Downstream vs. Upstream Inventory — Deferred Gross-Profit Calculations

Intra-entity inventory transfers between an investor and its equity-method investee require the deferral of unrealised gross profit until the inventory is sold to third parties.

Whether the transfer is downstream (investor to investee) or upstream (investee to investor) affects both the portion of profit deferred and how it is reported in the investor’s financial statements.

1. Nature of intra-entity inventory transfers

When inventory is sold between related parties, any unrealised gross profit embedded in the ending inventory must be deferred because the group has not yet earned revenue from a third-party sale. The core accounting principle is to avoid overstating consolidated earnings and assets with profits that have not left the reporting entity’s economic boundary.

2. Gross-profit components and calculation formula

To calculate deferred gross profit:

1. Identify the portion of ending inventory that originated from intra-entity sales.

2. Determine the intra-entity markup (or gross margin) on that inventory.

3. Apply the markup to the unsold inventory balance to compute the amount of unrealised profit.

Component	Description
Intra-entity transfer price	Selling price between investor and investee
Historical cost to transferor	Original cost of the inventory before markup
Gross profit per unit	Difference between transfer price and cost
Ending inventory from transferor	Quantity or value of unsold intra-entity goods
Deferred gross profit	Ending inventory × gross profit per unit (or %)

3. Direction of transaction: downstream vs. upstream

Direction	Transferor	Who defers the profit	Deferred portion	Effect on investor income
Downstream	Investor	Investor	100 % of unrealised profit	Full reduction of equity-method income
Upstream	Investee	Investor	Investor’s % ownership	Partial reduction based on ownership share

Downstream

The entire unrealised gross profit is deferred by the investor. The adjustment directly reduces the investor’s share of income from the investee. When the investee sells the inventory to external customers, the deferred amount is reversed into income.

Upstream

Only the investor’s share of the unrealised profit is deferred. The remaining portion is effectively attributable to non-controlling interests and remains in the investee’s reported income until realised.

4. Journal entry examples

Downstream transaction — deferral

If Investor A sells $100,000 of inventory to Investee B with a $30,000 unrealised gross profit remaining in ending inventory:

Entry to defer:

• debit Investment in B

• credit Investment Income(amount: $30,000)

Reversal in future period (after sale to third party):

• debit Investment Income

• credit Investment in B(amount: $30,000)

Upstream transaction — deferral (Investor owns 40 %)

If Investee B sells $60,000 of goods to Investor A with $12,000 gross profit still in Investor A’s ending inventory:

• Investor defers 40 % of $12,000 = $4,800

• debit Investment in B

• credit Investment Income(amount: $4,800)

Reversed when sold externally in same ownership proportion.

5. Carrying-amount adjustments

The deferred gross profit is excluded from the investor’s income and reduces the investment’s carrying amount in the balance sheet. Reversals restore both income and the carrying value of the investment when the inventory leaves the consolidated group.

Period	Net Income (Investee)	% Ownership	Gross Profit Deferred	Equity-Method Income Recognized
Year 1	$50,000	40 %	$4,800	$15,200 (20,000 – 4,800)
Year 2	$60,000	40 %	(reversal of $4,800)	$28,800 (24,000 + 4,800)

6. Timing mismatches and complexities

• Cross-period deferrals — If the inventory is not sold externally by year-end, the unrealised profit carries forward and must be tracked for reversal in the following period.

• Layering of transactions — Repeated intra-entity sales in subsequent periods require running schedules to isolate unrealised profit from each batch of goods.

• Currency effects — When the investor and investee operate in different currencies, deferred profit must be retranslated each reporting period, introducing FX gains or losses.

• System limitations — ERP systems must flag intra-entity inventory correctly and apply appropriate elimination logic to avoid understatements or overstatements.

7. Disclosures and audit focus

• Disclose material intra-entity inventory activity, the gross profit impact, and the method used to compute deferrals.

• Explain the ownership split applied for upstream transactions.

• Highlight any unusual deferrals or reversals affecting period-over-period comparability.

• Provide reconciliation schedules if intra-entity activity is frequent or material to net income or inventory balances.

Key take-aways

• Determine intra-entity gross profit using clear markup or margin methods.

• Apply full deferral in downstream cases and proportional deferral for upstream.

• Track and reverse profit when inventory is sold externally to ensure timely recognition.

• Maintain robust documentation and support for estimates, assumptions, and inventory flow classification.