Intercompany Accounting

Intercompany accounting is the part of corporate accounting that deals with transactions between legal entities under common ownership. When one subsidiary sells goods to another, a parent lends money to a subsidiary, or a shared service centre charges group companies for its work, each entity must record its side of the transaction in its own books. Intercompany accounting covers how those transactions are recorded, priced, agreed between the two sides, settled, and finally removed when the group prepares its combined accounts.

The subject matters because each entity is a separate legal and tax person, with its own statutory accounts and tax return, while the group reports to investors as a single economic unit. Transactions inside the group are real for the former and must disappear for the latter. Large multinational groups process very high volumes of such transactions, and weaknesses in handling them are a frequent cause of delays in the close and of findings by auditors.

• Trade in goods. A manufacturing entity sells to a distribution entity, creating intercompany revenue, purchases, receivables and payables.
• Services and recharges. Head office, technology, finance or research costs are allocated to the entities that benefit.
• Financing. Loans, cash pooling balances, guarantees and the interest on them.
• Royalties and licences. Fees for the use of brands, patents and software owned by one group entity.
• Dividends and capital. Distributions to parents, capital injections and transfers of assets or businesses.

Good practice treats intercompany activity as a process running from initiation to elimination. A transaction is initiated under a group policy and an agreement between the entities. Both sides record it, ideally at the same time, in the same amount and currency, with a common reference and using dedicated intercompany accounts in the chart of accounts that identify the counterparty. Modern enterprise resource planning systems can generate the mirror entry automatically when both entities are on one platform.

During the period, and again at period end, the balances each entity holds with every other are compared through intercompany reconciliation. Differences arise from timing, such as goods in transit or an invoice booked in different months; from exchange rates, where the two sides translate at different rates; and from errors or disputes. They are investigated and corrected before the books are closed. Balances are then settled, either by payment or through a netting arrangement in which each entity pays or receives a single net amount, a form of multilateral netting that reduces bank fees and foreign exchange dealing.

Finally, the matched balances and transactions are removed in consolidation through intercompany elimination, as part of consolidation accounting.

The prices charged between group entities determine how much profit is reported, and taxed, in each country. Tax law in most countries follows the arm's length principle set out in guidelines of the OECD: transactions between related parties should be priced as they would be between independent parties. The rules and methods are covered under transfer pricing. Groups must keep documentation supporting their prices, and large groups file country-by-country reports showing where revenue, profit and tax arise. Some obtain certainty in advance through an advance pricing agreement with tax authorities.

Other taxes also depend on intercompany records. Cross-border interest and royalties may be subject to withholding tax, intra-group supplies may carry value added tax, and limits on interest deductions apply to related-party loans. Customs values for imported goods are based on the intercompany price. Year-end adjustments made to bring entity profits into line with policy need to be reflected consistently in accounts, tax returns and customs declarations.

Leading groups set a global intercompany policy that defines which transactions are permitted, who may initiate them, the pricing basis, invoicing and settlement terms, cut-off dates and tolerance levels for differences. Written agreements support each type of charge. Ownership is assigned, often to a central team, with a rule for which side prevails when the two disagree. Balances are confirmed monthly, unreconciled items are aged and escalated, and settlement is enforced so that balances do not build up indefinitely. These steps form part of financial close management.

Typical difficulties include entities on different accounting systems with different charts of accounts and calendars; invoices raised by one side and not received or accepted by the other; long-outstanding balances that neither side can explain; foreign currency differences; and manual journals used to force agreement at group level without fixing the underlying records. Unreconciled balances can hide errors or fraud, and a balance written off in one entity without a matching entry in the other distorts both sets of statutory accounts. Trapped cash and unintended foreign exchange risk on unsettled loans are further consequences. Automation of matching and netting, and the standardisation of data, are the usual remedies, though they depend on consistent master data across the group.