Elimination of unrealized profit on intercompany sales of inventory

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 06

Intercompany Inventory

Transactions

6-2

Learning Objective 1

Understand and explain intercompany transfers and

why they must be eliminated.

6-3

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)

6-4

Arm’s-Length Transactions

Q: What are “Arm’s-length” Transactions?

A: “Transactions that take place between completely independent parties.”

huf
6-5

Categories of Transactions

 Arm’s 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-Arm’s Length Transactions

 Usually referred to as “related party transactions.”

 Include all intercompany transactions.

huf
huf
6-6

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

huf
6-7

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.

6-8

Intercompany Transactions: Additional Opportunities for Fraud

 Intercompany transactions sometimes occur to

 conceal embezzlements.

 overstate reported profits.

2 + 2 = 5

6-9

Example 1: Intercompany Loan

 A 12-year old girl lends $5 to her 17-year-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 family’s wealth.

 Not a transaction with a non-family person.

6-10

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?

6-11

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 Sleazy’s consolidated financial statements will be misstated?

6-12

Correcting Entries

 Conceptually, how would you correct each of these three problems?

To eliminate intercompany loans: Loan Payable xxx

Loan Receivable 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 Outsider: Sales xxx

Cost of Goods Sold xxx Inventory Unrealized GP

Easy! Just

reverse

More difficult

Easy! Just

reverse

6-13

Let’s 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?

6-14

Parent: Receivable 500

Cash 500

Sub: Cash 500

Payable 500

(a) Loan from Parent to Sub

Does this transaction include outsiders?

Parent $500 Sub

Reverse the entries made by the parent and the sub.

To eliminate intercompany loans: Loan Payable 500

Loan Receivable 500

huf
6-15

(b) Sale from Parent to Sub to Outsider

Parent Sub$250 $500$400

Are these legitimate transactions?

Keep This

Purchase

Keep This Sale

Eliminate effect of this internal

Transaction

Arm’s Length

Internal (fake)

Keep Sub’s Sale

Get rid of Parent’s Sale Get rid of Sub’s COGS

Keep Parent’s COGS

huf
huf
6-16

Parent’s sale to Sub:

Parent: Cash 400

Sales 400 COGS 250

Inventory 250 Sub: Inventory 400

Cash 400

Sub’s sale to Outsider:

Sub: Cash 500

Sales 500 COGS 400

Inventory 400

Reverse the rest!

(b) Sale from Parent to Sub to Outsider

Which transactions are legitimate?

To eliminate sale from Parent to Sub to Outsider: Sales (parent to sub) 400

Cost of Goods Sold (to outsider) 400

huf
6-17

(c) Sale From Parent to Sub (Not Outside)

Keep this

purchase

Eliminate effect of this internal

transaction

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 sub.

Parent: Cash 300

Sales 300 COGS 200

Inventory 200

Sub: Inventory 300

Cash 300

Parent $300 Sub$200

Is this a legitimate arm’s length transaction?

huf
6-18

Parent: Cash 300

Sales 300 COGS 200

Inventory 200

Sub: Inventory 300

Cash 300

Parent Sub$300

(c) Sale From Parent to Sub (Not Outside)

Reverse the entries made by the parent and sub.

To eliminate sale from Parent to Sub, not yet to Outsider: Sales 300

Cost of Goods Sold 200 Inventory 100(net)

huf
6-19

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 Outsider: Sales 300

Cost of Goods Sold 200 Inventory 100

6-20

Fully-adjusted Equity Method Adjustment

 Parent companies have to adjust their equity method investment accounts for certain transactions.

 At this point, let’s just consider one:

 Sale from parent to sub, but not yet sold to an outsider.

 It represents “fake profit” that hasn’t really been realized in an arm’s-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!

huf
huf
huf
6-21

Equity Method Adjustment Example

Sales $ 600 COGS 500 GP $ 100

Equity Method Entry:

Income from Sub 100 Investment in Sub 100

 The Parent recognized $100 of “fake gross profit!

 The Parent should have transferred the inventory at cost.

 This profit is not from a transaction with an arm’s length independent party.

Parent $600 Sub$500

Summary of the Transaction:  Parent purchased inventory for $500.  Parent sold the inventory to a Sub for $600.

huf
huf
6-22

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. (Don’t forget equity method entry!)

 Based on our “conceptual discussion,” what consolidation worksheet entries would you make?

6-23

Practice Quiz Question #1

Why must intercompany transactions be eliminated?

a. They portray the consolidated company’s results too conservatively.

b. They understate the results of the consolidated group.

c. They are arm’s length transactions.

d. They are not arm’s length transactions.

huf
6-24

Learning Objective 2

Understand and explain concepts associated with inventory transfers and

transfer pricing.

6-25

Issue #1: Eliminate Intercompany Transfers?

 Whether to Eliminate Intercompany Transactions in Consolidation:

 No controversy—they must be eliminated.

 Not eliminating them would cause two problems:

 Meaningless double-counting of

1. sales, and 2. expenses

 Potential to manipulate income.

6-26

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.

6-27

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 $1,000 Cost of sales 600 Gross profit $ 400

huf
huf
huf
6-28

Issue #3: Eliminate Income Tax Effects?

 Income taxes play a major role in intercompany sales and transfer pricing decisions.

 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.

huf
huf
6-29

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.

huf
huf
6-30

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.

 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.

P

S

NCI

huf
huf
6-31

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.

6-32

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

huf
huf
6-33

Review: Two Types of Transfers

Assume both transactions

took place during the same year.

Parent Sub$750 For $1,200$1,000

 Parent-to-sub-to-outsider

 Parent-to-sub-not-yet-to-outsider

Parent Sub$300 $400

huf
huf
huf
6-34

Understanding Inventory Transfers: Map it out

Splits out parent’s numbers.

Parent Sub$1,050 Unknown$1,400

$1,400 Split

Ending Inventory = $400

What happened to it?

Total Interco Sales Resold On hand

Sales 1,400 1,000 400

 COGS 1,050 750 300

Gross Profit 350 250 100

Gross Profit % 25%

Resold = $1,000

huf
huf
Not sold yet to I outsiders
huf
6-35

Calculating Unrealized Gross Profit

 Amounts that will always be known (given):

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.

Total Resold On hand

Sales (NEW basis) 1,000 200

 Cost of sales (OLD basis) 600

Gross Profit 400

Gross Profit % 40%

huf
huf
huf
6-36

Calculating Unrealized Gross Profit

 Completed Analysis:

 The Inventory/COGS Change in Basis Elimination Entry is derived from this analysis.

 Unrealized profit = Inventory on hand x GP%

= $200 x 40% = $80

Total Resold On hand

Sales (NEW basis) 1,000 800 200

 Cost of sales (OLD basis) 600 480 120

Gross Profit 400 320 80

Gross Profit % 40% Realized Unrealized

huf
huf
huf
نطلع اول البروفت عشان نطلع الكوست اوف قوود سولد
6-37

What happened to it?

Total Interco Sales

Resold On hand

Sales 1,400 1,000 400

 COGS 1,050 750 300

Gross Profit 350 250 100

Gross Profit % 25%

Transfer Price

Cost

Markup

Markup on Transfer Price

Inventory Transfers: Terminology

Watch out for terminology like “mark-up based on cost”!

huf
huf
huf
6-38

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

huf
6-39

Practice Quiz Question #2 Solution

Parent Sub$800,000 ??

Ending Inventory = $300,000

What happened to it?

Total Interco Sales Resold On hand

Sales 300,000

 COGS 800,000

Gross Profit ?

Gross Profit % 20%

6-40

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

6-41

Practice Quiz Question #3 Solution

Parent Sub? ?90,000

What happened to it?

Total Interco Sales Resold On hand

Sales 90,000 30,000

 COGS C

Gross Profit 0.25 C ?

Gross Profit % ?

$90,000 Split

Ending Inventory = $30,000

huf
huf
6-42

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

huf
huf
6-43

Practice Quiz Question #4 Solution

Parent Sub? unknown1,600,000

What happened to it?

Total Interco Sales Resold On hand

Sales 1,600,000 1,400,000

 COGS

Gross Profit ?

Gross Profit % ?

$1,600,000 Split

Ending Inventory = 200,000

Resold = $1,400,000

huf
6-44

Learning Objective 3

Prepare equity-method journal entries and elimination entries

for the consolidation of a subsidiary following downstream inventory

transfers.

6-45

Agreement between Parent Company and Consolidated Financial Statements

 Under the fully adjusted equity method,

 the parent company’s 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 parent’s books to defer unrealized gross profit, and

 prepare consolidation worksheet elimination entries to avoid double counting in the income statement and overstating inventory.

huf
huf
huf
6-46

Big Picture—Elimination entry: Sale From Parent to Sub to Outsider

Get rid of the non-arm’s-length transaction!

Parent Sub$250 $500$400

To eliminate sale from Parent to Sub to Outsider: Sales (Parent) 400

Cost of Goods Sold (Sub) 400

6-47

Big Picture—Elimination entry: Sale From Parent to Sub (not yet sold outside)

Reverse the entire transaction!

Parent Sub$250 $400

To eliminate sale from Parent to Sub, not yet to Outsider: Sales 400

Cost of Goods Sold 250 Inventory 150

Equity Method Entry:

Income from Sub 150 Investment in Sub 150

Sub’s inventory is overstated by $150

Sales $400 Cost of sales 250 Gross profit $ 150

Parent’s gross profit is overstated by $150

huf
6-48

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 buyer’s 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

huf
huf
huf
huf
huf
6-49

Parent Sub60,000 70,00075,000

Ending inventory = $10,000

What happened to it?Income Statements Parent Sub

Sales $75,000 $70,000 Cost of sales 60,000 65,000 Gross profit $15,000 $ 5,000

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.

$75,000 Split

Sold On-hand $65,000 $10,000 x 20% = $2,000

Unrealized GP

A Comprehensive Downstream Example

huf
huf
huf
حسب الكمية اللي تم بيعهاا
6-50

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 Sub’s ending inventory.

Total Sold On hand

Sales $75,000 $65,000 $10,000

 COGS 60,000 52,000 8,000

Gross Profit $15,000 $13,000 $ 2,000

huf
huf
الكمية اللي باعها السب للخارج تكلفتها بالنسبة للبيرنت كانت 52،٠٠٠ فهو ركز على حذف المعاملة اللي تم بيعها للخارج لانها خرجت من حسابات السب والبيرنت لانهم يعتبر واحد بالنهاية
huf
6-51

Part 1: Sale from Parent to Sub to Outsider

Get rid of the non-arm’s-length transaction!

Parent Sub$52,000 $70,000$65,000

To eliminate sale from Parent to Sub to Outsider: Sales (Parent) 65,000

Cost of Goods Sold (Sub) 65,000

huf
huf
سعر البيعة اللي كانت تكلفتها ٥٢.٠٠٠ كانت ٦٥،٠٠٠ حنحذفها لانها بيعت لطرف خارجي ثالث
6-52

Part 2: Sale from Parent to Sub (Not Outside)

Reverse the entire transaction!

Parent Sub$8,000 $10,000

To eliminate sale from Parent to Sub, not yet to Outsider: Sales (Parent) 10,000

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

Sub’s inventory is overstated by $2,000

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

Parent’s gross profit is overstated by $2,000

huf
6-53

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 Outsider: 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 73,000 Inventory 2,000

huf
6-54

Partial Consolidated Worksheet

Parent Sub DR CR Consol- idated

Income Statement

Sales 75,000 70,000 75,000 70,000

COGS 60,000 65,000 73,000 52,000

Gross Profit 15,000 5,000 75,000 73,000 18,000

Balance Sheet

Inventory 0 10,000 2,000 8,000

huf
6-55

Second Approach: Short Cut Method

Total Sold On hand

Sales $75,000 $65,000 $10,000

 COGS 60,000 52,000 8,000

Gross Profit $15,000 $13,000 $ 2,000

The numbers come right off the chart!

Sales 75,000 Cost of Goods Sold 73,000 Inventory 2,000

COGS Credit = $65,000 + $8,000

huf
6-56

Fully-adjusted Equity Method Adjustment

 Don’t forget that one of the desirable properties of using the equity method is that the parent’s 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 parent’s income!

6-57

Partial Consolidated Worksheet

Parent Sub DR CR Consol- idated

Income Statement

Sales 75,000 70,000 75,000 70,000

COGS 60,000 65,000 73,000 52,000

Inc from Sub 5,000 5,000

Net Income 20,000 5,000 80,000 73,000 18,000

Balance Sheet

Inventory 0 10,000 2,000 8,000

Not the same!

huf