Removal of the sale/purchase is often just the first in a series of consolidation entries necessi- tated by inventory transfers. Despite the previous elimination, unrealized gross profits created by such sales can still exist in the accounting records at year-end. These profits initially result when the merchandise is priced at more than historical cost. Actual transfer prices are estab- lished in several ways, including the normal sales price of the inventory, sales price less a spec- ified discount, or at a predetermined markup above cost. In a footnote to recent financial statements, Ford Motor Company explains that
Intercompany sales among geographic areas consist primarily of vehicles, parts, and compo- nents manufactured by the company and various subsidiaries and sold to different entities within the consolidated group; transfer prices for these transactions are established by agreement between the affected entities.
Regardless of the method used for this pricing decision, intra-entity profits that remain unrealized at year-end must be removed in arriving at consolidated figures.
All Inventory Remains at Year-End
In the preceding illustration, assume that Arlington acquired or produced this inventory at a cost of $50,000 and then sold it to Zirkin, an affiliated party, at the indicated $80,000 price.
From a consolidated perspective, the inventory still has a historical cost of only $50,000.
However, Zirkin’s records now report it as an asset at the $80,000 transfer price. In addition, because of the markup, Arlington has recorded a $30,000 gross profit as a result of this intra-entity sale. Because the transaction did not occur with an outside party, recognition of this profit is not appropriate for the combination as a whole.
Thus, although the consolidation entry TIshown earlier eliminated the sale/purchase figures, the $30,000 inflation created by the transfer price still exists in two areas of the individual statements:
• Ending inventory remains overstated by $30,000.
• Gross profit is artificially overstated by this same amount.
Correcting the ending inventory requires only reducing the asset. However, before decreas- ing gross profit, the accounts affected by the incomplete earnings process should be identified.
The ending inventory total serves as a negative component within the Cost of Goods Sold computation; it represents the portion of acquired inventory that was not sold. Thus, the
$30,000 overstatement of the inventory that is still held incorrectly decreases this expense (the inventory that was sold). Despite Entry TI, the inflated ending inventory figure causes cost of goods sold to be too low and, thus, profits to be too high by $30,000.For consolidation pur- poses, the expense is increased by this amount through a worksheet adjustment that properly removes the unrealized gross profit from consolidated net income.
Consequently, if all of the transferred inventory is retained by the business combination at the end of the year, the following worksheet entry also must be included to eliminate
4Alternative theoretical approaches to consolidation that advocate removing only the parent’s portion of intra-entity sales/purchases when a noncontrolling interest is present can be identified. In current practice, elimination of all intra-entity sales/purchases (as shown here) appears to predominate.
LO3
Prepare the consolidation entry to eliminate any intra-entity inventory gross profit that remains unrealized at (a) the end of the year of transfer and (b) the beginning of the subsequent period.
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the effects of the seller’s gross profit that remains unrealized within the buyer’s ending inventory:
Consolidation Entry G—Year of Transfer (Year 1) All Inventory Remains
Cost of Goods Sold (ending inventory component) . . . . 30,000
Inventory (balance sheet account) . . . . 30,000 To remove unrealized gross profit created by intra-entity sale.
This entry (labeled Gfor gross profit) reduces the consolidated Inventory account to its original $50,000 historical cost. Furthermore, increasing Cost of Goods Sold by $30,000 ef- fectively removes the unrealized amount from recognized gross profit. Thus, this worksheet entry resolves both reporting problems created by the transfer price markup.
Only a Portion of Inventory Remains
Obviously, a company does not buy inventory to hold it for an indefinite time. It either uses the acquired items within the company’s operations or resells them to unrelated, outside par- ties. Intra-entity profits ultimately are realized by subsequently consuming or reselling these goods. Therefore, only the transferred inventory still held at year-end continues to be recorded in the separate statements at a value more than the historical cost. For this reason, the elimi- nation of unrealized gross profit (Entry G) is based not on total intra-entity sales but only on the amount of transferred merchandise retained within the business at the end of the year.
To illustrate, assume that Arlington transferred inventory costing $50,000 to Zirkin, a re- lated company, for $80,000, thus recording a gross profit of $30,000. Assume further that by year-end Zirkin has resold $60,000 of these goods to unrelated parties but retains the other
$20,000 (for resale in the following year). From the viewpoint of the consolidated company, it has now earned the profit on the $60,000 portion of the intra-entity sale and need not make an adjustment for consolidation purposes.
Conversely, any gross profit recorded in connection with the $20,000 in merchandise that remains is still a component within Zirkin’s Inventory account. Because the gross profit rate was 371⁄2percent ($30,000 gross profit/$80,000 transfer price), this retained inventory is stated at a value $7,500 more than its original cost ($20,000 371⁄2%). The required reduction
Discussion Question
EARNINGS MANAGEMENT
Enron Corporation’s 2001 third-quarter 10-Q report disclosed the following transaction with LJM2, a nonconsolidated special purpose entity (SPE) that was formed by Enron:
In June 2000, LJM2 purchased dark fiber optic cable from Enron for a purchase price of $100 million. LJM2 paid Enron $30 million in cash and the balance in an interest- bearing note for $70 million. Enron recognized $67 million in pretax earnings in 2000 related to the asset sale. Pursuant to a marketing agreement with LJM2, Enron was compensated for marketing the fiber to others and providing operation and maintenance services to LJM2 with respect to the fiber. LJM2 sold a portion of the fiber to industry participants for $40 million, which resulted in Enron recognizing agency fee revenue of $20.3 million.
As investigations later discovered Enron controlled LJM2 in many ways.
The FASB ASC now requires the consolidation of SPEs (variable interest entities) that are essentially controlled by their primary beneficiary.
By selling goods to SPEs that it controlled but did not consolidate, did Enron overstate its earnings? What effect does consolidation have on the financial reporting for transac- tions between a firm and its controlled entities?
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Consolidated Financial Statements—Intra-Entity Asset Transactions 199
(Entry G) is not the entire $30,000 shown previously but only the $7,500 unrealized gross profit that remains in ending inventory.
Consolidation Entry G—Year of Transfer (Year 1) 25% of Inventory Remains (replaces previous entry)
Cost of Goods Sold (ending inventory component) . . . . 7,500
Inventory . . . . 7,500 To remove portion of intra-entity gross profit that is unrealized in year
of transfer.
Unrealized Gross Profit—Year Following Transfer (Year 2)
Whenever an unrealized intra-entity profit is present in ending inventory, one further con- solidation entry is eventually required. Although Entry Gremoves the gross profit from the consolidatedinventory balances in the year of transfer, the $7,500 overstatement remains within the separate financial records of the buyer and seller. The effects of this deferred gross profit are carried into their beginning balances in the subsequent year. Hence, a worksheet adjustment is necessary in the period following the transfer. For consolidation purposes, the unrealized portion of the intra-entity gross profit must be adjusted in two successive years (from ending inventory in the year of transfer and from beginning inven- tory of the next period).
Referring again to Arlington’s sale of inventory to Zirkin, the $7,500 unrealized gross profit is still in Zirkin’s Inventory account at the start of the subsequent year. Once again, the over- statement is removed within the consolidation process but this time from the beginning inven- tory balance (which appears in the financial statements only as a positive component of cost of goods sold). This elimination is termed Entry*G. The asterisk indicates that a previous year transfer created the intra-entity gross profits.
Consolidation Entry *G—Year Following Transfer (Year 2)
Retained Earnings (beginning balance of seller) . . . . 7,500
Cost of Goods Sold (beginning inventory component) . . . . 7,500 To remove unrealized gross profit from beginning figures
so that it is recognized currently in the period in which the earning process is completed.
Reducing Cost of Goods Sold (beginning inventory) through this worksheet entry increases the gross profit reported for this second year. For consolidation purposes, the gross profit on the transfer is recognized in the period in which the items are actually sold to outside parties. As shown in the following diagram, Entry Ginitially deferred the $7,500 gross profit because this amount was unrealized in the year of transfer. Entry *Gnow increases consolidated net income (by decreasing cost of goods sold) to reflect the earning process in the current year.
December 31, Year 1
Year 2
Inventory sold to outsider Year 1
Inventory transferred
Entry G defers
$7,500 gross profit Entry *G
recognizes $7,500 gross profit LO4
Understand that the consolida- tion process for inventory transfers is designed to defer the unrealized portion of an intra-entity gross profit from the year of transfer into the year of disposal or consumption.
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200 Chapter 5
In Entry *G,removal of the $7,500 from beginning inventory (within Cost of Goods Sold) appropriately increases current income and should not pose a significant conceptual problem.
However, the rationale for decreasing the seller’s beginning Retained Earnings deserves further explanation. This reduction removes the unrealized gross profit (recognized by the seller in the year of transfer) so that the profit is reported in the period when it is earned. Despite the consoli- dation entries in Year 1, the $7,500 gain remained on this company’s separate books and was closed to Retained Earnings at the end of the period. Recall that consolidation entries are never posted to the individual affiliate’s books. Therefore, from a consolidated view, the buyer’s Cost of Goods Sold (through the beginning inventory component) and the seller’s Retained Earnings accounts as of the beginning of Year 2 contain the unrealized profit, and must both be reduced in Entry *G.5 Intra-Entity Beginning Inventory Profit Adjustment—Downstream Sales
When Parent Uses Equity Method
The worksheet elimination of the sales/purchases balances (Entry TI) and the entry to remove the unrealized gross profit from ending Inventory in Year 1 (Entry G) are both standard, regard- less of the circumstances of the consolidation. Conversely, in one specific situation, the proce- dure used to eliminate the intra-entity gross profit from Year 2’s beginning account balances differs from the Entry *Gjust presented. If (1) the original transfer is downstream (made by the parent) and (2) the equity method has been applied for internal accounting purposes, the Equity in Subsidiary Earnings account replaces beginning Retained Earnings in Entry *G.
When using the equity method, the parent maintains appropriate income balances within its own individual financial records. Thus, the parent defers any unrealized gross profit at the end of Year 1 through an equity method adjustment that also decreases the Investment in Sub- sidiary account. With the profit deferred, the Retained Earnings of the parent/seller at the be- ginning of the following year is correctly stated. The parent’s Retained Earnings does not contain the unrealized gross profit and needs no adjustment.
At the end of Year 2, both the Equity in Subsidiary Earnings and the Investment accounts are in- creased in recognition of the previously deferred intra-entity profit. The Investment account—
having been decreased in Year 1 and increased in Year 2 for the intra-entity gross profit—thus no longer reflects any effects from the original deferral. For consolidation purposes, Entry *Gsimply transfers the income effect of the realized gross profit from the Equity in Subsidiary Earnings ac- count to Cost of Goods Sold, appropriately increasing current consolidated income. The remaining balance in the Equity in Subsidiary Earnings account now reflects the same activity represented in the Investment account and is subsequently eliminated against the Investment account.
Consolidation Entry *G—Year Following Transfer (Year 2) (replaces previous Entry *G when transfers have been downstream and the equity method used)6
Equity in Subsidiary Earnings . . . . 7,500
Cost of Goods Sold (beginning inventory component) . . . . 7,500 To recognize the previously deferred unrealized downstream inventory gross
profit as part of current year income. The Equity in Subsidiary Earnings account replaces the Retained Earnings account (used for upstream profit adjust- ments) when adjusting for downstream sales. The parent’s Retained Earnings account has already been corrected by application of the equity method.
5For upstream intra-entity profit in beginning inventory, the subsidiary’s retained earnings remain overstated and must be adjusted through Entry *G.
6A widely accepted alternative to recognizing realized intra-entity inventory profits in the subsidiary’s beginning inventory (downstream sale) when the parent uses the equity method (*G) is as follows:
Investment in Subsidiary 7,500
Cost of Goods Sold 7,500
In this case, the full amount of the Equity in Subsidiary Earnings is eliminated against the Investment in Subsidiary account in Consolidation Adjustment I.In either alternative adjustment for recognizing realized intra-entity inventory profits, the final consolidated balances remain exactly the same: Equity in Subsidiary Earnings 0, Investment in Subsidiary 0, and Cost of Goods Sold is reduced by $7,500.
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Finally, various markup percentages determine the dollar values for intra-entity profit deferrals.
Exhibit 5.1 shows formulas for both the gross profit rate and markup on cost and the relation between the two.
Unrealized Gross Profits—Effect on Noncontrolling Interest Valuation
The worksheet entries just described appropriately account for the effects of intra-entity in- ventory transfers on business combinations. However, one question remains: What impact do these procedures have on the valuation of a noncontrolling interest? In regard to this issue, paragraph 810-10-45-6 of the FASB ASC states,
The amount of intra-entity profit or loss to be eliminated in accordance with paragraph 810-10-45-1 is not affected by the existence of a noncontrolling interest. The complete elimi- nation of the intra-entity profit or loss is consistent with the underlying assumption that con- solidated financial statements represent the financial position and operating results of a single economic entity. The elimination of the intra-entity profit or loss may be allocated proportionately between the parent and noncontrolling interest.
The last sentence indicates that alternative approaches are available in computing the non- controlling interest’s share of a subsidiary’s net income. According to this pronouncement, un- realized gross profits resulting from intra-entity transfers may or may notaffect recognition of outside ownership. Because the amount attributed to a noncontrolling interest reduces consol- idated net income, the handling of this issue can affect the reported profitability of a business combination.
To illustrate, assume that Large Company owns 70 percent of the voting stock of Small Company. To avoid extraneous complications, assume that no amortization expense resulted from this acquisition. Assume further that Large reports current net income (from separate operations) of $500,000 while Small earns $100,000. During the current period, intra-entity transfers of $200,000 occur with a total markup of $90,000. At the end of the year, an unreal- ized intra-entity gross profit of $40,000 remains within the inventory accounts.
Clearly, the consolidated net income prior to the reduction for the 30 percent noncon- trolling interest is $560,000, the two income balances less the unrealized gross profit. The problem facing the accountant is the computation of the noncontrolling interest’s share of Small’s income. Because of the flexibility allowed by the FASB ASC,this figure may be
Consolidated Financial Statements—Intra-Entity Asset Transactions 201
EXHIBIT 5.1 Relationship between Gross Profit Rate and Markup on Cost
In determining appropriate amounts of intra-entity profits for deferral and subsequent recog- nition in consolidated financial reports, two alternative—but mathematically related—profit percentages are often seen. Recalling that Gross Profit Sales Cost of Goods Sold, then Gross profit rate (GPR)
Markup on cost (MC)
Example: Sales (transfer price) $1,000
Cost of goods sold 800
Gross profit $ 200
Here the GPR(200/1,000) 20% and the MC(200/800) 25%. In most intra-entity purchases and sales, the sales (transfer) price is known and therefore the GPRis the simplest percentage to use to determine the amount of intra-entity profit.
Intra-entity profit Transfer price GPR
Instead, if the markup on cost is available, it readily converts to a GPRby the preceding for- mula. In this case (0.25/1.25) 20%.
GPR 1 GPR Gross profit
Cost of goods sold MC 1 MC Gross profit
Sales
LO5
Understand the difference between upstream and downstream intra- entity transfers and how each affects the computation of noncon- trolling interest balances.
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202 Chapter 5
reported as either $30,000 (30 percent of the $100,000 earnings of the subsidiary) or
$18,000 (30 percent of reported income after that figure is reduced by the $40,000 unrealized gross profit).
To determine an appropriate valuation for this noncontrolling interest allocation, the rela- tionship between an intra-entity transaction and the outside owners must be analyzed. If a transfer is downstream (the parent sells inventory to the subsidiary), a logical view would seem to be that the unrealized gross profit is that of the parent company. The parent made the original sale; therefore, the gross profit is included in its financial records. Because the sub- sidiary’s income is unaffected, little justification exists for adjusting the noncontrolling inter- est to reflect the deferral of the unrealized gross profit. Consequently, in the example of Large and Small, if the transfers were downstream, the 30 percent noncontrolling interest would be
$30,000 based on Small’s reported income of $100,000.
In contrast, if the subsidiary sells inventory to the parent (an upstream transfer), the sub- sidiary’s financial records would recognize the gross profit even though part of this income re- mains unrealized from a consolidation perspective. Because the outside owners possess their interest in the subsidiary, a reasonable conclusion would be that valuation of the noncontrol- ling interest is calculated on the income this company actually earned.
In this textbook, the noncontrolling interest’s share of consolidated net income is computed based on the reported income of the subsidiary after adjustment for any unrealized upstream gross profits.Returning to Large Company and Small Company, if the $40,000 unrealized gross profit results from an upstream sale from subsidiary to parent, only $60,000 of Small’s
$100,000 reported income actually has been earned by the end of the year. The allocation to the noncontrolling interest is, therefore, reported as $18,000, or 30 percent of this realized income figure.
Although the noncontrolling interest figure is based here on the subsidiary’s reported in- come adjusted for the effects of upstream intra-entity transfers, GAAP, as quoted earlier, does not require this treatment. Giving effect to upstream transfers in this calculation but not to downstream transfers is no more than an attempt to select the most logical approach from among acceptable alternatives.7
Intra-Entity Inventory Transfers Summarized
To assist in overcoming the complications created by intra-entity transfers, we demonstrate the consolidation process in three different ways:
• Before proceeding to a numerical example, review the impact of intra-entity transfers on consolidated figures. Ultimately, the accountant must understand how the balances reported by a business combination are derived when unrealized gross profits result from either up- stream or downstream sales.
• Next, two different consolidation worksheets are produced: one for downstream transfers and the other for upstream. The various consolidation procedures used in these worksheets are explained and analyzed.
• Finally, several of the consolidation worksheet entries are shown side by side to illustrate the differences created by the direction of the transfers.
The Development of Consolidated Totals
The following summary discusses the accounts affected by intra-entity inventory transactions:
Revenues. The parent’s balance is added to the subsidiary’s balance, but all intra-entity transfers are then removed.
Cost of Goods Sold.The parent’s balance is added to the subsidiary’s balance, but all intra-entity transfers are removed. The resulting total is decreased by any beginning
7The 100 percent allocation of downstream profits to the parent affects its application of the equity method.
As seen later in this chapter, in applying the equity method, the parent removes 100 percent of intra-entity profits resulting from downstream sales from its investment and equity earnings accounts rather than its percentage ownership in the subsidiary.
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