Advanced Financial Reporting – Module 5

Contents
Advanced Financial Reporting – Module 5 ........................................................................... 1
Lesson 5.1 Accounting Acquisition Premium (AAP)........................................................ 1
Lesson 5.2 The Effect of AAP on Consolidated Financial Statements ............................. 5
Lesson 5.3 Consolidated Financial Statements with AAP–Part 1 ................................... 15
Lesson 5.3 Consolidated Financial Statements with AAP–Part 2 ................................... 22
Lesson 5.4 Intercompany Inventory Transactions ........................................................... 28

Lesson 5.1 Accounting Acquisition Premium (AAP)

In Module 2, we discussed how to prepare the consolidated balance sheet on a business

combination data. Now, in Module 5, we will discuss how to prepare the consolidated
financial statements subsequent to the acquisition date. The lesson number 1 will be about
accounting acquisition premium.
The difference between the fair value of the consideration transferred within a business
combination, and the book value of net assets acquired is called accounting acquisition
premium. We will call it in this course just AAP. So, fair value of consideration transferred
minus the book value of net assets acquired, the difference is the accounting acquisition
premium. What are the reasons for this difference? Can we identify the reasons for the
accounting acquisition premium?

As was previously discussed in Module 4, on the business combination data, the fair values
of assets and liabilities of the subsidiary may differ from their book values on the subsidiaries
books. The difference between the fair value of assets and liabilities acquired and their book
value is the identifiable portion of AAP. The remaining amount of the AAP that was not
identified– the unidentifiable portion of AAP–is the goodwill.
So, fair value of the consideration transferred minus the book value of net assets acquired is
the total amount of AAP. This total amount of AAP is allocated between the identifiable
portion of AAP, and the
unidentifiable portion of the AAP which is the goodwill.

So, let's see the following example. On January 1, 2018, company P paid $100 thousand for
all of the outstanding shares of common stock of Company S. Assume that on the acquisition
date, Company S had reported equity was $75 thousand.

The book values of all the assets and liabilities of Company S equal their fair values except
for the following. So, we have the difference between the fair values and the book values
only for the following three items: Equipment fair value of $50 thousand, the book value on
the subsidiaries books $55 thousand, land fair value $40 thousand and the book value was
$20 thousand, and accounts payable– a liability–with a fair value of $15 thousand and a book
value of $11 thousand.
First of all, let's calculate the total AAP. The total AAP is calculated as fair value of the
consideration transferred of $100 thousand minus the book value of identifiable net assets
acquired of $75 thousand. So, the total AAP is $25 thousand. Since assets equal liabilities
plus equity, the book value of net assets which is assets minus liability is exactly the equity of
the company.

After we calculated the total AAP, we can calculate the identifiable portion of the AAP. The
identifiable AAP. The identifiable AAP is calculated as the difference between the fair
values and the book values of all the identifiable assets acquired and liabilities assumed.

So, let's start with equipment. The fair value of the equipment was $50 thousand. The book
value was $55 thousand. So, we have a negative AAP for an equivalent of $5 thousand. Then
land, the fair value was $40 thousand. The book value was $20 thousand. We have a positive
AAP of $20 thousand for the land. Now, accounts payable. Please note, when I calculate
identifiable AAP for liabilities, they must be included as negative amount in this calculation.
So, the fair value of the liability is negative $15 thousand, the book value is negative $11
thousand, and the difference is a negative difference of $4 thousand.

All in all, we got the total identifiable positive AAP of $11 thousand. After we calculate the
identifiable portion of the AAP, we can calculate the remaining– the unidentifiable–AAP.
Since the total AAP was $25 thousand, and the identifiable portion of the AAP is $11
thousand, the difference is the unidentifiable AAP of $14 thousand which is the goodwill.
Also just to be on the safe side, you always can calculate the goodwill using the goodwill
equation. So, let's use the goodwill equation to calculate goodwill. Fair value of consideration
transferred of $100 thousand minus the fair value of identifiable net assets acquired.

In this specific situation, we know that the book value of net assets was $75 thousand. I also
know that $11 thousand is the excess of fair value over the book values. Plus $11 thousand
excess of fair value of assets over the book value. We will get $86 thousand. So, one more
time we calculated the goodwill as $14 thousand.
Lesson 5.2 The Effect of AAP on Consolidated Financial

Statements

In Lesson 2, we will discuss the effect of Accounting Acquisition Premium– the AAP–on the
consolidated financial statements reported by the parent company. When we discussed the
consolidation process, the first step was to combine the separate financial statements of the
parent company with the financial statements of the subsidiary.
We know that in the consolidated financial statements, the assets acquired, and the liabilities
assumed from the subsidiary must be reported based on their acquisition date fair values.

But on the subsidiaries books, the assets and liabilities are not reported based on the
acquisition date fair value.

Thus, consolidation adjustments are needed. So, let's discuss this adjustment in the following
example. On January 1, 2018, Company P acquired 100 percentages of Company S. On
the acquisition date, equipment was reported on Company S books at $50 thousand, while its
fair value was $110 thousand. The equipment is depreciated using the straight-line
depreciation method over its remaining useful life of 10 years.
What consolidation adjustments in respect to this equipment should be done by Company P
when it prepares its December 31, 2018 consolidated financial statements?

Company S reported in its 2018 income statement, depreciation expense for this is equivalent
of $5 thousand. The book value of this equipment was $50 thousand, and the remaining
useful life was 10 years.
However, in the consolidated income statement, depreciation expense for this equipment
must be reported at $11 thousand. Why? Because the acquisition date fair value of the
equipment is $110 thousand and the remaining useful life was 10 years. As usual, the first
step of the consolidation process is to combine the financial statements of the parent and
subsidiary.

Thus, the consolidation adjustments on December 31, 2018 will be to increase the
depreciation expense by $6 thousand. Because, it should be in the consolidated financial
statements, $11 thousand. Currently reported on Company S books, $5 thousand. So, the
adjustment increased depreciation expense.
This adjustment is exactly the amortization of the AAP for the equipment in 2018.

As we discussed, the AAP is the difference within the fair value and the book value of an
asset or liability. On the acquisition date, a positive AAP for the equipment was $60
thousand. $110 thousand fair value of the equipment minus $50 thousand a book value of the
equipment.
The remaining useful life of the equipment was 10 years. So, the AAP is amortized as the
asset is realized through this sale or depreciation. Thus, the annual amortization of the AAP
for the equivalent is $6 thousand. $60 thousand was the total AAP and the remaining useful
life, 10 years. Please note $6 thousand–this is exactly the consolidation adjustment to the
depreciation expense.

When we prepare the consolidated financial statements– subsequent to the acquisition date–
relevant expense account must be adjusted for the amortization of AAP.
Amortization of positive AAP increases the relevant expense account, while amortization of
negative AAP decreases the relevant expense account. What is the meaning of relevant
expense account? Relevant expense account means the expense account that is associated
with the assets or liabilities for which the AAP was amortized. For example, when the AAP
for inventories is amortized, the cost of goods sold income statement account is adjustment.
When the AAP for intangible asset is amortized, the amortization expense income statement
account is adjusted.

Using the data from the previous example, what should be the consolidation adjustment to the
carrying amount of the equipment on December 31, 2018?
On December 31, 2018, the equipment is reported on Company S books at $45 thousand. $50
thousand was the carrying amount on January 1, 2018 and $5 thousand was the depreciation
expense in 2019.

However, in the consolidated financial statements, these equipment must be reported based
on its acquisition date fair value of $110 thousand. Thus, in the consolidated financial
statements on December 31, 2018, the equipment must be reported at $99 thousand. Because
the acquisition date fair value of the equipment on the business combination date, January 1,
2018 was $110 thousand, and in the consolidated financial statements, depreciation expense
of $11 thousand was recognized in 2018.
The consolidation adjustment is to increase the carrying amount of the equipment by $54
thousand, because it should be in the consolidated financial statements, $99 thousand.
Currently report on Company S books, $45 thousand.

Please note $54 thousand–it is exactly the remaining balance of the AAP for the equipment
on December 31, 2018.
The AAP of the equipment on January 1, 2018 was $60 thousand. In 2018, $6 thousand of
AAP was amortized. So, the remaining amount of AAP at the end of the year is $54
thousand. So, as we can see, the remaining balance of the AAP, often assets or liability, is the
consolidation adjustment to the carrying amount of this assets or liability.

Remaining positive AAP is debited, increases the carrying amount of an asset, or decreases
the carrying amount of a liability.
Remaining negative AAP is credited, decreases the carrying amount of an asset, or increases
the carrying amount of a liability.

Lesson 5.3 Consolidated Financial Statements with AAP–Part 1

In Lesson 3, we will discuss how to prepare the consolidated financial statements with
account acquisition premium. Let's see the following example. On January 1 of 2018,
Company P paid $5,500 for all of the outstanding shares of common stock of Company S. On
the acquisition date, Company S reported equity of $3,500 and the book values of all its
assets and liabilities equaled their fair values except for building and equipment.
The building had a fair value of $4,000 and a carrying amount of $2,000, and it's remaining
useful life was 10 years. The equipment had a fair value of $2,500 and a carrying amount of
$3,000, and its remaining useful life was five years.

Company S depreciates its assets using the straight-line depreciation method. Assume the
acquisition was a taxable transaction. Since the acquisition is a taxable transaction, no default
taxes are recognized on the acquisition date.
The following are the separate financial statements of Companies P and S on December 31 of
2018, one year subsequent to the acquisition date. As usual, we need to prepare the five
columns consolidations spreadsheets. The first two columns are the separate financial
statements of the parent and the subsidiary, then debits and credits for consolidation
adjustments, and the last column will be the consolidated financial statements.

The first step of the consolidation process is to combine the financial statements of the
subsidiary with the separate financial statements of the parent company. So we will record
the income statement and a balance sheet of the subsidiary in a debit and a credit form. Please
note that in this journal entry, the beginning of the year balance of the retained earnings was
added. Since the beginning retained earnings plus the net income for the period, which is the
entire income statement minus the dividend declared is exactly the ending balance of the
retained earnings. So basically, we record the financial statement of the subsidiary in a debit
and a credit form.
After the P plus S step, now we need to make the necessary consolidation adjustments to
prepare the consolidated financial statements. First of all, we need to calculate the goodwill
that was recognized on the acquisition date. Now, let's calculate goodwill as unidentifiable
AAP. So first of all, let's calculate the total AAP as fair value of the consideration transferred
minus the book value of net assets of the subsidiary, 5,500 minus 3,500, I will get the total
AAP of $2,000.

The next step is to allocate the total AAP between the identifiable portion, identifiable AAP
and the unidentifiable AAP. We know that the identifiable AAP is the difference between the
fair values and the book values of identifiable assets and liabilities of the subsidiary.

In this specific case, we have difference only for two assets, for the building and equipment.
The fair value of the building was $4,000. The book value was 2,000. So I have a positive
AAP for the building of $2,000. The fair value of the equipment was $2,500 and the book
value was 3,000. So I have a negative AAP for the equivalent of $500. The total identifiable
AAP is 1,500. Since the total AAP is 2,000 and the identifiable AAP is 1,500, the remaining
amount, the unidentifiable AAP, which is the goodwill is $500.
Using the goodwill equation, we will get exactly the same amount of goodwill. Fair value of
the consideration transferred was $5,500. The fair value of identifiable net assets is $5,000.
The book value of net assets was 3,500 and the excess of the fair value over the book value of
assets acquired was $1,500, so the difference is a positive difference of $500, which is
goodwill.

We know that the consolidated income statement is adjusted for the amortization of AAP in
this year and the consolidated balance sheet should be adjusted for the remaining amount of
AAP in the end of the year. Thus, amortization table of AAP should be prepared.

The following is the amortization table of AAP. The first column is the beginning amount of
AAP, then amortization of the AAP in the current year, and then I have the remaining amount
of AAP. So for the building, the initial amount of AAP was $2,000, remaining useful life
was 10 years. So $200 of AAP was amortized in 2018 and the remaining amount of AAP is
1,800. The initial amount of AAP for equipment was $500 negative, remaining useful life
was five years. So 100 of negative AAP for the equipment was amortized in 2018.

The remaining amount of the AAP at the end of the year is negative 400. Then, goodwill of
$500 was recognized on the business combination date. We know that goodwill is an
intangible asset with indefinite useful life, and goodwill is never amortized. So the remaining
amount of AAP for goodwill is $500 at the end of the year.

In 2018, depreciation expense should be increased by $200 for the amortization of positive
AAP for the building and decreased by $100 for the amortization of a negative AAP for the
equipment. Thus, the total effect on the depreciation expense is an increase of $100. So the
consolidation adjustment for amortization of AAP will be an increase in depreciation expense
of $100. We will debit depreciation expense for $100.

In addition, at the end of 2018, the carrying amount of the building should be increased,
debited for its remaining positive AAP of 1,800, and the carrying amount of the equipment
should be decreased credited for its remaining negative AAP of $400. Also, let's not forget
about goodwill. Goodwill must be reported in the consolidated balance sheet. Thus, goodwill
is debited for $500. So the following are the adjustments: building increased by 1,800,
equipment decreased by 400, and goodwill is increased by $500.
Now, let's discuss the consolidation adjustments for dividends declared. Dividends declared
by the subsidiary were received by the parent company. These are not real dividends since no
dividends were paid to the shareholders of the consolidated group and no cash was paid
outside of the consolidated group. Thus, dividends paid by the subsidiary must not be
reported in the consolidated financial statement and they have no effect on the consolidated
retained earnings account. Only dividends paid by the parent company decrease the retained
earnings account reported in the consolidated balance sheet.

Thus, the consolidation adjustments will be dividends declared by the subsidiary must be
removed, credited.
Dividends received from the subsidiary cannot be recognized as an income in the
consolidated financial statements. Consolidated financial statements are reported as if the
parent and the subsidiary is this single economic entity, basically one company. Thus,
dividend income from the subsidiary must be removed, debited.

Lesson 5.3 Consolidated Financial Statements with AAP–Part 2

The starting point of the consolidation process is to combine the separate finance standards of
the parent with the separate financial standards of the subsidiary. So in respect to sales, no
adjustment should be made because we didn't have any inter-company sales in the current
year. The same idea for the cost of goods sold. P plus S together, $4.4 thousand.
We didn't have any inter-company sales and no amortization of AAP for inventory.
Depreciation expense in this specific year, we amortize the AAP for a building and
equipment. The total watts amortization of a positive AAP of $100. So we will increase the
depreciation expense for $100. The total amount in the consolidated financial statements,
1,800 interest expense. No adjustments should be done this year. So P plus S, 1,100.

Now dividend income. Please note, this entire amount of dividend income of
$1,000 was received from the subsidiary because the subsidiary declared and paid $1,000 of
dividends. Obviously these are inter-company dividends. We cannot recognize dividend
income from dividends from the subsidiary, because the parent and subsidiary are a single
economic entity. So we must remove the dividend income from the subsidiary. I will debit
dividend income for $1,000 and nothing is reported in the consolidated financial statements.
So we calculated the total consolidated net income of 3,700. Now, let's calculate the retained
earnings that should be reported in the consolidated financial statements.
The retained earnings at the beginning of the year on January 1st, 2018 is the retained
earnings of the parent company. Why? Because January 1st, 2018 is the business
combination date. Only on a business combination date, the equity in the consolidated
financial statements, are the equity accounts from the separate financial statements of the
parent. So 1.5 thousand exactly as the retained earnings of the parent company. So we must
remove retained earnings of the subsidiary and we will debit retained earnings from the
subsidiary for $500.

We just calculated the consolidated net income, and we know that the consolidated net
income for the period increases the retained earnings. One more time, only dividends
declared and paid by the parent company decrease the retained earnings account. Dividends
declared by the subsidiary are not real dividends, because no cash was paid outside of the
consolidated group. So we must remove credit dividends declared by the subsidiary and only
dividend declared by the parent decrease the consolidated retained earnings.

So we calculated the ending amount of retained earnings at 4,400 and we can insert it into the
balance sheet. Retained earnings for 4,400. Cash, no adjustment should be done to cash.
People assess together 3.5 thousand. Inventory, again, we didn't have any inter-company
inventory transactions, no amortization of AAP for inventory. So we can just combine P plus
S and we'll get 3.8 thousands. Building net amount, we know that we have any remaining
AAP for rebuilding. The remaining AAP is 1,800. Since the fair value of the building was
greater than the book value of the book on the business combination day, we will add the
remaining AAP of $1.8 thousand.

The total amount in the consolidated financial statements is 6,600. Now, equipment net
amount, we have a remaining AAP for an equipment of $400, since on the business
combination date, the fair value of the equipment was lower than the book value of the
equipment. We will decrease the equipment for the remaining AAP. So we'll credit it for
$400 and the amount that should be reported in the consolidated financial statements is
$6,000.
Now, no investment in subsidiary accounts should be reported in the consolidated financial
statements. So we must remove the investment in the subsidiary account and we will credit
5.5 thousands. So nothing will be reported in the consolidated financial statements. Let's not
forget to add the goodwill, because we know that goodwill must be reported in the
consolidated financial statements. On a business combination date, a goodwill of $500 was
recognized. So let's debit goodwill for $500.

We calculated the total assets in the consolidated financial statements, at 20,400. Accounts
payable, no adjustment should be done. The same idea for bonds payable, just P and S and
common stock in additional paid-in-capital. We know that we cannot report the equity
accounts of the subsidiary in the consolidated financial statements. So we must remove the
equity accounts of the subsidiary. We will debit $500 for common stock and we will debit
$2.5 thousand for the additional paid-in capital of the subsidiary. One thousand will be
reported in the consolidated financial statements for common stock and 5,000 will be
reported for the additional paid-in capital. All in all, the liabilities plus equity also equals
20,400.
Let's just double-check that my consolidation journal entries balanced. All the debits equals,
6,900 and all the credits equal 6,900. So my consolidations journal entry is balanced.

Now we can just recall it and then debit in a credit format.

So the following consolidation journal entry is recorded on December 31st, 2018.
Depreciation expense is debited for $100 dividend income from the subsidiary is removed
debited for $1,000. We must remove the beginning amount of retained earnings from the
subsidiary of $500. Building net amount is increased debited for $1.8 thousand for the
remaining positive AAP. Goodwill must be recognized in the consolidated financial
statements. So it is debited for $500. Now we must remove the equity of the subsidiary at the
end of the year. So the common stock of the subsidiary is debited for $500 and the additional
paid-in capital of the subsidiary is debited for $2.5 thousand.

Also as we previously discussed, dividend declared by the subsidies are not real dividends.
So we must remove credit dividends declared by the subsidiary for $1,000. Then equipment
must be decreased credited for $400 for the remaining negative AAP and obviously, an
investment as a subsidiary account must not be reported in the consolidated financial
statements. So we will credit the investment in subsidiary for $5.5 thousand. Obviously my
consolidation journal entry is balanced.
Lesson 5.4 Intercompany Inventory Transactions

In lesson four, we will discuss the consolidation adjustments for Inter-company inventory
transactions. The parent company and a subsidiary company, may be involving many Inter-
company transactions, such as sales of inventory, or items of property plan and equipment.
The transaction that reach the parent company sold something to the subsidiary is called a
Downstream Transaction.

The transaction in which the subsidiary sold something to the parent company is called an
Upstream Transaction.

We know that consolidated financial statements are reported as if the parent and subsidiary
are a single economic entity, basically one company.
Thus only transactions with parties outside of the consolidated group are reported in the
consolidated financial statements. No income from Inter-company Transactions can be
recognized in the consolidated financial statements, until it has been realized in a transaction
with the non-affiliated third party.

In respect to all the Inter-company Transactions, they are basically have only one simple rule.
In the consolidated financial statements, all the accounts are reported as if the Inter-company
Transaction had never happened.
So let's see how we can apply this rule to the following Inter-company Inventory Transaction.
Company P holds 100 percentage of company S. On January 1 Of 2018, company P
purchased $200 of inventory from a non-affiliated third party company A. In the same year in
2018, company P sold this inventory to company S for $500, and also in the same year in
2018, S sold this inventory to non-affiliated third party company B for $900.

In respect to this inventory transactions, the following balances were reported in the separate
financial statements of companies P and S on December 31 of 2018. So accompany P report
itself for $500 on the sale of this inventory to company S, company S reported sales of $900
on the sale of this inventory to company B. The cost of goods sold reported by company P
was $200, and the cost of goods sold reported by company S was $500.
So we have the following situation. Company P holds 100 percentages of company S. In
2018, company P acquired inventory from a non-affiliated third party company A for $200.
So inventory was purchased for $200. In the same year in 2018, company P sold the
inventory to company S for $500.

So the Inter-company Inventory Profit recognized by company P on this transaction is $300.

The Inter-company Inventory Profit, and we call the Inter-company Inventory Profit, the IAP,
Inter-company Inventory Profit on this transaction was $300, because company P sold this
inventory to company S for $500, while the cost of this inventory to Company P was only
200. Also in the same year in 2018, company S sold the inventory to some non-affiliated
third party company B for $900. So this inventory was sold by company S for $900.

Now, let's see this specific situation. We know that company P holds 100 percentage of
company S. So basically, weaned company P and S is a single economic entity. Single
economic entity, let's just call it the consolidated group. We know that in the consolidated
financial statements, all the accounts must be reported as if the Inter-company Transactions
had never happened. So from the consolidated financial statements perspectives, it's like the
group acquire this inventory for $200 in 2018, and in 2018, the group sold this inventory to
company B for about $900.

This transaction between P and S had never happened. If this is the case, in the consolidated
financial statements, the sales account should be reported at $900, should be reported at $900,
and cost of goods sold at $200, because the group purchased this inventory for $200.

So adjustment number one for Inventory Inter-company Transactions is to remove the Inter-
company cells in the current year.

Thus, both sales and cost of goods sold account must be decreased by the amount of Inter-
company cells in this year. Sales account is debited, and cost of goods sold account is
credited for $500.
Using the data from example number one, now assume that company S sold this inventory to
company B only 2019 instead of 2018. The consolidated financial statements are reported as
if the Inter-company Transactions had never happened. So the group acquired the inventory
for $200 and did not sell it in 2018.

So no sales and cost of goods sold accounts should be reported in the consolidated financial
statements. The inventory should be reported at $200 for the amount company P acquired this
inventory from company A. Thus the adjustments are decreased, debit sales for $500,
decrease credit cost of goods sold for $200, and decrease credit inventory for $300.
The Intercompany Inventory Profit, IIP recognized in 2018 was $300. Company P purchased
the inventory for $200 and sold it to company S for $500. No income from intercompany
transactions is recognized in the consolidated financial statements until it has been realized in
a transaction with the non-affiliated third party. Since this inventory was not sold by the end
of 2018, the ending inventory of IIP on December 31st, 2018 of $300 is eliminated.

So the adjustment number 2 for intercompany inventory transactions is to increase cost of

goods sold account and decrease inventory account by the amount of ending Intercompany
Inventory Profit, ending IIP.
Cost of goods sold account decreased by $200, a decrease of $500 or for the intercompany
sells in 2018, and an increase of $300 for the ending amount of IIP. The inventory was
decreased by $300 for the ending IIP.

In 2019, company S sold the inventory to a non-affiliated third party, company P for $900. So
in the consolidated financial statements, this transaction is treated as if the group sold
the inventory for $900, and the cost of this inventory to the group was only $200. Thus, sales
should be reported at $900. As we can see, no adjustments should be done to the sales
account. Since there were no intercompany sales in 2019, the cost of goods sold should be
$200, and no inventories reported since it was sold.

The only adjustment in 2019 is to decrease cost of goods sold by $300. The Intercompany
Inventory Profit, the IIP at the end of 2018 was $300.
Thus, this is the beginning amount of IIP in 2019. Since this inventory was sold in 2019, the
entire beginning amount of IIP of $300 is realized in 2019.

The adjustment number 3 for the intercompany inventory transactions is to decrease cost of
goods sold account by the amount of beginning IIP.
So in order to make all the necessary consolidation adjustments to sales, cost of goods sold,
and inventory accounts, we need to calculate the following three numbers.

Number 1, the intercompany sales in the current year. We know that the intercompany sales
in the current year decreased sales and cost of goods sold accounts. Also number 2, ending
IIP. Ending IIP increases cost of goods sold and decreases inventory. The third one is the
beginning amount of IIP. The beginning amount of IIP decreases the cost of goods sold
account.
The parent and subsidiary, maybe involving hundreds or thousands of intercompany
transactions. Thus, it might be very difficult to calculate the intercompany inventory profit
for each single separate sale.

The ending amount of intercompany inventory profit can be calculated as inventory

remaining on the purchaser's books multiplying by the gross profit percentage of the seller.
Let's see the following example. Company P holds 100 percentages of company S. Each
company routinely sells inventory to the other company.

During 2018, company P sold 20,000 of inventory to companies, with a profit margin of 25
percentages on the selling price. Twelve thousand of this inventory remains in December
31st, 2018 inventory of company S.
During 2018, company S sold 50,000 of inventory to company P, with a profit margin of 20
percentage of the selling price. Fourteen thousand of this inventory remains in December
31st, 2018 inventory of company P. Twenty five thousand of this intercompany sales is still
unpaid in the end of 2018.

As was previously discussed, to make the consolidation adjustments for the intercompany
inventory transactions, we need to calculate the intercompany sales in 2013, the December
31st, 2018 ending IIP, and the January 1st, 2018 beginning amount of IIP.
So let's calculate these three numbers. Intercompany sales in 2018 was $70,000, 20,000 plus
the 50,000. The ending amount of IIP at the end of 2018 was 5,800. Twelve thousand of
inventory is still on company's S books. The 25 percentages was the profits percentage
margin of company P. Plus $14,000 was the inventory on company's P books at the end of
the year, and 20 percentages was the profit margin of company S. The beginning amount
of IIP was zero, we don't have any information about intercompany transactions at the
beginning of the year.

So the year end, December 31st, 2018 consolidation adjustments are; sales account is
decreased, debited by $70,000. Cost of goods sold account decreased, credited by 64,200.
Decreases of $70,000 for intercompany sales and increase of $5,800 for the ending amount of
IIP. The inventory account is decreased, credited by $5,800.

As a result of the intercompany transactions, the inventory at the end of the year is
overstated. We must reduce the inventory back to its original cost as if the intercompany
transaction never happened. In order to reduce it back to its original cost, we must remove the
profit we see in this inventory. So we must remove, decrease the inventory by the
intercompany profit in this inventory.

In our example, at the end of the year, company P still owes company S $25,000 for the
purchase inventory. That's in its separate financial statements. In the end of the year,
company P reports accounts payable to company S of $25,000 and company S report in its
financial statements accounts receivable from Company P of $25,000. These are
intercompany balances.

In the consolidated financial statements, we must remove the intercompany balances.

Otherwise, the assets and liabilities will be overstated. The consolidation adjustment is to
decrease debit accounts payable and decrease credit accounts receivable by $25,000. So the
consolidation adjustment remove the intercompany balances.