Chapter 7

CHAPTER 7

INTERCOMPANY INVENTORY TRANSACTIONS

ANSWERS TO QUESTIONS

Q7-1   All inventory transfers between related companies must be eliminated to avoid an overstatement of revenue and cost of goods sold in the consolidated income statement. In addition, when unrealized profits exist at the end of the period, the eliminations are needed to avoid overstating inventory and consolidated net income.

Q7-2   An inventory transfer at cost results in an overstatement of sales and cost of goods sold. While net income is not affected, gross profit ratios and other financial statement analysis may be substantially in error if appropriate eliminations are not made.

Q7-3   An upstream sale occurs when the parent purchases items from one or more subsidiaries. A downstream sale occurs when the sale is made by the parent to one or more subsidiaries. Knowledge of the direction of sale is important when there are unrealized profits so that the person preparing the consolidation workpaper will know whether to reduce consolidated net income assigned to the controlling interest by the full amount of the unrealized profit (downstream) or reduce consolidated income assigned to the controlling and noncontrolling interests on a proportionate basis (upstream).

Q7-4   As in all cases, the total amount of the unrealized profit must be eliminated in preparing the consolidated statements. When the profits are on the parent company's books, consolidated net income and income assigned to the controlling interest are reduced by the full amount of the unrealized profit.

Q7-5   Consolidated net income is reduced by the full amount of the unrealized profits. In the upstream sale, the unrealized profits are apportioned between the parent company shareholders and the noncontrolling shareholders. Thus, consolidated net income assigned to the controlling and noncontrolling interests is reduced by a pro rata portion of the unrealized profits.

Q7-6   Income assigned to the...