Chapter 5 Intercompany Profit Transactions Inventories to accompany

Chapter 5: Intercompany Profit Transactions – Inventories to accompany Advanced Accounting, 11 th edition by Beams, Anthony, Bettinghaus, and Smith Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 -1

Intercompany Profits – Inventories: Objectives 1. Understand the impact of intercompany profit in inventories on preparing consolidation workpapers. 2. Apply the concepts of upstream versus downstream inventory transfers. 3. Defer unrealized inventory profits remaining in the ending inventory. 4. Recognize realized, previously deferred, inventory profits in the beginning inventory. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 -2

Objectives (cont. ) 5. Adjust the calculations of noncontrolling interest amounts in the presence of intercompany inventory profits. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 -3

Intercompany Profit Transactions – Inventories 1: INTERCOMPANY INVENTORY PROFITS Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 -4

Intercompany Transactions For consolidated financial statements v “intercompany balances and transactions shall be eliminated. ” [FASB ASC 810 -1045 -1] Show income and financial position as if the intercompany transactions had never taken place. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 -5

Intercompany Sales of Inventory Profits on intercompany sales of inventory v Recognized if goods have been resold to outsiders v Deferred if the goods are still held in inventory Previously deferred profits in beginning inventory are recognized in the period the goods are sold. Assuming FIFO v Beginning inventories are sold v Ending inventories are from current purchases Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 -6

No Intercompany Profits in Inventories During 2011, Pet sold goods costing $1, 000 to its subsidiary, Sim, at a gross profit of 30%. Sim had none of this inventory on hand at the end of 2011. The worksheet entry for 2011: Sales (-R, -SE) 1, 429 Cost of sales (-E, +SE) 1, 429 Eliminate intercompany 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. Pet's sales are reduced $1, 429. Sim's cost of sales are reduced $1, 429. Copyright © 2012 Pearson Education, 5 -7 Inc. Publishing as Prentice Hall The same entry is used if Sim sells to Pet.

Intercompany Profits Only in Ending Inventories Last year, 2011, Pal 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 2011. During 2012, Pal sold additional goods costing $900 to Sal at a gross profit of 40%. Sal has $200 of these goods on hand at 12/31/2012. Worksheet entries for 2012: Sales (-R, -SE) 1, 500 Cost of sales (-E, +SE) 1, 500 Eliminate intercompany sales = $900 / (1 -40%) = $1, 500 Cost of sales (E, -SE) 80 Inventory (-A) 80 Defer profit in ending inventory = $200 x 40% Copyright © 2012 Pearson Education, 5 -8 Inc. Publishing as Prentice Hall

Intercompany Profits Beginning and Ending Inventories Last year, 2011, 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 2011. During 2012, Pam sold additional goods costing $500 to Sir at a 30% mark-up. Sir has $260 of these goods on hand at 12/31/2012. Worksheet entries for 2012: Sales (-R, -SE) Cost of sales (-E, +SE) 650 Eliminate intercompany sales = $500 + 30%($500) = $650 Cost of sales (E, -SE) Inventory (-A) 60 Defer profits in ending inventory = $260 x 30%/130% Investment in Subsidiary (+A) Cost of sales (-E, +SE) 24 Realize profits from beginning inventory = $120 x 25%/125% = $24 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 -9

Intercompany Profit Transactions – Inventories 2: UPSTREAM & DOWNSTREAM INVENTORY SALES Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 -10

Upstream and Downstream Sales Parent sells to subsidiary Subsidiary 1 Parent Subsidiary 2 Subsidiary sells to parent Subsidiary 3 Upstream Sales Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 -11

Intercompany Inventory Sales The worksheet entries for eliminating intercompany profits for downstream sales Sales (-R, -SE) XXX Cost of sales (-E, +SE) XXX For the intercompany sales price Cost of sales (E, -SE) Inventory (-A) XX For the profits in ending inventory Investment in Subsidiary (+A) Cost of sales (-E, +SE) XX For the profits in beginning inventory For upstream sales, the last entry would include a debit to noncontrolling interest, sharing the realized profit between controlling and noncontrolling interests. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 -12

Data for Example For the year ended 12/31/2011: v Subsidiary income is $5, 200 v Subsidiary dividends are $3, 000 v Current amortization of acquisition price is $450 Intercompany (IC) sales information: v IC sales during 2011 were $650 v IC profit in ending inventory $60 v IC profit in beginning inventory $24 Copyright © 2012 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, 71 4 CI 80% share $3, 800 (60) 24 $3, 764 Income from subsidiary $2, 400 When parent makes the IC Subsidiary dividends $3, 000 sale, the impact of deferring and recognizing profits falls all to the parent. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall NCI 20% share $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 When subsidiary makes the IC sale, the impact of deferring and Subsidiary dividends $3, 000 recognizing profits is split among controlling and noncontrolling interests. CI 80% share $3, 800 (48) 19. 2 $3, 771. 2 Income from subsidiary $2, 400 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall NCI 20% share $950. 0 (12. 0) 4. 8 $942. 8 $600 5 -15

Intercompany Profit Transactions – Inventories 3: UNREALIZED PROFITS IN ENDING INVENTORIES Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 -16

Ending Inventory on Hand Intercompany profits in ending inventory v Eliminate at year end Working paper entry Cost of sales (E, -SE) Inventories (-A) For the unrealized profit Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall XXX 5 -17

Parent Accounting Pot owns 90% of Sot acquired at book value (no amortizations). During the current year, Sot reported $10, 000 income. Pot sold goods to Sot during the year for $15, 000 including a profit of $6, 250. Sot still holds 40% of these goods at the end of the year. Unrealized profit in ending inventory 40%(6, 250) = $2, 500 Pot's Income from Sot 90%(10, 000) – 2, 500 unrealized profits = $6, 500 Noncontrolling interest share 10%(10, 000) = $1, 000 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 -18

Entries Pot's journal entry to record income Investment in Sot (+A) Income from Sot (R, +SE) 6, 500 Worksheet entries to eliminate intercompany sale and unrealized profits Sales (-R, -SE) Cost of goods sold (-E, +SE) Cost of goods sold (E, -SE) Inventory (-A) Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 15, 000 2, 500 5 -19

Worksheet – Income Statement Pot Sales Sot $100. 0 $50. 0 Income from Sot 6. 5 Cost of sales (60. 0) Expenses (15. 0) Noncontrolling interest share Controlling interest share (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. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 -20

What if? If the sales had been upstream, by Sot to Pot: Unrealized profits in ending inventory 40%(6, 250) = $2, 500 Pot's Income from Sot 90%(10, 000 – 2, 500) = $6, 750 Noncontrolling interest share 10%(10, 000 – 2, 500) = $750 Upstream profits impact both: v Controlling interest share v Noncontrolling interest share Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 -21

Intercompany Profit Transactions – Inventories 4: RECOGNIZING PROFITS FROM BEGINNING INVENTORIES Copyright © 2012 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! Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 -23

Intercompany Profit Transactions – Inventories 5: IMPACT ON NONCONTROLLING INTEREST Copyright © 2012 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 of the intercompany sales Downstream sales v Full impact on parent Upstream sales v Share impact between parent and noncontrolling interest Copyright © 2012 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) Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 -26

Upstream Example with Amortization Perry acquired 70% of Salt on 1/1/2011 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. 2011 2012 Separate income Dividends Perry Salt $1, 25 $1, 50 0 $705 0 $745 $600 $280 $600 $300 During 2011, Salt sold goods for $700 to Perry at a 20% markup. $240 of these goods were in Perry's ending inventory. In 2012, Salt sold goods for $900 to Perry at a 25% Copyright © 2012 Pearson Education, 5 -27 Inc. Publishing as Prentice Hall markup and Perry still had $100 on hand at the end of

Analysis and Amortization Cost of 70% of Salt $420 Implied value of Salt 420/. 70 $600 Book value 200 + 200 Excess Allocated to: Inventory Building Goodwill 400 $200 Unamor Amor t t Unamort 1/1/11 2011 1/1/12 2012 12/31/12 50 (50) 0 0 0 100 (5) 95 (5) 90 50 200 (55) 145 (5) 140 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 -28

2011 Income Sharing (Upstream) Salt's net income Current amortizations Adjusted income Defer profits in EI Income recognized $705 (55) $650 (40) $610 CI 70% share $455 ($28) Income from Salt $427 $196 NCI 30% share $195 ($12) $183 Subsidiary dividends $280 $84 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 -29

Perry's 2011 Equity Entries Investment in Salt (+A) Cash (-A) For acquisition of 70% of Salt Cash (+A) Investment in Salt (-A) For dividends received Investment in Salt (+A) Income from Salt (R, +SE) For share of income Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 420 196 427 5 -30

2011 Worksheet Entries (1 of 3) 1. Adjust for errors & omissions - none 2. Eliminate intercompany profits and losses Sales (-R, -SE) 700 Cost of sales (-E, +SE) 700 Cost of Sales (E, -SE) 40 Inventory (-A) 40 3. Eliminate income & dividends from sub. and bring Investment account to its beginning balance Income from Salt (-R, -SE) 427 Dividends (+SE) 196 Investment in Salt (-A) 231 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 -31

2011 Entries (2 of 3) 4. Record noncontrolling interest in sub's earnings & dividends Noncontrolling interest share (-SE) Dividends (+SE) Noncontrolling interest (+SE) 183 84 99 5. Eliminate reciprocal Investment & sub's equity balances Capital stock (-SE) Retained earnings (-SE) Inventory (+A) Building (+A) Goodwill (+A) Investment in Salt (-A) Noncontrolling interest (+SE) Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 200 50 100 50 420 180 5 -32

2011 Entries (3 of 3) 6. Amortize fair value/book value differentials Cost of sales (E, -SE) Inventory (-A) Depreciation expense (E, -SE) Building (-A) 50 5 5 7. Eliminate other reciprocal balances – none Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 -33

2012 Income Sharing (Upstream) Salt's net income Current amortizations Adjusted income Defer profits in EI Realize profits from BI Income recognized Subsidiary dividends CI 70% share $518 ($14) $28 Income from Salt $532 $745 (5) $740 (20) 40 $760 $210 NCI 30% share $222 ($6) $12 $228 $300 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall $90 5 -34

Perry's 2012 Equity Entries Cash (+A) Investment in Salt (-A) For dividends received Investment in Salt (+A) Income from Salt (R, +SE) For share of income Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 210 532 5 -35

2012 Worksheet Entries (1 of 3) 1. Adjust for errors & omissions - none 2. Eliminate intercompany profits and losses Sales (-R, -SE) 900 Cost of sales (-E, +SE) Cost of Sales (E, -SE) 20 Inventory (-A) Investment in Salt (+A) 28 Noncontrolling interest (-SE) 12 Cost of sales (-E, +SE) 3. Eliminate income & dividends from sub. and bring Investment account to its beginning balance Income from Salt (-R, -SE) 532 Dividends (+SE) Investment in Salt (-A) Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 900 20 40 210 322 5 -36

2012 Entries (2 of 3) 4. Record noncontrolling interest in sub's earnings & dividends Noncontrolling interest share (-SE) Dividends (+SE) Noncontrolling interest (+SE) 228 90 138 5. Eliminate reciprocal Investment & sub's equity balances Capital stock (-SE) Retained earnings (-SE) Inventory (+A) Building (+A) Goodwill (+A) Investment in Salt (-A) Noncontrolling interest (+SE) Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 200 625 0 95 50 679 291 5 -37

2012 Entries (3 of 3) 6. Amortize fair value/book value differentials Depreciation expense (E, -SE) Building (-A) 5 5 7. Eliminate other reciprocal balances – none Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 -38

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