Since both the parent company and the subsidiary are owned by the same party, it makes sense that they’ll often engage in business activities with each other. When this happens, it’s referred to as an intercompany transaction. For accounting purposes, it’s recorded a little differently than transactions between a company and a third party, though.

If you want to get a full picture of a company’s financial health, you’ll need to ensure that intercompany transactions are accounted for with accuracy. This article provides an overview of intercompany transactions, what they look like, and how they’re noted within a company’s financial records.

What are intercompany transactions?

In short, intercompany transactions refer to business activity between two entities owned by the same parent company. These include transactions between the parent company and the subsidiary, or transactions between two subsidiaries owned by the same parent company. 

These can take a variety of different forms, and some common examples of intercompany transactions include loans, cost allocations, royalties, and the exchange of goods and services.

What are the types of intercompany transactions?

There are three types of intercompany transactions. First, downstream transactions refer to financial activity that passes from the parent company to the subsidiary. Meanwhile, upstream transactions pass from a subsidiary to its parent company. Lateral transactions describe business between two subsidiaries owned by the same parent company. 

What’s the difference between intercompany and intracompany transactions?

To qualify as an intercompany transaction, both the parent company and its subsidiaries must be considered as separate legal entities. If multiple subsidiaries are encompassed by the same legal entity, activities between them are recorded as intracompany transactions.

What are some examples of intercompany transactions?

Intercompany transactions can be both monetary and non-monetary: they might involve the transfer of debt, for example, or the exchange of personnel and other assets like equipment. These transactions are a means of optimizing the shared resources amongst an overall group. 

As an example, let’s consider a US-based company called Company A. Several subsidiaries fall under its umbrella of ownership: US-based Subsidiary B, and a Canadian-based Subsidiary C. Let’s look at how some common examples of intercompany transactions could apply to the group.

 

• • Loans: Company A might offer loans to Subsidiary B at a more generous rate than a third-party bank. This is an example of a downstream transaction, which could help Subsidiary B to expand its operations more efficiently, for example.
  • Dividends: Similarly, Company A could institute a profit-sharing agreement that allows it to distribute funds from its dividends to its subsidiaries. This is also considered a downstream transaction.
  • Royalties: Subsidiary B may make payments to Company A in exchange for the use of intellectual property (IP) rights like patents and copyrights. These royalties constitute an upstream transaction.

• Purchasing goods & services: Subsidiary B and C might purchase various goods and services from each other, such as equipment, inventory, or supplies. Personnel may move from one entity to another in order to maximize their impact, too. These are examples of lateral transactions.

Accounting for intercompany transactions

Intercompany transactions are more common than you might think. They’re a great way to share resources amongst the group, ensuring that both the parent company and its subsidiaries are set up for success.

However, it’s important to keep in mind that intercompany transactions have a different sort of impact on the group’s finances, and so they’re reported differently during the consolidation process. In this section, we’ll explore what that looks like in more detail.

How are intercompany transactions reported?

Intercompany transactions are reported on an entity’s financial statements in the same way as third-party transactions. 

For example, if Company A sells supplies to Subsidiary B, it would be reported as an accounts receivable entry for Company A and an accounts payable entry for Subsidiary B.

While intercompany transactions have a financial impact on the entities involved, they aren’t considered as either profits or losses for the whole group.

With that in mind, it’s essential that the financial statements for a parent company and its subsidiaries are consolidated during the financial close process. This results in a balance sheet, income statement, and cash flow statement for all entities owned by the company.  

Not only is it a requirement to provide this information to outside shareholders, but it’s also key to gaining a clear and accurate look at a company’s finances. 

Why is accurate intercompany accounting important?

Accurate and reliable reporting of intercompany transactions is essential for evaluating the financial health of a particular company. They’re also required for compliance with Generally Accepted Accounting Principles (GAAP) as well as many regulatory codes and rules. 

It makes sense that intercompany transactions are handled in a different way than third-party transactions. Since the entities involved are owned by the same parent company, these transactions aren’t considered as either profits or losses for the whole group, and they shouldn’t be reported as such. 

Accurate reporting is especially important in instances where a company has entities located in different tax jurisdictions. An entity may be subject to different rules and regulations than its parent company, for example, depending on its location.

Incorrect accounting of intercompany transactions comes with consequences. First, it obscures the true financial health of a company as well as its subsidiaries. A transaction that is reported more than once, for example, could inaccurately inflate the group’s overall numbers. 

Inaccurate reporting of intercompany transactions may or may not be done intentionally. For example, a flourishing parent company could cover costs for a fledgling subsidiary to make it appear more successful than it is in actuality in order to deceive its shareholders. Of course, this puts the company at risk for fines, lawsuits, and other regulatory repercussions.

What are the common challenges of intercompany accounting?

Accounting for intercompany transactions isn’t always an easy process. There are several key factors to keep in mind while consolidating a company’s financial records in order to ensure accurate reporting. A good accounting system will be able to tackle these with ease.

• Differences in accounting systems: Parent companies and their subsidiaries might rely on different programs to keep track of their accounts. This adds a layer of difficulty to the consolidation process, as it requires accountants to comb through unique and possibly unfamiliar record-keeping systems.

• International currencies & tax jurisdictions: Some subsidiaries owned by the parent company may be located abroad. In those instances, the consolidation process will need to account for international currencies in order to provide an accurate picture of the company’s finances. Even entities located in the same country may pose additional challenges if they fall under different jurisdictions, since they’ll need to comply with the relevant tax laws.

• Mistakes & errors: When it comes to intercompany transactions, accounting errors aren’t uncommon. It can be difficult to reconcile transactions across different entities, and some of these may be accidentally reported as either profits or losses. Not only do these mistakes obscure the actual, real-life performance of the company from stakeholders, but they also put it at risk for lawsuits and other costly legal consequences.

• Delays in financial close: Intercompany accounting takes time. It’s a tedious and time-consuming affair that must be performed with accuracy. Without the right systems in place, a company’s overall financial close process can be delayed, which isn’t ideal for any of the stakeholders involved.

Conclusion

Transactions between entities owned by the same parent company are an everyday part of the business landscape. Sharing resources, equipment, and supplies is often an effective way to boost the overall performance of the group. 

That said, intercompany transactions must be handled with care during the financial close process. Not only is it necessary to ensure regulatory compliance, but it’s also essential to avoid costly mistakes for the company. As such, intercompany accounting tends to be tricky, time-consuming work. 

In order to avoid these disruptions during financial close, it’s essential to put an effective strategy in place to manage and monitor intercompany transactions. Xledger’s cloud-based software offers an efficient and effective solution. Our Intercompany Transaction Software makes it easy to record, automate, and consolidate intercompany transactions. With advanced reporting and analytics on hand, you’re only a few clicks away from a more comprehensive look at your company’s finances.

Over 10,000 companies are already using Xledger to assist with finance and accounting compliance. Get started today.