intercompany profit transactions – inventories

1©2009 Accounting Department, University Of Siliwangi

Intercompany ProfitTransactions – Inventories

2©2009 Accounting Department, University Of Siliwangi

Intercompany Inventory Transactions

Revenue on sales between affiliated companiescannot be recognized until merchandise is sold

outside of the consolidated entity.

3©2009 Accounting Department, University Of Siliwangi

Intercompany Inventory Transactions

Periodicinventory

system

Sales

Purchases

Perpetualinventory

system

Sales

Cost of goods sold

4©2009 Accounting Department, University Of Siliwangi

Elimination of IntercompanyPurchases and Sales

Pint formed a subsidiary, Shep Corporation.

All Shep’s purchases are made fromPint at 20% above Pint’s cost.

Pint sold $20,000 of merchandiseto Shep for $24,000.

Shep sold all the merchandiseto its customers for $30,000.

5©2009 Accounting Department, University Of Siliwangi

Elimination of IntercompanyPurchases and Sales

Inventory 20,000Accounts Payable 20,000

To record purchases on account from other entities

Accounts Receivable 24,000Sales 24,000

To record intercompany sales to Shep

6©2009 Accounting Department, University Of Siliwangi

Elimination of IntercompanyPurchases and Sales

Cost of Sales 20,000Inventory 20,000

To record cost of sales to Shep

Investment 6,000Income from Shep 6,000

To record related equity interest

7©2009 Accounting Department, University Of Siliwangi

Elimination of IntercompanyPurchases and Sales

Inventory 24,000Accounts Payable 24,000

To record intercompany purchases from Pint

Accounts Receivable 30,000Sales 30,000

To record sales to outside customers

8©2009 Accounting Department, University Of Siliwangi

Elimination of IntercompanyPurchases and Sales

Cost of Sales 24,000Inventory 24,000

To record cost of sales to customers

9©2009 Accounting Department, University Of Siliwangi

Elimination of IntercompanyPurchases and Sales

100% Adjustments and Consol-Pint Shep Eliminations idated

Sales

Cost of sales

Gross profit

$24,000

20,000

$ 4,000

$30,000

24,000

$ 6,000

a 24,000

a 24,000

$30,000

20,000

$10,000

10©2009 Accounting Department, University Of Siliwangi

Elimination of UnrealizedProfit in Ending Inventory

During 2004, Pint sold merchandise thatcost $30,000 to Shep for $36,000.

Shep sold all but $6,000 of thismerchandise to its customers for $37,500.

11©2009 Accounting Department, University Of Siliwangi

Shep’s inventory $6,000Cost to Pint –5,000Unrealized profit in EI $1,000

Elimination of UnrealizedProfit in Ending Inventory

30,000 ÷ 36,000 = 5/6

5/6 × 30,000 = $25,000

1/6 × 36,000 = $6,000

1/6 × 30,000 = $5,000

12©2009 Accounting Department, University Of Siliwangi

Elimination of UnrealizedProfit in Ending Inventory

Adjustments and Consol-Pint Shep Eliminations idated

Sales

Cost of sales

Gross profit

Inventory

$36,000

30,000

$ 6,000

$37,500

30,000

$ 7,500

$ 6,000

a 36,000

b 1,000 a 36,000

b 1,000

$37,500

25,000

$12,500

$ 5,000

13©2009 Accounting Department, University Of Siliwangi

Recognition of UnrealizedProfit in Beginning Inventory

During 2005 Pint sold merchandisethat cost $40,000 to Shep for $48,000.

Shep sold 75% of this merchandiseto its customers for $45,000.

Shep also sold its beginning inventorywith a transfer price of $6,000 for $7,500.

14©2009 Accounting Department, University Of Siliwangi

Recognition of UnrealizedProfit in Beginning Inventory

25% × 48,000 = $12,000 Ending inventory

Shep’s inventory $12,000Cost to Pint (10,000)Unrealized profit in EI $ 2,000

$12,000 ÷ 1.2 = $10,000 EI transfer price

15©2009 Accounting Department, University Of Siliwangi

Recognition of UnrealizedProfit in Beginning Inventory

$7,500 – $5,000 BI = $2,500 from BI

75% × 48,000 = $30,000

$45,000 – $30,000 = $15,000

$15,000 + $2,500 = $17,500

16©2009 Accounting Department, University Of Siliwangi

Recognition of UnrealizedProfit in Beginning Inventory

Adjustments and Consol-Pint Shep Eliminations idated

Sales

Cost of sales

Gross profit

InventoryInvestmentin Shep

$48,000

40,000

$ 8,000

XXX

$52,500

42,000

$10,500

$12,000

a 48,000

c 2,000 a 48,000b 1,000

c 2,000

b 1,000

$52,500

35,000$17,500

$10,000

17©2009 Accounting Department, University Of Siliwangi

Downstream and Upstream Sales

Sales from topto bottom aredownstream.

Sales frombottom to topare upstream.

Parentto

Subsidiary Subsidiaryto

Parent

18©2009 Accounting Department, University Of Siliwangi

Downstream and Upstream Sales

In downstream sales, the parent company’sseparate income includes the full amount ofany unrealized profit, and the subsidiary’s

income is not affected.

In upstream sales, the subsidiary company’snet income includes the full amount of anyunrealized profit, and the parent company’s

separate income is not affected.

19©2009 Accounting Department, University Of Siliwangi

Downstream and Upstream Effectson Income Computations

80%-ownedParent Subsidiary

Sales $600 $300Cost of sales 300 180

Gross profit $300 $120Expenses 100 70

Parent’s separate income $200Subsidiary’s net income $ 50

20©2009 Accounting Department, University Of Siliwangi

Downstream and Upstream Effectson Income Computations

Intercompany sales during the year are $100,000.

The December 31 inventory includes$20,000 unrealized profit.

21©2009 Accounting Department, University Of Siliwangi

Downstream and Upstream Effectson Income Computations

The parent company’ssales and cost of sales

accounts reflect the$20,000 unrealized profit.

The $50,000subsidiary net

income equals itsrealized income.

22©2009 Accounting Department, University Of Siliwangi

Downstream and Upstream Effectson Income Computations

The subsidiary’s sales andcost of sales accounts reflectthe $20,000 unrealized profit.

The subsidiary’srealized income

is $30,000.

23©2009 Accounting Department, University Of Siliwangi

Downstream and Upstream Effectson Income Computations

Consolidated Income (000) Downstream Upstream

Sales ($900 – $100) $800 $800Cost of sales ($480 + $20 – $100) 400 400

Gross profit $400 $400Expenses ($100 + $70) 170 170

Total realized income $230 $230Less: Minority interest 10 6

Consolidated net income $220 $224

24©2009 Accounting Department, University Of Siliwangi

Downstream and Upstream Effectson Income Computations

Consolidated Income (000) Downstream Upstream

Parent’s separate income $200 $200Add: Income from subsidiary:Equity in subsidiary’s income less unrealized profit [($50,000 × 80%) – $20,000] 20Equity in subsidiary’s income [($50,000 – $20,000) × 80%] 24 Parent and consolidated net income $220 $224

25©2009 Accounting Department, University Of Siliwangi

Deferral of Intercompany Profitin Period of Sale: Downstream

90%-ownedPorter Sorter

Sales $100 $50Cost of sales 60 35

Gross profit $ 40 $15Expenses 15 5

Operating income $ 25 $10Income from Sorter 9 –

Net income $ 34 $10

26©2009 Accounting Department, University Of Siliwangi

Deferral of Intercompany Profitin Period of Sale: Downstream

Porter’s sales include $15,000 to Sorterat a profit of $6,250.

Sorter’s December 31, 2003, inventory includes40% of the merchandise from this transaction.

27©2009 Accounting Department, University Of Siliwangi

Deferral of Intercompany Profitin Period of Sale: Downstream

$15,000 – $6,250 = $8,750

$8,750 × 40% = $3,500

$15,000 × 40% = $6,000

$6,000 – $3,500 = $2,500

28©2009 Accounting Department, University Of Siliwangi

Deferral of Intercompany Profitin Period of Sale: Downstream

Investment in Sorter 9,000Income from Sorter 9,000

To record share of Sorter’s income

Income from Sorter 2,500Investment in Sorter 2,500

To eliminate unrealized profit on sales to Sorter

29©2009 Accounting Department, University Of Siliwangi

Partial Working PapersDecember 31, 2003

Adjustments/ Consol-Porter Shorter Eliminations idated

Income StatementSalesIncome from SorterCost of goods soldExpensesMinority interest expense ($10,000 × 10%)Net incomeBalance SheetInventoryInvestment in Sorter

$100 6.5 (60) (15)

$ 31.5

XXX

$50

(35) (5)

$10

$ 7.5

Dr. Cr.a 15c 6.5b 2.5 a 15

b 2.5 c 6.5

$135

(82.5) (20)

(1)$ 31.5

$ 5

30©2009 Accounting Department, University Of Siliwangi

Recognition of Intercompany Profitupon Sale to Outside Entities

Now assume that the merchandise acquired fromPorter during 2003 is sold by Sorter during 2004.

There are no intercompany transactionsbetween Porter and Sorter during 2004.

31©2009 Accounting Department, University Of Siliwangi

Recognition of Intercompany Profitupon Sale to Outside Entities

90%-ownedPorter Sorter

Sales $120 $60Cost of sales 80 40

Gross profit $ 40 $20Expenses 20 5

Operating income $ 20 $15Income from Sorter 13.5 –

Net income $ 33.5 $15This is before considering $2,500 unrealized profit in BI.

32©2009 Accounting Department, University Of Siliwangi

Recognition of Intercompany Profitupon Sale to Outside Entities

Investment in Sorter 13,500 Income from Sorter 13,500To record investment income from Sorter

Investment in Sorter 2,500 Income from Sorter 2,500To record realization of profit fromintercompany sales to Sorter

33©2009 Accounting Department, University Of Siliwangi

Partial Working PapersDecember 31, 2003

Adjustments/ Consol-Porter Shorter Eliminations idated

Income StatementSalesIncome from SorterCost of goods soldExpensesMinority interest expense ($15,000 × 10%)Net incomeBalance SheetInvestment in Sorter

$120 16 (80) (20)

$ 36

XXX

$60

(40) (5)

$15

Dr. Cr.

b 16 a 2.5

a 2.5 b 16

$180

(117.5) (25)

(1.5)$ 36

34©2009 Accounting Department, University Of Siliwangi

Consolidation Example – Intercompany

Profits: Downstream SalesSeay Corporation is a 90%-owned

subsidiary of Peak Corporation,acquired for $94,500 cash on July 1, 2003.

Seay’s net assets at date of acquisitionconsisted of $100,000 capital stock

and $5,000 retained earnings.

The cost of Peak’s 90% interest was equal to bookvalue and fair value of the interest acquired.

35©2009 Accounting Department, University Of Siliwangi

Consolidation Example – Intercompany

Profits: Downstream Sales

Cost: $105,000 × 90% = $94,500

Minority interest: $105,000 × 10% = $10,500

36©2009 Accounting Department, University Of Siliwangi

Consolidation Example – Intercompany

Profits: Downstream Sales

Peak sells inventory items to Seay on a regular basis.

Sales to S in 2007 (cost $15,000), selling price $20,000Unrealized profit in S’s inventory at 12/31/2006 2,000Unrealized profit in S’s inventory at 12/31/2007 2,500Seay’s accounts payable to Peak 12/31/2007 10,000

37©2009 Accounting Department, University Of Siliwangi

Consolidation Example – Intercompany

Profits: Downstream Sales

At 12/31/2006 Peak’s investment in Seayaccount had a balance of $128,500.

This balance consisted of Peak’s 90%equity in Seay’s $145,000 net assets onthat date less $2,000 unrealized profit

in Seay’s 12/31/2006 inventory.

38©2009 Accounting Department, University Of Siliwangi

Consolidation Example – Intercompany

Profits: Downstream Sales

$145,000 × 90% = $130,500

$130,500 – $2,000 = $128,500

39©2009 Accounting Department, University Of Siliwangi

Consolidation Example – Intercompany

Profits: Downstream Sales

Seay’s equity:Common stock $100,000Retained earnings 45,000Net assets $145,000

$45,000 – $5,000 = $40,000 increase in RE

$40,000 – $4,000 (minority interest) = $36,000

40©2009 Accounting Department, University Of Siliwangi

Consolidation Example – Intercompany

Profits: Downstream SalesDuring 2007, Peak made the following entries

on its books for the investment in Seay:

Cash 9,000Investment in Seay 9,000

To record dividends from Seay ($10,000 × 90%)

Investment in Seay 26,500Income from Seay 26,500

To record income from Seay for 2007

41©2009 Accounting Department, University Of Siliwangi

Consolidation Example – Intercompany

Profits: Downstream Sales

Equity in Seay’s net income: ($30,000 × 90%) $27,000Add: Inventory profits recognized in 2007 2,000Deduct: Inventory profits deferred at year end – 2,500Total $26,500

42©2009 Accounting Department, University Of Siliwangi

Consolidation Example – Intercompany

Profits: Downstream Sales

Peak’s Investment 94,500 36,000128,500 2,000 27,000

146,000

2,000

2,5009,000 Dividends

12/31/2006

12/31/2007

43©2009 Accounting Department, University Of Siliwangi

Consolidation Example – Intercompany

Profits: Downstream Sales

Minority Interest

1,000

10,500 4,00014,500 3,000

16,500 12/31/2007Dividends

12/31/2006

44©2009 Accounting Department, University Of Siliwangi

Consolidation Example – Intercompany

Profits: Upstream SalesSmith Corporation is an 80%-owned subsidiary

of Poch Corporation, acquired for $480,000cash on January 2, 2003.

Smith’s stockholders’ equity consisted of$500,000 capital stock and $100,000

retained earnings.

The cost of Poch’s 80% interest was equal tobook value and fair value of the interest acquired.

45©2009 Accounting Department, University Of Siliwangi

Consolidation Example – Intercompany

Profits: Upstream Sales

Smith sells inventory items to Poch on a regular basis.

Sales to P in 2004 $300,000Unrealized profit in P’s inventory at 12/31/2003 40,000Unrealized profit in P’s inventory at 12/31/2004 30,000Intercompany A/R and A/P at 12/31/2004 50,000

46©2009 Accounting Department, University Of Siliwangi

Consolidation Example – Intercompany

Profits: Upstream Sales

At December 31, 2003, Poch’s investment inSmith had an account balance of $568,000.

This balance consisted of $600,000 underlyingequity in Smith’s net assets ($750,000 × 80%)

less $32,000 unrealized profit in Poch’sDecember 31, 2003, inventory.

47©2009 Accounting Department, University Of Siliwangi

Consolidation Example – Intercompany

Profits: Upstream SalesDuring 2004, Poch made the following entries

on its books for the investment in Smith.

Cash 40,000Investment in Smith 40,000

To record dividends from Smith ($50,000 × 80%)

Investment in Smith 88,000Income from Smith 88,000

To record income from Smith for 2004

48©2009 Accounting Department, University Of Siliwangi

Consolidation Example – Intercompany

Profits: Upstream Sales

Equity in Smith’s net income ($100,000 × 80%) $80,000Add: 80% of $40,000 unrealized profit

deferred in 2003 32,000Less: 80% of $30,000 unrealized profit

at December 31, 2004 –24,000Total $88,000

49©2009 Accounting Department, University Of Siliwangi

Consolidation Example – Intercompany

Profits: Upstream Sales

Poch’s Investment480,000Income568,000 32,000 80,000616,000

32,00040,00024,000

Dividends12/31/2003

12/31/2004