How do unrealized intercompany inventory profits from a prior period affect the computation of consolidated net income when the inventory is resold in the current period?
The unrealized intercompany profits from prior period should be included in consolidated net income as well as the retained earnings of the company that realized the sale. The deferred unrealized profits indirectly affects the selling company’s retained earnings. Where the unrealized profits resulted from the parent company selling to a subsidiary, the income realized to the percentage controlled will add up with the whole amount of profit. With reference to Susan (2015) scholarly works, where profits are obtained from the subsidiary selling to the parent company revenue submitted to percentage controlled and non-controlled interest will be added up in the period the income or profit is realized .
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Therefore intercompany transactions involve the parent company selling inventory to subsidiary and vice versa. The selling company sells goods a price higher than the cost of buying the commodities. Where the goods are sold near the end of the financial year, some stocks remain unsold resulting in unrealized profits. Susan (2015) asserted that a selling company anticipates profits from goods purchased but where the inventory remains unsold to a third party this amounts to unrealized profits on the closing stock. From the group accounts rules any intercompany balances, intragroup dividends, intragroup sales, and unrealized profits are eliminated in full. The purposes to avoid overstating company balances and consolidated income statement. To eliminate the unrealized profits in closing stock group retained earnings account is debited while group inventory account is credited.
Is it important to know if the sale was upstream or downstream from a financial and economic perspective to the parent? Why?
Yes, it is necessary to know whether the sales made were upstream or downstream. For the upstream case that is subsidiary selling to parent company, the intercompany profit made is acknowledged by the subsidiary. The holding company identifies the proportion of share of profit. The amount is added to reserves of the following accounting period. Where the parent company sells to the subsidiary that is downstream method, the intercompany profit is recognized by the holding company. Thus, it is added to the retained earnings from the following years.
References
Susan M. A. (2015). Intercompany transactions snowball: how to cope. Strategic Finance , 96 (10), 48.
