Why inter-company activities needs to be eliminated from external financial statements

Intercompany activities need to be eliminated from external financial statements for several important reasons:

1. Avoid Double Counting: When a company engages in transactions with its subsidiaries or other related entities, those transactions are initially recorded in the separate financial statements of each entity. If these transactions were not eliminated, they would be counted multiple times in the consolidated financial statements, leading to an overstatement of assets, revenues, expenses, and equity.
2. Accurate Representation: External financial statements are intended to provide an accurate representation of a company’s financial position, performance, and cash flows to external stakeholders, such as investors, creditors, and regulators. Including intercompany transactions would distort this information and provide an inaccurate picture of the company’s financial health.
3. Comparability: Eliminating intercompany transactions ensures that the financial statements are comparable across different periods and with other companies in the same industry. If these transactions were not eliminated, it would be challenging to make meaningful comparisons and analyze trends over time.
4. Transparency: Eliminating intercompany transactions enhances the transparency of financial statements. Stakeholders can better understand the financial performance and position of the company without the noise created by internal transfers that do not represent economic activities with external parties.
5. Compliance: Accounting standards and regulations, such as International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP), require the elimination of intercompany transactions to ensure compliance with the principles of fair presentation and the accurate portrayal of financial information.
6. Legal and Regulatory Requirements: In many jurisdictions, there are legal and regulatory requirements that mandate the elimination of intercompany transactions from external financial statements. This is often to prevent fraudulent reporting or the manipulation of financial results.
7. Investor Confidence: Accurate and transparent financial statements help build investor confidence. When investors can rely on the information presented in a company’s financial statements, they are more likely to make informed investment decisions, which is essential for the functioning of capital markets.
8. Creditworthiness Assessment: Lenders and creditors rely on external financial statements to assess a company’s creditworthiness. Eliminating intercompany transactions ensures that the financial statements reflect the company’s true financial position, allowing creditors to make more informed lending decisions.

In summary, eliminating intercompany activities from external financial statements is necessary to ensure the accuracy, transparency, and comparability of financial information, which is essential for the proper functioning of financial markets and the trust of stakeholders. This process ensures that the financial statements reflect the economic reality of the company’s transactions with external parties, providing a reliable basis for decision-making and analysis.