acct 5319 ch. 5

unrealized gross profits- effect on noncontrolling interest

Accounts affected by intra-entity transactions: Revenues Cost of Goods Sold Expenses Noncontrolling Interest in Subsidiary's Net Income Retained Earnings at the Beginning of the Year Inventory Land, Buildings, and Equipment Noncontrolling Interest in Subsidiary at End of Year.

intra-entity transactions-downstream transfers

ENTRY *G If the transfer of inventory is downstream AND the parent uses the equity method, the following entry is used to recognize the remaining unrealized profit left at the end of the previous year. investment in sub DR COGS (beg. inv. component) CR Investment in Subsidiary account replaces the Retained Earnings account used for upstream sales.

intra-entity transactions- land transfer

ENTRY *GL As long as the land remains on the books of the buyer, the unrealized gain must be eliminated at the end of each fiscal period. R/E (Beg. bal. of seller) DR land CR Note: The original gain was closed to R/E at the end of that period. When we eliminate the gain in subsequent years, it must come from R/E.

intra-entity land transfers eliminating unrealized gains

ENTRY *GL (Year of sale) In the period the land is sold to a third party, the unrealized gain must be eliminated one more time, and also finally recognized as a REALIZED gain in the current period's consolidated financial statements. R/E (beg. bal. of seller) DR Gain on sale of land CR Note: Modify the entry to credit the Gain account instead of Land.

intra-entity transactions-depreciable asset transfers

ENTRY ED In addition, the buyer's depreciation is based on the inflated transfer price. The excess depreciation expense must be eliminated Accumulated Depr. DR Depreciation Expense CR (to eliminate overstatement of depreciation expense cause by inflated transfer price (labeled ED in reference to excess depreciation). Entry must be reported for all years of the equipments life)

Unrealized Gross Profit—Year Following Transfer (Year 2): . Intercompany Beginning Inventory Profit Adjustment—Downstream Sales when the Parent uses the Equity Method:

We will skip this section because it is purely a bookkeeping topic. Regardless of whether the entry transaction is upstream or downstream, please debit R/E and credit COGS for all *G entries.

intra-entity transactions

When companies affiliated through common control engage in intra-entity inventory transfers, consolidation procedures are required to eliminate sales and purchases balances. Transactions between a parent and subsidiary are considered "internal" transactions of a single entity. Effects of intra-entity transactions should be eliminated from the consolidated financial statements. Consolidated statements must reflect only transactions with outside parties.

Unrealized Gross Profits—Effect on Noncontrolling Interest Valuation:

An upstream inventory transaction is one in which the subsidiary sells to the parent. Recall from chapter 4 that the Noncontrolling Interest (NCI) in Subsidiary's Net Income account is the minority owner's share of the subsidiary's net income. In the case of an upstream inventory transaction, the subsidiary is overstating its income by the amount of the unrealized gross profit (i.e. the credit to the Inventory account in Entry G). Therefore, when calculating NCI in Sub's Net Income, the subsidiary's reported net income should be reduced by the unrealized gross profit

Unrealized Gross Profit—Year of Transfer (Year 1): Only a Portion of Inventory Remains:

As inventory is resold, the error created by the intercompany sale is reduced. The initial error in inventory is the intercompany gross profit. Therefore, the remaining error equals the intercompany gross profit times the portion of inventory that has not yet been resold to external parties, and this amount is used in Entry G.

Use the information in Example A except assume that Submarine did not resell any inventory. [Consolidation Entry TI is done regardless of whether any inventory is resold]

In this case, the Inventory account will be misstated because Submarine is carrying the Inventory at $80,000 instead of Parent's cost of $50,000. To correct this misstatement, Consolidation Entry G (gross profit) will credit Inventory for $30,000. COGS $30,000 Inventory $30,000 But why do we debit COGS for $30,000? Consolidated COGS should be zero because no inventory has been sold to external parties. Parent's COGS is $50,000 and Submarine's COGS is zero. Under the assumption that all inventory would be resold to external parties, Consolidation Entry TI (see Example A) credited COGS for $80,000, and therefore, the balance is COGS is a credit of $30,000 ($50,000 on Parent's books minus $80,000 from entry TI) just prior to entry G.

. Intercompany Inventory Transactions

are recorded as Sales and COGS on the seller's books, but from the perspective of the consolidated entity, this transaction was merely an internal transfer, not an external transaction. Therefore, Consolidation Entry TI (transferred inventory) debits Sales and credits COGS at the transfer price. Consolidation Entry TI reverses the effects on the seller's books for the intercompany inventory sale Consolidation Entry TI assumes that the inventory will be 100% resold to an external party by the end of the year, and is done regardless of whether any inventory is actually resold.

Intercompany Transfer of Depreciable Assets: Effect on Noncontrolling Interest Valuation—Depreciable Asset Transfers

Recall from chapter 4 that the Noncontrolling Interest (NCI) in Subsidiary's Net Income account is the minority owner's share of the subsidiary's net income. In the case of an upstream asset transfers, the subsidiary is misstating its income by the gain/loss in year 1 and the Depreciation Expense adjustment in subsequent years. Therefore, when calculating NCI in Sub's Net Income, the subsidiary's reported net income should be adjusted by the income statement effects in entries TA and ED.

Intercompany Inventory Transfers Summarized:

The accounts affected are Sales, COGS, Inventory, Income to NCI, and NCI. [The book also throws in expenses and land, buildings & equipment, but these are not related to Inventory.]

Intercompany Land Transfers:

The consolidated entity should not report any gains/losses from intercompany sales of land or depreciable assets.

Recognizing the Effect on Noncontrolling Interest Valuation—Land Transfers:

: In an upstream land transfer, Income in NCI is adjusted to reflect the gain/loss, and the NCI account is affected by the adjustment to Income in NCI. Also, the sub's R/E account is affected in subsequent years.

Unrealized Gross Profit—Year Following Transfer (Year 2):

At the beginning of year 2, beginning Retained Earnings is misstated because the parent and sub had recorded Sales and COGS in a way that was not appropriate for the consolidated entity. The amount of the misstatement is equal to last year's adjustment to the inventory account (entry G). Entry *G is to debit Retained Earnings and credit COGS for that amount. Entry *G adjusts COGS because when the transferred inventory is resold, COGS will be recorded at the transfer price instead of the original cost.

Parent Co. sells inventory with a cost of $50,000 to its 100% owned subsidiary, Submarine Co. for $80,000, and Submarine resells all inventory to external parties for $92,486. Parent records Sales on its books for $80,000 and COGS for $50,000. Submarine records Inventory at $80,000 at the transfer. When Submarine sells the inventory, Submarine records Sales of $92,486 and COGS of $80,000.

At this point, the misstated accounts are Sales and COGS. Sales is overstated because Parent recorded a transfer as Sales of $80,000. COGS is overstated because Parent recorded COGS at $50,000 and Submarine recorded COGS at $80,000 giving a total balance of $130,000. However, COGS should have a balance of $50,000 (the original cost to Parent). Consolidation Entry TI Sales $80,000 COGS $80,000 Sales at the resell price of $92,486 does not need to be corrected because it was to an external party, and therefore, a valid Sale for both Submarine and the consolidated entity.

Intercompany Transfer of Depreciable Assets: Depreciable Intercompany Asset Transfers—Downstream Transfers When the Parent Uses the Equity Method:

Because the equity method adjusts for intercompany transactions (see chapter 1), for downstream transactions, instead of using R/E, use Investment in Sub. [However, this modification will have NO effect on the consolidated statements. This is more of a bookkeeping topic. You have the instructor's permission to use Retained Earnings as illustrated in the previous section].

Eliminating Unrealized Gains—Land Transfers

Consolidation entry TL eliminates the gain/loss and adjusts the book value of the Land account back to its original cost. Because gains/losses are closed out a year-end, (a) entry TL needs to be done only in the year of the transfer (year 1), and (b) beginning in year 2, Retained Earnings is misstated from the gain/loss recorded at the transfer. Beginning in year 2, entry *GL will eliminate the prior year's gain/loss from Retained Earnings and will adjust the asset account back to its original cost. Entry *GL will need to be done every year until the land is sold to an outside party. In the year the land is sold to an outside party, entry *GL adjusts (beginning) Retained Earnings as usual, but reinstates the gain/loss instead of adjusting the Land account.

unrealized gross profit-intra-entity

ENTRY *G From a consolidated view, the buyer's Cost of Goods Sold (the beginning inventory component) and the seller's Retained Earnings accounts as of the beginning of Year 2 contain the unrealized profit, and must both be reduced in Entry *G in Year 2. R/E (beg. bal. of seller) DR COGS (beg. inv. component) CR Entry *G removes unrealized gross profit from beginning figures so that it is recognized in the consolidated income in the period in which it is earned.

unrealized gross-profit-intra-entity

ENTRY G (Gross Profit) Despite Entry TI, ending inventory may still be overstated due to the transfer price exceeding historical cost. Intra-entity profits that remain unrealized at year-end must be removed in arriving at consolidated figures. Unrealized gain is eliminated as follows in Year 1: COGS CR inventory DR (to remove unrealized gross profit credited by intra-entity sale) Note: The consolidated company has earned the profit on any portion of the intra-entity transaction that was sold to unrelated parties and does not need to make an adjustment for the sold items for consolidation purposes.

intra-entity transactions-depreciable asset transfers

ENTRY TA In the year of transfer, the unrealized gain must be eliminated and the assets restated to original historical cost. Gain on sale of equipment DR equipment DR accumulate depreciation CR (to remove unrealized gain and return equipment accounts to balances based on original historical cost. (labeled TA in reference to transferred asset))

sales and purchases-intra-entity

ENTRY TI (Transferred Inventory) Eliminate all intra-entity sales/purchases of inventory by eliminating the sales price of the transfer - which one company records as sales, and the other records as cost of goods sold. Sales DR COGS CR **the total recorded amounts are deleted entry TI eliminates "transferred inventory"

intra-entity transactions-land transfer

ENTRY TL If land is transferred between the parent and sub at a gain, the gain is considered unrealized and must be eliminated Gain on sale of land DR Land CR Note: By crediting land for the same amount, this effectively returns the land to its carrying value on the date of transfer.

Unrealized Gross Profit—Year of Transfer (Year 1): All Inventory Remains at the End of the Year:

If all inventory is unsold at year-end, the inventory account will be misstated by the amount of the intercompany gross profit ($30,000 in Example A). The combination of Consolidation Entry TI and G result in the correct balance of COGS for the consolidated statements (zero in Example B).

Intercompany Transfer of Depreciable Assets: Deferral of Unrealized Gains

When depreciable assets are transferred, the seller eliminates Accumulated Depreciation. In the year of transfer, entry TA removes the gain/loss, moves the asset back to its original cost, and reinstates Accumulated Depreciation. Because the asset has been revalued, Depreciation Expense and A/D are affected. Entry ED moves Depreciation Expense and A/D back to those calculations based on the original cost. Entry ED is exactly the same every year (assuming the straight-line method and a beginning of the year transfer). Entry *TA is different from entry TA because the gain/loss and prior year's depreciation expense were closed to Retained Earnings. Entry *TA adjusts the asset back to its original cost, adjusts Retained Earnings for prior year's income statement adjustments, and adjusts A/D for all prior years' A/D adjustments.

unrealized inventory gain- downstream transfers

Worksheet entries to eliminate sales/purchases balances (Entry TI) and to remove unrealized gross profit from ending Inventory in Year 1 (Entry G) are standard, regardless of the circumstances of the consolidation. BUT the procedure to eliminate intra-entity gross profit from Year 2's beginning account balances differs from the Entry *G just presented IF: (1) the original transfer is downstream (parent's) and (2) the parent applies the equity method for internal accounting purposes.