Advanced Financial Accounting I

UNIT-ONE
Accounting for Joint Ventures
What is meant by a “joint venture”?
The term joint venture can describe a range of different commercial arrangements between two or
more separate entities. Each party contributes resources to the venture and a new business is
created in which the parties collaborate together and share the risks and benefits associated with
the venture. A party may provide land, capital, intellectual property, experienced staff, equipment or
any other form of asset. Each generally has an expertise or need which is central to the development
and success of the new business which they decide to create together. It is also vital that the parties
have a ‘shared vision’ about the objectives for the JV.

A joint venture is a contractual arrangement whereby two or more parties undertake an economic
activity that is subject to joint control. A venturer is a party to a joint venture and has joint control
over that joint venture.

Joint control is the contractually agreed sharing of control over an economic activity, and exists
only when the strategic financial and operating decisions relating to the activity require the
unanimous consent of the parties sharing control (the venturers).

Contractual arrangement

The contractual arrangement may be evidenced in a number of ways, for example by a contract
between the venturers or minutes of discussions between the venturers. In some cases, the
arrangement is incorporated in the articles or other by-laws of the joint venture. Whatever its form,
the contractual arrangement is usually in writing and deals with such matters as:
a) the activity, duration and reporting obligations of the joint venture;
b) the appointment of the board of directors or equivalent governing body of the joint venture
and the voting rights of the venturers;
c) capital contributions by the venturers; and
d) the sharing by the venturers of the output, income, expenses or results of the joint venture.

A JV involves risk sharing; it is suitable where a jointly owned and managed business offers the
best structure for the management and mitigation of risk and realisation of benefits whether they
involve asset exploitation, improved public sector services or revenue generation. It should not be
seen as a delivery model in which the public sector seeks to transfer risk to the private sector
through the creation of an arm’s length relationship.
A joint venture is usually a temporary partnership without the use of a firm name, limited to
carrying out a particular business plan in which the persons concerned agree to contribute capital
and to share profits or losses. The parties in a joint venture are known as co-venturers and their
liability is limited to the adventure concerned for which they agree to contribute capital and share
profits or losses. Joint venture agreements can be made for other similar transactions, e.g,
 Joint consignment of goods

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  Underwriting of shares or debentures issued by a company
 Purchasing and selling of a specific property
 Production of a motion picture
 Construction of huge projects

Why enter into a JV?

There are many reasons why a business might consider entering into a JV. Some of the reasons are:
Access to resources, Shared risk, Flexibility, New market penetration, etc

Common reasons for failure

Before entering into a JV, the parties should ensure their understanding of the project, commercial
expectations and culture are as aligned as possible. The most common causes of unsuccessful JVs
can be grouped into the following categories: Mismatch of objectives, Cultural mismatches,
Imbalance in levels of expertise, investment or assets, etc
Features of a Joint venture
The main features of a joint venture are specifically made clear.
 Two or more person are needed.
 It is an agreement to execute a particular venture or a project.
 The joint venture business may not have a specific name.
 It is of temporary nature. So the agreement regarding the venture automatically stands termi-
nated as soon as the venture is complete.
 The co-ventures share profit and loss in an agreed ratio. The profits and losses are to be
shared equally if not agreed otherwise.
 The co-ventures are free to continue with their own business unless agreed otherwise during
the life of joint venture.

Differences between Joint venture, Partnership and Consignment

In joint venture and partnership some business is carried on by two or more persons and the
profits are shared by all of them. But there are some basic differences between the two which
are given below:
Point of Joint Venture Partnership
difference
Meaning Joint Venture is a business formed by A business arrangement where two
two or more than two persons for a or more persons agree to carry on
limited period and a specific purpose. business and have mutual share in
the profits and losses, is known as
Partnership.
Ascertainment At the end of the venture or on interim Annually
of Profit basis as the case may be.
Business Co-venturers Partners
carried on by
Basis of Liquidation Going Concern

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 Accounting
Trade Name No Yes

Difference Between Joint Venture and Consignment

The main differences between joint venture and consignment are as follows:
Point of Joint Venture Consignment
difference
Nature It is a temporary partnership It is an extension of business by
business without a firm name. principal through agent
2. Parties The parties involving in joint Consignor and consignee are
venture are known as co-ventures involving parties in the
consignment.
3. Relation The relation between co-ventures is The relation between the
just like the partners in partnership consignor and consignee is
firm. 'principal and agent'.
4. Sharing Profit The profits and losses of joint The profits and losses are not
venture are shared among the co- shared between the consignor and
ventures in their agreed proportion. consignee. Consignee gets only
the commission
5. The co-ventures in a joint venture In consignment, the consignor
Rights have equal rights enjoys principal's right whereas
consignee enjoys the right of
agent.
7. Ownership All the co-ventures are the owners The consignor is the owner of the
of the joint venture. business.
9. Basis of Cash basis of accounting is Actual basis is adopted in
Account applicable in joint venture. consignment
10.Continuit As soon as the particular venture is The continuity of business exists
y completed, the joint venture is according to the willingness of
terminated. both consignor and consignee.
6. Exchange of The co-ventures exchange the The consignee prepares an
Information required information among them account sale which contains a
regularly. details of business activities
carried on and is being sent to the
consignor.

Forms of joint venture

Joint ventures take many different forms and structures. This Standard identifies three broad types:
jointly controlled operations, jointly controlled assets and jointly controlled entities, that are

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commonly described as, and meet the definition of, joint ventures. The following characteristics are
common to all joint ventures:
a) two or more venturers are bound by a contractual arrangement; and
b) the contractual arrangement establishes joint control.

Jointly controlled operations

The operation of some joint ventures involves the use of the assets and other resources of the
venturers rather than the establishment of a corporation, partnership or other entity, or a financial
structure that is separate from the venturers themselves. Each venturer uses its own property, plant
and equipment and carries its own inventories. It also incurs its own expenses and liabilities and
raises its own finance, which represent its own obligations. An example of a jointly controlled
operation is when two or more venturers combine their operations, resources and expertise to
manufacture, market and distribute jointly a particular product, such as an aircraft. Different parts
of the manufacturing process are carried out by each of the venturers.

Jointly controlled assets

Some joint ventures involve the joint control, and often the joint ownership, by the venturers of one
or more assets contributed to, or acquired for the purpose of, the joint venture and dedicated to the
purposes of the joint venture. The assets are used to obtain benefits for the venturers. Each venturer
may take a share of the output from the assets and each bears an agreed share of the expenses
incurred.

These joint ventures do not involve the establishment of a corporation, partnership or other entity,
or a financial structure that is separate from the venturers themselves. Each venturer has control
over its share of future economic benefits through its share of the jointly controlled asset. Many
activities in the oil, gas and mineral extraction industries involve jointly controlled assets. For
example, a number of oil production companies may jointly control and operate an oil pipeline.
Each venturer uses the pipeline to transport its own product in return for which it bears an agreed
proportion of the expenses of operating the pipeline.

Jointly controlled entities

A jointly controlled entity is a joint venture that involves the establishment of a corporation,
partnership or other entity in which each venturer has an interest. The entity operates in the same
way as other entities, except that a contractual arrangement between the venturers establishes joint
control over the economic activity of the entity.

A jointly controlled entity controls the assets of the joint venture, incurs liabilities and expenses and
earns income. It may enter into contracts in its own name and raise finance for the purposes of the
joint venture activity. Each venturer is entitled to a share of the profits of the jointly controlled
entity, although some jointly controlled entities also involve a sharing of the output of the joint
venture.

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Equity method of accounting
A joint venturer is required to recognize its interest in a joint venture as an investment and shall
account for that investment using the equity method in accordance with IAS 28 Investments in
Associates and Joint Ventures unless the entity is exempted from applying the equity method.
Under the equity method, on initial recognition the investment in an associate or a joint venture is
recognized at cost and the carrying amount is increased or decreased to recognize the investor’s
share of the surplus or deficit of the investee after the date of acquisition. The investor’s share of the
investee’s surplus or deficit is recognized in the investor’s surplus or deficit. Distributions received
from an investee reduce the carrying amount of the investment. Adjustments to the carrying amount
may also be necessary for changes in the investor’s proportionate interest in the investee arising
from changes in the investee’s equity that have not been recognized in the investee’s surplus or
deficit. Such changes include those arising from the revaluation of property, plant and equipment
and from foreign exchange translation differences. The investor’s share of those changes is
recognized in net assets/equity of the investor.

An investment in an associate or a joint venture accounted for using the equity method shall
be classified as a non-current asset.

Application of the Equity Method

An entity with joint control of, or significant influence over, an investee shall account for its
investment in an associate or a joint venture using the equity method except when that investment
qualifies for exemption.

Exemptions from Applying the Equity Method

An entity need not apply the equity method to its investment in an associate or a joint venture if the
entity is a controlling entity that is exempt from preparing consolidated financial statements by the
scope exception

a) The entity itself is a controlled entity and the information needs of users are met by its
controlling entity’s consolidated financial statements, and, in the case of a partially owned
entity, all its other owners, including those not otherwise entitled to vote, have been
informed about, and do not object to, the entity not applying the equity method.
b) The entity’s debt or equity instruments are not traded in a public market (a domestic or
foreign stock exchange or an over-the-counter market, including local and regional
markets).
c) The entity did not file, nor is it in the process of filing, its financial statements with a
securities commission or other regulatory organization, for the purpose of issuing any class
of instruments in a public market, etc

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 Chapter Two
Accounting for Sales Agency, Branch, and Division
Introduction
Accounting for the operation of a business can become complicated whenever geographical
separation is encountered between the various facets of the organization. This unit examines the
special procedures necessary to record transactions occurring at significant distances from a central
office. Branch accounting is analyzed with illustrative examples.

Distinguishing Sales Agency, Branch, and Division

Sales Agency:
Sales agency is a term applied to a business unit that performs only a small portion of the functions
associated branch. A sales agency usually carries samples of products but does not have an
inventory of merchandise and usually lesser degree of autonomy.

Branch:
The term Branch is used to describe a business unit located at some distance from the Home Office.
Branches are economic and accounting entities. However, branches are not legal entity. Branches
may carry merchandise obtained from Home Office, make sales, approve customers’ credit, and
make collections from its customers.

Division:
Division is a business segment or a business enterprise which generally has more autonomy than a
branch. Division may be as separate company or may not be a separate company. If the division is
not a separate company, the accounting procedures are the same as Branch. If the division is a
separate company (subsidiary company), the financial accounting requires consolidation.
Differences between Sales Agency, Branch and Division
Characteristics Sales Agency Branch Division
Degree of Autonomy Low Moderate High
Accounting Entity No Yes Yes
Legal Entity No No Possible
Economic Entity No Yes Yes

Accounting System 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. For example, a sales agency usually carries
samples of products but does not have an inventory of merchandise. Orders are taken from
customers and transmitted to the Home Office, which approves the customers’ credit and ships the
merchandise directly to customers. The agency’s accounts receivable are maintained at the Home
Office, which also performs the collection function. An imprest cash fund generally is maintained at
the sales agency for the payment of operating expenses. A sales agency that does not carry an

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inventory of merchandise, maintain receivables, or make collections has no need for a complete set
of accounting records.
Overview of Branch accounting
The extensive use of branch operations is especially common in modern retailing where companies
attempt to attract customers by offering the convenience of numerous outlets. Relative small
companies often attempt to expand their market base by establishing additional outlets in nearby
communities. This type of internal division is not even restricted to the retail function. Branch
operations are commonly found in banking as well as in manufacturing and other industries.

Branches of an enterprise are not separate legal entities; they are separate economic and accounting
entities whose special features necessitate accounting procedures tailored for those features, such as
reciprocal ledger accounts. A branch may obtain merchandise solely from the home office, or a
portion may be purchased from outside suppliers. The cash receipts of the branch often are
deposited in a bank account belonging to the home office; branch expenses then are paid from a
bank account provided by the home office. P/

Accounting systems
The home office must decide how to account for the activities and transactions of the branches.
Accounting systems can be categorized as either centralized or decentralized.
Centralized Accounting
Under a centralized accounting system, a branch does not maintain a separate general ledger in
which to record the transaction. Instead, it sends source documents on sales, purchases, and payroll
to the home office. Centralized accounting systems are usually practical when the operations of the
branches do not involve complex manufacturing operations or extensive retailing or service
activities.
Decentralized Accounting
Under a decentralized accounting system, a branch maintains a separate general ledger in which to
record its transactions. Thus, the branch is a separate accounting entity, even though it is not a
separate legal entity. It prepares its own journal entries and financial statements, submitting later on
to the head office, usually on a monthly basis. The number and types of ledger accounts, the internal
control structure, the form and content of the financial statements, and the accounting policies
generally are prescribed by the home office.

Branch general ledger accounting

Intra Company/reciprocal ledger Accounts
A branch is established when a home office transfers cash, inventory, or other assets to an outlying
location. Because the home office views the assets transferred to the branch as an investment, it
makes the following entry:
Investment in branch - - - - - - - - - - - - - - - xx
Asset (s) - - - - - - - - - - - - - - - - - - - - xx

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On receipt of the assets from the home office, the branch makes the following entry:
Asset(s) - - - - - - - - - - - - - - - - - - - - - - xx
Home office equity - - - - - - - - - - - - - - xx
The balance in the Investment in Branch account on the books of the home office always equals the
balance in the Home Office Equity account on the books of the branch. In practice, these accounts
are referred to as the Intra Company or reciprocal accounts.

The home office equity account is a quasi-ownership equity account that shows the net investment
by the home office in the branch. Investment in branch is a non-current asset account. It is debited
for cash, merchandise, and services provided to the branch by the home office, and for net income
reported by the branch. And it is credited for cash or other assets received from the branch, and for
net loss reported by the branch. A separate investment account generally is maintained by the home
office for each branch.
Home Office Allocations
The home office usually arranges and pays for certain expenses that benefit the branches. The most
common example is insurance, advertisement, etc. In theory, some portion of the insurance expense
should be allocated to the various branches, so that the home office may determine the true
operating income or loss of each branch. In practice, however, allocation of home office expenses
varies widely. Numerous home offices allocate only those expenses that relate directly to the
branch operations, such as insurance. Some home offices without any revenue producing
operations of their own allocate all of their expenses to the branches.
An expense incurred by the home office and allocated to the branch is recorded by the home office:
Investment in branch………………………..xx
Appropriate expense account…………………..xx
The branch debits an expense account and credits home office account.

Inventory Transfer Accounts

When inventory is transferred from the home office to a branch, all that has really happened is that
the inventory has physically moved from one location in the company to another. A sale has not
occurred, because sales takes place only between the company and outside customers. To measure
the profitability of a branch, however, an intra company billing must be prepared. The branch uses
special purchase account called Shipment From Home office to record these inventory transfers and
makes the following entry:
Inventories (Shipments from home office) - - - - - - xx
Home office equity - - - - - - - xx
The home office uses a special contra purchases account called Shipments to Branch to record
inventory transfers. If the inventory is transferred and billed at the home office’s cost, the home
office makes the following entry:
Investment in branch - - - - - - - - - - - - - xx

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 Inventories (Shipments to branch) - - - - - - - - - - - - - - xx

Fixed Asset Accounts

Some home offices require their branches-fixed assets to be recorded on the books of the home
office instead of the books of the branches. Such a procedure automatically ensures that uniform
depreciation methods and asset lives are used for all branches. If plant asset is acquired by the
home office for the branch, the journal entry for the acquisition is: debit to an appropriate asset
account and credit to cash or an appropriate liability account. If the branch acquires a plant asset, it
debits the home office ledger account and credits cash or appropriate liability account. The home
office debits an asset account and credits investment in branch account.
The home office usually charges the branch for the depreciation expense of its fixed assets. It does
this by crediting accumulated depreciation and debiting the Investment in branch account instead of
debiting depreciation expense. The branch debits depreciation expense and credits the Home office
Equity account instead of crediting accumulated depreciation.

Transactions between branches

Efficient operations may on occasion require that merchandise or other assets be transferred from
one branch to another. Generally, a branch does not carry a reciprocal ledger account with another
branch but records the transfer in home office ledger account. The transfer of merchandise from one
branch to another branch does not justify increasing the carrying amount of inventories by the
freight costs incurred because of in direct routing. The amount freight costs properly included in
inventories at a branch is limited to the cost of shipping the merchandise directly from the home
office to its present location. Excess freight costs are recognized as expenses of the home office.

Separate financial statements for branch and home office

A separate income statement and balance sheet should be prepared for a branch so that management
of the enterprise may review the operating results and financial position of the branch. The separate
financial statements prepared for a branch may be revised at the home office to include expenses in-
curred by the home office allocable to the branch and to show the results of branch operations after
elimination of any inter company profits on merchandise shipments.
Separate financial statements also may be prepared for the home office so that management will be
able to appraise the results of its operations and its financial position. However, it is important to
emphasis that separate financial statements of the home office and of the branch are prepared for in-
ternal use only; they do not meet the needs of investors or other external users of financial state-
ments.

1.2. Combined financial statements for home office and branch

In preparation of a combined balance sheet, similar accounts are combined to produce a single total
amount for cash, trade account receivable, and other assets and liabilities of the enterprise as a
whole. However, reciprocal ledger accounts are eliminated because they have no significance when

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the branch and home office report as a single entity. The balance of the home office account is off -
set against the balance of the investment in branch account; also any receivable and payables be -
tween the home office and the branch (or between two branches) are eliminated. The operating re-
sults of the enterprise (the home office and all branches) are shown by an income statement in
which the revenue and expenses of the branches are combined with corresponding revenue and ex-
penses for the home office. Any intra company profits or losses are eliminated.

Chapter 3
IAS 12: Income Taxes
Learning Objectives
At the completion of studying this Standard, you will be able to:
 Define tax base and carrying amount
 Explain the difference between taxable income and accounting income
 Determine the temporary taxable and deductible difference
 Calculate the deferred taxes
 Identify the presentation and disclosure requirements related to income taxes
Basic Concepts
 Accounting profit: It is profit or loss for a period determined in accordance with IFRS
 Taxable profit (tax loss): It is the profit (loss) for a period, determined in accordance with
income tax law

Difference between AI and TI

Permanent Temporary

Deductible Taxable

IAS 12: Accounting for Taxation

 The amount of revenues and expenses recognized on P/L statement in a given period for tax-
ation purposes (as per tax rule) may differ from what is reported as per the accepted Ac -

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 counting Standards. Similarly the carrying amount of assets and liabilities reported on
SOFP as per the accepted accounting standards may differ from the tax base of these
amounts.
 These differences are resulted from the difference between the Tax rule and Accounting
standards.

As per IAS 12, income Tax Expense (benefit) consists two different taxes:
1. Current tax: The amount of income taxes payable (recoverable) in respect of the taxable profit
(tax loss) for a period.
2. Deferred tax represents taxes payable/recoverable in future periods in relation to transactions
which have taken place.
-Deferred tax Payable (deferred Tax Liability)
-Deferred tax Recoverable (deferred Tax Asset)
Is deferred tax an amount levied by government? Deferred tax is an accounting measure, rather
than a tax levied by government; used to match the tax effects of transactions with their accounting
impact and thereby produce less distorted results.

Basic Concepts in IAS 12

IAS 12 does not provide rules for computing current tax (since it is the taxation rule in each
jurisdiction that is applied to compute current tax). But IAS 12 requires a tax liability to be
recognized where an entity has unpaid current tax, whether it arises from current/prior periods.

 any unpaid tax in respect of the current or prior periods to be recognized as a liability.

IAS 12 also requires a tax asset to be recognized where an entity has overpaid its tax liabilities

 any excess tax paid in respect of current or prior periods over what is due should be
recognized as an asset

If current taxes payable > taxes paid, there will be Income taxes payable (liability)

If current income taxes payable < taxes paid, there will be Income taxes recoverable/receivable
(asset)

It is inherent in the recognition of an asset or liability that the reporting entity expects to recover or
settle the carrying amount of that asset or liability. This concept applies to taxes as follows:

 Tax Liability-Like any other liability it is recognized as a result of past transaction, ex-
pected to result in future probable outflow of economic benefit, measurable, controlled by
entity
 Tax Asset-Like any other asset it is recognized as a result of past transaction, expected to
provide probable future economic benefit, measurable, controlled by entity

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Measurement of Current tax liabilities (assets)
Current tax liabilities (assets) for the current and prior periods shall be measured: at the amount
expected to be paid to (recovered from) the taxation authorities, by using the tax rates (and tax
laws) that have been enacted or substantively enacted by the end of the reporting period.

Normally, current tax is recognized as income or expense and included in the net profit or loss for
the period.
Accounting for operating losses
Recognition of benefit from Tax Loss (Pre-tax Operating Loss) as an Asset
IAS 12 requires recognition as an asset of the benefit relating to any tax loss (Pre-tax Operating
Loss) that can be carried back to recover current tax of a previous period.

Usually, the tax code allows companies that report operating losses to claim a tax credit related to
these losses for taxes paid in the past (referred to as “carrybacks”) and
– to offset taxable income in periods following the operating loss (referred to as “car-
ryforwards”).
– An asset should be recognized in the period in which the loss is made
Therefore, an operating loss is used to offset either the Taxable Past Income or Taxable Future
Income (Carried Backward and Carried Forward). An operating loss occurs for tax purposes in a
year when tax deductible expenses exceed or greater than the taxable revenues (long term
projects/%completion method).
 Loss Carry Backward and Carry forward can create a difference in taxable income and ac-
counting income.

Recognition of Current tax when Accounting Income differs from Taxable

Income
1. Accounting profit: Net profit or loss for a period before deducting tax expense. It is a fi-
nancial reporting term. It is also often referred to as pre tax accounting profit/income be-
fore taxes, income for financial reporting purposes, or income for book purposes. Compa-
nies determine accounting profit according to accepted accounting standards/rules. They
measure it with the objective of providing useful information to investors and creditors.
2. Taxable profit (tax loss). The profit (loss) for a period, determined in accordance with
the rules established by the taxation authorities, upon which income taxes are payable (re-
coverable). It is a tax accounting term. It is also known as income for tax purposes. It
indicates the amount used to compute income taxes payable. Companies determine taxable
income according to the Internal Revenue Code (the tax code).

Presentation of current tax liabilities and assets

In the statement of financial position, tax assets and liabilities should be shown separately from
other assets and liabilities. The tax expense (income) related to the profit or loss from ordinary
activities should be shown in the statement of comprehensive income (i.e.. P/L statement)

Recognition of Deferred Tax Liabilities and Assets

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When accounting Income & taxable income differs due to temporary/timing difference, there will
be a difference between:
 tax expense reported on P/L statement and
 tax payable reported on SOFP
1. Amount of Tax Expense Reported on P/L Statement:
Tax expense is calculated based on accounting profit adjusted for permanent difference.
Tax Expense= Tax rate x Accounting profit adj. for P/Diff.
2. Amount of Tax Payable/liability reported on SOFP:
Tax liability is computed by applying tax rate on Taxable income
Tax Liability=Taxable income x Tax Rate

Temporary differences will result In recording deferred taxes,(deferred tax liability/asset).

Accounting profit is thus not the same as taxable profit. The variation is caused by the difference
between accounting principles of revenue and expense recognition and taxation principles. The
differences may be due to:
1) Permanent difference: This results from items that enter in computing accounting income
but not considered in computing taxable income Eg. Entertainment, donation
2) Temporary Difference/Timing difference: This results from timing difference in recognizing
an item as revenue/expense on P/L and asset/liability on SOFP due to the difference in
methods applied by tax authorities and accounting regulation. Temporary difference will re-
sult in deferred tax.
1. Permanent Differences
Some items of revenue and expense that a corporation reports for financial accounting purposes are
never reported for income tax purposes. These permanent differences never reverse in a later
accounting period. For example, Entertainment expense, Donation
2. Temporary differences:
These are differences between the carrying amount of an asset or liability in the SOFP and its
tax base. In other words, where carrying amount of an asset or liability is different from the tax base
a ‘temporary difference’ arises.
Carrying amount vs. tax base of asset or liability
Carrying amount is the amount the asset or liability is recorded at in the accounting records.
Tax base : -is the amount attributed to an asset or liability for tax purposes
- It represents the amount an asset or liability would be recorded at, if the
SOFP were prepared applying taxation rules.
Sources of Temporary differences
 Differences in depreciation method for Financial reporting & for tax purpose (effect is
shown on P/L statement)
 Revenue from the sale of goods is included in accounting profit when goods are delivered
but is included in taxable profit when cash is collected.
 An entity revalues property, plant and equipment (under the revaluation model treatment in
IAS 16 PPE) but no equivalent adjustment is made for tax purposes.

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  Prepaid expenses have already been deducted on a cash basis in determining the taxable
profit of the current or previous periods.
Temporary differences may be either: Taxable temporary differences or Deductable temporary
differences
1. Taxable temporary differences:
This results in an increase in future taxable amount as asset is recovered/liability is settled
-Creates a liability - Deferred tax liability
A deferred tax liability is the deferred tax consequences attributable to taxable temporary
differences. In other words, a deferred tax liability represents the increase in taxes payable in
future years as a result of taxable temporary differences existing at the end of the current
year.
2. Deductable temporary differences
Deductable temporary difference (Future taxable amount decrease) -This results in a decrease in
future taxable amount when asset is recovered/liability is settled
-Creates an asset - Deferred tax Asset
Deferred tax Asset is the deferred tax consequence attributable to deductible temporary differences.
In other words, a deferred tax asset represents the increase in taxes refundable (or saved) in
future years as a result of deductible temporary differences existing at the end of the current
year.

Presentation
 Current tax payable is always shown as a current liability.
 Deferred tax items cannot be shown as current assets or current liabilities.
 Current and deferred tax balances are to be shown as separate items (offsetting is not al -
lowed).
 Deferred tax assets or liabilities should not be discounted
Disclosure
 current tax expense (or income);
 any adjustments recognized in the period:
 for current tax of prior periods;
 from a previously unrecognized tax loss
 from a previously unrecognized temporary difference
 the amount of deferred tax expense (or income)
 an explanation of the relationship between tax expense (or income) and accounting profit
 a numerical reconciliation between the average effective tax rate and the applicable tax rate

CHAPTER FOUR
SHARE BASED PAYMENTS (IFRS 2)
INTRODUCTION
Relevant and faithfully represented financial information about an entity's share based payment
transactions is useful to existing and potential investors, creditors and employee in making
decisions about providing goods or services to the entity.

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SCOPE OF IFRS 2
IFRS 2 applies to transactions in which;
 Share or other equity instruments are issued in return for goods or services (eg. Employee
share options)
 The payment amount is based on the price of entity's shares (eg. Share appreciation rights)
IFRS 2 doesn’t apply to shares or other equity instruments issue as a consideration for business
combination

Objectives
The objective of this IFRS is to specify the financial reporting by an entity when it undertakes a
share-based payment transaction.
In particular, it requires an entity to reflect in its profit or loss and financial position the effects of
share-based payment transactions, including expenses associated with transactions in which share
options are granted to employees.
Definition
Share based payment?
It is an agreement between the entity and another party (suppliers, employee) to made payments
based on shares or share prices.
Or payment for goods or services in either:
 Shares
 Share options
 Cash payment based on share price
Share option: is the right to buy a certain number of shares at a fixed price, some period of time in
the future with in the company.
RECOGNITION OF SHARE BASED BAPMENT
Share based payment will be recognized when goods are obtained or services are received.
How share based payment will be recognized?
There are two alternatives;
The entity shall recognize a corresponding increase in
equity if the goods or services were received in an equity-settled share-based payment transaction,
Asset/expense . . . . Xx
Equity . . . . . . . . . . . . xx
or a liability if the goods or services were acquired in a cash-settled share-based payment
transaction.
Asset/expense . . . . . . xx
Liability . . . . . . . . . . . . . xx
Measurement of share based payments - Equity Settled
The entity shall measure the goods or services received at the fair value of the goods or services
received at the measurement date.
If the entity cannot estimate the fair value of goods or services received reliably , measure at the
fair value of equity instrument at the grant date.
For employee it might be difficult to measure the fair value services and, instead can use fair value
of equity instruments granted.

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Important terminologies
Grant date: today, a date where an agreement is made between an entity and employee to receive
cash or share options.
Vesting date: Employees become entitled to the share based payment. ( no of years from the grant
date will be indicated or other vesting conditions).
Exercise date: employee receives share based payment.

No vesting condition, non employee

Eg1. Entity ABC acquires inventories with a fair value of $100,000 and issues 100 shares to its
supplier as consideration. The inventories are received by Entity ABC on 1 April 2022 when Entity
ABC’s share price is $1200.
ABC recognizes the following journal entry on 1 April 2022:
Inventories …… $100,000
Equity . . . . ……$100,000
If Entity ABC cannot reliably estimate the fair value of the inventories on 1 April 2022, the journal
entry on 1 April 2022 will be:
Inventories . . . . . $120,000
Equity . . . . . . $120,000
Employee with no vesting condition
Eg2. Entity A contracted a consultant to advice on a new marketing campaign. The consultant
agreed to accept ordinary shares of Entity A as payment for his services. The consultant advice had
an invoice price of $ 3,000 and Entity A issued 100 ordinary shares with a par value of $10 each.
The entity determines that the invoice value of the consultant fees is the best estimate of the fair
value of the marketing advice. Consequently, Entity A accounts for the transaction as follows:
marketing expense……………..$3,000
ordinary share capital……………………………………… …………$1,000
Equity share premium account . . . . …………………………………..$2,000

Vesting conditions, employee service

Eg3. Entity B grants 100 share options to each of its 500 employees. Each grant is conditional upon
the employee working for the entity over the next three years. The entity estimates that, on the date
of grant, the fair value of each share option is $15. On the basis of a weighted-average probability,
the entity estimates that 20% of employees will leave during the three-year period and therefore
forfeit their rights to the share options.
If everything turns out exactly as expected, Entity B makes the following entries in the years during
the vesting period, for services received as consideration for the share options.
Year 1
staff compensation expense . . . . . $200,000
Equity . . . . . . . . . . . . . $200,000
(To recognize the receipt of employee services in exchange for share options)
Calculation: 50,000 options granted × 80% = 40,000 options expected to vest. 40,000 × $15 grant
date fair value of each option × 1/ 3 of vesting period elapsed = $200,000 recognized in Year 1, 2
&3
The facts are the same as in Example 21. However, in this example not everything turns out exactly
as expected. In particular:
 During Year 1, 20 employees leave.

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  At the end of Year 1 the entity revises its estimate of total employee
departures over the three-year period from 20% (100 employees) to 15% (75
employees).
 During Year 2, a further 22 employees leave.
 At the end of Year 2 the entity revises its estimate of total employee
departures over the three-year period from 15% to 12% (60 employees).
 During Year 3, a further 15 employees leave (i.e a total of 57 employees
forfeited their rights to the share options during the three-year period, and a
total of 44,300 share options (443 employees × 100 options per employee)
vested at the end of Year 3.
 Entity B records the equity compensation scheme using the following entries.
Year1
staff compensation expense . . . . . $212,500
Equity . . . . . . . . . . . . . $212,500
i.e: 50,000 options granted × 85% = 42,500 options expected to vest. 42,500 × $15 grant
date fair value of each option × 1/ 3 of vesting period elapsed = $212,500 recognized in
Year 1.
Year 2

Staff compensation expense . . . . . $227,500

Equity . . . . . . . . . . . . . $227,500
i.e: 50,000 options granted × 88% = 44,000 options expected to vest. 44,000 × $15 grant
date fair value of each option × 2/ 3 of vesting period elapsed = $440,000 recognized cumu-
latively to the end of Year 2. $440,000 less $212,500 recognized in Year 1 = $227,500 rec-
ognized inYear 2
 Year3
staff compensation expense . . . . . $224,500
Equity . . . . . . . . . . . . . $224,500

i.e: 44,300 options vested × $15 grant date fair value of each option × 3/ 3 of vesting period
elapsed = $664,500 recognized cumulatively to the end of Year 3. CU664,500 less $227,500
recognized in Year 2 less $212,500 recognized in Year 1 = $224,500 recognized in Year 3

(To recognize the receipt of employee services in exchange for share options)

Measurement of share based payment transactions – cash settled

Cash-settled share-based payment transactions, the entity shall measure the goods or services
acquired and the liability incurred at the fair value of the liability, subject to re -measurement until
the liability is settled.
The entity shall remeasure the fair value of the liability at the end of each reporting period and
recognized the change in profit or loss for the period.
Possible adjustment to the liability should be made at each reporting date, i.e;

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 Liability . . . . . .xx
Fair value adjustment (gain) . . . .xx
Or
Fair value adjustment (loss) . . . . . Xx
Liability . . . . . . . . xx
Disclosure
An entity shall disclose the following information about the nature and extent of
share-based payment arrangements that existed during the period:
 method of settlement
 Vesting conditions
 Method of measurement for liability and equity

Chapter Five
Agricultural activity (IAS 41)
This Standard shall be applied to account for the following when they relate to agricultural activity:
(a) biological assets; and
(b) agricultural produce at the point of harvest.
This Standard does not apply to:
 Land related to agricultural activity (see IAS 16 Property, Plant and Equipment and IAS 40
Investment Property).
 intangible assets related to agricultural activity (see IAS 38 Intangible Assets).
 Harvested agricultural produce (IAS 2, Inventory). However, it does apply to produce grow-
ing on bearer plants.
 Bearer plants related to agricultural activity (see IAS 16). However, IAS 41 applies to the
produce on those bearer plants.
 Government grants related to bearer plants (see IAS 20 Accounting for Government Grants
and Disclosure of Government Assistance).
Agricultural activity is the management by an enterprise of the biological transformation of bio-
logical assets for sale, into agricultural produce or into additional biological assets.
Terminology
 Biological asset (classified as a non-current asset) is a living animal or plant, such as sheep,
cows, fruit trees, or cotton plants.
 Agricultural produce is the harvested product of a biological asset, such as wool from a
sheep, milk from a dairy cow, picked fruit from a fruit tree, or cotton from a cotton plant.
 Harvest – is detachment of produce from a Biological asset or the cessation of biological
asset’s life.
 Entity A raises cattle, slaughters them at its abattoirs and sells the carcasses to the
local meat market. Which of these activities are in the scope of IAS 41?
Example 1
The cattle are biological assets while they are living. When they are slaughtered, biological
transformation ceases and the carcasses meet the definition of agricultural produce. Hence, Entity A

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should account for the live cattle in accordance with IAS 41 and the carcasses as inventory in
accordance with IAS 2 Inventories.

Recognition and measurement Biological asset

Initial measurement is:
 At Fair value less any estimated 'point of sale' costs
 If there is no fair value, then use the cost model
• This alternative basis is only allowed on initial recognition.
Subsequent measurement of Biological assets:
• Revalue to fair value less point of sale costs (net realizable value) at year end, taking any
gain or loss (changes in the NRV) to the statement of profit or loss.
Agricultural produce
• At the date of harvest the produce should be recognized and measured at fair value less esti-
mated costs to sell (NRV).
• Gains and losses on initial recognition are included in profit or loss (profit from operations)
for the period.
• After produce has been harvested:
 IAS 41 ceases to apply.
 Agricultural produce should be classified as inventory in the statement of financial position.
 Fair value less costs to sell at the point of harvest is taken as cost for the purpose of IAS 2
Inventories, which is applied from then onwards.
Fair value
Biological assets are measured at fair value less cost to sale and changes in fair value less cost to
sale are reported as part of profit for the period in the SPL.
 This means that a farmer’s profit for the year reflects:
 the increase in the value of his productive assets as a whole, as well as
 the profit on any sales made during the year.
Bearer plants
 Bearer plants are accounted for under IAS 16 Property, Plant and Equipment, rather than
IAS 41 Agriculture. A bearer plant is a living plant that:
 is used in the production or supply of agricultural produce;
 is expected to bear fruit for more than one period &
 Is unlikely that entity will harvest the plant as agricultural produce
 Therefore, items such as vines, tea bushes and fruit trees may be classed as bearer plants and
treated as property, plant and equipment rather than being accounted for under IAS 41 Agri-
culture.
Disclosures
 An entity shall disclose the aggregate gain or loss that arises on the initial recognition of bio-
logical assets and agricultural produce and the change in Fair value less estimated point-of
sale costs of the biological assets.

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  A description of each group of biological assets is also required.
 The methods and assumptions applied in determining fair value should also be disclosed.

CHAPTER SIX
INSURANCE CONTRACTS (IFRS 17)
Objectives of IFRS 17
• To establish principles for the recognition, measurement, presentation and disclosure of
insurance contracts.
• To ensure that an entity provides relevant information that faithfully represents those
contracts. This enables the users to assess the effect of insurance contracts on the financial
performance, financial position and cash flows of the company
Insurance contract: is A contract under which one party (the insurer) accepts significant insurance
risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified
uncertain future event (the insured event) adversely affects the policyholder.

Models for treatment of insurance contracts

As per IFRS 17 there are three allowable models
1. GMM (General Measurement Model): is default model.
2. PAA (Premium allocation Approach): for the insurance company which gives mainly short
term insurance services.
VFA (Variable Fee Approach): for the insurance company mainly gives “investment insurance
contracts with discretional participating features”.
Aggregation of Insurance Contracts
• Insurance company must assess the risk nature of each contracts
• The company must create portfolios of contracts subject to similar risks and managed
together
• The board oblige to divide a portfolio into, at a minimum, groups of:
A. Contracts that are onerous at initial recognition
B. Contracts that are not onerous at initial recognition and that have no significant
possibility of becoming onerous subsequently
C. Other contracts

Initial Recognition of Insurance contracts (GMM)

Basic steps in initial recognition
Step 1: Determination of fulfillment cash flows(FCF)
Step 2: Determination of Contractual Service Margin (CSM)
Steps to Determine FCF:
Step1: Estimation of cash inflows
Step2: Estimation of cash outflows
Step3:Determination of Present value of cash inflows & outflows
Step4: Non-financial risk adjustment
FCF is an explicit, unbiased, and probability-weighted estimate (i.e. expected value) of the present
value of the future cash flows that will arise as the insurer fulfils its insurance contract obligations,
including a risk adjustment for non-financial risk.

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 FCF= PV of inflows – PV of outflows - Risk adjustment
Where:
FCF: fulfillment cash flows
PV: present value
Risk adjustment: risk adjustment of non financial risks

Contractual service margin(CSM)

• Is the excess of estimated cash inflows over cash outflows including risk adjustment.
• CSM is unearned profit margin.
• CSM have to allocated to the coverage period
• The amount of premium collected or to be collected is not reported as revenue at the
beginning.
• CSM is not reported as revenue at the beginning.

Subsequent Recognition
1. Determination of incurred claim and liability of the remaining coverage period.
2. Recognition of insurance service result (insurance service revenue and insurance service
expense)
Example
• Awash Insurance Co. issues a group of insurance contracts with a coverage period of four
years. At inception, the total premiums from the group of 1,500 are received and insurance
acquisition cash flows of 100 are paid.
• Awash insurance: expects claims and expenses of 800 to be incurred evenly over the
coverage period. Claims are settled as they are incurred.
• The risk adjustment for non-financial risk on initial recognition is 80. For simplicity this
example assumes that it is released evenly over the coverage period.
• Over the coverage period, all events happen as expected and Awash does not change any
assumptions related to future periods.
Required: Show all necessary steps in initial and subsequent recognition of the contracts using
GMM.

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To measure insurance contract liability on initial recognition and at the end of the period.
Initial Year 1 Year 2 Year 3 Year 4
recognition

Estimates of the present value of cash 1,500 - - - -

Inflows
Estimates of the present value of cash (900) (600) (400) (200) -
outflows, including
Acquisition cash flows
Risk adjustment (80) (60) (40) (20) -
Fulfilment cash 520 (660) (440) (220) -
Flows
CSM (520) (390) (260) (130) -
Insurance (1,050) (700) (350) -
contract liability -

The change in the liability for remaining coverage for each period

Year 1 Year 2 Year 3 Year 4

Opening balance - (1,050) (700) (350) Premiums
received (1,500) - - - Acquisition cash flows
100
Expected claims 200 200 200 200
Risk adjustment recognized 20 20 20 20
CSM allocation 130 130 130 130
Closing balance (1,050) (700) (350) -

Insurance Revenue and Expense for each year

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 Year 1 Year 2 Year 3 Year 4

Expected claims 200 200 200 200

Risk adjustment 20 20 20 20
CSM allocation 130 130 130 130
Revenue for services provided 350 350 350 350
Revenue to cover acquisition cash flows 25 25 25 25
Insurance Revenue 375 375 375 375
Service expense 200 200 200 200
Insurance acquisition expense 25 25 25 25
Insurance service expenses 225 225 225 225
Insurance service result 150 150 150 150

Advanced Financial Accounting II

Chapter One
Business Combinations
Definition of Business Combination
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. Commonly, business
combinations are often referred to as mergers and acquisitions.
Business combinations are classified into two classes based on nature: friendly takeovers and
unfriendly (hostile) takeovers.
Friendly Takeover
 The Board of Directors of all constituent companies amicably (friendly) determine the terms
of the business combination.
 The proposal is submitted to share holders of all constituent companies for approval.
Hostile Takeovers
In this type of takeovers, the target combinees typically resist the proposed business combination.
Thus, the target combinee uses one or more of the following defensive tactics. Some of the tactics
are:
 White Knight: a search for a candidate to be the combinor in a friendly takeover.
 Scorched Earth: the disposal of one or more business segments that attracts the combinor.
The profitable segment can be disposed through sale or spin-off. This is sometimes called

23
 selling the crown jewels: The sale of valuable assets to others to make the firm less
attractive to the would-be acquirer.
 Poison Pill: an amendment of the articles of incorporation or bylaws to make it more
difficult to obtain stockholder approval for a takeover.

Types of Business Combinations

There are three types of business combinations: Horizontal Combination, Vertical Combination,
and Conglomerate Combination:
1. Horizontal Combination: is a combination involving enterprises in the same industry. E.g.
assume combination of BEDELE Brewery and HARAR Brewery
2. Vertical Combination: A Combination involving an enterprise and its customers or
suppliers. It is a combination involving companies engaged in different stages of production
or distribution. E.g.1: A Tannery Company acquiring a Shoes Company - Forward
E.g.2: Weaving Company acquiring both Ginning and Spinning Company - Backward
3. Conglomerate (Mixed) Combination: is a combination involving companies that are
neither horizontally nor vertically integrated. It is a combination between enterprises in
unrelated industries or markets.
Business Combinations: Why?
A business combination refers to any set of conditions in which two or more organizations are
joined together through common control. The company whose business is being sought is after
called the target company.
Why do business enterprises enter into a business combination? There are a number of reasons for
business combinations, some of the reasons are: Growth, Economies of Scale, Operating
Economies, Better Management, Monopolistic Ambitions, Diversification of Business Risk, Tax
Advantages, Elimination of Fierce Competition, Better Financial Planning& Getting financial gains.

Methods for Arranging Business Combinations

The four common methods for carrying out a business combination are: Statutory Merger, Statutory
Consolidation, Acquisition of Common Stock, and Acquisition of Assets.
1. Statutory Merger
Statutory Merger is a merger in which one of the merging companies continues to exist as a legal
entity while the other or other are dissolved. A business combination in which one company (the
survivor) acquires all the outstanding common stock of one or more other companies that are then
dissolved and liquidated, with their net assets owned by the survivor. E.g. ABC Company acquires
all the outstanding common stock (net assets) of XYZ Company where XYZ Company is legally
liquidated

24
 ABC Company
ABC Company
XYZ Company
2. Statutory Consolidation
It is a merger in which a new corporate entity is created from the two or more merging companies,
which cease to exist. E.g. ABC Company acquires XYZ Company; but a new Company AYZ is
created to issue common stocks for the two companies which are now defunct.
ABC Company
AYZ Company
XYZ Company
3. Acquisition of Common Stock
One corporation (the investor) may issue preferred or common stock, cash, debt, or a combination
thereof to acquire a controlling interest in the voting common stock of another corporation (the
investee). If a controlling interest in the combinee’s voting 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. E.g. ABC Company acquires over 50%
of the voting stock of XYZ Company, a parent–subsidiary relationship results and XYZ Company
is now a subsidiary of ABC Company (Parent)
ABC Company ABC Company Parent Company
Business
Combination
XYZ Company XYZ Company Subsidiary Company

4. Acquisition of Assets
A business enterprise may acquire all or most of the gross assets or net assets of another enterprise
for cash, debt, preferred or common stock, or a combination thereof. The transaction generally must
be approved by the boards of directors and stockholders of the constituent companies. The selling
enterprise may continue its existence as a separate entity or it may be dissolved and liquidated; it
does not become an affiliate of the combinor.
Accounting for Business Combinations
Acquisition method: The acquisition method (called the 'purchase method' in the 2004 version of
IFRS 3) is used for all business combinations.
The following steps should be undertaken in applying the acquisition method:
1. Identify the acquirer;

25
 2. Determine the acquisition date;
3. Recognition and measurement of the identifiable assets acquired, the liabilities assumed and
any non-controlling interest (NCI, formerly called minority interest) in the acquiree, and
4. Recognition and measurement of goodwill or a gain from a bargain purchase

Accounting for a business combination by the acquisition 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.

Computation of Cost of a Combinee

The cost of a combinee in a business combination accounted for by the acquisition method is the
total of:
 The amount of consideration paid by the combinor &
 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.
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. As per IFRS 3, contingent consideration must be measured at fair value at the time
of the business combination and is taken into account in the determination of goodwill.

An acquirer might incur various transaction costs related to a business combination. Examples are:
finder’s fees, professional or consulting fees (such as advisory, legal, accounting or valuation costs),
are collectively referred to as “acquisition-related costs.” Acquisition-related costs generally must
be accounted for separately from the business combination and expensed as incurred. In other
words, they are not capitalized as part of the business combination transaction.

26
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 (A gain from a bargain purchase)

Negative goodwill means an excess of current fair value of the combinee’s identifiable net assets
over their cost to the combinor. IFRS 3 allows an accounting policy choice, available on a
transaction by transaction basis, to measure non-controlling interests (NCI) at the date of
acquisition either at:
Fair (FULL) value method: e.g. Share price of NCI equity shares; or using other valuation
techniques if not publicly traded; In the FV method goodwill is recognized for both parent and NCI
or
Proportionate share (PARTIAL) METHOD: of the net identifiable assets of the entity acquired.
Argued that PARTIAL method of calculating goodwill only recognises the goodwill acquired by
the parent i.e. any goodwill attributable to NCI is not recognised.
As a general rule, the amount of goodwill is determined using the fair value of the consideration
transferred. The basic formula used to calculate goodwill is:
Goodwill = FV of the consideration transferred + Non controlling interest – FV of net assets
acquired
For business combinations achieved in stages, the fair value of the acquirer’s previously-held equity
interest in the acquiree is added to the total before subtracting the fair value of net assets acquired,
as follows:
Goodwill = FV of the consideration transferred + Non controlling interest + FV of the acquirer’s
previously-held equity interest – FV of net assets acquired
Positive goodwill
 Recognise as asset from date of acquisition
 Do not amortise
 Subject to annual impairment testing or more frequently if events or circumstances dictate
Bargain Purchase
 If the calculation of goodwill results in a negative balance, the transaction might be a
bargain purchase. In a bargain purchase, the acquirer essentially buys the net assets of the
acquiree at a discount.
 Bargain purchases are rare. They do, however, arise occasionally. For instance, a bargain
purchase might happen if the acquiree is under financial distress and must sell its business to
survive.

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  Before concluding that a bargain purchase has occurred, an acquirer is required to revisit
steps 3 and 4 of the acquisition method. Specifically, the acquirer must reassess:
 Whether it properly identified all assets acquired and liabilities assumed in the business
combination
 Whether these assets and liabilities were measured appropriately
 Whether the other amounts used to compute goodwill, such as the fair value of the
consideration transferred and non controlling interest, were determined correctly
 If, after this reassessment, the acquirer concludes that a bargain purchase has taken place,
the acquirer recognizes a gain on the bargain purchase.
 Treated as immediate income i.e. ‘credit P/L’ in arriving at profit or loss

Illustration of Purchase Accounting for Statutory Merger, with Goodwill

On December 31, 2009, 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 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 SECreg 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, 2009
Assets
Current assets 1,000,000
Plant assets (net) 3,000,000
Other assets 600,000
Total assets 4,600,000

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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

Using the guidelines in APB Opinion No. 16, the board of directors of Saxon Corporation
determined the current fair values of Mason Company’s assets and liabilities (identifiable net
assets) as follows:
Current assets 1,150,000
Plant assets 3,400,000
Other assets 600,000
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.
Required:
a) Pass necessary journal entries in the books of Saxon Corporation & Determine the
amount of goodwill.
b) Record the liquidation of mason company in conjunction with merger with Saxon Corpo-
ration:

Business Combination Disclosures

 Disclosures for business combinations and intangible assets. This includes, but is not limited
to:
 Reason for combination,
 Allocation of purchase price among assets and liabilities, and
 Goodwill or gain from bargain purchase.

CHAPTER TWO
CONSOLIDATIONS: ON DATE OF PURCHASE-TYPE BUSINESS COMBINATION

Parent Company- Subsidiary Relationships

IFRS 10 establishes principles for the presentation and preparation of consolidated financial
statements when an entity controls one or more other entities. 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

29
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.
Definition of Consolidation:
The process of combining the financial statements of a parent company and one or more legally
separate and distinct subsidiaries as a single economic entity for financial reporting purposes.

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.
De FACTO CONTROL
Entity can control with less than 50% of voting rights. Factors to consider include:
 size of the holding relative to the size and dispersion of other vote holders
 potential voting rights
 other contractual rights
If the above not conclusive consider additional facts and circumstances that provide evidence of
power (eg voting patterns at previous board meeting, etc)
An entity that has one or more subsidiaries (a parent) must present consolidated financial
statements.
PRINCIPLE
Consolidated financial statements present the parent and all its subsidiaries as financial statements
of a single economic entity
 uniform accounting policies
 same reporting periods
 eliminate intragroup transactions and balances
 non-controlling interest (the equity in a subsidiary that is not attributable, directly or
indirectly, to the parent) is presented within equity, separately from the parent share-
holders’ equity.
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 Dec. 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
Assume also that the business combination qualified for purchase accounting. 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:

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 PALM CORPORATION AND STAR COMPANY
Separate Financial Statements (prior to purchase-type business combination)
December 31, 1999
Palm Star
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
Liabilities and Stockholders’ Equity
Payable to Palm 25,000
Income taxes payable 26,000 10,000
Other liabilities 325,000 115,000
Common stock, $10 par 300,000
Common stock, $5 par 200,000
Additional paid in capital 50,000 58,000
Retained earnings 134,000 132,000
Total liab& stockholders’ equity 835,000 540,000
On December 31, 1999, current fair values of Star Company’s identifiable assets were the same as
their carrying amounts except for the following items:
Inventories 135,000
Plant assets (net) 365,000
Patent (net) 25,000
Palm Corporation recorded the combination as a purchase with the following entries:
Required:
a) Determine the amount of goodwill
b) Pass necessary journal entries in the books of Palm Corporation
c) Prepare elimination journal entry
d) prepare the Consolidated Balance sheet of Palm Corporation and its subsidiary on December
31, 1999 without the help of working paper
e) prepare the Consolidated Balance sheet of Palm Corporation and its subsidiary on December
31, 1999 with the help of working paper

Chapter Three
Foreign Currency Accounting
Accounting for Foreign Currency Transactions (IAS 21)
 The objective of this Standard is to prescribe foreign currency transactions, foreign
operations, translate financial statements into a presentation currency.
 The principal issues are which exchange rate(s) to use and how to report the effects of
changes in exchange rates in the financial statements.

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Businesses that involve in international trades or Multi-National Company (MNC) need foreign
currencies to enter into different transactions. A “Multi-National Company” is one that conducts its
business in more than one country via branches, joint ventures, subsidiaries etc. In most countries,
the foreign currency is treated as a commodity or a money-market instrument. Thus, different
Multi-National Companies (MNCs) involve buying and selling of foreign currency. The following
different Exchange Rates are applicable for buying and/or selling foreign currency:

Spot Rates: are rates used by banks for immediate delivery or receipts of a foreign currency. The
two spot rates are (i) Spot Selling Rate: The rate charged by the bank for current sales in foreign
currency; and (ii) Spot Buying Rate: The rate applied by the bank to acquire a foreign currency.
The spot buying rate is usually lower than the spot selling rate.

Forward Rates: are rates applied to foreign currency transactions to be consummated at a future
date. The two forward rates are (i) Forward Selling Rate: The rate charged by the bank for future
sales in foreign currency, and (ii) Forward Buying Rate: The rate applied by the bank to acquire a
foreign currency in the future. The forward buying rate is usually lower than forward selling rate.
Spread: is the difference between the selling and the buying spot rates and represent gross profit to
a foreign currency trader
Currency Related Terminology
 Functional Currency – is the currency of the environment in which an entity primarily
generates and expends cash. Functional currency is the monetary unit of account of the
Principal Economic Environment in which an economic entity operates.
 Reporting Currency – It is a currency in which the parent firm prepares its own financial
statements; that is, US dollars for a US companies or Birr for Ethiopian companies.
 Foreign Currency – any currency other than the reporting currency of the parent company
 Local Currency is the currency unit used in a country referenced. Local currency is the
currency in the country where the foreign subsidiary is operating. For example, Birr is the local
currency in Ethiopia.
 Exchange Difference (Spread)– difference resulting from translating a given number of units
of one currency into another currency at different exchange rates
 Foreign Operation – a subsidiary, associate, joint venture, or branch whose activities are based
in a country other than that of the reporting enterprise

CURRENCY RELATED EXPOSURE

1. Economic Exposure
It is sometimes called operating exposure. This is an exposure that measures the extent to which a
firm's market value is sensitive to unexpected changes in foreign currency. Currency fluctuations
affect the value of the firms’ cash flows, income statement and balance sheet by altering its
competitive position.

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2. Transaction Exposure
Transaction Exposure measures gains or losses that arise from the settlement of existing financial
obligations whose terms are stated in foreign currency. Transaction exposure measures the extent to
which income from individual transactions is affected by fluctuations in foreign exchange values.
For example, the transaction exposure may arise from the following transactions:
 Purchasing or selling on credit when prices are stated in a foreign currency
 Borrowing or lending funds when repayment is to be made in a foreign currency
 Being a party to an unperformed foreign exchange forward contract
 Acquiring assets or incurring liabilities denominated in a foreign currency
Foreign Currency Transaction Gains and Losses
IAS 21 states that: Recognize foreign currency transaction at the rate at the transaction date;
 An average rate for a period (e.g. week or month) may be used if exchange rates don’t
fluctuate significantly.
- Average rates not reliable if currency fluctuates significantly. In accounting policy
note in FS, disclose the policy. e.g. that rates at transaction dates are used.

During the period liabilities are open, if the selling spot rate decreases (foreign currency weakens
against the domestic currency), it results in a foreign currency transaction gain; if the selling spot
rate increases (foreign currency strengthens against the domestic currency), it will result in a foreign
currency transaction loss. Gains and losses are reported in a firm’s income statement in the period
in which they occur.

Example
Ethio Trading Company purchased goods on account from US Company on December 21, 2010
at $100,000 terms n/30. The spot selling rate for a dollar is Br 16.60

Inventories..............................................................................1,660,000
Accounts Payable.................................................... 1,660,000
To record purchase on 30-day open account from US supplier for $100,000, translated at the spot
selling rate $1 = Br 16.60

Determine the foreign currency transaction gain or loss for the Ethio Trading Company assuming
that on December 31, 2010, the spot selling rate for a US dollar was Br 16.58

Liability on December 21, 2010........................................................ Br 1,660,000

Less: Liability on December 31, 2010 ($100,000 @ 16.58).............. 1,658,000
Foreign currency transaction gain...................................................... Br 2,000
Journal Entry:
Accounts Payable............................................................................... 2,000
Foreign Currency Transaction Gain................................. 2,000

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Determine the foreign currency transaction gain or loss for the Ethio Trading Company assuming
that on maturity date, February 19, 2011, the spot selling rate for a US dollar was Br 16.61

Liability on December 31, 2010........................................................ Br 1,658,000

Less: Liability on December 31, 2005 ($100,000 @ 16.61).............. 1,661,000
Foreign currency transaction loss...................................................... (Br3,000)
Journal Entry:
Accounts Payable...............................................................................1,658,000
Foreign Currency Transaction Loss................................................... 3,000
Cash.................................................................................. 1,661,000
3. Translation Exposure or Accounting Exposure
Translation exposure is a risk attributed to change in a firm's financial position when the firm's
consolidated financial statements are affected by changes in foreign exchange rates. Translation
involves converting financial statements of foreign subsidiaries from the local currency to the home
currency. It is also known as Accounting Exposure. Translation exposure or accounting exposure
measures the potential losses or gains that would appear on the consolidated financial statements
following a change in exchange rates. It is a risk that a company's equities, assets, liabilities or
income will change in value as a result of changes in exchange rate. This occurs when a firm
denominates a portion of its equities, assets, liabilities or income in a foreign currency.
Translation Exchange Rates
In translation of foreign subsidiary financial statements, there needs to raise two questions:
1. How should translation gains and losses be reported in the financial statements or should be
accounted for? Should they be included in income?
2. What exchange rate should be used to translate each line of the foreign financial statements
into the domestic currency? That is which exchange rate should be used to translate foreign
currency account balances to reporting currency?
Translation methods may employ a single rate or multiple rates. There are three alternative
exchange rates for translation of foreign subsidiary financial statements: current rate, historical rate,
and average rate.
 Current Rate – exchange rate prevailing as of the financial statement date
 Historical Rate – exchange rate prevailing when a foreign currency asset was first
acquired or a foreign currency liability was first incurred
 Average Rate – is simple or weighted average exchange rate of either current or
historical exchange rates
Methods of Translation of Foreign Subsidiary's Financial Statement
If the exchange rate for the functional currency of a foreign subsidiary or branch remained constant
instead of fluctuating, translation of financial statements would be simple. All financial statement
amounts would be translated at the constant exchange rate. However, exchange rates fluctuate
frequently. Hence, a problem is faced which exchange rate to use. According to IAS 21, Monetary/

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Non monetary Method is use to translate foreign subsidiary financial statements from local
currency to parent company presentation currency.
Monetary/ Non-monetary Method
This method focuses on the financial character of assets & liabilities of the foreign subsidiary
financial statement rather than on their balance sheet classifications to determine appropriate rate.
Foreign currency assets and liabilities expressed as a fixed number of currency units are defined as
monetary (receivables and payables). Other items are non-monetary.
o Monetary Assets: are items that will be received in a fixed or determinable amount of

cash. Examples: Cash, Cash equivalents, Debt securities, Accounts receivable, Notes
receivable
o Non-monetary Assets: are items that will not be received in a fixed or determinable amount
of cash. Examples: Inventory, Prepaid expenses, Equity securities, Investment property,
Property, plant, and equipment, Intangible assets (e.g. goodwill)
o Monetary Liabilities: are items that will be paid in a fixed or determinable amount of cash.
Examples: Accounts payable, Notes payable, Bonds payable, Leases payable, Accruals,
Deferred tax (usual classification)
o Non-monetary Liabilities: are items that will not be paid in a fixed or determinable amount

of cash. Examples: Deferred income, Government grant

Balance sheet translation:

 All monetary items (Monetary assets & Liabilities) are translated by using current
exchange rate.
 All non monetary items (non Monetary assets & Liabilities) & all elements of
stockholders’ equity accounts are translated by using historical exchange rate.
 Revalued non-monetary items are translated by using the rate at the date of valuation.
Income statement translation:
 In the income statement, average exchange rates are applied to all revenues and expense
except depreciation expenses, amortization expense, and cost of goods sold, which are
translated at appropriate historical rates.

Translation and Remeasurement: Producing Financial Statements Using Translation

or Remeasurement, or Both.
 Remeasurement - is a process of converting the accounting records of an entity maintained
in a currency other than functional currency into the functional currency;
 Non-monetary assets, liabilities, and related income and expenses - use historical exchange
rate ;

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  Monetary assets, liabilities, and related income and expenses – use current exchange rate

 If entity’s functional currency is the reporting currency of the enterprise, re-measurement

avoids translation.
 If entity’s functional currency is different from the enterprise’s reporting currency, re-
measurement into the entity’s functional currency is followed by translation into the
reporting currency
Disclosures
 The standard requires an entity to disclose some important disclosures for the purpose of
fair and faithful presentation:
 Amount of exchange difference be recognized in profit or loss;
 Net exchange differences recognized under other comprehensive income
 whether presentation currency is different from functional currency and the reason for
this difference; any
 Whether there is any change in functional currency and reason for the change

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