Large companies often have multiple subsidiaries that do business with each other and, when they do, they’re required to follow the rules of intercompany accounting — the accounting process for internal transactions between legal entities within the same parent company.
While that definition may accurately conjure visions of large multinational conglomerates, intercompany accounting has applications in companies of all sizes. For example, a restaurant owner with two different locations may benefit by treating each location as a separate entity. When that happens, the owner needs to use intercompany accounting to properly reflect the results of the unified business.
Historically considered a bland branch of accounting, intercompany accounting has come under scrutiny by regulators in recent years, becoming one of the top reasons public companies must correct or restate their financial reports. The best practices that follow can help intercompany accounting be less cumbersome and more accurate.
What Is Intercompany Accounting?
The objective of intercompany accounting is to strip away the financial impact of internal transactions — financial interactions between related entities within the same parent company — to yield financial statements that only reflect activity with independent third parties. Intercompany accounting eliminates financial activity that takes place between two subsidiaries or between the parent and a subsidiary. Examples of events covered by intercompany accounting include sales of products, services or inventory, cost allocations, royalties, and debt financing between related companies.
Elements of intercompany accounting include governance and policies, transfer pricing, data management, transaction management, netting and settlement, reconciliation/elimination and reporting.
Key Takeaways
- Intercompany transactions are common and normal occurrences in businesses of all sizes and industries.
- Intercompany accounting has implications for many aspects of a business, including tax, compliance and accounting.
- Identifying and eliminating the financial effect of intercompany transactions can be a cumbersome, tedious process that delays a business’s financial close.
- Nine best practices, including automation, can help make intercompany accounting easier, faster and more accurate.
What Is an Intercompany Transaction?
Intercompany transactions are common and come in many forms. Their primary characteristic is that the participating entities are part of the same parent company, unlike “intracompany transactions” that occur between two units within the same legal entity. Because of the relationship between the two parties, intercompany transactions aren’t considered independent, arms-length transactions.
Intercompany Accounting Explained
Family economics offer a good illustration of intercompany activity and the importance of distinguishing between internal and third-party transactions.
When a mom receives a paycheck from her employer, that’s an independent third-party transaction that brings new funds into the family. When she gives each of her two daughters an allowance for doing their chores, that resembles a parent/subsidiary intercompany transaction. No new money came into the family — it simply moved between wallets within the household in exchange for services provided.
Further, when daughter A gasses up the car she shares with her sister and daughter B reimburses her for half the amount, that’s also like an intercompany transaction. But the payment to the gas station is a third-party transaction that reduces household funds. If daughter A charged her sister a per-gallon rate that was higher than she paid the gas station, that’s like intercompany profit. Such profit is not incremental to the household; rather, it is another example of shifting money within the household — just like transfer pricing shifts money between legal entities within a parent company.
Why Is Intercompany Accounting Important?
Companies can achieve many operating benefits from vertical and horizontal integration. From an accounting perspective, however, some of this “synergy” — specifically, any internally generated revenue and profit — must be eliminated during financial consolidation. For example, one subsidiary may supply another with raw materials, which keeps companywide manufacturing costs down, but the parent company cannot recognize revenue or profit from this internal transaction. At the most basic level, intercompany accounting ensures that a company’s financial statements do not include sales to “itself.” Beyond that, intercompany accounting helps business owners in many ways. It:
- Eliminates double counting of intercompany activity.
- Highlights activity among the entities within a group.
- Supports accurate tax filings across different jurisdictions.
- Aids cash movement and settlement, including of foreign currencies.
- Is necessary for compliance with Generally Accepted Accounting Principles (GAAP), Securities and Exchange Commission (SEC) rules and IRS codes.
Without intercompany accounting and related eliminations, companies can unintentionally obscure their operating results or intentionally — i.e., fraudulently — inflate sales and profit reporting.
Intercompany Accounting and Financial Close
Intercompany transactions are initially shown on each business entity’s separate financial statement as if they were third-party transactions. Intercompany accounting treatment is applied toward the end of the financial close process, when the subsidiaries’ financial statements are combined at the parent level, resulting in consolidated financial statements and tax filings.
Identifying intercompany transactions during the financial close process can be tricky and so might cause delays in producing consolidated financial information. Companies with multiple entities, whether the result of acquisitions or organic growth, often have different accounting systems in place — or even different versions of the same systems. The different systems might not integrate well with each other, so that both sides of an intercompany transaction cannot always communicate financial information automatically. As a result, finding, matching and netting intercompany transactions is often a very manual, labor-intensive process that is prone to errors and omissions.
Types of Intercompany Transactions
During the normal course of business, different units within a parent company may provide goods or services to each other. They can settle the interactions in cash or by journal entry in their general ledgers. There are generally three types of intercompany transactions, categorized as follows:
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Downstream:
Transactions that flow from a parent company to a subsidiary entity, such as when a parent gives a loan to a subsidiary. During consolidation, intercompany accounting eliminates the parent’s interest income and the subsidiary’s interest expense.
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Upstream:
Transactions that flow from a subsidiary to a parent company, such as a branch location selling land to its parent. Gains or losses from the sale are eliminated during consolidation.
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Lateral:
Transactions between two subsidiaries. If one subsidiary provided raw materials to another, any intercompany profit would be eliminated.
Challenges of Intercompany Accounting
Out of balance and undetected intercompany activity can significantly impact a parent company. There are several challenges within intercompany accounting that contribute to these problems, intricately woven into the fabric of managing large, multi-entity organizations.
- Disparate Accounting Systems: The first hurdle is the identification and cross-matching of intercompany activity across different entities. This challenge primarily stems from the use of disparate accounting systems that struggle to communicate due to inconsistent charts of accounts or incompatible data formats. Organizations tackle this issue by dedicating additional time and resources, with more mature companies moving towards fully automated transaction-level matching solutions.
- Transfer Pricing Analysis: Another critical aspect is ensuring consistency in the methods used by each entity for cross-charging, known as transfer pricing. These transactions, vital for tax implications, are governed by strict regulations. The complexity lies in choosing among five regulatory-compliant methods for calculating transfer prices, necessitating a blend of internal and external data. The real test is ensuring subsidiaries are employing consistent data in their transfer pricing calculations, considering each item must have a transfer price, potentially calculated through different methods.
- Settlement of Intercompany Transactions: The final challenge is the netting and settling of payments between parties upon completing an intercompany transaction. This process, often managed through journal entries or fund transfers, can be tedious and prone to delays when resources are constrained. Consequently, intercompany accounts may remain open for extended periods, which can obscure financial results and incur costs, such as the loss of potential interest or the impact of fluctuating foreign exchange rates.
Each of these challenges illustrates the complexities of intercompany accounting, underlining the importance of meticulous management and the potential for advanced solutions to streamline these critical processes.
Intercompany Accounting Risks
The risks of a poorly managed intercompany accounting process are most evident in financial misstatements, but they also impact several other areas across a company. For example, treasury issues — such as unpredictable cash flow, foreign exchange losses and even fraud —can arise from intercompany accounts that are not settled within a reasonable time frame. When subsidiaries are in different taxing jurisdictions, incorrect intercompany accounting increases the risk of tax penalties and interest arising from incorrect tax filings. Good intercompany accounting can help mitigate the risk of lost or misappropriated assets, like inventory and machinery.
The potential consequences of these risks sometimes make news headlines. Recent stories pulled from filings with the U.S. Securities and Exchange Commission (SEC) include lawsuits and penalties against companies and their officers. In one, a large multinational provider of oil and natural gas was sued by investors and fined by the SEC because “post closing plugs to intercompany accounts” misled investors about profitability and resulted in tax fraud. In another case, more than $12 million in penalties were levied against an advertising firm and its officers for failing to reconcile intercompany accounts for six years as a way to avoid missing profit targets.
3 Steps to Intercompany Accounting
To stay on the right side of compliance, tax and financial authorities’ oversight of intercompany accounting, companies should carefully follow three key principles. These high-level principles guide the steps and practices for their accounting departments:
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Establish governance:
Standards and policies should be developed and put in place to ensure consistent intercompany accounting processes, enforce compliance with relevant standards and establish a clear escalation path to remedy any issues that may arise. Policies also should outline broad issues like management oversight and performance metrics, as well as smaller details, such as identifying relevant intercompany products, creating consistent charts of accounts, pricing, hand-off points, ownership and necessary transaction approvals.
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Create accountability:
Identify the person(s) responsible for intercompany accounting and hold them accountable, with deadlines. Centralizing intercompany accounting tasks provides clear points of contact and ownership, in addition to consistency. In this way, intercompany transactions aren’t an afterthought likely to hold up the accounting close each month.
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Automate:
Use accounting software that automates transaction flow, thereby reducing the amount of manual intervention. Use automated intercompany accounting modules that integrate with disparate subsidiary financial systems.
Get the complete guide to intercompany accounting.
9 Best Practices for Intercompany Accounting
Companies with mature, efficient intercompany accounting processes stay compliant with regulators and keep their financial reputations intact by using these nine best practices:
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Standardize transfer pricing:
Accounting and tax standards require “arm’s-length” pricing between related companies. This means intercompany pricing should be similar to pricing for independent third parties. There are several accepted methods for developing transfer prices, and standardizing transfer prices includes selecting one (or sometimes more) of those methodologies.
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Flag transactions immediately:
Software controls can flag intercompany transactions, reducing the potential for them to slip through the cracks. Labeling transactions at inception, such as when purchase orders are opened, is more efficient than searching for activity after the fact. Timely identification also avoids accumulation that can slow down the financial close process.
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Automate intercompany eliminations:
After intercompany transactions are identified, they can be eliminated automatically as part of the consolidation process. Doing this reduces the need for manual intervention and reconciliation and concentrates the number of top-side adjustments only to those on an exception report. For example, intercompany accounts receivable on one subsidiary’s books can be eliminated by the related offsetting intercompany accounts payable on the other related party’s books.
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Settle accounts monthly:
Related parties can owe money to each other as a result of intercompany transactions. Such balances typically are netted against each other to avoid excessive shuffling of funds. It’s a best practice to settle intercompany netting on a timely basis, such as monthly, rather than leaving them unreconciled for multiple fiscal periods. Leaving them open can lead to errors and unclear subsidiary-level financial statements, which could mislead the managers who rely on them.
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Adopt continuous closing/continuous accounting:
Using a continuous closing approach (also called continuous accounting), where duties typically completed at the end of a fiscal close are done a little bit each day, helps manage intercompany accounting workflow and avoid time crunches at the end of each period. Continuous accounting also makes intercompany reconciliations easier because it’s simpler to investigate items when they are current and details are still fresh.
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Invest in technology:
Investing in the right technology to support automation is an important step that makes all accounting, including intercompany accounting, more efficient and accurate. Consider the systems already in place and aim to achieve the highest level of integration possible. Protect your technology investment by taking advantage of training and customer service offerings from software providers.
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Practice access and role management:
Because multiple parties are involved in intercompany transactions, it’s a best practice to assign accounting system access to the right people in a company, using their roles as a guide. In smaller companies, where employees and owners take on many roles, managing access can be tricky. Nonetheless, ensuring internal controls over intercompany accounting is a key step in preventing errors and fraud.
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Detailed reporting:
While eliminations are important at the consolidated parent level, subsidiary managers will want to see intact financial statements.
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Implement fixed assets management:
Many intercompany transactions involve the transfer of fixed assets from one subsidiary to another. When this happens, the asset and its related depreciation history must be properly transferred. Fixed asset management software makes it easier to track, locate and account for intercompany transactions involving property, plant and equipment.
Manage Intercompany Accounting With NetSuite
NetSuite Cloud Accounting Software helps companies implement these best practices for intercompany accounting via important features at both the subsidiary and parent levels. Within NetSuite’s software, each subsidiary has an independent set of books with a customized chart of accounts, so divisional management has a clear picture of their financial statements to help manage the business and gauge performance. Beyond that, a mapping feature funnels every subsidiary account into the right place at the parent level, enabling real-time consolidation for the accountants who work with the combined results.
This multidimensional functionality supports intercompany accounting and all of its related issues regarding taxes, foreign currency and treasury. It begins by tagging transactions when orders are created, and automatically connects and eliminates intercompany items so that the financial close process is faster and the risk of missing an intercompany transaction is lower. Similarly, automated balancing and netting enables more timely access to consolidated financial results. Additionally, a company can better enforce its standards and policies for transfer pricing by using NetSuite’s built-in price books, which keeps tax authorities happy.
Intercompany transactions — those in which two related business entities buy or sell goods or services to each other — must be properly eliminated for parent company financial statements to be correct. Incorrect or inefficient intercompany accounting processes can have far-reaching implications across a business’s treasury, tax and accounting functions. But the necessary intercompany reconciliations, settlement and netting, elimination and transfer pricing can become a cumbersome undertaking, especially when the volume of such transactions is high. Automation is a key practice to mitigate intercompany transaction challenges and manage intercompany accounting accurately and efficiently.
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Intercompany Accounting FAQs
What are intercompany transactions?
Intercompany transactions arise when two entities within the same legal parent engage in businesses activities with each other. Intercompany transactions can be downstream (parent to subsidiary), upstream (subsidiary to parent) or lateral (between subsidiaries).
What is an intercompany journal entry?
A journal entry adjusts the balance in the general ledger account of a company’s accounting records. An intercompany journal entry increases/decreases account balances arising from transactions between legal entities within the same parent company.
How do you do intercompany journal entries?
Journal entries are made on each related party’s books using intercompany accounts, such as “due to and due from” when a transaction arises. Eliminating journal entries are part of the intercompany accounting process and are made when subsidiary financial statements are combined to show the overall financial position of the parent company.
Why are intercompany transactions required?
Intercompany transactions often come about when related legal entities buy and sell to each other as part of their normal business operations. For example, two restaurants under common ownership may transfer perishable ingredients between each other as part of a bulk purchasing arrangement. Intercompany accounting ensures that a company’s financial statements do not include sales to “itself.”
