Intercompany Profit Transactions Inventories Chapter 5 2003 Prentice

Intercompany Profit Transactions – Inventories Chapter 5 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 -1

Learning Objective 1 Understand the impact of intercompany profit for inventories on preparation of consolidation working papers. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 -2

Intercompany Inventory Transactions Revenue on sales between affiliated companies cannot be recognized until merchandise is sold outside of the consolidated entity. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 -3

Intercompany Inventory Transactions Periodic inventory system Perpetual inventory system Sales Purchases Sales Cost of goods sold © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 -4

Elimination of Intercompany Purchases 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. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 -5

Elimination of Intercompany Purchases and Sales 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 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 -6

Elimination of Intercompany Purchases and Sales Cost of Sales 20, 000 Inventory To record cost of sales to Shep Investment 6, 000 Income from Shep To record related equity interest 20, 000 6, 000 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 -7

Elimination of Intercompany Purchases and Sales 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 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 -8

Elimination of Intercompany Purchases and Sales Cost of Sales 24, 000 Inventory 24, 000 To record cost of sales to customers © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 -9

Elimination of Intercompany Purchases and Sales Pint Sales Cost of sales Gross profit 100% Shep Adjustments and Eliminations $24, 000 $30, 000 a 24, 000 20, 000 Consolidated $30, 000 24, 000 a 24, 000 20, 000 $ 4, 000 $ 6, 000 $10, 000 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 10

Elimination of Unrealized Profit 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. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 11

Elimination of Unrealized Profit in Ending Inventory 30, 000 ÷ 36, 000 = 5/6 × 30, 000 = $25, 000 1/6 × 36, 000 = $6, 000 1/6 × 30, 000 = $5, 000 Shep’s inventory Cost to Pint Unrealized profit in EI $6, 000 – 5, 000 $1, 000 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 12

Elimination of Unrealized Profit in Ending Inventory Pint Sales Cost of sales Gross profit Inventory Shep Adjustments and Eliminations $36, 000 $37, 500 a 36, 000 30, 000 Consolidated $37, 500 30, 000 b 1, 000 a 36, 000 25, 000 $ 6, 000 $ 7, 500 $12, 500 $ 6, 000 b 1, 000 $ 5, 000 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 13

Recognition of Unrealized Profit 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. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 14

Recognition of Unrealized Profit in Beginning Inventory 25% × 48, 000 = $12, 000 Ending inventory $12, 000 ÷ 1. 2 = $10, 000 EI transfer price Shep’s inventory Cost to Pint Unrealized profit in EI $12, 000 (10, 000) $ 2, 000 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 15

Recognition of Unrealized Profit in Beginning Inventory $7, 500 – $5, 000 BI = $2, 500 from BI 75% × 48, 000 = $30, 000 $45, 000 – $30, 000 = $15, 000 + $2, 500 = $17, 500 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 16

Recognition of Unrealized Profit in Beginning Inventory Pint Sales Cost of sales Gross profit Inventory Investment in Shep Adjustments and Eliminations $48, 000 $52, 500 a 48, 000 Consolidated $52, 500 40, 000 42, 000 c 2, 000 a 48, 000 b 1, 000 35, 000 $ 8, 000 $10, 500 $17, 500 $12, 000 XXX c 2, 000 $10, 000 b 1, 000 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 17

Learning Objective 2 Apply the concepts of upstream versus downstream inventory transfers. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 18

Downstream and Upstream Sales from top to bottom are downstream. Parent to Subsidiary Sales from bottom to top are upstream. Subsidiary to Parent © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 19

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. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 20

Downstream and Upstream Effects on Income Computations Parent Sales Cost of sales Gross profit Expenses Parent’s separate income Subsidiary’s net income $600 300 $300 100 $200 80%-owned Subsidiary $300 180 $120 70 $ 50 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 21

Downstream and Upstream Effects on Income Computations Intercompany sales during the year are $100, 000. The December 31 inventory includes $20, 000 unrealized profit. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 22

Downstream and Upstream Effects on Income Computations 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. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 23

Downstream and Upstream Effects on Income Computations The subsidiary’s sales and cost of sales accounts reflect the $20, 000 unrealized profit. The subsidiary’s realized income is $30, 000. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 24

Downstream and Upstream Effects on Income Computations Consolidated Income (000) Downstream Upstream Sales ($900 – $100) Cost of sales ($480 + $20 – $100) Gross profit Expenses ($100 + $70) Total realized income Less: Minority interest Consolidated net income $800 400 $400 170 $230 10 $220 $800 400 $400 170 $230 6 $224 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 25

Downstream and Upstream Effects on Income Computations Consolidated Income (000) Downstream Upstream Parent’s separate income $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%] Parent and consolidated net income $220 $200 24 $224 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 26

Learning Objective 3 Defer unrealized inventory profits remaining in ending inventory of either the parent or subsidiary. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 27

Deferral of Intercompany Profit in Period of Sale: Downstream Porter Sales Cost of sales Gross profit Expenses Operating income Income from Sorter Net income $100 60 $ 40 15 $ 25 9 $ 34 90%-owned Sorter $50 35 $15 5 $10 – $10 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 28

Deferral of Intercompany Profit in 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. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 29

Deferral of Intercompany Profit in Period of Sale: Downstream $15, 000 – $6, 250 = $8, 750 × 40% = $3, 500 $15, 000 × 40% = $6, 000 – $3, 500 = $2, 500 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 30

Deferral of Intercompany Profit in Period of Sale: Downstream 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 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 31

Partial Working Papers December 31, 2003 Adjustments/ Consol. Porter Shorter Eliminations idated Income Statement Sales $100 Income from Sorter 6. 5 Cost of goods sold (60) Expenses (15) Minority interest expense ($10, 000 × 10%) Net income $ 31. 5 Balance Sheet Inventory Investment in Sorter XXX Dr. Cr. $50 a 15 $135 c 6. 5 (35) b 2. 5 a 15 (82. 5) (20) $10 $ 7. 5 (1) $ 31. 5 b 2. 5 $ c 6. 5 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 5 - 32

Learning Objective 4 Recognize realized, previously deferred inventory profits in the beginning inventory of either the parent or subsidiary. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 33

Recognition of Intercompany Profit upon 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. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 34

Recognition of Intercompany Profit upon Sale to Outside Entities Porter Sales Cost of sales Gross profit Expenses Operating income Income from Sorter Net income $120 80 $ 40 20 $ 20 13. 5 $ 33. 5 90%-owned Sorter $60 40 $20 5 $15 – $15 This is before considering $2, 500 unrealized profit in BI. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 35

Recognition of Intercompany Profit upon Sale to Outside Entities 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 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 36

Partial Working Papers December 31, 2003 Adjustments/ Consol. Porter Shorter Eliminations idated Income Statement Dr. Cr. Sales $120 $60 $180 Income from Sorter 16 b 16 Cost of goods sold (80) (40) a 2. 5 (117. 5) Expenses (20) (5) (25) Minority interest expense ($15, 000 × 10%) (1. 5) Net income $ 36 $15 $ 36 Balance Sheet Investment in Sorter XXX a 2. 5 b 16 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 37

Learning Objective 5 Adjust the calculations of minority interest amounts in the presence of intercompany inventory profits. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 38

Consolidation Example – Intercompany Profits: 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. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 39

Consolidation Example – Intercompany Profits: Downstream Sales Cost: $105, 000 × 90% = $94, 500 Minority interest: $105, 000 × 10% = $10, 500 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 40

Consolidation Example – Intercompany Profits: 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 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 41

Consolidation Example – Intercompany Profits: 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. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 42

Consolidation Example – Intercompany Profits: Downstream Sales $145, 000 × 90% = $130, 500 – $2, 000 = $128, 500 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 43

Consolidation Example – Intercompany Profits: Downstream Sales Seay’s equity: Common stock Retained earnings Net assets $100, 000 45, 000 $145, 000 $45, 000 – $5, 000 = $40, 000 increase in RE $40, 000 – $4, 000 (minority interest) = $36, 000 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 44

Consolidation Example – Intercompany Profits: 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 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 45

Consolidation Example – Intercompany Profits: Downstream Sales 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 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 46

Consolidation Example – Intercompany Profits: Downstream Sales 12/31/2006 12/31/2007 Peak’s Investment 94, 500 36, 000 2, 000 128, 500 2, 000 27, 000 2, 500 9, 000 146, 000 Dividends © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 47

Consolidation Example – Intercompany Profits: Downstream Sales Minority Interest 10, 500 4, 000 14, 500 3, 000 Dividends 1, 000 16, 500 12/31/2006 12/31/2007 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 48

Consolidation Example – Intercompany Profits: 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. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 49

Consolidation Example – Intercompany Profits: 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 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 50

Consolidation Example – Intercompany Profits: 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. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 51

Consolidation Example – Intercompany Profits: 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 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 52

Consolidation Example – Intercompany Profits: Upstream Sales Equity in Smith’s net income ($100, 000 × 80%) Add: 80% of $40, 000 unrealized profit deferred in 2003 Less: 80% of $30, 000 unrealized profit at December 31, 2004 Total $80, 000 32, 000 – 24, 000 $88, 000 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 53

Consolidation Example – Intercompany Profits: Upstream Sales 12/31/2003 12/31/2004 Poch’s Investment 480, 000 Income 32, 000 568, 000 40, 000 32, 000 24, 000 80, 000 616, 000 Dividends © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 54

End of Chapter 5 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 5 - 55