Note: I'm a beginner at advanced accounting, and I made this problem up. I'm not asking for help on "homework." I'm looking simply to understand the principle that this advanced accounting textbook is not that great at explaining. Because consolidations can be complex, I set this problem up by going through everything I understand first in an example problem and then asking my main question way down at the end. For those who don't want to read through my example but might be good at explaining the answer the my question... Why, for consolidation purposes, is retained earnings of the seller decreased in the year following a transer from Company A down to Company B, assuming the goods are sold in the following year... I know all about why COGS sold should be decreased, since Beg Inv is overstated since Ending Inventory was overstated in the first year... anyway, here's what I understand up until that point using a concrete example...
Year 1: Assume company A buys goods for $40,000 and sells them to company B for $100,000, and assume also that company A owns 100% of company B. Assume that at the end of the year, Company B, of the $100,000 it buys, has sold $70,000.
Ok, this causes the following Company A journal entries.
A COMPANY
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Debit: Purchase ,000
Credit: Cash $40,000
Self-explanatory.
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Debit: Cash 0,000
Credit: Sales $100,000
This is the entry that results from sales to Company B.
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Debit: COGS ,000
Credit: Purchase $40,000
This entry occurs because Company A has sold all of the $40,000 of goods to Company B, thus none of the $40,000 ends up in ending inventory. Remember, the cost of Purchases and Beginning Inventory can only end up in one of either TWO places: Ending Inventory or COGS: End Inv + COGS = Purchases + Beg Inv.
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Company B entries
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Debit: Purchase 0,000
Credit: Cash $100,000
Self-explanatory
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Debit: COGS 0,000
Credit: Purchase $100,000
Even though this entry could be combined with the entry below, it doesn't have to be and for understanding consolidation worksheet entries, it's best for me not to combine the two entries. That is, I simply dump all of the purchases into COGS with this entry and then adjust for what goes into ending inventory with the entry below. This COGS figure will be taken out in the consolidation worksheet entries.
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Debit: End Inv ,000
Credit: COGS $30,000
As I said in the question, Company B, of the $100,000, sold $70,000 of the goods. Thus, $30,000 remains from this $100,000 in Ending Inventory, so, since everything else is held constant, it must come from COGS. So we increase Ending Inventory and decrease COGS by what's left.
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Consolidated Worksheet entries for year 1.
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Debit: Sales 0,000
Credit: COGS $100,000
There is exactly one place in the above journal entries where I have a credit for sales of $100,000 (entry 2). There is also exactly one place in the above journal entries where I have COGS for $100,000 (entry 5). Take both of them out, and you are still in balance and on your way to having things the way they should be when the companies are viewed as a consolidation.
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Debit: End Inv $18,000
Credit: COGS $18,000
This was a tricky entry for me to understand. The KEY to understanding this entry is to look first at entry 3. Obviously, as you look at entry 3, you realize that, for consolidation purposes, there needs to be an adjustment, because not ALL of the goods have left the combined company, having been sold to outsiders, yet. That is, entry 3 has ALL of the goods as going into COGS with no ending inventory adjustment. There must be an ending inventory adjustment for consolidation purposes if there are still some goods in the combined company. What is the exact adjustment needed? It would be the percentage of goods left multipiplied by the original COGS. $30,000/$100,000 or 3/10 goods are left, so 3/10($40,000 original cost) $12,000 is what is left. So, we need a debit to ending inventory of $12,000 and a credit to COGS of $12,000. Well, Company B in entry 6 helps us out for consolidation purposes by adding Ending Inventory of $30,000 and lessening COGS by $30,000. However, this is too much of an adjustment. Thus, have to change this adjustment to equal an adjustment of $12,000. We do this by the consolidation debit of $18,000 to ending inventory and a credit to COGS of $18,000.
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OK, in the following year, Beginning Inventory for company B is going to be overstated by $18,000. Assuming all of this goes to COGS, this means COGS will be overstated and will need to be adjusted downward by $18,000. However, my book is telling me the corresponding entry to this problem is a Debit to the Retained earnings of the "seller," which I assume they mean in my case Company A. WHYYYY?