Chapter 6

Intercompany
Inventory
Transactions
McGraw-Hill/Irwin

Copyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objective 6-1

Understand and explain

intercompany transfers
and why they must be
eliminated.

6-2

Road Map: Intercompany

Transactions
Typical intercompany transactions

Intercompany reciprocal accounts

(Chapter 4)

Inventory transfers (Chapter 6)

Fixed asset transfers (Chapter 7)

Intercompany Indebtedness (Chapter 8)

6-3

Arms-Length Transactions
Q: What are Arms-length
Transactions?
A:

Transactions that take place

between completely
independent parties.

6-4

Categories of Transactions
Arms Length Transactions
The

only transactions that can be

reported in the consolidated statements.

We

want to report the results of our

interactions with outside parties!

Non-Arms Length Transactions

Usually

referred to as related party

transactions.

Include

all intercompany transactions.

6-5

Types of Related Party

Transactions
Involving only Individuals
Transactions

among family members

Involving Corporations
With

management and other employees

With

directors and stockholders

With

affiliates (controlled entities)

Probably constitutes at least 99% of all

corporate related-party transactions
6-6

Necessity of Eliminating
Intercompany Transactions
Eliminate all intercompany
transactions in consolidation:
Because

they are internal transactions

from a consolidated perspective.

Not

because they are related-party

transactions.

Only

transactions with outside unrelated

parties can be reported in the
consolidated statements.
6-7

Intercompany Transactions:
Additional Opportunities for Fraud

Intercompany transactions
sometimes
occur to
conceal

embezzlements.

overstate

reported profits.

+ 2

5
6-8

Example 1: Intercompany Loan

A 12-year old girl lends $5 to her 17year old brother.
From the standpoint of individuals, this
represents a receivable and a payable.
If the family prepares a consolidated
balance sheet, what is the effect?

No net change to the familys wealth.

Not a transaction with a non-family

person.
6-9

Example 2:
Sale from Parent to Sub to
Outsider
Parent has 19 subsidiaries.
Parent has received a $1 order from an
outsider.
Parent sells inventory to Sub 1 for $1.

Sub 1 sells the inventory to Sub 2 for $1.

Sub 2 sells the inventory to Sub 3 for $1.
The inventory is sold from one sub to another
until Sub 19 sells it to the outsider for $1.

The parent and each sub reports sales

of $1.
From a consolidated standpoint, what
6-10

Example 3: Sale from Parent to

Sub, But Not Yet to an Outsider
Sleazy Parent Company has one sub.
Sleazy Parent is preparing for an IPO.
Sleazy Parent owns lots of obsolete
inventory which it cannot sell.
Sleazy Parent sells the obsolete inventory
(costing $1,000) to its sub for $100,000.
Sleazy Sub now holds the inventory.
Without any adjustment, what items in
Sleazys consolidated financial statements
will be misstated?
6-11

Correcting Entries
Conceptually, how would you correct each of these
three problems?
Easy! To eliminate intercompany loans:
Loan Payable
Just
Loan Receivable
reverse
More
difficult

xxx
xxx

To eliminate sale from Parent to Sub to Outsider:

Sales
xxx
Cost of Goods Sold
xxx

To eliminate sale from Parent to Sub, not yet to Outsider

xxx
xxx
Unrealized GP

Easy!Sales
Just
Cost of Goods Sold
reverse Inventory

6-12

Lets work through an example:

Assume Parent Co. owns 100% of Sub Co.
The following intercompany transactions occurred
during the year:

Parent loaned $500 to Sub. To keep things simple,

assume that there is no interest revenue or interest
expense associated with this loan.

Parent made a sale to Sub for $400 cash. The inventory

had originally cost Parent $250. Sub then sold that same
inventory to an outsider for $500.

Parent made a sale to Sub for $300 cash. The inventory

had originally cost Parent $200. Sub has not yet sold that
same inventory to an outsider.

What consolidation worksheet entries would you

make?
6-13

(a) Loan from Parent to Sub

Does this transaction include
el!
c
n
a
C
outsiders?
Parent:
Receivable 500
Cash
500
Parent $500
Sub

Reverse the entries

made by the parent and
the sub.

Sub:
Cash
500
Payable

To eliminate intercompany loans:

Loan Payable
Loan Receivable

500

500
500
6-14

(b) Sale from Parent to Sub to

Outsider

Arms Keep Parents COGS Keep Subs Sale

Length
Are these legitimate transactions?
$250 Parent $400

Keep
This
Purchase

Sub $500

Eliminate effect
of this internal
Transaction

Keep
This
Sale

Get rid of Parents Sale

Get rid of Subs COGS
Internal (fake)

6-15

(b) Sale from Parent to Sub to

Outsider
Which transactions are
legitimate?
Parents sale to Sub:

Subs sale to Outsider:

!
Parent:
Sub:
Cancel
Cash 400
Cash
500
Sales
400
Sales
500
COGS 250
COGS
400
Inventory
250
Inventory
400
l!
Sub:
Cance
Inventory
400
Reverse the rest!
Cash
400
To eliminate sale from Parent to Sub to Outsider:
Sales (parent to sub)
400
Cost of Goods Sold (to outsider)
400
6-16

(c) Sale From Parent to Sub (Not

Outside)
Is this a legitimate arms length
transaction?

$200 Parent $300

Keep
this
purchase

Sub

Eliminate effect
of this internal
transaction

Parent:
Cash
300
Sales
300
COGS 200
Inventory
200
Sub:
Inventory300
Cash
300

Summary of the Transaction:

Parent purchased inventory for $200.
Parent sold the inventory to a Sub for $300.
Reverse the entries made by the parent and sub.

6-17

(c) Sale From Parent to Sub (Not

Outside)
Reverse the entries made by the parent
and sub.
ce l !
n
a
C
Parent:
Cash
300
Sales
300
Parent $300 Sub
COGS
200
Inventory
200
Sub:
Inventory 300
Cash
300
To eliminate sale from Parent to Sub, not yet to Outsider:
Sales
300
Cost of Goods Sold
200
Inventory
100
(net)
6-18

Summary of Consolidation
Entries:
To eliminate intercompany loans:
Loan Payable
Loan Receivable

500
500

To eliminate sale from Parent to Sub to Outsider:

Sales
400
Cost of Goods Sold
400
To eliminate sale from Parent to Sub, not yet to Outsider:
Sales
300
Cost of Goods Sold
200
Inventory
100

6-19

Fully-adjusted Equity Method

Adjustment
Parent companies have to adjust their equity
method investment accounts for certain
transactions.
At this point, lets just consider one:

Sale from parent to sub, but not yet sold to an

outsider.

It represents fake profit that hasnt really been

realized in an arms-length transaction.

Both the balance sheet and income

statement accounts need to be adjusted.
This is a REAL journal entry, not a
consolidation worksheet entry!

6-20

Equity Method Adjustment

Example
$500 Parent $600
Summary of the Transaction:
Parent purchased inventory for
$500.
Parent sold the inventory to a Sub
Equity
for
$600.Method Entry:
Income from Sub
Investment in Sub
100

Sales $ 600
COGS 500
GP
$ 100

Sub

100

The Parent recognized $100 of fake gross profit!

The Parent should have transferred the inventory at
cost.
This profit is not from a transaction with an arms-length

6-21

Group Practice
Assume Parent Co. owns 100% of Sub Co.
The following intercompany transactions occurred
during the year:

Parent loaned $100 to Sub. To keep things simple, assume

that there is no interest revenue or interest expense
associated with this loan.

Parent made a sale to Sub for $200 cash. The inventory

had originally cost Parent $120. Sub then sold that same
inventory to an outsider for $300.

Parent made a sale to Sub for $300 cash. The inventory

had originally cost Parent $180. Sub has not yet sold that
same inventory to an outsider. (Dont forget equity method
entry!)

Based on our conceptual discussion, what

consolidation worksheet entries would you make?

6-22

Consolidation Entries
To eliminate intercompany loans:
Loan Payable
Loan Receivable

100
100

To eliminate sale from Parent to Sub to Outsider:

Sales
200
Cost of Goods Sold
200
To eliminate sale from Parent to Sub, not yet to Outsider:
Sales
300
Cost of Goods Sold
180
Inventory
120

To correct inventory
Equityvalue
Method Entry:
Income from Sub
Investment in Sub

120
120
6-23

Practice Quiz Question #1

Why must intercompany
transactions be eliminated?
a. They portray the consolidated
companys results too
conservatively.
b. They understate the results of
the consolidated group.
c. They are arms-length
transactions.
d. They are not arms-length
transactions.
6-24

Practice Quiz Question #1

Solution
Why must intercompany
transactions be eliminated?
a. They portray the consolidated
companys results too
conservatively.
b. They understate the results of
the consolidated group.
c. They are arms-length
transactions.
d. They are not arms-length
transactions.
6-25

Learning Objective 6-2

Understand and explain

concepts associated
with inventory transfers
and transfer pricing.

6-26

Issue #1: Eliminate Intercompany

Transfers?
Whether to Eliminate Intercompany
Transactions in Consolidation:
No

controversythey must be
eliminated.

Not

eliminating them would cause two

problems:

Meaningless double-counting of
1. sales, and
2. expenses

Potential to manipulate income.

6-27

The Substance of Inventory

Transfers
The CONSOLIDATED Perspective:
Merely

the physical movement of

inventory from one location to another
location.

Similar

to the movement of inventory

from one division to another division.

Not

a bona fide transaction.

6-28

Issue #2: Which Measure of Profit

To Use?
Possible theoretical profit
measures:

Gross profit

Operating profit

Net income

Profit measure required under

GAAP:

Sales
$1,000
GrossCost
profit
(of the selling entity):
of sales
600
Gross profit
$ 400

6-29

Issue #3: Eliminate Income Tax

Effects?
Income taxes play a major role in
intercompany sales and transfer
pricing decisions.
Income taxes on the selling entitys
unrealized gross profit must also be
eliminated.
In this chapter:

No income tax entries are required.

Because we assume that the tax effects

have already been recorded in the
parents or the subsidiarys general

6-30

Issue #4: Whether To Eliminate

All or Some?
Downstream sales to a
partially-owned
subsidiary:

Eliminate 100% of
unrealized profit.

Fractional elimination is
prohibited.

Upstream sales from a

partially-owned
subsidiary:

Eliminate 100% of
unrealized profit.

Fractional elimination is

6-31

Issue #4: Whether To Eliminate

All or Some?
Downstream sales to a
partially-owned subsidiary:

Entire profit accrues to the

parent; thus, sharing is not
appropriate.

NCI

Upstream sales from a

partially-owned subsidiary:

Must share deferral with the NCI

shareholders (if amount is
material).

Because S profits are shared with

the NCI shareholders.

P
S
6-32

Inventory Transfers: What is

Realization?
Realization for consolidated
reporting purposes:
Does

not focus on whether the seller

has
delivered

the product,

collected

on the sale, or

reduced

to an acceptable level the

uncertainty about the net cash flow
effect of an earnings activity.

6-33

Inventory Transfers: What is

Realization?
Realization for consolidated reporting
purposes:

Depends on whether the BUYER has

resold the inventory to an outside
unaffiliated customer.
Parent

Sub

6-34

Review: Two Types of Transfers

Parent-to-sub-to-outsider

$750 Parent$1,000

Sub For $1,200

Parent-to-sub-not-yet-tooutsider

$300 Parent $400

Sub

Assume
both
transaction
s took
place
during the
same year.

6-35

Understanding Inventory
Transfers: Map it out
Ending Inventory = $400
Resold = $1,000
$1,400
Split

$1,050 Parent$1,400

Sub Unknown
What happened to
it?

Total Interco
Sales
Sales
COGS
Gross Profit
Gross Profit
%

Resold

On
hand

1,400

1,000

400

1,050

750

300

350

250

100

25%
Splits
out parents
numbers.

6-36

Calculating Unrealized Gross

Profit
Amounts that will always be known (given):
Total

Sales (NEW basis) 1,000

600
Cost of sales (OLD
basis)
Gross Profit
400
Profit % 40%
CRITICALGross
ASSUMPTION:

Resold

On
hand

200

The gross profit percentage derivable from the

total column applies to both (1) the inventory that
has been resold AND (2) the inventory that is still
on hand.
6-37

Calculating Unrealized Gross

Profit
Completed Analysis:
Total

Resold

On
hand

Sales (NEW basis) 1,000

800
200
600
480
120
Cost of sales (OLD
basis)
Gross Profit
400
320
80
Realized Unrealized
Gross Profit % 40%
The Inventory/COGS Change in Basis
Elimination Entry is derived from this analysis.
Unrealized profit = Inventory on hand x GP%
= $200 x 40% = $80
6-38

Inventory Transfers: Terminology

What happened
to it?

Transfer Price
Cost
Markup

Total
Interco
Sales
Sales
COGS

On
hand

1,400

1,000

400

1,050

750

300

350

250

100

Gross Profit

Markup on Gross Profit

Transfer Price
%

Resold

25%

Watch out for terminology like

mark-up based on cost!
6-39

Practice Quiz Question #2

For 20X8, Pete reported
intercompany cost of sales of
$800,000 (markup is 20% of
transfer price) to Sampras, which
reported $300,000 of
intercompany acquired inventory
at 12/31/X8. The unrealized profit
at 12/31/X8 is
a. $40,000.
b. $48,000.
c. $60,000.
d. $75,000.
e. None of the above.

6-40

Practice Quiz Question #2

Solution
Ending Inventory = $300,000
$???
Split
$800,000

Parent

Sub

What happened
to it?
Total Interco
Sales
Sales
COGS
Gross Profit

Resold

On
hand
300,00
0

800,000
?

6-41

Practice Quiz Question #2

Solution
Ending Inventory = $300,000
$???
Split
$800,000

Parent

Sub

What happened
to it?
Total Interco
Sales
Sales
COGS
Gross Profit

Resold

On
hand
300,00
0

800,000
60,0006-42

Practice Quiz Question #2

Solution
Ending Inventory = $300,000
$???
Split
$800,000

Parent

Sub

What happened
to it?
Total Interco
Sales
Sales
COGS
Gross Profit

S
800,000
.2 S

Resold

On
hand
300,00
0
60,0006-43

Practice Quiz Question #2

Solution
Ending Inventory = $300,000
$???
Split
$800,000

Parent

Sub

S 800,000 = .2 S
.8 S = 800,000
S = 800,000 / .8 = 1,000,000
6-44

Practice Quiz Question #2

Solution
Ending Inventory = $300,000
$???
Split
$800,000

Parent

Sub

What happened
to it?
Total Interco
Sales
Sales

1,000,000

COGS
Gross Profit

800,000
200,000

Resold

On
hand
300,00
0
60,0006-45

Practice Quiz Question #2

Solution

Ending Inventory = $300,000

Resold = $700,000
$1,000,000
Split
$800,000

Sales
COGS

Parent1,000,000 Sub

Unknown

What happened
to it?
Total Interco
Resold
On
Sales
hand
1,000,000 700,000 300,00
0
800,000 560,000 240,00
06-46

Practice Quiz Question #2

Solution
For 20X8, Pete reported
intercompany cost of sales of
$800,000 (markup is 20% of
transfer price) to Sampras, which
reported $300,000 of
intercompany acquired inventory
at 12/31/X8. The unrealized profit
at 12/31/X8 is
a. $40,000.
b. $48,000.
c. $60,000 ($300,000 EI x 0.20 GP
%).
d. $75,000.

6-47

Practice Quiz Question #3

For 20X8, Post reported $90,000
of intercompany sales (25%
markup on cost and fully paid for
by year end) to Script, which
reported $30,000 of intercompany
acquired inventory at 12/31/X8.
The unrealized profit at 12/31/X8
is
a. $0.
b. $6,000.
c. $7,500.
d. $30,000.
e. None of the above.

6-48

Practice Quiz Question #3

Solution
Ending Inventory = $30,000
$90,000
Split
?

Parent

90,000

Sub

What happened
to it?
Total Interco
Sales
Sales
COGS
Gross Profit

90,000
C
0.25 C

Resold

On
hand
30,000
?
6-49

Practice Quiz Question #3

Solution
Ending Inventory = $30,000
$90,000
Split
?

Parent

90,000

Sub

90,000 C = 0.25 C
1.25 C = 90,000
C = 90,000 / 1.25 = 72,000
6-50

Practice Quiz Question #3

Solution
Ending Inventory = $30,000
$90,000
Split
72,000

Parent

90,000

Sub

What happened
to it?
Total Interco
Sales
Sales
COGS
Gross Profit

90,000
72,000
18,000

Resold

On
hand
30,000
?
6-51

Practice Quiz Question #3

Solution
Ending Inventory = $30,000
$90,000
Split
72,000

Parent

90,000

Sub

What happened
to it?
Total Interco
Sales
Sales
COGS
Gross Profit

90,000
72,000
18,000

Resold

On
hand
30,000
6,000
6-52

Practice Quiz Question #3

Solution

Ending Inventory = $30,000

Resold = $60,000
$90,000
Split
72,000

Sales
COGS
Gross Profit

Parent

90,000

Total Interco
Sales
90,000
72,000
18,000

Sub

Unknown

What happened
to it?
Resold
On
hand
60,000 30,000
48,000 24,000
12,000

6,000
6-53

Practice Quiz Question #3

Solution
For 20X8, Post reported $90,000
of intercompany sales (25%
markup on cost and fully paid for
by year end) to Script, which
reported $30,000 of intercompany
acquired inventory at 12/31/X8.
The unrealized profit at 12/31/X8
is
a. $0.
b. $6,000 ($30,000 EI x 0.20 GP%).
c. $7,500.
d. $30,000.
e. None of the above.

6-54

Practice Quiz Question #4

For 20X8, Sempre (80% owned by
Para) reported $1,600,000 of
intercompany sales (1/3 markup
on cost) to Para, which resold
$1,400,000 of this inventory by
12/31/X8. The unrealized profit at
12/31/X8 is
a. $40,000.
b. $50,000.
c. $53,333.
d. $66,667.
e. None of the above.
6-55

Practice Quiz Question #4

Solution

Ending Inventory = 200,000

Resold = $1,400,000

$1,600,000
Split
?

Sales

Parent1,600,000 Sub

Total Interco
Sales
1,600,000

unknown

What happened
to it?
Resold
On
hand
1,400,0
00

COGS
Gross Profit

6-56

Practice Quiz Question #4

Solution

Ending Inventory = 200,000

Resold = $1,400,000

$1,600,000
Split
?

Sales
COGS
Gross Profit

Parent1,600,000 Sub

Total Interco
Sales
1,600,000

unknown

What happened
to it?
Resold
On
hand
1,400,0
00

C
1/3 C

6-57

Practice Quiz Question #4

Solution

Ending Inventory = 200,000

Resold = $1,400,000

$1,600,000
Split
?

Parent1,600,000 Sub

unknown

1,600,000 C = 1/3 C
4/3 C = 1,600,000
C = 1,600,000 / (4/3) = 1,200,000
6-58

Practice Quiz Question #4

Solution

Ending Inventory = 200,000

Resold = $1,400,000

$1,600,000
Split
1,200,000 Parent1,600,000

Sales
COGS
Gross Profit

Total Interco
Sales
1,600,000

Sub

unknown

What happened
to it?
Resold
On
hand
1,400,0
00

1,200,000
400,000

6-59

Practice Quiz Question #4

Solution

Ending Inventory = 200,000

Resold = $1,400,000

$1,600,000
Split
1,200,000 Parent1,600,000

Sales
COGS
Gross Profit

Total Interco
Sales
1,600,000

Sub

unknown

What happened
to it?
Resold
On
hand
1,400,0 200,00
00
0

1,200,000
400,000

6-60

Practice Quiz Question #4

Solution

Ending Inventory = 200,000

Resold = $1,400,000

$1,600,000
Split
1,200,000 Parent1,600,000

Sales
COGS
Gross Profit

Total Interco
Sales
1,600,000

Sub

unknown

What happened
to it?
Resold
On
hand
1,400,0 200,00
00
0

1,200,000
400,000

50,0006-61

Practice Quiz Question #4

Solution

Ending Inventory = 200,000

Resold = $1,400,000

$1,600,000
Split
1,200,000 Parent1,600,000

Sales
COGS

Total Interco
Sales
1,600,000
1,200,000

Sub

unknown

What happened
to it?
Resold
On
hand
1,400,0 200,00
00
0
1,050,0 150,00
00
06-62

Practice Quiz Question #4

Solution
For 20X8, Sempre (80% owned by
Para) reported $1,600,000 of
intercompany sales (1/3 markup
on cost) to Para, which resold
$1,400,000 of this inventory by
12/31/X8. The unrealized profit at
12/31/X8 is
a. $40,000.
b. $50,000 ($200,000 EI x 0.25 GP
%).
c. $53,333.
d. $66,667.
e. None of the above.

6-63

Learning Objective 6-3

Prepare equity-method
journal entries and
elimination entries for the
consolidation
of a subsidiary following
downstream inventory
transfers.

6-64

Agreement between Parent

Company and Consolidated
Financial Statements

Under the fully adjusted equity

method,

the parent companys financial statements

should report the same net income and
retained earnings amounts as appear in
the consolidated statements.

Therefore, we

record and equity method adjustment on

the parents books to defer unrealized
gross profit, and

prepare consolidation worksheet

elimination entries to avoid double
6-65

Big PictureElimination entry:

Sale From Parent to Sub to
Outsider
To eliminate sale from Parent to Sub to Outsider:
Sales (Parent)
400
Cost of Goods Sold (Sub)
400

Get rid of the non-arms-length

transaction!

$250

Parent

$400

Sub

$500
6-66

Big PictureElimination entry:

Sale From Parent to Sub (not yet
sold outside)
Reverse the entire
To eliminate sale from Parent
to Sub, not yet to Outsider:
transaction!
Sales
400
Cost of Goods Sold
250
Inventory
150
Equity Method Entry:
Income from Sub
Investment in Sub

Sales
$400
Cost of sales
250
Gross profit $ 150

$250

Parent

150
150
Parents gross profit is overstated
by $150
Subs inventory is overstated
by $150

$400

Sub
6-67

What to Look For

Most problems will contain

Inventory transferred from parent to sub

(downstream), or

Inventory transferred from sub to parent

(upstream).

Often part of the inventory is sold to

an outsider, but part remains in the
buyers ending inventory.
Key: Any problem can be split into two
parts

The portion of the inventory that is sold

The portion of the inventory that is still on hand 6-68

A Comprehensive Downstream
Example
During 20X8, Parent sold inventory originally
costing $60,000 to its 100% owned Sub for
$75,000. Sub sold most of the inventory
purchased from Parent (all but $10,000) for
$70,000 to outsiders during the year.
Income Statements
Parent
Sub
Sales
$75,000 $70,000
Cost of sales60,000 65,000
Gross profit$15,000 $ 5,000

What happened to
it? On-hand
Sold
$65,000$10,000
x 20% =
$2,000
Unrealized GP
Ending inventory =
$10,000
$75,000
Split

60,000

Parent 75,000

Sub

70,000
6-69

One Approach: Split into Two

Transactions
This transaction can be broken into two
pieces:

Parent sells Sub inventory with a cost of $52,000

for $65,000. Sub then sells this inventory to
outsiders for $70,000.

Parent sells Sub inventory with a cost of $8,000

for $10,000, which remains on hand in Subs
ending inventory.
Total
Sold
On
hand
Sales $75,00 $65,00 $10,000
0
0
60,000 52,000
8,000
COGS
Gross

$15,00

$13,00 $ 2,000

6-70

Part 1: Sale from Parent to Sub to

Outsider
To eliminate sale from Parent to Sub to Outsider:
Sales (Parent)
65,000
Cost of Goods Sold (Sub)
65,000

Get rid of the non-arms-length

transaction!

$52,000

Parent$65,000

Sub

$70,000
6-71

Part 2: Sale from Parent to Sub

(Not Outside)
Reverse the entire transaction!
To eliminate sale from Parent to Sub, not yet to Outsider:
Sales (Parent)
10,000
Cost of Goods Sold (Parent)
8,000
Inventory (basis correction)
2,000

Sales
$10,000
Cost of sales 8,000
Gross profit$ 2,000

$8,000

Parents gross profit is

overstated by $2,000
Subs inventory is overstated by
$2,000

Parent $10,000

Sub
6-72

Summary
To eliminate sale from Parent to Sub to Outsider :
Sales (Parent)
65,000
Cost of Goods Sold (Sub)
65,000
To eliminate sale from Parent to Sub, not yet to Outsider:
Sales (Parent)
10,000
Cost of Goods Sold (Parent)
8,000
Inventory (basis correction)
2,000
Can combine the two entries:
Sales
Cost of Goods Sold
Inventory

75,000
73,000
2,000

6-73

Partial Consolidated Worksheet

Paren
t

Sub

DR

CR

Conso
lidate
d

73,00
0
73,00
0

70,00
0
52,00
0
18,00
0

Income
Statement
Sales
COGS
Gross
Profit

75,00
75,00
70,000
0
0
60,00
65,000
0
15,00
75,00
5,000
0
0

6-74

Second Approach: Short Cut

Method
Total

On
hand
Sales $75,00 $65,00 $10,000
0
0
60,000 52,000
8,000
COGS
COGS
= $65,000
Gross Credit
$15,00
$13,00+$$8,000
2,000
Profit
0
0
The numbers come right off the chart!
Sales
Cost of Goods Sold
Inventory

Sold

75,000
73,000
2,000

6-75

Fully-adjusted Equity Method

Adjustment
Dont forget that one of the desirable
properties of using the equity method is
that the parents net income should be
equal to the consolidated net income.
If you only adjust for unrealized deferred
profit in the consolidation, the
consolidated net income will be different
from the parents income!

6-76

Partial Consolidated Worksheet

Paren
t

Sub

DR

CR

Conso
lidated

Income
Statement
Sales
COGS
Inc from
Sub

Net
Income

75,00
75,00
70,000
70,000
0
0
60,00
73,00
65,000
52,000
0
0
Not the same!
5,000
5,000
20,00
0

80,00 73,00
5,000
18,000
0
0
6-77

Fully-adjusted Equity Method

Adjustment
Dont forget that one of the desirable
properties of using the equity method is
that the parents net income should be
equal to the consolidated net income.
If you only adjust for unrealized deferred
profit in the consolidation, the
consolidated net income will be different
from the parents income!
Thus, an actual adjustment on the parents
books in addition to the worksheet entries
above.
Like we did for the excess fair value
amortization.

6-78

Fully-adjusted Equity Method

Adjustment
After calculating the unrealized
deferred profit, simply make an
extra adjustment to back it out.
Do this at the same time you
record the parents share of the
subs income.
Investment in
Sub
NI 5,000
2,000
2,000

Parent NI =
Consolidated
NI

Sales

$75,000
COGS

60,000
from
Gross profit

Income
Sub5,000 NI
$15,000

Unreal GP

Inc. from Sub

3,000
3,000
NI

Reverse next year when this$18,000

inventory is sold!

6-79

Partial Consolidated Worksheet

Paren
t

Sub

DR

CR

Cons
olidate
d

Income
Statement
Sales
COGS
Inc from
Sub

Net

75,00
75,00
70,00
70,000
0
0
0
60,00
73,00 52,00
Now
theyre
the same!
65,000
0
0
0
3,000

3,000

18,00

78,00 73,00

5,000

18,006-80

Practice Quiz Question #5

Under the fully adjusted equity
method, what is one benefit of
making an equity method
adjustment to defer unrealized
gross profit on inventory
transfers?
a. Consolidated net income always
increases.
b. Parent company net income
always increases.
c. Parent company net income is not
equal to consolidated net income.
6-81

Practice Quiz Question #5

Solution
Under the fully adjusted equity
method, what is one benefit of
making an equity method
adjustment to defer unrealized
gross profit on inventory
transfers?
a. Consolidated net income always
increases.
b. Parent company net income
always increases.
c. Parent company net income is not
equal to consolidated net income.
6-82

Review Exercise Part 1:

Downstream
Para sold inventory costing $100,000
to its 75%-owned subsidiary, Shute,
for $125,000 in 20X8.
NCI
Shute resold most of this inventory for
25%
$230,000 in 20X8.
At 12/31/X8, Shutes balance sheet
showed intercompany-acquired
inventory on hand of $20,000.

P
75%

Required:
Prepare the consolidation entry and/or entries
required at 12/31/X8 under the equity method.
Since this is a DOWNSTREAM transaction,
we dont share the GP deferral with the NCI.
6-83

Review Exercise Part 1: Big

Picture
Total

Sold

Sales 125,000
COGS 100,000
Gross
Profit
Gross
Profit %

On
hand
20,000

25,000
Ending Inventory = 20,000
Resold = $105,000
$125,000
split

$100,000

Parent$125,000

Sub

$230,000
6-84

Review Exercise Part 1: Big

Picture
Total
Sales
COGS

Sold

125,000
100,000

On
hand
20,000

Gross Profit
25,000
Gross Profit = 25,000 / 125,000 = 1/5
% = 20%

Ending Inventory = 20,000

Resold = $105,000

$125,000
split
$100,000

Parent$125,000

Sub

$230,000
6-85

Review Exercise Part 1: Big

Picture
Total
Sales
COGS

Sold

125,000 105,000
100,000 84,000

On
hand
20,000
16,000

Gross Profit
25,000 21,000
4,000
Gross Profit = 25,000 125,000 = 1/5 Unrealized
GP
% = 20%
Ending Inventory = 20,000
Resold = $105,000
$125,000
split
$100,000

Parent$125,000

Sub

$230,000
6-86

Review Exercise 1: Sale from

Parent to Sub to Outsider
To eliminate sale from Parent to Sub to Outsider:
Sales (Parent)
105,000
Cost of Goods Sold (Sub)
105,000

Get rid of the internal non-arms-length

transaction!

$84,000

Parent$105,000

Sub

$230,000
6-87

Review Exercise 1: Sale from

Parent to Sub (Not Yet Outside)
Reverse the entire
To eliminate sale from Parent
to Sub, not yet to Outsider:
transaction!
Sales (Parent)
Cost of Goods Sold (Parent)
Inventory (basis correction)

20,000

16,000
4,000

Sales
$20,000
Cost of sales16,000

Parents gross profit is overstated by

$4,000

Gross profit$ 4,000

Subs inventory is overstated by

$4,000

$16,000

Parent$20,000

Sub
6-88

Review Exercise 1: Summary

To eliminate sale from Parent to Sub to Outsider:
Sales (Parent)
105,000
Cost of Goods Sold (Sub)
105,000
To eliminate sale from Parent to Sub, not yet to Outsider:
Sales (Parent)
20,000
Cost of Goods Sold (Parent)
16,000
Inventory (basis correction)
4,000
Combine both entries:
Sales
Cost of Goods Sold
Inventory

125,000
121,000
4,000

Fully-adjusted Equity Method Entry on Parents

books:
Income from Sub
Investment in Sub

4,000
4,000
6-89

Review Exercise Part 1: Short

Cut
Total
Sales 125,000
COGS

100,000

Sold

On
hand
105,00 20,000
0
84,000 16,000

Gross 25,000 21,000

4,000 Unrealized
Profit
GP
COGS = 105,000 + 16,000 =
Credit 121,000
Worksheet
Elimination Entry:
Sales
Cost of Goods Sold
Inventory
4,000

125,000
121,000

6-90

Review Exercise 1: Equity Method

Entry
Investment in
75% NI Sub
93,750

4,000
4,000

Income from
Sub
93,750 75%
Defer GP

NI

Reverse next year!

6-91

Review Exercise 1: Equity

Method Reversal Next Year

Equity Method Adjustment on Parents books in

20X7:
Income from Sub
4,000
Investment in Sub
4,000
Reversal of 20X7 Deferral on Parents books in
20X8:
Investment in Sub
Income from Sub

4,000
4,000

6-92

Review Exercise Part 1

Worksheet Elimination Entry in Year 1:
Sales
125,000
Cost of Goods Sold
121,000
Inventory
4,000
FYI, this years deferral is REVERSED next year
to recognize when sold!

6-93

Review Exercise 1: Equity Method

Entry
Investment in
75% NI Sub
93,750
Low

4,000

4,000
4,000

Income from
Sub
93,750 75%
Defer GP

NI
89,750

Downstream, so dont split

the deferral with the NCI.

6-94

Review Exercise Part 1

Worksheet Elimination Entry in Year 1:
Sales
125,000
Cost of Goods Sold
121,000
Inventory
4,000
FYI, this years deferral is REVERSED next year
to recognize when sold!
Worksheet Elimination Entry in Year 2:
Investment in Sub
4,000
Cost of Goods Sold
4,000
INCREASES
income!
6-95

Review Exercise 1: Partial

Consolidated Worksheet

Parent

Sub

DR

CR

Consolidated

Income Statement
Sales

125,000

230,000

COGS

100,000

105,000

Inc from
Sub
Gross
Profit

89,750
114,750

230,000)
121,00
0

125,000

214,75 121,00
146,000)
0
0
31,250 Basic

114,750

84,000)

89,750 Basic

NCI in NI
CI in NI

125,00
0

125,000

(31,250)

246,00 121,00
114,750)
0
0
6-96

Learning Objective 6-4

Prepare equity-method
journal entries and
elimination entries for the
consolidation
of a subsidiary following
upstream inventory
transfers.

6-97

Partially Owned Upstream Sales

Must share deferral with the NCI
shareholders.
Simply split up the adjustment for
unrealized gross profitEquity Method
Adjustments
proportionately.
NCI
Investment in
Sub
NI 4,500
1,800
1,800

Income from Sub

10%

P
90%

4,500 NI
Defer GP
2,700
NCI in NA of Sub

Unreal GP
200

Worksheet
Entry Only
6-98

Review Exercise Part 2

In 20X7, Sensei, a 90%-owned subsidiary of
Padawan, sold inventory to Padawan for
$600,000, which includes a markup of 25% on
Senseis cost.
NCI
Padawan resold most of this inventory in 20X7 for
10%
$588,000.
At 12/31/X7, Padawan reported $110,000 of this
inventory in its balance sheet. (This ending
inventory was resold in 20X8 by Padawan.)
In 20X8, Sensei sold Padawan inventory for
$900,000 that had a cost of $675,000, of which
Padawan resold $700,000 by12/31/X8 for
$840,000.
Required:
Prepare the consolidation entry and/or entries
required at 12/31/X8 under the equity method.
Since this is an UPSTREAM transaction, we do

P
90%

6-99

Review Exercise Part 2: The Big

Picture20X7
Total
Sales
COGS
Gross Profit

Sold

600,000
C

On
hand
110,000

0.25C

Ending Inventory = $110,000

Sub

$600,000

Parent

?
6-100

Review Exercise Part 2: The Big

Picture20X7
Total
Sales

Sold

600,000

On
hand
110,000

COGS
Gross Profit
$600,000 C =
0.25C
C=
$600,000/1.25
= $480,000
?

Sub

Ending Inventory = $110,000

$600,000

Parent

?
6-101

Review Exercise Part 2: The Big

Picture20X7
Total
Sales
COGS

Sold

600,000
480,000

On
hand
110,000

Gross Profit 120,000

Gross Profit = 120,000 / 600,000 = 1/5 Unrealized
GP
% = 20%
$600,000 C =
0.25C
C=
$600,000/1.25
= $480,000
?

Sub

Ending Inventory = $110,000

$600,000

Parent

?
6-102

Review Exercise Part 2: The Big

Picture20X7
Total
Sales
COGS

Sold

600,000
480,000

On
hand
110,000

Gross Profit 120,000

22,000
Gross Profit = 120,000 / 600,000 = 1/5 Unrealized
GP
% = 20%
$600,000 C =
0.25C
C=
$600,000/1.25
= $480,000
?

Sub

Ending Inventory = $110,000

$600,000

Parent

?
6-103

Review Exercise Part 2: The Big

Picture20X7
Total
Sales
COGS

Sold

600,000
480,000

On
hand
490,000 110,000
392,000 88,000

Gross Profit 120,000

98,000 22,000
Gross Profit = 120,000 / 600,000 = 1/5 Unrealized
GP
% = 20%
$600,000 C =
0.25C
C=
$600,000/1.25
= $480,000
?

Sub

Ending Inventory = $110,000

$600,000

Parent

?
6-104

20X7 Upstream Sales: Elimination

Entries20X7 & 20X8
20X7 Worksheet Elimination Entry:
Sales
600,000
Cost of Goods Sold
578,000
Inventory
22,000

Deferred GP this year

reversed to recognize in
the financial statements
next year when sold.

NCI

10%

P
90%

S
6-105

20X7 Upstream Sales: Equity

Method Adjustments 20X7 &
20X8
20X7 Equity Method Adjustment on
Parents books:
Income from Sub
19,800
Investment in Sub
19,800

Deferral of GP in 20X7
because not yet sold this
year.
20X8 Equity Method Reversal of 20X7
Deferral (on Parents books):
Investment in Sub
Income from Sub

19,800
19,800

NCI

10%

P
90%

S
6-106

20X7 Upstream Sales: 20X7

Equity Accounts
Investment in
90% NI Sub
108,000
Low

19,800

19,800
19,800

Income from
Sub
108,000
X7 Deferral

90%

NI
88,200

6-107

20X7 Upstream Sales: Elimination

Entries20X7 & 20X8
20X7 Worksheet Elimination Entry:
Sales
600,000
Cost of Goods Sold
578,000
Inventory
22,000

Deferred GP this year

reversed to recognize in
the financial statements
next year when sold.

NCI

10%

P
90%

20X8 Worksheet Elimination Entry:

Investment in Sub
NCI in NA of Sub
Cost of Goods Sold

19,800
2,200
22,000

S
6-108

20X7 Upstream Sales: 20X7

Partial Worksheet
Parent

Sub

DR

CR

Consolidated

Income Statement
Sales

588,000

600,000

COGS

490,000

480,000

Inc from
Sub
Gross
Profit

88,200
186,200

588,000)
578,00
392,000)
0

88,200 Basic
120,000

NCI in NI
CI in NI

600,00
0

688,20 578,00
196,000)
0
0
9,800 Basic

186,200

120,000

(9,800)

698,00 578,00
186,200)
0
0
6-109

Review Exercise Part 2

In 20X7, Sensei, a 90%-owned subsidiary of
Padawan, sold inventory to Padawan for
$600,000, which includes a markup of 25% on
Senseis cost.
NCI
Padawan resold most of this inventory in 20X7 for
10%
$588,000.
At 12/31/X7, Padawan reported $110,000 of this
inventory in its balance sheet. (This ending
inventory was resold in 20X8 by Padawan.)
In 20X8, Sensei sold Padawan inventory for
$900,000 that had a cost of $675,000, of which
Padawan resold $700,000 by12/31/X8 for
$840,000.
Required:
Prepare the consolidation entry and/or entries
required at 12/31/X8 under the equity method.
Since this is an UPSTREAM transaction, we do

P
90%

6-110

Review Exercise Part 2: The Big

Picture20X8
Total

Sold

Sales 900,000
COGS

On
hand

700,00
0

675,000

Gross
Profit
Ending Inventory = $200,000

675,000

Sub

$900,000

Parent

?
6-111

Review Exercise Part 2: The Big

Picture20X8
Total

Sold

Sales 900,000
COGS

On
hand
700,00 200,00
0
0

675,000

Gross 225,000
Profit
Gross = 225,000 / 900,000 =
Ending Inventory = $200,000
Profit % 0.25

675,000

Sub

$900,000

Parent

?
6-112

Review Exercise Part 2: The Big

Picture20X8
Total

Sold

Sales 900,000
COGS

On
hand
700,00 200,00
0
0

675,000

Gross 225,000
Unrealized
Profit
GP
Gross = 225,000 / 900,000 =
Ending Inventory = $200,000
Profit % 0.25

675,000

Sub

$900,000

Parent

?
6-113

Review Exercise Part 2: The Big

Picture20X8
Total

Sold

Sales 900,000
COGS

On
hand
700,00 200,00
0
0

675,000

Gross 225,000
50,000 Unrealized
Profit
GP
Gross = 225,000 / 900,000 =
Ending Inventory = $200,000
Profit % 0.25

675,000

Sub

$900,000

Parent

?
6-114

Review Exercise Part 2: The Big

Picture20X8
Total

Sold

Sales 900,000
COGS
Gross
Profit
Gross
Profit %
675,000

On
hand
200,00
0
150,00
0
Unrealized
50,000
GP

700,00
0
675,000 525,00
0
225,000 175,00
0
Ending Inventory
= $200,000
= 225,000 / 900,000
=
0.25

Sub

$900,000

Parent

?
6-115

Review Exercise 2: Summary

To eliminate sale from Sub to Parent to Outsider:
Sales (Sub)
700,000
Cost of Goods Sold (Parent)
700,000
To eliminate sale from Sub to Parent, not yet to Outsider:
Sales (Sub)
200,000
Cost of Goods Sold (Sub)
150,000
Inventory (basis correction)
50,000
Combine both entries:
Sales
Cost of Goods Sold
Inventory

900,000
850,000
50,000

Fully-adjusted Equity Method Entry on Parents

books:
Income from Sub
Investment in Sub

45,000
45,000
6-116

Review Exercise 2: Short Cut

Total

Sold

Sales 900,000

On
hand
200,00
0
150,00
0
50,000

700,00
0
COGS 675,000 525,00
0
Gross Profit 225,000 175,00
0
CR =
700,000 + 150,000 =
The COGS
Elimination
Entry:
850,000
Sales
900,000
Cost of Goods Sold
Inventory
50,000

850,000

6-117

20X8 Upstream Sales: 20X8

Equity Accounts
Investment in
Low Sub
19,800
19,800
90% NI 19,800
202,500
45,000
45,000
Low
45,000

Income from
Sub
X7 Reversal
202,500
X8 Deferral
NI

90%

177,300

6-118

20X7 & 20X8 Upstream Sales:

20X8 Partial Worksheet
Parent

Sub

DR

900,000

CR

Consolidated

Income Statement
Sales

840,000

900,00
0

COGS

700,000

675,00
0

840,000)
850,00
503,000)
0
22,000

Income from
Sub

177,300

Gross Profit

317,300

177,300 Basic
225,00
0

NCI in NI
CI in NI

1,077,3
00

872,00
337,000)
0

19,700 Basic
317,300

225,00
0

1,097,0
00

(19,700)

872,00
317,300)
0

Balance Sheet
Inventory

200,000

50,000 150,000)

6-119

Learning Objective 6-5

Understand and explain

additional considerations
associated with
consolidation.

6-120

Additional Considerations
Sale from one subsidiary to
another

Transfers of inventory often occur

between companies that are under
common control or ownership.

The eliminating entries are identical to

those presented earlier for sales from a
subsidiary to its parent.

The full amount of any unrealized

intercompany profit is eliminated, with the
profit elimination allocated
proportionately against the ownership

6-121

Additional Considerations

Costs associated with

transfers

When one affiliate transfers

inventory to another, some
additional cost is often incurred.

Such costs should be treated in the

same way as if the affiliates were
operating divisions of a single
company.
6-122

Additional Considerations

Lower-of-cost-or-market

A company might write down

inventory purchased from an affiliate
under this rule if the market value at
the end of the period is less than the
intercompany transfer price.

6-123

Lower-of-Cost-or-Market Example
Assume that a parent company purchases inventory for
$20,000 and sells it to its subsidiary for $35,000. The
subsidiary still holds the inventory at year-end and
determines that its market value (replacement cost) is
$25,000 at that time. The subsidiary writes the inventory
down from $35,000 to its lower market value of $25,000 at
the end of the year and records the following entry:
Write-down Inventory to Market Value:
Loss on Decline in Value of Inventory 10,000
Inventory
10,000
Make the following worksheet eliminating entry:

Sales
35,000
Cost of Goods sold
Inventory
Loss on Decline in Value of Inventory

20,000
5,000
10,000
6-124

Additional Considerations
Sales and purchases before
affiliation

The consolidation treatment of profits on

inventory transfers that occurred before
the business combination depends on
whether the companies were at that time
independent and the sale transaction was
the result of arms-length bargaining.

As a general rule, the effects of

transactions that are not the result of
arms-length bargaining must be
eliminated.

6-125

Additional Considerations
In the absence of evidence to the contrary,
companies that have joined together in a
business combination are viewed as having
been separate and independent prior to the
combination.

If the prior sales were the result of arms-length

bargaining, they are viewed as transactions
between unrelated parties.

No elimination or adjustment is needed in

preparing consolidated statements subsequent
to the combination, even if an affiliate still holds
the inventory.
6-126

Practice Quiz Question #6

Peanut Co. regularly purchased
inventory from Snack Inc. in 20X3
when Peanut did not own any
Snack stock. On March 31, 20X4,
Peanut purchased 90% of Snack
Inc.s outstanding common stock.
a. Peanut should eliminate 90% of
Snacks first quarter 20X4 gross
profit.
b. Peanut should eliminate 100% of
Snacks first quarter 20X4 gross
profit.
c. Peanut should not eliminate any

6-127

Practice Quiz Question #6

Solution
Peanut Co. regularly purchased
inventory from Snack Inc. in 20X3
when Peanut did not own any
Snack stock. On March 31, 20X4,
Peanut purchased 90% of Snack
Inc.s outstanding common stock.
a. Peanut should eliminate 90% of
Snacks first quarter 20X4 gross
profit.
b. Peanut should eliminate 100% of
Snacks first quarter 20X4 gross
profit.
c. Peanut should not eliminate any

6-128

Conclusion

The End

6-129