- A manufacturing company faces a federal grand-jury investigation in the US involving intercompany cash transfers related to its tax planning.
- An insurance company is forced to restate financial results stemming from its failure to eliminate certain intercompany transactions related to variable interest entities.
- Insiders succeed in fraudulently overstating inventory because the company has weak internal controls over related-party transactions. The US Securities and Exchange Commission imposes a fine – and shareholders lodge two lawsuits.
- Improper intercompany accounting forces an oil company to restate its financial statements. Irate investors charge that it misled them about the effectiveness of its internal controls and hale the company to court.
These are real-life cases recounted in a Deloitte report, Cleaning Up Under the Bed: Why Intercompany Accounting Is Increasing Corporate Risk. They happened in the US, but could easily occur in Asia Pacific – and in any case, some of them probably involved business units and subsidiaries in this region.
“More and more companies are running into serious problems that have real financial costs as a result of improper or insufficient intercompany accounting practices”
For companies in Asia, the issue of intercompany accounting could come to the fore pretty quickly. Tax jurisdictions across the region have begun to adopt the finalized Base Erosion and Profit Shifting (BEPS) Action Plan under the auspices of the OECD and G20 countries, which include China, India, Indonesia and Japan.
China, India and Singapore will require country-by-country reporting next year, while Hong Kong will begin automatic information exchanges with other jurisdictions by end 2018. Asian companies with group revenues of around US$820 million should expect their intercompany accounting, among other things, scrutinized more closely by various tax authorities soon after.
“More and more companies are running into serious problems that have real financial costs as a result of improper or insufficient intercompany accounting practices,” writes Deloitte. “The reasons range from increased industry consolidation to growing globalization and integrated supply chains.”
It is time to address the issue – in Deloitte’s colorful words, to “clean up under the bed.” But how?
As consultants are wont to do, Deloitte recommends a sweeping solution. “What companies need,” it says, “is a holistic and preventive approach in which the primary stakeholders— accounting, tax, and treasury—work hand in hand to create a vision for the future that streamlines [intercompany accounting], from governance to reporting.”
To be fair, though, the proposed solution is sweeping because the problem could be broad and sweeping, too. After all, intercompany accounting extends beyond accounting and finance.
For example, finance may reach the financial-reporting goal of eliminating (to within a specific threshold) intercompany AR and AP transactions from the books. But this does not always mean that that exceptions and misclassifications have been addressed.
Failing to make good on this non-accounting goal could have legal implications, particularly with regards to taxation, as the increasing number of intercompany-accounting-related lawsuits suggests.
And what if a full list of approved intercompany balances cannot be produced for settlement? From finance’s point of view, unresolved intercompany positions could be accounted for as unrealized profits (or losses) in the financial statements.
But for treasury, which manages the netting and settlement of intercompany trade invoices, among others, unresolved positions can have a significant impact on real cash outflows, intercompany financing, global liquidity and foreign exchange exposures.
Intercompany accounting framework
Deloitte’s suggestion of a holistic approach makes sense in this context. “Getting everyone working from the same playbook and equipping them to clean up the [intercompany accounting] mess calls for a single vision for the future,” it argues. “To describe that future, a company will first need a framework that provides a holistic perspective and incorporates every aspect of ICA, from governance to reporting.”
This framework will help the company visualize intercompany accounting as an “as an interconnected, interdependent, end-to-end process while breaking it down into manageable pieces,” Deloitte continues. “Then, to address each component of the process, a company needs an approach that embeds both leading practices and a roadmap for adopting them.”
The leading companies are leveraging on automation with regards to transaction-level matching, reconciliation, and elimination, including clearing of original balances post-settlement
The Deloitte framework breaks down the intercompany accounting process into seven components, representing the accounting, treasury, tax, legal and business considerations associated with the issue:
Governance and policies: When the scope of inter-company accounting is regional or global, as is usually the case, it is important to have standard policies that govern critical areas such as data and chart of accounts, transfer pricing and allocation methods.
Deloitte notes that some leading companies have created a Center of Excellence jointly overseen by accounting, tax and treasury that serves as a resource to address standardization and other intercompany accounting issues. They have also put in place trade and service agreements that define and communicate roles and responsibilities.
Intercompany pricing: Tax authorities and other regulators are likely to zoom in on intercompany pricing in their efforts to ensure companies are not abusing transfer pricing and related practices to illegally hide or reduce tax obligations.
Leading companies have integrated transaction-level pricing and analytics in this area, reports Deloitte, and adopted a global pricing policy. To make sure pricing is made at arms’ length, as required by regulators, the tax and finance functions “are tightly integrated” and work together to determine the appropriate pricing.
Data management: Again, Deloitte notes the move by some leading companies to establish a Center of Excellence to manage master data, presumably the same CoE that oversees standardization.
“There is an integrated transaction flow across platforms with common charts of accounts, supported by integrated reporting capabilities that meet tax, statutory, and finance requirements,” writes Deloitte. “Trading partners are clearly identified and controlled, allowing transactions to be isolated for eliminations and reporting.”
Transaction management: Best practice is to inventory and categorize intercompany accounting transactions by type, and to standardize workflow and procedures for efficient processing and reporting.
“Corporate allocations and centralized service charges follow standard methods and use standard calculation vehicles to ensure consistency and efficient processing,” continues Deloitte.
The accounting firm notes the use of technology in transactions between legal entities to enable approval routing and dispute resolution. “Finally, materiality is often used to rationalize transaction volume,” it adds.
Netting and settlement: To ensure effectiveness in the critical treasury tasks of netting and settlement, leading companies create a defined cash management strategy to guide multilateral settlement, Deloitte reports.
“Leading practices also include automated, dynamic settlement with clearing of originating transactions on the local ledgers, and a strategy that defines when settlements require cash transactions versus accounting entries.”
Reconciliation and elimination: As CFOs know, reconciliation and elimination are resource- and time-intensive processes for the accounting department, more so when internal controls are not adequate.
The leading companies, says Deloitte, are leveraging on automation with regards to transaction-level matching, reconciliation, and elimination, including clearing of original balances post-settlement.
Internal and external reporting: Automation is also a go-to solution for leading companies when it comes to reporting, says Deloitte, including integrated financial, tax, statutory and regulatory reporting and analytics.
“These systems also offer dashboard visibility into customized performance metrics that require minimal manual intervention,” notes Deloitte.
Automation and mistrust of manual intervention are threads that run across the framework. But technology that automates and integrates intercompany accounting processes is not enough, Deloitte concedes, because intercompany accounting “was never a core element” of the design of enterprise resource planning and financial management systems.
“Designing an approach that is cross-functional, assigns ownership and accountability, and is based on well-delineated processes is critical to the success of [intercompany accounting] initiatives,” Deloitte stresses.
CFOs may or may not agree. But with tax authorities from Indonesia to Japan cracking down on the aggressive tax planning practices of the Apples and Googles of the world, it is clear that finance needs to do something now to prepare for a more stringent, and possibly more adversarial, relationship with Asian governments tomorrow.