Expand
Resize
Add to favorites
An investor applying the equity method may need to make adjustments to eliminate the effects of certain intercompany transactions. While ASC 323 refers to the consolidation guidance under ASC 810 for guidance on eliminations, the extent of the eliminations under the equity method are more limited than those required when consolidating a subsidiary.

4.2.1 Intercompany profits and losses

An investor should eliminate its intercompany profits or losses related to transactions with an investee until profits or losses are realized through transactions with third parties. For example, assume an investor holds a 25% interest in an investee entity and sells inventory at arm’s length to that investee. If the inventory remains on the books of the investee at the reporting date, then the investor would generally eliminate 25% of the intercompany profit. Once the inventory is sold by the investee to a third party, any previously eliminated intercompany profit is recognized. However, intercompany profits or losses should not be eliminated for arm’s-length transactions that do not result in an asset that remains on the books of either party. For example, an investee may provide outsourcing services to the investor for a fee. Intercompany profits or losses for this transaction would not be eliminated.
As discussed in ASC 323-10-35-8, there is a difference in intercompany elimination principles for equity method investments compared to consolidation. One example is when an investor leases an item to an investee under an operating lease arrangement. The investor would normally earn rental income while the investee recognizes rental expense in the same period. No intercompany elimination would be needed on the basis that the earnings process is complete (i.e., no asset such as inventory remains on the books of the investor/investee). In contrast, if the investor consolidated the investee, all rental income earned by the investor and all rental expense incurred by the investee would be eliminated in the consolidated financial statements.

ASC 323-10-35-7

Intra-entity profits and losses shall be eliminated until realized by the investor or investee as if the investee were consolidated. Specifically, intra-entity profits or losses on assets still remaining with an investor or investee shall be eliminated, giving effect to any income taxes on the intra-entity transactions, except for any of the following:

  1. A transaction with an investee (including a joint venture investee) that is accounted for as a deconsolidation of a subsidiary or a derecognition of a group of assets in accordance with paragraphs 810-10-40-3A through 40-5.
  2. A transaction with an investee (including a joint venture investee) that is accounted for as a change in ownership transaction in accordance with paragraphs 810-10-45-21A through 45-24
  3. A transaction with an investee (including a joint venture investee) that is accounted for as the derecognition of an asset in accordance with Subtopic 610-20 on gains and losses from the derecognition of nonfinancial assets.

ASC 323-10-35-8

Because the equity method is a one-line consolidation, the details reported in the investor’s financial statements under the equity method will not be the same as would be reported in consolidated financial statements under Subtopic 810-10. All intra-entity transactions are eliminated in consolidation under that Subtopic, but under the equity method, intra-entity profits or losses are normally eliminated only on assets still remaining on the books of an investor or an investee.

ASC 323-10-35-9

Paragraph 810-10-45-18 provides for complete elimination of intra-entity income or losses in consolidation and states that the elimination of intra-entity income or loss may be allocated between the parent and the noncontrolling interests. Whether all or a proportionate part of the intra-entity income or loss shall be eliminated under the equity method depends largely on the relationship between the investor and investee.

ASC 323-10-35-10

If an investor controls an investee through majority voting interest and enters into a transaction with an investee that is not at arm’s length, none of the intra-entity profit or loss from the transaction shall be recognized in income by the investor until it has been realized through transactions with third parties. The same treatment applies also for an investee established with the cooperation of an investor (including an investee established for the financing and operation or leasing of property sold to the investee by the investor) if control is exercised through guarantees of indebtedness, extension of credit and other special arrangements by the investor for the benefit of the investee, or because of ownership by the investor of warrants, convertible securities, and so forth issued by the investee.

ASC 323-10-35-11

In other circumstances, it would be appropriate for the investor to eliminate intra-entity profit in relation to the investor’s common stock interest in the investee. In these circumstances, the percentage of intra-entity profit to be eliminated would be the same regardless of whether the transaction is downstream (that is, a sale by the investor to the investee) or upstream (that is, a sale by the investee to the investor).

If an intercompany transaction is not considered to be at arm’s length, all (as opposed to a portion) of the intercompany profit or loss is eliminated until it has been realized through sale to third parties. Investors should consider all facts and circumstances to determine if the transaction is at arm’s length, including the transaction’s economic substance, whether the sales price is collectible, whether the sales price represents fair value, and if the terms of the transaction are similar to those in third-party transactions.
After consideration of the nature of the transaction and the relationship between the investor and investee, the appropriate portion (all or some) of intercompany profits or losses should be eliminated, even if the investor’s share of the unrealized profit to be eliminated exceeds the carrying amount of the equity method investment and would reduce the investor’s equity method investment balance below zero. Profits that were recognized before the investor acquired its interest in the investee, such as when inventories or other assets were sold by one company to another prior to the equity method investment, should generally not be eliminated.
The examples in ASC 323-10-55-27 through ASC 323-10-55-29 illustrate the elimination of intercompany profit in both upstream (investee sells inventory to investor) and downstream (investor sells inventory to investee) transactions within the scope of ASC 606.
The general approach to eliminate intercompany profits by debiting equity method earnings and crediting the equity method investment is an acceptable presentation method for both sales by an investor to an investee and sales by an investee to an investor. A net-of-tax basis of elimination is also considered acceptable because the presentation of equity in income of the investee under the equity method is normally on a single line, net-of-tax basis in the income statement of the investor.
Example EM 4-1 and Example EM 4-2 illustrate the general presentation approach and several alternatives for income statement and balance sheet presentations in the context of a sale of inventory within the scope of ASC 606, at arm’s length between an investor and investee. Example EM 4-3 and EM 4-4 illustrate the general presentation approach when the sale of an asset is within the scope of ASC 610-20 at arm’s length between an investor and investee.
EXAMPLE EM 4-1
Sale of inventory within the scope of ASC 606 — downstream
Investor has a 30% interest in Investee, and accounts for its investment under the equity method of accounting. Investor sells five units of inventory to Investee for $100 each for total intercompany sales of $500. As the Investor’s related cost for this inventory is $50 per unit ($250 in total), the intercompany profit related to this transaction is $250. As of the end of the Investee’s reporting period, two units remain in inventory. This results in an elimination of $30 intercompany profit before taking into consideration any tax effects ($50 profit per unit remaining in inventory × Investor’s 30% ownership interest in Investee). Investor and Investee are both subject to a 20% income tax rate. The sale of inventory by Investor to Investee is an arms-length transaction.
What are the ways in which the elimination entries can be determined?
Analysis
General approach: Debit equity method earnings and credit investment account on a net-of-tax basis to eliminate the profit for the two units left in inventory.
Dr. Equity method earnings
$24 1
Cr. Equity method investment
$24 1
Alternative 1: Debit cost of sales and credit the investment account for the pre-tax amount of the intercompany income elimination. Credit a deferred income tax provision in the income statement and debit a deferred income tax asset on the balance sheet.
Dr. Cost of sales
$30 2
Dr. Deferred income tax benefit
$6 3
Cr. Equity method investment
$30 2
Cr. Deferred income tax provision
$6 3
Alternative 2: Debit cost of sales and credit deferred income for the pre-tax amount. Credit a deferred income tax provision in the income statement and debit a deferred income tax asset on the balance sheet.
Dr. Cost of sales
$30 2
Dr. Deferred income tax benefit
$6 3
Cr. Deferred income
$30 2
Cr. Deferred income tax provision
$6 3
Alternative 3: Debit equity method earnings for the net-of-tax amount and a deferred income tax benefit for the amount of the tax benefit. Credit a deferred income account on the balance sheet.
Dr. Equity method earnings
$24 1
Dr. Deferred income tax benefit
$6 3
Cr. Deferred income
$30 2
1 $50 profit × 2 units on hand × Investors 30% ownership interest in Investee less 20% income tax
2 $50 profit × 2 units on hand × Investors 30% ownership interest in Investee
3 $50 profit × 2 units on hand × Investors 30% ownership interest in Investee × 20% income tax rate
EXAMPLE EM 4-2
Sale of inventory within the scope of ASC 606—upstream
Investor has a 30% interest in Investee, and accounts for its investment under the equity method of accounting. Investee sells five units of inventory to Investor for $100 each for total intercompany sales of $500. As the Investee’s related cost for this inventory is $50 per unit ($250 in total), the intercompany profit related to this transaction is $250. As of the end of the Investor’s reporting period, two units remain in inventory. This results in an elimination of $30 intercompany profit before taking into consideration any tax effects ($50 profit per unit remaining in inventory × Investor’s 30% ownership interest in Investee). Investor and Investee are both subject to a 20% income tax rate. The sale of inventory by Investee to Investor is an arms-length transaction.
What are the ways in which the elimination entries can be determined?
Analysis
General approach: Debit equity method earnings and credit investment account on a net-of-tax basis to eliminate the profit for the two units left in inventory.
Dr. Equity method earnings
$24 1
Cr. Equity method investment
$24 1
Alternative 1: Debit equity method earnings for the net-of-tax amount, credit inventory for the gross amount of the elimination, and debit the investment account for the amount of the tax benefit.
Dr. Equity method earnings
$24 1
Dr. Equity method investment
$6 2
Cr. Inventory
$30 3
When inventory has been acquired from a “cost company” (a joint venture formed to serve as a source of supply in which the venturers agree to take production of the investee proportionate to their respective interests; this is substantially a cost-sharing arrangement), the purpose of the intercompany income elimination is to reduce the investor’s inventory cost to the investee’s cost. In the “cost company” situation, Alternative 1 is an acceptable method to record the intercompany profit elimination.
Alternative 2: Debit equity method earnings and credit inventory for the net-of-tax amount
Dr. Equity method earnings
$24 1
Cr. Inventory
$24 1
1 $50 profit × 2 units on hand × Investors 30% ownership interest in Investee less 20% income tax
2 $50 profit × 2 units on hand × Investors 30% ownership interest in Investee × 20% income tax rate
3 $50 profit × 2 units on hand × Investors 30% ownership interest in Investee
EXAMPLE EM 4-3
Sale of equipment within the scope of ASC 610-20—downstream
Investor has a 30% interest in Investee, and accounts for its investment under the equity method of accounting. Investor sells equipment that is not a business and is not an output of its ordinary activities to Investee for $500. The sale of equipment to Investee is an arm’s length transaction. As the Investor’s related cost for this equipment is $200, the intra-entity profit related to this transaction is $300. This example does not include the effect of income taxes.
On the transaction closing date, Investor concludes the transaction is the sale of a nonfinancial asset within the scope of ASC 610-20 and that control of the equipment has transferred to Investee pursuant to the control criteria in ASC 606 and ASC 810. Investee does not intend to sell the equipment, which has a useful life of 10 years.
Analysis
Given control of the equipment has successfully transferred to Investee, Investor concludes that the equipment should be derecognized under the guidance in ASC 610-20. The gain of $300 is recognized immediately (i.e., no portion of profit or loss is eliminated) based on the guidance in ASC 323-10-35-7(c). Investor records the following journal entry to reflect the transaction.
Dr. Cash
$500
Cr. Equipment
$200
Cr. Gain on sale
$300
Investor would not defer any profit or adjust its equity method earnings related to this intra-entity sale in subsequent periods.
EXAMPLE EM 4-4
Sale of equipment within the scope of ASC 610-20—upstream
Investor has a 30% interest in Investee, and accounts for its investment under the equity method of accounting. Investee sells equipment that is not a business and is not an output of its ordinary activities for $500 to Investor. The sale of equipment to Investor is an arm’s length transaction. As the Investee’s related cost for this equipment is $200, the intra-entity profit related to this transaction is $300. Prior to the sale, it is assumed there are no basis differences associated with the equity method investment. This example does not include the effect of income taxes.
On the transaction closing date, Investee concludes the transaction is the sale of a nonfinancial asset within the scope of ASC 610-20 and that control of the equipment has transferred to Investor pursuant to the control criteria in ASC 606 and ASC 810. Investor does not intend to sell the equipment, which has a useful life of 10 years.
Analysis
Given that the transaction is upstream, and the equipment remains on Investor’s books, Investor must eliminate its share of Investee’s intra-entity profit. Specifically, ASC 323-10-35-7(c) does not apply to upstream transactions. There are multiple ways in which the Investor can account for this transaction with the Investee.
Alternative 1 - Recognize the intra-entity profit elimination against the equipment
Investor first records its share of Investee income in the following entry.
Dr. Equity method investment
$90 1
Cr. Equity method earnings
$90
Investor then records the purchase of the equipment and eliminates the intra-entity profit against the equipment acquired.
Dr. Equipment
$410 2
Dr. Equity method earnings
$90
Cr. Cash
$500
Annually, Investor recognizes depreciation expense of the equipment over the 10-year useful life of the asset.
Dr. Depreciation expense
$41 3
Cr. Accumulated depreciation
$41
1 $300 Investee profit on sale * 30% ownership interest in investee
2 $500 purchase price  less $90 intra-entity profit
3 $410 carrying value / 10-year useful life
Alternative 2 - Recognize the intra-entity profit elimination against the equity method investment
Investor records the purchase of equipment at the purchase price of $500.
Dr. Equipment
$500
Cr. Cash
$500
Investor records its share of Investee income similar to alternative 1 above.
Dr. Equity method investment
$90 4
Cr. Equity method earnings
$90
Rather the Eliminating the profit against the equipment as shown in alternative 1, the intra-entity profit is eliminated against the equity method investment as follows:
Dr. Equity method earnings
$90
Cr. Equity method investment
$90
This eliminating entry results in a basis difference between the Investor's share of the net assets of the Investee and the Investor's carrying value of the equity method investment. This basis difference is entirely attributed to the equipment and should be amortized over the remaining useful life of the equipment.
Annually, Investor recognizes depreciation expense of the equipment over the 10-year useful life of the asset.
Dr. Depreciation expense
$50 5
Cr. Accumulated depreciation
$50
Annually, Investor amortizes the basis difference attributable to the equipment over the 10-year useful life of the asset.
Dr. Equity method investment
$9 6
Cr. Equity method earnings
$9
It should be noted that the net effect on the income statement is the same under both of the above alternatives.
4 $300 Investee profit on sale * 30% ownership interest in investee
5 $500 carrying value / 10-year useful life
6 $90 basis difference / 10-year useful life
1 For transactions involving the purchase of real estate refer to ASC 970-323-30-7.
Expand

Welcome to Viewpoint, the new platform that replaces Inform. Once you have viewed this piece of content, to ensure you can access the content most relevant to you, please confirm your territory.

signin option menu option suggested option contentmouse option displaycontent option contentpage option relatedlink option prevandafter option trending option searchicon option search option feedback option end slide