 Hello and welcome to the session. This is Professor Farhad. In this session, we would look at the elimination of unrealized gain or losses on depreciable asset. This is different from the first section. In the first section, we looked at non-depreciable asset. So in this session, we have to deal with depreciation. This is part two of five, which is we have the previous session. And I suggest you view the previous session if you are not very comfortable with the topic. This topic is covered in advanced accounting and an advanced accounting course also covered on the CPA exam, specifically the far section. Additional lectures similar to this one can be found on my website. Now before we start, I would like to tell you I really like to connect with my viewers, with my followers, with my subscribers. So please connect with me on LinkedIn. I'm very active on LinkedIn. I do post lectures as well as other information about accounting, accounting career, the CPA exam and related topics. If you're a Facebook user, please connect with me on my Facebook page, Accounting Lectures. Obviously, all my lectures are housed on YouTube. So make sure you subscribe to my YouTube and please share and like my YouTube so others can benefit as well. If you are a Twitter user, this is my Twitter handle. Also, obviously my website is also another resource for you. So the first thing we're going to look at is the overall picture. What are the rules that we have to deal with when we are dealing with intercompany sale of depreciable property? So here's what's going to happen. The overall idea is this. We have the parent company and we have the subsidiary. So the parent might sell the subsidiary or the subsidiary might sell to the parent assets. And as a result of this exchange, one of these parties might have a gain or might have a loss. So we'll have a gain or a loss. We call those gains and losses, intercompany gains and losses. And when we prepare the consolidated financial statement for both the parent and the subsidiary, any intercompany gain and losses need to be eliminated. That's one thing. And we learned this in the prior session. Also, we have to keep the original cost of the assets of P company sold to sub. When we report the original cost of the asset, we have to report based on what P purchased the asset at, not what sub purchased it from the parent. Also, if sub sold something to P, we report the asset at the original cost of the sub because that's the original cost for the affiliated group. So those are the things that we talked about in the prior session, but now let's go over the rules. So we only report gains and losses that are the result of a sale of depreciable asset to outside party. So any gain and losses intercompany, which is inside parties are eliminated. Also, part of the elimination entries is to present the asset, the property and the consolidated balance sheet at the cost, at its cost to the affiliate. So it's its original cost, whatever that cost is to the affiliate. So if the sub sold it, it's the original cost of the sub of the P sold it, we have to go back and report it at the P cost. Also, so this is one in two, we already covered one in two in the first session. Now this is new. The third point is new three. We need to present accumulated depreciation, which is, which is an important concept in this session and the consolidated balance sheet based on the cost of the affiliated group. So remember, we are dealing with depreciable asset. And when we have depreciable asset, guess what, we are going to have, when we have depreciable asset, we're going to have accumulated depreciation. So what we are saying is the accumulated depreciation will have to be reported based on the original cost. And we're also going to have depreciation expense. We have depreciation expense because we have, we have to depreciate this asset. When we compute depreciation expense, the depreciation expense will have to be based on the original cost. Why? Because we have to report the asset in the consolidated financial statement at the original cost. Okay, so those are the four things. And keep the slide, copy the notes on the slide, because you're going to see, we're going to have to prepare the journal entries to comply with those rules, to make sure those rules are complied with. Also, we have to learn about something new. In this session is something called realization through usage. And what is realization through usage? So remember, when we sell, when a firm sells property or equipment to an affiliate, the price will differ from the book value. And because it differ, what's going to happen, we're going to either have a gain or a loss. So we're either going to have a gain, a G or an L, a gain or a loss. Now remember, we have to eliminate the gain or the loss. That's understandable. However, what we're going to have to do, if there's any gain or loss, okay, what's going to happen, the gain or the loss will be realized through a decrease or increase in depreciation. What does that mean? Okay, let me explain this to you. And we're going to see some numbers later on. From the viewpoint of the consolidated entity, the intercompany gain or loss is considered to be realized. So we're going to realize it from the use of the property or equipment in the generation of revenue. So simply put, we're going to recognize some of the gain and some of the losses. But how are we going to recognize it? You will see later through the use is measured through depreciation adjustment. So we're going to do adjustment to depreciation. What does that mean? If we have a gain, okay, what we're going to do, we're going to be depreciating, we're going to be reducing depreciation expense. And you will see that. So depreciation expense is reduced. And as we reduce depreciation expense, simply put, when your expense goes down, you have more gain. When we have a loss, we are going to increase depreciation expense. And you will see how when depreciation goes, depreciation expense goes up, when depreciation expense goes up, you will recognize the loss. You will recognize the loss. But we're going to be doing so in pieces. Because remember, depreciation is not taken all at once. It's taken over the years. So the gain and the losses will be realized through depreciation adjustment. Just know this rule. And you will see this in an example. And I will tell you this is the rule that you need to be aware of. Also, what's involved in the work paper elimination entries before we look at an example. Firm using the cost or partial equity method. An additional objective is to equate beginning consolidated retained earning with the amount of the consolidated retained earning reported in the prior period. Simply put, every period we have to start with the beginning retained earnings. And you'll see how we do so. For firms using the complete equity method, this objective is not necessary because the parent retained earning already reflect all the adjustments. And for upstream sales, the entries will also serve to equate beginning NCI and prior NCI. Again, we'll look at an example later. But those are the rules that we have to follow. So the best way to illustrate this is to work through an example. So let's take a look at this example. And for the illustration of this example, we're going to be using assuming we're using cost or partial equity. Let's take a look at this example. We have P company, Powell company owns 80% of the outstanding stocks of SAP. On June 30th, it's important to know the date because that makes a difference on the depreciation. Sullivan company sold equipment to P company for half a million. The cost to Sullivan company is 750. So Sullivan had a cost of an asset of 750 and had accumulated depreciation of 400. So they had accumulated depreciation. So they depreciated this asset over the years for $400,000. What does that mean? It means once we have depreciation, once we have accumulated depreciation, we can take cost minus accumulated depreciation, cost minus accumulated depreciation. So 780, 780 minus 400,000. It's going to give us the 780 minus 400,000. It's going to give us the book value of the asset. So the book value of the asset, the difference between those two, it's 380,000. That's the book value. That's the book value of the asset. So the book value, sorry my pen is not working properly, equal to 380. Now we sold it, the selling price was half a million. So S company sold it for half a million. That's mean we have a gain for the subsidiary for 120,000. So the gain for the subsidiary is 120,000. So the management of P company estimated that equipment has remaining life of four years. This is important from June 30th. So they're going to be appreciated based on four years. So that's important for us. In 2012, P company reported 300,000 and S company reported 200,000 in net income from their independent operations, including sales to affiliate, but excluding dividend or equity from income from the subsidiary. So this way they're telling us how much income they reported and how we measured that income. So the first thing we're going to do is we're going to record the transaction on the books of the parent company and on the books of the subsidiary. So the parent bought the asset. They paid $500,000 for it. They debit equipment, 500,000. They credit cash, 500,000. Salovin company sold the asset. Well, if they sold the asset they would receive cash of 500,000. They would remove the equipment from the books at 780,000. They would remove accumulated depreciation of 400,000 and they will book again, which I showed you how to compute for 120,000. Now, you might be asking why did he highlight those three entries in red? Look, what we have to do year after year is to do the following. Year after year we have to make sure the equipment is restored to 780, accumulated depreciation is restored to 400,000 and we have to remove this gain. And the reason that that's why I highlighted those three entries. So this is the entries that takes place. This entries took place on June 30th for both companies. But the end of the year what we have to do, we have to prepare a consolidated balance sheet or consolidated financial statement, not only a balance sheet. As a result, what we have to do, we have to restore the asset. Now the equipment is recorded at 500,000 at P company. That's incorrect. We have to restore the equipment back to 780,000. We eliminated 400,000 of accumulated depreciation. We have to go back and put that 400,000 on the books and we have a gain that we have to eliminate. Now the cash will basically cancel each other. Credit cash, debit cash. Well, what's going to happen when we consolidate they're gone. Okay, so in order to do so, so the first thing we have to do at the end of the year, and this is basically a good schedule to follow. Remember the original cost is 780. The selling price is 500,000. Therefore there's a difference of 280. Now the equipment is worth 280 less on the books. So the first thing we have to do is debit the equipment at the end of the year. So this is December 31st, 2011. So we have to restore the equipment back to 780. Why? Because the equipment now sitting on the parent company, the parent company books at 500,000. It's sitting on the books at 500,000. Okay, so if we look at the books of the parent company, so this is the parent company asset. Well, that's incorrect. Why? Because the asset needs to be reported at 780. Why? Because we need to restore it. We need to report it in the consolidated financial statement at its original cost, which is 780. Therefore we debit equipment 280,000. Now remember, when we sold the asset, the subsidiary had an accumulated depreciation of 400,000. Then what they did when they sold the asset, they debited accumulated depreciation. Therefore accumulated depreciation went down to zero. Guess what? We have to restore accumulated depreciation. Therefore we have to go back and credit. We have to go back and credit accumulated depreciation for 400,000. Therefore we're going to credit accumulated depreciation of 400,000. Okay, so we have to put the book on the books accumulated depreciation. And remember, we booked again of 120, which is we also have to eliminate the gain. And what do we do to eliminate the gain? Because this is an intercompany gain. We debit the gain. Therefore we debit the gain 120, and we credit accumulated depreciation. And what did we just do? What did we just do? We just restore, eliminate the intercompany gain, and restore the equipment to its original cost. This is how we remove the gain. Because remember, we had the gain here. S company reported the gain right here. We need to take out, and we did so. Then we needed to debit the equipment to 80 to make sure the equipment back to 780, and we need to put back accumulated depreciation. Now this entry will have will occur at the end of every year going forward. However, the gain will not be with us because the gain will be closed by the end of the year. Remember, the gain is a temporary account. So the gain will be closed. To what account will be closed? It will be closed to retained earnings. So what happened going forward, we are going to be debiting retained earnings to eliminate the effect of the gain from the consolidated financial statement. And we always have to go back, assuming we haven't sold the equipment. We have to go back and restore the equipment and restore accumulated depreciation. Okay. So now, oh, before we proceed, let me show you what's going to happen here. Remember, when the asset was on the books of the subsidiary, the asset has a cost of 780,000, and they were depreciating the asset at $95,000 per year. Okay. That was the base on the life of the asset. There were four year remaining, and they're supposed to depreciate the asset 95,000, 95,000, 95,000. Now, once the asset is on the books of the subsidiary, the depreciation became based on the, because they bought it at 500,000. So the cost is 500,000. And if you divide 500,000 by four, if you divide 500,000, if you take 500,000, and you'll divide 500,000 by four, that's equal to 125. Therefore, the sub will be depreciating the asset for 125 under books. The original depreciation amount was 95,000. Now, bear in mind, we're not giving detail of what's the original life of the asset. Maybe we are, maybe we are not, but it doesn't matter. The original depreciation was 95,000. No, we're not told, but no, that it's 95,000. Okay. So what does that mean? It means we're going to have excess depreciation of 30,000. Because the sub, what's going to happen? The sub company, they're going to depreciate this asset, I'm sorry, the parent company will start to depreciate this asset. And how would they depreciate this asset? Well, for every year, they will depreciate it by 125,000. So every year, what's going to happen, the parent company, they will debit depreciation expense 125, credit accumulated depreciation 125. Let me tell you about what's wrong with this entry. This entry is overstating depreciation. Depreciation is supposed to be only 95 because we depreciate the asset based on the original cost, based on the cost of the affiliate. What does that mean? It means we have per the whole year, for the whole year, we have 30,000 of excess depreciation. So now we have to journalize an entry to reverse this effect. Now, bear in mind for year one, for year one, we bought the asset June 30th. It means we only have half a year to take care of. Therefore, half a year, if $30,000 is for the whole year, for a half a year, we need to remove only 15,000. Therefore, what we have to do is to debit accumulated depreciation 15,000, credit depreciation expense 15,000. Why did we do so? Because the parent company is booking 125,000 of depreciation per year, which is $30,000 per year in excess of the original cost, of the original depreciation. But for year one, we only have to reverse 15,000. Why 15,000? Because for year one, we only had the asset for six out of the 12 months. Now, this is what I meant by, when I originally told you, realization through usage. By reducing depreciation expense, what we did is basically, we recognized again. By reducing depreciation expense in 15,000, we recognized again. And this is what we meant by realization through usage. This slide here, when I told you, I will show you what it means. And this is what we meant by realization through usage. What we do is, as we adjust depreciation, we recognize some of the gain. Now, if we had a loss, obviously, if the transaction had a loss, the entry will be the opposite. Why? Because then we'll have to debit depreciation expense, because we had a loss to basically, in quote, amortize or spread out. So that's, hopefully, you understand what we meant by realization, adjustment through realization. So to adjust depreciation expense to the correct amount, that's realizing a portion of the gain through usage. This is what we mean by realizing portion of the gain through usage. So this is all the entries that we need in 2011. Okay, let's review them again. By the end of the year, we eliminate the gain, restore the asset, and restore accumulated depreciation. Then we have to book another entry to fix, in quote, to fix or adjust depreciation. And here, since we had a gain on the entry to adjust depreciation, we're going to recognize some of the gain by reducing depreciation expense. Notice we credited depreciation expense. We reduced depreciation expense. Now, December 31st, 2012. This is a year later. A year later, remember, the work paper entries are not permanent. Therefore, they're gone. Now, by the end of the following year, we have to do the same thing. And what's the same thing? Do three things. Remove the gain, the $120,000 gain, restore the asset and restore the appreciation. So basically, what we have to do by the end of 2012, we have to go back and do the same thing as we did in 2011. Remember, the gain is gone. So all we have to do now, adjust the beginning retained earnings. So here's what's going to happen. We're going to debit. And again, we're using the cost and partial equity here. We're going to debit equipment, $280,000 to bring the equipment back to its original cost on the consolidated financial statement. We need to debit retained earnings. Now, what's going to happen now is this. Remember, we own only 80% of the subsidiary. Therefore, we debit beginning retained earning, 80%, and we debit non-controlling interest to make sure the non-controlling interest is updated to remaining 20%, which is $24,000. But in total, this is $120,000. But remember, some of the gain went to the NCI, which is $24,000. Therefore, we have to take out of OCI, $24,000. Then we restore depreciation by crediting accumulated depreciation. So we have to prepare this entry to basically bring everything back to the original status. Now, are we done yet? No, we still have to do another entry. And what's the other entry? Remember, we have to adjust depreciation. Because what happened is this. For year two, the parent company debited depreciation expense $125,000, credited accumulated depreciation $125,000. Remember, they are for the full year. For 2012, we had the asset for the full year. Therefore, depreciation expense is $125,000. Therefore, depreciation expense is $30,000 and access of the original depreciation. What do we have to do? We have to reduce depreciation expense by $30,000. That's the first thing we have to do. Therefore, we debit depreciation expense $30,000. And what we just did, we just we are also what we are doing is we are preparing this entry here in a sense. But this is for $30,000 to adjust depreciation expense to the correct amount, thus realizing a portion of the game. We're doing the same thing here. So what I did is I debited depreciation expense $30,000. What do I do? I debit, I credit depreciation expense, I credit accumulated depreciation $30,000. So that's for the current year. That's for the year two. Now remember, what we have to do, we have to reverse the $15,000 of depreciation of the prior year. What does that mean? Remember, in the prior year, this was part, this was part of the work papers. Okay. And basically, this will be gone. So this, this will be gone in a sense that it's not permanent. This entry is not permanent. What we have to do in year two, we have to restore this. We have to restore this entry. And how do we restore this? We're going to debit accumulated depreciation. We're going to debit, we're going to debit accumulated depreciation $15,000. And you might be asking, hold on a second, why don't I just debit accumulated depreciation? It's okay. I'm just showing you what's happening here. So I'm going to have to debit accumulated depreciation $15,000, then credit beginning retained earning for not for the full $15,000, I'm going to spread it $12,000 for the parent company and NCI will absorb $3,000. And what's this entry for? This entry to, to update, to update our consolidated financial statement to make sure the $15,000 of the prior year is accounted for. Okay. So simply put, can we consolidate those two entries? Sure. Rather than having two accumulated depreciation, we're going to have one. So let me just show you the consolidated entry and not the consolidated, the compound entry of the consolidated entry. Okay. So we're going to debit accumulated depreciation $45, credit depreciation expense, credit beginning retained earning and credit non-controlling interest. This is what I had earlier. So this $30,000 is for the current year and those $15,000 is from the prior year. But remember what we have to do now, make sure you, for the prior year, you update the beginning retained earning, 80% to the beginning retained earning of P and 3,000, which is 20% of the non-controlling interest. And this is using the cost or the partial equity method. Now for using the full equity method, the complete equity method, what's going to happen is, okay, this is the entry to restore the asset, to restore accumulated depreciation. And what we do is we debit investment in S company rather than beginning retained earnings. So notice we debit investment rather than beginning retained earning for 96, okay, because the investment is reflecting everything. And the second entry, what we do is we also, rather than the beginning retained earning, we credit the investment, we credit the investment account because everything is reflected in the investment account. Okay. So this is basically to show you if you're using the equity method. Okay. Now what happened if this was a downstream sale? So let's just flip the positions. Now what's going to happen, the parent company is selling the subsidiary. What would change if we're using the partial or the cost equity? Okay. The non-controlling interest of 20% will be included in the beginning retained earning of P company. Simply put, let me go up here. This non-controlling interest will be gone. And this will be 15,000. Okay. This is for using the cost of the partial, the cost or the partial equity method. If we're using the complete equity method, non-controlling interest of 20% will be included in the investment in Sullivan. This one here will be included with the 15,000. Simply put, because we're going from the parent to the subsidiary, there is no, we don't differentiate between the controlling and the non-controlling interest in a downstream sale. So there is no differentiation between the controlling and non-controlling interest when we're going from the parent company to the subsidiary. Okay. It's only we differentiate when we're going upstream from the subsidiary to the from the subsidiary to the parent company. This is when we differentiate. Hopefully this example kind of gave you more knowledge, a little bit more flexibility with learning this. If you have any questions, email me. This topic is covered on the exam on the CPA exam study hard. And if you want additional lectures, go to my website. If you happen to go to my website, please consider donating. Thank you very much. Study hard for the exam. It's worth it.