Chapter 5: Intercompany Profit Transactions Inventories

by Jeanne M. David, Ph.D., Univ. of Detroit Mercy to accompany Advanced Accounting, 10th edition by Floyd A. Beams, Robin P. Clement, Joseph H. Anthony, and Suzanne Lowensohn

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Intercompany Profits Inventories: Objectives

1. Understand the impact of intercompany profit for inventories on preparation of consolidation working papers. 2. Apply the concepts of upstream versus downstream inventory transfers. 3. Defer unrealized inventory profits remaining in ending inventory of either the parent or subsidiary.

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Objectives (cont.)
4. Recognize realized, previously deferred inventory profits in the beginning inventory of either the parent or subsidiary. 5. Adjust the calculations of noncontrolling interest amounts in the presence of intercompany inventory profits.

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Intercompany Profit Transactions Inventories

1: Intercompany Inventory Profits

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Intercompany Transactions
For consolidated financial statements, ARB No. 51 (as amended by FASB Statement No. 160) states: "intercompany balances and transactions shall be eliminated." Show income and financial position as if the intercompany transactions had never taken place.

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Intercompany Sales of Inventory

Profits on intercompany sales of inventory All 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 Consider a FIFO inventory system Beginning inventories are sold Ending inventories are from current period
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No Intercompany Profits in Inventories

During 2009, Pretty sold goods costing $1,000 to its subsidiary, Simple, at a gross profit of 30%. Simple had none of this inventory on hand at the end of 2009. Worksheet entry for 2009:
Sales Cost of sales Sales = $1,000 / (1-30%) = $1,429 1,429 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. Pretty's sales are reduced $1,429. Simple's cost of sales are reduced $1,429. The same entry is used if Simple sells to Pretty.
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Intercompany Profits Only in Ending Inventories

Last year, 2009, Paul 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 2009. During 2010, Paul sold additional goods costing $900 to Sal at a gross profit of 40%. Sal has $200 of these goods on hand at 12/31/2010. Worksheet entries for 2010:
Sales Cost of sales Sales = $900 / (1-40%) = $1,500 Cost of sales Inventory Ending inventory profit = $200 x 40%
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1,500 1,500 80 80
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Intercompany Profits Beginning and Ending Inventories

Last year, 2009, 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 2009. During 2010, Pam sold additional goods costing $500 to Sir at a 30% mark-up. Sir has $260 of these goods on hand at 12/31/2010. Worksheet entries for 2010: Sales 650 Cost of sales 650
Sales = $500 + 30%($500) = $650

Cost of sales Inventory

Ending inv. profits = $260 x 30%/130%

60

60
24 24
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Investment in Subsidiary Cost of sales

Begin. inv. profits = $120 x 25%/125% = $24
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Intercompany Profit Transactions Inventories

2: Upstream & Downstream Inventory Sales

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Upstream and Downstream Sales

Downstream Sales
Parent Parent sells to subsidiary

Subsidiary sells to parent

Subsidiary 1

Subsidiary 2

Subsidiary 3
Upstream Sales

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Intercompany Inventory Sales

The worksheet entries for eliminating intercompany profits for downstream sales
Sales Cost of sales
For the intercompany sales price

XXX XXX

Cost of sales Inventory

For the profits in ending inventory

XX
XX XX

Investment in Subsidiary Cost of sales

For the profits in beginning inventory

XX

For upstream sales, the last entry would also include a debit to noncontrolling interest, splitting the profit to be realized between controlling and noncontrolling interests.
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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 profits in ending inventory $60 IC profit in beginning inventory $24
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Income Sharing with Downstream Sales PARENT Makes Sale

Subsidiary net income Current amortizations Adjusted income Defer profits in EI Recognize profits in BI $5,200 (450) $4,750 (60) 24 CI 80% share $3,800 (60) 24 Income from subsidiary $3,764 $2,400 NCI 20% share

Income recognized
Subsidiary dividends

$4,714
$3,000

$950

When parent makes the IC sale, the impact of deferring and recognizing profits falls all to the parent.
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$600
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Income Sharing with Upstream Sales SUBSIDIARY Makes Sale

Subsidiary net income Current amortizations Adjusted income Defer profits in EI Recognize profits in BI Income recognized Subsidiary dividends $5,200 (450) $4,750 (60) 24 $4,714 $3,000 CI 80% share $3,800 (48) 19.2 Income from subsidiary $3,771.2 $2,400 NCI 20% share When subsidiary makes the IC sale, the impact of deferring and recognizing profits is split among controlling and noncontrolling interests.
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$950.0 (12.0) 4.8 $942.8

$600
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Intercompany Profit Transactions Inventories

3: Unrealized Profits in Ending Inventories

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Ending Inventory on Hand

Intercompany profits in ending inventory Eliminate at year end Working paper entry Cost of sales XXX Inventories XXX For the unrealized profit

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Parent Accounting
Porter owns 90% of Sorter acquired at book value (no amortizations). During the current year, Sorter reported $10,000 income. Porter sold goods to Sorter during the year for $15,000 including a profit of $6,250. Sorter still holds 40% of these goods at the end of the year. Unrealized profit in ending inventory 40%(6,250) = $2,500 Porter's Income from Sorter 90%(10,000) 2,500 unreal. Profits = $6,500 Noncontrolling interest share 10%(10,000) = $1,000
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Entries
Porter's journal entry to record income
Investment in Sorter Income from Sorter 6,500 6,500

Worksheet entries to eliminate intercompany sale and unrealized profits

Sales 15,000

Cost of sales Cost of sales Inventory

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15,000
2,500 2,500
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Worksheet Income Statement

Porter Sorter Sales Income from Sorter $100.0 6.5 $50.0 DR 15.0 6.5 CR Consol $135.0 0.0

Cost of sales
Expenses Noncontrolling interest share Controlling interest share

(60.0)
(15.0) $31.5

(35.0)
(5.0)

2.5 15.0
1.0

(82.5)
(20.0) (1.0) $31.5

$7.5

There would be a credit adjustment to Inventory for 2.5 on the balance sheet portion of the worksheet.

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What if?
If the sales had been upstream, by Sorter to Porter: Unrealized profits in ending inventory 40%(6,250) = $2,500 Porter's Income from Sorter 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
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Intercompany Profit Transactions Inventories

4: Recognizing Profits from Beginning Inventories

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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!

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Intercompany Profit Transactions Inventories

5: Impact on Noncontrolling Interest

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Direction of Sale and NCI

The impact of unrealized profits in ending inventory and realizing profits in beginning inventory depends on the direction Downstream sales Full impact on parent Upstream sales Share impact between parent and noncontrolling interest

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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)
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Upstream Example with Amortization

Perry acquired 70% of Salt on 1/1/2009 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.
2009 2010 Perry Salt Perry Salt $1,250 $705 $1,500 $745 $600 $280 $600 $300

Separate income Dividends

During 2009, Salt sold goods costing $700 to Perry at a 20% markup. $240 of these goods were in Perry's ending inventory. In 2010, Salt sold goods costing $900 to Perry at a 25% markup and Perry still had $100 on hand at the end of the year.
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Analysis and Amortization

Cost of 70% of Salt
Implied value of Salt 420/.70 Book value 200 + 200

$420
$600 400

Excess

$200
Unamort Amort 1/1/09 2009 50 (50) 100 (5) 50 0 200 (55) Unamort Amort 1/1/10 2010 0 0 95 (5) 50 0 145 (5) Unamort 12/31/10 0 90 50 140

Allocated to: Inventory Building Goodwill

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2009 Income Sharing (Upstream)

Salt's net income Current amortizations Adjusted income Defer profits in EI Income recognized $705 (55) $650 (40) $610 CI 70% share $455 ($28) Income from Salt $427 $196 NCI 30% share $195 ($12) $183

Subsidiary dividends

$280

$84
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Perry's 2009 Equity Entries

Investment in Salt Cash For acquisition of 70% of Salt Cash Investment in Salt For dividends received Investment in Salt Income from Salt For share of income
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420
420

196
196

427
427

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2009 Worksheet Entries

1. Adjust for errors & omissions - none 2. Eliminate intercompany profits and losses Sales 700 Cost of sales Cost of Sales 40

700

Inventory 40 3. Eliminate income & dividends from sub. and bring Investment account to its beginning balance

Income from Salt Dividends Investment in Salt

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427
196 231
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2009 Entries (2 of 3)
4. Record noncontrolling interest in sub's earnings & dividends
Noncontrolling interest share Dividends Noncontrolling interest 183 84 99

5. Eliminate reciprocal Investment & sub's equity balances

Capital stock Retained earnings Inventory Building Goodwill Investment in Salt Noncontrolling interest
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200 200 50 100 50 420 180

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2009 Entries (3 of 3)
6. Amortize fair value/book value differentials
Cost of sales Inventory 50 50

Depreciation expense Building

5
5

7. Eliminate other reciprocal balances none

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2010 Income Sharing (Upstream)

Salt's net income Current amortizations Adjusted income Defer profits in EI Realize profits from BI Income recognized Subsidiary dividends $745 (5) $740 (20) 40 $760 $300 CI 70% share $518 ($14) $28 Income from Salt $532 $210 NCI 30% share $222 ($6) $12 $228 $90
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Perry's 2010 Equity Entries

Cash Investment in Salt For dividends received Investment in Salt Income from Salt For share of income 210
210

532
532

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2010 Worksheet Entries

1. Adjust for errors & omissions - none 2. Eliminate intercompany profits and losses
Sales Cost of sales Cost of Sales Inventory Investment in Salt Noncontrolling interest Cost of sales 900 900 20 20 28 12 40

3. Eliminate income & dividends from sub. and bring Investment account to its beginning balance
Income from Salt Dividends Investment in Salt
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532 210 322

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2010 Entries (2 of 3)
4. Record noncontrolling interest in sub's earnings & dividends
Noncontrolling interest share Dividends Noncontrolling interest 228 90 138

5. Eliminate reciprocal Investment & sub's equity balances

Capital stock Retained earnings Inventory Building Goodwill Investment in Salt Noncontrolling interest
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200 625 0 95 50 679 291

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2010 Entries (3 of 3)
6. Amortize fair value/book value differentials
Depreciation expense Building 5 5

7. Eliminate other reciprocal balances none

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