ADVANCED FINANCIAL ACCOUNTING II

PREPARED BY ABDI DEREJE (MSc.)

DEPARTMENT OF ACCOUNTING AND FINANCE

MARCH 2023
SHAMBU ETHIOPIA

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 CHAPTER ONE
OVER VIEW OF ACCOUNTING FOR JOINT VENTURES AND PUBLIC ENTERPRISES

Accounting for joint ventures

In today’s business community, joint ventures are less common but still are employed for many projects
such as: (1) the acquisition, development, and sale of real property; (2) exploration for oil and gas; and
(3) construction of bridges, buildings, and dams.
A joint venture is defined as an association of two or more investors organized for the purpose of
sharing risks that the investors are unwilling to assume individually. The members of the joint venture
called Ventures may be organized as a corporation, a general partnership, or a limited partnership.
A joint venture may be organized as a corporation, in which case the ventures own shares in the
corporation unlike an ordinary corporation, in which management participation is determined by
majority shareholders, ventures in a corporate joint venture participates in the management of the
venture based on terms and conditions specified in a contract.
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Joint ventures may further be organized as unincorporated joint ventures, which are neither corporations
nor partnerships, and in which the ventures duties and rights are governed by a contract between the
parties.
The joint venture can be national or an international on, the latter being present if the ventures come
from different countries. Joint ventures have long been used in international business for expansion into
markets, particularly in developing countries. In recent years, joint ventures are being used as the
principal vehicle for foreign direct investments.
Nature of Joint Venture Businesses
A joint venture is often defined as a contractual arrangement involving the co-operative efforts and the
utilization of the resources of two or more ventures to accomplish an agreed- upon goals. In a joint
venture arrangement, the participating ventures generally decide major policies concerning the
undertaking by mutual agreement.
The legal form chosen for a particular joint venture arrangement results from a consideration of the
relationship desired by the participating ventures within parameters set by the objectives of the venture,
enterprise law of the country of operation, tax law, business environment, and so forth. Thus, a joint
venture may take the form of a partnership, a trust, undivided interests in an undertaking, or a
corporation (limited liability Company). Also, joint ventures are often created in the form of a
contractual arrangement for carrying out specific activities without forming a separate organizational
structure. Among others the following are main features of Joint Venture form of businesses
 the participating ventures enter into a contractual arrangement, typically in written ,
 The participants, by that contractual agreement, are given joint control of the undertaking
which is the object of the joint arrangement.
 The life of the joint venture is limited to that of the undertaking
 Decisions in essential to the accomplishment of a joint venture require the consent of all the
ventures.
 No unilaterally control by ventures over the venture.
1.3 Types of Joint Ventures
Considering the nature of joint venture arrangements, joint ventures can be classified as belonging to
one of the following types:
(a) Jointly controlled operations
A jointly controlled operation is a joint venture that involves the use of the assets and other resources of
the venturers. A venturer uses its own assets and incurs its own expenses and liabilities. Profits are
shared among the venturers in accordance with the contractual agreement.
To illustrate assume that Company X and Company Y decides to enter into a joint venture arrangement
to produce a new product. Company X undertakes one manufacturing process and Company Y
undertakes the other. X and Y each bear their own expenses and take an agreed share of the sales
revenue from the product. Furthermore, they jointly market and distribute the finished product using
each venture's resources such as its property, plant and equipment, technical expertise and employees.
In this specific example we can understand that the two venturers (X and Y) are simply agreed to
contribute perform the undertaking without contributing any assets to form a new business. The
venturers at the end of the venture agreed to share profit and losses according to their agreement.
(b) Jointly controlled assets
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A jointly controlled asset is a joint venture in which the venturers control jointly (and often own jointly)
an asset contributing to or acquired for the purpose of the joint venture. The each venturer takes a share
of the profit or income from the asset and each bears a share of the expenses involved. This type of joint
venture arrangement is prevalent in the oil and gas extractive industries.
To illustrate assume that Oliqa-Company and Gadiqa-Company enter into a contract to undertake oil
exploration and to build an oil pipeline. Oliqa-Company is responsible to purchase machineries and
construct buildings for office purposes, while Gadiqa-Company is responsible to build the oil pipeline.
As you can see from the illustration the two companies agreed to contribute assets to the joint venture
undertaking but not have any intention to form a new business organization. In simple talking, the
venturers perform the activities of the joint venture by using the contributed assets of the venture. The
income generated from the operations of the joint venture is shared between them according to their
agreements.
(c) Jointly controlled entities
A jointly controlled enterprise is a joint venture that involves the establishment of an enterprise,
partnership, or other enterprise in which each venture has an interest. The venturers agreed to make an
agreement profit sharing, and the capital contribution.
Generally, jointly controlled entities may be divided into two forms:
Incorporated joint ventures: This type of jointly controlled entities type of joint ventures has the
same features with a formal corporate form of business organizations. Among others it includes
separate legal entities, limited legal liabilities, separate accounting records and reports and the like
etc.
Unincorporated joint ventures: This type of joint ventures more or less similar with that of
partnerships and trusts. Thus, the following major features that include no separate legal entities,
unlimited legal liabilities, separate accounting records and reports etc characterize them.
To illustrate, assuming that SIIF-Company and NAAF-Company enter into a joint venture agreement to
manufacture and sell a new product. They set up an enterprise that carries out these activities. SIIF-
Company and NAAF-Company each own 50% of the equity share capital of the enterprise and are its
only directors. They share equally in major policy decisions and are each entitled to 50% of the profits
of the enterprise.
According to the illustration, the two venturer companies contribute resources for the operation of the
joint venture and at the same time they have formed a new organization that would take the
responsibility to run the operations of the joint venture
1.1.1. Accounting for investment in JV Businesses
One of the basic issues, among others, as far as joint ventures are concerned is accounting for joint
ventures. There are a number of accounting questions in relation to accounting for joint ventures,
however, for simplicity, accounting for joint venture may summarized in to three different accounting
aspects for joint ventures. These three aspects are the following:
I. Accounting and financial reporting of the joint venture
II. Accounting and financial reporting of each individual venturer
III. Consolidated financial statements of each individual venturer
The following subsequent paragraphs will deal about these major issues of joint ventures except the
third one because it will be covered in the last chapter of this module.

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 I. Accounting and financial reporting of the joint venture
The accounting and financial reporting of joint venture depends on the types of joint ventures either it is
jointly controlled operation, jointly controlled assets or jointly controlled entities.
Jointly Controlled Operations
A full set of separate accounting records may be kept for the joint venture so that the ventures can assess
the performance of the venture (e.g. through regular management accounts). Where the venture has a
full set of accounting records, the transactions are recorded in exactly the same way as for an ordinary
business. A separate income statement can be extracted from which each venture will be credited or
debited with his agreed share of the profit or loss. In theory it is possible for a jointly controlled
operation to have a full set of records, but this is rare in practice.
Due to the short lifetime or size of the joint venture, it is not considered worthwhile opening a new set of
records for what may only be a few transactions. In this case each venture will record transaction on
behalf of the venture in his own records, alongside his other business dealings.
II. Individual financial statements of the Ventures
In its separate financial statements each individual venture recognizes the assets that it controls and the
liabilities that it incurs as well as the expenses that it incurs and its share of the revenue that it earns
from the sale of goods or services by the joint venture.
Because the assets, liabilities, income and expenses are recognized in the separate financial statements
of a venture, they will automatically be included in the venture, they will automatically be included in
the venture’s consolidated financial statements, and no particular consolidation adjustments will be
required.
Jointly Controlled Assets
Although these are not separate legal entities, the resources contributed by the participating ventures are
combined together for the purpose of a joint venture project which is managed either by one venture
typically known as operator, or by a joint managements team. The joint venture, agreements defines the
responsibilities and obligations, of the operator, the interests of the parties etc. The distinctive feature of
a joint venture at this type is that each ventures possesses an undivided interest in its assets. The costs of
running the project are shared by the participating ventures on agreed basis; each venture usually takes a
portion of the output of the joint venture. This type of joint venture arrangements is prevalent in the
extractive industries (e.g. oil, gas, and minerals). An example of a jointly controlled assets venture is
where two or more oil exportation companies enter into a joint arrangement to undertaken oil
exploration or to build an oil pipeline.
These joint ventures normally maintain separate accounting records of the expenses incurred for the
undertaking, and the resources received from and the outputs delivered to the joint venture participants.
These accounting records are maintained by the operator of the undertaking. In most cases, the joint
venture agreement may include an accounting agreement encompass the approval, funding, reporting,
allocation, charging and audit of expenditures applicable to the joint venture.
Generally, the operator is given authority to commit and incur expenditures by virtue of an approved
AFE (Authority for Expenditure) within the agreed work programmer and budget. An AFE covers a
particular activity. In a joint venture for oil exploration, for example, it may cover an exploration well or
the construction of ROA of the production facilities. The AFE is normally broken down and reported
against controllable cost categories. As a result, a measure of control is exerted by the ventures (non-
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operation), while following the operator the flexibility to perform the task. Any revisions to work
programmer and budget are to be approved by the venturers periodically.
During the various stages of joint venture activity, the operator will receive cash and non-cash resources
from the participating venturers. The operator will make cash calls on the venturers and will deposit the
funds into bank accounts under joint names of the ventueres. The operator will have the authority to
operate these joint bank accounts. Disbursements will be made by the operator from these bank
accounts. If the operator is one of the venturers, financial operations of the joint venture undertaking
must be separated from its financial operations of over areas of involvement.
The accounting agreement for a joint venture involving joint venture assets, normally lays down
procedures for reporting back to the ventures, on a monthly basis, expenditures, commitments, estimated
total expenditures against budget, cash balances, accruals, etc. This information needs to be in sufficient,
detail for ventures to review the current management and also for them to use information as appropriate
in their own financial statements.
The accounting agreement generally specifies how the various costs are to be allocated between the
participating ventures. In accordance with the agreement, at regular intervals, the operator sends bills to
the individual ventures for their respective shares of the total joint venture costs. The simplest form of
allocation is where each partner has a fixed equity interest. After inception of the joint venture, the
percentage interests of the ventures may change. The cost allocation is adjourned to reflect these
circumstances.
Another level of allocation is accounting for the income or tariff derived from joint venture activity for
the use of its assets by enterprises other than the joint venture participants. Procedures for allocating the
revenues to the participating ventures of jointly controlled assets need to be agreed by all the ventures.
If the operator is one of the ventures and some of its own resources are used for joint venture activity,
there may be some problems in charging expenditures to the joint venture. There is no problem with
direct expenditures, so long as the operator's accounting system can clearly identify the costs to a
particular joint venture. Problems may arise over the amount to be charged to the joint venture for the
services of facilities and staff of large operator involved in many activities.
It is up to the participating ventures to come to an equitable arrangement. However, an underlying
principle in a cost sharing arrangement should be that the operator neither loses nor gains by virtue of
acting in that capacity.
In most cases, the arrangements for the jointly controlled assets contain provisions for audit
mechanisms. Thus, in detail the information substantiating the expenditure reports submitted by the
operator. Instead of performing individual audits, it is the usual practice for the participants to provide
members for a joint audit team to visit the operator's premises.
Jointly Controlled Entities
A jointly controlled entity keeps its own accounting records and prepares and presents financial
statements in the same way as any other enterprise. Each venture usually contributes cash or other
resources to the jointly controlled entity. For example, if the entity is a limited company a venture
normally exchanges cash or other assets for equity shares.
A venture can recognize a gain or loss in his income statement from contributing a non- monetary asset
to the jointly controlled entity in exchange for an equity interest. The recognition non- monetary
contributions by ventures appropriate unless.
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  The risks and rewards relating to the non- monetary asset are not transferred to the jointly
controlled entity
 The gain or loss cannot be measured reliability, or
 Similar assets are contributed by the other ventures.
The ventures’ interests in the joint venture are interests in the entity as a whole, not in its individual
assets and liabilities. Therefore, a venture’s interest in a jointly controlled entity is recognized in its own
financial statements as a non-current asset investment.
[Link]. Accounting for a Corporate Joint Venture
Corporate joint venture refers to a corporation owned and operated by a small group of businesses (the
joint venturers) as a separate and specific business or project for the mutual benefit of the members of
the group. A government may also be a member of the group. An entity which is a subsidiary of one of
the joint venturers is not a corporate joint venture. According to the Accounting Principles Board,
investors should account for investments in common stock of corporate joint ventures by the equity
method in consolidated financial statements.
Arguments for establishing a separate set of accounting records for every corporate joint venture of large
size and long duration are:
The complexity of modern business
The emphasis on good organization and strong internal control
The importance of income taxes
The extent of government regulation
In the stockholders’ equity accounts of the joint venture, each venture’s equity account is credited for
the amount of cash or non cash asset invested. The accounting records of such a corporate joint venture
include the usual ledger accounts for assets, liabilities, stockholders’ equity, revenue, and expenses. The
entire accounting process should conform to generally accounting practices, from the recording of
transactions to the preparation of financial statements.
[Link]. Accounting for an Unincorporated Joint Venture
Because the investor-venture in an unincorporated joint venture owns an undivided interest in each asset
and is proportionately liable for its share of each liability, the provisions of APB may not apply in such
cases. Investors in unincorporated joint ventures have, thus, the option of using either the equity method
of accounting or a proportionate share method of accounting for the investments.
Illustration: assume that X Company and Y Company each invested Br. 400,000 for a 50% interest in
unincorporated joint venture in January 2005. Condensed financial statements for XY Company for
2005 were as follows:
XY Company (A joint venture)
Income Statement
For the Year Ended December 31, 2021
Revenue 2,000,000
Less: Cost and Expenses 1,500,000
Net Income 500,000
Division of net income
X Company 250,000
Y Company 250,000
Total 500,000

XY Company (A joint venture)

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 Statement of Venturer’ Capital
For the Year Ended December 31, 2021
X Company Y Company Combined
Investment, Jan. 2 400,000 400,000 800,000
Add: Net income 250,000 250,000 500,000
Venturers’ Capital,
End of Year 650,000 650,000 1,300,000
XY Company (A joint venture)
Balance Sheet
December 31, 2021
Assets
Current Assets 1,600,000
Other Assets 2,400,000
Total Assets 4,000,000
Liabilities & Venturers’ Capital
Current Liabilities 800,000
Long term Debt 1,900,000
Venturers’ Capital:
X Company 650,000
Y Company 650,000 1,300,000
Total Liabilities & Capital 4,000,000
Under the equity method of accounting, both X Company and Y Company prepare the following journal entries for the
investment in the XY Company: 2005
Jan 2 Investment in XY Company (Joint Venture) 400,000
Cash 400,000
To record investment in joint venture

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

Investment Income 250,000
To record share of XY Company net income (500,000*.5)
Under the proportionate share method of accounting, in addition to the foregoing journal entries, both
X Company and Y Company prepare the following journal entry for their respective shares of the assets,
liabilities, revenue, and expenses of AB Company: 2021
Dec 31 Current Assets (50%) 800,000
Other Assets (50%) 1,200,000
Costs and Expenses (50%) 750,000
Investment Income 250,000
Current Liabilities (50%) 400,000
Long term Debt (50%) 950,000
Revenue (50%) 1,000,000
Investment in AB Co (Joint Venture) 650,000
 To record proportionate share of joint venture’s assets, liabilities, revenue, and expenses.
Use of the equity method of accounting for unincorporated joint ventures is consistent with APB
Opinion No. 18 but information on material assets and liabilities of a joint venture may be relegated to a
note to financial statements resulting in off-balance sheet financing. The proportionate share method of
accounting for unincorporated joint ventures avoids the problems of off-balance sheet financing but has
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the questionable practice of including portions of assets such as plant assets in each venturer’s balance
sheet.
Operating the Joint Venture

Decision Making
Joint venturers are free to conduct other business apart from the joint venture activities, even if it is in
direct competition with their joint venture. In addition no venturer has the authority to act on the other
venturers behalf with regard to assuming any liabilities or responsibilities. In this respect the joint
venture differs from the partnership structure. In most cases, the decision- making authority is shared by
the ventures on an equal basic and decisions are mutually agreed to.

Allocation of Joint Venture Income and Profits

Every joint venture must determine how the income of the venture will be divided among the co-
ventures. Note that for tax purposes, the salary paid to a venturer is not an expense. It is just part of the
income- splitting formula. For tax purposes maintain good records as to the amount taken out of the joint
venture and the amount of income share left inside the joint venture. Venturers may consider interest
(rent) on properties contributed, such as machinery, labour, and management.
Viewing Contributions
In calculating the contributions of each party, it is important to use realistic estimates of value. Use
market value in viewing assets. Review the profit-sharing ratio whenever there is a change in the relative
contributions of capital and labour or management by any of the parties.
Day-to-Day Operating Producers
The day- to-day handling of income and expenses for a joint venture is made simpler by establishing a
joint bank account for the joint venture and separate individual bank accounts for the individuals.
Accounting
For accounting purposes, a separate accounting system should handle all transactions through the joint
account. In addition, each individual should have an accounting system for his personal and business
related transactions handled through the individual bank accounts. The accounting system should
account for all flows of money between the individuals and the joint venture.
Dissolving the Joint Venture
On dissolution of a joint venture each party would be entitled to their individually owned assets, plus
their share of the inventories and other properties. Since in most cases the individual parties own the
assets contributed to the joint venture there is no taxable disposition of assets when the joint venture
winds down.
The joint venture agreement usually sets out the conditions upon which the joint venture is terminated.
These might include one of the ventures disposing of their assets used by the joint venture, or the death
of one of the ventures. It could also be the arrival of date upon which the parties have decided to
terminate the joint venture or when one of the parties gives notification
Formation of Joint Ventures
The formation of an international joint venture can be an extremely complex process. The goals of the
enterprise must be defined, the structure must be negotiated, numerous legal issues must be recognized

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and resolved, and potential areas of conflict between the JVPs must be identified and reconciled. Careful
planning is required at all stages.
The planning stages essential to the formation of a joint venture are outlined below. The important
considerations relevant to each stage are briefly discussed below.
Identifying Objectives
At the outset of every proposed joint venture, it is necessary to have an understanding of the basic
objectives of the proposed enterprise. This includes identification of the nature and scope of the
proposed undertaking, as well as the company's expectations and goals. For example, if X Companyis
seeking a short-term arrangement to measure the potential market for a product in a foreign country, a
licensing or straight forward contractual arrangement might be preferable to a joint venture, which
generally contemplates a longer term and more substantial commitment.
Selecting a Partner
If a joint venture is deemed desirable, one of the first considerations is the selection of a compatible
partner. A concern may initially seek a co-venturer of equal business structure and with comparable
corporate policies, philosophies, and financial resources. Through the process of active negotiation,
involving business people as well as lawyers, the JVPs should determine whether their objectives are
compatible. This process may be difficult, but it is important, particularly in the context of multinational
joint venturers, given the cultural linguistic, political, and social differences between the particular
similarly, there may be legal, accounting, and tax differences between the countries of the JVPs. Since
all of these differences may give rise to misunderstandings, they may be reconciled.
Choosing the Business Form
The next step is to choose the basic structure of the business venture. A variety of complex legal and
practical considerations are involved at this stage. It is necessary to identify the respective contributions
of the parties and the proposed financing arrangements in order to measure the compatibility of the
potential JVPs and to determine the appropriate organizational form. Frequently, one JVP looks for a
capital infusion and, in turn, shares its technology expertise, and know-how.
Identifying Legal Problems
At the beginning of the process, counsel must identify and resolve major legal issues and potential
problem areas, including governmental regulatory matters.
Identifying conflicts Between Partners
It is also important to identify potential areas of conflict between the JVPs so that they can be reconciled
prior to making an irrevocable commitment. For example, the parties may have to deal with differing tax
objectives resulting from fundamentally different business goals or, more commonly, from different
constraints of the tax laws and accounting practices of the home country. Early recognition of these
issues may allow the parties’ sufficient flexibility to structure issues may allow the parties sufficient
flexibility to structure the joint venture to avoid these problems.
Drafting the Joint Venture Agreement
Finally, after the goals, structure, and legal issues have been identified, it is necessary to draft the joint
venture agreement. International joint ventures often involve unique features, and careful draftsmanship
is required.
Disclosure Requirements

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 Disclosure of summarised financial information about material joint ventures or associates
(IFRS 12

Disclosure of Interests in Other Entities)—January 2015

The Interpretations Committee received a request to clarify the requirement to disclose
summary financial
information on material joint ventures or associates in paragraph 21(b) (ii) of IFRS 12
Disclosure of
Interests in Other Entities and its interaction with the aggregation principle in paragraphs
4 and B2–B6 of
IFRS 12.
The submitter asserts that there are two ways in which to interpret the application of those
paragraphs.
Either the information required in paragraph 21(b) (ii) of IFRS 12 can be disclosed in
aggregate for all
material joint ventures or associates, or such information should be disclosed individually
for each material
joint venture or associate.
The submitter also asked the Interpretations Committee to clarify the requirements in
paragraph 21(b) (ii)
of IFRS 12 when the information relates to a listed joint venture or associate, and local
regulatory
requirements would prevent the investor from disclosing such information until the joint
venture or
associate has released its own financial statements. Would the investor be excused from
disclosing the
information?
The Interpretations Committee noted that it expected the requirement in paragraph 21(b)
(ii) of IFRS 12 to
lead to the disclosure of summarised information on an individual basis for each joint
venture or associate
that is material to the reporting entity (i.e. this information should not be presented in
aggregate for all
material joint ventures or associates). The Interpretations Committee observed that this
reflects the IASB's
intentions as described in paragraph BC50 of IFRS 12.
The Interpretations Committee also noted that there is no provision in IFRS 12 that
permits the non-
disclosure of the information required in paragraph 21(b) (ii) of IFRS 12.
The Interpretations Committee was made aware of another concern relating to the
disclosures required by
IFRS 12 for joint ventures or associates in paragraphs 21(b) (ii), and paragraphs B12 and
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 B13. Some think
that these paragraphs do not specify the basis on which an entity should prepare the
required summarised
financial information for joint ventures and associates. The question raised is whether this
information
should be presented for each material joint venture or associate on an individual basis, or
whether this
information should be disclosed for the subgroup of the joint venture or associate together
with its
investees.
The Interpretations Committee observed that a reporting entity should present the
summarised financial
information required by paragraph 21(b) (ii) about a joint venture or an associate that is
material to the
reporting entity based on the consolidated financial statements for the joint venture or
associate, if it has
subsidiaries. If it does not have subsidiaries, the presentation should be based on the
financial statements of
the joint venture or associate in which its own joint ventures or associates are equity-
accounted. The
Interpretations Committee noted that these views are consistent with paragraph B14 (a),
which states that
‘the amounts included in the IFRS financial statements of the joint venture or associate
shall be adjusted to
reflect adjustments made by the entity using the equity method, such as fair value
adjustments made at the
time of acquisition and adjustments for differences in accounting policies’.
The Interpretations Committee analysed the results of the outreach request performed by
the staff. This
outreach indicated that no significant diversity has been observed in the application of
IFRS 12 related to
these issues.
In the light of the existing IFRS requirements, and on the basis of the outreach results
received, the
Interpretations Committee determined that neither an Interpretation nor an amendment to
a Standard was
necessary and therefore decided not to add this issue to its agenda.

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 CHAPTER TWO
ACCOUNTING FOR PUBLIC ENTERPRISES IN ETHIOPIA
2.1 What is Public Enterprise?
Public Enterprises may be defined as autonomous or semi-autonomous bodies owned by the
government and engaged in providing services and or products.
The growth of public enterprises has been partly by nationalization and partly through creation of new
ones. Some industries are also reserved for the public sector as a matter of national policy. Such
industries could be airways, defense industries, railways, telecommunication and the like.
Why Public Enterprises Needed?
The need to have public enterprises may be justified on a number of grounds, such as:
 Limitation of the free price mechanism: It is realized that in spite of all its advantages, a free price
mechanism had serious limitations which had to be overcome in the long term interests of the
economy. An economy can not sustain itself and grow unless it is healthy in terms of production
potential which should increase with the passage of time that is development of different economic
sectors in harmony or proper sectorial balance. However, the nature of market mechanism is such
that all economic activities are guided by economic rationalism which in the case of provision of
products or services means profitability. Market mechanism would refuse to run those productive
services which could not yield adequate profits. But such ventures are necessary for the development
of the economy. The public authorities thus maintain these projects at a loss and meet the loss from
their tax revenue.
 Basic industries need huge investment: Private enterprise is either not able to raise the necessary
funds or not ready to assume such large risks. In such cases, even if these enterprises could possibly

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 be profitable, the government has to step in to establish them. Cases of very long term projects also
come in this category.
 Government’s duty to help in economic development: Such a policy entails a number of
responsibilities and some of these results in the governments going in for various types of public
enterprises. In an underdeveloped country, additionally, we find that there is an overall shortage of
capital. It becomes, therefore, the task of the authorities to assume the responsibility of filling the
gap and thereby removing the specific shortages. The role of basic and key industries which provide
an impetus and necessary basis for the general economic development may also be mentioned in this
connection.
 It is not very likely that the private sector which moves solely on the basis of profit motive, will find
it always convenient to move ahead and establish these industries in time and adequate measure. The
private sector would find it easier and more profitable to expand at a rapid rate once basic inputs like
skilled human resource are created through education and training.
 Creation of economic surpluses and their utilization: A number of public undertakings directly
add to the capital assets of the economy in the form of roads, bridges, factories and the like. They
are, in so far as they are not in the public sector by virtue of nationalization only, net additions to the
capital stock of the country and, therefore, they contribute to its total productive power. Such an
addition might also result from utilization and exploitation of resources which were hitherto going
waste; or from change in the allocation of resources. Public enterprises can also help the economy a
lot by diverting its productive resources into those lines which will accelerate the growth process
later through a provision of an infrastructure, basic and key industries and so on.
 Final choices of projects are made in the interest of the economy as a whole: If social benefits
exceed social costs in the case of any service, then its production should be taken up. But it is
possible that on grounds of social benefits some projects are sound but not on grounds of
commercial profitability. Under such circumstances, these projects can be taken up by authorities in
the public sector.
 Limitation on demand of merit goods on account of price if left in private hands: Merit goods
are those expected to enhance the general welfare of the community and should be provided through
public enterprises either along with public enterprises or in place of it. It is generally believed that
the supply of such services should be adequate and should be available at low or zero prices so as to
encourage their consumption. In case of education, the government may not only provide it for free
but also insist that all children up to a certain age must attend schools.
 The overall economic policy of a country may dictate the use of public enterprises in some
sectors: There are some industries like electricity generation where there are economies of scale. If
such services are provided by a large number of firms competing with each other, it wouldn’t be
possible to reap these economies. Authorities may, therefore, think it more desirable to have a public
monopoly than private monopoly for such services.
 Effective economic control of the economy; Effective economic control of the whole economy is
sought to be brought in the hands of the state. In other words, the argument of not letting the
emergence of a monopoly in private hands is extended to the whole economy. The authorities might

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 plan to have a strategic control over the working of the whole economy through controlling certain
key sectors.
 Better protection of natural resources: In the case of some natural resources like forests, mines
and the like, the commercial interests of a private enterprise often come into conflict with those of
the nation. A private jungle contractor authorized to cut trees is likely to make a quick profit by
cutting down as many trees as possible. This may result in a large scale and quick denuding of the
land causing soil erosion and upsetting the ecological balance.
Forms of Public Enterprises
The enterprises which are not run on departmental basis have, in general, two forms. One is as a firm or
company owned and controlled by the government and functions under the same laws of the country as
private firms or companies of similar type.
Another form of public enterprise is what may be called the public corporation. Public corporations are
 Set up by legislation which defines:
 Sphere of activities
 Rights, immunities
 Artificial legal persons
 Can take independent decisions
 Can sue and be sued
 Have their own personnel policy, management pattern and the like
 Can retain and reuse their funds according to adopted policy
2.2 Overview of Ethiopian Public Enterprises Proclamation No. 25/1992
Proclamation No 25/1992 is a legal provision governing establishment and operation of public
enterprises in Ethiopia. The public enterprises in Ethiopia include those nationalized and established
afresh by the government over the years. As per the proclamation a public enterprise is defined as a
wholly state owned enterprise established pursuant to the proclamation to carry on for gain
manufacturing, distribution, service rendering or other economic and related activities.
According to this proclamation:
1. Every enterprise shall be established by regulation and the establishment regulation shall contain:
 The name of the enterprise
 A statement the enterprise shall be governed by the proclamation
 The purpose for which the enterprise is established
 The authorized capital
 The amount of initial capital paid up both in cash and in kind
 A statement that the enterprise shall not be liable beyond its total assets
 The head office of the enterprise
 A statement that may authorize the enterprise to open branches
 The name of the supervising authority
 The duration for which the enterprise is established
2. Each enterprise shall have:
 A supervising authority
 A management board
 Management
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  Necessary staff
3. A supervising authority is an authority that is designated by the Council of Ministers with a view to
protecting the ownership rights of the state.
4. Each enterprise shall keep accounts as per IFRS
5. Financial year of the enterprises shall be determined by the supervisory authority
6. Each enterprise shall have a Legal Reserve Fund (LRF)
 5% of net profit transferred annually to LRF until the fund equals 20% of the capital
 The fund may be utilized for covering:
 Losses
 Unforeseen expenses and liabilities
 The board of the enterprises, upon approval of the authority, may establish other funds
7. Taxes and Duties
 Shall be paid as per relevant provisions of applicable laws
8. State dividend
 The amount to be paid to the government in the form of state dividend shall be determined by
the supervisory authority based upon proposal of the board.

2.3 ACCOUNTING FOR THE FORMATION OF A PUBLIC ENTERPRISE

The requirements that need to be complied with in the middle of creating a public enterprise are set out
under articles 5 & 6 of Ethiopian Public Enterprises Proclamation No.25/1992. The basic requirement is
the determination of capital, which is the leverage of the enterprise over the years. The amount should
be known in advance. Capital may have two features. Authorized and paid up. Authorized capital is the
total amount of money or its worth formally adopted for the operation of the enterprise (Art 6(4). All the
authorized capital may not necessarily be paid beforehand. A certain amount may have to be paid in
advance before the commencement of the corporate life of the enterprise, and this constitutes paid up
capital (Art 6(5)). And any cash paid as part of the capital is to be deposited in a bank in the name and to
the account of the enterprise under formation. This would function as a security to third parties who in
good faith deal with the interim enterprise. Third parties are further helped to vindicate their rights and
the establishment the enterprise is reinvigorated by the impermissibility of withdrawing the deposited
funds until the enterprise acquires separate legal status (Art 5 (5)). There is no further condition with
capital payable in cash; it is the easy form of contribution. Capital could also be constituted by in kind
payments; this requires reduction to simplest form of monetary expression through correct valuation by
experts (Art 5 (1)(a)). The law has tried to make the expert valuation of the property more reasonable in
financial terms having regard to all the attendant circumstances by requiring the appointed experts to
prepare a report containing a detailed description of the property, the value given to each item
constituting the property and the method of valuation. Up until the enterprise is formed, the body called
the Supervising Authority undertakes similar obligations to that undertaken by founders of a share
company under the Commercial Code for incorrect valuation of property contributed in kind and for all
unnecessary expenses made prior to establishment.
Then after comes to a decisive stage of issuance of legislation for conferring on the enterprise the
capacity to live a legal life of its own. Article 6 of the Proclamation expressly states that every public
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enterprise is established by Council of Ministers Regulation, and the enterprise acquires a full-fledged
corporate status only upon enactment of regulations. This same provision lists down in a seemingly
limitative manner the details that the establishment regulation is to contain. The form, content and
purpose of establishment regulations of public enterprises are more or less similar, mutates mutandis, to
the memorandum of association of private business organizations, especially share company even
though the regulations are more authoritative and no additional requirement of registration is necessary.
Three of the ten items that the regulations should contain are unique to public enterprises – the statement
that the enterprise is governed by the Public Enterprises Proclamation (Art 6 (2)), the statement that the
enterprise shall not be liable beyond its total assets, and the name of the supervising authority (Art 6(9)).
We don’t find these in the memorandum of association of share companies as provided under Art 313 of
the Commercial Code. While these requirements can be inferred from the provisions of the proclamation
pursuant to which the regulations are issued, it is required that this state of affairs should be expressly
stated in the regulations for this legislative document is a direct authority from which the enterprise
acquires its existence. The regulations should also contain the statement that the enterprise may open
branches (Art 6(8)), but the share company memo of association goes one further step to require the
name of branches, if any (Art 313(3), commercial code). The MoA of Share Company on its part
contains certain elements that are not possessed by the regulations, differences mostly pertaining to the
shareholding and kinds of shares inherent in the nature of public companies.
The issuance of establishment regulations and their subsequent publishing in the Negarit Gazette would
give rise to legal personality which in turn warrants the conferring of capacity upon the enterprise.
Article 9 of the Proclamation grants general capacity, which is necessary to accomplish its purpose and
to perform related activities. This type of capacity is limited to powers incidental to effect the purpose
for which it is created. This power is co-extensive with the powers of all other economic activities and
demands the enterprise to operate within the general competitive atmosphere. Special capacity on the
other hand, as provided under Art 9(2), refers to certain particular capacities without limiting the
generality stated under Article 9(1). Most of the elements listed to constitute special capacity are as a
matter of principle attributes of personality. To sue and be sued; to acquire, possess, own, dispose of
(alienate), pledge or mortgage movable or immovable property; to enter into contractual transactions;
and to invest money received in revenue are all manifestations of special capacity and are of course
attributes of personality. Public enterprises are also entrusted with special capacity to issue and accept
negotiable instruments (commercial instruments, transferable securities, etc), and can also open and
operate bank accounts under such a capacity.
2.4 ACCOUNTING FOR THE OPERATION, DISSOLUTION AND LIQUIDATION

Accounting for the Operation of Public Enterprise

An enterprise, just like private traders and enterprises, is required to keep books of accounts following
Generally Accepted Accounting Principles (GAAP). Accordingly, a public enterprise should draw up
and maintain the two important accounting records: balance sheet and the profit and loss account. The
provisions in the proclamation regarding the keeping of accounts are not detailed enough. The
proclamation promises that the supervising authority issues directives on the details of the accounting
aspect of the enterprise meanwhile; there are detailed rules in the Commercial Code. We can apply these

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rules on accounting matters not sufficiently provided for in the Proclamation, by virtue of the cross-
referring provisions of Art 4 of Procl. No.25/1992.
According to Art 28(1), the accounting period of a public enterprise is a financial year that is to be
determined (by the supervising authority). This is a bit similar to the accounting year of business entities
governed by the Commercial Code (Art 67), except for those businesses at liberty to choose accounting
year of their own. The financial year is structurally and in composition different from the fiscal year of
public finance, that starts on Hamle 1 and ends on Sene 30, but it may coincide with such time wise. In
principle the closing of accounts coincides with the end of a financial year -- an enterprise must close its
accounts at least once annually, for instance, for tax purposes. Closing of accounts refers to the working
out of the whole expenses and income, and finally to determine profit or loss. The annual closing must
be completed within three months following the end of the financial year and failure to do so may entail
liability. The enterprise is obliged to prepare an annual report as regards the state of activities and affairs
during the last financial year and their financial equivalent, and the statement of achievements and major
plans/programs to be implemented in the upcoming financial year and the monetary equivalent
corresponding to them.
Reserve Funds: - These are all profits preserved for the undertaking and not forming part of the capital,
and profits not distributed as dividends. An enterprise has various reserve funds -- legal reserve funds,
technical reserves, etc. While legal reserve funds are imposed by law and are thus mandatory (that is
why they are legal), the establishment of other reserve funds and determination of their utilization is the
discretionary power of the concerned enterprise. A public enterprise is required not only to establish a
legal reserve fund but to maintain it while it continues its operations. This is effected by transferring 5%
of net profits into it annually until the reserve becomes 20% of the capital. There is a similar situation in
the Commercial Code on share companies (Arts 453,454,456). Its intended purpose is to maintain the
capital of the business entity, and particularly public enterprise may utilize the reserve fund for covering
losses and unforeseeable expenses and liabilities.
Payment of Taxes and Duties: - The provisions of the Proclamation state that the relevant laws
concerning taxes and duties would apply to enterprises [Art 30 [1]]. This means that the enterprise will
pay taxes and duties recognized by the Ethiopian law of taxation on all its taxable activities. All the
same, Art 30 (2) foresees the exemption of public enterprises from the obligation of paying taxes and
indeed gives license to the legislature to issue law to that effect. The exemption could specifically be
made of public enterprise, excluding other corporate entities from the privilege.
Payment of State Dividends: - It is a fact of the business world that the net profit obtained by a legal
business organization is ultimately to accrue into the patrimony of the owner or the shareholders as the
case may be. The state is an owner of public enterprises, and it is legitimately entitled to receive
dividends on the capital it has invested in public enterprise. The Public Enterprises Proclamation
No.25/1992 and the Distribution of Profits of Public Enterprises Regulation No.107/2004 both provide
for the payment of state dividend.
The dividend devolving upon the state is accounted for after the determination of the net profits. “Net
profits” is defined as any excess of all revenue and other receipts over costs and operating expenses
properly attributable to the operations of the financial year including depreciation, interest and taxes (Art
2(7) of procl, Art 2(2) of reg). And state dividend refers to the remaining balance after deduction of the
transfers to the legal reserve fund and other reserve funds from the net profits (Art 2(9) of procl, Art 3(1)
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of reg). Thus, the amount for payment into state budget is due after the actual cost of production and
rendition are deducted, tax obligations met, and allocation to reserve funds made. The public enterprise
supervising authority is an organ empowered to determine the amount of the divided to be paid to the
government from the net profits based on the legal provisions and proposal of the enterprise’s executive
(Art 11(8)). The supervising authority submits, under regulation No.107/2004, to the Ministry of Trade
and Industry a statement on the annual net profits of every public enterprise and the distribution of the
net profits (reserved deducted). Under these regulations, the net profits has two destinations-- 60% as
dividend to the government (Art 3(1)(a)) and the balance 40% to the Industrial Development Fund (Art
3(1)(b)).
The Industrial Development Fund is created by Proclamation No. 412/2004 (Art 13(2)), whose financial
sources are deductions from the net profits of public enterprises (Art 13(2)). The purpose of the fund is
to finance the rehabilitation and expansion of existing public enterprises and to undertake studies of
public enterprises to be established and to serve as the initial capital of same (Art 13(3)) of procl. No.
412/2004 cum Art 6 of reg No. 107/2004).

2.5 Dissolution and Winding-up

Dissolution refers to the coming into end of the corporate life of an enterprise because of occurrence of
something beyond its control. There are six grounds for the dissolution of a public enterprise stated
under Art 39 of the Proclamation. These are:
 The expiry of the life of the enterprise as fixed in its establishment regulations
 Completion of the venture for which the enterprise was established
 Failure of the purpose or impossibility of performance
 Loss of seventy-five percent of the paid up capital of the enterprise
 The judicial declaration of bankruptcy
A decision of the Council of Ministers affecting the existence of the enterprise (such as where the CMs
wants to dissolve enterprises that it deems not any more necessary). The Council of Ministers has, for
instance, dissolved the Engineering Design and Tool Enterprise established under Reg. No.124/1993
(Reg. No.15/1997) and Addis Metal Pressings Enterprise established by Reg. No.38/1998 (Reg.
No.102/2004).
While the last ground of dissolution is peculiar to public enterprises, all the other grounds are also
recognized under Art 495(1) of the Commercial Code in the event of dissolution of ordinary business
organizations. But there are a couple more grounds that appear in the list of Art 495(1) to dissolve
private business entities.
Winding-up is the process of liquidation of a public enterprise under dissolution. It involves, among
other things the appointment of liquidators and their rights and duties, calling creditors, payment of
debts the enterprise owes and collection of credits due to the enterprise, and the devolution of any
surplus assets to the government. Except in the case of bankruptcy, the liquidation process for all
grounds of dissolution is carried out in accordance with articles 41-45 of the Public Enterprises
Proclamation. With bankruptcy, the winding-up process is conducted pursuant to, mutatis mutandis, the
provisions on the bankruptcy proceedings in Book V of the Commercial Code. But even in this case, the
limitations associating to the amount of the assets in the bankruptcy for conducting the proceedings by

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way of summary procedure provided under article 1166(1)&(2) of the Code are not applicable to
dissolution of public enterprises. Summary procedure is upheld in the liquidation of public enterprises
irrespective of the requirements of the Commercial Code (Art 40(2)).
2.5 Privatization of Public Enterprises
Privatization Defined:
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.
According to Privatization of Public Enterprises Proclamation No. 146/1998:
1. "Privatization" means the transfer, through sale, of an enterprise or its unit or asset or government
share holdings in a share company to private ownership and includes:
a) the making of an enterprise a government contribution to a share company to be formed with
the participation of private investors; and
b) the privatization of the management of an enterprise.
2. "Sale or contribution of an Enterprise" means the sale or contribution of the businesses and assets of
an enterprise;
3. "Enterprise" means a public enterprise governed by the Public Enterprises Proclamation No. 25/1992
or an establishment designated by the Government as a public enterprise for the purpose of the
application of this Proclamation.
The privatization process covers not only the ownership and management transfer of public enterprises
to the private sector through sales, but also other forms of privatization such as lease arrangements,
management contracts, cutbacks in government activities, denationalization, deregulation, etc. Thus,
privatization is basically the transfer of government owned assets to the private sector.
2.6 Privatization in Ethiopia
As part of the country’s economic policy, the Ethiopian Privatization Agency (EPA) had passed through
a number of years of implementation of the proclamation for privatization of public enterprises. Since its
establishment by Proclamation No. 87/1994, the agency has privatized about 224 Public Enterprises,
branches and units which consist of department stores, warehouses, small hotels and tourism, factories,
farms, agro-industries, and so on. It still continues to privatize the remaining enterprises. The budget of
the Agency shall be allocated by the Government.
The Country's privatization process covers not only the ownership and management transfer of public
enterprises to the private sector through sales, but also other forms of privatization such as lease
arrangements, management contracts, cutbacks in government activities, denationalization, deregulation,
etc. Thus, privatization is basically the transfer of government owned assets to the private sector.
2.7 Objectives of Privatization
In Ethiopia, the objectives of privatization were the following:
1) to generate revenue required for financing development activities undertaken by the Government;
2) to change the role and participation of the Government in the economy to enable it exert more
effort on activities requiring its attention;

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 3) to promote the Country's economic development through encouraging the expansion of the private
sector.
Books of Accounts
1) EPA shall keep complete and accurate books of accounts.
2) The books of accounts and financial documents of the Agency shall be audited annually by the
Federal Auditor General or by an auditor appointed by him.

CHAPTER THREE
ACCOUNTING FOR SALES AGENCIES AND BRANCH OPERATION
3.1 Characteristics and principles

As a business enterprise grows, it may establish one or more branches to market its products over a large
territory. The term branch is used to describe a business unit located at some distance from the home
office. This unit carries merchandise obtained from the home office, makes sales, approves customers'
credit, and makes collections from its customers.
A branch may obtain merchandise solely from the home office, or a portion may be purchased from
outside suppliers. The cash receipts of the branch often are deposited in a bank account belonging to the
home office; the branch expenses then are paid from an impress cash fund or a bank account provided
by the home office. As the impress cash fund is depleted, the branch submits a list of cash payments
supported by vouchers and receives a check or a transfer from the home office to replenish the fund.
3.2 Distinguishing between Agencies and Branches

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A sales agency, sometimes referred to simply as an “agency,” usually is not an autonomous operation
but acts on behalf of the home office. A branch office usually has more autonomy and provides a greater
range of services than a sales agency does, although the degree differs with the individual company. A
branch typically stocks merchandise and fills customers’ orders. The amount of autonomy that the
branch manager is granted by the home office will vary from firm to firm, but regardless of the
responsibility granted, he or she is subject to the control of the home office and is governed by general
corporate policies.

3.3 Accounting for sales Agency

Because a sales agency normally does not have an accounting system, the home office records all
transactions involving the agency. For some types of transactions, the entries recorded by the home
office are based on source documents generated by the agency. The home office normally accounts for
the assets, revenues, and expenses of each agency separately. This allows the home office to maintain
control over the assets and provides information for assessing the performance of each agency.
 A sales agency usually carries samples of products but does not have inventory of merchandise
 Orders are taken from customers and transmitted to the home office, which approves customers’
credit and ships the merchandise directly to the customers
 Accounts receivables are managed by the home office
 An imprest cash fund is maintained at the sales agency for payment of operating expenses
 Hence, no need for complete accounting records at a sales agency other than a record of sales to
customers and a summary of cash payments supported by vouchers
 Separate revenue and expense accounts may be opened by the home office for each sales agency
so as to measure its profitability
 Subsidiary ledger accounts may be used to control fixed assets and cost of goods sold by sales
agencies
3.4 Accounting for Operation of Branches

A sales agency usually does not maintain a financial accounting system but only keeps sufficient records
to conduct its business. The home office maintains the accounting system, and the home office records
transactions of the agency. A branch, on the other hand, does maintain a complete financial accounting
system in most cases. The maintenance of separate accounting systems for the home office and each
branch often provides better control over operations and allows top management to assess the
performance of individual branches.

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Illustrative Journal Entries for Operations of a Branch
Assume that Nile Company bills merchandise to Bako Branch at home office cost and that Bako
Branch maintains complete accounting records and prepares financial statements. Both the home office
and the branch use the perpetual inventory system. Equipment used at the branch is carried in the home
office accounting records. Certain expenses, such as advertising and insurance, incurred by the home
office on behalf of the branch, are billed to the branch. Transactions and events during the first year
(2006) of operations of Bako Branch are summarized below (start-up costs are disregarded):
1. Cash of $1,000 was forwarded by the home office to Bako Branch.
2. Merchandise with a home office cost of $60,000 was shipped by the home office to Bako
Branch.
3. Equipment was acquired by Bako Branch for $500, to be carried in the home office accounting
records. (Other plant assets for Bako Branch generally are acquired by the home office.)
4. Credit sales by Bako Branch amounted to $80,000; the branch’s cost of the merchandise sold
was $45,000.
5. Collections of trade accounts receivable by Bako Branch amounted to $62,000.
6. Payments for operating expenses by Bako Branch totaled $20,000.
7. Cash of $37,500 was remitted by Bako Branch to the home office.
8. Operating expenses incurred by the home office and charged to Bako Branch totaled 3,000.
These transactions and events are recorded by the home office and Bako branch as follows (explanations
for the journal entries are omitted): Assume perpetual inventory system is used by the company.
Home office accounting records Bako Branch Accounting Records
1. Investment in Bako Branch ......1,000 Cash ...........................................1,000
Cash ............................... 1,000 Home office...................... 1,000
2. Investment in Bako Branch ......60,000 Inventories ................................60,000
Inventories ...................... 60,000 Home office.................... 60,000
3. Equipment: Bako Branch .................500 Home Office ...................................500
Investment in Bako Branch........ 500 Cash ..................................... 500
4. None Accounts Receivable .................80,000
Cost of goods sold .....................45,000
Sales ........................... 80,000
Inventories ................. 45,000
5. None Cash ......................................... 62,000
Accounts Receivable ... 62,000

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 6. None Operating Expense .................... 20,000
Cash ............................ 20,000
7. Cash ..............................37,500 Home Office ............................ 37,500
Investment in Bako Branch 37,500 Cash ........................... 37,500
8. Investment in Bako Branch 3,000 Operating Expenses ................. 3,000
Operating Expenses 3,000 Home Office ............. 3,000

3.5 Reciprocal accounts and their reconciliations

As an illustration of the procedure for reconciling reciprocal ledger account balances at year end, assume
that the home office and branch accounting records SUN Company contain the following data on
December31, 2006:
Investment in Moon Branch (in accounting records of Home Office)
Date Explanation Debit Credit Balance
2006
Nov.30 Balances 62,500dr
Dec.10 Cash received from branch 20,000 42,500dr
27 Collection of branch accounts receivable 1,000 41,500dr
29 Merchandise shipped to branch 8,000 49,500dr

Home Office (in accounting record of Moon Branch)

Date Explanation Debit Credit Balance
2006
Nov.30 Balances 62,500cr
Dec.10 Cash sent to home office 20,000 42,500cr
28 Acquired Equipment 3,000 39,500cr
30 Collection of home office accounts receivable 2,000 41,500cr

Comparison of the two reciprocal ledger accounts discloses four reconciling items, described as follows:
A debit of Birr 8,000 in the Investment in Moon Branch ledger account without a related credit
in the Home Office account.

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On December 29, the home office shipped merchandise costing Birr 8, 000 to the branch. The home office
debits its reciprocal ledger account with the branch on the date merchandise is shipped, but the branch
credits its reciprocal account with the home office when merchandise is received a few days later. The
required journal entry on December31, 2006, in the branch accounting records, assuming use of the
perpetual inventory system, appears below:
Inventories in Transit …………………………………………. 8,000
Home Office ……………………………………….. 8,000
To record shipment of merchandise in transit from home office
In taking a physical inventory on December31, 2006, the branch must add to the inventories on hand the
Birr8, 000 of merchandise in transit. When the merchandise is received in 2006, the branch debits
Inventories and credits Inventories in Transit.
A credit of Birr1,000 in the investment in Moon Branch ledger account without a related debit
in the Home Office account
On December 27, accounts receivable of the branch was collected by the home office. The collection
was recorded by the home office by a debit to cash and a credit to Investment in Moon Branch. No
journal entry was made by Moon Branch; therefore, the following journal entry is required in the
accounting records of Moon Branch on December 31, 2006:
Home Office …………………………………….. 1,000
Accounts Receivable …………………... 1,000
To record the collection of accounts receivable by home office
A debit of Birr 3,000 in the home office ledger account without a related credit in the
Investment in Moon Branch account.
On December 28, the branch acquired equipment for Birr 3,000. Because the equipment used by the
branch is carried in the accounting records of the home office, the journal entry made by the branch was
a debit to Home Office and a credit to Cash. No journal entry was made by the home office; therefore,
the following journal entry is required on December 31,2006, in the accounting records of the home
office:
Equipment …………………………………………….3,000
Investment in Moon Branch ………………. 3,000
To record equipment acquired by branch
A credit of Birr 2,000 in the Home Office ledger account without a related debit in the
Investment in Moon Branch account.

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On December 30, accounts receivables of the home office were collected by Moon Branch. The
collection was recorded by Moon Branch by a debit to Cash and a credit to Home Office. No journal
entry was made by the home office; therefore, the following journal entry is required in the accounting
records of the home office on December31, 2006:
Investment in Moon Branch ………………………….2,000
Accounts Receivable ……………………….. 2,000
To record collection of accounts receivable by Moon Branch
3.6 Transaction between branches

Branches sometimes transfer assets or services from one to another. While there are several ways of
accounting for such transfers, a commonly used approach is to treat the transfers as if they went through
the home office. The branches involved in an inter branch transfer generally account for the transfer as if
they are dealing with the home office rather than with another branch. One branch may transfer
excessive inventory to another branch that has an inventory shortage.
Example
Assume that Kooket Corporation’s Good branch transfers Birr7, 000 of cash and inventory costing
Birr22, 000 to the excellent branch; the Good branch records the following entry:
Home Office 29,000
Cash 7,000
Inventory 22,000
To record transfer of cash and inventory to Excellent branch.
The Excellent branch records the transfer with the following entry:
Cash 7,000
Inventory 22,000
Home Office 29,000
To Record the transfer of cash and inventory from Good branch
The transfer is recorded by the home office as follows:
Investment in Excellent Branch 29,000
Investment in Good Branch 29,000
To record the transfer of cash and inventory from Mayfield branch to Fairmont branch
Recognizing excess freight costs on merchandise transferred from one branch to another as expenses of
the home office is an example of the accounting principle that expenses and losses should be given
prompt recognition. The excess freight costs from such shipments generally result from inefficient

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planning of original shipments and should not be included in inventories.
In recognizing excess freight costs of inter branch transfers as expenses attributable to the home office,
the assumption was that the home office makes the decisions directing all shipments. If branch managers
are given authority to order transfers of merchandise between branches, the excess freight costs are
recognized as expenses attributable to the branches whose managers authorized the transfers.

CHAPTER FOUR
BUSINESS COMBINATION

4.1 Nature of Business Combinations

Business combinations are events or transactions in which two or more business enterprises, or their net
assets, are brought under common control in a single accounting entity. Other terms frequently applied
to business combinations are mergers and acquisitions.

Commonly used terms:

Combined enterprise: the accounting entity that results from business combination.
Constituent companies: the business enterprises that enter into a business combination.
Combinor: a constituent company entering into a purchase type business combination whose owners as a
group end up with control of the ownership interest in the combined enterprise.
Combinee: a constituent company other than the combinor in a business combination.
Business combinations may be friendly takeovers and hostile takeovers.
Friendly takeovers the boards of directors of the two constituent companies generally work out the terms
of the business combination amicably and submit the proposal to stockholders of all constituent
companies for approval.
A target company in a hostile takeover typically resists the proposed business combination by resorting
to various defensive tactics. Following are the common terms used to describe these defensive moves:
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Greenmail. The target company may pay a premium price (“greenmail”) to purchase treasury shares. It
may either buy shares already owned by a potential acquiring company or purchase shares from a
current owner who, it is feared, would sell to the acquiring company. The price paid for these shares in
excess of their market price may not be deducted from stockholders’ equity; instead, it is expensed.
White Knight. The target company locates a different company to acquire a controlling interest. This
could occur when the original acquiring company is in a similar industry and it is feared that current
management of the target company would be displaced. The replacement acquiring company, the “white
knight,” might be in a different industry and could be expected to keep current management intact.
Poison Pill. The “poison pill” involves the issuance of stock rights to existing shareholders to purchase
additional shares at a price far below fair value. However, the rights are exercisable only when an
acquiring company purchases or makes a bid to purchase a stated number of shares. The effect of the
options is to substantially raise the cost to the acquiring company. If the attempt fails, there is at least a
greater gain for the original shareholders.
Selling the Crown Jewels. This approach has the management of the target company selling vital assets
(the “crown jewels”) of the target company to others to make the company less attractive to the
acquiring company.
Leveraged Buyouts. The management of the existing target company attempts to purchase a controlling
interest in that company. Often, substantial debt will be incurred to raise the funds needed to purchase
the stock, hence the term “leveraged buyout.” When bonds are sold to provide this financing, the bonds
may be referred to as “junk bonds,” since they are often high interest and high-risk due to the high debt-
to-equity ratio of the resulting corporation.

Types of Business Combinations

There are three types of business combinations: Horizontal Combination, Vertical Combination, and
Conglomerate Combination:

1. Horizontal Combination: is a combination involving enterprises in the same industry.

2. Vertical Combination: A Combination involving an enterprise and its customers or suppliers. It is a
combination involving companies engaged in different stages of production or distribution. It is
classified into two: Backward Vertical Combination – combination with supplier and Forward Vertical
Combination – combination with customers. E.g.1: A Tannery Company acquiring a Shoes Company -
Forward

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Wollega university, Department of Accounting & Finance
3. Conglomerate (Mixed) Combination: is a combination involving companies that are neither
horizontally nor vertically integrated. It is a combination between enterprises in unrelated industries or
markets

1.1 Reasons for Business Combination

Why do business enterprises enter into a business combination? There are a number of reasons for
business combinations which are discussed as follows:
1. Growth
In recent years Growth has been main reason for business enterprises to enter into a business
combination. Firms can achieve growth through external and internal methods. The external (e.g.
business combination) method of achieving growth is more rapid than growth through internal methods,
as per advocates of external method. There is no question that expansion and diversification of product
lines, or enlarging the market share for current products, is achieved readily through a business
combination with another enterprise. Combinations enable satisfactory and balanced growth of an
enterprise. The company can cross many stages of growth at one time through combination. Growth
through combination is also cheaper and less risky. By acquiring other enterprises, a desired level of
growth can be maintained by an enterprise. When an enterprise tries to enter new line of activities then it
may face a number of problems in production, marketing, purchasing, etc. when some enterprises
already operating indifferent lines, they must have crossed many obstacles and difficulties. Combination
will bring together their experiences of different persons in varied activities. So combination will be the
best way of Growth.
2. Economies of Scale
A combined enterprise will have more resources at its command than the individual enterprises. This
will help in increasing the scale of operations and economies of large scale will be availed. The
economies of scale will occur as a result of more intensive utilization of production facilities,
distribution network, research and development facilities, etc. The economies of scale will lead to
financial synergies.
3. Operating Economies
A number of operating economies will be available with the combination of two or more enterprises.
Duplicating facilities in accounting, purchasing, marketing, etc will be eliminated. Operating
inefficiencies of small concerns will be controlled by superior management emerging from the
combinations. The acquiring company will be in a better position to operate than the acquired companies

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Wollega university, Department of Accounting & Finance
individually. Whether the horizontal or vertical business combinations it may provide operating
synergies when the duplicated facilities are eliminated.
4. Better Management
Combinations results in better management. Combinations result running the large scale enterprises. A
large enterprise can offer to use the service of expertise. Various managerial functions can be efficiently
managed by those persons who are qualified for such jobs. This is not possible for small individual
enterprises.
5. Monopolistic Ambitions
One of the important reasons behind business combination is monopolistic ambitions. The combined
enterprises try to control more and more enterprises in the same line so that they may be able to detect
their terms (E.g. set their price). But, the antitrust law is against this reason of business combination.

6. Diversification of Business Risk

When one company involves business combination, it can diversify risks of operations. A Company
involving business combination can minimize risks as the enterprise is diversifying operation or line of
their activity. Since different companies are already dealing in their respective lines, there will be risk
diversification.
7. Tax Advantages
When an enterprise with accumulated losses merges with a profit making enterprise, it is able to utilize
tax shields (benefits). An enterprise having losses will not be able to set-off losses against future profits,
because it is not a profit earning unit. On the other hand, if it merges with an enterprise earning profits
then the accumulated losses of one unit will be set-off against future profit of the other unit. In this way,
combinations will enable an enterprise to avail tax benefits. The tax law that permits setting off losses is
either Loss Carry Forward or Loss Carry Back.
8. Elimination of Fierce Competition
Combination of two or more enterprises will eliminate competition among them. The enterprises will be
able to save their advertising expenses. This enables the combined enterprise to reduce prices. The
consumer will also benefit in the form cheaper goods being made available to them.

1.2 Methods for Arranging Business Combinations

The four common methods for carrying out a business combination are:

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Wollega university, Department of Accounting & Finance
 Statutory Merger
Statutory Consolidation,
Acquisition of Common Stock, and
Acquisition of Assets

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Wollega university, Department of Accounting & Finance
 1. Statutory Merger

Statutory Merger is a merger in which one of the merging companies continues to exist as a legal entity while
the other or others are dissolved. A business combination in which one company (the survivor) acquires all
the outstanding common stock of one or more other companies then that dissolved and liquidated, with their
net assets owned by the survivor. The survivor can effect the transaction by exchanging voting common
stock or preferred stock, cash, or long-term debt (or a combination of these) for all of the outstanding voting
common stock of the acquired company or companies. It is executed under provisions of applicable state
laws. The boards of directors of the constituent companies normally negotiate the terms of a plan of merger,
which must then be approved by the stockholders of each company involved. In a statutory merger, one or
more of the combinee companies are liquidated and thus cease to exist as separate legal entities, and their
activities often are continued as divisions of the survivor, which now owns the net assets (assets minus
liabilities), rather than the outstanding common stock, of the liquidated corporations.

Statutory merger can be summarized in the following main points:

1. The boards of directors of the constituent companies work out the terms of the merger.

2. Stock holders of the constituent companies approve the term of the merger in accordance with
applicable corporate bylaws and state laws.

3. The survivor issues its common stock or other consideration to the stockholders of the constituent
companies in exchange for all their outstanding voting common stock of that company.

4. The survivor dissolves and liquidates the other constituter companies receiving in exchange for
common stock investments for the net assets of those companies.

2. Statutory Consolidation

Statutory Consolidation is a business combination in which a new corporation issues common stock for all
outstanding common stock of two or more other corporations that are then dissolved and liquidated, with
their net assets owned by the new corporation. It is a merger in which a new corporate entity is created from
the two or more merging companies, which cease to exist. It differs from statutory merger, in which one
survives as a legal entity from two or more constituent companies. The combination of A Corporation and B
to form AB is an example of this type of consolidation.

.
Also it is consummated in accordance with applicable state laws. However, in a consolidation, a new
corporation is formed to issue its common stock for the outstanding common stock of two or more existing
corporations, which then go out of existence.

The new corporation thus acquires the net assets of the defunct corporations, whose activities may be
continued as divisions of the new corporation.

Statutory consolidation can be summarized in the following main points

1. The boards of directors of the constituent companies work out the terms of the consolidation.

2. Stockholders of the constituent companies approve the terms of the consolidation in accordance with
applicable corporate bylaws and state laws.

3. A new corporation is formed to issue its common stock to the stock holders of the constituent
companies in exchange for all their outstanding voting common stock of those companies.

4. The new corporation dissolves and liquidates the constituent companies, receiving in exchange for its
common stock investment in the net assets of those companies.

3. Acquisition of common stock

One corporation (the investor) may issue preferred or common stock, cash, debt or a combination there of to
acquire from present stockholders a controlling interest in the voting common stock of another corporation
(the investee). This stock acquisition program may be accomplished through direct acquisition in the stock
market, through negotiations with the principal stockholders of a closely held corporation or through tender
offer to stockholders of a public owned corporation. A tender offer is a publicly (tender offer to stockholders
of a public owned) announced intention to acquire for a stated amount of consideration, a maximum number
of shares of the combinee common stock “tendered” by holders thereof to an agent such as an investment
banker or a commercial bank. The price per share stated in the tender offer usually is well above the
prevailing market price of the combinees’ common stock. If a controlling interest in the combinees voting
common stock is acquired, that corporation becomes affiliated with the combiner (parent company) as a
subsidiary, but is not dissolved and liquidated and remains a separate legal entity.

4. Acquisition of Assets

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A business enterprise may acquire from another enterprise all or most of the gross asset or net assets of other
enterprise for cash, debt, preferred or common stock or a combination thereof. The transaction generally
must be approved by the board of directors and stockholders of the constituent companies. The selling
enterprise may continue its existence as separate entity or may be dissolved and liquidated; it does not
become on affiliate of the combiner.

1.4 Methods of Accounting for Business Combinations

There were two methods of accounting for business combinations: Pooling-of-Interest and Purchase Method.
At present purchase method of accounting for business combinations are used.

Purchase method of Accounting for Bussiness combinations

In FASB statement No. 141, “Business combination” the FASB mandated purchase accounting for all
business combinations enter in to after June 30, 2001.

Initial recognition- Assets are commonly acquired in exchange transactions that trigger the initial recognition
of the assets acquired and any liabilities assumed. Initial measurement like other exchange transactions
generally, acquisitions are measured on the basis of the fair values exchanged.

Allocating cost: Acquiring assets in groups requires not only ascertain the cost of the asset or net asset group
but also allocating the cost to the individual assets (or individual assets and liabilities) that make up the
group.

Procedures under Purchase Method of Accounting for Business Combinations

1. Determination of the Combinor or the Acquiring Company – this steps deals with identification of the
combinor.

The Combinor

- The carrying amounts of the net assets are not affected by a BC.

- The IAS stated that in a business combination effected solely by the distribution of cash or other
assets or by incurring liabilities, the constituent company that distribute or incurring liability is
generally the acquiring company.

- Generally, the combinor is the constituent co. whose stockholders as a group retain or receive the
largest portion of the voting rights of the combined enterprise and they can elect a majority of the
governing BODS or other group of the combined enterprise.
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2. Determination of Cost of Acquisition – assets to be acquired and liabilities to be assumed are identified
and then, like other exchange transactions, measured on the basis of the fair values exchanged. The Cost
of combinee includes also some other costs as discussed below.

The cost of a combine on a BC accounted for by purchase method is the total of

(1) The amount of consideration paid by the combiner,

(2) The combiners DIRECT “out of pocket” costs of the combination &

(3) Any contingent consideration that is determinable on the date of the business combination.

Amount of Consideration:
This is the total amount of

 Cash paid,

 The Current fair value of other assets distributed,

 The present value of debt securities issued &

 The Current fair value (Market) value of equity security issued by the combiner.

Out of pocket costs are classified as direct and indirect.

Direct out of pocket costs

This includes
 Legal fees,

 Accounting, &

 Finder fees.

Finder fee- An amount paid to the investment banking firm or other organizations or individuals that
investigated the combinee, assisted in determining the price of the business combination & other wise
rendered service to bring about the combination.

BOND ISSUE COSTS- refers to cost of registering (with the SEC) and issuing DEBT SECURITIES in a
Business combination is debited to bond issue costs. They are not part of the cost of the combine.

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Cost of registering with SEC & issuing equity securities are not direct costs of the business combination but
are offset against the proceeds from the issuance of the securities.

Indirect out-of-pocket costs of the combination, such as salaries of officers involved in the combination, are
expensed as incurred by the constituent companies.

Direct out-of-Pocket Costs are added to the Cost of Acquisition of Combinee where as indirect outof-pocket
costs are immediately expensed by the constituent companies.

Contingent Consideration

Contingent consideration is additional cash, other assets, or securities that may be issuable in the future,
contingent on future events such as a specified level of earnings or a designated market price for a security
issued to complete the business combination.

• Contingent consideration that is determinable on the consummation date of a combination is recorded as

part of the cost of the combination.

• Contingent consideration not determinable on the date of the combination is recorded when the contingency
is resolved and the additional consideration is paid or issued (or becomes payable or issuable).

3. Allocating Cost of Combinee (Allocating Total Cost of Acquisition) – when assets are acquired in
groups, it requires not only ascertaining the cost of the asset (or net asset) group but also allocating that
cost to the individual assets (or individual assets and liabilities) that make up the group.

According to SFAS No. 141, the following principles for allocating cost of a combine in a purchase-type
business combination are applicable:

• The cost of a combinee in a business combination must be allocated to assets (other than goodwill) acquired
and liabilities assumed based on their estimated fair values on the date of the combination.

• Any excess of total costs of the acquired company over the amounts allocated to identifiable assets acquired
less liabilities assumed is assigned to goodwill.

As per SFAS No.141, methods for determining fair values of identifiable assets and liabilities of a purchased
combinee included:
• Present values for receivables and liabilities;
• Net realizable values for marketable securities, finished goods and goods-in-process inventories, and for
plant assets held for sale or for temporary use;
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• Appraised values for intangible assets, land, natural resources, and non-marketable securities; and
• Replacement cost for inventories of material and plant assets held for long-term use.

4. Determination of Goodwill –The goodwill should be determined and recorded under purchase method.

Goodwill: Goodwill frequently is recorded in purchase-type business combinations because the total cost of
the combinee exceeds the current fair value of identifiable net assets of the combinee. That is, goodwill is the
difference between the total acquisition costs less current fair value of the net assets (the current fair value of
the assets less current fair value of liabilities). The amount of goodwill recorded on the date the business
combination may be adjusted subsequently when contingent consideration becomes issuable. The goodwill
can be determined into two ways: Goodwill as payment for super profit (extra profit or excess income) and
Goodwill as excess cost of acquisition over the current fair value of net assets.

Negative G/W

In some purchase type business Combinations (Known as bargain purchase) the Current fair values assigned
to the identifiable net assets acquired exceed the total cost of the combine (acquistion). A bargain purchase is
most likely to occur for a combinee with a history of losses or when common stock prices are extremely low.
The excess of the current fair values over total cost is applied pro rata to reduce (but not below zero) the
amounts initially assigned to non-current assets other than investments accounted for by the equity method;
assets to be disposed of by sale; deferred tax assets; prepaid assets relating to pension or other postretirement
benefits; and any other current assets. If the foregoing proration does not extinguish the bargain-purchases
excess, a deferred credit, sometimes termed negative goodwill, is established. Negative goodwill means an
excess of current fair value of the combinee’s identifiable net assets over their cost to the combinor. Negative
Goodwill is recognized as an extraordinary gain by the combinor. (SFAS No. 141)

5. Recording the Acquisition – the transaction is recorded on the date of the business combinations is
consummated.

Under purchase accounting, both the combinor and combinee record transactions relating to the business
combination. The combinee that is dissolved and liquidated passed the following journal entries:

Books of Combinee Company (Acquired Company)

General journal entry passed For Liquidation of the Combinee

Liabilities (individually) ................................................ xxxxx

Common Stock .............................................................. xxxxx
.
PIC in excess of Par ...................................................... xxxxx
Retained Earnings ......................................................... xxxxx
All Assets (Individually) ................................... xxxxx
Books of Combinor Company (Acquiring Company)

General Journal Entry to be passed in the Books of the Combinor

1. Recording the payment (the purchase consideration or purchase price)

Investment in Combinee Company ......................................... xxxxx

Cash ................................................................................. xxxxx
Common Stock ................................................................ xxxxx
PIC in excess of Par ..................................................... xxxxx
Bonds ................................................................................ xxxxx
2. Recording direct out-of-pocket costs (legal and finder’s fee)

Investment in Combinee Company .......................................... xxxxx

Cash ............................................................................... xxxxx
3. Recording Assets and Liabilities (the Investment Account is replaced with assets and liabilities)

All Assets (individually) at CFV ....................................... xxxxx

Goodwill ................................................................................... xxxxx
Liabilities (individually) at CFV ............................... xxxxx
Investment in Combinee Company .......................... xxxxx
4. Recording Indirect Out-of-Pocket Costs

Indirect Expenses ..................................................................... xxxxx

Cash ........................................................................ xxxxx
5. Recording Reduction in PIC in excess of par for indirect expenses

PIC in Excess of Par ............................................................. xxxxx

Indirect Expenses............................................... xxxxx

Illustration of Purchase Accounting Method for Statutory Merger with Positive Goodwill
Example 1.1. Combinor Company acquired Combinee Company On December 31, 2014 with the following
balance sheet items:
.
Combinee Company
Balance Sheet
December 31, 2014
Assets Liabilities and Equity
Cash .......................................... 60,000 Current Liabilities ........................... 180,000
Other Current Assets ......... …..420,000 Long-term debts ............................... 250,000
Land ........................................ 400,000 Capital Stock (Br 10 Par) ............... 200,000
Building (net) ......................... 240,000 PIC in Excess of Par ........................ 320,000
Equipment (net) ...................... 280,000 Retained Earnings.............................. 450,000
Total Asset ........................... 1,400,000 Total Liabilities and Equity ............ 1,400,000
After in depth study, Combinor Company’s BOD established the following Current Fair Value for assets and
liabilities:
Other Current Assets .............................................. 500,000
Land ............................................................................... 450,000
Building (Net) ............................................................... 300,000
Equipment (Net) ............................................................ 250,000
Long-term debt ............................................................. 240,000
Accordingly on December 31, 2014 Combinor issued 100,000 shares of its Br. 10 Par (Current Fair Value of
Br. 13) Common Stock for all the net asset of Combinee on a purchase type of business combination. Also
on December 31, 2014 Combinor paid the following out-of-pocket costs in connection with the combination:
Finder’s Fees and Legal Fees .............................................. 180,000
Costs associated with issuance of shares ......................... 120,000
Required: Prepared General Journal Entries for Combinor Company on December 31, 2014.
Calculation of Total Acquisition Cost:
Common Stock (Br 13 @ 100,000 Shares) ............................... 1,300,000
Finder’s Fees and Legal Fees .......................................................... 180,000
Total Acquisition Cost .................................................................. 1,480,000
Calculation of Net Assets at CFV:
Cash ...................................................................................................... 60,000
Other Current Assets ..................................................................... 500,000
Land ....................................................................................................... 450,000
Building (net) ........................................................................................ 300,000
Equipment (net). ................................................................................... 250,000
.
Total Assets at CFV.......................................................................... 1,560,000
Less: Liabilities at CFV (180,000 + 240,000)............................... (420,000)
Net Assets at CFV .......................................................................... 1,140,000
Calculation of Goodwill:
Total Purchase Cost ............................................................................ 1,480,000
Less: Net Assets at CFV................................................................... (1,140,000)
Goodwill.................................................................................................. ….340,000
Journal Entries:
Recording the payment (the purchase consideration)
Investment in Combinee Company.......................... 1,300,000
Common Stock ......................................................... 1,000,000
PIC in excess of Par ................................................. 300,000
2. Recording Direct out-of-pocket costs (legal and finder’s fee)
Investment in Combinee Co............................... 180,000
Cash .............................................................................. 180,000
3. Recording Assets and liabilities
Cash ............................................................................................. 60,000
Other Current Assets............................................................ 500,000
Land ............................................................................................. 450,000
Building (net) .............................................................................. 300,000
Equipment (net) ......................................................................... 250,000
Goodwill ........................................................................................ 350,000
Current Liabilities .......................................... 180,000
Long-term debt .............................................. 240,000
Investment in Combinee Company ............... 1,480,000
4. Recording indirect out-of-pocket costs
Indirect Expenses.......................................................................... 120,000
Cash .............................................................................. 120,000
5. Recording reduction in PIC in excess of par for indirect expenses
PIC in Excess of Par ............................................................. 120,000
Indirect Expenses .......................................... 120,000

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Example 1.2: On December 31, Year 1, BITAMTU Company (the combinee) was merged into BITTU
Corporation (the combinor or surviving company). Both companies used the same accounting principles for
assets, liabilities, revenue, and expenses and both had a December 31 fiscal year. BITTU exchanged 150,000
shares of its Br 10 par common stock (Current Fair Value Br 25 a share) for all 100,000 issued and
outstanding shares of BITAMTU’S no-par, Br 10 stated value common stock. In addition, BITTU paid the
following out-of-pocket costs associated with the business combination:
Accounting fees:
For investigation of BITAMTU Company as prospective combine........................ Br 5,000
For SEC registration statement for Saxon common stock ..................................... 60,000
Legal Fees:
For the business combination ........................................................................................... 10,000
For SEC registration statement for Saxon common stock ..................................... 50,000
Finder’s fee .......................................................................................................................... 51,250
Printing charges for securities and SEC registration statement ............................ 23,000
SEC registration statement fee ..................................................................................... 750
Total out –of- pocket costs of business combination .............................................. 200,000
There was no contingent consideration in the merger contract. Immediately prior to the merger,
BITAMTU Company’s condensed balance sheet was as follows:
BITAMTU COMPANY (Combinee)
Balance sheet (Prior to Business Combination)
December 31, Year 1
Assets
Current assets............................................................ Br 1,000,000
Plant assets (net).............................................................. 3,000,000
Other assets ........................................................................ 600,000
Total assets ........................................................................ 4,600,000
Liabilities & Stockholder Equity
Current liabilities ................................................................ 500,000
Long-term debt................................................................. 1,000,000
Common stock, no par Br 10 stated value ................... 1,000,000
.
Paid in capital ........................................................................ 700,000
Retained Earnings ............................................................. 1,400,000
Total .................................................................................... 4,600,000

Using the guidelines in SFAS No. 141, “Business Combinations,” the board of directors of BITTU
Corporation determined the current fair values of BITAMTU Company’s identifiable assets and liabilities
(identifiable net assets) as follows:
Current asset.................................................................. Br 1,150,000
Plant assets ............................................................................ 3,400,000
Other assets ............................................................................ 600,000
Current liabilities.................................................................... (500,000)
Long-term debt (present value).......................................... (950,000)
Identifiable net assets of combinee................................... 3,700,000
The condensed journal entries that follow are required for BITTU Corporation (the Combinor) to record the
Merger with BITAMTU Company on December 31, Year 1, as a Purchase-type business combination.
BITTU uses an investment ledger account to accumulate the total cost of BITAMTU Co. prior to assigning
the cost to identifiable net assets and goodwill.
BITTU Corporation (Combinor)
Journal Entries
December 31, Year 1
 To record merger with BITAMTU Company as a purchase
Investment in BITAMTU Company Common Stock (150,000 X Br 25).............. 3,750,000
Common Stock (150,000 X Br 10) ................................................................... 1,500,000
Paid-in Capital in Excess of par ...................................................................... 2,250,000
 To record payment of direct costs incurred in merger with BITAMTU Company. Legal and finder's fees
in connection with the merger are recorded as an investment cost: other out-of-pocket costs are recorded
as a reduction in the proceeds received from issuance of common stock.
Investment in BITAMTU Company Common Stock
(Br5,000+Br10,000+ Br 51,250) ................................................................... 66,250
Paid-in Capital in Excess of par..................................................................... 133,750
Cash ............................................................................ 200,000
 To allocate cost of liquidated BITAMTU Company investment to identifiable assets and liabilities, with
the remainder to goodwill. Amount of goodwill is computed as follows:

.
Current Assets............................................................................................... 1,150,000
Plant Assets .................................................................................................... 3,400,000
Other Assets ................................................................................................... 600,000
Discount on Long-Term Debt ........................................................................ 50,000
Goodwill................................................................................................................. 116,250
Current Liabilities....................................................................................... 500,000
Long-Term Debt......................................................................................... 1,000,000
Investment in BITAMTU Company Stock .......................................... 3,816,250

Determination of Goodwill:
Total cost of investment (Br 3,750,000 + Br 66,250).............................................................. Br 3,816,250
Less: Net Assets (NAs) at CFV
Carrying amount of BITAMTU’S identifiable NAs
(4,600,000–1,500,000)……………………………………… ……………………………... 3,100,000
Excess (Deficiency) of current fair values assets and liabilities
Current assets............................................................................................ 150,000
Plant assets ................................................................................................. 400,000
Long-term debt............................................................................................ 50,000
Total Net Assets at CFV................................................................................................................ (3,700,000)
Amount of goodwill....................................................................................................................... Br 116,250

Note: No adjustments are made to reflect the current fair values of BITTU’S identifiable net assets or
goodwill as BITTU is the combinor.

BITAMTU company (the combinee) prepares the following condensed journal entry to record the dissolution
and liquidation of the company on Dec 31,1999.

Current liabilities 500,000

Long term debt 1,000,000
Common stock, $10 stated value 1,000,000
Paid in capital in excess of stated value 700,000
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 Retained Earnings 1,400,000
Current assets 1,000,000
Plant assets (net) 3,000,000
Other assets 600,000
 To record liquidation of company in conjunction with merger with BITTU Corporation
Illustration of purchase accounting for acquisition of net assets, with bargain purchase excess
On December 31,1999, Davis Corporation acquired the net assets of Fairmont Corporation directly from
Fairmont for 400,000 cash, in a purchase type business combination. Davis paid legal fees of 40,000 in
connection with the combination.

The condensed balance sheet of Fairmont prior to the business combination, with related current fair value
data, is presented below:

FAIRMONT CORPORATION (combinee)

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

Liabilities and Stockholders’ Equity

Current liabilities 240,000 240,000

Long term debt 500,000 520,000
Total liabilities 740,000
Common stock, $1 par 600,000
Deficit (140,000)
Total stockholders’ equity 460,000
Total liab & stockholders’ equity 1,200,000 760,000
.
Thus, Davis acquired identifiable net assets with current fair value of 500,000 (1,260,000-760,000) for a total
cost of 440,000 (400,000+40,000). The 60,000 excess of the current fair value of the assets over their cost is
prorated to plant and intangible assets in ratio of their respective current fair value.

To plant assets: 60000*900,000/900,000+100,000= 54,000

To intangible assets: 60,000*100,000/900,000+100,000= 6,000
Total 60,000
The journal entries below record Davis Corporation’s acquisition of the net assets of Fairmont Corporation
and payment of 40,000 legal fee.
Investment in Net Assets of Fairmont Corp 400,000
Cash 400,000
 To record acquisition of net assets of Fairmont Corporation

Investment in net assets of Fairmont Corp 40,000

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

Current assets 200,000

Investment in Marketable Debt Securities 60,000
Plant assets (900,000-54000) 846,000
Intangible assets (100,000-6,000) 94,000
Current liabilities 240,000
Long term debt 500,000
Premium on long term debt (520,000-500,000) 20,000
Investment in net assets of Fairmont 440,000
 To allocate total cost of net assets acquired to identifiable net assets, with excess of current fair value of
the net assets over cost allocated to noncurrent assets other than marketable securities

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6.

7. Pooling of Interest Accounting

The original premise of pooling of interest method was that certain business combinations involving the
exchange of common stock between an issuer and the stockholders of a combinee were more in the nature of
a combining of existing stockholder interests than an acquisition of assets or raising of capital.

Combining of existing stockholder interests was evidenced by combinations involving common stock
exchanges between corporations of approximately equal size. The stockholders and managements of these
corporations continue their relative interests and activities in the combined enterprise as they previously did
in the constituent companies. Because neither of the equal sized companies could be considered the
combinor, the pooling of interest method of accounting provided for carrying forward to the accounting
records of the combined enterprise the combined assets, liabilities, and retained earnings of the constituent
companies at their carrying amounts. The current fair value of the common stock issued to effect the business
combination and the current fair value of the combinee’s net assets are disregarded in pooling of interest
accounting. Further, because there is no identifiable combinor, the term issuer identifies the corporation that
issues its common stock to accomplish the combination

.
 Chapter-five
5.1. Consolidation on date of purchase
Parent company- subsidiary relationships
If the investor acquires a controlling interest in the investee, a parent- subsidiary relationship is established.
The investee becomes a subsidiary of the acquiring parent company but remains a separate legal entity.
Strict adherence to legal aspect requires issuance of separate financial statements for the parent company and
subsidiary but disregards the substance of the relationship. A parent company and its subsidiary are a single
economic entity. In recognition of this fact, consolidated financial statements are issued to report their
financial and operating results as though they comprised a single accounting entity.
Consolidated financial statements are similar to combined financial statements of home office and its
branches:
 Assets, liabilities, revenue, and expenses of the parent and its subsidiaries are totaled
 Intercompany transactions and balances are eliminated
 And the final consolidated amounts are reported
The financial accounting standards board requires consolidation of nearly all subsidiaries except those not
actually controlled.
The meaning of controlling interest
Traditionally, direct or indirect ownership of more than 50% of an investee’s outstanding common stock is
required to evidence controlling interest. But some circumstances may negate actual control despite existence
of stock ownership:
 A subsidiary in liquidation or reorganization in court supervised bankruptcy proceedings
 A foreign subsidiary in a country having severe production, monetary, or income tax restrictions
 Right of minority shareholders to effectively participate in the financial and operating activities of the
subsidiary
Control of a subsidiary might also be achieved indirectly. The traditional definition of control is criticized for
emphasizing the legal form over the economic substance.
Consolidation of wholly owned subsidiary on date of purchase- type business combination
There is no question of control of a wholly owned subsidiary. To illustrate, assume that on december 31,
2013, palm corporation issued 10,000 shares of its $10 par common stock (current fair value $45 a share) to
stockholders of star company for all outstanding $5 par common stock. There was no contingent
consideration. Out of pocket costs consist of:
finder’s and legal fee relating to business combination 50,000
costs associated with sec registration 35,000
total 85,000
Assume also that the business combination qualified for purchase accounting because required conditions for
pooling accounting were not met. Star company continues its corporate existence. Both constituent
companies had a december 31 fiscal year and used the same accounting policies.
Financial statements of the constituent companies prior to consummation of the business combination follow:

Palm corporation and star company

.
 Separate financial statements (prior to purchase-type business combination)
For year ended december 31, 2013
palm star
Income statement
Revenue
net sales 990,000 600,000
interest revenue 10,000
total 1,000,000 600,000
costs and expenses
cost of goods sold 635,000 410,000
operating expenses 158,333 73,333
interest expense 50,000 30,000
income taxes expense 62,667 34,667
total 906,000 548,000
Net income 94,000 52,000
Statement of retained earnings
Retained earnings, beginning 65,000 100,000
Add: net income 94,000 52,000
159,000 152,000
Less: dividends 25,000 20,000
Retained earnings, ending 134,000 132,000

Balance sheet
assets
Cash 100,000 40,000
Inventories 150,000 110,000
Other current assets 110,000 70,000
Receivable from star 25,000
Plant assets (net) 450,000 300,000
Patent (net) 20,000
total assets 835,000 540,000
Liabilities and stockholders’ equity
Payable to palm 25,000
Income taxes payable 26,000 10,000
Other liabilities 325,000 115,000
Common stock, $10 par 300,000
Common stock, $5 par 200,000
Additional paid in capital 50,000 58,000
Retained earnings 134,000 132,000
Total liab & stockholders’ equity 835,000 540,000

The december 31, 2013, current fair values of star company’s identifiable assets were the same as their
carrying amounts except the following:
.
 inventories 135,000
plant assets (net) 365,000
patent (net) 25,000
Palm corporation recorded the combination as a purchase with the following entries:
Investment in star co common stock 450,000
common stock (10,000*10) 100,000
paid in capital in excess of par 350,000

Investment in star co common stock 50,000

Paid in capital in excess of par 35,000
cash 85,000
The foregoing journal entries do not include any debits or credits to record individual assets and liabilities of
star company in the accounts of palm corporation because star is not liquidated as in merger but remains a
separate legal entity.
Preparation of consolidated balance sheet without a working paper
The operating results of palm and star prior to the date of their business combination those of two separate
economic as well as legal entities. A consolidated balance sheet is the only consolidated financial statement
issued by palm and star.
the preparation of a consolidated balance sheet may be accomplished without the use of a supporting
working paper. The parent company’s investment account and the subsidiary’s stockholder’s equity accounts
do not appear in the consolidated balance sheet because they are essentially reciprocal (intercompany)
accounts.
Under purchase accounting theory:
 The parent company (combiner) assets and liabilities (other than intercompany ones) are reflected
at carrying amounts
 The subsidiary (combine) assets and liabilities (other than intercompany ones) are reflected at
current fair values in the consolidated balance sheet
 Goodwill is recognized to the extent the cost of the parent’s investment exceeds the current fair
value of the subsidiary’s identifiable net assets
Applying the foregoing principles to the palm corporation star company relationship, the following
consolidated balance sheet is produced:
Palm corporation and subsidiary
Consolidated balance sheet
December 31, 2013
Assets
Current assets:
cash (15,000+40,000) 55,000
inventories (150,000+135,000) 285,000
other (110,000+70,000) 180,000
total current assets 520,000
Plant assets (net) (450,000+365,000) 815,000
Intangible assets
patent (net) (0+25,000) 25,000
.
 goodwill (net) 15,000 40,000
total assets 1,375,000
Liabilities and stockholders’ equity
Liabilities:
income taxes payable (26,000+10,000) 36,000
other (325,000+115,000) 440,000
total liabilities 476,000
Stockholders’ equity
common stock, $10 par 400,000
additional paid in capital 365,000
retained earnings 134,000 809,000
total stockholders’ equity 1,375,000

Working paper for consolidated balance sheet

Working paper is usually required even for a parent company and a wholly owned subsidiary.
Developing the elimination
The parent company’s investment account is similar to the home office’s investment in branch account.
However, the subsidiary is a separate corporation not a branch and has three conventional stockholders’
equity accounts rather than a single home office reciprocal account used by a branch. Accordingly, the
elimination of the intercompany accounts must decrease the investment account of the parent company and
the three stockholders’ equity accounts of the subsidiary to zero.
The completed elimination for palm corporation and subsidiary (in journal entry format) and the related
working paper for consolidated balance sheet are as follows:
a) common stock-star 200,000
additional paid in capital-star 58,000
retained earnings- star 132,000
inventories- star (135,000-110,000) 25,000
plant assets (net)-star (365,000-300,000) 65,000
patent (net)-star (25,000-20,000) 5,000
goodwill (net)-star (500,000-485,000) 15,000
investment in star co. Common stock 500,000
To eliminate intercompany investment and equity accounts of subsidiary

\
.
 Palm corporation and subsidiary
Working paper for consolidated balance sheet
December 31, 2013

palm star elimination consolidated

Assets
Cash 15,000 40,000 55,000
Inventories 150,000 110,000 a 25,000 285,000
Other current assets 110,000 70,000 180,000
Intercompany receivable/payable 25,000 (25,000)
Investment in star co 500,000 a (500,000)
Plant assets (net) 450,000 300,000 a 65,000 815,000
Patent (net) 20,000 a 5,000 25,000
Goodwill (net) a 15,000 15,000
total assets 1,250,000 515,000 (390,000) 1,375,000
Liabilities & stockholders’ equity
Income taxes payable 26,000 10,000 36,000
Other liabilities 325,000 115,000 440,000
Common stock, $10 par 400,000 400,000
Common stock, $5 par 200,000 a (200,000)
Additional paid in capital 365,000 58,000 a (58,000) 365,000
Retained earnings 134,000 132,000 a (132,000) 134,000
total 1,250,000 515,000 (390,000) 1,375,000

The following features of the above working paper should be noted:

 The elimination is only a part of the working paper and not entered into the books of the parent or
subsidiary
 The elimination is used to reflect the difference between current fair values and carrying amounts of the
subsidiary’s identifiable net assets as the subsidiary did not write up its assets to current fair value
 The elimination column reflects increases and decreases rather than debits and credits
 Intercompany receivables and payables are placed on the same line of the working paper for
consolidated balance sheet and combined to produce a consolidated amount of zero
 The consolidated paid in capital amounts are those of the parent company only. Subsidiaries’ paid in
capital amounts are always eliminated in the process of consolidation.
 Consolidated retained earnings are those of the parent company only in line with the theory that states
purchase accounting reflects a fresh start in an acquisition of net assets.
 The consolidated amounts reflect the financial position of a single economic entity comprising two
legal entities with all intercompany balances eliminated
The consolidated balance sheet is exactly the same as the one presented on page 4.

.
2.3 consolidation of partially owned subsidiary on date of purchase type business combination
The consolidation of a parent company with its partially owned subsidiary differs from a consolidation of
wholly owned subsidiary in one major respect- the recognition of minority interest.
Minority interest is a term applied to the claims of stockholders other than the parent company to the net
income or losses and net assets of the subsidiary. The minority interest in the subsidiary’s net income or
loss is displayed in the consolidated income statement, and the minority interest in the subsidiary’s net
assets is displayed in the consolidated balance sheet.
To illustrate, assume that on december 31, 2013, post corporation issued 57,000 of its $1 par common
stock (current fair value $20 a share)to stockholders of sage company in exchange for 38,000 of the
40,000 outstanding shares of $10 par common stock in a purchase type business combination. Thus, post
acquired 95% (38,000/40,000) interest in sage, which became its subsidiary. There was no contingent
consideration. Out of pocket costs are:
finder’s and legal fees 52,250
costs associated with sec registration 72,750
total 125,000
Financial statements of post and sage just prior to combination were as follows:

Post corporation and sage company

Separate financial statements (prior to purchase-type business combination)
For year ended December 31, 2013
Post sage
Income statement
net sales 5,500,000 1,000,000
costs and expenses
cost of goods sold 3,850,000 650,000
operating expenses 925,000 170,000
interest expense 75,000 40,000
income taxes expense 260,000 56,000
total 5,110,000 916,000
Net income 390,000 84,000

Statement of retained earnings

Retained earnings, beginning 810,000 290,000
Add: net income 390,000 84,000
1,200,000 374,000
Less: dividends 150,000 40,000
Retained earnings, ending 1,050,000 334,000

Balance sheet
Assets
Cash 200,000 100,000
Inventories 800,000 500,000
Other current assets 550,000 215,000
.
Plant assets (net) 3,500,000 1,100,000
Goodwill (net) 100,000
total assets 5,150,000 1,915,000
Liabilities and stockholders’ equity
Income taxes payable 100,000 16,000
Other liabilities 2,450,000 930,000
Common stock, $1 par 1,000,000
Common stock, $10 par 400,000
Additional paid in capital 550,000 235,000
Retained earnings 1,050,000 334,000
total liab & stockholders’ equity 5,150,000 1,915,000
The december 31, 2013, current fair values of sage company’s identifiable assets and liabilities were the
same as their carrying amounts except for the following:
inventories 526,000
plant assets (net) 1,290,000
leasehold 30,000
Sage company does not prepare journal entries related to the business as it is continuing as a separate legal
entity. But post corporation prepares the following entries:
investment in sage common stock
(57,000*20) 1,140,000
common stock (57,000*1) 57,000
paid in capital in excess of par 1,083,000
To record issuance of 57,000 shares of common to acquire 38,000 of sage company’s outstanding 40,000
shares
Investment in sage common stock 52,250
Paid in capital in excess of par 72,750
cash 125,000
To record payment of out of pocket expenses associated with business combination
Working paper for consolidated balance sheet
It is advisable to use a working paper for preparation of a consolidated balance sheet for a parent company
and its partially owned subsidiary due to complexities caused by the minority interest.
The differences between the carrying amounts of identifiable assets and liabilities of the subsidiary with
the current fair values must be reflected by means of elimination.
common stock-sage 400,000
additional paid in capital-sage 235,000
retained earnings-sage 334,000
inventories-sage (526,000-500,000) 26,000
plant assets (net) (1,290,000-1,100,000) 190,000
leasehold 30,000
investment in sage common stock-post 1,192,250
The debit side of the above entry represents the current fair values of sage company’s identifiable tangible
and intangible assets (1,215,000) while the credit side represents post’s total investment 1,192,250. Two
items should be recorded to complete the elimination: minority interest and goodwill.
.
Computation of minority interest
current fair value of sage’s identifiable net assets 1,215,000
minority interest (100-95) 0.05
minority interest (1,215,000*.05) 60,750
This is recorded as credit as it represents claim on the net assets.
Computation of goodwill
cost of post corporation’s 95% interest 1,192,250
less: current fair value of identifiable net assets acquired
(1,215,000*.95) 1,154,250
goodwill 38,000
The completed elimination in journal entry format would be:
Common stock-sage 400,000
additional paid in capital-sage 235,000
retained earnings-sage 334,000
inventories-sage (526,000-500,000) 26,000
plant assets (net) (1,290,000-1,100,000) 190,000
leasehold 30,000
goodwill 38,000
investment in sage common stock-post 1,192,250
minority interest 60,750
Working paper for consolidated balance sheet
The following is the working paper for consolidated balance sheet for post corporation and subsidiary
Post corporation and subsidiary
Working paper for consolidated balance sheet
December 31, 2013

post sage elimination consolidated

Assets
Cash 75,000 100,000 175,000
Inventories 800,000 500,000 a 26,000 1,326,000
Other current assets 550,000 215,000 765,000
Investment in sage co 1,192,250 a (1,192,250)
Plant assets (net) 3,500,000 1,100,000 a 190,000 4,790,000
Leasehold a 30,000 30,000
Goodwill (net) a 38,000 138,000
total assets 6,217,250 1,915,000 (908,250) 7,224,00

Liabilities & stockholders’ equity

Income taxes payable 100,000 16,000 116,000
Other liabilities 2,450,000 930,000 3,380,000
Minority interest a 60,750 60,750
.
Common stock, $1 par 1,057,000 1,057,000
Common stock, $5 par 400,000 a (400,000)
Additional paid in capital 1,560,250 235,000 a (235,000) 1,560,250
Retained earnings 1,050,000 334,000 a (334,000) 1,050,000
total 6,217,250 1,915,000 (908,250) 7,224,000

.
Nature of minority interest
Two concepts for consolidated financial statements have been developed to account for minority
interest: the parent company concept and the economic unit concept.
The parent company concept apparently treats the minority interest in net assets of a subsidiary as a
liability. This liability is increased by an expense representing the minority’s share of the subsidiaries
net income (or decreased by the minority’s share of net loss). Dividends declared to minority
shareholders decrease the liability to them.
The economic unit concept displays the minority interest in the subsidiary’s net assets stockholders’
equity section of the consolidated balance sheet. The consolidated income statement displays the
minority interest in the subsidiary’s net income as a subdivision of total consolidated net income.
Note that there is no ledger account for minority interest in net assets of subsidiary, in either parent
company’s or the subsidiary’s accounting records.
Advantages and shortcomings of consolidated financial statements
Advantages
 Enable stockholders and prospective investors to view comprehensive financial information
for the economic unit without regard for legal separateness of the individual companies.
Shortcomings
 Less useful to creditors of each company and minority stockholders as they do not give
information about operating results and financial position of the individual companies.
 Consolidated financial statements of diversified companies (conglomerates) are impossible to
classify into a single industry and thus cannot be used for comparative purposes by financial
analysts

CHAPTER SIX
56
Consolidation: subsequent to acquisition
Subsequent to the date of business combination, the parent company must account for the operating
results of the subsidiary: the net income or net loss and dividends declared and paid by the subsidiary.
Intercompany transactions must also be recorded.
Accounting for operating results of wholly owned purchased subsidiaries
There are two alternative methods for this purpose: the equity method and the cost method of
accounting.
Equity method
Under this method, the parent company recognizes its share of the subsidiary’s net income or net loss,
adjusted for depreciation and amortization of differences between current fair values and carrying
amounts of purchased subsidiary’s net assets on the date of the business combination, as well as its
share of dividend declared by the subsidiary.
The equity method is said to be consistent with the accrual basis of accounting as it recognizes
increases or decreases in the carrying amount of parent company’s investment in the subsidiary as net
income or net loss, not when they are paid as dividends. Thus, proponents claim, the equity method
stresses the economic substance of the parent subsidiary relationship. Dividends declared by the
subsidiary do not constitute revenue the parent company but are a liquidation of a portion of the
parent company’s investment in the subsidiary.
Cost method
Under this method, the parent company accounts for the operation of a subsidiary only to the extent
that dividends are declared by the subsidiary. Dividends declared by the subsidiary from net income
subsequent to the business combination are recognized as revenue by the parent company; dividends
declared by the subsidiary in excess of post-combination net income constitute a reduction of the
carrying amount of the parent company’s investment in the subsidiary. Net income or net loss of the
subsidiary is not recognized by the parent company.
Supporters claim that this method appropriately recognizes the legal form of parent subsidiary
relationship. Thus, a parent company realizes revenue when the subsidiary declares dividend, not
when it reports net income.
Illustration of equity method for wholly owned purchased subsidiary for first year after
business combination
Assume that palm corporation had used purchase accounting for business combination with its wholly
owned subsidiary, star company, and the star had a net income of 60,000 for the year ended
december 31, 2000. On december 20, 2000, star’s bods declared a cash dividend of $0.60 a share on
the 40,000 outstanding shares.
Dec. 20: star’s journal entry to record dividend declaration is:
dividends declared 24,000
intercompany dividends payable 24,000
to record declaration of dividend
Under the equity method of accounting, palm corporation prepares the following journal entries to
record the dividend and net income of star.
1) intercompany dividend receivable 24,000
57
 investment in star common stock 24,000
to record dividend declared by star company
2) investment in star company common stock 60,000
intercompany investment income 60,000
to record 100% of star company’s net income
The credit to investment in subsidiary account in the first entry reflects an underlying premise of the
equity method of accounting: dividends declared by a subsidiary represent a return of a portion of
the parent company’s investment in the subsidiary.
The second entry records the parents 100% share of the subsidiary’s net income. The subsidiary’s net
income accrues to the parent company under the equity method of accounting.
Adjustment of purchased subsidiary’s net income
Continuing with the palm corporation star company business combination, palm must prepare a third
journal entry to adjust star’s net income for depreciation and amortization attributable to the
difference between the current fair values and carrying amounts of star’s net assets on the date of
the business combination-december 31,1999. Because such differences were not recorded by the
subsidiary, its net income is overstated from the point of view of the consolidated entity.
On the date of the business combination, differences between current fair values and carrying
amounts of star company’s net assets were as follows:
Inventories (fifo) 25,000
Plant assets (net)
land 15,000
building (economic life 15 years) 30,000
machinery (economic life 10 years) 20,000 65,000
Patent (economic life 15 years) 5,000
Goodwill (economic life 30 years) 15,000
Total 110,000
Palm corporation prepares the following journal entry to reflect the effects of depreciation and
amortization on the above differences on the net income of star company for the year ended december
31, 2000:
Intercompany investment income 30,500
investment in star co common stock 30,500
To amortize differences between current fair value and carrying amounts
Inventories- to cost of goods sold 25,000
Building- depreciation (30,000/15) 2,000
Machinery-depreciation (20,000/10) 2,000
Patent-amortization (5,000/5) 1,000
Goodwill-amortization (15,000/30) 500
Total 30,500
Developing the elimination
Palm corporation’s use of equity method of accounting for its investment in star company results in a
balance in investment account that is a mixture of two components:
 The carrying amount of star’s net assets
58
  The excess of current fair values over the carrying amount of star’s identifiable net assets,
including goodwill, on the date of business combination
All three basic financial statements must be consolidated for accounting periods subsequent to the
date of purchase type business combination and hence the elimination working paper must include
accounts that appear in the constituent companies’ income statement, statement of retained earnings
and balance sheets.
The items that must be included in elimination are:
1. The subsidiary’s beginning of year stockholder’s equity and its dividends, and the parent’s
investment
2. The parent’s intercompany investment income
3. Unamortized current fair value excess of the subsidiary
4. Certain operating expenses of the subsidiary
Assume that star company allocates:
 Machinery depreciation and patent amortization to cost of goods sold
 Goodwill amortization to operating expenses
 Building depreciation 50% each to cost of goods sold and operating expenses
The working paper elimination in working paper format is as follows with the component items
numbered in accordance with the foregoing breakdown:
common stock-star 200,000 (1)
additional paid in capital-star 58,000 (1)
retained earnings-star 132,000 (1)
intercompany investment income-palm 29,500 (2)
plant assets (net)-star (65,000-4,000) 61,000 (3)
patent-star (net) (5,000-1,000) 4,000 (3)
goodwill-star (net) (15,000-500) 14,500 (3)
cost of goods sold-star 29,000 (4)
operating expenses-star 1,500 (4)
investment in star co common stock-palm 505,500 (1)
dividend declared-star 24,000 (1)
 To carry out the following:
a) Eliminate intercompany investment and equity accounts of subsidiary at beginning of
year and subsidiary dividend
b) provide for depreciation and amortization on difference between current fair values
and carrying amounts
c) Allocate unamortized differences to proper accounts

Working paper for consolidated financial statements

The following aspects of the working paper should be emphasized:
 The intercompany receivable and payable are placed on the same line and offset without
formal elimination

59
  The elimination cancels the subsidiary’s retained earnings balance at the date of business
combination, so that each of the three basic financial statements may be consolidated in turn.
 The fifo method is used to account for inventories by star company. Thus, the difference of
25,000 attributable to beginning inventories is allocated to cost of goods sold.
 One effect of the elimination is to reduce the difference between the carrying amounts and
current fair values by the amount of amortization. (110,000-30,500=79,500)
The parent company’s use of the equity method of accounting results in the equalities
described below: parent company net income = consolidated net income
Parent company retained earnings = consolidated retained earnings
Closing entries
To complete the accounting cycle closing entries are prepared in the usual fashion by both the parent
company and the subsidiary. State corporate laws generally require separate accounting for retained
earnings available for dividends to stockholders. Accordingly, net income legally available for palm’s
stockholders as dividends and adjusted net income of the subsidiary not distributed as dividend by the
subsidiary are segregated. Hence, the entry to close income summary is:
income summary 109,500
retained earnings of subsidiary (29,500-24,000) 5,500
retained earnings (109,500-5,500) 104,000
Palm corporation and subsidiary
Working paper for consolidated financial statements
For year ended december 31, 2000
Elimination
Palm Star increase
corporation company (decrease) Consolidated
Income statement
Revenue:
Net sales 1,100,000 680,000 1,780,000
Intercompany investment income 29,500 a) (29,500)
total revenue 1,129,500 680,000 (29,500) 1,780,000
Costs and expenses:
Cost of goods sold 700,000 450,000 a) 29,000 1,179,000
Operating expenses 217,667 130,000 a) 1,500 349,167
Interest expense 49,000 49,000
Income taxes expense 53,333 40,000 93,333
total costs and expenses 1,020,000 620,000 30,500 1,670,500
Net income 109,500 60,000 (60,000) 109,500

Statement of retained earnings

Retained earnings, beginning 134,000 132,000 a) (132,000) 134,000
Net income 109,500 60,000 (60,000) 109,500
sub total 243,500 192,000 (192,000) 243,500
60
 Dividends declared 30,000 24,000 a) (24,000) 30,000
Retained earnings, ending 213,500 168,000 (168,000) 213,500

balance sheet
assets
Cash 15,900 72,100 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 star co common stock 505,000 a) (505,000)
Plant assets (net) 440,000 340,000 a) 61,000 841,000
Patents (net) 16,000 a) 4,000 20,000
Goodwill (net) a) 14,500 14,500
total assets 1,208,900 650,100 (426,000) 1,433,500

Liabilities & stockholders' equity

Income taxes payable 40,000 20,000 60,000
Other liabilities 190,900 204,100 395,000
Common stock, $10 par 400,000 400,000
Common stock, $5 par 200,000 a) (200,000)
Additional paid in capital 365,000 58,000 a) (58,000) 365,000
Retained earnings 213,500 168,000 a) (168,000) 213,500
total liab & stockholders' equity 1,209,400 650,100 (168,000) 1,433,500
Accounting for operating results of partially owned purchased subsidiaries
 Requires computation of minority interest in net income or net loss of the subsidiary
 Under the parent company concept, the minority interest in net income or net loss of a
subsidiary is included as expense in the consolidated income statement
Illustration:
The post corporation- sage company consolidated entity is used to illustrate. Post owns 95% of the
outstanding common stock of sage and minority stockholders own the remaining 5%.
Assume that sage company declared and paid dividend of 1 a share and had a net income of 90,000
for the year ended 31 december 2000. Sage prepares the following entries for the declaration and
payment of the dividend:
dividends declared (40,000*$1) 40,000
dividends payable (40,000*.05) 2,000
intercompany dividends payable (40,000*.95) 38,000
 To record declaration of dividend
dividends payable 2,000
intercompany dividends payable 38,000
cash 40,000

61
  To record payment of dividend declared
Post’s journal entries with regards to sage’s operating results include the following:
intercompany dividends receivable 38,000
investment in sage co common stock 38,000
 To record dividend declared by sage company
Cash 38,000
intercompany dividends receivable 38,000
 To record receipt of dividend from sage company
investment in sage co common stock
(90,000*.95) 85,500
intercompany investment income 85,500
 To record 95% of net income of sage company for the year ended dec 31, 2000
As noted earlier, a purchase-type business combination involves a restatement of net asset values of
the subsidiary. However, the net income reported by sage company does not reflect cost expiration
attributable to the restated net asset values as the restatements were not entered in the company’s
accounting records. Assume that the difference was allocated to sage’s identifiable assets as follows:
inventories (fifo) 26,000
plant assets:
land 60,000
building (economic life 20 yrs) 80,000
machinery (economic life 5 yrs) 50,000 190,000
leasehold (economic life 6 yrs) 30,000
total 246,000
Post corporation prepares the following journal entry on december 31, 2000 to reflect the effect of the
differences between the current fair values and carrying amounts of partially owned subsidiary’s
identifiable net assets:
intercompany investment income 42,750
investment in sage co common stock 42,750
 To amortize differences between current fair values and carrying amounts of sage company’s
identifiable net assets on dec 31,1999
Inventories to cost of goods sold 26,000
Building – dep. (80,000/20) 4,000
Machinery – dep. (50,000/5) 10.000
Leasehold – amrt. (30,000/6) 5,000
Total difference applicable to 2000 45,000
Amortization for 2000 (45,000*.95) 42,750
Assume that sage company allocates:
 Machinery depreciation and leasehold amortization entirely to cost of goods sold
 Building depreciation 50% each to cost of goods sold and operating expenses
Next, the following entry is prepared to amortize the goodwill acquired by post in the business
combination with sage:
amortization expense (38,000/40) 950
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 investment in sage co common stock 950
 To amortize goodwill acquired in business combination with partially owned subsidiary
Goodwill in a business combination involving a partially owned subsidiary is attributed to the parent
rather than the subsidiary as per fasb recommendation. Consequently the amortization of the goodwill
is debited to amortization expense account of the parent company, with an offsetting credit to the
investment account thereby avoiding charging any goodwill amortization to the minority interest,
which did not acquire any goodwill.
Developing the elimination
Post corporation’s use of equity method of accounting for its investment in star company results in a
balance in investment account that is a mixture of two components:
 The carrying amount of sage’s net assets
 The excess of current fair values over the carrying amount of sage’s identifiable net assets,
including goodwill, on the date of business combination
The following is the working paper elimination in journal entry format
common stock-sage 400,000
additional paid in capital-sage 235,000
retained earnings-sage 334,000
intercompany investment income-post 42,750
plant assets-sage (190,000-14,000) 176,000
leasehold (net) (30,000-5,000) 25,000
goodwill (net)(38,000-950) 37,050
cost of goods sold-sage 43,000
operating expenses-sage 2,000
investment in sage co common stock-post 1,196,050
dividends declared-sage 40,000
minority interest in net assets of sub(60,750-2,000) 58,750
 To carry out the following:
a) Eliminate intercompany investment and amortization on differences combination date
current fair values and carrying amounts to appropriate assets
b) Provide for year 2000 depreciation and amortization on differences between current fair
values and carrying amounts of sage’s identifiable net assets:
Cgs op. Exp
inventories sold 26,000
building dep. 2,000 2,000
machinery dep. 10,000
leasehold amort 5,000
total 43,000 2,000
c) Allocate unamortized differences between combination date current fair values and
carrying amounts to appropriate assets
d) Establish minority interest of subsidiary at beginning of year (60,750), less minority
interest share of dividends declared by subsidiary during the year (40,000*.05=2,000)
B) minority interest in net income of sub 2,250
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 minority interest in net assets of sub 2,250
 To establish minority interest in subsidiary’s adjusted net income
Net income of subsidiary 90,000
Net reduction (43,000+2,000) 45,000
Adjusted net income 45,000
Minority interest (45,000*.05) 2,250
The minority interest is:
Sage company’s total stockholders’ equity 1,019,000
Add: unamortized difference 201,000
Sage’s adjusted stockholders’ equity 1,220,000
Minority interest 5% 61,000
Palm corporation and subsidiary
Working paper for consolidated financial statements
For year ended december 31, 2000
Elimination
Post Sage increase
Income statement corporation Company (decrease) Consolidated
Revenue:
1,089,00
Net sales 5,611,000 0 6,700,000
Intercompany investment income 42,750 a) (42,750)

1,089,00
total revenue 5,653,750 0 (42,750) 6,700,000
Costs and expenses:

Cost of goods sold 3,925,000 700,000 a) 43,000 4,668,000

Operating expenses 556,950 129,000 a) 2,000 687,950
Interest & tax expense 710,000 170,000 880,000
Minority interest in net income of sub b) 2,250 2,250

total costs and expenses 5,191,950 999,000 47,250 6,238,200

Net income 461,800 90,000 (90,000) 461,800

Statement of retained earnings

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Retained earnings, beginning 1,050,000 334,000 a) (334,000) 1,050,000
Net income 461,800 90,000 (90,000) 461,800

sub total 1,511,800 424,000 (424,000) 1,511,800

Dividends declared 158,550 40,000 a) (40,000) 158,550
Retained earnings, ending 1,353,250 384,000 (384,000) 1,353,250

Palm corporation and sbsidiary

Working paper for consolidated financial statements
For year ended december 31, 2000

Balance sheet

Assets

Inventories 861,000 439,000 1,300,000

Other current assets 639,000 371,000 1,010,000

Investment in sage co common stock 1,196,050 a) (1,196,050)

Plant assets (net) 3,600,000 1,150,000 a) 176,000 4,926,000

Leasehold (net) a) 25,000 25,000
Goodwill (net) 95,000 a) 37,050 132,050

total assets 6,391,050 1,960,000 (958,000) 7,393,050

Liabilities & stockholders' equity

Liabilities 2,420,550 941,000 3,361,550

Minority interest in net assets of sub a) 58,750 61,000
b) 2,250

Common stock, $1 par 1,057,000 1,057,000

Common stock, $10 par 400,000 a) (400,000)

Additional paid in capital 1,560,250 235,000 a) (235,000) 1,560,250

Retained earnings 1,353,250 384,000 (384,000) 1,353,250

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total liab & stockholders' equity 6,391,050 1,960,000 (958,000) 7,393,050

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