Intercompany Eliminations Explained
intercompany eliminations happen for business combinations. The whole thing kind of confuses me. Can you explain the process and the journal entries to record the intercompany eliminations?
Answer:
Remember that in a business combination, we are trying to eliminate any transactions between the parent and the subsidiary so that we only have transactions with 3rd parties left after our consolidating entries. So, let’s assume Company A owns Company B and A sells $120,000 of inventory to B. Let’s also assume that Company A gets a 40% margin on all sales and Company B has 30% of the inventory remaining at the end of the year.
With this set of facts, they could ask you a wide variety of questions on the CPA exam. One of the tricks to solving problems involving intercompany eliminations is to understand the entries that A and B would book in these cases. One of the other tricks is understanding the relationship between cost and margin percentage.
For example, Company A has a cost of $120,000. The margin is 40%. To determine the sales price, we need to divide the $120,000 cost by 60% (100%-40% margin). This gives us a sales amount of $200,000 and an intercompany profit amount of $80,000.
To record the sale, Company A would record the following entries:
dr. Intercompany Accounts Receivable 200,000
cr. Intercompany Sales 200,000
dr. Intercompany Cost of Sales 120,000
cr. Inventory 120,000
This set of entries records the sale and the receivable at the sales amount of $200,000 and relieves the inventory at the cost amount of $120,000.
The key thing to remember at this point is that Company B’s cost is the same as Company A’s sales price. Company B will book the following entry to record the inventory purchase:
dr. Inventory 200,000
cr. Intercompany Accounts Payable 200,000
At this point, you can see that the financial results of A have $80,000 of intercompany profit in them. We need to eliminate the effect of this sale because including it misstates the results to users of the financial statements (i.e. investors and creditors). If we did not eliminate this sale, companies could sell back and forth between their subsidiaries to inflate their results, but after those transactions, the consolidated company has not made any additional profit or brought in any additional cash.
We also need to eliminate some or all of the cost of sales. How much of the cost of sales depends on the profit amount and the amount of inventory remaining at the end of the year. In this case, 30% of the inventory is remaining in Company B’s inventory at the end of the year. Company B sold 70% of the inventory to 3rd parties. This means Company B would record cost of sales of $140,000 ($200,000 cost on Company B’s books multiplied by 70% of inventory sold).
To record the sales to these 3rd parties, Company B would record the following entry (I will ignore the sales part of the entry since that is irrelevant to the intercompany elimination):
dr. Cost of Sales 140,000
cr. Inventory 140,000
If we look at the earlier entry booked by Company A, we see that at this point, we have booked $260,000 in cost of sales ($120,000 original cost to Company A plus the $140,000 recorded by Company B). Obviously, we should not have cost of sales of $260,000 on the same inventory that originally cost $120,000. So, cost of sales is overstated and needs to be corrected.
There are a couple ways to figure out the adjustment to cost of sales and inventory. First, remember that when we record an elimination on intercompany sales, the Intercompany Sales account is always debited for the full sales amount. In this case, our debit is $200,000. No calculation is required – just take the full amount.
Our credit side of the entry will be made up of Cost of Sales and Inventory.
We are trying to get back to our original cost, eliminating the impact of the intercompany sale and profit. If our cost was originally $120,000 and we sold 70% to outside customers, our cost of sales should be $84,000. When we compare the cost of sales we have already booked of $260,000 to the $84,000 we should have, the credit to cost of sales should be $176,000. We can then back into the amount needed as a credit to inventory of $24,000 ($200,000 debit to sales minus $176,000 credit to cost of sales).
Alternatively, we can calculate the appropriate amount in ending inventory. We know the original cost was $120,000 and 30% remains in Company B’s ending inventory. This means we should end the year with $36,000 in ending inventory. But, we have $60,000 in ending inventory ($200,000 cost to Company B minus $140,000 relieved from inventory for sales). To get the $60,000 down to the appropriate amount of $36,000, we need a credit to inventory of $24,000.
Still another alternative is to calculate the amount of profit that remains in ending inventory. We know Company A recorded $80,000 of profit on the intercompany sale. Since 30% of the inventory remains with Company B, we can multiply the $80,000 profit by 30% to see that inventory is overstated by $24,000 of intercompany profit.
It is helpful to know all of these alternative methods for the CPA exam so that you can see the relationships between sales, cost of sales, inventory and profit.
The entry to eliminate the intercompany sales would be:
dr. Intercompany Sales 200,000
cr. Cost of Sales 176,000
cr. Inventory 24,000
The entry to eliminate the intercompany receivable and payable would be:
dr. Intercompany Accounts Payable 200,000
cr. Intercompany Accounts Receivable 200,000
The receivable and the payable just get eliminated against each other.
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