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INTERCOMPANY

INVENTORY AND LAND


PROFITS
Seda Oz, PhD

seda.oz@uwaterloo.ca

AFM 491, SAF, University of Waterloo

November 5, 2018 Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 1
INTERCOMPANY
REVENUE & EXPENSES
 Parents and subsidiaries frequently have sales and purchase
transactions between each other, or other transactions such as
intercompany rent, management fees, and interest.
 When not paid, these transactions can give rise to
intercompany balances such as receivables and payables.

 Intercompany transactions are recorded in the books of


each of the individual legal entities.
 These amounts would be included in separate entity financial
statements, and reported on separate entity income tax
returns.

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 2


INTERCOMPANY
REVENUE & EXPENSES
 However, in the consolidated financial statements:
 Income should be recognized only when it is earned in a
transaction with an outsider.

 Companies must have systems in place that can capture full


information regarding both internal and external sales and
purchases, in order that the appropriate eliminations may be
identified and made in the consolidated financial statements.

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 3


INTERCOMPANY
REVENUE & EXPENSES
 The selling company will generally have recorded a profit
on the intercompany sales.
 These profits are “unrealized” because they are only within
the combined entity, they are not objectively measurable, and
are not with an arm’s-length outsider.
 Intercompany sales are like moving a coin from one pocket in
a pair of pants to the other pocket; the pants still contain the
same coin and no income has been earned.
 Intercompany sales do not reflect the culmination of the
earning process.
 These unrealized profits, must be eliminated net of related
income taxes paid.

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 4


INTERCOMPANY
REVENUE & EXPENSES
 All intercompany sales or other intercompany income must
be eliminated against the related purchase or intercompany
expense.
 All intercompany balances (including receivables and
payables) are eliminated against each other.
 Since equal amounts of income and expenses are being
eliminated, there is no net effect on consolidated income.
 Only revenues, and expenses incurred with outside parties
should be reflected on the consolidated income statement.

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 5


EXAMPLES OF INTERCOMPANY
REVENUE & EXPENSES
 Intercompany management fees – often the parent will
charge its subsidiary companies a management fee as means
of allocating head office cost to all the companies within the
group.
 Intercompany rentals – occasionally, buildings or
equipment owned by one company are used by another
company within the group with a corresponding rental
charge.
 Intercompany interest revenue and expenses – one company
may record interest income on a loan to another company
which records a corresponding interest expense.

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 6


INTERCOMPANY
PROFITS
 Must keep track of asset sales inside the group.
 3 types:
 Profits in inventory
 Profits in non-depreciable assets
 Profits in depreciable assets

 intercompany sales  profit (loss) in unrealized to the group


(consolidation view)
 Outside sales  profit (loss) in realized to the group
(consolidation view)
 Intercompany profits (losses) must be eliminated as long as they are in
the group

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 7


INTERCOMPANY SALES
(ALL)
 Need to eliminate the Sale & Purchase
 If don’t eliminate
 get the same NI but overstate Rev & Exp
 If S sells to P and P resells it: (ignoring taxes)

S P P+S
S Sales 1,000 P Sales 1,200 Sales 2,200
S Exp 400 P Exp 1,000 Exp 1,400
S NI 600 P NI 200 NI 800
Not eliminated

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INTERCOMPANY SALES
(ELIMINATED)

P Cons
P Sales 1200 Sales 1,200
Exp 400
S Exp 400 P consolidated NI 800
entity Eliminated
Sales & COGS

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COMPARISON YR 1 ALL SOLD

P+S not eliminated P Consolidated


Sales 2,200 Sales 1,200
COGS 1,400 CGS 400
NI 800 NI 800

To eliminate:
P + S Adjust P Con
Sales
COGS

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 10


UNREALIZED PROFITS

 Must keep track of asset sales (capital assets or inventory)


inside the group.
 If asset still on hand at end of year => unrealized profit
(now on buyer’s books) needs to be eliminated as well as the
original sale. Adjust B/S (buyer) and I/S (seller).
 Want the Expense to be matched to Revenue
 For as long as the asset remains unsold.
 Then need to realize it when it is sold (for inventory assume
sold next period, unless specified) or used (capital assets).

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IF ASSET NOT SOLD:
UNREALIZED PROFIT
• If P hadn’t sold it yet – would have inventory on
their books @ $1000 that only cost the entity $400
• S would show a profit of $600 P Cons
Not Eliminated
Sales(S) 1,000
P Sales $0 Exp (S) 400
NI 600
P consolidated Inventory $1000
S Exp $400
entity
Sales 0
P Cons Exp 0
Eliminated NI 0
From Entity point of view – Acctg,
Adv Fin nothing
J Scott,sold
2016-17 Inventory $400
12

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 12


UNREALIZED PROFT YR1
 If not eliminated: No effect on
 Inventory & Net Income are overstated Cash flow
 Need to adjust sales, COGS and inventory accounts

1. Eliminate the inter co-sales (purchase)


 decrease in Sales $1,000 , decrease in COGS $1000

2. Eliminate the unrealized profit (end. inven.)


 decrease in Inventory $600, increase in COGS $600

Net effect: Decreased Sales by $3000, COGS by $400, and


Inventory by $600

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 13


COMPARISON YR1
UNREALIZED
P+S not eliminated P Consolidated
Sales 1,000 Sales 0
COGS 400 COGS 0
NI 600 NI 0
Invent 1,000 Invent 400
To eliminate:
P + S Adjust P Con
Sales
COGS
Invent.

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 14


UNREALIZED PROFIT YR 2
 Next year when sold
 Need to realize the profit held back in YR 1 (match the
expense to the revenue)
P’s uncons same as consolidated I/S
P’s I/S if it were not eliminated in previous yr
Sales 1,200 Only $200 of profit recognized by P.
Exp 1,000 Need to add in the profit from S that
NI 200 was held back in previous year ($600)

Want Sales1,200
Realize $600 held back by reducing
P Cons: Exp 400
the COGS cost (o/s inventory).
NI 800
Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 15
COMPARISON YR 2
REALIZED
P+S not eliminated P Consolidated
Sales 1,200 Sales 1,200
COGS 1,000 COGS 400
NI 200 NI 800

To eliminate:
P + S Adjust P Cons
Sales 1,200 + 0 = 1,200
COGS 1,200 + 0 - 600 = 400

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 16


WHAT ABOUT TAXES?
 Must make an adjustment for the income taxes
 Income taxes are computed at the individual company level
so the company that recorded the profit also recorded income
taxes on the profit
 The matching of expenses with revenues:
 Income tax should be expensed in the same period as revenue
is recorded
 The timing difference between the buyer’s tax basis in the
asset purchase and the cost of the transferred asset meets the
definition of a temporary difference and will give to deferred
income taxes on the consolidated financial statement

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 17


UNREALIZED PROFITS
TERMINOLOGY

P P
S sells to P
UPSTREAM

S S P sells to S
DOWNSTREAM

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UPSTREAM PROFITS
 The profit is eliminated from the selling company
 Upstream: where the subsidiary sells to the parent, or one
subsidiary sells to another subsidiary
 in upstream profits, we eliminate the S’s profit
 NCI will be affected (if any)
 Depends on which conceptual approach to consolidation is
followed…
 Entity method – they are inside the entity therefore eliminate
their share too

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 19


INVENTORY SALES UPSTREAM
UNREALIZED PROFIT
 If S sells to P & goods still on hand (in the group)
1. Reduce Sales & COGS by full amount
2. Increase COGS (P) by unrealized profit
Reduce Inventory
If ending inventory overstated then Beg Inv
COGS understated. + Purchases
Increasing an exp eliminates the profit CGAS
3. Reduce Income Tax expense - End Inv
Increase Deferred Tax Asset = COGS
(unrealized profit × tax rate)

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 20


EXAMPLE

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DATA
P buys 80% of S for $1,920,000
100% => 1920/.8 = $2,400,000

S’s Retained earnings $2,000,000


S’s Share capital $ 400,000
$2,400,000
Book value = Fair Value
No dividends either company P uses Cost
NCI date of acq = .20 x 2,400,000 = $480,000

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 22


I/S BEFORE
ELIMINATING PROFIT
2013 Inc St P 2013 Inc St S
Sales $2,000,000 Sales $ 1,000,000
COGS 1,200,000 COGS 600,000
Other exp 200,000 Other Exp 275,000
Invstmt Inc 0 Tax exp 25,000
Tax Exp 120,000 Net Income $100,000
Net Income $ 480,000
S sold $20,000 to P, P P owns 80% of S, no FVI,
has $5,000 still on hand no dividends paid

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 23


UNREALIZED PROFIT
• S sold $20,000 to P; $5,000 still on hand
– Assume gross margin ratio = 40%, t = 20%
– Unrealized profit = $5,000 x 40% = $2,000
1. Cons Sales & COGS o/s $20,000
Net
( Sales & COGS $20,000)
CGS
2. Ending inv. o/s $ ( Inv, COGS $2,000)
3. Tax expense o/s 20% x 2,000 = $400
$ ( tax expense, tax asset $400)
• Net Income o/s $2,000(1-.2) = $1,600

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 24


CONSOLIDATED I/S
UPSTREAM

Investment Income:
S’s Net income as reported $ 100,000
Less unrealized profit (after tax) 1,600
S’s adjusted NI 80%
98,400
P’s Share – 80% $ 78,720 20%

NCI’s share – 20% $ 19,680

NCI’s share is also reduced by unrealized profit

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 25


YR1 CONSOLIDATED NET INCOME
UPSTREAM

P’s net income 480,000


S’s net income 100,000
Less unrealized (1,600) 98,400
Cons NI 578,400

NCI’s (20%) of S’s adj NI: 19,680


P’s share of Cons NI 558,720
Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 26
YR1 R/E ADJUSTMENT &
NCI (ON B/S) UPSTREAM
S’s RE + P’s share NCI
Sh Capital Adj R/E B/S (20%)
Date of Acq
(slide 22)

+ % of S’s
Adjusted NI

End of Yr
(Adjusted)

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 27


NEXT YEAR: UNREALIZED
PROFIT IN BEGINNING
INVENTORY NOW REALIZED

• The next year P sells the inventory.


• Need to record the profit that was suppressed
last year.

Beg Inv If beginning inventory o/s then COGS o/s.


+ Purchases Decreasing an expense realizes (increases)
CGAS the profit.
- End Inv
= COGS Assume 2014 I/S is identical
to 2013 I/S

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 28


CONSOLIDATED I/S
UPSTREAM - REALIZED

Investment Income
S’s Net income as reported 100,000
Plus unrealized profit (after tax) 1,600
S’s adjusted NI 80%
101,600
20%
P’s Share – 80% 81,280
NCI’s share – 20% 20,320

NCI’s share is also increased by unrealized profit

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 29


YR 2 CONSOLIDATED NI
UPSTREAM

P’s net income 480,000


S’s net income 100,000
Plus realized 1,600
Cons NI

NCI’s (20%) of S’s adj NI:


P’s share of Cons NI

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 30


YR2 CONTINUITY INVESTMT
& NCI (B/S) UPSTREAM - REALIZED

S’s RE + P’s share NCI


Sh Capital Adj R/E B/S (BV)
Beg of Year 2,498,4 78,720 499,68

+ % of S’s 100 + 81.28 +2-/32


Adjusted NI 1.6
End of Yr 2,600 160.0 520.0

No adjustment
needed

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 31


ASK YOURSELF
 What is the sum over the 2 years of:
 P’s share of consolidated NI?
 NCI’s share of cons NI?
 Cons R/E?
 NCI on B/S?

 Like an inventory error, balances out & self-corrects over


the 2 years

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 32


IF P WERE USING EQUITY
METHOD
Investment Income calculation: YEAR 1
S’s NI $100,000
Less FV amortizations 0 Make the same
adjustments
Less unrealized profit 1,800
S’s adjusted NI 98,400
P’s 80% Investment Inc $ 78,720
Would increase Invstmt acct on B/S & R/E on
would be the same as Cons RE

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 33


REMEMBER
 Under equity method, P must acknowledge anything and
everything related to S, and business combination
 Investment account on uncons is affected by:
 S’s net income
 Equity method income investment acct both increases
 S’ discontinued operations
 Equity method income - disc investment acct both increases
 FV excess amortizations
 Equity method income investment acct both decreases
 Dividend income
 Cash increases investment acct decreases
 Unrealized profit
 Equity method income investment acct both decrease

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 34


DONWSTREAM PROFITS

 P sells to S
 Eliminate completely (always 100% for P)
 Reduce Cons. Net Income (for current period) (for
profit in P’s income)
 Reduce Cons Assets (S’s asset)
 NCI is not affected

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 35


DOWNSTREAM PROFITS

 The profit is eliminated from the selling company


 Downstream: where the parent sells to its subsidiary
 in downstream profits, we eliminate the P’s profit
 NCI will ……….. be affected (if any)

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 36


EXAMPLE (CONT)

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 37


I/S BEFORE
ELIMINATING PROFIT
2013 Inc St P 2013 Inc St S
Sales $2,000,000 Sales $ 1,000,000
COGS 1,200,000 COGS 600,000
Other exp 200,000 Other Exp 275,000
Invstmt Inc 0 Tax exp 25,000
Tax Exp 120,000 Net Income $100,000
Net Income $ 480,000
P sold $20,000 to S, S P owns 80% of S, no FVI,
has $5,000 still on hand no dividends paid

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 38


YR1 CONSOLIDATED I/S
DOWNSTREAM
P’s share of S’s Net Income
S’s Net income as reported (not adjusted)
P’s Share – 80%
NCI’s share – 20%

But P’s share of S’s Net income:


Less unrealized profits (only P adjusted) ()
Invstmt Income
(increase in the Invstmt B/S acct if using equity method)

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 39


YR1 CONSOLIDATED NET
INCOME
P’s net income
Less unrealized ()
S’s net income
Cons NI
Cons NI same as upstream (slide 26)
but allocation to P & S different
NCI’s (20%) of S’s adj NI:
P’s share of cons NI
Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 40
YR1 R/E ADJUSTMENT &
NCI (ON B/S) DOWNSTREAM
S’s RE + P’s share NCI
Sh Capital Adj R/E B/S (20%)
Date of Acq
(slide 22)

+ % of S’s
Adjusted NI

End of Yr
(Adjusted)

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 41


NCI END OF YR1
DOWNSTREAM
% of Book Value OR Continuity
S’s end of year BV Opening NCI (slide 22) $
Sh Capital $ Plus NCI’s % of
R/E S’s adj NI
Total Less S’s % dividends
Plus UNamortized
Acq Differential __ Ending balance $
Adjusted Value
[Higher than for upstream (slide 27) & =
BV of S without adjustments]
NCI 20% $

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 42


CONSOLIDATED I/S
DOWNSTREAM - REALIZED

Investment Income
S’s Net income as reported
S’s adjusted NI

P’s Share – 80% 80%


20%
+
NCI’s share – 20%

NCI’s share is not affected by unrealized profit


(downstream)

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 43


YR 2 CONSOLIDATED NI
DOWNSTREAM

P’s net income


S’s net income
Plus realized
Cons NI

NCI’s (20%) of S’s adj NI:


P’s share of Cons NI

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 44


YR2 CONTINUITY INVESTMT &
NCI (B/S) DOWNSTREAM - REALIZED

S’s RE + P’s share NCI


Sh Capital Adj R/E B/S (BV)
Beg of Year

+ % of S’s
Adjusted NI
End of Yr
No adjustment
needed

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 45


EQUITY METHOD
(USED BY P IN UNCONS FS)
 If P were using Equity Method on their books…

 On P’s unconsolidated I/S adjust Invstmt Inc to reduce net


income
 Even though it is P’s net income that is overstated, not S’s (no
other accounts related to S’s to adjust).
 Same calculation as on slide 38
 (100,000 x 80% - 1,600)
 Investment income = $78,400
 and increase in B/S account & R/E

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 46


INTERCOMPANY
LAND TRANSACTIONS

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INTERCOMPANY LAND
PROFIT HOLDBACK
 Companies often redistribute assets among various
corporate divisions within a group.
 Land and other non-depreciable assets may be sold
intercompany.
 The selling company will normally recognize a gain or loss
on the sale, and the buying company will record the assets at
the price charged by the seller.
 This cost may be higher or lower than the cost to the selling
company.
 The company must track the original cost and the
intercompany unrealized gain or loss.

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 48


INTERCOMPANY LAND
PROFIT HOLDBACK
 The gain or loss on these intercompany sales is always
unrealized to the group until (and unless) the asset is
subsequently sold to a buyer outside the group.
 The unrealized intercompany gain must be eliminated.

 All adjustments are made with the objective of presenting


the statements of the group to report as if the transaction
between the companies had never taken place.
 The asset is restated to its original cost to the seller until sold
to an outside party.

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 49


UNREALIZED PROFITS
LAND OR UNLIMITED LIFE ASSETS
 Adjustment the same as ending inventory
 Need to reduce the asset & the gain
 Assume S sold land with cost of $5,000 for $7,000 to P
1st Yr:
Decrease Gain $ & Decrease Asset $
Want asset @ cost = $
Increase Def Tax Asset $ & Decrease Inc Tax Exp $

 But is not Realized until sold


 In all subsequent yrs until sold still need to adjust S’s Book
Value (if Upstream) for calculating NCI
 & adjust Land on B/S & deferred tax asset

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 50


EXAMPLE

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LAND ADJUSTMENTS
P S adjustments Cons
Land

Def tax asset

I/S Gain
Inc tax exp

At end of year NCI I/S calculated on S’s adjusted NI;


and on adjusted BV for NCI B/S.

Need to keep adjusting NCI B/S until sold (next slide)

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 52


CONTINUITY INVSTMT & NCI
UPSTREAM SALE YR 2 LAND –
STILL UNREALIZED
S’s BV P’ R/E NCI
Adj B/S
Beg of Year
Beg of Year
Adjusted
+ % of S’s NI
(no adj.)
End of Yr
Adjusted (still)

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 53


 P sells it 3 years later for $
 P will only report a gain of $ (unconsolidated)
 remember it is on P’s books at $
 The gain to the Cons Entity should be $
 original cost

 Need to add the Gain that have been holding back ($) to
Gain recognized ($) and add back in the income tax (no
longer need the Deferred Tax Asset)

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 54


ASSOCIATED
COMPANIES

Significant Influence 20 – 50 %

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SIGNIFICANT INFLUENCE
ASSOCIATE CO
(EQUITY METHOD <50%)
 Equity method for Associated companies (significant
influence) has all the same adjustments
 Not P(uncons) using Equity Method – but for owning < 50%
 Need to do an acquisition differential
 but don’t gross up to 100%, just proportionally
 Need to be amortizing FVI (proportionally)
 Need to adjust for unrealized gains (proportionally)
 This was identified back in Chap 2, but not done

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 56


EXAMPLE

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 57


ASSUME P BOUGHT 40%
OF S FOR $1,000

Price for 40% $


40% of S’s Book Value
Acquisition Differential
Assume FV PPE greater by $75 (1)
PPE
Goodwill $

(1) FV is new information, 3 years useful life remaining

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 58


SAME UPSTREAM SALE

S’s reported net income $


P’s 40%
Less FV amort () ()
Less unrealized profit ( ()
Investment Income $
(equity method income)

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 59


ASPE
 When eliminating unrealized profits on downstream
transaction between an investor and its associate, the entire
profit is eliminated under ASPE.

 Only the investor’s proportionate interest is eliminated under


IFRSs.

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 60


BACK TO
CONSOLIDATION

Always remember that same theory applies to Equity method

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 61


LOSSES ON INTERCOMPANY
TRANSACTIONS
 Selling items at a loss should still eliminate any unrealized
ones
 But why selling at a loss? Impairment?

 Selling an asset at a loss raises the question of whether the


loss reflects the fair value and an impairment.
 If impairment is present the asset should be written down to
its net realizable value on separate F/S.
 If it wasn’t written down before being transferred then after the
unrealized loss is eliminated it will be back at cost
 Then need to write it down on Cons FS
 If impairment is not present and the loss does not reflect fair
value, the loss should be eliminated.

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 62


EXAMPLE

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 63


SELLING AT A LOSS
Impaired Not impaired
Cost to S $5,000 Cost to S $5,000
NRV $4,500 NRV $5,000
Sold to P for $4,800 Sold to P for $4,800
If all still on hand at yr end If all still on hand
would eliminate $200 loss => Eliminate the $200 loss
inventory goes back to 5,000 Inventory back to $5,000

Then P writes it down to


$4,500 on Cons FS

Copyright @ 2017 Seda Oz, PhD. All Rights Reserved 64

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