From the standpoint of management accounting, it's important to keep track of goods and funds that flow from one part of your company to another. However, for financial accounting, or reports prepared for external eyes such as bankers and tax agencies, these transactions are not relevant and need to be cleared from your books.
Intercompany accounting involves keeping track of intercompany accounts receivable and intracompany payables and then adjusting your journals so these entries don't show up in any external reporting.
TL;DR (Too Long; Didn't Read)
Intercompany payables are sums that are paid from one division of your business to another. For operational purposes, it is important to keep track of these exchanges, but external agencies don't consider them to be real transactions because no money has entered or left your business.
Types of Intercompany Payables
- Exchange of raw materials. If you run a bakery and your pastry department runs out of butter, it's much easier to get a few pounds from the line crew than to run to the store. However, doing so may confuse your cost accounting for the different departments unless you keep track of the fact that this ingredient has changed hands within your company. Your pastry department may not actually pay money to the kitchen crew for the butter, but the exchange should be logged and noted.
- Exchange of finished products. If your business operates two locations that carry the same products, you may run out of a specialty item at one storefront while you still have inventory at the other location. In some situations, it may make more sense for the depleted location to source the item from the location that still has it in stock rather than ordering a fresh batch from a distributor. The product may be selling better in one part of town than in another, so there isn't much need for the slower location to hold on to the items when the busier location needs them.
- Exchange of labor. Your business builds relationships with its employees and should be committed to giving them enough hours to survive. This is good business because it helps you to keep good people longer, and it's also simply the right thing to do. However, the demand for labor may fluctuate between different divisions of your company, so one branch may "lend" employees to another, and these intercompany exchanges should be recorded and treated as payables and receivables, at least for your internal accounting.
Intercompany Journal Entries
You can track your intercompany exchanges in whatever way makes the most sense for your business. There may be no money actually changing hands between two departments, but the division providing the goods would note a debit, and the section receiving them would record a credit.
Alternatively, your business may opt to actually transfer cash between two departments to offset a reallocation of products or personnel, and this exchange can appear on the books in much the same way as an external payable, at least for internal tracking purposes.
The most important thing to keep in mind when making these intracompany journal entries is that they are part of your internal records, but they should not enter into any of the reports that you provide for outside purposes, such as tax forms and loan applications.
You can use these numbers to understand how goods and funds are flowing between different parts of your operation, and they can also help you to fine tune your ordering and scheduling so these resources don't have to change hands internally in the future. However, they have little or no relevance to the question of whether your business has earned a profit overall.
In accounting, the term "reconciliation" usually refers to making sure that different parts of your accounting system match, such as ledgers and bank accounts. However, intercompany reconciliation isn't a process of balancing and adjusting books so the records from one part of your business match the records from another. Rather, this accounting chore involves cleaning up your books so the intercompany transactions you have added for internal purposes don't show up on the reports that you must submit externally.
It's easiest to sort through your records and remove the transactions that shouldn't be there if you set up your systems to flag these exchanges when you enter them the first time around. You can do this by creating separate categories or item listings for items and resources, such as personnel hours that are switched internally. If you have this degree of forethought when you set up your accounting system, it will be easy to capture and subtract intracompany accounts receivable and payables when the time comes to prepare external reports.
However, if you didn't foresee this need when you set up your bookkeeping system, you may need to do intracompany reconciliation manually, one transaction at a time. Of course, this will be more practical for a small company than for a large one. The more familiar your bookkeeper is with the logistics of your day-to-day operations, the easier it will be to find and flag the transactions that must be removed.
When departments or subsidiaries of your business exchange goods, services or labor, they may do so at cost, or they may add markups to these transactions. An exchange may be entered into your bookkeeping system at cost if your intracompany bookkeeping is straightforward and executed largely to develop an understanding of how resources are flowing within your business. Entering these transactions at cost can also be useful for cost accounting, allowing you to develop a sophisticated understanding of what each department is actually spending to create the goods and services it sells.
Intercompany transactions may include markups if your company sets and tracks metrics to evaluate how well different departments are performing. If the manufacturing arm of your business has invested the time and capital necessary to create viable products, it will look better on paper if it sells these products to an external firm with an added markup as opposed to exchanging the same product through an intracompany transaction that is recorded at cost.
It will be easier to reconcile intercompany accounts receivable and payables without added markups because these transactions show a more straightforward financial relationship between the goods and departments involved. However you handle intercompany markups, though, your processes and assumptions should be straightforward so you don't create extra work for yourself when it's time to reconcile.
Although intercompany accounting expresses and encapsulates something important about what is going on in your business, it also leaves you plenty of room to get in trouble if you don't make your entries honestly and accurately. If you're applying for a loan or trying to attract investors, your intercompany numbers are the easiest to inflate because the transactions they describe are valued and evaluated on terms that your company sets for itself. If your reconciliation process isn't thorough enough, you also run the risk of getting in trouble with tax agencies.
You can avoid many of these pitfalls by setting up solid systems from the outset. Be clear about why you are tracking and valuing transactions in the ways you choose to do so. Be transparent about your assumptions and meticulous about your bookkeeping, and your intercompany recording will be clear, useful and above board.