Exam 5: Consolidated Financial Statements Intra-Entity Asset Transactions

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In intra-entity transfers, a transfer price often exceeds the underlying cost of the inventory. Hence, the seller recognizes gross profit on its books that, with respect to the entire controlled group, is deferred until the asset is consumed or sold to an outside party. Any unrecognized intra-entity gross profit on merchandise still held by the buyer must be eliminated for consolidated financial statement purposes. With respect to the year of transfer, this consolidation procedure requires unrecognized intra-entity gross profit be deducted from the inventory account on the balance sheet, and from the ending inventory balance within cost of goods sold. In the year following the transfer (if the goods are resold or consumed), the unrecognized intra-entity gross profit must again be deducted for purposes of the consolidated financial statements. This second reduction is recorded on the worksheet as a reduction to the beginning inventory component of cost of goods sold, as well as to the beginning retained earnings balance of the original seller. This functions to defer the recognition of gross profit from the year of transfer to the year the underlying asset is consumed or sold to an unrelated third party. If the transfer was made on a downstream basis, and the parent company applied the equity method of accounting, a subsequent year adjustment must be recorded in the subsidiary investment account as opposed to the retained earnings account.