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Lecture 11

BU457 Lecture 11: Intercompany Inventory and Land Profits

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Bixia Xu

Intercompany Inventory and Land Profits 1. Intercompany Revenue and Expenses: • Although NI will be the same if intercompany transactions are included, Sales and COGS will be overstated as both items should only reflect sales to and purchases from outside the entity, therefore, must be eliminated to avoid double counting. o The same dollar amount is eliminated for both Sales and COGS. o NI and NCI are only allocations of the entity’s NI so they are not affected by the elimination of intercompany sales and purchases. o Regardless of who generates the revenue or who loans money, there is no difference with NI and NCI. • Must also eliminate intercompany management fees and rentals. • The elimination entries are recorded on the consolidated working papers and not in the separate-entity books of the parent and the subsidiary. 2. Intercompany Profits in Assets: • Must eliminate all intercompany profit/loss on the sale of an asset to another affiliated company when issuing consolidated statements (unrealized profit/loss). • When selling to an outsider, the profit is then realized. • Downstream Transaction: Parent sells to Subsidiary  eliminate Parent Profit • Upstream Transaction: Subsidiary sells to Parent or another Subsidiary of the Parent  eliminate Subsidiary Profit o Always eliminate profit from the selling company. • Any inventory sold within the group but not subsequently sold outside must be shown at its original cost with the unrealized profit eliminated net of the associated tax. o We have to hold back any unrealized net-of-tax profit when consolidating. o Income tax should be expensed in the same period revenue is recorded. o The timing difference gives rise to deferred income taxes. 3. Intercompany Profits in Inventory: • Elimination entry to eliminate unrealized gross profit in ending inventory: COGS XXX Ending Inventory XXX (This restores inventory to its original cost) • Elimination entry for prepaid tax on the unrealized profit: Deferred Income Tax XXX Tax Expense XXX (The tax expense has been reduced to match reduced income) 4. Inventory Results year-over-year: • In the first year: o COGS is increased o Ending inventory is decreased o Profit is held back until realized through a sale to an outsider o Deferred Tax Asset is established • In the second year: o COGS is decreased as Beginning Inventory is decreased to original cost o Profit is now realized o Income Tax Expense is increased 5. Intercompany Inventory Profits – “Upstream”: • Example: Parent’s inventory contains $1,000 of items purchased from the Subsidiary at the end of the year. Note: Gross Profit is 30%; Tax Rate is 40%. o Unrealized intercompany profit of $300 is held back and realized in the period it is sold to outsiders. o $120 Tax Expense is held back from consolidated NI as well (matching principle). ▪ Tax is reported at the individual company level. ▪ Income tax is expensed in the same period as the profit. ▪ This creates a temporary difference and causes deferred income taxes. ➢ Premature tax paid on the profit held back or income not yet earned  This is considered an ASSET • NCI is not affected by intercompany profits made on downstream transactions. o Since NCI shareholders do not have any interest in the parent company. • NCI is affected and will share in intercompany profits made on upstream transactions. o Since NCI shareholders have an interest in the subsidiary company. o NCI claims their percentage of after-tax profit in ending inventory. • Adjustments are needed to eliminate unrealized profits in order to properly apply the cost, revenue recognition, and matching principles. 6. Intercompany Inventory Profit – “Upstream Transaction” EXAMPLE: A)Intercompany Transactions: Intercompany sales and purchases 5,000 (A) Intercompany inventory profits: Ending Inventory – Sub Inc. selling 300 (B) Income Tax (40%) 120 (C) After-tax Profit 180 (D) Alternatively: Intercompany Balances: Sales and Purchase in Year XXX Accounts Receivable/Accounts Payable XXX Intercompany Inventory Profits: Before Tax Tax After Tax Opening Inventory – Sub Selling @ Profit: XXX XXX XXX Closing Inventory – Sub Selling @ Profit: XXX XXX XXX Note: For COGS ADD back EI SUBTRACT BI  Opposite for Income Tax B)Calculation of Consolidated NI: NI – Parent Co. 3,400 NI – Sub Inc. 1,700 Less: After-tax profit in ending inventory (D) 180 Adjusted NI – Sub Inc. 1,520 (E) NI 4,920 Attributable to… Shareholders of Parent 4,768 NCI (10% X (E) 1,520 “Adj. NI”) 152 Note: Subtract EI, ADD BI  Remove EI From Inventory by Inc. COGS (expense) C) Calculation of Consolidated Retained Earnings: Retained Earnings – Parent Co. 13,400 Retained Earnings – Sub Inc. 6,200 Acquisition Retained Earnings 4,500 Increase since Acquisition 1,700 Less: Profit in Ending Inventory (D)* 180 Adjusted Increase since Acquisition 1,520 Parent Co.’s Share 90% 1,368 Consolidated Retained Earnings 14,768 * OR BI if Beginning RE D)Calculation of NCI: Shareholders’ Equity – Sub Inc. Common Shares 8,000 Retained Earnings 6,200 14,200 Less: After-tax Profit in Ending Inventory (D)
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