1. The math: explain how you move from the details of a situation to the next level. Each of you will address this question differently. We are recording the acquisitions and operations of our company. What does this mean, using a specific example.

Topics

Intercompany Inventory Sales

1. Periodic Inventory System 2. Consolidated Cost of Goods Sold

Intercompany Plant Asset Sales

1. Working Paper for Date of Sale 2. Working Paper for Years Subsequent to Sale

Intercompany Inventory Sales

Periodic Inventory System

It is important to understand the cost of goods sold calculation in a periodic inventory system before preparing a consolidated income statement. As a review, consider the following example:

Example 1: Cost of Goods Sold Calculation

Assume Sarn Company has $30,000 of inventory at the beginning of the month (last month's ending inventory). Sarn purchased an additional $180,000 during the month (as shown in the general ledger), and they have $15,000 worth of inventory on hand at month end (counted). What was Sarn's cost of goods sold for the month?

Sound familiar? Remember calculating the cost of goods sold for an income statement in earlier accounting courses? On the income statement the cost of goods sold is calculated by subtracting the ending inventory from the goods available for sale (sum of the beginning inventory and purchases). This can be illustrated as follows:

It is clear from the left side of the above picture that the beginning inventory of $30,000 combined with purchases of $180,000 comprise $210,000 of goods available for sale. The right side has to have the same total ($210,000); you either sold the goods, or they are still in inventory. If you take a physical count and determine there is $15,000 left of inventory, then you must have sold inventory costing $195,000. Think of each side as the same loaf of bread, just sliced in a different place. This situation can be stated in equation form as follows:

BI + P = CGS + EI

or

CGS = BI + P - EI

The important thing to remember is that the beginning inventory and purchases have the same sign, whereas ending inventory would have the opposite sign. This is crucial for eliminating the correct amounts and preparing a consolidated income statement.

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Consolidated Cost of Goods Sold

Suppose Sarn Company, described in Example 1, is a 100 percent-owned subsidiary of Paul Company. All of the data from the example remains the same, but all of Sarn's inventory was purchased from Paul. During 1996, Sarn purchased merchandise from Paul in the amount of $180,000 at billed prices. Paul shipped this merchandise at 50 percent above its cost ($120,000), and this profit percentage was also used for shipments made to Sarn in 1995. Sarn's beginning inventory (merchandise at billed prices from Paul) was $30,000. The ending inventory was $15,000. Paul's cost of goods sold for the month was $550,000 (Paul sold to outsiders as well as Sarn). Sarn's cost of goods sold was $195,000 as previously calculated in Example 1 .

To obtain consolidated cost of goods sold, you must first add Paul's $550,000 cost of goods sold to Sarn's $195,000. The intercompany sales of $180,000, however, have to be eliminated to prevent these sales from being counted twiceonce as part of Paul's cost of goods sold when sold to Sarn, and a second time in Sarn's cost of goods sold when Sarn sells them to outsiders.

Sarn's beginning inventory of $30,000 consists of goods acquired from Paul last month. The actual cost to the consolidated entity was $20,000 (from module 1, a markup of 50 percent above cost means profit is one-third of billed price). If the $10,000 is not removed, then the consolidated goods available for sale and cost of goods sold would both be overstated.

Sarn's $15,000 of ending inventory also has to be adjusted for unrealized profit of $5,000 (again, one-third of the billed price). If this $5,000 is not removed, Sarn's ending inventory would be overstated which would understate Sarn's cost of goods sold. Therefore, unlike beginning inventory, the $5,000 must be added back to get cost of goods sold. Summarizing, the consolidated cost of goods sold is calculated as follows:

Notice that the Purchases (intercompany sales) and Beginning inventory have the same sign; both are negative. Yet the Ending inventory is positive (the opposite sign). Remember, the cost of goods sold calculation had the beginning inventory and purchases added together. This means they have the same sign. It is easy to see that purchases or intercompany sales must be eliminated to get consolidated cost of goods sold. Because Beginning inventory has the same sign as Purchases, it is easy to remember that the unrealized gross profit in beginning inventory must also be subtracted.

It is fairly easy to see, based on the above, that the unrealized profit in ending inventory has the opposite sign and must be added to calculate consolidated cost of sales. We are just trying to provide you with an intuitive way to remember whether beginning and ending inventory profit should be added or subtracted in the cost of goods sold calculation.

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Intercompany Plant Asset Sales

Working Paper for Date of Sale

In this section, we will try to provide you with some insight on preparing working paper elimination entries for intercompany plant asset sales.

Assume at the end of the year P sold equipment to its 100 percent-owned subsidiary, S Company, for $40,000 that had a cost of to P of $100,000, no salvage value, and a book value of $20,000 (accumulated depreciation on that date was $80,000). The equipment has been depreciated using the straight-line method and is expected to last four more years. P uses the equity method of accounting. S will continue depreciating the equipment straight-line over the remaining four years. How do you prepare a working paper related to the equipment sale?

First let's consider the actual journal entries made on both the parent's and the subsidiary's books related to the equipment sale. The journal entries on P's books follows:

The journal entry on S's books would be as follows:

Equipment 40,000 Cash 40,000

As P owns 100 perent of S, in the consolidated statements, P cannot include the gain of $20,000 as income. (How could you sell equipment to yourself?) Also, the consolidated equipment balance must contain the original book value for the equipment. (You can't write up equipment by $20,000.) Don't lose sight of the fact that all the consolidated entity really did was move this equipment from one location to another.

As in previous modules, the key is that there are three sets of books: P's, S's, and the consolidated company's. The consolidated company's balances only appear on a worksheet. Relevant accounts from the worksheet for this example appears below:

Given the P and S account totals, it is a lot easier to work backwards to prepare the working paper. The consolidated column of the working paper should have P's original book values of $100,000 for equipment and $80,000 for accumulated depreciation. There is $40,000 of debits for equipment on S's books. (Upon sale to S, the equipment was removed from P's books.) To end up with the original $100,000 historical cost to P, $60,000 of debits must appear in the Adjustment's column to add across correctly.

The accumulated depreciation was taken off P's books when the equipment was sold (see journal entry above). Because S just bought the equipment, it hasn't yet been depreciated by S. So both P and S have no accumulated depreciation on their books related to this equipment after the intercompany sale. To obtain the correct amount of accumulated depreciation, the $80,000 must appear in the Eliminations column.

The gain from the equipment sale appearing on P's books must be removed. The Adjustments column is debited for the amount of gain so when you add across, consolidated gain will be 0. The Adjustments column in general journal form from this working paper appears below:

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Working Paper for Years Subsequent to Sale

Selected accounts from P's consolidated working paper appear below for the end of the year following the year of the equipment sale:

One account on the working paper elimination that would not change from year to year is the equipment. Every year, unless the equipment is sold, we would still need a debit in the Adjustments column of $60,000 to bring the $40,000 on S's books back up to the original cost to P of $100,000.

At the end of each of the years following the intercompany equipment sale, S would make the following adjusting entry on its books to depreciate the equipment:

Depreciation expense 10,000 Accumulated depreciation 10,000 (40,000/4)

If S had not bought the equipment from P, there would have been only $5,000 of accumulated depreciation each year. Over the next four years, there would be a fully depreciated total of $100,000 in the accumulated depreciation account (before the sale to S, the original amount in P's accumulated account was $80,000). Assuming this is one big entity, at the end of the first year there should be $85,000 in the accumulated depreciation account. However, there is already $10,000 in S's column, therefore, we only need a $75,000 credit in the Adjustment column on the working paper to obtain $85,000 when we add across.

Each year, the amount in the Adjustments column for accumulated depreciation will be credited for $5,000 less, because S will be depreciating $10,000 each year instead of $5,000. Similarly, the depreciation expense on S's books would be $10,000. If P had not sold the equipment, only $5,000 of depreciation would be taken each year. So we are going to have to eliminate $5,000 of depreciation expense every year by crediting under the Adjustments account on the working paper.

The following would be the working paper for just the accounts related to the equipment sale at the end of the first year after the equipment sale:

The remaining $20,000 of adjustments would be the gain on the sale handled through the investment account. Remember, the parent would have made an entry on its books to adjust the equity in earnings of the sub for the equipment sale as follows:

Equity in earnings 20,000 Investment in S 20,000

Each year, we are going to recognize $5,000 of the gain through piecemeal recognition, so the amount of the investment account to eliminate will go down by $5,000 a year.

The following would be the working paper for just the accounts related to the equipment sale at the end of the second year after the equipment sale:

For each of the following years, the accumulated depreciation account elimination would be $5,000 less, and the same is true for the investment account. However, the elimination entries for the equipment and depreciation expense accounts would not change from year to year.