Intercompany inventory and other profits

Groups trade within themselves. In 2026 Blue Heron sells control panels to Larkspur for installation in Larkspur's sensor systems, and Larkspur sells sensor modules to Blue Heron. Each company records these sales and purchases in its own books at the agreed transfer price, as if dealing with an outsider. From the group's point of view, nothing has been sold until goods leave the group. This lesson shows how intercompany revenues, expenses and balances are eliminated, how unrealized profit in inventory is deferred until goods are sold outside, and how upstream profits affect NCI.

The single-entity principle

Consolidated statements report the group as if it were one company. One company cannot earn revenue by selling to itself, owe money to itself or charge itself interest. Every intragroup transaction must therefore be eliminated in full, regardless of the parent's percentage ownership: intercompany sales and purchases, receivables and payables, interest income and expense, management fees, rent, dividends and loans. Eliminating the revenue and the matching expense does not change consolidated profit; it only removes inflated amounts from both lines. Profit changes only when part of an intercompany profit remains inside the group at the reporting date.

Unrealized profit in ending inventory

When goods sold within the group are still in the buyer's inventory at year end, the buyer carries them at the transfer price, which includes the seller's profit. From the group's perspective that profit has not been earned, because no outside customer has bought the goods. The unrealized profit is eliminated from consolidated inventory and from consolidated profit. When the buyer sells the goods to an outsider in a later period, the profit is realized and recognized in consolidated profit in that period.

Upstream versus downstream

The direction of the sale determines who bears the unrealized profit. In a downstream sale, the parent is the seller, so the unrealized profit is in the parent's profit and is deducted entirely from profit attributable to the parent's owners. In an upstream sale, the subsidiary is the seller, so the unrealized profit is in the subsidiary's profit, and it is shared between the parent and NCI in proportion to their interests. NCI's share of profit is therefore based on the subsidiary's profit adjusted for upstream unrealized profits, as well as for amortization of the acquisition differential.

ASC 810-10-45 requires full elimination of intercompany profits and losses and allows the elimination to be allocated between the parent and the noncontrolling interest. Proportional allocation of upstream profit, as shown here, is the usual practice. For income taxes, ASC 740 still defers the seller's tax paid on intra-entity sales of inventory until the goods are sold outside the group, recording it as a prepaid tax; since ASU 2016-16 that exception no longer applies to transfers of other assets, whose tax effects are recognized immediately.

# 2026 consolidation with intercompany sales (illustrative, taxes ignored)
P = {"Revenue": 12_000_000, "Cost of sales": 7_200_000, "Operating expenses": 2_700_000, "Interest": 200_000, "Income tax": 400_000}
S = {"Revenue": 4_000_000, "Cost of sales": 2_400_000, "Operating expenses": 680_000, "Interest": 60_000, "Income tax": 260_000}
amort = {"Cost of sales": 100_000, "Operating expenses": 100_000}
up_sales, up_margin, up_left = 500_000, 0.30, 0.40      # Blue Heron -> Larkspur
dn_sales, dn_margin, dn_left = 300_000, 0.25, 0.20      # Larkspur -> Blue Heron
up_unreal = up_sales * up_margin * up_left
dn_unreal = dn_sales * dn_margin * dn_left
cons = {k: P[k] + S[k] + amort.get(k, 0) for k in P}
cons["Revenue"] -= up_sales + dn_sales
cons["Cost of sales"] += -(up_sales + dn_sales) + up_unreal + dn_unreal
profit = cons["Revenue"] - sum(v for k, v in cons.items() if k != "Revenue")
sub_profit = S["Revenue"] - sum(v for k, v in S.items() if k != "Revenue")
nci = 0.20 * (sub_profit - sum(amort.values()) - up_unreal)     # only upstream profit affects NCI
for k, v in cons.items():
    print(f"{k:<20}{v:>12,.0f}")
print(f"{'Profit':<20}{profit:>12,.0f}")
print(f"Unrealized: upstream {up_unreal:,.0f}, downstream {dn_unreal:,.0f}")
print(f"NCI share {nci:,.0f}; owners of parent {profit - nci:,.0f}")

Revenue               15,200,000
Cost of sales          8,975,000
Operating expenses     3,480,000
Interest                 260,000
Income tax               660,000
Profit                 1,825,000
Unrealized: upstream 60,000, downstream 15,000
NCI share 68,000; owners of parent 1,757,000

Consolidated revenue falls by the $800,000 of intercompany sales, and cost of sales falls by $800,000 less the $75,000 of unrealized profit. Consolidated profit for 2026 drops from $1,900,000 (lesson 5) to $1,825,000. NCI's share falls from $80,000 to $68,000, because it bears 20 percent of the $60,000 upstream profit, $12,000. The parent's owners bear the rest of the upstream profit ($48,000) and all of the downstream profit ($15,000), so profit attributable to owners of the parent falls from $1,820,000 to $1,757,000.

Realization in the following year

Unrealized profit at the end of one year becomes realized profit in the next, when the buyer sells the goods to outsiders, usually early in the year. On the worksheet for 2027, the opening inventory of the buyer still includes the profit, but consolidated opening retained earnings (and opening NCI, for upstream items) must exclude it. The entry debits opening retained earnings (and NCI, for its share of upstream profit) and credits cost of sales, which recognizes the deferred profit in 2027 consolidated profit.

Over the two years, the total profit is the same as it would have been with no deferral; the elimination only moves profit to the period in which the goods were sold outside the group. NCI carried forward also changes: at the end of 2026 it is $990,000 − $12,000 = $978,000, and at the end of 2027 it is $978,000 + $114,000 − $50,000 dividends = $1,042,000, which is lower than lesson 5's $1,050,000 by NCI's $8,000 share of the upstream profit still unrealized at the end of 2027.

Intercompany losses, transfer prices and taxes

Sometimes goods are transferred at less than the seller's cost. The unrealized loss is eliminated in the same way, unless the transfer price reflects a genuine decline in value. If the goods are worth less than cost to the group, the loss is evidence of impairment and is recognized: the group writes inventory down to net realizable value regardless of which entity holds it.

Transfer prices also matter for tax. Section 482 of the Internal Revenue Code lets the IRS reallocate income among related parties to reflect arm's-length prices, and penalties can apply. For financial reporting, ASC 740 defers the seller's current tax on intercompany inventory profit as a prepaid tax until the goods are sold outside the group, unlike IFRS, which recognizes deferred tax at the buyer's rate. When Larkspur later acquires its Canadian subsidiary, cross-border transfer pricing becomes a significant risk area.

Other intercompany items

Intercompany services such as management fees, rent and royalties are eliminated in full, with no profit deferral, because the service is consumed immediately. Intercompany loans and the related interest are eliminated. Intercompany dividends are eliminated, as lesson 5 showed. If intercompany profit is capitalized, for example when a parent builds equipment for a subsidiary or charges construction fees that the subsidiary capitalizes, the profit is unrealized until the asset is depreciated or sold, as lesson 7 shows for depreciable assets.