II - Inventories: Specific points
2. Elimination of profits in inventories
2.1. General principle
- Significant profits are eliminated directly in the books of the legal entities for profits realized from sales within the same legal entity, on the one hand, and at the Group level for profits realized from sales between legal entities on the other hand.
- Profits in inventories are eliminated in the selling division involved, and an adjustment of the corresponding inventory is done in the buying division.
2.2. Within the same legal entity
- The purpose of eliminating profits in inventories is to give the inventory a proper valuation within the legal entity, which will avoid prepaying taxes on unrealized profit.
- Profits in inventories generated by transfer of products within the same division or between two separate divisions, within the same legal entity, are eliminated under the heading R15430 "Elimination of margins in inventories" charged to the selling division concerned, with the finished goods inventory heading (A37000) of the buying division as the balance sheet counterpart.
As a means of simplification, the heading R15430 is sent at the level of division (within the same legal entity, the numer of divisions is rather limited).
2.3. Between separate legal entities
- For separate legal entities (which may be located in different countries), profits generated by the selling company are held in the inventory of the buying company, as for single companies.
- The difference lies in the fact that the selling company is liable for tax on the profit. Nothing can therefore be eliminated by the legal entity itself. The profit in inventories must, however, be eliminated for the income statement to be correct at Group level. It is thus at the consolidated level only (in a fictive company), in the selling division, under the heading R15430, that profits in inventory will be eliminated with the constitution of correlative deferred taxes if there are discrepancies between calculated taxes for Group reporting and the amount of taxes actually paid. Adjustment of corresponding finished goods inventory (A37000) will be done in the buying division.
Special case for a tax unit: When the buyer and seller are separate legal entities in the same country, but in a tax unit system, the rules to apply to profits in inventories realized between member entities of the tax unit, for setting up results of the tax unit, can be identical to those applied for the Group consolidation. If this elimination generates accounting entries in the local Books, they must be excluded in Group reporting to avoid double counting of the elimination.
2.4. Frequency of elimination
Yearly calculations suffice for reporting purposes, when reporting data is used as a basis for external communications. Within the same legal entity, eliminations can be done monthly or quarterly, but this is not mandatory.
2.5. Example of profits in inventory
Division A sells an item costing 100 to division B of the same legal entity for 110.
At the end of the period, the item is in B’s inventory.
A profit of 10 is recorded in division A.
In division B, no profit is recorded, since the item is in inventory.
The legal entity records -10 under R15430, in division A. In parallel, a write-down of 10 is recorded on the inventory value in division B. It is assumed that no other transactions are performed.
In the following period, the entry must be reversed:
+10 under R15430 in division A and increase inventory in division B by 10. It is assumed that all the initial inventories have been sold by the end of the second period. Since profits in inventories are eliminated once a year, this assumption is reasonable.
Division B sells the item to a third party for 150 and shows a profit of 40 (150 - 110). The total profit for the entity is 50 (40 in division B and 10 coming from division A).
Remark: With losses in inventories, the reasoning is similar but the signs are reversed.
However it is important to check that the inventories are not overvalued in relation to their market value:
- For finished goods, the comparison is relatively simple (lower of cost or market);
- For raw materials or semi-finished goods, no write-downs should be recorded as long as the corresponding finished product could be sold on the market without loss.