Intercompany Elimination

Intercompany elimination is the step in consolidation at which transactions and balances between entities of the same group are removed, so that the consolidated financial statements show only dealings with parties outside the group. A group cannot earn revenue by selling to itself, owe money to itself or own shares in itself. Without elimination, combining the accounts of a parent and its subsidiaries would overstate revenue, costs, assets and liabilities.

Both international and US accounting standards require intragroup items to be eliminated in full. Under IFRS 10, a parent eliminates intragroup assets and liabilities, equity, income, expenses and cash flows, together with profits and losses on intragroup transactions that are included in assets such as inventory and fixed assets. Elimination entries are made only in the consolidation workings; they do not alter the books of the individual entities, which remain valid for statutory and tax purposes. The day-to-day handling of the underlying transactions is covered under intercompany accounting.

• Balances. Intercompany receivables and payables, loans and accrued interest are set against each other.
• Revenue and expenses. Intragroup sales and the matching cost of purchases, management fees, royalties and interest income and expense are removed.
• Unrealised profit. Where goods or assets sold within the group are still held by the buying entity at the reporting date, the selling entity's profit has not yet been realised from the group's point of view and is removed from profit and from the asset's carrying amount.
• Investment and equity. The parent's investment in each subsidiary is eliminated against the subsidiary's share capital and pre-acquisition reserves, with any difference recognised as goodwill and non-controlling interests.
• Dividends. Dividends paid by a subsidiary to its parent are removed from the parent's income and from the subsidiary's distributions.

A parent sells goods that cost it 60 to its wholly owned subsidiary for 100. By the year end the subsidiary has sold half of the goods to outside customers for 70 and still holds the other half, carried at 50. In their own books, the parent shows revenue of 100 and cost of sales of 60; the subsidiary shows revenue of 70, cost of sales of 50 and inventory of 50.

From the group's viewpoint, the only sale was the one to outside customers for 70, the cost of the goods sold was 30, and the remaining inventory cost 30. Two entries achieve this. The first removes the internal sale by reducing revenue by 100 and cost of sales by 100. The second removes the unrealised profit in closing inventory, which is half of the parent's profit of 40, by increasing cost of sales by 20 and reducing inventory by 20. Consolidated cost of sales is then 60 plus 50, less 100, plus 20, which is 30, and inventory is 50 less 20, which is 30. In the following year, when the goods are sold outside the group, the deferred profit of 20 is recognised.

Where a subsidiary is not wholly owned, intragroup items are still eliminated in full. If the selling entity is the subsidiary, the unrealised profit removed is shared between the parent's owners and the non-controlling interest in proportion to their holdings. For associates and joint ventures accounted for by the equity method, there is no line-by-line consolidation, and unrealised profits on transactions with the investor are eliminated only to the extent of the investor's interest.

When a fixed asset is sold within the group at a gain, the gain is removed and the asset is restored to its original cost base; the excess depreciation charged by the buyer is reversed each year until the asset is fully depreciated or sold. Eliminating a profit also changes the group's carrying amount of the asset without changing its tax base, so a deferred tax adjustment is recognised. Where the two sides of a balance are in different currencies, the exchange difference recognised by one entity is not eliminated, since it reflects a real exposure of the group.

Elimination depends on the two sides agreeing. Before consolidation, entities confirm their balances with each other through intercompany reconciliation, and differences are resolved or, if small, absorbed under a tolerance policy. Each intercompany account is tagged with the identity of the trading partner so that consolidation software can match and eliminate pairs automatically. Unmatched amounts fall into a difference account, which should be near zero and is reviewed by the group finance team. Unrealised profit in inventory requires additional data that the ledger does not hold directly, such as the quantity of group-sourced stock on hand and the margin of the supplying entity.

The work is scheduled within the group close, after entity ledgers are locked and before the consolidated trial balance is finalised, and forms part of consolidation accounting and financial close management.

Errors in elimination misstate group revenue and margins, and unexplained differences are a common audit finding. Lenders and analysts rely on the consolidated figures for covenants and valuation, while tax authorities look at the entity accounts before elimination, where transfer pricing determines each entity's profit. Elimination therefore sits at the point where the group's legal structure and its economic reality are reconciled.

• IFRS Foundation