Chapter 5

Intercompany
Profit
Transactions –
Inventories
Intercompany Profits – Inventories:
Objectives
1. Understand the impact of intercompany profit
in inventories on preparing consolidation
workpapers.
2. Apply the concepts of upstream versus
downstream inventory transfers.
3. Defer unrealized inventory profits remaining in
the ending inventory.
4. Recognize realized, previously deferred,
inventory profits in the beginning inventory.

© Pearson Education Limited 2015 5-2

Objectives (cont.)

5. Adjust noncontrolling interest amounts in the

presence of intercompany inventory profits.

© Pearson Education Limited 2015 5-3

 Intercompany Profit Transactions – Inventories

1: INTERCOMPANY
INVENTORY PROFITS

© Pearson Education Limited 2015 5-4

Intercompany Transactions

For consolidated financial statements

– “intercompany balances and transactions shall be
eliminated.” [FASB ASC 810-10-45-1]
Show income and financial position as if the
intercompany transactions had never taken
place.

© Pearson Education Limited 2015 5-5

Intercompany Sales of Inventory

Profits on intercompany sales of inventory

– Recognized if goods have been resold to
outsiders
– Deferred if the goods are still held in inventory
Previously deferred profits in beginning
inventory are recognized in the period the
goods are sold. Assuming FIFO
– Beginning inventories are sold
– Ending inventories are from current purchases

© Pearson Education Limited 2015 5-6

No Intercompany Profits in
Inventories
During 2012, Pet sold goods costing $1,000 to its
subsidiary, Sim, at a gross profit of 30%. Sim had none of
this inventory on hand at the end of 2011. The worksheet
entry for 2011:

Sales (-R, -SE) 1,429

Cost of sales (-E, +SE) 1,429
Eliminate intercompany sales = $1,000 / (1-30%) = $1,429

All intercompany sales of inventories have been resold to

outside parties, so remove the full sales price from both
sales and cost of sales.
Pet's sales are reduced $1,429.
Sim's cost of sales are reduced $1,429.
The same entry is used if Sim sells to Pet.

© Pearson Education Limited 2015 5-7

Intercompany Profits Only in Ending
Inventories
Last year, 2011, Pal sold goods costing $500 to its
subsidiary, Sal, at a gross profit of 25%. Sal had none of
this inventory on hand at the end of 2011.
During 2012, Pal sold additional goods costing $900
to Sal at a gross profit of 40%. Sal has $200 of these
goods on hand at 12/31/2012. Worksheet entries for
2012:

Sales (-R, -SE) 1,500

Cost of sales (-E, +SE) 1,500
Eliminate intercompany sales = $900 / (1-40%) = $1,500
Cost of sales (E, -SE) 80
Inventory (-A) 80
Defer profit in ending inventory = $200 x 40%

© Pearson Education Limited 2015 5-8

Intercompany Profits Beginning and
Ending Inventories
Last year, 2011, Pam sold goods costing $300 to its
subsidiary, Sir, at mark-up of 25%. Sir had $120 of this
inventory on hand at the end of 2011.
During 2012, Pam sold additional goods costing $500 to
Sir at a 30% mark-up. Sir has $260 of these goods on
hand at 12/31/2012. Worksheet entries for 2012:
Sales (-R, -SE) 650
Cost of sales (-E, +SE) 650
Eliminate intercompany sales = $500 + 30%($500) = $650
Cost of sales (E, -SE) 60
Inventory (-A) 60
Defer profits in ending inventory = $260 x 30%/130%
Investment in Subsidiary (+A) 24
Cost of sales (-E, +SE) 24
Realize profits from beginning inventory = $120 x 25%/125% = $24

© Pearson Education Limited 2015 5-9

 Intercompany Profit Transactions – Inventories

2: UPSTREAM &
DOWNSTREAM
INVENTORY SALES

© Pearson Education Limited 2015 5-10

Upstream and Downstream Sales

Downstream
Sales

Parent sells to Parent Subsidiary sells

subsidiary to parent

Subsidiary Subsidiary Subsidiary

1 2 3
Upstream Sales

© Pearson Education Limited 2015 5-11

Intercompany Inventory Sales
The worksheet entries for eliminating intercompany profits for
downstream sales
Sales (-R, -SE) XXX
Cost of sales (-E, +SE) XXX
For the intercompany sales price
Cost of sales (E, -SE) XX
Inventory (-A) XX
For the profits in ending inventory
Investment in Subsidiary (+A) XX
Cost of sales (-E, +SE) XX
For the profits in beginning inventory

For upstream sales, the last entry would include a debit to

noncontrolling interest, sharing the realized profit between
controlling and noncontrolling interests.

© Pearson Education Limited 2015 5-12

Data for Example

For the year ended 12/31/2011:

– Subsidiary income is $5,200
– Subsidiary dividends are $3,000
– Current amortization of acquisition price is $450
Intercompany (IC) sales information:
– IC sales during 2011 were $650
– IC profit in ending inventory $60
– IC profit in beginning inventory $24

© Pearson Education Limited 2015 5-13

Income Sharing with Downstream
Sales – PARENT Makes Sale

Subsidiary net income $5,200 CI 80% share

Current amortizations (450) $3,800
Adjusted income $4,750
(60)

Defer profits in EI (60) 24

Recognize profits in BI 24 $3,764 Income from
subsidiary
Income
recognized $4,714 $2,400 NCI 20% share
Subsidiary dividends $3,000 $950

When parent makes the IC

sale, the impact of deferring
and recognizing profits falls
all to the parent. $600

© Pearson Education Limited 2015 5-14

Income Sharing with Upstream Sales
– SUBSIDIARY Makes Sale
CI 80% share

Subsidiary net income $5,200 $3,800

Current amortizations (450) (48)
Adjusted income $4,750 19.2
$3,771.2 Income from
Defer profits in EI (60) subsidiary
Recognize profits in BI 24
$2,400
Income recognized $4,714
NCI 20% share

Subsidiary dividends $3,000 $950.0

(12.0)

When subsidiary makes the IC 4.8

sale, the impact of deferring and $942.8
recognizing profits is split among
controlling and noncontrolling
interests. $600

© Pearson Education Limited 2015 5-15

 Intercompany Profit Transactions – Inventories

3: UNREALIZED PROFITS
IN ENDING INVENTORIES

© Pearson Education Limited 2015 5-16

Ending Inventory on Hand

Intercompany profits in ending inventory

– Eliminate at year end
Working paper entry

Cost of sales (E, -SE) XXX

Inventories (-A) XXX

For the unrealized profit

© Pearson Education Limited 2015 5-17

Parent Accounting
Pot owns 90% of Sot acquired at book value
(no amortizations). During the current year,
Sot reported $10,000 income. Pot sold goods to
Sot during the year for $15,000 including a
profit of $6,250. Sot still holds 40% of these
goods at the end of the year.
Unrealized profit in ending inventory
40%(6,250) = $2,500
Pot's Income from Sot
90%(10,000) – 2,500 unrealized profits = $6,500
Noncontrolling interest share
10%(10,000) = $1,000

© Pearson Education Limited 2015 5-18

Entries
Pot's journal entry to record income (net of
unrealized profit).

Investment in Sot (+A) 6,500

Income from Sot (R, +SE) 6,500

Worksheet entries to eliminate intercompany sale

and unrealized profits

Sales (-R, -SE) 15,000

Cost of goods sold (-E, +SE) 15,000

Cost of goods sold (E, -SE) 2,500

Inventory (-A) 2,500

© Pearson Education Limited 2015 5-19

Worksheet – Income Statement
Pot Sot DR CR Consol
$100.
Sales 0 $50.0 15.0 $135.0
Income from Sot 6.5 6.5 0.0
15.
Cost of sales (60.0) (35.0) 2.5 0 (82.5)
Expenses (15.0) (5.0) (20.0)
Noncontrolling interest
share 1.0 (1.0)
Controlling interest
share $31.5 $10.0 $31.5

There would be a credit adjustment to Inventory for $2.5 on

the balance sheet portion of the worksheet.

© Pearson Education Limited 2015 5-20

What if?
If the sales had been upstream, by Sot to Pot:
Unrealized profits in ending inventory
40%(6,250) = $2,500
Pot's Income from Sot
90%(10,000 – 2,500) = $6,750
Noncontrolling interest share
10%(10,000 – 2,500) = $750

Upstream profits impact both:

– Controlling interest share
– Noncontrolling interest share

© Pearson Education Limited 2015 5-21

 Intercompany Profit Transactions – Inventories

4: RECOGNIZING PROFITS
FROM BEGINNING
INVENTORIES

© Pearson Education Limited 2015 5-22

Intercompany Profits in Beginning
Inventory

Unrealized profits in
ending inventory one year

Become

Profits to be recognized in the beginning

inventory of the next year!
© Pearson Education Limited 2015 5-23
 Intercompany Profit Transactions – Inventories

5: IMPACT ON
NONCONTROLLING
INTEREST

© Pearson Education Limited 2015 5-24

Direction of Sale and NCI

The impact of unrealized profits in ending

inventory and realizing profits in beginning
inventory depends on the direction of the
intercompany sales
Downstream sales
– Full impact on parent
Upstream sales
– Share impact between parent and noncontrolling
interest

© Pearson Education Limited 2015 5-25

Calculating Income and NCI

Downstream sales:
Income from sub
= CI%(Sub's NI) – Profits in EI + Profits in BI
Noncontrolling interest share
= NCI%(Sub's NI)
Upstream sales:
Income from sub
= CI%(Sub's NI – Profits in EI + Profits in BI)
Noncontrolling interest share
= NCI%(Sub's NI – Profits in EI + Profits in BI)

© Pearson Education Limited 2015 5-26

Upstream Example with
Amortization
Perry acquired 70% of Salt on 1/1/2011 for $420 when Salt's
equity consisted of $200 capital stock and $200 retained
earnings. Salt's inventory was understated by $50 and building,
with a 20-year life, was understated by $100. Any excess is
goodwill.
2011 2012
Perry Salt Perry Salt
Separate income $1,250 $705 $1,500 $745
Dividends $600 $280 $600 $300

During 2011, Salt sold goods for $700 to Perry at a 20%

markup. $240 of these goods were in Perry's ending inventory.
In 2012, Salt sold goods for $900 to Perry at a 25% markup and
Perry still had $100 on hand at the end of the year.

© Pearson Education Limited 2015 5-27

Analysis and Amortization

Cost of 70% of Salt $420

Implied value of Salt 420/.70 $600
Book value 200 + 200 400
Excess $200

Unamort Amort Unamort Amort Unamort

Allocated to: 1/1/11 2011 1/1/12 2012 12/31/12
Inventory 50 (50) 0 0 0
Building 100 (5) 95 (5) 90
Goodwill 50 0 50 0 50
200 (55) 145 (5) 140

© Pearson Education Limited 2015 5-28

2011 Income Sharing (Upstream)

Salt's net income $705

CI 70% share
Current
amortizations (55) $455
Adjusted income $650 ($28)
$427 Income from Salt
Defer profits in EI (40)
Income recognized $610 $196

NCI 30% share

Subsidiary dividends $280 $195
($12)
$183

$84

© Pearson Education Limited 2015 5-29

Perry's 2011 Equity Entries

Investment in Salt (+A) 420

Cash (-A) 420
For acquisition of 70% of Salt
Cash (+A) 196
Investment in Salt (-A) 196
For dividends received
Investment in Salt (+A) 427
Income from Salt (R, +SE) 427
For share of income

© Pearson Education Limited 2015 5-30

2011 Worksheet Entries (1 of 3)

1. Adjust for errors & omissions - none

2. Eliminate intercompany profits and losses

Sales (-R, -SE) 700

Cost of sales (-E, +SE) 700

Cost of Sales (E, -SE) 40

Inventory (-A) 40

3. Eliminate income & dividends from sub. and bring Investment

account to its beginning balance
Income from Salt (-R, -SE) 427
Dividends (+SE) 196

Investment in Salt (-A) 231

© Pearson Education Limited 2015 5-31

2011 Entries (2 of 3)

4. Record noncontrolling interest in sub's earnings & dividends

Noncontrolling interest share (-SE) 183
Dividends (+SE) 84
Noncontrolling interest (+SE) 99
5. Eliminate reciprocal Investment & sub's equity balances
Capital stock (-SE) 200
Retained earnings (-SE) 200
Inventory (+A) 50
Building (+A) 100
Goodwill (+A) 50
Investment in Salt (-A) 420
Noncontrolling interest (+SE) 180

© Pearson Education Limited 2015 5-32

2011 Entries (3 of 3)

6. Amortize fair value/book value differentials

Cost of sales (E, -SE) 50

Inventory (-A) 50
Depreciation expense (E, -SE) 5
Building (-A) 5

7. Eliminate other reciprocal balances – none

© Pearson Education Limited 2015 5-33

2012 Income Sharing (Upstream)

Salt's net income $745

Current CI 70% share
amortizations (5) $518
Adjusted income $740 ($14)
$28
Defer profits in EI (20) $532 Income from
Realize profits from Salt
BI 40 $210
Income recognized $760
NCI 30% share
$222
Subsidiary dividends $300
($6)
$12
$228

$90
© Pearson Education Limited 2015 5-34
Perry's 2012 Equity Entries

Cash (+A) 210

Investment in Salt (-A) 210
For dividends received
Investment in Salt (+A) 532
Income from Salt (R, +SE) 532
For share of income

© Pearson Education Limited 2015 5-35

2012 Worksheet Entries (1 of 3)
1. Adjust for errors & omissions - none
2. Eliminate intercompany profits and losses
Sales (-R, -SE) 900
Cost of sales (-E, +SE) 900
Cost of Sales (E, -SE) 20
Inventory (-A) 20
Investment in Salt (+A) 28
Noncontrolling interest (-SE) 12
Cost of sales (-E, +SE) 40

3. Eliminate income & dividends from sub. and bring

Investment account to its beginning balance
Income from Salt (-R, -SE) 532
Dividends (+SE) 210
Investment in Salt (-A) 322

© Pearson Education Limited 2015 5-36

2012 Entries (2 of 3)

4. Record noncontrolling interest in sub's earnings &

dividends
Noncontrolling interest share (-SE) 228
Dividends (+SE) 90
Noncontrolling interest (+SE) 138

5. Eliminate reciprocal Investment & sub's equity balances

Capital stock (-SE) 200
Retained earnings (-SE) 625
Inventory (+A) 0
Building (+A) 95
Goodwill (+A) 50
Investment in Salt (-A) 679
Noncontrolling interest (+SE) 291

© Pearson Education Limited 2015 5-37

2012 Entries (3 of 3)

6. Amortize fair value/book value differentials

Depreciation expense (E, -SE) 5

Building (-A) 5

7. Eliminate other reciprocal balances – none

© Pearson Education Limited 2015 5-38