CHAPTER 17

Intercompany Profit Transactions

- Inventories
Many

business transactions between a parent company and its subsidiary

involve a profit (gain) or loss.
Among these transactions are intercompany sales of merchandise and
intercompany sales of plant assets.
Failure to eliminate unrealized profits and losses would result in
consolidated income statements reporting not only the results of
transactions with outsiders but also the results of related party
transactions within the affiliated group.

GENERAL OVERVIEW

The intercompany profit in inventory transfer between affiliates

is computed by multiplying the inventory held by the buying
affiliate which was acquired from the selling affiliate by the gross
profit rate based on sales of the selling affiliate.

Intercompany Sales at Cost

Merchandise sometimes is sold to related affiliates at the sellers

cost.
When an intercompany sale includes no profit or loss, the inventory
amounts at the end of the period require no adjustment for
consolidation because purchasing affiliates inventory carrying
amount is the same as the cost to the selling affiliate and the
consolidated entity.
At the time the inventory is resold to outsiders, the amount
recognized as cost of goods sold by the affiliate making the outside
sale is the cost to the consolidated entity.

Intercompany Sales at a Profit or

Loss

Companies usually mark up sale of inventory to affiliate by a certain

percentage of cost. For example, a company might mark up
inventory sale to affiliates by 50 percent of cost, selling inventory
that cost P2,000 to an affiliate for P3,000. The elimination process
must remove the effects of such sales from the consolidated
statements.

DOWNSTREAM SALE OF
INVENTORY

Downstream Intercompany sales of merchandise are those from a

parent company to its subsidiaries. For consolidation purposes,
profits recorded on an intercompany inventory sale are realized in
the period in which the inventory is resold to outsiders. Until the
point of resale, all intercompany profits must be deferred.

When a company sells merchandise to an affiliate, one of two

situations results:
(1) the merchandise is resold to outsiders during the same
period, and
(2)
the merchandise is resold to outsiders during the next
period resulting to unrealized profit in ending inventory.

Resale in the Year of Intercompany Sale

To illustrate the effect of a downstream sale, assume that on April 1,
2010, Pete Corp. sold merchandise costing P8,000 to Sake
Company for P10,000 or at a gross profit of 20% of sales. Assume
further that on November 7, 2010, Sake Company sells the
merchandise to outsiders for P15,000.

Parent and Subsidiary Companies entries

The two companies would prepare the ff journal entries to record the
above transactions:
Books of Pete Corporation:
2010
April 1 (1) Cash
10,000
Sales
10,000
To record sale of merchandise to Sake Co.
(2) Cost of goods sold
Inventory
To record cost of inventory sold

8,000
8,000

Books of Sake Company

2010
April 1 (3) Inventory
10,000
Cash
10,000
To record purchase of inventory from Pete
Nov. 7
(4) Cash
15,000
Sales
15,000
To record sale of inventory to outsiders.
(5) Cost of goods sold
10,000
Inventory
10,000
To record cost of inventory sold to outsiders.

Illustration 17-1
Item

Pete
Corporation

Sake
Company

Unadjusted
Balances

Consolidated
Amounts

Sales
Cost of goods sold

P10,000
(8,000)

P15,000
(10,000)

P25,000
(18,000)

P15,000
(8,000)

P2,000

P5,000

P7,000

P7,000

Gross profit

Working Paper Elimination Entries

Although consolidated gross profit correct even if no eliminations are made, the
totals for sales and cost of goods sold derived by simply adding the amounts on
the books of Pete and Sake are overstated for the consolidated entity. Since
consolidated sales and cost of goods sold should be P15,000 and P8,000,
respectively, rather than P25,000 and P18,000, the amount of intercompany
sale must be eliminated from both sales and cost of goods sold to correctly state
the consolidated totals. The elimination entry is therefore:

E (7) Sales

10,000

Cost of goods sold

10,000
To eliminate intercompany sale of inventory
Note that the working paper elimination entry does not affect the consolidated net
income because sales and cost of goods sold are both reduced by the same
amount. No elimination of intercompany profit is needed because all the
intercompany profit has been realized through resale of the inventory to
outsiders during the current year.

Resale in Subsequent Year Following

Intercompany Sale: Unrealized Intercompany
Profit in Ending Inventories
Any merchandise purchased from an affiliated company that remains
unsold on the date of Consolidated Statement of Financial Position
results in the overstatement of the purchasers ending inventories.
The overstatement is equal to the amount of the selling affiliates
unrealized intercompany profit included in the ending inventory. This
overstatement is cancelled through appropriate working elimination
in the preparation of consolidated financial statements.
Illustration. Assume again that Pete Corp. on April 1, 2010 sold
merchandise to Sake Co. costing P8,000 for P10,000 or at a gross
profit of 20%, out of which P4,000 remained unsold by Sake Co. on
December 31, 2010.

Parent and Subsidiary Companies Entries

The above transactions are recorded in summary form by the two
companies as follows:
Books of Pete Corporation. Pete records the sale of merchandise to
Sake with journal entries (1) and (2), given previously.
Books of Sake Company. Sake records the purchase of merchandise
from Pete with entry (3) and the sales of inventory to outsiders is
recorded as follows:
(6)

Cash

(7)

Sales
To record sales to outsiders
Cost of goods sold
Inventory
To record cost of goods sold

7,500
7,500
6,000
6,000

The intercompany gross profit in Petes sales to Sake during the year ended December
31,2010, is analyzed as follows:
Illustration 17-2
Gross profit
Selling Price
Cost
(20% of Selling Price)
Beginning inventory
Add: Sales
P10,000
P8,000
P2,000
Totals
P10,000
P8,000
P2,000
Less: Ending inventory 4,000
3,200
800
Cost of goods sold
P6,000
P4,800
P1,200

The foregoing analysis shows that the intercompany profit on sales by Pete to Sake
totaled of P2,000, and that p1,200 of this intercompany profit was realized through
Sakes sales of the acquired merchandise to outside customers. The remaining P800
of intercompany profit remains unrealized in Sakes inventories on December
31,2010.

Working Paper Elimination Entries

Base on the foregoing analysis, the working paper elimination
entries are required for Petes intercompany sales of
merchandise to Sake for the year ended December
31,2010:
E (8)

Sales
10,000
Cost of goods sold
10,000
To eliminate intercompany sale of inventory.

E (9)

Cost of goods sold

800
Inventory
800
To eliminate unrealized inventory profit.

Computation and Allocation of Consolidated

Net Income
The computation of consolidation net income (entity approach) and its
allocation on December 31, 2010 is computed as follows (net
income of Pete and Sake are assumed):
Petes net income from own operations (excluding dividend income)
50,000
Unrealized intercompany profit in ending inventory (Downstream sale) ( 800)
Petes realized income from outsiders
49,200
Sakes net income from own operations
20,000
Consolidated net income
P69,200
Attribute to NCI (P20,000x20%)
4,000
Attribute to parent shareholders
P65,200

Intercompany Profit in Beginning and Ending

Inventories

Additional problem will be encountered in the preparation of working

paper elimination entry for intercompany profits in the beginning
inventories of the purchasing affiliate.
Generally, it is assumed that on a first-in ,first-out basis, the
intercompany profit in the purchasers beginning inventories is
realized through sales of the merchandise to outsiders during the
following period.
Only the intercompany profit in ending inventories remains unrealized
at the end of the period.

Illustration

Continuing our illustration in the preceeding section, assume that

during the year 2011, Pete sold again merchandise to Sake for
P25,000 at a gross margin of 20%. Of this merchandise P6,000
remains in the ending inventories of Sake on December 31,
2011.

The intercompany sales transactions are analyzed as follows:

Illustration 17-3

Selling Price

Cost

Gross profit
(20% of Selling

Price)
Beginning inventory

P 4,000

P 3,200

P 800

Add: Sales

25,000

20,000

5,000

Totals
P29,000
Less: Ending inventories 6,000
Cost of goods sold
P23,000

P23,200
4,800
P18,400

P5,800
1,200
P4,600

Working Paper Elimination Entries

Base on the above analysis the working paper elimination entries
on December 31, 2011 are as follows:
E (10)

E (11)

E (12)

Sales

25,000

Cost of goods sold

25,000
To eliminate intercompany sales of merchandise.
Cost of goods sold
1,200
Inventory
1,200
To eliminate unrealized inventory profit.
Retained earnings, Jan. 1- Pete
800
Cost of goods sold
800
To eliminate realized inventory profit.

Computation and Allocation of Consolidated Net Income

Consolidated net income is computed and allocated on December 31,2011 as
follows (net income of Pete and Sake are assumed):
Petes net income from own operations(excluding dividend income)
Realized profit in beginning inventory ( downstream sale)
Unrealized profit in ending inventory (downstream sale)
Petes realized net income from outsiders
Sakes net income from own operations
Consolidated net income
Attribute to NCI (P50,000x20%)
Attribute to parent shareholders

P 80,000
800
( 1,200)
P 79,600
50,000
P129,600
10,000
P119,600

UPSTREAM SALE OF INVENTORY

Upstream intercompany sales are those from subsidiaries to
the parent company. When an upstream sale of inventory
occurs and the inventory is resold by the parent to
outsiders during the same period, all the parent entries and
the eliminating entries in the consolidated working paper
are identical to those in the downstream case.

Unrealized Intercompany Profit in Ending Inventories

An upstream sale with unrealized intercompany profit in ending
inventories can be illustrated using the example used for the
downstream sale.
Assume that Sake Company (an 80% owned subsidiary) during
the year ended December 31,2010 sold merchandise to Pete
corporation at a gross margin of 20% Sales by Sake to Pete for
the year totaled P10,000, of which P4,000 remained unsold by
Pete on December 31, 2010.
Pete Corporation and Sake Company Entries
The entries in the books of Pete and Sake are the same on the
downstream sale on page 252.
Working Paper Elimination Entries
The working paper elimination entries for consolidated financial
statement on December 31,2010 are also the same on the
downstream sale on page 252.

NCI in Net of Subsidiary

The unrealized intercompany profit in ending inventory of P800 is
attributable to Sake Company, the seller of the merchandise and
must be considered in the computation of the NCIs in Sakes net
income for the year ended December 31,2010. The computation is
as follows:
Sakes net income (assumed)
Unrealized intercompany profit in ending inventory

P20,000
(
800)

Sakes realized income

NCI in net income of subsidiary (19,200x20%)
3,840

19,200
P

Consolidated Net Income

Consolidated net income on December 31,2010 may be
computed and allocated as follows:
Petes net income (excluding dividend income)
Sakes realized net income:
Sakes net income
P20,000
Unrealized intercompany profit in ending inventory (
Consolidated net income
Attribute to NCI
Attribute to parent shareholders
P65,360

P50,000

800)

19,200
P69,200
3,840

Intercompany Profit in Beginning and Ending

Inventories
To continue our illustration, assume the same transactions in a
downstream sale on page 251.

Working Paper Elimination Entries

Base on the analysis of intercompany sale (illustration 17-3) on page
255 Sakes intercompany sales and intercompany cost of goods
sold for the year ended December 31,2011, has been closed with
other income and expense accounts to Sakes Retained Earnings
account. Consequently, from a consolidated point of view, Sakes
December 31,2010, retained earnings was overstated by P640
(80% of the P800 unrealized intercompany profit in Petes
inventories on December 31,2010). The remaining P160 of the
unrealized profit on December 31,2010 is attribute to the NCI. The
following working paper elimination entry on December 31,2011
reflects these facts:

E (13) Sales
25,000
Cost of goods sold
25,000
To eliminate intercompany sales of merchandise
E (14) Cost of goods sold
12,000
Inventory
12,000
To eliminate unrealized inventory profit
E (15) Retained Earnings. Jan 1-Pete
640
NCI
160
Cost of goods sold
800
To eliminate realized inventory profit.

The computations of NCI in net income of subsidiary and the

allocation of consolidated net income on December
31,2011 base on the above principle are as follows:
NCI in Net Income of Subsidiary-2011
Sake Company net income
Realized profit in beginning inventory
Unrealized profit in ending inventory

P20,000

Sakes realized income

P19,600

800
( 1,200)

NCI in net income of subsidiary (P19,600x20%)

P 3,920

Consolidated Net Income-2011

Petes net income from own operations
P50,000
Sakes realized net income:
Sakes net income
P20,000
Realized profit in beginning inventory
800
Unrealized profit in ending inventory
( 1,200)
Consolidated net income
Attribute to NCI
Attribute to parent shareholders

P69,600
3,920
P65,680

19,600

Summary Comparison of Working Paper Elimination Entries

To summarize the eliminating entries for the intercompany sales of inventory between
Pete Corporation and Sake Company, Illustration 17-4 below shows the elimination
entries in 2010 and 2011. Elimination entries are shown for both downstream and
upstream sales under the perpetual system.
Illustration 17-4
2010
Downstream Sale
Upstream Sale
Sales
10,000
Sales
10,000
Cost of goods sold
10,000
Cost of goods sold
10,000
Cost of goods sold
Inventory

800

Cost of goods sold

800
Inventory

800
800

2011
Downstream Sale
Sales

Upstream Sale

25,000
Sales
25,000
Cost of goods sold
25,000
Cost of goods sold
25,000
Cost of goods sold
1,200
Cost of goods sold
1,200
Inventory
1,200
Inventory
1,200
Retained earnings, 1/1-Pete 800
Retained earnings,1/1-Pete 640
Cost of goods sold
800 NCI
160
Cost of goods sold
800

Pete Corporation and Subsidiary

Working Paper Elimination Entries
December 31,2010-First Year

(E1) Dividend income

NCI
24,000
Dividends declared- Sake Company
6,000
To eliminate intercompany dividends and NCI
30,000
share of dividends (30,000x20%)
(E2) Common stock- Sake Company
200,000
Retained earnings- Sake Company
100,000
Investment in Sake company stock
240,000
NCI
60,000
To eliminate equity accounts of subsidiary and the
investment account for the parents share and recognize
NCI on date of acquisition

(E3) Inventory
5,000
Property and equipment
60,000
Goodwill
10,000
Investment in Sake Company stock
60,000
NCI
15,000
To allocate excess between investment cost and the
book value of identifiable assets acquired with the
remainder to goodwill.
(E4) Cost of goods sold
5,000
Operating expenses
6,000
Inventory
5,000
Property and equipment (net)
6,000
To amortize allocated excess.
(E5) Sales
10,000
Cost of goods sold
10,000
To eliminate intercompany sales during year 2008

(E6) Cost of goods sold

800
Inventory
800
To eliminate unrealized profit in ending inventory
of Pete Corp.
(E7) NCI in Net income of subsidiary
NCI
7,640
To recognize NCI in subsidiarys adjusted
7,640
net income for 2010. [P50,000-(11,000+800)]x20%

Illustration 17-5
Pete Corporation and Subsidiary
Working Paper for Consolidated Financial Statements
Year Ended December 31,2010- First Year

illustration--17-5.docx

The following points should be noted in the cost method

working papers (illustration 17-5) for Pete Corp and
Subsidiary in addition to the points previously mentioned in
Chapter 16:
1.
E(5) eliminates intercompany sales during the year 2010.
2.
E(6) eliminates the unrealized profit in ending inventory to
bring ending inventory of the consolidated entity to cost.
3.
Non- controlling interest (NCI) of P76,640 may be verified
as follows:

Net assets (S/E),1/2/010- S company

P300,000
Increase in adjusted undistributed earnings:
Adjusted net income (P50,000-P800)
49,200
Dividends
30,000
19,200
Net assets at book value, 12/31/010- S Company
P319,200
Unamortized excess (P75,000-P11,000)
64,000
Net assets at fair value,12/31/010- S Company
P383,200

NCI (383,200X20%)

P 76,640

4. The consolidated net income and its allocation on December

31,2010 may be verified as follows:
Petes net income
P164,000
Dividends income
(24,000)
Petes net income from own operations
P140,000
Sakes realized net income:
Sakes net income
P50,000
Amortization of allocated access
(11,000)
Unrealized profit in ending inventory
( 800)
38,200
Consolidated net income
P178,200
Attributable to NCI (P38,200x20%)
7,600
Attributable to parent shareholders
P170,560

The computation of consolidated retained earnings on

Decemberv31,2010 may be verified as follows:
Retained earnings, December 31,2010-Pete
Add: Petes share in the adjusted net increase in Sakes
retained earnings
Increase in retained earnings in 2010
Amortization
( 11,000)
Unrealized profit in ending inventory
Adjusted increase in retained earnings
Petes proportionate share
Consolidated retained earnings, Dec. 31,2010

P404,000

P20,000
(

800)

P 8,200
80%
6,560

P410,560

Pete Corporation and Subsidiary

Working Paper Elimination Entries
December 31,2011- Second Year
E(1)
Dividend Income
32,000
NCI
800
Dividends declared- Sake Company
40,000
To eliminate intercompany dividends and minority
share of dividends paid by Sake (P40,000x20%)
E(2)
Common stock- Sake Company
200,000
Retained earnings- Sake Company
100,000
Investment in Sake Company
240,000
NCI
60,000
To eliminate equity accounts of Sake and the investment
accounts for the parents interest and recognize NCI on
date of acquisition
E(3)
Inventory
5,000
Property and equipment
60,000
Goodwill
10,000
Investment in Sake Company
60,000
NCI
15,000
To allocate access

E(4)

Retained earnings, Jan.1- Sake

1,800
NCI
1,800
To assign to the non-controlling stockholders their share
of the increase in the subsidiarys retained earnings from
the acquisition date to the beginning of the current year.
Computed as follows:
Retained earnings, Jan. 1,2011- Sake
P120,000
Retained earnings, Jan. 1,2010- Sake
100,000
Increase in earnings-prior years
Amortization of allocated excess-2010
Adjusted increase
NCI (9,000x20%)

E(5)

P
P

20,000
( 10,000)
9,000
1,800

Retained earnings, Jan.1- Sake (2008)

11,000
Operating expenses (amortization) (2009)
6,000
Inventory
5,000
Property and equipment
12,000
To provide amortization of allocated excess
for 2010 and 2011.

E(6)

E(7)

E(8)

Sales
25,000
Cost of goods sold
25,000
To eliminate intercompany sale for 2011
Cost of goods sold
1,200
Inventory
1,200
To eliminate unrealized profit in ending inventory.
Retained earnings, Jan. 1 Pete
NCI
To recognize NCI in Sakes adjusted income for
2009, computed as follows:
Net income of Sake
P75,000
Adjustments:
Amortization
P(6,000)
Unrealized profit in ending inventory (1,200)
Realized profit beginning inventory
800
Adjusted net income of Sake
P68,600
NCI (P68,600x20%)

P13,720

(6,400)

The following are the important features of the working paper in

Illustration 17-6 for consolidated financial statements and the
working paper elimination entries for Pete Corporation and
Subsidiary for the year ended December 31, 2011:
1.
Intercompany dividend income of Pete Corporation for the year
2011 is eliminated in E(1).
2.
The equity accounts of the Sake Company on the date of
acquisition is fully eliminated in E (2)
3.
The Investment in Sake Company account of Pete is eliminated.
4.
E(5) continues the amortization of the allocated excess.
5.
E(6) eliminates intercompany sales in 2011.
6.
E(7) eliminates unrealized profit in ending inventory.
7.
E(8) eliminates realized profit in beginning inventory.

8.NCI of P82,360 in the working paper may be verified as follows:

Net assets (S/E), 1/1011- S Company
Increase in adjusted undistributed earninngs:
Undistributed earnings (P75,000-P40,000)
Realized profit in beginning inventory
Unrealized profit in ending inventory
Net assets at book value, 12/31/011
Unamortized excess (P75,000-P17,000)
Net assets at fair value, 12/31/011- S Company
NCI (P411,800x20%)

P319,200
P35,000
800
( 1,200)

34,600

353,800
58,000
P411,800
P 82,360

The computation and allocation of consolidated net income on

December 31,2011 is verified as follows:
Petes net income
Dividend income
Petes net income from own operations
Sakes realized net income from own operations:
Sakes net income
P75,000
Amortization-2011
( 6,000)
Realized profit in beginning inventory
Unrealized profit in ending inventory
Consolidated net income
Attributable to NCI (P68,600x20%)
Attributable to parent shareholders

P192,000
(32,000)
160,000

800
( 1,200)
P228,600
13,720
P214,880

68,600

Consolidated retained earnings on December 31,2011 may also be

verified as follows:
Retained earnings, December 31,2011-Pete
Add: Petes share in the adjusted net increase in Sakes
Retained earnings:
Increase in retained earnings in 2011
P35,000
Amortization
( 6,000)
Realized profit in beginning inventory
800
Unrealized profit in ending inventory
( 1,200)
Adjusted increase
P28,600
Petes proportionate share
80%
Petes share in Sakes adjusted undistributed earnings-2011
[(P20,000-P11,000+800)x80%]
6,560
Consolidated retained earnings, December 31,2011

P536,000

22,800

P565,440

Illustration17-6
Pete Corporation and Subsidiary
Working Paper for Consolidated Financial
Statements
Year Ended December 31,2011-Second Year
illustration 17-6.docx

Elimination Procedure for periodic Inventory System using the

Trial Balance Approach Working Paper
In the consolidation working papers in Illustration 17-5 and 17-6, the cost of
goods sold was included in the income statement, since both the parent
and the subsidiary used a perpetual inventory system. However, in the
working paper using the trial balance approach (Illustration 17-7) on page
264 and 265, a periodic inventory system is used. In this illustration, which
is based on the same data as illustration 17-6, the following differences in
working paper elimination procedures result in the use of a periodic
inventory system.
1.

2.

3.

The 2011 beginning inventories of Pete Company and Sake Company

P160,000 and P110,000 respectively are presented under the debits of
the trial balance. The beginning inventories less the intercompany profit in
Petes Companys beginning inventory are extended to the consolidated
statement comprehensive income.
The ending inventories of Pete Company and Sake Company of P180,000
and P90,000 respectively are presented twice. One under the debits and
the other under the credits. The ending inventories after adjustment less
the intercompany profit in ending inventories are extended twice, to the
consolidated statement of comprehensive income and to the consolidated
statement of financial position.
The purchases accounts, rather than the cost of goods sold, appear in the
trial balance and after eliminating the intercompany purchases, extended
to the consolidated column.

The elimination entries in journal entry form are as follows:

E(1) to E(5) are the same under the perpetual inventory system on page 259.
E (6) Sales 25,000
Purchases
25,000
To eliminate intercompany sales and purchases for 2011.
E (7) Inventory, December 31 (SCI)
1,200
Inventory, December 31, (SFP) 1,200
To eliminate unrealized profit in ending inventory
E (8) Retained earnings, January 1-Pete
NCI
160
Inventory, January 1
800

640

E(9) Same under the perpetual inventory system on page 260.

Illustration 17-7
Pete Company and Subsidiary S company
Consolidation Working Paper
Year Ended December 21,2011-Second Year
Trial
Balance
Pete Company
DEBITS
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.

Sake Company

Cash
231,000
85,000
Accounts receivable
150,000
80,000
Inventory, January 1
160,000
110,000
Plant and equipment
475,000
300,000
Investment in Sake Company
300,000
Goodwill
Purchases
200,000
140,000
Operating expenses
50,000
20,000
Other expenses
60,000
45,000
Dividends declared
60,000
40,000
Total debits
1,686,000
820,000
Inventory, December 31 (SFP)
180,000
90,000

Trial

Balance
Pete Company

Sake Company

CREDITS
Sales
450,000
300,000
Dividends income
32,000
Accounts payable
100,000
100,000
Bonds payable
200,000
100,000
Common stock
500,000
200,000
Retained earnings, January 1
404,000
120,000

Total credits
1,686,000
Inventory, December 31 (SCI)
180,000
Non Controlling (NCI)

Consolidated net income

NCI in net income of subsidiary
Balance attributable to parent
Controlling retained earnings to consolidated SFP

820,000
90,000

Consolidated
Consolidated
Consolidated
Elimination & Adjustments Income Statement Retained earnings
Debit
Credit
Dr(Cr)
Dr(Cr)
Dr(Cr)
316,000 1
230,000 2
(8)
800
269,200
3
(3) 60,000 (5) 12,000
823,000 4
(2)240,000
(3) 60,000
(3) 10,000

5
6
10,000 7

(6) 25,000
(5) 6,000

315,000
76,000
106,000
(1) 40,000
60,000

8
9
10
11
12

(3) 5,000

(7) 25,000
(1) 32,000

(2) 200,000

(5) 5,000
(7) 1,200

(725,000)

13
268,800 14
15
16
17
18
(200,000) 19
(300,000) 20
(500,000) 21

SFP

(2) 100,000
(4)
1,800
(5) 11,000
(8)
640
(7)
(1)
(8)

1,200
8,000
160

(9) 13,720
474,520

(410,560)

22
23
24
25
26

(268,800)

27

28
(2) 60,000
(82,360) 29
(3) 15,000
30
(4) 1,800
31
(9) 13,720
32
(228,600)
33
13,720
34
474,520
35
214,880
(214,880)
36
(565.440)
(565,440) 37

Effects of Lower-of-Cost-or-Market Method on Inventory Profit

Intercompany inventory in the hands of the purchaser may have been written
down by the purchaser to a market value lower than its cost at the time of the
intercompany sales. For example, assume that for P100,000. S Company
purchased goods that cost its parent company P80,000. Assume further that S
Company has all the goods in its ending inventory, but has written them down
to P84,000, the lower market value at the end of the period. As a result of this
write down, the inventory have to be reduced by P4,000 to reflect its costs to
the consolidated company (P80,000). The problem now is how to defer the
P4,000 inventory profit in the income allocation. As before, such profit is
deferred by recording it as debit on the intercompany sellers cost of goods
sold. In the subsequent period, the profit will be realized by the seller.
It may seen strange that the P16,000 of profit written off is realized, in affect by
the seller, since it is not deducted in the sellers income distribution. This is
proper, since the loss recognized by the seller is offset. Had the inventory been
written down to P80,000 or less, there would be no need to defer the offsetting
profit in the consolidated working paper.

Intercompany losses on Intercompany Sales

Assume a parent sells goods to a subsidiary for P10,000 and the goods cost the
parent P12,000. If the market value of the goods is P10,000 or less, the loss is
recognized in the consolidated income statement, even if the goods remain in
the subsidiarys ending inventory. Such loss may be recognized under the
lower-of-cost-or-market principle that applies to inventory. However, if the
intercompany sales price is below market value, the part of the loss that results
from the price being below market value cannot be recognized until the
subsidiary sells the goods to outsiders. Working paper elimination procedures
would be similar, but in reverse direction, to those used for unrealized profits.

APPENDIX: Intercompany Profits in Inventory-Equity Method

To illustrate the consolidation procedures under the equity method let us continue
the example presented in the appendix of Chapel 16. Assume that Sake
Company (an 80% owned subsidiary) sold inventory to Pete Corporation at a
gross profit rate of 20%. Sales made by Sake to Pete for the year 2010 totaled
P10,000, of which P4,000 remains unsold on December 31,2010. During 2011,
Sake again sold inventory to Pete, P25,000, of which P6,000 remains unsold on
December 31,2011. Goodwill if any is not impaired.
When using the equity method, the parent reduces its investment income and the
balance of the investment account for its share of unrealized intercompany
profits that arise during the period. Subsequently, the parent increases its
investment income and the carrying amount of the investment account when
the intercompany profits are realized through sales to outsiders.

Equity Method Entries-2010

In 2010,Pete Corporation records the normal equity method entries reflecting its
share of Sake Companys income and dividends, and an additional entry to
reduce investment income and the investment account by the parents share of
the unrealized intercompany profit arising during the year:
(1)

(2)

(4)

Cash
24,000
Investment in Sake Company stock
24,000
To record dividends from Sake (P30,000x80%)
Investment in Sake Company stock
40,000
Investment income
40,000
To record income from Sake (P50,000x80%)
Investment income
9,440
Investment in Sake Company stock
9,440
To adjust investment income for the following:
Amortization of allocated excess (P11,000x80%)
P8,800
Unrealized profit in ending inventory (P800x80%)
640
Total
P9,440

Working Paper Elimination Entries-2010

The following are the elimination entries needed to prepare consolidated
financial statements:
E(1) Investment income
30,560
NCI
6,000
Dividends declared
30,000
Investment in Sake Company stock
6,560
To eliminate investment income and dividends from Sake
E(2) to E(7) are the same under the cost method on page 256.
The working paper for consolidation financial statements on Dec. 31, 2010
showing the above elimination entries is presented in Illustration 17-7.
illustration 17-7.docx

Equity Method Entries- 2011

Journal entries made by the parent to recognize the results of subsidiarys
operation 2011 are:
(4) Cash
32,000
Investment in Sake Company stock
32,000
To records dividends from Sake (P40,000x80%)
(5) Investment in Sake Company stock
60,000
Investment income
60,000
To record income from Sake (P75,000x80%)
(6) Investment income
5,120
Investment in Sake Company stock
5,120
To adjust investment income for the following:
Amortization of allocated excess (P6,000x80%) (P4,800)
Realized profit in beginning inventory (P800x80%) 640
Unrealized profit in ending inventory (P1,200x80%)(960)
Net adjustment

(P5,120)

Working Paper Elimination Entries-2011

Working paper elimination entries needed for the preparation of consolidated
financial statements on December 31, are as follows:
E(1) Investment income
54,000
NCI
8,000
Dividends declared-Sake
40,000
Investment in Sake Company stock
22,880
To eliminate investment income and dividends from Sake.
E(2) Common stock- Sake Company
200,000
Retained earnings, Jan. 1-Sake Company 120,000
Investment in Sake Company stock
256,000
NCI
64,000
To eliminate equity accounts of Sake at the beginning of the year
against the investment account and NCI.
E(3) Property and Equipment
54,000
Goodwill
10,000
Investment in Sake Company stock
51,200
NCI
12,800
To allocate unamortized difference.

E(4) Not applicable under the equity method.

E(5) Operating expenses
6,000
Property and equipment
6,000
To amortize allocated excess to property and equipment.
E(6) to E(9) are the same under the cost method on page 260.
Except E(8) instead of debiting retained earnings, of Sake, investment
account is debited.
The consolidated working paper showing the above elimination is presented
in Illustration 17-8
Illustration 17-8
Pete Corporation and Subsidiary
Working Paper for Consolidated Financial Statements
Year Ended December 31,2011- second year
illustration 17-8.docx