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Intercompany Profit Transactions – Inventories. Chapter 5. Learning Objective 1. Understand the impact of intercompany profit for inventories on preparation of consolidation working papers. Intercompany Inventory Transactions. Revenue Recognition.

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learning objective 1
Learning Objective 1

Understand the impact of

intercompany profit for

inventories on preparation

of consolidation working papers.

intercompany inventory transactions
Intercompany Inventory Transactions

Revenue Recognition

Revenue on sales between affiliated companies

cannot be recognized until merchandise is sold

outside of the consolidated entity.

intercompany inventory transactions4
Intercompany Inventory Transactions

Purchasing Agent

Periodic

inventory

system

Sales

Purchases

Perpetual

inventory

system

Sales

Cost of goods sold

elimination of intercompany purchases and sales
Elimination of IntercompanyPurchases and Sales

Pint formed a subsidiary, Shep Corporation.

All Shep’s purchases are made from

Pint at 20% above Pint’s cost.

Pint sold $20,000 of merchandise

to Shep for $24,000.

Shep sold all the merchandise

to its customers for $30,000.

elimination of intercompany purchases and sales6
Elimination of IntercompanyPurchases and Sales

Pint’s Books

Inventory 20,000

Accounts Payable 20,000

To record purchases on account from other entities

Accounts Receivable 24,000

Sales 24,000

To record intercompany sales to Shep

elimination of intercompany purchases and sales7
Elimination of IntercompanyPurchases and Sales

Pint’s Books

Cost of Sales 20,000

Inventory 20,000

To record cost of sales to Shep

Investment 6,000

Income from Shep 6,000

To record related equity interest

elimination of intercompany purchases and sales8
Elimination of IntercompanyPurchases and Sales

Shep’s Books

Inventory 24,000

Accounts Payable 24,000

To record intercompany purchases from Pint

Accounts Receivable 30,000

Sales 30,000

To record sales to outside customers

elimination of intercompany purchases and sales9
Elimination of IntercompanyPurchases and Sales

Shep’s Books

Cost of Sales 24,000

Inventory 24,000

To record cost of sales to customers

elimination of intercompany purchases and sales10
Elimination of IntercompanyPurchases and Sales

100% Adjustments and Consol-

Pint Shep Eliminations idated

Sales

Cost of sales

Gross profit

$24,000

20,000

$ 4,000

$30,000

24,000

$ 6,000

a 24,000

a 24,000

$30,000

20,000

$10,000

elimination of unrealized profit in ending inventory
Elimination of UnrealizedProfit in Ending Inventory

During 2004, Pint sold merchandise that

cost $30,000 to Shep for $36,000.

Shep sold all but $6,000 of this

merchandise to its customers for $37,500.

elimination of unrealized profit in ending inventory12
Elimination of UnrealizedProfit in Ending Inventory

30,000 ÷ 36,000 = 5/6

5/6 × 30,000 = $25,000

1/6 × 36,000 = $6,000

1/6 × 30,000 = $5,000

Shep’s inventory $6,000

Cost to Pint –5,000

Unrealized profit in EI $1,000

elimination of unrealized profit in ending inventory13
Elimination of UnrealizedProfit in Ending Inventory

Adjustments and Consol-

Pint Shep Eliminations idated

Sales

Cost of sales

Gross profit

Inventory

$36,000

30,000

$ 6,000

$37,500

30,000

$ 7,500

$ 6,000

a 36,000

b 1,000 a 36,000

b 1,000

$37,500

25,000

$12,500

$ 5,000

recognition of unrealized profit in beginning inventory
Recognition of UnrealizedProfit in Beginning Inventory

During 2005 Pint sold merchandise

that cost $40,000 to Shep for $48,000.

Shep sold 75% of this merchandise

to its customers for $45,000.

Shep also sold its beginning inventory

with a transfer price of $6,000 for $7,500.

recognition of unrealized profit in beginning inventory15
Recognition of UnrealizedProfit in Beginning Inventory

25% × 48,000 = $12,000 Ending inventory

$12,000 ÷ 1.2 = $10,000 EI transfer price

Shep’s inventory $12,000

Cost to Pint (10,000)

Unrealized profit in EI $ 2,000

recognition of unrealized profit in beginning inventory16
Recognition of UnrealizedProfit in Beginning Inventory

$7,500 – $5,000 BI = $2,500 from BI

75% × 48,000 = $30,000

$45,000 – $30,000 = $15,000

$15,000 + $2,500 = $17,500

recognition of unrealized profit in beginning inventory17
Recognition of UnrealizedProfit in Beginning Inventory

Adjustments and Consol-

Pint Shep Eliminations idated

Sales

Cost of sales

Gross profit

Inventory

Investment

in Shep

$48,000

40,000

$ 8,000

XXX

$52,500

42,000

$10,500

$12,000

a 48,000

c 2,000 a 48,000

b 1,000

c 2,000

b 1,000

$52,500

35,000

$17,500

$10,000

learning objective 2
Learning Objective 2

Apply the concepts of

upstream versus downstream

inventory transfers.

downstream and upstream sales
Downstream and Upstream Sales

Sales from top

to bottom are

downstream.

Sales from

bottom to top

are upstream.

Parent

to

Subsidiary

Subsidiary

to

Parent

downstream and upstream sales20
Downstream and Upstream Sales

In downstream sales, the parent company’s

separate income includes the full amount of

any unrealized profit, and the subsidiary’s

income is not affected.

In upstream sales, the subsidiary company’s

net income includes the full amount of any

unrealized profit, and the parent company’s

separate income is not affected.

downstream and upstream effects on income computations
Downstream and Upstream Effectson Income Computations

80%-owned

Parent Subsidiary

Sales $600 $300

Cost of sales 300 180

Gross profit $300 $120

Expenses 100 70

Parent’s separate income $200

Subsidiary’s net income $ 50

downstream and upstream effects on income computations22
Downstream and Upstream Effectson Income Computations

Intercompany sales during the year are $100,000.

The December 31 inventory includes

$20,000 unrealized profit.

downstream and upstream effects on income computations23
Downstream and Upstream Effectson Income Computations

Downstream:

The parent company’s

sales and cost of sales

accounts reflect the

$20,000 unrealized profit.

The $50,000

subsidiary net

income equals its

realized income.

downstream and upstream effects on income computations24
Downstream and Upstream Effectson Income Computations

Upstream:

The subsidiary’s sales and

cost of sales accounts reflect

the $20,000 unrealized profit.

The subsidiary’s

realized income

is $30,000.

downstream and upstream effects on income computations25
Downstream and Upstream Effectson Income Computations

Consolidated Income (000) Downstream Upstream

Sales ($900 – $100) $800 $800

Cost of sales ($480 + $20 – $100) 400 400

Gross profit $400 $400

Expenses ($100 + $70) 170 170

Total realized income $230 $230

Less: Minority interest 10 6

Consolidated net income $220 $224

downstream and upstream effects on income computations26
Downstream and Upstream Effectson Income Computations

Consolidated Income (000) Downstream Upstream

Parent’s separate income $200 $200

Add: Income from subsidiary:

Equity in subsidiary’s income

less unrealized profit

[($50,000 × 80%) – $20,000] 20

Equity in subsidiary’s income

[($50,000 – $20,000) × 80%] 24

Parent and consolidated net income $220 $224

learning objective 3
Learning Objective 3

Defer unrealized inventory profits

remaining in ending inventory of

either the parent or subsidiary.

deferral of intercompany profit in period of sale downstream
Deferral of Intercompany Profitin Period of Sale: Downstream

90%-owned

Porter Sorter

Sales $100 $50

Cost of sales 60 35

Gross profit $ 40 $15

Expenses 15 5

Operating income $ 25 $10

Income from Sorter 9 –

Net income $ 34 $10

deferral of intercompany profit in period of sale downstream29
Deferral of Intercompany Profitin Period of Sale: Downstream

Porter’s sales include $15,000 to Sorter

at a profit of $6,250.

Sorter’s December 31, 2003, inventory includes

40% of the merchandise from this transaction.

deferral of intercompany profit in period of sale downstream30
Deferral of Intercompany Profitin Period of Sale: Downstream

$15,000 – $6,250 = $8,750

Cost

$8,750 × 40% = $3,500

$15,000 × 40% = $6,000

Unrealized profit

$6,000 – $3,500 = $2,500

deferral of intercompany profit in period of sale downstream31
Deferral of Intercompany Profitin Period of Sale: Downstream

Porter’s Books

Investment in Sorter 9,000

Income from Sorter 9,000

To record share of Sorter’s income

Income from Sorter 2,500

Investment in Sorter 2,500

To eliminate unrealized profit on sales to Sorter

partial working papers december 31 2003
Partial Working PapersDecember 31, 2003

Adjustments/ Consol-

Porter Shorter Eliminations idated

Income Statement

Sales

Income from Sorter

Cost of goods sold

Expenses

Minority interest expense

($10,000 × 10%)

Net income

Balance Sheet

Inventory

Investment in Sorter

$100

6.5

(60)

(15)

$ 31.5

XXX

$50

(35)

(5)

$10

$ 7.5

Dr. Cr.

a 15

c 6.5

b 2.5 a 15

b 2.5

c 6.5

$135

(82.5)

(20)

(1)

$ 31.5

$ 5

learning objective 4
Learning Objective 4

Recognize realized, previously

deferred inventory profits in

the beginning inventory of

either the parent or subsidiary.

recognition of intercompany profit upon sale to outside entities
Recognition of Intercompany Profitupon Sale to Outside Entities

Now assume that the merchandise acquired from

Porter during 2003 is sold by Sorter during 2004.

There are no intercompany transactions

between Porter and Sorter during 2004.

recognition of intercompany profit upon sale to outside entities35
Recognition of Intercompany Profitupon Sale to Outside Entities

90%-owned

Porter Sorter

Sales $120 $60

Cost of sales 80 40

Gross profit $ 40 $20

Expenses 20 5

Operating income $ 20 $15

Income from Sorter 13.5 –

Net income $ 33.5 $15

This is before considering $2,500 unrealized profit in BI.

recognition of intercompany profit upon sale to outside entities36
Recognition of Intercompany Profitupon Sale to Outside Entities

Porter’s Books

Investment in Sorter 13,500

Income from Sorter 13,500

To record investment income from Sorter

Investment in Sorter 2,500

Income from Sorter 2,500

To record realization of profit from

intercompany sales to Sorter

partial working papers december 31 200337
Partial Working PapersDecember 31, 2003

Adjustments/ Consol-

Porter Shorter Eliminations idated

Income Statement

Sales

Income from Sorter

Cost of goods sold

Expenses

Minority interest expense

($15,000 × 10%)

Net income

Balance Sheet

Investment in Sorter

$120

16

(80)

(20)

$ 36

XXX

$60

(40)

(5)

$15

Dr. Cr.

b 16

a 2.5

a 2.5 b 16

$180

(117.5)

(25)

(1.5)

$ 36

learning objective 5
Learning Objective 5

Adjust the calculations of minority

interest amounts in the presence

of intercompany inventory profits.

consolidation example intercompany profits downstream sales
Consolidation Example – IntercompanyProfits: Downstream Sales

Seay Corporation is a 90%-owned

subsidiary of Peak Corporation,

acquired for $94,500 cash on July 1, 2003.

Seay’s net assets at date of acquisition

consisted of $100,000 capital stock

and $5,000 retained earnings.

The cost of Peak’s 90% interest was equal to book

value and fair value of the interest acquired.

consolidation example intercompany profits downstream sales40
Consolidation Example – IntercompanyProfits: Downstream Sales

July 1, 2003

Cost: $105,000 × 90% = $94,500

Minority interest: $105,000 × 10% = $10,500

consolidation example intercompany profits downstream sales41
Consolidation Example – IntercompanyProfits: Downstream Sales

Peak sells inventory items to Seay on a regular basis.

Sales to S in 2007 (cost $15,000), selling price $20,000

Unrealized profit in S’s inventory at 12/31/2006 2,000

Unrealized profit in S’s inventory at 12/31/2007 2,500

Seay’s accounts payable to Peak 12/31/2007 10,000

consolidation example intercompany profits downstream sales42
Consolidation Example – IntercompanyProfits: Downstream Sales

At 12/31/2006 Peak’s investment in Seay

account had a balance of $128,500.

This balance consisted of Peak’s 90%

equity in Seay’s $145,000 net assets on

that date less$2,000 unrealized profit

in Seay’s 12/31/2006 inventory.

consolidation example intercompany profits downstream sales43
Consolidation Example – IntercompanyProfits: Downstream Sales

December 31, 2006

$145,000 × 90% = $130,500

$130,500 – $2,000 = $128,500

consolidation example intercompany profits downstream sales44
Consolidation Example – IntercompanyProfits: Downstream Sales

December 31, 2006

Seay’s equity:

Common stock $100,000

Retained earnings 45,000

Net assets $145,000

$45,000 – $5,000 = $40,000 increase in RE

$40,000 – $4,000 (minority interest) = $36,000

consolidation example intercompany profits downstream sales45
Consolidation Example – IntercompanyProfits: Downstream Sales

During 2007, Peak made the following entries

on its books for the investment in Seay:

Cash 9,000

Investment in Seay 9,000

To record dividends from Seay ($10,000 × 90%)

Investment in Seay 26,500

Income from Seay 26,500

To record income from Seay for 2007

consolidation example intercompany profits downstream sales46
Consolidation Example – IntercompanyProfits: Downstream Sales

December 31, 2007

Equity in Seay’s net income: ($30,000 × 90%) $27,000

Add: Inventory profits recognized in 2007 2,000

Deduct: Inventory profits deferred at year end – 2,500

Total $26,500

consolidation example intercompany profits downstream sales47
Consolidation Example – IntercompanyProfits: Downstream Sales

Peak’s Investment

94,500

36,000

128,500

2,000

27,000

146,000

2,000

2,500

9,000

12/31/2006

Dividends

12/31/2007

consolidation example intercompany profits downstream sales48
Consolidation Example – IntercompanyProfits: Downstream Sales

Minority Interest

1,000

10,500

4,000

14,500

3,000

16,500

12/31/2006

Dividends

12/31/2007

consolidation example intercompany profits upstream sales
Consolidation Example – IntercompanyProfits: Upstream Sales

Smith Corporation is an 80%-owned subsidiary

of Poch Corporation, acquired for $480,000

cash on January 2, 2003.

Smith’s stockholders’ equity consisted of

$500,000 capital stock and $100,000

retained earnings.

The cost of Poch’s 80% interest was equal to

book value and fair value of the interest acquired.

consolidation example intercompany profits upstream sales50
Consolidation Example – IntercompanyProfits: Upstream Sales

Smith sells inventory items to Poch on a regular basis.

Sales to P in 2004 $300,000

Unrealized profit in P’s inventory at 12/31/2003 40,000

Unrealized profit in P’s inventory at 12/31/2004 30,000

Intercompany A/R and A/P at 12/31/2004 50,000

consolidation example intercompany profits upstream sales51
Consolidation Example – IntercompanyProfits: Upstream Sales

At December 31, 2003, Poch’s investment in

Smith had an account balance of $568,000.

This balance consisted of $600,000 underlying

equity in Smith’s net assets ($750,000 × 80%)

less$32,000 unrealized profit in Poch’s

December 31, 2003, inventory.

consolidation example intercompany profits upstream sales52
Consolidation Example – IntercompanyProfits: Upstream Sales

During 2004, Poch made the following entries

on its books for the investment in Smith.

Cash 40,000

Investment in Smith 40,000

To record dividends from Smith ($50,000 × 80%)

Investment in Smith 88,000

Income from Smith 88,000

To record income from Smith for 2004

consolidation example intercompany profits upstream sales53
Consolidation Example – IntercompanyProfits: Upstream Sales

December 31, 2004

Equity in Smith’s net income ($100,000 × 80%) $80,000

Add: 80% of $40,000 unrealized profit

deferred in 2003 32,000

Less: 80% of $30,000 unrealized profit

at December 31, 2004 –24,000

Total $88,000

consolidation example intercompany profits upstream sales54
Consolidation Example – IntercompanyProfits: Upstream Sales

Poch’s Investment

480,000

Income

568,000

32,000

80,000

616,000

32,000

40,000

24,000

Dividends

12/31/2003

12/31/2004