Eliminating Entries

When a parent company and one or more subsidiaries are consolidated into a single set of financial statements, each entity's individual accounts are first combined by simply adding them together line by line. That combined figure, however, includes any transactions the entities conducted with each other, a parent selling inventory to a subsidiary, a subsidiary lending money to the parent, one subsidiary paying a management fee to another, none of which represents a transaction with an outside party.

Eliminating entries strip these internal transactions out so the consolidated statements show only the group's dealings with genuinely external customers, suppliers and lenders. The most common categories of eliminating entries cover intercompany sales and purchases, where revenue recorded by the selling entity and the matching cost recorded by the buying entity are both removed, since from the group's perspective no external sale occurred; intercompany receivables and payables, where a loan from parent to subsidiary appears as an asset on one entity's books and a liability on the other's, and both must be eliminated since the group cannot owe money to itself; intercompany dividends, where a subsidiary's dividend paid to the parent is eliminated because it is simply cash moving within the group, not income earned from an outside party; and unrealised intercompany profit in inventory, the more complex case where a subsidiary has not yet resold, to an outside customer, inventory it purchased from another group entity at a marked-up intercompany price.

Unrealised intercompany profit is the trickiest elimination in practice. If a subsidiary buys inventory from its parent at a price that includes the parent's normal profit margin, and the subsidiary has not yet sold that inventory to an external customer by the reporting date, the group's consolidated inventory value and consolidated profit are both overstated unless the unrealised portion of that intercompany profit is eliminated.

The elimination is reversed in the following period once the inventory is sold externally, so the profit is recognised by the group only when it is genuinely earned from an outside party, which can require careful tracking of intercompany inventory balances period over period. Eliminating entries are also required for gains or losses on intercompany asset sales, such as one subsidiary selling equipment to another at a price different from its book value, where any gain or loss recorded is unrealised from the group's perspective until the asset is eventually used up, depreciated, or sold outside the group, and for intercompany interest income and expense, where a loan between group entities generates interest income for the lending entity and interest expense for the borrowing entity that must both be removed since the group has not paid or received interest from an external party.

Getting eliminating entries wrong, or missing them entirely, is a well-known source of overstated consolidated revenue and profit, which is why auditors pay particular attention to intercompany transaction schedules and reconciliations during a group audit, and why groups with significant intercompany activity typically maintain a dedicated intercompany reconciliation process to ensure balances between entities agree before consolidation.