Financial consolidation: Dealing with intercompany transactions

Tracking intercompany transactions is often cited as one of the most common problems in financial consolidation. Intercompany transactions are transactions between two entities within the same company. Failing to adjust intercompany transactions results in consolidated financial statements that do not provide a true and fair view of the group’s financial position.

Contents

Classifications of intercompany transactions
- 1. Downstream transaction
- 2. Upstream transaction
- 3. Lateral transaction
Examples of how to handle intercompany transactions

Intercompany eliminations (ICE) are made to remove the profit/loss arising from intercompany transactions. No intercompany receivables, payables, investments, capital, revenue, cost of sales, or profits and losses are recognised in consolidated financial statements until they are realised through a transaction with an unrelated party.

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

Classifications of intercompany transactions

Intercompany transactions can be divided into three main categories:

1. Downstream transaction

This is a transaction from a parent to a subsidiary. In a downstream transaction, the parent records the transaction and the resulting profit or loss. Thus, profit/loss will be visible only to the parent’s shareholders, not to minority interests.

2. Upstream transaction

This is a transaction between a subsidiary and its parent.

3. Lateral transaction

This is a transaction between two subsidiaries of the same company.

In both lateral and upstream transactions, the subsidiary records the transaction and the resulting profit or loss. Thus, the profit/loss can be shared between majority and minority interests, as the parent’s shareholders and minority interests share the ownership of the subsidiary.

Intercompany transactions must be adjusted correctly in consolidated financial statements to show their impact on the consolidated entity instead of their impact solely on the parent or subsidiaries.

Understanding how intercompany transactions are recorded in each concerned entity’s journal entries and the impact of the transaction on each entity 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 previously accounted for as an asset in the parent’s balance sheet and as equity in the subsidiary’s balance sheet is eliminated. The subsidiary’s retained earnings are allocated proportionally to controlling and non-controlling interests.

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

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, eliminate intercompany revenue and cost of sales arising from the transaction.
In the consolidated balance sheet, eliminate intercompany payable and receivable, purchase, cost of sales, and profit/loss arising from transactions.

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

In consolidated income statements, eliminate intercompany revenue and cost of sales arising from the transaction.
In the consolidated balance sheet, eliminate intercompany payable and receivable. Profits and losses are eliminated against noncontrolling and controlling interests proportionally.

In a downstream intercompany loan, the interest charged is recognised as an expense by a borrower:

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

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

In consolidated income statements, interest income on intercompany loans is eliminated.
In the consolidated balance sheet, eliminate intercompany loans and the amount of capitalised interest associated with them. Since the subsidiary capitalises interest, the parent company does not recognise any interest income until the capitalised interest is depreciated.

Parent charges subsidiary management fee:

In consolidated income statements, eliminate intercompany revenue and expenses arising from the management fee and recognise management expenses attributable to NCI.
In the consolidated balance sheet, eliminate income from management fees; management fees attributable to NCI are recognised as income for the parent company.

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