6 Elimination of Unrealized Profit on Intercompany Sales

6 Elimination of Unrealized Profit on Intercompany Sales of Inventory Advanced Accounting, Fifth Edition Slide 6 -1

Learning Objectives Slide 6 -2 1. Describe the financial reporting objectives for intercompany sales of inventory. 2. Determine the amount of intercompany profit, if any, to be eliminated from the consolidated statements. 3. Understand the concept of eliminating 100% of intercompany profit not realized in transactions with outsiders, and know the authoritative position. 4. Distinguish between upstream and downstream sales of inventory. 5. Compute the noncontrolling interest in consolidated net income for upstream and downstream sales, when not all the inventory has been sold to outsiders. 6. Prepare consolidated workpapers for firms with upstream and downstream sales using the cost, partial equity, and complete equity methods. 7. Discuss the treatment of intercompany profit earned prior to the parent subsidiary affiliation.

Upstream and Downstream Sales of Inventory Company P P sells inventory Downstream Company S 1 S 2 sells inventory Upstream S 1 sells inventory Horizontal Company S 2 Consolidated Entity Profit (loss) that has not been realized through subsequent sales to third parties is defined as unrealized intercompany profit (loss) and must be eliminated in the preparation of consolidated financial statements. Slide 6 -3 LO 4 Upstream and downstream sales.

Effects of Intercompany Sales of Merchandise on the Determination of Consolidated Balances The financial reporting objectives are: Ø Consolidated sales include only sales with parties outside the affiliated group. Ø Consolidated cost of sales includes only the cost to the affiliated group of goods that have been sold to parties outside the affiliated group. Ø Consolidated inventory on the balance sheet is recorded at its cost to the affiliated group. Objective is to eliminate the effects of intercompany sales as if they had never occurred. Slide 6 -4 LO 1 Financial reporting objectives for intercompany sales.

Intercompany Sales of Merchandise Downstream Sales Determination of Consolidated Sales, Cost of Sales, and Inventory Balances Assuming Downstream Sales E 6 -7: (Downstream Sales-variation) Perkins Company owns 85% of Sheraton Company. Perkins Company sells merchandise to Sheraton Company at 20% above cost. During 2011 and 2012, such sales amounted to $450, 000 and $486, 000, respectively. At the end of each year, Sheraton Company had sold all of inventory purchased from Perkins to third parties. Required: Prepare the workpaper entries necessary to eliminate the effects of the intercompany sales for 2011. Slide 6 -5 LO 6 Consolidated workpapers for downstream sales.

Intercompany Sales of Merchandise Downstream Sales E 6 -7: Summary of 2011 Intercompany Sales 1. The “Total” column represents the Sales and COGS booked by Perkins to record the sale to Sheraton. The Sales amount also represents the cost of the inventory recorded by Sheraton. 2. The “Resold” column represents intercompany inventory that was resold to third parties. Portions resold are recorded in COGS. 3. “On Hand” represents intercompany inventory still on hand in Slide 6 -6 the affiliated group. LO 6 Consolidated workpapers for downstream sales.

Intercompany Sales of Merchandise Downstream Sales E 6 -7: Summary of 2011 Intercompany Sales Prepare the workpaper entry to eliminate intercompany sales for 2011. Sales Cost of Goods Sold (Purchases) 450, 000 To eliminate intercompany sales of merchandise Slide 6 -7 LO 6 Consolidated workpapers for downstream sales.

Intercompany Sales of Merchandise Downstream Sales Determination of Consolidated Sales, Cost of Sales, and Inventory Balances Assuming Downstream Sales E 6 -7: (Downstream Sales) Perkins Company owns 85% of Sheraton Company. Perkins Company sells merchandise to Sheraton Company at 20% above cost. During 2011 and 2012, such sales amounted to $450, 000 and $486, 000, respectively. At the end of each year, Sheraton Company had in its inventory one-third of the amount of goods purchased from Perkins during that year. Required: Prepare the workpaper entries necessary to eliminate the effects of the intercompany sales for 2011 and 2012. Slide 6 -8 LO 6 Consolidated workpapers for downstream sales.

Intercompany Sales of Merchandise Downstream Sales E 6 -7: Summary of 2011 Intercompany Sales Prepare the workpaper entry to eliminate intercompany sales for 2011. Sales Cost of Goods Sold (purchases) Cost of Goods Sold (ending inventory) Inventory 450, 000 25, 000 To eliminate intercompany sales and defer unrealized profit Slide 6 -9 LO 6 Consolidated workpapers for downstream sales.

Intercompany Sales of Merchandise Downstream Sales E 6 -7: Alternate View Workpaper entry to eliminate intercompany sales for 2011. Sales 1 Cost of Goods Sold 2 Inventory 3 1. 2. 3. Slide 6 -10 450, 000 375, 000 50, 000 25, 000 Original Sales and COGS recorded by Perkins (parent) is reversed. COGS overstated by Sheraton on resale of goods to third parties. Inventory on hand is overstated on Sheraton’s books by $25, 000 unrealized profit. LO 6 Consolidated workpapers for downstream sales.

Intercompany Sales of Merchandise Downstream Sales E 6 -7: Prepare the workpaper entry to eliminate intercompany sales for 2012. 2011 Unrealized Profit in Inventory Cost or Partial Equity Method * Retained earnings Cost of Goods Sold (beg. inventory) 25, 000 To realize the gross profit in inventory deferred in the prior period. * If the complete equity method is used, the debit is to the Investment account. Slide 6 -11 LO 6 Consolidated workpapers for downstream sales.

Intercompany Sales of Merchandise Downstream Sales E 6 -7: Prepare the workpaper entry to eliminate intercompany sales for 2012 Intercompany Sales Cost of Goods Sold (purchases) Cost of Goods Sold (ending inventory) Inventory 486, 000 27, 000 To eliminate intercompany sales and defer unrealized profit Slide 6 -12 LO 6 Consolidated workpapers for downstream sales.

Intercompany Sales of Merchandise Determination of Amount of Intercompany Profit Gross profit may be stated either as a percentage of sales or as a percentage of cost. When stated as a percentage of cost, it is referred to as “markup”. Inventory Pricing Adjustments The amount of intercompany profit subject to elimination should be reduced to the extent that the related goods have been written down by the purchasing affiliate. Slide 6 -13 LO 2 Determining the amount of intercompany profit.

Intercompany Sales of Merchandise Determination of Proportion of Intercompany Profit to Be Eliminated “The amount of intercompany profit or loss to be eliminated. . . is not affected by the existence of a minority [noncontrolling] interest. The complete elimination of the intercompany profit or loss is consistent with the underlying assumption that consolidated statements represent the financial position and operating results of a single business enterprise. ” [FASB ASC paragraph 810 -10 -45 -18] Slide 6 -14 LO 3 Eliminating 100% of intercompany profit.

Cost Method: Consolidated Statements Workpaper—Upstream Sales Determination of the Noncontrolling Interest in Combined Income—Upstream or Horizontal Sales Modification of the calculation of the noncontrolling interest is applicable only when the subsidiary is the selling affiliate (upstream or horizontal sales). Where the parent company is the selling affiliate (downstream sale), no adjustment is necessary in the calculation of the noncontrolling interest in consolidated net income. Slide 6 -15 LO 5 Noncontrolling interest (NCI) for upstream sales.

Cost Method: Consolidated Workpaper Upstream Sales P 6 -7: Paque Corporation owns 90% of the common stock of Segal Company. The stock was purchased for $810, 000 on January 1, 2009, when Segal Company’s retained earnings were $150, 000. The January 1, 2013, inventory of Paque Corporation includes $45, 000 of profit recorded by Segal Company on 2012 sales. During 2013, Segal Company made intercompany sales of $300, 000 with a markup of 20% of selling price. The ending inventory of Paque Corporation includes goods purchased in 2013 from Segal Company for $75, 000. Required: Prepare the worksheet entries and the consolidated statements workpaper for the year ended December 31, 2013. Slide 6 -16 LO 6 Consolidated workpapers for upstream Sales- Cost Method.

Upstream Sales Cost Method: Consolidated Workpaper P 6 -7: Prepare the worksheet entries for Dec. 31, 2013. Acquisition date retained earnings - Segal Retained earnings 1/1/13 - Segal Increase Ownership percentage 1. Investment in Segal $ 150, 000 180, 000 30, 000 90% $ 27, 000 Beg. Retained Earnings ‑ Pague Co. 27, 000 To establish reciprocity/convert to equity as of 1/1/2013. Slide 6 -17 LO 6 Consolidated workpapers for upstream Sales- Cost Method.

Upstream Sales Cost Method: Consolidated Workpaper P 6 -7: Prepare the worksheet entries for Dec. 31, 2013 Intercompany Sales 2. Sales Cost of Goods Sold (purchases) 3. Cost of Good Sold (ending inventory) Inventory 300, 000 15, 000 To eliminate intercompany sales and defer unrealized profit Slide 6 -18 LO 6 Consolidated workpapers for upstream Sales- Cost Method.

Cost Method: Consolidated Workpaper Upstream Sales P 6 -7: Prepare the worksheet entries for Dec. 31, 2013. 2012 Unrealized Profit in Inventory 4. Retained Earnings ($45, 000 x 90%) Noncontrolling Interest ($45, 000 x 10%) Cost of Goods Sold (beg. inventory) 40, 500 45, 000 To realize the gross profit in inventory deferred in the prior period. Slide 6 -19 LO 6 Consolidated workpapers for upstream Sales- Cost Method.

Cost Method: Consolidated Workpaper Upstream Sales P 6 -7: Prepare the worksheet entries for Dec. 31, 2013. 5. Dividend Income ($60, 000 x 90%) 54, 000 Dividends Declared 54, 000 To eliminate intercompany dividends 6. Beg. Retained Earnings - Segal Common Stock - Segal 180, 000 750, 000 Investment in Segal Noncontrolling Interest 837, 000 93, 000 To eliminate investment account and create NCI account Slide 6 -20 LO 6 Consolidated workpapers for upstream Sales- Cost Method.

Cost Method: Consolidated Workpaper Upstream Sales P 6 -7: (2) (5) (3) (2) (4) (1) (6) (5) NCI in Consolidated Income = 10% ($71, 250 + $45, 000 – $15, 000) = $10, 125 Slide 6 -21 LO 6 Consolidated workpapers for upstream Sales- Cost Method.

Cost Method: Consolidated Workpaper Upstream Sales P 6 -7: (3) (1) (6) (4) Slide 6 -22 (6) LO 6 Consolidated workpapers for upstream Sales- Cost Method.

Cost Method—Analysis of Consolidated Net Income and Consolidated Retained Earnings Consolidated Net Income Consolidated net income is the parent company’s income from its independent operations that has been realized in transactions with third parties plus (minus) subsidiary income (loss) that has been realized in transactions with third parties plus or minus adjustments for the period relating to the depreciation, amortization, and impairment of differences between implied and book values. Slide 6 -23 LO 6 Consolidated workpapers for upstream Sales- Cost Method.

Cost Method: Consolidated Net Income Upstream Sales P 6 -7: Prepare a calculation of Paque’s share of Segal’s income. Reported income of Segal $ 71, 250 Less: amortization of difference between implied and book value Less: unrealized profit on 2013 sales to Paque Plus: profit on prior year's sales to Paque realized in transactions with third parties in 2013 (15, 000) 45, 000 Subsidiary income included in consolidated income $ 101, 250 Paque's share of Segal’s income ($101, 250 x 90%) $ 91, 125 NCI share of Segal’s income ($101, 250 x 10%) Subsidiary income included in consolidated income Slide 6 -24 0 10, 125 $ 101, 250 LO 6 Consolidated workpapers for upstream Sales- Cost Method.

Cost Method: Consolidated Net Income Upstream Sales P 6 -7: Prepare a calculation of CI in Consolidated Income. Paque's net income $103, 500 Less: subsidiary dividend income (54, 000) Paque's net income from its independent operations 49, 500 Less: unrealized profit on 2013 sales to Segal 0 Plus: profit on prior year's sales to Segal realized in transactions with third parties in 2013 0 Paque's income from independent operations that has been realized in transactions with third parties Paque's share of Segal’s income (previous slide) Controlling interest in Consolidated net income Slide 6 -25 49, 500 91, 125 $140, 625 LO 6 Consolidated workpapers for upstream Sales- Cost Method.

Cost Method—Analysis of Consolidated Net Income and Consolidated Retained Earnings Consolidated retained earnings is the parent’s cost basis retained earnings that has been realized in transactions with third parties plus (minus) the parent’s share of the increase (decrease) in subsidiary retained earnings that has been realized in transactions with third parties from the date of acquisition to the current date plus (minus) the cumulative effect of adjustments to date relating to the amortization, depreciation, and impairment of differences between implied and book values. Slide 6 -26 LO 6 Consolidated workpapers for upstream Sales- Cost Method.

Consolidated Statements Workpaper — Partial Equity Method Reminder: The balances reported by the parent company in income, retained earnings, and the investment account differ depending on the method used by the parent company to record its investment. However, the method used by the parent company to record its investment has no effect on the consolidated balances. Slide 6 -27 LO 6 Consolidated workpapers – partial equity method.

Partial Equity Method: Workpaper Upstream Sales P 6 -13: (Note: This is the same problem as Problem 6 -7, but assuming the use of the partial equity method. ) Paque Corporation owns 90% of the common stock of Segal Company. The stock was purchased for $810, 000 on January 1, 2009, when Segal Company’s retained earnings were $150, 000. The January 1, 2013, inventory of Paque Corporation includes $45, 000 of profit recorded by Segal Company on 2012 sales. During 2013, Segal Company made intercompany sales of $300, 000 with a markup of 20% of selling price. The ending inventory of Paque Corporation includes goods purchased in 2013 from Segal Company for $75, 000. Paque Corporation uses the partial equity method to record its investment in Segal Company. Slide 6 -28 LO 6 Consolidated workpapers – partial equity method.

Upstream Sales Partial Equity Method: Workpaper P 6 -13: Prepare the worksheet entries for Dec. 31, 2013. 1. Equity in Subsidiary Income Investment in Segal Company Dividends declared ($60, 000 x 90%) 64, 125 10, 125 54, 000 To reverse the effect of parent entries for subsidiary dividends and income Slide 6 -29 LO 6 Consolidated workpapers – partial equity method.

Upstream Sales Partial Equity Method: Workpaper P 6 -13: Prepare the worksheet entries for Dec. 31, 2013 Intercompany Sales 2. Sales Cost of Goods Sold (purchases) 3. Cost of Goods Sold (end. inventory) Inventory 300, 000 15, 000 To eliminate intercompany sales and defer unrealized profit Slide 6 -30 LO 6 Consolidated workpapers – partial equity method.

Partial Equity Method: Workpaper Upstream Sales P 6 -13: Prepare the worksheet entries for Dec. 31, 2013. 2012 Unrealized Profit in Inventory 4. Retained Earnings ($45, 000 x 90%) Noncontrolling Interest ($45, 000 x 10%) Cost of Goods Sold (beg. inventory) 40, 500 45, 000 To realize the gross profit in inventory deferred in the prior period. Slide 6 -31 LO 6 Consolidated workpapers – partial equity method.

Partial Equity Method: Workpaper Upstream Sales P 6 -13: Prepare the worksheet entries for Dec. 31, 2013. 5. Beg. Retained Earnings - Segal Common Stock - Segal 180, 000 750, 000 Investment in Segal Noncontrolling Interest 837, 000 93, 000 To eliminate investment account and create NCI account Slide 6 -32 LO 6 Consolidated workpapers – partial equity method.

Upstream Sales Partial Equity Method: Workpaper P 6 -13: (2) (1) (3) (2) (4) (5) (1) NCI in Consolidated Income = 10% ($71, 250 + $45, 000 – $15, 000) = $10, 125 Slide 6 -33 LO 6 Consolidated workpapers – partial equity method.

Upstream Sales Partial Equity Method: Workpaper P 6 -13: (3) (5) (1) (5) (4) Slide 6 -34 (5) LO 6 Consolidated workpapers – partial equity method.

Partial Equity Method—Analysis of Consolidated Net Income and Consolidated Retained Earnings Consolidated Net Income Same as Cost Method Consolidated net income is the parent’s income from its independent operations that has been realized in transactions with third parties plus (minus) subsidiary income (loss) that has been realized in transactions with third parties plus or minus adjustments for the period relating to the depreciation, amortization, and impairment of differences between implied and book values. Slide 6 -35 LO 6 Consolidated workpapers – partial equity method.

Partial Equity Method—Analysis of Consolidated Net Income and Consolidated Retained Earnings When the parent uses the partial equity method, the parent’s share of subsidiary income since acquisition is already included in the parent’s reported retained earnings. Consequently, consolidated retained earnings is calculated as the parent’s recorded partial equity basis retained earnings that has been realized in transactions with third parties plus or minus the cumulative effect of the adjustments to date relating to the depreciation, amortization, and impairment of differences between implied and book values. Slide 6 -36 LO 6 Consolidated workpapers – partial equity method.

Consolidated Retained Earnings Partial Equity P 6 -13: Calculate consolidated retained earnings on Dec. 31, 2013. Paque's Retained Earnings on 12/31/13 $ 802, 125 Unrealized profit on downstream sales 0 Unrealized profit on upstream sales ($15, 000 x 90%) Consolidated retained earnings on 12/31/2013 Slide 6 -37 (13, 500) $ 788, 625 LO 6 Consolidated workpapers – partial equity method.

Complete Equity Method: Workpaper Upstream Sales P 6 -17: (Note: This is the same problem as Problem 6 -7 and 6 -13, but assuming the use of the complete equity method. ) Paque Corporation owns 90% of the common stock of Segal Company. The stock was purchased for $810, 000 on January 1, 2009, when Segal Company’s retained earnings were $150, 000. The January 1, 2013, inventory of Paque Corporation includes $45, 000 of profit recorded by Segal Company on 2012 sales. During 2013, Segal Company made intercompany sales of $300, 000 with a markup of 20% of selling price. The ending inventory of Paque Corporation includes goods purchased in 2013 from Segal Company for $75, 000. Paque Corporation uses the complete equity method to record its investment in Segal Company. Slide 6 -38 LO 6 Consolidated workpapers – complete equity method.

Complete Equity Method: Workpaper Upstream Sales P 6 -17: Prepare the worksheet entries for Dec. 31, 2013. 1. Equity in Subsidiary Income Investment in Segal Company Dividends declared ($60, 000 x 90%) 91, 125 37, 125 54, 000 To reverse the effect of parent company entries for subsidiary dividends and income Slide 6 -39 LO 6 Consolidated workpapers – complete equity method.

Upstream Sales Complete Equity Method: Workpaper P 6 -17: Prepare the worksheet entries for Dec. 31, 2013 Intercompany Sales 2. Sales Cost of Goods Sold (purchases) 3. Cost of Goods Sold (end. inventory) Inventory 300, 000 15, 000 To eliminate intercompany sales and defer unrealized profit Slide 6 -40 LO 6 Consolidated workpapers – complete equity method.

Complete Equity Method: Workpaper Upstream Sales P 6 -17: Prepare the worksheet entries for Dec. 31, 2013. 2012 Unrealized Profit in Inventory 4. Retained earnings ($45, 000 x 90%) Noncontrolling Interest ($45, 000 x 10%) Cost of Goods Sold (beg. inventory) 40, 500 45, 000 To realize the gross profit in inventory deferred in the prior period Slide 6 -41 LO 6 Consolidated workpapers – complete equity method.

Complete Equity Method: Workpaper Upstream Sales P 6 -17: Prepare the worksheet entries for Dec. 31, 2013. 5. Beg. Retained Earnings - Segal Common Stock - Segal 180, 000 750, 000 Investment in Segal Noncontrolling Interest 837, 000 93, 000 To eliminate investment account and create NCI account Slide 6 -42 LO 6 Consolidated workpapers – complete equity method.

Upstream Sales Complete Equity Method: Workpaper P 6 -17: (2) (1) (3) (2) (4) (5) (1) NCI in Consolidated Income = 10% ($71, 250 + $45, 000 – $15, 000) = $10, 125 Slide 6 -43 LO 6 Consolidated workpapers – complete equity method.

Upstream Sales Complete Equity Method: Workpaper P 6 -17: (3) (4) (5) (1) (5) (4) Slide 6 -44 (5) LO 6 Consolidated workpapers – complete equity method.

Complete Equity Method—Analysis of Consolidated Net Income and Consolidated Retained Earnings Under the complete equity method: Ø Consolidated net income equals the parent company’s recorded income. Ø Consolidated retained earnings equals the parent company’s recorded retained earnings. Slide 6 -45 LO 6 Consolidated workpapers – complete equity method.

Summary of Workpaper Entries To eliminate intercompany sales: All Methods Illustration 6 -21 Parent Selling (Downstream) Sales X Purchases (Cost of Sales) X To eliminate intercompany profit in ending inventory: All Methods Ending Inventory (Cost of Sales) Inventory (Balance Sheet) X X To recognize intercompany profit in beginning inventory realized during the year: Cost or Partial Equity Methods Beg. Retained Earnings—Parent Beg. Inventory - Income X X Statement (Cost of Sales) Complete Equity Method Investment in S Company Beg. Inventory - Income Statement (Cost of Sales) Slide 6 -46 X X

Summary of Workpaper Entries To eliminate intercompany sales: All Methods Illustration 6 -21 Subsidiary Selling (Upstream) Sales X Purchases (Cost of Sales) X To eliminate intercompany profit in ending inventory: All Methods Ending Inventory (Cost of Sales) Inventory (Balance Sheet) X X To recognize intercompany profit in beginning inventory realized during the year: Cost or Partial Equity Methods Complete Equity Method Slide 6 -47 Beg. Retained Earnings—Parent NCI in Equity Cost of Sales (beg. inventory) X X Investment in S Company NCI in Equity Cost of Sales (beg. inventory) X X

Intercompany Profit Prior To Parent– Subsidiary Affiliation Generally accepted accounting standards are silent as to the appropriate treatment of unrealized profit on assets that result from sales between companies prior to affiliation (preaffiliation profit). The question is whether preaffiliation profit should be eliminated in consolidation. In our opinion, workpaper entries eliminating preaffliation profit are inappropriate. Slide 6 -48 LO 7 Intercompany profit prior to affiliation.

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