Assignment of Advanced financialAccounting post Graduate regular program

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Table of Contents

Introduction to intercompany inventory transaction........................................................................0

Chapter eight....................................................................................................................................1

Intercompany...................................................................................................................................1

Inventory..........................................................................................................................................1

Transactions.....................................................................................................................................1

Intercompany Inventory Transactions.........................................................................................1

Transfers at Cost..........................................................................................................................1

Transfers at a Profit or Loss.........................................................................................................2

First Aspect: Income Statement Focus.........................................................................................3

Second Aspect: Balance Sheet Focus..........................................................................................3

Effect of Inventory System..........................................................................................................3

Downstream Sale–Perpetual System...........................................................................................3

1.profit Realized in Same Period.................................................................................................4

2.Profit Realized in Next Period..................................................................................................4

3.Inventory Held Two or More Periods.......................................................................................6

Upstream Sale – Perpetual System..............................................................................................7

Sale from One Subsidiary to Another..........................................................................................7

Costs Associated with Transfers..................................................................................................7

Lower of Cost or Market..............................................................................................................8

Sales and Purchases before Affiliation........................................................................................9

Summary of Key Concepts........................................................................................................10

Reference...................................................................................................................................10
 1. Introduction to intercompany inventory transaction

Inventory transactions are the most common form of inter corporate exchange.
Significantly, the consolidation procedures relating to inventory transfers are quite
similar to those discussed in Chapter relating to fixed assets.

When inventory is transferred from one affiliate to another, some additional cost, such as
freight, is often incurred in the transfer. Consolidated net income must be based on the
realized income of the transferring affiliate.

When one subsidiary sells merchandise to another subsidiary, the eliminating entries are
identical to those presented earlier for sales from a subsidiary to its parent. A review of all entries
recorded: Resale in Period of Intercompany Transaction Item Peerless Products 

Intercompany operations may involve trading operations, such as sale or purchase of inventory
or fixed assets, providing or receiving of loans, guarantees or other commitments, declaration
and payment of dividends. Intercompany eliminations are used to remove from the financial
statements of a group of companies any transactions involving dealings between the companies
in the group. There are three types of intercompany eliminations, which are:

 Intercompany debt. Eliminates any loans made from one entity to another within the
group, since these only result in offsetting notes payable and notes receivable, as well as
offsetting interest expense and interest income. These issues most commonly arise when
funds are being moved between entities by a centralized treasury department.
 Intercompany revenue and expenses. Eliminates the sale of goods or services from one
entity to another within the group. This means that the related revenues, cost of goods
sold, and profits are all eliminated. The reason for these eliminations is that a company
cannot recognize revenue from sales to itself; all sales must be to external entities. These
issues most commonly arise when a company is vertically integrated.
 Intercompany stock ownership. Eliminates the ownership interest of the parent company
in its subsidiaries.
 Intercompany transactions can be difficult to identify, and so require a system of controls
to ensure that each of these items is properly identified and brought to the attention of the
 corporate accounting staff. The issue is of particular concern when an acquisition has just
been completed, since the reporting controls are not yet in place at the new acquiree. If an
enterprise resource planning (ERP) system is in place throughout the company, these
transactions can typically be identified by flagging a transaction as it is created as being
an intercompany item. 

When an intercompany transaction has been identified in one period, it is entirely possible that
the same type of transaction will occur again in the future. Accordingly, a reasonable control is
for the corporate accounting staff to make a list of all intercompany transactions that have been
identified in the past, and see if they have been dealt with again in the current period. If not, there
may be an unflagged transaction that needs to be eliminated.

Given the difficulty of intercompany reporting, it is especially important to fully document the
associated controls and resulting journal entries, since they are likely to be reviewed in detail by
the company's

An intercompany transaction occurs when one division, department, or unit within an

organization participates in a transaction with another division, department, or unit in the same
organization. These transactions might involve a parent company and a subsidiary, two or more
subsidiaries, or even two or more departments within one unit. And they can occur for a variety
of reasons. For instance, a company may sell inventory from one division to another division, or
a parent company may loan money to one of its subsidiaries.

Each transaction has nuances to consider. For instance, if the transaction occurs between the
parent company and a subsidiary, accountants must treat it as an arm’s length transaction where
the two parties act independently as if they have no relationship to each other. Both the parent
company and the subsidiary must record it. At the consolidated level, accountants must eliminate
the intercompany transaction so that no profit or loss is recognized until it’s realized through a
transaction with an outside party.

Thus, inventory sales between these companies trigger the independent accounting systems of
both parties. ... The seller duly records revenue, and the buyer simultaneously enters the purchase
into its accounts.
Intercompany Inventory Transactions

• Inventory transactions are the most common form of intercorporate exchange.

• Significantly, the consolidation procedures relating to inventory transfers are quite

similar to those discussed in Chapter 6 relating to fixed assets.

• Conceptually, the elimination of inventory transfers between related companies is

no different than for other types of intercompany transactions.

• All revenue and expense items recorded by the participants must be eliminated fully
in preparing the consolidated income statement, and all profits and losses recorded
on the transfers are deferred until the items are sold to a nonaffiliate.

• The eliminations ensure that only the historical cost of the inventory to the
consolidated entity is included in the consolidated balance sheet when the inventory
is still on hand and is charged to cost of goods sold in the period the inventory is
resold to nonaffiliates.
Transfers at Cost

• Merchandise sometimes is sold to related companies at the seller’s cost or carrying

value.

• When an intercorporate sale includes no profit or loss, the balance sheet inventory
amounts at the end of the period require no adjustment for consolidation because the
carrying amount of the inventory for the purchasing affiliate is the same as the cost to
the transferring affiliate and the consolidated entity.

• Even when the intercorporate sale includes no profit or loss, however, an

eliminating entry is needed to remove both the revenue from the intercorporate sale
and the related cost of goods sold recorded by the seller. This avoids overstating
these two accounts.

• Consolidated net income is not affected by the eliminating entry when the transfer is
made at cost because both revenue and cost of goods sold are reduced by the same
amount.

• Companies use many different approaches in setting intercorporate transfer prices.

 • In some companies, the sale price to an affiliate is the same as the price to any other
customer.

• Some companies routinely mark up inventory transferred to affiliates by a certain

percentage of cost.

Transfers at a Profit or Loss

• Regardless of the method used in setting intercorporate transfer prices, the

elimination process must remove the effects of such sales from the consolidated
statements.

• When intercorporate sales include profits or losses, there are two aspects of the
workpaper eliminations needed in the period of transfer to prepare consolidated
financial statements

First Aspect: Income Statement Focus

• Elimination of the income statement effects of the intercorporate sale in the period in
which the sale occurs, including the sales revenue from the intercorporate sale and the
related cost of goods sold recorded by the transferring affiliate.
Second Aspect: Balance Sheet Focus

• Elimination from the inventory on the balance sheet of any profit or loss on the
intercompany sale that has not been confirmed by resale of the inventory to
outsiders.

Effect of Inventory System

• Most companies use either a perpetual or periodic inventory control system to

keep track of inventory and cost of goods sold.

• Because most companies use perpetual inventory systems, the discussion in the
chapter focuses on the consolidation procedures used in connection with
perpetual inventories.

Downstream Sale–Perpetual System

• For consolidation purposes, profits recorded on an intercorporate inventory sale are

recognized in the period in which the inventory is resold to an unrelated party.

• Consolidated net income must be based on the realized income of the

transferring affiliate.

• Because intercompany profits from downstream sales are on the books of the
parent, consolidated net income and the overall claim of parent company
shareholders must be reduced by the full amount of the unrealized profits.

• When a company sells an inventory item to an affiliate, one of three situations

results:
 1. The item is resold to a nonaffiliate during the same period;

2. The item is resold to a nonaffiliate during the next period; or,

3. The item is held for two or more periods by the purchasing affiliate.

1.profit Realized in Same Period

• Required Elimination Entry:

Sales $10,000

Cost of Goods Sold$10,000

• Note the elimination entry does not effect consolidated net income because sales
and cost of goods sold both are reduced by the same amount. [Continued on next
slide.]

• No elimination of intercompany profit is needed because all of the intercompany

profit has been realized through resale of the inventory to the external party during
the current period.

2.Profit Realized in Next Period

• When inventory is sold to an affiliate a profit and the inventory is not resold during
the same period, appropriate adjustments are needed to prepare consolidated financial
statements in the period of the intercompany sale and in each subsequent period until
the inventory is sold to a nonaffiliate. [Continued on next slide.]
• By way of illustration, assume that Peerless Products purchases inventory in 20X1
for $7,000 and sells the inventory during the year to Special Foods for $10,000.
Thereafter, Special Foods sells the inventory to Nonaffiliated Corporation for
$15,000 on January 2, 20X2.

• Required Elimination Entry (20X1):

Sales $10,000
Cost of Goods
Sold $7,000
Inventory $3,000
3.Inventory Held Two or More Periods

• Companies may carry the cost of inventory purchased from an affiliate for more
than one accounting period. For example, the cost of an item may be in a LIFO
inventory layer and would be included as part of the inventory balance until the
layer is liquidated.

• Prior to liquidation, an eliminating entry is needed in the consolidation workpaper

each time consolidated statements are prepared to restate the inventory to its cost to
the consolidated entity.

For example, if Special Foods continues to hold the inventory purchased from Peerless
Products, the following eliminating entry is needed in the consolidation workpaper
each time a consolidated balance sheet is prepared for years following the year of
intercompany sale, for as long as the inventory is held:

Retained Earnings,
January 1 $3,000
Eliminate beginning inventory profit.
Inventory $3,000
 Note: No income statement adjustments are needed in the periods following the
intercorporate sale until the inventory is resold to parties external to the consolidated
entity.

Upstream Sale – Perpetual System

• When an upstream sale of inventory occurs and the inventory is resold by the parent
to a nonaffiliate during the same period, all the eliminating entries in the
consolidation work paper are identical to those in the downstream case.

• When the inventory is not resold to a nonaffiliate before the end of the period, work
paper eliminating entries are different from the downstream case only by the
apportionment of the unrealized intercompany profit to both the controlling and
noncontrolling interests.

• The elimination of the unrealized intercompany profit must reduce the interests of
both ownership groups each period until the profit is confirmed by resale to the
inventory to a nonaffiliated party.

Sale from One Subsidiary to Another

• Transfers of inventory often occur between companies that are under common
control or ownership.

• When one subsidiary sells merchandise to another subsidiary, the eliminating

entries are identical to those presented earlier for sales from a subsidiary to its
parent.
• The full amount of any unrealized intercompany profit is eliminated, with the profit
elimination allocated proportionately against the ownership interests of the selling
subsidiary.

Costs Associated with Transfers

• When inventory is transferred from one affiliate to another, some additional cost, such
as freight, is often incurred in the transfer.

• This cost should be treated in the same way as if the affiliates were operating
divisions of a single company.

• If the additional cost would be inventoried in transferring the units from one
location to another within the same company, that treatment also would be
appropriate for consolidation.

Lower of Cost or Market

• Inventory purchased from an affiliate might be written down by the purchasing

affiliate under the lower-of-cost-or-market rule if the market value is less than the
intercompany transfer price. [Continued on next slide.]

• Such a situation can be illustrated by assuming that a parent company purchases

inventory for $20,000 and sells it to its subsidiary for $35,000. Also, assume that the
subsidiary still holds the inventory at year-end and determines that its market value
(replacement cost) is $25,000 at that time. [Continued on next slide.]

While this entry revalues the inventory to $25,000 on the books of the subsidiary, the
appropriate valuation from a consolidated viewpoint is the $20,000 original cost of the
inventory to the parent. Therefore, the eliminating entry—shown on the next slide—is
needed in the consolidated workpaper.
The subsidiary writes the inventory down from $35,000 to its lower market value of
$25,000 at the end of the year and records the following entry:

Loss on Decline
in
Value of
Inventory $10,000
Inventory $10,000

Write inventory down to market value.

• Sales $35,000
Cost of Goods
Sold $20,000
Inventory $5,000
Loss on Decline
in
Value of
Inventory $10,000

Eliminate intercompany sale of inventory.

• The inventory loss recorded by the subsidiary must be eliminated because the $20,000
inventory valuation for consolidation purposes is below the $25,000 market value of
the inventory.
Sales and Purchases before Affiliation

• Sometimes companies that have sold inventory to one another later join together in a
business combination.

• The consolidation treatment of profits on inventory transfers that occurred before

the business combination depends on whether the companies were at that time
independent and the sale transaction was the result of arm’s length bargaining.

• As a general rule, the effects of transactions that are not the result of arm’s length
bargaining must be eliminated.

• However, the combining of two companies does not necessarily mean that their prior
transactions with one another were not arm’s length.

• The circumstances surrounding the prior transactions, such as the price and quantity
of units transferred, would have to be examined.

• In the absence of evidence to the contrary, companies that have joined together in
a business combination are viewed as having been separate and independent prior
to the combination.

• Thus, if the prior sales were the result of arm’s-length bargaining, they are viewed
as transactions between unrelated parties.

• Accordingly, no elimination or adjustment is needed in preparing consolidated

statements subsequent to the combination, even if the inventory is still held by an
affiliate.
Summary of Key Concepts

• Consolidated financial statements are prepared for the consolidated entity as if it were
a single company.

• Therefore, the effects of all transactions between companies within the entity must be
eliminated in preparing consolidated financial statements.

• For intercompany inventory transactions, the intercompany sale and cost of goods
sold must be eliminated.

• In addition, the intercompany profit may not be recognized in consolidation until it

is confirmed by resale for the inventory to an external party.

• Unrealized intercompany profits must be eliminated fully and are allocated

proportionately against the stockholder groups of the selling affiliate.

• intercompany profits is sold during the period, consolidated cost of goods sold must
be adjusted to reflect the actual cost to the consolidated entity of the inventory sold;
if the inventory is still held at the end of the period, it must be adjusted to its actual
cost to the consolidated entity.
Reference

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 www.accountingnotes.net
 Google
 Docs.oracle.com