Spotlight Trained on Intercompany Accounting

Regulators are turning up the heat on the historically lax process of accounting for transactions between related legal entities.
David McCannAugust 31, 2016
Spotlight Trained on Intercompany Accounting

The days of lax accounting for intercompany transactions — those between separate legal entities under a single corporate umbrella — appear to be running out.

Several new and pending regulatory initiatives promise to create more standardization for how companies perform intercompany accounting (ICA) and force them to perform ICA on a timely and consistent basis. To date, the laxity in this area of accounting has created inefficiency, financial exposures, and reporting risk, according to Deloitte Advisory.

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The primary role of ICA is to make sure legal entities don’t show profits or losses on intercompany transactions that flow up into the parent company’s consolidated financial statements, thereby making them inaccurate. All such transactions are supposed to be netted out pre-consolidation; accountants call the process “elimination.”

But the potential for financial statement inaccuracies is significant, considering the massive number of intercompany transactions that must be recorded, tracked, and settled by companies with multiple subsidiaries or other independent affiliates.

“The sheer volume of transactions between these legal entities is many, many times what takes place with third parties like customers and vendors,” says Tom Toppen, a managing director with Deloitte Advisory.

Much of the attention governments around the world are now paying to intercompany transactions has flowed from increased tax-inversion activity in recent years, Toppen notes. In a tax inversion, a corporation relocates its legal domicile to a lower-tax nation, usually while retaining its operations in its higher-tax country of origin, in order to shift profits to the more favorable tax environment.

The Base Erosion and Profit Shifting (BEPS) initiative of the Organisation for Economic Co-Operation and Development (OECD), which is designed to ensure that corporations pay their fair share of taxes, “is starting to part the clouds,” Toppen says.

The OECD itself has no jurisdiction over companies. But its 35 member countries — which include a majority of the world’s major economic powers — and approximately 70 other OECD affiliate countries that are organizing their own BEPS regimes, do have such jurisdiction.

Progress on the OECD initiative, which was launched in 2012, has proceeded slowly but is picking up steam. That is pressuring companies to clean up their ICA. A significant section of the BEPS plan calls for country-by-country reporting, which means that a company must be able to report in isolation all of its business activities within a country, including intercompany transactions. To support these requirements, intercompany accounting processes must be clean, accurate, and reliable, according to Deloitte.

Also, in 2014, the U.S. Public Company Accounting Oversight Board released Auditing Standard 18, applicable to fiscal years that began after Dec. 14 of that year. The standard set requirements for auditors’ evaluations of how companies identify, account for, and disclose relationships and transactions between related parties.

The standard “has put more onus on the audit community to spend more time looking at intercompany transactions,” says Toppen.

Perhaps most significant, for U.S. companies, are regulations proposed by the Treasury Department and the IRS that would require companies to change how they approach intercompany financing and cash management. The regulations are intended to limit “earnings stripping,” or using cross-border debt to reduce U.S. income taxes.

The regulations would recast debt financings as equity if issued as part of, or within a 72-month time period surrounding, certain intercompany transactions.

Additionally, the regulations, proposed under Section 385 of the Internal Revenue Code, would allow the IRS to bifurcate related-party debt into debt and equity. The regulations also would impose strict documentation requirements on certain related-party debt instruments.

The regulations could become effective before year-end and would apply retroactively to intercompany financing instruments issued after April 5, 2016.

Cross-Functional Cooperation

To improve their ICA processes, companies should create a multifunctional team to oversee it, given that accounting, tax, and treasury all must be involved, according to Deloitte.

However, in a poll of 3,800 accounting, finance, and other corporate professionals that participated in a recent Deloitte webcast, only 24.4% said that such a multifunctional team leads ICA at their organization. More than half, 55.7%, said the accounting function runs ICA.

Even fewer of those polled said their ICA processes are in fine shape. More than a quarter of them (25.6%) said their company’s ICA framework is “developing — it’s a goal we want to achieve, but we have yet to standardize our governance.” Slightly more than 4 in 10 (42.5%) said their framework is “defined — aims to achieve consistency in intercompany accounting, but we’re still working on it.”

Only 9.2% of poll participants characterized their ICA framework as “leading — provides a holistic perspective, with efficient systems and communications across critical functions.”

AUg2016_IntercompanyMeanwhile, there are several key challenges in the implementation of a strong ICA framework (see chart; click on it to make it larger). Chief among them is the presence of disparate software systems among a company’s portfolio of legal entities.

“If the ERP used by one legal entity is different from the one used by another, ensuring that when the two entities trade inventory, say, the transaction is properly recorded on both sets of books is a very big challenge around ICA,” Toppen says. “When that’s not the case, the dominos start to fall. For example, you could run into foreign exchange issues.”

At least, forced by the regulatory environment, companies are starting to make progress with ICA. “I’m a former auditor,” says Toppen, “and traditionally you would look at these transactions and just cross your fingers that at the end of the day everything would net out.”