Advanced Accounting, Fourth Edition 6 Elimination of Unrealized Profit on Intercompany Sales of Inventory Advanced Accounting, Fourth Edition

Learning Objectives Describe the financial reporting objectives for intercompany sales of inventory. Determine the amount of intercompany profit, if any, to be eliminated from the consolidated statements. Understand the concept of eliminating 100% of intercompany profit not realized in transactions with outsiders, and know the authoritative position. Distinguish between upstream and downstream sales of inventory. Compute the noncontrolling interest in consolidated net income for upstream and downstream sales, when not all the inventory has been sold to outsiders. Prepare consolidated workpapers for firms with upstream and downstream sales using the cost, partial equity, and complete equity methods. Discuss the treatment of intercompany profit earned prior to the parent subsidiary affiliation.

Upstream and Downstream Sales of Inventory Company P P sells inventory Downstream S2 sells inventory Upstream S1 sells inventory Horizontal Company S1 Company S2 Consolidated Entity Profit (loss) that has not been realized through subsequent sales to third parties must be eliminated in the preparation of consolidated financial statements. LO 4 Upstream and downstream sales.

Effects of Intercompany Sales of Merchandise on the Determination of Consolidated Balances The financial reporting objectives are: Consolidated sales include only sales with parties outside the affiliated group. Consolidated cost of sales includes only the cost to the affiliated group of goods that have been sold to parties outside the affiliated group. Consolidated inventory on the balance sheet is recorded at its cost to the affiliated group. Objective is to eliminate the effects of intercompany sales as if they had never occurred. LO 1 Financial reporting objectives for intercompany sales.

Intercompany Sales of Merchandise Downstream Sales Intercompany Sales of Merchandise Determination of Consolidated Sales, Cost of Sales, and Inventory Balances Assuming Downstream Sales E6-7: Perkins Company owns 85% of Sheraton Company. Perkins Company sells merchandise to Sheraton Company at 20% above cost. During 2011 and 2012, such sales amounted to $450,000 and $486,000, respectively. At the end of each year, Sheraton Company had sold all of inventory purchased from Perkins to third parties. Required: Prepare the workpaper entries necessary to eliminate the effects of the intercompany sales for 2011. LO 6 Consolidated workpapers for downstream sales.

Intercompany Sales of Merchandise Downstream Sales Intercompany Sales of Merchandise E6-7: Summary of 2011 Intercompany Sales The “Total” column represents the Sales and COGS booked by Perkins to record the sale to Sheraton. The Sales amount also represents the cost of the inventory recorded by Sheraton. The “Resold” column represents intercompany inventory that was resold to third parties. Portions resold are recorded in COGS. “On Hand” represents intercompany inventory still on hand in the affiliate group. LO 6 Consolidated workpapers for downstream sales.

Intercompany Sales of Merchandise Downstream Sales Intercompany Sales of Merchandise E6-7: Summary of 2011 Intercompany Sales Prepare the workpaper entry to eliminate intercompany sales for 2011. Sales 450,000 Cost of Goods Sold (Purchases) 450,000 To eliminate intercompany sales of merchandise LO 6 Consolidated workpapers for downstream sales.

Intercompany Sales of Merchandise Determination of Amount of Intercompany Profit Gross profit may be stated either as a percentage of sales or as a percentage of cost. Inventory Pricing Adjustments The amount of intercompany profit subject to elimination should be reduced to the extent that the related goods have been written down by the purchasing affiliate. LO 2 Determining the amount of intercompany profit.

Intercompany Sales of Merchandise Determination of Proportion of Intercompany Profit to Be Eliminated The amount of intercompany profit or loss to be eliminated . . . is not affected by the existence of a minority [noncontrolling] interest. The complete elimination of the intercompany profit or loss is consistent with the underlying assumption that consolidated statements represent the financial position and operating results of a single business enterprise. [Accounting Research Bulletin (ARB) No. 51, paragraph 14] [ASC 810-10-45-6] LO 3 Eliminating 100% of intercompany profit.

Consolidated Retained Earnings Partial Equity Consolidated Retained Earnings P6-13: Calculate consolidated retained earnings on Dec. 31, 2013. Paque's Retained Earnings on 12/31/13 $ 802,125 Unrealized profit on downstream sales 0 Unrealized profit on upstream sales ($15,000 x 90%) Consolidated retained earnings on 12/31/2013 $ 788,625 (13,500) LO 6 Consolidated workpapers – partial equity method.

Complete Equity Method: Workpaper Upstream Sales Complete Equity Method: Workpaper P6-17: (Note: This is the same problem as Problem 6-7 and 6-13, but assuming the use of the complete equity method.) Paque Corporation owns 90% of the common stock of Segal Company. The stock was purchased for $810,000 on January 1, 2009, when Segal Company’s retained earnings were $150,000. The January 1, 2013, inventory of Paque Corporation includes $45,000 of profit recorded by Segal Company on 2012 sales. During 2013, Segal Company made intercompany sales of $300,000 with a markup of 20% of selling price. The ending inventory of Paque Corporation includes goods purchased in 2013 from Segal Company for $75,000. Paque Corporation uses the complete equity method to record its investment in Segal Company. LO 6 Consolidated workpapers – complete equity method.

Complete Equity Method: Workpaper Upstream Sales Complete Equity Method: Workpaper P6-17: Prepare the worksheet entries for Dec. 31, 2013. 1. Equity in Subsidiary Income 91,125 Investment in Segal Company 37,125 Dividends declared ($60,000 x 90%) 54,000 To reverse the effect of parent company entries for subsidiary dividends and income LO 6 Consolidated workpapers – complete equity method.

Complete Equity Method: Workpaper Upstream Sales Complete Equity Method: Workpaper P6-17: Prepare the worksheet entries for Dec. 31, 2013. 2013 Intercompany Sales 2. Sales 300,000 Cost of Goods Sold (purchases) 300,000 3. Cost of Goods Sold (end. inventory) 15,000 Inventory 15,000 To eliminate intercompany sales and defer unrealized profit LO 6 Consolidated workpapers – complete equity method.

Complete Equity Method: Workpaper Upstream Sales Complete Equity Method: Workpaper P6-17: Prepare the worksheet entries for Dec. 31, 2013. 2012 Unrealized Profit in Inventory 4. Retained earnings ($45,000 x 90%) 40,500 Noncontrolling Interest ($45,000 x 10%) 4,500 Cost of Goods Sold (beg. inventory) 45,000 To realize the gross profit in inventory deferred in the prior period LO 6 Consolidated workpapers – complete equity method.

Complete Equity Method: Workpaper Upstream Sales Complete Equity Method: Workpaper P6-17: Prepare the worksheet entries for Dec. 31, 2013. 5. Beg. Retained Earnings - Segal 180,000 Common Stock - Segal 750,000 Investment in Segal 837,000 Noncontrolling Interest 93,000 To eliminate investment account and create NCI account LO 6 Consolidated workpapers – complete equity method.

Complete Equity Method: Workpaper Upstream Sales Complete Equity Method: Workpaper P6-17: (2) (1) (3) (2) (4) (5) (1) NCI in Consolidated Income = 10%  ($71,250 + $45,000 – $15,000) = $10,125 LO 6 Consolidated workpapers – complete equity method.

Complete Equity Method: Workpaper Upstream Sales Complete Equity Method: Workpaper P6-17: (3) (4) (5) (1) (5) (4) (5) LO 6 Consolidated workpapers – complete equity method.

Complete Equity Method—Analysis of Consolidated Net Income and Consolidated Retained Earnings Under the complete equity method: Consolidated net income equals the parent company’s recorded income. Consolidated retained earnings equals the parent company’s recorded retained earnings. LO 6 Consolidated workpapers – complete equity method.

Summary of Workpaper Entries Illustration 6-21 Parent Selling (Downstream) To eliminate intercompany sales: All Methods Sales X Cost of Sales (purchases) X To eliminate intercompany profit in ending inventory: All Methods Cost of Sales (ending inventory) X Inventory X To recognize intercompany profit in beginning inventory realized during the year: Cost or Partial Beg. Retained Earnings—Parent X Equity Methods Cost of Sales (beg. inventory) X Complete Equity Investment in S Company X Method Cost of Sales (beg. inventory) X

Summary of Workpaper Entries Illustration 6-21 Subsidiary Selling (Upstream) To eliminate intercompany sales: All Methods Sales X Cost of Sales (purchases) X To eliminate intercompany profit in ending inventory: All Methods Cost of Sales (ending inventory) X Inventory X To recognize intercompany profit in beginning inventory realized during the year: Cost or Partial Beg. Retained Earnings—Parent X Equity Methods NCI in Equity X Cost of Sales (beg. inventory) X Complete Equity Investment in S Company X Method NCI in Equity X