Management Accounting Theory: Concept of Transfer Pricing
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Many companies find it mutually beneficial to transfer products to another department or a subsidiary. Instead of charging regular retail price for the products, the accountants for the transferring and receiving centers agree on a transfer price. In order for the transaction to be beneficial to both parties, the transfer price must be higher than the incremental cost of creating the product but lower than the current market price.
What Is Transfer Pricing?
Transfer Pricing is a topic under Management Accounting Theory, a Masters level course in Accounting. It is an accounting practice that represents the price that one division in a company charges another division for goods and services provided.
According to Investopedia, a leading research journal in accounting and business, Transfer Pricing is the price at which one subsidiary, or upstream division, of a company, sells goods and services to another subsidiary, or downstream division. Goods and services can include labor, components, parts used in production, and general consulting services.
Transfer pricing allows for the establishment of prices for the goods and services exchanged between a subsidiary, an affiliate, or commonly controlled companies that are part of the same larger enterprise. Transfer pricing can lead to tax savings for corporations, though tax authorities may contest their claims.
The concept is based on market prices in charging another division, subsidiary, or holding company for services rendered. However, companies have used inter-company transfer pricing to reduce the tax burden of the parent company. Companies charge a higher price to divisions in high-tax countries (reducing profit) while charging a lower price (increasing profits) for divisions in low-tax countries.
The Internal Revenue Service (IRS) states that transfer pricing should be the same between intercompany transactions that would have otherwise occurred had the company done the transaction outside the company.
Transfer Price and Management Accounting Theory
Transfer prices affect three management accounting areas.
First, transfer prices determine costs and revenues among transacting divisions, affecting the performance of each division.
Second, transfer prices affect division managers’ incentives to sell goods either internally or externally. If the transfer price is too low, the upstream division may refuse to sell its goods to the downstream division, potentially impairing the company’s profit-maximizing goal.
Finally, transfer prices are especially important when products are sold across international borders. The transfer prices affect the company’s tax liabilities if different jurisdictions have different tax rates.
How Transfer Pricing Works
Transfer pricing is an accounting and taxation practice that allows for pricing transactions internally within businesses and between subsidiaries that operate under common control or ownership. The transfer pricing practice extends to cross-border transactions as well as domestic ones.
Investopedia also states that transfer pricing is used to determine the cost to charge another division, subsidiary, or holding company for services rendered. Typically, transfer prices are priced based on the going market price for that good or service. Transfer pricing can also be applied to intellectual property such as research, patents, and royalties.
It states further that Multinational companies (MNC) are legally allowed to use the transfer pricing method for allocating earnings among their various subsidiary and affiliate companies that are part of the parent organization. However, companies at times can also use (or misuse) this practice by altering their taxable income, thus reducing their overall taxes. The transfer pricing mechanism is a way that companies can shift tax liabilities to low-cost tax jurisdictions.
Transfer Pricing and How It Affect Taxes
Transfer prices play a large role in determining the overall organization’s tax bill. If the downstream division is located in a Country or State with a higher tax rate compared to the upstream division, there is an incentive for the overall organization to make the transfer price as high as possible. This results in a lower overall tax bill for the entire organization.
However, there is a limit to what extent multinational organizations can overprice their goods and services for internal sales purposes. A host of complicated tax laws in different countries limit the ability to manipulate transfer prices.
To better understand how transfer pricing impacts a company’s tax bill, let’s consider the following scenario. Let’s say that an automobile manufacturer has two divisions: Division A, which manufactures software while Division B manufactures cars.
Division A sells the software to other carmakers as well as its parent company. Division B pays Division A for the software, typically at the prevailing market price that Division A charges other carmakers.
Let’s say that Division A decides to charge a lower price to Division B instead of using the market price. As a result, Division A’s sales or revenues are lower because of the lower pricing. On the other hand, Division B’s costs of goods sold (COGS) are lower, increasing the division’s profits. In short, Division A’s revenues are lower by the same amount as Division B’s cost savings—so there’s no financial impact on the overall organization.
However, let’s say that Division A is in a higher tax country than Division B. The overall company can save on taxes by making Division A less profitable and Division B more profitable. By making Division A charge lower prices and pass those savings onto Division B, boosting its profits through a lower COGS, Division B will be taxed at a lower rate. In other words, Division A’s decision not to charge market pricing to Division B allows the overall company to evade taxes.
In short, by charging above or below the market price, companies can use transfer pricing to transfer profits and costs to other divisions internally to reduce their tax burden. Tax authorities have strict rules regarding transfer pricing to attempt to prevent companies from using it to avoid taxes.
Transfer Pricing and the IRS
The IRS states that transfer pricing should be the same between intercompany transactions that would have otherwise occurred, had the company done the transaction with a party or customer outside the company. According to the IRS website, transfer pricing is defined as follows:
“The regulations under section 482 generally provide that prices charged by one affiliate to another, in an intercompany transaction involving the transfer of goods, services, or intangibles, yield results that are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances. 1
As a result, the financial reporting of transfer pricing has strict guidelines and is closely watched by tax authorities. Extensive documentation is often required by auditors and regulators. If the transfer value is done incorrectly or inappropriately, the financial statements may need to be restated, and fees or penalties could be applied.”
However, there is much debate and ambiguity surrounding how transfer pricing between divisions should be accounted for and which division should take the brunt of the tax burden.
Minimum Transfer Price and Tax Regulations
For accounting purposes, large corporations will evaluate their divisions separately for profit and loss. When these different divisions conduct business with one another, the minimum transfer price for a particular good will usually be close to the prevailing market rate for that good. That means that the division selling a good to another division will charge an amount equal to what they could achieve by selling to retail customers.
However, in some instances, companies will attempt to increase or decrease the transfer costs between divisions in order to lower the amount they pay in taxes. This deliberate manipulation of costs is more likely to occur when the divisions are located in different countries where one country is a tax haven and has a much lower tax rate than the other.
Obviously, the tax authorities in countries with higher tax rates frown upon this practice as it means lost revenue for them. Thus, these countries have strict regulations to prevent companies from using transfer pricing as a tax avoidance strategy.
Regulators look at the company’s financial statements to ensure their transfer pricing is in line with current market pricing. In general, these regulations attempt to ensure companies abide by arm’s length practices, which prevents collusion between divisions within the company to misstate transfer prices.
How Transfer Prices Are Determined
Transfer prices can be determined under the market-based, cost-based, or negotiated method. Under the market-based method, the transfer price is based on the observable market price for similar goods and services.
Under the cost-based method, the transfer price is determined based on the production cost plus a markup if the upstream division wishes to earn a profit on internal sales.
The negotiatiated method is applicable when divisions’ managers use a transfer price that is mutually beneficial for each division.
The transfer price impacts the performance of both subsidiaries that transact with one another. A price that is too low disincentivizes an upstream division from selling to a downstream division as it results in lower revenues. A price that is too high disincentives the downstream division from buying from the upstream division, as costs are too high.
Arriving at a fair transfer price is not only beneficial to both subsidiaries but allows a company to reach profit maximization, as well as allowing a company to possibly take advantage of favorable tax setups.
PRACTICAL: How to Calculate Transfer Pricing
Calculate the minimum transfer price for the firm transferring the product. The minimum transfer price equals the incremental cost to create one product. The incremental price includes direct labor, direct material and direct overhead costs but excludes the expenses the transferring center would have incurred whether or not it made the product. In other words, the minimum transfer price should be the additional cash outflows the company incurs by making the transferred product.
Find the maximum transfer price for the product. In general, the maximum transfer price for a product is the price a firm would have to pay for the product on the open market. Reference accounting records to calculate the average price the company has paid in the past for the same quantity of the transferred item. Alternatively, get quotes from one or two suppliers for the same quantity of the transferred goods.
Set the transfer price per item between the minimum and maximum price calculated. Add a percentage profit or include fixed project costs to arrive at a transfer price suitable for both parties. If the price is set below the minimum price, the transferring center will take a loss at the expense of the receiving firm. Conversely, the receiving center won’t benefit if the transfer price is set above the maximum.
Multiply the transfer price per item by the quantity of items transferred to arrive at the total transfer price. For example, say that a product has a transfer price of N1,500, and 100 items are transferred. The total transfer price is N1,500 multiplied by 100, or N150,000.
Record the transfer price as an intracompany expense to the receiving center and as intracompany revenue and cost of goods sold to the transferring center. For example, say that the item priced at N1500 cost N1000 to produce. The receiving firm debits the item asset account and credits intracompany expense for N150,000. The transferring firm debits cash for N150,000 and credits sales revenue for N150,000. It then debits cost of goods sold for N100,000 and credits the inventory account for N100,000.
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