Question

What effect does the elimination of intercompany sales and cost of goods sold have on consolidated net income? AND what effect does the elimination of intercompany accounts receivable and accounts payable have on consolidated working capital? Explain your answer.

Answer 1

Intercompany eliminations:

When one entity transacts with another company belonging to the same group of companies like giving debt or selling goods etc., then such transactions are called as intercompany transactions.

Since these transactions involve recognition of income or loans from dealings with themselves(same group of companies) it might show unfair representation of financial statements, hence such intercompany transactions must be eliminated in order to show true value of income or loss or current assets &liabilities.

1.Effect of elimination of Sales and cost of goods sold on consolidated Net income:

If the sales from one department(entity) to another is done at cost, then such an intercompany elimination will have NO EFFECT on Consolidated Net income because equal amounts of Sales and Cost of goods sold are eliminated from both the departments.This is beacuse sales for one entity becomes purchases for other entity, a transaction which increases net income for one department(sales) will decrease the bet income in other(purchaes) and thus nullifying the effect of such a intercompany transaction.

But if Sales are done from one department to other for a price greater than cost(at markup price) then it may lead to some unrealized grossprofits whose effect should be removed by giving propers debits or credits during the inter company eliminations.

2.Effect of elimination of Intercompany Accounts receivables and payables on Net working capital.

There is NO EFFECT of such elimination on Consolidated working capital beacuse the same amount of Receivables and payables accounts is deducted from both the departments.

The accounts receivable of one department/entity becomes the accounts payable of another.The total of (Current assets-current liabilities) arising from intercompany transactions(i.e debts) will be same in both the departments.If one dept has an increase in working capital, then other dept would have a decrease in working capital of equal amount.Such an intercompany transaction when eliminated it would lead to nil effect on Net working capital on whole.