Chapter 6

Intercompany
Inventory
Transactions
McGraw-Hill/Irwin

Copyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objective 6-1

Understand and explain

intercompany transfers
and why they must be
eliminated.

6-2

Road Map: Intercompany

Transactions
Typical intercompany transactions

Intercompany reciprocal accounts

(Chapter 4)

Inventory transfers (Chapter 6)

Fixed asset transfers (Chapter 7)

Intercompany Indebtedness (Chapter 8)

6-3

Arms-Length Transactions
Q: What are Arms-length
Transactions?
A:

Transactions that take place

between completely
independent parties.

6-4

Categories of Transactions
Arms Length Transactions
The

only transactions that can be

reported in the consolidated statements.

We

want to report the results of our

interactions with outside parties!

Non-Arms Length Transactions

Usually

referred
transactions.

Include

to

as related

party

all intercompany transactions.

6-5

Types of Related Party

Transactions
Involving only Individuals
Transactions

among family members

Involving Corporations
With

management and other employees

With

directors and stockholders

With

affiliates (controlled entities)

Probably constitutes at least 99%

corporate related-party transactions

of all

6-6

Necessity of Eliminating
Intercompany Transactions
Eliminate
all
intercompany
transactions in consolidation:
Because

they are internal transactions

from a consolidated perspective.

Not

because
transactions.

they

are

related-party

Only

transactions with outside unrelated

parties
can
be
reported
in
the
consolidated statements.
6-7

Intercompany Transactions:
Additional Opportunities for Fraud

Intercompany transactions
sometimes
occur to
conceal

embezzlements.

overstate

reported profits.

+ 2

5
6-8

Example 1: Intercompany Loan

A 12-year old girl lends $5 to her 17year old brother.
From the standpoint of individuals, this
represents a receivable and a payable.
If the family prepares a consolidated
balance sheet, what is the effect?

No net change to the familys wealth.

Not a transaction
person.

with

non-family
6-9

Example 2:
Sale from Parent to Sub to
Outsider
Parent has 19 subsidiaries.
Parent has received a $1 order from an
outsider.
Parent sells inventory to Sub 1 for $1.

Sub 1 sells the inventory to Sub 2 for $1.

Sub 2 sells the inventory to Sub 3 for $1.
The inventory is sold from one sub to another
until Sub 19 sells it to the outsider for $1.

The parent and each sub reports sales

of $1.
From a consolidated standpoint, what
6-10

Example 3: Sale from Parent to

Sub, But Not Yet to an Outsider
Sleazy Parent Company has one sub.
Sleazy Parent is preparing for an IPO.
Sleazy Parent owns lots of
inventory which it cannot sell.

obsolete

Sleazy Parent sells the obsolete inventory

(costing $1,000) to its sub for $100,000.
Sleazy Sub now holds the inventory.
Without any adjustment, what items in
Sleazys consolidated financial statements
will be misstated?
6-11

Correcting Entries
Conceptually, how would you correct each of these
three problems?
Easy! To eliminate intercompany loans:
Loan Payable
Just
Loan Receivable
reverse
Easy!
Just
reverse

xxx
xxx

To eliminate sale from Parent to Sub to Outsider:

Sales
xxx
Cost of Goods Sold
xxx

To eliminate sale from Parent to Sub, not yet to Outsider

xxx
More Sales
xxx
difficult Cost of Goods Sold
Inventory
Unrealized GP
6-12

Lets work through an example:

Assume Parent Co. owns 100% of Sub Co.
The following intercompany transactions occurred
during the year:
A. Parent loaned $500 to Sub. To keep things simple,
assume that there is no interest revenue or interest
expense associated with this loan.
B. Parent made a sale to Sub for $400 cash. The inventory
had originally cost Parent $250. Sub then sold that
same inventory to an outsider for $500.
C. Parent made a sale to Sub for $300 cash. The inventory
had originally cost Parent $200. Sub has not yet sold
that same inventory to an outsider.

What consolidation worksheet entries would you

make?
6-13

(a) Loan from Parent to Sub

Does this transaction include
el!
c
n
a
C
outsiders?
Parent:
Receivable 500
Cash
500
Parent $500
Sub

Reverse the entries

made by the parent and
the sub.

Sub:
Cash
500
Payable

To eliminate intercompany loans:

Loan Payable
Loan Receivable

500

500
500
6-14

(b) Sale from Parent to Sub to

Outsider
Keep Parents COGS Keep Subs Sale

$250 Parent $400

Keep
This
Purchase

Sub $500

Eliminate effect
of this internal
Transaction

Keep
This
Sale
6-15

(b) Sale from Parent to Sub to

Outsider
Item
Amounts
Sales
Cost of goods
sold
Gross profit

Unadjusted
Consolidated
Parent
Subsidiary
Totals
$400

$500

$900

-250
$ 150

-400
$ 100

-650
$ 250

(400)
(400)

$500
-250
$ 250

To eliminate sale from Parent to Sub to Outsider:

Sales (parent to sub)
400
Cost of Goods Sold (to outsider)
400
16

(c) Sale From Parent to Sub (Not

Outside)
Is this a legitimate arms length
transaction?

$250 Parent $400

Keep
this
purchase

Sub

Eliminate effect
of this internal
transaction

Parent:
Cash
400
Sales
400
COGS 250
Inventory
250
Sub:
Inventory400
Cash
400

Summary of the Transaction:

Parent purchased inventory for $250.
Parent sold the inventory to a Sub for $400.
Reverse the entries made by the parent and sub.

6-17

(c) Sale From Parent to Sub (Not

Outside)
Unadjusted
Consolidated
Parent
Subsidiary
Totals

Item
Amounts
Sales
Cost of goods
sold
Gross profit
Inventory

$400
-250
$ 150
$

-0-

-0-

$400

(400) $

-250
$ 150

(250)

-0-0$400

$400

(150)

-0-0-0$ 250

To eliminate sale from Parent to Sub, not yet to Outsider:

Sales
400
Cost of Goods Sold
250
Inventory
150
18

(c) Sale From Parent to Sub (4/5

to Outside)
Keep 4/5 Parents COGS Keep 4/5 Subs Sale

$200 Parent $400

Keep
This
Purchase

Sub $400

Eliminate effect
of this internal
Transaction

Keep
This
Sale
6-19

(c) Sale From Parent to Sub (4/5

to Outside)
Unadjusted
Consolidated
Parent
Subsidiary
Totals

Item
Amounts
Sales
Cost of goods
sold
Gross profit
Inventory

$ 400
-250
$ 150
$

-0-

400

$ 800

-320
80

-570
$ 230

$80

$80

(400) $ 400
(370)

-200
$ 200

(30) $

To eliminate sale from Parent to Sub, 4/5 to Outsider:

Sales
400
Cost of Goods Sold
370
Inventory
30
Represent amount of unrealized
20
profit

50

Summary of Consolidation
Entries:
To eliminate intercompany loans:
Loan Payable
Loan Receivable

500
500

To eliminate sale from Parent to Sub to Outsider:

Sales
400
Cost of Goods Sold
400
To eliminate sale from Parent to Sub, not yet to Outsider:
Sales
400
Cost of Goods Sold
250
Inventory
150
To eliminate sale from Parent to Sub, 4/5 to Outsider:
Sales
400
Cost of Goods Sold
370
Inventory
30
6-21

Fully-adjusted Equity Method

Adjustment
Parent companies have to adjust their equity
method investment accounts for certain
transactions.
At this point, lets just consider one:

Sale from parent to sub, but not yet sold to an

outsider.

It represents fake profit that hasnt really been

realized in an arms-length transaction.

Both the balance sheet and income

statement accounts need to be adjusted.
This is a REAL journal entry,
consolidation worksheet entry!

not

a
6-22

Equity Method Adjustment

Example
$500 Parent $600
Summary of the Transaction:
Parent purchased inventory for
$500.
Parent sold the inventory to a Sub
Equity
for
$600.Method Entry:
Income from Sub
Investment in Sub
100

Sales $ 600
COGS 500
GP
$ 100

Sub

100

The Parent recognized $100 of fake gross profit!

The Parent should have transferred the inventory at
cost.
This profit is not from a transaction with an arms-length

6-23

Group Practice
Assume Parent Co. owns 80% of Sub Co.
The following intercompany transactions occurred
during the year:

Parent loaned $100 to Sub. To keep things simple, assume

that there is no interest revenue or interest expense
associated with this loan.

Parent made a sale to Sub for $200 cash. The inventory

had originally cost Parent $120. Sub then sold that same
inventory to an outsider for $300.

Parent made a sale to Sub for $300 cash. The inventory

had originally cost Parent $180. Sub has not yet sold that
same inventory to an outsider. (Dont forget equity method
entry!)

Based on our conceptual discussion, what

consolidation worksheet entries would you make?

6-24

Consolidation Entries
To eliminate intercompany loans:
Loan Payable
Loan Receivable

100
100

To eliminate sale from Parent to Sub to Outsider:

Sales
200
Cost of Goods Sold
200
To eliminate sale from Parent to Sub, not yet to Outsider:
Sales
300
Cost of Goods Sold
180
Inventory
120

To correct inventory
Equityvalue
Method Entry:
Income from Sub
Investment in Sub

120
120
6-25

FIRSTTo
YEAR

Consolidation Entries Second

Year

eliminate sale from Parent to Sub, not yet to Outsider:

Sales
300
Cost of Goods Sold
180
Inventory
120
Equity Method Entry - Downstream:
Income from Sub
Investment in Sub
120

SECOND
YEAR

120

To realize sale from Sub to Outsider:

Investment in Sub
120
Cost of Goods Sold
Equity Method Entry - Downstream:
Investment in Sub
Income from Sub
120

120

120

6-26

Downstream and Upstream

Downstream sales to a
partially-owned subsidiary:

Up
m strea

Do
m wnst

rea

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).

Because S profits are shared with

the NCI shareholders.

NCI

P
S
6-27

FIRST To
YEAR

Consolidation Entries Second

Year

eliminate sale from Parent to Sub, not yet to Outsider:

Sales
300
Cost of Goods Sold
180
Inventory
120
Equity Method Entry - Upstream:
Income from Sub
80% x 120
Investment in Sub
80% x 120

SECOND
YEAR

To realize sale from Sub to Outsider:

Investment in Sub
80% x 120
NCI in NA
20% x 120
Cost of Goods Sold

120

Equity Method Entry - Upstream:

Investment in Sub
80% x 120
Income from Sub
80% x 120
6-28

Learning Objective 6-5

Understand and explain

additional considerations
associated with
consolidation.

6-29

Additional Considerations
Sale from
another

one

subsidiary

to

Transfers of inventory often

between companies that are
common control or ownership.

occur
under

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
6-30

Additional Considerations

Lower-of-cost-or-market

A company might write down

inventory purchased from an affiliate
under this rule if the market value at
the end of the period is less than the
intercompany transfer price.

6-31

Lower-of-Cost-or-Market Example
Assume that a parent company purchases inventory for
$20,000 and sells it to its subsidiary for $35,000. The
subsidiary still holds the inventory at year-end and
determines that its market value (replacement cost) is
$25,000 at that time. 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:
Write-down Inventory to Market Value:
Loss on Decline in Value of Inventory 10,000
Inventory
10,000
Make the following worksheet eliminating entry:

Sales
35,000
Cost of Goods sold
Inventory
Loss on Decline in Value of Inventory

20,000
5,000
10,000
6-32

Conclusion

The End

6-33

Exercise
Pisa Company acquired 75 percent of Siena
Company on January 1, 20X3 for $712,500. The fair
value of the noncontrolling interest was equal to 25
percent of book value. On the date of acquisition,
Siena had common stock outstanding of $300,000
and a balance in retained earnings of $650,000.
During 20X3, Siena purchased inventory for $35,000
and sold it to Pisa for $50,000. Of this amount, Pisa
reported $20,000 in ending inventory in 20X3 and
later sold it in 20X4. In 20X4, Pisa sold inventory it
had purchased for $40,000 to Siena for $60,000.
Siena sold $45,000 of this inventory in 20X4. Income
and dividend information for Siena for 20X3 and
20X4 are as follows:
34

Exercise (2)
Pisa Company uses equity method.
Required:
a. Present the worksheet elimination entries
necessary to prepare consolidated financial
statements for 20X3.
b. Present the worksheet elimination entries
necessary to prepare consolidated financial
statements for 20X4.

35

Answer (a)

36

Answer (a)-2

37

Answer (b)

38

Answer (b)-2

39