Breaking down Intercompany Transactions

I’ve been asked by colleagues to explain intercompany transactions in simple terms on several occasions. Each time, I referred to my illustration, which is pictured in this article. Intercompany accounting is a process where parent companies and their subsidiaries account for transactions between each other.  In other words, they are any transactions between related parties of a consolidated group.  Intercompany accounting can be used to creatively move revenues and expenses between subsidiaries and countries, taking advantage of the tax rate of each jurisdiction.  Intercompany transactions can be as complex or as simple as you make it.  I’ve seen companies use complex markup pricing strategies, whereas others keep the transfer pricing simple by using a specific markup percentage.

Intercompany transactions must be eliminated to prevent double counting on the books of the parent company and at the subsidiary level.  To avoid double counting, intercompany reconciliations should be performed monthly.

Outlined below is my most straightforward illustration of the transaction flows between two companies, and the financial effects at the company and consolidated group level. In this example, Company A sells inventory to company B at a markup. Company B then sells to a third party at a markup as well. At the consolidated level, the markup is eliminated and the intercomapny AR and AP are netted to zero. There is no double accounting of transactions.

intero graph 1

Some companies record intercompany transactions in the local currency of each subsidiary instead of the currency of the transaction.  This requires a lot of manual effort to maintain each month and is not the appropriate accounting for intercompany transactions relating to foreign currencies.  Instead, transactions should be posted in the same currency.  If company A has an invoice to company B for 100 Euro, then company B needs to also post a 100 Euro payable to company A regardless of the functional currency of company B.  Each month, either company A or B, or both need to revalue the remaining balance if the company’s functional currency is in a different currency than the recorded transaction currency.

Intercompany transactions that affect the P&L should be recorded using the average rate that will be used to translate the subsidiary balances to the consolidated financials at the end of the month.  This will ensure that your P&L will eliminate properly for that month.  If the daily rate is used, then minor differences will result at the consolidated level due to FX rate changes.  These differences should be eliminated; otherwise, your intercompany balances related to P&L will not reconcile.

When intercompany becomes very complex with multiple transactions across many companies, it may be helpful to have automated reports that can detail the out of balances.  This becomes critical if you have transactions around the globe and you want to close the books on schedule!