This chapter covers the third consolidation procedure: eliminate in full intra-group assets and liabilities, equity, income, expenses, and cash flows relating to transactions between entities of the group.

The focus here is on how to treat, in the consolidated financial statements:

• provisions for unrealised profit, and
• intra-group balances

These arise from transactions between a parent and its subsidiary.

Learning objectives

By the end of this chapter, you should be able to prepare an extract of a consolidated statement of financial position, including:

• Elimination of intra-group trading balances (excluding assets in transit)
• Removal of unrealised profit arising on intra-group trading

Background

Even after a parent obtains control, the parent and subsidiary still keep their own accounting records and can trade with each other. Common examples include sales of goods or services between the parent and a subsidiary.

At the end of the year, in the separate financial statements of the parent and subsidiary:

1. One company may have recorded a payable with a corresponding receivable recognised by the other arising from a credit trade between them. This is referred to as an intra-group trading balance.
2. One company may have recognised a profit on the sale of a good or service to the other company, which the other company may not have resold; hence, it may still be part of its inventories. This profit is referred to as an unrealised intra-group profit. Remember, consolidation is about presenting the financial statements of both the parent and subsidiary as if they are a single entity.

So, in the consolidated financial statements, we don’t expect to see amounts that arise purely from trade between the parent and the subsidiary. This is because a company cannot trade with itself.

For that reason, intra-group balances and unrealised profit included in the separate financial statements must be eliminated on consolidation. The rules for eliminating these balances are explained below.

Intra-group sales & the consolidated P/L statement

When preparing the consolidated statements of profit or loss, the full amount of any intra-group sales must be eliminated from revenue and cost of sales, regardless of whether the parent or subsidiary is the seller. The journal for eliminating the intra-group sales is given as:

Debit: Revenue Credit: Cost of sales

This elimination prevents double-counting of transactions that occurred within the group rather than with external parties. Without it, consolidated revenue and expenses would be overstated, which would misrepresent the group’s trading activity with external parties.

Illustration: Intra-group sales & consolidated P/L statement

Assuming a parent company produces a product for $ 3,000 and sells those goods to its subsidiary for $ 5,000. The subsidiary sold the goods bought from the parent to a third party for $ 6,000. See below an extract of the statement of profit or loss of the parent and the subsidiary.

	Parent ($)	Subsidiary ($)
Revenue	5,000	6,000
Cost of Sales	(3,000)	(5,000)
Gross Profit	2,000	1,000

Required: Explain how the intra-group sales should be treated when preparing the consolidated profit or loss statement. Suggested solution

Do you know the answer?

Provision for unrealized profit (PURP)

Definitions

Unrealised profit

When group entities trade inventory among themselves, any profit margin added by the selling entity represents unrealized profit from the group perspective until those goods are sold to external parties.

The consolidated financial statements treat the group as a single economic entity, so profit is recognized (i.e., realised) only when the inventory is sold to external (third-party) customers.

Until then, the profit is called unrealized profit and must be eliminated (i.e., adjusted) on consolidation. The adjustment reduces both group inventory values and retained earnings by the amount of unrealized profit.

This elimination prevents overstating group inventory and profits. It ensures the consolidated financial statements reflect only genuine economic activity with entities outside the group, not internal transfers.

We shall look at how to adjust for the unrealised profit in the following:

1. Consolidated statement of profit or loss
2. Consolidated statement of financial position

Consolidated statement of financial position

The unrealized profit adjustment varies depending on whether:

1. The seller is the parent and the buyer being the subsidiary
2. The seller is the subsidiary and the buyer is the parent

It also depends on whether full or partial eliminations apply (based on ownership percentages).

Where the subsidiary sold to the parent

1. Where the subsidiary sold to the parent after the acquisition date, the subsidiary would have debited cash/account receivables ledger and credited revenue ledger. Where the sales is at a margin, the revenue when matched against the related cost will show a difference which is the unrealised profit.
2. The parent would have the unsold goods acquired from the subsidiary as part of their inventories as at year-end.

Remember the unrealised profit would have increased the post-acquisition profit of the subsidiary. Because the post-acquisition profit was shared between the parent and the NCI in their respective share holdings, we need to reduce that in the same respective share of the unrealised profit.

The journal entry to be passed to eliminate the unrealised profit when consolidating the financial statement is given as:

Debit : Non-controlling interest (with NCIs % share of PURP)

Debit : Group retained earnings (with parent’s % share of PURP)

Credit : Inventory (i.e. the parent’s inventory)

Illustration 1: Elimination of PURP

A subsidiary company sold goods to a parent for $ 5 million and made a 20% profit margin. The parent owns 85% of the shares in the subsidiary. As at the year end, the parent still holds $2 million worth of the goods in inventory (at cost to the subsidiary) at the year end.

Required: Explain how this should be accounted for in the consolidated statement of financial position. Suggested solution:

Do you know the answer?

Step 1: Calculate the Unrealised Profit

Step 2: Eliminate the unrealised profit

Where the parent sold to the subsidiary

1. Here, the parent has recorded the unrealised profit, but the unsold inventory is held by the subsidiary.
2. Since the parent’s profit is not shared between the subsidiary and the parents during consolidation, the impact of the unrealised profit also wouldn’t be shared, as in the case where the subsidiary sold to the parent.

The journal entry to be passed to eliminate the PURP, when consolidating the financial statement, is given as:

Debit: Group retained earnings (with 100% of the PURP)

Credit: Inventory

Illustration 2: PURP

A parent company sold goods to a subsidiary for $ 5 million, making a profit of 20%. The parent owns 85% of the shares in the subsidiary. As at the year end, the subsidiary still holds $2 million worth of the goods in inventory (at cost to the parent) at the year end.

Required: Explain how this should be accounted for in the consolidated financial statements Suggested solution:

Do you know the answer?

Step 1: Calculate the Unrealised Profit

Step 2: Eliminate the unrealised profit

PURP & the consolidated profit or loss statement

In the intra-group sales illustration above, we assumed that all the goods acquired were sold by the subsidiary to an external party, so there was no unrealised profit. In that case, the consolidation adjustment is only to eliminate the intra-group sale (debit revenue, credit cost of sales).

Now consider what happens if some of the goods traded within the group remain unsold at the end of the year.

When eliminating unrealised profit, we credit inventory. This affects closing inventory, and closing inventory is used to calculate cost of sales. So, any adjustment to closing inventory must also be reflected in the cost of sales.

The Accounting equation for Cost of Sales:

Cost of Sales = Opening Inventory + Purchases - Closing Inventory

When we reduce closing inventory (by crediting it), the cost of sales increases. So, when there’s unrealised profit on intra-group sales, you need two adjustments:

1. Eliminate the intra-group sales and purchases:

Debit : Revenue (with the full intra-group sales amount)

Credit: Cost of Sales (with the full intra-group sales amount)

2. Eliminate the unrealised profit:

Debit : Cost of Sales (with the PURP amount)

Credit : Inventory (with the PURP amount)

Illustration: PURP and the consolidated profit or loss

Assuming a parent company produces a product for $ 3,000 and sells those goods to its subsidiary for $ 5,000. The subsidiary sold half of the goods bought from the parent to a third party for $ 6,000. At the end of the year, the remaining inventory was still held in stock by the subsidiary.

See below an extract of the statement of profit or loss of the parent and the subsidiary.

	Parent ($)	Subsidiary ($)
Revenue	5,000	6,000
Cost of Sales	(3,000)	(5,000)
Gross Profit	2,000	1,000

Required: Explain how the intra-group sales and PURP should be treated when preparing the consolidated profit or loss statement. Suggested solution:

Do you know the answer?

Step 1: Eliminate Intra-Group Sales

Step 2: Calculate and eliminate the PURP

The true presentation of the consolidated statement of profit or loss would be:

	$
Revenue (5,000 + 6,000 - 5,000)	6,000
Cost of Sales (3,000 + 5,000 - 5,000 + 1,000)	(4,000)
Gross Profit	2,000

Intra-group balances

Definitions

Intra-group balances

Arises when entities within the same group conduct business among themselves under credit terms. The selling entity would record a receivable while the buying entity would record a corresponding payable. These are called intra-group receivables and payables.

NOTE: Other cases of the intra-group balances, like asset and cash in transit, are not applicable in this syllabus.

These reciprocal balances should always match in value. They must be completely eliminated during consolidation to prevent overstating group assets and liabilities.

The journal entry to be passed to eliminate intra-group payables and receivables when consolidating the financial statement is given as:

Debit: Account payables Credit: Account receivables

Illustration: Elimination of intra-group balances

The parent sold goods worth $ 4,500 on credit to the subsidiary, for which the balance is still outstanding as at the end of the financial year. The extract of the statement of financial position of the individual entities is as follows:

	Parent ($)	Subsidiary ($)
Current Assets
Account receivables	10,000	5,000
Cash	20,000	13,000
Total current assets	30,000	18,000
Current Liabilities
Account payables	25,000	10,000
Tax liabilities	5,000	8,000
Total current liabilities	30,000	18,000

Required: Explain the treatment of the intra-group balance and prepare an extract of the consolidated statement of financial position as at the end of the year. Suggested solution:

Do you know the answer?

What is the treatment of the Intra-group balance

What Consolidation adjustment is required?