Companies account for certain investments in other companies through the equity method. This method applies when the investor owns between 20 percent and 50 percent of the investee's voting shares. An investor company uses the unrealized gross profit equity method to postpone revenues from the inter-company sale of inventory to or from the investee. Companies can also apply this method to the inter-company sale of depreciable assets and land.
Under the equity method, the investor books an investment in an investee as a long-term asset. Whenever the investee announces earnings, the investor adjusts the book value of the investment to reflect the investor's share of the investee's gain or loss. For example, if investor Small Corp purchases 40 percent of the shares of Teeny Inc. for $3 million, it would debit the investment in Teeny account and credit the cash account for $3 million. If Teeny announces $200,000 in net income for the quarter, Small would debit the investment in Teeny account and credit the investment income account for its 40 percent share, $80,000.
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Unrealized Gross Profit
Under the unrealized gross profit equity method, the investor-investee relationship requires that the inter-company seller of goods retains a partial interest in the inventory until the buyer disposes of the inventory. The sales of inventory between investor and investee, and the accompanying gross profit, must remain unrealized until the buyer sells or uses up the inventory. The rule applies to downstream transfers, in which the investor sells items to the investee, and to upstream transfers, in which the investee is the seller.
Downstream Sales Example
Suppose Small sells inventory costing $35,000 to Teeny for $50,000, a 30 percent, or $15,000, gross profit for the seller. By year's end, Teeny has sold $40,000 of this inventory, with the remaining $10,000 retained in its ending inventory. When Teeny sells the remaining $10,000 of inventory, Small's share of the profit is 30 percent, or $3,000. But since Small owns only 40 percent of Teeny, Small's actual unrealized gross profit is 40 percent of $3,000, or $1,200. Small records a debit to the investment income account and a credit to the investment in Teeny account for $1,200 to defer the unrealized gross profit. When Teeny sells the remaining inventory, Small reverses the deferral transaction and realizes the gross profit of $1,200.
Upstream Sales Example
The unrealized gross profit equity method also applies to upstream sales. Suppose Teeny sells inventory costing $40,000 to Small for $60,000, a gross profit of $20,000. From Small's point of view, $20,000 of $60,000, or 33.33 percent, of the sale price is the gross profit percentage. If Small has $15,000 of the inventory remaining at year end, the amount of gross profit tied up in the unsold inventory is 33.33 percent of $15,000, or $5,000. Multiplied by Small's 40 percent ownership share, the unrealized gross profit is $2,000, which Small debits to the investment income account and credits to the investment in Teeny account. Small reverses the deferral after selling the remaining inventory.