Abe Advanced Accounting Publication 11

SIMPLIFIED LECTURE NOTE ON ADVANCED
FINANCIAL ACCOUNTING
Teaching Material
Prepared by: Abebe Teka (Msc in Accounting and Finance)
Bale-Robe, 2014
I
Table of Contents
Contents
Chapter one: Over view of accounting for joint ventures and Public enterprises ……………..1
1.1.Characteristics and Historical Background of Joint venture …………………………………….1
1.2. Accounting for joint ventures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ………. . .
. .1
1.3. Accounting for public enterprises in Ethiopia ………………………………………………….. 5
1.4.Forms of Public Enterprises………………………………………………………………………7
Chapter two: Accounting for Sales Agencies and principal; Branches and Head office ……...10
2.1. Distinguishing Agency and Branch …………………………………………………………….10
2.2. Accounting for Sales Agency …………….…………………………………………………….10
2.3. Accounting for Branch …………………………………………………………………………12
2.4. Combined Financial Statements ……….……………………………………………………….18
2.5. Shipping Merchandise to Branches at Price above Cost………..………………………………22
2.6. Reconciliation of Reciprocal Accounts ……….………………………………………………..24
Chapter three: Installment and Consignment contracts
3.1. accounting for Installment Sales ……………………………………………………...….…….27
3.2. Consignment sales ……………………………………………………………………………..36
Chapter four: Business Combinations …………………………..…………………………….…47
4.1. nature of business combination .………………………………………………………………..47
4.2. Methods for Arranging Business Combinations ……………………………………………….48
4.3. Methods of Accounting for Business Combinations ………………………………….……….50
4.4. Comparison of Purchase Accounting and Pooling of Interest …………………………………61
4.5 Appraisal of Accounting Standards for Business Combination ….……………………………..63
Chapter five: Consolidations: on the date of purchase-type business combination ………………...64
5.1 Parent Company- Subsidiary Relationships …………………………………………………….64
5.2. Consolidated Financial Statement: Wholly owned subsidiary.…………………………………65
5.3. Consolidated Financial Statement : Partially Owned subsidiary ………………………………72
5.4. Consolidated Financial Statement: Subsequent to data of acquisition …..……………………..80
5.4.1. Accounting for Operating Results of Wholly Owned Purchased Subsidiaries ………………80
5.4.2. Accounting for Operating Results of Partially Owned Purchased Subsidiaries ……………..87
II
Chapter six: Foreign Currency Accounting ……………………………………………………..95
6.1. Introduction ……………………………………………………………………………………95
6.2 The Mechanics of Exchange Rates ……………………………………………………………..95
6.3. Foreign Currency Transaction Gains and Losses ……………………………………………...97
6.4. Unsettled Foreign Currency Transactions ……………………………………………………..99
6.5. Forward Exchange Contracts …………………………………………………………………101
Chapter seven: Segment Reporting and Interim Reporting …………………………………..102
7.1. Introduction …………………………………………………………………………………...102
7.2. Objectives of Segment Reporting and Applicable Accounting Standards ……………………102
7.3.Coverage of Segmental Reporting ……………………………………………………………..102
7.4. The position of security and exchange commission (sec) on segment reporting ……………..110
7.5. Interim financial reporting …………………………………………………………………….111
III
CHAPTER ONE
ACCOUNTING FOR JOINT VENTURES AND PUBLIC ENTERPRISES
1.1. Characteristics and Historical Background
Joint venture differs from a partnership in that it is limited to carrying out a single project such as,
production of a motion picture or construction of a building or dam. Historically, joint ventures were
used to finance the sale or exchange of a cargo or merchandise in a foreign country. In an era when
marine transportation and foreign trade involved may hazards, individuals (venturers) would band
together to undertake a venture of this type. The capital required usually was larger than one person
could provide, and the risks were too high to be borne alone. Because of the risks involved and the
relatively short duration of the project, no net income was recognized until the venture was completed.
At the end of the voyage, the net income or net loss was divided among venturers, and their association
was ended.
In this traditional form,

• Accounting for joint venture did not follow the accrual basis
• Net income not determined at regular intervals
• Measurement and reporting of net income or loss awaited completion of the venture
In today‟s business community, joint ventures are less common but still employed for many projects
such as:
• The acquisition, development, and sale of real property
• Exploration for oil and gas
• Construction of bridges, buildings, and dams
1.2. Accounting for a Joint Venture

1.2.1. Accounting for a Corporate or LLC Joint Venture
Corporate joint venture refers to a corporation owned and operated by a small group of businesses (the
joint venturers) as a separate and specific business or project for the mutual benefit of the members of
the group. A government may also be a member of the group. An entity which is a subsidiary of one of
the joint venturers is not a corporate joint venture. According to the Accounting Principles Board,
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investors should account for investments in common stock of corporate joint ventures by the equity
method in consolidated financial statements.
Arguments for establishing a separate set of accounting records for every corporate joint venture of large
size and long duration are:
• The complexity of modern business
• The emphasis on good organization and strong internal control
• The importance of income taxes
• The extent of government regulation
In the stockholders‟ equity accounts of the joint venture, each venturer‟s equity account is credited for
the amount of cash or non cash asset invested. The accounting records of such a corporate joint venture
include the usual ledger accounts for assets, liabilities, stockholders‟ equity, revenue, and expenses. The
entire accounting process should conform to generally accounting practices, from the recording of
transactions to the preparation of financial statements.
1.2.2. Accounting for an Unincorporated Joint Venture

Because the investor-venturer in an unincorporated joint venture owns an undivided interest in each
asset and is proportionately liable for its share of each liability, the provisions of APB may not apply in
such cases. Investors in unincorporated joint ventures have, thus, the option of using either the equity
method of accounting or a proportionate share method of accounting for the investments.
Illustration: assume that A Company and B Company each invested Br. 400,000 for a 50% interest in
unincorporated joint venture in January 19X9. Condensed financial statements for AB Company for
19X9 were as follows:
AB Company (A joint venture)
Income Statement
For the Year Ended December 31, 19X9
Revenue 2,000,000
Less: Cost and Expenses 1,500,000
Net Income 500,000
Division of net income
A Company 250,000
B Company 250,000
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Total 500,000

Statement of Venturer’ Capital
For the Year Ended December 31, 19X9
A Company B Company Combined

Investment, Jan. 2 400,000 400,000 800,000
Add: Net income 250,000 250,000 500,000
Venturers‟ Capital,
End of Year 650,000 650,000 1,300,000

Balance Sheet
December 31, 19X9
Assets
Current Assets 1,600,000
Other Assets 2,400,000
Total Assets 4,000,000
Liabilities & Venturers’ Capital

Current Liabilities 800,000
Long term Debt 1,900,000
Venturers‟ Capital:
A Company 650,000
B Company 650,000 1,300,000
Total Liabilities & Capital 4,000,000
Under the equity method of accounting, both A Company and B Company prepare the following
journal entries for the investment in the AB Company:
1999
Jan 2 Investment in AB Company (Joint Venture) 400,000
Cash 400,000
3
To record investment in joint venture
Dec 31 Investment in AB Company (Joint Venture) 250,000

Investment Income 250,000
To record share of AB Company net income (500,000*.5)
Under the proportionate share method of accounting, in addition to the foregoing journal entries, both
A Company and B Company prepare the following journal entry for their respective shares of the assets,
liabilities, revenue, and expenses of AB Company:
1999
Dec 31 Current Assets (50%) 800,000
Other Assets (50%) 1,200,000
Costs and Expenses (50%) 750,000
Investment Income 250,000
Current Liabilities (50%) 400,000
Long term Debt (50%) 950,000
Revenue (50%) 1,000,000
Investment in AB Co (Joint Venture) 650,000
To record proportionate share of joint venture‟s assets, liabilities, revenue, and expenses.
Use of the equity method of accounting for unincorporated joint ventures is consistent with APB
Opinion No. 18 but information on material assets and liabilities of a joint venture may be relegated to a
note to financial statements resulting in off-balance sheet financing. The proportionate share method of
accounting for unincorporated joint ventures avoids the problems of off-balance sheet financing but has
the questionable practice of including portions of assets such as plant assets in each venturer‟s balance
sheet.
1.3. ACCOUNTING FOR PUBLIC ENTERPRISES

Public Enterprises may be defined as autonomous or semi-autonomous bodies owned by the government
and engaged in providing services and or products.
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The growth of public enterprises has been partly by nationalization and partly through creation of new
ones. Some industries are also reserved for the public sector as a matter of national policy. Such
industries could be airways, defense industries, railways, telecommunication and the like.
The need to have public enterprises may be justified on a number of grounds:
• Limitation of the free price mechanism
It is realized that in spite of all its advantages, a free price mechanism had serious limitations which had
to be overcome in the long term interests of the economy. An economy can not sustain itself and grow
unless it is healthy in terms of production potential which should increase with the passage of time that
is development of different economic sectors in harmony or proper sectoral balance. However, the
nature of market mechanism is such that all economic activities are guided by economic rationalism
which in the case of provision of products or services means profitability. Market mechanism would
refuse to run those productive services which could not yield adequate profits. But such ventures are
necessary for the development of the economy. The public authorities thus maintain these projects at a
loss and meet the loss from their tax revenue.
• Basic industries need huge investment
Private enterprise is either not able to raise the necessary funds or not ready to assume such large risks.
In such cases, even if these enterprises could possibly be profitable, the government has to step in to
establish them. Cases of very long term projects also come in this category.
• Government‟s duty to help in economic development
Such a policy entails a number of responsibilities and some of these results in the governments going in
for various types of public enterprises. In an underdeveloped country, additionally, we find that there is
an overall shortage of capital. It becomes, therefore, the task of the authorities to assume the
responsibility of filling the gap and thereby removing the specific shortages. The role of basic and key
industries which provide an impetus and necessary basis for the general economic development may
also be mentioned in this connection.
It is not very likely that the private sector which moves solely on the basis of profit motive, will find it
always convenient to move ahead and establish these industries in time and adequate measure. The
private sector would find it easier and more profitable to expand at a rapid rate once basic inputs like
skilled human resource are created through education and training.
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• Creation of economic surpluses and their utilization
A number of public undertakings directly add to the capital assets of the economy in the form of roads,
bridges, factories and the like. They are, in so far as they are not in the public sector by virtue of
nationalization only, net additions to the capital stock of the country and, therefore, they contribute to its
total productive power. Such an addition might also result from utilization and exploitation of resources
which were hitherto going waste; or from change in the allocation of resources. Public enterprises can
also help the economy a lot by diverting its productive resources into those lines which will accelerate
the growth process later through a provision of an infrastructure, basic and key industries and so on.
• Final choice of projects are made in the interest of the economy as a whole
If social benefits exceed social costs in the case of any service, then its production should be taken up.
But it is possible that on grounds of social benefits some projects are sound but not on grounds of
commercial profitability. Under such circumstances, these projects can be taken up by authorities in the
public sector.
• Limitation on demand of merit goods on account of price if left in private hands
Merit goods are those expected to enhance the general welfare of the community and should be provided
through public enterprises either along with public enterprises or in place of it. It is generally believed
that the supply of such services should be adequate and should be available at low or zero prices so as to
encourage their consumption. In case of education, the government may not only provide it for free but
also insist that all children up to a certain age must attend schools.
• The overall economic policy of a country may dictate the use of public enterprises in some
sectors
There are some industries like electricity generation where there are economies of scale. If such services
are provided by a large number of firms competing with each other, it wouldn‟t be possible to reap these
economies. Authorities may, therefore, think it more desirable to have a public monopoly than private
monopoly for such services.
• Effective economic control of the economy
Effective economic control of the whole economy is sought to be brought in the hands of the state. In
other words, the argument of not letting the emergence of a monopoly in private hands is extended to the
whole economy. The authorities might plan to have a strategic control over the working of the whole
economy through controlling certain key sectors.
• Better protection of natural resources
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In the case of some natural resources like forests, mines and the like, the commercial interests of a
private enterprise often come into conflict with those of the nation. A private jungle contractor
authorized to cut trees is likely to make a quick profit by cutting down as many trees as possible. This
may result in a large scale and quick denuding of the land causing soil erosion and upsetting the
ecological balance.
1.4. Forms of Public Enterprises

The enterprises which are not run on departmental basis have, in general, two forms. One is as a firm or
company owned and controlled by the government and functions under the same laws of the country as
private firms or companies of similar type.
Another form of public enterprise is what may be called the public corporation.
• Public corporations are
Set up by legislation which defines:
Sphere of activities
Rights, immunities
Artificial legal persons

Can take independent decisions
Can sue and be sued
Have their own personnel policy, management pattern and the like
Can retain and reuse their funds according to adopted policy
PROCLAMATION NO 25/1992
Proclamation No 25/1992 is a legal provision governing establishment and operation of public
enterprises in Ethiopia. The public enterprises in Ethiopia include those nationalized and established
afresh by the government over the years. As per the proclamation a public enterprise is defined as a
wholly state owned enterprise established pursuant to the proclamation to carry on for gain
manufacturing, distribution, service rendering or other economic and related activities.
According to the proclamation:
• Every enterprise shall be established by regulation and the establishment regulation shall contain:
The name of the enterprise
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A statement the enterprise shall be governed by the proclamation
The purpose for which the enterprise is established
The authorized capital
The amount of initial capital paid up both in cash and in kind
A statement that the enterprise shall not be liable beyond its total assets
The head office of the enterprise
A statement that may authorize the enterprise to open branches
The name of the supervising authority
The duration for which the enterprise is established
• Each enterprise shall have:
A supervising authority
A management board
Management
Necessary staff
• A supervising authority is an authority that is designated by the Council of Ministers with a view
to protecting the ownership rights of the state.
• Each enterprise shall keep accounts as per GAAP
• Financial year of the enterprises shall be determined by the supervisory authority
• Each enterprise shall have a Legal Reserve Fund
5% of net profit transferred annually to LRF until the fund equals 20% of the capital
The fund may be utilized for covering:
Losses
Unforeseen expenses and liabilities
The board of the enterprises, upon approval of the authority, may establish other funds
• Taxes and Duties
Shall be paid as per relevant provisions of applicable laws
• State dividend
The amount to be paid to the government in the form of state dividend shall be
determined by the supervisory authority based upon proposal of the board
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CHAPTER TWO
ACCOUNTING FOR AGENCY & PRINCIPAL, HEAD OFFICE & BRANCH
2.1. Distinguishing Agency and Branch
An agency relationship refers a contract under which on or more persons (the principals) engage another
person‟s (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.
2.2. 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
Illustration: Journal Entries for a Sales Agency

Journal entries required at the home office in connection with a sales agency (Robe Agency), assuming
the perpetual inventory system is used:
9
HOME OFFICE
JOURNAL ENTRIES FOR ROBE AGENCY TRANSACTIONS
Inventory Samples: Robe Agency 1,500
Inventories 1,500
To record merchandise shipped to sales agency for use as samples
Imprest Cash Fund: Robe Agency 1,000

Cash 1,000
To establish imprest cash fund for sales agency
Trade Accounts Receivable 50,000

Sales: Robe Agency 50,000
To record sales made by sales agency
Cost of Goods Sold: Robe Agency 35,000

Inventories 35,000
To record cost of merchandise sold by sales agency
Operating Expenses: Robe Agency 10,000

Cash 10,000
To replenish imprest cash fund (several checks during the period)
Sales: Robe Agency 50,000

Cost of Goods Sold: Robe Agency 35,000
Operating Expenses: Robe Agency 10,000
Income Summary: Robe Agency 5,000
To close revenue and expense accounts to a separate income summary ledger account for a sales agency
Income Summary: Robe Agency 5,000

Income Summary 5,000
To close net income of sales agency to Income Summary ledger account
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2.3. 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.
2.3.1. 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 noncurrent 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 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.
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2.3.2. 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.
2.3.3. 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
• 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
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• 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.
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 Inventory from Home Office account.
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Home Office Branch
1. Investment in Br X 1,000 Cash 1,000
Cash 1,000 Home Office 1,000
2. Investment in Br X 60,000 Inventories 60,000

Inventories 60,000 Home Office 60,000
3. Equipment: Br X 500 Home Office 500

Investment in Br X 500 Cash 500
4. None Trade A/R 80,000

CGS 45,000
Sales 80,000
Inventories 45,000
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5. None Cash 62,000
Trade A/R 62,000
6. None Operating Exp 20,000

Cash 20,000
7. Cash 37,500 Home Office 37,500

Inv. In Br X 37,500 Cash 37,500
8. Inv in Br X 3,000 Operating Exp 3,000

Operating Exp 3,000 Cash 3,000
Adjusting and Closing Entries

None Sales 80,000
CGS 45,000
Op. Exp 23,000
Income Sum 12,000
Investment in Br X 12,000 Income Summary 12,000

Income Br X 12,000 Home Offic 12,000
Income Br X 12,000 None

2.3.4. 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.
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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 X and paid freight costs of
400. Subsequently, the home office instructed Branch X to transfer this merchandise to Branch Y.
Branch X paid 300 to carry out this order. The cost of direct shipment from home office to Y would
have been 500. The journal entries in the three sets of records would be:
Home Office
Investment in Branch X 6,400
Inventories 6,000
Cash 400
To record shipment of merchandise and payment of freight costs
Investment in Branch Y 6,500

Excess Freight Expense- Interbranch Transfers 200
To record transfer of merchandise from Branch X to Branch Y under instruction of the home office
Branch X
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
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Home Office 6,700
Inventories 6,000
Freight in 400
Cash 300
To record transfer of merchandise to Branch Y under instruction of home office and payment of freight
costs of 300
Branch Y
Inventories 6,000
Freight in 500
Home Office 6,500
To record receipt of merchandise from Branch X 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.
2.4. 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.
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.
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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.
2.4.1. 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.
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 Combined

Home Off Br X
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 75,000 12,000 87,000
Total 0 0
Statement of RE
Retained E Jan 1 (70,000) (70,000)
Net income (75,000) (12,000) (87,000)
Dividends 40,000 40,000
Retained E Dec 31 117,000
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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 a (26,000) ______
Equipment 150,000 150,000
Acc Dep. (10,000) (10,000)
Trade A\P (20,000) (20,000)
Home Office (26,000) b 26,000
Common Stock (150,000) (150,000)
Retained earnings (117,000)
Total 0 0 0 0
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 480,000
Cost of goods sold 280,000
Gross profit 200,000
Operating expenses 113,000
Net income 87,000
Earning per share of common stock 5.80
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S Corporation
Statement of Retained Earnings
For the Year Ended Dec 31, Year 1
Retained earnings, beginning of year 70,000

Add: Net income 87,000
Subtotal 157,000
Less: Dividends (2.67 per share) 40,000
Retained earnings, end of year 117,000
S Corporation
Balance Sheet
Dec 31, Year 1
Assets
Cash 30,000
Trade A/R (net) 57,000
Inventories 60,000
Equipment 150,000
Less: Accumulated Depreciation 10,000 140,000
Total assets 287,000
Liabilities and Stockholders’ Equity
Liabilities
Trade A/P 20,000
Stockholders‟ equity
Common stock (10 par) 150,000
Retained earnings 117,000 267,000
Total liabilities and stockholders‟ equity 287,000
2.5. Shipping Merchandise to Branches at Price above Cost
20
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.
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
21
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 10,500
To record net loss reported by branch
Allowance for Overvaluation of Inventories: Br X 22,500

To reduce allowance to amount by which ending inventories of branch exceed cost
To close branch net income (as adjusted)
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 Combined

Home Off Br X
Income statement
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 87,000
Total 0 0
Statement of RE
22
Retained E Jan 1 (70,000) (70,000)
Net income (75,000) 10,500 b(22,500) (87,000)
Dividends 40,000 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 (56,000) b 56,000
Common Stock (150,000) (150,000)
Retained earnings (117,000)
Total 0 0 0 0
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.
2.6. 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.
23
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 8,000
Home Office 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:
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
24
The effect of the foregoing end of year journal entries is to update the reciprocal ledger accounts as
shown below:
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 41,500 Cr
Add: 1. Merchandise shipped 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 (3,000)
Adjusted balances 48,500 48,500
25
CHAPTER THRE
ACCOUNTING FOR INSTALLMENT AND CONSIGNMENT SALES
3.1 ACCOUNTING FOR INSTALLEMNET SALES
Characteristics
An installment sale of real or personal property or service provides for a series of payments over a
period of months or years. There is usually a requirement for down payment as well as interest and
carrying charges on the unpaid balance.
The risk of non-collection to the seller is generally higher due to:
• Weaker financial position of customers in relation to those who buy on an open account
• Possible change in the credit rating and customers‟ ability to pay during the period covered by
the installment contract
To protect themselves from such risk, sellers generally select a form of contract called a security
agreement that enables them to repossess the property if the purchaser fails to make the payments. For
service type businesses, repossession obviously is not an available option. For certain types of
merchandise also the right to repossess may be more of threat than a real assurance against loss as the
merchandise sold may have been damaged or depreciated to a point where that it is worth less than the
balance due.
A basic rule designed to minimize loss from nonpayment of installment contract is to require sufficient
down payment to cover the loss of value when the merchandise moves out of the “new‟ category. A
corollary rule is that the payments by the purchaser should not be outstripped by the projected decline in
value of the merchandise sold.
The following problems lead many retailers to sale of installment receivables to finance companies that
specialize in credit and collection activities:
• Difficulty and expensiveness of the repossession process which may entail reconditioning and
repair
• Increased collection and accounting costs
• Tie up of large amount of working capital
Realization of Gross Profit on Installment Sales
26
The measurement of income from installment sales is complicated by the fact that the amounts of
revenue and related costs and expenses are seldom known in the accounting period when installment
sales are made. Substantial costs (as for collection, accounting, repairs, and repossession) may be
incurred in subsequent accounting periods. In some situations, the risk of non collection may be so great
as to raise doubt that any revenue or profit is realized at the time of sale.
The first objective in the development of accounting policies for installment sales should be a reasonable
matching of expenses and revenue. However, due to the inherent nature of installment sales, the
following three approaches are used for recognition of gross profit on installment sales:
1. the accrual basis of accounting
2. the cost recovery method of accounting
3. the installment method of accounting
Accrual basis of accounting

The entire gross profit is realized at the time of installment sale like sales on account. The excess of the
installment receivables over the cost of merchandise sold is realized gross profit. The journal entry
consists of debit to installment receivables and credit to installment sales. The cost of merchandise sold
is also credited to inventory and debited to cost of goods sold. No recognition is given to the sellers‟
retention of title to the merchandise because the normal expectation is completion of the contract
through collection of the receivable. The implicit assumption is that most expenses relating to the sale
will be recognized in the same accounting period.
Recognition of collection and doubtful installment receivables expenses in the period of the sale requires
estimates of the customer‟s performance over the entire term of the contract. Even if making such
estimates is considerably more difficult than the normal provision for doubtful accounts expense,
reasonably satisfactory estimates may be made with careful analysis of industry experience in most
situations.
Journal entries Debit to expense and credit to asset valuation account such as Allowance for doubtful
installment receivables and allowance for collection costs.
27
Cost Recovery Method of Accounting
Under the cost recovery method, no profit is recognized until all costs of the merchandise sold have been
recovered. After all costs are recovered, additional collections are recognized as revenue (gross profit
and interest revenue), and only current collection costs are recognized as expenses. This method is rarely
used; therefore, it is not illustrated.
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 that these two elements were
included in the selling price. Emphasis is shifted from the acquisition of installment receivables to
collection of the receivables as a basis for realization of gross profit; in other words, a modified cash
basis of accounting is substituted for the accrual basis of accounting.
Example: assume that a farm equipment dealer sells for Br. 10,000 a machine that cost Br. 7,000. The
Br. 3,000 excess of the sales price over cost is regarded as deferred gross profit and the 70: 30 ratio is
used to divide each collection between cost recovery and gross profit realization. At the end of each
period, the Deferred Gross Profit account balance will equal 30% of uncollected installment receivables
and the Realized Gross Profit on Installment Sales account shows 30% of the amount collected during
the period.
The installment method may be used for the computation of taxable income for “any disposition of
property where at least one payment is to be received after the close of the taxable year in which the
disposition occurs.” Although the income tax advantages of the installment method are readily apparent,
the theoretical support for it in financial accounting is less impressive.
Accordingly APB Opinion No. 10 virtually removed the installment method of accounting from the
body of generally accepted accounting principles because it reaffirmed the concept that income is
realized when sales is made, unless the circumstances are such that the collection of the selling price is
not reasonably assured.
The circumstances in which the use of the installment method of accounting is permitted are:
1. collection of installment receivables is not reasonably assured
2. installment receivables are collectible over an extended period of time, and
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3. there is no reasonable basis for estimating the degree of collectability of the installment
receivables
In such situations, either the installment method or the cost recovery method of accounting may be used.
Illustration
Single Sale of Land on the Installment Plan
The owner of land that has appreciated in value often is willing to sell only on the installment plan so
that the gain may be spread over several years for income tax purposes. Federal income tax regulations
permit the use of the installment method if the contract price will be collected in two or more
installments spanning two or more years.
Assume that Kane, whose fiscal year follows the calendar year, sold for $100,000 a parcel of land with a
carrying amount of $52,000. Commission and other costs were $8,000. Thus, the gain on the sale of the
land is $40,000 (100,000-52,000-8,000), and all cash collections are regarded as consisting of 60% cost
recovery and 40% realization of gain (profit).
The contract of sale required a down payment of $25,000 and promissory notes in the amount of
$75,000, with principal payments every six months for five years in the amount of $7,500 plus interest at
10% on the unpaid principal amount of the notes.
Journal entries
Year 1
Dec. 31 Cash (net of 8,000 commission) 17,000
Notes Receivable 75,000
Land 52,000
Deferred Gain on Installment Sales of Land 40,000
To record of land on the installment plan
31 Deferred Gain on Installment Sales of Land 10,000
Realized Gain on Installment Sales of Land 10,000
To record realized gain on collection of down payment (25,000*40%)
29
Year 2
June 30 Cash 11,250
Interest Revenue 3,750
To record semi-annual principal payment on notes receivable ($7,500), plus interest for six months
(75,000*0.1*6/12 =3,750)
Dec 31 Cash 10,875

Interest Revenue 3,375
To record semi-annual principal payment on notes receivable ($7,500), plus interest for six months
[(75,000-7,500)*0.1*6/12 =3,375)]
31 Deferred Gain on Installment Sales of Land 6,000

Realized Gain on Installment Sales of Land 6,000
To record realized gain on collection of notes receivable (15,000*40%)
If the land sales has been recorded as an ordinary sales, a gross profit of $ 40,000 would have been
recognized in Year 1; use of the installment method resulted in the recognition of only $10,000 gross
profit in Year 1, and $6,000 in each of the next 5 years. If the sale in the installment plan results in a
loss, the entire loss must be recognized in the year of sale.
Illustration of Accounting for Installment Sales of Merchandise

Assume Oak Desk Company sells merchandise on the installment plan as well as regular terms, and uses
the 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 credited for the amount of down
payment. The installment receivables ledger account thus provides a complete record of the transaction.
Doubtful installment receivables are recognized when the accounts are known to be uncollectible. The
following are included in the records of Oak Desk on Jan 1 Yr 5:
Installment receivables-Yr 3 20,000Dr
Installment receivables-Yr 4 85,000Dr
Deferred interest and carrying charges 17,500Cr
30
Deferred gross profit-Yr 3 installment sales 4,500Cr
Deferred gross profit-Yr 4 installment sales 19,460Cr
The gross profit rate on installment sales (excluding interest and carrying charges) was 25% in Yr 3 and
28% in Yr 4. During Yr 5, the following transactions were completed:
Information relating to Yr 5 installment sales
Installment sales (excluding 30,000 deferred
Interest and carrying charges) 200,000
Cost of installment sales 138,000
Deferred gross profit-Yr 5 (200,000-138,000) 62,000
Gross profit rate (62,000/200,000) 31%
Cash collections during Yr 5
Selling Interest and
Price Carrying Ch Total
Installment receivables-Yr 5 80,000 10,000 90,000

Totals 141,500 24,350 165,850
Customers who purchased merchandise in Yr 3 were unable to pay the balance of Br. 1,150 consisting
of 1,000 sales, 150 interest and carrying charges, and 250 (1000*.25) deferred gross profit. The net
realizable value of the merchandise repossessed was 650.
Recording Transactions and Events

Installment sales-Yr 5 230,000
Cot of installment sales 138,000
Installment sales 200,000
Deferred interest and C charges 30,000
Inventories 138,000
To record installment sales and cost of installment sales for Yr 5
31
Cash 165,850
Installment receivables- Yr 5 90,000
To record collections on installment contracts during Yr 5
Inventories (repossessed merchandise) 650

Deferred gross profit-Yr 3 250
Deferred interest and carrying 150
Doubtful installment rec. expense 100
Installment receivables Yr 3 1,150
To record default on Yr 3 installment receivables and repossession of merchandise
Adjusting entries on Dec 31 Yr 5

Installment sales 200,000
Cost of installment sales 138,000
Deferred gross profit-Yr 5 62,000
To record deferred gross profit on Yr 5 installment sales
Realized gross profit on installment sales 41,510
To record realized gross profit on installment sales as follows:
Yr 5 (80,000*0.31) 24,800
Yr 4 (44,500*0.28) 12,460
Yr 3 (17,000*0.25) 4,250
Total realized gross profit 41,510
Deferred interest and carrying charges 24,350
Revenue from interest and carrying charges 24,350
To record revenue from interest and carrying charges for Yr 5
32
Trade-ins:
A familiar example is the acceptance by a dealer of a used car as partial payment for a new car. An
accounting problem exists 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 net realizable value of the used car. A
rough approximation of the net realizable value may be the currently quoted wholesale price for used
cars of the particular make and model.
Presentation of Installment Data in Financial Statements

The presentation of accounts relating to installment sales in the financial statements raises theoretical
issues, regardless of whether the accrual basis of accounting or the installment method of accounting is
used.
Income Statement
A partial income statement of Oak Desk Company for Yr 5 under the installment method:
OAK DESK CPMPANY
PARTIAL INCOME STATEMENT
For the Year Ended Dec 31 Yr 5
Installment Regular Combined

sales sales
Sales 200,000 300,000 500,000
Cost of Goods Sold 138,000 272,000 360,000
Gross profit 62,000 78,000 140,000
Less: Deferred gross profit
On Yr 5 installment sales 37,200 37,200
Realized gross profit on Yr 5 24,800 78,000 102,800
Add: Realized gross profit on
Prior years‟ installment sales 16,710
Total realized gross profit 119,150
33
If the accrual basis of accounting is used for all sales, gross profit of 140,000 would be reported for the
year. The formal illustrated above is useful for internal purposes and not to report to outsiders. The
24,350 interest and carrying charges is reported as Other Revenue.
Balance Sheet
Installment receivables, net of deferred interest and carrying charges, are classified as current assets,
although the collection period often extends more than a year beyond the balance sheet date. This rule is
applicable whether the accrual basis of accounting or the installment method of accounting is used. The
definition of current assets specifically includes installment and notes receivables if they conform
generally to normal trade practices and credit terms in the industry. This classification is supported by
the concept that current assets include all resources expected to be realized in cash, sold, or consumed
during the normal operating cycle of the business enterprise. The listing of installment receivables in the
current asset section of the balance sheet is more informative when the amounts maturing each year are
disclosed.
The classification of deferred gross profit on installment sales in the balance sheet when the installment
method of accounting is used poses some troubles. A common practice was to classify the deferred gross
profit in the liabilities section of the balance sheet. Critics of this treatment pointed out that no obligation
to an outsider existed and the liability treatment was improper.
In view of these conflicting approaches, it is suggested that the deferred gross profit be subdivided into
three parts:
• an allowance for collection costs and doubtful receivables that would be deducted from
installment receivables
• a liability representing future income taxes on the gross profit not yet realized
• a residual income element
The residual income element would be classified by some accountants as a separate item in the
stockholders‟ equity section of the balance sheet and by others in an undefined section between
liabilities and stockholders‟ equity.
The lack of agreement as to classification of deferred gross profit is evidence of the inherent
contradiction between the installment method and the accrual basis of accounting. A satisfactory
34
solution in most cases is to recognize gross profit on installment sales on the accrual basis for financial
reporting and to defer recognition of gross profit for income tax purposes until installment receivables
are collected.
3.2 ACCOUNTING FOR CONSIGNMENT SALES

The Meaning of Consignments
The term consignment means transfer of possession of merchandise 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. The
relationship between the consignor and the consignee is that of principal and agent, and the law of
agency controls the determination of the obligations and rights of the two parties.
Consignees are responsible to consignors for merchandise placed in their custody until it is sold or
returned. Because consignees do not acquire title to the merchandise, they neither include it in
inventories nor record trade accounts 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 sold by the consignee, the resulting trade accounts receivable is the property of the
consignor.
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.
Distinguishing between a Consignment and a Regular Sales

When merchandise is shipped on consignment:
• Title does not pass and the consignor continues to carry the consigned merchandise as part of
inventories
• No revenue is recognized by the consignor at the time of shipment
• The consignor is the owner of any unsold consigned merchandise
Why consignment sale is preferred from outright sales could be:
• The consignor may be able to persuade dealers to stock the items on consignment basis than
outright purchase
35
• The consignor avoids the risk inherent in selling on credit to dealers of questionable financial
strength
• The acquisition of merchandise on consignment rather than by purchase requires less working
capital and avoids of the risk of loss if the merchandise cannot be sold.
Accounting for Consignor and Consignee

Receipt of shipment
The consignee may record receipt of shipments in any of several ways:
• The objective is to create a memorandum record of the consigned merchandise; no purchase has
been made and no liability exists
• The receipt could thus be recorded:
By a memorandum notation in the general journal
By an entry in a separate ledger of consignment shipments
By a memorandum entry in a general ledger account entitled Consignment In- Selam
PLC.
Illustration of the third alternative
Consignment In- Selam PLC
Date Explanation Debit Credit Balance
Received 10 TV sets to be sold
for 3,500 each at a commission
of 10% of selling price
The journal entries to record the payment of freight costs and sales of the merchandise by the consignee:
Consignment In- Selam PLC 500
Cash 500
To record payment of freight costs on shipment from consignor
Cash 35,000
Consignment In- Selam PLC 35,000
To record sales of 10 TV sets at 3,500 each
The journal entry to record 10% commission earned
36
Commission Revenue- Consignment Sales 3,500
To record 10% commission earned on TV sets sold
The remittance of cash to the consignor is recorded as debit to the consignment ledger account and
results in closing that account.
Cash 31,000
To record payment in full to consignor
The Account Sales

The report rendered by the consignee is called the account sales; it includes the quantity of merchandise
received and sold, expenditures made, advances made, and amounts owed or remitted. Payments may be
made as portions of the consigned merchandise are sold or may not be required until the merchandise is
sold or returned to the consignor.
Assume that Selam PLC, an importer and whole seller, ships 10 TV sets to Ahmed Kedir, a retailer in
Awasa to be sold at 3,500 rach. Freight costs of 500 are to be reimbursed to Ahmed. Ahmed also
receives a commission of 10% of the selling price. After selling the merchandise Ahmed sends Selam an
account sales similar to the one below, accompanied by a check for the amount due.
Ahmed Kedir
Awasa
Account Sales
Hamle 30, 1999
Sales for account and risk of:
Selam PLC
Addis Ababa
Sales: 10 TV sets @ Br. 3,500 35,000
Charges:
Freight cost 500
Commission (35,000*10%) 3,500 4,000
Balance (remittance to consignor) 31,000
Consigned TV sets on hand none
If merchandise is received on consignment from several consignors, a Consignments-In controlling

account may be used, and a supporting account for each consignment set up in a subsidiary
consignments ledger.
37
If the consignee does not measure profits from consignment sales separately from regular sales, the sale
of the consigned merchandise is credited to the regular sales account. Concurrently, a journal entry is
made debiting Cost of Goods Sold or Purchases and crediting Consignment In ledger account for the
amount payable to the consignor viz. sales price minus commission. No journal entry is made for
commission revenue as the profit element is measured by the difference between the amounts credited to
sales and debited to cost of goods sold.
This method looks less desirable in that it does not clearly show gross profit from consignment sales; but
it is the most practical one as it treats consigned merchandise as purchased upon sales there by
facilitating collection of sales taxes like VAT by the consignee and issuance of the consignee‟s invoice
to recognize the sales. The consignor also issues invoice to the consignee to this effect.
Accounting for Consignors

When a consignor ships merchandise to consignees, it is essential to have a record of this portion of
inventories. Therefore, the consignor may establish a Consignment Out account for every consignee (or
every shipment on consignment). The Consignment Out account represents a special category of
inventories.
Separate Measurement of Gross Profit

A separate measurement of gross profit on consignments becomes more desirable if consignment
transactions are substantial in relation to regular sales as compilation of direct costs may be an expensive
process, especially if the gross profit is computed by individual consignees or consignments.
Thus, a separation of consignment sales revenue from regular sales revenue usually is a minimum
procedure to develop information needed by management if consignment sales are an important part of
total sales volume. However, separation of consignment sales from regular sales is unnecessary if only
an occasional sale is made through consignees.
Accounting for Consignor Illustrated

The choice of accounting method by a consignor depends on whether:
i) Consignment gross profits are measured separately from those on regular sales?
38
ii) Sales on consignment are combined with regular sales?
Journal entries required under the two alternatives are illustrated by taking the data used for the
consignee; assume that the cost of TV sets shipped to Awasa is 2,500 each.
Upon shipment
The entry to be made under both alternatives would be:
Consignment Out-Ahmed Kedir 25,000
Inventories 25,000
Packing expenses of 300 allocated to consigned merchandise
Alternative i)
Consignment Out-Ahmed Kedir 300
Packing Expense 300
Alternative ii)
No entry required.
Consignment sales of 35,000 reported by consignee
Alternative i)
Cash 31,000
Consignment Out- Ahmed Kedir 500
Commission Expense- Cons Sales 3,500
Consignment Sales 35,000
Cost of Goods Sold 25,800
Consignment Out- Ahmed Kedir 25,800
Consignment sales 35,000

Less: Cost of Cons Sales 25,800
Commission 3,500 29,300
Gross profit on consignment sales 5,700
Alternative ii)
Cash 31,000
Freight Out Expense 500
39
Commission Expense 3,500
Sales 35,000

Included in total sales 35,000

Included in cost of all merchandise sold 25,000
Included in total packing expense 300
Included in total freight out expense 500
Included in total commission expense 3,500
If merchandise is received on consignment from several consignors, a Consignments-In controlling

account may be used, and a supporting account for each consignment set up in a subsidiary
consignments ledger.
If the consignee does not measure profits from consignment sales separately from regular sales, the sale
of the consigned merchandise is credited to the regular sales account. Concurrently, a journal entry is
made debiting Cost of Goods Sold or Purchases and crediting Consignment In ledger account for the
amount payable to the consignor viz. sales price minus commission. No journal entry is made for
commission revenue as the profit element is measured by the difference between the amounts credited to
sales and debited to cost of goods sold.
This method looks less desirable in that it does not clearly show gross profit from consignment sales; but
it is the most practical one as it treats consigned merchandise as purchased upon sales there by
facilitating collection of sales taxes like VAT by the consignee and issuance of the consignee‟s invoice
to recognize the sales. The consignor also issues invoice to the consignee to this effect.
Accounting for Consignors

When a consignor ships merchandise to consignees, it is essential to have a record of this portion of
inventories. Therefore, the consignor may establish a Consignment Out account for every consignee (or
40
every shipment on consignment). The Consignment Out account represents a special category of
inventories.
Separate Measurement of Gross Profit

A separate measurement of gross profit on consignments becomes more desirable if consignment
transactions are substantial in relation to regular sales as compilation of direct costs may be an expensive
process, especially if the gross profit is computed by individual consignees or consignments.
Thus, a separation of consignment sales revenue from regular sales revenue usually is a minimum
procedure to develop information needed by management if consignment sales are an important part of
total sales volume. However, separation of consignment sales from regular sales is unnecessary if only
an occasional sale is made through consignees.
Accounting for Consignor Illustrated

The choice of accounting method by a consignor depends on whether:
iii) Consignment gross profits are measured separately from those on regular sales?
iv) Sales on consignment are combined with regular sales?
Journal entries required under the two alternatives are illustrated by taking the data used for the
consignee; assume that the cost of TV sets shipped to Awasa is 2,500 each.
Upon shipment
The entry to be made under both alternatives would be:
Consignment Out-Ahmed Kedir 25,000
Inventories 25,000
Packing expenses of 300 allocated to consigned merchandise
Alternative i)
Packing Expense 300
Alternative ii)
No entry required.
Consignment sales of 35,000 reported by consignee
41
Alternative i)
Cash 31,000

Consignment sales 35,000

Less: Cost of Cons Sales 25,800
Commission 3,500 29,300
Gross profit on consignment sales 5,700
Alternative ii)
Cash 31,000
Sales 35,000

Included in total sales 35,000

Included in cost of all merchandise sold 25,000
Included in total packing expense 300
Included in total freight out expense 500
Included in total commission expense 3,500
Accounting for Partial Sale of Consigned Merchandise
42
Continuing the previous illustration, let us assume that four of the ten TV sets on consignment are sold
at the end of the accounting period. To prepare financial statements, the consignor must determine the
amount of gross profit realized on the sold units and the inventory value of the unsold units.
Journal entries under the two alternatives:
Consignment sales of 14,000 reported by consignee and payment of 5,000 received. Charges by
consignee: freight costs of 500 and commission of 1,400
Alternative i)
Cash 5,000
Cost of Consignment Sales 10,320

2500+30+50=2580*4
Inventories on consignment 15,480
Alternative ii)
Cash 5,000
Sales 14,000

2500*4
43
Packing Expenses (30*6) 180
Freight Out Exp (50*6) 300
Direct costs relating to unsold merchandise

Inventories on Consignment 15,480
Return of Unsold Merchandise by Consignee

Packing and shipping associated with consigned merchandise are properly included in cost. However, if
the consignee for any reason returns the merchandise to the consignor, the packing and shipping costs
should be recognized as an expense of the current accounting period. The place utility originally created
by these costs is lost when the merchandise is returned. Any return shipment and repair costs should also
be recognized as expense.
Advances from Consignees

Although cash advances from a consignee are sometimes credited to the consignment out account, a
better practice is to credit a liability account, Advance from Consignees. The consignment out account
then will continue to show the carrying amount of merchandise on consignment.
CHAPTER 4
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BUSINESS COMBINATIONS
4.1. Nature of Business Combinations
Business combinations are events or transactions in which two or more business enterprises, or their net
assets, are brought under common control in a single accounting entity. Other terms frequently applied
to business combinations are mergers and acquisitions.
Commonly used terms:

Combined enterprise: the accounting entity that results from business combination.
Constituent companies: the business enterprises that enter into a business combination.
Combiner: a constituent company entering into a purchase type business combination whose owners as
a group end up with control of the ownership interest in the combined enterprise.
Combinee: a constituent company other than the combinor in a business combination.
Business combinations may be friendly takeovers and hostile takeovers. Friendly takeovers the boards
of directors of the two constituent companies generally work out the terms of the business combination
amicably and submit the proposal to stockholders of all constituent companies for approval.
A target combinee in a hostile takeover typically resists the proposed business combination by resorting
to various defensive tactics.
Why do business enterprises enter into combinations? The overriding reason for combinors in recent
years has been growth. This is an external method of achieving growth and match more rapid than
growth through internal means. Expansion and diversification of product lines, or enlarging the market
share is achieved readily through a business combination. However, the disappointing experiences of
many combinors suggest much may be said in favor of more gradual and reasoned growth through
internal means, using available management and financial resources.
Other reasons for business combinations are obtaining new management strength or better use of
existing management and achieving manufacturing or other operating economies. A business
combination may be undertaken for income tax advantages available to one or more parties to the
combination.
45
The foregoing reasons do not apply to hostile takeovers. Critics complain that the „sharks‟ who engage
in hostile takeovers, and investment bankers and attorneys who counsel them, are motivated by the
prospect of substantial gains resulting from the sale of business segments of a combinee following the
business combination.
4.2 Methods for Arranging Business Combinations

The four common methods for carrying out a business combination are statutory merger, statutory
consolidation, common stock, and acquisition of assets.
Statutory Merger
Procedures in a statutory merger
• The boards of directors of the constituent companies work out the terms of the merger
• Stockholders of the constituent companies approve the terms of the merger, in accordance with
applicable corporate bylaws and state laws
• The survivor dissolves and liquidates the other constituent companies, receiving in exchange for
its common stock investments the net assets of those companies.
• Activities of the constituent companies are often continued as divisions of the survivor.
Statutory Consolidation
Procedures in a statutory consolidation
• The boards of directors of the constituent companies work out the terms of the merger
• Stockholders of the constituent companies approve the terms of the merger, in accordance with
applicable corporate bylaws and state laws
• A new corporation is formed to issue common stock to the stockholders of the constituent
companies in exchange for all their outstanding voting common stock of those companies.
• The new corporation dissolves and liquidates the other constituent companies, receiving in
exchange for its common stock investments the net assets of those companies.
46
Acquisition of Common Stock
One corporation, the investor, may issue preferred or common stock, cash, debt or a combination thereof
to acquire from present stockholders a controlling interest in the voting common stock of another
corporation, the investee. Stock acquisition may be accomplished through:
• Direct acquisition in the stock market
• Negotiation with the principal stockholders of a closely held corporation
• Through a tender offer to stockholders of a publicly owned corporation. The price per share state
in the tender offer usually is well above the prevailing market price
If a controlling interest in the combinee‟s common stock is acquired, that corporation becomes affiliated
with the combinor parent company as a subsidiary, but is not dissolved and liquidated and remains a
separate legal entity. Combinations arranged in this manner require authorization by the combinor‟s
board of directors and require ratification by the combinee‟s stockholders. Most hostile takeovers are
accomplished by this means.
Acquisition of Assets
A business enterprise may acquire from another enterprise all or most of its gross assets or net assets for
cash debt, preferred or common stock, or a combination thereof. The transaction generally must be
approved by the boards of the constituent companies. The selling enterprise may continue its existence
as a separate or it may be dissolved and liquidated; it does not become an affiliate of the combinor.
Establishing the Price for a Business Combination

The amount of cash or debt securities, or the number of shares of preferred or common stock, to be
issued in a business combination generally is determined by variations of the following methods:
• Capitalization of expected annual earnings of the combinee at a desired rate of return
• Determination of current fair value of combinee‟s net assets
The price for a business combination consummated for cash or debt generally is expressed in terms of
the total dollar amount of the consideration issued. When common stock is issued, the price is expressed
as a ratio of the number of shares of the combinor‟s common stock to be exchanged for each share of the
combinee‟s common stock.
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4.3 Methods of Accounting for Business Combinations
Purchase Accounting
Accounting for a business combination by the purchase method follows principles normally applicable
under historical cost accounting to record acquisition of assets and issuances of stock and to accounting
for assets and liabilities after acquisition.
• Assets (including goodwill) acquired for cash would be recognized at the amount of cash paid
• Assets acquired involving the issuance of debt, preferred stock, or common stock would be
recognized at the current fair value of the asset, or the debt or the stock, whichever was more
clearly evident.
Determination of the Combinor

Because the carrying assets of the combinor are not affected by a business combination, the combinor
must be accurately identified. The Accounting Principles Board provided the following for identifying
the combinor:
• A corporation which distributes cash or other assets or incurs liabilities to obtain the assets or
stock of another company
• The company which either retains or receives the larger portion of voting rights in the combined
enterprise
Computation of Cost of a Combinee
The cost of a combinee in a business combination accounted for by the purchase method is the total of:
• The amount of consideration paid by the combinor
• The combinor‟s direct out of pocket costs
• Any contingent consideration that is determinable on the date of the business combination
Amount of Consideration
This is the total amount of:
• cash paid
• the current fair value of other assets distributed
• the present value of debt securities issued, and
• the current fair/market value of equity securities issued by the combinor.
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Direct Out of Pocket Costs
Included in this category are:
• legal fees
• accounting fees
• finder‟s fees
A finder‟s fee is paid to the investment banking firm or other organization or individuals that
investigated the combinee, assisted in determining the price of the business combination, and otherwise
rendered services to bring about the combination.
Indirect out of pocket costs such as salaries of officers of the constituent companies involved in
negotiation and completion of the completion, are recognized as expenses incurred by the constituent
companies.
Contingent Considerations
Contingent consideration is additional cash, other assets, or securities that may be issued in the future,
contingent on future events such as a specified level of earnings or a designated market price for a
security that has been issued to complete the business combination.
Contingent consideration that is determinable on the consummation date of a combination is recorded as
part of the cost of the combination while that not determinable on the date of combination is recorded
when the contingency is resolved and the additional consideration is paid or issued or becomes payable
or issuable.
Allocation of Cost of a Combinee

APB Opinion No. 16 provides the following principles for allocating cost of a combinee in a purchase
type business combination.
• First, all identifiable assets acquired and liabilities assumed in a business combination should be
assigned a portion of the cost of the acquired company, normally equal to their fair values at the
date of acquisition
• Second, the excess of the cost of the acquired company over the sum of the amounts assigned to
identifiable assets acquired less liabilities assumed should be recorded as goodwill.
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Identifiable Assets and Liabilities
APB Opinion No. 16 provides guidelines for assigning values to a purchased combinee‟s identifiable
assets and liabilities.
• Present values for receivables and liabilities
• Net realizable values for:
marketable securities
Finished goods and in process inventories
Plant assets held for sale or temporary use
• Appraised values for:
Intangible assets
Land
Natural resources
Non marketable securities
• Replacement cost for:

For inventories of material and plant assets held for long term use.
Goodwill
Goodwill is recognized frequently because the total cost of the combinee exceeds the current fair value
of identifiable net assets. The amount of goodwill recognized at the outset may be adjusted subsequently
when contingent considerations become issuable.
Negative Goodwill
Negative goodwill means an excess of current fair value of the combinee‟s identifiable net assets over
their cost to the combinor.
Illustration of Purchase Accounting for Statutory Merger, with Goodwill

On December 31, 1999, Mason Company (the combinee) was merged into Saxon Corporation (the
combinor or the survivor). Both companies used the same accounting principles for assets, liabilities,
revenue and expenses and both had a December 31 fiscal year. Saxon issued 150,000 shares of its $10
par common stock (current fair value is $25 a share) to Mason‟s stockholders for all 100,000 issued and
50
outstanding shares of no-par, $10 stated value common stock. In addition, Saxon paid the following out
of pocket costs associated with the business combination:
Accounting fees:
For investigation of Mason as prospective combinee 5,000
For SEC registration statement for Saxon common stock 60,000
Legal fees:
For the business combination 10,000
For SEC registration statement for Saxon common stock 50,000
Finder‟s fee 51,250
Printer‟s charges for printing securities and SEC reg statement 23,000
SEC registration statement fee 750
Total out of pocket expenses 200,000
There was no contingent consideration in the merger contract.
Immediately prior to the merger, Mason Company‟s condensed balance sheet was as follows:
Mason Company (combinee)
Balance Sheet (prior to business combination)
December 31, 1999
Assets
Current assets 1,000,000
Plant assets (net) 3,000,000
Other assets 600,000
Total assets 4,600,000
Current liabilities 500,000

Long term debt 1,000,000
Common stock, no par, $10 stated value 1,000,000
Additional paid in capital 700,000
Retained earnings 1,400,000
Total liabilities and capital 4,600,000
51
Using the guidelines in APB Opinion No. 16, the board of directors of Saxon Corporation determined
the current fair values of Mason Company‟s and liabilities (identifiable net assets) as follows:
Plant assets 3,400,000
Current liabilities (500,000)
Long term debt (present value) (950,000)
Identifiable net assets of combinee 3,700,000
The following are journal entries required by Saxon Corporation to record the merger. Saxon uses the
investment ledger to accumulate the total cost prior to assigning the cost to identifiable net assets and
goodwill.
Investment in Mason Co common stock

(150,000*25) 3,750,000
Common stock (150,000*10) 1,500,000
Paid in capital in excess of par 2,250,000
To record merger with Mason Company as purchase
Investment in Mason co common stock

(5,000+10,000+51,250) 66,250
Paid in capital in excess of par
(60,000+50,000+23,000+750) 133,750
Cash 200,000
To record out of pocket costs incurred with Mason company. Accounting, legal, and finder‟s fees are as
investment cost; other out of pocket costs are recorded as a reduction in the proceeds received from
issuance of common stock.

Plant assets 3,400,000
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Discount on long term loan 50,000
Goodwill 116,250
Investment in Mason co common stock
(3,750,000+66,250) 3,816,250
To allocate total cost of liquidated Mason company to identifiable assets and liabilities, with the
remainder to goodwill. (income tax effects disregarded). Amount of goodwill is computed as follows:
Total cost of Mason company 3,816,250
Mason‟s identifiable net assets
(4,600,000-1,500,000) 3,100,000
Excess (deficiency) of current fair

value over carrying amounts
Current assets 150,000
Plant assets 400,000
Long term debt 50,000 3,700,000
Amount of goodwill 116,250
No adjustments are made to reflect the current fair values of Saxon‟s identifiable net assets or goodwill
as Saxon is the combinor.
Mason company records (the combinee) prepares the following condensed journal entry to record the
dissolution and liquidation of the company on Dec 31,1999.

Common stock, $10 stated value 1,000,000
Paid in capital in excess of stated value 700,000
Retained Earnings 1,400,000
53
To record liquidation of company in conjunction with merger with Saxon Corporation
Illustration of purchase accounting for acquisition of net assets, with bargain purchase excess
On December 31,1999, Davis Corporation acquired the net assets of Fairmont Corporation directly from
Fairmont for 400,000 cash, in a purchase type business combination. Davis paid legal fees of 40,000 in
connection with the combination.
The condensed balance sheet of Fairmont prior to the business combination, with related current fair
value data, is presented below:
FAIRMONT CORPORATION (combinee)

Balance Sheet (prior to business combination)
December 31,1999
Carrying Current
Amounts Fair Values
Assets
Current assets 190,000 200,000
Investment in marketable debt 50,000 60,000
Plant assets (net) 870,000 900,000
Intangible assets (net) 90,000 100,000
Total assets 1,200,000 1,260,000
Liabilities and Stockholders‟ Equity
Current liabilities 240,000 240,000

Long term debt 500,000 520,000
Total liabilities 740,000 760,000
Common stock, $1 par 600,000
Deficit (140,000)
Total stockholders‟ equity 460,000
54
Total liab & stockholders‟ equity 1,200,000
Thus, Davis acquired identifiable net assets with current fair value of 500,000 (1,260,000-760,000) for a
total cost of 440,000 (400,000+40,000). The 60,000 excess of the current fair value of the assets over
their cost is prorated to plant and intangible assets in ratio of their respective current fair value.
To plant assets: 60000*900,000/900,000+100,000= 54,000
To intangible assets: 60,000*100,000/900,000+100,000= 6,000
Total 60,000
The journal entries below record Davis Corporation‟s acquisition of the net assets of Fairmont
Corporation and payment of 40,000 legal fee.
Investment in Net Assets of Fairmont Corp 400,000
Cash 400,000
To record acquisition of net assets of Fairmont Corporation
Investment in net assets of Fairmont Corp 40,000

Cash 40,000
To record legal fee paid in acquisition of net assets of Fairmont Corporation
Current assets 200,000

Investment in Marketable Debt Securities 60,000
Plant assets (900,000-54000) 846,000
Intangible assets (100,000-6,000) 94,000
Long term debt 500,000
Premium on long term debt (520,000-500,000) 20,000
Investment in net assets of Fairmont 440,000
To allocate total cost of net assets acquired to identifiable net assets, with excess of current fair value of
the net assets over cost allocated to non current assets other than marketable securities
55
Pooling of Interest Accounting
The original premise of pooling of interest method was that certain business combinations involving the
exchange of common stock between an issuer and the stockholders of a combinee were more in the
nature of a combining of existing stockholder interests than an acquisition of assets or raising of capital.
Combining of existing stockholder interests was evidenced by combinations involving common stock
exchanges between corporations of approximately equal size. The stockholders and managements of
these corporations continue their relative interests and activities in the combined enterprise as they
previously did in the constituent companies. Because neither of the equal sized companies could be
considered the combinor, the pooling of interest method of accounting provided for carrying forward to
the accounting records of the combined enterprise the combined assets, liabilities, and retained earnings
of the constituent companies at their carrying amounts. The current fair value of the common stock
issued to effect the business combination and the current fair value of the combinee‟s net assets are
disregarded in pooling of interest accounting. Further, because there is no identifiable combinor, the
term issuer identifies the corporation that issues its common stock to accomplish the combination.
Illustration of pooling of interest accounting for statutory merger

The Saxon Corporation-Mason Company merger business combination would be accounted for as a
pooling of interest by the following journal entries in Saxon Corporation‟s accounting records:
Common stock, $10 par 1,500,000
Paid in capital in excess of par 200,000
Retained earnings 1,400,000
To record merger with Mason Company as a pooling of interest
Expenses of Business Combination 200,000

Cash 200,000
56
To record payment out of pocket costs incurred in a merger with Mason Company
Because a pooling type business combination is a combining of existing stockholder interest rather than
an acquisition of assets, an investment account is not used. Instead, Mason Company‟s assets, liabilities,
and retained earnings are assigned their carrying amounts in Mason‟s pre merger balance sheet. The
common stock issued by Saxon Corporation must be recorded at par (150,000*10), the 200,000 credit to
paid capital in excess of par is a balancing account for the journal entry.
Total paid in capital of Mason prior to merger
(1,000,000+700,000) 1,700,000
Less: par value of Saxon common stock issued 1,500,000
Amount credit to Paid in Cap in excess of par 200,000
If the par value of common stock issued is in excess of total paid in capital of Mason Company, Saxon‟s
paid in capital in excess of par would have been debited. If the balance of Saxon‟s Paid in Capital in
Excess of Par account were in sufficient to absorb the debit, Saxon‟s Retained Earnings account would
be reduced.
All out of pocket costs of the business combination are recognized as expense because a pooling type
business combination is neither an acquisition of assets nor a raising of capital. The expenses of business
combination are not deductible for tax purpose.
Mason‟s journal entries to record the dissolution and liquidation of the company would be identical to
the journal entry illustrated under the purchase method.
Comparison of Purchase and Pooling Accounting

The following table summarizes principal aspects of purchase accounting and pooling of interest
accounting for business combinations:
57
58
4.4 Comparison of Purchase Accounting and Pooling of Interest Accounting for Business Combinations
Aspect Purchase Accounting Pooling of Interest Accounting
Underlying premise Acquisition of assets Combining of stockholder interests
Applicability Combinations not meeting all Combinations meeting all 12 criteria for
12 criteria for pooling accounting pooling accounting
Accounting recognition At cost, including amount of At carrying amount of combinee‟s net assets
of investment in consideration, direct out of (all out of pocket costs are recognized as
combinee pocket costs, and determinable expenses of the issuer)
contingent consideration
Valuation of combinee‟s At current fair values on date at carrying amounts on date of combination
net asset in combined of combination
enterprise
Goodwill recognition Yes, if combinor‟s cost exceeds No
current fair value of combinee‟s
identifiable net assets
Retained earnings of No Yes
constituent companies
combined on date of
business combination
Financial statements
59
and notes for period
of business combin-
ation
Balance sheet Combinor‟s net assets at carrying Both issuer‟s and combinee‟s net assets
amount, combinee‟s net assets at carrying amount
current fair value
Income statement Combinor‟s operations for entire Both issuer‟s and combinee‟s operations
period, combinee‟s operations for entire period as though combination took
from date of combination to end place at beginning of period; prior periods
of period restated comparably
Disclosure of operation Pro forma for combined enterprise Separately for constituent companies for period
in notes for current and preceding period prior to combination
as though combination took place
at beginning of preceding period
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4.5 Appraisal of Accounting Standards for Business Combination
Criticism of Purchase Accounting
The principal criticism of purchase accounting is the residual basis for valuing goodwill. These critics
contend that part of the amounts thus assigned to goodwill probably apply to other identifiable tangible
assets. Accordingly, goodwill in a business combination should be valued directly and any remaining
cost not directly allocated to all identifiable assets including goodwill would be proportionately
apportioned to those assets or recognized as a loss.
Amortization of goodwill attributable to business combination is considered inappropriate and the

amount should be treated as a reduction of stockholders‟ equity of the combined enterprise.
Critics also argue that there is no theoretical support for the arbitrary reduction of previously determined
current fair values of assets by an apportioned amount of purchase price excess. Rather an amortization
of the entire bargain purchase excess is suggested.
The fact that current fair values of the net assets of the combinee only are reflected is also viewed as
inconsistent.
Criticism of Pooling Accounting

The principal objections to pooling accounting are:
• The assumption that some business combinations involving exchange of voting common stock
result in a combining of existing stockholder interests other than an acquisition of assets is
difficult to support in any accounting theory.
• The assets of the combinee are not accounted for at their cost to the issuer. As a result, net
income for each accounting period subsequent to a pooling type business combination is
misstated.
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CHAPTER 5
CONSOLIDATIONS: ON DATE OF PURCHASE-TYPE BUSINESS COMBINATION
5.1 Parent Company- Subsidiary Relationships
If the investor acquires a controlling interest in the investee, a parent- subsidiary relationship is
established. The investee becomes a subsidiary of the acquiring parent company but remains a separate
legal entity.
Strict adherence to legal aspect requires issuance of separate financial statements for the parent company
and subsidiary but disregards the substance of the relationship. A parent company and its subsidiary are
a single economic entity. In recognition of this fact, consolidated financial statements are issued to
report their financial and operating results as though they comprised a single accounting entity.
Consolidated financial statements are similar to combined financial statements of home office and its
branches:
• Assets, liabilities, revenue, and expenses of the parent and its subsidiaries are totaled
• Intercompany transactions and balances are eliminated
• And the final consolidated amounts are reported
The Financial Accounting Standards Board requires consolidation of nearly all subsidiaries except those
not actually controlled.
The Meaning of Controlling Interest

Traditionally, direct or indirect ownership of more than 50% of an investee‟s outstanding common stock
is required to evidence controlling interest. But some circumstances may negate actual control despite
existence of stock ownership:
• A subsidiary in liquidation or reorganization in court supervised bankruptcy proceedings
• A foreign subsidiary in a country having severe production, monetary, or income tax restrictions
• Right of minority shareholders to effectively participate in the financial and operating activities
of the subsidiary
Control of a subsidiary might also be achieved indirectly. The traditional definition of control is
criticized for emphasizing the legal form over the economic substance.
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5.2. Consolidation of Wholly Owned Subsidiary on Date of Purchase- Type Business Combination
There is no question of control of a wholly owned subsidiary. To illustrate, assume that on December
31, 1999, Palm Corporation issued 10,000 shares of its $10 par common stock (current fair value $45 a
share) to stockholders of Star Company for all outstanding $5 par common stock. There was no
contingent consideration. Out of pocket costs consist of:
Finder‟s and legal fee relating to business combination 50,000
Costs associated with SEC registration 35,000
Total 85,000
Assume also that the business combination qualified for purchase accounting because required
conditions for pooling accounting were not met. Star Company continues its corporate existence. Both
constituent companies had a December 31 fiscal year and used the same accounting policies.
Financial statements of the constituent companies prior to consummation of the business combination
follow:
PALM CORPORATION AND STAR COMPANY
Separate Financial Statements (prior to purchase-type business combination)
For Year Ended December 31, 1999
Palm Star
Income Statement
Revenue
Net sales 990,000 600,000
Interest revenue 10,000
Total 1,000,000 600,000
Costs and expenses

Cost of goods sold 635,000 410,000
Operating expenses 158,333 73,333
Interest expense 50,000 30,000
Income taxes expense 62,667 34,667
Total 906,000 548,000
Net income 94,000 52,000
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Retained earnings, beginning 65,000 100,000
Add: Net income 94,000 52,000
159,000 152,000
Less: Dividends 25,000 20,000
Retained earnings, ending 134,000 132,000
Balance Sheet
Assets
Cash 100,000 40,000
Inventories 150,000 110,000
Other current assets 110,000 70,000
Receivable from Star 25,000
Plant assets (net) 450,000 300,000
Patent (net) 20,000
Total assets 835,000 540,000
Payable to Palm 25,000
Income taxes payable 26,000 10,000
Other liabilities 325,000 115,000
Additional paid in capital 50,000 58,000
Total liab & stockholders‟ equity 835,000 540,000
The December 31, 1999, current fair values of Star Company‟s identifiable assets were the same as their
carrying amounts except the following:
Inventories 135,000
Plant assets (net) 365,000
Patent (net) 25,000
Palm Corporation recorded the combination as a purchase with the following entries:
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Investment in Star Co common stock 450,000
Common Stock (10,000*10) 100,000
Paid in Capital in Excess of Par 350,000
Investment in Star Co common stock 50,000

Cash 85,000
The foregoing journal entries do not include any debits or credits to record individual assets and
liabilities of Star Company in the accounts of Palm Corporation because Star is not liquidated as in
merger but remains a separate legal entity.
Preparation of Consolidated Balance Sheet without a Working Paper

The operating results of Palm and Star prior to the date of their business combination those of two
separate economic as well as legal entities. A consolidated balance sheet is the only consolidated
financial statement issued by Palm and Star.
The preparation of a consolidated balance sheet may be accomplished without the use of a supporting
working paper. The parent company‟s investment account and the subsidiary‟s stockholder‟s equity
accounts do not appear in the consolidated balance sheet because they are essentially reciprocal
(intercompany) accounts.
Under purchase accounting theory:
• The parent company (combinor) assets and liabilities (other than intercompany ones) are
reflected at carrying amounts
• The subsidiary (combine) assets and liabilities (other than intercompany ones) are reflected at
current fair values in the consolidated balance sheet
• Goodwill is recognized to the extent the cost of the parent‟s investment exceeds the current
fair value of the subsidiary‟s identifiable net assets
Applying the foregoing principles to the Palm Corporation Star Company relationship, the following
consolidated balance sheet is produced:
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PALM CORPORATION AND SUBSIDIARY
Consolidated Balance Sheet
December 31, 1999
Assets
Current assets:
Cash (15,000+40,000) 55,000
Inventories (150,000+135,000) 285,000
Other (110,000+70,000) 180,000
Total current assets 520,000
Plant assets (net) (450,000+365,000) 815,000
Intangible assets
Patent (net) (0+25,000) 25,000
Goodwill (net) 15,000 40,000
Total assets 1,375,000
Liabilities:
Income taxes payable (26,000+10,000) 36,000
Other (325,000+115,000) 440,000
Total liabilities 476,000
Stockholders‟ equity
Additional paid in capital 365,000
Total stockholders‟ equity 1,375,000
Working paper for consolidated balance sheet

Working paper is usually required even for a parent company and a wholly owned subsidiary.
Developing the elimination

The parent company‟s investment account is similar to the home office‟s investment in branch account.
However, the subsidiary is a separate corporation not a branch and has three conventional stockholders‟
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equity accounts rather than a single home office reciprocal account used by a branch. Accordingly, the
elimination of the intercompany accounts must decrease the investment account of the parent company
and the three stockholders‟ equity accounts of the subsidiary to zero.
The completed elimination for Palm Corporation and subsidiary (in journal entry format) and the related
working paper for consolidated balance sheet are as follows:
a) Common Stock-Star 200,000
Additional Paid in Capital-Star 58,000
Retained Earnings- Star 132,000
Inventories- Star (135,000-110,000) 25,000
Plant Assets (net)-Star (365,000-300,000) 65,000
Patent (net)-Star (25,000-20,000) 5,000
Goodwill (net)-Star (500,000-485,000) 15,000
Investment in Star Co Common Stock 500,000
To eliminate intercompany investment and equity accounts of subsidiary
67
Palm Corporation and Subsidiary
Working Paper for Consolidated Balance Sheet
December 31, 1999
Palm Star Elimination Consolidated
Assets
Cash 15,000 40,000 55,000
Inventories 150,000 110,000 a 25,000 285,000
Other current assets 110,000 70,000 180,000
Intercompany receivable/payable 25,000 (25,000)
Investment in Star Co 500,000 a (500,000)
Plant assets (net) 450,000 300,000 a 65,000 815,000
Patent (net) 20,000 a 5,000 25,000
Goodwill (net) a 15,000 15,000
Total assets 1,250,000 515,000 (390,000) 1,375,000
Liabilities & Stockholders’ Equity
Income taxes payable 26,000 10,000 36,000
Other liabilities 325,000 115,000 440,000
Common stock, $10 par 400,000 400,000
Common stock, $5 par 200,000 a (200,000)
68
Additional paid in capital 365,000 58,000 a (58,000) 365,000
Retained earnings 134,000 132,000 a (132,000) 134,000
Total 1,250,000 515,000 (390,000) 1,375,00
69
The following features of the above working paper should be noted:
• The elimination is only a part of the working paper and not entered into the books of the parent
or subsidiary
• The elimination is used to reflect the difference between current fair values and carrying amounts
of the subsidiary‟s identifiable net assets as the subsidiary did not write up its assets to current
fair value
• The elimination column reflects increases and decreases rather than debits and credits
• Intercompany receivables and payables are placed on the same line of the working paper for
consolidated balance sheet and combined to produce a consolidated amount of zero
• The consolidated paid in capital amounts are those of the parent company only. Subsidiaries‟
paid in capital amounts are always eliminated in the process of consolidation
• Consolidated retained earnings are those of the parent company only in line with the theory that
states purchase accounting reflects a fresh start in an acquisition of net assets
• The consolidated amounts reflect the financial position of a single economic entity comprising
two legal entities with all intercompany balances eliminated
The consolidated balance sheet is exactly the same as the one presented on page 6.
5.3 Consolidation of Partially Owned Subsidiary on Date of Purchase Type Business Combination
The consolidation of a parent company with its partially owned subsidiary differs from a consolidation
of wholly owned subsidiary in one major respect- the recognition of minority interest.
Minority interest is a term applied to the claims of stockholders other than the parent company to the net
income or losses and net assets of the subsidiary. The minority interest in the subsidiary‟s net income or
loss is displayed in the consolidated income statement, and the minority interest in the subsidiary‟s net
assets is displayed in the consolidated balance sheet.
To illustrate, assume that on December 31, 1999, Post Corporation issued 57,000 of its $1 par common
stock (current fair value $20 a share)to stockholders of Sage Company in exchange for 38,000 of the
40,000 outstanding shares of $10 par common stock in a purchase type business combination. Thus, Post
acquired 95% (38,000/40,000) interest in Sage, which became its subsidiary. There was no contingent
consideration. Out of pocket costs are:
Finder‟s and legal fees 52,250
Costs associated with SEC registration 72,750
70
Total 125,000
Financial statements of Post and Sage just prior to combination were as follows:
POST CORPORATION AND SAGE COMPANY

Separate Financial Statements (prior to purchase-type business combination)
For Year Ended December 31, 1999
Post Sage
Income Statement
Net sales 5,500,000 1,000,000
Costs and expenses
Cost of goods sold 3,850,000 650,000
Operating expenses 925,000 170,000
Income taxes expense 260,000 56,000
Total 5,110,000 916,000
Net income 390,000 84,000
Retained earnings, beginning 810,000 290,000
Add: Net income 390,000 84,000
1,200,000 374,000
Less: Dividends 150,000 40,000
Retained earnings, ending 1,050,000 334,000
Balance Sheet
Assets
Cash 200,000 100,000
Inventories 800,000 500,000
Other current assets 550,000 215,000
Plant assets (net) 3,500,000 1,100,000
Goodwill (net) 100,000
Total assets 5,150,000 1,915,000
71
Income taxes payable 100,000 16,000
Other liabilities 2,450,000 930,000
Common stock, $1 par 1,000,000
Additional paid in capital 550,000 235,000
Retained earnings 1,050,000 334,000
Total liab & stockholders‟ equity 5,150,000 1,915000
The December 31, 1999, current fair values of Sage Company‟s identifiable assets and liabilities were
the same as their carrying amounts except for the following:
Inventories 526,000
Leasehold 30,000
Sage Company does not prepare journal entries related to the business as it is continuing as a separate
legal entity. But Post Corporation prepares the following entries:
Investment in Sage Common Stock

(57,000*20) 1,140,000
Common Stock (57,000*1) 57,000
Paid in Capital in Excess of Par 1,083,000
To record issuance of 57,000 shares of common to acquire 38,000 of Sage Company‟s
outstanding 40,000 shares
Investment in Sage Common Stock 52,250
Cash 125,000
To record payment of out of pocket expenses associated with business combination

It is advisable to use a working paper for preparation of a consolidated balance sheet for a parent
company and its partially owned subsidiary due to complexities caused by the minority interest.
72
The differences between the carrying amounts of identifiable assets and liabilities of the subsidiary with
the current fair vales must be reflected by means of elimination.
Common stock-Sage 400,000

Additional Paid in Capital-Sage 235,000
Retained earnings-Sage 334,000
Inventories-Sage (526,000-500,000) 26,000
Plant Assets (net) (1,290,000-1,100,000) 190,000
Leasehold 30,000
Investment in Sage Common Stock-Post 1,192,250
The debit side of the above entry represents the current fair values of Sage Company‟s identifiable
tangible and intangible assets (1,215,000) while the credit side represents Post‟s total investment
1,192,250. Two items should be recorded to complete the elimination: minority interest and goodwill.
Computation of Minority Interest
Current fair value of Sage‟s identifiable net assets 1,215,000
Minority interest (100-95) 0.05
Minority interest (1,215,000*.05) 60,750
This is recorded as credit as it represents claim on the net assets.
Computation of goodwill
Cost of Post Corporation‟s 95% interest 1,192,250
Less: Current fair value of identifiable net assets acquired
(1,215,000*.95) 1,154,250
Goodwill 38,000
The completed elimination in journal entry format would be:
Common stock-Sage 400,000
Retained earnings-Sage 334,000
Inventories-Sage (526,000-500,000) 26,000
Plant Assets (net) (1,290,000-1,100,000) 190,000
73
Leasehold 30,000
Goodwill 38,000
Investment in Sage Common Stock-Post 1,192,250
Minority Interest 60,750

The following is the working paper for consolidated balance sheet for Post Corporation and subsidiary
74
Post Corporation and Subsidiary
December 31, 1999
Post Sage Elimination Consolidated
Assets
Cash 75,000 100,000 175,000
Inventories 800,000 500,000 a 26,000 1,326,000
Investment in Sage Co 1,192,250 a (1,192,250)
Plant assets (net) 3,500,000 1,100,000 a 190,000 4,790,000
Leasehold a 30,000 30,000
Goodwill (net) a 38,000 138,000
Total assets 6,217,250 1,915,000 (908,250) 7,224,000
Liabilities & Stockholders’ Equity
Other liabilities 2,450,000 930,000 3,380,000
Minority interest a 60,750 60,750
Common stock, $1 par 1,057,000 1,057,000
Common stock, $5 par 400,000 a (400,000)
75
Additional paid in capital 1,560,250 235,000 a (235,000) 1,560,250
Retained earnings 1,050,000 334,000 a (334,000) 1,050,000
Total 6,217,250 1,915,000 (908,250) 7,224,000
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Nature of Minority Interest
Two concepts for consolidated financial statements have been developed to account for minority
interest: the parent company concept and the economic unit concept.
The parent company concept apparently treats the minority interest in net assets of a subsidiary as a
liability. This liability is increased by an expense representing the minority‟s share of the subsidiaries
net income (or decreased by the minority‟s share of net loss). Dividends declared to minority
shareholders decrease the liability to them.
The economic unit concept displays the minority interest in the subsidiary‟s net assets stockholders‟
equity section of the consolidated balance sheet. The consolidated income statement displays the
minority interest in the subsidiary‟s net income as a subdivision of total consolidated net income.
Note that there is no ledger account for minority interest in net assets of subsidiary, in either parent
company‟s or the subsidiary‟s accounting records.
Advantages and Shortcomings of Consolidated Financial Statements

Advantages
• Enable stockholders and prospective investors to view comprehensive financial information for
the economic unit without regard for legal separateness of the individual companies.
Shortcomings
• Less useful to creditors of each company and minority stockholders as they do not give
information about operating results and financial position of the individual companies.
• Consolidated financial statements of diversified companies (conglomerates) are impossible to
classify into a single industry and thus cannot be used for comparative purposes by financial
analysts.
5.4. Consolidation: subsequent to date of purchase-type business combination
Subsequent to the date of business combination, the parent company must account for the operating
results of the subsidiary: the net income or net loss and dividends declared and paid by the subsidiary.
Intercompany transactions must also be recorded.
5.4.1 Accounting for Operating Results of Wholly Owned Purchased Subsidiaries

There are two alternative methods for this purpose: the equity method and the cost method of
accounting.
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Equity Method
Under this method, the parent company recognizes its share of the subsidiary‟s net income or net loss,
adjusted for depreciation and amortization of differences between current fair values and carrying
amounts of purchased subsidiary‟s net assets on the date of the business combination, as well as its share
of dividend declared by the subsidiary.
The equity method is said to be consistent with the accrual basis of accounting as it recognizes increases
or decreases in the carrying amount of parent company‟s investment in the subsidiary as net income or
net loss, not when they are paid as dividends. Thus, proponents claim, the equity method stresses the
economic substance of the parent subsidiary relationship. Dividends declared by the subsidiary do not
constitute revenue the parent company but are a liquidation of a portion of the parent company‟s
investment in the subsidiary.
Cost Method
Under this method, the parent company accounts for the operation of a subsidiary only to the extent that
dividends are declared by the subsidiary. Dividends declared by the subsidiary from net income
subsequent to the business combination are recognized as revenue by the parent company; dividends
declared by the subsidiary in excess of post-combination net income constitute a reduction of the
carrying amount of the parent company‟s investment in the subsidiary. Net income or net loss of the
subsidiary is not recognized by the parent company.
Supporters claim that this method appropriately recognizes the legal form of parent subsidiary
relationship. Thus, a parent company realizes revenue when the subsidiary declares dividend, not when
it reports net income.
Illustration of Equity Method for Wholly Owned Purchased Subsidiary for First Year after
Business Combination
Assume that Palm Corporation had used purchase accounting for business combination with its wholly
owned subsidiary, Star Company, and the Star had a net income of 60,000 for the year ended December
31, 2000. On December 20, 2000, Star‟s BODs declared a cash dividend of $0.60 a share on the 40,000
outstanding shares.
78
Dec. 20: Star’s journal entry to record dividend declaration is:
Dividends Declared 24,000
Intercompany Dividends Payable 24,000
To record declaration of dividend
Under the equity method of accounting, Palm Corporation prepares the following journal entries to
record the dividend and net income of Star.
1) Intercompany Dividend Receivable 24,000
Investment in Star Common Stock 24,000
To record dividend declared by Star Company
2) Investment in Star Company Common Stock 60,000
Intercompany Investment Income 60,000
To record 100% of Star Company‟s net income
The credit to investment in subsidiary account in the first entry reflects an underlying premise of the
equity method of accounting: dividends declared by a subsidiary represent a return of a portion of the
parent company’s investment in the subsidiary.
The second entry records the parents 100% share of the subsidiary‟s net income. The subsidiary‟s net
income accrues to the parent company under the equity method of accounting.
Adjustment of Purchased Subsidiary’s Net Income

Continuing with the Palm Corporation Star Company business combination, Palm must prepare a third
journal entry to adjust Star’s net income for depreciation and amortization attributable to the
difference between the current friar values and carrying amounts of Star’s net assets on the date of
the business combination-December 31,1999. Because such differences were not recorded by the
subsidiary, its net income is overstated from the point of view of the consolidated entity.
On the date of the business combination, differences between current fair values and carrying amounts
of Star Company‟s net assets were as follows:
Inventories (FIFO) 25,000
Plant assets (net)
Land 15,000
Building (economic life 15 years) 30,000
79
Machinery (economic life 10 years) 20,000 65,000
Patent (economic life 15 years) 5,000
Goodwill (economic life 30 years) 15,000
Total 110,000
Palm Corporation prepares the following journal entry to reflect the effects of depreciation and
amortization on the above differences on the net income of Star Company for the year ended December
31, 2000:
Investment in Star Co Common Stock 30,500
To amortize differences between current fair value and carrying amounts
Inventories- to cost of goods sold 25,000

Building- depreciation (30,000/15) 2,000
Machinery-depreciation (20,000/10) 2,000
Patent-Amortization (5,000/5) 1,000
Goodwill-amortization (15,000/30) 500
Total 30,500
Developing the Elimination
Palm Corporation‟s use of equity method of accounting for its investment in Star Company results in a
balance in investment account that is a mixture of two components:
• The carrying amount of Star‟s net assets
• The excess of current fair values over the carrying amount of Star‟s identifiable net assets,
including goodwill, on the date of business combination
All three basic financial statements must be consolidated for accounting periods subsequent to the date
of purchase type business combination and hence the elimination working paper must include accounts
that appear in the constituent companies‟ income statement, statement of retained earnings and balance
sheets.
The items that must be included in elimination are:
80
1. The subsidiary‟s beginning of year stockholder‟s equity and its dividends, and the parent‟s
investment
2. The parent‟s intercompany investment income
3. Unamortized current fair value excess of the subsidiary
4. Certain operating expenses of the subsidiary
Assume that Star Company allocates:

• Machinery depreciation and patent amortization to cost of goods sold
• Goodwill amortization to operating expenses
• Building depreciation 50% each to cost of goods sold and operating expenses
The working paper elimination in working paper format is as follows with the component items
numbered in accordance with the foregoing breakdown:
Common stock-Star 200,000 (1)
Additional Paid in Capital-Star 58,000 (1)
Retained Earnings-Star 132,000 (1)
Intrecompany Investment Income-Palm 29,500 (2)
Plant Assets (net)-Star (65,000-4,000) 61,000 (3)
Patent-Star (net) (5,000-1,000) 4,000 (3)
Goodwill-Star (net) (15,000-500) 14,500 (3)
Cost of Goods Sold-Star 29,000 (4)
Operating Expenses-Star 1,500 (4)
Investment in Star Co Common Stock-Palm 505,500 (1)
Dividend Declared-Star 24,000 (1)
To carry out the following:

a) Eliminate intercompany investment and equity accounts of subsidiary at beginning of
year and subsidiary dividend
b) Provide for depreciation and amortization on difference between current fair values and
carrying amounts
c) Allocate unamortized differences to proper accounts
81
Working Paper for Consolidated Financial Statements
The following aspects of the working paper should be emphasized:
• The intercompany receivable and payable are placed on the same line and offset without formal
elimination
• The elimination cancels the subsidiary‟s retained earnings balance at the date of business
combination, so that each of the three basic financial statements may be consolidated in turn.
• The FIFO method is used to account for inventories by Star Company. Thus, the difference of
25,000 attributable to beginning inventories is allocated to cost of goods sold.
• One effect of the elimination is to reduce the difference between the carrying amounts and
current fair values by the amount of amortization. (110,000-30,500=79,500)
• The parent company‟s use of the equity method of accounting results in the equalities described
below:
Parent company net income = consolidated net income
Parent company retained earnings = consolidated retained earnings
Closing Entries
To complete the accounting cycle closing entries are prepared in the usual fashion by both the parent
company and the subsidiary. State corporate laws generally require separate accounting for retained
earnings available for dividends to stockholders. Accordingly, net income legally available for Palm‟s
stockholders as dividends and adjusted net income of the subsidiary not distributed as dividend by the
subsidiary are segregated. Hence, the entry to close income summary is:
Retained Earnings of Subsidiary (29,500-24,000) 5,500
Retained Earnings (109,500-5,500) 104,000
82
PALM CORPORATION AND SBSIDIARY
WORKING PAPER FOR CONSOLIDATED FINANCIAL STATEMENTS
FOR YEAR ENDED DECEMBER 31, 2000
Elimination
Palm Star Increase
Corporation Company (Decrease) Consolidated
Income Statement
Revenue:
Net Sales 1,100,000 680,000 1,780,000
Intercompany investment income 29,500 a) (29,500)
Total revenue 1,129,500 680,000 (29,500) 1,780,000
Costs and expenses:
cost of goods sold 700,000 450,000 a) 29,000 1,179,000
Operating expenses 217,667 130,000 a) 1,500 349,167
Income taxes expense 53,333 40,000 93,333
Total costs and expenses 1,020,000 620,000 30,500 1,670,500
Net income 109,500 60,000 (60,000) 109,500

Retained earnings, beginning 134,000 132,000 a) 132,000 134,000
Net income 109,500 60,000 (60,000) 109,500
Sub total 243,500 192,000 (192,000) 243,500
Dividends declared 30,000 24,000 a) (24,000) 30,000
Retained earnings, ending 213,500 168,000 (168,000) 213,500
83
Balance Sheet
Assets
Cash 15,900 72,100 88,000
Intercompany receivable(payable) 24,000 (24,000)

Inventories 136,000 115,000 251,000
Investment in Star Co common stock 505,000 a) (505,000)
Plant assets (net) 440,000 340,000 a) 61,000 841,000
Patents (net) 16,000 a) 4,000 20,000
Goodwill (net) a) 14,500 14,500
Total assets 1,208,900 650,100 (426,000) 1,433,500
Liabilities & Stockholders' Equity

Other liabilities 190,900 204,100 395,000
Common stock, $10 par 400,000 400,000
Common stock, $5 par 200,000 a) (200,000)
a)
Additional paid in capital 365,000 58,000 (58,000) 365,000
Retained earnings 213,500 168,000 (168,000) 213,500
Toatal liab & stockholders' equity 1,209,400 650,100 (168,000) 1,433,500
5.4.2. Accounting for Operating Results of Partially Owned Purchased Subsidiaries

• Requires computation of minority interest in net income or net loss of the subsidiary
• Under the parent company concept, the minority interest in net income or net loss of a subsidiary
is included as expense in the consolidated income statement
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Illustration:
The Post Corporation- Sage Company consolidated entity is used to illustrate. Post owns 95% of the
outstanding common stock of Sage and minority stockholders own the remaining 5%.
Assume that Sage Company declared and paid dividend of 1 a share and had a net income of 90,000 for
the year ended 31 December 2000. Sage prepares the following entries for the declaration and payment
of the dividend:
Dividends Declared (40,000*$1) 40,000
Dividends Payable (40,000*.05) 2,000
Intercompany Dividends Payable (40,000*.95) 38,000
To record declaration of dividend
Dividends Payable 2,000
Intercompany Dividends Payable 38,000
Cash 40,000
To record payment of dividend declared
Post‟s journal entries with regards to Sage‟s operating results include the following:
Intercompany Dividends Receivable 38,000
Investment in Sage Co Common Stock 38,000
To record dividend declared by Sage Company
Cash 38,000
Intercompany Dividends Receivable 38,000
To record receipt of dividend from Sage Company
Investment in Sage Co Common Stock

(90,000*.95) 85,500
To record 95% of net income of Sage Company for the year ended Dec 31, 2000
As noted earlier, a purchase-type business combination involves a restatement of net asset values of the
subsidiary. However, the net income reported by Sage Company does not reflect cost expiration
attributable to the restated net asset values as the restatements were not entered in the company‟s
accounting records. Assume that the difference was allocated to Sage‟s identifiable assets as follows:
85
Inventories (FIFO) 26,000
Plant assets:
Land 60,000
Building (economic life 20 yrs) 80,000
Machinery (economic life 5 yrs) 50,000 190,000
Leasehold (economic life 6 yrs) 30,000
Total 246,000
Post Corporation prepares the following journal entry on December 31, 2000 to reflect the effect of the
differences between the current fair values and carrying amounts of partially owned subsidiary‟s
identifiable net assets:
Investment in Sage Co Common Stock 42,750
To amortize differences between current fair values and carrying amounts of Sage Company‟s
identifiable net assets on Dec 31,1999
Inventories to cost of goods sold 26,000
Building – Dep. (80,000/20) 4,000
Machinery – Dep. (50,000/5) 10.000
Leasehold – Amrt. (30,000/6) 5,000
Total difference applicable to 2000 45,000
Amortization for 2000 (45,000*.95) 42,750
Assume that Sage Company allocates :

• Machinery depreciation and leasehold amortization entirely to cost of goods sold
• Building depreciation 50% each to cost of goods sold and operating expenses
Next, the following entry is prepared to amortize the goodwill acquired by Post in the business
combination with Sage:
Amortization Expense (38,000/40) 950
Investment in Sage Co Common Stock 950
To amortize goodwill acquired in business combination with partially owned subsidiary
Goodwill in a business combination involving a partially owned subsidiary is attributed to the parent
rather than the subsidiary as per FASB recommendation. Consequently the amortization of the goodwill
86
is debited to Amortization Expense account of the parent company, with an offsetting credit to the
investment account thereby avoiding charging any goodwill amortization to the minority interest, which
did not acquire any goodwill.
Developing the Elimination

Post Corporation‟s use of equity method of accounting for its investment in Star Company results in a
balance in investment account that is a mixture of two components:
• The carrying amount of Sage‟s net assets
• The excess of current fair values over the carrying amount of Sage‟s identifiable net assets,
including goodwill, on the date of business combination
The following is the working paper elimination in journal entry format
Common Stock-Sage 400,000
Retained Earnings-Sage 334,000
Intercompany Investment Income-Post 42,750
Plant Assets-Sage (190,000-14,000) 176,000
Leasehold (net) (30,000-5,000) 25,000
Goodwill (net)(38,000-950) 37,050
Cost of Goods Sold-Sage 43,000
Operating Expenses-Sage 2,000
Investment in Sage Co Common Stock-Post 1,196,050
Dividends Declared-Sage 40,000
Minority Interest in Net Assets of Sub(60,750-2,000) 58,750
To carry out the following:

a) Eliminate intercompany investment and amortization on differences
combination date current fair values and carrying amounts to appropriate
assets
b) Provide for year 2000 depreciation and amortization on differences
between current fair values and carrying amounts of Sage‟s identifiable net
assets:
87
CGS Op. Exp
Inventories sold 26,000
Building Dep. 2,000 2,000
Machinery Dep. 10,000
Leasehold Amort 5,000
Total 43,000 2,000
c) Allocate unamortized differences between combination date current fair
values and carrying amounts to appropriate assets
d) Establish minority interest of subsidiary at beginning of year (60,750), less
minority interest share of dividends declared by subsidiary during the year
(40,000*.05=2,000)
b) Minority Interest in Net income of Sub 2,250
Minority interest in net assets of sub 2,250
To establish minority interest in subsidiary‟s adjusted net income
Net income of subsidiary 90,000
Net reduction (43,000+2,000) 45,000
Adjusted Net Income 45,000
Minority interest (45,000*.05) 2,250
The minority interest is:

Sage Company‟s total Stockholders‟ Equity 1,019,000
Add: Unamortized Difference 201,000
Sage‟s Adjusted Stockholders‟ Equity 1,220,000
Minority Interest 5% 61,000
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Elimination
Post Sage Increase
Corporation Company (Decrease) Consolidated
Income Statement
Revenue:
Net Sales 5,611,000 1,089,000 6,700,000

Intercompany investment income 42,750 a) (42,750)
Total revenue 5,653,750 1,089,000 (42,750) 6,700,000

Costs and expenses:
cost of goods sold 3,925,000 700,000 a) 43,000 4,668,000
Operating expenses 556,950 129,000 a) 2,000 687,950
Interest & tax expense 710,000 170,000 880,000

Minority interest in net income of
sub b) 2,250 2,250
Total costs and expenses 5,191,950 999,000 47,250 6,238,200
Net income 461,800 90,000 (90,000) 461,800
89
Retained earnings, beginning 1,050,000 334,000 a) (334,000) 1,050,000
Net income 461,800 90,000 (90,000) 461,800
Sub total 1,511,800 424,000 (424,000) 1,511,800
Dividends declared 158,550 40,000 a) (40,000) 158,550
Retained earnings, ending 1,353,250 384,000 (384,000) 1,353,250

Balance Sheet
Assets
Inventories 861,000 439,000 1,300,000
Other current assets 639,000 371,000 1,010,000
Investment in Sage Co common stock 1,196,050 a) (1,196,050)
Plant assets (net) 3,600,000 1,150,000 a) 176,000 4,926,000

Leasehold (net) a) 25,000 25,000
90
Goodwill (net) 95,000 a) 37,050 132,050
Total assets 6,391,050 1,960,000 (958,000) 7,393,050
Liabilities & Stockholders' Equity
Liabilities 2,420,550 941,000 3,361,550

Minority interest in net assets of sub a) 58,750 61,000
b) 2,250
Common stock, $1 par 1,057,000 1,057,000
Common stock, $10 par 400,000 a) (400,000)
Additional paid in capital 1,560,250 235,000 a) (235,000) 1,560,250
Retained earnings 1,353,250 384,000 (384,000) 1,353,250
Total liab & stockholders' equity 6,391,050 1,960,000 (958,000) 7,393,050
91
CHAPTER SIX
ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS
6.1.Introduction
Companies may make purchases from and sales to companies in other countries. Such transactions are settled in
either of the domestic currencies of the parties involved. Business transactions that are settled in a currency other
than of the domestic (home country) currency are referred to as foreign currency transactions. One of the
transacting parties usually will settle the transaction in its own domestic currency and also measure the
transaction in its own domestic currency. The other transacting party will settle the transaction in a foreign
currency but will need to measure the transaction in its domestic currency. To measure and record the transaction
in domestic currency, an exchange rate between the currencies should be developed. Given that rates of exchange
vary, the number of units of one currency required to acquire another currency could change between the time the
exchange (transaction) occurs and the payment is made. Therefore, such transactions may expose an entity to
risks and opportunities depending on how exchange rates change over time. To this end, the chapter focuses on
how a domestic entity should account for transactions which are denominated or settled in a foreign currency.
The currency used to settle the transaction is termed as the denominated currency where as, the currency used to
measure or record the transaction is referred to as the measurement currency. Whenever a transaction is
denominated in a currency different than the measurement currency, exchange rate risk exists, and exchange rates
must be used for measurement purposes. The process of expressing a transaction in the measurement currency
when it is dominated in a different currency is referred to as a foreign currency translation. Denominating a
transaction in a currency other than the entity‟s domestic or reporting currency requires the establishment of a rate
of exchange between the currencies.
6.2 The Mechanics of Exchange Rates

An exchange rate is a measure of how much of one currency may be exchanged for another currency. These rates
may be in the form of either direct or indirect quotes.
Direct Exchange Rates (quotes) measure how much of a domestic currency must be exchanged to receive one unit
of a foreign currency. It allows the party using the quote to understand the price of the foreign currency in terms
of its own base or domestic currency. Indirect Exchange Rates (quotes) measure how many units of the foreign
currency will be received for one unit of the domestic or “base” currency.
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Specifying the exchange rate as „Birr 25 per British pound‟ is an example for a direct exchange rate, then one
British pound would cost Birr 25. The indirect quote would be the reciprocal of the direct quote, or 0.04 British
pounds per Birr (Birr 1/Birr 25).
Exchange Rate Quotes
Direct quote Indirect Quote
1 British pound = birr 25 birr 1 = 0.04 British pound
Exchange rates are often quoted in terms of a buying rate (the bid price) and a selling rate the (offered price).The
buying and selling rates represent what the currency broker (usually a commercial bank) is willing to pay to
acquire or sell a currency. The difference between these two rates represents the broker‟s commission and often is
referred to as spread.
Exchange rates fall in to two primary groups, spot rate and forward rates.
Spot rate refers to the exchange rate for immediate delivery of currencies exchanged
Forward rate refers to the exchange rate of different currencies at a future point in time, such as in 30, 60, 90 or
180 days.
Changes in Exchange Rates
Exchange rates are continuously changing showing the strengthening or weakening of one currency relative to the
other.
Strengthening Currencies
A foreign currency that is strengthening in value in relation to the domestic currency becomes more expensive to
purchase because more amounts of the domestic currency is needed to obtain a unit of the foreign currency.
Accordingly, the Direct Exchange Rate increases.
If the British pound strengthens or gains against the Birr, the direct exchange rate will increase and the indirect
exchange rate will decrease because more amounts of birr is needed to obtain a unit of the pound. A weakening of
the birr has the same effect on the direct rate as does the strengthening of the foreign currency, the British pound
in this case.
Weakening Currencies
A foreign currency that is weakening in value in relation to the domestic currency becomes less expensive to
purchase because fewer amounts of the domestic currency are needed to obtain a unit of the foreign currency.
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Accordingly, the Direct Exchange Rate decreases.
If the British pound weakened against the Birr, the direct exchange rate will decrease and the indirect exchange
rate will increase. A strengthening of the birr has the same effect on the direct rate as does the weakening of the
foreign currency, the British pound in this case.
As a result of such fluctuations in the exchange rate, an exchange difference (Gain or Loss) results when there is a
change in the exchange rate between the transaction date and the date of settlement. When the transaction is
settled within the same accounting period as that in which it occurred, all the exchange difference is recognized in
that period. However, when the transaction is settled in a subsequent accounting period, the exchange difference
is recognized at the end of each intervening accounting period up to the period of settlement based on the change
in exchange rates on the statement date.
Basic Process for Translating Foreign Currency Denominated Transactions

a. Use the spot rate on the day that the transaction is first recorded to measure the transaction initially
b. Re measure the accounts that require foreign currency settlement from the first step on each balance sheet
date, using the spot rate for the balance sheet date – report any resultant translation gains or losses in
current earnings
c. On the settlement date re measure for a final time using the spot rate at that time with that gain or loss
since the last balance sheet date included in current earnings
6.3. Foreign Currency Transaction Gains and Losses

Changes in exchange rates do not affect transactions that are that are both denominated and measured in the
reporting entity‟s currency. Therefore, these transactions require no special accounting treatment. However, if a
transaction is denominated in a foreign currency and measured in the reporting entity‟s currency, changes in
exchange rate between the transaction date and the settlement date and/or the statement date result in a gain or
loss to the reporting entity. These gains and losses are referred to as exchange gains and losses, and their
reporting requires special accounting treatments.
Assume a U.S. company sells Equipment to a British company and the Equipment must be paid for in 30 days
with U.S. dollars. This transaction is denominated in dollars and will be measured by the U.S. Company in
dollars. Changes in exchange rate between the U.S. dollar and the British pound from the transaction date to the
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settlement date will not expose the U.S. company to any risk of gain or loss from exchange rate changes.
However, if we assume the transaction to be settled in British pounds, changes in the exchange rate subsequent to
the transaction date expose the U.S. Company to risk of exchange rate loss or gain. This is because the transaction
is denominated in British pounds but will be measured by the U.S. Company in dollars. If the U.S. dollar
strengthens against the British pound (British pound weakens), the U.S. Company will experience a loss because
it is holding an asset (a receivable of British pounds) whose price and value declined. If the dollar weakens, the
opposite effect would be experienced.
Illustration:
On June 1, 2009, a U.S. Company sells Mining Equipment which has a cost of $250,000 to a British Company for
180,000 British pounds, with payment due July 1, 2009. On June 1, 2009, the British pound is worth $1.70, and
on July 1, 2009, the pound is worth $1.60.
U.S. Company‟s Records British Company‟s Records
June 1, 2009
Accounts receivable 306,000
Sales Revenue 306,000 Equipment 180,000
Cost of Goods sold 250,000 Accounts Payable 180,000
Inventory 250,000
July 1, 2009
Cash 288,000*
Foreign Currency trans. Loss 18,000** Accounts Payable 180,000
Accounts Receivable 306,000 Cash 180,000
* $288,000 = 180,000 * $1.60

** $18,000 = [180,000 (1.70 – 1.60)]
The U.S. Company received the 180,000 pounds when the exchange rate is $1.60, making the dollar equivalent
value of the pounds $288,000 (180,000*$1.60)
The decrease in the value of the British pound form $1.70 to $1.60 resulted in an exchange loss to the U.S.
Company since the pounds it received are less valuable than they were at the transaction day. The British
company doesn‟t experience an exchange Gain or Loss. This is because the British company both measured and
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denominated the transaction in pounds.
6.4. Unsettled Foreign Currency Transactions

If a foreign currency transaction is unsettled at year-end, an unrealized gain or Loss should be recognized to
reflect the change in the exchange rate occurring between the transaction date and the end of the reporting period
(e.g., year-end).
This treatment focuses on accrual accounting and the fact that exchange gains and losses occur over time rather
than only at the date of settlement or payment. Therefore, at any given time the assets or liabilities arising from a
foreign currency transaction that is denominated in a foreign currency should be measured at its fair value as
suggested by the spot rate.
Illustration:
A U.S. Company purchased goods from a foreign company on November 1, 2009. The purchase in the amount of
1,000 Euros is to be paid on February 1, 2010, in Euros. The spot rate on the date of purchase was 1 Euro = $ 1.50
The exchange rates on December 31, 2009, end of the accounting period, and on the settlement date were 1 Euro
= $ 1.52 and 1 Euro = $ 1.55
U.S. Company Records:
Nov. 1, 2009
Inventory 1,500
Accounts Payable 1,500
Dec. 31, 2009

Foreign Currency trans. Loss 20
Accounts Payable 20
Feb. 1, 2010
Accounts Payable 1,520
Foreign Currency trans. Loss 30
Cash 1,550
The increase in the value of each Euro from $1.50 to $1.52 on December 31, 2009, resulted in a loss to the U.S.
Company since, as of year end, the company would have to pay out more dollars than originally recorded. In
other words, if the transaction had been settled at year-end, the U.S. Company would have so expend $1.520 to
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acquire 1,000 Euros. Therefore, a loss of $20 is traceable to the unperformed portion of the transaction.
On the settlement date, the dollar has further lost its value against the Euros by $0.03 ($1.55 - $1.52) from its year
end value. This resulted in additional loss of $30 ($0.03*1,000) to be recognized on the settlement date. Note that
the company experienced a loss of $50 due to changes in the exchange rate. This total loss is allocated between
2009 and 2010 in accordance with accrual accounting.
Conclusions:
Increase 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 loss to the enterprise because more
U.S. dollars are required to obtain the foreign currency. Conversely, decrease in the selling spot rate produces
foreign currency transaction gain to the enterprise because fewer U.S. dollars are required to obtain the foreign
currency. In contrast, increase 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. Where as, decreases in the buying spot rate produce foreign currency transaction losses.
6.5. Forward Exchange Contracts

An enterprise may enter into a forward exchange contract or another financial instrument that is in substance a
forward exchange contract, which is not intended for trading or speculation purposes, to establish the amount of
the reporting currency required or available at the settlement date of a transaction. The premium or discount
arising at the inception of such a forward exchange contract should be amortized as expense or income over the
life of the contract. Exchange differences on such a contract should be recognized in the statement of profit and
loss in the reporting period in which the exchange rates change. Any profit or loss arising on cancellation of
renewal of such a forward exchange contract should be recognized as income or as expense for the period.
The risks associated with changes in exchange rates may be mitigated by entering, into forward exchange
contracts. Any premium or discount arising at the inception of a forward exchange control is accounted for
separately from the exchange differences in forward exchange contract. The premium or discount on the contract
is measured by the difference between the exchange rate at the date of the inception of the forward exchange
contract and the forward rate specified in the contract. Exchange difference on a forward exchange contract is the
difference between (a) the foreign currency amount of the contract translated at the exchange rate at the reporting
date, or the settlement date where the transaction is settled during the reporting period, and (b) the same foreign
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currency amount translated at the latter of the date of inception of the forward exchange contract and the last
reporting date.
In recording a forward exchange contract intended for trading or speculation purposes, the premium or discount
on the contract is ignored and at each balance sheet date, the value of the contract is marked to its current market
value and the gain or loss on the contract is recognized.
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CHAPTER SEVEN
SEGMENT AND INTERIM REPORTING
7.1. Introduction
It is customary for many companies to diversify their operations into a variety of related and unrelated industry
areas. Financial analysts and other users of financial statements face difficulty in analyzing and interpreting
financial statements prepared for diversified companies. The reason is that different industry segments can have
differing growth potentials, capital requirements, and profitability characteristics. Some segments operate in a
stable industry, and others in highly cyclical, or high demand industry. In terms of capital requirements, the
segment may operate in labor-intensive, modest capital requirements, or high capital intensive industry. As a
result, it is not sound to combine all segments and evaluate the company‟s growth potential and profitability. In
order to make meaningful analysis, the total company financial data should be disaggregated into segments.
7.2. Objectives of Segment Reporting and Applicable Accounting Standards

According to FASB (statement No. 14), diversified companies should separately prepare reporting for each
segment. In the view of the FASB, financial information about business segments will assist financial statement
users in analyzing and understanding the financial statements of the enterprise by permitting better assessment of
the company‟s past performance and future prospects. Generally, segment information is based on the totals of
consolidated financial statements. Thus, the principles governing consolidations are used for segment reporting.
In segment reporting, transactions between segments are not eliminated for purposes of segment disclosures with
the exception of inter segment loans, advances and related interest. These items are generally excluded from
segment assets and revenues.
Coverage of Segmental Reporting

According to ∗Financial Accounting Standard Board (statement No. 14), an enterprise may have to disclose data
for one or more of the following areas:
Operations in different industries
Domestic and foreign operations
Export sales
Major customer
Each of these is explained in subsequent sections.
Operations in different industries
∗
FAS
FASB → Fina
Financial Acco
Accounti
unting Stand
Standard
ard Board
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A company may have segments in different industries. The company may not be required to report its operations
in different industries. In order to determine whether the company must report its operations in different
industries, several factors may be considered. The first factor is to identify the industry segments in which it
operates. The aim is to identify a reportable segment. A reportable segment is a significant component of a
company that provides related products and services primarily to unaffiliated customers. Besides, in order to be
reportable, a segment has to meet one of the three tests → revenue test, operating profit test, and asset test.
7.3.1.1 Revenue test

An industry segment is reportable if it meets the revenue test. The revenue test is met when an industry segment‟s
revenue is 10% or more of the combined revenue of all industry segments. Revenue includes inter segment sales
and transfers. Interest is included in the revenue test if the assets on which the interest is earned are included in
that segment‟s identifiable assets. The interest includes interest on inter segment trade receivables, but does not
include interest on intersegment loans and advances.
To illustrate, assume that Amtex company has 4 segments; namely, A, B, C, and D. tTeir sales are shown below:
Segments Total Elimination Consolidated

A B C D
Sales to unaffiliated $40,000 20,000 50,000 1,000 125,000 - 125,000
outsiders - 10,000 10,000 20,000 - 40,000 (40,000)
Inter segments sales
--- 50,000 30,000 70,000 15,000 165,000 (40,000) 125,000
Total sales
The benchmark for a 10% revenue test is $16500 (i.e. 10% of 165,000).
= 10% of total sales
Since the sales of segments A, B, and C are greater than the benchmark sales amount, they are considered
segments Segment D is not a reportable segment because its revenue is less than 10% of the total sales of all
segments (i.e 15,000).
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7.3.1.2 Operating profit test
Operating profit is defined as an industry segment‟s revenue minus all operating expenses. Operating profit
includes expenses that relate to inter segment sales or transfers and expenses allocated among segments on a
reasonable basis. Operating profit should not include revenues earned at the corporate level, general corporate
expenses, interest expense (except for financial segments), domestic and foreign income taxes, income or loss
from equity, investors, gain or loss on discontinued operations, extraordinary items, minority interest, and the
cumulative effect of an accounting change. Intersegment interest expenses and revenues of an industry segment
that is primarily financial in nature are included in determining the operating profit or loss of the segment.
The operating profit test is met when an industry segment absolute amount of its operating profit or loss is 10% or
more of the greater, in absolute amount of (1) the combined operating profits of all industry segments that do not
incur operating loss, or (2) the combined operating loss of all industry segments that did incur an operating loss.
To illustrate, assume that XYZ company has four segments; namely W, X, Y, & Z. Their operating profits/losses
are shown below:
Segments Corporate Consolidat
W X Y Z Administration ed
Operating profit (Loss) Br(50,000) Br(10,000) Br. 90,000 Br. 70,000 – Br. 100,000
Equity investment income 15,000 - - - 25,000 ---------- 40,000
Corporate expenses _ _ _ _ (12,000) (12,000)
Interest (5,000) (5,000)
Totals Br (35,000) (10,000) 90,000 70,000 8,000 123,000
In order to determine the reportable segment using the operating profit test, the following steps can be followed:
Step 1: Add the profits of all segments that reported a profit. In this case, segment Y and Z reported a profit and
their total operating profits are Br. 160,000 (i.e. 90,000 + 70,000 = Br. 160,00).
Step 2. Add the losses of all segments that reported a loss. In the forgoing example, segments W and X have
reported a loss. The total losses of both segments are Br. 60,000 (i.e 50,000 + 10,000 = 60,000).
Step 3. Determine the benchmark to identify reportable segment
Benchmark = 10% of total operating profit, or
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= 10% of total operating losses, i.e.
= 10% x 160,000 = 16,000
= 10% x 60,000 = 6,000
Step 4. Identify the reportable segment
The greater of the benchmark determined in step 3 is Br. 16,000. Thus, a segment whose operating profit is 10%
or more is reportable. As a result, segment W, Y, and Z are reportable because their operating profits or losses are
greater than Br. 16,000.
7.3.1.3 Asset test

The asset test is met when an industry segment‟s identifiable assets are 10% or more of the combined identifiable
assets of all industry segments. Identifiable assets include tangible and intangible assets (including good will)
used exclusively by an industry segment and an allocated portion of assets used jointly by two or more industry
segments. In the determination of segment‟s identifiable assets, asset valuation allowances should be taken into
account. Asset valuation allowances include allowance for doubtful accounts, accumulated depreciation,
marketable securities valuation allowance, and inventories valuation allowances.
The identifiable assets of the segment should not include assets maintained for general corporate purposes and
inter segment loans, advances, or investments, except for those of a financial segment.
To illustrate, suppose that the identifiable assets of XYZ company‟s segments are shown below (in thousands):
Segments Elimi Consolid

W X Y Z Corporate Total nations ated
Identifiable assets Br 40 50 300 90 – 480 - 480
Investments (inter segment) - - 20 – 60 80 – 80
Corporate _ _ _ _ 10 10 – 10
Loans (inter segment) 5 4 - - 8 17 (17) –
Totals 45 54 320 90 78 587 (17) 570
Besides, it is assumed that none of the segments is financial segment.
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To identify reportable segment, the following steps can be followed:
Step 1. Compute the total identifiable assets of all segment
Total identifiable assets = 480,000
Step 2. Determine the benchmark
Benchmark = 10% of total identifiable assets
= 10% x 480,000
= 48,000
Step 3. Identify a reportable segment
A reportable segment is one whose identifiable assets are 10% or more of total identifiable assets of all segments.
Since their identifiable assets are grater than Br. 48,000, segments X, Y, and Z are reportable segments.
Evaluation of reportable segments

According to statement No. 14 of FASB, an industry segment is considered reportable if it meets either revenue
test, operating profit test, or asset test. However, the statement also specified additional rules and criteria for a
final determination of a reportable segment. These rules and criteria include:
The segment should not be considered reportable when it meets only one of tests but is not expected to meet the
test in the future. A segment that does not meet any of tests may be considered reportable if it has been reportable
in prior years and is expected to meet one or more of the tests in the future.
The combined reportable segments must represent a substantial portions (at least 75%) of the total operations of
the enterprise. For example, if the total revenue of reportable segment is less than 75% of the total revenues of all
industry segments, additional segment must be identified as reportable segment. If the number of reportable
segments exceeds 10, it may be appropriate to combine the most closely related industry segments in to broader
reportable segments with a view of reducing their numbers.
7.3.2 Foreign operations

According to FASB statement No. 14, multinational companies are required to disclose domestic as well as
significant foreign operations. Multinational companies are those companies that establish their own plants in
different countries over the world. Foreign operations (for multinational companies) include those operations that
are located outside a “home country” and which produce revenue either:
• by unaffiliated customer sales
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• by intercompany sales
Foreign operations do not include the operation of unconsolidated subsidiaries and investees.
Multinational companies may group operations in individual foreign countries. The basis of grouping may be:
proximity
economic affinity, or
similarity in business environment
As indicated above, multinational companies are required to disclose only significant foreign operations. Foreign
operation is said to be significant if it meets either of the following two tests:
1. Revenue test
Revenue from sales to unaffiliated customers is 10% or more of consolidated revenue. In this case, if the revenue
from sales to unaffiliated customers is 10% or more of consolidated revenue, the operation should be reported
separately.
Example
Intel Telecommunication Company has subsidiaries in three different African countries. The sales results of
domestic and foreign operations are shown below (in thousands)
Domestic Kenya Uganda Togo Combined Elim Consolidations dated
Sales to unaffiliated
Customers 4000 1500 5000 700 11,200 – 11200
Inter area sales 500 – 200 – 700 (700) –
Total revenue 4500 1500 5200 700 11,900 (700) 11,200
Revenue test benchmark = 10% of consolidated revenues

= 10% x 11,200 = 1120
Domestic operations, Kenya operation, and Uganda operation are reportable operations because their revenue
from sales to unaffiliated customers is greater than 10% of consolidated revenue. Togo‟s operation is not
reportable because its sales ($700) are less than 10% of consolidated revenue.
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2. Asset test
If asset test is followed, the operation‟s identifiable assets should be 10% or more of consolidated assets in order
to be reportable.
Example
Intel Telecommunication Company has subsidiaries in three different African countries. The assets of domestic
and three foreign operations are shown below: (in thousands)
Domestic Kenya Uganda Togo Combined Eliminations Consolidated

Identifiable assets $20,000 5000 10,000 3000 38,000 – 38,000
Investments Affiliates 7000 – 2000 --- 9,000 – 9000
General corporate assets 12,000 12,000 – 12,000
Inter area advances 4000 1000 - - 5,000 (5000) –
Total assets 43,000 6000 12000 3000 64,000 (5000) 59000
Assets test benchmark = 10% of consolidated assets

= 10% x 59000 = 5900
On the basis of asset test, only domestic Kenya and Uganda operations are reportable because their identifiable
assets are greater than the asset test benchmark of $5900. Togo operation is not separately reported.
Generally, for all separately reportable operations as well as for the combined areas, revenues, profitability
information, and identifiable assets must be disclosed.
7.3.3 Export sales

Are foreign operations and export sales the same? No. Foreign operations and export sales are not the same
although it is not easy to identify the boundary between them. In general, as defined earlier, foreign operations are
those operations that are located outside a “home country” and which produce revenue from either sale to
unaffiliated customers or to members of a group of companies. On the other hand, export sales represent revenues
generated aboard from services provided by domestic offices. Export sales is said to occur if the company‟s
domestic operations sell to unaffiliated foreign customers. Export sales should be disclosed in total and when
appropriate by geographic area if such sales are at least 10% of the company‟s consolidated revenue.
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7.3.4 Major customer
According to Statement of Financial Accounting Standard (SFAS No. 30), a major customer is one that provides
a firm with 10% or more of the company‟s revenue. Major customer could be business concerns, domestic
government entity, or foreign government entity. According to the statement, the company has to disclose sales to
major customers.
7.4 The position of security and exchange commission (sec) on segment reporting
With respect to segment reporting, Financial Accounting Standard Board and SEC agreed in most cases except
the following:
FASBS requires segmental data only for those years for which a complete set of financial statements is prepared,
where as SEC requires segmental data for three years historical period.
FASB requires the reporting of major customers if sales represent 10% or more of total revenue, where as SEC
requires identification of major customer or customers if the loss of such a customer or customers would have a
materially adverse effect on the enterprise.
7.5 Interim financial reporting

Stakeholders, like investors, creditors, suppliers, and others, need information about the financial performance of
the enterprise. These users cannot wait for the end of the year to do so. They need financial information
periodically, at the end of either a month, quarter, or semiannually. This chapter deals with important issues like
accounting principles and practices used in the preparation of interim financial statements, and approaches to
preparing interim financial statements.
The need for interim reports

Interim financial reports are defined as reports prepared for a period of less than a year. The purpose of preparing
interim financial reports is to meet the needs of decision makers. Decision makers are interested in frequent and
timely information about the firm‟s financial position and results of operations. Among decision makers lenders
are the common users. They need to closely monitor the progress of borrowers so that problems can be identified
as early as possible. Another reason for the interest in interim financial reports is to use such reports as a basis for
projecting annual results.
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An interim financial report may include either a
• Selected financial data
• Complete set of financial statements
Although there is greater need for interim financial reports, there are problems associated in their preparation.
Some of them include the following:
It is difficult to make estimates and judgments as accurately as possible. When the accounting period gets shorter,
estimates and judgments cannot be accurately made.
The treatment of seasonal expenses. i.e. expenses that relate to a full year‟s activity but that occur randomly
during the year
7.5.2 Approaches to Interim Reporting

This relates to the view accountants hold about interim period. Accountants hold two views about interim period.
There are:
1. Discrete period approach

It is the approach in which each interim period is treated as a distinct accounting period. Alike annual financial
results, the same principles and processes are used in determining interim net income. Under this approach, any
outlay such as for advertising, repairs and maintenance would be expensed in the interim period in which the
outlay occurs.
2. Integral period approach

It is an approach in which an interim period is considered as an integral part of the annual period. Under this
approach, accruals, deferrals, estimates, and allocations depend on overall estimates of the relationship between
estimated annual revenues and expenses. Expenses, such as advertising and research and development costs will
be deferred so that a proper allocation between interim periods within one year can be achieved.
According to Accounting Principles Board ∗(APB) opinion No. 28, interims financial statements are based on
integral period approach. APB opinion No. 28 also stressed that interim financial statements should be based on
the same accounting principles and practices that are used in the preparation of annual financial statements.
∗
APB – Acco
Accounti
unting Principle
rinciples Boar
Board
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7.5.3 Standards for interim reporting of revenues, costs, and expenses
1. Revenues
Revenues should be recognized as earned during the interim period on the same basis as followed for the full
year. Seasonal variations in revenue should be disclosed by issuing data for the latest 12 months in addition to the
interim data.
2. Costs and expense

Direct costs and expenses
Costs and expenses may be classified into direct costs, and indirect costs. Direct costs and expenses are those that
can be associated with revenues, or directly associated with the products or services provided. They are also
called allocated product costs, and include all inventoriable direct costs (i.e. materials, labor, and manufacturing
overhead).
For interim periods, direct/allocated costs are treated in the same way as full year. However, APB opinion No. 28
provided the following exceptions with respect to the determination of cost of goods sold for interim financial
statements.
Enterprises that use the gross profit method at interim dates to estimate cost of goods sold should disclose their
practice in the interim financial statements.
Enterprises using the LIFO method of inventory may dig into LIFO layers temporarily during an interim period
because LIFO is an annual concept. Inventory losses resulting from market declines should not be deferred
beyond the interim period in which they occur. If losses are recovered in a subsequent interim period, gains
should be recognized to the extent of losses previously recognized. To illustrate, assume that the costs and market
value of inventory in the 1st quarter are Br. 10,000 and Br. 7000 respectively. Inventory loss to be reported in the
1st quarter would be Br. 3000 (i.e 10,000 – 7000 = 3000). If inventory value (market value) is Br. 14,000 in the
2nd quarter, gain is Br. 4000, but only Br. 3000 is recognized because loss was Br. 3000 in the 1st quarter.
Inventory losses due to temporary inventory market decline should not be recognized in interim period.
(Temporary inventory market decline is a market value decline in one interim period with an expected market
recovery in a subsequent interim period within the same fiscal year.
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To illustrate, the application of the lower-of-cost or market rule to interim reporting, let‟s consider the following
data. Grace Company accounts for its single merchandise item on the FIFO basis by applying the lower-of-cost or
market method. The company has 15000 units in stock with a cost of Br. 60,000 or Br. 4 per unit. For simplicity
of illustration, we assume that no purchases were made during the year (2003). Quarterly sales and end-of-quarter
replacement costs for inventory during the year were as follows:
Quarter Quarterly End of quarter

ended sales (units) Replacement cost/per unit
March 31 -----------------3000 --------------------------------.--Br. 5
June 30 -------------------2000 ---------------------------------------3
September 30 -----------3500 ---------------------------------------6
December 31 -----------2500 ----------------------------------------2
Assume that the replacement cost decline in the second was not considered to be temporarily. Grace Company‟s
cost of goods sold for four quarters, including the second quarter is computed as follows:
Cost of goods sold

Quarter ended Computation for quarter For quarter Cumulative
March 31 ------------------3000 x 4------------------------- 12,000 12,000
June 30 --------------------(2000 x 4) + (10,000 x 1)a -----18,000 30,000
September 30 -------------(3500 x 3) – (6500 x 1)b --------4,000 34,000
December 31 --------------(2500 x 4) + (4000 x 2)c ------18,000 52,000
10,000 units remaining in inventory multiplied by Br. 1 write down to lower replacement cost
6500 units in inventory multiplied by Br. 1 write-up to original FIFO cost.
4000 units remaining in inventory multiplied by Br. 2 write-down to lower replacement cost.
The Br. 52,000 cumulative cost of goods sold for Grace Company for 2003 may be verified as follows:
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Alternative 1:
11000 units sold during 2003, at Br. 4.00 FIFO cost
per unit (4 x 11,000) -------------------------------------------------------------44,000
Add: write-down of 2003 ending inventory to
replacement cost (4000 units x Br. 2.00) ------------------------------------------8,000
Cost of goods sold for 2003 ---------------------------------------------------------------52,000
Alternative 2
Cost of goods available for sale (15000 units x Br. 4) --------------------------------60,000
Less: Ending inventory, at lower of FIFO cost, or market
(4000 units x Br. 2) ------------------------------------------------------------------8,000
Cost of goods sold for 2003 --------------------------------------------------------------52,000
Therefore, if interim reports are prepared for the 2nd quarter, cost of goods sold is reported at Br. 18,000.
Enterprise using standard cost accounting for the determination of inventory and cost of goods sold should follow
the same procedures for interim periods as would apply to the entire fiscal year. The following guidelines may
apply to variances.
Planned or normal variances at the end of the interim period should be deferred at the interim date because they
are absorbed by the end of the fiscal year.
Unplanned or abnormal variances should be shown in the interim period during which they occur.
Indirect costs
Indirect costs represent those costs and expenses other than product cost (direct, or allocated costs). APB opinion
No. 28 has indicated the following standards with respect to costs and expenses other than product costs:
They should be charged to income in interim period as incurred or be allocated among interim period based on an
estimate of time expired, benefit received, or activity associated with the periods. The same procedures should be
used as annual reporting dates.
Those costs and expenses that cannot be readily identified with the activities or benefits of other interim periods
should be charged to the interim period in which incurred, and disclosures should be made.
Arbitrary assignment of the amount of indirect costs and expenses to an interim period should not be made.
110
Gains and losses that arise in any interim period similar to those that would not be deferred at year-end, should
not be deferred to later interim periods within the same fiscal year.
N.B
The above standards apply to such items as major repairs, quantity discounts, property taxes, and advertising
costs.
The above standards encourage enterprises to avoid year-end adjustments as much as possible may making
quarterly estimates of items, such as inventory shortages, bad debt expense, and contract adjustments.
7.5.4 Income taxes in interim financial statements

The determination of interim operating results requires the estimation of income tax provision for the interim
periods. According to APB opinion No. 28, the amount of income tax charged to an interim period should be
related to the expected annual income tax provision. To estimate interim income tax, we need to determine the
effective tax rate for the entire current fiscal period at the end of each interim period. This effective tax rate is
applied into interim income. Interim income tax expense (or benefit) is computed as follows:
Year-to-date tax expense or benefit ----------------------------------------------------------- xxx

Less: cumulative amounts of tax reported in the
previous interim period ----------------------------------------------------------------- xxx
Interim income tax expense or benefit ------------------------------------------------------- xxx
The effect of permanent tax differences should be estimated in determining the estimated effective annual tax
rate. Permanent tax differences include:
Percentage of depletion
Nontaxable income
Non taxable expense
In determining the estimated effective annual tax rate, we need to exclude the tax effect of non-ordinary items of
income or loss because they are sold net of income tax effect. Non ordinary item of income or expense include:
• Extra ordinary items
• Discontinued operations
111
• Cumulative effect of changes in accounting principles
Illustration
Suppose that Stars Company has pretax income of Br. 130,000 at the end of the first quarter. Assume further that
at the end of the first quarter, Stars estimated that effective annual tax rate is 59%. What is income tax provision
for the first quarter?
Tax provision for the 1st quarter is equal to pretax income times estimated effective income tax rate. i.e.
Income tax provision = Pretax income x Estimated effective tax rate

= 130,000 x 59%
= 76,700
To illustrate further, Stars Company had a pretax income of Br. 180,000 for second quarter. Its estimated
combined effective tax rate is 55% at the end of the second year. Income tax provision for the second quarter is
the difference between year to date tax expense (or benefit) and cumulative amounts of tax reported in the
previous interim period. i.e
Cumulative pretax income year-to-date (130,000 + 180,000) -----------------310,000

Tax at estimated combined rate of 55% ------------------------------------------170,500
Less: Income tax accrued first-in the 1st quarter --------------------------------- 76,700
Income tax provision for the second quarter --------------------------------------93,800
The above process is repeated for the third and fourth quarters. The effect of a change in the estimated full year
tax rate is included in the tax provision of the second quarter. As a result, retroactive revision is not undertaken.
Journal Entries
1. To record Stars‟ 1st quarter income tax provision
Income taxes expense ------------------------76,700
Income taxes payable -------------------------76,700
2. To record Stars‟ 2nd quarter income tax provision
Income taxes expense -------------------------93,800
112
Income taxes payable --------------------------93,800
Tax benefit arises when operating result for the quarter turned to be a loss and the realization of tax benefit is
assured reasonably. If income tax benefit resulting from operating loss is not reasonably assured, it is not realized.
To illustrate, consider the following data for Stars Company in year 3.
Pretax income Estimated

Quarter Current Year to date tax rate for year
First -----------------Br. (40,000) Br. (40,000) 70%
Second -------------------30,000 (10,000) 70%
Third ---------------------70,000 60,000 70%
Fourth --------------------90,000 150,000 65%
Assume that tax benefits that arise from loss are not assured beyond a reasonable doubt.
Based on the above data, income tax provision for each quarter can be determined as follows:
Tax provision for quarter three:

Cumulative pretax income year to date ------------------------------------------------- 60,000
Tax at estimated combined rate (70% x 60,000) ---------------------------------------42,000
Less: Income tax accrued for the 1st and 2nd quarters -------------------------------------0
Income tax provision for the 3rd quarter ------------------------------------------------ 42,000
Tax provision for 4th quarter:

Cumulative pretax income ---------------------------------------------------------------150,000
Tax at estimated combined rate of 65% --------------------------------------------------97500
Less: Tax accrued for 1st, 2nd, & 3rd quarters -------------------------------------------42,000
Income tax provision ---------------------------------------------------------------------- 55,500
The manner in which tax provisions (tax benefits) are determined differs if tax benefits arising from loss are
assured reasonably. To illustrate, consider the above data for Stars Company assuming that the realization of tax
113
benefits from the 1st quarter was assured reasonably. Then tax benefits or expense for each quarter can be
determined as follows:
First Quarter
Cumulative pretax income ------------------------------------------------------ (40,000)
Tax at estimated effective rate of 70% (40,000 x 0.70)---------------------- (28,000)
Quarter two
Cumulative pretax income ----------------------------------------------------- (10,000)
Tax at estimated combined rate of 70% (10,000 x 0.70)-------------------- (7000)
Less: Tax benefit accrued for 1st quarter ------------------------------------ (28,000)
Tax benefit in 2nd quarter ------------------------------------------------------- 21000
3rd quarter
Cumulative pretax income ------------------------------------------------------ 60,000
Tax at estimated combined rate of 70% (60,000 x 0.70)-------------------- 42,000
Less: Tax benefits accrued for 1st & 2nd quarters ----------------------------(7,000)
Tax provision for 3rd quarter --------------------------------------------------- 49,000
4th quarter
Cumulative pretax income -------------------------------------------------------150,000
Tax at estimated combined rate of 65% (150,000 x 0.65)- --------------------97500
Less: Tax accrued for three quarters -------------------------------------------- 42,000
Income tax provision for 4th quarter ---------------------------------------------55,500
7.5.5 Reporting of accounting changes and extra ordinary and other non-operating items
7.5.5.1 Reporting extra ordinary and other non-operating items
Extra ordinary items are events or transactions that are distinguished by their unusual nature and by the
infrequency of their occurrence. Any loss arising from extra ordinary events are shown in the income statement,
net of income taxes. Extraordinary and unusual items are reported in full as they occur so that their impact is
immediately known i.e. they are shown in the income statement in the interim period in which they occur.
114
7.5.5.2 Reporting gains or losses from disposal of business segment
Business segment is a component of a business enterprise whose activities represent a separate major line of
business or class of customer. Any gain or loss on the disposal of the segment is reported separately in the income
statement, net of the related income tax effects. In interim reports, any gain or loss resulting from disposal of
segment is reported in full in the interim period it arises.
7.5.5.3 Reporting accounting changes in interim periods

Business enterprises are required to use accounting principles consistently so that the financial performance of
two periods can be compared. However, management of a business enterprise may justify a change in accounting
principles on grounds that it is preferable. There are three types of accounting changes. These are changes in
accounting principles, a change in accounting estimates, and a change in reporting entity.
A change in accounting principles generally requires the inclusion of the cumulative effect of change to a new
principle in net income of the accounting period in which the change is made. Change in accounting estimates
affect only the current and future periods‟ financial statements. With regards to reporting accounting changes in
interim period, there are two principal provisions.
1. Accounting changes in the First interim period

If a change of accounting principles 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 include in net
income of the first interim period.
2. Accounting changes in other than the first interim period of an enterprise.

If a change of accounting principle is made in other than the first interim period no cumulative effect of the
change shall be included in net income of the period of the change. Instead, financial information for the pre-
change interim periods of the fiscal year in which the change is made shall be stated by applying the newly
adopted accounting principle to those prechance 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.
115
7.5.6 Disclosure of summarized interim financial data
In order to be timely, interim financial reports may not be as detail as annual financial reports. However they
should contain at minimum the following information: for the current quarter, the current year-to date, or the last
12 months to date.
• Sales (or gross revenue),
• Provision for income taxes
• Extra ordinary items
• Cumulative effect of change in accounting principles
• Net income
• Earning per share data
• Seasonal revenue, costs, or expenses
• Significant changes in estimates or provision for income taxes
• Disposal of a business segment
• Contingent items
• Significant changes in financial position
Note that interim reports may not be prepared for the 4th quarter of the fiscal year. In such case, annual financial
reports should disclose the effects of the following for the fourth quarter:
• Disposal of a segment
• Extraordinary items
• Changes in accounting principles
• The aggregate effect of year-end adjustments that are material to the 4th quarter results.
Summary
The users of financial statements are interested in segment reporting in order to analyze and interpret the firm‟s
past performance and to make predictions regarding the firm‟s future prospects. Given certain guidelines, most
firms (except closely held companies) are required to report segment information.
All segments are not reportable. In order to determine the reportable segment, the firm‟s profit centers are the
focus. There are three types of tests in identifying a reportable segment; namely, revenue test, operating profit
test, and asset test. If the revenue of the segment is 10% or more of the combined revenue of all industry
segments, it is reportable.
116
According to profit test, a segment is said to be reportable if its operating profit or loss is 10% or more of the
combined if its operating profit or loss of all segments. On the other hand, using asset test, if the segment‟s
identifiable assets are 10% or more of the combined identifiable assets of all segments, the segment is reportable.
A segment is said to be dominant if its revenues, operating profit, and assets comprise more than 90% of the
firm‟s revenues, operating profits, and assets. In this case, only dominant segment is reportable.
Firm‟s operating on multinational basis are required to disclose their foreign operations and export sales if they
constitute 10% or more of the total revenues of the firm.
If a customer provides 10% or more revenue to the firm, it is called a major customer, and should be disclosed.
Annual financial statements normally do not provide decision makers with the timely data needed to make
decisions. Thus, external decision makers need financial data for shorter intervals of time. Interim financial
statements are provided to external users to meet their needs.
Interim financial statements may be prepared using the discrete period approach, and integral period approach.
The integral period approach is presently used for interim reporting purposes.
Revenues in interim reports are recognized on the same basis used for annual reports. Costs and expenses that are
associated with revenue are allocated to the products or service rendered. Another costs and expenses are charged
to the interim period based on time expired, benefits received, or activities associated with the interim period.
The income tax provision for an interim period should use an effective annualized tax rate. Extraordinary and
other non-operating items should be recognized in the interim period in which they occur.
117
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
Commercial Code of Ethiopia: Art. 44-55, Art. 210-257, Art. 280-303, and Art. 510-554,
Modern Advanced Accounting: E. John Larsen, Eighth edition.
Larsen and Mosich, Advanced Accounting, 2nd, 3rd and 4th ed.
Richard E. Baker et al., Advanced Accounting, McGraw-HILL, 1989.
Simons, Advanced Accounting,
118
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SIMPLIFIED LECTURE NOTE ON ADVANCED

Prepared by: Abebe Teka (Msc in Accounting and Finance)

7.3.Coverage of Segmental Reporting ……………………………………………………………..102

In this traditional form,

1.2. Accounting for a Joint Venture

1.2.2. Accounting for an Unincorporated Joint Venture

AB Company (A joint venture)

A Company B Company Combined

AB Company (A joint venture)

Liabilities & Venturers’ Capital

Dec 31 Investment in AB Company (Joint Venture) 250,000

1.3. ACCOUNTING FOR PUBLIC ENTERPRISES

1.4. Forms of Public Enterprises

Artificial legal persons

2.2. Accounting for Sales Agency

Illustration: Journal Entries for a Sales Agency

Imprest Cash Fund: Robe Agency 1,000

Trade Accounts Receivable 50,000

Cost of Goods Sold: Robe Agency 35,000

Operating Expenses: Robe Agency 10,000

Sales: Robe Agency 50,000

Income Summary: Robe Agency 5,000

2.3.1. Reciprocal Accounts

2.3.3. Billings of Merchandise to Branches

Billing at a percentage above cost

Billing at Retail Selling Prices

Illustrative Journal Entries of Operation of a Branch

Summarized transactions of year 1

2. Investment in Br X 60,000 Inventories 60,000

3. Equipment: Br X 500 Home Office 500

4. None Trade A/R 80,000

6. None Operating Exp 20,000

7. Cash 37,500 Home Office 37,500

8. Inv in Br X 3,000 Operating Exp 3,000

Adjusting and Closing Entries

Investment in Br X 12,000 Income Summary 12,000

Income Br X 12,000 None

2.3.4. Transaction between Branches

Investment in Branch Y 6,500

2.4. Combined Financial Statements

2.4.1. Working Paper for Combined Financial Statements

Adjusted TB Elimination Combined

Retained earnings, beginning of year 70,000

Allowance for Overvaluation of Inventories: Br X 22,500

Working Paper when Billing to Branches at Price above Cost

Adjusted TB Elimination Combined

2.6. Reconciliation of Reciprocal Accounts

Home Office 1,000

M COMPANY- HOME OFFICE AND A BRANCH

Realization of Gross Profit on Installment Sales

Accrual basis of accounting

Installment Method of Accounting

Dec 31 Cash 10,875

31 Deferred Gain on Installment Sales of Land 6,000

Illustration of Accounting for Installment Sales of Merchandise

Installment receivables-Yr 5 80,000 10,000 90,000

Recording Transactions and Events