q1 and q2 – from ch6

q3 from ch 8

Instructions – PLEASE READ THEM CAREFULLY

· The Assignment must be submitted on Blackboard (WORD format only) via allocated folder.

· Assignments submitted through email will not be accepted.

· Students are advised to make their work clear and well presented, marks may be reduced for poor presentation. This includes filling your information on the cover page.

· Students must mention question number clearly in their answer.

· Late submission will NOT be accepted.

· Avoid plagiarism, the work should be in your own words, copying from students or other resources without proper referencing will result in ZERO marks. No exceptions.

· All answered must be typed using Times New Roman (size 12, double-spaced) font. No pictures containing text will be accepted and will be considered plagiarism).

· Submissions without this cover page will NOT be accepted.

1. The following intercompany transactions occurred during the year:

· Parent loaned $12500 to Sub. To keep things simple, assume that there is no interest revenue or interest expense associated with this loan.

· Parent made a sale to Sub for $13000 cash. The inventory had originally cost Parent $12220. Sub then sold that same inventory to an outsider for $14000.

· Parent made a sale to Sub for $15000 cash. The inventory had originally cost Parent $11280. Sub has not yet sold that same inventory to an outsider. (Don’t forget equity method entry!)

Based on our “conceptual discussion,” what consolidation worksheet entries would you make? (2 Marks)

2. Give two examples of Arm’s Length Transactions and Three Examples of Non Arm’s Length Transactions. (1 Mark)

3. Find the indirect exchange rates on the two dates and show the impact of changes in exchange rates on Imports and Exports. (2 Marks)

January, 2010	January 2011
Direct Exchange Rate (SAR/$)	SAR 3.75	SAR 3.50

Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Chapter 08

Multinational
Accounting:

Foreign Currency
Transactions and

Financial Instruments

8-2

Learning Objective 1

Understand how to make
calculations using foreign
currency exchange rates.

8-3

The Accounting Issues

 Foreign currency transactions of a U.S.
company denominated in other
currencies must be restated to their U.S.
dollar equivalents before they can be
recorded in the U.S. company’s books and
included in its financial statements.

◼ Translation: The process of restating foreign
currency transactions to their U.S. dollar
equivalent values

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8-4

The Accounting Issues

 Many U.S. corporations have
multinational operations

◼ The foreign subsidiaries prepare their financial
statements in the currency of their countries.

◼ The foreign currency amounts in these financial
statements have to be translated into their U.S.
dollar equivalents before they can be
consolidated with the U.S. parent’s financial
statements.

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الشركات الكبيرة لها فروع فيدول مختلفة وهاذي الدول تسجل قوائمها بالعملة المحلية لدولتها فعشان تتوحد القوائم لازم يعملو ترجمة للعملك

8-5

Foreign Currency Exchange Rates

 Foreign currency exchange rates between
currencies are established daily by
foreign exchange brokers who serve as
agents for individuals or countries
wishing to deal in foreign currencies.

◼ Some countries maintain an official fixed rate of
currency exchange

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8-6

Foreign Currency Exchange Rates

 Determination of exchange rates

◼ Exchange rates change because of a number of
economic factors affecting the supply of and
demand for a nation’s currency.

◼ Factors causing fluctuations are a nation’s

⚫ Level of inflation

⚫ Balance of payments

⚫ Changes in a country’s interest rate

⚫ Investment levels

⚫ Stability and process of governance

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الموازنة بين اللي يدخل للدولة واللي يطلع منها

8-7

Foreign Currency Exchange Rates

 Direct Exchange Rate (DER) is the number
of local currency units (LCUs) needed to
acquire one foreign currency unit (FCU)

◼ From the viewpoint of a U.S. entity:

U.S. dollar – equivalent value
1 FCU

DER =

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8-8

Foreign Currency Exchange Rates

 Indirect Exchange Rate (IER) is the
reciprocal of the direct exchange rate

◼ From the viewpoint of a U.S. entity:

1 FCU
U.S. dollar – equivalent value

IER =

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8-9

Foreign Currency Exchange Rates

 DER is identified as American terms

◼ To indicate that it is U.S. dollar–based and
represents an exchange rate quote from the
perspective of a person in the United States

 IER is identified as European terms

◼ To indicate the direct exchange rate from the
perspective of a person in Europe, which means
the exchange rate shows the number of units of
the European’s local currency units per one U.S.
dollar

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8-10

Foreign Currency Exchange Rates

 Changes in exchange rates

◼ Strengthening of the U.S. dollar—direct
exchange rate decreases, implies:

⚫ Taking less U.S. currency to acquire one FCU

⚫ One U.S. dollar acquiring more FCUs

◼ Weakening of the U.S. dollar—direct exchange
rate increases, implies:

⚫ Taking more U.S. currency to acquire one FCU

⚫ One U.S. dollar acquiring fewer FCUs

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كل ماقل نسبة التبادل كل ما كان ذاك موقي للعملة المحلية بمعنى تقل النسبة تزيد كميات التبادل لعملة قليلة

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8-11

Relationships between Currencies and Exchange
Rates

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8-12

Foreign Currency Exchange Rates

 Spot Rates versus Current Rates

◼ The spot rate is the exchange rate for immediate
delivery of currencies.

◼ The current rate is defined simply as the spot
rate on the entity’s balance sheet date.

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8-13

Foreign Currency Exchange Rates

 Forward Exchange Rates

◼ The forward rate on a given date is not the same
as the spot rate on the same date.

◼ Expectations about the relative value of
currencies are built into the forward rate.

◼ The Spread:

⚫ The difference between the forward rate and the spot
rate on a given date.

⚫ Gives information about the perceived strengths or
weaknesses of currencies

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سعر اليوم لعملية ستتم في المستبقل يعني لو المعاملة اتفقنا حتتم في المستقبل يصير نستعمل الفورورد لاني يمثل سبوت ريت مستقبلي

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8-14

Practice Quiz Question #1

Which of the following statements is false?

a. Most currency exchange rates are
determined by brokers on a daily basis.

b. Economic factors rarely affect exchange
rates.

c. Some countries maintain control over
their exchange rates.

d. When the U.S. dollar strengthens, it has
greater buying power overseas and can
buy more units of foreign currencies.

e. A spot rate is the exchange rate for
immediate delivery of a currency.

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8-15

Practice Quiz Question #2 Solution

Which of the following statements is false?
a. Most currency exchange rates are
determined by brokers on a daily basis.
b. Economic factors rarely affect exchange
rates.
c. Some countries maintain control over
their exchange rates.
d. When the U.S. dollar strengthens, it has
greater buying power overseas and can
buy more units of foreign currencies.
e. A spot rate is the exchange rate for
immediate delivery of a currency.

8-16

Learning Objective 2

Understand the accounting
implications of and be able

to make calculations related
to foreign currency

transactions.

8-17

Foreign Currency Transactions

 Foreign currency transactions are
economic activities denominated in a
currency other than the entity’s recording
currency.

 These include:
1. Purchases or sales of goods or services (imports or

exports), the prices of which are stated in a foreign
currency

2. Loans payable or receivable in a foreign currency

3. Purchase or sale of foreign currency forward exchange
contracts

4. Purchase or sale of foreign currency units

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اني اشتري عقود اليوم بقيمة المستقبل عشان متوقع السنين الجاية يزيد العقد

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معاملات العملة الاجنبية هي انشطة اقتصادية تنعمل بعملة غير العملة الاساسية

8-18

Foreign Currency Transactions

 For financial statement purposes, transactions
denominated in a foreign currency must be
translated into the currency the reporting
company uses

 At each balance sheet date, account balances
denominated in a currency other than the
entity’s reporting currency must be adjusted to
reflect changes in exchange rates during the
period

◼ The adjustment in equivalent U.S . dollar values is a
foreign currency transaction gain or loss for the entity
when exchange rates have changed

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اثر المعاملات الاجنبية تأثر على القوائم المالية

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لابد من عمل تعديل المعاملات عشان الريت يتغير دايماً

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8-19

Example: Foreign Currency Transactions

Assume that a U.S. company acquires €5,000 from its bank on
January 1, 20X1, for use in future purchases from German
companies. The direct exchange rate is $1.20 = €1; thus, the company
pays the bank $6,000 for €5,000, as follows:

The following entry records this exchange of currencies:

U.S. dollar equivalent value = Foreign currency units x Direct exchange rate
$6,000 = €5,000 x $1.20

January 1, 20X1
Foreign Currency Units (€ ) 6,000

Cash 6,000

On July 2, 20X1, the exchange rate is $1.100 = €1. The following adjusting
entry is required in preparing financial statements on July 1:

July 1, 20X1
Foreign Currency Transaction Loss 500

Foreign Currency Units (€ ) 500

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8-20

Foreign Currency Transactions

 Foreign currency import and export
transactions – Required accounting
overview (assuming the company does
not use forward contracts)

◼ Transaction date:

⚫ Record the purchase or sale transaction at the U.S.
dollar–equivalent value using the spot direct
exchange rate on this date

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8-21

Foreign Currency Transactions
 Foreign currency import and export
transactions – Required accounting
overview (assuming the company does
not use forward contracts)

◼ Balance sheet date:

⚫ Adjust the payable or receivable to its U.S. dollar–
equivalent, end-of-period value using the current
direct exchange rate

⚫ Recognize any exchange gain or loss for the change in
rates between the transaction and balance sheet
dates

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8-22

Foreign Currency Transactions
 Foreign currency import and export
transactions – Required accounting
overview (assuming the company does
not use forward contracts)

◼ Settlement date:

⚫ Adjust the foreign currency payable or receivable for
any changes in the exchange rate between the
balance sheet date (or transaction date) and the
settlement date, recording any exchange gain or loss
as required.

⚫ Record the settlement of the foreign currency
payable or receivable

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8-23

Foreign Currency Transactions

 The two-transaction approach

◼ Views the purchase or sale of an item as a
separate transaction from the foreign currency
commitment.

◼ The FASB established that foreign currency
exchange gains or losses resulting from the
revaluation of assets or liabilities denominated
in a foreign currency must be recognized
currently in the income statement of the period
in which the exchange rate changes.

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عند اعادة تقييم الاصول والمستحقات الربح والخسارة لازم تكون ريكوقنازيد في الفترة الحالية اللي حصل فيها التغيير

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عملية الشراء بالعملة الاجنبية منفصلة عن معاملات العملات

8-24

Comparative U.S. Company Journal Entries for Foreign Purchase
Transaction Denominated in Dollars versus Foreign Currency Units

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قلنا خسارة لانو بدل ما كنا حندفع ١٤ صرنا راح ندفع اكثر ١٦ بفرق ٢

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هاذي هي ال
Two way approach

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لو اخذت دين بعملة مش عملتي اروح احولهاا لعملتي

8-25

Practice Quiz Question #2

Which of the following statements is true?

a. Foreign currency transactions of a U.S.
Firm involve the exchange of goods from a
foreign country denominated in $ U.S.

b. The purchase or sale of an item is a
separate transaction from the foreign
currency commitment under the two
transaction approach.

c. Foreign currency exchange gains or losses
from the revaluation of assets or liabilities
denominated in a foreign currency must
be recognized in the period when the
exchange rate changes

8-26

Practice Quiz Question #2 Solution
Which of the following statements is true?
a. Foreign currency transactions of a U.S.
Firm involve the exchange of goods from a
foreign country denominated in $ U.S.
b. The purchase or sale of an item is a
separate transaction from the foreign
currency commitment under the two
transaction approach.
c. Foreign currency exchange gains or losses
from the revaluation of assets or liabilities
denominated in a foreign currency must
be recognized in the period when the
exchange rate changes

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8-27

Learning Objective 3

Understand how to hedge
international currency risk

using foreign currency
forward exchange financial

instruments.

8-28

Managing International Currency Risk with Foreign Currency
Forward Exchange Financial Instruments

 The accounting for derivatives and
hedging activities is guided by three
standards:

133 138 149

Amendments of importance to

multinational entities

Specific implementation

issues

FASB Statement No.

Defined derivatives and

established the general rule of

recognizing all derivatives as

either assets or liabilities in the

balance sheet and measuring

those financial instruments at

fair value

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تسترشد محاسبة المشتقات وأنشطة التحوط بثلاثة معايير:

8-29

Managing International Currency Risk with Foreign Currency
Forward Exchange Financial Instruments

 A financial instrument is cash, evidence of
ownership, or a contract that both:

1. imposes on one entity a contractual obligation to
deliver cash or another instrument, and

2. conveys to the second entity that contractual
right to receive cash or another financial
instrument.

 A derivative is a financial instrument or
other contract whose value is “derived
from” some other item that has a variable
value over time.

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الفكرة هي عشان نحمي نفسنا من الخطر تبع تغيرات العملة يصير نعمل صكوك مالية ممكن تكون نقدية او دلائل ملكية او عقود

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الأداة المالية هي نقد ، أو دليل على الملكية ، أو عقد يتضمن كليهما: . المشتق هو أداة مالية أو عقد آخر تكون قيمته “مشتقة من” عنصر آخر له قيمة متغيرة بمرور الوقت.

8-30

Managing International Currency Risk with Foreign Currency
Forward Exchange Financial Instruments

 Characteristics of derivatives:

◼ The financial instrument must contain one or
more underlyings and one or more notional
amounts, which specify the terms of the financial
instrument.

◼ The financial instrument/ contract requires no
initial net investment or an initial net investment
that is smaller than required for other types of
contracts expected to have a similar response to
changes in market factors.

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لازم يكون فيها شروط والكميات المحددة

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ماتتطلب يكون في صافي استثمار عشان يتم العقد ، حتى لو كانت العقود تخضع لنفس تأثير عوامل السوق

8-31

Managing International Currency Risk with Foreign Currency
Forward Exchange Financial Instruments
 Characteristics of derivatives:

◼ The contract terms:

⚫ Require or permit net settlement

⚫ Provide for the delivery of an asset that puts the
recipient in an economic position not
substantially different from net settlement, or

⚫ Allow for the contract to be readily settled net by
a market or other mechanism outside the
contract

8-32

Derivatives Designated as Hedges

 Two criteria to be met for a derivative
instrument to qualify as a hedging
instrument:

1. Sufficient documentation must be provided at
the beginning of the hedge term to identify the
objective and strategy of the hedge, the hedging
instrument and the hedged item, and how the
hedge’s effectiveness will be assessed on an
ongoing basis.

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عشان نعتبر المشتقات من صكوك التحوط لازم يكون فيها شيئين :

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توثيق كاافي ويكون كافي لما هالمعلومات تكون فيه …

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8-33

Derivatives Designated as Hedges
 Two criteria to be met for a derivative
instrument to qualify as a hedging
instrument:

2. The hedge must be highly effective throughout
its term

⚫ Effectiveness is measured by evaluating the
hedging instrument’s ability to generate changes
in fair value that offset the changes in value of the
hedged item.

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لازم يكون التحوط فعال ونقدر نقول عنو فعال لما..

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لما يصير بإمكاننا نعمل تغيير في القيمة العادلة للصك

8-34

Derivatives Designated as Hedges

 Fair value hedges are designated to hedge
the exposure to potential changes in the
fair value of:

a) a recognized asset or liability such as available-
for-sale investments, or

b) an unrecognized firm commitment for which a
binding agreement exists.

 The net gains and losses on the hedged
asset or liability and the hedging
instrument are recognized in current
earnings on the statement of income.

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لما يكون التحوط فعال ويغير القيمة تبع ايتم التحوط للقيمة العادلة هنا حيكون في ربح او خسارة وهالربح والخسارة يتسجل في قائمة الدهل الخالية

8-35

Derivatives Designated as Hedges

 Cash flow hedges

◼ Designated to hedge the exposure to potential
changes in the anticipated cash flows, either into
or out of the company, for

⚫ a recognized asset or liability such as future
interest payments on variable-interest debt, or

⚫ a forecasted cash transaction such as a forecasted
purchase or sale.

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تحوط قائمة التدفق المالي

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8-36

Derivatives Designated as Hedges
 Cash flow hedges

◼ Changes in the fair market value are separated
into an effective portion and an ineffective
portion

⚫ The net gain or loss on the effective portion of the
hedging instrument should be reported in other
comprehensive income

⚫ The gain or loss on the ineffective portion is
reported in current earnings on the statement of
income.

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ومش فقط التحوط على التغيير اللي حيكون متوقع او مستقبلي بل ايضا على القيم العادلة للمسجل في القائمة وبتنقسم ل نسبة فعالة وغير فعالة

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النسبة الفعالة تسجل في اوذر كوبرهنسيف

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الغير فعالة تسجل في قائمة الدخل

8-37

Derivatives Designated as Hedges

 Foreign currency hedges are hedges in
which the hedged item is denominated in
a foreign currency

◼ A fair value hedge of a firm commitment to enter
into a foreign currency transaction

◼ A cash flow hedge of a forecasted foreign
currency transaction

◼ A hedge of a net investment in a foreign
operation.

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هنا جينا لموضوعنا موضوع الشابتر لما نبغى نتحوط بشيء وهالشيء هو مصنف بعملة اجنبية

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8-38

Forward Exchange Contracts

 Forward Exchange Contracts

◼ Contracted through a dealer, usually a bank

◼ Possibly customized to meet contracting
company’s terms and needs

◼ Typically no margin deposit required

◼ Must be completed either with the underlying’s
future delivery or net cash settlement

8-39

Forward Exchange Contracts

 FASB 133 establishes a basic rule of fair
value for accounting for forward
exchange contracts

◼ Changes in the fair value are recognized in the
accounts, but the specific accounting for the
change depends on the purpose of the hedge

◼ For forward exchange contracts, the basic rule is
to use the forward exchange rate to value the
forward contract

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8-40

Case 1: Forward Exchange Contracts

Managing an Exposed Foreign Currency Net Asset or
Liability Position: Not a Designated Hedging Instrument

 This case presents the most common use of foreign
currency forward contracts, which is to manage a part of
the foreign currency exposure from accounts payable or
accounts receivable denominated in a foreign currency.

 Note that the company has entered into a foreign
currency forward contract but that the contract does not
qualify for or the company does not designate the forward
contract as a hedging instrument.

8-41

Case 2: Forward Exchange Contracts

Hedging an Unrecognized Foreign Currency Firm
Commitment: A Foreign Currency Fair Value Hedge

 This case presents the accounting for an unrecognized
firm commitment to enter into a foreign currency
transaction, which is accounted for as a fair value hedge.

 A firm commitment exists because of a binding agreement
for the future transaction that meets all requirements for
a firm commitment.

 The hedge is against the possible changes in fair value of
the firm commitment from changes in the foreign
currency exchange rates.

8-42

Case 3: Forward Exchange Contracts

Hedging a Forecasted Foreign Currency Transaction: A
Foreign Currency Cash Flow Hedge

 This case presents the accounting for a forecasted foreign
currency-denominated transaction, which is accounted
for as a cash flow hedge of the possible changes in future
cash flows.

 The forecasted transaction is probable but not a firm
commitment. Thus, the transaction has not yet occurred
nor is it assured; the company is anticipating a possible
future foreign currency transaction.

 Because the foreign currency hedge is against the impact
of changes in the foreign currency exchange rates used to
predict the possible future foreign currency-denominated
cash flows, it is accounted for as a cash flow hedge.

8-43

Case 4: Forward Exchange Contracts

Speculation in Foreign Currency Markets

 This case presents the accounting for foreign currency
forward contracts used to speculate in foreign currency
markets. These transactions are not hedging transactions.

 The foreign currency forward contract is revalued
periodically to its fair value using the forward exchange
rate for the remainder of the contract term.

 The gain or loss on the revaluation is recognized currently
in earnings on the statement of income.

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8-44

Practice Quiz Question #3

Which of the following is NOT one of the
criteria for a hedge to be considered
effective?

a. The hedge is based on an effective
interest rate.

b. Documentation of the objective, strategy,
and effectiveness of the hedge.

c. The hedge must be highly effective
through its term.

d. The effectiveness of the hedge is
assessed on an ongoing basis

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8-45

Practice Quiz Question #3 Solution

Which of the following is NOT one of the
criteria for a hedge to be considered
effective?
a. The hedge is based on an effective
interest rate.
b. Documentation of the objective, strategy,
and effectiveness of the hedge.
c. The hedge must be highly effective
through its term.
d. The effectiveness of the hedge is
assessed on an ongoing basis

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8-46

Learning Objective 4

Understand how to measure
hedge effectiveness, make

interperiod tax allocations for
foreign currency transactions,
and hedge net investments in

a foreign entity.

8-47

Additional Considerations

 Measuring hedge effectiveness

◼ Effectiveness: There will be an approximate
offset, within the range of 80 to 125 percent, of
the changes in the fair value of the cash flows or
changes in fair value to the risk being hedged

◼ Must be assessed at least every three months
and when the company reports financial
statements or earnings

◼ Intrinsic value and Time value

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8-48

Additional Considerations

 Interperiod tax allocation for foreign
currency gains (losses)

◼ Temporary differences in the recognition of
foreign currency gains or losses between tax
accounting and GAAP accounting require
interperiod tax allocation

◼ The temporary difference is recognized in
accordance with FASB Statement No. 109

8-49

Additional Considerations

 Hedges of a net investment in a foreign entity

◼ A number of balance sheet management tools
are available for a U.S. company to hedge its net
investment in a foreign affiliate.

◼ FASB 133 specifies that for derivative financial
instruments designated as a hedge of the foreign
currency exposure of a net investment in a
foreign operation, the portion of the change in
fair value equivalent to a foreign currency
transaction gain or loss should be reported in
other comprehensive income.

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8-50

Practice Quiz Question #4

Which of the following is the appropriate test
of hedge effectiveness?

a. The hedge offsets between 80-100% of
the cash flows or risk of the item hedged.

b. The hedge offsets between 100-125% of
the cash flows or risk of the item hedged.

c. The hedge offsets between 80-125% of
the cash flows or risk of the item hedged.

d. The hedge offsets between 80-150% of
the cash flows or risk of the item hedged.

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8-51

Practice Quiz Question #4 Solution

Which of the following is the appropriate test
of hedge effectiveness?
a. The hedge offsets between 80-100% of
the cash flows or risk of the item hedged.
b. The hedge offsets between 100-125% of
the cash flows or risk of the item hedged.
c. The hedge offsets between 80-125% of
the cash flows or risk of the item hedged.
d. The hedge offsets between 80-150% of
the cash flows or risk of the item hedged.

Conclusion

The End

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 06

Intercompany
Inventory

Transactions

6-2

Learning Objective 1

Understand and explain
intercompany transfers and

why they must be
eliminated.

6-3

Road Map: Intercompany Transactions

 Typical intercompany transactions

 Intercompany reciprocal accounts (Chapter 4)

 Inventory transfers (Chapter 6)

 Fixed asset transfers (Chapter 7)

 Intercompany Indebtedness (Chapter 8)

6-4

Arm’s-Length Transactions

Q: What are “Arm’s-length” Transactions?

A: “Transactions that take place between
completely independent parties.”

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6-5

Categories of Transactions

 Arm’s Length Transactions

 The only transactions that can be reported in the
consolidated statements.

 We want to report the results of our interactions
with outside parties!

 Non-Arm’s Length Transactions

 Usually referred to as “related party
transactions.”

 Include all intercompany transactions.

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6-6

Types of “Related Party” Transactions

 Involving only Individuals

 Transactions among family members

 Involving Corporations

 With management and other employees

 With directors and stockholders

 With affiliates (controlled entities)

 Probably constitutes at least 99% of all corporate
related-party transactions

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6-7

Necessity of Eliminating Intercompany Transactions

 Eliminate all intercompany transactions in
consolidation:

 Because they are internal transactions from a
consolidated perspective.

 Not because they are related-party transactions.

 Only transactions with outside unrelated parties
can be reported in the consolidated statements.

6-8

Intercompany Transactions: Additional
Opportunities for Fraud

 Intercompany transactions sometimes
occur to

 conceal embezzlements.

 overstate reported profits.

2 + 2 = 5

6-9

Example 1: Intercompany Loan

 A 12-year old girl lends $5 to her 17-year-old
brother.

 From the standpoint of individuals, this
represents a receivable and a payable.

 If the family prepares a “consolidated balance
sheet”, what is the effect?

 No net change to the family’s wealth.

 Not a transaction with a non-family person.

6-10

Example 2:
Sale from Parent to Sub to Outsider

 Parent has 19 subsidiaries.

 Parent has received a $1 order from an
outsider.

 Parent sells inventory to Sub 1 for $1.
 Sub 1 sells the inventory to Sub 2 for $1.

 Sub 2 sells the inventory to Sub 3 for $1.

 The inventory is sold from one sub to another until Sub 19
sells it to the outsider for $1.

 The parent and each sub reports sales of $1.

 From a consolidated standpoint, what is the
total amount of sales?

6-11

Example 3: Sale from Parent to Sub, But Not Yet to
an Outsider

 Sleazy Parent Company has one sub.

 Sleazy Parent is preparing for an IPO.

 Sleazy Parent owns lots of obsolete inventory
which it cannot sell.

 Sleazy Parent sells the obsolete inventory (costing
$1,000) to its sub for $100,000.

 Sleazy Sub now holds the inventory.

 Without any adjustment, what items in Sleazy’s
consolidated financial statements will be
misstated?

6-12

Correcting Entries

 Conceptually, how would you correct each of these three
problems?

To eliminate intercompany loans:
Loan Payable xxx

Loan Receivable xxx

To eliminate sale from Parent to Sub to Outsider:
Sales xxx

Cost of Goods Sold xxx

To eliminate sale from Parent to Sub, not yet to Outsider:
Sales xxx

Cost of Goods Sold xxx
Inventory Unrealized G

P

Easy!
Just

reverse

More
difficult

Easy!
Just
reverse

6-13

Let’s work through an example:

 Assume Parent Co. owns 100% of Sub Co.

 The following intercompany transactions occurred during
the year:

 Parent loaned $500 to Sub. To keep things simple, assume that
there is no interest revenue or interest expense associated with this
loan.

 Parent made a sale to Sub for $400 cash. The inventory had
originally cost Parent $250. Sub then sold that same inventory to an
outsider for $500.

 Parent made a sale to Sub for $300 cash. The inventory had
originally cost Parent $200. Sub has not yet sold that same
inventory to an outsider.

 What consolidation worksheet entries would you make?

6-14

Parent:
Receivable 500

Cash 500

Sub:
Cash 500

Payable 500

(a) Loan from Parent to Sub

Does this transaction include outsiders?

Parent $500 Sub

Reverse the entries made by
the parent and the sub.

To eliminate intercompany loans:
Loan Payable 500

Loan Receivable 500

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6-15

(b) Sale from Parent to Sub to Outsider

Parent Sub

$250 $500$400

Are these legitimate transactions?

Keep
This

Purchase

Keep
This
Sale

Eliminate effect
of this internal

Transaction

Arm’s
Length

Internal (fake)

Keep Sub’s Sale

Get rid of Parent’s Sale Get rid of Sub’s COG

S

Keep Parent’s COGS

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6-16

Parent’s sale to Sub:

Parent:

Cash 400

Sales 400
COGS 250

Inventory 250
Sub:

Inventory 400

Cash 400

Sub’s sale to Outsider:

Sub:
Cash 500

Sales 500
COGS 400

Inventory 400

Reverse the rest!

(b) Sale from Parent to Sub to Outsider

Which transactions are legitimate?

To eliminate sale from Parent to Sub to Outsider:
Sales (parent to sub) 400

Cost of Goods Sold (to outsider) 400

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6-17

(c) Sale From Parent to Sub (Not Outside)

Keep
this

purchase

Eliminate effect
of this internal

transaction

Summary of the Transaction:
 Parent purchased inventory for $200.
 Parent sold the inventory to a Sub for $300.

Reverse the entries made by the parent and sub.

Parent:

Cash 300

Sales 300
COGS 200

Inventory 200

Sub:
Inventory 300

Cash 300

Parent $300 Sub$200

Is this a legitimate arm’s length transaction?

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6-18

Parent:
Cash 300

Sales 300
COGS 200
Inventory 200
Sub:
Inventory 300
Cash 300

Parent Sub$300

(c) Sale From Parent to Sub (Not Outside)
Reverse the entries made by the parent and sub.

To eliminate sale from Parent to Sub, not yet to Outsider:
Sales 300

Cost of Goods Sold 200
Inventory 100

(net)

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6-19

Summary of Consolidation Entries:

To eliminate intercompany loans:
Loan Payable 500

Loan Receivable 500

To eliminate sale from Parent to Sub to Outsider:
Sales 400

Cost of Goods Sold 400

To eliminate sale from Parent to Sub, not yet to Outsider:
Sales 300
Cost of Goods Sold 200
Inventory 100

6-20

Fully-adjusted Equity Method Adjustment

 Parent companies have to adjust their equity
method investment accounts for certain
transactions.

 At this point, let’s just consider one:

 Sale from parent to sub, but not yet sold to an outsider.

 It represents “fake profit” that hasn’t really been realized
in an arm’s-length transaction.

 Both the balance sheet and income statement
accounts need to be adjusted.

 This is a REAL journal entry, not a consolidation
worksheet entry!

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6-21

Equity Method Adjustment Example

Sales $ 600
COGS 500
GP $ 100

Equity Method Entry:

Income from Sub 100
Investment in Sub 100

 The Parent recognized $100 of “fake gross profit!

 The Parent should have transferred the inventory at cost.

 This profit is not from a transaction with an arm’s length
independent party.

Parent $600 Sub$500

Summary of the Transaction:
 Parent purchased inventory for $500.
 Parent sold the inventory to a Sub for $600.

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6-22

Group Practice

 Assume Parent Co. owns 100% of Sub Co.
 The following intercompany transactions occurred during
the year:

 Parent loaned $100 to Sub. To keep things simple, assume that there
is no interest revenue or interest expense associated with this loan.

 Parent made a sale to Sub for $200 cash. The inventory had originally
cost Parent $120. Sub then sold that same inventory to an outsider for
$300.

 Parent made a sale to Sub for $300 cash. The inventory had originally
cost Parent $180. Sub has not yet sold that same inventory to an
outsider. (Don’t forget equity method entry!)

 Based on our “conceptual discussion,” what consolidation
worksheet entries would you make?

6-23

Practice Quiz Question #1

Why must intercompany transactions
be eliminated?

a. They portray the consolidated
company’s results too
conservatively.

b. They understate the results of the
consolidated group.

c. They are arm’s length
transactions.

d. They are not arm’s length
transactions.

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6-24

Learning Objective 2

Understand and explain
concepts associated with
inventory transfers and

transfer pricing.

6-25

Issue #1: Eliminate Intercompany Transfers?

 Whether to Eliminate Intercompany
Transactions in Consolidation:

 No controversy—they must be eliminated.

 Not eliminating them would cause two problems:

 Meaningless double-counting of

1. sales, and
2. expenses

 Potential to manipulate income.

6-26

The Substance of Inventory Transfers

 The CONSOLIDATED Perspective:

 Merely the physical movement of inventory
from one location to another location.

 Similar to the movement of inventory from one
division to another division.

 Not a bona fide transaction.

6-27

Issue #2: Which Measure of Profit To Use?

 Possible theoretical profit measures:

 Gross profit

 Operating profit

 Net income

 Profit measure required under GAAP:

 Gross profit (of the selling entity):

Sales $1,000
Cost of sales 600
Gross profit $ 400

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6-28

Issue #3: Eliminate Income Tax Effects?

 Income taxes play a major role in
intercompany sales and transfer pricing
decisions.

 Income taxes on the selling entity’s unrealized
gross profit must also be eliminated.

 In this chapter :

 No income tax entries are required.

 Because we assume that the tax effects have
already been recorded in the parent’s or the
subsidiary’s general ledger.

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6-29

Issue #4: Whether To Eliminate All or Some?

 Downstream sales to a
partially-owned subsidiary:

 Eliminate 100% of unrealized
profit.

 Fractional elimination is
prohibited.

 Upstream sales from a
partially-owned subsidiary:

 Eliminate 100% of unrealized
profit.
 Fractional elimination is
prohibited.

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6-30

Issue #4: Whether To Eliminate All or Some?

 Downstream sales to a partially-
owned subsidiary:

 Entire profit accrues to the parent;
thus, sharing is not appropriate.

 Upstream sales from a partially-
owned subsidiary:

 Must share deferral with the

NCI

shareholders (if amount is material).

 Because S profits are shared with the
NCI shareholders.

P
S

NCI

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6-31

Inventory Transfers: What is “Realization”?

 Realization for consolidated reporting
purposes:

 Does not focus on whether the seller has

 delivered the product,

 collected on the sale, or

 reduced to an acceptable level the
uncertainty about the net cash flow effect
of an earnings activity.

6-32

Inventory Transfers: What is “Realization”?
 Realization for consolidated reporting
purposes:

 Depends on whether the BUYER has resold the
inventory to an outside unaffiliated customer.

Parent Sub

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6-33

Review: Two Types of Transfers

Assume both
transactions

took place
during the
same year.

Parent Sub$750 For $1,200$1,000

 Parent-to-sub-to-outsider

 Parent-to-sub-not-yet-to-outsider

Parent Sub$300 $400

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6-34

Understanding Inventory Transfers: Map it out

Splits out parent’s numbers.

Parent Sub$1,050 Unknown$1,400

$1,400
Split

Ending Inventory = $400

What happened to it?

Total Interco Sales

Resold On hand

Sales 1,400 1,000 400

 COGS 1,050 750 300

Gross Profit 350 250 100

Gross Profit % 25%

Resold = $1,000

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Not sold yet to I outsiders

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6-35

Calculating Unrealized Gross Profit

 Amounts that will always be known (given):

CRITICAL ASSUMPTION:

 The gross profit percentage derivable from the total column
applies to both (1) the inventory that has been resold AND
(2) the inventory that is still on hand.

Total Resold On hand

Sales (NEW basis) 1,000 200

 Cost of sales (OLD basis) 600

Gross Profit 400

Gross Profit % 40%

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6-36

Calculating Unrealized Gross Profit

 Completed Analysis:

 The Inventory/COGS Change in Basis Elimination Entry
is derived from this analysis.

 Unrealized profit = Inventory on hand x GP%

= $200 x 40% = $80

Total Resold On hand

Sales (NEW basis) 1,000 800 200

 Cost of sales (OLD basis) 600 480 120

Gross Profit 400 320 80

Gross Profit % 40%
Realized Unrealized

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نطلع اول البروفت عشان نطلع الكوست اوف قوود سولد

6-37

What happened to it?

Total Interco
Sales

Resold On hand
Sales 1,400 1,000 400
 COGS 1,050 750 300
Gross Profit 350 250 100
Gross Profit % 25%

Transfer Price

Cost

Markup

Markup on
Transfer Price

Inventory Transfers: Terminology

Watch out for terminology like
“mark-up based on cost”!

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6-38

Practice Quiz Question #2

For 20X8, Pete reported intercompany
cost of sales of $800,000 (markup is 20%
of transfer price) to Sampras, which
reported $300,000 of intercompany
acquired inventory at 12/31/X8. The
unrealized profit at 12/31/X8 is:

a. $40,000
b. $48,000
c. $60,000
d. $75,000
e. None of the above

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6-39

Practice Quiz Question #2 Solution

Parent Sub$800,000 ??

Ending Inventory = $300,000

What happened to it?

Total Interco Sales Resold On hand

Sales 300,000

 COGS 800,000

Gross Profit ?

Gross Profit % 20%

6-40

Practice Quiz Question #3

For 20X8, Post reported $90,000 of
intercompany sales (25% markup on cost
and fully paid for by year end) to Script,
which reported $30,000 of intercompany
acquired inventory at 12/31/X8. The
unrealized profit at 12/31/X8 is:

a. $0
b. $6,000
c. $7,500
d. $30,000
e. None of the above

6-41

Practice Quiz Question #3 Solution

Parent Sub? ?90,000

What happened to it?
Total Interco Sales Resold On hand

Sales 90,000 30,000

 COGS C

Gross Profit 0.25 C ?

Gross Profit % ?

$90,000
Split

Ending Inventory = $30,000

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6-42

Practice Quiz Question #4

For 20X8, Sempre (80% owned by Para)
reported $1,600,000 of intercompany
sales (1/3 markup on cost) to Para, which
resold $1,400,000 of this inventory by
12/31/X8. The unrealized profit at
12/31/X8 is:

a. $40,000
b. $50,000
c. $53,333
d. $66,667
e. None of the above

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6-43

Practice Quiz Question #4 Solution

Parent Sub? unknown1,600,000

What happened to it?
Total Interco Sales Resold On hand

Sales 1,600,000 1,400,000

 COGS

Gross Profit ?
Gross Profit % ?

$1,600,000
Split

Ending Inventory = 200,000

Resold = $1,400,000

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6-44

Learning Objective 3

Prepare equity-method journal
entries and elimination entries

for the consolidation
of a subsidiary following

downstream inventory

transfers.

6-45

Agreement between Parent Company and
Consolidated Financial Statements

 Under the fully adjusted equity method,

 the parent company’s financial statements should
report the same net income and retained earnings
amounts as appear in the consolidated statements.

 Therefore, we

 record and equity method adjustment on the
parent’s books to defer unrealized gross profit,
and

 prepare consolidation worksheet elimination
entries to avoid double counting in the income
statement and overstating inventory.

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6-46

Big Picture—Elimination entry: Sale From Parent to
Sub to Outsider

Get rid of the non-arm’s-length transaction!

Parent Sub$250 $500$400

To eliminate sale from Parent to Sub to Outsider:
Sales (Parent) 400

Cost of Goods Sold (Sub) 400

6-47

Big Picture—Elimination entry: Sale From Parent to
Sub (not yet sold outside)

Reverse the entire transaction!

Parent Sub$250 $400

To eliminate sale from Parent to Sub, not yet to Outsider:
Sales 400

Cost of Goods Sold 250
Inventory 150

Equity Method Entry:

Income from Sub 150
Investment in Sub 150

Sub’s inventory is overstated by $150

Sales $400
Cost of sales 250
Gross profit $ 150

Parent’s gross profit is overstated by $150

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6-48

What to Look For

 Most problems will contain

 Inventory transferred from parent to sub (downstream),
or

 Inventory transferred from sub to parent (upstream).

 Often part of the inventory is sold to an
outsider, but part remains in the buyer’s
ending inventory.

 Key: Any problem can be split into two parts

 The portion of the inventory that is sold

 The portion of the inventory that is still on hand

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6-49

Parent Sub60,000 70,00075,000

Ending inventory = $10,000

What happened to it?Income Statements
Parent Sub

Sales $75,000 $70,000
Cost of sales 60,000 65,000
Gross profit $15,000 $ 5,000

During 20X8, Parent sold inventory originally costing
$60,000 to its 100% owned Sub for $75,000. Sub sold most
of the inventory purchased from Parent (all but $10,000)
for $70,000 to outsiders during the year.

$75,000
Split

Sold On-hand
$65,000 $10,000 x 20% = $2,000

Unrealized GP

A Comprehensive Downstream Example

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حسب الكمية اللي تم بيعهاا

6-50

One Approach: Split into Two Transactions

 This transaction can be broken into two pieces:

 Parent sells Sub inventory with a cost of $52,000 for
$65,000. Sub then sells this inventory to outsiders for
$70,000.

 Parent sells Sub inventory with a cost of $8,000 for
$10,000, which remains on hand in Sub’s ending
inventory.

Total Sold On hand

Sales $75,000 $65,000 $10,000

 COGS 60,000 52,000 8,000

Gross Profit $15,000 $13,000 $ 2,000

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الكمية اللي باعها السب للخارج تكلفتها بالنسبة للبيرنت كانت 52،٠٠٠ فهو ركز على حذف المعاملة اللي تم بيعها للخارج لانها خرجت من حسابات السب والبيرنت لانهم يعتبر واحد بالنهاية

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6-51

Part 1: Sale from Parent to Sub to Outsider

Get rid of the non-arm’s-length transaction!

Parent Sub$52,000 $70,000$65,000

To eliminate sale from Parent to Sub to Outsider:
Sales (Parent) 65,000

Cost of Goods Sold (Sub) 65,000

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سعر البيعة اللي كانت تكلفتها ٥٢.٠٠٠ كانت ٦٥،٠٠٠
حنحذفها لانها بيعت لطرف خارجي ثالث

6-52

Part 2: Sale from Parent to Sub (Not Outside)

Reverse the entire transaction!

Parent Sub$8,000 $10,000

To eliminate sale from Parent to Sub, not yet to Outsider:
Sales (Parent) 10,000

Cost of Goods Sold (Parent) 8,000
Inventory (basis correction) 2,000

Sub’s inventory is overstated by $2,000

Sales $10,000
Cost of sales 8,000
Gross profit $ 2,000

Parent’s gross profit is overstated
by $2,000

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6-53

Summary

To eliminate sale from Parent to Sub to Outsider :
Sales (Parent) 65,000

Cost of Goods Sold (Sub) 65,000

To eliminate sale from Parent to Sub, not yet to Outsider:
Sales (Parent) 10,000
Cost of Goods Sold (Parent) 8,000
Inventory (basis correction) 2,000

Can combine the two entries:
Sales 75,000

Cost of Goods Sold 7

3,000

Inventory 2,000

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6-54

Partial Consolidated Worksheet

Parent Sub DR CR
Consol-
idated

Income Statement

Sales 75,000 70,000 75,000 70,000

COGS 60,000 65,000 73,000 52,000

Gross Profit 15,000 5,000 75,000 73,000 18,000

Balance Sheet

Inventory 0 10,000 2,000 8,000

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6-55

Second Approach: Short Cut Method

Total Sold On hand
Sales $75,000 $65,000 $10,000
 COGS 60,000 52,000 8,000

Gross Profit $15,000 $13,000 $ 2,000

The numbers come right off the chart!

Sales 75,000
Cost of Goods Sold 73,000
Inventory 2,000

COGS Credit = $65,000 + $8,000

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6-56

Fully-adjusted Equity Method Adjustment

 Don’t forget that one of the desirable properties
of using the equity method is that the parent’s
net income should be equal to the consolidated
net income.

 If you only adjust for unrealized deferred profit
in the consolidation, the consolidated net income
will be different from the parent’s income!

6-57

Partial Consolidated Worksheet
Parent Sub DR CR
Consol-
idated
Income Statement
Sales 75,000 70,000 75,000 70,000
COGS 60,000 65,000 73,000 52,000

Inc from Sub 5,000 5,000

Net Income 20,000 5,000 80,000 73,000 18,000

Balance Sheet

Inventory 0 10,000 2,000 8,000

Not the same!

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6-58

Fully-adjusted Equity Method Adjustment
 Don’t forget that one of the desirable properties
of using the equity method is that the parent’s
net income should be equal to the consolidated
net income.

 If you only adjust for unrealized deferred profit
in the consolidation, the consolidated net income
will be different from the parent’s income!

 Thus, an actual adjustment on the parent’s books
in addition to the worksheet entries above.

 Like we did for the excess fair value amortization.

6-59

Fully-adjusted Equity Method Adjustment

 After calculating the unrealized
deferred profit, simply make an extra
adjustment to back it out.

 Do this at the same time you record
the parent’s share of the sub’s
income.

Investment in Sub Income from Sub

NI 5,000
2,000 Unreal GP 2,000

5,000 NI

3,000

Reverse next year when this inventory is sold!

Sales $75,000
COGS 60,000
Gross profit $15,000
Inc. from Sub 3,000
NI $18,000

Parent NI =
Consolidated NI

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6-60

Partial Consolidated Worksheet
Parent Sub DR CR
Consol-
idated
Income Statement
Sales 75,000 70,000 75,000 70,000
COGS 60,000 65,000 73,000 52,000

Inc from Sub 3,000 3,000

Net Income 18,000 5,000 78,000 73,000 18,000

Balance Sheet
Inventory 0 10,000 2,000 8,000

Now they’re the same!

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6-61

Practice Quiz Question #5

Under the fully adjusted equity method,
what is one benefit of making an equity
method adjustment to defer unrealized
gross profit on inventory transfers?

a. Consolidated net income always
increases.

b. Parent company net income always
increases.

c. Parent company net income is not equal
to consolidated net income.

d. Parent company net income equals
consolidated net income.

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6-62

Review Exercise Part 1: Downstream

 Para sold inventory costing $100,000 to its
75%-owned subsidiary, Shute, for $125,000
in 20X8.

 Shute resold most of this inventory for
$230,000 in 20X8.

 At 12/31/X8, Shute’s balance sheet showed
intercompany-acquired inventory on hand of
$20,000.

P
S
NCI

25% 75%

Required:

 Prepare the consolidation entry and/or entries required
at 12/31/X8 under the equity method.

 Since this is a DOWNSTREAM transaction, we don’t
share the GP deferral with the NCI.

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6-63

Review Exercise Part 1: Big Picture

Total Sold On hand

Sales 125,000 20,000

 COGS 100,000

Gross Profit 25,000

Gross Profit %

Parent Sub$100,000 $230,000$125,000

$125,000
split

Ending Inventory = 20,000

Resold = $105,000

6-64

Review Exercise 1: Sale from Parent to Sub to
Outsider

Parent Sub$84,000 $230,000$105,000

Get rid of the internal non-arm’s-length transaction!

To eliminate sale from Parent to Sub to Outsider:
Sales (Parent) 105,000

Cost of Goods Sold (Sub) 105,000

6-65

Review Exercise 1: Sale from Parent to Sub (Not Yet
Outside)

Reverse the entire transaction!

Parent Sub$16,000 $20,000

To eliminate sale from Parent to Sub, not yet to Outsider:
Sales (Parent) 20,000

Cost of Goods Sold (Parent) 16,000
Inventory (basis correction) 4,000

Sub’s inventory is overstated by $4,000

Sales $20,000
Cost of sales 16,000

Gross profit $ 4,000

Parent’s gross profit is overstated by $4,000

6-66

Review Exercise 1: Summary

Fully-adjusted Equity Method Entry on Parent’s books:

Income from Sub 4,000
Investment in Sub 4,000

To eliminate sale from Parent to Sub to Outsider:
Sales (Parent) 105,000

Cost of Goods Sold (Sub) 105,000

To eliminate sale from Parent to Sub, not yet to Outsider:
Sales (Parent) 20,000
Cost of Goods Sold (Parent) 16,000
Inventory (basis correction) 4,000

Combine both entries:
Sales 125,000

Cost of Goods Sold 121,000
Inventory 4,000

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6-67

Review Exercise Part 1: Short Cut

Total Sold On hand

Sales 125,000 105,000 20,000

 COGS 100,000 84,000 16,000

Gross Profit 25,000 21,000 4,000

COGS Credit = 105,000 + 16,000 = 121,000
Unrealized GP

Worksheet Elimination Entry:

Sales 125,000
Cost of Goods Sold 121,000
Inventory 4,000

6-68

Review Exercise Part 1

FYI, this year’s deferral is REVERSED next year to recognize
when sold!

Worksheet Elimination Entry in Year 1:

Sales 125,000
Cost of Goods Sold 121,000
Inventory 4,000

Worksheet Elimination Entry in Year 2:

Investment in Sub 4,000
Cost of Goods Sold 4,000

INCREASES income!

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لما يتم بيع المخزون مرة ثانية في السنة ٢ يصير لازم نزيد البروفت ونعترف فيه

6-69

Downstream, so don’t split
the deferral with the NCI.

Review Exercise 1: Equity Method Entry

Investment in Sub Income from Sub

75% NI 93,750
4,000 Defer GP 4,000

89,750

93,750 75% NI

Low 4,000

6-70

Review Exercise 1: Partial Consolidated Worksheet

Parent Sub DR CR
Consol-
idated
Income Statement

Sales 125,000 230,000 125,000 230,000)

COGS 100,000 105,000 121,000 84,000)

Inc from Sub 89,750 89,750 Basic

Gross Profit 114,750 125,000 214,750 121,000 146,000)

NCI in NI 31,250 Basic (31,250)

CI in NI 114,750 125,000 246,000 121,000 114,750)

Balance Sheet

Inventory 20,000 4,000 16,000)

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ثلاثة نقاط لازم نركز فيها لما نحل بذي الطريقة داون سترييم :
الاولى؛ جزء من اللي تم بيعو للسب تم بيعو لطرف ثالت وهو اللي راح نسجلو في قوائم السب مش الكمية كاملة (١٢٥٠٠٠) زي في المثال.
الثانية: الداونستريم بيطلب اننا ما نقسم الربح المزيف المؤجل للNCI فنحسب الرصيد الباقي تحت البيرنت
فقط
الثالث؛ ان حننقص كمية الNCI من القائمة الموحدة

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6-71

Review Exercise 1: Equity Method Reversal Next
Year

Equity Method Adjustment on Parent’s books in 20X7:

Income from Sub 4,000
Investment in Sub 4,000

Reversal of 20X7 Deferral on Parent’s books in 20X8:

Investment in Sub 4,000
Income from Sub 4,000

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6-72

Learning Objective 4

Prepare equity-method journal
entries and elimination entries
for the consolidation
of a subsidiary following

upstream inventory transfers.

6-73

Partially Owned Upstream Sales

 Must share deferral with the NCI shareholders.

 Simply split up the adjustment for unrealized
gross profit proportionately.

Investment in Sub Income from Sub

NI 4,500

1,800 Defer GP 1,800

4,500 NI

2,700

P
S
NCI

10% 90%

Unreal GP 200

NCI in NA of Sub

Equity Method
Adjustments

Worksheet
Entry Only

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6-74

Review Exercise Part 2

 In 20X7, Sensei, a 90%-owned subsidiary of Padawan,
sold inventory to Padawan for $600,000, which includes a
markup of 25% on Sensei’s cost.

 Padawan resold most of this inventory in 20X7 for
$588,000.

 At 12/31/X7, Padawan reported $110,000 of this
inventory in its balance sheet. (This ending inventory was
resold in 20X8 by Padawan.)

 In 20X8, Sensei sold Padawan inventory for $900,000 that
had a cost of $675,000, of which Padawan resold $700,000
by12/31/X8 for $840,000.

Required:

 Prepare the consolidation entry and/or entries required
at 12/31/X8 under the equity method.

 Since this is an UPSTREAM transaction, we do share the
GP deferral with the NCI.

P
S
NCI

10% 90%

6-75

Review Exercise Part 2: The Big Picture—20X7

Total Sold On hand

Sales 600,000 490,000 110,000

 COGS 480,000 392,000 88,000

Gross Profit 120,000 98,000

22,000

Gross Profit % = 120,000 ÷ 600,000 = 20%

Ending Inventory = $110,000

Sub Parent? ?$600,000

Unrealized GP

$600,000 – C = 0.25C
C = $600,000/1.25

= $480,000

6-76

20X7 Upstream Sales: Elimination Entries—20X7 &
20X8

P
S
NCI
10% 90%

20X7 Worksheet Elimination Entry:

Sales 600,000
Cost of Goods Sold 578,000
Inventory 22,000

20X8 Worksheet Elimination Entry:

Investment in Sub 19,800

NCI in NA of Sub 2,200
Cost of Goods Sold 22,000

Deferred GP this year “reversed”
to recognize in the financial

statements next year when sold.

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6-77

20X7 Upstream Sales: Equity Method Adjustments
— 20X7 & 20X8

P
S
NCI
10% 90%

20X7 Equity Method Adjustment on Parent’s books:

Income from Sub 19,800

Investment in Sub 19,800

20X8 Equity Method Reversal of 20X7 Deferral (on
Parent’s books):

Investment in Sub 19,800
Income from Sub 19,800

Deferral of GP in 20X7
because not yet sold this year.

6-78

20X7 Upstream Sales: 20X7 Equity Accounts

Investment in Sub Income from Sub

90% NI 108,000
19,800 X7 Deferral 19,800

88,200

108,000 90% NI

Low 19,800

6-79

20X7 Upstream Sales: 20X7 Partial Worksheet

Parent Sub DR CR
Consol-
idated
Income Statement

Sales 588,000 600,000 600,000 588,000)

COGS 490,000 480,000 578,000 392,000)

Inc from Sub 88,200 88,200 Basic

Gross Profit 186,200 120,000 688,200 578,000 196,000)

NCI in NI 9,800 Basic (9,800)

CI in NI 186,200 120,000 698,000 578,000 186,200)

Balance Sheet

Inventory 110,000 22,000 88,000)

6-80

Review Exercise Part 2
 In 20X7, Sensei, a 90%-owned subsidiary of Padawan,
sold inventory to Padawan for $600,000, which includes a
markup of 25% on Sensei’s cost.
 Padawan resold most of this inventory in 20X7 for
$588,000.
 At 12/31/X7, Padawan reported $110,000 of this
inventory in its balance sheet. (This ending inventory was
resold in 20X8 by Padawan.)
 In 20X8, Sensei sold Padawan inventory for $900,000 that
had a cost of $675,000, of which Padawan resold $700,000
by12/31/X8 for $840,000.
Required:
 Prepare the consolidation entry and/or entries required
at 12/31/X8 under the equity method.
 Since this is an UPSTREAM transaction, we do share the
GP deferral with the NCI.
P
S
NCI
10% 90%

6-81

Review Exercise Part 2: The Big Picture—20X8

Total Sold On hand

Sales 900,000 700,000 200,000

 COGS 675,000 525,000 150,000

Gross Profit 225,000 175,000 50,000

Gross Profit % = 225,000 ÷ 900,000 = 25%

Ending Inventory = $200,000

Sub Parent675,000 ?$900,000

Unrealized GP

6-82

Review Exercise 2: Summary

Fully-adjusted Equity Method Entry on Parent’s books:

Income from Sub 45,000
Investment in Sub 45,000

To eliminate sale from Sub to Parent to Outsider:
Sales (Sub) 700,000

Cost of Goods Sold (Parent) 700,000

To eliminate sale from Sub to Parent, not yet to Outsider:
Sales (Sub) 200,000

Cost of Goods Sold (Sub) 150,000
Inventory (basis correction) 50,000

Combine both entries:
Sales 900,000

Cost of Goods Sold 850,000
Inventory 50,000

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6-83

Review Exercise 2: Short Cut

Total Sold On hand
Sales 900,000 700,000 200,000
 COGS 675,000 525,000 150,000

Gross Profit 200,000 175,000 50,000

COGS CR = 700,000 + 150,000 = 850,000

The Elimination Entry:

Sales 900,000
Cost of Goods Sold 850,000
Inventory 50,000

6-84

20X8 Upstream Sales: 20X8 Equity Accounts

Investment in Sub Income from Sub

19,800 Low

19,800 X7 Reversal 19,800

202,500 90% NI90% NI 202,500
45,000 X8 Deferral 45,000

177,30045,000 Low

6-85

20X7 & 20X8 Upstream Sales: 20X8 Partial
Worksheet

Parent Sub DR CR
Consol-
idated
Income Statement

Sales 840,000 900,000 900,000 840,000)

COGS 700,000 675,000 850,000 503,000)

22,000

Income from Sub 177,300 177,300 Basic

Gross Profit 317,300 225,000 1,077,300 872,000 337,000)

NCI in NI 19,700 Basic (19,700)

CI in NI 317,300 225,000 1,097,000 872,000 317,300

Balance Sheet

Inventory 200,000 50,000 150,000)

Investment in Sub
Low by
45,000

19,800 Basic X

NCI in NA of Sub 2,200 2,200

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6-86

Learning Objective 5

Understand and explain
additional considerations

associated with consolidation.

6-87

Additional Considerations

 Sale from one subsidiary to another

 Transfers of inventory often occur between
companies that are under common control or
ownership.

 The eliminating entries are identical to those
presented earlier for sales from a subsidiary to its
parent.

 The full amount of any unrealized intercompany
profit is eliminated, with the profit elimination
allocated proportionately against the ownership
interests of the selling subsidiary.

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6-88

Additional Considerations

 Costs associated with transfers

 When one affiliate transfers inventory to
another, some additional cost is often
incurred.

 Such costs should be treated in the same
way as if the affiliates were operating
divisions of a single company.

6-89

Additional Considerations

 Lower-of-cost-or-market

 A company might write down inventory
purchased from an affiliate under this rule
if the market value at the end of the period
is less than the intercompany transfer
price.

6-90

Assume that a parent company purchases inventory for $20,000 and
sells it to its subsidiary for $35,000. The subsidiary still holds the
inventory at year-end and determines that its market value
(replacement cost) is $25,000 at that time. The subsidiary writes the
inventory down from $35,000 to its lower market value of $25,000 at
the end of the year and records the following entry:

Lower-of-Cost-or-Market Example

Write-down Inventory to Market Value:

Loss on Decline in Value of Inventory 10,000
Inventory 10,000

Sales 35,000
Cost of Goods sold 20,000
Inventory 5,000
Loss on Decline in Value of Inventory 10,000

Make the following worksheet eliminating entry:

6-91

Additional Considerations

 Sales and purchases before affiliation

 The consolidation treatment of profits on
inventory transfers that occurred before the
business combination depends on whether the
companies were at that time independent and the
sale transaction was the result of arm’s-length
bargaining.

 As a general rule, the effects of transactions that
are not the result of arm’s-length bargaining must
be eliminated.

6-92

Additional Considerations

 In the absence of evidence to the contrary,
companies that have joined together in a business
combination are viewed as having been separate
and independent prior to the combination.

 If the prior sales were the result of arm’s-length
bargaining, they are viewed as transactions between
unrelated parties.

 No elimination or adjustment is needed in preparing
consolidated statements subsequent to the combination,
even if an affiliate still holds the inventory.

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لو اتحدنا مع شركة اخرى في شهر ثلاثة مثلا من ٢٠١١ اي معاملة بيني وبين الطرف الثاني قبل شهر ٣ تبغى مكانها وكأنها حصلت مع طرف اخر مستقل

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6-93

Practice Quiz Question #6

Peanut Co. regularly purchased inventory
from Snack Inc. in 20X3 when Peanut did
not own any Snack stock. On March 31,
20X4, Peanut purchased 90% of Snack
Inc.’s outstanding common stock.

a. Peanut should eliminate 90% of Snack’s
first quarter 20X4 gross profit.

b. Peanut should eliminate 100% of
Snack’s first quarter 20X4 gross profit.

c. Peanut should not eliminate any of
Snack’s first quarter 20X4 gross profit.

d. Peanut should eliminate 100% of
Snack’s 20X4 gross profit.

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