Intercompany accounting, how does it work?

Intercompany accounting is a complex field for all businesses involved. But what exactly does it entail? What are the different steps to follow and the standards to adhere to? How can these processes be optimised? This article addresses the different stages involved in intercompany accounting, from accounting consolidation and the types of transactions habitually processed, to the various discrepancies that may arise when reconciling accounts.

What is the difference between intercompany and intracompany balancing?

Intercompany accounting is defined as all financial and commercial transactions carried out and recorded between separate legal entities or subsidiaries that belong to a single parent company, as well as the “elimination” of these flows at the closing of the financial year.

Intercompany accounting is relevant for all companies with external bodies or subsidiaries abroad. In most jurisdictions, drawing up consolidated accounts for intercompany flows is a requirement for companies of a certain size. This involves reviewing transactions that are both reciprocal (intercompany transactions or “intercos”, as they are conventionally known) and non-reciprocal.

That said, companies and subsidiaries within a single entity also tend to exchange goods and services with each other. These flows are commonly referred to as intracompany transactions.

As an example, a parent company purchasing products and selling them to a subsidiary is considered an intercompany transaction while a transaction between two subsidiaries of a same parent company is considered an intracompany transaction.

In the context of intercompany accounting, consolidation is defined as the mechanism by which a group cancels out the transactions made between its various entities. The aim is to combine the accounts of the parent company and its subsidiaries, allowing for the submission of an accurate balance sheet and income statement that reflect the group’s financial situation as a whole.

The larger the group is, the more complex its accounting consolidation process becomes. This is why companies must follow strict accounting standards. While every country has its own set of accounting standards, international companies must conform to an international set of rules and standards. To this end, the International Accounting Standards Board based in London established the International Financial Reporting Standards (IFRS). Despite adhering to strict accounting rules and standards, discrepancies can arise during the period of account reconciliation.

The reasons for these accounting discrepancies are, among others:

• Increasingly short closing lead times, which can vary from one subsidiary to another.
• The need to identify non-reciprocal transactions between the parent company and its subsidiaries, a sometimes tedious process.
• Subsidiaries located abroad record their transactions in their local currency, which can complicate the reconciliation process.

In light of these obstacles, CFOs, treasurers and other accounting professionals need to find adopt accounting best practices and solutions to simplify and streamline consolidation efforts. In concrete terms, this can mean standardising accounting procedures across the group or corporation’s various subsidiaries and digitally transforming the group’s financial and accounting functions.

But which kinds of intercompany transactions are concerned? What is the best procedure to follow to ensure smooth and efficient accounting consolidation?

Which transactions are involved in accounting consolidation?

There are two types of intra-group transactions:

• Reciprocal transactions (intercompany transactions or intercos)
  A corresponding amount exists in the accounts of another company within the group.
• Non-reciprocal transactions
  A corresponding amount is not identifiable in the accounts of another company within the group, but the transaction still needs to be eliminated.

The following are the most frequently observed intra-group transactions:

The elimination of reciprocal transactions (or intercos) is theoretically straightforward as the amount identified as a receivable in the accounts of one company within the group is treated as a debt in the accounts of another. The consolidated income statement does not change after the elimination process.

The elimination of non-reciprocal transactions is distinct because a corresponding amount is not identifiable in the accounts of another company within the group. The consolidated income statement is therefore modified after the elimination process.

But how to identify the transactions involved? Where does the consolidation process begin? What methods can be used to ensure the account statements are reliable?

What are the different steps involved in consolidation?

Accounting consolidation begins with the mapping out of a “consolidation scope”. This refers to the entities within a group to be included when establishing the group’s consolidated financial statements. Its range is determined by the parent company’s control over its subsidiaries. Once the scope has been defined, an inventory of the reciprocal transactions to be eliminated must then be drawn up and, lastly, the accounts must be reconciled in order to ascertain the veracity and compliance of all the transactions made.

1. Mapping out the consolidation scope

The inclusion of subsidiaries in the consolidation scope depends on the level of control the parent company has over the external entity. If it maintains more than 50% of the voting rights in a company, then this company’s inclusion in the consolidation scope is a must. This is because such voting rights attribute the parent company with overall responsibility for the subsidiary’s financial and operational policies.

2. Drawing up an inventory of intra-group transactions

The inventory – the second phase of accounting consolidation – consists of collecting all data on reciprocal and non-reciprocal intra-group transactions. This is the first step to cancelling them out. At this point, it is also essential to establish the materiality threshold, below which any reporting errors do not compromise the reliability of the corresponding financial statements.

The materiality threshold is governed by a set of professional standards and a series of best practices. While it may vary from industry to industry, the thresholds generally considered to be material are:

• Between 1% and 3% for turnover.
• Between 1% and 5% for shareholders’ equity.
• Between 5% and 10% for current net income.

3. Reconciling the accounts

Accounting consolidation also requires the completion of a reporting package. This lists the various transactions undertaken by companies within the group, making it possible to conduct a comparative analysis and reconcile the accounts. The latter refers to a comparison between two reciprocal accounts, or an assessment of non-reciprocal flows, with the ultimate goal of ascertaining the veracity and compliance of the amounts identified.

Reconciling intercompany flows can be tiresome and time-consuming. To do it right, the accounting professionals in each of the group’s different subsidiaries must work closely with their counterparts, in accordance with a series of preordained group-wide processes. During the reconciliation phase, it is important to establish:

• Precise methods for exchanging relevant accounting data.
• A strict schedule for exchanging relevant accounting data.
• Clear procedures for identifying and resolving any discrepancies.

Centralising processes is simpler in smaller groups and becomes infinitely more complex when there is a high level of intra-group transactions. When it comes to the latter, rigorous management in each subsidiary is required.

However, without stringent cooperation procedures, accounting discrepancies are likely to arise. So, how can these be resolved? Indeed, how can they be avoided altogether, and how can the accounting process be better streamlined?

Why accounting discrepancies arise and how to remedy them

To address intercompany accounting discrepancies, the reconciliation process needs to be optimised, adopting currency hedging solutions needs to be considered and a more unified approach to management needs to be adopted at group level.

The most common discrepancies in intercompany accounting are often due to the following factors:

• Different dates for recording relevant accounting data from one subsidiary to the next.
• Different closing deadlines.
• Intercompany transactions in foreign currencies, with an exchange rate that fluctuates between the date of transaction and the date of reconciliation. Tackling currency risk is one action that falls squarely within the common procedures to smoothen the intercompany accounting process.

Some of the ways a group can eliminate the resulting discrepancies include setting up:

• Top-down accounting management, imposing strict deadlines for the account reconciliation process across all subsidiaries.
• Intercompany reconciliation modules as a complement to the existing consolidation software in use. These can automate the reconciliation process across the entire group, using a common database shared by all subsidiaries.
• Platforms or services that allow a fixed exchange rate to be set per currency, especially useful for intra-group transactions denominated in foreign currencies.

Consolidation software is extremely widespread nowadays, but additional modules that automate and centralise reconciliation are not as commonly used, despite their obvious advantages. The same can be said of currency hedging solutions, such as currency forward contracts, which make it possible to set a fixed exchange rate for a specific period of time, thereby facilitating the reconciliation of accounts denominated in foreign currencies.

In a field as complex as intercompany accounting, process optimisation and digital transformation are essential to meet the regulatory requirements imposed on companies while improving their operational efficiency.

Accounting consolidation is one of the main challenges of intercompany accounting. Though often complex, it is mandatory for groups or corporations of a certain size, and it requires attention to detail and optimisation if it is to provide an accurate picture of a group’s financial situation.

Several phases are involved in the consolidation process, from mapping out the consolidation scope to drawing up an inventory of intra-group transactions and reconciling the group’s accounts. As with any closing period, discrepancies can arise, but there are digital solutions that make it easier to process and deal with them.

Ultimately, the accounting processes used by a group depend on a number of factors, from the group’s geographical location to the number of companies involved. For groups with subsidiaries whose accounting currency differs from the consolidation currency, hedging solutions are certainly worth exploring, as they help process intra-group transactions in a simpler manner and contribute to the optimisation of multicurrency cash flows.