Chapter 06 – INTERCOMPANY INVENTORY TRANSACTIONS
CHAPTER 6
INTERCOMPANY INVENTORY TRANSACTIONS
OVERVIEW OF CHAPTER
Chapters 6 and 7 focus on the elimination of the effects of transfers of assets and services
between companies included in a consolidated entity. The procedures to eliminate the effects of
intercorporate inventory transfers are developed in Chapter 6. A brief discussion about
worksheet entires needed for consolidation when inventory transfers are done at cost and when
done at a profit or loss is provided as an introduction.
Chapter 6 explains the consolidation procedures. In the initial illustration for downstream
transfers, inventory is sold by the parent to an affiliate in the first period and then resold to a
nonaffiliate during the same period. In the second illustration, inventory is sold to an affiliate in
the first period and resold to a nonaffiliate in the next period. Chapter 6 then illustrates upstream
transfers using a sale of inventory to the parent in the first period and resale to a nonaffiliate in
the second period. The chapter discussions and illustrations assume that the perpetual inventory
method is utilized because of its wide use in many companies.
The additional considerations section of the chapter presents discussions and illustrations
relating to sales from one subsidiary to another, costs associated with transfers, sales and
purchases before affiliation and the application of the lower of cost or market valuation to
intercompany inventories.
In Appendix 6A, consolidation procedures followed when the parent accounts for its
investment in the subsidiary under the modified equity method and the cost method are
presented.
LEARNING OBJECTIVES
When students finish studying this chapter, they should be able to:
LO 6-1 Understand and explain intercompany transfers and why they must be eliminated.
LO 6-2 Understand and explain concepts associated with inventory transfers and transfer
pricing.
LO 6-3 Prepare equity-method journal entries and consolidation entries for the consolidation
of a subsidiary following downstream inventory transfers.
LO 6-4 Prepare equity-method journal entries and consolidation entries for the consolidation
of a subsidiary following upstream inventory transfers.
Chapter 06 – INTERCOMPANY INVENTORY TRANSACTIONS
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LO 6-5 Understand and explain additional considerations associated with consolidation.
SYNOPSIS OF CHAPTER 6
Intercompany Inventory Transactions
Inventory Transfers at Samsung Electronics
LO 6-1 Understand and explain intercompany transfers and why they must be eliminated.
Overview of the Consolidated Entity and Intercompany Transactions
Elimination of Intercompany Transfers
Elimination of Unrealized Profits and Losses
LO 6-2 Understand and explain concepts associated with inventory transfers and transfer
pricing.
Inventory Transactions
Worksheet Consolidation Entries
Transfers at Cost
Transfers at a Profit or Loss
Calculating Unrealized Profit or Loss
Deferring Unrealized Profit or Loss on the Parent’s Books
Deferring Unrealized Profit or Loss in Consolidation
Why Adjust the Parent’s Books and Make Worksheet Entries?
LO 6-3 Prepare equity-method journal entries and consolidation entries for the consolidation
of a subsidiary following downstream inventory transfers.
Downstream Sale of Inventory
Resale in Period of Intercorporate Transfer
Resale in Period following Intercorporate Transfer
Inventory Held Two or More Periods
LO 6-4 Prepare equity-method journal entries and consolidation entries for the consolidation
of a subsidiary following upstream inventory transfers.
Upstream Sale of Inventory
Equity-Method Entries–20X1
Consolidation Worksheet–20X1
Consolidated Net Income–20X1
Equity-Method Entries–20X2
Consolidation Worksheet–20X2
Consolidated Net Income–20X2
LO 6-5 Understand and explain additional considerations associated with consolidation.
Chapter 06 – INTERCOMPANY INVENTORY TRANSACTIONS
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Additional Considerations
Sale from One Subsidiary to Another
Lower of Cost or Market
Sales and Purchases before Affiliation
Appendix 6A: Intercompany Inventory Transactions—Modified Equity Method and Cost
Method
Modified Equity Method
Modified Equity-Method Entries–20X1
Consolidation Entries–20X1
Modified Equity-Method Entries–20X2
Consolidation Entries–20X2
Cost Method
Consolidation Entries–20X1
Consolidation Entries–20X2
NOTES ON POWERPOINT SLIDES
We have attempted to provide PowerPoint slides that will be useful to a broad set of users. Since
instructors often have different styles and preferences, we have attempted to include slides that
will accommodate different approaches and that can be adapted to classes with different levels of
preparation. For example, some instructors prefer to introduce the material before students have
read the chapter. We have tried to facilitate these types of introductory discussions by including
slides that replicate key points from the chapter. Other instructors expect students to have read
the chapter and attempted homework problems before coming to class. As a result, they may not
find it useful to review all of the topics in the chapter or to include slides that simply review
many of the details they expect students to study before class. However, instructors following
this approach often like to use sample exercises and problems built into the slides that allow
them to have extended discussions or to facilitate group interaction in class.
If instructors elect to spend two class periods on the same subject, they might find a combination
of both styles to be useful by first introducing foundational material before students have read
the chapter and studied the topic, followed by an extended discussion the next class period after
students have read the chapter and attempted homework problems.
We have tried to develop slides that can facilitate a flexible approach to allow instructors to
select the slides that best match their objectives and style for class discussions. This is the reason
we are including over 100 slides for some chapters in the text. We do not expect all instructors
to use all slides, but the slide files should help support different teaching approaches and allow
instructors to select the subset of slides that best matches their specific discussion objectives.
The slides are organized by learning objective. We have included a slide at the beginning of
each learning objective to show where the new material begins. Instructors may or may not want
Chapter 06 – INTERCOMPANY INVENTORY TRANSACTIONS
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to use these learning objective slides in class. We provide them primarily as a way of organizing
the material. We also include short multiple choice questions at the end of most learning
objectives. Some instructors find it useful to pause periodically during class to assess students’
level of understanding. For this reason, we include several “practice quiz questions” that can be
used throughout class discussions to engage students, help them focus on key points, or to
facilitate group interaction. Finally, we provide longer exercises and problems that many
instructors find useful in assessing understanding and encouraging group learning.
LO 6-1 Understand and explain intercompany transfers and why they must be eliminated.
• Slides 3-6 summarize basic concepts related to intercompany transactions.
• Slides 7-9 introduce simple examples to help students understand some of the
problems associated with intercompany transactions and slide 10 describes
generically how these types of intercompany problems can be eliminated through
worksheet consolidation entries.
• Slides 11-21 follow a simple example illustrating the three types of intercompany
transactions previously discussed. Some instructors find this very slow, methodical
explanation useful in laying a foundation to help students understand the rest of this
chapter and the next two chapters. Note that the “stick figures” are supposed to help
students recognize “arms length” transactions between companies in the consolidated
group and independent outsiders.
LO 6-2 Understand and explain concepts associated with inventory transfers and transfer
pricing.
• Slides 25-32 raise important questions and provide answers about issues associated
with intercompany inventory transfers.
• Slides 33-41 introduce a very useful tool and terminology for calculating unrealized
inventory profits and eventually for preparing inventory consolidation entries. We
highly recommend the chart introduced in these slides. We have found this chart to be
one of the best tools for helping students to understand intercompany inventory
transfers. Note that the chart traces what happens to intercompany sales. Thus, the
top row is denominated in terms of the selling company’s sales dollars.
• Slides 42-65 walk students through three concrete examples and demonstrate how the
chart can be used. Sometimes questions will simply ask students to solve for
unrealized profits (which can be calculated fairly easily in most instances). However,
later, we demonstrate how the same chart can be used to quickly prepare the
inventory worksheet consolidation entry. Note that one of the most important things
for students to learn from these examples is to watch for markup based on cost or
transfer price.
LO 6-3 Prepare equity-method journal entries and consolidation entries for the consolidation
of a subsidiary following downstream inventory transfers.
• Slides 67 explains the need for an equity method adjustment under the fully adjusted
equity method to ensure that the parent’s income and balance sheet are correct in
order to maintain the “built–in” check figures discussed in previous chapters (i.e.,
Parent Company NI = Consolidated NI and Parent Company RE = Consolidated RE).
Chapter 06 – INTERCOMPANY INVENTORY TRANSACTIONS
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• Slides 68-70 summarize fairly concisely a suggested approach to solving inventory
problems (including worksheet consolidation entries).
• Slides 72-84 walk through an over example of a downstream sale. The data for this is
example does not come from text example of Peerless and Special Foods. This
example can be used by instructors who wish to use an example that separate from
the text example
• Slides 85-106 walk through a detailed example of Peerless and Special Foods.
• Slides 109-122 provide a detailed example of a set of partially owned downstream
inventory transactions. This example is important because it explains the worksheet
and equity method reversals that take place in the subsequent year (assuming the
inventory is sold during the next year). Note that in slide 108, the second
consolidation entry solves an important problem. In the first year, we defer the
unrealized profit. However, in the second year, when the inventory is actually sold,
we need to force the recognition of the previously deferred gross profit or else it will
never appear on the financial statements in either year. An important point to make in
this example is that in a downstream transaction, the deferral of unrealized gross
profit is not shared with the NCI shareholders. We often explain to our students that
since the NCI shareholders are assumed to own 0% of the parent company, they don’t
share in the deferral since the unrealized gross profit resides on the income statement
of the parent.
LO 6-4 Prepare equity-method journal entries and consolidation entries for the consolidation
of a subsidiary following upstream inventory transfers.
• Slide 124 summarizes the main difference between downstream and upstream
intercompany sales. Emphasize here that since the sale is upstream, the unrealized
gross profit resides on the income statement of the subsidiary company. Since the
NCI shareholders have an ownership interest in that income, they share the deferral of
unrealized gross profit with the parent company proportionately.
• Slides 125-141 again use Peerless and Special Foods and provide a similar example
only this time the sales are upstream. These slides follow the example presented in
the text for instructors who wish to present the text example using a step-by-step
illustration. This example also demonstrates the consolidation entry reversal and the
equity method reversal in the year subsequent to the deferral (assuming the inventory
is sold the next year). Note that there is data for two consecutive periods in this
example to help students see how while one year’s unrealized gross profit is deferred,
the prior year’s unrealized gross profit is reversed.
• Slides 142-163 again provide an upstream example for two consecutive periods,
however this example does not use the data from Peerless and Special Foods.so that it
can be used as a review example. Instructors may wish to choose between using
slides 125-141, or slides 142-163, depending on the example they wish to present.
LO 6-5 Understand and explain additional considerations associated with consolidation.
• Slides 164-171 briefly summarize the additional considerations at the end of the
chapters. Instructors should select those topics they deem to be important.
Chapter 06 – INTERCOMPANY INVENTORY TRANSACTIONS
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TEACHING IDEAS
1. Students could be asked to prepare a written memo discussing the pros and cons of
vertically integrating by acquiring a company that can supply input materials into your
company’s production processes. Most students will mention control over quality and
price management or other economic benefits of this arrangement. In today’s business
environment of targeted source suppliers and Just–In-Time manufacturing, is it still a
good economic decision to acquire a company just to have its productive output for input
into your company?
2. For a Fortune 100 company, students could be asked to determine the amount of
intercompany revenue that has been eliminated during the consolidation process. This can
be determined by analyzing the eliminations column in the segment disclosure footnote
which shows total revenue before elimination of the intercompany amounts and
consolidated revenue. Students could be asked to determine the percentage of total
revenue of the operating segments that is generated from intercompany transactions.
Then, students could be asked to determine the average gross profit percentage of the
consolidated entity by determining gross profit as a percentage of consolidated sales.
Students will find a large range of profit percentages with many in the 20-50 percent
range. Thus, intercompany profit can be a significant portion of the sales made between
members of the consolidated entity.
3. Students could be asked to obtain information on inventory methods used by the sample
firms in the Accounting Trends & Techniques. The information is included in “Section 2:
Balance Sheet Inventories.” Students will learn which methods are most commonly used
and can be asked to determine the effects on consolidation procedures when the parent
and subsidiary use different inventory methods.
Chapter 06 – INTERCOMPANY INVENTORY TRANSACTIONS
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DESCRIPTIONS OF CASES, EXERCISES, AND PROBLEMS
C6-1
LO 6-2
20 min.
M
Measuring Cost of Goods Sold
An understanding of the consolidation process used following an intercorporate
sale of inventory is needed to discuss the elimination rules proposed in the case.
Students are also asked how one would determine the amount of unrealized profit
at the end of an accounting period.
C6-2
LO 6-1,
LO 6-2
25 min.
M
Inventory Values and Intercompany Transfers
A company holds an ownership interest in both its supplier and customer.
Students are required to prepare a memorandum describing the effects of
intercompany transfers on the valuation of inventories and discuss how particular
ownership levels would help support the company’s inventory strategy for highly
appreciated inventory carried at LIFO valuation.
C6-3
LO 6-1
20 min.
M
Unrealized Inventory Profits
Students are required to give the conditions under which four situations could
occur when a parent company holds majority ownership of a subsidiary and
frequent intercompany inventory sales have been made. A good understanding of
the consolidation process is needed to provide appropriate answers.
C6-4
LO 6-3,
LO 6-4
25 min.
M
Eliminating Inventory Transfers
A parent company’s billing procedures do not differentiate between
intercompany and outside sales. The financial statement effect of not eliminating
intercompany sales and profits must be examined. In addition, students must
recommend a control system that would allow the parent company to identify the
information necessary for eliminating intercompany inventory sales. The effect
of the parent and subsidiaries utilizing different inventory cost flow assumptions
must also be explored. Furthermore, students should suggest how the company
can obtain the necessary information so that it can eliminate current period
intercompany sales.
C6-5
LO 6-1,
LO 6-2
30 min.
M
Intercompany Profits and Transfers of Inventory
Students must use the Internet or other data sources to answer questions about the
ways in which Xerox Corporation, ExxonMobil Corporation, and Ford Motor
Company price intercompany transfers of products and how profits on
intercompany transfers are treated for consolidation purposes.