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Advanced Financial Accounting (Edited)

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UNIT ONE: PARTNERSHIP LIQUIDATION, INCORPORATION & JOINT VENTURES
 Introduction
This unit discusses the liquidation of limited liability partnerships (LLPs) and limited
partnerships. At the same time, it tries to indicate accounting issues related to incorporation of a
limited liability partnership. Finally, the unit discusses accounting for both corporate and
unincorporated joint ventures- business enterprise with features similar to those of general
partnerships.
Learning outcomes: After studying this unit you are expected to:
 Understand the meaning of liquidation and the liquidation process
 Discuss about how loss or gain is divided among partners during liquidation
 Know how cash and other assets can be distributed to partners
 Understand the accounting matters related to incorporation of Limited Liability
Partnerships (LLPs)
 Understand accounting for joint ventures
1.1 Liquidation of a Partnership
Dear distance learner, in this unit you will study the meaning of partnerships liquidation, the
process of liquidation, division of losses and gains during liquidation and distribution of cash and
other assets to partners.
Liquidation of a partnership means winding up or termination of the business, usually by selling
the assets, paying the liabilities, and distributing the remaining cash to the partners. In some
cases, the business may be sold as a unit, with the purchaser assuming the liabilities; in other
cases, the assets may be sold in installments and most or all of the cash received must be used to
pay creditors. A business, which has ended normal operations and is in the process of converting
its assets into cash and making settlement with its creditors is said to be in liquidation or in the
process of being liquidated.
When the decision is made to liquidate a partnership, the accounting records should be adjusted
and closed, and the net income or net loss for the final period of operations entered in the capital
accounts of the partners.
The liquidation process usually begins with the sale (realization) of assets. The gains or losses
from realization of assets should be divided among the partners in the income-sharing ration and
entered in their capital accounts. The amounts shown as their respective equities at this point are
the basis for settlement. However, before any payment to partners, all outside creditors must be
paid in full. If the cash obtained through realization of assets is insufficient to pay liabilities in
full, any unpaid creditor may act to enforce collection from the personal assets of any partner,
regardless of whether that partner has a positive or negative capital account balance.
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1.1.1 Distribution of loss or gain
As assets are sold, loss or gain is apportioned among the partners' capital accounts in the income
sharing ratio. The amount of cash, if any, which a partner is entitled to receive in liquidation
cannot be determined until partners' capital account have been adjusted for any loss or gain on
the realization of the assets.
In this unit, we shall illustrate a series of liquidations in which the realization of assets is
completed before any payments are made to partners. Also, we shall consider liquidation in
installments; that is, payments to partners after some of the assets have been sold and the
liabilities paid, but with the final loss or gain from sale of the remaining assets not yet known:
The installment payments to partners are computed by a method which provides a safeguard
against overpayment.
Regardless of whether cash or other assets are being distributed to partners, it is imperative to
follow the basic rule that no distribution of assets may be made to partners until after all possible
losses and liquidation expenses have been taken into account.
Failure to follow this basic rule may result in overpayment of a partner. If the partner is unable to
return the excess payment, the person who authorized the improper distribution may become
personally liable for any losses sustained by the other partners.
1.1.2 Distribution of cash or other assets to partners
The order for distribution of cash is:
1.1.2.1 Payment of creditors in full,
1.1.2.2 Payment of partners' loan accounts, and
1.1.2.3 Payments of partners' capital accounts
The indicated priority of partners' loans over partners' capitals appears to be a legal fiction. This
rule is nullified for all practical purposes by an established legal doctrine called the right of
offset. If a partner has a debit balance in his or her capital account (or even a potential debit
balance depending on possible future losses), and credit balance in a partner's loan account must
be offset against the deficiency (or potential deficiency) in the capital account.
Because of the right of offset, the total amount of cash received by a partner during the
liquidation process always will be the same as if loans to the partnership had been recorded in
the capital account. Furthermore, the existence of a partner's loan account will not advance the
time of payment to any partner during the liquidation.
1.1.3 Determining the settlement with each partner
The amount which each partner receives from the liquidation of a partnership will be equal to:
1) The capital invested in the business, whether recorded in a capital account or in a loan
account;
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2) A share of operating net income or loss minus the drawings; and
3) A share of loss or gain from the realization of assets in the course of liquidation.
In other words, each partner will receive in the settlement the amount of his or her equity in the
partnership. The amount of a partner's equity is increased by the positive factors of investing
capital and sharing in net income: it is decreased by the negative factors of drawings and sharing
in net losses. If the negative factors are larger, the partner will have a capital deficiency (a debit
balance in a capital account). And the partner must pay to the partnership the amount of such
deficiency, Failure to make good a capital deficiency by payment to the partnership would mean
that the partner had not lived up to the partnership contract for sharing net income or loss. This
would cause the other partners to bear more than their contractual share of losses, or, stated
conversely, to receive less in settlement than their equities in the business.
1.1.4 Division of losses and gains during liquidation
The income-sharing ratio used during the operation of the partnership is also applicable to the
losses and gains during liquidation, unless the partners have a different agreement. A partnership
contract is not superseded because of the decision to cease operations; the agreement for division
of earnings therefore continues in force.
Accountants generally agree that the annual or quarterly determinations of net income or loss are
approximations because of the estimates involved on such matters as the economic life of plant
assets and the collectability of accounts receivable. Errors in these estimates affect the periodic
net income of loss allocated to the partners. Consequently, the net loss or gain resulting from the
liquidation of a partnership should be divided among the partners in the same ration used in
dividing net income or loss from normal operations.
When the net loss or gain from liquidation is divided among the partners, the final balances in
the partners' capital and loan accounts will be equal to the cash available for distribution to them.
Payments are then made in the amounts of the partners' respective equities in the business.
1.1.4.1 Equity of each partner sufficient to absorb that partner's share of loss from
liquidation
Assume that B and M partnerships decided to liquidate on August 1, 1999. Partners B and M
share earnings equally. Balance sheet just prior to liquidation is as follows.
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B & M partnerships
Balance Sheet
July 31, 1999
Assets
Cash…………………………..Br 60,000
Other Assets………………… 120,000
Total ……… ……………… Br180,000
Liabilities & partners’ capital
Liabilities …………………… Br 50,000
B, loan ……………………….. 10,000
B, Capital ………………………. 40,000
M, Capital………………………. 80,000
Total……………………………Br180,000
The non cash assets were sold for 30,000 cash, resultant loss of Br 90,000 to be shared equally
by B and M. The accountant will exercise the right of offset by transferring the Br 10,000 loan to
the capital account. Below is indicated the statement of liquidation and realization for the
company.
B & M partnerships
Statement of realization and liquidation
Assets
Balance before liquidation
Sale of assets at a loss of
90,000
Balances
Payment to creditors
Cash
60,000
30,000
90,000
(50,000)
Balances
Offset B’s capital deficit
against
Its loan account
40,000
Balances
Payment to partners
40,000
(40,000)
Other
120,000
120,000
Liabilities B, Loan
Partners’ Capital
B
M
40,000
80,000
(45,000) (45,000)
50,000
10,000
50,000
(50,000)
10,000
(5000)
35,000
10,000
(10,000)
(5000)
10,000
35,000
5000
(5000)
35,000
(35,000)
1.1.4.2 Equity of one partner not sufficient to absorb that partner's share of loss from
liquidation
In this case, the loss on realization of assets when distributed in the income-sharing ratio results
in a debit balance in the capital account of one of the partners. It may be assumed that the partner
with a debit balance has no loan account, or that the total of the partner's capital account and loan
account combined is less than the partner's share of the loss on realization. To fulfill an
agreement to share a given percentage of partnership earnings’ the partner must pay to the
partnership sufficient cash to eliminate any capital deficiency. If the partner is unable to do so,
the deficiency must be absorbed by the other partners as an additional loss to be shared in the
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same proportion as they have previously shared earnings among themselves. For our illustration,
let us use the following balance sheet for A, S, and M just before liquidation.
A, S & M partnerships
Balance Sheet
July 31, 1999
Liabilities & partners’ capital
Liabilities …………………… Br 160,000
A, Capital ………………………. 50,000
S, Capital ………………………. 40,000
Total ……… ………………. Br300, 000 M, Capital………………………. 50,000
Total……………………..….… Br 300,000
Assets
Cash…………………………..Br100,000
Other Assets……………………. 200,000
Income Sharing Ratio: A 50%, S 30% and M 20%
The other assets with a carrying amount of 200,000 are sold for 80,000 cash: loss of 120,000.
The loss is divided among partners as: 60,000 to A; 36,000 to S and 24,000 to M. In the
following statement of realization and liquidation, it is assumed that A pays 10,000 to the
partnership.
A, S & As partnerships
Statement of realization and liquidation
Liabilities Partners’ Capital
Assets
Cash
Other
Balance
before
liquidation
Sale
of
assets at a
loss
Balances
Payment to
creditors
100,000
200,000
80,000
(200,000)
Balances
Cash paid in
by A
20,000
10,000
180,000
(160,000)
Balances
30,000
Payment to (30,000)
partners
160,000
A
S
M
50,000
40,000
50,000
(60,000) (36,000) (24,000)
160,000
(160,000)
(10,000) 4000
26,000
(10,000) 4000
10,000
26,000
4000
(4000)
26,000
(26,000)
When both a limited liability partnership and some of the partners are insolvent, the legal rule of
marshaling of assets is applied. This rule states that creditors of each partner have first claim on
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his or her personal assets, and partnership creditors have first claim on partnership assets. Any
amounts payable to creditors of an insolvent limited liability partnership that has no assets may
be obtained from one or any combination of the solvent partners whose actions caused the
partnership’s insolvency. Any partner who is forced to invest in the partnership more than
originally agreed on has a right to collect from the other partners. However, if the other partners
were insolvent, this would be a meaningless right. The creditors of an insolvent partner may
claim only that partner’s equity interest, if any, in the partnership.
To illustrate the marshaling of assets, assume that, after the realization of all the non cash assets
of Alex, Belete & Chalie LLP, liabilities of $15,000 remain unpaid. Assume the following
financial status for each partner:
Partner Alex
Partner Belete
Partner Chalie
Partnership capital (deficit)
Br 15,000 Br
(12,500)
(17,500)
Net personal assets (deficit)
30,000
5,000
(2,500)
The partnership creditors can recover the entire $15,000 from Alex only if Alex’s actions caused
the partnership’s insolvency. If Belete was the cause, partnership creditors would receive only
$5,000 of their $15,000 total claims. The personal creditors of Chalie could not proceed against
the personal assets of either Alex or Belete, and they would not receive anything from the
partnership because Chalie has a capital deficit.
?
Review Question 1.1
1. What do you mean by liquidation of Partnership??
2. Explain the Process of liquidation
3. Explain the order of distribution of cash or other assets during liquidation
4. Clearly explain the rule of marshaling of assets when a limited partnership and some of the partners
are insolvent
5. Assume that Alemu and Debasu who are partners have capital account balances of $40,000 and $
30,000 respectively. Besides, Alemu has provided a loan $ 10,000 to the partnership. The partners
now decide to liquidate the partnership; what priority or advantage, if any, will Alemu enjoy in the
liquidation with respect to the loan account?
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1.2 Installment Payments to Partners
In this sub unit, you will study the liquidation process where the liquidation process extends over
several periods. And provided that the partners decided to receive cash as it is available, you will
study how cash can be distributed among partners in installments.
When the liquidation of a limited liability partnership is expected to extend over several months,
partners usually will want to receive cash (or other assets) as soon as possible. Installment
payments to partners may be made if precautions are taken to ensure that all creditors are paid
in full and that no partner is paid prematurely.
In installment liquidations, the liquidator must not authorize distributions to partners that may
have to be returned by the partners if large liquidation losses cause deficits in their partnership
equity (capital plus loan accounts). Installment distributions of cash or other assets to partners
are determined as follows:
a. Assume a total loss on the realization of all remaining non-cash assets.
b. Assume that any partner with a potential capital deficit will be unable to pay anything to
the partnership from personal assets.
To implement these assumptions, installment cash payments to partners are made as if no more
cash would become available, either from the realization of assets or from the collection of any
potential capital deficits.
When installment distributions to partners are made according to the rules listed in the first
paragraph, the effect will be to bring the partners’ equities to the income-sharing ratio as quickly
as possible. After installment distributions to partners have reduced the partners’ equities to the
income-sharing ratio, subsequent distributions of cash or other assets to partners may be made in
the income-sharing ratio.
A complete cash distribution program may be prepared before liquidation starts. The procedures
to be followed in the preparation of such a program are as follows:
a) Ascertain the equity (capital, plus any loan to the partnership, less any loan from the
partnership) for each partner.
b) Divide the equity of each partner by each partner’s income-sharing ratio to determine the
capital per unit of income sharing for each partner.
c) The partner with the largest capital per unit of income sharing is entitled to receive
enough cash to reduce his or her capital per unit of income sharing to the capital of the
partner with the second highest amount. The amount of cash to be paid at this point is
computed by multiplying the required reduction in the capital per unit of income sharing
of the highest-ranking partner by that partner’s income-sharing ratio.
d) The process described in c is continued until the capital per unit of income-sharing
amounts for all partners are equal. Additional cash distributions then may be made in the
income-sharing ratio.
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Partners Ras, Sam, and Tom share net income and losses in the ratio of 4:3:2, and have total
equities in the limited liability partnership as follows: Ras, Br16,000; Sam, Br.10,500; and Tom,
Br6,020. How should cash or other assets can be paid to the partners (after all liabilities have
been paid) as they become available in the course of liquidation? The answer may be developed
as follows:
Ras
Sam
Tom
Capital balances (equities) before liquidation
Income-sharing ratio
Capital per unit of income sharing
First cash of Br.2,000 (Br.500 x 4 = Br.2,000) to
Ras
Capital per unit of income sharing
Next Br.3,430 to Ray and Sam:
Br.490 x 4 or Br.1,960 to
Ray, and Br.490 x 3 or Br.1,470 to Sam
Capital per unit of income sharing
Any cash in excess of Br.5, 430 may be paid to
Ras, Sam, and Tom in the 4:3:2 ratios.
Br.16,000
4
Br. 4,000
Br.10,500
3
Br. 3,500
-
Br.6,020
2
Br.3,010
-
(500)
Br. 3,500
Br. 3,500
Br.3,010
(490)
Br. 3,010
(490)
Br. 3,010
Br.3,010
After cash or other assets of Br.5,430 are distributed to the partners as computed above, the
actual capital account balances would be in the income-sharing ratio of 4:3:2, as follows: Ras,
Br.12,040; Sam, Br.9,030; and Tom, Br.6,020.
In some cases, the liquidator may elect to set aside cash to pay any remaining liabilities and
potential liquidation costs and distribute any residual cash to partners according to the program
described on page 6.
The Uniform Limited Partnership Act provides that after outside creditors of a liquidating
limited partnership have been paid, the equities of the limited partners must be paid before the
general partner or partners may receive any cash. Also, the limited partners may agree that one or
more of them may have priority over the others regarding payments in liquidation of the limited
partnership.
1.3 Incorporation of a Limited Liability Partnership
In this subunit you are required to ponder about how an accountant treats a decision made by
partners to liquidate the partnership and change in to a Corporation.
If a limited liability partnership is incorporated, the net assets of the partnership must be restated
to current fair values before they are transferred to the corporation. This assures that the capital
stock of the corporation will be distributed to the partners in the ratio of their respective equities
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in the partnership. The accounting records of the partnership may be modified and continued in
use by the corporation, but usually a new set of accounting records is established for the
corporation.
Illustration: Assume that Belachew and Demelash, partners of B&D LLP, organized into B&D
Corporation to take over the net assets of the partnership. The Balance sheet of the partnership as
of June 30, 2005 EC is depicted below.
B & D Partnerships
Balance Sheet
As of June 30, 2005
Assets
Cash……………………………..Br 30,000
Accounts Receivable ……………..40,000
Inventories ………………………. 24,000
Equipment ………………………. 66,000
Accumulated Depreciation………(10,000)
Total Assets ………………… Br150,000
Liabilities & Partners’ Capital
Liabilities:
Accounts Payable ……………
Br50,000
Partners’ Capital
Belachew, Capital ………50,000
Dirirsa, Capital ………… 50,000
100,000
Total Liabilities & Capital
Br150,000
The partners agree the following adjustments to restate the net assets of the partnership to current
fair value.
1. Increase inventories to the current replacement cost of 34,000.
2. Increase the equipment cost to its current market value of 76,000 less accumulated
depreciation on this basis, 13,000.
1. Recognize accrued liabilities of 2,000 and
2. Recognize good will of 10,000
B & D Corporation is authorized to issue 20,000 shares of 10-par common stock. It issues 6250
shares valued at Br20 a share to the partnership, in exchange for the net assets of the partnership.
Note that the 6250 shares are divided between the partners in accordance with the adjusted
balances of their capital accounts. With this, the liquidation and dissolution process completes.
The accounting procedures:
In the accounting records of partnership:
1. Prepare journal entries revaluation of assets, including recognition of good will.
2. Record any cash withdrawals (not in this case) necessary to adjust partners’ capital account
balances to round amounts.
3. Record the transfer of assets and liabilities to the corporation, the receipt of the corporation’s
common stock by the partnership, and the distribution of the common stock to the partners in
settlement of the balances of their capital accounts.
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Journal entries to adjust and eliminate the accounting records of B &D LLP:
Inventories (34,000-24,000) …………………………………………... .10,000
Equipment (76,000-66000) ……………………………………………. 10,000
Goodwill ………………….. …………………………………………...10,000
Accumulated depreciation (13,000 – 10,000)……………..……………..3000
Accrued Liabilities ……………………………………………………... 2000
Belachew Capital ………………………………………………………12,500
Bemelash Capital ………………………… ……………………………12,500
To adjust assets and liabilities to agreed amounts and to divide net gain of 25,000 equally
Receivable from B &D Corporation (100,000 + 25,000) …………125,000
Accounts payable …………………………………………... 50,000
Accrued Liabilities ………………………………………… 2,000
Accumulated Depreciation ………………………………… 13,000
Cash ………………………………………………... 30,000
Accounts Receivable ……………………………… 40,000
Inventories ………………………………………… 34,000
Equipment ………………………………………… 76,000
Good Will ………………………………………… 10,000
To transfer assets and liabilities to B &D Corporation
Common stock of B &D Corporation ……………………… 125,000
(6250 x $20)
Receivable from B &D Corporation …............... 125,000
To record receipt of 6250, shares of $ 10 par common stock
Valued at $ 20 a share in payment for net assets transferred
To B &D Corporation
Belachew, Capital (3125 x $20) …………………….. 62,500
Dirirsa Capital (3125 x $20)………………………… 62,500
Common stock of B and D Corporation …… 125,000
To record distribution of common stock of B & D
Corporation to partners
Now let us see how we can record the above facts in the accounting records of the
corporation.
1. Record the acquisition of assets and liabilities (including obligation to pay for the net assets)
from the partnership at current fair values.
2. Record the issuance of common stock at current fair value in payment of the obligation to the
partnership.
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Journal entries for B & D Corporation:
Cash ………………………………………………... 30,000
Accounts Receivable ……………………………… 40,000
Inventories ………………………………………… 34,000
Equipment ………………………………………… 76,000
Good Will ………………………………………… 10,000
Accumulated Depreciation ………………………………… 13,000
Payable to B &D Partnerships (100,000 + 25,000) ………… 125,000
Accounts payable …………………………………………... 50,000
Accrued Liabilities ……………………………………….… 2,000
To record acquisition of assets and liabilities from
B & D partnerships
Payable to B &D Partnerships (100,000 + 25,000) ………… 125,000
Common stock (6250 x $10) ………………… 62,500
Paid in capital in excess of par ………………. 62,500
To record issuance 6250 shares common stock valued at $20 in payment for net assets of B & D
LLP
1.4 Joint Ventures
Dear distance learner, here you study about the mature of joint ventures, accounting
considerations for transactions made by joint ventures and other related matters.
A joint venture differs from a limited liability partnership in that it generally is limited to
carrying out a single project. Joint ventures may be created for such purposes as to develop a
tract of land, sell agricultural products, explore for natural resources, or undertake construction
projects.
A corporate joint venture is a corporation owned and operated by a small group of joint
ventures as a separate business enterprise. The investment in the common stock of a corporate
joint venture is accounted for by the equity method of accounting. Supplementary disclosure of
assets, liabilities, and results of operations of the corporate joint venture is made in a note to the
financial statements of each venturer if the investment in the venture is material.
Either the equity method of accounting or the proportionate share method of accounting may
be used for an investment in an unincorporated joint venture. In the proportionate share
method of accounting, the investor recognizes in its accounting records its share of each asset,
liability, revenue, and expense of the joint venture.
Current Accounting for Joint Ventures
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A joint venture may be organized as a corporation (corporate joint venture), as a partnership, or
as undivided interests under which each investor owns an undivided interest in each joint venture
asset and is liable for its share of each joint venture liability.
The purpose of a corporate joint venture is to share risks and rewards in developing a new
market, product or technology; to combine complementary technological knowledge; or to pool
resources in developing production or other facilities. A corporate joint venture also usually
provides an arrangement under which each joint venturer may participate, directly or indirectly,
in the overall management of the joint venture. Joint venturers thus have an interest or
relationship other than as passive investors.
Critics have argued that the lack of guidance in the accounting literature for unincorporated joint
ventures method, proportionate consolidation, or some combination of methods in the financial
statements of investors in joint ventures. Those critics have indicated that different investors with
similar investments in joint ventures use different methods to account for the investments.
Furthermore, some investors with investments in several unincorporated joint ventures use
different methods to account for the separate investments or, for a single investment, use a
method of accounting on the balance sheet that is different from the method used on the income
statement.
Critics also have argued that the equity method does not provide adequate information about the
investor's resources and obligations arising from the joint venture investment, particularly when
the joint venture is integrated with the investor's operations and is organized to achieve
efficiencies of scale or to share risks. In other instances, the equity method of accounting can
provide an opportunity to obtain off-balance-sheet financing since liabilities are netted against
assets to report a net investment in the joint venture. Furthermore, the equity method requires the
aggregation of the investor's share of revenues and expenses, thereby resulting in a line item on
the income statement referred to as net investment income. Critics believe that when the joint
venture is undertaken to enhance the operations of the investor, the aggregation and reporting of
net investment income does not present a true picture of the investor's operations. Supporters of
the equity method argue that unless the investor controls certain identified assets, the assets of
the joint venture are not the assets of the investor. Therefore, it is appropriate to record the joint
venture as an investment and not as individual assets and liabilities.
The Unconsolidated Entities (Joint Venture) Project
The Board will be investigating those criticisms, plus others, during the course of the project on
unconsolidated entities. Most would agree that the overriding question relating to joint venture
accounting is whether shared control (or joint control) is sufficiently different from control or
significant influence to require a separate method of reporting. Before answering that question,
the Board must arrive at generally accepted definitions of joint venture and shared control for
accounting purposes. A 1979 AICPA Issues Paper, Joint Venture Accounting, identified seven
factors that should be considered in defining a joint venture: (1) legal forms of the entities, (2)
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characteristics that differentiate the entities as a class from other entities, (3) relationships of the
entities to their owners, (4) purposes for which the entities are formed and operated, (5) limits on
the number of owners, (6) the nature of joint control, and (7) the duration of the entities. A
general definition of joint ventures might be aided by identifying types of joint ventures. In that
regard, the Pharmaceutical Research and Manufacturers Association has undertaken a project to
assist the Board in gathering information on the key characteristics of joint ventures currently in
use today. Other projects of that type would be beneficial to the Board.
The ultimate issue to be decided is the accounting method to be used for reporting investments in
joint ventures; and, if more than one method is allowed, the circumstances in which each method
should be used. The alternative methods described in the AICPA Issues Paper included) one-line
equity method, (2) expanded equity method, (3) proportionate consolidation, (4) cost method, (5)
fair market value, and (6) a combination of methods--for example, one method used in the
balance sheet and another in the income statement, or different types of methods for different
types of joint ventures. In examining the alternatives available and the circumstances in which
each method should be used, the Board would benefit from research aimed at the impact that
each method has on decisions of users and management.
Another issue that will need to be addressed is the types of disclosures that should be required
for investments in joint ventures. Disclosures could include separate financial statements or
summarized financial information of joint ventures, description of the investor's relationships
with joint ventures, fair market value of investments in joint ventures information about
operating, financing and other special agreements, arrangements, or commitments that the
investor may have with joint ventures.
?
Review Question 1.2
1. Describe the conditions whereby installment payment to partners may be allowed in the process of
liquidation
2. What do you mean by incorporation of limited liability partnership
3. Explain the difference between joint venture and partnership
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1.5 Unit Summary
1. The liquidation of a limited liability partnership means winding up, dissolution or
termination of the partnership by realizing the noncash assets, paying the liabilities, and
distributing the remaining cash to the partners. Liquidation may be completed quickly, or
it may require several months.
The term realization means the conversion of assets to cash.
2. When partners decide to liquidate their limited liability partnership, the partnership’s
accounting records are adjusted, and the net income or loss for the final period of
operations is entered in the partners’ capital accounts. Gains or losses on the realization
of assets, divided among the partners in the income-sharing ratio, also are entered in the
partners’ capital accounts.
3. After all noncash assets are realized and partnership creditors are paid, partners receive
cash payments equal to the balances of their capital accounts. If the cash generated from
the realization of noncash assets is insufficient to pay the liabilities, unpaid partnership
creditors may collect unpaid liabilities from the personal assets of any solvent partner
whose actions caused the partnership’s insolvency, even from partners who have debit
balances in their capital accounts.
4. If the realization of assets is completed before any cash is paid to the partners, the final
gain or loss on the realization of assets is known and is allocated to partners’ capital
accounts. In such cases, the available cash is paid to creditors and then to partners
according to the balances of their capital accounts. Deficits in the capital accounts of any
of the partners must be eliminated through additional investments by the affected
partners. However, if a deficit partner is insolvent, the deficit must be absorbed by the
other partners in their income-sharing ratio.
5. If the realization of assets has not been completed, and the final gain or loss on
realization of assets is not known, cash may be distributed to partners in installments as
long as sufficient cash is withheld to cover any unpaid liabilities and possible costs of
liquidation. The amount of cash that may be paid to partners at various stages of
liquidation is determined by preparation of an exhibit in which partners’ capital accounts
are charged for the maximum possible loss (including liquidation costs) that may be
incurred in winding up the limited liability partnership.
6. In the course of liquidation, partners may withdraw assets in kind. No distribution of
cash or other assets should be made to partners until after all possible losses and
liquidation costs have been considered. Each interim payment of cash to partners is made
on the assumption that it may be the last, that is, that no additional cash will be available
for partners.
7. Although partners’ loans to the partnership theoretically should be repaid before partners’
capitals, the right of offset requires that loan balances be added to the capital account
balances for liquidation purposes. The fact that a partner has made a loan to the
partnership does not mean that the partner will receive cash any sooner on liquidation.
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Thus, in a statement of realization and liquidation, loan and capital account balances may
be combined for each partner. However, loan and capital account balances are not
combined in the partnership ledger.
8. The income-sharing ratio used during the operation of a limited liability partnership also
is applicable to the gains and losses during liquidation. However, the partners may agree
to distribute liquidation gains and losses in a different ratio. When all liquidation gains
and losses are allocated to the partners’ capital accounts, the amount of cash available
(after payment of liabilities) is equal to the total of the balances of the partners’ capital
and loan accounts. Cash then is distributed to the partners in amounts equal to the total
amount of each partner’s capital and loan accounts.
9. In an insolvent limited liability partnership, at least one partner has a capital deficit. At
this point in the liquidation process, partnership creditors may demand payment from any
solvent partner whose actions caused the partnership’s insolvency. Payments to
partnership creditors by a partner from personal funds are recorded by debits to
partnership liability accounts and a credit to the partner’s capital account. If the partner
with the capital deficit pays the required amount, sufficient cash will be available to pay
the partnership creditors in full.
10. When both a limited liability partnership and some of the partners are insolvent, the legal
rule of marshaling of assets is applied. This rule states that creditors of each partner
have first claim on his or her personal assets, and partnership creditors have first claim on
partnership assets. Any amounts payable to creditors of an insolvent limited liability
partnership that has no assets may be obtained from one or any combination of the
solvent partners whose actions caused the partnership’s insolvency. Any partner who is
forced to invest in the partnership more than originally agreed on has a right to collect
from the other partners. However, if the other partners were insolvent, this would be a
meaningless right. The creditors of an insolvent partner may claim only that partner’s
equity interest, if any, in the partnership.
11. When the liquidation of a limited liability partnership is expected to extend over several
months, partners usually will want to receive cash (or other assets) as soon as possible.
Installment payments to partners may be made if precautions are taken to ensure that all
creditors are paid in full and that no partner is paid prematurely.
12. In installment liquidations, the liquidator must not authorize distributions to partners that
may have to be returned by the partners if large liquidation losses cause deficits in their
partnership equity (capital plus loan accounts). Installment distributions of cash or other
assets to partners are determined as follows:
a. Assume a total loss on the realization of all remaining noncash assets.
b. Assume that any partner with a potential capital deficit will be unable to pay anything
to the partnership from personal assets. To implement these assumptions, installment
cash payments to partners are made as if no more cash would become available, either
from the realization of assets or from the collection of any potential capital deficits.
13. When installment distributions to partners are made according to the rules listed in
number 12 above, the effect will be to bring the partners’ equities to the income- sharing
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ratio as quickly as possible. After installment distributions to partners have reduced the
partners’ equities to the income-sharing ratio, subsequent distributions of cash or other
assets to partners may be made in the income-sharing ratio.
14. A complete cash distribution program may be prepared before liquidation starts. The
procedures to be followed in the preparation of such a program are as follows:
a. Ascertain the equity (capital, plus any loan to the partnership, less any loan from the
partnership) for each partner.
c. Divide the equity of each partner by each partner’s income-sharing ratio to determine
the capital per unit of income sharing for each partner.
d. The partner with the largest capital per unit of income sharing is entitled to receive
enough cash to reduce his or her capital per unit of income sharing to the capital of
the partner with the second highest amount. The amount of cash to be paid at this
point is computed by multiplying the required reduction in the capital per unit of
income sharing of the highest-ranking partner by that partner’s income-sharing ratio.
e. The process described in c is continued until the capital per unit of income-sharing
amounts for all partners are equal. Additional cash distributions then may be made in
the income-sharing ratio.
15. In some cases, the liquidator may elect to set aside cash to pay any remaining liabilities
and potential liquidation costs and distribute any residual cash to partners
16. If a limited liability partnership is incorporated, the net assets of the partnership must be
restated to current fair values before they are transferred to the corporation. This assures
that the capital stock of the corporation will be distributed to the partners in the ratio of
their respective equities in the partnership. The accounting records of the partnership may
be modified and continued in use by the corporation, but usually a new set of accounting
records is established for the corporation.
17. A joint venture differs from a limited liability partnership in that it generally is limited
to carrying out a single project. Joint ventures may be created for such purposes as to
develop a tract of land, sell agricultural products, explore for natural resources, or
undertake construction projects.
18. A corporate joint venture is a corporation owned and operated by a small group of joint
venturers as a separate business enterprise. The investment in the common stock of a
corporate joint venture is accounted for by the equity method of accounting.
Supplementary disclosure of assets, liabilities, and results of operations of the corporate
joint venture is made in a note to the financial statements of each venturer if the
investment in the venture is material.
19. Either the equity method of accounting or the proportionate share method of
accounting may be used for an investment in an unincorporated joint venture. In the
proportionate share method of accounting, the investor recognizes in its accounting
records its share of each asset, liability, revenue, and expense of the joint venture.
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. Self Test Exercises
Part I: True or False Questions
Dear Distance learner, read the following sentences carefully and write TRUE if the statement is
correct or FALSE if the statement is incorrect in your notebook.
1. In the process of liquidation, outside creditors are given priority in the distribution of
cash or other assets.
2. Cash may be distributed to partners in installments as long as sufficient cash is withheld
to cover any unpaid liabilities and possible costs of liquidation.
3. There is no major difference between limited partnership and joint venture.
4. In most cases, the liquidation process starts with the realization of assets
5. The net loss or gain resulting from the liquidation of a partnership is divided among the
partners in the same ration used in the division of net income or loss during the normal
operations.
Part II: Multiple Choice Questions.
Dear Distance Learners choose the correct answer for the following questions and write the
capital letter of your correct choice in your notebook
1. Which one of the following is not true about the order of distribution of cash or other
assets in the process of liquidation
A. Payment of partners, payment of partners’ loan accounts, payment of creditors in full
B. Payment of partners’ loan accounts, payment of partners, payment of creditors
C. Payment of creditors in full, payment of partners’ loan accounts, payment of
partners’ capital accounts
D. A and C
E. None
2. Identify the wrong statement about the marshalling rule of assets in case of insolvent
partnership and partners
A. Creditors of each partner have first claim on the personal assets of that partner
B. Creditors of a partnership have first claim on the partnership assets
C. The creditors of the insolvent partner have the right to claim only the equity of
that partner
D. Creditors of an insolvent partnership have the right to claim from one or any
combination of the solvent partners
E. None
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3. ________ is the process of converting a limited liability partnership into a corporation.
A. Realization of limited liability
B. Liquidation of limited liability
C. Dissolution of limited liability
D. Incorporation of limited liability
E. All of the above
4. Which of the following is not true about liquidation of a limited partnership
A. Distribution can be made in cash, in kind or combination of cash and kind
B. All possible losses and liquidation costs need to be determined before distribution
C. General partners are given priority over limited partners
D. A and C
E. None
5. Which one of the following is not the purpose of forming corporate joint ventures?
A. Sharing possible risks as well as rewards
B. Combining complementary technological knowledge
C. Pooling resources and facilities
D. All of the above
E. None of the above
Part III: Matching
Dear Distance Learners, match items listed in column A with the items listed in Column B
Column A
Column B
1. Liquidation
A. Given Priority in the distribution of cash or other assets
2. Creditors
B. Rent of a manufacturing building
3. Income Sharing Ratio
C. The trade-off between fixed cost inputs and variable cost inputs
4. Joint Venture
D. Explains the order of claims of creditors on personal and
5. Marshalling Rule
partnership assets
E. Winding up of business organizations
F. A business organization established to carry out a single project
G. Given second level priority in the distribution of assets
H. Used as a basis for the distribution during liquidation
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Part IV: Fill in the Blank Spaces
Dear Distance Learners, fill in the blank spaces with the appropriate word or phrase.
1. ____________ is the process of formal termination of business organizations
2. ____________ a corporation owned and operated by a small group of joint venturers as a
separate business enterprise.
3. ____________ A method of payment whereby partners may receive cash or other
payments as soon as possible if precaution is made to ensure that all creditors are paid in
full and no partner is paid prematurely.
4. ____________ Creditors of each partner have first claim on his or her personal assets and
partnership creditors have first claim on partnership assets.
5. ___________ Converting a limited partnership into a corporation.
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 Answers Key to Self Test Exercises
Dear Distance Learners, check your answer for the above self test exercises
Part I: True/False Questions
1. True
2. True
3. False
4. True
5. True
Part II: Multiple Choice Questions
1. C
2. E
3. D
4. C
5. E
Part III: Matching Questions
1. E
2. A
3. H
4. F
5. D
Part IV: Fill in the Blank Space
1. Liquidation
2. Corporate Joint Venture
3. Installment Payment
4. Marshalling Rule
5. Incorporation
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UNIT TWO: INSTALLMENT SALES AND CONSIGNMENTS
 Introduction
Dear student, in your previous studies of financial accounting you were introduced with the
accounting treatment of credit sales made by companies. In this unit, you are going to study the
different forms of credit sales: Installment Sales and Consignment Sales.
After studying this unit, you are expected to:
• Distinguish an installment sale from an ordinary sale
• Use of the installment method for financial accounting purposes
• Revenue recognition by the installment method
• Differentiate a consignment of merchandise from a sale of merchandise
• Identify advantages of use of consignments from the point of view of consignors and
consignee
 Know accounting treatment of consignment sales both by the consigner and the
Consignee
2.1 INSTALLMENT SALES
Dear students, in this subunit you are introduced with the concept of Installment Sales, its
advantages over ordinary sales, its challenges to accountants and the different methods of
recognition of revenue for sales made on an installment plan. Please make note of each points
while studying and after the completion of this unit. So far so good! Let’s go along.
An Installment Sale is a sale of real or personal property or services which provides the buyer for
a series of payments over a period of months or years. In this type of sale, the buyer gets the
opportunity to pay the price little by little over an agreed period of time. The seller is required to
wait considerable agreed period of time to collect the full sales price of the merchandise or
service. Usually, but not always, a down payment of some amount, is required in installment
sales. Since the seller must wait a considerable period of time to collect the full sales price, it is
customary to provide for interest on the unpaid balance, and to add carrying charges to the listed
selling price.
For many types of business, the technique of installment sales has been a key factor in achieving
large-scale operations. The automobile industry, for example, could not have developed to
anything like its present size without the use of installment sales. The huge volume of output
achieved by the auto industry has made possible economies in tooling, production, and
distribution which could not have been achieved on a small scale of operation. Credit losses
often are increased when a business sells goods on the installment plan. But this disadvantage is
generally offset more by the expanded sales volume.
Installment sales pose some challenging problems for accountants. The most basic of these
problems is the matching of costs and revenue.
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•
•
•
•
Should the gross profit from an installment sale be treated as realized in the period
the sale occurs, or
Should it be spread over the life of the installment contract?
What should be done with costs which occur in periods subsequent to the sale?
How should defaults, trade-ins, and repossessions be handled?
2.1.1 Special Characteristics of installment sales
The risk of non collection to the seller is increased greatly when sales are made on the
installment plan. Customers generally are in weaker financial condition than those who buy on
open account: furthermore, the credit rating of the customers and their ability to pay may change
significantly during the period covered by an installment contract. To protect themselves against
this greater risk of no collection, sellers of real or personal property usually select a form of
contract called a security agreement which enables them to repossess the property if the buyer
fails to make payments.
A related problem is the increased collection expense when payments are spread over an
extended period. Accounting expenses also are multiplied by the use of installment sales, and
large amounts of working capital are tied up in installment receivables. In recognition of these
problems, many business executives have concluded that the handling of installment receivables
is a separate business, and they therefore sale their installment receivables to finance companies
which specialize in credit and collection activities.
2.1.2 Methods for recognition of profits on installment sales
The determination of net income on installment sales is complicated by the fact that the amounts
of revenue and related costs and expenses are seldom known in the period when the sale is made.
Substantial expenses (as for collection, accounting, repairs, and repossession) are likely to be
incurred in subsequent periods. In some businesses, the risk of non collection may be so great as
to raise doubts as to the recognition of any revenue or profit at the point of sale.
The first objective in the development of accounting policies for installment sales should be a
reasonable matching of costs and revenue. However, in recognition of the diverse business
conditions under which installment sales are made, accountants have used three approaches to
the problem:
(1) Recognition of gross profit at the time of sale:
(2) Cost recovery method: and
(3) Recognition of gross profit through the use of the installment method of accounting.
2.1.2.1 Recognition of Gross Profit at the Time of Sale
To recognize the entire gross profit at the time of an installment sale is to say in effect that
installment sales should be treated like regular sales on credit. The merchandise has been
delivered to the customer and an enforceable receivable of definite amount has been acquired.
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The excess of the receivable contract over the cost of merchandise delivered is realized gross
profit in the traditional meaning of the term. The journal entry consists of a debit to installment
Contracts Receivable and a credit to Installment Sales. If a perpetual inventory system is
maintained, another journal entry is needed to transfer the cost of the merchandise from the
inventories account to the cost of installment Sales account. No recognition is given to the
seller’s retention of title to the merchandise because the normal expectation is completion of the
contract through collection of the receivable. Implicit in this recognition of gross profit at the
time of sale is the assumption that all expenses relating to the sale will be recognized in the same
period so that the determination of net income consists of matching realized revenue with
expired costs.
The expenses associated with the sale include collection and doubtful accounts expenses.
Recognition of these expenses in the period of sake requires an estimate of the customer’s
performance over the entire term of the installment contract. Such an estimate may be
considerably more difficult to make than the normal provision made for doubtful accounts from
regular sales, which generally involve credit extension for 30 to 60 days. However, with careful
analysis of experience in the industry and in the particular business, reasonably satisfactory
estimates can be made in most situations. The journal entries to record such expenses would
consist of debits to expense accounts and credits to asset valuation accounts such as Allowance
for Doubtful Accounts and Allowance for Collection Costs. The allowance accounts would be
debited in later periods as uncollectible installment contract becomes known and as collection
costs are incurred.
2.1.2.2 Cost Recovery Method
In some cases accounts receivable may be collectible over a long period of time. In addition, the
terms of sale may not be definite, and the financial position of customers may be extremely
unpredictable, thus making it virtually impossible to find a reasonable basis for estimating the
degree of collectability of the receivables. In such cases, either the installment method or the cost
recovery method of accounting may be used for installment sales. Under the cost recovery
method, no profit is recognized until all costs of the item sold have been fully recovered. After
all costs have been recovered, additional collections on the installment receivables would be
recognized as revenue, and only current collection expenses would be charged to such revenue.
The cost recovery method of accounting is rarely used. Therefore it will not be illustrated in this
unit.
2.1.2.3 Recognition of Gross Profit through the Use of the Installment Method of
Accounting
The third approach to the measurement of income from installment sales is to recognize gross
profit in installments over the term of the contract on the basis of cash collections. Emphasis is
shifted from the acquisition of receivables to the collection of the receivables as the basis for
realization of gross profit; in other words, a modified cash basis of accounting is substituted for
the accrual basis. This modified cash basis of accounting is known as the installment method of
accounting.
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2.1.3 The Installment Method of Accounting
Under the installment method of accounting each cash collection on the contract is regarded as
including both a return of cost and a realization of gross profit in the ratio in which these two
elements were included in the selling price.
The opportunity to postpone the recognition of taxable income has been responsible for the
popularity of the installment method of accounting for income tax purposes. Although the
income tax advantages are readily apparent, the theoretical support for the installment method of
accounting is less impressive.
The installment method of accounting is permitted when:
(1) Collection of installment receivables is not reasonably assured:
(2) Receivables are collectible over an extended period of time: and
(3) There is no reasonable basis for estimating the degree of collectability.
In such situations, either the installment method or the cost recovery method of accounting may
be used.
Because the installment method still may be used for financial accounting purposes in some
cases and because it is widely used for income tax purposes, we shall illustrate its use in the
following pages, first for a single sale of real estate and then for sales of merchandise by a dealer.
Illustration 1: Single sale of real estate on the installment Plan
On September 30, Year 1, Ayat PLC sold for Br 50,000 (net of selling costs) a tract of land
which had a cost of Br 30,000. The company received a down payment of Br 8,000, the balance
to be received at the rate of Br3,000 every three months starting December 31, Year 1. In
addition, the buyer agreed to pay interest at the rate of 2% per quarter on the unpaid balance.
Because collection of the installments was highly uncertain, Ayat PLC elected to report the gain
on the installment basis, both for financial accounting and for income tax purposes Let us assume
that because this transaction was an isolated sale by a non dealer, there was no need to use an
installment Sales account; the deferred gain on sale of land was recorded at the time of sale.
Ayat PLC
Journal Entries to Record Sale of Land on installment Plan
for Year 1 and Year 2
Year 1
Sept. 1 Cash …………………………………… 8,000
Notes Receivable ……………………………… 42,000
Land …………………………………………….…………. 30,000
Deferred Gain on Sale of Land ………………..…..……… 20,000
Sold land on installment plan, receiving note calling for Payments of $3000 every six months
plus 2% quarterly interest on the unpaid balance.
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Dec. 31 Cash ………………………………………….3, 840
Notes Receivable ………………………………………………….3, 000
Interest revenue ………………………………………………………840
To record collection of the first installment and interest for the unpaid balance of Br 42,000 ( Br
42,000 X 2%=Br840)
Dec. 31 Deferred Gain on Sale of Land ……………… 4,400
Realized Gain on Sale of Land ……………………………….…… 4,400
To record gain computed at 60 %( 20,000/50000) of cash collected on the contract during year 1
Year 2
March 31 Cash ……………………………………….. 3,780
Interest Revenue ……………………………………………….….. 780
Notes Receivable …………………………………….………….. 3, 000
Collected quarterly installment on note receivable Plus interest for three months at 2% on
Br39,000
Journal entries for the remaining life of the note would follow the same pattern illustrated for
year 1 and year 2, assuming that the buyer makes all payments as required by contract.
The above example brings out the contrast between the timing of gross profits on ordinary sales
and on sales accounted for by the installment method. If the land sold by AYAT had been
recorded as an ordinary sale, a gross profit of Br 20,000 would have been reported in the year of
sale. Use of the installment method of accounting resulted in the recognition of only Br.4,400
gross profit in the year of sale, followed by a profit of Br4, 400 ($12,000 x 40% = $4,400) in
each of the next three years and Br1,200 for the fourth year final installment (Br3,000 X 40%). If
a sale on the installment plan results in a loss, the entire loss must be recognized in the year of
the sale.
Illustration 2: Sales of merchandise on the installment plan by a dealer
In the preceding example we dealt with a single sale of real estate on the installment plan by a
Non dealer. Now we shall consider a large volume of installment sales of merchandise by a
retailing company which uses the installment method of accounting because the collectability of
the receivables cannot be estimated.
A first requirement is to keep separate all sales made on the installment plan as distinguished
from ordinary sales. The accounting records for installment receivables usually are maintained
by contract rather than by customer; if several articles are sold on the installment plan to one
customer; it is convenient to account for each contract separately. However, it is not necessary to
compute the rate of gross profit on each individual installment sale or to apply a different rate to
collections on each individual contract. The average rate of gross profit on all installment sales
during a given year generally is computed and applied to all collections received (net of interest
and carrying charges) on installment receivables originating in that year.
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To illustrate the procedures of accounting for merchandise sales on the installment plan, assume
that Mamo Company sells merchandise on the installment plan as well as on regular terms (cash
or 30-day open accounts) and uses a perpetual inventory system. For an installment sale the
customer’s account is debited for the full amount of the selling price, including interest and
carrying charges, and is credited for the amount of the down payment. The installment contract
receivable thus provides a complete record of the transaction. Doubtful accounts expense is
recognized at the time the accounts are known to be uncollectible. Assume that at the beginning
of year 4 Mamo Company’s ledger included the following accounts:
Installment contracts receivable - Year 2 …………… Br 40,000 debit
Installment contracts receivable – Year 3 …………… 105,000 debit
Deferred interest and carrying charges on installment sales 21,750 credit
Deferred gross profit – Year 2 installment sales ………… 8,500 credit
Deferred gross profit – Year 3 installment sales ………… 24,990 credit
The gross profit rate on installment sales (excluding interest and carrying charges) was 25% in
year 2 and 28% year 3.
During Year 4, the following transactions relating to installment sales were completed by Mamo
Company:
(1) Installment sales, cost of installment sales, and deferred gross profit for Year 4 are listed
below:
Installment sales (not including Br 30,000 deferred interest and carrying Charges) … Br 400,000
Cost of installment sales ……………………………………….………………………… 276,000
Deferred gross profit – Year 4 installment sales ……………………………...…………. 124,000
Rate of gross profit on installment sales (124,000÷400,000)………………………………. 31%
(2) Cash collections on installment contracts during Year 4 are summarized below:
Installment contracts receivable Year 4 …
Installment contracts receivable Year 3 …
Installment contracts receivable Year 2 …
Total ………………….
Sales
Interest and
Price
carrying Charges
Br100,000
Br10,000
67,500
12,500
29,750
5,250
Br200, 650
Br27,750
Total cash
collected
Br110,000
80, 000
35,000
Br 225,000
(3) Customers who purchase merchandise in Year 2 were unable to pay the balance of their
contracts, Br5,000. The contracts consisted of Br 4,250 sales price and Br 750 in interest and
carrying charges, and included Br 1063 (Br 4,250 x 25% = Br 1063) of deferred gross profit. The
current fair (net realizable) value of the merchandise repossessed was Br 2500.
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(4) Deferred gross profit realized in year 4 is determined as follows:
Relating to year 4 sales, Br 100,000 x 31% ……………………… Br 31,000
Relating to year 3 sales, Br 67,500 x 28% ……………………… 18,900
Relating to year 2 sales, Br 31,500 x 25% ……………………… 7,437
Recording transactions: The journal entries to record the transactions for Mamo Company
relating to installment sales for Year 4 are given below:
Mamo Company
General Journal
Installment Contracts Receivable – year 4 ………….. 430,000
Installment Sales …………………………………… ………… 400,000
Deferred Interest and Carrying Charges on Installment Sales …… 30,000
To record installment sales during year 4
Cost of installment Sales ………………………………. 276,000
Inventories ………………………………………………………... 276,000
To record cost of installment sales
Cash ………………………………………………………… 225, 000
Installment Contracts Receivable – Year4 ………………………… 110,000
Installment Contracts Receivable - Year3 ………………………..…. 80,000
Installment Contracts Receivable Year2…………. ………….………35,000
To record collections on installment accounts during Year 4.
Inventories (repossessed merchandise) ……………………. 2,500
Deferred Gross Profit – Year 3 installment Sales …………. 1,063
Deferred interest and Carrying Charges on installment Sales. 750
Doubtful Accounts Expense ……………………………….. 687
Installment Contracts Receivable – Year 2 …………..……. 5,000
To record default of installment contracts originating in Year 2 and repossession of merchandise.
Adjusting entries: The adjusting journal entries for Mamo Company at December 31, year 4,
are as follows:
Installment Sales ………………………………………. 400,000
Cost of Installment Sales………………………………. 276,000
Deferred Gross Profit –Year 5 Installment Sales……… 124,000
To record deferred gross profit on Year 4 installment sales
Deferred Gross Profit – Year 4 Installment Sales………… 31,000
Deferred Gross Profit – Year 3 Installment Sales ……….. 18,900
Deferred Gross Profit – Year 2 Installment Sales ……….. 7,437
Realized gross profit on installment sales ………………… 57,337
To record realized gross profit as computed below:
Year 5: $100,000 x 31%.................................. Br 31,000
Year 4: $67,500 x 28% ……………………. 18,900
Year 3: $29,750 x 25% ……………………. 7,437
Total …………………………….. Br 57,688
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Deferred Interest and Carrying Charges on Installment Sales. 27,750
Revenue from Interest and Carrying Charges………... 27,750
To record interest and carrying charges earned during Year 4,
Consisting of following:
On Year 4 accounts …………………. Br 10,000
On Year 3 accounts …………………. 12,500
On Year 2 accounts………………….. 5,250
Total …………………. Br 27,750
The Realized Gross Profit on installment Sales and the Revenue from Interest and Carrying
Charges accounts would be closed to the income Summary account at the end of Year 4. The
accounts relating to installment sales appear in the general ledger at the end of Year 4 as follows:
Installment contracts receivable – year 3 …………….. Br 25,000 debit
Installment contracts receivable – year 5 ……………... 340,000 debit
Deferred interest and carrying charges on installment sales 23,250 credit
Deferred gross profit – year 3 installment sales ………….. 6,090 credit
Deferred gross profit – year 5 installment sales …………. 93,000 credit
These amounts may be rearranged in slightly different form to test the accuracy of the deferred
gross profit on installment contracts at the end of year 4:
Mamo Company
Proof of Deferred Gross Profit
December 31, Year 4
Year 3 accounts..
Year 5 accounts….
Total…………
Contracts
Receivable
Br 21,750
340,000
Br 361,750
Deferred
Interest and
Carrying
Charges
Br 3,250
20,000
Br 23,250
Net
Gross
Contracts Profit
receivable
%
Br 25,000
28
320,000
31
Br 345,000
Deferred
gross
profit
Br 6,090
93,000
Br 99,090
The use of the installment method of accounting requires installment contracts and collections to
be segregated by year of origin. In addition, the gross profit rate must be computed separately for
each year. However, a single controlling account for installment contracts receivable may be
year to ascertain uncollected balances by year of origin.
Defaults and Repossessions
Default:
Default; in this case, is failure of the customer to make the payment. If a customer defaults on an
installment contract for services and no further collection can be made, we have an example of
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default without the possibility of repossession. A similar situation exists for certain types of
merchandise which have no significant resale value. The journal entry required in such cases:
Deferred Gross Profit (Difference between Sales price and cost of sales)
XXX
Doubtful accounts expense*
XXX
Installment contracts receivable
XXXX
(*The doubtful accounts expense is equal to the unrecovered cost contained in the installment
contract receivable.)
Repossession:
Repossession, in this case is, taking back something from the buyer/customer when payments are
not made as per the contract. So, in most cases a default by a customer leads to
repossession/regain of merchandise. The doubtful accounts expense is reduced by the current
fair value of the property repossessed, and it is possible, though not likely, for the repossession to
result in a gain.
The principal difficulty in accounting for defaults followed by repossession is estimation of the
current fair value of the merchandise at the time of repossession. In setting a current fair value,
the objective is to choose an amount that will allow for any necessary reconditioning costs and
provide a normal gross profit on resale. As reconditioning costs are incurred, they should be
added to the inventories account, provided this does not become unreasonable in relation to the
expected selling price. In other words, the carrying amount of the repossessed merchandise for
financial accounting purposes should not exceed its net realizable value. When the installment
method of accounting is used, no loss or expense is recognized with respect to the deferred gross
profit and interest and carrying charges contained in the defaulted installment contracts, because
these amounts had not been recognized previously as realized revenue.
Other accounting issues relating to installment sales
Special accounting issues arise in connection with (1) acceptance of used property as a trade-in,
(2) computation of interest on installment contracts receivable, (3) the use of the installment
method of accounting solely for income tax purposes, and (4) retail land sales. These issues are
discussed in the following sections.
Trade-ins: The automobile business is a familiar example of the use of trade-ins; that is, the
acceptance by the dealer of a used automobile as partial payment for a new car. An accounting
problem is raised only if the dealer grants an over allowance on the used car taken in trade. An
over allowance is the excess of the trade-in allowance over the current fair value of the used
automobile in terms of the dealer’s ability to resell it at a price which will recover all direct costs
and result in a normal gross profit. A rough approximation of the current fair value of the used
automobile to the dealer may be the currently quoted wholesale price for used cars of the
particular make and model.
An over allowance on trade-ins is significant because it actually represent a reduction in the
stated selling price of the new merchandise. The stated selling price must be reduced by the
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amount of the over allowance to arrive at a valid amount for the net selling price for the new
merchandise. This net selling price less cost gives the gross profit on the sale of the new
merchandise.
Illustration:
MOENCO sold a new automobile for a list price of Br 6,600. Cash of Br 300 was received on
the sale, together with an old-model automobile accepted at a trade-in allowance of Br 1,500.
The balance of Br 4,800 was due in 24 monthly installments. Cost of the new automobile was Br
5,100. The company anticipated reconditioning cost on the trade-in of Br 200 and a resale price
of Br1,300. Used automobiles normally are sold at a gross profit of 25% of selling price. The old
automobile received as a trade in was sold at a price of Br 1,300 (a reconditioning cost of Br 200
was incurred). Now let us see how we compute current fair value of the trade in and the amount
of the over allowance:
Trade in allowance given to customer ………………………………………… Br 1,500
Deduct current fair value of trade-in:
Estimated resale value of article traded in………………………… Br 1,300
Less: Reconditioning cost ………………………………………..… Br 200
Gross profit margin ($1,300 x 25%)………………………….………. 325.52
Current fair value of article traded in ……………………………………………. 775
Over allowance on trade-in …….………………………………………………….725
Interest on Installment Contracts Receivable: Installment contracts usually provide for
interest and other so-called “carrying charges” to be paid concurrently with each installment
payment. Such deferred payment charges represent a cost of borrowing to the buyer and logically
may be referred to as “interest.” Only that portion of the payment which is applied to reduce the
principal of the contract is considered in the measurement of realized gross profit under the
installment method of accounting.
The arrangement for adding interest to installment contracts may follow the following plans:
1. Equal periodic payments, with a portion of each payment representing interest on the
uncollected balance of the principal and the remainder of the payment representing a
reduction in the principal
2. Interest computed on each individual installment payment from the beginning date of the
contract to the date each payment is received.
3. interest computed each moth on the balance of the principal outstanding during the month
4. interest computed throughout the entire contract period on the original amount of the sale
minus any down payment
Regardless of the plan used by dealers for adding interest to installment contracts, interest
revenue for financial accounting purposes should be computed periodically by application of the
effective interest rate to the unpaid balance of the installment contracts receivable.
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?
Review Question 2.1
1.
What do you mean by installment sales?
2.
What is the difference between Installment Sales and Ordinary Sale?
3.
What are the advantages and disadvantages (risks) of installment sales to the seller?
4.
What are the advantages and disadvantages of installment sale to the buyer
5.
List and discuss the different methods for recognition of profits on installment sales
6.
Explain the difference between Default and Repossession in Installment Sales
2.2 CONSIGNMETS
Dear distance learner, please make note of the following important points while studying
this unit.
• Terminology of consignments and parties involved
• The difference between a consignment and a sale
• The rights and duties of the consignee
• Accounting methods for both the consignor and the consignee
2.2.1 The Meaning of Consignments, Consignor and Consignee
The term consignment means the transfer of possession of merchandises from the Owner,
Principal or Consignor to another person called the Agent or Consignee who acts as the sales
representative of the owner. Title to the merchandise remains with the owner, who is called a
Principal or Consignor; the sales agent who has possession of the merchandise is called a
consignee or a commission merchant.
From a legal viewpoint a consignment represents a bailment. The relationship between the
consignor and consignee is that of principal and agent, and the law of agency controls the
determination of the obligations and rights of the two parties. (Please refer the Commercial and
Civil codes of Ethiopia)
2.2.2 Duties of the consignee
Consignees are responsible to consignors for the merchandise placed in their custody until the
merchandise is sold or returned. Since consignees do not acquire title to the merchandise, they
neither include it in inventories nor record on an account payable or other liability. The only
obligation of consignees is to give reasonable care to the consigned merchandise and to account
for it to consignors. When the merchandise is sold by a consignee, the resulting account
receivable is the property of the consignor. At this point the consignor recognizes the passage of
title to the purchaser and also recognizes gross profit or loss on the sale. The shipment of
merchandise on consignment may be referred to by the consignor as a consignment out, and by
the consignee as a consignment in.”
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2.2.3 Consignment versus a Sale:
Even though both sale and consignment involve the shipment of merchandise, a clear distinction
between the two is necessary for the proper measurement of income.
Here are the very basic points:
 Because title does not pass when merchandise is shipped on consignment, the consignor
continues to carry the consigned merchandise as part of inventories. No profit should be
recognized at the time of the consignment shipment because there is no change in
ownership of merchandise.
 If the consignee’s business should fail, the consignor would not be in the position of a
creditor: instead, the consignor would have the right to take possession of any unsold
consigned merchandise.
2.2.4 Why should a producer or wholesaler prefer to consign merchandise rather than to
make outright sales?
1. From the view point of the consignor:
One possible reason, especially with new products, is that the consignor may be able to
persuade dealers to stock the items on consignment, whereas they would not be willing to
purchase the merchandise outright. Secondly, the consignor avoids the risk inherent in
selling on credit to dealers of questionable financial strength.
2. From the viewpoint of a consignee,
The acquisition of a stock of merchandise on consignment rather than by purchase has the
obvious advantage of requiring less capital investment. The consignee also avoids the
risk of loss if the merchandise cannot be sold because of style obsolescence and physical
deterioration.
2.2.5 Rights and duties of the consignee
When merchandise is shipped on consignment, a formal written contract is needed on such
points as credit terms to be granted to customers by the consignee, expenses of the consignee to
be reimbursed by the consignor, commissions allowable to the consignee, frequency of reporting
and payment by the consignee, and handling and care of the consigned merchandise. In addition
to the explicit contractual arrangements, the general rights and duties of the consignee may be
summarized as follows;
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Rights of Consignee
Duties of Consignee
1. To
receive
compensation
for
merchandise sold for the account of
consignor
2. To
receive
reimbursement
for
expenditures (such as freight and
insurance) made in connection with the
consignment
To give care and protection reasonable in
relation to the nature of the consigned
merchandise
To keep the consigned merchandise separate from
other inventories or be able to identify the
consigned merchandise. Similarly, the consignee
must identify and segregate the consignment
receivables from other receivables
To use care in extending credit on the sale of
consigned merchandise and to be diligent in setting
prices on consigned merchandise and in collecting
consignment receivables.
To render complete reports of sales of consigned
merchandise and to make appropriate and timely
payments to the consignor
3. To sell consigned merchandise on
credit if the consignor has not
forbidden credit sales
4. To make the usual warranties as to
the quality of the consigned
merchandise and to bind the consignor
to honor such warranties
In granting credit, as in caring for the consigned merchandise, the consignee is obliged to act
prudently and to protect the interests of the consignor. Because the receivables from the sale of
consigned merchandise are the property of the consignor, the consignor bears any credit losses
provided the consignee has exercised due care in granting credit and making collections.
However, the consignee may guarantee the collection of receivables; under this type of
consignment contract, the consignee is said to be a Del Credere Agent.
The consignee must also follow any special instructions by the consignor as to care of the
merchandise. If the consignee acts prudently in providing appropriate care and protection, the
consignee is not liable for any damage to the merchandise which may occur. Although the
consignee is not usually obligated to maintain a separate bank account for cash from
consignment sales, a strict legal view of the relationship between consignor and consignee
requires separate identification of all property belonging to the consignor.
2.2.6 The Account Sales
The report rendered by the consignee is called an Account Sales. Account Sales shows the
merchandise received, merchandise sold, expenses incurred, advances made, and amounts owed
or remitted. Payments may be scheduled as agreed portions of the shipment are sold or may not
be required until the consigned merchandise either has been sold or has been returned to the
consignor. The following table shows sample Account Sales Report.
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Alem and Associates Co.
Bahir Dar
Account Sales
June 30,1999
Sales for account and risk of:
Star Business Group
Addis Ababa
Sales: 30 [email protected] Br 2,000
Charges:
Freight
Commission(10% of 60,000)
Balance(check enclosed)
Unsold refrigerators(consigned)
Br 60,000
Br 500
6,000
6,500
Br 53,500
none
2.2.7 Accounting Methods for the Consignee (Consignment In Account)
The objective in recording the receipt of the 30 refrigerators by Alem and associates Co. is to
create a memorandum record of the consigned merchandize as no purchase has been made and
no liability exists. The receipt of this merchandise could be recorded in the following ways:
 By a memorandum notation in the general journal or
 By an entry in a separate ledger of consignment shipments or
 By a memorandum entry in a general ledger account entitled Consignment In- Star
Business Group.
For our explanation purpose we use the last approach.
Consignment In- Star
Received 30 refrigerators sets to be sold for Br 2,000 each at a 10% commission
Journal entries for Alem Company
Consignment In-Star …………………………………500
Cash………………………………………………………… 500
(Paid freight charges on shipment from consignor)
Cash ………………………………………………… 60, 000
Consignment In- Star ………………………………………… 60,000
Sold 30 refrigerators at Br 2,000 each
Consignment In _Star ………………………………… 6,000
Commission revenue-Consignment sales …………………. 6,000
(Commission of 10% earned on refrigerators sold)
Cash………………………………………………………... 53,500
Consignment In-star ……………………………………………….53, 500
(Payment in full to consignor)
After postings of the above entries, Consignment- In account appears as follows:
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Consignment In Star
Received 30 refrigerators sets to be sold for Br 2,000 each, Sold 30 refrigerators @ Br 2000 each
which totals Br 60000, at a 10% commission
Freight Expense
500
Commission earned
6000
Payment to Consignor
53500
60,000
60,000
At the end of the accounting period when financial statements are prepared, some Consignment
in accounts in the subsidiary consignments ledger may have debit balances and others credit
balances.
 A debit balance will exist in a Consignment in account if the total of expenditures,
commissions, and advances to the consignor is larger than the proceeds of sales of that
particular lot of consigned merchandise.
 A credit balance will exist if the proceeds of sales are in excess of the expenditures,
commissions, and advances to the consignor.
The total of the Consignment In accounts with debit balances should be included among the
current assets in the balances sheet; the total of the Consignment In accounts with credit balances
should be classified as a current liability. Any commissions earned but not recorded should be
entered in the accounts before financial statements are prepared. The balance of the
Consignments In controlling account represents the difference between the Consignment in
accounts with debit balances and those with credit balances. This net figure should not be
presented in the balance sheet, because it would violate the accounting principle which prohibits
the offsetting of asset and liability accounts.
2.2.8 Accounting Methods for Consignor (Consignment Out Account)
Consignment Out Account is an account of the consignor for recording consignment related
transaction for each consignee. When the consignor ships merchandise to consignees, it is
essential to have a record of the location of this portion of inventories. Therefore, the consignor
may establish in the general ledger a Consignment Out Account for every consignee (or every
shipment on consignment). If consignment shipments are numerous, the consignor may prefer to
use a controlling account for subsidiary consignment out accounts. If the inventory records are
computerized, special coding Consignment Out identifies inventories in the hands of
consignees. The Consignment Out Account should not be intermingled with accounts receivable,
because it represents a special category of inventories rather than receivables.
2.2.9 Should Gross Profits on Consignments be Determined Separately?
First, let us distinguish between a separate determination of net income on consignment sales and
a separate determination of gross profits on consignment sales. Another possibility to consider is
a separate determination of consignment revenue apart from other sales revenue.
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Naturally, it would be useful to have very detailed information on the relative profitability of
selling through consignees as compared to selling through other channels of distribution.
However, our inclination to develop such information must be influenced by several practical
considerations. First, the determination of a separate net income from consignment sales seldom
is feasible, because this would require allocations of many operating expenses on a rather
arbitrary basis. The work required would be extensive, and the resulting data would be no better
than the arbitrary expense allocations.., In general, therefore, the determination of net income
from consignment sales cannot be justified.
The determination of gross profits from consignment sales as distinguished from gross profits on
other sales is much simpler, because it is base on the identification of direct costs associated with
the consignments. However, the compilation of these direct costs can be an expensive process
especially if the gross profit is computed by individual consignments or consignees.
Management should weigh the cost of this extra work against the need for information on
consignment gross profits. A separate determination of gross profits on consignments becomes
more desirable if consignment transactions are substantial in relation to other sales.
A separation of consignment sales from other sales is usually a minimum step to develop
information needed by management if consignment sales are an important part of total sales
Additional Explanation about separate and integrated determination of gross profit is indicated in
the table below
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Star Business Group: Journal Entries, Ledger account and Income statement presentation for a completed consignment
Explanation
1. Shipment of goods costing Br. 1,500 on
consignment
2. Packing expense of Br. 500
3. Consignment sale of Br. 60,000 reported
by the consignee and payment of Br.
53,500 received; charges of Br 500
freight costs and commission of Br
6,000.
4. Cost of consignment sales recorded Br
46,000 = ( 45,000 + 500 + 500)
5. Summary of Consignment out account
Gross profit determined separately
Consignment Out _Alem Co…..45,000
Inventories……………... 45,000
Consignment Out- Alem ……… 500
Packing expense …….... 500
Cash …………………………... 53,500
Consignment Out –Alem Co ….. 500
Commission expense ………….. 6,000
Consignment Sales ……. 6,000
Cost of consignment sales ……. 46,000
Cost of goods sold …………….. 45,000
Consignment Out _ Alem ….. 46,000
Consignment Out –Alem Co 45,000
Consignment out – Alem Co
Consignment out – Alem Co
45,000
500
500
46,000
6. Income statement presentation
Gross profit not determined separately
Consignment Out _Alem Co…..45,000
Inventories……………... 45,000
No journal entry required- the expense is
reported among other operating expenses
Cash …………………………... 53,500
Freight Expense ……………….. 500
Commission expense …………. . 6,000
Sales …………………… 6,000
46,000
45,000
45,000
46,000
Consignment Sales ………………. 60,000
Less : Cost of consignment sales 46,000
Commission expense ….. 6000
52,000
Gross profit on consignment
8,000
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Included in total sales
60,000
Included in all cost of goods sold 45,000
Included in total packing expense
500
Included in total freight expense
500
Included in total commission expense 500
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2.2.10 Accounting for Partial Sale of Consigned Goods
In the preceding examples, we have assumed that the consignor received an account sales
showing that the entire consignment had been sold by the consignee. The account sale was
accompanied by remittance in full, and the consignor’s journal entries were designed to record
the gross profit from the completed consignment. However, there may be cases whereby part of
the consignment are returned unsold by the consignee as discussed below
2.2.10.1 Return of Unsold Merchandise by Consignee: We have stressed that the costs
of packing and shipping merchandise to a consignee, whether paid directly by the consignor
or by the consignee, properly are included in inventories. However, if the consignee for any
reason returns merchandise to the consignor, the packing and freight costs incurred on the
original outbound shipment should be written off as expense of the current period. The place
utility originally created by these costs is lost when the merchandise is returned. Any
charges borne by the consignor on the return shipment also should be treated as expense,
along with any repair expenditures necessary to place the merchandise in salable condition.
Finally, a clear distinction should be made between freight costs on consignment shipments
and outbound freight on regular sales. The latter is a current expense, because the revenue
from sale of the merchandise is recognized in the current period. The freight costs create an
increment in value of the merchandise which is still the property of the consignor. This
increment, along with the cost of acquiring or producing the merchandise is to be offset
against revenue in a future period when the consigned merchandise is sold.
2.2.10.2 Advances from consignees: Although cash advances from a consignee sometimes
are credited to the Consignment Out account, a better practice is to credit a liability account,
Advances from Consignees. The Consignment Out account will then continue to show the
carrying amount of a liability to the Consignee.
2.2.11 Nature of the Consignment Out Account
When accounting students encounter for the first time a ledger account such as Consignment
Out, they may gain a clear understanding of five types of accounts: assets, liabilities, owners’
equity, revenue, and expenses. Classification of the Consignment Out account within this
structure will depend upon the method employed by a particular company in consignments.
Whether or not a company uses a system of determining gross profits on consignment sales
separately from regular sales, the Consignment Out account belongs in the asset category. The
account is debited for the cost of merchandise shipped to a consignee; when the consignee
reports sale of all or a portion of the merchandise, the cost is transferred from Consignment Out
to Cost of Consignment Sales. To be even more specific, Consignment Out is a current asset, one
of the inventories group to be listed on the balance sheet as inventories on Consignment, or
perhaps combined with other inventories if the amount is not material. As stated earlier, the costs
of packing and transporting consigned merchandise constitute costs of inventories, and these
costs should be debited to the Consignment Out account.
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Another concept of the Consignment Out account not illustrated in this unit but used by some
companies is summarized briefly as follows: The Consignment Out account may be debited for
the cost of merchandise shipped to the consignee and credited for the sales proceeds remitted by
the consignee. This normally will result in a credit balance in the Consignment Out account
when the entire shipment has been sold. This credit balance represents the profit earned by the
consignor. The account is closed by a debit to Consignment Out and a credit to and account such
as Profit on Consignment Sales. No separate account is used for consignment Sales, and the
income statement does not show the amount of sales made through consignees. Under this
system, the Consignment Out account does not fit into any of the five basic classes of accounts.
It is a mixture of asset elements and revenue and must be closed or reduced to its asset element
(cost of unsold consigned merchandise) before financial statements are prepared at the end of an
accounting period. The methods we have illustrated in accounting for consignments are widely
used, but many variations from these methods are possible.
2.3 Unit Summary
1. Installment sales pose some challenging problems for accountants. The most basic of these
problems is the matching of costs and revenue.
2. An installment sale is a sale of real or personal property or services which provides for a
series of payments over a period of months or years. A down payment usually, but not
always, is required.
3. The risk of non collection to the seller is increased greatly when sales are made on the
installment plan. To protect themselves against this greater risk of no collection, sellers of
real or personal property usually select a form of contract called a security agreement which
enables them to repossess the property if the buyer fails to make payments.
4. The first objective in the development of accounting policies for installment sales should be a
reasonable matching of costs and revenue. However, in recognition of the diverse business
conditions under which installment sales are made, accountants have used three approaches
to the problem:
(1) Recognition of gross profit at the time of sale:
(2) Cost recovery method: and
(3) Recognition of gross profit through the use of the installment method of accounting.
5. Recognize the entire gross profit at the time of an installment sale is to say in effect that
installment sales should be treated like regular sales on credit. The merchandise has been
delivered to the customer and an enforceable receivable of definite amount has been
acquired. The excess of the receivable contract over the cost of merchandise delivered is
realized gross profit in the traditional meaning of the term. The expenses associated with the
sale include collection and doubtful accounts expenses. Recognition of these expenses in the
period of sale requires an estimate of the customer’s performance over the entire term of the
installment contract.
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6. Under the cost recovery method, no profit is recognized until all costs of the item sold have
been fully recovered. After all costs have been recovered, additional collections on the
installment receivables would be recognized as revenue, and only current collection expenses
would be charged to such revenue.
7. The third approach to the measurement of income from installment sales is to recognize gross
profit in installments over the term of the contract on the basis of cash collections. Emphasis
is shifted from the acquisition of receivables to the collection of the receivables as the basis
for realization of gross profit; in other words, a modified cash basis of accounting is
substituted for the accrual basis. This modified cash basis of accounting is known as the
installment method of account.
8. Under the installment method of accounting each cash collection on the contract is regarded
as including both a return of cost and a realization of gross profit in the ratio in which these
two elements were included in the selling price. The opportunity to postpone the recognition
of taxable income has been responsible for the popularity of the installment method of
accounting for income tax purposes. Although the income tax advantages are readily
apparent, the theoretical support for the installment method of accounting is less impressive.
9. If a customer defaults on an installment contract for services and no further collection can be
made, we have an example of default without the possibility of repossession. A similar
situation exists for certain types of merchandise which have no significant resale value.
However, in most cases a default by a customer leads to repossession of merchandise. The
doubtful accounts expense is reduced by the current fair value of the property repossessed,
and it is possible, though not likely, for the repossession to result in a gain.
10. When the installment method of accounting is used, no loss or expense is recognized with
respect to the deferred gross profit and interest and carrying charges contained in the
defaulted installment contracts, because these amounts had not been recognized previously as
realized revenue.
11. Special accounting issues arise in connection with (1) acceptance of used property as a tradein, (2) computation of interest on installment contracts receivable, (3) the use of the
installment method of accounting solely for income tax purposes, and (4) retail land sales.
These issues are discussed in the following sections.
12. The term consignment means a transfer of possession of merchandises from the owner to
another person who acts as the sales agent of the owner. Title to the merchandise remains
with the owner, who is called a consignor; the sales agent who has possession of the
merchandise is called a consignee or a commission merchant.
13. The relationship between the consignor and consignee is that of principal and agent, and the
law of agency controls the determination of the obligations and rights of the two parties.
14. Consignees are responsible to consignors for the merchandise placed in their custody until
the merchandise is sold or returned. The only obligation of consignees is to give reasonable
care to the consigned merchandise and to account for it to consignors. When the merchandise
is sold by a consignee, the resulting account receivable is the property of the consignor. At
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this point the consignor recognizes the passage of title to the purchaser and also recognizes
and grosses profit or loss on the sale.
15. The shipment of merchandise on consignment may be referred to by the consignor as a
consignment out, and by the consignee as a consignment in.”
16. Even though both a sale and a consignment involve the shipment of merchandise, a clear
distinction between the two is necessary for the proper measurement of income.
17. When merchandise is shipped on consignment, a formal written contract is needed on such
points as credit terms to be granted to customers by the consignee, expenses of the consignee
to be reimbursed by the consignor, commissions allowable to the consignee, frequency of
reporting and payment by the consignee, and handling and care of the consigned
merchandise.
18. The report rendered by the consignee is called an Account Sales; it shows the merchandise
received, merchandise sold, expenses incurred, advances made, and amounts owed or
remitted.
19. The objective in recording the receipt of merchandise by a consignee is to create a
memorandum record of the consigned merchandize as no purchase has been made and no
liability exists. The receipt of this merchandise could be recorded in the following ways: By a
memorandum notation in the general journal or by an entry in a separate ledger of
consignment shipments or by a memorandum entry in a general ledger account entitled
Consignment
20. The total of the Consignment in accounts with debit balances should be included among the
current assets in the balances sheet; the total of the Consignment in accounts with credit
balances should be classified as a current liability. Any commissions earned but not recorded
should be entered in the accounts before financial statements are prepared. The balance of the
Consignments in controlling account represents the difference between the Consignment in
accounts with debit balances and those with credit balances. This net figure should not be
presented in the balance sheet, because it would violate the accounting principle which
prohibits the offsetting of asset and liability accounts.
21. The consignor may establish in the general ledger a Consignment Out account for every
consignee (or every shipment on consignment). The Consignment Out account should not be
intermingled with accounts receivable, because it represents a special category of inventories
rather receivables.
22. A separation of consignment sales from other sales is usually a minimum step to develop
information needed by management if consignment sales are an important part of total sales
volume. On the other hand, no separation of consignment sales from other sales may be
justified if only an occasional sale is made on a consignment basis.
23. If the consignee for any reason returns merchandise to the consignor, the packing and freight
costs incurred on the original outbound shipment should be written off as expense of the
current period. The place utility originally created by these costs is lost when the
merchandise is returned. Any charges borne by the consignor on the return shipment also
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should be treated as expense, along with any repair expenditures necessary to place the
merchandise in salable condition.
24. A clear distinction should be made between freight costs on consignment shipments and
outbound freight on regular sales. The latter is a current expense, because the revenue from
sale of the merchandise is recognized in the current period.
25. Whether or not a company uses a system of determining gross profits on consignment sales
separately from regular sales, the Consignment Out account belongs in the asset category.
The account is debited for the cost of merchandise shipped to a consignee; when the
consignee reports sale of all or a portion of the merchandise, the cost is transferred from
Consignment Out to Cost of Consignment Sales.
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. Self Test Exercises
Part I: True or False Questions
Dear Distance learner, read the following sentences carefully and write TRUE if the statement is
correct or FALSE if the statement is incorrect in your notebook.
1. There is no major difference between Installment Sale and Consignment Sale
2. The larger the volume of installment sales, the higher the risk of no collection, the higher
the bad debt expenses and counting costs.
3. In installment sale, there is no transfer of title of ownership from the seller to the buyer
until the installment payment is fully paid.
4. In installment sale, the accounting method of recognition of gross profit at the time of
sale has the same accounting treatment as the ordinary sale on credit.
5. Consignment is the transfer of possession from the consignee to the consignor.
6. Though it is difficult to determine net income for consignments, it is possible to
determine gross profit for each consignment sales
Part II: Multiple Choice Questions.
Dear Distance Learners choose the correct answer for the following questions and write the
capital letter of your correct choice in your notebook
1. ------------------- is a sale of real or personal property or services which provides the buyer
for a series of payments over a period of months or years.
A. Trade off
B. Consignment Sale
C. Installment Sale
D. A and C
E. None
2. Identify the wrong statement about Installment Sale
A. Gives the buyer an opportunity to pay the price little by little in an agree period of
time.
B. The risk of default payment and un collectability is high compared to ordinary
sales
C. It gives the seller the opportunity to increase sales volume
D. The seller is required to wait considerable agreed period of time to collect the full
sales price of the merchandise or service
E. None
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3. Identify the correct statement about consignment.
A. It is the transfer of ownership of merchandise from the Consignor to the
Consignee
B. It is the transfer of possession of merchandise from the agent to the principal
based on agency relationship
C. It is the transfer of possession of merchandise from the Principal to the Agent
based on agency relationship
D. In consignment, there is not transfer of title between the Consignor and the
Consignee
E. C and D
F. All of the above
4. Which of the following is/are not the rights and duties of the Consignee/Agent
A. Taking the ownership of the merchandise from the Consignor
B. Taking possession of merchandise from the Consignor and handling the
merchandise in care and protection
C. Receiving instructions from the Consignor and making reports to the Consignor
about the consigned merchandise
D. Sometimes, collecting receivables from the buyers
E. None
5. Which one of the following is not included in the Account Sales Report of the
Consignee?
A. Merchandise received
B. Merchandise Sold
C. Expenses incurred in handling and selling the merchandise
D. All of the above
E. None of the above
6. All consignment shipments of the consignor to each consignee are recorded in the ____
account of the consignor
A. Consignment In
B. Consignment Out
C. Default Account
D. Repossession Account
E. All of the above
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Part III: Matching
Dear Distance Learners, match items listed in column A with the items listed in Column B
Column A
Column B
A. Consignor’s Account for recording consignment shipments
to each Consignee
B. Consignee’s Account for recording consignments received
from each consignor
C. The sales representative or agent of the owner of the
merchandise
D. The Principal or owner of the merchandise
E. The buyer pays the price in a series of payments over an
agreed period of time
F. Taking back or regain of merchandize or property from the
buyer when the buyer defaults to pay as per the contract
G. Governs the relationship between the Consignor &
Consignee
H. Used as a basis for the distribution during liquidation
I. Transfer of possession of merchandise from the consignor to
the agent/consignee
J. Failure of the buyer to make payments as per the contract
K. A Consignee who collects receivables
1. Installment Sale
2. Consignment
3. Consignor
4. Consignee
5. Default
6. Repossession
7. Del Credere Agent
8. Consignment In
9. Consignment Out
10. Law of Agency
Part IV: Fill in the Blank Spaces
Dear Distance Learners, fill in the blank spaces with the appropriate word or phrase.
1. ____________ Method of sale of merchandise whereby the buyer pays of the price of
goods and services little by little in a serious of payments.
2. ____________ Give me your old car with some amount of additional money and I will give
you a new car of similar type.
3. ____________ An agent/consignee who may also take the responsibility for collecting
receivables from buyers
4. ____________
Determines the relationships,
obligations, rights, duties and
responsibilities of the Consignor and the Consignee
5. ___________ Reacquisition or Regaining merchandise or property which was sold on
installment sale
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 Answers Key to Self Test Exercises
Dear Distance Learners, check your answer for the above self test exercises
Part I: True/False Questions
1. False
2. True
3. False
4. True
5. False
6. True
Part II: Multiple Choice Questions
1. C
2. E
3. E
4. A
5. E
6. B
Part III: Matching Questions
1. E
2. I
3. D
4. C
5. J
6. F
7. K
8. B
9. A
10. G
Part IV: Fill in the Blank Space
1. Installment Sale
2. Trade In
3. Del Credere Agent
4. The Law of Agency
5. Repossession
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UNIT THREE: BUSINESS COMBINATIONS
 Introduction
The purpose of this unit is to explore the meaning and the broad accounting implications of
business combinations. First, you will examine the general meaning of business combination,
which can mean a purchase of assets as well as a purchase of a subsidiary. Next, you will look
more closely at the issues surrounding purchase of a subsidiary and consolidation at the date of
acquisition.
Learning Objectives
When you have completed this unit, you should be able to
1. Describe the major economic advantages of business combinations.
2. Understand the basic accounting differences between acquisitions accomplished by
purchasing of assets of a company versus purchasing a controlling interest in the voting
common stock of a company.
3. Allocate the purchase cost to the assets and liabilities of the acquired company.
4. Account for assets and liabilities included in a business combination that involves goodwill.
5. Account for acquired assets and liabilities subsequent to a purchase
6. Explain the special issues that may arise in a purchase and show how to account for them.
3.1 Definition of a Business Combination
Dear students, in this unit, you will be introduced to the key definition of business combination
and the three key points in business combination. Please make note of the points.
A business combination occurs when one corporation obtains control of a group of net assets of
another corporation that constitutes a going concern. A key words here are control and going
concern.
Control can be obtained either by:
1. buying the assets themselves (which automatically gives control to the buyer), or
2. buying control (part of the assets of the business) in the corporation that owns the assets
(which makes the purchased corporation a subsidiary).
Going Concern: A second key aspect of the definition of a business combination is that the
purchaser acquires control over “net assets that constitute a business”, a going concern. That is,
purchasing a group of idle assets is not a business combination.
Net asset: A third aspect is the phrase net assets—a net asset means assets minus liabilities.
Business combinations often (but not always) require the buyer to assume some or all of the
seller’s liabilities. When the purchase is accomplished by buying control over another
corporation, liabilities are automatically part of the package. But when the purchaser buys a
group of assets separately, there may or may not be liabilities attached, such as when one
corporation sells an operating division to another company. In any discussion of business
combinations, remember that net assets includes any related liabilities.
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Finally, observe that business combination is not synonymous with consolidation. The
subsidiaries may be either parent- founded or purchased. A purchased subsidiary usually is the
result of a business combination. But sometimes one corporation will buy control over a shell
corporation or a defunct corporation. Since the acquired company is not an operating business,
no business combination has occurred. As well, not all business combinations result in a parentsubsidiary relationship. When a business combination is a direct purchase of net assets, the
acquired assets and liabilities are recorded directly on the books of the acquirer, as we shall
discuss shortly.
Therefore, Business Combination is the process whereby a particular corporation acquires
control of the net asset of another ongoing corporation or other business by purchasing all or part
of the net asset of the business
3.2 Accounting for Business Combinations: General Approach
In this sub unit, you know about the approaches of accounting for business combinations and the
steps involved in it such as measuring the cost of the purchase, determination of fair values of
assets and liabilities acquired and then allocation of the cost.
The general approach to accounting for business combinations, whether (1) direct purchase of
net assets or (2) purchase of control, is a three-step process:
a. Measure the cost of the purchase
b. Determine the fair values of the assets and liabilities acquired
c. Allocate the cost on the basis of the fair values
The mechanics of accounting for the acquisition will depend on the nature of the purchase,
particularly on whether the purchase was of the net assets directly or of control over the net
assets through acquisition of shares of the company that owns the assets. Let’s look at the
general features that apply to all business combinations before we worry about the acquisition
method used.
3.2.1 Measuring the Acquisition Cost of the Business
The acquirer/buyer may pay for the assets (1) in cash or other assets, (2) by issuing its own
shares as consideration for the net assets acquired, or (3) by using a combination of cash and
shares. When the purchase is in cash, it is not difficult to determine the total cost of the net assets
acquired. When the purchase is paid for with other assets, the cost is measured by the fair value
of the assets surrendered in exchange.
One of the most common methods of acquiring the net assets of another company is for the
acquirer to issue its own shares in full or partial payment for the net assets acquired. When shares
are issued for the purchase, the cost of the purchase is the value of the shares issued. If the
acquirer is a public company, then the valuation of the shares issued is based on the market value
of the existing shares.
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Note that although the valuation of the shares issued is based on the market value, the value
assigned to the newly issued shares may not actually be the market price on the date of
acquisition. The value assigned to the issued shares is more likely to reflect an average price for
a period (e.g., 60 days) surrounding the public announcement of the business combination. The
assigned value may be further decreased to allow for the under-pricing that is necessary for a
new issue of shares. Nevertheless, the value eventually assigned to shares issued by a public
company normally will bear a proximate relationship to the value of the shares in the public
marketplace.
A business combination, whether paid for by assets or by shares, may include a provision for
contingent consideration. Contingent consideration is an add-on to the base price that is
determined some time after the deal is finalized. The amount of contingent consideration can be
based on a number of factors, such as:
• a fuller assessment of the finances and operations of the acquired company,
• the outcome of renegotiating agreements with debt holders,
• achievement of stated earnings objectives in accounting periods following the
change of control, or
• Achievement of a target market price for the acquirer’s shares by a specified
future date.
Contingent consideration that is paid in future periods usually is considered to be additional
compensation. The treatment of additional compensation varies:
• If the additional future amount can be estimated at the time that the business
combination takes place, the estimate is included in the original calculation of the
cost of the purchase
• If the amount cannot be estimated at the date of the combination but additional
compensation is paid in the future, the fair value of the net assets is adjusted
(usually by increasing the amount of goodwill attributed to the purchase)
• If additional shares are issued because the market price of the issued shares falls
below a target price (or fails to reach a target price in the future), the additional
shares do not represent an additional cost, but simply the issuance of more shares
to maintain the same purchase price.
Valuation of shares issued by a private company is even more judgmental. If it is not feasible to
place a reliable value on the shares issued, it will instead be necessary to rely upon the fair value
of the net assets acquired in order to measure the cost of the purchase. In practice, the fair values
assigned to the acquired assets and liabilities in a purchase by a private corporation often are
remarkably similar to their recorded book values on the books of the acquirer. There is a lot of
room for the exercise of professional judgment in determining the cost of an acquisition.
3.2.2 Determining the Current Fair Value of the Business
Guidelines for determining fair values of net assets:
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1. Net realizable value for assets held for sale or conversion into cash
2. Replacement cost for productive assets such as raw materials and tangible capital assets
3. Appraisal values for intangible capital assets, land, natural resources, and non marketable
securities
4. Market value for liabilities, discounted at the current market rate of interest
3.2.3 Allocating the Cost to the Net Asset of the Business
The third step in accounting for a business combination is to allocate the cost. It is a generally
accepted principle of accounting that when a company acquires a group of assets for a single
price, the total cost of the assets acquired is allocated to the individual assets on the basis of their
fair market values. If a company buys land and a building for a lump sum, for example, the land
and building are recorded at their proportionate cost, as determined by estimates of their fair
values.
The same general principle applies to assets and liabilities acquired in a business combination.
The total cost of the purchase is allocated on the basis of the fair market values of the assets and
liabilities acquired. However, the price paid for the operating unit will be determined in part by
its earnings ability. The acquirer may or may not choose to continue to operate the unit in the
same manner; but regardless of the acquirer’s plans, the price to be paid will take into account
the acquired unit’s estimated future net revenue stream.
If the unit has been successful and has demonstrated an ability to generate above-average
earnings, then the acquirer will have to pay a price that is higher than the aggregate fair value of
the net assets. On the other hand, if the unit has not been successful, the price may be less than
the fair value of the net assets (but not normally less than the liquidating value of the net assets
including tax effects).
Goodwill acquired in a purchase of net assets is recorded on the acquirer’s books, along with the
fair values of the other assets and liabilities acquired. It is important to understand that goodwill
is a purchased asset. The purchaser paid good money (or shares) for the goodwill just as surely as
for buildings and inventory.
The allocation process, therefore, is essentially a two-step process:
1. Acquisition cost is allocated to the fair values of the net assets acquired, and
2. Any excess of acquisition cost over the aggregate fair value is viewed as goodwill.
3.3 The Methods and Illustrations of Business Combinations:
3.3.1 Direct Purchase of Net Assets: with Illustration
The following discussion illustrates the mechanics of accounting for a business combination
when the business is acquired through direct acquisition of the net assets of the acquired
company.
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To illustrate the accounting for a direct purchase of net assets, assume that on December 31,
2006, Alem Ltd. (Purchase) acquires all of the assets and liabilities of Target Ltd. (Target) by
issuing 40,000 Purchase common shares to Target. Before the transaction, Alem Ltd had 160,000
common shares outstanding. After the transaction, 200,000 Purchase shares are outstanding, of
which Target owns 20%. The pre-transaction balance sheets of both companies are shown on the
next page.
The estimated fair values of Target’s assets and liabilities are shown below. Their aggregate fair
value is Birr 1,100,000. If we assume that the market value of Alem’s shares is Br. 30 each, then
the total cost of the acquisition is Br.1, 200,000. The transaction will be recorded on the books of
Alem as follows:
Cash and receivables 200,000
Inventory 50,000
Land 400,000
Buildings and equipment 550,000
Goodwill 100,000
Accounts payable 100,000
Common shares 1,200,000
PRE-TRANSACTION BALANCE SHEETS (exhibit 3.1)
December 31, 2006
Alem Ltd.
Target Ltd.
Cash
Br.1,000,000
Br 50,000
Accounts receivable
2,000,000
150,000
Inventory
200,000
50,000
Land
1,000,000
300,000
Buildings and equipment
3,000,000
500,000
Accumulated depreciation
(1,200,000)
(150,000)
Total assets
Br6,000,000
Br900,000
Accounts payable
Br1,000,000
Br100,000
Long-term notes payable
400,000
Common shares*
2,600, 000
200,000
Retained earnings
2,000,000
600,000
Total liabilities and shareholders’ equity
Br6,000,000
Br900,000
* For Alem Ltd.—160,000 shares outstanding
Fair values of Target Ltd’s net assets:
Cash
Accounts receivable
Inventory
Land
Buildings and equipment
Accounts payable
Total
Br50, 000
150,000
50,000
400,000
550,000
(100,000)
Br1, 100,000
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The selling company, Target, will record the transaction by writing off all of its assets and
liabilities and entering the new asset of Alem’s shares, recognizing a gain of Br.400, 000 on the
transaction.
Alems’s assets and liabilities increase by the amount of the fair values of the acquired assets and
by the purchased goodwill, while Target’s previous net assets have been replaced by its sole
remaining asset, the shares in Alem. If the transaction had been for cash instead of Alem shares,
Target’s sole remaining asset would have been the cash received. After the net asset, Alem has
been recorded, Alem Ltd. will account for the assets as they would any new assets. There is no
special treatment required.
POST-TRANSACTION BALANCE SHEETS (exhibit 3.2)
December 31, 2001
Purchase Ltd.
Target Ltd.
Cash
Br1,050,000
Br —
Accounts receivable
2,150,000
—
Inventory
250,000
—
Land
1,400,000
—
Buildings and equipment
3,550,000
—
Accumulated depreciation
(1,200,000)
—
Goodwill
100,000
Investment in Alem Ltd. shares
—
1,200,000
Total assets
Br7,300,000
Br1,200,000
Accounts payable
Br1,100,000
Br —
Long-term notes payable
400,000
—
Common shares*
3,800,000
200,000
Retained earnings
2,000,000
1,000,000
Total liabilities and shareholders’ equity Br7, 300,000
Br.1, 200,000
* for Alem Ltd. 200,000 shares outstanding
3.3.2
Purchase of Shares
Reasons for purchasing shares
In your previous reading, you understood that buying the assets (or net assets) of another
company is one way to accomplish a business combination. Here you will be introduced with
another common method, purchase of Shares (part of ownership of the business). A much more
common method of acquiring control over the assets of another company is to buy the voting
shares of the other business. If one company buys a controlling block of the shares of another
company, then control over the assets has been achieved, and the acquirer/buyer has a new
subsidiary.
An acquirer can obtain a controlling share interest by any one or a combination of three methods:
• buying sufficient shares on the open market,
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• entering into private sale agreements with major shareholders, or
• issuing a public tender offer to buy the shares.
Unlike a direct purchase of assets, when a business combination is achieved by an acquisition of
shares, the acquired company continues to carry its assets and liabilities on its own books. The
purchaser has acquired control over the assets, but has not acquired the assets themselves.
Purchase of shares rather than assets has the obvious advantage that control can be obtained by
buying considerably less than 100% of the shares. Control can be obtained at substantially less
cost than would be the case if the acquirer purchased the assets directly.
There are several other advantages to buying shares rather than the net assets themselves:
• The shares may be selling at a price on the market that is less than the fair value per
share (or even book value per share) of the net assets. The acquirer can therefore
obtain control over the assets at a lower price than could be negotiated for the assets
themselves.
• By buying shares rather than assets, the acquirer ends up with an asset that is more
easily saleable than the assets themselves, in case the acquirer later decides to divest
itself of the acquired business, or a portion thereof.
• The acquirer may prefer to retain the newly acquired business as a separate entity for
legal, tax, and business reasons. The acquired business’s liabilities need not be
assumed directly, and there is no interruption of the business relationships built up by
the acquired corporation.
• Income tax impacts can be a major factor in the choice between purchasing assets and
purchasing shares. A purchase of shares may benefit the seller because any gain to the
seller on a sale of shares will be taxed as a capital gain.
3.3.3 Share Exchanges
There are many different ways in which shares can be exchanged in order to accomplish a
business combination. Some of the more common and straightforward methods include the
following:
• The acquirer (combiner) issues new shares to the shareholders of the acquired company
in exchange for the shares of the target company (the combinee).
• Subsidiaries of the acquirer issue shares in exchange for the acquirer’s shares.
• A new corporation is formed; the new corporation issues shares to the shareholders of
both the combiner and the combinee in exchange for the outstanding shares of both
companies.
• The shareholders of the two corporations agree to a statutory amalgamation.
• The acquiree issues new shares to the shareholders of the acquirer in exchange for the
acquirer’s outstanding shares.
The first method listed above is the most common approach. The acquirer ends up having more
shares outstanding in the hands of shareholders, while the acquiree’s shares that were previously
held by external shareholders are now held by the acquirer. Both corporations continue to exist
as separate legal entities, but the acquirer’s shareholder base has been expanded to include
shareholders who had previously been shareholders of the acquiree. The acquiree does not hold
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any shares in the acquirer; it is the former shareholders of the acquiree who hold the newly
issued acquirer shares.
The second approach is similar to the first, except that the acquirer does not issue its own shares
to acquire the company directly. Instead, the acquirer obtains indirect control by having its
subsidiaries issue new shares to acquire the company. This approach is useful when the acquirer
does not want to alter the ownership percentages of the existing shareholders by issuance of
additional shares. For example, if the controlling shareholder of the acquirer owns 51% of the
acquirer’s shares, the issuance of additional shares would decrease the controlling shareholder’s
interest to below 50%, and control could be lost. But if the acquirer has a subsidiary that is, say,
70% owned, quite a number of additional shares could be issued by the subsidiary without
jeopardizing the parent’s control.
Under the third method, a new company is created that will hold the shares of both the other
combining companies. The holding company issues its new shares in exchange for the shares of
both of the acquiree and the acquirer. After the exchange, the shares of both operating companies
are held by the holding company, while the shares of the holding company are held by the former
shareholders of both the acquiree and the acquirer.
3.3.4 Statutory Amalgamation
In a statutory amalgamation, the shareholders of the two corporations approve the combination
or amalgamation of the two companies into a single surviving corporation. Statutory
amalgamations are governed by the law under which the companies are incorporated. For two
corporations to amalgamate, they must be incorporated under the same law. The shareholders of
the combined company are the former shareholders of the two combining companies. Statutory
amalgamation is the only method of combination wherein the combining companies cease to
exist as separate legal entities. It is also the only method of share exchange in which the assets of
both companies end up being recorded on the books of one company, similar to the recording of
assets in a direct purchase of net assets. In all other forms of share exchange, there is no transfer
of assets and thus no recording of the acquiree’s assets on the acquirer’s books: the results of the
combination are reported by means of consolidated financial statements, as we discussed in the
previous unit. In contrast, consolidated statements are not needed for the combined companies
after a statutory amalgamation because only one company survives. Of course, if either
amalgamating company had subsidiaries, it would still be necessary to prepare consolidated
statements that include those subsidiaries.
Illustration of a share exchange
To illustrate the acquirer’s accounting for a purchase of shares, assume that on December 31,
2001, Alem Ltd. acquires all of the outstanding shares of Target Ltd. by issuing 40,000 Purchase
shares with a market value of Br30, or Br1,200,000 total, in exchange. After the exchange of
shares, all of the Target shares will be held by the corporate entity of Alem, while the newly
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issued shares of Alem will be held by the former shareholders of Target and not by Target as a
corporate entity. Target will have no shares external to the combined entity, while the
shareholder base and the number of shares outstanding for Alem have increased. When Alem
acquires the shares, the entry to record the purchase on the books of Alem will be as follows:
Investment in Target 1,200,000
Common shares 1,200,000
There will be no entry on Target’s books, because Target is not a party to the transaction; the
transaction is with the shares of Target and not with the company itself. After the original
purchase is recorded, the investment is accounted for on ALem’s books by either the cost or
equity method as indicated in the table below,
Before the exchange
After the exchange
Alem Ltd.
Target Ltd. ALem Ltd. Target Ltd
Cash
Br 1,000,000 Br 50,000
Br1,000,000 Br50,000
Accounts receivable
2,000,000
150,000
2,000,000
150,000
Inventory
200,000
50,000
200,000
50,000
Land
1,000,000
300,000
1,000,000
300,000
Buildings and equipment
3,000,000
500,000
3,000,000
500,000
Accumulated depreciation
-1,200,000
-150,000
-1,200,000
-150,000
Investment in Target Ltd. `
—
—
1,200,000
Total assets
Br6,000,000 Br900,000
Br7,200,000 Br900,000
Accounts payable
Br1,000,000 Br100,000
Br1,000,000 Br100,000
Long-term notes payable
400,000
—
400,000
Common shares*
2,600,000
200,000
3,800,000
200,000
Retained earnings
2,000,000
600,000
2,000,000
600,000
Total liabilities and share equity
Br6,000,000 Br900,000
Br7,200,000 Br900,000
*For Alem Ltd., 160,000 shares before the exchange; 200,000 shares after the exchange.
The post-transaction amounts on Alems’s separate-entity balance sheet differ from the pretransaction amounts only in one respect—Alem now has an account, “Investment in Target
Ltd.,” that reflects the cost of buying Target’s shares, offset by an equal increase in Alems’s
common share account. The purchase price was Br1, 200,000, determined by the value of the
40,000 Purchase common shares given to Target’s shares in exchange for their shares in Target.
Target’s balance sheet is completely unaffected by the exchange of shares. Target’s owner has
changed, but nothing has changed in the company’s accounts. Target’s net asset book value was
Br800, 000 prior to the change of ownership, and remains 800,000 after the change of
ownership. Target is now a subsidiary of Alem, and therefore Alem will prepare consolidated
financial statements for public reporting purposes.
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3.4 Negative Goodwill
It is not unusual, however, for the total fair value of the assets and liabilities to be greater than
the purchase price. This excess of fair values over the purchase price is commonly known as
negative goodwill, although the title is not particularly indicative of the accounting treatment of
the amount. The total of the net debits (to record the fair values) is greater than the credits (to
record the consideration paid), and therefore there are more debits than credits in the
consolidated statements—not a tolerable situation in a double-entry system. The task is to correct
the balance by either increasing the credits or decreasing the debits. Negative goodwill is, in
essence, an indication that the acquirer achieved a bargain purchase. A bargain purchase is
possible for a variety of reasons. If the acquisition is by a purchase of shares, then the market
price of the acquiree’s shares may be well below the net asset value per share. Or if the acquiree
is a private company, a bargain purchase may be possible if the present owners are anxious to
sell because of the death of the founder-manager, divorce, changed family financial position, or
simply an inability to manage effectively. When any company buys an asset at a bargain price,
the asset is recorded at its cost to the purchaser, and not at any list price or other fair value.
For example, suppose that a company buys a large computer from a financially troubled
distributor for only Br 80,000. The price of the computer from any other source would be Br
120,000. On the buyer’s books, the computer obviously would be recorded at Br 80,000, not at
Br120,000 with an offsetting credit for Br40,000.
The same general principle applies to bargain purchases in business combinations. The purchase
price is allocated to the acquired assets and liabilities on the basis of fair values, but not
necessarily at fair values if the total fair value exceeds the purchase price. A problem does arise,
however, in deciding to which assets and liabilities the bargain prices or negative goodwill
should be assigned.
A business combination involves the assets and liabilities of a going concern. The net assets
acquired usually comprise a mixture of financial and non financial, current and long-term assets
and liabilities. Because the various assets and liabilities have varying impacts on reported
earnings, the allocation of negative goodwill will affect the amount of future revenues and
expenses.
For example, suppose that Alem acquired all of the shares of Target, as above, but at a cost of
only Br 1,050,000. Since the fair value of Target’s net assets is Br1,100,000, negative goodwill
of Br50,000 exists. Target’s assets and liabilities will be reported on Alems’s consolidated
balance sheet at a total amount of Br1,050,000. Br50,000 less than their fair values. At least one
of the Target assets must be reported at an amount that is less than its fair value.
If the negative goodwill were assigned to inventory, Target’s inventory would be consolidated at
zero value, since the fair value of Target’s inventory was assumed to be Br 50,000.
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Reduction in the cost assigned to inventory will flow through to the income statement in the
following year as a reduction in cost of goods sold and an increase in net income. If, on the other
hand, the negative goodwill were assigned to buildings and equipment, then the effect of the
bargain purchase would be recognized over several years in the form of reduced depreciation on
the lower cost allocated to buildings and equipment.
Allocation of the negative goodwill to land would result in no impact on earnings until the land
was sold; allocation to monetary receivables would result in a gain when the receivables were
collected.
Negative Goodwill Should Be Allocated in the following order:
1. pro rata to any intangible assets that do not have an observable market value, and then
2. Pro rata to depreciable non-financial assets (both tangible and intangible).
If the purchase price allocations to the non-financial assets have all been reduced to zero and
there still is negative goodwill remaining, the remaining amount is recognized as an
extraordinary gain, even though the normal conditions for recognizing an extraordinary gain
have not been met.
?
Review Question 3.1
1. What do you mean by Business Combination?
2. What are the three methods of paying the price of purchased assets in business combination?
3. List and Discuss the three accounting steps in Business Combination
4. Explain the difference between business combination and amalgamation
5. Explain the situations whereby goodwill and negative goodwill can occur in business combination
3.5 Summary of Key Points
1. A business combination is the acquisition of net assets or control over net assets that
constitute a functioning business. Control over net assets is usually obtained by buying a
majority of the shares in the operating company that owns the assets. When control is
acquired, the acquired net assets remain the property of the controlled subsidiary. Therefore,
consolidated financial statements are necessary.
2. Accounting for a business combination requires three steps: (1) determine the cost of the
acquisition, or purchase price, (2) determine the fair values of the acquired assets and
liabilities, and (3) allocate the purchase price to the identifiable assets and liabilities, with
any excess attributed to goodwill. The basis for the allocation of purchase price is the fair
values of the acquired assets and liabilities. If the purchase price is less than the aggregate
fair value of the net assets, negative goodwill arises. The value assigned to non-financial
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assets, starting with intangible assets with no observable market value, must be reduced
until the total allocated amount equals the purchase price. If the purchase price is less than
the fair value of the non-financial assets, the excess of fair value over the purchase price is
recognized as an extraordinary item. A purchase of net assets may be accomplished (1) by
paying cash or other assets or (2) by issuing shares. A combination of cash and shares may
be used. When shares are issued, the purchase price is based on the market value of the
shares, if determinable. If the market value of issued shares is not determinable, the fair
value of the net assets acquired may be used as the measure of the purchase price. Fair
values are determined on various bases, depending on the type of asset or liability.
Generally, fair values of assets are based on net realizable values, replacement costs, and
appraised values. Liabilities are measured at their discounted present value, using the market
rate of interest at the time of the combination. If the net assets are purchased directly, the
fair values of the acquired assets and liabilities are recorded on the books of the acquirer.
There is no parent subsidiary relationship because the acquirer did not buy another
corporation— it bought the net assets instead.
3. Acquisition of majority control over another company enables the investor to obtain control
over the assets without having to pay the full fair value of the assets. Shares can be
purchased for cash or other assets. Alternatively, the purchaser can issue its own shares in
exchange for the shares of the acquiree. If there is an exchange of shares, the acquirer does
not have to give up any cash. The previous holders of the acquiree’s shares now hold shares
in the acquirer instead.
4. Theoretically, there are three approaches to reporting consolidated financial statements
following purchase of control over another corporation: pooling, purchase, and new entity.
Under the pooling method, the book values of the parent and the subsidiary are simply
added together and reported as the consolidated amounts. Under purchase accounting, the
date-of acquisition fair values of the subsidiary are added to the parent’s book values. The
purchase method of consolidation gives the same results as if the net assets had been
purchased directly. With the new-entity method, the fair values of the parent and the
subsidiary are added together to form a new basis of accountability for the ongoing
economic entity.
. Self Test Exercises
Part I: True or False Questions
Dear Distance learner, read the following sentences carefully and write TRUE if the statement is
correct or FALSE if the statement is incorrect in your notebook.
1. There is no major difference between Business Combination & Consolidation
2. Business Combination requires acquisition of control by buying the net asset of another
business as a whole or the majority of the net asset of the ongoing business.
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3. In the business combination process, if the acquisition cost of the business is greater than
the current fair value of the business, the difference is recorded as the goodwill of the
business
4. Statutory amalgamation is the only method of combination whereby the combining
companies cease to exist as separate legal entities.
5. In Statutory Amalgamation, the shareholders of the combined company are different from
former shareholders of the two combining companies
Part II: Multiple Choice Questions.
Dear Distance Learners choose the correct answer for the following questions and write the
capital letter of your correct choice in your notebook
1. In Business Combination, the acquirer or buyer may pay in:
A. Cash or other assets
B. Shares
C. A and B
D. None
2. Which of the following method(s) can be used to determine the fair value of net assets of
the business in business combination
A. Net realizable value of assets
B. Replacement cost of productive assets
C. Appraisal value of intangible assets
D. Current market value of liabilities
E. All
3. Business Combination requires:
A. Obtaining Control by purchasing the net asset of the ongoing business as a whole
B. Obtaining Control over the majority of the net assets of the business by buying
part of the ongoing
C. Consolidation of the business
D. A and B
E. All of the Above
F. None of the above
4. Which of the following is/are not part of the accounting steps of business combination?
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A. Measuring the acquisition cost of the business
B. Determining the current fair value of the net assets of the business
C. Allocating the total cost of net assets of the business to each asset of the business
D. All of the above
E. None
5. Identify the wrong statement about Statutory Amalgamation and Combination
A. The combining companies are dissolved in statutory amalgamation
B. In statutory amalgamation, the shareholders of the combining companies may
continue as the shareholders of the amalgamated company
C. In Statutory Amalgamation, the two combining companies are amalgamated into
one surviving company
D. All of the above
E. None of the above
Part III: Matching
Dear Distance Learners, match items listed in column A with the items listed in Column B
Column A
1. Business Combination
2. Amalgamation
Column B
A. When the acquisition cost of the net asset of the combining
business is less than the current fair value of the net asset
3. Current Fair Value
B. The purchasing cost of the net asset of the combining business
4. Acquisition Cost
C. Combining two corporations into a new business entity
5. Goodwill
D. The market price of the net assets of the combining business
6. Negative goodwill
E. Purchase of net asset of the business
F. When the acquisition cost of the net asset of the combining
business is greater than the current fair value of the net asset
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 Answers Key to Self Test Exercises
Dear Distance Learners, check your answer for the above self test exercises
Part I: True/False Questions
1. False
2. True
3. True
4. True
5. False
Part II: Multiple Choice Questions
1. C
2. E
3. D
4. E
5. E
Part III: Matching Questions
1. E
2. C
3. D
4. B
5. F
6. A
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UNIT 4: ACCOUNTING FOR BRANCHES
 Introduction
Dear distance learner, as businesses grow, it is often important to establish branches in different
parts of the country. Therefore, in this unit, you will study the accounting methods employed by
a company when it has a branch or branches scattered all over a country or a city. That is you
will learn about the accounting treatment of transactions that exist between the head office and
its branches.
A branch is a unit of a business enterprise located at some distance from the Home/Head Office.
A branch generally carries a stock of merchandise obtained from the Head Office, makes sales,
approves customers’ credit and makes collections on trade accounts receivable.
The merchandise of a branch may be obtained exclusively from the home office, or a portion
may be purchased from outside suppliers. The cash receipts of the branch may be deposited in a
bank account of the home office; branch expenses then are paid from an imp rest cash fund
provided by the home office. The imp rest cash fund is replenished periodically by the home
office. Alternatively, a branch may maintain its own bank account. Certain units or segments of a
business enterprise may be operated as divisions. A division may consist of either a series of
branches or one or more corporations. When a segment is operated as a corporation, it is known
as a subsidiary of the parent company.
Learning Outcomes:
After completing studying this unit, you are expected to know about:
 The definition of a branch and how a branch acquires and effects payments for its
expenditures.
 The accounting methods employed by companies for their branches
 The nature of reciprocal accounts
 Billings of merchandise to branches
 Reconciliation of reciprocal accounts
 Financial statements prepared by branches and the home office
 Inter branch transactions
4.1 Accounting for Branches
In this unit, you will study about why companies may prefer to centralize or decentralize the
accounting system of their branch/es and the treatment of start up costs of opening a new branch.
In the subunits that follow, you need to make sure that you clearly understand the treatment of
transactions between the home office and its branch such as reciprocal ledger accounts, the
alternative methods of billings of merchandise to branches and the preparation of separate as
well as combined financial statements
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The extent of the accounting activity at a branch depends upon company policy. The policies of
one company may provide for a complete set of accounting records at each branch; policies of
another company may call for concentration of all accounting records in the home office. In
some of the drug and grocery chain stores, for example, the branches submit daily reports and
documents to the home office, which enters all transactions by branches in computerized
accounting records kept in a central location. The home office may not even conduct operations
on its own but merely serve as an accounting and control center for the branches.
In many fields of business the branch maintains a complete set of accounting records consisting
of journals, Ledgers, and a chart of accounts similar to those of an independent business.
Financial statements are prepared at regular intervals by the branch and forwarded to the home
office. The number and types of accounts, the internal control system, the form and content of
financial statements, and the accounting policies generally are prescribed by the home office.
Internal auditors may perform examinations to determine whether branch personnel carry out
these policies and procedures.
The accounting records for branches may be centralized in the home office or may be
decentralized so that each branch maintains a complete set of accounting records. If the
accounting records are centralized in the home office, each branch prepares daily reports and
documents that are used as sources for journal entries in the accounting records of the home
office. If a branch maintains its own accounting records, some transactions or events relating to
the branch may be recorded by the home office. Periodic financial statements are provided by the
branch to the home office so that combined statements may be prepared. In this course therefore
we assume that a branch maintains its accounts of records.
4.2 Start-up Costs of Opening New Branches
Some businesses would capitalize and amortize such start-up costs on the grounds that such costs
are necessary for successful operation of the branch at a new location. Most enterprises
recognized start-up costs in connection with the opening of a branch as expenses of the
accounting period in which the costs are incurred. The decision should be based on the principle
that net income is measured by matching expired costs with realized revenue. Costs that benefit
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future accounting periods are deferred and allocated to those periods. Seldom is there complete
certainty that a new branch will achieve a profitable level of operations in later years.
4.3 Reciprocal Accounts
The accounting records of a branch include a Home Office ledger account that is credited for
assets and services provided by the home office, and for branch net income. The Home Office
account is debited for any assets and services provided by the branch to the home office or to
other branches and for branch net losses. The Home Office account thus is an ownership equitytype account representing the net investment of the home office in the branch. At the end of the
accounting period when the branch closes its accounts, the Income Summary account is closed to
the Home Office account. A net income increases the credit balance in the Home Office account;
a net loss decreases this balance. A home office maintains a reciprocal ledger account,
Investment in Branch, which is debited for the assets and other services provided to a branch,
and for net income of the branch; it is credited for the assets and services received from the
branch, and for branch net losses. A home office generally charges its branches for expenses
(such as insurance, interest, property taxes, advertising and depreciation) incurred for the benefit
of the branch. Such expenses must be allocated to branch operations to measure the profitability
of each branch. In the home office accounting records, a reciprocal account with a title such as
investment in Branch is maintained. This account is debited for the cash, merchandise, and
services provided to the branch, and for net income earned by the branch. It is credited for the
cash or other assets received from the branch and for any net loss incurred by the branch. A
separate investment account generally is maintained by the home office for each branch. If there
is only one branch, the account title is likely to be investment in Branch; if there are numerous
branches, each account title will include a name or number to identify the individual branch
4.4 Expenses Incurred by Home Office and Charged to Branches
If an asset is purchased by the home office for the branch, the journal entry for the acquisition is
a debit to an asset account and credit to Cash or Accounts Payable. If the branch acquires a plant
asset, it will debit the Home Office account and credit Cash or Accounts Payable. The home
office debits an asset account, such as Equipment: Branch Z, and Credits the reciprocal account
Investment in Branch Z If the home office does not make sales itself but functions only as a
control center, most or all of its expenses may be allocated to the branches. To facilitate
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comparison of the operating results of the various branches, the home office may charge each
branch interest on the capital invested in that branch. Such interest expense recorded by the
branches would be offset by interest revenue to the home office and would not appear in the
combined income statement of the company as a whole.
4.5 Alternative Methods of Billing Merchandise Shipments to Branch
Three alternative methods are available to the home office for pricing merchandise shipped to a
branch. The merchandise shipped may be billed
1) At cost,
2) At cost plus and appropriate percentage, or
3) At retail selling price.
The shipment of merchandise to a branch does not constitute a sale because ownership of the
merchandise does not change.
Billing at cost is the simplest procedure and is widely used. It avoids the complication of
unrealized gross profit in inventories and permits the financial statements of the branch to give a
meaningful picture of operations. However, billing merchandise to branches at cost attributes all
gross profits of the organization to the branches, even though some of the merchandise may be
manufactured by the home office. Under these circumstances, cost may not be most realistic
basis for pricing shipments to branches. When merchandise is billed at a price above home office
cost (or at branch retail selling price), the valuation assigned to branch inventory at the end of the
accounting period must be reduced to cost when combined financial statements are prepared.
4.6 Expenses Incurred By Home Office and Allocated to Branches
If a plant asset is acquired by the home office for a branch, the journal entry for the acquisition is
a debit to an asset account such as Equipment: Branch Z and a credit to Cash or a Liability
Account. The home office also usually acquires insurance, pays property and other taxes, and
does advertising that benefits all branches. An expense incurred by home office for a branch is
recorded by home office by a debit to Investment in Branch and a credit to an appropriate
expense account; the branch debits an expense account and credits Home Office.
If the home office does not make sales and serves only as accounting center, then most or all of
its expenses may be allocated to branches.
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To facilitate comparison of the operating results of the various branches, the home office may
charge each branch interest on the capital invested in that branch. Such interest expense
recognized by the branches would be offset by interest revenue recognized by the home office
and would not be displayed in the combined income statement of the business enterprise as a
whole.
Illustration
 In a typical Home Office and Branch transactions and events (Perpetual Inventory
System), the transactions and events are recorded by the Home Office and by a Branch
are depicted in the following illustration. The explanations for the journal entries are
omitted.
Transactions:
1. The Home office sent cash of 1000 to its branch
2. The home office shipped merchandise costing Br. 60,000 at cost
3. The branch purchased an equipment costing Br. 500
4. The branch sold merchandise costing Br. 45,000 for Br. 80,000 on account.
5. The branch collected cash of Br. 62,000 from its debtors.
6. The branch paid Br. 20,000 for its expenses.
7. The branch sent cash of Br. 37,500 to the home office.
8. The home office allocated expense of Br. 3000 to the branch.
The expense was originally recorded by the office as a debit to operating expenses.
Home Office Accounting Records
Branch Accounting Records
Journal Entries
1. Investment in Branch
Cash
2. Investment in Branch
Inventories
3. Equipment : Branch
Investment in Branch
4. None.
1,000
Cash
1,000
60,000
60,000
500
500
5. None
6. None
7. Cash
Journal Entries
37,500
Home Office
Inventories
Home Office
Home Office
Cash
Trade Accts Receivables
Cost of Goods Sold
Sales
Inventories
Cash
Trade Accts. Receivable
Operating Exps.
Cash
Home Office
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1,000
1,000
60,000
60,000
500
500
80,000
45,000
80,000
45,000
62,000
62,000
20,000
20,000
37,500
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Investment in Branch
8. Investment in Branch
Operating Exps.
37,500
3,000
3,000
Cash
Operating Exps.
Home Office
37,500
3,000
3,000
4.7 Separate Financial Statements for Branch and Home Office
A separate income statement and balance sheet should be prepared by the branch so that
management may review the operating results and financial position of the branch. The income
statement has no unusual features if merchandise is billed to the branch at cost. However, if
merchandise is billed to the branch at retail selling price, the income statement will show a net
loss approximating the amount of operating expenses. The only unusual aspect of the balance
sheet for a branch is the use of the Home Office account in lieu of the ownership equity accounts
used by a separate business entity. The separate financial statements prepared by a branch may
be revised at the home office to include expenses incurred by the home office allocable to the
branch, and to show branch operations after elimination of any intra company profits.
Separate financial statements also may be prepared for the home office so that management will
be able to appraise the results of its operations and its financial position. However, it is important
to emphasize that separate financial statements of the home office and of the branch are prepared
for internal use only: they do not meet the needs of investors, bankers, or other external users of
financial statements.
4.8 Combined/Consolidated Financial Statements for Home Office and Branch
A balance sheet for distribution to bankers, creditors, stockholders, and government agencies
must show the financial position of the business enterprise as a single unit. A convenient starting
point in the preparation of a combined balance sheet consists of the adjusted trial balances of the
home office and of the branch. A working paper for the combination of these trial balances is
illustrated on the next page. When the branch acquires merchandise from outsiders as well as
from the home office, the merchandise acquired from the home office should be recorded in a
separate account such as inventories from Home Office.
4.8.1 Working paper for Combined Financial Statements
A working paper for combined financial statements has three purposes:
(1) To combine assets and liabilities accounts
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(2) To eliminate any intra company profits or losses, and
(3) To eliminate the reciprocal accounts
Any elimination or offsetting the balances is done only on working paper. No entry is to be made
in the accounting record of either Home office or branch. Because the only purpose of the
working paper is to facilitate the preparation of combined financial statements. An example of a
typical working paper, when billing to branches is done at cost, is shown on the following table.
4.8.2 Illustration of the Working Paper
Please make note that the balances on the adjusted trail balance column of the home office are
arbitrary figures and of the branch are from Illustration I above.
SBH COMPANY
Working Paper for Combined Financial Statements of Home Office and Branch
For Year Ended December 31, 2002
(Perpetual Inventory System: Billings at Cost)
Adjusted Trial Balances
Home Office
Branch
Eliminations
Combined
Dr (Cr)
Dr (Cr)
Dr (Cr)
Dr (Cr)
Income Statement
Sales
(400,000)
(80,000)
(480,000)
Cost of goods sold
235,000
45,000
280,000
Operating expenses
90,000
23,000
113,000
Net Income (to statement of
75,000
12,000
87,000
retained earnings
below)
Totals
0
0
0
Statement of Retained
Earnings
Retained earnings, beginning of
year
Net (Income) (from income
statement above)
Dividends declared
Retained earnings, end of year
(to balance sheet below)
Totals
(70,000)
(75,000)
(70,000)
(12,000)
40,000
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40,000
117,000
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Balance Sheet
Cash
Trade accounts receivable (net)
Inventories
Investment in Branch
Equipment
Accumulated depreciation of
equipment
Trade accounts payable
Home office
Common stock, $ 10 par
Retained earnings (from
statement of retained earnings
above)
Totals
25,000
39,000
45,000
26,000
150,000
(10,000)
5,000
18,000
15,000
30,000
57,000
60,000
(26,000)
150,000
(10,000)
(20,000)
(20,000)
(26,000)
26,000
150,000)
0
(150,000)
(117,000)
0
0
0
4.9 Billing of Merchandise to Branches at Prices above Home Office Cost
The home offices of some business enterprises bill merchandise shipped to branches at home
office cost plus a markup percentage (or alternatively at branch retail selling prices). Because
both these methods involve similar modifications of accounting procedures, a single example
illustrates the key points involved, using the illustration discussed above.
Under this assumption, the journal entries for the first year's events and transactions by the Home
Office and Branch are the same as those presented on the above Illustration except for the journal
entries for shipments of merchandise form the Home Office to the Branch. These shipments
($60,000 cost + 50% markup on cost = $90,000) are recorded under the perpetual inventory
system as follows:
Home office Accounting Records Journal Entries
Branch Accounting Records Journal Entries
2. Investments in Branch
90,000
Inventories
60,000
Allowance for Overvaluation of Inventories
30,000
Inventories 90,000
Home office 90,000
If merchandise is billed to a branch at a price above home office cost and the perpetual
inventory system is used;
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•
•
The home office debits Investment in Branch for the billed price of the merchandise,
credits Inventories for the cost of the merchandise, and credits Allowance for
Overvaluation of Inventories: Branch for the excess of the billed price over cost.
The branch debits Inventories and credits Home Office at billed prices of
merchandise; sales by the branch are debited to Cost of Goods Sold and credited to
Inventories at billed prices.
Investment in Branch:
This account is $30,000 larger than the $26,000 balance in the prior illustration (I).
The increase represents the 50% markup over cost ($60,000) of the merchandise shipped to the
Branch.
Investment in Mason Branch
Date Explanation
2002 Cash sent to branch
Merchandise billed to branch
at markup of 50% over home office cost
Equipment acquired by branch carried
in home office accounting records
Cash received from branch
Operating expenses billed to branch
Debit
1,000
Credit
90,000
91,000 dr
500
37,500
3,000
Balance
1,000 dr
90,500 dr
53,000 dr
56,000 dr
Home office
In the accounting records of the Branch, the Home Office ledger account now has a credit
balance of Br. 56,000, before the accounting records are closed and the branch net income or loss
is entered in the Home Office account, as illustrated below:
Home Office
Date Explanation
2002 Cash received from home office
Merchandise received from home office
Equipment acquired
Cash sent to home office
Operating expenses billed by home office
Debit
Credit
1,000
90,000
500 90,
37,000
3,000
Balance
1000 cr
91,000 cr
500 cr
53,000 cr
56,000 cr
The Branch recorded the merchandise received from the home office at billed prices of Br.
90,000; the home office recorded the shipment by credits of $60,000 to Inventories and $30,000
to Allowance for Overvaluation of Inventories: Mason Branch. Use of the allowance account
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enables the home office to maintain a record of the cost of merchandise shipped to Mason
Branch as well as the amount of the unrealized gross profit on the shipments.
At the end of the accounting period, the Branch reports its inventories (at billed prices) at
Br. 22,500. The cost of these inventories is Br. 15,000 (Br. 22,500 / 1.50 = Br. 15,000).
In the home office accounting records, the required balance of the Allowance for Overvaluation
of Inventories: Branch ledger account is Br. 7,500 (Br. 22,500 -Br15, 000 = Br. 7,500); thus, this
account balance must be reduced from its present amount of Br. 30,000 to Br. 7,500. The reason
for this reduction is that the 50% markup of billed prices over cost has become realized gross
profit to the home office with respect to the merchandise sold by the branch. Consequently, at the
end of the year the home office reduces its allowance for overvaluation of the branch inventories
to the $7,500 excess valuation contained in the ending inventories. The debit adjustment of
$22,500 in the allowance account is offset by a credit to the Realized Gross Profit: Mason
Branch Sales account, because it represents additional gross profit of the home office resulting
from sales by the branch.
These matters are illustrated in the home office end-of-period adjusting and closing entries on
page 93.
4.10
Working Paper When Billings to Branches at Prices above Cost
When a home office bills merchandise shipments to branches at prices above home office cost,
preparation of the working paper for combined financial statements is facilitated by an analysis
of the flow of merchandise to a branch, such as the following:
Flow of Merchandise for Mason Branch
During XXXX
Billed Price
Home Office Cost Markup (50% of Cost;
33% of Billed Price)
Beginning inventories
Add: Shipments from home office
Br90,000
Br 60,000
Br30,000
Available for sale
Less: Ending inventories
Br 90,000
22,500
Br 60,000
15,000
Br 30,000
7,500
Cost of goods sold
Br 67,500
Br 45,000
Br 22,500
The Markup column in the foregoing analysis provides the information needed for the
Eliminations column in the working paper for combined financial statements below A separate
income statement and balance sheet for each branch may be prepared for use by enterprise
management. The income statement has no unusual features if merchandise is billed to a branch
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at home office cost. However, if merchandise is billed at a price above cost, the branch trial
balance must be adjusted by the home office so that cost of the merchandise sold by the branch is
stated at cost to the home office.
A combined balance sheet for home office and branch shows the financial position of the
business enterprise as a single entity. In the working paper for combined financial statements, the
assets and liabilities of the branch are substituted for the Investment in Branch ledger account
included in the adjusted trial balance of the home office. This is accomplished by elimination of
the balances of the Home Office and Investment in Branch reciprocal ledger accounts.
Illustration 3
SBH COMPANY
Working Paper for Combined Financial Statements of Home Office and Branch
For Year Ended December 31, 2002
(Perpetual Inventory System: Billings above Cost)
Adjusted Trial Balances
Home Office Branch
Eliminations Combined
Dr (Cr)
Dr (Cr)
Dr (Cr)
Dr (Cr)
Income Statement
Sales
(400,000)
(80,000)
(480,000)
Cost of goods sold
235,000
67,500
(22,500)
280,000
Operating expenses
90,000
23,000
113,000
Net Income (loss) (to statement of retained
75,000
(10,500)
22,500
87,000
earnings)
Totals
0
0
0
Statement of Retained Earnings
Retained earnings, beginning of year
Net (Income) (from income statement
above)
Dividends declared
Retained earnings, end of year (to balance
sheet below)
Totals
Balance Sheet
Cash
Trade accounts receivable (net)
Inventories
(70,000)
(75,000)
10,500
(22,500)
40,000
(70,000)
(87,000)
40,000
117,000
0
0
25,000
39,000
45,000
5,000
18,000
22,500
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0
(7,500)
30,000
57,000
60,000
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Investment in Branch
Allowance for Overvaluation of Inventories:
Branch
Equipment
Accumulated depreciation of equipment
Trade accounts payable
Home office
Common stock, $ 10 par
Retained earnings (from statement of
retainedearnings above)
Totals
56,000
(30,000)
(56,000)
30,000
150,000
(10,000)
(20,000)
(56,000)
56,000
0
0
(150,000)
0
0
150,000
(10,000)
(20,000)
0
(150,000)
(117,000)
0
Note:
The above working paper differs from the working paper on Illustration I by the inclusion of
elimination to restate the ending inventories of the branch to cost. Also, the income reported by
the home office is adjusted by the Br.22,500 of merchandise’ markup that was realized as a result
of sales by the branch.
Home Office Adjusting and Closing Entries and Branch Closing Entries
The year end adjusting and closing entries of the home office are illustrated below
Income: Branch ……………………………………….. 10,500
Investment in Branch …………………………….. 10,500
To record net loss reported by branch
Allowance for Overvaluation Inventories: Branch ……… 22,500
Realized Gross Profit: Branch ……………………… 22,500
To reduce allowance to amount by which ending inventories
Of branch exceed cost.
Realized Gross Profit: Branch ……………………………. 22,500
Income: Branch ……………………………………….. 10,500
Income Summary ……………………………………… 12,000
To close net loss and realized gross profit to Income summary
Ledger account
Branch Accounting Record Closing Entries
Sales ………………………………………………………80.000
Income Summary …………………………………………10,500
Cost of goods sold …………………………………… 67,500
Operating Expenses …………………………………. 23,000
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To close revenue and expense ledger accounts
Home Office ………………………………………………10,500
Income Summery …………………………………….. 10,500
To close the net loss in the income summery account to the head office account
4.11
The Use of Periodic Inventory System
If a home office and branch use the periodic inventory system, the home office debits
Investment in Branch for the billed price of the merchandise shipped, credits Shipments to
Branch for the home office cost of the merchandise shipped, and credits any excess of billed
price over cost to Allowance for Overvaluation of Inventories: Branch. The branch debits
Shipments from Home Office and credits Home Office at billed price. At the end of the
accounting period, the home office reduces (debits) Allowance for Overvaluation of Inventories:
Branch for the amount of overvaluation applicable to the branch’s cost of goods sold and credits
the amount of the reduction to the Realized Gross Profit: Branch Sales ledger account.
4.12 Reconciliation of Reciprocal Accounts
Dear distance learner, please clearly understand how you can make a statement of reconciliation
of reciprocal ledger accounts when these accounts are not in agreement at the end of a period.
Try to remember your study in principles of accounting about reconciliation of bank statements
with a company’s cash ledger account.
At the end of an accounting period, the investment in Branch account in the home office
accounting records may not agree with the Home Office account in the branch accounting
records. Because certain transactions may have been recorded by one office but not by the other.
The situation is comparable to that of reconciling the ledger account for Cash in Bank with the
balance shown by the bank statement. The lack of agreement between the reciprocal accounts
causes no difficulty during the accounting period, but at the end of the accounting period the
reciprocal accounts must be brought into agreement before combined financial statements are
prepared. In such cases the reciprocal ledger accounts must be reconciled and brought up to date
before combined financial statements are prepared.
Investment in Dessie Branch (in accounting records of Home Office)
Date
2002
Nov. 30
Dec. 1 0
27
29
Explanation
Balance
Cash received from branch
Collection of branch trade accounts receivable
Merchandise shipped to branch
Debit
Credit
10,000
1,000
Balance
50,000 dr
40,000 dr
39,000 dr
47,000 dr
8,000
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Home Office (in accounting records of Dessie Branch)
Date
2002
Nov. 30
Dec. 7
Dec 28
Dec 30
Explanation
Balance
Debit
Cash sent to home office
Acquired equipment
Collection of home office
trade accounts receivable
10,000
Credit
Balance
50,000 cr
40,000 cr
37,000 cr
39,000 cr
3,000
2,000
Comparison of the two reciprocal ledger accounts discloses four reconciling items, described as
follows:
1. A debit of Br.8, 000 in the Investment in Dessie Branch ledger account without a related
credit in the Home Office account. On December 29, 2000, the home office shipped
merchandise costing Br 8,000 to the branch. The home office debits its reciprocal ledger
account with the branch on the date merchandise is shipped, but the branch credits its
reciprocal account with the home office when the merchandise is received a few days later.
The required journal entry on December 31, 2000, in the branch accounting records,
assuming use of the perpetual inventory system, appears below:
Inventory …………………………………. 8,000
Home office ………………………… 8,000
In taking a physical inventory on December 31, 2000, the branch must add to the inventories on
hand the Br 8,000 of merchandise in transit. When the merchandise is received in 2001, the
branch debits Inventories and credits Inventories in Transit.
2. A credit of Br 1,000 in the Investment in Dessie Branch ledger account without a related
debit in the Home Office account. On December 27, 2000, trade accounts receivables of the
branch were collected by the home office. The collection was recorded by the home office
by a debit to Cash and a credit to Investment in Dessie Branch, no journal entry was made
by Dessie Branch;
Therefore, the following journal entry is required in the accounting records of Dessie
Branch on December 31, 2000:
Home Office …………………………………….. 1,000
Trade accounts receivable ………………... 1,000
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3. A debit of Br. 3,000 in the Home Office ledger account without a related credit in the
Investment in Dessie Branch account. On December 28, 2000, the branch acquired
equipment for Br 3,000. Because the equipment used by the branch is carried in the
accounting records of the home office, the journal entry made by the branch was a debit to
Home Office and a credit to Cash. No journal entry was made by the home office;
therefore, the following journal entry is required on December 31, 2000, in the accounting
records of the home office:
Equipment: Dessie Branch ………………………. 3,000
Investment in Dessie Branch …………….. 3,000
4. A credit of Br 2,000 in the Home Office ledger account without a related debit in the
Investment in Dessie Branch account. On December 30, 2000, trade accounts receivable of
the home office was collected by Dessie Branch. The collection was recorded by Dessie
Branch by a debit to Cash and a credit to Home Office. No journal entry was made by the
home office. Therefore, the following journal entry is required in the accounting records of
the home office on December 31, 2000:
Investment in Dessie Branch ……………….. 2000
Trade accounts receivable ………………….. 2000
The effect of the foregoing end-of-period journal entries is to update the reciprocal ledger
accounts. Please see the following reconciliation statement:
XYZ Company- Home Office and Dessie Branch
Reconciliation of Reciprocal Ledger Accounts
December 31, 2000
Investment in Dessie
Branch account (Home
office Accounting records)
47,000 dr
2000
Home Office
Account (Branch
Accounting Records)
39,000 cr.
8000
Less : 2. Branch accounts receivable
collected by Home office
3. Equipment purchased by branch
(3000)
(1000)
Reconciled Balance
Br 46,000 dr.
Br. 46,000 cr.
Balances before adjustments
Add: 1 Merchandise shipped to branch by
home office
4 Home office accounts receivable
collected by the Branch
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4.13 Transactions Between Branches
If the home office operates more than one branch, certain transactions, such as merchandise
shipments, may take place between branches. Such inter branch transactions usually are cleared
through the Home Office ledger account. For example, if Arsi Branch ships merchandise with a
cost of Br 400 to Bahir Dar Branch and the periodic inventory system is used, the following
journal entries (explanations omitted) are required:
Accounting records of Arsi Branch:
Home Office
400
Shipments from Home Office
Accounting records of Bahir Dar Branch:
Shipments from Home Office
400
Home Office
Accounting records of home office:
Investment in Bahir Dar
400
Investment in Arsi Branch
400
400
400
The transfer of merchandise from one branch to another does not justify increasing the carrying
amount of inventories by the additional freight costs incurred because of the indirect routing.
Excess freight costs incurred as a result of such transfers are recognized as operating expenses of
the home office because the home office makes the decision to transfer the merchandise.
?
Review Question 4.1
1. What do you mean by a branch for a particular business?
2. What is reciprocal account?
3. Explain the use of reciprocal ledger accounts in home office and branch accounting systems?
4. Explain the purpose of the financial statements prepared by the branches, the home office and
combined financial statements.
5. Show the journal entries that are used by the home office and the branch when merchandise is shipped
to the branch using the perpetual and the periodic inventory systems. The Home Office ledger account
in the accounting records of the Tabor Branch had a credit balance of Br 12,000 at the end of April,
and the Investment in Branch account in the accounting records of the home office had a debit balance
of Br 15,000. Discuss the most likely reason for the discrepancy in the two ledger account balances.
6. Neither the Markos Branch nor the home office of Alemu Company had completed any intracompany
transactions during the last half of May. However, the credit balance of the branch's Home Office
ledger account on May 31 was larger than the debit balance of the home office's Investment in Markos
Branch account. What is most likely reason for this discrepancy?
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4.14 UNIT Summery
1. A branch is a unit of a business enterprise located some distance from the home office. A
branch generally caries a stock of merchandise obtained from the home office, makes sales,
approves customers' credit and makes collections on trade accounts receivable.
2. The merchandise of a branch may be obtained exclusively from the home office or a portion
may be purchased from outside suppliers. The cash receipts of the branch may be deposited
in a bank account of the home office; branch expenses then are paid from an imprest cash
fund provided by the home office. The imprest cash fund is replenished periodically by the
home office. Alternatively, a branch may maintain its own bank account.
3. Certain units or segments of a business enterprise may be operated as divisions. A division
may consist of either a series of branches or one or more corporations. When a segment is
operated as a corporation, it is known as a subsidiary of the parent company.
4. Costs of organizing a new branch and operating losses during the initial period of operations
should be recognized as expenses, not as deferred charges.
5. The accounting records for branches may be centralized in the home office or may be
decentralized so that each branch maintains a complete set of accounting records. If the
accounting records are centralized in the home office, each branch prepares daily reports and
documents that are used as sources for journal entries in the accounting records of the home
office. If a branch maintains its own accounting records, some transactions or events relating
to the branch may be recorded by the home office. Periodic financial statements are provided
by the branch to the home office so that combined statements may be prepared.
6. The accounting records of a branch include a Home Office ledger account that is credited
for assets and services provided by the home office, and for branch net income. The Home
Office account is debited for any assets and services provided by the branch to the home
office or to other branches, and for branch net losses. The Home Office account thus is an
ownership equity-type account representing the net investment of the home office in the
branch.
7. A home office maintains a reciprocal ledger account, Investment in Branch, which is
debited for the assets and other services provided to a branch, and for net income of the
branch; it is credited for the assets and services received from the branch, and for branch net
losses.
8. A home office generally charges its branches for expenses (such as insurance, interest,
property taxes, advertising, and depreciation) incurred for the benefit of the branch. Such
expenses must be allocated to branch operations to measure the profitability of each branch.
9. Merchandise shipped by a home office to branches may be billed at home office cost, at
home office cost plus a markup, or at branch retail selling price. A shipment of merchandise
to a branch is not a sale. Billing at home office cost attributes the entire gross profit on
merchandise sold by a branch to the branch. When merchandise is billed at a price above
home office cost (or at branch retail selling price), the valuation assigned to branch inventory
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at the end of the accounting period must be reduced to cost when combined financial
statements are prepared.
10. If merchandise is billed to a branch at a price above home office cost and the perpetual
inventory system is used, the home office debits Investment in Branch for the billed price of
the merchandise, credits Inventories for the cost of the merchandise, and credits Allowance
for Overvaluation of Inventories: Branch for the excess of the billed price over cost. The
branch debits Inventories and credits Home Office at billed prices of merchandise; sales by
the branch are debited to Cost of Goods Sold and credited to Inventories at billed prices.
11. A separate income statement and balance sheet for each branch may be prepared for use by
enterprise management. The income statement has no unusual features if merchandise is
billed to a branch at home office cost. However, if merchandise is billed at a price above
cost, the branch trial balance must be adjusted by the home office so that cost of the
merchandise sold by the branch is stated at cost to the home office.
12. A combined balance sheet for home office and branch shows the financial position of the
business enterprise as a single entity. In the working paper for combined financial statements,
the assets and liabilities of the branch are substituted for the Investment in Branch ledger
account included in the adjusted trial balance of the home office. This is accomplished by
elimination of the balances of the Home Office and Investment in Branch reciprocal ledger
accounts.
13. If a home office and branch use the periodic inventory system, the home office debits
Investment in Branch for the billed price of the merchandise shipped, credits Shipments to
Branch for the home office cost of the merchandise shipped, and credits any excess of billed
price over cost to Allowance for Overvaluation of Inventories: Branch. The branch debits
Shipments from Home Office and credits Home Office at billed price. At the end of the
accounting period, the home office reduces (debits) Allowance for Overvaluation of
Inventories: Branch for the amount of overvaluation applicable to the branch's cost of goods
sold and credits the amount of the reduction to the Realized Gross Profit: Branch Sales ledger
account.
14. At the end of an accounting period, the balance of the Investment in Branch ledger account
may not agree with the balance of the Home Office account. In such cases the reciprocal
ledger accounts must be reconciled and brought up to date before combined financial
statements are prepared.
15. If the home office operates more than one branch, certain transactions, such as merchandise
shipments, may take place between branches. Such inter branch transactions usually are
cleared through the Home Office ledger account. The transfer of merchandise from one
branch to another does not justify increasing the carrying amount of inventories by the
additional freight costs incurred because of the indirect routing. Excess freight costs incurred
as a result of such transfers are recognized as operating expenses of the home office because
the home office makes the decision to transfer the merchandise.
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. Self Test Exercises
Part I: True or False Questions
Dear Distance learner, read the following sentences carefully and write TRUE if the statement is
correct or FALSE if the statement is incorrect in your notebook.
1. Reciprocal ledger accounts are maintained only for the purpose of head office and branch
transactions
2. When the merchandise is shipped to the branch at any method of billing, there is no
change of ownership of the merchandise.
3. For the head office and the branches, separate financial statements are prepared for
internal and external uses.
4. Reciprocal accounts are eliminated from the combined financial statements
5. The imprest cash fund is replenished periodically by the branch.
Part II: Multiple Choice Questions.
Dear Distance Learners choose the correct answer for the following questions and write the
capital letter of your correct choice in your notebook
1. The accounting record such as the home office and investment in branch accounts
maintained by the branch and the head office for the purpose of head office and branch
transaction is known as_________
A. Debit Account
B. Credit Account
C. Reciprocal Ledger Account
D. All of the above
E. None
2. When the head office sends an executive table set to the branch, what will be the possible
way of recording the transaction between the head office and the branch?
A. The head office credits the Investment In Branch reciprocal account
B. The branch debits the Home Office reciprocal account
C. A and B
D. None
3. When the head office sends merchandise to the branch, the head office may charge/bill
the branch at______
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A. At the cost of the merchandise
B. At cost plus certain percentage of the cost of the merchandise
C. At selling price of the merchandise
D. All of the Above
E. None of the above
4. Which of the following is/are not true about branch accounting
A. Separate financial statements are prepared for internal use only
B. Only the consolidated financial statements of the business are used for external use
C. Only the separate financial statements are used for internal use
D. A and B
E. None
5. Replenishing the imprest cash fund of the branches is the responsibility of the _____
A. The Branch
B. The Head Office
C. The Customers
D. All of the above
E. None of the above
6. All consignment shipments of the consignor to each consignee are recorded in the ____
account of the consignor
A. Consignment In
B. Consignment Out
C. Default Account
D. Repossession Account
E. All of the above
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Part III: Matching
Dear Distance Learners, match items listed in column A with the items listed in Column B
Column A
1. Branch
Column B
A. The petty cash fund allocated by the head office to the branch
2. Reciprocal Account
3. Combined Financial
Statement
for paying branch expenses
B. The only reciprocal ledger account of the branch
C. A ledger account maintained only for the purpose of head office
4. Imprest Cash Fund
5. Home Office
and branch transactions.
D. The statement that shows the financial position of the head
office and branch as a single unit
E. Unit of the business established at some distance from the head
office
Part IV: Fill in the Blank Spaces
Dear Distance Learners, fill in the blank spaces with the appropriate word or phrase.
1. ____________ is the only reciprocal ledger account of the head office
2. ____________ is the only reciprocal ledger account of the branches
3. ____________ the money allocated for paying expenses of the branches
4. ____________
is a unit of a business enterprise located some distance from the home
office
5. ___________ Segment or division of a company that has its own branches or corporations
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 Answers Key to Self Test Exercises
Dear Distance Learners, check your answer for the above self test exercises
Part I: True/False Questions
1. True
2. True
3. False
4. True
5. False
Part II: Multiple Choice Questions
1. C
2. E
3. D
4. C
5. B
Part III: Matching Questions
1. E
2. C
3. D
4. A
5. B
Part IV: Fill in the Blank Space
1. Investment in Branch
2. Home Office
3. Imprest Cash Fund
4. Branch
5. Subsidiary of the Parent Company
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UNIT FIVE: SEGMENTS; INTERIM REPORTS; REPORTING FOR THE SEC
 Introduction
Dear distance learner, this unit deals with three topics that have received considerable attention
from accountants. Reporting for segments of a business enterprise and interim reports have been
the subjects of pronouncements of the Financial Accounting Standards Board (FASB), the
American Institute of Certified Public Accountants, and the Securities and Exchange
Commission (SEC). In addition, the specialized requirements of accounting and reporting for the
SEC by enterprises subject to its jurisdiction have undergone substantial modifications in recent
years. All three topics are of considerable significance for accountants who deal with publicly
owned corporations.
Learning Outcomes:
After studying this unit, you are expected to know about:
• The meaning of a business segment in today’s complex business environment
• Why reporting the operation activities of a business segment is important?
• The historical background of segment reporting
• The different proposals outlined by different authorities with regard to segment
reporting
• The SEC’s different requirements for segment information
• The purpose of interim reports
• Accounting Principles Board (APB) opinion about the preparation of interim reports
by corporations
5.1 Definition of Business Segment and Segment Reporting
While studying this unit, please make note of the following important points.
• The meaning of a business segment
• The different principles outlined by the FASB and APB regarding segment reporting in
different periods of time and the information requirements of each of the principles and
opinions thereof
• And the disclosures required of segment reports
The Accounting Principles Board (APB) defined a business segment as "a component of an
entity whose activities represent a separate major line of business or class of customer. Unlike
branches, business segments are components of the company which may be within the same
location. The wave of conglomerate business combinations in past years, involving companies in
different industries or markets, led to consideration of appropriate methods for reporting
disaggregated financial data for business segments. Financial analysts and others interested in
comparing one diversified business enterprise with another found that consolidated financial
statements did not supply enough information for meaningful comparative statistics regarding
operations of the diversified enterprises in specific industries.
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5.2 Background of Segment Reporting
In 1976, the FASB issued FASB Statement No. 14, "Financial Reporting for Segments of a
Business Enterprise." Defining an industry segment as "a component of an enterprise engaged in
providing a product or service or a group of related products and services primarily to
unaffiliated customers (i.e., customers outside the enterprise) for a profit," the FASB required
business enterprises having industry segments to disclose certain information regarding their
operations in different industries, their foreign operations and export sales, and their major
customers. Among the information to be disclosed was the following:
1) Segment revenue, including inter segment sales or transfers.
2) Segment operating profit or loss, defined as segment revenue less expenses directly
traceable to the segment and reasonably allocated non traceable expenses.
3) Segment identifiable assets, including an allocated portion of assets used jointly by two
or more segments.
4) Segment depreciation, depletion, and amortization.
5) Additions to segment plant assets.
6) Equity in net assets and net income or loss of influenced investees whose operations are
integrated vertically with those of the segment.
7) Effect of change in accounting principles on segment operating profit or loss.
Comparable information was required to be disclosed for an enterprise's operations in individual
foreign countries or groups of countries, its export sales, and its major customers. Both
maximum and minimum limitations were placed on the number of segments or foreign areas for
which the information was to be provided. Enterprise management was given considerable
latitude in identifying enterprise industry segments and allocating non traceable expenses to
segments, and in the method of disclosure of the required information; that is, within the
enterprise's financial statements, in the notes to the financial statements, or in a separate exhibit.
5.3 Proposal to Improve Segment Reporting
In 1994, the AICPA's Special Committee on Financial Reporting issued a report that addressed
concerns about the relevance and usefulness of business enterprise reporting. Among the
committee’s recommendations for improvements in disclosure of business segment information
were stated as follows:
Segment reporting should be improved by better aligning the information in business reporting
with the segment information that companies report internally to senior management or the
board of directors.
When reporting about each segment, companies should avoid arbitrary allocations made solely
for purposes of business reporting. Instead, companies should report information in the same
way they determine it for internal reporting and disclose the methods used. Companies also
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should disclose more detailed financial information about each investment in, or affiliation with,
an unconsolidated entity that is individually significant.
In response to the above, in 1997 the FASB issued Statement No. 131. By this statement the
FASB replaced the term industry segment as used in FASB Statement No. 14 with the term
operating segment, which is determined as follows: An operating segment is a component of an
enterprise:
a) That engages in business activities from which it may earn revenues and incur expenses
(including revenues and expenses relating to transactions with other components of the
same enterprise),
b) Whose operating results are regularly reviewed by the enterprise's chief operating
decision maker to make decisions about resources to be allocated to the segment and
assess its performance, and
c) For which discrete financial information is available.
For reportable operating segments of a business enterprise as specified by the FASB, it
mandated several disclosures, including the following:
a) Factors used to identify reportable segments
b) Types of products and services from which each reportable segment derives its Revenue
c) Segment profit or loss and segment total assets, as measured by the internal financial
reporting system
d) Selected components of revenues and expenses included in the measurement of
reportable segment profit or loss, such as interest revenue and interest expense
e) Reconciliation of total reportable segments' profit or loss to the enterprise's pretax income
from continuing operations
f) Explanation of how segment profit or loss is measured
g) Reconciliation of total of reportable segments' assets to total assets
h) Investments in influenced investees included in segment assets
i) Total expenditures for additions to long-lived segment assets
j) In certain cases, selected information about reportable segments that operate in more
than one country
k) Information about the enterprise’s reliance on major customers: those who provide 10
percent of the enterprise’s total revenue
In addition to the foregoing information required to be provided in annual financial reports, the
FASB required selected comparable information to be disclosed in interim reports to an
enterprise's shareholders.
Following are examples of disclosures required by the FASB for reportable segment profit or
loss and components thereof; segment assets and liabilities; and reconciliations of segment totals
to pre-tax income from continuing operations and to consolidated total assets and total liabilities.
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EXAMPLE COMPANY
Information about Segment Profit or Loss and Segment Assets and Liabilities for the Year
Ended March 31, 1999 (amounts in thousands)
Operating Segment
No.1 No.2 Total
--------------------------------------------------------------------------------------------------------Revenues from external customers
XXX XX XXX
Inter segment revenues
Segment profit
Interest expense
Depreciation and amortization expense
Income taxes expense
Segment assets
Additions to plant and intangible assets
EXAMPLE COMPANY
Reconciliation of Operating Segment Totals to Consolidated Totals
For Year Ended March 31, 1999
(Amounts in thousands)
Revenues
Profit
Assets
--------------------------------------------------------------------------------------------------------Segment totals
Elimination of intersegment items
Unallocated expenses
Consolidated amounts
5.4 Allocation of Non Traceable Expenses to Operating Segments
The FASB required a reasonable basis for allocations such as non traceable expenses. I.e., those
enterprise expenses which are not identifiable with operations of a specific operating segment in
the measurement of reportable segment profit or loss. Accordingly, enterprise management must
devise an appropriate method for apportioning non traceable expenses to the operating segments.
Methods that have been used for such allocations include ratios based on operating segment
revenues, payroll totals, average plant assets and inventories, or a combination thereof.
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Example: assume the following data for Agri-foods product Corporation:
Company
Operating Segments
Total
Beverages Food Products
(1) Net sales (operating segment revenues)
Br 458,315
Br 374,985 Br 833,300
Traceable expenses
249,990
291,655
541,645
Non traceable expenses
Br166,660
166,660
Total expenses
166,660
249,990
291,655
708,305
Income before income taxes
124,995
Income taxes expense
49,998
Net income
Br74,997
(2) Payroll totals
Br 49,998 Br133,328
Br199,992
Br383,318
(3) Average plant assets and inventories
Br66,664 Br516,646
Br1,149,954 Br1,733,264
Computation of a ratio for allocating non traceable expenses to operating segments based on the
three factors described above is as follows:
Beverages
Food Products
(1) Ratio of operating segment Br 453, 315 = 54%
Br 374,985 =46%
revenue
833,300
Br 833,300
(2) Ratio of segment payroll totals
Br133,328 =40%
Br 199,992 = 60%
Br 333,320
Br 333,320
(3) Ratio of average plant assets and
Br 516,646 =31%
Br1,149,954 = 69%
Inventories
Br 1,666,600
Br 1,666,600
Totals
125%
175%
Arithmetic averages (divide by 3)
41.67%
58.33%
The Br 166,600 amount of non traceable expenses of the home office of the Corporation is
allocated to the two operating segments as follows:
1. To Beverages segment (166,600 x 0.4167)
Br 69,422
2. To Food Products segment (Br166,600 x 0.5833)
97,178
Total non traceable expenses
Br. 166,600
Then the Segment profit (loss) for the two operating segments of Agri product Corporation is
computed as follows
Beverages
Food products
Totals
Net sales
Br 458,315
Br 374,985
Br 833,300
Traceable expenses
Non traceable expenses
Total expenses
Segment profit (loss)
249990
69422
319412
1 38903
291655
97178
388833
-13848
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5.5 SEC Requirements for Segment Information
The SEC disclosure requirements for operating segments, in addition to the requirements of the
FASB, are as follows:
1. Amount or percentage of total revenue contributed by any class of product or services
that accounted for 10% or more of total revenue during the past three years.
2. The name of a major customer (see page 601), together with its relationship to the
reporting enterprise, if loss of the customer would have a material adverse effect on the
enterprise.
3. Information about foreign operations or export sales that are expected to material in the
future.
5.6 Reporting the Disposal of a Business Segment
To this point, you have been studying about accounting standards developed by the FASB for
financial reporting for existing operating segments. The consideration of segment reporting is
concluded with the reporting for effects of the disposal of a business segment.
The APB's (APB Opinion no 30) conclusions included the following with respect to disposal of a
business segment. APB stated the term discontinued operations as the operations of a segment of
a business. . . that has been sold, abandoned, spun off, or otherwise disposed of or, although still
operating, is the subject of a formal plan for disposal. The Board concludes that the results of
continuing operations should be reported separately from discontinued operations and that any
gain or loss from disposal of a segment of a business. . . should be reported in conjunction with
the related results of discontinued operations and not as an extraordinary item. Accordingly,
operations of a segment that has been or will be discontinued should be reported separately as a
component of income before extraordinary items and the cumulative effect of accounting
changes (if applicable) in the following manner:
Income from continuing operations before income taxes
Provisions for income taxes
Income from continuing operations
Discontinued operations
Income (loss) from operations of discontinued Division Z
(less applicable income taxes of X)
Loss on disposal of Division Z, including provision for
operating losses during phase-out period (less applicable
income taxes of Br_)
Net income
Br XXX
X
Br XXX
XX
XX
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Br XXX
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5.6.1 Provisions of APB opinion No. 30 Income from Continuing Operations
The purpose of the income from continuing operations amount is to provide a basis of
comparison in the comparative income statements of a business enterprise that has discontinued
a business segment. In order for the income from continuing operations amounts to be
comparable, the operating results of the discontinued segment of the enterprise must be excluded
from income from continuing operations for all accounting periods presented in comparative
income statements.
5.6.2 Income (Loss) from Discontinued Operations
The income or loss, net of applicable income taxes, of discontinued operations (business
segment) is included in its entirety in this section. The net-of-tax income or loss of the
discontinued operations is for the period from the beginning of the year until the measurement
date, defined as the date on which management of the company committed itself to a formal plan
for disposal of the segment.
5.6.3 Gain (Loss) on Disposal of Discontinued Operations
Included in the gain or loss recognized on discontinued operations is the following:
1. Income or loss from discontinued operations during phase-out period. The phase-out
period is the period between the measurement date and disposal date-the date of closing
the sale of the discontinued operations or ceasing the operations of an abandoned
segment.
2. The gain or loss on the sale or abandonment of the industry segment.
3. The income taxes allocated to 1 and 2 above.
If the measurement date and the disposal date are in the same accounting period, the income
statement for that period displays actual amounts for income from continuing operations, income
(loss) from discontinued operations, and gain (loss) on disposal of discontinued operations.
However, if the disposal date is in an accounting period subsequent to the period of the
measurement date, management of the enterprise must estimate on the measurement date
whether disposal of the discontinued operations, including operating results of the phase-out
period, will result in a gain or a loss, net of income taxes. If a gain is anticipated, it is not
recognized until the disposal date; if a loss is expected, it must be recognized on the
measurement date.
5.6.4 Disclosure of Disposal of a Business Segment
Because of the significance of discontinued operations in the financial history of a business
enterprise, the Accounting Principles Board required the following disclosures: In addition to the
amounts that should be disclosed in the financial statements . . . , the notes to financial
statements for the period encompassing the measurement date should disclose:
1. The identity of the segment of business that has been or will be discontinued
2. The expected disposal date, if known
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3. The expected manner of disposal
4. A description of the remaining assets and liabilities of the segment at the balance sheet date
5. The income or loss from operations and any proceeds from the disposal of the segment
during the period from the measurement date to the date of the balance sheet.
An example of disclosure of discontinued operations for Example Company follows:
1999
Income from continuing operations
Discontinued operations-Note 4:
Loss from operations, net of income tax credits
of $1,073,000, $1,009,000 and $193,000
Loss on disposition, net of deferred income tax
credit of $2,590,000
Br3,473,524
1998
1997
Br5,053,483
Br6,182,139
(Br1,317,783) (Br1,406,017) (Br268,904)
(Br3,307,500)
(Br4,625,283) (Br1,406,017) (Br268,904)
Net(loss )/income
?
(Br1,151,759) Br3,647,466
Br5,913,236
Review Question 5.1
1. Define business segment from APB and FASB perspectives
2. How do you differentiate business segment from a branch?
3. Why business segment reporting is important?
4. Differentiate between the measurement date and the disposal date for the discontinuance of a
business segment.
5. Is the concept of segment reporting consistent with the theory of consolidated financial statements?
Explain.
6. Discuss how a disposal of a business segment is to be reported in financial statements as per APB
opinion number 30.
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5.7 Interim Financial Reports
Dear distance learner, whilst studying this unit, make note of the following important points.
• Understand the unresolved problems in preparing interim financial reports before the
coming of APB opinion number 28.
• APB opinion number 28 guidelines in preparing interim financial reports by companies
• And the concluding remark regarding the principles guiding interim financial reports
Generally, financial statements are issued for the full fiscal year of a business enterprise. In
addition, many enterprises issue complete financial statements for interim accounting periods
during the course of a fiscal year. For example, a closely held company with outstanding bank
loans may be required to provide monthly or quarterly financial statements to the lending bank.
However, interim financial statements usually are associated with the quarterly reports issued by
publicly owned companies to their Stockholders, the Securities and Exchange Commission, and
the stock exchanges that list their capital stock.
5.7.1 Problems in Interim Financial Reports
Prior to the issuance of Opinion No. 28, there were unresolved problems regarding interim
financial reports, including the following:
1. Enterprises employed a wider variety of accounting practices and estimating techniques for
interim financial reports than they used in the annual financial statements audited by
independent CPAs. The enterprises' implicit view was that any misstatements in interim
financial reports would be corrected by auditors' proposed adjustments for the annual
financial statements.
2. Seasonal fluctuations in revenue and irregular incurrence of costs and expenses during the
course of a business enterprise's fiscal year limited the comparability of operating results for
interim periods of the fiscal year. Further, time constraints in the issuance of interim
statements limited the available time to accumulate end-of period data for inventories,
payables, and related expenses.
3. Accountants held two divergent views on the theoretical issues underlying interim financial
statements. These differing views are described below:
a. Under the discrete theory, each interim period is considered a basic accounting
period; thus, the results of operations for each interim period are measured in
essentially the same manner as for an annual accounting period. Under this theory,
deferrals, accruals, and estimations at the end of each interim period are determined
by following essentially the same principles and estimates or judgments that apply to
annual periods.
b. Under the integral theory, each interim period is considered an integral part of the
annual period. Under this theory, deferrals, accruals, and estimates at the end of each
interim period are affected by judgments made at the interim date as to results of
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operations for the remainder of the annual period. Thus, an expense item that might be
considered as falling entirely within an annual period (no fiscal yearend accrual or
deferral) might be allocated among interim periods based on estimated time, sales
volume, production volume, or some other basis.
The problems discussed in the preceding section led to a number of published interim income
statements with substantial quarterly earnings and income statements for the year with a
substantial net loss.
APB Opinion No. 28
The stated objectives for APB opinion No. 28 were to provide guidance on accounting issues
peculiar to interim reporting and to set forth minimum disclosure requirements for interim
financial reports of publicly owned enterprises. One part of the opinion dealt with standards for
measuring interim financial information and another covered disclosure of summarized interim
financial data by publicly owned enterprises. The APB established guidelines for the following
components of interim financial reports: revenue, costs associated with revenue, all other costs
and expenses and income taxes expense. These guidelines are discussed in the following
sections.
Revenue
Revenue from products sold or services rendered should be recognized for an interim period on
the same basis as followed for the full year. Further, business enterprises having significant
seasonal variations in revenue should disclose the seasonal nature of their activities.
Costs Associated with Revenue
Costs and expenses associated directly with or allocated to products sold or services rendered
include costs of material, direct labor, and factory overhead. APB Opinion No. 28 required the
same accounting for these costs and expenses in interim financial reports as in fiscal-year
financial statements. However, the Opinion provided the following exceptions with respect to the
measurement of cost of goods sold for interim financial reports
1. Enterprises that use the gross margin method at interim dates to estimate cost of goods sold
should disclose this fact in interim financial reports. In addition, any material adjustments
reconciling estimated interim inventories with annual physical inventories should be
disclosed.
2. Enterprises that use the last-in, first-out inventory method and temporarily deplete a base
layer of inventories during an interim reporting period should include in cost of goods sold or
the interim period the estimated cost of replacing the depleted LIFO base layer.
Illustration:
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Assume that Merawi Company uses the last-in, first-out inventory valuation method. It
temporarily depleted a base layer of inventories with a cost of Br 180,000 during the second
quarter of the year ending December 31, 1999. Replacement cost of the depleted base layer was
Br 220,000 on June 30, 1999. In addition to the usual debit to Cost of Goods Sold and credit to
Inventories for the quarter ended June 30, 1999, which would include the Br 180,000 amount
from the base layer, Merawi prepares the following journal entry on June 30, 1999:
Cost of Goods sold (220,000-180,000) ……….. ………………………………. 40,000
Liabilities arising from depletion of base layer of LIFO Inventories………... 40,000
To record obligation to replenish temporarily depleted base layer of LIFO inventories
Assume that merchandise with a total cost of Br 250,000 was purchased by Merawi on
July 23, 1999. The following journal entry is required by the company.
Inventories (250,000 – 20,000) …………………………………………………… 210,000
Liabilities arising from depletion of base layer of LIFO Inventories……….......... 40,000
Accounts Payable ………………………………………………………………. 250,000
To record purchase of merchandise and restoration of depleted base layer LIFO inventories
3. Lower-of-cost-or-market write-downs of inventories should be provided for interim periods
as for complete fiscal years, unless the interim date market declines in inventory are
considered temporary and not applicable at the end of the fiscal year. If an inventory market
write-down in one interim period is offset by an inventory market price increase in a
subsequent interim period, a gain is recognized in the subsequent period to the extent of the
loss recognized in preceding interim periods of the fiscal year.
Example
Assume that Reta Company uses lower-of-cost or-market, first-in, first-out cost, for valuing its
single merchandise item. It had 10,000 units of merchandise with first-in, first out cost of Br
100,000, or Br 10 a unit, in inventory on January 1, 1999. Assume further that Reta made no
purchases during 1999. Quarterly sales and end-of-quarter replacement costs for inventory
during 1999 were as follows:
Quarter Ended
Mar. 31
June 30
Sept. 30
Dec. 31
Quarterly Sales (Units)
2,000
1,500
2,000
1,200
End-of-Quarter Inventory
Replacement Costs (Per Unit)
Br 12
8
11
7
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If the replacement cost (market) decline in the second quarter was not considered to be
temporary, Reta Company's cost of goods sold for the four quarters of 1999 would be computed
as follows:
Quarter Ended
Mar. 31
June 30
Sept. 30
Dec. 31
Cost of Goods Sold
Computation
for Quarter for Quarter Cumulative
2000 x 10
Br. 20,000
Br 20,000
(1,500 X Br10) + (6,500 X $2)*
28,000
48,000
(2,000 X Br8) - (4,500 X br2) ŧ
7,000
55,000
(1,200 X Br10) + (3,300 X Br3) ŧ ŧ 21,900
76,900
*6,500 units remaining in inventory multiplied by Br 2 write-down to lower replacement cost
ŧ 4,500 units in inventory multiplied by Br 2 write-up to original first-in, first-out cost
ŧ ŧ 3,300 units remaining in inventory multiplied by Br 3 write-down to lower replacement cost.
The Br 76,900 cumulative cost of goods sold for Reynolds Company for 1999 may be verified as
follows:
6,700 units sold during 1999, at Br 10 FIFO cost per unit
Br 67,000
Write down of 1999 ending inventory to replacement cost (3,300 units x Br3)
9,900
Cost of goods sold for 1999
Br 76,900
Alternative Verification
Cost of goods available for sale (10,000 x Br 10)
Less: Ending Inventory, at lower of FIFO cost or market (3,300 x Br 7)
Cost of goods sold for 1999
Br 100,000
23,100
Br 76,900
4. Enterprises using standard costs for inventories and cost of goods sold generally should
report standard cost variances for interim periods as they do for fiscal years. Planned
variances in materials prices, volume, or capacity should be deferred at the end of interim
periods if the variances are expected to be absorbed by the end of the fiscal year.
All Other Costs and Expenses
The following guidelines for all costs and expenses other than those associated with revenue are
set forth in APE Opinion No. 28:
Costs and expenses other than product costs should be charged to income in interim periods as
incurred, or be allocated among interim periods based on an estimate of time expired, benefit
received or activity associated with the periods. Procedures adopted for assigning specific cost
and expense items to an interim period should be consistent with the bases followed by the
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company in reporting results of operations at annual reporting dates. However, when a specific
cost or expense item charged to expense for annual reporting purposes benefits more than one
interim period, the cost or expense item may be allocated to those interim periods. . . .
The amounts of certain costs and expenses are frequently subjected to year-end adjustments even
though they can be reasonably approximated at interim dates. To the extent possible such
adjustments should be estimated and the estimated costs and expenses assigned to interim
periods so that the interim periods bear a reasonable portion of the anticipated annual amount.
Examples of such items include inventory shrinkage, allowance for uncollectible accounts,
allowance for quantity discounts, and discretionary yearend bonuses.
APB Opinion No. 28 includes a number of specific applications of the preceding guidelines.
Income Taxes Expense
The techniques for recognizing income taxes expense in interim financial reports were described
as follows:
At the end of each interim period the company should make its best estimate of the effective tax
rate expected to be applicable for the full fiscal year. The rate so determined should be used in
providing for income taxes on a current year-to-date basis. The effective tax rate should reflect
anticipated . . . foreign tax rates, percentage depletion . . . and other available tax planning
alternatives. However, in arriving at this effective tax rate no effect should be included for the
tax related to significant unusual or extraordinary items that will be separately reported or
reported net of their related tax effect in reports for the interim period or for the fiscal year.
Illustration:
Assume that on September 30, 1999, the end of the first quarter of 2000, Kosoye Company’s
actual first quarter and forecasted fiscal year operating results were as follows:
Revenue
Less: Costs and expenses other than income taxes
Income before income taxes
First quarter
(Actual)
Fiscal Year
(Estimated)
Br. 500,000
350,000
150,000
Br 2,200,000
1,540,000
660,000
Assume further that there were no temporary differences between Kosoye pretax financial
income and taxable income, but that Kosoye had the following estimated permanent differences
between pre-tax financial income and federal and state taxable income for the 1999/2000 fiscal
year:
Dividend received deduction
Premiums on officers' life insurance
Br 55,000
20,000
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If Kosoye's nominal federal and state income tax rates total 35%, Kosoye estimates its effective
combined income tax rate for 2000 as follows:
Estimated income before income taxes
Br 660,000
Add: Nondeductible premiums on officers' life insurance
20,000
Less: Dividend received deduction
(55,000)
Estimated taxable income
Br 625,000
Estimated combined federal and state income taxes (Br 625,000 x 0.35)
Br 218,750
Estimated effective combined federal and state income tax rate for 1999
(Br 218,750 ÷ Br 660,000)
33%
Kosoye's journal entry for income taxes on March 31, 1999, is as follows:
Income Taxes Expense ………………………………………… 49,500
Income Taxes Payable …………………………… 49,500
[To provide for estimated federal and state income taxes for the first quarter of 1999 (Br150,000
x 0.33 = Br 49,500)].
For the second quarter of 1999/2000, Kosoye again estimates an effective combined federal and
state income tax rate based on more current projections for permanent differences between pretax financial income and taxable income for the entire year. However, the new effective rate is
not applied retroactively to restate the first quarter's income taxes expense.
Example
Assume that Kosoye's second-quarter estimate of the effective combined federal and state
income tax rate was 40% and that Kosoye's pre-tax financial income for the second quarter was
Br 200,000. Kosoye prepares the following journal entry on December 31, 1999, for income
taxes expense for the second quarter of 1999/2000:
Income Taxes Expense ………………………………………………….. 90,500
Income Taxes Payable ……………………………………………….. 90,500
(To provide for estimated federal and state income taxes for the second quarter of 1999/2000 as
follows:
Cumulative income taxes expense (Br 350,000 X 0.40) Br 140,000
Less: Income taxes expense for first quarter
49,500
Income taxes expense for second quarter
Br 90,500
Reporting Accounting Changes in Interim Periods
In 1974, the FASB issued FASB Statement No.3 as an amendment to APB Opinion No. 28.
Following are the two principal provisions of FASB Statement No.3:
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A. If a cumulative effect type accounting change is made during the first interim period of
an enterprise's fiscal year, the cumulative effect of the change on retained earnings at the
beginning of that fiscal year shall be included in net income of the first interim period
(and in last-twelve-months-to-date financial reports that include that first interim period).
B. IIII. If a cumulative effect type accounting change is made in other than the first interim
period of an enterprise's fiscal year, no cumulative effect of the change shall be included
in net income of the period of the change. Instead, financial information for the prechange interim periods of the fiscal year in which the change is made shall be restated by
applying the newly adopted accounting principle to those pre-change interim periods. The
cumulative effect of the change on retained earnings at the beginning of that fiscal year
shall be included in restated net income of the first interim period of the fiscal year in
which the change is made (and in any year-to-date or last-twelve-months-to-date
financial reports that include the first interim period). Whenever financial information
that includes those pre change interim periods is presented, it shall be presented on the
restated basis.
Disclosure of Interim Financial Data
As minimum disclosure, APB Opinion No. 28 provided that the following data should be
included in publicly owned enterprises' interim financial reports to stockholders. The data are to
be reported for the most recent quarter and the year to date, or 12 months to date of the quarter's
end.
1. Sales or gross revenue, income taxes expense, extraordinary items (including related income
tax effects), cumulative effect of a change in accounting principle or practice, and net
income.
2. Basic and diluted earnings per share data for each period presented (as amended by FASB
Statement No. 128, "Earnings per Share").
3. Seasonal revenue, costs, or expenses.
4. Significant changes in estimates or provisions for income taxes.
5. Disposal of a business segment and extraordinary, unusual, or infrequently occurring items.
6. Contingent items.
7. Changes in accounting principle or estimate.
8. Significant changes in financial position.
Conclusions on Interim Financial Reports
APB Opinion No. 28, FASB Statement No.3, and FASB Interpretation No. 18 represented a
substantial effort to upgrade the quality of interim financial reports. However, controversy
continues on the subject of interim financial reporting-especially concerning the APB's premise
that an interim period should be accounted for as an integral part of the applicable annual period.
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In recognition of this controversy and other problems of interim financial reporting, the FASB
undertook a comprehensive study of the topic, and issued a Discussion Memorandum entitled
"Interim Financial Accounting and Reporting." However, because of more pressing matters on
its agenda, the FASB abandoned the project a few years later.
IASC 34, "Interim Financial Reporting"
In IASC 34, the International Accounting Standards Committee (IASC) specified the condensed
financial statements and other data to be included in quarterly or semiannual reports:
comparative balance sheets, income statements, cash flows statements, and equity changes
statements, together with basic and diluted earnings per share and selected notes to financial
statements. Presumably the IASC provided more specificity than is present in APB Opinion No.
28 because of the detailed requirements for financial statements included in the SEC's Form 10Q and the instructions thereto.
?
Review Question 5.2
1. What is Interim Financial Statement?
2. What is the importance of interim financial statement?
3. Discuss the provisions of APB opinion number 28 regarding the requirements in preparing interim
financial statements.
4. Show how lower of cost or market accounting for inventories applied in interim financial reports.
5. Explain the techniques for measurement of income taxes expense in interim financial reports.
5.8 UNIT SUMMARY
1. According to the FASB, a component of an entity comprises operations and cash flows that
can be clearly distinguished operationally and for financial reporting purposes.
2. The concept of disaggregated disclosure regarding business components dates back more
than 40 years, and is opposed to the philosophy that consolidated financial statements rather
than separate ones fairly present the financial position and operations of an economic entity,
regardless of its legal or business component structure.
3. In 1976, the FASB required certain information to be disclosed regarding the industry
segments, foreign operations and export sales, and major customers of segmented business
enterprises. Both maximum and minimum limitations were placed on the number of
segments or foreign areas for which information was to be provided. Enterprise management
was given considerable latitude in identifying segments, allocating non traceable expenses to
them, and disclosing the required information.
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4. In 1997, the FASB issued Statement No. 131, "Disclosures About Segments . . .," which
provided different standards of disclosure for operating segments of a business enterprise.
Statement No. 131 gave far more latitude to enterprise management in identifying segments
and measuring the quantitative information to be disclosed for them. The FASB required a
reasonable basis for procedures for allocating non traceable expenses to segments.
5. Methods that have been used by business enterprises to allocate non traceable expenses to
operating segments include allocation ratios based on segment revenues, payroll totals,
average plant assets and inventories, or a combination thereof.
6. In Regulation S-K, the SEC set forth requirements for reporting segment information in
filings with it.
7. In FASB Statement No 144, the Financial Accounting Standards Board provided standards
for disclosure of the disposal of a component such as an operating segment. Income or loss
from discontinued operations (net of applicable income taxes), including the gain or loss (net
of taxes) from disposal of the segment, is displayed following income from continuing
operations in the income statement. This amount is not an extraordinary item.
8. Interim financial reports are exemplified by the quarterly reports issued by publicly
owned companies to their stockholders, the SEC, and the stock exchanges that list their
securities. APB Opinion No. 28, "Interim Financial Reporting," provides guidelines on
accounting and disclosure issues relating to interim financial reports.
9. Revenue from products sold or services rendered is recognized when realized during an
interim accounting period on the same basis as followed for the full year. In addition,
business enterprises having significant seasonal variations in revenue are to disclose the
seasonal nature of their activities.
10. Costs and expenses associated directly with or allocated to products sold, such as material,
direct labor, and factory overhead, are accounted for in interim reports as they are in fiscal
year financial statements. However, four exceptions are provided in APB Opinion No. 28 for
the measurement of cost of goods sold for interim financial reports. These exceptions cover
the gross margin method of estimating cost of goods sold for interim accounting periods;
temporary depletion of last-in, first-out inventories layers during interim periods; interim
period lower-of-cost-or-market write-downs of inventories; and standard costs variances for
interim periods.
11. All costs and expenses other than those associated with revenue are either recognized as
expenses in interim accounting periods when incurred, or allocated among interim periods
based on an estimate of time expired, benefit received, or activity associated with the period.
The procedures adopted for allocating costs and expenses to interim periods should be
consistent with allocation procedures for the costs and expenses in annual financial
statements. APB Opinion No. 28 also required that expenses such as inventory shrinkage,
doubtful accounts expense, and year-end bonuses be allocated to interim accounting periods
in proportion to estimated annual amounts.
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12. With respect to income tax provisions in interim reports, APB Opinion No. 28 required at
the end of each interim accounting period an estimate of the expected effective income tax
rate for the full year. Income taxes expense for each interim period is based on the estimated
effective income tax rate on a year-to-date basis.
Estimated effective income tax rates should reflect anticipated foreign tax rates and available
tax-planning alternatives.
13. The following items are among the minimum data required by APB Opinion No. 28 to be
reported in interim reports to stockholders: (a) sales or gross revenue, income taxes expense,
extraordinary items, cumulative effect of an accounting change, and net income; (b) basic
and diluted earnings per share; (c) seasonal revenue, costs, or expenses; (d) significant
changes in income tax estimates or provisions; (e) contingent items; and (f) significant
changes in financial position.
14. FASB Statement No. 141, "Business Combinations," requires substantial disclosures
regarding combinations completed in the interim period.
. Self Test Exercises
Part I: True or False Questions
Dear Distance learner, read the following sentences carefully and write TRUE if the statement is
correct or FALSE if the statement is incorrect in your notebook.
1. According to APB, a business segment is a component of an entity (business
organization) whose activities represent a separate major line of business or class of
customer
2. The procedures adopted for allocating costs and expenses to interim periods should be
consistent with allocation procedures for the costs and expenses in annual financial
statements
3. All expenses and revenues of a company are directly traceable to a particular segment
4. Disaggregated/Segment disclosure of financial reports is based on the philosophy that
segment reports fairly present the financial position and operations of an economic entity.
5. Interim financial statements are prepared at the end of the fiscal year.
Part II: Multiple Choice Questions.
Dear Distance Learners choose the correct answer for the following questions and write the
capital letter of your correct choice in your notebook
1. According to FASB, a component of an enterprise engaged in providing a product or
service primarily to unaffiliated customers for a profit is known as_________
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A. A business Branch
B. A business Conglomerate
C. Business Segment
D. All of the above
E. None
2. According to FASB, which of the following segment information is/are not required to be
disclosed?
A. Segment operating profit or loss
B. Segment revenue
C. The age, race and religion of the owner of the business
D. All of the above
E. None
3. According to APB, which of the following information should be disclosed when a
particular segment of a company is disposed for any reason?
A. The expected manner of the disposal
B. The expected date of the disposal
C. The name of the segment to be disposed
D. All of the Above
E. None of the above
4. Apart from the financial statement prepared at the end of the fiscal year, financial
statements can be prepared at any time in the middle of the fiscal year. These statements
are known as_________
A. Consolidated financial statements
B. Combined financial statements
C. Segment financial statements
D. Interim financial statements
E. All of the above
5. Which of the following ratios can be used as a method for allocating non traceable
expenses to operating segments of the company? include allocation ratios based on
segment revenues, payroll totals, average plant assets and inventories, or a combination
thereof.
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A. Segment revenue and total revenue ratio
B. Segment payroll and total payroll ratio
C. Segment asset and total asset ratio
D. All of the above
E. None of the above
Part III: Matching
Dear Distance Learners, match items listed in column A with the items listed in Column B
Column A
1. Business Segment
2. Interim Financial
Statement
3. Combined Financial
Statement
4. FASB Statement No 144
5. FASB Statement No. 141
Column B
A. Standards for disclosure of the disposal of a component such as
an operating segment
B. "Business Combinations," requires substantial disclosures
regarding combinations completed in the interim period.
C. Financial statement disclosing the position of a company in the
middle of the fiscal year
D. The statement that shows the financial position of the company
as a single unit
E. Component of a company specialized in a particular product
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 Answers Key to Self Test Exercises
Dear Distance Learners, check your answer for the above self test exercises
Part I: True/False Questions
1. True
2. True
3. False
4. True
5. False
Part II: Multiple Choice Questions
1. C
2. C
3. D
4. D
5. D
Part III: Matching Questions
1. E
2. C
3. D
4. A
5. B
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UNIT SIX: ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS
Introduction
Each country uses its own currency as the unit of value for the purchase and sale of goods and
services. For example the currency used in Ethiopia is Birr, in the US is Dollar and in India is
Rupee. In most countries, a foreign country's currency is treated as though it were a commodity,
or a money-market instrument. In the United States, for example, foreign currencies are bought
and sold by the international banking departments of commercial banks. These foreign currency
transactions are entered into on behalf of the banks' multinational enterprise customers, and for
the banks' own account.
Learning Outcomes:
Dear distance learner, after studying this unit, you are required to clearly understand:
• The meaning of foreign currency translations
• Terminologies with respect to foreign currency exchanges
• Treatment of transactions involving foreign currencies and FASB’s statement no. 52
• Meaning and treatment of forward contracts involving foreign transactions
6.1 Foreign Currency Translations
In this unit, you will study the meaning of foreign currency translations, terminologies involving
foreign currency translations, accounting methods used by companies involving foreign currency
transactions and requirements of FASB statement number 52 concerning accounting for foreign
currency transactions.
Foreign Currency Transaction is the Process of expressing amounts denominated in one currency
in terms of a second currency, by using the exchange rate between the currencies. Assets and
liabilities are translated at the current exchange rate at the balance sheet date. Income statement
items are typically translated at the weighted-average exchange rate for the period. Cumulative
(total) translation gains and losses are reported separately as a component of
Stockholders' Equity under "Accumulated Other Comprehensive Income." They are not included
in net income unless there is a sale or liquidation of the investment in the foreign entity.
The buying and selling of foreign currencies as though they were commodities result in variation
in the exchange rate between the currencies of two countries. For example, a daily newspaper
might quote exchange rates for the British pound (£) as follows, based on the prior day's
transactions in the pound:
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Foreign Currency
Dollars in
In Dollars
Foreign Currency
Britain (Pound)
1. 6065
0.6225
The first column indicates that £1 could be exchanged for approximately $1.61 and the second
column indicates that $1 could be exchanged for approximately $0.62. Note that the two
exchange rates are reciprocals (1 ÷1.6065 - 0.6225).
The exchange rate illustrated above is the selling spot rate charged by the bank for current sales
of the foreign currency. The spot rate refers to the current market rate for a currency. The bank's
buying spot rate for the currency typically is less than the selling spot rate; the agio (or spread)
between the selling and buying spot rates represents gross profit to a trader in foreign currency.
In addition to spot rates, there are forward exchange rates, which apply to foreign currency
transactions to be consummated on a future date.
Factors influencing fluctuations in exchange rates include a nation's balance of payments surplus
or deficit, differing global rates of inflation, money-market variations (such as interest rates) in
individual countries, capital investments levels, and monetary actions of central banks of various
nations.
6.2 Transactions Involving Foreign Currencies
A multinational (or transnational) enterprise is a business enterprise that carries on operations in
more than one nation, through a network of branches; divisions influenced investees, joint
ventures, and subsidiaries. Multinational enterprises obtain material and capital in countries
where such resources are plentiful. Multinational enterprises manufacture their products in
nations where wages and other operating costs are low and they sell their products in countries
that provide profitable markets.
A multinational enterprise headquartered in Ethiopia engages in sales, purchases, and loans with
independent foreign enterprises as well as with its branches, divisions, influenced investees, or
subsidiaries in other countries; though not a common phenomenon in the country. If the
transactions with independent foreign enterprises are denominated (or expressed) in terms of the
Ethiopian Birr, no accounting problems arise for the Ethiopian multinational enterprise. As we
are following the generally accepted accounting principles of U.S.A., we assume that the
multinational company is a US company. The sale, purchase, or loan transaction is recorded in
dollars in the accounting records of the U.S. enterprise; and the independent foreign enterprise
must obtain or dispose of the dollars necessary to complete the transaction through the foreign
exchange department of its bank
Often, however, the transactions described above are negotiated and settled in terms of the
foreign enterprise's local currency unit (LCU). In such circumstances, the U.S. enterprise must
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account for the transaction denominated in foreign currency in terms of U.S. dollars. This
accounting, described as foreign currency translation, is accomplished by applying the
appropriate exchange rate between the foreign currency and the U.S. dollar.
Multinational corporations are required by Statement 52 (FASB 52) of Financial Accounting
Standards Board, to restate assets and liabilities, plus earnings of foreign subsidiaries in terms of
a national reference currency. The resulting foreign currency translation exposure is recorded as
an equity account on the balance sheet. At large banks, adjusted foreign currency translation is
included as part of equity capital.
6.3 Summary of Statement No. 52 (Foreign Currency Translation (Issued 12/81)
Application of this Statement will affect financial reporting of most companies operating in
foreign countries. The differing operating and economic characteristics of varied types of foreign
operations will be distinguished in accounting for them. Adjustments for currency exchange rate
changes are excluded from net income for those fluctuations that do not impact cash flows and
are included for those that do. The requirements reflect these general conclusions:
The economic effects of an exchange rate change on an operation that is relatively self contained
and integrated within a foreign country relate to the net investment in that operation. Translation
adjustments that arise from consolidating that foreign operation do not impact cash flows and are
not included in net income.
The economic effects of an exchange rate change on a foreign operation that is an extension of
the parent's domestic operations relate to individual assets and liabilities and impact the parent's
cash flows directly. Accordingly, the exchange gains and losses in such an operation are included
in net income.
Contracts, transactions, or balances that are in fact, effective hedges of foreign exchange risk will
be accounted for as hedges without regard to their form.
More specifically, this Statement replaces FASB Statement No. 8, Accounting for the
Translation of Foreign Currency Transactions and Foreign Currency Financial Statements, and
revises the existing accounting and reporting requirements for translation of foreign currency
transactions and foreign currency financial statements. It presents standards for foreign currency
translation that are designed to
1) Provide information that is generally compatible with the expected economic effects of a
rate change on an enterprise's cash flows and equity and
2) Reflect in consolidated statements the financial results and relationships as measured in
the primary currency in which each entity conducts its business (referred to as its
"functional currency").
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An entity's functional currency is the currency of the primary economic environment in which
that entity operates. The functional currency can be the dollar or a foreign currency depending on
the facts. Normally, it will be the currency of the economic environment in which cash is
generated and expended by the entity. An entity can be any form of operation, including a
subsidiary, division, branch, or joint venture. The Statement provides guidance for this key
determination in which management's judgment is essential in assessing the facts.
A currency in a highly inflationary environment (3-year inflation rate of approximately 100
percent or more) is not considered stable enough to serve as a functional currency and the more
stable currency of the reporting parent is to be used instead.
The functional currency translation approach adopted in this Statement encompasses:
a) Identifying the functional currency of the entity's economic environment
b) Measuring all elements of the financial statements in the functional currency
c) Using the current exchange rate for translation from the functional currency to the
reporting currency, if they are different
d) Distinguishing the economic impact of changes in exchange rates on a net investment
from the impact of such changes on individual assets and liabilities that are receivable or
payable in currencies other than the functional currency
Translation adjustments are an inherent result of the process of translating a foreign entity's
financial statements from the functional currency to U.S. dollars. Translation adjustments are not
included in determining net income for the period but are disclosed and accumulated in a
separate component of consolidated equity until sale or until complete or substantially complete
liquidation of the net investment in the foreign entity takes place.
Transaction gains and losses are a result of the effect of exchange rate changes on transactions
denominated in currencies other than the functional currency (for example, a U.S. company may
borrow Swiss francs or a French subsidiary may have a receivable denominated in Kroner from a
Danish customer). Gains and losses on those foreign currency transactions are generally included
in determining net income for the period in which exchange rates change unless the transaction
hedges a foreign currency commitment or a net investment in a foreign entity. Intercompany
transactions of a long term investment nature are considered part of a parent's net investment and
hence do not give rise to gains or losses.
6.4 Purchase of Merchandise from a foreign Supplier
To illustrate a purchase of merchandise from a foreign supplier, assume that on April 18, 1999,
Worldwide Corporation purchased merchandise from a German supplier at a cost of 100,000
Euros. The April 18, 1999 selling spot rate was €1 = $1.054 Because Worldwide was a customer
of good credit standing, the German supplier made the sale on 3D-day open account. Assuming
that Worldwide uses the perpetual inventory system, it records the April 18, 1999, purchase as
follows:
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Inventories
Trade Accounts Payable
105,000
105,000
To record purchase on 30-day open account from German Supplier for €100,000 translated at
selling spot rate of €1 = $1.05 (€100,000 x $ 1.05 = $105,000
The Selling spot was used in the journal entry, because it was the rate at which the liability to the
German supplier could have been settled on April 18, 1999.
6.5 Foreign Currency Transaction Gains and Losses
During the period that the trade account payable to the German supplier remains unpaid, the
selling spot rate for the Euro may change. If the selling spot rate decreases (the Euro weakens
against the Dollar), Worldwide will realize a foreign currency transaction gain; But, if the selling
spot rate increases (the Euro strengthens against the Dollar), Worldwide will incur a foreign
currency transaction loss. Foreign currency transaction gains and losses are included in the
measurement of net income for the accounting period in which the spot rate changes.
6.6 Two-Transaction Perspective and One-Transaction Perspective
In effect, supporters of the one-transaction perspective for foreign trade activities consider the
original amount recorded for a foreign merchandise purchase as an estimate, subject to
adjustment when the exact cash outlay required for the purchase is known. Thus, the onetransaction proponents emphasize the cash-payment aspect, rather than the bargained-price
aspect of the transaction.
6.7 Sale of Merchandise to a Foreign Customer
Assume that on May 17, 1999, Worldwide Corporation, which uses the perpetual inventory
system, sold merchandise acquired from a US supplier for $ 12,000 to a French customer for
€15,000, with payment due June 16, 1999. On May 17, 1999, the buying spot rate for the euro
was €1 = $1.01. Worldwide prepares the following journal entries on May 17, 1999:
Trade Accounts Receivable
15,150
Sales
15,150 (to record sale on 30-day open account to
French customer for €15,000 translated at buying spot rate of € 1=$1.01 (€15,000x$1.01 =
$15,150)).
Cost of goods Sold
Inventories
12,000
12,000 (to record cost of merchandise sold to French customer)
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6.8 Loan Payable Denominated in a Foreign Currency
If a U.S. multinational enterprise elects to borrow a foreign currency amounting to $69,000 to
pay for merchandise acquired from a Swiss supplier, the following journal entries would be
illustrative (Sfr is the symbol for the Swiss franc):
1999
Apr, 30 Inventories
69,000
Trade Account Payable
69,000
(to record purchase from Swiss supplier for Sfr 100,000, Translated at selling spot
rate of Sfr 1 = $0.69 (Sfr 100,000 x $69,000)
30
Trade Account Payable
69,000
Notes Payable
69,000
(to record borrowing of Sfrl00, 000 from bank on 30-day, 6% loan to be repaid in Swiss francs
and payment of liability to Swiss supplier)
May 30 Notes Payable
69,000
Interest Expense
345 ($69,000 x 0.06x30/360)
Foreign Currency Transaction Losses 201
Cash
69,546
(to record payment for $100,500 draft to settle Sfr 100,000, 30-day, 6% note, together with
Sfr500 interest (Sfr100,000x 0.06 x30/360 = Sfr500) at selling spot rate of Sfr 1 = $0.692
(Sfr100,500 x 0.692 = $69,546), and recognition of foreign, Currency transaction loss)
6.9 Loan Receivable Denominated in a Foreign Currency
A U.S. multinational enterprise/s receipt of a promissory note denominated in a foreign currency
might be illustrated by the following journal entries:
1999
Notes Receivable
980,000
May 31
Sales
980,000
To record sale to Belgian customer for 60-day 9% Promissory Note for €1,000,000, translated at
buying spot rate of €l = $0.98 (€1,000,000 x $0.98 = $980,000).
31
Cost of Goods Sold
Inventories
820,000
820,000
To record cost of merchandise sold to Belgian customer.
June 30
Note Receivable
30,000
Interest Receivable
7,575 ($1,010,000 x 0.09 x30/360)
Interest Revenue
7,575
Foreign Currency Transaction Gains
30,000
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To recognize foreign currency transaction gain applicable to May 31,1999, sale to Belgian
customer and to accrue interest On note receivable from the customer, valued at the buying spot
Rate of €1 = $1.01 Transaction gain is computed as follows:
Receivable translated at June 30, 1999, buying spot
Rate (€1,000,000 x $1.01)
$1,010,000
Receivable recorded on May 31, 1999
980,000
Transaction gain
$ 30,000
July 30
Cash (€1,015,000 x $0.99)
1,004,850
Foreign Currency Transaction Losses
Notes Receivable
Interest Receivable
Interest Revenue
[(€1,000,000 x $0.99) x 0.09 x 30/360]
20,150
1,010,000
7,575
7,425
To record receipt and conversion to dollars of €1,015,000 Draft to settle 60-day, 9% note,
together with €15,000 Interest (€1,000,000 x 0.09 x 60/360 = €15,000), and recognition of
foreign currency transaction loss of$20,150 [€1,000,000 + €7,500) x ($1,01 - $0.99) = $20,150].
6.10 Conclusions Regarding Transactions Involving Foreign Currencies
From the foregoing examples, it is evident that increases in the selling spot rate for a foreign
currency required by a U.S. multinational enterprise to settle a liability denominated in that
currency generate foreign currency transaction losses to the enterprise because more U.S. dollars
are required to obtain the foreign currency. Conversely, decreases in the selling spot rate produce
foreign currency transaction gains to the enterprise because fewer U.S. dollars are required to
obtain the foreign currency. In contrast, increases in the buying spot rate for a foreign currency to
be received by a U.S. multinational enterprise in settlement of a receivable denominated in that
currency generate foreign currency transaction gains to the enterprise: decreases in the buying
spot rate produce foreign currency transaction losses. Mastery of these relationships assures a
clearer understanding of the effects of changes in exchange rates for foreign currencies.
6.10.1 Spot and Forward Rates
Foreign currency trades can be executed on a spot or forward basis. The spot rate is the price at
which a foreign currency can be purchased or sold today. In contrast, the forward rate is the
price today at which foreign currency can be purchased or sold sometime in the future. Because
many international business transactions take some time to be completed, the ability to lock in a
price today at which foreign currency can be purchased or sold at some future date has definite
advantages. The forward rate can exceed the spot rate on a given date, in which case the foreign
currency is said to be selling at a premium in the forward market, or the forward rate can be less
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than the spot rate, in which case it is selling at a discount. Currencies sell at premium or a
discount because of differences in interest rates between two countries. When the interest rate in
the foreign country exceeds the interest rate domestically, the foreign currency sells at a discount
in the forward market. Conversely, if the foreign interest rate is less than the domestic rate, the
foreign currency sells at a premium. For ward rates are said to be unbiased predictors of the
future spot rate. The spot rate for British pounds on February 9, 2000, indicates that one pound
could have been purchased on that date for $1.6170. On the same day, the one-month forward
rate was $1.6167. By entering into a forward contract on February 9, it was possible to guarantee
that pounds could be purchased on March 9 at a price of $1.6167, regardless of what the spot rate
turned out to be on March 9. Entering into the forward contract to purchase pounds would have
been beneficial if the spot rate on March 9 were greater than $1.6167. On the other hand, such a
forward contract would have been detrimental if the spot rate were less than $1.6167. In either
case, the forward contract must be honored and pounds must be purchased on March 9 at
$1.6167.
6.10.2 Option Contracts
To provide companies more flexibility than exists with a forward contract, a market for foreign
currency options has developed. A foreign currency option gives the holder of the option the
right but not the obligation to trade foreign currency in the future. A put option is for the sale of
foreign currency by the holder of the option; a call is for the purchase of foreign currency by the
holder of the option. The strike price is the exchange rate at which the option will be executed if
the holder of the option decides to exercise the option. The strike price is similar to a forward
rate. There are generally several strike prices to choose from at any particular time. Foreign
currency options may be purchased either on the Philadelphia Stock Exchange or directly from a
bank in the so-called over the- counter market.
Unlike a forward contract, where banks earn their profit through the spread between buying and
selling rates, options must actually be purchased by paying an option premium. The option
premium is a function of two components: intrinsic value and time value. The intrinsic value of
an option is equal to the gain that could be realized by exercising the option immediately.
Example:
If a spot rate for a foreign currency is $1.00, a call option (to purchase foreign currency) with a
strike price of $.97 has an intrinsic value of $.03, whereas a put option with a strike price of $.97
has an intrinsic value of zero. An option with a positive intrinsic value is said to be "in the
money." The time value of an option relates to the fact that the spot rate can change over time
and cause the option to become in the money. Even though a 90-day call option with a strike
price of $1.00 has zero intrinsic value when the spot rate is $1.00, it will still have a positive time
value if there is a chance that the spot rate could increase over the next 90 days and bring the
option into the money.
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The value of a foreign currency option can be determined by applying an adaptation of the
Black-Scholes option pricing formula. This formula is discussed in detail in your course
‘Financial markets and Institutions’. In very general terms, the value of an option is a function
of the difference between the current spot rate and strike price, the difference between domestic
and foreign interest rates, the length of time to expiration, and the potential volatility of changes
in the spot rate.
6.10.3 Forecasted Transactions
SFAS 133 also allows the use of hedge accounting for foreign currency forward contracts and
options used to hedge forecasted foreign currency transactions (transactions which are expected
to occur but for which a contractual agreement does not exist). A hedge of a forecasted
transaction is referred to as a cash flow hedge. For hedge accounting to apply, the forecasted
transaction must be probable (likely to occur), the hedging relationship must be appropriately
documented, and the hedge must be highly effective in offsetting fluctuations in cash flows
associated with foreign currency risk. The accounting for a hedge of a forecasted transaction
(cash flow hedge) differs from the accounting for a hedge of a foreign currency firm
commitment (fair value hedge) in two ways.
 Unlike the accounting for a firm commitment, there is no recognition of gains and losses
on a forecasted transaction.
 The hedging instrument (forward contract or option) is reported at fair value, but because
there is no gain or loss on the forecasted transaction to offset against, changes in the fair
value of the hedging instrument are not reported as gains and losses in net income.
Instead they are reported outside of net income in other comprehensive income
(explained below). On the projected date of the forecasted transaction, the cumulative
change in fair value is transferred from other comprehensive income to net income.
6.10.4 Foreign Currency Borrowing
In addition to the receivables and payables that arise from import and export activities,
companies often must account for foreign currency borrowings, another type of foreign currency
transaction. Companies borrow foreign currency from foreign lenders either to finance foreign
operations or perhaps to take advantage of more favorable interest rates. Accounting for a
foreign currency borrowing is complicated by the fact that both the principal and interest are
denominated in foreign currency and both create an exposure to foreign exchange risk.
6.10.5 Hedging Instruments
There are probably as many different corporate strategies regarding hedging foreign exchange
risk as there are companies exposed to that risk. Some companies simply require hedges of all
foreign currency transactions. Others require the use of a forward contract hedge when the
forward rate results in a greater cash inflow or smaller cash outflow than with the spot rate. Still
other companies have proportional hedging policies that require hedging on some predetermined
percentage (e.g., 50 percent, 60 percent, or 70 percent) of transaction exposure.
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The introduction of the euro as a common currency throughout much of Europe should reduce
the need for hedging in that region of the world. For example, a German company purchasing
goods from a Spanish supplier will no longer have an exposure to foreign exchange risk as both
countries use a common currency. This will also be true for German subsidiaries of U.S. parent
companies. However, any transactions denominated in euros between the U.S. parent and its
German (or other euro zone) subsidiary will continue to be exposed to foreign exchange risk.
6.10.6 Foreign Currency Loan
At times companies might lend foreign currency to related parties, creating the of site situation as
with a foreign currency borrowing. The accounting involves keel track of a note receivable and
interest receivable both of which are denominated in foreign currency. Fluctuations in the U.S.
dollar value of the principal and interest generally give rise to foreign exchange gains and losses
that would be included in inco Under SFAS 52, an exception arises when the foreign currency
loan is being made (a long-term basis to a foreign branch, subsidiary, or equity method affiliate.
Fon exchange gains and losses on "intercompany foreign currency transactions that ar a longterm investment nature (that is, settlement is not planned or anticipated in foreseeable future)"
are deferred in other comprehensive income until the loan is paid.12 Only the foreign exchange
gains and losses related to the interest receivable recorded currently in net income.
6.10.7 Speculative Foreign Currency Forward Contract
A forward exchange contract does not necessarily have to serve as a hedge. Companies also can
acquire such contracts as investments for speculative purposes. If a fluctuation is anticipated in
the value of a particular currency, a forward exchange contract can negotiated in hopes of
realizing a profit from the expected movement. SFAS 133 quires a speculative forward contract
to be reported at fair value with gains and 10: recognized currently in income.
6.10.8 Forward Contracts
Forward contracts are another type of transaction involving currencies. A forward contract is an
agreement to exchange currencies of different countries on a specified future date at the forward
rate in effect when the contract was made. Forward rates may be larger or smaller than spot rates
for a foreign currency, depending on the foreign currency dealer's expectations regarding
fluctuations in exchange rates for the currency.
For example, a newspaper had the following data regarding fluctuations in exchange rates for the
currency. For example, a newspaper had the following data regarding the British pound (£) and
the Swiss fanc (Sfr):
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Forward contracts are derivative instruments, defined by the FASB as follows:
A derivative instrument is a financial instrument or other contract with all three of the following
characteristics:
A. It has (1) one or more underlyings and (2) one or mote notional amounts or payment
provisions or both. Those terms determine the amount of the settlement or settlements, and, in
some cases, whether or not a settlement is required.
B. It requires no initial net investment or an initial net investment that is smaller than would be
required for other types of contracts that would be expected to have a similar response to changes
in market factors.
C. Its terms require or permit net settlement, it can readily be settled net by a means outside the
contract, or it provides for delivery of an asset that puts the recipient in a position not
substantially different from net settlement. In accordance with the foregoing, the underlying for a
forward contract is the contracted forward rate, and the notional amount is the number of foreign
currency units specified in the forward contract.
?
Review Question 6.1
1.
2.
3.
4.
5.
6.
7.
8.
What do you mean by Foreign Currency?
What is Foreign Currency Translation?
Describe the difference between spot rate and forward rate.
What is the proper accounting for a foreign currency forward contract entered into for
speculative purposes?
What is hedge accounting?
Why is the accounting for a foreign currency borrowing more complicated than the
accounting for a foreign currency payable arising from an import purchase?
How does a foreign currency option different from a foreign currency forward contract?
Why might a company prefer to use an option rather than a forward contract? And vice
versa?
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6.11 UNIT SUMMARY
1. Multinational enterprises must translate to their country of currency the financial statements
of their foreign divisions, branches, subsidiaries, or other investees that are denominated in
foreign functional currencies. Translation of foreign investees’ financial statements is a
problem because of fluctuations in exchange rates between the dollar and other currencies.
2. An entity’s functional currency is the currency of the primary economic environment in
which the entity operates; generally, that is the currency of the environment in which an
entity primarily generates and expends cash.
3. The functional currency of an entity with operations that are relatively self contained and
integrated within a country generally is the currency of that country. However, the U.S.
dollar may be the functional currency of a foreign branch of a U.S. multinational enterprise if
the branch’s operations are an extension of the home office’s operations. FASB Statement
No. 52, “Foreign Currency Translation,” provided several guidelines for the determination of
an entity’s functional currency.
4. Three methods of foreign currency translation have been developed: the current/noncurrent
method, the monetary/nonmonetary method, and the current rate method. (A fourth
method, the temporal method, essentially is the same as the monetary/nonmonetary
method.) The three methods differ principally in translation techniques for balance sheet
amounts.
5. In the current/noncurrent method of foreign currency translation, current assets and current
liabilities of the foreign investee are translated at the current exchange rate in effect on the
balance sheet date. All other assets and liability accounts, and the owners’ equity accounts,
are translated at historical rates in effect when the items originally were recognized in the
accounting records. In the income statement, depreciation and amortization expense are
translated at historical rates applicable to the related assets, and all other expense and revenue
items are translated at an average exchange rate for the accounting period.
6. Although proponents of the current/noncurrent method claim that it best reflects liquidity
aspects of a foreign investee’s financial position, critics point out that with respect to
inventories, the current/noncurrent method represents a departure from historical cost,
because it requires the translation of inventories at the current rate rather than at historical
rates.
7. In the monetary/nonmonetary method of foreign currency translation, monetary assets and
liabilities are translated at the current exchange rate. (Monetary assets and liabilities are
claims or obligations expressed in a fixed monetary amount.)
All other assets, liabilities, and owners’ equity items are translated at appropriate historical
rates. In the income statement, depreciation and amortization expense and cost of goods sold
are translated at appropriate historical rates; all other revenue and expense items are
translated at average exchange rates for the accounting period.
8. The current rate method of foreign currency translation was proposed by critics of the
monetary/nonmonetary method, who claimed the latter method incorrectly stressed the
parent company aspects of a foreign investee’s financial position and operating results. In
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the current rate method, all balance sheet items other than owners’ equity are translated at the
current exchange rate. Owners’ equity items are translated at historical rates. Revenue and
expenses are translated at the current exchange rate if practicable; otherwise, an average rate
for the accounting period is used.
9. FASB Statement No. 52, “Foreign Currency Translation,” adopted the current rate method
for translating a foreign entity’s financial statements from the entity’s functional currency
to the reporting currency of the parent company (the U.S. dollar for a U.S. multinational
enterprise). Account balances must be remeasured to the foreign entity’s functional currency
if the accounting records are not maintained in the functional currency. Remeasurement
essentially is accomplished by the monetary/nonmonetary method described in
paragraph7. If a foreign entity’s functional currency is the U.S. dollar, remeasurement
eliminates the need for translation.
10. In the remeasurement of the trial balance of a foreign division or branch, or the financial
statements of a foreign subsidiary or other investee, to its U.S. dollar functional currency, the
amounts in foreign currency are multiplied by the appropriate exchange rate to obtain the
amounts in U.S. dollars. A debit balance (loss) or credit balance (gain) foreign currency
transaction gain or loss is computed to balance the remeasured trial balance or financial
statements. This foreign currency transaction gain or loss enters into the measurement of
combined consolidated net income. Home office or intercompany accounts may be
“remeasured” by substitution of the balance in U.S. dollars of the reciprocal account in the
multinational company’s accounting records. In the translation of the trial balance of a
foreign division or branch, or the financial statements of a foreign subsidiary or other
investee from a foreign functional currency to U.S. dollars, the amounts in foreign currency
are multiplied by the appropriate current exchange rate to obtain the amounts in U.S. dollars.
Debit balance or credit balance foreign currency translation adjustments are computed to
balance the translated trial balance or financial statements. Foreign currency translation
adjustments are displayed in the statement of comprehensive income.
11. Other matters covered in FASB Statement No. 52 include certain foreign currency
transaction gains and losses excluded from net income, functional currency in highly
inflationary economies, income taxes related to foreign currency translation, and disclosure
of foreign currency translation. FASB Statement No. 52 has been criticized for a number of
reasons, especially for its alleged establishment of an indefensible distinction between
foreign currency transaction gains and losses and foreign currency translation
adjustments.
12. Exposure to foreign exchange risk can be eliminated through hedging. A foreign currency
asset (receivable) exposure is hedged by creating a foreign currency liability (payable) of
similar magnitude and maturity. A foreign currency liability exposure is hedged by creating
an offsetting foreign currency asset
13. One popular means of hedging is the forward exchange contract, an agreement to exchange
currencies in the future at a predetermined rate. Under FASB 133, a forward contract is
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reported on the balance sheet (as either an asset or a liability) at its fair value. Foreign
currency options are another popular tool for hedging foreign exchange risk. SFAS 133
requires foreign currency options to be recorded as an asset when purchased, with changes in
fair value recognized over time.
14. If a foreign currency firm commitment is being hedged (fair value hedge), gains and losses
on the hedging instrument as well as on the underlying firm commitment should be
recognized in net income. The firm commitment account created to offset the gain or loss on
firm commitment is treated as an adjustment to the underlying transaction when it takes
place.
15. If a forecasted transaction is being hedged (cash flow hedge), changes in the fair value of the
hedging instrument are reported in other comprehensive income. The cumulative change in
fair value reported in other comprehensive income is included in net income in the period in
which the forecasted transaction was originally anticipated to take place.
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Reference
Hoyle, Schaefer & Doupink, Advanced accounting, 10th Ed
Larson. , Advanced Accounting. 11th edition
Richard E.Baker et al. Advanced Accounting. 7th Edition, FT Prentice Hall- Financial Times,
United Kingdom, 2004
Public Enterprises Proclamation No. 25/1992
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