Slide 10-1 Copyright © 2000 by Harcourt, Inc. All rights reserved. 10 CHAPTER 10 INTERCOMPANY INVENTORY TRANSFERS.

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Slide 10-1 Copyright © 2000 by Harcourt, Inc. All rights reserved. 10 CHAPTER 10 INTERCOMPANY INVENTORY TRANSFERS

Slide 10-2 Copyright © 2000 by Harcourt, Inc. All rights reserved. 10 FOCUS OF CHAPTER 10 l Conceptual Issues l Procedures for Calculating Unrealized Profit l Procedures for Deferring Unrealized Profit: n The Complete Equity Method n The Partial Equity Method n The Cost Method

Slide 10-3 Copyright © 2000 by Harcourt, Inc. All rights reserved. 10 Conceptual Issues: Issue #1-- Should We or Shouldn’t We? l Whether to Eliminate Intercompany Transactions in Consolidation: n No controversy --they must be eliminated. n Not eliminating causes two problems: s Meaningless double-counting of (1) sales and (2) cost and expenses. s Potential to manipulate income.

Slide 10-4 Copyright © 2000 by Harcourt, Inc. All rights reserved. 10 The Substance of Inventory Transfers l The CONSOLIDATED Perspective: n Merely the physical movement of inventory from one location to another location. n Similar to the movement of inventory from one division to another division. n NOT a bona fide transaction. l The SEPARATE COMPANY Perspective: n A bona fide transaction.

Slide 10-5 Copyright © 2000 by Harcourt, Inc. All rights reserved. 10 Conceptual Issues: Issue #2-- Which Measure of Profit To Use? l Possible Theoretical Profit Measures: n Gross profit. n Operating profit. n Net income. l Profit Measure Required To Be Used By GAAP: n GROSS PROFIT (of the selling entity). Sales $1,000 Cost of sales (600) GROSS profit. $ 400

Slide 10-6 Copyright © 2000 by Harcourt, Inc. All rights reserved. 10 Conceptual Issues: Issue #3--Whether To Eliminate Income Tax Effects ? lIncome taxes on the selling entity’s UNREALIZED gross profit must also be eliminated. lIn this chapter : n No income tax entries are required. n Because we assume that the tax effects have already been recorded in the parent’s or the subsidiary’s general ledger. s DONE FOR SIMPLICITY ONLY.

Slide 10-7 Copyright © 2000 by Harcourt, Inc. All rights reserved. 10 Conceptual Issues: Issue #4-- Whether To Eliminate All or Some? l DOWNSTREAM Sales to a Partially Owned Subsidiary: n Eliminate 100% of unrealized profit. n Fractional elimination is prohibited. l UPSTREAM Sales from a Partially Owned Subsidiary: n Eliminate 100% of unrealized profit. n Fractional elimination is prohibited.

Slide 10-8 Copyright © 2000 by Harcourt, Inc. All rights reserved. 10 Conceptual Issues: Issue #5-- Whether To Share the Deferral? l DOWNSTREAM Sales to a Partially Owned Subsidiary: n Entire profit accrues to the parent-- thus sharing is not appropriate. l UPSTREAM Sales from a Partially Owned Subsidiary: n Must share deferral with the NCI shareholders (if amount is material).

Slide 10-9 Copyright © 2000 by Harcourt, Inc. All rights reserved. 10 Inventory Transfers: A Whole New Slant on “Realization” l REALIZATION--What to focus on for consolidated reporting purposes: n Not on whether the SELLER has-- s Delivered the product, s Collected on the sale, or s Reduced to an acceptable level the uncertainty about the net cash flow effect of an earnings activity.

Slide Copyright © 2000 by Harcourt, Inc. All rights reserved. 10 Inventory Transfers: A Whole New Slant on “Realization” l REALIZATION--What to focus on for consolidated reporting purposes: n But on whether the BUYER has-- s Resold the inventory to an outside unaffiliated customer.

Slide Copyright © 2000 by Harcourt, Inc. All rights reserved. 10 Inventory Transfers: Unrealized Profit-- Searching for that Old Basis l The Objective: n To change the inventory’s carrying value from the NEW basis of accounting to the OLD basis of accounting.

Slide Copyright © 2000 by Harcourt, Inc. All rights reserved. 10 Inventory Transfers: Calculating Unrealized Gross Profit--The Matrix Amounts That Will ALWAYS Be Known (Given): Re- On Total Sold Hand Interco. sales (NEW basis) $1,000 $200 Interco. cost of sales (OLD basis).. (600) ____ ____ Gross Profit $ 400 Gross Profit Percentage % CRITICAL ASSUMPTION: The gross profit percentage derivable from the total column applies to both (1) the inventory that has been resold AND (2) the inventory that is still on hand.

Slide Copyright © 2000 by Harcourt, Inc. All rights reserved. 10 Inventory Transfers: Calculating Unrealized Gross Profit--Matrix Completed Analysis: Re- On Total Sold Hand Interco. sales (NEW basis) $1,000 $800 $200 Interco. cost of sales (OLD basis).. (600) (480) (120) Gross Profit $ 400 $320 $ 80 REALIZED UNREALIZED The Inventory/COS Change in Basis Elimination Entry is derived from this analysis.