Advance Ii

Chapter Four: Business Combinations
Chapter Four
Business Combinations
Chapter Outline:
 Definition, Classes, and Types of Business Combinations
 Reasons for business combinations
 Methods for Arranging Business Combination
 Establishing the Price for a Business Combination
 Accounting Methods for Business Combinations
Chapter objectives:
After completing this chapter, you would be able to:
 Understand the economic motivations underlying business combinations
 Learn about the alternative forms of business combinations, from both the legal and
accounting perspectives
 Understand alternative approaches to the financing of mergers and acquisitions
 Introduce concepts of accounting for business combinations emphasizing the purchase
method
 See how firms make cost allocations in a purchase method combination
Chapter Prerequisite: Intermediate Financial Accounting II (Acct 302)
Time Required: 10 Hours
4.1 Business of Combination: An Overview

4.1.1 Definition of Business Combination
Business combinations are events or transactions in which two or more business enterprises, or their
net assets, are brought under common control in a single accounting entity. According to the
Financial Accounting Standards Board, a business combination is an event or a procedure, in which,
an entity acquires net assets that constitute a business or acquires equity interests of one or more
other entities and obtains control over that entity or entities ( SFAS No. 141). Commonly, business
combinations are often referred to as mergers and acquisitions.
Amalgamation – two or more firms may amalgamate, either by taking over or by the formation of a
new firm. A decision to amalgamate shall be taken by each of the firms concerned. Special meetings
of shareholders of different classes or meetings of debenture holders shall approve the taking over
or being taken over (Art.549 & 550, Commercial Code of Ethiopia)
The Financial Accounting Standards Board has suggested the following definitions for terms used
in business combinations:
 Combined Enterprise: The accounting entity that results from a business combination.
 Constituent Companies: The business enterprises that enter into a combination.
 Combinor A constituent company entering into a combination whose owners as a group
ends up with control of the ownership interests in the combined enterprise.
 Combinee a constituent company other than the combinor in a business combination. The
term acquired, acquiree and combinee can be used interchangeably.
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The following are the assertions relating to business combinations as per SFAS No.141
1. Business combination is a transaction or other event in which an acquirer obtains control of one
or more businesses.
2. An acquirer can be identified in every business combination.
3. The business combination acquisition date is the date the acquirer obtains control of the
acquiree.
4. A business combination is accounted for by applying the acquisition method.
5. By obtaining control of an acquiree, an acquirer becomes responsible and accountable for all of
the acquiree’s assets, liabilities, and activities, regardless of the percentage of its ownership in
the acquiree.
Business Combinations
Friendly Takeovers Hostile Takeovers
4.1.2 Classes of Business Combinations

Business combinations are classified into two classes based on nature: friendly takeovers and
unfriendly (hostile) takeovers.
Friendly Takeover
 The Board of Directors of all constituent companies amicably (friendly) determine the terms
of the business combination.
 The proposal is submitted to share holders of all constituent companies for approval.
Hostile Takeovers
In this type of takeovers, the target combinee typically resists the proposed business combination.
Thus, the target combinee uses one or more of the following defensive tactics.
1. Pac-man Defense: a threat to undertake in a hostile takeover of the prospective
combinor.
2. White Knight: a search for a candidate to be the combinor in a friendly takeover.
3. Scorched Earth: the disposal of one or more business segments that attracts the
combinor. The profitable segment can be disposed through sale or spin-off. This is
sometimes called selling the crown jewels: The sale of valuable assets to others to make
the firm less attractive to the would-be acquirer. The negative aspect is that the firm, if it
survives, is left without some important assets
4. Shark Repellent: an acquisitions of substantial amounts of outstanding common stock
for the treasury or for retirement, or the incurring of substantial long-term debt in
exchange for outstanding common stock.
5. Poison Pill: an amendment of the articles of incorporation or bylaws to make it more
difficult to obtain stockholder approval for a takeover.
6. Greenmail: an acquisition of common stock presently owned by the prospective
combinor at a price substantially in excess of the prospective combinor’s cost, with the
stock thus acquired placed in the treasury or retired
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4.1.3 Types of Business Combinations

There are three types of business combinations: Horizontal Combination, Vertical Combination,
and Conglomerate Combination:
1. Horizontal Combination: is a combination involving enterprises in the same industry. E.g.
assume combination of BEDELE Brewery and HARAR Brewery
2. Vertical Combination: A Combination involving an enterprise and its customers or
suppliers. It is a combination involving companies engaged in different stages of production
or distribution. 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
E.g.2: Weaving Company acquiring both Ginning and Spinning Company - Backward
3. Conglomerate (Mixed) Combination: is a combination involving companies that are
neither horizontally nor vertically integrated. It is a combination between enterprises in
unrelated industries or markets.
Antitrust Considerations
Antitrust litigations are one obstacle faced by large corporations that undertake business
combinations. A business combination that leads to lessen the competition or tend to create a
monopoly is not allowed by the government. Government on occasion has opposed concentration of
economic power in large business enterprises as the formation of monopoly discourages
competition. Antitrust is a law that encourages perfect competition and discourages monopoly.
Business combinations may lead to formation of monopoly so that they are challenged department
of government. The type of combination determines the degree of concentration of economic
power. Horizontal combinations create the largest concentration of economic power and play a
negative role in discouraging competition than the other two types of business combinations.
4.2 Business Combinations: Why?

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, it may face a number of problems in production, marketing,
purchasing. Business combination enables to acquire or merge with an enterprise already operating
indifferent lines that have crossed many obstacles and difficulties. Combination will bring together
experiences of different persons in varied activities. So combination will be the best way of Growth.
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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 so that 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 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 such type 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.
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9. Better Financial Planning
A combined enterprise will be able to plan their resources in a better way. The collective finance of
merged enterprises will be more and their utilization may be better than in separate enterprises. It
may happen that one of the merging enterprises has short Gestation period (A period of time from
making investment to collecting the returns) while the other has longer Gestation period. The profits
with short gestation period will be utilized to finance the other enterprise with long gestation period.
When the enterprise with longer gestation period starts earning profits then it will improve financial
position as a whole.
10. Getting financial gains

Critics have alleged that the foregoing reasons attributed to the “urge to merge” (business
combinations) do not apply to unfriendly takeovers. These critics complain that the “Sharks” who
engage in unfriendly takeovers need financial benefits after assessing the prospect of substantial
gains resulting from the sale of business segments of a combine following the business
combination.
4.3 Methods for Arranging Business Combinations

The four common methods for carrying out a business combination are:
 Statutory Merger
 Statutory Consolidation,
 Acquisition of Common Stock, and
 Acquisition of Assets
1. Statutory Merger
Statutory Merger is a merger in which one of the merging companies continues to exist as a legal
entity while the other or other are dissolved. A business combination in which one company (the
survivor) acquires all the outstanding common stock of one or more other companies that are then
dissolved and liquidated, with their net assets owned by the survivor. 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.
E.g. ABC Company acquires all the outstanding common stock (net assets) of XYZ Company
where XYZ Company is legally liquidated
ABC Company
ABC Company
XYZ Company
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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 Chrysler Corporation and Daimler-Benz to form DaimlerChrysler
is an example of this type of consolidation.
E.g. ABC Company acquires XYZ Company; but a new Company AYZ is created to
issue common stocks for the two companies which are now defunct.
ABC Company
AYZ Company
XYZ Company
3. Acquisition of Common Stock
One corporation (the investor) may issue preferred or common stock, cash, debt, or a combination
thereof to acquire a controlling interest in the voting common stock of another corporation (the
investee). 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 a tender offer to stockholders of a publicly owned corporation. A tender offer is a publicly
announced intention to acquire, for a stated amount of consideration, a maximum number of shares
of the combinee’s 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 combinee’s common stock. If a controlling interest in the combinee’s
voting common stock is acquired, that corporation becomes affiliated with the combinor (parent
company) as a subsidiary but is not dissolved and liquidated and remains a separate legal entity.
The business combination through this method requires authorization by the combinor’s board of
directors and may require ratification by the combinee’s stockholders. Most hostile takeovers are
accomplished by this means.
E.g. ABC Company acquires over 50% of the voting stock of XYZ Company, a parent–subsidiary
relationship results and XYZ Company is now a subsidiary of ABC Company (Parent)
ABC Company ABC Company Parent Company
Business
Combination
XYZ Company XYZ Company Subsidiary Company
4. Acquisition of Assets
A business enterprise may acquire all or most of the gross assets or net assets of another enterprise
for cash, debt, preferred or common stock, or a combination thereof. The transaction generally must
be approved by the boards of directors and stockholders of the constituent companies. The selling
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enterprise may continue its existence as a separate entity or it may be dissolved and liquidated; it
does not become an affiliate of the combinor.
Summary of Methods for Arranging Business Combinations
Type of Combination Action of Acquiring Company Action of Acquired Company

Statutory
Merger Acquires all stock or net assets Dissolves & goes out of business. It
and then transfers assets & may also remain as separate
liabilities to its own books. division of the acquiring company
Statutory
Consolidation Newly created to receive Both original companies may
assets or capital stock of dissolve while remaining as
original companies separate divisions of newly created
company.
Acquisition of
Common Stock Acquires more than 50% stock Remains in existence as legal
that is recorded as an corporation, although now a
investment. Controls decision subsidiary of the acquiring
making of acquired company. company.
Acquisition of
Assets Acquires all or most of the The acquiree company may remain
gross assets in existence or may be liquidated
but not a subsidiary of the acquiring
company
The last two methods for carrying out a business combination, the combinor issues its common
stock, cash, debt, or a combination thereof, to acquire the common stock or the net assets of the
combinee. These two methods do not involve the liquidation of the combinee.
4.4) Determination of the Price for a Business Combination

Establishing the price for a business combination is a very important early step in planning a
business combination. The price for a business combination consummated for cash or debt
generally is expressed in terms of the total dollar amount of the consideration issued. When
common stock is issued by the combinor in a business combination, the price is expressed as a ratio
of the number of shares of the combinor’s common stock to be exchanged for each share of the
combinee’s common stock
Illustration of Exchange Ratio The negotiating officers of Palmer Corporation have agreed with
the shareholders of Simpson Company to acquire all 20,000 outstanding shares of Simpson
common stock for a total price of Br 1,800,000. Palmer’s common stock presently is trading in the
market at Br 65 a share. Stockholders of Simpson agree to accept 30,000 shares of Palmer’s
common stock at a value of Br 60 a share in exchange for their stock holdings in Simpson. The
exchange ratio is expressed as 1.5 shares of Palmer’s common stock for each share of Simpson’s
common stock, in accordance with the following computation:
Number of shares of Palm corporation common stock to be issued.............. 30,000
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Number of shares of Simpson company stock to be exchanged....................20,000
Exchange ratio: 30,000 / 20,000.................................................................... 1.5:1
The amount of cash or debt securities, or the number of shares of common or preferred stock, to be
issued in a business combination generally is determined by variations of two methods:
1. Capitalization of expected average annual earnings of the combinee at a desired rate of
return. Expected average income is calculated by taking the incomes earned during the
recent years. The abnormal items, if any, included in the income of any year should be
eliminated.
2. Determination of current fair value of the combinee’s net assets (including goodwill).
Capitalization of Expected Average annual earnings

Example 4.1: Assume that the business earned the following profit for the last five years:
Year Net Income
2001........................................Br 90,000
2002........................................ 110,000
2003........................................ 120,000
2004........................................ 140,000
2005........................................ 130,000
Note: the Br 140,000 profit in the Year 2004 included extraordinary gain of Br 40,000 which is
required to be excluded in the computation of expected average profit, and thus the profit for that
same year is Br 100,000. The average operating income of the five years is expected to continue in
the future and in this industry the average return on asset is 10% of the fair market value of the
identifiable assets. Instruction: Determine the fair value of the assets under capitalization method.
 Calculation of Average expected future Income (earnings)
Average Expected Income = 90,000 + 110,000 + 120,000 + 100,000 + 130,000 = Br 110,000
5
 Capitalized Fair Value of Assets = Br 110,000 / 10% = Br 1,100,000
4.5) Accounting Methods for Business Combinations

There were two methods of accounting for business combinations: Pooling-of-Interest and Purchase
Method. Some business combinations were accounted for under Pooling-of-Interest while some
business combinations were accounted for under purchase accounting method, in the past.
1. Pooling-of-Interest Accounting
The original premise of the pooling-of-interests method was that certain business combinations
involving the issuance 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 shareholders and managements of these corporations continued their relative interests and
activities in the combined enterprise as they previously did in the constituent companies. Because
neither of the like-size constituent companies could be considered the combinor under the criteria
set forth to determine combinor, the pooling-of-interests method of accounting provided for
carrying forward to the accounting records of the combined enterprise the combined assets,
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liabilities, and retained earnings of the constituent companies at their carrying amounts in the
accounting records of the constituent companies. 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 a pooling of interests Under Pooling-of-Interest (Uniting Interest) accounting
method, the balance sheet items of the two companies are simply added together. Pooling of
interests was the preferable method to use because it doesn't result in the creation of goodwill. This
in turn leads to higher reported earnings. Pooling of interests required the following 12 criteria to be
met:
Attributes of the Combining Companies

1. Autonomous (two-year rule)
2. Independent (10% rule)
Manner of Combining Interest
3. Single transaction (completed in one year following the initiation)
4. Exchange of common stock (90% "substantially all" rule)
5. No equity changes in contemplation of combination (two-year rule)
6. Shares reacquired only for purposes other than combination
7. No change in proportionate equity interests
8. Voting rights immediately exercisable
9. Combination resolved at consummation (no pending provisions)
Absence of Planned Transactions
10. Issuing company does not agree to reacquire shares
11. Issuing company does not make deals to benefit former stockholders
12. Issuing company does not plan to dispose of assets within two years
Using the pooling-of-interests method, companies could add together the book values of their net
assets without indicating which entity was the “purchaser” and which was the “purchased.” When
this method was used, investors often had difficulty identifying who was buying whom or
determining how to evaluate the transactions. Thus, FASB ruled out Pooling-of-Interests through
FASB Statement No. 141 in 2001 for new business combinations. FASB unanimously voted to
eliminate pooling of interests as an acceptable method of accounting for business combinations.
2. Purchase Accounting
Because the majority of business combinations involve an identified combinor and one or more combinees,
many accountants consider it logical to account for business combinations, regardless of how consummated,
as the acquisition of assets. Thus, assets (including goodwill) acquired in a business combination for cash
would be recorded at the amount of cash paid, and assets acquired in a business combination involving the
issuance of debt, preferred stock, or common stock would be recorded at the current fair value of
the assets or of the debt or stock, whichever was more clearly evident.
Under purchased method change in the basis of accounting occurs, thus acquired entity’s assets are
to be recorded at their current fair values not at book value and goodwill is also created. This
approach is known as purchase accounting for business combination, and was widely used prior to
the increase in popularity of pooling-of-interests accounting. According to SFAS No. 141, the
following principles should be used for applying Acquisition (Purchase) Method of Accounting for
business combinations:
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 Recognition Principle - in a business combination accounted for under purchase accounting, the
acquirer recognizes all of the assets acquired and all of the liabilities assumed.
 Fair Value Measurement Principle - in a business combination, the acquirer measures each
recognized asset acquired and each liability assumed and any non-controlling interests at its
acquisition date fair value.
 Disclosure Principle – the acquirer should include the information in its financial statement so
as to help users of financial statements evaluate the nature and financial effect of business
combinations recognized by the acquirer. The disclosure should include primary reasons for the
business combination; the allocation of purchase price paid to the assets acquired and liabilities
assumed by major balance sheet caption; and when significant, disclosure of other information
such as amount of goodwill by reportable segment and the amount of purchase price assigned to
each major intangible asset class
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
2. Determination of the Acquisition Cost – 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.
3. Allocation of the Acquisition Cost – 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.
4. Determination of Goodwill –The goodwill should be determined and recorded under

purchased method
5. Recording the Acquisition– the transaction is recorded as of the date of business combination
6. Consolidation of Financial Statement and Accounting after business combinations - the

nature of an asset and the manner of its acquisitions determines an acquiring entity’s
subsequent accounting for the asset (This will be discussed in chapter five)
1. Determination of the Combinor

To use the purchase method, one company must be designated as the “acquiring company or
combinor”. Because the carrying amounts of the net assets of the combinor are not affected by a
business combination, the combinor must be accurately identified. Thus, FASB provided the
following guidelines in SFAS No. 141 for identifying the combinor (acquiring company):
 The FASB stated that in a business combination effected solely by the distribution of cash or
other assets or by incurring liabilities, the constituent company that distributes cash or other
assets or incurs liabilities is generally the acquiring entity [SFAS 141, Par. 17].
 For combinations effected by the issuance of equity securities, the common theme is that the
combinor is the constituent company whose stockholders as a group retains or receives the largest
portion of the voting rights of the combined enterprise and thereby can elect a majority of the
governing board of directors or other group of the combined enterprise. The company that issues the
equity interest is generally the acquiring company. [SFAS141, Par. 18]
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2. Determination of the Acquisition Cost

The acquisition cost in a business combination accounted for by the purchase method is the total of:
 The amount of purchase consideration paid by the combinor.
 The combinor’s direct out-of-pocket costs of the combination.
 Any contingent consideration that is determinable on the date of the business
combination
A. Amount of Consideration - this is the total amount of cash paid, the current fair value of other
assets distributed, the present value of debt securities issued, and the current fair (or market) value
of equity securities issued by the combinor.
B. Out-of-Pocket Costs - included in this category are legal fees and finder’s fees. A finder’s fee is
paid to the investment banking firm or other organizations or individuals that investigated the
combine, assisted in determining the price of the business combination, and otherwise rendered
services to bring about the combination. Costs of registering and issuing debt securities in a
business combination are debited to Bond Issue Costs; they are not part of the cost of the combinee.
Costs of registering and 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.
Out-of-Pocket Costs of Business Combinations
Direct out-of-Pocket Costs Indirect out-of-Pocket Costs
Finders fees Salary and overhead costs incurred in negotiation
Travel costs Allocation of general expenses
Accounting fees Fees associated with registering securities with SEC
Legal fees Cost of issuing equity securities
Investment banker advisory fees Cost of debt securities
Direct out-of-Pocket Costs are added to the Cost of Acquisition of Combinee where as indirect out-
of-pocket costs are immediately expensed by the constituent companies.
C. 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).
Illustration of Contingent Consideration - the contract for Norton Company’s acquisition of the
net assets of Robinson Company provided that Norton would pay Br 800,000 cash for Robinson’s
net assets (including goodwill), which would be included in the Robinson Division of Norton
Company. The following contingent consideration also was included in the contract:
1. Norton was to pay Robinson Br 100 a unit for all sales by Robinson Division of a slow-moving
product that had been written down to scrap value by Robinson prior to the business combination.
No portion of the Br 800,000 price for Robinson’s net assets involved the slow-moving product.
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2. Norton was to pay Robinson 25% of any pre-tax accounting income in excess of Br 500,000
(excluding income from sale of the slow-moving product) of Robb Division for each of the four
years subsequent to the business combination.
On January 2, Year 1, the date of completion of the business combination, Robinson Company had
firm, non-cancelable sales orders for 500 units of the slow-moving product. The sales orders and all
units of the slow-moving product were transferred to Norton by Robinson. Norton’s cost of the net
assets acquired from Robinson should include Br 50,000 (500 @ Br 100 = Br 50,000) for the
determinable contingent consideration attributable to the backlog of sales orders for the slow-
moving product. However, because any pre-tax accounting income of Robb Division for the next
four years cannot be determined on January 2, Year 1, no provision for the 25% contingent
consideration is included in Norton’s cost on January 2, Year 1.
Subsequent Issuance of Contingent Consideration

Contingent consideration that is determinable on the date of a purchase-type business combination
is included in the measurement of cost of acquisition. Any other contingent consideration is
recorded when the contingency is resolved and the additional consideration becomes issuable or is
issued. Returning to the Norton Company illustration, assume that by December 31, Year 1, the end
of the first year following Norton’s acquisition of the net assets of Robinson Company, another 300
units of the slow-moving product had been sold, and Norton’s Robb Division had pre-tax
accounting income of Br 580,000 (exclusive of income from the slow-moving product). On
December 31, Year 1, Norton would prepare the following journal entry to record the resolution of
contingent consideration:
Goodwill............................................................................... 50,000
Payable to Robinson Company.................................. 50,000
To record payable contingent consideration applicable to January2, 1999, business combination
as follows:
Sale of slow-moving product (300 @ Br100)................................................... 30,000
Pre-tax income of Robinson division [(580,000 – 500,000 @.25]................... 20,000
Total payable..................................................................................................... 50,000
The additional goodwill in the foregoing journal entry is amortized over the remaining economic
life of the goodwill recorded in the business combination. Some purchase-type business
combinations involve contingent consideration based on subsequent market prices of debt or equity
securities issued to effect the combination. Unless the subsequent market price equals at least a
minimum amount on a subsequent date or dates, additional securities, cash, or other assets must be
issued by the combinor to compensate for the deficiency.
3. Allocation of the Acquisition Cost

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
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Identifiable Assets and liabilities
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;
 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.
In addition, the Financial Accounting Standards Board has provided the following guidelines:
1. The following combinee intangible assets were to be recognized individually and valued at fair
value:
 Assets arising from contractual or legal rights, such as patents, copyrights, and franchises.
 Other assets that are separable from the combinee entity and can be sold, licensed,
exchanged, and the like, such as customer lists and non-patented technology.
2. A part of the cost of a combinee is allocable to identifiable tangible and intangible assets that
resulted from research and development activities of the combined enterprise. Subsequently, such
assts are to be expensed, as required by FASB Statement No. 2, unless they may be used for other
than research and development activities in the future.
3. In a business combination, leases of the combinee-lessee are classified by the combined
enterprise as they were by the combinee unless the provisions of the lease are modified to the extent
it must be considered a new lease. Thus, unmodified capital leases of the combinee are treated as
capital leases by the combined enterprise, and the leased property and related liability are
recognized in accordance with the guidelines of FASB statement No. 141.
4. A combinee in a business combination may have pre-acquisition contingencies, which are
contingent assets (other than potential income tax benefits of a loss carry forward), contingent
liabilities, or contingent impairments of assets, that existed prior to completion of the business
combination. If so, an allocation period, generally not longer than one year from the date the
combination is completed, may be used to determine the current fair value of a pre-acquisition
contingency. A portion of the cost of a purchased combinee is allocated to a pre-acquisition contingency
whose fair value is determined during the allocation period. Otherwise, an estimated amount is assigned to a
pre-acquisition contingency if it appears probable that an asset existed, a liability had been incurred, or an
asset had been impaired at the completion of the combination. Any adjustment of the carrying amount of a
pre-acquisition contingency subsequent to the end of the allocation period is included in the measurement of
net income for the accounting period of the adjustment.
4. Determination of Goodwill
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
1. Goodwill as payment for super profit (extra profit or excess income)
By Temtim D 13
The purchaser (Combinor) may attempt to forecast the future income of the target company
(combinee) in order to arrive at a logical purchase price. Goodwill is a payment for above normal
expected future earnings. Earnings above the normal return are taken as the base for calculating the
value of Goodwill.
Example 4.2: You are given the following data:
Total Current Fair Value of Gross Assets......................................................Br 85,000
Industry Normal rate of return is................................................................... 10%
Expected average future earning.................................................................... 10,500
Required:
A. Calculate the goodwill at four years’ excess income
B. Calculate goodwill if the combinor expects the excess income for ever
C. Calculate goodwill when the combinor expects the excess income only for 10 years
D. Calculate goodwill if the current fair value of liabilities Br 10,000 and total acquisition cost of
Br 90,000
Determination of the Extra Profit:
Expected Profit ..................................................................................Br 10,500
Less: Normal Profit (= Br 85,000 @ 10%) ....................................... (8,500)
Extra profit......................................................................................... 2,000
Calculation of Goodwill
A. Calculate the goodwill at four years’ excess income
 Goodwill = Extra Profit @ 4
 Goodwill = Br 2,000 @ 4= Br 8,000
B. Calculate goodwill if the combinor expects the excess income for ever
 Goodwill = Extra profit / industry normal rate of return = Br 2,000 / 10% = Br 20,000
C. Calculate goodwill when the combinor expects the excess income only for 10 years
 Goodwill = Extra profit @ PVIF of Ordinary Annuity (10% for 10 Years)
 Goodwill = Br 2,000 @ 6.145 = Br 12,290
D. Calculate goodwill if the current fair value of liabilities Br 10,000 and total acquisition cost of
Br 90,000
 Goodwill = Total Acquisition Cost – Current Fair Value of Net Assets
 Current Fair Value of Net Assets = Total CFV of Assets – CFV of Liabilities
 Current Fair Value of Net Assets = Br 85,000 – 10,000 = Br 75,000
 Goodwill = Br 90,000 – 75,000 = Br 15,000
2. Goodwill as excess cost of acquisition over the current fair value of net assets
When goodwill is determine as excess cost of acquisition over the current fair value of net assets
one of the following circumstances may occur:
 If total Acquisitions Cost = FMV of the net Assets, no goodwill is recognized
 If Total Acquisitions Cost > FMV of the net Assets, it will result in a positive goodwill
 If Total Acquisitions Cost < FMV of the net Assets, it will result in a Negative Goodwill
Negative Goodwill
 In some purchase-type business combinations (known as bargain purchases), the current fair
values assigned to the identifiable net assets acquired exceed the total cost of the combinee
(acquisition cost).
 A bargain purchase is most likely to occur for a combinee with a history of losses or when
common stock prices are extremely low.
By Temtim D 14
 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)
Example 4.3: Green Company is considering acquiring the assets of Gold Company by assuming
Gold’s liabilities and by making cash payment. Gold Company has the following balance sheet on
the date of negotiations:
Gold Company
Balance Sheet
December 31, 1994
Assets: Liabilities and Equity:
Accounts Receivable..................................100,000 Total Liabilities.................................... 200,000
Inventory....................................................100,000 Capital Stock (Br10 Par)...................... 100,000
Land...........................................................100,000 Additional PIC..................................... 200,000
Building (Net)............................................220,000 Retained Earnings............................... 300,000
Equipment (Net)........................................280,000
Total Asset.................................................800,000 Total Liabilities and Equity.................. 800,000
Appraisal indicates that the inventory is undervalued by Br 25,000; building is undervalued by Br
80,000; the equipment is overstated by Br 30,000; and the liability is overstated by Br 10,000.
Determine the Goodwill that is recognized if Green Company pays Br 900,000 cash for the net
assets of Gold Company.
Calculation of Net Assets:
Particulars Birr
Accounts Receivable......................................... 100,000
Inventory........................................................... 125,000
Land................................................................... 100,000
Building (Net)................................................... 300,000
Equipment (Net)................................................ 250,000
Gross Identifiable Assets................................... 875,000
Less: CFV of total Liabilities............................(210,000)
Net Assets at CFV............................................. 665,000
Calculation of Goodwill:
Total Acquisition Cost................................. Br 900,000
Less: Net Assets at CFV...............................(665,000)
Goodwill.......................................................
Br 235,000
5. Recording the Acquisition
By Temtim D 15
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
Additional PIC – CS...........................................................
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...........................................xxxx
x
Cash............................................................................ xxxxx
Common Stock........................................................... xxxxx
Additional PIC – CS.................................................. xxxxx
Bonds......................................................................... xxxxx
2. Recording direct out-of-pocket costs (legal and finder’s fee)
Investment in Combinee Company........................................... xxxxx
Cash......................................................................... xxxxx
3. Recording the Indirect Out-of-Pocket Costs
Indirect out of pocket costs first are debited to the indirect expenses account for all the Indirect out
of pocket costs and then closed to the Additional PIC account. The other alternative is to directly
debit Additional PIC for the amount of indirect out of pocket costs as just below.
Addition PIC – CS.................................................................... xxxxx
Cash......................................................................... xxxxx
4. Recording Assets and Liabilities (the Investment Account is replaced with assets and
liabilities)
All Assets, Individually, at CFV............................................... xxxx
x
Goodwill................................................................................... xxxx
x
Liabilities (Individually) at CFV............................... xxxxx
Investment in Combinee Company............................ xxxxx
Illustration on Purchase Method of Accounting for Statutory Merger with Positive Goodwill
Example 4.4: Combinor Company acquired Combinee Company On December 31, 2002 with the
following balance sheet items:
By Temtim D 16
Combinee Company
Balance Sheet
December 31, 2002
Cash....................................................... 60,000 Current Liabilities............................ 180,000
Other Current Assets............................. 420,000 Long-term debt................................. 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, 2002 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, 2002 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, 2002
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
Total Purchase Cost........................................................................
1,480,000
Less: Net Assets at CFV.................................................................
(1,140,000)
Goodwill.........................................................................................
(340,000)
By Temtim D 17
Journal Entries:
1. 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 Company................................................. 180,000
Cash............................................................................... 180,000
3. Recording indirect out-of-pocket costs
Additional PIC – CS......................................................................
120,00
0
Cash...............................................................................120,000
4. Recording Assets and liabilities (Allocation)

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
Example 4.5: On December 31, Year 1, META Company (the combinee) was merged into
SAXON 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. SAXON 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 META’s no-par, Br 10 stated value
common stock. In addition, Saxon paid the following out-of-pocket costs associated with the
business combination:
Accounting fees:
For investigation of META Company as prospective combinee..........................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,
META Company’s condensed balance sheet was as follows:
By Temtim D 18
META COMPANY (Combinee)

Balance sheet (Prior to Business Combination)
December 31, Year 1
Assets:
Current assets............................................................ Br1,000,000
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 Saxon
Corporation determined the current fair values of META Company’s identifiable assets and
liabilities (identifiable net assets) as follows:
Current asset...................................................................
Br1,150,000
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 SAXON Corporation (the Combinor) to
record the Merger with META Company on December 31, Year 1, as a Purchase-type business
combination. SAXON uses an investment ledger account to accumulate the total cost of META
Company prior to assigning the cost to identifiable net assets and goodwill.
By Temtim D 19
SAXON Corporation (Combinor)

Journal Entries
December 31, Year 1
To record merger with META Company as a purchase.
Investment in META 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 META 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 META Company Common Stock
(Br5,000+Br10,000+ Br 51,250)................................................................... 66,250
Paid-in Capital in Excess...............................................................................133,750
Cash...................................................................... 200,000
To allocate cost of META 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 META 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 META’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)
By Temtim D 20
Amount of goodwill................................................................................... Br 116,250
NOTE: No adjustments are made in the foregoing journal entries to reflect the current fair values
of Saxon’s identifiable net assets or goodwill, because SAXON is the Combinor in the business
combination. META Company (the combinee) prepares the condensed journal entry below to
record the dissolution and liquidation of the company on December 31, Year 1:
META COMPANY (Combinee)

Journal Entry
December 31, Year 1
Current Liabilities..................................................... 500,000
Long-Term Debt.......................................................1,000,000
Common Stock, Br 10 stated value..........................1,000,000
Paid-in Capital in Excess of Stated value................. 700,000
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
Saxon Corporation
Exercise 4.1: Grant Company has been looking to expand its operations and has decided to
acquire the assets of TURNER Company and MURPHY Company. GRANT Company will
issue 25,000 shares of its Br 10 par common stock to acquire the net assets of Turner Company
and will issue 12,000 shares to acquire the net asset of Murphy Company. The Balance Sheet of
the acquired companies (combinees) is as follows:
Turner Murphy
Company Company
Assets: In Birr In Birr
Accounts Receivables................................................. 200,000 80,000
Inventory..................................................................... 150,000 85,000
Land............................................................................ 150,000 50,000
Building...................................................................... 500,000 300,000
Accumulated Depreciation......................................... (150,000) (110,000)
Total Assets................................................................. 850,000 405,000
....................................................................................
....................................................................................
....................................................................................
Liabilities and SH Equity:
Current liabilities........................................................ 160,000 55,000
Bonds payable............................................................. 100,000 100,000
Common Stock (Br 10 par)........................................ 300,000 100,000
By Temtim D 21
Retained earnings........................................................ 290,000 150,000
Total liabilities and equity.......................................... 850,000 405,000
The following current fair values (CFV) are agreed upon by the BODs of the combinees companies
and Grant Company while the others have the same book values and current fair values:
Turner Murphy
Company Company
Inventory..................................................................... 200,000 100,000
Land............................................................................ 200,000 60,000
Building (net).............................................................. 400,000 350,000
Bonds payable............................................................. 80,000 95,000
Grant’s stock is currently traded at Br 40 per share. Grant will incur Br 5,000 direct acquisition
cost in Turner Company and Br 4,000 of direct acquisition cost in Murphy Company. Grant also
incurred Br 13,000 other indirect cost of acquisition and Br 15,000 registration and issue cost.
Required: Record the acquisition cost on the books of Grant Company using Purchase Accounting
principles (Purchase Method)
Checking Figures: Turner Company Murphy Company
Total Acquisition Cost................................... Br 1,005,000 Br 484,000
Net assets....................................................... 760,000 440,000
Goodwill........................................................ 245,000 44,000
Example 4.6: Purchase Accounting for Acquisition of Assets, with “Negative Goodwill”
On December 31, Year 1, Davis Corporation acquired the net assets of Fairmont Corporation for
Br 400,000 cash, in a purchase-type business combination. Davis paid legal fees of Br 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 Combination)
December 31, Year 1
Carrying Market
Amounts Values
Assets:
Current assets......................................................................... Br190,000 Br 200,000
Investment in marketable securities....................................... 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 &Stockholders' Equity:
Current Liabilities.................................................................. 240,000 240,000
Long-term debt....................................................................... 500,000 520,000
Total Liabilities...................................................................... 740,000 760,000
Common stock, Br 1 par ....................................................... 600,000
Deficit (Dr. balance in Retained earnings)............................ (140,000)
Total stockholders' equity...................................................... 460,000
Total liabilities & stockholders' equity....................... 1,200,000
By Temtim D 22
Thus, Davis Corporation acquired identifiable net assets with a current fair value of Br 500,000
(Br 1,260,000 – Br 760,000 = Br 500,000) for a total cost of Br 440,000 (i.e. Br 400,000 + Br
40,000). The Br 60,000 excess of current fair value of the net assets over their cost to Davis
Corporation (500,000 – 440,000 = 60,000) is prorated to the plant assets and intangible assets in
the ratio of their respective current fair values as follows:
 Prorated to plant assets: (900,000 / 1,000,000) @ 60,000 = 54,000
 Prorated to intangible assets: (100,000 /100,000) @ 60,000 = 6,000
No part of the Br 60,000 bargain-purchase excess is allocated to current assets and to the investment
in marketable securities. The journal entries for by Davis Corporation for acquisition of the net
assets of Fairmont Corporation and payment of Br 40,000 legal fees are shown below:
To record acquisition of net assets of Fairmont corporation
Investment in net assets of Fairmont Corporation.............................. 400,000
Cash .................................................................................... 400,000
To record payment of legal fees incurred in acquisition of net assets
Investment in net assets of Fairmont Corporation.............................. 40,000
Cash........................................................................................ 40,000
To allocate total cost of net assets acquired to identifiable net assets, with excess of current fair
value of the net assets over their cot prorated to noncurrent assets other than investments in
marketable debt securities.(income tax effects are disregarded)
Current assets.......................................................................................................200,000
Investment in marketable debt securities............................................................. 60,000
Plant assets (900,000- 54,000).............................................................................846,000
Intangible assets (100,000 -6,000)....................................................................... 94,000
Current liabilities..................................................................................... 240,000
Lon-term Debt.......................................................................................... 500,000
Premium on long-term debts (520,000- 500,000).................................... 20,000
Investment in net assets of Fairmont Corporation (400,000+ 40,000).... 400,000
Exercise 4.2: Thompson Company is purchasing the net assets of Green Company on December
31, 2003, when Green Company has the following B/Sheet
Green Company (Combinee)
Balance Sheet
December 31, 2003
Other Current Assets.............................100,000 Current Liabilities .......................................90,000
Land...................................................... 50,000 Common Stock (Br 10 Par).. 200,000
Building (Net).......................................200,000 Retained Earnings................ 140,000
Equipment (Net).................................... 60,000 Total stockholders’ Equity .......................... 340,000
Goodwill............................................... 20,000
Total Asset............................................430,000 Total Liabilities and Equity.........................
430,000
Thompson Company has obtained the following Current Fair Values for Green Company
accounts:
Assets: Birr
By Temtim D 23
Other Current Assets..................................................... 120,000

Land .............................................................................. 100,000
Building (Net)................................................................ 250,000
Equipment (Net)............................................................ 150,000
Current Liabilities.......................................................... 92,000
Direct acquisition costs are Br 18,000 and indirect acquisition costs are Br 5,000. Determine the
Negative Goodwill and show the proration to noncurrent assets and prepare journal entries to record
the purchase of Green Company assuming the cash payment by Thompson Company is Br
450,000. Thompson Company will assume the liabilities.
Checking Figures:
Total Acquisition Cost..................................................... Br 468,000
Net Assets........................................................................ 528,000
Negative Goodwill........................................................... Br 60,000
Exercise 4.3: the Combinor Company acquires the Combinee at a total acquisition cost of Br
1,800,000 where the Current Fair Value of Net Assets is Br 2,000,000. The only Noncurrent Assets
that can be used to prorate negative Goodwill is a Building (net) with CFV of Br 130,000.
Determine the Negative Goodwill that is recorded in the books of Combinor Company
6. Financial Statement and Accounting after business combinations

Under both purchase accounting, the balance sheet for the combined enterprise issued as of the date
of the business combination accomplished through statutory merger, statutory consolidation, or
acquisition of assets includes all the assets and liabilities of the constituent companies. The
consolidated balance sheet issued immediately following a combination that results in a parent-
subsidiary relationship will be described in the next chapter. In a balance sheet following a purchase
type business combination, assets and liabilities of the combinor are at carrying amounts, assets
acquired from the combinee are at current fair values (adjusted for any bargaining purchase excess),
and retained earnings is that of the combinor only. The income statement of the combined enterprise
for the accounting period in which a purchase type business combination occurred includes the
operating results of the combinee after the date of the combination only.
Disclosure of Business Combinations in a Note to the Financial Statements

Because of the complex nature of business combinations and their effects on the financial position
and operating results of the combined enterprise, extensive disclosure is required for the periods in
which they occur.
Disclosures under the Purchase Method

The Accounting Principles Board required disclosure of the following aspects of a purchase – type
business combination in a note to the financial statements for the period in which the business
combination took place: name and brief description of the combinee; period for which combinee’s
operating results are included in the income statement of the combined enterprise; cost of the
combinee, including number of shares and value per share of common stock issued, and nature of
and accounting treatment for contingent consideration; amortization policy for goodwill recorded in
the combination; and pro forma operating results for the combined enterprise for the current and
By Temtim D 24
preceding accounting periods as though the combination had occurred at the beginning of the
preceding period. Subsequently, the Financial Accounting Standards Board waived the pro forma
disclosures for nonpublic enterprises whose debt and equity securities are not publicly traded.
The following note to the financial statement of a publicly owned company illustrates the required
disclosures for a purchase-type business combination:
Purchase On April 1, Year 2, the company acquired substantially all the assets, including
inventories, of Combine Company of Br 8,400,000 cash and an agreement to make future payments
through July, Year 5, contingent on sales of one of the acquired brands. The acquisition has been
accounted for as a purchase, and the excess (Br 399,000) of the consideration paid on acquisition
over the current fair value of the identifiable tangible and intangible net assets acquired is being
amortized over 15 years. Contingent payments are also being recorded as intangible assets and
amortized over the then remaining economic life. The results of operations of Combinee are
included in the consolidated income statement since the date of acquisition. Had the acquisition
taken place on January 1, Year 1, unaudited pro forma sales for the years ended December 31, Year
2 and Year 1 would be Br 793,627,000 and Br 777,715,000, respectively, and unaudited pro forma
data reflect adjustment for amortization of intangible assets and imputed interest.
Purchase Accounting for Statutory Consolidation

Because a new corporation issues common stock to effect a statutory consolidation, one of the
constituent companies must be identified as the combinor, under the criteria described to identify
combinor. Once the combinor has been identified, the new corporation recognizes net assets
acquired from the combinor at their carrying amount in the combinor’s accounting records;
however, net assets acquired from the combinee are recorded by the new corporation at their
current fair values. To illustrate, assume the following condensed balance sheets of the constituent
companies involved in a purchase-type statutory consolidation on December 31, Year 1999:
Lamson Corporation & Donald Company
December 31, 1999
Asset LAMSON DONALD
Company Company
Current assets..........................................................Br 600,000 400,000
Plant asset (net)....................................................... 1,800,000 1,200,000
Other assets............................................................. 400,000 300,000
Total assets............................................................. 2,800,000 1,900,000
Liabilities & Shareholders Equity
Current liabilities.................................................... 400,000 300,000
Long-term debt....................................................... 500,000 200,000
Common stock, Br10.............................................. 430,000 620,000
Paid in capital......................................................... 300,000 400,000
Retained Earning.................................................... 1,170,000 380,000
Total........................................................................ 2,800,000 1,900,000
The current fair values of both companies’ liabilities were equal to carrying amounts. Current fair
values of identifiable assets were as follows for Lamson and Donald, respectively: current assets,
By Temtim D 25
Br 800,000 and Br 500,000; plant assets, Br 2,000,000 and Br 1,400,000; other assets, Br 500,000
and Br 400,000.
On December 31, Year 1999, in a statutory consolidation approved by shareholders of both

constituent companies, a new corporation, LamDon Corporation, issued 74,000 shares of no stated
value common stock with an agreed value of Br 60 a share, based on the following valuations
assigned to the two constituent companies’ identifiable net assets and goodwill.
LAMSON DONALD
Corporation Company
Current Fair Value of Identifiable Net Assets:
Lamson: Br 800,000 + 2,000,000+500,000-400,000-500,000...... 2,400,000
Donald: Br 500,000 +1,400,000+400,000-300,000 -200,000........ 1,800,000
Goodwill assigned to determine number of shares issued............. 180,000 60,000
Net assets’ current fair value......................................................... 2,580,000 1,860,000
Number of shares of LamDon to be issued to constituent
companies’ Stockholders, at Br 60 a share agreed value............... 43,000 31,000
58% 42%
Because the former shareholders of Lamson Corporation receive the largest interest in the common
stock of LamDon Corporation (43/74 or 58%), Lamson is the combinor in the purchase-type
business combination. Assuming that LAMDON paid a Br 200,000 out-of-pocket cost which
comprises Br 110,000 direct and Br 90,000 indirect for the statutory consolidation after it was
consummated on December 31, Year 1999; LAMDON’s journal entries would be as follows:
To record consolidation of Lamson corporation and Donald company as a purchase

Investment in Lamson and Donald Company (74,000 @ 60).............................4,440,000
Common Stock, no-par ........................................................................... 4,440,000
To record payment of costs incurred in consolidation of Lamson Corporation and Donald

Company. Accounting legal and finder’s fee in connection with the consolidation are recorded as
investment cost; pother out-of-pocket costs are recorded as a reduction in the proceeds received
from the issuance of common stock.
Investment in Lamson and Donald Company common stock......................110,000
Common stock, no par.................................................................................. 90,000
Cash ..................................................................................... 200,000
To allocate total cost of investment to identifiable assets and liabilities, at carrying mount for
combinor Lamson corporation’s net assets and at current fair value for combinee Donald
company’s net assets.(income tax effects are disregarded).
Assume Lamson Corporation was identified as Combinor and valued Current Assets at Br 500,000;
Plant assets at Br 1,400,000; and Other assets at Br 400,000 of Donald Company:
Current assets (600,000 + 500,000)..................................................................... 1,100,000
Plant assets (1,800,000 + 1,400,000)................................................................... 3,200,000
Other assets (400,000 +400,000)......................................................................... 800,000
By Temtim D 26
Goodwill.............................................................................................................. 850,000
Current liabilities (400,000 +300,000)........................................................... 700,000
Long-term Debt (500,000+ 200,000) ............................................................ 700,000
Investment in Lamson and Donald Co common tock (4,440,000+110,000).. 4,550,000
Note in the foregoing journal entry that because of the combinor’s net assets’ being recorded at
carrying amount and because of the Br110,000 direct costs of the business combination, the amount
of goodwill is Br850,000, rather than Br240,000 (Br180,000+Br60,000=Br240,000), the amount
assigned by the negotiating directors to goodwill in the determination of the number of shares of
common stock to be issued in the combination.
Amount of Goodwill is computed as follows:
Total cost of investment (4,440,000 + 110,000) ........................................Br4,550,000
Less: Carrying amount of Lamson’s Identifiable net Assets...................... (1,900,000)
Current Fair Value of Donald’s Identifiable net assets .............................. (1,800,000)
Amount of Goodwill................................................................................... Br850,000
Appraisal of Accounting Standards for Business Combinations

The accounting standards for business combinations described and illustrated in the preceding pages
of may be criticized on grounds that they are not consistent with the conceptual framework for
financial accounting and reporting.
Criticism of Purchase Accounting:

The principal criticisms of purchase accounting center on the recognition of goodwill. Many
accountants take exception to the residual basis for valuing goodwill established in APB Opinion
No. 16. These critics contend that part of the amount thus assigned to goodwill probably apply to
other identifiable intangible assets. Accordingly, goodwill in a business combination should be
valued directly by use of methods as described in your Intermediate Accounting course. Any
remaining cost not directly allocated to all identifiable tangible and intangible assets and to
goodwill would be apportioned to those assets based on the amounts assigned in the first valuation
process or recognized as loss. The accounting described for the excess of current fair values over
total cost in a bargain-purchase business combination also has been challenged. Critics maintain
there is no theoretical support for the arbitrary reduction of previously determined current fair
values of assets by an apportioned amount of the bargain-purchase excess. They suggest the
amortization treatment described on page 6 for the entire bargain-purchase excess. Other
accountants question whether current fair values of the combinor’s net assets-especially goodwill-
should be disregarded in accounting for a current fair values for net assets of the combine only, in
view of the significance of many combinations involving large constituent companies.
Exercise 4.4: On January 31, 2004, EDGET Corporation acquired for Br five hundred forty
thousands (540,000) cash all the net assets except cash of HIBRET Company and paid Br 60,000 to
a law firm for legal services in connection with the business combination. The balance sheet of
HIBRET Company on January 31, 2004 was as follows:
HIBRET Company
Balance Sheet
January 31, 2004
Assets: Liabilities and Shareholders’ Equity
By Temtim D 27
Cash ........................................... 40,000 Liabilities.................................. 620,000
Other Current Assets.................. 280,000 Common Stock.........................................
250,000
Plant Assets (net)........................ 760,000 Retained Earning......................................
330,000
Intangible Assets ....................... 120,000
Total Assets ............................... 1,200,00 Total Liab. & SHEs..................................
1,200,000
0
The present value of HIBRET Company’s liabilities on January 31, 2004 was Br 620,000, the
current fair values of its non-cash assets were as follows on January 31, 2004:
Other current assets..........................................................300,000
Plant Assets......................................................................874,000
Intangible Assets.............................................................. 76,000
Instruction: Prepare journal entries for EDGET Corporation on January 31, 2004 to record the
acquisition of net assets of HIBRET Company’s except cash
Checking Figures:
Total Acquisition Cost............................................................ 600,000
Net Assets............................................................................... 630,000
Goodwill (Negative)............................................................... 30,000
Adjusted Plant Assets (874,000 – 27,600).............................. 846,400
Adjusted Intangible Assets (76,000 – 2,400).......................... 73,600
Exercise 4.5:
The balance sheet and the current fair values of EXCEL Corporation on March 31, 2002 were as
follows:
EXCEL Corporation
Balance Sheet
March 31, 2002
Assets Liabilities and Shareholders’ Equity
BV CFV BV CFV
Other Current Assets................................
500,000 575,000 Current liabilities......................................
300,000 300,000
Plant Assets (net)........... 1,000,00 1,200,000 Liabilities .................................400,000 450,000
0
Patent (net).............................
100,000 50,000 Common Stock (10 par)...........................
100,000
Retained Earning......................................
800,000
Total Assets..........................
1,600,00 Total Liab. & SHEs..................................
1,600,00
0 0
On April 1, 2002, VALUE Corporation issued 50,000 shares of its no-par, no stated value common
stock (CFV Br 14 a share) and Br 225,000 cash for the net assets of EXCEL Corporation in a
purchase type business combination. Of the Br 125,000 out-of-pocket costs paid by VALUE
Corporation on April 14, 2002, Br 50,000 were legal fees and finder’s fees related to the business
combination and the remaining related to the issuance of common stock. Required: prepare journal
entries for VALUE Corporation on March 31, 2002 to record the business combination with
EXCEL Corporation
Checking Figures:
By Temtim D 28
Total Acquisition Cost............................................................975,000

Net Assets...............................................................................
1,075,000
Goodwill, Negative.................................................................100,000
Adjusted Plant Assets (1,200,000 – 96,000)........................... 1,104,000
Adjusted Patent (50,000 – 4,000)........................................... 46,000
Exercise 4.6: MOON Corporation agreed to purchase net assets of SUN Corporation. Just prior
to the acquisition, SUN’s Balance Sheet is as follows:
SUN Corporation
Balance Sheet
January 31, 2001
Assets: Liabilities and Shareholders’ Equity:
Accounts Receivable................................
200,00 Current Liabilities.....................................
80,000
0
Inventory...................................................
270,00 Mortgage Payable.....................................
250,000
0
Equipment (net)........................................
100,00 Common Stock (Br 10 par)......................
100,000
0
_______ Retained Earnings.....................................
140,000
Total Assets .............................................
570,00 Total Liab. & SHEs..................................
570,000
0
The market values agree with Book Values except for the equipment which has an estimated market
value of Br 40,000. MOON Corporation paid Br 10,000 for direct acquisition costs and Br 15,000
for indirect acquisition cost to consummate the transaction. Record the purchase on the MOON
Corporation assuming the cash paid to SUN Corporation is:
1. Br 180,000
2. Br 140,000
Also give the journal entry to liquidation of SUN Corporation
Checking Figures: Case 1 Case 2
Total Acquisition Cost...............................................................Br 190,000 Br 150,000
Net Assets..................................................................................
180,000 180,000
Goodwill....................................................................................10,000 (30,000)
Problem 4.1:
On December 31, 2006, Alpha Corporation issued 18,000 shares of its Br 2 par (current fair value
of Br 10 per share) common stock for all the outstanding common stock of Beta Corporation in a
statutory merger. Out-of-pocket costs of the business combination paid by Alpha on December 31,
2006 are:
Direct costs of the business combination ............................... Br 22,000
Cost of registering and issuing common stock....................... 15,000
By Temtim D 29
Total out-of-pocket costs of business combination ............... Br 37,000
Beta had the following balance sheet on December 31, 2006:

Beta Corporation
Balance Sheet
December 31, 2006
Book Market
Value Value
Assets: In Birr In Birr
Inventories.................................................................................. 96,000 110,000
Other current assets.................................................................... 52,000 52,000
Plant assets (net)........................................................................ 172,00 195,000
Total assets................................................................................. 320,000 357,000
Liabilities & Stockholders' Equity:
Liabilities................................................................................... 175,000 175,000
Common Stock, Br 5 par........................................................... 20,000
Additional paid-in capital.......................................................... 50,000
Retained earnings....................................................................... 75,000
Total liabilities & Stockholders' equity..................................... 320,000
Additional Information: a special copyright was not previously recorded on Beta’s records. The
copyright has a current fair market value of Br 2,000. Beta had also Goodwill from previous
business combinations that amounts Br 5,000 on the date of business combination.
Required: Record the business combination under purchasing accounting. Show the calculation
that backs up the entries
By Temtim D 30
Chapter Five: Consolidated Financial Statements
Chapter Five
Consolidation of Financial Statements under Purchase
Accounting
Chapter outlines:
 Consolidated Financial statements on the date of business combinations under Purchase
Accounting
 Consolidation on the date of business combination for wholly owned subsidiary
 Consolidation on the date of business combination for partially owned subsidiary
 Consolidated Financial statements subsequent to date of business combinations
 Consolidation subsequent to date of business combination under equity method of
investment for wholly owned subsidiary
 Consolidation subsequent to date of business combination under cost method of investment
for wholly owned subsidiary
Chapter objectives:
 Recognize investors’ varying levels of influence or control based on the level of stock
ownership.
 Anticipate how accounting adjusts to reflect the economics underlying varying levels of
investor influence
 Apply the fair value/cost and equity methods of accounting for stock investments
 Identify factors beyond stock ownership that affect an investor’s ability to exert influence or
control
 Apply the equity method to purchase price allocations
 Recognize the benefits and limitations of consolidated financial statements
 Understand the requirements for inclusion of a subsidiary in consolidated financial
statements
 Apply the consolidations concepts to parent company recording of the investment in a
subsidiary company at the date of acquisition
 Allocate the excess of the investment cost over the book value of the subsidiary at the date
of acquisition
 Prepare a consolidated balance sheet at the date of acquisition, including preparation of
eliminating entries
 Learn the concept of minority interest when the parent company acquires less than 100% of
the subsidiary’s outstanding common stock
 Prepare consolidated balance sheets subsequent to the date of acquisition, including
preparation of eliminating entries
 Apply the concepts underlying preparation of a consolidated income statement
 Amortize the excess of the investment cost over the book value in periods subsequent to the
acquisition
 Prepare consolidated working papers for the year of acquisition when the parent company
uses the full equity method to account for its investment in a subsidiary.
 Prepare consolidated working papers for the year subsequent to acquisition
31
 Allocate excess of purchase price over book value to include identifiable net assets.
 Understand the impact of intercompany profit for inventories on preparation of
consolidation working papers
Chapter Prerequisite: Financial Accounting II and Accounting for Business Combination
5.1) Basic Concepts of Consolidated Financial Statements

The Parent prepares Parent Financial Statements while the Subsidiary prepares Subsidiary Financial
Statements. However, Consolidated Financial Statements is prepared by the Parent by combining
separate financial statements of the parent and the subsidiary as the Parent Company is the
Reporting Entity
The Parent and Subsidiary Relationships

 If the Parent Company owns more than 50% voting stock of another company, that company is
an Affiliate
 The combinor’s acquisition of common stock of a combinee corporation resorts to
investor-investee (parent-subsidiary) relationship.
 If the investor acquires a controlling interest, a parent-subsidiary relationship is established.
The investee becomes a subsidiary of the acquiring parent company (investor) but remains a
separate legal entity.
 Strict adherence to the legal aspect would require issuance of separate financial statements for
the parent company and the subsidiary on the date of combination and for all subsequent
periods.
 But strict adherence to the legal form disregards the substance of most parent-subsidiary
relationship. A parent company and its subsidiary are a single economic entity.
 Hence, consolidated financial statement are issued to report the financial position and operating
results of a parent company and its subsidiaries as thought they comprised a single accounting
entity.
Nature of consolidated financial statements
They are similar to the combined financial statements for a Home Office and its branches. Assets,
liabilities, revenue, and expenses of the parent company and its subsidiaries are totaled; inter-
company transactions and balances are eliminated; and the final consolidated amounts are reported
in the balance sheet, income statements, statement of stockholders’ equity, and statement of cash
flows. However, the separate legal entity status of the parent and subsidiary corporations
necessitates eliminations that are generally more complex.
Should all subsidiaries be consolidated?
There is no reason for excluding from consolidation any subsidiary that is controlled. This is
because the purpose of consolidation is to present for a single entity the combined resources,
obligations and operating results of a family of related corporations. In FASB statement No.94
Consolidation of all majority-owned subsidiaries issued in 1987, FASB required the consolidation
of nearly all subsidiaries. Only subsidiaries not actual controlled were excluded from consolidation.
The Meaning of Controlling Interest
Traditionally, an investor’s direct or indirect ownership of more than 50% of an investee’s
outstanding common stock has been required to evidence the controlling interest underlying a
32
parent-subsidiary relationship. However, even though such a common stock ownership exists,
other circumstances may negate the parent company’s actual control of the subsidiary.
For Example:
1. Subsidiary in liquidation or reorganization in court and supervised by bankruptcy proceedings
is not controlled by its parent.
2. A foreign subsidiary in a country having severe production, monetary or income tax
restrictions may be subject to the authority of the foreign country rather than the parent company.
3. If minority shareholders of a subsidiary have the right to participate effectively in the financial
and operating activities of the subsidiary in the ordinary course of business, the subsidiary’s
financial statements should not be consolidated with those of the parent company.
Example of Controlling Interest

 Direct Controlling Interest = Father – Son Relationship
ABC Company 80% Inv’t KLM Company
 Indirect Controlling Interest = Father – Son – Grandson Relationship
Father and Son together control Grandson
ABC Company Over 80% XYZ Company
40% Inv’t
40% Investment
KLM Company
Father controls Son; Son controls Grandson
90% KLM Company 80% XYZ Company
ABC Company
Parent Company’s control of a subsidiary might be achieved indirectly as follows:

Example: If ABC Company owns 80% of outstanding common stock of XYZ Company and 40%
of KLM Company’s common stock and also XYZ Company owns 40% of KLM Company’s
common stock, ABC Company controls both XYZ and KLM Company. ABC Company owns 72%
of KLM Company (40% directly and 32% indirectly).
Criticism of Traditional concept of control

 Many accountants criticize the traditional definition of control described above which
emphasizes legal form.
 They argue that an investor owning less than 50% of an investee’s voting common stock in
substance may control the affiliate, especially if the remaining stock is scattered among a large
number of shareholders who do not attend shareholder’s meetings or give proxies
 Effective control of an investee is also possible if individuals comprising management of the
investor corporation own a substantial number of shares of the investee or successfully solicit
proxies from the investee’s other shareholders.
 The SEC in financial reporting Release No 25 required companies to emphasize economic
substance over legal form in adopting a consolidation policy.
33
 The FASB also issued a discussion memorandum which dealt at length with the question of
ownership (legal form) versus control (economic substance) as a basis for consolidation.
FASB’S proposed redefinition of Control

 Based on the discussion memorandum FASB issued a proposed statement that would have
defined control of an entity as power over its assets. That is power to use or direct the use of the
individual assets of another entity in essentially the same way as the controlling entity can use
its own assets.
 In 1999, the FASB issued a revised proposed statement that would define control as a parent
company’s non-shared decision-making ability that enables it to guide the ongoing activities
of its subsidiary and to use that power to increase the benefits that it derives and limit the losses
that it suffers from the activities of that subsidiary.
 The proposed statement further stated that in the absence of evidence that demonstrated
otherwise, the existence of control of a corporation shall be presumed if an entity (including its
subsidiaries):
1. Has a majority voting interest in the election of a corporation’s governing body or a right
to appoint a majority of the members of its governing body.
2. Has a large minority voting interest in the election of a corporation’s governing body and
no other party or organized group of parties has a significant voting interest.
3. Has a unilateral ability to (1) Obtain a majority voting interest in the election of a
corporation’s governing body or (2) Obtain a right to appoint a majority of the corporation’s
governing body through the present ownership of convertible securities or other rights that are
currently exercisable at the option of the holder and the expected benefit from converting
those securities or exercising that right exceeds its expected cost.
 By the latter proposal, the FASB planned to repeal the long standing requirement of majority
ownership of an investee’s outstanding common stock as a prerequisite for consolidation.
 Objectively determined legal form was to be replaced by subjectivity determined economic
substance as the basis for consolidated financial statements.
Steps for Consolidation

1. Update the balances of accounts affected by business combination transaction
2. Record the financial information for both Parent and Subsidiary on the worksheet
3. Remove the Investment in Subsidiary balance
4. Remove the Subsidiary’s equity account balances
5. Remove Intercompany transactions (e.g. payables and receivables)
6. Adjust the Subsidiary’s net assets to CFV
7. Allocate any excess of cost over CFV to identifiable intangible assets or goodwill
8. Combine all account balances
5.2) Consolidation of Wholly Owned Subsidiary on the Date of Business

Combination under Purchase Accounting
34
Example 5.1: There is no question of control of a wholly owned subsidiary. Thus, as an

illustration assume that on December 31, 2002, PALM Corporation issued 10,000 shares of its 10
par common stock (current fair value Br45 a share) to shareholder of STARR Company for all the
outstanding Br 5 par common stock of Starr. There was no contingent consideration. Out of pocket
costs of the business combination paid by Palm Corp on December 31, 2002 consisted of the
following;
Finder’s fees and legal fees of the combination............................................. Br 60,000
Costs of issuing common stock.................................................... 35,000
Total costs.................................................................................... Br 95,000
Assume also that the combination qualified for purchase accounting. Starr Company was to
continue its corporate existence as a wholly owned subsidiary of Palm Corporation. Both
companies had a December 31 fiscal year and use the same accounting policies. Income tax rate for
both companies was 40%. Financial statements of the two companies as of December 31, 2002
prior to combination are presented below follow:
Palm Starr
Corporation Company
35
Income statement
Net sales.......................................................... Br 990,000 Br 600,000
Interest revenue............................................... 10,000 - 0-
Total Revenues............................................... 1,000,000 600,000
Cost & expenses:
Cost of goods sold........................................... 635,000 410,000
Operating expense........................................... 158,333 73,333
Interest expense............................................... 50,000 30,000
Income tax Expense........................................ 62,667 34,667
Total Costs and expenses................................ (906,000) (548,000)
Net income...................................................... 94,000 52,000
Statement of RES
Retained Earnings beginning of year.............. 65,000 100,000
Add: Net income............................................. 94,000 52,000
Less: dividends............................................... (25,000) (20,000)
Retained Earnings ending of year................... 134,000 132,000
Balance sheet
Assets:
Cash................................................................ Br100, 000 Br 40,000
Inventories...................................................... 150,000 110,000
Other current assets......................................... 110,000 70,000
Receivable from Starr Co................................ 25,000
Plant asset (net)............................................... 450,000 300,000
Patent (net)...................................................... -0- 20,000
Total ............................................................... 835,000 540,000
Liability and SHE:
Payable to Palm Corp...................................... 25,000
Income taxes payable...................................... 26,000 10, 000
Other liabilities............................................... 325,000 115,000
Common stock Br 10 par................................ 300,000
Common stock for Br 5 par............................. 200,000
Additional Paid in capital ............................... 50,000 58,000
Retained Earnings........................................... 134,000 132,000
Total liabilities and SHE................................. 835,000 540,000
On Dec, 31, 2002 current fair values of Starr Company’s identifiable assets and liabilities were the
same as their carrying amount, except for the following 3 assets:
Fair Values:
Inventories.......................................... Br 135,000
............................................................
............................................................
Plant assets (net).............................. Br 365,000
Patent (net)....................................... Br 25,000
Because Starr was to continue as a separate corporation and generally accepted principles do not
sanction write-ups of assets of a going concern, Starr didn’t prepare journal entries for the
36
combination. Palm Corporation recorded the combination as a purchase on December 31, 2002
with the following journal entries.
1. Issuance of 10,000 common stocks to stockholders of Starr Company
Investment in Starr Company..................................................... 450,000
Common Stock..................................................... 100,000
Additional PIC – Common Stock........................ 350, 000
2. Out of pocket costs
Investment in Starr Company..................................................... 60,000
Additional PIC - CS.................................................................... 35,000
Cash....................................................................... 95,000
The above entries are the same as the entries for a statutory merger accounted for using Purchase
Method but they do not include any debit or credit, to record individual assets and liabilities of
Starr Company in the records of Palm Corporation. This is because the investee was not
liquidated as in a merger; it remains a separate legal entity.
Preparation of Consolidated Balance Sheet

Purchase accounting for the business combination of Palm Corporation and Starr Company
requires a fresh start for the consolidated entity. This reflects the theory that a business
combination that meets the requirement of purchase accounting is an acquisition of the combines’
net assets (assets less liabilities) by the combinor.
1. The operating results of the two companies prior to combination are those of two separate
economic- as well as legal – entities. Accordingly, a consolidated balance sheet is the only
consolidated financial statement issued by the investor (Palm Corporation) on the date of the
business combination. This can be done with the use of a working paper.
2. 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 reciprocal or intercompany
accounts.
3. Under purchase accounting theory, the parent company (combinor) assets and liabilities are
reflected at carrying amount and that of the subsidiary (the combinee’s) at current fair values
except inter company accounts, in the consolidated balance sheet.
4. Goodwill is recognized to the extent the cost of the parent company’s investment in 100% of
the subsidiary’s outstanding common stock exceeds the current fair value of the subsidiary’s
identifiable net assets.
37
Based on the foregoing data, the following consolidated Balance sheet is prepared
Palm Corporation and Subsidiary
Consolidated Balance Sheet
December 31, 2002
Assets:
Cash (5,000 + 40,000)................................................................................. 45,000
Inventories (150,000 + 135,000)................................................................. 285,000
Others (110,000 + 70,000).......................................................................... 180,000
Plant assets (net) (450,000 + 365,000)....................................................... 815,000
Patent (net) (0+25,000)............................................................................... 25,000
Good will.................................................................................................... 25,000
Total assets.................................................................................................. 1,375,000
Liabilities and Shareholders’ Equity:
Liabilities:
Income taxes payable (26,000 + 10,000).................................................... 36,000
Others (325,000 + 115,000)........................................................................ 440,000
Stock holder’s equity:
Common stock, Br 10 par........................................................................... 400,000
Additional Paid in capital............................................................................ 365,000
Retained Earnings....................................................................................... 134,000
Total liabilities & shareholder’s equity....................................................... 1,375,000
Goodwill = Investment in Starr Company - Values of Starr Company’s net assets at CFV
Goodwill = 510,000 – (Br 635,000 – 150,000) = Br510,000 – 485,000 = 25,000
Working Paper for Consolidated Balance Sheet
 Preparation of consolidated balance sheet on the date of purchase type business combination
usually requires the use of a working paper for consolidated balance sheet, even for a parent
company and a wholly owned subsidiary.
 A consolidated balance sheet is prepared using a working paper for Palm Corporation a shown
below.
 The working paper for consolidated balance sheet on the date of purchase-type business combination has
the following features:
1. The elimination is not entered in either the parent company’s or the subsidiary’s accounting records; it is
only a part of the working paper for preparation of the consolidated balance sheet.
2. The elimination is used to reflect differences between current fair values and carrying amounts of the
subsidiary’s identifiable net assets because the subsidiary did not write up its assets to current fair values
on the date of the business combination.
3. The Elimination column in the working paper for consolidated balance sheet reflects increases and
decreases, rather than debits and credits. Debits and credits are not appropriate in a working paper
dealing with financial statements.
4. Intercompany receivables and payables are placed on the same line of the working paper for
consolidated balance sheet and are combined to produce a consolidated amount of zero.
5. The respective corporations are identified in the working paper elimination. The reason for precise
identification is to deal with the eliminations of intercompany profits (or gains).
6. The consolidated paid-in capital amounts are those of the parent company only. Subsidiary’s Paid-in
capital amounts always are eliminated in the process of consolidation.
38
7. Consolidated retained earnings on the date of purchase-type business combination include only the
retained earnings of the parent company. This treatment is consistent with the theory that purchase
accounting reflects a fresh start in an acquisition of net assets (assets less liabilities), not a combining of
existing stockholder interest.
8. The amounts in the consolidated column of the working paper for consolidated balance sheet reflects the
financial position of a single economic entity comprising two legal entities, with all intercompany
balances of the two entities eliminated

December 31, 2002
Palm Starr Elimination Consolidated
Corporation Company
Assets: ↑ (↓)
Cash 5,000 40,000 45,000
Inventories...............................................................................
150,000 110,000 25,000 285,000
Other current assets.................................................................
110,000 70,000 180,000
Intercompany receivables 25,000 (25,000)
(payables)
Investment in Starr Co.............................................................
500,000 (500,000)
Plan asset (net).........................................................................
450,000 300,000 65,000 815,000
Patent (net)..............................................................................
-0- 20,000 5,000 25,000
Goodwill (net).........................................................................
-0- __-0- 25,000 25,000
Total asset ...............................................................................
1,250,000 515,000 (390,000) 1,375,000
Liabilities & SHE:
Income taxes Payables.............................................................
26,000 10,000 – 36,000
Other Liabilities ......................................................................
325,000 115,000 – 440,000
Common stock Br 10 par.........................................................
400,000 – – 400,000
Common stock Br 5 par...........................................................
– 200,000 (200,000) –
Additional Paid in capital........................................................
365,000 58,000 ( 58,000 ) 365,000
Retained Earnings....................................................................
134,000 132,000 (132,000) 134,000
Total Liab. & SHE...................................................................
1,250,000 515,000 (390,000) 1,375,000
Working Paper Elimination Journal Entries shown below:

Debit Credit
Common stocks Br 5 par-Starr...................... 200,000
Additional paid in capital-Starr...................... 58,000 Reciprocal Ledger Accounts (390,000)
Retained Earnings-Starr................................. 132,000
Inventories (135,000-110,000)....................... 25,000
Plant assets (net) (365,000-300,000)............. 65,000 Increase in Assets (95,000)
Patent (net) (25,000-20,000).......................... 5,000
Goodwill (net) (500,000-485,000)................. 25,000 Excess Cost
Investment in Starr Company.............. 510,000
Br 390,000 represents the carrying amounts of the net assets of Star Company. Br 110,000 (500,000
– 390,000) is attributable to the excess of current fair values over carrying amounts of certain
identifiable assets of Starr and Goodwill.
39
Example 5.2:
XYZ Corporation issued 20,000 shares of its Br 10 par Common Stock (CFV of Br 45 a share) to
the stockholders of ABC Company for all the outstanding Br 5 Common Stock of ABC Company.
The out-of-pocket cost of the business combination paid by XYZ Company on December 31, 2002,
consisted of the following:
1. Finder’s fees and legal fees............................................................ 100,000
2. Registration expenses .................................................................... 70,000
Total .................................................................................................... 170,000
The Business Combination qualified for purchase accounting. ABC Company is to continue its
corporate existence as a wholly owned subsidiary of XYZ Corporation. The Balance Sheet of XYZ
Corporation and ABC Company for the year ended December 31, 2002 prior to Consummation of
the business combination are below:
XYZ Corporation and ABC Company

Balance Sheet
December 31, 2002
XYZ ABC XYZ ABC
Company Company Company Company
Cash ..........................................................................
200,000 80,000 Payable to XYZ Co...................................................
50,000
Inventories.................................................................
300,000 220,000 Income tax payable....................................................
52,000 20,000
Other Current Assets.................................................
220,000 140,000 Other liabilities .........................................................
650,000 230,000
Receivable from ABC...............................................
50,000 Common Stock (10 Par)............................................
600,000 ─
Plant Assets (net) ......................................................
900,000 600,000 Common Stock (5 par)..............................................
─ 400,000
Patent (net)................................................................
–– 40,000 Additional PIC...........................................................
100,000 116,000
Retained Earning ......................................................
268,000 264,000
Total Assets...............................................................
1,670,00 1,080,000 Total Liab. & SHEs ..................................................
1,670,00 1,080,000
0 0
The December 31, 2002 CFVs of ABC Company identifiable assets and liabilities were the same as
carrying amount except for the three assets listed below:
1. Inventories...................................................................................... 270,000
2. Plant assets (net)............................................................................. 730,000
3. Patent (net)...................................................................................... 50,000
Pass necessary journal entries in the books of XYZ Corporation and prepare the Consolidated
Balance sheet of XYZ Corporation and its subsidiary ABC Company on December 31, 2002
1. Issuance of 20,000 shares of common stocks
Investment in ABC Company (20,000@45)............................900,000
Common Stock (20,000 shares @ Br 10)........................ 200,000
Additional PIC (20,000 shares @ 35)....................... 700,000
2. Out-of-Pocket Costs
Investment in ABC Company..................................................100,000
Additional PIC (Indirect Expenses)............................................. 70,000
Cash......................................................................... 170,000
40
Total acquisition cost (investment cost)........................................ 1,000,000
Net Assets of ABC Company
Cash........................................................................... 80,000
Inventories................................................................. 270,000
Other Current Assets................................................. 140,000
Plant (net).................................................................. 730,000
Patent (net)................................................................ 50,000
Total.......................................................................... 1,270,000
Less: Liabilities
Payable to XYZ Corporation .....................
50,000
Income Tax Payable....................................
20,000
Other Liabilities .......................................
230,000
Total liabilities........................................................... (300,000)
Net Assets.................................................................. 970,000
Goodwill.................................................................... 30,000
Consolidated Balance sheet

XYZ Corporation and ABC Company
Consolidated Balance sheet
December 31, 2002
Assets:
Cash (200,000 – 170,000 + 80,000)............................................. 110,000
Inventories (300,000 + 270,000).................................................. 570,000
Others Current Assets (220,000 + 140,000)................................ 360,000
Plant assets (net) (900,000 + 730,000)........................................1,630,000
Patent (net) (0+50,000)................................................................ 50,000
Good will..................................................................................... 30,000
Total assets...................................................................................2,750,000
Liabilities and SHE:
Liabilities:
Income taxes payable (52,000 + 20,000)..................................... 72,000
Others (650,000 + 230,000)......................................................... 880,000
Common stock, Br 10 Par............................................................ 800,000
Additional Paid in capital............................................................. 730,000
Retained Earnings........................................................................ 268,000
Total liabilities & shareholder’s equity........................................2,750,000
41
Working Paper Elimination in the form of Journal Entries:

Debit Credit
Common stocks Br 5 par................................ 400,000
Additional paid in capital .............................. 116,000 Reciprocal Ledger Accounts (780,000)
Retained Earnings.......................................... 264,000
Inventories (270,000 – 220,000).................... 50,000
Plant assets (net) (730,000 – 600,000)........... 130,000 Increase in Assets (190,000)
Patent (net) (50,000 – 40,000)....................... 10,000
Goodwill (net) (1,000,000 – 970,000)........... 30,000 Excess Cost
Investment in Starr Company..... 1,000,000
Exercise 5.1 On July 1, 2000 LEE Company exchanged 18,000 of its Br 30 market value shares
(Br 10 par) for all the outstanding shares of BLACK Company. LEE paid direct acquisition costs of
Br 20,000 and paid Br 5,000 in stock issuance costs. The two companies had the following Balance
sheet on July 1, 2002
LEE and BLACK Company
Balance Sheet (Prior to Business Combination)
July 1, 2002
LEE BLACK LEE BLACK
Corporation Company Corporation Company
Cash............................ 50,000 70,000 Current Liabilities................. 180,000 60,000
Inventories.................. 120,000 60,000 Common Stock (10 Par)........ 400,000
Land........................... 100,000 40,000 Common Stock (5 par).......... 200,000
Building (net)............. 300,000 120,000 Retained Earnings................. 420,000 140,000
Equipment (net........... 430,000 110,000
Total Assets................ 1,000,000 400,000 Total Liab. & SHEs............... 1,000,000 400,000
The following market values differ from book values for BLACK Company’s Assets:
Inventories...................................................................... 65,000
Land................................................................................ 100,000
Building (net).................................................................. 150,000
Equipment (net).............................................................. 75,000
Instructions:
1. Record the investment in BLACK Company and any other entry necessitated by the purchase
method
2. Prepare a consolidated Balance Sheet as of July 1, 2006, on the date of purchase
Checking Figures:
Total Acquisition Cost (18,000@30 + 20,000).................................. 560,000
Net Assets (460,000 – 60,000)........................................................... 400,000
Goodwill............................................................................................
160,000
Consolidated cash..............................................................................
95,000
42
Consolidated inventories ..................................................................
185,000
Consolidated Current liabilities.........................................................
240,000
Exercise 5.2:
Balance Sheet of PELLMAN Corporation and SHIRE Company on May 31, 2004, together with
current fair values of SHIRE identifiable Net Assets are shown below:
PELLMAN and SHIRE Company

May 31, 2004
PELLMAN SHIRE PELLMAN SHIRE
Cash ...........................................................................................
500,000 10,000 Current Liabilities......................................................................
500,000 80,000
Trade A/Receivable...................................................................
700,000 60,000 Long-term Debt..........................................................................
1,000,000 400,000
Inventories..................................................................................
1,450,000 120,000 Common Stock (10 Par).............................................................
1,500,000 100,000
Plant Assets (net).......................................................................
2,850,000 610,000 Additional PIC...........................................................................
1,200,000 40,000
Retained Earnings......................................................................
1,300,000 180,000
Total Assets................................................................................
5,500,000 800,000 Total Liab. & SHEs....................................................................
5,500,000 800000
The following current fair values differ from book values for SHIRE Company’s Assets and
Liabilities:
Inventories................................................................ 140,000
Plant Assets (net)...................................................... 690,000
Long-term Debt........................................................ 440,000
On May 31, 2004, PELLMAN acquiring all 10,000 shares of SHIRE’s outstanding common stock
by paying Br 300,000 cash to SHIRE’s shareholders and Br 50,000 cash for finders and legal fees
related to the business combinations. There was no contingent consideration and SHIRE became a
subsidiary of PELLMAN Corporation
Instruction:
1. Prepare journal entries for PELLMAN Corporation to record business combination with SHIRE
Company on May 31, 2004 as a purchase
2. Prepare a consolidated balance sheet on May 31, 2004 showing the workings
Checking Figures:
Total Acquisition Cost................................................... 350,000
Net Assets (900,000 – 520,000)..................................... 380,000
Goodwill (negative)....................................................... 30,000
Consolidated cash........................................................... 160,000
Consolidated total assets................................................6,020,000
Consolidated Long-term debt.........................................1,440,000
43
5.3) Consolidation of Partially Owned Subsidiary on the Data of Business

Combination Under Purchase Accounting
Consolidation of a parent company and its partially owned subsidiary differs from the consolidation
of a wholly owned subsidiary in one major respect - the recognition of minority interest (non-
controlling interest).
 Minority interest or no controlling interest is a term applied to the claims of stockholders other
than the parent company (controlling interest) to the net income or losses and net assets of the
subsidiary. The minority interest in the subsidiary’s net income or losses is displayed in the
consolidated income statement, and the minority interest in the subsidiary’s net assets is displayed
in the consolidated balance sheet.
Example 5.3: To illustrate the consolidation techniques for a purchase type business
combination involving a partially owned subsidiary, assume the following facts:
On December 31,2003 Post Corporation issued 57,000 shares of its Br 1 par common stock
(Current fair value Br 20 a share ) to stockholders of Sage Company in exchange for 38,000 of the
40,000 outstanding shares of Sage’s Br 10 par common stock Thus Post acquired 95% of the
interest in Sage (38/40). There was no contingent consideration. Out-of-pocket costs of the
combination paid in cash by Post on December 31, 2003 were as follows:
 Finder’s and legal fees of Combination....................................Br 52, 250
 Cost of issuing shares................................................................ 72,750
 Total.......................................................................................... 125,000
Financial statements of the two companies before the combination are as follows:
Income statement Post Sage
Corporation Company
Net sales ...................................................................
Br 5,500,000 Br 1,000,000
Costs & Expenses:
Cost of goods sold.....................................................
3,850,000 650,000
Operating expense.....................................................925,000 170,000
Interest expense.........................................................
75,000 40,000
Income tax Expense.................................................. 260,000 56,000
Total Costs and expenses..........................................
(5,110,000) (916,000)
Net income................................................................
390,000 84,000
Statement of RES
Retained Earnings, beginning of year....................... 810,000 290,000
Add: Net income.......................................................390,000 84,000
Sub-totals...................................................................
1,200,000 374,000
Less: Dividends.........................................................
(150,000) (40,000)
Retained Earnings End of the year............................ 1,050,000 334,000
44
Balance Sheet
BALANCE SHEET
Post Sage
Corporation Company
Assets:
Cash .........................................................
Br 200,000 Br 100,000
Inventories................................................ 800,000 500,000
Other current assets.................................. 550,000 215,000
Plant asset, (net) .......................................3,500,000 1,100,000
Goodwill (net)........................................... 100,000 __-0-
Total.........................................................5,150, 000 1,915,000
Liability and SHE:
Income taxes payable................................ 100,000 16,000
Other liabilities.........................................2,450,000 930,000
Common stock Br 1 par............................1,000,000
Common stock for Br 10 par.................... 400,000
Additional Paid in capital......................... 550,000 235,000
Retained Earnings....................................1,050,000 334,000
Total liabilities and SHE...........................5,150, 000 1,915,000
On Dec, 31, 2003 current fair values of Sage company’s identifiable assets and liabilities were the
same as their carrying amount, except for the following assets:
Market Values
Inventories.......................................... Br 526,000
............................................................
............................................................
Plant assets (net).............................. Br1,290,000
Leasehold......................................... Br30,000
Post Corporation records the combination with Sage Company as a purchase and thus, the
following journal entries are made:
1. Issuance of 57,000 shares to Sage company
Investment in Sage Company (57,000 shares @ Br 20)................ 1,140,000
Common Stock........................................................... 57, 000
....................................................................................
Paid in capital............................................................ 1,083,000
2. To record out-of-pocket cost
Investment in Sage Company........................................................ 52,25
0
Paid in capital.................................................................................
72,75
0
Cash l........................................................................ 125,000
Investment in Subsidiary Account
45
Investment in Sage Company
1,140,000
52,250
1,192,250

As minority interest in net assets of a partially owned subsidiary& measurement of goodwill
acquired in the combination complicates the process, it is advisable to use a working paper.
Developing the Elimination
 Common stock –Sage Company ........................................................400,000
 Additional paid in capital- Sage Company......................................... 235,000
 RES, Sage Company...........................................................................334,000
 Intercompany accounts (net assets = A – L).......................................969,000
The footing of Br 969,000 of the debit items of the partial elimination above represents the
carrying amounts of the net assets of Sage Company and is Br 223,250 less than the investment
in Sage Company of Br 1,192,250. Part of this Br 223,250 difference is the excess of the total cost
of Post Corporation’s investment in Sage Company plus the minority interest in Sage
Company’s net assets over the carrying amounts of Sage’s identifiable net assets. Difference
between current fair vales and carrying amount of combinee’s identifiable assets are presented
below:
 Inventories (526,000 – 500,000)......................................................... 26,000
 Plant assets (net) (1,290,000 – 1,100,000)..........................................190,000
 Leasehold............................................................................................ 30,000
 Total....................................................................................................246,000
Working Paper Elimination Journal Entry:
Common Stock – Sage Company............................................ 400,000
Additional paid in capital – Sage Company............................ 235,000
RES – Sage Company............................................................ 334,000
Inventories (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 Company.................................... 1,192,250
Minority Interest in Net Assets of Subsidiary............ 60,750
Computation of Goodwill and Minority Interest:
The revised footing of Br 1,215,000 (969,000 + 246,000) of the debit items of the above partial
elimination represents the current fair values of Sage Company’s identifiable net assets on
December 31, 2003. Two items must be recorded to complete the elimination for Post Corporation
and Subsidiary. Thus, Minority Interest and Goodwill should be computed. First, computations of
Minority interest in combinee’s identifiable net assets
Minority interest:
46
CFV of net assets................................................................. 1,215,000
Minority interest (100% – 95%) ......................................... 5%
Minority interest (5% @ 1,215,000) .................................. 60,750 – This is recorded by crediting
Minority Interest Account like liability
Alternative way of Calculating Net Assets at CFV:
Cash....................................................................................... 100,000
Inventories............................................................................. 526,000
Other Current Assets............................................................. 15,000
Plant (net).............................................................................. 1,290,000
Leasehold.............................................................................. 30,000
Total Assets at CFV.............................................................. 2,161,000
Less: Liabilities at CFV (16,000 + 930,000)......................... 946,000)
Net Assets at CFV................................................................. 1,215,000
Goodwill:
Second, the Goodwill acquired by Post Corporation in the business combination with Sage
Company is computed as follows and recorded:
Investment for 95% interest in Sage Company........................................... 1,192,250
Less: CFV of 95% of Investment in net assets (1,215,000 @ 0.95).......... 1,154,250
Goodwill acquired by Post Corporation .................................................... 38,000
The working paper for consolidated balance sheet is presented below:

Post Corporation and Subsidiary
December 31, 2003
Post Sage
Elimination Consolidated
Corporation Company
Assets: ↑ (↓)
Cash.................................................................................
75,000 100,000 175,000
Inventories.......................................................................
800,000 500,000 26,000 1,326,000
Other current assets 550,000 215,000 765,000
Investment in Sage Co.....................................................
1,192,250 (1,192,250)
Plan asset (net).................................................................
3,500,000 1,100,000 190,000 4,790,000
Leasehold Assets (net).....................................................
-0- -0- 30,000 30,000
Goodwill (net)..................................................................
100,000 38,000 138,000
Total asset .......................................................................
6,217,250 1,915,000 (908,250 7,224,000
Liabilities & SHE:
Income taxes Payables.....................................................
100,000 16,000 – 116,000
Other Liabilities...............................................................
2,450,000 930,000 – 3,380,000
Minority Interest in NAs Sub 60,750 60,750
Common stock Br 1 par...................................................
1,057,000 – 1,057,000
Common stock Br 10 par.................................................
– 400,000 (400,000) –
Additional Paid in capital.................................................
1,560,250 235,000 ( 235,000) 1,560,250
Retained Earnings............................................................
1,050,000 334,000 (334,000) 1,050,000
47
Total Liability & SHE .....................................................
6,217,250 1,915,000 (908,250) 7,224,000
Consolidated Balance sheet of the parent company and partially owned subsidiary
December 31, 2003
Assets:
Cash......................................................................................................... Br 175, 000
Inventories............................................................................................... 1,326,000
Other Current assets................................................................................. 765,000
Total current assets.................................................................................. 2, 266,000
Plant assets, net........................................................................................ 4,790,000
Leasehold.................................................................................................. 30,000
Goodwill.................................................................................................... 138,000
Total assets.............................................................................................. 7,224,000
Liabilities:
Income tax payable.................................................................................. 116,000
Other........................................................................................................ 3,380,000
Minority Interest in net assets of subs...................................................... 60,750
Total liabilities......................................................................................... 3,556,750
Stockholders’ Equity:
Common stock Br 1par............................................................................ 1,057,000
Additional PIC......................................................................................... 1,560,250
Retained Earnings.................................................................................... 1, 050,000
Total Shareholders’ Equity...................................................................... 3,667,250
Total Liability and SHE........................................................................... 7,224,000
Example 5.4:
On 31 October 2003, SELALE Company acquires 83% of the common stock of BIRITY Company
in exchange for 50,000 Br 2 Stated Value (Br 10 Current Fair Value a share) shares of common
stock. There was no contingent consideration. Out-of-pocket costs of the business combination paid
by SELALE Company on 31 October 2003 were as follows:
Legal and Finder’s Fees......................................................... 34,750
Stock Registration Costs........................................................ 55,250
Total....................................................................................... 90,000
There was inter-company transaction between the constituent companies prior to the
business combination. BIRITY was to be a subsidiary of SELALE Company. The separate balance
sheet of the constituent companies prior to the Business combination follows:
48
SELALE AND BIRITY Company

Separate Balance Sheet (Prior to Business Combination)
October 31, 2003
SELALE BIRITY SELALE BIRITY
Cash 250,000 150,000 Income tax payable 40,000 60,000
Inventories 860,000 600,000 Current Liabilities 390,000 854,000
Other current asset 500,000 260,000 Long-term Debt 950,000 1,240,000
Plant Assets, net 3,400,000 1,500,000 CS, no-par (Br 2 Stated V) 1,5000,000 ––
Patent, net –– 80,000 Common Stock (10 Par) 100,000
Additional PIC 1,500,000 ––
Retained Earnings 630,000 336,000
Total Assets 5,010,000 2,540,000 Total Liab. & SHEs 5,010,000 2,540,000
The Current Fair Values of BIRITY’s identifiable net assets were the same as the carrying amounts
on October 31, 2003; except for the following:
Inventories................................................................................
Br620,000
Patent, net.................................................................................
95,000
Plant Assets, net........................................................................
1,550,000
Long-term debt.........................................................................
1,225,000
Instructions:
1. Prepare journal entries in the books of SELALE Company on October 31, 2003 to record
the business combination as a purchase
2. Prepare a working paper elimination (in journal entry) on October 31, 2003 and
Consolidated Balance Sheet of SELALE Company and Subsidiary
Solution:
Calculation of total acquisition cost (investment):
Purchase consideration (50,000 Share @ Br 10)........................................ 500,000
Direct out-of-pocket costs.......................................................................... 34,750
Total Investment......................................................................................... 534,750
Calculation of Net Assets:
Cash....................................................................................... 150,000
Inventories............................................................................. 620,000
Other Current Assets.............................................................. 260,000
Plant Assets, net..................................................................... 1,550,000
Patent, net.............................................................................. 95,000
49
Total Assets........................................................................... 2,675,000

Less: Liabilities
Income tax payable........................................................... 60,000
Other current liabilities..................................................... 854,000
Long-term debt................................................................. 1,225,000
Total liabilities.................................................................... (2,139,000)
Total Net Assets.................................................................. 536,000
 SELALE Company’s share of net Assets = 83% @ 536,000 = 444,880
 Goodwill = Total Investment – share of Net Assets
 Goodwill = 534,750 – 444,880 = Br 89,870
Calculation of Minority Interest in Net Assets:

 Minority Interest = 17% of Net Assets of BIRITY Co
 Minority Interest = 536,000 @ 17% = Br 91,120 Reported as liability
1. Journal Entries:
Issuance of 50,000 shares to BIRITY Company
Investment in BIRITY Company (50,000 shares @ Br 10)..................500,00
0
Common Stock................................................................. 100,000
Additional PIC.................................................................. 400,000
To record out-of-pocket cost
Investment in BIRITY Company..........................................................34,75
0
Additional PIC - CS..............................................................................55,25
0
Cash.................................................................................. 90,000
Working Paper Elimination Journal Entries:

Common Stock – BIRITY Company ................................................... 100,000
Retained Earnings- BIRITY Company................................................. 336,000
Inventories (620,000 – 600,000)........................................................... 20,000
Plant assets (net) (1,550,000-1,500,000)............................................... 50,000
Patent, net..............................................................................................
15,000
Long-term Debt..................................................................................... 15,000
Goodwill................................................................................................
89,870
Investment in BIRITY Company..................................... 534,750
Minority Interest in Net Assets of Subsidiary.................. 91,120
50
2. Preparation of Consolidated Balance Sheet

SELALE Company And BIRITY Company
October 31, 2003
Assets:
Cash (250,000 + 150,000 – 90,000)..................................................... Br310,000
Inventories (860,000 + 600,000 + 20,000)........................................... 1,480,000
Other Current assets (500,000 + 260,000)............................................ 760,000
Plant assets (net) (3,400,000 + 1,500,000 + 50,000)............................ 4,950,000
Patents (net) (0 + 80,000 + 15,000)...................................................... 95,000
Goodwill.............................................................................................. 89,870
Total Assets.......................................................................................... 7,684,870
Liabilities:
Income tax payable (40,000 + 60,000)................................................. 100,000
Other Current Liabilities (390,000 + 854,000)..................................... 1,244,000
Long-term Debt (950,000 + 1,240,000 – 15,000)................................. 2,175,000
Minority Interest in net assets of the Subsidiary................................... 91,120
Common stock Br 2 Stated Value no-par stock................................... 1,600,000
Additional PIC.................................................................................... 1,844,750
Retained Earnings............................................................................... 630,000
Total Liability and SHE..................................................................... 7,684,870
Problem 5.2:
Great Company has been looking to expand its operations and has decided to acquire the assets of
TURE Company and MURAD Company. Great Company will issue 25,000 shares of its Br 10 par
common stock to acquire the net assets of TURE Company and 8,000 shares to acquire 98% of the
net asset of MURAD Company. The Balance Sheet of the three companies on December 31, 2005,
the scheduled date of business combination, is given as follows:
GREAT TURE MURAD
Company Company Company
Assets In Birr In Birr In Birr
Cash.................................................................................
300,000 80,000 30,000
Accounts Receivables......................................................
525,000 120,000 50,000
Inventory..........................................................................
340,000 150,000 135,000
Land.................................................................................
420,000 150,000 150,000
Building...........................................................................
800,000 500,000 150,000
51
Accumulated Depreciation...............................................
(130,000) (150,000) (110,000)
Total Assets.....................................................................
2,255,000 850,000 405,000
Liabilities and SH Equity:
Current liabilities.............................................................
75,000 160,000 55,000
Bonds payable..................................................................
180,000 100,000 100,000
Common Stock (Br 10 par).............................................
1,000,000 270,000 100,000
Additional PIC.................................................................
400,000 30,000 -0-
Retained earnings.............................................................
600,000 290,000 150,000
Total liabilities and equity...............................................
2,255,000 850,000 405,000
The following current fair values (CFV) are agreed upon by the BODs of the combinee companies
and Great Company while the others have the same book values and current fair values
TURE MURAD
Company Company
Inventory 160,000 150,000
Land 200,000 240,000
Building, net 400,000 60,000
Bonds payable 80,000 95,000
Great Company’s stock is currently traded at Br 40 per share. Great will incur Br 25,000 direct
acquisition cost in TURE Company and Br 14,000 of direct acquisition cost in MURAD Company.
Great also incurred Br 13,000 other indirect cost of acquisition and Br 15,000 stock registration and
issue cost in the acquisition of the two companies.
Required:
1. Prepare elimination journal entries assuming that purchased method is appropriate. Show the
necessary calculation that supports the recording and pass the journal entry of each combinee
separately.
2. Prepare Consolidated balance sheet on the date of business combination consolidating all the
combinees
5.4) Consolidations Concepts and Minority Interest

The appropriate classification and presentation of minority interest in consolidated financial
statements is a perplexing problem, due to the reason that it is:
 recognized only in the consolidation process
 does not result from the business transactions of either the parent or subsidiary
Different concepts of consolidation have been developed to account for minority interest: (1) Parent
Company Concept; (2) Economic Unit Concept (either with purchased or full goodwill); and (3)
Proportionate Share Concept
1. Parent Company Concept

The parent company concept emphasizes the interests of the parent’s shareholders. This concept
treats the minority interest in net assets of a subsidiary as a liability. This liability is increased each
accounting period subsequent to the date of a business combination by an expense representing the
minority’s share of the subsidiary’s net income. Consolidated financial statements reflect the
stockholders’ interest in the parent itself plus their undivided interests in the net asset of the
subsidiaries. The consolidated balance sheet is essentially a modification of the parent’s balance
52
sheet with assets and liabilities of all subsidiaries substituted for the parent’s investment in
subsidiaries.
To summarize, the Parent Company Concept of Consolidation:

 Treats the minority interest in subsidiary’s net assets as a liability
 The liability increases by minority’s share of net income
 The liability decreases by minority’s share of net losses
 Dividends declared by the subsidiary to minority stockholders decreases the liability
2. Economic Unit Concept

In the economic unit concept, the minority interest in the subsidiary’s net assets is displayed in
the stockholders’ equity section of the consolidated balance sheet. The consolidated income
statements display the minority interest in the subsidiary’s net income as a subdivision of total
consolidated net income.
Economic Unit Concept:

 emphasizes control of the whole by a single management
 sometimes called the entity theory
 Consolidated financial statements are intended to provide information about a group of legal
entities – a parent and its subsidiaries – operating as a single unit.
 Both controlling and consolidated net income is net of the minority’s share of the
subsidiary’s net income.
In substance minority shareholders are special classes of creditors to the consolidated company
because they exercise no control of ownership over operations of either parent (subsidiary). If
consolidated financial statements are to present fairly the operating results and financial position of
a single economic entity the niceties of minority shareholder’s ownership of part of the subsidiary
should be disregarded. The display of minority interest in the liability section is consistent with the
parent company concept of consolidated statements. There is no ledger account for minority interest
in net assets of subsidiary, in either the parent company’s or subsidiary’s records.
Example: Economic Unit Concept with Purchased Goodwill

The previous computation of minority interest and goodwill was based on two the following
premises: (i) identifiable net assets of a partially owned subsidiary should be valued on a single
basis at CFV; and (ii) only subsidiary goodwill acquired by the parent Company should be
recognized, in accordance with the cost method of valuing assets.
Subsidiary’s Net Assets............................................................... 969,000
Excess of CFV over Book Value................................................. 246,000
CFV of Net Assets...................................................................... 1,215,000
Parent Company’s Share in Subsidiary....................................... 95%
Minority Interest in Subsidiary.................................................... 5%
Acquisition Cost.......................................................................... 1,192,250
Solution:
Minority Interest = 5% @ Net Assets
53
Minority Interest = 5% @ 1,215,000

Minority Interest = Br 60,750
Goodwill= Acquisition Cost – Share of Net Assets
Goodwill= 1,192,250 – (95% @ 1,215,000)
Goodwill= 1,192,250 – 1,154,250
Goodwill=Br 38,000
Alternative Method of Valuing Minority Interest & Good Will
Two other alternatives procedures for computing minority interest and goodwill have been
suggested:
3. Economic Unit Concept of Consolidation with Full Goodwill
CFV is assigned to total net assets of Subsidiary including goodwill through independent implied or
inferred value. This is to value minority interest in net assets of subsidiary and goodwill is to obtain
a CFV for 100% of a partially owned purchased subsidiary’s total net assets, either through
independent measurement of minority interest or by inference from the cost of the parent
company’s investment in subsidiary. Independent measurement of the minority might be
accomplished by reference to quoted market price of publicly traded common stock owned by
minority stockholders of subsidiary. By inference from the cost of post corporation’s investment is
as follows:
Total cost of investment of Post corporation in Sage Company............................. 1,192,250
Post Corporation’s percentage of ownership in Sage Company............................. 95%
Implied CFV of 100% of Sage’s total net assets (1,192,250/0.95)......................... 1,255,000
Minority Interest: (5% @1,255,000)...................................................................... 62,750
Goodwill (1,255,000 – 1,215,000), which is CFV Sage Company’s NA............... 40,000
.................................................................................................................................
4. Proportionate Concept of Consolidation

The first alternative would assign Fair Values to a partially owned purchased subsidiary’s
identifiable assets only to the extent of the Parent Company’s Ownership Interest therein. For
example; 95% in the example above; 95%@246,000=233,700 which is the total difference between
CFV and Carrying Amounts of Sage Company’s identifiable net assets. The minority interest in net
assets of the subsidiary would be based on the carrying amounts of the subsidiary’s identifiable net
assets rather than CFV.
 Minority Interest = 5% @ 969,000 carrying value of net assets = 48,450
 Goodwill =1,192,250 – [(95% @ 969,000) + (95% @ 246,000)]=38,000
Acquisition Cost....................................................................................... 1,192,250
Book value of subsidiary..........................................................................969,000
Minority interest (5%@969,000).............................................................(48,450 920,550
)
Cost in-excess of the book value.............................................................. 271,700
Allocation based on CFV in-excess of book value (246,000@95%)...... 233,700
Goodwill.................................................................................................. 38,000
The Goodwill would be the same as computed previously. The 233,700 would be reflected in the
aggregate debits to inventories, plant assets, and leasehold in the working paper elimination.
54
Supporters argue that CFV of combinee’s identifiable net assets of the subsidiary should be
reflected in consolidated financial statements only to the extent that they have been acquired by the
combinor.
5.5) Other Issues of Consolidations and Push Down Accounting

Bargain Purchases: There may be excess of CFV of subsidiary’s net assets over the cost of parent
Company’s investment in the subsidiary’s Common Stock (negative goodwill). The same principle
as the previous chapter (pro rata reduction) is applied.
Disclosure of Consolidation Policy: In notes to financial statements, a description of consolidation

policy shall be reflected in consolidated financial statements.
Advantages and Shortcomings of Consolidated Financial Statement

 They are useful principally to stockholders and prospective investors of the parent company.
These users are given comprehensive financial information for the economic unit represented by
the parent company and its subsidiaries, without regard for legal separateness of the individual
companies.
 Creditors of each consolidated company and minority shareholders of subsidiaries have only
limited use from consolidated financial statements because they do not show individual
financial position and operating results. In addition creditors of constituent companies can’t
ascertain the asset coverage of their claims
 The major criticism of consolidated statements comes from financial analysts. They argue that
consolidated statements of diversified companies (conglomerates) are impossible to classify in a
single industry. Hence, they stat that such statements can’t be used for comparative purposes or
for financial analysis.
Push-Down Accounting for a Purchased Subsidiary

Significant problem (question) is the appropriate basis of accounting for assets and liabilities of
purchased subsidiaries that issue separate statements to outsiders. Some accountants argue that they
should report in their separate statement based on carrying values before the combination because
GAAPs do not allow writing up of assets by a going concern. Others recommend that the values
assigned to purchase subsidiary’s net assets in the consolidated statements shall be pushed down to
the subsidiary for incorporation in its separate statements. They argue the combination is an event
warranting recognition of current fair values. The SEC sanctioned (requires use of) push down
accounting for purchased subsidiaries.
In some situations when common stock is acquired, the subsidiary will adjust its books to reflect the
current values at date of acquisition. In other words, adjusting entries are made on the subsidiaries
books rather than just working paper entries. Therefore, subsequent working papers will not have
to deal with the excess value elements as they will be taken care of by the subsidiary’s accounting
department (depreciation, amortization, etc.). SEC Staff Bulletin No. 54 requires push-down
accounting in the separate financial statements of a subsidiary acquired in a purchase transaction
Parent’s Ownership % Guidelines

 90% or more Substantially owned – push-down accounting is required
55
 80 to 89% Push-down accounting is encouraged but not required

 Below 80% Push-down accounting may not be appropriate (e.g., subsidiary
has substantial preferred stock or public debt outstanding
5.6) Consolidated Financial Statements: Subsequent to Date of Business

Combination under Purchase Accounting
Subsequent to date of a business combination the parent company accounts for operating results
of subsidiary. That is it accounts for:
 Net income or net loss, and
 Dividends declared paid by subsidiary
In addition, a number of intercompany transactions and event that frequently occur in a Parent-
Subsidiary relationship shall be recorded. All the three basic financial statements must be
consolidated for accounting periods subsequent to the date of purchase type business combination.
The items that must be included in the elimination are:
1. The Subsidiary’s beginning-of-year stockholder’s Equity and its dividends,
2. The parent’s investment, and the parent’s investment income accounts;
3. Unamortized Current Fair Value excesses of the subsidiary’s net assets; and
4. Certain operating expenses of the subsidiary
A parent company may choose the Equity Method or the Cost Method to account for the
operating results of consolidated purchased subsidiaries.
1. Equity Method
 The Parent company records its share of subsidiary’s net income or net loss, adjusted for
depreciation and amortization of differences between current fair values and carrying amounts of a
purchased subsidiary’s net asset on the date of business combination, as well as its share of
dividends declared by subsidiary.
 Proponents of the equity method of accounting maintain that the method is consistent with
accrual accounting, because it recognizes increases or decreases in the carrying amounts of parent
company’s investment in the subsidiary when they are realized by the subsidiary as net income or
net loss, not when they are paid by the subsidiary as dividends.
 Proponents claim that it stresses the economic substance of the parent-subsidiary relationship
because the two companies constitute a single economic entity for financial accounting.
 They also claim that dividends declared by subsidiary are not revenues to the parent (as claimed
by cost methods): instead, they are liquidations (reduction) of investment in subsidiary.
2. Cost Method
 Parent Company accounts for the operations of a subsidiary only to the extent that dividends
are decrared by subsidisry.
 Dividends declared by the subsidiry subsequent to the business combination are revenue to
parent company
 Dividends declared by the subsidiary in excess of postcombination net income are reduction in
carrying amount of the investrment in subsidiary. (Liquidating Dividend).
56
 Net income or net loss of subsidiary is not recorded by parent company when the cost method
of accounting is used.
 Supporters argue that the cost method appropriatly recoginizes legal form of the parent
company – subsidiary relationship.
 Parent company and subsidiry are sparate legal entities; accounting for a subsidiary’s
operations should recognize the separatness, according to proponents of cost method.
Choosing Between the Two Metheds

 Consolidated financial statement amounts are the same regadless of the mehods used. But
the working paper eliminations are different
 The equity method is appropriate for pooled subsidaries as well purchased subsidiaries.
5.7) Accounting for Operating Results of Wholly Owned Purchased

Subsidiaries: Subsequent to Date of Business Combination
Illustration of eqiuity method for wholly owned purchased subsidiary for first year after business
Combination.
Example 5.5:(A Continuation of Example 5.1)
1. Assume that Starr Company had net income of Br 60,000 for the year ended December 31,
2003, and dividends of Br 24,000 are declared on December 20, 2003.
December 20, 2003:
Dividends Declared................................................................
24,000
Intercompany Dividends Payable......................... 24,000
Intercompany dividends payable will be eliminated when preparing consolidated statement.
Palm corporation will record the follwing entry:

December 20, 2003:
Intercompany Dividend Receivable.......................................
24,000
Inv’t in Starr Company Common 24,000
Stock.....................................................................
December 31, 2003:
Investment in Starr Company Common Stock...................... 60,000
Intercompany Investment Income......................... 60,000
2. Adjustment of purchased subsidiary’s net income:
Palm must prepare a third equity method journal entry on December 31,2003 to adjust Starr’s net
income for depreciation and amortization attributable to the difference between CFV and carrying
values of Starr’s Company net assets on December 31,2002, the date of combination. Because such
differences were not considered by the subsidiary, the subsidiary’s 2003 net income is overstated
from the point of view of the consolidated entity. Assume that on December 31, 2002 (date of
combination), differences between CFV& carrying values of Starr company’s net assets were as
follow:
December December
31, 2002 31, 2003
Inventories (FIFO)...................................................... Br 25,000 ─
57
Plant Assets, net:

Land..................................................................... 15,000 15,000
Building (10 Years).............................................. 30,000 27,000
Machinery (10 Years).......................................... 20,000 18,000
Patent (5 Years).......................................................... 5,000 4,000
Goodwill (No Impairment)......................................... 25,000 25,000
Total............................................................................ 120,000 89,000
 Plant Assets, net (December 31, 2002) = 15,000 + 30,000 + 20,000 = Br65,000
 Plant Assets, net (December 31, 2003) = 15,000 + 27,000 = Br60,000
Palm Corporation prepares the following additional equity method journal entry to reflect the
effects of depreciation and amortization of the differences between the CFV and carrying amounts
of Starr Company’s net assets on Starr's net income for the year ended Dec.31.2003.
The amount of amortization, which the difference between CFVs and carrying amounts of Starr
Company’s net assets on December 31, 2003 is determined as follows:
Inventories sold and included in the COGS............. Br25,000
Building - depreciation (30,000 /10)........................ 3,000
Machinery – depreciation (20,000/ 15).................... 2,000
Patent-amortization (5,000/ 5).................................. 1,000
Total......................................................................... 31,000
December 31, 2003:

Intercompany Investment Income..........................................
31,000
Investment in Starr Company....................................... 31,000
Note: Intercompany Investment Income = 60,000 - 31,000 = 29,000
The working paper elimination subsequent to combination must include accounts that appear in the
constituent companies’ income statement, Retained Earnings statement and balance sheet because
all the three statement are to be consolidated. A consolidated statement of cash flows is prepared
from the three basic consolidated financial statements and their information.
Developing the Elimination Journal Entries:

The working paper eliminations are as follows:
A. Removing Subsidiary’ Equity Account and Increase in Assets
Common stock–Starr Company...................................200,00
0
Add paid in capital–Starr Company............................. 58,00
0
Retained Earnings–Starr Company..............................132,00
0
Inter-company Investment Income.............................. 29,00
0
Plant asset, net–Starr Company................................... 60,00
0
Patent (net)–Starr Company......................................... 4,00
0
58
Goodwill (net)–Starr Company.................................... 25,00
0
COGS–Starr Company................................................. 25,00
0
Operating Expenses–Starr Company........................... 6,00
0
Investment in Starr Company....................... 515,000
Dividends–Starr Company........................... 24,000
The above working paper elimination journal entry is to eliminate intercompany investment and
equity accounts of subsidiary at beginning of year, and subsidiary dividend.
B. For year 2003 depreciation and amortization on differences between fair values and carrying
amounts of Starr's net assets based on the following assumptions:
COGS Expenses
Inventories sold.......................................................... Br 25,000
Building depreciation ................................................ 3,000
Machinery depreciation............................................. 2,000
Patent amortization.................................................... ______ 1,000
Total ....................................................................... 25,000 6,000
C. Allocate unamortized differences between the combination date CFVs and carrying amounts of
Starr’s net asset.
Working Paper Eliminations for Equity Method

 Three components of the subsidiary’s stockholders’ equity are reciprocal to the parent
company’s Investment Ledger Account.
 The subsidiary’s beginning-of-year retained earnings amount is eliminated.
 Subsidiary’s dividends are an offset to the subsidiary’s retained earnings.
 The balance of the parent company’s Investment Ledger Account is net of the dividends
received from the subsidiary.
 The elimination of the subsidiary’s beginning-of-year retained earnings makes beginning-of-
year consolidated retained earnings identical to the end-of-previous-year consolidated retained
earnings.
 The debits to the subsidiary’s plant assets, patent, and goodwill bring into the consolidated
balance sheet the un-amortized differences between current fair values and carrying amounts
of the subsidiary’s assets on the date of the business combination.
59
 The amount of the parent company’s inter-company investment income is an element of the
balance of the parent’s Investment Ledger Account.

Working Paper For Consolidated Financial Statements
For Year Ended Dec.31,2003
Palm Starr Eliminatio Conso-
Types of financial statements: Corporation Company n lidated
Income statement
Revenue:
Net Sales................................................... 1,100,000 680,000 1,780,000
Intercompany Investment Income............ 29,000 a (29,000)
Total Revenue 1,129,000 680,000 (29,000) 1,780,000
Cost of goods sold.................................... 700,000 450,000 a 25,000 1,175,000
Operating expenses................................... 217,667 130,000 a 6,000 353,667
Interest expense........................................ 49,000 49,000
Income tax expenses................................. 53,333 40,000 93,333
Total Costs and Expenses....................... 1,020,000 620,000 *31,000 1,671,000
Net income 109,000 60,000 (60,000) 109,000
Statement of Retained Earnings
Retained Earnings Jan.1, 2003................. 134,000 132,000 a (132,000) 134,000
Net income for the year............................ 109,000 60,000 (60,000) 109,000
Subtotal..................................................... 243,000 192,000 (192,000) 243,000
Dividend Declared.................................... 30,000 24,000 **a (24,000) 30,000
Retained Earnings end of year.................. 213,000 168,000 (168,000) 213,000
Balance Sheet
Cash.......................................................... 5,900 72,100 78,000
60
Intercompany Receivables (Payables)...... 24,000 (24,000) –

Inventories................................................ 136,000 115,000 251,000
Other current assets.................................. 88,000 131,000 219,000
Investment in Starr Company................... 515,000 – a (515,000) –
Plant asset, net.......................................... 440,000 340,000 a 60,000 840,000
Patent, net................................................. – 16,000 a 4,000 20,000
Goodwill, net............................................ – – a 25,000 25,000
Total Asset............................................... 1,208,900 650,100 (426,000) 1,433,000
Liability and SHE
Income tax payable................................... 40,000 20,000 60,000
Other liabilities......................................... 190,900 204,100 395,000
Common stock Br 10 par.......................... 400,000 – 400,000
Common stock Br 5 par............................ – 200,000 a (200,000) –
Additional paid-in capital......................... 365,000 58,000 a (58,000) 365,000
Retained Earnings..................................... 213,000 168,000 a (168,000) 213,000
Total Liability & SHE ........................... 1,208,900 650,100 (426,000) 1,433,000
*Br 31,000 is an increase in total costs and expenses and a decrease in net income; **Br
24,000 is a decrease in dividends and an increase in retained earnings.
Note: Use the working paper and prepare consolidated financial statements (Consolidated income
statement, statement of retained Earning and balance sheet)
 Income Statement
PALM CORPORATION AND SUBSIDIARY
Consolidated Income Statement
For Year Ended December 31, 2003
Net sales........................................................................................... Br1,780,000
Cost and expenses:
Cost of goods sold................................................................. 1,175,000
Operating expenses................................................................ 353,667
Interest Expense..................................................................... 49,000
Income Taxes Expense.......................................................... 93,333
Total costs and expenses........................................................ (1,671,000)
Net Income....................................................................................... Br109,000
Basic earnings per share (40,000 shares outstanding)....................... Br2.74
 Statement of Retained Earnings
Consolidated Statement of Retained Earnings
For year ended December 31, 2003
Retained earnings, beginning of year.......................................................... Br134,000
Add: Net Income......................................................................................... 109,000
Subtotal....................................................................................................... Br243,000
Less: Dividends (Br 0.75 a share)............................................................... 30,000
Retained earnings, end of year.................................................................... Br213,000
 Balance Sheet
61
December 31, 2003
Assets:
Cash.......................................................................................................................... 78,000
Inventories................................................................................................................ 251,000
Other Assets............................................................................................................. 219,000
Plant Assets, net....................................................................................................... 841,000
Patent, net................................................................................................................. 20,000
Goodwill................................................................................................................... 25,000
Total Assets............................................................................................................. 1,433,000
Liabilities and Stockholders’ Equity:
Liabilities:
Income taxes payable............................................................................................... 60,000
Other liabilities......................................................................................................... 395,000
Common stock, Br10 par.......................................................................................... 400,000
Additional paid-in capital......................................................................................... 365,000
Retained earnings..................................................................................................... 213,500
Total liabilities and stockholders’ equity.................................................................. 1,433,000
The following point are noticeable in the consolidated financial statements and the working paper:
 In effect, the elimination of the inter-company investment income comprises a reclassification
of the inter-company investment income to the adjusted components of the subsidiary’s net
income in the consolidated income statement.
 The increases in the subsidiary’s cost of goods sold and operating expenses, in effect, reclassify
the comparable decrease in the parent company’s Investment ledger account under the equity
method of accounting.
 The inter-company receivable and payable, placed in adjacent columns on the same line, are
offset without a formal elimination.
 The elimination cancels all inter-company transactions and balances not dealt with by the offset
described above.
 The elimination cancels the subsidiary’s retained earnings balance at the beginning-of-year, so
that each of the three basic financial statements may be consolidated in turn.
 The first-in, first-out method is used by subsidiary to account for inventories; thus the difference
attributable to subsidiary’s beginning inventories is allocated to cost of goods sold for the year
ended.
 Income tax effects of the elimination’s increase in subsidiary’s expenses are not included in the
elimination.
 One of the effects of the elimination is to reduce the differences between the current fair values
and the carrying amounts of the subsidiary’s net assets, except land and goodwill, on the
business combination date.
 The 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
62
 Despite the equalities, consolidated financial statements are superior to parent company
financial statements for the presentation of financial position and operating results of parent
and subsidiary companies.
CLOSING ENTRIES:
After consolidated financial statements have been completed, both the parent company and its
subsidiaries prepare closing entries and post to ledger accounts, to complete the accounting cycle
for the year. The subsidiary’s closing entries are prepared in the usual fashion. However, the parent
company’s use of equity method of accounting necessitates specialized closing entries. The equity
method of accounting disregards legal form in favor of economic substance. However, state
corporation laws generally require separate accounting for retained earnings available for dividends
to stockholders.
For the Parent Company (Palm Corporation), the December 31, 2003 closing entries under the
Equity method of accounting for purchased subsidiary are as follows:
To close revenue accounts:
Net Sales................................................................................1,100,00
0
Investment Income from subsidairy........................... 29,00
0
Income Summary....................................................... 1,129,000
To close expense accounts:

Income Summary...................................................................
1,020,000
Cost of Goods Sold..................................................... 700,000
Operating Expenses..................................................... 217,667
Interest Expense.......................................................... 49,000
Income Tax Expense................................................... 53,333
To close income summary accounts; to transfer net income legally available for dividends to
retained earnings; and to segregate 100% share of adjusted net income of subsidiary not
distributed as dividends by the subsidiary:
Income Summary..................................................................................
109,00
0
Retained Earnings of Subsidiary (29,000 – 24,000)................. 5,000
Retained Earnings (109,000- 5,000)......................................... 104,000
To close dividends declared accounts:
Retained Earnings 30,000
Dividend 30,000
Problem 5.3:
Assume that SRS Company is a wholly owned purchased subsidiary of RSR Company. SRS had net
income of Br 80,000 for the year ended December 31, 2003 a year after business Combination and
dividends of Br 50,000 are declared on December 20, 2003. The Parent decided to amortize Br
35,000 excess acquisition cost in 2003.
1. Determine by how much the investment in subsidiary account decreases or increases
63
2. Record each of the foregoing event under equity method of accounting
3. Determine the investment of income
5.8) Accounting for Operating Results of partially Owned purchased

Subsidiaries Subsequent to Date of Business Combination
This requires computation of the minority interest in net income or net loss of the subsidiary. Under
the parent concept of the consolidated financial statements, the consolidated income statement of a
parent company and its partially owned subsidiary includes an expense: minority interest in net
income (loss) of subsidiary. In the consolidated balance sheet, the minority interest in net assets of
subsidiary is displayed among liabilities.
Illustration of Equity method for partially owned purchases subsidiary for first year after
Business Combination (Continuing with Post-Sage company relationship)
Example 5.6: Assume that on December 5, 2004 Sage Company declared dividend of Br 1 per
Share Payable on December 19, 2004 and net income of Sage for the year was Br 90,000.
Sage records the following journal entries.
December 5, 2004: To record declaration of dividend payable
Dividends Declared (40,000 @ 1)........................................................40,000
Dividends Payable (Br 40,000 @ 0.05).................................... 2,000
Intercompany Dividends Payable (40,000 @ 0, 95)................. 38,000
December 19, 2004: To record payment of dividend declared
Dividends Payable................................................................................ 2,00
0
Intercompany Dividends Payable.........................................................38,00
0
Cash................................................................................... 40,000
...........................................................................................
Post Corporation record the following journal entries for 2004, under the equity method in relation
with subsidiary
1. December 5, 2004: to record dividend declared by Sage Company for proportionate Share
of Dividend
Intercompany Dividend Receivable......................................................38,000
Investment in Sage Company.......................................... 38,000
2. December 19, 2004: To record receipt of dividend from Sage Company

Cash.......................................................................................................38,000
Intercompany Dividend Receivable................................. 38,000
(Proportionate Share of Dividend)
3. December 31, 2004:

Investment in Sage Company................................................................ 85,50
0
Intercompany Investment Income (95% @ 90,000 =85,500)..... 85,500
64
To record 95% of net income of sage company for the year ended dec.31, 2004 Adjustment of
purchased Subsidiary’s net income. Assume the following CFV and carrying values:
Excess Dec.31,
Cost Expens Balance
e
Inventories (FIFO) ..................................... 26,000 (26,000) ─
Plant Assets, net:
Land...................................................... 60,000 ─ 60,000
...............................................................
Building (20 Years)............................... 80,000 (4,000) 76,000
...............................................................
Machinery (5 Years)............................. 50,000 (10,000) 40,000
Leasehold (6Years)............................... 30,000 (5,000) 25,000
Total............................................................ 246,000 (45,000) 201,000
Plant Assets, net (December 31, 2003) = 60,000 + 80,000 + 50,000 = 190,000
Plant Assets, net (December 31, 2004) = 60,000 + 76,000 + 40,000 = 176,000
4. Post Corporation prepares the following additional entry to record the amortization of excess
cost:
Intercompany Investment Income (95% @ 45,000)............................. 42,750
...............................................................................................................
...............................................................................................................
Investment in Sage Company Common Stock......................... 42,750
The Investment in Sage Company

Investment in Sage Company
1,192,250 38,000 Dividend
85,500 42,750 Amortization of Excess Cost
1,197,000
Note: Goodwill in a business combination involving a partially owned subsidiary is attributable

to the parent company in a partially owned subsidiary rather than the subsidiary. Consequently,
amortization of goodwill is debited to the amortization Expense ledger account of the parent
company.
Developing the Elimination Entries

 Post Corporation uses the equity method of accounting for its investment in Sage Company
results in balance the Investment ledger account that is a mixture of three components.
i. The carrying amount of Sage's identifiable net assets
ii. the "current fair value excess or Excess Cost over CFV: which is attributable to Sage's
identifiable assets: and
iii. the goodwill acquired by post in the business combination with Sage
65
A. The Eliminations column of the working paper is presented below:
Common Stock –Sage Company...................................................400,000
Add paid in capital – Sage Company.............................................235,000
Retained Earning – Sage Company...............................................334,000
Investment Income from the Subsidiary........................................42,750
Plant Assets (net) – Sage Company...............................................176,000
Leasehold – Sage Company...........................................................25,000
Goodwill – Sage Company............................................................ 38,000
CGS – Sage Company....................................................................26,000
Operating Expenses- Sage Company.............................................19,000
Investment in Sage Company......................................... 1,197,000
Dividends – Sage Company........................................... 40,000
Minority Interest in Net Asses of the sub....................... 58,750
* Minority interest in dividend declared by the subsidiary Br 40,000 @ 0.05 = Br 2000. Thus the
Minority Interest in Net Assets of the Subsidiary would be 60,750 – 2000 = Br58,750.
**For year 2004 depreciation and amortization on differences between CFVs and carrying
amounts of Sage’s net assets are as follows:
Operating
COGS
Expenses
Inventories Sold............................................................ 26,000
Building Depreciation................................................... 4,000
Machinery Depreciation................................................ 10,000
Leasehold Amortization................................................ 5,000
Total.............................................................................. 26,000 19,000
B.
Minority Interest in Net Income and Net Assets
Minority Interest in Net Income of Subsidiary..................................... 2,250
Minority Interest in Net Assets of Subsidiary..................... 2,250
Minority interest in subsidiary's adjusted net income for year 2000 is computed as
follows:
Net Income of Subsidiary .......................................................................Br 90,000
Net reduction of elimination (A) (43,000 + 2000)................................... (45,000)
Adjusted Net Income of subsidiary.......................................................... 45,000
Minority Interest in Adjusted Income (45,000 x 0.05)............................ (2,250)

Working paper for consolidated Financial statements
For year Ended Dec.31,2004
Post
Corporatio Sage Elimination Consolidated
n Company
Income Statement
Revenue:
1,089,00
Net Sales...................................................................
5,611,000 0 6,700,000
66
Intercompany Investment Income.............................

42,750 a (42,750)
1,089,00
Total Revenue..........................................................
5,653,750 0 (42,750) 6,700,000
Cost of goods sold.....................................................
3,925,000 700,000 a 26,000 4,651,000
Operating expenses...................................................
556,000 129,000 a 19,000 704,000
Interest and income tax expense............................... 710,000 170,000 880,000
Minority Interest in the net income of Sub................................ b 2,250 2,250
Total costs and Expenses........................................ 5,191,000 999,000 *47,250 6,237,250
Net income................................................................
462,750 90,000 (90,000) 462,750
Statement of Retained Earrings
Retained Earnings Jan.1.2004................................... 1,050,000 334,000 a (334,000) 1,050,000
Net income for the year............................................. 462,750 90,000 (90,000) 462,750
Subtotal..............................................................1,512,750 424,000 (424,000) 1,512,750
Dividend Declared..................................................... 158,550 40,000 **a ( 40,000) 158,550
Retained Earnings end of year.................................. 1,354,200 384,000 (384,000) 1,354,200
Balance Sheet
Assets:
Inventories.................................................................
861,000 439,000 1,300,000
Other Current Assets................................................. 639,000 371,000 1,010,000
Investment in Sage Company CS............................. 1,197,000 a (1,197,000)
1,150,00
Plant asset( net).........................................................
3,600,000 0 a 176,000 4,926,000
Leasehold(net)........................................................... a 25,000 25,000
Goodwill ( net)..........................................................
95,000 a 38,000 133,000
1,960,00
Total Asset.................................................................
6,392,000 0 (958,000) 7,394,000
Liability and SHE:
Liabilities.................................................... 2,420,550 941,000 3,361,550
Minority Interest in the Net Asset a 58,750
Subsidiary.................................................................. b 2,250 61,000
Common stock Br 1 par............................................ 1,057,000 1,057,000
Common stock Br 10 par.......................................... 400,000 a (400,000)
Additional paid-in capital..........................................
1,560,250 235,000 a (235,000) 1,560,250
Retained Earnings.....................................................
1,354,200 384,000 (384,000) 1,354,200
1,960,00
Total Liability & SHE...............................................
6,392,000 0 (958,000) 7,394,000
* An increase in total costs and expenses and a decrease in net income ** A decrease in
dividends and an increase in retained earnings
Consolidated Financial statements

The consolidated income statement, statement of retained earnings and balance sheet of Post
Corporation and subsidiary for the year ended Dec.31, 2004 are shown below:
 Income Statement
67
Post Corporation and Subsidiary Sage Company
Consolidated Income statement
For the year ended December 31, 2004
Net Sales ............................................................................................... Br 6,700,000
Costs and Expenses:
Cost of Goods Sold............................................................................... 4,651,000
Operating Expense................................................................................ 704,000
Interest and Income Tax Expense......................................................... 880,000
Minority Interest in Net Income of The Subsidiary.............................. 2,250
Total Costs and Expenses...................................................................... (6,237,250)
Net Income............................................................................................ Br462,750
Earning per share of common stock (462,750 / 1,057,000 shares) Br 0.44
 Retained Earning Statement
Consolidated Retained Earning Statement
For year ended Dec.31 2004
Retained earnings, beginning of the year..................................................................... Br 1,050,000
Add: Net income.......................................................................................................... 462,750
Subtotal......................................................................................................................... 1,512,750
Less: Dividends (Br 0.15 a share)................................................................................ (158,550)
Retained Earnings, Ending of the Year........................................................................ 1,354,200
 Balance Sheet
For year ended Dec.31, 2004
Assets:
Inventories............................................................................................... 1,300,000
Other Assets............................................................................................ 1,010,000
Plant Assets, net....................................................................................... 4,926,000
Leasehold, net.......................................................................................... 25,000
Goodwill, net........................................................................................... 133,000
Total assets.............................................................................................. 7,394,000
Liabilities and Stockholders' Equity:
Liabilities:
Liabilities Other Than Minority Interest.................................................. 3,361,550
Minority interest in net assets of subsidiary............................................. 61,000
Stockholders' Equity:
Common stock, Br 1par........................................................................... 1,057,000
Additional Paid In Capital....................................................................... 1,560,250
Retained Earnings.................................................................................... 1,354,200
Total liabilities and stockholders' equity.................................................. 7,394,000
CLOSING ENTRIES:
Parent's Dec.31 2004 closing entries under the Equity method of accounting for purchased
subsidiary are as follows:
To close revenue accounts
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Net Sales................................................................................ 5,611,000
Intercompany investment income.......................................... 42,750
Income summary................................................... 5,653,750
To close expense accounts:
Income Summary................................................................... 5,191,000
Cost of Goods Sold................................................ 3,925,000
Operating Expenses 556,000
Interest and Income tax expense............................ 710,000
To close income summary accounts; to transfer net income legally available for dividends to
retained earnings; and to segregate 95% share of adjusted net income of subsidiary not
distributed as dividends:
Income Summary............................................................................ 462,75
0
Retained Earnings of Subsidiary (42,750 – 38,000)....... 4,750
........................................................................................
Retained Earnings (462,750 – 4,750)............................. 458,000
To close dividends declared accounts:
Retained Earnings.................................................................. 158,550
Dividend Declared................................................. 158,550
5.9) Cost Method for Partially Owned Purchased Subsidiary

To illustrate the cost method of accounting for the operating results of a purchased Subsidiary, the
Post Corporation-Sage Company business combination, which involves a partially owned
subsidiary, is used. Post acquired 95% of Sage’s outstanding common stock at a total cost
(including out-of-pocket costs) of Br1, 192.250 on December 31, 2003 Sage’s operations for the
first two years following the business combination included the following:
Year Ended Net Dividends
December 31 Income Declared
2004 Br90,000 Br 40,000
2005 105,000 50,000
Illustration of Cost Method for partially Owned Purchased Subsidiary for First Year after
Business Combination
If Post Corporation used the cost method, rather than the equity method, of accounting for Sage
company’s operating results for the year ended December 31, 2004, Post Corporation would not
prepare journal entries to record Sage’s net income for the year. Post would record Sage’s dividend
declaration as follows on November 24, 2004:
Intercompany Dividends Receivable............................................ 38,000
Intercompany Dividends Revenue................................ 38,000
To record dividend declared by Sage Company
Post’s journal entry for receipt of the dividend from Sage would be the same under the cost method
as under the equity method of accounting.
Working Paper for Consolidated Financial Statements
69
The working paper for consolidated financial statements and the related working paper for consolidated
financial statements and the related working paper eliminations (in journal entry format) for Post corporation
and subsidiary for the year ended December 31,2004 follow:
Working paper for consolidated Financial statements
For year Ended Dec.31,2004
Post Sage Elimination Consolidated
Income statement
Revenue:
Net Sales....................................................... 5,611,000 1,089,000 6,700,000
Intercompany Investment Income................. 38,000 c (38,000)
Total Revenue............................................... 5,649,000 1,089,000 (38,000) 6,700,000
Cost of goods sold.......................................... 3,925,000 700,000 a 26,000 4,651,000
Operating expenses........................................ 556,000 129,000 a 19,000 704,000
Interest and income tax expense................... 710,000 170,000 880,000
Minority interest in net income of Sub...... b 2,250 2,250
Total costs and Expenses............................... 5,191,000 999,000 *47,250 6,237,250
Net income..................................................... 458,000 90,000 (85,250) 462,750
Statement of Retained Earrings
Retained Earnings Jan.1.2004........................ 1,050,000 334,000 a (334,000) 1,050,000
Net income for the year.................................. 458,000 90,000 (85,250) 462,750
Subtotal.......................................................... 1,508,000 424,000 (419,250) 1,512,250
Dividend Declared......................................... 158,550 40,000 ** a ( 40,000) 158,550
Retained Earnings end of year....................... 1,349,450 384,000 (379,250) 1,354,200
Balance sheet
a 26,000
Inventories...................................................... 861,000 439,000 b (26,000) 1,300,000
Other Current Assets...................................... 639,000 371,000 1,010,000
Investment in Sage Company....................... 1,192,250 a (1,192,250)
a 190,000
Plant asset, net................................................ 3,600,000 1,150,000 b (14,000) 4,926,000
a 30,000
Leasehold, net................................................ b (5,000) 25,000
Goodwill, net.................................................. 95,000 a 38,000 133,000
Total Asset.................................................... 6,387,250 1,960,000 (953,250) 7,394,000
Liability and SHE........................................
Liabilities....................................................... 2,420,550 941,000 3,361,550
Minority Interest in Net Asset of the a 60,750
Subsidiary..................................................... c (2000)
d 2,250 61,000
Common Stock Br 1 par................................ 1,057,000 1,057,000
Common Stock Br 10 par.............................. 400,000 (400,000)
Additional Paid In Capital............................. 1,560,250 235,000 (235,000) 1,560,250
Retained Earnings.......................................... 1,349,450 384,000 (379,250) 1,354,200
Total Liability & SHE................................. 6,387,250 1,960,000 (953,250) 7,394,000
*An increase in total costs and expenses, and a decrease in net income ** A decrease in dividends and
an increase in retained earnings
Working Paper Eliminations (Cost method)
70
December 31, 2000

A. To eliminate intercompany investment and equity accounts of Subsidiary on date of business
combination (Dec.31,2003); to Allocate excess of cost over carrying amounts of identifiable
Assets acquired, with remainder to goodwill; and to establish Minority Interest in net assets of
subsidiary on date of business combination (Br1,215,000 @ 0.05 = Br 60.750).
Common Stock – Sage.............................................................................. 400,000
Additional Paid-in Capital-Sage............................................................... 235,000
Retained Earnings –Sage.......................................................................... 334,000
Inventories – Sage.....................................................................................26,000
Plant Assets, net-Sage...............................................................................
190,000
Leasehold, net – Sage...............................................................................30,000
Goodwill, net – Post..................................................................................38,000
Investment in Sage Company Common Stock-post ................ 1,192,250
Minority Interest in Net Assets of Subsidiary........................... 60,750
B. To provide for year 2004 depreciation and amortization on differences between business
combination date current fair Values and carrying amounts of Sage’s identifiable assets and to
amortize goodwill acquired in business combination
Cost of Goods Sold – Sage.............................................................26,000
Operating Expenses – Sage.............................................................19,000
Inventories – Sage............................................................... 26,000
Plant Assets, net – Sage...................................................... 14,000
Leasehold, net – Sage......................................................... 5,000
 The Allocation as Follows:
COGS Operating
Expenses
Inventories Sold...................................................... 26,000
Building Depreciation............................................. 4,000
Machinery Depreciation.......................................... 10,000
Leasehold Amortization.......................................... 5,000
Total........................................................................ 26,000 19,000
C. To eliminate Intercompany Dividends and minority interest share thereof (40,000 @ 0.05 =
2000)
Intercompany Dividends revenue-Post................................................ 38,000
Minority interest in net assets of subsidiary........................................ 2,000
Dividend declared-Sage...................................................... 40,000
D. To Record Minority Interest in Net Income of Subsidiary
Minority interest in net income of subsidiary....................................... 2,250
Minority interest in net assets of subsidiary.................. 2,250
To establish minority interest in subsidiaries adjusted net income for year 2000 as follows:
Net income of subsidiary.................................................... Br 90,000
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Net reduction in elimination (b).......................................... (45,000)
Adjusted net income of subsidiary...................................... 45,000
Minority interest share (45,000 @ 0.05)............................. 2,250
The points that follow relative to the cost-method working papers for Post Corporation and
Subsidiary should be noted:
1. The consolidated amounts in the cost-method working paper for consolidated financial
statements are identical to the consolidated amounts in the equity method working paper (page
20). This outcome results from the use of different eliminations in the two methods.
2. Three cost-method elimination, (a), (b), and (c), are required to accomplish what single
equity-method elimination, (a) on page 19, does. The reason is that the parent company’s
accounting records are used in the equity method to reflect the parent’s share of the
subsidiary’s adjusted net income or net loss.
3. Elimination (a) deals with the intercompany investment and subsidiary equity accounts on the
date of the business combination. This account technique is necessary because the parent’s
investment in Sage company common stock method.
4. The parent company’s cost-method net income and retained earnings are not the same as the
consolidated amounts. Thus, the consolidated amounts on December 31, 2000, may be proved
as follows, to assure their accuracy:
Consolidated Net Income:

Net income of Post Corporation..................................................Br 458,000
Add: Post's share of Sage Company’s adjusted net income not
Distributed as dividends [(Br 45,000- 40,000) x 0.95]............ 4,750
Consolidated net income ............................................................. 462,750
Consolidated Retained Earning:
Retained earnings of Post Corporation........................................Br 1,349,450
Add: Post's share of adjusted net increase in Sage Company's
Retained earnings [(Br 50,000-45,000) x0.95] ..................... 4,750
Consolidated Retained Earnings.................................................. 1,354,200
CLOSING ENTRIES
There are no unusual features of closing entries for a parent company that uses the cost method of
accounting of a subsidiary's operating results. The Intercompany dividends revenue ledger account
is closed with other revenue accounts to the Income Summary account. Because the parent
company does not record the undistributed earnings of subsidiaries under the cost method, Retained
earnings Subsidiary ledger account is unnecessary.
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Chapter Six: Foreign Subsidiaries and Consolidated Financial Statements
Chapter Six
Foreign Subsidiaries and Consolidated Financial
Statements
Chapter outlines:
 Accounting for foreign currency transactions
 Transaction, Translation, and Economic exposures
 Foreign exchange rate and functional currency
 Basic translation methods: the current/non-current; the current; the monetary/non-monetary and
the temporal method
 Translation foreign currency financial statement under the current rate method
 Re-measurement foreign currency financial statements
Chapter objectives:
 Introduce foreign currency and definitions.
 Understand quotation conventions for foreign currency and exchange rates
 Learn foreign-currency-denominated transactions accounting
 Understand the functional currency concept
 Determine a subsidiary’s functional currency
 Produce financial statements using translation or re-measurement, or both
 Apply the current rate translation method.
 Apply the temporal translation method
Chapter Prerequisite: Intermediate Financial Accounting II (Acct 302) and Business
Combinations
6.1 Accounting for Foreign Currency Transactions

Businesses that involve in international trades or Multi-National Company (MNC) need foreign
currencies to enter into different transactions. A “Multi-National Company” is one that conducts its
business in more than one country via branches, joint ventures, subsidiaries etc. In most countries,
the foreign currency is treated as a commodity or a money-market instrument. Thus, different
Multi-National Companies (MNCs) involve buying and selling of foreign currency. The following
different Exchange Rates are applicable for buying and/or selling foreign currency:
Spot Rates: are rates used by banks for immediate delivery or receipts of a foreign currency. The
two spot rates are (i) Spot Selling Rate: The rate charged by the bank for current sales in foreign
currency; and (ii) Spot Buying Rate: The rate applied by the bank to acquire a foreign currency.
The spot buying rate is usually lower than the spot selling rate.
Forward Rates: are rates applied to foreign currency transactions to be consummated at a future
date. The two forward rates are (i) Forward Selling Rate: The rate charged by the bank for future
sales in foreign currency, and (ii) Forward Buying Rate: The rate applied by the bank to acquire a
foreign currency in the future. The forward buying rate is usually lower than forward selling rate.
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Spread: is the difference between the selling and the buying spot rates and represent gross profit to
a foreign currency trader
The transactions engaged into by the multinational company must be recorded in the reporting
currency in the accounting records of the enterprise. The appropriate spot rate is used for this
purpose. If the spot exchange rate for the foreign currency changes on the date of financial
statement preparation prior to settlement of the transaction, or on the settlement date itself, a
foreign currency transaction gain or loss is recognized for display in the income statement of the
enterprise for the accounting period in which the rate changes. For MNC, if all its transactions are
accounted for in one currency, no problem arises, however often local currencies are used and thus,
MNCs are exposed to different risks as discussed in the next topic as a result of foreign exchange
rate fluctuations.
6.1.1 Economic, Transaction, and Translation Exposure
1. Economic Exposure
It is sometimes called operating exposure. This is an exposure that measures the extent to which a
firm's market value is sensitive to unexpected changes in foreign currency. Currency fluctuations
affect the value of the firms’ cash flows, income statement and balance sheet by altering its
competitive position. Economic Exposure is the sensitivity of the future home currency value of the
firm’s assets and liabilities and the firm’s operating cash flow to random changes in exchange rates.
Economic exposures measures the change in the present value of the firm resulting from any change
in expected future operating cash flows caused by an unexpected change in exchange rates.
2. Transaction Exposure
Transaction Exposure measures gains or losses that arise from the settlement of existing financial
obligations whose terms are stated in foreign currency. Transaction exposure measures the extent to
which income from individual transactions is affected by fluctuations in foreign exchange values. It
is the risk of loss due to adverse foreign exchange rate movements that affect the home currency
value of import and export contracts denominated in a foreign currency. It is also the risk, faced by
companies involved in international trade that currency exchange rates will change after the
companies have already entered into financial obligations. Such exposure to fluctuating exchange
rates can lead to major losses for firms. It usually takes place from changes in exchange rates
between dates of inception of a contract denominated in foreign currency and settlement of the
contract. For example, the transaction exposure may arise from the following transactions:
 Purchasing or selling on credit when prices are stated in a foreign currency
 Borrowing or lending funds when repayment is to be made in a foreign currency
 Being a party to an unperformed foreign exchange forward contract
 Acquiring assets or incurring liabilities denominated in a foreign currency
Foreign Currency Transaction Gains and Losses

During the period liabilities are open, if the selling spot rate decreases (foreign currency weakens
against the domestic currency), it results in a foreign currency transaction gain; if the selling spot
rate increases (foreign currency strengthens against the domestic currency), it will result in a foreign
currency transaction loss. Gains and losses are reported in a firm’s income statement in the period
in which they occur.
74
Example 6.1:
Ethio Trading Company purchased goods on account from US Company on December 21, 2010
at $100,000 terms n/30. The spot selling rate for a dollar is Br 16.60
Inventories..............................................................................1,660,000
Accounts Payable.................................................... 1,660,000
To record purchase on 30-day open account from US supplier for $100,000, translated at the spot
selling rate $1 = Br 16.60
Determine the foreign currency transaction gain or loss for the Ethio Trading Company assuming
that on December 31, 2010, the spot selling rate for a US dollar was Br 16.58
Liability on December 21, 2010........................................................ Br 1,660,000

Less: Liability on December 31, 2005 ($100,000 @ 16.58).............. 1,658,000
Foreign currency transaction gain...................................................... Br 2,000
Journal Entry:
Accounts Payable............................................................................... 2,000
Foreign Currency Transaction Gain................................. 2,000
Determine the foreign currency transaction gain or loss for the Ethio Trading Company assuming
that on maturity date, February 19, 2011, the spot selling rate for a US dollar was Br 16.61
Liability on December 31, 2010........................................................ Br 1,658,000

Less: Liability on December 31, 2005 ($100,000 @ 16.61).............. 1,661,000
Foreign currency transaction loss...................................................... (Br3,000)
Journal Entry:
Accounts Payable...............................................................................1,658,000
Foreign Currency Transaction Loss................................................... 3,000
Accounts Payable............................................................. 1,661,000
Exercise 6.1: Ethio Trading Company purchased goods on account from US Company on
December 21, 2010 at $100,000 terms n/30. The spot selling rate for a dollar is Br16.60 on the date
of transaction. On December 31, 2010, the spot selling rate for a US dollar was Br 16.63. On
Maturity date, February 19, 2011, the spot selling rate for a US dollar was Br 16.59. Instruction:
Record the foreign currency transaction on each date.
3. Translation Exposure or Accounting Exposure

Translation exposure is a risk attributed to change in a firm's financial position when the firm's
consolidated financial statements are affected by changes in foreign exchange rates. Translation
involves converting financial statements of foreign subsidiaries from the local currency to the home
currency. It is also known as Accounting Exposure. Translation exposure or accounting exposure
measures the potential losses or gains that would appear on the consolidated financial statements
following a change in exchange rates. It is a risk that a company's equities, assets, liabilities or
income will change in value as a result of changes in exchange rate. This occurs when a firm
denominates a portion of its equities, assets, liabilities or income in a foreign currency. The
translation adjustments are an inherent result of the process of translating a foreign entity's financial
75
statements from the functional currency to reporting currency. Translation adjustments are not
included in determining net income for the period but are disclosed and accumulated in a separate
component of consolidated equity until sale or until complete or substantially complete liquidation
of the net investment in the foreign entity takes place.
6.2 Accounting for Translation of Foreign Currency Financial Statements

6.2.1 Translation Terminology
 Functional Currency – SFAS No. 52 is the primary source of GAAP for translation of foreign
currency financial statements. Statement of Financial Accounting Standards No. 52 (SFAS 52)
introduced the concept of the Functional Currency. SFAS No. 52 defined the Functional
Currency of a foreign entity as the currency of the primary economic environment in which the
entity operates; normally, that is the currency of the environment in which an entity primarily
generates and expends cash. Functional currency is the monetary unit of account of the
Principal Economic Environment in which an economic entity operates. The functional
currency is used to differentiate between two types of foreign operations:
 Those that are self-contained and integrated into a local environment
 Those that are an extension of the parent and integrated with the parent
 Reporting Currency – is the currency in which the parent company prepares its financial
statements; that is the currency used in published reports and financial documents of the parent
company. It is a currency in which the parent firm prepares its own financial statements; that is,
US dollars for a US companies or Birr for Ethiopian companies.
 Foreign Currency – any currency other than the reporting currency of the parent company
 Local Currency is the currency unit used in a country referenced. Local currency is the
currency in the country where the foreign subsidiary is operating. For example, Birr is the local
currency in Ethiopia.
 Exchange Difference (Spread)– difference resulting from translating a given number of units
of one currency into another currency at different exchange rates
 Foreign Operation – a subsidiary, associate, joint venture, or branch whose activities are based
in a country other than that of the reporting enterprise
6.2.2 Identifying Functional Currency

The functional currency for a given foreign operation is a matter of fact. Management judgment is
required in the functional currency determination process. FASB provided that the salient (most
important) economic factors set forth below and possibly others, should be considered both
individually and collectively when determining the functional currency.
 Cash Flow Indicator – denomination of cash flows.
 Sales Price Indicator – responsiveness of selling prices to exchange rates on a short-term
basis.
 Sales Market Indicator - existence of an active local sales market for the product
 Expense Indicator – existence of a local source for operating costs
 Financing Indicator – denomination of the firm's primary financing
 Intercompany Indicator – the volume of intercompany transactions.
To determine the functional currency, the most heavily weighted factors are indicators related to
Cash Flows and Expense and Revenue Items . Based on the above six indicators,
Multinational company may use the reporting currency or local currency, or foreign currency other
76
than local currency for the operation of foreign subsidiary. The functional currency may be the
currency of the country in which the foreign entity is located (local currency), the reporting
currency, or the currency of other foreign country (foreign currency).
 If the foreign entity's operations are self-contained and integrated in a particular country and are
not dependent on the economic environment of the parent company, the functional currency is
the foreign currency (either local currency or foreign currency other than local currency).
 The functional currency of a foreign company would be the reporting currency if the foreign
operation is an integral component or extension of the parent company's operations. That is, the
daily operations and cash flows of the foreign operation of the foreign entity are dependent on
the economic environment of the parent company.
 An exception is required for subsidiaries located in environments in which the cumulative rate
of inflation during the preceding three years exceeds 100 percent. In such hyper inflationary
environments, the reporting currency becomes the functional currency. A Local Currency can be
a Functional Currency only in a Stable Economy if:
• Cash flows are local currency
• Sales prices are determined by local conditions / in local currency
• Expenses are paid in local currency / driven by local conditions
• Financing done in local currencies
• Inventory value liked to local conditions.
When a multinational enterprise prepares consolidated or combined financial statements that

include the operating results, financial position and cash flows of foreign subsidiaries or branches,
the enterprise must translate the amounts in the financial statements of the foreign entities from the
entities’ functional currency to the reporting currency. Similar treatment must be given to
investments in other (foreign) investee’s for which the parent company uses the equity method of
accounting. In addition, if foreign entity’s accounting records are maintained in a local currency of
the foreign country that is not the entity’s functional currency; the foreign entity’s account
balances must be re-measured to the functional currency from local currency
6.2.3 Translation Exchange Rates

In translation of foreign subsidiary financial statements, there needs to raise two questions:
1. How should translation gains and losses be reported in the financial statements or should be
accounted for? Should they be included in income?
2. What exchange rate should be used to translate each line of the foreign financial statements
into the domestic currency? That is which exchange rate should be used to translate foreign
currency account balances to reporting currency?
Translation methods may employ a single rate or multiple rates. There are three alternative
exchange rates for translation of foreign subsidiary financial statements: current rate, historical rate,
and average rate.
 Current Rate – exchange rate prevailing as of the financial statement date
 Historical Rate – exchange rate prevailing when a foreign currency asset was first
acquired or a foreign currency liability was first incurred
 Average Rate – is simple or weighted average exchange rate of either current or
historical exchange rates
77
6.2.4 Alternative Methods of Translation of Foreign Subsidiary's Financial Statement

If the exchange rate for the functional currency of a foreign subsidiary or branch remained constant
instead of fluctuating, translation of financial statements would be simple. All financial statement
amounts would be translated at the constant exchange rate. However, exchange rates fluctuate
frequently. Hence, a problem is faced which exchange rate to use. The several methods (translation
models) for foreign currency translation may be grouped into four basic classes as shown below:
1. Current / Non-current Method
2. Monetary/ Non monetary Method
3. Temporal Method
4. Current Rate Method
In general, all the four translation models agree on the translation of sales revenues & other
revenues and most operating expenses on the income statement except depreciation expense.
Typically, these are translated using the historical rate in effect when the revenue was earned or
the expense recognized. That may be an average rate for the period.
1. Current / Noncurrent Method

This method focuses on traditional accounting classification for assets and liabilities:
Balance Sheet Translation:
 Current items on the balance sheet (current assets and current liabilities) are translated at the
current rate.
 Long-term items on the balance sheet (all other assets & liabilities) and the elements of
owners ‘equity are translated at historical rates
Income statement Translation:
 Depreciation expense & amortization expenses are translated at historical rates applicable to
the related assets.
 All other revenues and expenses are recognized at an average exchange rate for the
accounting period.
This method was sanctioned by AICPA for many years. Today it has few supporters. The principal
objection of this method is with respect to inventories; it represents a departure from historical cost.
Inventories are translated at current rate, rather than at historical rates in effect when the
inventories were acquired, if the current/ noncurrent method of translating foreign currency
accounts is applied. Cost of Goods Sold is translated at the current rate because inventory is
translated at current rate as it is current asset. Translation gains and losses under this method are
generally included in Net Income, but treatment is flexible.
2. Monetary/ Non-monetary Method

This method focuses on the financial character of assets & liabilities of the foreign subsidiary
financial statement rather than on their balance sheet classifications to determine appropriate rate.
Foreign currency assets and liabilities expressed as a fixed number of currency units are defined as
monetary (receivables and payables). Other items are non-monetary.
Balance sheet translation:
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 Monetary items are translated at the current rate – i.e. monetary assets & liabilities
representing claims & obligations expressed in a fixed monetary amount are translated at
the current rate.
 Nonmonetary items are translated at the historical rate – i.e. all other assets and liabilities,
and owners' equity amounts are translated at historical rates. Non-monetary items include
fixed assets, long-term investments, and inventories.
Income statement translation:
 In the income statement, average exchange rates are applied to all revenues and expense
except depreciation expenses, amortization expense, and cost of goods sold, which are
translated at appropriate historical rates.
 Supporters of this method emphasized its retention of the historical cost principle in the
foreign entity’s financial statements. It was sanctioned by FASB until the issuance of
FASB statement No 52.
Main difference between Current-Noncurrent and Monetary-Nonmonetary:
 Translation rates used for noncurrent receivables and payables is current rate
 Translation rates used for inventory, and prepaid items is historical rate
3. Temporal Method
The temporal model considers currency translation as a measurement conversion process. This
method cannot be used to change the attribute of an item being measured; it can only change the
unit of measure. The temporal method is very similar to Monetary / Nonmonetary unless there is
significant difference in GAAP. Both may present identical results. Differences occur for items that
have been revalued. If no revaluation is allowed, the two methods yield identical results. Temporal
method considers time dimensions and foreign balance sheet items are measured accordingly based
on three different values: Past exchange prices – Historical Cost, Current exchange prices - Current
Value, Future Values
 Cash, receivables, and payables are translated at the current rate
 Other assets and liabilities may be translated at current or historical rates, depending on
their characteristics
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 Assets and liabilities carried at past exchange prices are translated at historical rates
 Assets and liabilities carried at current purchase or sales exchange prices or future
exchange prices would be translated at current rates
 This flexible method ensures that parent currency is the single unit of measure
 Cost of Goods Sold and Depreciation Expense are translated at their historical rate.
Exchange gains and losses from translation are included in current net income.
Criticisms of Temporal Method
 The results of translation frequently do not reflect the underlying economic reality of
foreign operations. This is underscored by the volatility of reported earnings using this
method
 Financial results and relationships are distorted. The use of the temporal method can cause
distortions such that a net income in the foreign currency translates to a net loss in the
home currency.
 Sources of these problems are the requirement for current recognition of the unrealized
exchange adjustment and translation of inventories and fixed assets at historical rates,
while the debt used to acquire these assets is translated at current rates.
4. Current Rate Method

 All balance sheet amounts other than owners’ equity items are translated at the current rate.
 Owners' equity items are translated at the historical rates.
 Revenues and gains and expenses and losses are translated at the rates in existence during the
period when the transactions occurred (if practical); otherwise an average exchange rate is used
for all revenuers and expenses.
This method provides that all financial relationship remain the same in both local currency and
reporting currency. The translation adjustment which result from the application of these rules are
reported as a separate component in owners' equity of the parent company's consolidated balance
sheet (or parent – only balance sheet if consolidation was not deemed appropriate).
6.2.5 Translation and Remeasurement: Producing Financial Statements Using
Translation or Remeasurement, or Both.
Translation of Foreign Currency Financial Statements (SFAS No. 52)
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Translation involves expressing functional currency measurements into the reporting currency.
FASB statement No 52 adopted the current rate method for translating a foreign entity’s financial
statements, from the entity’s functional currency to the reporting currency of the parent company.
Re-measurement of a Foreign Entity’s Records

When the foreign entity’s books are not maintained in its functional currency, the foreign currency
financial statements must be remeasured into the functional currency. This is accomplished using
the Temporal Method or Monetary and Non-monetary method. FASB provided guidelines for re-
measurement. The re-measurement process should produce the same result as if the entity’s books
or records had been initially maintained in the functional currency. To accomplish this result;
historical exchange rate is used for some items and current rate is used for others. The monetary
assets and liabilities are remeasured using the current exchange rates while the non-monetary items
are remeasured at historical rates. The gain /loss from re-measurement is recognized in income
measurement
1. Items remeasured using historical rate are:

 Marketable securities carried at cost like equity securities and debt securities not intended to
be held until maturity
 Inventories carried at cost
 Short term prepayment such as insurance, advertising, and rent
 Plant assets and accumulated depreciation
 Intangible assets and related accumulated amortization
 Deferred charges & credits
 Deferred revenue
 Common stock
 Preferred stock carried at issuance price
 Examples of revenue & expenses related to non-monetary items are Cost of good sold;
Depreciation of Plant assets; Amortization of intangibles; and Amortization of deferred
charges/ credits
2. All other items are re measured using the current rate – for example sales and operating
expenses
The appropriate historical or current exchange rate generally is the rate applicable to conversion of
the foreign currency for dividends remittances. For instance, a U.S. multinational enterprise having
foreign branches, investees, or subsidiaries typically uses the buying spot rate on the balance sheet
date or applicable historical date to re-measure the foreign currency financial statements.
As per law of the land (law of the country), financial statements are prepared in a currency of that
land regardless of the control existed. Accounting records and books are also maintained in local
currency. This determines whether to apply re-measurement or translation to produce foreign
financial statements.
1. If functional currency is the parent company’s currency (reporting currency), no translation is
required but re-measurement of foreign subsidiary financial statements at monetary / non-
monetary method eliminates the need for translation.
2. If functional currency is local currency, translation of foreign currency financial statements
should be done.
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3. If functional currency is a foreign currency other than local currency, first re-measurement is
undertaken at monetary / non monetary method (temporal method) from local currency to
functional currency and then translation is accomplished at current method from functional
currency to reporting currency. That is, if a foreign entity’s accounting records are maintained in
a currency other than its functional currency, account balances shall be remeasured to the
functional currency before the statements are translated. If re-measurement is required, it must
precede translation.
Functional Currency Currency of Records Required Procedures

Case 1 Local Currency Local Currency Translation
Case 2 Reporting Currency Local Currency Remeasurement
Case 3 Other Foreign Currency Local Currency Remeasurement & Translation
Example: A US Company having subsidiary in UK

Functional Currency Currency of Records Required Procedures
Case 1 British Pounds British Pounds Translation
Case 2 US Dollar British Pounds Remeasurement
Case 3 Euro British Pounds Remeasurement & Translation
Example 6.2: Illustration of Re measurement of a foreign entity’s Account Balances

Assume the SPS Company whose HO is in US made investment by opening a branch in Ethiopia.
SPS Company bills merchandise to branch at cost and both use perpetual inventory system. The
functional currency is USD, although the Ethiopian Branch maintains its accounting records in
ETB.
Transactions of the Year 1999:

1. Cash of $1,000 was sent by Head Office to the Ethiopian Branch ($1= Br 8.55)
2. Merchandise of $100,000 was shipped at cost to Ethiopian Branch ($1 = Br 8.55)
3. Equipment of Br 8,400 was acquired by branch to be carried in HO records ($1 = Br 8.40)
4. Sales by the branch total Br 639,000 ($1 = Br 8.52) COGS = Br 383,400
5. Collection by branch Br 516,000 ($1 = Br 8.6)
6. Payments operating expenses by branch Br 172,000 ($1 = 8.6 Br)
7. Cash of Br 34,200 was remitted to the Ho ($1 = 8.55 Br)
8. Operating expenses incurred by HO & charged to branch $2,000 ($1= Br 8.55)
Additional Information:
 The exchange rate at the beginning was Br 8.55..........(1)
 The exchange rate at the year was Br 8.47...................(2)
 Average rate = (8.47+8.55) / 2 = Br 8.51.....................(3)
Instruction: Record the above transaction by the Home Office and by Branch.
Home Office( US Dollar) Ethio Branch (Br)
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1. Investment in Ethio branch........ 1,000 Cash...................................
8,550
Cash............................................ 1,000 Home Office............... 8,550
2. Investment in Ethio branch........ 100,000 Inventories................ 855,000
Inventories................................. 100,000 Home Office...... 855,000
3. Equipment: Ethio Branch........... 1,000 Home Office................... 8,400
Investment in Ethio Branch........ 1,000 Cash........................ 8,400
4. None Trade A/R................. 639,000
COGS....................... 383,400
Sales................. 639,000
Inventories......... 383,400
5. None Cash.......................... 516,000
Trade A/R.......... 516,000
6. None Operating Expense... 172,000
Cash................... 172,000
7. Cash............................................ 4,000 Home Office................34,200
Investment in Ethio Branch......... 4,000 Cash.................. 34,200
8. Investment in Ethio Branch....... 2,000 Operating Expense......17,100
Operating expense........................ 2,000 Home Office.......... 17,100
The balance of Investment in Branch and Home Office Accounts are as follows:
Investment in Ethio Branch Home Office
1,000 1,000 8,400 8,550
100,000 4,000 34,200 855,000
2,000 17,100
98,000 838,050
Branch Trial Balance

SPS Company
Ethio Branch Trial Balance
December 31, 1999
Debit Credit
Cash................................................................
Br 309,950
Accounts Receivable...................................... 123,000
Inventories......................................................
471,600
Home Office................................................... 838,050
Sales............................................................... 639,000
..................................................................
Cost of Goods Sold........................................ 383,400
Operation expenses........................................ 189,100
Totals 1,477,050 1,477,050
Branch Trial Balance after Remeasurement
SPS Company
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Remeasurement of Ethio branch Trial Balance
December 31, 1999
Balance (Br ) Exchange Balance ($)
Dr (Cr) Rates Dr (Cr)
Cash.....................................................Br 309,950 8.47 (1) $36,594
A/R..................................................... 123,000 8.47 (1) 14,522
Inventories.......................................... 471,600 8.55 (2) 55,158
Home Office....................................... (838,050) (98,000)
Sales................................................... (639,000) 8.51 (3) (75,088)
COGS................................................. 383,400 8.55 (2) 44,842
Operating expenses............................ 189,100 8.51 (3) 22,221
Subtotal.............................................. -0- 249
Remeasurement Gain......................... -0- (249)
Totals.................................................. -0- -0-
The transaction Gain is not a ledger account but used to reconcile the total debits and credits of the
branch's re-measured trial balance. It is used in measuring branch net income for the year. In a
review of the re-measurement of the Ethio branch trial balance, the following four features should
be noted:
1. Monetary assets are re-measured at the current rate; the single non-monetary asset- inventory- is
re-measured at the appropriate historical rate.
2. To achieve the same result as re-measurement of the Home Office ledger account at appropriate
historical rates, the balance of the Home Office's Investment in Ethio Branch account (in
dollars) is substituted for the Branch's Home Office account (in Birr). All equity ledger
accounts- regardless of legal form of the investee- are re-measured at historical rates
3. A simple average of beginning-of -year and end of year exchange rates is used to re-measure
revenue and expense accounts other than cost of goods sold, which is re-measured at the
appropriate historical rates. In practice, a quarterly, monthly or even daily weighted average
might be computed.
4. A balancing amount labeled foreign currency transaction loss, which is not a ledger account, is
used to reconcile the total debits and total credits of the branch's re-measured trial balance.
After the trial balance of Ethio branch has been re-measured from Birr to dollar, combined financial
statements for Home Office and branch may be prepared.
Example 6.3: Illustration on Translation of a Foreign Entity's Financial Statements

If a foreign entity's financial statements are expressed in a functional currency other than the parent
company's reporting currency, those amounts must be translated to the reporting currency by the
current rate method.
Translation of Financial Statements of Foreign Influenced Investee

To illustrate the translation of the financial statements of a foreign investee whose functional
currency is its local currency, assume that on May 31, 1999, Colossus Company, a U.S.
multinational company, acquired 30% of the outstanding common stock of a corporation in
Venezuela, which is termed Venezuela Investee. Although the investment of Colossus enabled it
to exercise influence (but not control) over the operations and financial policies of Venezuela
Investee, that entity’s functional currency was the Bolivar (B). Colossus acquired its investment in
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Venezuela Investee for B 600,000, which Colossus acquired at the selling spot rate of B1 = $0.25,
for a total cost of $150,000. Out-of-pocket costs of the investment may be disregarded.
Stockholders’ equity of Venezuela investee on May 31, 1999, was as follows:
Common Stock............................................................................................ B 500,000
Additional paid-in capital........................................................................... 600,000
Retained earnings........................................................................................ 900,000
Total stockholders’ equity........................................................................... B 2,000,000
There was no difference between the cost of Colossus Company’s investment and its equity in the
net assets of Venezuela Investee (B 2,000,000 @ 0.30 = B600,000, the cost of the investment). The
exchange rates for the Bolivar were as follows:
May 31, 1999....................................................................................................... $0.25 (1)
May 31, 2000....................................................................................................... 0.27 (2)
Average for year ended May 31, 2000................................................................. 0.26 (3)
Translation of Venezuela Investee’s financial statements from the functional currency to the U.S
dollar reporting currency for the year ended May 31, 2000, is illustrated below:
Venezuela Investee
Translation of Income Statement & Retained Earning Statement to U.S dollar
For year ended May 31, 2000
Venezuela Exchange
Income statement Bolivars Rates USD
Net sales............................................ B6,000,000 $0.26(3) 1,560,000
Costs and expenses............................ (4,000,000) 0.26(3) (1,040,000)
Net income........................................ 2,000,000 $ 520,000
Statement of Retained Earnings
Retained earning, Beginning............. B 900,000 0.25(1) $ 225,000
Add: net income................................ 2,000,000 520,000
Subtotal............................................. 2,900,000 745,000
Less: dividends*................................ 600,000 0.27(2) 162,000
Retained Earnings, end of year......... B 2,300,000 $583,000
Balance Sheet
Venezuela Investee
Translation of Balance Sheet to U.S dollar
For year ended May 31, 2000
Venezuela B Exchange Rates USD
Assets
Current assets................................................. B 200,000 0.27(2) $ 54,000
Plant assets (net)............................................ 4,500,000 0.27(2) 1,215,000
Other assets.................................................... 300,000 0.27(2) 81,000
Total assets.................................................... B 5,000,000 1,350,000
Liabilities and SHE
Current liabilities........................................ B 100,000 0.27(2) $27,000
Long-term debt........................................... 1,500,000 0.27(2) 405,000
Common stock............................................. 500,000 0.25(1) 125,000
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Paid in capital............................................. 600,000 0.25(1) 150,000
Retained earnings....................................... 2,300,000 583,000
Foreign currency translation adjustments 60,000
Total liabilities and stockholders' Equity. B 5,000,000 $1,350,000
 Dividends were declared May 31, 2000
 Income tax effects are disregarded
 Average rate was given for the year ended May 31, 2000
 Historical rate was given for the year ended May 31, 1999, date of Colossus
Company’s investment
 Current rate was given for the year ended May 31, 2000
In a review of the translation of the foreign investee’s financial statements above, the following
features may be emphasized:
1. All assets and liabilities are translated at the current rate.
2. The paid-in capital amounts and the beginning retained earnings are translated at the historical
rate on the date of Colossus Company’s acquisition of its investment in Venezuela Investee.
3. The average rate for the year ended may 31, 2000, is used to translate all revenue and expenses
in the income statement.
4. A balancing amount labeled foreign currency translation adjustments, which is not a ledger
account, is used to reconcile total liabilities and stockholders’ equity with total assets in the
translated balance sheet of Venezuela Investee. Foreign currency translation adjustments are
displayed in the accumulated other comprehensive income section of the translated balance
sheet.
Following the translation of Venezuela Investee’s financial statements from Bolivar's ( the
functional currency of Venezuela Investee) to U.S dollars (the reporting currency of Colossus
Company), on May 31, 2000, Colossus prepares the following journal entries in U.S dollars under
the equity method of accounting for an investment in common stock:
To record 30% of net income of Venezuela Invested (Income tax effects are disregarded):
Investment in Venezuela Investee Common Stock ($520,000 @ 0.30)..............156,000
Investment income............................................................................. 156,000
To record 30% of other comprehensive income component of Venezuela Investee’s stockholders’
equity (Income tax effects are disregarded)(To record foreign currency translation adjustment):
Investment in Venezuela Investee Common Stock ($60,000 @ 0.3)..................18,000
Foreign Currency Translation Adjustments.......................................... 18,000
To record dividends receivable from Venezuela Investee:

Dividends Receivable ($162,000 @ 0.30)...........................................................48,600
Investment in Venezuela Investee Common Stock................................ 48,600
The $275,400 balance of the investment account is equal to Colossus Company’s share of the total
stockholders’ equity, including foreign currency translation adjustments, in the translated balance
sheet of Venezuela Investee: [($125,000 + $150,000 + $583,000 + $60,000) @ 0.30 = $275,400].
Foreign currency translation adjustments, which are not operating revenues, gains, expenses, or
losses, do not enter into the measurement of the translated net income or dividends of Venezuela
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Investee; however, the investor’s share of the translation adjustments is reflected in the investor’s
Investment ledger account as other comprehensive income. Foreign currency translation
adjustments are displayed in accumulated other comprehensive income in the stockholders’ equity
section of Venezuela investee’s translated balance sheet until sale or liquidation of all or part of
Colossus Company’s investment in Venezuela Investee. At that time, the appropriate amount of the
foreign currency translation adjustment is included in the measurement of the gain or loss on sale or
liquidation of the investment in Venezuela Investee.
6.2.6 Other Aspects of Foreign Currency Translation

In addition to topics discussed thus far, FASB statement No 52 included the following:
1. Transaction Gains and Losses Excluded from Net Income
The FASB required that gains and losses from the following foreign currency transactions be
accounted for in the same manner as foreign currency translation adjustment:
 Foreign currency translation that are designated as, and are effective as, economic hedges of
a net investment in a foreign entity, commencing as of the designation date.
 Intercompany foreign currency transactions that are of a long term investment nature (i.e.
Settlement is not planned of anticipated in the foreseeable future), when the entities to the
transaction are consolidated, combined or accounted for the equity method.
2. Functional currency in Highly Inflationary Economies

The FASB required that the functional currency of a foreign entity in a highly inflationary economy
be identified as the reporting currency.
 Highly inflationary economy is one having cumulative inflation of 100% or more over a 3
year period. Thus financial statement of a foreign entity experiencing severe inflation is
remeasured in the reporting currency regardless of the criteria for determination of the
functional currency.
3. Income Taxes Related to Foreign Currency Translation

Conventional interperiod and intraperiod income tax allocation procedures were prescribed by
FASB for the income tax effects of foreign currency translation as follows:
 Interperiod tax allocation for temporary differences associated with foreign currency
transaction gains / losses that are reported in different periods for financial accounting and
income taxes.
 Interperiod tax allocation for temporary differences associated with foreign currency
translation adjustments that do not meet the criteria for non recognition of deferred tax
liabilities for undistributed earnings of foreign subsidiaries
 Interperiod tax allocation for foreign currency translation adjustment included in the owners'
equality section of the balance sheet.
4. Disclosure of Foreign Currency translation

The FASB required disclosures in the income statement or in a note to the financial statements, of
the aggregate foreign currency transaction gains / losses of an accounting period. Further, the FASB
required disclosure of changes in foreign currency translation adjustments (as well as other
components of accumulated other comprehensive income) during the accounting period. The FASB
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also has specified additional disclosures for required contracts or other financial instruments
designated as hedges of the foreign currency exposure of a net investment in a foreign operation.
International Accounting Standard 21

The provisions of IAS 21 "the effects of changes in foreign exchange rates "dealing with translation
of foreign currency financial statements are compatible with those of FASB statement No 52
"Foreign currency translations". A difference is that IAS 21 states preference for applying price
level adjustment (covered in IAS 29, "financial Reporting in hyperinflationary economies") prior to
the translation of financial statements of foreign entities operating in highly inflationary economies.
Appraisal of Accounting Standards for Foreign Currency Translation

Among the criticisms of FASB statement No 52 are the following:
1. It established identifiable distinction b/n transaction gains/losses arising from re-measurement
and translation adjustments arising from translation. Both involve comparable activities
restatement of amounts in foreign currency to another currency should be treated alike.
2. It abandoned the historical - cost principle by sanctioning use of the current rare method for
translation of foreign currency financial statements.
 It appears that FASB statement No 52 has been accepted by the business community.
 FASB statement No 8 which was suppressed by FASB statement No52 was in effect for
little more thane 6 years, during which time it was subject to continuous controversy
 FASB statement No 8 was criticized for it requirements that translation adjustment be
included in met income and that the monetary/ non monetary method be used to translate
foreign entity's financial statement.
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Chapter Seven: Accounting for Segment and Interim Reporting
Chapter Seven
Accounting For Segment and Interim Reporting
Chapter outlines:
 Meaning and nature of industry segment
 Identifying reportable industry segment
 Determining segment profit or loss and allocating non-traceable expenses
 Reporting discontinue business segment
 Accounting for Interim reporting
 Disclosures of interim financial statements
Chapter objectives:
 Understand Segment and Interim Financial Reporting
 Understand how non-traceable expenses are allocated to segments
 Apply reportable operating segment tests
 Understand the similarities and differences of interim reporting and annual reporting
 Compute segment profit or loss
 Compute interim-period income tax expense
Chapter Prerequisite: Intermediate Financial Accounting II

7.1 Accounting for Segment Reporting; Computation of segment profit and loss
What is Operating Segment?
An operating or industry segment is a component of an enterprise engaged in providing a product or
service or a group of related products and services primarily to outsiders or unaffiliated customers
for a profit.
Segment Reporting
Disaggregating financial information of an enterprise is known as segment reporting. It is
sufficient to disaggregate revenues, operating profit or loss and assets identified with particular
segment.
Uses of Segment Reporting
There are purposes for which segment reporting is prepared. These are:
1. It permits the users of financial statement to make better assessment of a Company’s past
performance and future prospects.
2. Disaggregated information provides insight into the differences in segment like profitability,
degrees of risk, sources of risk, opportunity for growth, and demands for capital and there by
enables a better assessment of the uncertainness associated with the amounts and timings of
future cash flows.
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7.1.1 Identification of Reportable Industry Segment
The reportable industry segments are identified by the application of quantitative tests specified by
the standards of FASB. A reportable Operating segment is any industry segment meeting one of the
following three numerical tests:
 Revenue Test
 Operating Profit/Loss Test
 Identifiable Assets Test
Only one test has to be satisfied for a segment to be reportable.

 10% Revenue Test
A segment’s total revenue must equal or exceed 10% of the combined revenue of all the industry
segments of the company. The total Revenues of the segment include both sales to unaffiliated and
inter segmental revenues.
 10% Operating Profit or Loss Test
The absolute amount of operating profit or loss for each segment must equal or exceed 10% of the
absolute value of the combined operating profit of all industry segments that did not incur an
operating loss OR the absolute value of the combined operating loss of all industry segments that
incurred an operating loss, respectively.
 10% Identifiable Assets Test
An identifiable asset of the segment must equal 10% or more of the combined identifiable assets of
all the industry segments.
 Other Guidelines
The combined sales revenues of the disclosed segments must equal or exceed 75% of the total
company sales. Intersegment sales are excluded from the total. Segments must be added until the
75% test is met, even if the additional segments do not meet the reportable segment criteria.
Example 7.1: Western Corporation is a conglomerate entity with operation in four industry
segments. The revenue, operating profit and losses, and identifiable asset attributable to each
segment are as follows:
Particulars A B C D
Revenues: Br Br Br Br
 Sales to unaffiliated customers.......... 7,500 2,000 1,000 10,000
 Inter-Segment Sales...........................2,000 - 500 2,500
Operating Profit (Loss) .................................2,500 (500) (1,500) 3,500
Identifiable Assets..........................................
80,000 30,000 20,000 120,000
Instruction: Determine a reportable segment from all the industry segments of Western
Corporation.
1. 10% Revenue Test
Total revenue of all the segments ............................................ Br 25,500
10% Revenue............................................................................ Br 2,550
 Segment A: 9,500 > 2,550 – It is a reportable segment.
 Segment B: 2,000 < 2,550 – Not a reportable segment.
 Segment C: 1,500 < 2,550 – Not a reportable segment.
 Segment D: 12,500 > 2,550 – It is a reportable segment
2. 10% Operating Profit (loss) Test
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Total profits (2,500 + 3,500) ....................................................Br 6,000
10% profit (6,000 x 10%) ........................................................ Br 600
Segment B: 500 < 600 – it is not reportable segment
Segment C: 1,500 > 600 – it is reportable segment
3. 10% Identifiable Assets Test
Total identifiable asset..............................................................Br 250,000
10% identifiable........................................................................ 25,000
Segment B: 30,000 > 25,000 – Reportable Segment
Therefore, all the segments; A, B, C, D are reportable segments
7.1.2 Preparation of Segment Profit or Loss Statement

To calculate segment profit or loss, non-traceable expense has to be allocated to all the segments
according to some suitable basis.
Allocation of Non-Traceable Expenses:
Non-Traceable Expenses are those expenses of an enterprise not identifiable with operation of a
specific operating segment for measurement of segment profit or loss.
Allocation or Apportionment:
Non-traceable expenses are to be allocated among the segment on some reasonable basis. The
management of the enterprise should devise an appropriate method. The following are some of the
methods used in allocation:
1. Ratio of Segment Revenue (Sales Ratio),
2. Ratio of Payroll Total (Payroll Ratio)
3. Ratio of Average Plant Assets and inventories
4. Combined Ratio of all the above- they will take the weighted average of the above three (the
Three Factor Ratio).
Example 7.2: The following data are given to you for Multi-Product Corporation.
Operating segment
Company Chemica Food Product Total
l
Net Sales – 110,000 90,000 200,000
Traceable expense – 60,000 70,000 130,000
Non-Traceable expense 40,000 – – 40,000
Total expense – – – 170,000
Income Before Tax – – – 30,000
Income taxes (40%) – – – 12,000
Net Income – – – 18,000
Payroll totals 12,000 32,000 48,000 92,000
Average plant assets & inventories 16,000 124,000 276,000 416,000
Instruction: Prepare a statement showing segment profit or loss allocating non-traceable expenses
by three factor ratios.
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Calculation of Three Factor Ratio:
1. Sales Ratio
Total Sales.................................................................................200,000
Sales of Chemical Product Segment.........................................110,000
Percentage of Chemical Product Segment = 110,000 / 200,000 = 55%
Sales of Food Products Segment............................................... 90,000
Percentage of Food Products Segment = 90,000 / 200,000 = 45%
2. Payroll Totals Ratio

Total payroll...........................................................................80,000
Chemical Segment..........................32,000 / 80,000 @ 100 = 40%
Food Segment.................................48,000 / 80,000 @ 100 = 60%
3. Ratio of Plant Asset and Inventories
Total plant asset and inventories............................................400,000
Chemical...................................... 124,000 / 400,000 @ 00 = 31%
Food............................................ 276,000 / 400,000 @ 100 = 69%
4. Calculation of the Three-Factor Ratio
Chemical products segment = (55 + 40 + 31) / 3 = 126 / 3 @ 100 = 42%
Food products segment = (45 + 60 + 69) / 3 = 174 / 3 @ 100 = 58%
Chemical Food Product Total
Statement Showing Profit or Loss Product Segment
Net Sales (A)..............................................................
110,000 90,000 200,000
Expenses:
Traceable expenses....................................................
60,000 70,000 130,000
Non traceable expense allocated on the
basis of three factor ratio of 42% & 58%.................. 16,800 23,200 40,000
Total Expenses (B).....................................................
76,800 93,200 170,000
Before Tax Segment Profit (A-B).............................. 33,200 (3200) 30,000
Example 7.3:
Data for the three operating segments of Buna Company for the year ended June 30, 2003 were as
follows.
Operating Segment.....................................................
Alpha Beta Gamma Total
Segment Revenues:
Sales to unaffiliated customers..................................
200,000 250,000 300,000 750,000
Intersegment sales......................................................
25,000 20,000 15,000 60,000
Traceable expenses:
Inter segment purchase..............................................
30,000 10,000 20,000 60,000
Other traceable expenses............................................
100,000 150,000 250,000 500,000
Non-traceable expenses.............................................
– – – 75,000
Instruction: Prepare a working paper to compute segment profit (loss) of each of the operating
segment of Bunna company for the year ended June 30, 2003 assuming Bunna allocate non-
traceable expenses to operating segment in the ratio of segment sales to sales to unaffiliated
customers.
92
Calculating Ratio of Segment Sales to Sales to Unaffiliated Customers:
Alpha Segment = 200,000 / 750,000 @100=26.67%
Beta Segment = 250,000 / 750,000 @ 100=33.33 %
Gamma Segment=300,000@750,000@ 100= 40%
Total ratio..................................................... 4: 5: 6
Statement showing Segment Revenue and Operating Profit and Loss of Peacock Company for the
year ended June 30, 2003
Alpha Beta Gamma Total
Sales to unaffiliated customers.................................. 200,000 250,000 300,000 750,000
Intersegment sales......................................................
25,000 20,000 15,000 60,000
Segment Revenue (A)................................................
225,000 270,000 315,000 810,000
Traceable Expenses:
Inter segment purchases.............................................30,000 10,000 20,000 60,000
Others traceable expenses..........................................
100,000 150,000 250,000 500,000
Total Purchase............................................................
130,000 160,000 270,000 560,000
Non-Traceable Expense (4: 5: 6)............................... 20,000 25,000 30,000 75,000
Total Expense (B)......................................................
150,000 185,000 300,000 635,000
Operating Profit (A-B)..............................................
75,000 85,000 15,000 175,000
Example 7.4: ROBA Company operates in three different industries, each of which is
appropriately regarded as an operating segment. Segment A contributed 60% of ROBA’s total sales
in the year 2003. Sales for Segment A were Br 900,000 and traceable expenses were Br 400,000 in
the year 2003. ROBA’s total non-traceable expenses for the year 2003 were Br 600,000. ROBA
allocates non-traceable expenses based on the ratio of segment sales to total sales, an appropriate
method of allocation. Prepare a working paper to compute the segment profit or loss for ROBA
Company segment A for the year 2003.
Computation of Segment Profit or Loss for Segment A of ROBA Company for the year 2003
Sales of Segment A................................................................ 900,000
Less: total expenses
Traceable Expenses................................................................400,000
Non-traceable Expenses (60% @ 600,000)...........................360,000
Total Expenses....................................................................... 760,000
Segment A: Operating Profit................................................. 140,000
Example7.5:
The non-traceable expenses of PEACOCK Company for the year ended June 30, 2002 totaled Br
620,000. The net sales, payroll and average plant assets and inventories for the two operating
segments of PEACOCK Company were as follows:
Particulars Chemical Sporting Goods
Net sales.....................................................................
2,800,000 1,200,000
Payroll totals..............................................................
300,000 200,000
Average Plant Assets and inventories........................ 1,420,000 580,000
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Instruction: Prepare a working paper to allocate PEACOCK Company’s non-traceable expenses
to the Chemical Segment and Sporting Goods Segment for the year ended June 30, 2002
assuming that such expenses are allocated on the basis of arithmetic average of the percentage of
net sales, payroll totals and average plant assets and inventories (the three factor ratio):
Calculation of Ratios:
1. Sales Ratio
 Chemical Segment = 2,800,000 / 4,000,000 @ 100 = 70%
 Sporting Goods Segment = 1,200,000 / 4,000,000 @100 = 30%
2. Payroll Ratio
 Chemical Segment = 300,000 / 500,000 @ 100 = 60%
 Sporting goods Segment = 200,000 / 500,000 @ 100 = 40%
3. Average Plant Assets and Inventories Ratio
 Chemical Segment = 1,420,000 / 2,000,000 @ 100 = 71%
 Sporting Goods Segment = 580,000 / 2,000,000 @ 100 = 29%
4. Arithmetic Average of the Three factor Ratio
 Chemical Segment = (70% + 60% + 71%) / 3 = 201 / 3 = 67%
 Sporting Segment = (30% + 40% + 29%) / 3 = 99 / 3 = 33%
 The Three Factor Ratio is 67:33
5. Allocation Non-Traceable Expenses to the two operating segments:
 Chemical Segment = (620,000 @ 67/100) = 415,400
 Sporting goods Segment = (620,000 @ 33/100) = 204,600
Exercise 7.1:
CAD Company allocates non-traceable expenses to its three operating segments in the ratio of net
sales to unaffiliated customers. For the year ended April 30, 2004, relevant data were as follows:
Particular A B C
Revenues (In ETB):
Net sales to unaffiliated customers................ 500,000 300,000 200,000
Inter segment transfers out (sales)................. 80,000 40,000 20,000
Costs and Expenses (In ETB):
Traceable expenses........................................ 400,000 100,000 200,000
Inter-segment transfers-in (purchase from)... 30,000 60,000 50,000
The non-traceable expenses of CAD Company for the year ended then totaled Br 100,000. Prepare a
working paper to compute for each operating segment of CAD Company the following amount of
the year ended April 30, 2004:
 Revenue
 Expenses
 Segment profit or Loss (use column for each industry segment)
Checking Figures:
Segment A Segment B Segment C
Total Expenses...........................................................
480,000 190,000 270,000
Operating profit or loss..............................................
100,000 150,000 (50,000)
94
Exercise 7.2:
Data with respect to the operating segment of AWASH Company for the year ended November 31,
2005 are as follows:
Particulars A B C D Total
 Net sales to outsiders........................................ 80,00 40,000 50,000 10,000 180,000
0
 Inter-segments sales (transfer out)..................... 4,000 8,000 2,000 6,000 20,000
 Inter-segment purchases (transfers-in)............... 8,000 6,000 4,000 2,000 20,000
 Other transferable expenses............................... 18,00 12,000 10,000 20,000 60,000
0
 Non-traceable expenses..................................... – – – – 40,000
Awash allocates non-traceable expenses to operating segments by the following reasonable
methods; 40% to A, 30% to B, 20% to C and 10% to D.
Instruction: Prepare a working paper to compute the segment profit or loss for Awash Company’s
four operating segments for the year ended November 31, 2005:
Checking Figures:
Segments.......................................................
Segment A Segment B Segment C Segment D
Operating Expenses.......................................
42,000 30,000 22,000 26,000
Operating profit or loss..................................
42,000 18,000 30,000 (10,000)
Exercise 7.3:
CANON Company has 3 stores, each of which is an industry segment. The operating results for
each store, before allocating the non-traceable expenses, for the year ended 2004, were as shown
below:
Stores: GG FI DL Total
Net sales................................................................416,000 353,600 270,400 1,040,000
Cost of goods sold.................................................215,700 183,300 140,200 539,200
Gross profit on sales..............................................200,300 170,300 130,200 500,800
Less: Fixed Operating expenses............................ 60,800 48,750 50,200 159,750
Variable Operating expenses........................ 54,700 64,220 27,448 146,368
Total Operating expenses......................................115,500 112,970 77,648 306,118
Income before non-traceable expenses................. 84,800 57,330 52,552 194,682
Non-traceable expenses in the year 2004 were as follows:

Warehouse and Delivery Expenses:
Warehouse Depreciation.................................................................
20,000
Warehouse Operations....................................................................
30,000
Delivery Expenses...........................................................................
40,000
Total Warehouse and Delivery Expenses........................................ 90,000
Corporate Office Expenses:
Advertising Expenses......................................................................
18,000
Corporate Office Salaries................................................................
37,000
Other Corporate Office Expenses....................................................
28,000
Total Corporate Office Expenses..................................................... 83,000
95
Total Non-Traceable Expenses........................................................ Br173,000
Additional Information:
Delivery expense varies with distance and the number of deliveries. The distances from the
warehouse to each store and the number of deliveries made in 2004 were as follows:
Store Miles No of Deliveries Total Miles
GG 150 112 16,800
FI 120 64 12,800
DL 100 104 10,400
Instructions:
A. Allocate company’s non-traceable expenses under each of the following plans; and compute the
income or loss of each store.
Plan 1: allocate all non-traceable expenses on the basis of sales volume
Plan 2: First allocate corporate office salaries and other corporate expenses equally to warehouse
operations and each store; second allocate the resulting warehouse operations expenses, warehouse
depreciation and advertising expenses to each store on the basis of sales volume; and third allocate
delivery expenses on the basis of delivery miles times number of deliveries.
B. Which plan would you advice the management to adopt? Why?
Checking Figures:
GG Store FI Store DL Store Total
Non-traceable expenses Plan 1...................... 69,200 58,820 44,980 173,000
Operating Profit Plan 1..................................
15,600 (1,440) 7,572 21,682
Sales Volume Ratio........................................40% 34% 26% 100%
Delivery miles Ratio......................................42% 32% 26% 100%
Operating Profit Plan 2..................................18,050 (365) 3997 21,682
Answer for Instruction A:
PLAN 1: statement showing the segment income allocating all non-traceable expenses on the basis
of sales volume:
Stores GG Store FI Store DL Store Total
Income before non-traceable expenses (A)......... 84,800 57,300 52,552 194,682
Non-traceable expenses:
Warehouse & delivery expenses: (40:34:26)....... 36,000 30,600 23,400 90,000
Corporate Office Expenses: (40:34:26)............... 33,200 28,220 21,580 83,000
Total Non-traceable expenses (B)....................... 69,200 58,820 44,980 173,000
Operating Profit or Loss...................................... 15,600 (1,490) 7,572 21,682
PLAN 2: Workings:
First step: Allocation of corporate office salaries and other corporate expenses equally to warehouse
operation and stores
Corporate Office Salaries..................................................................Br 37,000
Other corporate office expense.........................................................Br 28,000
Total.................................................................................................. 65,000
Equal allocation to stores & warehouse 65,000/4 = ......................... 16,250
96
Total Warehouse Operation Expenses (30,000 + 16,250) =.............
46,250
Statement Showing the Segment Income or Loss
GG FI DL Total
Store Store Store
Income before allocation of non-traceable expense (A)................ 84,800 57,330 52,55 194,682
2
Less: Non-traceable expenses:
FIRST: Equal allocation of corporate office expense and
corporate office salaries (37,000 + 28,000 = 65,000).................... 16,250 16,250 16,25 48,750
0
SECOND:
(i) Warehouse Operations Expenses on sales basis (40:34:26)...... 18,500 15,725 12,02 46,250
5
(ii) Warehouse Depreciation (40:34:26)........................................ 8,000 6,800 5,200 20,000
(iii) Advertising Expenses (40:34:26)............................................ 7,200 6,120 4,680 18,000
THIRD: Delivery expenses on Delivery miles basis (42:32:26). . 16,800 12,800 10,40 40,000
0
Total Non-traceable expenses (B).................................................. 66,750 57,695 45,55 173,000
5
Operating profit (loss) (A – B)....................................................... 18,050 (365) 3,997 29,682
Answer for Instruction B: the management should adopt plan 2, because it is allocating expenses
on appropriate basis of allocation.
7.1.3 Reporting Disposal of a Business Segment

APB opinion No. 30, deals with the reporting of the disposal of a business segment of a business
that has been sold, abandoned, spin-off or otherwise disposed of or although still operating, is the
subject of a formal plan for disposal. According to APB Opinion No. 30:
1. The APB concludes that the results of continuing operations should be reported separately from
discontinued operations.
2. Any gain or loss from the disposal of a segment of a business should be reported in conjunction
with the related results of discontinued operations.
Form of Reporting the Disposal of a Business Segment:

Income fro continuing operation before income taxes.............................................. xxx
Less: Income tax........................................................................................................ xxx
Income from continuing operations........................................................................... xxx
Discontinued operations:
Income (loss) from operations of discontinued segment, net of tax.......................... xxx
Loss or Gain on the disposal of the discontinued division, net of tax....................... xxx
Net Income (Loss)..................................................................................................... xxx
Income from Continuing Operations:
97
To facilitate comparison, the operating results of the discontinued segment of the enterprise must be
excluded from income from continuing operations for all accounting periods presented in
comparative income statements.
Example 7.6: A Company has 5 Segments:
 Comparative income statements for 3 years 2003, 2004 & 2005 are given
 One segment is disposed in 2004
 For all the three years, income from continuing operations exclude the operating results of
the discontinued segments so that comparison of the continued operation is possible
Income (loss) from Discontinued Operations:

Income (loss), net of applicable income taxes, of discontinued segment, for the year of disposal up
to the measurement data should be included.
Gain (loss) on Disposal of Discontinued Operations:
This includes the following items:
1. Income (loss) from discontinued operations during phase-out period
2. Gain (loss) on the sale of the segment
3. Income taxes allocated to 1 & 2 above
The following are useful information to determine gain (loss) on disposal of discontinued
operations:
 Measurement Date – it is the date on which the decision to dispose the segment is taken
 Disposal Date – it is the actual date of execution of disposal of the segment
 Phase out Period – it is the period between the measurement date and the disposal date. The
time gap between the measurement and actual disposal dates.
Note: If the actual disposal date is in the next accounting period, if a profit is expected, it will not
be recognized until the disposal date. But, if loss is anticipated, then such loss is to be included in
the period of measurement.
Example 7.7: BERUK Company, a diversified manufacturing enterprise had four operating
division engaged in the manufacturing of products in each of the following industries.
 Food products
 Health aids
 Textiles and
 Office equipment
Financial data for the two years ended Dec.31, 2004 and 2003 are shown below:
Particulars Net Sales Cost of Goods Sold Operating Expenses
Industry Segment 2004 2003 2004 2003 2004 2003
Food products.........................
3,500,000 3,000,000 2,400,000 1,800,000 550,000 275,000
Health Aids............................
2,000,000 1,270,000 1,100,000 700,000 300,000 125,000
Textiles...................................
1,580,000 1,400,000 500,000 900,000 200,000 150,000
Office Equipments................. 920,000 1,330,000 800,000 1,000,000 650,000 750,000
Total......................................
8,000,000 7,000,000 4,800,000 4,400,000 1,700,000 1,300,000
On Jan.1st 2004 BRUKE Company adopted a plan to sell the assets and product line of office
equipment division at an anticipated gain. On September 1 st, 2004, the division’s assets and
98
products line were sold for Br 2,100,000 cash at a gain of 640,000 (exclusive of operations during
the phase out period).
BRUKE’s textile’s division has manufacturing plants that produced a variety of textile products. In
April 2004, BRUKE sold one of these plants and realized a gain of 130,000. After this sale the
operations at the plant that was sold were transferred to the remaining 5 textile plants that BRUKE
continued to operate.
In August 2004, the main warehouse of the food products division located on the banks of the larger
river was flooded when the river over flew. The resulting uninsured damage of Br 420,000 is not
included in the financial data above. Historical records indicate that the river normally over flows
every four to five years, causing flood damage to adjacent property. For the two years ended 31st
December 2003 & 2004, BRUKE realized interest revenue on investments of Br 70,000 and Br
40,000, respectively. For the two years ended Dec. December 31st, 2003 & 2004, BRUKE net
income was Br 960,000 and Br 670,000, respectively. Income tax expenses for each of the two
years should be completed at a rate of 40%.
Required: Prepare comparative income statements for BRUKE Company for the years ended
December 31, 2003 & 2004
Solution:
I. Calculation of profit before tax for 2004:
Particulars Food Health Textiles Office
Products Aids Equipment
Net sales......................................... 3,500,000 2,000,000 1,580,000 920,000
Less: Cost of goods sold................. 2,400,000 1,100,000 500,000 800,000
Gross Profit.................................... 1,100,000 900,000 1,050,000 120,000
Less Operating expense.................. 550,000 300,000 200,000 650,000
Operating Profit (loss).................... 550,000 600,000 880,000 (530,000)
II. Calculation of Income from Continuing Segments for 2004:

Food Products...................................................................................... 550000
Health Aids.......................................................................................... 600,000
Textiles................................................................................................ 880,000
Operating income before tax............................................................... 2,030,000
Add: Gain on sale of Plant of textile segment..................................... 130,000
Income before abnormal loss............................................................... 2,160,000
Less: Abnormal loss due to flood damage in Food Segment.............. (420,000)
Income before tax from continuing operation..................................... 1,740,000
Less: Income tax expense (40% @ 1,740,000)................................... (696,000)
Income from continuing operation...................................................... 1,044,000
III.Calculation of profit before tax for 2003:
Particulars Food Health Textiles Office
Products Aids Equipment
Net sales..............................................................
3,000,000 1,270,000 1,400,000 1,330,000
Less: Cost of goods sold......................................1,800,000 700,000 900,000 1,000,000
Gross Profit..........................................................
1,200,000 570,000 500,000 330,000
Less Operating expense....................................... 275,000 125,000 150,000 750,000
99
Operating Profit (loss).........................................
925,000 445,000 350,000 (420,000)
IV. Calculation of Income from Continuing Segment for 2003:
Food Products........................................................................ 925,000
Health Aids............................................................................ 445,000
Textiles................................................................................... 350,000
Operating income before tax..................................................1,720,000
Less: Income tax expense (40% @ 1,740,000)......................(688,000)
Income from continuing operation.........................................1,032,000
V. Calculation of income form discontinued Segment for 2004:

Operating profit (loss)................................................................... (530,000)
Gain on sale of equipment segment............................................... 640,000
Income from discontinued segment............................................... 110,000
Less Income tax expense (0.4 @ 110000)..................................... 44,000
Net income from discontinued operations..................................... 66,000
VI. Other Income for 2004:
Interest on investment .................................................................... 70,000
Less: Income Tax expense at 40%..................................................... (28,000)
Net Income ...................................................................................... 42,000
VII. Calculation of Income (Loss) from Discontinued Operation for 2003:
Operating losses.......................................................................... (420,000)
Tax savings on loss @ 40%....................................................... 168,000
Operating loss from Discontinue Segment.............................. 252,000
VIII. Calculation of Other Income for 2003:

Interest on Investment................................................................ 40,000
Less: Income tax expense @ 40%............................................ 16,000
Net Income.................................................................................. 24,000
BRUKE Co
Comparative Income Statement
For the years ended Dec. 31, 2003 and 2004
2003 2004
Income from continuing segment........................................ 1,044,000 1,032,000
Profit/loss from discontinued operation............................... 66,000 (252,000)
Other income....................................................................... 42,000 24,000
Net Income.......................................................................... 1,152,000 804,000
Example 7.8: CRESCENT Company had a net income of Br 600,000 for the year ended
December 31, 1998, after inclusion of the following events or transactions that occurred during the
year:
1. The decision was made on January 2nd, to dispose the Block operating segment
2. The Cinder Block operating segment was disposed on July 1st, 1998
100
3. Operating income from Jan 2nd to June 30th for the Block operating segment amounted to
Br 90,000 before income taxes
4. Cinder Block operating segments net assets with a carrying amount of Br 250,000 were
disposed of for Br 100,000.
CRESCENT Company was subject to income taxes at the rate of 40%.

Required:
A. Prepare a working paper to compute CRESCENT Company’s income from continuing
operations for the year ended Dec. 31, 1998.
B. Prepare a working paper to compute current total income taxes for the year ended Dec. 31 st,
1998
Solution:
A. Computation of income from continuing operations of CRESCENT Company for the year
ended Dec.31, 1998.
Net Income of the Company (i.e. after 40% tax)..................................................................... 600,000
Add: Income taxes (600,000/ 60%) @ 40%............................................................................ 400,000
Income before taxes................................................................................................................ 1,000,000
Less: Operating Income of the Cinder Block Segment during the phase out period................ (90,000)
Sub-totals................................................................................................................................ 910,000
Add: loss o the disposal of Cinder Block Segment (250,000 – 100,000)................................. 150,000
Income from continuing operations before tax........................................................................ 1,060,000
B. Computation of total income taxes of CRESCENT Company for the year ended December 31,
1998.
Income from cont. operations.............................................................. 1,060,000
Less: Income tax @ 40%.....................................................................(424,000)
Income from continuing operation...................................................... 636,000
Income (loss) form discontinued operation.........................................
90,000
Loss on disposal of discontinued segment..........................................
(150,000)
Loss from the discontinued segment ..................................................
(60,000)
Income tax saving at 40% (60,000 @ 40%)........................................ 24,000 (36,000)
Net income of the company................................................................. 600,000
Income tax for continuing operations.................................................. 424,000
Less: tax saving in disc co. operation..................................................(24,000)
Total Income tax.................................................................................. 400,000
Example 7.9: TATA Company’s accounting records for the year ended August 31, 2004 include
the following data with respect to Wallace division, an operating segment. Sale of net assets of that
division to Excel Enterprise for Br 300,000 was authorized by TATA’s BODs on August 31 st, 2004.
Closing date of disposal was expected to be February 28, 2005.
Wallace Davison
Net sales for the year ended August 2004...............................................200,000
Cost & Expense........................................................................................ 50,000
Estimated Operating losses for 6 months ending February 28, 2005...... 40,000
Estimated carrying amount of net assets Feb. 28, 2005...........................330,000
101
TATA’s income tax rate is 40%, for the year ended August 31 st, 2004 and TATA had Br 640,000
income from continuing operations before income taxes
Instruction: Prepare a partial income statement for TATA Company for the year ended August
31st, 2004 to present for the foregoing information.
Solution:
Partial income statement of TATA Company for the year ended August 31 st,
2004
Income from continuing operation before tax ............................................. 640,000
Income tax expense @ 40% ........................................................................ (256,000)
Income from continuing operations ............................................................. 384,000
Discontinued operations (Wallace Division)
Income from operations discontinued segment
For the year ended August 31st, 2004 (200,000 – 150,000) = 50,000
Less: Tax................................................................................ (20,000)
Income from operations of Discontinued Segment .............. 30,000
Gain (loss) on disposal of discontinued segment
Operating loss during the phase-out period...........................40,000
Loss on disposal of dis. Segment (330,000 – 300,000) = 30,000
Gain (loss) on disposal of discontinued segment...................(70,000)
Tax saving (70,000 @ 40%).................................................. 28,000
Loss on disposal of discontinued segment................................................ (42,000)
Net income................................................................................................. 372,000
Exercise 7.4: For the year ended June 30, 2006 DISCO Company which has an income tax rate of
40% had the following pre-tax amount
1. Income from continuing operation Br 1,000,000
2. Loss from disposal of net assets of discontinued division “X” (an operating segment) of Br
60,000
3. Loss from operation of division X from July 1st through the measurement date march 31st 2007
amounted Br 150,000
4. Losses from operations of division X from April 1st, 2007 through the disposal date, May 31,
2007 is Br 20,000
Instruction: Prepare a partial income statement for DISCO Company for the year ended June 30,
2006 beginning with income from continuing operation
Exercise 7.5 CHIKO Company’s accountant prepared the following comparative income statement
CHIKO Company
Income statement
December 31, 2001, 2002, 2003
102
Particulars 2003 2002 2001

Net sales.........................................................
10,000,000 9,600,000 8,8000,000
COGS.............................................................
6,200,000 6,000,000 5,400,000
Gross Profit....................................................
3,800,000 3,600,000 3,400,000
Operating Expenses....................................... 2,200,000 2,400,000 2,100,000
Income from Operations................................ 1,600,000 1,200,000 1,300,000
Gain on disposal of a segment.......................900,000 – –
Income before income tax.............................. 2,500,000 1,200,000 1,300,000
Income tax expense........................................ 1,000,000 480,000 520,000
Net income.....................................................
1,500,000 720,000 780,000
During the audit, it is discovered that CHIKO Company entered into contract on January 2 nd, 2003
to sell for 3,200,000, the assets and product line of one of its operating segments. The sale was
completed on December 31, 2003, for a gain of Br 900,000 before income taxes. The discontinued
operations contribution to CHIKO’s income before income taxes for each year was as follows:
2003 2002 2001
Br 640,000 loss Br 500,000 loss Br 200,000
Required: Prepare Correct Partial Comparative Income Statements for the three years ended
December 31, 2003 assuming that income from discontinued segment were ignored. Begin the
income statement with income from continuing operation before income taxes.
7.2 Interim Financial Reporting

Generally financial statements are issued at the end of the fiscal year. In APB Opinion No. 28, the
Accounting Principles Board adopted the integral theory for interim reports of a fiscal year. Under
this, each interim period is considered an integral part of the annual reporting period rather than a
discrete accounting period. Thus, many enterprises issue complete financial statements for interim
accounting periods during the course of a fiscal year. For example, a closely held company with
outstanding bank loans may be required to provide monthly or quarterly financial statements to the
lending bank. The Securities and Exchange Commission listing agreements require the listed
companies to publish quarterly interim financial statements. The APB established guidelines for
following components of interim financial reports: revenue, costs associated revenue, all other costs
and expenses, and income taxes expense
1. Revenue: Revenue from products sold or services rendered should be recognized for an interim
period on the same basis as followed for the full year.
2. Cost Associated with Revenue
Cost and expenses directly associated with or allocated to products sold or services rendered
required the same accounting in interim financial reports as in a fiscal-year financial statements.
The following are exceptions:
 Enterprise that uses Gross Margin Method to estimate cost should disclose this fact in
interim financial report. Material adjustments reconciling inventories with annual physical
inventories should be disclosed.
 Enterprise that use LIFO inventory method should include the estimated cost of replacing
the depleted LIFO base layer.
 Lower of cost or market write downs of inventories should be provided for interim periods
as for complete period unless decline in inventory on interim date is considered temporary.
103
 Enterprise using Standard Cost should report Standard Cost Variances for interim report.
Calculation of Cost of Goods Sold:
Example 7.10: LUNA Company sells a single product which it purchases from three different
vendors. On August 31, 2002, LUNA’s inventory of the product consisted of 1,000 units at FIFO
Cost of Br 7,500. LUNA’s merchandise transactions, for the year ended December August 31,
2003, were as follows:
Units Cost Units End of Quarter

Quarter Ended
Purchased per unit Sold Replacement Cost
Nov. 30, 2003 5,000 Br 8.00 4,500 Br 8.50
Feb. 28, 2003 6,000 Br 8.50 7,000 Br 9.00
May 31, 2003 8,000 Br 9.00 6,500 Br 8.50
Aug. 31, 2003 6,000 Br 8.50 5,500 Br 9.50
Compute LUNA Company’s COGS for each of the quarters of the year ended December 31, 2003
assuming that declines were not considered to temporary. Show your computations:
Quarter I: Sales 4,500 units
I. Cost of Goods Sold:
 1,000 units @ Br 7.50............................................................ 7,500
 3,500 units @ Br 8.00............................................................28,000
 4,500 units..............................................................................35,500
II. Ending (Closing) Inventory:
 Ending Inventory Units = (1,000 + 5,000 – 4,500) =...... 1,000 units
 Inventory at FIFO Cost = (1,500 @ Br 8.0)....................Br 12,000
 Inventory at Market Price (1,500 @ Br 8.50).................. 12,750
 Ending Inventory at LCM................................................ Br 12,000
Quarter II: Sales 7,000 units
 1,500 units @ Br 8.00...................................................... 12,000
 5,500 units @ Br 8.50...................................................... 46,750
 7,000 units........................................................................ 58,750
 Ending Inventory Units = (1,500 + 6,000 – 7,000).......... 500 units
 Inventory at FIFO Cost = (500 @ Br 8.50)..................... Br 4,250
 Inventory at Market Price (500 @ Br 9.00)..................... 4,500
 Ending Inventory at LCM................................................ Br 4,250
Quarter III: Sales 6,500 units
 500 units @ Br 8.50......................................................... 4,250
 6,000 units @ Br 9.00...................................................... 54,000
 6,500 units........................................................................ 58,250
 Add: the excess of actual cost of Ending
104
Inventory Over the replacement cost
(500 + 8000 – 6500) = 2,000 @ Br 0.50.......................... 1.000
 Ending Inventory at LCM.......................................... Br 59,250
 Ending Inventory Units = (500 + 8,000 – 6,500) =... 2,000 units
 Inventory at FIFO Cost = (2,000 @ Br 9.0)..............Br 18,000.00
 Inventory at Market Price (2,000 @ Br 8.50)............ 17,000.00
 Ending Inventory at LCM..........................................Br 17,000.00
Quarter IV: Sales 5,500 units

 2,000 units @ Br 9.00................................................ 18,000
 3,500 units @ Br 8.50................................................ 29,750
 5,500 units.................................................................. 47,750
 Less: Write-off in earlier Quarter as the
The market price has gone down...................... 1,000
 Cost of Goods Sold.............................................. Br 46,750
 Ending Inventory Units = (2,000 + 6,000 – 5,500) = 2,500 units
 Inventory at FIFO Cost = (2,500 @ Br 8.50)............ Br 21,250
 Inventory at Market Price (2,500 @ Br 9.50)............23,750.00
 Ending Inventory at LCM.......................................... Br 21,250
Example 7.11: PUBLIC Company, which uses the perpetual inventory and LIFO method of
valuing inventory, has temporarily depleted base layer of its inventory with a cost of Br 85,000
during the third Quarter of its fiscal year ending February 28, 2005. Replacement Cost of the
depleted inventory was Br 105,000 on November 30, 2004. On December 31, 2004 PUBLIC made
its first purchases of merchandise during the Fourth Quarter at a total cost of Br 180,000 on open
account (credit basis). Prepare journal entries for PUBLIC COMPANY on November 30 and
December 31, 2004
November 30, 2004: depleted LIFO Base layer is Br 105,000 – 85,000 = Br 20,000
Cost of Goods Sold.................................................................................................20,000
Liability Arising from Depletion of Base Layer of LIFO Inventories........ 20,000
December 31, 2004:
Inventories ..................................................................................................... 160,000
Liability Arising from Depletion of Base Layer of LIFO Inventories .......... 20,000
Trade Accounts Payable........................................................... 180,000
3. All Other Cost and Expenses
 All other costs and expenses are allocated to interim periods as incurred or on the basis of
time expired, benefit received, or activity associated with the periods.
4. Income Taxes Expense
 To estimate income taxes expense for interim periods, a business enterprise must estimate an
effective income tax rate for the full fiscal year at the end of each interim period and
apply the estimated rate to year-to-date pre-tax income.
105
 The result is reduced by income taxes expense provided for prior interim periods to obtain
income taxes expense for the current interim period.
Example 7.12: MAXIMA Corporation’s statutory income tax rate is 40%. MAXIMA forecasts
Pre-tax accounting income of Br 300,000 for the year ending April 30, 1997, and no temporary
differences exists between pre-tax accounting income and taxable income. MAXIMA forecasts the
following permanent differences between pre-tax accounting income and taxable income for the
year ending April 30, 1997.
Dividend Received............................................................................................ Br 60,000
Goodwill Amortization..................................................................................... 30,000
Instruction: Compute MAXIMA Corporation’s estimated effective income tax rate (EEITR) for
the year ending April 30, 1997
Solution:
Pre-tax accounting income............................................................... Br 300,000
Add: Amortization of Goodwill (non-deductible expense).............. 30,000
Less: Dividend Received.................................................................. (60,000)
Estimated Taxable Income............................................................... 270.000
Income tax expense (270,000 @ 40%)............................................. 108,000
EEITR = Income tax / Pre-tax accounting income
EEITR = Br 108,000 / 300,000 = 36%
Example 7.13: BAKO Company has a fiscal year ending on April 30. On July 31, 2001, the end
of the 1st Quarter of 2002, BAKO had an effective income tax rate of 55% for 2002. On October 31,
2001, the end 2nd Quarter of 2002, BAKO estimated an Effective Tax Rate of 52%. Pre-tax
accounting income for BAKO was as follows:
 For the three months ended July 31, 2001......................................... Br 600,000
 For the three months ended October 31, 2001................................... Br 750,000
Instruction: Prepare Journal Entries for Income tax expenses of BAKO Company on July 31 and
October 31, 2001
Solution:
Income tax expense for Quarter ended July 31, 2001 (600,000 @ 55%) = Br 330,000
Journal Entry:
Income Tax Expense........................................................................330,00
0
Income Tax Payable....................................................... 330,000
Income tax expense for Quarter ended October 31, 2001:
Cumulative Income for Quarters ending October 31, 2001 (600,000 + 750,000) = 1,350,000
Cumulative Income Tax Expense for two Quarters (1,350,000 @ 52%).................. 702,000
Less: Income tax expense for the 1st Quarter............................................................. (330,000)
Income tax expense for the 2nd Quarter.................................................................... 372,000
Journal Entry:
0
106
Example 7.14:
For its first two quarters of Calendar year 2006, this is its fiscal year; ENTOTO Company had the
following data:
Quarter Ended Pre-tax Financial Income EEITR for the Year
March 31, 2006 500,000 38.6%
June 30, 2006 600,000 41.2%
Prepare Journal Entries for ENTOTO Company to accrue income tax expenses for the 1 st two
quarters of 2006
Solution:
Quarter 1:
Income tax expense for Quarter ended March 31, 2006 (500,000 @ 38.6%) = Br 193,000
Journal Entry:
0
Quarter 2:
Cumulative Income for two Quarters (500,000 + 600,000)................................ 1,100,000
Cumulative Income Tax Expense for two Quarters (1,100,000 @ 41.2%)......... 453,200
Less: Income tax expense for the 1st Quarter....................................................... (193,000)
Income tax expense for the 2nd Quarter.............................................................. 260,200
Journal Entry:
0
Example 7.15: On January 31, 2002, the end of the 1st Quarter of its fiscal year ending October
31, 2002, KASCO Company had the following ledger account balances:
 Income tax expense....................................................................................... Br 160,000
 Liability arising from depletion of Base layer of LIFO inventory................ 30,000
On February 1, 2002 KASCO purchased merchandise costing Br 110,000 on account and on April
30, 2002, KASCO estimated total income tax expense of Br 340,000 for the six month ended on
that date. KASCO uses the perpetual inventory system. Prepare journal entries for KASCO
Company on February 1, and April 30, 2002, for the foregoing facts
February 1, 2002:
Inventories......................................................................................................80,000
Liability Arising from Depletion of Base Layer of LIFO Inventories ..........30,000
Trade Accounts Payable................................................................. 110,000
April 30, 2002:
Cumulative Income Tax for two Quarters..................................................... 340,000
Less: Income tax expense for the 1st Quarter.................................................(160,000)
Income tax expense for the 2nd Quarter........................................................ 180,000
Journal Entry:
0
107
Disclosure of Interim Financial Data

As minimum disclosure, APB Opinion No. 28 provided that the following data should be included
in publicly owned enterprise’s interim financial reports to stockholders. The data are to be reported
for the most recent quarter and the year to date, or 12 months to date of the quarter’s end:
 Sales or gross revenue, income tax expenses, extraordinary items, cumulative effect of a
change in accounting principle or practice, and net income
 Basic and diluted earnings per share data for each period presented
 Seasonal revenue, costs, or expenses
 Significant changes in estimates or provisions for income taxes
 Disposal of a business segment and extraordinary, unusual, or infrequently occurring items
 Contingents items
 Changes in accounting principle or estimate
 Significant changes in financial position
The FASB has required the following additional disclosures for reportable operating segments in
interim reports: revenues from external customers; Intersegment revenues; segment profit or loss;
segment assets if material changes have occurred since the most recent year-end financial
statements; description of differences from last annual report in the basis for segmentation or for the
measurement of segment profit or loss; and reconciliation of total reportable segments’ profit or loss
to the enterprise’s pre-tax income from continuing operations. The minimum requirements are:
 Sales or gross revenue,
 Income taxes expense,
 Net income, and
 Basic and diluted earnings per share data
REPORTING FOR SEC

SEC has Enforcement Actions Dealing with Wrongful Application. SEC enforced numerous actions
for overstatements of quarterly earnings reported in Form 10-Q. Techniques used in such
overstatements are
 Premature recognition (“front-ending”) of revenues
 Creation of fictitious inventories
 Use of improper Gross Margin percentages
 Improper deferral of cost that should have be recognized as expense
 Overstatement of percentage of completion on construction-type contracts.
Problem 7.1:
AKT Company allocates non-traceable expenses to operating segments on the basis of sales ratio. It
is a diversified manufacturing enterprise had four operating division engaged in the manufacturing
of products in each of the following industries.
 Electronics Division
 Medical Equipments Division
 Office equipment
Financial data for the year ended December 31, 2004 are shown below:
108
Industry Segment Net Sales Cost of Goods Operating

Sold Expenses
Electronics Division................... 2,400,000 1,650,000 215,000
Medical Equipments.................. 1,600,000 800,000 325,000
Office Equipment....................... 1,200,000 1,100,000 150,000
Total........................................... 5,200,000 3,550,000 690,000
On
December 31, 2004; AKT Company adopted a plan to sell the office equipment division at an
anticipated loss. The discontinued segment will be disposed at a loss of Br 70,000 and loss form
operating the discontinued segment during phase out period estimated to be Br 60,000. AKT
Company disposed one of the manufacturing plant assets of Medical Equipments division during
year 2004 and realized a gain of Br 80,000. Required: Prepare partial income statements for the
year ended December 31, 2004, assuming AKT Company’s income tax rate is 40%, Br 120,000
non-traceable expense, and only the three industry segments. Back up the income statement with the
necessary computations
109
Text Book and References
Text Book:
E. John Larsen (2003), Modern Advanced Accounting, 9th Edition, The McGraw-Hill Companies,
Inc, USA
References:
Beams, Anthony, Clement, and Lowensohn (2003), Advanced Accounting, 8th Edition, Prentice
Hall Business Publishing, USA
Baker, Lembke, and King (1999), Advanced Financial Accounting, Fourth Edition, the McGraw-
Hill Companies, Inc., USA
Hoyle, Schaefer, and Doupnik (2004), Advanced Accounting, 7th Edition, The McGraw-Hill
Companies, Inc,USA,
110

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Chapter Four: Business Combinations

4.1 Business of Combination: An Overview

Friendly Takeovers Hostile Takeovers

4.1.2 Classes of Business Combinations

4.1.3 Types of Business Combinations

4.2 Business Combinations: Why?

6. Diversification of Business Risk

8. Elimination of Fierce Competition

10. Getting financial gains

4.3 Methods for Arranging Business Combinations

Summary of Methods for Arranging Business Combinations

Type of Combination Action of Acquiring Company Action of Acquired Company

4.4) Determination of the Price for a Business Combination

Capitalization of Expected Average annual earnings

4.5) Accounting Methods for Business Combinations

Attributes of the Combining Companies

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

6. Consolidation of Financial Statement and Accounting after business combinations - the

1. Determination of the Combinor

2. Determination of the Acquisition Cost

Subsequent Issuance of Contingent Consideration

3. Allocation of the Acquisition Cost

5. Recording the Acquisition

Books of Combinee Company (Acquired Company)

Books of Combinor Company (Acquiring Company)

Calculation of Net Assets at CFV:

2. Recording Direct out-of-pocket costs (legal and finder’s fee)

4. Recording Assets and liabilities (Allocation)

META COMPANY (Combinee)

SAXON Corporation (Combinor)

Amount of goodwill................................................................................... Br 116,250

META COMPANY (Combinee)

Other Current Assets..................................................... 120,000

6. Financial Statement and Accounting after business combinations

Disclosure of Business Combinations in a Note to the Financial Statements

Disclosures under the Purchase Method

Purchase Accounting for Statutory Consolidation

On December 31, Year 1999, in a statutory consolidation approved by shareholders of both

To record consolidation of Lamson corporation and Donald company as a purchase

To record payment of costs incurred in consolidation of Lamson Corporation and Donald

Appraisal of Accounting Standards for Business Combinations

Criticism of Purchase Accounting:

Total Acquisition Cost............................................................975,000

Beta had the following balance sheet on December 31, 2006:

5.1) Basic Concepts of Consolidated Financial Statements

The Parent and Subsidiary Relationships

Example of Controlling Interest

Parent Company’s control of a subsidiary might be achieved indirectly as follows:

Criticism of Traditional concept of control

FASB’S proposed redefinition of Control

Steps for Consolidation

5.2) Consolidation of Wholly Owned Subsidiary on the Date of Business

Example 5.1: There is no question of control of a wholly owned subsidiary. Thus, as an

Preparation of Consolidated Balance Sheet

Palm Corporation and Subsidiary

Working Paper Elimination Journal Entries shown below:

XYZ Corporation and ABC Company

Consolidated Balance sheet

Working Paper Elimination in the form of Journal Entries: