:Consolidated Financial Statements - Intercompany Transfers

Intercompany transfers are transactions that occur between two different units of same organization. Transactions that flow from parent to the subsidiary is are known as downstream transfers, whereas transactions that flow from subsidiary to the parent are known as upstream transfers (Jacobides & Winter, 2005).

When some item is sold to subsidiary by the parent then it is downstream transfer and in this case profit is charged to parent due to its elimination on downstream sales. This type of transfer is known as downstream transfer as the direction of flow of transaction is from upward to downward that is from parent to subsidiary. In such case, removal of 100% unrealized profit from consolidated net income is done. In case of downstream transfers, non-controlling interest is not affected. When some item is sold to parent by the subsidiary, then it is upstream transfer and at the time of elimination of profit, it is charged to the subsidiary. This type of transfer is known as upstream transfer, as the direction of flow of transaction is from downward to upward that is from subsidiary to parent. In case of upstream transfer, non-controlling interest is affected. Some portion of unrealized profit is issues to the NCI and ultimately remainder is received by the parent (Mills & Plesko, 2003).

In a downstream transfer, transaction and any profit or loss resulting from it is recorded by parent. So, only shareholders of parent unit can see this profit or loss and these are not visible to minority interests.

Upstream and downstream transfers can occur due to different reasons. Normally, these transactions occur due to the existence of relationships between various units of a firm. The units can be parent and a subsidiary, two different subsidiaries, divisions or departments of an organization. These transfers are mainly used in case of vertically integrated organizations. Moreover, these can be used for transferring plant asset from one unit to other for taking benefits of changing demand across product lines. Upstream and downstream transfers occur in order to save cost. The business units instead of purchasing items from outside sources prefer getting assets or any other related item from other units.

Upstream and downstream transactions are required to be adjusted in consolidated financial statements for showing their effect on consolidate entity rather than its effect on parent or subsidiary solely. Consolidated financial statements show combined effect of upstream and downstream transactions. It is important to understand ways of recording intercompany transfers in each journal entry and the effect of transaction on entity for determining ways of adjusting intercompany transactions in consolidated financial statements (Hartgraves & Benston, 2002).

Advantages & Disadvantages

There are different advantages and disadvantages of upstream and downstream transfers.

Advantages of Upstream Transfers

• In case of upstream transfers, intercompany revenue arising from the transaction is eliminated.
• The upstream transfers result in elimination of intercompany expenses.
• Due to upstream transfers intercompany payables are eliminated.
• The contribution is shared among units.

Disadvantages of Upstream Transfers

• The parent unit has to pay management fee.

Advantages of Downstream Transfers

• The original cost of asset is restored.
• In case of downstream transfers, parent company gains interest income.

Disadvantages of Downstream Transfers

• Depreciation is calculated on original cost, so reduces net profit.
• The subsidiary has to pay high cost of sales, so gross profit is reduced.
• The subsidiary has to pay high expense.

References

Hartgraves, A. L., & Benston, G. J. (2002). The evolving accounting standards for special purpose entities and consolidations. Accounting Horizons, 16(3), 245-258.

Jacobides, M. G., & Winter, S. G. (2005). The co?evolution of capabilities and transaction costs: Explaining the institutional structure of production. Strategic Management Journal, 26(5), 395-413.

Mills, L. F., & Plesko, G. A. (2003). Bridging the reporting gap: A proposal for more informative reconciling of book and tax income. National Tax Journal, 865-893.