 Hello and welcome to the session in which we will discuss intercompany inventory sale. What is this topic? Well intercompany inventory sale is when we have a parent company and a subsidiary. Now the parent company might sell inventory to the subsidiary or the subsidiary might sell inventory to the parent company as long as this transaction is within the parent and the subsidiary's subsidiary parameters. What does that mean? It means as long as the inventory is not sold to an outsider. For example, the parent company did not sell this inventory to a third party or the subsidiary did not sell this inventory to a third party outside this box. What happened actually is there was a transfer of inventory inside the company. Why? Because the parent and the subsidiaries are consolidating. So when they sell to each other and no sale is conducted is no inventory is sold to a third party then it's merely transfer of inventory between the two. As a result we don't recognize any profit. Now if the inventory is sold to a third party then a profit is recognized. If some of the inventory is sold and the other is not then we're going to have to have a third profit and we'll discuss all these topics in this session. Let's go ahead and get started. Basically the central team is the profit cannot be recognized until the goods are finally sold to an unrelated party. I call it third party. The reason I called it third because I'm assuming parent and sub. Now if the sub also sold to another sub that's part of this group then it's still not a third party. Third party means unrelated party but I call it third to kind of make the point it's parent sub and we have a third outside party. But however this is what we have to keep in mind. From a record keeping perspective both parent and subsidiaries record sale and purchase. Now when we have the parent and when we have the sub remember each one of them they have their own accounting system and you have to keep that in mind. So for example if the parent sold to the sub we have a sale here we have a purchase here of the sub sale to the parent we have a sale here and we have a purchase here. So each company because they're independent they keep the record but it's merely a transfer of inventory for the overall group for the overall company. Now the consolidated financial statement when we consolidate between the two it should reflect the transfer of inventory if it's not sold to an outside party. This is the and the reason I'm emphasizing the theme because if you understand the concept it's easier to start to see the journal entries because it's going to get a little bit more complicated. So once again if we have a parent selling to a sub as long as it's inside this box the sub did not sell to an outsider nothing really happened we have to eliminate this entry the sale and the purchase because it's merely a transfer of inventory and the same concept if the sub sold to the inventory. Now the best way to start to illustrate this concept is to actually look at an example. I'm going to start with a simple example as always to illustrate the point get you familiar with the journal entries then we will work another more challenging we'll add scenarios to the example to make it more challenging and to make the point of the lesson. So we have a parent company sold 80 000 of inventory to a sub the cost for the parent company is 50 000. So first we're going to look at the journal entries from the parent company what would the parent company do the parent company will debit cash assuming they've debited cash now if they don't debit cash they will debit something called do from sub which is a receivable which is a receivable from the sub all they simply have an account receivable just in case in your tax book or in your CPA review course use different language but I'm going to keep it simple and using cash so it could be do from sub or account receivable they will credit sales they will debit cost of goods sold and they will credit inventory the sub the subsidiary they will debit either inventory or they're using the periodic purchases and they will credit cash all they will credit accounts payable if they bought it on account or due to parent if they use due to do from if the company uses this now here's what we're going to assume we're going to assume that the subsidiary did not sell anything from this inventory so this is the first assumption we are going to make to keep this example simple to kind of get you warmed up so simply put they purchased the inventory and they did not sell it to an outside party so they did not sell it there was no sale well what's going to happen then when we consolidate we're going to have to assume this sale did not exist okay that's the first thing this did not happen so we have to kind of do something to make this go away and we're going to have to make an adjustment to reflect the original original the original cost for the inventory because now based on the subsidiary if you look at the subsidiary it looks as we have inventory with a cost of 80 000 that's wrong that's not true our inventory has a cost of 50 not not 80 000 so we have to fix this problem how do we fix this problem let's see how do we fix this problem let's start step by step well let's see what what problem fix itself we have credit debit the cash credit the cash basically those naturally they will eliminate each other we have sales of 80 000 we have credit sales is this a legitimate sales and the reason is not you cannot report the sales when you do the consolidation so we have to debit we have to debit sales we have to get rid of sales we also have cost of goods sold of 50 000 do we really have cost of goods sold of 50 000 and the answer is no we don't this cost of goods sold was related related to the sale and the sale is not really a good sale so we have to credit cost of goods sold one more problem we have we have if we look at our inventory overall for the whole company if we look at it that way we have inventory of 80 inventory of sorry inventory debit of 80 on the sub and i'm going to combine the two inventory credited 50 on the parent we have 30 000 in access inventory what do we have to do with this access 30 000 and this is basically well it's we have you can look at this 30 000 access inventory in two ways you can say it's it's the same thing you can say this is access inventory that's one thing you can call it access inventory which is which it is our inventory is inflated by 30 000 or you can say this 30 000 is the profit for the parent profit for parent how so let me show you the parent recorded sales which they did on their books they would still record the sale of 80 000 they record the cost of goods sold of 50 they have a profit of 30 so this profit is this inventory here so whether you say it's an access profit from the parent or you say it's inflated inventory it doesn't really matter we have to remove that 30 000 of inventory therefore we credit inventory for 30 000 let me show you the journal entry that we prepare so this way you are familiar with this so this is the journal entry the 30 000 we said cash is gone we debit sales 30 000 sales is gone we credit cost of goods sold 50 000 this is gone and what we need to do here we need to credit inventory in additional 30 000 to get rid of the the get rid of the access inventory to get rid of the access inventory so the inventory is reported at 50 000 so this is the elimination entry what did we assume here we assume that nothing was sold to the outsider so we have to kind of eliminate everything and this is exactly what we did now in some books or in some cost accounting not cost accounting some advanced accounting courses in some books or some cp review course they will combine those two they will combine those two and they will debit sales and credit cost of goods sold for the total because they assume you know once it's once it's once it's on the subsidiary it's sold so first they assume it's sold therefore the whole thing was cost of goods sold therefore they debit sales credit cost of goods sold so this is alternative alternative way of looking at it so this is one way to look at it maybe your textbook do it in two steps maybe your textbook first they assume they reverse the sales and they assume everything is sold then then they remove the the third gross profit then they debit cost of goods sold then they would reduce inventory then they will credit debit cost of goods sold and credit inventory which is if you take those two entries it's the same thing as this and take a second and look at it those are the same two entries except in your book first they kind of debit sales and debit cost of goods sold for the full amount then they find out that there's 30 000 of the third profit we have to kind of back out the deferred intra company gross profit we do so we increase cost of goods sold and once increased cost of goods sold we reduce profit and we credit inventory to reduce inventory so this 30 000 reduced reduction in inventory is to reduce the inventory and as a result what happened is you increased cost of goods sold which is you eliminated your profit again this you don't do both you either do this your textbook will show this or it will show this i want to make sure i cover both this way you are covered now one more thing i want you i want to make sure you are very familiar with before we proceed in this one is this formula here how to compute cost of goods sold beginning inventory plus purchases equal the goods available for sale then we deduct ending inventory from goods available for sale to get to cost of goods sold make sure you know this formula inside out now here's what we need to know if your if your ending inventory goes up your cost of goods sold goes down and you can use numbers to say this there is a negative relationship between ending inventory and cost of goods sold so in your textbook or in your cpr view course what they might be using they might be they might be adjusting inventory remember every time we increase ending inventory every time we increase ending inventory we reduce cost of goods sold and the opposite is true if we reduce ending inventory we increase cost of goods sold and if we increase cost of goods sold we reduce profit okay so make sure you know this make sure you know this okay now here's what we need to show so that's why i'm showing you here what happened here is we is we reduce so notice here just kind of show you this point in this problem we credited inventory so ending inventory went down as a result cost of goods sold went up as a result the 30 000 dollar is gone the 30 000 profit is gone now sometime in some textbook what they use they adjust sometime you have to adjust beginning inventory the relationship between beginning inventory and cost of goods sold is a positive relationship what does that mean it means every time you reduce beginning inventory you sorry you reduce every time you reduce beginning inventory you reduce cost of goods sold okay they they work together and every time you increase beginning inventory you increase cost of goods sold and the reason i'm mentioning this once again because we're gonna use beginning adjusting beginning inventory but also it's something that you critically need to know because this is how they try to trick you on the exam now let's move on to the next option the next option is the subsidiaries bought this inventory well obviously they bought them but they don't plan to hold them forever in this example we assume they they purchased them but they did not sell them so now we have to work with the example where they actually sell the inventory some of it if they sell all of it it's easy if they sell some of it there's some complication we're gonna assume they sell some of it but before we proceed i would like to remind you to show you how to sell part of it whether you are a student or a CPA candidate take a look at my website farhatlectures.com the reason you are watching this is because you are either a student or a CPA candidate looking for something and you found me that's great i'm glad you did but i can help you further with your CPA review course i don't replace your course that's not my intent nor your accounting course i can help you understand the material better i have lectures multiple choice through false that that helps you with your accounting courses everything is organized by chapter my CPA review material is aligned with your becker wiley roger gleam so it's very easy to go back and forth between my material and your CPA review course i also give you access to all previously AI CPA released questions with detailed solution please connect with me on linkedin if you haven't done so take a look at my linkedin recommendation like this recording the mere fact that you found it it's helping you it might help others so share it with other connect with me on instagram facebook twitter reddit and i started a facebook group me account called CPA exam support group by all means join us so you can connect with other individuals that are studying for the exam now the subsidiary again what we said is they don't hold the inventory they want to sell it let's assume the subsidiary sold 60 000 out of the 80 000 remember they purchased this this is the entry from the prior slide they purchased 80 000 of inventory now they sold 60 000 and they sold it for 110 it doesn't matter what they sold it for but we're going to assume for 110 now the subsidiary will have to journalize the sale why because now this is a revenue recognition process that has been completed so the revenue recognition has been completed for 60 000 this is what the subsidiary would do they will debit cash 110 or they will debit a count receivable if they sold it on account they will credit sales 110 then they will debit cost of goods sold 60 000 they will credit inventory 60 000 let's now take a look at the sub inventory the inventory they originally recorded 80 000 when they purchased it from us now they sold it to an outside party of 60 000 they have inventory left of 20 000 good this inventory is an interrelated inventory why because it's purchased from the parent company part of this inventory is actual inventory and part of it is profit how do we know which part which part of it is profit which part of it is inventory because this 20 000 is inflated inventory inflated inventory well we have to compute the gross profit of the parent company the parent company sold you for sold you the inventory for 80 000 we said we have a cost of 50 so cost 50 divided by 80 the gross profit percentage for the parent company is 36.5 what does that mean it means part of your inventory is profit and that profit is 37.5 what does that mean it means of that 20 000 20 000 7 500 is profit and the remainder which is 12 500 is actual inventory again the 20 000 of inventory this is inventory on the sub books it's inflated it's inflated because it has a profit portion and an actual inventory portion so what do we have to do we have to fix this we cannot report the inventory at 20 000 at the end of the year because we still have 20 000 of inventory and if we sold everything then there's nothing to worry about if we sold everything we sold everything for example if we sold the whole 80 000 for 150 will debit cash 150 credit sales 150 debit cost of goods sold 80 credit inventory 80 and we have no inventory to worry about practically it will be easy peasy problem but we have to worry about this 20 000 now we have to look at the adjusting entry that we have to make elimination entry to take care of this 7 500 and report the proper numbers on the financial statements on the consolidated financial statement so i'm going to have three columns for you what should we report on the consolidated financial statements what's reported on the parent company what's reported on the sub and i'm going to show you what adjustment do we need to make let's start the parent has a sales of 80 000 correct this is this is the sales of 80 000 the sub has a sale of 110 000 well the sub has this sale to an outside party in your opinion which of these sales should appear on the consolidated financial statement and i hope you know that only the sale to an outsider should appear because remember this parent company sale is an interrelated party therefore what we have to do we have to debit debit sales 80 000 if we debit sales 80 000 this is gone what's left is the 110 it doesn't matter what's left what's whatever is this could be 110 could be five zillion okay it doesn't matter what we sell to an outsider is what's left what's reported on the financial statement consolidated financial statement therefore now we are starting to prepare the elimination entries we're going to debit sales this is debit sales of 80 000 let's take a look at inventory how much inventory is on the parent's company for that for that inventory and the reason is zero there's no inventory on the parent's company because they transfer it to the sub the sub has inventory of 20 000 this one right here the sub has inventory of 20 000 is this really true is this how much we need to report on the consolidated financial statement and the answer is no we need to report only 12 500 12 500 right here well if that's the case we need to credit our inventory credit our inventory 7 500 by crediting inventory 5 500 we would report inventory 12 500 remember what is this credit inventory this is by this credit is deferring the profit so by crediting inventory remember crediting inventory means what means reducing inventory means reducing inventory what does it mean reducing inventory it means increasing remember what i told you when you reduce your ending inventory you increase cost of goods sold what does that mean if you increase cost of goods sold it means you're lowering your profit i hope this makes sense so the reason why we credit inventory by crediting inventory we're deferring profit because by crediting inventory we increase our cost of goods sold and I showed you the formula in the previous slide where I showed you make sure you know the relationship okay so we're basically hitting two birds with one stone or something like this where we reduce inventory to adjust inventory and at the same time we adjust our cost of goods sold now let's talk about cost of goods sold the subsidiary has 60 000 of cost of goods sold the parent company has 50 000 of cost of goods sold what should we report in cost of goods sold on the consolidated financial statement well let's think about this what is the true cost of goods sold the true cost of goods sold is the true inventory that was sold from has a cost of 50 remember the inventory has a cost of 50 000 okay this is the original cost of the inventory and what happened is this we sold of the inventory we sold 60 out of 80 so the subsidiary sold 60 out of 80 so let's see what is 60 out of 80 well what we did is 60 out of 80 is we sold 75 percent of the inventory because 60 000 divided by 80 000 is 75 therefore we need to expense 75 percent of the original cost of the inventory and what is that that's 37 500 that's 37 500 so this is the cost of goods sold that should be on the consolidated financial statement and it's no it's no it's no coincident that 37 500 plus 12 500 equal to the original cost of 50 okay just it's no coincidence that we are dealing with the original 50 000 so if we need to come up with 37 500 we have 50 plus 50 plus 60 equal to 110 of cost of goods sold between the parent and the subsidiary i'm going to put this in a different color the quite let me put it in a different different color purple no okay that's fine let me do it in purple so this way it appears a little bit more okay so this is 110 what entry do we need to make to make cost of goods sold equal to 37 500 we need to credit cost of goods sold by 72 500 so be careful what you are being asked on the exam this is the adjustment right here there's a lot of arrows here okay this is the adjustment they might ask you what is the adjustment you need to make or they might ask you what entries what are the final balances those are the final balances those are the balances that goes on the financial statement the balances on the consolidated financial statement in this column has the adjusting entries let me eliminate everything so we have a clearer picture this is the adjusting entry the elimination entry debit sales 80 000 credit cost of goods sold 72 500 credit inventory 7 500 remember by crediting inventory you are hitting two uh two birds with the same stone now again in some textbook what they do they debit sales and credit cost of goods sold for the total of 80 000 if that happens then you have to make another entry debit cost of goods sold increase your cost of goods sold and you reduce inventory for the the third profit so if you so if your textbook debited sales credited cost of goods sold credited cost of goods sold for 80 000 if that's what they did then they have to defer the intercompany profit but this entry here does this by crediting inventory now are we done yet and the answer is no we have to learn about one more entry at least kind of to make sure you're aware of it assuming 50 in year two so we're going we're going to go to year two and assuming this company uses 50 first and first out and selling their inventory what's going to happen is this you remember from this 20 000 we deferred 7 500 in in profit we deferred in profit now what's going to happen we assume that year two if this was if this happened in year one we deferred the 7 500 we're going to assume in year two we're going to recognize we're going to sell the inventory and recognize the 7 500 so now what we need to do when we start the year when we start the year when we start the year and we sell the inventory we need to make another entry and that entry is to reduce the 7 500 because the consolidated financial statement has 7 500 from the prior year in profit we need to move this profit from year one to year two how do we do so we debit beginning retained earnings we reduce beginning retained earnings and we credit cost of goods sold by reducing inventory by crediting cost of goods sold what you do is you increase your profit for we increase your profit by 7 500 therefore you took the 7 500 that was deferred from the prior year and you recognize that in this year now if you're using the equity method for this downstream sale you will debit investment in subcredit cost of goods sold in case you are dealing with an equity investment method it will deal about the equity investment later on what should you do now you should go to farhatlectures.com and work mcqs true false look at additional resources subscribe it's going to help you it's going to help you understand the material better that's what I do I help you do better that's why you are watching me because you need that additional help I can help you more on farhatlectures.com invest in yourself invest in your career good luck study hard and of course stay safe