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.
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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.
Best Practices for Intercompany Accounting
Intercompany accounting can be a complex and confusing area of accounting. The following best practices can reduce the risk of incorrect accounting in this area:
Establish clear intercompany policies and procedures. The parent company should document formal policies governing intercompany transactions, including pricing, invoicing, currency conversion, and settlement timelines. This ensures consistency and reduces the risk of disputes or errors between subsidiaries.
Standardize intercompany agreements. All intercompany transactions should be supported by formal agreements outlining the terms, pricing, and services provided. Standardized agreements help meet regulatory requirements and ensure transactions are conducted at arm's length.
Use centralized intercompany reconciliation tools. Implement centralized systems or software dedicated to managing and reconciling intercompany balances regularly. This improves efficiency, reduces manual errors, and accelerates month-end and year-end closing processes.
Perform regular intercompany reconciliations. Reconciliations between subsidiaries should be performed monthly or quarterly to identify and resolve discrepancies early. Frequent reconciliations help prevent large adjustments at year-end, improving the accuracy of consolidated financial statements.
Provide training for accounting teams. Subsidiary and corporate accounting staff should be trained on intercompany accounting procedures, common issues, and compliance requirements. Well-trained staff reduce the risk of errors and improve coordination between entities.
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.