Shortcut Charlie usually manages to develop some simple rule to handle even the most complex situations. In providing for the elimination of the effects of inventory transfers between the parent company and a subsidiary or between subsidiaries, Shortcut started with the following rules.

1. When the buyer continues to hold the inventory at the end of the period, credit cost of goods sold for the amount recorded as cost of goods sold by the company that made the intercompany sale.

2. When the buyer resells the inventory before the end of the period, credit cost of goods sold for the amount recorded as cost of goods sold by the company that made the intercompany sale plus the profit recorded by that company.

3. Debit sales for the total amount credited in rule 1 or 2 above. One of the new employees is seeking some assistance in understanding how the rules work and why.

Required

a. Explain why rule 1 is needed when consolidated statements are prepared.

b. Explain what is missing from rule 1, and prepare an alternative or additional statement for the elimination of unrealized profit when the purchasing affiliate does not resell to an unaffiliated company in the period in which it purchases inventory from an affiliate.

c. Does rule 2 lead to the correct result? Explain your answer.

d. The rules do not provide assistance in determining how much profit was recorded by either of the two companies. Where should the employee look to determine the amount of profit referred to in rule 2?