Intercompany accounting

What is Intercompany Accounting?

Intercompany accounting is a set of procedures used by a parent company to eliminate transactions occurring between its subsidiaries.  For example, if one subsidiary has sold goods to another subsidiary, this is not a valid sale transaction from the perspective of the parent company, since the transaction occurred internally. Consequently, the sale must be removed from the books at the point when the consolidated financial statements of the parent company are being prepared, so that it does not appear in the financial statements.

Intercompany accounting can be one of the key bottlenecks in the process of closing the books for a parent company, and so should be a focus of management attention to find ways to streamline the process.

Related AccountingTools Courses

Closing the Books

The Soft Close

The Year-End Close

How to Identify Intercompany Transactions

Intercompany transactions can be flagged in an organization's accounting system at the point of origination, so that they can be automatically backed out when the consolidated financial statements are prepared. If there is no flagging feature in the software, then the transactions must be manually identified, which is subject to a high degree of error. The latter case is most common in a smaller organization that has used a less feature-rich accounting system, and now finds that it does not have the necessary transaction flagging features needed to account for its subsidiaries.

Elimination of Unrealized Profits on Intercompany Sales

Affiliated organizations might sell goods to each other. This is especially common in a vertically-integrated business, where goods from an upstream provider are sold to a downstream subsidiary, which integrates these purchased items into its own products. For the purposes of a subsidiary’s internal financial reporting, these sales are recorded as sales, with a cost of goods sold and a reported profit or loss. However, this is not the case from the perspective of the consolidated entity, where these sale transactions need to be identified and eliminated. If these sales were not eliminated, then the consolidated entity would essentially be internally generating fake sales. More specifically, for the purpose of creating consolidated financial statements, intercompany sales and the cost of these intercompany sales must be stripped out of the financial statements. Furthermore, all inventory stated on the consolidated entity’s balance sheet must be recorded at its cost to the affiliated group. In short, consolidated financial statements must show results and a financial position as though the intercompany transactions had never happened.