Advanced Accounting Jeter ● Chaney Elimination of Unrealized Profit on Intercompany Sales of Inventory Prepared by Sheila Ammons, Austin Community College Learning Objectives • • Describe the financial reporting objectives for intercompany sales of inventory • Understand the concept of eliminating 100% of intercompany profit not realized in transactions with outsiders, and know the authoritative position • • • • Determine the amount of intercompany profit, if any, to be eliminated from the consolidated statements 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 Copyright © 2015 John Wiley & Sons, Inc All rights reserved Upstream and Downstream Sales of Inventory Company P P sells inventory Downstream S2 sells inventory 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 Upstream and downstream3 sales 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 Financial reporting objectives for intercompany4 sales 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 Consolidated workpapers for downstream5 sales Copyright © 2015 John Wiley & Sons, Inc All rights reserved Intercompany Sales of Merchandise Downstream Sales E6-7: Summary of 2014 Intercompany Sales Intercompany Sales Intercompany COGS Gross profit $ $ Total 450,000 375,000 75,000 (COGS) Resold $ 450,000 375,000 $ 75,000 (Inventory) On Hand $ $ - 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 The “Resold” column represents intercompany inventory that was resold to third parties Portions resold are recorded in COGS “On Hand” represents intercompany inventory still on hand in the affiliated group LO Consolidated workpapers for downstream6 sales Copyright © 2015 John Wiley & Sons, Inc All rights reserved Intercompany Sales of 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 LO Consolidated workpapers for downstream7 sales Copyright © 2015 John Wiley & Sons, Inc All rights reserved Intercompany Sales of Merchandise Determination of Consolidated Sales, Cost of Sales, and Inventory Balances • Downstream Sales 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 Consolidated workpapers for downstream8 sales Copyright © 2015 John Wiley & Sons, Inc All rights reserved Intercompany Sales of 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 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 Consolidated workpapers for downstream9 sales Copyright © 2015 John Wiley & Sons, Inc All rights reserved Intercompany Sales of Merchandise E6-7: Alternate View Workpaper entry to eliminate intercompany sales for 2014 Downstream Sales Sales 450,000 Cost of Sales Cost of Sales 375,000 Inventory – Balance Sheet 50,000 Original Sales and Cost of Sales recorded by Perkins (parent) is reversed Cost of Sales overstated by Sheraton on resale of goods to third parties Inventory on hand is overstated on Sheraton’s books by $25,000 unrealized profit 25,000 10 sales LO Consolidated workpapers for downstream Copyright © 2015 John Wiley & Sons, Inc All rights reserved Partial Equity Method: Workpaper Upstream Sales P6-13 (3) (5) (1) (5) (4) (5) LO Consolidated workpapers – partial equity 34 method Copyright © 2015 John Wiley & Sons, Inc All rights reserved Partial Equity Method—Analysis of Consolidated Net Income Same as Cost Method Consolidated Net Income • The parent’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 Consolidated workpapers – partial equity 35 method Copyright © 2015 John Wiley & Sons, Inc All rights reserved Partial Equity Method—Analysis of Consolidated Net Income Partial Equity Method—Analysis of Consolidated Net Income Consolidated Retained Earnings • • When the parent uses the partial equity method, the parent’s share of subsidiary income since acquisition is already included in the parent’s reported retained earnings Consequently, consolidated retained earnings is calculated as the parent’s 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 differences between implied and book values LO Consolidated workpapers – partial equity 36 method Copyright © 2015 John Wiley & Sons, Inc All rights reserved Consolidated Retained Earnings 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 Unrealized profit on upstream sales ($15,000 x 90%) (13,500) Consolidated retained earnings on 12/31/2016 $ 788,625 LO Consolidated workpapers – partial equity 37 method Copyright © 2015 John Wiley & Sons, Inc All rights reserved Complete Equity Method: Workpaper • • • Upstream Sales 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 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 Paque Corporation uses the complete equity method to record its investment in Segal Company LO Consolidated workpapers – complete equity 38 method Copyright © 2015 John Wiley & Sons, Inc All rights reserved Complete Equity Method: Workpaper Upstream Sales P6-17: Worksheet entries for Dec 31, 2016 Equity in Subsidiary Income 91,125 Investment in Segal Company 37,125 Dividends Declared ($60,000 x 90%) To reverse the effect of parent company entries for subsidiary dividends and income 54,000 LO Consolidated workpapers – complete equity 39 method Copyright © 2015 John Wiley & Sons, Inc All rights reserved Complete Equity Method: Workpaper Upstream Sales P6-17: Worksheet entries for Dec 31, 2016 2016 Intercompany Sales Sales 300,000 Purchases (Cost of Sales) End Inventory (Cost of Sales) Inventory (Balance Sheet) 300,000 15,000 15,000 To eliminate intercompany sales and defer(eliminate) unrealized profit in ending inventory LO Consolidated workpapers – complete equity 40 method Copyright © 2015 John Wiley & Sons, Inc All rights reserved Complete Equity Method: Workpaper Upstream Sales P6-17: Worksheet entries for Dec 31, 2016 2015 Unrealized Profit in Inventory Investment in Segal ($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 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 LO Consolidated workpapers – complete equity 41 method Copyright © 2015 John Wiley & Sons, Inc All rights reserved Complete Equity Method: Workpaper Upstream Sales P6-17: Worksheet entries for Dec 31, 2016 Beg Retained Earnings - Segal 180,000 Common Stock - Segal 750,000 Investment in Segal Noncontrolling Interest 837,000 93,000 To eliminate investment account and create NCI account LO Consolidated workpapers – complete equity 42 method Copyright © 2015 John Wiley & Sons, Inc All rights reserved Complete Equity Method: Workpaper Upstream Sales P6-17 (2) (1) (3) (2) (4) (5) (1) NCI in Consolidated Income = 10% × ($71,250 + $45,000 – $15,000) = $10,125 LO Consolidated workpapers – complete equity 43 method Copyright © 2015 John Wiley & Sons, Inc All rights reserved Complete Equity Method: Workpaper Upstream Sales P6-17 (3) (4) (5) (1) (5) (4) (5) LO Consolidated workpapers – complete equity 44 method Copyright © 2015 John Wiley & Sons, Inc All rights reserved Complete Equity Method—Analysis of Consolidated Net Income and Consolidated Retained Earnings • • Consolidated net income is the sum of the following components: – Parent company’s 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 company’s recorded income – Consolidated retained earnings equals the parent company’s recorded retained earnings LO Consolidated workpapers – complete equity 45 method Copyright © 2015 John Wiley & Sons, Inc All rights reserved Summary of Workpaper Entries Illustration 6-21 To eliminate intercompany sales: All Methods Sales Parent Selling (Downstream) X 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 Equity Methods Beg Retained Earnings—Parent X Beg Inventory - Income X Statement (Cost of Sales) Complete EquityInvestment in S Company Method X Beg Inventory - Income Statement (Cost of Sales) X 46 Copyright © 2015 John Wiley & Sons, Inc All rights reserved Summary of Workpaper Entries Illustration 6-21 To eliminate intercompany sales: All Methods Sales X Purchases (Cost of Sales) Subsidiary Selling (Upstream) 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 Earnings—Parent X Equity Methods NCI in Equity X Beg Inventory (Cost of Sales) X Complete EquityInvestment in S Company Method NCI in Equity X X Beg Inventory (Cost of Sales) X 47 Copyright © 2015 John Wiley & Sons, Inc All rights reserved 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 48 LO Intercompany profit prior to affiliation Copyright © 2015 John Wiley & Sons, Inc All rights reserved ... of Sales recorded by Perkins (parent) is reversed Cost of Sales overstated by Sheraton on resale of goods to third parties Inventory on hand is overstated on Sheraton’s books by $25,000 unrealized... 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. .. 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 The “Resold” column represents