What Is Intercompany Accounting
Apr 11, 2022 | By Michael Whitmire
When two or more companies or different legal entities share the same parent company, transactions between the subsidiaries and with the parent company are never independent. One entity may purchase goods and services from another, or the parent company may incur payroll costs and other administrative expenses on behalf of subsidiaries.
While the parent and subsidiaries need to account for these transaction, they should not be included as profits and losses on the consolidated financial statements. Intercompany accounting is the process of ensuring those transactions are appropriately accounted for at the entity level and eliminated during the consolidation.
What Are the Key Elements in Intercompany Accounting?
An intercompany transaction occurs when one entity participates in a financial transaction with a related entity. The transaction might involve a parent company and a subsidiary or two or more subsidiaries of the same parent.
The nature of these transactions can vary. They may include the sale of products or services from one entity to another or loaning money from a parent company to a subsidiary.
Each entity involved in the transaction must record the transaction in their own books, but those transactions must be eliminated so that no profit or loss is recognized from intercompany transactions on the group consolidated level.
There are three main types of transactions of note in intercompany accounting:
- Downstream transactions. A downstream transaction flows from the parent to a subsidiary, with the parent recording the transaction as a profit or loss. For example, the parent company may sell an asset or inventory to a subsidiary.
- Upstream transaction. An upstream transaction flows from the subsidiary to the parent, with the subsidiary recording a profit or loss. For example, the subsidiary may sell goods to the parent company, which may or may not be sold to a third party in the future.
- Lateral transaction. A lateral transaction occurs between two subsidiaries under a common parent company. For example, Subsidiary A provides IT services to Subsidiary B for a fee.
Understanding the type of intercompany transaction you’re dealing with is key to understanding how the transaction is recorded in the respective entity’s books, their impact on the income statement and balance sheet, and how to adjust the consolidated financials.
Best Practices in Intercompany Accounting
Managing intercompany transactions can be time-consuming and prone to human error — especially if the entities involved use different general ledger or enterprise resource planning (ERP) systems.
The following best practices can help ensure you get intercompany accounting right in order to prepare accurate consolidated financial statements.
Create Global Policies for Intercompany Transactions
Intercompany transactions can present a number of challenges for companies that operate globally. For example, related entities may record transactions in different currencies and record two sides of the transaction on different dates, leading to discrepancies in the exchange rates.
To minimize complications, create high-level policies that address these variations across all entities. This can include establishing common charts of accounts, standardizing reporting capabilities across all entities, and addressing foreign exchange and currency.
Set Up Due To/Due From Accounts
Due to/Due from accounts allow you to track funds owed between parents and subsidiaries. These accounts are similar to accounts payable and accounts receivable but allow you to separate transactions with related parties from those of unrelated vendors and customers.
You can either set up separate Due to and Due from accounts in the chart of accounts for each entity or set up one account named “Due to/From Company X.” The second option makes managing the balances simpler because as debits and credits are recorded in the account, they cancel each other out without manual adjustments.
Implement a Continuous Close Practice
In a continuous close practice, the accounting staff breaks down the month-end close process into day-to-day activities instead of closing the books at the period-end. Because intercompany transactions are matched, reconciled, and eliminated in real-time, it’s much easier and faster to close the books at month-end and turn financial statements from each entity into one consolidated financial statement.
Automate Transaction Matching
Eliminating and reconciling intercompany transaction intercompany transactions can take a lot of time — especially if you need to reconcile transactions across various systems. Consider investing in accounting software solutions that automate the process of matching routine transactions between related entities. This allows you to focus on investigating unusual or problematic transactions.
Intercompany Accounting Transactions and its Types
Eliminating intercompany transactions involves removing any transactions between related entities so they do not impact the company’s consolidated financial statements.
There are generally three types of intercompany transactions to be eliminated:
- Intercompany revenues and expenses. Transactions that involve the sale of goods or services to an affiliated company need to be eliminated because a company can’t recognize revenue from the sale of items to itself. Eliminating the revenue, cost of goods sold or cost of sales, and profits ensures these transactions have no effect on the company’s consolidated financial statements or income tax return.
- Intercompany stock ownership. Eliminating intercompany stock ownership takes out the assets and shareholders’ equity accounts for the parent company’s ownership of its subsidiaries.
- Intercompany debt. When a parent company makes a loan to a subsidiary, the parent company has a note receivable and the subsidiary has a note payable. When consolidating the two entities, both the note receivable and the note payable must be eliminated.
Challenges of Intercompany Accounting and How to Tackle Them
Intercompany accounting and eliminations can be time- and labor-intensive, but companies can’t afford to neglect them. If intercompany transactions aren’t properly accounted for and eliminated, the result is inaccurate financial reporting and increased exposure to regulatory fines and fees.
Here are some of the most common challenges of intercompany accounting and solutions for tackling each of them.
Disparate Systems and Manual Processes
The process of identifying and eliminating intercompany transactions can be error-prone and inefficient if the related entities deploy different general ledger or ERP systems. In this case, the process usually involves multiple spreadsheets, and each system’s unique characteristics complicate the process of validating journal entries.
Intercompany Foreign Currency Transactions
Intercompany eliminations can be particularly complex when different entities use multiple currencies. For example, if Subsidiary A records a transaction in Euros while Subsidiary B records the related transaction in U.S. Dollars, the result is an out-of-balance intercompany transaction with potential tax complications.
The situation gets more complicated when the accounting teams at each entity book the entries on different days, as this impacts the currency exchange rates for each day.
Lack of Standardized Processes
When related companies lack standardized processes and internal governance rules stipulating who can and can’t conduct intercompany transactions, or there’s a lack of compliance with established policies, intercompany transactions may take place without the appropriate documentation and expose the organization to violations of regulatory requirements.
Processes should also address:
- Transfer pricing. Intercompany agreements can mitigate transfer pricing risks by providing evidence for defending transfer pricing policies in the event of a tax audit. Following standardized methods for corporate allocations and centralized service charges can help ensure consistency and efficient processing.
- Cash management. Processes should also address cash management strategies to define when settling a transaction requires an accounting entry versus when it requires an exchange of cash.
- Data management. A master data management process can help ensure that new accounts are set up to align with the company’s policies and all intercompany transactions are processed according to a standardized method.
With multiple stakeholders, complicated agreements, large transaction volumes, and increased regulatory scrutiny, having a structured, standardized intercompany accounting process is essential.
Using multi-entity ERP software can address all of these challenges. It reduces confusion by collecting each entity’s information in a single database. This allows the accounting team to effortlessly record transactions and transfers between different entities and simplifies consolidated financial reporting.
Role of Intercompany Accounting in the Financial Close
Intercompany reconciliations are a key aspect of the financial close for related entities with consolidated financial statements, but it can also be one of the key bottlenecks in the process of closing the books for the parent company.
For relatively small companies, the accounting team may be able to manually match and eliminate all intercompany transactions without too much effort. However, for larger companies with many intercompany transactions, and foreign currency issues, manual processes can be time-consuming and error-prone — especially if there’s limited visibility between entities.
Working with clean data and automating the reconciliation and elimination of routine transactions will help you achieve a faster close because accountants don’t have to waste time identifying and eliminating recurring transactions.
Automation can also remove the burden of identifying intercompany transactions across multiple ERP systems and ensure that close tasks are completed in the right order and with the appropriate oversight.
All of this can help your organization address underlying issues in your close and identify opportunities to streamline your processes to further accelerate the close.