INTERCOMPANY INVENTORY TRANSFERS

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CHAPTER 9

• INTERCOMPANY INVENTORY TRANSFERS

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FOCUS OF CHAPTER 9

• Conceptual Issues
• Procedures for Calculating Unrealized Profit
• Procedures for Deferring Unrealized Profit
• The Complete Equity Method
• The Partial Equity Method
• The Cost Method

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Conceptual Issues Issue 1Should We or
Shouldnt We?

• Whether to Eliminate Intercompany Transactions in
  Consolidation
• No controversythey must be eliminated.
• Not eliminating causes two problems
• Meaningless double-counting of (1) sales and (2)
  cost and expenses.
• Potential to manipulate income.

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The Substance of Inventory Transfers

• The CONSOLIDATED Perspective
• Merely the physical movement of inventory from
  one location to another location.
• Similar to the movement of inventory from one
  division to another division.
• NOT a bona fide transaction.
• The SEPARATE COMPANY Perspective
• A bona fide transaction.

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Conceptual Issues Issue 2Which Measure of
Profit To Use?

• Possible Theoretical Profit Measures
• Gross profit.
• Operating profit.
• Net income.
• Profit Measure Required To Be Used By GAAP
• GROSS PROFIT (of the selling entity).

Sales.................... 1,000 Cost of
sales....... (600) GROSS profit. 400
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Conceptual Issues Issue 3Whether To Eliminate
Income Tax Effects ?

• Income taxes on the selling entitys UNREALIZED
  gross profit must also be eliminated.
• In this chapter
• No income tax entries are required.
• Because we assume that the tax effects have
  already been recorded in the parents or the
  subsidiarys general ledger.
• DONE FOR SIMPLICITY ONLY.

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Conceptual Issues Issue 4Whether To Eliminate
All or Some?

• DOWNSTREAM Sales to a Partially Owned Subsidiary
• Eliminate 100 of unrealized profit.
• Fractional elimination is prohibited.
• UPSTREAM Sales from a Partially Owned
  Subsidiary
• Eliminate 100 of unrealized profit.
• Fractional elimination is prohibited.

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Conceptual Issues Issue 5Whether To Share the
Deferral?

• DOWNSTREAM Sales to a Partially Owned Subsidiary
• Entire profit accrues to the parentthus sharing
  is not appropriate.
• UPSTREAM Sales from a Partially Owned
  Subsidiary
• Must share deferral with the NCI shareholders (if
  amount is material).

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Inventory Transfers A Whole New Slant on
Realization

• REALIZATIONWhat to focus on for consolidated
  reporting purposes
• Not on whether the SELLER has
• Delivered the product,
• Collected on the sale, or
• Reduced to an acceptable level the uncertainty
  about the net cash flow effect of an earnings
  activity.

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Inventory Transfers A Whole New Slant on
Realization

• REALIZATIONWhat to focus on for consolidated
  reporting purposes
• But on whether the BUYER has
• Resold the inventory to an outside unaffiliated
  customer.

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Inventory Transfers Unrealized ProfitSearching
for that Old Basis

• The Objective
• To change the inventorys carrying value from the
  NEW basis of accounting to the OLD basis of
  accounting.

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Inventory Transfers Calculating Unrealized Gross
ProfitThe Analysis
Amounts That Will ALWAYS Be Known (Given)

Re- On

Total Sold Hand Interco. sales (NEW
basis)............. 1,000
200 Interco. cost of sales (OLD basis)..
(600) ____ ____ Gross
Profit.................................... 400
Gross Profit Percentage...............
40 CRITICAL ASSUMPTION The gross profit
percentage derivable from the total column
applies to both (1) the inventory that has been
resold AND (2) the inventory that is still on
hand.

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Inventory Transfers Calculating Unrealized
Gross ProfitThe Analysis
Completed Analysis

Re- On
Total Sold
Hand Interco. sales (NEW basis)..............
1,000 800 200 Interco. cost of sales
(OLD basis).. (600) (480) (120)
Gross Profit....................................
400 320 80
REALIZED


UNREALIZED The Inventory/COS
Change in Basis Elimination Entry is derived
from this analysis.

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Inventory Transfers A Point to Remember

• Intercompany Sales and Intercompany Cost of Sales
  accounts are eliminated only in years in which
  intercompany sales occur.

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Inventory Transfers The Two Procedural Methods

• MODULE 1 The Complete Equity Method
• Unrealized profit is deferred in the selling
  entitys general ledger.
• MODULE 2 The Partial Equity Method
• Unrealized profit is deferred in the
  consolidation process.

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MiscellaneousLower-of-Cost-or-Market Adjustments

• For consolidated reporting purposes, the
  appropriate valuation of intercompany- acquired
  inventory is
• The lower of
• the selling entitys cost or
• the market value.

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Miscellaneous Partial OwnershipsReporting to
the NCI Shareholders

• Under existing GAAP, a partially owned
  subsidiary
• Need not defer any of its unrealized intercompany
  gross profit in reporting to its NCI shareholders.

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Review Question 1

• For 2006, Paxco reported 60,000 of intercompany
  sales (25 markup on cost and fully paid for by
  Y/E) to Saxco, which reported 20,000 of
  intercompany acquired inventory at 12/31/06. The
  unrealized profit at 12/31/06 isA. -0- B.
  4,000 C. 5,000 D. 20,000 E. None of the
  above.

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Review Question 1With Answer

• For 2006, Paxco reported 60,000 of intercompany
  sales (25 markup on cost and fully paid for by
  Y/E) to Saxco, which reported 20,000 of
  intercompany acquired inventory at 12/31/06. The
  unrealized profit at 12/31/06 isA. -0- B.
  4,000 (20 of 20,000 Y/E inventory) C.
  5,000 D. 20,000 E. None of the above.

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Review Question 2

• For 2006, Punco reported intercompany cost of
  sales of 1,600,000 (markup is 20 of transfer
  price) to Sunco, which reported 600,000 of
  intercompany acquired inventory at 12/31/06. The
  unrealized profit at 12/31/06 isA. 80,000 B.
  96,000 C. 120,000 D. 150,000 E. None
  of the above.

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Review Question 2With Answer

• For 2006, Punco reported intercompany cost of
  sales of 1,600,000 (markup is 20 of transfer
  price) to Sunco, which reported 600,000 of
  intercompany acquired inventory at 12/31/06. The
  unrealized profit at 12/31/06 isA. 80,000 B.
  96,000 C. 120,000 (20 of 600,000 Y/E
  inventory)D. 150,000 E. None of the above.

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Review Question 3

• For 2006, Salco (80 owned by Palco) reported
  800,000 of intercompany sales (1/3 markup on
  cost) to Palco, which resold 700,000 of this
  inventory by 12/31/06. The unrealized profit at
  12/31/06 isA. 20,000 B. 25,000 C.
  26,667 D. 33,333 E. None of the above.

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Review Question 3With Answer

• For 2006, Salco (80 owned by Palco) reported
  800,000 of intercompany sales (1/3 markup on
  cost) to Palco, which resold 700,000 of this
  inventory by 12/31/06. The unrealized profit at
  12/31/06 isA. 20,000 B. 25,000 (25 x
  100,000 inventory on hand) C. 26,667 D.
  33,333 E. None of the above.

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End of Chapter 9

• Time to Clear Things UpAny Questions?