One kind of intercompany item needs further consideration. A corporation may, as the holder of the notes of an allied company, have had those notes discounted. On the maker’s books the notes appear as a liability. On the holder’s books, after discount, the notes will be shown as a contingent asset offset by a contingent liability of equal amount. Upon consolidation of all the balance sheets, neither the contingent asset nor liability will appear, being canceled against each other, but the full liability as maker of the notes must be shown; for now that the notes have passed into possession of an outsider, the bank, the liability is no longer an intercompany liability but one for which the consolidated interests are fully liable.
Reconcilement of Current Accounts
Previous to the consolidation of the balance sheets, it is possible that some of the intercompany accounts may need reconciliation just as any other current accounts. For instance, Company A may have shipped goods to Company B and have charged B’s account, but A’s account on B’s records may not yet have been credited because the goods have not yet been received. All items in transit will require reconciliation. These are all intercompany transactions which will be eliminated upon consolidation; but to make exact cancellation possible, the intercompany current accounts on the books of the various companies must be reconciled.
Valuation of Inventory
The problem of the valuation of the stock-in-trade inventory on the consolidated balance sheet is perhaps the most troublesome. The situation with regard to inventories of stock-in-trade is often complicated by the fact that the same raw material or partly finished material may pass through the hands of several companies each doing certain processes upon it. The process of manufacture may not be completed until the goods are turned over ultimately to the holding company for sale and final distribution to the consumer. This—or other possible variations of the procedure—is usually the situation so far as stock-in-trade is concerned. Inasmuch as the various subsidiaries are independent corporate organizations, the price at which they transfer their product to the allied subsidiaries is not cost price but a sale price determined, perhaps not by market conditions, but rather by some fixed policy set by the holding company; although it frequently happens that market price is the price at which the partially completed product is turned over to allied subsidiaries. However determined, the price includes an element of profit which from the standpoint of the holding company is not a realized profit until the goods are finally disposed of to the outside consumer. Were the manufacture carried out by a single corporate organization, the product, as it passed through its various stages of manufacture, would be charged into each succeeding stage at the costs accumulated during preceding stages, and the element of profit would not need to be considered until the product was ultimately sold by the holding company.
Thus, the valuation at which the inventory of stock-in-trade is carried on the books of the various subsidiaries is often inflated by the profit in each case, so that by the time the product reaches the holding company it may carry a very large element of unrealized profit. While from the standpoint of each subsidiary company the act of transfer has been legally a sale and therefore the seller is entitled to a profit on the sale, without which there would be no element of profit appearing in the operations of each subsidiary company at any time, from the standpoint of the holding company such transactions are in no sense sales, but are simple transfers from one process or stage of manufacture to another.
In order to show the true condition as to the value of the inventory of stock-in-trade on the consolidated balance sheet, it becomes necessary to eliminate these intercompany items of profit loaded onto the goods at the time of transfer between companies. The figure at which the value of the consolidated inventories will appear in the consolidated balance sheet should represent the actual cost figure, as if the entire process of manufacture were carried on under one corporate organization. The corresponding offset to this reduction in value of the consolidated inventories will appear as a reduction in the surplus as shown on the consolidated balance sheet.
This principle of inventory valuation should always be applied to the full in the case where the holding company is the complete owner of all its subsidiaries. It cannot, however, be too rigorously lived up to under conditions where the holding company may not have absolute control over the policies of the subsidiary companies. It may sometimes even be modified by the fact that the product as turned over by one company to another is in such stage of completion that there is a ready market for it outside that of the allied subsidiaries. The accountant is, however, treading on somewhat uncertain ground when he attempts to incorporate any element of profit in the consolidated inventory. Conservative management as adopted by some of our largest corporations eliminates all elements of profit, and that should be the standard practice. Only under unusual circumstances and after a very careful consideration of all the conditions should the consolidated inventory be carried at any other valuation than that of full manufacturing cost.
Reserve for Intercompany Profits
In eliminating intercompany profits from the valuation of the inventory, use is sometimes made of a Reserve for Intercompany Profits account. The reserve is created by a charge against Surplus. The inflated valuation of the inventory is allowed to stand but it is offset by this reserve in sufficient amount to reduce its value to a cost basis.