Question

Water Products Corporation has been supplying high-quality bathroom fixtures to its customers for several decades and uses a LIFO inventory system. Rapid increases in the cost of fixtures have resulted in inventory values substantially below current replacement cost. To bring its inventory carrying costs up to more reasonable levels, Water Products sold its entire inventory to Plumbers Products Corporation and purchased an entirely new supply of inventory items from Growinkle Manufacturing. Water Products owns common stock of both Growinkle and Plumbers Products.

Research  Water Products' external auditor immediately pointed out that under some ownership levels of these two companies, Water Products could accomplish its goal and under other levels it could not.

Required:

Explain to Water Products' president the effects of intercompany transfers on the valuation of inventories and discuss the effects that different ownership levels of Growinkle and Plumbers Products would have on the success of Water Products' plan. What are some possible ethical considerations involved, if any?

Answer 1

Explanation of case : As per accounting standards, inventories must be recognized at cost or net realizable value (i.e. current replacement cost). In the given case water products corporation (WPC) sells its stock to Plumbers product corp (PPC) and buys new stock from Gowinkle Mfg. (GM)

Effects of transctn: WPC sells stock to PPC at cost + Gross margin (mark up) hence stock value in the books of PPC will increase also it buys the stock from GM at GM's cost plus markup hence stock in the books of PPC and WPC will reflect reasonable value due to this transaction. However, stock in the books of GM Will reduce and also GM and WPC will book inter company profits which is not actually a profit at group level and hence they may have to pay additional taxes on these profits.

This was the explanation about effects on accounting and taxation, now on ethical side as the stock is moving within same management companies transfer pricing norms to be followed strictly, and also the transaction value must be calculated appropriately, it must not be influenced on the virtue of relation. Transaction value must be as per market standards or computed as per transfer pricing norms.

Further such transactions are called as "Related party Transactions" and hence to be reported appropriately to shareholders in board's report and in financial statements.