CH 5 - ADV

To summarize, for intra-entity beginning inventory profits resulting from downstream transfers when the parent applies the equity method:

-The parent's beginning retained earnings reflect the consolidated balance from application of the equity method and need no adjustment. -The parent's Investment in Subsidiary account as of the beginning of Year 2 contains a credit from the deferral of Year 1 intra-entity downstream profits. -Worksheet Entry *G debits the Investment account and credits Cost of Goods Sold, effectively recognizing the profit in the year of sale to outsiders.

To reiterate, the accounting consequences stemming from land transfers are these:

1- In the year of transfer, any intra-entity gain is deferred, and the Land account is reduced to historical cost. When an upstream sale creates the gain, the amount also is excluded in calculating the noncontrolling interest's share of the subsidiary's net income for that year. 2- Each year thereafter, the intra-entity gain will be removed from the seller's beginning Retained Earnings. If the transfer was upstream, eliminating this earlier gain directly affects the balances recorded within both Entry *C (if conversion to the equity method is required) and Entry S. The additional equity accrual (Entry *C, if needed) as well as the elimination of beginning Stockholders' Equity (Entry S) must be based on the newly adjusted balance in the subsidiary's Retained Earnings. This deferral process also has an impact on the noncontrolling interest's share of the subsidiary's net income, but only in the year of transfer and the eventual year of sale. 3- If the land is ever sold to an outside party, the original gain is recognized and reported in consolidated net income.

As in the accounting for inventory transfers, the entire consolidation process demonstrated here accomplishes two major objectives:

1. It reports historical cost for the transferred land for as long as it remains within the business combination. 2. It defers income recognition until the land is sold to outside parties.

Downstream Sales and EQUITY Method: the Investment in Subsidiary account replaces the parent's beginning Retained Earnings in Consolidation Entry *G

At year-end, using the equity method, the parent increases its Investment in Subsidiary account for beginning inventory intra-entity gross profits. These same intra-entity profits were recorded as decreases to the Investment account in the prior year. Consolidation Entry I, however, removes the current-year equity income accruals from the Investment in Subsidiary account as part of the investment elimination sequence. With the equity income accrual removed, the beginning inventory intra-entity profit reappears as a credit to the Investment in Subsidiary account's beginning-of-the-year balance.

Recognizing the Effect on Noncontrolling Interest—Land Transfers

If the original sale was a downstream transaction, neither the annual deferral nor the eventual recognition of the intra-entity gain has any effect on the noncontrolling interest. The rationale for this treatment, as previously indicated, is that profits from downstream transfers relate solely to the parent company. Conversely, if the transfer is made upstream, deferral and recognition of gains are attributed to the subsidiary and, hence, to the noncontrolling interest. As with inventory, all noncontrolling interest balances are computed on the reported earnings of the subsidiary after adjustment for any upstream transfers.

In the year of the intra-entity fixed asset transfer, consolidation procedures to remove the intra-entity gain and its effects on the asset, depreciation expense, and accumulated depreciation are relatively straightforward. First, a worksheet entry eliminates the gain and returns the asset and accumulated depreciation accounts to their pre-transfer amounts. Then, a second worksheet entry accordingly reduces the overstated current year depreciation expense and related accumulated depreciation.

In years subsequent to the intra-entity asset transfer, we observe that the gain on sale recognized by the seller has now been closed to Retained Earnings. The overstated depreciation expense also has been closed to the Retained Earnings of the buyer. Consolidation worksheet entries thus reflect the net effect of the gain on sale and the overstated depreciation on the affiliate's separate accounting records.

According to FASB, The elimination of the intra-entity income or loss ____ be allocated between the parent and noncontrolling interests.

MAY *Note the direction of intra-entity transfer!

Upstream Sales: Whenever intra-entity profit is present in ending inventory, one further consolidation entry is eventually required. Although Entry G removes the gross profit from the consolidated inventory balances in the year of transfer, the $7,500 overstatement remains within the separate financial records of the buyer and seller. The effects of this deferred gross profit are carried into their beginning balances in the subsequent year. Hence, a worksheet adjustment is necessary in the period following the transfer. For consolidation purposes, the ending inventory portion of intra-entity gross profit must be adjusted in two successive years (from ending inventory in the year of transfer and from beginning inventory of the next period).

Referring again to Arlington's sale of inventory to Zirkin, the $7,500 intra-entity gross profit is still in Zirkin's Inventory account at the start of the subsequent year. Once again, the overstatement is removed within the consolidation process but this time from the beginning inventory balance (which appears in the financial statements only as a positive component of cost of goods sold). This consolidation worksheet entry is labeled *G. The asterisk indicates that a previous-year transfer created the intra-entity gross profits.

T/F: Even after Entry TI, Gross Profit and Ending Inventory still do not reflect the correct amounts. (assuming inventory has NOT yet been sold)

TRUE; Correcting the ending inventory requires only reducing the asset. However, correcting gross profit requires a careful analysis of the effect of the intra-entity transfer on the Cost of Goods Sold account.

The gain on the original transfer is recognized in consolidated net income only when the land is subsequently disposed of to an outside party.

Therefore, appropriate consolidation techniques must be designed to eliminate the intra- entity gain each period until the time of resale.

All Inventory Remains (YR 1) Consequently, if all of the transferred inventory is retained by the business combination at the end of the year, the following worksheet entry also must be included to eliminate the effects of the seller's gross profit that remains within the buyer's ending inventory:

This entry (labeled G for gross profit) reduces the consolidated Inventory account to its original $50,000 historical cost. Furthermore, increasing Cost of Goods Sold by $30,000 effectively removes the intra-entity amount from recognized gross profit. Thus, this worksheet entry resolves both reporting problems created by the transfer price markup.

However, if the sale is upstream, then the intra-entity gross profit deferral is attributable to the subsidiary, and one could argue that the non-controlling interest's share of the income is ____.

affected

An intra-entity transfer is merely the internal movement of inventory, an event that creates no net change in the financial position of the business combination taken as a whole. Thus, in producing consolidated financial statements, the recorded effects of these transfers are ___.

eliminated so that consolidated statements reflect only transactions (and thus profits) with outside parties.

If downstream: Note that the reduction in Retained Earnings is changed to an ____ in the ____ account when the original sale is downstream and the parent has applied the equity method. In that specific situation, equity method adjustments have already corrected the timing of the parent's intra-entity gain. Removing the gain has created a reduction in the Investment account that is appropriately allocated to the subsidiary's Land account on the worksheet.

increase; Investment in Subsidiary

If the sale is downstream, then the intra-entity gross profit deferral is attributable to the parent, and one could argue that the non-controlling interest's share of the income is ____.

not affected

Only a Portion of Inventory Remains (YR 1) The ending inventory intra- entity gross profit elimination (Entry G) is based not on total intra-entity sales but only on ___.

the amount of transferred merchandise retained within the business at the end of the year.