advanced financial accounting 7e (baker lembre king).chap007

8/7/2019 Advanced Financial Accounting 7e (Baker Lembre King).Chap007

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McGraw-Hill/Irwin 2008 The McGraw-Hill Companies, Inc. All rights reserved.

7

Intercompany Inventory Transactions


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Inventory transactions are the most commonform of intercorporate exchange.

Significantly, the consolidation proceduresrelating to inventory transfers are quite similar

to those discussed in Chapter 6 relating tofixed assets.


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Conceptually, the elimination of inventorytransfers between related companies is no

different than for other types of intercompanytransactions.


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All revenue and expense items recorded bythe participants must be eliminated fully in

preparing the consolidated income statement,and all profits and losses recorded on thetransfers are deferred until the items are soldto a nonaffiliate.


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The eliminations ensure that only the historicalcost of the inventory to the consolidated entity

is included in the consolidated balance sheetwhen the inventory is still on hand and ischarged to cost of goods sold in the periodthe inventory is resold to nonaffiliates.


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Transfers at Cost

Merchandise sometimes is sold to relatedcompanies at the sellers cost or carrying value.

When an intercorporate sale includes no profitor loss, the balance sheet inventory amounts at

the end of the period require no adjustment forconsolidation because the carrying amount ofthe inventory for the purchasing affiliate is thesame as the cost to the transferring affiliate and

the consolidated entity.


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Transfers at Cost

Even when the intercorporate sale includes noprofit or loss, however, an eliminating entry is

needed to remove both the revenue from theintercorporate sale and the related cost ofgoods sold recorded by the seller.


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Transfers at Cost

This avoids overstating these two accounts.

Consolidated net income is not affected by theeliminating entry when the transfer is made atcost because both revenue and cost of goods

sold are reduced by the same amount.


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Transfers at a Profit or Loss

Companies use many different approaches insetting intercorporate transfer prices.

In some companies, the sale price to an affiliateis the same as the price to any other customer.

Some companies routinely mark up inventorytransferred to affiliates by a certain percentageof cost.


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Transfers at a Profit or Loss

Regardless of the method used in settingintercorporate transfer prices, the elimination

process must remove the effects of such salesfrom the consolidated statements.

When intercorporate sales include profits orlosses, there are two aspects of the workpapereliminations needed in the period of transfer toprepare consolidated financial statements (see

next two slides).


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First Aspect: Income Statement Focus

When intercompany sales include profits orlosses, the workpaper eliminations needed forconsolidation in the period of transfer mustadjust accounts in both the consolidated incomestatement and balance sheet.


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First Aspect: Income Statement Focus

Income statement: sales and cost of goods sold.The sales revenue from the intercompany saleand the related cost of goods sold recorded bythe transferring affiliate must be removed.


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Second Aspect: Balance Sheet Focus

Elimination from the inventory on the balancesheet of any profit or loss on the intercompany

sale that has not been confirmed by resale ofthe inventory to outsiders.

Profit or loss on the intercompany sale must beremoved so the inventory is reported at the costof the consolidated entity.


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Effect of Inventory System

Most companies use either a perpetual orperiodic inventory control system to keeptrack of inventory and cost of goods sold.


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Effect of Inventory System

Because most companies use perpetualinventory systems, the discussion in the chapterfocuses on the consolidation procedures usedin connection with perpetual inventories.


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Downstream SalePerpetual System

For consolidation purposes, profits recorded onan intercorporate inventory sale are recognizedin the period in which the inventory is resold toan unrelated party.


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Consolidated net income must be based on therealized income of the transferring affiliate.

Because intercompany profits from downstreamsales are on the books of the parent,consolidated net income and the overall claim of

parent company shareholders must be reducedby the full amount of the unrealized profits.


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When a company sells an inventory item toan affiliate, one of three situations results:

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

by the purchasing affiliate.


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1. Profit Realized in Same Period

Required Elimination Entry:

Sales $10,000Cost of Goods Sold $10,000

*Note the elimination entry does not effect consolidated netincome because sales and cost of goods sold both arereduced by the same amount.

[Continued on next slide.]


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1. Profit Realized in Same Period

No elimination of intercompany profit is neededbecause all of the intercompany profit has been

realized through resale of the inventory to theexternal party during the current period.


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2. Profit Realized in Next Period

When inventory is sold to an affiliate at a profitand the inventory is not resold during the same

period, appropriate adjustments are needed toprepare consolidated financial statements inthe period of the intercompany sale and in eachsubsequent period until the inventory is sold to

a nonaffiliate.[Continued on next slide.]


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By way of illustration, assume that PeerlessProducts purchases inventory in 20X1 for $7,000

and sells the inventory during the year to SpecialFoods for $10,000. Thereafter, Special Foodssells the inventory to Nonaffiliated Corporationfor $15,000 on January 2, 20X2.


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Required Elimination Entry (20X1):

Sales $10,000Cost of Goods Sold $7,000

Inventory $3,000


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3. Inventory Held Two or More Periods

Companies may carry the cost of inventory

purchased from an affiliate for more than oneaccounting period. For example, the cost ofan item may be in a LIFO inventory layer andwould be included as part of the inventorybalance until the layer is liquidated.


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Prior to liquidation, an eliminating entry is

needed in the consolidation workpaper eachtime consolidated statements are prepared torestate the inventory to its cost to theconsolidated entity.


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For example, if Special Foods continues to hold

the inventory purchased from Peerless Products.

The following eliminating entry is needed in theconsolidation workpaper each time a consolidated

balance sheet is prepared for years following the

year of intercompany sale, for as long as the

inventory is held:

[Continued on next slide]


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Retained Earnings, January 1 $3,000

Inventory $3,000

Eliminate beginning inventory profit.


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Note: No income statement adjustments are

needed in the periods following the intercorporate

sale until the inventory is resold to parties external

to the consolidated entity.


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Upstream Sale Perpetual System

When an upstream sale of inventory occurs andthe inventory is resold by the parent to a

nonaffiliate during the same period All the eliminating entries in the consolidation

work paper are identical to those in thedownstream case.


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When the inventory is not resold to a nonaffiliatebefore the end of the period, work paper

eliminating entries are different from thedownstream case only by the apportionment ofthe unrealized intercompany profit to both thecontrolling and noncontrolling interests.


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The elimination of the unrealized intercompanyprofit must reduce the interests of both

ownership groups each period until the profit isconfirmed by resale of the inventory to anonaffiliated party.


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Sale from One Subsidiary to Another

Transfers of inventory often occur betweencompanies that are under common control or

ownership. When one subsidiary sells merchandise to

another subsidiary, the eliminating entries areidentical to those presented earlier for sales

from a subsidiary to its parent.


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Sale from One Subsidiary to Another

The full amount of any unrealized intercompany

profit is eliminated, with the profit eliminationallocated proportionately against the ownershipinterests of the selling subsidiary.


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Costs Associated with Transfers

When inventory is transferred from one affiliate

to another, some additional cost, such as freight,is often incurred in the transfer.

This cost should be treated in the same way asif the affiliates were operating divisions of asingle company.


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Costs Associated with Transfers

If the additional cost would be inventoried in

transferring the units from one location toanother within the same company, thattreatment also would be appropriate forconsolidation.


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Lower of Cost or Market

Inventory purchased from an affiliate might bewritten down by the purchasing affiliate under

the lower-of-cost-or-market rule if the marketvalue at the end of the period is less than theintercompany transfer price.



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Such a situation can be illustrated by assumingthat a parent company purchases inventory for

$20,000 and sells it to its subsidiary for $35,000.Also, assume that the subsidiary still holds theinventory at year-end and determines that itsmarket value (replacement cost) is $25,000 at

that time.



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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:

Loss on Decline in

Value of Inventory $10,000

Inventory $10,000

Write inventory down to market value.


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While this entry revalues the inventory to$25,000 on the books of the subsidiary, the

appropriate valuation from a consolidatedviewpoint is the $20,000 original cost of theinventory to the parent.

7 40


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Therefore, the eliminating entryshown on the

next slideis needed in the consolidated

workpaper.

7 41


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Sales $35,000

Cost of Goods Sold $20,000

Inventory $5,000

Loss on Decline in

Value of Inventory $10,000Eliminate intercompany sale ofinventory.

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The inventory loss recorded by the subsidiary

must be eliminated because the $20,000inventory valuation for consolidation purposes isbelow the $25,000 market value of the inventory.

7 43


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Sales and Purchases before Affiliation

Sometimes companies that have sold inventory

to one another later join together in a businesscombination.


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As a general rule, the effects of transactions that

are not the result of arms length bargainingmust be eliminated.

However, the combining of two companies doesnot necessarily mean that their prior transactionswith one another were not arms length.

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The circumstances surrounding the prior

transactions, such as the price and quantity ofunits transferred, would have to be examined.

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In the absence of evidence to the contrary,

companies that have joined together in abusiness combination are viewed as havingbeen separate and independent prior to thecombination.

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Thus, if the prior sales were the result of

arms-length bargaining, they are viewed astransactions between unrelated parties.

Accordingly, no elimination or adjustment isneeded in preparing consolidated statementssubsequent to the combination, even if theinventory is still held by an affiliate.

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Additional Considerations

The frequency of intercompany inventory

transfers and the varied circumstances underwhich they may occur raise a number ofadditional implementation issues.

Transfers of inventory often occur between

companies that are under common control orownership.

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Summary of Key Concepts

Consolidated financial statements are preparedfor the consolidated entity as if it were a single

company.

Therefore, the effects of all transactions betweencompanies within the entity must be eliminatedin preparing consolidated financial statements.

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For intercompany inventory transactions, the

intercompany sale and cost of goods sold mustbe eliminated.

In addition, the intercompany profit may not berecognized in consolidation until it is confirmedby resale of the inventory to an external party.

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Unrealized intercompany profits must be

eliminated fully and are allocated proportionatelyagainst the stockholder groups of the sellingaffiliate.


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If the inventory is still held at the end of the

period, it must be adjusted to its actual cost tothe consolidated entity.

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You Will Survive This Chapter!!!

You cant make money selling to yourself !!!


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7


End of Chapter

advanced financial accounting 7e (baker lembre king).chap007

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