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.
An intercompany invoice is a document that details a transaction between two units, divisions, or subsidiaries within the same parent company. It will have all the same information that any other invoice would have, including:
The name of the entity or unit providing the good or service
The recipient entity or unit of the good or service
The good or service provided
The date on which it was provided
The quantity or amount that was provided
The value of the resource that was exchanged
Intercompany reconciliation is the verification of transactions that take place between two units or subsidiaries of the same parent company.
Intercompany reconciliation is performed much like other forms of account reconciliation. However, there are some steps that are unique to the process. As account reconciliation ensures the validity and accuracy of business accounting in general, intercompany reconciliation is the process of verifying the records of intercompany accounting, specifically.
Intercompany reconciliation 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.
When organizations significantly expand their global footprints, a spiraling number of intercompany transactions are generated and immediately complicated by local tax policies, currencies, transfer pricing, and disparate systems and applications.
If these kinds of transactions are not eliminated correctly, any out-of-balance accounts can seriously impact financial statements, creating compliance issues, the risk of restatement, SEC imposed fines, and shareholder lawsuits.
The complexity of intercompany accounting increases as it expands beyond accounting and finance and into the tax and treasury department. Companies must analyze the value chain to understand and execute accurate taxing policies and transfer pricing agreements. Understanding cross-country netting rules and consolidating for settlement requires detailed transaction information.
As volume grows, the use of spreadsheets, email or verbal approvals, or other workarounds exposes organizations to significant financial, compliance, and reputation risk.
Utilizing standard data parameters greatly increases the efficiency of the intercompany accounting and reconciliation process, by eliminating or reducing the need to search and find data pertaining to intercompany transactions.
This process is often referred to as master data management. The term describes the process by which a business takes steps throughout the enterprise to ensure the uniformity, accuracy, and consistency of its data.
Much of a business’s financial activity takes place between and within subsidiaries or divisions of the same parent company. This has become even more commonplace in today’s global economy.
Journal entries of intercompany transactions are an important step in the business accounting process. They allow the business to record and evaluate all manner of financial activity thoroughly and accurately.
An effective intercompany accounting process helps the business avoid double entries in more than one of its subsidiaries or divisions. It allows the company to evaluate the full monetary value of its transactions, to provide accurate financial statements, and to avoid disputes.
Intercompany accounting helps businesses with multiple divisions and subsidiaries prepare accurate consolidated financial statements, to provide a clear and transparent picture of its financial health, and avoid disputes.
Without thorough and accurate intercompany accounting, companies leave themselves vulnerable. Businesses will not be able to properly reconcile transactions that take place between entities or to accurately assess profits and losses. This undermines the ability of the parent company to prepare accurate consolidated financial statements. The role and contribution of each entity to the parent company’s overall performance and financial health cannot be accurately ascertained. Inadequate intercompany accounting can also lead to financial disputes between entities under the same parent company.
Intercompany transactions can artificially inflate profits and liabilities in the business. Intercompany accounting operates on the principle that only transactions with outside entities can create a profit or a liability. Therefore, all intercompany transactions must cancel out to zero in the business accounting records.
For example, if a subsidiary purchases supplies from another, it will record a $1000 transaction in its purchase account. At the same time, the entity that sold the supplies will record the transaction for the same amount in its sales account.
Intercompany reconciliation will make sure that these two transactions are properly recorded in the ledgers for both subsidiaries, and that they ultimately cancel out, or equal zero, and do not appear in the consolidated financial statement for the parent business.
Intercompany transactions can include a number of different kinds of financial activity. Related units can buy and sell goods or services, just like they do with outside customers. They can also exchange other resources, such as fees, inventory, cash, capital, dividends, raw materials, parts, staff, and loans. Any of these types of transactions require documentation.
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