Having a hard time wrapping my head around this… Company owns 30% of a subsidiary. During the year, company sold them 120MM in inventory for 180MM (so we have a 60MM profit). The subidiary only sold 120MM of the 180 we sold to them. So I get it, there is 33% of the goods left unsold. Why would we not reduce our 60MM profit by the full 20MM dollars? Why is part of that attributable to the subsidiary? The way this problem is solved, of that 20MM unrealized profit, our share is only 30%, or 6MM. So we reduce our 60MM by 6MM.
It seems that that money is OUR profit. Why do we give 30% of the unrealized profit to our subsidiary? This problem was a konvexity item set, but example 6 on page 126 of FRA book is set up the exact same way.
Thanks for any help!
this is one part that continues to haunt me!
Is it possible that it is just convention and that further discounting by the share of ownership is arbitrary? The purpose of the rule is to prevent company’s from using intercompany sales to overstate financial results. So it makes sense to discount the portion of the gain that has not yet been sold to a third party ($20mm). But this is probably not the best representation of the actual realizable value of the gain, since it fully discounts the unsold portion. So there needs to be some other discount factor that reduces the amount by which the gain is discounted.
The proportionate share of ownership fits this purpose nicely, such that the greater the share of ownership, the greater the reduction in the total gain.
I just made this up, but it makes sense to me and that’s how I’m going to remember it for the test.