Solution manual advanced accounting 9e by hoyle ch05

Any transferred inventory retained at the end of the year is recorded at its transfer price which in many cases will include an unrealized gross profit 1.. For consolidation purposes, t

CHAPTER 5 CONSOLIDATED FINANCIAL STATEMENTS - INTERCOMPANY ASSET TRANSACTIONS

Chapter Outline

I The transfer of assets between the companies forming a business combination is a common

practice The opportunity for such direct acquisition (especially of inventory) is often the

underlying motive for the creation of the combination

II Intercompany inventory transfers

A The individual accounting systems of the two companies will record the transfer as a sale

by one party and as a purchase by the other

B Because the transaction was not made with an outside, unrelated party, the sales and purchases balances created by the transfer must be eliminated in the consolidation

process (Entry Tl)

C Any transferred inventory retained at the end of the year is recorded at its transfer price which in (many cases) will include an unrealized gross profit

1 For consolidation purposes, this intercompany gross profit must be deferred by

eliminating the amount from the inventory account on the balance sheet and from the ending inventory figure within cost of goods sold (Entry G)

2 Because the effects of the transfer carry over into the subsequent fiscal period, the unrealized gross profit must also be removed a second time: from the beginning inventory component of cost of goods sold and from the beginning retained earnings balance (Entry *G)

a The retained earnings figure being adjusted is that of the original seller

b If the equity method has been applied and the transfer was made downstream (by the parent), the beginning retained earnings account will be correct; therefore, in this one case, the adjustment is to the Equity in Investment Earnings account

3 The consolidation process is designed to shift the profit from the period of transfer into the time period in which the goods are actually sold to unrelated parties or consumed

D Effect of deferral process on the valuation of a noncontrolling interest

1 Official accounting pronouncements do not currently specify whether deferral of

unrealized profits has an effect on the valuation of noncontrolling interest balances

2 This textbook adjusts the noncontrolling interest balances but only if the sale was made upstream from subsidiary to parent Downstream sales are made by the parent and, thus, are viewed as having no effect on the outside interest

III Intercompany land transfers

A Any gain created by intercompany land transfers is unrealized and will remain so until the land is sold to an outside party

B For each subsequent consolidation, the recorded value of the land account must be reduced to original cost with the unrealized gain that was recorded by the seller also being eliminated

1 In the year of transfer, an actual gain account exists within the accounting records of the seller and must be removed

2 In all later time periods, since the unrealized gain has become an element of the seller's beginning retained earnings balance, the reduction is made to this equity account

3 If the land is ever sold to an outside party, the intercompany gain is realized and has

to be recognized within that time period

IV Intercompany transfer of depreciable assets

A As with other intercompany transfers, any unrealized gross profit must be deferred for consolidation purposes to establish appropriate historical cost balances

B However, the difference between the transfer-based accounting value and the historical cost of the asset will change each year because of the effects of depreciation The amount of unrealized gain within retained earnings will also be reduced annually since excess depreciation expense is recognized (and closed into retained earnings) based on the inflated transfer price

C Consequently, elimination of the unrealized gain (within retained earnings) and the reduction of the asset value to historical cost will differ from year to year

D Also within the consolidation process, the recorded depreciation expense must be

decreased every period to an amount appropriately based on the asset's original

acquisition price

Learning Objectives

1 Understand that intercompany asset transfers often create accounting effects within the financial records of the individual companies that must be eliminated or adjusted prior to production of consolidated financial statements

2 Eliminate the sales and purchases balances that are created by the intercompany transfer of inventory (Entry Tl)

3 Compute the amount of unrealized gross profit included in the recorded value of any

transferred inventory that is still being held by the buyer at the end of a fiscal period

4 Prepare the consolidation entry (Entry G) to eliminate any intercompany inventory gross profit that remains unrealized at the end of the year of transfer

5 Understand that the consolidation process for inventory transfers is designed to defer the unrealized portion of an intercompany gross profit from the year of transfer into the year of disposal or consumption

6 Make the consolidation entry (Entry *G) to eliminate unrealized intercompany gross profits from beginning retained earnings (or in one specific instance from the Equity in Subsidiary Earnings account) and from the cost of goods sold for the period following the year of transfer

7 Understand the difference in upstream and downstream transfers and how each affects the computation of noncontrolling interest balances

8 Eliminate any unrealized gain created by the intercompany transfer of land from the

accounting records of the year of transfer and subsequent years

9 Understand that the elimination process for unrealized gross profits created by intercompany land transfers must be repeated in each fiscal period for as long as the asset is held within the business combination

10 Realize that the account balances created by an unrealized gain resulting from the

intercompany transfer of a depreciable asset will change from period to period because of the effect of depreciation expense

11 Compute and eliminate the unrealized gain created by intercompany transfers of depreciable assets for any date subsequent to the transaction

12 Produce the worksheet entry to reduce depreciation expense from a figure based on transfer price to one calculated from the asset's historical cost balance

Answers to Discussion Questions

Earnings Management

By selling goods to special purpose entities that it controlled but did not consolidate, did Enron overstate its earnings?

According to the Power’s Report (Report of Investigation by the Special Investigative Committee of

the Board of Directors of Enron Corp.—February 1, 2004)

These partnerships—Chewco, LJM1, and LJM2—were used by Enron

Management to enter into transactions that it could not, or would not, do with

unrelated commercial entities Many of the most significant transactions apparently

were designed to accomplish favorable financial statement results,

not to achieve bona fide economic objectives or to transfer risk (page 4)

Assuming Enron controlled LJM2, the transactions that produced the $67 million gain and the $20.3 million agency fee were not arm’s length and thus did not provide a proper basis for recognizing income

What effect does consolidation have on the financial reporting for transactions with controlled

entities?

In consolidation, all intercompany profit would have been deferred until the goods were sold to an outside party Also the intercompany note receivable and payable would have been eliminated in consolidation

Despite their potential for economic and business benefits, the use of SPEs has

always raised the question of whether the sponsoring company has some other

accounting motivations, such as hiding of debt, hiding of poor-performing assets, or

earnings management Additionally, explosive growth in the use of SPEs led to

debates among managers, auditors and accounting standard setters as to whether

and when SPEs should be consolidated This is because the intended accounting

effects of SPEs can only be achieved if the SPEs are reported as unconsolidated

entities separate from the sponsoring entity

FASB Activity on Special Purpose Entities

Fortunately the FASB’s Interpretation 46R Consolidation of Variable Interest Entities explains how to identify an SPE that is not subject to control through voting ownership interests, but is nonetheless controlled by another enterprise and therefore subject to consolidation The FASB requires each enterprise involved with an SPE to determine whether the financial support provided by that

enterprise makes it the primary beneficiary of the SPE’s activities The primary beneficiary of the SPE would then be required to include the assets, liabilities, and results of the activities of the SPE in

its consolidated financial statements

What Price Should We Charge Ourselves?

Transfer pricing is actually a topic for a managerial accounting discussion Students, though, need to

be aware that managerial and financial accounting do overlap at times In this illustration, the price set by company officials for this component will affect the specific consolidation procedures needed

in the preparation of financial statements for external reporting purposes

Since Slagle owns 100 percent of Harrison's common stock, consolidated net income will not be

altered by the transfer pricing decision All intercompany transactions as well as unrealized profits will

be eliminated entirely However, because the sales are upstream, if a noncontrolling interest had been present, the portion of the subsidiary's income attributed to these outside owners would be influenced by the markup Both the noncontrolling interest figure on the balance sheet and on the income statement are impacted by the amount of profits that remain unrealized when transactions are from subsidiary to parent

To the accountant, the easiest approach is to set the transfer price at the seller's cost ($70.00 in this case) No intercompany profits are created and the consolidation process is less complicated

However, as indicated in the narrative, that price may penalize the seller since no profits are

recognized by that profit center In addition, the buyer will then show artificially inflated income Thus, some amount of profit is usually built into transfer pricing decisions Those students who have

already completed cost/managerial accounting can be asked to describe the various factors that should influence the establishment of this price Interaction between accounting courses is beneficial

to the students

Answers to Questions

1 One reason for the significant volume and frequency of intercompany transfers is that many

business combinations are specifically organized so that the companies can provide

products for each other This design is intended to benefit the business combination as a whole because of the economies provided by vertical integration In effect, more profit can often be generated by the combination if one member is able to buy from another rather than from an outside party

2 The sales between Barker and Walden totaled $100,000 Regardless of the ownership

percentage or the markup, the $100,000 was simply an intercompany asset transfer Thus, within the consolidation process, the entire $100,000 should be eliminated from both the Sales and the Purchases (Inventory) accounts

3 Sales price per unit ($900,000 ÷ 3,000 units) $ 300

Number of units in Safeco’s ending inventory × 500

Intercompany inventory at transfer price $150,000

Gross profit rate (.6 ÷ 1.6) 375

Intercompany profit in ending inventory $56,250

4 In intercompany transactions, a transfer price is often established that exceeds the cost of

the inventory Hence, the seller is recording a gross profit on its books that, from the

perspective of the business combination as a whole, remains unrealized until the asset is consumed or sold to an outside party Any unrealized gross profit on merchandise still held

by the buyer must be eliminated whenever consolidated financial statements are produced For the year of transfer, this consolidation procedure is carried out by removing the

unrealized gross profit from the inventory account on the balance sheet and from the ending inventory balance within cost of goods sold In the year following the transfer (if the goods are resold or consumed), the unrealized gross profit must again be eliminated within the

consolidation process This second reduction is made on the worksheet to the beginning inventory component of cost of goods sold as well as to the beginning retained earnings balance of the original seller The gross profit is then moved into the year of realization If the transfer was downstream in direction and the parent company has applied the equity

method, the adjustment in the subsequent year must be made to the equity in subsidiary earnings account rather than to retained earnings

5 On the individual financial records of James, Inc., a gross profit is recorded in the year of

transfer From the viewpoint of the business combination, this gross profit is actually earned

in the period in which the products are sold or consumed by Matthews Co An initial

consolidation entry must be made in the year of transfer to defer any gross profit that remains unrealized A second entry must be made in the following time period to allow the gross profit

to be recognized in the year of its ultimate realization

6 Currently, no official accounting pronouncement answers the question as to the relationship

between unrealized intercompany profits and noncontrolling interest values, although the issue has been under study by the FASB This textbook reasons that unrealized profits relate

to the seller and to the computation of the seller's income Therefore, any unrealized profits created by upstream transfers (from subsidiary to parent) are attributed to the subsidiary The effects resulting from the deferral and eventual recognition of these intercompany profits are considered to have an impact on the calculation of noncontrolling interest balances In

contrast, unrealized profits from downstream transfers are viewed as relating solely to the parent (as the seller) and, thus, have no effect on the noncontrolling interest

7 The basic consolidation process does not differ between downstream and upstream

transfers Sales and purchases (Inventory) balances created by the transactions must be eliminated in total Any unrealized gross profits remaining at the end of a fiscal period are deferred until ultimately earned through sale or consumption of the assets

The direction of intercompany transfers (upstream versus downstream) does have one effect

on consolidated financial statements In computing noncontrolling interest balances (if

present), the deferral of unrealized gross profits on upstream sales is taken into account

Downstream sales, however, are attributed to the parent and are viewed as having no impact

on the outside interest

8 The computation of this noncontrolling interest balance is dependent on the direction of the

intercompany transactions that is not indicated in this question If the unrealized gross profits were created by downstream sales from King to Pawn, they relate only to King The

noncontrolling interest in the subsidiary's net income is not affected and would be $11,000 ($110,000 × 10%) In contrast, if the transfers were upstream from Pawn to King, the deferral and recognition of the profits are attributed to Pawn Pawn's "realized" income would be

$80,000 and the noncontrolling interest's share of the subsidiary's income is reported as

$8,000:

Pawn's reported income $110,000

Recognition of prior year unrealized gross profit 30,000

Deferral of current year unrealized gross profit (60,000)

Pawn's realized income $80,000

Outside ownership percentage 10%

Noncontrolling interest in subsidiary's income $ 8,000

9 The deferral and subsequent recognition of intercompany profits are allocated to the

noncontrolling interest in the same periods as the parent When one affiliate sells to another affiliate, ownership does not change and therefore the underlying profit is deferred When the purchasing affiliate subsequently sells the inventory to an entity outside the affiliated group, ownership changes, and the profit may be recognized Intercompany profits are not really eliminated, but simply deferred until a sale to an outsider takes place

10 Several differences can be cited that exist between the consolidated process applicable to

inventory transfers and that which is appropriate for land transfers The total intercompany Sales balance is offset against Purchases (Inventory) when inventory is transferred but no corresponding entry is needed when land is involved Furthermore, in the year of the sale, ending unrealized inventory gross profits are eliminated through an adjustment to cost of goods sold but a specific gross profit account exists (and must be removed) when land has been sold Finally, unrealized inventory gross profits are usually expected to be realized in the year following the transfer This effect is mirrored in that period by reduction of the

beginning inventory figure (within cost of goods sold) For land transfers, however, the

unrealized gain must be repeatedly deferred in each fiscal period for as long as the land continues to be held within the business combination

11 As long as the land is held by the parent, its recorded value must be reduced to historical

cost within each consolidated set of financial statements In the year of the original transfer, the asset reduction is offset against the subsidiary's recorded gain For all subsequent years

in which the property is held, the credit to the Land account is made against the beginning retained earnings balance of the subsidiary (since the unrealized gain will have been closed into that account)

According to this question, the land is eventually sold to an outside party The intercompany gain (which has been deferred in each of the previous years) is realized by the sale and should be recognized in the consolidated statements of this later period

Because the transfer was upstream from subsidiary to parent, the above consolidated entries will also affect any noncontrolling interest balances being reported Because of the deferral of the intercompany gross profit, the realized income balances applicable to the subsidiary will be less than the reported values In the year of resale, however, the realized income for consolidation purposes is higher than reported All noncontrolling interest totals are computed on the realized balances rather than the reported figures

12 Depreciable assets are often transferred between the members of a business combination at

amounts in excess of book value The buyer will then compute depreciation expense based

on this inflated transfer price rather than on an historical cost basis From the perspective of the business combination, depreciation should be calculated solely on historical cost figures Thus, within the consolidation process for each period, adjustment of the depreciation (that is recorded by the buyer) is necessary to reduce the expense to a cost-based figure

13 From the viewpoint of the business combination, an unrealized gain has been created by the

intercompany transfer and must be eliminated whenever consolidated financial statements are produced This unrealized gain is closed by the seller into retained earnings necessitating subsequent reductions to that account In the individual financial records, however, another income effect is created which gradually reduces the overstatement of retained earnings each period The asset will be depreciated by the buyer based on the inflated transfer price The resulting expense will be higher than the amount appropriate to the historical cost of the item Because this excess depreciation is closed into retained earnings annually, the

overstatement of the equity account is gradually reduced to a zero balance over the life of the asset

Answers to Problems

1 C

2 B Inventory remaining $100,000 × 50% = $50,000 Unrealized gross profit (based

on Lee's markup as the seller) $50,000 × 40% = $20,000 The ownership

percentage has no impact on this computation

3 A

4 C UNREALIZED GROSS PROFIT, 12/31/09

Intercompany Gross profit ($100,000 – $75,000) $25,000 Inventory Remaining at Year's End 16% Unrealized Intercompany Gross profit, 12/31/09 $4,000

UNREALIZED GROSS PROFIT, 12/31/10

Intercompany Gross profit ($120,000 – $96,000) $24,000 Inventory Remaining at Year's End 35% Unrealized Intercompany Gross profit, 12/31/10 $8,400

CONSOLIDATED COST OF GOODS SOLD

Parent balance $380,000 Subsidiary Balance 210,000 Remove Intercompany Transfer (120,000) Recognize 2009 Deferred Gross profit (4,000) Defer 2010 Unrealized Gross profit 8,400 Cost of Goods Sold $474,400

5 A Intercompany sales and purchases of $100,000 must be eliminated

Additionally, an unrealized gross profit of $10,000 must be removed from

ending inventory based on a markup of 25 percent ($200,000 gross

profit/$800,000 sales) which is multiplied by the $40,000 ending balance This

deferral increases cost of goods sold because ending inventory is a negative

component of that computation Thus, cost of goods sold for consolidation purposes is $690,000 ($600,000 + $180,000 – $100,000 + $10,000)

6 C The only change here from Problem 5 is the markup percentage which would

now be 40 percent ($120,000 gross profit  $300,000 sales) Thus, the

unrealized gross profit to be deferred is $16,000 ($40,000 × 40%) Consequently, consolidated cost of goods sold is $696,000 ($600,000 + $180,000 – $100,000 +

$16,000)

7 B UNREALIZED GROSS PROFIT, 12/31/09

Ending inventory $40,000 Markup ($33,000/$110,000) 30% Unrealized intercompany gross profit, 12/31/09 $12,000

UNREALIZED GROSS PROFIT, 12/31/10

Ending inventory $50,000 Markup ($48,000/$120,000) 40% Unrealized intercompany gross profit, 12/31/10 $20,000

NONCONTROLLING INTEREST IN SUBSIDIARY'S INCOME

Reported income for 2010 $90,000 Realized gross profit deferred in 2009 12,000 Deferral of 2010 unrealized gross profit (20,000) Realized income of subsidiary $82,000 Outside ownership 10% Noncontrolling interest $8,200

8 A Individual Records after Transfer

12/31/09

Machinery—$40,000

Gain—$10,000

Depreciation expense $8,000 ($40,000/5 years)

Income effect net—$2,000 ($10,000 – $8,000)

Adjustments for Consolidation Purposes:

2009: $2,000 income is reduced to a $6,000 expense (income is reduced

by $8,000)

2010: $8,000 expense is reduced to a $6,000 expense (income is increased

by $2,000)

9 B UNREALIZED GAIN

Transfer Price $280,000 Book Value (cost after two years of depreciation) 240,000 Unrealized Gain $40,000

EXCESS DEPRECIATION

Annual Depreciation Based on Cost ($300,000/10 years) $30,000 Annual Depreciation Based on Transfer Price

($280,000/8 years) 35,000 Excess Depreciation $5,000

ADJUSTMENTS TO CONSOLIDATED NET INCOME

Defer Unrealized Gain $(40,000) Remove Excess Depreciation 5,000 Decrease to Consolidated Net Income $(35,000)

10 D Add the two book values and remove $100,000 intercompany transfers

11 C Intercompany gross profit ($100,000 - $80,000) $20,000

Inventory remaining at year's end 60% Unrealized intercompany gross profit $12,000

CONSOLIDATED COST OF GOODS SOLD

Parent balance $140,000 Subsidiary balance 80,000 Remove intercompany transfer (100,000) Defer unrealized gross profit (above) 12,000 Cost of goods sold $132,000

12 C Consideration transferred $260,000

Noncontrolling interest fair value 65,000

Suarez total fair value $325,000

Book value of net assets (250,000)

Excess fair over book value $75,000

Annual Excess

Excess fair value assigned to undervalued assets:

Equipment 25,000 5 years $5,000 Secret Formulas $50,000 20 years 2,500 Total -0- $7,500

Consolidated Expenses = $37,500 (add the two book values and include

current year amortization expense)

13 A 20% of the beginning book value $50,000

Excess fair value allocation (20%× $75,000) 15,000

20% share of Suarez net income

adjusted for amortization (20% × [110,000 – 7,500]) 20,500

Ending noncontrolling interest balance $85,500

14 C Add the two book values plus the original allocation ($25,000) less one year of

excess amortization expense ($5,000)

15 B Add the two book values less the ending unrealized gross profit of $12,000

Intercompany Gross profit ($100,000 – $80,000) $20,000 Inventory Remaining at Year's End 60% Unrealized Intercompany Gross profit, 12/31 $12,000

16 (15 Minutes) (Determine selected consolidated balances; includes inventory

transfers and an outside ownership.)

Customer list amortization = $65,000/5 years = $13,000 per year

Intercompany Gross profit ($160,000 – $120,000) $40,000 Inventory Remaining at Year's End 20% Unrealized Intercompany Gross profit, 12/31 $8,000

CONSOLIDATED TOTALS

 Inventory = $592,000 (add the two book values and subtract the ending

unrealized gross profit of $8,000)

 Sales = $1,240,000 (add the two book values and subtract the $160,000

intercompany transfer)

 Cost of Goods Sold = $548,000 (add the two book values and subtract the

intercompany transfer and add [to defer] ending unrealized gross profit)

 Operating Expenses = $443,000 (add the two book values and the

amortization expense for the period)

 Noncontrolling Interest in Subsidiary's Net Income = $8,700 (30 percent of

the reported income after subtracting 13,000 excess fair value amortization and deferring $8,000 ending unrealized gross profit) Gross profit is included

in this computation because the transfer was upstream from Sanchez to Preston

17 (60 minutes) (Downstream intercompany profit adjustments when parent uses

equity method and a noncontrolling interest is present)

Consideration transferred by Corgan $980,000

Noncontrolling interest fair value 245,000

Smashing’s acquisition-date fair value 1,225,000

Book value of subsidiary 950,000

Excess fair over book value 275,000

Excess assigned to covenants 275,000

Useful life in years ÷ 20

2009 Ending Inventory Profit Deferral

 Cost = $100,000 ÷ 1.6 = $62,500

 Intercompany Gross profit = $100,000 – $62,500 = $37,500

 Ending inventory gross profit = $37,500 × 40% = $15,000

2010 Ending Inventory Profit Deferral

 Cost = $120,000 ÷ 1.6 = $75,000

 Intercompany Gross profit = $120,000 – $75,000 = $45,000

 Ending inventory gross profit = $45,000  40% = $18,000

a Investment account:

Consideration transferred, January 1, 2009 $980,000 Smashing’s 2009 income × 80% $120,000

Covenant amortization (13,750 × 80%) (11,000) Ending inventory profit deferral (100%) (15,000)

Smashing’s 2010 income × 80% $104,000 Covenants amortization (13,750 × 80%) (11,000) Beginning inventory profit recognition 15,000 Ending inventory profit deferral (100%) (18,000)

18 (40 Minutes) (Series of independent questions concerning various aspects of

the consolidation process when intercompany transfers have occurred)

a 2009 Unrealized gross profit to be recognized in 2010

Total interco gross profit on transfers ($90,000 – $54,000) $36,000 Inventory retained at end of 2009 20% Unrealized gross profit—12/31/09 $7,200

2010 Unrealized Gross profit Deferred

Total interco gross profit on transfers ($120,000 – $66,000) $54,000 Inventory retained at end of 2010 30% Unrealized gross profit—12/31/10 $16,200

18 a (continued)

Noncontrolling Interest's Share of Kane's Income

Kane's reported income 2010 $110,000 Amortization of excess fair value to intangibles (5,000)

2009 gross profit realized in 2010 (upstream sales) 7,200

2010 gross profit deferred (upstream sales) (16,200) Kane's realized income $96,000 Noncontrolling interest ownership 20%

b Inventory—Smith book value $140,000 Inventory—Kane book value 90,000 Unrealized gross profit, 12/31/10 (see part a) (16,200)

(Direction of transfer has no impact here)

c Downstream transfers do not affect the noncontrolling interest

Kane's reported income—2010 $110,000 Noncontrolling interest ownership 20%

d Smith's reported income 2010 $300,000 Elimination of intercompany dividend income recorded

by parent ($40,000 × 80%) (32,000) Kane's reported income 2010 110,000 Amortization expense (given) (5,000) Realization of 2009 intercompany gross profit (see part a) 7,200 Deferral of 2010 intercompany gross profit (see part a) (16,200)

e Because the parent applies the partial equity method, its retained earnings balance does not reflect the consolidated balance Excess amortization and the effect of the unrealized gain at that date must be taken into account to arrive at a consolidated total

Smith's retained earnings, December 31, 2010 (given) $600,000 Excess amortizations 2009–2010 ($5,000× 2) (10,000) Deferral of parent's 12/31/10 interco gross profit (part a) (16,200)

18 (continued)

f Because the parent applies the partial equity method, its retained earnings balance does not equal the consolidated balance Excess amortizations must be taken into account to arrive at a consolidated total In addition, because the intercompany transfer was upstream, the parent's equity

accrual did not reflect the intercompany profit deferral Income recognition would have been based on the subsidiary's reported figures rather than its realized income The parent would have included the $16,200 ending

unrealized gross profit in the subsidiary's income in computing the annual equity accrual Hence, that portion of the accrual (80% of $16,200 or $12,960)

is overstated, causing the parent's retained earnings to be too high by that amount; reduction is necessary to arrive at the consolidated balance

The adjustment caused by the intercompany transfer can be computed in a second manner The entire $16,200 unrealized gross profit will be deferred

on the consolidated statements However, because the transfer was

upstream, the portion of the subsidiary's income assigned to the outside owners will be reduced by 20 percent of that deferral or $3,240 The net effect on consolidated net income (and, hence, on the ending retained

earnings balance) is $12,960

Smith's retained earnings, December 31, 2010 (given) $600,000 Excess Amortizations, 2009–2010 ($5,000 × 2) (10,000) Reduction of equity accrual because of subsidiary's unrealized

gross profit (explained above) (12,960) CONSOLIDATED RETAINED EARNINGS, 12/31/10 $577,040

g Land—Smith’s book value $600,000 Land—Kane's book value 200,000 Elimination of unrealized gain on intercompany land (20,000) CONSOLIDATED LAND ACCOUNT $780,000

18 (continued)

h The intercompany transfer was upstream from Kane to Smith Because the transfer occurred in 2009, beginning retained earnings of the seller for 2010 contains the remaining portion of the unrealized gain

Transfer Pricing Figures

Depreciation expense = $16,000 ($80,000/5) Income effect = $4,000 ($20,000 – $16,000) Accumulated depreciation = $16,000

2010 Depreciation expense = $16,000

Accumulated depreciation = $32,000 Historical Cost Figures

To change beginning of year figures to historical cost by removing impact of

2009 transactions Retained earnings reduction removes $4,000 income effect (above) and replaces it with $12,000 depreciation expense for 2009

Transfer price depreciation: $80,000/5 yrs = $16,000

Historical cost depreciation (based on book value): $60,000/5 yrs = $12,000

18 (continued)

Noncontrolling Interest in Kane's Income

Kane's reported income less excess amortization $105,000 Reduction of depreciation expense to historical cost figure 4,000 Kane's realized income $109,000 Outside ownership percentage 20% Noncontrolling interest in Kane’s income $21,800

19 (20 Minutes) (Consolidation entries and noncontrolling interest balances

affected by inventory transfers.)

a Conversion from Markup on Cost to Gross Profit Rate

Markup (given as a percentage of cost) 25% Convert to gross profit rate [.25  (1.00 + 0.25)] 20%

Noncontrolling Interest's Share of Subsidiary’s Income

Reported income of subsidiary—2010 $160,000

2009 intercompany gross profit realized in 2010

($250,000 × 30% × 20% ) 15,000

2010 intercompany gross profit deferred

($300,000 × 30% × 20% ) (18,000) Realized income of subsidiary—2010 $157,000 Outside ownership 40% Noncontrolling interest's share of subsidiary's income $62,800

To eliminate intercompany inventory sale and purchase

20 (30 Minutes) (Compute selected balances based on three different

intercompany asset transfer scenarios)

a Consolidated Cost of Goods Sold

Penguin’s cost of goods sold $290,000 Snow’s cost of goods sold 197,000 Elimination of 2010 intercompany transfers (110,000) Reduction of beginning Inventory because of

2009 unrealized gross profit ($28,000/1.4 = $20,000 cost; $28,000 transfer price less $20,000

cost = $8,000 unrealized gross profit) (8,000) Reduction of ending inventory because of

2010 unrealized gross profit ($42,000/1.4 = $30,000 cost; $42,000 transfer price less $30,000

cost = $12,000 unrealized gross profit) 12,000 Consolidated cost of goods sold $381,000

Noncontrolling Interest in Subsidiary’s Net Income

Because all intercompany sales were downstream, the deferrals do not affect Snow Thus, the noncontrolling interest is 20% of the $58,000

(revenues minus cost of goods sold and expenses) reported income or

$11,600

b Consolidated Cost of Goods Sold

Penguin book value $290,000 Snow book value 197,000 Elimination of 2010 intercompany transfers (80,000) Reduction of beginning inventory because of

2009 unrealized gross profit ($21,000/1.4 = $15,000 cost; $21,000 transfer price less $15,000

cost = $6,000 unrealized gross profit) (6,000) Reduction of ending inventory because of

2010 unrealized gross profit ($35,000/1.4 = $25,000 cost; $35,000 transfer price less $25,000

cost = $10,000 unrealized gross profit) 10,000 Consolidated cost of goods sold $411,000

Noncontrolling Interest in Subsidiary's Net income

Since all intercompany sales are upstream, the effect on Snow's income must be reflected in the noncontrolling interest computation:

Snow reported income $58,000

2009 unrealized gross profit realized in 2010 (above) 6,000

2010 unrealized gross profit to be realized in 2011 (above) (10,000) Snow realized income $54,000 Outside ownership percentage 20% Noncontrolling interest in Snow's income $10,800

c Consolidated Buildings (Net)

Penguin’s buildings $358,000 Snow's buildings 157,000 Remove write-up created by transfer

($80,000 – $50,000) $(30,000) Remove excess depreciation created by transfer

($30,000 unrealized gain over 5 year life) (2 years) 12,000 (18,000) Consolidated buildings (net) $497,000

Consolidated Expenses

Penguin’s book value $150,000 Snow's book value 105,000 Remove excess depreciation on transferred building

($30,000) unrealized gain/5 years) (6,000) Consolidated expenses $249,000

Noncontrolling Interest in Subsidiary’s Net Income

Because the transfer was made downstream, it has no effect on the

noncontrolling interest Thus, Snow's reported income ($58,000 computed

as revenues minus cost of goods sold and expenses) is used for this computation The 20 percent outside ownership will be allotted income of

$11,600 (20% × $58,000)

21 (15 Minutes) (Prepare consolidated income statement with a wholly-owned

subsidiary, includes transfers)

a In this business combination, the direction of the intercompany transfers (either upstream or downstream) is not important to the consolidated totals Because Akron controls all of Toledo's outstanding stock, no

noncontrolling interest figures are computed If present, noncontrolling interest balances are affected by upstream sales but not by downstream For purposes of a 2010 consolidation, the following worksheet entries

would affect income statement balances:

To recognize excess amortization expense for the current period

Entry Tl

Sales 320,000 Cost of Goods Sold 320,000

To eliminate intercompany transfers of inventory during 2010

b By including the impact of each of these four consolidation entries, the following income statement can be created from the individual account balances:

AKRON, INC AND CONSOLIDATED SUBSIDIARY

Income Statement Year Ending December 31, 2010 Sales $1,380,000 Cost of goods sold 575,000 Gross profit 805,000 Operating expenses 635,000 Consolidated net income $170,000

22 (60 minutes) (Downstream intercompany asset transfer when parent uses

equity method and when a noncontrolling interest is present)

a Investment account:

Consideration paid (fair value) 1/1/09 $810,000 Netspeed’s reported income for 2009 $80,000

Netspeed’s adjusted net income $68,000

Quickport's ownership percentage 90%

Quickport's share of Netspeed’s income $61,200

Gain on equipment transfer deferral (3,000)

Depreciation adjustment (6 months) 500

Equity in earnings of Netspeed Company, $58,700 Quickport’s share of Netspeed’s dividends (90%) (7,200)

Netspeed’s reported income for 2010 $115,000

Netspeed’s adjusted 2010 net income $103,000

Quickport's share of Netspeed income $92,700

*ED Equity in earnings of S 1,000

To transfer the current realized portion of the intercompany equipment gain from the Equity in Earnings of S account to increase current consolidated income through a reduction in depreciation expense

23 (20 Minutes) (Consolidation entries for intercompany equipment transfer.)

INDIVIDUAL RECORDS BASED ON TRANSFER PRICE

 Accumulated depreciation = $57,000 (3 years)

CONSOLIDATED REPORTING BASED ON HISTORICAL COST

To adjust beginning-of-year amounts to balances for consolidated entity Retained earnings adjustment reduces $7,000 credit balance to

$20,000 debit balance as computed above

Entry ED Accumulated Depreciation 9,000 Depreciation Expense 9,000

To remove excess depreciation for current year to reflect an allocation of the historical cost ($10,000) rather than the transfer price ($19,000)

24 (20 Minutes) (Determine consolidated net income when an intercompany

transfer of equipment occurs Includes an outside ownership)

a Income—Slaughter $220,000 Income—Bennett 90,000 Excess amortization for unpatented technology (8,000) Remove unrealized gain on equipment (50,000) ($120,000 – $70,000)

Remove excess depreciation created by

inflated transfer price ($50,000 ÷ 5) 10,000 Consolidated net income $262,000

b Income calculated in (part a.) $262,000 Noncontrolling interest in Bennett's income

Income—Bennett $90,000 Excess amortization (8,000) Adjusted net income $82,000 Noncontrolling interest in Bennett’s income (10%) (8,200) Consolidated net income to parent company $253,800

c Income calculated in (part a.) $262,000 Noncontrolling interest in Bennett's income (see Schedule 1) (4,200) Consolidated net income to parent company $257,800

Schedule 1: Noncontrolling Interest in Bennett's Income (includes upstream transfer)

Reported net income of subsidiary $90,000 Excess amortization (8,000) Eliminate unrealized gain on equipment transfer (50,000) Eliminate excess depreciation ($50,000 ÷ 5) 10,000 Bennett's realized net income $42,000 Outside ownership 10% Noncontrolling interest in subsidiary's income $ 4,200

d Net income 2010—Slaughter $240,000 Net income 2010—Bennett 100,000 Excess amortization (8,000) Eliminate excess depreciation stemming from transfer

($50,000 ÷ 5) (year after transfer) 10,000 Consolidated net income $342,000

25 (35 minutes) (Compute consolidated totals with transfers of both inventory and

a building.)

Excess Amortization Expenses

Equipment $60,000 ÷ 10 years = $6,000 per year

Franchises $80,000 ÷ 20 years = $4,000 per year

Annual excess amortizations $10,000

Unrealized Gross profit—Inventory, 1/1/11

Markup ($70,000 – $49,000) $21,000 Markup percentage ($21,000 ÷ $70,000) 30%

Remaining inventory $30,000 Markup percentage 30% Unrealized gross profit, 1/1/11 $9,000

Unrealized Gross profit—Inventory, 12/31/11

Markup ($100,000 – $50,000) $50,000 Markup percentage ($50,000 ÷ $100,000) 50%

Remaining inventory $40,000 Markup percentage 50% Unrealized gross profit, 12/31/11 $20,000

Impact of intercompany Building Transfer

12/31/10—Transfer price figures

Transfer price $50,000 Gain on transfer ($50,000 – $30,000) 20,000 Depreciation expense ($50,000 ÷ 5) 10,000 Accumulated depreciation 10,000 12/31/11—Transfer price figures

Depreciation expense 10,000 Accumulated depreciation 20,000 12/31/10—Historical cost figures

Historical cost $70,000 Depreciation expense ($30,000 book value ÷ 5 years) 6,000 Accumulated depreciation ($40,000 + $6,000) 46,000 12/31/11—Historical cost figures

Depreciation expense 6,000 Accumulated depreciation 52,000

25 (continued)

CONSOLIDATED BALANCES

 Sales = $1,000,000 (add the two book values and subtract $100,000 in

intercom-pany transfers)

 Cost of Goods Sold = $571,000 (add the two book values and subtract $100,000 in

intercompany purchases Subtract $9,000 because of the previous year unrealized gross profit and add $20,000 to defer the current year unrealized gross profit.)

 Operating Expenses = $206,000 (add the two book values and include the $10,000

excess amortization expenses but remove the $4,000 in excess depreciation

expense [$10,000 – $6,000] created by building transfer)

 Investment Income = $0 (the intercompany balance is removed so that the

individual revenue and expense accounts of the subsidiary can be shown)

 Inventory = $280,000 (add the two book values and subtract the $20,000 ending

unrealized gross profit)

 Equipment (net) = $292,000 (add the two book values and include the $60,000

allocation from the acquisition-date fair value less three years of excess

amortizations)

 Buildings (net) = $528,000 (add the two book values and subtract the $20,000

unrealized gain on the transfer after two years of excess depreciation [$4,000 per year])

26 (35 Minutes) (Prepare consolidation entries for a business combination with

intercompany inventory and equipment transfers; includes an outside

Entry *TA

Equipment 4,000 Investment in Sledge 2,400 Accumulated Depreciation 6,400

To adjust the equipment balance to original cost ($16,000) and to adjust accumulated depreciation to the correct consolidated January 1, 2011 balance ($7,000 less $600 extra depreciation in 2010) The net reduction

to the reported equipment balance (cost less A.D = $2,400) equals the amount of unrealized gain at January 1, 2011 The $2,400 debit to the Investment account appropriately transfers the reduction in the net book value of the transferred equipment to the subsidiary’s accounts The Investment account was reduced by $3,000 in 2010 for the original intercompany gain and increased by $600 in 2010 for the extra depreciation ($3,000 gain/5 years) through application of the equity method Entry ED (below) completes the adjustment of A.D and depreciation expense to their correct December 31, 2011 balances

Entry S

Common Stock (Sledge) 120,000 Retained Earnings, 1/1/11 (adjusted) (Sledge) 258,000 Investment in Sledge (80%) 302,400 Noncontrolling interest in Sledge, 1/1/11 (20%) 75,600

To eliminate subsidiary's stockholders' equity accounts (after adjustment for Entry *G) and recognize noncontrolling interest balance as of January

1, 2011

Entry A

Contracts ($60,000 – $3,000 for 2 years) 54,000 Buildings ($20,000 – $2,000 for 2 years) 16,000 Investment in Sledge (80%) 56,000 Noncontrolling interest in Sledge, 1/1/11 (20%) 14,000

To recognize acquisition-date fair value allocations adjusted for 2 years

of amortization (2009 and 2010)

Entry E

Depreciation Expense 2,000 Amortization Expense 3,000 Contracts ($60,000 ÷ 20 years) 3,000 Buildings ($20,000 ÷ 10 years) 2,000

To record excess amortizations for 2011 based on allocations and useful lives

Entry TI

Sales 20,000 Cost of Goods Sold 20,000

To eliminate intercompany inventory transfers during 2011

Entry ED

Accumulated Depreciation 600 Depreciation Expense 600

To eliminate excess depreciation on equipment recorded at transfer price Expense is being reduced from the recorded amount ($2,400 or

$12,000 ÷ 5) to historical cost figure ($1,800 or $9,000 ÷ 5)

26 (continued)

b Noncontrolling Interest in the Subsidiary's Income 2011

Revenues $130,000 Cost of goods sold (70,000) Other expenses (40,000) Excess acquisition-date fair value amortization (5,000) Income adjusted for amortization $15,000 Gross profit on 2010 upstream inventory transfer

realized in 2011 (Entry *G) 2,000 Gross profit on 2011 upstream inventory transfer

deferred until 2012 (Entry G) (4,500) Realized income of subsidiary—2011 $12,500 Outside ownership 20% Noncontrolling interest in subsidiary's net income $2,500

27 (65 Minutes) (Determine consolidation totals after answering a series of

questions about combination and intercompany inventory transfers)

a Consideration transferred $342,000

Noncontrolling interest fair value 38,000

Subsidiary fair value at acquisition-date 380,000

Book value (326,000)

Fair value in excess of book value $54,000 Annual Excess

Excess fair value assignments Life Amortizations

To building 18,000 9 yrs $2,000

To patented technology 36,000 6 yrs 6,000 Totals -0- $8,000

b Because Brey sold inventory to Petino, the transfers are upstream

c Gross profit on 2010 transfers ($135,000 – $81,000) $54,000 Gross profit percentage ($54,000 ÷ $135,000) 40%

Inventory remaining, 12/31/10 $37,500 Gross profit percentage 40% Unrealized gross profit, January 1, 2011 $15,000

d Gross profit on 2011 transfers ($160,000 – $92,800) $67,200 Gross profit percentage ($67,200 ÷ $160,000) 42%

Inventory remaining, 12/31/11 $50,000 Gross profit percentage 42%