Cruella Inc. owns 85% of Horace Co. During 20X9, Cruella sells goods to Horace with a 25% gross profit. Horace sold all of these goods to a 3rd party in 20X9. For the 20X9 consolidated financial statements. How should the summation of the Cruella and Horace income statement items be adjusted?

a. No adjustment is needed.
b. Sales and COGS should be reduced by 80% of the intercompany sales amount.
c. Net income should be reduced by 80% of the gross profit on intercompany sales amount.
d. All intercompany sales and costs of goods sold must be eliminated in consolidation

Option A is the correct answer,no adjustment is needed.

Explanation:

When related companies sell to each other,the sales transaction is not sales in actual sense,as it is likened to the left hand of an individual exchanging cash with the right hand,in other words, the cash is still owned by the same person.

The same concept is applicable to subsidiaries and parent,the sales recorded from a group perspective is when they sold to external third parties.

When sales happen between related companies, a provision for unrealized profits has to be made to the tune of inventory purchased from related companies  not yet sold externally,as the whole of the goods have been to third parties, no such provision or adjustment is required.

d. All intercompany sales and costs of goods sold must be eliminated in consolidation.

Explanation:

For a group of companies, the figure to be used in the profit and loss account must only be sales to and purchases from customers or companies that are not part of the group. For this reason, intra group sales are to be eliminated from sales and cost of sales figures used in the profit and loss account.

In addition, unrealized profit on goods should also be eliminated in case there are some of the goods related intra good sales that are not yet sold.

Therefore, the correction is d. All intercompany sales and costs of goods sold must be eliminated in consolidation.

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