Elimination of unrealised profits arising on the transfer of TNCA within a group

ACCA Paper F7 and Paper P2 article

Supplement to ACCA course notes for June 2012 exams, by Mike Little OpenTuition F7/P2 Tutor

Those of you who follow my lectures and worked examples may remember that I have a degree of conflict with the printed solutions to examination questions in the situation of the treatment of the elimination of unrealised profits arising on the transfer of tangible non-current assets within a group. ( Pups on TNCA transfers )
Ever since I started teaching consolidations the treatment of unrealised profits and the consequent adjustment for the excess depreciation on the unrealised profit has been the same, consistent “4 legged” entry. Repeatedly I am recorded as saying that “Conceptually, the only logical adjustment is ….”
The issue is this! Inconsistently, the major publishers have either treated the adjustment as a “net” adjustment or as a “4 legged” adjustment. Now, it seems there is only one acceptable method – the “net” method. Let me illustrate the problem with a brief example.

On the first day of the accounting period, the parent company sells an item of plant to the subsidiary and recognises a profit of $8,000. At the date of sale the plant had a remaining useful life of 4 years with no residual value. Incidentally, the sale could be from the subsidiary to the parent. In that case, wherever you read parent in this note, substitute the word subsidiary and vice versa.

Since time immemorial, I have treated the adjustment as a removal of unrealised profit in the parent ( Dr Retained earnings and Cr TNCA $8,000 ) and the adjustment for the “excess” depreciation in the subsidiary ( Dr TNCA and Cr Retained earnings $2,000 ).
The rationale is that the parent has recognised the $8,000 profit and the subsidiary has “over-charged” the $2,000 depreciation on that excess profit.

With recent effect, this 4 legged adjustment is not appropriate. Only the net approach is acceptable. The net approach says that, whereas the parent has recognised the unrealised profit of $8,000, as each of the four years go by, an appropriate proportion of that $8,000 is realised. So, by the end of the first year, $2,000 of the $8,000 has been realised – $2,000 of the asset has been used up.

Thus the adjustment to eliminate the unrealised profit is now the“net” adjustment. In our example, in the seller’s records, the adjustment would be Dr Retained earnings and Cr TNCA with $6,000. Whichever way is used, the affect on the TNCA is the same. However, there is an implication for the calculation of the non-controlling interest.
Following the 4 legged route, there will always be an adjustment in the subsidiary’s retained earnings – either because it has made the original sale to the parent and therefore recognised the $8,000 or because it has bought from the parent and therefore “overcharged” the $2,000 depreciation.
Under the “net” method, the only company to be affected by this pup elimination will be the selling company – in our example, the parent.
This difference in the treatment has sometimes / inconsistently resulted in a minor difference between the printed solution and my own version of the answer. The difference equates to the non-controlling interest’s share of the excess depreciation. In our example, say 20% of the $2,000.

A new chapter in my life therefore begins today because, with immediate effect, I shall be applying the “net” adjustment method when dealing with the elimination of the unrealised profit which has been recognised on the intra-group transfer of some TNCA.
And for bringing this to my attention, I should like to thank AmbitiousMe in the F7 forum / Ask the tutor forum.