Why do we eliminate unrealized profit on intercompany inventory in consolidation?

Question

AcadiFi · Accepted Answer

Consolidated statements are supposed to show results as if the parent and subsidiary were a single economic entity. If one affiliate sells inventory to another and the inventory is still on hand at year-end, the group has not yet earned that profit from an outside customer. The intercompany sale created profit in separate-company books, but not for the consolidated entity, so the unrealized portion must be eliminated from ending inventory and consolidated income.

Example: Juniper Home Goods sells inventory to its subsidiary for $150,000. Juniper's original cost was $120,000, so separate-company profit is $30,000. At year-end, 40 percent of the inventory remains unsold to outside customers. The unrealized profit is $30,000 x 40 percent = $12,000. In consolidation, reduce inventory by $12,000 and reduce income by $12,000. If the sale was upstream from sub to parent, the same inventory adjustment still happens, though the effect on noncontrolling interest may differ depending on ownership.

```mermaid
flowchart LR
  A[Parent sells] --> B[Sub buys]
  B --> C[Inventory still inside group]
  C --> D[Profit not realized externally]
  D --> E[Eliminate profit]
```

The FAR trap is eliminating the entire intercompany sale even when most of the inventory was sold outside before year-end. Only the unrealized portion still in ending inventory remains deferred. Once an outside customer buys the goods, that deferred profit becomes realized in consolidation. Practice more in our CPA FAR question bank.

Why do we eliminate unrealized profit on intercompany inventory in consolidation?

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