Intercompany Transfers: Introduction

A consolidation means that you combine the financial results of a parent company with a subsidiary company. A parent company buys a percentage of a subsidiary's equity. At the end of a month or year, all parties would like to see the combined results of the parent and the “sub”.

When you consolidate financials, you don’t want to count any activities twice. One control to avoid double-counting is to eliminate the impact of intercompany transactions. By intercompany, we mean transactions between the parent and the sub.

It’s not surprising that a parent and sub would do business with each other. One entity might be a supplier to the other. Assume the parent makes blue jeans and the subsidiary supplies the denim material for the jeans. So, sub sells denim to the parent.

Obviously, the sub will sell the denim to the parent for a profit. In consolidation, the profit on the sub’s sale to the parent should be eliminated. Here’s another way to think about it: the parent and sub should only include those transactions with third parties- not with each other. Again, this should be implemented when the financials are consolidated. If you’re considering the companies individually, you would not eliminate any transactions.

Upstream vs. downstream transactions

A upstream transaction occurs when a sub sells to a parent. Downstream is the reverse: when a parent company sells to a sub.

What gets eliminated in consolidation?

Consider the sub selling denim to the parent example again. What is the financial impact of the sale? Well, the sub booked a profit- the difference between their costs and the sale price. In consolidation, that profit should be eliminated.

Now, mull over the impact on the parent. The parent company bought the denim. They paid the sub’s retail price. In consolidation, you eliminate the profit. So, it also makes sense to post the denim purchase to the parent’s books at the sub’s cost. In other words, the denim is sold to the sub without any profit. The purchase (an inventory account) on the parent’s books would be at the sub’s cost.

The next blog will explain more on intercompany transactions. In the meantime, this video will help:

http://www.youtube.com/watch?v=uA2pDqb0Pdg

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Author/ Cost Accounting for Dummies (John Wiley and Sons) March 2013