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IntercompanyEliminationsExplainedPedersonCPAReviewPedersonCPAReview

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Intercompany Eliminations Explained

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1Rob,

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Idontreallyunderstandhowintercompanyeliminationshappenforbusinesscombinations.Thewholething
kindofconfusesme.Canyouexplaintheprocessandthejournalentriestorecordtheintercompany
eliminations?
Answer:
Rememberthatinabusinesscombination,wearetryingtoeliminateanytransactionsbetweentheparent
andthesubsidiarysothatweonlyhavetransactionswith3rdpartiesleftafterourconsolidatingentries.So,
letsassumeCompanyAownsCompanyBandAsells$120,000ofinventorytoB.Letsalsoassumethat
CompanyAgetsa40%marginonallsalesandCompanyBhas30%oftheinventoryremainingattheend
oftheyear.
Withthissetoffacts,theycouldaskyouawidevarietyofquestionsontheCPAexam.Oneofthetricksto
solvingproblemsinvolvingintercompanyeliminationsistounderstandtheentriesthatAandBwouldbookin
thesecases.Oneoftheothertricksisunderstandingtherelationshipbetweencostandmarginpercentage.

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Forexample,CompanyAhasacostof$120,000.Themarginis40%.Todeterminethesalesprice,we
needtodividethe$120,000costby60%(100%40%margin).Thisgivesusasalesamountof$200,000
andanintercompanyprofitamountof$80,000.
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Torecordthesale,CompanyAwouldrecordthefollowingentries:
dr.IntercompanyAccountsReceivable200,000
cr.IntercompanySales200,000
dr.IntercompanyCostofSales120,000
cr.Inventory120,000
Thissetofentriesrecordsthesaleandthereceivableatthesalesamountof$200,000andrelievesthe
inventoryatthecostamountof$120,000.
ThekeythingtorememberatthispointisthatCompanyBscostisthesameasCompanyAssalesprice.
CompanyBwillbookthefollowingentrytorecordtheinventorypurchase:
dr.Inventory200,000
cr.IntercompanyAccountsPayable200,000
Atthispoint,youcanseethatthefinancialresultsofAhave$80,000ofintercompanyprofitinthem.We
needtoeliminatetheeffectofthissalebecauseincludingitmisstatestheresultstousersofthefinancial
statements(i.e.investorsandcreditors).Ifwedidnoteliminatethissale,companiescouldsellbackand
forthbetweentheirsubsidiariestoinflatetheirresults,butafterthosetransactions,theconsolidated
companyhasnotmadeanyadditionalprofitorbroughtinanyadditionalcash.
Wealsoneedtoeliminatesomeorallofthecostofsales.Howmuchofthecostofsalesdependsonthe
profitamountandtheamountofinventoryremainingattheendoftheyear.Inthiscase,30%ofthe
inventoryisremaininginCompanyBsinventoryattheendoftheyear.CompanyBsold70%ofthe
inventoryto3rdparties.ThismeansCompanyBwouldrecordcostofsalesof$140,000($200,000coston
CompanyBsbooksmultipliedby70%ofinventorysold).
Torecordthesalestothese3rdparties,CompanyBwouldrecordthefollowingentry(Iwillignorethesales
partoftheentrysincethatisirrelevanttotheintercompanyelimination):
dr.CostofSales140,000
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cr.Inventory140,000
IfwelookattheearlierentrybookedbyCompanyA,weseethatatthispoint,wehavebooked$260,000in
costofsales($120,000originalcosttoCompanyAplusthe$140,000recordedbyCompanyB).Obviously,
weshouldnothavecostofsalesof$260,000onthesameinventorythatoriginallycost$120,000.So,cost
ofsalesisoverstatedandneedstobecorrected.
Thereareacouplewaystofigureouttheadjustmenttocostofsalesandinventory.First,rememberthat
whenwerecordaneliminationonintercompanysales,theIntercompanySalesaccountisalwaysdebited
forthefullsalesamount.Inthiscase,ourdebitis$200,000.Nocalculationisrequiredjusttakethefull
amount.
OurcreditsideoftheentrywillbemadeupofCostofSalesandInventory.
Wearetryingtogetbacktoouroriginalcost,eliminatingtheimpactoftheintercompanysaleandprofit.If
ourcostwasoriginally$120,000andwesold70%tooutsidecustomers,ourcostofsalesshouldbe
$84,000.Whenwecomparethecostofsaleswehavealreadybookedof$260,000tothe$84,000we
shouldhave,thecredittocostofsalesshouldbe$176,000.Wecanthenbackintotheamountneededasa
credittoinventoryof$24,000($200,000debittosalesminus$176,000credittocostofsales).
Alternatively,wecancalculatetheappropriateamountinendinginventory.Weknowtheoriginalcostwas
$120,000and30%remainsinCompanyBsendinginventory.Thismeansweshouldendtheyearwith
$36,000inendinginventory.But,wehave$60,000inendinginventory($200,000costtoCompanyBminus
$140,000relievedfrominventoryforsales).Togetthe$60,000downtotheappropriateamountof$36,000,
weneedacredittoinventoryof$24,000.
Stillanotheralternativeistocalculatetheamountofprofitthatremainsinendinginventory.Weknow
CompanyArecorded$80,000ofprofitontheintercompanysale.Since30%oftheinventoryremainswith
CompanyB,wecanmultiplythe$80,000profitby30%toseethatinventoryisoverstatedby$24,000of
intercompanyprofit.
ItishelpfultoknowallofthesealternativemethodsfortheCPAexamsothatyoucanseetherelationships
betweensales,costofsales,inventoryandprofit.
Theentrytoeliminatetheintercompanysaleswouldbe:
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dr.IntercompanySales200,000
cr.CostofSales176,000
cr.Inventory24,000
Theentrytoeliminatetheintercompanyreceivableandpayablewouldbe:
dr.IntercompanyAccountsPayable200,000
cr.IntercompanyAccountsReceivable200,000
Thereceivableandthepayablejustgeteliminatedagainsteachother.
YoucanfindmoretipsandtrickslikethisinmyCPAreviewcourse.

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COMMENTS FOR THIS ARTICLE: (6)


http://www.pedersoncpareview.com/intercompanyeliminationsexplained/

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Jaesays:
May4,2014at1:23am

Iftheparentissuedaninterestfeeshorttermloantothesubsidiary,howwouldthis
transactionbeeliminated?
Reply

MarianWhitesays:
May9,2014at4:34pm

Thiswasexplainedverywell.Iaminterestedinreceivingmoreinformationlikethis.
Reply

hameed_beenish@yahoo.comsays:
October2,2014at7:32am

Itsreallyhelpfultounderstandtheconcept.thanks
Reply

angelinasays:
February11,2015at1:27pm

Iftherearenointercompanyprofits,andonly70%ofpurchasesfromparentwassoldby
thesubsidiary,(nobeginninginventory)whatwouldbetheeliminatingentry?
1.DebitSales$200K
CreditCostofsales$140K
CreditInventory$60K
or
2.:
DebitSales$140K
CreditCostofsales$140K
Thanks.
Reply

angelinasays:
February11,2015at3:38pm
http://www.pedersoncpareview.com/intercompanyeliminationsexplained/

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Furthertomyearlierposting,hereis3rdentrywhichIbelieveisthecorrecteliminatingentryifthere
arenointercompanyprofits.
3.DebitSales$200K
CreditCostofSales$200
Reply

Robsays:
February12,2015at9:08am

Angelina,
AreyouassumingthatCompanyAscostis$200,000andthesalepricetoCompanyBisalso
$200,000?
Ifso,thenyes,your3rdentryisthecorrectone.
Rob
Reply

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JUNE24,2013@10:12PM|CATEGORY:QUESTIONSANDANSWERS|TAGGEDAS:BUSINESSCOMBINATIONS,INTERCOMPANY
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