What are intercompany eliminations?
Intercompany eliminations are used to remove from the financial statements of a group of companies any transactions involving dealings between the companies in the group.
There are three types of intercompany eliminations, which are:
- Intercompany debt. Eliminates any loans made from one entity to another within the group, since these only result in offsetting notes payable and receivable, as well as offsetting interest expense and interest income. These issues most commonly arise when funds are being moved between entities by a centralized treasury department.
- Intercompany revenue and expenses. Eliminates the sale of goods or services from one entity to another within the group. This means that the related revenues, cost of goods sold, and profits are all eliminated. The reason for these eliminations is that a company cannot recognize revenue from sales to itself; all sales must be to external entities. These issues most commonly arise when a company is vertically integrated.
- Intercompany stock ownership. Eliminates the ownership interest of the parent company in its subsidiaries.
Intercompany transactions can be difficult to identify, and so require a system of controls
to ensure that each of these items is properly identified and brought to the attention of the corporate accounting staff. The issue is of particular concern when an acquisition has just been completed, since the reporting controls are not yet in place at the new acquiree. If an enterprise resource planning (ERP) system is in place throughout the company, these transactions can typically be identified by flagging a transaction as it is created as being an intercompany item.
When an intercompany transaction has been identified in one period, it is entirely possible that the same type of transaction will occur again in the future. Accordingly, a reasonable control is for the corporate accounting staff to make a list of all intercompany transactions that have been identified in the past, and see if they have been dealt with again in the current period. If not, there may be an unflagged transaction that needs to be eliminated.
Given the difficulty of intercompany reporting, it is especially important to fully document the associated controls and resulting journal entries, since they are likely to be reviewed in detail by the company's auditors.