Chapter

Intercompany Inventory and Land Profits

6
Intercompany Revenue and Expenses – To ensure that consolidated financial statements reflect
only transactions between the single entity and those outside the entity, all intercompany
transactions are eliminated. The elimination of intercompany revenues and expenses does not
affect the net income of this entity (since we eliminate an equal amount from revenue and
expense); therefore, it cannot affect the amounts allocated to the two equities in the balance
sheet.

Intercompany Profits in Assets – Intercompany profits in assets are not recognized in the
consolidated financial statements until the assets have been sold outside the group or consumed.
(The concept of realization as a result of consumption is discussed in the next chapter.) A
transaction with an outside entity that is not associated with the consolidated group is referred to
as an arm’s-length transaction. Revenue is recognized when it is earned in a transaction with an
outsider in accordance with the revenue recognition principle. The cost of sales is expensed in
the same period as the revenue in accordance with the matching principle. If the intercompany
sales transactions are not eliminated, then sales and cost of sales would be overstated for the
consolidated entity. The elimination entries are recorded on the consolidated working papers and
not in the separate-entity books of the parent and the subsidiary.

Three types of unrealized intercompany profits (losses) in assets are eliminated:

• Profits in inventory;
• Profits in non-depreciable assets; and
• Profits in depreciable assets.
The first two of these will be discussed in this chapter; the last one will be discussed in Chapter
7.

Downstream and upstream are defined by who the seller is. When the parent sells to the
subsidiary, the transaction is referred to as a downstream transaction. When the subsidiary sells
to the parent or another subsidiary, the transaction is referred to as an upstream transaction. The
company doing the selling is the one recognizing the profit on the sale. When we eliminate the
profit from intercompany transactions, we should take it away from the selling company, that is,
from the company that recognized the profit in the first place.

Holdback of Intercompany Inventory and Land Profits – The elimination of unrealized

intercompany profits in assets reduces the net income of the consolidated entity. Also, it will
affect the amount allocated to non-controlling interest only if the subsidiary was the selling
company. Non-controlling interest is not affected by intercompany profits made on downstream
transactions. Non-controlling interest is affected and will share in intercompany profits made on
upstream transactions. Non-controlling interest is based on subsidiary’s shareholders’ equity
after it has been adjusted for unrealized profit on upstream transactions. The income tax recorded
on the unrealized profit is also removed from the consolidated income statement and is shown as
deferred income taxes until a sale to outsiders takes place.

The unrealized profit is always deducted from the selling company’s income (for instance,
unrealized profits on downstream transactions are deducted from the parent’s separate-entity
income, whereas unrealized profits on upstream transactions are deducted from the subsidiary’s
separate-entity income). The unrealized profits are eliminated on the consolidated financial
statements, and thus, by eliminating the unrealized profit, the asset (inventory, land, etc) is now
stated at cost to the consolidated entity. However, note that the unrealized profits are not
eliminated on the separate-entity financial statements. The unrealized profits will be eliminated
from retained earnings of the selling company on the consolidated working papers each year
until the land is sold to outsiders.

The adjustments to eliminate the unrealized profits are needed in order to properly apply the cost,
revenue recognition, and matching principles.

Realization of Intercompany Inventory and Land Profits – When the assets that contain the
intercompany profit are sold outside (or consumed), the profit is considered realized and is
reflected in the consolidated income statement. When the profits are realized, they are credited to
the income of the original seller. The appropriate income tax is removed from the consolidated
balance sheet and reflected as an expense in the income statement. The adjustments for income
tax ensure that income tax expense is properly matched to income recognized on the
consolidated income statement. Income tax should be expensed in the same period as revenue.
The unrealized profit is deducted from the inventory to bring inventory back to its original cost
in accordance with the historical cost principle.

Unrealized Profits with Associates – When the investor only has significant influence in an
associate, it cannot control the decisions made by the associate. As such, transactions with the
associate are similar to transactions with outsiders. Therefore, the accounting for unrealized
profits on downstream transactions is a bit different for an investment in an associate. Rather
than eliminating all of the profit, only the investor’s percentage ownership of the associate times
the profit earned on the transaction with the associate is eliminated.

Equity Method Journal Entries – The equity method captures the net effect of all consolidation
entries including the adjustments for unrealized and realized profits on intercompany
transactions. The parent’s income under the equity method should be equal to consolidated net
income. This is why the equity method is referred to as the one-line consolidation.

Losses on Intercompany Transactions – When one affiliated company sells inventory to another
affiliated company at a loss, the intercompany transaction and any unrealized losses should be
eliminated on consolidation in a similar fashion to the previous discussion for unrealized profits.
However, selling inventory at a loss raises a red flag that it may be impaired. If the inventory is
impaired, it should be written down to its net realizable value. Ideally, the impairment should be
reported on the separate-entity statements. If not, the impairment will have to be reported on the
consolidated statements. Impairment tests for inventory are usually performed at the end of the
fiscal period. When intercompany losses are eliminated, the inventory is brought back to the
original cost to the selling entity. Inventory on the consolidated balance sheet should be reported
at the lower of cost and net realizable value. Intercompany transactions are not always
consummated at market value, which means that artificial gains and losses may be recognized in
the separate-entity financial statements as a result of the related-party transactions.

Intercompany Transfer Pricing – From a financial reporting point of view we are not concerned
with the amount of profit earned by each company, but only with eliminating intercompany
transactions and profits that are unrealized because they have not been sold outside the
consolidated “single entity.” From a Canadian taxation point of view, the consolidated entity is
not subject to tax; rather each company pays tax on its taxable income. It should seem obvious
that the management of the parent company would be interested in maximizing the after-tax
profit of this single entity if possible. Intercompany transactions are sometimes undertaken to
transfer profit from high-tax to low-tax jurisdictions. This will often bring companies into
conflict with the governments of the high-tax-rate jurisdictions.

ASPE Differences
As mentioned in Chapter 3, private companies can either consolidate their subsidiaries or report
their investments in subsidiaries under the cost method, equity method, or at fair value.