What are the intercompany transactions and why they are important for businesses today?

Tracking intercompany transactions is regarded as one of the most typical problems with fiscal consolidation. Intercompany transactions are transactions that occur between two substances of the same company. Not balancing intercompany transactions results in consolidated financial statements that do not offer an objective and fair view of its financial situation.

Intercompany exclusions (ICE) are made to remove the profit/loss arising from intercompany transactions. No intercompany receivables, payables, investments, revenue, capital, cost of sales, or profits and losses are recognised in consolidated financial statements till a transaction realises them with an independent party.

The total amount of unrealised profits/loss to be discharged in intercompany transactions does not vary regardless of whether the subsidiary is wholly-owned (noncontrolling interest, NCI, does not exist) or partially owned. However, if the subsidiary is partly owned (i.e., NCI exists), eliminating such profit/loss may be designated between the majority and minority interests.

Classification of intercompany transactions

Intercompany sales can be divided into three main categories:

1. Downstream transaction: This is a transaction from the origin to the subsidiary. In a downstream step, the parent registers the transaction and the profit/loss resulting from it. Hence, profit/loss will be apparent to the parent’s stockholders only and not to the minority interests.
2. Upstream transaction: This is a performance from subsidiary to parent.
3. Lateral transaction: This is a transaction between two subsidiaries of the same company. In both parallel and upstream transactions, the subsidiary reports the transaction and the profit/loss. Therefore, the profit/loss can be shared between majority and minority interests, as the parent’s shareholders and minority matter share the subsidiary’s ownership.

Intercompany transactions must be adjusted correctly in consolidated financial statements to present their impact on the consolidated entity instead of solely impacting the parent or subsidiaries. Understanding how intercompany transactions are recorded in each entity’s journal entries and the result of each entity’s trade is necessary to determine how to adjust intercompany transactions in the consolidated financial statement. Some examples of intercompany transactions and how to account for them will be discussed below.

Examples of how to handle intercompany transactions

Parent investment in a subsidiary before accounted for as an asset in the parent’s balance sheet and equity in the subsidiaries’ stability sheet is eliminated. The subsidiary’s held earnings are allocated proportionally to controlling and noncontrolling interests.

During a downstream transaction, the parent markets an asset to its subsidiary: eliminating asset disposal (for parent company), a help acquired (for subsidiary), gain/loss from disposal; restoring the original cost of the purchase and the accumulated depreciation based on the actual price.

Inventory sales in downstream transactions (from parent to subsidiary) are accounted for as internal transfers between departments of a single entity:

• In consolidated income statements, exclude intercompany revenue and cost of sales arising from the transaction.
• In the consolidated balance sheet, stop intercompany payable and receivable, purchase, cost of sales, and profit/loss arising from the transaction.

Inventory sales in upstream steps (from subsidiary to parent):

• In consolidated income statements, discharge intercompany income and cost of sales resulting from the transaction.
• In the consolidated balance sheet, release intercompany obligatory and receivable. Profits and losses are excluded against noncontrolling and controlling share proportionally.

Downstream intercompany loan, the profit charged is recognised as an expense by a borrower:

• In consolidated earnings statements, interest income (approved by the parent) and expense (classified by the subsidiary) is eliminated.
• In the consolidated balance sheet, intercompany loans previously recognised as assets (for the parent company) and liability (for the subsidiary) are eliminated. In this case, noncontrolling interests bear their share for the interest expense; thus, the parent company recognises that part of the interest income.

In downstream intercompany loans, from parent to a subsidiary, interest is capitalised. This is when a subsidiary borrows from a parent for capital investments (e.g., to build an office building).

• In consolidated earnings statements, interest income on intercompany loans is eliminated.
• The consolidated balance sheet reduces intercompany loans and the amount of capitalised interest from any outstanding intercompany loans. Since the subsidiary capitalises the part, the parent company does not realise any interest income until the capitalised interest is depreciated.

Parent charges subsidiary management fee:

• In consolidated revenue statements, reduce intercompany revenue and expenses resulting from the management fee and understand management expenses attributable to NCI.
• The consolidated balance sheet excludes income from management fees; management pays attributable to NCI are accepted as income for the parent company.