CH 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.
Determine the amount of intercompany profit, if any, to be eliminated from
the consolidated statements.
Understand the concept of eliminating 100% of intercompany profit not
realized in transactions with outsiders, and know the authoritative position.
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 S2 sells inventory

Downstream 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 downstream sales.
3
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 intercompany sales.

4
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 downstream sales.

5
Merchandise
Downstream
E6-7: Summary of 2014 Intercompany Sales Sales
(COGS) (Inventory)
Total Resold On Hand
Intercompany 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.

6
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

7
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 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.

8
Merchandise
Downstream
E6-7: Summary of 2014 Intercompany Sales 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

9
Merchandise
E6-7:
Alternate
View
Workpaper entry to eliminate intercompany sales for 2014. Downstream
Sales 1 450,000 Sales
1
Cost of Sales 375,000
Cost of Sales 2
50,000
Inventory Balance Sheet 3 25,000
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 Sheratons books by $25,000 unrealized profit.

10
Merchandise
Downstream
E6-7: Workpaper entry to eliminate intercompany sales for 2015. Sales
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
Merchandise
Downstream
E6-7: Workpaper entry to eliminate intercompany sales for 2015.
Sales
2015 Intercompany Sales
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
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.
LO 2 Determining the amount of intercompany profit.

13
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]
LO 3 Eliminating 100% of intercompany profit.
14
Cost Method: Consolidated Statements
WorkpaperUpstream Sales
Determination of the Noncontrolling Interest in
Combined IncomeUpstream 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.
LO 5 Noncontrolling interest (NCI) for upstream sales.

15
Cost Method: Consolidated
Workpaper Upstream
P6-7: Paque Corporation owns 90% of the Sales
common stock of Segal Company. The stock was purchased for
$810,000 on January 1, 2012, when Segal Companys 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.
LO 6 Consolidated workpapers for upstream Sales- Cost Method.

16
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
Workpaper Upstream
P6-7: Worksheet entries for Dec. 31, 2016. Sales
2. Sales 300,000
3. Ending Inventory (Cost of Sales) 15,000
Inventory (Balance Sheet) 15,000
To eliminate intercompany sales and eliminate (defer) unrealized profit in ending
inventory

18
Workpaper
Upstream
Sales
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
Workpaper
Upstream
Sales
5. Dividend Income ($60,000 x 90%) 54,000
Dividends Declared 54,000
To eliminate intercompany dividends
6. Beg. Retained Earnings - Segal 180,000

Common Stock - Segal 750,000
Investment in Segal 837,000
Noncontrolling Interest 93,000
To eliminate investment account and create NCI account

20
Workpaper
Upstream Sales
P6-7 Eliminations Consolidated
Income Statement Paque Segal Debit (2)
Credit NCI Balances
Sales $ 1,650,000 $ 795,000 300,000 $ 2,145,000
(5)
Dividend income 54,000 54,000 -
Total revenue 1,704,000 795,000 (3) (2)
2,145,000
Cost of goods sold 1,290,000 517,500 15,000 300,000 1,477,500
(4)
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 Statement

Retained earnings, 1/1
(4) (1)
Paque 811,500 40,500 27,000 798,000
(6)
Segal 180,000 180,000 -
Net income 103,500 71,250 369,000 345,000 10,125 140,625
(5)
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
NCI in Consolidated Income = 10% ($71,250 + $45,000 $15,000) = $10,125

21
Workpaper
P6-7 Upstream Sales
(1) (3)
(6)
(6)
(4) (6)

22
Cost MethodAnalysis of Consolidated Net
Income and Consolidated Retained Earnings
Consolidated Net Income
The parent companys 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
Net Income
Upstream Sales
P6-7: Prepare a calculation of Paques share of Segals 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 Segals income ($101,250 x 90%) $ 91,125

NCI share of Segals income ($101,250 x 10%) 10,125
Subsidiary income included in consolidated income $ 101,250

24
Net Income Upstream Sales
P6-7: Prepare a calculation of CI in Consolidated Income.
Paque's net income $103,500
Less: subsidiary dividend income (54,000)
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 49,500
Paque's share of Segals income (previous slide) 91,125
Controlling interest in Consolidated net income $140,625

25
Cost MethodAnalysis of Consolidated Net
Income and Consolidated Retained Earnings
Consolidated Retained Earnings
The parents cost basis retained earnings that has been
plus (minus) the parents 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 date
plus (minus) the cumulative effect of adjustments to date
relating to the amortization, depreciation, and impairment
of differences between implied and book values.

26
Consolidated Statements Workpaper Partial
Equity Method
Review:
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.
LO 6 Consolidated workpapers partial equity method.

27
Partial Equity Method:
Workpaper Upstream Sales
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,
2012, when Segal Companys retained earnings were $150,000.
$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. Paque Corporation uses the
partial equity method to record its investment in Segal Company.

28
Workpaper
Upstream Sales
1. Equity in Subsidiary Income 64,125

Investment 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

29
Workpaper
P6-13: Worksheet entries for Dec. 31, 2016. Upstream Sales
2. Sales 300,000
3. End. Inventory (Cost of Sales) 15,000
To eliminate intercompany sales and defer (eliminate) unrealized profit in ending
inventory

30
Workpaper
P6-13: Worksheet entries for Dec. 31, 2016. Upstream
Sales
4. Beg. Retained Earnings - P ($45,000 x 90%) 40,500

NCI in Equity ($45,000 x 10%) 4,500
To realize (recognize) the gross profit in inventory deferred in the prior period
and to reduce CI and NCI for their share of unrealized profit at beginning of year

31
Workpaper
Upstream
Sales

32
Workpaper
Upstream Sales
P6-13
(2)
(1)
(3) (2)
(4)
(4)
(5)
(1)

33
P6-13
(3)
(5)
(1)
(5)
(4) (5)

34
Partial Equity MethodAnalysis of
Consolidated Net Income Same as Cost Method
The parents income from its independent operations

that has been realized in transactions with third parties
plus (minus) subsidiary income (loss) that has been
plus or minus adjustments for the period relating to
the depreciation, amortization, and impairment of

35
Partial Equity
Partial Equity MethodAnalysis
MethodAnalysis of
of Consolidated
Net Income
When the parent uses the partial equity method, the parents
share of subsidiary income since acquisition is already
included in the parents reported retained earnings.
Consequently, consolidated retained earnings is calculated as
the parents 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

36
Partial Equity
P6-13: Calculate consolidated retained earnings on Dec. 31, 2016.
Paque's Retained Earnings on 12/31/16 $ 802,125

Unrealized profit on downstream sales 0
Unrealized profit on upstream sales ($15,000 x 90%) (13,500)
Consolidated retained earnings on 12/31/2016 $ 788,625

37
Complete Equity Method:
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,
2012, when Segal Companys retained earnings were $150,000.
$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. Paque Corporation uses the complete equity method
to record its investment in Segal Company
LO 6 Consolidated workpapers complete equity method.

38
Workpaper
1. Equity in Subsidiary Income 91,125

Investment in Segal Company
37,125
Dividends
To reverse the effectDeclared ($60,000 x 90%)
of parent company entries for
54,000
subsidiary dividends and income

39
Workpaper
P6-17: Worksheet entries for Dec. 31, 2016. Upstream
Sales
2. Sales 300,000
3. End. Inventory (Cost of Sales) 15,000
To eliminate intercompany sales and defer(eliminate) unrealized profit in ending
inventory

40
Workpaper
4. Investment in Segal ($45,000 x 90%) 40,500

NCI in Equity($45,000 x 10%) 4,500
To recognize intercompany profit in beginning inventory realized during the year in the proper
accounts for presentation on the consolidated financial statements; that is, even though the parent has
adjusted its equity in subsidiary income, the effect must be shown in the cost of sales account (as the equity in
subsidiary income is eliminated

41
Workpaper
Upstream
P6-17: Worksheet entries for Dec. 31, 2016. Sales

42
P6-17
(2)
(1)
(3) (2)
(4)
(5)
(1)

43
Workpaper
Upstream Sales
P6-17
(3)
(4) (5)
(1)
(5)
(4) (5)

44
Complete Equity MethodAnalysis of
Consolidated Net Income and Consolidated
Retained Earnings
Consolidated net income is the sum of the following components:
Parent companys net income from its independent operations that
has been realized in transactions with third parties plus (minus)
reported subsidiary income (loss) that has been realized in
transactions with third parties plus (minus) adjustments for the
period relating to the depreciation, amortization, and impairment
of differences between implied and book values.
Under the complete equity method:
Consolidated net income equals the parent companys recorded
income.
Consolidated retained earnings equals the parent companys
recorded retained earnings.

45
Summary of Workpaper Entries
Illustration 6-21
To eliminate intercompany sales:
All Methods Sales X Parent Selling (Downstream)
Purchases (Cost of Sales) X
To eliminate intercompany profit in ending inventory:
All Methods Ending Inventory (Cost of Sales) X
Inventory (Balance Sheet) X
To recognize intercompany profit in beginning inventory realized during the year:
Cost or Partial Beg. Retained EarningsParent X
Equity Methods Beg. Inventory - Income
Statement (Cost of Sales) X
Complete Equity Investment in S Company X
Method Beg. Inventory - Income
Statement (Cost of Sales) X
46
Summary of Workpaper Entries
To eliminate intercompany sales: Illustration 6-21
All Methods Sales X Subsidiary Selling (Upstream)

Purchases (Cost of Sales) X
To eliminate intercompany profit in ending inventory:
All Methods Ending Inventory (Cost of Sales) X
Inventory (Balance Sheet) X
To recognize intercompany profit in beginning inventory realized during the year:
Cost or Partial Beg. Retained EarningsParent X
Equity Methods NCI in Equity X
Beg. Inventory (Cost of Sales) X
Complete Equity Investment in S Company X

Method NCI in Equity X
Beg. Inventory (Cost of Sales) X
47
Intercompany Profit Prior To Parent
Subsidiary Affiliation
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.
LO 7 Intercompany profit prior to affiliation.

48

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What are the financial reporting objectives for intercompany sales of inventory?

What are the financial reporting objectives for intercompany sales of inventory?

What is the difference between upstream and downstream sales?

What is the difference between upstream and downstream sales?

Advanced

P sells inventory S2 sells inventory

LO 1 Financial reporting objectives for intercompany sales.

Required: Prepare the workpaper entries necessary to eliminate the

LO 6 Consolidated workpapers for downstream sales.

LO 6 Consolidated workpapers for downstream sales.

Prepare the workpaper entry to eliminate intercompany sales for

LO 6 Consolidated workpapers for downstream sales.

Required: Prepare the workpaper entries necessary to eliminate the

LO 6 Consolidated workpapers for downstream sales.

Prepare the workpaper entry to eliminate intercompany sales for 2014.

LO 6 Consolidated workpapers for downstream sales.

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

LO 6 Consolidated workpapers for downstream sales.

2014 Unrealized Profit in Inventory

Cost or Partial Equity Method *

LO 6 Consolidated workpapers for downstream sales.

LO 2 Determining the amount of intercompany profit.

LO 5 Noncontrolling interest (NCI) for upstream sales.

LO 6 Consolidated workpapers for upstream Sales- Cost Method.

1. Investment in Segal 27,000

LO 6 Consolidated workpapers for upstream Sales- Cost Method.

2016 Intercompany Sales

LO 6 Consolidated workpapers for upstream Sales- Cost Method.

4. Beg. Retained Earnings - P ($45,000 x 90%) 40,500

LO 6 Consolidated workpapers for upstream Sales- Cost Method.

6. Beg. Retained Earnings - Segal 180,000

LO 6 Consolidated workpapers for upstream Sales- Cost Method.

Retained Earnings Statement

LO 6 Consolidated workpapers for upstream Sales- Cost Method.

LO 6 Consolidated workpapers for upstream Sales- Cost Method.

LO 6 Consolidated workpapers for upstream Sales- Cost Method.

Paque's share of Segals income ($101,250 x 90%) $ 91,125

LO 6 Consolidated workpapers for upstream Sales- Cost Method.

LO 6 Consolidated workpapers for upstream Sales- Cost Method.

LO 6 Consolidated workpapers for upstream Sales- Cost Method.

LO 6 Consolidated workpapers partial equity method.

LO 6 Consolidated workpapers partial equity method.

1. Equity in Subsidiary Income 64,125

LO 6 Consolidated workpapers partial equity method.

LO 6 Consolidated workpapers partial equity method.

4. Beg. Retained Earnings - P ($45,000 x 90%) 40,500

LO 6 Consolidated workpapers partial equity method.

LO 6 Consolidated workpapers partial equity method.

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

LO 6 Consolidated workpapers partial equity method.

The parents income from its independent operations

LO 6 Consolidated workpapers partial equity method.

LO 6 Consolidated workpapers partial equity method.

Paque's Retained Earnings on 12/31/16 $ 802,125

LO 6 Consolidated workpapers partial equity method.

LO 6 Consolidated workpapers complete equity method.

1. Equity in Subsidiary Income 91,125

LO 6 Consolidated workpapers complete equity method.

LO 6 Consolidated workpapers complete equity method.