How do you eliminate unrealized profit on upstream and downstream transactions under the equity method?

When an investor and investee trade with each other, any unrealized profit in unsold inventory at period-end must be eliminated. The direction of the sale determines whose financial statements are affected.

Definitions:

• Downstream: Investor sells to investee (profit originates on investor's books)
• Upstream: Investee sells to investor (profit originates on investee's books)

Key Rule: Under the equity method, the investor eliminates its proportionate share of unrealized profit regardless of direction. This differs from full consolidation, where 100% of intercompany profit is eliminated.

Downstream Example:

Harrison Corp (investor, 40% ownership) sells inventory to Maplewood Inc (investee) for $500,000. Harrison's cost was $350,000. At year-end, 60% of the inventory remains unsold by Maplewood.

Unrealized profit = ($500,000 - $350,000) x 60% = $90,000

Harrison's share to eliminate = 40% x $90,000... Actually, for downstream transactions, the investor eliminates 100% of the unrealized profit because the profit originated on the investor's own books.

Elimination = $90,000 (full amount)

Adjustment: Reduce equity income by $90,000.

Upstream Example:

Maplewood Inc (investee) sells inventory to Harrison Corp (investor) for $800,000. Maplewood's cost was $600,000. At year-end, 25% remains unsold by Harrison.

Unrealized profit = ($800,000 - $600,000) x 25% = $50,000

For upstream transactions, the investor eliminates only its proportionate share because the profit is on the investee's books.

Elimination = 40% x $50,000 = $20,000

Adjustment: Reduce equity income by $20,000.

Summary Table:

When Inventory Is Subsequently Sold:

The elimination reverses in the period the goods are sold to an external party. So if Maplewood sells the remaining 60% of Harrison's inventory in Year 2, the $90,000 reversal increases Harrison's equity income in Year 2.

Exam tip: The exam loves to test whether you remember that downstream = 100% elimination and upstream = proportionate share. Also watch for questions that span two periods to test the reversal logic.

Practice upstream and downstream elimination in our CFA Level II FRA course.