Adjusting for inter company transactions

I can’t seem to find anywhere in Schweser which explains why to get to adjusted COGS for consolidation of a subsidiary you need to take COGS of the subsidiary and then subtract a % of the subsidiaries revenue? Question 1 - #89470 The California Wines owns 40% of a joint venture, Western Vineyards. Vineyard’s income statement for this period is as follows: Revenues $10,000 Less: cost of goods sold (COGS) 7,500 Gross profit $2,500 Less: selling and administrative expenses 500 Operating income $2,000 Less: interest expense 500 Earnings before taxes $1,500 Less tax 600 Net income $900 California Wines purchases 30% of the output of Vineyard. The amount of revenues, COGS, and net income of Vineyard to be included in the California Wine’s income statement under proportionate consolidation are, respectively: A) $0; $0; $0. B) $4,000; $3,000; $360. C) $2,800; $1,800; $360. Your answer: C was correct! [(0.4)($10,000)] − [(0.4)(0.3)($10,000)] = $2,800; [(0.4)($7,500)] − [(0.4)(0.3)($10,000)] = $1,800; (0.4)($900) = $360.

Calif wines owns 40% of West Vineyard, also buys back 30% of output of West Vinyard. Since it owns 40% - 40% of West’s profits are already in its books. Now if it just used the 30% output directly - it would be double counting - profits, etc. etc. so you need to back out the portion of the output not owned by Calif Wines. Since output of West = Input for Calif - remove 40% of 30% of the COGS of West Vineyard from Sales. 10000 - .4 * .3 * 7500 for the Sales part.

0.40*10K would have been the pro-rates share to the parent from the sub, had there been no intercompany transactions, but, since there are 30%, we know that the 10K revenue of the sub already has the sales caused due to the 30% share of the 40% ownership, hence we need to back that out [0.4*0.3*10K]. Same is the case for COGS: which is the usual pro-rated COGS - the 30% of the 40% share of parent transactions backed out. Ofcourse NI is the direct pro-rate number as the intercompany transactions have been taken care already in the above adjustments.

I think a more intuitive way to think about it is in terms of profit. We know that gross profit is 2500, and the that the parent company under proportional consolidation will have 2500*0.4 = 1000 reflected on its income statement, and ultimately, the pro-rata share of all the line items below that to get 900*0.4 = 360 net income from the joint venture subtract out the revenues that are double counted. 10000 - 10000*.3 = 7000 Take 40% of this .4*7000 = 2800 We know that gross profit has to be the same, so 2800 - COGS = 1000, COGS = 1800 I don’t think this is specifically mentioned in Schweser, only undoing profits that haven’t been realized yet

Thanks for the responses…TheAliman thinking of it like that is very helpful. Essentially you have to think of COGS as a plug figure. Is there no way to directly adjust COGS?

7500 - (0.4 * .3 * 10000) B sold 10000 - of which 40% was on A’s books. Your COGS was 7500 30% was an intercompany transfer. So COGS and Sales are linked. For Sales remove 12% (40% of 30%) of SALES for COGS remove 12% of Sales. So Sales = 10000 * .4 - 12% * 10000 = 28% of 10000 = 2800 COGS = 7500* .4 - 12% of 10000 = 3000 - 1200 = 1800 Net Income = 40% of Subs = .4 * 900 = 360

But intuitiveley why not just remove 30% of 40% of COGS from COGS? Why are we removing the sales adjustment from a COGS figure? I underastand it works as a plug but why is it not possible to directlty adjust it?

bcos you did not sell your COGS as COGS itself - you sold it with a profit as your Revenue number… so Aliman’s way of removing the profit part of it is the way to look at this transaction.

This is a great example of questions where you can save time. If you know the revenue to include there is absolutely no reason to waste time on the other two calculations. Many people who doubt their knowledge need to triple prove their answers by doing all 3 calcs which is a complete waste of time. There are a lot of questions like this, where knowing one element of the answer can get you to the right choice, or you can waste time reconfirming what you already know.

yeah super is right. give the answer choices a hard look. Either solve for revenue or COGS, easier to solve for revenue. Proportionate consolidation, so revenue = 4000 in the event there is no intercompany transaction. But there are intercompany transactions so, revenue can’t be 4k, neither can it be 0, hence C is the right answer. I don’t think CFAI is going to give us such silly answer choices, but if you must solve for revenue, then 4k revenue if no intercompany transaction. but 30% of the 10k is sold to california, of which 40% is califiornia’s own share. so .3*.4*10k needs to be taken out from the 4k leaving you with effective revenue of 2800. As and when California sells that 30% to other parties, it’ll recognize revenue in its own books.