What Is Intercompany Accounting? Best Practices and Management (2024)

Large companies often have multiple subsidiaries that do business with each other and, whenthey do, they’re required to follow the rules of intercompany accounting — theaccountingprocess for internal transactions between legal entities within the same parent company.

While that definition may accurately conjure visions of large multinational conglomerates,intercompany accounting has applications in companies of all sizes. For example, arestaurant owner with two different locations may benefit by treating each location as aseparate entity. When that happens, the owner needs to use intercompany accounting toproperly reflect the results of the unified business.

Historically considered a bland branch of accounting, intercompany accounting has come underscrutiny by regulators in recent years, becoming one of the top reasons public companiesmust correct or restate their financial reports. The best practices that follow can helpintercompany accounting be less cumbersome and more accurate.

What Is Intercompany Accounting?

The objective of intercompany accounting is to strip away the financial impact of internaltransactions — financial interactions between related entities within the same parentcompany — to yield financial statements that only reflect activity with independentthirdparties. Intercompany accounting eliminates financial activity that takes place between twosubsidiaries or between the parent and a subsidiary. Examples of events covered byintercompany accounting include sales of products, services or inventory, cost allocations,royalties, and debt financing between related companies.

Elements of intercompany accounting include governance and policies, transfer pricing, datamanagement, transaction management, netting and settlement, reconciliation/elimination andreporting.

Key Takeaways

• Intercompany transactions are common and normal occurrences in businesses of all sizesand industries.
• Intercompany accounting has implications for many aspects of a business, including tax,compliance and accounting.
• Identifying and eliminating the financial effect of intercompany transactions can be acumbersome, tedious process that delays a business’s financial close.
• Nine best practices, including automation, can help make intercompany accounting easier,faster and more accurate.

What Is an Intercompany Transaction?

Intercompany transactions are common and come in many forms. Their primary characteristic isthat the participating entities are part of the same parent company, unlike“intracompanytransactions” that occur between two units within the same legal entity. Because oftherelationship between the two parties, intercompany transactions aren’t consideredindependent, arms-length transactions.

Intercompany Accounting Explained

Family economics offer a good illustration of intercompany activity and the importance ofdistinguishing between internal and third-party transactions.

When a mom receives a paycheck from her employer, that’s an independent third-partytransaction that brings new funds into the family. When she gives each of her two daughtersan allowance for doing their chores, that resembles a parent/subsidiary intercompanytransaction. No new money came into the family — it simply moved between walletswithin thehousehold in exchange for services provided.

Further, when daughter A gasses up the car she shares with her sister and daughter Breimburses her for half the amount, that’s also like an intercompany transaction. Butthepayment to the gas station is a third-party transaction that reduces household funds. Ifdaughter A charged her sister a per-gallon rate that was higher than she paid the gasstation, that’s like intercompany profit. Such profit is not incremental to thehousehold;rather, it is another example of shifting money within the household — just liketransferpricing shifts money between legal entities within a parent company.

Why Is Intercompany Accounting Important?

Companies can achieve many operating benefits from vertical and horizontal integration. Froman accounting perspective, however, some of this “synergy” — specifically,any internallygenerated revenue and profit — must be eliminated during financial consolidation. Forexample, one subsidiary may supply another with raw materials, which keeps companywidemanufacturing costs down, but the parent company cannot recognize revenue or profit fromthis internal transaction. At the most basic level, intercompany accounting ensures that acompany’s financial statements do not include sales to “itself.” Beyondthat, intercompanyaccounting helps business owners in many ways. It:

• Eliminates double counting of intercompany activity.
• Highlights activity among the entities within a group.
• Supports accurate tax filings across different jurisdictions.
• Aids cash movement and settlement, including of foreign currencies.
• Is necessary for compliance with Generally Accepted Accounting Principles (GAAP),Securities and Exchange Commission (SEC) rules and IRS codes.

Without intercompany accounting and related eliminations, companies can unintentionallyobscure their operating results or intentionally — i.e., fraudulently — inflatesales andprofit reporting.

Intercompany Accounting and Financial Close

Intercompany transactions are initially shown on each business entity’s separatefinancialstatement as if they were third-party transactions. Intercompany accounting treatment isapplied toward the end of the financial close process, when thesubsidiaries’ financial statements are combined at the parent level, resulting inconsolidated financial statements and tax filings.

Identifying intercompany transactions during the financial close process can be tricky and somight cause delays in producing consolidated financial information. Companies with multipleentities, whether the result of acquisitions or organic growth, often have differentaccounting systems in place — or even different versions of the same systems. Thedifferentsystems might not integrate well with each other, so that both sides of an intercompanytransaction cannot always communicate financial information automatically. As a result,finding, matching and netting intercompany transactions is often a very manual,labor-intensive process that is prone to errors and omissions.

Types of Intercompany Transactions

During the normal course of business, different units within a parent company may providegoods or services to each other. They can settle the interactions in cash or by journalentry in their general ledgers. There are generally three types of intercompanytransactions, categorized as follows:

• Downstream:

  Transactions that flow from a parent company to a subsidiary entity, such as when aparent gives a loan to a subsidiary. During consolidation, intercompany accountingeliminates the parent’s interest income and the subsidiary’s interestexpense.

• Upstream:

  Transactions that flow from a subsidiary to a parent company, such as a branchlocation selling land to its parent. Gains or losses from the sale are eliminatedduring consolidation.

• Lateral:

  Transactions between two subsidiaries. If one subsidiary provided raw materials toanother, any intercompany profit would be eliminated.

Challenges of Intercompany Accounting

Out of balance and undetected intercompany activity can significantly impact a parentcompany. There are several challenges within intercompany accounting that contribute tothese problems, intricately woven into the fabric of managing large, multi-entityorganizations.

• Disparate Accounting Systems: The first hurdle is the identificationand cross-matching of intercompany activity across different entities. This challengeprimarily stems from the use of disparate accounting systems that struggle tocommunicate due to inconsistent charts of accounts or incompatible data formats.Organizations tackle this issue by dedicating additional time and resources, with moremature companies moving towards fully automated transaction-level matching solutions.
• Transfer Pricing Analysis: Another critical aspect is ensuringconsistency in the methods used by each entity for cross-charging, known as transferpricing. These transactions, vital for tax implications, are governed by strictregulations. The complexity lies in choosing among five regulatory-compliant methods forcalculating transfer prices, necessitating a blend of internal and external data. Thereal test is ensuring subsidiaries are employing consistent data in their transferpricing calculations, considering each item must have a transfer price, potentiallycalculated through different methods.
• Settlement of Intercompany Transactions: The final challenge is thenetting and settling of payments between parties upon completing an intercompanytransaction. This process, often managed through journal entries or fund transfers, canbe tedious and prone to delays when resources are constrained. Consequently,intercompany accounts may remain open for extended periods, which can obscure financialresults and incur costs, such as the loss of potential interest or the impact offluctuating foreign exchange rates.

Each of these challenges illustrates the complexities of intercompany accounting, underliningthe importance of meticulous management and the potential for advanced solutions tostreamline these critical processes.

Intercompany Accounting Risks

The risks of a poorly managed intercompany accounting process are most evident in financialmisstatements, but they also impact several other areas across a company. For example,treasury issues — such as unpredictable cash flow, foreign exchange losses and evenfraud—can arise from intercompany accounts that are not settled within a reasonable timeframe.When subsidiaries are in different taxing jurisdictions, incorrect intercompany accountingincreases the risk of tax penalties and interest arising from incorrect tax filings. Goodintercompany accounting can help mitigate the risk of lost or misappropriated assets, likeinventory and machinery.

The potential consequences of these risks sometimes make news headlines. Recent storiespulled from filings with the U.S. Securities and Exchange Commission (SEC) include lawsuitsand penalties against companies and their officers. In one, a large multinational providerof oil and natural gas was sued by investors and fined by the SEC because “postclosingplugs to intercompany accounts” misled investors about profitability and resulted intaxfraud. In another case, more than $12 million in penalties were levied against anadvertising firm and its officers for failing to reconcile intercompany accounts for sixyears as a way to avoid missing profit targets.

3 Steps to Intercompany Accounting

To stay on the right side of compliance, tax and financial authorities’ oversight ofintercompany accounting, companies should carefully follow three key principles. Thesehigh-level principles guide the steps and practices for their accounting departments:

1. Establish governance:

   Standards and policies should be developed and put in place to ensure consistentintercompany accounting processes, enforce compliance with relevant standards andestablish a clear escalation path to remedy any issues that may arise. Policies alsoshould outline broad issues like management oversight and performance metrics, aswell as smaller details, such as identifying relevant intercompany products,creating consistent charts of accounts, pricing, hand-off points, ownership andnecessary transaction approvals.

   See Also

   What are Intercompany Transactions? | F&A Glossary

2. Create accountability:

   Identify the person(s) responsible for intercompany accounting and hold themaccountable, with deadlines. Centralizing intercompany accounting tasks providesclear points of contact and ownership, in addition to consistency. In this way,intercompany transactions aren’t an afterthought likely to hold up theaccountingclose each month.

3. Automate:

   Use accounting software that automates transaction flow, thereby reducing the amountof manual intervention. Use automated intercompany accounting modules that integratewith disparate subsidiary financial systems.

9 Best Practices for Intercompany Accounting

Companies with mature, efficient intercompany accounting processes stay compliant withregulators and keep their financial reputations intact by using these nine best practices:

1. Standardize transfer pricing:

   Accounting and tax standards require “arm’s-length” pricing betweenrelatedcompanies. This means intercompany pricing should be similar to pricing forindependent third parties. There are several accepted methods for developingtransfer prices, and standardizing transfer prices includes selecting one (orsometimes more) of those methodologies.

2. Flag transactions immediately:

   Software controls can flag intercompany transactions, reducing the potential for themto slip through the cracks. Labeling transactions at inception, such as whenpurchase orders are opened, is more efficient than searching for activity after thefact. Timely identification also avoids accumulation that can slow down thefinancial close process.

3. Automate intercompany eliminations:

   After intercompany transactions are identified, they can be eliminated automaticallyas part of the consolidation process. Doing this reduces the need for manualintervention and reconciliation and concentrates the number of top-side adjustmentsonly to those on an exception report. For example, intercompany accounts receivableon one subsidiary’s books can be eliminated by the related offsettingintercompanyaccounts payable on the other related party’s books.

4. Settle accounts monthly:

   Related parties can owe money to each other as a result of intercompany transactions.Such balances typically are netted against each other to avoid excessive shufflingof funds. It’s a best practice to settle intercompany netting on a timelybasis,such as monthly, rather than leaving them unreconciled for multiple fiscal periods.Leaving them open can lead to errors and unclear subsidiary-level financialstatements, which could mislead the managers who rely on them.

5. Adopt continuous closing/continuous accounting:

   Using a continuous closing approach (also called continuous accounting), where dutiestypically completed at the end of a fiscal close are done a little bit each day,helps manage intercompany accounting workflow and avoid time crunches at the end ofeach period. Continuous accounting also makes intercompany reconciliations easierbecause it’s simpler to investigate items when they are current and detailsarestill fresh.

6. Invest in technology:

   Investing in the right technology to support automation is an important step thatmakes all accounting, including intercompany accounting, more efficient andaccurate. Consider the systems already in place and aim to achieve the highest levelof integration possible. Protect your technology investment by taking advantage oftraining and customer service offerings from software providers.

7. Practice access and role management:

   Because multiple parties are involved in intercompany transactions, it’s a bestpractice to assign accounting system access to the right people in a company, usingtheir roles as a guide. In smaller companies, where employees and owners take onmany roles, managing access can be tricky. Nonetheless, ensuring internal controlsover intercompany accounting is a key step in preventing errors and fraud.

8. Detailed reporting:

   While eliminations are important at the consolidated parent level, subsidiarymanagers will want to see intact financial statements.

9. Implement fixed assets management:

   Many intercompany transactions involve the transfer of fixed assets from onesubsidiary to another. When this happens, the asset and its related depreciationhistory must be properly transferred. Fixed assetmanagement software makes it easier to track, locate and account forintercompany transactions involving property, plant and equipment.

Manage Intercompany Accounting With NetSuite

NetSuite CloudAccounting Software helps companies implement these best practices for intercompanyaccounting via important features at both the subsidiary and parent levels. WithinNetSuite’s software, each subsidiary has an independent set of books with a customizedchartof accounts, so divisional management has a clear picture of their financial statements tohelp manage the business and gauge performance. Beyond that, a mapping feature funnels everysubsidiary account into the right place at the parent level, enabling real-timeconsolidation for the accountants who work with the combined results.

This multidimensional functionality supports intercompany accounting and all of its relatedissues regarding taxes, foreign currency and treasury. It begins by tagging transactionswhen orders are created, and automatically connects and eliminates intercompany items sothat the financial close process is faster and the risk of missing an intercompanytransaction is lower. Similarly, automated balancing and netting enables more timely accessto consolidated financial results. Additionally, a company can better enforce its standardsand policies for transfer pricing by using NetSuite’s built-in price books, whichkeeps taxauthorities happy.

Intercompany transactions — those in which two related business entities buy or sellgoods orservices to each other — must be properly eliminated for parent company financialstatementsto be correct. Incorrect or inefficient intercompany accounting processes can havefar-reaching implications across a business’s treasury, tax and accounting functions.Butthe necessary intercompany reconciliations, settlement and netting, elimination and transferpricing can become a cumbersome undertaking, especially when the volume of such transactionsis high. Automation is a key practice to mitigate intercompany transaction challenges andmanage intercompany accounting accurately and efficiently.

Intercompany Accounting FAQs

What are intercompany transactions?

Intercompany transactions arise when two entities within the same legal parent engage inbusinesses activities with each other. Intercompany transactions can be downstream (parentto subsidiary), upstream (subsidiary to parent) or lateral (between subsidiaries).

What is an intercompany journal entry?

A journal entry adjusts the balance in the general ledger account of a company’saccountingrecords. An intercompany journal entry increases/decreases account balances arising fromtransactions between legal entities within the same parent company.

How do you do intercompany journal entries?

Journal entries are made on each related party’s books using intercompany accounts,such as“due to and due from” when a transaction arises. Eliminating journal entries arepart of theintercompany accounting process and are made when subsidiary financial statements arecombined to show the overall financial position of the parent company.

Why are intercompany transactions required?

Intercompany transactions often come about when related legal entities buy and sell to eachother as part of their normal business operations. For example, two restaurants under commonownership may transfer perishable ingredients between each other as part of a bulkpurchasing arrangement. Intercompany accounting ensures that a company’s financialstatements do not include sales to “itself.”