Intercompany depreciable assets and bonds

Lesson 6 dealt with goods that pass through the group quickly. Some intercompany transactions involve long-lived assets, and their effects last for years. In 2027 Larkspur sells a used machine to Blue Heron, Blue Heron sells a parcel of land to Larkspur, and Larkspur buys some of Blue Heron's bonds on the open market. Each transaction creates a gain or loss in one company's books that, from the group's point of view, either has not happened yet or happened differently. This lesson shows how to eliminate and gradually realize those effects.

Intercompany sales of land

Land is not depreciated, so a gain on an intercompany sale of land remains unrealized until the land is sold to an outsider. On consolidation, the gain is eliminated and the land is restored to its original cost to the group. Every year after, while the land is still held, the worksheet repeats the elimination against opening retained earnings (and NCI, if the seller was the subsidiary). When the buyer eventually sells the land outside the group, the group recognizes the whole gain, measured from the original cost.

Intercompany sales of depreciable assets

When the asset is depreciable, the unrealized gain is realized gradually through depreciation. The buyer depreciates the asset on its transfer price, which includes the seller's gain, so its depreciation is higher than the group's depreciation on the original carrying amount. Each year the excess depreciation is eliminated, which realizes part of the gain. By the end of the asset's life the whole gain has been realized, and consolidated profit over the life is the same as if no transfer had occurred.

On the worksheet in the year of transfer, three things happen: the gain is eliminated; the asset and its accumulated depreciation are restored to the amounts the seller carried (gross cost and accumulated depreciation, as many groups prefer, or simply the net carrying amount); and the year's excess depreciation is removed. In later years, the cumulative unrealized gain at the start of the year is charged to opening retained earnings (and NCI for upstream transfers), and the current year's excess depreciation is removed again.

# Downstream equipment transfer: Larkspur sells a machine to Blue Heron on 1 January 2027
cost, accum, price, life = 300_000, 100_000, 260_000, 5
carrying = cost - accum
gain = price - carrying
excess_dep = gain / life
print(f"Gain recorded by Larkspur: {gain:,.0f}; excess depreciation each year: {excess_dep:,.0f}")
print(f"{'Year':>4} {'Gain eliminated':>16} {'Dep reduced':>12} {'Net effect':>11} {'Unrealized at end':>18}")
unreal = 0
for i, yr in enumerate(range(2027, 2032)):
    g = gain if i == 0 else 0
    unreal += g - excess_dep
    print(f"{yr:>4} {g:>16,.0f} {excess_dep:>12,.0f} {-g + excess_dep:>11,.0f} {unreal:>18,.0f}")

Gain recorded by Larkspur: 60,000; excess depreciation each year: 12,000
Year  Gain eliminated  Dep reduced  Net effect  Unrealized at end
2027           60,000       12,000     -48,000             48,000
2028                0       12,000      12,000             36,000
2029                0       12,000      12,000             24,000
2030                0       12,000      12,000             12,000
2031                0       12,000      12,000                  0

The schedule shows the unrealized gain falling to zero at the end of 2031. If Blue Heron sold the machine to an outsider before then, the remaining unrealized gain would be realized immediately as part of the group's gain or loss on disposal.

Intercompany bonds and the constructive retirement

A different situation arises when one group member buys the bonds of another from outside investors. Blue Heron issued $1,000,000 of 10-year, 5 percent bonds at par on 1 January 2025, with interest paid annually. On 1 January 2027, when market rates have risen, Larkspur buys 40 percent of them, $400,000 of face value, in the market for $384,000. In Blue Heron's books the bonds are still a liability at par. In Larkspur's books they are an investment at $384,000. From the group's point of view, however, $400,000 of debt owed to outsiders has been retired for $384,000: the bonds are now owed by one member of the group to another and must be eliminated.

The difference between the carrying amount of the bonds in the issuer's books and the price paid by the buyer is recognized as a gain or loss on constructive retirement in consolidated profit in the year of purchase. Here the group recognizes a gain of $400,000 − $384,000 = $16,000. In later years, the separate books record interest that the consolidated statements eliminate: Blue Heron records interest expense of $20,000 on the $400,000, and Larkspur records interest income of $20,000 plus amortization of its $16,000 discount. Because Larkspur's discount amortization effectively recognizes the gain bit by bit in its own books, the consolidation reverses that amortization each year, so that the gain is counted only once, in the year of purchase.

US GAAP also leaves the attribution of a constructive retirement gain between the parent and the noncontrolling interest to policy. A common approach attributes it to the issuer of the bonds, here Blue Heron, so that the noncontrolling interest shares 20 percent; another divides it between issuer and purchaser. The policy should be applied consistently.

# Constructive gain when Larkspur buys 40% of Blue Heron's bonds on 1 January 2027
face, coupon_rate, years_left, price = 400_000, 0.05, 8, 384_000
cf = face * coupon_rate
lo, hi = 0.0, 0.2
for _ in range(100):                       # solve for the yield that prices the bonds at 384,000
    y = (lo + hi) / 2
    pv = sum(cf / (1 + y) ** t for t in range(1, years_left + 1)) + face / (1 + y) ** years_left
    lo, hi = (y, hi) if pv > price else (lo, y)
gain = face - price                        # issuer carries its bonds at par
print(f"Purchase yield: {y:.4%}; constructive gain on retirement: {gain:,.0f}")
cv, net_2027 = price, None
print(f"{'Year':>4} {'Larkspur interest income':>25} {'Blue Heron expense':>19} {'Consolidated effect':>20}")
for i, yr in enumerate(range(2027, 2030)):
    income = cv * y
    cv += income - cf
    effect = (gain if i == 0 else 0) - (income - cf)   # gain recognized up front, then reverses
    if i == 0: net_2027 = effect
    print(f"{yr:>4} {income:>25,.0f} {cf:>19,.0f} {effect:>20,.0f}")
# 2027 consolidated profit and NCI after all items (lessons 5-7)
before = 2_275_000; nci_before = 114_000
equip, land = -60_000 + 12_000, -60_000
profit = before + equip + land + net_2027
nci = nci_before + 0.20 * land + 0.20 * net_2027     # land and bonds relate to Blue Heron (issuer/seller)
print(f"2027 consolidated profit {profit:,.0f}; NCI {nci:,.0f}; owners of parent {profit - nci:,.0f}")

Purchase yield: 5.6349%; constructive gain on retirement: 16,000
Year  Larkspur interest income  Blue Heron expense  Consolidated effect
2027                    21,638              20,000               14,362
2028                    21,730              20,000               -1,730
2029                    21,828              20,000               -1,828
2027 consolidated profit 2,181,362; NCI 104,872; owners of parent 2,076,490

The program finds a purchase yield of about 5.63 percent. In 2027 Larkspur's own books record interest income of $21,638, including $1,638 of discount amortization. On consolidation, the group recognizes the $16,000 gain and eliminates both companies' interest, so the net 2027 effect is $16,000 − $1,638 = $14,362. In 2028 and 2029 the effect is negative, by the amount of Larkspur's discount amortization, because that amortization would otherwise count the gain a second time. Combined with the equipment and land transfers, 2027 consolidated profit falls from the $2,275,000 of lesson 6 to about $2,181,362, and NCI's share falls from $114,000 to about $104,872.

Gains and losses on retirement in practice

A constructive gain arises when market interest rates have risen since the bonds were issued, because the bonds can be bought below their carrying amount; a constructive loss arises when rates have fallen. The amount depends on the issuer's carrying amount, including any unamortized premium, discount or transaction costs, not on face value alone. If the issuer had issued at a discount, the gain would be the difference between the issuer's amortized cost and the buyer's price. Groups sometimes buy back each other's bonds as an inexpensive way to reduce external debt without the issuer formally redeeming them, but the accounting treats the result as a retirement.

Putting the worksheet together

By the third or fourth year after an acquisition, a consolidation worksheet carries a series of recurring adjustments: the acquisition-date eliminations and cumulative amortization of the acquisition differential (lesson 5), unrealized profits in opening and closing inventory (lesson 6), cumulative unrealized gains on land and depreciable assets, and the effects of intercompany bonds. A useful discipline is to keep a schedule for each item showing its effect on opening retained earnings, opening NCI, current-year profit and closing balances. The schedule makes it easier to prove consolidated retained earnings and NCI and to check that every deferred gain is eventually realized.