Definition: An intercompany transaction is one between a parent company and its subsidiaries or other related entities.
Unintended consequences: Intercompany transactions often cause problems with the relationship between a parent company and its bankers and lenders.
Reasons why: The reasons are many, but the key issues relate to taking cash and other assets away from the parent company to help with other related entities, which are sometimes start-ups or other similar types of companies that do not have the financial liquidity to operate on their own without assistance from the parent company.
Expenses: It’s easy for a parent company to incur administrative expenses (additional payroll, computers, etc.) that are not allocated to the related entities. This has the effect of showing increases in expense to the parent company, which then begins to show lower profits.
COGS: It’s easy for a parent to purchase inventory that is subsequently transferred to related entities. This transfer of inventory is often done without any paperwork recorded in the parent company, which has an effect of overstating inventory on the parent company and understating inventory of the related entity. This issue may become more complex if the parent company sells inventory to the related entity. For example, does the parent company sell the inventory at cost or a markup? If the inventory is sold for a markup, how is the intercompany sales transaction ultimately eliminated in order to not inflate sales shown to the banker? If intercompany sales are made, what is the strategic plan to protect all entities from taxing authorities related to sales and/or use taxes?
Accounts payable: It’s easy for a parent company to purchase inventory and other such items from its existing vendors. After all, the related entities may not be credit worthy and the parent company’s vendors may not want to take the credit risk of a new or newer entity. This causes a myriad of questions, such as, who ultimately pays the vendors? How are the payables to be properly reflected on the balance sheets of both companies, etc.?
Staff: Not every privately-held company has accounting staff who are trained and experienced enough to properly handle intercompany transactions. For example, one company we know of had nine wholly-owned subsidiaries. The parent company showed that subsidiary #1 owed it $105,000 on the accounts receivable trial balance. Company #1 showed that it owed the parent company $5,000 on its accounts payable. We showed this problem to the parent company’s accounting staff and asked about the $100,000 discrepancy. The staff person told us that she did not know which amount was correct. The next question was asked to the business owner, who was seeking a loan from a bank, “How can a bank have any confidence in the accuracy of your financial statements if your accounting staff can’t record the transactions within your own companies correctly?”
Cash: Let’s imagine the owner of a parent company wire transfers $100,000 to a related entities bank account. Will the parent company’s staff have what it takes to ask the owner why the transfer was made? Will the company’s staff assume this is an intercompany loan, a payment on some kind of debt or a permanent creation of equity between the two entities? Even worse, how will the owner of the parent company know that that specific transaction is recorded properly for income tax purposes when the tax CPA prepares tax returns for the two entities?
Sales: Let’s assume the parent company (Company A) had sales of $10,000,000 during a specific period of time. Let’s assume the parent company owns 100% of the stock of a related entity (Company B) and that $1,000,000 of the $10M sales of Company A’s sales were to Company B. What amount of sales is Company A going to report to its banker? Will it report sales of $10M or $9M? Which is the correct amount and how will the $1M of intercompany sales be reported on the consolidating or consolidated financial statements of Company A and Company B?
It’s complicated: The above examples (Expenses, COGS, Accounts Payable, Staff, Cash, Sales) are a just few of the complexities of intercompany transactions with related parties (a parent company and its subsidiaries or related entities). These complexities become even more compounded with the topics of intercompany eliminations, proper income tax reporting, proper sales or use tax reporting, etc. Simply stated, the joys of creating subsidiary companies and/or investing in related entities may become nightmares unless strategic planning is made to solve the complexities of such relationships. An owner may not want to assume that its existing accounting and operational staff have sufficient experience to properly handle these complexities.
Loan covenants: Most bankers place restrictive financial loan covenants in the loans that are given to a company. Someone in the company needs to be aware of these covenants. These covenants should be monitored monthly in order for the owner to be made aware if a loan covenant has been violated or is close to being violated. Immediate action should be considered if loan covenant compliance is in danger.
Bankers: Bankers have a right to receive financial statements that are timely and accurate. They are usually sufficiently trained to read and understand consolidating or consolidated financial statements between a parent company and its subsidiaries or related entities. Bankers should not be expected to readily accept a “surprise,” such as a parent company having a good income statement but material losses in subsidiary companies. Bankers should not be expected to readily accept significant amounts of cash to be transferred from a parent company to a subsidiary company. Strategic planning on proper communication with bankers and lenders is paramount regarding this subject.
Tax basis: There is an almost hidden issue between a parent company and related entities on the subject of income tax reporting. This issue sometimes causes significant pain to owners of privately-held companies. Subsidiary companies are sometimes “start-ups” that incur income statement losses during the first few years. Owners of parent companies often do not mind a loss in a subsidiary company because they feel the loss will be combined with profits of other companies when income tax returns are created. Some owners are unpleasantly surprised that certain losses in subsidiary companies can’t be used to offset income of other companies due to a general rule that is referred to as “basis.” This issue of “basis” can often be solved if financial information is timely and the owner, management and independent tax CPAs are given time for planning before an opportunity is lost.