Accounting for Intercompany Transactions

What accounting for intercompany transactions is, and why it matters

Accounting for intercompany transactions is the bookkeeping for transactions between entities under common control: a parent and its subsidiary, or two subsidiaries of the same group. Every intercompany transaction is recorded twice, once on each entity's books, and the two entries must mirror each other. A sale on one side is a purchase on the other, a receivable on one side is a payable on the other.

It matters for three reasons. First, transfer pricing: the price charged between related parties has to be arm's length, and the accounting is where that price actually lands in each entity's income and tax base. Second, consolidation: when the group reports as a single economic entity, all of these intra-group amounts have to be eliminated, because a group cannot recognize profit or revenue from selling to itself. Third, audit and tax defense: clean, reconciled intercompany balances are one of the first things an auditor or a tax authority tests, and unreconciled differences are a common source of adjustments.

The structure in our example

The US parent (USP) is the principal. It owns the intellectual property and the brand, decides what to make, owns the finished inventory, sells to third-party customers, and bears the market risk (will the goods sell, and at what price). The Canadian subsidiary (CanCo) is a contract manufacturer. It makes the product to USP's specification, sells its entire output to USP, and carries very little risk. Because CanCo is a limited-risk manufacturer, it should earn a modest but reliable return, while the upside and the downside sit with the principal.

Choosing the transfer pricing method

For a routine contract manufacturer, the usual method is a cost-plus approach, tested under the transactional net margin method (TNMM) using a net cost-plus markup. The idea is simple: CanCo recovers all of its manufacturing costs and earns an agreed markup on top. The markup is benchmarked against what independent contract manufacturers earn, typically a single-digit percentage of total cost. We will use 8% on fully loaded manufacturing cost.

On CAD 1,000,000 of fully loaded cost (materials, direct labor, and manufacturing overhead), an 8% markup is CAD 80,000, so the intercompany price CanCo charges USP is CAD 1,080,000. That CAD 80,000 is CanCo's routine operating profit. Everything USP earns above its own costs when it sells to the end customer is the residual, the reward for owning the IP and bearing the market risk.

A note on currency, and who bears the FX risk

CanCo's functional currency is the Canadian dollar; USP's is the US dollar. A deliberate design choice follows from CanCo being limited-risk: the intercompany invoice is denominated in CAD, CanCo's own currency. That way CanCo has no foreign-currency exposure on the receivable, and the transactional FX risk sits with USP, the entity that is supposed to bear risk. USP records a CAD-denominated payable and remeasures it into USD at each reporting date, taking any gain or loss to its income statement.

We will use 1.35 CAD per USD on the invoice date and 1.40 CAD per USD at period end (the Canadian dollar weakens). At 1.35, CAD 1,080,000 is USD 800,000. At 1.40, the same CAD 1,080,000 payable is only USD 771,429, so USP's liability shrinks in USD terms and it books an FX gain of USD 28,571.

Journal entries on CanCo's books (CAD)

CanCo accumulates its manufacturing costs in inventory as it produces, then recognizes the intercompany sale to USP. Because the receivable is in CAD, CanCo's functional currency, there is no FX entry.

Result on CanCo: revenue 1,080,000, COGS 1,000,000, operating profit 80,000, exactly the 8% cost-plus return. CanCo also holds an intercompany receivable of CAD 1,080,000.

Journal entries on USP's books (USD)

USP records the purchase as inventory and a CAD-denominated payable, translated at the spot rate on the date of the transaction. At period end it remeasures the payable, and when it sells to the end customer it recognizes external revenue and relieves inventory.

Result on USP (assuming all goods are sold): external revenue 1,000,000, COGS 800,000, gross profit 200,000, plus a 28,571 FX gain. After remeasurement the CAD payable is USD 771,429, the same figure CanCo's CAD receivable translates to at the closing rate, so the two balances agree.

Eliminating the intercompany amounts on consolidation

The group reports in USD. CanCo's CAD statements are translated into USD (income at the average rate, balance sheet at the closing rate, with the difference going to a cumulative translation adjustment in equity). On consolidation, the intra-group amounts have to come out so the group does not double-count revenue or show a balance it owes to itself.

Entry A is shown at the USD-translated amount of the intra-group sale; the two legs are equal and opposite, so consolidated revenue and consolidated COGS each drop by the same amount and group profit is unaffected. Entry B removes the mirror receivable and payable. What remains in the consolidated accounts is exactly the real economics: USD 1,000,000 of external revenue, the group's true production cost, CanCo's routine profit, and USP's residual.

The piece people miss: unrealized profit in ending inventory

The eliminations above assume USP sold everything to outside customers. Suppose instead that USP still holds 25% of the goods in inventory at period end. CanCo has already booked its full CAD 80,000 markup, but from the group's point of view, 25% of that profit has not been earned yet because the goods have not left the group. That portion of profit is sitting inside USP's inventory and must be removed until the goods are sold externally.

This writes the unsold inventory back down to the group's cost of producing it and defers CAD 20,000 of profit. When USP sells those goods next period, the entry reverses and the profit is recognized by the group. The figure is computed in CAD (the currency of the profit) and translated into USD for the consolidation.

Practical pointers

Keep CanCo's actual margin on target. Costs move during the year, so the realized markup drifts away from 8%. Most groups run a true-up at quarter or year end, an additional intercompany invoice or credit that pulls CanCo's net margin back to the benchmarked return. Book the true-up to intercompany revenue, not to a non-operating account, so it lands in the tested margin.

Reconcile both sides every period. The intercompany receivable on CanCo and the payable on USP should agree after translation; chase any difference before it compounds. Settle the balances on a regular cadence so they do not build into something that looks like disguised financing. Denominate the invoice deliberately, since the currency you choose decides which entity carries the FX, and that choice should match where you intend the risk (and reward) to sit. Finally, make sure the legal agreement, the invoices, and the accounting all tell the same story; that consistency is what makes the position defensible.

This guide is for educational purposes and uses simplified figures. It is not accounting, tax, or legal advice. Real engagements involve specific facts, local GAAP or IFRS rules, and benchmarking that should be reviewed with your advisors.