Chapter 5
INTERCOMPANY PROFIT TRANSACTIONS - INVENTORIES
Comprehensive Chapter Outline
THE EFFECTS OF TRANSACTIONS BETWEEN AFFILIATED COMPANIES
(INTERCOMPANY TRANSACTIONS) MUST BE ELIMINATED IN
CONSOLIDATION.
A
Reciprocal account balances are eliminated.
B
Gains and losses from intercompany transactions are eliminated until realized through
use or through sale to an outside entity.
1
The total amount of the intercompany profit is eliminated, whether or not there
is a minority interest.
2
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.
ELIMINATION OF INTERCOMPANY SALES AND COST OF GOODS SOLD (OR
PURCHASES) DOES NOT AFFECT CONSOLIDATED INCOME, BUT IT REDUCES
CONSOLIDATED SALES AND CONSOLIDATED COST OF GOODS SOLD TO
AMOUNTS PURCHASED FROM AND SOLD TO OUTSIDE ENTITIES.
A
Under a periodic inventory system, the working paper entry is a debit to sales and a
credit to purchases.
B
Under a perpetual inventory system, the working paper entry is a debit to sales and a
credit to cost of goods sold. The perpetual inventory system is discussed and illustrated
in the chapter.
SALES OF INVENTORY ITEMS FROM A PARENT COMPANY TO ITS
SUBSIDIARY ARE DESIGNATED DOWNSTREAM SALES AND SALES FROM A
SUBSIDIARY TO ITS PARENT ARE DESIGNATED UPSTREAM SALES.
(Illustration 5-1)
A
Downstream sales
1
The parent company’s separate income includes the unrealized profit (in its sales
and cost of sales accounts).
2
The subsidiary’s net income is not affected; therefore, minority interest expense
is computed as the subsidiary’s reported net income times the minority interest
percentage.
3
The subsidiary’s ending inventory includes the unrealized profit until the
merchandise is sold to outside entities.
4
B
a
The subsidiary’s ending inventory reflects the transfer price, rather than
the cost to the consolidated entity.
b
In the consolidation working papers, the inventory is reduced to its cost
basis by a debit to cost of goods sold and a credit to ending inventory.
Under the equity method, the full amount of unrealized profit from intercompany
downstream sales is charged against income from subsidiary.
Upstream sales
1
The subsidiary’s net income includes the full amount of the unrealized profits
(included in its sales and cost of goods sold accounts).
a
The unrealized profit in the subsidiary’s net income is allocated
proportionately to the majority and minority stockholders in this book.
b
Consolidated net income and minority interest expense are computed on
the basis of income that is realized from the viewpoint of the
consolidated entity.
c
A subsidiary’s realized income is its reported net income, adjusted for
intercompany profits from upstream sales.
2
The parent company’s separate income is not affected by unrealized profits from
upstream sales, but its net income (which includes investment income) is
affected.
3
The parent company’s ending inventory includes the unrealized inventory profit
until the merchandise is sold to outside entities.
4
Under the equity method, only the parent’s proportionate share of unrealized
profits from intercompany upstream sales is charged against income from the
subsidiary.
ACCOUNTING FOR UNREALIZED PROFITS FROM DOWNSTREAM SALES
A
In the consolidation working papers, the full amount of the intercompany sales is
eliminated from sales and cost of goods sold.
B
The unrealized profit is deferred until it is realized when sold to an outside entity.
C
1
Deferral is accomplished in the consolidation working papers by a working paper
entry that increases cost of goods sold for the unrealized profit and reduces the
ending inventory to its cost basis.
2
From the consolidated entity viewpoint, unrealized profits in the ending inventory
understates cost of goods sold and overstates consolidated net income.
3
Under the equity method, the full amount of the unrealized profit in the
subsidiary’s inventory is eliminated from investment income and from the
investment in subsidiary account on the parent company books.
When the inventory items acquired by the subsidiary from the parent company are sold
to outside entities, the intercompany profit is realized.
1
The unrealized profits in the ending inventory of one period are the unrealized
profits in the beginning inventory in the next period.
2
The effect of unrealized profits in the beginning inventory is just opposite to that
of unrealized profits in the ending inventory.
a
Unrealized profits in the ending inventory (year of intercompany sale)
have a direct relationship to consolidated net income.
b
Unrealized profits in the beginning inventory (year of sale to outside
entities) have an inverse relationship to consolidated net income.
3
Under the equity method, the investment in subsidiary and income from
subsidiary amounts are increased for the realization of the intercompany profits
from the preceding period.
4
Realization of deferred profits in the subsidiary’s beginning inventory overstates
cost of goods sold from the consolidated viewpoint.
5
The working paper entry to record the realization of deferred profits is a debit to
the investment in subsidiary account and a credit to cost of goods sold.
6
a
The beginning inventory account can not be adjusted directly because it
has already been closed to the cost of goods sold account.
b
The debit to the investment account reestablishes reciprocity between the
investment balance at the beginning of the period and the subsidiary’s
equity accounts at the same date.
Unrealized inventory profits in consolidated financial statements are selfcorrecting over any two accounting periods.
ACCOUNTING FOR UNREALIZED PROFITS FROM UPSTREAM SALES
A
As in the case of downstream sales, the full amount of the sales is eliminated from sales
and cost of sales in the consolidation working papers.
B
Intercompany sales from the subsidiary to the parent company increase the subsidiary’s
sales, cost of goods sold, gross profit, and net income.
C
The unrealized profit remains in the parent company’s inventory until the items are sold
to outside entities.
D
1
If the selling subsidiary is 100% owned, the parent company defers 100% of any
unrealized profits in the year of the intercompany sale.
2
If the selling subsidiary is partially owned, the parent company defers only its
proportionate share of the unrealized profits in the year of the intercompany sale.
3
The minority interest expense is reduced for its proportionate share of any
unrealized subsidiary profits. To compute minority interest expense, the
unrealized profit is subtracted from the subsidiary’s reported net income, and the
resulting subsidiary realized income is multiplied by the minority interest
percentage.
Intercompany profit is recognized and realized when the inventory items are sold to
outside entities.
1
Unrealized profits in the beginning inventory overstate cost of goods sold.
a
In the consolidation working papers, a working paper entry reduces cost
of goods sold to its cost basis (credit) and adjusts the investment account
and beginning minority interest (debits) for the previously deferred
unrealized profits in the beginning inventory.
b
2
Recall that the effect of unrealized profits in a beginning inventory on
parent company and consolidated net income are opposite the effect of
unrealized profits in an ending inventory.
Under the equity method, realization of previously deferred intercompany profits
increases investment income and the investment in subsidiary account for the
parent company’s proportionate share.