Chapter 6

Intercompany
Inventory
Transactions
McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objective 1

Understand and explain

intercompany transfers
and why they must be
eliminated.

6-2

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)

6-3

Arms-Length Transactions
Q: What are Arms-length
Transactions?
A:

Transactions that take place between

completely independent parties.

6-4

Categories of Transactions
Arms 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-Arms Length Transactions

Usually

referred to as related party

transactions.

Include

all intercompany transactions.

6-5

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
6-6

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.

6-7

Intercompany Transactions:
Additional Opportunities for
Fraud
Intercompany
transactions sometimes
occur to
conceal

embezzlements.

overstate

reported profits.

+ 2

5
6-8

Example 1: Intercompany Loan

A 12-year old girl lends $5 to her 17year-old brother.
From the standpoint of individuals, this
represents a receivable and a payable.
If the family prepares a consolidated
balance sheet, what is the effect?

No net change to the familys wealth.

Not a transaction with a non-family person.

6-9

Example 2:
Sale from Parent to Sub to
Outsider
Parent
has 19 subsidiaries.
Parent has received a $1 order from an
outsider.
Parent sells inventory to Sub 1 for $1.

Sub 1 sells the inventory to Sub 2 for $1.

Sub 2 sells the inventory to Sub 3 for $1.
The inventory is sold from one sub to another until
Sub 19 sells it to the outsider for $1.

The parent and each sub reports sales of

$1.
From a consolidated standpoint, what is
the total amount of sales?
6-10

Example 3: Sale from Parent to

Sub, But Not Yet to an Outsider
Sleazy Parent Company has one sub.
Sleazy Parent is preparing for an IPO.
Sleazy Parent owns lots of obsolete
inventory which it cannot sell.
Sleazy Parent sells the obsolete inventory
(costing $1,000) to its sub for $100,000.
Sleazy Sub now holds the inventory.
Without any adjustment, what items in
Sleazys consolidated financial statements
will be misstated?
6-11

Correcting Entries
Conceptually, how would you correct each of these
three problems?
Easy! To eliminate intercompany loans:
Loan Payable
xxx
Just
Loan Receivable
reverse
More
difficult

Easy!
Just
reverse

xxx

To eliminate sale from Parent to Sub to Outsider:

Sales
xxx
Cost of Goods Sold
xxx

To eliminate sale from Parent to Sub, not yet to Out

Sales
xxx
Cost of Goods Sold
xxx
Inventory
Unrealized GP
6-12

Lets 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?
6-13

(a) Loan from Parent to Sub

Does this transaction include outsiders?

Parent $500

Sub

Reverse the entries

made by the parent and
the sub.

Cancel!

Parent:
Receivable 500
Cash

500

Sub:
Cash
Payable

500
500

To eliminate intercompany loans:

Loan Payable
500
Loan Receivable

500
6-14

(b) Sale from Parent to Sub to

Outsider
Arms
Length

Keep Parents COGS Keep Subs Sale

Are these legitimate transactions?
$250 Parent $400

Keep
This
Purchase

Sub $500

Eliminate effect
of this internal
Transaction

Keep
This
Sale

Get rid of Parents Sale

Get rid of Subs COGS
Internal (fake)

6-15

(b) Sale from Parent to Sub to

Outsider

Which transactions are legitimate?

Parents sale to Sub:

Subs sale to Outsider:

!
Parent:
Sub:
Cancel
Cash
400
Cash
500
Sales
400
Sales
500
COGS
250
COGS
400
Inventory
250
Inventory
400
l!
Sub:
Cance
Inventory
400
Reverse the rest!
Cash
400
To eliminate sale from Parent to Sub to Outsider:
Sales (parent to sub)
400
Cost of Goods Sold (to outsider)
400
6-16

(c) Sale From Parent to Sub (Not

Outside)

Is this a legitimate arms length transaction?

$200 Parent $300

Keep
this
purchase

Sub

Eliminate effect
of this internal
transaction

Parent:
Cash 300
Sales
300
COGS 200
Inventory
200
Sub:
Inventory300
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 su
6-17

(c) Sale From Parent to Sub (Not

Outside)

Reverse the entries made by the parent and sub.

c el!
n
a
C
Parent:
Cash
300
Sales
300
COGS
200
Inventory
200
Sub:
Inventory 300
Cash
300

Parent $300

Sub

To eliminate sale from Parent to Sub, not yet to Outsider

Sales
300
Cost of Goods Sold
200
Inventory
100
(net)
6-18

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 Outsid

Sales
300
Cost of Goods Sold
200
Inventory
100

6-19

Fully-adjusted Equity Method

Adjustment
Parent companies have to adjust their equity
method investment accounts for certain
transactions.
At this point, lets just consider one:

Sale from parent to sub, but not yet sold to an

outsider.

It represents fake profit that hasnt really been

realized in an arms-length transaction.

Both the balance sheet and income statement

accounts need to be adjusted.
This is a REAL journal entry, not a consolidation
worksheet entry!
6-20

Equity Method Adjustment

Example
$500 Parent $600

Sub

Sales $ 600
COGS 500
GP
$ 100

Summary of the Transaction:

Parent purchased inventory for
$500.
Parent sold the inventory to a Sub
Equity
for
$600.Method Entry:
Income from Sub
100
Investment in Sub
The Parent recognized $100 of fake gross profit!
100
The Parent should have transferred the inventory at cost.
This profit is not from a transaction with an arms length
independent party.

6-21

Group Practice
Assume Parent Co. owns 100% of Sub Co.
The following intercompany transactions occurred
during the year:

Parent loaned $100 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 $200 cash. The inventory had
originally cost Parent $120. Sub then sold that same
inventory to an outsider for $300.

Parent made a sale to Sub for $300 cash. The inventory had
originally cost Parent $180. Sub has not yet sold that same
inventory to an outsider. (Dont forget equity method entry!)

Based on our conceptual discussion, what

consolidation worksheet entries would you make?
6-22

Consolidation Entries
To eliminate intercompany loans:
Loan Payable
100
Loan Receivable

100

To eliminate sale from Parent to Sub to Outsider:

Sales
200
Cost of Goods Sold
200

To eliminate sale from Parent to Sub, not yet to Outsid

Sales
300
Cost of Goods Sold
180
Inventory
120
To correct inventory value

Equity Method Entry:

Income from Sub

120
Investment in Sub
6-23

Practice Quiz Question #1

Why must intercompany
transactions be eliminated?
a. They portray the
consolidated companys
results too conservatively.
b. They understate the results
of the consolidated group.
c. They are arms length
transactions.
d. They are not arms length
transactions.
6-24

Practice Quiz Question #1

Solution
Why must intercompany
transactions be eliminated?
a. They portray the
consolidated companys
results too conservatively.
b. They understate the results
of the consolidated group.
c. They are arms length
transactions.
d. They are not arms length
transactions.
6-25

Learning Objective 2

Understand and explain

concepts associated
with inventory transfers
and transfer pricing.

6-26

Issue #1: Eliminate Intercompany

Transfers?

Whether to Eliminate Intercompany

Transactions in Consolidation:
No

controversythey must be eliminated.

Not

eliminating them would cause two

problems:

Meaningless double-counting of
1. sales, and
2. expenses

Potential to manipulate income.

6-27

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.

6-28

Issue #2: Which Measure of Profit

To Use?
Possible theoretical profit measures:

Gross profit

Operating profit

Net income

Profit measure required under GAAP:

Gross profit (of the selling entity):

Sales
Cost of sales
Gross profit

$1,000
600
$ 400
6-29

Issue #3: Eliminate Income Tax

Effects?
Income taxes play a major role in
intercompany sales and transfer pricing
decisions.
Income taxes on the selling entitys
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 parents or the
subsidiarys general ledger.
6-30

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.
6-31

Issue #4: Whether To Eliminate

All or Some?

Downstream sales to a
partially-owned subsidiary:

Entire profit accrues to the parent;

thus, sharing is not appropriate.
NCI

Upstream sales from a

partially-owned subsidiary:

Must share deferral with the NCI

shareholders (if amount is
material).

Because S profits are shared with

the NCI shareholders.

S
6-32

Inventory Transfers: What is

Realization?
Realization for consolidated
reporting purposes:
Does

not focus 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.

6-33

Inventory Transfers: What is

Realization?
Realization for consolidated reporting
purposes:

Depends on whether the BUYER has

resold the inventory to an outside
unaffiliated customer.
Parent

Sub

6-34

Review: Two Types of Transfers

Parent-to-sub-to-outsider

$750 Parent$1,000

Sub For $1,200

Parent-to-sub-not-yet-tooutsider

$300 Parent $400

Sub

Assume
both
transactions
took place
during the
same year.
6-35

Understanding Inventory
Transfers: Map it out

Ending Inventory = $400

Resold = $1,000

$1,400
Split

$1,050 Parent$1,400

Sub

Unknown

What happened to
it?
Total Interco
Sales
Sales
COGS
Gross Profit
Gross Profit
%

Resold

On
hand

1,400

1,000

400

1,050

750

300

350

250

100

Splits
25% out parents numbers.
6-36

Calculating Unrealized Gross

Profit
Amounts that will always be known (given):
Total

Sales (NEW basis) 1,000

Cost of sales (OLD
basis)
Gross Profit

Resold

On
hand

200

600
400

Gross Profit % 40%

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.
6-37

Calculating Unrealized Gross

Profit
Completed Analysis:
Total

Sales (NEW basis) 1,000

Cost of sales (OLD
basis)
Gross Profit

Resold

On
hand

800

200

600

480

120

400

320

80

Realized Unrealized

Gross Profit % 40%

The Inventory/COGS Change in Basis Elimination
Entry is derived from this analysis.
Unrealized profit
= Inventory on hand x GP%
= $200 x 40% = $80

6-38

Inventory Transfers: Terminology

What happened
to it?
Total
Interco
Sales

Transfer Price
Cost
Markup
Markup on
Transfer Price

Sales
COGS

On
hand

1,400

1,000

400

1,050

750

300

350

250

100

Gross Profit
Gross Profit
%

Resold

25%

Watch out for terminology like

mark-up based on cost!
6-39

Practice Quiz Question #2

For 20X8, Pete reported
intercompany cost of sales of
$800,000 (markup is 20% of
transfer price) to Sampras, which
reported $300,000 of
intercompany acquired inventory
at 12/31/X8. The unrealized profit
at 12/31/X8 is:
a.$40,000
b.$48,000
c.$60,000
d.$75,000
e.None of the above

6-40

Practice Quiz Question #2

Solution
For 20X8, Pete reported
intercompany cost of sales of
$800,000 (markup is 20% of
transfer price) to Sampras, which
reported $300,000 of
intercompany acquired inventory
at 12/31/X8. The unrealized profit
at 12/31/X8 is:
a.$40,000
b.$48,000
c.$60,000 ($300,000 EI x 0.20 GP%)
d.$75,000
e.None of the above

6-41

Practice Quiz Question #2

Solution

Ending Inventory = $300,000

$800,000

Parent

Sub

What happened
to it?
Total Interco
Sales
Sales
COGS
Gross Profit

Resold

On
hand
300,00
0

800,000
?

6-42

Practice Quiz Question #2

Solution

Ending Inventory = $300,000

$800,000

Parent

Sub

What happened
to it?
Total Interco
Sales
Sales
COGS
Gross Profit

Resold

On
hand
300,00
0

800,000
60,000 6-43

Practice Quiz Question #2

Solution

Ending Inventory = $300,000

$800,000

Parent

Sub

What happened
to it?
Total Interco
Sales
Sales
COGS
Gross Profit

Resold

On
hand
300,00
0

800,000
.2 S

60,000 6-44

Practice Quiz Question #2

Solution

Ending Inventory = $300,000

$800,000

Parent

Sub

S 800,000 = .2 S
.8 S = 800,000
S = 800,000 / .8 = 1,000,000
6-45

Practice Quiz Question #2

Solution

Ending Inventory = $300,000

$800,000

Parent

Sub

What happened
to it?
Total Interco
Sales
Sales

1,000,000

COGS
Gross Profit

800,000
200,000

Resold

On
hand
300,00
0
60,000 6-46

Practice Quiz Question #2

Solution

Ending Inventory = $300,000

Resold = $700,000

$1,000,000
Split
$800,000

Parent1,000,000 Sub

Unknown

What happened
to it?
Total Interco
Sales
Sales
COGS

Resold

1,000,000 700,000
800,000 560,000

On
hand
300,00
0
240,00
0 6-47

Practice Quiz Question #3

For 20X8, Post reported $90,000
of intercompany sales (25%
markup on cost and fully paid for
by year end) to Script, which
reported $30,000 of intercompany
acquired inventory at 12/31/X8.
The unrealized profit at 12/31/X8
is:
a.$0
b.$6,000
c.$7,500
d.$30,000
e.None of the above

6-48

Practice Quiz Question #3

Solution
For 20X8, Post reported $90,000
of intercompany sales (25%
markup on cost and fully paid for
by year end) to Script, which
reported $30,000 of intercompany
acquired inventory at 12/31/X8.
The unrealized profit at 12/31/X8
is:
a.$0
b.$6,000 ($30,000 EI x 0.20 GP%)
c.$7,500
d.$30,000
e.None of the above

6-49

Practice Quiz Question #3

Solution

Ending Inventory = $30,000

$90,000
Split
?

Parent

90,000

Sub

What happened
to it?
Total Interco
Sales
Sales
COGS
Gross Profit

90,000

Resold

On
hand
30,000

C
0.25 C

?
6-50

Practice Quiz Question #3

Solution

Ending Inventory = $30,000

$90,000
Split
?

Parent

90,000

Sub

90,000 C = 0.25 C
1.25 C = 90,000
C = 90,000 / 1.25 = 72,000
6-51

Practice Quiz Question #3

Solution

Ending Inventory = $30,000

$90,000
Split
72,000

Parent

90,000

Sub

What happened
to it?
Total Interco
Sales
Sales

90,000

COGS
Gross Profit

72,000
18,000

Resold

On
hand
30,000
6,000
6-52

Practice Quiz Question #3

Solution

Ending Inventory = $30,000

Resold = $60,000

$90,000
Split
72,000

Parent

90,000

Sub

Unknown

What happened
to it?
Total Interco
Sales

Resold

On
hand

Sales

90,000

60,000

30,000

COGS
Gross Profit

72,000

48,000

24,000

18,000

12,000

6,000
6-53

Practice Quiz Question #4

For 20X8, Sempre (80% owned by
Para) reported $1,600,000 of
intercompany sales (1/3 markup
on cost) to Para, which resold
$1,400,000 of this inventory by
12/31/X8. The unrealized profit at
12/31/X8 is:
a.$40,000
b.$50,000
c.$53,333
d.$66,667
e.None of the above
6-54

Practice Quiz Question #4

Solution
For 20X8, Sempre (80% owned by
Para) reported $1,600,000 of
intercompany sales (1/3 markup
on cost) to Para, which resold
$1,400,000 of this inventory by
12/31/X8. The unrealized profit at
12/31/X8 is:
a.$40,000
b.$50,000 ($200,000 EI x 0.25 GP%)
c.$53,333
d.$66,667
e.None of the above
6-55

Practice Quiz Question #4

Solution
Ending Inventory = 200,000
Resold = $1,400,000
$1,600,000
Split
?

Parent1,600,000 Sub

unknown

What happened
to it?
Total Interco
Sales
Sales
COGS
Gross Profit

1,600,000

Resold

On
hand

1,400,0
00
?

6-56

Practice Quiz Question #4

Solution
Ending Inventory = 200,000
Resold = $1,400,000
$1,600,000
Split
?

Parent1,600,000 Sub

unknown

What happened
to it?
Total Interco
Sales
Sales
COGS
Gross Profit

1,600,000

Resold

On
hand

1,400,0
00

C
1/3 C

6-57

Practice Quiz Question #4

Solution
Ending Inventory = 200,000
Resold = $1,400,000
$1,600,000
Split
?

Parent1,600,000 Sub

unknown

1,600,000 C = 1/3 C
4/3 C = 1,600,000
C = 1,600,000 / (4/3) = 1,200,000
6-58

Practice Quiz Question #4

Solution
Ending Inventory = 200,000
Resold = $1,400,000
$1,600,000
Split
1,200,000 Parent1,600,000

Sub

unknown

What happened
to it?
Total Interco
Sales
Sales

1,600,000

COGS
Gross Profit

1,200,000
400,000

Resold

On
hand

1,400,0
00
?

6-59

Practice Quiz Question #4

Solution
Ending Inventory = 200,000
Resold = $1,400,000
$1,600,000
Split
1,200,000 Parent1,600,000

Sub

unknown

What happened
to it?
Total Interco
Sales
Sales
COGS

Resold

On
hand

1,600,000

1,400,0
00

200,00
0

1,200,000

1,050,0
00

150,00
0 6-60

Learning Objective 3

Prepare equity-method
journal entries and
elimination entries for the
consolidation
of a subsidiary following
downstream inventory
transfers.

6-61

Agreement between Parent

Company and Consolidated
Financial
Under
the fullyStatements
adjusted equity
method,

the parent companys financial statements

should report the same net income and retained
earnings amounts as appear in the consolidated
statements.

Therefore, we

record and equity method adjustment on the

parents books to defer unrealized gross profit,
and

prepare consolidation worksheet elimination

entries to avoid double counting in the income
statement and overstating inventory.
6-62

Big PictureElimination entry:

Sale From Parent to Sub to
Outsider
To eliminate sale from Parent to Sub to Outsider:
Sales (Parent)
400
Cost of Goods Sold (Sub)
400

Get rid of the non-arms-length transaction!

$250

Parent

$400

Sub

$500

6-63

Big PictureElimination entry:

Sale From Parent to Sub (not yet
Reverse the entire transaction!
sold outside)

To eliminate sale from Parent to Sub, not yet to Outside

Sales
400
Cost of Goods Sold
250
Inventory
150
Equity Method Entry:
Income from Sub

Sales
$400
Cost of sales
250
Gross profit $ 150

$250

Parent

150
Investment in Sub
Parents gross profit
150is overstated
by $150
Subs inventory is overstated
by $150

$400

Sub
6-64

What to Look For

Most problems will contain

Inventory transferred from parent to sub

(downstream), or

Inventory transferred from sub to parent

(upstream).

Often part of the inventory is sold to an

outsider, but part remains in the buyers
ending inventory.
Key: Any problem can be split into two parts

The portion of the inventory that is sold

The portion of the inventory that is still on hand

6-65

A Comprehensive Downstream
Example

During 20X8, Parent sold inventory originally costing

$60,000 to its 100% owned Sub for $75,000. Sub sold
most of the inventory purchased from Parent (all but
$10,000) for $70,000 to outsiders during the year.
Income Statements
Parent
Sub
Sales
$75,000
$70,000
Cost of sales
60,000
65,000
Gross profit
$15,000
$ 5,000
60,000

What happened to
it? On-hand
Sold
$65,000 $10,000 x 20% =
$2,000
Unrealized GP
Ending inventory =
$10,000

Parent 75,000

$75,000
Split

Sub

70,000

6-66

One Approach: Split into Two

Transactions
This transaction can be broken into two
pieces:

Parent sells Sub inventory with a cost of $52,000 for

$65,000. Sub then sells this inventory to outsiders for
$70,000.

Parent sells Sub inventory with a cost of $8,000 for

$10,000, which remains on hand in Subs ending
inventory.

Total

Sold

On
hand

Sales

$75,00
0

$65,00 $10,000
0

COGS
Gross

60,000

52,000

$15,00

$13,00 $ 2,000

8,000
6-67

Part 1: Sale from Parent to Sub to

Outsider
To eliminate sale from Parent to Sub to Outsider:
Sales (Parent)
65,000
Cost of Goods Sold (Sub)
65,000

Get rid of the non-arms-length transaction!

$52,000

Parent$65,000

Sub

$70,000

6-68

Part 2: Sale from Parent to Sub

(Not Outside)
Reverse the entire transaction!

To eliminate sale from Parent to Sub, not yet to Outside

Sales (Parent)
10,000
Cost of Goods Sold (Parent)
8,000
Inventory (basis correction)
2,000

Sales
$10,000
Cost of sales 8,000
Gross profit$ 2,000

$8,000

Parents gross profit is

overstated by $2,000
Subs inventory is overstated by
$2,000

Parent $10,000

Sub
6-69

Summary
To eliminate sale from Parent to Sub to Outsider :
Sales (Parent)
65,000
Cost of Goods Sold (Sub)
65,000

To eliminate sale from Parent to Sub, not yet to Outsid

Sales (Parent)
10,000
Cost of Goods Sold (Parent)
8,000
Inventory (basis correction)
2,000
Can combine the two entries:
Sales
75,000
Cost of Goods Sold
Inventory

73,000
2,000

6-70

Partial Consolidated Worksheet

Paren
t

Sub

DR

CR

Conso
lidate
d

Income
Statement
Sales

75,00
75,00
70,000
0
0

COGS

60,00
65,000
0

Gross
Profit

15,00
0

5,000

75,00
0

70,00
0
73,00
0

52,00
0

73,00
0

18,00
0

6-71

Second Approach: Short Cut

Method
Total

Sales

$75,00
0

Sold

On
hand

$65,00 $10,000
0

60,000 52,000
8,000
COGS
COGS
= $65,000
Gross Credit
$15,00
$13,00+$$8,000
2,000
Profit
0
0
The numbers come right off the chart!
Sales
Cost of Goods Sold
Inventory

75,000
73,000
2,000

6-72

Fully-adjusted Equity Method

Adjustment
Dont forget that one of the desirable
properties of using the equity method is
that the parents net income should be
equal to the consolidated net income.
If you only adjust for unrealized deferred
profit in the consolidation, the
consolidated net income will be different
from the parents income!

6-73

Partial Consolidated Worksheet

Paren
t

Sub

DR

CR

Conso
lidate
d

Income
Statement
Sales

75,00
75,00
70,000
0
0

COGS

60,00
73,00 52,00
65,000 Not the same!
0
0
0

Inc from
Sub

Net

5,000

5,000

20,00

80,00

70,00
0

73,00

18,00 6-74

Fully-adjusted Equity Method

Adjustment
Dont forget that one of the desirable
properties of using the equity method is
that the parents net income should be
equal to the consolidated net income.
If you only adjust for unrealized deferred
profit in the consolidation, the
consolidated net income will be different
from the parents income!
Thus, an actual adjustment on the
parents books in addition to the
worksheet entries above.
Like we did for the excess fair value

6-75

Fully-adjusted Equity Method

Adjustment
After calculating the unrealized
deferred profit, simply make an
extra adjustment to back it out.
Do this at the same time you
record the parents share of the
subs income.
Investment in
Sub
NI 5,000
2,000
2,000

Parent NI =
Consolidated
NI

Sales

$75,000
COGS

60,000
from
Gross profit

Income
Sub5,000 NI
$15,000

Unreal GP

Inc. from Sub

3,000
3,000
NI

Reverse next year when this$18,000

inventory is sold!

6-76

Partial Consolidated Worksheet

Paren
t

Sub

DR

CR

Conso
lidate
d

Income
Statement
Sales

75,00
75,00
70,000
0
0

COGS

60,00
52,00
Now theyre 73,00
the same!
65,000
0
0
0

Inc from
Sub

Net

3,000

3,000

18,00

78,00

70,00
0

73,00

18,00 6-77

Practice Quiz Question #5

Under the fully adjusted equity
method, what is one benefit of
making an equity method
adjustment to defer unrealized
gross profit on inventory
transfers?
a. Consolidated net income always
increases.
b. Parent company net income
always increases.
c. Parent company net income is not
equal to consolidated net income.
6-78

Practice Quiz Question #5

Solution
Under the fully adjusted equity
method, what is one benefit of
making an equity method
adjustment to defer unrealized
gross profit on inventory
transfers?
a. Consolidated net income always
increases.
b. Parent company net income
always increases.
c. Parent company net income is not
equal to consolidated net income.
6-79

Review Exercise Part 1:

Downstream

Para sold inventory costing $100,000

to its 75%-owned subsidiary, Shute,
for $125,000 in 20X8.
NCI
Shute resold most of this inventory for
25%
$230,000 in 20X8.
At 12/31/X8, Shutes balance sheet
showed intercompany-acquired
inventory on hand of $20,000.

P
75%

Required:
Prepare the consolidation entry and/or entries
required at 12/31/X8 under the equity method.
Since this is a DOWNSTREAM transaction,
we dont share the GP deferral with the NCI.
6-80

Review Exercise Part 1: Big

Picture
Total

Sold

Sales 125,000

On
hand

20,000

COGS 100,000
Gross 25,000
Profit
Gross
Profit %

Ending Inventory = 20,000

Resold = $105,000
$125,000
split

$100,000

Parent$125,000

Sub

$230,000

6-81

Review Exercise Part 1: Big

Picture
Total

Sold

Sales 125,000

On
hand
20,000

COGS 100,000
Gross 25,000
Profit
Ending =
Inventory = 20,000
Gross = 25,000 125,000
Profit % 20%
Resold = $105,000
$125,000
split
$100,000

Parent$125,000

Sub

$230,000

6-82

Review Exercise Part 1: Big

Picture
Total

Sold

On
hand

Sales 125,000

105,00 20,000
0

COGS 100,000
Gross 25,000
Profit

84,000 16,000
21,000

4,000 Unrealized
GP

Ending Inventory = 20,000

Gross = 25,000 125,000 =

Resold = $105,000
Profit % 20%
$125,000
split
$100,000

Parent$125,000

Sub

$230,000

6-83

Review Exercise 1: Sale from

Parent to Sub to Outsider
To eliminate sale from Parent to Sub to Outsider:
Sales (Parent)
105,000
Cost of Goods Sold (Sub)
105,000

Get rid of the internal non-arms-length transaction!

$84,000

Parent$105,000

Sub

$230,000

6-84

Review Exercise 1: Sale from

Parent to Sub (Not Yet Outside)
Reverse the entire transaction!

To eliminate sale from Parent to Sub, not yet to Outside

Sales (Parent)
20,000
Cost of Goods Sold (Parent)
16,000
Inventory (basis correction)
4,000

Sales
$20,000
Cost of sales16,000

Parents gross profit is overstated by

$4,000

Gross profit$ 4,000

Subs inventory is overstated by

$4,000

$16,000

Parent$20,000

Sub
6-85

Review Exercise 1: Summary

To eliminate sale from Parent to Sub to Outsider:
Sales (Parent)
105,000
Cost of Goods Sold (Sub)
105,000

To eliminate sale from Parent to Sub, not yet to Outsid

Sales (Parent)
20,000
Cost of Goods Sold (Parent)
16,000
Inventory (basis correction)
4,000
Combine both entries:
Sales
Cost of Goods Sold
Inventory

125,000
121,000
4,000

Fully-adjusted Equity Method Entry on Parents

books:
Income from Sub
4,000
Investment in Sub
6-86

Review Exercise Part 1: Short

Cut
Total

Sold

On
hand

Sales 125,000

105,00 20,000
0

COGS 100,000
Gross 25,000
Profit

84,000 16,000
21,000

4,000 Unrealized
GP

COGS = 105,000 + 16,000 =

Credit 121,000
Worksheet
Elimination Entry:
Sales

125,000
Cost of Goods Sold
121,000
Inventory
6-87

Review Exercise Part 1

Worksheet Elimination Entry in Year 1:
Sales
125,000
Cost of Goods Sold
121,000
FYI, this years deferral is REVERSED
Inventory
next year
to recognize when sold!
4,000
Worksheet Elimination Entry in Year 2:
Investment in Sub
4,000
Cost of Goods Sold
4,000
INCREASES
income!
6-88

Review Exercise 1: Equity Method

Entry
Investment in
75% NI Sub
93,750
Low

4,000

4,000
4,000

Income from
Sub
93,750 75%
Defer GP

NI
89,750

Downstream, so dont split

the deferral with the NCI.

6-89

Review Exercise 1: Partial

Consolidated Worksheet
Parent

Sub

DR
125,000

CR

Consolidated

Income Statement
Sales

125,000

230,000

COGS

100,000

105,000

Inc from
Sub

89,750

Gross
Profit

114,750

121,00
0

125,000

214,750

121,00
146,000)
0

31,250 Basic
114,750

Balance Sheet

84,000)

89,750 Basic

NCI in NI
CI in NI

230,000)

125,000

246,000

(31,250)

121,00
114,750)
0
6-90

Review Exercise 1: Equity

Method Reversal Next Year

Equity Method Adjustment on Parents books in

20X7:
Income from Sub
4,000
Investment in Sub
4,000
Reversal of 20X7 Deferral on Parents
books in
20X8:
Investment in Sub
4,000
Income from Sub
4,000

6-91

Learning Objective 4

Prepare equity-method
journal entries and
elimination entries for the
consolidation
of a subsidiary following
upstream inventory
transfers.

6-92

Partially Owned Upstream Sales

Must share deferral with the NCI
shareholders.
Simply split up the adjustment for
Equity Method
unrealized gross profit proportionately.
Adjustments

Investment in
Sub
NI 4,500
1,800
1,800

Income from Sub

NCI

10%

P
90%

4,500 NI
Defer GP
2,700
NCI in NA of Sub

Unreal GP
200

Worksheet
Entry Only
6-93

Review Exercise Part 2

In 20X7, Sensei, a 90%-owned subsidiary of Padawan, sold inventory
to Padawan for $600,000, which includes a markup of 25% on Senseis
cost.
Padawan resold most of this inventory in 20X7 for $588,000.
At 12/31/X7, Padawan reported $110,000 of this inventory in its
NCI
balance sheet. (This ending inventory was resold in 20X8 by Padawan.)
In 20X8, Sensei sold Padawan inventory for $900,000 that had a cost
of $675,000, of which Padawan resold $700,000 by12/31/X8 for 10%
$840,000.
Required:
Prepare the consolidation entry and/or entries required at 12/31/X8
under the equity method.
Since this is an UPSTREAM transaction, we do share the GP deferral
with the NCI.

P
90%

6-94

Review Exercise Part 2: The Big

Picture20X7
Total

Sold

Sales 600,000
COGS

480,000

Gross 120,000
$600,000 C =
Profit

490,00 110,00
0
0
392,00 88,000
0

Sub

Unrealized
GP

98,000 22,000

0.25C
Gross
= 120,000
C=
$600,000/1.25
Profit
% 20%
= $480,000
?

On
hand

Ending Inventory = $110,000

600,000
=

$600,000

Parent

?
6-95

20X7 Upstream Sales: Elimination

Entries20X7 & 20X8
20X7 Worksheet Elimination Entry:
Sales
600,000
Cost of Goods Sold
578,000
Inventory
22,000
Deferred GP this year

reversed to recognize in
the financial statements
next year when sold.

NCI

10%

20X8 Worksheet Elimination Entry:

Investment in Sub
19,800
NCI in NA of Sub
2,200
Cost of Goods Sold
22,000

P
90%

S
6-96

20X7 Upstream Sales: Equity

Method Adjustments 20X7 &
20X8
20X7 Equity Method Adjustment on
Parents books:
Income from Sub
19,800
Investment in Sub
19,800
Deferral of GP in 20X7

because not yet sold this

year.

NCI

10%

20X8 Equity Method Reversal of 20X7

Deferral (on Parents books):
Investment in Sub
19,800
Income from Sub
19,800

P
90%

S
6-97

20X7 Upstream Sales: 20X7

Equity Accounts
Investment in
90% NI Sub
108,000
Low

19,800

19,800
19,800

Income from
Sub
108,000
X7 Deferral

90%

NI
88,200

6-98

20X7 Upstream Sales: 20X7

Partial Worksheet
Parent

Sub

DR
600,000

CR

Consolidated

Income Statement
Sales

588,000

600,000

COGS

490,000

480,000

Inc from
Sub

88,200

Gross
Profit

186,200

578,00
392,000)
0
88,200 Basic

120,000

NCI in NI
CI in NI

588,000)

688,200

578,00
196,000)
0

9,800 Basic
186,200

Balance Sheet

120,000

698,000

(9,800)

578,00
186,200)
0
6-99

Review Exercise Part 2

In 20X7, Sensei, a 90%-owned subsidiary of Padawan, sold inventory
to Padawan for $600,000, which includes a markup of 25% on Senseis
cost.
Padawan resold most of this inventory in 20X7 for $588,000.
At 12/31/X7, Padawan reported $110,000 of this inventory in its
NCI
balance sheet. (This ending inventory was resold in 20X8 by Padawan.)
In 20X8, Sensei sold Padawan inventory for $900,000 that had a cost
of $675,000, of which Padawan resold $700,000 by12/31/X8 for 10%
$840,000.
Required:
Prepare the consolidation entry and/or entries required at 12/31/X8
under the equity method.
Since this is an UPSTREAM transaction, we do share the GP deferral
with the NCI.

P
90%

6-100

Review Exercise Part 2: The Big

Picture20X8
Total

Sold

Sales 900,000
COGS

675,000

Gross 225,000
Profit

On
hand

700,00 200,00
0
0
525,00 150,00
0
0
175,00 50,000
0

Unrealized
GP

Ending Inventory = $200,000

Gross = 225,000 900,000
=
Profit % 25%

675,000

Sub

$900,000

Parent

?
6-101

Review Exercise 2: Summary

To eliminate sale from Sub to Parent to Outsider:
Sales (Sub)
700,000
Cost of Goods Sold (Parent)
700,000

To eliminate sale from Sub to Parent, not yet to Outsid

Sales (Sub)
200,000
Cost of Goods Sold (Sub)
150,000
Inventory (basis correction)
50,000
Combine both entries:
Sales
Cost of Goods Sold
Inventory

900,000
850,000
50,000

Fully-adjusted Equity Method Entry on Parents

books:
Income from Sub
45,000
Investment in Sub
6-102

Review Exercise 2: Short Cut

Total
Sales 900,000
COGS

Sold

On
hand

700,00 200,00
0
0

675,000

525,00 150,00
0
0

Gross Profit 200,000

175,00 50,000
0

The COGS
Elimination
Entry:
CR =
700,000 + 150,000
850,000
Sales
900,000
Cost of Goods Sold

850,000
Inventory
6-103

20X8 Upstream Sales: 20X8

Equity Accounts
Investment in
Sub
19,800 Low
19,800
90% NI 19,800
202,500
45,000
45,000
45,000 Low

Income from
Sub
X7 Reversal
202,500
X8 Deferral
NI

90%

177,300

6-104

20X7 & 20X8 Upstream Sales:

20X8 Partial Worksheet
Parent

Sub

DR

900,000

CR

Consolidated

Income Statement
Sales

840,000

900,00
0

COGS

700,000

675,00
0

840,000)
850,000

503,000)

22,000
Income from
Sub

177,300

Gross Profit

317,300

NCI in NI
CI in NI

177,300 Basic
225,00 1,077,30
872,000 337,000)
0
0
19,700 Basic

(19,700)

317,300

225,00 1,097,00
872,000
0
0

317,300

200,000

50,000

150,000)

Balance Sheet
Inventory

6-105

Learning Objective 5

Understand and explain

additional considerations
associated with
consolidation.

6-106

Additional Considerations
Sale from one subsidiary to another

Transfers of inventory often occur between

companies that are under common control or
ownership.

The eliminating entries are identical to those

presented earlier for sales from a subsidiary
to its parent.

The full amount of any unrealized

intercompany profit is eliminated, with the
profit elimination allocated proportionately
against the ownership interests of the selling
subsidiary.
6-107

Additional Considerations

Costs associated with

transfers

When one affiliate transfers

inventory to another, some
additional cost is often incurred.

Such costs should be treated in the

same way as if the affiliates were
operating divisions of a single
company.
6-108

Additional Considerations

Lower-of-cost-or-market

A company might write down

inventory purchased from an affiliate
under this rule if the market value at
the end of the period is less than the
intercompany transfer price.

6-109

Lower-of-Cost-or-Market Example
Assume that a parent company purchases inventory for $20,000
and sells it to its subsidiary for $35,000. The subsidiary still holds
the inventory at year-end and determines that its market value
(replacement cost) is $25,000 at that time. The subsidiary writes
the inventory down from $35,000 to its lower market value of
$25,000 at the end of the year and records the following entry:

Write-down Inventory to Market Value:

Loss on Decline in Value of Inventory 10,000
Inventory
Make the following worksheet eliminating10,000
entry:

Sales
35,000
Cost of Goods sold
Inventory
Loss on Decline in Value of Inventory

20,000
5,000
10,000
6-110

Additional Considerations
Sales and purchases before
affiliation

The consolidation treatment of profits on

inventory transfers that occurred before the
business combination depends on whether
the companies were at that time
independent and the sale transaction was
the result of arms-length bargaining.

As a general rule, the effects of transactions

that are not the result of arms-length
bargaining must be eliminated.
6-111

Additional Considerations
In the absence of evidence to the contrary,
companies that have joined together in a
business combination are viewed as having
been separate and independent prior to the
combination.

If the prior sales were the result of arms-length

bargaining, they are viewed as transactions
between unrelated parties.

No elimination or adjustment is needed in

preparing consolidated statements subsequent
to the combination, even if an affiliate still holds
the inventory.
6-112

Practice Quiz Question #6

Peanut Co. regularly purchased
inventory from Snack Inc. in 20X3
when Peanut did not own any
Snack stock. On March 31, 20X4,
Peanut purchased 90% of Snack
Inc.s outstanding common stock.
a. Peanut should eliminate 90% of
Snacks first quarter 20X4 gross
profit.
b. Peanut should eliminate 100% of
Snacks first quarter 20X4 gross
profit.
c. Peanut should not eliminate any
of Snacks first quarter 20X4

6-113

Practice Quiz Question #6

Solution

Peanut Co. regularly purchased

inventory from Snack Inc. in 20X3
when Peanut did not own any
Snack stock. On March 31, 20X4,
Peanut purchased 90% of Snack
Inc.s outstanding common stock.
a. Peanut should eliminate 90% of
Snacks first quarter 20X4 gross
profit.
b. Peanut should eliminate 100% of
Snacks first quarter 20X4 gross
profit.
c. Peanut should not eliminate any
of Snacks first quarter 20X4

6-114

Conclusion

The
The End
End