Chapter 6: Intercompany Transactions and Profit Elimination

6.1 Nature of Intercompany Transactions

Intercompany transactions occur between entities within a group and include:

• Sales and purchases of goods or services
• Intercompany loans and interest
• Intercompany dividends
• Guarantees and management fees

6.2 Calculating Unrealized Profits in Inventory

When one group entity sells inventory to another at a markup, part of that profit may be unrealized if the inventory remains unsold at period-end.

1. Determine intercompany sales value and markup percentage.
2. Calculate cost = Sales ÷ (1 + markup).
3. Compute gross profit = Sales – Cost.
4. Multiply gross profit by the proportion of inventory unsold to find unrealized profit.

6.3 Eliminating Intercompany Revenue, COGS and Inventory Profit

On consolidation, eliminate:

Dr Intercompany revenue        XXX,XXX  
  Cr Intercompany cost of sales     XXX,XXX  

Dr Intercompany profit (P&L)    XXX,XXX  
  Cr Inventory (unrealized profit)   XXX,XXX  

These entries remove the effects of intercompany margins and ensure consolidated profit and inventory reflect external transactions only.

6.4 Treatment of Intra-group Dividends

Dividends declared by a subsidiary to the parent are eliminated in consolidation:

Dr Equity – retained earnings      XXX,XXX  
  Cr Dividend income (P&L)             XXX,XXX  

This prevents double-counting of profit distributions within the group.

6.5 Worked Example

Scenario: Entity A sells goods to Entity B for \$600,000, at 25% markup on cost. At year-end, 25% of goods (sales value \$150,000) remain in B’s inventory.

1. Cost = 600,000 ÷ 1.25 = \$480,000; gross profit = \$120,000.
2. Unrealized profit = 120,000 × (150,000 ÷ 600,000) = \$30,000.

Dr Intercompany revenue           600,000  
  Cr Intercompany cost of sales        480,000  
  Cr Intercompany profit (P&L)         120,000  

Dr Intercompany profit (P&L)         30,000  
  Cr Inventory                           30,000  

6.6 Practice Problems

1. Entity X sells inventory to Entity Y for \$800,000 at a 20% markup. If 40% of the goods remain unsold, calculate the unrealized profit and journal entries.
2. Subsidiary declares a dividend of \$200,000 to the parent. Show the elimination entry in consolidation.

6.7 Strategic Approach: Intercompany Transactions & Profit Elimination

Use this step-by-step framework to identify, calculate and eliminate all intercompany effects in a group consolidation:

1. Identify All Intercompany Flows
   Compile a list of transactions between group entities, including:
   • Sales and purchases of goods or services
   • Intercompany loans and interest
   • Intercompany dividends
   • Guarantees, management fees, or other related-party charges
2. Gather Transaction Details
   For each intercompany transaction, record:
   • Amount, date and parties involved
   • Markup percentage (if sale of inventory)
   • Outstanding balances at period-end (receivables/payables)
3. Calculate Unrealized Profits
   For intragroup sales of inventory or fixed assets:
   1. Determine cost to seller: Sales price ÷ (1 + markup).
   2. Compute gross profit: Sales price – cost.
   3. Identify unsold portion: % of closing inventory still held by group.
   4. Compute unrealized profit: Gross profit × (unsold value ÷ sales price).
4. Eliminate Intercompany Balances
   Remove reciprocal balances so only external receivables/payables remain: Dr Intercompany payables XXX Cr Intercompany receivables XXX
5. Eliminate Intercompany Income & Expenses
   Reverse intragroup sales and related cost of sales: Dr Intercompany revenue XXX Cr Intercompany COGS XXX
6. Eliminate Unrealized Profit in Inventory
   Remove profit embedded in closing inventory: Dr Intercompany profit XXX Cr Inventory XXX
7. Eliminate Intra-group Dividends
   Prevent double-counting of profit distributions: Dr Retained earnings (subsidiary) XXX Cr Dividend income (parent P&L) XXX
8. Prepare Elimination Schedules
   Document all elimination entries in a clear grid showing:
   • Line item (e.g. revenue, COGS, inventory, receivables, payables, dividends)
   • Dr/Cr amount
   • Reference to trial-balance and consolidation worksheet
9. Review & Reconcile
   Ensure post-elimination that:
   • No intercompany balances remain on the consolidated BS
   • Consolidated P&L only reflects external revenue and expenses
   • Group inventory excludes unrealized profit
10. Disclose in Notes
    In the consolidation note, describe:
    • Nature and amount of intercompany eliminations
    • Policy for unrealized profit elimination (IAS 2)
    • Policy for dividend elimination