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. 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.”

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.

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

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 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?

6-9 Parent: Receivable500 Cash500 Sub: Cash500 Payable500 Cancel! (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 Payable500 Loan Receivable500

6-10 (b) Sale from Parent to Sub to Outsider ParentSub $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

6-11 Parent’s sale to Sub: Parent: Cash400 Sales400 COGS250 Inventory250 Sub: Inventory400 Cash400 Sub’s sale to Outsider: Sub: Cash500 Sales500 COGS400 Inventory400 Reverse the rest! Cancel! (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

6-12 (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: Cash300 Sales300 COGS200 Inventory200 Sub: Inventory300 Cash300 Parent $300 Sub $200 Is this a legitimate arm’s length transaction?

6-13 Parent: Cash300 Sales300 COGS200 Inventory200 Sub: Inventory300 Cash300 Cancel! ParentSub $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: Sales300 Cost of Goods Sold200 Inventory 100 (net)

6-14 Summary of Consolidation Entries: To eliminate intercompany loans: Loan Payable500 Loan Receivable500 To eliminate sale from Parent to Sub to Outsider: Sales400 Cost of Goods Sold400 To eliminate sale from Parent to Sub, not yet to Outsider: Sales300 Cost of Goods Sold200 Inventory 100

6-15 Chapter 6 Prepare equity-method journal entries and elimination entries for the consolidation of a subsidiary following downstream inventory transfers. Prepare equity-method journal entries and elimination entries for the consolidation of a subsidiary following downstream inventory transfers.

6-16 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.

6-17 Big Picture—Elimination entry: Sale From Parent to Sub to Outsider Get rid of the non-arm’s-length transaction! ParentSub $250$500$400 To eliminate sale from Parent to Sub to Outsider: Sales (Parent)400 Cost of Goods Sold (Sub)400

6-18 Big Picture—Elimination entry: Sale From Parent to Sub (not yet sold outside) Reverse the entire transaction! ParentSub $250$400 To eliminate sale from Parent to Sub, not yet to Outsider: Sales400 Cost of Goods Sold250 Inventory 150 Equity Method Entry: Income from Sub150 Investment in Sub150 Sub’s inventory is overstated by $150 Sales$400 Cost of sales250 Gross profit$ 150 Parent’s gross profit is overstated by $150

6-19 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

6-20 ParentSub 60,00070,00075,000 Ending inventory = $10,000 What happened to it? Income Statements ParentSub Sales$75,000$70,000 Cost of sales60,00065,000 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 SoldOn-hand $65,000$10,000 x 20% = $2,000 Unrealized GP A Comprehensive Downstream Example

6-21 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. TotalSoldOn hand Sales$75,000$65,000$10,000  COGS 60,00052,0008,000 Gross Profit$15,000$13,000$ 2,000

6-22 Part 1: Sale from Parent to Sub to Outsider Get rid of the non-arm’s-length transaction! ParentSub $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

6-23 Part 2: Sale from Parent to Sub (Not Outside) Reverse the entire transaction! ParentSub $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$10,000 Cost of sales8,000 Gross profit$ 2,000 Parent’s gross profit is overstated by $2,000

6-24 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: Sales75,000 Cost of Goods Sold73,000 Inventory 2,000

6-25 Partial Consolidated Worksheet ParentSubDRCR Consol- idated Income Statement Sales75,00070,00075,00070,000 COGS60,00065,00073,00052,000 Gross Profit15,0005,00075,00073,00018,000 Balance Sheet Inventory010,0002,0008,000

6-26 Second Approach: Short Cut Method TotalSoldOn hand Sales$75,000$65,000$10,000  COGS 60,00052,0008,000 Gross Profit$15,000$13,000$ 2,000 The numbers come right off the chart! Sales75,000 Cost of Goods Sold73,000 Inventory 2,000 COGS Credit = $65,000 + $8,000

6-27 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!

6-28 Partial Consolidated Worksheet ParentSubDRCR Consol- idated Income Statement Sales75,00070,00075,00070,000 COGS60,00065,00073,00052,000 Inc from Sub 5,000 Net Income20,0005,00080,00073,00018,000 Balance Sheet Inventory010,0002,0008,000 Not the same!

6-29 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!  Thus, an actual adjustment on the parent’s books in addition to the worksheet entries above.  Like we did for the excess fair value amortization.

6-30 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 parent’s share of the sub’s income. Investment in SubIncome from Sub NI 5,000 2,000 Unreal GP 2,000 5,000 NI 3,000 Reverse next year when this inventory is sold! Sales$75,000 COGS60,000 Gross profit$15,000 Inc. from Sub3,000 NI$18,000 Parent NI = Consolidated NI

6-31 Partial Consolidated Worksheet ParentSubDRCR Consol- idated Income Statement Sales75,00070,00075,00070,000 COGS60,00065,00073,00052,000 Inc from Sub 3,000 Net Income18,0005,00078,00073,00018,000 Balance Sheet Inventory010,0002,0008,000 Now they’re the same!

6-32 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. d.Parent company net income equals consolidated net income. 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. d.Parent company net income equals consolidated net income.

6-33 Review Exercise Part 1: Downstream  Para sold inventory costing $100,000 to its 75%-owned subsidiary, Shute, for $125,000 in 20X8.  Shute resold most of this inventory for $230,000 in 20X8.  At 12/31/X8, Shute’s balance sheet showed intercompany-acquired inventory on hand of $20,000. P S NCI 25% 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 don’t share the GP deferral with the NCI.

6-34 Review Exercise Part 1: Big Picture TotalSoldOn hand Sales125,00020,000  COGS 100,000 Gross Profit25,000 Gross Profit % ParentSub $100,000$230,000$125,000 $125,000 split Ending Inventory = 20,000 Resold = $105,000

6-35 Review Exercise 1: Sale from Parent to Sub to Outsider ParentSub $84,000$230,000$105,000 Get rid of the internal non-arm’s-length transaction! To eliminate sale from Parent to Sub to Outsider: Sales (Parent)105,000 Cost of Goods Sold (Sub)105,000

6-36 Review Exercise 1: Sale from Parent to Sub (Not Yet Outside) Reverse the entire transaction! ParentSub $16,000$20,000 To eliminate sale from Parent to Sub, not yet to Outsider: Sales (Parent)20,000 Cost of Goods Sold (Parent)16,000 Inventory (basis correction) 4,000 Sub’s inventory is overstated by $4,000 Sales$20,000 Cost of sales16,000 Gross profit$ 4,000 Parent’s gross profit is overstated by $4,000

6-37 Review Exercise 1: Summary Fully-adjusted Equity Method Entry on Parent’s books: Income from Sub4,000 Investment in Sub4,000 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 Outsider: Sales (Parent)20,000 Cost of Goods Sold (Parent)16,000 Inventory (basis correction)4,000 Combine both entries: Sales125,000 Cost of Goods Sold121,000 Inventory 4,000

6-38 Review Exercise Part 1: Short Cut TotalSoldOn hand Sales125,000105,00020,000  COGS 100,00084,00016,000 Gross Profit25,00021,0004,000 COGS Credit= 105, ,000 = 121,000 Unrealized GP Worksheet Elimination Entry: Sales125,000 Cost of Goods Sold121,000 Inventory4,000

6-39 Review Exercise Part 1 FYI, this year’s deferral is REVERSED next year to recognize when sold! Worksheet Elimination Entry in Year 1: Sales125,000 Cost of Goods Sold121,000 Inventory4,000 Worksheet Elimination Entry in Year 2: Investment in Sub4,000 Cost of Goods Sold4,000 INCREASES income!

6-40 Downstream, so don’t split the deferral with the NCI. Review Exercise 1: Equity Method Entry Investment in SubIncome from Sub 75% NI 93,750 4,000 Defer GP 4,000 89,750 93,750 75% NI Low 4,000

6-41 Review Exercise 1: Partial Consolidated Worksheet ParentSubDRCR Consol- idated Income Statement Sales125,000230,000125,000230,000) COGS100,000105,000121,00084,000) Inc from Sub89,750 Basic Gross Profit114,750125,000214,750121,000146,000) NCI in NI31,250Basic(31,250) CI in NI114,750125,000246,000121,000114,750) Balance Sheet Inventory20,0004,00016,000)

6-42 Review Exercise 1: Equity Method Reversal Next Year Equity Method Adjustment on Parent’s books in 20X7: Income from Sub4,000 Investment in Sub4,000 Reversal of 20X7 Deferral on Parent’s books in 20X8: Investment in Sub4,000 Income from Sub4,000

6-43 Learning Objective 4 Prepare equity-method journal entries and elimination entries for the consolidation of a subsidiary following upstream inventory transfers. Prepare equity-method journal entries and elimination entries for the consolidation of a subsidiary following upstream inventory transfers.

6-44 Partially Owned Upstream Sales  Must share deferral with the NCI shareholders.  Simply split up the adjustment for unrealized gross profit proportionately. Investment in SubIncome from Sub NI 4,500 1,800 Defer GP 1,800 4,500 NI 2,700 P S NCI 10% 90% Unreal GP 200 NCI in NA of Sub Equity Method Adjustments Worksheet Entry Only

6-45 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 Sensei’s 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 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 $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 S NCI 10% 90%

6-46 Review Exercise Part 2: The Big Picture—20X7 TotalSoldOn hand Sales600,000490,000110,000  COGS 480,000392,00088,000 Gross Profit120,00098,00022,000 Gross Profit %= 120,000 ÷ 600,000 = 20% Ending Inventory = $110,000 SubParent ??$600,000 Unrealized GP $600,000 – C = 0.25C C= $600,000/1.25 = $480,000

X7 Upstream Sales: Elimination Entries—20X7 & 20X8 P S NCI 10% 90% 20X7 Worksheet Elimination Entry: Sales600,000 Cost of Goods Sold578,000 Inventory22,000 20X8 Worksheet Elimination Entry: Investment in Sub19,800 NCI in NA of Sub2,200 Cost of Goods Sold22,000 Deferred GP this year “reversed” to recognize in the financial statements next year when sold.

X7 Upstream Sales: Equity Method Adjustments — 20X7 & 20X8 P S NCI 10% 90% 20X7 Equity Method Adjustment on Parent’s books: Income from Sub19,800 Investment in Sub19,800 20X8 Equity Method Reversal of 20X7 Deferral (on Parent’s books): Investment in Sub19,800 Income from Sub19,800 Deferral of GP in 20X7 because not yet sold this year.

X7 Upstream Sales: 20X7 Equity Accounts Investment in SubIncome from Sub 90% NI 108,000 19,800 X7 Deferral 19,800 88, ,000 90% NI Low 19,800

X7 Upstream Sales: 20X7 Partial Worksheet ParentSubDRCR Consol- idated Income Statement Sales588,000600, ,000) COGS490,000480,000578,000392,000) Inc from Sub88,200 Basic Gross Profit186,200120,000688,200578,000196,000) NCI in NI9,800Basic(9,800) CI in NI186,200120,000698,000578,000186,200) Balance Sheet Inventory110,00022,00088,000)

6-51 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 Sensei’s 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 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 $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 S NCI 10% 90%

6-52 Review Exercise Part 2: The Big Picture—20X8 TotalSoldOn hand Sales900,000700,000200,000  COGS 675,000525,000150,000 Gross Profit225,000175,00050,000 Gross Profit %= 225,000 ÷ 900,000 = 25% Ending Inventory = $200,000 SubParent 675,000?$900,000 Unrealized GP

6-53 Review Exercise 2: Summary Fully-adjusted Equity Method Entry on Parent’s books: Income from Sub45,000 Investment in Sub45,000 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 Outsider: Sales (Sub)200,000 Cost of Goods Sold (Sub)150,000 Inventory (basis correction)50,000 Combine both entries: Sales900,000 Cost of Goods Sold850,000 Inventory 50,000

6-54 Review Exercise 2: Short Cut TotalSoldOn hand Sales900,000700,000200,000  COGS 675,000525,000150,000 Gross Profit200,000175,00050,000 COGS CR= 700, ,000 = 850,000 The Elimination Entry: Sales900,000 Cost of Goods Sold850,000 Inventory50,000

X8 Upstream Sales: 20X8 Equity Accounts Investment in SubIncome from Sub 19,800 Low 19,800 X7 Reversal 19, ,500 90% NI90% NI 202,500 45,000 X8 Deferral 45, ,30045,000 Low

X7 & 20X8 Upstream Sales: 20X8 Partial Worksheet ParentSubDRCR Consol- idated Income Statement Sales840,000900, ,000) COGS700,000675,000850,000503,000) 22,000 Income from Sub177,300 Basic Gross Profit317,300225,0001,077,300872,000337,000) NCI in NI19,700Basic(19,700) CI in NI317,300225,0001,097,000872,000317,300 Balance Sheet Inventory200,00050,000150,000) Investment in Sub Low by 45,000 19,800 Basic X NCI in NA of Sub2,200

6-57 Learning Objective 5 Understand and explain additional considerations associated with consolidation.