INTERCOMPANY PROFIT TRANSACTIONS—INVENTORIES

We prepare consolidated statements to show the financial position and the results of
operations of two or more affiliates as if they were one entity. We eliminate the effects of
transactions between the affiliates (referred to as intercompany transactions) from
consolidated financial statements.

Intercompany transactions may result in reciprocal account balances on the books of the
affiliates. For example, intercompany sales transactions produce reciprocal sales and
purchases (or cost of goods sold) balances, as well as reciprocal balances for accounts
receivable and accounts payable.

Intercompany transactions are intracompany transactions from the viewpoint of the

consolidated entity; therefore, we eliminate their effects in the consolidation process.

Elimination of Intercompany purchases and Sales

We eliminate intercompany sales and purchases (or cost of goods sold) in the consolidation
process in order to report consolidated sales and purchases (or cost of goods sold) at
amounts purchased from and sold to outside entities.

Pop Corporation formed a subsidiary, Son Corporation, in 2016 to retail a special line of
Pop’s merchandise. All Son’s purchases are made from Pop Corporation at 20 percent
above Pop’s cost.

During 2016, Pop sold merchandise that cost $40,000 to Son for $48,000, and Son sold all
the merchandise to its customers for $60,000. Both Pop and Son record journal entries
relating to the merchandise on their separate books, as follows:
The elimination is as follows:

Elimination of unrealized profit in Ending Inventory

The consolidated entity realizes and recognizes the full amount of intercompany profit on
sales between affiliates in the period in which the merchandise is resold to outside entities.
Until reselling the merchandise, any profit or loss on intercompany sales is unrealized, and
we must eliminate its effect in the consolidation process.

The ending inventory of the purchasing affiliate reflects any unrealized profit or loss on
intercompany sales because that inventory reflects the intercompany transfer price rather
than cost to the consolidated entity. The elimination is a debit to cost of goods sold and a
credit to the ending inventory for the amount of unrealized profit. The credit reduces the
inventory to its cost basis to the consolidated entity; and the debit to cost of goods sold
increases cost of goods sold to its cost basis. These relationships are illustrated by
continuing the Pop and Son example for 2017.

During 2017 Pop sold merchandise that cost $60,000 to Son for $72,000, and Son sold all
but

$12,000 of this merchandise to its customers for $75,000. Journal entries relating to the
merchandise transferred intercompany during 2017 are as follows:

Pop’s sales for 2017 include $72,000 sold to Son, and its cost of sales reflects the $60,000
cost of merchandise transferred to Son. Son’s $75,000 sales for 2017 consist of
merchandise acquired from Pop, and its $60,000 cost of sales equals 5/6, or
$60,000/$72,000, of the $72,000 transfer price of merchandise acquired from Pop. The
remaining merchandise acquired from Pop in 2017 stays in Son’s December 31, 2017,
inventory at the $12,000 transfer price, which includes $2,000 unrealized profit.
The eliminations follow:

The first entry eliminates intercompany sales and cost of sales, journalized as follows:

Recognition of unrealized profit in Beginning Inventory

Unrealized profit in an ending inventory is realized for consolidated statement purposes

when the merchandise is sold outside the consolidated entity. Ordinarily, realization occurs
in the immediately succeeding fiscal period, so firms simply defer recognition for
consolidated statement purposes until the following year. Recognition of the previously
unrealized profit requires a workpaper credit to cost of goods sold because the amount of
the beginning inventory is reflected in cost of goods sold when the perpetual system is
used.

These complications do not affect consolidated gross profit, however, and we extend the
previous example to reflect 2018 operations for Pop and Son.

During 2018, Pop Corporation sold merchandise that cost $80,000 to Son for $96,000, and
Son sold 75 percent of the merchandise for $90,000. Son also sold the items in the
beginning inventory with a transfer price of $12,000 to its customers for $15,000. Journal
entries relating to the merchandisetransferred intercompany follow:

Son sold 75 percent of the merchandise purchased from Pop, so its ending inventory in
2018

is $24,000 ($96,000 * 25%) and that inventory includes $4,000 unrealized profit [$24,000 -

($24,000/1.2 transfer price)].

Journal entries to eliminate the effects of intercompany transactions between Pop and Son
for 2018 follow:

Downstream And Upstream Sales

A downstream sale is a sale by a parent to a subsidiary. A sale by a subsidiary to a parent is

an upstream sale. The upstream and downstream designations relate to the usual diagram
of affiliation structures that places the parent at the top. Thus, sales from top to bottom are
downstream, and sales from bottom to top are upstream.

Consolidated statements eliminate reciprocal sales and cost of goods sold amounts for both
upstream and downstream sales. We also eliminate unrealized gross profit in ending
inventory in its entirety for both downstream and upstream sales. However, the effect of
unrealized profits in ending inventory on separate parent statements (as investor) and on
consolidated financial statements (which show income to the controlling and
noncontrolling stockholders) is determined by both the direction of the intercompany sales
activity and the percentage ownership of the subsidiary, except for 100 percent–owned
subsidiaries that have no noncontrolling ownership.

In the case of downstream sales, the parent’s separate income includes the full amount of
unrealized profit (included in sales and cost of sales accounts), and the subsidiary’s income
is unaffected.

When sales are upstream, the subsidiary’s net income includes the full amount of any
unrealized profit (included in sales and cost of sales accounts), and the parent’s separate
income is unaffected.
The consolidation process eliminates the full amount of intercompany sales and cost of
sales for both downstream and upstream sales. However, the noncontrolling interest share
may be affected if the subsidiary’s net income includes unrealized profit (the upstream
situation). It is not affected if the parent’s separate income includes unrealized profit (the
downstream situation) because the noncontrolling shareholders have an interest only in
the income of the subsidiary.

Unrealized Profits From Downstream Sales

Deferral of Intercompany profit in period of Intercompany Sale

The following example illustrates the deferral of unrealized profits on downstream sales.

Pam Corporation owns 90 percent of the voting stock of Sun Corporation. Separate income
statements of Pam and Sun for 2016, before consideration of unrealized profits, are as
follows (in thousands):

Pam’s sales include $15,000 to Sun at a profit of $6,250, and Sun’s December 31, 2016,
inventory includes 40 percent of the merchandise from the intercompany transaction.
Pam’s operating income reflects the $2,500 unrealized profit in Sun’s inventory ($6,000
transfer price less $3,500 cost).

On its separate books, Pam records its share of Sun’s income and defers recognition of the
unrealized profit with the following entries:
The second entry on Pam’s books reduces Pam’s income from Sun from $9,000 to $6,500.

Reciprocal sales and cost of goods sold, as well as all unrealized profit, must be eliminated
in consolidated financial statements. These adjustments are shown in the partial
workpaper in Exhibit 5-2.

Entry a deducts the full amount of intercompany sales from sales and cost of goods sold.
Entry b then corrects cost of goods sold for the unrealized profit at year-end and reduces
the inventory to its cost basis to the consolidated entity.

Note that entries a and b are equivalent to a single debit to sales for $15,000, a credit to
cost of goods sold for $12,500, and a credit to inventory for $2,500.

In examining Exhibit 5-2, observe that Pam’s net income on an equity basis is equal to the
controlling share of consolidated net income. This equality would not have occurred
without the equity method journal entry that reduced Pam’s income from $34,000 to
$31,500. The $1,000 noncontrolling interest share shown in Exhibit 5-2 is not
affected by the unrealized profit on Pam’s sales because noncontrolling stockholders
share only in subsidiary profit and Sun’s reported income for 2016 (equal to its realized
income) is unaffected by the unrealized profit in its ending inventory.
Recognition of Intercompany profit upon Sale to Outside Entities

Now assume that the merchandise acquired from Pam during 2016 is sold by Sun during
2017, and there are no intercompany transactions between Pam and Sun during 2017.
Separate income statements for 2017 before consideration of the $2,500 unrealized profit
in Sun’s beginning inventory are as follows (in thousands):
Pam’s operating income for 2017 is unaffected by the unrealized profit in Sun’s December
31, 2016, inventory. But Sun’s 2017 profit is affected because the $2,500 overstatement of
Sun’s beginning inventory overstates cost of goods sold from a consolidated viewpoint.
From Pam’s viewpoint, the unrealized profit from 2016 is realized in 2017, and its
investment income is recorded and adjusted as follows:

The last entry increases Pam’s investment from $13,500 to $16,000 and Pam’s net income
from $33,500 to $36,000. The partial workpaper for Pam and Sun for 2017 reflects the
adjusted amounts as shown in Exhibit 5-3.

In examining Exhibit 5-3, note that entry a debits the Investment in Sun account and credits
cost of goods sold for $2,500. The beginning inventory of Sun has already been closed to
cost of goods sold under a perpetual inventory system, so the inventory cannot be adjusted.
The adjustment to the investment account is necessary to increase the investment account
at the beginning of the year to reflect realization during 2017 of the unrealized profit that
was deferred at the end of 2016

This adjustment reestablishes reciprocity between the investment balance at January 1,

2017, and the subsidiary equity accounts at the same date. It is important to record this
adjustment before eliminating reciprocal investment and equity balances. The computation
of noncontrolling interest share in Exhibit 5-3 is unaffected because the sales are
downstream.

Unrealized inventory profits in consolidated financial statements are self-correcting over

any two accounting periods and are subject to the same type of analysis as inventory
errors. Total consolidated net income for Pam and Sun for 2016 and 2017 is unaffected by
the $2,500 deferral in 2016 and recognition in 2017. The significance of the adjustments
lies in the accurate statement of the consolidated income for each period.

Unrealized Profits From Upstream Sales

Sales by a subsidiary to its parent increase the sales, cost of goods sold, and gross profit of
the subsidiary, but they do not affect the operating income of the parent until the
merchandise is resold by the parent to outside entities. The parent’s net income is affected
in the year of transfer from the subsidiary, however, because the parent recognizes its
share of the subsidiary’s income on an equity basis. If the selling subsidiary is a 100
percent–owned affiliate, the parent defers 100 percent of any unrealized profit in the year
of intercompany sale. If the subsidiary is a partially owned affiliate, the parent defers only
its proportionate share of the unrealized subsidiary profit.

Deferral of Intercompany profit in period of Intercompany Sale

Assume that Son Corporation (subsidiary) sells merchandise that it purchased for $7,500 to
Pop Corporation (parent) for $20,000 during 2016 and that Pop Corporation sold 60
percent of the merchandise to outsiders during the year for $15,000. At year-end the
unrealized inventory profit is $5,000 (cost $3,000, but included in Pop’s inventory at
$8,000). If Son reports net income of $50,000 for 2016, Pop recognizes its proportionate
share as shown in Exhibit 5-4.

The exhibit compares parent-company accounting for a one-line consolidation of a 100

percent–owned subsidiary and a 75 percent–owned subsidiary.

As the illustration shows, if Pop records 100 percent of Son’s income under the equity
method, it must eliminate 100 percent of any unrealized profit included in that income.
However, if Pop records only 75 percent of Son’s income under the equity method, it must
eliminate only 75 percent of any unrealized profit included in Son’s income. In both cases,
Pop eliminates all the unrealized profit from its income and investment accounts.

Exhibit 5-5 illustrates partial consolidation workpapers for Pop Corporation and its 75
percent– owned subsidiary, Son Corporation. Although the amounts for sales, cost of goods
sold, and expenses are presented without explanation, the data provided are consistent
with previous assumptions for Pop and Son Corporations.

Part B of Exhibit 5-4 explains the $33,750 income from Son that appears in Pop’s separate
income statement in Exhibit 5-5. Noncontrolling interest share is computed by subtracting
unrealized profit from Son’s reported income and multiplying by the noncontrolling
interest percentage. Failure to adjust the noncontrolling interest share for unrealized profit
will result in a lack of equality between parent net income on an equity basis and the
controlling share of consolidated net income. This potential problem is, of course, absent in
the case of a 100 percent–owned subsidiary because there is no noncontrolling interest.
Recognition of Intercompany profit upon Sale to Outside Entities

The effect of unrealized profits in a beginning inventory on parent and consolidated net
incomes is just the opposite of the effect of unrealized profits in an ending inventory. That
is, the relationship between unrealized profits in ending inventories (year of intercompany
sale) and consolidated net income is direct, whereas the relationship between unrealized
profit in beginning inventories (year of sale to outside entities) and consolidated net
income is inverse.

This is illustrated by continuing the Pop and Son example to show realization during 2017
of the $5,000 unrealized profit in the December 31, 2016, inventories. Assume that there
are no intercompany transactions between Pop and Son during 2017, that Son is a 75
percent–owned subsidiary of Pop, and that Son reports income f $60,000 for 2017. Pop
records its share of Son’s income under the equity method as follows:
Exhibit 5-6 illustrates consolidation procedures for unrealized profits in beginning
inventories from upstream sales for Pop and Subsidiary. Several of the items in Exhibit 5-6
differ from those for upstream sales with unrealized profit in the ending inventory (Exhibit
5-5). In particular, cost of goods sold is overstated (because of the overstated beginning
inventory) and requires a worksheet adjustment to reduce it to its cost basis. This is shown
in entry a, which also adjusts the investment account and beginning noncontrolling
interest. Consolidated statements require the allocation between the investment balance
(75%) and the noncontrolling interest (25%) for unrealized profits in beginning
inventories from upstream sales to correct for prior-year effects on the investment account
and the noncontrolling interest.