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Lecture 11

BU457 Lecture Notes - Lecture 11: Deferred Tax, Deferred Income, Retained Earnings

Course Code
Bixia Xu

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Intercompany Inventory and Land Profits
1. Intercompany Revenue and Expenses:
Although NI will be the same if intercompany transactions
are included, Sales and COGS will be overstated as both
items should only reflect sales to and purchases from
outside the entity, therefore, must be eliminated to avoid
double counting.
o The same dollar amount is eliminated for both Sales
and COGS.
o NI and NCI are only allocations of the entity’s NI so
they are not affected by the elimination of
intercompany sales and purchases.
o Regardless of who generates the revenue or who loans
money, there is no difference with NI and NCI.
Must also eliminate intercompany management fees and
The elimination entries are recorded on the consolidated
working papers and not in the separate-entity books of the
parent and the subsidiary.
2. Intercompany Profits in Assets:
Must eliminate all intercompany profit/loss on the sale of
an asset to another affiliated company when issuing
consolidated statements (unrealized profit/loss).
When selling to an outsider, the profit is then realized.
Downstream Transaction: Parent sells to Subsidiary
eliminate Parent Profit
Upstream Transaction: Subsidiary sells to Parent or
another Subsidiary of the Parent eliminate
Subsidiary Profit
o Always eliminate profit from the selling company.
Any inventory sold within the group but not subsequently
sold outside must be shown at its original cost with the
unrealized profit eliminated net of the associated tax.
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o We have to hold back any unrealized net-of-tax profit
when consolidating.
o Income tax should be expensed in the same period
revenue is recorded.
o The timing difference gives rise to deferred income
3. Intercompany Profits in Inventory:
Elimination entry to eliminate unrealized gross profit
in ending inventory:
Ending Inventory XXX
(This restores inventory to its original cost)
Elimination entry for prepaid tax on the unrealized
Deferred Income Tax XXX
Tax Expense XXX
(The tax expense has been reduced to match reduced
4. Inventory Results year-over-year:
In the first year:
o COGS is increased
o Ending inventory is decreased
o Profit is held back until realized through a sale to an
o Deferred Tax Asset is established
In the second year:
o COGS is decreased as Beginning Inventory is
decreased to original cost
o Profit is now realized
o Income Tax Expense is increased
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5. Intercompany Inventory Profits “Upstream”:
Example: Parent’s inventory contains $1,000 of items
purchased from the Subsidiary at the end of the year.
Note: Gross Profit is 30%; Tax Rate is 40%.
o Unrealized intercompany profit of $300 is held back
and realized in the period it is sold to outsiders.
o $120 Tax Expense is held back from consolidated NI
as well (matching principle).
Tax is reported at the individual company level.
Income tax is expensed in the same period as
the profit.
This creates a temporary difference and causes
deferred income taxes.
Premature tax paid on the profit held back
or income not yet earned This is
considered an ASSET
NCI is not affected by intercompany profits made on
downstream transactions.
o Since NCI shareholders do not have any interest in
the parent company.
NCI is affected and will share in intercompany profits
made on upstream transactions.
o Since NCI shareholders have an interest in the
subsidiary company.
o NCI claims their percentage of after-tax profit in
ending inventory.
Adjustments are needed to eliminate unrealized profits in
order to properly apply the cost, revenue recognition, and
matching principles.
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