Intercompany Eliminations
for Manufacturing

IFRS 10 intercompany eliminations for Manufacturing

Manufacturing groups generate more intercompany transactions per entity than almost any other industry. A parent company buys raw materials centrally, transfers them to a production subsidiary at cost-plus, that subsidiary manufactures finished goods and sells them to a distribution entity (also at a markup), and the distribution entity sells to external customers. Each internal transfer creates revenue, cost of sales, receivables, payables, and potentially unrealised profit sitting in inventory at year end. IFRS 10.B86 requires all of this to wash out in the consolidated numbers, but tracing the chain across four entities with different ERPs and different chart of accounts structures is where groups consistently struggle.

The group structures in manufacturing tend to be functionally segmented. You'll see a holding company at the top, one or two production entities (sometimes in different countries to access cheaper labour or raw materials), a shared services entity handling procurement or IT, and one or more distribution entities closer to end markets. Ownership is typically 100% for production subsidiaries, though joint ventures at 50-60% ownership appear in markets where local regulations require a domestic partner. The intercompany transaction types that dominate are inventory transfers at transfer prices (often set by transfer pricing policies for tax purposes rather than at arm's length market prices), intercompany service charges for shared procurement or quality control functions, intercompany loans funding capital expenditure at production sites, and licence or royalty fees for proprietary manufacturing processes. Transfer pricing adds a layer of difficulty because the markup applied on intercompany sales is often set to satisfy tax authorities in each jurisdiction rather than to reflect genuine economic value added at each stage.

Unrealised profit on intercompany inventory is the single biggest elimination issue in manufacturing. At any reporting date, a manufacturing group will hold raw materials, work-in-progress, and finished goods that have passed through at least one intercompany transfer. Each transfer included a markup. The auditor needs to quantify the total unrealised profit embedded in closing inventory and eliminate it. This requires knowing the transfer price and the original cost to the group, then applying both to the quantity of intercompany-sourced inventory on hand. Many manufacturing clients can't produce this data cleanly because their inventory systems track purchase cost (which includes the intercompany markup) rather than original cost to the group. The FRC and PCAOB have both flagged insufficient testing of transfer pricing adjustments in group audits. The PCAOB's 2023 inspection observations noted that auditors sometimes accept management's unrealised profit calculation without independently verifying the margin applied or the inventory quantities.

Start the elimination process by obtaining the intercompany transfer pricing policy and verifying the markup percentages applied at each stage of the supply chain. Request an aged inventory listing from each entity that identifies which items were sourced from another group member. Calculate the unrealised profit using the formula: closing intercompany inventory quantity multiplied by the intercompany markup per unit. For work-in-progress, the calculation is harder because the intercompany component (transferred raw materials) is only a portion of the total WIP cost. You'll need to estimate the intercompany content in WIP using bill-of-materials data or a reasonable allocation method. Document your approach and cross-reference it to the group's transfer pricing documentation (which exists for tax purposes and provides a useful audit trail).