advance accounting ch06

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Elimination of UnrealizedElimination of UnrealizedProfit on Intercompany Profit on Intercompany Sales of InventorySales of Inventory

Advanced Accounting, Fifth Edition

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1. Describe the financial reporting objectives for intercompany sales of inventory.

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

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

4. Distinguish between upstream and downstream sales of inventory.5. Compute the noncontrolling interest in consolidated net income for

upstream and downstream sales, when not all the inventory has been sold to outsiders.

6. Prepare consolidated workpapers for firms with upstream and downstream sales using the cost, partial equity, and complete equity methods.

7. Discuss the treatment of intercompany profit earned prior to the parent subsidiary affiliation.

Learning ObjectivesLearning Objectives

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Upstream and Downstream Sales of Upstream and Downstream Sales of InventoryInventory

LO 4 Upstream and downstream sales.LO 4 Upstream and downstream sales.

Company P

Company S2

P sells inventory

Downstream

S2 sells inventory UpstreamS1 sells

inventory HorizontalCompany S1

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.

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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.

LO 1 Financial reporting objectives for intercompany sales.LO 1 Financial reporting objectives for intercompany sales.

Effects of Intercompany Sales of Effects of Intercompany Sales of Merchandise onMerchandise onthe Determination of Consolidated the Determination of Consolidated BalancesBalances

Objective is to eliminate the effects of intercompany sales as if they had never occurred.

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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.

Intercompany Sales of Merchandise Intercompany Sales of Merchandise

Determination of Consolidated Sales, Cost of Sales, and Inventory Balances Assuming Downstream Sales

LO 6 Consolidated workpapers for downstream sales.LO 6 Consolidated workpapers for downstream sales.

Downstream Sales

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E6-7: Summary of 2011 Intercompany Sales(COGS) (Inventory)

Total Resold On HandIntercompany Sales 450,000$ 450,000$ -$ Intercompany COGS 375,000 375,000 - Gross profit 75,000$ 75,000$ -$

1. 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.

Downstream Sales

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(COGS) (Inventory)Total Resold On Hand

Intercompany Sales 450,000$ 450,000$ -$ Intercompany COGS 375,000 375,000 - Gross profit 75,000$ 75,000$ -$

Sales 450,000

Cost of Goods Sold (Purchases)450,000

To eliminate intercompany sales of merchandise

Prepare the workpaper entry to eliminate intercompany sales for 2011.

Downstream Sales

E6-7: Summary of 2011 Intercompany Sales

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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.


Determination of Consolidated Sales, Cost of Sales, and Inventory Balances Assuming Downstream Sales


Downstream Sales

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E6-7: Summary of 2011 Intercompany Sales2011 (COGS) (Inventory)

Total Resold On HandIntercompany Sales 450,000$ 300,000$ 150,000$ Intercompany COGS 375,000 250,000 125,000 Gross profit 75,000$ 50,000$ 25,000$

Sales 450,000Cost of Goods Sold (purchases) 450,000

Cost of Goods Sold (ending inventory) 25,000Inventory 25,000

To eliminate intercompany sales and defer unrealized profit

Prepare the workpaper entry to eliminate intercompany sales for 2011.

Downstream Sales

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E6-7: 2011 (COGS) (Inventory)Total Resold On Hand

Intercompany Sales 450,000$ 300,000$ 150,000$ Intercompany COGS 375,000 250,000 125,000 Gross profit 75,000$ 50,000$ 25,000$

Sales 450,000Cost of Goods Sold 375,000Cost of Goods Sold 50,000Inventory 25,000

Workpaper entry to eliminate intercompany sales for 2011.

Downstream Sales

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1

2

3

1. Original Sales and COGS recorded by Perkins (parent) is reversed.2. COGS 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.

Alternate View

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E6-7: Prepare the workpaper entry to eliminate intercompany sales for 2012.


Intercompany Sales 150,000$ Intercompany COGS 125,000 Gross profit 25,000$

Downstream Sales

2011 Unrealized Profit in Inventory

Cost or Partial Equity Method *Retained earnings 25,000

Cost of Goods Sold (beg. inventory) 25,000To 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.

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E6-7: Prepare the workpaper entry to eliminate intercompany sales for 2012.



Downstream Sales

2012 Intercompany Sales

Sales 486,000Cost of Goods Sold (purchases) 486,000

Cost of Goods Sold (ending inventory) 27,000Inventory 27,000


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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”.


Determination of Amount of Intercompany Profit

LO 2 Determining the amount of intercompany profit.LO 2 Determining the amount of intercompany profit.

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.

Inventory Pricing Adjustments

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“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]


Determination of Proportion of Intercompany Profit to Be Eliminated

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

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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.

Cost Method: Consolidated StatementsCost Method: Consolidated StatementsWorkpaper—Upstream SalesWorkpaper—Upstream Sales

Determination of the Noncontrolling Interest in Combined Income—Upstream or Horizontal Sales

LO 5 Noncontrolling interest (NCI) for upstream sales.LO 5 Noncontrolling interest (NCI) for upstream sales.

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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 LO 6 Consolidated workpapers for upstream Sales- Cost

Method.Method.

Cost Method: Consolidated WorkpaperCost Method: Consolidated WorkpaperUpstream Sales

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Investment in Segal 27,000Beg. Retained Earnings ‑ Pague Co.

27,000

Acquisition date retained earnings - Segal $ 150,000Retained earnings 1/1/13 - Segal 180,000Increase 30,000Ownership percentage 90%

$ 27,000

To establish reciprocity/convert to equity as of 1/1/2013.

P6-7: Prepare the worksheet entries for Dec. 31, 2013.

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


1.

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2. Sales 300,000Cost of Goods Sold (purchases) 300,000

3. Cost of Good Sold (ending inventory) 15,000Inventory 15,000





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Intercompany SalesIntercompany COGSGross profit 45,000$


4. Retained Earnings ($45,000 x 90%) 40,500Noncontrolling Interest ($45,000 x 10%) 4,500

Cost of Goods Sold (beg. inventory) 45,000To realize the gross profit in inventory deferred in the prior

period.

Cost Method: Consolidated WorkpaperCost Method: Consolidated Workpaper


Upstream Sales


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Dividend Income ($60,000 x 90%) 54,000Dividends Declared

54,000

Beg. Retained Earnings - Segal 180,000Common Stock - Segal 750,000

Investment in Segal837,000Noncontrolling Interest 93,000



To eliminate intercompany dividends

To eliminate investment account and create NCI account


5.

6.

Sheila

Sheila

This should be 90% per page 368. 90% makes the math correct.

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ConsolidatedIncome Statement Paque Segal Debit Credit NCI BalancesSales 1,650,000$ 795,000$ 300,000 2,145,000$ Dividend income 54,000 54,000 -

Total revenue 1,704,000 795,000 2,145,000 Cost of goods sold 1,290,000 517,500 15,000 300,000 1,477,500

45,000 Other expenses 310,500 206,250 516,750

Total cost and expense 1,600,500 723,750 1,994,250 Net income 103,500 71,250 150,750 Noncontrolling interest 10,125 (10,125) Net income 103,500$ 71,250$ 369,000$ 345,000$ 10,125$ 140,625$

Retained Earnings StatementRetained earnings, 1/1

Paque 811,500 40,500 27,000 798,000 Segal 180,000 180,000 -

Net income 103,500 71,250 369,000 345,000 10,125 140,625 Dividends declared (150,000) (60,000) 54,000 (6,000) (150,000) Retained earnings, 12/31 765,000$ 191,250$ 589,500$ 426,000$ 4,125$ 788,625$

EliminationsP6-7:


(2)(5)

(4)

(2)

(1)

(4)(6)

(5)

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


(3)

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ConsolidatedBalance Sheet Paque Segal Debit Credit NCI BalancesCash 93,000$ 75,000$ 168,000$ Accounts receivable 319,500 168,750 488,250 Inventory 210,000 172,500 15,000 367,500 Investment in Segal 810,000 27,000 837,000 - Other assets 750,000 630,000 1,380,000

Total assets 2,182,500$ 1,046,250$ 2,403,750$ -

Accounts payable 105,000$ 45,000$ 150,000$ Other current liabilities 112,500 60,000 172,500 Common stock 1,200,000 750,000 750,000 1,200,000 Retained earnings 765,000 191,250 589,500 426,000 4,125 788,625 NCI in net assets 4,500 93,000 88,500

92,625 92,625 Total liab. & equity 2,182,500$ 1,046,250$ 1,371,000$ 1,371,000$ 2,403,750$

Eliminations


(3)(6)

(1)

(6)

(6)

(4)

P6-7:


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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.

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


24 LO 6 Consolidated workpapers for upstream Sales- Cost LO 6 Consolidated workpapers for upstream Sales- Cost

Method.Method.

Cost Method: Consolidated Net IncomeCost Method: Consolidated Net IncomeUpstream Sales

Reported income of Segal $ 71,250Less: amortization of difference between

implied and book value 0Less: unrealized profit on 2013 sales to Paque Plus: profit on prior year's sales to Paque realized

in transactions with third parties in 2013 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

(15,000)

P6-7: Prepare a calculation of Paque’s share of Segal’s income.

25 LO 6 Consolidated workpapers for upstream Sales- Cost LO 6 Consolidated workpapers for upstream Sales- Cost

Method.Method.

Cost Method: Consolidated Net IncomeCost Method: Consolidated Net IncomeUpstream Sales

Paque's net income $103,500Less: subsidiary dividend income Paque's net income from its independent operations 49,500Less: unrealized profit on 2013 sales to Segal 0Plus: profit on prior year's sales to Segal realized

in transactions with third parties in 2013 0Paque's income from independent operations that

has been realized in transactions with third parties 49,500Paque's share of Segal’s income (previous slide)

91,125Controlling interest in Consolidated net income

$140,625

(54,000)

P6-7: Prepare a calculation of CI in Consolidated Income.

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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 dateplus (minus) the cumulative effect of adjustments to date relating to the amortization, depreciation, and impairment of differences between implied and book values.

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


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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.

Consolidated Statements Workpaper —Consolidated Statements Workpaper —Partial Equity MethodPartial Equity Method

LO 6 Consolidated workpapers – partial equity method.LO 6 Consolidated workpapers – partial equity method.

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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.

Partial Equity Method: WorkpaperPartial Equity Method: Workpaper Upstream Sales


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Equity in Subsidiary Income 64,125Investment in Segal Company 10,125 Dividends declared ($60,000 x 90%) 54,000


To reverse the effect of parent entries for subsidiary dividends and income

1.



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3. Cost of Goods Sold (end. inventory) 15,000Inventory 15,000





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4. Retained Earnings ($45,000 x 90%) 40,500Noncontrolling Interest ($45,000 x 10%) 4,500


period.




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Investment in Segal837,000Noncontrolling Interest 93,000To eliminate investment account and create NCI

account

5.




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ConsolidatedIncome Statement Paque Segal Debit Credit NCI BalancesSales 1,650,000$ 795,000$ 300,000 2,145,000$ Equity in Segal income 64,125 64,125 -


45,000 Other expenses 310,500 206,250 516,750



Paque 838,500 40,500 798,000 Segal 180,000 180,000 -


EliminationsP6-13:

(2)(1)

(4)

(2)

(4)(5)

(1)




(3)

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ConsolidatedBalance Sheet Paque Segal Debit Credit NCI BalancesCash 93,000$ 75,000$ 168,000$ Accounts receivable 319,500 168,750 488,250 Inventory 210,000 172,500 15,000 367,500 Investment in Segal 847,125 837,000 -

10,125 Other assets 750,000 630,000 1,380,000

Total assets 2,219,625$ 1,046,250$ 2,403,750$ -



Eliminations

(3)(5)

(5)

(5)

(4)

P6-13:



(1)

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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.

Partial Equity Method—Analysis of Partial Equity Method—Analysis of Consolidated Net Income and Consolidated Net Income and Consolidated Retained EarningsConsolidated Retained EarningsConsolidated Net Income Same as Cost

Method


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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.

Consolidated Retained Earnings

Partial Equity Method—Analysis of Partial Equity Method—Analysis of Consolidated Net Income and Consolidated Net Income and Consolidated Retained EarningsConsolidated Retained Earnings


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Consolidated Retained EarningsConsolidated Retained Earnings Partial Equity

Paque's Retained Earnings on 12/31/13 $ 802,125Unrealized profit on downstream sales 0Unrealized profit on upstream sales ($15,000 x 90%)Consolidated retained earnings on 12/31/2013 $ 788,625

(13,500)

P6-13: Calculate consolidated retained earnings on Dec. 31, 2013.


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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.

Complete Equity Method: WorkpaperComplete Equity Method: WorkpaperUpstream Sales

LO 6 Consolidated workpapers – complete equity method.LO 6 Consolidated workpapers – complete equity method.

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Equity in Subsidiary Income 91,125Investment in Segal Company 37,125 Dividends declared ($60,000 x 90%) 54,000


To reverse the effect of parent company entries for subsidiary dividends and income

1.



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3. Cost of Goods Sold (end. inventory) 15,000Inventory 15,000





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4. Retained earnings ($45,000 x 90%) 40,500Noncontrolling Interest ($45,000 x 10%) 4,500


period




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Investment in Segal837,000Noncontrolling Interest 93,000To eliminate investment account and create NCI

account

5.


Complete Equity Method: WorkpaperComplete Equity Method: Workpaper


Upstream Sales

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ConsolidatedIncome Statement Paque Segal Debit Credit NCI BalancesSales 1,650,000$ 795,000$ 300,000 2,145,000$ Equity in Segal income 91,125 91,125 -


45,000 Other expenses 310,500 206,250 516,750



Paque 798,000 798,000 Segal 180,000 180,000 -


EliminationsP6-17:

(2)(1)

(4)

(2)

(5)

(1)


(3)



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ConsolidatedBalance Sheet Paque Segal Debit Credit NCI BalancesCash 93,000$ 75,000$ 168,000$ Accounts receivable 319,500 168,750 488,250 Inventory 210,000 172,500 15,000 367,500 Investment in Segal 833,625 40,500 837,000 -

37,125 Other assets 750,000 630,000 1,380,000

Total assets 2,206,125$ 1,046,250$ 2,403,750$ -



Eliminations

(3)(5)

(5)

(5)

(4)

P6-17:

(1)



(4)

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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.

Complete Equity Method—Analysis of Complete Equity Method—Analysis of Consolidated Net Income and Consolidated Net Income and Consolidated Retained EarningsConsolidated Retained Earnings


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To eliminate intercompany sales:All Methods Sales X

Purchases (Cost of Sales) XTo eliminate intercompany profit in ending inventory:All Methods Ending Inventory (Cost of Sales) X

Inventory (Balance Sheet) XTo recognize intercompany profit in beginning inventory realized during the year:Cost or Partial Beg. Retained Earnings—Parent X Equity Methods Beg. Inventory - Income Statement (Cost of Sales) XComplete Equity Investment in S Company XMethod Beg. Inventory - Income Statement (Cost of Sales) X

Summary of Workpaper EntriesSummary of Workpaper Entries

Parent Selling (Downstream)

Illustration 6-21

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To eliminate intercompany sales:All Methods Sales X

Purchases (Cost of Sales) XTo eliminate intercompany profit in ending inventory:All Methods Ending Inventory (Cost of Sales) X

Inventory (Balance Sheet) XTo 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 XMethod NCI in Equity X

Cost of Sales (beg. inventory) X

Summary of Workpaper EntriesSummary of Workpaper Entries

Subsidiary Selling (Upstream)

Illustration 6-21

Sheila

The 2 entries for NCI in Equity have been changed to debit entries.

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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).The question is whether preaffiliation profit should be eliminated in consolidation. In our opinion, workpaper entries eliminating preaffliation profit are inappropriate.

Intercompany Profit Prior To Parent–Intercompany Profit Prior To Parent–Subsidiary AffiliationSubsidiary Affiliation

LO 7 Intercompany profit prior to affiliation.LO 7 Intercompany profit prior to affiliation.

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