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Intercompany Transactions in Accounting

This document provides an instructional module for an accounting course on business combinations. It discusses downstream sales of inventory between a parent company and its 80% owned subsidiary. The parent company sold $10,000 of inventory, costing $7,500, to the subsidiary. At year-end, the subsidiary still had $5,000 of that inventory remaining unsold. The module provides journal entries for the transaction and calculations to eliminate unrealized intercompany profit and determine consolidated net income and its allocation between the parent and non-controlling interest.

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MILBERT DE GRACIA
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41 views5 pages

Intercompany Transactions in Accounting

This document provides an instructional module for an accounting course on business combinations. It discusses downstream sales of inventory between a parent company and its 80% owned subsidiary. The parent company sold $10,000 of inventory, costing $7,500, to the subsidiary. At year-end, the subsidiary still had $5,000 of that inventory remaining unsold. The module provides journal entries for the transaction and calculations to eliminate unrealized intercompany profit and determine consolidated net income and its allocation between the parent and non-controlling interest.

Uploaded by

MILBERT DE GRACIA
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

Prepared by: HAZEL JADE E.

VILLAMAR__
E-mail Address: _hazeljade.villamar@[Link].ph________

Central Luzon State University


Science City of Muñoz 3120
Nueva Ecija, Philippines

Instructional Module for the Course


ACCTG 2215 / Accounting for Business Combinations

Module 2
Topic 3 (Downstream Sale of Inventory II)
Overview

This course covers the concepts and application of the different standards
related to accounting for business combination. It involves techniques and
methodologies on how to deal properly with issues and problems involving
business combination that are likely to be encountered in practice and in the
National CPA Licensure Examination.

I. Objectives
At the end of the module, the following are expected to:

A. To understand the concept of intercompany transactions;

B. Identify the effect of intercompany transactions to financial statements; and

C. Compute the effect of intercompany sales.


ACCTG 2215 / Accounting for Business Combinations

DOWNSTREAM SALE OF INVENTORY

Resale in Subsequent Period Following Intercompany Sale:


Unrealized Intercompany Profit in Ending Inventories

Any merchandise purchased from an affiliated company that remains unsold on the
date of Consolidated Statement of Financial Position results in the overstatement of
purchaser’s ending inventories. The overstatement is equal to the amount of the selling
affiliate’s unrealized intercompany profit included in the ending inventory.

Assume that on March 1, 2020, Parent Company sold merchandise to Sub Company
(an 80% owned subsidiary) costing P7,500 for P10,000 or at a gross profit of 25%, out of
which P5,000 remained unsold by Sub Company on December 31, 2020. The inventories
sold to outsiders by Sub Company were marked up at 20% on cost. The following entries
were recorded by each company:

Books of Parent Company:


03/01/2020 Cash 10,000
Sales 10,000
To record the sale to Sub Company.

Cost of goods sold 7,500


Inventory 7,500
To record the cost of inventory sold.

Books of Sub Company:


03/01/2020 Inventory 10,000
Cash 10,000
To record the purchase from Parent.

12/31/2020 Cash 6,000


Sales 6,000
To record the sale to outsiders.

Cost of goods sold 5,000


Inventory 5,000
To record the cost of goods sold.

Page 2 of 5
ACCTG 2215 / Accounting for Business Combinations

Selling Price Cost Gross Profit (25%)


Beginning Inventory - - -
Add: Sales P 10,000 P 7,500 P 2,500
Totals P 10,000 P 7,500 P 2,500
Less: Ending Inventory 5,000 3,750 1,250
Cost of goods sold P 5,000 **P 3,750 P 1,250

Parent Sub Unadjusted Consolidated


Company Company Balances Balances
Sales P 10,000 P 6,000 P 16,000 P 6,000
COGS 7,500 5,000 12,500 **3,750
Gross profit P 2,500 P 1,000 P 3,500 P 2,250

Based on the foregoing analysis, the working paper elimination entries are required
for Parent’s intercompany sales of merchandise to Sub for the year ended December 31,
2020:
Sales 10,000
Cost of goods sold 10,000
To eliminate intercompany sale of inventory.

Cost of goods sold 1,250


Inventory 1,250
To eliminate unrealized inventory profit.

Proof:
Assume that Sub Company sold all the inventory during the period, the following is
the expected consolidated income of the two companies:
Parent Sub Unadjusted Consolidated
Company Company Balances Balances
Sales P 10,000 P 12,000 P 22,000 P 12,000
COGS 7,500 10,000 17,500 7,500
Gross profit P 2,500 P 2,000 P 4,500 P 4,500

Since the Sub Company was able to sell only P5,000 worth of its
inventories, or 50% of the available inventories, the Gross Profit for the period
is also 50% of the expected consolidated gross profit which is equal to P2,250.

Page 3 of 5
ACCTG 2215 / Accounting for Business Combinations

Computation and Allocation of Consolidated Net Income

The computation of consolidated net income and its allocation on December 31, 2020
is computed as follows (net income of both companies are assumed):

Parent’s net income form own operations 50,000


Unrealized intercompany profit on inventory (1,250)
Parent’s realized income from outsiders 48,750
Sub’s net income from own operations 24,000
Consolidated net income 72,750
Attributable to NCI (24,000 x 20%) 4,800
Attributable to parent shareholders 67,950

Intercompany Profit in Beginning and Ending Inventories

Generally, it is assumed that on a first-in, first-out basis, the intercompany profit in


the purchaser’s beginning inventories is realized through sales of the merchandise to
outsiders during the following period. Only the intercompany profit in ending inventories
remains unrealized at the end of the period.

Page 4 of 5
ACCTG 2215 / Accounting for Business Combinations

REFERENCES:

Advanced Accounting Principles and Procedural Applications Volume 2 by Pedro P. Guerrero


and Jose F. Peralta

Page 5 of 5

Common questions

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Eliminating intercompany sales of inventory from consolidated financial statements is necessary to prevent overstatement of sales and cost of goods sold figures. This involves creating elimination entries that adjust these figures, ensuring the consolidated sales reflect only transactions with external parties .

The cost of goods sold (COGS) helps in identifying the actual profit versus the unrealized profit from downstream sales. By adjusting COGS in consolidation, the overstated profit in intercompany transactions is identified and eliminated, ensuring that the realized profit is accurately reflected .

Accurately computing the effects of intercompany sales is crucial in CPA licensure examination preparation as it tests candidates' understanding of key accounting principles in business combinations. Precise adjustments for intercompany profits and inventory valuations are fundamental skills needed to assure compliance with accounting standards .

Under the FIFO basis, intercompany profit in the purchaser's beginning inventory is assumed to be realized through sales to outsiders in the succeeding period, leaving only the profit in ending inventories unrealized at the end of the period. This method influences when the intercompany profit is considered realized or unrealized .

Intercompany transactions in business combinations affect financial statements by leading to overstatements. For example, if merchandise purchased from an affiliated company remains unsold at the end of the period, the purchaser’s ending inventories are overstated by the amount of the selling affiliate's unrealized intercompany profit .

Sub Company's marking up of inventories at different rates impacts consolidated reporting by affecting the calculation of consolidated gross profit. Different mark-up rates alter the COGS, which in turn impacts the gross profit that is reported after eliminating intercompany sales and unrealized profits .

Consolidated net income is calculated by combining net incomes from all entities within the group and adjusting for any unrealized intercompany profits. It is distributed among the parent and non-controlling interests based on ownership percentages, where non-controlling interest is represented as a proportionate share of a subsidiary's net income .

Eliminating unrealized intercompany profit is essential to provide a fair representation of financial statements by not overstating income from unsold inventory between affiliates. It ensures that consolidated financial statements report only realized gains and depict accurate inventories and profits .

Partial inventory sales by subsidiaries impact financial consolidation by requiring adjustments for unrealized intercompany profits on unsold inventory. Only actual profits from sold inventories are realized; unadjusted sales may cause misrepresentation in profits and inventory valuation in consolidated financial statements .

Accounting guidelines assume that intercompany profit in the purchaser’s beginning inventories is realized through sales to outsiders in the subsequent period, while only the intercompany profit in ending inventories remains unrealized. This assumption relies on the principle of matching profit realization with actual sales events .

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