrow the money, lend it to Sola, and charge Sola interest. For consolidated reporting purposes, it does not matter on which entity’s books the debt is recorded. This is an external reporting issue only if Pola or Sola issues separate financial statements. 8-14 • ADVANCED ACCOUNTING: Concepts and Practice FAP 8-1 (continued) Requirement 6 (comparing the two operations): The calculations in requirements 1 and 2 show that Sola has higher ROE than Pola. Thus Sola appears to be more efficient than Pola, perhaps because not enough expenses are being allocated to Sola. Of critical importance is whether the allocations are being done on an incremental basis or on a proportional basis. Incremental analysis. Sola benefits by $5,000 because its insurance cost is that much less because it is the second location ($16,000 instead of $21,000 on a stand-alone basis).The information in the problem states that only insurance of $16,000, (a traceable cost), the additional audit cost of $4,000 (an incremental cost), and a pro rata portion ($7,000) of the advertising expenses were allocated to Sola. Are there additional incremental costs that have not been allocated to Sola? Without knowing this information, a meaningful incremental analysis is not possible. For example, perhaps the purchasing department has expanded because it now buys for Sola as well as for Pola. If there are no other incremental costs, however, the results show that, incrementally, this has been a very worthwhile expansion—Pola’s 2006 ROE (on a combined basis will increase). Proportional analysis. To meaningfully compare Sola with Pola from an operational perspective, proportional analysis is necessary. Accordingly, Pola’s overhead should be analyzed to determine which expenses would be incurred regardless of which of the two locations existed. Examples are costs of the purchasing department, the president’s salary, and the annual audit. Such expenses—possibly labeled general corporate expenses—could then be apportioned between the parent and the subsidiary based on relative revenues, square footage, or some other basis. If the president of the company spends two days per week at the subsidiary and three days at the parent, it seems logical that 40% of his or her salary should be allocated to the subsidiary. Otherwise, the subsidiary will report zero for these items and the parent will bear all of these costs. This point becomes more evident if top management decides to conduct its headquarters activities at the new location (possibly because of its nicer facilities or more desirable location). Such a move effectively makes the old location the subsidiary. We believe that profitability should be viewed using both incremental analysis (reveals whether the increased level of operations is worthwhile) and proportional analysis (achieves better comparability between the two stores as to operating results). Additional factors that may complicate the comparison follow: a. Pola has existed for 10 years. Its fixed assets are undervalued by $200,000. Using current values for its fixed assets (instead of book values), Pola’s BEP is 13% ($160,000/$1,200,000)--not 16%. Likewise, Pola’s ROE is 12% ($72,000/$600,000)—not 18%. Current values should be used in these computations because it results in using the true amount of capital tied up in the business. b. Both entities use the double-declining-balance method to calculate depreciation expense. Accordingly, Sola is incurring much higher depreciation expense than Pola, which is 10 years into the life cycle. Requirement 7: If Sola were to issue separate financial statements, for whatever reason, the following reporting issues would arise: a. Allocating income tax expense (not presently done). b. Allocating other general and administrative expenses that benefit Sola. c. Pushing down and recording the $800,000 bank debt on Sola’s books. Disclosures regarding the manner of making allocations would be necessary. Introduction to Intercompany Transactions • 8-15 U CHAPTER ETHICS QUESTIONS U Corporate Loyalty—Does It Require Questionable Practices? (page 275) (Estimated time: 15 minutes) Question 1: The best course of action is to convey to your boss the potentially adverse legal consequences of such an action. The potential for criminal charges for misapplication of funds exists. A corporate accountant who is involved in a possible scandal will have an extremely difficult time gaining future employment as a result of having compromised his or her integrity. Question 2: It would be most prudent to obtain approval of this arrangement from the financial regulators. Otherwise, the con- sequences could be quite serious, as the solution to the following requirement indicates. Question 3: The consequences of implementing a questionable tax-sharing arrangement without the approval of the financial regulators could result in criminal charges being brought against the accountant. Real-world example—Lincoln Savings & Loan. In October 1993, the former chief financial officer of American Continental Corporation (ACC—the parent company of Lincoln Savings & Loan), Andrew F. Ligget, was sentenced to two years in federal prison and ordered to pay $148,000 for his role in the Lincoln S & L scandal. Ligget participated in devising a fraudulent tax-sharing arrangement whereby money was transferred from Lincoln to its parent, ACC. Ligget pleaded guilty to felony charges of misapplication of funds. He admitted to making payments of about $28 million to ACC under a tax-sharing agreement that prosecutors contended was a vehicle for diverting funds from Lincoln to ACC. Ligget was the first of eight former associates of Charles Keating III to be sentenced. Relatives on the Payroll—A Family Matter? (page 282) (Estimated time: 15 minutes) Question 1: The substance of paying these relatives appears to be embezzlement. These salaries are probably on the parent’s books instead of the subsidiary’s books to avoid scrutiny by the federal financial institution regulators, who most likely would discover that certain expenses are way out of line. Question 2: If you believe that management lacks integrity, you should resign. A real-world example —Lincoln Savings & Loan. In the Lincoln S & L scandal (which cost taxpayers $2 billion), American Continental Corporation (ACC) was its parent company. Charles Keating III, the president of ACC, had numerous relatives on ACC’s payroll. Over a three-year period, approximately $35 million in salaries were paid to himself and his relatives, who served in nearly meaningless capacities. Arthur Andersen & Co. (for 1983–1985) and Arthur Young (for 1986 and 1987) audited both Lincoln and ACC. None of the excessive salaries paid during the years 1985–1987 caused them to resign.
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