Advanced Accounting by Debra Jeter and Paul Chaney Chapter 6: Elimination of Unrealized Profit on Intercompany Sales of Inventory Slides Authored by Hannah Wong, Ph.D. Rutgers University

Intercompany Sales of Inventory Parent Company Downstream Sale Upstream Sale Subsidiary Subsidiary Horizontal Sale

Financial Reporting Objectives Consolidated sales = sales with parties outside the affiliated group Consolidated COGS = cost to the affiliated group of goods that have been sold to outside parties Consolidated inventory = inventory at its cost to the affiliated group

Financial Reporting Objectives To present consolidated balances of sales, cost of sales, and inventory as if the intercompany sale had never occurred.

Downstream Sales : No Unrealized Profit Outsider Supplier Parent Company Purchased for $200,000 Sold for $250,000 Sold for $270,000 Subsidiary Outside Customer

Downstream Sales No Unrealized Profit - EE Purchases 250,000 To eliminate intercompany purchase that the subsidiary has recorded To eliminate intercompany sale that the parent has recorded

Downstream Sales: Unrealized Profit in Ending Inventory Outsider Supplier Parent Company Purchased for $200,000 Sold for $250,000 Note: it is the parent who records the intercompany profit, thus the parent’s income needs to be adjusted in consolidation Sold 60% of goods Subsidiary Outside Customer

Downstream Sales - EE Year of Intercompany Sale Purchases 250,000 Ending Inventory - Inc. state. (COGS) 20,000 Inventory - balance sheet 20,000 To eliminate intercompany sale and purchases To exclude the unrealized profit from consolidated net income To exclude the unrealized profit from ending inventory

Downstream Sales - EE Year after Intercompany Sale Cost or Partial Equity Methods Beginning R/E - P 20,000 Beginning Inventory - Inc. State. (Cost of sales) 20,000 The intercompany profit in beginning inventory is excluded from last year’s consolidated NI, hence this year’s 1/1 R/E To include the intercompany profit in beginning inventory, which is realized in the current year

Downstream Sales - EE Year after Intercompany Sale Complete Equity Method Investment in S 20,000 Beginning Inventory - Inc. State. (Cost of sales) 20,000 The intercompany profit in beginning inventory is excluded from last year’s consolidated NI, hence the investment account To include the intercompany profit in beginning inventory, which is realized in the current year

Amount of Intercompany Profit Gross profit method intercompany profit that should be eliminated = ending inventory of buying affiliate x selling affiliate’s gross profit rate (i.e., gross profit / cost)

Elimination of Downstream Intercompany Profit eliminate the parent’s and the noncontrolling stockholders’ portion of intercompany profit despite partial ownership of the parent required by current GAAP Partial elimination eliminate only the parent’s portion of intercompany profit

Upstream Sales Outsider Supplier Subsidiary Parent Outside Company Purchase Intercompany Sale Note: it is the subsidiary who records the intercompany profit, thus the subsidiary’s income needs to be adjusted in consolidation Parent Company Outside Customer Sell

Upstream Sales An Example Parent Company $400,000 intercompany merchandise in ending inventory 80% owned Subsidiary Profit margin = 25% x selling price Total sales $700,000

Upstream Sales Cost or Partial Equity Methods Year of Intercompany Sale - EE’s Sales 700,000 Purchases 700,000 Ending Inventory - Inc. state. (COGS) 100,000 Inventory - balance sheet 100,000 To eliminate intercompany sale and purchases To exclude the unrealized profit (400,000x25%) from consolidated net income To exclude the unrealized profit from ending inventory

Upstream Sales - EE Cost or Partial Equity Methods Year after Intercompany Sale - EE’s Parent’s share of unrealized profit in beginning inventory Beginning R/E - P ($100,000x80%) 80,000 Beginning R/E - S ($100,000x20%) 20,000 Beginning Inventory - Inc. State. (Cost of sales) 100,000 To include the intercompany profit in beginning inventory, which is realized in the current year Noncontrolling interests’ share of unrealized profit in beginning inventory

Cost or Partial Equity Methods Noncontrolling Interest in Income Reported income of S Upstream-sale profit in ending inventory Upstream-sale profit in beginning inventory Adjusted NI of S x Noncontrolling % Noncontrolling interest in income

Cost and Partial Equity Methods Controlling Interest in Income Downstream-sale profit in ending inventory Reported income of P Downstream-sale profit in beginning inventory Amortization of purchase differential (Adjusted NI of S) x (P %) Consolidated income

Cost and Partial Equity Methods Consolidated Retained Earnings P% x (Upstream-sale profit in P’s ending inventory) Reported R/E of P Downstream-sale profit in S’s ending inventory P’s share of increase in S R/E since acquisition Accumulative amortization of purchase differential Consolidated R/E

Upstream Sales Complete Equity Method Year of Intercompany Sales - Journal Entries Equity in subsidiary income 80,000 Investment in S 80,000 To exclude the unrealized profit (400,000x25%) from equity in subsidiary income

Upstream Sales Complete Equity Method Year after Intercompany Sales - Journal Entries Investment in S 80,000 Equity in subsidiary net income 80,000 To include in equity in subsidiary income the intercompany profit, which is realized in the current year

Upstream Sales Complete Equity Method Year of Intercompany Sales - EE’s Sales 700,000 Purchases 700,000 Ending Inventory - Income Statement 100,000 Inventory - Balance Sheet 100,000 To eliminate intercompany sale and purchases To exclude the unrealized profit (400,000x25%) from equity in subsidiary income

Upstream Sales Complete Equity Method Year after Intercompany Sale - EE Parent’s share of unrealized profit in beginning inventory Investment in S 80,000 Beginning retained earnings - S 20,000 1/1 Inventory - Income Statement 100,000 To include the intercompany profit in beginning inventory, which is realized in the current year Noncontrolling interests’ share of unrealized profit in beginning inventory

Upstream Sales Complete Equity Method Consolidated net income = Reported net income of Parent Consolidated retained earnings = Reported retained earnings of Parent

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