Intercompany sales of Inventories practice materials PDF

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Intercompany sales of Inventories lecture notes and practice materials....

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Big Picture in Focus: ULOb. Account for intercompany sales of inventory Metalanguage The most essential terms below are operationally defined for you to have a better understanding of this section in the course. 1. Downstream sale of inventory. This is an intercompany sale of merchandise made from a parent company down to its subsidiaries. For consolidation purposes, this should not be reflected in the consolidated financial statements. 2 Upstream sale of inventory. This is a sale of inventory from subsidiary to a parent company.

Essential Knowledge A. Introduction Many business transactions between a parent company and its subsidiary involve a profit (gain) or loss. Among these transactions are intercompany sales of merchandise and intercompany sales of plant assets. Consolidated statements are prepared to show the financial position and the results of operations of two or more affiliated companies as if they are one business company. As such, the unrealized profits or losses arising from these intercompany transactions must be eliminated in the preparation of consolidated statements, until intercompany profits or losses are realized through the sale of the asset to outsiders. Failure to eliminate unrealized profits and losses would result in consolidated statements of comprehensive income reporting not only the results of transactions with outsiders but also the results of related party transactions within the affiliated group. Similarly, nonrecognition of realized profits and losses would misstate consolidated comprehensive income. Management can manipulate the computation of consolidated comprehensive income by not eliminating unrealized intercompany profit and losses in the preparation of Consolidated Statement of comprehensive income. The intercompany profit in inventory transfer between affiliates is computed by multiplying the inventory held by the buying affiliate which was acquired from the selling affiliate by the gross profit rate based on sales of the selling affiliate. When an intercompany sale includes no profit or loss, the inventory amounts at the end of the period require no adjustment for consolidation. However, an eliminating entry is needed to remove the intercompany sale and related cost of goods sold recorded by the seller. Consolidated comprehensive income is not affected by the eliminating entry

when the intercompany sale is made at cost because both sales revenue and cost of goods sold are reduced by the same amount. When intercompany sales include profits or losses (with mark-up), the working paper eliminations needed for consolidation have two goals: 1. Elimination of the effects in the statement of CI of the intercompany sale by removing the sales revenue from the intercompany sale and the related costs of goods sold recorded by the selling affiliate. 2. Elimination from the inventory on the Statement of Financial Position of any profit or loss on the intercompany sale that has not been confirmed or realized by resale of the inventory to outsiders. Inventory reported in the consolidated statement of financial position must be reported at cost to the consolidated entity. Any profits or losses arising from intercompany sales must be eliminated. B. Downstream sale of inventory For consolidation purposes, profits recorded on an intercompany inventory sale are realized in the period in which the inventory is resold to outsiders. Until the point of resale, all intercompany profits must be deferred. Consolidated CI must be based on the realized income of the selling affiliate. If the intercompany sales of merchandise are made by the parent company or by a wholly owned subsidiary, there is no effect on any NCI in CI or loss, because the selling affiliate does not have NCI. When a company sells merchandise to an affiliate, one of two situations results: (1) the merchandise is resold to outsiders during the same period, and (2) the merchandise is resold to outsiders during the next period resulting in unrealized profit in ending inventory. The data of Pete Corporation and Sake Company in previous unit will be used to illustrate the consolidation process under each of the alterative. Assume that Pete Corporation purchases 80% of the common stock of Sake Company on December 31, 2020. Resale in the Year of Intercompany Sale To illustrate the effect of a downstream sale, assume that on April 1, 2021, Pete Corporation sold merchandise costing P8,000 to Sake Company for P10,000 or at a gross profit of 20% of sales. Assume further that on November 7, 2021, Sake Company sold the merchandise to outsiders for P15,000. Parent and Subsidiary entries Pete Corporation: April 1 (1)

Cash Sales

10,000 10,000

To record sale of merchandise to Sake Co. (2)

Sake Company: April 1 (1)

Item

Cost of goods sold 8,000 Inventory 8,000 To record cost of inventory sold.

Inventory 10,000 Cash 10,000 To record purchase of inventory from Pete.

(2)

Cash

15,000 Sales 15,000 To record sale of inventory to outsiders.

(3)

Cost of goods sold 10,000 Inventory 10,000 To record cost of inventory sold to outsiders. (perpetual)

Pete Corp

Sales 10,000 COS (8,000) Gross profit 2,000

Sake Co. 15,000 (10,000) 5,000

Unadjusted Balances 25,000 (18,000) 7,000

Consolidated amounts 15,000 (8,000) 7,000

Working Paper Elimination Entries Although consolidated gross profit is correct even if no eliminations are made, the totals for sales and cost of goods sold derived by simply adding the amounts on the books of Pete Corporation and Sake Company are overstated for the consolidated entity. Since consolidated sales and cost of goods sold should be P15,000 and P8,000, respectively, rather than P25,000 and P18,000, the amount of intercompany sale must be eliminated from both sales and cost of goods sold to correctly state the consolidated totals. The elimination entry (after elimination entries from 1-6 in the previous unit) is therefore: E(7)

Sales

10,000 Cost of goods sold 10,000 To eliminate intercompany sale of inventory.

Note that the working paper elimination entry does not affect the consolidated CI because sales and cost of goods sold are both reduced by the same amount. No elimination of intercompany profit is needed because all the intercompany profit has been realized through resale of the inventory to outsiders during the current year: Resale in Subsequent Year Following Intercompany Sale

Any merchandise purchased from an affiliated company that remains unsold on the date of Consolidated Statement of Financial Position results in the overstatement of the purchasers ending inventories. The overstatement is equal to the amount other selling affiliate's unrealized intercompany profit and included in the ending inventory. This overstatement is cancelled through appropriate working paper elimination in the preparation of consolidated financial statements. Illustration. Assume again that Pete Corporation on April 1, 2021 sold merchandise to Sake Company costing P8,000 for P10,000 or at a gross profit of 20%, out of which P4,000 remained unsold by Sake Company on December 31, 2021. Parent and Subsidiary Companies Entries Pete Corporation. Journal entries are the same in the previous illustration. Sake Company. Same entry for recognizing purchase from Pete. The sale of inventory to outsiders is as follows: (2)

Cash

7,500 Sales 7,500 To record sales to outsiders (half of SP to outsiders, P15,000).

(3)

Cost of goods sold 6,000 Inventory 6,000 To record cost of goods sold Selling price

Beginning inventory Add: Sales Less: Ending inventory Cost of goods sold

10,000 4,000 6,000

Cost 8,000 3,200 4,800

Gross Profit (20% of SP) 2,000 800 1,200

The foregoing analysis shows that the intercompany profit on sales by Pete Corporation to Sake Company totaled P2,000, and that P1,200 of this intercompany profit was realized through Sake Company's sales of the acquired merchandise to outside customers. The remaining P800 of intercompany profit remains unrealized in Sake Company's inventories on December 31, 2021. Working Paper Elimination Entries Based on the foregoing analysis, the working paper elimination entries are required for Pete Corporation's intercompany sales of merchandise to Sake Company for the year ended December 31, 2021: E(7)

Sales

10,000 Cost of goods sold 10,000

To eliminate intercompany sale of inventory. E(8)

Cost of goods sold 800 Inventory 800 To eliminate unrealized inventory profit.

The effect of the above eliminations are as follows: E(7) eliminates Pete Corporation's intercompany sales to Sake Company and the related cost of goods sold. This removes the overstatement of the consolidated amounts for sales and cost of goods sold. E(8) removes the intercompany profit from Sake's cost of goods sold, thereby reducing the consolidated inventories to actual cost for the consolidated entity. Computation and Allocation of Consolidated Comprehensive Income The computation of consolidated net income (entity approach) and its allocation on December 31, 2021 is computed as follows (CI of Pete Corporation and Sake Company are assumed): Pete Corporation CI from own operations (excluding dividends income) Unrealized intercompany profit in ending inventory (downstream sale) Pete Corporation realized income from outsiders Sake Company CI from own operation Consolidated CI Attributable to NCI (20,000 x 20%) Attributable to parent

50,000 (800) 49,200 20,000 69,200 (4,000) 65,200

Intercompany Profit in Beginning and Ending Inventories Additional problem will be encountered in the preparation of working paper elimination entry for intercompany profits in the beginning inventories of the purchasing affiliate. Generally, it is assumed that on a first-in, first-out basis, the intercompany profit in the purchaser's beginning inventories is realized through sales of the merchandise to outsiders during the following period. Only the intercompany profit in ending inventories remains unrealized at the end of the period. Continuing our illustration in the preceding section, assume that during the year 2022, Pete Corporation sold again merchandise to Sake Company for P25,000 at a gross margin of 20%. Of this merchandise, P6,000 remains in the ending inventories of Sake Company on December 31, 2022. The intercompany sales transactions are analyzed as follows: Selling price Beginning inventory Add: Sales

4,000 25,000

Cost 3,200 20,000

Gross Profit (20% of SP) 800 5,000

Less: Ending inventory Cost of goods sold

6,000 23,000

4,800 18,400

1,200 4,600

Working Paper Elimination Entries E(7)

Sales

25,000 Cost of goods sold 25,000 To eliminate intercompany sale of inventory.

E(8)

Cost of goods sold 1,200 Inventory 1,200 To eliminate unrealized inventory profit.

E(9)

Retained earnings, beg – Pete 800 Cost of goods sold To eliminate realized inventory profit.

800

Pete Corporation's intercompany sales and cost of goods sold in prior year, 2021 had been closed with other income accounts to Retained Earnings account on December 31, 2021. Therefore, from a consolidated point of view, Pete Corporation's December 31, 2021 retained earnings was overstated by P800 representing unrealized intercompany profit in Sake Company's inventories on December 31, 2021. This unrealized profit was charged to cost of goods sold when Sake Company sold the inventory during the period, thus, overstating the cost of goods sold for 2022. Computation and Allocation of Consolidated Comprehensive Income The computation of consolidated net income (entity approach) and its allocation on December 31, 2021 is computed as follows (CI of Pete Corporation and Sake Company are assumed): Pete Corporation CI from own operations (excluding dividends income) 80,000 Unrealized intercompany profit in ending inventory (downstream sale) (1,200) Realized intercompany profit in ending inventory (downstream sale) 800 Pete Corporation realized income from outsiders 79,600 Sake Company CI from own operation 50,000 Consolidated CI 129,600 Attributable to NCI (50,000 x 20%) (10,000) Attributable to parent 119,600 C. Upstream sale of inventory When an upstream sale of inventory occurs and the inventory is resold by the parent to outsiders during the same period, all the parent entries and the eliminating entries in the consolidated working paper are identical to those in the downstream case.

When the inventory is not resold to outsiders before the end of the period, working paper eliminating entries are different from the downstream case only by the apportionment of the unrealized intercompany to both the controlling and NCI. The intercompany profit in an upstream sale is recognized by the subsidiary and shared between the controlling interest and NCI. Therefore, the elimination of the unrealized intercompany profit will reduce the interests of both ownership groups until the profit is realized by resale of the inventory to outsiders. Unrealized Intercompany Profit in Ending Inventories An upstream sale with unrealized intercompany profit in ending inventories can be illustrated using the example used for the downstream sale. Assume that Sake Company (an 80% owned subsidiary) during the year ended December 31, 2021 sold merchandise to Pete Corporation at a gross margin of 20%. Sales by Sake Company to Pete Corporation for the year totaled P10,000, of which P4,000 remained unsold by Pete Corporation on December 31, 2021. Pete Corporation and Sake Company Entries. The entries in the books of Pete and Sake are the same on the downstream sale in the previous discussion. Sake Company: April 1 (1)

(2)

Pete Corporation: April 1 (1)

Cash

10,000 Sales 10,000 To record sale of merchandise to Pete Corp. Cost of goods sold 8,000 Inventory 8,000 To record cost of inventory sold. Inventory 10,000 Cash 10,000 To record purchase of inventory from Sake.

(2)

Cash

15,000 Sales 15,000 To record sale of inventory to outsiders.

(3)

Cost of goods sold 10,000 Inventory 10,000 To record cost of inventory sold to outsiders. (perpetual)

Working Paper Elimination Entries

The working paper elimination entries for consolidated financial statement on December 31, 2021 are also the same on the downstream sale on previous discussion. E(7)

Sales

10,000 Cost of goods sold 10,000 To eliminate intercompany sale of inventory.

NCI in Comprehensive Income of Subsidiary The unrealized intercompany profit in ending inventory of P800 is attributable to Sake Company, the seller of the merchandise and must be considered in the computation of the NCI in Sake Company's CI for the year ended December 31, 2020. The computation is as follows: Sake Company’s CI (assumed) Unrealized intercompany profit in ending inventory Sake Company’s realized income NCI in CI of subsidiary (19,200 x 20%)

20,000 (800) 19,200 3,840

Consolidated CI: Pete Corporation’s CI (excluding dividend income) Sake Company’s realized CI: CI 20,000 Unrealized profit in ending inventory (800) Consolidated CI Attributable to NCI Attributable to parent

50,000 19,200 69,200 3,840 65,360

Intercompany Profit in Beginning and ending Inventories To continue our illustration, assume the same transactions in downstream sale. Working Paper Elimination Entries Based on the analysis of intercompany sale, Sake Company's intercompany sales and intercompany cost of goods sold for the year ended December 31, 2022, were closed to Retained Earnings account. Consequently, from a consolidated point of view, Sake Company's December 31, 2021, retained earnings was overstated by P640 (80% of the P800 unrealized intercompany profit in Pete Corporation's inventories on December 31, 2021). The remaining P160 of the unrealized profit on December 31, 2021 is attributable to the NCI. The following working paper elimination entry on December 31, 2022 reflects these facts: E(7)

Sales

25,000 Cost of goods sold 25,000 To eliminate intercompany sale of inventory.

E(8)

Cost of goods sold 1,200 Inventory 1,200 To eliminate unrealized inventory profit.

E(9)

Retained earnings, beg – Pete 640 NCI 160 Cost of goods sold To eliminate realized inventory profit.

800

Since NCI is considered to be a part of the consolidated stockholders' equity, then they are considered as part owners of the consolidated assets. As such, their share in intercompany profits in inventories is considered not realized. Accordingly, intercompany profits or losses in inventories resulting from upstream sale by a partially owned subsidiary must be considered in the computation of the NCI in CI of subsidiary, and in the computation of the portion of retained earnings of the subsidiary to be included in consolidated retained earnings. The subsidiary CI must be increased by the realized intercompany profit in the parent's beginning inventories and decreased by the unrealized intercompany profit in the parent's ending inventories. Failure to do so would assign the entire intercompany profit to the consolidated Cl. The computations of NCI in CI of subsidiary and the allocation of consolidated CI on December 31, 2022 based on the above principle are as follows: NCI in CI of Subsidiary: Sake Company’s CI (assumed) 20,000 Unrealized intercompany profit in ending inventory (1,200) Realized intercompany profit in ending inventory 800 Sake Company’s realized income 19,600 NCI in CI of subsidiary (19,600 x 20%) 3,920 Consolidated CI: Pete Corporation’s CI (excluding dividend income) Sake Company’s realized CI: CI 20,000 Unrealized profit in ending inventory (1,200) Realized profit in ending inventory 800 Consolidated CI Attributable to NCI Attributable to parent

50,000

19,600 69,600 (3,920) 65,680

D. COMPREHENSIVE ILLUSTRATION This illustration is for Pete Corporation and its partially owned subsidiary, Sake Co., for the year ended December 31, 2020 and 2021 (upstream sale).

Pete Corporation and Subsidiary Working paper elimination entries December 31, 2020 – First year E(1)

Dividend Income 24,000 NCI (20%) 6,000 Dividends declared – Sake Company 30,000 To eliminate intercompany dividends and establish minority interest share. E(2) ) Common stock – Sake Company 200,000 Retained earnings – Sake Company 100,000 Investment in Sake Company 240,000 NCI 60,000 To eliminate the intercompany investment and the subsidiary’s stockholders equity, and to establish minority interest. E(3)

Inventory 5,000 Property and equipment 60,000 Goodwill 10,000 Investment in Sake Company 60,000 NCI 15,000 To allocate excess between investment and book value of identifiable assets acquired with remainder to goodwill. E(4)

Cost of goods sold 5,000 Operating expenses 6,000 Inventory 5,000 Property and equipment 6,000 To amortize allocated excess to identifiable assets. E(5)

Sales

10,000 Cost of goods sold 10,000 To eliminate intercompany sale of inventory.

E(6)

Cost of goods sold 800 Inventory 800 To eliminate unrealized inventory profit.

E(7)

NCI in CI subsidiary 7,640 NCI 7,640 To recognize NCI in subsidiary’s net income for the year. CI of subsidiary 50,000 Amortization per E(4) (11,000) Unrealized profit (800) Adjusted CI of subsidiary 38,200 NCI share (38,200 x 20%) 7,640

a. The NCI of P76,640 can be verified by the following computation: Net assets at BV, 1/2/2020 – S Company Increase in earnings, 2020: Net income 49,200 Dividends paid (30,0...