Intercompany accounting: entries and reconciliation

Intercompany accounting: the short answer

Intercompany accounting is the recording, matching and elimination of transactions between legal entities in the same group, such as sales, service fees, loans and dividends. Each entity records its side in its own ledger, the two sides must agree, and everything is eliminated on consolidation. It matters because unmatched intercompany balances are one of the most common causes of late closes and misstated group accounts.

Inside a single company, a transfer between two branches is just an internal movement. Between two companies it is a real transaction with legal, tax and often VAT consequences, even though the group as a whole has done nothing with the outside world. Intercompany accounting has to serve both views at once: correct books for each entity, and clean eliminations for the group.

Types of intercompany transactions

Most groups generate the same handful of transaction types. Each one needs an agreed pricing basis, an agreed document and an agreed account on both sides before the first posting, otherwise the month-end reconciliation becomes an investigation.

• Sales of goods between group companies, such as a manufacturing entity selling to a distribution entity.
• Services and management fees, such as head-office finance, IT or HR services charged to subsidiaries.
• Cost recharges, where one entity pays a shared cost, such as insurance or software licences, and recharges the others.
• Intercompany loans and the interest on them, including cash pooling arrangements.
• Royalties and licence fees for the use of brands, patents or software owned by another group entity.
• Dividends from subsidiaries to their parent.
• Transfers of fixed assets or employees between entities.
• Capital contributions and share issues to fund a subsidiary.

Mirror entries: recording both sides

Every intercompany transaction produces a pair of entries that mirror each other: an intercompany receivable in one entity equals an intercompany payable in the other, and intercompany income equals intercompany expense. Using dedicated intercompany accounts, often called due from and due to accounts, keeps these balances separate from third-party receivables and payables, and tagging each line with the counterparty entity lets the balances be matched pair by pair.

Example. Parent A provides management services to Subsidiary B for EUR 30,000 a year and has lent B EUR 500,000 at 4% interest. A charges the fee and the interest at the year end. The two ledgers look like this. VAT may also apply to the management fee, and where A and B are in different EU member states the service is usually subject to the reverse charge in B's country, so B self-accounts for the VAT.

• A, loan advanced: Dr Intercompany loan receivable (B) 500,000 / Cr Bank 500,000.
• B, loan received: Dr Bank 500,000 / Cr Intercompany loan payable (A) 500,000.
• A, management fee: Dr Intercompany receivable (B) 30,000 / Cr Management fee income 30,000.
• B, management fee: Dr Management fee expense 30,000 / Cr Intercompany payable (A) 30,000.
• A, interest at 4%: Dr Intercompany receivable (B) 20,000 / Cr Interest income 20,000.
• B, interest at 4%: Dr Interest expense 20,000 / Cr Intercompany payable (A) 20,000.

Matching and reconciling intercompany balances

At each month end every pair of entities should confirm their balances with each other before the consolidation begins. The common causes of differences are timing (goods or cash in transit), cut-off (one side booked in this month and the other in the next), foreign exchange, disputed charges, and plain posting errors such as an invoice booked twice or to a third-party supplier account.

Example. At 31 December, A shows EUR 185,000 due from B, but B shows only EUR 162,000 due to A, a difference of EUR 23,000. Investigation finds three items. B paid A EUR 8,000 on 31 December that A has not yet recorded (cash in transit). A invoiced goods for EUR 20,000 on 30 December that B has not yet received or booked (invoice in transit). B booked a EUR 5,000 recharge twice. After adjustments both sides agree at EUR 177,000.

The rule of thumb is that the entity at fault corrects its own books, and items genuinely in transit are adjusted in the consolidation, not by forcing one side to match the other. A standing tolerance for tiny differences is acceptable; an unexplained plug is not.

• A's balance: 185,000 - 8,000 cash received from B = 177,000.
• B's balance: 162,000 + 20,000 invoice in transit - 5,000 duplicate = 177,000.
• Check of the difference: 8,000 + 20,000 - 5,000 = 23,000 = 185,000 - 162,000.

Settlement and netting

Intercompany balances should be settled regularly, not left to accumulate for years. Long-outstanding trading balances attract tax questions, because a tax authority may treat an unpaid balance as an undocumented loan that should carry interest, and they make foreign exchange exposure harder to manage.

Netting reduces the number of payments. In bilateral netting two entities offset what they owe each other and pay only the difference. In multilateral netting a central treasury or netting centre calculates each entity's net position across the whole group. Example: A owes B EUR 50,000, B owes C EUR 30,000 and C owes A EUR 20,000. Net positions are A minus 30,000 (receives 20,000, pays 50,000), B plus 20,000 (receives 50,000, pays 30,000) and C plus 10,000 (receives 30,000, pays 20,000); they sum to zero. Instead of EUR 100,000 of gross payments, A pays EUR 30,000 into the netting centre, which pays B EUR 20,000 and C EUR 10,000.

Each entity records the netting settlement as a payment or receipt against its intercompany accounts, clearing the gross balances. Netting needs a legal agreement between the participating entities, and some countries restrict cross-border netting or require central bank reporting, so check local rules before including an entity.

Eliminations on consolidation

IFRS 10 requires intragroup assets, liabilities, equity, income, expenses and cash flows to be eliminated in full on consolidation, together with profits or losses on intragroup transactions recognised in assets such as inventory and fixed assets. Our guide on consolidation accounting works through a full two-company example; the most common intercompany eliminations are summarised here.

Fixed asset transfers need an elimination that lasts for the asset's life. Example: A sells equipment with a carrying amount of EUR 60,000 to B for EUR 100,000, making a gain of EUR 40,000. B depreciates EUR 100,000 over five years, EUR 20,000 a year, while the group's cost basis would give EUR 12,000 a year. On consolidation: Dr Gain on disposal 40,000 / Cr Equipment 40,000 in the year of transfer, then each year Dr Accumulated depreciation 8,000 / Cr Depreciation expense 8,000, until the unrealised gain has been fully released after five years.

• Intercompany receivables and payables: Dr Intercompany payable / Cr Intercompany receivable.
• Intercompany loans: Dr Intercompany loan payable / Cr Intercompany loan receivable; and Dr Interest income / Cr Interest expense.
• Management fees and recharges: Dr Management fee income / Cr Management fee expense.
• Intercompany sales of goods: Dr Revenue / Cr Cost of sales, plus removal of unrealised profit left in closing inventory.
• Dividends from a subsidiary: Dr Dividend income / Cr Dividends paid (in equity), with any non-controlling share going to non-controlling interest.
• Transfers of fixed assets: remove the gain and the excess depreciation, as in the example.

Foreign currency intercompany balances

When group entities have different functional currencies, an intercompany balance denominated in one currency is a foreign currency monetary item for the other entity, and its exchange differences do not disappear on consolidation. IAS 21 para 45 explains why: an intragroup monetary asset or liability cannot be eliminated against the matching item without showing the results of currency fluctuations, because the group is genuinely exposed to the currency.

Example. B's functional currency is CAD and it owes A EUR 100,000. At the start of the year the rate is 1.50 CAD per EUR, so B carries a payable of CAD 150,000. At the year end the rate is 1.55, so B retranslates the payable to CAD 155,000 and records an exchange loss of CAD 5,000 in profit or loss. A has no exchange difference because the balance is in its own currency. On consolidation the payable and receivable eliminate, but the exchange loss stays in group profit or loss.

There is one exception. A loan whose settlement is neither planned nor likely in the foreseeable future forms part of the parent's net investment in the foreign operation; exchange differences on it are recognised in other comprehensive income in the consolidated statements. Our guide on IAS 21 covers foreign currency accounting in more depth.

Transfer pricing basics

Tax authorities expect intercompany prices to follow the arm's length principle: the price should be what independent parties would have agreed in comparable circumstances. The principle is set out in Article 9 of the OECD Model Tax Convention and developed in the OECD Transfer Pricing Guidelines, and most countries apply it in domestic law, for example section 247 of Canada's Income Tax Act. Mispricing does not change group profit before tax, but it moves taxable profit between countries, which is exactly what authorities examine.

Groups document their pricing with intercompany agreements and transfer pricing documentation. Under the OECD's three-tier approach, larger groups prepare a master file and local files, and groups with consolidated revenue of EUR 750 million or more file country-by-country reports. The Guidelines describe five main methods.

• Comparable uncontrolled price (CUP): the price charged in comparable transactions between independent parties.
• Resale price method: the resale price to third parties less an appropriate gross margin for the distributor.
• Cost plus method: the supplier's costs plus an appropriate mark-up, common for services and contract manufacturing.
• Transactional net margin method (TNMM): compares a net profit indicator with that of comparable independent companies.
• Transactional profit split: divides combined profit on highly integrated transactions according to each party's contribution.

Controls and common mistakes

A clear intercompany policy prevents most problems: which entity invoices, how prices are set, which accounts and counterparty codes are used, the cut-off date for intercompany postings each month, settlement terms, and who resolves disputes. The mistakes below appear in almost every group that lacks one.

• Posting intercompany items to third-party receivable and payable accounts, so they cannot be identified for elimination.
• One side booking a charge the other side never agreed, leaving a permanent difference.
• No intercompany cut-off date, so month-end differences are all timing and nobody can see real errors.
• Forcing a match with a plug entry instead of finding and correcting the cause.
• Eliminating intercompany sales but not the unrealised profit in inventory or fixed assets.
• Charging management fees with no agreement or documentation to support the arm's length price.
• Ignoring VAT and withholding tax on cross-border intercompany services and royalties.
• Letting trading balances age for years without settlement or interest.

Intercompany accounting in Skyline Nexus ERP

In Skyline Nexus ERP each group company runs as its own business with its own ledger, and the Consolidation area brings them together. A business group lists its parent and subsidiaries with ownership percentages and methods, and an Intercompany Accounts mapping identifies the accounts that hold balances between members. When a consolidation is run for a period, each member's trial balance is snapshotted and translated into the group currency, intercompany balances are eliminated, and the consolidated reports can be approved, locked and printed. Access is limited to administrators with the manage consolidation permission.

Within each entity, the chart of accounts supports the discipline intercompany accounting needs. An account can be flagged Requires Party, so every manual journal line posted to it must name a contact, and each journal line can carry a contact, a cost centre and a project. Movements between branches of the same business are different: a stock transfer between locations stays inside one legal entity, so no intercompany entries arise, and branch figures are viewed through the location filter on the Trial Balance, Profit and Loss and Balance Sheet rather than through intercompany accounts.