X Inc. owns 80% of Y Inc. During 2020, X Inc. sold inventory to Y for $10,000. Half of this inventory remained in Y's warehouse at year end. Y Inc. sold inventory to X Inc. for $5,000. 40% of this inventory remained in X's warehouse at year end.
Both companies are subject to a tax rate of 40%. The gross profit percentage on sales is 20% for both companies. Unless otherwise stated, assume X Inc. uses the cost method to account for its investment in Y Inc.
Assuming that X Inc. used the equity method instead of the cost method, what adjustment would have to be made to the investment in Y account to adjust for any unrealized profits on Y's sales to X?

Question

Quizplus · Accepted Answer

Under the equity method, unrealized profits on intercompany transactions must be eliminated. In this case, Y Inc. sold inventory worth $5,000 to X Inc. with a gross profit of $1,000 (20% of $5,000). Since X Inc. owns an 80% controlling interest in Y Inc., the unrealized after-tax profit to be eliminated in the investment account is $240 ($1,000 * 40% * 80%). Therefore, the investment account would have to be reduced by $192 ($240 * 80%) to adjust for any unrealized profits on Y's sales to X.

X Inc Owns 80% of Y Inc