Companies within a corporate group trade with each other to share resources, streamline supply chains, and manage risks. Examples include selling inventory or sharing services.
When one group company trades with, lends to, or pays another, the exchange is known as an intercompany transaction. Although convenient, intercompany transactions can present problems when it comes to consolidating financial reports. Intra-group transactions and balances, including any unrealised profits remaining in assets such as inventory, must be eliminated when preparing consolidated group reports.
To complete this process, many use transaction-level financial consolidation software. This software is designed specifically for multi-entity groups and can automate intra-group eliminations using configured rules and suitable source data.
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What Are Intercompany Transactions?
An intercompany transaction is any transaction between entities within the same corporate group, including transactions between a parent and its subsidiaries or between subsidiaries.
Common examples include:
- Intercompany sales and purchases
- Loans between group companies
- Interest charged on intercompany loans
- Management fees or shared-service charges
- Transfers of assets between group entities
- Dividends paid between group companies
For example, when a subsidiary provides a service on credit to another subsidiary, a receivable and a payable are recorded. The selling company records the revenue and the receivable, and the buying company records the expense and the payable.
Why Do Intercompany Transactions Need to Be Eliminated on Consolidation?
Intercompany transactions need to be eliminated on consolidation in order to create an accurate picture of the group’s financial standing. Financial consolidation combines the financial information of a parent and its subsidiaries, with adjustments and eliminations to present the group as one economic entity. Intercompany revenue and corresponding purchases must be eliminated during consolidation to calculate the group’s revenue from external customers.
For example, one subsidiary provided $1,000 of management services to another subsidiary; the first company will record $1,000 worth of revenue, while the latter company will record $1,000 of expenses. Without elimination, the group’s revenue and expenses would each be overstated by $1,000, although this service transaction would not change total group profit.
The service transaction took place within the group and generated no revenue from an external customer. Therefore, these intercompany transactions must be eliminated from consolidated results while remaining recorded in each company’s own accounts. Without elimination, group revenue, expenses, assets, and liabilities may be overstated. For goods or asset transfers, any unrealised intra-group profit remaining in inventory or other assets must also be eliminated.
How Are Intercompany Transactions Eliminated?
Using specialised accounting or consolidation software to eliminate intercompany transactions on consolidation automatically is common among many businesses. Eliminating intercompany transactions manually in spreadsheets is error-prone and takes significantly more time.
Whether done automatically or manually, the process is the same:
- Intercompany transactions are identified – Transactions made between group companies are flagged.
- Matching and reconciliation – Corresponding amounts recorded by the group companies are compared, and differences in timing, currency, or accounting treatment are investigated and resolved. A sale may be recorded as an expense or an asset by the buyer, depending on its nature.
- Elimination journal entries – Elimination journal entries are then posted at the consolidation layer. These entries eliminate the relevant intra-group amounts from consolidated results. The original entries remain in each company’s accounts, and transaction-level consolidation software can retain visibility of both the source transactions and the elimination entries through drill-downs.
