Transfer Pricing?

Question

Please explain the concept and details of transfer pricing. What is the role of auditor for this?

Answer 1

Transfer pricing is the price at which goods are exchanged between two separate accounting systems within the same holding company. Say a holding company owns a painting contractor and they also own a real estate development firm. Each business has its own accounting, its own income statement, and its own balance sheet. But each is owned by the same entity.

Now let’s say that your painting company is going to do all your painting for your real estate development firm. You’ll set a price for this work – a transfer price.

Further let’s say that your Real Estate Development Company has not enough cash and too many expenses. Let’s say that it is not as profitable as you’d like.

Let’s say that your Painting business is cash rich and does not have enough expenses to cover all its revenue, so profits (ergo taxes) are higher than you’d like.

There are many accounting tricks that can be done with transfer pricing. You could set your transfer pricing high (say 1.5 times market rates). You do a bunch of work and bill at the higher price. Then you could age the accounts receivable at the Painting firm (basically don’t transfer the money). Then after a year or two you could write off the un-collected debt as an expense for the Painting Company. Technically you are supposed to send a 1099 to your creditors in default when you write off their bad debt. They receive the benefit of having debt erased. Would it surprise you if more than half of those 1099s actually make it into the “system”?

This scheme transfers cash (in terms of services rendered) to the Real Estate Development company. It gets something for nothing, which may bring it closer to profitability. The scheme transfers expenses to the painting company. The painting company avoids taxes.

This is one of the ways businesses avoid paying taxes. This type of corporate shell game of course was raised to an art form by the folks at Enron, and is well lambasted in the two-cows joke.

http://www.bluecollardollar.com/two_cows.html

But in truth had Enron been a private company, I am guessing that most of the shenanigans they pulled would have been perfectly legitimate, and undiscoverable.

As far as the auditor goes, typically theirs is the role of mushroom: Kept in the dark and fed a bunch of BS. Under this scheme since each is a separate business, each is audited independently.

Answer 2

I'm not very sure too. I may be wrong so please take it with a pinch of salt. From what I've read before, Transfer Pricing (TP) is a process that takes place between 2 cost centres. e.g. from assembly line 1 to assembly line 2. The product incur extra costs during assembly 1 and then this cost is added to the original cost. The total cost is then markup by a certain % and 'sold' to assembly 2. As to why it is called an accounting trick, I guess that's because everything took place within the organisation. It's just like you buy a pen for $10 and you sold it to your mum for $12. You made a profit of $2. But in actual fact, it's still money from your own family. Overall as a family, you are not any better off.