Are intercompany transactions in scope? 2540



  • Should controls surrounding intercompany sales/purchase be included in the SOX testing efforts? Or would an overall control of a reconciliation/elimination process satisfy that objective?



  • In principle controls concerning intercompany transactions that impact the financial statements of the individual group companies are in scope. Since the assessment of the effectiveness of internal control over financial reporting and the external auditor’s audit are risk based you need to consider:

    1. the magnitude of the impact of the intercompany transactions compared to the consolidated numbers (i.e. without eliminations for intercompany trandsactions).
    2. the inherent risk of errors in intercompany transactions and the risk that the controls surrounding intercompany transactions fail
      In many companies there is a separate ERP system where the daily transactions occurr and where the individual group companies produce their financial statements and a separate consolidation system that produces the consolidated financial statements. The two systems may have an interface or upload capabilities or may work based on manual data entry. Typically the intercompany transactions in the ERP system need to be identified so that they can be separately entered in the consolidation system for later elimination.
      Unless you work for a company that does frequent acquisitions of new subsidiaries or that frequently sells subsidiaries, you will have a pretty stable environment with a relatively fixed number of intercompany vendors and intercompany customers. This lends itself to a baseline audit approach.
      You will have the usual recociliation issues related to time-lags with intercompany transactions, such as a good already shipped by the vendor, but not yet received by the customer or payments of invoices already made by the customer but not yet received by the vendor. Some consolidation systems handle this by requiring one side of the intercompany transaction to not enter the transaction as an intercompany transaction and automatically creating a mirroring entry through the other intercompany transaction party’s transaction.
      In my personal opinion, intercompany transactions are rather of a lower risk and can be handled by a baseline audit and then only checking for new acquisitions and divestitures. On the other hand, the valuation of newly acquired assets and of goodwill and related impairment tests is more complex and risky.


  • Am I missing the point here because I don’t understand terminology? I thought intercompany transactions were internal transactions between different business units of the same company. Therefore upon consolidation they net off to zero. Thus I would have thought that the only control I would look for is someone ensuring that they do net off to zero.
    So where is my understanding flawed?



  • It is not always that intercompany transactions will be fully knocked off on consolidation. In a manufacturing setup, where a sale made by a company to its parent/ subsidiary and the item sold continues to be in the inventory of receiving organization, there is certain amount of unrealized gain that will be booked in the selling organizations book.
    There will be an overstatement of profit and inventory in the above scenario and hence an impact on the financial statements.
    The above is just an example. As rightly mentioned earlier, a risk and impact based approach needs to be adopted before considering/ not considering intercompany transactions



  • WrightLot,
    The controls should ensure that all intercompany transactions are entered as intercompany transactions and that no third-party transactions are erroneously entered as intercompany transactions. Otherwise the consolidation eliminations of the ‘flagged’ intercompany transactions are not correct and sales, receivables and profit may be over- or understated. Incorrect prices (or other valuation issues) should be no problem if the transaction is correctly entered as an intercompany transaction because the elimination during consolidation will take out the value on both ends of the flagged interco transactions anyhow.
    The example provided with an intercompany sale where the receiving group company keeps the item in inventory and has not sold it on to a third party at the period end is not quite correct. When the vendor finishes manufacturing of the item, the vendor already debits finished goods inventory and credits changes in inventory of finished goods (at full or a standard cost). The intercompany sale (i.e. delivery with debit changes in inventory of finished goods and credit of inventory and debit interco receivables and credit interco sales revenue and the corresponding entries on the interco cumstomer end) gets fully eliminated. There is no profit realization since finished goods are typically valued at full or standard cost and the same would happen if there would be no intercompany sale and they would just be produced and put into the inventory.



  • I’ll add that IC transactions can also impact reportable business segments results such that your segment footnote could be incorrect if the IC entries are not properly recorded.
    I have also seen where companies will just hang up any IC out of balance in other accrued liabilities in order to eliminate any timing differences when consolidating results. This could easily lead to misstatements either on the balance sheet or income statement.
    We have multiple entities with differing period reporting dates. This means that we always have timing differences in our IC balances that need to be identified and properly recorded in our consolidation process.



  • Thanks KY/gmerkl, I was not aware of that. All the companies that I have worked with intercompany balances have been out of scope because the netted off to zero on consolidation. The nearest I came to it was for a financial services industry where different companies could be set up as with profit or unit linked so movements between them would have an impact on the P-and-L. In truth in these companies the intercompany transactions were really journals moving items around rather than actual business transactions.



  • WrightLot,
    The example provided with an intercompany sale where the receiving group company keeps the item in inventory and has not sold it on to a third party at the period end is not quite correct. When the vendor finishes manufacturing of the item, the vendor already debits finished goods inventory and credits changes in inventory of finished goods (at full or a standard cost). The intercompany sale (i.e. delivery with debit changes in inventory of finished goods and credit of inventory and debit interco receivables and credit interco sales revenue and the corresponding entries on the interco cumstomer end) gets fully eliminated. There is no profit realization since finished goods are typically valued at full or standard cost and the same would happen if there would be no intercompany sale and they would just be produced and put into the inventory.
    What about the margin that is booked in the selling company’s books? If an item of 10 USD is sold to intercompany at 12USD, it becomes inventory in buying company’s books are 12USD( which maybe the full or standard cost for buying company) with a margin of 2USD in selling company and an inventory over-valuation of 2USD in receiving company’s books? Since one item is in P-and-L and other in B/S, unless appropriate entries are passed in either books, the numbers will remain overstated…
    isnt this a possible scenario/ reason by IC transactions should be under scrutiny?



  • NC,
    ‘It is not always that intercompany transactions will be fully knocked off on consolidation. In a manufacturing setup, where a sale made by a company to its parent/ subsidiary and the item sold continues to be in the inventory of receiving organization, there is certain amount of unrealized gain that will be booked in the selling organizations book. There will be an overstatement of profit and inventory in the above scenario and hence an impact on the financial statements.’
    If the intercompany delivery and invoicing are correctly entered as intercompany transactions and if the consolidation system is correctly set up it will eliminate both the receipt of the delivery (debit inventory credit invoices to be received) and the receipt of the invoice (debit invoices to be received credit interco payables) on the receiving group comany’s end in addition to eliminating the corresponding entries on the selling group company’s end. After the consolidation eliminations there is nothing in the receiving company’s inventory and it does not have a profit. Neither does the selling company have any revenues or receivables and thus no profit from the interco transaction.
    You only have an issue if the interco transactions have not been entered as interco and have been posted to a wrong third party vendor or customer.


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