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Intercompany Profit Transactions – Inventories

Learn about revenue recognition between affiliated companies, impact on inventories, elimination of intercompany transactions, and consolidation adjustments with practical examples.

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Intercompany Profit Transactions – Inventories

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  1. Intercompany ProfitTransactions – Inventories Chapter 5

  2. Learning Objective 1 Understand the impact of intercompany profit for inventories on preparation of consolidation working papers.

  3. Intercompany Inventory Transactions Revenue Recognition Revenue on sales between affiliated companies cannot be recognized until merchandise is sold outside of the consolidated entity.

  4. Intercompany Inventory Transactions Purchasing Agent Periodic inventory system Sales Purchases Perpetual inventory system Sales Cost of goods sold

  5. Elimination of IntercompanyPurchases 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.

  6. Elimination of IntercompanyPurchases and Sales Pint’s Books 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

  7. Elimination of IntercompanyPurchases and Sales Pint’s Books Cost of Sales 20,000 Inventory 20,000 To record cost of sales to Shep Investment 6,000 Income from Shep 6,000 To record related equity interest

  8. Elimination of IntercompanyPurchases and Sales Shep’s Books 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

  9. Elimination of IntercompanyPurchases and Sales Shep’s Books Cost of Sales 24,000 Inventory 24,000 To record cost of sales to customers

  10. Elimination of IntercompanyPurchases and Sales 100% Adjustments and Consol- Pint Shep Eliminations idated Sales Cost of sales Gross profit $24,000 20,000 $ 4,000 $30,000 24,000 $ 6,000 a 24,000 a 24,000 $30,000 20,000 $10,000

  11. Elimination of UnrealizedProfit 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.

  12. Elimination of UnrealizedProfit in Ending Inventory 30,000 ÷ 36,000 = 5/6 5/6 × 30,000 = $25,000 1/6 × 36,000 = $6,000 1/6 × 30,000 = $5,000 Shep’s inventory $6,000 Cost to Pint –5,000 Unrealized profit in EI $1,000

  13. Elimination of UnrealizedProfit in Ending Inventory Adjustments and Consol- Pint Shep Eliminations idated Sales Cost of sales Gross profit Inventory $36,000 30,000 $ 6,000 $37,500 30,000 $ 7,500 $ 6,000 a 36,000 b 1,000 a 36,000 b 1,000 $37,500 25,000 $12,500 $ 5,000

  14. Recognition of UnrealizedProfit 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.

  15. Recognition of UnrealizedProfit in Beginning Inventory 25% × 48,000 = $12,000 Ending inventory $12,000 ÷ 1.2 = $10,000 EI transfer price Shep’s inventory $12,000 Cost to Pint (10,000) Unrealized profit in EI $ 2,000

  16. Recognition of UnrealizedProfit in Beginning Inventory $7,500 – $5,000 BI = $2,500 from BI 75% × 48,000 = $30,000 $45,000 – $30,000 = $15,000 $15,000 + $2,500 = $17,500

  17. Recognition of UnrealizedProfit in Beginning Inventory Adjustments and Consol- Pint Shep Eliminations idated Sales Cost of sales Gross profit Inventory Investment in Shep $48,000 40,000 $ 8,000 XXX $52,500 42,000 $10,500 $12,000 a 48,000 c 2,000 a 48,000 b 1,000 c 2,000 b 1,000 $52,500 35,000 $17,500 $10,000

  18. Learning Objective 2 Apply the concepts of upstream versus downstream inventory transfers.

  19. Downstream and Upstream Sales Sales from top to bottom are downstream. Sales from bottom to top are upstream. Parent to Subsidiary Subsidiary to Parent

  20. 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.

  21. Downstream and Upstream Effectson Income Computations 80%-owned Parent Subsidiary Sales $600 $300 Cost of sales 300 180 Gross profit $300 $120 Expenses 100 70 Parent’s separate income $200 Subsidiary’s net income $ 50

  22. Downstream and Upstream Effectson Income Computations Intercompany sales during the year are $100,000. The December 31 inventory includes $20,000 unrealized profit.

  23. Downstream and Upstream Effectson Income Computations Downstream: 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.

  24. Downstream and Upstream Effectson Income Computations Upstream: The subsidiary’s sales and cost of sales accounts reflect the $20,000 unrealized profit. The subsidiary’s realized income is $30,000.

  25. Downstream and Upstream Effectson Income Computations Consolidated Income (000) Downstream Upstream Sales ($900 – $100) $800 $800 Cost of sales ($480 + $20 – $100) 400 400 Gross profit $400 $400 Expenses ($100 + $70) 170 170 Total realized income $230 $230 Less: Minority interest 10 6 Consolidated net income $220 $224

  26. Downstream and Upstream Effectson Income Computations Consolidated Income (000) Downstream Upstream Parent’s separate income $200 $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%] 24 Parent and consolidated net income $220 $224

  27. Learning Objective 3 Defer unrealized inventory profits remaining in ending inventory of either the parent or subsidiary.

  28. Deferral of Intercompany Profitin Period of Sale: Downstream 90%-owned Porter Sorter Sales $100 $50 Cost of sales 60 35 Gross profit $ 40 $15 Expenses 15 5 Operating income $ 25 $10 Income from Sorter 9 – Net income $ 34 $10

  29. Deferral of Intercompany Profitin 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.

  30. Deferral of Intercompany Profitin Period of Sale: Downstream $15,000 – $6,250 = $8,750 Cost $8,750 × 40% = $3,500 $15,000 × 40% = $6,000 Unrealized profit $6,000 – $3,500 = $2,500

  31. Deferral of Intercompany Profitin Period of Sale: Downstream Porter’s Books 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

  32. Partial Working PapersDecember 31, 2003 Adjustments/ Consol- Porter Shorter Eliminations idated Income Statement Sales Income from Sorter Cost of goods sold Expenses Minority interest expense ($10,000 × 10%) Net income Balance Sheet Inventory Investment in Sorter $100 6.5 (60) (15) $ 31.5 XXX $50 (35) (5) $10 $ 7.5 Dr. Cr. a 15 c 6.5 b 2.5 a 15 b 2.5 c 6.5 $135 (82.5) (20) (1) $ 31.5 $ 5

  33. Learning Objective 4 Recognize realized, previously deferred inventory profits in the beginning inventory of either the parent or subsidiary.

  34. Recognition of Intercompany Profitupon 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.

  35. Recognition of Intercompany Profitupon Sale to Outside Entities 90%-owned Porter Sorter Sales $120 $60 Cost of sales 80 40 Gross profit $ 40 $20 Expenses 20 5 Operating income $ 20 $15 Income from Sorter 13.5 – Net income $ 33.5 $15 This is before considering $2,500 unrealized profit in BI.

  36. Recognition of Intercompany Profitupon Sale to Outside Entities Porter’s Books 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

  37. Partial Working PapersDecember 31, 2003 Adjustments/ Consol- Porter Shorter Eliminations idated Income Statement Sales Income from Sorter Cost of goods sold Expenses Minority interest expense ($15,000 × 10%) Net income Balance Sheet Investment in Sorter $120 16 (80) (20) $ 36 XXX $60 (40) (5) $15 Dr. Cr. b 16 a 2.5 a 2.5 b 16 $180 (117.5) (25) (1.5) $ 36

  38. Learning Objective 5 Adjust the calculations of minority interest amounts in the presence of intercompany inventory profits.

  39. Consolidation Example – IntercompanyProfits: 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.

  40. Consolidation Example – IntercompanyProfits: Downstream Sales July 1, 2003 Cost: $105,000 × 90% = $94,500 Minority interest: $105,000 × 10% = $10,500

  41. Consolidation Example – IntercompanyProfits: 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

  42. Consolidation Example – IntercompanyProfits: 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.

  43. Consolidation Example – IntercompanyProfits: Downstream Sales December 31, 2006 $145,000 × 90% = $130,500 $130,500 – $2,000 = $128,500

  44. Consolidation Example – IntercompanyProfits: Downstream Sales December 31, 2006 Seay’s equity: Common stock $100,000 Retained earnings 45,000 Net assets $145,000 $45,000 – $5,000 = $40,000 increase in RE $40,000 – $4,000 (minority interest) = $36,000

  45. Consolidation Example – IntercompanyProfits: 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

  46. Consolidation Example – IntercompanyProfits: Downstream Sales December 31, 2007 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

  47. Consolidation Example – IntercompanyProfits: Downstream Sales Peak’s Investment 94,500 36,000 128,500 2,000 27,000 146,000 2,000 2,500 9,000 12/31/2006 Dividends 12/31/2007

  48. Consolidation Example – IntercompanyProfits: Downstream Sales Minority Interest 1,000 10,500 4,000 14,500 3,000 16,500 12/31/2006 Dividends 12/31/2007

  49. Consolidation Example – IntercompanyProfits: 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.

  50. Consolidation Example – IntercompanyProfits: 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

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