Question

In the case of human relations, marriages occur frequently. Once the business combination occurs, the assets and liabilities of the company become one. This is the same when a parent company buys a subsidiary corporation. You have noticed in your reading that intercompany transfers must be adjusted. With this in mind, please answer the following questions: • Why are adjustments necessary for intercompany transfers? • What are some ways the financials would be misstated if these intercompany transfers were not adjusted? • Provide an example on how a firm could manipulate the firm’s financial position and how these intercompany entries fix this problem.

Answer 1

Why are adjustments necessary for intercompany transfers?

Answer: The purpose of consolidated financial statements is to present a tue and fair view of the parent entity as a whole to its creditors and shareholderrs. Intercompany transactions include hidden profits made by virtue of transactions between the group companies and such profits are not realised as they are transactions between the same persons.

What are some ways the financials would be misstated if these intercomany transfers were not adjusted?

In case of ntercompany transfer of inventory i.e inter company sale purchase transactions the inventory sould be transferred at arms length price or else it might represent inflated sales of one company and thus reflect high turnover whereas for the purchasing company the purchase cost would be inflated resulting into a decline in profits.

If the stocks so purchased via inter company transfers remains unsold in the hands of purchasing company then it might lead to inflation in closing inventory and hence the amount of inventories as reflected in the balance sheet would also be inflated.

Similarly the figures representing debtors aand creditors would increase while in reality those debtors might not be realised and the creditors might not be paid as group companies would not actually transfer money to each other on account of such transactions as they are mere adjustment entries.

Provide an example on how a firm could manipulate the firms financial position and how these intercompany entries fix this problem.

Answer: A firm might ask its group company to make sales to it at an inflated price so that it could show inflated purchases and then reduce its profits in order to avoid tax. Similarly, in order to improve its currrent ratio, a company might use the same technique and purchase inventory at a higher price from group company to show huge increase in current assets and improved current ratio. A company might avail a loan from its group company at high interest rates in order to avail higher deduction of interest expense to reduce profits and evade taxes. Thus all the intercompany transactions should be remeasured at an amount equivalent to arms length price in order to escape all sorts of manipulations.