Intercompany Inventory Transactions: Mcgraw-Hill/Irwin © 2008 The Mcgraw-Hill Companies, Inc. All Rights Reserved

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7

Intercompany Inventory Transactions

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc. All rights reserved.


7-2

Intercompany Inventory Transactions

• Inventory transactions are the most common


form of intercorporate exchange.
• The elimination of inventory transfers between
related companies is no different than for other
types of intercompany transactions.
• All revenue and expense must be eliminated
fully and all profits and losses recorded on the
transfers are deferred until the items are sold
to a nonaffiliate.
7-3

Intercompany Inventory Transactions

• The eliminations ensure that only the historical


cost of the inventory to the consolidated entity
is included in the consolidated balance sheet
when the inventory is still on hand and is
charged to cost of goods sold in the period
the inventory is resold to nonaffiliates.
7-4

Transfers at Cost

• Merchandise sometimes is sold to related


companies at the seller’s cost or carrying value.
• When an intercorporate sale includes no profit
or loss, the balance sheet inventory amounts at
the end of the period require no adjustment for
consolidations. However, an eliminating entry is
needed to remove both the revenue and related
cost of goods sold.
Sales XXX
COGS XXX
7-5

Transfers at a Profit or Loss

• Companies use many different approaches in


setting intercorporate transfer prices.

• In some companies, the sale price to an affiliate


is the same as the price to any other customer.

• Some companies routinely mark up inventory


transferred to affiliates by a certain percentage
of cost.
7-6

Transfers at a Profit or Loss

• Regardless of the method used in setting


intercorporate transfer prices, the elimination
process must remove the effects of such sales
from the consolidated statements.

• When intercorporate sales include profits or


losses, there are two aspects of the workpaper
eliminations needed in the period of transfer to
prepare consolidated financial statements.
7-7

First Aspect: Income Statement Focus

• When intercompany sales include profits or


losses, the workpaper eliminations needed for
consolidation in the period of transfer must
adjust accounts in both the consolidated income
statement and balance sheet.
• Income statement: sales and cost of goods sold.
The sales revenue from the intercompany sale
and the related cost of goods sold recorded by
the transferring affiliate must be removed.
7-8

Second Aspect: Balance Sheet Focus

• Elimination from the inventory on the balance


sheet of any profit or loss on the intercompany
sale that has not been confirmed by resale of
the inventory to outsiders.
• Profit or loss on the intercompany sale must be
removed so the inventory is reported at the cost
of the consolidated entity.
7-9

Downstream Sale–Perpetual System

• When a company sells an inventory item to


an affiliate, one of three situations results:
1. The item is resold to a nonaffiliate during
the same period;
2. The item is resold to a nonaffiliate during
the next period; or,
3. The item is held for two or more periods
by the purchasing affiliate.
7-10

1. Profit Realized in Same Period

• Required Elimination Entry:


Sales $10,000
Cost of Goods Sold $10,000

• Note the elimination entry does not effect consolidated


net income because sales and cost of goods sold both
are reduced by the same amount.
• No elimination of intercompany profit is needed because
all of the intercompany profit has been realized through
resale of the inventory to the external party during the
current period.
7-11

2. Profit Realized in Next Period

• When inventory is sold to an affiliate at a profit


and the inventory is not resold during the same
period, appropriate adjustments are needed to
prepare consolidated financial statements in
the period of the intercompany sale and in each
subsequent period until the inventory is sold to
a nonaffiliate. [Continued on next slide.]
7-12

2. Profit Realized in Next Period

• By way of illustration, assume that Peerless


Products purchases inventory in 20X1 for $7,000
and sells the inventory during the year to Special
Foods for $10,000. Thereafter, Special Foods
sells the inventory to Nonaffiliated Corporation for
$15,000 on January 2, 20X2.
• Required Elimination Entry (20X1):
Sales $10,000
Cost of Goods Sold $7,000
Inventory $3,000
7-13

3. Inventory Held Two or More Periods

• Companies may carry the cost of inventory


purchased from an affiliate for more than one
accounting period.
7-14

3. Inventory Held Two or More Periods

For example, if Special Foods continues to hold


the inventory purchased from Peerless Products,
the following eliminating entry is needed in the
consolidation workpaper each time a consolidated
balance sheet is prepared for years following the
year of intercompany sale, for as long as the
inventory is held:
Retained Earnings, January 1 $3,000
Inventory $3,000
Eliminate beginning inventory profit.
7-15

Upstream Sale – Perpetual System

• When an upstream sale of inventory occurs and


the inventory is resold by the parent to a
nonaffiliate during the same period, all the
eliminating entries in the consolidation work
paper are identical to those in the downstream
case.
7-16

Upstream Sale – Perpetual System

• When the inventory is not resold to a nonaffiliate


before the end of the period, work paper
eliminating entries are different from the
downstream case only by the apportionment of
the unrealized intercompany profit to both the
controlling and noncontrolling interests.
• The elimination of the unrealized intercompany
profit must reduce the interests of both
ownership groups each period until the profit is
resold to a nonaffiliated party.
7-17

Lower of Cost or Market

• Inventory purchased from an affiliate might be


written down by the purchasing affiliate under
the lower-of-cost-or-market rule if the market
value at the end of the period is less than the
intercompany transfer price. [Continued on next
slide.]
7-18

Lower of Cost or Market

• Such a situation can be illustrated by assuming


that a parent company purchases inventory for
$20,000 and sells it to its subsidiary for $35,000.
Also, assume that the subsidiary still holds the
inventory at year-end and determines that its
market value (replacement cost) is $25,000 at
that time. [Continued on next slide.]
7-19

Lower of Cost or Market

The subsidiary writes the inventory down from


$35,000 to its lower market value of $25,000 at the
end of the year and records the following entry:
Loss on Decline in
Value of Inventory $10,000
Inventory $10,000

Write inventory down to market value.


7-20

Lower of Cost or Market

While this entry revalues the inventory to $25,000


on the books of the subsidiary, the appropriate
valuation from a consolidated viewpoint is the
$20,000 original cost of the inventory to the parent.
Therefore, the eliminating entry—shown on the
next slide—is needed in the consolidated
workpaper.
7-21

Lower of Cost or Market

• Sales $35,000
Cost of Goods Sold $20,000
Inventory $5,000
Loss on Decline in
Value of Inventory $10,000
Eliminate intercompany sale of
inventory.
7-22

Lower of Cost or Market

• The inventory loss recorded by the subsidiary


must be eliminated because the $20,000
inventory valuation for consolidation purposes is
below the $25,000 market value of the inventory.

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