solution manual advanced financial accounting 8th edition baker chap007

CHAPTER 7 INTERCOMPANY INVENTORY TRANSACTIONS ANSWERS TO QUESTIONS Q7-1 All inventory transfers between related companies must be eliminated to avoid an overstatement of revenue and co

CHAPTER 7 INTERCOMPANY INVENTORY TRANSACTIONS

ANSWERS TO QUESTIONS

Q7-1 All inventory transfers between related companies must be eliminated to avoid an

overstatement of revenue and cost of goods sold in the consolidated income statement In addition, when unrealized profits exist at the end of the period, the eliminations are needed to avoid overstating inventory and consolidated net income

Q7-2 An inventory transfer at cost results in an overstatement of sales and cost of goods

sold While net income is not affected, gross profit ratios and other financial statement analysis may be substantially in error if appropriate eliminations are not made

Q7-3 An upstream sale occurs when the parent purchases items from one or more

subsidiaries A downstream sale occurs when the sale is made by the parent to one or more subsidiaries Knowledge of the direction of sale is important when there are unrealized profits

so that the person preparing the consolidation workpaper will know whether to reduce consolidated net income assigned to the controlling interest by the full amount of the unrealized profit (downstream) or reduce consolidated income assigned to the controlling and noncontrolling interests on a proportionate basis (upstream)

Q7-4 As in all cases, the total amount of the unrealized profit must be eliminated in

preparing the consolidated statements When the profits are on the parent company's books, consolidated net income and income assigned to the controlling interest are reduced by the full amount of the unrealized profit

Q7-5 Consolidated net income is reduced by the full amount of the unrealized profits In the

upstream sale, the unrealized profits are apportioned between the parent company shareholders and the noncontrolling shareholders Thus, consolidated net income assigned

to the controlling and noncontrolling interests is reduced by a pro rata portion of the unrealized profits

Q7-6 Income assigned to the noncontrolling interest is affected when unrealized profits are

recorded on the subsidiary's books as a result of an upstream sale A downstream sale should have no effect on the income assigned to noncontrolling interest because the profits are on the books of the parent

Q7-7 The basic eliminating entry needed when the item is resold before the end of the

period is:

Q7-8 The basic eliminating entry needed when one or more of the items are not resold

before the end of the period is:

Q7-9 Cost of goods sold is reported by the consolidated entity when inventory is sold to an

external party The amount reported as cost of goods sold is based on the amount paid for the inventory when it was produced or purchased from an external party If inventory has been purchased by one company and sold to a related company, the cost of goods sold recorded on the intercorporate sale must be eliminated

Q7-10 No adjustment to retained earnings is needed if the intercorporate sales have been

made at cost or if all intercorporate sales have been resold to an external party in the same accounting period If not all of the intercorporate sales have been resold by the end of the period, consolidated retained earnings must be reduced by the parent's proportionate share

of any unrealized profits

Q7-11 A proportionate share of the realized retained earnings of the subsidiary are assigned

to the noncontrolling interest Any unrealized profits on upstream sales are deducted proportionately from the amount assigned to the noncontrolling interest and consolidated retained earnings Unrealized profits on downstream sales are deducted entirely from the retained earnings assigned to the consolidated entity

Q7-12 When inventory profits from a prior period intercompany transfer are realized in the

current period, the profit is added to consolidated net income and to the income assigned to the shareholders of the company that made the intercompany sale If the unrealized profits arise from a downstream sale, income assigned to the controlling interest will increase by the full amount of profit realized When the profits arise from an upstream sale, income assigned

to the controlling and noncontrolling interests will be increased proportionately in the period the profit is realized Thus, knowledge of whether the profits resulted from an upstream or a downstream sale is imperative in assigning consolidated net income to the appropriate shareholder group

Q7-13 Consolidated retained earnings must be reduced by the full amount of any unrealized

profit on the parent company books

Q7-14 Consolidated retained earnings must be reduced by the parent's proportionate share

of the unrealized profit on the subsidiary's books

Q7-15* Sales between subsidiaries are treated in the same manner as upstream sales

Whenever the profits are on the books of one of the subsidiaries, the unrealized profits at the end of the period are eliminated and consolidated net income and income assigned to the controlling and noncontrolling interests is reduced

Q7-16* When a company is acquired in a business combination the transactions occurring

before the combination generally are regarded as transactions with unrelated parties and no adjustments or eliminations are needed All transactions between the companies following the combination must be fully eliminated

SOLUTIONS TO CASES

C7-1 Measuring Cost of Goods Sold

a While the rule covers only a part of the elimination needed, Charlie is correct in that the cost of goods sold recorded by the selling company must be eliminated to avoid overstating that caption in the consolidated income statement

b The rules will result in the proper consolidated totals if rule #1 is expanded to include a debit to sales and a credit to ending inventory for the amount of profit recorded by the company that sold to its affiliate

c The way in which the rule is stated makes it appear to be incorrect, but it is correct The rule is appropriate in that the cost of goods sold recorded by the purchasing affiliate is equal

to the cost of goods sold to the first owner plus the profit the first owner recorded on the sale Eliminating these amounts therefore eliminates the appropriate amount of cost of goods sold

If an equal amount of sales is eliminated, the rule should result in proper consolidated financial statement totals

d The employee would be forced to look at the books of the selling affiliate and determine the difference between the intercorporate sale price and the price it paid to acquire or produce the items If the items sold to affiliates are routinely produced and costs do not fluctuate greatly, it may be possible to use some form of gross profit ratio to estimate the amount of unrealized profit

C7-2 Inventory Values and Intercompany Transfers

MEMO

To: President

Water Products Corporation

From: , CPA

Re: Inventory Sale and Purchase of New Inventory

If Water Products holds only a small percent of the ownership of Plumbers Products and Growinkle Manufacturing, it should have no difficulty in reporting the desired results This would not be the case if the two companies are subsidiaries of Water Products

C7-2 (continued)

The consolidated income statement should include the same amount of income on the inventory sold to Plumbers Supply and resold during the year as would have been recorded if Water Products had sold the inventory directly to the purchaser Any income recorded by Water Products on inventory not resold by Plumbers Supply must be eliminated

Similarly, the consolidated income statement should include the same amount of income on the inventory purchased by Water Products and resold during the year as would have been recorded if Growinkle Manufacturing had sold the inventory directly to the purchaser Any income recorded by Growinkle Manufacturing on inventory not resold by Water Products must be eliminated

Consolidated net income may increase if Plumbers Supply is able to sell the inventory it purchased from Water Products at a higher price than would have been received by Water Products or if it is able to sell a larger number of units The same can be said for the inventory purchased by Water Products from Growinkle Manufacturing It is important to recognize that the transfer of inventory between Water Products and its subsidiaries does not

in itself generate income for the consolidated entity

An additional level of complexity may arise in this situation if Water Products uses the LIFO inventory method It might, for example, be forced to carry over its LIFO cost basis on the old inventory sold to Plumbers Supply to the new inventory purchased from Growinkle Manufacturing since it was replaced within the accounting period

Primary citation:

ARB 51, Par 6

C7-3 Intercorporate Inventory Transfers

MEMO

To: Treasurer

Evert Corporation

From: , CPA

Re: Inventory Sale to Parent

This memo is prepared in response to your request for information on the appropriate treatment of intercompany inventory transfers in consolidated financial statements The specific eliminating entries required in this case depend on the valuation assigned to the inventory at December 31, 20X2

Frankle Company sold inventory with a carrying value of $240,000 to Evert for $180,000 on December 20, 20X2 Since the exchange price was well below Frankle’s cost, consideration should be given to whether the inventory should be reported at $180,000 or $240,000 in the consolidated statements at December 31, 20X2, under the lower-of-cost-or-market rule While the value of the inventory apparently had fallen below Frankle’s carrying value, the accounting standards indicate no loss should be recognized when the evidence indicates that cost will be recovered with an approximately normal profit margin upon sale in the

ordinary course of business [ARB 43, Chapter 4, Par 9]

We are told the management of Frankle considered the drop in prices to be temporary and Evert was able to sell the inventory for $70,000 more than the original amount paid by Frankle It therefore seems appropriate for the consolidated entity to report the inventory at Frankle’s cost of $240,000 at December 31, 20X2

In preparing the consolidated statements at December 31, 20X2 and 20X3, the effects of the

intercompany transfer should be eliminated [ARB 51, Par 6]

The following eliminating entry is required at December 31, 20X2:

The above entry will increase the carrying value of the inventory to $240,000 Eliminating sales of $180,000 and cost of goods sold of $240,000 will increase consolidated net income

by $60,000 and income assigned to the noncontrolling interest by $6,000 ($60,000 x 10) These changes will result in an increase in consolidated retained earnings and the amount assigned to the noncontrolling shareholders in the consolidated balance sheet by $54,000 and $6,000, respectively

C7-3 (continued)

The following eliminating entry is required at December 31, 20X3:

The above entry will reduce consolidated net income by $60,000 and income assigned to the noncontrolling interest by $6,000 ($60,000 x 10) The credits to retained earnings and noncontrolling interest are needed to bring the beginning balances into agreement with those reported at December 31, 20X2

No eliminations are required for balances reported at December 31, 20X3, because the inventory has been sold to a nonaffiliate prior to year-end

Primary citations:

ARB 43, CH 4, Par 9

ARB 51, Par 6

C7-4 Unrealized Inventory Profits

a When the amount of unrealized inventory profits on the books of the subsidiary at the beginning of the period is greater than the amount at the end of the period, the income assigned to the noncontrolling interest for the period will exceed a pro rata portion of the reported net income of the subsidiary

b The subsidiary apparently had less unrealized inventory profit at the end of the period than it did at the start of the period In addition, the parent must have had more unrealized profit on its books at the end of the period than it did at the beginning The negative effect of the latter apparently offset the positive effect of the reduction in unrealized profits by the subsidiary

c The most likely reason is that a substantial amount of the parent company sales was made to its subsidiaries and the cost of goods sold on those items was eliminated in preparing the consolidated statements

d A loss was recorded by the seller on an intercompany sale of inventory to an affiliate and the purchaser continues to hold the inventory

C7-5 Eliminating Inventory Transfers

a If no intercompany sales are eliminated, the income statement may include overstated sales revenue and cost of goods sold The net impact on income will depend upon whether there were more unrealized profits at the beginning or end of the year If Ready Building does not hold total ownership of the subsidiaries, the amount of income assigned to noncontrolling shareholders is likely to be incorrect as well

Inventory, current assets and total assets, retained earnings, and stockholders' equity are likely to be overstated if inventories are sold to affiliates at a profit If the companies pay income taxes on their individual earnings, the amount of income tax expense also will be overstated in the period in which unrealized profits are reported and understated in the period in which the profits are realized

b Because profit margins vary considerably, the amount of unrealized profit may vary considerably if uneven amounts of product are purchased by affiliates from period to period Ready Building needs to establish a formal system to monitor intercompany sales Perhaps the best alternative would be to establish a separate series of accounts to be used solely for intercompany transfers Alternatively, it may be possible to use unique shipping containers for intercompany sales or to specifically mark the containers in some way to identify the intercompany shipments at the time of receipt The purchaser might then use a different type

of inventory tag or mark these units in some way when the product is received and placed in inventory Inventory count teams could then easily identify the product when inventories are taken

c A number of factors might be considered The most important inventory system is the one used by the company making the intercompany purchase When intercompany inventory purchases are bunched at the end of the year, the amount of unrealized profit included in ending inventory may be quite different under FIFO versus LIFO If intercompany purchases are placed in a LIFO inventory base, inventories may be misstated for a period of years before the inventory is resold Eliminating entries must be made each of the years until resale to avoid a misstatement of assets and equities In those cases where the intercompany purchases are in high volume and the inventory turns over very quickly, a small amount of inventory left at the end of the period may be immaterial and of little concern Typically, a parent will align inventory costing methods subsequent to a subsidiary acquisition to avoid problems caused by differences in accounting for the same items or types of items

C7-5 (continued)

d It may be necessary to start by looking at intercorporate cash receipts and disbursements

to determine the extent of intercorporate sales One or more months might be selected and all vouchers examined to establish the level of intercorporate sales and the profit margins recorded on the sales For those products sold throughout the year, it may be possible to estimate for the year as a whole based on an examination of several months Once total intercompany sales and profit margins have been estimated, the amount of unrealized profit

at year end should be estimated One approach would be to take a physical inventory of the specific product types which have been identified and attempt to trace back using the product identification numbers or shipping numbers to determine what portion of the inventory on hand was purchased from affiliates

C7-6 Intercompany Profits and Transfers of Inventory

a The intercompany transfers of Xerox (www.xerox.com) between segments are apparently relatively insignificant because they are not reported in the notes to the consolidated financial statements relating to segment reporting For consolidation purposes, all significant intercompany accounts and transactions are eliminated

b Exxon Mobil (www.exxonmobil.com) prices intercompany transfers at estimated market prices The amount of intercompany transfers is large In the fiscal year ending December

31, 2006, Exxon Mobil reported eliminations of $368 billion of intersegment transfers, which does not include intercompany transfers within segments This amount represents nearly 50 percent of total reported segment sales For consolidation purposes, Exxon Mobil eliminates the effects of intercompany transactions

c Ford Motor Company (www.ford.com) intercompany transfers consist primarily of vehicles, parts, and components manufactured by the company and its subsidiaries, with a smaller amount of financial and other services included The amount of intercompany transfers is significant, totaling almost $4 billion, but is relatively small in relation to sales to unaffiliated customers The amount has been decreasing in recent years The effects of intercompany transfers are eliminated in consolidation

Proportion of inventory unsold at year end

6 c Inventory reported by Banks ($175,000 + $60,000) $235,000

Unrealized profit at year end

E7-2 Multiple-Choice Questions on the Effects of Inventory Transfers

[AICPA Adapted]

1 b Cost of goods sold reported by Park $ 800,000

Cost of goods sold reported by Small 700,000

Cost of goods sold reported by Park on

E7-4 Multiple-Choice Questions — Consolidated Balances

Income to Dresser’s noncontrolling

E7-5 Multiple-Choice Questions — Consolidated Income Statement

1 a $20,000 = $30,000 x [($48,000 - $16,000) / $48,000]

3 a $7,000 = [($67,000 - $32,000) x 20]

E7-6 Realized Profit on Intercompany Sale

a Journal entries recorded by Nordway Corporation:

E7-7 Sale of Inventory to Subsidiary

a Journal entries recorded by Nordway Corporation:

E7-8 Inventory Transfer between Parent and Subsidiary

a Karlow Corporation reported cost of goods sold of $820,000 ($82 x 10,000 desks) and Draw Company reported cost of goods sold of $658,000 ($94 x 7,000 desks)

b Cost of goods sold for the consolidated entity is $574,000 ($82 x 7,000 desks)

E7-9 Income Statement Effects of Unrealized Profit

a Sale price to Holiday Bakery per bag ($900,000 / 100,000) $ 9.00

Required Adjustment to Cost of Goods Sold:

Cost of goods sold — Holiday ($9.00 x 80,000 units) 720,000

$1,320,000 Consolidated cost of goods sold ($6.00 x 80,000 units) (480,000)

$550,000

Less: Income assigned to noncontrolling interest

($150,000 - $60,000 unrealized profit) x 40 (36,000)

Alternate computation:

Unrealized profits ($3.00 x 20,000 units) (60,000)

54,000

E7-10 Prior-Period Unrealized Inventory Profit

Cost of goods sold from inventory held, January 1, 20X9 $120,000

b Assuming the basic equity method is used by Holiday Bakery in

accounting for its investment in Farmco Products, the following

eliminating entry is needed:

$60,000 = 20,000 bags x $3.00

$550,000

Less: Income assigned to noncontrolling shareholders

Alternate computation:

186,000

E7-11 Computation of Consolidated Income Statement Data

$600,000 Intercompany sales by Prem Company in 20X5 $ 30,000

Intercompany sales by Cooper Company in 20X5 80,000 (110,000)

$370,000

Adjustment to cost of goods sold:

CGS charged by Prem on sale to Cooper $ 20,000

Unrealized profit on sale to Prem Company

E7-12 Sale of Inventory at a Loss

a Entries recorded by Trent Company

Sale of inventory to Gord Corporation

Record cost of goods sold

Entries recorded by Gord Corporation

Sale of inventory to nonaffiliates

Unrealized loss on intercorporate sale

Income to assigned to noncontrolling interest

E7-12 (continued)

d Eliminating entry, December 31, 20X8:

Computation of cost of goods sold to be eliminated

E7-13 Intercompany Sales

a Consolidated net income for 20X4:

$250,000

b Inventory balance, December 31, 20X5:

Inventory reported by Hollow Corporation $ 30,000

Unrealized profit on books of Surg

Corporation

($135,000 - $90,000) x ($30,000/$135,000) (10,000) $20,000

Unrealized profit on books of Hollow

Corporation

($280,000 - $140,000) x ($110,000/$280,000) (55,000) 55,000

c Consolidated cost of goods sold for 20X5:

CGS on sale of inventory on hand January 1, 20X5

d Income assigned to controlling interest:

$305,000 Add: Inventory profit of prior year realized in 20X5 15,000 Less: Unrealized inventory profit — Surg Corporation (10,000)

Unrealized inventory profit — Hollow Corporation (55,000) Income to noncontrolling interest

E7-14 Consolidated Balance Sheet Workpaper

Eliminate investment balance

Consolidated Balance Sheet Workpaper

December 31, 20X8

Item Corp Co Debit Credit idated

(3) 10,000 200,000 Buildings and Equipment

E7-15* Multiple Transfers between Affiliates

a Entries recorded by Klon Corporation

Sale of inventory to Brant Company

Record cost of goods sold

Entries recorded by Brant Company

Sale of inventory to Torkel Company

Record cost of goods sold

Entries recorded by Torkel Company

Sale of inventory to nonaffiliates

Record cost of goods sold

b Cost of goods sold for 20X8 should be reported as $60,000

[$90,000 x ($100,000 / $150,000)]

c Inventory at December 31, 20X8, should be reported at $40,000

[$60,000 x ($100,000 / $150,000)]

Computation of cost of goods sold to be eliminated

Computation of reduction to carrying value of inventory

E7-16 Inventory Sales

a Journal entries recorded by Spice Company:

Record purchases from nonaffiliate

Record sale to Herb Corporation

Record cost of goods sold to Herb Corporation

Journal entries recorded by Herb Corporation:

Record purchases from Spice Company

Record sale of items to nonaffiliates

E7-17 Prior-Period Inventory Profits

a Eliminating entries:

Eliminate beginning inventory profit:

Unrealized profit, December 31, 20X9 (50,000)

Noncontrolling interest's share of ownership x .25 x .25 Income assigned to noncontrolling interest $ 85,000 $ 95,000

Eliminate beginning inventory profit

Eliminate intercompany sale of inventory

P7-19 Unrealized Profit on Upstream Sales

20X2 20X3 20X4 Operating income reported by Pacific $150,000 $240,000 $300,000

$250,000 $330,000 $460,000 Inventory profit, December 31, 20X2

Income to noncontrolling interest:

P7-20 Net Income of Consolidated Entity

$183,000

Amortization of differential

Less: Income to noncontrolling interest

($65,000 + $40,000 - $55,000 - $3,000) x 30 (14,100)

P7-21 Correction of Eliminating Entries

a Proportion of intercompany inventory purchases resold during 20X5:

Cost of inventory sold ($140,000 / 1.40) (100,000)

Proportion of intercompany sale held by

Proportion of intercompany purchases resold

b Eliminating entries, December 31, 20X5:

Eliminate intercompany receivable/payable

Eliminate intercompany sale of inventory

P7-22 Incomplete Data

a Increase in fair value of buildings and equipment:

b Accumulated depreciation for consolidated entity:

Cumulative write-off of differential

c Amount paid by Lever to acquire ownership in Tropic:

d Investment in Tropic Company stock reported at December 31, 20X6:

Tropic's common stock outstanding December 31, 20X6 $ 60,000 Tropic's retained earnings reported December 31, 20X6 112,000

Unamortized differential ($5,000 x 2 years) x 75 7,500

e Intercorporate sales of inventory in 20X6:

P7-22 (continued)

f Unrealized inventory profit, December 31, 20X6:

g Eliminating entry to remove the effects of intercompany inventory

sales during 20X6:

h Unrealized inventory profit at January 1, 20X6:

Reduction of cost of goods sold for intercompany

Cost of goods sold reported in consolidated

Additional adjustment to cost of goods sold

i Accounts receivable reported by Lever at December 31, 20X6:

Accounts receivable reported for consolidated entity $145,000

Adjustment for intercompany receivable/payable:

Accounts payable reported for consolidated

P7-23 Eliminations for Upstream Sales

a Eliminating entries, December 31, 20X8:

Eliminate income from subsidiary

Assign income to noncontrolling interest

Eliminate beginning investment balance

Eliminate beginning inventory profit

$100,000 x ($105,000 / $150,000)

$135,000 Required elimination

Income assigned to noncontrolling interest

c Noncontrolling interest, December 31, 20X8:

$335,000 Proportion of stock held by noncontrolling

P7-24 Multiple Inventory Transfers

a Consolidated net income for 20X8:

Unrealized profit, December 31, 20X8

($35,000 - $15,000) x ($7,000 / $35,000) (4,000) $ 76,000

Profit realized from 20X7

Unrealized profit, December 31, 20X8

($72,000 - $63,000) x ($12,000 / $72,000) (1,500) 38,000

Profit realized from 20X7

Unrealized profit, December 31, 20X8

($45,000 - $27,000) x ($15,000 / $45,000) (6,000) 17,000

b Inventory balance, December 31, 20X8:

c Income assigned to noncontrolling interest in 20X8:

Proportion of stock held by

Proportion of stock held by

P7-25 Consolidation with Inventory Transfers and Other Comprehensive Income

a Balance in investment account at December 31, 20X5:

Proportionate share of Tall's net assets,

b Investment income for 20X5:

c Income to noncontrolling interests for 20X5:

20X4 inventory profits realized in 20X5

20X5 unrealized inventory profits

Proportion of ownership held by noncontrolling

d Balance assigned to noncontrolling interest in consolidated balance

sheet:

Unrealized inventory profits at

Proportion of ownership held by noncontrolling

P7-25 (continued)

e Inventory reported in consolidated balance sheet:

Less: Unrealized profit

$6,000 - [$6,000 x ($24,000 / $36,000)] (2,000) 98,000

f Consolidated net income for 20X5:

20X4 inventory profits realized in 20X5

Unrealized inventory profits on 20X5 sales

g Eliminating entries, December 31, 20X5

Eliminate income from subsidiary

Assign income to noncontrolling interest

P7-25 (continued)

E(3) Other Comprehensive Income from

Eliminate other comprehensive income

Additional Paid-In Capital — Tall Corporation 200,000

Accumulated Other Comprehensive Income 10,000

Eliminate beginning investment balance

Eliminate beginning inventory profit

of Tall Company

Eliminate beginning inventory profit

of Priority Corporation

Eliminate intercompany sale of inventory

by Priority Corporation

Eliminate intercompany sale of inventory

by Tall Company

P7-26 Multiple Inventory Transfers between Parent and Subsidiary

a Eliminating entries:

Eliminate beginning inventory profit

Eliminate intercompany sale of inventory

by Proud Company

Eliminate intercompany sale of inventory

by Slinky Company

b Computation of cost of goods sold for consolidated entity:

Inventory produced by Proud in 20X5

Cost of goods sold reported in

P7-27 Consolidation following Inventory Transactions

a Entries recorded by Bell on its investment in Troll:

Record dividends from Troll: $10,000 x 60

Record equity-method income: $30,000 x 60

b Eliminating entries, December 31, 20X2:

Eliminate income from subsidiary

Assign income to noncontrolling interest:

$11,680 = ($30,000 + $3,400 - $4,200) x 40

$67,200 = ($100,000 + $50,000 + $18,000) x 40

Eliminate beginning inventory profit of Troll Corporation:

P7-27 (continued)

Consolidation Workpaper December 31, 20X2 Bell Troll Eliminations Consol- Item Co Corp Debit Credit idated

carry forward 277,200 70,000 144,720 65,700 268,180 Cash and Accounts