 This is Professor Farhad and this session would look an example that deals with downstream sales eliminating unrealized profit. Many students were asking me about this topic repeatedly so finally I came in and I'm going to work a few examples about this topic. This topic is covered in an advanced accounting course and it's also very importantly covered on the CPA exam. Now I do have lectures about downstream sales on my website under the advanced accounting course but in this session I will work an example and I'll have to say a simple example just to start to build your knowledge about this topic. So let's start with the example here. P company, PS parent company owns 80% of the outstanding stock of S company which is the subsidiary. During 2014 S company reported their income of 525 and declared no dividend. At the end of the year S company inventory included 487 an unrealized profit on purchases from P company. Enter company sales for 2014 total 2.7. Prepare the journal entry from all consolidated financial statement work paper entries necessary at the end of the year to eliminate the effect of the 2014 intercompany sales. So basically what we are saying is this we have P company, we have the parent company and we have the subsidiary and what happened the subsidiary sold to the parent company the subsidiary sold to the parent company they sold them 2.7 million worth of merchandise worth of product of which and and they told us S company still have 487 of profit that's as a result of a sales to S company so S is selling to P. So the best way to illustrate to in my opinion the best way to do is to see to illustrate this is to see the journal entry both on the sub and on the parent company so when the sub made the sale the sub will say well I'm going to debit account receivable parent company 2.7 million and I'm going to credit sales parent company 2.7 million okay the parent company would say okay I made a purchase I'm going to debit purchases of 2.7 million and I'm gonna credit my accounts payable dash sub 2.7 million okay so far so good so this is basically the basic journal entries for both companies now I'm gonna make an assumption here and I'm gonna tell you why I'm making this assumption I'm gonna make this assumption to be able to explain to you the journal entries to tell you how we end up with the journal entries now here it says the profit the unrealized profit is 486500 so I'm gonna make the following assumption I'm gonna assume that P did not sell anything from the purchases so P bought those 2.7 million last day of the year and they were not able to sell anything to the outsider okay so no sale has happened what does that mean it means S company they have another entry to make because S company has a profit of 487000 it means their cost of goods sold was 2,212,500 and they reduced their inventory by 2,212,500 you might be asking hold on a second how did you just came up with this figure did you just kind of came out you know bring it out of you know out of the hat no not at all what I assumed is this I assume since they have a profit of 487,500 it means their sale was 2.7 million I assumed their cost of goods sold was 2,112,500 so this will give them a profit of 487,500 which is an intercompany profit which is which is needed to be eliminated when we prepare the consolidated entry so this is where the 487 came from so this is what happened right before right before we are starting to consolidate to prepare the work paper entries now let's see what we need to do now well first thing is we have to eliminate the sales so the sales let's start let me use a different color sales will be eliminated against the purchases so we debit sales for the parent company 2.7 million we credit purchases 2.7 million okay what happened is this intercompany sales and intercompany purchase has been eliminated now obviously also we close AP to AR AP against the AR that's not a problem now what remain is this we have now we still have two issues to deal with what are those two issues one is this 487,500 remember this is an intercompany profit this is intercompany profit so this profit that that the subsidiary recorded will have to be eliminated it's unrealized profit that's unrealized profit why because P company did not sell any of it okay so it's so we have to eliminate this so let's think about this how can we eliminate the profit on the sub well one thing to do how can how can I eliminate this well if I increase the cost I can eliminate it if I increase the cost of goods sold by 487 simply if I add 487 not delete if I add 487 500 to the cost of goods sold to the cost of goods sold my profit will go down to zero so let's do that so i'm gonna debit cost of goods sold 487 500 so this is I told me this is one problem that I still have there's a second problem what's the second problem let me put the second problem here on the parent company side I have a second problem what's the second problem remember the parent company did not sell those merchandise so what does that mean it means those merchandise are I'm gonna inflated in what sense they are inflated well the cost to the whole company to the parent and to the sub the cost to both is 22,500 but when the parent company bought it they bought it at 2.7 therefore they have an inflated inventory by how much it's inflated inflated inventory by the inflated inventory by the profit well then we have to reduce the inventory we have to reduce our inventory on the parent company by 487 500 again why did I do this because the parent company purchased from the sub let's assume the sub that let's make it easy the sub sold them something for ten dollars so the sub will debit a count receivable ten credit sales ten but let's assume for the sub cost of goods sold is eight for the sub okay so what happened is this this cost of goods sold an inventory when transfer to the parent company it became ten dollars why because the parent company will debit purchases for ten credit ap for ten therefore the eight dollars the cost of goods sold for both of them should be eight dollars what happened when the when the parent company bought it and they still have it it's inflated therefore they have to reduce this they have to reduce their inventory by two dollars which is why they have to reduce the inventory by the profit therefore the second entry is the debit cost of goods sold in credit inventory so hopefully this simple example again we're going to be adding more complication to this as we start to add up more but you want to make sure you understand this before you move on before you move on before you move on okay because we're going to we're going to be dealing with opening account and the ending account and sometime we're going to assume that we did not send all the inventory so how do we have to deal with those adjusted entries but for now if you have any questions email me also you could visit my website for head lecturers dot com for additional lectures if you happen to visit the website by all means please consider donating and if you're studying for your CPA exam as always study hard it's worth