Question

Assume a parent company owns a 100% controlling interest in its long-held subsidiary. The following excerpts are from the parent’s and subsidiary’s “stand-alone” pre-consolidation income statements for the year ending in December 31, 2019, prior to any investment bookkeeping or intercompany adjustments.

	Parent	Subsidiary
Revenues	4,000,000	2,500,000
Cost of goods sold	(2,800,000)	(1,500,000)
Gross profit	1,200,000	1,000,000
Selling general & administrative expenses	(780,000)	(606,000)
Net income	420,000	394,000

On January 1, 2019, neither company held any inventories purchased from the other affiliate. All of the sales made by either company have the same gross margin regardless of whether they are made to affiliate or non-affiliates. The subsidiary declared and paid $200,000 of dividends during 2019.

1. Assume during the year ended December 31, 2019, a parent sold to its subsidiary $500,000 of merchandise. At December 31, 2019, the subsidiary still held in its inventory 25% of the goods purchased from the parent during 2019. What is the amount of “income from subsidiary” recognized by the parent company if it applies the equity method of pre-consolidation investment bookkeeping?

a) 356,200

b) 394,000

c) 420,000

d) 431,300

2. Assume during the year ended December 31, 2019, a subsidiary sold to its parent $400,000 of merchandise. At December 31, 2019, the parent still held in its inventory 25% of the goods purchased from the parent during 2019. What is the amount of “income from subsidiary” recognized by the parent company if it applies the equity method of pre-consolidation investment bookkeeping?

a) 234,000

b) 294,000

c) 354,000

d) 356,500

Answer 1

		Parent	Subsidiary
	Computation of gross profit ratio	30%	40%
		(1200000/4000000)	(1000000/2500000)
1.	Since parent has sold goods to subsidiary it is a downstream transaction.
	Unrealised profit on closing stock shall not be eliminated from subsidiary's books.
	hence, correct answer for "income from subsidiary" will be (b) 394,000
2.	Closing stock in parents books	$100,000
	Unrealised profit	$40,000	(100000*40%)
	net income of subsidiary	$394,000
	Less : unrealised profit	$40,000
	Income from subsidiary	$354,000
	Hence, correct answer is c) 354,000