Question

Our accountant has informed me that we need to eliminate the intra-group transactions before we prepare the consolidated financial statements. I don’t understand why we need to record these transactions in the first place, when we end up eliminating them. I don’t have an accounting background, but it makes sense not to record these transactions in any books when we end up deleting them in the worksheet later?

Answer 1

In accounting, we have legal entity concept that states the company as a distinct and separate entity from its owners. Thus both the holding company as well as their subsidiary companies have got their own separate legal entities and hence are required to prepare their own financial statements for every accounting period. Such statements are commonly referred to as 'Standalone financial statements'. While the companies prepare these statements, every transaction regardless of whether they had happened between related entities or not, shall be recorded as though happened with totally unrelated outside entity. Thus, the subsidiary reports its transactions with the parents and parent report its transaction with subsidiary.

Meanwhile, the statutory accounting reporting framework requires the holding or parent company to report it's consolidated financial position for the year in its annual report. This report shall follow the stand alone statements within the annual report. For this purpose, we consolidate the financial statements by making adjustments to eliminate inter company transactions.

Not recording transactions in the first place is contrary to the legal entity concept. Not eliminating inter-company transcations in the second place is contrary to the consolidation concept. Thus both will result in misstatements making financial statements to be untrue and incorrect.