You, the controller, recently had the following discussion with the president:
President: I just don’t understand why we can’t recognize the revenue from the intercompany sale of inventory on the consolidated financial statements. The subsidiary company sold the goods to the parent at fair value and received the cash for the sale. We need to record the profit on this sale in order to maintain a steady earnings growth for our company. Otherwise, the bank will be concerned about our ability to repay the loan.
Controller: You are right that the subsidiary has received the cash, but that is not the main criterion for determining when to recognize the revenue. Furthermore, you need to understand that the consolidated financial statements are different from the individual financial statements for the parent and the subsidiary.
President: I have never understood why we need to prepare consolidated financial statements. It is just extra work. Who uses these statements? Furthermore, the profit on the intercompany transaction should be reported on the income statement because tax had to be paid on this profit. Surely, if tax is paid, the profit is legitimate.
Controller: Once again, cash payments do not determine when we report income tax expense on the income statement. How about we get together for lunch tomorrow? I will prepare a brief presentation to illustrate the difference between the income for the parent and subsidiary and the income for the consolidated entity and will explain how all of these statements properly apply generally accepted accounting principles for revenue and expense recognition.
As part of the presentation, you decided to prepare monthly income statements for the parent, subsidiary, and consolidated entity for the following situation:
• Parent owns 100% of the subsidiary.
• Subsidiary buys goods from outsiders for $200 in July and sells them to Parent in August at a markup of 20% of cost.
• In September, Parent sells these goods to an outsider at a markup of 20% of selling price.
• Both companies pay income tax at the rate of 40%.
Required:
Prepare notes for your presentation to the president.