Intercompany Eliminations (#332)
/The Nature of Intercompany Eliminations
Intercompany eliminations occur when a business has subsidiaries that engage in activities with each other. For example, a manufacturing subsidiary sells some of its widgets to another subsidiary that specializes in selling them to outsiders. The manufacturing subsidiary records a sale and a profit on these transactions. If the buying subsidiary then sells the widgets to an outsider, then the consolidated financials for the combined business will record the sale twice – once for the internal sale and once for the external sale. Which is a great way to generate fake sales. Which is why we have intercompany eliminations. When producing consolidated financial statements for the entire business, including all subsidiaries, these intercompany transactions have to be backed out. In this example, you’d have to reverse the internal sale, including reversing the internal cost of goods sold, which in turn eliminates the internally-generated profit or loss.
When to Use Intercompany Eliminations
So, when do we have to do these intercompany eliminations? The basic rule is that you can only recognize sales or profits when the transaction is with a third party – so any transactions between subsidiaries that generate sales or profits have to be eliminated. Also, any intercompany transactions that move account balances around have to be eliminated. Which calls for an example. Let’s say that a corporate parent loans money to its subsidiaries, and charges them interest for the privilege. When the parent does this, it records interest income, while the subsidiaries record interest expense. This is a wash, since the recorded income and expense offset each other, resulting in no change in the overall profit or loss of the consolidated entity. However, it creates an interest income line item and an interest expense line where there weren’t any before – so these intercompany transactions also have to be eliminated. So those are the two rules of intercompany eliminations.
Examples of Intercompany Eliminations
So let’s apply some examples to these rules. First, what if the corporate parent employs most of the staff, and bills them out to the subsidiaries based on hours worked? This won’t impact reported profits, as long as no profit percentage is added to the intercompany billings, so rule one is not violated. Also, rule two is not violated, since the staffing expense is not being shifted among different financial statement line items – it’s still going to be reported as compensation expense on the consolidated financials. In short, no need for an intercompany elimination.
On the other hand, if the staff were billed out by the parent entity at a profit, then the profit would have to be backed out.
Here’s another example. What if the corporate parent’s overhead expenses are allocated to the subsidiaries? It doesn’t impact profits and it still appears in the same expense line item in the consolidated financials, so there’s no need to do any eliminations.
And one more example. A subsidiary sells some machinery to another subsidiary, and does so at a profit. This is not so good, because you can only recognize a profit if the equipment is sold to a third party. So, the gain on the sale will have to be eliminated. But we’re not done yet, because the purchasing subsidiary has acquired the machinery at a higher price, and so has to depreciate more expense per month than the selling entity was doing. This means that the incremental increase in recognized depreciation also has to be eliminated.
So as you can see, expense allocations across the various entities are generally going to be OK, while sale transactions or anything creating a gain or loss will require an elimination.
Intercompany Payables and Receivables
But no matter what type of transaction it might be, there’s another problem, which is the associated intercompany accounts receivable and accounts payable. For example, if an expense allocation is just handled as an intercompany journal entry, then there’s no receivable or payable on the books of anyone, and so there’s no need to deal with intercompany eliminations. However, if one entity bills another one for these charges and this billing is not paid at month-end, then this creates an account receivable on the books of the billing entity and an account payable on the books of the receiving entity – and those receivables and payables will appear on the consolidated balance sheet – which we don’t want.
What this means is that every unsettled intercompany receivable and payable on the books at the end of a reporting period has to be eliminated before you can create consolidated financial statements.
Now, all of this is quite annoying. It can be all too easy to miss some of these transactions on your books, which the auditors might find at year-end, and require an embarrassing adjusting entry to fix.
Intercompany Elimination Tracking
How can you make sure that all eliminating entries are made? The best approach is to operate the parent business and all of its subsidiaries on the same accounting database, so that every entity in the overall business is automatically flagged by the accounting software, which then takes care of the eliminations for you. If each business is instead operating its own accounting system, then you’re going to have to institute a manual month-end review of all transactions, to see if there are any intercompany transactions that need to be backed out. It’s an annoyance, but that’s what you get with a decentralized accounting system.