What should be done with intercompany profits in ending inventory?

• A. They are included in retained earnings for consolidation
• B. They are eliminated from the cost of goods sold
• C. They are recorded as an operating expense
• D. They are treated as an additional income source

Answer: (B)

When dealing with intercompany profits in ending inventory, it is essential to eliminate any unrealized profits in order to present a true and fair view of the consolidated financial statements. Since these profits are not realized in transactions with external parties, they should not be included in the cost of goods sold.

In consolidation, the profits from transactions between the parent company and its subsidiaries, or between subsidiaries themselves, can create inflated revenue figures if not properly adjusted. By eliminating these intercompany profits from the cost of goods sold, the consolidated financial statements accurately reflect the cost incurred by the group as a whole, removing the effects of internal transactions.

This ensures that the profit from the sale of inventory within the group is only recognized when the inventory is sold to external parties, thus aligning revenue recognition with the economic reality of the transactions. This treatment is important for compliance with accounting principles such as the matching principle, which states that expenses should be matched to the revenues they help generate.