Chapter 5 Intercompany Profit Transactions Inventories by Jeanne

Chapter 5: Intercompany Profit Transactions – Inventories by Jeanne M. David, Ph. D. , Univ. of Detroit Mercy to accompany Advanced Accounting, 10 th edition by Floyd A. Beams, Robin P. Clement, Joseph H. Anthony, and Suzanne Lowensohn © Pearson Education, Inc. publishing as Prentice Hall 5 -1

Intercompany Profits – Inventories: Objectives 1. Understand the impact of intercompany profit for inventories on preparation of consolidation working papers. 2. Apply the concepts of upstream versus downstream inventory transfers. 3. Defer unrealized inventory profits remaining in ending inventory of either the parent or subsidiary. © Pearson Education, Inc. publishing as Prentice Hall 5 -2

Objectives (cont. ) 4. Recognize realized, previously deferred inventory profits in the beginning inventory of either the parent or subsidiary. 5. Adjust the calculations of noncontrolling interest amounts in the presence of intercompany inventory profits. © Pearson Education, Inc. publishing as Prentice Hall 5 -3

Intercompany Profit Transactions – Inventories 1: Intercompany Inventory Profits © Pearson Education, Inc. publishing as Prentice Hall 5 -4

Intercompany Transactions • For consolidated financial statements, ARB No. 51 (as amended by FASB Statement No. 160) states: – "intercompany balances and transactions shall be eliminated. " • Show income and financial position as if the intercompany transactions had never taken place. © Pearson Education, Inc. publishing as Prentice Hall 5 -5

Intercompany Sales of Inventory • Profits on intercompany sales of inventory – All recognized if goods have been resold to outsiders – Deferred if the goods are still held in inventory • Previously deferred profits in beginning inventory are recognized • Consider a FIFO inventory system – Beginning inventories are sold – Ending inventories are from current period © Pearson Education, Inc. publishing as Prentice Hall 5 -6

No Intercompany Profits in Inventories • During 2009, Pretty sold goods costing $1, 000 to its subsidiary, Simple, at a gross profit of 30%. Simple had none of this inventory on hand at the end of 2009. Worksheet entry for 2009: Sales Cost of sales Sales = $1, 000 / (1 -30%) = $1, 429 • All intercompany sales of inventories have been resold to outside parties, so remove the full sales price from both sales and cost of sales. – Pretty's sales are reduced $1, 429. – Simple's cost of sales are reduced $1, 429. • The same entry is used if Simple sells to Pretty. © Pearson Education, Inc. publishing as Prentice Hall 5 -7

Intercompany Profits Only in Ending Inventories • Last year, 2009, Paul sold goods costing $500 to its subsidiary, Sal, at a gross profit of 25%. Sal had none of this inventory on hand at the end of 2009. • During 2010, Paul sold additional goods costing $900 to Sal at a gross profit of 40%. Sal has $200 of these goods on hand at 12/31/2010. Worksheet entries for 2010: Sales Cost of sales Sales = $900 / (1 -40%) = $1, 500 Cost of sales Inventory Ending inventory profit = $200 x 40% © Pearson Education, Inc. publishing as Prentice Hall 1, 500 80 80 5 -8

Intercompany Profits Beginning and Ending Inventories Last year, 2009, Pam sold goods costing $300 to its subsidiary, Sir, at mark-up of 25%. Sir had $120 of this inventory on hand at the end of 2009. During 2010, Pam sold additional goods costing $500 to Sir at a 30% mark-up. Sir has $260 of these goods on hand at 12/31/2010. Worksheet entries for 2010: Sales 650 Cost of sales 650 Sales = $500 + 30%($500) = $650 Cost of sales Inventory 60 Ending inv. profits = $260 x 30%/130% Investment in Subsidiary Cost of sales 24 Begin. inv. profits = $120 x 25%/125% = $24 © Pearson Education, Inc. publishing as Prentice Hall 5 -9

Intercompany Profit Transactions – Inventories 2: Upstream & Downstream Inventory Sales © Pearson Education, Inc. publishing as Prentice Hall 5 -10

Upstream and Downstream Sales Parent Subsidiary sells to parent Parent sells to subsidiary Subsidiary 1 Subsidiary 2 Subsidiary 3 Upstream Sales © Pearson Education, Inc. publishing as Prentice Hall 5 -11

Intercompany Inventory Sales • The worksheet entries for eliminating intercompany profits for downstream sales Sales Cost of sales XXX For the intercompany sales price Cost of sales Inventory XX For the profits in ending inventory Investment in Subsidiary Cost of sales XX For the profits in beginning inventory For upstream sales, the last entry would also include a debit to noncontrolling interest, splitting the profit to be realized between controlling and noncontrolling interests. © Pearson Education, Inc. publishing as Prentice Hall 5 -12

Data for Example • For the year ended 12/31/2011: – Subsidiary income is $5, 200 – Subsidiary dividends are $3, 000 – Current amortization of acquisition price is $450 • Intercompany (IC) sales information: – IC sales during 2011 were $650 – IC profits in ending inventory $60 – IC profit in beginning inventory $24 © Pearson Education, Inc. publishing as Prentice Hall 5 -13

Income Sharing with Downstream Sales – PARENT Makes Sale Subsidiary net income $5, 200 Current amortizations (450) Adjusted income $4, 750 Defer profits in EI (60) Recognize profits in BI 24 Income recognized $4, 714 Subsidiary dividends CI 80% share $3, 800 (60) 24 $3, 764 Income from subsidiary $2, 400 NCI 20% share $3, 000 When parent makes the IC sale, the impact of deferring and recognizing profits falls all to the parent. © Pearson Education, Inc. publishing as Prentice Hall $950 $600 5 -14

Income Sharing with Upstream Sales – SUBSIDIARY Makes Sale Subsidiary net income $5, 200 Current amortizations (450) Adjusted income $4, 750 Defer profits in EI (60) Recognize profits in BI 24 Income recognized $4, 714 Subsidiary dividends $3, 000 When subsidiary makes the IC sale, the impact of deferring and recognizing profits is split among controlling and noncontrolling interests. © Pearson Education, Inc. publishing as Prentice Hall CI 80% share $3, 800 (48) 19. 2 $3, 771. 2 Income from subsidiary $2, 400 NCI 20% share $950. 0 (12. 0) 4. 8 $942. 8 $600 5 -15

Intercompany Profit Transactions – Inventories 3: Unrealized Profits in Ending Inventories © Pearson Education, Inc. publishing as Prentice Hall 5 -16

Ending Inventory on Hand • Intercompany profits in ending inventory – Eliminate at year end • Working paper entry Cost of sales XXX Inventories XXX For the unrealized profit © Pearson Education, Inc. publishing as Prentice Hall 5 -17

Parent Accounting Porter owns 90% of Sorter acquired at book value (no amortizations). During the current year, Sorter reported $10, 000 income. Porter sold goods to Sorter during the year for $15, 000 including a profit of $6, 250. Sorter still holds 40% of these goods at the end of the year. • Unrealized profit in ending inventory 40%(6, 250) = $2, 500 • Porter's Income from Sorter 90%(10, 000) – 2, 500 unreal. Profits = $6, 500 • Noncontrolling interest share 10%(10, 000) = $1, 000 © Pearson Education, Inc. publishing as Prentice Hall 5 -18

Entries • Porter's journal entry to record income Investment in Sorter Income from Sorter 6, 500 • Worksheet entries to eliminate intercompany sale and unrealized profits Sales Cost of sales Inventory © Pearson Education, Inc. publishing as Prentice Hall 15, 000 2, 500 15, 000 2, 500 5 -19

Worksheet – Income Statement Porter Sales $100. 0 Income from Sorter 6. 5 Cost of sales (60. 0) Expenses (15. 0) Noncontrolling interest share Controlling interest share $50. 0 (35. 0) (5. 0) $31. 5 $7. 5 DR CR Consol 15. 0 $135. 0 6. 5 0. 0 2. 5 15. 0 (82. 5) (20. 0) 1. 0 (1. 0) $31. 5 There would be a credit adjustment to Inventory for 2. 5 on the balance sheet portion of the worksheet. © Pearson Education, Inc. publishing as Prentice Hall 5 -20

What if? If the sales had been upstream, by Sorter to Porter: • Unrealized profits in ending inventory 40%(6, 250) = $2, 500 • Porter's Income from Sorter 90%(10, 000 – 2, 500) = $6, 750 • Noncontrolling interest share 10%(10, 000 – 2, 500) = $750 • Upstream profits impact both – Controlling interest share – Noncontrolling interest share © Pearson Education, Inc. publishing as Prentice Hall 5 -21

Intercompany Profit Transactions – Inventories 4: Recognizing Profits from Beginning Inventories © Pearson Education, Inc. publishing as Prentice Hall 5 -22

Intercompany Profits in Beginning Inventory Unrealized profits in ending inventory one year Become Profits to be recognized in the beginning inventory of the next year! © Pearson Education, Inc. publishing as Prentice Hall 5 -23

Intercompany Profit Transactions – Inventories 5: Impact on Noncontrolling Interest © Pearson Education, Inc. publishing as Prentice Hall 5 -24

Direction of Sale and NCI The impact of unrealized profits in ending inventory and realizing profits in beginning inventory depends on the direction • Downstream sales – Full impact on parent • Upstream sales – Share impact between parent and noncontrolling interest © Pearson Education, Inc. publishing as Prentice Hall 5 -25

Calculating Income and NCI Downstream sales: Income from sub = CI%(Sub's NI) – Profits in EI + Profits in BI Noncontrolling interest share = NCI%(Sub's NI) Upstream sales: Income from sub = CI%(Sub's NI – Profits in EI + Profits in BI) Noncontrolling interest share = NCI%(Sub's NI – Profits in EI + Profits in BI) © Pearson Education, Inc. publishing as Prentice Hall 5 -26

Upstream Example with Amortization Perry acquired 70% of Salt on 1/1/2009 for $420 when Salt's equity consisted of $200 capital stock and $200 retained earnings. Salt's inventory was understated by $50 and building, with a 20 year life, was understated by $100. Any excess is goodwill. Separate income Dividends 2009 2010 Perry Salt $1, 250 $705 $1, 500 $745 $600 $280 $600 $300 During 2009, Salt sold goods costing $700 to Perry at a 20% markup. $240 of these goods were in Perry's ending inventory. In 2010, Salt sold goods costing $900 to Perry at a 25% markup and Perry still had $100 on hand at the end of the year. © Pearson Education, Inc. publishing as Prentice Hall 5 -27

Analysis and Amortization Cost of 70% of Salt $420 Implied value of Salt 420/. 70 $600 Book value 200 + 200 400 Excess Allocated to: Inventory Building Goodwill $200 Unamort Amort 1/1/09 2009 1/1/10 2010 50 (50) 0 0 100 (5) 95 (5) 50 0 200 (55) 145 (5) © Pearson Education, Inc. publishing as Prentice Hall Unamort 12/31/10 0 90 50 140 5 -28

2009 Income Sharing (Upstream) Salt's net income Current amortizations Adjusted income Defer profits in EI Income recognized $705 (55) $650 CI 70% share $455 ($28) Income from Salt $427 (40) $610 $196 NCI 30% share $195 ($12) $183 Subsidiary dividends $280 $84 © Pearson Education, Inc. publishing as Prentice Hall 5 -29

Perry's 2009 Equity Entries Investment in Salt Cash For acquisition of 70% of Salt Cash Investment in Salt For dividends received Investment in Salt Income from Salt For share of income © Pearson Education, Inc. publishing as Prentice Hall 420 196 427 5 -30

2009 Worksheet Entries 1. Adjust for errors & omissions - none 2. Eliminate intercompany profits and losses Sales 700 Cost of sales 700 Cost of Sales 40 Inventory 40 3. Eliminate income & dividends from sub. and bring Investment account to its beginning balance Income from Salt 427 Dividends 196 Investment in Salt 231 © Pearson Education, Inc. publishing as Prentice Hall 5 -31

2009 Entries (2 of 3) 4. Record noncontrolling interest in sub's earnings & dividends Noncontrolling interest share Dividends Noncontrolling interest 183 84 99 5. Eliminate reciprocal Investment & sub's equity balances Capital stock Retained earnings Inventory Building Goodwill Investment in Salt Noncontrolling interest © Pearson Education, Inc. publishing as Prentice Hall 200 50 100 50 420 180 5 -32

2009 Entries (3 of 3) 6. Amortize fair value/book value differentials Cost of sales Inventory Depreciation expense Building 50 5 5 7. Eliminate other reciprocal balances – none © Pearson Education, Inc. publishing as Prentice Hall 5 -33

2010 Income Sharing (Upstream) Salt's net income $745 Current amortizations (5) Adjusted income $740 Defer profits in EI (20) Realize profits from BI 40 Income recognized $760 Subsidiary dividends $300 CI 70% share $518 ($14) $28 Income from Salt $532 $210 NCI 30% share $222 ($6) $12 $228 $90 © Pearson Education, Inc. publishing as Prentice Hall 5 -34

Perry's 2010 Equity Entries Cash Investment in Salt For dividends received Investment in Salt Income from Salt For share of income © Pearson Education, Inc. publishing as Prentice Hall 210 532 5 -35

2010 Worksheet Entries 1. Adjust for errors & omissions - none 2. Eliminate intercompany profits and losses Sales Cost of sales Cost of Sales Inventory Investment in Salt Noncontrolling interest Cost of sales 900 Income from Salt Dividends Investment in Salt 532 900 20 20 28 12 3. Eliminate income & dividends from sub. and bring Investment account to its beginning balance © Pearson Education, Inc. publishing as Prentice Hall 40 210 322 5 -36

2010 Entries (2 of 3) 4. Record noncontrolling interest in sub's earnings & dividends Noncontrolling interest share Dividends Noncontrolling interest 228 90 138 5. Eliminate reciprocal Investment & sub's equity balances Capital stock Retained earnings Inventory Building Goodwill Investment in Salt Noncontrolling interest © Pearson Education, Inc. publishing as Prentice Hall 200 625 0 95 50 679 291 5 -37

2010 Entries (3 of 3) 6. Amortize fair value/book value differentials Depreciation expense Building 5 5 7. Eliminate other reciprocal balances – none © Pearson Education, Inc. publishing as Prentice Hall 5 -38

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