How do you handle multi-period intercompany inventory profit elimination for downstream sales?

Question

AcadiFi · Accepted Answer

Multi-period inventory eliminations are a staple CFA Level II vignette. The core principle: unrealized intercompany profit must be eliminated until confirmed by a sale to an outside party.

**Key Facts:**
- Downstream sale (parent Halcyon sells to sub Sagebrush)
- Cost to Halcyon: $500K
- Transfer price: $750K
- Intercompany profit: $250K
- Gross margin: $250K / $750K = 33.3%

**Year 1 Analysis**

Sagebrush sold 60% externally. The remaining 40% is still in Sagebrush's inventory at the $750K transfer price.

- Unrealized profit in ending inventory = 40% x $250K = **$100K**
- Realized profit (sold externally) = 60% x $250K = **$150K** (no elimination needed)

Year 1 consolidation entry:
- DR: Revenue — $750K (eliminate entire intercompany sale)
- CR: COGS — $650K (eliminate intercompany COGS, but keep $100K unrealized profit out)
- CR: Inventory — $100K (reduce inventory to original cost basis)

Net effect on consolidated income: **-$100K** (the unrealized portion)

**Year 2 Analysis**

Sagebrush sells the remaining 40% of inventory to external customers. The $100K of previously unrealized profit is now realized.

Year 2 consolidation entry:
- DR: Retained earnings (opening) — $100K
- CR: COGS — $100K

This reverses the prior-year elimination and allows Year 2 consolidated income to pick up the $100K profit that was deferred.

**NCI Impact: None for Downstream**

Since Halcyon (parent) is the seller, the unrealized profit is entirely attributable to the parent. NCI's share of Sagebrush's consolidated income is unaffected.

| Year | Unrealized Profit | Adjustment to Consolidated Income | NCI Impact |
|---|---|---|---|
| Year 1 | $100K | -$100K | None |
| Year 2 | $0 | +$100K | None |
| **Net** | **$0** | **$0** | **None** |

**Exam tip:** If inventory turns over within the year, there may be no elimination needed. Always check the ending inventory balance for unsold intercompany goods. And remember — downstream = parent only; upstream = NCI shares.

For comprehensive consolidation practice, check out our CFA Level II FRA materials.

How do you handle multi-period intercompany inventory profit elimination for downstream sales?

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