CHAPTER 9 INTERCOMPANY INVENTORY TRANSFERS

FOCUS OF CHAPTER 9 Conceptual Issues Procedures for Calculating Unrealized Profit Procedures for Deferring Unrealized Profit: – The Complete Equity Method – The Partial Equity Method – The Cost Method

Conceptual Issues: Issue #1 Should We or Shouldn’t We? Whether to Eliminate Intercompany Transactions in Consolidation: – No controversy—they must be eliminated. – Not eliminating causes two problems: Meaningless double-counting of (1) sales and (2) cost and expenses. Potential to manipulate income.

The Substance of Inventory Transfers The CONSOLIDATED Perspective: – Merely the physical movement of inventory from one location to another location. – Similar to the movement of inventory from one division to another division. – NOT a bona fide transaction. The SEPARATE COMPANY Perspective: – A bona fide transaction.

Conceptual Issues: Issue #2 Which Measure of Profit To Use? Possible Theoretical Profit Measures: – Gross profit. – Operating profit. – Net income. Profit Measure Required To Be Used By GAAP: – GROSS PROFIT (of the selling entity). Sales $1,000 Cost of sales (600) GROSS profit. $ 400

Conceptual Issues: Issue #3 Whether To Eliminate Income Tax Effects ? Income taxes on the selling entity’s UNREALIZED gross profit must also be eliminated. In this chapter : – No income tax entries are required. – Because we assume that the tax effects have already been recorded in the parent’s or the subsidiary’s general ledger. DONE FOR SIMPLICITY ONLY.

Conceptual Issues: Issue #4 Whether To Eliminate All or Some? DOWNSTREAM Sales to a Partially Owned Subsidiary: – Eliminate 100% of unrealized profit. – Fractional elimination is prohibited. UPSTREAM Sales from a Partially Owned Subsidiary: – Eliminate 100% of unrealized profit. – Fractional elimination is prohibited.

Conceptual Issues: Issue #5 Whether To Share the Deferral? DOWNSTREAM Sales to a Partially Owned Subsidiary: – Entire profit accrues to the parent—thus sharing is not appropriate. UPSTREAM Sales from a Partially Owned Subsidiary: – Must share deferral with the NCI shareholders (if amount is material).

Inventory Transfers: A Whole New Slant on “Realization” REALIZATION — What to focus on for consolidated reporting purposes: – Not on whether the SELLER has— Delivered the product, Collected on the sale, or Reduced to an acceptable level the uncertainty about the net cash flow effect of an earnings activity.

Inventory Transfers: A Whole New Slant on “Realization” REALIZATION—What to focus on for consolidated reporting purposes: – But on whether the BUYER has: Resold the inventory to an outside unaffiliated customer.

Inventory Transfers: Unrealized Profit—Searching for that Old Basis The Objective: – To change the inventory’s carrying value from the NEW basis of accounting to the OLD basis of accounting.

Inventory Transfers: Calculating Unrealized Gross Profit—The Analysis 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.

Inventory Transfers: Calculating Unrealized Gross Profit—The Analysis 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.

Inventory Transfers: A Point to Remember Intercompany Sales and Intercompany Cost of Sales accounts are eliminated only in years in which intercompany sales occur.

Inventory Transfers: The Two Procedural Methods MODULE 1: The Complete Equity Method: – Unrealized profit is deferred in the selling entity’s general ledger. MODULE 2: The Partial Equity Method: – Unrealized profit is deferred in the consolidation process.

Miscellaneous: Lower-of-Cost-or-Market Adjustments For consolidated reporting purposes, the appropriate valuation of intercompany- acquired inventory is: – The lower of: (1) the selling entity’s cost or (2) the market value.

Miscellaneous: Partial Ownerships— Reporting to the NCI Shareholders Under existing GAAP, a partially owned subsidiary: – Need not defer any of its unrealized intercompany gross profit in reporting to its NCI shareholders.

Review Question #1 For 2006, Paxco reported $60,000 of intercompany sales (25% markup on cost and fully paid for by Y/E) to Saxco, which reported $20,000 of intercompany acquired inventory at 12/31/06. The unrealized profit at 12/31/06 is: A. $ -0- B. $4,000 C. $5,000 D. $20,000 E. None of the above.

Review Question #1 With Answer For 2006, Paxco reported $60,000 of intercompany sales (25% markup on cost and fully paid for by Y/E) to Saxco, which reported $20,000 of intercompany acquired inventory at 12/31/06. The unrealized profit at 12/31/06 is: A. $ -0- B. $4,000 (20% of $20,000 Y/E inventory) C. $5,000 D. $20,000 E. None of the above.

Review Question #2 For 2006, Punco reported intercompany cost of sales of $1,600,000 (markup is 20% of transfer price) to Sunco, which reported $600,000 of intercompany acquired inventory at 12/31/06. The unrealized profit at 12/31/06 is: A. $80,000 B. $96,000 C. $120,000 D. $150,000 E. None of the above.

Review Question #2 With Answer For 2006, Punco reported intercompany cost of sales of $1,600,000 (markup is 20% of transfer price) to Sunco, which reported $600,000 of intercompany acquired inventory at 12/31/06. The unrealized profit at 12/31/06 is: A. $80,000 B. $96,000 C. $120,000 (20% of $600,000 Y/E inventory) D. $150,000 E. None of the above.

Review Question #3 For 2006, Salco (80% owned by Palco) reported $800,000 of intercompany sales (1/3 markup on cost) to Palco, which resold $700,000 of this inventory by 12/31/06. The unrealized profit at 12/31/06 is: A. $20,000 B. $25,000 C. $26,667 D. $33,333 E. None of the above.

Review Question #3 With Answer For 2006, Salco (80% owned by Palco) reported $800,000 of intercompany sales (1/3 markup on cost) to Palco, which resold $700,000 of this inventory by 12/31/06. The unrealized profit at 12/31/06 is: A. $20,000 B. $25,000 (25% x $100,000 inventory on hand) C. $26,667 D. $33,333 E. None of the above.

End of Chapter 9 Time to Clear Things Up—Any Questions?