Accounting for transactions among related entities in a consolidated group is starting to carry some new risk, as regulatory authorities worldwide sharpen their focus on various aspects of intercompany cross-border activity.
Some companies are starting to discover they’ve lost track of important information by not having accounting processes that are aligned and consistent across different entities in a consolidated organization, says Kyle Cheney, a partner with Deloitte & Touche. He analogized it to the childhood habit of cleaning a bedroom room by stuffing everything under the bed. “Over the years, you start to lose things that are really important,” he says.
Driven by modern conventions of globalization and integrated supply chains, the volume of intercompany transactions for many multinational companies has become even greater than sales to third parties, says Cheney. It might include, for example, the transfer of goods and services among related entities in a group, hedging activities, intercompany lending, and other common liquidity management practices. He’s aware of companies where intercompany activity can be measured in the trillions of dollars. “It just dwarfs the revenue line, so there are risks that come from that,” he says.
On the financial reporting and auditing side, the Public Company Accounting Oversight Board and the Securities and Exchange Commission have brought plenty of heightened scrutiny to the completeness and accuracy of books and records over the past several years. On the tax side, U.S. tax authorities have already applied plenty of scrutiny to transfer pricing, or the pricing of those intercompany exchanges of goods and services to assure they are occurring at arm’s length pricing for tax purposes.
Now authorities in dozens of countries are asking for an even closer look at intercompany activity, inspired by concerns that companies are gaming tax rules to avoid tax liabilities. The Organisation for Economic Co-operation and Development’s Base Erosion and Profit Shifting project is inspiring numerous countries, including the United States, to adopt new regulations to make it more difficult for companies to dodge international tax on overseas earnings.
“If you haven’t looked under the bed in 20 years, you’re not sure what’s under there. It becomes frightening.”
Peter Bible, Chief Risk Officer, EisnerAmper
The U.S. Treasury’s proposed regulations to revise Section 385 of the Tax Code is perhaps the starkest example. Treasury is ramming new rules into the final weeks of the current presidential administration to make it exceedingly more difficult for companies to get tax-favored treatment on intercompany lending and even common corporate treasury tactics for managing liquidity. And it follows new rules on country-by-country reporting meant to help tax authorities sort out where companies generate their revenue.
The piling on, says Cheney, is beginning to expose holes or weak spots in intercompany accounting. “The risks are across the board, and a lot of companies are starting to recognize that,” he says. A recent Deloitte webcast poll revealed less than 10 percent of nearly 4,000 participants believed they had a good handle on intercompany accounting.
Peter Bible, chief risk officer for audit firm EisnerAmper and former chief accounting officer for General Motors, says the traditional focus for intercompany activity was simply to assure account balances across entities net out to zero. “Historically, it only became problematic if you tried to sell a company or subsidiary or put it into bankruptcy or reorganization,” he says.
Now that tax authorities are digging deeper, companies are finding problems. “If you haven’t looked under the bed in 20 years, you’re not sure what’s under there,” he says. “It becomes frightening.”
WHAT’S AFFECTED BY ICA
Below, Deloitte explains the three major functions impacted by intercompany accounting:
Accounting: The accounting function is focused on financial accounting and reporting. The primary risk of improper ICA for accounting is financial misstatements, which can impact the company’s reputation, stock price, and shareholder value. Weaknesses in internal controls may surface during an audit, particularly since the Public Company Accounting Oversight Board has revised and tightened AS 18, the standard covering auditing for related parties. Finally, insufficient ICA transparency and control provide the opportunity for misappropriation of assets, allowing unscrupulous professionals to hide assets flowing out of the organization to fictitious vendors or accounts.
Tax: The tax function focuses on the financial positions of individual legal entities. Transactions between countries are subject to specific tax laws. Misclassified profits between countries can result in tax penalties, interest, and reputational damage. Tax organizations of large multinationals have been particularly impacted by new requirements for country-by-country reporting in the European Union. This legislation, based on the guidelines from the Organisation for Economic Co-operation and Development’s Base Erosion and Profit Shifting project, stipulates that the ultimate parent entity of a multinational group set out global data by country for its fiscal year in a prescribed template, together with a list of entities by country of residence and an indication of their activities. The goal of these requirements is for companies to present financial statements that are transparent and well-governed for individual countries, allowing regulators to easily identify the standalone financials in each respective country. Intercompany discrepancies between in-country legal entities must be reconciled and remediated in order to support accurate country-by-country reporting.
Treasury: The treasury organization receives details of intercompany trade transactions and manages the netting and settlement of intercompany trade invoices. It also manages intercompany financing and global liquidity and foreign exchange (FX) exposures. When ICA is unable to deliver a full list of approved intercompany balances for settlement, a trade imbalance will persist, impacting intercompany liquidity. ICA in this case becomes not just a liquidity issue; it also impacts FX. Unresolved intercompany positions may cause unrealized gains and losses for accounting purposes, but real cash outflows from a tax perspective.
Good intercompany accounting is simply good bookkeeping, says Jim Burton, partner in charge of audit methodologies for Grant Thornton. He too, however, has seen the attitude that if the account balances net to zero, there should be no problem.
“Not a lot of time or attention is spent on regularly reconciling internal control accounting,” he says. Small variances may be regarded as immaterial, so unimportant to investigate. “The unrecognized items can grow to an amount that you can’t deal with in one month,” he says.
To be fair, there’s plenty of detail that goes into assuring one entity in a consolidated organization is recording a transaction in the same way as its counterpart so that the accounts ultimately will reconcile. The entries have to be booked differently for accounting purposes than for tax purposes because the rules are different, and they may be getting booked under more than one set of accounting rules if the organization is subject to both U.S. Generally Accepted Accounting Principles and International Financial Reporting Standards, says Chris Wright, managing director for consulting firm Protiviti.
Timing differences might also affect how entries are booked across entities, says Wright. “If a transaction involves funds flowing between entities, you might have a check sent by one entity by a cutoff date, but not received by the other by that same cutoff date,” he says. “And you could have foreign currency issues. It might be booked in dollars by one entity and in euros by another. All of those are pitfalls now, and they will be exacerbated by new rules.”
Paul DeCrane, a principal at EY who leads the global treasury services practice, says he sees companies taking a wait-and-see approach on the massive new U.S. Treasury proposal before mobilizing their own operations. “Companies should have a readiness approach to how this will be handled when the regulation goes live, and the assumption is it will go live,” he says.
The proposed regulations will require companies to set up lending operations almost to the level of an independent bank, says DeCrane, to determine and document appropriate loan pricing and payment tracking. It will represent not just a compliance exercise, but also a potential change operationally to how corporate treasuries function going forward, DeCrane says. Companies may decide to rethink how they manage liquidity under the new rules, he says.
The task will be daunting but not insurmountable, says Wright. “There are tools and techniques that can be used,” he says. “There are portals and repositories that can help document and preserve documentation.”
Cheney is advising companies to bring together a team consisting of corporate treasury, tax, and accounting to sort out where the consolidated entity may have exposures and determine how to address them. Decentralized companies with disparate systems are likely to face the biggest challenges, he says. Even companies that run on a single enterprise resource planning system are likely to have issues. “The first step is admitting you have a problem,” he says.