Question

What are the complications intercompany profits create for the use of the sophisticated equity method?

Answer 1

(Q) What are the complications intercompany profits create for the use of the sophisticated equity method?

(Ans)  Chapter 3 demonstrated the use of the sophisticated equity method for the parent's recording of its investment in a subsidiary. Recall that one major difference between the simple and sophisticated equity methods was that the latter records subsidiary income net of amortizations of excess. In contrast, the simple equity method ignores amortizations and records as income for the parent the subsidiary reported income multiplied by the parent's percentage of ownership. Some companies using the sophisticated equity method will proceed to the next level of complexity. Instead of adjusting for their share of the income reported by the subsidiary (as under the simple equity method), they will adjust for their share of subsidiary income after it is adjusted for the intercompany profits. This means that, before the parent can make an equity adjustment for income of the subsidiary,it must prepare an income distribution schedule for the subsidiary company. The adjusted net income derived in the income distribution schedule will become the income to which the parent ownership percentage is applied to arrive at equity income

The added complexity of the sophisticated equity method is unwarranted when statements are to be consolidated, since the subsidiary income and the investment in subsidiary accounts are eliminated entirely. However, this procedure must be used in the rare case when a subsidiary is not to be consolidated or when parent only statements are to be prepared as a supplement to the consolidated statements.