Intercompany accounting is the recording of financial transactions between two different entities that are related by the same parent company. The transactions may occur between the parent and one of its subsidiaries, or between two subsidiaries. They may also occur between groups, subdivisions, or departments within the same company.
Intercompany accounting is an important step in the business accounting process. It allows the business to record and evaluate all manner of financial activity thoroughly and accurately. For a given business, not all transactions are external. Those that occur within or between entities within the parent company can equally impact its overall financial health as those that involve external, client-customer transactions.
Intercompany accounting allows a business to maintain the same detailed journal entries for intercompany transactions as it would for all other financial activities. The recorded information allows the company to evaluate the full monetary value of its transactions, and to provide accurate financial statements.
Intercompany transactions must be recorded properly because the two entities are not independent, and for this reason, the parent business cannot record the transactions as a profit or loss. A business cannot record a profit or loss by conducting business with itself. Transactions can only affect profit or loss when they involve an independent, outside entity.
Many businesses have divisions, subsidiaries, franchises, or other units that act independently, but are owned by the larger, parent company. For example, 3M—the office supply manufacturer—owns Scotch Tape, Post-It, Bondo, and several other manufacturers of popular office products.
However, not all intercompany scenarios involve large, international businesses. Many are also entirely domestic and operate on a smaller scale. For example, a lawn care company may spin off a smaller start-up to develop and sell a new line of grass seeds. The start-up will act independently but is owned by and receives financing from the parent company.
Any time an exchange of financial value takes place between any of the two entities in these scenarios, the transaction must be accounted for and ultimately reconciled. It cannot be overlooked or disregarded because the two entities are related.
Intercompany reconciliation will look different depending on the business. For example, a large, multi-national corporation with subsidiaries around the globe will have a much different process for reconciling its intercompany transactions than a small, domestic company with one or two subsidiaries.
Intercompany transactions are recorded in different ways depending on the nature of the transaction. For example, if one subsidiary of a company sells inventory to another, the transaction will be recorded as an account receivable entry for the selling subsidiary and as an account payable for the purchasing subsidiary. If a parent company makes a loan to one of its subsidiaries, it will be recorded as an asset for the parent company and as a liability for the subsidiary. In either case, the transactions will be eliminated before the consolidated financial statement is prepared.
Intercompany transactions occur in one of three ways:
• Downstream transactions refer to transactions that originate from the parent company and are directed to one of its subsidiaries
• An upstream transaction is a financial activity that is directed from the subsidiary to the parent company
• Lateral transactions take place between two subsidiaries of the same parent company
In the process of intercompany accounting, it is vital that both parties accurately record the transaction and that they do so in a similar manner, using the same descriptive terms and values. This ensures that the transaction can be correctly recorded, processed, and eliminated by both entities.
Because intercompany transactions cannot be reported as a profit, they must be eliminated. They must cancel out, or equal zero, in the final accounting process. The parent business cannot have an intercompany transaction with a value greater than zero in the closing period statements.
Managing intercompany transactions can be labor-intensive and costly. Reconciling large volumes of data and tracing back errors to mitigate risk is often hampered by limited cross-entity visibility. Because it’s highly distributed, there can be fewer controls and lower accountability.
Correctly classifying profits across countries requires following specific local tax laws and transfer pricing agreements. Regulatory authorities are requiring country-by-country reporting and access to detailed transactions in order to avoid significant fines and fees.
Cumulatively, they can drain valuable finance, accounting, tax and treasury resources, create redundant work and outstanding balances, and elevate exposure risk.
In fact, per Audit Analytics, intercompany issues were the fifth highest reason for restatement, and in the top quartile between 2001 and 2014.