2. Advanced Accounting, Fourth Edition6
Elimination of Unrealized
Profit on Intercompany
Sales of Inventory
Advanced Accounting, Fourth Edition

3. 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.

4. 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.

5. 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.

6. 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: (Downstream Sales-variation) 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.

7. 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.

8. 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.

9. 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: (Downstream Sales) 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 in its inventory one-third of the amount of goods purchased from Perkins during that year.
Required: Prepare the workpaper entries necessary to eliminate the effects of the intercompany sales for 2011 and 2012.
LO 6 Consolidated workpapers for downstream sales.

10. 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
Cost of Goods Sold (ending inventory) 25,000
Inventory 25,000
To eliminate intercompany sales and defer unrealized profit
LO 6 Consolidated workpapers for downstream sales.

11. Intercompany Sales of Merchandise
Downstream Sales
Intercompany Sales of Merchandise
E6-7:
Alternate View
Workpaper entry to eliminate intercompany sales for 2008.
Sales 450,000
Cost of Goods Sold 375,000
Cost of Goods Sold 50,000
Inventory 25,000 1 1 2 3
Original Sales and COGS recorded by Perkins (parent) is reversed.
COGS overstated by Sheraton on resale of goods to third parties.
Inventory on hand is overstated on Sheraton’s books by $25,000 unrealized profit.
LO 6 Consolidated workpapers for downstream sales.

12. Intercompany Sales of Merchandise
Downstream Sales
Intercompany Sales of Merchandise
E6-7: Prepare the workpaper entry to eliminate intercompany sales for 2012.
2011 Unrealized Profit in Inventory
Cost or Partial Equity Method *
Retained earnings 25,000
Cost of Goods Sold (beg. inventory) 25,000
To realize the gross profit in inventory deferred in the prior period.
* If the complete equity method is used, the debit is to the Investment account.
LO 6 Consolidated workpapers for downstream sales.

13. Intercompany Sales of Merchandise
Downstream Sales
Intercompany Sales of Merchandise
E6-7: Prepare the workpaper entry to eliminate intercompany sales for 2012.
2012 Intercompany Sales
Sales 486,000
Cost of Goods Sold (purchases) 486,000
Cost of Goods Sold (ending inventory) 27,000
Inventory 27,000
To eliminate intercompany sales and defer unrealized profit
LO 6 Consolidated workpapers for downstream sales.

14. 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.

15. 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 ]
LO 3 Eliminating 100% of intercompany profit.

16. Cost Method: Consolidated Statements Workpaper—Upstream Sales
Determination of the Noncontrolling Interest in Combined Income—Upstream or Horizontal Sales
Modification of the calculation of the noncontrolling interest is applicable only when the subsidiary is the selling affiliate (upstream or horizontal sales).
Where the parent company is the selling affiliate (downstream sale), no adjustment is necessary in the calculation of the noncontrolling interest in consolidated net income.
LO 5 Noncontrolling interest (NCI) for upstream sales.

17. Cost Method: Consolidated Workpaper
Upstream Sales
Cost Method: Consolidated Workpaper
P6-7: 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.
Required: Prepare the worksheet entries and the consolidated statements workpaper for the year ended December 31, 2013.
LO 6 Consolidated workpapers for upstream Sales- Cost Method.

18. Cost Method: Consolidated Workpaper
Upstream Sales
Cost Method: Consolidated Workpaper
P6-7: Prepare the worksheet entries for Dec. 31, 2013.
Acquisition date retained earnings - Segal $ 150,000
Retained earnings 1/1/13 - Segal 180,000
Increase 30,000
Ownership percentage 90%
$ 27,000 1.
Investment in Segal 27,000
Beg. Retained Earnings ‑ Pague Co. 27,000
To establish reciprocity/convert to equity as of 1/1/2013.
LO 6 Consolidated workpapers for upstream Sales- Cost Method.

19. Cost Method: Consolidated Workpaper
Upstream Sales
Cost Method: Consolidated Workpaper
P6-7: 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 Good Sold (ending inventory) 15,000
Inventory 15,000
To eliminate intercompany sales and defer unrealized profit
LO 6 Consolidated workpapers for upstream Sales- Cost Method.

20. Cost Method: Consolidated Workpaper
Upstream Sales
Cost Method: Consolidated Workpaper
P6-7: 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 for upstream Sales- Cost Method.

21. Cost Method: Consolidated Workpaper
Upstream Sales
Cost Method: Consolidated Workpaper
P6-7: Prepare the worksheet entries for Dec. 31, 2013. 5.
Dividend Income ($60,000 x 80%) 54,000
Dividends Declared 54,000
To eliminate intercompany dividends 6.
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 for upstream Sales- Cost Method.

22. Cost Method: Consolidated Workpaper
Upstream Sales
Cost Method: Consolidated Workpaper
P6-7:
(2)
(5)
(3)
(2)
(4)
(4)
(1)
(6)
(5)
NCI in Consolidated Income = 10%  ($71,250 + $45,000 – $15,000) = $10,125
LO 6 Consolidated workpapers for upstream Sales- Cost Method.

23. Cost Method: Consolidated Workpaper
Upstream Sales
Cost Method: Consolidated Workpaper
P6-7:
(3)
(1)
(6)
(6)
(4)
(6)
LO 6 Consolidated workpapers for upstream Sales- Cost Method.

24. Cost Method—Analysis of Consolidated Net Income and Consolidated Retained Earnings
Consolidated net income is the parent company’s income from its independent operations that has been realized in transactions with third parties
plus (minus) subsidiary income (loss) that has been realized in transactions with third parties
plus or minus adjustments for the period relating to the depreciation, amortization, and impairment of differences between implied and book values.
LO 6 Consolidated workpapers for upstream Sales- Cost Method.

25. Cost Method: Consolidated Net Income
Upstream Sales
Cost Method: Consolidated Net Income
P6-7: Prepare a calculation of Paque’s share of Segal’s income.
Reported income of Segal $ 71,250
Less: amortization of difference between
implied and book value 0
Less: unrealized profit on 2013 sales to Paque
Plus: profit on prior year's sales to Paque realized
in transactions with third parties in ,000
Subsidiary income included in consolidated income $ 101,250
Paque's share of Segal’s income ($101,250 x 90%) $ 91,125
NCI share of Segal’s income ($101,250 x 10%) 10,125
(15,000)
LO 6 Consolidated workpapers for upstream Sales- Cost Method.

26. Cost Method: Consolidated Net Income
Upstream Sales
Cost Method: Consolidated Net Income
P6-7: Prepare a calculation of CI in Consolidated Income.
Paque's net income $103,500
Less: subsidiary dividend income
Paque's net income from its independent operations 49,500
Less: unrealized profit on 2013 sales to Segal 0
Plus: profit on prior year's sales to Segal realized
in transactions with third parties in
Paque's income from independent operations that
has been realized in transactions with third parties 49,500
Paque's share of Segal’s income (previous slide) 91,125
Controlling interest in Consolidated net income $140,625
(54,000)
LO 6 Consolidated workpapers for upstream Sales- Cost Method.

27. Cost Method—Analysis of Consolidated Net Income and Consolidated Retained Earnings
Consolidated Consolidated retained earnings is the parent’s cost basis retained earnings that has been realized in transactions with third parties
plus (minus) the parent’s share of the increase (decrease) in subsidiary retained earnings that has been realized in transactions with third parties from the date of acquisition to the current date
plus (minus) the cumulative effect of adjustments to date relating to the amortization, depreciation, and impairment of differences between implied and book values.
LO 6 Consolidated workpapers for upstream Sales- Cost Method.

28. Consolidated Statements Workpaper — Partial Equity Method
Reminder:
The balances reported by the parent company in income, retained earnings, and the investment account differ depending on the method used by the parent company to record its investment.
However, the method used by the parent company to record its investment has no effect on the consolidated balances.
LO 6 Consolidated workpapers – partial equity method.

29. Partial Equity Method: Workpaper
Upstream Sales
Partial Equity Method: Workpaper
P6-13: (Note: This is the same problem as Problem 6-7, but assuming the use of the partial 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 partial equity method to record its investment in Segal Company.
LO 6 Consolidated workpapers – partial equity method.

30. Partial Equity Method: Workpaper
Upstream Sales
Partial Equity Method: Workpaper
P6-13: Prepare the worksheet entries for Dec. 31, 2013. 1.
Equity in Subsidiary Income 64,125
Investment in Segal Company ,125
Dividends declared ($60,000 x 90%) 54,000
To reverse the effect of parent entries for subsidiary dividends and income
LO 6 Consolidated workpapers – partial equity method.

31. Partial Equity Method: Workpaper
Upstream Sales
Partial Equity Method: Workpaper
P6-13: 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 – partial equity method.

32. Partial Equity Method: Workpaper
Upstream Sales
Partial Equity Method: Workpaper
P6-13: 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 – partial equity method.

33. Partial Equity Method: Workpaper
Upstream Sales
Partial Equity Method: Workpaper
P6-13: 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 – partial equity method.

34. Partial Equity Method: Workpaper
Upstream Sales
Partial Equity Method: Workpaper
P6-13:
(2)
(1)
(3)
(2)
(4)
(4)
(5)
(1)
NCI in Consolidated Income = 10%  ($71,250 + $45,000 – $15,000) = $10,125
LO 6 Consolidated workpapers – partial equity method.

35. Partial Equity Method: Workpaper
Upstream Sales
Partial Equity Method: Workpaper
P6-13:
(3)
(5)
(1)
(5)
(4)
(5)
LO 6 Consolidated workpapers – partial equity method.

36. Partial Equity Method—Analysis of Consolidated Net Income and Consolidated Retained Earnings
Same as Cost Method
Consolidated net income is the parent’s income from its independent operations that has been realized in transactions with third parties
plus (minus) subsidiary income (loss) that has been realized in transactions with third parties
plus or minus adjustments for the period relating to the depreciation, amortization, and impairment of differences between implied and book values.
LO 6 Consolidated workpapers – partial equity method.

37. Partial Equity Method—Analysis of Consolidated Net Income and Consolidated Retained Earnings
When the parent uses the partial equity method, the parent’s share of subsidiary income since acquisition is already included in the parent’s reported retained earnings.
Consequently, consolidated retained earnings is calculated as the parent’s recorded partial equity basis retained earnings that has been realized in transactions with third parties plus or minus the cumulative effect of the adjustments to date relating to the depreciation, amortization, and impairment of differences between implied and book values.
LO 6 Consolidated workpapers – partial equity method.

38. 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/ $ 788,625
(13,500)
LO 6 Consolidated workpapers – partial equity method.

39. 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.

40. 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 ,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.

41. 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.

42. 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.

43. 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.

44. 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.

45. 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.

46. 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.

47. 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

48. 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

49. Intercompany Profit Prior To Parent– Subsidiary Affiliation
Generally accepted accounting standards are silent as to the appropriate treatment of unrealized profit on assets that result from sales between companies prior to affiliation (preaffiliation profit).
LO 7 Intercompany profit prior to affiliation.

50. Copyright
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