What is Intercompany Accounting?
What is Intercompany Accounting?
Intercompany accounting stands for the processing and accounting of inter-company/internal financial activities and events that cross legal entities, branches, or national borders. This may include (but is not limited to) the sales of products and services, fee sharing, royalties, cost allocations, and financing activities. Intercompany accounting is a broader segment than accounting – it extends into various functions, which include finance, tax, and treasury. According to the accounting firm, Grant Thornton LLP, intercompany transactions account for 30-40% of the global economy, which amounts to almost $40 trillion annually, and is further ranked as the ‘5th most common cause of corporate financial restatements’.
A 3-Step Approach to Intercompany Accounting
The transactions are important for many reasons, such as compliance with local tax codes, accurate reporting, regulations, good governance in general, and accounting rules. Financial institutions that need to improve their intercompany accounting can use this 3-step approach to intercompany accounting to improve their performance:
- Establish Standards, Policies, and Procedures: The foremost step to improve intercompany accounting is to establish a consistent process that can help identify, authorize, and clear the intercompany transactions. Although it would be easier to go with automation as the initial step, since the manual processes serve as an issue (they do not have consistent standards), chances are that attempting to automate the intercompany accounting will turn into a failure.
The policies and procedures are meant to include a list of what products and services are supposed to be provided between subsidiaries, along with transfer pricing for each, and the level of authorization needed for any transaction. Some other specifications may include a list of designated intercompany accounts, rules to identify and complete transactions, and a schedule that has specific deadlines to clear the balances every month.
- Automate the processes: According to a survey by Deloitte on ‘Intercompany Accounting & Process Management’, 54% of the companies still rely on manual intercompany processing, 47% only have ad hoc netting capabilities, while 30% report a significant out-of-balance position. After the policies and procedures are integrated and followed, the next step is to go for automation. The reason behind this is that keeping up with thousands of transactions by using spreadsheets is an inefficient method – one that only increases the risk of having errors. Further, in the case of companies that have subsidiaries in various countries, it becomes even more challenging to keep track. Alongside this, dealing with the currency exchange rates, the local tax codes, and the different rules for accounting can make it impossible to complete the process on time.
Yet, not all accounting solutions can manage intercompany transactions. There is software designed for emerging companies, which does not typically support multiple business entities. This can be a critical limitation, as it makes identifying and matching the transactions between various subsidiaries a manual process.
The minimum requirement from the software is that it should be able to tag intercompany purchase orders and sales orders when they are created, and link them automatically. This will help the accounting team, as they will no longer have to search amongst thousands of transaction entries to find the matching pairs. The revenue and expenses of intercompany transactions should be removed automatically from consolidated financial statements, specifically during the closing process. Another requirement from the software system is that it should also include intercompany netting functionality, which not only saves time and effort during the settlement process, but also saves money by reducing the number of invoices that need to be generated, plus payments that have to be processed every month.
- Centralize: It is mainly the corporate accounting staff’s job to manage intercompany accounting, which means that most things get done as part of the closing procedure. Yet, as the accounting team has other responsibilities, it isn’t ideal to wait until the end of the month, as it would extend the close cycle. On its own, the intercompany elimination can add days to the procedure if it’s not automated, which has an impact on the timings of the reports. The added pressure to close the books at the earliest may also increase the risk of errors.
So, centralizing the intercompany accounting serves as one of the best practices, either under a select person, or, in case there is a larger volume of people, a group of individuals under the supervision of the corporate controller. While dedicating resources to manage an activity that isn’t categorized as strategic could be a bit hard to explain, the efficiencies that companies gain, along with the improved supervision of this process, eventually pays its dividends. Managing the process centrally requires visibility into all intercompany transactions, which is difficult for companies that rely on multiple, differing accounting systems. So, in case one truly wants to control the process, it’s difficult to manage the business with different subsidiaries on a single accounting platform.
Types of Intercompany Transactions
The three main types of intercompany transactions include: downstream, upstream, and lateral. Let’s understand how each of these intercompany transactions is recorded in the respective unit’s books. Also, their impact, and how to adjust the financials that are consolidated.
- Downstream Transaction: This type of transaction flows from the parent company, down to a subsidiary. With this transaction, the parent company records it with the applicable profit or loss. The transaction is made transparent and can be viewed by the parent company and its stakeholders, but not to the subsidiaries. For example, a downstream transaction would be the parent company selling an asset or inventory to a subsidiary.
- Upstream Transaction: This type of transaction is the reverse of downstream and flows from the subsidiary to the parent entity. For an upstream transaction, the subsidiary will record the transaction along with related profit or loss. An example would be when a subsidiary might transfer an executive to the parent company for a time period, charging the parent company by the hour for the executive’s services. For such a case, the majority and minority interest stakeholders can share the profit/loss, as they share ownership of the subsidiary.
- Lateral Transaction: This transaction occurs between two subsidiaries within the same parent organization. The subsidiary/subsidiaries record their lateral transaction along with profit and loss, which is similar to accounting for an upstream transaction. For example, when one subsidiary provides IT services to another, with a fee.
Intercompany Transactions Accounting Importance
Intercompany transactions are of great importance, as they can help to greatly improve the flow of finances and assets. Studies on transfer pricing help to ensure that the intercompany transfer pricing falls within reach of total pricing in order to avoid any unnecessary audits.
Such intercompany transactions accounting can help with keeping records for resolving tax disputes, mainly in the countries/jurisdictions where the markets are upcoming and new, and where there is little to no regulation governing the related parties’ transactions. The following are a few areas that are affected by the use of intercompany transactions accounting:
- Loan participation
- Sales and transfer of assets
- Insurance policies
- Transactions that have member banks and affiliates
- The management and service fees
What is an Intercompany Transaction?
Intercompany transactions happen when the unit of a legal entity makes a transaction with another unit of the same entity. There are many international companies that take advantage of intercompany transfer pricing or other related party transactions. This is to influence IC-DISC, promote improved transaction taxes, and, effectively, enhance efficiency within the financial institution. The transactions are essential to maximizing the allocation of income and deduction. Here are a few examples of such transactions:
- Between two departments
- Between two subsidiaries
- Between the parent company and subsidiary
- Between two divisions
There are two basic categories of intercompany transactions: direct and indirect intercompany transactions.
- Direct Intercompany Transactions: These transactions may happen from intercompany transactions between two different units within the same company entity. They can aid in notes payable and receivable, and also interest expense and revenues.
- Indirect Intercompany Transactions: These transactions occur when the unit of an entity obtains the debt/assets issued to another company that is unrelated, with the help of another unit in the original parent company. Such transactions can help various economic factors, including the elimination of interest expense on the retired debt, create gain or loss for early debt retirement, or remove the investment in interest and bond revenue.
Intercompany Accounting Best Practices
In a survey conducted in 2016 by Deloitte, which included over 4,000 accounting professionals, nearly 80% experienced challenges related to intercompany accounting. The issue was around differing software systems within and across financial institute units and divisions, intercompany settlement processes, management of complex legal agreements, transfer pricing compliance, and FX exposure. With issues such as multiple stakeholders, large transaction volumes, complicated entity agreements, and increased regulatory scrutiny, it’s clear that intercompany accounting requires a structured, end-to-end process. Here are some of the intercompany accounting best practices:
Streamline and Optimize the Process with Technology
It is counted as intercompany accounting best practices to have technology-enabled coordination and orchestration streamline intercompany accounting across the entire financial institution. Automation removes the burden of having to identify counterparties across various ERP systems. The integrated workflows ensure that tasks are completed in the correct order and in the most efficient timeframes, with the removal of any additional managers, who would waste their time chasing the completion of this task.
With automation, users can collaborate more easily and resources are deployed more efficiently. The employees who were previously occupied by keeping the data moving are freed to perform tasks of higher-value. With this, the result is faster resolution, along with timely and accurate elimination of intercompany transactions, cost savings, reduced cycle times, and an accelerated closing.
Streamline the Intercompany Process with a Single View
The elimination of intercompany transactions as a collaborative process requires the counterparties to have full visibility of their respective balances, along with the differences between them, and the underlying transactions. In an intragroup trade, too, counterparties need shared access to a common view of their intercompany positions.
With KPI monitoring, there is an overview of intercompany accounting status, which highlights potential delays in real-time and in a visual manner. The dashboards and alerts allow for companies to manage their progress in real-time, giving accounting professionals an overview of tasks that haven’t yet started or finished. With this visibility, team leaders can review bottlenecks by task, individual, cost center, as well as entity.
Eliminate Intercompany Mismatches Early on in the Process
In order to minimize delays around the agreement of intercompany differences, one needs to start the process prior to usual in the reporting cycle. By viewing intercompany mismatches this early on in the reporting cycle, individual companies can take remedial action and correct their positions before the consolidation is attempted.
The direct integration with the ERP systems allows financial institutes to extract invoice details to help reconcile differences in a more detailed manner. After resolving the differences, adjustments can be posted directly into ERP systems through the process, without manually posting reconciling journal entries. This is why automation effectively turns the intercompany process into a preliminary close, well in advance of the normal reporting cycle, every month.
Manage Intercompany Risk
One can eliminate endless standalone spreadsheets, which are typically used by individuals to manage intercompany accounting, by using an automated system that gives companies one version of the truth, along with an audit trail of activities detailing when and by whom they were completed. The workflows give the company employees ownership of every activity and eliminate the interdependencies of these tasks.
Financial institutes are able to orchestrate and monitor intercompany accounting as a fundamental part of their internal controls. The role-based security, aligned with the company’s underlying applications, maintains the integrity of roles and access. At the same time, one can attach or store procedures and policy documents in task list items, which are made immediately available to the people performing the intercompany tasks.
Devise Bullet-Proof Centralized Governance and Policies
For effective intercompany accounting, standard global policies are required to govern critical areas, such as data or charts of accounts, transfer pricing, and allocation methods. Companies may establish a center of excellence with joint supervision from accounting, tax, and treasury. It serves as a resource to address global process standardization and issues related to intercompany accounting. Having a single company-wide process would mean that companies adhere to best practices and give all finance stakeholders immediate visibility of issues, tasks, and bottlenecks that need escalation or remediation. This can help financial institutes benchmark their performance, address underlying issues, and facilitate post-close reviews. Further, it would help them to subsequently streamline activities in order to encourage a continuous process improvement and accelerate the close.