Chapter 5: Intercompany Profit

Transactions – Inventories
by Jeanne M. David, Ph.D., Univ. of Detroit Mercy

to accompany
Advanced Accounting, 10th edition
by Floyd A. Beams, Robin P. Clement,
Joseph H. Anthony, and Suzanne Lowensohn

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 Intercompany Profits –
Inventories: Objectives
1. Understand the impact of intercompany profit
for inventories on preparation of consolidation
working papers.
2. Apply the concepts of upstream versus
downstream inventory transfers.
3. Defer unrealized inventory profits remaining
in ending inventory of either the parent or
subsidiary.

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 Objectives (cont.)
4. Recognize realized, previously deferred
inventory profits in the beginning inventory of
either the parent or subsidiary.
5. Adjust the calculations of noncontrolling
interest amounts in the presence of
intercompany inventory profits.

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Intercompany Profit Transactions – Inventories
1: Intercompany Inventory Profits

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 Intercompany Transactions
• For consolidated financial statements, ARB No.
51 (as amended by FASB Statement No. 160)
states:
– "intercompany balances and transactions
shall be eliminated."
• Show income and financial position as if the
intercompany transactions had never taken
place.

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 Intercompany Sales of Inventory
• Profits on intercompany sales of inventory
– All 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
• Consider a FIFO inventory system
– Beginning inventories are sold
– Ending inventories are from current period
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 No Intercompany Profits in
Inventories
• During 2009, Pretty sold goods costing $1,000 to
its subsidiary, Simple, at a gross profit of 30%.
Simple had none of this inventory on hand at
the end of 2009. Worksheet entry for 2009:
Sales 1,429
Cost of sales 1,429
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.
– Pretty's sales are reduced $1,429.
– Simple's cost of sales are reduced $1,429.
• The same entry is used if Simple sells to Pretty.
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 Intercompany Profits Only in
Ending Inventories
• Last year, 2009, Paul 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 2009.
• During 2010, Paul sold additional goods costing
$900 to Sal at a gross profit of 40%. Sal has
$200 of these goods on hand at 12/31/2010.
Worksheet entries for 2010:
Sales 1,500
Cost of sales 1,500
Sales = $900 / (1-40%) = $1,500
Cost of sales 80
Inventory 80
Ending inventory profit = $200 x 40%
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 Intercompany Profits Beginning
and Ending Inventories
Last year, 2009, 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 2009.
During 2010, Pam sold additional goods costing $500 to Sir
at a 30% mark-up. Sir has $260 of these goods on hand
at 12/31/2010. Worksheet entries for 2010:
Sales 650
Cost of sales 650
Sales = $500 + 30%($500) = $650
Cost of sales 60
Inventory 60
Ending inv. profits = $260 x 30%/130%
Investment in Subsidiary 24
Cost of sales 24
Begin. inv. profits = $120 x 25%/125% = $24
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Intercompany Profit Transactions – Inventories
2: Upstream & Downstream
Inventory Sales

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 Upstream and Downstream Sales

Downstream
Sales
Parent

Subsidiary sells
Parent sells to to parent
subsidiary

Subsidiary 1 Subsidiary 2 Subsidiary 3

Upstream Sales

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 Intercompany Inventory Sales
• The worksheet entries for eliminating
intercompany profits for downstream sales
Sales XXX
Cost of sales XXX
For the intercompany sales price
Cost of sales XX
Inventory XX
For the profits in ending inventory
Investment in Subsidiary XX
Cost of sales XX
For the profits in beginning inventory
For upstream sales, the last entry would also include a debit
to noncontrolling interest, splitting the profit to be realized
between controlling and noncontrolling interests.
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 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 profits in ending inventory $60
– IC profit in beginning inventory $24

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 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)
24
Defer profits in EI (60) $3,764 Income from subsidiary
Recognize profits in BI 24
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
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 Income Sharing with Upstream
Sales – SUBSIDIARY Makes Sale
Subsidiary net income $5,200 CI 80% share
Current amortizations (450) $3,800
Adjusted income $4,750 (48)
19.2
Defer profits in EI (60) $3,771.2 Income from subsidiary
Recognize profits in BI 24
Income recognized $4,714 $2,400
NCI 20% share
Subsidiary dividends $3,000
$950.0
When subsidiary makes the IC sale, (12.0)
the impact of deferring and
recognizing profits is split among 4.8
controlling and noncontrolling $942.8
interests.
$600
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Intercompany Profit Transactions – Inventories
3: Unrealized Profits in Ending
Inventories

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 Ending Inventory on Hand
• Intercompany profits in ending inventory
– Eliminate at year end
• Working paper entry
Cost of sales XXX
Inventories XXX
For the unrealized profit

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

• Worksheet entries to eliminate intercompany

sale and unrealized profits
Sales 15,000
Cost of sales 15,000
Cost of sales 2,500
Inventory 2,500

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 Worksheet – Income Statement
Porter Sorter DR CR Consol
Sales $100.0 $50.0 15.0 $135.0
Income from Sorter 6.5 6.5 0.0
Cost of sales (60.0) (35.0) 2.5 15.0 (82.5)
Expenses (15.0) (5.0) (20.0)
Noncontrolling interest share 1.0 (1.0)
Controlling interest share $31.5 $7.5 $31.5
There would be a credit adjustment to Inventory for 2.5 on the
balance sheet portion of the worksheet.

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 What if?
If the sales had been upstream, by Sorter to
Porter:
• Unrealized profits in ending inventory
40%(6,250) = $2,500
• Porter's Income from Sorter
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
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Intercompany Profit Transactions – Inventories
4: Recognizing Profits from
Beginning Inventories

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 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!

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Intercompany Profit Transactions – Inventories
5: Impact on Noncontrolling Interest

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 Direction of Sale and NCI
The impact of unrealized profits in ending
inventory and realizing profits in beginning
inventory depends on the direction
• Downstream sales
– Full impact on parent
• Upstream sales
– Share impact between parent and
noncontrolling interest

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 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)
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 Upstream Example with
Amortization
Perry acquired 70% of Salt on 1/1/2009 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.
2009 2010
Perry Salt Perry Salt
Separate income $1,250 $705 $1,500 $745
Dividends $600 $280 $600 $300
During 2009, Salt sold goods costing $700 to Perry at a
20% markup. $240 of these goods were in Perry's
ending inventory.
In 2010, Salt sold goods costing $900 to Perry at a 25%
markup and Perry still had $100 on hand at the end of
the year.
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 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: 1/1/09 2009 1/1/10 2010 12/31/10
Inventory 50 (50) 0 0 0
Building 100 (5) 95 (5) 90
Goodwill 50 0 50 0 50
200 (55) 145 (5) 140

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 2009 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
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 Perry's 2009 Equity Entries
Investment in Salt 420
Cash 420
For acquisition of 70% of Salt
Cash 196
Investment in Salt 196
For dividends received
Investment in Salt 427
Income from Salt 427
For share of income

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 2009 Worksheet Entries
1. Adjust for errors & omissions - none
2. Eliminate intercompany profits and losses
Sales 700
Cost of sales 700
Cost of Sales 40
Inventory 40
3. Eliminate income & dividends from sub. and bring
Investment account to its beginning balance
Income from Salt 427
Dividends 196
Investment in Salt 231
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 2009 Entries (2 of 3)
4. Record noncontrolling interest in sub's earnings &
dividends
Noncontrolling interest share 183
Dividends 84
Noncontrolling interest 99
5. Eliminate reciprocal Investment & sub's equity
balances
Capital stock 200
Retained earnings 200
Inventory 50
Building 100
Goodwill 50
Investment in Salt 420
Noncontrolling interest 180
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 2009 Entries (3 of 3)
6. Amortize fair value/book value differentials
Cost of sales 50
Inventory 50
Depreciation expense 5
Building 5

7. Eliminate other reciprocal balances – none

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 2010 Income Sharing (Upstream)
Salt's net income $745 CI 70% share
Current amortizations (5) $518
Adjusted income $740 ($14)
$28
Defer profits in EI (20) $532 Income from Salt
Realize profits from BI 40
Income recognized $760 $210
NCI 30% share
Subsidiary dividends $300 $222
($6)
$12
$228

$90
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 Perry's 2010 Equity Entries
Cash 210
Investment in Salt 210
For dividends received
Investment in Salt 532
Income from Salt 532
For share of income

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 2010 Worksheet Entries
1. Adjust for errors & omissions - none
2. Eliminate intercompany profits and losses
Sales 900
Cost of sales 900
Cost of Sales 20
Inventory 20
Investment in Salt 28
Noncontrolling interest 12
Cost of sales 40
3. Eliminate income & dividends from sub. and bring
Investment account to its beginning balance
Income from Salt 532
Dividends 210
Investment in Salt 322
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 2010 Entries (2 of 3)
4. Record noncontrolling interest in sub's earnings &
dividends
Noncontrolling interest share 228
Dividends 90
Noncontrolling interest 138
5. Eliminate reciprocal Investment & sub's equity
balances
Capital stock 200
Retained earnings 625
Inventory 0
Building 95
Goodwill 50
Investment in Salt 679
Noncontrolling interest 291
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 2010 Entries (3 of 3)
6. Amortize fair value/book value differentials
Depreciation expense 5
Building 5
7. Eliminate other reciprocal balances – none

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