When one enterprise purchases services from a related enterprise, the purchasing enterprise typically records an expense transaction and the selling enterprise records a revenue transaction.
Related companies frequently purchase services from one another. These services may be of many different types; intercompany purchases of consulting, engineering, marketing, and maintenance services are common.
When one company purchases services from a related company, the purchaser typically records an expense and the seller records revenue. When consolidated financial statements are prepared, both the revenue and the expense must be eliminated.
For example, if the parent sells consulting services to the subsidiary for $50,000, the parent would recognize
$50,000 of consulting revenue on its books and the subsidiary would recognize $50,000 of consulting expense. In the consolidation worksheet, an elimination entry would be needed to reduce both consulting revenue (debit) and consulting expense (credit) by $50,000. Because the revenue and expense are equal and both are eliminated, income is unaffected by the elimination. Even though income is not affected, the elimination is still important, however, because otherwise both revenues and expenses are overstated.
Generally, a simplistic approach is appropriate in eliminating intercompany transfers of services by assuming that the services benefit the current period and, therefore, any intercompany profit on the services becomes realized within the period of transfer. Accordingly, no elimination entries relating to the current period’s transfer of services are needed in future periods because the intercompany profit is considered realized in the transfer period.
Usually the assumption that the profit on intercompany sales of services is realized in the period of sale is realistic. In some cases, however, realization of intercompany profit on the services does not occur in the period the services are provided, and the amounts are significant.
For example, if the parent company charges a subsidiary for architectural services to design a new manufacturing facility for the subsidiary, the subsidiary would include that cost in the capitalized cost of the new facility. From a consolidated point of view, however, any profit the parent recognized on the intercompany sale of services (revenue over the cost of providing the service) would have to be eliminated from the reported cost of the new facility until the intercompany profit became realized. Realization would be viewed as occurring over the life of the facility. Thus, elimination entries would be needed each year similar to those illustrated later in the chapter for intercompany fixed asset transfers.