CHAPTER 9

INTERCOMPANY INVENTORY TRANSFERS

FOCUS OF CHAPTER 9

• Conceptual Issues• Procedures for Calculating Unrealized Profit• Procedures for Deferring Unrealized Profit:

– The Complete Equity Method– The Partial Equity Method– The Cost Method

Conceptual Issues: Issue #1Should We or Shouldn’t We?

• Whether to Eliminate Intercompany Transactions in Consolidation:– No controversy—they must be

eliminated.– Not eliminating causes two problems:

• Meaningless double-counting of (1) sales and (2) cost and expenses.

• Potential to manipulate income.

The Substance of Inventory Transfers

• The CONSOLIDATED Perspective:– Merely the physical movement of

inventory from one location to another location.

– Similar to the movement of inventory from one division to another division.

– NOT a bona fide transaction.• The SEPARATE COMPANY Perspective:

– A bona fide transaction.

Conceptual Issues: Issue #2Which Measure of Profit To Use?

• Possible Theoretical Profit Measures:– Gross profit.– Operating profit.– Net income.

• Profit Measure Required To Be Used By GAAP:– GROSS PROFIT

(of the selling entity).Sales.................... $1,000Cost of sales....... (600) GROSS profit. $ 400

Conceptual Issues: Issue #3Whether To Eliminate Income Tax Effects ?

• Income taxes on the selling entity’s UNREALIZED gross profit must also be eliminated.

• In this chapter :– No income tax entries are required.– Because we assume that the tax effects

have already been recorded in the parent’s or the subsidiary’s general ledger.• DONE FOR SIMPLICITY ONLY.

Conceptual Issues: Issue #4Whether To Eliminate All or Some?

• DOWNSTREAM Sales to a Partially Owned Subsidiary:– Eliminate 100% of unrealized profit.– Fractional elimination is prohibited.

• UPSTREAM Sales from a Partially Owned Subsidiary:– Eliminate 100% of unrealized profit.– Fractional elimination is prohibited.

Conceptual Issues: Issue #5Whether To Share the Deferral?

• DOWNSTREAM Sales to a Partially Owned Subsidiary:– Entire profit accrues to the parent—thus

sharing is not appropriate.• UPSTREAM Sales from a Partially

Owned Subsidiary:– Must share deferral with the NCI

shareholders (if amount is material).

Inventory Transfers: A Whole New Slant on “Realization”

• REALIZATION—What to focus on for consolidated reporting purposes:– Not on whether the SELLER has—

• Delivered the product,• Collected on the sale, or• Reduced to an acceptable level the

uncertainty about the net cash flow effect of an earnings activity.

Inventory Transfers: A Whole New Slant on “Realization”

• REALIZATION—What to focus on for consolidated reporting purposes:– But on whether the BUYER has:

• Resold the inventory to an outside unaffiliated customer.

Inventory Transfers: Unrealized Profit—Searching for that Old Basis

• The Objective: – To change the inventory’s carrying value

from the NEW basis of accounting to the OLD basis of accounting.

Inventory Transfers: Calculating Unrealized Gross Profit—The Analysis

Amounts That Will ALWAYS Be Known (Given): Re- On Total Sold HandInterco. sales (NEW basis)............. $1,000 $200Interco. cost of sales (OLD basis).. (600) ____ ____ Gross Profit.................................... $ 400 Gross Profit Percentage............... 40%

CRITICAL ASSUMPTION: The gross profit percentage derivable from the total column applies to both (1) the inventory that has been resold AND (2) the inventory that is still on hand.

Inventory Transfers: Calculating Unrealized Gross Profit—The Analysis

Completed Analysis: Re- On Total Sold HandInterco. sales (NEW basis).............. $1,000 $800 $200Interco. cost of sales (OLD basis).. (600) (480) (120) Gross Profit.................................... $ 400 $320 $ 80

REALIZED UNREALIZED The Inventory/COS Change in Basis Elimination Entry is derived from this analysis.

Inventory Transfers: A Point to Remember

• Intercompany Sales and Intercompany Cost of Sales accounts are eliminated only in years in which intercompany sales occur.

Inventory Transfers: The Two Procedural Methods

• MODULE 1: The Complete Equity Method:– Unrealized profit is deferred in the

selling entity’s general ledger.• MODULE 2: The Partial Equity Method:

– Unrealized profit is deferred in the consolidation process.

Miscellaneous:Lower-of-Cost-or-Market Adjustments

• For consolidated reporting purposes, the appropriate valuation of intercompany- acquired inventory is:

– The lower of:

(1) the selling entity’s cost or

(2) the market value.

Miscellaneous: Partial Ownerships—Reporting to the NCI Shareholders

• Under existing GAAP, a partially owned subsidiary:– Need not defer any of its unrealized

intercompany gross profit in reporting to its NCI shareholders.

Review Question #1For 2006, Paxco reported $60,000 of intercompany sales (25% markup on cost and fully paid for by Y/E) to Saxco, which reported $20,000 of intercompany acquired inventory at 12/31/06. The unrealized profit at 12/31/06 is:A. $ -0- B. $4,000 C. $5,000 D. $20,000 E. None of the above.

Review Question #1With Answer

For 2006, Paxco reported $60,000 of intercompany sales (25% markup on cost and fully paid for by Y/E) to Saxco, which reported $20,000 of intercompany acquired inventory at 12/31/06. The unrealized profit at 12/31/06 is:A. $ -0- B. $4,000 (20% of $20,000 Y/E inventory) C. $5,000 D. $20,000 E. None of the above.

Review Question #2For 2006, Punco reported intercompany cost of sales of $1,600,000 (markup is 20% of transfer price) to Sunco, which reported $600,000 of intercompany acquired inventory at 12/31/06. The unrealized profit at 12/31/06 is:A. $80,000 B. $96,000 C. $120,000 D. $150,000 E. None of the above.

Review Question #2With Answer

For 2006, Punco reported intercompany cost of sales of $1,600,000 (markup is 20% of transfer price) to Sunco, which reported $600,000 of intercompany acquired inventory at 12/31/06. The unrealized profit at 12/31/06 is:A. $80,000 B. $96,000 C. $120,000 (20% of $600,000 Y/E inventory)D. $150,000 E. None of the above.

Review Question #3For 2006, Salco (80% owned by Palco) reported $800,000 of intercompany sales (1/3 markup on cost) to Palco, which resold $700,000 of this inventory by 12/31/06. The unrealized profit at 12/31/06 is:A. $20,000 B. $25,000 C. $26,667 D. $33,333 E. None of the above.

Review Question #3With Answer

For 2006, Salco (80% owned by Palco) reported $800,000 of intercompany sales (1/3 markup on cost) to Palco, which resold $700,000 of this inventory by 12/31/06. The unrealized profit at 12/31/06 is:A. $20,000 B. $25,000 (25% x $100,000 inventory on hand)

C. $26,667 D. $33,333 E. None of the above.

End of Chapter 9

Time to Clear Things Up—Any Questions?