Intercompany Profit Transactions – Inventories Chapter 5: Intercompany Profit Transactions – Inventories Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1

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

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

1: Intercompany Inventory Profits Intercompany Profit Transactions – Inventories 1: Intercompany Inventory Profits Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Intercompany Transactions For consolidated financial statements “intercompany balances and transactions shall be eliminated.” [FASB ASC 810-10-45-1] Show income and financial position as if the intercompany transactions had never taken place. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Intercompany Sales of Inventory Profits on intercompany sales of inventory 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 in the period the goods are sold. Assuming FIFO Beginning inventories are sold Ending inventories are from current purchases Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

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: 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. The same entry is used if Sim sells to Pet. Sales (-R, -SE) 1,429 Cost of sales (-E, +SE) Eliminate intercompany sales = $1,000 / (1-30%) = $1,429 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

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) Eliminate intercompany sales = $900 / (1-40%) = $1,500 Cost of sales (E, -SE) 80 Inventory (-A) Defer profit in ending inventory = $200 x 40% Copyright ©2012 Pearson Education, 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) 650 Cost of sales (-E, +SE) Eliminate intercompany sales = $500 + 30%($500) = $650 Cost of sales (E, -SE) 60 Inventory (-A) Defer profits in ending inventory = $260 x 30%/130% Investment in Subsidiary (+A) 24 Realize profits from beginning inventory = $120 x 25%/125% = $24 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

2: Upstream & Downstream Inventory Sales Intercompany Profit Transactions – Inventories 2: Upstream & Downstream Inventory Sales Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

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

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

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 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 profit in ending inventory $60 IC profit in beginning inventory $24 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

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 $3,000 CI 80% share $3,800 (60) 24 $3,764   $2,400 Income from subsidiary NCI 20% share $950   $600 When parent makes the IC sale, the impact of deferring and recognizing profits falls all to the parent. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

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 CI 80% share $3,800 (48) 19.2 $3,771.2   $2,400 Income from subsidiary NCI 20% share $950.0 (12.0) 4.8   $942.8 $600 When subsidiary makes the IC sale, the impact of deferring and recognizing profits is split among controlling and noncontrolling interests. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

3: Unrealized Profits in Ending Inventories Intercompany Profit Transactions – Inventories 3: Unrealized Profits in Ending Inventories Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

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

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

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

Worksheet – Income Statement   Pot Sot DR CR Consol Sales $100.0 $50.0 15.0 $135.0 Income from Sot 6.5 0.0 Cost of sales (60.0) (35.0) 2.5 (82.5) Expenses (15.0) (5.0) (20.0) Noncontrolling interest share 1.0 (1.0) Controlling interest share $31.5 $7.5 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

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 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: Controlling interest share Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

4: Recognizing Profits from Beginning Inventories Intercompany Profit Transactions – Inventories 4: Recognizing Profits from Beginning Inventories Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

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: Impact on Noncontrolling Interest Intercompany Profit Transactions – Inventories 5: Impact on Noncontrolling Interest Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

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 Full impact on parent Upstream sales Share impact between parent and noncontrolling interest Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

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: = CI%(Sub's NI – Profits in EI + Profits in BI) = NCI%(Sub's NI – Profits in EI + Profits in BI) Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

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. 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% markup and Perry still had $100 on hand at the end of the year. 2011 2012 Perry Salt Separate income $1,250 $705 $1,500 $745 Dividends $600 $280 $300 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

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

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

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

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

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

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

2012 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 $532   $210 Income from Salt NCI 30% share $222 ($6) $12 $228   $90 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

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

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

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

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

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall