Chapter 4 Intercompany Transactions: Topic 1, Merchandise. Student Learning Outcomes
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1 Chapter 4 Intercompany Transactions: Topic 1, Merchandise Dr. Chula King Advanced Accounting The University of West Florida 1 Student Learning Outcomes Explain why transactions between members of a consolidated firm should not be reflected in the consolidated financial statements Defer intercompany profits on merchandise sales when appropriate and eliminate the double counting of sales between affiliates Next topic: Intercompany sales of depreciable assets and intercompany loans and notes 2 Back to Intermediate I: Perpetual Inventory System Purchased $10,000 of inventory for cash: Sold all of the inventory for $15,000: Cost of Goods Sold (COGS) 10,000 Gross Profit = Sales COGS = 15,000 10,000 = 5,000 Gross Profit % = Gross Profit Sales = 5,000 15,000 = 33% 3
2 The Problem Company A Company B 10,000 15,000 20,000 Cash 20,000 Sales 20,000 COGS 10,000 COGS 15,000 What is the combined sales? 15, ,000 = 35,000 What is the combined COGS? 10, ,000 = 25,000 What sales should be recognized by the group? What COGS should be recognized by the group? 4 The Culprit Company A Company B 10,000 15,000 20,000 Cash 20,000 Sales 20,000 COGS 10,000 COGS 15,000 What is the combined sales? 15, ,000 = 35,000 What is the combined COGS? 10, ,000 = 25,000 What sales should be recognized by the group? What COGS should be recognized by the group? 5 The Solution Eliminate the intercompany sale: COGS 15,000 6
3 What if the Intercompany Inventory is Still on Hand? Company A 10,000 15,000 COGS 10,000 Company B What is book value of ending inventory? 15,000 What should be the value of the ending inventory? What is the culprit? The $5,000 gross profit from the intercompany sale (15,000-10,000) 7 The Solution Eliminate the gross profit in the ending inventory COGS 5,000 Whose? Inventory 5,000 The Seller s! Why the Seller s? Just because! 8 From Intermediate II Ending inventory is overstated Cost of goods sold is understated Net Income is overstated Retained earnings is overstated What about next year? Beginning inventory is overstated and Retained earnings is overstated So What? Must eliminate gross profit from beginning inventory Retained earnings 5,000 Cost of Goods Sold 5,000 Whose? The Seller s! Just because! 9
4 The Rules The SELLER is charged for ALL Income effects of the eliminations. Eliminate the intercompany sale Sales (seller) COGS (seller) Because the seller is charged with both income statement components of the intercompany sale, the effect on income is zero. 10 The Rules (continued) Eliminate gross profit in beginning inventory (overstatement of beginning inventory) Gross profit % x intercompany goods in beginning inventory Parent is the seller: Retained Earnings (parent/seller) COGS (parent/seller) Subsidiary is the seller: Retained Earnings (parent %) Retained Earnings (subsidiary NCI%) COGS (subsidiary/seller) 11 The Rules (continued) Eliminate gross profit in ending inventory (overstatement of ending inventory) Gross Profit % x intercompany goods in ending inventory COGS (seller) Inventory 12
5 Anything Else? Lower of Cost or Market (LOCOM) Back to Intermediate I Cost versus Market Lower of cost or market If market is lower COGS Inventory Elimination of Gross Profit in E/I COGS Inventory LOCOM to intercompany goods Any LOCOM applied has already eliminated part or all of the gross profit in ending inventory Elimination entry eliminates any remaining gross profit in ending inventory 13 Example P Corporation owns 80% of S Company. During 20X1 P sold $80,000 in goods to S for $100,000. S held $20,000 of goods purchased from P in its beginning inventory, and $30,000 of such goods in its ending inventory. What elimination entries would be required? Gross profit = $100,000 $80,000 = $20,000 Gross profit % = $20, ,000 = 20% 14 The Facts P (the parent) is the seller Intercompany sales = $100,000 Gross profit in beginning inventory = 20% x $20,000 = $4,000 Gross profit in ending inventory = 20% x $30,000 = $6,000 15
6 Elimination Entries Sales (P) 100,000 COGS (P) 100,000 (to eliminate intercompany sale) R/E P 4,000 COGS (P) 4,000 (to eliminate gross profit in beginning inventory) COGS (P) 6,000 Inventory 6,000 (to eliminate gross profit in ending inventory) 16 What if S had been the seller? Sales (S) 100,000 COGS (S) 100,000 (to eliminate intercompany sale) R/E P (80% x 4,000) 3,200 R/E S (20% x 4,000) 800 COGS (S) 4,000 (to eliminate gross profit in beginning inventory) COGS (S) 6,000 Inventory 6,000 (to eliminate gross profit in ending inventory) 17 Concluding Comments Intercompany sales of inventory must be eliminated to avoid double counting The Rules The SELLER is charged for ALL Income effects of the eliminations. Eliminate the intercompany sale Eliminate gross profit in beginning inventory; parent is seller R/E P; Subsidiary is seller split R/E Eliminate gross profit in ending inventory, adjusted for any LOCOM valuation 18
7 The Next Step Topic 2 Intercompany sales of depreciable assets and intercompany loans and notes Work Exercise 3 Work Problems 2, 5 Intercompany sales of inventory 19
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