Z 15030000120164005 CH 06

Advanced
Accounting
Jeter Chaney
Elimination of
Unrealized
Profit on Intercompany
Sales of Inventory
Prepared by Sheila Ammons, Austin Community College
Learning Objectives
Describe the financial reporting objectives for intercompany sales of
inventory.
Determine the amount of intercompany profit, if any, to be eliminated from
the consolidated statements.
Understand the concept of eliminating 100% of intercompany profit not
realized in transactions with outsiders, and know the authoritative position.
Distinguish between upstream and downstream sales of inventory.
Compute the noncontrolling interest in consolidated net income for upstream
and downstream sales, when not all the inventory has been sold to outsiders.
Prepare consolidated workpapers for firms with upstream and downstream
sales using the cost, partial equity, and complete equity methods.
Discuss the treatment of intercompany profit earned prior to the parentsubsidiary affiliation.
2
Copyright 2015. John Wiley & Sons, Inc. All rights reserved.
Upstream and Downstream Sales of

Inventory
Company P
P sells inventory
Downstream
Company S1
S2 sells inventory
Upstream
S1 sells inventory
Horizontal
Company S2
Consolidated Entity
Profit (loss) that has not been realized through subsequent sales to
third parties is defined as unrealized intercompany profit (loss) and
must be eliminated in the preparation of consolidated financial
statements.
3
LO 4 Upstream and downstream sales.
Effects of Intercompany Sales of Merchandise on

the Determination of Consolidated Balances
The financial reporting objectives are:
Consolidated sales include only sales with parties
outside the affiliated group.
Consolidated cost of sales includes only the cost to
the affiliated group of goods that have been sold to
parties outside the affiliated group.
Consolidated inventory on the balance sheet is
recorded at its cost to the affiliated group.
Objective is to eliminate the effects of intercompany sales as if they had never
occurred.
4
LO 1 Financial reporting objectives for intercompany sales.
Intercompany Sales of
Merchandise
Downstream
Determination of Consolidated Sales,
Sales
Cost of Sales, and Inventory Balances
E6-7: (Downstream Sales-variation) Perkins Company owns
85% of Sheraton Company. Perkins Company sells merchandise
to Sheraton Company at 20% above cost. During 2014 and 2015,
such sales amounted to $450,000 and $486,000, respectively. At
the end of each year, Sheraton Company had sold all of
inventory purchased from Perkins to third parties.
Required: Prepare the workpaper entries necessary to eliminate the

effects of the intercompany sales for 2014.
5
LO 6 Consolidated workpapers for downstream sales.
Merchandise
Downstream
Sales
E6-7: Summary of 2014 Intercompany Sales

Intercompany Sales
Intercompany COGS
Gross profit
$
$
Total
450,000
375,000
75,000
(COGS)
Resold
$
450,000
375,000
$
75,000
(Inventory)
On Hand
$
$
-
1. The Total column represents the Sales and COGS booked by Perkins to
record the sale to Sheraton. The Sales amount also represents the cost of
the inventory recorded by Sheraton.
2. The Resold column represents intercompany inventory that was resold to
third parties. Portions resold are recorded in COGS.

3. On Hand represents intercompany inventory still on hand in the affiliated
group.
6
Merchandise
Downstream
Sales
Prepare the workpaper entry to eliminate intercompany sales for

2014.
Sales 450,000
Purchases (Cost of Sales)
450,000
To eliminate intercompany sales
7
Merchandise
Downstream
Determination of Consolidated Sales,
Sales
Cost of Sales, and Inventory Balances
E6-7: (Downstream Sales-variation) Perkins Company owns 85%
of Sheraton Company. Perkins Company sells merchandise to
Sheraton Company at 20% above cost. During 2014 and 2015, such
sales amounted to $450,000 and $486,000, respectively. At the end
of each year, Sheraton Company had in its inventory one-third of
the amount of goods purchased from Perkins during that year.
Required: Prepare the workpaper entries necessary to eliminate the

effects of the intercompany sales for 2014 and 2015.
8
Merchandise
Downstream
Sales
Prepare the workpaper entry to eliminate intercompany sales for 2014.

Sales
450,000
Purchases (Cost Sales)
Ending Inventory Income Statement (Cost of Sales) 25,000
Inventory - Balance Sheet
450,000
25,000
To eliminate intercompany sales and defer (eliminate) the unrealized gross profit in
ending inventory until it is sold to outsiders
9
Merchandise
E6-7:
Alternate
View
Workpaper entry to eliminate intercompany sales for 2014.
Sales 1
1
Cost of Sales
2
Cost of Sales
Inventory Balance Sheet
1.
2.
3.
450,000
Downstream
Sales
375,000
50,000
25,000
Original Sales and Cost of Sales recorded by Perkins (parent) is reversed.

Cost of Sales overstated by Sheraton on resale of goods to third parties.
Inventory on hand is overstated on Sheratons books by $25,000 unrealized profit.
10
Merchandise
E6-7: Workpaper entry to eliminate intercompany sales for 2015.
Downstream
Sales
2014 Unrealized Profit in Inventory
Cost or Partial Equity Method *

Beg. Retained Earnings P Company
25,000
Beg. Inventory Income Statement (Cost of Sales)
25,000
To realize (recognize) the gross profit in beginning inventory deferred in the prior
period
* If the complete equity method is used, the debit is to the Investment account.
11
Merchandise
E6-7: Workpaper entry to eliminate intercompany sales for 2015.
2015 Intercompany Sales
Sales
End. Inventory Cost of Sales
Inventory Balance Sheet
Downstream
Sales
486,000
486,000
27,000
27,000
To eliminate intercompany sales and defer (eliminate) unrealized profit in ending

inventory
12
Merchandise
Determination of Amount of Intercompany Profit
Gross profit may be stated either as a percentage of
sales or as a percentage of cost. When stated as a
percentage of cost, it is referred to as markup.
Inventory Pricing Adjustments
The amount of intercompany profit subject to
elimination should be reduced to the extent that the
related goods have been written down by the
purchasing affiliate.
13
LO 2 Determining the amount of intercompany profit.
Merchandise
Determination of Proportion of Intercompany Profit to
Be Eliminated
The amount of intercompany profit or loss to be
eliminated . . . is not affected by the existence of a
minority [noncontrolling] interest.
The complete elimination of the intercompany profit or
loss is consistent with the underlying assumption that
consolidated statements represent the financial position
and operating results of a single business enterprise.
[FASB ASC paragraph 810-10-45-18]
14
LO 3 Eliminating 100% of intercompany profit.
Cost Method: Consolidated Statements

WorkpaperUpstream Sales
Determination of the Noncontrolling Interest in
Combined IncomeUpstream or Horizontal Sales
Modification of the calculation of the noncontrolling
interest is applicable only when the subsidiary is the
selling affiliate (upstream or horizontal sales).
Where the parent company is the selling affiliate
(downstream sale), no adjustment is necessary in the
calculation of the noncontrolling interest in
consolidated net income.
15
LO 5 Noncontrolling interest (NCI) for upstream sales.
Cost Method: Consolidated

Workpaper
Upstream
Sales
P6-7: Paque Corporation owns 90% of the
common stock of Segal Company. The stock was purchased for
$810,000 on January 1, 2012, when Segal Companys retained
earnings were $150,000.
The January 1, 2016, inventory of Paque Corporation includes
$45,000 of profit recorded by Segal Company on 2015 sales.
During 2016, Segal Company made intercompany sales of
$300,000 with a markup of 20% of selling price. The ending
inventory of Paque Corporation includes goods purchased in 2016
from Segal Company for $75,000.
Required: Prepare the worksheet entries and the consolidated
statements workpaper for the year ended December 31, 2016.
16
LO 6 Consolidated workpapers for upstream Sales- Cost Method.

Workpaper
Upstream
Sales
P6-7: Worksheet entries for Dec. 31, 2016.

Acquisition date retained earnings - Segal
Retained earnings 1/1/16 - Segal
Increase
Ownership percentage
$ 150,000
180,000
30,000
90%
$ 27,000
1. Investment in Segal
27,000
Beg. Retained Earnings Pague Co.
27,000
To establish reciprocity/convert to equity as of 1/1/2016
17

Workpaper
Upstream
Sales
2.
3.
Sales 300,000
Ending Inventory (Cost of Sales)
Inventory (Balance Sheet)
300,000
15,000
15,000
To eliminate intercompany sales and eliminate (defer) unrealized profit in ending

inventory
18

Workpaper
4.
Beg. Retained Earnings - P ($45,000 x 90%)

40,500
NCI in Equity ($45,000 x 10%)
4,500
Beg. Inventory - Income Statement (Cost of Sales)
Upstream
Sales
45,000
To realize (recognize) the gross profit in inventory deferred in the prior period
and reduce CI and NCI for their share of unrealized profit at beginning of year
19

Workpaper
5. Dividend Income
54,000
($60,000 x 90%)
Dividends Declared
Upstream
Sales
54,000
To eliminate intercompany dividends
6. Beg. Retained Earnings - Segal

Common Stock - Segal
Investment in Segal
Noncontrolling Interest
180,000
750,000
837,000
93,000
To eliminate investment account and create NCI account

20

Workpaper
Upstream Sales
P6-7
Income Statement
Sales
Dividend income
Total revenue
Cost of goods sold
Other expenses
Total cost and expense
Net income
Noncontrolling interest
Net income
Paque
$ 1,650,000
54,000
1,704,000
1,290,000
Segal
$ 795,000
310,500
1,600,500
103,500
206,250
723,750
71,250
Retained Earnings Statement

Retained earnings, 1/1
Paque
Segal
Net income
Dividends declared
Retained earnings, 12/31
$
103,500
811,500
795,000
517,500
71,250
Eliminations
Debit
Credit
(2)
300,000
(5)
54,000
15,000
$ 369,000
40,500
180,000
369,000
180,000
103,500
71,250
(150,000)
(60,000)
765,000 $ 191,250 $ 589,500
(3)
300,000
45,000
$ 345,000
(4)
(6)
27,000
345,000
54,000
$ 426,000
NCI
(2)
(4)
Consolidated
Balances
$
2,145,000
2,145,000
1,477,500
516,750
1,994,250
150,750
(10,125)
140,625
10,125
(6,000)
4,125 $
798,000
140,625
(150,000)
788,625
10,125
10,125
(1)
(5)
NCI in Consolidated Income = 10% ($71,250 + $45,000 $15,000) = $10,125

21

Workpaper
Upstream Sales
P6-7
(3)
(6)
(1)
(6)
(4)
(6)
22
Cost MethodAnalysis of Consolidated Net

Income and Consolidated Retained Earnings
Consolidated Net Income
The parent companys income from its independent
operations that has been realized in transactions with
third parties
plus (minus) subsidiary income (loss) that has been
realized in transactions with third parties
plus or minus adjustments for the period relating to
the depreciation, amortization, and impairment of
differences between implied and book values.
23

Net Income
Upstream Sales
P6-7: Prepare a calculation of Paques share of Segals income.
Reported income of Segal
$ 71,250
Less: amortization of difference between
implied and book value
0
Less: unrealized profit on 2016 sales to Paque
(15,000)
Plus: profit on prior year's sales to Paque realized
in transactions with third parties in 2016
45,000
Subsidiary income included in consolidated income
$ 101,250
Paque's share of Segals income ($101,250 x 90%)
$ 91,125
NCI share of Segals income ($101,250 x 10%)

Subsidiary income included in consolidated income
10,125
$
101,250
24

Net Income
P6-7: Prepare a calculation of CI in Consolidated Income.
Paque's net income
Less: subsidiary dividend income
Upstream Sales
$103,500
(54,000)
Paque's net income from its independent operations 49,500

Less: unrealized profit on 2016 sales to Segal
Plus: profit on prior year's sales to Segal realized

in transactions with third parties in 2016
Paque's income from independent operations that

has been realized in transactions with third parties 49,500
Paque's share of Segals income (previous slide)
91,125
Controlling interest in Consolidated net income
$140,625
25
Cost MethodAnalysis of Consolidated Net

Income and Consolidated Retained Earnings
Consolidated Retained Earnings
The parents cost basis retained earnings that has been
plus (minus) the parents share of the increase (decrease)
in subsidiary retained earnings that has been realized in
transactions with third parties from the date of acquisition
to the current date
plus (minus) the cumulative effect of adjustments to date
relating to the amortization, depreciation, and impairment
of differences between implied and book values.
26
Consolidated Statements Workpaper Partial

Equity Method
Review:
The balances reported by the parent company in
income, retained earnings, and the investment account
differ depending on the method used by the parent
company to record its investment.
However, the method used by the parent company to
record its investment has no effect on the consolidated
balances.
27
LO 6 Consolidated workpapers partial equity method.
Partial Equity Method:

Workpaper
Upstream Sales
P6-13: (Note: This is the same problem as Problem 6-7, but

assuming the use of the partial equity method.)
Paque Corporation owns 90% of the common stock of Segal
Company. The stock was purchased for $810,000 on January 1,
2012, when Segal Companys retained earnings were $150,000.
$45,000 of profit recorded by Segal Company on 2015 sales.
During 2016, Segal Company made intercompany sales of
$300,000 with a markup of 20% of selling price. The ending
inventory of Paque Corporation includes goods purchased in 2016
from Segal Company for $75,000. Paque Corporation uses the
partial equity method to record its investment in Segal Company.
28

Workpaper
1. Equity in Subsidiary Income
Investment in Segal Company
10,125
Dividends Declared ($60,000 x 90%)
54,000
Upstream Sales
64,125
To reverse the effect of parent entries for subsidiary dividends and

income
29

Workpaper
Upstream Sales
2.
3.
Sales 300,000
300,000
End. Inventory (Cost of Sales) 15,000
15,000
To eliminate intercompany sales and defer (eliminate) unrealized profit in ending
inventory
30

Workpaper
4.
Beg. Retained Earnings - P ($45,000 x 90%)

40,500
NCI in Equity ($45,000 x 10%)
4,500
Upstream
Sales
45,000
To realize (recognize) the gross profit in inventory deferred in the prior period
and to reduce CI and NCI for their share of unrealized profit at beginning of year
31

Workpaper
Investment in Segal
180,000
750,000
Upstream
Sales
837,000
93,000
32

Workpaper
Upstream Sales
P6-13
(2)
(1)
(3)
(2)
(4)
(4)
(5)
(1)

33

Workpaper
Upstream Sales
P6-13
(3)
(5)
(1)
(5)
(4)
(5)
34
Partial Equity MethodAnalysis of

Same as Cost Method
The parents income from its independent operations
that has been realized in transactions with third parties
plus (minus) subsidiary income (loss) that has been
plus or minus adjustments for the period relating to
the depreciation, amortization, and impairment of
35
Partial
Equity
MethodAnalysis
Partial Equity
MethodAnalysis
of
of Consolidated
Net Income
Consolidated
Net Income
When the parent uses the partial equity method, the parents
share of subsidiary income since acquisition is already
included in the parents reported retained earnings.
Consequently, consolidated retained earnings is calculated as
the parents recorded partial equity basis retained earnings
that has been realized in transactions with third parties plus
or minus the cumulative effect of the adjustments to date
relating to the depreciation, amortization, and impairment of
36

Partial Equity
P6-13: Calculate consolidated retained earnings on Dec. 31, 2016.

Paque's Retained Earnings on 12/31/16
$ 802,125
Unrealized profit on downstream sales
Unrealized profit on upstream sales ($15,000 x 90%)

Consolidated retained earnings on 12/31/2016
(13,500)
$ 788,625
37
Complete Equity Method:

Workpaper
Upstream Sales
P6-17: (Note: This is the same problem as Problem 6-7 and 6-13,
but assuming the use of the complete equity method.)
Paque Corporation owns 90% of the common stock of Segal
Company. The stock was purchased for $810,000 on January 1,
2012, when Segal Companys retained earnings were $150,000.
$45,000 of profit recorded by Segal Company on 2015 sales. During
2016, Segal Company made intercompany sales of $300,000 with a
markup of 20% of selling price. The ending inventory of Paque
Corporation includes goods purchased in 2016 from Segal Company
for $75,000. Paque Corporation uses the complete equity method
to record its investment in Segal Company
38
LO 6 Consolidated workpapers complete equity method.

Workpaper
1. Equity in Subsidiary Income
Investment in Segal Company
37,125
Dividends
($60,000 x 90%)
To reverse
the effectDeclared
of parent company
entries for
54,000
subsidiary
dividends and income
Upstream Sales
91,125
39

Workpaper
2.
3.
Upstream
Sales
Sales 300,000
300,000
End. Inventory (Cost of Sales) 15,000
15,000
To eliminate intercompany sales and defer(eliminate) unrealized profit in ending
inventory
40

Workpaper
Upstream Sales
4.
Investment in Segal ($45,000 x 90%)

40,500
NCI in Equity($45,000 x 10%)
4,500
45,000
To recognize intercompany profit in beginning inventory realized during the year in the proper
accounts for presentation on the consolidated financial statements; that is, even though the parent has
adjusted its equity in subsidiary income, the effect must be shown in the cost of sales account (as the equity in
subsidiary income is eliminated
41

Workpaper
Investment in Segal
Upstream
Sales
180,000
750,000
837,000
93,000
42

Workpaper
Upstream Sales
P6-17
(2)
(1)
(3)
(2)
(4)
(5)
(1)

43

Workpaper
Upstream Sales
P6-17
(3)
(4)
(5)
(1)
(5)
(4)
(5)
44
Complete Equity MethodAnalysis of

Consolidated Net Income and Consolidated
Retained Earnings
Consolidated net income is the sum of the following components:
Parent companys net income from its independent operations that
has been realized in transactions with third parties plus (minus)
reported subsidiary income (loss) that has been realized in
transactions with third parties plus (minus) adjustments for the
period relating to the depreciation, amortization, and impairment
of differences between implied and book values.
Under the complete equity method:
Consolidated net income equals the parent companys recorded
income.
Consolidated retained earnings equals the parent companys
recorded retained earnings.
45
Summary of Workpaper Entries

Illustration 6-21
To eliminate intercompany sales:

All Methods Sales
X
Parent Selling (Downstream)

X
To eliminate intercompany profit in ending inventory:

All Methods Ending Inventory (Cost of Sales) X
X
To recognize intercompany profit in beginning inventory realized during the year:
Cost or Partial
Equity Methods
Beg. Retained EarningsParent

Beg. Inventory - Income
X
X
Statement (Cost of Sales)
Complete Equity Investment in S Company

Method
Beg. Inventory - Income
Statement (Cost of Sales)
X
46
Summary of Workpaper Entries

Illustration 6-21
To eliminate intercompany sales:

All Methods Sales
Subsidiary Selling (Upstream)

X
To eliminate intercompany profit in ending inventory:

All Methods Ending Inventory (Cost of Sales)
Inventory (Balance Sheet) X
To recognize intercompany profit in beginning inventory realized during the year:

Cost or Partial
Beg. Retained EarningsParent
Equity Methods
NCI in Equity
X
Beg. Inventory (Cost of Sales)
X
Complete Equity Investment in S Company

Method NCI in Equity
X
Beg. Inventory (Cost of Sales)
X
47
Intercompany Profit Prior To Parent

Subsidiary Affiliation
Generally accepted accounting standards are silent as to
the appropriate treatment of unrealized profit on assets
that result from sales between companies prior to
affiliation (preaffiliation profit).
The question is whether preaffiliation profit should be
eliminated in consolidation.
In our opinion, workpaper entries eliminating
preaffliation profit are inappropriate.
48
LO 7 Intercompany profit prior to affiliation.

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Advanced

Prepared by Sheila Ammons, Austin Community College

Upstream and Downstream Sales of

Effects of Intercompany Sales of Merchandise on

Required: Prepare the workpaper entries necessary to eliminate the

E6-7: Summary of 2014 Intercompany Sales

third parties. Portions resold are recorded in COGS.

Prepare the workpaper entry to eliminate intercompany sales for

To eliminate intercompany sales

Required: Prepare the workpaper entries necessary to eliminate the

Prepare the workpaper entry to eliminate intercompany sales for 2014.

Original Sales and Cost of Sales recorded by Perkins (parent) is reversed.

2014 Unrealized Profit in Inventory

Cost or Partial Equity Method *

To eliminate intercompany sales and defer (eliminate) unrealized profit in ending

Cost Method: Consolidated Statements

Cost Method: Consolidated

Cost Method: Consolidated

P6-7: Worksheet entries for Dec. 31, 2016.

Beg. Retained Earnings Pague Co.

To establish reciprocity/convert to equity as of 1/1/2016

Cost Method: Consolidated

2016 Intercompany Sales

To eliminate intercompany sales and eliminate (defer) unrealized profit in ending

Cost Method: Consolidated

Beg. Retained Earnings - P ($45,000 x 90%)

Cost Method: Consolidated

To eliminate intercompany dividends

6. Beg. Retained Earnings - Segal

To eliminate investment account and create NCI account

Cost Method: Consolidated

Retained Earnings Statement

NCI in Consolidated Income = 10% ($71,250 + $45,000 $15,000) = $10,125

Cost Method: Consolidated

Cost MethodAnalysis of Consolidated Net

Cost Method: Consolidated

NCI share of Segals income ($101,250 x 10%)

Cost Method: Consolidated

Less: subsidiary dividend income

Paque's net income from its independent operations 49,500

Plus: profit on prior year's sales to Segal realized

Paque's income from independent operations that

Controlling interest in Consolidated net income

Cost MethodAnalysis of Consolidated Net

Consolidated Statements Workpaper Partial

Partial Equity Method:

P6-13: (Note: This is the same problem as Problem 6-7, but

Partial Equity Method:

To reverse the effect of parent entries for subsidiary dividends and

Partial Equity Method:

2016 Intercompany Sales

Partial Equity Method:

Beg. Retained Earnings - P ($45,000 x 90%)

Partial Equity Method:

To eliminate investment account and create NCI account

Partial Equity Method:

NCI in Consolidated Income = 10% ($71,250 + $45,000 $15,000) = $10,125

Partial Equity Method:

Partial Equity MethodAnalysis of

Consolidated Retained Earnings

P6-13: Calculate consolidated retained earnings on Dec. 31, 2016.

Unrealized profit on downstream sales

Unrealized profit on upstream sales ($15,000 x 90%)