Intercompany Profit Transactions – Inventories Chapter 5

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

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

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

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.

Elimination of Intercompany Purchases 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

Elimination of Intercompany Purchases 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

Elimination of Intercompany Purchases 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

Elimination of Intercompany Purchases and Sales Shep’s Books Cost of Sales 24,000 Inventory 24,000 To record cost of sales to customers

Elimination of Intercompany Purchases 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 $30,000 20,000 $10,000

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.

Elimination of Unrealized Profit 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

Elimination of Unrealized Profit 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

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.

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 $12,000 Cost to Pint (10,000) Unrealized profit in EI $ 2,000

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 $15,000 + $2,500 = $17,500

Recognition of Unrealized Profit 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

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

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

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.

Downstream and Upstream Effects on 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

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

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.

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.

Downstream and Upstream Effects on 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

Downstream and Upstream Effects on 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 [($50,000 – $20,000) × 80%] 24 Parent and consolidated net income $220 $224

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

Deferral of Intercompany Profit in 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

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.

Deferral of Intercompany Profit in 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

Deferral of Intercompany Profit in 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

Partial Working Papers December 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

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

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.

Recognition of Intercompany Profit upon 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.

Recognition of Intercompany Profit upon 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

Partial Working Papers December 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

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

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.

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

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

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.

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

Consolidation Example – Intercompany Profits: 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

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

Consolidation Example – Intercompany Profits: 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

Consolidation Example – Intercompany Profits: 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

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

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.

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

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.

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

Consolidation Example – Intercompany Profits: Upstream Sales December 31, 2004 Equity in Smith’s net income ($100,000 × 80%) $80,000 Add: 80% of $40,000 unrealized profit deferred in 2003 32,000 Less: 80% of $30,000 unrealized profit at December 31, 2004 –24,000 Total $88,000

Consolidation Example – Intercompany Profits: Upstream Sales Poch’s Investment 480,000 Income 568,000 32,000 80,000 616,000 32,000 40,000 24,000 12/31/2003 Dividends 12/31/2004

End of Chapter 5