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CHAPTER 10

CHAPTER 10. INTERCOMPANY INVENTORY TRANSFERS. FOCUS OF CHAPTER 10. 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 10

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  1. CHAPTER 10 INTERCOMPANY INVENTORY TRANSFERS

  2. FOCUS OF CHAPTER 10 • Conceptual Issues • Procedures for Calculating Unrealized Profit • Procedures for Deferring Unrealized Profit: • The Complete Equity Method • The Partial Equity Method • The Cost Method

  3. Conceptual Issues: Issue #1--Should 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.

  4. 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.

  5. Conceptual Issues:Issue #2--Which 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

  6. Conceptual Issues:Issue #3--Whether 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.

  7. Conceptual Issues:Issue #4--Whether 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.

  8. Conceptual Issues:Issue #5--Whether 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).

  9. 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 floweffect of an earnings activity.

  10. 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 anoutsideunaffiliated customer.

  11. 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.

  12. Inventory Transfers: Calculating Unrealized Gross Profit--The Matrix 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.

  13. Inventory Transfers: Calculating Unrealized Gross Profit--Matrix 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.

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