Question

On 1 July 2018, Sunflower Ltd acquired 90% of the share capital to gain control of Palm Ltd. The following intra-group transactions occurred during the year ending 30 June 2019. (i) During the 2018 - 2019 period, Sunflower Ltd sold inventory to Palm Ltd for $1600,000. Sunflower Ltd purchased this inventory at $1000,000. By 30 June 2019, Palm Ltd has sold 70% of that inventory to third party.

(ii) Palm Ltd declared a final dividend of $1300, 000 from current year’s profits.

(iii) Palm Ltd paid Sunflower Ltd, a fee for administrative services they provided of $40,000. (iv) Palm Ltd has an intra-group loan with Sunflower Ltd. Sunflower Ltd provided a loan of $10,000,000. The loan charges 4% interest annually. One half of the interest for the current year remains unpaid at 30 June 2019.

(v) Palm Ltd sold a land to Sunflower Ltd for $560000. The land was purchased by Palm Ltd at $ 300000.

Required:

(a) Prepare the journal entries required to eliminate the intra-group transactions above.

(b) When are profits realised in relation to inventory transfers within the group? (1 mark)

(c) What are the rules for the elimination entry for intra-group transactions relating to dividend declared by the parent company and dividend declared by the subsidiary company? (1 mark)

Answer 1

(a) Journal entries for elimination:

1. Elimination of unrealized profit on inventory:

Since 70% of the inventory has been sold to a third party, the balance 30% inventory will inherently have "unrealised profit" of Sunflower. This is due to the fact that Sunflower's sales will show a profit, but those inventory have not yet been sold as they are still lying with Palm. This profit will be computed as follows:

Total Inventory Left (%) = 30%

Therefore, 30% of (1,600,000 - 1,000,000) = 180,000 is the unrealised profit on the inventory. Hence, the following entry will be passed to reverse the profits:

Accounts title	Debit	Credit
Cost of Goods Sold	$180,000
Closing Inventory		$180,000

2. Elimination of dividend payable by Palm and dividend receivable by Sunflower:

Accounts title	Debit	Credit
Dividend Payable (Liability) (1,300,000 * 90%)	$1,170,000
Dividend Receivable (Asset)		$1,170,000

3. Elimination of administrative expense and service fee income:

Accounts title	Debit	Credit
Service fees (Income)	$40,000
Administrative expense (Expense)		$40,000

4. Elimination of interest expense, payable and borrowings:

Loan Payable (Liability)	10,000,000
Loan Receivable (Asset)C		10,000,000
Interest Income (Income) ($10,000,000 * 4%)	400,000
Interest Expense (Expense)		400,000
Interest Payable (Liability) (400,000 * 1 / 2)	200,000
Interest Receivable (Asset)		200,000

5. Sale of land worth 560,000 (cost is 300,000):

Profit on sale of land (Income)	260,000
Land (Asset)		260,000

(b) Profit accounting for inventory transfers within the Group:

In case of Consolidated Financial Statements, profits on inventory sold within the Group are not technically profits of the Group. Its like one family member making sales to another family member. Since consolidated financial statements are the financial results of the family as whole, it makes no difference if the transactions are within the family.

As a result, profits or losses will only occur when there are transactions with third parties. Therefore, if there is any inventory as at the year-end in the Balance Sheet, the actual profits will only be realized when the inventory are sold to a third party.

(c) Elimination of dividends declared by the Parent and Subsidiary:

In case of dividends declared by the Subsidiary, it will need to be eliminated as we have done above. This is similar to the example where one family makes a sale to another family member. It makes no difference to the family as a whole. As a result, one needs to eliminate only the dividends pertaining to the Parent's ownership (in the above case 90%). This is because the balance 10% are paid to external investors (minority investors).

When it comes to the Parent declaring dividends, the money doesn't go to the subsidiary. The money goes directly to external investors. Hence, dividends declared by the Parent will not be eliminated in the Consolidated Financial Statements