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Extracted from Kaplan Text Example 2 Associates in CIS (Page 116)
During the year, Parent sold goods to the Associate for $ 1 million at a mark-up of 25%. At the year end A still held one quarter of these goods in inventory.
Parent holds 30% of the equity share capital of the Associate.
Unrealized profit = $15000 (I understand how this is calculated)
In the consolidated income statement, this amount ($15000) will be added (increase) to the cost of sales.
I cannot understand (the logic behind it) why the unrealised profit is added to the cost of sales?
Thanks.
Hi frafiq81,
In this case when parent sales goods to the associate company its the parent company that is having a profit of $15000 and if we just analyze in which account head this profit goes into, we will see that its cost of sales in parent company which is further composed of opening inventory + purchases – closing inventory. so whatever inventory parent had sold because it sold more than the cost ( as it has gained 25% markup over that which is equal to $15000 as you have calculated already) is already added to parent’s closing inventory and we know that when the closing inventory goes up the ‘cost of sales’ goes down hence decreasing the cost of sales. As we want to reverse that transaction for the purpose of consolidated accounts because it wasn’t deemed as a sale to third party so we add this to consolidated cost of sales account to reverse that transaction. I tried my best so that this makes sense to you!
Hope this helpsThanks for your time.
Since the inventory was sold by the parent to the associate, so shouldn’t the unrealized profit be included in the inventory of the entity which made the purchase (the associate in here) instead of the parent company which made the sale?
Whoever is the seller makes the profit. Here its parent entity and the purchaser(associate) will have an increased valuation of its inventory since it purchased the inventory as if it purchased that not from its parent but a third party.But for the purpose of making consolidated statements we assume that two group companies cannot trade with each other at normal commercial terms so what we do is we eliminate the unrealized profit in SFP as follows:
Dr group retained earnings (parent = seller)
Cr Investment in associate
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