Chapter 5: Intercompany Profit Transactions

– Inventories

5-1
 Intercompany Profits – Inventories:
Objectives
1. Understand the impact of intercompany profit in
inventories on preparing consolidation workpapers.
2. Apply the concepts of upstream versus downstream
inventory transfers.
3. Defer unrealized inventory profits remaining in the
ending inventory.
4. Recognize realized, previously deferred, inventory
profits in the beginning inventory.

5-2
 Objectives (cont.)

5. Adjust the calculations of noncontrolling interest

amounts in the presence of intercompany inventory
profits.

5-3
Intercompany Profit Transactions – Inventories

1: INTERCOMPANY
INVENTORY PROFITS

5-4
 Intercompany Transactions
For consolidated financial statements
 “intercompany balances and transactions shall be
eliminated.” [FASB ASC 810-10-45-1]
Show income and financial position as if the
intercompany transactions had never taken
place.

5-5
 Intercompany Sales of Inventory
Profits on intercompany sales of inventory
 Recognized if goods have been resold to outsiders
 Deferred if the goods are still held in inventory
Previously deferred profits in beginning
inventory are recognized in the period the
goods are sold. Assuming FIFO
 Beginning inventories are sold
 Ending inventories are from current purchases

5-6
 No Intercompany Profits in Inventories
During 2011, Pet sold goods costing $1,000 to its
subsidiary, Sim, at a gross profit of 30%. Sim had none of
this inventory on hand at the end of 2011. The worksheet
entry for 2011:
Sales (-R, -SE) 1,429
Cost of sales (-E, +SE) 1,429
Eliminate intercompany sales = $1,000 / (1-30%) = $1,429
All intercompany sales of inventories have been resold to
outside parties, so remove the full sales price from both
sales and cost of sales.
Pet's sales are reduced $1,429.
Sim's cost of sales are reduced $1,429.
The same entry is used if Sim sells to Pet.
5-7
 Intercompany Profits Only in Ending
Inventories
Last year, 2011, Pal sold goods costing $500 to its
subsidiary, Sal, at a gross profit of 25%. Sal had
none of this inventory on hand at the end of 2011.
During 2012, Pal sold additional goods costing
$900 to Sal at a gross profit of 40%. Sal has $200
of these goods on hand at 12/31/2012. Worksheet
entries for 2012:
Sales (-R, -SE) 1,500
Cost of sales (-E, +SE) 1,500
Eliminate intercompany sales = $900 / (1-40%) = $1,500
Cost of sales (E, -SE) 80
Inventory (-A) 80
Defer profit in ending inventory = $200 x 40%
5-8
 Intercompany Profits Beginning and Ending
Inventories
Last year, 2011, Pam sold goods costing $300 to its subsidiary, Sir, at mark-up
of 25%. Sir had $120 of this inventory on hand at the end of 2011.
During 2012, Pam sold additional goods costing $500 to Sir at a 30% mark-up.
Sir has $260 of these goods on hand at 12/31/2012. Worksheet entries for
2012:

Sales (-R, -SE) 650

Cost of sales (-E, +SE) 650
Eliminate intercompany sales = $500 + 30%($500) = $650
Cost of sales (E, -SE) 60
Inventory (-A) 60
Defer profits in ending inventory = $260 x 30%/130%
Investment in Subsidiary (+A) 24
Cost of sales (-E, +SE) 24
Realize profits from beginning inventory = $120 x 25%/125% = $24
5-9
Intercompany Profit Transactions – Inventories

2: UPSTREAM &
DOWNSTREAM INVENTORY
SALES

5-10
 Upstream and Downstream Sales

Downstream Sales

Parent sells to Parent Subsidiary sells to

subsidiary parent
Subsidiary Subsidiary Subsidiary
1 2 3

Upstream Sales

5-11
 Intercompany Inventory Sales
The worksheet entries for eliminating intercompany
profits for downstream sales
Sales (-R, -SE) XXX
Cost of sales (-E, +SE) XXX
For the intercompany sales price
Cost of sales (E, -SE) XX
Inventory (-A) XX
For the profits in ending inventory
Investment in Subsidiary (+A) XX
Cost of sales (-E, +SE) XX
For the profits in beginning inventory
For upstream sales, the last entry would include a
debit to noncontrolling interest, sharing the realized
profit between controlling and noncontrolling interests.
5-12
 Data for Example
For the year ended 12/31/2011:
 Subsidiary income is $5,200
 Subsidiary dividends are $3,000
 Current amortization of acquisition price is $450
Intercompany (IC) sales information:
 IC sales during 2011 were $650
 IC profit in ending inventory $60
 IC profit in beginning inventory $24

5-13
 Income Sharing with Downstream Sales –
PARENT Makes Sale
Subsidiary net income $5,200 CI 80% share
Current amortizations (450) $3,800
Adjusted income $4,750 (60)
    24
Defer profits in EI (60) $3,764 Income from subsidiary
Recognize profits in BI 24  
Income recognized $4,714 $2,400
    NCI 20% share
Subsidiary dividends $3,000
$950
When parent makes the IC sale, the  
impact of deferring and recognizing  
profits falls all to the parent.  
$600
5-14
 Income Sharing with Upstream Sales –
SUBSIDIARY Makes Sale
Subsidiary net income $5,200 CI 80% share
Current amortizations (450) $3,800
Adjusted income $4,750 (48)
    19.2
Defer profits in EI (60) $3,771.2 Income from subsidiary
Recognize profits in BI 24  
Income recognized $4,714 $2,400
    NCI 20% share
Subsidiary dividends $3,000
$950.0
When subsidiary makes the IC sale, the (12.0)
impact of deferring and recognizing profits
is split among controlling and 4.8 
noncontrolling interests.  $942.8

$600
5-15
Intercompany Profit Transactions – Inventories

3: UNREALIZED PROFITS IN
ENDING INVENTORIES

5-16
 Ending Inventory on Hand
Intercompany profits in ending inventory
 Eliminate at year end
Working paper entry

Cost of sales (E, -SE) XXX

Inventories (-A) XXX
For the unrealized profit

5-17
 Parent Accounting
Pot owns 90% of Sot acquired at book value (no
amortizations). During the current year, Sot reported $10,000
income. Pot sold goods to Sot during the year for $15,000
including a profit of $6,250. Sot still holds 40% of these
goods at the end of the year.
Unrealized profit in ending inventory
40%(6,250) = $2,500
Pot's Income from Sot
90%(10,000) – 2,500 unrealized profits = $6,500
Noncontrolling interest share
10%(10,000) = $1,000

5-18
 Entries
Pot's journal entry to record income
Investment in Sot (+A) 6,500
Income from Sot (R, +SE) 6,500

Worksheet entries to eliminate intercompany

sale and unrealized profits
Sales (-R, -SE) 15,000
Cost of goods sold (-E, +SE) 15,000
Cost of goods sold (E, -SE) 2,500
Inventory (-A) 2,500

5-19
 Worksheet – Income Statement

  Pot Sot DR CR Consol

Sales $100.0 $50.0 15.0   $135.0
Income from Sot 6.5   6.5   0.0
Cost of sales (60.0) (35.0) 2.5 15.0 (82.5)
Expenses (15.0) (5.0)     (20.0)
Noncontrolling interest share     1.0   (1.0)
Controlling interest share $31.5 $7.5     $31.5

There would be a credit adjustment to Inventory for $2.5 on the

balance sheet portion of the worksheet.

5-20
 What if?
If the sales had been upstream, by Sot to Pot:
Unrealized profits in ending inventory
40%(6,250) = $2,500
Pot's Income from Sot
90%(10,000 – 2,500) = $6,750
Noncontrolling interest share
10%(10,000 – 2,500) = $750

Upstream profits impact both:

 Controlling interest share
 Noncontrolling interest share
5-21
Intercompany Profit Transactions – Inventories

4: RECOGNIZING PROFITS
FROM BEGINNING
INVENTORIES

5-22
 Intercompany Profits in Beginning Inventory

Unrealized profits in
ending inventory one year

Become

Profits to be recognized in the beginning

inventory of the next year!

5-23
Intercompany Profit Transactions – Inventories

5: IMPACT ON
NONCONTROLLING
INTEREST

5-24
 Direction of Sale and NCI
The impact of unrealized profits in ending
inventory and realizing profits in beginning
inventory depends on the direction of the
intercompany sales
Downstream sales
 Full impact on parent
Upstream sales
 Share impact between parent and noncontrolling
interest

5-25
 Calculating Income and NCI
Downstream sales:
Income from sub
= CI%(Sub's NI) – Profits in EI + Profits in BI
Noncontrolling interest share
= NCI%(Sub's NI)
Upstream sales:
Income from sub
= CI%(Sub's NI – Profits in EI + Profits in BI)
Noncontrolling interest share
= NCI%(Sub's NI – Profits in EI + Profits in BI)

5-26
 Upstream Example with Amortization
Perry acquired 70% of Salt on 1/1/2011 for $420 when Salt's equity
consisted of $200 capital stock and $200 retained earnings. Salt's
inventory was understated by $50 and building, with a 20-year life, was
understated by $100. Any excess is goodwill.
2011 2012
Perry Salt Perry Salt
Separate income $1,250 $705 $1,500 $745
Dividends $600 $280 $600 $300
During 2011, Salt sold goods for $700 to Perry at a 20% markup. $240
of these goods were in Perry's ending inventory.
In 2012, Salt sold goods for $900 to Perry at a 25% markup and Perry
still had $100 on hand at the end of the year.
5-27
 Analysis and Amortization

Cost of 70% of Salt $420

Implied value of Salt 420/.70 $600
Book value 200 + 200 400
Excess $200

  Unamort Amort Unamort Amort Unamort

Allocated to: 1/1/11 2011 1/1/12 2012 12/31/12
Inventory 50 (50) 0 0 0
Building 100 (5) 95 (5) 90
Goodwill 50 0 50 0 50
  200 (55) 145 (5) 140

5-28
 2011 Income Sharing (Upstream)

Salt's net income $705 CI 70% share

Current amortizations (55) $455
Adjusted income $650 ($28)
    $427 Income from Salt
Defer profits in EI (40)  
Income recognized $610 $196
 
  NCI 30% share
Subsidiary dividends $280 $195
($12)
$183
 
$84
5-29
 Perry's 2011 Equity Entries

Investment in Salt (+A) 420

Cash (-A) 420
For acquisition of 70% of Salt
Cash (+A) 196
Investment in Salt (-A) 196
For dividends received
Investment in Salt (+A) 427
Income from Salt (R, +SE) 427
For share of income

5-30
 2011 Worksheet Entries (1 of 3)
1. Adjust for errors & omissions - none
2. Eliminate intercompany profits and losses
Sales (-R, -SE) 700
Cost of sales (-E, +SE) 700
Cost of Sales (E, -SE) 40
Inventory (-A) 40

3. Eliminate income & dividends from sub. and bring

Investment
Income from account to its beginning balance
Salt (-R, -SE) 427
Dividends (+SE) 196
Investment in Salt (-A) 231
5-31
 2011 Entries (2 of 3)
4. Record noncontrolling interest in sub's earnings &
dividends
Noncontrolling interest share (-SE) 183
Dividends (+SE) 84
Noncontrolling interest (+SE) 99
5. Eliminate reciprocal Investment & sub's equity
balances
Capital stock (-SE) 200
Retained earnings (-SE) 200
Inventory (+A) 50
Building (+A) 100
Goodwill (+A) 50
Investment in Salt (-A) 420
Noncontrolling interest (+SE) 180
5-32
 2011 Entries (3 of 3)
6. Amortize fair value/book value differentials
Cost of sales (E, -SE) 50
Inventory (-A) 50
Depreciation expense (E, -SE) 5
Building (-A) 5

7. Eliminate other reciprocal balances – none

5-33
 2012 Income Sharing (Upstream)
   
Salt's net income $745 CI 70% share
Current amortizations (5) $518
Adjusted income $740 ($14)
    $28
Defer profits in EI (20) $532 Income from Salt
Realize profits from BI 40  
Income recognized $760 $210
    NCI 30% share
Subsidiary dividends $300 $222
($6)
$12
$228
 
$90
5-34
 Perry's 2012 Equity Entries

Cash (+A) 210

Investment in Salt (-A) 210
For dividends received
Investment in Salt (+A) 532
Income from Salt (R, +SE) 532
For share of income

5-35
 2012 Worksheet Entries (1 of 3)
1. Adjust for errors & omissions - none
2. Eliminate intercompany profits and losses
Sales (-R, -SE) 900
Cost of sales (-E, +SE) 900
Cost of Sales (E, -SE) 20
Inventory (-A) 20
Investment in Salt (+A) 28
Noncontrolling interest (-SE) 12
Cost of sales (-E, +SE) 40

3. Eliminate income & dividends from sub. and bring

Income from Salt
Investment (-R, -SE)
account to its beginning balance 532
Dividends (+SE) 210
Investment in Salt (-A) 322
5-36
 2012 Entries (2 of 3)
4. Record noncontrolling interest in sub's earnings &
dividends
Noncontrolling interest share (-SE) 228
Dividends (+SE) 90
Noncontrolling interest (+SE) 138
5. Eliminate reciprocal Investment & sub's equity balances
Capital stock (-SE) 200
Retained earnings (-SE) 625
Inventory (+A) 0
Building (+A) 95
Goodwill (+A) 50
Investment in Salt (-A) 679
Noncontrolling interest (+SE) 291
5-37
 2012 Entries (3 of 3)
6. Amortize fair value/book value differentials
Depreciation expense (E, -SE) 5
Building (-A) 5

7. Eliminate other reciprocal balances – none

5-38