Part 3
Treatment of ending inventory
related to Intra-entity inventory
transfers under the equity method
Deferral of Unrealized Profits
in Inventory
INVESTOR
Downstream
Sale
INVESTEE
INVESTOR
Upstream
Sale
INVESTEE
Profits on unsold inventory at the end
of the period must be deferred until
sold to an outside party.
1-3
Unrealized Gains in Inventory
Let’s look at an Investor that has 200 units of
inventory with a cost of $10,000.
INVESTOR
sells 200 units of
inventory with a
total cost of
$10,000.
Let us assume
that the
Investor sells
the inventory to
a 25% owned
subsidiary for
$12,500.
1-4
Unrealized Gains in Inventory
60 of the original 200 units (30%) remain “unsold” to an
“outside” party. We must defer our share (25%) of
the original ($12,500-$10,000) $2,500 of
intercompany profit that is unrealized (30%).
INVESTOR
sells 200 units of
inventory with a
total cost of
$10,000.
25% ownership
Subsidiary buys 200
units of inventory
and pays a total of
$12,500.
Intercompany
Sale of 200 units
Investee sells only 140
units to a 3rd party
Outside Party
1-5
Unrealized Gains in Inventory
 Compute the deferral by multiplying:
Intercompany
Profit
%
unsold
x
(12,500-10,000)=$2,500
×
30%
% owned by
x
investor
×
25% = $187.50
 The required journal entry is:
GENERAL JOURNAL
Date
Year
End
Description
Equity in Investee Income
Investment in Investee
Page
Debit
##
Credit
187.50
187.50
1-6
Unrealized Gains in Inventory
 In the period following the period of the transfer,
the remaining inventory is often sold.
 When that happens, the original entry is reversed . .
.
GENERAL JOURNAL
Date
Description
next Investment in Investee
period
Equity in Investee Income
Page
Debit
##
Credit
187.50
187.50
The reversal takes place during the period that
the inventory is sold to an outside party.
Example
At the beginning of 2017 Big Incorporated, buys 25% of
Little for $600,000. The net assets of Little at the time
were $2,000,000. Any excess over book was attributed to a
patent with a 10 year life. Little reported net income of
$125,000 for 2017,$150,000 for 2018 and paid dividends of
$15,000 each year. Big immediately started buying inventory:
Year
2017
2018
Cost to Little
200,000
240,000
Transfer Price
350,000
400,000
Amount held by
Big at year end
126,000( at Big’s price)
140,000
What journal entry will be recorded at the end of
2017 and 2018 to defer the unrealized gain?
2. What is the balance in the investment account at the
end of 2018?
3. What is the equity income for 2017 and 2018
1.
1-8
Unrealized Gains in Inventory
 Compute the deferral for 2017:
Intercompany
Profit
%
% owned by
x
x
unsold
investor
(350,000-200,000) × (126,000)/350,000)) x .25 =
150,000
x
.36
x
.25 = $13,500
 The required journal entry is:
GENERAL JOURNAL
Date
Description
31-Dec Equity in Little Income
Investment in Little
Page
Debit
##
Credit
13,500
13,500
1-9
Unrealized Gains in Inventory
 Compute the deferral for 2018:
Intercompany
Profit
%
% owned by
x
x
unsold
investor
(400,000-240,000) × (140,000)/400,000)) x 25% =
160,000
x
.35
x
.25 = $14,000
 The required journals entries assuming sold 2017 purchases:
GENERAL JOURNAL
Date
Description
Page
##
Debit
Credit
1-Jan Investment in Little
13,500
Equity in Little Income Reverse out last years
deferred profit
GENERAL JOURNAL
Date
Description
31-Dec Equity in Little Income
Investment in Little
Page
Debit
13,500
##
Credit
14,000
14,000
What is the balance in the investment account at the
end of 2018?
Determine value of patent for amortization
Consideration at 100% $600,000/.25 = $2,400,000
Less Net book value of Little
2,000,000
Difference attributed to Patent
400,000
Annual Amortization = 400,000/10 years = $40,000 x .25 = $10,000
Balance in Investment in Little end 2018
Investment
600,000
2017 Net income( .25 x 125,000) 31,250
Dividend (.25 x 15,000)
<3750>
Amortization(.25 x 40,000) <10,000>
Deferred profit
<13,500> 4,000
2018 Net income( .25 x 150,000) 37,500
Dividend (.25 x 15,000)
<3750>
Amortization(.25 x 40,000) <10,000>
Deferred profit 2017
13,500
Deferred profit 2018
<14,000> 23,250
2018 Balance Investment in Little 627,250
What is the equity income for 2018
2017 Net income( .25 x 125,000) 31,250
Amortization(.25 x 40,000)
<10,000>
Deferred profit 2017
<13,500>
Investment income 2017
7,750
2018 Net income( .25 x 150,000)
Amortization(.25 x 40,000)
Deferred profit 2017
Deferred profit 2018
Investment Income 2018
Must reverse
out previous
years deferred
profit
37,500
<10,000>
13,500
<14,000>
27,000
Reminder: Dividends are not part of income for parent
when using the equity method!