FAR Practice Question – Eliminations and Consolidations

Prestige Worldwide owns 90% of Alaska’s common stock and 80% of Hawaii’s common stock. The remaining common shares of Alaska and Hawaii are owned by their respective employees. Alaska sells exclusively to Hawaii, Hawaii buys exclusively from Alaska, and Hawaii sells exclusively to unrelated companies. Selected Year 1 information for Alaska and Hawaii follows:

What amount should be reported as gross profit in Alaska and Hawaii’s combined income statement for the year ended December 31, Year 1?

A) \$26,000

B) \$41,000

C) \$47,800

D) \$56,000

\$41,000 is correct. Since Alaska sells to Hawaii, that is an example of an intercompany transaction that must be eliminated. Since Alaska sold the product to Hawaii at a markup of 30% (\$130,000 of sales vs \$100,000 of cost of sales), that means that there is sales and cost of sales that must be eliminated in the consolidated financials.

Since this question is asking about gross profit, we need to figure out what the 3rd party sales to customers were and what the related cost of sales figure. We know that 3rd party sales to customers are \$91,000, since Hawaii is the only entity that sells directly to customers. However, the \$65,000 of cost of sales is incorrect because that includes the markup from Alaska.

Step 1) If we create an inventory rollforward for Hawaii, we can see that they purchased \$130,000 of product from Alaska, and since \$65,000 is still in inventory, that means that they sold 50% of what they purchased.

Step 2) If we take that 50% ratio and apply it cost of goods sold for Alaska, that means that of the \$100,000 that it actually cost to produce the goods that were sold to the end customer, only 50% or \$50,000 should be recognized in cost of sales. The other \$50,000 is still in inventory.

Step 3) Now that we know cost of sales with no markup is \$50,000, when we subtract that from sales to customer of \$91,000, we are left with gross profit of \$41,000.

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