advanced accounting 6e by jeter chaney chapter 06

Advanced Accounting

Jeter ● Chaney

Elimination of Unrealized
Profit on Intercompany
Sales of Inventory

1

Prepared by Sheila Ammons, Austin Community College


Learning Objectives

•
•

Describe the financial reporting objectives for intercompany sales of inventory.

•

Understand the concept of eliminating 100% of intercompany profit not realized in transactions
with outsiders, and know the authoritative position.

•
•
•
•

Determine the amount of intercompany profit, if any, to be eliminated from the consolidated

statements.

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.

2
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


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 is defined as unrealized intercompany
profit (loss) and must be eliminated in the preparation of consolidated financial statements.

LO 4 Upstream and downstream3 sales.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


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 intercompany4 sales.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Intercompany Sales of Merchandise
Determination of Consolidated Sales,

Downstream Sales

Cost of Sales, and Inventory Balances

•

E6-7: (Downstream Sales-variation) Perkins Company owns 85% of Sheraton Company.
Perkins Company sells merchandise to Sheraton Company at 20% above cost. During 2014 and
2015, 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 2014.

LO 6 Consolidated workpapers for downstream5 sales.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Intercompany Sales of Merchandise
Downstream Sales
E6-7: Summary of 2014 Intercompany Sales

Intercompany Sales
Intercompany COGS
Gross profit

1.

$
$

Total
450,000

375,000
75,000

(COGS)
Resold
$
450,000
375,000
$
75,000

(Inventory)
On Hand
$
$
-

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.

2.

The “Resold” column represents intercompany inventory that was resold to third parties. Portions resold are recorded in COGS.

3.

“On Hand” represents intercompany inventory still on hand in the affiliated group.

LO 6 Consolidated workpapers for downstream6 sales.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.

Intercompany Sales of Merchandise

Downstream Sales

E6-7: Summary of 2014 Intercompany Sales

Prepare the workpaper entry to eliminate intercompany sales for 2014.

Sales 450,000
Purchases (Cost of Sales)

450,000

To eliminate intercompany sales

LO 6 Consolidated workpapers for downstream7 sales.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Intercompany Sales of Merchandise
Determination of Consolidated Sales,
Cost of Sales, and Inventory Balances

•

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 2014 and
2015, 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 2014 and 2015.

LO 6 Consolidated workpapers for downstream8 sales.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Intercompany Sales of Merchandise
Downstream Sales
E6-7: Summary of 2014 Intercompany Sales

Prepare the workpaper entry to eliminate intercompany sales for 2014.
Sales 450,000
Purchases (Cost Sales)

450,000

Ending Inventory – Income Statement (Cost of Sales)

25,000

Inventory - Balance Sheet

25,000

To eliminate intercompany sales and defer (eliminate) the unrealized gross profit in ending inventory until it is sold to outsiders

LO 6 Consolidated workpapers for downstream9 sales.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Intercompany Sales of Merchandise
E6-7:

Alternate View

Workpaper entry to eliminate intercompany sales for 2014.

Downstream Sales

1
Sales 450,000

Cost of Sales
Cost of Sales

1

375,000

2

Inventory – Balance Sheet

50,000

3

1.

Original Sales and Cost of Sales recorded by Perkins (parent) is reversed.

2.

Cost of Sales overstated by Sheraton on resale of goods to third parties.

3.

Inventory on hand is overstated on Sheraton’s books by $25,000 unrealized profit.

25,000

10 sales.
LO 6 Consolidated workpapers for downstream
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Intercompany Sales of Merchandise
Downstream Sales
E6-7: Workpaper entry to eliminate intercompany sales for 2015.
2014 Unrealized Profit in Inventory

Cost or Partial Equity Method *
Beg. Retained Earnings – P Company

25,000

Beg. Inventory – Income Statement (Cost of Sales)

25,000

To realize (recognize) the gross profit in beginning inventory deferred in the prior period

* If the complete equity method is used, the debit is to the Investment account.
11 sales.
LO 6 Consolidated workpapers for downstream
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Intercompany Sales of Merchandise
Downstream Sales
E6-7: Workpaper entry to eliminate intercompany sales for 2015.
2015 Intercompany Sales

Sales 486,000
Purchases (Cost of Sales)

486,000

End. Inventory – Cost of Sales

27,000

Inventory – Balance Sheet

27,000

To eliminate intercompany sales and defer (eliminate) unrealized profit in ending inventory

12 sales.
LO 6 Consolidated workpapers for downstream
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


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. When
stated as a percentage of cost, it is referred to as “markup”.

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.

13 profit.
LO 2 Determining the amount of intercompany
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


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.” [FASB ASC paragraph 810-10-45-18]

14 profit.
LO 3 Eliminating 100% of intercompany
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


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.

15 sales.

LO 5 Noncontrolling interest (NCI) for upstream
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Cost Method: Consolidated Workpaper

•
•
•

Upstream Sales

P6-7: Paque Corporation owns 90% of the
common stock of Segal
Company. The stock was purchased for $810,000 on January 1, 2012, when Segal Company’s
retained earnings were $150,000.
The January 1, 2016, inventory of Paque Corporation includes $45,000 of profit recorded by
Segal Company on 2015 sales. During 2016, 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 2016 from Segal Company for $75,000.
Required: Prepare the worksheet entries and the consolidated statements workpaper for the year
ended December 31, 2016.

16
LO 6 Consolidated workpapers for upstream Sales- Cost Method.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Cost Method: Consolidated Workpaper

Upstream Sales

P6-7: Worksheet entries for Dec. 31, 2016.
Acquisition date retained earnings - Segal

$ 150,000

Retained earnings 1/1/16 - 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 1/1/2016

17
LO 6 Consolidated workpapers for upstream Sales- Cost Method.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Cost Method: Consolidated Workpaper

Upstream Sales

P6-7: Worksheet entries for Dec. 31, 2016.
2016 Intercompany Sales

2.

Sales 300,000
Purchases (Cost of Sales)

3.

Ending Inventory (Cost of Sales)
Inventory (Balance Sheet)

300,000
15,000
15,000

To eliminate intercompany sales and eliminate (defer) unrealized profit in ending inventory

18
LO 6 Consolidated workpapers for upstream Sales- Cost Method.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Cost Method: Consolidated Workpaper
Upstream Sales

P6-7: Worksheet entries for Dec. 31, 2016.
2015 Unrealized Profit in Inventory

4.

Beg. Retained Earnings - P ($45,000 x 90%)

40,500

NCI in Equity ($45,000 x 10%)

4,500

Beg. Inventory - Income Statement (Cost of Sales)

45,000

To realize (recognize) the gross profit in inventory deferred in the prior period and reduce CI and NCI for their share of unrealized profit at
beginning of year

19
LO 6 Consolidated workpapers for upstream Sales- Cost Method.

Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Cost Method: Consolidated Workpaper
Upstream Sales

P6-7: Worksheet entries for Dec. 31, 2016.
5.

Dividend Income

54,000

($60,000 x 90%)

Dividends Declared

54,000

To eliminate intercompany dividends

6.

Beg. Retained Earnings - Segal

180,000

Common Stock - Segal

750,000

Investment in Segal
Noncontrolling Interest

837,000
93,000

To eliminate investment account and create NCI account

20
LO 6 Consolidated workpapers for upstream Sales- Cost Method.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Cost Method: Consolidated Workpaper
Upstream Sales
P6-7

Income Statement
Sales
Dividend income
Total revenue
Cost of goods sold
Other expenses
Total cost and expense
Net income
Noncontrolling interest
Net income

Paque

$ 1,650,000
54,000
1,704,000
1,290,000

Segal
$ 795,000

310,500
1,600,500
103,500

206,250
723,750
71,250

$

Retained Earnings Statement
Retained earnings, 1/1
Paque
Segal
Net income
Dividends declared
Retained earnings, 12/31
$

103,500

811,500

795,000
517,500

$

71,250

Eliminations
Debit
Credit
(2)
300,000
(5)
54,000
15,000

$ 369,000

40,500
180,000
369,000

180,000
103,500
71,250
(150,000)
(60,000)
765,000 $ 191,250 $ 589,500

(3)

300,000
45,000

$ 345,000

(4)

27,000

NCI

(2)
(4)

$

Consolidated
Balances
$
2,145,000
2,145,000
1,477,500

$

516,750
1,994,250
150,750

(10,125)
140,625

10,125
(6,000)
4,125 $

798,000
140,625
(150,000)
788,625

10,125
10,125

(1)

(6)

345,000
54,000
$ 426,000

(5)

$

NCI in Consolidated Income = 10% × ($71,250 + $45,000 – $15,000) = $10,125

21

LO 6 Consolidated workpapers for upstream Sales- Cost Method.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Cost Method: Consolidated Workpaper
Upstream Sales

P6-7

(3)
(6)

(1)
(6)

(4)

(6)

22
LO 6 Consolidated workpapers for upstream Sales- Cost Method.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Cost Method—Analysis of Consolidated Net Income and Consolidated Retained
Earnings
Consolidated Net Income

•

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.

23
LO 6 Consolidated workpapers for upstream Sales- Cost Method.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Cost Method: Consolidated
Net Income
Upstream Sales

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 2016 sales to Paque

(15,000)

Plus: profit on prior year's sales to Paque realized
in transactions with third parties in 2016

45,000

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

Subsidiary income included in consolidated income

$

101,250

24
LO 6 Consolidated workpapers for upstream Sales- Cost Method.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.

Cost Method: Consolidated
Net Income

Upstream Sales

P6-7: Prepare a calculation of CI in Consolidated Income.
Paque's net income

$103,500
(54,000)

Less: subsidiary dividend income
Paque's net income from its independent operations

49,500

Less: unrealized profit on 2016 sales to Segal

0

Plus: profit on prior year's sales to Segal realized
in transactions with third parties in 2016

0

Paque's income from independent operations that
has been realized in transactions with third parties
Paque's share of Segal’s income (previous slide)

49,500

91,125

Controlling interest in Consolidated net income

$140,625

25
LO 6 Consolidated workpapers for upstream Sales- Cost Method.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.