CHAPTER 3: AGENCIES & PRINCIPAL, HEAD OFFICE &
BRANCH
3.1 Distinguishing Agency and Branch
An agency relationship refers a contract under which one or more
persons (the principals) engage another persons (the agents) to carry out
some service on their behalf that involves delegating some decision
making authority to the agent.
Branch is a business unit located at some distance from the home office.
This unit carries merchandise, makes sales, and makes collections from
its customers.
3.2 Accounting for Sales Agency
The term sales agency sometimes is applied to a business unit that
performs only a small portion of the functions traditionally associated
with a branch.

A sales agency usually carries samples of products but does not
have inventory of merchandise

Orders are taken from customers and transmitted to the home
office,
which
approves
customers’
credit
and
ships
the
merchandise directly to the customers


Accounts receivables are managed by the home office
An imprest cash fund is maintained at the sales agency for
payment of operating expenses

Hence, no need for complete accounting records at a sales agency
other than a record of sales to customers and a summary of cash
payments supported by vouchers

Separate revenue and expense accounts may be opened by the
home office for each sales agency so as to measure its profitability

Subsidiary ledger accounts may be used to control fixed assets and
cost of goods sold by sales agencies
1
Illustration: Journal Entries for a Sales Agency
Journal entries required at the home office in connection with a sales
agency (Shashemene Agency), assuming the perpetual inventory
system is used:
HOME OFFICE
JOURNAL ENTRIES FOR SHASHEMENE AGENCY TRANSACTIONS
Inventory Samples: Shashemene Agency
1,500
Inventories
1,500
To record merchandise shipped to sales agency for use as samples
Imprest Cash Fund: Shashemene Agency
Cash
To establish imprest cash fund for sales agency
1,000
Trade Accounts Receivable
Sales: Shashemene Agency
To record sales made by sales agency
50,000
1,000
Cost of Goods Sold: Shashemene Agency
35,000
Inventories
To record cost of merchandise sold by sales agency
50,000
35,000
Operating Expenses: Shashemene Agency
10,000
Cash
10,000
To replenish imprest cash fund (several checks during the period)
Sales: Shashemene Agency
50,000
Cost of Goods Sold: Shashemene Agency
35,000
Operating Expenses: Shashemene Agency
10,000
Income Summary: Shashemene Agency
5,000
To close revenue and expense accounts to a separate income
summary ledger account for a sales agency
Income Summary: Shashemene Agency
5,000
Income Summary
5,000
To close net income of sales agency to Income Summary ledger
account
2
3.3 Accounting for Branch
The accounting work done at each branch depends upon the policy or
the accounting system of the enterprise which may provide for a
complete set of accounting records at each branch or keep all accounting
records in the home office.
A branch may, accordingly, maintain a complete set of accounting
records consisting of journals ledgers and chart of accounts similar to
those
of
an
independent
business
enterprise,
prepare
financial
statements and periodically forward to the home office.
Transactions recorded by the branch should include all controllable
expenses and revenue for which the branch manager is responsible.
Expenses such as depreciation and branch plant assets are generally
maintained by the home office.
3.4 Reciprocal Accounts
The accounting records maintained by a branch include a Home Office
ledger account that is credited for all merchandise, cash, or other
resources provided by the home office; it is debited for all cash
merchandise or other asset sent to the home office or to other branches.
The Home Office account is a quasi-ownership equity account that shows
the net investment by 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 of the Home Office account; a net loss
decreases this balance.
In the home office accounting records, a reciprocal ledger account with a
title such as Investment in Branch is maintained. This non current asset
account is debited for cash, merchandise, and services provided to the
branch by the home office, and for net income reported by the branch. It
is credited for the cash or other assets received from the branch, and for
3
any net loss reported by the branch. Thus, the Investment in Branch
account reflects the equity method of accounting. A separate investment
account is generally maintained by the home office for each branch.
At the end of an accounting period, the balance of the Investment in
Branch X ledger account in the accounting records of the home office
may not agree with the balance of the Home Office account in the records
of Branch X, because certain transactions may have been recorded by
one office but not by the other. These balances of the reciprocal accounts
must be brought into agreement before combined financial statements
are prepared.
3.5 Expenses Incurred by Home Office and Allocated to Branches
Some business enterprises follow a policy of notifying each branch of
expenses incurred by the home office on behalf of the branch. When
such a policy is adopted, an expense incurred by the home office and
allocated to a branch is recorded by the home office by a debit to
Investment in Branch and credit to an appropriate expense account; the
branch debits an expense account and credits Home Office. Expenses
paid by the home office and allocable to branches may be insurance,
property and other taxes, depreciation, and advertising.
Expenses of the home office may also be allocated to branches especially
if the home office does not make sales and functions only as accounting
and control center. The head office may also charge each branch interest
on the capital invested there in. such expenses would not appear in the
combined income statement as they would be offset against interest
revenue recorded by the home office.
3.6 Billings of Merchandise to Branches
Three alternative methods are available to the home office for billing
merchandise shipped to its branches:

At cost

At a percentage above cost
4

At the retail selling price
Shipment of merchandise to a branch does not constitute a sale as the
ownership does not change.
Billing at cost

The simplest and widely used procedure

Avoids complications of unrealized gross profits on inventories

Attributes all gross profit to the branches even if some of the
merchandise may be manufactured by the home office
Billing at a percentage above cost

Intended to allocate reasonable gross profit to the home office

Under this method, the net income reported by the branch is
understated and the ending inventories are overstated for the
enterprise as a whole

Adjustments must be made to eliminate intra company profits in
preparation of combined financial statements
Billing at Retail Selling Prices

Based on a desire to strengthen internal control over inventories

The home office record of shipments to a branch, when considered
along with sales reported with the branch, provide a perpetual
inventory stated at selling price

Any difference with periodic physical count should be investigated
promptly
Illustrative Journal Entries of Operation of a Branch
Assume that S Company bills merchandise to Branch X at cost and the
branch maintains complete accounting records and prepares financial
statements.
Both the branch and home office use the perpetual inventory system.
Equipment used at the branch is carried in home office records.
Expenses such as advertising and insurance are incurred by the home
office and billed to the branch.
5
Summarized transactions of year 1
1. Cash of 1,000 was forwarded to Branch X
2. Merchandise with cost of 60,000 was shipped to Branch X
3. Equipment of 500 acquired by Branch X, to be carried in home
office records
4. Credit sales by Branch X amounted to 80,000; the cost of
merchandise sold was 45,000.
5. Collections of trade accounts receivable pf 62,000 made by Branch
X.
6. Payments for operating expenses by Branch X totaled 20,000
7. Cash of 37,500 remitted to home office by Branch X
8. Operating expenses charged to Branch X by home office totaled
3,000
When a branch obtains merchandise from outsiders also, the
merchandise acquired from the home office should be recorded in a
separate Inventories from Home Office account.
Home Office
1. Investment in Br X
1,000
Cash
Branch
1,000
Cash
2. Investment in Br X
Home Office
60,000
Inventories
1,000
60,000
Inventories
3. Equipment: Br X
Investment in Br X
1,000
Home Office
500
60,000
60,000
500
Home Office
500
Cash
4. None
500
Trade A/R
80,000
CGS
45,000
6
Sales
80,000
Inventories
45,000
5. None
Cash
62,000
Trade A/R
6. None
Operating Exp
62,000
20,000
Cash
7. Cash
37,500
Inv. In Br X
Home Office
37,500
8. Inv in Br X
3,000
Operating Exp
20,000
37,500
Cash
Operating Exp
3,000
37,500
3,000
Cash
3,000
Adjusting and Closing Entries
None
Sales
Investment in Br X
12,000
Income Br X
Income Br X
CGS
45,000
Op. Exp
23,000
Income Sum
12,000
Income Summary 12,000
12,000
12,000
80,000
Home Office
12,000
None
Income Summary 12,000
7
3.7 Transaction between Branches
Efficient operation may on occasion require that assets be transferred
from one branch to another. A branch does not carry a reciprocal
account with another branch but records the transfer in the Home Office
account.
For example if Branch A transfers merchandise to Branch B, Branch A
debits Home Office and credits Inventories, while Branch B debits
Inventories and credit Home Office. The Home Office records the transfer
by debiting Investment in Branch B and crediting Investment in Branch
A.
The additional freight cost due to the indirect routing does not justify
increase in the carrying amount of inventories. Only freight costs of the
direct shipment from the home office are included in inventory costs.
Illustration: The home office shipped merchandise costing 6,000 to
Branch D and paid freight costs of 400. Subsequently, the home office
instructed Branch D to transfer this merchandise to Branch E. Branch D
paid 300 to carry out this order. The cost of direct shipment from home
office to E would have been 500. The journal entries in the three sets of
records would be:
Home Office
Investment in Branch D
6,400
Inventories
6,000
Cash
400
To record shipment of merchandise and payment of freight costs
Investment in Branch E
6,500
Excess Freight Expense- Interbranch Transfers
200
Investment in Branch D
6,700
To record transfer of merchandise from Branch D to Branch E under
instruction of the home office
8
Branch D
Freight in
400
Inventories
6,000
Home Office
6,400
To record receipt of merchandise from home office with freight costs paid
in advance by home office
Home Office
6,700
Inventories
6,000
Freight in
400
Cash
300
To record transfer of merchandise to Branch E under instruction of home
office and payment of freight costs of 300
Branch E
Inventories
6,000
Freight in
500
Home Office
6,500
To record receipt of merchandise from Branch D transferred under
instruction of home office and normal freight billed by home office.
The excessive freight costs from such shipments generally result from
inefficient planning of original shipments and should not be included in
inventories. If branch managers are given authority to order transfer of
merchandise between branches, the excess freight costs should be
recorded as expenses attributable to the branches.
4.8 Combined Financial Statements
A balance sheet for distribution to external users the financial position of
the business enterprise as a single entity. A convenient starting point in
the preparation consists of the adjusted trial balances of the home office
and the branches.
The assets and liabilities of the branch are substituted for the
Investment in Branch ledger account included in the home office trial
balance. Similar accounts are combined to produce a single total amount
for cash, trade receivables, and other assets and liabilities of the
enterprise as a whole.
9
Reciprocal accounts are eliminated as they have no significance when the
branch and home office report as a single entity. The balance of the
Home Office account is offset against the balance of the Investment in
Branch account.
The operating results of the enterprise (the home office and the branches)
are shown by an income statement in which the revenue and expenses of
the branch are combined with the revenue and expenses of the home
office. Any intracompany profits or losses are eliminated.
Working Paper for Combined Financial Statements
A working paper for combined financial statements has three purposes:

To combine ledger account balances like assets and liabilities

To eliminate any intra company profits or looses

To eliminate the reciprocal accounts
Illustration: the same data is going to be used. Assuming that all the
year end routine adjustments are made, the working paper is begun with
adjusted trial balances of the home office and Branch X.
10
S CORPORATION
Working Paper for Combined Financial Statements of Home Office and
Branch X
For the Year Ended December 31, Year 1
(Perpetual Inventory System: Billing at Cost)
Adjusted TB
Elimination
Home Off
Br X
Combined
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
75,000
12,000
87,000
Income statement
Total
0
0
Statement of RE
Retained E Jan 1
(70,000)
Net income
(75,000)
Dividends
40,000
(70,000)
(12,000)
(87,000)
40,000
Retained E Dec 31
117,000
Balance sheet
Cash
25,000
5,000
30,000
Trade A\R (net)
39,000
18,000
57,000
Inventories
45,000
15,000
60,000
Investment in Br X
26,000
Equipment
a (26,000)
150,000
150,000
Acc Dep.
(10,000)
(10,000)
Trade A\P
(20,000)
(20,000)
Home Office
Common Stock
(26,000)
b 26,000
(150,000)
(150,000)
Retained earnings
Total
(117,000)
0
0
0
0
11
In the elimination column, elimination (a) offsets the balance of
Investment in Branch X account against the balance of the Home Office
account. This elimination appears in the working paper only. Combined
financial statements of S Corporation prepared on the basis of the above
working paper are:
S Corporation
Income Statement
For the Year Ended Dec 31, Year 1
Sales
Cost of goods sold
Gross profit
Operating expenses
Net income
Earning per share of common stock
480,000
280,000
200,000
113,000
87,000
5.80
S Corporation
Statement of Retained Earnings
For the Year Ended Dec 31, Year 1
Retained earnings, beginning of year
Add: Net income
Subtotal
Less: Dividends (2.67 per share)
Retained earnings, end of year
70,000
87,000
157,000
40,000
117,000
12
S Corporation
Balance Sheet
Dec 31, Year 1
Assets
Cash
Trade A/R (net)
Inventories
Equipment
Less: Accumulated Depreciation
Total assets
30,000
57,000
60,000
150,000
10,000
140,000
287,000
Liabilities and Stockholders Equity
Liabilities
Trade A/P
20,000
Stockholders’ equity
Common stock (10 par)
Retained earnings
Total liabilities and stockholders’ equity
267,000
287,000
150,000
117,000
Shipping Merchandise to Branches at Price above Cost
As explained earlier, some businesses bill merchandise shipped to
branches at cost plus a markup percentage or retail selling prices.
Because both methods involve similar modification of accounts, a single
example is used to illustrate the key points.
Change one assumption of the former example to: the home office bills
merchandise shipped to branches at 50% above cost. The merchandise
shipment in the previous example is thus billed at 90,000 (60,000+50%
mark up of 30,000) and are recorded as follows:
Home Office
Investment in Br X
90,000
Inventories
60,000
Overvaluation of inv: Br X
30,000
Use of the allowance account enables the home office to maintain record
of unrealized gross profit on shipments.
13
Branch
Inventories
90,000
Home Office
90,000
The two reciprocal accounts at branch and head office viz. Home Office
and Investment in Branch X accounts will have balances of 56,000
before the accounts are closed and net income or loss entered. This
amount is 30,000 larger than the balance in the previous illustration as
a result of change in billing method.
At the end of the period the branch will report its inventories at billed
prices of 22,500 (15,000*50%). In the records of the home office the
required balance of the Allowance for Overvaluation of Inventories:
Branch X account is 7,500 (22,500-15,000); thus, this account balance
must be reduced to 7,500 from the present amount of 30,000 to
represent the excess valuation contained in the ending inventories of the
branch.
Under the present assumption the branch reports a net loss of 10,500.
The adjustment of 22,500 is transferred as credit to Income: Branch X
account, because it represents additional gross profit over that reported
by the branch. Thus the actual net income for Branch X is 12,000, the
same as the previous illustration.
The following journal entries are passed in the home office records.
Income: Branch X
Investment in Branch X
10,500
10,500
To record net loss reported by branch
Allowance for Overvaluation of Inventories: Br X
Income: Branch X
22,500
22,500
To reduce allowance to amount by which ending inventories of branch
exceed cost
Income: Branch X
Income Summary
12,000
12,000
To close branch net income (as adjusted)
14
Working Paper when Billing to Branches at Price above Cost
S CORPORATION
Working Paper for Combined Financial Statements of Home Office and
Branch X
For the Year Ended December 31, Year 1
(Perpetual Inventory System: Billing above Cost)
Adjusted TB
Elimination
Home Off
Br X
Combined
Sales
(400,000)
(80,000)
(480,000)
Cost of Goods Sold
235,000
67,500 a (22,500)
280,000
Operating expenses
90,000
23,000
113,000
Net income
75,000
(10,500) b 22,500
Income statement
Total
0
87,000
0
Statement of RE
Retained E Jan 1
(70,000)
Net income
(75,000)
Dividends
40,000
(70,000)
10,500 b(22,500)
(87,000)
40,000
Retained E Dec 31
117,000
Balance sheet
Cash
25,000
5,000
30,000
Trade A\R (net)
39,000
18,000
57,000
Inventories
45,000
22,500 a(7,500)
60,000
Investment in Br X
56,000
c (56,000)
Allowance for over v
(30,000)
a 30,000
Equipment
150,000
150,000
Acc Dep.
(10,000)
(10,000)
Trade A\P
(20,000)
(20,000)
Home Office
Common Stock
(56,000)
b 56,000
(150,000)
(150,000)
Retained earnings
Total
(117,000)
0
0
0
0
15
a) To reduce ending inventories and cost of goods sold of branch to
cost, and to eliminate balance in Allowance for Overvaluation of
Inventories: Branch X ledger account.
b) To increase net income of branch by portion of merchandise
markup that was realized.
c) To eliminate reciprocal ledger accounts.
Reconciliation of Reciprocal Accounts
In a previous section, the nature of reciprocal accounts and the necessity
for their reconciliation before the combined financial statements are
prepared was described. The situation is comparable to that of
reconciling the ledger account for Cash in Bank with the balance in the
monthly bank statement.
Illustration: Assume the home office and the branch accounting records
contain the following data and the balances of the Home Office account
and Investment in Branch accounts on Dec 31 are 41,500 Cr. and
49,500 Dr. respectively. Comparison of the two reciprocal accounts
discloses four reconciling items.
1. A debit of 8,000 in Investment in Branch account without a related
credit in Home Office account
Merchandise shipped to branch on Dec 29 but not received at year
end. Required journal in branch accounting records:
Inventories in Transit
Home Office
8,000
8,000
To record shipment of merchandise in transit from home office
The inventories in transit must be included in inventories in hand.
2. A credit of 1,000 in the Investment in Branch account without a
related debit in the Home Office account
The home office collected trade accounts receivable of the branch.
The journal entry required in the records of the branch on Dec 31:
16
Home Office
1,000
Trade A/R
1,000
To record collection of accounts receivable by home office
3. A debit of 3,000 in the Home Office ledger account without a
related credit in Investment in Branch account
The branch acquired equipment for 3,000 on Dec 28 and debited
Home Office as equipment used by branch is carried in records of
the home office. The journal entry required in the records of the
home office:
Equipment: Branch
3,000
Investment in Branch
3,000
To record equipment acquired by branch
4. A credit of 2,000 in the Home Office ledger account without a
related debit in the Investment in Branch account
Accounts receivable of the home office was collected on Dec 30 and
recorded as credit to Home Office. Journal entry required in the
records of the home office on Dec 31
Investment in Branch
2,000
Trade A/R
2,000
To record collection of receivable by branch
The effect of the foregoing end of year journal entries is to update the
reciprocal ledger accounts as shown below:
17
M COMPANY- HOME OFFICE AND A BRANCH
RECONCILIATION OF RECIPROCAL LEDGER ACCOUNTS
DEC 31, 19X9
Investment in
Home Office
Branch
Balance before adjustment
49,500 Dr
Add: 1. Merchandise shipped
41,500 Cr
8,000
4. Home office A/R
collected by branch
2,000
Less: 2. Branch A/R
Colleted by H.O.
(1,000)
3. Equipment acquired
By branch
Adjusted balances
(3,000)
48,500
48,500
Accounting for Foreign Branches and Foreign Currency Transactions
Foreign Currency Transactions
In most countries, a foreign currency is treated as a commodity or money
market instrument. Foreign currencies are bought and sold by the
international banking departments of commercial banks. The buying and
selling of foreign currencies result in variation in the exchange rates of
between the currencies of two countries. Exchange rates may be quoted
as:
Britain (pound)
Foreign currency
In dollars
1.6065
Dollars in
foreign currency
0.6225
Ethiopia (birr)
0.1093
9.1520
The exchange rate illustrated above is the selling spot rate charged by
the bank for current sales of the foreign currency. The bank’s buying
spot rate for the currency typically is less than the selling spot rate, the
agio or spread between the buying and the selling rates represents gross
profit to a trader in foreign currency.
18
To illustrate, a US firm that requires £10,000 would pay $ 16,065 at the
above exchange rate.
A multinational enterprise may engage in sales, purchases, and loans
with independent foreign enterprises as well as with its branches,
divisions, influenced investees, or subsidiaries in other countries. If the
transaction with independent foreign enterprise is denominated or
expressed in terms of the currency of the multinational’s country
(dollars), no accounting problem arises for the multinational enterprise.
The sale, purchase, or loan transaction is recorded in that currency
(dollar) in the accounting records of the multinational, the independent
foreign enterprise must obtain the currency necessary to complete the
transaction.
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 US enterprise must account for the transaction
denominated in foreign currency in terms of US dollars. This accounting,
described as foreign currency translation, is accomplished by applying
the appropriate exchange rate between the foreign currency and the US
dollar.
To illustrate: assume that on April 18 Year 6, Worldwide Corporation
purchased merchandise from a UK supplier at a cost of £100,000. The
April 18, Year 6 selling spot rate was £1= $1.6065. The UK supplier
made the sale on 30 day open account.
Assuming Worldwide uses the perpetual inventory system, it records the
purchase as follows:
Inventories
Trade Accounts Payable
160,650
160,650
To record purchase on a 30 day open account from a UK supplier
for £100,000, translated at selling spot rate of £1= $1.6065.
The selling spot rate was used in the journal entry, because it was the
rate at which the liability could have been settled on April 18 Year 6.
19
Transaction Gains and Losses
During the period that the trade account payable to the UK supplier
remains unpaid, the selling spot rate for pound may change. If the selling
spot rate decreases, Worldwide will realize a transaction gain; if the
selling spot rate increases, Worldwide would incur a transaction loss.
Transaction gains and losses are included in the measurement of net
income.
To illustrate, assume that on April 30 Year 6, the selling spot rate for
pound was £1= $1.6050 and Worldwide prepares financial statements
monthly. The journal entry with respect to the trade accounts payable
would be:
Trade Accounts Payable
150
Transaction Gains and Losses
150
To recognize transaction gain applicable April 18 Year 6, purchase
from a UK supplier: [(100,000*1.6065) - (100,000*1.6050)].
Assume further that the selling spot rate on May 18, Year 6 was £1=
$1.6030. The journal entry for payment of the liability is shown below:
Trade A/P
160,500
Transaction Gains and Losses
200
Cash
160,300
To record payment of £100,000 and recognize transaction gain
The above process essentially reflects two separate transactions. One
transaction
was
the
purchase
of
the
merchandise;
the
second
transaction was the acquisition of the foreign currency required to pay
the liability for the merchandise purchased. This two transaction
perspective was sanctioned by the FASB in FASB Statement No. 52.
Advocates of an opposing viewpoint, the one transaction perspective,
maintain that Worldwide’s total transaction gain of $350 should be
applied to reduce the cost of merchandise purchased. Under this
approach, there is no need to prepare the entry on April 30 but the
following journal entry would be prepared on May 18, Year 6 (assuming
20
that all the merchandise purchased on April 18 have been sold by May
18):
Trade Accounts Payable
160,650
Cost of Goods Sold
350
Cash
160,300
To record payment of £100,000 (100,000* 1.6030) to settle liability
to the UK supplier and offset resultant transaction gain against
cost of goods sold.
Supporters of the one transaction perspective consider the original
amount recorded as an estimate subject to adjustment when the exact
cash outlay required for the purchase is known. Thus, the emphasis is
on the cash payment aspect rather than the bargained price aspect of the
transaction.
The separability of the merchandising and financing aspects of a foreign
trade transaction is an undeniable fact. In delaying the payment of a
foreign trade purchase transaction, an importer has made a decision to
take the risk of exchange rate fluctuations. This risk assumption is
measured by the transaction gain or loss recorded at the time of payment
for the purchase of merchandise (or on the dates of intervening financial
statements).
Accounting for Foreign Branches
When the US multinational enterprise prepares consolidated financial
statements that include the assets, liabilities, and operation of foreign
subsidiaries or branches, the US enterprise must translate the amounts
in the financial statements of the foreign entities from the entities’
functional currency to US dollars. Similar treatment must be given to the
assets
and
income
statement
amounts
associated
with
foreign
subsidiaries that are not consolidated, and with other foreign investees
for which the US enterprise uses the equity method of accounting.
21
Functional Currency
FASB defines functional currency as follows:
An entity’s functional currency is the currency of the primary economic
environment in which the entity operates; normally, that is the currency
of the environment in which an entity primarily generates and expends
cash.
For an entity with operations that are relatively self contained and
integrated and within a particular country, the functional currency
generally would be the currency of that country. The parent’s currency
generally would be the functional currency for the operations that are
direct and integral component or extension of the parent company’s
operations.
Alternative Methods for Translating Foreign Entity’s Financial Statements
If the exchange rate for the functional currency of a foreign subsidiary or
branch remained constant instead of fluctuating, translation of the
foreign entity’s financial statement to US dollars would be simple. All
financial statement amounts would be translated to US dollars at the
constant exchange rate. However, exchange rates fluctuate frequently.
Translation Methods
Current exchange rate is the spot rate in effect on the balance sheet
date of the foreign entity.
Historical exchange rate is the spot rate in effect on the date a
transaction takes place.
Current /Non- current Method

Current assets and current liabilities are translated at the
exchange rate in effect on the balance sheet date of the foreign
entity (current rate).

All other assets and liabilities, and the elements of owners’ equity
are
translated
at
the
historical
rates
in
effect
when
the
transactions were first recorded.
22

Depreciation and amortization are translated at historical rates
applicable to the related assets.

All other revenues and expenses are translated at an average
exchange rate for the accounting period.
Monetary/non-monetary Method/Temporal Method

Monetary
assets
and
liabilities-
those
representing
claims
or
obligations expressed in a fixed monetary amount- are translated at
the current exchange rate.

All other assets liabilities and owners’ equity accounts are translated
at appropriate historical rates.

Average exchange rates are applied to all revenue and expenses except
depreciation and amortization, and cost of goods sold which are
translated at appropriate historical rates.
Current Rate Method

All balance sheet amounts other than owners’ equity are translated at
the current exchange rate.

Owners’ equity amounts are translated at historical rates.

All revenue and expenses may be translated at the current rate on the
respective transaction dates, if practical. Otherwise, an average
exchange rate is used for all revenues and expenses.
Standard for Translation Established by the Financial Accounting
Standards Board
Objectives of translation

Provide information that is generally compatible with the exposed
economic effects of an exchange rate change on an enterprise’s
cash flow and equity

Reflect, in consolidated statements, the financial results and
relationships of the individual consolidated entities as measured in
their functional currencies in conformity with US GAAP.
23
FASB Statement No. 52 adopted the current rate method described above
for translating a foreign entity’s financial statements from the entity’s
functional currency to the reporting currency of the parent company,
which for a US enterprise is the US dollar. If a foreign entity’s accounting
records are maintained in a currency other than its functional currency,
account balances must be re measured to the functional currency before
the financial statements may be translated. Re measurement essentially
is accomplished by the monetary/non monetary method of translation.
Translation of Financial Statements of Foreign Influenced Investee
Assume that on May 31 Year 6, Colossus Company, a US multinational
company, acquired 30% of the outstanding common stock of a
corporation in Venezuela, which we term the Venezuela Investee. The
functional currency of the foreign entity is Bolivar (B). Colossus acquired
its investment in Venezuela Investee for B 600,000 when the selling spot
rate was 1B=$0.25 for $150,000. Out of pocket costs may be
disregarded. Stockholders equity of Venezuela Investee on May 31, Year
6 was as follows:
B
Common stock
500,000
Additional paid-in capital
600,000
Retained earnings
900,000
Total stockholders’ equity
2,000,000
Hence, no difference between equity and cost of investment of Colossus
(2,000,000*0.3=600,000). The exchange rates for the bolivar were as
follows:
May 31, Year 6
$0.25
May 31 Year 7
0.27
Average for the year ended May 31, Year 7
0.26
24
VENEZUELA INVESTEE
TRANSLATION OF FINANCIAL STATEMENTS TO US DOLLARS
FOR YEAR ENDED MAY 31, YEAR 7
Venezuelan
bolivars
Exchange US dollars
rate
Net sales
6,000,000
0.26(1)
1,560,000
Costs and expenses
4,000,000
0.26(1)
1,040,000
Net income
2,000,000
Income Statement
520,000
Statement of Retained Earnings
Retained earnings, beg
900,000
0.25(2)
225,000
Add: Net Income
2,000,000
520,000
Sub totals
2,920,000
745,000
Less: Dividends
Retained earnings, ending
600,000
0.27(3)
2,300,000
162,000
583,000
Balance Sheet
Assets
Current assets
Plant assets (net)
Other assets
Total assets
200,000
0.27(3)
54,000
4,500,000
0.27(3)
1,215,000
300,000
0.27(3)
81,000
5,000,000
1,350,000
Liabilities & Stockholders’ Equity
Current liabilities
100,000
0.27(3)
27,000
Long term debt
1,500,000
0.27(3)
405,000
Common stock
500,000
0.25(2)
125,000
Additional paid in capital
600,000
0.25(2)
150,000
Retained earnings
2,300,000
Cumulative translation adj.
Total liab & stockholders’ eq 5,000,000
583,000
60,000
1,350,000
25
(1) Average rate for year ended May 31, Year 7
(2) Historical rate (on May 31, Year 6, date of investment by Colossus)
(3) Current rate (May 31, Year 7)
(4) A balancing figure labeled cumulative translation adjustments,
which is not a ledger account, is used to reconcile the balances of
total liabilities and stockholders’ equity with total assets.
Following the translation, Colossus prepares the following entries
under the equity method of accounting for the investment in common
stock:
Investment in Venezuela Investee
($520,000*.3)
156,000
Investment Income
156,000
To record 30% of net income of Venezuela Investee
Dividends Receivable ($162,000*.3)
48,600
Investment in Venezuela Investee
48,600
To record dividends received from Venezuela investee
After the foregoing journal entries are posted, the investment ledger of
Colossus Company would have a balance of 257,400Dr composed of:
Opening/original investment
150,000Dr
Net income
156,000Dr
Dividend
Balance
48,600Cr
257,400Dr
Translation and Consolidation of Financial Statements of Foreign
Subsidiary
To illustrate, assume that on August 31, 1999 SoPac Corporation a US
enterprise with no other subsidiaries, acquired at the selling spot rate of
$NZ1=$0.52 a draft for 500,000 New Zealand dollars ($NZ), which it
issued to acquire all 10,000 authorized $NZ 50 par common stock of
newly organized Anzac Ltd., a New Zealand enterprise.
26
SoPac prepared the following journal entry for the investment:
Aug. 31 Investment in Anzac Ltd.
($NZ 500,000*0.52)
260,000
Cash
260,000
To record acquisition of 10,000 shares of $NZ50 par
common stock of Anzac, Ltd.
Anzac, Ltd was self contained in New Zealand and its functional currency
is the New Zealand dollar.
ANZAC, LTD.
INCOME STATEMENT
FOR THE YEAR ENDED AUGUST 31, 2000
$NZ
Revenue:
Net sales
240,000
Other
60,000
Total Income
300,000
Costs and expenses
Cost of goods sold
Operating expenses
Total costs and expenses
Net income (retained earnings, ending)
180,000
96,000
276,000
24,000
27
ANZAC, LTD.
BALANCE SHEET
AUGUST 31, 2000
Assets
Cash
10,000
Trade accounts receivable (net)
40,000
Inventories
180,000
Short term prepayments
4,000
Plant assets (net)
320,000
Intangible assets (net)
20,000
Total assets
574,000
Liabilities and Stockholders’ Equity
Notes payable
20,000
Trade accounts payable
30,000
Total liabilities
50,000
Common stock, $NZ50 par
500,000
Retained earnings
24,000
Total stockholders’ equity
524,000
Total liabilities & stockholders’ equity
574,000
The exchange rates for the New Zealand dollar were as follows:
Aug 31, 1999
$0.52
Aug 31, 2000
$0.50
Average for the year
$0.51
28
ANZAC, LTD.
Translation of Financial Statements to US Dollars
FOR THE YEAR ENDED AUGUST 31, 2000
Exchange
$NZ
rate
Net sales
240,000
Other
60,000
Total Income
0.51(1)
0.51(1)
300,000
USD
122,400
30,600
153,000
Costs and expenses
Cost of goods sold
180,000
0.51(1)
91,800
96,000
0.51(1)
48,960
Operating expenses
Total costs and expenses
276,000
Net income (retain ear, ending)
140,760
24,000
12,240
Cash
10,000
0.50(2)
5,000
Trade accounts receivable (net)
40,000
0.50(2)
20,000
180,000
0.50(2)
90,000
4,000
0.50(2)
2,000
320,000
0.50(2)
160,000
20,000
0.50(2)
10,000
Inventories
Short term prepayments
Plant assets (net)
Intangible assets (net)
Total assets
574,000
287,000
Notes payable
20,000
0.50(2)
Trade accounts payable
30,000
0.50(2)
15,000
500,000
0.52(3)
260,000
Common stock, $NZ50 par
Retained earnings
24,000
Foreign Curr. Tran. Adj
Total liab & stockholders’ equity
10,000
12,240
(10,240)
574,000
287,000
(1) Average for year ended Aug. 31,2000
(2) Current rate On Aug. 31,2000
(3) Historical rate of Aug. 31,1999
29
Following the translation, SoPac prepares the following journal entries in
US dollars under the equity method of accounting for investment in
common stock:
Investment in Anzac Common Stock
12,240
Intracompany Investment Income
12,240
To record 100% of net income of Anzac Ltd
Foreign Currency Translation Adjustments
10,240
Investment in Anzac Common Stock
10,240
To record 100% of other comprehensive income component of
Anzac Ltd.’s stockholders’ equity
After the foregoing journal entries are posted, the balance of SoPac’s
Investment in Anzac Ltd. Common Stock ledger account is $ 262,000
(260,000+12,240-10,240), which is equal to the stockholder’s equity of
Anzac,
Ltd.,
including
foreign
currency
translation
adjustments
(260,000+12,240-10,240). SoPac is now able to prepare the following
working paper elimination I journal entry format.
SOPAC CORPORATION
Working Paper Elimination
August 31, 2000
(a) Common Stock-Anzac
Intracompany Investment Income-SoPac
Investment in Anzac, Ltd., Common Stock-SoPac
Foreign Currency Translation Adj.- SoPac
260,000
12,240
262,000
10,240
To eliminate intracompany investment and equity accounts of subsidiary
30