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Consolidation – Intercompany Transactions

Sale of Inventories (Guerrero & Peralta, 2017)

Many business transactions between a parent company and its subsidiary involve a profit or loss. Among
these transactions are intercompany sales of merchandise inventory and plant assets. Consolidated
statements are prepared to show the financial position and operations of two (2) or more affiliated
companies as if they are one business. Thus, the unrealized profits or losses arising from the said
transactions must be eliminated to prepare consolidated financial statements.

Intercompany profit in inventory transfer can be computed by multiplying the inventory held by the buying
affiliate, which was acquired from the selling affiliate, by the gross profit rate based on sales of the selling
affiliate.

The working paper elimination entries used in preparing consolidated financial statements must fully
eliminate the effects of all transactions between related companies. When there are intercompany inventory
transactions, the “eliminating entries” are needed to remove the revenue and expenses related to the
intercompany transfers recorded by the individual companies. The elimination ensures that only the
historical cost of the inventory still on hand is included in the consolidated Statement of Financial Position.

Intercompany Sales at Cost

Merchandise sometimes is sold to related affiliates at the seller’s cost. When an intercompany sale includes
no profit or loss, the inventory amounts at the end of the period require no adjustments for consolidation.
When the inventory is resold to outsiders, the amount recognized as the cost of goods sold by the affiliate
is the cost to the consolidated entity.

However, even when the intercompany sale includes no profit or loss, the “eliminating entry” is needed to
remove the intercompany sale, and the related costs of goods sold recorded by the seller. This avoids
overstating the said accounts. The consolidated comprehensive income is not affected by eliminating entry
when the intercompany sale is made at cost. It is because both sales revenue and cost of goods sold are
reduced by the same amount.

Intercompany Sales at a Profit or Loss

The sale of inventory to affiliates is usually “marked-up” by a certain percentage based on cost. For example,
a company may mark up 50% of its inventory sale to its affiliates. Hence, inventory costing P2,000 will be
sold for P3,000. The elimination process will remove the effects of the sale in the consolidated statements.

When intercompany sales include profits or losses, the working paper eliminations needed for the
consolidation have two (2) goals:

• Elimination of the effects in the statement of comprehensive income (SCI) of the intercompany sale by
removing the sales revenue from the intercompany sale and the related costs of goods sold recorded
by the selling affiliate.
• Elimination from the inventory on the statement of financial position (SFP) of any profit or loss on the
intercompany sale that has not been confirmed or realized by resale of the inventory to outsiders.

Inventory reported in the consolidated statement of financial position must be reported at a cost to the
consolidated entity. Any profit or loss arising from intercompany sales must be eliminated.

There are two (2) ways of selling the inventory between affiliates, downstream and upstream sales.

• Downstream intercompany sales. These are sales made by a parent company to its subsidiaries. For
consolidation purposes, profits recorded on an intercompany inventory sale are realized in the period
in which the inventory is resold to outsiders. Until the point of resale, all intercompany profits must be
deferred. Consolidated comprehensive income must be based on the realized income of the selling
affiliate. If the intercompany sales of merchandise are made by the parent company or by a wholly-
owned subsidiary, there is no effect on any non-controlling interest (NCI) in the consolidated income or
loss. It is because the selling affiliate does not have an NCI.

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Illustrative Example I:
On January 2, 20X1, Peter Corporation (PC) purchases 80% of the common stock of Saul Company
(SC) for P300,000. On May 20X1, PC sold merchandise costing P8,000 to SC for P10,000. Saul
Company sold the merchandise to outsiders for P15,000.

Required: Prepare the necessary entries to be made by both companies.

Answer: The journal entries to record the sale of inventory are as follows:

Books of Peter Corporation

Books of Saul Company

Given below is an analysis of the transaction.

Item Peter Saul Unadjusted Consolidated

Corporation Company Balances Amounts
Sales P10,000 P15,000 P25,000 P15,000
Cost of Goods Sold (8,000) (10,000) (18,000) (8,000)
Gross Profit P2,000 P5,000 P7,000 P7,000

Although the consolidated gross profit is correct, even if no eliminations are made, the total sales and
cost of goods sold derived by simply adding the amounts on the books of Peter Corporation and Saul
Company are overstated. Since consolidated sales and cost sales and cost should be P15,000 and
P8,000, respectively, rather than P25,000 and P18,000, an elimination entry must be prepared, as
follows:

Ending Inventory

Any merchandise purchased from an affiliated company that remains unsold on the date of preparing
the Consolidated Statement of Financial Position will overstate the purchaser’s ending inventory. This
overstatement can be canceled through working paper elimination entries.

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Illustrative Example II:

Assume again that Peter Corporation sold merchandise to Saul Company on April 1, 20X1 costing
P8,000 for P10,000. Out of which, P4,000 remain unsold by Saul on December 31, 20X1. Saul uses in
all of its sales a 25% mark-up rate based on cost.

Required: Prepare the necessary entries to be made by both companies.

Answer: The journal entries to record the sale of inventory are as follows:

Books of Peter Corporation

Books of Saul Company

The intercompany gross profit in Peter Corporation’s sales to Saul Company can be analyzed as
follows:

Item Selling Price Cost Gross Profit

Beginning Inventory - - -
Add: Intercompany Sales P10,000 P8,000 P2,000
Totals P10,000 P8,000 P2,000
Less: Ending Inventory 4,000 3,200 800
Cost of Goods Sold P6,000 P,4800 P1,200

The analysis above shows that the intercompany profit on sales by Peter Corporation to Saul Company
totaled P2,000 and that P1,200 of this intercompany profit was realized through Saul Company’s sales
to outside parties of the acquired merchandise. The remaining P800 of intercompany profit remains
unrealized in Saul Company’s inventories on December 31, 20X1. The following working paper
elimination entries may be prepared about the transaction.

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The effect of the given elimination entries are as follows:

o The first entry eliminates Peter Corporations’ intercompany sales to Saul Company and the
related cost of goods sold. This removes the overstatement of the consolidated amounts for
sales and the cost of goods sold.
o The second removes the intercompany profit from Saul’s cost of goods sold, thereby reducing
the consolidated inventories to the actual cost for the consolidated entity.

Intercompany Profit in Beginning and Ending Inventories

Problems are also encountered in preparing the working elimination entries when the beginning
inventory of the affiliate includes purchases from the parent. Generally, it is assumed that on a first-in,
first-out basis, the intercompany profit in the purchaser’s beginning inventories will be realized through
sales of the merchandise to outsiders during the following period. Only the intercompany profit in the
ending inventories remain unrealized at the end of the period.

Illustrative Example III:

In addition to the previously given transactions, Peter Corporation sold another merchandise to Saul
Company for P25,000 at gross margin of 20%. Of the said merchandise, P6,000 remains in the ending
inventory of 20X2. The intercompany transactions are analyzed as follows:

Item Selling Price Cost Gross Profit

Beginning Inventory P4,000 P3,200 P800
Add: Intercompany Sales 25,000 20,000 5,000
Totals P29,000 P23,200 P5,800
Less: Ending Inventory 6,000 4,800 1,200
Cost of Goods Sold P23,000 P18,400 P4,600

Given below are the working paper elimination entries:

Peter Corporation’s intercompany sales and cost of goods sold in 20X1 have been closed already with
the other income accounts and then to the retained earnings. Thus, from the consolidation point of view,
Peter Corporation’s retained earnings account was overstated by P800, which is the unrealized profit
in Saul’s inventory on December 31, 20X1. However, in 20X2, the said unrealized profit was charged
to the cost of goods sold when it was sold. Thus, overstating the consolidated cost of goods sold in
20X2.

Computation and Allocation of Consolidated Comprehensive Income

To allocate the consolidated income involving inventories, one may follow the formula below:

Parent Corporations’ Comprehensive Income from Own Operation xxx

Add: Realized Profit in Beginning Inventory xxx
Less: Unrealized Profit Ending Inventory (xxx)
Parent Corporation’s Realized Comprehensive Income xxx
Add: Subsidiary’s Comprehensive Income xxx
Consolidated Comprehensive Income xxx
Less: Attributable to Non-Controlling Interest (NCI) xxx
Attributable to Parent Corporation’s Shareholders xxx

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Illustrative Example IV:

Applying the above formula, the allocation of consolidated net income for Peter Corporation and Saul
Company in each year are is given below. Assuming that its income from operation amounts to P50,000
and P80,000 for 20X1 and 20X2, respectively.

20X1 20X2
Peter Corporations’ Comprehensive Income from Own Operation P50,000 P80,000
Add: Realized Profit in Beginning Inventory 800
Less: Unrealized Profit Ending Inventory 800 1,200
Peter Corporation’s Realized Comprehensive Income 49,200 P79,600
Add: Saul’s Comprehensive Income (SCI) 20,000 50,000
Consolidated Comprehensive Income P69,200 P129,600
Less: Attributable to Non-Controlling Interest (NCI) (SCI x 20%) 4,000 10,000
Attributable to Parent Corporation’s Shareholders P65,200 P119,600

• Upstream intercompany sales. These are sales from subsidiaries to the parent company. When an
upstream sale of inventory occurs, and the inventory is resold by the parent to outsiders, the same
process of consolidation made in downstream sales shall apply. However, when the inventory is not
resold to outsiders before the end of the period, there is now a difference in the elimination entries. The
difference pertains to the apportionment of unrealized intercompany profit to both the controlling and
NCI.

Unrealized Intercompany Profit in Ending Inventories

An upstream sale with unrealized intercompany profit ending inventories can be illustrated as follows:

Illustrative Example V:
Assume that Saul Company, which is 80% owned by Peter Corporation, sold merchandise to the latter
during 20X1 at a gross margin of 20%. The sale amounted to P10,000 wherein P4,000 was remain
unsold by Peter Corporation as of December 31, 20X1.

Both journal and working paper elimination entries that will be prepared are the same as the
downstream sales in Illustrative Example I.

Intercompany Profit in Beginning and Ending Inventories

In addition to the previously given transactions, Saul Company sold another merchandise to Pater
Corporation for P25,000 at a gross margin of 20%. Of the said merchandise, P6,000 remains in the
ending inventory of 20X2. Given below are the elimination entries to be made.

NCI is considered part of the consolidated stockholder’s equity, and thus, they are considered part
owners of the consolidated assets. As such, their share in the intercompany profits in inventories is
considered not realized.

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Accordingly, the subsidiary’s consolidated comprehensive income must be increased by the realized
intercompany profit in the beginning inventories and decreased by the unrealized intercompany profit
in the parent’s ending inventories.

Computation and Allocation of Consolidated Comprehensive Income

In allocating for the consolidated comprehensive income, one may follow these steps:

1. Solve for the realized comprehensive income of the subsidiary.

Subsidiary’s Comprehensive Income xxx

Add: Realized Profit in Beginning Inventory xxx
Less: Unrealized Profit Ending Inventory (xxx)
Subsidiary’s Realized Comprehensive Income

2. Then, prepare the allocation.

Parent Corporations’ Comprehensive Income from Own Operation xxx

Add: Subsidiary’s Realized Comprehensive Income xxx
Consolidated Comprehensive Income xxx
Less: Attributable to Non-Controlling Interest (NCI) xxx
Attributable to Parent Corporation’s Shareholders xxx

Illustrative Example VI:

For the above transactions, the allocation is as follows.

1. Solve for the realized comprehensive income of the subsidiary.

20X1 20X2
Subsidiary’s Comprehensive Income (Assumed) P20,000 P20,000
Add: Realized Profit in Beginning Inventory 800
Less: Unrealized Profit Ending Inventory 800 1,200
Subsidiary’s Realized Comprehensive Income P19,200 P19,600

2. Then, prepare the allocation.

20X1 20X2
Parent Corporations’ Comprehensive Income from Own Operation P50,000 P50,000
Add: Subsidiary’s Realized Comprehensive Income 19,200 19,600
Consolidated Comprehensive Income P69,200 69,600
Less: Attributable to Non-Controlling Interest (NCI) 3,840 3,920
Attributable to Parent Corporation’s Shareholders P65,360 P65,680

Effect of Lower-of-Cost or Market Method on Inventory Profit

The purchaser may have written down intercompany inventory into a market value lower than its cost
at the time of the intercompany sales. For example, S company purchased goods for P100,000 that
costs its parent company P80,000. S company has all the goods in its ending inventory but has written
down to P84,000, the lower market value at the end of the period. This reduces inventory by P4,000 to
reflect its costs to the consolidated company. The P4,000 will now be deferred by recording it as a debit
to the intercompany seller’s cost of goods sold.

Sale of Property, Plant, and Equipment (Guerrero & Peralta, 2017)

Intercompany sales of property, plant, and equipment (PPE) differs from intercompany sales of
merchandise in two (2) aspects. First, intercompany sales of PPE between affiliated companies are unusual
transactions. Second, the relatively long useful lives of PPE require the passage of many accounting periods
before intercompany gains or losses on sales of these assets are realized in transactions with outsiders.
Intercompany sale of PPE can be divided into two (2) whether the asset is depreciable or non-depreciable.

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• Non-depreciable PPE. When the intercompany sale of non-depreciable PPE occurs, eliminations are
often needed in the preparation of consolidated financial statements for as long as the assets are held
by the acquiring company. The simplest example is the intercompany sale of land.

When land is sold between affiliated companies at book value, no special adjustments or eliminations
are needed in preparing the consolidated financial statements. It is because both the income and assets
are stated correctly from a consolidated point of view, and thus, the seller will not record any gain or
loss.
Now, intercompany sale of land at gain requires adjustments or eliminations in the consolidation
process. The land must be reported at its original cost in the consolidated financial statements as long
as it is held within the consolidated entity, regardless of which affiliate holds the land.

Illustrative Example VII:

On July 1, 20X1, Peter Corporation sold land costing P100,000 to its subsidiary, Saul Company, for
P175,000. The companies shall prepare the following entries:

Peter Corporation

Saul Company

The intercompany sale causes the seller to recognize a P75,000 gain and the book value of land
increase by the same amount. However, neither of the said amounts will be reported in the consolidated
financial statements. It is because the P75,000 intercompany gain is unrealized from a consolidation
point of view. The land has not been sold to outsiders, and therefore, it must be continuously reported
in the consolidated financial statements at its original cost. The elimination entry that will be prepared
is as follows:

Allocation of Unrealized Profit

Generally, gains and losses are not considered realized by the consolidated entity until a sale is made
to outsiders. Unrealized gains and losses are eliminated in preparing consolidated financial statements
against the interests of those shareholders who recognized the gains or losses. The direction of the
sale determines which shareholder shall absorb the elimination of unrealized intercompany gains or
losses. Given below are the ways on eliminating the unrealized intercompany gains and losses:

Sale Elimination
Downstream Against controlling interest

Upstream:
Wholly-owned subsidiary Against controlling interest
Partially-owned subsidiary Proportionately against the controlling and NCI

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Illustrative Example VIII:

Peter Corporation owns 80% of the common stock of Saul Company. The companies reported
P500,000 and P300,000 comprehensive income, respectively. Included in the comprehensive income
is an unrealized gain of P50,000 on the intercompany sale of PPE. If the sale is downstream, all
unrealized profits are eliminated from the controlling interest’s share of income. The consolidated
comprehensive income is allocated as follows:

Peter Corporations’ Comprehensive Income from Own Operation P500,000

Less: Unrealized Intercompany Gain (Downstream) (50,000)
Parent Corporation’s Realized Comprehensive Income 450,000
Add: Subsidiary’s Comprehensive Income (SCI) 300,000
Consolidated Comprehensive Income P750,000
Less: Attributable to Non-Controlling Interest (NCI) (SCI x 20%) 60,000
Attributable to Parent Corporation’s Shareholders P690,000
On the other hand, if the intercompany sale is from subsidiary to parent, the unrealized profit on the
upstream sale is eliminated proportionately from the interests of the controlling and non-controlling
shareholders. The consolidated comprehensive income is allocated as follows:

Peter Corporations’ Comprehensive Income from Own Operation P500,000

Add: Subsidiary’s Realized Comprehensive Income (SCI)
Comprehensive Income P300,000
Unrealized Intercompany Gain (50,000) 250,000
Consolidated Comprehensive Income P750,000
Less: Attributable to Non-Controlling Interest (NCI) (SCI x 20%) 50,000
Attributable to Parent Corporation’s Shareholders P700,000
Note that unrealized intercompany gains or losses are always fully eliminated in preparing consolidated
financial statements. An NCI in a selling subsidiary affects only the allocation of the eliminated
unrealized gain or loss and not the amount eliminated.
Subsequent Disposition
Unrealized intercompany gain on the sale of assets is viewed as being realized when the assets are
resold to outsiders. For consolidation purposes, the gain or loss recognized by the affiliate to outsiders
must be adjusted for the previously unrealized intercompany gain or loss. While the sellers reported a
profit on the sale to outsiders based on that affiliate’s cost, the gain reported by the consolidated entity
is based on the cost of the asset to the consolidated entity.

When a previously unrealized intercompany gain is realized, the effects of the profit elimination must
be reversed. At the time of realization, the full amount of the intercompany gain is added to the
consolidated income computation. It must also be assigned to the shareholder interest from which it
originally was eliminated.

Illustrative Example IX:

Assume that as a continuation of Illustrative Example VII, Saul Company sold the land to outsiders for
P225,000 on March 1, 20X2.

Saul Company recognizes P50,000 gain on sale to outsiders of P50,000 (P225,000 – P175,000).
However, for consolidation purposes, the gain must be P125,000, which the difference between the
price at which the land left the consolidated entity, which is P225,000, and the original cost of the land
of P100,000.

In the consolidation working paper, the land no longer needs to be reduced by the unrealized gain
because it was already realized. The consolidated entity no longer holds the land. Instead, the gain
recognized by Saul Company must be adjusted to reflect the gain of P125,000. The entry to be made
is as follows:

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• Depreciable PPE. Unrealized intercompany gains on a depreciable PPE are viewed as being realized
gradually over the remaining life of the asset as it is used by the purchasing affiliate. In effect, a portion
of the unrealized gain is realized in each period as benefits are derived from the asset.

The amount of depreciation to be recognized in each period is based on the intercompany selling price.
However, for consolidation purposes, depreciation must be based on the cost of the asset. Thus,
“eliminating” entries are needed to restate the asset, accumulated depreciation, and depreciation
expense.

Downstream Sale

The case of Peter Corporation and Saul Company is modified to reflect an example of a downstream
sale of depreciable assets.

Illustrative Example X:

On January 2, 20X1, Peter Corporation (PC) purchases 80% of the common stock of Saul Company
(SC) for P300,000. SC has P200,000 and P100,000 common stock and retained earnings, respectively.
On December 31, 20X1, for P70,000, PC sold equipment to SC. The equipment generally cost PC
P90,000 when purchased three (3) years ago. Moreover, it is depreciated over its life of 10 years using
the straight-line method with no residual value. Saul has the following data for years 20X1 and 20X2:

Items 20X1 20X2

Dividends Paid to PC P24,000 P32,000
Comprehensive Income from Operation 50,000 74,000

Required: Prepare the necessary entries about the sale of equipment in 20X1 and 20X2.

Answer:

1. First, determine the gain on the sale of equipment.

Sale Price of the Equipment P70,000

Less: Book Value of the Equipment 63,000
Gain on Sale of Equipment P7,000

The book value was derived as follows:

Original Cost P90,000

Less: Accumulated Depreciation (P90,000/10) x 3 27,000
Book Value of the Equipment P63,000

2. Prepare the entries in 20X1:

Books of Peter Corporation

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Books of Saul Company

Below are the elimination entries that will appear in the consolidating paper:

The elimination entry on the unrealized gain from the downstream sale of equipment is based on
the following analysis:

Amounts from Elimination Consolidated

Trial Balance Amounts
Machinery and Equipment P70,000 P20,000 P90,000
Accumulated Depreciation - (27,000) (27,000)
Gain on Sale of Equipment (7,00) 7,000 -

As a result of the entry made based on the above analysis, the P70,000 equipment Stated in SC’s
trial balance will now be reported in the consolidated statement of financial position (SFP) at its
original cost of P90,000. Moreover, the P7,000 unrealized intercompany gain on the sale of the
equipment was also eliminated. It is because such an amount must not appear in the consolidated
statements. On the other hand, the entry on the depreciation let SC depreciate the equipment equal
to the amount shown on PC’s book had the equipment not been sold.

Then, prepare the entries in 20X2:

In 20X2, SC will be depreciating the P70,000 cost of the equipment it purchased from PC over its
remaining life of seven (7) years.

Books of Peter Corporation:

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Books of Saul Company:

The depreciation expense is P1,000 more per year than the depreciation that would have been
recorded each year by PC if there is no intercompany sale.

Below are the elimination entries that will appear in the consolidating paper:

Upstream Sale
The treatment of unrealized profits arising from intercompany sales is the same as that of the
downstream sale. The unrealized gain and subsequent realization must be allocated between the
parent and NCI.

Illustrative Example X:

Assume instead that on December 31, 20X1 for P70,000, Saul Company (SC) sold equipment to
Peter Corporation (PC). The equipment generally cost SC P90,000 when purchased three (3) years
ago. Moreover, it is depreciated over its life of 10 years using the straight-line method with no
residual value.

Required: Prepare the necessary entries about the sale of equipment in 20X1 and 20X2.

Answer:

1. Apply the steps in the downstream sale. First, determine the gain on sale, which is P7,000.
Now the total comprehensive income of SC for 20X1 will be P57,000.

2. Then prepare the entries for 20X1:

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Books of Peter Corporation:

Books of Saul Company:

Below are the elimination entries that will appear in the consolidating paper:

The share of NCI from SC’s consolidated net income is computed as follows:

Saul Company’s Comprehensive Income P57,000

Less: Unrealized Gain 7,000
Adjusted Saul Company’s Comprehensive Income P50,000
Non-Controlling Interest’s (NCI) Share 20%
NCI’s Share from Income of Subsidiary P10,000

Afterward, prepare the entries for 20X2.

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Books of Pete Corporation

Below are the elimination entries that will appear in the consolidation working paper:

The following shall be noted in the consolidation working paper:

• The NCI’s Share from Income was computed as follows:

Saul Company’s Comprehensive Income P75,000

Less: Realized Gain 1,000
Adjusted Saul Company’s Comprehensive Income P76,000
Non-Controlling Interest’s (NCI) Share 20%
NCI’s Share from Income of Subsidiary P10,000

• The last two (2) elimination entries eliminate the effects of the intercompany sale.
Considering that under an upstream sale, the unrealized gain of P7,000 is apportioned
to the parent's retained earnings (P7,000 x 80%) and NCI (P7,000 x20%).

Reference:
Guerrero, P., & Peralta, J. (2017). Advanced accounting: Principles and procedural applications, volume 2,
2017 ed. GIC Enterprises & Co., Inc.

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