Advanced Accounting

Thirteenth Edition, Global Edition

Chapter 5
Intercompany Profit
Transactions –
Inventories

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Intercompany Profits – Inventories:
Objectives
5.1 Understand the impact of intercompany inventory
profit on consolidation work papers.
5.2 Apply the concepts of upstream versus downstream
inventory transfers.
5.3 Defer unrealized inventory profits remaining in the
ending inventory.
5.4 Recognize realized, previously deferred inventory
profits in the beginning inventory.
5.5 Adjust noncontrolling interest amounts in the
presence of intercompany inventory profits.

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5.1 Intercompany Inventory
Transactions

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• Firm recognize revenue when it is realized, that is,
when it is earned. For revenue to be earned from
the viewpoint of the consolidated entity, there must
be a sale to outside entities.
• Revenue on sales between affiliates cannot be
recognized until merchandise is sold outside of the
consolidated entity.
• The sale of inventory items by one company to an
affiliate produces reciprocal sales and purchases
accounts as well as reciprocal accounts receivable
and accounts payable..

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• 1. 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%
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.
•

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Pop’s Book Son’s Book
• Inventory $40,000 • Inventory $48,000
Accounts payable $40,000 Accounts payable $48,000
To record purchases on account from To record intercompany purchases
other entities. from Pop.
• Accounts receivable $48,000 • Accounts receivable $60,000
sales $48,000 sales $60,000
To record intercompany sales to Son.
• Cost of sales $40,000 • Cost of sales $48,000
Inventory $40,000 Inventory $48,000

2015/8/30 7
 Pop Son consolidate

Sales $48,000 $60,000 $?

Cost of Sales (40,000) (48,000) (?)

Gross Profit $ 8,000 $ 12,000 $?

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Elimination of Intercompany Purchases and
Sales

• Under a periodic inventory system, the

workpaper entry is a debit to sales and a
credit to purchases.
• Under a perpetual inventory system
(discussed in the text), the workpaper entry
is a debit to sales and a credit to cost of
goods sold.

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 Pop Son adjustments consolidate
Sales $48,000 $60,000 48,000 $60,000
Cost of Sales (40,000) (48,000) 48,000 (40,000)
Gross Profit $ 8,000 $ 12,000 $ 20,000
The worksheet entry for 2016:

Sales (-R, -SE) 48,000 blank

Cost of sales (-E, +SE) blank 48,000
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blank blank
Elimination of Intercompany Purchases and
Sales

• The elimination of intercompany sales and

purchases (or cost of goods sold) does not
affect consolidated net income.
• However, consolidated sales, cost of goods
sold, and purchases will be reduced.
• Since an equal amount of sales and cost of
sales is eliminated, neither gross profit nor
net income is affected.

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• Transactions between affiliated companies
(intercompany transactions) must be eliminated
during the consolidation process.
• Reciprocal account balances are eliminated. For
example, intercompany sales transactions create
reciprocal sales and purchases accounts as well as
reciprocal accounts receivable and accounts
payable.

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Unrealized profits in ending inventory

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 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.

Pop’s Book Son’s Book

• Inventory $60,000 • Inventory $72,000
Accounts payable $60,000 Accounts payable $72,000
To record purchases on account To record intercompany purchases
from other entities. from Pop.
• Accounts receivable $72,000 • Accounts receivable $75,000
sales $72,000 sales $75,000
To record intercompany sales to
Son. • Cost of sales $60,000
• Cost of sales $60,000 Inventory
Inventory $60,000
$60,000

14
During 2017, Pop sold goods costing $60,000 to
Son for $72,000. Son sold all but $12,000 of the
inventory to its customers for $75,000.
Pop Son adjustments consolidated
Sales $72,000 $75,000 ?
Cost of Sales (60,000) (60,000) ?

Gross Profit $12,000 $15,000 ?

Balance sheet
Inventory $12,000 ?

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• The consolidated entity views this as an
intercompany transfer of merchandise that costs
$60,000:
• $50,000(or 5/6) of this merchandise was then sold
to outside entities for $75,000.
• $10,000(or 1/6) remains in inventory at year-end.
• The consolidated entity realizes a gross profit of
$25,000.

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Intercompany Profits Only in Ending
Inventories (continued)
Worksheet entries for 2017:
Sales (-R, -SE) 72,000 Blank
Cost of sales (-E, +SE) Blank 72,000
blank Blank
Cost of sales (E, -SE) 2,000

Inventory (-A) 2,000

blank blank

Defer the $2,000 intercompany profit that remains unrealized ($27,000

combined gross profit - $25,000 consolidated gross profit) and reduce
the ending inventory from $12,000 to $10,000 cost to the consolidated
entity.

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 Pop Son adjustments consolidated

Sales $72,000 $75,000 $72,000 $75,000

Cost of Sales (60,000) (60,000) $2,000 $72,000 (50,000)

Gross Profit $12,000 $15,000 $25,000

Balance sheet

Inventory $12,000 $2,000 $10,000

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unrealized profits in the ending inventory
• The unrealized profit is deferred until it is
realized when sold to an outside entity.
• 1 Deferral is accomplished with a
workpaper entry that increases cost of
goods sold for the unrealized profit and
reduces ending inventory to its cost basis (to
the consolidated entity).
•  2 From the consolidated entity viewpoint,
unrealized profits in the ending inventory
understate cost of goods sold and overstate
consolidated net income. 

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• Under the equity method, Pop’s one-line consolidation
entry reduces Income form Son by the $2,000 unrealized
profit in the ending inventory and accordingly reduces the
Investment in Son account by $2,000.
• Income form Son $2,000
Investment in Son $2,000

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Q1,Q2
Recognition of Unrealized profits in
beginning inventory

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• C. During 2018, Pop sold merchandise that
cos $80,000 to Son for $96,000, and Son
sold 75% of the merchandise for $90,000.
• Son also sold the beginning inventory with a
transfer price of $12,000 to its customers for
$15,000.

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 During 2018, Pop sold merchandise that cos $80,000 to Son for $96,000,
and Son sold 75% of the merchandise for $90,000. Son also sold the
beginning inventory with a transfer price of $12,000 to its customers for
$15,000.

Pop’s Book Son’s Book

• Inventory $80,000 • Inventory $96,000
Accounts payable $80,000 Accounts payable $96,000
To record purchases on account To record intercompany purchases
from other entities. from Pop.
• Accounts receivable $96,000 • Accounts receivable $105,000
sales $96,000 sales $105,000
To record intercompany sales to
Son. • Cost of sales $84,000
• Cost of sales $80,000 Inventory
Inventory $84,000
$80,000
96,000*75% + 12,000 = 84,000
• From the viewpoint of the consolidated entity,
merchandise that costs $80,000 was transferred
intercompany :
• $60,000(75%) of this merchandise, plus $10,000
beginning inventory, was sold for $105,000.
• $20,000(25%) remains in inventory at year-end.
• The consolidated entity realizes a gross profit of
$35,000.

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 Pop Son adjustments consolidated
Sales $96,000 $105,000 ?
Cost of Sales (80,000) (84,000)* ?

Gross Profit $16,000 $21,000 ?

*96,000*0.75+12,000=84,000
Balance sheet
Inventory $24,000 ?
96,000*0.25

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Intercompany Profits Beginning and
Ending Inventories (continued)
Worksheet entries for 2018:
Sales (-R, -SE) 96,000 blank

Cost of sales (-E, +SE) blank 96,000

Eliminate intercompany sales blank blank
Cost of sales (E, -SE) 4,000 blank

Inventory (-A) blank 4,000

Defer unrealized profit in ending inventory blank blank

Son sold 75% of the merchandise purchased form 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).

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Intercompany Profits Beginning and
Ending Inventories (continued)
Worksheet entries for 2018:
Investment in Son (+A) 2,000 k

Cost of sales (-E, +SE) 2,000

Realize previously deferred profit from beginning
inventory blank blank

From the viewpoint of the consolidated entity, the $2,000 overstated beginning
inventory overstates cost of sales in 2018.
This entry recognizes previously deferred profit from 2017 by reducing
consolidated cost of sales and thereby increasing consolidated gross profit.

Debit to the Investment in Son

Adjust for the Investment in Son in 2017 to defer unrealized profit in the ending
inventory of that year.

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 Pop Son adjustments consolidated
Sales $96,000 $105,000 $96,000 $105,000
Cost of Sales (80,000) (84,000)* $4,000 $96,000 (70,000)
$2,000
Gross Profit $16,000 $21,000 $35,000
*96,000*0.75+12,000=84,000

Balance sheet
Inventory $24,000 $4,000 $20,000
96,000*0.25 80,000*0.25

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• The effect of unrealized profits in the beginning
inventory is the opposite of the effect of
unrealized profits in the ending inventory.
• a Unrealized profits in the ending inventory
(year of intercompany sale) have a direct
relationship to consolidated net income.
• b Unrealized profits in the beginning inventory
(year of sale to outside entities) have an inverse
relationship to consolidated net income. 

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Intercompany Sales of Inventory
Profits on intercompany sales of inventory
– Recognized if goods have been resold to
outsiders
– Deferred if the goods are still held in inventory
Previously deferred profits in beginning inventory are
recognized in the period the goods are sold.

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Q3
5.2 Downstream And Upstream Sales

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Assume that the separate incomes of Pop and its 80%
owned Son for 2016 are as follows
P175
(in thousands):
Blank
Pop Son
Sales $600 $300
Cost of sales 300 180
Gross profit 300 120
Expenses 100 70
Pop’s separate income $200 blank
Son’s net income $50
Intercompany sales during the year are $100,000,
and the December 31,2016, inventory includes
$20,000 unrealized profit.

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If intercompany sales are downstream
• Income from son=?
• Noncontrolling interest share=?
If intercompany sales are upstream
• Income from son=?
• Noncontrolling interest share=?

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 Downstream sales
• sales from a parent to its subsidiary.

1. The consolidation process eliminates the full amount of

intercompany sales and cost of sales, regardless of
whether the sales are downstream or upstream.
2. the parent company’s separate income includes the
unrealized profit (in its sales and cost of sales accounts).
3. The subsidiary’s net income is not affected; therefore, the
noncontrolling interest is computed as the subsidiary’s
reported net income multiplied by the noncontrolling
interest percentage.

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 Downstream sales
4. The subsidiary’s ending inventory includes the unrealized
profit until the merchandise is sold to outside entities.
a) The subsidiary’s ending inventory reflects the transfer
price, rather than the cost to the consolidated entity.
b) In the consolidation workpapers, the inventory is reduced
to its cost basis by a debit to cost of goods sold and a
credit to ending inventory.
5. Under the equity method, the full amount of unrealized
profit from intercompany downstream sales is charged
against the income from subsidiary (i.e., not allocated to
the noncontrolling interest).

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Unrealized profit in ending inventory
= $20,000
Pop's Income from Sun
80%(50,000) – 20,000 unrealized profits = $20,000
Noncontrolling interest share
20%(50,000) = $10,000

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Upstream sales==sales from a subsidiary to its parent
1. Again, the consolidation process eliminates the full amount
of intercompany sales and cost of sales, regardless of
whether the sales are downstream or upstream.
2. The subsidiary’s net income includes the unrealized profit (in
its sales and cost of sales accounts).
a) The unrealized profit in the subsidiary’s net income is
allocated proportionately to the controlling and
noncontrolling interests in our text.
b) Consolidated net income and noncontrolling interest are
computed on the basis of income that is realized from the
viewpoint of the consolidated entity.
c) A subsidiary’s realized income is its reported net income,
adjusted for intercompany profits from upstream sales.
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Upstream sales==sales from a subsidiary to its parent
3. The parent company’s separate income is not affected by
unrealized profits from upstream sales, but its net income,
which includes investment income, is affected.
4. The parent company’s ending inventory includes the
unrealized inventory profit until the merchandise is sold to
outside entities.
5. Under the equity method, only the parent’s proportionate
share of unrealized profits from intercompany upstream sales
is charged against income from the subsidiary.

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Assume that the separate incomes of Pop and
its 80% owned Son for 2016 are as follows
(in thousands):
Blank
Pop Son
Sales $600 $300
Cost of sales 300 180
Gross profit 300 120
Expenses 100 70
Pop’s separate income $200 blank
Son’s net income $50
Intercompany sales during the year are $100,000,
and the December 31,2016, inventory includes
$20,000 unrealized profit.

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Unrealized profit in ending inventory
= $20,000
Pop's Income from Sun
80%(50,000– 20,000 unrealized profits) = $24,000
Noncontrolling interest share
20%(50,000– 20,000 unrealized profits) = $6,000

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downstream, by Pop to Son upstream, by Sun to Pam

• Unrealized profit in ending • Unrealized profit in ending

inventory =$20,000 inventory =$20,000

• Pop's Income from Son • Pop's Income from Son

= 80%(50,000) – 20,000 = 80%(50,000 – 20,000 )

= $20,000 = $24,000

• Noncontrolling interest • Noncontrolling interest

share share

=20%(50,000) = $10,000 =20%(50,000-20,000)

=$6,000

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Q4, Q5