Intercompany Inventory Transactions Chapter 06 Intercompany Inventory Transactions Note: Students sometimes like to print slides as “handouts” with 1, 2, 3, 4, 6, or 9 slides per page for taking notes in class. It is sometimes best to print them using the “pure black and white” option on the color/gray scale dropdown menu to avoid dark boxes that are not conducive to note taking. Be aware that many instructors will only cover a sub-set of the slides available in this file. Also note that we have removed slides containing solutions to group or individual in-class exercises. You may want to print some slides (such as worksheets or slides with a large quantity of calculations) as a full page slide to facilitate working the exercise in class.

Understand and explain intercompany transfers and why they must be Learning Objective 1 Understand and explain intercompany transfers and why they must be eliminated.

Road Map: Intercompany Transactions Typical intercompany transactions Intercompany reciprocal accounts (Chapter 4) Inventory transfers (Chapter 6) Fixed asset transfers (Chapter 7) Intercompany Indebtedness (Chapter 8)

Arm’s-Length Transactions Q: What are “Arm’s-length” Transactions? A: “Transactions that take place between completely independent parties.”

Categories of Transactions Arm’s Length Transactions The only transactions that can be reported in the consolidated statements. We want to report the results of our interactions with outside parties! Non-Arm’s Length Transactions Usually referred to as “related party transactions.” Include all intercompany transactions.

Types of “Related Party” Transactions Involving only Individuals Transactions among family members Involving Corporations With management and other employees With directors and stockholders With affiliates (controlled entities) Probably constitutes at least 99% of all corporate related-party transactions

Necessity of Eliminating Intercompany Transactions Eliminate all intercompany transactions in consolidation: Because they are internal transactions from a consolidated perspective. Not because they are related-party transactions. Only transactions with outside unrelated parties can be reported in the consolidated statements.

Let’s work through an example: Assume Parent Co. owns 100% of Sub Co. The following intercompany transactions occurred during the year: Parent loaned $500 to Sub. To keep things simple, assume that there is no interest revenue or interest expense associated with this loan. Parent made a sale to Sub for $400 cash. The inventory had originally cost Parent $250. Sub then sold that same inventory to an outsider for $500. Parent made a sale to Sub for $300 cash. The inventory had originally cost Parent $200. Sub has not yet sold that same inventory to an outsider.  What consolidation worksheet entries would you make?

(a) Loan from Parent to Sub Does this transaction include outsiders? Cancel! Parent: Receivable 500 Cash 500 Parent Sub $500 Sub: Cash 500 Payable 500 Reverse the entries made by the parent and the sub. To eliminate intercompany loans: Loan Payable 500 Loan Receivable 500

(b) Sale from Parent to Sub to Outsider Arm’s Length Keep Parent’s COGS Keep Sub’s Sale Are these legitimate transactions? Parent Sub $250 $400 $500 Get rid of Sub’s COGS Get rid of Parent’s Sale Keep This Purchase Eliminate effect of this internal Transaction Keep This Sale Internal (fake)

(b) Sale from Parent to Sub to Outsider Which transactions are legitimate? Parent’s sale to Sub: Sub’s sale to Outsider: Parent: Cash 400 Sales 400 COGS 250 Inventory 250 Cancel! Sub: Cash 500 Sales 500 COGS 400 Inventory 400 Sub: Inventory 400 Cash 400 Cancel! Reverse the rest! To eliminate sale from Parent to Sub to Outsider: Sales (parent to sub) 400 Cost of Goods Sold (to outsider) 400

(c) Sale From Parent to Sub (Not Outside) Is this a legitimate arm’s length transaction? Parent: Cash 300 Sales 300 COGS 200 Inventory 200 Parent Sub $200 $300 Keep this purchase Eliminate effect of this internal transaction Sub: Inventory 300 Cash 300 Summary of the Transaction: Parent purchased inventory for $200. Parent sold the inventory to a Sub for $300. Reverse the entries made by the parent and sub.

(c) Sale From Parent to Sub (Not Outside) Reverse the entries made by the parent and sub. Cancel! Parent: Cash 300 Sales 300 COGS 200 Inventory 200 Parent Sub $300 Sub: Inventory 300 Cash 300 To eliminate sale from Parent to Sub, not yet to Outsider: Sales 300 Cost of Goods Sold 200 Inventory 100 (net)

Summary of Consolidation Entries: To eliminate intercompany loans: Loan Payable 500 Loan Receivable 500 To eliminate sale from Parent to Sub to Outsider: Sales 400 Cost of Goods Sold 400 To eliminate sale from Parent to Sub, not yet to Outsider: Sales 300 Cost of Goods Sold 200 Inventory 100