Rift Valley University Jimma Campus

College of business and economics

Department of accounting and finance

Course; Advanced financial accounting II

Course code ACFN 4102

Year 4 semesters 2

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Contents
CHAPTER ONE ............................................................................................................................. 2
1. over view of accounting for joint ventures and Public enterprises ............................................. 3
1.1 Nature of Joint Venture Businesses ...................................................................................... 3
1.2 Accounting for investment in JV Businesses ........................................................................ 6
1.3 Public Enterprises ............................................................................................................... 12
1.3.1 Accounting for public enterprises ................................................................................ 13
1.4 Privatization of public Enterprises ...................................................................................... 16
CHAPTER TWO .......................................................................................................................... 17
2. AGENCY AND PRINCIPAL; HEAD OFFICE AND BRANCH ........................................... 17
2.1 Branches and Divisions....................................................................................................... 17
2.2. Types of Branches.............................................................................................................. 17
2.3. Accounting System for a Branch ....................................................................................... 19
2.4 Alternative Methods of Billing Merchandise Shipment to branches .................................. 22
2.5 TRANSACTIONS BETWEEN BRANCHES ........................................................................ 30
3. BUSINESS COMBINATION (IFRS 3) ................................................................................... 34
CHAPTER FOUR ......................................................................................................................... 43
4. CONSOLIDATED FINANCIAL STATEMENTS ................................................................. 43
5.1 Consolidated Financial Statements: Nature and Meaning .................................................. 43
4.2 Methods of Accounting for Investment in Other Firms ...................................................... 43
4.3 Consolidation of Wholly Owned Subsidiary on Date of Business Combination ............... 44
Chapter 5 ....................................................................................................................................... 58
5. Accounting for Foreign Currency Transactions........................................................................ 58
CHAPTER-SIX............................................................................................................................. 67
6. SEGMENT REPORTING, INTERIM REPORTING AND FINANCIAL FORECASTS
SEGMENT REPORTING ............................................................................................................ 67

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 CHAPTER ONE

1. over view of accounting for joint ventures and Public enterprises

1.1 Nature of Joint Venture Businesses

A joint venture is an association of two or more persons based on contract who combine their
money, property, knowledge, skills, experience, time or other resources in furtherance of a
particular project or undertaking, usually agreeing to share the profits and the losses and each
having some degree of control over the venture. The following terms related to joint venture.

Joint venture: a contractual agreement whereby two or more parties undertake an economic
activity that is subject to joint control.
Venture: a party to a joint venture and has joint control over that joint venture.
Investor in a joint venture: a party to a joint venture and does not have joint control over that
joint venture
Control; the power to govern the financial and operating policies of an activity so as to obtain
benefits from it.
Joint control: the contractually agreed sharing of control over an economic activity.

Whether a joint venture exists is a question of fact to be decided according to the facts and
circumstances of each case. Generally, the object and the motive behind a joint venture are the
anticipated profits derived from a specific business enterprise.

Some of the essential elements of a joint venture include:

 A communal interest and joint effort in reaching the purpose of the joint venture
 The right of each co-venturer party to control and manage property to be used in the
venture
 The right of each co-venturer party to direct the policy of conduct of which will guide the
joint venture
 Sharing in both the profits and losses from the venture
 The existence of a contract between the various parties
 Proportionate contributions by each party
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  Mutual risk-sharing

However, none of these elements alone are sufficient. Thus, a joint venture exists when two or
more persons combine in a joint business enterprise for their mutual benefit with an
understanding that they are to share in the profits or losses and each to have a voice in its
management.

Benefits of joint venture

Businesses of any size can use joint ventures to strengthen long-term relationships or to
collaborate on short-term projects. A successful joint venture can offer:

 access to new markets and distribution networks

 increased capacity
 sharing of risks and costs with a partner
 access to greater resources, including specialized staff, technology and finance

A joint venture can also be very flexible. For example, a joint venture can have a limited life
span and only cover part of what you do, thus limiting the commitment for both parties and the
business' exposure.

The risks of joint ventures

Collaborating with another business can be complex. It takes time and effort to build the right
relationship. Problems are likely to arise if:

 the objectives of the venture are not 100 per cent clear and communicated to everyone
involved;
 the partners have different objectives for the joint venture;
 there is an imbalance in levels of expertise, investment or assets brought into the venture
by the different partners;
 different cultures and management styles result in poor integration and cooperation
 the partners don't provide sufficient leadership and support in the early stages

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Types of Joint ventures

Joint ventures may appear in incorporated or unincorporated form (i.e. a joint venture need not
result in the creation of a separate legal entity). ―Strategic alliances‖ in which companies agree to
work together to promote each other‘s products or services may also be considered joint
ventures.

Depending on the underlying economic activity, it can be established as business enterprise or as

project. Moreover, based on the contractual agreement between venturers Joint venture can be
organized in one of the following three ways:

 Jointly controlled operations. There may not be a joint venture legal entity. Instead, the
joint venture uses the assets and other resources of the venturers. Each venturer uses its
own assets, incurs its own expenses, and raises its own financing. The joint venture
agreement states how the revenue and expenses related to the joint venture are to be
shared among the venturers.
 Jointly controlled asset. Venturers may jointly control or own the assets contributed to or
acquired by a joint venture. Each venturer may receive a share of the assets' output and
accept a share of the expenses incurred. There may not be a joint venture legal entity.
 Jointly controlled entities. This type of joint venture involves a legal entity in which each
venturer has an interest. The new legal entity controls the joint venture's assets and
liabilities, as well as its revenue and expenses; it can enter into contracts and raise
financing. Each venturer is entitled to a share of any output generated by the new entity.
A jointly controlled entity maintains its own accounting records and prepares financial
statements from those records. If a venturer contributes cash or other assets to a jointly
controlled entity, the venturer records this transfer as an investment in the jointly
controlled entity.

In all three of these types of joint veture, there are two or more venturers that are bound by a
contractual agreement that establishes joint control over the entity.

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1.2 Accounting for investment in JV Businesses
Generally accepted accounting principles (GAAP) recognize three different approaches to the
financial reporting of investments:
 The fair-value method.
 The consolidation of financial statements.
 The equity method.
Accounting for a joint venture depends upon the level of influence exercised over the venture.
Because voting power, typically accompanies ownership of equity shares, influence increases
with the relative size of ownership. The resulting influence can be very little, a significant
amount, or, in some cases, complete control. If a significant amount of influence is exercised, the
equity method of accounting must be used provided that the investor company is in incorporated
form.

How can we know existence of significant Influence?

The essential rules governing the existence of significant influence are:

 Voting power. Significant influence is supposed to be present if an investor and its

subsidiaries hold at least 20 percent of the voting power of a joint venture. This is the
overriding rule governing the existence of significant influence.
 Board seat. The investor controls a seat on the joint venture‘s board of directors.
 Personnel. Managerial personnel are shared between the entities.
 Policy making. The investor participates in the policy making processes of the joint
venture. For example, the investor can affect decisions concerning distributions to
shareholders.
 Technological dependency or Technical information. Essential technical information is
provided by one party to the other.
 Transactions. There are material transactions between the entities.

No single one of these guides should be used exclusively in assessing the applicability of the
equity method. Instead, all are evaluated together to determine the presence or absence of the
sole criterion: the ability to exercise significant influence over the investee. To provide a degree

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of consistency in applying this standard, the FASB provides a general ownership test: If an
investor holds between 20 and 50 percent of the voting stock (direct or indirect) of the investee,
significant influence is normally assumed and the equity method is applied.

According to the new standard IFRS 11 which was being applied starting from January 1, 2013,
classification and accounting treatment of joint arrangements is summarized in the flowchart
below:

IFRS 11 Joint arrangement

No legal entity Separate legal entity

Joint operation/Assets Joint venture

Recognition of Equity method

A,L, R, Exp.

Joint ventures involve the creation of a separate legal entity. They are different from
collaborative arrangements, jointly controlled operations and jointly controlled assets, in which
activities normally are not conducted through a separate entity, like a corporation or partnership.

Equity Method

If significant influence is present, an investor should account for its investment in an joint
venture using the equity method. There is a possibility for extended application of Equity
Method Applicability; for some investments that either fall short of or exceed 20 to 50 percent
ownership, the equity method is nonetheless appropriately used for financial reporting.
The equity method employs the accrual basis for recognizing the investor‘s share of investee
income. Accordingly, the investor recognizes income as it is earned by the investee. In essence,
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the equity method mandates that the initial investment be recorded at cost, after which the
investment is adjusted for the actual performance of the joint venture. The following calculation
illustrates how the equity method operates:
+ Initial investment recorded at cost
+/- Investor's share of joint venture profit or loss
- Distributions received from the joint venture
= Ending investment in joint venture
The investor‘s share of the joint venture‘s profits and losses are recorded within the income
statement of the investor. In applying the equity method items appearing separately in the
investee‘s income statement require similar treatment by the venture, for example if the joint
venture records changes in its other comprehensive income, the venture (investor) should record
its share of these items within other comprehensive income, as well. This handling is intended to
mirror the close relationship between the two companies. However; the non-operating income
should be reported as a separate item only if the figure is considered to be material with respect
to the venture‘s (investor‘s) own operations.

If a joint venture reports a large loss, or a series of losses, it is possible that recording the
investor‘s share of these losses will result in a substantial decline of the investor‘s recorded
investment in the joint venture. If so, the investor stops using the equity method when its
investment reaches zero. If an investor‘s investment in a joint venture has been written down to
zero, but it has other investments in the joint venture (such as loans), the investor should
continue to recognize its share of any additional joint venture losses and offset them against the
other investments, in sequence of the seniority of those investments (with offsets against the
most junior items first). If the joint venture later begins to report profits again, the investor does
not resume use of the equity method until such time as its share of joint venture profits have
offset all joint venture losses that were not recognized during the period when use of the equity
method was suspended.

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A. Accounting for a corporate joint venture
A corporate joint venture refers to a corporation owned and operated by a small group of
business (the ―joint ventures‘ 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.
 Each joint venture may participate in the overall management of the venture directly or
indirectly.
 The ownership of a corporate joint venture seldom changes and its stock is usually not
publicly traded.
 Important points to bear in mind are:
1. A separate rate of accounting records is to be established for every corporate joint
ventures of large size and long duration.
2. Each venture‘s capital account is credited in the accounting records of the joint
venture for the amount of cash or non cash investments.
3. The use of Accrual basis of accounting and periodic financial statements for the
venture permit regular reporting of the share of net income or net loss allocable to
each venture.
4. The accounting records of such a corporate joint venture include the usual ledger
accounts for assets, liabilities, owner‘s equity revenue and expenses.
5. The entire accounting process should be in conformity with GAAP.
 Investors should account for investments in common stock of a corporate joint
venture by the equity method.
B. Accounting for an incorporated joint venture
In an incorporated joint venture the investor (venturer) owns an undivided interest in each
asset and is proportionately liable for its share of each liability. Two alternative methods for
accounting for an unincorporated joint venture may be adopted by investors. These are
1. The equity method of accounting for the investments and
2. The proportionate share method of accounting for the investment.
Example: Alem Company and Gebre Company each invested $500,000 for a 50% interest in
an un incorporated joint venture on January 2-1998 condensed financial statements for the
joint venture, Alge Co. for 1998 where as follows.
Revenue 1,500,000
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Costs and expenses 1,000,000
Net income $500,000
Division of Net income
Alem Company (50%) 250,000
Gebre company (50%) 250,000

ALGO Company
A joint Venture
Statement of ventures capital
For year ended Dec 31, 1998
Alem Co Gebre Co Combined
Investment on January 2, 1998 500,000 500,000 1000,000
Add: Net income for the year 250,000 250,000 500,000
Ventures capital end of the year 750,000 750,000 1,500,000

B/sheet
Assets Liabilities and Venture capital
Current Assets(given) 1,800,000 Current liable (given) 800,000
Other Assets (given) 2,500,000 Long term debt (given) 750,000
Alem Capital 750,000
Gebre Capital 750,000
Total Assets 4,300,000 4,300,000

Required:
Record the journal entries by Alem Company and Gebre company by:
A. The equity method of Accounting and
B. The proportionate share method of Accounting.
 Under the equity method of accounting both Alem company and Gebre company
would prepare the following journal entries to reflect their investments in AlGe
Company.
January 2 , 1998
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 Investment in AlGe Company 500,000
Cash 500,000
(Entry by the separate companies (Alem and Gebre)
Dec 31, 1998
Invest in AlGe Company 250,000
Investment income 250,000
(Entry in the partners in their own companies)
B. Under the proportionate share method of accounting, in addition to the above two journal
entries, both Alem Co and Gebre Co. would prepare the following journal entry for their
respective shares of the asset, liabilities, revenue and expenses of AlGe Company.
Dec 31 1998
Current Assets 50% cash 900,000
Other Assets 50% 1,250,000
Costs and expenses 500,000
Investment income 250,000
Current liabilities 50% equally 400,000
Long ter Liability 1,000,000
Revenue 750,000
Investment in AlGe Company 750,000
Dissolved or Terminated?

Likewise, dissolution or termination of a joint venture will depend largely on the facts of the
circumstances. Joint ventures may be terminated through the following means:

 According to termination or dissolution provisions in the joint venture contract. (Most

joint venture contracts will state a date upon which the venture is to expire)
 According to a court-ordered decree
 At the will of any one of the co-venturers. Again, provisions regarding at-will dissolution
will likely be contained in the contract.

The following are some of the common reasons why joint ventures are dissolved:

 The stated aims of the venture have not been met, or have already been satisfied
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  The aims of the venture have become impossible to fulfill
 One or more parties disagree with the aims of the venture, or have developed different
business goals
 Market conditions have rendered the joint venture unprofitable, inappropriate, or
irrelevant
 Legal or financial hardships have arisen

Upon dissolution, the different co-venturers are usually entitled to profits which are
proportionate to the amount of contributions that they have provided. Or, distributions may be
dictated by the terms contained in the contract. Debts will also be dealt with similarly.

However, if there are any outstanding claims or liabilities, these will likely be deducted from the
party‘s distributions during the wind-up phase. Finally, a party to a joint venture may be
terminated from the project prior to dissolution if they have significantly refused to perform their
obligations.

1.3 Public Enterprises

Public Enterprise is a business organization wholly or partly owned by the state and controlled
through a public authority ( proc no; 25/1992).

Examples of public enterprise in Ethiopia are

• Ethiopian fruit and vegitable sh. Co.
• Ambo mineral water factory
• National Alcohol & liquor factory
• Mugger cement factory
• Bole printing enterprise
• Etc….

Benefits of Public Enterprises

The operation of public enterprises is highly beneficial to the economy. The contribution of
public enterprises can be viewed from two perspectives:
I. Economic benefit
II. Social benefit
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Economic benefits: A public enterprise produces important impacts that strengthen the economy
by providing the following economic benefits:
 They generate revenue for the government
 Dividend, interest on loans, excise duty, sales taxes, corporate taxes etc. are paid to the
government by public enterprises.
 Save scarce foreign exchange either by exporting or generating goods and services of the
country by substituting the imported products.
 Help in reducing regional disparities
 Provide infrastructural facilities for the development of the economy and the private sector.
 Exploit the natural and technological resources of the state.
Social Benefits- Social benefits of PE’s are
 It provides job opportunity
 It serve as a model for employers by providing different welfare benefits like housing,
medical, transport etc.

1.3.1 Accounting for public enterprises

Accounting for public enterprises must be based on clear understanding of the underlying
assumptions to be made on the character of public enterprise, and the type or structural
relationship established.
The workable assumptions in this case are:
 The public enterprise is involved in profit.
 The economic performance of the public enterprise is measured by its financial
profitability.
Financial profitability is determined by Net income or surplus.
 Financial profitability must be distinguished from Social profitability that should be
measured also additionally where possible.
According to proclamation no 25/1992, as incorporate entity of market economy the capital
section of the public enterprise composed of the following parts:
1. Capital: the original value of the net asset assigned to the enterprise by the state at the
time of its establishment.
2. Legal Reserve: 5% of net income of the financial year.
3. Other reserve/retain earning: may be established with the approval of the supervisory.
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 4. State dividend payable: the remaining balance after deductions of the transfer to the legal
reserve fund and other reserve.
Formation of Public Enterprise
• Example: The government formed XYZ Enterprises with Authorized capital of birr
50,000,000 in accordance with the requirement of proc. No. 25/1992 with investment of
the following assets:
Cash Birr 15,000,000
Equipment (Fair value) 700,000
The journal entry for the formation of XYZ enterprise would be as follows:
Cash ---------------------------- 15,000,000
Equipment (Fair) ------------ 700,000
State Capital -------------- 15,700,000
Operation of Public Enterprises
• In order to look at the accounting for the operation of public enterprise assume the
following information for XYZ Enterprise:
XYZ Enterprise
Trial Balance
Dec. 31,2020
Cash Birr 10,050,000
Account Receivable ---------------- 2,600,000
Property, Plant & Equipment ---- 2,200,000
Accumulated Depreciation ------- Br 50,000
Accounts Payable ------------------- 150,000
Notes Payable ---------------------- 200,000
State Capital ------------------------ 15,700,000
Sales ---------------------------------- 5,000,000
Operating Expense ---------------- 2,950,000
Purchases -------------------------- 3,300,000
Total --------------------------------- 21,100,000 21,100,000

Additional Information
 Ending inventory is Birr 1,600,000
 The BOD decided to establish other reserves of Birr 100,000 from the net income
of the year.
 Profit tax rate is 35%.
 Legal reserve 5% of profit.
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 Required
On the basis of the above information prepare

 Income statement for year end Dec. 31,2020.

 Balance sheet & Journal entries to close the income summary account

XYZ enterprise
Income statement
for the year ended Dec, 31, 2020

Sales 5,000,000

Less; Cost of goods sold 1,700,000

Gross profit 3,300,000

Less; Operating expense 2,950,000

Income before tax 350,000

Less ;Income tax( 35%) 122,500

Net Income Birr 227,500

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 XYZ enterprise

Balance Sheet
As of Dec 31 2020
Item Dr
Cash 10,050,000

Account Receivable 2,600,000

Ending inventory 1600,000
Property, plant ,Equipment 2,200,000

Accumulated Depreciation

Accounts Payable
Income tax payable

Notes Payable
State dividend payable

State Capital
Legal Reserve(5%*net profit)
Other Reserve
Total 16,450,000

1.4 Privatization of public Enterprises

Privatization can be defined as the act of reducing the role of government, or increasing the role
of the private sector, in an activity or in the ownership of assets.
This is to say, the public enterprises are being privatized with the view to increasing private
sector participation in the market and improving their performance.
The main objectives of privatization:
 Achieving wider share ownership.
 Introducing more competition.
 Changing the public-private sector mix.
 Improving the performance of public enterprises.
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 CHAPTER TWO

2. AGENCY AND PRINCIPAL; HEAD OFFICE AND BRANCH

2.1 Branches and Divisions
Branches and divisions are separate economic and accounting entities from their home office.
However, they are not separate legal entities from their home office.
Branch: a business unit located at some distance from the home office. This unit carries
merchandise obtained from the home office
ce, makes sales, approves customers‘ credit, makes collections from its customers, and remits
cash received.
Divisions: a segment of a business entity which generally has more autonomy than a branch.
Accounting for a division not operated as a separate corporation (i.e., subsidiary company) is
similar to that of branches. Accounting for a division operated as a separate corporation is
different from that of branches and consolidated financial statements are required for these
business organizations.
Sales Agency: Sales agency is a term applied to a business unit that:
 Performs only a small portion of the functions associated branch.
 Usually carries samples of products but does not have an inventory of merchandise and
 Usually lesser degree of autonomy.

Start-up Costs of Opening New Branches

All start-up costs, including Costs associated with organizing a branch or division should be
expensed in the accounting period in which the costs are incurred.

2.2. Types of Branches

Branches may be classified as under from the accounting point of view:
1. Inland Branches
2. Foreign Branches

1. Inland Branches
The branches opened in the different parts of the nation, where the original undertaking being
registered are called inland branches. These types of branches are also called home branches or
national branches. There are two types of inland branches, which are:
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 A. Dependent branch
B. Independent branch

A). Dependent Branch

Dependent branches are the branches that do not keep their records but all the records are
maintained by head office. They are not authorized to act solely without the prior permission of
the head office. All the plans, policies, rules and regulations of these branches are totally
formulated and executed by the head office. In other words, all the functions of dependent
branch are totally controlled by head office.
Under dependent branch, two types of branches are included, which is termed as service branch
and retail branch.
* Service Branch: All the branches which are booking or executing orders on behalf of head
office are called service branches. These are the branches which are busy in execution all the
orders for the sake of head office.
* Retail Branch: Retail branches are also dependent branches, but they are concerned with the
head office for selling goods, produced by the head office itself or purchased from outside in a
bulky position and are sent to the retail selling branches for selling them out as like.
b). Independent Branch
The branches that can keep their accounts themselves and sell goods that are sent by the head
office as well as those purchased by them are known as independent branches. These are the
branches which can sell the goods to head office too. They can pay their own expenses and can
deposit their collection in their own name in the bank. These branches record separately
And independently all the transactions which are even recorded by the head office.
2. Foreign Branches
Because of the rapid development of trade, commerce and industries and with the growing tough
competition, the business enterprises are opening their branches abroad in order to capture the
potential market and accelerate their business globally. Therefore, the branches established
abroad is called foreign branch. The accounting procedure of foreign branch is just like an
independent branch except in the following cases:
- Exchange rate and conversion of foreign currency into home currency.
- Effects of foreign exchange rate are to be incorporated in the books of head office.

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Where a company organizes its sales by establishing a branch or branches in the country, its head
office either run it as a selling agency branch and or autonomous branch. The characteristics or
features of these two types of branches are tabulated as follows:

Dependent Branch Autonomous Branch

Goods for resale supplied by

Goods for resale are supplied head office and branch
by the head office outlets may make some local
purchase

Branch outlets may have

Activities are strictly
some local control over its
controlled by the head office.
activities

Accounting records are Branch maintains its own

maintained by the head office accounting record

The branch managers are Branch managers are able to

given very little autonomy to make considerable decision
make decisions for the branch. making on the management
Normally all instructions are and business policies at the
from the head office. branches

2.3. Accounting System for a Branch

Two alternative systems:
1. The branch does not maintain a complete set of accounting records. The home
office serves only as an accounting and control center for the branches.
2. The branch maintains a complete set of accounting records consisting of
journal entries and ledger accounts. Financial statements are prepared by the
branch account and forwarded to the home office.
Financial statements are prepared at regular intervals by the branch and forwarded to the H.O.
(we are dealing with a branch with full autonomous).
All the above are generally prescribed by the H.O.

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 Transactions recorded by the branch should include all controllable expenses and revenue for
which the branch manager is responsible. If the branch manager has responsibility over all
branch assets, liabilities, receipts, and expenditures then the branch accounting system should
reflect this responsibility.
 Expenses such as depreciation are not subject to control by a branch manager. Therefore both
the branch plant assets and the related depreciation ledger accounts generally are maintained
by the H.O.
Reciprocal Ledger Accounts:
 Home Office Ledger Account:
This account is used by the branch to account for all transactions with the home office.
a. It is debited for all cash, merchandise, or other assets sent by the branch to the home
office or to other branches.
b. It is credited for all cash, merchandise or other assets provided by the home office to
the branch.
The H.O account (which is maintained in the branch records) is like an ownership equity account
in that it represents the equity of the H.O in the net assets of the branch (i.e. net investment by
the H.O in the branch)
At the end of the accounting period when the branch closes its accounting records, the income
summary account (showing net income or net loss) is closed to the H.O account
 Investment in Branch Ledger Account
This account is a reciprocal ledger account (to Home Office account) used by the home office
to account for any transactions with the branches.
a. It is debited for cash, merchandise and services provided to the branch by the home
office and for the net income reported by the branch.
b. It is credited for cash, or other assets received from the branch, and for net losses
reported by the branch

Note:
 The ―H.O‖ account and the ―investment in branch‖ account are reciprocal accounts which
mean that they display the same numerical balances, although one balance is a debit and
the other is a credit.

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  When combined financial statements are prepared for the H.O and its branch, the H.O
account and the investment in branch account are offset against one another and there by
eliminated from the combined statements.
 Acquisition of Plant Assets Used in Branch 
 If a plant asset is acquired by the home office for a branch‘s usage and the accounting
record for the plant asset is maintained by the home office, the accounting treatments
are:
 For the home office: debit a plant asset account: branch, credit cash or a liability account
 For the branch: no entry.
If a plant asset is acquired by a branch for its usage but the accounting record for this plant
asset is maintained by the home office,
The accounting treatments are:
 For the branch: debit Home Office and credit cash or a liability account.
 For the home office: debit a plant asset account: branch, and credit
Investment in Branch account.
 Expense Incurred by Home Office and Allocated to Branches
The home office may acquire plant assets and insurance for these assets. These plant
assets are carried in the home office accounting record but used by branches. The home
office may pay some taxes on behalf of branches, and arrange for advertising that
benefits all branches if the home office chooses to allocate these expenses to branches,
the accounting treatments are:
A. For the home office: debit Investment in Branch account, credit expense account.
B. For the branch: debit expense account, credit Home Office account
Accounting entries for transactions between branch and head office branch account.
TRANSACTIONS Branch book H.office book
Goods supplied to Inventories dr investment in branch dr
branch by head office HO cr Inventories cr
Cash received from HO Cash dr investment in branch dr
HO cr Cash cr
Goods returned to HO HO dr Inventories D

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 by branch r
Inventories cr investment in branch cr
Cash sent to HO by HO dr Cash dr
branch Cash cr investment in branch cr
When asset purchased HO dr CASH dr
by branch and asset Cash cr investment in branch cr
account is kept by HO
Depreciation for the Depreciation exp dr investment in branch dr
above Head office cr Branch asset account
HO expenses Expense account dr investment in branch t D
chargeable to branch r
Head office cr Expense account cr

2.4 Alternative Methods of Billing Merchandise Shipment to branches

There are three alternative methods available to the home office for billing merchandise shipped
to its branches
1. Billed at the At Home Office cost,
2. Billed at the At a percentage above Home Office cost, and
3. Billed at the At the branch‘s retail selling price
 Billing shipments to a branch at Home Office cost

When merchandise is billed to a branch at the Home Office cost, the cost of inventory at the
home office is equal to the cost of inventory at the branch
 This is the simplest procedure.
 It avoids the complication of inventories and permits the financial statements of branches
to give a meaningful picture of operations.
 Strength: widely used because of its simplicity
 Weakness: attributes all gross profits of the business to the branches.
 Billing shipments at a percentage above Home Office cost (such as 110% of cost)

 This may be intended to allocate a reasonable gross profit to the Home Office.

22
 When merchandise is billed to a branch at a price above Home Office cost, the net income
reported by the branch is understated and
 The ending inventories are over-stated for the enterprise as a whole.
 Adjustments must be made by the Home Office to eliminate the excess of billed prices over
cost (intra company profits) in the preparation of combined financial statements for the
Home Office and the branch.
 Billing shipments to a branch at branch retail selling prices
 The inventories ledger account of the branch shows the merchandise received and sold at
retail selling prices.
 Consequently, the account will show the ending inventories that should be on hand at retail
prices.
 Strength: to increases internal control over inventories at branches.
 Weakness: no gross profit assigned to the branches and the branch‘s net loss will equal its
operating expenses.

EXAMPLE 1
Assume that ABC Trading House (GTH), whose H.O is located in JIMMA, has several
branches in the country. One of its branches is called Bonga branch located in Bonga. The H.O
bills merchandise to Bonga branch at cost and the branch maintains complete accounting records
and prepares financial statement.
Both the H.O and the branch use perpetual inventory system. Equipment used at the branch is
carried in the H.O accounting records (branch does not maintain fixed asset accounts.)
Certain expenses, such as advertising and insurance are incurred by the H.O on the behalf of the
branch and are billed to the branch. Transactions and events during the 1st year of operations of
bonga branch (for the year 2009) are summarized below.
1. Cash of $1,000 was forwarded to bonga branch by the H.O.
2. Merchandise with a cost of $60,000 was shipped to bonga branch.
3. Equipment was acquired by Bonga branch for $500 to be carried in the H.O accounting
records (other plant assets for Bonga branch generally are acquired by the H.O)
4. Credit sales by bonga branch amounted to $80,000, the cost of the merchandise sold was
$45,000.

23
 5. Bonga branch collected $62,000 on account.
6. Bonga branch paid operating expenses totaled $20,000
7. Bonga branch remitted (transferred) cash of $37,500 to the H.O
8. Operating expenses incurred by the H.O and charged (allocated) to bonga branch total
$3,000.
Required: Recorder the above transactions in the H.O and branch accounting records.
Solution
Home office Records:
1. Investment in bonga branch 1000( dr)
Cash 1000(cr)
2. Investment in bonga branch 60,000( dr)
Inventories 60,000( dr)
3. Equipment: bonga 500( dr)
Investment in bonga branch 500( cr)
4. No entry at the H.O
5. No entry
6. No entry
7. Cash 37,500( dr)
Investment in bonga branch 37,500( cr)
8. Investment in bonga branch 3000( dr)
Operating expenses 3000( cr)
Branch Records:
1. Cash 1000
H.O 1000
H.O shows (indicates) the claim of the H.Office in the branch.
2. Inventories 6,0000
Home office 60,000
3. H.O 500
Cash 500

4. A/R 80,000
24
 Sales 80,000
Cost of gods sold 45,000
Inventories 45,000
5. Cash 62,000
A/R 62,000
6. Operating expense 20,000
Cash 20,000
7. H.O 37,500
Cash 37,500
8. Operating Expenses 3000
H.O 3000
Since the operating expenses paid by the H.O are not its own operating expense the expenses of
the H.O must be deducted. Hence total operating expense of the branch is this 3000 + 20,000
(entry 6 of the branch) = 23,000.
Note: If a branch obtains merchandise from outsiders as well as from the H.O, the merchandise
acquired from the H.O should be recorded in separate inventories from H.O ledger accounts.
Inventories xxx
H.O xxx
Inventories xxx
Cash/ A/P xxx
In the Home office accounting records, an investment in bonga Branch ledger account has a debit
balance of $26,000 before.
(a) The accounting records are closed, and
(b) The branch net income is transferred to the Investment in bonga Branch ledger account.
Investment in bonga Branch

Balance 0 (3) 500

(1) 1,000 (7) 37,500
(2) 60,000
(8) 3,000
Balance 26,000
25
In bonga Branch accounting records, the ‗Home Office‘‘ ledger account has a credit balance of
$26,000 before,
(a) The accounting records are closed, and
(b) The net income of the branch is transferred to the Home Office Ledger account.
Home office
(3) 500 Balance 0
(7) 37,500
(1) 1,000
(2) 60,000
(8) 3,000
Balance 26,000
Assume that the perpetual inventories at the end of the year 2009 for bonga Branch had been
verified by a physical count. That is,
Inventories

(2) 60,000 (4) 45,000

Balance (ending inventory) 15,000

Note: the physical count made at the end of 2009 at Bonga Branch had verified that the inventory
that is actually on hand is what is indicated by the perpetual inventory record.
The end-of-period Reporting by bonga Branch to the Home Office and closing entries are shown
below. (These are adjusting and closing entries that relate to the branch operations during 2009).
Home Office Records Branch Records
No Entry Sales 80,000
Cost of Goods Sold 45,000
Operating Expenses 23,000
Income Summary 12,000
Investment in bonga Branch 12,000 Income Summary 12,000
Income: bonga Branch 12,000 Home office 12,000
Income: bonga Branch 12,000
Income Summary 12,000

26
 End-of- period Reporting by Branch and closing Procedures
At the end of the accounting period, the branch reports the results of its operations to the home
office. On the basis of this report, the home office records the branch income.
 BRANCH REPORTING AND CLOSING PROCEDURES
The report by the branch to its home office may take the form of branch Financial Statements
or simply a trial balance of branch accounts.
 WORKING PAPER FOR COMBINED FINANCIAL STATEMENTS
A working paper for combined Financial Statements has three purposes:
A. To combine ledger account balances for like assets and liabilities
B. To eliminate any inter-company profits or losses, and
C. To eliminate the reciprocal accounts.
The working paper illustrated on this page for ABC Trading House is based on the transactions
And events illustrated for the home office (ABC. Trading House) and the branch (Bonga Branch)
for the year 2009.
 The adjusted (pre closing) trial balance at December 31, 2009 for bonga Branch reflects
the 2009 operating transactions. On the basis of this information, bonga Branch
prepares Financial Statements for its home office:
 The adjusted (pre closing) trial balance of ABC Trading House, the home office, is also
shown. Note that additional data is assumed for the home office trial balance that is not
presented in the 2009 transactions and events.
 The trial balances are assumed to incorporate all the routine year-end adjusting entries
by both the home office and branch except those related to items in transit between the
home office and branch or those related to errors.
ABC Trading House
Working paper for combined Financial Statements of H.O and Bonga Branch
For year ended December 31, 2009
(Perpetual Inventory system: Billing at cost)

27
 Adjusted Trial Balance Elimination Combined
Home office Brach
Debit Credit Debit Credit Debit Credit Debit Credit
Cash $25,000 5,000 $30,000
Accounts Receivable 39,000 18,000 57,000
Inventories 45,000 15,000 60,000
Investment in Axum 26,000 (a)
Branch 26000
Equipment 150,000 150,000
Accumulated 10,000 10,000
Depreciation
Accounts payable 20,000 20,000
Common Stock 150,00 150,00
0 0
Retained earnings 70,000 70,000
Home office 26,000 (A)
26000
Sales 400,00 80,000 480,00
0 0
Cost of Goods Sold 235,000 45,000 280,000
Operating Expenses 90,000 23,000 113,000
Dividends 40,000 40,000
Totals 650,000 650,00 106,00 106,00 26,000 26,000 730,000 730,00
0 0 0 0
Not that the $26,000 debit balance of the Investment in Bonga Branch ledger account and the
$26,000 credit balance of the Home Office Account are the balances before the respective
accounting records are closed (i.e. they are pre closing balances). That is, before the $12,000 net
income of bonga Branch is entered in these two reciprocal accounts. In the Elimination column,
Elimination (a) offsets the balance of the Investment in bonga Branch account against the
balance of the Home office Account. This elimination appears in the working paper only; it

28
is not recorded in the accounting records of either the home office or branch, because its
purpose is only to facilitate the preparations of combined Financial Statements.
Elimination (a) eliminates the pre closing home office account balance from bonga Branch‘s
home office account and the home office‘s investment in bonga branch account as follows:
Home office 26,000
Investment in bonga Branch ------------------------ 26,000
The above entry is recorded as elimination only on the working paper but not recorded on either
the Home Office or the branch accounting records. If the foregoing elimination were not made,
the combined balance sheet would show an investment represented by its own equity, which is
contrary to fundamental accounting measurement rules.
Closing entries by the branch transfer the balances of all revenue and expense accounts to an
income summary account and transfer the income summary account balance to the home office
account. After closing, the home office account appears as follows:
Home Office

(3) 500 Balance 0

(7) 1 37,500 (1) 1000
(2) 60,000
(8) 3,000
Balance 26,000
Closing 12,000
Balance 38,000
The year-end Balance of the home office account ($38,000) represents the equity of the home
office in bonga branch at year end. Note that, in our example the home office account is the only
equity account on the branch balance sheet. If a branch is, however, authorized to incur liabilities
then the year-end branch balance sheet may also reflect accounts payable as well as the home-
office Equity.
Upon receipt of the financial statement or trial balance from its branch, a home office records the
branch income by crediting a single income account and debiting the investment in branch
account. Thus, the detailed revenues and expenses of the branch are not recorded on the records
of the home office. In addition, as part of its closing entries, the home office must close its
29
income from branch account to its income summary. Immediately after closing, the investment
in branch account appears as follows.
Investment in bonga Branch
Balance 0 (3) 500
(1) 1,000 (7) 37500
(2) 60,000
(8) 3,000
Balance 26,000
Closing 12,000
Balance 38,000
The investment in branch account is a control account for the net assets of the branch. The
investment in bonga branch account balance of $38,000, in our example, represents the cash,
accounts receivable, and inventory balances ($5000+$18,000+$15000) reported on the branch‘s
balance sheet at year-end.
2.5 TRANSACTIONS BETWEEN BRANCHES
Efficient operation may on occasion require that 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 the H.O account.
E.g. Branch – A shipped merchandise to branch B. The branches and their H.O maintain
perpetual inventory system.
Make necessary journal entries.
Branch A
H.O xx
Inventories xx
Branch B
Inventories xx
H.O xx
H.O
Investment in Branch B xx
Invest in branch A xx
Note: 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 indirect routing. The

30
amount of freight costs properly included in inventories at a branch is limited to the cost of
shipping the merchandise directly from the H.O to its present location. Excess freight costs
should be recorded as expenses of the H.O.

Branch A Freight cost = 600

Freight cost = 800

Home office Direct rout Branch B

Freight cost = 1000

The excess amount (800 + 600 – 1000) = 400 which is resulted from management error is
sometimes called penalty to management and is treated as operating expense for the H.O.
Illustration on Excess freight costs on inters branch transfers of Merchandise.
The H.O shipped merchandise costing $6,000 to branch D and paid freight costs of $400.
Subsequently, the H.O instructed branch ‗D‘ to transfer this merchandise to branch E freight
costs of $300 were paid by branch D to carry out this order. If the merchandise had been shipped
directly from the H.O to branch E; the freight costs would have been $500. Assuming the H.O
and its branches use perpetual inventory system makes all the necessary journal entries in the
three sets of accounting records.
A. In accounting records of the H.O
* To record shipment of merchandise and payment of freight costs.
Investment in branch D (6000 + 400) = 6400
Inventories 6000
Cash (freight charge) 400
To record transfer of merchandise from branch D to branch E under the instruction of the H.O.
Inter-branch freight of $300 paid by branch D caused total freight costs on this merchandise to
exceed direct shipment cost by $200 i.e. 200(excess freight cost) = total freight cost – Direct
freight cost. This excess (200) is expense of the H.O and shows management error or
miscalculation.
Investment in Branch E $6,500
Excess freight expense $200
Investment in D $6,700

31
- 6700 = 6000 + 400 + 300 -> Freight cost from D to E paid by D on behalf of H.O.
B. In the Accounting records of Branch D;
To record the receipt of Merchandise from the H.O with freight costs paid in advance by the
H.O.
Inventories $6000
Freight in cost paid in advance by H.O $400
H.O $6400
* To Record transfer of Merchandise to Branch E under instruction of H.O and payment of fright
costs of $300.
H.O $6,700
Inventories $6,000
Freight in cost $400
Cash $300
C. In the Accounting records of Branch E
* To record the receipt of merchandise from Branch D transferred under the instruction of the
H.O and normal freight cost billed (direct cost that could have been incurred (500)) by the H.O
Inventories $6,000
Freight in $500
H.O $6,500
* Note:
Excess freight costs generally result from inefficient planning or management error of original
shipments should not be included in inventories. They must be treated as operating expenses.
Example 2 H.O purchased goods at $60,000 cash terms FOB. Shipping point (by the buyer).
Total transportation cost of 10,000 cash was paid for the total items having the cost of 60,000
Inventories costing 30,000 (which is half of the total items) were transferred to branch F and H.O
paid $1200 freight in advance.
Record the transactions in H.O and the Branch F (Assuming perpetual inventory system)
H.O Records:
Investment in Branch F $36,200
Inventories $30,000

32
 Cash for freight costs (10,000 – 5,000 + 1,200) $6,200
N.B the freight cost of 10,000 is paid for total inventory cost of 60,000. Divide it equally
between the 30,000 inventories shipped and 30,000 inventories remained in the H.O.
Branch F
Inventories $30,000
Freight costs (5000 +1200) $6200
H.O $36200

33
 CHAPTER 3
3. BUSINESS COMBINATION (IFRS 3)
According to International financial reporting standard (IFRS) 3. A business combination is a
transaction or other event in which a reporting entity (the acquirer) obtains control of one or
more businesses (the acquiree).
Business combinations represent accounting transactions in which two or more business entities
are bringing together under common control in a single accounting entity. Other terms frequently
applied to business combinations are mergers and acquisitions.
The following definitions for the terms commonly used in discussions of business combinations.
Acquirer/Combiner: a constituent company entering into a purchase type of business
combination whose owners as a group end up with control of the ownership interests in the
combined enterprise.
Acquire/Combine: a constituent company other than the Combinor in a business combination.
A transaction will be identified as a business combination, if it entails all of the following:
 There is an Acquirer in the business combination,
 Acquiree meets the definition of ‗Business‘.
 The transaction results in control of one entity over one or more other entities,
The assets acquired and liabilities assumed constitute a business and business has three essential
elements input, process and output.
Reasons for business combinations
If expansion is a proper goal of business enterprise, why would a business expand through
combination Rather than by building new facilities? Among the many possible reasons are the
following:
1. Cost Advantage. It is frequently less expensive for a firm to obtain needed facilities through
combination than through development.
2. Lower Risk. The purchase of established product lines and markets is usually less risky than
developing new products and markets.
3. Fewer Operating Delays. Plant facilities acquired in a business combination are operative
and already meet environmental and other governmental regulations. The time to market is
critical, especially in the technology industry. Firms constructing new facilities can expect

34
 numerous delays in construction, as well as in getting the necessary governmental approval
to commence operations.
4. Avoidance of Takeovers. Many companies combine to avoid being acquired themselves.
Smaller companies tend to be more vulnerable to corporate takeovers;therefore, many of
them adopt aggressive buyer strategies to defend against takeoverattempts by other
companies.
5. Acquisition of Intangible Assets. Business combinations bring together both intangible and
tangible resources. The acquisition of patents, mineral rights, research, customer databases,
or management expertise may be a primary motivating factor in a business combination
Economic Structure of the Combination
 Horizontal Integration: A horizontal combination is one between companies that are
competitors, within the same industry and on the same level of activity. For example, two
airline companies combine or two computer software companies combine.
 Vertical Integration: A vertical combination is one between companies in different but
successive stages of production or distribution. For example, a manufacturing company
merges with a mining company or an automobile company acquires automobile
dealerships.
 Conglomerate: A conglomerate combination is one between companies in unrelated
industries or markets. This is a procedure for companies that want to diversify. For
example, a manufacturing company acquires a financial services company
Legal Forms of the Combination
 A statutory merger; results when one company acquires all the net assets of one or more
other companies through an exchange of stock, payment of cash or other property, or the
issue of debt instruments (or a combination of these methods). Such that only the Combinor
survives as a separate legal entity. The combinee or combinees may be liquidated or
continue operating as a division of the Combinor. Thus, if A Company acquires B Company
in a statutory merger, the combination is often expressed as:

35
 A Company

A Company B Company
+ =

 A statutory consolidation results when a new corporation is formed to acquire two or more
other corporations through an exchange of voting stock; the acquired corporations then cease
to exist as separate legal entities. In other words, only the new company survives as a
separate legal entity and the old companies are dissolved. Thus, if C Company is formed to
consolidate A Company and B Company.

 A stock acquisition occurs when one corporation pays cash or issues stock or debt for all or
part of the voting stock of another company, and the acquired company remains intact as a
separate legal entity. All companies continue as separate legal entities following the business
combination. The investment in the acquired companies is carried as a long-term asset on the
acquiring company‘s books. Acquiring company is referred to as the parent, while the
acquired company (or companies) is referred to as a subsidiary (or subsidiaries. Thus, if A
Company acquires more than 50% of the voting stock of B Company, a parent - subsidiary
relationship results. Consolidated financial statements are prepared and the business
combination is often expressed as:

Financial Financial Consolidated Financial

Statements of + =
Statements of Statements of A Company
A Company B Company and B Company

Acquisition of Assets: A business enterprise may acquire from another enterprise all or most of
the gross assets of the other 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
Combiner. From an accounting perspective.
36
The distinction that is most important at this stage is between an asset acquisition and a stock
acquisition.
An asset acquisition involves the purchase of all of the acquired company‘s net assets, whereas a
stock acquisition involves the attainment of control via purchase of a controlling interest in the
stock of the acquired company.
The Accounting Concept of Business Combinations describes that One or more corporations
become subsidiaries; one company transfers its net assets to another; each company transfers
its net assetsto a newly formed corporation.
The concept emphasizes the creation of a single entity and the independence of the combining
companies before their union. Dissolution of the legal entity is not necessary within the
accounting concept.

Accounting Method and procedures for Business Combinations

Once a transaction by acquirer is identified as business combination, the acquirer shall account
for each business combination using acquisition method.
The acquisition method (AQM)
In the Acquisition Methods, there are four steps to be followed:
1. Identify the acquirer;
2. Determine the acquisition date;
3. Recognize and measure the identifiable Assets acquired, Liability assumed and any NCI in
the acquire; and

37
 4. Recognize and measure goodwill or gain from a bargain purchase.
1. identify the acquirer;
In business combination, one of the combining entities shall be identified as the acquirer.
In a business combination achieved primarily by transferring cash or other assets or by incurring
liabilities, acquirer is the combining entity (existing) or new entity (consolidation) that transfers
the cash or other assets or incurs the liabilities
2. Determining the acquisition date
a. The acquisition date is the date on which the acquirer obtains control
i. often the date the consideration is transferred, assets are acquired and liabilities
assumed—closing date
ii. may be other dates (earlier or later than the closing date) at which control is assumed-
Agreement
3. Recognition & Measurement of Identifiable Assets Acquired & the Liability Assumed
and NCI in the Acquire
Generally, the consideration given (price paid) by the acquirer is assumed to be the fair value of
the acquire as an entity.
IFRS 3 requires the consideration given in a business combination to be measured at fair value.
This is calculated as the sum of the acquisition-date fair values of the assets transferred by the
acquirer, the liabilities incurred by the acquirer to former owners of the acquire, and the equity
interests issued by the acquirer
Non-controlling interest ( NCI)
 The interest in acquire which is held by the party other than the acquirer is termed as NCI;
4. Recognize and measure goodwill or gain from a bargain purchase.
The liabilities assumed and any non-controlling interest (formerly called minority interest) in the
acquire. Any resulting goodwill or gain from a bargain purchase should be recognized.
When the price paid exceeds the fair values assigned to net assets, the excess is treated as
goodwill. Goodwill is later on tested for impairment.
When the price paid is less than the fair values assigned to net assets, a ―bargain purchase‖ has
occurred. The excess is recorded as gain on the acquisition.

38
  2. Valuation of Non-controlling interest: two options to measure the non-controlling
interest NCI at the date of acquisition:
i. date of acquisition fair value, which is normally the quoted price of interest held by NCI or
ii. proportionate share in net assets of acquire
NCI is calculated using both methods mentioned above.
Example 1: Goodwill and NCI
P Corporation. acquires 80% share in S Ltd. for cash payment of birr 100 000. On the acquisition
date, the aggregate value of S‘s identifiable assets and liabilities in line with IFRS 3 is birr
110,000. The FV of NCI (remaining 20% share) is birr 25,000. This amount was determined
with the reference of market price of S‘s ordinary shares before the acquisition date.
Required
Calculate the goodwill and NCI using both methods mentioned above as follows:

At acquisition date, allocate the cost of a business combination by recognising the acquiree‘s
identifiable net assets at their acquisition-date fair value.

39
Any difference between the cost of the combination and the acquirer‘s interest in the fair value of
the net assets acquired should be accounted for as goodwill/ gain from bargain purchase
� The goodwill can be either positive or negative:
 If the goodwill is positive, then intangible asset which is subject to annual impairment test
should be recognized;
 If the goodwill is negative, then it is a gain from bargain purchase.
Before recognizing a gain on a bargain purchase, the acquirer should.
 Review the procedures for recognizing Assets, Liability‘s, and NCI, previously held
interest and consideration transferred (i.e. check whether they are error-free);
 Recognize a gain on bargain purchase in profit or loss.
Accounting for Additional costs of BC
Costs and expenses of accomplishing the business combination are different types of costs and
expenses incurred during the search phase, the investigation phase, and the consummation
phase of a business combination. They can be grouped into the following categories:
 Costs to acquire the combination candidate: these include the following( Category A)
 Finder‘s fees
 Accounting fees for a pre-acquisition audit, and
 Legal fees in connection with the contract to acquire the candidate.
 Costs to finance the legal fees in the combination: these include the following( Category B)
 Accounting and legal fees in connection with a registration statement,
 Cost of printing stock certificates, and
 Registration costs.
The costs in category A would be incurred regardless of the mode of financing, that is, cash,
common stock, debt and so on. Thus, in purchase accounting where a new basis of accountability
prevails, these costs are capitalized as part of the cost of the investment. This treatment is not
different from pre-acquisition costs (commissions, legal, etc) of acquiring real property or
machinery.
The costs in category B, however, arise only when the mode of financing is other than cash.
Therefore, these costs arise from the financial aspects of issuing additional securities or debt and,

40
accordingly, are treated as a reduction of the proceeds of the financing. They are not capitalized
when purchase accounting is used.
Example 2: BC stock acquisition with Good Will
On January 1, Year 1, Big Company exchanged 10,000 shares of Br10 par value common stock
with a fair value of Br415,000 for 100% of the outstanding stock of Small Company in a
business combination properly accounted for as an acquisition. In addition Big Co. paid Br35,
000 in legal fees. At the date of acquisition, the fair and book value of Small Co.'s net assets
totaled Br300, 000 [=Asset 600,000 - liability 300,000]. Registration fees were Br20, 000.
Required
Record the Journal entry for the acquisition:
Assets (various) ................................................... 600,000
Goodwill… .........................................................115,000
Legal expense…......................................................35,000
Liabilities (Various) ............................................................................... 300,000
Common stock… .................................................................................... 100,000
Additional paid-in capital [315,000-20,000] ...........................................295,000
Cash [=35,000 + 20,000] ......................................................................... 55,000
Example 3: BC stock acquisition with Negative Good Will/ Gain from bargain purchase
On January 1, Year 1, Big Company exchanged 10,000 shares of Br10 par value common stock
with a fair value of Br250,000 for 100% of the outstanding stock of Sub Company in a business
combination properly accounted for as an acquisition. In addition Big Co. paid Br35, 000 in legal
fees. At the date of acquisition, the fair and book value of Sub Co.'s net assets totaled Br300,000
[=Asset 600,000- liabilty300,000]. Registration fees were Br20, 000.
Journal entry to record the acquisition:
Assets (various) ................................................... 600,000
Legal expense…......................................................35,000
Liabilities (Various) ................................................................................ 300,000
Common stock… .................................................................................... 100,000
Additional paid-in capital ........................................................................130,000
Cash [=35,000 + 20,000] .......................................................................... 55,000

41
 Gain on acquisition-PL ............................................................................. 50,000
Example 4: BC stock acquisition with NCI and Good Will
On January 1, Year 1, Big Company exchanged 10,000 shares of Br10 par value common stock
with a fair value of Br415,000 for 80% of the outstanding stock of Sub Company in a business
combination properly accounted for as an acquisition. In addition Big Co. paid Br35, 000 in legal
fees. At the date of acquisition, the fair and book value of Sub Co.'s net assets totaled Br300,000
[=600,000-300,000]. Registration fees were Br20, 000.
Journal entry to record the acquisition:
Assets (various) ................................................... 600,000
Goodwill… ..........................................................175,000
Legal expense…......................................................35,000
Liabilities (Various) ................................................................................ 300,000
Common stock… .................................................................................... 100,000
Additional paid-in capital [315,000-20,000] ...........................................295,000
Cash [=35,000 + 20,000] .......................................................................... 55,000
NCI............................................................................................................ 60, 000

42
 CHAPTER FOUR

4. CONSOLIDATED FINANCIAL STATEMENTS

5.1 Consolidated Financial Statements: Nature and Meaning
5.1.1 NATURE of Consolidated Financial Statements
Consolidated financial statements are somewhat similar to the combined financial statements that
consists a home office and its branches. In a consolidated financial statement, assets, liabilities,
revenue, and expenses of the parent company and its subsidiaries are totaled; intercompany
transactions and balances are eliminated; and the final consolidated amounts are reported in the
consolidated balance sheet, income statement, statement of stockholders' equity, and statement of
cash flows.
The consolidated financial statements are pooled from the separate legal entity status of the
parent and subsidiary corporations which necessitates eliminations that generally are somewhat
complex. It must be made clear that the investor need not consolidate all subsidiaries where it
holds more than 50% of the shares.

4.2 Methods of Accounting for Investment in Other Firms

Accountants can follow one of the following methods:
 The Equity Method  The Partial Equity Method
 The Cost Method
To summarize the above differences in the accounting methods for the investment account and
the income from the investment under the three methods, let‘s look at the following table:

METHOD INVESTMENT ACCOUNT INCOME ACCOUNT

Income Accrued As Earned;

Continually Adjusted to Reflect
EQUITY Amortization And Other Adjustments
Ownership of Acquired Company.
Are Recognized.

Cash Received Recorded As

COST Remains at Initially Recorded Cost.
Dividend Income.

43
 Adjusted Only for Accrued Income and
PARTIAL Income Accrued as Earned; No Other
Dividends Received from Acquired
EQUITY Adjustments Recognized.
Company.

4.3 Consolidation of Wholly Owned Subsidiary on Date of Business

Combination
To begin with, we consider the consolidation of financial statements from the parent and
subsidiary as of the date of business combination where the parent holds 100% of the
subsidiary‘s stocks.
For example assume that on December 31, 2005, Palm Corporation issued 10,000 shares of
Br.10 par common stock (current fair value Br.50 per share) to stockholders of Starr Company
for all the outstanding Br. 5 par common stock of Starr. Out-of-pocket costs of the business
combination paid by Palm on December 31, 2005, consisted of the following:
Finder's and legal fees relating to business combination Br. 50,000
Costs associated with registration 35,000
Total out-of-pocket costs of business combination Br85,000
Assume also that Starr Company was to continue its corporate existence as a wholly owned
subsidiary of Palm Corporation. Both companies use a December 31 fiscal year and used the
same accounting principles and procedures; thus, no adjusting entries were required for either
company prior to the combination.
Financial statements of Palm Corporation and Starr Company for the year ended December 31,
2005, prior to consummation of the business combination, follow:

PALM CORPORATION AND STARR COMPANY

Separate Financial Statements (prior to business combination)
For Year Ended December 31, 2005

44
 PALM CORPORATION AND STARR COMPANY
Income Statements (prior to business combination)
For Year Ended December 31, 2005

Palm Starr
Corporation Company
Revenue:
Net sales Br. 990,000 Br. 600,000
Interest revenue 10,000 -
Total revenue Br. 1,000,000 Br. 600,000
Costs and expenses:
Cost of goods sold Br. 635,000 Br. 410,000
Operating expenses 158,333 73,333
Interest expense 50,000 30,000
Income taxes expense 62,667
34,667
Total costs and expenses Br. 906,000 Br. 548,000
Net income Br. 94,000 Br. 52,000

PALM CORPORATION AND STARR COMPANY

Statements of Retained Earnings (prior to business combination)
For Year Ended December 31, 2005

Palm Starr
Corporation Company
Retained earnings, beginning of year Br. 65,000 Br. 100,000
Add: Net income 94,000 52,000

45
 Subtotals Br. 159,000 Br. 152,000
Less: Dividends 25,000 20,000
Retained earnings, end of year Br. 134,000 Br. 132,000

PALM CORPORATION AND STARR COMPANY

Balance Sheets (prior to business combination)
December 31, 2005

Palm Starr
Corporation Company
Assets
Cash Br. 100,000 Br. 40,000
Inventories 150,000 110,000
Other current assets 110,000 70,000
Receivable from Starr Company 25,000 ----
Plant assets (net) 450,000 300,000
Patent (net) ---- 20,000
Total assets Br. 835,000 Br. 540,000

Liabilities and Stockholders' Equity

Payables to Palm Corporation ---- Br. 25,000
Income taxes payable Br. 26,000 10,000
Other liabilities 325,000 150,000
Common stock, Br10 par 300,000 ----
Common stock, Br5 par ---- 200,000
Additional paid-in capital 50,000 58,000
Retained earnings 134,000 132,000
Total liabilities and stockholders' equity Br. 835,000 Br. 540,000

The December 31, 2005, current fair values of Starr Company's identifiable assets and liabilities
were the same as their carrying amounts, except for the three assets listed below:

Current Fair
Values,
December 31,
2005
Inventories Br. 135,000
Plant assets (net) 365,000
Patent (net) 25,000

46
Because Starr was to continue as a separate corporation and current generally accepted
accounting principles do not sanction write-ups of assets of a going concern, Starr did not
prepare journal entries for the business combination.
Palm Corporation recorded the combination on December 31, 2005, with the following journal
entries:

PALM CORPORATION (COMBINOR)

Journal Entries
December 31, 2005
Investment in Star Company Common Stock (10,000 x Br. 50) 500,000
………………………
Common Stock (10,000 x Br. 100,000
10)…………………………………………………..
Paid-in Capital in Excess of par 400,000
……………………………………………………
To record the issuance of 10,000 shares of common stock for all the outstanding common stock
Of Starr Company in a business combination.

Investment Expense……………………………………………… 50,000

Paid-inCapitalinExcess 35,000
Par………………………………………………………………
Cash…………………………………………………………………… 85,000
………………
To record payment of out-of-pocket costs of business combination with Starr Company.

Unlike the journal entries for a merger illustrated in the previous unit the foregoing journal
entries do not include any debits or credits to record individual assets and liabilities of Starr
Company in the accounting records of Palm Corporation. The reason is that Starr was not
liquidated as in a merger; it remains a separate legal entity.
 Preparation of Consolidated Balance Sheet without a Working Paper
The preparation of a consolidated balance sheet for a parent company and its wholly owned
subsidiary 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. The parent company (combiner) assets and liabilities (other than intercompany ones)
47
are reflected at carrying amounts, and 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 excess cost of the parent's investment in 100% of the subsidiary's
outstanding common stock exceeds the current fair value of the subsidiary's identifiable net
assets, both tangible and intangible.
Applying the foregoing principles to the Palm Corporation and Starr Company parent-
subsidiary relationship, the following consolidated balance sheet is produced:

PALM CORPORATION AND SUBSIDIARY

Consolidated Balance Sheet
December 31, 2005

Assets
Current assets:
Cash (Br. 15,000 + Br. 40,000) Br. 55,000
Inventories (Br. 150,000 + Br. 135,000) 285,000
Other current asset (Br. 110,000 + Br. 70,000) 180,000
Total current assets Br. 520,000
Plant assets (net) (Br. 450,000 + Br. 365,000) 815,000
Intangible assets:
Patent (net) (Br. 0 + Br. 25,000) Br. 25,000
Goodwill 15,000 40,000
Total assets Br. 1,375,000

Liabilities and Stockholders' Equity

Liabilities:
Income taxes payable (Br. 26,000 + Br. 10,000) Br. 36,000
Other current liabilities (Br. 325,000+ Br.
150,000) 475,000
Total liabilities Br. 476,000
Stockholders' equity:
Common stock, Br. 10 par Br. 400,000
Additional paid-in capital 415,000
Retained earnings 134,000
899,000
Total liabilities and stockholders' equity Br. 1,375,000

48
The following are significant aspects of the consolidated balance sheet:
1. The first amounts in the computations of consolidated assets and liabilities (except
goodwill) are the parent company’s carrying amounts; the second amounts are the
subsidiary’s current fair values.
2. Intercompany accounts (parent's investment, subsidiary's stockholders' equity, and
intercompany receivable/payable) are excluded from the consolidated balance sheet.
3. Goodwill in the consolidated balance sheet is the cost of the parent company's investment
(Br. 500,000) less the current fair value of the subsidiary's identifiable net assets (Br.
485,000), or Br. 15,000. The Br. 485,000 current fair value of the subsidiary's identifiable
assets is computed as follows: Br. 40,000 + Br. 135,000 + Br. 70,000 + Br. 365,000 +
Br. 25,000 –Br. 25,000 –Br. 10,000 – Br. 115,000 = Br. 485,000.

4.4 Consolidated Financial Statements: Subsequent to Date of Business Combination

We will limit the illustration of the subsequent date of purchase choosing one method of
accounting for the investment.
The Equity method and where the subsidiary is a wholly owned one. To make ends meet, we will
continue to use the example seen in the above.
Assume that Palm Corporation had appropriately accounted for the December 31, 2005,
business combination with its wholly owned subsidiary, Starr Company and that Starr had a net
income of Br. 60,000 for the year ended December 31, 2006. Assume further that on December
20, 2006, Starr's board of directors declared a cash dividend of Br. 0.60 a share on the 40,000
outstanding shares of common stock owned by Palm. The dividend was payable January 8,
2007, to stockholders of record December 29, 2006.
Starr's December 20, 2006, journal entry to record the dividend declaration is as follows:

2006 2 Dividends Declared (40,000 x Br. 0.60) 24,000

December 0 Intercompany Dividends Payable 24,000
To record declaration of dividend payable January 8, 2007, to stock- holders of record
December 29, 2006.

49
Starr's credit to the Intercompany Dividends Payable ledger account indicates that the liability
for dividends payable to the parent company must be eliminated in the preparation of
consolidated financial statements for the year ended December 31, 2006.
Under the equity method of accounting, Palm Corporation prepares the following journal entries
to record the dividend and net income of Starr for the year ended December 31, 2006:

2006
December 2 Intercompany Dividends Receivable 24,000
0
Investment in Starr Company Stock 24,000
To record dividend declared by Starr company, payable January 8, 2007, to
stockholders of record Dec, 29, 2006.
3 Investment in Starr Company Common Stock 60,000
1 Intercompany Investment Income 60,000
To record 100% of Starr Company’s net income for the year ended Dec. 31,
2006.

The parent's first journal entry records the dividend declared by the subsidiary in the
Intercompany Dividends Receivable account and is the counterpart of the subsidiary's journal
entry to record the declaration of the dividend. The credit to the Investment in Starr Company
Common Stock account in the first journal entry reflects an underlying evidence 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 parent's second journal entry records the parent's 100% share of the subsidiary's net income
for 2006. The subsidiary's net income accrues to the parent company under the equity method of
accounting, similar to the accrual of interest on a note receivable or an investment in bonds.
In addition to the two previous journal entries, Palm must prepare a third equity-method journal
entry on December 31, 2006, to adjust Starr's net income for depreciation and amortization
attributable to the differences between the current fair values and carrying amounts of Starr's
identifiable net assets on December 31, 2005, the date of the Palm-Starr business combination.
Because such differences were not recorded by the subsidiary, the subsidiary's 2006 net income
is overstated from the point of view of the consolidated entity.

50
Assume that the December 31, 2005 (date of business combination), differences between the

Difference Inventories (first-in, first-out cost) Br.

between Current 25,000
Fair Values and Plant assets (net):
Carrying Land Br. 15,000
Amounts of Building (economic File 15 years) 30,000
Wholly Owned Machinery (economic life 10 years) 20,000 65,000
Subsidiary’s Patent (economic life 5 years) 5,000
Assets on Date of Goodwill (not impaired as of December 31,
Business 2006) 15,000
Combination Total Br.
110,000

current fair values and carrying amounts of Starr Company's net assets were as follows:
Palm Corporation prepares the following additional equity-method journal entry to reflect the
effects of depreciation and amortization of the differences between the current fair values and
carrying amounts of Starr Company's identifiable net assets on Starr's net income for the year
ended December 31, 2006:

2006
December 3 Intercompany Investment Income 30,000
1
Investment in Starr Company Stock 30,000

To amortize differences between current fair values and carrying

amounts of Starr Company’s net assets on Dec. 31, 2005, as
follows:
3
1 Inventories-to cost of goods sold Br. 25,000
Building-depreciation (Br30,000 ÷ 15) 2,000
Machinery-depreciation (Br20,000 ÷ 10) 2,000
Patent-amortization (Br5,000 ÷ 5) 1,000
Total amortization applicable to Br. 30,000
2006
(Income tax effects are disregarded.)

51
We will next see what must be done to facilitate the consolidation. The first step to be done is
preparing the elimination entries.
Working Paper for Consolidated Financial Statements
We continue to apply the equity method to illustrate the preparation of consolidated financial
statements using a work paper. The work paper follows the discussion of the components and
their computation.
We start with the balance sheet of a year ago that we used form Palm Corporation and Starr
Company.
The inter-company receivable and payable is the Br. 24,000 dividend payable by Starr to Palm
on December 31, 2006. (The advances by Palm to Starr that were outstanding on December 31,
2005, were repaid by Starr on January 2, 2006.)
The following aspects of the working paper for consolidated financial statements of Palm
Corporation and subsidiary should be emphasized:
1. The intercompany receivable and payable are offset without a formal elimination.
2. The elimination cancels the subsidiary's retained earnings balance at the beginning of the
year (the date of the business combination), so that each of the basic financial statements
may be consolidated in turn. (All financial statements of a parent company and a subsidiary
are consolidated for accounting periods subsequent to the business combination.)
3. The first-in, first-out method is used by Starr Company to account for inventories; thus, the
Br. 25,000 difference attributable to Starr's beginning inventories is allocated to cost of
goods sold for the year ended December 31, 2006.
4. One of the effects of the elimination is to reduce the differences between the current fair
values and the carrying amounts of the subsidiary's net assets, except land and goodwill, on
the business combination date. The effect of the reduction is as follows:

Total difference on date of business combination (Dec. 31, 2005) Br.

110,000
Less: Reduction in elimination (a) (Br. 29,000 + Br. 1,000) 30,000

Unamortized difference, Dec, 31, 2006 (Br. 61,000 + Br. 4,000 + Br. Br.
15,000) 80,000
The joint effect of Palm Corporation's use of the equity method of accounting and the annual
elimination will be to extinguish Br. 50,000 of the Br. 80,000 difference above through Palm's
52
Investment in Starr Company Common Stock ledger account. Remember that the Br. 15,000
balance applicable to Starr's land will not be extinguished; the Br. 15,000 balance applicable to
Starr's goodwill will be reduced only if the goodwill in subsequently impaired.
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
5. The equalities exist when the equity method of accounting is used and intercompany profits
and sales are ignored. Despite the equalities indicated above, consolidated financial
statements are superior to parent company financial statements for the presentation of
financial position and operating results of parent and subsidiary companies. The effect of the
consolidation process for Palm Corporation and subsidiary is to reclassify Palm's Br.
30,000 share of its subsidiary's adjusted net income to the revenue and expense
components of that net income. Similarly, Palm's Br. 506,000 investment in the subsidiary
is replaced by the assets and liabilities comprising the subsidiary's net assets.
6. Palm's ending retained earnings amount in the working paper, which is equal to consolidated
retained earnings, includes only Palm's Br. 30,000 share of the subsidiary's adjusted net
income for the year ended December 31, 2006, the first year of the parent- subsidiary
relationship.
Equity Method: Wholly Owned Subsidiary Subsequent to Date of Business Combination

53
 PALM CORPORATION AND SUBSIDIARY
Working Paper for Consolidated Financial Statements
For Year Ended December 31, 2006

Elimination
Palm Starr Increase
Corporati Company (Decrease) Consolidat
on ed
Income Statement
Revenue:
Net sales 680,000 ---- 1,780,000
1,100,000
Inter-company Investment 30,000 (a) ----
Income (30,000)
Total revenue 1,130,000 680,000 (30,000) 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) 1,000 348,667
Interest expense ---- 49,000 ---- 49,000
Income taxes expense 93,333 93,333
Total costs and exp 1, 620,000 30,000* 1,670,000
020,000
Net income 110,000 60,000 (60,000) 110,000

Statement of Retained Earnings

Beginning Retained earnings 134,000 132,000 (a) 134,000

(132,000)
Net Income 110,000 60,000 (60,000) 110,000
Sub total 244,000 192,000 (192,000) 244,000
Dividends declared 30,000 24,000 (a) 30,000
(24,000)**
Ending Retained earnings 214,000 168,000 (168,000) 214,000

Balance Sheet
Assets
Cash 15,900 72,100

54
 88,000
Intercompany receivable (payable) 24,000 (24,000) ---- ----
Inventories 136,000 115,000 251,000
Other current assets 88,000 131,000 219,000
Investment in Starr Co. Common 506,000 ---- (a) ----
Stock (506,000)
Plant assets (net) 440,000 340,000 (a) 841,000
61,000
Patent (net) 16,000 (a) 20,000
4,000
Goodwill (a) 15,000
15,000
Total assets 1,209,900 650,100 (426,000) 1,434,000

Liabilities and Stockholder’s

Equity
Income taxes payable 40,000 20,000 ---- 60,000
Other liabilities 190,900 204,100 ---- 395,000
Common stock, Br. 10 par 400,000 400,000
Common stock, Br. 5 par 200,000 (a)
(200,000)
Additional Paid-in Capital 365,000 58,000 (a) 365,000
(58,000)
Retained earnings 214,000 168,000 (168,000) 214 000
Total Liabilities and Stockholders‘ 1,209,900 650,100 (426,000) 1,434,000
Equity

* an increase in total costs and expenses and a decrease in

net income
**a decrease in dividends and an increase in retained
earnings

The above working paper is a tool to facilitating the preparation of consolidated financial
statements.
The consolidated income statement, statement of retained earnings, and balance sheet of Palm
Corporation and subsidiary for the year ended December 31, 2006, are as follow.

55
The amounts in the consolidated financial statements are taken from the consolidated column of
the above working paper.

PALM CORPORATION AND SUBSIDIARY

Consolidated Income Statement
For Year Ended December 31, 2006

Net sales ………………….................. Br.1,780,000

Costs and expenses:
Cost of goods sold…………………………………….. Br. 1, 179,000
Operating expenses ………………………………... 348,667
Interest expense ……………………………………. 49,000
Income taxes expense………………………………. 93,333
Total costs and expenses ………………. 1,670,000
Net income …………………………………………… Br. 110,000
Basic Earnings per share of common stock (40,000
shares outstanding) Br. 2.75
PALM CORPORATION AND SUBSIDIARY
Consolidated Statement of Retained Earnings
For Year Ended December 31, 2006

Retained earnings, beginning of year Br. 134,000

Add: Net income 110,000
Subtotal Br. 244,000
Less: Dividends (Br. 0.75 a share) 30,000
Retained earnings, end of year Br. 214,000
PALM CORPORATION AND SUBSIDIARY
Consolidated Balance Sheet
December 31, 2006

Assets
Current assets:
Cash Br. 88,000
Inventories 251,000
Other 219,000
Total current assets Br. 558,000
56
Plant assets (net) 841,000

Intangible assets:
Patent (net) Br. 20,000
Goodwill 15,000
35,000
Total assets Br.
1,434,000

Liabilities and Stockholders' Equity

Liabilities:
Income taxes payable Br.
60,000
Other current liabilities 395,000
Total liabilities Br. 455,000
Stockholders' equity:
Common stock, Br. 10 par Br. 400,000
Additional paid-in capital 365,000
Retained earnings 214,000
979,000
Total liabilities and stockholders' equity Br.
1,434,000

57
 Chapter 5

5. Accounting for Foreign Currency Transactions

Businesses are usually involved in purchase, sales, and/or loan transactions with foreign
companies. These results in transactions being denominated (expressed) in another currency than
the reporting currency of the business. Transactions are translated into the reporting currency on
the date of the transaction. On date of payment or collection related to the transaction or on the
balance sheet date, the exchange rates could differ from those on the date of recording the
original transaction - implying the need to recognize foreign exchange gains or losses.
Exchange Rates - Means of Translation
Translation is the process of expressing monetary amounts that are stated in terms of a foreign
currency in the currency of the reporting entity by using an appropriate exchange rate. An
exchange rate ―is the ratio between a unit of one currency and the amount of another currency
for which that unit can be exchanged at a particular time.‖
These rates may be in the form of either direct or indirect quotes made by commercial banks. A
direct quote measures how much of the domestic currency must be exchanged to receive a unit
of the foreign currency. (for an Ethiopian company) is one in which the exchange rate is quoted
in terms of how many Ethiopian birr can be converted into one unit of foreign currency.
Example: 1USD = ETB 40.50 means it takes ETB 40.50 to purchase 1 USD.
If the direct exchange rate increases, the foreign currency is strengthening relative to the dollar
because more dollars are needed to purchase the equivalent amount of foreign currency.
Similarly if the direct exchange rate decreases, the dollar is strengthening relative to the foreign
currency.
Indirect quotes, measure how many units of foreign currency will be received for a unit of the
domestic currency. Exchange rates are also stated in terms of converting one unit of the domestic
currency into units of a foreign currency, which is called an indirect quotation. Example: Br.
0.02469 USD = ETB1. The indirect rate is the reciprocal of the direct rate, i.e. divide the direct
rate into 1 (1/40.50 =0.02469).
Foreign currencies are traded on both spot markets and forward (or future) markets. Exchange
rates may be quoted for the immediate delivery of currencies exchanged (spot rate), or for future

58
delivery (forward or future rate) of currencies exchanged. The forward rate is an exchange rate
established at the time a forward exchange contract is negotiated. The bank‘s buying spot rate for
the currency typically is less than the selling spot rate; the agio (or spread) between the selling
and buying spot rates represents gross profit to a trader in foreign currency. A forward exchange
contract is a contract to exchange at specified rate (the forward rate) currencies of different
countries on a stipulated future date.
In both the spot and forward markets, a foreign exchange trader provides a quotation for buying
(the bid rate) and a quotation for selling (the offer rate) foreign currency. The trader's buying
rate will be lower than the quoted selling rate, and the spread between the two rates is profit for
the trader. In each unsettled foreign currency transaction, there are three stages of concern to the
accountant.
a. At the date the transaction is first recognized. Each asset, liability, revenue, expense, gain,
or loss arising from the transaction is measured and recorded in ETB by multiplying the units
of foreign currency by the current exchange rate.
b. At each balance sheet date that occurs between the transaction date and the settlement
date.
Recorded balances that are denominated in a foreign currency are adjusted to reflect the current
exchange rate in effect at the balance sheet date.
c. At the settlements date. In the case of a foreign currency payable, an Ethiopian firm must
convert ETB into foreign currency units to settle the account, whereas foreign currency units
received to settle a foreign currency receivable will be converted into ETB.
The increase or decrease in the expected cash flow is generally reported as a foreign currency
transaction gain or loss, sometimes referred to as an exchange gain or loss, in determining net
income for the current period. Exceptions to this treatment of transaction gains and losses are
Intercompany transactions that are of a long-term financing or capital nature between an investor
and an investee that is consolidated, combined, or accounted for by the equity method.
To illustrate the application of exchange rates, assume that an Ethiopian business enterprise
required €10,000 (10,000 Euros) to pay for merchandise acquired from a Germany supplier. At
the Br. 16, selling spot rate, the Ethiopian multinational enterprise would pay Br. 160, 000
(€10,000 × Br. 16 = Br. 160, 000) for the 10,000 Euros. If on the date of settlement the exchange

59
rate between Birr and Euro differs from the Br. 16 per Euro it will result in exchange rate gain or
loss. Let‘s illustrate the exchange rate variation and its accounting treatment from the side of
Ethiopian multinational firm (buyer in this case).
Case A. Exchange rate between Birr and Euro is 17.
Case B. Exchange rate between Birr and Euro is 15.
The accounting treatment of the foreign currency transactions can be summarized and shown as
follows:
Table 1: Accounting for foreign currency transactions
Transaction date Balance sheet date Settlement date

Record accounts Settle accounts

Record transaction as: denominated in foreign denominated in foreign
Units of foreign currency currency as: currency as:
X Units of foreign currency Units of foreign currency
Current exchange rate X X
Current exchange rate Current exchange rate

Transaction date Balance sheet date Settlement date

Foreign currency Foreign currency

transaction gain/loss = transaction gain/loss =
Units of foreign currency Units of foreign currency
X X
Change in exchange rate Change in exchange rate

Treatment of foreign
Income Statement
currency transaction gain/loss Income Statement

A. Foreign Currency-Denominated Purchase (Import) Transaction

To illustrate a purchase of merchandise from a foreign supplier, assume that on December 15,
2020, Worldwide Corporation purchased merchandise from a U.S. supplier at a cost of 10,000
dollars. The U.S. supplier made the sale on 30-day open account.

60
 Inventory delivered
15/12/2020
Ethiopian U.S.
Firm
Firm

10,000 dollars to be paid

On 15/01/2021
Spot rates (selling):
Transaction date: ETB 12.50
Balance sheet date: ETB 12.40
Settlement date: ETB 12.20

 Conceptually, the firm has essentially three alternatives at year end:

– Ignore the fluctuation. Ignoring the loss is potentially dangerous.
– Adjust the amount of the purchase (called the one transaction approach). Adjustment of the
price of the purchase transaction does not reflect the economic reality that the purchase
occurred on Dec. 15 when the rate was ETB12.50.
– Recognize the change in currency value as an exchange loss (the two transaction approach).
The two transaction approach is the preferred (and generally accepted) alternative. The
recognition of the exchange rate fluctuation as a separate economic event is consistent with
the view that the purchase is entirely separate from any arrangement which may have been
made for payment.
 The journal entry on the transaction date for Worldwide to record the purchase on 30-days
open account from US supplier for Br.10,000, translated at selling spot rate of US1=ETB
12.50 (Br.10, 000* ETB12.50=ETB125,000) is as follows:
Inventories…...........................................................................125,000
Accounts Payable (10,000 dollars x ETB 12.50/USD)............. 125,000
The selling spot was used in the journal entry, because it was the rate at which the liability to the
US supplier could have been settled on January 15, 2021.
Foreign Currency Transaction Gains and Losses-During the period that the trade account
payable to the US supplier remains unpaid, the selling spot rate for the dollar may change. If the
selling spot rate decreases (the dollar weakens against the birr.) Worldwide will realize a foreign

61
currency transaction gain; if the selling spot rate increases (the dollar strengthens against the
birr); Worldwide will incur a foreign currency transaction loss. Foreign currency transaction
gains and losses are included in the measurement of net income for the accounting period in
which the spot rate changes.
To illustrate, assume that on December 31, 2020, the selling spot rate for the US was Br.1 =
ETB 12.40 and Worldwide prepares financial statements monthly. The accountant for worldwide
records the following journal entries with respect to the trade account payable to the US supplier:
Accounts Payable 1,000
Foreign Currency Gains [10,000 USD x ETB (12.50-12.40)/USD] 1,000
To recognize foreign currency transaction gain applicable to December 31, 2020, Purchase from
US supplier, as follows:
Liability recorded on Dec. 15 ETB 125,000
Less: Liability translated at Dec.31, 2020, selling spot rate:
Br.1=ETB12.40 (Br.10,000 * ETB12.40=Br.124,000) 124,000
Foreign currency transaction gains ETB 1,000
Assume further that the selling spot rate on January 15, 2021, was $.1=ETB12.20. The January
15, 2021, journal entry for Worldwide‘s payment of the liability to the US supplier is shown
below:
Trade Accounts Payable (ETB125,000-ETB 1,000) 124,000
Foreign Currency Gains [10,000 Dollars x ETB (12.40-12.20)/USD] 2,000
Cash (10,000 dollars*ETB 12.20/USD) 122,000
To record payment for Br.10,000 draft to settle liability to US Supplier, and recognition of
transaction gain (Br.10,000 * ETB12.2=Br.122,000).
Two-Transaction Perspective and One-Transaction Perspective: The above journal entries
reflect the two-transaction perspective for interpreting a foreign trade transaction. Under this
concept, this was sanctioned by the FASB in FASB Statement No. 52, Worldwide‘s dealings
with the US supplier essentially were two separate transactions. One transaction was the
purchase of the merchandise; the second transaction was the acquisition of the foreign currency
required to pay the liability for the merchandise purchased. Supporters of the two-transaction

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perspective argue that an importer‘s or exporter‘s assumption of a risk of fluctuations in the
exchange rate for a foreign currency is a financing decision, not a merchandising decision.
Advocates of an opposing viewpoint, the one-transaction perspective, maintain that
Worldwide‘s total foreign currency transaction gain of ETB3, 000 (ETB1,000 + ETB2,000 =
ETB3,000) on its purchase from the US supplier should be applied to reduce the cost of the
merchandise purchased. Under this approach, Worldwide would not prepare a journal entry on
December 31, 2020, but would prepare the following journal entry on January 15, 2021
(assuming that all the merchandise purchased on December 15 had been sold by January 15):
Trade Accounts Payable 125,000
Cost of Goods Sold 3,000
Cash 122.000
To record payment for Br.10,000 *ETB12.20= ETB122,000 to settle liability to US supplier and
offset of resultant transaction gain against cost of goods sold.
In effect, supporters of the one-transaction perspective for foreign trade activities consider the
original amount recorded for a foreign merchandise purchase as an estimate, subject to
adjustment when the exact cash outlay required for the purchase is known. Thus, the one-
transaction proponents emphasize the cash-payment aspect, rather than the bargained-price
aspect, of the transaction.
B. Sale of Merchandise to a Foreign Customer
Assume that on June 17, 2020, worldwide Corporation, which uses the perpetual inventory
system, sold merchandise with cost of ETB 122,000 to a US customer for USD15, 000, with
payment due July 16, 2020. On June 17, 2020, the buying spot rate for the USD was
Br.1=ETB12.10.
Inventory
delivered
Ethiopian 17/06/2020
Firm US firm
15,000 dollars to be
Received on 16/07/2020
Spot rates (buying):
Transaction date : ETB12.10
Balance sheet date: ETB12.07
Settlement date : ETB12.075

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To record sale on 30-days open account to US customer for Br.15,000, translated at buying spot
rate of ETB12.10 (Br.15, 000 * ETB12.10=ETB181,500) Worldwide prepares the following
journal entries on June 17, 2020 (transaction date).

Accounts Receivable (15,000 dollars x ETB12.10/USD) 181,500

Cost of Goods Sold 122,000
Sales 181,500
Inventories 122,000

Assuming that the buying spot rate for the USD was Br.1 = ETB12.07 (the USD weakened
against the ETB) on June 31, 2020 (balance sheet date), when Worldwide prepared its customary
monthly financial statements, the following journal entry is appropriate:

Foreign Currency Losses [15,000 Dollars ETB (12.10- 450

12.07)/USD]
Accounts Receivable 450

To recognize transaction loss applicable to June 17, 2020, sale to US customer as follows:
Asset recorded on June 17, 2020 ETB 181,500
Less: Asset translated at June 30, 2009, @ buying spot 181,050
rate=15,000 dollars X ETB 12.07/USD
Foreign currency transaction loss ETB 450
If on July 16, 2020 (settlement date), the date when Worldwide received a draft for Br.15, 000
from the US customer, the USD had strengthened against the ETB to a buying spot rate of Br.1 =
ETB12.075, Worldwide‘s journal entry would be as follows:
To
Cash (15,000dollars*ETB12.075/USD) 181,125
Accounts Receivable (181,500-450) 181,050
Foreign Currency Gains[15,000 dollars x ETB(12 75
12..07)/USD]
record receipt and conversion to ETB of Br.15, 000 draft in payment of Receivable from US
customer, and recognition of foreign currency transaction Gain (Br.15,000 * ETB12.075=ETB
181,125).
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C. Loan Payable Denominated in a Foreign Currency
If a multinational enterprise elects to borrow a foreign currency to pay for merchandise acquired
from a foreign supplier, the following journal entries would be illustrative:

2020 Inventories 125,000

Apr. 30 Trade Accounts Payable 125,000
To record purchase from US supplier for Br.10,000 Translated at selling spot rate of USD1 =
ETB12.50 (USD10, 000 * ETB12.50 = ETB125, 000).

2020 Trade Accounts Payable 125,000

Apr. 30 Notes Payable 125,000

To record borrowing of USD 10,000 from bank on 30-days, 6% Loan to be repaid in dollars, and
payment of liability to US supplier.

2020 Notes Payable 125,000

May 30 Interest Expense (Br.10,000 * 0.06 * 630
30/360*ETB12.60)
Foreign Currency Transaction Losses 1000
Cash 126,630
To record
Payment for Br.10,050 draft to settle Br.10, 000,30-days, 6% note, together with Br.50 interest,
at selling spot rate of USD1 = ETB12.60 (Br.10, 050 * 12.60 = ETB 126630), and recognition of
foreign currency transaction loss.
D. Loan Receivable Denominated in a Foreign Currency
A multinational enterprise‘s receipt of a promissory note denominated in a foreign currency
might be illustrated by the following journal entries.

2020 Notes Receivable 126,000

May 30 Cost of Goods Sold 100,000
Sales/Cash 126,000
Inventories 100,000

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To record sale to US customer for 60-day, 9% promissory note for Br.10, 000 * ETB 12.60=
ETB 126, 000).

2020 Notes Receivable 1,000

June 30 Interest Receivable(Br.10,000 * 0.09 * 952.5
30/360*ETB12.70)
Interest Revenue 952.5
Foreign Currency Transaction Gains 1,000

To recognize foreign currency transaction gain applicable to May 31, 2020, sale to US customer
and to accrue interest on note receivable from the customer, valued at the buying spot rate of
USD1= ETB12.70.

The Note: Computation of transaction gain

Receivable translated at June 30, buying spot Rate (Br.10,000 ETB127,000
*ETB12.70)
Receivable recorded on May 31, 2020 126,000
Transaction gain ETB1,000
transaction gain is computed as follows:

2020 Cash (Br.10,150 *ETB 12.65) 128397.5

June 30 Foreign Currency Losses 503.75
[(Br.10,000 + Br.75)*(ETB12.70-ETB12.65)
=]
Notes Receivable (ETB127,000- 127,000
ETB1,000)
Interest Receivable 952.5
Interest 948.75
Revenue[Br.10,000*12.65*.09*30/360]

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 CHAPTER-SIX

6. SEGMENT REPORTING, INTERIM REPORTING AND FINANCIAL

FORECASTS SEGMENT REPORTING
The Accounting Principles Board defined a business segmentas component of an entity whose
activities represent a separate major line of business or class of customers. Financial analysts and
others interested in comparing one diversified business enterprise with another found that
consolidated financial statements of conglomerate business combination did not supply enough
information for meaning-full comparative statistics regarding operations of the diversified
enterprises in specific industry.
The concept of segment reporting was controversial because it was opposed to the philosophy
that consolidated financial statement rather than separate financial statement fairly present the
financial position and operating, results of an economic entity.
Regardless of the legal or business-segment structure of the entity FASB: Defines: Industry
Segment‘s a component of an enterprise engaged in providing a product or service or a group of
related products and services primarily to unaffiliated customers (i.e., customers outside the
enterprise) for a profit.
Adopting the management approach to segment reporting, which requires segmentation of
business activities based on the way enterprises managed, FASB replaced the term industry
segment by operating segment.
Operating segment: - is a component of an enterprise;
(a) That engages in business activities from which it may earn revenues and incur
Expense(including revenues and expenses relating to transaction which other Component of
the same enterprise)
(b) Whose operating results are regulating reviewed by the enterprise's chief operating decision
makes decisions about its resources to be allocated to the segment and assess performance,
(c) For which discrete financial information is available.

For reportable operating segments of a business enterprise as specifically by theFASB,it

mandated several disclosures, including the following.

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1. Factors used to identify reportable segment
2. Types of products and services from which each reportable segment derives its revenue
3. Segment profit or loss and segment total assets, as measured by the internal financial
reporting system.
4. Selected components of revenues and expenses included in the management of reportable
segment profit loss, Such as interest revenue& interest expense.
5. Reconciliation of total reportable segments' profit or loss to the enterprise pretax income from
continuing operations
6. Explanation of how segment profit or loss is measured
7. Reconciliation' of total of reportable segments' assets to total assets
8. Investments influenced investees included assets.
9. Total expenditure for additions to long lived segment assets
10. In certain cases, selected information about reportable segments that operate in more than
one country
11. Information about the enterprise‘s reliance on major customers: those who provide 10% or
more of the enterprise‘s total revenues.

Allocation of Non-traceable Expense($ to operatin2 Segments

The FASB required a reasonable basis for allocations such as non-traceable expenses- those
enterprise expenses not identifiable with operations of specific operating segments- To those
segments in the measurement of reportable segment profit or loss.Accordingly, enterprise
management must devise an appropriate method for apportioning non-traceable expenses to the
operating segments. Methods that have been used for such allocation include ratio based on
operating segment revenues, payroll totals, average plant assets and inventories, or a
combination thereof.
Allocation of home office expenses commonly incurred for the segments should be madebased
on Arithmetic average of three factor ratios.
These three factors are
1. Ratio of segment Payroll to total payroll of all segments
2. Ratio of segment operating revenue to total revenue of all segments
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3. Ratio of segment Average Plant assets and inventory to total of all segments plant assets and
inventories
Interim Financial Reports
Generally, Financial statements are issued for the full fiscal year of a business enterprise. In
addition, many enterprises issue complete financial statements for interim accounting periods
during the course of a fiscal year. For example, a closely held co. with outstanding bank loans
may be required to provide monthly or quarterly financial statement to the lending bank,
However, interim financial statements usually associated with the quarterly reports issued by
publicly owned companies and the stock exchanges that list their capital stock.
APB opinion No.28
The stated objectives APB opinion No 28 were to provide guidance on accounting issues
peculiar to interim reporting and to set forth minimum disclosures requirements for interest
financial reports of publicly owned enterprises one part of the opinion deal with standards for
measuring interim financial information and another covered disclosures of summarized interim
financial data by publicly owned enterprise. In APB opinion No 28, Adopted the integral theory
that interim periods should be considered as integral parts of the annual accounting period. The
APB established guideline for the following components of interim financial reports: revenue,
costs associated with revenue, all other costs and expenses, and income taxes expense. These
guidelines are discussed in the following sections.
Revenue
Revenue from products sold or services rendered should be recognized for an interim period on
the same basis as followed for the full year. Further, business enterprises having significant
seasonal variations in revenue should disclose the seasonal nature of their activities.
Costs associated with revenue
Costs and expenses associated directly with or allocated to products sold or services rendered
include costs of material, direct labor, and factory overhead. APB opinion No, 28 required the
same accounting for these costs and expenses in interim financial reports as in fiscal year
financial statements. However, the opinion provided the following exceptions with respect to the
measurement of cost of goods sold for interim financial reports.

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1. Enterprises that use the gross margins method at interim dates to estimate cost of goods sold
should disclose this fact in interim financial reports. In addition any material adjustment
reconciling estimated interim inventories with annual physical inventories should be
disclosed.
2. Enterprises that use the LAST-IN- FIRST OUT inventory method and TEMPORARILY
deplete a base year of inventories during an interim reporting period should include in cost of
goods sold for the interim period the estimated COST OF REPLACING THE DEPLETED
LIFO base layer.

All Other costs and Expenses

Costs and expenses other than product costs should be charged to income in interim periods as
incurred, or be allocated among interim periods base on an estimate of time expired, benefit
received or activity associated with the periods. Procedures adopted for assigning specific cost
and expense items to an interim period should be consistent with the bases followed by the
company in reporting results of operations at annual reporting dates.
However, when a specific cost or expense item charged to expense for annual reporting purposes
benefits more than one interim period, the cost or expense item may be allocated to those interim
periods.
Disclosures of Interim Financial Data
As minimum disclosure, APB opinion No.28 provided that the following data should be included
in publicly owned enterprises interim financial reports to stockholders. The data are to be
reported for the most recent quarter and the year to date, or 12 months to data of the quarter‘s
end.
1. Sales or gross revenue, income taxes expense, extra ordinary items (including related
income tax effect) cumulative effect of a change in accounting principle or practice and
net income.
2. Basic and diluted EPS data for each period, presented
3. Seasonal revenue, costs, or expenses
4. Significant changes in estimates or provisions for income taxes.
5. Disposal of a business segment and extraordinary. Unusual or infrequently accruing item.
6. Contingent items.
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 7. Changes in accounting principle or estimate
8. Significant changes in financial position

For enterprises that complete an material business combination in an interim period. The FASB
requires disclosure of the following though the most recent interim period of the relevant fiscal
year.
1. The name and a brief description of the acquired entity and the percentage of voting
equity interests acquired.
2. The primary reasons for the acquisition including a description of the factors that
contributed to a purchase price those results in recognition of good will.
3. The period for which the results of operations of the acquired entity are included in
the income statement of the combined entity.
4. The cost of the acquired entity and if applicable. The number of shares of equity
interests (Such as common shares, preferred shares, or partnership interests) issued or
assumable, the value assigned to those interests and the basis for determining that
value.
5. Supplemental pro-forma information that discloses the results of operations for the
current year up to date of the most recent interim statement of financial position
presented (and for the corresponding periods in the preceding year) as though the
business combination had been competed as of the beginning of the period being
reported on. That pro-forma information shall display, at a minimum. Cumulative

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