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Application and analysis exercises

Exercise 28.1

Current and prior periods intragroup transfers of inventories

Joey Ltd owns all of the share capital of Chandler Ltd. The income tax rate is 30%. The following transactions
took place during the periods ended 30 June 2022 or 30 June 2023.

(a) In January 2023, Joey Ltd sells inventories to Chandler Ltd for $45 000 in cash. These inventories had
previously cost Joey Ltd $30 000, and remain unsold by Chandler Ltd at the end of the period.
(b) In February 2023, Joey Ltd sells inventories to Chandler Ltd for $51 000 in cash. These inventories had
previously cost Joey Ltd $36 000, and are on-sold externally on 2 April 2023.
(c) In February 2023, Chandler Ltd sells inventories to Joey Ltd for $66 000 in cash (original cost to Chandler
Ltd was $48 000) and half are on-sold externally by 30 June 2023.
(d) In March 2023, Joey Ltd sold inventories for $30 000 to Zara Ltd, an external entity. These inventories were
transferred from Chandler Ltd on 1 June 2022. The inventories had originally cost Chandler Ltd $18 000,
and were sold to Joey Ltd for $36 000.

Required
In relation to the above intragroup transactions:
1. Prepare adjusting journal entries for the consolidation worksheet at 30 June 2023.
2. Explain in detail why you made each adjusting journal entry.
(LO2 and LO3)

1.
JOEY LTD – CHANDLER LTD
30 June 2023

(a) Sales revenue Dr 45 000


Cost of sales Cr 30 000
Inventories Cr 15 000

Deferred tax asset Dr 4 500


Income tax expense Cr 4 500

(b) Sales revenue Dr 51 000


Cost of sales Cr 51 000

(c) Sales revenue Dr 66 000


Cost of sales Cr 57 000
Inventories Cr 9 000

Deferred tax asset Dr 2 700


Income tax expense Cr 2 700

(d) Retained earnings (1/7/22) Dr 12 600


Income tax expense Dr 5 400
Cost of sales Cr 18 000

2. Detailed explanations on the adjusting journal entries


30 June 2023:

(a) The first adjusting entry eliminates the unrealised profit in closing inventories at 30 June
2023. As the inventories remain unsold at the end of the period, at 30 June 2023 the entire
profit on the intragroup sale is unrealised and should be eliminated on consolidation by:
- Debiting Sales Revenue with an amount equal to the intragroup price
- Crediting Cost of Sales with an amount equal to the original cost of inventories
- Crediting Inventories with an amount equal to the unrealised profit (i.e. the entire
profit on the intragroup sale).
The second adjusting entry recognises the tax effect of the elimination of the unrealised profit
in closing inventories at 30 June 2023 by raising a Deferred Tax Asset for the tax recognised
by Joey Ltd in advance on the unrealised intragroup profit.

(b) The only adjusting entry eliminates the intragroup sales revenue recognised by Joey Ltd
(on the intragroup sale) and the cost of sales recognised by Chandler Ltd (on the external sale)
as the profit on the intragroup sale is entirely realised during the current period. As the
inventories are sold by the end of the period to an external entity, at 30 June 2023 the entire
profit on the intragroup sale is realised; however, the aggregate sales revenues and cost of sales
are overstated from the group’s perspective as they include the intragroup sales revenue and
the cost of sales recognised based on the price paid intragroup by Chandler Ltd. On
consolidation, this overstatement needs to be corrected. There won’t be any tax-effect
adjustment entry as the only adjusting entry posted now does not have any net effect on the
profit or on the carrying amount of inventories.

(c) The first adjusting entry eliminates the unrealised profit in closing inventories at 30 June
2023. As half of the inventories remain unsold at the end of the period, at 30 June 2023 half of
the profit on the intragroup sale is unrealised and should be eliminated on consolidation by:
• Debiting Sales Revenue with an amount equal to the intragroup price – this eliminates the
amount recognised by Chandler Ltd on the intragroup sale, so that the consolidated figure
reflects only the sales revenues generated from transactions with external parties
• Crediting Inventories with an amount equal to the unrealised profit (i.e. half of the profit
on the intragroup sale) – this corrects the overstatement of inventories still on hand (half of
the original amount transferred intragroup) that are recorded by Joey Ltd based on the
intragroup price, making sure that those inventories are recorded at the original cost to the
group
• Crediting Cost of Sales with an amount equal to the difference between the debit amount
to Sales Revenue and the credit amount to Inventories – this eliminates the Cost of Sales
recognised by Chandler Ltd (which was based on the original cost) and adjusts the Cost of
Sales recognised by Joey Ltd (which was based on the intragroup price), so that the
consolidated figure reflects only the cost of sales of the inventories sold to the external
party based on their original cost to the group.
The second adjusting entry recognises the tax effect of the elimination of the unrealised profit
in closing inventories at 30 June 2023 by raising a Deferred Tax Asset for the tax recognised
by Chandler Ltd in advance on the unrealised intragroup profit.

(d) In this case, the unrealised profit in closing inventories from the period ended 30 June 2022
and recognised as unrealised profit in opening inventories in this period becomes realised by
the end of the current period. As such, this profit needs to be transferred from the previous
period to the current period by:
• Debiting Retained Earnings (1/7/22) with an amount equal to the after-tax unrealised profit
in opening inventories – this eliminates the unrealised profit from the prior period’s profit
• Crediting Cost of Sales with an amount equal to the before-tax unrealised profit in opening
inventories – this increases the current profit as the previously unrealised profit is now
realised.

As a result of this transfer of profit to the current period, the current period profit increases and
a tax effect should also be recognised in the adjusting entry by:
• Debiting Income Tax Expense with an amount equal to the tax on the unrealised profit in
opening inventories.
Exercise 28.2

Current and prior periods intragroup transfers of inventories

Monica Ltd owns all the share capital of Phoebe Ltd. The income tax rate is 30%. The following transactions
took place during the periods ended 30 June 2022 or 30 June 2023.
(a) On 1 May 2022, Monica Ltd sold inventories to Phoebe Ltd for $5 000 on credit, recording a profit of $1000.
Half of the inventories were unsold by Phoebe Ltd at 30 June 2022 and none at 30 June 2023. Phoebe Ltd
paid half the amount owed on 15 June 2022 and the rest on 1 July 2022.
(b) On 10 June 2022, Phoebe Ltd sold inventories to Monica Ltd for $18 000 in cash. The inventories had
previously cost Phoebe Ltd $14 000. Half of these inventories were unsold by Monica Ltd at 30 June 2022
and 30% at 30 June 2023.
(c) On 1 January 2023, Phoebe Ltd sold inventories costing $5000 to Monica Ltd at a transfer price of $8000,
paid in cash. The entire inventories were sold by Monica Ltd to external entities by 30 June 2023.

Required
In relation to the above intragroup transactions:
1. Prepare adjusting journal entries for the consolidation worksheet at 30 June 2022 and 30 June 2023.
2. Explain in detail why you made each adjusting journal entry.
(LO2 and LO3)

1. At 30 June 2022, there will only be adjusting entries for transactions (a) and (b) as these are
the only transactions related to the financial period ended on 30 June 2022. At 30 June 2023,
there will be adjusting entries for all transactions.

30 June 2022

(a) Sales revenue Dr 5 000


Cost of sales Cr 4 500
Inventories Cr 500

Deferred tax asset Dr 150


Income tax expense Cr 150

Accounts payable Dr 2 500


Accounts receivable Cr 2 500

(b) Sales revenue Dr 18 000


Cost of sales Cr 16 000
Inventories Cr 2 000

Deferred tax asset Dr 600


Income tax expense Cr 600

30 June 2023

(a) Retained earnings (1/7/22) Dr 350


Income tax expense Dr 150
Cost of sales Cr 500
(b) Retained earnings (1/7/22) Dr 2 000
Cost of sales Cr 800
Inventories Cr 1 200

Deferred tax asset Dr 360


Income tax expense Dr 240
Retained earnings (1/7/22) Cr 600

(c) Sales revenue Dr 8 000


Cost of sales Cr 8 000

2. Detailed explanations on the adjusting journal entries

30 June 2022:

(a) The first adjusting entry eliminates the unrealised profit in closing inventories at 30 June
2022. As half of the inventories remain unsold at the end of the period, at 30 June 2022 half of
the entire profit on the intragroup sale is unrealised and should be eliminated on consolidation
by:
• Debiting Sales Revenue with an amount equal to the intragroup price – to eliminate the
intragroup revenues
• Crediting Inventories with an amount equal to the unrealised profit – to decrease the value
of the inventories left on hand with the group to their original cost to the group
• Crediting Cost of Sales with an amount equal to the intragroup price minus the amount of
credit to Inventories – to adjust the aggregate figure for Cost of Sales to the amount that
should be recognised by the group, i.e. the original cost of the inventories sold to external
parties.

The second adjusting entry recognises the tax effect of the elimination of the unrealised profit
in closing inventories at 30 June 2022 by raising a Deferred Tax Asset for the tax recognised
by Monica Ltd on the unrealised profit.

The third adjusting entry eliminates the intragroup Accounts Payable and Accounts Receivable
for the amount still unpaid on the intragroup sale.

(b) The first adjusting entry eliminates the unrealised profit in closing inventories at 30 June
2022. As half of the inventories remain unsold at the end of the period, at 30 June 2022 half of
the entire profit on the intragroup sale is unrealised and should be eliminated on consolidation
by:
• Debiting Sales Revenue with an amount equal to the intragroup price
• Crediting Inventories with an amount equal to the unrealised profit – to decrease the value
of the inventories left on hand with the group to their original cost to the group
• Crediting Cost of Sales with an amount equal to the intragroup price minus the amount of
credit to Inventories.

The second adjusting entry recognises the tax effect of the elimination of the unrealised profit
in closing inventories at 30 June 2022 by raising a Deferred Tax Asset for the tax recognised
by Phoebe Ltd in advance on the unrealised intragroup profit.
30 June 2023:

(a) In this case, the unrealised profit in closing inventories from the period ended 30 June 2022
and recognised as unrealised profit in opening inventories in this period becomes realised by
the end of the current period. As such, this profit needs to be transferred from the previous
period to the current period by:
• Debiting Retained Earnings (1/7/22) with an amount equal to the after-tax unrealised profit
in opening inventories – this eliminates the unrealised profit from the prior period’s
earnings
• Crediting Cost of Sales with an amount equal to the before-tax unrealised profit in opening
inventories – this increases the current profit as the previously unrealised profit is now
realised.

As a result of this transfer of profit to the current period, the current period profit increases and
a tax effect should also be recognised in the adjusting entry by:
• Debiting Income Tax Expense with an amount equal to the tax on the unrealised profit in
opening inventories.

(b) In this case, a part (20%) of the inventories originally transferred intragroup in the previous
period is sold during the current period to external parties, while another part (30%) is still
unsold. That means that the unrealised profit in closing inventories from the period ended 30
June 2022 and recognised as unrealised profit in opening inventories in this period is only
partly realised by the end of the current period. This is recognised in the first adjusting entry
by:
• Debiting Retained Earnings (1/7/22) with an amount equal to the before-tax unrealised
profit in opening inventories – this eliminates the unrealised profit from the prior period’s
profit
• Crediting Cost of Sales with an amount equal to the unrealised profit in opening inventories
that becomes realised during the current period – this increases the current profit as the
previously unrealised profit is now realised
• Crediting Inventories with an amount equal to the unrealised profit in opening inventories
that is still unrealised at the end of the current period – this decreases the value of the
inventories still on hand to their original cost to the group.

As a result of the recognition of the part of profit that is realised in the current period, the
current period profit increases and a current tax effect should also be recognised by:
• Debiting Income Tax Expense with an amount equal to the tax on the part of the unrealised
profit in opening inventories that is realised by the end of the period.

As a result of the elimination of the part of the profit that is unrealised by the end of the current
period, a deferred tax effect should also be recognised by:
• Debiting Deferred Tax Asset with an amount equal to the tax on the part of the unrealised
profit in opening inventories that is still unrealised at the end of the period.

Given that Retained Earnings only recognises profits after tax, debiting Retained Earnings
(1/7/22) in the first adjusting entry with the before-tax unrealised profit eliminated from that
account more than what it should and therefore the balance of Retained Earnings (1/7/22)
should be adjusted by:
• Crediting Retained Earnings (1/7/22) with an amount equal to the tax on the unrealised
profit in opening inventories – this ensures that the net adjustment to Retained Earnings
(1/7/22) is only for the after-tax unrealised profit.

(c) The only adjusting entry eliminates the intragroup sales revenue recognised by Phoebe Ltd
(on the intragroup sale) and the cost of sales recognised by Monica Ltd (on the external sale)
as the profit on the intragroup sale is entirely realised during the current period. As the
inventories are sold by the end of the period to an external entity, at 30 June 2023 the entire
profit on the intragroup sale is realised; however, the aggregate sales revenues and cost of sales
are overstated from the group’s perspective as they include the intragroup sales revenue and
the cost of sales recognised based on the price paid intragroup by Monica Ltd. On
consolidation, this overstatement is corrected. There won’t be any tax-effect adjustment entry
as the only adjusting entry posted now does not have any net effect on the profit or on the
carrying amount of inventories.

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