Prepared by: HAZEL JADE E.

VILLAMAR__
E-mail Address: _hazeljade.villamar@clsu2.edu.ph________

Central Luzon State University

Science City of Muñoz 3120
Nueva Ecija, Philippines

Instructional Module for the Course

ACCTG 2215 / Accounting for Business Combinations

Module 2
Topic 1 (Intercompany Profit
Transactions – Inventory)
Overview

This course covers the concepts and application of the different

standards related to accounting for business combination. It involves
techniques and methodologies on how to deal properly with issues and
problems involving business combination that are likely to be encountered
in practice and in the National CPA Licensure Examination.

I. Objectives
At the end of the module, the following are expected to:

A. To understand the concept of intercompany transactions;

B. Identify the effect of intercompany transactions to financial statements; and

C. Compute the effect of intercompany sales.

 ACCTG 2215 / Accounting for Business Combinations

INTERCOMPANY PROFIT TRANSACTIONS – INVENTORIES

Business transactions between a parent company and its subsidiary may involve a
profit or a loss and among those transactions are intercompany sales of merchandise and
intercompany sales of plant assets. Upon consolidation, the statements showing the
financial position and the results of operations of two or more affiliated companies shall be
presented as if they were one business company. Any unrealized profits or losses in the
intercompany transactions must be eliminated in the preparation of consolidated
statements, until intercompany profits or losses are realized through the sale to outsiders.

The intercompany profit in inventory transfer between affiliates is computed by

multiplying the inventory held by the buying affiliate which was acquired from the selling
affiliate by the gross profit rate based on sales of the selling affiliate.

Intercompany Sales at Cost

Sometimes, merchandise is sold to related affiliates at the seller’s cost. When an

intercompany sale includes no profit or loss, the inventory amounts at the end of the period
require no adjustment for consolidation because purchasing affiliate’s inventory carrying
amount is the same as the cost to the selling affiliate and the consolidated entity.

Even when the intercompany sale includes no profit or loss, however, an eliminating entry
is needed to remove the intercompany sale and the related cost of goods sold related by
the seller to avoid the overstating of the two accounts. On the other hand, consolidated net
income is not affected by the eliminating entry when the eliminating entry when the
intercompany sale is made at cost because both sales revenue and cost of goods sold are
reduced by the same amount.

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 ACCTG 2215 / Accounting for Business Combinations

Intercompany Sales at a Profit or Loss

Normally, companies include a mark-up on sale of inventory at a certain percentage. As

such, the elimination process must remove the effects of such sales from the consolidated
statements. When intercompany sales include profits or losses, the working paper
eliminations needed for consolidation in the period of sale have two goals:
a. Elimination of the income statement effects of the intercompany sale in the period
of sale, removing the sales revenue from the intercompany sale and the related
costs of goods sold recorded by the selling affiliate; and
b. Elimination from the inventory on the Statement of Financial Position of any profit
or loss on the intercompany sale that has not been confirmed or realized by resale
of the inventory to outsiders.

Inventory reported in the consolidated statement of financial position must be reported at

cost to the consolidated entity. Therefore, if profits or losses have been recorded on the
inventory acquired in an intercompany sale, those profits and losses must be eliminated to
state the inventory in the consolidated statement of financial position at its cost to the
consolidated entity.

DOWNSTREAM SALE OF INVENTORY

Downstream intercompany sales of merchandise are those from a parent company to its
subsidiaries. For consolidation purposes, profits recorded on an intercompany inventory is
resold to outsiders. Until the point of resale, all intercompany profits must be deferred.
Consolidated net income must be based on the realized income of the selling affiliate.

If the intercompany sales of merchandise are made by the parent company or by a wholly
owned subsidiary, there is no effect on any NCI in net income or loss, because the selling
affiliate does not have NCI.

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 ACCTG 2215 / Accounting for Business Combinations

When a company sells merchandise to an affiliate, the merchandise may be resold to

outsiders during the same period or during the next period resulting to unrealized profit in
ending inventory.

UPSTREAM SALE OF INVENTORY

Upstream intercompany sales are those from subsidiaries to the parent company. When an
upstream sale of inventory occurs and the inventory is resold by the parent to outsiders
during the same period, all the parent entries and the eliminating entries in the consolidated
working paper are identical to those in the downstream case.

When the inventory is not resold to outsiders before the end of the period, working paper
eliminating entries are different from a downstream case only by the apportionment of the
unrealized intercompany to both the controlling and NCI. The intercompany profit in an
upstream sale is recognized by the subsidiary and shared between the controlling interest
and NCI. Therefore, the elimination of the unrealized intercompany profit must reduce the
interests of both ownership groups until the profit is realized by resale of the inventory to
outsiders.

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 ACCTG 2215 / Accounting for Business Combinations

REFERENCES:

Advanced Accounting Principles and Procedural Applications Volume 2 by Pedro P. Guerrero

and Jose F. Peralta

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