Advanced Accounting by Debra Jeter and Paul Chaney

Advanced Accounting by Debra Jeter and Paul Chaney Chapter 6: Elimination of Unrealized Profit on Intercompany Sales of Inventory Slides Authored by Hannah Wong, Ph. D. Rutgers University 6 -0

Intercompany Sales of Inventory Parent Company Downstream Sale Upstream Sale Subsidiary Horizontal Sale obj 1 6 -1

Financial Reporting Objectives l Consolidated sales = sales with parties outside the affiliated group l Consolidated COGS = cost to the affiliated group of goods that have been sold to outside parties l Consolidated inventory = inventory at its cost to the affiliated group obj 1 6 -2

Financial Reporting Objectives l To present consolidated balances of sales, cost of sales, and inventory as if the intercompany sale had never occurred. obj 1 6 -3

Downstream Sales : No Unrealized Profit Outsider Supplier Purchased for $200, 000 Parent Company Sold for $250, 000 Sold for $270, 000 Subsidiary obj 2 Outside Customer 6 -4

Downstream Sales No Unrealized Profit - EE Sales 250, 000 Purchases To eliminate intercompany sale that the parent has recorded obj 2 250, 000 To eliminate intercompany purchase that the subsidiary has recorded 6 -5

Downstream Sales: Unrealized Profit in Ending Inventory Outsider Supplier Purchased for $200, 000 Parent Company Sold for $250, 000 Note: it is the parent who records the intercompany profit, thus the parent’s income needs to be adjusted in consolidation obj 2 Sold 60% of goods Subsidiary Outside Customer 6 -6

Downstream Sales - EE Year of Intercompany Sales 250, 000 Purchases 250, 000 To eliminate intercompany sale and purchases Ending Inventory - Inc. state. (COGS) Inventory - balance sheet To exclude the unrealized profit from consolidated net income obj 2 20, 000 To exclude the unrealized profit from ending inventory 6 -7

Downstream Sales - EE Year after Intercompany Sale Cost or Partial Equity Methods Beginning R/E - P 20, 000 Beginning Inventory - Inc. State. (Cost of sales) 20, 000 The intercompany profit in beginning inventory is excluded from last year’s consolidated NI, hence this year’s 1/1 R/E obj 2 To include the intercompany profit in beginning inventory, which is realized in the current year 6 -8

Downstream Sales - EE Year after Intercompany Sale Complete Equity Method Investment in S 20, 000 Beginning Inventory - Inc. State. (Cost of sales) 20, 000 obj 2 The intercompany profit in beginning inventory is excluded from last year’s consolidated NI, hence the investment account To include the intercompany profit in beginning inventory, which is realized in the current year 6 -9

Amount of Intercompany Profit Gross profit method intercompany profit that should be eliminated = ending inventory of buying affiliate x selling affiliate’s gross profit rate (i. e. , gross profit / cost) obj 2 6 - 10

Elimination of Downstream Intercompany Profit l 100% elimination the parent’s and the noncontrolling stockholders’ portion of intercompany profit n eliminate despite partial ownership of the parent n required by current GAAP l Partial elimination only the parent’s portion of intercompany profit n eliminate obj 3 6 - 11

Upstream Sales Outsider Supplier Purchase Note: it is the subsidiary who records the intercompany profit, thus the subsidiary’s income needs to be adjusted in consolidation obj 4 Subsidiary Intercompany Sale Parent Company Sell Outside Customer 6 - 12

Upstream Sales An Example Profit margin = 25% x selling price obj 4, 5 80% owned Subsidiary Total sales $700, 000 Parent Company $400, 000 intercompany merchandise in ending inventory 6 - 13

Upstream Sales Cost or Partial Equity Methods Year of Intercompany Sale - EE’s Sales 700, 000 Purchases 700, 000 To eliminate intercompany sale and purchases Ending Inventory - Inc. state. (COGS) Inventory - balance sheet To exclude the unrealized profit (400, 000 x 25%) from consolidated net income obj 4, 5 100, 000 To exclude the unrealized profit from ending inventory 6 - 14

Upstream Sales - EE Cost or Partial Equity Methods Year after Intercompany Sale - EE’s Parent’s share of unrealized profit in beginning inventory Beginning R/E - P ($100, 000 x 80%) 80, 000 Beginning R/E - S ($100, 000 x 20%) 20, 000 Beginning Inventory - Inc. State. (Cost of sales) 100, 000 Noncontrolling interests’ share of unrealized profit in beginning inventory obj 4, 5 To include the intercompany profit in beginning inventory, which is realized in the current year 6 - 15

Cost or Partial Equity Methods Noncontrolling Interest in Income Reported income of S Upstream-sale profit in ending inventory Upstream-sale profit in beginning inventory Adjusted NI of S x Noncontrolling % Noncontrolling interest in income obj 4, 5 6 - 16

Cost and Partial Equity Methods Controlling Interest in Income Downstream-sale profit in ending inventory Reported income of P Amortization of purchase differential Downstream-sale profit in beginning inventory (Adjusted NI of S) x (P %) Consolidated income obj 4, 5 6 - 17

Cost and Partial Equity Methods Consolidated Retained Earnings P% x (Upstream-sale profit in P’s ending inventory) Downstream-sale profit in S’s ending inventory Accumulative amortization of purchase differential Reported R/E of P P’s share of increase in S R/E since acquisition Consolidated R/E obj 4, 5 6 - 18

Upstream Sales Complete Equity Method Year of Intercompany Sales - Journal Entries Equity in subsidiary income Investment in S 80, 000 To exclude the unrealized profit (400, 000 x 25%) from equity in subsidiary income obj 4, 5 6 - 19

Upstream Sales Complete Equity Method Year after Intercompany Sales - Journal Entries Investment in S Equity in subsidiary net income 80, 000 To include in equity in subsidiary income the intercompany profit, which is realized in the current year obj 4, 5 6 - 20

Upstream Sales Complete Equity Method Year of Intercompany Sales - EE’s Sales 700, 000 Purchases 700, 000 To eliminate intercompany sale and purchases Ending Inventory - Income Statement Inventory - Balance Sheet 100, 000 To exclude the unrealized profit (400, 000 x 25%) from equity in subsidiary income obj 4, 5 6 - 21

Upstream Sales Complete Equity Method Year after Intercompany Sale - EE Parent’s share of unrealized profit in beginning inventory Investment in S Beginning retained earnings - S 1/1 Inventory - Income Statement Noncontrolling interests’ share of unrealized profit in beginning inventory obj 4, 5 80, 000 20, 000 100, 000 To include the intercompany profit in beginning inventory, which is realized in the current year 6 - 22

Upstream Sales Complete Equity Method Consolidated net income = Reported net income of Parent Consolidated retained earnings = Reported retained earnings of Parent obj 4, 5 6 - 23

Add Excel for L 06 obj 6 6 - 24

Preaffiliation Profit Should We Eliminate? l GAAP is silent as to elimination of preaffiliation profit. l If selling company is the subsidiary, the retained earning is eliminated in consolidation. l If selling company is the parent, elimination would cause double counting of profit. obj 7 6 - 25

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