Many businesses consist of multiple units that act independently but are owned by a larger parent company. These units have transactions with each other, in the form of sales and purchases, loans, staffing, and other exchanges of resources that carry monetary value.
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. In this form of business accounting, known as intercompany accounting, the transactions cannot be recorded as a profit or loss because a business cannot record a profit or loss by conducting business with itself.
According to this principal, the transaction will ultimately cancel out, or equal zero. This is referred to as intercompany elimination because the transaction will be eliminated before consolidated financial statements are generated. The resulting statement will only reflect business transactions with outside, unrelated entities.
Many businesses are composed of various units, divisions, or subsidiary companies that are owned by the same parent. For example, in the office supply industry, 3M owns Scotch Tape, Post-It, Bondo, and several other manufacturers. In the auto industry, the Indian car company Tata Motors owns both Land Rover and Jaguar. Gatorade and Starbucks, two internationally recognized and extremely successful beverage companies, are owned, along with nearly two dozen other brands, by the parent company PepsiCo.
Not all intercompany scenarios involve large, international businesses. Many are also entirely domestic and operate on a smaller scale. They can happen within subsidiaries or divisions of much smaller enterprises. For example, a lawn care company may spin off a smaller start-up to develop and sell a new line of grass seeds. A computer manufacturer may create a separate business to develop a new software product. In either case, the start-up will act independently but is owned by, and receives financing from, the parent company.
When either of the two entities engages in a transaction—when it exchanges a resource of monetary value—with the other entity, this is considered an intercompany transaction. Any of the intercompany transactions described above must be recorded, reconciled, and ultimately, eliminated.
Intercompany transactions, and their eliminations, typically fall into one of three broad categories depending on the nature of the transaction:
Intercompany debt concerns loans made between units or subsidiaries that are related to the same parent company
Intercompany revenue and expenses concern sales of products or services between two inter-related units
Intercompany stock ownership occurs when a parent company owns stocks in one of its subsidiaries
Intercompany transactions can also be categorized according to the “direction” of the exchange:
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
All of the above transactions must be eliminated when the business is preparing its consolidated financial statements. Intercompany accounting is a complex process, and transactions can be easily missed. This is why businesses must have controls in place to correctly record, then later recognize, capture, and correctly eliminate all intercompany transactions. This is done preceding the generation of consolidated financial statements.
The double-entry system of accounting also offers another safeguard by ensuring that the exchange will be offset in the ledger on both sides of the transaction. For example, if a subsidiary of a company sells inventory to another subsidiary, 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, both sides of the transaction will eventually be eliminated.
By eliminating all intercompany transactions, the business can generate a consolidated financial statement for all its constituent units and subsidiaries which reflects its true profits and losses as a result of business conducted (only) with outside entities or customers. This represents a more accurate representation of the business’s financial activity.
Intercompany transactions occur in many ways. For example, if the parent company of a spinoff were to provide working capital or a loan for the venture, this would be considered an intercompany transaction. Similarly, if the parent company pays part or all of a supplier’s invoice to the subsidiary, this would also be considered an intercompany transaction. In either case, the transactions will be eliminated before the consolidated financial statement is prepared.
Eliminating intercompany transactions is an important accounting function that ensures accuracy in the business’s financial statements. Intercompany transactions can artificially inflate profits and liabilities in the business, which leads to inaccurate financial statements. Intercompany elimination ensures that only transactions with outside entities are recorded as a profit or a liability.
Intercompany elimination faces a number of challenges because of the nature of the transactions that are being reconciled. These may include poor record keeping, such as invoicing errors and inconsistent account period recording. Exchange rate differences can also be an issue for international companies.
Businesses can proactively address these challenges. To begin, all journal entries that involve an intercompany transaction should use a standard means of identification and data entry. Utilizing these standard data parameters will greatly increase the efficiency of the elimination process, by eliminating or reducing the need to search and find data pertaining to intercompany transactions.
The business should also have a standard method of extracting the data for intercompany transactions. Both entities in the transaction should utilize this method to increase the efficiency of the process.
Finally, the business will benefit from having a centralized means of eliminating all intercompany transactions once they have been gathered. Automated solutions, in the form of software, will make this process much easier.