Equity Method — Eliminating Intra-Entity Profits & Reporting Investor Earnings

The consolidated and equity-method financial statements must purge the illusion of profit arising from transactions between the investor and its equity-method investee.

Only gains earned through dealings with outsiders truly enhance the combined economic position; therefore, any intra-entity profit embedded in inventory, fixed assets, intangibles, or services is deferred until the related asset is sold or consumed externally.

1. Nature of intra-entity transactions and why elimination is required

Intra-entity transactions occur whenever the investor sells goods or services to the investee (downstream), the investee sells to the investor (upstream), or either party sells to another entity under common control. Although each side recognises revenue and cost individually, the group has not generated earnings until the asset leaves the related-party network. Eliminating the unrealised portion prevents overstating consolidated profit, assets, and equity.

2. Downstream versus upstream transactions

Transaction Type	Direction	Who defers the unrealised profit?	Portion eliminated
Downstream	Investor to investee	Investor	100 %
Upstream	Investee to investor	Investor	Investor’s % share

Downstream

The parent or investor transfers inventory, property, or services to the investee. The entire unrealised profit is initially embedded in the investor’s separate-entity income; elimination therefore reduces the investor’s reported equity-method income by the full amount of unrealised gain.

Upstream

The investee sells to the investor. Elimination reduces the investor’s share of the investee’s income in proportion to its ownership percentage. Because the gain sits in the investee’s books, any non-controlling shareholders in the investee keep their proportional share of the unrealised profit until the asset is sold to outsiders.

3. Mechanics of profit elimination

Asset Type	Key Adjustments	Reversal Trigger
Inventory	Defer unrealised gross profit on unsold intra-entity goods	Sale to external customer
Fixed Assets	Defer gain and excess depreciation/amortisation	Periodic depreciation until asset is fully used or sold
Intangibles	Same as fixed assets if amortisable	Over useful life or on disposal
Services	Defer profit if services create capitalised WIP or development assets	Asset consumed or sold externally

Inventory transactions

Determine the portion of ending inventory still on hand that originated from related-party sales. Multiply that quantity by the intra-entity gross profit per unit to compute unrealised profit. Defer the amount by:

• Crediting the investment income line (downstream) or

• Crediting investment income for the investor’s share and non-controlling interest for the balance (upstream).

Fixed-asset and intangible transfers

Calculate the gain deferred plus the difference in depreciation or amortisation based on the asset’s original carrying amount versus its stepped-up related-party basis. Adjust both investment income and the asset’s carrying amount to reflect depreciation based on the lower historical basis until the gain is fully realised or the asset is retired.

4. Effect on the investor’s income statement

• Downstream inventory gains — 100 % of the unrealised gross profit reduces equity-method earnings in the period of sale; reversal occurs as the inventory is sold externally.

• Upstream inventory gains — Only the investor’s ownership share is deferred each period.

• Fixed-asset transfers — Eliminate any unrealised portion of the gain and adjust for excess depreciation every period until the asset’s useful life ends.

• Timing mismatches — Deferrals may span several accounting periods, requiring detailed tracking schedules to ensure subsequent reversal is captured accurately.

5. Carrying-amount reconciliation incorporating deferrals

Component	Impact on Carrying Amount
Opening balance	Starting point of investment account
+ Share of investee’s net income	Increases carrying amount
– Intra-entity profit deferred	Reduces carrying amount
± Share of OCI items	Adjusts based on OCI exposure
– Dividends or returns of capital	Reduces investment value
– Amortisation of basis differences	Reduces investment balance gradually
– Impairment losses	Write-down to recoverable amount
= Closing balance	Ending investment value

6. Presentation and disclosure requirements

• Identify the nature of significant intra-entity transactions and the policy for eliminating unrealised profits.

• Disclose the aggregate amount of profit deferred and the amount realised in the current period.

• Present schedules of cumulative unrealised profit in inventory and long-term assets if material to users’ understanding of performance and position.

• Explain any judgment applied in determining which transactions are considered downstream versus upstream when ownership structures are complex.

7. Advanced issues and special situations

• Multiple-layer chains — When an investee itself holds interests in other related entities, unrealised profit must be traced through each layer to avoid double elimination or omission.

• Partial disposals — If a portion of an investee interest is sold but significant influence remains, any previously deferred profit is re-measured based on the new ownership percentage.

• Contribution of non-monetary assets — Gains on assets contributed to a joint venture or associate are deferred in full (or proportionally) until the venture sells the asset externally, subject to exceptions for a loss of control scenario.

• Service transactions — Where services create work-in-process inventory or capitalised development costs, eliminate related profits by treating the cost component as the lower of cost or market until third-party revenue is recognised.

8. Emerging guidance and practice considerations

• Ongoing standard-setter deliberations propose aligning upstream and downstream treatment under IFRS, potentially requiring full gain deferral in all cases to simplify application.

• Digital platforms create new forms of intra-entity transactions (e.g., internally generated licensing arrangements) that demand robust tracking mechanisms to isolate and defer embedded profit.

• Audit regulators continue to scrutinise the accuracy of intra-entity profit calculations, especially where ERP systems lack automated intercompany elimination functionality.

Key take-aways

• Identify downstream and upstream transactions promptly and determine the unrealised profit component.

• Maintain detailed schedules to track beginning balances, current-period deferrals, reversals, and the remaining unrealised amount for each asset category.

• Reconcile investment income each period to ensure profit deferrals and reversals align with the investor’s ownership percentage and the investee’s external sales activity.