Downstream Sale of Inventory

My video lectures about downstream sale of inventory, elimination of  intercompany sales of inventory and profit,  downstream sales and how to compute inventory of the purchasing from affiliate can be found in my advanced accounting course and CPA exam lessons.  Or browse from the menu above.

Advanced Accounting Course
Advanced Accounting Course

Intercompany sales of inventory are eliminated, and adjustments made, to report sales revenue, cost of sales, and inventory balances as if the intercompany sale had not occurred. Thus, consolidated sales reflects only sales with “outsiders,” consolidated cost of sales reflects the cost to the consolidated entity, and consolidated inventory is reported at its cost to the consolidated entity (affiliated group).

Intercompany sales (and selling prices) do affect the allocation of profits to the controlling and noncontrolling interests, once the profit is realized through sales to outsiders. Thus, intercompany profit needs to be eliminated only if assets are still on the books of the consolidated entity (one of the members of the affiliated group). In such cases, the amount of profit to be eliminated may be calculated using the selling affiliate’s gross profit rate, which may be stated as a percentage of either sales or costs. (The amount of profit to be eliminated is the same, regardless of how the percentage is stated.)

Proponents of 100% elimination regard all the intercompany profit associated with assets remaining in the affiliated group to be unrealized. Proponents of partial elimination regard only the parent company’s share of the profit recognized by the selling affiliate to be unrealized. Both current and past GAAP require 100% elimination of intercompany profit in the preparation of consolidated financial statements.

Sales from a parent company to one or more of its subsidiaries are referred to as downstream sales. Sales from subsidiaries to the parent company are referred to as upstream sales.

For downstream sales, no modification to the calculation of the noncontrolling interest in consolidated income is needed. For upstream or horizontal sales, however, the noncontrolling interest in income must be adjusted. The reported income of the subsidiary (the selling affiliate) is reduced by the amount of gross profit remaining in ending inventory of the purchasing affiliate before multiplying by the noncontrolling percentage interest; it is increased for gross profit realized from beginning inventory.

In the consolidated workpapers, eliminating and adjusting entries serve to eliminate intercompany sales and adjust both beginning and ending inventories for the effects of any gross profit included from intercompany sales. The noncontrolling interest in consolidated income reflects the adjustment described in the preceding learning objective for upstream (or horizontal) sales. The final column of the workpapers is identical, regardless of whether the parent uses the cost, partial equity, or complete equity method for consolidated investments.

Generally accepted accounting standards are silent as to the appropriate treatment of unrealized profit on assets that result from sales between companies prior to affiliation (pre affiliation profit). The question is whether preaffiliation profit should be eliminated in consolidation. In our opinion, workpaper entries eliminating preaffiliation profit are inappropriate.