intercompany transaction: inventory

Intercompany Transaction: Inventories

ARTHIK DAVIANTI

Understand the impact of intercompany profit

in inventories

Intercompany Transaction

• Consolidated financial statements – as if two or more affiliates are one entity• Transaction between affiliates must be eliminated• The objective is to show the income and financial

position of the consolidated entity as they would have appeared if the intercompany transaction had never taken place• This situation depends on the existence of arm’s

length transaction

• Firms recognize revenue when it is realized – when it is earned.• For consolidated entity, revenue earns when there is a

sale to outside entities.• Revenue between affiliates cannot be recognized until

merchandise sold outside of the consolidated entity.• Affiliates’ sales produce reciprocal sales and cost of

good sold accounts – should be eliminated.• This elimination will not affect consolidated net

income.

Intercompany Transaction: Inventory

• Transfer at cost – sold at cost or carrying valueNo profit or loss – no adjustmentElimination to remove revenue and related cost of goods sold

• Transfer at a profit or loss – sold at a mark up (or less than cost)

Profit or loss is considered realized by the selling company, but not for consolidation – until resale to an unrelated party, referred to as unrealized intercompany profit


Elimination for consolidation:Income statement: Sales and cost of goods soldThe sales revenue from the intercompany sale and the related cost of goods sold recorded by the transferring affiliate must be removed.Balance sheet: InventoryThe profit or loss on the intercompany sale must be removed so the inventory is reported at the cost to the consolidated entity.


• For consolidation purposes – profits from intercompany inventory sale are recognized in the period of a resold to an unrelated party.• Downstream sale – a sale from a parent to a subsidiary,

gain or loss accrues to the parent company.• Upstream sale – a sale from a subsidiary to a parent,

gain or loss accrues to the subsidiary.• Three situations: (1) the item is resold to a nonaffiliate

during the same period, (2) the item is resold to a nonaffiliate during the next period, or (3) the item is held for two or more periods.


1. Peerless Products Corp purchases 80% of Special Foods Inc.’s stock on December 31, 20X1, at the stock’s book value of $240,000. The fair value of Special Food’s non controlling interest on that date is $60,000, the book value of those shares.

2. During 20X1, Peerless reports separate income of $140,000 income from regular operation and declares dividends of $60,000. Special Foods reports net income of $50,000 and declares dividends of $30,000.

3. Peerless accounts for its investments in Special Foods using the equity method and adjusts for unrealized intercompany profits using the fully adjusted equity method.

Downstream Sale of Inventory

On March 1, 20X1, Peerless buys inventory for $7,000 and resell it to Special Foods for $10,000 on April 1. Peerless records the following entries:

Downstream Sale of Inventory: Illustration

March 1, 20X1Inventory 7,000

Cash7,000

To record inventory purchaseApril 1, 20X1Cash 10,000

Sales10,000

Cost of goods sold 7,000Inventory

7,000To record sale and cost of inventory sold to Special Foods

Special Foods entry for the purchase of the inventory from Peerless:

Downstream Sale of Inventory: Illustration

April 1, 20X1Inventory 10,000

Cash10,000

To record inventory purchase from Peerless

Inventory is resold to a nonaffiliate during the same period, November 5, 20X1, for 15,000. Special Foods’ entry:

Resale in Period of Intercompany Transaction

November 5, 20X1Cash 15,000

Sales15,000

Cost of goods sold 10,000Inventory

10,000To record sale and cost of inventory sold to Nonaffiliated

Parent Sub$7,000 For $15,000$10,000

3/120X1

4/120X1

11/520X1

A review of all entries recorded:

Resale in Period of Intercompany Transaction

Item Peerless Products

Special Foods

Unadjusted Totals

Consolidated amounts

Sales 10,000 15,000 25,000 15,000Cost of goods sold (7,000) (10,000) (17,000) (7,000)Gross profit 3,000 5,000 8,000 8,000

The amount of intercompany sale must be eliminated:Sales 10,000

Cost of goods sold10,000

Extending the previous illustration – Special Foods sells the inventory to Nonaffiliated Corporation for $15,000 on January 2, 20X2.Equity method entries to record income and dividends for 20X1:

Resale in Period following Intercompany Transaction

Parent Sub$7,000 For $15,000$10,000

3/120X1

4/120X1

1/220X2

Investment in Special Foods 40,000Income from Special Foods

40,000To record Peerless 80% share of income


Cash 24,000Investment in Special Foods 24,000

To record Peerless 80% share of dividend

The downstream sale of inventory to Special Foods results in $3,000 of unrealized profits. Under the fully adjusted equity method, Peerless defers the entire $3,000 (assumes that the NCI shareholders do not own Peerless stock):Income from Special Foods 3,000

Investment in Special Foods 3,000To defer unrealized gross profit on inventory sales to Special Foods not yet resold


Book Value CalculationsInvestmentAccount Common RetainedNCI (20%) (80%) Stock Earnings

Original book value 60,000 240,000 200,000 100,000+ Net income 10,000 40,000 50,000- Dividend (6,000) (24,000) (30,000)

Ending book value 64,000 256,000 200,000 120,000

=

Elimination entries for consolidation worksheet:


Basic investment account elimination entry:Common Stock 200,000Retained Earnings 100,000Income from Special Foods 37,000NCI in NI of Special Foods 10,000

Dividends Declared30,000

Investment in Special Foods253,000NCI in NA of Special Foods

64,000

The amounts in the Income from Special Foods and Investment in Special Foods are reduced by the $3,000 deferral (worksheet, Baker p. 262).

Elimination of intercompany sale (ending inventory):Sales 10,000


Inventory3,000

• Resold by the parent to a nonaffiliate during the same period, all the parent’s equity method entries, and the elimination entries in the consolidation worksheet are identical with those in the downstream case.• When the inventory is not resold to nonaffiliated

before the end of the period – consider the apportionment of the unrealized intercompany profit to both CI and NCI.

Upstream Sale of Inventory

Cash 24,000Investment in Special Foods 24,000

To record Peerless 80% share of dividend

Upstream Sale of InventoryEquity method entries to record income and dividends for 20X1 (these entries are the same as in the illustration of the downstream sale and the difference is the unrealized gross profit is deferred only by Peerless’ ownership percentage: $3,000 X 80% = $2,400):

Investment in Special Foods 40,000Income from Special Foods

40,000To record Peerless 80% share of income

Income from Special Foods 2,400Investment in Special Foods 2,400

To defer unrealized gross profit on inventory sales to Special Foods not yet resold


Book Value CalculationsInvestmentAccount Common RetainedNCI (20%) (80%) Stock Earnings

Original book value 60,000 240,000 200,000 100,000+ Net income 10,000 40,000 50,000- Dividend (6,000) (24,000) (30,000)

Ending book value 64,000 256,000 200,000 120,000

=

Elimination entries for consolidation worksheet:


Basic investment account elimination entry:Common Stock 200,000Retained Earnings 100,000Income from Special Foods 37,600NCI in NI of Special Foods 9,400

Dividends Declared30,000

Investment in Special Foods253,600NCI in NA of Special Foods

63,400

The amounts in the Income from Special Foods and Investment in Special Foods are reduced by the $3,000 deferral (worksheet, Baker p. 268).

Elimination of intercompany sale (ending inventory):Sales 10,000


Inventory3,000

Source:

BAKER CHRISTENSEN COTTLRELLAdvanced Financial Accounting

Ninth Edition

McGRAW HILL INTERNATIONAL EDITION

intercompany transaction: inventory

Business