Down stream sale for intercompany transaction

On Schweser Notes Book 2, page 122. When discuss the downstream sale, it mentioned that “investor must eliminate the pro-rata share of the profit that is unconfirmed”. In the example below (4th line in P123), it use: “unconfirmed amount X 30% ownership interest”. My question is: given it’s downstream sale, should the invstor remove all unconfirmed amount from the book? At least that’s how my accounting professor says. The CFAI use similar logic in the book as well. Anyone want to give it a shot? Thanks!

pro rata share of unconfirmed profits must be removed. – this is right. think about it – downstream sale - A has a 30% investment in B. A sold stuff to B for a Profit – definition of Downstream Sale. A recognized full profit on its books, but B used only a portion of the goods. So the unused “unconfirmed” profit must be removed…

Sorry that I didn’t make the question clear. I’m wondering if we need to multiple the owner’s interest in a downstream sale. Here is an example: Company P owns 30% of S, during the year, if there is $1M GP from S to P (upstream sale), we should remove: 30% X $1M = 300K from the earning. However, for a downstream sale, if P sale to S inventory and unsold at the end of the year, the GP of the inventory is $1M. How much should be removed from the P’s income? $1M or $300K? From what’s I remember, P should remove all $1M, however, Schweser mentioned that it should remove only $300M from the book.

only 300k …

Blackdog, the profit on goods of 700K sold has already been realised i.e earned. Why would you want to remove the profit that has ACTUALLY been earned? It does not matter that the subsidiary has earned the same profit and not the parent company. We remove the 300K of profit as it has not been realised/earned yet. This is mainly attributed to the principle of conservatism and also the principle that you cannot record a profit just by dealing with your own self. Only when you sell the goods, would you record the profit. Hope this helps.

Why has the $300k of profit not been realised or earned? Sorry I’m not questioning you I just dont understand this bit, although I do get the double counting part.

A sold 700K to B. (recognizing a profit) B has only sold a portion of the material - so essentially if the entire profit were recognized by A --> this would be a mistake - overstating earnings for A. (And making numbers ROE, etc. etc. and EPS better for A). If you looked at the situation - A has the ability to control B - and in extreme cases - A could simply “park” its unwanted inventory by selling it to B - and make a profit from the deal. So as analysts we need to back out parts of profit that are not “really profits”.

Blackdog, This took a while for me to understand too. This is the way I look at this - hope it helps: Since A owns 30% of B, 1M profit that A made selling to B can be split into 2 parts. - 300K from selling to the 30% part it owns in B - 700K from selling to 70% it does not own in B. Although the 1M has not left B’s premses, the 700 K can be immediately recognized as that is like selling to external parties. So that leaves the 300 K which will be recognized when the entire 1M leaves B’s premisies. Hope I have not confused you more. Thadi

That’s a good explanation. Acutually that’s how the downstream sales has been dealt with JV, only the portion of your ownership is recognized during the proportional consolidation process. What confuse me is that my accounting text gave the example that the whole $1M should be removed from the book. Unfortunately what I learned is Canadian GAAP which is neither 100% same as US GAAP nor IFRS. I’ll try to see if I could find some US GAAP related material on this.

In CFAI Vol 2, page 23, example 6: Jones (who owns 25% of Jason) sold $96k of inventory to Jason for $160k. Jason resold $120k of this inventory. Then in calcuuating the equity income in I/S of Jones, they subtracted $4k for unrealized profit (25% of $16k). Why so?

Jones sold inventory to Jason and recognized a profit. now if it includes Jason and recognized everything there – it is going to double count the profit. So you need to unwind and remove the portions of the unrecognized profits. That is what is being done. 160K was the sale value, orig value was 96K. Ownership percent = 25% Jason sold 120K of this material. so remove parent’s share of the portion of unrecognized profits. Ownership Share = 25% of Portion of Unrecognized profits Portion of Unrecognized profits = 40/160 * (160-96) so 25% of 16K = 4K removed.

I see, another way of thinking about this, is that the remaining $40k of inventory at Jason, when sold will realize a total pofit of $16k (b/c cost of $40k inventory is $24k, i.e., $96/$160 = 60% which is cost). Of that $16k profit, Jones will receive $4k, next period. Cool. What if Jason returns the inventory of $40k back to Jones, how does Jones account for that? It will not recognize the $4k profit, that’s one, but not sure if it needs to do anything else.

thadim, looking at what you wrote: > Since A owns 30% of B, 1M profit that A made selling to B can be split into 2 parts. - 300K from selling to the 30% part it owns in B - 700K from selling to 70% it does not own in B. I don’t think it’s correct to think of it in this way. What A needs to deduct is not related to its percentage of ownership per se, but to its percentage of the unrealized profit of the *remaining goods* in B’s inventory.

I am a little bit confused by this one but writing it over here has cleared it in my head. On pg 22 it clearly says: in a downstream sale, the profit is recorded on the investor’s profit and loss statement. And it says unrealized profits to be eliminated to the extent of investory’s interest in associate. So. Investor: Jones associate/investee: Jason Jones selling to Jason. Jones cost =96k Jones Sell price = 160k. Profit 64k. So Jone’s Income statement should say: Profit by sale of inventory: 64k Less Unrealized profit as Jason haven’t sold part of the inventory: but less skip that part for now. Now come to Equity Income on Jones IS. realize first that Jones can’t reconize any gain here from sale of inventory, as it has already accounted for 64k above. But it needs to deduct that part of gain which is not yet realized. So out of the 64k how much has not been realized??? Let’s say now for a second Jason didn’t sell anything for this year. So how much would Jason realize as gain then?? 75% of 64K: 48k. If jason sold all of the invetory then how much would Jason realize?? 64k as showed above. So basically by virtue of Jason selling the inventory worth 160k Jones realizes additional 16k. So If Jason only sold inventory worth 120k, Jones can only realize 12k. Hence 4K UNREALIZED GAIN. — To add a twist, now let’s say Jason marks up and sells all the inventory for 200k to Johny. then Jason’s equity income should go up by another 10k (25% of 40K) and +4 k as there will be nothing that is unrealized. But don’t worry about equity income, cuz Jason’s marking up will be captured in Jason’s Net Income. — to add another twist, let’s say Jason sells only half the inventory for 160k. then unrealized gains will be 8k. and what is teh increase in equity income for Jones. — Now let’s say if Jason returns the inventory back to Jason worth 40k in the same year. Then Jones IS must less then profit by sale on inventory by 16k. Increase inventory by 24k. Reduce Cash/Jason’s Ac by 40k. And there shouldn’t be any unrealized gain as long as jason sells all the 120k.

Jones owns 25% of Jason. Jones sold $160k to Jason. It cost Jones $96K. Jones initial profit from sale: $64K — Jason sold $120K worth of the inventory. Jason still has $40K remaining, OR 25% — Since Jason only sold 75%, Jones can’t recognize the full 100% of his profit from selling the goods to Jason. So, we know that he’ll have to remove at least some part of $64K in profit from his income statement. Jones Profit was: $64K. Jason only sold 75%. Therefore, since Jones owns 25% of Jason, Jones must remove 25% of 25% of his profit or: .25 * .25 * $64K = $4K ---- Great thread. This one had me going back and reviewing as well.

> Let’s say now for a second Jason didn’t sell anything for this year. So how much would Jason realize as gain then?? 75% of 64K: 48k. If jason sold all of the invetory then how much would Jason realize?? 64k as showed above. so if Jason didn’t sell anything, then Jones (the investor) would in essence record a normal profit on its I/S of $64k and immediately deduct the unrealized profit on $160k inventory left at Jason, so how much does Jones deduct? The problem I have (now that I keep thinking about this) is that Jones may keep the full profit of $64 intact, only if Jason sells all of the inventory. But if Jason does not sell anything, then Jones should wipe out *all* of that $64 of profit by deducting (I suppose) $64k, but how is that done using the same calculation we are doing above?

He wouldn’t wipe out the full $64K… he only owns a 25% stake. Math: 25% Stake * 100% unsold items * $64K Profit = $16K write down ---- Anyone confirm?

There is very good explanation on the issue on the following book (Page 151):,M1 Unfortunately I cannot copy the paragraph over.

So does Jones deduct $64k if nothing is sold by Jason, or $16k? If $16k,as it looks like it, then how could it have a profit of $64k - $16k=$48k when none of its goods were sold?

Dreary It was an arms-length sale with a profit of 64K from Jones to Jason. So theoretically 64K should be recognized. Now because Jason has not been able to sell anything - 16K is being reduced. If you look at the original transaction, and the fact that it was an arms-length transaction - 64K profit on Sales was made.