 Hello and welcome to the session in which we would look at intercompany transactions specifically that deals with inventory transaction intercompany eliminating transaction that deals with inventory gives students the most headache whether it's in the advanced accounting course or the CPA exam review courses. This session is designed specifically for my CPA review students. If you are an accounting students and looking to dig deep more into this topic, well, you have to go to my advanced accounting course. Otherwise, you have if you are a CPA candidate, you're in the right place, unless you felt you need more by all means go to my advanced accounting course. So inventory transaction are no different than land transaction intercompany transaction, no different than intercompany fixed asset or depreciable asset transaction. What does that mean? It means we have a parent and we have a sub. And as long as it's a downstream sale from the parent to the sub or from the sub to the parent, it's inside this box, it will need to be eliminated. Once we sell it to the outside party, then we have then we have to recognize the profit. So the total amount of intercompany sales and cost of goods sold should be eliminated from the consolidated financial statement. So anything that happened in this box and it doesn't doesn't spill to the outside will need to be eliminated. In addition, any intercompany profit resulting from intercompany sale of inventory must also be eliminated. Of course, we're going to eliminate the payable, the receivable as well as any profit because any intercompany profit because when the parent sells to the sub, they may sell it at a profit or when the sub sells to the parent, they might sell it at a profit. If the inventory purchased or sold by the sub or by the parent was still in stock and not sold to a third party, the profit is eliminated from the value of ending inventory. And you'll see how if the inventory was sold to a third party, the profit is eliminated from cost of goods sold. Actually, the example that we work, it's going to illustrate both points. So let's assume that company A acquired 100% of the common stock of company B. So we're even keeping it easier. We own 100%. There's a 100% relationship. Now in my advanced accounting course, I make it a little bit more complicated, but this is good enough for your CPA review. During the year, company A sold merchandise for 160,000 to company B, which in turn sold 70% of those merchandise to an external party with a profit margin of 25% before the year end. The cost of goods sold to B amounted to 125 at A's book. It means company A sold the inventory for 160. Solder merchandise for 160. The cost of goods sold was 125. It means they booked a profit of 35,000 and this is company A. Now they're asking you to prepare the eliminating journal entries required for consolidation purposes. Now before we look at the consolidating entries, I would like to remind you whether you are a student or a CPA candidate. Most likely you're a CPA candidate and you landed on this recording. That's great. I'm glad you did. I can help you if you're looking for help. I can help you how I explain the material differently. I don't replace your beloved CPA review course. You could use me as an addition. My subscription I would say technically is nominal and if you can't afford it, email me. I'll try to work something with you. If you have not connected with me on social media, please do so. My LinkedIn, take a look at my LinkedIn recommendation. YouTube likes this recording. It helps me a lot. Connect with me on Instagram, Facebook, Twitter, Reddit and group me. And I do give you access to thousands of multiple choice questions on my website including previously released AICPA questions. So let's journalize first company A entries. Company A made a sale to the sub. They debit a count receivable sub 160,000. They will credit sales sub 160,000. And you're going to see why I'm differentiating making sure you understand this is to the sub. Also they will debit cost of goods sold again. This is the sale that was related to the sub 125 and they will credit inventory 125. Now it's important to compute the gross profit percentage for this transaction. Company A, which is the parent company made $35,000 profit on a $160,000 sale, which is 160 minus 125 will give them 135. The gross profit percentage, which is very important, write it down 21.875. Now what would company do? Company B, company two or company B, the sub will debit inventory for 160 and they will credit accounts payable and say we owe the parent company $160,000. That's the journal entry that they make. Now we have to be aware that company B sold 70% of this inventory. 70% was sold to an outsider. What does that mean? It means 160,000 times 70% equal to 112. It means the cost of goods sold for company B. This is again, this is under company B. Let me differentiate. This is cost of goods sold company B 112. Now bear in mind, if they have 160, they sold 70%, 30%. It's still sitting in their inventory at 48,000. Now, why am I mentioning this? Well, because both of these figures, when we consolidate both of these figures, the 112 and the 48 are inflated. Also make a note of this and you're going to see how we're going to fix this problem. Now I'm going to go a step further. I'm going to go a step further and show you how much was the sales amount. Usually on the CPA exam, they don't ask you this, but I want to show you what was the sales amount. What was the journal entry that the sub did? Usually they don't go into this details in your CPA review course. But the point is you might need this details in order to understand. So let's see, B sold at a profit margin of 25%. Here's what we know. We don't know what the sales amount is. We're going to call it X. X, which is sales minus cost of goods sold, which is giving from the 70% of the inventory that we have equal the profit margin is 0.25 of X. Now all you have to do is solve for X and when you solve for X, you find out that X equal to 149,333. You simply subtract 0.25 X from both sides and you will add 112 for both end and you will find out. And then you solve and you would solve for X and X equal to 149,333. Company B will credit sales, will debit account receivable to an outside party, which is a legitimate sale. They will debit cost of goods sold for 112 and they would reduce their inventory by 112. So just make a note of this that they had company B had inventory of 160, now they reduced it by 112. Therefore on company B, just since they keep track of each company separately, just I want you to keep track of this. I want you to see the big picture. So if we take 160 minus 112, we will see that company B make a note of this. They still have 48,000 of inventory, which is an inflated figure. We'll take care of that shortly. Now, let's start with the easy-peasy eliminating entry. We need to eliminate the account receivable for the sub against the accounts payable for the parent. Done with this. So this is basically done. Okay, that's done. Now, this is what we did on the prior slide. Now let's go ahead and prepare the eliminating entry. What is the problem here? Let's look at the problem and try to solve them problem by problem. Well, the intercompany sales cost of goods sold and profit should be eliminated. This is already gone. We said this is already gone from the prior slide, right? Now, this number has to be gone. This is sales intercompany sales. This number has to be gone cost of goods sold. And also remember 160 minus 125 gave us profit of 35. This is an intercompany profit. Well, it is and it's not. It is an intercompany profit, but some of the goods were sold to an outsider. Okay, so we're going to remove the sales. We're going to look at the journal entry momentarily. Remove the sale, remove the cost of goods sold and remove the profit. Now, bear in mind the elimination of the sales is easy. The elimination of the cost of goods sold is easy as well. However, when it comes to the profit, we're going to have to be very careful. Why? The elimination of the profit is a little bit more complicated as we need to separate the profit on the goods sold to a third party, which is a legitimate profit we need to keep. And the profit that's still intercompany profit, same thing with cost of goods, same thing with inventory. We need to keep the inventory that is net of the profit amount. Net means you have to take the profit out of the inventory by reducing the inventory. Let's go ahead and start the journal entries, which is going to clarify everything that we talked about in those three steps. First, debit sales, 160,000. This sales was an intercompany. It's gone. Credit cost of goods sold, gone. This is for 125,000. Now, remember, this cost of goods sold is also overstated. Why? Because this cost of goods sold include profit from the parent company. How do we resolve this? Well, cost of goods sold is 112. Remember, 21.875% is the profit that A added to us. So what do we have to do? We have to back out. So we'll take cost of goods sold multiplied by the gross profit percentage. So simply put, we have to reduce this cost of goods sold 24,500. Now, in your CPA review course, they might combine those two figures and not really show you where they're coming from. I would rather show you that you are eliminating two cost of goods sold. One for the sub and one the cost of goods sold that I told you it was inflated up front. We're not done yet. We are still inflated. First of all, the journal entry does not balance. We are also inflating the inventory. Remember, we had 48,000 of inventory left on the sub, which is company B. Of that amount, 21.875 is profit. I have to reduce my inventory by this amount, which is 10,500. So what I did is I removed my intercompany sales. I removed my intercompany cost of goods sold. I reduced my cost of goods sold to kind of take the profit out and I reduced my ending inventory. Everything is a reduction. Let's summarize. Let's try to kind of basically, basically kind of I like to prepare what's called the reconciliation to make sure I want you to see this whole thing. What's the consolidated ending inventory? Well, the consolidated ending inventory, remember company B had 48,000 of ending inventory. Then we have to deduct 10,500 out of it. So the ending inventory consolidated inventory from this is 37,500. And basically, if you want to also what you could do, you could take 160 minus 125 minus the inventory you're going to get to 37,000 minus 112. You're going to get to 37,500. Also, your cost of goods sold. What's your consolidated cost of goods sold? Well, we started with 125. Then when company B sold cost of goods sold, they added 112. Then when we consolidated, we took out the 125. We subtracted, we subtracted the 125. So this 125 and this 125 is done. Then we deducted again from the cost of goods sold of company B 24,500. Therefore, ending cost of goods sold and the consolidated from this transaction is 87,500. Hold on a second. So my ending inventory is this much consolidated and cost of goods sold this much. Let's add those two numbers together. If we add 87,500 plus 37,500, they're going to add up to 125,000. Hold on a second. This was the original goods that company A gave up. Exactly. And this 125, this 125, some of it is sold, which was expensed as cost of goods sold 87,500 based on company A cost. And some of it's still an ending inventory 37,500 based on A cost. So everything when we consolidate, revert back to as if company A never sold, did not sell it internally. And this is exactly what we did. And notice it will reconcile. Okay. Now, what should you do now? Go to farhatlectures.com and work MCQs and exercises that's going to help you understand this topic better. If you're not a subscriber, invest in yourself. Don't shortchange yourself. I can help you understand it a little better, little differently, and that might be enough to get you there. Good luck. Study hard and stay safe.