Un-realized Profits (With Illustration) | Holding Companies

The below mentioned article provides a short note on the Un-realised Profits arising from Transaction between the Holding Company and Subsidiary Company.

Usually, there will be transactions between the holding company and the subsidiary company involving profits and losses. Suppose, H Ltd. (the holding company) buys from S Ltd. (the subsidiary company) goods of the value of Rs 20,000 on which S Ltd. has put a profit of 25% on selling price.

It means that S Ltd. has made a profit of Rs. 5,000 on goods sold to H. Ltd. If H Ltd. is able to sell these goods, it does not matter because the whole profit—the Rs 5,000 charged by S. Ltd. and whatever profit H Ltd. makes—is realised.

But if the goods remain unsold and are taken in stock at the close of the financial year, the profit charged by S Ltd. remains un-realised and it will not be proper to credit the Profit and Loss Account with such a profit.

Either a reserve should be created or the value of closing stock written down. If a portion of the goods has been sold, proportionate reserve should be created for un-realised profit on unsold goods. But if there are outside shareholders in the subsidiary company, they will treat the profit made by the subsidiary company as realised.

Similarly, if the holding company sells goods to S Ltd. and the goods remain unsold, the holding company can treat the profits as realised so far as the outside shareholders are concerned. This means that the reserve to be created in respect of un-realised profit should be reduced by the share applicable to the outside shareholders Suppose, H Ltd. holds 3,000 shares in S Ltd. out of the total 4,000 shares.

During the year, S Ltd. sold goods costing Rs 50,000 to H Ltd. at a profit of 20% on cost. At the end of the year, H Ltd. has still in stock a portion of these goods and this was valued by H Ltd. at Rs 30,000 (cost to H Ltd.) The total un-realised profit is Rs 30,000 X 20/120 or Rs 5,000.

Since the outside shareholders have one-fourth interest, Rs 1,250, i.e., 5000/4 may be treated as realised and a reserve of the remaining balance, viz., Rs 3,750 created by debit to the Profit and Loss Account.

The point will also arise when fixed assets are transferred at a profit or loss. It will have to be treated exactly in the same way in which sale of goods is treated. The modern practice is to create the whole of the profit mentioned in these paragraphs as un-realised without adjustment for minority interest. Hence, a reserve equal to the total un-realised profit may be created.

Illustration 1:

On 31st March, 2012 the Balance Sheets of H Ltd. and its subsidiary S Ltd. stood as follows:—

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