Intercompany Transaction

INTERCOMPANY TRANSACTIONS: MERCHANDISE, PLANT ASSETS, AND NOTES

The accounting ramifications of consolidated statements do not end with procedures for eliminating the parent’s investment in the subsidiary and the adjustments which stem from that elimination. It is common for the affiliated firms to engage in continuing business transactions with each other. The more integrated the firms are in terms of types of operations, the more numerous the intercompany transactions become. The most common of these transactions are intercompany sales of merchandise, services and plant assets.

     Consolidated statements become the single set of statements for the parent-subsidiary entity. Transactions between the separate legal entities should not be reflected in the consolidated statements. Instead, these statements should reflect only those transactions with firms outside the consolidated group. In other words, intercompany transactions must undergo elimination procedures. For each type of intercompany transaction, the applicable theory for elimination and resulting worksheet procedures are mastered by determining what evidence of the transaction should remain on the consolidated statements from the viewpoint of a consolidated entity.

INTERCOMPANY MERCHANDISE SALES

It is common to find that the goods sold by one member of an affiliated group have been purchased from another member of the group. One firm may produce component parts that are assembled by its affiliate, which sells the final product.ood asics a b In other cases the product may be produced entirely by one member firm and sold on a wholesale basis to another member firm, which is responsible for selling and servicing the product to the final users. Taken as a whole, these different examples of merchandise sales present the most common type of intercompany transaction and must be understood as a basic feature of consolidated reporting.

           Sales between affiliated firms will be recorded in the normal manner on the books of the separate firms. Remember that each firm is a separate legal entity maintaining its own accounting records. Thus sales to and purchases from an affiliated firm are recorded as if they were transactions made with a firm outside the consolidated group, and the separate financial statements of the affiliated firms will include these purchase and transactions. Since these sales do not involve parties outside the consolidated group, they cannot be acknowledged in consolidated statements.

           Following are the procedures for consolidating affiliated firms engaged in intercompany merchandise sales:

1. The intercompany sale must be eliminated to avoid double counting tto understand this requirement, assume that Company P sells merchandise, which cost $1000, to a subsidiary, Company S, for $1200. Company S, in turn, sells the merchandise to an outside party for $1500. If no elimination is made, the consolidated income statement would show the following with respect to the two transactions:

    Sales………………………………………………….. $2700 ($1500 outside sale plus $1200 sale to Company S)

    Less cost of goods sold…………………………… 2200 ($1000 cost to Company P plus $1200 purchase by Company S)

Gross profit…………………………………………………………. $ 500 (18.5% gross profit rate)

While the gross profit is correct, sales and the cost of goods sold are inflated. As a result, the gross profit percentage is understated, since the $500 gross profit appears to relate $2700 of sales. The intercompany should remain on the consolidated income statement with respect to the two transactions is: