Ch06 Jeter

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Accounting
Jeter ● Chaney

Elimination of
Unrealized
Profit on Intercompany
Sales of Inventory

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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.

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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.
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Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
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.


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Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
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.


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Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Intercompany Sales of
Merchandise
Downstream
E6-7: Summary of 2014 Intercompany Sales Sales

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.

LO 6 Consolidated workpapers for downstream sales.


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Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Intercompany Sales of
Merchandise Downstream
Sales
E6-7: Summary of 2014 Intercompany 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 $ -
Prepare the workpaper entry to eliminate intercompany sales for
2014.
Sales 450,000
Purchases (Cost of Sales) 450,000
To eliminate intercompany sales

LO 6 Consolidated workpapers for downstream sales.


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Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
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 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.
LO 6 Consolidated workpapers for downstream sales.
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Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Intercompany Sales of
Merchandise
Downstream
E6-7: Summary of 2014 Intercompany Sales Sales
2014 (COGS) (Inventory)
Total Resold On Hand
Intercompany Sales $ 450,000 $ 300,000 $ 150,000
Intercompany COGS 375,000 250,000 125,000
Gross profit $ 75,000 $ 50,000 $ 25,000
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

LO 6 Consolidated workpapers for downstream sales.


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Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Intercompany Sales of
Merchandise
2014 (COGS) (Inventory)
E6-7: Total Resold On Hand
Intercompany Sales $ 450,000 $ 300,000 $ 150,000
Alternate Intercompany COGS 375,000 250,000 125,000
View Gross profit $ 75,000 $ 50,000 $ 25,000

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 Sheraton’s books by $25,000 unrealized profit.

LO 6 Consolidated workpapers for downstream sales.


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Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Intercompany Sales of
Merchandise Downstream
E6-7: Workpaper entry to eliminate intercompany sales for 2015. Sales

2014 Unrealized Profit in Inventory


(COGS) (Inventory)
Total Resold On Hand
Intercompany Sales $ 150,000
Intercompany COGS 125,000
Gross profit $ 25,000

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.

LO 6 Consolidated workpapers for downstream sales.


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Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Intercompany Sales of
Merchandise
Downstream
E6-7: Workpaper entry to eliminate intercompany sales for 2015.
Sales
2015 Intercompany Sales
(COGS) (Inventory)
Total Resold On Hand
Intercompany Sales $ 486,000 $ 324,000 $ 162,000
Intercompany COGS 405,000 270,000 135,000
Gross profit $ 81,000 $ 54,000 $ 27,000

Sales 486,000
Purchases (Cost of 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
LO 6 Consolidated workpapers for downstream sales.
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Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Intercompany Sales of
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.


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Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Intercompany Sales of
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.
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Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Cost Method: Consolidated Statements
Workpaper—Upstream Sales
Determination of the Noncontrolling Interest in
Combined Income—Upstream 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.


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Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
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 Company’s 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.
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Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Cost Method: Consolidated
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

LO 6 Consolidated workpapers for upstream Sales- Cost Method.


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Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Cost Method: Consolidated
Workpaper Upstream
P6-7: Worksheet entries for Dec. 31, 2016. Sales

2016 Intercompany Sales


(COGS) (Inventory)
Total Resold On Hand
Intercompany Sales $ 300,000 $ 225,000 $ 75,000
Intercompany COGS 240,000 180,000 60,000
Gross profit $ 60,000 $ 45,000 $ 15,000

2. Sales 300,000
Purchases (Cost of 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

LO 6 Consolidated workpapers for upstream Sales- Cost Method.


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Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Cost Method: Consolidated
Workpaper
Upstream
P6-7: Worksheet entries for Dec. 31, 2016. Sales
2015 Unrealized Profit in Inventory
(COGS) (Inventory)
Total Resold On Hand
Intercompany Sales
Intercompany COGS
Gross profit $ 45,000

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

LO 6 Consolidated workpapers for upstream Sales- Cost Method.


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Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Cost Method: Consolidated
Workpaper
Upstream
P6-7: Worksheet entries for Dec. 31, 2016. 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

LO 6 Consolidated workpapers for upstream Sales- Cost Method.


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Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Cost Method: Consolidated
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

LO 6 Consolidated workpapers for upstream Sales- Cost Method.


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Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Cost Method: Consolidated
Workpaper
P6-7 Upstream Sales

Eliminations Consolidated
Balance Sheet Paque Segal Debit Credit NCI Balances
Cash $ 93,000 $ 75,000 $ 168,000
(3)
Accounts receivable 319,500 168,750 (1)
(6)
488,250
Inventory 210,000 172,500 15,000 367,500
Investment in Segal 810,000 27,000 837,000 -
Other assets 750,000 630,000 1,380,000
Total assets $ 2,182,500 $ 1,046,250 $ 2,403,750
-
Accounts payable $ 105,000 $ 45,000 $ 150,000
(6)
Other current liabilities 112,500 60,000 172,500
Common stock 1,200,000 750,000 750,000 1,200,000
(4) (6)
Retained earnings 765,000 191,250 589,500 426,000 4,125 788,625
NCI in net assets 4,500 93,000 88,500
92,625 92,625
Total liab. & equity $ 2,182,500 $ 1,046,250 $ 1,371,000 $ 1,371,000 $ 2,403,750

LO 6 Consolidated workpapers for upstream Sales- Cost Method.


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Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Cost Method—Analysis of Consolidated Net
Income and Consolidated Retained Earnings
Consolidated Net Income
• The parent company’s 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.

LO 6 Consolidated workpapers for upstream Sales- Cost Method.


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Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Cost Method: Consolidated
Net Income
Upstream Sales
P6-7: Prepare a calculation of Paque’s share of Segal’s 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 Segal’s income ($101,250 x 90%) $ 91,125


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

LO 6 Consolidated workpapers for upstream Sales- Cost Method.


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Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Cost Method: Consolidated
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 Segal’s income (previous slide) 91,125
Controlling interest in Consolidated net income $140,625

LO 6 Consolidated workpapers for upstream Sales- Cost Method.


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Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Cost Method—Analysis of Consolidated Net
Income and Consolidated Retained Earnings
Consolidated Retained Earnings
• The parent’s cost basis retained earnings that has been
realized in transactions with third parties
– plus (minus) the parent’s 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.
LO 6 Consolidated workpapers for upstream Sales- Cost Method.
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Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.

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