Ventana Research Analyst Perspectives

Reduce Risk and Improve Departmental Effectiveness with Intercompany Financial Management

Posted by Robert Kugel on May 24, 2021 3:00:00 AM

VR_2021_OOF_Assertion_4_Square (1) (1)Ventana Research defines intercompany financial management as a discipline for structuring and handling transactions within a corporation and between its legal entities. IFM is designed to maximize staff efficiency and accounting accuracy while optimizing tax exposure, minimizing tax leakage and ensuring consistent tax and regulatory compliance. Today, IFM is an obscure topic, but I assert that by 2025, one-half of organizations with 10,000 or more employees will have implemented intercompany financial management to achieve tax, risk-management and financial close benefits.

IFM issues arise because almost all midsize and larger corporations are made up of multiple legal entities – sometimes hundreds or even thousands. Legal entities are significant because they introduce tax and regulatory considerations into intercompany transactions.

From the outside, a corporation might look like a single thing, but the internal mechanics of creating, selling and delivering products and services often involve posting related accounting transactions in multiple parts of an organization. For example, several business units might produce various components or provide services for a corporation’s division that assembles these into a final product or service. Each business unit bills that final product division, and that final product or service division turns around and pays the component makers. When it comes to tallying up the bookkeeping to produce the parent corporation’s financial statements, all those intercompany transactions are supposed to cancel each other out. Usually, they do, but because each side of the transaction is recorded separately, it’s also common to find errors, slight discrepancies in volume and price, currency translation differences and other adjustments that have to be identified and then corrected. The process can be complicated if an intercompany transaction involves multiple legal entities buying and selling, especially if the transaction spans multiple countries, each with their own currency, tax regimes and legal jurisdictions.

And where these transactions cross national borders, multiple complications arise. The transactions may involve different currencies and be subject to a set of disparate import and export regulations as well as tariffs and taxes. When IFM is not managed properly in a cross-border transaction, value-added tax “leakage” can occur if one corporate entity fails to claim a refund that it is owed. Another tax risk arises if a company is deemed to have a “permanent establishment” in a country, and therefore have a taxable presence. The company must be able to document that the volume of its work in that country is below the legal threshold.

The degree to which a corporation faces IFM challenges is a function of the number of legal entities and the ownership arrangements among those entities, the intricacy of its production and delivery chains, the complexity of its worldwide tax situation and the number of ERP systems it uses. As a rule, a corporation with even a moderately complex legal entity and ownership structure that operates in multiple tax jurisdictions and has ERP systems from more than a handful of vendors should assess how well it is handling IFM.

Ventana_Research_Benchmark_Research_Office_of_Finance_19_15_A_Fast_Quarterly_Close_20200924 (1) (2)One indicator of IFM effectiveness is how long it takes to complete the accounting close. If completing the close takes more than one business week, it’s likely that IFM issues are a contributing factor. Our Office of Finance Benchmark Research found that only one-half of companies complete their monthly close within six business days. Our research also finds that the length of the close is unrelated to company size and industry, and that the quality and effectiveness of how the process is organized and managed is a major factor in how long it takes to close. The complexities of the process and the need to support global and local requirements at the same time can contribute to a longer-than-necessary close.

The ironic thing about intercompany financial management is that because it’s so obscure and technical, those at the top of the company who stand to benefit the most aren’t aware that doing it well can have a meaningful impact on the bottom line, improve financial control and reduce reputational and other risks. Few, if any, in the company recognize that IFM is a systemic issue that must be tackled holistically, rather than piecemeal. Done well, IFM can benefit a broad set of people and roles in a company. The CFO benefits from efficiency gains, deeper insight and greater control. Those in a range of finance and accounting department roles benefit from reduced staff workloads, greater efficiency, better control and more accurate managerial accounting. In multinational companies where people, products and services routinely cross legal entities and borders, sourcing and supply chain managers as well as human resources have better understanding of total costs.

Larger corporations that operate in multiple countries often adopt a shared services center. The main reason they do so is to reduce costs by eliminating duplication of efforts, choosing a lower-cost location for the center, or achieving greater efficiency through better utilization of skilled personnel. But a shared services organization can also offer better and more consistent performance, especially where specialized skills or knowledge are needed. Because the organization centralizes tasks, there is potentially more effective control of processes, since these are consistent and easier to monitor. And it can also provide the company headquarters greater visibility into performance as well as issues and opportunities. Although cost cutting through more efficient execution was once its focus, corporations with the most mature shared services organizations use them as a way of achieving consistently higher quality in process execution, more effective control and improved risk management. A finance and accounting shared services organization is well-positioned to take charge of IFM. But they need the tools and capabilities to do that.

Five elements are necessary for performing IFM well, including:

  • Accurate, consistent and timely intercompany financial data that is immediately accessible. This means assembling all relevant information from every ERP system in the organization and, wherever necessary, enriching the data with, for example, legal entity identification.
  • Automated invoice processing for accuracy and efficiency. Technology in the form of application programming interfaces and robotic process automation makes it possible to automate data movements to ensure they are accurate, timely and secure.
  • A global billing and payments capability that provides speed and accuracy.
  • A tax rules engine that accurately applies rates to individual line items and is capable of compliance with the rising requirements for digital tax filings.
  • Having people with training, expertise and experience to handle the ongoing exceptions and ambiguities that arise in the process.

Intercompany financial management is a discipline that goes beyond simply reconciling accounting entries. It creates and applies global process consistency to ensure the application of best practices everywhere. It can substantially reduce and maybe eliminate tax leakages – especially in value-added taxes. It can make a shorter accounting close possible with no sacrifice to accuracy or control. To the extent that transactions involve anything more than simple chargebacks, it can automate that process for accuracy, speed and consistency. It diminishes risks – accounting risks, tax risks and reputational risks. I recommend that corporations operating in more than a handful of tax jurisdictions with even a modestly complex legal entity structure investigate and assess how well it is handling its intercompany accounting and tax.

Regards,

Robert Kugel

Topics: Office of Finance, Business Planning, Financial Performance Management, ERP and Continuous Accounting, Revenue, robotic finance, lease and tax accounting

Robert Kugel

Written by Robert Kugel

Rob heads up the CFO and business research focusing on the intersection of information technology with the finance organization and business. The financial performance management (FPM) research agenda includes the application of IT to financial process optimization and collaborative systems; control systems and analytics; and advanced budgeting and planning. Prior to joining Ventana Research he was an equity research analyst at several firms including First Albany Corporation, Morgan Stanley, and Drexel Burnham, and a consultant with McKinsey and Company. Rob was an Institutional Investor All-American Team member and on the Wall Street Journal All-Star list. Rob has experience in aerospace and defense, banking, manufacturing and retail and consumer services. Rob earned his BA in Economics/Finance at Hampshire College, an MBA in Finance/Accounting at Columbia University, and is a CFA charter holder.