 Hello, and welcome to the session in which you would look at intercompany gross profit of inventory when we are accounting for an investment using the equity method. Now I triple quadruple underline the word equity because we're going to have to deal with this issue later on when we do, when we deal with consolidation. When do we use the equity method? Well remember, the equity method is used when you own, when you have significant influence and you own between 20 to 50 percent of the company. Now if you want to know what happened after 50, you have control less than, less than 20. We use the fair value that those are the general rules. So simply put when you sell inventory to another one of your investees or your investee sells inventory to you, well the idea is any entity cannot recognize profit through activities with itself. Now what you're doing you are dealing technically with yourself, you're selling to your investee or your investee selling to you. So this is what we're going to be explaining in this session, but please I'm going to repeat myself one more time. We are using the equity method, not the consolidation for this example because eventually we're going to have to deal with that. And it's treated a little bit differently, that's the idea. Now this topic is covered on the CPA exam as well as the advanced accounting courses. Whether you are a student or a CPA candidate, especially if you're a CPA candidate, I strongly suggest you take a look at my website, farhatlectures.com. No, I don't replace your CPA review course. That's not what I do, that's not what I intend to do. What I can be is useful addition. Think of me as a supplement, as a vitamin pill, as an alternative explanation, alternative resource to your CPA review course. By doing so I can help you understand your CPA review course better. By doing so you will do better on the exam itself. Your risk is one month of subscription. You can give it a try. I can tell you thousands of students tried before you and they liked it. If not, you lost $30. Your potential gain is passing the exam and if not for anything, take a look at my website to find out how well your university doing on the CPA exam. I do have resources for other college courses as well. If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation, like this recording, share it with others, connect with me on Instagram, Facebook, Twitter and Reddit. So the idea of this session is that using the equity method you cannot recognize profit through basically inter-company transaction. Now although you don't own the full company, you own 40% but let's assume you sold inventory to a 40% owned company. Basically it's an inter-company transaction. It's between you and your investor. What you have to do is you have to delay 40% of the gross profit until the inventory is sold because you sold it to a company that you own 40% of it. Well, you look at your profit, the gross profit to be specific and you delay only, listen to me carefully, 40%. Why? Because you only own 40%. When do you have to delay them? You have to delay them until that party, that investor, sold them to an independent party or if they consume them, they're gone. So the investor recognized the remaining gross profit, which is the remaining gross profit, whatever is now sold and done. And how do we do so? How do we account for this transaction? We account for the deferral, profit deferral, it means we're kicking the profit down the road and subsequent recognition through an adjustment to the equity and investee income, to the income account and to the investment account itself. So when we defer it, we're going to reduce income and reduce assets. When we reverse and you're going to see, we're going to do the opposite. We're going to increase the asset and increase the income once we can recognize. The best way to illustrate this is to actually look at an actual example. Okay, let's look at big company owns 40% of small company. In 2021, big company sells inventory at a price of 50,000. Now, I don't, I'd not put downstream sale on the title because it will scare people. Yeah, what is a downstream sale? This is a downstream sale because the parent company or big company selling to small company. So the parent company selling to the subsidiary, the investor is selling to the investee. Okay, so this is a downstream sale. So you understand what a downstream sale is. Okay, in this figure, the 50,000 include a gross profit of 15,000. Okay, which is 30%. So 30% of the sale is profit and the remaining is cost to us. By the end of the year, the subsidiary sold 40,000. That's good. If they, if we, if we sold them 50, they sold 40,000 to outside parties. What does that mean? It means they still have 10,000 in inventory remaining for subsequent year. They did not sell it. So what's going to happen is we're going to have to delay the gross profit recognition for that $10,000 that of our inventory that still sits in the small company's warehouses. So what is the profit? Well, the gross profit is, you know, if we have 10,000, 30%, the gross profit for everything is 3,000. Now bear in mind, do we own 100% of small company? No, we only own 40%. So notice here, very important, I'm going to highlight in yellow. I should have did it in yellow, but I will, I can highlight now. Only 40% of the investee's stock is held. So just 1,200 of this profit will be deferred. We don't deferred full 3,000. We only defer 40% because we own 40%. Now let's take a look at the journal entry. We debit income. We reduce income and we credit asset. We reduce the asset. Simply put, we reduce the income and we reduce the asset. Now what's going to happen when they sell it in the following year and the subsequent year? We reverse the entry. How do we reverse the entry? We debit investment. We credit equity for that amount when the inventory is sold. So this is an example of a downstream sale. Now also we need to take a look at an upstream sale. Upstream sale actually will treat it the same for as downstream. Now let me just explain one thing real quick. Remember, we're using the equity method. Upstream and downstream are the same using the equity method. When we get the consolidation, when we own more than 50%, upstream sale will be treated differently. We'll get to that later. Okay? So it's only treated the same because we're using the equity method here. So again, big company owns 40% of small company. During the current year, small company sells merchandise costing 40 to big company for 60. So here what happened is small is selling too big. That's why we call it upstream sale. We're going from small to big. Now we need to know what's the gross profit. The gross profit is we made a profit of 20. The small company made profit of 20. 20 divided by 60. The gross profit is 33%. So the gross profit may not be given. You have to compute the gross profit. And I hope you know if you're taking advanced accounting, you should know how to compute gross profit. And if not, it's not a big deal. Go to four-hat lectures, go to your basic accounting, and I can help you with that or any other topic for that matter if you are lacking any prerequisite knowledge. The most difficult thing in accounting, when you faced something in accounting, let me tell you why you find difficulty in it. Not because it's difficult. Accounting is straightforward. It's adding, deducting, following, I would say, simple rules. Sometimes they're a little bit complicated. That's fine. But the difficulty stems from the fact that you might be lacking some prior knowledge that's making your current understanding difficult. And that's why on my website, when I give access, I give access to everything because I want students to be able to go back to other courses if need be and have access to that prerequisite knowledge. So it doesn't matter. The gross profit is 33%. By the end of the year, big companies still retain 15,000 of these goods. Now we have to know how much of the gross profit they need to defer and small company report 120,000 for the year. So let's go ahead and start with the 120,000 because it's easy to deal with it. If they reported 120,000, we own 40% of it. We're going to debit investment in small company 48,000, credit equity in investment company 48,000. Now remember this 120,000 include the sale that they made to us, the sale that they made to us and the profit that they booked, which is 20,000. What do we have to do now? We have to figure out how much inventory remained. Well, we have remained 15,000. Of that amount, 33% is the gross profit. Therefore there's a $5,000 profit was included in that net income. We have to back some of it out. How much do we back out of it? Our ownership level 40%. So we have to back out $2,000 from our income in the investee. Therefore we debit income from the investee or in equity in investee income, reduce income and credit the asset, which is basically the opposite of this. Basically reducing the asset, reducing the income. And basically if I ask you how much income that you made for that year, your income is 46,000. Now obviously when you sell the remaining inventory, the remaining 15,000, you would reverse this. I mean, I should have mentioned this, but put it on the slide, but it's obvious that you have to reverse it. At the end of this session, again, I'm going to remind you, if you're a CPA candidate, what I offer you is an alternative explanation, not a replacement of your CPA review course. You know what? I wish I can replace it. I can't. I cannot do, I cannot claim something I cannot do, but I can help you tremendously improve your score, improve your understanding. That's all what you need sometimes, those extra 5, 7 to 10 points, that's all. And you put the CPA behind you, focus on your career, move on with your life. Study hard, the CPA is worth it. Good luck.