Downstream and upstream sale adjustments

[neptunhiker]

Hi,
my question relates to Example 6 of Reading 18 (Equity Method with Sale of Inventory: Downstream Sale).
Jones Company owns 25% of James Company. Jones sells inventory worth 96,000 to James for 160,000 in 2011. In my opinion this should be reported as a gain of 64,000 on Jones’ income statement because it is a downstream sale and Jones is the investor. Because James only sells 120,000 of the inventory in 2011 to a third pary (i.e. 75%), the equity method requires an adjustment for the unrealized profit. The solution states that this adjustment is -4000 which is 64,000 * 25% (Jones owns 25% of James) * 25% (1-0.75 unrealized profit). The one line item on Jones’ income statement is thus reduced by 4000. However, as I mentioned in the beginning, Jones as the investor should have recorded, if I am not mistaken, a gain of 64,000 due to the sale of inventory worth 96,000 for 160,000. Overall, the total effect would be a gain of 64,000 minus the adjustment in the one line item of 4000 which is equal to 60,000. I am confused as to how this makes sense. Shouldn’t the overall effect be that the gain of the downstream sale should be reduced by 25% because only 75% have been resold by James, so that 64,000-16,000=48,000?
Thanks for helping out.

 

[40yoCFAcandidate]

You are close.
First, the sale entry will not affect the Investment Accounts at all. It will be COGS, Inventory, Sales Revenue, and Cash. No effect at all yet on the Investment account or Investment Income. If the affiliate sold everything before the reporting date, I do not beleive any adjusting entry would be required. Jones would just record 25% of James’ Net Income. Plus the $64K gross profit from the sale. Done.
But, since the investee (James) still holds inventory that the investor (Jones) made a profit on, we must eliminate part of the $64K gross profit until the inventory is sold. How much?
Gross Profit x Unsold Inventory% x % ownership ($64*.25*.25). After James sells the inventory, Jones can reverse that entry.
I actually don’t thnk that this is super-solid conceptually. it is more like a partial hold-back until the inventory is sold to a third party. But there you have it.

 

[saurabhm]

Hi, When there is an arms length transaction ( transaction between an independent buyer and independent seller), only the allocated share of unrealized gain or loss would be elminated. In this case the unrealized gain is 25% of 64000 = 16000. Hence based on 25% of share it holds, 4000 need to be eliminated.
You are right. Jone’s income statement would record a gain of 64 K. But when you come down to Equity income line, Jone cannot put any more profit as 64K is already realized, he has to deduct now the unrealized gain. That unrealized gain is based on the share. In this case, the unrealized gain is 16k and share is 25% , hence 4000 will be deducted in the Equity income section.