One of the most complex aspects of multi-entity accounting is dealing with intercompany eliminations. If this step isn’t performed properly, it can inflate your data and ultimately mislead the users of the financial statements.
In this post, we’ll discuss what intercompany eliminations are, how to account for them, and provide real examples of performing intercompany eliminations.
Before we dive into intercompany eliminations, it's important to understand how intercompany transactions work because they are the basis of intercompany eliminations.
So what is an intercompany transaction?
It's a transaction that occurs across affiliates (the parent or subsidiaries of the parent company) within a parent company. As intercompany transactions are simply asset transfers among affiliates, they don't change the parent company's net assets.
However, intercompany transactions still need to be recorded so that each subsidiary knows what they owe/are owed from the other subsidiaries and/or the parent company.
There are three different types of intercompany transactions:
Now that you understand how intercompany transactions work, you'll probably realize that some accounting entries need to be eliminated to avoid inflating the final consolidated balance sheet. Therefore, you'll have to perform intercompany eliminations.
Intercompany eliminations cancel intercompany transactions that don't impact the parent company's net assets. This ensures that the parent company's financial statements can be accurately consolidated.
Otherwise, the parent company's balance sheet might become inflated (we'll discuss specific scenarios below).
However, not every single intercompany transaction warrants an elimination.
Specifically, if you have a transaction where the underlying transaction and the intercompany transactions are tied together, you should not perform an intercompany elimination.
An example of this scenario would be the corporate parent transferring cash to a subsidiary to help them fund operations. The cash balance that has been transferred still needs to be recorded at the consolidated level. At the end of the day, your goal is to ensure that any activity that is purely between companies is equal to zero. However, in this case, the cash did actually transfer. Therefore, that transaction needs to be reflected at the consolidated level.
To give you some clarity, there are three main types of intercompany eliminations.
The three main types of intercompany eliminations are:
Below, we'll discuss the three main types of intercompany eliminations.
Intercompany debt is when there is a loan between a subsidiary and another subsidiary or the parent company. An example of intercompany debt is if the parent company pays for a warehouse that several subsidiaries use. In this case, each subsidiary has an expense, but because the parent company paid it, an intercompany elimination would have to occur. This is because, in a traditional loan involving a third party, the cash flow and interest expense/interest income impact the parent company's net assets. However, if the debt occurs among affiliates of the parent company, it's simply a transfer of assets and doesn't impact the parent company's net assets.
This means that from an accounting perspective, the elimination is performed by canceling the note receivable and note payable among affiliates.
When goods or services are bought and sold within the parent company and its subsidiaries, the revenue and expenses associated with each intercompany sale should be eliminated. This is because the parent company's consolidated net assets remain unchanged.
So, in addition to eliminating the sales recorded, you should also eliminate interest or revenue on loans and the cost of goods sold from an intercompany sale.
Finally, each parent company needs to eliminate assets and stockholders' equity accounts for each subsidiary. Otherwise, it can inflate the parent company's financial data.
To help you visualize the process, here’s a quick walkthrough of an example of executing intercompany eliminations.
In this example, the parent company pays a vendor bill on behalf of the subsidiary.
Traditionally, most intercompany accounting processes were performed in Excel, and the elimination and consolidation process was highly manual.
The problem with manual financial consolidation and elimination is that it's time-consuming and exposes your data to manual errors.
To solve these problems, we built SoftLedger, which streamlines the entire workflow for you.
Simply turning on the intercompany elimination automation setting inside the system ensures it will automatically eliminate the financial impact of an intercompany journal entry at the parent of both locations used in the intercompany entry. The best part is that this all happens in near real-time.
So as soon as an entry is made, you'll be able to see the impact without ever opening a single spreadsheet.
To see for yourself if SoftLedger is a good fit for you, schedule a demo today.