assignment

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 06

Intercompany Inventory

Transactions

6-2

Learning Objective 1

Understand and explain intercompany transfers and

why they must be eliminated.

6-3

Road Map: Intercompany Transactions

 Typical intercompany transactions

 Intercompany reciprocal accounts (Chapter 4)

 Inventory transfers (Chapter 6)

 Fixed asset transfers (Chapter 7)

 Intercompany Indebtedness (Chapter 8)

6-4

Arm’s-Length Transactions

Q: What are “Arm’s-length” Transactions?

A: “Transactions that take place between completely independent parties.”

6-5

Categories of Transactions

 Arm’s Length Transactions

 The only transactions that can be reported in the consolidated statements.

 We want to report the results of our interactions with outside parties!

 Non-Arm’s Length Transactions

 Usually referred to as “related party transactions.”

 Include all intercompany transactions.

6-6

Types of “Related Party” Transactions

 Involving only Individuals

 Transactions among family members

 Involving Corporations

 With management and other employees

 With directors and stockholders

 With affiliates (controlled entities)

 Probably constitutes at least 99% of all corporate related-party transactions

6-7

Necessity of Eliminating Intercompany Transactions

 Eliminate all intercompany transactions in consolidation:

 Because they are internal transactions from a consolidated perspective.

 Not because they are related-party transactions.

 Only transactions with outside unrelated parties can be reported in the consolidated statements.

6-8

Intercompany Transactions: Additional Opportunities for Fraud

 Intercompany transactions sometimes occur to

 conceal embezzlements.

 overstate reported profits.

2 + 2 = 5

6-9

Example 1: Intercompany Loan

 A 12-year old girl lends $5 to her 17-year-old brother.

 From the standpoint of individuals, this represents a receivable and a payable.

 If the family prepares a “consolidated balance sheet”, what is the effect?

 No net change to the family’s wealth.

 Not a transaction with a non-family person.

6-10

Example 2: Sale from Parent to Sub to Outsider

 Parent has 19 subsidiaries.

 Parent has received a $1 order from an outsider.

 Parent sells inventory to Sub 1 for $1.  Sub 1 sells the inventory to Sub 2 for $1.

 Sub 2 sells the inventory to Sub 3 for $1.

 The inventory is sold from one sub to another until Sub 19 sells it to the outsider for $1.

 The parent and each sub reports sales of $1.

 From a consolidated standpoint, what is the total amount of sales?

6-11

Example 3: Sale from Parent to Sub, But Not Yet to an Outsider

 Sleazy Parent Company has one sub.

 Sleazy Parent is preparing for an IPO.

 Sleazy Parent owns lots of obsolete inventory which it cannot sell.

 Sleazy Parent sells the obsolete inventory (costing $1,000) to its sub for $100,000.

 Sleazy Sub now holds the inventory.

 Without any adjustment, what items in Sleazy’s consolidated financial statements will be misstated?

6-12

Correcting Entries

 Conceptually, how would you correct each of these three problems?

To eliminate intercompany loans: Loan Payable xxx

Loan Receivable xxx

To eliminate sale from Parent to Sub to Outsider: Sales xxx

Cost of Goods Sold xxx

To eliminate sale from Parent to Sub, not yet to Outsider: Sales xxx

Cost of Goods Sold xxx Inventory Unrealized GP

Easy! Just

reverse

More difficult

Easy! Just

reverse

6-13

Let’s work through an example:

 Assume Parent Co. owns 100% of Sub Co.

 The following intercompany transactions occurred during the year:

 Parent loaned $500 to Sub. To keep things simple, assume that there is no interest revenue or interest expense associated with this loan.

 Parent made a sale to Sub for $400 cash. The inventory had originally cost Parent $250. Sub then sold that same inventory to an outsider for $500.

 Parent made a sale to Sub for $300 cash. The inventory had originally cost Parent $200. Sub has not yet sold that same inventory to an outsider.

 What consolidation worksheet entries would you make?

6-14

Parent: Receivable 500

Cash 500

Sub: Cash 500

Payable 500

(a) Loan from Parent to Sub

Does this transaction include outsiders?

Parent $500 Sub

Reverse the entries made by the parent and the sub.

To eliminate intercompany loans: Loan Payable 500

Loan Receivable 500

6-15

(b) Sale from Parent to Sub to Outsider

Parent Sub$250 $500$400

Are these legitimate transactions?

Keep This

Purchase

Keep This Sale

Eliminate effect of this internal

Transaction

Arm’s Length

Internal (fake)

Keep Sub’s Sale

Get rid of Parent’s Sale Get rid of Sub’s COGS

Keep Parent’s COGS

6-16

Parent’s sale to Sub:

Parent: Cash 400

Sales 400 COGS 250

Inventory 250 Sub: Inventory 400

Cash 400

Sub’s sale to Outsider:

Sub: Cash 500

Sales 500 COGS 400

Inventory 400

Reverse the rest!

(b) Sale from Parent to Sub to Outsider

Which transactions are legitimate?

To eliminate sale from Parent to Sub to Outsider: Sales (parent to sub) 400

Cost of Goods Sold (to outsider) 400

6-17

(c) Sale From Parent to Sub (Not Outside)

Keep this

purchase

Eliminate effect of this internal

transaction

Summary of the Transaction:  Parent purchased inventory for $200.  Parent sold the inventory to a Sub for $300. Reverse the entries made by the parent and sub.

Parent: Cash 300

Sales 300 COGS 200

Inventory 200

Sub: Inventory 300

Cash 300

Parent $300 Sub$200

Is this a legitimate arm’s length transaction?

6-18

Parent: Cash 300

Sales 300 COGS 200

Inventory 200

Sub: Inventory 300

Cash 300

Parent Sub$300

(c) Sale From Parent to Sub (Not Outside)

Reverse the entries made by the parent and sub.

To eliminate sale from Parent to Sub, not yet to Outsider: Sales 300

Cost of Goods Sold 200 Inventory 100(net)

6-19

Summary of Consolidation Entries:

To eliminate intercompany loans: Loan Payable 500

Loan Receivable 500

To eliminate sale from Parent to Sub to Outsider: Sales 400

Cost of Goods Sold 400

To eliminate sale from Parent to Sub, not yet to Outsider: Sales 300

Cost of Goods Sold 200 Inventory 100

6-20

Fully-adjusted Equity Method Adjustment

 Parent companies have to adjust their equity method investment accounts for certain transactions.

 At this point, let’s just consider one:

 Sale from parent to sub, but not yet sold to an outsider.

 It represents “fake profit” that hasn’t really been realized in an arm’s-length transaction.

 Both the balance sheet and income statement accounts need to be adjusted.

 This is a REAL journal entry, not a consolidation worksheet entry!

6-21

Equity Method Adjustment Example

Sales $ 600 COGS 500 GP $ 100

Equity Method Entry:

Income from Sub 100 Investment in Sub 100

 The Parent recognized $100 of “fake gross profit!

 The Parent should have transferred the inventory at cost.

 This profit is not from a transaction with an arm’s length independent party.

Parent $600 Sub$500

Summary of the Transaction:  Parent purchased inventory for $500.  Parent sold the inventory to a Sub for $600.

6-22

Group Practice

 Assume Parent Co. owns 100% of Sub Co.

 The following intercompany transactions occurred during the year:

 Parent loaned $100 to Sub. To keep things simple, assume that there is no interest revenue or interest expense associated with this loan.

 Parent made a sale to Sub for $200 cash. The inventory had originally cost Parent $120. Sub then sold that same inventory to an outsider for $300.

 Parent made a sale to Sub for $300 cash. The inventory had originally cost Parent $180. Sub has not yet sold that same inventory to an outsider. (Don’t forget equity method entry!)

 Based on our “conceptual discussion,” what consolidation worksheet entries would you make?

6-23

Practice Quiz Question #1

Why must intercompany transactions be eliminated?

a. They portray the consolidated company’s results too conservatively.

b. They understate the results of the consolidated group.

c. They are arm’s length transactions.

d. They are not arm’s length transactions.

6-24

Learning Objective 2

Understand and explain concepts associated with inventory transfers and

transfer pricing.

6-25

Issue #1: Eliminate Intercompany Transfers?

 Whether to Eliminate Intercompany Transactions in Consolidation:

 No controversy—they must be eliminated.

 Not eliminating them would cause two problems:

 Meaningless double-counting of

1. sales, and 2. expenses

 Potential to manipulate income.

6-26

The Substance of Inventory Transfers

 The CONSOLIDATED Perspective:

 Merely the physical movement of inventory from one location to another location.

 Similar to the movement of inventory from one division to another division.

 Not a bona fide transaction.

6-27

Issue #2: Which Measure of Profit To Use?

 Possible theoretical profit measures:

 Gross profit

 Operating profit

 Net income

 Profit measure required under GAAP:

 Gross profit (of the selling entity):

Sales $1,000 Cost of sales 600 Gross profit $ 400

6-28

Issue #3: Eliminate Income Tax Effects?

 Income taxes play a major role in intercompany sales and transfer pricing decisions.

 Income taxes on the selling entity’s unrealized gross profit must also be eliminated.

 In this chapter :

 No income tax entries are required.

 Because we assume that the tax effects have already been recorded in the parent’s or the subsidiary’s general ledger.

6-29

Issue #4: Whether To Eliminate All or Some?

 Downstream sales to a partially-owned subsidiary:

 Eliminate 100% of unrealized profit.

 Fractional elimination is prohibited.

 Upstream sales from a partially-owned subsidiary:

 Eliminate 100% of unrealized profit.

 Fractional elimination is prohibited.

6-30

Issue #4: Whether To Eliminate All or Some?

 Downstream sales to a partially- owned subsidiary:

 Entire profit accrues to the parent; thus, sharing is not appropriate.

 Upstream sales from a partially- owned subsidiary:

 Must share deferral with the NCI shareholders (if amount is material).

 Because S profits are shared with the NCI shareholders.

P

S

NCI

6-31

Inventory Transfers: What is “Realization”?

 Realization for consolidated reporting purposes:

 Does not focus on whether the seller has

 delivered the product,

 collected on the sale, or

 reduced to an acceptable level the uncertainty about the net cash flow effect of an earnings activity.

6-32

Inventory Transfers: What is “Realization”?

 Realization for consolidated reporting purposes:

 Depends on whether the BUYER has resold the inventory to an outside unaffiliated customer.

Parent Sub

6-33

Review: Two Types of Transfers

Assume both transactions

took place during the same year.

Parent Sub$750 For $1,200$1,000

 Parent-to-sub-to-outsider

 Parent-to-sub-not-yet-to-outsider

Parent Sub$300 $400

6-34

Understanding Inventory Transfers: Map it out

Splits out parent’s numbers.

Parent Sub$1,050 Unknown$1,400

$1,400 Split

Ending Inventory = $400

What happened to it?

Total Interco Sales Resold On hand

Sales 1,400 1,000 400

 COGS 1,050 750 300

Gross Profit 350 250 100

Gross Profit % 25%

Resold = $1,000

6-35

Calculating Unrealized Gross Profit

 Amounts that will always be known (given):

CRITICAL ASSUMPTION:

 The gross profit percentage derivable from the total column applies to both (1) the inventory that has been resold AND (2) the inventory that is still on hand.

Total Resold On hand

Sales (NEW basis) 1,000 200

 Cost of sales (OLD basis) 600

Gross Profit 400

Gross Profit % 40%

6-36

Calculating Unrealized Gross Profit

 Completed Analysis:

 The Inventory/COGS Change in Basis Elimination Entry is derived from this analysis.

 Unrealized profit = Inventory on hand x GP%

= $200 x 40% = $80

Total Resold On hand

Sales (NEW basis) 1,000 800 200

 Cost of sales (OLD basis) 600 480 120

Gross Profit 400 320 80

Gross Profit % 40% Realized Unrealized

6-37

What happened to it?

Total Interco Sales

Resold On hand

Sales 1,400 1,000 400

 COGS 1,050 750 300

Gross Profit 350 250 100

Gross Profit % 25%

Transfer Price

Cost

Markup

Markup on Transfer Price

Inventory Transfers: Terminology

Watch out for terminology like “mark-up based on cost”!

6-38

Practice Quiz Question #2

For 20X8, Pete reported intercompany cost of sales of $800,000 (markup is 20% of transfer price) to Sampras, which reported $300,000 of intercompany acquired inventory at 12/31/X8. The unrealized profit at 12/31/X8 is:

a. $40,000 b. $48,000 c. $60,000 d. $75,000 e. None of the above

6-39

Practice Quiz Question #2 Solution

Parent Sub$800,000 ??

Ending Inventory = $300,000

What happened to it?

Total Interco Sales Resold On hand

Sales 300,000

 COGS 800,000

Gross Profit ?

Gross Profit % 20%

6-40

Practice Quiz Question #3

For 20X8, Post reported $90,000 of intercompany sales (25% markup on cost and fully paid for by year end) to Script, which reported $30,000 of intercompany acquired inventory at 12/31/X8. The unrealized profit at 12/31/X8 is:

a. $0 b. $6,000 c. $7,500 d. $30,000 e. None of the above

6-41

Practice Quiz Question #3 Solution

Parent Sub? ?90,000

What happened to it?

Total Interco Sales Resold On hand

Sales 90,000 30,000

 COGS C

Gross Profit 0.25 C ?

Gross Profit % ?

$90,000 Split

Ending Inventory = $30,000

6-42

Practice Quiz Question #4

For 20X8, Sempre (80% owned by Para) reported $1,600,000 of intercompany sales (1/3 markup on cost) to Para, which resold $1,400,000 of this inventory by 12/31/X8. The unrealized profit at 12/31/X8 is:

a. $40,000 b. $50,000 c. $53,333 d. $66,667 e. None of the above

6-43

Practice Quiz Question #4 Solution

Parent Sub? unknown1,600,000

What happened to it?

Total Interco Sales Resold On hand

Sales 1,600,000 1,400,000

 COGS

Gross Profit ?

Gross Profit % ?

$1,600,000 Split

Ending Inventory = 200,000

Resold = $1,400,000

6-44

Learning Objective 3

Prepare equity-method journal entries and elimination entries

for the consolidation of a subsidiary following downstream inventory

transfers.

6-45

Agreement between Parent Company and Consolidated Financial Statements

 Under the fully adjusted equity method,

 the parent company’s financial statements should report the same net income and retained earnings amounts as appear in the consolidated statements.

 Therefore, we

 record and equity method adjustment on the parent’s books to defer unrealized gross profit, and

 prepare consolidation worksheet elimination entries to avoid double counting in the income statement and overstating inventory.

6-46

Big Picture—Elimination entry: Sale From Parent to Sub to Outsider

Get rid of the non-arm’s-length transaction!

Parent Sub$250 $500$400

To eliminate sale from Parent to Sub to Outsider: Sales (Parent) 400

Cost of Goods Sold (Sub) 400

6-47

Big Picture—Elimination entry: Sale From Parent to Sub (not yet sold outside)

Reverse the entire transaction!

Parent Sub$250 $400

To eliminate sale from Parent to Sub, not yet to Outsider: Sales 400

Cost of Goods Sold 250 Inventory 150

Equity Method Entry:

Income from Sub 150 Investment in Sub 150

Sub’s inventory is overstated by $150

Sales $400 Cost of sales 250 Gross profit $ 150

Parent’s gross profit is overstated by $150

6-48

What to Look For

 Most problems will contain

 Inventory transferred from parent to sub (downstream), or

 Inventory transferred from sub to parent (upstream).

 Often part of the inventory is sold to an outsider, but part remains in the buyer’s ending inventory.

 Key: Any problem can be split into two parts

 The portion of the inventory that is sold

 The portion of the inventory that is still on hand

6-49

Parent Sub60,000 70,00075,000

Ending inventory = $10,000

What happened to it?Income Statements Parent Sub

Sales $75,000 $70,000 Cost of sales 60,000 65,000 Gross profit $15,000 $ 5,000

During 20X8, Parent sold inventory originally costing $60,000 to its 100% owned Sub for $75,000. Sub sold most of the inventory purchased from Parent (all but $10,000) for $70,000 to outsiders during the year.

$75,000 Split

Sold On-hand $65,000 $10,000 x 20% = $2,000

Unrealized GP

A Comprehensive Downstream Example

6-50

One Approach: Split into Two Transactions

 This transaction can be broken into two pieces:

 Parent sells Sub inventory with a cost of $52,000 for $65,000. Sub then sells this inventory to outsiders for $70,000.

 Parent sells Sub inventory with a cost of $8,000 for $10,000, which remains on hand in Sub’s ending inventory.

Total Sold On hand

Sales $75,000 $65,000 $10,000

 COGS 60,000 52,000 8,000

Gross Profit $15,000 $13,000 $ 2,000

6-51

Part 1: Sale from Parent to Sub to Outsider

Get rid of the non-arm’s-length transaction!

Parent Sub$52,000 $70,000$65,000

To eliminate sale from Parent to Sub to Outsider: Sales (Parent) 65,000

Cost of Goods Sold (Sub) 65,000

6-52

Part 2: Sale from Parent to Sub (Not Outside)

Reverse the entire transaction!

Parent Sub$8,000 $10,000

To eliminate sale from Parent to Sub, not yet to Outsider: Sales (Parent) 10,000

Cost of Goods Sold (Parent) 8,000 Inventory (basis correction) 2,000

Sub’s inventory is overstated by $2,000

Sales $10,000 Cost of sales 8,000 Gross profit $ 2,000

Parent’s gross profit is overstated by $2,000

6-53

Summary

To eliminate sale from Parent to Sub to Outsider : Sales (Parent) 65,000

Cost of Goods Sold (Sub) 65,000

To eliminate sale from Parent to Sub, not yet to Outsider: Sales (Parent) 10,000

Cost of Goods Sold (Parent) 8,000 Inventory (basis correction) 2,000

Can combine the two entries: Sales 75,000

Cost of Goods Sold 73,000 Inventory 2,000

6-54

Partial Consolidated Worksheet

Parent Sub DR CR Consol- idated

Income Statement

Sales 75,000 70,000 75,000 70,000

COGS 60,000 65,000 73,000 52,000

Gross Profit 15,000 5,000 75,000 73,000 18,000

Balance Sheet

Inventory 0 10,000 2,000 8,000

6-55

Second Approach: Short Cut Method

Total Sold On hand

Sales $75,000 $65,000 $10,000

 COGS 60,000 52,000 8,000

Gross Profit $15,000 $13,000 $ 2,000

The numbers come right off the chart!

Sales 75,000 Cost of Goods Sold 73,000 Inventory 2,000

COGS Credit = $65,000 + $8,000

6-56

Fully-adjusted Equity Method Adjustment

 Don’t forget that one of the desirable properties of using the equity method is that the parent’s net income should be equal to the consolidated net income.

 If you only adjust for unrealized deferred profit in the consolidation, the consolidated net income will be different from the parent’s income!

6-57

Partial Consolidated Worksheet

Parent Sub DR CR Consol- idated

Income Statement

Sales 75,000 70,000 75,000 70,000

COGS 60,000 65,000 73,000 52,000

Inc from Sub 5,000 5,000

Net Income 20,000 5,000 80,000 73,000 18,000

Balance Sheet

Inventory 0 10,000 2,000 8,000

Not the same!

6-58

Fully-adjusted Equity Method Adjustment

 Don’t forget that one of the desirable properties of using the equity method is that the parent’s net income should be equal to the consolidated net income.

 If you only adjust for unrealized deferred profit in the consolidation, the consolidated net income will be different from the parent’s income!

 Thus, an actual adjustment on the parent’s books in addition to the worksheet entries above.

 Like we did for the excess fair value amortization.

6-59

Fully-adjusted Equity Method Adjustment

 After calculating the unrealized deferred profit, simply make an extra adjustment to back it out.

 Do this at the same time you record the parent’s share of the sub’s income.

Investment in Sub Income from Sub

NI 5,000 2,000 Unreal GP 2,000

5,000 NI

3,000

Reverse next year when this inventory is sold!

Sales $75,000 COGS 60,000 Gross profit $15,000 Inc. from Sub 3,000 NI $18,000

Parent NI = Consolidated NI

6-60

Partial Consolidated Worksheet

Parent Sub DR CR Consol- idated

Income Statement

Sales 75,000 70,000 75,000 70,000

COGS 60,000 65,000 73,000 52,000

Inc from Sub 3,000 3,000

Net Income 18,000 5,000 78,000 73,000 18,000

Balance Sheet

Inventory 0 10,000 2,000 8,000

Now they’re the same!

6-61

Practice Quiz Question #5

Under the fully adjusted equity method, what is one benefit of making an equity method adjustment to defer unrealized gross profit on inventory transfers?

a. Consolidated net income always increases.

b. Parent company net income always increases.

c. Parent company net income is not equal to consolidated net income.

d. Parent company net income equals consolidated net income.

6-62

Review Exercise Part 1: Downstream

 Para sold inventory costing $100,000 to its 75%-owned subsidiary, Shute, for $125,000 in 20X8.

 Shute resold most of this inventory for $230,000 in 20X8.

 At 12/31/X8, Shute’s balance sheet showed intercompany-acquired inventory on hand of $20,000.

P

S

NCI

25% 75%

Required:

 Prepare the consolidation entry and/or entries required at 12/31/X8 under the equity method.

 Since this is a DOWNSTREAM transaction, we don’t share the GP deferral with the NCI.

6-63

Review Exercise Part 1: Big Picture

Total Sold On hand

Sales 125,000 20,000

 COGS 100,000

Gross Profit 25,000

Gross Profit %

Parent Sub$100,000 $230,000$125,000

$125,000 split

Ending Inventory = 20,000

Resold = $105,000

6-64

Review Exercise 1: Sale from Parent to Sub to Outsider

Parent Sub$84,000 $230,000$105,000

Get rid of the internal non-arm’s-length transaction!

To eliminate sale from Parent to Sub to Outsider: Sales (Parent) 105,000

Cost of Goods Sold (Sub) 105,000

6-65

Review Exercise 1: Sale from Parent to Sub (Not Yet Outside)

Reverse the entire transaction!

Parent Sub$16,000 $20,000

To eliminate sale from Parent to Sub, not yet to Outsider: Sales (Parent) 20,000

Cost of Goods Sold (Parent) 16,000 Inventory (basis correction) 4,000

Sub’s inventory is overstated by $4,000

Sales $20,000 Cost of sales 16,000

Gross profit $ 4,000

Parent’s gross profit is overstated by $4,000

6-66

Review Exercise 1: Summary

Fully-adjusted Equity Method Entry on Parent’s books:

Income from Sub 4,000 Investment in Sub 4,000

To eliminate sale from Parent to Sub to Outsider: Sales (Parent) 105,000

Cost of Goods Sold (Sub) 105,000

To eliminate sale from Parent to Sub, not yet to Outsider: Sales (Parent) 20,000

Cost of Goods Sold (Parent) 16,000 Inventory (basis correction) 4,000

Combine both entries: Sales 125,000

Cost of Goods Sold 121,000 Inventory 4,000

6-67

Review Exercise Part 1: Short Cut

Total Sold On hand

Sales 125,000 105,000 20,000

 COGS 100,000 84,000 16,000

Gross Profit 25,000 21,000 4,000

COGS Credit = 105,000 + 16,000 = 121,000 Unrealized GP

Worksheet Elimination Entry:

Sales 125,000 Cost of Goods Sold 121,000 Inventory 4,000

6-68

Review Exercise Part 1

FYI, this year’s deferral is REVERSED next year to recognize when sold!

Worksheet Elimination Entry in Year 1:

Sales 125,000 Cost of Goods Sold 121,000 Inventory 4,000

Worksheet Elimination Entry in Year 2:

Investment in Sub 4,000 Cost of Goods Sold 4,000

INCREASES income!

6-69

Downstream, so don’t split the deferral with the NCI.

Review Exercise 1: Equity Method Entry

Investment in Sub Income from Sub

75% NI 93,750 4,000 Defer GP 4,000

89,750

93,750 75% NI

Low 4,000

6-70

Review Exercise 1: Partial Consolidated Worksheet

Parent Sub DR CR Consol- idated

Income Statement

Sales 125,000 230,000 125,000 230,000)

COGS 100,000 105,000 121,000 84,000)

Inc from Sub 89,750 89,750 Basic

Gross Profit 114,750 125,000 214,750 121,000 146,000)

NCI in NI 31,250 Basic (31,250)

CI in NI 114,750 125,000 246,000 121,000 114,750)

Balance Sheet

Inventory 20,000 4,000 16,000)

6-71

Review Exercise 1: Equity Method Reversal Next Year

Equity Method Adjustment on Parent’s books in 20X7:

Income from Sub 4,000 Investment in Sub 4,000

Reversal of 20X7 Deferral on Parent’s books in 20X8:

Investment in Sub 4,000 Income from Sub 4,000

6-72

Learning Objective 4

Prepare equity-method journal entries and elimination entries

for the consolidation of a subsidiary following

upstream inventory transfers.

6-73

Partially Owned Upstream Sales

 Must share deferral with the NCI shareholders.

 Simply split up the adjustment for unrealized gross profit proportionately.

Investment in Sub Income from Sub

NI 4,500

1,800 Defer GP 1,800

4,500 NI

2,700

P

S

NCI

10% 90%

Unreal GP 200

NCI in NA of Sub

Equity Method Adjustments

Worksheet Entry Only

6-74

Review Exercise Part 2

 In 20X7, Sensei, a 90%-owned subsidiary of Padawan, sold inventory to Padawan for $600,000, which includes a markup of 25% on Sensei’s cost.

 Padawan resold most of this inventory in 20X7 for $588,000.

 At 12/31/X7, Padawan reported $110,000 of this inventory in its balance sheet. (This ending inventory was resold in 20X8 by Padawan.)

 In 20X8, Sensei sold Padawan inventory for $900,000 that had a cost of $675,000, of which Padawan resold $700,000 by12/31/X8 for $840,000.

Required:

 Prepare the consolidation entry and/or entries required at 12/31/X8 under the equity method.

 Since this is an UPSTREAM transaction, we do share the GP deferral with the NCI.

P

S

NCI

10% 90%

6-75

Review Exercise Part 2: The Big Picture—20X7

Total Sold On hand

Sales 600,000 490,000 110,000

 COGS 480,000 392,000 88,000

Gross Profit 120,000 98,000 22,000

Gross Profit % = 120,000 ÷ 600,000 = 20%

Ending Inventory = $110,000

Sub Parent? ?$600,000

Unrealized GP

$600,000 – C = 0.25C C = $600,000/1.25

= $480,000

6-76

20X7 Upstream Sales: Elimination Entries—20X7 & 20X8

P

S

NCI

10% 90%

20X7 Worksheet Elimination Entry:

Sales 600,000 Cost of Goods Sold 578,000 Inventory 22,000

20X8 Worksheet Elimination Entry:

Investment in Sub 19,800

NCI in NA of Sub 2,200 Cost of Goods Sold 22,000

Deferred GP this year “reversed” to recognize in the financial

statements next year when sold.

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20X7 Upstream Sales: Equity Method Adjustments — 20X7 & 20X8

P

S

NCI

10% 90%

20X7 Equity Method Adjustment on Parent’s books:

Income from Sub 19,800 Investment in Sub 19,800

20X8 Equity Method Reversal of 20X7 Deferral (on Parent’s books):

Investment in Sub 19,800

Income from Sub 19,800

Deferral of GP in 20X7 because not yet sold this year.

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20X7 Upstream Sales: 20X7 Equity Accounts

Investment in Sub Income from Sub

90% NI 108,000 19,800 X7 Deferral 19,800

88,200

108,000 90% NI

Low 19,800

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20X7 Upstream Sales: 20X7 Partial Worksheet

Parent Sub DR CR Consol- idated

Income Statement

Sales 588,000 600,000 600,000 588,000)

COGS 490,000 480,000 578,000 392,000)

Inc from Sub 88,200 88,200 Basic

Gross Profit 186,200 120,000 688,200 578,000 196,000)

NCI in NI 9,800 Basic (9,800)

CI in NI 186,200 120,000 698,000 578,000 186,200)

Balance Sheet

Inventory 110,000 22,000 88,000)

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Review Exercise Part 2

 In 20X7, Sensei, a 90%-owned subsidiary of Padawan, sold inventory to Padawan for $600,000, which includes a markup of 25% on Sensei’s cost.

 Padawan resold most of this inventory in 20X7 for $588,000.

 At 12/31/X7, Padawan reported $110,000 of this inventory in its balance sheet. (This ending inventory was resold in 20X8 by Padawan.)

 In 20X8, Sensei sold Padawan inventory for $900,000 that had a cost of $675,000, of which Padawan resold $700,000 by12/31/X8 for $840,000.

Required:

 Prepare the consolidation entry and/or entries required at 12/31/X8 under the equity method.

 Since this is an UPSTREAM transaction, we do share the GP deferral with the NCI.

P

S

NCI

10% 90%

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Review Exercise Part 2: The Big Picture—20X8

Total Sold On hand

Sales 900,000 700,000 200,000

 COGS 675,000 525,000 150,000

Gross Profit 225,000 175,000 50,000

Gross Profit % = 225,000 ÷ 900,000 = 25%

Ending Inventory = $200,000

Sub Parent675,000 ?$900,000

Unrealized GP

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Review Exercise 2: Summary

Fully-adjusted Equity Method Entry on Parent’s books:

Income from Sub 45,000 Investment in Sub 45,000

To eliminate sale from Sub to Parent to Outsider: Sales (Sub) 700,000

Cost of Goods Sold (Parent) 700,000

To eliminate sale from Sub to Parent, not yet to Outsider: Sales (Sub) 200,000

Cost of Goods Sold (Sub) 150,000 Inventory (basis correction) 50,000

Combine both entries: Sales 900,000

Cost of Goods Sold 850,000 Inventory 50,000

6-83

Review Exercise 2: Short Cut

Total Sold On hand

Sales 900,000 700,000 200,000

 COGS 675,000 525,000 150,000

Gross Profit 200,000 175,000 50,000

COGS CR = 700,000 + 150,000 = 850,000

The Elimination Entry:

Sales 900,000 Cost of Goods Sold 850,000 Inventory 50,000

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20X8 Upstream Sales: 20X8 Equity Accounts

Investment in Sub Income from Sub

19,800 Low

19,800 X7 Reversal 19,800

202,500 90% NI90% NI 202,500 45,000 X8 Deferral 45,000

177,30045,000 Low

6-85

20X7 & 20X8 Upstream Sales: 20X8 Partial Worksheet

Parent Sub DR CR Consol- idated

Income Statement

Sales 840,000 900,000 900,000 840,000)

COGS 700,000 675,000 850,000 503,000)

22,000

Income from Sub 177,300 177,300 Basic

Gross Profit 317,300 225,000 1,077,300 872,000 337,000)

NCI in NI 19,700 Basic (19,700)

CI in NI 317,300 225,000 1,097,000 872,000 317,300

Balance Sheet

Inventory 200,000 50,000 150,000)

Investment in Sub Low by 45,000

19,800 Basic X

NCI in NA of Sub 2,200 2,200

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Learning Objective 5

Understand and explain additional considerations

associated with consolidation.

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Additional Considerations

 Sale from one subsidiary to another

 Transfers of inventory often occur between companies that are under common control or ownership.

 The eliminating entries are identical to those presented earlier for sales from a subsidiary to its parent.

 The full amount of any unrealized intercompany profit is eliminated, with the profit elimination allocated proportionately against the ownership interests of the selling subsidiary.

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Additional Considerations

 Costs associated with transfers

 When one affiliate transfers inventory to another, some additional cost is often incurred.

 Such costs should be treated in the same way as if the affiliates were operating divisions of a single company.

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Additional Considerations

 Lower-of-cost-or-market

 A company might write down inventory purchased from an affiliate under this rule if the market value at the end of the period is less than the intercompany transfer price.

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Assume that a parent company purchases inventory for $20,000 and sells it to its subsidiary for $35,000. The subsidiary still holds the inventory at year-end and determines that its market value (replacement cost) is $25,000 at that time. The subsidiary writes the inventory down from $35,000 to its lower market value of $25,000 at the end of the year and records the following entry:

Lower-of-Cost-or-Market Example

Write-down Inventory to Market Value:

Loss on Decline in Value of Inventory 10,000 Inventory 10,000

Sales 35,000 Cost of Goods sold 20,000 Inventory 5,000 Loss on Decline in Value of Inventory 10,000

Make the following worksheet eliminating entry:

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Additional Considerations

 Sales and purchases before affiliation

 The consolidation treatment of profits on inventory transfers that occurred before the business combination depends on whether the companies were at that time independent and the sale transaction was the result of arm’s-length bargaining.

 As a general rule, the effects of transactions that are not the result of arm’s-length bargaining must be eliminated.

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Additional Considerations

 In the absence of evidence to the contrary, companies that have joined together in a business combination are viewed as having been separate and independent prior to the combination.

 If the prior sales were the result of arm’s-length bargaining, they are viewed as transactions between unrelated parties.

 No elimination or adjustment is needed in preparing consolidated statements subsequent to the combination, even if an affiliate still holds the inventory.

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Practice Quiz Question #6

Peanut Co. regularly purchased inventory from Snack Inc. in 20X3 when Peanut did not own any Snack stock. On March 31, 20X4, Peanut purchased 90% of Snack Inc.’s outstanding common stock.

a. Peanut should eliminate 90% of Snack’s first quarter 20X4 gross profit.

b. Peanut should eliminate 100% of Snack’s first quarter 20X4 gross profit.

c. Peanut should not eliminate any of Snack’s first quarter 20X4 gross profit.

d. Peanut should eliminate 100% of Snack’s 20X4 gross profit.