CHAPTER 4 4 Transactions: Merchandise, Plant Assets, and Notes Fundamentals of Advanced Accounting 1st Edition Fischer, Taylor, and Cheng

Intercompany Transactions Transactions between parent and sub Must be eliminated Consolidated statements represent separate companies as if they were one entity Common intercompany transactions Merchandise for resale Land Fixed assets Notes receivable/payable Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Intercompany Sales Effect on Gross Profit Parent sells inventory to Sub: Cost = $1,000 Sell price = $1,200 Sub sells to outside party: Cost = $1,200 Sell price = $1,500 Gross Profit is unaffected. Gross Profit % is distorted unless intercompany transactions are eliminated. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Intercompany Transactions Intercompany receivables/payables must be eliminated! Represent transfers of funds Internal loans No profit on intercompany sales can be recognized! Unless goods are sold to an outside party Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Elimination of Intercompany Inventory Sales Discussed in four sections No intercompany goods in beginning or ending inventory Intercompany goods in ending inventory Intercompany goods in both beginning and ending inventory Intercompany goods in both beginning and ending inventory: Periodic inventory method Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

No Intercompany Goods – Beginning or Ending Inventory Review worksheet 4-1 P owns 80% of S’ stock. Purchase price = pro rata share of sub’s book value. P uses the equity method. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

No Intercompany Goods – Beginning or Ending Inventory (Continued) Sub sells inventory to parent Cost = $80,000 Sell price = $100,000 GP% = 20% Parent sells inventory to third party Cost = $100,000 Sell price = $150,000 Parent owes $25,000 to sub for inventory purchases Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

No Intercompany Goods – Beginning or Ending Inventory (Continued) CY1 Sub Income - Par 60,000 Invest. In Sub - Par 60,000 (Eliminates current year income and creates date alignment) EL Common Stock - Sub 80,000 Retained Earnings - Sub 56,000 Invest. In Sub - Par 136,000 (Eliminates investment account against 80% of equity) IS Sales 100,000 Cost of goods sold** 100,000 (Eliminates intercompany merchandise sales) IA Account payable 25,000 Accounts receivable 25,000 (Eliminates intercompany unpaid trade balances) **Includes $80,000 C of G S from Sub to Parent and $20,000 C of G S from Parent to outside party. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Intercompany Inventory Remains in Ending Inventory Review worksheet 4-2 Assume same facts as to acquisition. Sub sells inventory to parent Cost = $80,000 Sell price = $100,000 GP% = 20% Parent sells inventory to third party Cost = $60,000 Sell price = $90,000 Intercompany inventory of $40,000 in parent’s ending inventory Parent owes $25,000 to sub for inventory purchases Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Intercompany Inventory Remains in Ending Inventory (continued) CY1 Sub Income - Par 60,000 Invest. In Sub - Par 60,000 (Eliminates current year income and creates date alignment) EL Common Stock - Sub 80,000 Retained Earnings - Sub 56,000 Invest. In Sub - Par 136,000 (Eliminates investment account against 80% of equity) IS Sales 100,000 Cost of goods sold 100,000 (Eliminates intercompany merchandise sales) EI Cost of goods sold 8,000 Inventory 8,000 (Eliminates intercompany profit in ending inventory) IA Account payable 25,000 Accounts receivable 25,000 (Eliminates intercompany unpaid trade balances) Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Intercompany Inventory in Beginning and Ending Inventory Parent’s 1/1 inventory includes $40,000 of interco. goods. Sub sold $120,000 of goods to parent. Sub recorded 20% gross profit on interco. sales. Parent owes $60,000 to sub for inventory at 12/31. Parent’s 12/31 inventory includes $30,000 of interco. goods. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Intercompany Inventory Remains in Ending Inventory – Journal Entries CY1 Sub Income - Par 48,000 Invest. In Sub - Par 48,000 (Eliminates current year income and creates date alignment) EL Common Stock - Sub 80,000 Retained Earnings - Sub 116,000 Invest. In Sub - Par 196,000 (Eliminates investment account against 80% of equity) BI Retained Earnings 1/1 - Par 6,400 Retained Earnings 1/1 - Sub 1,600 Invest. In Sub - Par 8,000 (Eliminates profit in beginning inventory and reduces current year C of G S) IS Sales 120,000 Cost of goods sold 120,000 (Eliminates intercompany merchandise sales) Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

EI Cost of goods sold 6,000 Inventory 6,000 IA Account payable 60,000 Intercompany Inventory Remains in Ending Inventory – Journal Entries (continued) EI Cost of goods sold 6,000 Inventory 6,000 (Eliminates intercompany profit in ending inventory) IA Account payable 60,000 Accounts receivable 60,000 (Eliminates intercompany unpaid trade balances) Review worksheet 4-3 Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Eliminations for Periodic Inventories Review worksheet 4-4 Beginning inventory balances appear in the trial balance Purchases account appears in trial balance Entry BI credits beginning inventory balance Entry IS credits the purchases account Ending inventory balances appear as: A debit to inventory A credit to cost of goods sold Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Intercompany Sales of Plant Assets Any plant asset can be sold between parent and sub Sale of assets can result in gains/losses Buyer records asset at purchase price (includes gain/loss) In consolidation, sale of plant assets are considered internal transfers Depreciable vs. non-depreciable asset transfer Non-depreciable: defer gain until sold to outside party Depreciable: amortize gain/loss over useful life Adjust depreciation of transferred asset in consolidation to reflect original cost Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Sale of Non-Depreciable Asset Elimination entry “LA” Eliminates the interco. gain in year of sale Eliminates the interco. gain from retained earnings in years subsequent to sale Reclassifies gain from retained earnings to current year gain/loss Example Sub (80% owned) sells land to Parent Sale price: $30,000 Cost: $20,000 $10,000 gain is deferred Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. 6

Example: Sub (80%) Sells Land to Parent Gain is deferred until land is sold to outside party! Year of sale: LA Gain on land sale 10,000 Land 10,000 Later years: LA RE - Sub 2,000 RE - Parent 8,000 Land 10,000 Year of sale to third party: LA RE - Sub 2,000 RE – Parent 8,000 Gain on land sale 10,000 Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. 6

Sale of Depreciable Asset Elimination entries “F” F1: Year of sale: Eliminates the interco. gain Years subsequent to sale: Eliminates the interco. gain from retained earnings Corrects accumulated depreciation F2: Adjusts depreciation back to calculation based on historical cost Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. 6

Sale of Depreciable Asset (Example) Parent sells machine to Sub Sale price: $30,000 Historical cost: $32,000 Accumulated depreciation: $12,000 $10,000 gain based on $20,000 net book value Sub assumes 5 year remaining life Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Sale of Depreciable Asset – Elimination Entries Year of sale: F1 Gain on sale of machine 10,000 Machine 10,000 (Defer gain on sale and return asset to cost) F2 Accum. Depreciation 2,000 Depreciation Expense 2,000 (Reduce to depreciation based on historical cost) Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. 7

Sale of Depreciable Asset – Elimination Entries (continued) Year after sale: F1 Retained earnings 8,000 Accum. Depreciation 2,000 Machine 10,000 (Defer gain on sale and return asset to cost) F2 Accum. Depreciation 2,000 Depreciation Expense 2,000 (Reduce to depreciation based on historical cost) Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. 7

Fixed Asset Worksheets WS 4-5 (year of sale) F1 removes $10,000 profit from machinery; defers $10,000 gain F2 adjusts depreciation and realizes $2,000 gain IDS takes away $10,000 from P [seller], gives back $2,000 WS 4-6 (end of second period after sale) F1 removes profit from machinery; corrects last year's depreciation and defers $8,000 profit as of 1/1/X2 IDS just gives back $2,000 currently realized gain to P Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. 8

Intercompany Debt Common for parent to lend funds to sub Parent charges sub interest Entry LN: LN1 Eliminates intercompany debt Eliminates accrued interest LN2 Eliminates intercompany interest revenue/expense Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. 11

Intercompany Debt - Example 7/1 Sub borrows 10,000 from Parent Maturity: 1 year Interest rate: 8% Interest due at maturity Interest accrued at 12/31: $400 Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. 11

Intercompany Debt – Elimination Entries LN1 Note payable 10,000 Note receivable 10,000 Interest payable 400 Interest receivable 400 (Eliminate interco. debt and accrued interest) LN2 Interest income 400 Interest expense 400 (Eliminate interco. interest) Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. 7