Intercompany Transactions

Unrealized Gross Profit Equity Method

Article written by EricBank

The equity method describes how an investing company (the investor) accounts for its stake in another company, the investee. Normally, the investor must own between 20 percent and 50 percent of the investee's voting shares to qualify for equity-method accounting. The unrealized gross profit equity method, or UGPEM, permits the investor to defer revenues generated from certain inter-company transactions with the investee. These include inventory sales between the two companies and the sale of depreciable assets.

Equity Method

According to the equity method, an investment in an investee company is booked by the investor as a long-term asset. To acknowledge the investor's share of investee profits and losses, it adjusts the investment's book value whenever earnings are announced by the investee. For example, suppose Medium Corporation buys 20 percent of Tiny Corp for $2 million. Medium's accountant would book the $2 million as a debit to its Tiny Corp long-term asset account and as a credit to cash. When Tiny Corp next announces quarterly results, it reports net income of $100,000. Medium's 20 percent share amounts to $20,000, which it debits to the Tiny Corp asset account and credits to an income account, with a name like "Tiny Corp Investment Income."

Unrealized Gross Profit

Under the investor-investee relationship of UGPEM, the inventory seller maintains partial ownership of the goods until the buyer sells them all. Until the buyer uses up or sells the inventory, the gross profit accompanying the sale of the inventory between investee and investor is not realized. This applies when the investee sells the inventory to the investor -- an upstream transfer -- and also when the investor is the seller, a downstream transfer.

Downstream Transfer Example

Let's imagine that Medium Corp sells inventory to Tiny that it paid $35,000 to acquire. Medium sell the goods for a 30 percent profit of $15,000, making the sale price $50,000. As of the end of the year, Tiny has sold 80 percent of the inventory -- $40,000 of its cost-- leaving another $10,000 in Tiny's ending inventory. When Tiny finally unloads the remaining inventory, Medium will garner 30 percent, or $3,000, of the profit. However, since Medium owns only 20 percent of Tiny, its unrealized gross profit will be $600, which is $3,000 times 20 percent. At year-end, Medium postpones the unrealized gross profit by booking $600 as a debit to investment income and as a credit to the long-term asset account. After Tiny sells the remaining inventory, Medium enters a reversal transaction and recognizes the $600 gross profit.

Upstream Transfer Example

Upstream sales also receive UGPEM treatment. For example, if Tiny sell Medium inventory costing $40,000 for $60,000, then $20,000 is the gross profit. From Medium's perspective, the $20,000 represents a 33.3 percent gross profit ratio. Now suppose $15,000 of the inventory is still owned by Medium at year's end. This means that 33.3 percent of $15,000, or $5,000, is still tied up in unsold goods. Multiplying this amount by the 20 percent ownership percentage yields an unrealized gross profit of $1,000. Therefore, Medium books the $1,000 deferral as a debit to the investment income account and a credit to the long-term asset at year-end. After disposing of the remaining goods, Medium reverses the deferral.