General Overview of Intercompany

After reading this training article, learners will understand the meaning of intercompany and different types of intercompany transactions that can happens. Understand why intercompany transactions are required while preparing consolidated financial statements, differentiate between upstream and downstream intercompany transactions and understand the concept of intercompany reconciliations.

What are intercompany transactions?

An intercompany transaction occurs when one unit of an entity is involved in a transaction with another unit of the same entity. Most of the transactions involve two unrelated entities. An intercompany transaction occurs when one unit of an entity transacts with another unit of the same entity. It is a transaction between two associated companies who file a consolidated tax return or financial statement.

Why intercompany transactions occur?

While these transactions can occur for a variety of reasons, they often occur as a result of the normal business relationships that exist between the units of the entity. These units may be the parent and a subsidiary, two subsidiaries, two divisions, or two departments of one entity. It is common for vertically integrated organizations to transfer inventory among the units of the consolidated entity.

Accounting Treatment for Intercompany Transactions:

An intercompany transaction is recognized in the financial records of both units of the entity. From the consolidated entity’s perspective, the transaction is initially unrealized because unrelated parties are not involved, so the intercompany transaction needs to be interpreted differently than it was by either of the participating units. The difference in interpretation generally results in the elimination of certain account balances from the consolidated financial statements.

The purpose of consolidated statements is to present the results of operations and the financial position of a parent company and its subsidiaries. Regardless of the type of transaction, the occurrence of an intercompany transaction, if not removed (eliminated) from the consolidated financial statements, will often result in a misrepresentation of the consolidated entity’s financial position.

Below are some of the reasons of occurrence of Intercompany Transactions-

• These transactions can occur for a variety of reasons, and normally occur as a result of the normal business relationships between the units of the entity.

• An intercompany transaction is recognized in the financial records of both units of the entity.

• These transactions might or might not be cash settled.

• From the consolidated entity’s perspective, the transaction is initially unrealized because unrelated parties are not involved; therefore, intercompany transaction needs to be eliminated from the consolidated financial statements.

Types of Intercompany Transactions:

Intercompany transactions can be classified as:

• Downstream Intercompany Transactions- Transactions flowing from the parent to the subsidiary.

• Upstream Intercompany Transactions - Transactions flowing from the parent to the subsidiary.

• Lateral Intercompany Transactions - Transactions between subsidiaries

Impact of Intercompany Transactions:

Interpreting the impact of intercompany transactions on the financial records of the units involved begins with understanding how the transactions are initially recognized on each unit’s financial records. Intercompany transactions needs an effective system to manage them appropriately as it can be a complex process for companies operating in multiple countries. Some complexities are streamlining intercompany trading with unlimited trading partners, local statutory compliance with intercompany invoices for each of the trading partners, intercompany reconciliation and transaction-level balancing for sub-ledger applications and intercompany eliminations at period close.

It is also important to understand how each intercompany transaction impacts the income statement and balance sheet of the company involved in the period of the intercompany transaction as well as in subsequent periods.

Intercompany V/s Intracompany Transactions:

Intercompany Transactions are between two or more related internal legal entities with common control, i.e. in the same enterprise. Intracompany transactions are between two or more entities within the same legal entity. Hence intercompany is cross legal entities and intracompany is across various units belonging to the same legal entity. Rules for intracompany processing can be determined by the organization based on internal procedures and guidelines, however for intercompany transactions, companies need to follow the certain rules and  laws.

Intercompany Reconciliations:

Intercompany reconciliations are required to ensure that balances owed to and from companies (legal entities) in the same group are in agreement so that when group accounts are prepared the intercompany balances all cancel out on consolidation. As organizations use multi-currency and different accounting systems, balances at business units or subsidiary companies may not match with each other and the year end process can be delayed. Too many reconciling differences may require investigation or resolution before the balances are acceptable to management and/or auditors.

Some of the factors that give rise to intercompany differences are:

• Individual companies doing intercompany transactions and not confirming the same to each others.

• Wrong posting to/from intercompany accounts, may post balances due from other members of the group to sundry debtors or creditors.

• Currency rate differences due to recording transactions on different dates may translate at different values when accounts are consolidated.

• Summarization by aggregating amounts and posting them as a single journal when the subsidiaries posts amounts individually.

• Subsidiaries identified incorrectly by each other.

Oracle Prospective of Intercompany and Intracompany

In order to record Intercompany transactions in Oracle,  we need to create an intercompany segment  with optional qualifier. Also we need to create separate GL accounts for each pair of companies doing business with each other. We can include multiple accounts to records intercompany transactions. Let’s say our company does business with 100 other sister companies. Using "intercompany segment" method we need one account while using "multiple accounts" method we need 100 accounts.

It is very important to set up intercompany segments while creating segments in COA because Oracle does not support adding/changing segments to structure once we start using Ledger.

Intercompany Segment

The purpose of Intercompany Segment is to keep the number of natural accounts used for Intercompany to a minimum.  In absence of Intercompany Segment, we have to allocate a natural account for each company in our Group. Secondly, usage of intercompany segment enables tracking of intercompany transactions better by using the segment value to analyze transaction data particularly when we use transfer pricing. As long as we use the same segment structure.

With the help of Intercompany Segment we can always use that segment to track Intercompany transactions. By looking at the Segment we can determine where the Intercompany transactions belongs to. For example if we have 25  entities across globe, then we can have 1 Intercompany AR account and 1 Intercompany AP account and use this segment to identify the Intercompany entity. If we don’t have an Intercompany Segment, the only way to track is to have multiple Intercompany Accounts for each combination which is a tedious effort.

Advantage of having an intercompany segment

1. Helps to keep minimum natural account being used for identifying Intercompany.  In absence of Intercompany segment, we need to have a natural account for each of the intercompany we want to keep track of.  With Intercompany Segment, since Intercompany is identified by a segment, we can use one natural account for multiple intercompany.

This will be particularly useful when we have a number of inter / Intra Companies to  keep track of.

2. While consolidating accounts, we have to eliminate intercompany sales and inter-company COGS.  With Intercompany segment, we will be able to easily identify such intercompany transactions which needs elimination.

3. Another advantage of having an Intercompany segment in CoA is that we can create either customized reports or reports through Financial Statement Generator (not applicable in Fusion General Ledger) to track the transactions coming from an Intercompany source.

When a group of two or more businesses is required to report financial results on a consolidated basis, generally accepted accounting principles, or GAAP, require the elimination of intercompany sales during the consolidation process. Eliminating the intercompany sales of an Asset has an immediate effect on the amount of consolidated net income reported on the profit and loss statement. The necessary elimination entries can affect future consolidated net income if the Asset is ever sold to an unrelated party.

An intercompany sale refers to any type of transaction between two businesses that are members of the same consolidated group, such as between a parent company and one of its subsidiaries (Downstream Intercompany) . Because these companies report a single consolidated net income figure, GAAP requires the elimination of all profits and losses that are attributed to intercompany transactions to ensure that net income is as accurate as possible. Without this elimination requirement, companies can manipulate their earnings, misleading current and prospective investors and creditors.

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