When goods are sold between group companies but remain unsold to external customers at year end, the selling entity may have recorded a profit that the group as a whole has not yet earned. This unrealised profit on inventory needs to be identified and eliminated in the consolidated accounts, which makes the review an important part of year-end closing for Hong Kong groups.
How unrealised profit arises
Suppose Company A manufactures goods at a cost of HK$800 and sells them to its subsidiary, Company B, for HK$1,000, recording a profit of HK$200. If Company B still holds the goods at year end, however, the group has not yet earned that HK$200 from an external customer, so the intercompany profit is eliminated on consolidation and the inventory is generally carried at the underlying group cost of HK$800, subject to any required inventory write-down.
The calculation becomes more complex where goods move through several group entities, different mark-ups are used or only part of the inventory remains on hand, so management should identify material stock purchased from group companies and determine whether internal profits remain embedded in the closing balance.
What finance teams should review
Before closing the books, the review should normally consider:
- Inventory quantities remaining on hand.
- The identity of the supplying group company.
- The transfer price.
- The original cost to the group.
- The applicable gross profit or mark-up percentage.
- Subsequent sales after year end.
- Any inventory write-downs for obsolescence or net realisable value.
An average gross profit percentage may sometimes provide a reasonable estimate where transactions are homogeneous, although management should assess whether the result reflects the inventory actually held. Where margins vary significantly between products or transactions, a more detailed calculation may be necessary.
Why unrealised losses also need attention
An intercompany sale below cost may indicate that the inventory has genuinely declined in value, particularly where the lower transfer price reflects obsolescence, damage or falling market prices. Although the internal loss is eliminated on consolidation, management should separately assess whether a write-down is required at group level, so that eliminating the intercompany transaction does not remove a genuine loss in inventory value.
Consider the tax consequences
Consolidation adjustments generally do not alter the taxable profits of the individual legal entities, which can create temporary differences and give rise to deferred tax consequences. Finance teams should therefore consider the applicable tax treatment and retain sufficient records to bridge the legal-entity accounts to the consolidation adjustment.
Build the review into the year end close
A common audit problem arises when management calculates unrealised profit only after the auditors request it, because product-level information may by then be difficult to reconstruct, especially where the inventory system does not retain the identity of the supplying group company. Identifying intercompany inventory during the normal closing process helps ensure that the information needed for the calculation is available before audit queries arise.
Where these transactions are significant, the finance team should prepare a schedule showing closing quantities, transfer prices, original group costs, unrealised margins and the resulting consolidation adjustment, with supporting records that explain how the figures were determined.
The central principle is that a group cannot generate profit simply by selling goods to itself, so profit from these inventory transactions should generally arise only when the goods are sold outside the group.