affiliated consolidated entity is an aggregation of a number of different companies. The financial statements prerequisitey the individual affiliates are consolidated into a single set of financial statements representing the financial position and operating results of the entire economic entity as if it were a single company.
A parent organization and its subsidiaries frequently participate in different transactions among themselves. For instance, manufacturing organization (a parent company) regularly have subsidiaries that create raw materials or produce components to be used in the production of parent organization. Such transactions often are crucial to the operations of the overall consolidated entity. These transactions between affiliated companies are referred to as intercompany or intercorporate transfers.
The main idea behind consolidated financial statements is that they report the activities of the consolidating entities as if the separate entities actually constitute a single organization. Because single companies are not permitted to reflect internal transactions in their financial statements, consolidated entities also must exclude from their financial statements the effects of transactions that are totally within the consolidated entity.
Intercompany Elimination of Transfers
No differentiation is made between wholly owned and less than wholly owned subsidiaries with regard to the elimination of intercompany transfers. The concentration in consolidation is on the single entity concept rather than on the percentage of ownership. Once the prerequisites for consolidation are met, a company becomes part of a single economic entity, and all transactions with related companies become internal transfers that must be eliminated fully, regardless of the percentage of ownership held.
Elimination of Unrealized Profits and Losses
Companies usually record transactions with affiliates on the same basis as transactions with unaffiliated, including the recognition of profits and losses. Profit or loss from selling an item to a related company usually is considered realized at the time of the sale from the selling company’s standpoint, but the profit is not realized for consolidation until resale to an unaffiliated company. This unconfirmed profit from an intercompany transfer is referred to as unrealized intercompany profit.
Transfers at Cost
Goods are sometimes sold to affiliated companies at the seller’s cost or carrying value. When an intercorporate sale includes no profit or loss, the balance sheet inventory at the end of the period need no modification for consolidation because the buying company’s inventory is the same as the cost to the transferring affiliate and the consolidated entity. At the time the inventory is resold to an unaffiliated, the amount recognized as cost of goods sold by the affiliate making the outside sale is the cost to the consolidated entity.
Even when the intercorporate sale includes no profit or loss, however, a worksheet elimination entry is needed to remove both the revenue and the cost of goods sold recorded by the seller from the intercorporate sale and any unpaid payable or receivable balance that may remain. This worksheet elimination entry avoids overstating these two accounts. The elimination entry does not affect consolidated net income when the transfer is made at cost because both revenue and cost of goods sold are reduced by the same amount.
Transfers at a Profit or Loss
Organizations use many different methods in setting intercompany transfer prices. In some organizations, the sale price to an affiliate is the same as the price to any other customer. Some companies routinely mark up inventory transferred to affiliates by a certain percentage of cost. Other companies have elaborate transfer pricing policies
designed to encourage internal sales. Regardless of the method used in setting intercompany transfer prices, the elimination procedure must exterminate the consequents of such sales from the consolidated statements.
Two Types of Intercompany Inventory Transfers
Calculating Unrealized Profit or Loss
The calculation of unrealized intercompany profit or loss is an important step in eliminating the effects of intercompany transfers. In order to illustrate this calculation, it is important to first understand that there are two types of intercompany inventory transfers:
(1) a transfer from one affiliate to another, which is then sold to an independent unaffiliated and
(2) a transfer from one affiliate to another, which has not yet been sold to an independent unaffiliated. Figure above presents examples of each type of transfer.
In each case, Company A purchases inventory in an arm’s-length transaction from an independent party. Company A then transfers the inventory to Company B (an affiliate) at a profit. In case 1, Company B eventually sells the inventory to an unrelated party. However, in case 2, Company B still holds the inventory at the end of the reporting period. The gross profit on the case 2 transfer from Company A to Company B represents unrealized intercompany profit because the inventory has not yet been sold to an independent party. When companies sell to affiliated companies on a regular basis, at the end of a reporting period, some of the inventory is often still on hand awaiting the sale to an independent party. Thus, the two cases in Figure above could represent intercompany sales (1) during the period and (2) just prior to the end of the period. The following chart summarizes these intercompany inventory transactions:
Company A has total intercompany sales of $4,000 to Company B with total gross profit on these sales of $800. These sales can be divided into two categories: (1) those that Company B eventually resells during the current period, $3,000, and (2) those that are still in Company B’s inventory at the end of the accounting period, $1,000. The gross profit on the intercompany sales that have not yet been realized through a sale to an independent third-party, $200, should be deferred until this inventory is eventually resold to an unaffiliated. Under the fully adjusted equity method, this unrealized gross profit is deferred on the parent company’s books through an equity method entry (discussed in more detail later). All intercompany sales are also deferred in the consolidated financial statements through a worksheet elimination entry(ies).
It is sometimes necessary to use the gross profit percentage to estimate the unrealized gross profit on intercompany transfers, assuming that the selling company uses a constant markup percentage on all intercompany transfers. For example, assume that Company A transfers inventory costing $9,000 to Company B, an affiliated company, for $10,000. At the end of the accounting period, Company B still has $3,000 of this inventory on hand in its warehouse. To calculate the unrealized profit given this limited information, first calculate gross profit and gross profit percentage on total intercompany sales.
Gross profit is $1,000. Thus, gross profit percentage is 10 percent ($1,000 ÷ $10,000). If we assume the gross profit percentage is the same across all intercompany sales, we can estimate the unrealized gross profit on intercompany sales (lower right-hand corner of the chart) by multiplying the balance on hand in intercompany inventory by the gross profit percentage to calculate the unrealized gross profit of $300 ($3,000 × 10%).
Intercompany Eliminations Example
To explain how to separately eliminate the effects of these types of inventory transfers, we repeat the summary of the transactions from above:
We first focus on Column (1), which summarizes all sales of inventory from Company A to Company B that have eventually been sold to a unaffiliated company. The inventory was primarily purchased in an arm’s-length transaction for $2,400. It was then transferred from Company A to Company B for $3,000. Eventually, this inventory was sold to an unrelated company for $3,500. The only portion of this transaction that does not involve an unaffiliated party is the $3,000 internal transfer, which needs to be eliminated. In this transaction, it turns out that Company A’s transfer price or sales revenue is $3,000. Company B primarily records its inventory at this same amount, but when it is sold, $3,000 is removed from inventory and recorded as cost of goods sold. Thus, the elimination entry to remove the effects of this transfer removes Company A’s sales revenue and Company B’s cost of goods sold related to this intercompany transfer as follows:
We next turn our attention to Column (2), which outline all inventory sales from Company A to Company B that are not yet sold to a unaffiliated company. Company A primarily purchased the inventory from an unaffiliated company for $800 and then transferred it to Company B for $1,000. The unrealized gross profit on this transfer is $200. Two problems are connected with this transaction. First, Company A’s income is overstated by $200. Second, Company B’s inventory is overstated by $200. Although the inventory was purchased in an arm’s-length transaction for $800, the intercompany transfer resulted in the basis of the inventory being raised by $200. To guarantee that the consolidated financial statements will appear as if the inventory had remain on Company A’s books (as if it had not been transferred), we prepare the following elimination entry: