 Hello, and welcome to this session. This is Professor Farhad. In this session, we would look at a downstream sales eliminating unrealized profit. In this session, I will work an example where we have two years back to back. Because in the prior session, I work one simple example. This time, I'm going to add a little bit more complication. Obviously, this topic is covered in an advanced accounting course, and this is also covered on the CPA exam. Now, you may not get a similar exercise to one that I will show you today, because the exercise that I will show you will be comprehensive. You may see it as a simulation, but you are expected to answer multiple choice questions about one specific aspect of the problem that I will be covering today. Now, if you want additional lecture, please go to my website, farhadlectures.com, where you would have additional explanation about this topic. But let's go ahead and get started to see what this problem requires us to do. So this is pretty comprehensive. If you can follow this problem, I would say you will be good with downstream sales, including two years back to back. So let's go ahead and get started. We have P company owns 80% of the common stock of S company. So we have a parent and a subsidiary. P company sells merchandise to S company. This is a downstream sale. It's going from P to S downstream. That's the first thing you want to know, because we have downstream, and we also have upstream. Two different things. We'll work on an upstream later on. To S company, add a 25% above cost. So what they do is this, whatever their cost is, whatever P company cost is, they will take the cost X and they multiply it by 1.25, and that's their sales to P company. That's their sales to P company. Okay, during 2014, 2015, such sales amounted to 65 and 475 respectively. So in one year, they sold them to 65 and another 475. The 2014 and the 2015 ending inventory of S company included goods purchase from peer company for 125 and 170. So now what they did, they purchased merchandise from P company. And in 2014 of the 265, they still have 125 remained. And of the 475, they have 170 remained. P company reported their income from its independent operation including inter company profit on inventory sales to affiliate of 450 in 2014 and 480 in 2015. S reported their income of 225 in 2014, 275 in 2015 that not declare any cash dividend and there are no inter company sales prior to 2014. Excellent. Requirement A, prepare the journal entry from all entries necessary in the consolidated financial statement work paper to eliminate the effect of inter company sales for each year, 2014 and 2015. Let's go ahead and get started. So what do we have? Well, the first thing we're gonna do is eliminate the sales. So we'll work it one year at a time. So for year 2014, for year 2014, hopefully you can see this. Sales was 265,000. Well, what we do is we debit sales 265,000 and we credit purchases 265,000. Why do we do this? This is to eliminate inter company sales. We're done. Now, what were we told? We are told that in 2014 S company S company still have 125,000. So we sold them to 65. They still have 125,000. What does that mean? Well, it means two things. It means two things. One, it means they have a profit, unrealized profit, okay? And two, inventory is inflated. Two issues we have to deal with. Therefore we have to book another entry to solve these two issues. Now, how do we book an entry to eliminate the unrealized profit and eliminate the inflated inventory? Now, first we need to know how much is the unrealized profit and how much is the inventory? What we were told, we were told that when P company sells to S company, they sold it at 25% above cost. So whatever P company cost is, they will go ahead and sell it above. So what we have here is they still have 125,000. What does that mean? It means P company, what they did, they took some amount, multiplied by 1.25 to come up with this ending inventory of 125. What does that mean? It means the true cost for P company is 125 divided by 1.25. And let's do so. Let me show you what would happen if we do so. So basically what I'm doing, I'm taking out the profit. So 125, 125,000 divided by 1.25. That's 100,000. It means the inventory should be reported at 100,000. What does that mean? It means I have to credit. So the inventory is inflated by, inventory is inflated by 25,000 because the true cost for the consolidated company is 100,000. The reason it's 125 because when we sold it to S, we added that $25,000 to it. Therefore, we have to credit inventory for the balance sheet of 25,000. Now, what do we debit? So this is the credit. What do we debit? Okay, what do we debit? Well, generally speaking, you would say, so we solve the inflated problem. We solve this problem. We solve the inventory is reduced. Now, how do we solve the unrealized profit? To solve the unrealized profit, we have to debit cost of goods sold. But how do we debit cost of goods sold? I received a few emails from students saying, could you please explain to us because we did not understand why did you debited beginning inventory? So I'm gonna explain this in detail. So what I did is I created this Excel sheet that's gonna show you the second entry basically to eliminate the unrealized profit and ending inventory. And here's what I did. I worked with two fictitious companies, a parent and a subsidiary right there. This is the sales for the parent company, sales for the subsidiary. And hopefully you remember that beginning inventory, which is for the parent company is 100 plus purchases of 200 gives you something called available for sale. And once we subtract ending inventory from available for sale, we get to cost of goods sold. And the same thing for the subsidiary, we have beginning inventory 120, purchases are 400 available for sale 520, the combination of those ending inventory is 60 available for sale minus ending inventory gives us cost of goods available for sale. So hopefully you know this formula. Let me do it one more time. I just wanna, I just want to kind of make sure you know this very, very well, because if this is basic, but people once they get to advance accounting, they forget the basics. So beginning inventory plus purchases equal to goods available for sale. And what we do, we subtract ending inventory and that's gonna give us cost of goods sold. So this is the formula for cost of goods sold. I know it's there in numbers that I wanted to show it to you. Now, what do we need to know about this formula? What do we need to know? Here's what we need to know. We need to know the following relationship. Here's what we need to know. We need to know that every time, let me show you this in numbers, every time I'm gonna start with ending inventory. I'm gonna start with the parent company and illustrate this concept. Okay, so I'm gonna highlight this in yellow because I'm working in this column. So you focus with me. I'm gonna be working in this column. Let me show you what happened if I inflate ending inventory. What does it mean, inflate? I'm gonna increase it. I'm gonna take ending inventory. It's 40 right now and make it 100. My cost of sales went down by 60. Notice it was 40. Cost of goods sold was 260. When I increased this by 60, so what I did is I took the 40 and added 60 to it. It made it 100. Whoops, and I added 60 to it. It made it 100. So what does that mean? So the first thing you wanna know is this, and this is a basic formula that you learn in accounting 101 that again, you don't really pay attention in those courses. When ending inventory goes up, okay, your cost of goods sold goes down. Let me write it one more time here for you. EI ending inventory goes up. This mean cost of goods sold goes down. Also we can say if ending inventory goes down, your cost of goods sold goes up, okay? So they have the opposite relationship. So hopefully you learned this. Now, let me go back and show you the relationship between beginning inventory. Let me go back to the original numbers. The original number was 40. Let me go back to the original numbers. Let me show you the relationship between beginning inventory and cost of goods sold. Again, I'm working in that yellow column. I'm gonna take the beginning inventory and make it 200. Whoops, if I made it 200, cost of goods sold became 360. If I take the 100, oops, let me go back there. If I took the 100 and I made it 50, cost of goods sold went down. Hold on a second. If I make it 200, it goes up. If I make it 50, cost of goods sold goes down. Let me go back to 100. What can I say? Well, here's what I can say. Here's what I can say. I can say that as beginning inventory goes up, cost of goods sold goes up, okay? They work together. So beginning inventory and cost of goods sold work together. As beginning inventory goes down, cost of goods sold goes down. So what can I say? That's what I'm gonna say. I'm gonna say if my beginning inventory goes up, my cost of goods sold goes up. If my beginning inventory goes down, my cost of goods sold goes down, all right? So make sure you know this relationship. Then I'm gonna, one more item I need to clarify before we proceed is purchases. I'm gonna take purchases and double it. If I double purchases to 400, my cost of goods sold goes up. If I make the purchases 100, my cost of goods sold goes down by 100. Oh, what does that mean? Well, it seems purchases works just like beginning inventory. When P goes up, cost of goods sold goes up. When purchases goes down, cost of goods sold goes down. Very important relationship, those two work together. Same way. There's a positive relationship between them and cost of goods sold. And here we have a negative relationship. It means they are inversely related to each other. So, having said so, and very, very extremely important. I'm using too many words. Extremely important concept you need to know for the CPA exam. You also learn this in your inventory accounts and your inventory chapter. So let's go back to what we are doing here. And what we are doing is working with this problem. And remember what we did is we eliminated, we reduced ending inventory by 25. Therefore what I would do to offset this entry, I will debit, as I said, I will debit cost of goods sold up. I don't debit cost of goods sold directly. What I would do is I will debit beginning inventory, beginning inventory for 25,000. And let me show you what's gonna happen if I debit beginning inventory. If I debit beginning inventory, notice here the consolidated 220. Where is that coming from? I have beginning inventory of 100 for the parent, subsidiary 120, right now the total is 220. If I debit beginning inventory of 25, my beginning inventory will go, let me show you, my beginning inventory, if I debit it by 25, my beginning inventory will go up. And what happened when my beginning inventory goes up? My cost of goods sold goes up. So what I needed to do, I needed to debit beginning inventory because when I increase beginning inventory, my cost of goods sold goes up. And why do I need to do so? Because I need to eliminate the profit. I need to eliminate the profit. And what I just did, I solved the two problems that I had. I solved the two problems, I eliminated the profit by debiting beginning inventory, which is what I did, is I debited cost of goods sold as a result and I credited inventory. Let me show you on the Excel sheet what happened to inventory too. So when I debited, this was 25, when I debited beginning inventory, I credited inventory. So let's assume for inventory I had just for the sake of simplicity, 1000 for the parent and 1000 for the subsidiary, just making up those numbers, okay? Well, what's gonna happen is this. If I have, so I have 1000 for the parent plus 1000 for the sub plus the debit minus the credit in what's gonna happen, the 25. Notice my inventory was 2000 when I debited beginning inventory and accredited inventory. My inventory went down to 1975, which I did solve my problem and my problem was my inventory was inflated. Therefore, those are the two entries that you will need and we're using, by the way, the cost method here. Those are the two entries that you will need for year one, for year one. One entry to eliminate sales and really to eliminate sales and cost of goods sold. Why? Because I credited purchases and what happened when I credit purchases, my cost of goods sold goes down. So to eliminate sales and cost of goods sold. Okay, sales for the parent company, cost of goods sold for the subsidiary and the second entry to do so. So we just, what we just did, we just completed the two entries for 2000 and 2014. Okay, now we need to do the same thing for 2015. 2015, the sales was 475,000. Let me eliminate the sales now. 2015, again, I will debit sales. How much was it? 475, 475,000 credit purchases, which is really incredible cost of goods sold, 475,000. Then I also have to eliminate the profit that remained. How much remain an inventory? What remain an inventory is 170,000. Okay, so how do I do this? Well, when they sold it to me, they sold it to me at 25 above cost. Therefore, 170 divided by 1.25. Let me see how much is that? 170,000 divided by 1.25. Oops, 170,000 divided by 1.25. That's equal to 136,000. Okay, 136,000. Well, I'm not done yet. So if I take 170 minus 136, that's gonna keep me 34,000 in profit. Therefore, there is 34,000 in profit in this 170,000. It's simply put, my inventory is inflated. Therefore, I have to credit my inventory, 34,000. And I have to debit cost of goods sold. But what do I debit? I debit beginning inventory. I have to debit beginning inventory of 34,000. So this is to eliminate the unrealized profit. Basically the same thing I did in 2014. I still have one entry to make, a third entry to make for 2015. And why do I have a third entry to make? It's because in 2015, what happened is we assumed that we have sold the inventory. We assumed that this inventory here, this inventory, the 125, we assumed that this inventory sold. And if this inventory is sold, we realized the profit of 100 and, sorry, we realized the profit of 25,000. Because remember, what we did in 2014, we said, take the profit out. Take the profit out. What we do in 2015, we say, hold on a second. We already sold those 125,000 that include the 25,000 in profit. Therefore, I have to reverse what we did earlier. And how do I reverse it? For example, what I do is ending inventory rather than, basically I have to do the opposite of what I did. The opposite of what I did. So beginning inventory here was debited. I'm gonna credit beginning inventory. I'm gonna credit beginning inventory for 25,000. Let me show you what happened if I credit beginning inventory. If I credit, so I'm gonna do the opposite now. Eliminate this, delete this. And I'm gonna credit beginning inventory. Notice, cost of goods sold was 720. If I credit beginning inventory, cost of goods sold goes down because now I am realizing my profit. And what I do as an offset to this entry, an offset, I will debit the beginning retained earning of the parent company for 25,000. And basically what I did is this entry that I made earlier to take the profit out because it was sitting there. In year two, I assume that 125,000 of inventory is sold. And as a result, I can recognize my profit. Therefore to recognize intercompany profit and beginning inventory. So this is the third entry that is needed. And obviously the following year, in year 2016, what I have to do in 2016, I have to take this entry here and do the same thing and realize the 34,000 by debiting beginning inventory retained earning for the parent company and crediting beginning inventory. Because the following year you have to reverse this entry. Hopefully this is making more sense to you now. So we did the first problem or requirement A, let's look at requirement B. Requirement B said calculate the amount of non-controlling interest to be deducted from the consolidated income and the consolidated income statement for 2014 and 2015. So now we need to compute the income that goes to the, that goes to the minority or non-controlling interest. Well, we control 80%. Well, if we control 80%, they get 20%. And there's no dividend here. So that's pretty easy exercise to do. So for the year 2014 for the year 2014, the income was 225,000 and 20% goes to the non-controlling interest. That's 45,000. And in 2015, the income was 275,000 and 20% goes to the non-controlling interest, which is equal to 55,000. So this is the non-controlling interest, non-controlling interest. So this is pretty easy, okay? And we didn't have any dividend to worry about. So C, compute, calculate the controlling interest in the consolidated income of 2015. So now we have to compute the consolidated income. All right, let's start with what they actually reported. P company reported net income from its independent operation, including intercompany profit on inventory sales to affiliate of 450 in 2014 and 480 in 2015. We're looking for 2050. So we're gonna start with 480. So they reported 480. Let me see if I can do it here. They reported 480,000, but that included, remember that included, they told us it included intercompany profit. What does that mean? That means we have to take out, remember the 34,000, okay? Because that 34,000 is included. So I have to take out the 34,000 that I computed here for 2015, but I have to add the 2014, the one that I deferred from 2014 to 25,000. Now I can recognize it, okay? So that's what we have now. So we're starting with 480. That included everything. We deduct the amount of profit that's setting an inventory that it's not realized yet. Then we add the profit that's coming from last year that's gonna give us 471,000. Then we're gonna add to this, we're gonna add to this the subsidiary income and the subsidiary income is how much? We're gonna look, we're looking for the subsidiary income for 2015. Subsidiary net income is for 275. But remember, the subsidiary income is 275. But remember, we're only gonna get 80% out of it because 20% went to 20% went to the non-controlling interest and 20, we already computed the 20%. The 20% is 55. Therefore, we have to deduct 55,000 from this. Well, 55,000 minus, so 275 minus 55,000, okay? Equal to 220, let me just double check the math. In other words, of the 275, as a parent, we recognize 80% of this 220 it is, then to 20. Therefore, the consolidated is 690,1000 is the consolidated income. If you can follow this example from A to Z, show how you eliminated sales, how we eliminated the profit in inventory, then the following year we eliminated the sales, the profit in inventory. Then we reinstated, then we went back and we recognize the profit for the intercompany profit, which is this entry here for the second year, then you should be good to go. And hopefully you would understand, again, take some time and understand this relationship. Please, please take some time. So simply put, simply put, and this formula is, let me show you what's in this formula. You could do this on your own. So you will take the parent plus the subsidiary plus the debit minus the credit, okay? Here you'll take the parent plus the subsidiary plus the debit minus the credit, available for sale as a computation. Again, you will take the beginning and the parent company plus the subsidiary plus the debit minus the credit. Okay, so you could set up the formula and basically cost of goods sold equal to beginning plus purchases minus ending. Okay, and you could play with these figures until you are comfortable with this. Don't go to the CPA exam if you're not 100% comfortable with this formula. Because again, as my experience when I teach CPA, students, they get so confused about this formula. Although it's a formula, they should have learned in accounting 101. And that's why when I teach accounting 101, I drill my students into this formula. I tell them, you're gonna see it again. Make sure you know it. Make sure you know it. You're gonna see it again. And this is the summary of all the relationship between all the different account right here. I gave you the summary. Okay, here's the summary. Ending inventory and cost of goods sold, negative relationship, ending inventory and ending inventory. I'm sorry, beginning inventory and cost of goods sold. Positive relationship purchases and cost of goods sold positive relationship. So this is positive relationship with cost of goods sold and this is a negative relationship with cost of goods sold. If you have any questions, email me. If you're studying for your CPA exam, as always study hard. And if you happen to go to my website for additional lectures, please consider donating, study hard for the exam. It's worth it.