In either alternative adjustment for recognizing realized
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 not affect 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 ⫽ 2001,000 ⫽ 20 and the MC ⫽ 200800 ⫽ 25. In most intra-entity purchases and sales, the sales transfer price is known and therefore the GPR is 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 GPR by the preceding for- mula. In this case 0.251.25 ⫽ 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
7
The 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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Consolidated Financial Statements—Intra-Entity Asset Transactions 203
unrealized gross profit thus raising net income and increased by any ending unrealized gross profit reducing net income.
Expenses. The parent’s balance is added to the subsidiary’s balance plus any amortization expense for the year recognized on the acquisition-date fair value allocations.
8
Noncontrolling Interest in Subsidiary’s Net Income. The subsidiary’s reported net income is adjusted for any excess acquisition-date fair-value amortizations and the effects of
unrealized gross profits on upstream transfers but not downstream transfers and then multiplied by the percentage of outside ownership.
Retained Earnings at the Beginning of the Year. As discussed in previous chapters, if the equity method is applied, the parent’s balance mirrors the consolidated total. When any
other method is used, the parent’s beginning Retained Earnings must be converted to the equity method by Entry C. Accruals for this purpose are based on the income actually
earned by the subsidiary in previous years reported income adjusted for any unrealized upstream gross profits.
Inventory. The parent’s balance is added to the subsidiary’s balance. Any unrealized gross profit remaining at the end of the current year is removed to adjust the reported balance
to historical cost. Land, Buildings, and Equipment. The parent’s balance is added to the subsidiary’s
balance. This total is adjusted for any excess fair-value allocations and subsequent amortization.
9
Noncontrolling Interest in Subsidiary at End of Year. The final total begins with the non- controlling interest at the beginning of the year. This figure is based on the subsidiary’s
book value on that date plus its share of any unamortized acquisition-date excess fair value less any unrealized gross profits on upstream sales. The beginning balance is
updated by adding the portion of the subsidiary’s income assigned to these outside owners as computed earlier and subtracting the noncontrolling interest’s share of the
subsidiary’s dividend payments.
Intra-Entity Inventory Transfers Illustrated
To examine the various consolidation procedures required by intra-entity inventory transfers, assume that Top Company acquires 80 percent of the voting stock of Bottom Company on
January 1, 2010. The parent pays 400,000 and the acquisition-date fair value of the noncon- trolling interest is 100,000. Top allocates the entire 50,000 excess fair value over book value
to adjust a database owned by Bottom to fair value. The database has an estimated remaining life of 20 years.
The subsidiary reports net income of 30,000 in 2010 and 70,000 in 2011, the current year. Dividend payments are 20,000 in the first year and 50,000 in the second. Top applies
the initial value method so that the parent records dividend income of 16,000 20,000 ⫻ 80 and 40,000 50,000 ⫻ 80 during these two years. Using the initial value method in
this next example avoids the problem of computing the parent’s investment account balances. However, this illustration is subsequently extended to demonstrate the changes necessary
when the parent applies the equity method.
After the takeover, intra-entity inventory transfers between the two companies occurred as shown in Exhibit 5.2. A 10,000 intra-entity debt also exists as of December 31, 2011.
The 2011 consolidation of Top and Bottom is presented twice. First, the transfers are as- sumed to be downstream from parent to subsidiary Exhibit 5.3. Second, consolidated figures
are recomputed with the transfers being viewed as upstream Exhibit 5.4. This distinction is significant only because of a noncontrolling interest.
8
As discussed later in this chapter, worksheet adjustments remove excess depreciation following depreciable asset transfer between companies within a business combination at a price more than the book value.
9
As discussed later in this chapter, if land, buildings, or equipment is transferred between parent and subsidiary, the separately reported balances must be returned to historical cost figures in deriving consoli-
dated totals.
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204 Chapter 5
2010 2011
Transfer prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000
100,000 Historical cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
60,000 70,000
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
30,000 Inventory remaining at year-end at transfer price . . . . . .
16,000 20,000
Gross profit percentage . . . . . . . . . . . . . . . . . . . . . . . . . . 25
30 Gross profit remaining in year-end inventory . . . . . . . . . .
4,000 6,000
EXHIBIT 5.2
Intra-Entity Transfers
Downstream Sales
In the first example, all inventory transfers are assumed to be downstream from Top to Bot- tom. Based on that perspective, the worksheet to consolidate these two companies for the year
ending December 31, 2011, is in Exhibit 5.3. Most of the worksheet entries found in Exhibit 5.3 are described and analyzed in previous
chapters of this textbook. Thus, only four of these entries are examined in detail along with the computation of the noncontrolling interests in the subsidiary’s income.
Entry G Entry G removes the unrealized gross profits carried over from the previous pe-
riod. The gross profit on the 16,000 in transferred merchandise held by Bottom at the begin- ning of the current year was unearned and deferred in the 2010 consolidated statements. The
gross profit rate Exhibit 5.2 on these items was 25 percent 20,000 gross profit80,000 transfer price, indicating an unrealized profit of 4,000 25 percent of the remaining 16,000
in inventory. To recognize this gross profit in 2011, Entry G reduces cost of goods sold or the beginning inventory component of that expense by that amount and Top’s as the seller of
the goods January 1, 2011, Retained Earnings. Essentially the 4,000 gross profit is removed from 2010 retained earnings and recognized in 2011 consolidated net income.
Entry G creates two effects: First, last year’s profits, as reflected in the seller’s beginning
Retained Earnings, are reduced because the 4,000 gross profit was not earned at that time. Second, the reduction in Cost of Goods Sold creates an increase in current year income. From
a consolidation perspective, the gross profit is correctly recognized in 2011 when the inven- tory is sold to an outside party.
Entry C Chapter 3 introduced Entry C as an initial consolidation adjustment required
whenever the parent does not apply the equity method. Entry C converts the parent’s begin- ning Retained Earnings to a consolidated total. In the current illustration, Top did not accrue
its portion of the 2010 increase in Bottom’s book value [30,000 income less 20,000 paid in dividends ⫻ 80, or 8,000] or record the 2,000 amortization expense for this same period.
Because the parent recognized neither number in its financial records, the consolidation process adjusts the parent’s beginning retained earnings by 6,000 Entry C. The intra-entity
transfers do not affect this entry because they were downstream; the gross profits had no im- pact on the income the subsidiary recognized.
Entry TI Entry TI eliminates the intra-entity salespurchases for 2011. The entire 100,000
transfer recorded by the two parties during the current period is removed to arrive at consoli- dated figures for the business combination.
Entry G Entry G defers the unrealized gross profit remaining at the end of 2011. The
20,000 in transferred merchandise Exhibit 5.2 that Bottom has not yet sold has a gross profit rate of 30 percent 30,000 gross profit100,000 transfer price; thus, the unrealized
gross profit amounts to 6,000. On the worksheet, Entry G eliminates this overstatement in the Inventory asset balance as well as the ending inventory negative component of Cost of
Goods Sold. Because the gross profit remains unrealized, the increase in this expense appro- priately decreases consolidated income.
Noncontrolling Interest’s Share of the Subsidiary’s Income
In this first illustration, the intra-entity transfers are downstream. Thus, the unrealized gross profits are considered to relate solely to the parent company, creating no effect on the subsidiary
or the outside ownership. For this reason, the noncontrolling interest’s share of the subsidiary’s
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Consolidated Financial Statements—Intra-Entity Asset Transactions 205
EXHIBIT 5.3
Downstream Inventory Transfers TOP COMPANY AND BOTTOM COMPANY
Consolidation: Acquisition Method Consolidation Worksheet
Investment: Initial Value Method For Year Ending December 31, 2011
Ownership: 80 Consolidation Entries
Top Bottom
Noncontrolling Consolidated
Accounts Company
Company Debit
Credit Interest
Totals Income Statement
Sales 600,000
300,000 TI100,000 800,000
Cost of goods sold 320,000
180,000 G 6,000
G 4,000 402,000
TI100,000 Operating expenses
170,000 50,000
E 2,500 222,500
Dividend income 40,000
I 40,000 Separate company net income
150,000 70,000
Consolidated net income 175,500
Noncontrolling interest in Bottom Company’s income
13,500 † 13,500
Top’s interest in consolidated net income
162,000
Statement of Retained Earnings
Retained Earnings 1111 Top Company
650,000 G 4,000
C 6,000 652,000
Bottom Company 310,000
S310,000 ‡ Net income above
150,000 70,000
162,000 Dividends paid
70,000 50,000
I 40,000 10,000
70,000 Retained earnings 123111
730,000 330,000
744,000
Balance Sheet
Cash and receivables 280,000
120,000 P 10,000
390,000 Inventory
220,000 160,000 G
6,000 374,000
Investment in Bottom 400,000
C 6,000 –0–
S368,000 A 38,000
Land 410,000 200,000
610,000 Plant assets net
190,000 170,000
360,000 Database
–0– –0– A 47,500
E 2,500
45,000 Total assets
1,500,000 650,000
1,779,000 Liabilities
340,000 170,000
P 10,000 500,000
Noncontrolling interest in Bottom Company, 1111
S 92,000 A 9,500
101,500 Noncontrolling interest in
Bottom Company, 123111 105,000 105,000
Common stock 430,000
150,000 S150,000
430,000 Retained earnings 123111 above
730,000 330,000
744,000 Total liabilities and equities
1,500,000 650,000
676,000 676,000
1,779,000
Note: Parentheses indicate a credit balance. †Because intra-entity sales are made downstream by the parent, the subsidiary’s earned income is the 70,000 reported figure less 2,500 excess amortization with a 20 allocation to the noncontrolling
interest 13,500. ‡Boxed items highlight differences with upstream transfers examined in Exhibit 5.4.
Consolidation entries: G
Removal of unrealized gross profit from beginning figures so that it can be recognized in current period. Downstream sales attributed to parent. C
Recognition of increase in book value and amortization relating to ownership of subsidiary for year prior to 2011. S
Elimination of subsidiary’s stockholders’ equity accounts along with recognition of January 1, 2011, noncontrolling interest. A
Allocation of subsidiary’s fair value in excess of book value, unamortized balance as of January 1, 2011. I
Elimination of intra-entity dividends recorded by parent as income. E
Recognition of amortization expense for current year on database. P
Elimination of intra-entity receivablepayable balances. TI
Elimination of intra-entity salespurchases balances. G
Removal of unrealized gross profit from ending figures so that it can be recognized in subsequent period.
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206 Chapter 5
EXHIBIT 5.4
Upstream Inventory Transfers TOP COMPANY AND BOTTOM COMPANY
Consolidation: Acquisition Method Consolidation Worksheet
Investment: Initial Value Method For Year Ending December 31, 2011
Ownership: 80 Consolidation Entries
Top Bottom
Noncontrolling Consolidated
Accounts Company
Company Debit
Credit Interest
Totals Income Statement
Sales 600,000
300,000 TI100,000 800,000
Cost of goods sold 320,000
180,000 G 6,000
G 4,000 402,000
TI100,000 Operating expenses
170,000 50,000
E 2,500 222,500
Dividend income 40,000
I 40,000 Separate company net income
150,000 70,000
Consolidated net income 175,500
Noncontrolling interest in Bottom Company’s income
13,100 † 13,100
Top’s interest in consolidated net income
162,400
Statement of Retained Earnings
Retained earnings 1111 Top Company
650,000 C 2,800
652,800 Bottom Company
310,000 G 4,000
S306,000 ‡ Net income above
150,000 70,000
162,400 Dividends paid
70,000 50,000
I 40,000 10,000
70,000 Retained earnings 123111
730,000 330,000
745,200
Balance Sheet
Cash and receivables 280,000
120,000 P 10,000
390,000 Inventory
220,000 160,000 G
6,000 374,000
Investment in Bottom 400,000
C 2,800 –0–
S364,800 A 38,000
Land 410,000 200,000
610,000 Plant assets net
190,000 170,000
360,000 Database
–0– –0– A 47,500
E 2,500
45,000 Total assets
1,500,000 650,000
1,779,000 Liabilities
340,000 170,000
P 10,000 500,000
Noncontrolling interest in Bottom Company, 1111
S 91,200 A 9,500
100,700 Noncontrolling interest in Bottom
Company, 123111 103,800 103,800
Common stock 430,000
150,000 S150,000
430,000 Retained earnings 123111 above
730,000 330,000
745,200 Total liabilities and equities
1,500,000 650,000
668,800 668,800
1,779,000
Note: Parentheses indicate a credit balance. †Because intra-entity sales were upstream, the subsidiary’s 70,000 income is decreased for the 6,000 gross profit deferred into next year and increased for 4,000 gross profit deferred from the previous
year. After further reduction for 2,500 excess amortization, the resulting 65,500 provides the noncontrolling interest with a 13,100 allocation 20. ‡Boxed items highlight differences with downstream transfers examined in Exhibit 5.3.
Consolidation entries: G
Removal of unrealized gross profit from beginning figures so that it can be recognized in current period. Upstream sales attributed to subsidiary. C
Recognition of earned increase in book value and amortization relating to ownership of subsidiary for year prior to 2011. S
Elimination of adjusted stockholders’ equity accounts along with recognition of January 1, 2011, noncontrolling interest. A
Allocation of subsidiary’s fair value in excess of book value, unamortized balance as of January 1, 2011. I
Elimination of intra-entity dividends recorded by parent as income. E
Recognition of amortization expense for current year on fair value allocated to value of database. P
Elimination of intra-entity receivablepayable balances. TI
Elimination of intra-entity salespurchases balances. G
Removal of unrealized gross profit from ending figures so that it can be recognized in subsequent period.
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Consolidated Financial Statements—Intra-Entity Asset Transactions 207
income is unaffected by the downstream intra-entity profit deferral and subsequent recognition. Therefore, Top allocates 13,500 of Bottom’s income to the noncontrolling interest computed
as 20 percent of 67,500 70,000 reported income less 2,500 current year database excess fair-value amortization.
By including these entries along with the other routine worksheet eliminations and adjust- ments, the accounting information generated by Top and Bottom is brought together into a sin-
gle set of consolidated financial statements. However, this process does more than simply delete intra-entity transactions; it also affects reported income. A 4,000 gross profit is re-
moved on the worksheet from 2010 figures and subsequently recognized in 2011 Entry G. A 6,000 gross profit is deferred in a similar fashion from 2011 Entry G and subsequently
recognized in 2012. However, these changes do not affect the noncontrolling interest because the transfers were downstream.
Upstream Sales
A different set of consolidation procedures is necessary if the intra-entity transfers are up- stream from Bottom to Top. As previously discussed, upstream gross profits are attributed to
the subsidiary rather than to the parent company. Therefore, had these transfers been upstream, the 4,000 gross profit moved from 2010 into the current year Entry G and the 6,000 un-
realized gross profit deferred from 2011 into the future Entry G are both considered adjust- ments to Bottom’s reported totals.
Tying upstream gross profits to Bottom’s income complicates the consolidation process in several ways:
• Deferring the 4,000 gross profit from 2010 into 2011 dictates the adjustment of the sub-
sidiary’s beginning Retained Earnings balance as the seller of the goods to 306,000 rather than 310,000 found in the company’s separate records on the worksheet.
• Because 4,000 of the income reported for 2010 was unearned at that time, Bottom’s book
value did not increase by 10,000 during the previous period income less dividends as stated in the introduction but only by an earned amount of 6,000.
• Bottom’s earned income for the year 2011 is 65,500 rather than the 70,000 found within
the company’s separate financial statements. This 65,500 figure is based on adjusting the timing of the reported income to reflect the deferral and recognition of the intra-entity gross
profits and excess fair-value amortization.
Earned Income of Subsidiary—Upstream Transfers Add: Gross
Less: Gross Profit Bottom’s 2011
Profit from Reported in 2011
2011 Income of Bottom Income Less 2,500
Previous Period to Be Realized in
Company from Excess Amortization
Realized in 2011 Later Period
Consolidated Perspective
67,500 4,000
6,000 65,500
Determinations of Bottom’s beginning Retained Earnings realized to be 306,000 and its 2011 income as 65,500 are preliminary calculations made in anticipation of the consolidation
process. These newly computed totals are significant because they serve as the basis for sev- eral worksheet entries. However, the subsidiary’s financial records remain unaffected. In ad-
dition, because the initial value method has been applied, no change is required in any of the parent’s accounts on the worksheet.
To illustrate the effects of upstream inventory transfers, in Exhibit 5.4, we consolidate the financial statements of Top and Bottom again. The individual records of the two companies
are unchanged from Exhibit 5.3: The only difference in this second worksheet is that the intra- entity transfers are assumed to have been made upstream from Bottom to Top. This single
change creates several important differences between Exhibits 5.3 and 5.4.
1. Because the intra-entity sales are made upstream, the 4,000 deferral of the beginning
unrealized gross profit Entry G is no longer a reduction in the parent company’s retained
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208 Chapter 5
earnings, if Bottom sold the merchandise; thus, the elimination made in Exhibit 5.4 reduces that company’s January 1, 2011, equity balance. Following this entry, Bottom’s beginning Re-
tained Earnings on the worksheet is 306,000, which is, as discussed earlier, the appropriate total from a consolidated perspective.
2. Because 4,000 of Bottom’s 2010 income is deferred until 2011, the increase in the subsidiary’s book value in the previous year is only 6,000 rather than 10,000 as re-
ported. Consequently, conversion to the equity method Entry C requires an increase of just 2,800:
6,000 earned increase in subsidiary’s book value during 2010 ⫻ 80 . . . . . . . . . . . . . . . . .
4,800 2010 amortization expense 80 ⫻ 2,500 . . . . . . . . . . . . . . . . .
2,000 Increase in parent’s beginning retained
earnings Entry C . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2,800