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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.
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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 CostMethod
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 manipulateincome.
The Substance of Inventory Transfers • The CONSOLIDATED Perspective: • Merely the physical movement of inventory from onelocation to anotherlocation. • Similar to the movement of inventory from onedivision to anotherdivision. • 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.................... $1,000 Cost of sales....... (600) GROSS profit. $ 400
Conceptual Issues:Issue #3Whether To Eliminate Income Tax Effects ? • Income taxes on the selling entity’sUNREALIZEDgross 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’sgeneral ledger. • DONEFOR SIMPLICITY ONLY.
Conceptual Issues:Issue #4Whether To Eliminate All or Some? • DOWNSTREAM Sales to a Partially Owned Subsidiary: • Eliminate 100% of unrealized profit. • Fractionalelimination is prohibited. • UPSTREAM Sales from a Partially Owned Subsidiary: • Eliminate 100% of unrealized profit. • Fractionalelimination 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 outsideunaffiliated 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- OnTotalSoldHand Interco. sales (NEW basis)............. $1,000 $200 Interco. 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- OnTotalSoldHand Interco. sales (NEW basis).............. $1,000 $800 $200 Interco. 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: • the selling entity’s cost or • 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 #1 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 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 #2 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 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 #3 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 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?