An intercompany transaction is when a sale occurs between two divisions, units, or entities within the same organization. There are many instances where modern companies must make these types of transactions. For example, a parent company might loan money to one of its subsidiaries or a department might transfer inventory to another unit.
At this point you may be wondering, how do you account for these types of transactions? This blog will answer some of the most commonly asked questions about intercompany accounting.
Interested in a specific aspect of intercompany accounting? Click on the question below to skip ahead.
- What is intercompany accounting?
- What is an intercompany journal entry?
- Why is it important to record intercompany transactions?
- What are the challenges of intercompany accounting?
- What are the best practices for intercompany accounting?
- What are the three types of intercompany transactions?
- What is the purpose of intercompany eliminations?
- What are the three types of intercompany eliminations?
- What are the best practices for financial consolidation?
- How can innovation support coherent intercompany accounting?
What is intercompany accounting?
Intercompany accounting comprises all financial and commercial transactions documented between separate legal entities belonging to the same parent company. These types of transactions may occur between:
- The parent company and one of its subsidiaries
- Two or more subsidiaries
- Subdivisions, groups, or departments within the same entity
What is an intercompany journal entry?
An intercompany journal entry is a financial record in the accounting ledger that specifically relates to intercompany transactions. Anytime a transaction occurs between two related entities, the exchange must be recorded and reconciled. A few examples of intercompany journal entries include:
- Intercompany sales and purchases
- Financing activities
- Leases
- Fee sharing
- Cost allocations
- Dividends
- Royalties
Why is it important to record intercompany transactions?
Intercompany journal entries enable companies to meet the same standards of detailed accounting that are expected of all other financial activities. A transaction may only impact a business’ profit and loss statement when it involves an independent, external entity.
Since the entities involved in an intercompany transaction are related, they are not independent, and therefore it would be wrong for the parent company to record a profit or loss. However, by reviewing intercompany journal entries, companies can evaluate the full monetary value of their collective transactions and cultivate a nuanced understanding of their overall financial health.
Accurate financial records of intercompany transactions are vital to strict adherence to regulatory compliance. Accounting principles like ASC 810 and IFRS 10 provide the requirements for preparation and presentation of consolidated financial statements.
What are the challenges of intercompany accounting?
Intercompany accounting has become a staple of everyday business, increasingly companies must develop protocols to mitigate the risk posed by handling high volumes of transactions between related entities. The five core intercompany accounting challenges multi-entities face include:
- Resource draining, time-consuming processes
- Complications due to inconsistent intercompany accounting policies
- Researching discrepancies and rectifying errors across various entities
- Lack of tools and disparate, decentralized accounting systems
- Failure to keep up with local regulatory compliance and accounting standards
What are the best practices for intercompany accounting?
To reduce the complications introduced by intercompany accounting, companies of all sizes must adopt rigorous policies and implement robust processes. Without a proper financial backbone, companies risk non-compliance and hours of lost time as their systems buckle from expansion. Below lists five intercompany accounting best practices all multi-companies can take advantage of:
- Follow an established framework
- Create global accounting policies
- Invest in centralized data management
- Automate reconciliations and eliminations
- Implement continuous close accounting
What are the three types of intercompany transactions?
Downstream transaction
A downstream transaction occurs when the parent company sells to its subsidiary. In this case, the parent company is responsible for recording the transaction and any profit or loss. The transaction is not transparent to the subsidiaries, only the parent company and its stakeholders.
Upstream transaction
An upstream transaction occurs when a subsidiary sells to its parent company. In this type of transaction, the subsidiary is responsible for record-keeping and documenting any profit or loss. Not only is the transaction visible to minority and majority interest stakeholders, but they can also share the profit or loss because they share ownership of the subsidiary.
Lateral transaction
A lateral transaction occurs when two subsidiaries belonging to the same parent company sell to each other. Similar to an upstream transaction, either or both subsidiaries may record the transaction and applicable profit or loss.
What is the purpose of intercompany eliminations?
The intercompany eliminations process involves deleting transactions made between related entities from the financial statements. This process is essential to mitigate the effects of intercompany transactions on the bottom line and present clear, consolidated financial statements that explicitly show third party transactions.
Further reading: The complete guide to financial consolidation
What are the three types of intercompany eliminations?
Elimination of intercompany revenues and expenses
Transactions involving sales or interest payments between affiliated companies are referred to as intercompany revenues and expenses. These transactions are disregarded by the accounting team because a business cannot record sales of goods to itself as revenue, and the company’s consolidated net assets are unaffected by the removal of linked revenue, cost of goods sold, and profits.
Elimination of intercompany stock ownership
When intercompany stock ownership is eliminated, the assets and stakeholders’ equity accounts for the parent company’s ownership of the subsidiaries are eliminated. The accounting team must create an intercompany elimination to take the profit out of retained earnings.
Elimination of intercompany debt
Intercompany debt is eliminated when a parent firm lends money to a subsidiary, and each party has a note payable and a note receivable. The loan is reduced to a simple cash exchange when the two companies are consolidated; therefore, the accounting team must cancel both the payment and the receivable.
What are the best practices for financial consolidation?
Determining how to manage your intercompany transactions and maintain accurate multi-entity financial records can be a daunting task, but it’s well worth it to develop efficient and effective reporting protocols so that leadership can make data-driven decisions that maximize your company’s resources.
Implement the following eight best practices to streamline financial consolidation and master intercompany accounting:
- Introduce consistent standards across all reporting and data entry
- Invest in reporting tools that allow you a 360-degree view of your company’s performance
- Enable your team with continuous training and change management
- Identify and eliminate bottlenecks in the workflow
- Make sure the finance team is thoroughly trained and has complete administrative powers
- Focus on fast close and reporting cycles for optimum performance
- Stay on top of IFRS and GAAP regulations to enable compliance
- Automate matching, reporting and eliminations for intercompany transactions
How can innovation support coherent intercompany accounting?
A robust financial management solution, like Multi-Entity Management (MEM), provides a secure, centralized environment for intercompany accounting and empowers your company to gain better insights with real-time consolidated reporting. Directly embedded in Dynamics GP and Dynamics 365 Business Central, complete your intercompany transactions from end to end within a single database or instance while protecting your data with a scalable security setup customized to your organizational structure.
