Modern Advanced

Accounting
Modern Advanced
Accounting
Tenth Edition

E. John Larsen
University of Southern California

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MODERN ADVANCED ACCOUNTING
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Library of Congress Cataloging-in-Publication Data

Larsen, E. John.
Modern advanced accounting/E. John Larsen.--10th ed.
p. cm.
Includes index.
ISBN 0-07-292255-9 (alk. paper)
1. Accounting. I. Title.
HF5635.L3267 2006
657’.046--dc22 2004059223

www.mhhe.com
Preface
A MODERN APPROACH TO ADVANCED ACCOUNTING
Like the nine editions preceding it, Modern Advanced Accounting, 10e, provides students with
the tools necessary to succeed in the modern world of accounting. The emphasis throughout
the book is on financial accounting concepts and on the application of those concepts to prob-
lems arising in both business and nonbusiness organizations. Specialized accounting entities
such as partnerships and affiliated companies and topics such as international accounting
standards and business segments are dealt with in terms of current-day accounting issues. The
book continues to earn high praise from reviewers and adopters for the following:

Case Studies That Challenge Students to Get Beyond the Basics

Modern Advanced Accounting, 10e, continues to emphasize case studies involving analyti-
cal and conceptual thinking on both accounting and ethical issues, some of which require
students to research suggested references on the Internet. These cases challenge students to
stretch their thinking beyond the basic accounting issues.

A Special Emphasis on Ethics

Modern Advanced Accounting begins with a chapter on ethical issues in accounting, and in-
tegrates coverage of ethics as appropriate in the subsequent chapters. Coverage of ethical
issues in those chapters is denoted by a special icon. The ethics codes of the AICPA, FEI,
and IMA are presented, along with summaries of numerous SEC Accounting and Auditing
Enforcement Releases and illustrations of financial accounting and reporting from public
companies’ financial reports.

Extensive End-of-Chapter Material to Ensure Mastery of the Material

The learning and assignment material provided at the end of the chapter is divided into four
groups: review questions, exercises, cases, and problems. Review questions may be used by
students as a self-testing and review device to measure comprehension of key points. Exer-
cises typically cover a specific point or topic and do not require extensive computations.
Cases require analytical reasoning, but generally require little or no quantitative data. Stu-
dents are required to analyze business situations, to apply accounting standards, and to pro-
pose or evaluate a course of action. Finally, the problems demonstrate the concepts presented
in the theoretical discussion included in the chapter. Ample opportunity exists to vary
homework assignments from term to term.

A UNIQUE ORGANIZATION TO FACILITATE LEARNING

Following the first chapter on ethical issues in advanced accounting, the remaining 18 chap-
ters are grouped into five areas of concentration to facilitate the planning and presentation
of the subject matter and make it easier for students to learn and retain the concepts and
procedures presented.

Part One: Accounting for Partnerships and Branches (Chapters 2 through 4)

Following ethical issues in Chapter 1, the first section deals with the accounting principles
and procedures for partnerships, joint ventures, and branch operations. Partnerships (lim-
ited liability, general, and limited) and joint ventures are covered in Chapters 2 and 3, which
take the student from the basic concepts of partnership accounting often presented in an
v
vi Preface

introductory accounting course to the more complex problems of income sharing, realign-
ment of partners’ equities, and liquidation. Chapter 4, which deals with home office–branch
relationships and combined financial statements, provides a logical stepping-stone to the
six chapters dealing with business combinations and consolidated financial statements.

Part Two: Business Combinations and Consolidated Financial

Statements (Chapters 5 through 10)
The sequencing of topics in Chapters 5 through 10 is designed to take the student from the
less complex date-of-business combination accounting and financial statement display is-
sues to the more rigorous features of post-combination accounting and display matters.
Where appropriate, provisions of the FASB’s proposed Statement, “Consolidated Financial
Statements: Purpose and Policy,” are discussed in Chapters 6 through 10.

Part Three: International Accounting: Reporting of Segments, for Interim

Periods, and to the SEC (Chapters 11 through 13)
The many complex matters involved in international accounting are discussed in Chapters 11
and 12, which emphasize the increasing importance and impact of the International Ac-
counting Standards Board. The three topics covered in Chapter 13 are indirectly related to
the subject matter of Chapters 11 and 12 and thus are included here.

Part Four: Accounting for Fiduciaries (Chapters 14 and 15)

The fourth section of the book includes chapters entitled “Bankruptcy: Liquidation and Re-
organization” and “Estates and Trusts.” Although some instructors may not cover these two
traditional topics in their courses, I believe that it is imperative to include them for those
who wish to do so. Many accountants in today’s practice environment must assist clients
with problems of bankruptcy, liquidation, reorganization, and the accounting for estates and
trusts.

Part Five: Accounting for Nonbusiness Organizations (Chapters 16 through 19)

In Chapters 17 through 19, students progress from accounting and financial statement display
issues for a governmental entity’s general fund through its other governmental-type funds to
its proprietary and fiduciary funds and its comprehensive annual financial report. No specific
type of nonprofit organization is emphasized in Chapter 16; instead, an overview of account-
ing and reporting issues for various such organizations are dealt with; and in Chapter 19 stu-
dents are referred to a Journal of Accountancy that illustrates a city’s financial statements.

NEW TO THE TENTH EDITION

The text and supplementary materials have been revised to reflect the latest accounting pro-
nouncements and standards, including:
• The Sarbanes-Oxley Act of 2002 and its creation, the Public Company Accounting Over-
sight Board, in Chapters 1 and 13.
• The Financial Accounting Standards Board’s reexamination of purchase accounting for
business combinations in Chapter 5.
• Variable interest entities and special purpose entities in Chapter 6.
• Financial Accounting Standards Board/International Accounting Standards Board con-
vergence project in Chapter 11.
• FASB Interpretation No. 46 (original and revised), “Consolidation of Variable Interest
Entities” in Chapter 6.
 Preface vii

• FASB Statement No. 144, “Accounting for the Impairment or Disposal of Long-Lived
Assets” in Chapter 13.
• GASB Statement No. 42, “Accounting and Reporting for Impairment of Capital Assets
and for Insurance Recoveries” in Chapter 18.
• GASB Statement No. 41, “Budgetary Comparison Schedules—Perspective Differences”
in Chapter 19.
• GASB Statement No. 44, “Economic Condition Reporting: The Statistical Section” in
Chapter 19.

A COMPREHENSIVE ARRAY OF SUPPLEMENTS TO FACILITATE

TEACHING AND LEARNING
Modern Advanced Accounting, 10e, is accompanied by a comprehensive package of sup-
plementary items for both students and instructors.
The Study Guide/Working Papers (ISBN: 007299116X) supplement is available for
students to purchase. The Study Guide, prepared by the author, is designed to help students
measure their progress by providing immediate feedback. It contains an outline of the im-
portant points for each chapter, plus a variety of objective questions, short exercises, and a
case. Answers to the questions, exercises, and case are at the end of each Study Guide chap-
ter to help students evaluate their understanding of the subject matter.
Accounting Working Papers for the problems are included in the same supplement as the
Study Guide. On these working papers the organization names, problem numbers, numer-
ous headings, and some preliminary data (such as trial balances) have been entered to save
students time and to facilitate review by the instructor.
The Instructor’s Resource CD-rom (IRCD, ISBN: 0072993995), prepared by the au-
thor of the text, is a comprehensive resource for instructors combining several teaching
supplements into one easy-to-use format. The IRCD contains the following:
• Instructor’s Resource Guide: This teaching aid is designed to assist instructors in prepar-
ing assignments and in covering the material in class. It includes a description of end-of-
chapter coverage, suggested assignments, objectives of chapter and suggested teaching
approach, and review of the chapter.
• Solutions Manual: The Solutions Manual contains answers to all review questions, ex-
ercises, cases, and problems in the text. In addition, at the beginning of each chapter,
there are short descriptions, time estimates, and difficulty ratings for each of the prob-
lems to help instructors to choose problems that best fit the needs of their individual
courses in terms of scope, level, and emphasis.
• Test Bank: The Test Bank contains true/false and multiple choice questions, short problems,
and a case for each chapter. Complete answers are provided for all questions, problems,
and cases.
• Computerized Test Bank: It can be used to create different versions of the same test,
change the answer order, edit and add questions, and conduct online testing.
• PowerPoint ® Slides: PowerPoint ® lecture outlines are provided for all chapters.
Online Learning Center with PowerWeb (URL: www.mhhe.com/larsen10e) is a book-
specific website that includes the following:
• PowerWeb: This feature is a unique website that extends the learning experience beyond
the core textbook and includes the following learning aids:
• Current readings with assessments
• Study tips and self-quizzes
viii Preface

• Links to related sites

• Web research guide
• Access to Northern Light Search Engine providing Internet access to additional
articles
• Online Quizzes: Interactive quizzes provide an additional opportunity for self-study and
review
• Text Updates: As appropriate, new standards and pronouncements are posted to the
Online Learning Center.
• Professional Resources: Links to appropriate professional resources are also provided.
Acknowledgments
I am deeply grateful to the following key players in the development of the Tenth Edition
of Modern Advanced Accounting:
• My beloved wife, Kathleen, whose enthusiasm for the Tenth Edition—the eighth that
she has assisted me in producing—led to her finding time in her busy career for proof-
reading and making suggestions on content of chapters, as well as providing encourage-
ment during trying times.
• The primary McGraw-Hill/Irwin editors with whom I dealt: Editorial Assistants Andy
Set and Jennifer Jelinski, who skillfully dealt with original manuscript, communication
with copyright waiver grantors, and overall logistical problems, always with patience
and warmth.
• The McGraw-Hill/Irwin book team—Marketing Manager Rich Kolasa, Executive
Editor Tim Vertovec, Project Manager Bruce Gin, Production Supervisor Debra R.
Sylvester, Designer Mary Kazak, Media Producer Victor Chiu, and Supplement Pro-
ducer Matt Perry—for their encouragement, patience, and extreme professionalism.
• The Financial Accounting Standards Board and the Governmental Accounting Stan-
dards Board, for permission to quote from Statements, Discussion Memoranda, Inter-
pretations, and Exposure Drafts. Portions of various FASB documents, copyright
by Financial Accounting Standards Board, 401 Merritt 7, P.O. Box 5116, Norwalk,
Connecticut 06856-5116, U.S.A., are reprinted with permission. Complete copies of
these documents are available from the FASB. Portions of various GASB documents,
copyright by Governmental Accounting Standards Board, 401 Merritt 7, P.O. Box 5116,
Norwalk, Connecticut 06856-5116, U.S.A., are reprinted with permission. Complete
copies of these documents are available from the GASB.
• The McGraw-Hill Companies for permission to reproduce in Chapter 13 excerpts from
the 2003 annual report of The McGraw-Hill Companies.
• Ronald R. Barnes, Executive Director/Trustee of The Kenneth T. and Eileen L. Norris
Foundation, for permission to reproduce the Foundation’s financial statements in
Chapter 16.
In addition to the numerous reviewers who have provided comments and suggestions for
prior editions, I wish to especially thank those who provided feedback in preparation for this
edition:
Eric Carlsen J. Edward Ketz
Kean College of New Jersey Penn State University
Joanne Duke Reg Rezac
San Francisco State University Texas Women’s University
George F. Gardner James Yang
Bemidji State University Montclair State University
Arthur A. Hiltner
University of North Dakota

ix
Brief Contents
Preface v 11 International Accounting Standards;
Accounting for Foreign Currency
1 Ethical Issues in Advanced Transactions 478
Accounting 1 12 Translation of Foreign Currency Financial
Statements 503
PART ONE 13 Reporting for Components; Interim
Accounting for Partnerships Reports; Reporting for the SEC 541
and Branches 25
2 Partnerships: Organization and PART FOUR
Operation 25 Accounting for Fiduciaries 607
3 Partnership Liquidation and Incorporation; 14 Bankruptcy: Liquidation and
Joint Ventures 75 Reorganization 607
4 Accounting for Branches; Combined 15 Estates and Trusts 638
Financial Statements 121
PART FIVE
PART TWO Accounting for Nonbusiness
Business Combinations and Consolidated Organizations 670
Financial Statements 164
16 Nonprofit Organizations 670
5 Business Combinations 164
17 Governmental Entities: General Fund 714
6 Consolidated Financial Statements:
18 Governmental Entities: Other
On Date of Business Combination 207
Governmental Funds and Account
7 Consolidated Financial Statements: Groups 748
Subsequent to Date of Business
19 Governmental Entities: Proprietary Funds,
Combination 261
Fiduciary Funds, and Comprehensive
8 Consolidated Financial Statements: Annual Financial Report 780
Intercompany Transactions 322
9 Consolidated Financial Statements: GLOSSARY 814
Income Taxes, Cash Flows, and INDEX 825
Installment Acquisitions 385
10 Consolidated Financial Statements:
Special Problems 429

PART THREE
International Accounting: Reporting
of Segments, for Interim Periods,
and to the SEC 478

x
Contents

Preface v Income-Sharing Plans for Limited Liability

Partnerships 29
Partners’ Equity in Assets versus Share in Earnings 29
Chapter 1 Division of Net Income or Loss 29
Ethical Issues in Advanced Accounting 1 Financial Statements for an LLP 36
Scope of Chapter 1 Correction of Partnership Net Income of
What Is Fraudulent Financial Reporting? 2 Prior Period 39
An Example of Fraudulent Financial Reporting 2 Changes in Ownership of Limited Liability
Ethical Standards for Preparers of Financial Statements Partnerships 39
and Financial Reports 3 Accounting for Changes in Partners 39
Significant Events in the Establishment of Ethical Accounting and Managerial Issues 40
Standards for Management Accountants and Financial Admission of a New Partner 40
Executives 4 Acquisition of an Interest by Payment to One or
Analysis of Ethical Standards for Management More Partners 40
Accountants and Financial Executives 6 Investment in Partnership by New Partner 42
Concluding Observations 7 Bonus or Goodwill Allowed to Existing Partners 42
Appendix 1 Bonus or Goodwill Allowed to New Partner 44
IMA Standards of Ethical Conduct for Members 8 Retirement of a Partner 45
Appendix 2 Limited Partnerships 47
FEI Code of Ethics 10 Accounting for Limited Partnerships 48
Appendix 3 Financial Statements for Limited Partnerships 48
AICPA Code of Professional Conduct 11 SEC Enforcement Actions Dealing with Wrongful
Review Questions 20 Application of Accounting Standards for
Exercises 20 Partnerships 50
Cases 22 AAER 202 50
AAER 214 50
Review Questions 51
PART ONE Exercises 52
ACCOUNTING FOR PARTNERSHIPS Cases 61
AND BRANCHES 25 Problems 65

Chapter 2 Chapter 3
Partnerships: Organization and Partnership Liquidation and Incorporation;
Operation 25 Joint Ventures 75
Scope of Chapter 25 Scope of Chapter 75
Organization of a Limited Liability Partnership 26 Liquidation of a Partnership 75
Characteristics of an LLP 26 The Meaning of Liquidation 75
Deciding between an LLP and a Corporation 26 Division of Losses and Gains during Liquidation 76
Is the LLP a Separate Entity? 27 Distribution of Cash or Other Assets to Partners 76
The Partnership Contract 27 Payments to Partners of an LLP After All Noncash
Ledger Accounts for Partners 28 Assets Realized 77
Loans to and from Partners 28 Equity of Each Partner Is Sufficient to Absorb Loss
Valuation of Investments by Partners 29 from Realization 77

xi
xii Contents

Equity of One Partner Is Not Sufficient to Absorb Transactions between Branches 142
That Partner’s Share of Loss from Realization 78 SEC Enforcement Action Dealing with Wrongful
Equities of Two Partners Are Not Sufficient to Absorb Application of Accounting Standards for Divisions 143
Their Shares of Loss from Realization 80 Review Questions 143
Partnership Is Insolvent but Partners Are Solvent 81 Exercises 144
General Partnership Is Insolvent and Partners Are Cases 151
Insolvent 83 Problems 154
Installment Payments to Partners 85
General Principles Guiding Installment Payments 86
Determining Appropriate Installment Payments PART TWO
to Partners 86 BUSINESS COMBINATIONS AND
Preparation of a Cash Distribution Program 87
CONSOLIDATED FINANCIAL
Withholding of Cash for Liabilities and
STATEMENTS 164
Liquidation Costs 92
Liquidation of Limited Partnerships 93
Chapter 5
Incorporation of a Limited Liability Partnership 93
Joint Ventures 97 Business Combinations 164
Present-Day Joint Ventures 97 Scope of Chapter 165
Accounting for a Corporate or LLC Joint Venture 98 Business Combinations: Why and How? 165
Accounting for an Unincorporated Joint Venture 99 Antitrust Considerations 166
SEC Enforcement Actions Dealing with Methods for Arranging Business Combinations 166
Wrongful Application of Accounting Standards for Establishing the Price for a Business Combination 167
Joint Ventures 101 Purchase Method of Accounting for Business
Review Questions 102 Combinations 168
Exercises 103 Determination of the Combinor 169
Cases 111 Computation of Cost of a Combinee 169
Problems 114 Allocation of Cost of a Combinee 170
Illustration of Purchase Accounting for Statutory Merger,
Chapter 4 with Goodwill 171
Accounting for Branches; Combined Illustration of Purchase Accounting for Acquisition of Net
Financial Statements 121 Assets, with Bargain-Purchase Excess 174
Other Topics in Accounting for Business Combinations 175
Scope of Chapter 121 Appraisal of Accounting Standards for Business
Branches and Divisions 121 Combinations 182
Start-Up Costs of Opening New Branches 122 SEC Enforcement Actions Dealing with Wrongful
Accounting System for a Branch 122 Application of Accounting Standards for Business
Reciprocal Ledger Accounts 123 Combinations 182
Expenses Incurred by Home Office and Allocated AAER 38 182
to Branches 123 AAER 275 183
Alternative Methods of Billing Merchandise Shipments AAER 598 183
to Branches 124 AAERs 601, 606, and 607 183
Separate Financial Statements for Branch and for Review Questions 184
Home Office 124 Exercises 184
Combined Financial Statements for Home Office Cases 193
and Branch 125 Problems 196
Working Paper for Combined Financial Statements 127
Billing of Merchandise to Branches at Prices above Chapter 6
Home Office Cost 130 Consolidated Financial Statements: On Date
Working Paper When Billings to Branches Are at
of Business Combination 207
Prices above Cost 136
Treatment of Beginning Inventories Priced above Cost 136 Scope of Chapter 207
Reconciliation of Reciprocal Ledger Accounts 138 Parent Company–Subsidiary Relationships 207
 Contents xiii

Nature of Consolidated Financial Statements 207 Illustration of Equity Method for Partially Owned
Should All Subsidiaries Be Consolidated? 208 Subsidiary for First Year after Business Combination 277
The Meaning of Controlling Interest 208 Illustration of Equity Method for Partially Owned
Criticism of Traditional Concept of Control 209 Subsidiary for Second Year after Business
FASB’s Proposed Redefinition of Control 209 Combination 287
The Problem of Variable Interest Entities 210 Concluding Comments on Equity Method
Consolidation of Wholly Owned Subsidiary on Date of Accounting 292
of Business Combination 211 Appendix
Consolidation of Partially Owned Subsidiary on Date Cost Method for Partially Owned Subsidiary 292
of Business Combination 220 Review Questions 298
Nature of Minority Interest 225 Exercises 299
Consolidated Balance Sheet for Partially Owned Cases 309
Subsidiary 227 Problems 311
Alternative Methods for Valuing Minority Interest
and Goodwill 227 Chapter 8
Bargain-Purchase Excess in Consolidated Balance Consolidated Financial Statements:
Sheet 229
Intercompany Transactions 322
Disclosure of Consolidation Policy 231
International Accounting Standard 27 231 Scope of Chapter 322
Advantages and Shortcomings of Consolidated Financial Accounting for Intercompany Transactions Not
Statements 232 Involving Profit (Gain) or Loss 322
“Push-Down Accounting” for a Subsidiary 232 Loans on Notes or Open Accounts 322
SEC Enforcement Actions Dealing with Wrongful Leases of Property under Operating Leases 325
Application of Accounting Standards for Consolidated Rendering of Services 325
Financial Statements 234 Income Taxes Applicable to Intercompany
AAER 34 234 Transactions 325
AAER 1762 234 Summary: Intercompany Transactions Not Involving
Review Questions 235 Profit or Loss 326
Exercises 236 Accounting for Intercompany Transactions Involving
Cases 246 Profit (Gain) or Loss 326
Problems 249 Importance of Eliminating or Including Intercompany
Profits (Gains) and Losses 326
Chapter 7 Intercompany Sales of Merchandise 327
Intercompany Sales of Merchandise at Cost 327
Consolidated Financial Statements:
Unrealized Intercompany Profit in Ending
Subsequent to Date of Business
Inventories 328
Combination 261 Intercompany Profit in Beginning and Ending
Scope of Chapter 261 Inventories 331
Accounting for Operating Results of Wholly Owned Intercompany Profit in Inventories and Amount
Subsidiaries 261 of Minority Interest 332
Equity Method 261 Should Net Profit or Gross Profit Be Eliminated? 333
Cost Method 262 Intercompany Sales of Plant Assets 333
Choosing between Equity Method and Cost Intercompany Gain on Sale of Land 333
Method 262 Intercompany Gain on Sale of Depreciable Plant
Illustration of Equity Method for Wholly Owned Asset 335
Subsidiary for First Year after Business Intercompany Lease of Property under Capital/
Combination 262 Sales-Type Lease 339
Illustration of Equity Method for Wholly Owned Intercompany Sales of Intangible Assets 344
Subsidiary for Second Year after Business Acquisition of Affiliate’s Bonds 345
Combination 273 Illustration of Acquisition of Affiliate’s Bonds 345
Accounting for Operating Results of Partially Owned Accounting for Gain in Subsequent Years 348
Subsidiaries 276 Reissuance of Intercompany Bonds 352
xiv Contents

Illustration of Effect of Intercompany Profits (Gains) Subsidiary’s Issuance of Additional Shares of Common
on Minority Interest 352 Stock to the Public 436
Comprehensive Illustration of Working Paper Subsidiary’s Issuance of Additional Shares of Common
for Consolidated Financial Statements 355 Stock to Parent Company 438
SEC Enforcement Action Dealing with Wrongful Subsidiary with Preferred Stock Outstanding 440
Accounting for an Intercompany Account 363 Illustration of Minority Interest in Subsidiary
AAER 992 363 with Preferred Stock 440
Review Questions 363 Preferred Stock Considerations subsequent to Date
Exercises 364 of Business Combination 442
Cases 371 Stock Dividends Distributed by a Subsidiary 444
Problems 374 Illustration of Subsidiary Stock Dividend 445
Treasury Stock Transactions of a Subsidiary 446
Chapter 9 Illustration of Treasury Stock Owned by Subsidiary
on Date of Business Combination 446
Consolidated Financial Statements: Income
Illustration of Treasury Stock Acquired by Subsidiary
Taxes, Cash Flows, and Installment
subsequent to Business Combination 447
Acquisitions 385 Indirect Shareholdings and Parent Company’s
Scope of Chapter 385 Common Stock Owned by a Subsidiary 449
Income Taxes in Business Combinations Indirect Shareholdings 449
and Consolidations 385 Parent Company’s Common Stock Owned
Income Taxes Attributable to Current Fair Values by a Subsidiary 455
of a Combinee’s Identifiable Net Assets 385 Concluding Comments on Special Problems 457
Income Taxes Attributable to Undistributed Earnings Review Questions 457
of Subsidiaries 387 Exercises 458
Income Taxes Attributable to Intercompany Cases 464
Profits (Gains) 389 Problems 465
Consolidated Statement of Cash Flows 397
Illustration of Consolidated Statement of Cash Flows 397
Installment Acquisition of Subsidiary 401 PART THREE
Illustration of Installment Acquisition of Parent INTERNATIONAL ACCOUNTING:
Company’s Controlling Interest 401 REPORTING OF SEGMENTS, FOR
Parent Company’s Journal Entries for Installment INTERIM PERIODS, AND TO
Acquisition 402 THE SEC 478
Working Paper for Consolidated Financial
Statements 404 Chapter 11
Review Questions 406 International Accounting Standards;
Exercises 407 Accounting for Foreign Currency
Cases 415
Transactions 478
Problems 416
Scope of Chapter 478
Chapter 10 International Accounting Standards Board 479
Accounting for Foreign Currency Transactions 480
Consolidated Financial Statements:
FASB Statements No. 52 and No. 133 481
Special Problems 429
Transactions Involving Foreign Currencies 481
Scope of Chapter 429 Purchase of Merchandise from a Foreign Supplier 481
Changes in Parent Company’s Ownership Interest Foreign Currency Transaction Gains and Losses 482
in a Subsidiary 429 Sale of Merchandise to a Foreign Customer 483
Parent Company Acquisition of Minority Loan Payable Denominated in a Foreign Currency 484
Interest 429 Loan Receivable Denominated in a Foreign Currency 485
Parent Company Sale of a Portion of Its Subsidiary Conclusions regarding Transactions Involving Foreign
Common Stockholdings 432 Currencies 485
 Contents xv

Forward Contracts 486 SEC Enforcement Action Dealing with Wrongful

International Accounting Standards 21 and 39 492 Application of Accounting Standards for Operating
Disclosures regarding Foreign Currency Transactions 492 Segments 547
Review Questions 492 Interim Financial Reports 547
Exercises 493 Problems in Interim Financial Reports 548
Cases 498 APB Opinion No. 28 549
Problems 498 Reporting Accounting Changes in Interim
Periods 553
Chapter 12 Conclusions on Interim Financial Reports 555
IAS 34, “Interim Financial Reporting” 555
Translation of Foreign Currency Financial
SEC Enforcement Actions Dealing with Wrongful
Statements 503
Application of Accounting Standards for Interim
Scope of Chapter 503 Financial Reports 555
Functional Currency 503 Reporting for the SEC 557
Alternative Methods for Translating Foreign Entities’ Nature of Reporting to the SEC 557
Financial Statements 505 Organization and Functions of the SEC 558
Standards for Translation Established by the Financial Interaction between SEC and FASB 559
Accounting Standards Board 506 The SEC and the Public Company Accounting Oversight
Remeasurement of a Foreign Entity’s Board (PCAOB) 561
Accounts 506 Appendix
Illustration of Remeasurement of a Foreign Entity’s Excerpts from the 2003 Annual Report of
Account Balances 507 The McGraw-Hill Companies, Inc. 562
Translation of a Foreign Entity’s Financial Review Questions 588
Statements 511 Exercises 588
Translation of Financial Statements of Foreign Influenced Cases 587
Investee 511 Problems 600
Translation and Consolidation of Financial Statements
of Foreign Subsidiary 514
PART FOUR
Summary: Remeasurement and Translation 520
Other Aspects of Foreign Currency Translation 520
ACCOUNTING FOR FIDUCIARIES 607
International Accounting Standard 21 522 Chapter 14
Appraisal of Accounting Standards for Foreign Currency
Bankruptcy: Liquidation and
Translation 522
Review Questions 523
Reorganization 607
Exercises 523 Scope of Chapter 607
Cases 528 The Bankruptcy Code 608
Problems 529 Bankruptcy Liquidation 608
Debtor’s (Voluntary) Petition 608
Chapter 13 Creditor’s (Involuntary) Petition 609
Unsecured Creditors with Priority 609
Reporting for Components; Interim
Property Claimed as Exempt 610
Reports; Reporting for the SEC 541
Role of Court in Liquidation 610
Scope of Chapter 541 Role of Creditors 610
Reporting for Components of an Entity 541 Role of Trustee 610
Background of Components Reporting 541 Discharge of Debtor 610
Proposal to Improve Segment Reporting 542 Role of Accountant in Bankruptcy Liquidation 611
Allocation of Nontraceable Expenses to Operating Financial Condition of Debtor Enterprise: The Statement
Segments 544 of Affairs 611
SEC Requirements for Segment Information 546 Estimated Amounts to Be Recovered by Each Class
Reporting the Disposal of a Business Segment 546 of Creditors 615
International Accounting Standard 14 547 Accounting and Reporting for Trustee 615
xvi Contents

Bankruptcy Reorganization 617 Concluding Observations on Accounting for Nonprofit

Appointment of Trustee or Examiner 618 Organizations 687
Plan of Reorganization 618 Appendix
Accounting for a Reorganization 618 Excerpts from the 2003 Annual Report of The
Disclosure of Reorganization 620 Kenneth T. and Eileen L. Norris Foundation 688
Review Questions 621 Review Questions 693
Exercises 622 Exercises 694
Cases 629 Cases 699
Problems 630 Problems 701

Chapter 17
Chapter 15
Governmental Entities: General Fund 714
Estates and Trusts 638
Scope of Chapter 714
Scope of Chapter 638
Nature of Governmental Entities 714
Legal and Accounting Aspects of Estates 638
Objectives of Financial Reporting for Governmental
Provisions of Uniform Probate Code Governing
Entities 715
Estates 638
Accounting and Reporting Standards for Governmental
Provisions of Revised Uniform Principal and Income Act
Entities 716
Governing Estates 641
The Governmental Financial Reporting Entity 717
Illustration of Accounting for an Estate 642
Funds: The Principal Accounting Unit for Governmental
Legal and Accounting Aspects of Trusts 652
Entities 717
Provisions of Uniform Probate Code Governing
The Modified Accrual Basis of Accounting 719
Trusts 652
Recording the Budget 719
Provisions of Revised Uniform Principal and Income Act
Accounting and Reporting for a Governmental Entity’s
Governing Trusts 653
General Fund 723
Illustration of Accounting for a Trust 653
Illustration of Accounting for a General Fund 723
Review Questions 655
Trial Balance at End of Fiscal Year for a General
Exercises 656
Fund 728
Cases 663
Financial Statements for a General Fund 729
Problems 665
Closing Entries for a General Fund 731
Review Questions 732
PART FIVE Exercises 733
ACCOUNTING FOR NONBUSINESS Cases 738
ORGANIZATIONS 670 Problems 740

Chapter 16 Chapter 18
Nonprofit Organizations 670 Governmental Entities: Other Governmental
Scope of Chapter 670
Funds and Account Groups 748
Accounting Standards for Nonprofit Scope of Chapter 748
Organizations 670 Other Governmental Funds 748
Characteristics of Nonprofit Organizations 671 Accounting and Reporting for Special Revenue
Fund Accounting by Nonprofit Organizations 672 Funds 748
Unrestricted Fund 673 Accounting and Reporting for Capital Projects
Restricted Fund 680 Funds 751
Endowment Fund 681 Accounting and Reporting for Debt Service Funds 755
Agency Fund 682 Permanent Funds 758
Annuity and Life Income Funds 682 General Capital Assets and General Long-Term Debt
Loan Fund 683 Account Groups 758
Plant Fund 683 Accounting and Reporting for General Capital Assets
Financial Statements of Nonprofit Organizations 683 Account Group 758
 Contents xvii

Accounting and Reporting for General Long-Term Debt Accounting and Reporting for Pension Trust
Account Group 760 Funds 792
Capital Leases of Governmental Entities 762 Accounting and Reporting for Investment Trust
Accounting for Special Assessment Bonds 763 Funds 793
Review Questions 766 Comprehensive Annual Financial Report
Exercises 767 of Governmental Entities 794
Cases 771 GASB Statement No. 33—A Preliminary
Problems 773 Step 795
Subsequent Steps—GASB Statements No. 35, 37,
Chapter 19 38, and 41 796
Governmental Entities: Proprietary Funds, Composition of a Governmental Entity’s Comprehensive
Fiduciary Funds, and Comprehensive Annual Financial Report 796
Annual Financial Report 780 SEC Enforcement Action Dealing with Wrongful
Application of Accounting and Reporting Standards
Scope of Chapter 780 for Governmental Entity 798
Proprietary Funds 780 AAER 970 798
Accounting and Reporting for Enterprise Funds 781 Review Questions 799
Accounting and Reporting for Internal Service Exercises 799
Funds 785 Cases 803
Applicability of FASB Pronouncements to Proprietary Problems 805
Funds 788
Fiduciary Funds 788
Accounting and Reporting for Agency Funds 788
Glossary 814
Accounting and Reporting for Private-Purpose
Trust Funds 789 Index 825
Chapter One

Ethical Issues in
Advanced Accounting
Scope of Chapter
Ethics—right conduct—has been a subject of discussion for centuries. For example:
In Nicomachean Ethics, Book II, Aristotle (384–322 BC) wrote:
[I]t is no easy task to be good. . . . wherefore, goodness is both rare and laudable and noble.
In Meditations, Books III and VII, Marcus Aurelius (121–180 AD) declared:
A man then must stand erect, not kept erect by others. . . . Be thou erect or be made erect.
William Shakespeare (1564 –1616) provided the following speeches in two of his plays:
lago. Good name in man and woman, dear my lord,
Is the immediate jewel of their souls,
Who steals my purse steals trash; ’tis something, nothing;
’Twas mine, ’tis his, and has been slave to thousands;
But he that filches from me my good name
Robs me of that which not enriches him
And makes me poor indeed.
(Othello, 3.3. 155–160)
Mowbray, The purest treasure mortal times afford
Is spotless reputation: . . .
Mine honour is my life; both grow in one;
Take honour from me, and my life is done. . . .
(The Tragedy of King Richard II, 1.1. 177–183)

Recent highly publicized accounting scandals have made it clear that ethical conduct of
accountants has not met the standards inherent in the foregoing quotations. In the article
“Scandal Scorecard,” The Wall Street Journal described 12 egregious accounting frauds in-
volving publicly owned business enterprises; many of the frauds involved the chief finan-
cial officer, controller, chief accounting officer, and other accountants of the enterprises.1
One outcome of those and other scandals was the enactment of the federal Sarbanes-Oxley
Act of 2002 (SOX), which authorized the establishment of a Public Company Accounting
Oversight Board to regulate the conduct of accountants both in public practice and in pub-
licly owned business enterprises.
The vocabulary of accounting now includes the following terms:
Cute accounting to describe stretching the form of accounting standards to the limit,
regardless of the substance of the underlying business transactions or events
Cooking the books to indicate fraudulent financial reporting
1
“Scandal Scorecard,” The Wall Street Journal, October 3, 2003, p. B1.
1
2 Chapter 1 Ethical Issues in Advanced Accounting

Many topics of advanced accounting have been the subject of both cute accounting and
cooking the books by accounting executives of business enterprises. Because the chief fi-
nancial officer, the controller, the chief accounting officer, and the accounting staffs of busi-
ness enterprises have the primary responsibility for preparing financial statements and
financial reports and disseminating them to users, this chapter deals with the ethical stan-
dards appropriate for those preparers. In this and subsequent chapters, Securities and Ex-
change Commission (SEC) enforcement actions dealing with fraudulent financial reporting
are described for the topics covered in those chapters.

WHAT IS FRAUDULENT FINANCIAL REPORTING?

The following covers misstatements in financial statements that are caused by fraudulent fi-
nancial reporting, and the reasons for and methods of committing fraud:
Misstatements arising from fraudulent financial reporting are intentional misstatements or
omissions of amounts or disclosures in financial statements to deceive financial statement
users. Fraudulent financial reporting may involve acts such as the following:

• Manipulation, falsification, or alteration of accounting records or supporting documents

from which financial statements are prepared
• Misrepresentation in, or intentional omission from, the financial statements of events, trans-
actions, or other significant information
• Intentional misapplication of accounting principles relating to amounts, classification, man-
ner of presentation, or disclosure

Fraud frequently involves the following: (a) a pressure or an incentive to commit fraud
and (b) a perceived opportunity to do so. . . . For example, fraudulent financial reporting may
be committed because management is under pressure to achieve an unrealistic earnings target.
Fraud may be concealed through falsified documentation, including forgery. For example,
management that engages in fraudulent financial reporting might attempt to conceal mis-
statements by creating fictitious invoices.
Fraud also may be concealed through collusion among management, employees, or third
parties. For example, through collusion, false evidence that control activities have been per-
formed effectively may be presented.2

AN EXAMPLE OF FRAUDULENT FINANCIAL REPORTING

The SEC’s Accounting and Auditing Enforcement Release No. 923, “Securities and Ex-
change Commission v. Joseph C. Allegra, David Hersh, J. Ledd Ledbetter and H. Flynn
Clyburn . . .” (AAER 923), issued June 11, 1997, provides an example of fraudulent finan-
cial reporting carried out by the president and chief executive officer; the chief financial of-
ficer, treasurer, and secretary; the chief operating officer and senior executive vice
president; and another executive vice president of a national provider of alternate site health
care services. According to the SEC, the four officers overstated the company’s net income
for the quarters ended December 31, 1992, and March 31, 1993, by taking the following
“cooking the books” actions:
1. Recognizing January 1993 revenues in December 1992 and April 1993 revenues in
March 1993, and artificially accelerating product delivery schedules at the end of both
quarters, an artifice termed channel stuffing.
2. Deferring writeoffs of uncollectible accounts past the end of the appropriate quarter.
2
AICPA Professional Standards, vol. 1,“U.S. Auditing Standards,” sec. 316.
 Chapter 1 Ethical Issues in Advanced Accounting 3

Also, according to the SEC, the chief financial officer (a CPA) overstated quarterly
income by:
1. Recognizing in the quarter ended March 31, 1993, a gain from the sale of an asset dur-
ing the quarter ended June 30, 1993.
2. Recognizing as assets certain expenses incurred during the quarters ended December 31,
1992, and March 31, 1993.
3. Making fictitious journal entries in connection with business combinations accom-
plished in March 1993, the effect of which was to understate doubtful accounts
expense.
In a “consent decree” in which the four officers neither admitted nor denied the SEC’s alle-
gations, they agreed to numerous monetary and other penalties.

ETHICAL STANDARDS FOR PREPARERS OF FINANCIAL

STATEMENTS AND FINANCIAL REPORTS
Many past efforts to develop ethical standards for accountants focused on CPAs in the
practice of public accounting—primarily auditing. For example, although the first code of
ethics of the American Institute of Certified Public Accountants (AICPA) was adopted in
1917, prior to 1988 few of its provisions applied to AICPA members in industry. The
Institute of Management Accountants (IMA), an organization devoted primarily to the in-
terest of accountants in industry, first issued its Standards of Ethical Conduct for Mem-
bers in 1983. The Financial Executives International (FEI), an organization of financial
vice presidents, controllers, and treasurers of business enterprises, first issued its Code of
Ethics in 1985.
Presumably, the lack of formal ethical standards for management accountants and fi-
nancial executives prior to 1983 stemmed from the view that the first line of defense against
improper financial reporting was provided by independent CPAs, subject to ethics codes of
their states of licensure, who audited financial statements of business enterprises, and that
preparers of those statements had only a secondary role in assuring quality financial re-
porting. This view was prevalent even though the AICPA had long included statements such
as the following in its pronouncements on auditing:
The financial statements are management’s responsibility. The auditor’s responsibility is to
express an opinion on the financial statements. Management is responsible for adopting
sound accounting policies and for establishing and maintaining an internal control structure
that will, among other things, record, process, summarize, and report financial data that is
consistent with management’s assertions embodied in the financial statements. The internal
control structure should include an accounting system to identify, assemble, analyze, classify,
record, and report an entity’s transactions and to maintain accountability for the related assets
and liabilities. The entity’s transactions and the related assets and liabilities are within the
direct knowledge and control of management. The auditor’s knowledge of these matters is
limited to that acquired through the audit. Thus, the fair presentation of financial position,
results of operations, and cash flows in conformity with generally accepted accounting prin-
ciples is an implicit and integral part of management’s responsibility. The independent audi-
tor may make suggestions about the form or content of the financial statements or draft them,
in whole or in part, based on information from management’s accounting system. However,
the auditor’s responsibility for the financial statements he has audited is confined to the
expression of his opinion on them.3

3
AICPA Professional Standards, vol. 1, “U.S. Auditing Standards,” sec. 110.02 (prior to amendment).
4 Chapter 1 Ethical Issues in Advanced Accounting

Significant Events in the Establishment of Ethical Standards

for Management Accountants and Financial Executives
The Seaview Symposium of 1970
An early effort to establish ethical standards for preparers of financial statements occurred
at a 1970 symposium of members of the AICPA, the FEI, the Financial Analysts Federation,
and the Robert Morris Associates (an organization of credit grantors), which took place at
Seaview Country Club, Absecon, New Jersey. Papers and discussions at this symposium
criticized the lack of a code of ethics for members of the FEI, given that the other three par-
ticipating organizations had such codes.4

The Equity Funding Fraud of 1973

In 1973, a major fraud, of about nine years’ duration, was discovered at Equity Funding
Corporation of America (Equity), a seller of mutual fund shares that were pledged by the
investors to secure loans to finance life insurance premiums. During the nine-year period,
at least $143 million of fictitious pretax income was generated—a period in which Equity
reported a total net income of $76 million, instead of the real pretax losses totaling more
than $67 million.5 The fraud was carried out by at least 10 executives of Equity, including
the chief executive officer (CEO), chief financial officer (CFO), controller, and treasurer;
several of the executives were CPAs with public accounting experience. The fraudulent
conduct of these CPAs, all of whom presumably had at one time been subject to the
AICPA’s Code of Professional Ethics during their public accounting careers, furnished
clear evidence of the need for ethics codes for management accountants and other financial
executives.

Action by the IMA

In 1983, the IMA issued Standards of Ethical Conduct for Practitioners of Management
Accounting and Financial Management, the third in a series of Statements on Manage-
ment Accounting. The current IMA standards, which are presented in Appendix 1 at the
end of this chapter (pages 8 through 10), cover the management accountant’s obligations as
to competence, confidentiality, integrity, and objectivity, and they provide guidance for res-
olutions of ethical conflict. Noteworthy in the preamble to the standards (pages 8–9) is the
management accountant’s obligation not to condone violations of the standards by others in
the organization.

Action by the FEI

The Code of Ethics first promulgated by the FEI in 1985 and as subsequently amended is
in Appendix 2 (pages 10–11). Although briefer than the IMA standards, the FEI’s code cov-
ers essentially the same areas of professional conduct as do the IMA standards.

Treadway Commission Recommendations

The National Commission on Fraudulent Financial Reporting (Treadway Commission),
which had been sponsored by the AICPA, the IMA, the FEI, the American Accounting As-
sociation (composed primarily of accounting educators), and the Institute of Internal Audi-
tors, issued its report in 1987. Defining fraudulent financial reporting as “intentional or
reckless conduct, whether act or omission, that results in materially misleading financial

4
John C. Burton, ed., Corporate Financial Reporting: Ethical and Other Problems (New York: AICPA, 1972),
pp. 7, 51–52, 109, 420–421.
5
Report of the Trustee of Equity Funding Corporation of America, October 31, 1974, p. 12.
 Chapter 1 Ethical Issues in Advanced Accounting 5

statements,”6 the Treadway Commission made 49 recommendations for curbing such

reporting. The recommendations dealt with the public company; the independent public ac-
countant; the SEC, financial institution regulators, and state boards of accountancy; and ed-
ucation. Stating that “the responsibility for reliable financial reporting resides first and
foremost at the corporate level,”7 the Treadway Commission included the following among
its recommendations for the public company:
Recommendations: Public companies should maintain accounting functions that are
designed to meet their financial reporting obligations.
A public company’s accounting function is an important control in preventing and detect-
ing fraudulent financing reporting. The accounting function must be designed to allow the
company and its officers to fulfill their statutory financial disclosure obligations.
As a member of top management, the chief accounting officer helps set the tone of the or-
ganization’s ethical conduct and thus is part of the control environment. Moreover, the chief
accounting officer is directly responsible for the financial statements, and can and should
take authoritative action to correct them if necessary. He generally has the primary responsi-
bility for designing, implementing, and monitoring the company’s financial reporting system
and internal accounting controls. The controller may serve as the chief accounting officer, or
the chief financial officer also may perform the functions of a chief accounting officer.
The chief accounting officer’s actions especially influence employees who perform the ac-
counting function. By establishing high standards for the company’s financial disclosures, the
chief accounting officer guides others in the company toward legitimate financial reporting.
Moreover, the chief accounting officer is in a unique position. In numerous cases, other
members of top management, such as the chief executive officer, pressure the chief account-
ing officer into fraudulently manipulating the financial statements. An effective chief ac-
counting officer is familiar with the company’s financial position and operations and thus
frequently is able to identify unusual situations caused by fraudulent financial reporting per-
petrated at the divisional level.
The chief accounting officer has an obligation to the organization he serves, to the public,
and to himself to maintain the highest standards of ethical conduct. He therefore must be pre-
pared to take action necessary to prevent fraudulent financial reporting. His efforts may en-
tail bringing matters to the attention of the CEO, the CFO, the chief internal auditor, the audit
committee, or the entire board of directors.
The Financial Executives [International] (FEI) and the [Institute of Management Accountants
(IMA)] play active roles in enhancing the financial reporting process by sponsoring research,
technical professional guidance, and continuing professional education and by participating in
the shaping of standards. Both organizations also have promulgated codes of conduct that
strongly encourage reliable financial reporting. Public companies should encourage their ac-
counting employees to support these organizations and adhere to their codes of conduct.8

Revision of AICPA Ethics Rules

In 1988, the members of the AICPA approved a revised Code of Professional Conduct to
replace the Code of Professional Ethics that previously had been in effect. This action was
triggered by the 1986 Report of the Special Committee on Standards of Professional Con-
duct for Certified Public Accountants (Anderson Committee), which recommended re-
structuring the AICPA’s ethics code to improve its relevance and effectiveness.9 A key
element of the Anderson Committee recommendations was extension of applicability of the
Rules of Professional Conduct of the revised Code of Professional Conduct to AICPA

6
Report of the National Commission on Fraudulent Financial Reporting (New York: 1987), p. 2.
7
Ibid., p. 6.
8
Ibid., pp. 36–37.
9
Report of the Special Committee on Standards of Professional Conduct for Certified Public Accountants
(New York: AICPA, 1986), p. 1.
6 Chapter 1 Ethical Issues in Advanced Accounting

members who are not practicing in a CPA firm.10 Thus, Rules 102, 201, 202, 203, 302, and
501 of the Code of Professional Conduct in Appendix 3 (pages 11 through 20) apply to all
AICPA members, including those in private industry, governmental entities, nonprofit or-
ganizations, and academia.

Authority of the Public Company Accounting Oversight Board

Title I of the Sarbanes-Oxley Act of 2002 authorized the Public Company Accounting
Oversight Board to establish ethical standards for audits of publicly owned companies. As
of the date of this writing, no such standards had been issued.

Analysis of Ethical Standards for Management Accountants

and Financial Executives
A review of the contents of the IMA, FEI, and AICPA ethics pronouncements in Appen-
dixes 1, 2, and 3 reveals several similarities. All three require members of the respective or-
ganizations to be competent, act with integrity and objectivity, maintain confidentiality of
sensitive information, avoid discreditable acts, and avoid conflicts of interest. Only the IMA
and FEI codes specifically require communication of complete information to users of their
members’ reports; AICPA members indirectly are comparably obligated by Rule 202.
Rule 203 of the AICPA code requires compliance with generally accepted accounting
principles. One might prefer that both the IMA and the FEI codes had comparable explicit
provisions, given management accountants’ and financial executives’ primary responsibil-
ity for financial statements and financial reports.
Another difference among the three ethics codes is that the IMA and FEI standards in
essence require members to report violations of the standards by members of their organiza-
tions to responsible officials of the organizations. The AICPA code has no such requirement.
The issues of conflicts of interest and discreditable acts are discussed further in the fol-
lowing sections.

Conflicts of Interest
Conflicts of interest result when individuals reap inappropriate personal benefits from their
acts in an official capacity. For example, a chief accounting officer might cook the books to
overstate pretax income of the employer corporation in order to obtain a larger performance
bonus. Alternatively, the controller of a publicly owned corporation might engage in insider
trading11 to maximize gains or minimize losses on purchases or sales of the employer cor-
poration securities. For example, in Accounting and Auditing Enforcement Release
(AAER) 344 (December 10, 1991), the SEC reported the permanent disbarment from prac-
tice of the controller, a CPA, of a publicly owned company, who had allegedly engaged in
insider trading and thus avoided losses of more than $73,000 on sales of the employer com-
pany’s common stock. According to the SEC, the controller had acted with senior manage-
ment of the company to overstate the company’s earnings by more than $38,000,000 over a
two-and-one-half-year period. The controller was ordered to disgorge the $73,000 and pay
a penalty of the same amount.

Discreditable Acts
None of the three ethics codes presented in appendixes to this chapter defines discreditable
acts. Probably the term cannot be adequately defined or circumscribed; what is a discreditable

10
Ibid., p. 23.
11
Section 21A of the Securities Exchange Act of 1934 defines insider trading as “purchasing or selling a
security while in possession of material, nonpublic information . . . or . . . communicating such information
in connection with a securities transaction.”
 Chapter 1 Ethical Issues in Advanced Accounting 7

act to one observer might not be so construed by another. For example, might a member of
the IMA, FEI, or AICPA observing another member’s substance abuse construe the act as
discreditable to the abusive member, the member’s employer, the organization, or other en-
tities? Such questions are difficult to answer in a society in which some condone personal
actions that are condemned by others.

Concluding Observations
In considering episodes of cooking the books, described in subsequent chapters, the reader
should keep in mind that, although the Treadway Commission stated, “The incidence of
fraudulent financial reporting cannot be quantified with any degree of precision,”12 it also
gave the following data:
1. The number of SEC proceedings against reporting companies from 1981 to 1986 was
less than 1% of the number of financial reports filed with the SEC during that period.
2. The chairman of the Federal Deposit Insurance Corporation contended that manage-
ment fraud (presumably including cooking the books) contributed to one-third of bank
failures.
3. Ten percent of total bankruptcies in a study authorized by the Treadway Commission in-
volved fraudulent financial reporting.
4. Former SEC chairman John Shad estimated that all fraudulent securities activities
amount to a fraction of 1% of the $50 billion of corporate and government securities
traded daily.13
Thus, cooking the books episodes, though serious and despicable, apparently do not indi-
cate a wholesale breakdown of ethical conduct by management accountants and financial
executives of business enterprises.
An important question to consider is: Can the codes of conduct for management ac-
countants and financial executives established by the IMA, the FEI, and AICPA help those
key players in corporate financial reporting to resist pressures, often from top management
but sometimes from within themselves, to falsify financial statements and financial reports?
Or is it too much to expect such individuals, whose livelihoods and careers depend a great
deal on what is in those statements and reports, to be completely impartial in their prepara-
tion? Ralph E. Walters, CPA, former director of Professional Conduct for The California
Society of Certified Public Accountants, has considered this thorny question:
An obligation to be impartial seems to me to place a new and possibly unrealistic burden on the
management accountant. Traditionally, most employees have felt an obligation, within the bounds
of honesty and integrity, to put the best face upon their employer’s affairs. For example, there is
still some latitude in selection and judgment in the application of GAAP [generally accepted ac-
counting principles]. Some managers consistently opt for the most aggressive principle or appli-
cation. The aggregate effect is to bias the financial statements. They may be in accordance with
GAAP, but the quality of earnings is suspect. They are not impartial. This condition is not un-
common in practice (it is a principal reason we need independent auditors). An accountant asso-
ciated with this condition is literally violating the AICPA Code. The [IMA] Code is less clear.
Is this interpretation realistic? Do management accountants generally understand this?
I doubt it. In fairness to their members and to the public, the AICPA and the [IMA] need to
put their heads together and agree how much objectivity management accountants can be
expected to live with, including some examples in real-life situations. The positions should
be consistent and must be made clear to all management accountants.14

12
Report of the National Committee on Fraudulent Financial Reporting, p. 25.
13
Ibid., pp. 25–26.
14
Ralph E. Walters, “Ethics and Excellence,” Management Accounting, January 1990, p. 12.
8 Chapter 1 Ethical Issues in Advanced Accounting

The questions raised in the foregoing paragraph are difficult to answer. However, the
SEC has emphasized the importance of objectivity as follows, in rejecting the “good
soldier” rationalization of unethical conduct by a corporate controller (a CPA):
The Commission cannot condone [the controller’s] conduct. [The controller] has or had available
to him more than sufficient information to be aware that the financial statements he prepared and
the periodic reports he signed were materially inaccurate. Under the circumstances, and as a se-
nior level financial officer and the highest level CPA within [the corporation] involved in the fi-
nancial reporting process, [the controller] owed a duty to [the corporation] and its shareholders
not to assist in, or even acquiesce in, [the corporation’s] issuance of such financial statements.
Although [the controller] may have made the appropriate recommendations to his corporate su-
pervisors, when those recommendations were rejected, [the controller] acted as the “good sol-
dier,” implementing their directions which he knew or should have known were improper.15

In like vein, the SEC commented as follows on the behavior of a corporate controller
who, despite his knowledge of cooking the books activities directed by the company’s for-
mer CEO and former CFO, took no remedial actions:
As controller, [the CPA] had a duty to satisfy himself that [the company’s] financial state-
ments were properly stated under GAAP. [The controller] knew or recklessly disregarded
facts indicating that, as a result of the fraudulent entries, [the company’s] reported financial
statements during fiscal year 1990 . . . were materially false and misleading. Although [the
company’s] former CEO and CFO devised and directed the improper practices resulting in
[the company’s] false recording and reporting, in the Commission’s view, this does not justify
[the controller’s] failure to take sufficient steps to satisfy himself that the transactions were
properly recorded . . . This failure was inconsistent with his duties as . . . controller.16

At the beginning of their professional careers, students of advanced accounting might

well reflect on their sense of ethical values and decide on a course of action if they find
themselves in a position such as the foregoing ones.

Appendix 1

IMA Standards of Ethical Conduct for Members*

In today’s modern world of business, individuals in management accounting and financial
management constantly face ethical dilemmas. For example, if the accountant’s immediate
superior instructs the accountant to record the physical inventory at its original costs when
it is obvious that the inventory has a reduced value due to obsolescence, what should the ac-
countant do? To help make such a decision, here is a brief general discussion of ethics and
the “Standards of Ethical Conduct for Members.” Ethics, in its broader sense, deals with
human conduct in relation to what is morally good and bad, right and wrong. To determine
whether a decision is good or bad, the decision-maker must compare his/her options with
some standard of perfection. This standard of perfection is not a statement of static position
but requires the decision-maker to assess the situation and the values of the parties affected
by the decision. The decision-maker must then estimate the outcome of the decision and be
responsible for its results. Two good questions to ask when faced with an ethical dilemma

15
AAER 93, “ . . . In the Matter of Michael R. Maury,” March 26, 1986.
16
AAER 538, “ . . . In the Matter of Michael V. Barnes,” March 11, 1994.
* Source: Ethics Hotline (for members only) © 2000, Institute of Management Accountants, Inc.
 Chapter 1 Ethical Issues in Advanced Accounting 9

are, “Will my actions be fair and just to all parties affected?” and “Would I be pleased to
have my closest friends learn of my actions?”
Individuals in management accounting and financial management have a unique set of
circumstances relating to their employment. To help them assess their situation, the Insti-
tute of Management Accountants (IMA) has developed the following “Standards of Ethical
Conduct for Members.”

STANDARDS OF ETHICAL CONDUCT FOR MEMBERS

Members of IMA have an obligation to the public, their profession, the organizations they
serve, and themselves to maintain the highest standards of ethical conduct. In recognition
of this obligation, the IMA has promulgated the following standards of ethical conduct for
its members. Members shall not commit acts contrary to these standards nor shall they con-
done the commission of such acts by others within their organizations.
Members shall abide by the more stringent code of ethical conduct, whether that is the
standards widely practiced in their country or IMA’s Standards of Ethical Conduct. In no
case will a member conduct herself or himself by any standard that is not at least equiva-
lent to the standards identified for members in IMA’s Standards of Ethical Conduct.
The standards of ethical conduct for IMA members are published in SMA (Statement on
Management Accounting) 1C.
Competence
Members have a responsibility to:
• Maintain an appropriate level of professional competence by ongoing development of
their knowledge and skills.
• Perform their professional duties in accordance with relevant laws, regulations, and
technical standards.
• Prepare complete and clear reports and recommendations after appropriate analyses of
relevant and reliable information.
Confidentiality
Members have a responsibility to:
• Refrain from disclosing confidential information acquired in the course of their work ex-
cept when authorized, unless legally obligated to do so.
• Inform subordinates as appropriate regarding the confidentiality of information acquired
in the course of their work and monitor their activities to assure the maintenance of that
confidentiality.
• Refrain from using or appearing to use confidential information acquired in the course
of their work for unethical or illegal advantage either personally or through third parties.
Integrity
Members have a responsibility to:
• Avoid actual or apparent conflicts of interest and advise all appropriate parties of any po-
tential conflict.
• Refrain from engaging in any activity that would prejudice their ability to carry out their
duties ethically.
• Refuse any gift, favor, or hospitality that would influence or would appear to influence
their actions.
• Refrain from either actively or passively subverting the attainment of the organization’s
legitimate and ethical objectives.
10 Chapter 1 Ethical Issues in Advanced Accounting

• Recognize and communicate professional limitations or other constraints that would

preclude responsible judgment or successful performance of an activity.
• Communicate unfavorable as well as favorable information and professional judgments
or opinions.
• Refrain from engaging in or supporting any activity that would discredit the profession.
Objectivity
Members have a responsibility to:
• Communicate information fairly and objectively.
• Disclose fully all relevant information that could reasonably be expected to influence an
intended user’s understanding of the reports, comments, and recommendations presented.

RESOLUTION OF ETHICAL CONFLICT

In applying the standards of ethical conduct, members may encounter problems in identi-
fying unethical behavior or in resolving an ethical conflict. When faced with significant eth-
ical issues, members should follow the established policies of the organization bearing on
the resolution of such conflict. If these policies do not resolve the ethical conflict, such
members should consider the following courses of action.
• Discuss such problems with the immediate superior except when it appears that the su-
perior is involved, in which case the problem should be presented initially to the next
higher managerial level. If a satisfactory resolution cannot be achieved when the prob-
lem is initially presented, submit the issues to the next higher managerial level. If the im-
mediate superior is the chief executive officer, or equivalent, the acceptable reviewing
authority may be a group such as the audit committee, executive committee, board of di-
rectors, board of trustees, or owners. Contact with levels above the immediate superior
should be initiated only with the superior’s knowledge, assuming the superior is not in-
volved. Except where legally prescribed, communication of such problems to authorities
or individuals not employed or engaged by the organization is not considered appropriate.
• Clarify relevant ethical issues by confidential discussion with an objective advisor (e.g.,
IMA Ethics Counseling Service) to obtain a better understanding of possible courses of
action. Consult your own attorney as to legal obligations and rights concerning the eth-
ical conflict.
• If the ethical conflict still exists after exhausting all levels of internal review, there may
be no other recourse on significant matters than to resign from the organization and to
submit an informative memorandum to an appropriate representative of the organiza-
tion. After resignation, depending on the nature of the ethical conflict, it may also be ap-
propriate to notify other parties.
From Institute of Management Accountants, Statements on Management Accounting: Standards
of Ethical Conduct for Management Accountants, Statement No. 1C (10 Paragon Drive, Montvale, NJ
07645, April 1997). Reprinted with permission.

Appendix 2

FEI Code of Ethics

FEI’s mission includes significant efforts to promote ethical conduct in the practice of fi-
nancial management throughout the world. Senior financial officers hold an important and
elevated role in corporate governance. While members of the management team, they are
 Chapter 1 Ethical Issues in Advanced Accounting 11

uniquely capable and empowered to ensure that all stakeholders’ interests are appropriately
balanced, protected and preserved. This Code provides principles to which members are
expected to adhere and advocate. They embody rules regarding individual and peer re-
sponsibilities, as well as responsibilities to employers, the public, and other stakeholders.
Violations of FEI’s Code of Ethics may subject the member to censure, suspension or ex-
pulsion under procedural rules adopted by FEI’s Board of Directors.
All members of FEI will:
1. Act with honesty and integrity, avoiding actual or apparent conflicts of interest in per-
sonal and professional relationships.
2. Provide constituents with information that is accurate, complete, objective, relevant,
timely and understandable.
3. Comply with applicable rules and regulations of federal, state, provincial, and local
governments, and other appropriate private and public regulatory agencies.
4. Act in good faith, responsibly, with due care, competence and diligence, without mis-
representing material facts or allowing one’s independent judgment to be subordinated.
5. Respect the confidentiality of information acquired in the course of one’s work except
when authorized or otherwise legally obligated to disclose. Confidential information
acquired in the course of one’s work will not be used for personal advantage.
6. Share knowledge and maintain skills important and relevant to constituents’ needs.
7. Proactively promote ethical behavior as a responsible partner among peers, in the work
environment and the community.
8. Achieve responsible use of and control over all assets and resources employed or
entrusted.
9. Report known or suspected violations of this Code in accordance with the FEI Rules
of Procedure.
10. Be accountable for adhering to this Code.
Source: Financial Executives International Code of Ethics

Appendix 3

AICPA Code of Professional Conduct*

COMPOSITION, APPLICABILITY, AND COMPLIANCE
The Code of Professional Conduct of the American Institute of Certified Public Accoun-
tants consists of two sections—(1) the Principles and (2) the Rules. The Principles provide
the framework for the Rules, which govern the performance of professional services by
members. The Council of the American Institute of Certified Public Accountants is autho-
rized to designate bodies to promulgate technical standards under the Rules, and the bylaws
require adherence to those Rules and standards.
The Code of Professional Conduct was adopted by membership to provide guidance and
rules to all members—those in public practice, in industry, in government, and in education—
in the performance of their professional responsibilities.

* From American Institute of Certified Public Accountants, Code of Professional Conduct. Copyright ©
2000 by American Institute of Certified Public Accountants, Inc. (New York). Reprinted with permission.
(Not included are the Statements on Standards for Tax Services incorporated in the Code in 2000.)
12 Chapter 1 Ethical Issues in Advanced Accounting

Compliance with the Code of Professional Conduct, as with all standards in an open so-
ciety, depends primarily on members’ understanding and voluntary actions, secondarily on
reinforcement by peers and public opinion, and ultimately on disciplinary proceedings,
when necessary, against members who fail to comply with the Rules.

OTHER GUIDANCE
Interpretations of Rules of Conduct consist of interpretations which have been adopted, af-
ter exposure to state societies, state boards, practice units and other interested parties, by
the professional ethics division’s executive committee to provide guidelines as to the scope
and application of the Rules but are not intended to limit such scope or application. A mem-
ber who departs from such guidelines shall have the burden of justifying such departure in
any disciplinary hearing. Interpretations which existed before the adoption of the Code of
Professional Conduct on January 12, 1988, will remain in effect until further action is deemed
necessary by the appropriate senior technical committee.
Ethics Rulings consist of formal rulings made by the professional ethics division’s exec-
utive committee after exposure to state societies, state boards, practice units and other
interested parties. These rulings summarize the application of Rules of Conduct and Inter-
pretations to a particular set of factual circumstances. Members who depart from such rul-
ings in similar circumstances will be requested to justify such departures. Ethics Rulings
which existed before the adoption of the Code of Professional Conduct on January 12,
1988, will remain in effect until further action is deemed necessary by the appropriate
senior technical committee.
Publication of an Interpretation or Ethics ruling in The Journal of Accountancy consti-
tutes notice to members. Hence, the effective date of the pronouncement is the last day of
the month in which the pronouncement is published in The Journal of Accountancy. The
professional ethics division will take into consideration the time that would have been rea-
sonable for the member to comply with the pronouncement.
A member should also consult, if applicable, the ethical standards of his state CPA soci-
ety, state board of accountancy, the Securities and Exchange Commission, and any other
governmental agency which may regulate his client’s business or use his report to evaluate
the client’s compliance with applicable laws and related regulations.

SECTION I: PRINCIPLES
Preamble
Membership in the American Institute of Certified Public Accountants is voluntary. By ac-
cepting membership, a certified public accountant assumes an obligation of self-discipline
above and beyond the requirements of laws and regulations.
These Principles of the Code of Professional Conduct of the American Institute of Cer-
tified Public Accountants express the profession’s recognition of its responsibilities to the
public, to clients, and to colleagues. They guide members in the performance of their pro-
fessional responsibilities and express the basic tenets of ethical and professional conduct.
The Principles call for an unswerving commitment to honorable behavior, even at the sac-
rifice of personal advantage.
Article I: Responsibilities
In carrying out their responsibilities as professionals, members should exercise sensitive
professional and moral judgments in all their activities.
As professionals, certified public accountants perform an essential role in society. Consis-
tent with that role, members of the American Institute of Certified Public Accountants have
responsibilities to all those who use their professional services. Members also have a
 Chapter 1 Ethical Issues in Advanced Accounting 13

continuing responsibility to cooperate with each other to improve the art of accounting,
maintain the public’s confidence, and carry out the profession’s special responsibilities for
self-governance. The collective efforts of all members are required to maintain and enhance
the traditions of the profession.
Article II: The Public Interest
Members should accept the obligation to act in a way that will serve the public interest,
honor the public trust, and demonstrate commitment to professionalism.
A distinguishing mark of a profession is acceptance of its responsibility to the public. The
accounting profession’s public consists of clients, credit grantors, governments, employers,
investors, the business and financial community, and others who rely on the objectivity and
integrity of certified public accountants to maintain the orderly functioning of commerce.
This reliance imposes a public interest responsibility on certified public accountants. The
public interest is defined as the collective well-being of the community of people and insti-
tutions the profession serves.
In discharging their professional responsibilities, members may encounter conflicting
pressures from among each of those groups. In resolving those conflicts, members should
act with integrity, guided by the precept that when members fulfill their responsibility to the
public, clients’ and employers’ interests are best served.
Those who rely on certified public accountants expect them to discharge their responsi-
bilities with integrity, objectivity, due professional care, and a genuine interest in serving
the public. They are expected to provide quality services, enter into fee arrangements, and
offer a range of services—all in a manner that demonstrates a level of professionalism con-
sistent with these Principles of the Code of Professional Conduct.
All who accept membership in the American Institute of Certified Public Accountants
commit themselves to honor the public trust. In return for the faith that the public reposes
in them, members should seek continually to demonstrate their dedication to professional
excellence.
Article III: Integrity
To maintain and broaden public confidence, members should perform all professional re-
sponsibilities with the highest sense of integrity.
Integrity is an element of character fundamental to professional recognition. It is the qual-
ity from which the public trust derives and the benchmark against which a member must
ultimately test all decisions.
Integrity requires a member to be, among other things, honest and candid within the
constraints of client confidentiality. Service and the public trust should not be subordinated
to personal gain and advantage. Integrity can accommodate the inadvertent error and the
honest difference of opinion; it cannot accommodate deceit or subordination of principle.
Integrity is measured in terms of what is right and just. In the absence of specific rules,
standards, or guidance, or in the face of conflicting opinions, a member should test deci-
sions and deeds by asking: “Am I doing what a person of integrity would do? Have I re-
tained my integrity?” Integrity requires a member to observe both the form and the spirit of
technical and ethical standards; circumvention of those standards constitutes subordination
of judgment.
Integrity also requires a member to observe the principles of objectivity and indepen-
dence and of due care.
Article IV: Objectivity and Independence
A member should maintain objectivity and be free of conflicts of interest in discharging pro-
fessional responsibilities. A member in public practice should be independent in fact and
appearance when providing auditing and other attestation services.
14 Chapter 1 Ethical Issues in Advanced Accounting

Objectivity is a state of mind, a quality that lends value to a member’s services. It is a distin-
guishing feature of the profession. The principle of objectivity imposes the obligation to be
impartial, intellectually honest, and free of conflicts of interest. Independence precludes rela-
tionships that may appear to impair a member’s objectivity in rendering attestation services.
Members often serve multiple interests in many different capacities and must demon-
strate their objectivity in varying circumstances. Members in public practice render attest,
tax, and management advisory services. Other members prepare financial statements in the
employment of others, perform internal auditing services, and serve in financial and man-
agement capacities in industry, education, and government. They also educate and train
those who aspire to admission into the profession. Regardless of service or capacity, mem-
bers should protect the integrity of their work, maintain objectivity, and avoid any subordi-
nation of their judgment.
For a member in public practice, the maintenance of objectivity and independence re-
quires a continuing assessment of client relationships and public responsibility. Such a
member who provides auditing and other attestation services should be independent in fact
and appearance. In providing all other services, a member should maintain objectivity and
avoid conflicts of interest.
Although members not in public practice cannot maintain the appearance of indepen-
dence, they nevertheless have the responsibility to maintain objectivity in rendering pro-
fessional services. Members employed by others to prepare financial statements or to
perform auditing, tax, or consulting services are charged with the same responsibility for
objectivity as members in public practice and must be scrupulous in their application of
generally accepted accounting principles and candid in all their dealings with members in
public practice.

Article V: Due Care

A member should observe the profession’s technical and ethical standards, strive continu-
ally to improve competence and the quality of services, and discharge professional respon-
sibility to the best of the member’s ability.
The quest for excellence is the essence of due care. Due care requires a member to dis-
charge professional responsibilities with competence and diligence. It imposes the obliga-
tion to perform professional services to the best of a member’s ability with concern for the
best interest of those for whom the services are performed and consistent with the profes-
sion’s responsibility to the public.
Competence is derived from a synthesis of education and experience. It begins with a
mastery of the common body of knowledge required for designation as a certified public
accountant. The maintenance of competence requires a commitment to learning and
professional improvement that must continue throughout a member’s professional life. It
is a member’s individual responsibility. In all engagements and in all responsibilities, each
member should undertake to achieve a level of competence that will assure that the quality of
the member’s services meets the high level of professionalism required by these Principles.
Competence represents the attainment and maintenance of a level of understanding and
knowledge that enables a member to render services with facility and acumen. It also
establishes the limitations of a member’s capabilities by dictating that consultation or
referral may be required when a professional engagement exceeds the personal competence
of a member or a member’s firm. Each member is responsible for assessing his or her own
competence—of evaluating whether education, experience, and judgment are adequate for
the responsibility to be assumed.
Members should be diligent in discharging responsibilities to clients, employers, and the
public. Diligence imposes the responsibility to render services promptly and carefully, to
be thorough, and to observe applicable technical and ethical standards.
 Chapter 1 Ethical Issues in Advanced Accounting 15

Due care requires a member to plan and supervise adequately any professional activity
for which he or she is responsible.
Article VI: Scope and Nature of Services
A member in public practice should observe the Principles of the Code of Professional
Conduct in determining the scope and nature of services to be provided.
The public interest aspect of certified public accountants’ services requires that such ser-
vices be consistent with acceptable professional behavior for certified public accountants.
Integrity requires that service and the public trust not be subordinated to personal gain and
advantage. Objectivity and independence requires that members be free from conflicts of
interest in discharging professional responsibilities. Due care requires that services be pro-
vided with competence and diligence.
Each of these Principles should be considered by members in determining whether or
not to provide specific services in individual circumstances. In some instances, they may
represent an overall constraint on the nonaudit services that might be offered to a specific
client. No hard-and-fast rules can be developed to help members reach these judgments,
but they must be satisfied that they are meeting the spirit of the Principles in this regard.
In order to accomplish this, members should
• Practice in firms that have in place internal quality-control procedures to ensure that ser-
vices are competently delivered and adequately supervised.
• Determine, in their individual judgments, whether the scope and nature of other services
provided to an audit client would create a conflict of interest in the performance of the
audit function for that client.
• Assess, in their individual judgments, whether an activity is consistent with their role as
professionals.

SECTION II: RULES

Applicability
The bylaws of the American Institute of Certified Public Accountants require that members
adhere to the Rules of the Code of Professional Conduct. Members must be prepared to jus-
tify departures from these Rules.
Definitions17
[Pursuant to its authority under the bylaws (BL § 3.6.2.2) to interpret the Code of Profes-
sional Conduct, the Professional Ethics Executive Committee has issued the following
definitions of terms appearing in the code effective November 30, 1989.]
Attest engagement. An attest engagement is an engagement that requires indepen-
dence as defined in AICPA Professional Standards.
Attest engagement team. The attest engagement team consists of individuals partic-
ipating in the attest engagement, including those who perform concurring and second
partner reviews. The attest engagement team includes all employees and contractors
retained by the firm who participate in the attest engagement, irrespective of their
functional classification (for example, audit, tax, or management consulting services).
The attest engagement team excludes specialists as discussed in SAS No. 73, Using
the Work of a Specialist [AU section 336], and individuals who perform only routine
clerical functions, such as word processing and photocopying.
Client. A client is any person or entity, other than the member’s employer, that engages
a member or a member’s firm to perform professional services or a person or entity
17
As adopted, January 12, 1988, unless otherwise indicated
16 Chapter 1 Ethical Issues in Advanced Accounting

with respect to which professional services are performed. For purposes of this paragraph,
the term “employer” does not include—
a. Entities engaged in the practice of public accounting; or
b. Federal, state, and local governments or component units thereof provided the
member performing professional services with respect to those entities—
i. Is directly elected by voters of the government or component unit thereof
with respect to which professional services are performed; or
ii. Is an individual who is (1) appointed by a legislative body and (2) subject to
removal by a legislative body; or
iii. Is appointed by someone other than the legislative body, so long as the ap-
pointment is confirmed by the legislative body and removal is subject to
oversight or approval by the legislative body.
Close relative. A close relative is a parent, sibling, or nondependent child.
Council. The Council of the American Institute of Certified Public Accountants.
Covered member. A covered member is—
a. An individual on the attest engagement team;
b. An individual in a position to influence the attest engagement;
c. A partner or manager who provides nonattest services to the attest client begin-
ning once he or she provides ten hours of nonattest services to the client within
any fiscal year and ending on the later of the date (i) the firm signs the report on
the financial statements for the fiscal year during which those services were pro-
vided or (ii) he or she no longer expects to provide ten or more hours of nonat-
test services to the attest client on a recurring basis;
d. A partner in the office in which the lead attest engagement partner primarily
practices in connection with the attest engagement;
e. The firm, including the firm’s employee benefit plans; or
f. An entity whose operating, financial, or accounting policies can be controlled
(as defined by generally accepted accounting principles [GAAP] for consolidation
purposes) by any of the individuals or entities described in (a) through (e) or by
two or more such individuals or entities if they act together.
Financial institution. A financial institution is considered to be an entity that, as part
of its normal business operations, makes loans or extends credit to the general public.
In addition, for automobile leases addressed under interpretation 101-5, Loans From
Financial Institution Clients, an entity would be considered a financial institution if it
leases automobiles to the general public.
Financial statements. A presentation of financial data, including accompanying
notes, if any, intended to communicate an entity’s economic resources and/or obliga-
tions at a point in time or the changes therein for a period of time, in accordance with
generally accepted accounting principles or a comprehensive basis of accounting other
than generally accepted accounting principles.
Incidental financial data to support recommendations to a client or in documents
for which the reporting is governed by Statements on Standards for Attestation
Engagements and tax returns and supporting schedules do not, for this purpose, consti-
tute financial statements. The statement, affidavit, or signature of preparers required
on tax returns neither constitutes an opinion on financial statements nor requires a dis-
claimer of such opinion.
Firm. A firm is a form of organization permitted by law or regulation whose character-
istics conform to resolutions of the Council of the American Institute of Certified Public
Accountants that is engaged in the practice of public accounting. Except for purposes
 Chapter 1 Ethical Issues in Advanced Accounting 17

of applying Rule 101: Independence, the firm includes the individual partners thereof.
[Revised November, 2001.]
Institute. The American Institute of Certified Public Accountants.
Interpretations of rules of conduct. Pronouncements issued by the division of pro-
fessional ethics to provide guidelines concerning the scope and application of the rules
of conduct.
Member. A member, associate member, or international associate of the American
Institute of Certified Public Accountants.
Practice of public accounting. The practice of public accounting consists of the perfor-
mance for a client, by a member or a member’s firm, while holding out as CPA(s), of the
professional services of accounting, tax, personal financial planning, litigation support ser-
vices, and those professional services for which standards are promulgated by bodies des-
ignated by Council, such as Statements of Financial Accounting Standards, Statements on
Auditing Standards, Statements on Standards for Accounting and Review Services, State-
ments on Standards for Consulting Services, Statements of Governmental Accounting
Standards, and Statements on Standards for Attestation Engagements.
However, a member or a member’s firm, while holding out as CPA(s), is not considered
to be in the practice of public accounting if the member or the member’s firm does not per-
form, for any client, any of the professional services described in the preceding paragraph.
Professional Services. Professional services include all services performed by a
member while holding out as a CPA.

RULES
Rule 101 Independence
A member in public practice shall be independent in the performance of professional ser-
vices as required by standards promulgated by bodies designated by Council.
Rule 102 Integrity and Objectivity
In the performance of any professional service, a member shall maintain objectivity and in-
tegrity, shall be free of conflicts of interest, and shall not knowingly misrepresent facts or
subordinate his or her judgment to others.
Rule 201 General Standards
A member shall comply with the following standards and any interpretations thereof by
bodies designated by Council.
A. Professional Competence. Undertake only those professional services that the
member or the member’s firm can reasonably expect to be completed with profes-
sional competence.
B. Due Professional Care. Exercise due professional care in the performance of pro-
fessional services.
C. Planning and Supervision. Adequately plan and supervise the performance of pro-
fessional services.
D. Sufficient Relevant Data. Obtain sufficient relevant data to afford a reasonable basis for
conclusions or recommendations in relation to any professional services performed.
Rule 202 Compliance with Standards
A member who performs auditing, review, compilation, management consulting, tax, or
other professional services shall comply with standards promulgated by bodies designated
by Council.
18 Chapter 1 Ethical Issues in Advanced Accounting

Rule 203 Accounting Principles

A member shall not (1) express an opinion or state affirmatively that the financial state-
ments or other financial data of any entity are presented in conformity with generally
accepted accounting principles or (2) state that he or she is not aware of any material mod-
ifications that should be made to such statements or data in order for them to be in confor-
mity with generally accepted accounting principles, if such statements or data contain any
departure from an accounting principle promulgated by bodies designated by Council to
establish such principles that has a material effect on the statements or data taken as a
whole. If, however, the statements or data contain such a departure and the member can
demonstrate that due to unusual circumstances the financial statements or data would
otherwise have been misleading, the member can comply with the rule by describing the
departure, its approximate effects, if practicable, and the reasons why compliance with the
principle would result in a misleading statement.
Rule 301 Confidential Client Information
A member in public practice shall not disclose any confidential client information without
the specific consent of the client.
This rule shall not be construed (1) to relieve a member of his or her professional oblig-
ations under rules 202 and 203, (2) to affect in any way the member’s obligation to comply
with a validly issued and enforceable subpoena or summons, or to prohibit a member’s com-
pliance with applicable laws and government regulations, (3) to prohibit review of a mem-
ber’s professional practice under AICPA or state CPA society or Board of Accountancy
authorization, or (4) to preclude a member from initiating a complaint with, or responding
to any inquiry made by, the ethics division or trial board of the Institute or a duly constituted
investigative or disciplinary body of a state CPA society or Board of Accountancy.
Members of any of the bodies identified in (4) above and members involved with pro-
fessional practice reviews identified in (3) above shall not use to their own advantage or dis-
close any member’s confidential client information that comes to their attention in carrying
out those activities. This prohibition shall not restrict members’ exchange of information in
connection with the investigative or disciplinary proceedings described in (4) above or the
professional practice reviews described in (3) above.
Rule 302 Contingent Fees18
A member in public practice shall not
1. Perform for a contingent fee any professional services for, or receive such a fee from, a
client for whom the member or the member’s firm performs
a. an audit or review of a financial statement; or
b. a compilation of a financial statement when the member expects, or reasonably might
expect, that a third party will use the financial statement and the member’s compila-
tion report does not disclose a lack of independence; or
c. an examination of prospective financial information;
or
2. Prepare an original or amended tax return or claim for a tax refund for a contingent fee
for any client.
The prohibition in (1) above applies during the period in which the member or the mem-
ber’s firm is engaged to perform any of the services listed above and the period covered by
any historical financial statements involved in any such listed services.

18
Laws or board of accountancy rules of some states prohibit the receipt of contingent fees by CPAs.
(Author’s note)
 Chapter 1 Ethical Issues in Advanced Accounting 19

Except as stated in the next sentence, a contingent fee is a fee established for the per-
formance of any service pursuant to an arrangement in which no fee will be charged unless
a specified finding or result is attained, or in which the amount of the fee is otherwise de-
pendent upon the finding or result of such service. Solely for purposes of this rule, fees are
not regarded as being contingent if fixed by courts or other public authorities, or, in tax mat-
ters, if determined based on the results of judicial proceedings or the findings of govern-
mental agencies.
A member’s fees may vary depending, for example, on the complexity of services
rendered.
Rule 401 [Reserved]
Rule 501 Acts Discreditable
A member shall not commit an act discreditable to the profession.
Rule 502 Advertising and Other Forms of Solicitation
A member in public practice shall not seek to obtain clients by advertising or other forms
of solicitation in a manner that is false, misleading, or deceptive. Solicitation by the use of
coercion, over-reaching, or harassing conduct is prohibited.
Rule 503 Commissions and Referral Fees19
A. Prohibited Commissions
A member in public practice shall not for a commission recommend or refer to a client any
product or service, or for a commission recommend or refer any product or service to be
supplied by a client, or receive a commission, when the member or the member’s firm also
performs for that client
a. an audit or review of a financial statement; or
b. a compilation of a financial statement when the member expects, or reasonably might
expect, that a third party will use the financial statement and the member’s compilation
report does not disclose a lack of independence; or
c. an examination of prospective financial information.
This prohibition applies during the period in which the member is engaged to perform
any of the services listed above and the period covered by any historical financial state-
ments involved in such listed services.
B. Disclosure of Permitted Commissions
A member in public practice who is not prohibited by this rule from performing services
for or receiving a commission and who is paid or expects to be paid a commission shall
disclose that fact to any person or entity to whom the member recommends or refers a
product or service to which the commission relates.
C. Referral Fees
Any member who accepts a referral fee for recommending or referring any service of a
CPA to any person or entity or who pays a referral fee to obtain a client shall disclose such
acceptance or payment to the client.
Rule 504
[There is currently no rule 504.]

19
Laws or board of accountancy rules of some states prohibit the payment or receipt of commissions by
CPAs. (Author’s note)
20 Chapter 1 Ethical Issues in Advanced Accounting

Rule 505 Form of Organization and Name

A member may practice public accounting only in the form of organization permitted by
law or regulation whose characteristics conform to resolutions of Council.
A member shall not practice public accounting under a firm name that is mislead-
ing. Names of one or more past owners may be included in the firm name of a successor
organization.
A firm may not designate itself as “Members of the American Institute of Certified Pub-
lic Accountants” unless all of its owners are members of the Institute.

Review 1. What are cute accounting and cooking the books?

Questions 2. Why is the Equity Funding Corporation of America fraud significant for management
accountants and financial executives?
3. Identify the four components of ethical conduct for management accountants, set
forth in Standards of Ethical Conduct for Members of the Institute of Management
Accountants.
4. How did the National Commission on Fraudulent Financial Reporting (Treadway
Commission) define fraudulent financial reporting?
5. What Rules of Professional Conduct of the American Institute of Certified Public
Accountants apply to all members of the AICPA, including management accountants?
6. Do the ethics codes of the Institute of Management Accountants and the Financial
Executives International require their members to comply with generally accepted ac-
counting principles? Explain.
7. What is insider trading of corporate securities?
8. Does the Securities and Exchange Commission accept a “good soldier” rationalization
for fraudulent financial reporting? Explain.
9. What are the obligations of management accountants regarding conflicts of interest?
10. Does the Code of Ethics of the Financial Executives International require FEI mem-
bers to maintain the confidentiality of information acquired in the course of their work
in all circumstances? Explain.
11. Does the Code of Professional Conduct of the American Institute of Certified Public
Accountants require AICPA members in industry to maintain the appearance of inde-
pendence? Explain.
12. What classes of accountants are subject to regulation by the Public Company Account-
ing Oversight Board?

Exercises
(Exercise 1.1) Select the best answer for each of the following multiple-choice questions:
1. The bylaws of the AICPA require members to adhere to the Code of Professional Con-
duct section entitled:
a. Principles
b. Rules
c. Interpretations
d. Ethics Rulings
 Chapter 1 Ethical Issues in Advanced Accounting 21

2. A rule of the AICPA Code of Professional Conduct that does not apply to AICPA
members in private industry is:
a. Rule 101 Independence.
b. Rule 102 Integrity and Objectivity.
c. Rule 201 General Standards.
d. Rule 203 Accounting Principles.
e. None of the foregoing.
3. Conduct of a member’s personal affairs is addressed in the ethics code or codes of:
a. The American Institute of Certified Public Accountants only.
b. The Financial Executives International.
c. The Institute of Management Accountants only.
d. None of the three organizations cited above.
4. According to the National Commission on Fraudulent Financial Reporting (Treadway
Commission), the responsibility for reliable financial reporting lies first and foremost:
a. At the corporate level.
b. With the SEC.
c. With independent auditors.
d. With state boards of accountancy.
5. Does fraudulent financial reporting include:

Cooking the Books? Cute Accounting?

a. No Yes
b. No No
c. Yes Yes
d. Yes No

6. According to the AICPA, are financial statements of a business enterprise that have
been drafted by the enterprise’s independent auditors on its behalf the representations
of the enterprise’s:

Management? Independent Auditors?

a. Yes Yes
b. Yes No
c. No Yes
d. No No

7. Standards of Ethical Conduct for Members of the Institute of Management Accoun-

tants deal with all of the following except:
a. Competence
b. Confidentiality
c. Independence
d. Integrity
e. Objectivity
8. The Report of the National Commission on Fraudulent Financial Reporting did not
include recommendations for:
a. Financial institution regulators.
b. Legal counsel of business enterprises.
c. Educators.
d. State boards of accountancy.
22 Chapter 1 Ethical Issues in Advanced Accounting

9. Are conflicts of interest addressed directly in the ethics codes of the:

IMA? FEI? AICPA?

a. Yes Yes Yes
b. Yes No Yes
c. No Yes Yes
d. No No Yes

10. Compliance with generally accepted accounting principles is required by the ethics
code of the:
a. AICPA only.
b. AICPA and FEI.
c. AICPA and IMA.
d. AICPA, FEI, and IMA.
11. According to Standards of Ethical Conduct for Members of the Institute of Manage-
ment Accountants, management accountants faced with significant ethical issues
should first:
a. Discuss the issue with the immediate superior, except when it appears the superior
is involved.
b. Clarify relevant concepts by confidential discussion with an objective adviser.
c. Discuss the issue with the audit committee of the board of directors.
d. Follow the established policies of the business enterprise bearing on the resolution
of such issues.
12. The section of the American Institute of Certified Public Accountants Code of Profes-
sional Conduct that governs the performance of professional services by AICPA mem-
bers is the:
a. Principles
b. Rules
c. Bylaws
d. Technical standards

Cases
(Case 1.1) Suppose you were to participate in a debate of the following resolution:
Resolved, that the following sentence from the Preamble to Section I: Principles of the
AICPA Code of Professional Conduct is overly idealistic in today’s society:
The Principles call for an unswerving commitment to honorable behavior, even at the sacrifice of
personal advantage.
Instructions
Would you support the affirmative or the negative side of the debate? Explain.
(Case 1.2) In his Meditations, the Roman emperor Marcus Aurelius Antoninus wrote as follows (Books III
and VII):
A man must stand erect, not be kept erect by others. . . .
Be thou erect or be made erect.
Instructions
Evaluate the usefulness of the ethics rules of the AICPA, FEI, and IMA in relation to the
foregoing quotations.
 Chapter 1 Ethical Issues in Advanced Accounting 23

(Case 1.3) Chief executive officers (CEOs) of business enterprises often pressure enterprise chief
financial officers (CFOs) or controllers to cook the books.
Instructions
Evaluate the ethics rules of the IMA, FEI, and AICPA as guidelines for resisting the pres-
sures described above.
(Case 1.4) General Instruction D(2)(a) of Form 10-K, Annual Report, requires the report, filed with
the SEC, to be signed by the registrant company’s principal financial officer and controller
or principal accounting officer. Similarly, General Instruction G of Form 10-Q, Quarterly
Report, requires the report, filed with the SEC, to be signed by the principal financial or
chief accounting officer of the registrant company.
Instructions
How should the chief financial officer (CFO) and the controller of an SEC registrant enter-
prise view the obligation to sign the registrant’s Form 10-K and Form 10-Q reports to the
SEC? Explain.
(Case 1.5) According to Ralph E. Walters (page 7 of the text): “An obligation to be impartial seems to
me to place a new and possibly unrealistic burden on the management accountant.”
Instructions
Do you agree with Walters? Explain.
(Case 1.6) An earlier version of the Financial Executives International Code of Ethics required FEI
members to conduct their personal affairs, as well as their business affairs, with honesty
and integrity. The current version does not have that requirement.
Instructions
Did the FEI err in removing the foregoing requirement from its ethics code? Explain.
(Case 1.7) Vernon Cass, chief financial officer of Tingley Corporation, a publicly owned enterprise,
asked his subordinate, John Conroy, CPA and controller of Tingley, if any accounting
changes might be made before the forthcoming close of the fiscal year to enhance Tingley’s
earnings for the year. Conroy suggested that he might extend economic lives of plant assets,
reduce the percentage used to estimate doubtful accounts expense based on net credit sales,
and defer, rather than expense, certain advertising costs that consistently had been recog-
nized as expenses in prior years. Cass instructed Conroy to formalize a proposal incorpo-
rating those suggestions, for consideration by the audit committee of Tingley’s board of
directors.
Instructions
Evaluate the actions of Vernon Cass and John Conroy. (Suggestion: Consider the provisions
of APB Opinion No. 20, “Accounting Changes,” and Statement on Auditing Standards
No. 57, “Auditing Accounting Estimates,” in your discussion.)
(Case 1.8) The following excerpt is from Standards of Ethical Conduct for Members of the Institute
of Management Accountants:
If [an] ethical conflict still exists after exhausting all levels of internal review, there may be no
other recourse on significant matters than to resign from the organization and to submit an infor-
mative memorandum to an appropriate representative of the organization.

Instructions
What is your opinion of the foregoing excerpt? Explain.
(Case 1.9) Certified public accountants (CPAs) typically are subject to codes of ethics or conduct en-
acted by state boards of accountancy that license the accountants.
24 Chapter 1 Ethical Issues in Advanced Accounting

Instructions
Given that CPAs are subject to oversight by state boards of accountancy, what is the
incentive—if any—for CPAs in management accounting to be members of the AICPA, the
FEI, or the IMA? Explain.
(Case 1.10) You are the chief financial officer of Playthings, Inc., a newly organized, publicly owned
manufacturer of toys and games. Roy Weber, the chairman of the audit committee of the
company’s board of directors, asks you to consider at what point, under generally accepted
accounting principles, the company can recognize revenue for “bill and hold” sales of toys
to retailers. He stresses that it is imperative for the company to comply with federal and
state securities laws.
Instructions
Prepare a memorandum to answer the audit committee chairman after you have researched
the following:
Statement of Financial Accounting Concepts No. 6, “Elements of Financial
Statements,” pars. 78, 79.
Statement of Financial Accounting Concepts No. 5, “Recognition and Measurement
in Financial Statements of Business Enterprises,” pars. 83, 84.
Uniform Commercial Code, secs. 401, 501.
SEC Accounting Series Release No. 292, “ . . . In the Matter of Arthur Andersen & Co.”
SEC Accounting and Auditing Enforcement Release No. 108, “ . . . In the Matter of
Stewart Parness.”
SEC Accounting and Auditing Enforcement Release No. 817, “ . . . In the Matter of
Cypress Bioscience Inc. . . .”
(Case 1.11) In a September 1998 speech, former Securities and Exchange Commission Chairman
Arthur Levitt used the term cookie-jar reserves to describe a “cooking the books” tech-
nique used by some publicly owned companies to manage earnings. The technique involved
establishing fictitious liabilities for bogus expenses or realized and earned revenues in a
highly profitiable quarter or fiscal year, and reversing the liabilities in subsequent low earn-
ings periods.
Instructions
a. Obtain and study SEC AAER 1140, “In the Matter of W. R. Grace & Co., Respondent”
(June 30, 1999) and describe the “cookie-jar reserves” technique used by Grace.
b. Review the Staff Accounting Bulletins issued by the SEC subsequent to June 30, 1999,
and briefly describe the provisions of a Bulletin dealing with the Grace matter and the
SEC staff’s resultant requirements.
Chapter Two

Partnerships:
Organization and
Operation

Scope of Chapter
The Uniform Partnership Act, which has been adopted by most of the states, defines a part-
nership (often referred to as a firm) as “an association of two or more persons to carry on,
as co-owners, a business for profit.” In this definition, the term persons includes individu-
als and other partnerships, and in some states, corporations. Partnerships generally are as-
sociated with the practice of law, medicine, public accounting, and other professions, and
also with small business enterprises. In some states licensed professional persons such as
CPAs are forbidden to incorporate because the creation of a corporate entity might weaken
the confidential relationship between the professional person and the client. However, a
number of states have approved legislation designed to permit professional corporations,
which have various requirements as to professional licensing of stockholders, transfers of
stock ownership, and malpractice insurance coverage.
The traditional form of partnership under the Uniform Partnership Act has been the
general partnership, in which all partners have unlimited personal liability for unpaid
debts of the partnership. However, laws of several states now permit the formation of lim-
ited liability partnerships (LLPs), which have features of both general partnerships and
professional corporations. Individual partners of LLPs are personally responsible for their
own actions and for the actions of partnership employees under their supervision; how-
ever, they are not responsible for the actions of other partners. The LLP as a whole, like a
general partnership, is responsible for the actions of all partners and employees. Since
many of the issues of organization, income-sharing plans, and changes in ownership of
now-prevalent LLPs are similar to those of general partnerships, LLPs are discussed in
this section. The organization of limited liability partnerships and income-sharing plans
and changes in ownership of such partnerships are discussed and illustrated first, followed
by an explanation of the characteristics of, accounting for, and financial statements of
limited partnerships (which differ significantly from LLPs). The chapter ends with a
description of SEC enforcement actions involving unethical violations of accounting stan-
dards for partnerships.
25
26 Part One Accounting for Partnerships and Branches

ORGANIZATION OF A LIMITED LIABILITY PARTNERSHIP

Characteristics of an LLP
The basic characteristics of an LLP are:
Ease of Formation In contrast with a corporation, a limited liability partnership may be
created by an oral or a written contract between two or more persons, or may be implied by
their conduct. This advantage of convenience and minimum cost of the formation of a part-
nership in some cases may be offset by certain difficulties inherent in such an informal or-
ganizational structure. LLPs that are accounting or law firms generally must register with
the state licensing authority.
Limited Life An LLP may be ended by the death, retirement, bankruptcy, or incapacity of
a partner. The admission of a new partner to the partnership legally dissolves the former
partnership and establishes a new one.
Mutual Agency Each partner has the authority to act for the limited liability partnership
and to enter into contracts on its behalf. However, acts beyond the normal scope of business
operations, such as the obtaining of a bank loan by a partner, generally do not bind the part-
nership unless specific authority has been given to the partner to enter into such transactions.
Co-Ownership of Partnership Assets and Earnings When individuals invest assets in an
LLP, they retain no claim to those specific assets but acquire an ownership equity in net assets
of the partnership. Every member of an LLP also has an interest in partnership earnings; in
fact, participation in earnings and losses is one of the tests of the existence of a partnership.

Deciding between an LLP and a Corporation

One of the most important considerations in choosing between a limited liability partner-
ship and the corporate form of business organization is the income tax status of the enter-
prise and of its owners. An LLP pays no income tax but is required to file an annual
information return showing its revenue and expenses, the amount of its net income, and
the division of the net income among the partners. The partners report their respective
shares of the ordinary net income from the partnership and such items as dividends and
charitable contributions in their individual income tax returns, regardless of whether they
received more or less than this amount of cash from the partnership during the year.
A corporation is a separate legal entity subject to a corporate income tax. The net income,
when and if distributed to stockholders as dividends, often has been taxable income to stock-
holders. Certain corporations with few stockholders may elect to be taxed as partnerships, pro-
vided their net income or loss is assumed by their stockholders. These corporations file
information returns as do partnerships, and their stockholders report their respective shares of
the year’s net income or loss on individual tax returns. Thus, a limited liability partnership may
incorporate as a Subchapter S Corporation to retain the advantages of limited liability but at the
same time elect to be taxed as a partnership. Income tax rates and regulations are subject to fre-
quent change, and new interpretations of tax laws often arise. The tax status of the owners also
is likely to change from year to year. For these reasons, management of a business enterprise
should review the tax implications of the limited liability partnership and corporate forms of or-
ganization so that the enterprise may adapt most successfully to the income tax environment.
The burden of taxation is not the only factor influencing a choice between the limited li-
ability partnership and the corporate form of organization. Perhaps the factor that most of-
ten tips the scales in favor of incorporation is the opportunity for obtaining larger amounts
of capital when ownership may be divided into shares of capital stock, readily transferable,
and offering the advantages inherent in the separation of ownership and management.
Another reason for choosing the corporate form of organization is the limited liability of
all stockholders for unpaid debts of the corporation.
 Chapter 2 Partnerships: Organization and Operation 27

Is the LLP a Separate Entity?

In accounting literature, the legal status of partnerships sometimes has received more em-
phasis than the fact that they are business enterprises. It has been common practice to dis-
tinguish a partnership from a corporation by saying that a partnership is an “association of
persons” and a corporation is a separate entity. Such a distinction stresses the legal form
rather than the economic substance of the business organization. In terms of managerial
policy and business objectives, limited liability partnerships are as much business and ac-
counting entities as are corporations. Limited liability partnerships typically are guided by
long-range plans not likely to be affected by the admission or withdrawal of a single part-
ner. In these firms the accounting policies should reflect the fact that the partnership is an
accounting entity apart from its owners.
Treating the LLP as an economic and accounting entity often will aid in developing fi-
nancial statements that provide the most meaningful presentation of financial position and
results of operations. Among the accounting policies to be stressed is continuity in asset
valuation, despite changes in the income-sharing ratio and changes in ownership. Another
appropriate policy may be recognizing as operating expenses the salaries for personal ser-
vices rendered by partners who also hold managerial positions. In theoretical discussions,
considerable support is found for treating every business enterprise as an accounting entity,
apart from its owners, regardless of the form of organization. A managing partner under
this view is both an employee and an owner, and the salary for the personal services ren-
dered by a partner is an operating expense of the partnership.
The inclusion of partners’ salaries among operating expenses has been opposed by some
accountants on grounds that partners’ salaries may be set at unrealistic levels and that a
partnership is an association of individuals who are owners and not employees of the part-
nership, despite their managerial or other functions.
A limited liability partnership has the characteristics of a separate entity in that it may hold
title to property, may enter into contracts, and in some states may sue or be sued as an entity.
In practice, most accountants treat limited liability partnerships as separate entities with con-
tinuity of accounting policies and asset valuations not interrupted by changes in ownership.

The Partnership Contract

Although a partnership may exist on the basis of an oral agreement or may be implied by
the actions of its members, good business practice requires that the partnership contract be
in writing. The most important points covered in a contract for a limited liability partner-
ship are the following:
1. The date of formation and the planned duration of the partnership, the names of the part-
ners, and the name and business activities of the partnership.
2. The assets to be invested by each partner, the procedure for valuing noncash invest-
ments, and the penalties for a partner’s failure to invest and maintain the agreed amount
of capital.
3. The authority of each partner and the rights and duties of each.
4. The accounting period to be used, the nature of accounting records, financial statements,
and audits by independent public accountants.
5. The plan for sharing net income or loss, including the frequency of income measure-
ment and the distribution of the income or loss among the partners.
6. The salaries and drawings allowed to partners and the penalties, if any, for excessive
withdrawals.
7. Insurance on the lives of partners, with the partnership or surviving partners named as
beneficiaries.
28 Part One Accounting for Partnerships and Branches

8. Provision for arbitration of disputes and liquidation of the partnership at the end of the
term specified in the contract or at the death or retirement of a partner. Especially im-
portant in avoiding disputes is agreement on procedures such as binding arbitration for
the valuation of the partnership assets and the method of settlement with the estate of a
deceased partner.
One advantage of preparing a partnership contract with the aid of attorneys and accoun-
tants is that the process of reaching agreement on specific issues will develop a better under-
standing among the partners on many issues that might be highly controversial if not settled at
the outset. However, it is seldom possible to cover in a partnership contract every issue that
may later arise. Revision of the partnership contract generally requires the approval of all partners.
Disputes arising among partners that cannot be resolved by reference to the partnership
contract may be settled by binding arbitration or in the courts. A partner who is not satis-
fied with the handling of disputes always has the right to withdraw from the partnership.

Ledger Accounts for Partners

Accounting for an LLP differs from accounting for a single proprietorship or a corporation
with respect to the sharing of net income and losses and the maintenance of the partners’
ledger accounts. Although it might be possible to maintain partnership accounting records
with only one ledger account for each partner, the usual practice is to maintain three types
of accounts. These partnership accounts consist of (1) capital accounts, (2) drawing or per-
sonal accounts, and (3) accounts for loans to and from partners.
The original investment by each partner is recorded by debiting the assets invested, cred-
iting any liabilities assumed by the partnership, and crediting the partner’s capital account
with the current fair value of the net assets (assets minus liabilities) invested. Subsequent
to the original investment, the partner’s equity is increased by additional investments and
by a share of net income; the partner’s equity is decreased by withdrawal of cash or other
assets and by a share of net losses.
Another possible source of increase or decrease in partners’ ownership equity results
from changes in ownership, as described in subsequent sections of this chapter.
The original investment of assets by partners is recorded by credits to the capital ac-
counts; drawings (withdrawals of cash or other assets) by partners in anticipation of net in-
come or drawings that are considered salary allowances are recorded by debits to the
drawing accounts. However, a large withdrawal that is considered a permanent reduction in
the ownership equity of a partner is debited directly to the partner’s capital account.
At the end of each accounting period, the net income or net loss in the partnership’s In-
come Summary ledger account is transferred to the partners’ capital accounts in accordance
with the partnership contract. The debit balances in the drawing accounts at the end of the
period also are closed to the partners’ capital accounts. Because the accounting procedures
for partners’ ownership equity accounts are not subject to state regulations as in the case of
capital stock and other stockholders’ equity accounts of a corporation, deviations from the
procedures described here are possible.

Loans to and from Partners

Occasionally, a partner may receive cash from the limited liability partnership with the in-
tention of repaying this amount. Such a transaction may be debited to the Loans Receivable
from Partners ledger account rather than to the partner’s drawing account.
Conversely, a partner may make a cash payment to the partnership that is considered a
loan rather than an increase in the partner’s capital account balance. This transaction is
recorded by a credit to Loans Payable to Partners and generally is accompanied by the is-
suance of a promissory note. Loans receivable from partners are displayed as assets in the
 Chapter 2 Partnerships: Organization and Operation 29

partnership balance sheet and loans payable to partners are displayed as liabilities. The clas-
sification of these items as current or long-term generally depends on the maturity date, al-
though these related party transactions may result in noncurrent classification of the
partners’ loans, regardless of maturity dates.
If a substantial unsecured loan has been made by a limited liability partnership to a part-
ner and repayment appears doubtful, it is appropriate to offset the receivable against the
partner’s capital account balance. If this is not done, partnership total assets and total part-
ners’ equity may be misleading. In any event, the disclosure principle requires separate list-
ing of any receivables from partners.

Valuation of Investments by Partners

The investment by a partner in the firm often includes assets other than cash. It is impera-
tive that the partners agree on the current fair value of nonmonetary assets at the time of
their investment and that the assets be recognized in the accounting records at such values.
Any gains or losses resulting from the disposal of such assets during the operation of the
partnership, or at the time of liquidation, generally are divided according to the plan for
sharing net income or losses. Therefore, equitable treatment of the individual partners re-
quires a starting point of current fair values recorded for all noncash assets invested in the
firm. Thus, partnership gains or losses from disposal of noncash assets invested by the part-
ners will be measured by the difference between the disposal price and the current fair
value of the assets when invested by partners, adjusted for any depreciation, amortization,
or impairment losses to the date of disposal.

INCOME-SHARING PLANS FOR LIMITED LIABILITY PARTNERSHIPS

Partners’ Equity in Assets versus Share in Earnings
The equity of a partner in the net assets of the limited liability partnership should be dis-
tinguished from a partner’s share in earnings. Thus, to say that David Jones is a one-third
partner is not a clear statement. Jones may have a one-third equity in the net assets of the
partnership but have a larger or smaller share in the net income or losses of the firm. Such
a statement might also be interpreted to mean that Jones was entitled to one-third of the net
income or losses, although his capital account represented much more or much less than
one-third of the total partners’ capital. To state the matter concisely, partners may agree on
any type of income-sharing plan (profit and loss ratio), regardless of the amount of their
respective capital account balances. The Uniform Partnership Act provides that if partners
fail to specify a plan for sharing net income or losses, it is assumed that they intended to
share equally. Because income sharing is of such great importance, it is rare to find a situ-
ation in which the partnership contract is silent on this point.

Division of Net Income or Loss

The many possible plans for sharing net income or loss among partners of a limited liabil-
ity partnership are summarized in the following categories:
1. Equally, or in some other ratio.
2. In the ratio of partners’ capital account balances on a particular date, or in the ratio of
average capital account balances during the year.
3. Allowing interest on partners’ capital account balances and dividing the remaining net
income or loss in a specified ratio.
4. Allowing salaries to partners and dividing the resultant net income or loss in a specified
ratio.
30 Part One Accounting for Partnerships and Branches

5. Bonus to managing partner based on income.

6. Allowing salaries to partners, allowing interest on capital account balances, and divid-
ing the remaining net income or loss in a specified ratio.
These alternative income-sharing plans emphasize that the value of personal services
rendered by individual partners may vary widely, as may the amounts of capital invested by
each partner. The amount and quality of managerial services rendered and the amount of
capital invested often are important factors in the success or failure of a limited liability
partnership. Therefore, provisions may be made for salaries to partners and interest on their
respective capital account balances as a preliminary step in the division of income or loss.
Any remaining income or loss then may be divided in a specified ratio.
Another factor affecting the success of a limited liability partnership may be that one of
the partners has large personal financial resources, thus giving the partnership a strong credit
rating. Similarly, a partner who is well known in a profession or an industry may make an
important contribution to the success of the partnership without participating actively in the
operations of the partnership. These two factors may be incorporated in the income-sharing
plan by careful selection of the ratio in which any remaining net income or loss is divided.
The following examples show how each of the methods of dividing net income or loss
may be applied. This series of illustrations is based on data for Alb & Bay LLP, which had
a net income of $300,000 for the year ended December 31, 2005, the first fiscal year of
operations. The partnership contract provides that each partner may withdraw $5,000 cash
on the last day of each month; both partners did so during 2005. The drawings are recorded
by debits to the partners’ drawing accounts and are not a factor in the division of net income
or loss; all other withdrawals, investments, and net income or loss are entered directly in the
partners’ capital accounts.
Partner Alb invested $400,000 on January 1, 2005, and an additional $100,000 on April 1.
Partner Bay invested $800,000 on January 1, 2005, and withdrew $50,000 on July 1. These
transactions and events are summarized in the following Capital, Drawing, and Income
Summary ledger accounts:

Ledger Accounts Alb, Capital Bay, Capital

for Alb and Bay
2005 2005 2005
Jan. 1 400,000 July 1 50,000 Jan. 1 800,000
Apr. 1 100,000

Alb, Drawing Bay, Drawing

2005 2005
Jan.–Dec. 60,000 Jan.–Dec. 60,000

Income Summary

2005
Dec. 31 300,000

Division of Earnings Equally or in Some Other Ratio

Many limited liability partnership contracts provide that net income or loss is to be divided
equally. Also, if the partners have made no specific agreement for income sharing, the Uni-
form Partnership Act provides that an intent of equal division is assumed. The net income
of $300,000 for Alb & Bay LLP is transferred by a closing entry on December 31, 2005,
 Chapter 2 Partnerships: Organization and Operation 31

from the Income Summary ledger account to the partners’ capital accounts by the follow-
ing journal entry:

Journal Entry to Close Income Summary 300,000

Income Summary Alb, Capital 150,000
Ledger Account Bay, Capital 150,000
To record division of net income for 2005.

The drawing accounts are closed to the partners’ capital accounts on December 31,
2005, as follows:

Journal Entry to Close Alb, Capital 60,000

Drawing Accounts Bay, Capital 60,000
Alb, Drawing 60,000
Bay, Drawing 60,000
To close drawing accounts.

After the drawing accounts are closed, the balances of the partners’ capital accounts
show the ownership equity of each partner on December 31, 2005.
If Alb & Bay LLP had a net loss of, say, $200,000 during the year ended December 31,
2005, the Income Summary ledger account would have a debit balance of $200,000. This
loss would be transferred to the partners’ capital accounts by a debit to each capital account
for $100,000 and a credit to the Income Summary account for $200,000.
If Alb and Bay share earnings in the ratio of 60% to Alb and 40% to Bay and net income
was $300,000, the net income would be divided $180,000 to Alb and $120,000 to Bay. The
agreement that Alb should receive 60% of the net income (perhaps because of greater
experience and personal contacts) would cause Partner Alb to absorb a larger share of the
net loss if the partnership operated unprofitably. Some partnership contracts provide that a net
income is to be divided in a specified ratio, such as 60% to Alb and 40% to Bay, but that a
net loss is divided equally or in some other ratio. Another variation intended to compensate
for unequal contributions by the partners provides that an agreed ratio (60% and 40% in
this example) shall be applicable to a specified amount of income but that any additional
income shall be shared in some other ratio.

Division of Earnings in Ratio of Partners’ Capital Account Balances

Division of partnership earnings in proportion to the capital invested by each partner is most
likely to be found in limited liability partnerships in which substantial investment is the princi-
pal ingredient for success. To avoid controversy, it is essential that the partnership contract spec-
ify whether the income-sharing ratio is based on (1) the original capital investments, (2) the
capital account balances at the beginning of each year, (3) the balances at the end of each year
(before the division of net income or loss), or (4) the average balances during each year.
Continuing the illustration for Alb & Bay LLP, assume that the partnership contract pro-
vides for division of net income in the ratio of original capital investments. The net income
of $300,000 for 2005 is divided as follows:
Division of Net
Income in Ratio of Alb: $300,000 $400,000 $1,200,000 $100,000
Original Capital
Bay: $300,000 $800,000 $1,200,000 $200,000
Investments
32 Part One Accounting for Partnerships and Branches

The journal entry to close the Income Summary ledger account would be similar to the
journal entry illustrated on page 31.
Assuming that the net income is divided in the ratio of capital account balances at the
end of the year (before drawings and the division of net income), the net income of
$300,000 for 2005 is divided as follows:
Division of Net Alb: $300,000 $500,000 $1,250,000 $120,000
Income in Ratio of
Bay: $300,000 $750,000 $1,250,000 $180,000
End-of-Year Capital
Account Balances Division of net income on the basis of (1) original capital investments, (2) yearly begin-
ning capital account balances, or (3) yearly ending capital account balances may prove in-
equitable if there are material changes in capital accounts during the year. Use of average
balances as a basis for sharing net income is preferable because it reflects the capital actu-
ally available for use by the partnership during the year.
If the partnership contract provides for sharing net income in the ratio of average capi-
tal account balances during the year, it also should state the amount of drawings each part-
ner may make without affecting the capital account. In the example for Alb & Bay LLP, the
partners are entitled to withdraw $5,000 cash monthly. Any additional withdrawals or in-
vestments are entered directly in the partners’ capital accounts and therefore influence the
computation of the average capital ratio. The partnership contract also should state whether
capital account balances are to be computed to the nearest month or to the nearest day.
The computations of average capital account balances to the nearest month and the
division of net income for Alb & Bay LLP for 2005 are as follows:

ALB & BAY LLP

Computation of Average Capital Account Balances
For Year Ended December 31, 2005

Average
Increase Capital Fraction Capital
(Decrease) Account of Year Account
Partner Date in Capital Balance Unchanged Balances
1
Alb Jan. 1 400,000 400,000 ⁄4 100,000
3
Apr.1 100,000 500,000 ⁄4 375,000
475,000
1
Bay Jan. 1 800,000 800,000 ⁄2 400,000
1
July 1 (50,000) 750,000 ⁄2 375,000
775,000
Total average capital account balances for Alb and Bay 1,250,000
Division of net income:
To Alb: $300,000 $475,000/$1,250,000 114,000
To Bay: $300,000 $775,000/$1,250,000 186,000
Total net income 300,000

Interest on Partners’ Capital Account Balances with Remaining

Net Income or Loss Divided in Specified Ratio
In the preceding section, the plan for dividing the entire net income in the ratio of partners’
capital account balances was based on the assumption that invested capital was the domi-
nant factor in the success of the partnership. However, in most cases the amount of invested
capital is only one factor that contributes to the success of the partnership. Consequently,
 Chapter 2 Partnerships: Organization and Operation 33

many partnerships choose to divide only a portion of net income in the capital ratio and to
divide the remainder equally or in some other specified ratio.
To allow interest on partners’ capital account balances at 15%, for example, is the same
as dividing a part of net income in the ratio of partners’ capital balances. If the partners
agree to allow interest on capital as a first step in the division of net income, they should
specify the interest rate to be used and also state whether interest is to be computed on cap-
ital account balances on specific dates or on average capital balances during the year.
Again refer to Alb & Bay LLP with a net income of $300,000 for 2005 and capital ac-
count balances as shown on page 30. Assume that the partnership contract allows interest
on partners’ average capital account balances at 15%, with any remaining net income or
loss to be divided equally. The net income of $300,000 for 2005 is divided as follows:

Division of Net Alb Bay Combined

Income with Interest
Interest on average capital account balances:
Allowed on Average
Alb: $475,000 0.15 $ 71,250 $ 71,250
Capital Account
Bay: $775,000 0.15 $116,250 116,250
Balances
Subtotal $187,500
Remainder ($300,000 $187,500)
divided equally 56,250 56,250 112,500
Totals $127,500 $172,500 $300,000

The journal entry to close the Income Summary ledger account on December 31, 2005,
is similar to the journal entry illustrated on page 31.
As a separate case, assume that Alb & Bay LLP had a net loss of $10,000 for the year
ended December 31, 2005. If the partnership contract provides for allowing interest on cap-
ital accounts, this provision must be enforced regardless of whether operations are prof-
itable or unprofitable. The only justification for omitting the allowance of interest on
partners’ capital accounts during a loss year would be in the case of a partnership contract
containing a specific provision requiring such omission. Note in the following analysis that
the $10,000 debit balance of the Income Summary ledger account resulting from the net
loss is increased by the allowance of interest to $197,500, which is divided equally:

Division of Net Loss Alb Bay Combined

Interest on average capital account balances:
Alb: $475,000 0.15 $ 71,250 $ 71,250
Bay: $775,000 0.15 $116,250 116,250
Subtotal $ 187,500
Resulting deficiency ($10,000 $187,500)
divided equally (98,750) (98,750) 197,500
Totals $ (27,500) $ 17,500 $ (10,000)

The journal entry to close the Income Summary ledger account on December 31, 2005,
is shown below:

Closing the Income Alb, Capital 27,500

Summary Ledger Income Summary 10,000
Account with a Debit Bay, Capital 17,500
Balance To record division of net loss for 2005.
34 Part One Accounting for Partnerships and Branches

At first thought, the idea that a net loss of $10,000 should cause one partner’s capital to
increase and the other partner’s capital to decrease may appear unreasonable, but there is
sound logic to support this result. Partner Bay invested substantially more capital than did
Partner Alb; this capital was used to carry on operations, and the partnership’s incurring of
a net loss in the first year is no reason to disregard Bay’s larger capital investment.
A significant contrast between two of the income-sharing plans discussed here (the capital-
ratio plan and the interest-on-capital-accounts plan) is apparent if one considers the case of a
partnership operating at a loss. Under the capital-ratio plan, the partner who invested more
capital is required to bear a larger share of the net loss. This result may be considered unrea-
sonable because the investment of capital presumably is not the cause of a net loss. Under the
interest plan of sharing earnings, the partner who invested more capital receives credit for this
factor and is charged with a lesser share of the net loss, or may even end up with a net credit.
Using interest allowances on partners’ capital accounts as a technique for sharing partner-
ship earnings equitably has no effect on the measurement of the net income or loss of the part-
nership. Interest on partners’ capital accounts is not an expense of the partnership, but interest
on loans from partners is recognized as expense and a factor in the measurement of net income
or loss of the partnership. Similarly, interest earned on loans to partners is recognized as part-
nership revenue. This treatment is consistent with the point made on pages 28–29 that loans to
and from partners are assets and liabilities, respectively, of the limited liability partnership.
Another item of expense arising from dealings between a partnership and one of its part-
ners is commonly encountered when the partnership leases property from a lessor who is
also a partner. Rent expense is recognized by the partnership in such situations. The lessor,
although a partner, also is a lessor to the partnership.

Salary Allowance with Resultant Net Income or Loss Divided in Specified Ratio
Salaries and drawings are not the same thing. Because the term salaries suggests weekly or
monthly cash payments for personal services that are recognized as operating expenses by
the limited liability partnership, accountants should be specific in defining the terminology
used in accounting for a partnership. This text uses the term drawings in only one sense: a
withdrawal of cash or other assets that reduces the partner’s equity but has no part in the di-
vision of net income. In the discussion of partnership accounting, the word salaries means
an operating expense included in measuring net income or loss. When the term salaries is
used with this meaning, the division of net income is the same, regardless of whether the
salaries have been paid.
A partnership contract that authorizes partners to make regular withdrawals of specific
amounts should state whether such withdrawals are intended to be a factor in the division
of net income or loss. For example, assume that the contract states that Partner Alb may
make drawings of $3,000 monthly and Partner Bay $8,000. If the intent is not clearly stated
to include or exclude these drawings as an element in the division of net income or loss,
controversy is probable, because one interpretation will favor Partner Alb and the opposing
interpretation will favor Partner Bay.
Assuming that Partner Alb has more experience and ability than Partner Bay and also
devotes more time to the partnership, it seems reasonable that the partners will want to rec-
ognize the more valuable contribution of personal services by Alb in choosing a plan for di-
vision of net income or loss. One approach to this objective would be to adopt an unequal
ratio: for example, 70% of net income or loss to Alb and 30% to Bay. However, the use of
such a ratio usually is not a satisfactory solution, for the same reasons mentioned in criti-
cizing the capital ratio as a profit-sharing plan. A ratio based only on personal services may
not reflect the fact that other factors are important in determining the success of the part-
nership. A second point is that if the partnership incurs a loss, the partner rendering more
personal services will absorb a larger portion of the loss.
 Chapter 2 Partnerships: Organization and Operation 35

A solution to the problem of recognizing unequal personal services by partners is to

provide in the partnership contract for different salaries to partners, with the resultant net
income or loss divided equally or in some other ratio. Applying this reasoning to the
continuing illustration for Alb & Bay LLP, assume that the partnership contract provides for
an annual salary of $100,000 to Alb and $60,000 to Bay, with resultant net income or loss
to be divided equally. The salaries are paid monthly during the year. The net income of
$140,000 for 2005 is divided as follows:

Division of $140,000 Alb Bay Combined

Net Income after
Salaries $100,000 $ 60,000 $160,000
Salaries Expense
Net income ($300,000 $160,000)
divided equally 70,000 70,000 140,000
Totals $170,000 $130,000 $300,000

The following journal entries are required for the foregoing:

1. Monthly journal entries debiting Partners’ Salaries Expense,
$13,333 ($160,000 12 $13,333) and crediting Alb, Capital,
$8,333 ($100,000 12 $8,333) and Bay, Capital,
$5,000 ($60,000 12 $5,000).
2. Monthly journal entries debiting Alb, Drawing, $8,333 and Bay, Drawing, $5,000 and
crediting Cash, $13,333.
3. End-of-year journal entry debiting Income Summary, $140,000, and crediting Alb,
Capital, $70,000 and Bay, Capital, $70,000.

Bonus to Managing Partner Based on Income

A partnership contract may provide for a bonus to the managing partner equal to a speci-
fied percentage of income. The contract should state whether the basis of the bonus is net
income without deduction of the bonus as an operating expense or income after the bonus. For
example, assume that the Alb & Bay LLP partnership contract provides for a bonus to Part-
ner Alb of 25% of net income (without deduction of the bonus) and that the remaining income
is divided equally. The net income is $300,000. After the bonus of $75,000 ($300,000
0.25 $75,000) to Alb, the remaining $225,000 of income is divided $112,500 to Alb and
$112,500 to Bay. Thus, Alb’s share of income is $187,500 ($75,000 $112,500
$187,500), and Bay’s share is $112,500; the bonus is not recognized as an operating expense
of the limited liability partnership.
If the partnership contract provided for a bonus of 25% of income after the bonus to
Partner Alb, the bonus is computed as follows:
Bonus Based on Bonus income after bonus $300,000
Income after Bonus
Let X income after bonus
0.25X bonus
Then 1.25X $300,000 income before bonus
X $300,000 1.25
X $240,000
0.25X $60,000 bonus to Partner Alb1
1
An alternative computation consists of converting the bonus percentage to a fraction. The bonus then may
be computed by adding the numerator to the denominator and applying the resulting fraction to the income
before the bonus. In the preceding example, 25% is converted to 1⁄4; and adding the numerator to the
denominator, the 1⁄4 becomes 1⁄5(4 1 5). One-fifth of $300,000 equals $60,000, the bonus to Partner Alb.
36 Part One Accounting for Partnerships and Branches

Thus, the prebonus income of $300,000 in this case is divided $180,000 ($60,000
$120,000 $180,000) to Alb and $120,000 to Bay, and the $60,000 bonus is recognized as
an operating expense of the partnership.
The concept of a bonus is not applicable to a net loss. When a limited liability partner-
ship operates at a loss, the bonus provision is disregarded. The partnership contract also
may specify that extraordinary items or other unusual gains and losses are to be excluded
from the basis for the computation of the bonus.

Salaries to Partners with Interest on Capital Accounts

Many limited liability partnerships divide income or loss by allowing salaries to partners
and also interest on their capital account balances. Any resultant net income or loss is di-
vided equally or in some other ratio. Such plans have the merit of recognizing that the
value of personal services rendered by different partners may vary, and that differences
in amounts invested also warrant recognition in an equitable plan for sharing net income
or loss.
To illustrate, assume that the partnership contract for Alb & Bay LLP provides for the
following:
1. Annual salaries of $100,000 to Alb and $60,000 to Bay, recognized as operating expense
of the partnership, with salaries to be paid monthly.
2. Interest on average capital account balances, as computed on page 33.
3. Remaining net income or loss divided equally.
Assuming income of $300,000 for 2005 before annual salaries expense, the $140,000
net income [$300,000 ($100,000 $60,000) $140,000] is divided as follows:

Division of Net Alb Bay Combined

Income after Salaries
Interest on average capital account balances:
Expense
Alb: $475,000 0.15 $71,250 $ 71,250
Bay: $775,000 0.15 $116,250 116,250
Subtotal $187,500
Resulting deficiency ($187,500 $140,000)
divided equally (23,750) (23,750) (47,500)
Totals $47,500 $ 92,500 $140,000

The journal entries to recognize partners’ salaries expense, partners’ withdrawals of the
salaries, and closing of the Income Summary ledger account are similar to those described
on page 35.

Financial Statements for an LLP

Income Statement
Explanations of the division of net income among partners may be included in the part-
nership’s income statement or in a note to the financial statements. This information is re-
ferred to as the division of net income section of the income statement. The following
illustration for Alb & Bay LLP shows, in a condensed income statement for the year ended
 Chapter 2 Partnerships: Organization and Operation 37

December 31, 2005, the division of net income as shown above and the disclosure of
partners’ salaries expense, a related party item:

ALB & BAY LLP

Income Statement
For Year Ended December 31, 2005

Net sales $3,000,000

Cost of goods sold 1,800,000
Gross margin on sales $1,200,000
Partners’ salaries expense $160,000
Other operating expenses 900,000 1,060,000
Net income $ 140,000
Division of net income:
Partner Alb $ 47,500
Partner Bay 92,500
Total $140,000

Note that because a partnership is not subject to income taxes, there is no income taxes
expense in the foregoing income statement. A note to the partnership’s financial statements
may disclose this fact and explain that the partners are taxed for their shares of partnership
income, including their salaries.

Statement of Partners’ Capital

Partners and other users of limited liability partnership financial statements generally want
a complete explanation of the changes in the partners’ capital accounts each year. To meet
this need, a statement of partners’ capital is prepared. The following illustrative statement
of partners’ capital for Alb & Bay LLP is based on the capital accounts presented on page 30
and includes the division of net income illustrated in the foregoing income statement.

ALB & BAY LLP

Statement of Partners’ Capital
For Year Ended December 31, 2005

Partner Alb Partner Bay Combined

Partners’ original investments,
beginning of year $400,000 $800,000 $1,200,000
Additional investment
(withdrawal) of capital 100,000 (50,000) 50,000
Balances before salaries,
net income, and drawings $500,000 $750,000 $1,250,000
Add: Salaries 100,000 60,000 160,000
Net income 47,500 92,500 140,000
Subtotals $647,500 $902,500 $1,550,000
Less: Drawings 100,000 60,000 160,000
Partners’ capital, end of year $547,500 $842,500 $1,390,000

Partners’ capital at end of year is reported as owners’ equity in the December 31, 2005,
balance sheet of the partnership that follows.
38 Part One Accounting for Partnerships and Branches

Balance Sheet
A condensed balance sheet for Alb & Bay LLP on December 31, 2005, is presented below.

ALB & BAY LLP

Balance Sheet
December 31, 2005

Assets Liabilities and Partners’ Capital

Cash $ 50,000 Trade accounts payable $ 240,000
Trade accounts Long-term debt 370,000
receivable 40,000 Total liabilities $ 610,000
Inventories 360,000 Partners’ capital:
Plant assets (net) 1,550,000 Partner Alb $547,500
Partner Bay 842,500 1,390,000
Total liabilities and
Total assets $2,000,000 partners’ capital $2,000,000

Statement of Cash Flows

A statement of cash flows is prepared for a partnership as it is for a corporation. This fi-
nancial statement, the preparation of which is explained and illustrated in intermediate ac-
counting textbooks, displays the net cash provided by operating activities, net cash used in
investing activities, and net cash provided or used in financing activities of the partnership.
A statement of cash flows for Alb & Bay LLP under the indirect method, which includes the
net income from the income statement on page 37 and the investments and combined draw-
ings from the statement of partners’ capital on page 37, is as follows:

ALB & BAY LLP

Statement of Cash Flows (indirect method)
For Year Ended December 31, 2005

Cash flows from operating activities:

Net income $ 140,000
Adjustments to reconcile net income to net cash
provided by operating activities:
Partners’ salaries expense $ 160,000
Depreciation expense 20,000
Increase in trade accounts receivable (40,000)
Increase in inventories (360,000)
Increase in trade accounts payable 240,000 20,000
Net cash provided by operating activities $ 160,000
Cash flows from investing activities:
Acquisition of plant assets $(1,200,000)
Cash flows from financing activities:
Partners’ investments $1,300,000
Partner’s withdrawal (50,000)
Partners’ drawings (160,000)
Net cash provided by financing activities 1,090,000
Net increase in cash (cash at end of year) $ 50,000
Exhibit I Noncash investing and financing activity:
Capital lease obligation incurred for plant assets $ 370,000
 Chapter 2 Partnerships: Organization and Operation 39

Correction of Partnership Net Income of Prior Period

Any business enterprise, whether it be a single proprietorship, a partnership, or a corpora-
tion, will from time to time discover errors made in the measurement of net income in prior
accounting periods. Examples include errors in the estimation of depreciation, errors in in-
ventory valuation, and omission of accruals of revenue and expenses. When such errors are
discovered, the question arises as to whether the corrections should be treated as part of the
measurement of net income for the current accounting period or as prior period adjust-
ments and entered directly to partners’ capital accounts.
The correction of prior years’ net income is particularly important when the partner-
ship’s income-sharing plan has been changed. For example, assume that in 2005 the net in-
come for Alb & Bay LLP was $300,000 and that the partners shared the net income equally,
but in 2006 they changed the income-sharing ratio to 60% for Alb and 40% for Bay. Dur-
ing 2006 it was determined that the inventories at the end of 2005 were overstated by
$100,000 because of computational errors. The $100,000 reduction in the net income for
2005 should be divided $50,000 to each partner, in accordance with the income-sharing
ratio in effect for 2005, the year in which the error occurred.
Somewhat related to the correction of errors of prior periods is the treatment of nonop-
erating gains and losses. When the income-sharing ratio of a partnership is changed, the
partners should consider the differences that exist between the carrying amounts of assets
and their current fair values. For example, assume that Alb & Bay LLP owns land acquired
for $20,000 that had appreciated in current fair value to $50,000 on the date when the
income-sharing ratio is changed from 50% for each partner to 60% for Alb and 40% for
Bay. If the land were sold for $50,000 just prior to the change in the income-sharing ratio,
the $30,000 gain would be divided $15,000 to Alb and $15,000 to Bay; if the land were sold
immediately after establishment of the 60 : 40 income-sharing ratio, the gain would be di-
vided $18,000 to Alb and only $12,000 to Bay.
A solution sometimes suggested for such partnership problems is to revalue the partner-
ship’s assets to current fair value when the income-sharing ratio is changed or when a new
partner is admitted or a partner retires. In some cases the revaluation of assets may be jus-
tified, but in general the continuity of historical cost valuations in a partnership is desirable
for the same reasons that support the use of that valuation principle in accounting for cor-
porations. A secondary objection to revaluation of assets is that, with a few exceptions such
as marketable securities, satisfactory evidence of current fair value is seldom available. The
best solution to the problem of a change in the ratio of income sharing usually is achieved
by making appropriate adjustments to the partners’ capital accounts rather than by a re-
statement of carrying amounts of assets.

CHANGES IN OWNERSHIP OF LIMITED LIABILITY PARTNERSHIPS

Accounting for Changes in Partners
Most changes in the ownership of a limited liability partnership are accomplished without
interruption of its operations. For example, when a large LLP promotes one of its employ-
ees to partner, there is usually no significant change in the finances or operating routines of
the partnership. However, from a legal viewpoint a partnership is dissolved by the retire-
ment or death of a partner or by the admission of a new partner.
Dissolution of a partnership also may result from the bankruptcy of the firm or of any
partner, the expiration of a time period stated in the partnership contract, or the mutual
agreement of the partners to end their association.2 Thus, the term dissolution may be
2
The dissolution of a partnership is defined by the Uniform Partnership Act as “the change in the
relation of the partners caused by any partner ceasing to be associated in the carrying on as distinguished
from the winding up of the business.”
40 Part One Accounting for Partnerships and Branches

used to describe events ranging from a minor change of ownership interest not affecting
operations of the partnership to a decision by the partners to terminate the partnership.
Accountants are concerned with the economic substance of an event rather than with its
legal form. Therefore, they must evaluate all the circumstances of the individual case to de-
termine how a change in partners should be recorded. The following sections of this chapter
describe and illustrate the principal kinds of changes in the ownership of a partnership.

Accounting and Managerial Issues

Although a partnership is ended in a legal sense when a partner withdraws or a new partner
is admitted, the partnership often continues operations with little outward evidence of change.
In current accounting practice, a partner’s interest often is considered a share in the part-
nership that may be transferred, much as shares of a corporation’s capital stock are trans-
ferred among stockholders, without disturbing the continuity of the partnership. For example,
if a partner of a CPA firm retires or a new partner is admitted to the firm, the contract for
the change in ownership should be planned carefully to avoid disturbing client relation-
ships. In a large CPA firm with hundreds of partners, the decision to promote an employee
to the rank of partner generally is made by a committee of partners rather than by action of
all partners.
Changes in the ownership of a partnership raise a number of accounting and managerial
issues on which an accountant may serve as consultant. Among these issues are the setting
of terms for admission of a new partner, the possible revaluation of existing partnership
assets, the development of a new plan for the division of net income or loss, and the deter-
mination of the amount to be paid to a retiring partner.

Admission of a New Partner

When a new partner is admitted to a firm of two or three partners, it is particularly appro-
priate to consider the fairness and adequacy of past accounting policies and the need for
correction of errors in prior years’ accounting data. The terms of admission of a new
partner often are influenced by the level and trend of past earnings, because they may be
indicative of future earnings. Sometimes accounting policies such as the use of the com-
pleted-contract method of accounting for construction-type contracts or the installment method
of accounting for installment sales may cause the accounting records to convey a misleading
impression of earnings in the years preceding the admission of a new partner. Accordingly, ad-
justments of the partnership accounting records may be necessary to restate the carrying
amounts of assets and liabilities to current fair values before a new partner is admitted.
As an alternative to revaluation of the existing partnership assets, it may be preferable to
evaluate any differences between the carrying amounts and current fair values of assets and
adjust the terms for admission of the new partner. In this way, the amount invested by the
incoming partner may be set at a level that reflects the current fair value of the net assets of
the partnership, even though the carrying amounts of existing partnership assets remain un-
changed in the accounting records.
The admission of a new partner to a partnership may be effected either by an acquisition
of all or part of the interest of one or more of the existing partners or by an investment of
assets by the new partner with a resultant increase in the net assets of the partnership.

Acquisition of an Interest by Payment

to One or More Partners
If a new partner acquires an interest from one or more of the existing partners, the event is
recorded by establishing a capital account for the new partner and decreasing the capital ac-
count balances of the selling partners by the same amount. No assets are received by the
partnership; the transfer of ownership is a private transaction between two or more partners.
 Chapter 2 Partnerships: Organization and Operation 41

As an illustration of this situation, assume that Lane and Mull, partners of Lane & Mull
LLP, share net income or losses equally and that each has a capital account balance of
$60,000. Nash (with the consent of Mull) acquires one-half of Lane’s interest in the part-
nership by a cash payment to Lane. The journal entry to record this change in ownership
follows:

Nash Acquires One- Lane, Capital ($60,000 1

⁄2) 30,000
Half of Lane’s Interest Nash, Capital 30,000
in Partnership To record transfer of one-half of Lane’s capital to Nash.

The cash paid by Nash for half of Lane’s interest may have been the carrying amount of
$30,000, or it may have been more or less than the carrying amount. Possibly no cash price
was established; Lane may have made a gift to Nash of the equity in the partnership. Re-
gardless of the terms of the transaction between Lane and Nash, the journal entry illustrated
above is all that is required in the partnership’s accounting records; no change has occurred
in the partnership assets, liabilities, or total partners’ capital.
To explore further some of the implications involved in the acquisition of an interest by
a new partner, assume that Nash paid $40,000 to Lane for one-half of Lane’s $60,000 eq-
uity in the partnership. Some accountants have suggested that the willingness of the new
partner to pay $10,000 [$40,000 ($60,000 1⁄2) $10,000] in excess of the carrying
amount for a one-fourth interest in the total capital of the partnership indicates that the to-
tal capital is worth $40,000 ($10,000 0.25 $40,000) more than is shown in the ac-
counting records. They reason that the carrying amounts of partnership assets should be
written up by $40,000, or goodwill of $40,000 should be recognized with offsetting credits
of $20,000 each to the capital accounts of the existing partners, Lane and Mull. However,
most accountants take the position that the payment by Nash to Lane is a personal transac-
tion between them and that the partnership, which has neither received nor distributed any
assets, should prepare no journal entry other than an entry recording the transfer of one-half
of Lane’s capital to Nash.
What are the arguments for these two opposing views? Those who advocate a write-up
of assets stress the legal concept of dissolution of the former partnership and formation of
a new partnership. This change in identity of owners, it is argued, justifies a departure from
the going-concern principle and the revaluation of partnership assets to current fair values
to achieve an accurate measurement of the capital invested by each member of the new
partnership.
The opposing argument, that the acquisition of an interest by a new partner requires
only a transfer from the capital account of the selling partner to the capital account of the
new partner, is based on several points. First, the partnership did not participate in nego-
tiating the price paid by Nash to Lane. Many factors other than the valuation of partner-
ship assets may have been involved in the negotiations between the two individuals.
Perhaps Nash paid more than the carrying amount because Nash was allowed generous
credit terms by Lane or received more than a one-fourth share in partnership net income.
Perhaps the new partner was anxious to join the firm because of the personal abilities of
Lane and Mull or because of the anticipated growth of the partnership. Further, goodwill,
defined as the excess of the cost of an acquired company over the sum of its identifiable
net assets,3 attaches only to a business as a whole.4 For these and other reasons, one may

3
FASB Statement No. 142, “Goodwill and Other Intangible Assets,” par. F1.
4
Ibid.
42 Part One Accounting for Partnerships and Branches

conclude that the cash paid for a partnership interest by a new partner to an existing
partner does not provide sufficient evidence to support changes in the carrying amounts of
the partnership’s assets.

Investment in Partnership by New Partner

A new partner may gain admission by investing assets in the limited liability partnership,
thus increasing its total assets and partners’ capital. For example, assume that Wolk and
Yary, partners of Wolk & Yary LLP, share net income or loss equally and that each has a
capital account balance of $60,000. Assume also that the carrying amounts of the partner-
ship assets are approximately equal to current fair values and that Zell owns land that might
be used for expansion of partnership operations. Wolk and Yary agree to admit Zell to the
partnership by investment of the land; net income and losses of the new firm are to be
shared equally. The land had cost Zell $50,000, but has a current fair value of $80,000. The
admission of Zell is recorded by the partnership as follows:

New Partner Invests Land 80,000

Land Zell, Capital 80,000
To record admission of Zell to partnership.

Zell has a capital account balance of $80,000 and thus owns a 40% [$80,000 ($60,000
$60,000 $80,000) 0.40] interest in the net assets of the firm. The fact that the three
partners share net income and losses equally does not require that their capital account bal-
ances be equal.

Bonus or Goodwill Allowed to Existing Partners

In a profitable, well-established firm, the existing partners may insist that a portion of the
investment by a new partner be allocated to them as a bonus or that goodwill be recog-
nized and credited to the existing partners. The new partner may agree to such terms be-
cause of the benefits to be gained by becoming a member of a firm with high earning
power.

Bonus to Existing Partners

Assume that in Cain & Duke LLP, the two partners share net income and losses equally
and have capital account balances of $45,000 each. The carrying amounts of the part-
nership net assets approximate current fair values. The partners agree to admit Eck to a
one-third interest in capital and a one-third share in net income or losses for a cash in-
vestment of $60,000. The net assets of the new firm amount to $150,000 ($45,000
$45,000 $60,000 $150,000). The following journal entry gives Eck a one-third interest
in capital and credits the $10,000 bonus ($60,000 $50,000 $10,000) equally to Cain
and Duke in accordance with their prior contract to share net income and losses equally:

Recording Bonus to Cash 60,000

Existing Partners Cain, Capital ($10,000 1
⁄2) 5,000
Duke, Capital ($10,000 1⁄2) 5,000
Eck, Capital ($150,000 1⁄3) 50,000
To record investment by Eck for a one-third interest in capital,
with bonus of $10,000 divided equally between Cain and Duke.
 Chapter 2 Partnerships: Organization and Operation 43

Goodwill to Existing Partners

In the foregoing illustration, Eck invested $60,000 but received a capital account balance
of only $50,000, representing a one-third interest in the net assets of the firm. Eck might
prefer that the full amount invested, $60,000, be credited to Eck’s capital account. This
might be done while still allotting Eck a one-third interest if goodwill is recognized by the
partnership, with the offsetting credit divided equally between the two existing partners. If
Eck is to be given a one-third interest represented by a capital account balance of $60,000,
the indicated total capital of the partnership is $180,000 ($60,000 3 $180,000), and
the total capital of Cain and Duke must equal $120,000 ($180,000 2⁄3 $120,000). Be-
cause their present combined capital account balances amount to $90,000, a write-up of
$30,000 in the net assets of the partnership is recorded as follows:

Recording Implied Cash 60,000

Goodwill Goodwill ($120,000 $90,000) 30,000
Cain, Capital ($30,000 1⁄2) 15,000
Duke, Capital ($30,000 1⁄2) 15,000
Eck, Capital 60,000
To record investment by Eck for a one-third interest in capital, with credit
offsetting goodwill of $30,000 divided equally between Cain and Duke.

Evaluation of Bonus and Goodwill Methods

When a new partner invests an amount larger than the carrying amount of the interest
acquired, the transaction should be recorded by allowing a bonus to the existing partners.
The bonus method adheres to the valuation principle and treats the partnership as a going
concern.
The alternative method of recording the goodwill implied by the amount invested by
the new partner is not considered acceptable by the author. Use of the goodwill method
signifies the substitution of estimated current fair value of an asset rather than valuation
on a cost basis. The goodwill of $30,000 recognized in the foregoing example was not
paid for by the partnership. Its existence is implied by the amount invested by the new
partner for a one-third interest in the firm. The amount invested by the new partner may
have been influenced by many factors, some of which may be personal rather than eco-
nomic in nature.
Apart from the questionable theoretical basis for such recognition of goodwill, there are
other practical difficulties. The presence of goodwill created in this manner is likely to
evoke criticism of the partnership’s financial statements, and such criticism may cause the
partnership to write off the goodwill.5 Also, if the partnership were liquidated, the goodwill
would have to be written off as a loss.

Fairness of Asset Valuation

In the foregoing examples of bonus or goodwill allowed to the existing partners, it was as-
sumed that the carrying amounts of assets of the partnership approximated current fair val-
ues. However, if land and buildings, for example, have been owned by the partnership for
many years, their carrying amounts and current fair values may be significantly different.
To illustrate this problem, assume that the net assets of Cain & Duke LLP, carried at
$90,000, were estimated to have a current fair value of $120,000 at the time of admission

5
As indicated on page 41, only acquired goodwill should be recognized, and, as explained in Chapter 5,
it currently must be written off, in whole or in part, when it is determined to be impaired.
44 Part One Accounting for Partnerships and Branches

of Eck as a partner. The previous example required Eck to receive a one-third interest in
partnership net assets for an investment of $60,000. Why not write up the partnership’s
identifiable assets from $90,000 to $120,000, with a corresponding increase in the capital
account balances of the existing partners? Neither a bonus nor the recognition of goodwill
then would be necessary to record the admission of Eck with a one-third interest in net as-
sets for an investment of $60,000 because this investment is equal to one-third of the total
partnership capital of $180,000 ($120,000 $60,000 $180,000).
Such restatement of asset values would not be acceptable practice in a corporation when
the market price of its capital stock had risen. If one assumes the existence of certain con-
ditions in a partnership, adherence to cost as the basis for asset valuation is as appropriate
a policy as for a corporation. These specific conditions are that the income-sharing ratio
should be the same as the share of equity of each partner and that the income-sharing ratio
should continue unchanged. When these conditions do not exist, a restatement of net assets
from carrying amount to current fair value may be the best way of achieving equity among
the partners.

Bonus or Goodwill Allowed to New Partner

A new partner may be admitted to a limited liability partnership because it needs cash or
because the new partner has valuable skills and business contacts. To ensure the admission
of the new partner, the present firm may offer the new partner a larger equity in net assets
than the amount invested by the new partner.

Bonus to New Partner

Assume that the two partners of Farr & Gold LLP, who share net income and losses equally
and have capital account balances of $35,000 each, offer Hart a one-third interest in net as-
sets and a one-third share of net income or losses for an investment of $20,000 cash. Their
offer is based on a need for more cash and on the conviction that Hart’s personal skills and
business contacts will be valuable to the partnership. The investment of $20,000 by Hart,
when added to the existing capital of $70,000, gives total capital of $90,000 ($20,000
$70,000 $90,000), of which Hart is entitled to one-third, or $30,000 ($90,000 1⁄3
$30,000). The excess of Hart’s capital account balance over the amount invested represents
a $10,000 bonus ($30,000 $20,000 $10,000) allowed to Hart by Farr and Gold. Be-
cause those partners share net income or losses equally, the $10,000 bonus is debited to
their capital accounts in equal amounts, as shown by the following journal entry to record
the admission of Hart to the partnership:

Recording Bonus to Cash 20,000

New Partner Farr, Capital ($10,000 1
⁄2) 5,000
1
Gold, Capital ($10,000 ⁄2) 5,000
Hart, Capital 30,000
To record admission of Hart, with bonus of $10,000 from Farr and Gold.

In outlining this method of accounting for the admission of Hart, it is assumed that the
net assets of the partnership were valued properly. If the admission of the new partner to a
one-third interest for an investment of $20,000 was based on recognition that the net assets
of the existing partnership were worth only $40,000, consideration should be given to writ-
ing down net assets by $30,000 ($70,000 $40,000 $30,000). Such write-downs would
be appropriate if, for example, trade accounts receivable included doubtful accounts or if
inventories were obsolete.
 Chapter 2 Partnerships: Organization and Operation 45

Goodwill to New Partner

Assume that the new partner Hart is the owner of a successful single proprietorship that Hart
invests in the partnership rather than making an investment in cash. Using the same data as in
the preceding example, assume that Farr and Gold, with capital account balances of $35,000
each, give Hart a one-third interest in net assets and net income or losses. The identifiable tan-
gible and intangible net assets of the proprietorship owned by Hart are worth $20,000, but, be-
cause of its superior earnings record, a current fair value for the total net assets is agreed to
be $35,000. The admission of Hart to the partnership is recorded as shown below:

New Partner Invests Identifiable Tangible and Intangible Net Assets 20,000
Single Proprietorship Goodwill ($35,000 $20,000) 15,000
with Goodwill Hart, Capital 35,000
To record admission of Hart; goodwill is attributable to superior
earnings of single proprietorship invested by Hart.

The point to be stressed is that generally goodwill is recognized as part of the investment
of a new partner only when the new partner invests in the partnership a business enterprise
of superior earning power. If Hart is admitted for a cash investment and is credited with a
capital account balance larger than the cash invested, the difference should be recorded as
a bonus to Hart from the existing partners, or undervalued tangible or identifiable intangi-
ble assets should be written up to current fair value. Goodwill should be recognized only
when substantiated by objective evidence, such as the acquisition of a profitable business
enterprise.

Retirement of a Partner
A partner retiring from a limited liability partnership usually receives cash or other assets
from the partnership. It is also possible that a retiring partner might arrange for the sale of
his or her partnership interest to one or more of the continuing partners or to an outsider.
Because the accounting principles applicable to the latter situation already have been con-
sidered, the discussion of the retirement of a partner is limited to the situation in which the
retiring partner receives assets of the partnership.
An assumption underlying this discussion is that the retiring partner has a right to with-
draw under the terms of the partnership contract. A partner always has the power to
withdraw, as distinguished from the right to withdraw. A partner who withdraws in viola-
tion of the terms of the partnership contract, and without the consent of the other partners,
may be liable for damages to the other partners.

Computation of the Settlement Price

What is a fair measurement of the equity of a retiring partner? A first indication is the re-
tiring partner’s capital account balance, but this amount may need to be adjusted before it
represents an equitable settlement price. Adjustments may include the correction of errors
in accounting data or the recognition of differences between carrying amounts of partner-
ship net assets and their current fair values. Before making any adjustments, the accountant
should refer to the partnership contract, which may contain provisions for computing the
amount to be paid to a retiring partner. For example, these provisions might require an
appraisal of assets, an audit by independent public accountants, or a valuation of the part-
nership as a going concern according to a prescribed formula. If the partnership has not
maintained accurate accounting records or has not been audited, it is possible that the
partners’ capital account balances are misstated because of incorrect depreciation expense,
failure to provide for doubtful accounts expense, and other accounting deficiencies.
46 Part One Accounting for Partnerships and Branches

If the partnership contract does not contain provisions for the computation of the retir-
ing partner’s equity, the accountant may obtain written authorization from the partners to
use a specific method to determine an equitable settlement price.
In most cases, the equity of the retiring partner is computed on the basis of current fair
values of partnership net assets. The gain or loss indicated by the difference between the
carrying amounts of assets and their current fair values is divided in the income-sharing ra-
tio. After the equity of the retiring partner has been computed in terms of current fair val-
ues for assets, the partners may agree to settle by payment of this amount, or they may
agree on a different amount. The computation of an estimated current fair value for the re-
tiring partner’s equity is a necessary step in reaching a settlement. An independent decision
is made whether to recognize the current fair values and the related changes in partners’
capital in the partnership’s accounting records.

Bonus to Retiring Partner

The partnership contract may provide for the computation of internally generated goodwill
at the time of a partner’s retirement and may specify the methods for computing the good-
will. Generally, the amount of the computed goodwill is allocated to the partners in the
income-sharing ratio. For example, assume that partner Lund is to retire from Jorb, Kent &
Lund LLP. Each partner has a capital account balance of $60,000, and net income and
losses are shared equally. The partnership contract provides that a retiring partner is to re-
ceive the balance of the retiring partner’s capital account plus a share of any internally gen-
erated goodwill. At the time of Lund’s retirement, goodwill in the amount of $30,000 is
computed to the mutual satisfaction of the partners. In the opinion of the author, this
goodwill should not be recognized in the accounting records of the partnership by a
$30,000 debit to Goodwill and a $10,000 credit to each partner’s capital account.
Serious objections exist to recording goodwill as determined in this fashion. Because
only $10,000 of the goodwill is included in the payment for Lund’s equity, the remaining
$20,000 of goodwill has not been paid for by the partnership. Its display in the balance
sheet of the partnership is not supported by either the valuation principle or reliable evi-
dence. The fact that the partners “voted” for $30,000 of goodwill does not meet the need for
reliable evidence of asset values. As an alternative, it would be possible to recognize only
$10,000 of goodwill and credit Lund’s capital account for the same amount, because this
amount was paid for by the partnership as a condition of Lund’s retirement. This method is
perhaps more justifiable, but reliable evidence that goodwill exists still is lacking. (As in-
dicted on page 41, FASB Statement No. 142, “Accounting for Goodwill . . . ,” provides that
goodwill attaches only to a business as a whole and is recognized only when a business is
acquired.) The most satisfactory method of accounting for the retirement of partner Lund is
to record the amount paid to Lund for goodwill as a $10,000 bonus. Because the settlement
with Lund is for the balance of Lund’s capital account of $60,000, plus estimated goodwill
of $10,000, the following journal entry to record Lund’s retirement is recommended:

Bonus Paid to Retiring Lund, Capital 60,000

Partner Jorb, Capital ($10,000 1
⁄2) 5,000
1
Kent, Capital ($10,000 ⁄2) 5,000
Cash 70,000
To record payment to retiring partner Lund, including a bonus of $10,000.

The bonus method illustrated here is appropriate whenever the settlement with the
retiring partner exceeds the carrying amount of that partner’s capital. The agreement for
 Chapter 2 Partnerships: Organization and Operation 47

settlement may or may not use the term goodwill; the essence of the matter is the determi-
nation of the amount to be paid to the retiring partner.
Bonus to Continuing Partners
A partner anxious to escape from an unsatisfactory business situation may accept less than
his or her partnership equity on retirement. In other cases, willingness by a retiring partner
to accept a settlement below carrying amount may reflect personal problems. Another pos-
sible explanation is that the retiring partner considers the net assets of the partnership to be
overvalued or anticipates less partnership net income in future years.
In brief, there are many factors that may induce a partner to accept less than the carry-
ing amount of his or her capital account balance on withdrawal from the partnership. Be-
cause a settlement below carrying amount seldom is supported by objective evidence of
overvaluation of assets, the preferred accounting treatment is to leave net asset valuations
undisturbed unless a large amount of impaired goodwill is carried in the accounting
records as a result of the prior admission of a partner as described on page 45. The differ-
ence between the retiring partner’s capital account balance and the amount paid in settle-
ment should be allocated as a bonus to the continuing partners.
For example, assume that the three partners of Merz, Noll & Park LLP share net in-
come or losses equally, and that each has a capital account balance of $60,000. Noll retires
from the partnership and receives $50,000. The journal entry to record Noll’s retirement
follows:

Bonus to Continuing Noll, Capital 60,000

Partners Cash 50,000
Merz, Capital ($10,000 1⁄2) 5,000
Park, Capital ($10,000 1⁄2) 5,000
To record retirement of Partner Noll for an amount less than carrying
amount of Noll’s equity, with a bonus to continuing partners.

The final settlement with a retiring partner often is deferred for some time after the part-
ner’s withdrawal to permit the accumulation of cash, the measurement of net income to date
of withdrawal, the obtaining of bank loans, or other acts needed to complete the transaction.
Death of a Partner
Limited liability partnership contracts often provide that partners shall acquire life insur-
ance policies on each others’ lives so that cash will be available for settlement with the es-
tate of a deceased partner. A buy-sell agreement may be formed by the partners, whereby
the partners commit their estates to sell their equities in the partnership and the surviving
partners to acquire such equities. Another form of such an agreement gives the surviving
partners an option to buy, or right of first refusal, rather than imposing on the partnership
an obligation to acquire the deceased partner’s equity.

LIMITED PARTNERSHIPS
The legal provisions governing limited partnerships (not to be confused with limited lia-
bility partnerships) are provided by the Uniform Limited Partnership Act. Among the fea-
tures of a limited partnership are the following:
1. There must be at least one general partner, who has unlimited liability for unpaid debts
of the partnership.
48 Part One Accounting for Partnerships and Branches

2. Limited partners have no obligation for unpaid liabilities of the limited partnership; only
general partners have such liability.
3. Limited partners have no participation in the management of the limited partnership.
4. Limited partners may invest only cash or other assets in a limited partnership; they may
not provide services as their investment.
5. The surname of a limited partner may not appear in the name of the partnership.
6. The formation of a limited partnership is evidenced by a certificate filed with the
county recorder of the principal place of business of the limited partnership. The cer-
tificate includes many of the items present in the typical partnership contract of a lim-
ited liability partnership (see pages 27–28); in addition, it must include the name and
residence of each general partner and limited partner; the amount of cash and other
assets invested by each limited partner; provision for return of a limited partner’s in-
vestment; any priority of one or more limited partners over other limited partners; and
any right of limited partners to vote for election or removal of general partners, termi-
nation of the partnership, amendment of the certificate, or disposal of all partnership
assets.

Membership in a limited partnership is offered to prospective limited partners in units

subject to the Securities Act of 1933. Thus, unless provisions of that Act exempt a lim-
ited partnership, it must file a registration statement for the offered units with the Secu-
rities and Exchange Commission (SEC) and undertake to file periodic reports with the
SEC. The SEC has provided guidance for such registration and reporting in Industry
Guide 5: Preparation of Registration Statements Relating to Interests in Real Estate
Limited Partnerships.
Large limited partnerships that engage in ventures such as oil and gas exploration and
real estate development and issue units registered with the SEC are termed master limited
partnerships.

Accounting for Limited Partnerships

The accounting for business transactions and events of limited partnerships parallels the ac-
counting for limited liability partnerships, except that limited partners do not have periodic
drawings debited to a Drawing ledger account. With respect to additions and retirements of
limited partners, who may be numerous, the limited partnership should maintain a sub-
sidiary limited partners’ ledger, similar to the stockholders’ ledger of a corporation, with
capital accounts for each limited partner showing investment units, increases for net in-
come and decreases for net losses, and decreases for retirements.

Financial Statements for Limited Partnerships

In Staff Accounting Bulletin 40, the SEC provided standards for financial statements of
limited partnerships filed with the SEC, as follows.6

The equity section of a [limited] partnership balance sheet should distinguish between
amounts ascribed to each ownership class. The equity attributed to the general partners
should be stated separately from the equity of the limited partners, and changes in the num-
ber of equity units . . . outstanding should be shown for each ownership class. A statement of
changes in partnership equity for each ownership class should be furnished for each period
for which an income statement is included.

6
Staff Accounting Bulletin 40, Topic F, Securities and Exchange Commission (Washington, DC: 1981).
 Chapter 2 Partnerships: Organization and Operation 49

The income statements of [limited] partnerships should be presented in a manner which

clearly shows the aggregate amount of net income (loss) allocated to the general partners and
the aggregate amount allocated to the limited partners. The statement of income should also
state the results of operations on a per unit basis.

Although the foregoing standards are mandatory only for limited partnerships subject to the
SEC’s jurisdiction, they are appropriate for other limited partnerships.
To illustrate financial statements for a limited partnership, assume that Wesley Randall
formed Randall Company, a limited partnership that was exempt from the registration re-
quirements of the Securities Act of 1933. On January 2, 2005, Wesley Randall, the general
partner, acquired 30 units at $1,000 a unit, and 30 limited partners acquired a total of 570 units
at $1,000 a unit. The limited partnership certificate for Randall Company provided that lim-
ited partners might withdraw their net equity (investment plus net income less net loss) only
on December 31 of each year. Wesley Randall was authorized to withdraw $500 a month at
his discretion, but he had no drawings during 2005. Randall Company had a net income of
$90,000 for 2005, and on December 31, 2005, two limited partners withdrew their entire
equity interest of 40 units.
The following condensed financial statements (excluding a statement of cash flows) in-
corporate the foregoing assumptions and comply with the provisions of Staff Accounting
Bulletin 40:

RANDALL COMPANY (a limited partnership)

Income Statement
For Year Ended December 31, 2005

Revenue $400,000
Costs and expenses 310,000
Net income $ 90,000
Division of net income ($150* per unit based on 600
weighted-average units outstanding):
To general partner (30 units) $ 4,500
To limited partners (570 units) 85,500
Total $90,000

*$90,000 600 units outstanding throughout 2005 $150.

RANDALL COMPANY (a limited partnership)

Statement of Partners’ Capital
For Year Ended December 31, 2005

General Partner Limited Partners Combined

Units Amount Units Amount Units Amount

Initial investments, beginning of year 30 $30,000 570 $570,000 600 $600,000
Add: Net income 4,500 85,500 90,000
Subtotals 30 $34,500 570 $655,500 600 $690,000
Less: Redemption of units 40 46,000* 40 46,000
Partners’ capital, end of year 30 $34,500 530 $609,500 560 $644,000

*(40 $1,000) (40 $150) $46,000.

50 Part One Accounting for Partnerships and Branches

RANDALL COMPANY (a limited partnership)

Balance Sheet
December 31, 2005

Assets Liabilities and Partners’ Capital

Current assets $ 240,000 Current liabilities $ 100,000
Other assets 760,000 Long-term debt 256,000
Total liabilities $ 356,000
Partners’ capital ($1,150*
per unit based on 560
units outstanding):
General partner $ 34,500
Limited partners 609,500 644,000
Total liabilities and
Total assets $1,000,000 partners’ capital $1,000,000

*$644,000 560 $1,150.

SEC ENFORCEMENT ACTIONS DEALING WITH

WRONGFUL APPLICATION OF ACCOUNTING
STANDARDS FOR PARTNERSHIPS
In 1982, the Securities and Exchange Commission (SEC) initiated a series of Accounting
and Auditing Enforcement Releases (AAERs) to report its enforcement actions involving
accountants. Following are summaries of two AAERs dealing with violations of account-
ing standards for partnerships.

AAER 202
AAER 202, “Securities and Exchange Commission v. William A. MacKay and Muncie A.
Russell” (September 29, 1988), deals with a general partnership formed by the former chief
executive officer (CEO) and chief financial officer (CFO) (a CPA) of American Biomateri-
als Corporation, a manufacturer of medical and dental products. The SEC alleged that the
partnership, Kirkwood Associates, ostensibly an executive search firm, had received more
than $410,000 from American Biomaterials for nonexistent services. The partnership had
no offices or employees, and its telephone number and address were those of a telephone
answering and mail collection service. Although its CEO and CFO directly benefited from
the $410,000 payments, American Biomaterials did not disclose this related-party trans-
action in its report to the SEC. The CEO and the CFO, without admitting or denying the
SEC’s allegations, consented to the federal court’s permanently enjoining them from vio-
lating the federal securities laws.

AAER 214
In AAER 214, “Securities and Exchange Commission v. Avanti Associates First Mortgage
Fund 84 Limited Partnership et al.” (January 11, 1989), the SEC reported on a federal
court’s entry of a permanent injunction against the general partner (a CPA) of a limited
partnership that in turn was the general partner of a second limited partnership that made
and acquired short-term first mortgage loans on real property. According to the SEC, the
financial statements of the second limited partnership, filed with the SEC in Form 10-K, in-
cluded a note that falsely reported the amount and nature of a related-party transaction.
 Chapter 2 Partnerships: Organization and Operation 51

Correct reporting of the related-party transaction would have disclosed that the CPA had
improperly profited from a kickback scheme involving payments made by borrowers from
the limited partnership to a distant relative of the CPA. In a related enforcement action, re-
ported in AAER 220, “. . . In the Matter of Richard P. Franke . . .” (March 24, 1989), the
SEC permanently prohibited appearing or practicing before it by the CPA who had ostensi-
bly audited the limited partnership’s financial statements that were included in Form 10-K.

Review 1. In the formation of a limited liability partnership, partners often invest nonmonetary
assets such as land, buildings, and machinery, as well as cash. Should nonmonetary as-
Questions sets be recognized by the partnership at current fair value, at cost to the partners, or at
some other amount? Explain.
2. Some large CPA firms have thousands of staff members, and hundreds of partners, and
operate on a national or an international basis. Would the professional corporation
form of organization be more appropriate than the limited liability partnership form for
such large organizations? Explain.
3. Explain the limited liability partnership balance sheet display of loans to and from
partners and the accounting for interest on such loans.
4. Explain how partners’ salaries should be displayed in the income statement of a lim-
ited liability partnership, if at all.
5. List at least five items that should be included in a limited liability partnership
contract.
6. List at least five methods by which net income or losses of a limited liability partner-
ship may be divided among partners.
7. Ainsley & Burton LLP admitted Paul Craig to a one-third interest in the firm for his
investment of $50,000. Does this mean that Craig would be entitled to one-third of the
partnership’s net income or losses?
8. Duncan and Eastwick are negotiating a partnership contract, with Duncan to invest
$60,000 and Eastwick $20,000 in the limited liability partnership. Duncan suggests
that interest at 8% be allowed on average capital account balances and that any re-
maining net income or losses be divided in the ratio of average capital account bal-
ances. Eastwick prefers that the entire net income or losses be divided in the ratio of
average capital account balances. Comment on these proposals.
9. The partnership contract of Peel & Quay LLP is brief on the sharing of net income and
losses. It states: “Net income is to be divided 80% to Peel and 20% to Quay, and each
partner is entitled to draw $2,000 a month.” What difficulties do you foresee in imple-
menting this contract? Illustrate possible difficulties under the assumption that the
partnership had a net income of $100,000 in the first year of operations.
10. Muir and Miller operated Muir & Miller LLP for several years, sharing net income and
losses equally. On January 1, 2005, they agreed to revise the income-sharing ratio to
70% for Muir and 30% for Miller, because of Miller’s desire for semiretirement. On
March 1, 2005, the partnership received $10,000 in settlement of a disputed amount re-
ceivable on a contract completed in 2004. Because the outcome of the dispute had been
uncertain, no trade account receivable had been recognized. Explain the accounting
treatment you would recommend for the $10,000 cash receipt.
11. Should the carrying amounts of a limited liability partnership’s assets be restated to
current fair values when a partner retires or a new partner is admitted to the firm?
Explain.
52 Part One Accounting for Partnerships and Branches

12. A new partner admitted to a limited liability partnership often is required to invest an
amount of cash larger than the carrying amount of the interest in net assets the new
partner acquires. In what way might such a transaction be recorded? What is the prin-
cipal argument for each method?
13. Two partners invested $2,000 each to form a limited liability partnership for the con-
struction of a shopping center. The partnership obtained a bank loan of $800,000 to fi-
nance construction, but no payment on this loan was due for two years. Each partner
withdrew $50,000 cash from the partnership from the proceeds of the loan. How
should the investment of $4,000 and the withdrawal of $100,000 be displayed in the fi-
nancial statements of the partnership?
14. A CPA firm was asked to express an auditors’ opinion on the financial statements of a
limited partnership in which a corporation was the general partner. Should the finan-
cial statements of the limited partnership and the auditors’ report thereon include the
financial statements of the general partner?
15. How do the financial statements of a limited partnership differ from those of a limited
liability partnership?
16. Differentiate between a limited liability partnership (LLP) and a limited partnership.

Exercises
(Exercise 2.1) Select the best answer for each of the following multiple-choice questions:
1. The partnership contract of Lowell & Martin LLP provided for salaries of $45,000 to
Lowell and $35,000 to Martin, with any remaining income or loss divided equally.
During 2005, pre-salaries income of Lowell & Martin LLP was $100,000, and both
Lowell and Martin withdrew cash from the partnership equal to 80% of their salary
allowances. During 2005, Lowell’s equity in the partnership:
a. Increased more than Martin’s equity.
b. Decreased more than Martin’s equity.
c. Increased the same amount as Martin’s equity.
d. Decreased the same amount as Martin’s equity.
2. When Andrew Davis retired from Davis, Evans & Fell LLP, he received cash in excess
of his capital account balance. Under the bonus method, the excess cash received by
Davis:
a. Reduced the capital account balances of Evans and Fell.
b. Had no effect on the capital account balances of Evans and Fell.
c. Was recognized as goodwill of the partnership.
d. Was recognized as an operating expense of the partnership.
3. A large cash withdrawal by Partner Davis from Carr, Davis, Exley & Fay LLP, which
is viewed by all partners as a permanent reduction of Davis’s ownership equity in the
partnership, is recorded with a debit to:
a. Loan Receivable from Davis.
b. Davis, Drawing.
c. Davis, Capital.
d. Retained Earnings.
4. The partnership contract for Gore & Haines LLP provided that Gore is to receive an
annual salary of $60,000, Haines is to receive an annual salary of $40,000, and the
 Chapter 2 Partnerships: Organization and Operation 53

net income or loss (after partners’ salaries expense) is to be divided equally between
the two partners. Net income of Gore & Haines LLP for the fiscal year ended Decem-
ber 31, 2005, was $90,000. The appropriate closing entry for net income on December 31,
2005, is a debit to Income Summary for $90,000 and credits to Gore, Capital and
Haines, Capital, respectively, of:
a. $54,000 and $36,000.
b. $55,000 and $35,000.
c. $45,000 and $45,000.
d. Some other amounts.
5. Which of the following is an expense of a limited liability partnership?
a. Interest on partners’ capital account balances.
b. Interest on loans from partners to the partnership.
c. Both a and b .
d. Neither a nor b .
6. The CPA partners of Tan, Ullman & Valdez LLP shared net income and losses 25%,
35%, and 40%, respectively. On January 31, 2006, by mutual consent of the partners,
Julio Valdez withdrew from the partnership, receiving $162,000 for his $150,000 cap-
ital account balance. The preferable journal entry (explanation omitted) for the part-
nership on January 31, 2006, is:

(a) Valdez, Capital 150,000

Tan, Capital ($12,000 25/60) 5,000
Ullman, Capital ($12,000 35/60) 7,000
Cash 162,000
(b) Valdez, Capital 162,000
Goodwill 12,000
Valdez, Capital ($162,000 $150,000) 12,000
Cash 162,000
(c) Goodwill ($12,000 0.40) 30,000
Valdez, Capital 162,000
Tan, Capital ($30,000 0.25) 7,500
Ullman, Capital ($30,000 0.35) 10,500
Valdez, Capital ($30,000 0.40) 12,000
Cash 162,000
(d) Valdez, Capital ($12,000 0.40) 4,800
Valdez, Capital ($150,000 $4,800) 145,200
Tan, Capital ($12,000 0.25) 3,000
Ullman, Capital ($12,000 0.35) 4,200
Loss on Withdrawal of Partner 4,800
Cash 162,000

7. The two partners of Adonis & Brutus LLP share net income and losses in the ratio of
7 : 3, respectively. On February 1, 2005, their capital account balances were as follows:
Adonis $70,000
Brutus 60,000
54 Part One Accounting for Partnerships and Branches

Adonis and Brutus agreed to admit Cato as a partner on February 1, 2005, with a one-
third interest in the partnership capital and net income or losses for an investment
of $50,000. The new partnership will begin with total capital of $180,000. Immediately
after Cato’s admission to the partnership, the capital account balances of Adonis,
Brutus, and Cato, respectively, are:
a. $60,000, $60,000, $60,000.
b. $63,000, $57,000, $60,000.
c. $63,333, $56,667, $60,000.
d. $70,000, $60,000, $50,000.
e. Some other amounts.
8. According to this text, the recognition of goodwill in the accounting records of a lim-
ited liability partnership may be appropriate for:
a. The admission of a new partner for a cash investment.
b. The retirement of an existing partner.
c. Either of the foregoing situations.
d. Neither of the foregoing situations.
9. The partnership contract for Clark & Davis LLP provides that “net income or losses
are to be distributed in the ratio of partners’ capital account balances.” The appro-
priate interpretation of this provision is that net income or losses should be distrib-
uted in:
a. The ratio of beginning capital account balances.
b. The ratio of average capital account balances.
c. The ratio of ending account balances (before distribution of net income or loss).
d. One of the foregoing methods to be specified by partners Clark and Davis.
10. Salaries to partners of a limited liability partnership typically should be accounted
for as:
a. A device for sharing net income.
b. An operating expense of the partnership.
c. Drawings by the partners from the partnership.
d. Reductions of the partners’ capital account balances.
11. The income-sharing provision of the contract that established Early & Farber LLP pro-
vided that Early was to receive a bonus of 20% of income after deduction of the bonus,
with the remaining income distributed 40% to Early and 60% to Farber. If income be-
fore the bonus of Early & Farber LLP was $240,000 for the fiscal year ended August 31,
2005, the capital accounts of Early and Farber should be credited, respectively, in the
amounts of:
a. $120,000 and $120,000.
b. $124,800 and $115,200.
c. $96,000 and $144,000.
d. $163,200 and $76,800.
e. Some other amounts.
12. Which of the following typical expense of a corporation is not relevant for a limited
liability partnership?
a. Salaries expense.
b. Interest expense.
c. Income taxes expense.
d. Pension expense.
e. None of the above.
 Chapter 2 Partnerships: Organization and Operation 55

13. Are the results of operations on a per unit basis displayed in the income statement of a:

Limited Liability Partnership? Limited Partnership?

a. Yes Yes
b. Yes No
c. No Yes
d. No No

(Exercise 2.2) On January 2, 2005, Carle and Dody established Carle & Dody LLP, with Carle investing
$80,000 and Dody investing $70,000 on that date. The income-sharing provisions of the
partnership contract were as follows:
CHECK FIGURE 1. Salaries of $30,000 per annum to each partner.
Credit Dody, capital, 2. Interest at 6% per annum on beginning capital account balances of each partner.
a total of $9,975.
3. Remaining income or loss divided equally.
Pre-salary income of Carle & Dody LLP for the month of January 2005 was $20,000. Nei-
ther partner had a drawing for that month.
Prepare journal entries for Carle & Dody LLP on January 31, 2005, to provide for part-
ners’ salaries and close the Income Summary ledger account. Show supporting computa-
tions in the explanations for the entries.
(Exercise 2.3) Activity in the capital accounts of the partners of Webb & Yu LLP for the fiscal year ended
December 31, 2005, follows:

CHECK FIGURE
Webb, Capital Yu, Capital
b. Net income to Yu,
$28,000. Balances, Jan. 1 $40,000 $80,000
Investment, July 1 20,000
Withdrawal, Oct. 1 40,000

Net income of Webb & Yu LLP for the year ended December 31, 2005, amounted to
$48,000.
Prepare a working paper to compute the division of the $48,000 net income of Webb &
Yu LLP under each of the following assumptions:
a. The partnership contract is silent as to sharing of net income and losses.
b. Net income and losses are divided on the basis of average capital account balances (not
including the net income or loss for the current year).
c. Net income and losses are divided on the basis of beginning capital account balances.
d. Net income and losses are divided on the basis of ending capital account balances (not
including the net income or loss for the current year).
(Exercise 2.4) The partnership contract of Ray, Stan & Todd LLP provided that Ray was to receive a bonus
equal to 20% of income and that the remaining income or loss was to be divided 40% each
to Ray and Stan and 20% to Todd. Income of Ray, Stan & Todd LLP for 2005 (before the
bonus) amounted to $127,200.
Explain two alternative ways in which the bonus provision might be interpreted, and pre-
pare a working paper to compute the division of the $127,200 income of Ray, Stan & Todd
LLP for 2005 under each interpretation.
56 Part One Accounting for Partnerships and Branches

(Exercise 2.5) The partnership contract of Jones, King & Lane LLP provided for the division of net in-
come or losses in the following manner:
CHECK FIGURE 1. Bonus of 20% of income before the bonus to Jones.
Net income to Jones, 2. Interest at 15% on average capital account balances to each partner.
$27,000.
3. Residual income or loss equally to each partner.
Net income of Jones, King & Lane LLP for 2005 was $90,000, and the average capital
account balances for that year were Jones, $100,000; King, $200,000; and Lane,
$300,000.
Prepare a working paper to compute each partner’s share of the 2005 net income of
Jones, King & Lane LLP.
(Exercise 2.6) The partnership contract of Ann, Bud & Cal LLP provides for the remuneration of partners
as follows:
CHECK FIGURE 1. Salaries of $40,000 to Ann, $35,000 to Bud, and $30,000 to Cal, to be recognized annu-
Debit bonus expense, ally as operating expense of the partnership in the measurement of net income.
$10,000. 2. Bonus of 10% of income after salaries and the bonus to Ann.
3. Remaining net income or loss 30% to Ann, 20% to Bud, and 50% to Cal.
Income of Ann, Bud & Cal LLP before partners’ salaries and Ann’s bonus was $215,000 for
the fiscal year ended December 31, 2005.
Prepare journal entries for Ann, Bud & Cal LLP on December 31, 2005, to (1) accrue
partners’ salaries and Ann’s bonus and (2) close the Income Summary ledger account
(credit balance of $100,000) and divide the net income among the partners. Show support-
ing computations in the explanation for the second journal entry.

(Exercise 2.7) The partnership contract for Bates & Carter LLP provided for salaries to partners and the
division of net income or losses as follows:
CHECK FIGURE 1. Salaries of $40,000 a year to Bates and $60,000 a year to Carter.
Net income to Bates, 2. Interest at 12% a year on beginning capital account balances.
$42,400.
3. Remaining net income or loss 70% to Bates and 30% to Carter.
For the fiscal year ended December 31, 2005, Bates & Carter LLP had presalaries income
of $200,000. Capital account balances on January 1, 2005, were $400,000 for Bates and
$500,000 for Carter; Bates invested an additional $100,000 in the partnership on Septem-
ber 30, 2005. In accordance with the partnership contract, both partners drew their salary
allowances in cash from the partnership during the year.
Prepare journal entries for Bates & Carter LLP on December 31, 2005, to (1) accrue
partners’ salaries and (2) close the Income Summary (credit balance of $100,000) and
drawing accounts. Show supporting computations in the journal entry closing the Income
Summary account.

(Exercise 2.8) Emma Neal and Sally Drew are partners of Neal & Drew LLP sharing net income or losses
equally; each has a capital account balance of $200,000. Sally Drew (with the consent of
Neal) sold one-fifth of her interest to her daughter Paula for $50,000, with payment to be
made to Sally Drew in five annual installments of $10,000, plus interest at 15% on the un-
paid balance.
Prepare a journal entry for Neal, Drew & Drew LLP to record the change in ownership,
and explain why you would or would not recommend a change in the valuation of net as-
sets in the accounting records of Neal, Drew & Drew LLP.
 Chapter 2 Partnerships: Organization and Operation 57

(Exercise 2.9) On January 31, 2005, Nancy Ross and John Clemon were admitted to Logan, Marsh &
Noble LLP (CPA firm), which had net assets of $120,000 prior to the admission and an
CHECK FIGURE income-sharing ratio of Logan, 25%; Marsh, 35%; and Noble, 40%. Ross paid $20,000 to
Credit Clemon, capital, Carl Logan for one-half of his 20% share of partnership net assets on January 31, 2005, and
$14,000. Clemon invested $20,000 in the partnership for a 10% interest in the net assets of Logan,
Marsh, Noble, Ross & Clemon LLP. No goodwill was to be recognized as a result of the
admission of Ross and Clemon to the partnership.
Prepare separate journal entries on January 31, 2005, to record the admission of Ross
and Clemon to Logan, Marsh, Noble, Ross & Clemon LLP.

(Exercise 2.10) Partners Arne and Bolt of Arne & Bolt LLP have capital account balances of $30,000 and
$20,000, respectively, and they share net income and losses in a 3 : 1 ratio.
Prepare journal entries to record the admission of Cope to Arne, Bolt & Cope LLP
under each of the following conditions:
CHECK FIGURE a. Cope invests $30,000 for a one-fourth interest in net assets; the total partnership capital
b. Credit Arne, capital, after Cope’s admission is to be $80,000.
$19,500. b. Cope invests $30,000, of which $10,000 is a bonus to Arne and Bolt. In conjunction
with the admission of Cope, the carrying amount of the inventories is increased by
$16,000. Cope’s capital account is credited for $20,000.

(Exercise 2.11) Lamb and Meek, partners of Lamb & Meek Limited Liability Partnership who share net in-
come and losses 60% and 40%, respectively, had capital account balances of $70,000 and
$60,000, respectively, on June 30, 2005. On that date Lamb and Meek agreed to admit
Niles to Lamb, Meek & Niles Limited Liability Partnership with a one-third interest in total
partnership capital of $180,000 and a one-third share of net income or losses, for a cash
investment of $50,000.
Prepare a working paper to compute the balances of the Lamb, Capital, Meek, Capital
and Niles, Capital ledger accounts on June 30, 2005, following the admission of Niles to
Lamb, Meek & Niles Limited Liability Partnership.

(Exercise 2.12) Floyd Austin and Samuel Bradford are partners of Austin & Bradford LLP who share net
income and losses equally and have equal capital account balances. The net assets of the
CHECK FIGURE partnership have a carrying amount of $80,000. Jason Crade is admitted to Austin, Bradford &
b. Credit Crade, capital, Crade LLP with a one-third interest in net income or losses and net assets. To acquire this
$34,000. interest, Crade invests $34,000 cash in the partnership.
Prepare journal entries to record the admission of Crade in the accounting records of
Austin, Bradford & Crade LLP under the:
a. Bonus method.
b. Revaluation of net assets method, assuming partnership inventories are overstated.

(Exercise 2.13) On August 31, 2005, Logan and Major, partners of Logan & Major Limited Liability Part-
nership who had capital account balances of $80,000 and $120,000, respectively, on that
CHECK FIGURE date and who shared net income and losses in a 2 : 3 ratio, agreed to admit Nelson to Logan,
Sept. 30, credit Major, Major & Nelson Limited Liability Partnership with a 20% interest in net assets and net in-
capital, $24,000. come in exchange for a $60,000 cash investment. Logan and Major were to retain their
prior income-sharing arrangement with respect to the 80% remainder of net income (100%
20% 80%). On September 30, 2005, after the closing of the partnership’s revenue and
expense ledger accounts, the Income Summary ledger account had a credit balance of
$50,000.
58 Part One Accounting for Partnerships and Branches

Prepare journal entries for Logan, Major & Nelson Limited Liability Partnership to
record the admission of Nelson on August 31, 2005, and to close the Income Summary
ledger account on September 30, 2005.
(Exercise 2.14) On January 31, 2005, partners of Lon, Mac & Nan LLP had the following loan and capital
account balances (after closing entries for January):

CHECK FIGURE
Loan receivable from Lon $ 20,000 dr
Credit Ole, capital,
Loan payable to Nan 60,000 cr
$52,000.
Lon, Capital 30,000 dr
Mac, Capital 120,000 cr
Nan, Capital 70,000 cr

The partnership’s income-sharing ratio was Lon, 50%; Mac, 20%; and Nan, 30%.
On January 31, 2005, Ole was admitted to the partnership for a 20% interest in total
capital of the partnership in exchange for an investment of $40,000 cash. Prior to Ole’s
admission, the existing partners agreed to increase the carrying amount of the partnership’s
inventories to current fair value, a $60,000 increase.
Prepare journal entries on January 31, 2005, for Lon, Mac, Nan & Ole LLP to record the
$60,000 increase in the partnership’s inventories and the admission of Ole for a $40,000
cash investment.
(Exercise 2.15) On May 31, 2004, Ike Loy was admitted to Jay & Kaye LLP by investing Loy Company, a
highly profitable proprietorship having identifiable tangible and intangible net assets of
$600,000, at carrying amount and current fair value. Prior to Loy’s admission, capital ac-
count balances and income-sharing percentages of Jay and Kaye were as follows:

CHECK FIGURE
Capital Account Income-Sharing
May 31, 2005, credit
Balances Percentages
Loy, capital, a total
of $72,000. Jay $400,000 60%
Kaye 500,000 40%

The partnership contract for the new Jay, Kaye & Loy LLP included the following
provisions:
1. Loy was to receive a capital account balance of $660,000 on his admission to the part-
nership on May 31, 2004.
2. Income for the fiscal year ending May 31, 2005, and subsequent years was to be allo-
cated as follows:
a. Bonus of 10% of income after the bonus to Loy.
b. Resultant net income or loss 30% to Jay, 20% to Kaye, and 50% to Loy.
Income before the bonus for the year ended May 31, 2005, was $132,000.
Prepare journal entries for Jay, Kaye & Loy LLP on May 31, 2004, and May 31, 2005
(the latter to accrue Loy’s bonus and to close the Income Summary ledger account having
a credit balance of $120,000).
(Exercise 2.16) The inexperienced accountant for Fox, Gee & Hay LLP prepared the following journal en-
tries during the fiscal year ended August 31, 2005:
 Chapter 2 Partnerships: Organization and Operation 59

2004

Sept. 1 Cash 50,000

Goodwill 150,000
Fox, Capital ($150,000 0.25) 37,500
Gee, Capital ($150,000 0.75) 112,500
Hay, Capital 50,000
CHECK FIGURE
Credit Hay, capital, a To record admission of Hay for a 20% interest in net assets,
with goodwill credited to Fox and Gee in their former
net amount of $12,000.
income-sharing ratio. Goodwill is computed as follows:
Implied total capital, based on Hay’s
investment ( $50,000 5) $250,000
Less: Net assets prior to Hay’s admission 100,000
Goodwill $150,000

2005

Aug. 31 Income Summary 30,000

Fox, Capital ($30,000 0.20) 6,000
Gee, Capital ($30,000 0.60) 18,000
Hay, Capital ($30,000 0.20) 6,000
To divide net income for the year in the residual income-
sharing ratio of Fox, 20%; Gee, 60%; Hay, 20%. Provision
in partnership contract requiring $40,000 annual salary
allowance to Hay is disregarded because income before
salary is only $30,000.

Prepare journal entries for Fox, Gee & Hay LLP on August 31, 2005, to correct the ac-
counting records, which have not been closed for the year ended August 31, 2005. Assume
that Hay’s admission to the partnership should have been recorded by the bonus method.
Do not reverse the foregoing journal entries.
(Exercise 2.17) On June 30, 2005, the balance sheet of King, Lowe & More LLP and the partners’ respec-
tive income-sharing percentages were as follows:

CHECK FIGURE
KING, LOWE & MORE LLP
Credit cash, $107,000.
Balance Sheet
June 30, 2005

Assets
Current assets $185,000
Plant assets (net) 200,000
Total assets $385,000
Liabilities and Partners’ Capital
Trade accounts payable $ 85,000
Loan payable to King 15,000
King, capital (20%) 70,000
Lowe, capital (20%) 65,000
More, capital (60%) 150,000
Total liabilities and partners’ capital $385,000
60 Part One Accounting for Partnerships and Branches

King decided to retire from the partnership on June 30, 2005, and by mutual agreement of
the partners the plant assets were adjusted to their total current fair value of $260,000. The
partnership paid $92,000 cash for King’s equity in the partnership, exclusive of the loan,
which was repaid in full. No goodwill was to be recognized in this transaction.
Prepare journal entries for King, Lowe & More LLP on June 30, 2005, to record the ad-
justment of plant assets to current fair value and King’s retirement.
(Exercise 2.18) The partners’ capital (income-sharing ratio in parentheses) of Nunn, Owen, Park & Quan LLP
on May 31, 2005, was as follows:

CHECK FIGURE
Nunn (20%) $ 60,000
Credit Reed, capital,
Owen (20%) 80,000
$22,000.
Park (20%) 70,000
Quan (40%) 40,000
Total partners’ capital $250,000

On May 31, 2005, with the consent of Nunn, Owen, and Quan:
1. Sam Park retired from the partnership and was paid $50,000 cash in full settlement of
his interest in the partnership.
2. Lois Reed was admitted to the partnership with a $20,000 cash investment for a 10%
interest in the net assets of Nunn, Owen, Quan & Reed LLP.
No goodwill was to be recognized for the foregoing events.
Prepare journal entries on May 31, 2005, to record the foregoing events.
(Exercise 2.19) The accountant for Tan, Ulm & Vey LLP prepared the following journal entry on January
31, 2005:

2005

Jan. 31 Goodwill ($12,000 0.40) 30,000

Vey, Capital ($150,000 $12,000) 162,000
Tan, Capital ($30,000 0.25) 7,500
Ulm, Capital ($30,000 0.35) 10,500
Vey, Capital ($30,000 0.40) 12,000
Cash 162,000
To record withdrawal of Ross Vey, with a cash payment of
$162,000, compared with his prewithdrawal capital account
balance, and recognition of implicit goodwill, allocated in
partners’ income-sharing ratio of 25% : 35% : 40%.

Prepare a journal entry for Tan, Ulm & Vey LLP on January 31, 2005, to correct, not re-
verse, the foregoing entry. Show supporting computations in the explanation for the entry.
(Exercise 2.20) Macco Company (a limited partnership) was established on January 2, 2005, with the is-
suance of 10 units at $10,000 a unit to Malcolm Cole, the general partner, and 40 units in
the aggregate to five limited partners at $10,000 a unit. The certificate for Macco provided
that Cole was authorized to withdraw a maximum of $24,000 a year on December 31 of each
year for which net income was at least $100,000 and that limited partners might withdraw
 Chapter 2 Partnerships: Organization and Operation 61

their equity for cash or promissory notes on December 31 of each year only. For 2005
Macco Company had a net income of $300,000, and on December 31, 2005, Cole withdrew
$24,000 cash and a limited partner redeemed 10 units, receiving a two-year promissory
note bearing interest at 10%.
Prepare a statement of partners’ capital for Macco Company (a limited partnership) for
the fiscal year ended December 31, 2005.

Cases
(Case 2.1) The author of Modern Advanced Accounting takes the position (page 27) that salaries
awarded to partners of a limited liability partnership should be recognized as operating
expenses of the partnership. Some other accountants maintain that partners’ salaries should
be accounted for as a step in the division of net income or losses of a limited liability
partnership.

Instructions
Which method of accounting for partners’ salaries do you support? Explain.
(Case 2.2) During your audit of the financial statements of Arnold, Bright & Carle LLP for the fiscal
year ended January 31, 2005, you review the following general journal entry:

2004

Feb. 1 Cash 120,000

Goodwill 60,000
Arnold, Capital ($60,000 0.60) 36,000
Bright, Capital ($60,000 0.40) 24,000
Carle, Capital 120,000
To record admission of Carla Carle to Arnold & Bright LLP
for a one-third interest in total capital, with implicit goodwill
allocated to Arnold and Bright in their income-sharing ratio.
Goodwill is computed as follows:
Implied total capital of partnership based
on Carle’s investment ($120,000 3) $ 360,000
Less: Total capital of Arnold and Bright (180,000)
Cash invested by Carle (120,000)
Goodwill $ 60,000

Instructions
Is recognition of goodwill in the foregoing journal entry in accordance with generally
accepted accounting principles? Explain.
(Case 2.3) In a classroom discussion of accounting standards for limited liability partnerships, student
Ronald suggested that interest on partners’ capital account balances, allocated in accor-
dance with the partnership contract, should be recognized as an operating expense by the
partnership.

Instructions
What is your opinion of student Ronald’s suggestion? Explain.
62 Part One Accounting for Partnerships and Branches

(Case 2.4) The partners of Arch, Bell & Cole LLP had the following capital account balances and
income-sharing ratio on May 31, 2005 (there were no loans receivable from or payable to
partners):

Partner Capital Account Balance Income-Sharing Ratio

Arch $120,000 35%
Bell 210,000 25
Cole 90,000 40
Totals $420,000 100%

The partners are considering admission of Sidney Dale to the new Arch, Bell, Cole & Dale
LLP for a 25% interest in partnership capital and a 20% share of net income. They request
your advice on the preferability of Dale’s investing cash in the partnership compared with
their selling to Dale one-fourth of each of their partnership interests.
Instructions
Present the partners of Arch, Bell & Cole LLP with the advantages and disadvantages of
the two possible methods of the admission of Dale. Disregard income tax considerations.
(Case 2.5) During your audit of Nue & Olde LLP for its first year of operations, you discover the
following end-of-year adjusting entry in the partnership’s general journal:

2005

Dec. 31 Partners’ Income Taxes Expense 40,000

Partners’ Income Taxes Payable 40,000
To provide for income taxes payable on Nue’s and Olde’s
individual income tax returns based on their shares of
partnership income for 2005.

Instructions
Is the recognition of income taxes expense in the foregoing journal entry in accordance
with generally accepted accounting principles? Explain, including in your explanation the
accepted definitions of expense and income taxes expense.

(Case 2.6) Dee, Ern & Fay LLP, whose partners share net income and losses equally, had an operating
income of $30,000 for the first year of operations. However, near the end of that year, the
partners learned of two unfavorable developments: (a) the bankruptcy of Sasha Company,
maker of a two-year promissory note for $20,000 payable to Partner Dee that had been in-
dorsed in blank to the partnership by Dee at face amount as Dee’s original investment, and
(b) the appearance on the market of new competing patented devices that rendered worth-
less a patent with a carrying amount of $10,000 that had been invested in the partnership
by Ern as part of Ern’s original investment.
Dee, Ern & Fay LLP had retained the promissory note made by Sasha Company with the
expectation of discounting it when cash was needed. Quarterly interest payments had been
received regularly prior to the bankruptcy of Sasha, but present prospects were for no fur-
ther collections of interest or principal.
Fay argues that the $30,000 operating income should be divided $10,000 to each part-
ner, with the $20,000 loss on the uncollectible note debited to Dee’s capital account and the
$10,000 loss on the worthless patent debited to Ern’s capital account.
 Chapter 2 Partnerships: Organization and Operation 63

Instructions
Do you agree with Fay? Explain.
(Case 2.7) A series of substantial net losses from operations has resulted in the following balance
sheet drafted by the controller of Nobis, Ortho & Parr LLP:

NOBIS, ORTHO & PARR LLP

Balance Sheet
July 31, 2005

Assets
Current assets $420,000
Plant assets (net) 550,000
Total assets $970,000

Liabilities and Partners’ Capital

Current liabilities $380,000
Long-term debt 420,000
Total liabilities $800,000
Art Nobis, capital $ 130,000
June Ortho, capital (120,000)
Carl Parr, capital 160,000
Total partners’ capital 170,000
Total liabilities and partners’ capital $970,000

Concerned about the partnership’s high debt-to-equity ratio of 470.6% ($800,000

$170,000 470.6%), the partners consult with Jack Julian, CPA, controller of the partner-
ship, who is a member of the AICPA, FEI, and IMA (see Chapter 1), regarding the propri-
ety of converting partner Ortho’s capital deficit to an account receivable. Ortho shows
Julian a personal financial statement showing net assets of more than $400,000; Ortho
points out that the bulk of her assets are in long-term investments that are difficult to liqui-
date to obtain cash for investment in the partnership. Partner Ortho is willing to pledge
high-grade securities in her personal portfolio of investments to secure the $120,000
amount.
Instructions
May Jack Julian ethically comply with the request of the partners of Nobis, Ortho & Parr
LLP? Explain.
(Case 2.8) Jean Rogers, CPA, is a member of the AICPA, the IMA, and the FEI (see Chapter 1); she is
employed as the controller of Barnes, Egan & Harder LLP. On June 30, 2005, the end of the
partnership’s fiscal year, partner Charles Harder informed Rogers that the proceeds of a
$100,000 personal loan to him by Local Bank on a one-year, 8% promissory note had been
deposited in the partnership’s checking account at Local Bank. Showing Rogers a memo
signed by all three partners that approved the partnership’s repayment of Harder’s personal
loan, including interest, Harder instructed Rogers to account for the loan proceeds as a
credit to his partnership capital account and to recognize the partnership’s subsequent pay-
ments of principal and interest on the loan with debits to Charles Harder, Drawing and
Interest Expense, respectively.
Instructions
May Jean Rogers ethically comply with Charles Harder’s request? Explain.
64 Part One Accounting for Partnerships and Branches

(Case 2.9) Carl Dobbs and David Ellis formed Dobbs & Ellis LLP on January 2, 2005. Dobbs invested
cash of $50,000, and Ellis invested cash of $20,000 and marketable equity securities
(classified as available for sale) with a current fair value of $80,000. A portion of the secu-
rities was sold at carrying amount in January 2005 to provide cash for operations of the
partnership.
The partnership contract stated that net income and losses were to be divided in the cap-
ital ratio and authorized each partner to withdraw $1,000 monthly. Dobbs withdrew $1,000
on the last day of each month during 2005, but Ellis made no withdrawals during 2005 until
July 1, when he withdraw all the securities that had not been sold by the partnership. The
securities that Ellis withdrew had a current fair value of $41,000 when invested in the part-
nership on January 2, 2005, and a current fair value of $62,000 on July 1, 2005, when with-
drawn. Ellis instructed the accountant for Dobbs & Ellis LLP to record the transaction by
reducing Ellis’s capital account balance by $41,000, which was done. Income from opera-
tions of Dobbs & Ellis LLP for 2005 amounted to $24,000.

Instructions
Determine the appropriate division of net income of Dobbs & Ellis LLP for 2005. If the
income-sharing provision of the partnership contract is unsatisfactory, state the assump-
tions you would make for an appropriate interpretation of the partners’ intentions. Describe
the journal entry, if any, that you believe should be made for Dobbs & Ellis LLP. (Disregard
income taxes.)
(Case 2.10) George Lewis and Anna Marlin are partners of Lewis & Marlin LLP, who share net in-
come and losses equally. They offer to admit Betty Naylor to Lewis, Marlin & Naylor LLP
for a one-third interest in net assets and in net income or losses for an investment of
$50,000 cash. The total capital of Lewis & Marlin LLP prior to Naylor’s admission was
$110,000. Naylor makes a counteroffer of $40,000, explaining that her investigation of
Lewis & Marlin LLP indicates that many trade accounts receivable are past due and that a
significant amount of the inventories is obsolete. Lewis and Marlin deny both of these
allegations. They contend that inventories are valued in accordance with generally
accepted accounting principles and that the accounts receivable are fully collectible. How-
ever, after prolonged negotiations, the admission price of $40,000 proposed by Naylor is
agreed upon.

Instructions
Explain two ways in which the admission of Naylor might be recorded by Lewis, Marlin &
Naylor LLP, and indicate which method is preferable.
(Case 2.11) Lowyma Company LLP, a partnership of Ed Loeser, Peter Wylie, and Herman Martin, has
operated successfully for many years, but Martin now plans to retire. In discussions of the
settlement to be made with Martin, the point was made that inventories had been valued at
last-in, first-out cost for many years. Martin suggested that because the partnership had be-
gun managing inventories by the just-in-time system, the first-in, first-out cost of the in-
ventories should be determined and the excess of this amount over the carrying amount of
the inventories should be recognized as a gain to the partnership to be shared equally by the
three partners. Loeser objected to this suggestion on grounds that any method of inventory
valuation would give reasonably accurate results provided it were followed consistently and
that a departure from the long-established last-in, first-out method of inventory valuation
used by the partnership would produce an erroneous earnings record for the life of the part-
nership to date.

Instructions
Evaluate the objections of Ed Loeser by reference to APB Opinion No. 20, “Accounting
Changes.”
 Chapter 2 Partnerships: Organization and Operation 65

Problems
(Problem 2.1) Among the business transactions and events of Oscar, Paul & Quinn LLP, whose partners
shared net income and losses equally, for the month of January 2005, were the following:
Jan. 2 With the consent of Paul and Quinn, Oscar made a $10,000 cash advance to the
partnership on a 12% demand promissory note.
6 With the consent of Oscar and Paul, Quinn withdrew from the partnership
merchandise with a cost of $4,000 and a fair value of $5,200, in lieu of a regular
cash drawing. The partnership uses the perpetual inventory system.
13 The partners agreed that a patent with a carrying amount of $6,000, which had
been invested by Paul when the partnership was organized, was worthless and
should be written off.
27 Paul paid a $2,000 trade account payable of the partnership.
Instructions
Prepare journal entries for the foregoing transactions and events of Oscar, Paul & Quinn
LLP and the January 31, 2005, adjusting entry for the note payable to Oscar.
(Problem 2.2) The condensed balance sheet of Gee & Hawe LLP on December 31, 2004, follows:

CHECK FIGURE
GEE & HAWE LLP
a. Credit Ivan, capital,
Balance Sheet
$120,000; b. Net
December 31, 2004
income to Hawe,
$12,000. Assets Liabilities and Partners’ Capital
Current assets $100,000 Liabilities $300,000
Plant assets (net) 500,000 Louis Gee, capital 200,000
Ray Hawe, capital 100,000
Total $600,000 Total $600,000

Gee and Hawe shared net income or losses 40% and 60%, respectively. On January 2, 2005,
Lisa Ivan was admitted to Gee, Hawe & Ivan LLP by the investment of the net assets of her
highly profitable proprietorship. The partners agreed to the following current fair values of
the identifiable net assets of Ivan’s proprietorship:

Current assets $ 70,000

Plant assets 230,000
Total assets $300,000
Less: Liabilities 200,000
Net assets $100,000

Ivan’s capital account was credited for $120,000. The partners agreed further that the
current fair values of the net assets of Gee & Hawe LLP were equal to their carrying
amounts and that the accounting records of the old partnership should be used for the new
partnership. The following partner-remuneration plan was adopted for the new partnership:
1. Salaries of $10,000 to Gee, $15,000 to Hawe, and $20,000 to Ivan, to be recognized as
expenses of the partnership.
2. A bonus of 10% of income after deduction of partners’ salaries and the bonus to Ivan.
3. Remaining income or loss as follows: 30% to Gee, 40% to Hawe, and 30% to Ivan.
66 Part One Accounting for Partnerships and Branches

For the fiscal year ended December 31, 2005, Gee, Hawe & Ivan LLP had income of
$78,000 before partners’ salaries and the bonus to Ivan.
Instructions
Prepare journal entries for Gee, Hawe & Ivan LLP to record the following (include sup-
porting computations in the explanations for the entries):
a. The admission of Ivan to the partnership on January 2, 2005.
b. The partners’ salaries, bonus, and division of net income for the year ended Decem-
ber 31, 2005.
(Problem 2.3) Ross & Saye LLP was organized and began operations on March 1, 2004. On that date,
Roberta Ross invested $150,000, and Samuel Saye invested land and building with current
fair values of $80,000 and $100,000, respectively. Saye also invested $60,000 in the part-
nership on November 1, 2004, because of its shortage of cash. The partnership contract in-
cludes the following remuneration plan:

CHECK FIGURE
Ross Saye
a. Net income to Ross,
$66,000; b. Saye, Annual salary (recognized as operating expense) $18,000 $24,000
capital, $294,000. Annual interest on average capital account balances 10% 10%
Remainder 60% 40%

The annual salary was to be withdrawn by each partner in 12 monthly installments.

During the fiscal year ended February 28, 2005, Ross & Saye LLP had net sales of
$500,000, cost of goods sold of $280,000, and total operating expenses of $100,000 (in-
cluding partners’ salaries expense but excluding interest on partners’ average capital account
balances). Each partner made monthly cash drawings in accordance with the partnership
contract.
Instructions
a. Prepare a condensed income statement of Ross & Saye LLP for the year ended Febru-
ary 28, 2005. Show the details of the division of net income in a supporting exhibit.
b. Prepare a statement of partners’ capital for Ross & Saye LLP for the year ended Febru-
ary 28, 2005.
(Problem 2.4) Partners Lucas and May formed Lucas & May LLP on January 2, 2005. Their capital ac-
counts showed the following changes during:

CHECK FIGURE
Lucas, May,
b. Net income to May,
Capital Capital
$43,500; d. Net
income to Lucas, Original investments, Jan. 2, 2005 $120,000 $180,000
$28,800. Investments: May 1 15,000
July 1 15,000
Withdrawals: Nov. 1 (30,000) (75,000)
Capital account balances, Dec. 31, 2005 $105,000 $120,000

The income of Lucas & May LLP for 2005, before partners’ salaries expense, was
$69,600. The income included an extraordinary gain of $12,000.
Instructions
Prepare a working paper to compute each partner’s share of net income of Lucas & May
LLP for 2005 to the nearest dollar, assuring the following alternative income-sharing plans:
 Chapter 2 Partnerships: Organization and Operation 67

a. The partnership contract is silent as to division of net income or loss.

b. Income before extraordinary items is shared equally after allowance of 10% interest on
average capital account balances (computed to the nearest month) and after salaries of
$20,000 to Lucas and $30,000 to May recognized as operating expenses by the partner-
ship. Extraordinary items are shared in the ratio of original investments.
c. Income before extraordinary items is shared on the basis of average capital account bal-
ances, and extraordinary items are shared on the basis of original investments.
d. Income before extraordinary items is shared equally between Lucas and May after a
20% bonus to May based on income before extraordinary items after the bonus. Extra-
ordinary items are shared on the basis of original investments.
(Problem 2.5) Alex, Baron & Crane LLP was formed on January 2, 2005. The original cash investments
were as follows:

CHECK FIGURE
Alex $ 96,000
a. Net income to Alex,
Baron 144,000
$11,760; b. Crane,
Crane 216,000
capital, $202,540.

According to the partnership contract, the partners were to be remunerated as follows:

1. Salaries of $14,400 for Alex, $12,000 for Baron, and $13,600 for Crane, to be recog-
nized as operating expenses by the partnership.
2. Interest at 12% on the average capital account balances during the year.
3. Remainder divided 40% to Alex, 30% to Baron, and 30% to Crane.
Income before partners’ salaries for the fiscal year ended December 31, 2005, was
$92,080. Alex invested an additional $24,000 in the partnership on July 1; Crane withdrew
$36,000 from the partnership on October 1; and, as authorized by the partnership contract,
Alex, Baron, and Crane each withdrew $1,250 monthly against their shares of net income
for the year.
Instructions
a. Prepare a working paper to divide the $92,080 income before partners’ salaries of the
Alex, Baron & Crane LLP for the year ended December 31, 2005, among the partners.
Show supporting computations.
b. Prepare a statement of partners’ capital for the Alex, Baron & Crane LLP for the year
ended December 31, 2005.
(Problem 2.6) Partner Eng plans to withdraw from Chu, Dow & Eng LLP on July 10, 2005. Partnership
assets are to be used to acquire Eng’s partnership interest. The balance sheet for the part-
nership on that date follows:
CHECK FIGURE
CHU, DOW & ENG LLP
a. Debit Chu, capital,
Balance Sheet
$2,400; c. Debit Chu,
July 10, 2005
capital, $15,000.
Assets Liabilities and Partners’ Capital
Cash $ 74,000 Liabilities $ 45,000
Trade accounts receivable (net) 36,000 Chu, capital 120,000
Plant assets (net) 135,000 Dow, capital 60,000
Goodwill (net) 30,000 Eng, capital 50,000
Total $275,000 Total $275,000
68 Part One Accounting for Partnerships and Branches

Chu, Dow, and Eng share net income and losses in the ratio of 3 : 2 : 1, respectively.

Instructions
Prepare journal entries to record Eng’s withdrawal from the Chu, Dow & Eng LLP on July 10,
2005, under each of the following independent assumptions:
a. Eng is paid $54,000, and the excess paid over Eng’s capital account balance is recorded
as a bonus to Eng from Chu and Dow.
b. Eng is paid $45,000, and the difference is recorded as a bonus to Chu and Dow from Eng.
c. Eng is paid $45,000, and goodwill currently in the accounting records of the partner-
ship, which arose from Chu’s original investment of a highly profitable proprietorship,
is reduced by the total amount of impairment implicit in the transaction.
d. Eng accepts cash of $40,500 and plant assets (equipment) with a current fair value of
$9,000. The equipment had cost $30,000 and was 60% depreciated, with no residual
value. (Record any gain or loss on the disposal of the equipment in the partners’ capital
accounts.)

(Problem 2.7) Yee & Zane LLP has maintained its accounting records on the accrual basis of accounting,
except for the method of handling uncollectible account losses. Doubtful accounts expense
has been recognized only when specific trade accounts receivable were determined to be
uncollectible.
CHECK FIGURE The partners of Yee & Zane LLP are anticipating the admission of Arne to the firm on
a. Debit Yee, capital, December 31, 2005, and they retain you to review the partnership accounting records be-
$3,530; b. Credit Arne, fore this action is taken. You suggest that the firm change retroactively to the allowance
capital, $20,000. method of accounting for doubtful accounts receivable so that the planning for admission
of Arne may be based on the accrual basis of accounting. The following information is
available:

Year Trade Additional

Accounts Trade Accounts Receivable Written Off Estimated
Receivable Uncollectible
Originated 2003 2004 2005 Accounts
2002 $1,200 $ 200
2003 1,500 1,300 $ 600 $ 450
2004 1,800 1,400 1,250
2005 2,200 4,800
Totals $2,700 $3,300 $4,200 $6,500

The partners shared net income and losses equally through 2004. In 2005 the income-
sharing plan was changed as follows: salaries of $8,000 and $6,000 to Yee and Zane, re-
spectively, to be expensed by the partnership; the resultant net income or loss to be divided
60% to Yee and 40% to Zane. Income of Yee & Zane LLP for 2005 was $52,000 before
partners’ salaries expense.

Instructions
a. Prepare a journal entry for Yee & Zane LLP on December 31, 2005, giving effect to the
change in accounting method for doubtful accounts expense. Support the entry with an
 Chapter 2 Partnerships: Organization and Operation 69

exhibit showing changes in doubtful accounts expense for the year ended December 31,
2005.
b. Assume that after you prepared the journal entry in a above, Yee’s capital account bal-
ance was $48,000, Zane’s capital account balance was $22,000, and Arne invested
$30,000 for a 20% interest in net assets of Yee, Zane & Arne LLP and a 25% share in net
income or losses. Prepare a journal entry for Yee, Zane & Arne LLP to record the ad-
mission of Arne on December 31, 2005, by the bonus method.

(Problem 2.8) Following are financial statements and additional information for Alef, Beal & Clarke
LLP:

CHECK FIGURE
ALEF, BEAL & CLARKE LLP
Net cash provided by
Income Statement
operating activities,
For Year Ended December 31, 2005
$45,804.
Revenue and gain:
Fees $480,000
Gain on disposal of equipment 600
Total revenue and gain $480,600
Expenses:
Depreciation $ 3,220
Other 427,670
Total expenses 430,890
Net income $ 49,710
Division of net income:
Partner Alef $ 22,280
Partner Beal 5,150
Partner Clarke 22,280
Total $ 49,710

ALEF, BEAL & CLARKE LLP

Statement of Partners’ Capital
For Year Ended December 31, 2005

Alef Beal Clarke Combined

Partners’ capital, beginning of year $ 9,805 $ 10,680 $ 12,089 $ 32,574
Add: Net income 22,280 5,150 22,280 49,710
Goodwill recognized on
partner Beal’s retirement 1,000 1,000 1,000 3,000
Subtotals $ 33,085 $ 16,830 $ 35,369 $ 85,284
Less: Drawings (16,735) (4,830) (15,700) (37,265)
Retirement of partner Beal (12,000) (12,000)
Partners’ capital, end of year $ 16,350 $ -0- $ 19,669 $ 36,019
70 Part One Accounting for Partnerships and Branches

ALEF, BEAL & CLARKE LLP

Comparative Balance Sheets
December 31, 2005, and 2004

Dec. 31, Dec. 31, Increase

2005 2004 (Decrease)
Assets
Current assets:
Cash $ 8,589 $ 3,295 $ 5,294
Trade accounts receivable 12,841 8,960 3,881
Allowance for doubtful accounts (930) (1,136) (206)*
Supplies 983 412 571
Total current assets $21,483 $11,531 $ 9,952
Investments:
Cash surrender value of life insurance
policies $ 4,060 $ 5,695 $ (1,635)
Plant assets:
Land $ 4,200 $ 4,200 $ 0
Buildings and equipment 40,800 30,090 10,710
Accumulated depreciation of buildings and
equipment (12,800) (13,480) (680)†
Net plant assets $32,200 $20,810 $11,390
Goodwill $ 3,000 $ 3,000
Total assets $60,743 $38,036 $22,707

Liabilities and Partners’ Capital

Current liabilities:
Note payable to bank $ 3,330 $ 3,330
Trade accounts payable 1,681 $ 2,984 (1,303)
Accrued liabilities 1,913 2,478 (565)
Current portion of long-term debt 5,600 5,600
Total current liabilities $12,524 $ 5,462 $ 7,062
Long-term debt:
Equipment contract payable, due $300
monthly plus interest at 6% $ 4,200 $ 4,200
Note payable to retired partner, due $2,000
each July 1 plus interest at 5% 8,000 8,000
Total long-term debt $12,200 $12,200
Total liabilities $24,724 $ 5,462 $19,262
Partners’ capital:
Partner Alef $16,350 $ 9,805 $ 6,545
Partner Beal 10,680 (10,680)
Partner Clarke 19,669 12,089 7,580
Total partners’ capital $36,019 $32,574 $ 3,445
Total liabilities and partners’ capital $60,743 $38,036 $22,707

*A decrease in the allowance and an increase in total current assets.

†
A decrease in accumulated depreciation and an increase in net plant assets.

Additional Information
1. Alef, Beal, and Clarke shared net income and losses equally. On July 1, 2005, after the
$15,450 net income of the partnership for the six months ended June 30, 2005, had been di-
vided among the partners, Andrew Beal retired from the partnership, receiving $2,000 cash
 Chapter 2 Partnerships: Organization and Operation 71

and a 5%, five-year promissory note for $10,000 in full settlement of his interest. The
partners agreed to recognize goodwill of $3,000 prior to Beal’s retirement and to retain
Beal’s name in the partnership name. Alef and Clarke agreed to share net income and
losses equally following Beal’s retirement.
2. Following Beal’s withdrawal, the insurance policy on his life was canceled, and the part-
nership received the cash surrender value of $3,420.
3. The partnership had acquired equipment costing $15,210 on August 31, 2005, for $6,210
cash and an equipment contract payable $300 a month at the end of each month beginning
September 30, 2005, plus interest at 6%. The partnership made required payments when due.
4. On September 30, 2005, the partnership had disposed of equipment that had cost $4,500
for $1,200, recognizing a gain of $600.
5. The partnership had borrowed $3,330 from the bank on a six-month, 8% promissory
note due April 15, 2006.
Instructions
Prepare a statement of cash flows under the indirect method for Alef, Beal & Clarke LLP
for the year ended December 31, 2005. A working paper is not required.
(Problem 2.9) Southwestern Enterprises (a limited partnership) was formed on January 2, 2005, with the
issuance of 1,200 units, $1,000 each, as follows:

CHECK FIGURE
Laurence Douglas, general partner, 400 units $ 400,000
Net income to limited
10 limited partners, 800 units total 800,000
partners, $360,000.
Total (1,200 units) $1,200,000

The trial balance of Southwestern Enterprises on December 31, 2005, the end of its first
year of operations, is as follows:

SOUTHWESTERN ENTERPRISES (a limited partnership)

Trial Balance
December 31, 2005

Debit Credit
Cash $ 20,000
Trade accounts receivable 90,000
Allowance for doubtful accounts $ 10,000
Inventories 100,000
Plant assets 1,500,000
Accumulated depreciation of plant assets 100,000
Note payable to bank 20,000
Trade accounts payable 50,000
Accrued liabilities 30,000
Laurence Douglas, capital 400,000
Laurence Douglas, drawings 0
Limited partners, capital 800,000
Limited partners, redemptions 260,000
Net sales 1,400,000
Cost of goods sold 700,000
Operating expenses 140,000
Totals $2,810,000 $2,810,000
72 Part One Accounting for Partnerships and Branches

Additional Information
1. The Limited Partners, Capital and Limited Partners, Redemptions ledger accounts are
controlling accounts supported by subsidiary ledgers.
2. The certificate for Southwestern Enterprises provides that general partner Laurence
Douglas may withdraw cash each December 31 to the extent of his unit participation in
the net income of the limited partnership. Douglas had no drawings for 2005. The cer-
tificate also provides that limited partners may withdraw their net equity only on June 30
or December 31 of each year. Two limited partners, each owning 100 units in South-
western Enterprises, withdrew cash for their equity during 2005, as shown by the fol-
lowing Limited Partners, Redemptions ledger account:

Limited Partners, Redemptions

Date Explanation Debit Credit Balance
2005
June 30 100 units @ $1,100 110,000 110,000 dr
Dec. 31 100 units @ $1,500 150,000 260,000 dr

3. Net income of Southwestern Enterprises for the year ended December 31, 2005, was
subdivided as follows:

Six months ended June 30, 2005 $120,000

Six months ended Dec. 31, 2005 440,000
Net income, year ended Dec. 31, 2005 $560,000

4. The 10%, six-month bank loan had been received on December 31, 2005.
5. There were no disposals of plant assets during 2005.
Instructions
Prepare an income statement, a statement of partners’ capital, a balance sheet, and a state-
ment of cash flows (indirect method) for Southwestern Enterprises (a limited partnership)
for the year ended December 31, 2005. Show net income per weighted-average unit sepa-
rately for the general partner and the limited partners in the income statement, and show
partners’ capital per unit in the balance sheet. A working paper is not required for the state-
ment of cash flows.
(Problem 2.10) The partners of Noble & Roland LLP have asked you to review the following balance sheet
(AICPA Professional Standards, vol. 2, “Compilation and Review of Financial Statements,”
sec. AR100.04 defines review as follows:
CHECK FIGURE Review of financial statements. Performing inquiry and analytical procedures that provide the
b. Total assets, accountant with a reasonable basis for expressing limited assurance that there are no material
$115,000. modifications that should be made to the statements in order for them to be in conformity
with generally accepted accounting principles or, if applicable, with another comprehensive
basis of accounting.

Also, sec. AR100.35 states: “Each page of the financial statements reviewed by the ac-
countant should include a reference such as ‘See Accountant’s Review Report.’ ”)
 Chapter 2 Partnerships: Organization and Operation 73

NOBLE & ROLAND LLP

Balance Sheet
June 30, 2005

Assets
Current assets:
Cash and cash equivalents $ 3,000
Short-term investments in marketable equity
securities, at cost 10,000
10% note receivable, due on demand 20,000
Trade accounts receivable 40,000
Short-term prepayments 1,000
Total current assets $ 74,000
Equipment, net of accumulated depreciation $4,000 50,000
Total assets $124,000

Liabilities and Partners’ Capital

Current liabilities:
Trade accounts payable $ 15,000
Accrued liabilities 2,000
Total current liabilities $ 17,000
Long-term debt:
8% note payable, due June 30, 2009 5,000
Total liabilities $ 22,000
Partners’ capital:
Partner Anne Noble $62,000
Partner Janice Roland 40,000
Total partners’ capital 102,000
Total liabilities and partners’ capital $124,000

Your review of the foregoing balance sheet disclosed the following:

1. The partners had requested your review because the bank considering their application for
a 30-day, 12%, unsecured loan of $5,000 had requested a review because of concern about
the partnership’s high current ratio of $4.35 to $1 ($74,000 $17,000 $4.35 to $1).
2. The short-term investments, properly classified as available for sale, had a current fair
value of $6,000. Because of the substantial unrealized loss on the investments, the part-
nership had no present plans to dispose of them in the near future.
3. The note receivable had been executed by partner Janice Roland two years ago; because
interest had been paid to June 30, 2005, the partnership had no present plans to demand
payment of the principal.
4. Trade accounts receivable totaling $5,000 are estimated to be doubtful of collection.
5. Payee of the note payable was partner Anne Noble.
6. Interest rates on the note receivable and note payable, and depreciation of the equipment,
appeared appropriate.
Instructions
a. Prepare journal entries to correct the accounting records of Noble & Roland LLP as of
June 30, 2005. Allocate all entries affecting income statement accounts to the partners’
capital accounts in their income-sharing ratio: Noble, 60%; Roland, 40%.
b. Prepare a corrected balance sheet for Noble & Roland LLP as of June 30, 2005.
74 Part One Accounting for Partnerships and Branches

In preparing the solution, refer to the following sources:

Accounting Research Bulletin No. 43, “Restatement and Revision of Accounting
Research Bulletins,” chs. 1A5 and 3A4.
APB Opinion No. 12, “Omnibus Opinion—1967,” pars. 2 and 3.
Statement of Financial Accounting Standards No. 57, “Related Party Disclosures,”
par. 2.
Statement of Financial Accounting Standards No. 115, “Accounting for Certain Invest-
ments in Debt and Equity Securities,” pars. 12b, 13, and 17.
Statement of Financial Accounting Standards No. 130, “Reporting Comprehensive
Income,” pars. 26 and 33a.
Chapter Three

Partnership Liquidation
and Incorporation;
Joint Ventures
Scope of Chapter
This chapter deals with the liquidation of limited liability partnerships (LLPs) and limited
partnerships. It also covers accounting issues related to incorporation of a limited liability
partnership. The final section of the chapter discusses and illustrates accounting for both
corporate and unincorporated joint ventures—business enterprises with features similar to
those of general partnerships.

LIQUIDATION OF A PARTNERSHIP
The Meaning of Liquidation
The liquidation of a limited liability partnership means winding up its activities, usually by
selling assets, paying liabilities, and distributing any remaining cash to the partners. In
some cases, the partnership net assets may be sold as a unit; in other cases, the assets may
be sold in installments, and most or all of the cash received must be used to pay partnership
creditors. This process of liquidation may be completed quickly, or it may require several
months.
When the decision is made to liquidate a limited liability partnership, the accounting
records of the partnership should be adjusted and closed, and the net income or loss for the
final period of operations entered in the capital accounts of the partners.
The liquidation process usually begins with the realization (conversion to cash) of non-
cash assets. Absent provisions of the partnership contract to the contrary, the losses or
gains from realization of assets are divided among the partners in the income-sharing ra-
tio and entered in their capital accounts. The amounts shown as their respective equities at
this point are the basis for settlement. However, before any payment to partners, all out-
side creditors of the limited liability partnership must be paid in full. If the cash obtained
from the realization of assets is insufficient to pay liabilities in full, an unpaid creditor may
act to enforce collection from the personal assets of any solvent partner whose actions
caused the partnership’s insolvency, regardless of whether that partner has a credit or a
debit capital account balance. As pointed out in Chapter 2, a partnership is treated as an
entity for many purposes such as changes in partners, but it may not use the shield of a
75
76 Part One Accounting for Partnerships and Branches

separate entity to protect culpable partners personally against the claims of unpaid part-
nership creditors.

Division of Losses and Gains during Liquidation

The underlying theme in accounting for the liquidation of a limited liability partnership
may be stated as follows: Divide the loss or gain from the realization of noncash assets
before distributing cash. As assets are realized, any loss or gain is allocated to the partners’
capital accounts in the income-sharing ratio. The income-sharing ratio used during the op-
eration of the partnership is applicable also to the losses and gains during liquidation, un-
less the partners have a different agreement.
When the net loss or gain from liquidation is divided among the partners and outside
creditors have been paid, the final credit balances of the partners’ capital and loan ledger ac-
counts will be equal to the cash available for distribution to them. Payments are then made
in the amounts of the partners’ respective equities in the partnership.

Distribution of Cash or Other Assets to Partners

The Uniform Partnership Act lists the order for distribution of cash by a liquidating part-
nership as (1) payment of creditors in full, (2) payment of loans from partners, and (3) pay-
ment of partners’ capital account credit balances. The indicated priority of partners’ loans
over partners’ capital appears to be a legal fiction. This rule is nullified for practical pur-
poses by an established legal doctrine called the right of offset. If a partner’s capital ac-
count has a debit balance (or even a potential debit balance depending on possible future
realization losses), any credit balance in that partner’s loan account must be offset against
the deficit (or potential deficit) in the capital account. However, if a partner with a loan
account receives any cash, the payment is recorded by a debit to the loan account to the
extent of the balance of that account.
Because of the right of offset, the total amount of cash received by a partner during liq-
uidation always will be the same as if loans to the partnership had been recorded in the part-
ner’s capital account. Furthermore, the existence of a partner’s loan account will not advance
the time of payment to any partner during the liquidation. Consequently, in the preparation
of a statement of realization and liquidation (see page 77), the number of columns may be
reduced by combining the amount of a partner’s loan with the amount shown in the partner’s
capital account. Thus, the statement of realization and liquidation will include only one
column for each partner; the first amount in the column will be the total equity (including
any loans) of the partner at the beginning of liquidation.
Combining the capital and loan ledger account balances of a partner in the statement of
realization and liquidation does not imply combining these accounts in the partnership
ledger. Separate ledger accounts for capital and for loans should be maintained to provide
a clear record of the terms under which assets were invested by the partners.
A partner may choose to receive certain noncash assets, such as computers or office
furniture, in kind rather than to convert such property to cash. Regardless of whether non-
cash assets are distributed to partners, it is imperative to follow the rule that no distribu-
tion of assets may be made to partners until after all outside partnership creditors have
been paid.
The following section of this chapter illustrates a series of liquidations in which the
realization of noncash assets is completed before any payments are made to partners.
Another section illustrates liquidation in installments; that is, payments to partners after a
portion of the noncash assets has been realized and all liabilities to outsiders have been
paid, but with the final loss or gain from realization of the remaining assets not known. The
installment payments to partners are computed by a method that provides a safeguard
against overpayment.
 Chapter 3 Partnership Liquidation and Incorporation; Joint Ventures 77

PAYMENTS TO PARTNERS OF AN LLP AFTER

ALL NONCASH ASSETS REALIZED
Equity of Each Partner Is Sufficient to Absorb
Loss from Realization
Assume that Abra and Barg, who share net income and losses equally, decide to liquidate
Abra & Barg LLP. A balance sheet on June 30, 2005, just prior to liquidation, follows:

Balance Sheet of ABRA & BARG LLP

Limited Liability Balance Sheet
Partnership Prior to June 30, 2005
Liquidation
Assets Liabilities and Partners’ Capital
Cash $10,000 Liabilities $20,000
Other assets 75,000 Loan payable to Barg 20,000
Abra, capital 40,000
Barg, capital 5,000
Total $85,000 Total $85,000

As a first step in the liquidation, the noncash assets with a carrying amount of $75,000
realized cash of $35,000, with a resultant loss of $40,000 absorbed equally by Abra and
Barg. Because Barg’s capital account balance is only $5,000, the partnership’s accountant
exercises the right of offset by transferring $15,000 from Barg’s loan ledger account to
Barg’s capital account. The statement of realization and liquidation below, covering the pe-
riod July 1 through 15, 2005, shows the division of the realization loss between the part-
ners, the payment of outside creditors, the offset of Barg’s capital deficit against Barg’s loan,
and the distribution of the remaining cash to the partners. (The income-sharing ratio ap-
pears next to each partner’s name.)

ABRA & BARG LLP

Statement of Realization and Liquidation
July 1 through 15, 2005

Partners’ Capital
Assets
Barg, Abra Barg
Cash Other Liabilities loan (50%) (50%)
Balances before liquidation $10,000 $75,000 $20,000 $20,000 $40,000 $ 5,000
Realization of other assets at a
loss of $40,000 35,000 (75,000) (20,000) (20,000)
Balances $45,000 $20,000 $20,000 $20,000 $(15,000)
Payment to creditors (20,000) (20,000)
Balances $25,000 $20,000 $20,000 $(15,000)
Offset Barg’s capital deficit
against Barg’s loan (15,000) 15,000
Balances $25,000 $ 5,000 $20,000 $ -0-
Payments to partners (25,000) (5,000) (20,000) -0-
78 Part One Accounting for Partnerships and Branches

In the foregoing statement of realization and liquidation, Barg’s loan account balance of
$20,000 and capital account balance of $5,000 might have been combined to obtain an
equity of $25,000 for Barg. As stated earlier, such a procedure would be appropriate be-
cause the legal priority of a partner’s loan account has no significance in determining either
the total amount of cash paid to a partner or the timing of cash payments to partners during
liquidation.
In the foregoing illustration, Partner Abra received cash of $20,000 and Partner Barg re-
ceived $5,000. Neither partner received cash until after partnership creditors had been paid
in full. Because the only partnership asset is $25,000 cash at this point, it is reasonable to
assume that checks to Abra and Barg for $20,000 and $5,000, respectively, were prepared
and delivered to the partners at the same time. It is thus apparent that a partner’s loan ac-
count has no special significance in the liquidation process. Therefore, succeeding illustra-
tions do not show a partner’s loan ledger account in a separate column of the statement of
realization and liquidation. Whenever a partner’s loan account is involved, its balance may
be combined with the partner’s capital account balance in the statement of realization and
liquidation.

Equity of One Partner Is Not Sufficient to Absorb

That Partner’s Share of Loss from Realization
In this case, the loss on realization of assets, when distributed in the income-sharing ratio,
results in a debit balance in the capital account of one of the partners. It may be assumed
that the partner with a debit balance has no loan account or that the total of the partner’s
capital account and loan account combined is less than the partner’s share of the loss on re-
alization. To fulfill an agreement to share a specified percentage of partnership losses, the
partner must pay to the partnership sufficient cash to eliminate any capital deficit. If the
partner is unable to do so, the deficit must be absorbed by the other partners as an addi-
tional loss to be shared in the same proportion as they have previously shared net income
or losses among themselves. To illustrate, assume the balance sheet below for Diel, Ebbs &
Frey LLP just prior to liquidation:

Balance Sheet for DIEL, EBBS & FREY LLP

Limited Liability Balance Sheet
Partnership to Be May 20, 2005
Liquidated
Assets Liabilities and Partners’ Capital
Cash $ 20,000 Liabilities $ 30,000
Other assets 80,000 Diel, capital 40,000
Ebbs, capital 21,000
Frey, capital 9,000
Total $100,000 Total $100,000

The income-sharing ratio is Diel, 20%; Ebbs, 40%; and Frey, 40%. The other assets with
a carrying amount of $80,000 realized $50,000 cash, resulting in a loss of $30,000. Partner
Frey is charged with 40% of this loss, or $12,000 ($30,000 0.40 $12,000), which cre-
ates a deficit of $3,000 in Frey’s capital account. In the following statement of realization
and liquidation, it is assumed that Frey pays the $3,000 to the partnership:
 Chapter 3 Partnership Liquidation and Incorporation; Joint Ventures 79

DIEL, EBBS & FREY LLP

Statement of Realization and Liquidation
May 21 through 31, 2005

Partners’ Capital
Assets
Diel, Ebbs Frey
Cash Other Liabilities (20%) (40%) (40%)
Balances before liquidation $20,000 $80,000 $30,000 $40,000 $21,000 $ 9,000)
Realization of other assets at a
loss of $30,000 50,000 (80,000) (6,000) (12,000) (12,000)
Balances $70,000 $30,000 $34,000 $ 9,000 $ (3,000)
Payment to creditors (30,000) (30,000)
Balances $40,000 $34,000 $ 9,000 $ (3,000)
Cash received from Frey 3,000 3,000
Balances $43,000 $34,000 $ 9,000 $ -0-
Payments to partners (43,000) (34,000) (9,000) -0-

Illustration of
Completed Liquidation
Next, change one condition of the foregoing illustration by assuming that partner Frey
of Limited Liability
Partnership (Above) was not able to pay the $3,000 capital deficit to the partnership. If the cash available after
payment of creditors is to be distributed to Diel and Ebbs without a delay to determine the
Illustration of collectibility of the $3,000 claim against Frey, the statement of realization and liquidation
Incomplete would appear as illustrated below:
Liquidation of Limited
Liability Partnership

DIEL, EBBS & FREY LLP

Statement of Realization and Liquidation
May 21 through 31, 2005

Partners’ Capital
Assets
Diel, Ebbs Frey
Cash Other Liabilities (20%) (40%) (40%)
Balances before liquidation $20,000 $80,000 $30,000 $40,000 $21,000 $ 9,000
Realization of other assets at a
loss of $30,000 50,000 (80,000) (6,000) (12,000) (12,000)
Balances $70,000 $30,000 $34,000 $ 9,000 $ (3,000)
Payment to creditors (30,000) (30,000)
Balances $40,000 $34,000 $ 9,000 $ (3,000)
Payments to partners (40,000) (33,000) (7,000)
Balances $ 1,000 $ 2,000 $ (3,000)

The cash payments of $33,000 to Diel and $7,000 to Ebbs leave both with a sufficient
capital account credit balance to absorb their share of the additional loss if Frey is unable
to pay $3,000 to the partnership. The income-sharing ratio is 20% for Diel and 40% for
Ebbs; consequently, the possible additional loss of $3,000 would be charged to them in the
proportion of 2⁄6, or $1,000, to Diel and 4⁄6, or $2,000, to Ebbs. The payment of the $40,000
cash available to partners is divided between them in a manner that reduces Diel’s capital
account balance to $1,000 and Ebbs’s balance to $2,000.
80 Part One Accounting for Partnerships and Branches

If the $3,000 is later collected from Frey, this amount will be divided $1,000 to Diel and
$2,000 to Ebbs. The foregoing statement of realization and liquidation then may be com-
pleted as follows:

Completion of Partners’ Capital

Liquidation; Capital Assets
Diel Ebbs Frey
Deficit Paid by
Cash Liabilities (20%) (40%) (40%)
Partner Frey
Balances (from page 79) $1,000 $2,000 $(3,000)
Cash received from
Frey $3,000 3,000
Payments to partners (3,000) (1,000) (2,000)

However, if the $3,000 receivable from Frey is uncollectible, the statement of realization
and liquidation would be completed with the write-off of Frey’s capital deficit shown as an
additional loss absorbed by Diel and Ebbs as follows:

Completion of Partners’ Capital

Liquidation; Partner Assets
Diel Ebbs Frey
Frey Unable to Pay
Cash Liabilities (20%) (40%) (40%)
Capital Deficit
Balances (from page 79) $1,000 $2,000 $(3,000)
Additional loss from
Frey’s uncollectible
capital deficit (1,000) (2,000) 3,000

Equities of Two Partners Are Not Sufficient to Absorb

Their Shares of Loss from Realization
It already has been noted that inability of a partner to pay the partnership for a capital
deficit causes an additional loss to the other partners. A partner may have sufficient capital,
or combination of capital and loan accounts, to absorb any direct share of loss on the real-
ization of noncash assets, but not sufficient equity to absorb additional actual or potential
losses caused by inability of the partnership to collect the deficit in another partner’s capi-
tal account. In brief, one capital deficit, if not collectible, may cause a second capital deficit
that may or may not be collectible.
Assume that Judd, Kamb, Long, and Marx, partners of Judd, Kamb, Long & Marx LLP,
share net income and losses 10%, 20%, 30%, and 40%, respectively. Their capital account
balances for the period August 1 through 15, 2005, are as shown in the statement of real-
ization and liquidation on page 81, supported by the table that follows.
Table 3.1 on page 81, which supports the statement of realization and liquidation on that
page, shows that the $20,000 of available cash may be distributed $16,000 to Judd and
$4,000 to Kamb. If the $24,000 deficit in Marx’s capital account proves uncollectible, the ad-
ditional loss to be divided among the other three partners will cause Long’s capital account
to change from a $6,000 credit balance to a $6,000 debit balance (deficit). Therefore, Long
is not eligible to receive a cash payment. If this deficit in Long’s capital account proves un-
collectible, the balances remaining in the capital accounts of Judd and Kamb, after the cash
payments to them totaling $20,000, will be equal to the amounts ($2,000 and $4,000, re-
spectively) needed to absorb the additional loss shifted from Long’s capital account.
 Chapter 3 Partnership Liquidation and Incorporation; Joint Ventures 81

JUDD, KAMB, LONG & MARX LLP

Statement of Realization and Liquidation
August 1 through 15, 2005

Partners’ Capital
Assets
Judd Kamb Long Marx
Cash Other Liabilities (10%) (20%) (30%) (40%)
Balances before
liquidation $ 20,000 $200,000 $120,000 $30,000 $32,000 $30,000 $ 8,000
Realization of other
assets at a loss of
$80,000 120,000 (200,000) (8,000) (16,000) (24,000) (32,000)
Balances $140,000 $120,000 $22,000 $16,000 $ 6,000 $(24,000)
Payment to creditors (120,000) (120,000)
Balances $ 20,000 $22,000 $16,000 $ 6,000 $(24,000)
Payments to partners
(Table 3.1) (20,000) (16,000) (4,000)
Balances $ 6,000 $12,000 $ 6,000 $(24,000)

TABLE 3.1
JUDD, KAMB, LONG & MARX LLP
Computation of Cash Payments to Partners
August 15, 2005

Partners’ Capital
Judd (10%) Kamb (20%) Long (30%) Marx (40%)
Capital account balances
before distribution of cash
to partners $22,000 $16,000 $ 6,000 $(24,000)
Additional loss to Judd, Kamb,
and Long if Marx’s deficit
is uncollectible (ratio of
10 : 20 : 30) (4,000) (8,000) (12,000) 24,000
Balances $18,000 $ 8,000 $ (6,000)
Additional loss to Judd and
Kamb if Long’s deficit is
uncollectible (ratio of 10 : 20) (2,000) (4,000) 6,000
Amounts that may be paid to
partners $16,000 $ 4,000

Partnership Is Insolvent but Partners Are Solvent

If a limited liability partnership is insolvent, it is unable to pay all outside creditors, and at
least one and perhaps all of the partners will have debit balances in their capital accounts.
In any event, the total of the capital account debit balances will exceed the total of the credit
balances. If the partner or partners with a capital deficit pay the required amount to the part-
nership, it will have cash to pay its liabilities in full. However, the partnership creditors may
demand payment from any solvent partner whose actions caused the partnership’s insol-
vency, regardless of whether the partner’s capital account has a debit balance or a credit bal-
ance. In terms of relationships with creditors, the limited liability partnership is not a
separate entity. A partner who makes payments to partnership creditors receives a credit to
82 Part One Accounting for Partnerships and Branches

his or her capital account. As an illustration of an insolvent partnership whose partners are
solvent (have personal assets in excess of liabilities), assume that Nehr, Ordo & Page LLP,
whose partners share net income and losses equally, had the following balance sheet just
prior to liquidation on May 10, 2005:

Balance Sheet for NEHR, ORDO & PAGE LLP

Limited Liability Balance Sheet
Partnership to Be May 10, 2005
Liquidated
Assets Liabilities and Partners’ Capital
Cash $ 15,000 Liabilities $ 65,000
Other assets 85,000 Nehr, capital 18,000
Ordo, capital 10,000
Page, capital 7,000
Total $100,000 Total $100,000

On May 12, 2005, the other assets with a carrying amount of $85,000 realize $40,000
cash, which causes a loss of $45,000 to be divided equally among the partners. The total
cash of $55,000 is paid to the partnership creditors, which leaves unpaid liabilities of
$10,000. Partner Nehr’s capital account has a credit balance of $3,000 after absorbing one-
third of the loss. Partners Ordo and Page owe the partnership $5,000 and $8,000, respectively.
Assuming that on May 30, 2005, Ordo and Page pay in the amounts of their deficiencies,
the partnership will use $10,000 of the $13,000 available cash to pay the remaining liabili-
ties and will distribute $3,000 to Nehr. These events are summarized in the statement of
realization and liquidation below.

NEHR, ORDO & PAGE LLP

Statement of Realization and Liquidation
May 12 through 30, 2005

Assets Partners’ Capital

Cash Other Liabilities Nehr (1⁄3) Ordo (1⁄3) Page (1⁄3)
Balances before liquidation $ 15,000 $ 85,000 $65,000 $18,000 $ 10,000 $ 7,000
Realization of other assets at a
loss of $45,000 40,000 (85,000) (15,000) (15,000) (15,000)
Balances $ 55,000 $65,000 $ 3,000 $ (5,000) $ (8,000)
Partial payment to creditors (55,000) (55,000)
Balances $ -0- $10,000 $ 3,000 $ (5,000) $ (8,000)
Cash invested by Ordo and Page 13,000 5,000 8,000
Balances $ 13,000 $10,000 $ 3,000
Final payment to creditors (10,000) (10,000)
Balances $ 3,000 $ 3,000
Payment to Nehr (3,000) (3,000)

It should be noted that if a limited liability partnership is insolvent because of an adverse

award of damages in a lawsuit, and the partner or partners responsible for the damages are
solvent, they alone of the partners must pay the amount of damages that the insolvent LLP is
unable to pay. However, if such partners also are insolvent, both they and the LLP may have
 Chapter 3 Partnership Liquidation and Incorporation; Joint Ventures 83

to file for liquidation under Chapter 7 of the U.S. Bankruptcy Code, which is discussed in
Chapter 14 of this textbook. The partners of the LLP not responsible for the award of dam-
ages, unless they too were insolvent, apparently would not have to undertake bankruptcy
proceedings.

General Partnership Is Insolvent and Partners Are Insolvent

In the foregoing illustration of an insolvent limited liability partnership, the partners were
solvent and therefore able to pay their capital deficits to the partnership. Now consider an
insolvent general partnership in which one or more of the partners are insolvent. This
situation raises a question as to the relative rights of two groups of creditors: (1) credi-
tors of the partnership and (2) creditors of the partners. The relative rights of these two
groups of creditors are governed by the provisions of the Uniform Partnership Act relat-
ing to the marshaling of assets. These rules provide that assets of the general partnership
(including partners’ capital deficits) are first available to creditors of the partnership and
that assets of the partners are first available to their creditors. After the liabilities of the
partnership have been paid in full, the creditors of an individual partner have a claim
against the assets (if any) of the partnership to the extent of that partner’s equity in the
partnership.
After the creditors of a partner have been paid in full from the assets of the partner, any
remaining assets of the partner are available to partnership creditors, regardless of whether
the partner’s capital account has a credit balance or a debit balance. Such claims by credi-
tors of the partnership are permitted only when these creditors are unable to obtain pay-
ment from the partnership.
To illustrate the relative rights of creditors of an insolvent general partnership and per-
sonal creditors of an insolvent partner, assume that the Rich, Sand & Toll Partnership, a
general partnership whose partners share net income and losses equally, has the partnership
balance sheet below just prior to liquidation on November 30, 2005:

Balance Sheet of RICH, SAND & TOLL PARTNERSHIP

General Partnership Balance Sheet
Prior to Liquidation November 30, 2005

Assets Liabilities and Partners’ Capital

Cash $ 10,000 Liabilities $ 60,000
Other assets 100,000 Rich, capital 5,000
Sand, capital 15,000
Toll, capital 30,000
Total $110,000 Total $110,000

Assume also that on November 30, 2005, the partners have the following assets and lia-
bilities other than their equities in the partnership:

Partners’ Personal Personal Personal

Assets and Liabilities Partner Assets Liabilities
Rich $100,000 $25,000
Sand 50,000 50,000
Toll 5,000 60,000
84 Part One Accounting for Partnerships and Branches

The realization of other assets of the partnership results in a loss of $60,000, as shown in the
following statement of realization and liquidation for the period December 1 through 12, 2005:

RICH, SAND & TOLL PARTNERSHIP

Statement of Realization and Liquidation
December 1 through 12, 2005

Assets Partners’ Capital

1
Cash Other Liabilities Rich ( ⁄3) Sand (1⁄3) Toll (1⁄3)
Balances before liquidation $10,000 $100,000 $60,000 $ 5,000 $ 15,000 $ 30,000
Realization of other assets at a
loss of $60,000 40,000 (100,000) (20,000) (20,000) (20,000)
Balances $50,000 $60,000 $(15,000) $ (5,000) $ 10,000
Partial payment to creditors (50,000) (50,000)
Balances $10,000 $(15,000) $ (5,000) $ 10,000

Liquidation of General The creditors of the partnership have received all the cash of the general partnership and
Partnership Not still have unpaid claims of $10,000. They cannot collect from Sand or Toll because the as-
Completed sets of these two partners are just sufficient or are insufficient to pay their personal liabili-
ties. However, the partnership creditors may collect the $10,000 in full from Rich, who is
solvent. By chance, Rich has a capital deficit of $15,000, but this is of no concern to cred-
itors of the partnership, who may collect in full from any partner who has sufficient assets,
regardless of whether that partner’s capital account has a debit balance or a credit balance.
The statement of realization and liquidation is now continued below to show Rich’s pay-
ment of the final $10,000 owed to partnership creditors. Because the assumptions about
Rich’s finances showed that Rich had $100,000 of assets and only $25,000 of liabilities,
Rich is able to invest in the partnership the additional $5,000 needed to offset Rich’s capi-
tal deficit. This $5,000 cash is paid to partner Toll, the only partner with a capital account
credit balance.

Continuation of Partners’ Capital

Statement of 1
Cash Liabilities Rich ( ⁄3) Sand (1⁄3) Toll (1⁄3)
Realization and
Liquidation for Balances (from above) $ 10,000 $(15,000) $(5,000) $10,000
General Partnership Payment by Rich to
partnership creditors (10,000) 10,000
Balances $ (5,000) $(5,000) $10,000
Cash invested by Rich $5,000 5,000
Balances $5,000 $(5,000) $10,000
Payment to Toll
(or Toll’s creditors) (5,000) (5,000)
Balances $(5,000) $ 5,000

The continued statement of realization and liquidation now shows that Sand owes
$5,000 to the partnership; however, Sand’s assets of $50,000 are exactly equal to Sand’s
personal liabilities of $50,000. Under the Uniform Partnership Act, all the assets of Sand
will go to Sand’s creditors; therefore, the $5,000 deficit in Sand’s capital account represents
an additional loss to be shared equally by Rich and Toll. To conclude the liquidation, Rich,
who is solvent, pays $2,500 to the partnership, and the $2,500 will be paid to Toll or to
 Chapter 3 Partnership Liquidation and Incorporation; Joint Ventures 85

Toll’s creditors, because Toll is insolvent. These payments are shown below to complete the
statement of realization and liquidation for the Rich, Sand & Toll Partnership:

Completion of Partners’ Capital

Liquidation of General 1
Cash Rich ( ⁄3) Sand (1⁄3) Toll (1⁄3)
Partnership
Balances (from page 84) $(5,000) $ 5,000
Write-off of Sand’s capital deficit as
uncollectible $(2,500) 5,000 (2,500)
Balances $(2,500) $ 2,500
Cash invested by Rich $ 2,500 2,500
Balances $ 2,500 $ 2,500
Payment to Toll (or Toll’s creditors) (2,500) (2,500)

The final results of the liquidation show that the partnership creditors received payment
in full because of the financial status of partner Rich. Because Rich was solvent, the credi-
tors of Rich also were paid in full. The creditors of Sand were paid in full, thereby ex-
hausting Sand’s assets; however, because Sand failed to pay the $5,000 capital deficit to the
partnership, an additional loss of $5,000 was absorbed by Rich and Toll. The creditors of
Toll received all of Toll’s separate assets of $5,000 and also $7,500 from the partnership,
representing Toll’s equity in the firm. However, Toll’s creditors were able to collect only
$12,500 ($5,000 $7,500 $12,500) on their total claims of $60,000.

INSTALLMENT PAYMENTS TO PARTNERS

In the foregoing illustrations of partnership liquidation, all the partnership noncash assets
were realized and the total loss from liquidation was divided among the partners before any
cash payments were made to them. However, the liquidation of some partnerships may ex-
tend over several months. In such extended liquidations, the partners usually will want to
receive cash as it becomes available rather than wait until all noncash assets have been re-
alized. Installment payments to partners are appropriate if necessary safeguards are used to
ensure that all partnership creditors are paid in full and that no partners are paid more than
the amount to which they would be entitled after all losses on realization of assets are
known.
Liquidation in installments is a process of realizing some assets, paying creditors, pay-
ing the remaining available cash to partners, realizing additional assets, and making addi-
tional cash payments to partners. The liquidation continues until all noncash assets have
been realized and all cash has been distributed to partnership creditors and partners.
The circumstances of installment liquidations of partnerships vary; consequently, the ap-
proach of this text is to emphasize the general principles guiding liquidation in installments
rather than to provide illustrations of all possible liquidation situations. Among the vari-
ables that cause partnership liquidations to differ are the sufficiency of each partner’s capi-
tal to absorb that partner’s share of the possible losses remaining after each installment
payment of cash, the shifting of losses from one partner to another because of inability to
collect a capital deficit, the offsetting of loan account balances against capital deficits, and
the possible need for setting aside cash to pay future liquidation costs or unrecorded part-
nership liabilities.
86 Part One Accounting for Partnerships and Branches

General Principles Guiding Installment Payments

The critical element in installment liquidations is that the liquidator authorizes cash pay-
ments to partners before all losses that may be incurred in the liquidation are known. If
payments are made to partners and later losses cause deficits in the partners’ capital ac-
counts, the liquidator will have to request the return of the payments. If the payments
cannot be recovered, the liquidator may be liable to the other partners for the loss caused
them by the inappropriate distribution of cash. Because of this danger, the only safe pol-
icy for determining installment cash payments to partners is the following worst-case
scenario:
1. Assume a total loss on all remaining noncash assets, and provide for all possible losses,
including potential liquidation costs and unrecorded liabilities.
2. Assume that any partner with a potential capital deficit will be unable to pay anything
to the partnership; thus, distribute each installment of cash as if no more cash will be
forthcoming, either from realization of assets or from collection of capital deficits from
partners.
Under these assumptions, the liquidator will authorize a cash payment to a partner only
if that partner has a capital account credit balance (or in capital and loan accounts com-
bined) in excess of the amount required to absorb a portion of the maximum possible loss
that may be incurred on liquidation. A partner’s “share of the maximum possible loss”
would include any loss that may result from the inability of other partners to pay any po-
tential capital deficits to the partnership.
When installment payments are made according to these rules, the effect will be to bring
the equities of the partners to the income-sharing ratio as quickly as possible. When install-
ment payments have proceeded to the point that the partners’ capital and loan account
balances (equities) correspond with the income-sharing ratio, all subsequent payments
may be made in that ratio, because each partner’s equity will be sufficient to absorb an ap-
propriate share of the maximum possible remaining loss.

Determining Appropriate Installment Payments to Partners

The amounts of cash that may be distributed safely to the partners each month (or at any
other point in time) may be determined by computing the impact on partners’ equities (cap-
ital and loan account balances) of the maximum possible loss on noncash assets remaining
to be realized and the resultant potential impact on partners’ capital. To illustrate, assume
that the partners of Urne, Vint & Wahl LLP, who share net income and losses in a 4 : 3 : 2
ratio, decide to liquidate the partnership and to distribute cash in installments. The balance
sheet for Urne, Vint & Wahl LLP just prior to the beginning of liquidation on July 5, 2005,
is as follows:

Balance Sheet of URNE, VINT & WAHL LLP

Limited Liability Balance Sheet
Partnership Prior to July 5, 2005
Liquidation in
Assets Liabilities and Partners’ Capital
Installments
Cash $ 8,000 Liabilities $ 61,000
Other assets 192,000 Urne, capital 40,000
Vint, capital 45,000
Wahl, capital 54,000
Total $200,000 Total $200,000
 Chapter 3 Partnership Liquidation and Incorporation; Joint Ventures 87

To simplify the illustration, assume that noncash assets were realized as follows:

Realization of Other URNE, VINT & WAHL LLP

Assets by Liquidating Realization of Other Assets
Partnership July 6 through September 30, 2005

Carrying Cash
Amount of Loss Received by
Date, 2005 Assets Realized on Realization Partnership
July 31 $ 62,000 $13,500 $ 48,500
August 31 66,000 36,000 30,000
September 30 64,000 31,500 32,500
Totals $192,000 $81,000 $111,000

Thus, on July 31, 2005, $56,500 ($8,000 $48,500 $56,500) of cash is available for
distribution. The first claim to the cash is that of partnership creditors; because their claims
total $61,000, the entire $56,500 available on July 31 is paid to creditors, leaving an unpaid
balance of $4,500 ($61,000 $56,000 $4,500), and the partners receive nothing on that
date.
On August 31, 2005, $30,000 cash is available for distribution; the first $4,500 is paid to
creditors, leaving $25,500 ($30,000 $4,500 $25,500) available for distribution to part-
ners. Under the worst-case scenario described on page 86 the appropriate distribution of the
$25,500 to partners is determined as follows:

Determination of Cash Urne Vint Wahl

Distributions to
Capital account balances, July 5, 2005 $ 40,000 $ 45,000 $ 54,000
Partners, Aug. 31,
Allocation of loss on July 31, 2005, realization
2005
of noncash assets ($13,500) (6,000) (4,500) (3,000)
Allocation of loss on Aug. 31, 2005, realization
of noncash assets ($36,000) (16,000) (12,000) (8,000)
Capital account balances, Aug. 31, 2005 $ 18,000 $ 28,500 $ 43,000
Allocation of maximum potential loss on remain-
ing noncash assets ($64,000) (28,445) (21,333) (14,222)
Potential capital account balances $(10,445) $ 7,167 $ 28,778
Allocation of potential loss from uncollectibility of
Urne’s potential capital deficit in ratio of 3 : 2 10,445 (6,267) (4,178)
Appropriate cash payments to partners, Aug. 31, 2005 $ 0 $ 900 $ 24,600

A technique similar to that above would be used to determine the appropriate payment
to partners of the $32,500 cash available on September 30, 2005.

Preparation of a Cash Distribution Program

Although the method for determining cash payments to partners illustrated in the fore-
going section is sound, it is somewhat cumbersome. Furthermore, it does not show at
the beginning of the liquidation how cash might be divided among the partners as it
88 Part One Accounting for Partnerships and Branches

becomes available. For these reasons, it is more efficient to prepare in advance a com-
plete cash distribution program to show how cash may be divided during liquidation. If
such a program is prepared, any amounts of cash received from the realization of part-
nership assets may be paid immediately to partnership creditors and the partners as
specified in the program.
Using the data for Urne, Vint & Wahl LLP illustrated on page 87, the following cash
distribution program may be prepared; the working paper supporting the cash distribution
program and an explanation of the preparation of the working paper are below and on pages 89
and 90:

URNE, VINT & WAHL LLP

Cash Distribution Program
July 5, 2005

Creditors Urne Vint Wahl

First $ 61,000 100%
Next 24,000 100%
Next 25,000 60% 40%
All over $110,000 ⁄9
4 3
⁄9 2
⁄9

Procedures for developing the following working paper.1

1. The “capital account balances before liquidation” represent the equities of the partners
in the partnership, that is, the balance of a partner’s capital account, plus or minus the
balance (if any) of a loan made by a partner to the partnership or a loan made by the
partnership to a partner.
2. The capital account balance before liquidation for each partner is divided by each
partner’s income-sharing ratio to determine the amount of capital per unit of income
(loss) sharing for each partner. This procedure is critical because it (1) identifies the
partner with the largest capital per unit of income (loss) sharing who, therefore, will
be the first to receive cash, (2) facilitates the ranking of partners in the order in which
they are entitled to receive cash, and (3) provides the basis for computing the amount
of cash each partner receives at various stages of liquidation. Because Wahl’s capital
per unit of income (loss) sharing is largest ($27,000), Wahl is the first partner to re-
ceive cash (after all partnership creditors have been paid), followed by Vint and finally
by Urne.
3. Wahl receives enough cash to reduce Wahl’s capital of $27,000 per unit of income (loss)
sharing to $15,000, equal to the balance for Vint, the second-ranking partner. To ac-
complish this,Wahl’s capital per unit of income (loss) sharing must be reduced by
$12,000, and because Wahl has two units of income (loss) sharing,Wahl receives
$24,000 ($12,000 2 $24,000) before Vint receives any cash.

1
The procedure for preparing a cash distribution program illustrated herein may be used regardless of
the number of partners involved or the complexity of the income-sharing ratio. For example, assume that
partners share net income and losses as follows: Abt 41.2%, Bry 32.3%, Cam 26.5%. The income-
sharing ratio may be stated as 412 for Abt, 323 for Bry, and 265 for Cam to apply the techniques
illustrated in this section.
 Chapter 3 Partnership Liquidation and Incorporation; Joint Ventures 89

URNE, VINT & WAHL LLP

Working Paper for Cash Distributions to Partners during Liquidation
July 5, 2005

Urne Vint Wahl

Capital account balances before liquidation $40,000 $45,000 $54,000
Income-sharing ratio 4 3 2
Divide capital account balances before
liquidation by income-sharing ratio to
obtain capital per unit of income (loss)
sharing for each partner $10,000 $15,000 $27,000
Required reduction in capital per unit of
income (loss) sharing for Partner Wahl to
reduce Wahl’s balance to equal the next
largest balance (for Partner Vint). This is the
amount of the first cash distribution to a
partner per unit of the partner’s income
(loss) sharing. Because Wahl has 2 units
of income (loss) sharing, Wahl receives the
first $24,000 ($12,000 2 $24,000) (12,000)
Capital per unit of income (loss) sharing after
payment of $24,000 to Wahl $10,000 $15,000 $15,000
Required reduction in capital per unit of income
(loss) sharing for Partners Vint and Wahl to
reduce their balances to equal Partner Urne’s
balance, which is the smallest capital per
unit of income (loss) sharing. The required
reduction is multiplied by each partner’s
income-sharing ratio to compute the amount
of cash to be paid. Thus, Vint receives
$15,000 ($5,000 3 $15,000), and Wahl
receives $10,000 ($5,000 2 $10,000) (5,000) (5,000)
Capital per unit of income (loss) sharing after
payment of $15,000 to Vint and $34,000
to Wahl. Remaining cash may be
distributed in the income-sharing ratio $10,000 $10,000 $10,000

4. At this point, the capital per unit of income (loss) sharing for both Vint and Wahl is
$15,000, indicating that they are entitled to receive cash until their capital per unit of
income (loss) sharing is reduced by $5,000 to the $10,000 balance for Urne, the lowest-
ranking partner. Because Vint has three units and Wahl has two units of income (loss)
sharing, Vint receives $15,000 ($5,000 3 $15,000) and Wahl receives an additional
$10,000 ($5,000 2 $10,000) before Urne receives any cash. After Wahl receives
$24,000, Vint and Wahl would share any amount of cash available to a maximum amount
of $25,000 in a 3 : 2 ratio.
5. After Vint has received $15,000 and Wahl has received $34,000 ($24,000 $10,000
$34,000), the capital per unit of income (loss) sharing is $10,000 for each partner, and
any additional cash is paid to the partners in the income-sharing ratio (4 : 3 : 2), because
their capital account balances have been reduced to the income-sharing ratio. This is
illustrated on the next page.
90 Part One Accounting for Partnerships and Branches

Reduction of Capital Urne (4⁄9) Vint (3⁄9) Wahl (2⁄9)

Account Balances to
Capital account balances before liquidation $40,000 $ 45,000 $54,000
Income-Sharing Ratio
First payment of cash to Wahl (24,000)
Second payment of cash to Vint and Wahl
in 3 : 2 ratio (15,000) (10,000)
Capital account balances (in income-sharing ratio
of 4 : 3 : 2) after payment of total of $49,000
to Vint and Wahl $40,000 $ 30,000 $20,000

Only when installment payments reach the point at which partners’ capital account balances
correspond with the income-sharing ratio may subsequent cash payments be made in that
ratio.
A cash distribution program such as the one on page 88 also may be used to ascertain an
equitable distribution of noncash assets to partners. The current fair value of noncash assets
such as marketable securities, inventories, or equipment distributed to partners is treated as
equivalent to cash payments. If a distribution of noncash assets departs from the cash dis-
tribution program by giving one of the partners a larger distribution than that partner is
entitled to receive, subsequent distributions should be adjusted to allow the remaining
partners to “make up” the distribution prematurely made to one of the partners. In such
cases, a revised cash distribution program must be prepared, because the original rela-
tionship among the partners’ capital account balances has been disrupted.
Any losses or gains on the realization of assets during liquidation are allocated to the
partners in the income-sharing ratio, unless the partnership contract specifies another
allocation procedure. Thus, the degree to which the capital account balances do not
correspond with the income-sharing ratio is not altered by such losses or gains. Conse-
quently, losses or gains from the realization of assets in the course of partnership liq-
uidation do not affect the cash distribution program prepared prior to the start of
liquidation.
To illustrate how the cash distribution program on page 88 may be used, assume that the
realization of other assets by Urne, Vint & Wahl LLP from July 6 through September 30,
2005, is as shown on page 87. The cash available each month is paid to creditors and part-
ners according to the cash distribution program on page 88. The distributions of cash are
summarized below:

URNE, VINT & WAHL LLP

Distributions of Cash to Creditors and Partners
July 6 through September 30, 2005

Partners’ Capital
Date Cash Liabilities Urne (4⁄9) Vint (3⁄9) Wahl (2⁄9)
July 31 (includes $8,000
on hand on July 5) $ 56,500 $56,500
August 31 30,000 4,500 $24,000
$ 900 600}
September 30 32,500
$4,000
14,100
3,000
9,400
2,000
}
Totals $ 119,000 $61,000 $4,000 $18,000 $36,000
 Chapter 3 Partnership Liquidation and Incorporation; Joint Ventures 91

The entire cash balance of $56,500 available on July 31 is paid to creditors, leaving
$4,500 in unpaid liabilities. When $30,000 becomes available on August 31, $4,500 is
paid to creditors, leaving $25,500 to be paid to the partners according to the cash distri-
bution program on page 88. The program requires Wahl to receive 100% of the first
$24,000 available for distribution to partners, and for Vint and Wahl to share the next
$25,000 in a 3 : 2 ratio. On August 31 only $1,500 ($30,000 $4,500 $24,000
$1,500) is available for payment to Vint and Wahl; thus, they receive $900 and $600, re-
spectively. Of the $32,500 available on September 30, the first $23,500 is paid to Vint
and Wahl in a 3 : 2 ratio, or $14,100 and $9,400, respectively, in order to complete the
distribution of $25,000 to Vint and Wahl before Urne participates; this leaves $9,000
($32,500 $23,500 $9,000) to be distributed to Urne, Vint, and Wahl in the 4 : 3 : 2
income-sharing ratio.
A complete statement of realization and liquidation for Urne, Vint & Wahl LLP
follows.

URNE, VINT & WAHL LLP

Statement of Realization and Liquidation
July 6 through September 30, 2005

Assets Partners’ Capital

4
Cash Other Liabilities Urne ( ⁄9) Vint (3⁄9) Wahl (2⁄9)
Balances before liquidation $ 8,000 $192,000 $ 61,000 $ 40,000 $ 45,000 $ 54,000
July 31 installment:
Realization of other assets at a loss
of $13,500 48,500 (62,000) (6,000) (4,500) (3,000)
Balances 56,500 $130,000 $ 61,000 $ 34,000 $ 40,500 $ 51,000
Payment to creditors $(56,500) (56,500)
Balances $ -0- $130,000 $ 4,500 $ 34,000 $ 40,500 $ 51,000
Aug. 31 installment:
Realization of other assets at a loss
of $36,000 30,000 (66,000) (16,000) (12,000) (8,000)
Balances $ 30,000 $ 64,000 $ 4,500 $ 18,000 $ 28,500 $ 43,000
Payment to creditors (4,500) (4,500)
Balances $ 25,500 $ 64,000 $ 18,000 $ 28,500 $ 43,000
Payments to partners (25,500) (900) (24,600)
Balances $ -0- $ 64,000 $ 18,000 $ 27,600 $ 18,400
Sept. 30 installment:
Realization of other assets at a loss
of $31,500 32,500 (64,000) (14,000) (10,500) (7,000)
Balances $ 32,500 $ 4,000 $ 17,100 $ 11,400
Payments to partners (32,500) (4,000) (17,100) (11,400)

The journal entries to record the realization of assets and to complete the liquidation of
Urne, Vint & Wahl LLP are as follows:
92 Part One Accounting for Partnerships and Branches

Journal Entries to 2005

Record Liquidation of
Limited Liability July 31 Cash 48,500
Partnership in Urne, Capital 6,000
Installments Vint, Capital 4,500
Wahl, Capital 3,000
Other Assets 62,000
To record realization of assets and division of $13,500 loss
among partners in 4 : 3 : 2 ratio.

31 Liabilities 56,500
Cash 56,500
To record payment to creditors.

Aug. 31 Cash 30,000

Urne, Capital 16,000
Vint, Capital 12,000
Wahl, Capital 8,000
Other Assets 66,000
To record realization of assets and division of $36,000 loss
among partners in 4 :3 : 2 ratio.

31 Liabilities 4,500
Vint, Capital 900
Wahl, Capital 24,600
Cash 30,000
To record payment to creditors and first installment
to partners.

Sept. 30 Cash 32,500

Urne, Capital 14,000
Vint, Capital 10,500
Wahl, Capital 7,000
Other Assets 64,000
To record realization of remaining assets and division of
$31,500 loss among partners in 4 :3 : 2 ratio.

30 Urne, Capital 4,000

Vint, Capital 17,100
Wahl, Capital 11,400
Cash 32,500
To record final installment to partners to complete the
liquidation of the partnership.

Withholding of Cash for Liabilities and Liquidation Costs

As previously emphasized, partnership creditors are entitled to payment in full before any-
thing is paid to partners. However, in some cases the liquidator may find it more convenient
to set aside sufficient cash required to pay certain recorded liabilities, and to distribute the
remaining cash to the partners. The withholding of cash for payment of recorded liabilities
is appropriate when for any reason it is not practicable or advisable (as when the amount of
the claim is in dispute) to pay the liabilities before cash is distributed to partners. An
 Chapter 3 Partnership Liquidation and Incorporation; Joint Ventures 93

amount of cash set aside, and equal to recorded unpaid liabilities, is not a factor in
computing possible future liquidation losses; the possible future loss is measured by the
amount of noncash assets, any unrecorded liabilities, and any liquidation costs that may be
incurred.
Any costs incurred during the liquidation of a partnership are deducted from partners’
capital account balances to compute the cash available for distribution to partners. Costs
of liquidation thereby are treated as part of the total loss from liquidation. However, in
some cases, the liquidator may wish to withhold cash in anticipation of future liquidation
costs. The amount of cash set aside for future liquidation costs or for payment of un-
recorded liabilities should be combined with the amount of noncash assets in the compu-
tation of the maximum possible loss that may be incurred to complete the liquidation of
the partnership.

Liquidation of Limited Partnerships

Most of the discussion of the liquidation of limited liability partnerships and general part-
nerships, in preceding sections of this chapter, applies to the liquidation of limited partner-
ships. However, the Uniform Limited Partnership Act provides that after outside creditors
of a limited partnership have been paid, the equities of the limited partners must be paid be-
fore the general partner or partners may receive any cash. Further, the limited partners may
agree that one or more of them may have priority over the others regarding payments in liq-
uidation of the limited partnership.

INCORPORATION OF A LIMITED LIABILITY PARTNERSHIP

Partners may evaluate the possible advantages to be gained by incorporating a partnership.
Among such advantages are limited liability of stockholders, ease of attracting additional
capital, and possible income tax advantages.
To ensure that each partner receives an equitable portion of the capital stock issued
by the new corporation, the assets of the partnership must be adjusted to current fair
value before being transferred to the corporation. Any identifiable intangible asset or
goodwill developed by the partnership is included among the assets transferred to the
corporation.
To illustrate the incorporation of a partnership, assume that Blair and Benson, partners
of Blair & Benson LLP, who share net income and loss in a 4 : 1 ratio, organize B & B Cor-
poration to take over the net assets of the partnership. The balance sheet of the partnership
on June 30, 2005, the date of incorporation, is as follows:

Balance Sheet of BLAIR & BENSON LLP

Limited Liability Balance Sheet
Partnership Prior to June 30, 2005
Incorporation
Assets
Cash $12,000
Trade accounts receivable $28,100
Less: Allowance for doubtful accounts 600 27,500
Inventories, first-in, first-out cost 25,500
Equipment, at cost $60,000
Less: Accumulated depreciation of equipment 26,000 34,000
Total assets $99,000

(continued)
94 Part One Accounting for Partnerships and Branches

BLAIR & BENSON LLP

Balance Sheet (concluded)
June 30, 2005

Liabilities and Partners’ Capital

Liabilities:
Trade accounts payable $35,000
Partners’ capital:
Blair, capital $47,990
Benson, capital 16,010 64,000
Total liabilities and partners’ capital $99,000

After an appraisal of the equipment and an audit of the partnership’s financial state-
ments, the partners agree that the following adjustments are required to restate the net as-
sets of the partnership to current fair value:

1. Increase the allowance for doubtful accounts to $1,000.

2. Increase the inventories to current replacement cost of $30,000.
3. Increase the equipment to its reproduction cost new, $70,000, less accumulated depreci-
ation on this basis, $30,500; that is, to current fair value, $39,500.
4. Recognize accrued liabilities of $1,100.
5. Recognize goodwill of $10,000.

B & B Corporation is authorized to issue 10,000 shares of $10 par common stock. It
issues 5,500 shares of common stock valued at $15 a share to the partnership in ex-
change for the net assets of the partnership. The 5,500 shares received by the partner-
ship are divided between the partners on the basis of the adjusted balances of their
capital accounts. (Partners may withdraw small amounts of cash to round their capital
account balances to even amounts, thus avoiding the issuance of fractional shares of
common stock.) This procedure completes the dissolution and liquidation of the
partnership.
Although the accounting records of the partnership may be modified to serve as the
records of the new corporation, it is customary to use a new set of accounting records for
the corporation. If this alternative is followed, the procedures required are:

In Accounting Records of Partnership:

1. Prepare journal entries for revaluation of assets, including recognition of goodwill.
2. Record any cash withdrawals necessary to adjust partners’ capital account balances to
round amounts. (In some instances, the contract may require transfer to the corporation
of all assets except cash.)
3. Record the transfer of assets and liabilities to the corporation, the receipt of the corpo-
ration’s common stock by the partnership, and the distribution of the common stock to
the partners in settlement of the balances of their capital accounts.
 Chapter 3 Partnership Liquidation and Incorporation; Joint Ventures 95

The journal entries to adjust and eliminate the accounting records of the Blair & Benson
LLP on June 30, 2005, are as follows:

Journal Entries for Inventories ($30,000 $25,500) 4,500

Blair & Benson LLP Equipment ($70,000 $60,000) 10,000
Goodwill 10,000
Allowance for Doubtful Accounts ($1,000 $600) 400
Accumulated Depreciation of Equipment
($30,500 $26,000) 4,500
Accrued Liabilities Payable 1,100
Blair, Capital ($18,500 0.80) 14,800
Benson, Capital ($18,500 0.20) 3,700
To adjust assets and liabilities to agreed amounts and to divide net gain
of $18,500 between partners in 4 : 1 ratio

Receivable from B & B Corporation ($64,000 $18,500) 82,500

Trade Accounts Payable 35,000
Accrued Liabilities Payable 1,100
Allowance for Doubtful Accounts 1,000
Accumulated Depreciation of Equipment 30,500
Cash 12,000
Trade Accounts Receivable 28,100
Inventories 30,000
Equipment 70,000
Goodwill 10,000
To record transfer of assets and liabilities to B & B Corporation.

Common Stock of B & B Corporation (5,500 $15) 82,500

Receivable from B & B Corporation 82,500
To record receipt of 5,500 shares of $10 par common stock valued at
$15 a share in payment for net assets transferred to B & B Corporation.

Blair, Capital ($47,990 $14,800: 4,186 $15) 62,790

Benson, Capital ($16,010 $3,700; 1,314 $15) 19,710
Common Stock of B & B Corporation 82,500
To record distribution of common stock of B & B Corporation to
partners: 4,186 shares to Blair and 1,314 shares to Benson.

In Accounting Records of Corporation:

1. Record the acquisition of assets and liabilities (including obligation to pay for the net
assets) from the partnership at current fair values.
2. Record the issuance of common stock at current fair value in payment of the obligation
to the partnership.
The journal entries in the accounting records of B & B Corporation on June 30, 2005, are
illustrated on the next page:
96 Part One Accounting for Partnerships and Branches

Journal Entries for Cash 12,000

B & B Corporation Trade Accounts Receivable 28,100
Inventories 30,000
Equipment 39,500
Goodwill 10,000
Allowance for Doubtful Accounts 1,000
Trade Accounts Payable 35,000
Accrued Liabilities Payable 1,100
Payable to Blair & Benson LLP 82,500
To record acquisition of assets and liabilities from Blair & Benson LLP.

Payable to Blair & Benson LLP 82,500

Common Stock, $10 par (5,500 $10) 55,000
Paid-In Capital in Excess of Par 27,500
To record issuance of 5,500 shares of common stock valued at $15 a
share in payment for net assets of Blair & Benson LLP.

Note that the allowance for doubtful accounts is recognized in the accounting records of
B & B Corporation because the specific accounts receivable that may not be collected are
not known. In contrast, the depreciation recognized by the Blair & Benson Partnership is
disregarded by B & B Corporation because the “cost” of the equipment to the new corpo-
ration is $39,500.
The balance sheet for B & B Corporation on June 30, 2005, is as follows:

B & B CORPORATION
Balance Sheet
June 30, 2005

Assets
Cash $ 12,000
Trade accounts receivable $ 28,100
Less: Allowance for doubtful accounts 1,000 27,100
Inventories, at current replacement cost 30,000
Equipment, at current fair value 39,500
Goodwill 10,000
Total assets $118,600

Liabilities and Stockholders’ Equity

Liabilities:
Trade accounts payable $ 35,000
Accrued liabilities payable 1,100
Total liabilities $ 36,100
Stockholders’ equity:
Common stock, $10 par, authorized 10,000 shares, issued and
outstanding 5,500 shares $ 55,000
Additional paid-in capital 27,500 82,500
Total liabilities and stockholders’ equity $118,600
 Chapter 3 Partnership Liquidation and Incorporation; Joint Ventures 97

JOINT VENTURES
A joint venture differs from a partnership in that it is limited to carrying out a single pro-
ject, such as production of a motion picture or construction of a building. Historically, joint
ventures were used to finance the sale or exchange of a cargo of merchandise in a foreign
country. In an era when marine transportation and foreign trade involved many hazards, in-
dividuals (venturers) would band together to undertake a venture of this type. The capital
required usually was larger than one person could provide, and the risks were too high to be
borne alone. Because of the risks involved and the relatively short duration of the project,
no net income was recognized until the venture was completed. At the end of the voyage,
the net income or net loss was divided among the venturers, and their association was
ended.
In its traditional form, the accounting for a joint venture did not follow the accrual basis
of accounting. The assumption of continuity was not appropriate; instead of the determina-
tion of net income at regular intervals, the measurement and reporting of net income or loss
awaited the completion of the venture.

Present-Day Joint Ventures

In today’s business community, joint ventures are less common but still are employed for
many projects such as (1) the acquisition, development, and sale of real property; (2) ex-
ploration for oil and gas; and (3) construction of bridges, buildings, and dams.
The term corporate joint venture also is used by many large American corporations to
describe overseas operations by a corporation whose ownership is divided between an
American company and a foreign company. Many examples of jointly owned companies
also are found in some domestic industries. A corporate joint venture and the accounting
for such a venture currently are described in APB Opinion No. 18, “The Equity Method of
Accounting for Investments in Common Stock,” as follows:
“Corporate joint venture” refers to a corporation owned and operated by a small group of
businesses (the “joint venturers”) as a separate and specific business or project for the mu-
tual benefit of the members of the group. A government may also be a member of the group.
The purpose of a corporate joint venture frequently is to share risks and rewards in develop-
ing a new market, product or technology; to combine complementary technological knowl-
edge; or to pool resources in developing production or other facilities. A corporate joint
venture also usually provides an arrangement under which each joint venturer may partici-
pate, directly or indirectly, in the overall management of the joint venture. Joint venturers
thus have an interest or relationship other than as passive investors. An entity which is a
subsidiary of one of the “joint venturers” is not a corporate joint venture. The ownership of
a corporate joint venture seldom changes, and its stock is usually not traded publicly. A mi-
nority public ownership, however, does not preclude a corporation from being a corporate
joint venture.

*****
The [Accounting Principles] Board concludes that the equity method best enables
investors in corporate joint ventures to reflect the underlying nature of their investment in
those ventures. Therefore, investors should account for investments in common stock of cor-
porate joint ventures by the equity method, in consolidated financial statements. [Emphasis
added.]

*****
When investments in common stock of corporate joint ventures or other investments
accounted for under the equity method are, in the aggregate, material in relation to the
98 Part One Accounting for Partnerships and Branches

financial position or results of operations of an investor, it may be necessary for summa-

rized information as to assets, liabilities, and results of operations of the investees to be pre-
sented in the notes or in separate statements, either individually or in groups, as
appropriate.2

A recent variation of the corporate joint venture is the limited liability company (LLC)
joint venture, which is the corporate version of the limited liability partnership discussed
in Chapter 2 and this chapter. An example of the formation of two LLC joint ventures is
found in the following note to the financial statements of Stone Container Corporation, a
publicly owned enterprise:
Notes to Financial Statements
3. (In Part): Joint Ventures, Acquisitions and Investments
On May 30, 1996, the Company entered into a joint venture with Four M Corporation
(“Four M”) to form Florida Coast Paper Company, L.L.C. (“Florida Coast”) to purchase a
paperboard mill located in Port St. Joe, Florida, from St. Joe Paper Company for $185 mil-
lion plus applicable working capital. As part of the transaction, Florida Coast sold, through a
private placement, debt of approximately $165 million. Pursuant to an exchange offer, such
privately-placed debt was exchanged for registered notes identical to the privately-placed
notes. The Company accounts for its investment in Florida Coast under the equity method.
Concurrent with the formation of the joint venture, the Company and Four M entered into
output purchase agreements with Florida Coast which require each of the joint venture part-
ners to purchase 50 percent of the production of Florida Coast. The output purchase agree-
ments also require the Company and Four M to equally share in the funding of certain cash
flow deficits of Florida Coast.
On July 12, 1996, the Company and Gaylord Container Corporation entered into a joint
venture whereby the retail bag packaging businesses of these two companies were con-
tributed to form S&G Packaging Company, L.L.C. (“S&G”). The Company accounts for its
interest in S&G under the equity method. S&G produces paper grocery bags and sacks, han-
dle sacks and variety bags, with estimated annual sales in excess of $300 million and serves
supermarkets, quick service restaurants, paper distributors and non-food mass merchandisers
throughout North America and the Caribbean.3

Accounting for a Corporate or LLC Joint Venture

The complexity of modern business, the emphasis on good organization and strong in-
ternal control, the importance of income taxes, the extent of government regulation, and
the need for preparation and retention of adequate accounting records are strong argu-
ments for establishing a separate set of accounting records for every corporate joint ven-
ture of large size and long duration. In the stockholders’ equity accounts of the joint
venture, each venturer’s account is credited for the amount of cash or noncash assets in-
vested. The fiscal year of the joint venture may or may not coincide with the fiscal years
of the venturers, but the use of the accrual basis of accounting and periodic financial
statements for the venture permit regular reporting of the share of net income or loss al-
locable to each venturer.
The accounting records of such a corporate joint venture include the usual ledger ac-
counts for assets, liabilities, stockholders’ equity, revenue, and expenses. The entire

2
APB Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock,” AICPA
(New York: 1971), pars. 3d, 16, 20d, as amended by FASB Statement No. 94, “Consolidation of All
Majority-Owned Subsidiaries.”
3
AICPA, Accounting Trends & Techniques, 51st ed. (Jersey City, NJ: 1997), p. 58.
 Chapter 3 Partnership Liquidation and Incorporation; Joint Ventures 99

accounting process should conform to generally accepted accounting practices, from the
recording of transactions to the preparation of financial statements.

Accounting for an Unincorporated Joint Venture

As indicated on page 97, APB Opinion No. 18 required venturers to use the equity method
of accounting for investments in corporate joint ventures. That Opinion did not address
accounting for investments in unincorporated joint ventures. However, the AICPA subse-
quently interpreted APB Opinion No. 18 as follows:
[B]ecause the investor-venturer [in an unincorporated joint venture] owns an undivided inter-
est in each asset and is proportionately liable for its share of each liability, the provisions of
[APB Opinion No. 18 related to the equity method of accounting] may not apply in some in-
dustries. For example, where it is the established industry practice (such as in some oil and
gas venture accounting), the investor-venturer may account in its financial statements for its
pro rata share of the assets, liabilities, revenues, and expenses of the venture.4

In view of the foregoing, it appears that either of two alternative methods of accounting
may be adopted by investors in unincorporated joint ventures; thus, some investors have the
option of using either the equity method of accounting or a proportionate share method
of accounting for the investments. The two methods may be illustrated by assuming that
Arthur Company and Beatrice Company each invested $400,000 for a 50% interest in an
unincorporated joint venture on January 2, 2005. Condensed financial statements (other
than a statement of cash flows) for the joint venture, Arbe Company, for 2005 were as
follows:

ARBE COMPANY (a joint venture)

Income Statement
For Year Ended December 31, 2005

Revenue $2,000,000
Less: Cost and expenses 1,500,000
Net income $ 500,000
Division of net income:
Arthur Company $250,000
Beatrice Company 250,000
Total $500,000

ARBE COMPANY (a joint venture)

Statement of Venturers’ Capital
For Year Ended December 31, 2005

Arthur Beatrice
Company Company Combined
Investments, Jan. 2 $400,000 $400,000 $ 800,000
Add: Net income 250,000 250,000 500,000
Venturers’ capital, end of year $650,000 $650,000 $1,300,000

4
The Equity Method of Accounting for Investments in Common Stock: Accounting Interpretation of APB
Opinion No. 18, No. 2, “Investments in Partnerships and Ventures,” AICPA (New York: 1971).
100 Part One Accounting for Partnerships and Branches

ARBE COMPANY (a joint venture)

Balance Sheet
December 31, 2005

Assets
Current assets $1,600,000
Other assets 2,400,000
Total assets $4,000,000

Liabilities and Venturers’ Capital

Current liabilities $ 800,000
Long-term debt 1,900,000
Venturers’ capital:
Arthur Company $ 650,000
Beatrice Company 650,000 1,300,000
Total liabilities and venturers’ capital $4,000,000

Under the equity method of accounting, both Arthur Company and Beatrice Company
prepare the following journal entries for the investment in Arbe Company:

Venturer’s Journal 2005

Entries for
Unincorporated Joint Jan. 2 Investment in Arbe Company (Joint Venture) 400,000
Venture under Equity Cash 400,000
Method of Accounting To record investment in joint venture.

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

Investment Income 250,000
To record share of Arbe Company net income ($500,000
0.50 $250,000).

Under the proportionate share method of accounting, in addition to the two foregoing
journal entries, both Arthur Company and Beatrice Company prepare the following journal
entry for their respective shares of the assets, liabilities, revenue, and expenses of Arbe
Company:

Venturer’s Additional 2005

Journal Entry for
Unincorporated Joint Dec. 31 Current Assets ($1,600,000 0.50) 800,000
Venture under Other Assets ($2,400,000 0.50) 1,200,000
Proportionate Share Costs and Expenses ($1,500,000 0.50) 750,000
Method of Accounting Investment Income 250,000
Current Liabilities ($800,000 0.50) 400,000
Long-Term Debt ($1,900,000 0.50) 950,000
Revenue ($2,000,000 0.50) 1,000,000
Investment in Arbe Company (Joint Venture) 650,000
To record proportionate share of joint venture’s assets,
liabilities, revenue, and expenses.
 Chapter 3 Partnership Liquidation and Incorporation; Joint Ventures 101

Use of the equity method of accounting for unincorporated joint ventures is consistent
with the accounting for corporate joint ventures specified by APB Opinion No. 18. How-
ever, information on material assets and liabilities of a joint venture may be relegated to a
note to financial statements (see footnote 2, par. 20d on page 98), thus resulting in off–
balance sheet financing. The proportionate share method of accounting for unincorpo-
rated joint ventures avoids the problem of off–balance sheet financing but has the ques-
tionable practice of including portions of assets such as plant assets in each venturer’s
balance sheet.
Given the Financial Accounting Standards Board’s statement that “Information about an
enterprise gains greatly in usefulness if it can be compared with similar information about
other enterprises,”5 it is undesirable to have two significantly different generally accepted
accounting methods for investments in unincorporated joint ventures. Accordingly, the
FASB has undertaken a study of the accounting for investments in joint ventures, as well as
the accounting for all investments for which the equity method of accounting presently is
used.
In International Accounting Standard 31 ( IAS 31), “Financial Reporting of Interests
in Joint Ventures,” the International Accounting Standards Board, which is discussed in
Chapter 11, permits either the proportionate consolidation method (analogous to the pro-
portionate share method described on page 99) or the equity method for a venturer’s in-
vestment in a jointly controlled entity, which might be a corporation or a partnership. As
pointed out on page 99, U.S. generally accepted accounting principles require the equity
method of accounting for investments in corporate joint ventures but permit either the eq-
uity method or the proportionate share method of accounting for investments in unincor-
porated joint ventures.

SEC ENFORCEMENT ACTIONS DEALING WITH

WRONGFUL APPLICATION OF ACCOUNTING
STANDARDS FOR JOINT VENTURES
AAER 40, “Securities and Exchange Commission v. Chronar Corp.” (October 3, 1984), re-
ported a permanent injunction against a corporation engaged in research and development
of solar photovoltaic technology and the design, development, and marketing of manufac-
turing processes and equipment for photovoltaic panels. The SEC alleged that the corpo-
ration had prematurely recognized revenue (under the proportionate share method of
accounting) from a joint venture of which it was a 51% owner. The “revenue” was from the
corporation itself, in transactions fraught with uncertainties. The result of the inappropriate
recognition of revenue and related expenses of the joint venture by the corporation was a
48% understatement of the corporation’s nine-month net loss reported to the SEC in its quar-
terly report on Form 10-Q. In a related enforcement action, reported in AAER 78, “. . . In the
Matter of Seidman & Seidman . . .” (October 10, 1985), the CPA firm that had reviewed the
corporation’s nine-month financial statements was censured by the SEC and undertook to
improve its professional standards.
The SEC reported in AAER 102, “. . . In the Matter of Ray M. VanLandingham and
Wallace A. Patzke, Jr.” (June 20, 1986), the issuance of an order requiring the chief ac-
counting officer and the controller (both CPAs) of a corporate marketer of petroleum

5
Statement of Financial Accounting Concepts No. 2, “Qualitative Characteristics of Accounting Informa-
tion,” FASB (Stamford, CT: 1980), par. 111.
102 Part One Accounting for Partnerships and Branches

products to comply with provisions of the Securities Exchange Act of 1934 and related
rules. The SEC found that the two executives were responsible for the corporation’s failure
to write down by at least $100 million its investment (carried at $311 million) in a joint
venture that operated an oil refinery. The write-down was necessitated by the corporation’s
unsuccessful efforts to sell its investment in the joint venture at a price significantly below
the carrying amount of the investment.

Review 1. Alo and Bel, partners of Alo & Bel LLP, have capital accounts of $60,000 and
$80,000, respectively. In addition, Alo has made an interest-bearing loan of $20,000
Questions
to the partnership. If Alo and Bel now decide to liquidate the partnership, what prior-
ity or advantge, if any, does Alo have in the liquidation with respect to the loan ledger
account?
2. Explain the procedure to be followed in a limited liability partnership liquidation when
a debit balance arises in the capital account of one of the partners.
3. In the liquidation of Cor, Don & Ell LLP, the realization of noncash assets resulted in
a loss that produced the following balances in the partners’ capital accounts: Cor,
$25,000 credit; Don, $12,500 credit; and Ell, $5,000 debit. The partners shared net in-
come and losses in a 5 : 3 : 2 ratio. All liabilities have been paid, and $32,500 of cash
is available for distribution to partners. However, it is not possible to determine at pre-
sent whether Ell will be able to pay in the $5,000 capital deficit. May the cash on hand
be distributed without a delay to determine the collectibility of the amount due from
Ell? Explain.
4. After realization of all noncash assets and distributing all available cash to creditors,
the insolvent Fin, Guy & Han Partnership (a general partnership) still had trade ac-
counts payable of $12,000. The capital account of Fin had a credit balance of $16,000
and that of Guy had a credit balance of $2,000. Creditors of the partnership demanded
payment from Fin, who replied that the three partners shared net income equally and
had begun operations with equal capital investments. Fin therefore offered to pay the
creditors one-third of their claims and no more. What is your opinion of the position
taken by Fin? What is the balance of Han’s capital account? What journal entry, if any,
should be made in the partnership accounting records for a payment by Fin to the part-
nership creditors?
5. In Ile, Job & Key, LLP, Ile is the managing partner. The partnership contract provides
that Ile is to receive an annual salary of $12,000, payable in 12 equal monthly install-
ments, and the resultant net income or loss is to be divided equally. On June 30, 2005,
the partnership suspended operations and began liquidation. Because of a shortage of
cash, Ile had not drawn any salary for the last two months of operations. How should
Ile’s claim for $2,000 of “unpaid wages” be accounted for in the liquidation of the
partnership?
6. Lud and Moy, partners of the liquidating Lud & Moy LLP, share net income and losses
equally. State reasons for allocation of losses incurred in the realization of assets
equally or in the ratio of capital account balances.
7. Explain the basic principle to be observed in the distribution of cash in installments to
partners when the liquidation of a limited liability partnership extends over several
months.
8. During the installment liquidation of a limited liability partnership, it is appropriate to
estimate the loss from realization of noncash assets. What journal entries, if any,
 Chapter 3 Partnership Liquidation and Incorporation; Joint Ventures 103

should be made to recognize in the partners’ capital accounts their respective shares of
the loss that may be incurred during the liquidation?
9. Nom, Orr & Pan LLP is to be liquidated over several months, with installment distrib-
utions of cash to the partners. Will the total amount of cash received by each partner
under these circumstances be more, less, or the same amount as if the liquidator had
retained all cash until all noncash assets had been realized and then had made a single
cash payment to each of the partners?
10. Under what circumstances, if any, is it appropriate for a limited liability partnership
undergoing installment liquidation to distribute cash to partners in the income-sharing
ratio?
11. Rab, San, and Tay, partners of Rab, San & Tay LLP who share net income or losses
equally, had capital account balances of $30,000, $25,000, and $21,000, respectively,
when the partnership began liquidation. Among the assets was a promissory note re-
ceivable from San in the amount of $7,000. All partnership liabilities had been paid.
The first assets realized during the liquidation were marketable debt securities (classi-
fied as held to maturity) with a carrying amount of $15,000, for which cash of $18,000
was received. How should this $18,000 be divided among the partners?
12. When Urb, Van & Woo LLP began liquidation, the capital account credit balances were
Urb, $38,000; Van, $35,000; and Woo, $32,000. When the liquidation was complete,
Urb had received less cash than either of the other two partners. What factors might ex-
plain why the partner with the largest capital account balance might receive the small-
est amount of cash in liquidation?
13. Yang and Zee, partners of Yang & Zee LLP, decided to incorporate the partnership as
Yang-Zee Corporation. The entire capital stock of Yang-Zee Corporation was divided
equally between Yang and Zee because they had equal capital account balances in the
partnership. An appraisal report obtained on the date of incorporation indicated that
the land and buildings had increased in value by 50% while owned by the partnership.
Should the carrying amounts of those assets be increased to appraisal value or valued
at cost less accumulated depreciation to the partnership when recognized in Yang-Zee
Corporation’s accounting records? Explain.
14. Explain how a joint venture differs from a partnership.
15. What are corporate joint ventures? What accounting standards for such ventures were
established in APB Opinion No. 18, “The Equity Method of Accounting for Invest-
ments in Common Stock”?
16. Compare the equity method of accounting with the proportionate share method of
accounting for an investment in an unincorporated joint venture.

Exercises
(Exercise 3.1) Select the best answer for each of the following multiple-choice questions:
1. If Jebb, a partner with a loan receivable from a liquidating limited liability partnership,
receives less cash than the amount of the loan during the liquidation, the payment is
recorded with a debit to the partnership’s ledger account entitled:
a. Loan Receivable from Jebb.
b. Jebb, Capital.
c. Jebb, Drawing.
d. Loan Payable to Jebb.
104 Part One Accounting for Partnerships and Branches

2. Is the balance of the Loan Payable to Partner Jones ledger account combined with the bal-
ance of the Partner Jones, Capital account of a liquidating limited liability partnership in:

The Partnership’s The Partnership’s Statement

General Ledger? of Realization and Liquidation?
a. Yes Yes
b. Yes No
c. No Yes
d. No No

3. In the liquidation of a limited liability partnership, a loan payable to a partner:

a. Must be offset against that partner’s capital account balance before liquidation
commences.
b. Will not advance the time of payment to that partner during the liquidation.
c. Has the same priority as amounts payable to outside creditors of the partnership.
d. Must be closed to that partner’s drawing account.
4. In the liquidation of a limited liability partnership, cash received by a partner having a
loan receivable from the partnership is debited to the partner’s:
a. Loan account.
b. Capital account.
c. Drawing account.
d. Retained earnings account.
5. Prior to the beginning of liquidation, the liabilities and partners’ capital of Mann, Nunn &
Ogg LLP, whose partners shared net income and losses equally, consisted of Liabili-
ties, $60,000; Loan Payable to Ogg, $21,000; Mann, Capital, $30,000; Nunn, Capital,
$60,000; and Ogg, Capital, $39,000. If, after realization of all noncash assets and pay-
ment of all outsider liabilities, $60,000 cash was available for distribution to partners
on January 31, 2005, partner Ogg should receive:
a. $60,000
b. $39,000
c. $30,000
d. $21,000
e. Some other amount
6. The marshaling of assets provisions of the Uniform Partnership Act provide that un-
paid creditors of an insolvent general partnership have first claim to assets of:
a. The partnership.
b. A solvent partner.
c. An insolvent partner.
d. Either the partnership or a solvent partner, as elected by the creditor.
7. May unpaid creditors of an insolvent liquidating general partnership obtain payment
from a personally solvent partner whose partnership capital account has a:

Debit Balance? Credit Balance?

a. Yes Yes
b. Yes No
c. No Yes
d. No No
 Chapter 3 Partnership Liquidation and Incorporation; Joint Ventures 105

8. The ledger accounts of the liquidating Gill, Hall & James LLP included Loan Receiv-
able from Gill, $10,000 dr; Loan Payable to Hall, $20,000 cr; Gill, Capital, $30,000 dr;
Hall, Capital, $60,000 cr; James, Capital, $50,000 cr. The partners share net income
and losses 20%, 40%, and 40%, respectively. In the preparation of a cash distribution
to partners during liquidation working paper, beginning capital per unit of income-
sharing amounts are:

Gill Hall James

a. ($40,000) $80,000 $50,000
b. ($20,000) $20,000 $12,500
c. ($15,000) $15,000 $12,500
d. -0- $80,000 $50,000

9. In the liquidation of a limited liability partnership in installments, the partner who re-
ceives the first payment of cash after all liabilities have been paid is the partner having
the largest:
a. Capital account balance.
b. Capital per unit of income sharing.
c. Income-sharing percentage.
d. Loan account balance.
10. In the preparation of a cash distribution program for the liquidating Marlo, Noble &
Owen LLP, the balance of the Loan Receivable from Partner Marlo ledger account in
the accounting records of the partnership is:
a. Added to the Partner Marlo, Drawing, account balance.
b. Deducted from the Partner Marlo, Capital, account balance.
c. Included with the total of the noncash assets accounts.
d. Disregarded.
11. In the installment liquidation of a limited liability partnership, the income-sharing ratio
is used for cash payments to partners:
a. At no time.
b. Throughout the course of the liquidation.
c. Once the partners’ capital account balances have been reduced to the income-
sharing ratio.
d. Only for asset realizations that result in gains.
12. May a balance sheet prepared for a corporation on the date it was created from the in-
corporation of a limited liability partnership display in stockholders’ equity:

Common Stock? Additional Paid-in Capital? Retained Earnings?

a. Yes Yes Yes
b. Yes Yes No
c. Yes No No
d. Yes No Yes

13. The proportionate share method of accounting is appropriate for:

a. Corporate joint ventures only.
b. Unincorporated joint ventures only.
c. Both corporate joint ventures and unincorporated joint ventures.
d. Neither corporate joint ventures nor unincorporated joint ventures.
106 Part One Accounting for Partnerships and Branches

(Exercise 3.2) After the realization of all noncash assets and the payment of all liabilities, the balance
sheet of the liquidating Pon, Quan & Ron LLP on January 31, 2005, showed Cash, $15,000;
CHECK FIGURE Pon, Capital, ($9,000); Quan, Capital, $8,000; and Ron, Capital, $16,000, with ( ) indicat-
Debit Ron, capital, ing a capital deficit. The partners share net income and losses equally.
$11,500. Prepare a journal entry for Pon, Quan & Ron LLP on January 31, 2005, to show the pay-
ment of $15,000 cash in a safe manner to the partners. Show computations in the explana-
tion for the journal entry.
(Exercise 3.3) Archer and Bender, partners of Archer & Bender LLP, who share net income and losses in
a 60 : 40 ratio, respectively, decided to liquidate the partnership. A portion of the noncash
assets had been realized, but assets with a carrying amount of $42,000 were yet to be
CHECK FIGURE realized. All liabilities had been paid, and cash of $20,000 was available for distribution
Cash to Archer, to partners. The partners’ capital account credit balances were $40,000 for Archer and
$14,800. $22,000 for Bender.
Prepare a working paper to compute the amount of cash (totaling $20,000) to be dis-
tributed to each partner.
(Exercise 3.4) Carlo and Dodge started Carlo & Dodge LLP some years ago and managed to operate prof-
itably for several years. Recently, however, they lost a lawsuit requiring payment of large
damages because of Carlo’s negligence and incurred unexpected losses on trade accounts
receivable and inventories. As a result, they decided to liquidate the partnership. After all
noncash assets were realized, only $18,000 was available to pay liabilities, which amounted
to $33,000. The partners’ capital account balances before the start of liquidation and their
income-sharing percentages are shown below:

CHECK FIGURE
Capital Account Balances Income-Sharing Percentages
b. Credit Dodge,
capital, $9,675. Carlo $23,000 55%
Dodge 13,500 45%

a. Prepare a working paper to compute the total loss incurred on the liquidation of the
Carlo & Dodge LLP.
b. Prepare a journal entry to record Carlo’s payment of $15,000 to partnership creditors
and to close the partners’ capital accounts. Carlo was barely solvent after paying the
partnership creditors, but Dodge had net assets, exclusive of partnership interest, in ex-
cess of $100,000.

(Exercise 3.5) The balance sheet of Rich, Stowe & Thorpe LLP on the date it commenced liquidation was
as follows, with the partners’ income-sharing ratio in parentheses:

CHECK FIGURE
RICH, STOWE & THORPE LLP
Cash to Rich, $8,000.
Balance Sheet
September 24, 2005

Assets Liabilities and Partners’ Capital

Cash $ 20,000 Liabilities $240,000
Other assets 480,000 Rich, capital (40%) 80,000
Stowe, capital (40%) 120,000
Thorpe, capital (20%) 60,000
Total liabilities and
Total assets $500,000 partners’ capital $500,000
 Chapter 3 Partnership Liquidation and Incorporation; Joint Ventures 107

On September 24, 2005, other assets with a carrying amount of $360,000 realized $300,000
cash, and $320,000 ($20,000 $300,000 $320,000) cash was paid in a safe manner.
Prepare journal entries for Rich, Stowe & Thorpe LLP on September 24, 2005.
(Exercise 3.6) On June 3, 2005, the partners of Ace, Bay & Cap LLP agreed (1) to liquidate the partner-
ship, (2) to share gains and losses on the realization of noncash assets in the ratio 1 : 3 : 4,
and (3) to disburse the $80,000 available cash on June 3 in a safe manner. In addition to
cash, the June 3 balance sheet of the partnership had other assets, $100,000; liabilities,
$50,000; Ace, capital, $60,000; Bay, capital, $40,000; and Cap, capital, $30,000. The part-
nership had no loans receivable from or payable to the partners.
Prepare a journal entry for Ace, Bay & Cap LLP on June 3, 2005, to record the dis-
bursement of $80,000 cash. Show computations in the explanation for the entry.
(Exercise 3.7) After realization of a portion of the noncash assets of Ed, Flo & Gus LLP, which was
being liquidated, the capital account balances were Ed, $33,000; Flo, $40,000; and Gus,
$42,000. Cash of $42,000 and other assets with a carrying amount of $78,000 were
CHECK FIGURE on hand. Creditors’ claims total $5,000. The partners share net income and losses in a
Cash to Flo, $13,000. 5 : 3 : 2 ratio.
Prepare a working paper to compute the cash payments (totaling $37,000) that may be
made to the partners.
(Exercise 3.8) When Hale and Ian, partners of Hale & Ian LLP who shared net income and losses in a
4 : 6 ratio, were incapacitated in an accident, a liquidator was appointed to wind up the part-
nership. The partnership’s balance sheet showed cash, $35,000; other assets, $110,000;
liabilities, $20,000; Hale, capital, $71,000; and Ian, capital, $54,000. Because of the spe-
cialized nature of the noncash assets, the liquidator anticipated that considerable time
CHECK FIGURE would be required to dispose of them. The costs of liquidating the partnership (advertising,
Cash to Hale, $5,000. rent, travel, etc.) were estimated at $10,000.
Prepare a working paper to compute the amount of cash (totaling $5,000) that may be
distributed to each partner.
(Exercise 3.9) The following balance sheet was available for Jones, Kell & Lamb LLP on March 31, 2005
(each partner’s income-sharing percentage is shown in parentheses):

CHECK FIGURE
JONES, KELL & LAMB LLP
b. Cash to Lamb,
Balance Sheet
$17,000.
March 31, 2005

Assets Liabilities and Partners’ Capital

Cash $ 25,000 Liabilities $ 52,000
Other assets 180,000 Jones, capital (40%) 40,000
Kell, capital (40%) 65,000
Lamb, capital (20%) 48,000
Total $205,000 Total $205,000

a. The partnership was being liquidated by the realization of other assets in installments.
The first realization of noncash assets having a carrying amount of $90,000 realized
$50,000, and all cash available after settlement with creditors was distributed to part-
ners. Prepare a working paper to compute the amount of cash each partner should re-
ceive in the first installment.
b. If the facts are as in a above, except that $3,000 cash is withheld for anticipated liqui-
dation costs, compute the amount of cash that each partner should receive.
108 Part One Accounting for Partnerships and Branches

c. As a separate case, assume that each partner appropriately received some cash in the
distribution after the second realization of noncash assets. The cash to be distributed
amounted to $14,000 from the third realization of noncash assets, and other assets with
a $6,000 carrying amount remained. Prepare a working paper to show how the $14,000
is distributed to the partners.
(Exercise 3.10) On November 10, 2005, May, Nona, and Olive, partners of May, Nona & Olive LLP, had
capital account balances of $20,000, $25,000, and $9,000, respectively, and shared net in-
come and losses in a 4 : 2 : 1 ratio.
CHECK FIGURE a. Prepare a cash distribution program for liquidation of the May, Nona & Olive Partner-
b. $26,000. ship in installments, assuming liabilities totaled $20,000 on November 10, 2005.
b. How much cash was paid to all partners if May received $4,000 on liquidation?
c. If May received $13,000 cash pursuant to liquidation, how much did Olive receive?
d. If Nona received only $11,000 as a result of the liquidation, what was the loss to the
partnership on the realization of assets? (No partner invested any additional assets in the
partnership.)
(Exercise 3.11) Following is the balance sheet of Paul & Quinn LLP on June 1, 2005:

CHECK FIGURE
PAUL & QUINN LLP
Cash to Quinn in Aug.,
Balance Sheet
$9,000.
June 1, 2005

Assets Liabilities and Partners’ Capital

Cash $ 5,000 Liabilities $20,000
Other assets 55,000 Paul, capital 22,500
Quinn, capital 17,500
Total $60,000 Total $60,000

The partners share net income and net losses as follows: Paul, 60%; Quinn, 40%. In June,
other assets with a carrying amount of $22,000 realized $18,000, creditors were paid in
full, and $2,000 was paid to the partners in a manner to reduce their capital account bal-
ances closer to the income-sharing ratio. In July, other assets with a carrying amount of
$10,000 realized $12,000, liquidation costs of $500 were paid, and cash of $12,500 was
distributed to the partners. In August, the remaining other assets realized $22,500, and fi-
nal settlement was made between the partners.
Prepare a working paper to compute the amount of cash each partner should receive in
June, July, and August 2005.
(Exercise 3.12) On September 26, 2005, prior to commencement of liquidation of Orville, Paula & Quincy
LLP, the partnership had total liabilities of $80,000 and partners’ capital account credit bal-
ances of $120,000 for Orville, $160,000 for Paula, and $80,000 for Quincy. There were no
loans to or from partners in the partnership’s accounting records. The partners shared net
income and losses as follows: Orville, 30%; Paula, 50%; Quincy, 20%.
Prepare a cash distribution program for Orville, Paula & Quincy LLP on September 26,
2005.
(Exercise 3.13) On January 21, 2005, the date the partners of Ang, Bel & Cap LLP decided to liquidate the
partnership, its balance sheet showed cash, $33,000; other assets, $67,000; trade accounts
CHECK FIGURE payable, $20,000; loan payable to Ang, $12,000; Ang, capital, $28,000; Bel, capital,
Debit loan payable to $18,000; and Cap, capital, $22,000. The partnership’s income-sharing ratio was Ang, 50%;
Ang, $5,000. Bel, 30%; Cap, 20%. The accountant for the partnership prepared the following cash
 Chapter 3 Partnership Liquidation and Incorporation; Joint Ventures 109

distribution program (to facilitate installment payments to partners) on January 21, 2005:
First $20,000, 100% to creditors; next $6,000, 100% to Cap; next $14,000, 5⁄7 to Ang and
2
⁄7 to Cap; all over $40,000, in income-sharing ratio. On the basis of the foregoing, the part-
ners decided to pay the entire cash of $33,000 on January 21, 2005, in a safe manner con-
sistent with the Uniform Partnership Act.
Prepare a journal entry to record the Ang, Bel & Cap LLP payment of $33,000 cash on
January 21, 2005.
(Exercise 3.14) The net equities and income-sharing ratio for the partners of Ruiz, Salvo, Thomas & Urwig
LLP before liquidation was authorized on May 5, 2005, were as follows:

Ruiz Salvo Thomas Urwig

Net equity in partnership $36,000 $32,400 $8,000 $(100)
Income-sharing ratio 3 4 2 1

Assets were expected to realize cash significantly in excess of carrying amounts.

Prepare a program showing how cash should be distributed to the partners as it becomes
available in the course of liquidation if liabilities of the partnership totaled $15,000 on
May 5, 2005.
(Exercise 3.15) On September 30, 2005, the partners of Allen, Brown & Cox LLP, who shared net income
and losses in the ratio of 5 : 3 : 2, respectively, decided to liquidate the partnership. The
partnership trial balance on that date was as follows:

ALLEN, BROWN & COX LLP

Trial Balance
September 30, 2005

Debit Credit
Cash $ 18,000
Loan receivable from Allen 30,000
Trade accounts receivable (net) 66,000
Inventories 52,000
Machinery and equipment (net) 189,000
Trade accounts payable $ 53,000
Loan payable to Brown 20,000
Allen, capital 118,000
Brown, capital 90,000
Cox, capital 74,000
Totals $355,000 $355,000

The partners planned a lengthy time period for realization of noncash assets in order to
minimize liquidation losses. All available cash, less an amount retained to provide for fu-
ture liquidation costs, was to be distributed to the partners at the end of each month.
Prepare a cash distribution program for Allen, Brown & Cox LLP on September 30,
2005, showing how cash should be distributed to creditors and to partners as it becomes
available during liquidation. Round amounts to the nearest dollar.
(Exercise 3.16) The balance sheet of Davis, Evans & Fagin LLP on September 29, 2005, included cash,
$20,000; other assets, $262,000; liabilities, $50,000; and total partners’ capital, $232,000.
110 Part One Accounting for Partnerships and Branches

On that date, the three partners decided to dissolve and liquidate the partnership. The cash
distribution program prepared by the partnership’s accountant follows:

CHECK FIGURE
DAVIS, EVANS & FAGIN LLP
Cash to Fagin,
Cash Distribution Program
$24,000.
September 29, 2005

Total Creditors Davis Evans Fagin

First $ 50,000 100%
Next 34,000 100%
Next 48,000 331⁄3% 662⁄3%
All over $132,000 40% 20% 40%

On September 30, 2005, noncash assets with a carrying amount of $140,000 were sold for
$100,000 cash.
Prepare journal entries for Davis, Evans & Fagin LLP on September 30, 2005, to record
the realization of $140,000 of noncash assets and the payment of all available cash on that
date in accordance with the cash distribution program.
(Exercise 3.17) The balance sheet of Venner & Wigstaff LLP, immediately before the partnership was in-
corporated as Venwig Corporation, follows:

CHECK FIGURE
VENNER & WIGSTAFF LLP
Total assets, $146,000.
Balance Sheet
September 30, 2005

Assets Liabilities and Partners’ Capital

Cash $ 10,500 Trade accounts payable $ 16,400
Trade accounts receivable 15,900 Venner, capital 60,000
Inventories 42,000 Wigstaff, capital 52,000
Equipment (net of $18,000
accumulated depreciation) 60,000
Total $128,400 Total $128,400

The following adjustments to the balance sheet of the partnership were recommended by a
CPA before accounting records for Venwig Corporation were to be established:
1. An allowance for doubtful accounts was to be established in the amount of $1,200.
2. Short-term prepayments of $800 were to be recognized.
3. The current fair value of inventories, $48,000, and the current fair value of equipment,
$72,000, were to be recognized.
4. Accrued liabilities of $750 were to be recognized.
Prepare a balance sheet for Venwig Corporation on October 1, 2005, assuming that 10,000
shares of $5 par common stock were issued to the partners in exchange for their equities in
the partnership. Fifty thousand shares of common stock were authorized to be issued.
(Exercise 3.18) On January 2, 2005, Yale Corporation and Zola Corporation each invested $500,000 in an
unincorporated joint venture, Y-Z Company, the income or losses of which were to be shared
equally. On December 31, 2005, financial statements of Y-Z Company showed total rev-
enue, $800,000; total costs and expenses, $600,000; total current assets, $600,000; net plant
 Chapter 3 Partnership Liquidation and Incorporation; Joint Ventures 111

assets, $1,500,000; total current liabilities, $300,000; total long-term debt, $600,000; and to-
tal venturers’ capital, $1,200,000. Neither venturer had drawings during 2005.
a. Prepare journal entries for Yale Corporation for the year ended December 31, 2005, to
record its investment in Y-Z Company under the equity method of accounting.
b. Prepare an additional journal entry for Yale Corporation on December 31, 2005, to com-
plete the journal entries (together with those in a) required for the investment in Y-Z
Company under the proportionate share method of accounting.

Cases
(Case 3.1) Professor Lewis posed the following question to students of advanced accounting: “Does
the limited liability partnership form of business enterprise damage the mutual agency
characteristic of a general partnership?”
Instructions
How would you answer Professor Lewis’s question? Explain.
(Case 3.2) The partners of the liquidating Nance, Olson & Peale LLP have requested Nancy Lane,
CPA, to assist in the liquidation. Lane discovered considerable disarray in the partnership’s
accounting records for liabilities, especially for trade accounts payable. Despite the condi-
tion of the accounting records, the partners have urged Lane to prepare a cash distribution
program to show how cash received from the realization of noncash assets might be dis-
tributed to creditors and to partners as it became available.
Instructions
Is Nancy Lane able to prepare a cash distribution program, given the condition of the
Nance, Olson & Peale LLP accounting records? Explain.
(Case 3.3) The Berg, Hancock & Loomis Partnership (a general partnership) was insolvent and in the
process of liquidation under the Uniform Partnership Act. After the noncash assets were re-
alized and the resultant loss was distributed equally among the partners in accordance with
the partnership contract, their financial positions were as follows:

Financial Position
Other Than Equity
in Partnership
Equity in
Partnership Assets Liabilities
Jack Berg $30,000 $110,000 $45,000
Diane Hancock (21,000) 20,000 40,000
David Loomis (55,000) 55,000 45,000

Several partnership creditors remained unpaid, but the partnership had no cash.
Instructions
Explain the prospects for collection by:
a. The creditors of the partnership.
b. The creditors of each partner.
c. Jack Berg from the other partners. Compute the total loss that Berg will incur on the liq-
uidation of the partnership.
112 Part One Accounting for Partnerships and Branches

(Case 3.4) Lois Allen and Barbara Brett established a limited liability partnership and shared net in-
come and losses equally. Although the partners began business with equal capital account
balances, Allen made more frequent authorized cash withdrawals than Brett, with the result
that her capital account balance became the smaller of the two. The partners decided to liq-
uidate the partnership on June 30, 2005; on that date the accounting records were closed
and financial statements were prepared. The balance sheet included capital of $40,000 for
Allen and $60,000 for Brett, as well as a $10,000 loan payable to Brett.
The liquidation of the partnership was managed by Allen, because Brett was hospital-
ized by illness on July 1, 2005, the day after partnership operations were suspended. The
procedures followed by Allen were as follows: (1) realize all the noncash assets at the best
amounts obtainable; (2) pay the outside creditors in full; (3) pay Brett’s loan; and (4) divide
all remaining cash between Brett and herself in the 40 : 60 ratio represented by their capi-
tal account balances.
When Brett was released from the hospital on July 5, 2005, Allen informed her that
through good luck and hard work, she had been able to realize the noncash assets and com-
plete the liquidation during the five days of Brett’s hospitalization. Thereupon, Allen deliv-
ered two partnership checks to Brett. One check was for $10,000 in payment of the loan;
the other was in settlement of Brett’s capital account balance.
Instructions
a. Do you approve of the procedures followed by Allen in the liquidation? Explain.
b. Assume that the liquidation procedures followed resulted in the payment of $24,000 to
Brett in addition to the payment of her loan in full. What was the partnership’s gain or
loss on the realization of assets? If you believe that other methods should have been fol-
lowed in the liquidation, explain how much more or less Brett would have received un-
der the procedure you recommend.

(Case 3.5) The Wells, Conner & Zola Partnership, a general partnership CPA firm, has been forced to
liquidate because of the bankruptcy of partner Lewis Zola, which caused the dissolution of
the firm. On the date of Zola’s bankruptcy filing, the partnership’s balance sheet was as
shown below, with the partners’ income-sharing percentages in parentheses.

WELLS, CONNER & ZOLA PARTNERSHIP

Balance Sheet
October 31, 2005

Assets Liabilities and Partners’ Capital

Cash $ 60,000 Trade accounts payable $140,000
Trade accounts receivable 120,000 Interest payable to Wells 10,000
Office equipment (net) 240,000 10% note payable to Wells 100,000
Library (net) 90,000 Wells, capital (50%) 280,000
Goodwill (net) 40,000 Conner, capital (30%) 80,000
Zola, capital (20%) (60,000)
Total liabilities and
Total assets $550,000 partners’ capital $550,000

In a meeting with the three partners, you, as the partners’ accountant, are asked to su-
pervise the liquidation of the partnership. In response to partner John Wells’s assertion that,
according to his attorney, the partnership had to pay the note and interest payable to Wells
after all trade accounts payable had been paid, you explain your understanding of the right
of offset, which gives the Wells loan no priority over partners’ capital. You point out that the
 Chapter 3 Partnership Liquidation and Incorporation; Joint Ventures 113

amounts to be realized for the partnership’s office equipment and library are uncertain and
that in an enforced liquidation losses may be incurred on the realization of those assets. You
also indicate that the impaired partnership goodwill has no realizable value and should be
written off to the partners’ capital accounts at once.
Your statements cause consternation to partners John Wells and Kathleen Conner. Wells
points out that he has been absorbing the majority of the partnership’s recent operating
losses, and that his loan to the partnership was necessitated by a cash shortage. Conner ob-
jects to sharing any part of the write-off of impaired goodwill, reminding Wells, Zola, and
you that the goodwill was recognized in the admission of Zola to the former Wells & Conner
partnership for his investment of his highly profitable CPA firm proprietorship. Noting that
Zola’s personal bankruptcy was most likely an outgrowth of his deteriorating relationship
with Wells, partnership clients, and her, Conner strongly urges that Zola’s capital account
be charged for the entire $40,000 carrying amount of the impaired goodwill.
After further acrimonious discussion, the three partners request you to “go back to the
drawing board” and return with a recommendation on how best to resolve the issues raised
by Wells and Conner. In response to your inquiry, both Wells and Conner emphasize that
they intend to continue the practice of public accounting in some form; Zola states that he
has no future career plans until the resolution of his bankruptcy filing.
Instructions
Prepare a memo for your recommendations for the three partners in response to the issues
they have raised. Include in your recommendations your views on the desirability of the
partners’ retaining an independent attorney to resolve the issues raised.
(Case 3.6) Anne Sanchez, chief accounting officer of the Kane & Grant Partnership (a general part-
nership), is a member of the IMA, the FEI, and the AICPA (see Chapter 1). Partners Jane
Kane and Lloyd Grant inform Sanchez of their plans to incorporate the highly profitable
partnership, with a view to a public offering to outside investors in the future. Indicating
their desire for the best possible balance sheet for the new corporation, they ask Sanchez to
reconsider her insistence that the partnership account for its 50% investment in KG/WM
Company, an unincorporated joint venture, by the proportionate share method. Partner
Kane shows Sanchez the following comparative balance sheet data for the partnership
under two methods of accounting for the investment in KG/WM Company:

KANE & GRANT PARTNERSHIP

Condensed Balance Sheets
April 30, 2005

Proportionate
Share Method Equity Method
Assets
Investment in KG/WM Company $ 0 $ 600,000
Other assets 3,800,000 2,400,000
Total assets $3,800,000 $3,000,000

Liabilities and Partners’ Capital

Total liabilities $2,000,000 $1,200,000
Partners’ capital 1,800,000 1,800,000
Total liabilities and partners’ capital $3,800,000 $3,000,000

Kane points out that under the proportionate share method of accounting for the in-
vestment in KG/WM Company, the Kane & Grant Partnership’s debt-to-equity ratio is
114 Part One Accounting for Partnerships and Branches

111% ($2,000,000 $1,800,000 111%), while under the equity method of accounting
for the investment the partnership’s debt-to-equity ratio is only 67% ($1,200,000
$1,800,000 67%).
Instructions
May Anne Sanchez ethically comply with the request of Jane Kane and Lloyd Grant? Explain.
(Case 3.7) The Financial Accounting Standards Board is studying the accounting for investments in
both corporate joint ventures and unincorporated joint ventures.
Instructions
Do you favor requiring a single accounting method for investments in both corporate and un-
incorporated joint ventures? If so, what should the accounting method be? If not, should one
accounting method be mandatory for investments in corporate joint ventures, and another
method mandatory for investments in unincorporated joint ventures? Or should alternative
accounting methods be available for investments in both types of joint ventures? Explain.

Problems
(Problem 3.1) During liquidation, the Doris, Elsie & Frances Partnership (a general partnership) became
insolvent. On January 17, 2005, after all noncash assets had been realized and all available
cash had been distributed to creditors, the balance sheet of the partnership was as follows:

DORIS, ELSIE & FRANCES PARTNERSHIP

Balance Sheet
January 17, 2005

Liabilities and Partners’ Capital

Trade accounts payable $ 60,000
Doris, capital 120,000
Elsie, capital (160,000)
Frances, capital (20,000)
Total liabilities and partners’ capital $ -0-

The partners shared net income and losses (including gains and losses in liquidation) in the
ratio 20%, 50%, and 30%, respectively. On January 17, 2005, when the financial positions
of the partners were as shown below, Elsie and Frances invested in the partnership all cash
available under the marshaling of assets provisions of the Uniform Partnership Act:

Partner Assets* Liabilities*

Doris $ 60,000 $ 80,000
Elsie 280,000 200,000
Frances 250,000 240,000

*Excludes equity in partnership

Instructions
Prepare journal entries for the Doris, Elsie & Frances Partnership on January 17, 2005, to
record the receipt of cash from Elsie and Frances, the appropriate distribution of the cash,
and the completion of the partnership liquidation.
 Chapter 3 Partnership Liquidation and Incorporation; Joint Ventures 115

(Problem 3.2) Following is the balance sheet of Olmo, Perez & Quinto LLP on January 31, 2005, the date
the partners authorized liquidation of the partnership. There were no unrecorded liabilities.

CHECK FIGURE
OLMO, PEREZ & QUINTO LLP
Feb. 5, debit Olmo,
Balance Sheet
capital, $73,333.
January 31, 2005

Assets Liabilities and Partners’ Capital

Cash $ 10,000 Trade accounts payable $ 90,000
Loan receivable from Perez 50,000 Loan payable to Olmo 60,000
Other assets (net) 240,000 Olmo, capital 140,000
Perez, capital (70,000)
Quinto, capital 80,000
Total liabilities and
Total assets $300,000 partners’ capital $300,000

Additional Information for 2005:

1. The partners’ income (loss)-sharing ratio was Olmo, 40%; Perez, 40%; and Quinto, 20%.
2. On February 1, noncash assets with a carrying amount of $180,000 realized $140,000,
and all available cash was paid to creditors and to partners.
3. On February 4, noncash assets with a carrying amount of $60,000 realized $50,000, and
that amount was paid to partners.
4. On February 5, Perez, who was almost insolvent, paid $30,000 on the loan from the part-
nership. Olmo and Quinto agreed that the partnership would receive no further cash from
Perez, and they instructed the accountant to close the partnership’s accounting records.

Instructions
Prepare journal entries for Olmo, Perez & Quinto LLP on February 1, 4, and 5, 2005. Dis-
regard costs of the liquidation. Round all amounts to the nearest dollar. (Preparation of a
cash distribution program as a supporting exhibit is recommended.)
(Problem 3.3) The loan and capital account balances of Hal, Ian, Jay & Kay LLP were as follows on Sep-
tember 25, 2005, the date that the partnership began liquidation:

CHECK FIGURE
Debit Credit
All cash over $185,000
in income-sharing Loan receivable from Jay $10,000
ratio. Loan payable to Hal $20,000
Hal, capital 50,000
Ian, capital 25,000
Jay, capital 70,000
Kay, capital 50,000

Partnership liabilities totaled $80,000 on September 25, 2005. The partners shared net in-
come and losses and realization gains and losses as follows: Hal, 20%; Ian, 25%; Jay, 30%;
and Kay, 25%.
Instructions
Prepare a cash distribution program for Hal, Ian, Jay & Kay LLP on September 25, 2005.
(Problem 3.4) Carson and Worden decided to dissolve and liquidate Carson & Worden LLP on Septem-
ber 23, 2005. On that date, the balance sheet of the partnership was as follows:
116 Part One Accounting for Partnerships and Branches

CHECK FIGURE
CARSON & WORDEN LLP
b. Oct. 1, debit Carson,
Balance Sheet
capital, $4,800. September 23, 2005

Assets Liabilities and Partners’ Capital

Cash $ 5,000 Trade accounts payable $ 15,000
Other assets 100,000 Loan payable to Worden 10,000
Carson, capital 60,000
Worden, capital 20,000
Total $105,000 Total $105,000

On September 23, 2005, noncash assets with a carrying amount of $70,000 realized
$60,000, and $64,000 was paid to creditors and partners, $1,000 being retained to cover
possible liquidation costs. On October 1, 2005, the remaining noncash assets realized
$18,000 (net of liquidation costs), and all available cash was distributed to partners. Carson
and Worden share net income and losses 40% and 60%, respectively.
Instructions
a. Prepare a cash distribution program for Carson & Worden LLP on September 23, 2005,
to determine the appropriate distribution of cash to partners as it becomes available.
b. Prepare journal entries for Carson & Worden LLP on September 23 and October 1, 2005,
to record the realization of assets and distributions of cash to creditors and partners.
(Problem 3.5) The statement of realization and liquidation for Luke, Mayo & Nomura LLP was as
follows:

LUKE, MAYO & NOMURA LLP

Statement of Realization and Liquidation
April 30 through June 1, 2005

Trade
Assets Partner’s Capital
Accounts
Cash Other Payable Luke Mayo Nomura
Balances before liquidation
(April 30, 2005) $ 20,000 $200,000 $120,000 $ 10,000 $ 30,000 $ 60,000
Realization of other assets
at a loss of $120,000
(May 9, 2005) 80,000 (200,000) (40,000) (40,000) (40,000)
Balances $100,000 $120,000 $ (30,000) $(10,000) $ 20,000
Payment to creditors (May
12, 2005) (100,000) (100,000)
Balances $ 20,000 $ (30,000) $(10,000) $ 20,000
Payment by Luke to
partnership creditors
(May 18, 2005) (20,000) 20,000
Balances $ (10,000) $(10,000) $ 20,000
Cash invested by Luke and
Mayo (May 25, 2005) $ 20,000 10,000 10,000
Balances $ 20,000 $ 20,000
Payment to Nomura (June
1, 2005) (20,000) (20,000)
 Chapter 3 Partnership Liquidation and Incorporation; Joint Ventures 117

Instructions
Prepare journal entries (omit explanations) for the liquidation of Luke, Mayo & Nomura
LLP on May 9, 12, 18, and 25 and June 1, 2005. Use a single Other Assets ledger account.
(Problem 3.6) On December 31, 2005, the accounting records of Luna, Nava & Ruby LLP included the
following ledger account balances:
CHECK FIGURES
(Dr) Cr
a. Loss from
liquidation, $78,750; Luna, drawing $(24,000)
b. Payment to Luna, Ruby, drawing (9,000)
$59,625. Loan payable to Nava 30,000
Luna, capital 123,000
Nava, capital 100,500
Ruby, capital 108,000

Total assets of the partnership amounted to $478,500, including $52,500 cash, and part-
nership liabilities totaled $150,000. The partnership was liquidated on December 31, 2005,
and Ruby received $83,250 cash pursuant to the liquidation. Luna, Nava, and Ruby shared
net income and losses in a 5 : 3 : 2 ratio, respectively.
Instructions
a. Prepare a working paper to compute the total loss from the liquidation of Luna, Nava &
Ruby LLP on December 31, 2005.
b. Prepare a statement of realization and liquidation for Luna, Nava & Ruby LLP on De-
cember 31, 2005.
c. Prepare journal entries for Luna, Nava & Ruby LLP on December 31, 2005, to record
the liquidation.

(Problem 3.7) The following balance sheet was prepared for Haye & Lee LLP immediately prior to
liquidation:
CHECK FIGURES
HAYE & LEE LLP
Apr. 15, debit Lee,
Balance Sheet (unaudited)
capital, $2,900.
March 31, 2005

Assets Liabilities and Partners’ Capital

Cash $ 10,000 Liabilities $ 27,000
Investments in marketable Haye, capital 72,000
equity securities (available Lee, capital 31,000
for sale) 44,000
Accumulated other
Other assets 100,000 comprehensive income 24,000
Total $154,000 Total $154,000

Haye and Lee shared operating income or losses in a 2 : 1 ratio and gains and losses on invest-
ments in a 3 : 1 ratio. The transactions and events to complete the liquidation were as follows:
2005
Apr. 1 Haye withdrew the marketable equity securities at the agreed current fair value
of $44,000.
3 Other assets and the trade name, Haley’s, were sold to Wong Products for
$200,000 face amount of 12% bonds with a current fair value of $180,000. The
gain on this transaction was an investment gain. The bonds were classified as
available for sale.
118 Part One Accounting for Partnerships and Branches

Apr. 7 Wong Products 12% bonds with a face amount of $40,000 were sold for
$35,600 cash. The loss on this transaction was an investment loss.
8 Liabilities were paid.
10 Haye withdrew $100,000 face amount and Lee withdrew $60,000 face amount
of Wong Products 12% bonds at carrying amounts.
15 Available cash was paid to Haye and to Lee.
Instructions
Prepare journal entries for Haye & Lee LLP to record the foregoing transactions and
events. Disregard interest on the bonds of Wong Products.
(Problem 3.8) Following is the balance sheet for Adams, Barna & Coleman LLP on June 4, 2005, imme-
diately prior to its liquidation:
CHECK FIGURES
ADAMS, BARNA & COLEMAN LLP
Final cash payments:
Balance Sheet
Adams, $100; Barna,
June 4, 2005
$16,100.
Assets Liabilities and Partners’ Capital
Cash $ 6,000 Liabilities $ 20,000
Other assets 94,000 Loan payable to Barna 4,000
Adams, capital 27,000
Barna, capital 39,000
Coleman, capital 10,000
Total $100,000 Total $100,000

The partners shared net income and losses as follows: Adams, 40%; Barna, 40%; and
Coleman, 20%. On June 4, 2005, the other assets realized $30,700, and $20,500 had to be paid
to liquidate the liabilities because of an unrecorded trade account payable of $500. Adams and
Barna were solvent, but Coleman’s personal liabilities exceeded personal assets by $5,000.
Instructions
a. Prepare a statement of realization and liquidation for Adams, Barna & Coleman LLP on
June 4, 2005. Combine Barna’s loan and capital account balances.
b. Prepare journal entries for Adams, Barna & Coleman LLP to record the liquidation on
June 4, 2005.
c. How much cash would other assets have to realize on liquidation in order for Coleman
to receive enough cash from the partnership to pay personal creditors in full? Assume
that $20,500 is required to liquidate the partnership liabilities.
(Problem 3.9) The accountant for Smith, Jones & Webb LLP prepared the following balance sheet imme-
diately prior to liquidation of the partnership:
CHECK FIGURE
SMITH, JONES & WEBB LLP
Final cash payments:
Balance Sheet
$28,000 to each
April 30, 2005
partner.
Assets Liabilities and Partners’ Capital
Cash $ 20,000 Liabilities $ 80,000
Other assets 280,000 Smith, capital 60,000
Jones, capital 70,000
Webb, capital 90,000
Total $300,000 Total $300,000
 Chapter 3 Partnership Liquidation and Incorporation; Joint Ventures 119

During May 2005, noncash assets with a carrying amount of $105,000 realized $75,000,
and all liabilities were paid. During June, noncash assets with a carrying amount of
$61,000 realized $25,000, and in July the remaining noncash assets with a carrying amount
of $114,000 realized $84,000. The cash available at the end of each month was distributed
promptly. The partners shared net income and losses equally.

Instructions
Prepare a statement of realization and liquidation for Smith, Jones & Webb LLP covering
the entire period of liquidation (May through July 2005) and a supporting working paper
showing the computation of installment payments to partners as cash becomes available.
(Problem 3.10) Denson, Eastin, and Feller, partners of Denson, Eastin & Feller LLP, shared net income and
losses in a 5 : 3 : 2 ratio, respectively. On December 31, 2005, at the end of an unprofitable
year, they decided to liquidate the partnership. The partners’ capital account credit balances
on that date were as follows: Denson, $22,000; Eastin, $24,900; Feller, $15,000. The lia-
bilities in the balance sheet amounted to $30,000, including a loan of $10,000 payable to
CHECK FIGURE Denson. The cash balance was $6,000.
b. Total amount The partners planned to realize the noncash assets over a long period and to distribute
realized, $61,900. cash when it became available. All three partners were solvent.

Instructions
Prepare a cash distribution program for Denson, Eastin & Feller LLP on December 31,
2005, and answer each of the following questions; prepare a working paper to show how
you reached your conclusions. (Each question is independent of the others.)
a. If Eastin received $2,000 from the first distribution of cash to partners, how much did
Denson and Feller each receive at that time?
b. If Denson received total cash of $20,000 as a result of the liquidation, what was the total
amount realized by the partnership on the noncash assets?
c. If Feller received $6,200 on the first distribution of cash to partners, how much did
Denson receive at that time?

(Problem 3.11) After several years of successful operation of Lord & Lee LLP, partners Lord and Lee de-
cided to incorporate the partnership and issue common stock to public investors.
On January 2, 2006, Lord-Lee Corporation was organized with authorization to issue
CHECK FIGURES 150,000 shares of $10 par common stock, and it issued 20,000 shares for cash to public
a. Jan. 2, debit Lord, investors at $16 a share. Lord and Lee agreed to accept shares of common stock at $16 a
capital, $72,000; share in amounts equal to their respective partnership capital account balances, after the
c. Total assets, adjustments indicated on page 120, and after making cash withdrawals sufficient to avoid
$527,550. the need for issuing less than a multiple of 100 shares to either of the two partners. In
payment for such shares, the partnership’s net assets were transferred to the corporation
and common stock certificates were issued. Accounting records were established for the
corporation.
120 Part One Accounting for Partnerships and Branches

The post-closing trial balance of Lord & Lee LLP on December 31, 2005, follows:

LORD & LEE LLP

Post-Closing Trial Balance
December 31, 2005

Debit Credit
Cash $ 37,000
Trade accounts receivable 30,000
Inventories 56,000
Land 28,000
Buildings 50,000
Accumulated depreciation of buildings $ 17,000
Trade accounts payable 10,000
Lord, capital 63,000
Lee, capital 111,000
Totals $201,000 $201,000

The partnership contract provided that Lord was to receive 40% of net income or losses
and Lee was to receive 60%. The partners approved the following adjustments to the ac-
counting records of the partnership on December 31, 2005:
1. Recognize short-term prepayments of $1,500 and accrued liabilities of $750.
2. Provide an allowance for doubtful accounts of $12,000.
3. Increase the carrying amount of land to current fair value of $45,000.
4. Increase the carrying amount of inventories to replacement cost of $75,000.
Instructions
a. Prepare a journal entry for Lord & Lee LLP on December 31, 2005, to record the fore-
going adjustments and on January 2, 2006, to record the liquidation of the partnership.
b. Prepare journal entries on January 2, 2006, to record Lord-Lee Corporation’s issuances
of common stock to public investors, Lord, and Lee.
c. Prepare a balance sheet for Lord-Lee Corporation on January 2, 2006, after the forego-
ing transactions and events had been recorded.
Chapter Four

Accounting for
Branches; Combined
Financial Statements
Scope of Chapter
The accounting and reporting for segments of a business enterprise—primarily branches
and divisions—are dealt with in this chapter. Although branches of an enterprise are not
separate legal entities, they are separate economic and accounting entities whose special
features necessitate accounting procedures tailored for those features, such as reciprocal
ledger accounts.

BRANCHES AND DIVISIONS

As a business enterprise grows, it may establish one or more branches to market its prod-
ucts over a large territory. The term branch is used to describe a business unit located
at some distance from the home office. This unit carries merchandise obtained from
the home office, makes sales, approves customers’ credit, and makes collections from its
customers.
A branch may obtain merchandise solely from the home office, or a portion may be pur-
chased from outside suppliers. The cash receipts of the branch often are deposited in a bank
account belonging to the home office; the branch expenses then are paid from an imprest
cash fund or a bank account provided by the home office. As the imprest cash fund is de-
pleted, the branch submits a list of cash payments supported by vouchers and receives a
check or an electronic or wire transfer from the home office to replenish the fund.
The use of an imprest cash fund gives the home office considerable control over the cash
transactions of the branch. However, it is common practice for a large branch to maintain
its own bank accounts. The extent of autonomy and responsibility of a branch varies, even
among different branches of the same business enterprise.
A segment of a business enterprise also may be operated as a division, which generally
has more autonomy than a branch. The accounting procedures for a division not organized
as a separate corporation (subsidiary company) are similar to those used for branches.
When a business segment is operated as a separate corporation, consolidated financial
statements generally are required. Consolidated financial statements are described in

121
122 Part One Accounting for Partnerships and Branches

Chapters 6 through 10; accounting and reporting problems for business segments are included
in Chapter 13.

START-UP COSTS OF OPENING NEW BRANCHES

The establishment of a branch often requires the incurring of considerable costs before
significant revenue may be generated. Operating losses in the first few months are likely.
In the past, some business enterprises would capitalize and amortize such start-up costs
on the grounds that such costs are necessary to successful operation at a new location.
However, most enterprises recognized start-up costs in connection with the opening of a
branch as expenses of the accounting period in which the costs are incurred. The decision
should be based on the principle that net income is measured by matching expired costs
with realized revenue. Costs that benefit future accounting periods are deferred and allo-
cated to those periods. Seldom is there complete certainty that a new branch will achieve
a profitable level of operations in later years. In recognition of this fact, in 1998 the AICPA
Accounting Standards Executive Committee issued Statement of Position 98-5 (SOP 98-5),
“Reporting on the Costs of Start-Up Activities,” which required expensing of all start-up
costs, including those associated with organizing a new entity such as a branch or
division.1

ACCOUNTING SYSTEM FOR A BRANCH

The accounting system of one business enterprise with branches may provide for a com-
plete set of accounting records at each branch; policies of another such enterprise may keep
all accounting records in the home office. For example, branches of drug and grocery chain
stores submit daily reports and business documents to the home office, which enters all
transactions by branches in computerized accounting records kept in a central location. The
home office may not even conduct operations of its own; it may serve only as an account-
ing and control center for the branches.
A branch may maintain a complete set of accounting records consisting of journals,
ledgers, and a chart of accounts similar to those of an independent business enterprise. Fi-
nancial statements are prepared by the branch accountant and forwarded to the home office.
The number and types of ledger accounts, the internal control structure, the form and con-
tent of the financial statements, and the accounting policies generally are prescribed by the
home office.
This section focuses on a branch operation that maintains a complete set of account-
ing records. Transactions recorded by a branch should include all controllable expenses
and revenue for which the branch manager is responsible. If the branch manager has
responsibility over all branch assets, liabilities, revenue, and expenses, the branch ac-
counting records should reflect this responsibility. Expenses such as depreciation often
are not subject to control by a branch manager; therefore, both the branch plant assets

1
It is interesting to note that 23 years before the issuance of SOP 98-5, FASB member Walter Schuetze
dissented to the issuance of Statement of Financial Accounting Standards No. 7, “Accounting and
Reporting by Development Stage Enterprises,” because it did not address the issue of accounting for
start-up costs.
 Chapter 4 Accounting for Branches; Combined Financial Statements 123

and the related depreciation ledger accounts generally are maintained by the home
office.

Reciprocal Ledger Accounts

The accounting records maintained by a branch include a Home Office ledger account that
is credited for all merchandise, cash, or other assets provided by the home office; it is deb-
ited for all cash, merchandise, or other assets sent by the branch to the home office or to
other branches. The Home Office account is a quasi-ownership equity account that shows
the net investment by the home office in the branch. At the end of an accounting period
when the branch closes its accounting records, the Income Summary account is closed to
the Home Office account. A net income increases the credit balance of the Home Office ac-
count; a net loss decreases this balance.
In the home office accounting records, a reciprocal ledger account with a title such as
Investment in Branch is maintained. This noncurrent asset account is debited for cash, mer-
chandise, and services provided to the branch by the home office, and for net income re-
ported by the branch. It is credited for cash or other assets received from the branch, and
for net losses reported by the branch. Thus, the Investment in Branch account reflects the
equity method of accounting. A separate investment account generally is maintained by the
home office for each branch. If there is only one branch, the account title is likely to be In-
vestment in Branch; if there are numerous branches, each account title includes a name or
number to identify each branch.

Expenses Incurred by Home Office

and Allocated to Branches
Some business enterprises follow a policy of notifying each branch of expenses incurred
by the home office on the branch’s behalf. As stated on page 122, plant assets located at a
branch generally are carried in the home office accounting records. If a plant asset is ac-
quired by the home office for the branch, the journal entry for the acquisition is a debit to
an appropriate asset account such as Equipment: Branch and a credit to Cash or an appro-
priate liability account. If the branch acquires a plant asset, it debits the Home Office ledger
account and credits Cash or an appropriate liability account. The home office debits an as-
set account such as Equipment: Branch and credits Investment in Branch.
The home office also usually acquires insurance, pays property and other taxes, and
arranges for advertising that benefits all branches. Clearly, such expenses as depreciation,
property taxes, insurance, and advertising must be considered in determining the prof-
itability of a branch. A policy decision must be made as to whether these expense data are
to be retained at the home office or are to be reported to the branches so that the income
statement prepared for each branch will give a complete picture of its operations. An ex-
pense incurred by the home office and allocated to a branch is recorded by the home office
by a debit to Investment in Branch and a credit to an appropriate expense ledger account;
the branch debits an expense account and credits Home Office.
If the home office does not make sales, but functions only as an accounting and
control center, most or all of its expenses may be allocated to the branches. To facilitate
comparison of the operating results of the various branches, the home office may charge
each branch interest on the capital invested in that branch. Such interest expense recog-
nized by the branches would be offset by interest revenue recognized by the home office
and would not be displayed in the combined income statement of the business enterprise
as a whole.
124 Part One Accounting for Partnerships and Branches

Alternative Methods of Billing Merchandise Shipments

to Branches
Three alternative methods are available to the home office for billing merchandise shipped
to its branches. The shipments may be billed (1) at home office cost, (2) at a percentage
above home office cost, or (3) at the branch’s retail selling price. The shipment of mer-
chandise to a branch does not constitute a sale, because ownership of the merchandise does
not change.
Billing at home office cost is the simplest procedure and is widely used. It avoids the
complication of unrealized gross profit in inventories and permits the financial statements
of branches to give a meaningful picture of operations. However, billing merchandise to
branches at home office cost attributes all gross profits of the enterprise to the branches,
even though some of the merchandise may be manufactured by the home office. Under
these circumstances, home office cost may not be the most realistic basis for billing ship-
ments to branches.
Billing shipments to a branch at a percentage above home office cost (such as 110% of
cost) may be intended to allocate a reasonable gross profit to the home office. When mer-
chandise is billed to a branch at a price above home office cost, the net income reported by
the branch is understated and the ending inventories are overstated for the enterprise as
a whole. Adjustments must be made by the home office to eliminate the excess of billed
prices over cost (intracompany profits) in the preparation of combined financial statements
for the home office and the branch.
Billing shipments to a branch at branch retail selling prices may be based on a desire to
strengthen internal control over inventories. The Inventories ledger account of the branch
shows the merchandise received and sold at retail selling prices. Consequently, the account
will show the ending inventories that should be on hand at retail prices. The home office
record of shipments to a branch, when considered along with sales reported by the branch,
provides a perpetual inventory stated at selling prices. If the physical inventories taken pe-
riodically at the branch do not agree with the amounts thus computed, an error or theft may
be indicated and should be investigated promptly.

Separate Financial Statements for Branch

and for Home Office
A separate income statement and balance sheet should be prepared for a branch so that
management of the enterprise may review the operating results and financial position of the
branch. The branch’s income statement has no unusual features if merchandise is billed to
the branch at home office cost. However, if merchandise is billed to the branch at branch re-
tail selling prices, the branch’s income statement will show a net loss approximating the
amount of operating expenses. The only unusual aspect of the balance sheet for a branch is
the use of the Home Office ledger account in lieu of the ownership equity accounts for a
separate business enterprise. The separate financial statements prepared for a branch may
be revised at the home office to include expenses incurred by the home office allocable to
the branch and to show the results of branch operations after elimination of any intracom-
pany profits on merchandise shipments.
Separate financial statements also may be prepared for the home office so that manage-
ment will be able to appraise the results of its operations and its financial position. How-
ever, it is important to emphasize that separate financial statements of the home office and
of the branch are prepared for internal use only; they do not meet the needs of investors or
other external users of financial statements.
 Chapter 4 Accounting for Branches; Combined Financial Statements 125

Combined Financial Statements for Home Office and Branch

A balance sheet for distribution to creditors, stockholders, and government agencies must
show the financial position of a business enterprise having branches as a single entity. A
convenient starting point in the preparation of a combined balance sheet consists of the ad-
justed trial balances of the home office and of the branch. A working paper for the combi-
nation of these trial balances is illustrated on page 128.
The assets and liabilities of the branch are substituted for the Investment in Branch
ledger account included in the home office trial balance. Similar accounts are combined to
produce a single total amount for cash, trade accounts receivable, and other assets and lia-
bilities of the enterprise as a whole.
In the preparation of a combined balance sheet, reciprocal ledger accounts are elimi-
nated because they have no significance when the branch and home office report as a single
entity. The balance of the Home Office account is offset against the balance of the Invest-
ment in Branch account; also, any receivables and payables between the home office and
the branch (or between two branches) are eliminated.
The operating results of the enterprise (the home office and all branches) are shown by
an income statement in which the revenue and expenses of the branches are combined with
corresponding revenue and expenses for the home office. Any intracompany profits or
losses are eliminated.

Illustrative Journal Entries for Operations of a Branch

Assume that Smaldino Company bills merchandise to Mason Branch at home office
cost and that Mason Branch maintains complete accounting records and prepares finan-
cial statements. Both the home office and the branch use the perpetual inventory sys-
tem. Equipment used at the branch is carried in the home office accounting records.
Certain expenses, such as advertising and insurance, incurred by the home office on
behalf of the branch, are billed to the branch. Transactions and events during the first
year (2005) of operations of Mason Branch are summarized below (start-up costs are
disregarded):
1. Cash of $1,000 was forwarded by the home office to Mason Branch.
2. Merchandise with a home office cost of $60,000 was shipped by the home office to
Mason Branch.
3. Equipment was acquired by Mason Branch for $500, to be carried in the home office ac-
counting records. (Other plant assets for Mason Branch generally are acquired by the
home office.)
4. Credit sales by Mason Branch amounted to $80,000; the branch’s cost of the merchan-
dise sold was $45,000.
5. Collections of trade accounts receivable by Mason Branch amounted to $62,000.
6. Payments for operating expenses by Mason Branch totaled $20,000.
7. Cash of $37,500 was remitted by Mason Branch to the home office.
8. Operating expenses incurred by the home office and charged to Mason Branch totaled
$3,000.
126 Part One Accounting for Partnerships and Branches

These transactions and events are recorded by the home office and by Mason Branch as
follows (explanations for the journal entries are omitted):
Home Office Accounting Records

Typical Home Office Home Office Accounting Records Mason Branch Accounting Records
and Branch Journal Entries Journal Entries
Transactions and
Events (Perpetual (1) Investment in Mason Cash 1,000
Inventory System) Branch 1,000 Home Office 1,000
Cash 1,000

(2) Investment in Mason Inventories 60,000

Branch 60,000 Home Office 60,000
Inventories 60,000

(3) Equipment: Mason Home Office 500

Branch 500 Cash 500
Investment in
Mason Branch 500

(4) None Trade Accounts

Receivable 80,000
Cost of Goods Sold 45,000
Sales 80,000
Inventories 45,000

(5) None Cash 62,000

Trade
Accounts
Receivable 62,000

(6) None Operating

Expenses 20,000
Cash 20,000

(7) Cash 37,500 Home Office 37,500

Investment in Cash
Mason Branch 37,500 37,500

(8) Investment in Mason Operating

Branch 3,000 Expenses 3,000
Operating Home Office 3,000
Expenses 3,000

If a branch obtains merchandise from outsiders as well as from the home office, the mer-
chandise acquired from the home office may be recorded in a separate Inventories from
Home Office ledger account.
In the home office accounting records, the Investment in Mason Branch ledger ac-
count has a debit balance of $26,000 [before the accounting records are closed and the
branch net income of $12,000 ($80,000 $45,000 $20,000 $3,000 $12,000) is
transferred to the Investment in Mason Branch ledger account], as illustrated on the
next page.
 Chapter 4 Accounting for Branches; Combined Financial Statements 127

Reciprocal Ledger Investment in Mason Branch

Account in Accounting
Date Explanation Debit Credit Balance
Records of Home
Office Prior to Equity- 2005 Cash sent to branch 1,000 1,000 dr
Method Adjusting Merchandise billed to branch at home
Entry office cost 60,000 61,000 dr
Equipment acquired by branch, carried in
home office accounting records 500 60,500 dr
Cash received from branch 37,500 23,000 dr
Operating expenses billed to branch 3,000 26,000 dr

In the accounting records of Mason Branch, the Home Office ledger account has a credit
balance of $26,000 (before the accounting records are closed and the net income of
$12,000 is transferred to the Home Office account), as shown below:
Home Office

Reciprocal Ledger Home Office

Account in Accounting
Date Explanation Debit Credit Balance
Records of Mason
Branch Prior to 2005 Cash received from home office 1,000 1,000 cr
Closing Entry Merchandise received from home office 60,000 61,000 cr
Equipment acquired 500 60,500 cr
Cash sent to home office 37,500 23,000 cr
Operating expenses billed by home office 3,000 26,000 cr

Working Paper for Combined Financial Statements

A working paper for combined financial statements has three purposes: (1) to combine
ledger account balances for like revenue, expenses, assets, and liabilities, (2) to eliminate
any intracompany profits or losses, and (3) to eliminate the reciprocal accounts.
Assume that the perpetual inventories of $15,000 ($60,000 $45,000 $15,000) at
the end of 2005 for Mason Branch had been verified by a physical count. The working
paper illustrated on page 128 for Smaldino Company is based on the transactions and
events illustrated on pages 125 and 126 and additional assumed data for the home office
trial balance. All the routine year-end adjusting entries (except the home office entries on
page 130) are assumed to have been made, and the working paper is begun with the ad-
justed trial balances of the home office and Mason Branch. Income taxes are disregarded
in this illustration.
Note that the $26,000 debit balance of the Investment in Mason Branch ledger ac-
count and the $26,000 credit balance of the Home Office account are the balances before
the respective accounting records are closed, that is, before the $12,000 net income of
Mason Branch is entered in these two reciprocal accounts. In the Eliminations column,
elimination (a) offsets the balance of the Investment in Mason Branch account against
the balance of the Home Office account. This elimination appears in the working paper
only; it is not entered in the accounting records of either the home office or Mason
Branch because its only purpose is to facilitate the preparation of combined financial
statements.
128 Part One Accounting for Partnerships and Branches

Combined Financial Statements Illustrated

The following working paper provides the information for the combined financial state-
ments (excluding a statement of cash flows) of Smaldino Company on page 129.

SMALDINO COMPANY
Working Paper for Combined Financial Statements of Home Office and Mason Branch
For Year Ended December 31, 2005
(Perpetual Inventory System: Billings at Cost)

Adjusted Trial Balances

Home Office Mason Branch Eliminations Combined
Dr (Cr) Dr (Cr) Dr (Cr) Dr (Cr)
Income Statement
Sales (400,000) (80,000) (480,000)
Cost of goods sold 235,000 45,000 280,000
Operating expenses 90,000 23,000 113,000
Net income (to statement of retained earnings
below) 75,000 12,000 87,000
Totals -0- -0- -0-
Statement of Retained Earnings
Retained earnings, beginning of year (70,000) (70,000)
Net (income) (from income statement above) (75,000) (12,000) (87,000)
Dividends declared 40,000 40,000
Retained earnings, end of year (to balance
sheet below) 117,000
Totals -0-
Balance Sheet
Cash 25,000 5,000 30,000
Trade accounts receivable (net) 39,000 18,000 57,000
Inventories 45,000 15,000 60,000
Investment in Mason Branch 26,000 (a) (26,000)
Equipment 150,000 150,000
Accumulated depreciation of equipment (10,000) (10,000)
Trade accounts payable (20,000) (20,000)
Home office (26,000) (a) 26,000
Common stock, $10 par (150,000) (150,000)
Retained earnings (from statement of retained
earnings above) (117,000)
Totals -0- -0- -0- -0-

(a) To eliminate reciprocal ledger account balances.

 Chapter 4 Accounting for Branches; Combined Financial Statements 129

SMALDINO COMPANY
Income Statement
For Year Ended December 31, 2005

Sales $480,000
Cost of goods sold 280,000
Gross margin on sales $200,000
Operating expenses 113,000
Net income $ 87,000
Basic earnings per share of common stock $ 5.80

SMALDINO COMPANY
Statement of Retained Earnings
For Year Ended December 31, 2005

Retained earnings, beginning of year $ 70,000

Add: Net income 87,000
Subtotal $157,000
Less: Dividends ($2.67 per share) 40,000
Retained earnings, end of year $117,000

SMALDINO COMPANY
Balance Sheet
December 31, 2005

Assets
Cash $ 30,000
Trade accounts receivable (net) 57,000
Inventories 60,000
Equipment $150,000
Less: Accumulated depreciation 10,000 140,000
Total assets $287,000

Liabilities and Stockholders’ Equity

Liabilities
Trade accounts payable $ 20,000
Stockholders’ equity
Common stock, $10 par, 15,000 shares authorized,
issued, and outstanding $150,000
Retained earnings 117,000 267,000
Total liabilities and stockholders’ equity $287,000

Home Office Adjusting and Closing Entries and Branch Closing Entries
The home office’s equity-method adjusting and closing entries for branch operating results
and the branch’s closing entries on December 31, 2005, are as follows (explanations for the
entries are omitted):
130 Part One Accounting for Partnerships and Branches

Adjusting and Closing Home Office Accounting Records Mason Branch Accounting Records
Entries (Perpetual Adjusting and Closing Entries Closing Entries
Inventory System)
None Sales 80,000
Cost of Goods
Sold 45,000
Operating
Expenses 23,000
Income
Summary 12,000

Investment in Mason Income Summary 12,000

Branch 12,000 Home Office 12,000
Income: Mason
Branch 12,000

Income: Mason Branch 12,000 None

Income
Summary 12,000

Billing of Merchandise to Branches at Prices

above Home Office Cost
As stated on page 124, the home offices of some business enterprises bill merchandise
shipped to branches at home office cost plus a markup percentage (or alternatively at
branch retail selling prices). Because both these methods involve similar modifications of
accounting procedures, a single example illustrates the key points involved, using the illus-
tration for Smaldino Company on pages 125 and 126 with one changed assumption: the
home office bills merchandise shipped to Mason Branch at a markup of 50% above home
office cost, or 331⁄3% of billed price.2
Under this assumption, the journal entries for the first year’s events and transactions by
the home office and Mason Branch are the same as those presented on page 126, except for
the journal entries for shipments of merchandise from the home office to Mason Branch.
These shipments ($60,000 cost 50% markup on cost $90,000) are recorded under the
perpetual inventory system as follows:

Journal Entries for Home Office Accounting Records Mason Branch Accounting Records
Shipments to Branch Journal Entries Journal Entries
at Prices above Home
Office Cost (Perpetual (2) Investment in Mason Inventories 90,000
Inventory System) Branch 90,000 Home Office 90,000
Inventories 60,000
Allowance for
Overvaluation
of Inventories:
Mason Branch 30,000

In the accounting records of the home office, the Investment in Mason Branch ledger
account on page 131 now has a debit balance of $56,000 before the accounting records
are closed and the branch net income or loss is entered in the Investment in Mason
2
Billed price cost 0.50 cost; therefore, markup on billed price is 0.50/(1 0.50), or 331⁄3%.
 Chapter 4 Accounting for Branches; Combined Financial Statements 131

Branch account. This account is $30,000 larger than the $26,000 balance in the prior illus-
tration (page 127). The increase represents the 50% markup over cost ($60,000) of the mer-
chandise shipped to Mason Branch.

Reciprocal Ledger Investment in Mason Branch

Account in Accounting
Date Explanation Debit Credit Balance
Records of Home
Office, Prior to Equity- 2005 Cash sent to branch 1,000 1,000 dr
Method Adjusting Merchandise billed to branch at markup
Entry of 50% over home office cost, or
331⁄3% of billed price 90,000 91,000 dr
Equipment acquired by branch, carried in
home office accounting records 500 90,500 dr
Cash received from branch 37,500 53,000 dr
Operating expenses billed to branch 3,000 56,000 dr

In the accounting records of Mason Branch, the Home Office ledger account now has a
credit balance of $56,000, before the accounting records are closed and the branch net in-
come or loss is entered in the Home Office account, as illustrated below:

Reciprocal Ledger Home Office

Account in Accounting
Date Explanation Debit Credit Balance
Records of Mason
Branch Prior to 2005 Cash received from home office 1,000 1,000 cr
Closing Entry Merchandise received from home office 90,000 91,000 cr
Equipment acquired 500 90,500 cr
Cash sent to home office 37,000 53,000 cr
Operating expenses billed by home office 3,000 56,000 cr

Mason Branch recorded the merchandise received from the home office at billed prices
of $90,000; the home office recorded the shipment by credits of $60,000 to Inventories and
$30,000 to Allowance for Overvaluation of Inventories: Mason Branch. Use of the al-
lowance account enables the home office to maintain a record of the cost of merchandise
shipped to Mason Branch as well as the amount of the unrealized gross profit on the
shipments.
At the end of the accounting period, Mason Branch reports its inventories (at billed
prices) at $22,500. The cost of these inventories is $15,000 ($22,500 1.50 $15,000).
In the home office accounting records, the required balance of the Allowance for Overval-
uation of Inventories: Mason Branch ledger account is $7,500 ($22,500 $15,000
$7,500); thus, this account balance must be reduced from its present amount of $30,000 to
$7,500. The reason for this reduction is that the 50% markup of billed prices over cost has
become realized gross profit to the home office with respect to the merchandise sold by
the branch. Consequently, at the end of the year the home office reduces its allowance for
overvaluation of the branch inventories to the $7,500 excess valuation contained in the end-
ing inventories. The debit adjustment of $22,500 in the allowance account is offset by a
credit to the Realized Gross Profit: Mason Branch Sales account, because it represents ad-
ditional gross profit of the home office resulting from sales by the branch.
These matters are illustrated in the home office end-of-period adjusting and closing en-
tries on page 134.
132 Part One Accounting for Partnerships and Branches

Working Paper When Billings to Branches Are

at Prices above Cost
When a home office bills merchandise shipments to branches at prices above home office
cost, preparation of the working paper for combined financial statements is facilitated by an
analysis of the flow of merchandise to a branch, such as the following for Mason Branch of
Smaldino Company:

SMALDINO COMPANY
Flow of Merchandise for Mason Branch
During 2005

Home Markup
Office (50% of Cost;
Billed Price Cost 331⁄3% of Billed Price)
Beginning inventories
Add: Shipments from home office $90,000 $60,000 $30,000
Available for sale $90,000 $60,000 $30,000
Less: Ending inventories 22,500 15,000 7,500
Cost of goods sold $67,500 $45,000 $22,500

The Markup column in the foregoing analysis provides the information needed for the
Eliminations column in the working paper for combined financial statements below and on
page 133.

SMALDINO COMPANY
Working Paper for Combined Financial Statements of Home Office and Mason Branch
For Year Ended December 31, 2005
(Perpetual Inventory System: Billings above Cost)

Adjusted Trial Balances

Home Office Mason Branch Eliminations Combined
Dr (Cr) Dr (Cr) Dr (Cr) Dr (Cr)
Income Statement
Sales (400,000) (80,000) (480,000)
Cost of goods sold 235,000 67,500 (a) (22,500) 280,000
Operating expenses 90,000 23,000 113,000
Net income (loss) (to statement of retained
earnings below) 75,000 (10,500) (b) 22,500 87,000
Totals -0- -0- -0-
Statement of Retained Earnings
Retained earnings, beginning of year (70,000) (70,000)
Net (income) loss (from income statement
above) (75,000) 10,500 (b) (22,500) (87,000)
Dividends declared 40,000 40,000
Retained earnings, end of year (to
balance sheet on page 133) 117,000
Totals -0-
(continued)
 Chapter 4 Accounting for Branches; Combined Financial Statements 133

SMALDINO COMPANY
Working Paper for Combined Financial Statements of Home Office and Mason Branch (concluded)
For Year Ended December 31, 2005
(Perpetual Inventory System: Billings above Cost)

Adjusted Trial Balances

Home Office Mason Branch Eliminations Combined
Dr (Cr) Dr (Cr) Dr (Cr) Dr (Cr)
Balance Sheet
Cash 25,000 5,000 30,000
Trade accounts receivable (net) 39,000 18,000 57,000
Inventories 45,000 22,500 (a) (7,500) 60,000
Investment in Mason Branch 56,000 (c) (56,000)
Allowance for overvaluation of inventories:
Mason Branch (30,000) (a) 30,000
Equipment 150,000 150,000
Accumulated depreciation of equipment (10,000) (10,000)
Trade accounts payable (20,000) (20,000)
Home office (56,000) (c) 56,000
Common stock, $10 par (150,000) (150,000)
Retained earnings (from statement of
retained earnings on page 132) (117,000)
Totals -0- -0- -0- -0-

(a) To reduce ending inventories and cost of goods sold of branch to cost, and to eliminate unadjusted balance of Allowance of Overvaluation of Inventories: Mason Branch
ledger account.
(b) To increase income of home office by portion of merchandise markup that was realized by branch sales.
(c) To eliminate reciprocal ledger account balances.

The foregoing working paper differs from the working paper on page 128 by the inclu-
sion of an elimination to restate the ending inventories of the branch to cost. Also, the in-
come reported by the home office is adjusted by the $22,500 of merchandise markup that
was realized as a result of sales by the branch. As stated on page 127, the amounts in the
Eliminations column appear only in the working paper. The amounts represent a mechani-
cal step to aid in the preparation of combined financial statements and are not entered in the
accounting records of either the home office or the branch.

Combined Financial Statements

Because the amounts in the Combined column of the working paper on page 132 and above
are the same as in the working paper prepared when the merchandise shipments to the
branch were billed at home office cost, the combined financial statements are identical to
those illustrated on page 129.

Home Office Adjusting and Closing Entries and Branch Closing Entries
The December 31, 2005, adjusting and closing entries of the home office are illustrated on
page 134.
134 Part One Accounting for Partnerships and Branches

End-of-Period Home Home Office Accounting Records Adjusting

Office Adjusting and and Closing Entries
Closing Entries
Income: Mason Branch 10,500
Investment in Mason Branch 10,500
To record net loss reported by branch.

Allowance for Overvaluation of Inventories: Mason Branch 22,500

Realized Gross Profit: Mason Branch Sales 22,500
To reduce allowance to amount by which ending inventories of
branch exceed cost.

Realized Gross Profit: Mason Branch Sales 22,500

Income: Mason Branch 10,500
Income Summary 12,000
To close branch net loss and realized gross profit to Income Summary
ledger account. (Income tax effects are disregarded.)

After the foregoing journal entries have been posted, the ledger accounts in the home of-
fice general ledger used to record branch operations are as follows:

End-of-Period Investment in Mason Branch

Balances in
Date Explanation Debit Credit Balance
Accounting Records
of Home Office 2005 Cash sent to branch 1,000 1,000 dr
Merchandise billed to branch at markup
of 50% above home office cost, or
331⁄3% of billed price 90,000 91,000 dr
Equipment acquired by branch,
carried in home office accounting
records 500 90,500 dr
Cash received from branch 37,500 53,000 dr
Operating expenses billed to branch 3,000 56,000 dr
Net loss for 2005 reported by branch 10,500 45,500 dr

Allowance for Overvaluation of Inventories: Mason Branch

Date Explanation Debit Credit Balance
2005 Markup on merchandise shipped to
branch during 2005 (50% of cost) 30,000 30,000 cr
Realization of 50% markup on mer-
chandise sold by branch during
2005 22,500 7,500 cr
(continued)
 Chapter 4 Accounting for Branches; Combined Financial Statements 135

End-of-Period Realized Gross Profit: Mason Branch Sales

Balances in
Date Explanation Debit Credit Balance
Accounting Records
of Home Office 2005 Realization of 50% markup on mer-
(concluded) chandise sold by branch during 2005 22,500 22,500 cr
Closing entry 22,500 -0-

Income: Mason Branch

Date Explanation Debit Credit Balance
2005 Net loss for 2005 reported by branch 10,500 10,500 dr
Closing entry 10,500 -0-

In the separate balance sheet for the home office, the $7,500 credit balance of the Al-
lowance of Overvaluation of Inventories: Mason Branch ledger account is deducted from
the $45,500 debit balance of the Investment in Mason Branch account, thus reducing the
carrying amount of the investment account to a cost basis with respect to shipments of mer-
chandise to the branch. In the separate income statement for the home office, the $22,500
realized gross profit on Mason Branch sales may be displayed following gross margin on
sales, $165,000 ($400,000 sales $235,000 cost of goods sold $165,000).
The closing entries for the branch at the end of 2005 are as follows:

Closing Entries for Mason Branch Accounting Records

Mason Branch Closing Entries
(Perpetual Inventory
System) Sales 80,000
Income Summary 10,500
Cost of Goods Sold 67,500
Operating Expenses 23,000
To close revenue and expense ledger accounts.

Home Office 10,500

Income Summary 10,500
To close the net loss in the Income Summary account to the
Home Office account.

After these closing entries have been posted by the branch, the following Home Office
ledger account in the accounting records of Mason Branch has a credit balance of $45,500,
the same as the debit balance of the Investment in Mason Branch account in the accounting
records of the home office:

Compare this Ledger Home Office

Account with
Date Explanation Debit Credit Balance
Investment in Mason
Branch Account 2005 Cash received from home office 1,000 1,000 cr
Merchandise received from home office 90,000 91,000 cr
Equipment acquired 500 90,500 cr
Cash sent to home office 37,500 53,000 cr
Operating expenses billed by home office 3,000 56,000 cr
Net loss for 2005 10,500 45,500 cr
136 Part One Accounting for Partnerships and Branches

Treatment of Beginning Inventories Priced above Cost

The working paper on pages 132–133 shows how the ending inventories and the re-
lated allowance for overvaluation of inventories were handled. However, because
2005 was the first year of operations for Mason Branch, no beginning inventories were
involved.

Perpetual Inventory System

Under the perpetual inventory system, no special problems arise when the beginning in-
ventories of the branch include an element of unrealized gross profit. The working paper
eliminations would be similar to those illustrated on pages 132–133.

Periodic Inventory System

The illustration of a second year of operations (2006) of Smaldino Company demon-
strates the handling of beginning inventories carried by Mason Branch at an amount
above home office cost. However, assume that both the home office and Mason Branch
adopted the periodic inventory system in 2006. When the periodic inventory system is
used, the home office credits Shipments to Branch (an offset account to Purchases) for
the home office cost of merchandise shipped and Allowance for Overvaluation of In-
ventories for the markup over home office cost. The branch debits Shipments from
Home Office (analogous to a Purchases account) for the billed price of merchandise
received.
The beginning inventories for 2006 were carried by Mason Branch at $22,500, or 150%
of the cost of $15,000 ($15,000 1.50 $22,500). Assume that during 2006 the home
office shipped merchandise to Mason Branch that cost $80,000 and was billed at $120,000,
and that Mason Branch sold for $150,000 merchandise that was billed at $112,500. The
journal entries (explanations omitted) to record the shipments and sales under the periodic
inventory system are illustrated below:

Journal Entries for Home Office Accounting Records Mason Branch Accounting Records
Shipments to Branch Journal Entries Journal Entries
at a Price above Home
Office Cost (Periodic Investment in Mason Shipments from
Inventory System) Branch 120,000 Home Office 120,000
Shipments to Home office 120,000
Mason Branch 80,000
Allowance for
Overvaluation
of Inventories:
Mason Branch 40,000

None Cash (or Trade

Accounts
Receivable) 150,000
Sales 150,000

The branch inventories at the end of 2006 amounted to $30,000 at billed prices, repre-
senting cost of $20,000 plus a 50% markup on cost ($20,000 1.50 $30,000). The flow
of merchandise for Mason Branch during 2006 is summarized on page 137.
 Chapter 4 Accounting for Branches; Combined Financial Statements 137

SMALDINO COMPANY
Flow of Merchandise for Mason Branch
During 2006

Home Markup
Office (50% of Cost;
Billed Price Cost 331⁄3% of Billed Price)
Beginning inventories (from
page 132) $ 22,500 $ 15,000 $ 7,500
Add: Shipments from home
office 120,000 80,000 40,000
Available for sale $142,500 $ 95,000 $ 47,500
Less: Ending inventories (30,000) (20,000) (10,000)
Cost of goods sold $112,500 $ 75,000 $ 37,500

The activities of the branch for 2006 and end-of-period adjusting and closing entries are
reflected in the four home office ledger accounts below and on page 138.

End-of-Period Investment in Mason Branch

Balances in
Date Explanation Debit Credit Balance
Accounting Records
of Home Office 2006 Balance, Dec. 31, 2005 (from page 134) 45,500 dr
Merchandise billed to branch at markup
of 50% above home office cost, or
331⁄3% of billed price 120,000 165,500 dr
Cash received from branch 113,000 52,500 dr
Operating expenses billed to branch 4,500 57,000 dr
Net income for 2006 reported by
branch 10,000 67,000 dr

Allowance for Overvaluation of Inventories: Mason Branch

Date Explanation Debit Credit Balance
2006 Balance, Dec. 31, 2005 (from page 134) 7,500 cr
Markup on merchandise shipped to
branch during 2006 (50% of cost) 40,000 47,500 cr
Realization of 50% markup on
merchandise sold by branch during
2006 37,500 10,000 cr

Realized Gross Profit: Mason Branch Sales

Date Explanation Debit Credit Balance
2006 Realization of 50% markup on
merchandise sold by branch during
2006 37,500 37,500 cr
Closing entry 37,500 -0-
(continued)
138 Part One Accounting for Partnerships and Branches

End-of-Period Income: Mason Branch

Balances in
Date Explanation Debit Credit Balance
Accounting Records
of Home Office 2006 Net income for 2006 reported by
(concluded) branch 10,000 10,000 cr
Closing entry 10,000 -0-

In the accounting records of the home office at the end of 2006, the balance required in
the Allowance for Overvaluation of Inventories: Mason Branch ledger account is $10,000,
that is, the billed price of $30,000 less cost of $20,000 for merchandise in the branch’s end-
ing inventories. Therefore, the allowance account balance is reduced from $47,500 to
$10,000. This reduction of $37,500 represents the 50% markup on merchandise above cost
that was realized by Mason Branch during 2006 and is credited to the Realized Gross
Profit: Mason Branch Sales account.
The Home Office account in the branch general ledger shows the following activity and
closing entry for 2006:

Reciprocal Ledger Home Office

Account in Accounting
Date Explanation Debit Credit Balance
Records of Mason
Branch 2006 Balance, Dec. 31, 2005 (from page 135) 45,500 cr
Merchandise received from home office 120,000 165,500 cr
Cash sent to home office 113,000 52,500 cr
Operating expenses billed by home office 4,500 57,000 cr
Net income for 2006 10,000 67,000 cr

The working paper for combined financial statements under the periodic inventory sys-
tem, which reflects pre-adjusting and pre-closing balances for the reciprocal ledger ac-
counts and the Allowance for Overvaluation of Inventories: Mason Branch account, is on
page 139.

Reconciliation of Reciprocal Ledger Accounts

At the end of an accounting period, the balance of the Investment in Branch ledger account
in the accounting records of the home office may not agree with the balance of the Home
Office account in the accounting records of the branch because certain transactions may
have been recorded by one office but not by the other. The situation is comparable to that of
reconciling the ledger account for Cash in Bank with the balance in the monthly bank state-
ment. The lack of agreement between the reciprocal ledger account balances causes no
difficulty during an accounting period, but at the end of each period the reciprocal account
balances must be brought into agreement before combined financial statements are
prepared.
As an illustration of the procedure for reconciling reciprocal ledger account balances at
year-end, assume that the home office and branch accounting records of Mercer Company
on December 31, 2005, contain the data on page 140.
 Chapter 4 Accounting for Branches; Combined Financial Statements 139

SMALDINO COMPANY
Working Paper for Combined Financial Statements of Home Office and Mason Branch
For Year Ended December 31, 2006
(Periodic Inventory System: Billings above Cost)

Adjusted Trial Balances

Home Office Mason Branch Eliminations Combined
Dr (Cr) Dr (Cr) Dr (Cr) Dr (Cr)
Income Statement
Sales (500,000) (150,000) (650,000)
Inventories, Dec. 31, 2005 45,000 22,500 (b) (7,500) 60,000
Purchases 400,000 400,000
Shipments to Mason Branch (80,000) (a) 80,000
Shipments from home office 120,000 (a) (120,000)
Inventories, Dec. 31, 2006 (70,000) (30,000) (c) 10,000 (90,000)
Operating expenses 120,000 27,500 147,500
Net income (to statement of retained
earnings below) 85,000 10,000 (d) 37,500 132,500
Totals -0- -0- -0-
Statement of Retained Earnings
Retained earnings, beginning of year
(from page 132) (117,000) (117,000)
Net (income) (from income statement above) (85,000) (10,000) (d ) (37,500) (132,500)
Dividends declared 60,000 60,000
Retained earnings, end of year (to balance
sheet below) 189,500
Total -0-
Balance Sheet
Cash 30,000 9,000 39,000
Trade accounts receivable (net) 64,000 28,000 92,000
Inventories, Dec. 31, 2006 70,000 30,000 (c) (10,000) 90,000
Allowance for overvaluation of inventories:
b r
Mason Branch (47,500) (a) 40,000
(b) 7,500
Investment in Mason Branch 57,000 (e) (57,000)
Equipment 158,000 158,000
Accumulated depreciation of equipment (15,000) (15,000)
Trade accounts payable (24,500) (24,500)
Home office (57,000) (e) 57,000
Common stock, $10 par (150,000) (150,000)
Retained earnings (from statement of
retained earnings above) (189,500)
Totals -0- -0- -0- -0-

(a) To eliminate reciprocal ledger accounts for merchandise shipments.

(b) To reduce beginning inventories of branch to cost.
(c) To reduce ending inventories of branch to cost.
(d) To increase income of home office by portion of merchandise markup that was realized by branch sales.
(e) To eliminate reciprocal ledger account balances.
140 Part One Accounting for Partnerships and Branches

Reciprocal Ledger Investment in Arvin Branch (in accounting records of Home Office)
Accounts before
Date Explanation Debit Credit Balance
Adjustments
2005
Nov. 30 Balance 62,500 dr
Dec. 10 Cash received from branch 20,000 42,500 dr
27 Collection of branch trade accounts
receivable 1,000 41,500 dr
29 Merchandise shipped to branch 8,000 49,500 dr

Home Office (in accounting records of Arvin Branch)

Date Explanation Debit Credit Balance
2005
Nov. 30 Balance 62,500 cr
Dec. 7 Cash sent to home office 20,000 42,500 cr
28 Acquired equipment 3,000 39,500 cr
30 Collection of home office trade
accounts receivable 2,000 41,500 cr

Comparison of the two reciprocal ledger accounts discloses four reconciling items,
described as follows:
1. A debit of $8,000 in the Investment in Arvin Branch ledger account without a re-
lated credit in the Home Office account.
On December 29, 2005, the home office shipped merchandise costing $8,000 to the
branch. The home office debits its reciprocal ledger account with the branch on the date
merchandise is shipped, but the branch credits its reciprocal account with the home of-
fice when the merchandise is received a few days later. The required journal entry on
December 31, 2005, in the branch accounting records, assuming use of the perpetual
inventory system, appears below:

Branch Journal Entry Inventories in Transit 8,000

for Merchandise in Home Office 8,000
Transit from Home To record shipment of merchandise in transit from home office.
Office

In taking a physical inventory on December 31, 2005, the branch personnel must add
to the inventories on hand the $8,000 of merchandise in transit. When the merchandise
is received in 2006, the branch debits Inventories and credits Inventories in Transit.
2. A credit of $1,000 in the Investment in Arvin Branch ledger account without a re-
lated debit in the Home Office account.
On December 27, 2005, trade accounts receivable of the branch were collected by the
home office. The collection was recorded by the home office by a debit to Cash and a
credit to Investment in Arvin Branch. No journal entry had been made by Arvin Branch;
therefore, the following journal entry is required in the accounting records of Arvin
Branch on December 31, 2005:

Branch Journal Entry Home Office 1,000

for Trade Accounting Trade Accounts Receivable 1,000
Receivable Collected To record collection of accounts receivable by home office.
by Home Office
 Chapter 4 Accounting for Branches; Combined Financial Statements 141

3. A debit of $3,000 in the Home Office ledger account without a related credit in the
Investment in Arvin Branch account.
On December 28, 2005, the branch acquired equipment for $3,000. Because the equip-
ment used by the branch is carried in the accounting records of the home office, the jour-
nal entry made by the branch was a debit to Home Office and a credit to Cash. No
journal entry had been made by the home office; therefore, the following journal entry
is required on December 31, 2005, in the accounting records of the home office:

Home Office Journal Equipment: Arvin Branch 3,000

Entry for Equipment Investment in Arvin Branch 3,000
Acquired by Branch To record equipment acquired by branch.

4. A credit of $2,000 in the Home Office ledger account without a related debit in the
Investment in Arvin Branch account.
On December 30, 2005, trade accounts receivable of the home office were collected
by Arvin Branch. The collection was recorded by Arvin Branch by a debit to Cash and a
credit to Home Office. No journal entry had been made by the home office; therefore,
the following journal entry is required in the accounting records of the home office on
December 31, 2005:

Home Office Journal Investment in Arvin Branch 2,000

Entry for Trade Trade Accounts Receivable 2,000
Accounts Receivable To record collection of accounts receivable by Arvin Branch.
Collected by Branch

The effect of the foregoing end-of-period journal entries is to update the reciprocal
ledger accounts, as shown by the following reconciliation:

MERCER COMPANY—HOME OFFICE AND ARVIN BRANCH

Reconciliation of Reciprocal Ledger Accounts
December 31, 2005

Investment in Arvin Home Office

Branch Account Account
(in home office (in branch
accounting records) accounting records)
Balances before adjustments $49,500 dr $41,500 cr
Add: (1) Merchandise shipped to
branch by home office 8,000
(4) Home office trade accounts
receivable collected by
branch 2,000
Less: (2) Branch trade accounts
receivable collected by
home office (1,000)
(3) Equipment acquired by
branch (3,000)
Adjusted balances $48,500 dr $48,500 cr
142 Part One Accounting for Partnerships and Branches

Transactions between Branches

Efficient operations may on occasion require that merchandise or other assets be transferred
from one branch to another. Generally, a branch does not carry a reciprocal ledger account
with another branch but records the transfer in the Home Office ledger account. For exam-
ple, if Alba Branch ships merchandise to Boro Branch, Alba Branch debits Home Office
and credits Inventories (assuming that the perpetual inventory system is used). On receipt
of the merchandise, Boro Branch debits Inventories and credits Home Office. The home of-
fice records the transfer between branches by a debit to Investment in Boro Branch and a
credit to Investment in Alba Branch.
The transfer of merchandise from one branch to another does not justify increasing the
carrying amount of inventories by the freight costs incurred because of the indirect routing.
The amount of freight costs properly included in inventories at a branch is limited to the
cost of shipping the merchandise directly from the home office to its present location. Ex-
cess freight costs are recognized as expenses of the home office.
To illustrate the accounting for excess freight costs on interbranch transfers of mer-
chandise, assume the following data. The home office shipped merchandise costing $6,000
to Dana Branch and paid freight costs of $400. Subsequently, the home office instructed
Dana Branch to transfer this merchandise to Evan Branch. Freight costs of $300 were paid
by Dana Branch to carry out this order. If the merchandise had been shipped directly from
the home office to Evan Branch, the freight costs would have been $500. The journal en-
tries required in the three sets of accounting records (assuming that the perpetual inventory
system is used) are as follows:

In Accounting Records of Home Office:

Investment in Dana Branch 6,400

Inventories 6,000
Cash 400
To record shipment of merchandise and payment of freight costs.

Investment in Evan Branch 6,500

Excess Freight Expense—Interbranch Transfers 200
Investment in Dana Branch 6,700
To record transfer of merchandise from Dana Branch to Evan Branch under
instruction of home office. Interbranch freight of $300 paid by Dana
Branch caused total freight costs on this merchandise to exceed direct
shipment costs by $200 ($400 $300 $500 $200).

In Accounting Records of Dana Branch:

Freight In (or Inventories) 400

Inventories 6,000
Home Office 6,400
To record receipt of merchandise from home office with freight costs paid
in advance by home office.
 Chapter 4 Accounting for Branches; Combined Financial Statements 143

Home Office 6,700

Inventories 6,000
Freight In (or Inventories) 400
Cash 300
To record transfer of merchandise to Evan Branch under instruction of home
office and payment of freight costs of $300.

In Accounting Records of Evan Branch:

Inventories 6,000
Freight In (or Inventories) 500
Home Office 6,500
To record receipt of merchandise from Dana Branch transferred under
instruction of home office and normal freight costs billed by home office.

Recognizing excess freight costs on merchandise transferred from one branch to another
as expenses of the home office is an example of the accounting principle that expenses and
losses should be given prompt recognition. The excess freight costs from such shipments
generally result from inefficient planning of original shipments and should not be included
in inventories.
In recognizing excess freight costs of interbranch transfers as expenses attributable to
the home office, the assumption was that the home office makes the decisions directing all
shipments. If branch managers are given authority to order transfers of merchandise be-
tween branches, the excess freight costs are recognized as expenses attributable to the
branches whose managers authorized the transfers.

SEC ENFORCEMENT ACTION DEALING WITH

WRONGFUL APPLICATION OF ACCOUNTING
STANDARDS FOR DIVISIONS
The SEC’s AAER 35, “Securities and Exchange Commission v. Stauffer Chemical Com-
pany” (August 13, 1984), describes a federal court’s entry of a permanent injunction
against a corporation engaged in the manufacture and sale of chemicals and chemical-
related products. The SEC found that the corporation had overstated its earnings by means
of three major misstatements, one of which was the failure to eliminate $1.1 million of in-
tracompany profits in inventories shipped from one of the corporation’s divisions to another
division. The court also ordered the corporation to file timely with the SEC a Form 8-K,
“Current Report,” describing its restatement of its previously reported revenue and earnings
for the effects of the three major misstatements.

Review 1. Some branches maintain complete accounting records and prepare financial state-
ments much the same as an autonomous business enterprise. Other branches perform
Questions
only limited accounting functions, with most accounting activity concentrated in the
home office. Assuming that a branch has a complete set of accounting records, what
criterion or principle would you suggest be used in deciding whether various types of
144 Part One Accounting for Partnerships and Branches

expenses applicable to the branch should be recognized by the home office or by the
branch?
2. Explain the use of reciprocal ledger accounts in home office and branch accounting
systems in conjunction with the periodic inventory system.
3. The president of Sandra Company informs you that a branch is being opened and
requests your advice: “I have been told that we may bill merchandise shipped to the
branch at cost, at branch retail selling prices, or anywhere in between. Do certified pub-
lic accountants really have that much latitude in the application of generally accepted
accounting principles?”
4. Jesse Corporation operates 10 branches in addition to its home office and bills mer-
chandise shipped by the home office to the branches at 10% above home office cost. All
plant assets are carried in the home office accounting records. The home office also con-
ducts an advertising program that benefits all branches. Each branch maintains its own
accounting records and prepares separate financial statements. In the home office, the
accounting department prepares financial statements for the home office and combined
financial statements for the enterprise as a whole.
Explain the purpose of the financial statements prepared by the branches, the home
office financial statements, and the combined financial statements.
5. The accounting policies of Armenia Company provide that equipment used by its
branches is to be carried in the accounting records of the home office. Acquisitions of
new equipment may be made either by the home office or by the branches with the ap-
proval of the home office. Slauson Branch, with the approval of the home office, ac-
quired equipment at a cost of $17,000. Describe the journal entries for the Slauson
Branch and the home office to record the acquisition of the equipment.
6. Explain the use of and journal entries for a home office’s Allowance for Overvaluation
of Inventories: Branch ledger account.
7. The reciprocal ledger account balances of Meadow Company’s branch and home office
are not in agreement at year-end. What factors might have caused this?
8. Ralph Company operates a number of branches but centralizes its accounting records in
the home office and maintains control of branch operations. The home office found that
Ford Branch had an ample supply of a certain item of merchandise but that Gates
Branch was almost out of the item. Therefore, the home office instructed Ford Branch to
ship merchandise with a cost of $5,000 to Gates Branch. What journal entry should Ford
Branch make, and what principle should guide the treatment of freight costs? (Assume
that Ford Branch uses the perpetual inventory system.)

Exercises
(Exercise 4.1) Select the best answer for each of the following multiple-choice questions:
1. May the Investment in Branch ledger account of a home office be accounted for by the:

Cost Method of Equity Method of

Accounting? Accounting?
a. Yes Yes
b. Yes No
c. No Yes
d. No No
 Chapter 4 Accounting for Branches; Combined Financial Statements 145

2. Which of the following generally is not a method of billing merchandise shipments by

a home office to a branch?
a. Billing at cost.
b. Billing at a percentage below cost.
c. Billing at a percentage above cost.
d. Billing at retail selling prices.
3. A branch journal entry debiting Home Office and crediting Cash may be prepared for:
a. The branch’s transmittal of cash to the home office only.
b. The branch’s acquisition for cash of plant assets to be carried in the home office ac-
counting records only.
c. Either a or b.
d. Neither a nor b.
4. A home office’s Allowance for Overvaluation of Inventories: Branch ledger account,
which has a credit balance, is:
a. An asset valuation account.
b. A liability account.
c. An equity account.
d. A revenue account.
5. Does a branch use a Shipments from Home Office ledger account under the:

Perpetual Inventory Periodic Inventory

System? System?
a. Yes Yes
b. Yes No
c. No Yes
d. No No

6. A journal entry debiting Cash in Transit and crediting Investment in Branch is required for:
a. The home office to record the mailing of a check to the branch early in the ac-
counting period.
b. The branch to record the mailing of a check to the home office early in the ac-
counting period.
c. The home office to record the mailing of a check by the branch on the last day of the
accounting period.
d. The branch to record the mailing of a check to the home office on the last day of the
accounting period.
7. For a home office that uses the periodic inventory system of accounting for shipments
of merchandise to the branch, the credit balance of the Shipments to Branch ledger ac-
count is displayed in the home office’s separate:
a. Income statement as an offset to Purchases.
b. Balance sheet as an offset to Investment in Branch.
c. Balance sheet as an offset to Inventories.
d. Income statement as revenue.
8. If the home office maintains accounts in its general ledger for a branch’s plant assets,
the branch debits its acquisition of office equipment to:
a. Home Office.
b. Office Equipment.
c. Payable to Home Office.
d. Office Equipment Carried by Home Office.
146 Part One Accounting for Partnerships and Branches

9. In a working paper for combined financial statements of the home office and the
branch of a business enterprise, an elimination that debits Shipments to Branch and
credits Shipments from Home Office is required under:
a. The periodic inventory system only.
b. The perpetual inventory system only.
c. Both the periodic inventory system and the perpetual inventory system.
d. Neither the periodic inventory system nor the perpetual inventory system.
10. The appropriate journal entry (explanation omitted) for the home office to recognize
the branch’s expenditure of $1,000 for equipment to be carried in the home office ac-
counting records is:
a. Equipment 1,000
Investment in Branch 1,000
b. Home Office 1,000
Equipment 1,000
c. Investment in Branch 1,000
Cash 1,000
d. Equipment: Branch 1,000
Investment in Branch 1,000

11. On January 31, 2005, East Branch of Lyle Company, which uses the perpetual inven-
tory system, prepared the following journal entry:

Inventories in Transit 10,000

Home Office 10,000
To record shipment of merchandise in transit from home office.

When the merchandise is received on February 4, 2005, East Branch should:

a. Prepare no journal entry.
b. Debit Inventories and credit Home Office, $10,000.
c. Debit Home Office and credit Inventories in Transit, $10,000.
d. Debit Inventories and credit Inventories in Transit, $10,000.
12. If a home office bills merchandise shipments to the branch at a markup of 20% on cost,
the markup on billed price is:
a. 162⁄3%
b. 20%
c. 25%
d. Some other percentage
13. The appropriate journal entry (explanation omitted) in the accounting records of the
home office to record a $10,000 cash remittance in transit from the branch at the end
of an accounting period is:
a. Cash 10,000
Cash in Transit 10,000
b. Cash in Transit 10,000
Investment in Branch 10,000
c. Cash 10,000
Home Office 10,000
d. Cash in Transit 10,000
Cash 10,000
 Chapter 4 Accounting for Branches; Combined Financial Statements 147

(Exercise 4.2) On September 1, 2005, Pasadena Company established a branch in San Marino. Following
are the first three transactions between the home office and San Marino branch of Pasadena
Company:
Sept. 1 Home office sent $10,000 to the branch for an imprest bank account.
2 Home office shipped merchandise costing $60,000 to the branch, billed at a
markup of 20% on billed price.
3 Branch acquired office equipment for $3,000, to be carried in the home office
accounting records.
Both the home office and the San Marino branch of Pasadena Company use the perpetual
inventory system.
Prepare journal entries (omit explanations) for the foregoing transactions:
a. In the accounting records of the home office.
b. In the accounting records of the San Marino branch.
(Exercise 4.3) On September 1, 2005, Western Company established the Eastern Branch. Separate ac-
counting records were set up for the branch. Both the home office and the Eastern
Branch use the periodic inventory system. Among the intracompany transactions were the
following:
Sept. 1 Home office mailed a check for $50,000 to the branch. The check was received
by the branch on September 3.
4 Home office shipped merchandise costing $95,000 to the branch at a billed
price of $125,000. The branch received the merchandise on September 8.
11 The branch acquired a truck for $34,200. The home office maintains the plant
assets of the branch in its accounting records.
Prepare journal entries (omit explanations) for the foregoing intracompany transactions
in the accounting records of (a) the home office and (b) the Eastern Branch.
(Exercise 4.4) Among the journal entries of the home office of Watt Corporation for the month of January
2005, were the following:

2005
Jan. 2 Investment in Wilshire Branch 100,000
Inventories 80,000
Allowance for Overvaluation of Inventories: Wilshire Branch 20,000
To record merchandise shipped to branch.

18 Equipment: Wilshire Branch 5,000

Investment in Wilshire Branch 5,000
To record acquisition of equipment by branch for cash.

31 Investment in Wilshire Branch 8,000

Operating Expenses 8,000
To record allocation of operating expenses to branch.

Prepare related journal entries for the Whilshire Branch of Watt Corporation: the branch
uses the perpetual inventory system.
148 Part One Accounting for Partnerships and Branches

(Exercise 4.5) Among the journal entries for business transactions and events of the Hoover Street Branch
of Usc Company during January 2005, were the following:

CHECK FIGURE
Jan 10, Credit 2005
allowance for Jan. 12 Inventories 60,000
overvaluation of Home Office 60,000
inventories, $12,000. To record the receipt of merchandise shipped Jan. 10 from the
home office and billed at a markup of 20% on billed price.
25 Cash 25,000
Home Office 25,000
To record collection of trade accounts receivable of home office.
31 Operating Expenses 18,000
Home Office 18,000
To record operating expenses allocated by home office.

Prepare appropriate journal entries for the home office of Usc Company.
(Exercise 4.6) Among the journal entries of the home office of Turbo Company for the month ended
August 31, 2005, were the following:

2005
Aug. 6 Investment in Lido Branch 10,000
Cash 10,000
To record payment of account payable of branch.
14 Cash 6,000
Investment in Lido Branch 6,000
To record collection of trade account receivable of branch.
22 Equipment: Lido Branch 20,000
Investment in Lido Branch 20,000
To record branch acquisition of equipment for cash, to be
carried in home office accounting records.

Prepare appropriate journal entries (omit explanations) for Lido Branch of Turbo
Company.
(Exercise 4.7) Prepare journal entries in the accounting records of both the home office and the Exeter
Branch of Wardell Company to record each of the following transactions or events (omit
explanations):
a. Home office transferred cash of $5,000 and merchandise (at home office cost) of $10,000
to the branch. Both the home office and the branch use the perpetual inventory system.
b. Home office allocated operating expenses of $1,500 to the branch.
c. Exeter Branch informed the home office that it had collected $416 on a note payable to
the home office. Principal amount of the note was $400.
d. Exeter Branch made sales of $12,500, terms 2/10, n /30, and incurred operating ex-
penses of $2,500. The cost of goods sold was $8,000, and the operating expenses were
paid in cash.
e. Exeter Branch had a net income of $500. (Debit Income Summary in the accounting
records of the branch.)
 Chapter 4 Accounting for Branches; Combined Financial Statements 149

(Exercise 4.8) Leland Company has a policy of accounting for all plant assets of its branches in the
accounting records of the home office. Contrary to this policy, the accountant for Davis
Branch prepared the following journal entries for the equipment acquired by Davis Branch
at the direction of the home office:

2005
Aug. 1 Equipment 20,000
Cash 20,000
To record acquisition of equipment with an economic life of 10
years and a residual value of $2,000

Dec. 31 Depreciation Expense 750

Accumulated Depreciation of Equipment 750
To recognize depreciation of equipment by the straight-line
method ($18,000 5⁄120 $750).

Prepare appropriate journal entries for Davis Branch and the home office on December 31,
2005, the end of the fiscal year, assuming that the home office had prepared no journal
entries for the equipment acquired by the Davis Branch on August 1, 2005. Neither set of
accounting records has been closed.
(Exercise 4.9) The home office of Figueroa Company ships merchandise to the Nine-Zero Branch at a
billed price that includes a markup on home office cost of 25%. The Inventories ledger ac-
count of the branch, under the perpetual inventory system, showed a December 31, 2004,
CHECK FIGURE debit balance, $120,000; a debit for a shipment received January 16, 2005, $500,000; total
Markup in cost of credits for goods sold during January 2005, $520,000; and a January 31, 2005, debit bal-
goods sold, $104,000. ance, $100,000 (all amounts are home office billed prices).
Prepare a working paper for the home office of Figueroa Company to analyze the flow
of merchandise to Nine-Zero Branch during January 2005.
(Exercise 4.10) The flow of merchandise from the home office of Southern Cal Company to its 32 Branch
during the month of April 2005, may be analyzed as follows:

CHECK FIGURE
SOUTHERN CAL COMPANY
Apr. 30 balance,
Flow of Merchandise for 32 Branch
$20,000 credit. For Month Ended April 30, 2005

Billed Price Cost Markup

Beginning inventories $180,000 $150,000 $ 30,000
Add: Shipment from home office (Apr. 16) 540,000 450,000 90,000
Available for sale $720,000 $600,000 $120,000
Less: Ending inventories 120,000 100,000 20,000
Cost of goods sold $600,000 $500,000 $100,000

From the foregoing information, reconstruct a three-column ledger account Allowance

for Overvaluation of Inventories: 32 Branch for the home office of Southern Cal Company,
beginning with the March 31, 2005, balance, $30,000 credit.
(Exercise 4.11) On May 31, 2005, Portland Street Branch (the only branch) of Trapp Company reported a
net income of $80,000 for May 2005, and a $240,000 ending inventory at billed price of
merchandise received from the home office at a 25% markup on billed price. Prior to
150 Part One Accounting for Partnerships and Branches

adjustment, the May 31, 2005, balance of the home office’s Allowance for Overvaluation of
Inventories: Portland Street Branch was $200,000 credit.
Prepare journal entries (omit explanations) on May 31, 2005, for the home office of
Trapp Company to reflect the foregoing facts.
(Exercise 4.12) Tillman Textile Company has a single branch in Toledo. On March 1, 2005, the home of-
fice accounting records included an Allowance for Overvaluation of Inventories: Toledo
Branch ledger account with a credit balance of $32,000. During March, merchandise cost-
CHECK FIGURE ing $36,000 was shipped to the Toledo Branch and billed at a price representing a 40%
b. Debit allowance for markup on the billed price. On March 31, 2005, the branch prepared an income statement
overvaluation of indicating a net loss of $11,500 for March and ending inventories at billed prices of
inventories, $46,000. $25,000.
a. Prepare a working paper to compute the home office cost of the branch inventories on
March 1, 2005, assuming a uniform markup on all shipments to the branch.
b. Prepare a journal entry to adjust the Allowance for Overvaluation of Inventories:
Toledo Branch ledger account on March 31, 2005, in the accounting records of the
home office.
(Exercise 4.13) The home office of Glendale Company, which uses the perpetual inventory system, bills
shipments of merchandise to the Montrose Branch at a markup of 25% on the billed
price. On August 31, 2005, the credit balance of the home office’s Allowance for Over-
valuation of Inventories: Montrose Branch ledger account was $60,000. On Sep-
CHECK FIGURE tember 17, 2005, the home office shipped merchandise to the branch at a billed price of
Sept. 30, credit $400,000. The branch reported an ending inventory, at billed price, of $160,000 on Sep-
realized gross profit, tember 30, 2005.
$120,000. Prepare journal entries involving the Allowance for Overvaluation of Inventories:
Montrose Branch ledger account of the home office of Glendale Company on September 17
and 30, 2005. Show supporting computations in the explanations for the entries.
(Exercise 4.14) On January 31, 2005, the unadjusted credit balance of the Allowance for Overvaluation of
Inventories: Vermont Avenue Branch of the home office of Searl Company was $80,000.
The branch reported a net income of $60,000 for January 2005 and an ending inventory on
January 31, 2005, of $81,000, at billed prices that included a markup of 50% on home of-
fice cost.
Prepare journal entries (omit explanations) for the home office of Searl Company on
January 31, 2005, for the foregoing facts.
(Exercise 4.15) The home office of Gomez Company bills its only branch at a markup of 25% above home
office cost for all merchandise shipped to that Perez Branch. Both the home office and the
CHECK FIGURE branch use the periodic inventory system. During 2005, the home office shipped merchan-
Credit realized gross dise to the branch at a billed price of $30,000. Perez Branch inventories for 2005 were as
profit, $5,100. follows:

Jan. 1 Dec. 31
Purchased from home office (at billed price) 15,000 19,500
Purchased from outsiders 6,800 8,670

Prepare journal entries (including adjusting entry) for the home office of Gomez Com-
pany for 2005 to reflect the foregoing information.
(Exercise 4.16) Samore, Inc., bills its only branch for merchandise shipments at a markup of 30% above
home office cost. The branch sells the merchandise at a markup of 10% above billed price.
 Chapter 4 Accounting for Branches; Combined Financial Statements 151

Shortly after the close of business on January 28, 2005, some of the branch merchandise
was destroyed by fire. The following additional information is available:

CHECK FIGURE Inventories, Jan. 1 (at billed prices from home office) $15,600
b. Debit loss from fire,
Inventories, Jan. 28, of merchandise not destroyed (at selling prices) 7,150
$36,400.
Shipments from home office from Jan. 1 to Jan. 28 (at billed prices) 71,500
Sales from Jan. 1 to Jan. 28 51,840
Sales returns from Jan. 1 to Jan. 28 (merchandise actually returned) 3,220
Sales allowances from Jan. 1 to Jan. 28 (price adjustments) 300

a. Prepare a working paper to compute the estimated cost (to the home office) of the mer-
chandise destroyed by fire at the branch of Samore, Inc., on January 28, 2005.
b. Prepare a journal entry for the branch to recognize the uninsured fire loss on January 28,
2005. Both the home office and the branch use the perpetual inventory system.
(Exercise 4.17) On May 31, 2005, the unadjusted balances of the Investment in Troy Branch ledger account
of the home office of Argos Company and the Home Office account of the Troy Branch of
Argos Company were $380,000 debit and $140,000 credit, respectively.
Additional Information
1. On May 31, 2005, the home office had shipped merchandise to the branch at a billed
price of $280,000; the branch did not receive the shipment until June 3, 2005. Both the
home office and the branch use the perpetual inventory system.
2. On May 31, 2005, the branch had sent a $10,000 “dividend” to the home office, which
did not receive the check until June 2, 2005.
3. On May 31, 2005, the home office had prepared the following journal entry, without no-
tifying the branch:

Cash 50,000
Investment in Troy Branch 50,000
To record collection of a trade account receivable of branch.

Prepare journal entries (omit explanations) on May 31, 2005, for (a) the home office and
(b) the Troy Branch of Argos Company to reconcile the reciprocal ledger accounts.

Cases
(Case 4.1) The management of Longo Company, which has a June 30 fiscal year and sells merchan-
dise at its home office and six branches, is considering closing Santee Branch because of
its declining sales volume and excessive operating expenses. Longo’s contract with Lewis
Hanson, manager of Santee Branch, provides that Hanson is to receive a termination bonus
of 15% of the branch’s net income in its final period of operations, but no bonus in the event
of a net loss in the final period. The contract is silent as to the measurement of the branch’s
net income or loss.
For the period July 1 through October 31, 2005, the date Santee Branch ceased opera-
tions, its income statement prepared in the customary fashion by the branch accountant re-
ported a net loss of $10,000. Hanson pointed out to Longo management that the loss was
net of $30,000 advertising expenses that had been apportioned to the branch by Longo’s
152 Part One Accounting for Partnerships and Branches

home office in September 2005, prior to Longo management’s decision to close the branch
on October 31. Hanson alleged that it was inappropriate for the branch to absorb advertis-
ing costs for a period in which it would no longer be making sales presumably initiated in
part by the advertising. The controller of Longo responded that under the same line of rea-
soning, the branch’s October 31, 2005, inventories, which included a $60,000 markup over
home office cost, should be reduced by that amount, with a corresponding increase in the
branch’s net loss, because the home office would never realize the markup through future
sales by Santee Branch.

Instructions
Do you agree with the Santee Branch manager, with the controller of Longo Company,
with both, or with neither? Explain.
(Case 4.2) Fortunato Company, which had operated successfully in a single location for many years,
opened a branch operation in another city. The products sold by Fortunato in its home of-
fice required federal and state regulatory agency approval; the home office had secured
such approval long ago. However, new approval of those agencies was required before
Fortunato was authorized to produce and sell the same products at the new branch.
After the branch had been established and had begun testing its manufacturing equipment
and considering development of possible new products other than those manufactured by the
home office, management of Fortunato met to discuss accounting for operating costs of the
new branch prior to its authorization to manufacture and sell products. Controller Robert
Engle pointed out that when the home office had been established, it was a development stage
enterprise prior to obtaining approval for production and sale of its products, with specialized
financial statements display requirements provided by FASB Statement No. 7, “Accounting
and Reporting by Development Stage Enterprises.” Engle added that Fortunato, as currently
an operating enterprise, was not authorized to use such specialized requirements for the new
branch. The vice president for legal affairs, Nancy Kubota, stated that the current regulatory
agency environment was much stricter than it had been when Fortunato’s home office ob-
tained authorization for its production and sales, and that a several-month waiting period
might be anticipated before approval of the branch’s operations. Pending such approval, the
branch could not legally even manufacture products for stockpiling in inventories.
Chief executive officer Michael Kantor expressed dismay at the prospect described by
Kubota, stating that a long period of “marking time” at the branch, with no revenue avail-
able to cover operating costs, would generate substantial losses for Fortunato as a whole un-
less the costs could be deferred as start-up costs. Financial vice president Mary Sage asked
Engle if there were any published financial accounting standards for start-up costs. Engle
replied in the affirmative, pointing out that in 1998 the AICPA’s Accounting Standards Ex-
ecutive Committee had issued Statement of Position 98-5, “Reporting on the Costs of
Start-Up Activities,” which mandated expensing of start-up costs. Sage then asked Engle if
the “marking time” costs incurred by the branch prior to regulatory agency approval might
be accounted for as deferred charges or intangible assets. Engle stated that he would answer
that question after consulting accepted accounting definitions of assets, intangible assets,
contingent assets, expenses, and losses.

Instructions
How should Robert Engle answer Mary Sage’s question? Explain, after researching the
foregoing definitions.
(Case 4.3) Kevin Carter, CPA, a member of the IMA, the FEI, and the AICPA (see Chapter 1), is the
newly hired controller of Oilers, Inc., a closely held manufacturer of replacement parts
for oil well drilling equipment. Oilers distributes its products through its home office and
 Chapter 4 Accounting for Branches; Combined Financial Statements 153

14 branches located near oil fields in several southwestern states. Shortly after being em-
ployed, Carter learned that the reciprocal ledger accounts at Oilers’s home office and 14
branches were out of balance by substantial amounts and that no member of the home
office accounting department could remember when—if ever—the reciprocal ledger
accounts had been in balance. In response to Carter’s astonished inquiries, the home office
chief accountant stated that:
1. Oilers, Inc., had never been audited by independent CPAs, and it had no internal audit
staff.
2. Management of Oilers, in reviewing financial statements of the 14 branches, concen-
trated on branch income statements and was unconcerned about the out-of-balance sta-
tus of the branches’ Home Office ledger accounts.
3. To facilitate elimination of the reciprocal ledger account balances in the working paper
for combined financial statements of the home office and 14 branches of Oilers, the
chief accountant debited Miscellaneous Expense or credited Miscellaneous Revenue for
the aggregate amount of the unlocated differences. These “plug” amounts were reported
in the federal and state income tax returns filed by Oilers.

Instructions
What is your advice to Kevin Carter? Should he permit the practice described above to con-
tinue? If not, should he request management of Oilers to contract for an independent audit?
Alternatively, should he authorize the accountant at each of the 14 branches to adjust the
branch’s Home Office ledger account balance to agree with the home office’s reciprocal In-
vestment in Branch account balance, with the unlocated difference debited to Miscella-
neous Expense or credited to Miscellaneous Revenue, as appropriate? Should some other
course of action be taken? Explain.
(Case 4.4) The management of Windsor Company, which has several branches as well as a home of-
fice, is planning to sell the net assets of Southwark Branch to an unrelated business enter-
prise. As controller of Windsor, you are asked by the board of directors if you can prepare
separate financial statements for Southwark Branch for the prospective purchaser. Among
the directors’ questions are the following:
1. What specific financial statements are appropriate, and what are their titles?
2. Would there be an equity section in a balance sheet for the branch?
3. How should unrealized intracompany markup above home office cost in the branch’s
ending inventories be treated in the branch’s separate financial statements?
Before attempting to answer the directors’ questions, you consult the following sources:
AICPA Professional Standards, vol. 2, “Accounting & Review Services,” etc.:
AR100.04, ET 92.04.
Statement of Financial Accounting Concepts No. 1, “Objectives of Financial
Reporting by Business Enterprises,” par. 6.
Statement of Financial Accounting Concepts No. 6, “Elements of Financial
Statements,” par. 24.
Statement of Financial Accounting Standards No. 57, “Related Party Disclosures,”
par. 2.

Instructions
After consulting the foregoing sources, prepare a memorandum to the board of directors of
Windsor Company in answer to their questions.
154 Part One Accounting for Partnerships and Branches

(Case 4.5) Langley, Inc., operates a number of branches as well as a home office. Each branch stocks
a complete line of merchandise obtained almost entirely from the home office. The
branches also handle their billing, approve customer credit, and make cash collections.
Each branch has its own bank account, and each maintains accounting records. However,
all plant assets at the branches are carried in the accounting records of the home office and
are depreciated in those records by the straight-line method at 10% a year, with no residual
value.
On July 1, 2005, the manager of Lola Branch acquired office equipment. The equipment
had a cash price of $2,400 but was acquired on the installment plan with no down payment
and 24 monthly payments of $110 beginning August 1, 2005. No journal entry was made
for this transaction by the branch until August 1, when the first monthly payment was
recorded by a debit to Miscellaneous Expense. The same journal entry was made in each of
the four remaining months of 2005.
On December 2, 2005, the branch manager became aware that equipment could be ac-
quired by the branches only with prior approval by the home office. Regardless of whether
the home office or the branches acquired plant assets, such assets were to be carried in the
accounting records of the home office, but any gain or loss on the disposal of equipment
was to be recognized in the accounting records of the branches. To avoid criticism, the
manager of the Lola Branch immediately disposed of the office equipment acquired July 1
by sale for $1,500 cash to an independent store. The manager then paid the balance due on
the installment contract using a personal check and the $1,500 check received from sale of
the equipment. In consideration of the advance payment of the remaining installments on
December 3, 2005, the equipment dealer agreed to a $150 reduction in the $240 interest
portion of the contract. No journal entry was prepared for the sale of the equipment or the
settlement of the liability.
Assume that you are a CPA engaged to audit the financial statements of Langley, Inc.
During your visit to Lola Branch you analyze the Miscellaneous Expense ledger account
and investigate the five monthly debits of $110. This investigation discloses the acquisition
and subsequent disposal of the office equipment. After some hesitation, the branch manager
gives you a full explanation of the events.

Instructions
a. Describe (do not prepare) the journal entries that should have been made by Lola Branch
for the foregoing transactions and events.
b. Describe (do not prepare) the journal entries that should have been made by the home
office of Langley, Inc., for the foregoing transactions and events.
c. Prepare a single journal entry for Lola Branch on December 31, 2005, to correct its ac-
counting records.
d. Prepare a single journal entry for the home office of Langley, Inc., on December 31,
2005, to correct its accounting records.

Problems
(Problem 4.1) Hartman, Inc., established Reno Branch on January 2, 2005. During 2005, Hartman’s home
office shipped merchandise to Reno Branch that cost $300,000. Billings were made at
prices marked up 20% above home office cost. Freight costs of $15,000 were paid by the
home office. Sales by the branch were $450,000, and branch operating expenses were
$96,000, all for cash. On December 31, 2005, the branch took a physical inventory that
 Chapter 4 Accounting for Branches; Combined Financial Statements 155

showed merchandise on hand of $72,000 at billed prices. Both the home office and the
branch use the periodic inventory system.
Instructions
Prepare journal entries for Reno Branch and the home office of Hartman, Inc., to record the
foregoing transactions and events, ending inventories, and adjusting and closing entries on
December 31, 2005. (Allocate a proportional amount of freight costs to the ending inven-
tories of the branch.)
(Problem 4.2) Included in the accounting records of the home office and Wade Branch, respectively, of
Lobo Company were the following ledger accounts for the month of January 2005:

CHECK FIGURE
Investment in Wade Branch (in Home Office accounting records)
Adjusted balances
$42,600. Date Explanation Debit Credit Balance
2005
Jan. 1 Balance 39,200 dr
9 Shipment of merchandise 4,000 43,200 dr
21 Receipt of cash 1,600 41,600 dr
27 Collection of branch trade accounts
receivable 1,100 40,500 dr
31 Shipment of merchandise 6,000 46,500 dr
31 Payment of branch trade accounts
payable 2,000 48,500 dr

Home Office (in Wade Branch accounting records)

Date Explanation Debit Credit Balance
2005
Jan. 1 Balance 39,200 cr
10 Receipt of merchandise 4,000 43,200 cr
19 Remittance of cash 1,600 41,600 cr
28 Acquisition of furniture 1,200 40,400 cr
30 Return of merchandise 2,200 38,200 cr
31 Remittance of cash 2,500 35,700 cr

Instructions
a. Prepare a working paper to reconcile the reciprocal ledger accounts of Lobo Company’s
home office and Wade Branch to the corrected balances on January 31, 2005.
b. Prepare journal entries on January 31, 2005, for the (1) home office and (2) Wade
Branch of Lobo Company to bring the accounting records up to date. Both the home
office and the branch use the perpetual inventory system.

(Problem 4.3) The home office of Styler Corporation operates a branch to which it bills merchandise at
prices marked up 20% above home office cost. The branch obtains merchandise only from
CHECK FIGURES the home office and sells it at prices averaging markups 10% above the prices billed by the
a. Debit loss from fire, home office. Both the home office and the branch maintain perpetual inventory records and
$19,800; b. Debit loss both close their accounting records on December 31.
from fire, $16,500. On March 10, 2005, a fire at the branch destroyed a part of the inventories. Immedi-
ately after the fire, a physical inventory of merchandise on hand and not damaged
amounted to $16,500 at branch retail selling prices. On January 1, 2005, the inventories
of the branch at billed prices had been $18,000. Shipments from the home office during
156 Part One Accounting for Partnerships and Branches

the period January 1 to March 10, 2005, were billed to the branch in the amount of
$57,600. The accounting records of the branch show that net sales during this period
were $44,880.

Instructions
Prepare journal entries on March 10, 2005, to record the uninsured loss from fire in the
accounting records of (a) the branch and (b) the home office of Styler Company. Show sup-
porting computations for all amounts. Assume that the loss was reported at billed prices by
the branch to the home office and that it was recorded in the intracompany reciprocal ledger
accounts.
(Problem 4.4) On December 31, 2005, the Investment in Ryble Branch ledger account in the accounting
records of the home office of Yugo Company shows a debit balance of $55,500. You ascer-
tain the following facts in analyzing this account:
CHECK FIGURES 1. On December 31, 2005, merchandise billed at $5,800 was in transit from the home
a. Unadjusted balance, office to the branch. The periodic inventory system is used by both the home office and
$49,680; d. Adjusted the branch.
balances, $57,480.
2. The branch had collected a home office trade account receivable of $560 on December 30,
2005; the home office was not notified.
3. On December 29, 2005, the home office had mailed a check for $2,000 to the branch,
but the accountant for the home office had recorded the check as a debit to the Chari-
table Contributions ledger account; the branch had not received the check as of Decem-
ber 31, 2005.
4. Branch net income for December 2005 was recorded erroneously by the home office at
$840 instead of $480 on December 31, 2005. The credit was recorded by the home office
in the Income: Ryble Branch ledger account.
5. On December 28, 2005, the branch had returned supplies costing $220 to the
home office; the home office had not recorded the receipt of the supplies. The
home office records acquisitions of supplies in the Inventory of Supplies ledger
account.

Instructions
a. Assuming that all other transactions and events have been recorded properly, prepare
a working paper to compute the unadjusted balance of the Home Office ledger
account in the accounting records of Yugo Company’s Ryble Branch on December
31, 2005.
b. Prepare journal entries for the home office of Yugo Company on December 31, 2005, to
bring its accounting records up to date. Closing entries have not been made.
c. Prepare journal entries for Ryble Branch of Yugo Company on December 31, 2005, to
bring its accounting records up to date.
d. Prepare a reconciliation on December 31, 2005, of the Investment in Ryble branch
ledger account in the accounting records of the home office and the Home Office ac-
count in the accounting records of Ryble Branch of Yugo Company. Use a single col-
umn for each account and start with the unadjusted balances.
(Problem 4.5) Trudie Company’s home office bills shipments of merchandise to its Savoy Branch at 140%
of home office cost. During the first year after the branch was opened, the following were
among the transactions and events completed:
1. The home office shipped merchandise with a home office cost of $110,000 to Savoy
Branch.
 Chapter 4 Accounting for Branches; Combined Financial Statements 157

2. Savoy Branch sold for $80,000 cash merchandise that was billed by the home office at
$70,000, and incurred operating expenses of $16,500 (all paid in cash).
3. The physical inventories taken by Savoy Branch at the end of the first year were $82,460
at billed prices from the home office.
Instructions
a. Assuming that the perpetual inventory system is used both by the home office and by
Savoy Branch, prepare for the first year:
(1) All journal entries, including closing entries, in the accounting records of Savoy
Branch of Trudie Company.
(2) All journal entries, including the adjustment of the Inventories Overvaluation
account, in the accounting records of the home office of Trudie Company.
b. Assuming that the periodic inventory system is used both by the home office and by
Savoy Branch, prepare for the first year:
(1) All journal entries, including closing entries, in the accounting records of Savoy
Branch of Trudie Company.
(2) All journal entries, including the adjustment of the Inventories Overvaluation ac-
count, in the accounting records of the home office of Trudie Company.
(Problem 4.6) You are making an audit for the year ended December 31, 2005, of the financial statements
of Kosti-Marian Company, which carries on merchandising operations at both a home
office and a branch. The unadjusted trial balances of the home office and the branch are
shown below:

CHECK FIGURE KOSTI-MARIAN COMPANY

c. Combined net
Unadjusted Trial Balances
income, $63,120. December 31, 2005

Home Office Branch

Dr (Cr) Dr (Cr)
Cash $ 22,000 $ 10,175
Inventories, Jan. 1, 2005 23,000 11,550
Investment in branch 60,000
Allowance for overvaluation of branch inventories,
Jan. 1, 2002 (1,000)
Other assets (net) 197,000 48,450
Current liabilities (35,000) (8,500)
Common stock, $2.50 par (200,000)
Retained earnings, Jan. 1, 2005 (34,000)
Dividends declared 15,000
Home office (51,000)
Sales (169,000) (144,700)
Purchases 190,000
Shipments to branch (110,000)
Shipments from home office 104,500
Freight-in from home office 5,225
Operating expenses 42,000 24,300
Totals $ -0- $ -0-
158 Part One Accounting for Partnerships and Branches

The audit for the year ended December 31, 2005, disclosed the following:
1. The branch deposits all cash receipts in a local bank for the account of the home office.
The audit working papers for the cash cutoff include the following:

Date Deposited Date Recorded

Amount by Branch by Home Office
$1,050 Dec. 27, 2005 Dec. 31, 2005
1,100 Dec. 30, 2005 Not recorded
600 Dec. 31, 2005 Not recorded
300 Jan. 2, 2006 Not recorded

2. The branch pays operating expenses incurred locally from an imprest cash account that
is maintained with a balance of $2,000. Checks are drawn once a week on the imprest
cash account, and the home office is notified of the amount needed to replenish the ac-
count. On December 31, 2005, a $1,800 reimbursement check was in transit from the
home office to the branch.
3. The branch received all its merchandise from the home office. The home office bills the
merchandise shipments at a markup of 10% above home office cost. On December 31,
2005, a shipment with a billed price of $5,500 was in transit to the branch. Freight costs
of common carriers typically are 5% of billed price. Freight costs are considered to
be inventoriable costs. Both the home office and the branch use the periodic inventory
system.
4. Beginning inventories in the trial balance are shown at the respective costs to the
home office and to the branch. The physical inventories on December 31, 2005, were as
follows:

Home office, at cost $30,000

Branch, at billed price (excluding shipment in transit and freight) 9,900

Instructions
a. Prepare journal entries to adjust the accounting records of the home office of Kosti-
Marian Company on December 31, 2005.
b. Prepare journal entries to adjust the accounting records of Kosti-Marian Company’s
branch on December 31, 2005.
c. Prepare a working paper for combined financial statements of Kosti-Marian Company
(use the format on page 139). Compute the amounts in the adjusted trial balances for the
home office and the branch by incorporating the journal entries in (a) and (b) with the
amounts in the unadjusted trial balances.
(Problem 4.7) On January 4, 2005, Solis Company opened its first branch, with instructions to Steven
Carr, the branch manager, to perform the functions of granting credit, billing customers,
accounting for receivables, and making cash collections. The branch paid its operating ex-
penses by checks drawn on its bank account. The branch obtained merchandise solely from
the home office; billings from these shipments were at cost to the home office. The
adjusted trial balances for the home office and the branch on December 31, 2005, were as
follows:
 Chapter 4 Accounting for Branches; Combined Financial Statements 159

CHECK FIGURE
SOLIS COMPANY
a. Combined net
Adjusted Trial Balances
income, $117,400. December 31, 2005

Home Office Branch

Dr (Cr) Dr (Cr)
Cash $ 46,000 $ 14,600
Notes receivable 7,000
Trade accounts receivable (net) 80,400 37,300
Inventories 95,800 24,200
Investment in branch 82,700
Furniture and equipment (net) 48,100
Trade accounts payable (41,000)
Common stock, $2 par (200,000)
Retained earnings, Dec. 31, 2004 (25,000)
Dividends declared 30,000
Home office (82,700)
Sales (394,000) (101,100)
Cost of goods sold 200,500 85,800
Operating expenses 69,500 21,900
Totals $ -0- $ -0-

The physical inventories on December 31, 2005, were in agreement with the perpetual
inventory records of the home office and the branch.
Instructions
a. Prepare a four-column working paper for combined financial statements of the home of-
fice and branch of Solis Company for the year ended December 31, 2005.
b. Prepare closing entries on December 31, 2005, in the accounting records of the branch
of Solis Company.
c. Prepare adjusting and closing entries pertaining to branch operations on December 31,
2005, in the accounting records of the home office of Solis Company.
(Problem 4.8) The unadjusted general ledger trial balances on December 31, 2005, for Calco Corpora-
tion’s home office and its only branch are shown below and on page 160:

CHECK FIGURE CALCO CORPORATION

c. Combined net
Unadjusted Trial Balances
income, $107,000. December 31, 2005

Home Office Branch

Dr (Cr) Dr (Cr)
Cash $ 28,000 $ 23,000
Trade accounts receivable (net) 35,000 12,000
Inventories, Jan. 1, 2005 (at cost to home office) 70,000 15,000
Investment in branch 30,000
Equipment (net) 90,000
Trade accounts payable (46,000) (13,500)
Accrued liabilities (14,000) (2,500)
Home office (19,000)
(continued)
160 Part One Accounting for Partnerships and Branches

CALCO CORPORATION
Unadjusted Trial Balances (concluded)
December 31, 2005

Home Office Branch

Dr (Cr) Dr (Cr)
Common stock, $10 par (50,000)
Retained earnings, Jan. 1, 2005 (48,000)
Dividends declared 10,000
Sales (450,000) (100,000)
Purchases 290,000 24,000
Shipments from home office 45,000
Operating expenses 55,000 16,000
Totals $ -0- $ -0-

Your audit disclosed the following:

1. On December 10, 2005, the branch manager acquired equipment for $500, but failed to
notify the home office. The branch accountant, knowing that branch equipment is car-
ried in the home office ledger, recorded the proper journal entry in the branch account-
ing records. It is Calco’s policy not to recognize depreciation on equipment acquired in
the last half of a year.
2. On December 27, 2005, Mojo, Inc., a customer of the branch, erroneously paid its ac-
count of $2,000 to the home office. The accountant made the correct journal entry in the
home office accounting records but did not notify the branch.
3. On December 30, 2005, the branch remitted to the home office cash of $5,000, which
had not been received by the home office as of December 31, 2005.
4. On December 31, 2005, the branch accountant erroneously recorded the December al-
located expenses from the home office as $500 instead of $5,000.
5. On December 31, 2005, the home office shipped merchandise billed at $3,000 to the
branch; the shipment had not been received by the branch as of December 31, 2005.
6. The inventories on December 31, 2005, excluding the shipment in transit, were: home
office—$60,000 (at cost); branch—$20,000 (consisting of $18,000 from home office at
billed prices and $2,000 from suppliers). Both the home office and the branch use the
periodic inventory system.
7. The home office erroneously billed shipments to the branch at a markup of 20% above
home office cost, although the billing should have been at cost. The Sales ledger account
was credited for the invoices’ price by the home office.

Instructions
a. Prepare journal entries for the home office of Calco Corporation on December 31, 2005,
to bring the accounting records up to date and to correct any errors. Record ending in-
ventories by an offsetting credit to the Income Summary ledger account. Do not prepare
other closing entries.
b. Prepare journal entries for the branch of Calco Corporation on December 31, 2005, to
bring the accounting records up to date and to correct any errors. Record ending inven-
tories at cost to the home office by an offsetting credit to the Income Summary ledger
account. Do not prepare other closing entries.
c. Prepare a working paper to summarize the operations of Calco Corporation for the year
ended December 31, 2005. Disregard income taxes and use the following column headings:
 Chapter 4 Accounting for Branches; Combined Financial Statements 161

Revenue and Expenses Home Office Branch Combined

(Problem 4.9) The following reciprocal ledger accounts were included in the accounting records of the
home office and the Lee Branch of Kreshek Company on April 30, 2005. You have been re-
tained by Kreshek to assist it with some accounting work preliminary to the preparation of
financial statements for the quarter ended April 30, 2005.

CHECK FIGURE
Investment in Lee Branch
b. Adjusted balances,
$143,390. Date Explanation Debit Credit Balance
2005
Feb. 1 Balance 124,630 dr
6 Shipment of merchandise, 160 units
@ $49 7,840 132,470 dr
17 Note receivable collected by branch 2,500 134,970 dr
Mar. 31 Cash deposited by branch 2,000 132,970 dr
Apr. 2 Merchandise returned by branch 450 132,520 dr
26 Loss on disposal of branch equipment 780 133,300 dr
28 Operating expenses charged to branch 1,200 134,500 dr
29 Corrected loss on disposal of branch
equipment from $780 to $250 530 133,970 dr

Home Office
Date Explanation Debit Credit Balance
2005
Feb. 1 Balance 124,630 cr
8 Merchandise from home office, 160 units
@$49 7,480 132,110 cr
14 Received shipment directly from supplier,
invoice to be paid by home office 2,750 134,860 cr
15 Note receivable collected for home
office 2,500 137,360 cr
Mar. 30 Deposited cash in account of home
office 2,000 135,360 cr
31 Returned merchandise to home office 450 134,910 cr
Apr. 29 Paid repair bill for home office 375 134,535 cr
30 Excess merchandise returned to home
office (billed at cost) 5,205 129,330 cr
30 Preliminary net income for quarter
(before any required corrections) 13,710 143,040 cr

Additional Information
1. Branch equipment is carried in the accounting records of the home office; the home of-
fice notifies the branch periodically as to the amount of depreciation applicable to equip-
ment used by the branch. Gains or losses on disposal of branch equipment are reported
to the branch and included in the income statement of the branch.
2. Because of the error in recording the shipment from the home office on February 8,
2005, the sale of the 160 units has been debited improperly by the branch to cost of
goods sold at $46.75 a unit.
162 Part One Accounting for Partnerships and Branches

3. On April 30, 2005, the branch collected trade accounts receivable of $350 belonging to
the home office, but the branch employee who recorded the collection mistakenly treated
the trade accounts receivable as belonging to the branch.
4. The branch accountant recorded the preliminary net income of $13,710 by a debit to
Income Summary and a credit to Home Office, although the revenue and expense ledger
accounts had not been closed.
Instructions
a. Reconcile the reciprocal ledger accounts of the home office and Lee Branch of Kreshek
Company to the correct balances on April 30, 2005. Use a four-column working paper
(debit and credit columns for the Investment in Lee Branch account in the home office
accounting records and debit and credit columns for the Home Office account in the
branch accounting records). Start with the unadjusted balances on April 30, 2005, and
work to corrected balances, including explanations of all adjusting or correcting items.
b. Prepare journal entries for Lee Branch of Kreshek Company on April 30, 2005, to bring
its accounting records up to date, assuming that corrections still may be made to revenue
and expense ledger accounts. The branch uses the perpetual inventory system. Do not
prepare closing entries.
c. Prepare journal entries for the home office of Kreshek Company on April 30, 2005, to
bring its accounting records up to date. The home office uses the perpetual inventory
system and has not prepared closing entries. Do not prepare closing entries.
(Problem 4.10) Arnie’s, a single proprietorship owned by Arnold Nance, sells merchandise at both its home
office and a branch. The home office bills merchandise shipped to the branch at 125% of
home office cost, and is the only supplier for the branch. Shipments of merchandise to the
branch have been recorded improperly by the home office by credits to Sales for the billed
price. Both the home office and the branch use the perpetual inventory system.
Arnie’s has engaged you to audit its financial statements for the year ended December 31,
2005. This is the first time the proprietorship has retained an independent accountant. You
were provided with the following unadjusted trial balances:

CHECK FIGURE
ARNIE’S
c. Combined net
Unadjusted Trial Balances
income, $86,600.
December 31, 2005

Home Office Vida Branch

Dr (Cr) Dr (Cr)
Cash $ 31,000 $ 13,000
Trade accounts receivable (net) 20,000 22,000
Inventories 40,000 8,000
Investment in branch 45,000
Equipment (net) 150,000
Trade accounts payable $ (23,000)
Accrued liabilities $ (2,000)
Note payable, due 2008 (51,000)
Arnold Nance, capital, Jan. 1, 2005 (192,000)
Arnold Nance, drawing 50,000
Home office (10,000)
Sales (390,000) (160,000)
Cost of goods sold 250,000 93,000
Operating expenses 70,000 36,000
Totals $ -0- $ -0-
 Chapter 4 Accounting for Branches; Combined Financial Statements 163

Additional Information
1. On January 1, 2005, inventories of the home office amounted to $25,000 and inventories
of the branch amounted to $6,000. During 2005, the branch was billed for $105,000 for
shipments from the home office.
2. On December 28, 2005, the home office billed the branch for $12,000, representing the
branch’s share of operating expenses paid by the home office. This billing had not been
recorded by the branch.
3. All cash collections made by the branch were deposited in a local bank to the bank ac-
count of the home office. Deposits of this nature included the following:

Date Deposited Date Recorded

Amount by Vida Branch by Home Office
$5,000 Dec. 28, 2005 Dec. 31, 2005
3,000 Dec. 30, 2005 Not recorded
7,000 Dec. 31, 2005 Not recorded
2,000 Jan. 2, 2006 Not recorded

4. Operating expenses incurred by the branch were paid from an imprest bank account that
was reimbursed periodically by the home office. On December 30, 2005, the home of-
fice had mailed a reimbursement check in the amount of $3,000, which had not been re-
ceived by the branch as of December 31, 2005.
5. A shipment of merchandise from the home office to the branch was in transit on De-
cember 31, 2005.

Instructions
a. Prepare journal entries to adjust the accounting records of Arnie’s home office on De-
cember 31, 2005. Establish an allowance for overvaluation of branch inventories.
b. Prepare journal entries to adjust the accounting records of Vida Branch on December 31,
2005.
c. Prepare a working paper for combined financial statements of Arnie’s on December 31,
2005 (use the format on pages 132–133). Compute the amounts for the adjusted trial
balances for the home office and the branch by incorporating the journal entries in (a)
and (b) with the amounts in the unadjusted trial balances.
d. After the working paper in (c) is completed, prepare all required adjusting and closing
entries on December 31, 2005, in the accounting records of Arnie’s home office.
Chapter Five

Business Combinations
The Financial Accounting Standards Board has provided the following working definition
of business combination:
[A] business combination occurs when an entity acquires net assets that constitute a business
or acquires equity interests of one or more other entitites and obtains control over that entity
or entities.1

Footnotes to this definition amplify the terms entity, business, and control as follows:2
Entity: A business enterprise, a new entity formed to complete a business combination, or a
mutual enterprise—an entity, not investor-owned, that provides dividends, lower costs, or
other economic benefits directly to its owners, members, or participants.
Business: An asset group that constitutes a business as characterized by the Emerging Issues
Task Force (EITF) in EITF Issue No. 98-3, “Determining Whether a Nonmonetary Trans-
action Involves Receipt of Productive Assets or of a Business.”
Control: Ownership by one company, directly or indirectly, of the outstanding voting shares
of another company.

In common parlance, business combinations are often referred to as mergers and

acquisitions.
The Financial Accounting Standards Board has suggested the following definitions for
terms commonly used in discussions of business combinations.3
Combined enterprise The accounting entity that results from a business
combination.
Constituent companies The business enterprises that enter into a business
combination.
Combinor A constituent company entering into a business combination whose
owners as a group end up with control of the ownership interests in the combined
enterprise.
Combinee A constituent company other than the combinor in a business
combination.
Business combinations may be divided into two classes—friendly takeovers and hostile
takeovers. In a friendly takeover, the boards of directors of the constituent companies gen-
erally work out the terms of the business combination amicably and submit the proposal to

1
FASB Statement No. 141, “Business Combinations” (Norwalk: FASB, 2001), par. 9.
2
Ibid., pars. 9 and F1.
3
FASB Discussion Memorandum, “An Analysis of Issues Related to Accounting for Business Combina-
tions and Purchased Intangibles” (Stamford: FASB, 1976), p. 3.

164
 Chapter 5 Business Combinations 165

stockholders of all constituent companies for approval. A target combinee in a hostile

takeover typically resists the proposed business combination by resorting to one or more
defensive tactics with the following colorful designations:
Pac-man defense A threat to undertake a hostile takeover of the prospective
combinor.
White knight A search for a candidate to be the combinor in a friendly takeover.
Scorched earth The disposal, by sale or by a spin-off to stockholders, of one or more
profitable business segments.
Shark repellent An acquisition 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.
Poison pill An amendment of the articles of incorporation or bylaws to make it more
difficult to obtain stockholder approval for a takeover.
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.

Scope of Chapter
The first section of this chapter presents reasons for the popularity of business combina-
tions and techniques for arranging them. Then, purchase accounting—the only acceptable
method—for business combinations is explained and illustrated.

BUSINESS COMBINATIONS: WHY AND HOW?

Why do business enterprises enter into a business combination? Although a number of
reasons have been cited, probably the overriding one for combinors in recent years
has been growth. Business enterprises have major operating objectives other than
growth, but that goal increasingly has motivated combinor managements to undertake
business combinations. Advocates of this external method of achieving growth point
out that it is much more rapid than growth through internal means. 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. However, the disappointing experiences of many combinors engaging in
business combinations suggest that much may be said in favor of more gradual and
reasoned growth through internal means, using available management and financial
resources.
Other reasons often advanced in support of business combinations are obtaining
new management strength or better use of existing management and achieving manu-
facturing or other operating economies. In addition, a business combination may be
undertaken for the income tax advantages available to one or more parties to the
combination.
Critics have alleged that the foregoing reasons attributed to the “urge to merge” (busi-
ness combinations) do not apply to hostile takeovers. These critics complain that the
“sharks” who engage in hostile takeovers, and the investment bankers and attorneys who
counsel them, are motivated by the prospect of substantial gains resulting from the sale of
business segments of a combinee following the business combination.
166 Part Two Business Combinations and Consolidated Financial Statements

Antitrust Considerations
One obstacle faced by large corporations that undertake business combinations is the pos-
sibility of antitrust litigation. The U.S. government on occasion has opposed concentration
of economic power in large business enterprises. Consequently, business combinations fre-
quently have been challenged by the Federal Trade Commission or the Antitrust Division of
the Department of Justice, under the provisions of Section 7 of the Clayton Act, which
reads in part as follows:

No corporation engaged in commerce shall acquire, directly or indirectly, the whole or any
part of the stock or other share capital and no corporation subject to the jurisdiction of the
Federal Trade Commission shall acquire the whole or any part of the assets of another corpo-
ration engaged also in commerce, where in any line of commerce in any section of the coun-
try the effect of such acquisition may be substantially to lessen competition or to tend to
create a monopoly.

The breadth of the preceding legislation has led to federal antitrust action against all
types of business combinations: horizontal (combinations involving enterprises in the
same industry), vertical (combinations between an enterprise and its customers or sup-
pliers), and conglomerate (combinations between enterprises in unrelated industries or
markets).

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.

Statutory Merger
As its name implies, a statutory merger is executed under provisions of applicable state
laws. In a statutory merger, the boards of directors of the constituent companies approve
a plan for the exchange of voting common stock (and perhaps some preferred stock,
cash, or long-term debt) of one of the corporations (the survivor) for all the outstanding
voting common stock of the other corporations. Stockholders of all constituent compa-
nies must approve the terms of the merger; some states require approval by two-thirds
of the stockholders. The survivor corporation issues its common stock or other consid-
eration to the stockholders of the other corporations in exchange for all their holdings,
thus acquiring ownership of those corporations. The other corporations then are dis-
solved and liquidated and thus cease to exist as separate legal entities, and their activ-
ities 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.
To summarize, the procedures in a statutory merger are:
1. The boards of directors of the constituent companies work out the terms of the
merger.
2. Stockholders of the constituent companies approve the terms of the merger, in accor-
dance with applicable corporate bylaws and state laws.
3. The survivor issues its common stock or other consideration to the stockholders of the
other constituent companies in exchange for all their outstanding voting common stock
of those companies.
4. The survivor dissolves and liquidates the other constituent companies, receiving in ex-
change for its common stock investments the net assets of those companies.
 Chapter 5 Business Combinations 167

Statutory Consolidation
A statutory consolidation also is consummated in accordance with applicable state laws.
However, in a consolidation a new corporation is formed to issue its common stock for the
outstanding common stock of two or more existing corporations, which then go out of
existence. The new corporation thus acquires the net assets of the defunct corporations,
whose activities may be continued as divisions of the new corporation.
To summarize, the procedures in a statutory consolidation are:
1. The boards of directors of the constituent companies work out the terms of the consoli-
dation.
2. Stockholders of the constituent companies approve the terms of the consolidation, in ac-
cordance with applicable corporate bylaws and state laws.
3. A new corporation is formed to issue its common stock to the stockholders of the con-
stituent companies in exchange for all their outstanding voting common stock of those
companies.
4. The new corporation dissolves and liquidates the constituent companies, receiving in ex-
change for its common stock investments the net assets of those companies.

Acquisition of Common Stock

One corporation (the investor) may issue preferred or common stock, cash, debt instru-
ments, or a combination thereof, to acquire from present stockholders a controlling interest
in the voting common stock of another corporation (the investee). This stock acquisition
program may be accomplished through direct acquisition in the stock market, through ne-
gotiations 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 an-
nounced 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 con-
trolling interest in the combinee’s voting common stock is acquired, that corporation be-
comes affiliated with the combinor parent company as a subsidiary, but is not dissolved
and liquidated and remains a separate legal entity. Business combinations arranged
through common stock acquisitions require authorization by the combinor’s board of di-
rectors and may require ratification by the combinee’s stockholders. Most hostile takeovers
are accomplished by this means.
Business combinations that result in a parent company–subsidiary relationship are dis-
cussed in Chapter 6.

Acquisition of Assets
A business enterprise may acquire from another enterprise all or most of the gross assets or
net assets of the other enterprise for cash, debt instruments, preferred or common stock, or
a combination thereof. The transaction generally must be approved by the boards of direc-
tors and stockholders or other owners of the constituent companies. The selling enterprise
may continue its existence as a separate entity or it may be dissolved and liquidated; it
does not become an affiliate of the combinor.

Establishing the Price for a Business Combination

An important early step in planning a business combination is deciding on an appropriate
price to pay. The amount of cash or debt securities, or the number of shares of preferred or
168 Part Two Business Combinations and Consolidated Financial Statements

common stock, to be issued in a business combination generally is determined by varia-

tions of the following methods:
1. Capitalization of expected average annual earnings of the combinee at a desired rate of
return.
2. Determination of current fair value of the combinee’s net assets (including goodwill).
The price for a business combination consummated for cash or debt instruments gener-
ally is expressed in terms of the total dollar amount of the consideration issued. When com-
mon 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 stockholders of
Simpson Company to acquire all 20,000 outstanding shares of Simpson common stock for a
total price of $1,800,000. Palmer’s common stock presently is trading in the market at $65
a share. Stockholders of Simpson agree to accept 30,000 shares of Palmer’s common stock
at a value of $60 a share in exchange for their stock holdings in Simpson. The exchange ra-
tio is expressed as 1.5 shares of Palmer’s common stock for each share of Simpson’s com-
mon stock, in accordance with the following computation:

Computation of Number of shares of Palmer Corporation common stock to be issued 30,000

Exchange Ratio in Number of shares of Simpson Company common stock to be exchanged 20,000
Business Combination Exchange ratio: 30,000 20,000 1.5 : 1

PURCHASE METHOD OF ACCOUNTING FOR

BUSINESS COMBINATIONS
In FASB Statement No. 141, “Business Combinations,” the FASB mandated purchase ac-
counting for all business combinations entered into after June 30, 2001.4 The key compo-
nents of purchase accounting were identified as follows by the FASB:5
Initial recognition: Assets are commonly acquired in exchange transactions that trigger
the initial recognition of the assets acquired and any liabilities assumed.
Initial measurement: Like other exchange transactions generally, acquisitions are
measured on the basis of the fair values exchanged.
Allocating cost: Acquiring assets in groups requires not only 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.
Accounting after acquisition: The nature of an asset and not the manner of its
acquisitions determines an acquiring entity’s subsequent accounting for the asset.
The foregoing provide the foundation for applying the purchase method of accounting for
business combinations.

4
FASB Statement No. 141, par. 13.
5
Ibid., pars. 4, 5, 7, 8.
 Chapter 5 Business Combinations 169

Determination of the 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. The FASB stated that
in a business combination effected solely by the distribution of cash or other assets or
by incurring liabilities, the combinor is the distributing or incurring constituent com-
pany.6 For combinations effected by the issuance of equity securities, consideration of
all the facts and circumstances is required to identify the combinor. However, a common
theme is that the combinor is the constituent company whose stockholders as a group re-
tain or receive 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.7

Computation of Cost of a Combinee

The cost of a combinee in a business combination accounted for by the purchase method is
the total of (1) the amount of consideration paid by the combinor, (2) the combinor’s direct
“out-of-pocket” costs of the combination, and (3) any contingent consideration that is de-
terminable on the date of the business combination.

Amount of Consideration
This is the total amount of cash paid, the current fair value of other assets distributed, the
present value of debt securities issued, and the current fair (or market) value of equity se-
curities issued by the combinor.

Direct Out-of-Pocket Costs

Included in this category are some legal fees, some accounting fees, and finder’s fees. A
finder’s fee is paid to the investment banking firm or other organization or individuals that
investigated the combinee, assisted in determining the price of the business combination,
and otherwise rendered services to bring about the combination.
Costs of registering with the SEC 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 reg-
istering with the SEC and issuing equity securities are not direct costs of the business com-
bination 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 of constituent compa-
nies involved in negotiation and completion of the combination, are recognized as expenses
incurred by the constituent companies.

Contingent Consideration
Contingent consideration is additional cash, other assets, or securities that may be is-
suable in the future, contingent on future events such as a specified level of earnings or
a designated market price for a security that had been issued to complete the business
combination. Contingent consideration that is determinable on the consummation date
of a combination is recorded as part of the cost of the combination; contingent consid-
eration not determinable on the date of the combination is recorded when the contin-
gency is resolved and the additional consideration is paid or issued (or becomes payable
or issuable).

6
Ibid., par. 16.
7
Ibid., par. 17.
170 Part Two Business Combinations and Consolidated Financial Statements

Illustration of Contingent Consideration

The contract for Norton Company’s acquisition of the net assets of Robinson Company pro-
vided that Norton would pay $800,000 cash for Robinson’s net assets (including goodwill),
which would be included in the Robb Division of Norton Company. The following contin-
gent consideration also was included in the contract:
1. Norton was to pay Robinson $100 a unit for all sales by Robb 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 $800,000 price for Robinson’s net assets involved the
slow-moving product.
2. Norton was to pay Robinson 25% of any pretax financial income in excess of $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, 2005, the date of completion of the business combination, Robinson Com-
pany had firm, noncancelable 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 includes $50,000 (500 $100
$50,000) for the determinable contingent consideration attributable to the backlog of sales
orders for the slow-moving product. However, because any pretax accounting income of
Robb Division for the next four years cannot be determined on January 2, 2005, no provision
for the 25% contingent consideration is included in Norton’s cost on January 2, 2005. The
subsequent accounting for such contingent consideration is described on pages 178–179.

Allocation of Cost of a Combinee

The FASB required that the cost of a combinee in a business combination 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 over the amounts thus al-
located is assigned to goodwill.8 Methods for determining fair values included present val-
ues for receivables and most liabilities; net realizable value less a reasonable profit for work
in process and finished goods inventories; and appraised values for land, natural resources,
and nonmarketable securities.9 In addition, the following combinee intangible assets were
to be recognized individually and valued at fair value:10
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, ex-
changed, and the like, such as customer lists and unpatented technology

Other matters involved in the allocation of the cost of a combinee in a business combi-
nation are:
1. 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 combinee or are to be used
in research and development activities of the combined enterprise. Subsequently, such
assets are to be expensed, as required by FASB Statement No. 2, “Accounting for Re-
search and Development Costs,” unless they may be used for other than research and de-
velopment activities in the future.11

8
Ibid., pars. 35, 43.
9
Ibid. par. 37.
10
Ibid., pars. 39, A14.
11
FASB Interpretation No. 4, “Applicability of FASB Statement No. 2 to Business Combinations
Accounted for by the Purchase Method” (Stamford: FASB, 1975), pars. 4–5.
 Chapter 5 Business Combinations 171

2. 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 a lease are modified to
the extent it must be considered a new lease.12 Thus, unmodified capital leases of the
combinee are treated as capital leases by the combined enterprise, and the leased prop-
erty and related liability are recognized in accordance with the guidelines of FASB
Statement No. 141.
3. A combinee in a business combination may have preacquisition contingencies, which are
contingent assets (other than potential income tax benefits of a loss carryforward), contin-
gent 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 preacquisition contingency. A portion of the cost of a combinee is allocated to a preac-
quisition contingency whose fair value is determined during the allocation period. Other-
wise, an estimated amount is assigned to a preacquisition 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 preac-
quisition contingency subsequent to the end of the allocation period is included in the
measurement of net income for the accounting period of the adjustment.13

Goodwill
Goodwill frequently is recognized in business combinations because the total cost of the
combinee exceeds the current fair value of identifiable net assets of the combinee. The
amount of goodwill recognized on the date the business combination is consummated may
be adjusted subsequently when contingent consideration becomes issuable, as illustrated on
page 178.14

“Negative Goodwill”
In some business combinations (known as bargain purchases), the current fair values as-
signed to the identifiable net assets acquired exceed the total cost of the combinee. A bar-
gain purchase is most likely to occur for a combinee with a history of losses or when
common stock prices are extremely low. The excess of the current fair values over total cost
is applied pro rata to reduce (but not below zero) the amounts initially assigned to all the
acquired assets except financial assets other than investments accounted for by the equity
method; assets to be disposed of by sale; deferred tax assets; prepaid assets relating to pen-
sion or other postretirement benefits; and any other current assets. If any excess of current
fair values over cost of the combinee’s net assets remains after the foregoing reduction, it is
recognized as an extraordinary gain by the combinor.15

Illustration of Purchase Accounting for Statutory Merger,

with Goodwill
On December 31, 2005, Mason Company (the combinee) was merged into Saxon Corpo-
ration (the combinor or survivor). Both companies used the same accounting principles for
assets, liabilities, revenue, and expenses and both had a December 31 fiscal year. Saxon
issued 150,000 shares of its $10 par common stock (current fair value $25 a share) to

12
FASB Interpretation No. 21, “Accounting for Leases in a Business Combination” (Stamford: FASB,
1978), pars. 12–15.
13
FASB Statement No. 141, par. 40.
14
Ibid., par. 28.
15
Ibid., pars. 44, 45.
172 Part Two Business Combinations and Consolidated Financial Statements

Mason’s stockholders for all 100,000 issued and outstanding shares of Mason’s no-par,
$10 stated value common stock. In addition, Saxon paid the following out-of-pocket costs
associated with the business combination:

Combinor’s Out-of- Accounting fees:

Pocket Costs of For investigation of Mason Company as prospective combinee $ 5,000
Business Combination For SEC registration statement for Saxon common stock 60,000
Legal fees:
For the business combination 10,000
For SEC registration statement for Saxon common stock 50,000
Finder’s fee 51,250
Printer’s charges for printing securities and SEC 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, Mason Company’s condensed balance sheet was as
follows:

Combinee’s Balance MASON COMPANY (combinee)

Sheet Prior to Merger Balance Sheet (prior to business combination)
Business Combination December 31, 2005

Assets
Current assets $1,000,000
Plant assets (net) 3,000,000
Other assets 600,000
Total assets $4,600,000

Liabilities and Stockholders’ Equity

Current liabilities $ 500,000
Long-term debt 1,000,000
Common stock, no-par, $10 stated value 1,000,000
Additional paid-in capital 700,000
Retained earnings 1,400,000
Total liabilities and stockholders’ equity $4,600,000

Using the guidelines in FASB Statement No. 141, “Business Combinations” (see page 170),
the board of directors of Saxon Corporation determined the current fair values of Mason
Company’s identifiable assets and liabilities (identifiable net assets) as follows:

Current Fair Values Current assets $1,150,000

of Combinee’s Plant assets 3,400,000
Identifiable Net Assets Other assets 600,000
Current liabilities (500,000)
Long-term debt (present value) (950,000)
Identifiable net assets of combinee $3,700,000
 Chapter 5 Business Combinations 173

The condensed journal entries that follow are required for Saxon Corporation (the com-
binor) to record the merger with Mason Company on December 31, 2005, as a business
combination. Saxon uses an investment ledger account to accumulate the total cost of
Mason Company prior to assigning the cost to identifiable net assets and goodwill.

Combinor’s Journal SAXON CORPORATION (combinor)

Entries for Business Journal Entries
Combination December 31, 2005
(Statutory Merger)
Investment in Mason Company Common Stock
(150,000 $25) 3,750,000
Common Stock (150,000 $10) 1,500,000
Paid-in Capital in Excess of Par 2,250,000
To record merger with Mason Company.

Investment in Mason Company Common Stock

($5,000 $10,000 $51,250) 66,250
Paid-in Capital in Excess of Par
($60,000 $50,000 $23,000 750) 133,750
Cash 200,000
To record payment of out-of-pocket costs incurred in merger
with Mason Company. Accounting, legal, and finder’s fees in
connection with the merger are recognized as an investment
cost; other out-of-pocket costs are recorded as a reduction
in the proceeds received from issuance of common stock.

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 Mason Company Common Stock
($3,750,000 $66,250) 3,816,250
To allocate total cost of liquidated Mason Company to
identifiable assets and liabilities, with the remainder to
goodwill. (Income tax effects are disregarded.) Amount
of goodwill is computed as follows:
Total cost of Mason Company
($3,750,000 $66,250) $3,816,250
Less: Carrying amount of
Mason’s identifiable net
assets ($4,600,000
$1,500,000) $3,100,000
Excess (deficiency) of
current fair values of
identifiable net assets
over carrying amounts:
Current assets 150,000
Plant assets 400,000
Long-term debt 50,000 3,700,000
Amount of goodwill $ 116,250
174 Part Two Business Combinations and Consolidated Financial Statements

Note that 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.
Accounting for the income tax effects of business combinations is considered in Chapter 9.
Mason Company (the combinee) prepares the condensed journal entry below to record
the dissolution and liquidation of the company on December 31, 2005.

Recording the MASON COMPANY (combinee)

Liquidation of Journal Entry
Combinee December 31, 2005

Current Liabilities 500,000

Long-Term Debt 1,000,000
Common Stock, $10 stated value 1,000,000
Paid-in Capital in Excess of Stated Value 700,000
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.

Illustration of Purchase Accounting for Acquisition of

Net Assets, with Bargain-Purchase Excess
On December 31, 2005, Davis Corporation acquired all the net assets of Fairmont Corpo-
ration directly from Fairmont for $400,000 cash, in a business combination. Davis paid
legal fees of $40,000 in connection with the combination.
The condensed balance sheet of Fairmont prior to the business combination, with related
current fair value data, is presented below:

Balance Sheet of FAIRMONT CORPORATION (combinee)

Combinee Prior to Balance Sheet (prior to business combination)
Business Combination December 31, 2005

Carrying Current
Amounts Fair Values
Assets
Current assets $ 190,000 $ 200,000
Investment in marketable debt securities (held to maturity) 50,000 60,000
Plant assets (net) 870,000 900,000
Intangible assets (net) 90,000 100,000
Total assets $1,200,000 $1,260,000

Liabilities and Stockholders’ Equity

Current liabilities $ 240,000 $ 240,000
Long-term debt 500,000 520,000
Total liabilities $ 740,000 $ 760,000
Common stock, $1 par $ 600,000
Deficit (140,000)
Total stockholders’ equity $ 460,000
Total liabilities and stockholders’ equity $1,200,000
 Chapter 5 Business Combinations 175

Thus, Davis acquired identifiable net assets with a current fair value of $500,000
($1,260,000 $760,000 $500,000) for a total cost of $440,000 ($400,000 $40,000
$440,000). The $60,000 excess of current fair value of the net assets over their cost to Davis
($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:

Allocation of Excess $900,000

of Current Fair To plant assets: $60,000 $54,000
$900,000 $100,000
Value over Cost of $100,000
Identifiable Net Assets To intangible assets: $60,000 6,000
$900,000 $100,000
of Combinee in Total excess of current fair value of identifiable net assets over
Business Combination combinor’s cost $60,000

No part of the $60,000 bargain-purchase excess is allocated to current assets or to the in-
vestment in marketable securities.
The journal entries below record Davis Corporation’s acquisition of the net assets of
Fairmont Corporation and payment of $40,000 legal fees:

Combinor’s Journal DAVIS CORPORATION (combinor)

Entries for Business Journal Entries
Combination December 31, 2005
(Acquisition of Net
Assets) Investment in Net Assets of Fairmont Corporation 400,000
Cash 400,000
To record acquisition of net assets of Fairmont Corporation.

Investment in Net Assets of Fairmont Corporation 40,000

Cash 40,000
To record payment of legal fees incurred in acquisition of net
assets of Fairmont Corporation.

Current Assets 200,000

Investments 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
Long-Term Debt 500,000
Premium on Long-Term Debt ($520,000 $500,000) 20,000
Investment in Net Assets of Fairmont Corporation
($400,000 $40,000) 440,000
To allocate total cost of net assets acquired to identifiable net assets, with
excess of current fair value of the net assets over their cost prorated to
noncurrent assets other than investment in marketable debt securities.
(Income tax effects are disregarded.)

Other Topics in Accounting for Business Combinations

Statutory Consolidation
Because a new corporation issues common stock to effect a statutory consolidation, one of
the constituent companies in a statutory consolidation must be identified as the combinor,
under the criteria described on page 169. Once the combinor has been identified, the new
176 Part Two Business Combinations and Consolidated Financial Statements

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
recognized by the new corporation at their current fair value.
To illustrate, assume the following balance sheets of the constituent companies involved
in a statutory consolidation on December 31, 2005:

LAMSON CORPORATION AND DONALD COMPANY

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

Lamson Donald
Corporation Company
Assets
Current assets $ 600,000 $ 400,000
Plant assets (net) 1,800,000 1,200,000
Other assets 400,000 300,000
Total assets $2,800,000 $1,900,000

Liabilities and Stockholders’ Equity

Current liabilities $ 400,000 $ 300,000
Long-term debt 500,000 200,000
Common stock, $10 par 430,000 620,000
Additional paid-in capital 300,000 400,000
Retained earnings 1,170,000 380,000
Total liabilities and stockholders’ equity $2,800,000 $1,900,000

The current fair values of both companies’ liabilities were equal to carrying amounts. Cur-
rent fair values of identifiable assets were as follows for Lamson and Donald, respectively:
current assets, $800,000 and $500,000; plant assets, $2,000,000 and $1,400,000; other as-
sets, $500,000 and $400,000.
On December 31, 2005, in a statutory consolidation approved by shareholders of both
constituent companies, a new corporation, LamDon Corporation, issued 74,000 shares of
no-par, no-stated-value common stock with an agreed value of $60 a share, based on the
following valuations assigned by the negotiating directors to the two constituent compa-
nies’ identifiable net assets and goodwill:

Computation of Lamson Donald

Number of Shares of Corporation Company
Common Stock Issued
Current fair value of identifiable net assets:
in Statutory
Lamson: $800,000 $2,000,000 $500,000
Consolidation
$400,000 $500,000 $2,400,000
Donald: $500,000 $1,400,000 $400,000
$300,000 $200,000 $1,800,000
Goodwill 180,000 60,000
Net assets’ current fair value $2,580,000 $1,860,000
Number of shares of LamDon common stock to
be issued to constituent companies’ stockholders,
at $60 a share agreed value 43,000 31,000
 Chapter 5 Business Combinations 177

Because the former stockholders of Lamson Corporation receive the larger interest in the
common stock of LamDon Corporation (43⁄74, or 58%), Lamson is the combinor in the busi-
ness combination. Assuming that LamDon paid $200,000 out-of-pocket costs of the statu-
tory consolidation after it was consummated on December 31, 2005, LamDon’s journal
entries would be as follows:

Journal Entries for LAMDON CORPORATION

New Corporation for Journal Entries
Business Combination December 31, 2005
(Statutory
Consolidation) Investment in Lamson Corporation and Donald Company
Common Stock (74,000 $60) 4,440,000
Common Stock, no par 4,400,000
To record consolidation of Lamson Corporation and Donald Company
as a purchase.

Investment in Lamson Corporation and Donald Company

Common Stock 110,000
Common Stock, no par 90,000
Cash 200,000
To record payment of costs incurred in consolidation of Lamson
Corporation and Donald Company. Accounting, legal, and finder’s
fees in connection with the consolidation are recorded as
investment cost; other out-of-pocket costs are recorded as a
reduction in the proceeds received from the issuance of common
stock.

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
Goodwill 850,000
Current Liabilities ($400,000 $300,000) 700,000
Long-Term Debt ($500,000 $200,000) 700,000
Investment in Lamson Corporation and Donald Company
Common Stock ($4,440,000 $110,000) 4,550,000
To allocate total cost of investment to identifiable assets and
liabilities, at carrying amount for combinor Lamson Corporation’s
net assets and at current fair value for combinee Donald
Company’s net assets. (Income tax effects are disregarded.)
Amount of goodwill is computed as follows:
Total cost of investment
($4,440,000 $110,000) $4,550,000
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 $ 850,000

Note in the foregoing journal entry that because of the combinor’s net assets’ being recog-
nized at carrying amount and because of the $110,000 direct out-of-pocket costs of the
business combination, the amount of goodwill is $850,000, rather than $240,000 ($180,000
$60,000 $240,000), the amount assigned by the negotiating directors to goodwill in the
178 Part Two Business Combinations and Consolidated Financial Statements

determination of the number of shares of common stock to be issued in the combination

(see page 176).

Subsequent Issuance of Contingent Consideration

As indicated on page 169, contingent consideration that is determinable on the date of a
business combination is included in the measurement of cost of the combinee. 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 on page 170, assume that by December 31,
2005, 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 pretax financial income of $580,000 (exclusive of income from the slow-
moving product). On December 31, 2005, Norton prepares the following journal entry to
record the resolution of contingent consideration:

Journal Entry for Goodwill 50,000

Contingent Payable to Robinson Company 50,000
Consideration To record payable contingent consideration applicable to January 2, 2005,
Involving Subsequent business combination as follows:
Sales and Earnings Sales of slow-moving product (300 $100) $30,000
Pretax income of Robb Division
[($580,000 $500,000) 0.25] 20,000
Total payable $50,000

Some business combinations involve contingent consideration based on subsequent

market prices of debt or equity securities issued to effect the combination. Unless the sub-
sequent market price equals at least a minimum amount on a subsequent date or dates, ad-
ditional securities, cash, or other assets must be issued by the combinor to compensate for
the deficiency.
For example, assume the following journal entry for the statutory merger of Soltero Cor-
poration and Mero Company on January 2, 2005:

Journal Entry for Investment in Mero Company Common Stock (120,000 $12) 1,440,000
Business Combination Common Stock, $5 stated value (120,000 $5) 600,000
(Statutory Merger) Paid-in Capital in Excess of Stated Value 840,000
To record merger with Mero Company as a purchase.

Assume that terms of the Soltero–Mero business combination required Soltero to issue ad-
ditional shares of its common stock to the former stockholders of Mero if the market price
of Soltero’s common stock was less than $12 a share on December 31, 2005. If the market
price of Soltero’s common stock was $10 on that date, Soltero prepares the following jour-
nal entry on that date:
 Chapter 5 Business Combinations 179

Journal Entry for Paid-in Capital in Excess of Stated Value (24,000 $5) 120,000
Contingent Common Stock to Be Issued for Contingent Consideration 120,000
Consideration To record additional shares of common stock to be issued under
Involving Subsequent terms of Jan. 2, 2005, merger with Mero Company, as follows:
Market Price of Required value of common stock issued in merger
Common Stock (120,000 $12) $1,440,000
Less: Market value of common stock, Dec. 31, 2005
(120,000 $10) 1,200,000
Market value of additional common stock to be issued $ 240,000
Number of additional shares of common stock to be
issued ($240,000 $10) 24,000

The foregoing journal entry is in accord with the following provisions of FASB Statement
No. 141, “Business Combinations”:
The issuance of additional securities or distribution of other consideration upon resolution of
a contingency based on security prices shall not affect the cost of the [combinee], regardless
of whether the amount specified is a security price to be maintained or a higher security price
to be achieved. When the contingency is resolved and additional consideration is distrib-
utable, the [combinor] shall record the current fair value of the additional consideration is-
sued or issuable. However, the amount previously recorded for securities issued at the date of
[the business combination] shall be simultaneously reduced to the lower current value of
those securities. Reducing the value of debt securities previously issued to their later fair
value results in recording a discount on debt securities. The discount should be amortized
from the date the additional securities are issued.16

IFRS3, “Business Combinations”

The International Accounting Standards Board (IASB) formerly required purchase-type
accounting for all business combinations except those deemed a uniting of interests, de-
fined as a combination in which the stockholders of the constituent companies combine
into one entity the whole of the net assets and operations of those companies to achieve a
continuing mutual sharing of the risks and benefits of the combined enterprise.
However, in 2004 the IASB mandated, in International Financial Reporting Standard 3,
“Business Combinations,” purchase-type accounting for all business combinations, and pe-
riodic testing of goodwill for impairment.

Accounting for Acquired Intangible Assets Subsequent to a

Business Combination
In FASB Statement No. 142, “Goodwill and Other Intangible Assets,” the Financial
Accounting Standards Board provided that intangible assets with finite useful lives were to
be amortized over those estimated useful lives. In contrast, goodwill and other intangible
assets with indefinite useful lives were not to be amortized but were to be tested for
impairment at least annually.17 The FASB also provided detailed procedures for impair-
ment tests.18 Those procedures typically are described and illustrated in intermediate ac-
counting textbooks.

16
FASB Statement No. 141, par. 30.
17
FASB Statement No. 142, “Goodwill and Other Intangible Assets,” pars. 11, 16, 18.
18
Ibid. pars. 17, 19–25.
180 Part Two Business Combinations and Consolidated Financial Statements

Financial Statements Following a Business Combination

The balance sheet for a combined enterprise issued as of the date of a business combina-
tion accomplished through a statutory merger, statutory consolidation, or acquisition of as-
sets 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 is described in Chapter 6.) In a balance sheet following a business
combination, assets and liabilities of the combinor are at carrying amount, assets acquired
from the combinee are at current fair value (adjusted for any bargain-purchase excess as
illustrated on page 175), and retained earnings is that of the combinor only. The income
statement of the combined enterprise for the accounting period in which a business combi-
nation occurred includes the operating results of the combinee after the date of the com-
bination only.

Disclosure of Business Combinations in a Note to 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.
Following are the extensive disclosure requirements for business combinations estab-
lished by the FASB: 19
The notes to the financial statements of a combined entity shall disclose the following
information in the period in which a material business combination is completed:

1. The name and a brief description of the acquired entity and the percentage of voting
equity interests acquired
2. The primary reasons for the acquisition, including a description of the factors that con-
tributed to a purchase price that results in recognition of goodwill
3. The period for which the results of operations of the acquired entity are included in the
income statement of the combined entity
4. The cost of the acquired entity and, if applicable, the number of shares of equity inter-
ests (such as common shares, preferred shares, or partnership interests) issued or is-
suable, the value assigned to those interests, and the basis for determining that value
5. A condensed balance sheet disclosing the amount assigned to each major asset and lia-
bility caption of the acquired entity at the acquisition date
6. Contingent payments, options, or commitments specified in the acquisition agree-
ment and the accounting treatment that will be followed should any such contingency
occur
7. The amount of purchased research and development assets acquired and written off in
the period . . . and the line item in the income statement in which the amounts written
off are aggregated
8. For any purchase price allocation that has not been finalized, that fact and the reasons
therefor. In subsequent periods, the nature and amount of any material adjustments made
to the initial allocation of the purchase price shall be disclosed.

The notes to the financial statements also shall disclose the following information in the
period in which a material business combination is completed if the amounts assigned to

19
Ibid., pars. 51–55.
 Chapter 5 Business Combinations 181

goodwill or to other intangible assets acquired are significant in relation to the total cost of
the acquired entity:

1. For intangible assets subject to amortization:

a. The total amount assigned and the amount assigned to any major intangible asset
class
b. The amount of any significant residual value, in total and by major intangible asset
class
c. The weighted-average amortization period, in total and by major intangible asset
class
2. For intangible assets not subject to amortization, the total amount assigned and the
amount assigned to any major intangible asset class
3. For goodwill:
a. The total amount of goodwill and the amount that is expected to be deductible for tax
purposes
b. The amount of goodwill by reportable segment (if the combined entity is required
to disclose segment information in accordance with FASB Statement No. 131, “Dis-
closures about Segments of an Enterprise and Related Information,” unless not
practicable)

The notes to the financial statements shall disclose the following information if a series
of individually immaterial business combinations completed during the period are material
in the aggregate:

1. The number of entities acquired and a brief description of those entities

2. The aggregate cost of the acquired entities, the number of equity interests (such as com-
mon shares, preferred shares, or partnership interests) issued or issuable, and the value
assigned to those interests
3. The aggregate amount of any contingent payments, options, or commitments and the
accounting treatment that will be followed should any such contingency occur (if poten-
tially significant in relation to the aggregate cost of the acquired entities)
4. Information regarding intangible assets and goodwill if the aggregate amount assigned to
those assets acquired is significant in relation to the aggregate cost of the acquired entities

If the combined entity is a public business enterprise, the notes to the financial
statements shall include the following supplemental information on a pro forma basis
for the period in which a material business combination occurs (or for the period in
which a series of individually immaterial business combinations occur that are material
in the aggregate):

1. Results of operations for the current period as though the business combination or com-
binations had been completed at the beginning of the period, unless the acquisition was
at or near the beginning of the period
2. Results of operations for the comparable prior period as though the business combina-
tion or combinations had been completed at the beginning of that period if comparative
financial statements are presented

At a minimum, the supplemental pro forma information shall display revenue, income
before extraordinary items and the cumulative effect of accounting changes, net income,
and earnings per share. In determining the pro forma amounts, income taxes, interest
expense, preferred share dividends, and depreciation and amortization of assets shall be
182 Part Two Business Combinations and Consolidated Financial Statements

adjusted to the accounting base recognized for each in recording the combination. Pro
forma information related to results of operations of periods prior to the combination shall
be limited to the results of operations for the immediately preceding period. Disclosure also
shall be made of the nature and amount of any material, nonrecurring items reported in the
pro forma results of operations.

APPRAISAL OF ACCOUNTING STANDARDS FOR

BUSINESS COMBINATIONS
The accounting standards for business combinations described and illustrated in the pre-
ceding pages of this chapter may be criticized on grounds that they are not consistent with
the conceptual framework for financial accounting and reporting.
The principal criticisms of purchase accounting center on the recognition of good-
will. Many accountants take exception to the residual basis for valuing goodwill estab-
lished in FASB Statement No. 141. These critics contend that part of the amounts 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 de-
scribed in intermediate accounting textbooks. 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 a loss.
Other accountants question whether current fair values of the combinor’s net assets—
especially goodwill—should be disregarded in accounting for a business combination.
They maintain it is inconsistent to reflect current fair values for net assets of the combinee
only, in view of the significance of many combinations involving large constituent com-
panies.
The FASB has undertaken a reexamination of purchase accounting, despite the recency
of its issuance of FASB Statement No. 141, because of many questions that have been
posed regarding the accounting standards established in that pronouncement. As of the date
of this writing, the FASB had not issued a revised Standard.

SEC ENFORCEMENT ACTIONS DEALING WITH

WRONGFUL APPLICATION OF ACCOUNTING
STANDARDS FOR BUSINESS COMBINATIONS
AAER 38
AAER 38, “Securities and Exchange Commission v. Corda Diversified Technologies Inc.,
et al.” (September 10, 1984), reports a federal court’s entry of an injunction against a cor-
porate manufacturer and marketer of residential, commercial, and industrial hardware
and its CEO, CFO, and independent auditors. The SEC stated that the corporation, which
formerly had been a publicly owned “shell” with no operations, had wrongly been iden-
tified as the combinor in a business combination with a privately owned company. Be-
cause the former stockholders of the privately owned corporation controlled 75% of the
outstanding common stock of the “shell” following the business combination, the pri-
vately owned company was the combinor. Nonetheless, it was improperly accounted for
as the combinee, and its assets were carried at current fair values in the consolidated fi-
nancial statements. The result was that consolidated total assets, reported as $15,119,727,
were overstated by at least $9 million. In a related enforcement action, reported in AAER 39,
 Chapter 5 Business Combinations 183

“. . . In the Matter of Smith & Stephens Accountancy Corporation and James J. Smith”
(September 10, 1984), the SEC permanently prohibited the independent auditors of the
manufacturing corporation from appearing or practicing before the SEC, with the proviso
that, under specified conditions, the auditors could apply for reinstatement after two
years.

AAER 275
In AAER 275, “. . . In the Matter of Charles C. Lehman, Jr.” (September 28, 1990), the
SEC reported the permanent disbarment of a CPA from appearing or practicing before it,
with the proviso that the CPA might, if he complied with specified conditions, apply for
reinstatement in 18 months. According to the SEC, the CPA, on behalf of the firm of
which he was managing partner, improperly expressed an unqualified audit opinion on the
financial statements of a combined enterprise following a merger in which the survivor
was improperly identified as the combinor. The merging company actually was the combi-
nor because following the business combination its former sole stockholder owned 82.8% of
the outstanding common stock of the survivor. The consequence of the misidentification
of the combinor was the overstatement of a principal asset of the combined enterprise by
12,045% ($1,342,600 compared with $11,055).

AAER 598
A significant part of AAER 598, “. . . In the Matter of Meris Laboratories, Inc.,
Stephen B. Kass, and John J. DiPitro” (September 26, 1994), deals with an independent
clinical laboratory’s improper accounting for direct out-of-pocket costs of business
combinations. According to the SEC, included in such costs, which were capitalized
as part of the total costs of the combinations, were payroll costs of employees who were
to be terminated following the combinations; write-offs of combinee accounts receiv-
able; erroneously paid sales commissions; various recurring internal costs of operations;
and payments under consulting contracts. The aggregate overstatement of income re-
sulting from the improper accounting was 80%. The SEC ordered the clinical labora-
tory, its CEO, and its CFO (a CPA) to cease and desist from violating the federal
securities laws.

AAERs 601, 606, and 607

The SEC undertook enforcement actions against the engagement partner and audit man-
ager of a CPA firm and the controller of the firm’s audit client as reported in the following
releases:
• AAER 601, “. . . In the Matter of Martin Halpern, CPA” (September 27, 1994).
• AAER 606, “. . . In the Matter of Louis Fox, CPA” (September 28, 1994).
• AAER 607, “. . . In the Matter of Jeffrey R. Pearlman, CPA” (September 28, 1994).
The SEC found that the engagement partner and manager of the CPA firm had failed to
comply with generally accepted auditing standards in the audit of financial statements
prepared by the controller following a business combination in which the combinor was
improperly identified as the combinee. The result was a nearly $18,000,000 overstate-
ment of the combinor’s patents in the financial statements of the combined enterprise.
The audit manager was permanently barred from practicing before the SEC, and the en-
gagement partner and company controller were similarly barred, but for a period of
three years.
184 Part Two Business Combinations and Consolidated Financial Statements

Review 1. Define business combination.

Questions 2. Differentiate between a statutory merger and a statutory consolidation.
3. Identify two methods that may be used, individually or jointly, to determine an appro-
priate price to pay for a combinee in a business combination.
4. How is the combinor in a business combination determined?
5. State how each of the following out-of-pocket costs of a merger business combination
is accounted for by the combinor:
a. Printing costs for proxy statement mailed to combinor’s stockholders in advance of
special meeting to ratify terms of the merger.
b. Legal fees for negotiating the merger.
c. CPA firm’s fees for auditing financial statements in SEC registration statement cov-
ering shares of common stock issued in the merger.
d. Printing costs for common stock certificates issued in the merger.
e. Legal fees for SEC registration statement covering shares of common stock issued
in the merger.
f. CPA firm’s fees for advice on income tax aspects of the merger.
6. Goodwill often is recognized in business combinations. Explain the meaning of good-
will and negative goodwill.
7. Define contingent consideration in a business combination.
8. How is the total cost of a combinee allocated in a business combination?
9. Define the term preacquisition contingencies.
10. What combinee intangible assets other than goodwill are to be given accounting recog-
nition in a business combination?

Exercises
(Exercise 5.1) Select the best answer for each of the following multiple-choice questions:
1. Is one or more of the constituent companies always liquidated in a business combination
carried out by means of:

A Statutory An Acquisition of
A Statutory Merger? Consolidation? Common Stock?
a. Yes Yes Yes
b. Yes No Yes
c. Yes Yes No
d. No Yes Yes

2. The cost of a combinee in a business combination includes all the following except:
a. Legal fees and finder’s fee.
b. Cost of registering and issuing debt securities issued to effect the combination.
c. Amount of consideration.
d. Contingent consideration that is determinable.
 Chapter 5 Business Combinations 185

3. A target company’s defense against an unfriendly takeover that involves the disposal of
one or more profitable business segments of the target is termed:
a. Pac-man defense b. Scorched earth c. Shark repellent d. Poison pill
4. Are the combinees always liquidated in business combinations accomplished by a(n):

Statutory Statutory Acquisition of Acquisition

Merger? Consolidation? Common Stock? of Assets?
a. Yes Yes Yes No
b. Yes Yes No Yes
c. Yes Yes No No
d. Yes No No Yes

5. In a “bargain purchase” business combination, the excess of the current fair value of the
combinee’s identifiable net assets over the cost to the combinor is:
a. Credited to the combinor’s Negative Goodwill ledger account.
b. Offset against the balance of the combinor’s Investment in Combinee Company
ledger account.
c. Credited to the combinor’s Additional Paid-in Capital ledger account.
d. Accounted for in some other manner.
6. The term survivor is associated with a business combination accomplished through:
a. A statutory merger.
b. A statutory consolidation.
c. An acquisition of common stock.
d. An acquisition of assets.
7. Does the date-of-combination cost of the combinee in a business combination
include:

Determinable Contingent Nondeterminable

Consideration? Contingent Consideration?
a. Yes Yes
b. Yes No
c. No Yes
d. No No

8. In the balance sheet of a combined enterprise on the date of a business combination, un-
allocated negative goodwill is displayed:
a. In stockholders’ equity.
b. In a note to financial statements.
c. As an offset to total assets.
d. As a deferred credit.
e. In some other manner.
(Exercise 5.2) The balance sheet of Mel Company on January 31, 2005, showed current assets, $100,000;
other assets, $800,000; current liabilities, $80,000; long-term debt, $240,000; common
stock (10,000 shares, $10 par), $100,000; and retained earnings, $480,000. On that date,
CHECK FIGURE Mel merged with Sal Corporation in a business combination in which Sal issued 35,000
Debit goodwill, shares of its $1 par (current fair value $20 a share) common stock to stockholders of Mel
$90,000. in exchange for all their outstanding common stock. The current fair values of Mel’s
186 Part Two Business Combinations and Consolidated Financial Statements

liabilities were equal to their carrying amounts; the current fair values of Mel’s current assets
and other assets (none intangible) were $120,000 and $850,000, respectively, on January 31,
2005. Also on that date, Sal paid direct out-of-pocket costs of the business combination,
$40,000, and costs of registering and issuing its common stock, $70,000.
Prepare journal entries (omit explanations) for Sal Corporation to record its merger with
Mel Company on January 31, 2005. (Disregard income taxes.)
(Exercise 5.3) The condensed balance sheet of Geo Company on March 31, 2005, is shown below:

GEO COMPANY
Balance Sheet (prior to business combination)
March 31, 2005

Assets
CHECK FIGURE Cash $ 20,000
Amount of goodwill, Other current assets 140,000
$10,000. Plant assets (net) 740,000
Total assets $900,000

Liabilities and Stockholders’ Equity

Current liabilities $ 80,000
Long-term debt 200,000
Common stock, $2 par 180,000
Additional paid-in capital 120,000
Retained earnings 320,000
Total liabilities and stockholders’ equity $900,000

On March 31, 2005, Master Corporation paid $700,000 cash for all the net assets of Geo
(except cash) in a business combination. The carrying amounts of Geo’s other current as-
sets and current liabilities were the same as their current fair values. However, current fair
values of Geo’s plant assets and long-term debt were $920,000 and $190,000, respectively.
Also on March 31, Master paid the following direct out-of-pocket costs for the business
combination with Geo:

Legal fees $ 10,000

Finder’s fee 70,000
CPA firm’s fee for audit of Geo Company’s March 31, 2005, financial
statements 20,000
Total out-of-pocket costs of business combination $100,000

Prepare a working paper to compute the amount of goodwill or bargain-purchase excess

in the business combination of Master Corporation and Geo Company on March 31, 2005.
(Disregard income taxes.)
(Exercise 5.4) The balance sheet of Combinee Company on January 31, 2005, was as follows:
 Chapter 5 Business Combinations 187

CHECK FIGURE COMBINEE COMPANY

Debit goodwill,
Balance Sheet (prior to business combination)
$85,257. January 31, 2005

Assets Liabilities and Stockholders’ Equity

Current assets $ 300,000 Current liabilities $ 200,000
Plant assets 600,000 Long-term debt 300,000
Other assets 100,000 Common stock, no
par or stated value 100,000
Retained earnings 400,000
Total liabilities and
Total assets $1,000,000 stockholders’ equity $1,000,000

On January 31, 2005, Combinor Company issued $700,000 face amount of 6%, 20-year
bonds due January 31, 2025, with a present value of $625,257 at a 7% yield, to Combinee
Company for its net assets. On January 31, 2005, the current fair values of Combinee’s li-
abilities equaled their carrying amounts; however, current fair values of Combinee’s assets
were as follows:

Current assets $320,000

Plant assets 680,000
Other assets (none intangible) 120,000

Also on January 31, 2005, Combinor paid out-of-pocket costs of the combination as
follows:

Accounting, legal, and finder’s fees incurred for combination $ 80,000

Costs of registering 6% bonds with SEC 110,000
Total out-of-pocket costs $190,000

Prepare journal entries (omit explanations) dated January 31, 2005, for Combinor Com-
pany to record its acquisition of the net assets of Combinee Company. (Disregard income
taxes.)
(Exercise 5.5) On March 31, 2005, Combinor Company issued 100,000 shares of its $1 par common stock
(current fair value $5 a share) for the net assets of Combinee Company. Also on that date,
Combinor paid the following out-of-pocket costs in connection with the combination:

Finder’s, accounting, and legal fees relating to business combination $ 70,000

Costs associated with SEC registration statement 50,000
Total out-of-pocket costs of business combination $120,000

The balance sheet of Combinee on March 31, 2005, with related current fair values, was as
follows:
188 Part Two Business Combinations and Consolidated Financial Statements

CHECK FIGURE COMBINEE COMPANY

Debit goodwill,
Balance Sheet (prior to business combination)
$20,000. March 31, 2005

Carrying Current
Amounts Fair Values
Assets
Current assets $200,000 $260,000
Plant assets (net) 400,000 480,000
Other assets (none intangible) 140,000 150,000
Total assets $740,000

Liabilities and Stockholders’ Equity

Current liabilities $ 80,000 $ 80,000
Long-term debt 260,000 260,000
Common stock, no par or stated value 150,000
Retained earnings 250,000
Total liabilities and stockholders’ equity $740,000

Prepare journal entries (omit explanations) for Combinor Company on March 31, 2005,
to record the business combination with Combinee Company. (Disregard income taxes.)
(Exercise 5.6) On May 31, 2005, Byers Corporation acquired for $560,000 cash all the net assets except
cash of Sellers Company, and paid $60,000 cash to a law firm for legal services in connection
with the business combination. The balance sheet of Sellers on May 31, 2005, was as follows:

CHECK FIGURE
SELLERS COMPANY
Debit goodwill,
Balance Sheet (prior to business combination)
$30,000. May 31, 2005

Assets Liabilities and Stockholders’ Equity

Cash $ 40,000 Liabilities $ 620,000
Other current assets (net) 280,000 Common stock, $1 par 250,000
Plant assets (net) 760,000 Retained earnings 330,000
Intangible assets (net) 120,000 Total liabilities and
Total assets $1,200,000 stockholders’ equity $1,200,000

The present value of Sellers’s liabilities on May 31, 2005, was $620,000. The current fair
values of its noncash assets were as follows on May 31, 2005:

Other current assets $300,000

Plant assets 780,000
Intangible assets (all recognizable under generally accepted
accounting principles for business combinations) 130,000

Prepare journal entries (omit explanations) for Byers Corporation on May 31, 2005, to
record the acquisition of the net assets of Sellers Company except cash. (Disregard income
taxes.)
(Exercise 5.7) On September 26, 2005, Acquirer Corporation paid $160,000 cash to Disposer Company
for all its net assets except cash, and $10,000 for direct out-of-pocket costs of the business
 Chapter 5 Business Combinations 189

combination. There was no contingent consideration. Current fair values of Disposer’s iden-
tifiable net assets on September 26, 2005, were as follows:

CHECK FIGURE
Current Fair
Debit intangible assets,
Values
$47,500.
Cash $ 10,000
Other current assets 120,000
Plant assets 150,000
Intangible assets (all recognizable in accordance with generally
accepted accounting principles for business combinations) 50,000
Current liabilities 90,000
Long-term debt (face amount $60,000) 50,000

Prepare journal entries (omit explanations) for Acquirer Corporation on September 26,
2005, to record the business combination. (Disregard income taxes.)
(Exercise 5.8) On December 31, 2005, Combinor Company issued 100,000 shares of its $1 par common
stock (current fair value $5 a share) in exchange for all the outstanding common stock of
Combinee Company in a statutory merger. Also on that date, Combinor paid the following
out-of-pocket costs in connection with the combination:

CHECK FIGURE
Accounting, finder’s, and legal fees relating to business combination $ 70,000
Credit paid-in capital,
Costs associated with SEC registration statement 50,000
$400,000.
Total out-of-pocket costs of business combination $120,000

The balance sheet of Combinee on December 31, 2005, was as follows:

COMBINEE COMPANY
Balance Sheet (prior to business combination)
December 31, 2005

Assets
Current assets $200,000
Plant assets (net) 400,000
Other assets (none intangible) 140,000
Total assets $740,000

Liabilities and Stockholders’ Equity

Current liabilities $ 80,000
Long-term debt 260,000
Common stock, no par or stated value 150,000
Retained earnings 250,000
Total liabilities and stockholders’ equity $740,000

The current fair values of Combinee’s identifiable net assets were equal to their carrying
amounts on December 31, 2005.
Prepare journal entries (omit explanations) for Combinor Company on December 31, 2005,
to record the business combination with Combinee Company. (Disregard income taxes.)
(Exercise 5.9) The balance sheet of Combinee Company on September 24, 2005, was as follows:
190 Part Two Business Combinations and Consolidated Financial Statements

CHECK FIGURE
COMBINEE COMPANY
Credit paid-in capital,
Balance Sheet (prior to business combination)
$2,900,000. September 24, 2005

Current assets $ 200,000 Current liabilities $ 100,000

Plant assets 700,000 Long-term debt 300,000
Other assets Common stock, no par or
(none intangible) 100,000 stated value 200,000
Retained earnings 400,000
Total liabilities and
Total assets $ 1,000,000 stockholders’ equity $1,000,000

On that date, Combinor Corporation issued 100,000 shares of its $1 par ($30 current fair
value) common stock for all the outstanding common stock of Combinee Company in a statu-
tory merger and paid the following out-of-pocket costs in connection with the combination:

Direct out-of-pocket costs of the combination $130,000

Costs associated with SEC registration statement 50,000
Total out-of-pocket costs $180,000

The current fair values of Combinee’s identifiable net assets were equal to their carrying
amounts; however, $400,000 of Combinor’s cost was allocable to identifiable tangible and
intangible assets of Combinee that resulted from Combinee’s research and development ac-
tivities. Those assets had no further use in research and development projects.
Prepare journal entries (omit explanations) on September 24, 2005, for (a) Combinor Cor-
poration and (b) Combinee Company to record the statutory merger. (Disregard income taxes.)
(Exercise 5.10) The balance sheet of Nestor Company on February 28, 2005, with related current fair val-
ues of assets and liabilities, was as follows:

CHECK FIGURE
NESTOR COMPANY
Credit paid-in capital,
Balance Sheet (prior to business combination)
$600,000.
February 28, 2005

Carrying Current
Amounts Fair Values
Assets
Current assets $ 500,000 $ 520,000
Plant assets (net) 1,000,000 1,050,000
Other assets (none intangible) 300,000 310,000
Total assets $1,800,000

Liabilities and Stockholders’ Equity

Current liabilities $ 300,000 $ 300,000
Long-term debt 400,000 480,000
Common stock, $1 par 500,000
Additional paid-in capital 200,000
Retained earnings 400,000
Total liabilities and stockholders’ equity $1,800,000
 Chapter 5 Business Combinations 191

On February 28, 2005, Bragg Corporation issued 600,000 shares of its $1 par common
stock (current fair value $2 a share) to Lucy Rowe, sole stockholder of Nestor Company,
for all 500,000 shares of Nestor common stock owned by her, in a merger business combi-
nation. Because the merger was negotiated privately and Rowe signed a “letter agreement”
not to dispose of the Bragg common stock she received, the Bragg stock was not subject to
SEC registration requirements. Thus, only $8,000 in legal fees was incurred to effect the
merger; these fees were paid in cash by Bragg on February 28, 2005.
Prepare journal entries for Bragg Corporation on February 28, 2005, to record the busi-
ness combination with Nestor Company. (Disregard income taxes.)
(Exercise 5.11) The condensed balance sheet of Maxim Company on December 31, 2005, prior to the busi-
ness combination with Sorrel Corporation, was as follows:

CHECK FIGURE
MAXIM COMPANY
Debit paid-in capital,
Balance Sheet (prior to business combination)
$40,000
December 31, 2005

Assets
Current assets $ 400,000
Plant assets (net) 1,200,000
Other assets (none intangible) 200,000
Total assets $1,800,000

Liabilities and Stockholders’ Equity

Current liabilities $ 300,000
Common stock, $1 par 400,000
Additional paid-in capital 200,000
Retained earnings 900,000
Total liabilities and stockholders’ equity $1,800,000

On December 31, 2005, Sorrel issued 800,000 shares of its $1 par common stock (current
fair value $3 a share) for all the outstanding common stock of Maxim in a statutory merger.
Also on December 31, 2005, Sorrel paid the following out-of-pocket costs of the business
combination with Maxim:

Finder’s and legal fees relating to business combination $30,000

Costs associated with SEC registration statement 40,000
Total out-of-pocket costs of business combination $70,000

On December 31, 2005, the current fair values of Maxim’s other assets and current liabili-
ties equaled their carrying amounts; current fair values of Maxim’s current assets and plant
assets were $500,000 and $1,500,000, respectively.
Prepare journal entries (omit explanations) for Sorrel Corporation on December 31,
2005, to record the business combination with Maxim Company. (Disregard income taxes.)
(Exercise 5.12) On August 31, 2005, Combinor Corporation entered into a statutory merger business com-
bination with Combinee Company, by issuing 100,000 shares of $1 par common stock hav-
ing a current fair value of $20 a share for all 50,000 outstanding shares of Combinee’s
no-par, no-stated-value common stock. Also, Combinor paid the following out-of-pocket
costs of the combination on August 31, 2005:
192 Part Two Business Combinations and Consolidated Financial Statements

CHECK FIGURE
Finder’s and legal fees relating to business combination $100,000
Credit paid-in capital,
Costs associated with SEC registration statement 150,000
$1,900,000.
Total out-of-pocket costs of business combination $250,000

On August 31, 2005, Combinee’s balance sheet included the following:

Carrying Amounts Current Fair Values

Current assets $ 500,000 $ 600,000
Plant assets (net) 2,600,000 2,800,000
Current liabilities 400,000 400,000
Long-term debt 1,000,000 1,000,000
Common stock 800,000
Retained earnings 900,000

Prepare journal entries (omit explanations) for Combinor Corporation on August 31,
2005, to record the statutory merger with Combinee Company. (Disregard income taxes.)
(Exercise 5.13) On November 1, 2005, Sullivan Corporation issued 50,000 shares of its $10 par common
stock in exchange for all the common stock of Mears Company in a statutory merger. Out-
CHECK FIGURE of-pocket costs of the business combination may be disregarded. Sullivan tentatively
b. Basic EPS, $2.64. recorded the shares of common stock issued at par and debited the Investment in Mears
Company Common Stock ledger account for $500,000. Mears Company was liquidated
and became Mears Division of Sullivan Corporation. The net income of Sullivan Corpora-
tion and Mears Company or Mears Division during 2005 was as follows:

Jan. 1 through Oct. 31 Nov. 1 through Dec. 31

Sullivan Corporation $420,000 $80,000*
Mears Company 350,000
Mears Division of Sullivan
Corporation 50,000

*Excludes any portion of Mears Division net income.

Condensed balance sheet information and other data for 2005 follow:

Mears
Division
Mears of Sullivan
Sullivan Corporation
Company Corporation
Oct. 31 Dec. 31 Oct. 31 Dec. 31
Assets $3,500,000 $4,080,000 $4,000,000 $4,150,000
Liabilities 500,000 500,000 1,000,000 1,100,000
Common stock, $10 par 2,000,000 2,500,000 2,000,000
Retained earnings 1,000,000 1,080,000* 1,000,000
Market price per share
of common stock 100 130 20

*Excludes any portion of Mears Division net income.

 Chapter 5 Business Combinations 193

Neither Sullivan nor Mears Company declared or paid dividends during 2005. In recent
months, Sullivan’s common stock had been trading at about 40 times earnings; prior to
November 1, 2005, Mears Company common stock had been trading at 10 times earnings.
Answer the following questions, assuming that the difference between current fair val-
ues and carrying amounts of Mears Company’s identifiable net assets applies to land.
Show supporting computations and disregard income taxes.
a. What is Sullivan’s net income for the year ended December 31, 2005?
b. What is Sullivan’s basic earnings per share for the year ended December 31, 2005?
c. What is the amount of Sullivan’s retained earnings on December 31, 2005?
(Exercise 5.14) On December 31, 2005, Tucker Corporation acquired all the net assets of Loring Company
for 100,000 shares of Tucker’s $2 par common stock having a current fair value of $16 a
share. Terms of the business combination required Tucker to issue additional shares of
common stock to Loring on December 31, 2006, if the market price of the common stock
CHECK FIGURE was less than $16 a share on that date. Sufficient shares would be issued to make the
Number of additional aggregate market value of the total shares issued to Loring equal to $1,600,000 on Decem-
shares to be issued, ber 31, 2006. The market price of Tucker’s common stock on that date was $10 a share.
60,000. Prepare a journal entry for Tucker Corporation on December 31, 2006, to record the ad-
ditional shares of common stock issuable to Loring Company on that date.

Cases
(Case 5.1) You have been engaged to audit the financial statements of Solamente Corporation for the
fiscal year ended May 31, 2005. You discover that on June 1, 2004, Mika Company had
been merged into Solamente in a business combination. You also find that both Solamente
and Mika (prior to its liquidation) incurred legal fees, accounting fees, and printing costs
for the business combination; both companies debited those costs to an intangible asset
ledger account entitled “Cost of Business Combination.” In its journal entry to record the
business combination with Mika, Solamente increased its Cost of Business Combination
account by an amount equal to the balance of Mika’s comparable ledger account.

Instructions
Evaluate Solamente’s accounting for the out-of-pocket costs of the business combination
with Mika.
(Case 5.2) You are the controller of Software Company, a distributor of computer software, which is
planning to acquire a portion of the net assets of a product line of Midge Company, a com-
petitor enterprise. The projected acquisition cost is expected to exceed substantially the cur-
rent fair value of the identifiable net assets to be acquired, which the competitor has agreed
to sell because of its substantial net losses of recent years. The board of directors of Soft-
ware asks if the excess acquisition cost may appropriately be recognized as goodwill.

Instructions
Prepare a memorandum to the board of directors in answer to the question, after consulting
the following:
Statement of Financial Accounting Concepts No. 6, “Elements of Financial
Statements,” par. 25.
FASB Statement No. 141, “Business Combinations,” pars. 9, 43, F1 (Goodwill).
FASB Statement No. 142, “Goodwill and Other Intangible Assets,” par. B67.
194 Part Two Business Combinations and Consolidated Financial Statements

(Case 5.3) On February 15, 2005, officers of Shane Corporation agreed with George Merlo, sole stock-
holder of Merlo Company and Merlo Industries, Inc., to acquire all his common stock own-
ership in the two companies as follows:
1. 10,000 shares of Shane’s $1 par common stock (current fair value $30 a share) would be
issued to George Merlo on February 28, 2005, for his 1,000 shares of $10 par common
stock of Merlo Company. In addition, 20,000 shares of Shane common stock would be
issued to George Merlo on February 28, 2010, if aggregate net income of Merlo Com-
pany for the five-year period then ended exceeded $300,000.
2. $250,000 cash would be paid to George Merlo on February 28, 2005, for his 10,000
shares of $1 par common stock of Merlo Industries, Inc. In addition $250,000 in cash
would be paid to George Merlo on February 28, 2010, if aggregate net income of Merlo
Industries, Inc., for the five-year period then ended exceeded $300,000.
Both Merlo Company and Merlo Industries, Inc., were to be merged into Shane on Feb-
ruary 28, 2005, and were to continue operations after that date as divisions of Shane.
George Merlo also agreed not to compete with Shane for the period March 1, 2005,
through February 28, 2010. Because the merger was negotiated privately and George Merlo
signed a “letter agreement” not to dispose of the Shane common stock he received, the
business combination was not subject to the jurisdiction of the SEC. Out-of-pocket costs of
the business combination may be disregarded.
Selected financial statement data of the three constituent companies as of February 28,
2005 (prior to the merger), were as follows:

Shane Merlo Merlo

Corporation Company Industries, Inc.
Total assets $25,000,000 $ 500,000 $ 600,000
Stockholders’ equity 10,000,000 200,000 300,000
Net sales 50,000,000 1,500,000 2,500,000
Basic earnings per share 5 30 3

The controller of Shane prepared the following condensed journal entries to record the
merger on February 28, 2005:

Assets other than goodwill 600,000

Goodwill 10,000
Liabilities 300,000
Common Stock 10,000
Common Stock to Be Issued 20,000
Paid-in Capital in Excess of Par 280,000
To record merger with Merlo Company, with identifiable assets and
liabilities recorded at current fair values and goodwill recognized.

Assets 650,000
Goodwill 150,000
Liabilities 300,000
Payable to George Merlo 250,000
Cash 250,000
To record merger with Merlo Industries, Inc., with assets and
liabilities of Merlo Industries, Inc., recorded at current fair
values and goodwill recognized.
 Chapter 5 Business Combinations 195

Instructions
Do you concur with the controller’s journal entries? Explain.
(Case 5.4) Robert Frank, sole stockholder of Frank Electronics, Inc., a non-publicly owned corpora-
tion, has brought you the following balance sheets:

FRANK ELECTRONICS, INC.

Balance Sheet
March 31, 2005

Assets Liabilities and Stockholder’s Equity

Current assets $150,000 Current liabilities $ 70,000
Plant assets (net) 300,000 Long-term debt 130,000
Intangible assets (net)* 50,000 Common stock, no par
or stated value,
10,000 shares authorized,
issued, and outstanding 100,000
Retained earnings 200,000
Total liabilities and
Total assets $500,000 stockholder’s equity $500,000

*All recognizable under generally accepted accounting principles for business combinations.

LESTER ENTERPRISES, INC.

Balance Sheet
March 31, 2005

Assets Liabilities and Stockholder’s Equity

Cash $ 50,000 Liabilities $ 0
Common stock subscriptions Common stock, no par or
receivable 5,000 stated value, 50,000
Investments in shares authorized:
marketable equity Issued and outstanding,
securities (available 10,000 shares 80,000
for sale) 45,000 Subscribed, 5,000 shares 5,000
Retained earnings 11,000
Accumulated other
comprehensive income 4,000
Total liabilities and
Total assets $100,000 stockholder’s equity $100,000

Robert Frank states that he wants your advice on the proper accounting for a proposed
business combination (statutory merger) to be consummated shortly after March 31, 2005,
in which Lester Enterprises would issue 12,000 shares of common stock to Robert Frank in
exchange for his 10,000 shares of Frank Electronics common stock. The Lester Enterprises
shares would be assigned a fair value of $40 per share; if Lester Enterprises were deemed
the combinor, the $180,000 excess [(12,000 $40) ($100,000 $200,000) $180,000]
would be allocated to Frank Electronics assets as follows:
196 Part Two Business Combinations and Consolidated Financial Statements

Current assets $ 40,000

Plant assets 90,000
Intangible assets 20,000
Goodwill 30,000
Total $180,000

In response to your inquiries, Robert Frank explained that Lester Enterprises, now solely
owned by George Lester, was registered with the Securities and Exchange Commission be-
cause it had been a publicly owned corporation before George Lester had “bought out” the
other five shareholders. Later, George Lester sold all operating assets of Lester Enterprises
to an unrelated publicly owned corporation in exchange for equity securities of that corpo-
ration (Lester Enterprises’ marketable equity securities investment). Robert Frank also
stated that George Lester had subscribed to 5,000 shares of Lester Enterprises common
stock on March 31, 2005, and that the subscription price of $5,000 was payable on June 30,
2005.

Instructions
Would Lester Enterprises, Inc., be the combinor in the merger with Frank Electronics, Inc.?
Explain.
(Case 5.5) Paragraph B121 of FASB Statement No. 141, “Business Combinations,” reads in part as
follows:
Based on its analysis, the [Financial Accounting Standards] Board concluded that core good-
will meets the assets definition in [Statement of Financial Accounting Concepts No. 6,
“Elements of Financial Statements”] . . .

Instructions
After reading paragraphs B101 through B120 of Statement No. 141, do you agree with the
FASB’s conclusion? Explain.

Problems
(Problem 5.1) On January 31, 2005, La Salle Corporation acquired for $540,000 cash all the net assets ex-
cept cash of De Soto Company and paid $60,000 cash to a law firm for legal services in
connection with the business combination. The balance sheet of De Soto Company on Jan-
uary 31, 2005, prior to the business combination, was as follows:

CHECK FIGURE
DE SOTO COMPANY
Debit plant assets,
Balance Sheet (prior to business combination)
$846,400.
January 31, 2005

Assets Liabilities and Stockholders’ Equity

Cash $ 40,000 Liabilities $ 620,000
Other current assets (net) 280,000 Common stock, no par or
Plant assets (net) 760,000 stated value 250,000
Intangible assets (net) 120,000 Retained earnings 330,000
Total liabilities and
Total assets $1,200,000 stockholders’ equity $1,200,000
 Chapter 5 Business Combinations 197

The current fair value of De Soto’s liabilities on January 31, 2005, was $620,000. The cur-
rent fair values of its noncash assets were as follows on January 31, 2005:

Other current assets $300,000

Plant assets 874,000
Intangible assets (All recognizable under generally accepted
accounting principles for business combinations.) 76,000

Instructions
Prepare journal entries for La Salle Corporation on January 31, 2005, to record the acqui-
sition of the net assets of De Soto Company except cash. Show computations in the expla-
nations for the journal entries where appropriate. (Disregard income taxes.)
(Problem 5.2) The balance sheet of Cooper Company on August 31, 2005, with related current fair value
data, was as follows:

CHECK FIGURE
COOPER COMPANY
Debit goodwill,
Balance Sheet (prior to business combination)
$88,120.
August 31, 2005

Carrying Current
Amounts Fair Values
Assets
Current assets $180,000 $ 220,000
Plant assets (net) 640,000 700,000
Intangible assets (net) (All recognizable under
generally accepted accounting principles for
business combinations.) 80,000 90,000
Total assets $900,000 $1,010,000

Liabilities and Stockholders’ Equity

Current liabilities $ 80,000 $ 80,000
Long-term debt 200,000 190,000
Total liabilities $280,000 $ 270,000
Common stock, no par or stated value $400,000
Retained earnings 220,000
Total stockholders’ equity $620,000
Total liabilities and stockholders’ equity $900,000

On August 31, 2005, Lionel Corporation issued $1 million face amount of 10-year, 10%
bonds (interest payable each February 28 and August 31), to yield 14%, for all the net as-
sets of Cooper. Bond issue costs paid by Lionel on August 31, 2002, totaled $60,000, and
the accounting and legal fees to effect the business combination, paid on August 31, 2005,
were $40,000.

Instructions
Prepare journal entries on August 31, 2005, to record Lionel Corporation’s acquisition of
the net assets of Cooper Company. Show the computation of goodwill in the explanation
of the relevant journal entry. (Disregard income taxes.)
(Problem 5.3) The journal entries for the business combination of Wabash Corporation and Indiana Com-
pany on December 31, 2005, were as follows:
198 Part Two Business Combinations and Consolidated Financial Statements

WABASH CORPORATION
Journal Entries
December 31, 2005

Investment in Indiana Company Common Stock 10,000,000

12% Bonds Payable 10,000,000
To record merger with Indiana Company.

CHECK FIGURE Investment in Indiana Company Common Stock 150,000

Debit plant assets Bond Issue Costs 50,000
$9,800,000. Cash 200,000
To record payment of costs incurred in merger with
Indiana Company.

Current Assets ($3,140,000 $560,000) 3,700,000

Plant Assets ($9,070,000 $330,000) 9,400,000
Goodwill 400,000
Current Liabilities 3,350,000
Investment in Indiana Company Common Stock 10,150,000
To allocate total cost of Indiana Company investment to
identifiable assets and liabilities, with the remainder to
goodwill. (Income tax effects are disregarded.) Amount
of goodwill is computed as follows:
Total cost of investment
($10,000,000 $150,000) $10,150,000
Less: Carrying amount of
identifiable net assets
[($3,140,000
$9,070,000)
$3,350,000] $8,860,000
Excess of current fair
values of identifiable
net assets over
carrying amounts
($560,000
$330,000) 890,000 9,750,000
Amount of goodwill $ 400,000

Additional Information
1. The stockholders’ equity section of Indiana Company’s balance sheet on December 31,
2005 (prior to the merger), included the following:

Common stock, $1 par $5,000,000

Retained earnings 3,860,000
Total stockholders’ equity $8,860,000

2. There was no contingent consideration in connection with the business combination.

Instructions
Prepare journal entries (omit explanations) for Wabash Corporation for the business com-
bination on December 31, 2005, under the assumptions that, instead of issuing bonds,
 Chapter 5 Business Combinations 199

Wabash had issued 1 million shares of its no-par, no-stated-value common stock with a cur-
rent fair value of $10 a share to effect the combination, that the bond issue costs were costs
of issuing common stock, that the current fair value of the plant assets was $9,900,000, and
that all other facts remained the same.
(Problem 5.4) The balance sheet of Combinee Company on October 31, 2005, was as follows:

CHECK FIGURE
COMBINEE COMPANY
Debit goodwill,
Balance Sheet (prior to business combination)
$340,000. October 31, 2005

Assets
Cash $ 60,000
Other current assets 420,000
Plant assets (net) 920,000
Total assets $1,400,000

Liabilities and Stockholders’ Equity

Current liabilities $ 180,000
Long-term debt 250,000
Common stock, $5 par 200,000
Additional paid-in capital 320,000
Retained earnings 450,000
Total liabilities and stockholders’ equity $1,400,000

Combinor Corporation’s board of directors established the following current fair values
for Combinee’s identifiable net assets other than cash:

Other current assets $ 500,000

Plant assets (net) 1,000,000
Current liabilities 180,000
Long-term debt 240,000

Accordingly, on October 31, 2005, Combinor issued 100,000 shares of its $10 par (cur-
rent fair value $13) common stock for all the net assets of Combinee in a business combi-
nation. Also on October 31, 2005, Combinor paid the following out-of-pocket costs in
connection with the combination:

Finder’s fee, accounting fees, and legal fees to effect combination $180,000
Costs associated with SEC registration statement 120,000
Total out-of-pocket costs of business combination $300,000

Instructions
Prepare journal entries for Combinor Corporation on October 31, 2005, to record the busi-
ness combination with Combinee Company. (Disregard income taxes.)
(Problem 5.5) Condensed balance sheet data of Conner Company and Capsol Company on July 31, 2005,
were as follows:
200 Part Two Business Combinations and Consolidated Financial Statements

CHECK FIGURE
Conner Capsol
Debit goodwill,
Company Company
$180,000.
Total assets $700,000 $670,000
Total liabilities $300,000 $300,000
Common stock, $25 par 200,000 250,000
Additional paid-in capital 80,000 130,000
Retained earnings (deficit) 120,000 (10,000)
Total liabilities and stockholders’ equity $700,000 $670,000

On July 31, 2005, Conner and Capsol entered into a statutory consolidation. The new
company, Consol Corporation, issued 45,000 shares of $10 par common stock for all the
outstanding common stock of Conner and 30,000 shares for all the outstanding common
stock of Capsol. Out-of-pocket costs of the business combination may be disregarded.

Instructions
Prepare journal entries for Consol Corporation on July 31, 2005, to record the business
combination. Assume that Capsol is the combinor; that current fair values of identifiable as-
sets are $800,000 for Conner and $700,000 for Capsol; that each company’s liabilities are
fairly stated at $300,000; and that the current fair value of Consol’s common stock is $14 a
share. (Disregard income taxes.)
(Problem 5.6) The condensed balance sheets of Silva Corporation, the combinor, prior to and subsequent
to its March 1, 2005, merger with Marvel Company, are as follows:

CHECK FIGURE
SILVA CORPORATION
Credit additional paid-
Balance Sheets (prior to and subsequent to business combination)
in capital, net,
March 1, 2005
$550,000.
Prior to Subsequent to
Business Business
Combination Combination
Assets
Current assets $ 500,000 $ 850,000
Plant assets (net) 1,000,000 1,800,000
Total assets $1,500,000 $2,650,000

Liabilities and Stockholders’ Equity

Current liabilities $ 350,000 $ 600,000
Long-term debt 100,000 150,000
Common stock, $1 par 400,000 700,000
Additional paid-in capital 310,000 860,000
Retained earnings 340,000 340,000
Total liabilities and stockholders’ equity $1,500,000 $2,650,000

Prior to the business combination, Marvel had, at both carrying amount and current fair
value, total assets of $1,200,000 and total liabilities of $300,000. Out-of-pocket costs of the
business combination, $50,000, were paid by Silva on March 1, 2005; consideration for the
combination was common stock having a current fair value of $870,000.
 Chapter 5 Business Combinations 201

Instructions
Reconstruct the journal entries (omit explanations) that Silva Corporation prepared on
March 1, 2005, to record the business combination with Marvel Company. (Disregard in-
come taxes.)
(Problem 5.7) On October 31, 2005, Solomon Corporation issued 20,000 shares of its $1 par (current fair
value $20) common stock for all the outstanding common stock of Midland Company in
a statutory merger. Out-of-pocket costs of the business combination paid by Solomon on
October 31, 2005, were as follows:

CHECK FIGURE
Direct costs of the business combination $20,870
Debit goodwill,
Costs of registering and issuing common stock 31,130
$50,870.
Total out-of-pocket costs of business combination $52,000

Midland’s balance sheet on October 31, 2005, follows:

MIDLAND COMPANY
Balance Sheet (prior to business combination)
October 31, 2005

Assets
Inventories $140,000
Other current assets 80,000
Plant assets (net) 380,000
Total assets $600,000

Liabilities and Stockholders’ Equity

Payable to Solomon Corporation $ 75,000
Other liabilities 225,000
Common stock, $3 par 30,000
Additional paid-in capital 120,000
Retained earnings 150,000
Total liabilities and stockholders’ equity $600,000

Additional Information
1. The current fair values of Midland’s other current assets and all its liabilities equaled the
carrying amounts on October 31, 2005.
2. Current fair values of Midland’s inventories and plant assets were $170,000 and
$420,000, respectively, on October 31, 2005.
3. Solomon’s October 31, 2005, balance sheet included an asset entitled Receivable from
Midland Company in the amount of $75,000.
Instructions
Prepare Solomon Corporation’s journal entries on October 31, 2005, to record the business
combination with Midland Company. (Disregard income taxes.)
202 Part Two Business Combinations and Consolidated Financial Statements

(Problem 5.8) The balance sheet on March 31, 2005, and the related current fair value data for Edgar
Company were as follows:

CHECK FIGURE
EDGAR COMPANY
Debit patent, $46,000.
Balance Sheet (prior to business combination)
March 31, 2005

Current
Carrying Fair
Amounts Values
Assets
Current assets $ 500,000 $ 575,000
Plant assets (net) 1,000,000 1,200,000
Patent (net) 100,000 50,000
Total assets $1,600,000

Liabilities and Stockholders’ Equity

Current liabilities $ 300,000 $ 300,000
Long-term debt 400,000 450,000
Common stock, $10 par 100,000
Retained earnings 800,000
Total liabilities and stockholders’ equity $1,600,000

On April 1, 2005, Value Corporation issued 50,000 shares of its no-par, no-stated-value
common stock (current fair value $14 a share) and $225,000 cash for the net assets of
Edgar Company, in a business combination. Of the $125,000 out-of-pocket costs paid by
Value on April 1, 2005, $50,000 were accounting, legal, and finder’s fees related to the busi-
ness combination, and $75,000 were costs related to the issuance of common stock.
Instructions
Prepare journal entries for Value Corporation on April 1, 2005, to record the business com-
bination with Edgar Company. (Disregard income taxes.)
(Problem 5.9) Molo Company merged into Stave Corporation in a business combination completed
April 30, 2005. Out-of-pocket costs paid by Stave on April 30, 2005, in connection with the
combination were as follows:

CHECK FIGURE
Finder’s, accounting, and legal fees relating to the business combination $15,000
Debit goodwill,
Costs associated with SEC registration statement for securities issued to
$4,355,000.
complete the business combination 10,000
Total out-of-pocket costs of business combination $25,000

The individual balance sheets of the constituent companies immediately prior to the merger
were as follows:
 Chapter 5 Business Combinations 203

STAVE CORPORATION AND MOLO COMPANY

Balance Sheets (prior to business combination)
April 30, 2005

Stave Molo
Corporation Company
Assets
Current assets $ 4,350,000 $ 3,000,000
Plant assets (net) 18,500,000 11,300,000
Patents (net) 450,000 200,000
Deferred charges 150,000
Total assets $23,450,000 $14,500,000

Liabilities and Stockholders’ Equity

Liabilities $ 2,650,000 $ 2,100,000
Common stock, $10 par 12,000,000
Common stock, $5 par 3,750,000
Additional paid-in capital 4,200,000 3,200,000
Retained earnings 5,850,000 5,450,000
Less: Treasury stock, at cost, 100,000 shares (1,250,000)
Total liabilities and stockholders’ equity $23,450,000 $14,500,000

Additional Information
1. The current fair values of the identifiable assets and liabilities of Stave Corporation and
of Molo Company were as follows on April 30, 2005:

STAVE CORPORATION AND MOLO COMPANY

Current Fair Values of Identifiable Net Assets
April 30, 2005

Stave Molo
Corporation Company
Current assets $ 4,950,000 $ 3,400,000
Plant assets (net) 22,000,000 14,000,000
Patents 570,000 360,000
Deferred charges 150,000
Liabilities (2,650,000) (2,100,000)
Identifiable net assets $25,020,000 $15,660,000

2. There were no intercompany transactions prior to the business combination.

3. Before the business combination, Stave had 3,000,000 shares of common stock autho-
rized, 1,200,000 shares issued, and 1,100,000 shares outstanding. Molo had 750,000
shares of common stock authorized, issued, and outstanding.
4. Molo Company was dissolved and liquidated on completion of the merger.
Instructions
Prepare journal entries for Stave Corporation on April 30, 2005, to record the business combi-
nation with Molo Company under the following assumptions: Stave paid $3,100,000 cash
204 Part Two Business Combinations and Consolidated Financial Statements

and issued 10% bonds at face amount of $16,900,000 for all the outstanding common stock
of Molo. The current fair value of the bonds was equal to their face amount. (Disregard
bond issue costs and income taxes.)
(Problem 5.10) Coolidge Corporation agreed to pay $850,000 cash and issue 50,000 shares of its $10 par ($20
current fair value a share) common stock on September 30, 2005, to Hoover Company for all
the net assets of Hoover except cash. In addition, Coolidge agreed that if the market value of
its common stock was not $20 a share or more on September 30, 2006, a sufficient number
of additional shares of common stock would be issued to Hoover to make the aggregate mar-
ket value of its Coolidge common shareholdings equal to $1 million on that date.
The balance sheet of Hoover on September 30, 2005, with related current fair values of
assets and liabilities, is as follows:

CHECK FIGURE
HOOVER COMPANY
a. Debit patent,
Balance Sheet (prior to business combination)
$95,000.
September 30, 2005

Current
Carrying Fair
Amounts Values
Assets
Cash $ 100,000 $ 100,000
Trade accounts receivable (net) 300,000 300,000
Inventories 520,000 680,000
Short-term prepayments 20,000 20,000
10% investment in Truman Company common stock
(long-term, available for sale) 180,000 180,000
Land 500,000 650,000
Other plant assets (net) 1,000,000 1,250,000
Patent (net) 80,000 100,000
Total assets $2,700,000

Liabilities and Stockholders’ Equity

Current liabilities $ 700,000 $ 700,000
Long-term debt 500,000 480,000
Common stock, $5 par 600,000
Additional paid-in capital 400,000
Retained earnings 500,000
Total liabilities and stockholders’ equity $2,700,000

Out-of-pocket costs of the business combination paid by Coolidge on September 30,

2005, were as follows:

Audit fees—SEC registration statement $ 30,000

Finder’s fee 35,000
Legal fees—business combination 15,000
Legal fees—SEC registration statement 20,000
Printing costs—securities and SEC registration statement 25,000
SEC registration fee 350
Total out-of-pocket costs of business combination $125,350
 Chapter 5 Business Combinations 205

Instructions
a. Prepare the September 30, 2005, journal entries for Coolidge Corporation to reflect the
foregoing transactions and events. (Disregard income taxes.)
b. Assume that on September 30, 2006, the market value of Coolidge Corporation’s com-
mon stock was $16 a share. Prepare a journal entry to record the issuance of additional
shares of Coolidge common stock to Hoover Company on that date and the payment of
cash in lieu of fractional shares, if any.

(Problem 5.11) The board of directors of Solo Corporation is considering a merger with Mono Company.
The most recent financial statements and other financial data for the two companies, both
of which use the same accounting principles and practices, are shown below:

CHECK FIGURE
SOLO CORPORATION AND MONO COMPANY
Basic earnings per
Balance Sheets (prior to business combination)
share, $3.00.
October 31, 2005

Solo Mono
Corporation Company
Assets
Current assets $ 500,000 $ 200,000
Plant assets (net) 1,000,000 1,500,000
Other assets 300,000 100,000
Total assets $1,800,000 $1,800,000

Liabilities and Stockholders’ Equity

Current liabilities $ 400,000 $ 100,000
Long-term debt 500,000 1,300,000
Common stock, $10 par 600,000 100,000
Additional paid-in capital 100,000 100,000
Retained earnings 200,000 200,000
Total liabilities and stockholders’ equity $1,800,000 $1,800,000

SOLO CORPORATION AND MONO COMPANY

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

Solo Mono
Corporation Company
Net sales $5,000,000 $1,000,000
Costs and expenses:
Cost of goods sold $3,500,000 $ 600,000
Operating expenses 1,000,000 200,000
Interest expense 200,000 50,000
Income taxes expense 120,000 60,000
Total costs and expenses $4,820,000 $ 910,000
Net income $ 180,000 $ 90,000
Retained earnings, beginning of year 20,000 110,000
Retained earnings, end of year $ 200,000 $ 200,000
Basic earnings per share $3.00 $9.00
Price-earnings ratio 10 5
206 Part Two Business Combinations and Consolidated Financial Statements

Solo’s directors estimated that the out-of-pocket costs of the merger would be as follows:

Finder’s fee and legal fees for the merger $ 5,000

Costs associated with SEC registration statement 7,000
Total out-of-pocket costs of merger $12,000

The fair values of Mono’s liabilities on October 31, 2005, were equal to their carrying
amounts. Current fair values of Mono’s assets on that date were as follows:

Current assets (difference from balance sheet amount of $200,000

attributable to inventories carried at first-in, first-out cost that were
sold during the year ended October 31, 2006) $ 230,000
Plant assets (difference from balance sheet amount of $1,500,000
attributable to land—$60,000 and to depreciable assets with a
five-year remaining economic life—$40,000) 1,600,000
Other assets (difference from balance sheet amount of $100,000
attributable to leasehold with a remaining term of four years) 120,000

Solo’s board of directors is considering the following plan for effecting the merger, as
follows: Issue 15,000 shares of common stock with a current fair value of $20 a share,
$100,000 cash, and a 15%, three-year note for $200,000 for all the outstanding common
stock of Mono. The present value of the note would be equal to its face amount.
Under the plan, Mono would be liquidated but would continue operations as a division
of Solo.

Instructions
To assist Solo Corporation’s board of directors in their evaluation of the plan, prepare a
working paper to compute or prepare the following for the plan as though the merger had
been effected on October 31, 2005 (disregard income taxes):
a. Net income and basic earnings per share (rounded to the nearest cent) of Solo for the
year ended October 31, 2005.
b. Net income and basic earnings per share (rounded to the nearest cent) of Solo for the
year ending October 31, 2006, assuming the same sales and cost patterns for the year
ended October 31, 2005. Goodwill, if any, is not expected to become impaired.
c. Pro forma balance sheet of Solo following the business combination on October 31,
2005.
Chapter Six
One

Consolidated Financial
Statements: On Date of
Business Combination
Scope of Chapter
Topics dealt with in Chapter 6 include the nature of consolidated financial statements; the
concept of control versus ownership as the basis for such financial statements; the problem
of variable interest entities; the preparation of consolidated financial statements involving
both wholly owned and partially owned subsidiaries; the nature of minority (noncontrol-
ling) interest and its valuation; and “push-down” accounting for separate financial state-
ments of subsidiaries.

PARENT COMPANY–SUBSIDIARY RELATIONSHIPS

Chapter 5 includes the terms investor and investee in the discussion of business combina-
tions involving a combinor’s acquisition of common stock of a combinee corporation. If the
investor acquires a controlling interest in the investee, a parent–subsidiary relationship is
established. The investee becomes a subsidiary of the acquiring parent company (investor)
but remains a separate legal entity.
Strict adherence to the legal aspects of such a business combination would require the
issuance of separate financial statements for the parent company and the subsidiary on the
date of the combination, and also for all subsequent accounting periods of the affiliation.
However, such strict adherence to legal form disregards the substance of most parent–
subsidiary relationships: A parent company and its subsidiary are a single economic entity.
In recognition of this fact, consolidated financial statements are issued to report the finan-
cial position and operating results of a parent company and its subsidiaries as though they
comprised a single accounting entity.

Nature of Consolidated Financial Statements

Consolidated financial statements are similar to the combined financial statements
described in Chapter 4 for a home office and its branches. Assets, liabilities, revenue, and
expenses of the parent company and its subsidiaries are totaled; intercompany transactions
and balances are eliminated; and the final consolidated amounts are reported in the consol-
idated balance sheet, income statement, statement of stockholders’ equity, and statement of
cash flows.
207
208 Part Two Business Combinations and Consolidated Financial Statements

However, the separate legal entity status of the parent and subsidiary corporations
necessitates eliminations that generally are more complex than the combination elimi-
nations described and illustrated in Chapter 4 for a home office and its branches. Before
illustrating consolidation eliminations, it is appropriate to examine some basic principles
of consolidation.

Should All Subsidiaries Be Consolidated?

In the past, a wide range of consolidation practices existed among major corporations in the
United States. For example, the forty-second edition of Accounting Trends & Techniques
(published in 1988), the AICPA’s annual survey of accounting practices in the published
financial statements of 600 companies, reported the following:1
1. A total of 456 companies consolidated all significant subsidiaries, but 136 companies ex-
cluded some significant subsidiaries from the consolidated financial statements. (The re-
maining eight companies surveyed did not issue consolidated financial statements.)
2. The principal types of subsidiaries excluded from consolidation were foreign subsidiaries,
finance-related subsidiaries, and real estate subsidiaries. “Finance-related subsidiaries” in-
cluded finance companies, insurance companies, banks, and leasing companies.
Such wide variations in consolidation policy were undesirable and difficult to justify
from a theoretical point of view. The purpose of consolidated financial statements is to pre-
sent for a single accounting entity the combined resources, obligations, and operating
results of a family of related corporations; consequently, there is no reason for excluding
from consolidation any subsidiary that is controlled. The argument that finance-related sub-
sidiaries should not be consolidated with parent manufacturing or retailing enterprises
because of their unique features is difficult to justify, considering the wide variety of pro-
duction, marketing, and service enterprises that are consolidated in a conglomerate or
highly diversified family of corporations.
In FASB Statement No. 94, “Consolidation of All Majority-Owned Subsidiaries,” issued
in 1987, the Financial Accounting Standards Board required the consolidation of nearly all
subsidiaries, effective for financial statements for fiscal years ending after December 15,
1988. Only subsidiaries not actually controlled (as described in the following section) were
exempted 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 parent–subsidiary relationship. However, even though such a common stock ownership ex-
ists, other circumstances may negate the parent company’s actual control of the subsidiary.
For example, a subsidiary that is in liquidation or reorganization in court-supervised bank-
ruptcy proceedings is not controlled by its parent company. Also, 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 of the parent company. Further, if minority
shareholders of a subsidiary have the right effectively to participate 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.2
It is important to recognize that a parent company’s control of a subsidiary might be
achieved indirectly. For example, if Plymouth Corporation owns 85% of the outstanding
common stock of Selwyn Company and 45% of Talbot Company’s common stock, and Selwyn

1
Accounting Trends & Techniques, 42nd ed. (New York: AICPA, 1988), p. 45.
2
Emerging Issues Task Force (of FASB) Issue 96-16, “Minority Shareholder Veto Rights.”
 Chapter 6 Consolidated Financial Statements: On Date of Business Combination 209

also owns 45% of Talbot’s common stock, both Selwyn and Talbot are controlled by Plymouth,
because it effectively controls 90% of Talbot. This effective control consists of 45% owned di-
rectly and 45% indirectly. Additional examples of indirect control are in Chapter 10.

Criticism of Traditional Concept of Control

Many accountants have criticized the traditional definition of control described in the pre-
ceding section, which emphasizes legal form. These accountants maintain that an investor
owning less than 50% of an investee’s voting common stock in substance may control the
affiliate, especially if the remaining common stock is scattered among a large number of
stockholders who do not attend stockholder meetings or give proxies. Effective control of
an investee also is possible if the individuals comprising management of the investor cor-
poration own a substantial number of shares of common stock of the investee or success-
fully solicit proxies from the investee’s other stockholders.
Furthering the foregoing views, in Financial Reporting Release No. 25, the Securities and
Exchange Commission (SEC) required companies subject to its jurisdiction to emphasize eco-
nomic substance over legal form in adopting a consolidation policy.3 Subsequently, the
Financial Accounting Standards Board issued a Discussion Memorandum, “An Analysis of Is-
sues Related to Consolidation Policy and Procedures,” which dealt at length with the question
of ownership (legal form) versus control (economic substance) as a basis for consolidation.4

FASB’s Proposed Redefinition of Control

Following the issuance of the Discussion Memorandum described in the preceding section,
the FASB issued a Proposed Statement that would have defined control of an entity as power
over its assets—power to use or direct the use of the individual assets of another entity in es-
sentially the same ways as the controlling entity can use its own assets.5 In the face of strenu-
ous objections by financial statement preparers to the foregoing definition, 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.6 The Proposed Statement further stated that:
. . . in the absence of evidence that demonstrates otherwise, the existence of control of a
corporation shall be presumed if an entity (including its subsidiaries):
(a) 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
(b) Has a large minority voting interest [for example, exceeding 56% of the votes typically
cast] in the election of a corporation’s governing body and no other party or organized
group of parties has a significant voting interest
(c) Has a unilateral ability to (1) obtain a majority voting interest in the election of a corpo-
ration’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.7

3
Codification of Financial Reporting Policies, Securities and Exchange Commission (Washington, 1986),
Sec. 105.
4
FASB Discussion Memorandum, “. . . Consolidation Policy and Procedures” (Norwalk: FASB, 1991), pars.
35–48.
5
Proposed Statement of Financial Accounting Standards, “Consolidated Financial Statements: Policies
and Procedures” (Norwalk: FASB, 1995), par. 10.
6
Proposed Statement of Financial Accounting Standards, “Consolidated Financial Statements: Purpose
and Policy” (Norwalk: FASB, 1999), par. 10.
7
Ibid., par. 18.
210 Part Two Business Combinations and Consolidated Financial Statements

By the latter proposal, the FASB planned to repeal the long-standing requirement of ma-
jority ownership of an investee’s outstanding common stock as a prerequisite for consoli-
dation. Objectively determined legal form was to be replaced by subjectively determined
economic substance as the basis for consolidated financial statements.
After nearly two years of extensive consideration of this proposal, the FASB reported that,
“after careful consideration, the Board determined that, at this time, there is not sufficient
Board member support to proceed with . . . a final Statement on consolidation policy . . .”8
Accordingly, ownership of more than 50% of an investee’s outstanding common stock gener-
ally remains the basis for consolidation of financial statements in most circumstances.

The Problem of Variable Interest Entities

The FASB’s failure to issue a final Statement based on its 1999 proposal, as described in the
foregoing section, left unresolved the question of when—if at all—to consolidate special
purpose entities. That term was used throughout the 1999 Exposure Draft,9 but it was not
clearly defined therein.10 However, two researchers at Emory University developed the fol-
lowing definition:
[Special purpose entities] typically are defined as entities created for a limited purpose, with
a limited life and limited activities, and designed to benefit a single company. They may take
the legal form of a partnership, corporation, trust, or joint venture.11

Special purpose entities came into prominence with the massive accounting fraud at Enron
Corp., a Houston-based energy supplier, which was bankrupt following the fraud.
In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable In-
terest Entities,” to provide standards for consolidation of entities in which the controlling
financial interest may be achieved through arrangements that do not involve voting inter-
ests.12 Because the term special purpose entity had been used without being clearly defined,
the FASB referred to entities subject to the requirements of the Interpretation as variable
interest entities.13
In Interpretation No. 46, the FASB defined variable interest entity as “an entity subject
to consolidation according to the provisions of this Interpretation.”14 Thus, one has to look
to paragraph 5 of the Interpretation for guidance as to the nature of a variable interest en-
tity; in that paragraph the FASB sets forth two alternative conditions requiring consolida-
tion of such an entity.15 Elsewhere in the Interpretation, the FASB gave this opinion:
An enterprise shall consolidate a variable interest entity if that enterprise has a [contractual,
ownership, or other pecuniary interest in the entity that changes with changes in the entity’s
net assets value] and that will absorb a majority of the entity’s expected losses if they occur,
receive a majority of the entity’s expected residual returns if they occur, or both.16

The ink was hardly dry on Interpretation No. 46, when, in October 2003, the FASB is-
sued a Proposed Interpretation, and in December 2003 a Revised Interpretation to clarify

8
Status Report, FASB, April 13, 2001.
9
1999 Exposure Draft, pars. 110, 124, 141, 167b, 242.
10
Ibid., par. 6.
11
Al L. Hartgraves and George J. Benston,“The Evolving Accounting Standards for Special Purpose
Entities and Consolidations,” Accounting Horizons Vol.16, no. 3 (Sept. 2002), p. 246.
12
FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (Norwalk: FASB, 2003), par. 1.
13
Ibid., par. C4.
14
Ibid., par. 2a.
15
Ibid., par. 5.
16
Ibid., pars. 14, 2c.
 Chapter 6 Consolidated Financial Statements: On Date of Business Combination 211

some of the provisions of “FIN 46.” No less than 15 of the 29 basic paragraphs of FIN 46
were modified, deleted, or superseded by the Proposed Interpretation.
In view of the complexity of the accounting standards for variable interest entities and
the fluid state of their provisions, such entities are not discussed further in this textbook.

CONSOLIDATION OF WHOLLY OWNED SUBSIDIARY

ON DATE OF BUSINESS COMBINATION
There is no question of control of a wholly owned subsidiary. Thus, to illustrate consoli-
dated financial statements for a parent company and a wholly owned subsidiary, assume
that on December 31, 2005, Palm Corporation issued 10,000 shares of its $10 par com-
mon stock (current fair value $45 a share) to stockholders of Starr Company for all the
outstanding $5 par common stock of Starr. There was no contingent consideration. Out-
of-pocket costs of the business combination paid by Palm on December 31, 2005, con-
sisted of the following:

Combinor’s Out-of- Finder’s and legal fees relating to business combination $50,000
Pocket Costs of Costs associated with SEC registration Statement for Palm common stock 35,000
Business Combination Total out-of-pocket costs of business combination $85,000

Assume also that Starr Company was to continue its corporate existence as a wholly
owned subsidiary of Palm Corporation. Both constituent companies had a December 31 fis-
cal year and used the same accounting principles and procedures; thus, no adjusting entries
were required for either company prior to the combination. The income tax rate for each
company was 40%.
Financial statements of Palm Corporation and Starr Company for the year ended
December 31, 2005, prior to consummation of the business combination, follow:

PALM CORPORATION AND STARR COMPANY

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

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

(continued)
212 Part Two Business Combinations and Consolidated Financial Statements

PALM CORPORATION AND STARR COMPANY

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

Palm Starr
Corporation Company
Statements of Retained Earnings
Retained earnings, beginning of year $ 65,000 $100,000
Add: Net income 94,000 52,000
Subtotals $ 159,000 $152,000
Less: Dividends 25,000 20,000
Retained earnings, end of year $ 134,000 $132,000

Balance Sheets
Assets
Cash $100,000 $ 40,000
Inventories 150,000 110,000
Other current assets 110,000 70,000
Receivable from Starr Company 25,000
Plant assets (net) 450,000 300,000
Patent (net) 20,000
Total assets $835,000 $540,000

Liabilities and Stockholders’ Equity

Payables to Palm Corporation $ 25,000
Income taxes payable $ 26,000 10,000
Other liabilities 325,000 115,000
Common stock, $10 par 300,000
Common stock, $5 par 200,000
Additional paid-in capital 50,000 58,000
Retained earnings 134,000 132,000
Total liabilities and stockholders’ equity $835,000 $540,000

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

Current Fair Values of Current

Selected Assets of Fair Values,
Combinee Dec. 31, 2005
Inventories $135,000
Plant assets (net) 365,000
Patent (net) 25,000

Because Starr was to continue as a separate corporation and current generally accepted
accounting principles do not sanction write-ups of assets of a going concern, Starr did not
 Chapter 6 Consolidated Financial Statements: On Date of Business Combination 213

prepare journal entries for the business combination. Palm Corporation recorded the com-
bination on December 31, 2005, with the following journal entries:

Combinor’s Journal PALM CORPORATION (COMBINOR)

Entries for Business Journal Entries
Combination December 31, 2005
(acquisition of 100%
of subsidiary’s Investment in Starr Company Common Stock (10,000 $45) 450,000
outstanding common Common Stock (10,000 $10) 100,000
stock) Paid-in Capital in Excess of Par 350,000
To record issuance of 10,000 shares of common stock for all the
outstanding common stock of Starr Company in a business
combination.

Investment in Starr Company Common Stock 50,000

Paid-in Capital in Excess of Par 35,000
Cash 85,000
To record payment of out-of-pocket costs of business combination with
Starr Company. Finder’s and legal fees relating to the combination are
recorded as additional costs of the investment; costs associated with the
SEC registration statement are recorded as an offset to the previously
recorded proceeds from the issuance of common stock.

The first journal entry is similar to the entry illustrated in Chapter 5 (page 173) for a
statutory merger. An Investment in Common Stock ledger account is debited with the
current fair value of the combinor’s common stock issued to effect the business combi-
nation, and the paid-in capital accounts are credited in the usual manner for any com-
mon stock issuance. In the second journal entry, the direct out-of-pocket costs of the
business combination are debited to the Investment in Common Stock ledger account,
and the costs that are associated with the SEC registration statement, being costs of is-
suing the common stock, are applied to reduce the proceeds of the common stock
issuance.
Unlike the journal entries for a merger illustrated in Chapter 5, the foregoing journal en-
tries do not include any debits or credits to record individual assets and liabilities of Starr
Company in the accounting records of Palm Corporation. The reason is that Starr was not
liquidated as in a merger; it remains a separate legal entity.
After the foregoing journal entries have been posted, the affected ledger accounts of
Palm Corporation (the combinor) are as follows:

Ledger Accounts of Cash

Combinor Affected by
Date Explanation Debit Credit Balance
Business Combination
2005
Dec. 31 Balance forward 100,000 dr
31 Out-of-pocket costs of business
combination 85,000 15,000 dr

(continued)
214 Part Two Business Combinations and Consolidated Financial Statements

Investment in Starr Company Common Stock

Date Explanation Debit Credit Balance
2005
Dec. 31 Issuance of common stock in
business combination 450,000 450,000 dr
31 Direct out-of-pocket costs of
business combination 50,000 500,000 dr

Common Stock, $10 Par

Date Explanation Debit Credit Balance
2005
Dec. 31 Balance forward 300,000 cr
31 Issuance of common stock in
business combination 100,000 400,000 cr

Paid-in Capital in Excess of Par

Date Explanation Debit Credit Balance
2005
Dec. 31 Balance forward 50,000 cr
31 Issuance of common stock in
business combination 350,000 400,000 cr
31 Costs of issuing common stock in
business combination 35,000 365,000 cr

Preparation of Consolidated Balance Sheet without a Working Paper

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 involves a parent company–subsidiary relationship is an acquisition of the combinee’s
net assets (assets less liabilities) by the combinor. The operating results of Palm and Starr
prior to the date of their business combination are those of two separate economic—as well
as legal—entities. Accordingly, a consolidated balance sheet is the only consolidated fi-
nancial statement issued by Palm on December 31, 2005, the date of the business combi-
nation of Palm and Starr.
The preparation of a consolidated balance sheet for a parent company and its wholly
owned subsidiary may be accomplished without the use of a supporting working paper.
The parent company’s investment account and the subsidiary’s stockholder’s equity ac-
counts do not appear in the consolidated balance sheet because they are essentially reci-
procal (intercompany) accounts. The parent company (combinor) assets and liabilities
(other than intercompany ones) are reflected at carrying amounts, and the subsidiary
(combinee) assets and liabilities (other than intercompany ones) are reflected at current
fair values, in the consolidated balance sheet. Goodwill is recognized to the extent the
cost of the parent’s investment in 100% of the subsidiary’s outstanding common stock ex-
ceeds the current fair value of the subsidiary’s identifiable net assets, both tangible and
intangible.
Applying the foregoing principles to the Palm Corporation and Starr Company
parent–subsidiary relationship, the following consolidated balance sheet is produced:
 Chapter 6 Consolidated Financial Statements: On Date of Business Combination 215

PALM CORPORATION AND SUBSIDIARY

Consolidated Balance Sheet
December 31, 2005

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

Liabilities and Stockholders’ Equity

Liabilities:
Income taxes payable ($26,000 $10,000) $ 36,000
Other ($325,000 $115,000) 440,000
Total liabilities $ 476,000
Stockholders’ equity:
Common stock, $10 par $400,000
Additional paid-in capital 365,000
Retained earnings 134,000 899,000
Total liabilities and stockholders’ equity $1,375,000

The following are significant aspects of the consolidated balance sheet:

1. The first amounts in the computations of consolidated assets and liabilities (except
goodwill) are the parent company’s carrying amounts; the second amounts are the sub-
sidiary’s current fair values.
2. Intercompany accounts (parent’s investment, subsidiary’s stockholders’ equity, and in-
tercompany receivable/payable) are excluded from the consolidated balance sheet.
3. Goodwill in the consolidated balance sheet is the cost of the parent company’s invest-
ment ($500,000) less the current fair value of the subsidiary’s identifiable net assets
($485,000), or $15,000. The $485,000 current fair value of the subsidiary’s identifiable
net assets is computed as follows: $40,000 $135,000 $70,000 $365,000
$25,000 $25,000 $10,000 $115,000 $485,000.

Working Paper for Consolidated Balance Sheet

The preparation of a consolidated balance sheet on the date of a business combination usually
requires the use of a working paper for consolidated balance sheet, even for a parent com-
pany and a wholly owned subsidiary. The format of the working paper, with the individual
balance sheet amounts included for both Palm Corporation and Starr Company, is shown
on page 216.

Developing the Elimination

As indicated on page 214, Palm Corporation’s Investment in Starr Company Common
Stock ledger account in the working paper for consolidated balance sheet is similar to a
216 Part Two Business Combinations and Consolidated Financial Statements

home office’s Investment in Branch account, as described in Chapter 4. However, Starr

Company is a separate corporation, not a branch; therefore, Starr has the three conven-
tional stockholders’ equity accounts rather than the single Home Office reciprocal ac-
count used by a branch. Accordingly, the elimination for the intercompany accounts of
Palm and Starr must decrease to zero the Investment in Starr Company Common Stock
account of Palm and the three stockholder’s equity accounts of Starr. Decreases in assets
are effected by credits, and decreases in stockholder’s equity accounts are effected by
debits; therefore, the elimination for Palm Corporation and subsidiary on December 31,
Format of Working 2005 (the date of the business combination), is begun as shown at the bottom of this page
Paper for Consolidated (a journal entry format is used to facilitate review of the elimination):
Balance Sheet for
Wholly Owned
Subsidiary on Date of
Business Combination

PALM CORPORATION AND SUBSIDIARY

Working Paper for Consolidated Balance Sheet
December 31, 2005

Eliminations
Palm Starr Increase
Corporation Company (Decrease) Consolidated
Assets
Cash 15,000 40,000
Inventories 150,000 110,000
Other current assets 110,000 70,000

Intercompany receivable (payable) 25,000 (25,000)

Investment in Starr Company
common stock 500,000
Plant assets (net) 450,000 300,000
Patent (net) 20,000
Goodwill
Total assets 1,250,000 515,000

Liabilities and Stockholders’ Equity

Income taxes payable 26,000 10,000
Other liabilities 325,000 115,000
Common stock, $10 par 400,000
Common stock, $5 par 200,000
Additional paid-in capital 365,000 58,000
Retained earnings 134,000 132,000
Total liabilities and stockholders’ equity 1,250,000 515,000

Elimination of Common Stock—Starr 200,000

Intercompany Additional Paid-in Capital—Starr 58,000
Accounts Retained Earnings—Starr 132,000
390,000
Investment in Starr Company Common Stock—Palm 500,000
 Chapter 6 Consolidated Financial Statements: On Date of Business Combination 217

The footing of $390,000 of the debit items of the foregoing partial elimination repre-
sents the carrying amount of the net assets of Starr Company and is $110,000 less than the
credit item of $500,000, which represents the cost of Palm Corporation’s investment in
Starr. As indicated on page 212, part of the $110,000 difference is attributable to the excess
of current fair values over carrying amounts of certain identifiable tangible and intangible
assets of Starr. This excess is summarized as follows (the current fair values of all other
assets and liabilities are equal to their carrying amounts):

Differences between Excess of

Current Fair Values Current Fair
and Carrying Amounts Values over
of Combinee’s Current Carrying Carrying
Identifiable Assets Fair Values Amounts Amounts
Inventories $135,000 $110,000 $25,000
Plant assets (net) 365,000 300,000 65,000
Patent (net) 25,000 20,000 5,000
Totals $525,000 $430,000 $95,000

Generally accepted accounting principles do not presently permit the write-up of a go-
ing concern’s assets to their current fair values. Thus, to conform to the requirements of
purchase accounting for business combinations, the foregoing excess of current fair values
over carrying amounts must be incorporated in the consolidated balance sheet of Palm Cor-
poration and subsidiary by means of the elimination. Increases in assets are recorded by
debits; thus, the elimination for Palm Corporation and subsidiary begun above is continued
as follows (in journal entry format):

Use of Elimination to Common Stock—Starr 200,000

Reflect Current Fair Additional Paid-in Capital—Starr 58,000
Values of Combinee’s Retained Earnings—Starr 132,000
Identifiable Assets Inventories—Starr ($135,000 $110,000) 25,000
Plant Assets (net)—Starr ($365,000 $300,000) 65,000
Patent (net)—Starr ($25,000 $20,000) 5,000
485,000
Investment in Starr Company Common Stock—Palm 500,000

The revised footing of $485,000 of the debit items of the foregoing partial elimination
is equal to the current fair value of the identifiable tangible and intangible net assets of
Starr Company. Thus, the $15,000 difference ($500,000 $485,000 $15,000) between
the cost of Palm Corporation’s investment in Starr and the current fair value of Starr’s iden-
tifiable net assets represents goodwill of Starr, in accordance with purchase accounting the-
ory for business combinations, described in Chapter 5 (pages 170–171). Consequently, the
December 31, 2005, elimination for Palm Corporation and subsidiary is completed with a
$15,000 debit to Goodwill—Starr.
218 Part Two Business Combinations and Consolidated Financial Statements

Completed Elimination and Working Paper for Consolidated Balance Sheet

The completed elimination for Palm Corporation and subsidiary (in journal entry format)
and the related working paper for consolidated balance sheet are as follows:

Completed Working PALM CORPORATION AND SUBSIDIARY

Paper Elimination for Working Paper Elimination
Wholly Owned December 31, 2005
Purchased Subsidiary
on Date of Business (a) Common Stock—Starr 200,000
Combination Additional Paid-in Capital—Starr 58,000
Retained Earnings—Starr 132,000
Inventories—Starr ($135,000 $110,000) 25,000
Plant Assets (net)—Starr ($365,000 $300,000) 65,000
Patent (net)—Starr ($25,000 $20,000) 5,000
Goodwill—Starr ($500,000 $485,000) 15,000
Investment in Starr Company Common Stock—Palm 500,000
To eliminate intercompany investment and equity accounts of subsidiary
Working Paper for on date of business combination; and to allocate excess of cost over
carrying amount of identifiable assets acquired, with remainder to
Consolidated Balance
goodwill. (Income tax effects are disregarded.)
Sheet for Wholly
Owned Subsidiary on
Date of Business
Combination

PALM CORPORATION AND SUBSIDIARY

Working Paper for Consolidated Balance Sheet
December 31, 2005

Eliminations
Palm Starr Increase
Corporation Company (Decrease) Consolidated
Assets
Cash 15,000 40,000 55,000
Inventories 150,000 110,000 (a) 25,000 285,000
Other current assets 110,000 70,000 180,000
Intercompany receivable (payable) 25,000 (25,000)
Investment in Starr Company common
stock 500,000 (a) (500,000)
Plant assets (net) 450,000 300,000 (a) 65,000 815,000
Patent (net) 20,000 (a) 5,000 25,000
Goodwill (a) 15,000 15,000
Total assets 1,250,000 515,000 (390,000) 1,375,000

Liabilities and Stockholders’ Equity

Income taxes payable 26,000 10,000 36,000
Other liabilities 325,000 115,000 440,000
Common stock, $10 par 400,000 400,000
Common stock, $5 par 200,000 (a) (200,000)
Additional paid-in capital 365,000 58,000 (a) (58,000) 365,000
Retained earnings 134,000 132,000 (a) (132,000) 134,000
Total liabilities and stockholders’ equity 1,250,000 515,000 (390,000) 1,375,000
 Chapter 6 Consolidated Financial Statements: On Date of Business Combination 219

The following features of the working paper for consolidated balance sheet on the date
of the business combination should be emphasized:
1. The elimination is not entered in either the parent company’s or the subsidiary’s ac-
counting records; it is only a part of the working paper for preparation of the consoli-
dated 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 Eliminations 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 rather than trial
balances.
4. Intercompany receivables and payables are placed on the same line of the working pa-
per 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 explained in Chapter 8 dealing with the eliminations of in-
tercompany profits (or gains).
6. The consolidated paid-in capital amounts are those of the parent company only. Sub-
sidiaries’ paid-in capital amounts always are eliminated in the process of consolidation.
7. Consolidated retained earnings on the date of a business combination includes only
the retained earnings of the parent company. This treatment is consistent with the the-
ory that purchase accounting reflects a fresh start in an acquisition of net assets (as-
sets less liabilities).
8. The amounts in the Consolidated column of the working paper for consolidated balance
sheet reflect the financial position of a single economic entity comprising two legal en-
tities, with all intercompany balances of the two entities eliminated.

Consolidated Balance Sheet

The amounts in the Consolidated column of the working paper for consolidated balance
sheet are presented in the customary fashion in the consolidated balance sheet of Palm
Corporation and subsidiary that follows. In the interest of brevity, notes to financial

PALM CORPORATION AND SUBSIDIARY

Consolidated Balance Sheet
December 31, 2005

Assets
Current assets:
Cash $ 55,000
Inventories 285,000
Other 180,000
Total current assets $ 520,000
Plant assets (net) 815,000
Intangible assets:
Patent (net) $ 25,000
Goodwill 15,000 40,000
Total assets $1,375,000

(continued)
220 Part Two Business Combinations and Consolidated Financial Statements

PALM CORPORATION AND SUBSIDIARY

Consolidated Balance Sheet (concluded)
December 31, 2005

Liabilities and Stockholders’ Equity

Liabilities:
Income taxes payable $ 36,000
Other 440,000
Total liabilities $ 476,000
Stockholders’ equity:
Common stock, $10 par $400,000
Additional paid-in capital 365,000
Retained earnings 134,000 899,000
Total liabilities and stockholders’ equity $1,375,000

statements and other required disclosures are omitted. The consolidated amounts are the
same as those in the consolidated balance sheet on page 215.
In addition to the foregoing consolidated balance sheet on December 31, 2005, Palm
Corporation’s published financial statements for the year ended December 31, 2005, in-
clude the unconsolidated income statement and statement of retained earnings illustrated
on pages 211 and 212 and an unconsolidated statement of cash flows.

CONSOLIDATION OF PARTIALLY OWNED SUBSIDIARY

ON DATE OF BUSINESS COMBINATION
The 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 mi-
nority interest. Minority interest, or noncontrolling interest, is a term applied to the claims
of stockholders other than the parent company (the controlling interest) to the net income
or losses and net assets of the subsidiary. The minority interest in the subsidiary’s net in-
come 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.
To illustrate the consolidation techniques for a business combination involving a par-
tially owned subsidiary, assume the following facts. On December 31, 2005, Post Corpora-
tion issued 57,000 shares of its $1 par common stock (current fair value $20 a share) to
stockholders of Sage Company in exchange for 38,000 of the 40,000 outstanding shares of
Sage’s $10 par common stock in a business combination. Thus, Post acquired a 95% inter-
est (38,000 40,000 0.95) in Sage, which became Post’s subsidiary. There was no con-
tingent consideration. Out-of-pocket costs of the combination, paid in cash by Post on
December 31, 2005, were as follows:

Combinor’s Out-of- Finder’s and legal fees relating to business combination $ 52,250
Pocket Costs of Costs associated with SEC registration statement 72,750
Business Combination Total out-of-pocket costs of business combination $125,000

Financial statements of Post Corporation and Sage Company for their fiscal year ended
December 31, 2005, prior to the business combination, are on page 221. There were no in-
tercompany transactions prior to the combination.
 Chapter 6 Consolidated Financial Statements: On Date of Business Combination 221

POST CORPORATION AND SAGE COMPANY

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

Post Sage
Corporation Company
Income Statements
Net sales $5,500,000 $1,000,000
Costs and expenses:
Costs of goods sold $3,850,000 $ 650,000
Operating expenses 925,000 170,000
Interest expense 75,000 40,000
Income taxes expense 260,000 56,000
Total costs and expenses $5,110,000 $ 916,000
Net income $ 390,000 $ 84,000

Statements of Retained Earnings

Retained earnings, beginning of year $ 810,000 $ 290,000
Add: Net income 390,000 84,000
Subtotals $1,200,000 $ 374,000
Less: Dividends 150,000 40,000
Retained earnings, end of year $1,050,000 $ 334,000

Balance Sheets
Assets
Cash $ 200,000 $ 100,000
Inventories 800,000 500,000
Other current assets 550,000 215,000
Plant assets (net) 3,500,000 1,100,000
Goodwill (net) 100,000
Total assets $5,150,000 $1,915,000

Liabilities and Stockholders’ Equity

Income taxes payable $ 100,000 $ 16,000
Other liabilities 2,450,000 930,000
Common stock, $1 par 1,000,000
Common stock, $10 par 400,000
Additional paid-in capital 550,000 235,000
Retained earnings 1,050,000 334,000
Total liabilities and stockholders’ equity $5,150,000 $1,915,000

The December 31, 2005, current fair values of Sage Company’s identifiable assets and
liabilities were the same as their carrying amounts, except for the following assets:

Current Fair Values of Current

Selected Assets of Fair Values,
Combinee Dec. 31, 2005
Inventories $ 526,000
Plant assets (net) 1,290,000
Leasehold 30,000
222 Part Two Business Combinations and Consolidated Financial Statements

Sage Company did not prepare journal entries related to the business combination be-
cause Sage is continuing as a separate corporation, and current generally accepted account-
ing principles do not permit the write-up of assets of a going concern to current fair values.
Post recorded the combination with Sage by means of the following journal entries:

Combinor’s Journal POST CORPORATION (COMBINOR)

Entries for Business Journal Entries
Combination December 31, 2005
(acquisition of 95% of
subsidiary’s outstanding Investment in Sage Company Common Stock
common stock) (57,000 $20) 1,140,000
Common Stock (57,000 $1) 57,000
Paid-in Capital in Excess of Par 1,083,000
To record issuance of 57,000 shares of common stock for
38,000 of the 40,000 outstanding shares of Sage
Company common stock in a business combination.

Investment in Sage Company Common Stock 52,250

Paid-in Capital in Excess of Par 72,750
Cash 125,000
To record payment of out-of-pocket costs of business combination
with Sage Company. Finder’s and legal fees relating to the
combination are recorded as additional costs of the investment;
costs associated with the SEC registration statement are recorded
as an offset to the previously recorded proceeds from the issuance
of common stock.

After the foregoing journal entries have been posted, the affected ledger accounts of Post
Corporation are as follows:

Ledger Accounts of Cash

Combinor Affected by
Date Explanation Debit Credit Balance
Business Combination
2005
Dec. 31 Balance forward 200,000 dr
31 Out-of-pocket costs of business
combination 125,000 75,000 dr

Investment in Sage Company Common Stock

Date Explanation Debit Credit Balance
2005
Dec. 31 Issuance of common stock in
business combination 1,140,000 1,140,000 dr
31 Direct out-of-pocket costs of
business combination 52,250 1,192,250 dr

(continued)
 Chapter 6 Consolidated Financial Statements: On Date of Business Combination 223

Common Stock, $1 Par

Date Explanation Debit Credit Balance
2005
Dec. 31 Balance forward 1,000,000 cr
31 Issuance of common stock in
business combination 57,000 1,057,000 cr

Paid-In Capital in Excess of Par

Date Explanation Debit Credit Balance
2005
Dec. 31 Balance forward 550,000 cr
31 Issuance of common stock in
business combination 1,083,000 1,633,000 cr
31 Costs of issuing common
stock in business combination 72,750 1,560,250 cr

Working Paper for Consolidated Balance Sheet

Because of the complexities caused by the minority interest in the net assets of a partially
owned subsidiary and the measurement of goodwill acquired in the business combination,
it is advisable to use a working paper for preparation of a consolidated balance sheet for a
parent company and its partially owned subsidiary on the date of the business combination.
The format of the working paper is identical to that illustrated on page 216.

Developing the Elimination

The preparation of the elimination for a parent company and a partially owned sub-
sidiary parallels that for a wholly owned subsidiary described earlier in this chapter.
First, the intercompany accounts are reduced to zero, as shown below (in journal entry
format):

Elimination of Common Stock—Sage 400,000

Intercompany Additional Paid-in Capital—Sage 235,000
Accounts of Parent Retained Earnings—Sage 334,000
Company and 969,000
Subsidiary on Date of Investment in Sage Company Common Stock—Post 1,192,250
Business Combination

The footing of $969,000 of the debit items of the partial elimination above represents
the carrying amount of the net assets of Sage Company and is $223,250 less than the credit
item of $1,192,250. Part of this $223,250 difference is the excess of the total of the cost of
Post Corporation’s investment in Sage Company and the minority interest in Sage Com-
pany’s net assets over the carrying amounts of Sage’s identifiable net assets. This excess
may be computed as follows, from the data provided on page 221 (the current fair values of
all other assets and liabilities of Sage are equal to their carrying amounts):
224 Part Two Business Combinations and Consolidated Financial Statements

Differences between Excess of

Current Fair Values Current Fair
and Carrying Amounts Values over
of Combinee’s Current Carrying Carrying
Identifiable Assets Fair Values Amounts Amounts
Inventories $ 526,000 $ 500,000 $ 26,000
Plant assets (net) 1,290,000 1,100,000 190,000
Leasehold 30,000 30,000
Totals $1,846,000 $1,600,000 $246,000

Under current generally accepted accounting principles, the foregoing differences are
not entered in Sage Company’s accounting records. Thus, to conform with the requirements
of purchase accounting, the differences must be reflected in the consolidated balance sheet
of Post Corporation and subsidiary by means of the elimination, which is continued below:

Use of Elimination to Common Stock—Sage 400,000

Reflect Current Fair Additional Paid-in Capital—Sage 235,000
Values of Identifiable Retained Earnings—Sage 334,000
Assets of Subsidiary Inventories—Sage ($526,000 $500,000) 26,000
on Date of Business Plant Assets (net)—Sage ($1,290,000 $1,100,000) 190,000
Combination
Leasehold—Sage 30,000
1,215,000

Investment in Sage Company Common Stock—Post 1,192,250

The revised footing of $1,215,000 of the debit items of the above partial elimination repre-
sents the current fair value of Sage Company’s identifiable tangible and intangible net as-
sets on December 31, 2005.
Two items now must be recorded to complete the elimination for Post Corporation and
subsidiary. First, the minority interest in the identifiable net assets (at current fair values)
of Sage Company is recorded by a credit. The minority interest is computed as follows:

Computation of Current fair value of Sage Company’s identifiable net assets $1,215,000
Minority Interest in Minority interest ownership in Sage Company’s identifiable
Combinee’s net assets (100% minus Post Corporation’s 95% interest) 0.05
Identifiable Net Assets Minority interest in Sage Company’s identifiable net assets
($1,215,000 0.05) $ 60,750

Second, the goodwill acquired by Post Corporation in the business combination with Sage
Company is recorded by a debit. The goodwill is computed below:

Computation of Cost of Post Corporation’s 95% interest in Sage Company $1,192,250

Goodwill Acquired by Less: Current fair value of Sage Company’s identifiable net assets
Combinor acquired by Post ($1,215,000 0.95) 1,154,250
Goodwill acquired by Post Corporation $ 38,000
 Chapter 6 Consolidated Financial Statements: On Date of Business Combination 225

The working paper elimination for Post Corporation and subsidiary may now be com-
pleted as follows:

Completed Working POST CORPORATION AND SUBSIDIARY

Paper Elimination for Working Paper Elimination
Partially Owned December 31, 2005
Subsidiary on Date of
Business Combination (a) Common Stock—Sage 400,000
Additional Paid-in Capital—Sage 235,000
Retained Earnings—Sage 334,000
Inventories—Sage ($526,000 $500,000) 26,000
Plant Assets (net)—Sage ($1,290,000 $1,100,000) 190,000
Leasehold—Sage 30,000
Goodwill—Post ($1,192,250 $1,154,250) 38,000
Investment in Sage Company Common Stock—Post 1,192,250
Minority Interest in Net Assets of Subsidiary 60,750
To eliminate intercompany investment and equity accounts of
subsidiary on date of business combination; to allocate
excess of cost over carrying amount of identifiable assets
acquired, with remainder to goodwill; and to establish
minority interest in identifiable net assets of subsidiary on
date of business combination ($1,215,000 0.05 $60,750).
(Income tax effects are disregarded.)

Working Paper for Consolidated Balance Sheet

The working paper for the consolidated balance sheet on December 31, 2005, for Post Cor-
poration and subsidiary is on page 226.

Nature of Minority Interest

The appropriate classification and presentation of minority interest in consolidated finan-
cial statements has been a perplexing problem for accountants, especially because it is rec-
ognized only in the consolidation process and does not result from a business transaction
or event of either the parent company or the subsidiary. Two concepts for consolidated fi-
nancial statements have been developed to account for minority interest—the parent com-
pany concept and the economic unit concept. The FASB has described these two concepts
as follows:
The parent company concept emphasizes the interests of the parent’s shareholders. As a
result, the consolidated financial statements reflect those stockholders’ interests in the
parent itself, plus their undivided interests in the net assets of the parent’s subsidiaries.
The consolidated balance sheet is essentially a modification of the parent’s balance sheet
with the assets and liabilities of all subsidiaries substituted for the parent’s investment
in subsidiaries.
. . . [T]he stockholders’ equity of the parent company is also the stockholders’ equity of the
consolidated entity. Similarly, the consolidated income statement is essentially a modification
of the parent’s income statement with the revenues, expenses, gains, and losses of subsidiaries
substituted for the parent’s income from investment in the subsidiaries.
The economic unit concept emphasizes control of the whole by a single management. As
a result, under this concept (sometimes called the entity theory in the accounting literature),
consolidated financial statements are intended to provide information about a group of legal
entities—a parent company and its subsidiaries—operating as a single unit. The assets,
226 Part Two Business Combinations and Consolidated Financial Statements

POST CORPORATION AND SUBSIDIARY

Working Paper for Consolidated Balance Sheet
December 31, 2005

Eliminations
Post Sage Increase
Corporation Company (Decrease) Consolidated
Assets
Cash 75,000 100,000 175,000
Inventories 800,000 500,000 (a) 26,000 1,326,000
Other current assets 550,000 215,000 765,000
Investment in Sage Company common stock 1,192,250 (a) (1,192,250)
Plant assets (net) 3,500,000 1,100,000 (a) 190,000 4,790,000
Leasehold (a) 30,000 30,000
Goodwill 100,000 (a) 38,000 138,000
Total assets 6,217,250 1,915,000 (908,250) 7,224,000

Liabilities and Stockholders’ Equity

Income taxes payable 100,000 16,000 116,000
Other liabilities 2,450,000 930,000 3,380,000
Common stock, $1 par 1,057,000 1,057,000
Common stock, $10 par 400,000 (a) (400,000)
Additional paid-in capital 1,560,250 235,000 (a) (235,000) 1,560,250
Minority interest in net assets of subsidiary (a) 60,750 60,750
Retained earnings 1,050,000 334,000 (a) (334,000) 1,050,000
Total liabilities and stockholders’ equity 6,217,250 1,915,000 (908,250) 7,224,000

Working Paper for

Consolidated Balance
Sheet for Partially
Owned Subsidiary on
Date of Business liabilities, revenues, expenses, gains, and losses of the various component entities are the
Combination assets, liabilities, revenues, expenses, gains, and losses of the consolidated entity. Unless
all subsidiaries are wholly owned, the business enterprise’s proprietary interest (its residual
owners’ equity—assets less liabilities) is divided into the controlling interest (stockholders
or other owners of the parent company) and one or more noncontrolling interests in sub-
sidiaries. Both the controlling and the noncontrolling interests are part of the proprietary
group of the consolidated entity, even though the noncontrolling stockholders’ ownership
interests relate only to the affiliates whose shares they own.17

In accordance with the foregoing quotation, the parent company concept of consol-
idated financial statements apparently treats the minority interest in net assets of a sub-
sidiary 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 (or decreased by the minority’s share of the subsidiary’s net
loss). Dividends declared by the subsidiary to minority stockholders decrease the liabil-
ity to them. Consolidated net income is net of the minority’s share of the subsidiary’s
net income.
In the economic unit concept, the minority interest in the subsidiary’s net assets is dis-
played in the stockholders’ equity section of the consolidated balance sheet. The consoli-
dated income statement displays the minority interest in the subsidiary’s net income as a

17
FASB Discussion Memorandum,“. . . Consolidation Policy and Procedures” (Norwalk: FASB, 1991),
pars. 63–64.
 Chapter 6 Consolidated Financial Statements: On Date of Business Combination 227

subdivision of total consolidated net income, similar to the division of net income of a
partnership (see page 37).
Absent specific accounting standards dealing with minority interest in subsidiaries, in
prior years publicly owned companies used the parent company concept exclusively.
Nonetheless, in 1995 the FASB expressed a preference for the economic unit concept,
despite its emphasis on the legal form of the minority interest in a subsidiary.18 This action
was consistent with an earlier FASB rejection of the idea that the minority interest in net
assets is a liability:
Minority interests in net assets of consolidated subsidiaries do not represent present obliga-
tions of the enterprise to pay cash or distribute other assets to minority stockholders. Rather,
those stockholders have ownership or residual interests in components of a consolidated
enterprise.19

Having abandoned its attempts to issue a pronouncement on consolidation policy and pro-
cedure (see page 210), the FASB in 2000 included the following in a Proposed Statement
of Financial Accounting Standards, “Accounting for Financial Instruments with Charac-
teristics of Liabilities, Equity, or Both”:
An equity instrument that is issued by a less-than-wholly-owned subsidiary included in the
reporting entity to an entity outside the consolidated group and thus representing the noncon-
trolling equity interest in that subsidiary shall be reported in the consolidated financial state-
ments as a separate component of equity.20

In view of the FASB’s actions described in the foregoing section, the economic unit con-
cept of displaying minority interest is stressed throughout this book.

Consolidated Balance Sheet for

Partially Owned Subsidiary
The consolidated balance sheet of Post Corporation and its partially owned subsidiary, Sage
Company, is on page 228. The consolidated amounts are taken from the working paper for
consolidated balance sheet on page 226.
The display of minority interest in net assets of subsidiary in the equity section of the
consolidated balance sheet of Post Corporation and subsidiary is consistent with the eco-
nomic unit concept of consolidated financial statements. It should be noted that there is no
ledger account for minority interest in net assets of subsidiary, in either the parent com-
pany’s or the subsidiary’s accounting records.

Alternative Methods for Valuing Minority Interest

and Goodwill
The computation of minority interest in net assets of subsidiary and goodwill on page 224
is based on two premises. First, the identifiable net assets of a partially owned subsidiary
should be valued on a single basis—current fair value, in accordance with purchase
accounting theory for business combinations. Second, only the subsidiary goodwill
acquired by the parent company should be recognized, in accordance with the cost method
for valuing assets.

18
“Consolidated Financial Statements: Policy and Procedure,” pars. 22–24.
19
Statement of Financial Accounting Concepts No. 6, “Elements of Financial Statements” (Norwalk:
FASB, 1985), par. 254.
20
Proposed Statement of Financial Accounting Standards,“Accounting for Financial Instruments with
Characteristics of Liabilities, Equity, or Both” (Norwalk: FASB, 2000), par. 36. (Note: The final Statement,
No. 150 issued in 2003, did not include the cited sentence.)
228 Part Two Business Combinations and Consolidated Financial Statements

POST CORPORATION AND SUBSIDIARY

Consolidated Balance Sheet
December 31, 2005

Assets
Current assets:
Cash $ 175,000
Inventories 1,326,000
Other 765,000
Total current assets $2,266,000
Plant assets (net) $4,790,000
Intangible assets:
Leasehold $ 30,000
Goodwill 138,000 168,000
Total assets $7,224,000

Liabilities and Stockholders’ Equity

Liabilities:
Income taxes payable $ 116,000
Other 3,380,000
Total liabilities $3,496,000
Stockholders’ equity:
Common stock, $1 par $1,057,000
Additional paid-in capital 1,560,250
Minority interest in net assets of subsidiary 60,750
Retained earnings 1,050,000 3,728,000
Total liabilities and stockholders’ equity $7,224,000

Two alternatives to the procedure described on page 227 have been suggested. The first
alternative would assign current fair values to a partially owned subsidiary’s identifiable net
assets only to the extent of the parent company’s ownership interest therein. Under this
alternative, $233,700 ($246,000 0.95 $233,700) of the total difference between cur-
rent fair values and carrying amounts of Sage Company’s identifiable net assets summa-
rized on page 224 would be reflected in the aggregate debits to inventories, plant assets, and
leasehold in the working paper elimination for Post Corporation and subsidiary on Decem-
ber 31, 2005. The minority interest in net assets of subsidiary would be based on the car-
rying amounts of Sage Company’s identifiable net assets, rather than on their current fair
values, and would be computed as follows: $969,000 0.05 $48,450. Goodwill would
be $38,000, as computed on page 224. Supporters of this alternative argue that current fair
values of a combinee’s identifiable net assets should be reflected in consolidated financial
statements only to the extent (percentage) that they have been acquired by the combinor. The
balance of the combinee’s net assets, and the related minority interest in the net assets, should
be reflected in consolidated financial statements at the carrying amounts in the subsidiary’s
accounting records. Thus, identifiable net assets of the subsidiary would be valued on a hybrid
basis, rather than at full current fair values as required by purchase accounting theory.
The other alternative for valuing minority interest in net assets of subsidiary and good-
will is to obtain a current fair value for 100% of a partially owned subsidiary’s total net
assets, either through independent measurement of the minority interest or by inference
from the cost of the parent company’s investment in the subsidiary. Independent measure-
ment of the minority interest might be accomplished by reference to quoted market prices
 Chapter 6 Consolidated Financial Statements: On Date of Business Combination 229

of publicly traded common stock owned by minority stockholders of the subsidiary. The
computation of minority interest and goodwill of Sage Company by inference from the cost
of Post Corporation’s investment in Sage is as follows:

Computation of Total cost of Post Corporation’s investment in Sage Company $1,192,250

Minority Interest and Post’s percentage ownership of Sage 0.95
Goodwill of Partially Implied current fair value of 100% of Sage’s total net assets
Owned Subsidiary ($1,192,250 0.95) $1,255,000
Based on Implied Total Minority interest ($1,255,000 0.05) $ 62,750
Current Fair Value of Goodwill ($1,255,000 $1,215,000, the current fair value of
Subsidiary Sage’s identifiable net assets) $ 40,000

Supporters of this approach contend that a single valuation method should be used for
all net assets of a subsidiary—including goodwill—regardless of the existence of a minor-
ity interest in the subsidiary. They further maintain that the goodwill should be attributed to
the subsidiary, rather than to the parent company, as is done for a wholly owned subsidiary,
in accordance with the theory of purchase accounting for business combinations.
A summary of the three methods for valuing minority interest and goodwill of a par-
tially owned subsidiary (derived from the December 31, 2005, business combination of
Post Corporation and Sage Company) follows:

Comparison of Three Minority

Methods for Valuing Interest
Minority Interest and Total in Net
Goodwill of Partially Identifiable Assets of
Owned Subsidiary Net Assets Subsidiary Goodwill
1. Identifiable net assets recorded at current
fair value; minority interest in net assets of
subsidiary based on identifiable net assets $1,215,000 $60,750 $38,000
2. Identifiable net assets recorded at current
fair value only to extent of parent company’s
interest; balance of net assets and minority
interest in net assets of subsidiary reflected
at carrying amounts 1,202,700* 48,450 38,000
3. Current fair value, through independent
measurement or inference, assigned to total
net assets of subsidiary, including goodwill 1,215,000 62,750 40,000

*$969,000 ($246,000 0.95) $1,202,700.

In 1995, the Financial Accounting Standards Board tentatively expressed a preference

for the method of valuing minority interest and goodwill set forth in method 1 above.21
Accordingly, that method is illustrated in subsequent pages of this book.

Bargain-Purchase Excess in Consolidated Balance Sheet

A business combination that results in a parent company–subsidiary relationship may in-
volve an excess of current fair values of the subsidiary’s identifiable net assets over the cost
of the parent company’s investment in the subsidiary’s common stock. If so, the accounting

21
“Consolidated Financial Statements: Policy and Procedures,” par. 27.
230 Part Two Business Combinations and Consolidated Financial Statements

standards described in Chapter 5 (page 171) are applied. The excess of current fair values
over cost (bargain-purchase excess) is applied pro rata to reduce the amounts initially as-
signed to noncurrent assets other than financial assets (excluding investments accounted for
by the equity method), assets to be disposed of by sale, deferred tax assets, and prepaid as-
sets relating to pensions and other postretirement benefit plans.

Illustration of Bargain-Purchase Excess: Wholly Owned Subsidiary

On December 31, 2005, Plowman Corporation acquired all the outstanding common stock
of Silbert Company for $850,000 cash, including direct out-of-pocket costs of the business
combination. Stockholders’ equity of Silbert totaled $800,000, consisting of common
stock, $100,000; additional paid-in capital, $300,000; and retained earnings, $400,000. The
current fair values of Silbert’s identifiable net assets were the same as their carrying
amounts, except for the following:

Current Fair Values of Current Carrying

Selected Assets of Fair Values Amounts Differences
Combinee
Inventories $ 339,000 $320,000 $19,000
Long-term investments in marketable
debt securities (held to maturity) 61,000 50,000 11,000
Plant assets (net) 1,026,000 984,000 42,000
Intangible assets (net) 54,000 36,000 18,000

Thus, the current fair values of Silbert’s identifiable net assets exceeded the amount
paid by Plowman by $40,000 [($800,000 $19,000 $11,000 $42,000 $18,000)
$850,000 $40,000]. This $40,000 bargain-purchase excess is offset against amounts
originally assigned to Silbert’s plant assets and intangible assets in proportion to their cur-
rent fair values ($1,026,000:$54,000 95:5). The December 31, 2005, working paper
elimination for Plowman Corporation and subsidiary is as follows:

Working Paper PLOWMAN CORPORATION AND SUBSIDIARY

Elimination for Wholly Working Paper Elimination
Owned Subsidiary December 31, 2005
with Bargain-Purchase
Excess on Date of (a) Common Stock—Silbert 100,000
Business Combination Additional Paid-in Capital—Silbert 300,000
Retained Earnings—Silbert 400,000
Inventories—Silbert ($339,000 $320,000) 19,000
Long-Term Investments in Marketable Debt Securities—Silbert
($61,000 $50,000) 11,000
Plant Assets (net)—Silbert
[($1,026,000 $984,000) ($40,000 0.95)] 4,000
Intangible Assets (net)—Silbert
[($54,000 $36,000) ($40,000 0.05)] 16,000
Investment in Silbert Company Common Stock—Plowman 850,000
To eliminate intercompany investment and equity accounts of
subsidiary on date of business combination; and to allocate
$40,000 excess of current fair values of subsidiary’s identifiable
net assets over cost to subsidiary’s plant assets and intangible
assets in ratio of $1,026,000:$54,000, or 95%:5%. (Income
tax effects are disregarded.)
 Chapter 6 Consolidated Financial Statements: On Date of Business Combination 231

Illustration of Bargain-Purchase Excess: Partially Owned Subsidiary

The Plowman Corporation–Silbert Company business combination described in the fore-
going section is now changed by assuming that Plowman acquired 98%, rather than 100%,
of Silbert’s common stock for $833,000 ($850,000 0.98 $833,000) on December 31,
2005, with all other facts remaining unchanged. The excess of current fair values of
Silbert’s identifiable net assets over Plowman’s cost is $39,200 [($890,000 0.98)
$833,000 $39,200]. Under these circumstances, the working paper elimination for
Plowman Corporation and subsidiary on December 31, 2005, is as follows:

Working Paper PLOWMAN CORPORATION AND SUBSIDIARY

Elimination for Working Paper Elimination
Partially Owned December 31, 2005
Subsidiary with
Bargain-Purchase (a) Common Stock—Silbert 100,000
Excess on Date of Additional Paid-in Capital—Silbert 300,000
Business Combination Retained Earnings—Silbert 400,000
Inventories—Silbert ($339,000 $320,000) 19,000
Long-Term Investments in Marketable Debt Securities—Silbert
($61,000 $50,000) 11,000
Plant Assets (net)—Silbert [($42,000 ($39,200 0.95)] 4,760
Intangible Assets (net)—Silbert [$18,000 ($39,200 0.05)] 16,040
Investment in Silbert Company Common Stock—Plowman 833,000
Minority Interest in Net Assets of Subsidiary ($890,000 0.02) 17,800
To eliminate intercompany investment and equity accounts of
subsidiary on date of business combination; to allocate parent
company’s share of excess ($39,200) of current fair values of
subsidiary’s identifiable net assets over cost to subsidiary’s
plant assets and intangible assets in ratio of 95%:5%; and
to establish minority interest in net assets of subsidiary on date
of business combination. (Income tax effects are disregarded.)

Disclosure of Consolidation Policy

Currently, the “Summary of Significant Accounting Policies” note to financial statements
required by APB Opinion No. 22, “Disclosure of Accounting Policies,” and by Rule 3A-03
of the SEC’s Regulation S-X, which is discussed in Chapter 13, generally includes a de-
scription of consolidation policy reflected in consolidated financial statements. The follow-
ing excerpt from an annual report of The McGraw-Hill Companies, Inc., a publicly owned
corporation, is typical:
Principles of consolidation. The consolidated financial statements include the accounts of all
subsidiaries and the company’s share of earnings or losses of joint ventures and affiliated
companies under the equity method of accounting. All significant intercompany accounts and
transactions have been eliminated.

International Accounting Standard 27

Among the provisions of IAS 27, “Consolidated Financial Statements and Accounting
for Investments in Subsidiaries,” are the following:
1. Consolidation policy is based on control rather than solely on ownership. Control is de-
scribed as follows:
Control (for the purpose of this Standard) is the power to govern the financial and operating
policies of an enterprise so as to obtain benefits from its activities.
232 Part Two Business Combinations and Consolidated Financial Statements

*****
Control is presumed to exist when the parent owns, directly or indirectly through sub-
sidiaries, more than one half of the voting power of an enterprise unless, in exceptional cir-
cumstances, it can be clearly demonstrated that such ownership does not constitute control.
Control also exists even when the parent owns one half or less of the voting power of an en-
terprise when there is:
(a) power over more than one half of the voting rights by virtue of an agreement with other
investors;
(b) power to govern the financial and operating policies of the enterprise under a statute or an
agreement;
(c) power to appoint or remove the majority of the members of the board of directors or equiv-
alent governing body; or
(d ) power to cast the majority of votes at meetings of the board of directors or equivalent
governing body.

2. Intercompany transactions, profits or gains, and losses are eliminated in full, regardless
of an existing minority interest.
3. The minority interest in net income of subsidiary is displayed separately in the consoli-
dated income statement. The minority interest in net assets of subsidiary is displayed
separately from liabilities and stockholders’ equity in the consolidated balance sheet.
Thus, the IASB rejected both the parent company concept and the economic unit con-
cept (see pages 225–226).
4. In the unconsolidated financial statements of a parent company, investments in sub-
sidiaries that are included in the consolidated statements may be accounted for by either
the equity method, as required by the SEC, or the cost method.

Advantages and Shortcomings of Consolidated

Financial Statements
Consolidated financial statements are useful principally to stockholders and prospective in-
vestors of the parent company. These users of consolidated financial statements are pro-
vided with 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 stockholders of subsidiaries
have only limited use for consolidated financial statements, because such statements do
not show the financial position or operating results of the individual companies compris-
ing the consolidated group. In addition, creditors of the constituent companies cannot as-
certain the asset coverages for their respective claims. But perhaps the most telling
criticism of consolidated financial statements has come from financial analysts. These
critics have pointed out that consolidated financial statements of diversified companies
(conglomerates) are impossible to classify into a single industry. Thus, say the financial
analysts, consolidated financial statements of a conglomerate cannot be used for com-
parative purposes. The problem of financial reporting by diversified companies is con-
sidered in Chapter 13.

“Push-Down Accounting” for a Subsidiary

A thorny challenge for accountants has been choosing the appropriate basis of ac-
counting for assets and liabilities of a subsidiary that, because of a substantial minority
interest, loan agreements, legal requirements, or other commitments, issues separate fi-
nancial statements to outsiders following the business combination. Some accountants
 Chapter 6 Consolidated Financial Statements: On Date of Business Combination 233

have maintained that because generally accepted accounting principles do not permit
the write-up of assets by a going concern, the subsidiary should report assets, liabili-
ties, revenue, and expenses in its separate financial statements at amounts based on car-
rying amounts prior to the business combination. Other accountants have recommended
that the values assigned to the subsidiary’s net assets in the consolidated financial state-
ments be “pushed down” to the subsidiary for incorporation in its separate financial
statements. These accountants believe that the business combination is an event that
warrants recognition of current fair values of the subsidiary’s net assets in its separate
statements.
In Staff Accounting Bulletin No. 54, the Securities and Exchange Commission staff
sanctioned push-down accounting for separate financial statements of subsidiaries that
are substantially wholly owned by a parent company subject to the SEC’s jurisdiction.22
(The securities laws administered by the SEC, and the SEC’s own rules, sometimes re-
quire a parent company to include separate financial statements of a subsidiary in its
reports to the SEC.) This action by the SEC staff was followed several years later by the
FASB’s issuance of a Discussion Memorandum, “. . . New Basis Accounting,” which
solicited views on when, if ever, a business enterprise should adjust the carrying amounts
of its net assets, including goodwill, to current fair values, including push-down account-
ing situations.23
In the absence of definitive guidelines from the FASB, companies that have applied
push-down accounting apparently have used accounting techniques analogous to quasi-
reorganizations (which are discussed in intermediate accounting textbooks) or to reorgani-
zations under the U.S. Bankruptcy Code (discussed in Chapter 14). That is, the restatement
of identifiable assets and liabilities of the subsidiary and the recognition of goodwill are
accompanied by a write-off of the subsidiary’s retained earnings; the balancing amount is
an increase in additional paid-in capital of the subsidiary.24
To illustrate push-down accounting, I return to the Post Corporation–Sage Company
business combination, specifically to the working paper for consolidated balance sheet on
page 226. To apply the push-down accounting techniques described in the previous para-
graph, the following working paper adjustment to the Sage Company balance sheet
amounts would be required:

Working Paper Inventories 26,000

Adjustment for Push- Plant Assets (net) 190,000
Down Accounting for Leasehold 30,000
Subsidiary’s Separate Goodwill 38,000
Balance Sheet Retained Earnings 334,000
Additional Paid-in Capital 618,000
To adjust carrying amounts of identifiable net assets, to recognize
goodwill, and to write off retained earnings in connection with
push-down accounting for separate financial statements.

22
Staff Accounting Bulletin No. 54, Securities and Exchange Commission (Washington: 1983).
23
FASB Discussion Memorandum,“. . . New Basis Accounting (Norwalk: FASB, 1991), pars. 1–11.
24
Hortense Goodman and Leonard Lorensen, Illustrations of “Push Down” Accounting (New York:
AICPA, 1985).
234 Part Two Business Combinations and Consolidated Financial Statements

Sage Company’s separate balance sheet reflecting push-down accounting is the following:

SAGE COMPANY
Balance Sheet (push-down accounting)
December 31, 2005

Assets
Current assets:
Cash $ 100,000
Inventories ($500,000 $26,000) 526,000
Other 215,000
Total current assets $ 841,000
Plant assets (net) ($1,100,000 $190,000) 1,290,000
Leasehold 30,000
Goodwill 38,000
Total assets $2,199,000

Liabilities and Stockholders’ Equity

Liabilities:
Income taxes payable $ 16,000
Other 930,000
Total liabilities $ 946,000
Stockholders’ equity:
Common stock, $10 par $400,000
Additional paid-in capital ($235,000 $618,000) 853,000 1,253,000
Total liabilities and stockholders’ equity $2,199,000

A note to financial statements would describe Sage Company’s business combination

with Post Corporation and its adjustments to reflect push-down accounting in its balance
sheet.
Note that the $38,000 goodwill in Sage Company’s separate balance sheet is attributed
to Post Corporation in the working paper elimination on page 225. As explained in Chapter 7,
the attribution to Post Corporation is required to avoid applying any amortization of the
goodwill to minority stockholders’ interest in net income of Sage.

SEC ENFORCEMENT ACTIONS DEALING WITH

WRONGFUL APPLICATION OF ACCOUNTING STANDARDS
FOR CONSOLIDATED FINANCIAL STATEMENTS
AAER 34
“Securities and Exchange Commission v. Digilog, Inc. and Ronald Moyer,” reported in
AAER 34 (July 5, 1984), deals with the issue of whether Corporation A, though in form
not a conventional subsidiary, in substance was controlled by Corporation B and thus
should have been a party to consolidated financial statements with Corporation B, which
developed, manufactured, and sold electronic equipment. In reporting a federal court’s
entry of a permanent injunction against Corporation B and its CEO, the SEC opined that,
although Corporation A’s initial issuance of 50 shares of common stock was to the CEO of
 Chapter 6 Consolidated Financial Statements: On Date of Business Combination 235

Corporation B (for $50,000), Corporation B nonetheless substantively controlled Corpo-

ration A for the following reasons:
1. Corporation B provided initial working capital of $450,000 to Corporation A in ex-
change for promissory notes convertible within five years to 90% of the authorized com-
mon stock of Corporation A.
2. Corporation B sublet office space and provided accounting, financial, and administrative
services to Corporation A.
3. Corporation B sold equipment, software, furniture, and other items to Corporation A for
cash and a $92,000 interest-bearing promissory note.
4. Corporation B ultimately made loans and extended credit to, and guaranteed bank loans
of, Corporation A that totaled $4.9 million.
5. All promissory notes issued by Corporation A to Corporation B were secured by the for-
mer’s accounts receivable, inventories, and equipment.
Despite Corporation B’s management’s having been informed by its independent auditors that
its financial statements need not be consolidated with those of Corporation A, the SEC ruled
to the contrary, maintaining that substance prevailed over form (Corporation B’s CEO, rather
than Corporation B itself, owned all 50 shares of Corporation A’s outstanding common stock).
In a related enforcement action, reported in AAER 45, “ . . . In the Matter of Coopers &
Lybrand and M. Bruce Cohen, C.P.A.” (November 27, 1984), the SEC set forth its acceptance
of the undisclosed terms of a “Consent and Settlement” with the CPA firm and its engage-
ment partner that had audited Corporation B’s unconsolidated financial statements.

AAER 1762
“In the Matter of David Decker, CPA, and Theodore Fricke, CPA, Respondents,” reported
in AAER 1762 (April 24, 2003), describes the failed audit of an enterprise engaged in buy-
ing, selling, and leasing new and used transportation equipment such as trailers and trucks.
According to the SEC, the two auditors did not challenge the enterprise’s consolidating of
a subsidiary acquired in 1999 in its 1998 financial statements. The result was a 177% over-
statement of the enterprise’s revenues for 1998. The SEC enjoined the two auditors from
further violations of the federal securities laws and barred them from appearing or practic-
ing before the SEC for at least three years and two years, respectively.

Review 1. Discuss the similarities and dissimilarities between consolidated financial statements
for a parent company and its subsidiaries and combined financial statements for the
Questions home office and branches of a single legal entity.
2. The use of consolidated financial statements for reporting to stockholders is common.
Under some conditions, certain subsidiaries may be excluded from consolidation. List
the conditions under which subsidiaries sometimes are excluded from consolidated
financial statements.
3. The controller of Pastor Corporation, which has just become the parent of Sexton
Company in a business combination, inquires if a consolidated income statement is re-
quired for the year ended on the date of the combination. What is your reply? Explain.
4. In a business combination resulting in a parent–subsidiary relationship, the identifiable net
assets of the subsidiary must be reflected in the consolidated balance sheet at their current
fair values on the date of the business combination. Does this require the subsidiary to en-
ter the current fair values of the identifiable net assets in its accounting records? Explain.
236 Part Two Business Combinations and Consolidated Financial Statements

5. Are eliminations for the preparation of consolidated financial statements entered in the
accounting records of the parent company or of the subsidiary? Explain.
6. Differentiate between a working paper for consolidated balance sheet and a consoli-
dated balance sheet.
7. Describe three methods that have been proposed for valuing minority interest and
goodwill in the consolidated balance sheet of a parent company and its partially owned
subsidiary.
8. Compare the parent company concept and the economic unit concept of consolidated
financial statements as they relate to the display of minority interest in net assets of
subsidiary in a consolidated balance sheet.
9. The principal limitation of consolidated financial statements is their lack of separate
information about the assets, liabilities, revenue, and expenses of the individual com-
panies included in the consolidation. List the problems that users of consolidated
financial statements encounter as a result of this limitation.
10. What is push-down accounting?

Exercises
(Exercise 6.1) Select the best answer for each of the following multiple-choice questions:
1. A parent company’s correctly prepared journal entry to record the out-of-pocket costs
of the acquisition of the subsidiary’s outstanding common stock in a business combi-
nation was as follows (explanation omitted):

Investment in Sullivan Company Common Stock 36,800

Cash 36,800

The implication of the foregoing journal entry is that the consideration issued by the
parent company for the outstanding common stock of the subsidiary was:
a. Cash.
b. Bonds.
c. Common stock.
d. Cash, bonds, or common stock.
2. The traditional definition of control for a parent company–subsidiary relationship
(parent’s ownership of more than 50% of the subsidiary’s outstanding common stock)
emphasizes:
a. Legal form.
b. Economic substance.
c. Both legal form and economic substance.
d. Neither legal form nor economic substance.
3. An investor company that owns more than 50% of the outstanding voting common
stock of an investee may not control the investee if:
a. The investee is in reorganization in bankruptcy proceedings.
b. There is a large passive minority interest in the investee.
c. A part of the investor company’s ownership is indirect.
d. The investee is a finance-related enterprise.
 Chapter 6 Consolidated Financial Statements: On Date of Business Combination 237

4. FASB Statement No. 94, “Consolidation of All Majority Owned Subsidiaries,” ex-
empts from consolidation:
a. No subsidiaries of the parent company.
b. Foreign subsidiaries of the parent company.
c. Finance-related subsidiaries of the parent company.
d. Subsidiaries not controlled by the parent company.
5. If, on the date of the business combination, C consideration given to the former
stockholders of wholly owned subsidiary Stacey Company by Passey Corporation;
DOP direct out-of-pocket costs of the combination; CA carrying amount,
and CFV current fair value of Stacey’s identifiable net assets; and GW
goodwill:
a. C DOP CA GW
b. C DOP CFV GW
c. C DOP CFV GW
d. C CA GW DOP
6. In a completed working paper elimination (in journal entry format) for a parent com-
pany and its wholly owned subsidiary on the date of the business combination, the total
of the debits generally equals the:
a. Parent company’s total cost of its investment in the subsidiary.
b. Carrying amount of the subsidiary’s identifiable net assets.
c. Current fair value of the subsidiary’s identifiable net assets.
d. Total paid-in capital of the subsidiary.
7. In a working paper elimination (in journal entry format) for the consolidated balance
sheet of a parent company and its wholly owned subsidiary on the date of a business
combination, the subtotal of the debits to the subsidiary’s stockholders’ equity accounts
equals the:
a. Current fair value of the subsidiary’s identifiable net assets.
b. Current fair value of the subsidiary’s total net assets, including goodwill.
c. Balance of the parent company’s investment ledger account.
d. Carrying amount of the subsidiary’s identifiable net assets.
8. In the working paper for consolidated balance sheet prepared on the date of the business
combination of a parent company and its wholly owned subsidiary, whose liabilities had
current fair values equal to their carrying amounts, the total of the Eliminations column
is equal to:
a. The current fair value of the subsidiary’s identifiable net assets.
b. The total stockholder’s equity of the subsidiary.
c. The current fair value of the subsidiary’s total net assets, including goodwill.
d. An amount that is not determinable.
9. On the date of the business combination of Pobre Corporation and its wholly owned
subsidiary, Sabe Company, Pobre paid (1) $100,000 to the former stockholders of Sabe
for their stockholders’ equity of $65,000 and (2) $15,000 for direct out-of-pocket costs
of the combination. Goodwill recognized in the business combination was $10,000.
The current fair value of Sabe’s identifiable net assets was:
a. $65,000 b. $75,000 c. $105,000 d. $115,000 e. $125,000
10. Differences between current fair values and carrying amounts of the identifiable net as-
sets of a subsidiary on the date of a business combination are recognized in a:
a. Working paper elimination.
b. Subsidiary journal entry.
238 Part Two Business Combinations and Consolidated Financial Statements

c. Parent company journal entry.

d. Note to the consolidated financial statements.
11. In a business combination resulting in a parent company–wholly owned subsidiary re-
lationship, goodwill developed in the working paper elimination is attributed:
a. In its entirety to the subsidiary.
b. In its entirety to the parent company.
c. To both the parent company and the subsidiary, in the ratio of current fair values of
identifiable net assets.
d. In its entirety to the consolidated entity.
12. In a consolidated balance sheet of a parent company and its partially owned subsidiary,
minority interest in net assets of subsidiary is displayed as a:
a. Liability under the economic unit concept but a part of consolidated stockholders’
equity under the parent company concept.
b. Part of consolidated stockholders’ equity under the economic unit concept but a
liability under the parent company concept.
c. Liability under both the economic unit concept and the parent company concept.
d. Part of consolidated stockholders’ equity under both the economic unit concept and
the parent company concept.
13. On the date of the business combination of a parent company and its partially owned
subsidiary, under the computation method used in this book, the amount assigned to
minority interest in net assets of subsidiary is based on the:
a. Cost of the parent company’s investment in the subsidiary’s common stock.
b. Carrying amount of the subsidiary’s identifiable net assets.
c. Current fair value of the subsidiary’s identifiable net assets.
d. Current fair value of the subsidiary’s total net assets, including goodwill.
14. The debits in the working paper elimination (in journal entry format) for the consoli-
dated balance sheet of Parent Corporation and 90%-owned Subsidiary Company to-
taled $2,080,000, including a debit of $80,000 to Goodwill—Parent. The credit
elements of the elimination are:

Investment in Subsidiary Minority Interest in

Company Common Stock—Parent Net Assets of Subsidiary
a. $2,000,000 $ 80,000
b. $1,880,000 $200,000
c. $1,872,000 $208,000
d. Some other amounts.

15. The cost of Paul Corporation’s 80% investment in Seth Company’s outstanding voting
common stock was $1,200,000, and the current fair value of Seth’s identifiable net as-
sets, which had a carrying amount of $1,000,000, was $1,250,000. Under the compu-
tation method used in this book, Goodwill—Paul and Minority Interest in Net Assets
of Subsidiary are, respectively:
a. $200,000 and $250,000.
b. $200,000 and $200,000.
c. $250,000 and $300,000.
d. Some other amounts.
 Chapter 6 Consolidated Financial Statements: On Date of Business Combination 239

16. Has push-down accounting for a subsidiary’s separate financial statements been sanc-
tioned by the:

FASB? SEC?
a. Yes Yes
b. Yes No
c. No Yes
d. No No

(Exercise 6.2) On March 31, 2005, Pyre Corporation acquired for $8,200,000 cash all the outstanding
common stock of Stark Company when Stark’s balance sheet showed net assets of
CHECK FIGURE $6,400,000. Out-of-pocket costs of the business combination may be disregarded.
Amount of goodwill, Stark’s identifiable net assets had current fair values different from carrying amounts
$200,000. as follows:

Carrying Current
Amounts Fair Values
Plant assets (net) $10,000,000 $11,500,000
Other assets 1,000,000 700,000
Long-term debt 6,000,000 5,600,000

Prepare a working paper to compute the amount of goodwill to be displayed in the con-
solidated balance sheet of Pyre Corporation and subsidiary on March 31, 2005.
(Exercise 6.3) Single Company’s balance sheet on December 31, 2005, was as follows:

CHECK FIGURE
SINGLE COMPANY
a. Amount of
Balance Sheet (prior to business combination)
goodwill, $620,000. December 31, 2005

Assets
Cash $ 100,000
Trade accounts receivable (net) 200,000
Inventories 510,000
Plant assets (net) 900,000
Total assets $1,710,000

Liabilities and Stockholders’ Equity

Current liabilities $ 310,000
Long-term debt 500,000
Common stock, $1 par 100,000
Additional paid-in capital 200,000
Retained earnings 600,000
Total liabilities and stockholders’ equity $1,710,000

On December 31, 2005, Phyll Corporation acquired all the outstanding common stock of
Single for $1,560,000 cash, including direct out-of-pocket costs. On that date, the current
240 Part Two Business Combinations and Consolidated Financial Statements

fair value of Single’s inventories was $450,000 and the current fair value of Single’s plant
assets was $1,000,000. The current fair values of all other assets and liabilities of Single
were equal to their carrying amounts.
a. Prepare a working paper to compute the amount of goodwill to be displayed in the
December 31, 2005, consolidated balance sheet of Phyll Corporation and subsidiary.
b. Prepare a working paper to compute the amount of consolidated retained earnings to be
displayed in the December 31, 2005, consolidated balance sheet of Phyll Corporation
and subsidiary, assuming that Phyll’s unconsolidated balance sheet on that date included
retained earnings of $2,500,000.

(Exercise 6.4) Following are the December 31, 2005, balance sheets of two companies prior to their busi-
ness combination:

CHECK FIGURE
PELERIN CORPORATION AND SOUTH COMPANY
b. Plant assets,
Separate Balance Sheets (prior to business combination)
$6,400,000. December 31, 2005
(000 omitted)

Pelerin South
Corporation Company
Assets
Cash $ 3,000 $ 100
Inventories (at first-in, first-out cost, which
approximates current fair value) 2,000 200
Plant assets (net) 5,000 700*
Total assets $10,000 $1,000

Liabilities and Stockholders’ Equity

Current liabilities $ 600 $ 100
Common stock, $1 par 1,000 100
Additional paid-in capital 3,000 200
Retained earnings 5,400 600
Total liabilities and stockholders’ equity $10,000 $1,000

*Current fair value, Dec. 31, 2005, $1,500,000.

a. On December 31, 2005, Pelerin Corporation acquired all the outstanding common stock
of South Company for $2,000,000 cash. Prepare a working paper to compute the amount
of goodwill to be displayed in the consolidated balance sheet of Pelerin Corporation and
subsidiary on December 31, 2005.
b. On December 31, 2005, Pelerin Corporation acquired all the outstanding common stock
of South Company for $1,600,000 cash. Prepare a working paper to compute the amount
of plant assets to be displayed in the consolidated balance sheet of Pelerin Corporation
and subsidiary on December 31, 2005.

(Exercise 6.5) The separate balance sheets of Painter Corporation and Sawyer Company following their
business combination, in which Painter acquired all of Sawyer’s outstanding common
stock, were as follows:
 Chapter 6 Consolidated Financial Statements: On Date of Business Combination 241

CHECK FIGURE PAINTER CORPORATION AND SAWYER COMPANY

Total assets, $780,000.
Separate Balance Sheets (following business combination)
May 31, 2005

Painter Sawyer
Corporation Company
Assets
Inventories $ 60,000 $ 30,000
Other current assets 140,000 110,000
Investment in Sawyer Company common stock 250,000
Plant assets (net) 220,000 160,000
Goodwill (net) 10,000
Total assets $680,000 $300,000

Liabilities and Stockholders’ Equity

Current liabilities $100,000 $ 70,000
Bonds payable 104,000 30,000
Common stock, $1 par 200,000 80,000
Additional paid-in capital 116,000 70,000
Retained earnings 160,000 50,000
Total liabilities and stockholders’ equity $680,000 $300,000

On May 31, 2005, the current fair values of Sawyer’s inventories and plant assets (net) were
$40,000 and $180,000, respectively; the current fair values of its other assets and its liabil-
ities were equal to their carrying amounts.
Prepare a consolidated balance sheet for Painter Corporation and subsidiary on May 31,
2005, without using a working paper. (Disregard income taxes.)

(Exercise 6.6) On May 31, 2005, Pristine Corporation acquired for $950,000 cash, including direct out-
of-pocket costs of the business combination, all the outstanding common stock of Superb
CHECK FIGURE Company. There was no contingent consideration involved in the combination. Superb was
Debit goodwill— to be a subsidiary of Pristine.
Superb, $50,000.
Additional Information for May 31, 2005
1. Superb’s stockholders’ equity prior to the combination was as follows:

Common stock, $1 par $100,000

Additional paid-in capital 200,000
Retained earnings 450,000
Total stockholders’ equity $750,000

2. Superb’s liabilities had current fair values equal to their carrying amounts. Current fair
values of Superb’s inventories, land, and building (net) exceeded carrying amounts by
$60,000, $40,000, and $50,000, respectively.
Prepare a working paper elimination, in journal entry format (omit explanation) for the con-
solidated balance sheet of Pristine Corporation and subsidiary on May 31, 2005. (Disregard
income taxes.)
242 Part Two Business Combinations and Consolidated Financial Statements

(Exercise 6.7) The condensed separate and consolidated balance sheets of Perth Corporation and its sub-
sidiary, Sykes Company, on the date of their business combination, were as follows:

CHECK FIGURE PERTH CORPORATION AND SUBSIDIARY

Debit goodwill—
Separate and Consolidated Balance Sheets (following business combination)
Sykes, $20,000. June 30, 2005

Perth Sykes
Corporation Company Consolidated
Assets
Cash $ 100,000 $ 40,000 $ 140,000
Inventories 500,000 90,000 610,000
Other current assets 250,000 60,000 310,000
Investment in Sykes Company common
stock 440,000
Plant assets (net) 1,000,000 360,000 1,440,000
Goodwill (net) 100,000 120,000
Total assets $2,390,000 $550,000 $2,620,000

Liabilities and Stockholders’ Equity

Income taxes payable $ 40,000 $ 35,000 $ 75,000
Other liabilities 580,600 195,000 775,600
Common stock 1,020,000 200,000 1,020,000
Additional paid-in capital 429,400 210,000 429,400
Retained earnings (deficit) 320,000 (90,000) 320,000
Total liabilities and stockholders’ equity $2,390,000 $550,000 $2,620,000

Reconstruct the working paper elimination for Perth Corporation and subsidiary on
June 30, 2005 (in journal entry format), indicated by the above data. (Disregard income taxes.)
(Exercise 6.8) On November 1, 2005, Prox Corporation issued 10,000 shares of its $10 par ($30 current
fair value) common stock for 85 of the 100 outstanding shares of Senna Company’s $100
par common stock, in a business combination. Out-of-pocket costs of the business combi-
nation were as follows:

Legal and finder’s fees associated with the business combination $36,800
Costs incurred for SEC registration statement for Prox common stock 20,000
Total out-of-pocket costs of business combination $56,800

On November 1, 2005, the current fair values of Senna’s identifiable net assets were equal to
their carrying amounts. On that date, Senna’s stockholders’ equity consisted of the following:

Common stock, $100 par $ 10,000

Additional paid-in capital 140,000
Retained earnings 70,000
Total stockholders’ equity $220,000

Prepare journal entries for Prox Corporation on November 1, 2005, to record the busi-
ness combination with Senna Company. (Disregard income taxes.)
 Chapter 6 Consolidated Financial Statements: On Date of Business Combination 243

(Exercise 6.9) On February 28, 2005, Ploy Corporation acquired 88% of the outstanding common stock
of Skye Company for $50,000 cash and 5,000 shares of Ploy’s $10 par common stock with
a current fair value of $20 a share. Out-of-pocket costs of the business combination paid by
Ploy on February 28, 2005, were as follows:

CHECK FIGURE
Finder’s and legal fees relating to business combination $15,000
b. (1) Goodwill,
Costs associated with SEC registration statement 10,000
$15,400.
Total out-of-pocket costs of business combination $25,000

On February 28, 2005, Skye’s stockholders’ equity consisted of common stock, $1 par,
$10,000; additional paid-in capital, $30,000; and retained earnings, $60,000. Carrying
amounts of the three following identifiable assets or liabilities of Skye were less than cur-
rent fair values on February 28, 2005, by the amounts indicated:

Inventories $20,000
Plant assets (net) 80,000
Bonds payable, due February 28, 2011 30,000

a. Prepare journal entries for Ploy Corporation on February 28, 2005, to record the busi-
ness combination with Skye Company. (Disregard income taxes.)
b. Prepare a working paper to compute the following amounts for the consolidated balance
sheet of Ploy Corporation and subsidiary on February 28, 2005:
(1) Goodwill (neither Ploy nor Skye had goodwill in its separate balance sheet).
(2) Minority interest in net assets of subsidiary.
(Exercise 6.10) Pullin Corporation acquired 70% of the outstanding common stock of Style Company on
July 31, 2005. The unconsolidated balance sheet of Pullin immediately after the business
CHECK FIGURE combination and the consolidated balance sheet of Pullin Corporation and subsidiary were
a. Total current assets, as follows:
$42,000.

PULLIN CORPORATION
Unconsolidated and Consolidated Balance Sheets
July 31, 2005

Unconsolidated Consolidated
Assets
Current assets $106,000 $146,000
Investment in Style Company common stock 100,000
Plant assets (net) 270,000 370,000
Goodwill 11,100
Total assets $476,000 $527,100

Liabilities and Stockholders’ Equity

Current liabilities $ 15,000 $ 28,000
Common stock, no par or stated value 350,000 350,000
Minority interest in net assets of subsidiary 38,100
Retained earnings 111,000 111,000
Total liabilities and stockholders’ equity $476,000 $527,100
244 Part Two Business Combinations and Consolidated Financial Statements

Of the excess payment for the investment in Style Company common stock, $10,000 was
ascribed to undervaluation of Style’s plant assets and the remainder was ascribed to good-
will. Current assets of Style included a $2,000 receivable from Pullin that arose before the
business combination.
a. Prepare a working paper to compute the total current assets in Style Company’s separate
balance sheet on July 31, 2005.
b. Prepare a working paper to compute the total stockholders’ equity in Style Company’s
separate balance sheet on July 31, 2005.
c. Prepare a working paper to show how the goodwill of $11,100 included in the July 31,
2005, consolidated balance sheet of Pullin Corporation and subsidiary was computed.
(Exercise 6.11) Polter Corporation acquired 80% of the outstanding common stock of Santo Company on
October 31, 2005, for $800,000, including direct out-of-pocket costs of the business com-
CHECK FIGURE bination. The working paper elimination (in journal entry format) on that date was as fol-
Credit to minority lows (explanation omitted):
interest, $200,000.

POLTER CORPORATION AND SUBSIDIARY

Working Paper Elimination
October 31, 2005

Common Stock—Santo 50,000

Additional Paid-in Capital—Santo 60,000
Retained Earnings—Santo 490,000
Inventories—Santo 50,000
Plant Assets (net)—Santo 100,000
Goodwill—Polter [$800,000 ($750,000 0.80)] 200,000
Investment in Santo Company Common Stock—Polter 800,000
Minority Interest in Net Assets of Subsidiary
($750,000 0.20) 150,000

Assuming that a value is to be imputed for 100% of Santo Company’s net assets (in-
cluding goodwill) from Polter Corporation’s $800,000 cost, prepare a working paper to
compute the debit to Goodwill and the credit to Minority Interest in Net Assets of Sub-
sidiary in the foregoing working paper elimination.
(Exercise 6.12) Combinor Corporation and Combinee Company had been operating separately for five
years. Each company had a minimal amount of liabilities and a simple capital structure
consisting solely of common stock. Combinor, in exchange for its unissued common stock,
acquired 80% of the outstanding common stock of Combinee. Combinee’s identifiable net
CHECK FIGURE assets had a current fair value of $800,000 and a carrying amount of $600,000. The current
Method 3 minority fair value of the Combinor common stock issued in the business combination was
interest, $175,000. $700,000. Out-of-pocket costs of the combination may be disregarded.
Prepare a working paper to compute the minority interest in net assets of subsidiary and
the goodwill that would be displayed in the consolidated balance sheet of Combinor Cor-
poration and subsidiary, under three alternative methods of computation as illustrated on
page 229.
(Exercise 6.13) On May 31, 2005, Pismo Corporation acquired for $760,000 cash, including direct out-of-
CHECK FIGURE pocket costs of the business combination, 80% of the outstanding common stock of Sobol
Debit goodwill— Company. There was no contingent consideration involved in the combination. Sobol was
Pismo, $80,000. to be a subsidiary of Pismo.
 Chapter 6 Consolidated Financial Statements: On Date of Business Combination 245

Additional Information for May 31, 2005:

1. Sobol Company’s stockholders’ equity prior to the combination was as follows:

Common stock, no par or stated value $300,000

Retained earnings 400,000
Total stockholders’ equity $700,000

2. Differences between current fair values and carrying amounts of Sobol’s identifiable as-
sets were as follows (the current fair values of Sobol’s other assets and its liabilities
equaled their carrying amounts):

Current Fair Values Carrying Amounts Differences

Inventories $ 120,000 $ 80,000 $ 40,000
Land 300,000 250,000 50,000
Building (net) 800,000 740,000 60,000
Totals $1,220,000 $1,070,000 $150,000

Prepare a working paper elimination, in journal entry format (omit explanation) for the
consolidated balance sheet of Pismo Corporation and subsidiary on May 31, 2005. (Disre-
gard income taxes.)
(Exercise 6.14) The working paper elimination (in journal entry format) on August 31, 2005, for the con-
solidated balance sheet of Payton Corporation and subsidiary is shown below. On that date,
Payton acquired most of the outstanding common stock of Sutton Company for cash.

CHECK FIGURE
PAYTON CORPORATION AND SUBSIDIARY
c. Goodwill, $6,000.
Working Paper Elimination
August 31, 2005

Common Stock—Sutton 60,000

Additional Paid-in Capital—Sutton 35,250
Retained Earnings—Sutton 50,100
Inventories—Sutton 3,900
Plant Assets (net)—Sutton 28,500
Patent—Sutton 4,500
Goodwill—Payton 5,280
Investment in Sutton Company Common Stock—Payton 165,660
Minority Interest in Net Assets of Subsidiary 21,870
To eliminate intercompany investment and equity accounts of
subsidiary on date of business combination; to allocate excess
of cost over current fair values of identifiable net assets acquired
to goodwill; and to establish minority interest in net assets of
subsidiary on date of business combination. (Income tax effects
are disregarded.)

Answer the following questions (show supporting computations):

a. What percentage of the outstanding common stock of the subsidiary was acquired by the
parent company?
246 Part Two Business Combinations and Consolidated Financial Statements

b. What was the aggregate current fair value of the subsidiary’s identifiable net assets on
August 31, 2005?
c. What amount would be assigned to goodwill under the method that infers a total cur-
rent fair value for the subsidiary’s total net assets, based on the parent company’s
investment?
d. What amount would be assigned to minority interest in net assets of subsidiary under the
method described in (c)?

Cases
(Case 6.1) In the absence of definitive guidelines from the FASB, companies that have applied push-
down accounting in the separate financial statements of substantially wholly owned sub-
sidiaries have used accounting techniques analogous to quasi-reorganizations or to
reorganizations under the U.S. Bankruptcy Code. That is, the restatement of the subsidiary’s
identifiable assets and liabilities to current fair values and the recognition of goodwill are
accompanied by a write-off of the subsidiary’s retained earnings; the balancing amount is
an increase in additional paid-in capital of the subsidiary.

Instructions
What is your opinion of the foregoing accounting practice? Explain.

(Case 6.2) In paragraph 44 of Statement of Financial Accounting Standards No. 141, “Business Com-
binations,” the Financial Accounting Standards Board directed that if the sum of the fair val-
ues of assets acquired and liabilities assumed in a business combination exceeds the cost of
the acquired enterprise, such excess should be allocated as a pro rata reduction of amounts
that otherwise would have been assigned to noncurrent assets other than specified exceptions.

Instructions
What support, if any, do you find for the action of the FASB? Explain.

(Case 6.3) On January 2, 2005, the board of directors of Photo Corporation assigned to a voting trust
15,000 shares of the 60,000 shares of Soto Company common stock owned by Photo. The
trustee of the voting trust presently has custody of 40,000 of Soto’s 105,000 shares of is-
sued common stock, of which 5,000 shares are in Soto’s treasury. The term of the voting
trust is three years.

Instructions
Are consolidated financial statements appropriate for Photo Corporation and Soto Com-
pany for the three years ending December 31, 2007? Explain.

(Case 6.4) On July 31, 2005, Paley Corporation transferred all right, title, and interest in several of its
current research and development projects to Carla Saye, sole stockholder of Saye Com-
pany, in exchange for 55 of the 100 shares of Saye Company common stock owned by
Carla Saye. On the same date, Martin Morgan, who is not related to Paley Corporation,
Saye Company, or Carla Saye, acquired for $45,000 cash the remaining 45 shares of Saye
Company common stock owned by Carla Saye. Carla Saye notified the directors of Paley
Corporation of the sale of common stock to Morgan.
Because Paley had recognized as expense the costs related to the research and develop-
ment when the costs were incurred, Paley’s controller prepared the following journal entry
to record the business combination with Saye Company:
 Chapter 6 Consolidated Financial Statements: On Date of Business Combination 247

Investment in Saye Company Common Stock (55 $1,000) 55,000

Gain on Disposal of Intangible Assets 55,000
To record transfer of research and development projects to Carla
Saye in exchange for 55 shares of Saye Company common stock.
Valuation of the investment is based on an unrelated cash issuance of
Saye Company common stock on this date.

Instructions
a. Do you concur with the foregoing journal entry? Explain.
b. Should the $55,000 gain be displayed in a consolidated income statement of Paley
Corporation and subsidiary for the year ended July 31, 2005? Explain.
(Case 6.5) On May 31, 2005, Patrick Corporation acquired at 100, $500,000 face amount of Stear
Company’s 10-year, 12%, convertible bonds due May 31, 2010. The bonds were convert-
ible to 50,000 shares of Stear’s voting common stock ($1 par), of which 40,000 shares
were issued and outstanding on May 31, 2005. The controller of Patrick, who also is one
of three Patrick officers who serve on the five-member board of directors of Stear, pro-
poses to issue consolidated financial statements for Patrick Corporation and Stear Com-
pany on May 31, 2005.
Instructions
Do you agree with the Patrick controller’s proposal? Explain.

(Case 6.6) In January 2005, Pinch Corporation, a chain of discount stores, began a program of busi-
ness combinations with its principal suppliers. On May 31, 2005, the close of its fiscal
year, Pinch paid $8,500,000 cash and issued 100,000 shares of its common stock (current
fair value $20 a share) for all 10,000 outstanding shares of common stock of Silver Com-
pany. Silver was a furniture manufacturer whose products were sold in Pinch’s stores. To-
tal stockholders’ equity of Silver on May 31, 2005, was $9,000,000. Out-of-pocket costs
attributable to the business combination itself (as opposed to the SEC registration state-
ment for the 100,000 shares of Pinch’s common stock) paid by Pinch on May 31, 2005,
totaled $100,000.
In the consolidated balance sheet of Pinch Corporation and subsidiary on May 31,
2005, the $1,600,000 [$8,500,000 (100,000 $20) $100,000 $9,000,000] dif-
ference between the parent company’s cost and the carrying amounts of the sub-
sidiary’s identifiable net assets was allocated in accordance with purchase accounting
as follows:

Inventories $ 250,000
Plant assets 850,000
Patents 300,000
Goodwill 200,000
Total excess of cost over carrying amounts of subsidiary’s net assets $1,600,000

Under terms of the indenture for a $1,000,000 bond liability of Silver, Pinch was oblig-
ated to maintain Silver as a separate corporation and to issue a separate balance sheet for
Silver each May 31. Pinch’s controller contends that Silver’s balance sheet on May 31,
2005, should value net assets at $10,600,000—their cost to Pinch. Silver’s controller
248 Part Two Business Combinations and Consolidated Financial Statements

disputes this valuation, claiming that generally accepted accounting principles require is-
suance of a historical cost balance sheet for Silver on May 31, 2005.
Instructions
a. Present arguments supporting the Pinch controller’s position.
b. Present arguments supporting the Silver controller’s position.
c. Which position do you prefer? Explain.
(Case 6.7) The board of directors of Purdido Corporation have just directed Purdido’s officers to aban-
don further efforts to complete an acquisition of all the outstanding common stock of Sontee
Company in a business combination that would have resulted in a parent company–subsidiary
relationship between Purdido and Sontee. After learning of the board’s decision, Purdido’s
chief financial officer instructed the controller, a CPA who is a member of the AICPA, the
FEI, and the IMA (see Chapter 1), to analyze the out-of-pocket costs of the abandoned
proposed combination. After some analysis of Purdido’s accounting records, the controller
provided the following summary to the CFO:

PURDIDO CORPORATION
Out-of-Pocket Costs of Abandoned Business Combination
April 17, 2005

Legal fees relating to proposed business combination $120,000

Finder’s fee relating to proposed business combination 0*
Costs associated with proposed SEC registration statement for Purdido
common stock to have been issued in the business combination 180,000
Total out-of-pocket costs of abandoned business combination $300,000

*Finder’s fee was contingent on successful completion of the business combination.

Noting that recognition of the entire $300,000 as expense on April 17, 2005, would have
a depressing effect on earnings of Purdido for the quarter ending June 30, 2005, the CFO
instructed the controller to expense only $120,000 and to debit the $180,000 amount to the
Paid-in Capital in Excess of Par ledger account. In response to the controller’s request for
justification of such a debit, the CFO confided that Purdido’s board was presently engaged
in exploring other business combination opportunities, and that the costs incurred on the
proposed SEC registration statement thus had future benefits to Purdido.
Instructions
May the controller of Purdido Corporation ethically comply with the CFO’s instructions?
Explain.

(Case 6.8) Assume you are a CPA and a member of the AICPA, the FEI, and the IMA (see Chap-
ter 1). You are CFO of a publicly owned corporation whose CEO is planning to become
the sole stockholder of a newly established corporation in a situation with characteris-
tics similar to those described in Securities and Exchange Commission AAER 34,
“Securities and Exchange Commission v. Digilog, Inc. and Ronald Moyer” (described
on pages 234–235). When you inform the CEO of the SEC’s findings in AAER 34, the
CEO informs you that the corporation’s independent auditors have provided a copy of
a reply by the AICPA’s Technical Information Service to a question involving a situa-
tion similar to that in AAER 34 and that the Technical Information Service answer was
that consolidated financial statements were not required. The CEO gives you Section
1400.07, “Reporting on Company Where Option to Acquire Control Exists,” of the
 Chapter 6 Consolidated Financial Statements: On Date of Business Combination 249

AICPA Technical Practice Aids and orders you not to insist on consolidation of “his”
corporation’s financial statements.
Instructions
What are your ethical obligations in this matter? Explain.

(Case 6.9) In a classroom discussion of the appropriate balance sheet display of the minority interest
in net assets of a consolidated subsidiary, student Michael expressed a dislike for both the
economic unit concept favored by the FASB and the alternative parent company concept.
According to Michael, the minority interest in net assets of a subsidiary is neither a part of
consolidated stockholders’ equity, as suggested by the economic unit concept, nor a liabil-
ity, as indicated by the parent company concept. Michael favored displaying minority
interest in the “mezzanine” section of the consolidated balance sheet, between liabilities
and stockholders’ equity. Michael suggested a precedent for such display in the Securities
and Exchange Commission’s comparable mandated display for redeemable preferred stock,
per Section 211 of the SEC’s Codification of Financial Reporting Policies. Student Roger
disagreed with student Michael, pointing out that the FASB’s Statement of Financial Ac-
counting Concepts No. 6, “Elements of Financial Statements,” does not identify an element
entitled mezzanine.
Instructions
Do you support the view of student Michael or of student Roger? Explain.

Problems
(Problem 6.1) On September 30, 2005, Parr Corporation paid $1,000,000 to shareholders of Sane Com-
pany for 90,000 of Sane’s 100,000 outstanding shares of no-par, no-stated-value common
stock; additionally, Parr paid direct out-of-pocket costs of the combination totaling $80,000
on that date. Carrying amounts and current fair values of Sane’s identifiable net assets on
September 30, 2005, were analyzed as follows:

CHECK FIGURE
Common stock, no par $400,000
b. Debit goodwill—
Retained earnings 500,000
Parr, $189,000.
Total carrying amount of identifiable net assets $900,000
Add: Differences between current fair value and carrying amount:
Inventories (first-in, first-out cost) 30,000
Plant assets (net) 60,000
Total current fair value of identifiable net assets $990,000

Instructions
a. Prepare journal entries for Parr Corporation on September 30, 2005, to record the busi-
ness combination with Sane Company. (Disregard income taxes.)
b. Prepare a working paper elimination for Parr Corporation and subsidiary (in journal en-
try format) on September 30, 2005. (Disregard income taxes.)
(Problem 6.2) On September 30, 2005, Philly Corporation issued 100,000 shares of its no-par, no-stated-
value common stock (current fair value $12 a share) for 18,800 shares of the outstanding
$20 par common stock of Stype Company. The $150,000 out-of-pocket costs of the
250 Part Two Business Combinations and Consolidated Financial Statements

business combination paid by Philly on September 30, 2005, were allocable as follows:
60% to finder’s, legal, and accounting fees directly related to the business combination;
40% to the SEC registration statement for Philly’s common stock issued in the business
combination. There was no contingent consideration.
Immediately prior to the business combination, separate balance sheets of the con-
stituent companies were as follows:

CHECK FIGURE
PHILLY CORPORATION AND STYPE COMPANY
b. Debit goodwill—
Separate Balance Sheets (prior to business combination)
Philly, $115,000. September 30, 2005

Philly Stype
Corporation Company
Assets
Cash $ 200,000 $ 100,000
Trade accounts receivable (net) 400,000 200,000
Inventories (net) 600,000 300,000
Plant assets (net) 1,300,000 1,000,000
Total assets $2,500,000 $1,600,000

Liabilities and Stockholders’ Equity

Current liabilities $ 800,000 $ 400,000
Long-term debt 100,000
Common stock, no par or stated value 1,200,000
Common stock, $20 par 400,000
Retained earnings 500,000 700,000
Total liabilities and stockholders’ equity $2,500,000 $1,600,000

Current fair values of Stype’s identifiable net assets differed from their carrying amounts
as follows:

Current Fair Values,

Sept. 30, 2005
Inventories $ 340,000
Plant assets (net) 1,100,000
Long-term debt 90,000

Instructions
a. Prepare journal entries for Philly Corporation on September 30, 2005, to record the
business combination with Stype Company. (Disregard income taxes.)
b. Prepare a working paper for consolidated balance sheet and related working paper elim-
ination (in journal entry format) for Philly Corporation and subsidiary on September 30,
2005. Amounts in the working papers should reflect the journal entries in (a). (Disregard
income taxes.)

(Problem 6.3) Separate balance sheets of Pellman Corporation and Shire Company on May 31, 2005,
together with current fair values of Shire’s identifiable net assets, are as follows:
 Chapter 6 Consolidated Financial Statements: On Date of Business Combination 251

CHECK FIGURE PELLMAN CORPORATION AND SHIRE COMPANY

b. Consolidated plant
Separate Balance Sheets (prior to business combination)
assets, $3,510,000. May 31, 2005

Shire Company
Pellman Carrying Current
Corporation Amounts Fair Values
Assets
Cash $ 550,000 $ 10,000 $ 10,000
Trade accounts receivable (net) 700,000 60,000 60,000
Inventories 1,400,000 120,000 140,000
Plant assets (net) 2,850,000 610,000 690,000
Total assets $5,500,000 $800,000

Liabilities and Stockholders’ Equity

Current liabilities $ 500,000 $ 80,000 $ 80,000
Long-term debt 1,000,000 400,000 440,000
Common stock, $10 par 1,500,000 100,000
Additional paid-in capital 1,200,000 40,000
Retained earnings 1,300,000 180,000
Total liabilities and stockholders’ equity $5,500,000 $800,000

On May 31, 2005, Pellman acquired all 10,000 shares of Shire’s outstanding common
stock by paying $300,000 cash to Shire’s stockholders and $50,000 cash for finder’s and le-
gal fees relating to the business combination. There was no contingent consideration, and
Shire became a subsidiary of Pellman.
Instructions
a. Prepare journal entries for Pellman Corporation to record the business combination with
Shire Company on May 31, 2005. (Disregard income taxes.)
b. Prepare a working paper for consolidated balance sheet of Pellman Corporation and sub-
sidiary on May 31, 2005, and the related working paper elimination (in journal entry
format). Amounts in the working papers should reflect the journal entries in (a). (Disre-
gard income taxes.)
(Problem 6.4) On April 30, 2005, Powell Corporation issued 30,000 shares of its no-par, no-stated-value
common stock having a current fair value of $20 a share for 8,000 shares of Seaver Com-
pany’s $10 par common stock. There was no contingent consideration; out-of-pocket costs
of the business combination, paid by Seaver on behalf of Powell on April 30, 2005, were
as follows:

Finder’s and legal fees relating to business combination $40,000

Costs associated with SEC registration statement 30,000
Total out-of-pocket costs of business combination $70,000

Separate balance sheets of the constituent companies on April 30, 2005, prior to the
business combination, were as follows:
252 Part Two Business Combinations and Consolidated Financial Statements

CHECK FIGURE
POWELL CORPORATION AND SEAVER COMPANY
c. Minority interest
Separate Balance Sheets (prior to business combination)
in net assets, $140,000. April 30, 2005

Powell Seaver
Corporation Company
Assets
Cash $ 50,000 $ 150,000
Trade accounts receivable (net) 230,000 200,000
Inventories 400,000 350,000
Plant assets (net) 1,300,000 560,000
Total assets $1,980,000 $1,260,000

Liabilities and Stockholders’ Equity

Current liabilities $ 310,000 $ 250,000
Long-term debt 800,000 600,000
Common stock, no par or stated value 500,000
Common stock, $10 par 100,000
Additional paid-in capital 360,000
Retained earnings (deficit) 370,000 (50,000)
Total liabilities and stockholders’ equity $1,980,000 $1,260,000

Current fair values of Seaver’s identifiable net assets were the same as their carrying
amounts, except for the following:

Current Fair Values

Apr. 30, 2005
Inventories $440,000
Plant assets (net) 780,000
Long-term debt 620,000

Instructions
a. Prepare a journal entry for Seaver Company on April 30, 2005, to record its payment of
out-of-pocket costs of the business combination on behalf of Powell Corporation.
b. Prepare journal entries for Powell Corporation to record the business combination with
Seaver Company on April 30, 2005. (Disregard income taxes.)
c. Prepare a working paper for consolidated balance sheet of Powell Corporation and sub-
sidiary on April 30, 2005, and the related working paper elimination (in journal entry
format). Amounts in the working papers should reflect the journal entries in (a) and (b).
(Disregard income taxes.)

(Problem 6.5) On July 31, 2005, Pyr Corporation issued 20,000 shares of its $2 par common stock (cur-
rent fair value $10 a share) for all 5,000 shares of outstanding $5 par common stock of
Soper Company, which was to remain a separate corporation. Out-of-pocket costs of the
business combination, paid by Pyr on July 31, 2005, are shown below:

CHECK FIGURE
Finder’s and legal fees related to business combination $20,000
b. Consolidated
Costs associated with SEC registration statement for Pyr common stock 10,000
goodwill, $35,000.
Total out-of-pocket costs of business combination $30,000
 Chapter 6 Consolidated Financial Statements: On Date of Business Combination 253

The constituent companies’ separate balance sheets on July 31, 2005, prior to the busi-
ness combination, follow:

PYR CORPORATION AND SOPER COMPANY

Separate Balance Sheets (prior to business combination)
July 31, 2005

Pyr Soper
Corporation Company
Assets
Current assets $ 800,000 $150,000
Plant assets (net) 2,400,000 300,000
Goodwill 20,000
Total assets $3,200,000 $470,000

Liabilities and Stockholders’ Equity

Current liabilities $ 400,000 $120,000
Long-term debt 1,000,000 200,000
Common stock, $2 par 800,000
Common stock, $5 par 25,000
Additional paid-in capital 400,000 50,000
Retained earnings 600,000 75,000
Total liabilities and stockholders’ equity $3,200,000 $470,000

Soper’s goodwill, which had resulted from its July 31, 2001, acquisition of the net assets
of Solo Company, was not impaired.
Soper’s assets and liabilities having July 31, 2005, current fair values different from their
carrying amounts were as follows:

Current
Carrying Fair
Amounts Values
Inventories $ 60,000 $ 65,000
Plant assets (net) 300,000 340,000
Long-term debt 200,000 190,000

There were no intercompany transactions prior to the business combination, and there
was no contingent consideration in connection with the combination.
Instructions
a. Prepare Pyr Corporation’s journal entries on July 31, 2005, to record the business com-
bination with Soper Company. (Disregard income taxes.)
b. Prepare a working paper elimination (in journal entry format) and the related working pa-
per for consolidated balance sheet of Pyr Corporation and subsidiary on July 31, 2005.
Amounts in the working papers should reflect the journal entries in (a). (Disregard in-
come taxes.)
254 Part Two Business Combinations and Consolidated Financial Statements

(Problem 6.6) The unconsolidated and consolidated balance sheets of Pali Corporation and subsidiary on
August 31, 2005, the date of Pali’s business combination with Soda Company, are as follows:

CHECK FIGURE
PALI CORPORATION
Debit additional paid-
Unconsolidated and Consolidated Balance Sheets
in capital, $120,000.
August 31, 2005

Unconsolidated Consolidated
Assets
Cash $ 120,000 $ 160,000
Trade accounts receivable (net) 380,000 540,000
Inventories 470,000 730,000
Investment in Soda Company common stock 380,000
Plant assets (net) 850,000 1,470,000
Goodwill 8,000
Total assets $2,200,000 $2,908,000

Liabilities and Stockholders’ Equity

Current liabilities $ 430,000 $ 690,000
Long-term debt 550,000 730,000
Premium on long-term debt 20,000
Minority interest in net assets of subsidiary 248,000
Common stock, $1 par 500,000 500,000
Additional paid-in capital 440,000 440,000
Retained earnings 280,000 280,000
Total liabilities and stockholders’ equity $2,200,000 $2,908,000

On August 31, 2005, Pali had paid cash of $3 a share for 60% of the outstanding shares
of Soda’s $1 par common stock and $20,000 cash for legal fees in connection with the busi-
ness combination. There was no contingent consideration. The equity (book value) of
Soda’s common stock on August 31, 2005, was $2.80 a share, and the amount of Soda’s
retained earnings was twice as large as the amount of its additional paid-in capital. The
excess of current fair value of Soda’s plant assets over their carrying amount on August 31,
2005, was 12⁄3 times as large as the comparable excess for Soda’s inventories on that date.
The current fair values of Soda’s cash, trade accounts receivable (net), and current liabili-
ties were equal to their carrying amounts on August 31, 2005.
Instructions
Reconstruct the working paper elimination (in journal entry format) for the working paper
for consolidated balance sheet of Pali Corporation and subsidiary on August 31, 2005.
(Disregard income taxes.)
(Problem 6.7) On October 31, 2005, Pagel Corporation acquired 83% of the outstanding common stock of
Sayre Company in exchange for 50,000 shares of Pagel’s no-par, $2 stated value ($10 current
fair value a share) common stock. There was no contingent consideration. Out-of-pocket
costs of the business combination paid by Pagel on October 31, 2005, were as follows:

Legal and finder’s fees related to business combination $34,750

Costs associated with SEC registration statement for Pagel’s common stock 55,250
Total out-of-pocket costs of business combination $90,000
 Chapter 6 Consolidated Financial Statements: On Date of Business Combination 255

There were no intercompany transactions between the constituent companies prior to the
business combination. Sayre was to be a subsidiary of Pagel. The separate balance sheets
of the constituent companies prior to the business combination follow:

CHECK FIGURE PAGEL CORPORATION AND SAYRE COMPANY

b. Consolidated total
Separate Balance Sheets (prior to business combination)
assets, $7,684,870. October 31, 2005

Pagel Sayre
Corporation Company
Assets
Cash $ 250,000 $ 150,000
Inventories 860,000 600,000
Other current assets 500,000 260,000
Plant assets (net) 3,400,000 1,500,000
Patents (net) 80,000
Total assets $5,010,000 $2,590,000

Liabilities and Stockholders’ Equity

Income taxes payable $ 40,000 $ 60,000
Other current liabilities 390,000 854,000
Long-term debt 950,000 1,240,000
Common stock, no-par, $2 stated value 1,500,000
Common stock, $10 par 100,000
Additional paid-in capital 1,500,000
Retained earnings 630,000 336,000
Total liabilities and stockholders’ equity $5,010,000 $2,590,000

Current fair values of Sayre’s identifiable net assets were the same as their carrying
amounts on October 31, 2005, except for the following:

Current Fair Values

Inventories $ 620,000
Plant assets (net) 1,550,000
Patents (net) 95,000
Long-term debt 1,225,000

Instructions
a. Prepare Pagel Corporation’s journal entries on October 31, 2005, to record the business
combination with Sayre Company. (Disregard income taxes.)
b. Prepare working paper eliminations (in journal entry format) on October 31, 2005, and
the related working paper for the consolidated balance sheet of Pagel Corporation and
subsidiary. Amounts in the working papers should reflect the journal entries in (a). (Dis-
regard income taxes.)
(Problem 6.8) On January 31, 2005, Porcino Corporation issued $50,000 cash, 6,000 shares of $2 par
common stock (current fair value $15 a share), and a 5-year, 14%, $50,000 promissory note
payable for all 10,000 shares of Secor Company’s outstanding common stock, which were
owned by Lawrence Secor. The only out-of-pocket costs paid by Porcino to complete the
business combination were legal fees of $10,000, because Porcino’s common stock issued
256 Part Two Business Combinations and Consolidated Financial Statements

in the combination was not subject to the registration requirements of the SEC. There was
no contingent consideration, and 14% was the fair rate of interest for the promissory note
issued by Porcino in connection with the business combination.
Separate balance sheets of Porcino and Secor on January 31, 2005, prior to the business
combination, were as follows:
CHECK FIGURE PORCINO CORPORATION AND SECOR COMPANY
b. Consolidated
Separate Balance Sheets (prior to business combination)
intangible assets, January 31, 2005
$215,000.
Porcino Secor
Corporation Company
Assets
Inventories $ 380,000 $ 60,000
Other current assets 640,000 130,000
Plant assets (net) 1,520,000 470,000
Intangible assets (net) 160,000 40,000
Total assets $2,700,000 $700,000

Liabilities and Stockholders’ Equity

Current liabilities $ 420,000 $200,000
Long-term debt 650,000 300,000
Common stock, $2 par 800,000
Common stock, $15 par 150,000
Additional paid-in capital 220,000 160,000
Retained earnings (deficit) 610,000 (110,000)
Total liabilities and stockholders’ equity $2,700,000 $700,000

Current fair values of Secor’s identifiable net assets that differed from their carrying
amounts on January 31, 2005, were as follows:

Current Fair Values

Inventories $ 70,000
Plant assets (net) 540,000
Intangible assets (net) 60,000
Long-term debt 350,000

Instructions
a. Prepare journal entries for Porcino Corporation on January 31, 2005, to record its busi-
ness combination with Secor Company. (Disregard income taxes.)
b. Prepare a working paper for consolidated balance sheet of Porcino Corporation and sub-
sidiary on January 31, 2005, and the related working paper elimination (in journal entry
format). Amounts in the working papers should reflect the journal entries in (a). (Disre-
gard income taxes.)
(Problem 6.9) On June 30, 2005, Pandit Corporation issued a $300,000 note payable, due $60,000 a year
with interest at the fair rate of 15% beginning June 30, 2006, for 8,500 of the 10,000 out-
standing shares of $10 par common stock of Singh Company. Legal fees of $20,000 in-
curred by Pandit in connection with the business combination were paid on June 30, 2005.
Separate balance sheets of the constituent companies, immediately following the busi-
ness combination, are shown on page 257.
 Chapter 6 Consolidated Financial Statements: On Date of Business Combination 257

CHECK FIGURES:
PANDIT CORPORATION AND SINGH COMPANY
a. Credit cost of goods
Separate Balance Sheets (following business combination)
sold, $60,000; June 30, 2005
b. Consolidated total
assets, $1,842,000. Pandit Singh
Corporation Company
Assets
Cash $ 80,000 $ 60,000
Trade accounts receivable (net) 170,000 90,000
Inventories 370,000 120,000
Investment in Singh Company common stock 320,000
Plant assets (net) 570,000 240,000
Goodwill (net) 50,000
Total assets $1,560,000 $510,000

Liabilities and Stockholders’ Equity

Trade accounts payable $ 220,000 $120,000
Income taxes payable 100,000 40,000
15% note payable, due $60,000 annually 300,000
Common stock, $10 par 250,000 100,000
Additional paid-in capital 400,000 130,000
Retained earnings 290,000 120,000
Total liabilities and stockholders’ equity $1,560,000 $510,000

Additional Information
1. An independent audit of Singh Company’s financial statement for the year ended June
30, 2005, disclosed that Singh’s July 1, 2004, inventories had been overstated $60,000
due to double counting; and that Singh had omitted from its inventories on June 30,
2005, merchandise shipped FOB shipping point by a vendor on June 30, 2005, at an
invoiced amount of $35,000. Corrections of Singh’s inventories errors are not reflected
in Singh’s balance sheet.
2. Both Pandit and Singh had an income tax rate of 40%.
3. Current fair values of Singh’s net assets reported in Singh’s balance sheet on June 30,
2005, differed from carrying amounts as follows:

Current Fair Values

Inventories $150,000
Plant assets (net) 280,000

Instructions
a. Prepare a journal entry or entries (including income tax effects) to correct the invento-
ries’ misstatements in Singh Company’s financial statements for the year ended June 30,
2005. Singh’s accounting records have not been closed for the year ended June 30, 2005.
b. Prepare a working paper elimination (in journal entry format) and a working paper for
the consolidated balance sheet of Pandit Corporation and subsidiary on June 30, 2005.
Amounts in the working papers for Singh Company should reflect the adjusting journal
entry or entries prepared in (a). (Disregard income taxes.)
(Problem 6.10) On page 258 are the separate balance sheets of Pliny Corporation and Sylla Company on
December 31, 2005, prior to their business combination.
258 Part Two Business Combinations and Consolidated Financial Statements

CHECK FIGURES:
PLINY CORPORATION AND SYLLA COMPANY
a. Total debits to
Separate Balance Sheets (prior to business combination)
Investment account, December 31, 2005
$1,502,727;
b. Debit goodwill— Pliny Sylla
Sylla, $15,626. Corporation Company
Assets
Inventories $ 800,000 $ 300,000
Other current assets 1,200,000 500,000
Long-term investments in marketable debt securities
(held to maturity) 200,000
Plant assets (net) 2,500,000 900,000
Intangible assets (net) 100,000 200,000
Total assets $4,600,000 $2,100,000

Liabilities and Stockholders’ Equity

Current liabilities $1,400,000 $ 300,000
10% note payable, due June 30, 2010 2,000,000
12% bonds payable, due Dec. 31, 2015 500,000
Common stock, $1 par 600,000 200,000
Additional paid-in capital 200,000 400,000
Retained earnings 400,000 700,000
Total liabilities and stockholders’ equity $4,600,000 $2,100,000

On December 31, 2005, Pliny paid $100,000 cash and issued $1,500,000 face amount
of 14%, 10-year bonds for all the outstanding common stock of Sylla, which became a sub-
sidiary of Pliny. On the date of the business combination, 16% was the fair rate of interest
for the bonds of both Pliny and Sylla, both of which paid interest on June 30 and Decem-
ber 31. There was no contingent consideration involved in the business combination, but
Pliny paid the following out-of-pocket costs on December 31, 2005:

Finder’s and legal fees relating to business combination $50,000

Costs associated with SEC registration statement for Pliny’s bonds 40,000
Total out-of-pocket costs of business combination $90,000

In addition to the 12% bonds payable, Sylla had identifiable net assets with current fair
values that differed from carrying amounts on December 31, 2005, as follows:

Current Fair Values

Inventories $330,000
Long-term investments in marketable debt securities 230,000
Plant assets (net) 940,000
Intangible assets (net) 220,000

Instructions
a. Prepare journal entries for Pliny Corporation to record the business combination with
Sylla Company on December 31, 2005. Use a calculator or present value tables to com-
pute the present value, rounded to the nearest dollar, of the 14% bonds issued by Pliny.
(Disregard income taxes.)
 Chapter 6 Consolidated Financial Statements: On Date of Business Combination 259

b. Prepare a working paper for consolidated balance sheet for Pliny Corporation and sub-
sidiary on December 31, 2005, and the related working paper elimination (in journal en-
try format). Use a calculator or present value tables to compute the present value,
rounded to the nearest dollar, of the 12% bonds payable of Sylla. Amounts in the work-
ing papers should reflect the journal entries in (a). (Disregard income taxes.)
(Problem 6.11) You have been engaged to audit the financial statements of Parthenia Corporation and sub-
sidiary for the year ended June 30, 2005. The working paper for consolidated balance sheet
CHECK FIGURES: of Parthenia and subsidiary on June 30, 2005, prepared by Parthenia’s inexperienced ac-
a. Debit Investment
countant, is at the bottom of this page.
account, $70,000;
b. Credit minority
In the course of your audit, you reviewed the following June 30, 2005, journal entries in
interest in net assets, the accounting records of Parthenia Corporation:
$62,000.
Investment in Storey Company Common Stock 220,000
Goodwill 60,000
Cash 280,000
To record acquisition of 4,000 shares of Storey Company’s
outstanding common stock in a business combination,
and to record acquired goodwill as follows:
Cash paid for Storey common stock $280,000
Less: Stockholders’ equity of Storey, June 30, 2005 220,000
Goodwill acquired $ 60,000

Expenses of Business Combination 10,000

Cash 10,000
To record payment of legal fees in connection with business
combination with Storey Company.

PARTHENIA CORPORATION AND SUBSIDIARY

Working Paper for Consolidated Balance Sheet
June 30, 2005

Eliminations
Parthenia Storey Increase
Corporation Company (Decrease) Consolidated
Assets
Cash 60,000 50,000 110,000
Trade accounts receivable (net) 120,000 90,000 210,000
Inventories 250,000 160,000 410,000
Investment in Storey Company common stock 220,000 (a) (220,000)
Plant assets (net) 590,000 500,000 1,090,000
Goodwill (net) 60,000 60,000
Total assets 1,300,000 800,000 (220,000) 1,880,000

Liabilities and Stockholders’ Equity

Current liabilities 200,000 280,000 480,000
Long-term debt 500,000 300,000 800,000
Common stock, $5 par 100,000 100,000
Common stock, $10 par 50,000 (a) (50,000)
Additional paid-in capital 200,000 70,000 (a) (70,000) 200,000
Retained earnings 300,000 100,000 (a) (100,000) 300,000
Total liabilities and stockholders’ equity 1,300,000 800,000 (220,000) 1,880,000
260 Part Two Business Combinations and Consolidated Financial Statements

Your inquiries of directors and officers of Parthenia and your review of supporting doc-
uments disclosed the following current fair values for Storey’s identifiable net assets that
differ from carrying amounts on June 30, 2005:

Current Fair Values

Inventories $180,000
Plant assets (net) 530,000
Long-term debt 260,000

Instructions
a. Prepare a journal entry to correct Parthenia Corporation’s accounting for its June 30,
2005, business combination with Storey Company. Parthenia’s accounting records have
not been closed. (Disregard income taxes.)
b. Prepare a corrected working paper for consolidated balance sheet of Parthenia Corpora-
tion and subsidiary on June 30, 2005, and related working paper elimination (in journal
entry format). Amounts in the working papers should reflect the journal entries in (a).
(Disregard income taxes.)
Chapter Seven

Consolidated Financial
Statements: Subsequent
to Date of Business
Combination
Scope of Chapter
Subsequent to the date of a business combination, the parent company must account for the
operating results of the subsidiary: the net income or net loss and dividends declared and
paid by the subsidiary. In addition, a number of intercompany transactions and events that
frequently occur in a parent company–subsidiary relationship must be recorded.
In this chapter the accounting for operating results of both wholly owned and partially
owned subsidiaries is described and illustrated. Accounting for intercompany transactions
not involving a profit (gain) or a loss, as well as those involving a profit or a loss, are dealt
with in Chapter 8.

ACCOUNTING FOR OPERATING RESULTS OF

WHOLLY OWNED SUBSIDIARIES
In accounting for the operating results of consolidated subsidiaries, a parent company may
choose the equity method or the cost method of accounting.

Equity Method
In the equity method of accounting, the parent company recognizes its share of the sub-
sidiary’s net income or net loss, adjusted for depreciation and amortization of differ-
ences between current fair values and carrying amounts of a subsidiary’s identifiable net
assets on the date of the business combination, as well as its share of dividends declared
by the subsidiary. Thus, the equity method of accounting for a subsidiary’s operating re-
sults is similar to home office accounting for a branch’s operations, as described in
Chapter 4.
Proponents of the equity method of accounting maintain that the method is consistent
with the accrual basis of accounting because it recognizes increases or decreases in the
carrying amount of the 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

261
262 Part Two Business Combinations and Consolidated Financial Statements

subsidiary as dividends. Thus, proponents claim, the equity method stresses the eco-
nomic substance of the parent company–subsidiary relationship because the two compa-
nies constitute a single economic entity for financial accounting. Proponents of the equity
method also claim that dividends declared by a subsidiary do not constitute revenue to
the parent company, as maintained by advocates of the cost method; instead, dividends
are a liquidation of a portion of the parent company’s investment in the subsidiary.

Cost Method
In the cost method of accounting, the parent company accounts for the operations of a sub-
sidiary only to the extent that dividends are declared by the subsidiary. Dividends declared
by the subsidiary from net income subsequent to the business combination are recognized
as revenue by the parent company; dividends declared by the subsidiary in excess of post-
combination net income constitute a reduction of the carrying amount of the parent com-
pany’s investment in the subsidiary. Net income or net loss of the subsidiary is not
recognized by the parent company when the cost method of accounting is used.
Supporters of the cost method contend that the method appropriately recognizes the le-
gal form of the parent company–subsidiary relationship. Parent company and subsidiary
are separate legal entities; accounting for a subsidiary’s operations should recognize the
separateness, according to proponents of the cost method. Thus, a parent company realizes
revenue from an investment in a subsidiary when the subsidiary declares a dividend, not
when the subsidiary reports net income. The cost method of accounting is illustrated in the
appendix at the end of this chapter (pages 292–298).

Choosing between Equity Method and Cost Method

Consolidated financial statement amounts are the same, regardless of whether a parent
company uses the equity method or the cost method to account for a subsidiary’s opera-
tions. However, the working paper eliminations used in the two methods are different, as
illustrated in subsequent sections of this chapter.

Illustration of Equity Method for Wholly Owned Subsidiary

for First Year after Business Combination
Assume that Palm Corporation had appropriately accounted for the December 31,
2005, business combination with its wholly owned subsidiary, Starr Company (see
pages 211–213 for a description of the business combination), and that Starr had a
net income of $60,000 (income statement is on page 269) for the year ended December
31, 2006. Assume further that on December 20, 2006, Starr’s board of directors declared
a cash dividend of $0.60 a share on the 40,000 outstanding shares of common stock
owned by Palm. The dividend was payable January 8, 2007, to stockholders of record
December 29, 2006.
Starr’s December 20, 2006, journal entry to record the dividend declaration is as
follows:

Wholly Owned 2006

Subsidiary’s Journal Dec. 20 Dividends Declared (40,000 $0.60) 24,000
Entry for Declaration Intercompany Dividends Payable 24,000
of Dividend To record declaration of dividend payable Jan. 8, 2007, to stock-
holders of record Dec. 29, 2006.
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 263

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

Parent Company’s 2006

Equity-Method Journal Dec. 20 Intercompany Dividends Receivable 24,000
Entries to Record Investment in Starr Company Stock 24,000
Operating Results of To record dividend declared by Starr Company, payable
Wholly Owned Jan. 8, 2007, to stockholders of record Dec. 29, 2006.
Subsidiary
31 Investment in Starr Company Common Stock 60,000
Intercompany Investment Income 60,000
To record 100% of Starr Company’s net income for the year
ended Dec. 31, 2006. (Income tax effects are disregarded.)

The parent’s first journal entry records the dividend declared by the subsidiary in
the Intercompany Dividends Receivable account and is the counterpart of the sub-
sidiary’s journal entry to record the declaration of the dividend. The credit to the In-
vestment in Starr Company Common Stock account in the first journal entry reflects
an underlying premise of the equity method of accounting: dividends declared by a
subsidiary represent a return of a portion of the parent company’s investment in the
subsidiary.
The parent’s second journal entry records the parent’s 100% share of the subsidiary’s net
income for 2006. The subsidiary’s net income accrues to the parent company under the eq-
uity method of accounting, similar to the accrual of interest on a note receivable or an in-
vestment in bonds.
The income tax effects of Palm Corporation’s accrual of its share of Starr Com-
pany’s net income are disregarded at this time. Income tax allocation problems asso-
ciated with all aspects of parent company and subsidiary accounting are considered in
Chapter 9.

Adjustment of Subsidiary’s Net Income

In addition to the two foregoing journal entries, Palm must prepare a third equity-method
journal entry on December 31, 2006, to adjust Starr’s net income for depreciation and
amortization attributable to the differences between the current fair values and carrying
amounts of Starr’s identifiable net assets on December 31, 2005, the date of the
Palm–Starr business combination. Because such differences were not recorded by the
subsidiary, the subsidiary’s 2006 net income is overstated from the point of view of
the consolidated entity.
Assume that the December 31, 2005 (date of business combination), differences be-
tween the current fair values and carrying amounts of Starr Company’s net assets were as
follows (see Chapter 6, pages 216 and 217):
264 Part Two Business Combinations and Consolidated Financial Statements

Differences between Inventories (first-in, first-out cost) $ 25,000

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

Palm Corporation prepares the following additional equity-method journal entry to re-
flect the effects of depreciation and amortization of the differences between the current fair
values and carrying amounts of Starr Company’s identifiable net assets on Starr’s net in-
come for the year ended December 31, 2006:

Parent Company’s 2006

Equity-Method Journal Dec. 31 Intercompany Investment Income 30,000
Entry to Record Investment in Starr Company Common Stock 30,000
Operating Results of To amortize differences between current fair values and
Wholly Owned carrying amounts of Starr Company’s net assets on
Subsidiary Attributable Dec. 31, 2005, as follows:
to Depreciation and Inventories—to cost of goods sold $25,000
Amortization of Building—depreciation ($30,000 15) 2,000
Subsidiary’s Net Assets Machinery—depreciation ($20,000 10) 2,000
Patent—amortization ($5,000 5) 1,000
Total amortization applicable to 2006 $30,000
(Income tax effects are disregarded.)

After the three foregoing journal entries are posted, Palm Corporation’s Investment in
Starr Company Common Stock and Intercompany Investment Income ledger accounts are
as follows:

Ledger Accounts of Investment in Starr Company Common Stock

Parent Company Using
Date Explanation Debit Credit Balance
Equity Method of
Accounting for Wholly 2005
Owned Subsidiary Dec. 31 Issuance of common stock in
business combination 450,000 450,000 dr
31 Direct out-of-pocket costs of
business combination 50,000 500,000 dr
2006
Dec. 20 Dividend declared by Starr 24,000 476,000 dr
31 Net income of Starr 60,000 536,000 dr
31 Amortization of differences between
current fair values and carrying
amounts of Starr’s net assets 30,000 506,000 dr
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 265

Intercompany Investment Income

Date Explanation Debit Credit Balance
2006
Dec. 31 Net income of Starr 60,000 60,000 cr
31 Amortization of differences between
current fair values and carrying
amounts of Starr’s net assets 30,000 30,000 cr

Developing the Elimination

Palm Corporation’s use of the equity method of accounting for its investment in Starr Com-
pany results in a balance in the Investment account that is a mixture of two components:
(1) the carrying amount of Starr’s identifiable net assets and (2) the excess on the date of
business combination of the current fair values of the subsidiary’s net assets (including
goodwill) over their carrying amounts, net of depreciation and amortization (“current fair
value excess”). These components are analyzed below:

PALM CORPORATION
Analysis of Investment in Starr Company Common Stock Ledger Account
For Year Ended December 31, 2006

Carrying Current Fair

Amount Value Excess Total
Beginning balances (date of business
combination) $390,000 $110,000 $500,000
Net income of Starr 60,000 60,000
Amortization of differences
between current fair values and Intercompany investment
u
carrying amounts of Starr’s income, $30,000
identifiable net assets (30,000) (30,000)
Dividend declared by Starr (24,000) (24,000)
Ending balances $426,000 $ 80,000 $506,000

The $426,000 ending balance of the Carrying Amount column agrees with the total
stockholder’s equity of Starr Company on December 31, 2006 (see balance sheet section of
working paper for consolidated financial statements on page 269), as follows:

Wholly Owned Common stock, $5 par $200,000

Subsidiary’s Additional paid-in capital 58,000
Stockholder’s Equity, Retained earnings 168,000
Dec. 31, 2006 Total stockholder’s equity $426,000

The $80,000 ending balance of the Current Fair Value Excess column agrees with the
December 31, 2006, total of the unamortized balances for each of the respective assets of
Starr Company, as shown on page 266.
266 Part Two Business Combinations and Consolidated Financial Statements

Unamortized Balances, Dec. 31, Amortization for Balances,

Differences between 2005 (p. 264) Year 2006 (p. 264) Dec. 31, 2006
Current Fair Values
Inventories $ 25,000 $(25,000)
and Carrying Amounts
Plant assets (net):
of Wholly Owned
Land $ 15,000 $15,000
Subsidiary’s Assets
Building 30,000 $ (2,000) 28,000
One Year Subsequent
Machinery 20,000 (2,000) 18,000
to Business
Total plant assets $ 65,000 $ (4,000) $61,000
Combination
Patent $ 5,000 $ (1,000) $ 4,000
Goodwill 15,000 15,000
Totals $110,000 $(30,000) $80,000

It is evident from the analysis of Palm Corporation’s Investment ledger account that the
working paper elimination subsequent to the date of a business combination must include ac-
counts that appear in the constituent companies’ income statements and statements of retained
earnings, as well as in their balance sheets, because all three basic financial statements must
be consolidated for accounting periods subsequent to the date of a business combination.
(A consolidated statement of cash flows is prepared from the three basic consolidated finan-
cial statements and other information, as explained in Chapter 9.) The items that must be in-
cluded in the elimination are (1) the subsidiary’s beginning-of-year stockholder’s equity and
its dividends, and the parent’s investment; (2) the parent’s intercompany investment income;
(3) unamortized current fair value excesses of the subsidiary; and (4) certain operating ex-
penses of the subsidiary. Assuming that Star Company allocates machinery depreciation and
patent amortization entirely to cost of goods sold, and building depreciation 50% each to cost
of goods sold and operating expenses, the working paper elimination (in journal entry format)
for Palm Corporation and subsidiary on December 31, 2006, is as follows, with the compo-
nent items numbered in accordance with the foregoing breakdown:

Working Paper PALM CORPORATION AND SUBSIDIARY

Elimination for Wholly Working Paper Elimination
Owned Subsidiary for December 31, 2006
First Year Subsequent
to Date of Business (a) Common Stock—Starr 200,000 (1)
Combination Additional Paid-in Capital—Starr 58,000 (1)
Retained Earnings—Starr 132,000 (1)
Intercompany Investment Income—Palm 30,000 (2)
Plant Assets (net)—Starr ($65,000 $4,000) 61,000 (3)
Patent (net)—Starr ($5,000 $1,000) 4,000 (3)
Goodwill—Starr 15,000 (3)
Cost of Goods Sold—Starr 29,000 (4)
Operating Expenses—Starr 1,000 (4)
Investment in Starr Company Common Stock—Palm 506,000 (1)
Dividends Declared—Starr 24,000 (1)
To carry out the following:
(a) Eliminate intercompany investment and equity accounts of
subsidiary at beginning of year, and subsidiary dividend.
(b) Provide for Year 2006 depreciation and amortization on
differences between current fair values and carrying
amounts of Starr’s net assets as follows:

(continued)
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 267

PALM CORPORATION AND SUBSIDIARY

Working Paper Elimination (concluded)
December 31, 2006

Cost
of Goods Operating
Sold Expenses
Inventories sold $25,000
Building depreciation 1,000 $1,000
Machinery depreciation 2,000
Patent amortization 1,000
Totals $29,000 $1,000

(c) Allocate unamortized differences between combination

date current fair values and carrying amounts of
Starr’s net assets to appropriate assets.
(Income tax effects are disregarded.)

Comments on components of the foregoing working paper elimination, numbered to

correspond with the four categories on page 266, follow:
(1) As indicated in Chapter 6 (page 214), the three components of the subsidiary’s stock-
holder’s equity are reciprocal to the parent company’s Investment ledger account. How-
ever, because a consolidated statement of retained earnings is prepared for each year
following a business combination, the subsidiary’s beginning-of-year retained earn-
ings amount is eliminated, together with the subsidiary’s dividends, which are an off-
set to the subsidiary’s retained earnings. (As illustrated in the analysis on page 265, 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 on page 269
identical to the end-of-previous-year consolidated retained earnings (see page 218 in
Chapter 6).
(2) As illustrated in the analysis on page 265, the amount of the parent company’s inter-
company investment income is an element of the balance of the parent’s Investment
ledger account. In effect, the elimination of the intercompany investment income, cou-
pled with items described in (4) below, comprises a reclassification of the intercom-
pany investment income to the adjusted components of the subsidiary’s net income in
the consolidated income statement.
(3) The debits to the subsidiary’s plant assets, patent, and goodwill bring into the consoli-
dated balance sheet the unamortized differences between current fair values and car-
rying amounts of the subsidiary’s assets on the date of the business combination (see
the analysis on page 266).
(4) The increases in the subsidiary’s cost of goods sold and operating expenses, totaling
$30,000 ($29,000 $10,000 $30,000), in effect reclassify the comparable decrease
in the parent company’s Investment ledger account under the equity method of ac-
counting (see the analysis on page 265) to the appropriate categories for the consoli-
dated income statement.
268 Part Two Business Combinations and Consolidated Financial Statements

Working Paper for Consolidated Financial Statements

The working paper for consolidated financial statements for Palm Corporation and sub-
sidiary for the year ended December 31, 2006, is on page 269. The intercompany receivable
and payable is the $24,000 dividend payable by Starr to Palm on December 31, 2006. (The
advances by Palm to Starr that were outstanding on December 31, 2005, were repaid by
Starr January 2, 2006.)
The following aspects of the working paper for consolidated financial statements of
Palm Corporation and subsidiary should be emphasized:
1. The intercompany receivable and payable, placed in adjacent columns on the same line,
are offset without a formal elimination.
2. The elimination cancels all intercompany transactions and balances not dealt with by the
offset described in 1 above.
3. The elimination cancels the subsidiary’s retained earnings balance at the beginning of
the year (the date of the business combination), so that each of the three basic financial
statements may be consolidated in turn. (All financial statements of a parent company
and a subsidiary are consolidated for accounting periods subsequent to the business
combination.)
4. The first-in, first-out method is used by Starr Company to account for inventories; thus,
the $25,000 difference attributable to Starr’s beginning inventories is allocated to cost of
goods sold for the year ended December 31, 2006.
5. Income tax effects of the elimination’s increase in Starr Company’s expenses are not in-
cluded in the elimination. Accounting for income tax effects in consolidated financial
statements is considered in Chapter 9.
6. 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, excepting land
and goodwill, on the business combination date. The effect of the reduction is as
follows:

Total difference on date of business combination (Dec. 31, 2005) $110,000

Less: Reduction in elimination (a) ($29,000 $1,000) 30,000
Unamortized difference, Dec. 31, 2006 ($61,000 $4,000 $15,000) $ 80,000

The joint effect of Palm Corporation’s use of the equity method of accounting and the
annual elimination will be to extinguish $50,000 of the $80,000 difference above
through Palm’s Investment in Starr Company Common Stock ledger account. The
$15,000 balance applicable to Starr’s land will not be extinguished; the $15,000
balance applicable to Starr’s goodwill will be reduced only if the goodwill in sub-
sequently impaired.
7. 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
The equalities exist when the equity method of accounting is used if there are no
intercompany profits accounted for in the determination of consolidated net assets. In-
tercompany profits (gains) are discussed in Chapter 8.
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 269

Equity Method: Wholly Owned Subsidiary Subsequent to Date of Business Combination

PALM CORPORATION AND SUBSIDIARY

Working Paper for Consolidated Financial Statements
For Year Ended December 31, 2006

Elimination
Palm Starr Increase
Corporation Company (Decrease) Consolidated
Income Statement
Revenue:
Net sales 1,100,000 680,000 1,780,000
Intercompany investment income 30,000 (a) (30,000)
Total revenue 1,130,000 680,000 (30,000) 1,780,000
Costs and expenses:
Cost of goods sold 700,000 450,000 (a) 29,000 1,179,000
Operating expenses 217,667 130,000 (a) 1,000 348,667
Interest expense 49,000 49,000
Income taxes expense 53,333 40,000 93,333
Total costs and expenses 1,020,000 620,000 30,000* 1,670,000
Net income 110,000 60,000 (60,000) 110,000

Statement of Retained Earnings

Retained earnings, beginning of year 134,000 132,000 (a) (132,000) 134,000
Net income 110,000 60,000 (60,000) 110,000
Subtotal 244,000 192,000 (192,000) 244,000
Dividends declared 30,000 24,000 (a) (24,000)† 30,000
Retained earnings, end of year 214,000 168,000 (168,000) 214,000

Balance Sheet
Assets
Cash 15,900 72,100 88,000
Intercompany receivable (payable) 24,000 (24,000)
Inventories 136,000 115,000 251,000
Other current assets 88,000 131,000 219,000
Investment in Starr Company common stock 506,000 (a) (506,000)
Plant assets (net) 440,000 340,000 (a) 61,000 841,000
Patent (net) 16,000 (a) 4,000 20,000
Goodwill (a) 15,000 15,000
Total assets 1,209,900 650,100 (426,000) 1,434,000

Liabilities and Stockholders’ Equity

Income taxes payable 40,000 20,000 60,000
Other liabilities 190,900 204,100 395,000
Common stock, $10 par 400,000 400,000
Common stock, $5 par 200,000 (a) (200,000)
Additional paid-in capital 365,000 58,000 (a) (58,000) 365,000
Retained earnings 214,000 168,000 (168,000) 214,000
Total liabilities and stockholders’ equity 1,209,900 650,100 (426,000) 1,434,000

*An increase in total costs and expenses and a decrease in net income.
†
A decrease in dividends and an increase in retained earnings.
270 Part Two Business Combinations and Consolidated Financial Statements

8. Despite the equalities indicated above, consolidated financial statements are supe-
rior to parent company financial statements for the presentation of financial position
and operating results of parent and subsidiary companies. The effect of the consoli-
dation process for Palm Corporation and subsidiary is to reclassify Palm’s $30,000
share of its subsidiary’s adjusted net income to the revenue and expense compo-
nents of that net income. Similarly, Palm’s $506,000 investment in the subsidiary is
replaced by the assets and liabilities comprising the subsidiary’s net assets.
9. Purchase accounting theory requires the exclusion from consolidated retained earn-
ings of a subsidiary’s retained earnings on the date of a business combination. Palm
Corporation’s use of the equity method of accounting meets this requirement. Palm’s
ending retained earnings amount in the working paper, which is equal to consolidated
retained earnings, includes only Palm’s $30,000 share of the subsidiary’s adjusted net
income for the year ended December 31, 2006, the first year of the parent-subsidiary
relationship.

Consolidated Financial Statements

The consolidated income statement, statement of retained earnings, and balance sheet of
Palm Corporation and subsidiary for the year ended December 31, 2006, are as follows.
The amounts in the consolidated financial statements are taken from the Consolidated col-
umn in the working paper on page 269.

PALM CORPORATION AND SUBSIDIARY

Consolidated Income Statement
For Year Ended December 31, 2006

Net sales $1,780,000

Costs and expenses:
Cost of goods sold $1,179,000
Operating expenses 348,667
Interest expense 49,000
Income taxes expense 93,333
Total costs and expenses 1,670,000
Net income $ 110,000
Basic earnings per share of common stock
(40,000 shares outstanding) $2.75

PALM CORPORATION AND SUBSIDIARY

Consolidated Statement of Retained Earnings
For Year Ended December 31, 2006

Retained earnings, beginning of year $134,000

Add: Net income 110,000
Subtotal $244,000
Less: Dividends ($0.75 a share) 30,000
Retained earnings, end of year $214,000
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 271

PALM CORPORATION AND SUBSIDIARY

Consolidated Balance Sheet
December 31, 2006

Assets
Current assets:
Cash $ 88,000
Inventories 251,000
Other 219,000
Total current assets $ 558,000
Plant assets (net) 841,000
Intangible assets:
Patent (net) $ 20,000
Goodwill 15,000 35,000
Total assets $1,434,000

Liabilities and Stockholders’ Equity

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

Closing Entries
After consolidated financial statements have been completed, both the parent company and
its subsidiaries prepare and post closing entries, 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 the equity method of accounting necessitates specialized closing entries.
The equity method of accounting disregards legal form in favor of the economic sub-
stance of the relationship between a parent company and its subsidiaries. However, state
corporation laws generally require separate accounting for retained earnings available for
dividends to stockholders. Accordingly, Palm Corporation prepares the closing entries il-
lustrated below and on page 272 on December 31, 2006, after the consolidated financial
statements have been completed:

Parent Company’s Net Sales 1,100,000

Dec. 31, 2006, Closing Intercompany Investment Income 30,000
Entries under the Income Summary 1,130,000
Equity Method of To close revenue accounts.
Accounting for
Subsidiary Income Summary 1,020,000
Cost of Goods Sold 700,000
Operating Expenses 217,667
Interest Expense 49,000
Income Taxes Expense 53,333
To close expense accounts.
272 Part Two Business Combinations and Consolidated Financial Statements

Income Summary 110,000

Retained Earnings of Subsidiary ($30,000 $24,000) 6,000
Retained Earnings ($110,000 $6,000) 104,000
To close Income Summary account; 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.

Retained Earnings 30,000

Dividends Declared 30,000
To close Dividends Declared account.

After the foregoing closing entries have been posted, Palm Corporation’s Retained Earn-
ings and Retained Earnings of Subsidiary ledger accounts are as shown below:

Parent Company’s Retained Earnings

Ledger Accounts for
Date Explanation Debit Credit Balance
Retained Earnings
2005
Dec. 31 Balance 134,000 cr
2006
Dec. 31 Close net income available for
dividends 104,000 238,000 cr
31 Close Dividends Declared account 30,000 208,000 cr

Retained Earnings of Subsidiary

Date Explanation Debit Credit Balance
2006
Dec. 31 Close net income not available
for dividends 6,000 6,000 cr

The third closing entry excludes from Palm Corporation’s retained earnings the amount
of Palm’s net income not available for dividends to Palm’s stockholders—$6,000. This
amount is computed as follows:

Adjusted net income of Starr Company recorded by Palm Corporation in

Intercompany Investment Income ledger account $30,000
Less: Dividends declared by Starr to Palm 24,000
Amount of Starr’s adjusted net income not distributed as a dividend to Palm $ 6,000

Palm’s Retained Earnings of Subsidiary ledger account thus contains the amount of Starr’s ad-
justed net income (less net losses) since the date of the business combination that has not
been distributed by Starr to Palm as dividends. This amount is termed the undistributed earn-
ings of the subsidiary and is equal to the net increase in the balance of Palm’s Investment in
Starr Company Common Stock ledger account (page 264) since December 31, 2005, the date
of the business combination ($506,000 $500,000 $6,000). In addition, the total of the
ending balances of Palm’s Retained Earnings and Retained Earnings of Subsidiary ledger ac-
counts is equal to consolidated retained earnings, as shown on page 273:
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 273

Total of Parent Balances, Dec. 31, 2006:

Company’s Two Retained earnings $208,000
Retained Earnings Retained earnings of subsidiary 6,000
Account Balances Total (equal to consolidated retained earnings, Dec. 31, 2006—see
Equals Consolidated page 271) $214,000
Retained Earnings

Illustration of Equity Method for Wholly Owned Subsidiary

for Second Year after Business Combination
In this section, the Palm Corporation–Starr Company example is continued to illustrate ap-
plication of the equity method of accounting for a wholly owned subsidiary for the second
year following a business combination. On December 17, 2007, Starr Company declared a
dividend of $40,000, payable January 6, 2008, to Palm Corporation, the stockholder of
record December 28, 2007. For the year ended December 31, 2007, Starr had a net income
of $90,000, and its goodwill was not impaired.
After the posting of appropriate journal entries for 2007 under the equity method of
accounting, selected ledger accounts for Palm Corporation are as follows:

Ledger Accounts of Investment in Starr Company Common Stock

Parent Company under
Date Explanation Debit Credit Balance
the Equity Method of
Accounting for Wholly 2005
Owned Subsidiary Dec. 31 Issuance of common stock in
business combination 450,000 450,000 dr
31 Direct out-of-pocket costs of
business combination 50,000 500,000 dr
2006
Dec. 20 Dividend declared by Starr 24,000 476,000 dr
31 Net income of Starr 60,000 536,000 dr
31 Amortization of differences
between current fair values
and carrying amounts of
Starr’s net assets 30,000 506,000 dr
2007
Dec. 17 Dividend declared by Starr 40,000 466,000 dr
31 Net income of Starr 90,000 556,000 dr
31 Amortization of differences
between current fair values
and carrying amounts of
Starr’s net assets (see page 274) 5,000* 551,000 dr

Intercompany Investment Income

Date Explanation Debit Credit Balance
2006
Dec. 31 Net income of Starr 60,000 60,000 cr
31 Amortization of differences between
current fair values and carrying
amounts of Starr’s net assets 30,000 30,000 cr
31 Closing entry 30,000 -0-

(continued)
274 Part Two Business Combinations and Consolidated Financial Statements

Intercompany Investment Income (concluded)

Date Explanation Debit Credit Balance
2007
Dec. 31 Net income of Starr 90,000 90,000 cr
31 Amortization of differences between
current fair values and carrying
amounts of Starr’s net assets 5,000* 85,000 cr

*Building depreciation ($30,000 15) $2,000

Machinery depreciation ($20,000 10) 2,000
Patent amortization ($5,000 5) 1,000
Total amortization applicable to 2004 $5,000

Developing the Elimination

The working paper elimination for December 31, 2007, is developed in much the same way
as the elimination for December 31, 2006, as illustrated below (in journal entry format):

Working Paper PALM CORPORATION AND SUBSIDIARY

Elimination for Wholly Working Paper Elimination
Owned Subsidiary for December 31, 2007
Second Year
Subsequent to Date of (a) Common Stock—Starr 200,000
Business Combination Additional Paid-in Capital—Starr 58,000
Retained Earnings—Starr ($168,000 $6,000) 162,000
Retained Earnings of Subsidiary—Palm 6,000
Intercompany Investment Income—Palm 85,000
Plant Assets (net)—Starr ($61,000 $4,000) 57,000
Patent (net)—Starr ($4,000 $1,000) 3,000
Goodwill—Starr 15,000
Cost of Goods Sold—Starr 4,000
Operating Expenses—Starr 1,000
Investment in Starr Company Common Stock—Palm 551,000
Dividends Declared—Starr 40,000
To carry out the following:
(a) Eliminate intercompany investment and equity accounts of
subsidiary at beginning of year, and subsidiary dividend.
(b) Provide for Year 2007 depreciation and amortization on
differences between current fair values and carrying amounts
of Starr’s net assets as follows:

Cost
of Goods Operating
Sold Expenses
Building depreciation $1,000 $1,000
Machinery depreciation 2,000
Patent amortization 1,000
Totals $4,000 $1,000

(c) Allocate unamortized differences between combination date

current fair values and carrying amounts of Starr’s net assets
to appropriate assets.
(Income tax effects are disregarded.)
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 275

The principal new feature of the foregoing elimination is the treatment of the beginning-
of-year Retained Earnings ledger account balance of the subsidiary, Starr Company. Because
consolidated retained earnings of Palm Corporation and subsidiary on December 31, 2006,
included the amount of $6,000, representing the undistributed earnings of the subsidiary for
the year ended December 31, 2006, only $162,000 ($168,000 $6,000 $162,000) is
eliminated from the subsidiary’s retained earnings balance on January 1, 2007. In addition,
the $6,000 balance (before the closing entry for 2007) of the parent company’s Retained
Earnings of Subsidiary ledger account is eliminated, to avoid “double counting” of the
undistributed earnings of the subsidiary as of January 1, 2007, in the consolidated financial
statements of Palm Corporation and subsidiary for the year ended December 31, 2007.

Working Paper for Consolidated Financial Statements

The features of the December 31, 2007, elimination for Palm Corporation and subsidiary
described in the foregoing section are illustrated in the following partial working paper for
consolidated financial statements. The net income and dividends for Palm Corporation are
assumed for illustrative purposes.

Equity Method: Wholly Owned Subsidiary Subsequent to Date of Business Combination

PALM CORPORATION AND SUBSIDIARY

Partial Working Paper for Consolidated Financial Statements
For Year Ended December 31, 2007

Eliminations
Palm Starr Increase
Corporation Company (Decrease) Consolidated
Statement of Retained Earnings
Retained earnings, beginning of year 208,000 168,000 (a) (162,000) 214,000
Net income 245,000 90,000 (90,000)* 245,000
Subtotal 453,000 258,000 (252,000) 459,000
Dividends declared 60,000 40,000 (a) (40,000)† 60,000
Retained earnings, end of year 393,000 218,000 (212,000) 399,000

Balance Sheet
Common stock, $10 par 400,000 400,000
Common stock, $5 par 200,000 (a) (200,000)
Additional paid-in capital 365,000 58,000 (a) (58,000) 365,000
Retained earnings 393,000 218,000 (212,000) 399,000
Retained earnings of subsidiary 6,000 (a) (6,000)
Total stockholders’ equity 1,164,000 476,000 (476,000) 1,164,000
Total liabilities and stockholders’ equity x,xxx,xxx xxx,xxx (476,000) x,xxx,xxx

*Decrease in intercompany investment income ($85,000), plus total increase in costs and expenses ($4,000 $1,000), equals $90,000.
†
A decrease in dividends and an increase in retained earnings.

The elimination of only $162,000 of the balance of the subsidiary’s beginning-of-year

retained earnings results in consolidated retained earnings of $214,000 at the beginning of
the year (January 1, 2007). This amount is equal to consolidated retained earnings on
December 31, 2006 (see page 270). In addition, the total of the parent company’s two
retained earnings amounts in the working paper for consolidated financial statements
($393,000 $6,000 $399,000) is identical to the amount of consolidated retained earn-
ings on December 31, 2007.
276 Part Two Business Combinations and Consolidated Financial Statements

Closing Entries
The amount of the undistributed earnings of Starr Company for 2007 is $45,000, computed
as follows:

Adjusted net income of Starr Company recorded by Palm Corporation in

Intercompany Investment Income ledger account (page 274) $85,000
Less: Dividends declared by Starr to Palm 40,000
Amount of Starr’s adjusted net income not distributed as a dividend to Palm $45,000

In the December 31, 2007, closing entries for Palm Corporation, $45,000 of Palm’s
$245,000 net income for 2007 is closed to the Retained Earnings of Subsidiary ledger
account. The remaining $200,000 ($245,000 $45,000 $200,000) is closed to the
Retained Earnings account, because it is available for dividends to the stockholders of
Palm. Following the posting of the closing entries, the two ledger accounts are as follows:

Parent Company’s Retained Earnings

Ledger Accounts for
Date Explanation Debit Credit Balance
Retained Earnings
2005
Dec. 31 Balance 134,000 cr
2006
Dec. 31 Close net income available for
dividends 104,000 238,000 cr
31 Close Dividends Declared account 30,000 208,000 cr
2007
Dec. 31 Close net income available for
dividends 200,000 408,000 cr
31 Close Dividends Declared account 60,000 348,000 cr

Retained Earnings of Subsidiary

Date Explanation Debit Credit Balance
2006
Dec. 31 Close net income not available for
dividends 6,000 6,000 cr
2007
Dec. 31 Close net income not available for
dividends 45,000 51,000 cr

Again, the balance of Palm’s Retained Earnings of Subsidiary ledger account,

$51,000, is equal to the net increase in the balance of Palm’s Investment in Starr Com-
pany Common Stock account (page 273) since the date of the business combination
($551,000 $500,000 $51,000). Further, the total of the ending balances of the fore-
going retained earnings accounts, $399,000 ($348,000 + $51,000 $399,000) is equal
to consolidated retained earnings of $399,000 on December 31, 2007 (see page 275).

ACCOUNTING FOR OPERATING RESULTS OF

PARTIALLY OWNED SUBSIDIARIES
Accounting for the operating results of a partially owned subsidiary requires the computa-
tion of the minority interest in net income or net losses of the subsidiary. Thus, under the
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 277

economic unit concept of consolidated financial statements, the consolidated income

statement of a parent company and its partially owned subsidiary includes an allocation of
total consolidated income (loss) to the parent company and the minority interest. In the
consolidated balance sheet, the minority interest in net assets of subsidiary is displayed in
stockholders’ equity.

Illustration of Equity Method for Partially Owned Subsidiary

for First Year after Business Combination
The Post Corporation–Sage Company consolidated entity described in Chapter 6 (pages
220–221) is used in this section to illustrate the equity method of accounting for the
operating results of a partially owned subsidiary. Post owns 95% of the outstanding com-
mon stock of Sage, and minority stockholders own the remaining 5%.
Assume that Sage Company on November 24, 2006, declared a $1 a share dividend,
payable December 16, 2006, to stockholders of record December 1, 2006, and that Sage
had a net income of $90,000 for the year ended December 31, 2006. Sage prepares the
following journal entries for the declaration and payment of the dividend:

Partially Owned 2006

Subsidiary’s Journal Nov. 24 Dividends Declared (40,000 $1) 40,000
Entries for Declaration Dividends Payable ($40,000 0.05) 2,000
and Payment of Intercompany Dividends Payable ($40,000 0.95) 38,000
Dividend To record declaration of dividend payable Dec. 16, 2006, to
stockholders of record Dec. 1, 2006.

Dec. 16 Dividends Payable 2,000

Intercompany Dividends Payable 38,000
Cash 40,000
To record payment of dividend declared Nov. 24, 2006,
to stockholders of record Dec. 1, 2006.

Post’s journal entries for 2006, under the equity method of accounting, include the
following:

Parent Company’s 2006

Equity-Method Journal Nov. 24 Intercompany Dividends Receivable 38,000
Entries to Record Investment in Sage Company Common Stock 38,000
Operating Results To record dividend declared by Sage Company, payable
of Partially Owned Dec. 16, 2006, to stockholders of record Dec. 1, 2006.
Subsidiary
Dec. 16 Cash 38,000
Intercompany Dividends Receivable 38,000
To record receipt of dividend from Sage Company.

31 Investment in Sage Company Common Stock ($90,000 0.95) 85,500

Intercompany Investment Income 85,500
To record 95% of net income of Sage Company for the year
ended Dec. 31, 2006. (Income tax effects are disregarded.)
278 Part Two Business Combinations and Consolidated Financial Statements

As pointed out on page 224, a business combination involves a restatement of net asset
values of the subsidiary. Sage Company’s net income of $90,000 does not reflect cost expi-
rations attributable to Sage’s restated net asset values, because the restatements were not
entered in Sage’s accounting records. Consequently, the depreciation and amortization of
the $246,000 difference between the current fair values of Sage’s identifiable net assets on
December 31, 2005, the date of the business combination, and the carrying amounts of
those net assets must be accounted for by Post Corporation. Assume, as in Chapter 6
(page 224), that the difference was allocable to Sage’s identifiable assets as follows:

Differences between Inventories (first-in, first-out cost) $ 26,000

Current Fair Values Plant assets (net):
and Carrying Amounts Land $60,000
of Partially Owned Building (economic life 20 years) 80,000
Subsidiary’s Machinery (economic life 5 years) 50,000 190,000
Identifiable Net Assets Leasehold (economic life 6 years) 30,000
on Date of Business Total $246,000
Combination

In addition, Post had acquired in the business combination goodwill attributable to Sage
in the amount of $38,000, computed as follows:

Computation of
Cost of Post Corporation’s 95% interest in Sage Company $1,192,250
Goodwill Acquired by
Less: 95% of $1,215,000 aggregate current fair values of Sage’s
Combinor
identifiable net assets 1,154,250
Goodwill acquired by Post $ 38,000

Post Corporation prepares the following journal entry on December 31, 2006, under the
equity method of accounting to reflect the effects of the differences between current fair
values and carrying amounts of the partially owned subsidiary’s identifiable net assets:

Parent Company’s Intercompany Investment Income 42,750

Equity-Method Journal Investment in Sage Company Common Stock 42,750
Entry to Record To amortize differences between current fair values and carrying amounts
Amortization of of Sage Company’s identifiable net assets on December 31, 2006,
Partially Owned as follows:
Subsidiary’s Identifiable Inventories—to cost of goods sold $26,000
Net Assets Building—depreciation ($80,000 20) 4,000
Machinery—depreciation ($50,000 5) 10,000
Leasehold—amortization ($30,000 6) 5,000
Total difference applicable to 2006 $45,000
Amortization for 2006 ($45,000 0.95) $42,750
(Income tax effects are disregarded.)

Assuming the goodwill acquired by Post in the business combination was not impaired
as of December 31, 2006, Post prepares no journal entry to reduce the carrying amount of
the goodwill.
After the foregoing journal entry is posted, Post Corporation’s Investment in Sage Com-
pany Common Stock and Intercompany Investment Income ledger accounts are as follows:
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 279

Ledger Accounts of Investment in Sage Company Common Stock

Parent Company under
Date Explanation Debit Credit Balance
Equity Method of
Accounting for 2005
Dec. 31 Issuance of common stock in
business combination 1,140,000 1,140,000 dr
31 Direct out-of-pocket costs of
business combination 52,250 1,192,250 dr
2006
Nov. 24 Dividend declared by Sage 38,000 1,154,250 dr
Dec. 31 Net income of Sage 85,500 1,239,750 dr
31 Amortization of differences
between current fair values
and carrying amounts of
Sage’s identifiable net assets 42,750 1,197,000 dr

Intercompany Investment Income

Date Explanation Debit Credit Balance
2006
Dec. 31 Net income of Sage 85,500 85,500 cr
31 Amortization of differences
between current fair values
and carrying amounts of
Sage’s identifiable net assets 42,750 42,750 cr

The $42,750 balance of Post Corporation’s Intercompany Investment Income account

represents 95% of the $45,000 adjusted net income ($90,000 $45,000 $45,000) of
Sage Company for the year ended December 31, 2006.
Developing the Elimination
Post Corporation’s use of the equity method of accounting for its investment in Sage
Company results in a balance in the Investment ledger account that is a mixture of three
components: (1) the carrying amount of Sage’s identifiable net assets; (2) the “current fair

POST CORPORATION
Analysis of Investment in Sage Company Common Stock Ledger Account
For Year Ended December 31, 2006

Carrying Current Fair

Amount Value Excess Goodwill Total
Beginning balances $920,550 $233,700 $38,000 $1,192,250
Net income of Sage
($90,000 0.95) 85,500 85,500
Amortization of differences Intercompany
between current fair values investment
and carrying amounts of v
income,
Sage’s identifiable net assets $42,750
($45,000 0.95) (42,750) (42,750)
Dividend declared by Sage
($40,000 0.95) (38,000) (38,000)
Ending balances $968,050 $190,950 $38,000 $1,197,000
280 Part Two Business Combinations and Consolidated Financial Statements

value excess,” which is attributable to Sage’s identifiable net assets; and (3) the goodwill
acquired by Post in the business combination with Sage. These components are analyzed
on page 279.
The minority interest in Sage’s net assets (which is not recorded in a ledger account) may
be analyzed similarly, except that there is no goodwill attributable to the minority interest:

POST CORPORATION
Analysis of Minority Interest in Net Assets of Sage Company
For Year Ended December 31, 2006

Carrying Current Fair

Amount Value Excess Total
Beginning balances $48,450 $12,300 $60,750
Net income of Sage ($90,000 0.05) 4,500 4,500
Minority interest
Amortization of differences between
in net income
current fair values and carrying u
of subsidiary,
amounts of Sage’s identifiable net
$2,250
assets ($45,000 0.05) (2,250) (2,250)
Dividend declared by Sage
($40,000 0.05) (2,000) (2,000)
Ending balances $50,950 $10,050 $61,000

The $1,019,000 ($968,050 $50,950 $1,019,000) total of the ending balances of the
Carrying Amount columns of the two foregoing analyses agrees with the total stockhold-
ers’ equity of Sage Company on December 31, 2006 (see balance sheet section of working
paper for consolidated financial statements on page 283), as follows:

Partially Owned Common stock, $10 par $ 400,000

Subsidiary’s Additional paid-in capital 235,000
Stockholders’ Equity, Retained earnings 384,000
Dec. 31, 2006 Total stockholders’ equity $1,019,000

The $201,000 ($190,950 $10,050 $201,000) total of the ending balances of the
Current Fair Value Excess columns of the two analyses agrees with the December 31, 2006,
total of the unamortized balances for each of the respective identifiable assets of Sage Com-
pany, as follows:

Unamortized Balances, Amortization

Differences between Dec. 31, 2005 for Year 2006 Balances,
Current Fair Values and (p. 278) (p. 278) Dec. 31, 2006
Carrying Amounts of
Inventories $ 26,000 $(26,000)
Partially Owned
Plant assets (net):
Subsidiary’s Identifiable
Land $ 60,000 $ 60,000
Assets One Year
Building 80,000 $ (4,000) 76,000
Subsequent to Business
Machinery 50,000 (10,000) 40,000
Combination
Total plant assets $190,000 $(14,000) $176,000
Leasehold $ 30,000 $ (5,000) $ 25,000
Totals $246,000 $(45,000) $201,000
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 281

Assuming that Sage Company allocates machinery depreciation and leasehold amor-
tization entirely to cost of goods sold, and building depreciation 50% each to cost of
goods sold and operating expenses, the working paper eliminations (in journal entry for-
mat) for Post Corporation and subsidiary on December 31, 2006, are as shown below and
on page 282. The reference numbers in parentheses relate to the discussion in the fol-
lowing paragraph.
Comments on components of the first working paper elimination follow:
1. As indicated in Chapter 6 (page 214), the three components of the subsidiary’s stock-
holders’ equity are reciprocal to the parent company’s Investment account. However,
because a consolidated statement of retained earnings is to be prepared for the first
year following the business combination, the subsidiary’s beginning-of-year re-
tained earnings amount is eliminated, together with the subsidiary’s dividends,
which are an offset to the subsidiary’s retained earnings. Further, the beginning-of-
year minority interest, $60,750 (see page 224 of Chapter 6), is reduced by the minor-
ity interest’s share of the subsidiary’s dividends, $2,000, as a counterpart of the
parent company’s reduction of its Investment account balance by $38,000, its share
of the subsidiary’s dividends (see the analysis of the Investment account on page 279).
2. As illustrated in the analysis on page 279, the amount of the parent company’s inter-
company investment income is an element of the balance of the parent’s Investment
ledger account. In effect, the elimination of the intercompany investment income, cou-
pled with items described in (4) on page 282, comprises a reclassification of the inter-
company investment income to the adjusted components of the subsidiary’s net income
in the consolidated income statement.
3. The debits to the subsidiary’s plant assets and leasehold bring into the consolidated bal-
ance sheet the unamortized differences between current fair values and carrying
amounts of the subsidiary’s identifiable assets on the date of the business combination
(see the analysis on page 280). Further, the debit to the parent company’s goodwill
brings the amount of that asset into the consolidated balance sheet.

Working Paper POST CORPORATION AND SUBSIDIARY

Eliminations for Working Paper Eliminations
Partially Owned December 31, 2006
Subsidiary for First
Year Subsequent to (a) Common Stock—Sage 400,000 (1)
Date of Business Additional Paid-in Capital—Sage 235,000 (1)
Combination Retained Earnings—Sage 334,000 (1)
Intercompany Investment Income—Post 42,750 (2)
Plant Assets (net)—Sage ($190,000 $14,000) 176,000 (3)
Leasehold (net)—Sage ($30,000 $5,000) 25,000 (3)
Goodwill—Post 38,000 (3)
Cost of Goods Sold—Sage 43,000 (4)
Operating Expenses—Sage 2,000 (4)
Investment in Sage Company Common Stock—Post 1,197,000 (1)
Dividends Declared—Sage 40,000 (1)
Minority Interest in Net Assets of Subsidiary
($60,750 $2,000) [See (d).] 58,750 (1)

(continued)
282 Part Two Business Combinations and Consolidated Financial Statements

POST CORPORATION AND SUBSIDIARY

Working Paper Eliminations (concluded)
December 31, 2006

To carry out the following:

(a) Eliminate intercompany investment and equity
accounts of subsidiary at beginning of year, and
subsidiary dividends.
(b) Provide for Year 2006 depreciation and amortization on
differences between current fair values and carrying
amounts of Sage’s identifiable net assets as follows:

Cost
of Goods Operating
Sold Expenses
Inventories sold $26,000
Building depreciation 2,000 $2,000
Machinery depreciation 10,000
Leasehold amortization 5,000
Totals $43,000 $2,000

(c) Allocate unamortized differences between combination

date current fair values and carrying amounts to
appropriate assets.
(d) Establish minority interest in net assets of subsidiary
at beginning of year ($60,750), less minority interest
share of dividends declared by subsidiary during year
($40,000 0.05 $2,000).
(Income tax effects are disregarded.)

(b) Minority Interest in Net Income of Subsidiary 2,250

Minority Interest in Net Assets of Subsidiary 2,250
To establish minority interest in subsidiary’s adjusted
net income for Year 2006 as follows:
Net income of subsidiary $90,000
Net reduction of elimination (a)
($43,000 $2,000) (45,000)
Adjusted net income of subsidiary $45,000
Minority interest share ($45,000 0.05) $ 2,250

4. The increases in the subsidiary’s cost of goods sold and operating expenses, totaling
$45,000 ($43,000 $2,000 $45,000), in effect reclassify the comparable decreases
totaling $45,000 ($42,750 $2,250 $45,000) in the parent company’s Investment ac-
count and the minority interest in net assets of the subsidiary, respectively (see the analy-
ses on pages 279 and 280) to the appropriate categories for the consolidated income
statement.

Working Paper for Consolidated Financial Statements

The working paper for consolidated financial statements for Post Corporation and sub-
sidiary for the year ended December 31, 2006, is shown on page 283.
The following aspects of the working paper for consolidated financial statements of Post
Corporation and subsidiary should be emphasized:
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 283

Equity Method: Partially Owned Subsidiary Subsequent to Date of Business Combination

POST CORPORATION AND SUBSIDIARY

Working Paper for Consolidated Financial Statements
For Year Ended December 31, 2006

Eliminations
Post Sage Increase
Corporation Company (Decrease) Consolidated
Income Statement
Revenue:
Net sales 5,611,000 1,089,000 6,700,000
Intercompany investment income 42,750 (a) (42,750)
Total revenue 5,653,750 1,089,000 (42,750) 6,700,000
Costs and expenses:
Costs of goods sold 3,925,000 700,000 (a) 43,000 4,668,000
Operating expenses 556,000 129,000 (a) 2,000 687,000
Interest and income taxes expense 710,000 170,000 880,000
Minority interest in net income
of subsidiary (b) 2,250 2,250
Total costs and expenses and
minority interest 5,191,000 999,000 47,250† 6,237,250
Net income 462,750 90,000 (90,000) 462,750

Statement of Retained Earnings

Retained earnings, beginning of year 1,050,000 334,000 (a) (334,000) 1,050,000
Net income 462,750 90,000 (90,000) 462,750
Subtotal 1,512,750 424,000 (424,000) 1,512,750
Dividends 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 common
stock 1,197,000 (a) (1,197,000)
Plant assets (net) 3,600,000 1,150,000 (a) 176,000 4,926,000
Leasehold (net) (a) 25,000 25,000
Goodwill 95,000 (a) 38,000 133,000
Total assets 6,392,000 1,960,000 (958,000) 7,394,000

Liabilities and Stockholders’ Equity

Liabilities 2,420,550 941,000 3,361,550
Common stock, $1 par 1,057,000 1,057,000
Common stock, $10 par 400,000 (a) (400,000)
Additional paid-in capital 1,560,250 235,000 (a) (235,000) 1,560,250
Minority interest in net (a) 58,750
r
assets of subsidiary (b) 2,250 61,000
Retained earnings 1,354,200 384,000 (384,000) 1,354,200
Total liabilities and stockholders’
equity 6,392,000 1,960,000 (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.
284 Part Two Business Combinations and Consolidated Financial Statements

1. Income tax effects of the increase in Sage Company’s costs and expenses are not in-
cluded in elimination (a). Income tax effects in consolidated financial statements are
considered in Chapter 9.
2. Elimination (a) cancels Sage’s retained earnings balance at the beginning of the year.
This step is essential for the preparation of all three basic consolidating financial
statements.
3. The parent company’s use of the equity method of accounting results in the following
equalities:
Parent company net income consolidated net income
Parent company retained earnings consolidated retained earnings
These equalities exist in the equity method of accounting if there are no intercompany
profits (gains) or losses eliminated for the determination of consolidated net assets.
Intercompany profits are discussed in Chapter 8.
4. One of the effects of elimination (a) is to reduce the differences between the current
fair values of the subsidiary’s identifiable net assets on the business combination
date and their carrying amounts on that date. The effect of the reduction is as
follows:

Aggregate difference on date of business combination (Dec. 31, 2005) $246,000

Less: Reduction in elimination (a) ($43,000 $2,000) 45,000
Unamortized difference, Dec. 31, 2006 ($176,000 $25,000) $201,000

The joint effect of Post’s use of the equity method of accounting and the annual elim-
inations will be to extinguish $141,000 of the remaining $201,000 difference through
Post’s Investment in Sage Company Common Stock ledger account. The $60,000
applicable to Sage’s land will not be extinguished.
5. The minority interest in net assets of subsidiary on December 31, 2006, may be verified
as follows:

Sage Company’s total stockholders’ equity, Dec. 31, 2006 $1,019,000

Add: Unamortized difference computed in 4, above 201,000
Sage’s adjusted stockholders’ equity, Dec. 31, 2006 $1,220,000
Minority interest in net assets of subsidiary ($1,220,000 0.05) $ 61,000

6. The minority interest in net income of subsidiary is recognized in elimination (b) in the
amount of $2,250 (5% of the adjusted net income of Sage Company) as an increase in
minority interest in net assets of subsidiary and in the minority interest in total consol-
idated income, with the remaining consolidated income being the parent’s share
thereof.

Consolidated Financial Statements

The consolidated income statement, statement of retained earnings, and balance sheet of Post
Corporation and subsidiary for the year ended December 31, 2006, are shown on pages 285
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 285

and 286. The amounts in the consolidated financial statements are taken from the Consoli-
dated column in the working paper on page 283.

POST CORPORATION AND SUBSIDIARY

Consolidated Income Statement
For Year Ended December 31, 2006

Net sales $6,700,000

Costs and expenses:
Cost of goods sold $4,668,000
Operating expenses 687,000
Interest and income taxes expense 880,000
Total costs and expenses 6,235,000
Total consolidated income $ 465,000
Less: Minority interest in net income of subsidiary 2,250
Net income $ 462,750
Basic earnings per share of common stock (1,057,000 shares outstanding) $ 0.44

POST CORPORATION AND SUBSIDIARY

Consolidated Statement of Retained Earnings
For Year Ended December 31, 2006

Retained earnings, beginning of year $1,050,000

Add: Net income 462,750
Subtotal $1,512,750
Less: Dividends ($0.15 a share) 158,550
Retained earnings, end of year $1,354,200

POST CORPORATION AND SUBSIDIARY

Consolidated Balance Sheet
December 31, 2006

Assets
Current assets:
Inventories $1,300,000
Other 1,010,000
Total current assets $2,310,000
Plant assets (net) 4,926,000
Intangible assets:
Leasehold (net) $ 25,000
Goodwill 133,000 158,000
Total assets $7,394,000

(continued)
286 Part Two Business Combinations and Consolidated Financial Statements

POST CORPORATION AND SUBSIDIARY

Consolidated Balance Sheet (concluded)
December 31, 2006

Liabilities and Stockholders’ Equity

Liabilities
Total liabilities $3,361,550
Stockholders’ equity:
Common stock, $1 par $1,057,000
Additional paid-in capital 1,560,250
Minority interest in net assets of subsidiary 61,000
Retained earnings 1,354,200 4,032,450
Total liabilities and stockholders’ equity $7,394,000

Closing Entries
As indicated on page 271, legal considerations necessitate the following closing entries for
Post Corporation on December 31, 2006:

Parent Company’s Net Sales 5,611,000

Dec. 31, 2006, Closing Intercompany Investment Income 42,750
Entries under the Income Summary 5,653,750
Equity Method of To close revenue accounts.
Accounting for
Subsidiary Income Summary 5,191,000
Cost of Goods Sold 3,925,000
Operating Expenses 556,000
Interest and Income Taxes Expense 710,000
To close expense accounts.

Income Summary 462,750

Retained Earnings of Subsidiary ($42,750 $38,000) 4,750
Retained Earnings ($462,750 $4,750) 458,000
To close Income Summary account; 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.

Retained Earnings 158,550

Dividends Declared 158,550
To close Dividends Declared account

After the foregoing closing entries have been posted, Post’s Retained Earnings and
Retained Earnings of Subsidiary ledger accounts are as follows:
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 287

Parent Company’s Retained Earnings

Ledger Accounts for
Date Explanation Debit Credit Balance
Retained Earnings
2005
Dec. 31 Balance 1,050,000 cr
2006
Dec. 31 Close net income available for
dividends 458,000 1,508,000 cr
31 Close Dividends Declared account 158,550 1,349,450 cr

Retained Earnings of Subsidiary

Date Explanation Debit Credit Balance
2006
Dec. 31 Close net income not available
for dividends 4,750 4,750 cr

The $4,750 balance of Post’s Retained Earnings of Subsidiary ledger account represents
Post’s share of the undistributed earnings of Sage Company for the year ended December
31, 2006. The undistributed earnings of the subsidiary may be reconciled to the increase in
Post’s investment ledger account balance (see page 279) as follows:

Balance, Dec. 31, 2006 $1,197,000

Balance, Dec. 31, 2005 1,192,250
Difference—equal to undistributed earnings of subsidiary for 2006 $ 4,750

In addition, the total of the ending balances of Post’s Retained Earnings and Retained
Earnings of Subsidiary ledger accounts is equal to consolidated retained earnings, as
shown below:

Total of Parent Balances, Dec. 31, 2006:

Company’s Two Retained earnings $1,349,450
Retained Earnings Retained earnings of subsidiary 4,750
Account Balances Total (equal to consolidated retained earnings, Dec. 31, 2006—see
Equals Consolidated page 286) $1,354,200
Retained Earnings

Illustration of Equity Method for Partially Owned Subsidiary

for Second Year after Business Combination
In this section, the Post Corporation–Sage Company example is continued to demonstrate
application of the equity method of accounting for a partially owned purchased subsidiary
for the second year following the business combination. On November 22, 2007, Sage
Company declared a dividend of $50,000, payable December 17, 2007, to stockholders of
record December 1, 2007. For the year ended December 31, 2007, Sage had a net income
of $105,000. Post’s share of the dividend was $47,500 ($50,000 0.95 $47,500), and
Post’s share of Sage’s net income was $99,750 ($105,000 0.95 $99,750). The good-
will acquired by Post in the business combination was not impaired.
288 Part Two Business Combinations and Consolidated Financial Statements

After the posting of appropriate journal entries for 2007 under the equity method of ac-
counting, selected ledger accounts for Post Corporation are as follows:

Ledger Accounts of Investment in Sage Company Common Stock

Parent Company under
Date Explanation Debit Credit Balance
Equity Method of
Accounting for 2005
Partially Owned Dec. 31 Issuance of common stock in
Subsidiary business combination 1,140,000 1,140,000 dr
31 Direct out-of-pocket costs of
business combination 52,250 1,192,250 dr
2006
Nov. 24 Dividend declared by Sage 38,000 1,154,250 dr
Dec. 31 Net income of Sage 85,500 1,239,750 dr
31 Amortization of differences
between current fair values
and carrying amounts of
Sage’s identifiable net assets 42,750 1,197,000 dr
2007
Nov. 22 Dividend declared by Sage 47,500 1,149,500 dr
Dec. 31 Net income of Sage 99,750 1,249,250 dr
31 Amortization of differences
between current fair values
and carrying amounts of
Sage’s identifiable net
assets 18,050* 1,231,200 dr

Intercompany Investment Income

Date Explanation Debit Credit Balance
2006
Dec. 31 Net income of Sage 85,500 85,500 cr
31 Amortization of differences
between current fair values
and carrying amounts of
Sage’s identifiable net assets 42,750 42,750 cr
31 Closing entry 42,750 -0-
2007
Dec. 31 Net income of Sage 99,750 99,750 cr
31 Amortization of differences
between current fair values
and carrying amounts of
Sage’s identifiable net assets 18,050* 81,700 cr

*Building depreciation ($80,000 20) $ 4,000

Machinery depreciation ($50,000 5) 10,000
Leasehold amortization ($30,000 6) 5,000
Total amortization applicable to 2007 $19,000
Post Corporation’s share ($19,000 0.95) $18,050

Developing the Eliminations

The working paper eliminations for December 31, 2007, are developed in much the
same way as for the eliminations for December 31, 2006, as illustrated on page 289
(in journal entry format):
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 289

Working Paper POST CORPORATION AND SUBSIDIARY

Eliminations for Working Paper Eliminations
Partially Owned December 31, 2007
Subsidiary for Second
Year Subsequent to (a) Common Stock—Sage 400,000
Date of Business Additional Paid-in Capital—Sage 235,000
Combination Retained Earnings—Sage ($384,000 $4,750) 379,250
Retained Earnings of Subsidiary—Post 4,750
Intercompany Investment Income—Post 81,700
Plant Assets (net)—Sage ($176,000 $14,000) 162,000
Leasehold (net)—Sage ($25,000 $5,000) 20,000
Goodwill—Post 38,000
Cost of Goods Sold—Sage 17,000
Operating Expenses—Sage 2,000
Investment in Sage Company Common Stock—Post 1,231,200
Dividends Declared—Sage 50,000
Minority Interest in Net Assets of Subsidiary
($61,000 $2,500) 58,500
To carry out the following:
(a) Eliminate intercompany investment and equity accounts of
subsidiary at beginning of year, and subsidiary dividend.
(b) Provide for Year 2007 depreciation and amortization on
differences between current fair values and carrying amounts
of Sage’s identifiable net assets as follows:

Cost of
Goods Operating
Sold Expenses
Building depreciation $ 2,000 $2,000
Machinery depreciation 10,000
Leasehold amortization 5,000
Totals $17,000 $2,000

(c) Allocate unamortized differences between combination date

current fair values and carrying amounts to appropriate assets.
(d) Establish minority interest in net assets of subsidiary at beginning
of year ($61,000), less minority interest share of dividends
declared by subsidiary during year ($50,000 0.05 $2,500).
(Income tax effects are disregarded.)

(b) Minority Interest in Net Income of Subsidiary 4,300

Minority Interest in Net Assets of Subsidiary 4,300
To establish minority interest in subsidiary’s adjusted net income for
Year 2007 as follows:
Net income of subsidiary $105,000
Net reduction in elimination (a)
($17,000 $2,000) (19,000)
Adjusted net income of subsidiary $ 86,000
Minority interest share ($86,000 0.05) $ 4,300
290 Part Two Business Combinations and Consolidated Financial Statements

Because consolidated retained earnings of Post Corporation and subsidiary on Decem-

ber 31, 2006, included the amount of $4,750, representing the parent company’s share of
the undistributed earnings of the subsidiary for the year ended December 31, 2006, only
$379,250 ($384,000 $4,750 $379,250) is eliminated from the subsidiary’s retained
earnings on January 1, 2007. In addition, the $4,750 balance (before the closing entry for
2007) of the parent company’s Retained Earnings of Subsidiary ledger account is elimi-
nated, to avoid “double counting” of the undistributed earnings of the subsidiary as of Jan-
uary 1, 2007, in the consolidated financial statements of Post Corporation and subsidiary
for the year ended December 31, 2007.

Working Paper for Consolidated Financial Statements

The aspects of the December 31, 2007, eliminations for Post Corporation and subsidiary
described in the foregoing paragraph are illustrated in the following partial working paper
for consolidated financial statements. The amounts presented for Post Corporation are
assumed.

Equity Method: Partially Owned Subsidiary Subsequent to Date of Business Combination

POST CORPORATION AND SUBSIDIARY

Partial Working Paper for Consolidated Financial Statements
For Year Ended December 31, 2007

Eliminations
Post Sage Increase
Corporation Company (Decrease) Consolidated
Statement of Retained Earnings
Retained earnings, beginning of year 1,349,450 384,000 (a) (379,250) 1,354,200
Net income 353,550 105,000 (105,000)* 353,550
Subtotal 1,703,000 489,000 (484,250) 1,707,750
Dividends declared 158,550 50,000 (a) (50,000)† 158,550
Retained earnings, end of year 1,544,450 439,000 (434,250) 1,549,200

Balance Sheet
Total liabilities x,xxx,xxx xxx,xxx xxx,xxx xxx,xxx
Common stock, $1 par 1,057,000 1,057,000
Common stock, $10 par 400,000 (a) (400,000)
Additional paid-in capital 1,560,250 235,000 (a) (235,000) 1,560,250
Minority interest in net assets of (a) 58,500
b r
subsidiary (b) 4,300 62,800
Retained earnings 1,544,450 439,000 (434,250) 1,549,200
Retained earnings of subsidiary 4,750 (a) (4,750)
Total stockholders’ equity 4,166,450 1,074,000 (1,011,200) 4,229,250
Total liabilities and stockholders’ equity x,xxx,xxx x,xxx,xxx (1,011,200) x,xxx,xxx

*Decrease in intercompany investment income ($81,700), plus total increase in costs and expenses and minority interest ($17,000 $2,000 $4,300), equals $105,000.
†
A decrease in dividends and an increase in retained earnings.

The December 31, 2007, balance of the minority interest in net assets of subsidiary may
be verified as follows:
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 291

Proof of Minority Sage Company’s total stockholders’ equity, Dec. 31, 2007 $1,074,000
Interest in Net Assets Add: Unamortized difference between combination date current fair
of Subsidiary values and carrying amounts of Sage’s identifiable net assets
($162,000 $20,000) 182,000
Sage’s adjusted stockholders’ equity, Dec. 31, 2007 $1,256,000
Minority interest in net assets of subsidiary ($1,256,000 0.05) $ 62,800

Closing Entries
Post Corporation’s share of the undistributed earnings of Sage Company for 2007 is
$34,200, computed as follows:

Parent Company’s Adjusted net income of Sage Company recorded by Post Corporation in
Share of Undistributed Intercompany Investment Income ledger account (page 288) $81,700
Earnings of Subsidiary Less: Post’s share of dividends declared by Sage ($50,000 0.95) 47,500
Post’s share of amount of Sage’s adjusted net income not distributed as
dividends $34,200

In the December 31, 2007, closing entries for Post Corporation, $34,200 of Post’s net in-
come for 2007 is closed to the Retained Earnings of Subsidiary ledger account. The re-
maining $319,350 ($353,550 $34,200 $319,350) is closed to the Retained Earnings
account, because it is available for dividends to the stockholders of Post. Following the
posting of the closing entries, the two ledger accounts are as follows:

Parent Company’s Retained Earnings

Ledger Accounts for
Date Explanation Debit Credit Balance
Retained Earnings
2005
Dec. 31 Balance 1,050,000 cr
2006
Dec. 31 Close net income available for
dividends 458,000 1,508,000 cr
31 Close Dividends Declared
account 158,550 1,349,450 cr
2007
Dec. 31 Close net income available for
dividends 319,350 1,668,800 cr
31 Close Dividends Declared
account 158,550 1,510,250 cr

Retained Earnings of Subsidiary

Date Explanation Debit Credit Balance
2006
Dec. 31 Close net income not
available for dividends 4,750 4,750 cr
2007
Dec. 31 Close net income not
available for dividends 34,200 38,950 cr
292 Part Two Business Combinations and Consolidated Financial Statements

The $38,950 balance of Post’s Retained Earnings of Subsidiary ledger account represents
Post’s share of the undistributed earnings of Sage Company since December 31, 2005, the
date of the business combination. The undistributed earnings of the subsidiary may be rec-
onciled to the increase in Post’s Investment ledger account balance (see page 288) as follows:

Balance, Dec. 31, 2007 $1,231,200

Balance, Dec. 31, 2006 1,197,000
Difference—equal to undistributed earnings of subsidiary for 2007 $ 34,200

In addition, the total of the December 31, 2007, ending balances of Post’s Retained Earn-
ings and Retained Earnings of Subsidiary ledger accounts is equal to consolidated earnings,
as shown below:

Total of Parent Balances, Dec. 31, 2007:

Company’s Two Retained earnings $1,510,250
Retained Earnings Retained earnings of subsidiary 38,950
Account Balances Total (equal to consolidated earnings, Dec. 31, 2007—see page 290) $1,549,200
Equals Consolidated
Retained Earnings
Concluding Comments on Equity Method of Accounting
In today’s financial accounting environment, the equity method of accounting for a sub-
sidiary’s operations is preferable to the cost method for the following reasons:
1. The equity method, which is consistent with the accrual basis of accounting, emphasizes
economic substance of the parent company–subsidiary relationship, while the cost
method emphasizes legal form. Financial accounting stresses substance over form.
2. The equity method permits the use of parent company journal entries to reflect many
items that must be included in working paper eliminations in the cost method. Formal
journal entries in the accounting records provide a better record than do working paper
eliminations.
3. The equity method facilitates issuance of separate financial statements for the parent
company, if required by Securities and Exchange Commission regulations or other con-
siderations.
4. Except when intercompany profits (gains) or losses (discussed in Chapter 8) exist in assets
or liabilities to be consolidated, the parent company’s net income and combined retained
earnings account balances are identical in the equity method to the related consolidated
amounts. Thus, the equity method provides a useful self-checking technique.
For these reasons, the equity method of accounting for a subsidiary’s operations is
emphasized in the following chapters.

Appendix

Cost Method for Partially Owned Subsidiary

To illustrate the cost method of accounting for the operating results of a subsidiary, the Post
Corporation–Sage Company business combination, which involves a partially owned sub-
sidiary, is used. Post acquired 95% of Sage’s outstanding common stock at a total cost (in-
cluding out-of-pocket costs) of $1,192,250 on December 31, 2005. Sage’s operations for
the first two years following the business combination included the following:
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 293

Year Ended Dividends

Dec. 31, Net Income Declared
2006 $ 90,000 $40,000
2007 105,000 50,000

ILLUSTRATION OF COST METHOD FOR

PARTIALLY OWNED 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, 2006, Post 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, 2006:

Parent Company’s Intercompany Dividends Receivable 38,000

Cost-Method Journal Intercompany Dividends Revenue 38,000
Entry to Record To record dividend declared by Sage Company, payable Dec. 16, 2006, to
Dividend Declared by stockholders of record Dec. 1, 2006. (Income tax effects are disregarded.)
Partially Owned
Subsidiary
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 illustrated on page 277.

Working Paper for Consolidated Financial Statements

The 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, 2006, follow:
Cost Method: Partially Owned Subsidiary Subsequent to Date of Business Combination

POST CORPORATION AND SUBSIDIARY

Working Paper for Consolidated Financial Statements
For Year Ended December 31, 2006

Eliminations
Post Sage Increase
Corporation Company (Decrease) Consolidated
Income Statement
Revenue:
Net sales 5,611,000 1,089,000 6,700,000
Intercompany dividends revenue 38,000 (c) (38,000)
Total revenue 5,649,000 1,089,000 (38,000) 6,700,000
Cost and expenses:
Cost of goods sold 3,925,000 700,000 (b) 43,000 4,668,000
Operating expenses 556,000 129,000 (b) 2,000 687,000
Interest and income taxes expense 710,000 170,000 880,000
Minority interest in net income of subsidiary (d) 2,250 2,250
Total costs and expenses and minority
interest 5,191,000 999,000 47,250* 6,237,250
Net income 458,000 90,000 (85,250) 462,750
(continued)
294 Part Two Business Combinations and Consolidated Financial Statements

POST CORPORATION AND SUBSIDIARY

Working Paper for Consolidated Financial Statements (concluded)
For Year Ended December 31, 2006

Eliminations
Post Sage Increase
Corporation Company (Decrease) Consolidated
Statement of Retained Earnings
Retained earnings, beginning of year 1,050,000 334,000 (a) (334,000) 1,050,000
Net income 458,000 90,000 (85,250) 462,750
Subtotal 1,508,000 424,000 (419,250) 1,512,750
Dividends declared 158,550 40,000 (c) (40,000)† 158,550
Retained earnings, end of year 1,349,450 384,000 (379,250) 1,354,200

Balance Sheet
Assets
Inventories 861,000 439,000 (a)
r 26,000 1,300,000
r
(b) (26,000)
Other current assets 639,000 371,000 1,010,000
Investment in Sage Company common stock 1,192,250 (a) (1,192,250)
Plant assets (net) 3,600,000 1,150,000 (a)
r 190,000 4,926,000
r
(b) (14,000)
Leasehold (net) (a)
r 30,000 25,000
r
(b) (5,000)
Goodwill 95,000 (a) 38,000 133,000
Total assets 6,387,250 1,960,000 (953,250) 7,394,000

Liabilities and Stockholders’ Equity

Liabilities 2,420,550 941,000 3,361,550
Common stock, $1 par 1,057,000 1,057,000
Common stock, $10 par 400,000 (a) (400,000)
Additional paid-in capital 1,560,250 235,000 (a) (235,000) 1,560,250
Minority interest in net assets of subsidiary (a) 60,750
s
(c) (2,000)s 61,000
(d) 2,250
Retained earnings 1,349,450 384,000 (379,250) 1,354,200
Total liabilities and stockholders’ equity 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 POST CORPORATION AND SUBSIDIARY

Eliminations (Cost Working Paper Eliminations
Method) for Partially December 31, 2006
Owned Subsidiary for
First Year Subsequent (a) Common Stock—Sage 400,000
to Date of Business Additional Paid-in Capital—Sage 235,000
Combination Retained Earnings—Sage 334,000
Inventories—Sage 26,000
Plant Assets (net)—Sage 190,000
Leasehold (net)—Sage 30,000
Goodwill—Post 38,000
Investment in Sage Company Common Stock—Post 1,192,250
Minority Interest in Net Assets of Subsidiary 60,750

(continued)
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 295

POST CORPORATION AND SUBSIDIARY

Working Paper Eliminations (concluded)
December 31, 2006

To eliminate intercompany investment and equity accounts of

subsidiary on date of business combination (Dec. 31, 2005);
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 ($1,215,000 0.05 $60,750).

(b) Cost of Goods Sold—Sage 43,000

Operating Expenses—Sage 2,000
Inventories—Sage 26,000
Plant Assets (net)—Sage 14,000
Leasehold (net)—Sage 5,000
To provide for Year 2006 depreciation and amortization on
differences between business combination date current fair
values and carrying amounts of Sage’s identifiable assets as
follows:

Cost of
Goods Operating
Sold Expenses
Inventories sold $26,000
Building depreciation 2,000 $2,000
Machinery depreciation 10,000
Leasehold amortization 5,000
Totals $43,000 $2,000

(Income tax effects are disregarded.)

(c) Intercompany Dividends Revenue—Post 38,000

Minority Interest in Net Assets of Subsidiary 2,000
Dividends Declared—Sage 40,000
To eliminate intercompany dividends and minority interest share
thereof ($40,000 0.05 $2,000).

(d) Minority Interest in Net Income of Subsidiary 2,250

Minority Interest in Net Assets of Subsidiary 2,250
To establish minority interest in subsidiary’s adjusted net income
for Year 2006 as follows:
Net income of subsidiary $90,000
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
296 Part Two Business Combinations and Consolidated Financial Statements

paper (page 283). This outcome results from the use of different eliminations in the two
methods.
2. Three cost-method eliminations, (a), (b), and (c), are required to accomplish what a sin-
gle equity-method elimination, (a) on pages 281 and 282, 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 elimination is identical to the one on
page 225 of Chapter 6. This accounting technique is necessary because the parent’s
Investment in Sage Company Common Stock account is maintained at the cost of the
original investment in the cost 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, 2006, may
be proved as follows, to assure their accuracy:

Proof of Consolidated Consolidated Net Income:

Net Income and Net income of Post Corporation $458,000
Consolidated Retained Add: Post’s share of Sage Company’s adjusted net income not
Earnings under Cost distributed as dividends [($45,000 $40,000) 0.95] 4,750
Method Consolidated net income $462,750

Consolidated Retained Earnings:

Retained earnings of Post Corporation $1,349,450
Add: Post’s share of adjusted net increase in Sage Company’s
retained earnings [($50,000 $45,000) 0.95] 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 for 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 sub-
sidiaries under the cost method, a Retained Earnings of Subsidiary ledger account is
unnecessary in the cost method.

ILLUSTRATION OF COST METHOD FOR

PARTIALLY OWNED SUBSIDIARY FOR SECOND YEAR
AFTER BUSINESS COMBINATION
The only journal entry prepared by Post Corporation for the Year 2007 operating results
of Sage Company under the cost method of accounting is to accrue $47,500 of
intercompany dividends revenue ($50,000 0.95 $47,500) on November 22, 2007.
The working paper eliminations (in journal entry format) on December 31, 2007, are
as follows:
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 297

Working Paper POST CORPORATION AND SUBSIDIARY

Eliminations (Cost Working Paper Eliminations
Method) for Partially December 31, 2007
Owned Subsidiary for
Second Year Subsequent (a) Common Stock—Sage 400,000
to Date of Business Additional Paid-in Capital—Sage 235,000
Combination Retained Earnings—Sage 334,000
Inventories—Sage 26,000
Plant Assets (net)—Sage 190,000
Leasehold (net)—Sage 30,000
Goodwill—Post 38,000
Investment in Sage Company Common Stock—Post 1,192,250
Minority Interest in Net Assets of Subsidiary 60,750
To eliminate intercompany investment and equity accounts of
subsidiary on date of business combination (Dec. 31, 2005);
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.

(b) Retained Earnings—Sage 45,000

Cost of Goods Sold—Sage 17,000
Operating Expenses—Sage 2,000
Inventories—Sage 26,000
Plant Assets (net)—Sage 28,000
Leasehold—Sage 10,000
To provide for Years 2006 and 2007 depreciation and amortization
on differences between business combination date current fair
values and carrying amounts of Sage’s identifiable assets;
Year 2006 amounts are debited to Sage’s retained earnings;
Year 2007 amounts are debited to Sage’s operating expenses.

(c) Retained Earnings—Sage ($61,000 $60,750) 250

Minority Interest in Net Assets of Subsidiary 250
To provide for net increase in minority interest from date of
business combination to beginning of year.

(d) Intercompany Dividends Revenue—Post 47,500

Minority Interest in Net Assets of Subsidiary 2,500
Dividends Declared—Sage 50,000
To eliminate intercompany dividends and minority interest share of
dividends ($50,000 0.05 $2,500).

(e) Minority Interest in Net Income of Subsidiary 4,300

Minority Interest in Net Assets of Subsidiary 4,300
To establish minority interest in subsidiary’s adjusted net income
for Year 2007 as follows:
Net income of subsidiary $105,000
Net reduction in elimination (b) (19,000)
Adjusted net income of subsidiary $ 86,000
Minority interest share ($86,000 0.05) $ 4,300
298 Part Two Business Combinations and Consolidated Financial Statements

Because the parent company does not record depreciation and amortization applicable
to the differences between the current fair values and carrying amounts of the subsidiary’s
identifiable net assets, elimination (b) must provide for total depreciation and amortization
for both years since the business combination. In addition, elimination (c) must account for
the net increase in the minority interest in net assets of the subsidiary from the business
combination date to the beginning of the current year.
Working Paper for Consolidated Financial Statements
The following partial working paper for consolidated financial statements illustrates the re-
tained earnings changes for Post Corporation and subsidiary during Year 2007. The consol-
idated amounts are identical to those under the equity method of accounting (see page 290):

Cost Method: Partially Owned Subsidiary Subsequent to Date of Business Combination

POST CORPORATION AND SUBSIDIARY

Partial Working Paper for Consolidated Financial Statements
For Year Ended December 31, 2007

Eliminations
Post Sage Increase
Corporation Company (Decrease) Consolidated
Statement of Retained Earnings
(a) (334,000)
s c
Retained earnings, beginning of year 1,349,450 384,000 (b) (45,000) 1,354,200
(c) (250)
Net income 319,350 105,000 (70,800)* 353,550
Subtotal 1,668,800 489,000 (450,050) 1,707,750
Dividends declared 158,550 50,000 (d) (50,000)† 158,550
Retained earnings, end of year 1,510,250 439,000 (400,050) 1,549,200

*Decrease in intercompany dividends revenue ($47,500), plus total increase in costs and expenses and minority interest ($17,000 $2,000 $4,300), equals $70,800.
†
A decrease in dividends and an increase in retained earnings.

Review 1. “Consolidated financial statement amounts are the same, regardless of whether a parent
company uses the equity method or the cost method to account for a subsidiary’s opera-
Questions
tions.” Why is this statement true?
2. When there are no intercompany profits (gains) or losses in consolidated assets or lia-
bilities, the equity method of accounting produces parent company net income that
equals consolidated net income. The equity method also results in parent company re-
tained earnings of the same amount as consolidated retained earnings. Why, then, are
consolidated financial statements considered superior to separate financial statements of
the parent company when the parent company uses the equity method? Explain.
3. Describe the special features of closing entries for a parent company that accounts for
its subsidiary’s operating results by the equity method.
4. Strake Company, a 90%-owned subsidiary of Peale Corporation, had a net income of
$50,000 for the first year following the business combination. However, the working pa-
per elimination for the minority interest in the subsidiary’s net income was in the amount
of $3,500 rather than $5,000. Is this difference justifiable? Explain.
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 299

5. Discuss some of the advantages that result from the use of the equity method, rather than
the cost method, of accounting for a subsidiary’s operating results.
6. Both Parnell Corporation and Plankton Company have wholly owned subsidiaries. Par-
nell has an Intercompany Dividends Revenue ledger account, and an Intercompany In-
vestment Income account is included in the Plankton ledger. Do both companies use the
same method of accounting for their subsidiaries’ operating results? Explain.
7. Plumstead Corporation’s 92%-owned subsidiary declared a dividend of $3 a share on its
50,000 outstanding shares of common stock. How does Plumstead record this dividend
under:
a. The equity method of accounting?
b. The cost method of accounting?
8. Is a Retained Earnings of Subsidiary ledger account required for a parent company that
uses the equity method of accounting for the subsidiary’s operations? Explain.

Exercises
(Exercises 7.1) Select the best answer for each of the following multiple-choice questions:
1. Concepts underlying the equity method and the cost method of accounting for the op-
erating results of a subsidiary may be summarized as follows:

Equity Method Cost Method

a. Legal form Economic substance
b. Legal form Legal form
c. Economic substance Economic substance
d. Economic substance Legal form

2. Under the equity method of accounting for the operating results of a subsidiary, divi-
dends declared by the subsidiary to the parent company are accounted for by the par-
ent company as:
a. Dividend revenue on the declaration date.
b. A reduction of the investment in subsidiary on the payment date.
c. Dividend revenue on the payment date.
d. A reduction of the investment in subsidiary on the declaration date.
3. In a closing entry at the end of an accounting period, a parent company that uses the
equity method of accounting for the operations of a subsidiary credits the Retained
Earnings of Subsidiary account in the amount of the:
a. Balance of the subsidiary’s Retained Earnings account.
b. Dividends declared by the subsidiary to the parent.
c. Parent’s share of the subsidiary’s net income.
d. Parent’s share of the undistributed earnings of the subsidiary.
4. Under the equity method of accounting, dividends declared by the subsidiary to the
parent company are credited to the parent’s:
a. Intercompany Dividends Receivable account.
b. Investment in Subsidiary Common Stock account.
c. Retained Earnings of Subsidiary account.
d. Retained Earnings account.
300 Part Two Business Combinations and Consolidated Financial Statements

5. After completion of the parent company’s equity-method journal entries for its prof-
itable wholly owned subsidiary’s operating results, the balance of the parent’s Inter-
company Investment Income ledger is equal to the:
a. Subsidiary’s net income.
b. Subsidiary’s net Income, less amortization of current fair value differences of the
subsidiary’s identifiable net assets.
c. Subsidiary’s net income, less amortization of current fair value differences of the
subsidiary’s net assets, including goodwill.
d. Increase in the after-closing balance of the subsidiary’s Retained Earnings ledger
account.
6. The end-of-period closing entries for a parent company that uses the equity method of
accounting for the operating results of a wholly owned subsidiary include a credit to
the Retained Earnings of Subsidiary ledger account in the amount of the:
a. Ending retained earnings of the subsidiary.
b. Net income of the subsidiary for the period.
c. Undistributed earnings of the subsidiary for the period.
d. Dividends declared by the subsidiary during the period.
7. The accuracy of the minority interest in net assets of a partially owned subsidiary sub-
sequent to the date of the business combination may be verified by applying the mi-
nority interest percentage to the:
a. Total stockholders’ equity of the subsidiary.
b. Balance of the parent company’s Investment in Subsidiary Common Stock account.
c. Total stockholders’ equity of the subsidiary plus unamortized current fair value
differences.
d. Amount in c plus unimpaired goodwill.
8. On any date, the balance of a parent company’s Retained Earnings of Subsidiary ac-
count attributable to a wholly owned subsidiary is equal to the:
a. Balance of the subsidiary’s Retained Earnings account.
b. Net increase in the parent’s Investment in Subsidiary Common Stock account since
the date of the business combination.
c. Total net income of the subsidiary since the date of the business combination.
d. Total dividends declared by the subsidiary since the date of the business combination.
9. During a fiscal year, the balance of a parent company’s Investment in Subsidiary Com-
mon Stock ledger account for a wholly owned subsidiary, for which the parent company
uses the equity method of accounting, increases by the amount of the subsidiary’s:
a. Adjusted net income.
b. Dividends.
c. Adjusted net income plus dividends.
d. Undistributed earnings.
10. If a parent company uses the equity method of accounting, in the working paper elim-
inations for the second and succeeding years following a business combination be-
tween the parent company and its wholly owned subsidiary, the amount eliminated for
the subsidiary’s retained earnings is the balance of the subsidiary’s Retained Earnings
Ledger account:
a. At the beginning of the year.
b. On the date of the business combination.
c. At the end of the year.
d. At the beginning of the year, less the balance of the parent’s Retained Earnings of
Subsidiary account.
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 301

11. The 80%-owned subsidiary of a parent company reported a net income of $80,000 for
the year ended May 31, 2006. The parent company’s appropriate journal entry under
the equity method of accounting is (explanation omitted):
a. Investment in Subsidiary Company Common Stock 80,000
Investment Income 80,000
b. Intercompany Investment Income 80,000
Investment in Subsidiary Company Common Stock 80,000
c. Investment in Subsidiary Company Common Stock 64,000
Intercompany Investment Income 64,000
d. Intercompany Investment Income 64,000
Investment in Subsidiary Company Common Stock 64,000
12. The post-closing balances of the Retained Earnings ledger accounts of Panich Corpo-
ration and its 80%-owned subsidiary, Swenson Company, on February 28, 2006, were
as follows (there were no intercompany profits or losses):

Panich Corporation:
Retained earnings $1,600,000
Retained earnings of subsidiary 80,000
Swenson Company:
Retained earnings 460,000

Consolidated retained earnings of Panich Corporation and subsidiary on February 28,

2006, is:
a. $1,600,000.
b. $1,680,000.
c. $1,968,000.
d. $2,060,000.
e. Some other amount.
13. An Intercompany Dividends Receivable ledger account is used in:
a. The cost method of accounting only.
b. The equity method of accounting only.
c. Both the cost method and the equity method of accounting.
d. Neither the cost method nor the equity method of accounting.
14. Under the equity method of accounting, a parent company uses the Retained Earnings
of Subsidiary ledger account for a subsidiary:
a. For closing entries only.
b. For dividends declared by the subsidiary only.
c. For both dividends declared by the subsidiary and closing entries.
d. For neither dividends declared by the subsidiary nor closing entries.
15. On May 31, 2005, the date of the business combination of Passey Corporation and its
80%-owned subsidiary, Sandy Company, for which Passey uses the equity method of
accounting, the balance of Sandy’s Retained Earnings account was $100,000, and on
May 31, 2006, the after-closing balance was $120,000. Prior to Passey’s May 31,
2006, closing entries, the balance of its Retained Earnings of Subsidiary ledger ac-
count was:
a. Zero.
b. $80,000.
c. $100,000.
d. An undeterminable amount.
302 Part Two Business Combinations and Consolidated Financial Statements

16. At the end of an accounting period, a parent company that uses the equity method of
accounting for its partially owned subsidiary closes its:
a. Dividends Declared ledger account.
b. Intercompany Dividends Receivable ledger account.
c. Dividends Payable ledger account.
d. Intercompany Dividends Payable ledger account.
(Exercise 7.2) The September 30, 2005, date-of-combination current fair value differences of the net assets
of Spence Company, wholly owned subsidiary of Pence Corporation, were as shown below.
In addition, goodwill of $45,000 was recognized in the Pence–Spence business combination.

Current Fair Value Carrying Amount Difference

Inventories (first-in,
first-out cost) $120,000 $100,000 $ 20,000
Plant assets (depreciable
over 10-year life) 680,000 560,000 120,000
Identifiable intangible
assets (amortizable
over 5-year life) 160,000 120,000 40,000

During the fiscal year ended September 30, 2006, the following occurred:

Sept. 1 Spence declared a dividend of $80,000 to Pence.

18 Spence paid the $80,000 dividend to Pence.
30 Spence reported a net income of $980,000 for the year to Pence.
30 The goodwill was determined to be unimpaired.

Prepare journal entries (omit explanations) for Pence Corporation to record the operat-
ing results of Spence Company for fiscal year 2006, under the equity method of account-
ing. (Disregard income taxes.)
(Exercise 7.3) Following are all details of three ledger accounts of a parent company that uses the equity
method of accounting for its subsidiary’s operating results:

Intercompany Dividends Receivable

2006 2006
Aug. 16 36,000 Aug. 27 36,000

Investment in Subsidiary Common Stock

2005 2006
Sept. 1 630,000 Aug. 16 36,000
2006 Aug. 31 5,000
Aug. 31 72,000

Intercompany Investment Income

2006 2006
Aug. 31 5,000 Aug. 31 72,000

Draft the most logical explanation for each of the transactions or events recorded in the
foregoing ledger accounts.
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 303

(Exercise 7.4) The working paper elimination for a parent company and its wholly owned subsidiary on
the date of their business combination was as shown below:

CHECK FIGURE
PRISTINE CORPORATION AND SUBSIDIARY
Debit goodwill—
Working Paper Elimination
Superb, $50,000. May 31, 2005

Common Stock—Superb 100,000

Additional Paid-in Capital—Superb 200,000
Retained Earnings—Superb 450,000
Inventories (first-in, first-out cost)—Superb 60,000
Land—Superb 40,000
Building—Superb 50,000
Goodwill—Superb 50,000
Investments in Superb Company Common Stock—Pristine 950,000
To eliminate intercompany investment and equity accounts of
subsidiary on date of business combination; and to allocate excess
of cost over carrying amount of identifiable net assets acquired, with
remainder to goodwill. (Income tax effects are disregarded.)

Additional Information
1. For the fiscal year ended May 31, 2006, Superb had a net income of $80,000 and
declared and paid a dividend of $30,000 (debited to the Dividends Declared ledger
account) to Pristine.
2. Superb uses first-in, first-out cost for inventories and straight-line depreciation and
amortization for plant and intangible assets.
3. On May 31, 2005, Superb’s building had a remaining economic life of 10 years, and the
consolidated goodwill was unimpaired as of May 31, 2006.
4. Superb includes depreciation expense in cost of goods sold.
Prepare a working paper elimination, in journal entry format (omit explanation) for Pris-
tine Corporation and subsidiary on May 31, 2006. (Disregard income taxes.)
(Exercise 7.5) The working paper elimination (in journal entry format) for Polar Corporation and its
wholly owned subsidiary, Solar Company, on July 31, 2005, the date of the business com-
bination, was as follows:

CHECK FIGURE POLAR CORPORATION AND SUBSIDIARY

Debit goodwill—Solar,
Working Paper Elimination
$20,000. July 31, 2005

(a) Common Stock, no-par—Solar 50,000

Retained Earnings—Solar 250,000
Inventories (first-in, first-out cost)—Solar 30,000
Plant Assets (depreciable, net)—Solar 120,000
Goodwill—Solar 20,000
Investment in Solar Company Common Stock—Polar 470,000
To eliminate intercompany investment and equity accounts of
subsidiary on date of business combination; and to allocate excess
of cost over carrying amount of identifiable assets acquired, with
remainder to goodwill. (Income tax effects are disregarded.)
304 Part Two Business Combinations and Consolidated Financial Statements

Additional Information
1. For the fiscal year ended July 31, 2006, Solar declared dividends (debiting the Dividends
Declared ledger account) of $20,000 and had a net income of $50,000, for which Polar
applied the equity method of accounting.
2. Solar uses a 10-year economic life for depreciable plant assets, with depreciation ex-
pense included in cost of goods sold.
3. The consolidated goodwill was unimpaired as of July 31, 2006.
Prepare a working paper elimination (in journal entry format) for Polar Corporation and sub-
sidiary on July 31, 2006. Omit the explanation for the elimination. (Disregard income taxes.)
(Exercise 7.6) The date-of-business combination working paper eliminates (in journal entry format, ex-
planation omitted) for the consolidated balance sheet of Paro Corporation and its wholly
owned subsidiary, Savo Company, was as follows:

CHECK FIGURE
PARO CORPORATION AND SUBSIDIARY
Debit goodwill—Savo,
Working Paper Elimination
10,000. February 28, 2005

Common Stock—Savo 50,000

Retained Earnings—Savo 80,000
Inventories—Savo (first-in, first-out cost) 10,000
Plant Assets (net)—Savo (10-year economic life) 60,000
Goodwill—Savo 10,000
Investment in Savo Company Common Stock—Paro 210,000

On February 3, 2006, Savo declared a dividend of $20,000 to its stockholder; on February 27,
2006, Savo paid the dividend; and on February 28, 2006, Savo reported a net income of
$60,000 for the fiscal year then ended. Savo includes all depreciation and amortization in
cost of goods sold. The consolidated goodwill was unimpaired as of February 28, 2006.
Prepare a working paper elimination (in journal entry format; omit explanation) for con-
solidated financial statements of Paro Corporation and subsidiary on February 28, 2006.
(Disregard income taxes.)
(Exercise 7.7) The working paper elimination (in journal entry format) for Parry Corporation and sub-
sidiary on October 31, 2005, the date of the business combination, was as follows:

CHECK FIGURE PARRY CORPORATION AND SUBSIDIARY

b. Debit goodwill—
Working Paper Elimination
Samuel, $60,000. October 31, 2005

(a) Common Stock—Samuel 100,000

Additional Paid-in Capital—Samuel 150,000
Retained Earnings—Samuel 200,000
Plant Assets (net)—Samuel (depreciable) 250,000
Goodwill—Samuel 60,000
Investment in Samuel Company Common Stock—Parry 760,000
To eliminate intercompany investment and equity accounts of
subsidiary on date of business combination; and to allocate
excess of cost over carrying amount of identifiable assets
acquired, with remainder to goodwill.
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 305

For the fiscal year ended October 31, 2006, Samuel had a net income of $50,000, and on
October 31, 2006, Samuel declared dividends of $20,000, payable November 16, 2006.
Samuel depreciates plant assets by the straight-line method at a 10% rate with no residual
value and includes plant assets depreciation in cost of goods sold. The consolidated good-
will was unimpaired as of October 31, 2006.
a. Prepare Parry Corporation’s October 31, 2006, journal entries to record the operating re-
sults and dividend of Samuel Company under the equity method of accounting. (Disre-
gard income taxes and omit explanations.)
b. Prepare the October 31, 2006, working paper elimination (in journal entry format) for
Parry Corporation and subsidiary. (Disregard income taxes and omit explanation.)
(Exercise 7.8) The working paper elimination (explanation omitted) on the date of the Pulp Corporation–
Stump Company business combination was as follows:

CHECK FIGURE PULP CORPORATION AND SUBSIDIARY

b. Debit goodwill—
Working Paper Elimination
Stump, $40,000. January 31, 2005

Common Stock, no par or stated value—Stump 100,000

Retained Earnings—Stump 180,000
Inventories (first-in, first-out cost)—Stump 20,000
Plant Assets—Stump (depreciable, 5-year life)—Stump 100,000
Goodwill—Stump 40,000
Investment in Stump Company Common Stock—Pulp 440,000

For the fiscal year ended January 31, 2006, Stump had a net income of $240,000, and on
that date it declared and paid a dividend of $120,000. Stump includes plant asset deprecia-
tion expense in cost of goods sold. The consolidated goodwill was unimpaired.
a. Prepare journal entries (omit explanations) for Pulp Corporation on January 31, 2006,
to record the operations of Stump Company under the equity method of accounting.
(Disregard income taxes.)
b. Prepare a working paper elimination, in journal entry format (omit explanation), for
Pulp Corporation and subsidiary on January 31, 2006. (Disregard income taxes.)
(Exercise 7.9) Palmer Corporation had the following ledger account on December 31, 2007:

CHECK FIGURE
Investment in Sim Company Common Stock
Balance, Dec. 31, 2007,
$61,000 credit. Date Explanation Debit Credit Balance
2005
Dec. 31 Issuance of common stock in
business combination 840,000 840,000 dr
31 Direct out-of-pocket costs of
business combination 40,000 880,000 dr
2006
Oct. 14 Dividend declared by Sim 20,000 860,000 dr
Dec. 31 Net income of Sim 60,000 920,000 dr
31 Amortization of differences
between current fair values
and carrying amounts of Sim’s net
assets 14,500 905,500 dr
(continued)
306 Part Two Business Combinations and Consolidated Financial Statements

Investment in Sim Company Common Stock (concluded)

Date Explanation Debit Credit Balance
2007
Oct. 18 Dividend declared by Sim 50,000 855,500 dr
Dec. 31 Net income of Sim 90,000 945,500 dr
31 Amortization of differences
between current fair values and
carrying amounts of Sim’s net
assets 4,500 941,000 dr

Prepare a three-column Retained Earnings of Subsidiary ledger account for Palmer Cor-
poration, and post appropriate closing entries for December 31, 2006, and December 31,
2007, to the account.
(Exercise 7.10) On March 31, 2005, Pitt Corporation acquired for cash 90% of the outstanding common
stock of Scow Company. The $100,000 excess of Pitt’s investment over 90% of the current
fair value (and carrying amount) of Scow’s identifiable net assets was allocable to goodwill,
which was considered totally impaired as of March 31, 2006, because for the fiscal year
ended that date, Scow had a net loss of $130,000 and declared no dividends.
Disregarding income taxes, prepare a working paper to compute the balance of Pitt Cor-
poration’s Intercompany Investment Income ledger account under the equity method of ac-
counting on March 31, 2006.
(Exercise 7.11) On January 2, 2005, Ply Corporation acquired 75% of the outstanding common stock of
Spade Company for $345,000 cash, including out-of-pocket costs. The investment was ac-
counted for by the equity method. On January 2, 2005, Spade’s identifiable net assets (car-
rying amount and current fair value) were $300,000. Ply determined that the excess of the
cost of its investment over the current fair value of Spade’s identifiable net assets was at-
CHECK FIGURE tributable to goodwill. Spade’s net income for the fiscal year ended December 31, 2006,
Balance, Dec. 31, 2006, was $160,000. During Year 2006, Ply received $60,000 cash dividends from Spade. There
$405,000. were no other transactions between the two enterprises, and consolidated goodwill was
unimpaired as of December 31, 2006.
Prepare a working paper to compute the balance of Ply Corporation’s Investment in
Spade Company Common Stock ledger account (after adjustment) on December 31, 2006,
disregarding income taxes.
(Exercise 7.12) On January 2, 2005, Plain Corporation acquired 80% of Sano Company’s outstanding com-
mon stock for an amount of cash equal to 80% of the carrying amount (and current fair
value) of Sano’s identifiable net assets on that date. The balances of Plain’s and Sano’s Re-
tained Earnings ledger accounts on January 2, 2005, were $500,000 and $100,000, respec-
tively. During 2005, Plain had a net income of $200,000 under the equity method of
CHECK FIGURE accounting and declared dividends of $50,000, and Sano had a net income of $40,000 and
Consolidated retained declared dividends of $20,000. There were no other intercompany transactions between
earnings, $650,000. Plain and Sano.
Prepare a working paper to compute the consolidated retained earnings of Plain Corpo-
ration and subsidiary on December 31, 2005. (Disregard income taxes.)
(Exercise 7.13) Pinson Corporation owned a 90% interest in a subsidiary, Solomon Company, which was
accounted for by the equity method. During Year 2006, Pinson had income, exclusive of in-
tercompany investment income, of $145,000, and Solomon had a net income of $120,000.
Solomon declared and paid a $40,000 dividend during Year 2006. There were no differences
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 307

CHECK FIGURE between the current fair values and carrying amounts of Solomon’s identifiable net assets
Consolidated net on the date of the business combination, and there was no goodwill in the business combi-
income, $253,000. nation.
Prepare a working paper to compute the consolidated net income of Pinson Corporation
and subsidiary for Year 2006. (Disregard income taxes.)
(Exercise 7.14) The working paper elimination (explanation omitted) on the date of the Pallid Corporation–
Sallow Company business combination was as follows:

CHECK FIGURE PALLID CORPORATION AND SUBSIDIARY

b. Debit goodwill—
Working Paper Elimination
Pallid, $20,000. January 31, 2005

Common Stock, no par or stated value—Sallow 50,000

Retained Earnings—Sallow 90,000
Inventories (first-in, first-out cost)—Sallow 10,000
Plant Assets—Sallow (depreciable, 10-year life) 50,000
Goodwill—Pallid 20,000
Investment in Sallow Company Common Stock—Pallid 190,000
Minority Interest in Net Assets of Subsidiary ($200,000 0.15) 30,000

For the fiscal year ended January 31, 2006, Sallow had a net income of $120,000, and on
that date it declared dividends totaling $60,000, to be paid February 28, 2006.
a. Prepare journal entries (omit explanations) for Pallid Corporation on January 31, 2006,
to record the operations of Sallow Company under the equity method of accounting.
(Disregard income taxes.) Consolidated goodwill was unimpaired as of January 31, 2006.
b. Prepare working paper eliminations, in journal entry format (omit explanations), for Pal-
lid Corporation and subsidiary on January 31, 2006. Sallow includes depreciation in
cost of goods sold. (Disregard income taxes.)
(Exercise 7.15) The retained earnings ledger accounts of Putter Corporation and its 80%-owned subsidiary,
Simmer Company, were as follows for the two years following their business combination
CHECK FIGURE on May 31, 2005. There were no intercompany profits (gains) or losses in transactions
Ending retained between the two enterprises during the two years ended May 31, 2007.
earnings, $810,000.
Putter Corporation:

Retained Earnings
Date Explanation Debit Credit Balance
2005
May 31 Balance 640,000 cr
2006
May 31 Close net income available for
dividends ($140,000 $28,000) 112,000 752,000 cr
31 Close Dividends Declared account 60,000 692,000 cr
2007
May 31 Close net income available for
dividends ($180,000 $52,000) 128,000 820,000 cr
31 Close Dividends Declared account 90,000 730,000 cr
308 Part Two Business Combinations and Consolidated Financial Statements

Retained Earnings of Subsidiary

Date Explanation Debit Credit Balance
2006
May 31 Close net income not available
for dividends [($80,000 $15,000
$30,000) 0.80] 28,000 28,000 cr
2007
May 31 Close net income not available for
dividends [($120,000 $5,000
$50,000) 0.80] 52,000 80,000 cr

Simmer Company:

Retained Earnings
Date Explanation Debit Credit Balance
2005
May 31 Balance 100,000 cr
2006
May 31 Close net income 80,000 180,000 cr
31 Close Dividends Declared account 30,000 150,000 cr
2007
May 31 Close net income 120,000 270,000 cr
31 Close Dividends Declared account 50,000 220,000 cr

Prepare the statement of retained earnings section of the working paper for consolidated
financial statements of Putter Corporation and subsidiary for the year ended May 31, 2007.
(Exercise 7.16) Selected ledger account balances for Parton Corporation on May 31, 2006, were as follows:

CHECK FIGURE Investment in (80% owned) Starter Company common stock

Credit retained earnings
($60,000 net increase from May 31, 2005) $620,000 dr
of subsidiary, $35,000.
Intercompany investment income 95,000 cr
Dividends declared 50,000 dr
Sales (no offset accounts) 840,000 dr
Cost of goods sold 378,000 dr
Operating expenses and income taxes expense 212,000 dr

Prepare closing entries (omit explanations) for Parton Corporation on May 31, 2006.
(Exercise 7.17) The balance of Putnam Corporation’s Investment in Salisbury Company Common Stock
ledger account on September 30, 2006, was $265,000. The 20% minority interest in net as-
CHECK FIGURE sets of subsidiary in the consolidated balance sheet of Putnam Corporation and subsidiary
d. Minority interest in on September 30, 2006, was $60,000. For the year ended September 30, 2007, Salisbury
net income, $9,100. had a net income of $50,000 and declared and paid dividends of $18,750. Amortization for
the year ended September 30, 2007, was as follows:

Differences between current fair values and carrying amounts of Salisbury’s

identifiable net assets on date of business combination $4,500
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 309

Prepare a working paper to compute the following:

a. Balance of Putnam Corporation’s Investment in Salisbury Company Common Stock
ledger account on September 30, 2007.
b. Balance of Putnam Corporation’s Intercompany Investment Income ledger account on
September 30, 2007, before closing entry.
c. Amount of closing entry credit to Putnam’s Retained Earnings of Subsidiary ledger
account on September 30, 2007.
d. Minority interest in net income of subsidiary in consolidated income statement of
Putnam Corporation and subsidiary for year ended September 30, 2007.
e. Minority interest in net assets of subsidiary in consolidated balance sheet of Putnam
Corporation and subsidiary on September 30, 2007.

Cases
(Case 7.1) You have recently become the controller of Precision Corporation, a manufacturing enter-
prise that has begun a program of expansion through business combinations. On February 1,
2005, two weeks prior to your controllership appointment, Precision had completed the
acquisition of 85% of the outstanding common stock of Sloan Company for $255,000 cash,
including out-of-pocket costs. You are engaged in a discussion with Precision’s chief ac-
countant concerning the appropriate accounting method for Precision’s interest in Sloan
Company’s operating results. The chief accountant strongly supports the cost method of ac-
counting, offering the following arguments:
1. The cost method recognizes that Precision and Sloan are separate legal entities.
2. The existence of a 15% minority interest in Sloan requires emphasis on the legal sepa-
rateness of the two companies.
3. A parent company recognizes revenue under the cost method only when the subsidiary
declares dividends. Such dividend revenue is consistent with the revenue realization
principle of financial accounting. The Intercompany Investment Income account
recorded in the equity method of accounting does not fit the definition of realized
revenue.
4. Use of the equity method of accounting might result in Precision’s declaring dividends
to its shareholders out of “paper” retained earnings that belong to Sloan.
5. The cost method is consistent with other aspects of historical-cost accounting, because
working paper eliminations, rather than journal entries in ledger accounts, are used to
recognize amortization of differences between current fair values and carrying amounts
of Sloan’s identifiable net assets.

Instructions
Prepare a rebuttal to each of the chief accountant’s arguments.
(Case 7.2) John Raymond, chief financial officer of publicly owned Punjab Corporation, is concerned
about the negative impact on Punjab’s quarterly earnings resulting from its December 31,
2005, business combination with wholly owned Selvidge Company, its only subsidiary. With
the end of the first quarter of Year 2006 approaching and the required filing of Form 10-Q,
“Quarterly Report,” with the Securities and Exchange Commission, Raymond has consid-
ered the required depreciation and amortization of the current fair value excesses resulting
from the business combination, as follows:
310 Part Two Business Combinations and Consolidated Financial Statements

Depreciable plant assets (5-year remaining composite economic

life to Selvidge) $200,000
Patent (3-year remaining economic life, 8-year remaining
legal life to Selvidge) 96,000
Goodwill 160,000

Reviewing controller Nancy Wade’s forecasts of pre-tax income of Punjab and Selvidge in
their separate income statements for the three months ending March 31, 2006, Raymond
made the following estimates:

Forecasted pre-tax income for 3 months ended

Mar. 31, 2006:
Punjab Corporation $ 80,000
Selvidge Company 40,000
Total $120,000
Per share (100,000 weighted-average shares
expected to be outstanding) $1.20
Less: Depreciation and amortization of date-of-business
combination current fair value excess:
Plant assets ($200,000 1⁄ 5 1⁄ 4 ) $10,000
Patent ($96,000 1⁄ 3 1⁄ 4 ) 8,000
18,000
Adjusted forecasted pre-tax income $102,000
Per share $1.02

Pointing out to Wade that the 15% decrease in forecasted pre-tax earnings per share
($0.18 $1.20 15%) would be difficult to explain to Punjab’s board of directors,
Raymond asked her to increase the remaining composite economic life of Selvidge’s de-
preciable plant assets to 10 years from 5 years and to use the remaining legal life, rather
than the remaining economic life, of the patent as its basis of amortization. In reply,
Wade informed Raymond that before acquiescing to his request, she would have to re-
search the following literature of accounting and auditing:
FASB Statement No. 142, “Goodwill and Other Intangible Assets,” paragraph 11
APB Opinion No. 20, “Accounting Changes,” paragraphs 10, 31, and 33
AICPA Professional Standards, vol. 1, “U.S. Auditing Standards,” Sections AU342.05
and AU420.14
Instructions
After researching the foregoing references, state your opinion as to how Nancy Wade
should respond to John Raymond’s request.
(Case 7.3) In a classroom discussion of accounting standards for consolidated financial statements,
student Rachel questioned the propriety of displaying dividends payable to minority stock-
holders of a partially owned subsidiary as a liability in the consolidated balance sheet.
She pointed out that, under the economic unit concept of consolidated financial statements,
the minority interest in net assets of subsidiary is displayed with stockholders’ equity in the
consolidated balance sheet, and that dividends payable to minority stockholders clearly are
a part of the interest of those stockholders in the net assets of the subsidiary. In response,
student Carl contended that dividends payable to minority stockholders unquestionably
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 311

meet the definition of liabilities in paragraph 35 of Statement of Financial Accounting

Concepts No. 6, “Elements of Financial Statements.”
Instructions
Do you support the view of student Rachel or of student Carl? Explain.

Problems
(Problem 7.1) The working paper elimination for Prem Corporation and its subsidiary, Supp Company, on
December 31, 2005, the date of the business combination, follows (in journal entry format):

CHECK FIGURES
PREM CORPORATION AND SUBSIDIARY
a. Balance of
Working Paper Elimination
Investment account, December 31, 2005
Dec. 31, 2006,
$190,000 dr; b. Debit (a) Common Stock—Supp 10,000
goodwill—Supp,
Additional Paid-in Capital—Supp 40,000
$12,000.
Retained Earnings—Supp 50,000
Inventories—Supp (first-in, first-out cost) 20,000
Plant Assets—Supp (economic life 10 years) 60,000
Goodwill—Supp 12,000
Investment in Supp Company Common Stock—Prem 192,000
To eliminate intercompany investment and equity accounts of
subsidiary on date of business combination; and to allocate excess
of cost over carrying amount of identifiable assets acquired, with
remainder to goodwill. (Income tax effects are disregarded.)

On December 8, 2006, Supp declared, and on December 18, 2006, paid, a dividend to
Prem of $6,000, and it had a net income of $30,000 for 2006. Prem used the equity method
of accounting for Supp’s operating results. Consonsolidated goodwill was unimpaired as of
December 31, 2006.
Instructions
a. Set up a three-column ledger account for Prem Corporation’s Investment in Supp Com-
pany Common Stock ledger account, bring forward the December 31, 2005, debit bal-
ance of $192,000, and post the required entries to the account for Year 2006. (Disregard
income taxes.)
b. Prepare a working paper elimination (in journal entry format) for Prem Corporation and
subsidiary on December 31, 2006, disregarding income taxes. Supp Company includes
straight-line depreciation expense in cost of goods sold and amortization expense in op-
erating expenses.
(Problem 7.2) On September 5, 2006, Soy Company, the 80%-owned subsidiary of Pro Corporation, de-
clared a cash dividend of $1 a share on its 100,000 outstanding shares of $1 par common
CHECK FIGURE stock. The dividend was paid on September 26, 2006. For the fiscal year ended September
Sept. 30, debit 30, 2006, the first year of the Pro–Soy affiliation, Soy had a net income of $300,000. In ad-
intercompany
dition to goodwill of $80,000, the September 30, 2005 (date of the business combination)
investment income,
$57,600.
working paper elimination (in journal entry format) for Pro Corporation and subsidiary in-
cluded the following debits:
312 Part Two Business Combinations and Consolidated Financial Statements

Inventories (first-in, first-out cost)—Soy $60,000

Plant assets (net) (all depreciable over a 10-year economic life, straight-line
method)—Soy 80,000
Discount on long-term debt (5-year remaining term)—Soy 20,000

Instructions
Prepare journal entries for Pro Corporation on September 5, 26, and 30, 2006, to record its
equity method of accounting for the operating results of Soy Company. Use the straight-
line method of amortization for discount on long-term debt, and disregard income taxes.
Consolidated goodwill was unimpaired as of September 30, 2006.
(Problem 7.3) The working paper elimination (in journal entry format) for Promo Corporation and
subsidiary on March 31, 2005, the date of the business combination, was as follows:

CHECK FIGURE
PROMO CORPORATION AND SUBSIDIARY
b. Balance of
Working Paper Elimination
Investment account, March 31, 2005
Mar. 31, 2006,
$502,000; c. Debit (a) Common Stock, $1 par—Sanz 50,000
goodwill—Sanz,
Additional Paid-in Capital—Sanz 100,000
$40,000.
Retained Earnings—Sanz 150,000
Inventories—Sanz (first-in, first-out cost) 20,000
Land—Sanz 50,000
Other Plant Assets—Sanz (economic life 10 years) 80,000
Goodwill—Sanz 40,000
Investment in Sanz Company Common Stock—Promo 490,000
To eliminate intercompany investment and equity accounts of
subsidiary on date of business combination; and to allocate excess
of cost over carrying amounts of identifiable assets acquired, with
remainder to goodwill. (Income tax effects are disregarded.)

For the fiscal year ended March 31, 2006, Sanz had a net income of $60,000. Sanz declared
a cash dividend of $0.40 a share on March 1, 2006, and paid the dividend on March 15,
2006. (Sanz had not declared or paid dividends during the year ended March 31, 2005.)
Sanz uses the straight-line method for depreciation expense and amortization expense, both
of which are included in operating expenses. Consolidated goodwill was not impaired as of
March 31, 2006.
Instructions
a. Prepare journal entries for Promo Corporation to record the operating results of Sanz
Company for the year ended March 31, 2006, under the equity method of accounting.
(Disregard income taxes.)
b. Prepare three-column ledger accounts for Promo Corporation’s Investment in Sanz
Company Common Stock and Intercompany Investment Income ledger accounts, and
post the journal entries in (a).
c. Prepare a working paper elimination for Promo Corporation and subsidiary on March 31,
2006 (in journal entry format). (Disregard income taxes.)
(Problem 7.4) Penn Corporation’s October 31, 2006, journal entries to record the operations of its
80%-owned subsidiary, Soper Company, during the first year following the business com-
bination, were as follows:
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 313

CHECK FIGURE
Total credits to Intercompany Dividends Receivable 16,000
minority interest in net Investment in Soper Company Common Stock 16,000
assets, $50,400. To record $1 a share dividend declared by Soper Company, payable
Nov. 7, 2006, to stockholders of record Oct. 31, 2006.

Investment in Soper Company Common Stock 40,000

Intercompany Investment Income 40,000
To record 80% of Soper Company’s net income for the year ended
Oct. 31, 2006. (Income tax effects are disregarded.)

Intercompany Investment Income 22,400

Investment in Soper Company Common Stock 22,400
To amortize differences between current fair values and carrying
amounts of Soper Company’s identifiable net assets on Oct. 31, 2006.
Inventories—to cost of goods sold $20,000
Plant assets—depreciation ($80,000 10) 8,000
Total difference $28,000
Amortization ($28,000 0.80) $22,400
(Income tax effects are disregarded.)

Additional Information
1. Penn had acquired 16,000 shares of Soper’s $1 par common stock on October 31, 2005,
at a total cost, including out-of-pocket costs, of $240,000. The minority interest in net
assets of subsidiary on that date was $50,000.
2. On October 31, 2006, the balances of Soper’s Common Stock, Paid-in Capital in
Excess of Par, and Retained Earnings ledger accounts were in the ratio of 1 : 3 : 5,
respectively.
3. Soper allocates depreciation expense 75% to cost of goods sold and 25% to operating
expenses.
4. Consolidated goodwill of $40,000 was unimpaired as of October 31, 2006.
Instructions
Prepare working paper eliminations (in journal entry format) for Penn Corporation and
subsidiary on October 31, 2006. (Suggestion: Use T accounts to determine balances of
ledger accounts of the parent company and subsidiary.) (Disregard income taxes.)
(Problem 7.5) On January 2, 2006, Pewter Corporation made the following investments:
CHECK FIGURE 1. Acquired for cash 80% of the 1,000 shares of outstanding common stock of Stewart
b. Minority interest in Company at $70 a share. The stockholders’ equity of Stewart on January 2, 2006, con-
net assets of Skate, sisted of the following:
$29,700.

Common stock, no par or stated value $50,000

Retained earnings 20,000
Total stockholders’ equity $70,000

2. Acquired for cash 70% of the 3,000 shares of outstanding common stock of Skate Com-
pany at $40 a share. The stockholders’ equity of Skate on January 2, 2006, consisted of
the following:
314 Part Two Business Combinations and Consolidated Financial Statements

Common stock, $20 par $ 60,000

Additional paid-in capital 20,000
Retained earnings 40,000
Total stockholders’ equity $120,000

Out-of-pocket costs of the two business combinations may be disregarded. An analysis of

the retained earnings of each company for Year 2006 follows:

Pewter Stewart Skate

Corporation Company Company
Balances, beginning of year $240,000 $ 20,000 $ 40,000
Net income (loss) 104,600* 36,000 (12,000)
Cash dividends declared and paid,
Dec. 31, 2006 (40,000) (16,000) (9,000)
Balances, end of year $304,600* $ 40,000 $ 19,000

*Before giving effect to journal entries in a(2), below.

Instructions
a. Prepare journal entries for Pewter Corporation to record the following for Year 2006:
(1) Investments in subsidiaries’ common stock
(2) Parent company’s share of subsidiaries’ net income or net loss (disregarding income
taxes), under the equity method of accounting
(3) Parent company’s share of subsidiaries’ dividends declared, under the equity
method of accounting (Do not prepare journal entries for receipt of cash.)
b. Prepare a working paper to compute the minority interest in each subsidiary’s net assets
on December 31, 2006.
c. Prepare a working paper to compute the amount to be reported as consolidated retained
earnings of Pewter Corporation and subsidiaries on December 31, 2006.
(Problem 7.6) Analyses of the Investment in State Company Common Stock ledger account of Parks Cor-
poration (State’s parent company), the minority interest in net assets of State, and the dif-
CHECK FIGURE ferences between current fair values and carrying amounts of State’s identifiable net assets
b. Debit goodwill— on May 31, 2005, the date of the Parks–State business combination, were as follows for the
Parks, $50,000. fiscal year ended May 31, 2006:

PARKS CORPORATION
Analysis of Investment in State Company Common Stock Ledger Account
For Year Ended May 31, 2006

Carrying Current Fair

Amount Value Excess Goodwill Total
Beginning balances $400,000 $80,000 $50,000 $530,000
Net income of State Company 80,000 80,000 Intercompany
Amortization of differences between investment
current fair values and carrying amounts t income,
of State’s identifiable net assets (7,200) (7,200) $72,800
Dividends declared by State (30,000) (30,000)
Ending balances $450,000 $72,800 $50,000 $572,800
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 315

PARKS CORPORATION
Analysis of Minority Interest in Net Assets of State Company
For Year Ended May 31, 2006

Carrying Current Fair

Amount Value Excess Total
Beginning balances $100,000 $20,000 $120,000
Minority
Net income of State Company 20,000 20,000
interest
Amortization of differences between current
fair values and carrying amounts of State’s t in net income
of subsidiary,
identifiable net assets (1,800) (1,800)
$18,200
Dividend declared by State (7,500) (7,500)
Ending balances $112,500 $18,200 $130,700

PARKS CORPORATION
Analysis of Differences between Current Fair Values and Carrying Amounts of
State Company’s Identifiable Net Assets
For Year Ended May 31, 2006

Balances, Balances,
May 31, Amortization May 31,
2005 for Year 2006 2006
Plant assets (net):
Land $ 39,000 $39,000
Buildings 36,000 $4,000 32,000
Machinery 25,000 5,000 20,000
Total plant assets $100,000 $9,000 $91,000

State had 10,000 shares of $1 par common stock outstanding on May 31, 2005, that had
been issued for $5 a share when State was organized. There has been no change in State’s
paid-in capital since State’s organization. State includes straight-line depreciation expense
of plant assets in cost of goods sold. Dividends were declared by State on May 31, 2006.
Consolidated goodwill was unimpaired as of May 31, 2006.
Instructions
a. Reconstruct Parks Corporation’s journal entries for the year ended May 31, 2006, to
record the operating results of State Company under the equity method of accounting.
(Disregard income taxes.)
b. Prepare working paper eliminations for Parks Corporation and subsidiary (in journal en-
try format) on May 31, 2006. (Disregard income taxes.)
(Problem 7.7) Paseo Corporation acquired 82% of Steppe Company’s outstanding common stock for
$328,000 cash on March 31, 2005. Out-of-pocket costs of the business combination may
be disregarded. Steppe’s stockholders’ equity on March 31, 2005, was as follows:

Common stock, $2 par $ 50,000

Additional paid-in capital 75,000
Retained earnings 135,000
Total stockholders’ equity $260,000
316 Part Two Business Combinations and Consolidated Financial Statements

Additional Information
1. All of Steppe’s identifiable net assets were fairly valued at their March 31, 2005, carry-
ing amounts except for the following:

CHECK FIGURE Current

b. Credit Investment
Carrying Fair
account, $346,450.
Amounts Values
Land $100,000 $120,000
Building (net) (10-year economic life) 200,000 250,000
Patent (net) (8-year economic life) 60,000 80,000

2. Goodwill resulting from the business combination was unimpaired as of March 31, 2006.
Steppe used the straight-line method for depreciation and amortization. Steppe included de-
preciation expense in cost of goods sold and amortization expense in operating expenses.
3. During the fiscal year ended March 31, 2006, Steppe had a net income of $1.20 a share
and declared and paid no dividends. There were no intercompany transactions between
Paseo and Steppe.
Instructions
a. Prepare Paseo Corporation’s journal entries to record Steppe Company’s operating re-
sults for the year ended March 31, 2006, under the equity method of accounting. (Dis-
regard income taxes.)
b. Prepare working paper eliminations (in journal entry format) for Paseo Corporation and
subsidiary on March 31, 2006. (Disregard income taxes.)

(Problem 7.8) Pavich Corporation acquired 75% of the outstanding common stock of Sisler Company on
October 1, 2005, for $547,500, including direct out-of-pocket costs. Sisler’s stockholders’
equity on October 1, 2005, was as follows:

CHECK FIGURES
Common stock, $5 par $250,000
b. Total credits to
Additional paid-in capital 100,000
minority interest in net
Retained earnings 200,000
assets: Sept. 30, 2006,
Total stockholders’ equity $550,000
$170,250;

Additional Information
1. Current fair values of Sisler’s identifiable net assets exceed their carrying amounts on
October 1, 2005, as follows:

Excess of Current
Fair Values over
Carrying Amounts
Inventories (first-in, first-out cost) $30,000
Plant assets (net) (economic life 10 years) 50,000
Patent (net) (economic life 5 years) 20,000

2. Both Pavich and Sisler included depreciation expense in cost of goods sold and amorti-
zation expense in operating expenses. Both companies used the straight-line method for
depreciation. Consolidated goodwill was unimpaired as of September 30, 2006 and 2007.
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 317

3. For the two fiscal years ended September 30, 2007, Sisler had net income and declared
and paid dividends as follows:

Year Ended Sept. 30, Net Income Dividends

2006 $ 80,000 $10,000
2007 120,000 75,000

Instructions
a. Prepare journal entries for Pavich Corporation on September 30, 2006, and September 30,
2007, to record under the equity method of accounting the operating results of Sisler
Company for the two years ended on those dates. Do not prepare entries for the declara-
tion of Sisler’s dividends; assume the dividends were received by Pavich on September
30 of each year. (Disregard income taxes.)
b. Prepare working paper eliminations (in journal entry format) for Pavich Corporation and
subsidiary on September 30, 2006, and September 30, 2007. (Disregard income taxes.)
c. Prepare a three-column ledger account for Pavich Corporation’s Retained Earnings of
Subsidiary ledger account, showing the closing entries posted to that account on
September 30, 2006, and September 30, 2007.
(Problem 7.9) The working paper elimination for Plumm Corporation and its wholly owned subsidiary, Stamm
Company, on the date of the business combination was as follows (in journal entry format):

CHECK FIGURE
PLUMM CORPORATION AND SUBSIDIARY
b. Debit goodwill—
Working Paper Elimination
Stamm, $40,000. November 30, 2005

Common Stock—Stamm 80,000

Additional Paid-in Capital—Stamm 200,000
Retained Earnings—Stamm 220,000
Inventories—Stamm 20,000
Goodwill—Stamm 40,000
Investment in Stamm Company Common Stock—Plumm 560,000
To eliminate intercompany investment and equity accounts of
subsidiary on date of business combination; and to allocate excess
of cost over carrying amounts of identifiable assets acquired, with
remainder to goodwill. (Income tax effects are disregarded.)

Separate financial statements of Plumm and Stamm for the fiscal year ended November
30, 2006, were as follows:

PLUMM CORPORATION AND STAMM COMPANY

Separate Financial Statements (for first year following business combination)
For Year Ended November 30, 2006

Plumm Stamm
Corporation Company
Income Statements
Revenue:
Net sales $ 800,000 $415,000
Intercompany investment income 70,000
Total revenue $ 870,000 $415,000
(continued)
318 Part Two Business Combinations and Consolidated Financial Statements

PLUMM CORPORATION AND STAMM COMPANY

Separate Financial Statements (for first year following business combination) (concluded)
For Year Ended November 30, 2006

Plumm Stamm
Corporation Company
Income Statements
Costs and expenses:
Cost of goods sold $ 500,000 $110,000
Operating expenses 233,333 155,000
Income taxes expense 26,667 60,000
Total costs and expenses $ 760,000 $325,000
Net income $ 110,000 $ 90,000

Statements of Retained Earnings

Retained earnings, beginning of year $ 640,000 $220,000
Net income 110,000 90,000
Subtotals $ 750,000 $310,000
Dividends 60,000 30,000
Retained earnings, end of year $ 690,000 $280,000

Balance Sheets
Assets
Investment in Stamm Company common stock $ 600,000
Other 1,840,000 $960,000
Total assets $2,440,000 $960,000

Liabilities and Stockholders’ Equity

Liabilities $ 650,000 $400,000
Common stock, $1 par 500,000 80,000
Additional paid-in capital 600,000 200,000
Retained earnings 690,000 280,000
Total liabilities and stockholders’ equity $2,440,000 $960,000

Consolidated goodwill was unimpaired as of November 30, 2006.

Instructions
a. Reconstruct the journal entries for Plumm Corporation on November 30, 2006, under
the equity method of accounting, to record the operating results of Stamm Company for
the fiscal year ended November 30, 2006, including Stamm’s dividend declared and paid
on that date. (Do not prepare a journal entry for the declaration of the dividend.)
(Disregard income taxes.)
b. Prepare a working paper for consolidated financial statements of Plumm Corporation
and subsidiary for the year ended November 30, 2006, and the related working paper
elimination (in journal entry format). (Disregard income taxes.)
(Problem 7.10) Ping Corporation acquired 80% of the outstanding common stock of Stang Company on
CHECK FIGURE December 31, 2002, for $120,000. On that date, Stang had one class of common stock out-
b. Credit Investment standing with a carrying amount of $100,000 and retained earnings of $30,000. Ping had a
account, $143,200. $50,000 deficit in retained earnings.
Additional Information
1. Ping acquired the Stang common stock from Stang’s major stockholder primarily to
acquire control of signboard leases owned by Stang. The leases were to expire on
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 319

December 31, 2007, and Ping’s executives estimated that the leases, which were not renew-
able, were worth at least $20,000 more than their carrying amount when the Stang common
stock was acquired. Stang includes signboard leases amortization in other expenses.
2. The separate financial statements for both companies for the year ended December 31,
2006, were as follows:

PING CORPORATION AND SUBSIDIARY

Separate Financial Statements (prior to business combination)
For Year Ended December 31, 2006

Ping Stang
Corporation Company
Income Statements
Net sales $420,000 $300,000
Costs and expenses:
Cost of goods sold $315,000 $240,000
Other expenses 65,000 35,000
Total costs and expenses $380,000 $275,000
Net income $ 40,000 $ 25,000

Statements of Retained Earnings

Retained earnings, beginning of year $ 15,000 $ 59,000
Net income 40,000 25,000
Subtotals $ 55,000 $ 84,000
Dividends 9,000
Retained earnings, end of year $ 55,000 $ 75,000

Balance Sheets
Assets
Current assets $172,000 $199,100
Investment in Stang Company common stock 120,000
Land 25,000 10,500
Building and equipment 200,000 40,000
Accumulated depreciation (102,000) (7,000)
Signboard leases (net) 8,400
Total assets $415,000 $251,000

Liabilities and Stockholders’ Equity

Dividends payable $ 9,000
Other current liabilities $ 60,000 67,000
Common stock, no par or stated value 300,000 100,000
Retained earnings 55,000 75,000
Total liabilities and stockholders’ equity $415,000 $251,000

3. Stang declared a 9% cash dividend on December 20, 2006, payable January 16, 2007, to
stockholders of record December 31, 2006. Ping carried its investment at cost and had
not recorded Stang’s dividend on December 31, 2006. Ping neither declared nor paid
dividends during Year 2006.
Instructions
a. Prepare adjusting entries for Ping Corporation on December 31, 2006, to convert its ac-
counting for Stang Company’s operating results to the equity method of accounting.
(Disregard income taxes.)
320 Part Two Business Combinations and Consolidated Financial Statements

b. Prepare a working paper for consolidated financial statements of Ping Corporation and
subsidiary on December 31, 2006, and the related working paper eliminations (in jour-
nal entry format). Amounts for Ping Corporation should reflect the adjusting entries pre-
pared in a. (Disregard income taxes.)
(Problem 7.11) On June 30, 2006, Petal Corporation acquired for cash of $19 a share, including out-of-
pocket costs, all the outstanding common stock of Sepal Company. Both companies con-
tinued to operate as separate entities. Petal adopted the equity method of accounting for
Sepal’s operating results.
Additional Information
1. On June 30, 2006, Sepal’s balance sheet was as follows:

CHECK FIGURE
SEPAL COMPANY
Consolidated total
Balance Sheet (prior to business combination)
assets, $31,310,000. June 30, 2006

Assets
Cash $ 700,000
Trade accounts receivable (net) 600,000
Inventories 1,400,000
Plant assets (net) 3,300,000
Other assets 500,000
Total assets $6,500,000

Liabilities and Stockholders’ Equity

Trade accounts payable and other current liabilities $ 700,000
Long-term debt 2,600,000
Other liabilities 200,000
Common stock, $1 par 1,000,000
Additional paid-in capital 400,000
Retained earnings 1,600,000
Total liabilities and stockholders’ equity $6,500,000

2. On June 30, 2006, Sepal’s assets and liabilities having current fair values that were dif-
ferent from carrying amounts were as follows:

Current Fair Values

Plant assets (net) $16,400,000
Other assets 200,000
Long-term debt 2,200,000

The differences between current fair values and carrying amounts resulted in a debit or
credit to depreciation or amortization for the consolidated financial statements for the
six-month period ended December 31, 2006, as follows:

Plant assets (net) $500,000 debit

Other assets 10,000 credit
Long-term debt 5,000 debit
Total $495,000 debit
 Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination 321

3. The amount paid by Petal in excess of the current fair value of the identifiable net assets
of Sepal was attributable to goodwill.
4. The Year 2006 net income (or net loss) for each company was as follows:

Petal Sepal
Corporation Company
Jan. 1 to June 30, 2006 $ 250,000 $ (750,000)
July 1 to Dec. 31, 2006 1,070,000 1,250,000

The $1,070,000 net income of Petal included Petal’s equity in the adjusted net income of
Sepal for the six months ended December 31, 2006.
5. On December 31, 2006, the end of the fiscal year, the separate balance sheets for both
companies were as follows:

PETAL CORPORATION AND SUBSIDIARY

Separate Balance Sheets (six months subsequent to business combination)
December 31, 2006

Petal Sepal
Corporation Company
Assets
Cash $ 3,500,000 $ 625,000
Trade accounts receivable (net) 1,400,000 1,500,000
Inventories 1,000,000 2,500,000
Investment in Sepal Company common stock 19,755,000
Plant assets (net) 2,000,000 3,100,000
Other assets 100,000 475,000
Total assets $ 27,755,000 $ 8,200,000

Liabilities and Stockholders’ Equity

Trade accounts payable and other current liabilities $ 1,500,000 $ 1,100,000
Long-term debt 4,000,000 2,600,000
Other liabilities 750,000 250,000
Common stock, $1 par 10,000,000 1,000,000
Additional paid-in capital 5,000,000 400,000
Retained earnings 6,505,000 2,850,000
Total liabilities and stockholders’ equity $ 27,755,000 $ 8,200,000

6. Consolidated goodwill was unimpaired as of December 31, 2006.

Instructions
Prepare a consolidated balance sheet for Petal Corporation and its wholly owned subsidiary,
Sepal Company, on December 31, 2006. Do not use a working paper, but show supporting
computations. (Disregard income taxes.)
Chapter Eight

Consolidated Financial
Statements:
Intercompany
Transactions
Scope of Chapter
This chapter describes and illustrates the accounting and working paper eliminations for
related party transactions between a parent company and its subsidiaries. One class of
transactions does not include intercompany profits (gains) or losses; the other class does.
The accounting techniques for such transactions are designed to ensure that consolidated
financial statements include only those balances and transactions resulting from the
consolidated group’s dealings with outsiders. To this end, separate ledger accounts should
be established for all intercompany assets, liabilities, revenue, and expenses. These sepa-
rate accounts clearly identify the intercompany items that must be eliminated in the prepa-
ration of consolidated financial statements.

ACCOUNTING FOR INTERCOMPANY TRANSACTIONS NOT

INVOLVING PROFIT (GAIN) OR LOSS
Intercompany transactions that do not include an intercompany profit or loss are loans on
promissory notes or open accounts, leases of property under operating leases, and render-
ing of services.

Loans on Notes or Open Accounts

Parent companies generally have more extensive financial resources or bank lines of credit
than do their subsidiaries. Also, it may be more economical in terms of favorable interest
rates for the parent company to carry out all the affiliated group’s borrowings from finan-
cial institutions. Under these circumstances, the parent company may make loans to its sub-
sidiaries for their working capital or other needs. Generally, the rate of interest on such
loans exceeds the parent company’s borrowing rate.
To illustrate, assume that during the year ended December 31, 2007, Palm Corpora-
tion made the following cash loans to its wholly owned subsidiary, Starr Company, on
promissory notes:
322
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 323

Loans by Parent Term of Note,

Company to Wholly Date of Note Months Interest Rates, % Amount
Owned Subsidiary
Feb. 1, 2007 6 10 $10,000
Apr. 1, 2007 6 10 15,000
Sept. 1, 2007 6 10 21,000
Nov. 1, 2007 6 10 24,000

To differentiate properly between intercompany loans and loans with outsiders, Palm
Corporation and Starr Company would use the following ledger accounts to record the
foregoing transactions (assuming all promissory notes were paid when due):

Ledger Accounts of PALM CORPORATION LEDGER STARR COMPANY LEDGER

Parent Company and Intercompany Notes Receivable Intercompany Notes Payable
Subsidiary for 2007 2007 2007 2007
Intercompany Loan
Feb. 1 10,000 Aug. 1 10,000 Aug. 1 10,000 Feb. 1 10,000
Transactions
Apr. 1 15,000 Oct. 1 15,000 Oct. 1 15,000 Apr. 1 15,000
Sept. 1 21,000 Sept. 1 21,000
Nov. 1 24,000 Nov. 1 24,000

Intercompany Interest Receivable Intercompany Interest Payable

2007 2007
Dec. 31 1,100 Dec. 31 1,100

Intercompany Interest Revenue Intercompany Interest Expense

2007 2007
Aug. 1 500 Aug. 1 500
Oct. 1 750 Oct. 1 750
Dec. 31 1,100 Dec. 31 1,100

In the working paper for consolidated financial statements for Palm Corporation and
subsidiary for the year ended December 31, 2007, the foregoing ledger accounts appear as
shown below:

PALM CORPORATION AND SUBSIDIARY

Partial Working Paper for Consolidated Financial Statements
For Year Ended December 31, 2007

Eliminations
Palm Starr Increase
Corporation Company (Decrease) Consolidated
Income Statement
Intercompany revenue
(expenses) 2,350 (2,350)

Balance Sheet
Intercompany receivables
(payables) 46,100* (46,100)

*$45,000 $1,100 $46,100.

324 Part Two Business Combinations and Consolidated Financial Statements

It is apparent from the foregoing illustration that careful identification of intercompany

ledger account balances in the accounting records of the affiliated companies is essential
for correct elimination of the intercompany items in the working paper for consolidated
financial statements.

Discounting of Intercompany Notes

If an intercompany note receivable is discounted at a bank by the payee, the note in effect
is payable to an outsider—the discounting bank. Consequently, discounted intercompany
notes are not eliminated in a working paper for consolidated financial statements.
Suppose, for example, that on December 1, 2007, Palm Corporation had discounted at a
12% discount rate the $24,000 note receivable from Starr Company. Palm would prepare
the following journal entry:

Parent Company’s Cash ($25,200 $1,260) 23,940

Journal Entry for Interest Expense ($1,260 discount $1,000*) 260
Discounting of Note Intercompany Notes Receivable 24,000
Receivable from Intercompany Interest Revenue ($24,000 0.10 1 12) 200
Subsidiary To record discounting of 10%, six-month note receivable from Starr
Company dated Nov. 1, 2007, at a discount rate of 12%. Cash
proceeds are computed as follows:
Maturity value of note
[$24,000 ($24,000 0.10 6 12)] $25,200
Less: Discount ($25,200 0.12 5 12) 1,260
Proceeds $23,940

5
*Interest on note that accrues to discounting bank during discount period: $24,000 0.10 ⁄12 $1,000

The foregoing journal entry recognizes intercompany interest revenue for the one month
the note was held by Palm. This approach is required because Starr recognizes in its ac-
counting records one month of intercompany interest expense on the note.
To assure proper accountability for the $24,000 note, Palm should notify Starr of the
discounting. Starr would then prepare the following journal entry on December 1, 2007:

Subsidiary Journal Intercompany Notes Payable 24,000

Entry for Parent Intercompany Interest Expense 200
Company’s Notes Payable 24,000
Discounting of Note Interest Payable 200
Payable by Subsidiary To transfer 10%, six-month note payable to Palm Corporation dated
to Parent Company Nov. 1, 2007, from intercompany notes to outsider notes. Action is
necessary because Palm Corporation discounted the note on this date.

In the foregoing journal entry, Starr credited Interest Payable rather than Intercompany
Interest Payable for the $200 accrued interest on the note. This approach is required
because the discounting bank, not Palm, is now the payee for the total maturity value of
the note.
Under the note discounting assumption, the ledger accounts related to intercompany
notes would appear in the December 31, 2007, working paper for consolidated financial
statements as follows:
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 325

PALM CORPORATION AND SUBSIDIARY

Partial Working Paper for Consolidated Financial Statements
For Year Ended December 31, 2007

Eliminations
Palm Starr Increase
Corporation Company (Decrease) Consolidated
Income Statement
Intercompany revenue
(expenses) 2,150* (2,150)*

Balance Sheet
Intercompany receivables
(payables) 21,700† (21,700)†

*$200 less than in illustration on page 323 because $24,000 discounted note earned interest for one month rather than two months.
†
$21,000 note dated Sept. 1, 2007, plus $700 accrued interest.

Leases of Property under Operating Leases

If a parent company leases property to a subsidiary, or vice versa, it is essential that both
affiliates use the same accounting principles for the lease. If the lease is an operating lease,
the lessor affiliate recognizes the rental payments as intercompany rent revenue, and the lessee
affiliate recognizes the payments as intercompany rent expense. (For a sales-type/capital
lease,1 the lessor affiliate recognizes a sale of the property, and the lessee affiliate accounts for
the lease as an acquisition of the property. Accounting for a capital lease often involves inter-
company profits or losses, which are discussed in a subsequent section of this chapter.)
To illustrate consolidation techniques for an intercompany operating lease, assume that
Palm Corporation leased space for a sales office to Starr Company under a 10-year lease
dated February 1, 2007. The lease required monthly rentals of $2,500 payable in advance
the first day of each month beginning February 1, 2007.
In the income statement section of the working paper for consolidated financial state-
ments for the year ended December 31, 2007, Palm’s $27,500 ($2,500 11 $27,500) in-
tercompany rent revenue would be offset against Starr’s $27,500 intercompany rent expense
in a manner similar to the offset of intercompany interest revenue and expense illustrated
above. There would be no intercompany assets or liabilities to be offset in an operating
lease for which rent is paid in advance at the beginning of each month.

Rendering of Services
One affiliate may render services to another, with resultant intercompany fee revenue and
expenses. A common example is the management fee charged to subsidiaries by a parent
company that is a holding company with no significant operations.
Management fees often are billed monthly by the parent company, computed as a per-
centage of the subsidiary’s net sales, number of employees, total assets, or some other mea-
sure. No new consolidation problems are introduced by intercompany fee revenue and
expenses. However, care must be taken to make certain that both the parent company and
the subsidiary record the fee billings in the same accounting period.

Income Taxes Applicable to Intercompany Transactions

The intercompany revenue and expense transactions illustrated in this section do not
include an element of intercompany profit (gain) or loss for the consolidated entity. This is

1
The accounting for operating leases and capital leases is explained in intermediate accounting textbooks.
326 Part Two Business Combinations and Consolidated Financial Statements

true because the revenue of one affiliate exactly offsets the expense of the other affiliate in
the income statement section of the working paper for consolidated financial statements.
Consequently, there are no income tax effects associated with the elimination of the inter-
company revenue and expenses, whether the parent company and its subsidiaries file sepa-
rate income tax returns or a consolidated income tax return.

Summary: Intercompany Transactions Not

Involving Profit or Loss
The preceding sections have emphasized the necessity of clearly identifying intercompany
ledger account balances in the accounting records of both the parent company and the sub-
sidiary. This careful identification facilitates the elimination of intercompany items in the
preparation of consolidated financial statements. Sometimes, the separate financial state-
ments of a parent company and a subsidiary include differing amounts for intercompany
items that should offset. Before preparation of the working paper for consolidated financial
statements, journal entries should be prepared to correct intercompany balances or to bring
such balances up to date.

ACCOUNTING FOR INTERCOMPANY TRANSACTIONS

INVOLVING PROFIT (GAIN) OR LOSS
Many business transactions between a parent company and its subsidiaries involve a profit
(gain) or loss. Among these transactions are intercompany sales of merchandise, intercom-
pany sales of plant assets, intercompany leases of property under capital/sales-type leases,
and intercompany sales of intangible assets. Until intercompany profits or losses in such
transactions are realized through the sale of the asset to an outsider or otherwise, the un-
realized profits or losses must be eliminated in the preparation of consolidated financial
statements.
In addition, a parent or subsidiary company’s acquisition of its affiliate’s bonds in
the open market may result in a realized gain or loss to the consolidated entity. Such a
realized gain or loss is not recognized in the separate income statement of either the par-
ent company or the subsidiary, but it must be recognized in the consolidated income
statement.
The remainder of this chapter discusses and illustrates the working paper eliminations
for intercompany transactions of the types described above. The focus is on intercompany
transactions involving profits (gains), although such transactions also may involve losses.

Importance of Eliminating or Including Intercompany Profits

(Gains) and Losses
The importance of eliminating unrealized intercompany profits (gains) and losses and
recognizing realized gains or losses in the preparation of consolidated income state-
ments cannot be overemphasized. Failure to eliminate unrealized profits and losses
would result in consolidated income statements that report not only results of transac-
tions with those outside the consolidated entity but also the results of related party ac-
tivities within the affiliated group. Similarly, nonrecognition of realized gains and losses
would misstate consolidated net income. The parent company’s management would have
free rein to manipulate consolidated net income (“manage earnings”) if unrealized in-
tercompany profits and losses were not eliminated in the preparation of consolidated
income statements.
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 327

INTERCOMPANY SALES OF MERCHANDISE

Intercompany sales of merchandise are a natural outgrowth of vertical business combina-
tions, which involve a combinor and one or more of its customers or suppliers as combinees.
Downstream intercompany sales of merchandise are those from a parent company to its sub-
sidiaries. Upstream intercompany sales are those from subsidiaries to the parent company.
Lateral intercompany sales are between two subsidiaries of the same parent company.
The intercompany sales of merchandise between a parent company and its subsidiary
are similar to the intracompany shipments of merchandise by a home office to a branch,
described in Chapter 4.

Intercompany Sales of Merchandise at Cost

Intercompany sales of merchandise may be made at a price equal to the selling company’s
cost. If so, the working paper elimination is the same, whether all the goods were sold by
the purchasing affiliate or whether some of the goods remained in the purchaser’s invento-
ries on the date of the consolidated financial statements. For example, assume that Palm
Corporation (the parent company) during the year ended December 31, 2007, sold mer-
chandise costing $150,000 to Starr Company (the subsidiary) at a selling price equal to
the cost of the merchandise. Assume further that Starr’s December 31, 2007, inventories in-
cluded $25,000 of merchandise obtained from Palm and that Starr still owed Palm $15,000
for merchandise purchases on December 31, 2007. (Starr also had purchased merchandise
from other suppliers during Year 2007.)
The two companies would prepare the following aggregate journal entries for the fore-
going transactions, assuming that both companies used the perpetual inventory system:
Journal Entries for Parent Company’s Downstream Sales of Merchandise to Subsidiary at Cost and
Subsidiary’s Sales of Merchandise to Outsiders

Palm Corporation Journal Entries Starr Company Journal Entries

Intercompany Accounts Inventories 150,000

Receivable 150,000 Intercompany Accounts
Intercompany Sales 150,000 Payable 150,000
To record sales to Starr Company. To record purchases from Palm
Corporation.
Intercompany Cost of Goods
Sold 150,000
Inventories 150,000
To record cost of goods sold to
Starr Company.

Cash 135,000 Intercompany Accounts Payable 135,000

Intercompany Accounts Cash 135,000
Receivable 135,000 To record payments made to
To record payments received Palm Corporation.
from Starr Company.
Trade Accounts Receivable 160,000
Sales 160,000
To record sales.

Cost of Goods Sold 125,000

Inventories 125,000
To record cost of goods sold.
328 Part Two Business Combinations and Consolidated Financial Statements

The working paper for consolidated financial statements for Palm Corporation and
subsidiary for the year ended December 31, 2007, would include the following data with
regard to intercompany sales of merchandise only:

Partial Working Paper PALM CORPORATION AND SUBSIDIARY

for Consolidated Partial Working Paper for Consolidated Financial Statements
Financial Statements— For Year Ended December 31, 2007
Intercompany Sales of
Eliminations
Merchandise at Cost
Palm Starr Increase
Corporation Company (Decrease) Consolidated
Income Statement
Intercompany revenue
(expenses) *

Balance Sheet
Intercompany receivable
(payable) 15,000 (15,000)

*Palm Corporation’s $150,000 intercompany sales and intercompany cost of goods sold are offset in Palm’s separate income statement
in the working paper.

Note that Starr Company’s cost of goods sold for Year 2007 and inventories on Decem-
ber 31, 2007, are not affected by working paper eliminations. From a consolidated entity
viewpoint, both Starr’s cost of goods sold and Starr’s inventories are stated at cost; no ele-
ment of intercompany profit or loss is involved.

Unrealized Intercompany Profit in Ending Inventories

More typical than the intercompany sales of merchandise at cost described in the preced-
ing section are intercompany sales involving a gross profit. The gross profit margin may
be equal to, more than, or less than the margin on sales to outsiders. The selling affiliate’s
intercompany gross profit is realized through the purchasing affiliate’s sales of the ac-
quired merchandise to outsiders. Consequently, any merchandise purchased from an af-
filiated company that remains unsold on the date of a consolidated balance sheet results in
the overstatement (from a consolidated point of view) of the purchaser’s ending invento-
ries. The overstatement is equal to the amount of the selling affiliate’s unrealized inter-
company gross profit included in the ending inventories. This overstatement is canceled
through an appropriate working paper elimination in the preparation of consolidated
financial statements.
Suppose, for example, that Sage Company (the 95%-owned subsidiary) during the year
ended December 31, 2007, began selling merchandise to Post Corporation (the parent
company) at a gross profit margin of 20%. Sales by Sage to Post for the year totaled
$120,000, of which $40,000 remained unsold by Post on December 31, 2007. On that date,
Post owed $30,000 to Sage for merchandise. Both companies used the perpetual inventory
system.
The transactions described in the foregoing paragraph are recorded in summary form by
the two companies as follows:
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 329

Journal Entries for Partially Owned Subsidiary’s Upstream Sales of Merchandise to Parent Company
at a Gross Profit and Parent’s Sales of the Merchandise to Outsiders

Post Corporation Journal Entries Sage Company Journal Entries

Inventories 120,000 Intercompany Accounts

Intercompany Accounts Receivable 120,000
Payable 120,000 Intercompany Sales 120,000
To record purchases from Sage To record sales to Post
Company. Corporation.

Intercompany Cost of Goods

Sold 96,000
Inventories 96,000
To record cost of goods sold to
Post Corporation.

Intercompany Accounts Payable 90,000 Cash 90,000

Cash 90,000 Intercompany Accounts
To record payments made to Receivable 90,000
Sage Company. To record payments received
from Post Corporation.
Trade Accounts Receivable 100,000
Sales 100,000
To record sales.

Cost of Goods Sold 80,000

Inventories 80,000
To record cost of goods sold.

The intercompany gross profit in Sage’s sales to Post during the year ended Decem-
ber 31, 2007, is analyzed as follows:

Analysis of Gross Gross Profit

Profit Margin in (25% of Cost; 20%
Partially Owned Selling Price Cost of Selling Price)
Subsidiary’s Upstream
Beginning inventories
Sales of Merchandise
Add: Sales $120,000 $96,000 $24,000
to Parent Company
Subtotals $120,000 $96,000 $24,000
for First Year
Less: Ending
inventories 40,000 32,000 8,000
Cost of goods sold $ 80,000 $64,000 $16,000

The foregoing analysis shows that the intercompany gross profit on sales by Sage to Post
totaled $24,000, and that $16,000 of this intercompany profit was realized through Post’s
sales of the acquired merchandise to outside customers. The remaining $8,000 of inter-
company profit remains unrealized in Post’s inventories on December 31, 2007.
The following working paper elimination (in journal entry format) is required for
Sage’s intercompany sales of merchandise to Post for the year ended December 31,
2007:
330 Part Two Business Combinations and Consolidated Financial Statements

Working Paper POST CORPORATION AND SUBSIDIARY

Elimination for First Partial Working Paper Eliminations
Year of Intercompany December 31, 2007
Sales of Merchandise
at a Gross Profit (b) Intercompany Sales—Sage 120,000
Margin Intercompany Cost of Goods Sold—Sage 96,000
Cost of Goods Sold—Post 16,000
Inventories—Post 8,000
To eliminate intercompany sales, cost of goods sold, and unrealized
intercompany profit in inventories. (Income tax effects are disregarded.)

The effects of the foregoing elimination are as follows: First, it eliminates Sage’s inter-
company sales to Post and the related intercompany cost of goods sold; this avoids the over-
statement of the consolidated amounts for sales and cost of goods sold, which should
represent merchandise transactions with customers outside the consolidated entity. Second,
the elimination removes the intercompany gross profit from Post’s cost of goods sold, thus
restating it to the cost of the consolidated entity. Finally, the elimination reduces the con-
solidated inventories to actual cost for the consolidated entity.
Entering the preceding elimination in the working paper for consolidated financial state-
ments results in the consolidated amounts shown below (amounts for total sales to outsiders
and cost of goods sold are assumed):

Partial Working Paper POST CORPORATION AND SUBSIDIARY

for Consolidated Partial Working Paper for Consolidated Financial Statements
Financial Statements— For Year Ended December 31, 2007
First Year of Inter-
Eliminations
company Sales of
Post Sage Increase
Merchandise at a
Corporation Company (Decrease) Consolidated
Gross Profit
Income Statement
Revenue:
Sales 5,800,000 1,200,000 7,000,000
Intercompany sales 120,000 (b) (120,000)
Costs and expenses:
Cost of goods sold 4,100,000 760,000 (b) (16,000) 4,844,000
Intercompany cost of
goods sold 96,000 (b) (96,000)

Balance Sheet
Assets
Intercompany receivable
(payable) (30,000) 30,000
Inventories 900,000 475,000 (b) (8,000) 1,367,000

Note that the $120,000 elimination of intercompany sales, less the $112,000 total
($16,000 $96,000 $112,000) of the two cost of goods sold eliminations, equals
$8,000 — the amount of the intercompany profit eliminated from inventories. This $8,000
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 331

unrealized intercompany profit is attributable to Sage Company—the seller of the mer-

chandise—and must be taken into account in the computation of the minority interest in
Sage’s net income for the year ended December 31, 2007. The $8,000 also enters into the
computation of Sage’s portion of consolidated retained earnings on December 31, 2007.
These procedures are illustrated in the following sections.
If the intercompany sales of merchandise are made by a parent company or by a wholly
owned subsidiary, there is no effect on any minority interest in net income or loss, because
the selling affiliate does not have minority stockholders. Thus, it is important to identify,
by company name, the financial statement items that are affected by working paper elimi-
nations for intercompany sales of merchandise, so that the minority interest in net income
or loss of a partially owned subsidiary that makes upstream or lateral sales of merchandise
at a gross profit may be computed correctly.

Intercompany Profit in Beginning and Ending Inventories

The working paper elimination for intercompany sales of merchandise is complicated by
intercompany profits in the beginning inventories of the purchaser. It is generally assumed
that, on a first-in, first-out basis, the intercompany profit in the purchaser’s beginning in-
ventories is realized through the purchaser’s sales of the merchandise to outsiders during
the ensuing accounting period. Only the intercompany profit in ending inventories remains
unrealized at the end of the period.
Continuing the illustration from the preceding section, assume that Sage Company’s in-
tercompany sales of merchandise to Post Corporation during the year ended December 31,
2008, are:

Analysis of Gross Gross Profit

Profit Margin in (25% of Cost; 20%
Partially Owned Selling Price Cost of Selling Price)
Subsidiary’s Upstream
Beginning inventories $ 40,000 $ 32,000 $ 8,000
Sales of Merchandise
Add: Sales 150,000 120,000 30,000
to Parent Company
Subtotals $190,000 $152,000 $38,000
for Second Year
Less: Ending
inventories 60,000 48,000 12,000
Cost of goods sold $130,000 $104,000 $26,000

Sage’s intercompany sales and intercompany cost of goods sold for the year ended
December 31, 2007, had been closed with other income statement amounts to Sage’s
Retained Earnings ledger account. Consequently, from a consolidated point of view,
Sage’s December 31, 2007, retained earnings was overstated by $7,600 (95% of the
$8,000 unrealized intercompany profit in Post’s inventories on December 31, 2007). The
remaining $400 of unrealized profit on December 31, 2007, is attributable to the minor-
ity interest in net assets of Sage Company, the seller of the merchandise. The following
working paper elimination (in journal entry format) on December 31, 2008, reflects
these facts:
332 Part Two Business Combinations and Consolidated Financial Statements

Working Paper POST CORPORATION AND SUBSIDIARY

Elimination for Second Partial Working Paper Eliminations
Year of Intercompany December 31, 2008
Sales of Merchandise
at a Gross Profit (b) Retained Earnings—Sage ($8,000 0.95)* 7,600
Margin Minority Interest in Net Assets of Subsidiary ($8,000 0.05) 400
Intercompany Sales—Sage 150,000
Intercompany Cost of Goods Sold—Sage 120,000
Cost of Goods Sold—Post 26,000
Inventories—Post 12,000
To eliminate intercompany sales, cost of goods sold, and
unrealized intercompany profits in inventories. (Income tax
effects are disregarded.)

*As indicated in Chapter 7 (page 267), this elimination is posted to the beginning-of-year retained earnings in the statement of retained
earnings section of the working paper for consolidated financial statements.

Intercompany Profit in Inventories and

Amount of Minority Interest
Accountants have given considerable thought to intercompany profits in purchases and
sales transactions of partially owned subsidiaries. There is general agreement that all the
unrealized intercompany profit in a partially owned subsidiary’s ending inventories should
be eliminated for consolidated financial statements. This holds true whether the sales to
the subsidiary are downstream from the parent company or are made by a wholly owned
subsidiary of the same parent.
There has been no such agreement on the treatment of intercompany profit in the parent
company’s or a subsidiary’s inventories from upstream or lateral sales by a partially owned
subsidiary. Two alternative approaches have been suggested.
1. The first approach is elimination of intercompany profit only to the extent of the par-
ent company’s ownership interest in the selling subsidiary’s common stock. This ap-
proach is based on the parent company concept of consolidated financial statements
(see Chapter 6, pages 225 and 226), in which the minority interest is considered to be
a liability of the consolidated entity. If the minority stockholders are considered
outside creditors, intercompany profit in the parent company’s ending inventories has
been realized to the extent of the minority stockholders’ interest in the selling
subsidiary.
2. The second approach is elimination of all the intercompany profit. The economic unit
concept of consolidated financial statements (see Chapter 6, pages 226 and 227), in
which the minority interest is considered to be a part of consolidated stockholders’
equity, underlies this approach. If minority stockholders are part owners of consolidated
assets, their share of intercompany profits in inventories has not been realized.
The FASB expressed a preference for the second approach, in the following passage:
The effects on equity of eliminating intercompany profits and losses on assets that remain
within the group shall be allocated between the controlling interest and the noncontrolling
interest on the basis of their proportionate interests in the selling affiliate.2

2
Proposed Statement of Financial Accounting Standards, “Consolidated Financial Statements: Policy and
Procedures” (Norwalk: FASB, 1995), par. 19.
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 333

Consequently, intercompany profits or losses in inventories resulting from upstream or

lateral sales of merchandise by a partially owned subsidiary must be considered in the
computation of the minority interest in net income of the subsidiary, and in the computa-
tion of the portion of retained earnings of the subsidiary to be included in consolidated
retained earnings. The subsidiary’s net income must be increased by the realized inter-
company profit in the purchasing affiliate’s beginning inventories and decreased by the
unrealized intercompany profit in the purchasing affiliate’s ending inventories. Failure to
do so would attribute the entire intercompany profit effects to the consolidated net income.
(See page 354 for an illustration of the computation of minority interest in net income of a
partially owned subsidiary that makes intercompany sales of merchandise.)

Should Net Profit or Gross Profit Be Eliminated?

Some accountants have discussed the propriety of eliminating intercompany net profit,
rather than gross profit, in inventories of the consolidated entity. There is little theoretical
support for such a proposal. First, elimination of intercompany net profit would in effect
capitalize operating (selling and administrative) expenses in consolidated inventories. Sell-
ing expenses are always period costs, and only in unusual circumstances are some admin-
istrative expenses capitalized in inventories as product costs. Second, the measurement of
net profit for particular merchandise requires many assumptions as to allocations of com-
mon costs.

INTERCOMPANY SALES OF PLANT ASSETS

Intercompany sales of plant assets differ from intercompany sales of merchandise in two re-
spects. First, intercompany sales of plant assets between affiliated companies are rare trans-
actions. In contrast, intercompany sales of merchandise occur frequently, once a program
of such sales has been established. Second, the relatively long economic lives of plant as-
sets require the passage of many accounting periods before intercompany gains or losses on
sales of these assets are realized in transactions with outsiders. Conversely, intercompany
profits in consolidated inventories at the end of one accounting period usually are realized
through the purchaser’s sale of the merchandise to outsiders during the ensuing period.
These differences are illustrated in the working paper elimination for intercompany gains
or losses on sales of plant assets described in the following sections.

Intercompany Gain on Sale of Land

Suppose that, during the year ended December 31, 2007, Post Corporation (the parent com-
Journal Entries for pany) sold to Sage Company (the partially owned subsidiary) for $175,000 a parcel of land
Parent Company’s that had cost Post $125,000. Sage acquired the land for a new building site. The two com-
Downstream Sale of panies would record the transaction as follows (disregarding income tax effects to Post
Land to Partially Corporation):
Owned Subsidiary

Post Corporation Journal Entry Sage Company Journal Entry

Cash 175,000 Land 175,000

Land 125,000 Cash 175,000
Intercompany To record acquisition of land
Gain on Sale of Land 50,000 from Post Corporation.
To record sale of land to Sage
Company.
334 Part Two Business Combinations and Consolidated Financial Statements

In consolidated financial statements for the year ended December 31, 2007, the land
must be valued at its historical cost to the consolidated entity. Also, the $50,000 intercom-
pany gain must be eliminated, because it has not been realized in a transaction with an out-
sider. Accordingly, the following working paper elimination (in journal entry format) is
required on December 31, 2007:

Working Paper POST CORPORATION AND SUBSIDIARY

Elimination for Year Partial Working Paper Eliminations
of Intercompany Sale December 31, 2007
of Land at a Gain
(c) Intercompany Gain on Sale of Land—Post 50,000
Land—Sage 50,000
To eliminate unrealized intercompany gain on sale of land. (Income
tax effects are disregarded.)

The working paper elimination is entered as follows in the working paper for consoli-
dated financial statements for the year ended December 31, 2007:

Partial Working Paper POST CORPORATION AND SUBSIDIARY

for Consolidated Partial Working Paper for Consolidated Financial Statements
Financial For Year Ended December 31, 2007
Statements—Year of
Elimination
Intercompany Sale
Post Sage Increase
of Land at a Gain
Corporation Company (Decrease) Consolidated
Income Statement
Intercompany gain
on sale of land 50,000 (c) (50,000)

Balance Sheet
Land (for building 175,000 (c) (50,000) 125,000
site)

Because land is not a depreciable plant asset, in subsequent years no journal entries
affecting the land would be made by Sage unless the land were resold to an outsider (or
back to Post). Nevertheless, in ensuing years, as long as Sage owns the land, its $175,000
cost to Sage is overstated $50,000 for consolidated financial statement purposes. Because
the intercompany gain of $50,000 on the sale of land was closed with other income state-
ment amounts to Post’s Retained Earnings ledger account on December 31, 2007, the fol-
lowing working paper elimination (in journal entry format) is required for Year 2008 and
subsequent years:

Working Paper POST CORPORATION AND SUBSIDIARY

Elimination for Years Partial Working Paper Eliminations
Subsequent to December 31, 2008
Intercompany Sale
of Land at a Gain (c) Retained Earnings—Post 50,000
Land—Sage 50,000
To eliminate unrealized intercompany gain in land. (Income tax
effects are disregarded.)
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 335

The foregoing working paper elimination has no effect on the minority interest in the net
income or net assets of the subsidiary, because the unrealized gain was attributable en-
tirely to the parent company, the seller.
Suppose that, instead of constructing a building on the land, Sage sold the land to an
outsider for $200,000 during the year ended December 31, 2009. Sage would prepare the
following journal entry to record the sale:

Subsidiary’s Journal Cash 200,000

Entry for Sale of Land Land 175,000
to an Outsider Gain on Sale of Land 25,000
To record sale of land to an outsider.

The consolidated income statement for the year ended December 31, 2009, must show
that, for consolidated purposes, a $75,000 gain was realized on Sage’s sale of the land. This
$75,000 gain consists of the $25,000 gain recognized by Sage and the previously unreal-
ized $50,000 intercompany gain on Post’s sale of the land to Sage two years earlier. The fol-
lowing working paper elimination (in journal entry format) is required on December 31,
2009:

Working Paper POST CORPORATION AND SUBSIDIARY

Elimination to Partial Working Paper Eliminations
Recognize Realization December 31, 2009
of Intercompany Gain
on Sale of Land (c) Retained Earnings—Post 50,000
Gain on Sale of Land—Post 50,000
To recognize $50,000 gain on Post Corporation’s sale of land to Sage
Company resulting from sale of land by Sage to an outsider.
(Income tax effects are disregarded.)

No further eliminations with respect to the land would be required after 2009.

Intercompany Gain on Sale of Depreciable Plant Asset

Periodic depreciation expense causes a significant difference in the working paper elimina-
tions for an unrealized intercompany gain on the sale of a depreciable plant asset, compared
with the eliminations described in the preceding section. Because the unrealized intercom-
pany gain must be eliminated from the valuation of the depreciable asset in a consolidated
balance sheet, the appropriate gain element also must be eliminated from the related de-
preciation expense in a consolidated income statement. This concept is illustrated in the fol-
lowing pages.

Intercompany Gain on Date of Sale of Depreciable Plant Asset

The date-of-sale working paper elimination for the intercompany sale of a depreciable plant
asset is identical to the comparable elimination for land. On the date of sale, no deprecia-
tion expense has been recognized by the affiliate that acquired the plant asset.
To illustrate, assume that on December 31, 2007, Sage Company (the partially owned
subsidiary) sold some of its production machinery to Post Corporation (the parent com-
pany). Details of the sale and depreciation policy of the machinery are as follows:
336 Part Two Business Combinations and Consolidated Financial Statements

Details of Machinery Selling price of machinery to Post Corporation $ 60,000

Sold Upstream to Cost of machinery to Sage Company when acquired Jan. 2, 2005 50,000
Parent Company by Estimated residual value:
Partially Owned To Sage Company, Jan. 2, 2005 $ 4,000
Subsidiary To Post Corporation, Dec. 31, 2007 4,000
Economic life:
To Sage Company, Jan. 2, 2005 10 years
To Post Corporation, Dec. 31, 2007 5 years
Annual depreciation expense (straight-line method):
To Sage Company ($46,000 0.10) $ 4,600
To Post Corporation ($56,000 0.20) 11,200

The two companies would account for the sale on December 31, 2007, as follows:

Journal Entries for Post Corporation Journal Entry Sage Company Journal Entry
Partially Owned
Subsidiary’s Upstream Machinery 60,000 Cash 60,000
Sale of Machinery to Cash 60,000 Accumulated
Parent Company To record acquisition Depreciation
of machinery from ($4,600 3) 13,800
Sage Company. Machinery 50,000
Intercompany
Gain on sale
of Machinery 23,800
To record sale of
machinery to Post
Corporation.

The following working paper elimination (in journal entry format) is required for con-
solidated financial statements on December 31, 2007, the date of intercompany sale of the
machinery:

Working Paper POST CORPORATION AND SUBSIDIARY

Elimination on Date of Partial Working Paper Eliminations
Intercompany Sale of December 31, 2007
Machinery at a Gain
(d) Intercompany Gain on Sale of Machinery—Sage 23,800
Machinery—Post 23,800
To eliminate unrealized intercompany gain on sale of machinery.
(Income tax effects are disregarded.)

The elimination results in the machinery’s being valued in the consolidated balance
sheet at its carrying amount to Sage Company—the seller—as follows:

Effect of Elimination Cost of machinery to Post Corporation (acquirer parent company) $60,000
of Unrealized Less: Amount of elimination—intercompany gain 23,800
Intercompany Profit Difference—equal to carrying amount [cost ($50,000), less accumulated
on Upstream Sale of depreciation ($13,800)] of machinery to Sage Company (seller subsidiary) $36,200
Machinery
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 337

Elimination of the $23,800 intercompany gain on the sale of machinery is taken into ac-
count in the computation of the minority interest in the net income of the partially owned
subsidiary—the seller—for Year 2007. The $23,800 elimination also enters into the com-
putation of Sage’s retained earnings, for consolidation purposes, on December 31, 2007.
These matters are also illustrated on pages 353–354.

Intercompany Gain Subsequent to Date of Sale of Depreciable Plant Asset

An appropriate intercompany gain element must be eliminated from depreciation expense
for a plant asset acquired by one affiliate from another at a gain. The following working
paper elimination (in journal entry format) for Post Corporation and subsidiary on Decem-
ber 31, 2008 (one year after the intercompany sale of machinery), illustrates this point:

Working Paper POST CORPORATION AND SUBSIDIARY

Elimination for First Partial Working Paper Eliminations
Year Subsequent to December 31, 2008
Intercompany Sale of
Machinery at a Gain (d) Retained Earnings—Sage ($23,800 0.95) 22,610
Minority Interest in Net Assets of Subsidiary ($23,800 0.05) 1,190
Accumulated Depreciation—Post 4,760
Machinery—Post 23,800
Depreciation Expense—Post 4,760
To eliminate unrealized intercompany gain in machinery and in related
depreciation. (Income tax effects are disregarded.) Gain element
in straight-line depreciation computed as $23,800 0.20 $4,760,
based on five-year economic life.

Because Sage Company’s intercompany gain on sale of the machinery was closed to
Sage’s Retained Earnings ledger account on December 31, 2007, the working paper elimi-
nation on December 31, 2008, corrects the overstatement of Sage’s beginning-of-year
retained earnings from the viewpoint of the consolidated entity. In addition, the minority
interest’s share of the overstatement in the beginning retained earnings of Sage is recorded.
The intercompany gain eliminated from Post Corporation’s depreciation expense may be
verified as follows:

Verification of Post’s annual straight-line depreciation expense [($60,000 $4,000) 0.20] $11,200
Intercompany Gain Less: Straight-line depreciation expense for a five-year economic life, based
Element in on Sage’s carrying amount on date of sale [($36,200 $4,000) 0.20] 6,440
Depreciation Expense Difference—equal to intercompany gain element in Post’s
of Parent Company annual depreciation expense $ 4,760

Intercompany Gain in Depreciation and Minority Interest

From the point of view of the consolidated entity, the intercompany gain element of the
acquiring affiliate’s annual depreciation expense represents a realization of a portion of
the total intercompany gain by the selling affiliate. Depreciation, in this view, is in effect an
indirect sale of a portion of the machinery to the customers of Post Corporation—the
acquirer of the machinery. The selling prices of Post’s products produced by the machinery
are established at amounts adequate to cover all costs of producing the products, including
depreciation expense.
338 Part Two Business Combinations and Consolidated Financial Statements

Thus, the $4,760 credit to Post’s depreciation expense in the December 31, 2008, work-
ing paper elimination illustrated above in effect increases Sage’s net income for consoli-
dated purposes. This increase must be considered in the computation of the minority
interest in the subsidiary’s net income for the year ended December 31, 2008, and of the
amount of the subsidiary’s retained earnings included in consolidated retained earnings
on that date, as illustrated on page 360.

Intercompany Gain in Later Years

Working paper eliminations for later years in the economic life of the machinery sold at an
intercompany gain must reflect the fact that the intercompany gain element in the acquir-
ing affiliate’s annual depreciation expense in effect represents a realization of a portion of
the total intercompany gain by the selling affiliate. For example, the working paper elimi-
nation (in journal entry format) for Post Corporation and subsidiary on December 31, 2009
(two years following the intercompany sale of the machinery), is as follows:

Working Paper POST CORPORATION AND SUBSIDIARY

Elimination for Second Partial Working Paper Eliminations
Year Subsequent to December 31, 2009
Intercompany Sale of
Machinery at a Gain (d) Retained Earnings—Sage [($23,800 $4,760) 0.95] 18,088
Minority Interest in Net Assets of Subsidiary
[($23,800 $4,760) 0.05] 952
Accumulated Depreciation—Post ($4,760 2) 9,520
Machinery—Post 23,800
Depreciation Expense—Post 4,760
To eliminate unrealized intercompany gain in machinery and related
depreciation. (Income tax effects are disregarded.)

The credit amounts of the foregoing elimination for Year 2009 are the same as those for
Year 2008. The credit amounts will remain unchanged for all working paper eliminations
during the remaining economic life of the machinery, because of the parent company’s use
of the straight-line method of depreciation. The $19,040 total ($18,088 $952 $19,040)
of the debits to Sage’s retained earnings and to the minority interest in net assets of sub-
sidiary represents the unrealized portion of the total intercompany gain at the beginning
of Year 2009. Each succeeding year, the unrealized portion of the total intercompany gain
decreases, as indicated by the following summary of the working paper elimination debits
for those years:

Debit Elements of POST CORPORATION AND SUBSIDIARY

Working Paper Partial Working Paper Eliminations—Debits Only
Eliminations for Third, December 31, 2010 through 2012
Fourth, and Fifth Years
Year Ended Dec. 31,
Subsequent to
Intercompany Sale of 2010 2011 2012
Machinery at a Gain
Debits
(d) Retained earnings—Sage $13,566 $ 9,044 $ 4,522
Minority interest in net assets of subsidiary 714 476 238
Accumulated depreciation—Post 14,280 19,040 23,800
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 339

At the end of Year 2012, the entire $23,800 of intercompany gain has been realized
through Post Corporation’s annual depreciation expense. Thereafter, the working paper
elimination below (in journal entry format) is required for the machinery until it is sold or
scrapped:

Working Paper POST CORPORATION AND SUBSIDIARY

Elimination Following Partial Working Paper Eliminations
End of Economic Life December 31, 2013
of Machinery Sold at
an Intercompany Gain Accumulated Depreciation—Post 23,800
Machinery—Post 23,800
To eliminate intercompany gain in machinery and related accumulated
depreciation. (Income tax effects are disregarded.)

INTERCOMPANY LEASE OF PROPERTY UNDER

CAPITAL/SALES-TYPE LEASE
Land and buildings, machinery and equipment, and other property may be transferred from
one affiliate to another under a lease that is a sales-type lease to the lessor and a capital
lease to the lessee.3 If so, a number of intercompany ledger accounts must be established
by both the lessor and the lessee to account for the lease.
To illustrate, assume that on January 2, 2007, Palm Corporation (the parent company)
leased equipment carried in its inventory to Starr Company (the wholly owned sub-
sidiary) under a four-year sales-type lease requiring Starr to pay Palm $10,000 on each
January 2, 2007 through 2010, with a bargain purchase option of $1,000 payable on Jan-
uary 2, 2011. Palm’s implicit interest rate, which was known to Starr and was less than
Starr’s incremental borrowing rate, was 8%. The economic life of the equipment to Starr
was six years, with no residual value. The cost of the leased equipment, which had been
carried in Palm’s Inventories ledger account, was $30,000, and there were no initial direct
costs under the lease.
The present value of the minimum lease payments, which constitutes Palm’s net invest-
ment in the lease, is computed as follows (using a calculator or present value tables):

Computation of Present value of $10,000 each year for four years at

Present Value of 8% ($10,000 3.577097) $35,771
Minimum Lease Present value of $1,000 in four years at 8% ($1,000 0.735030) 735
Payments Palm Corporation’s net investment in the lease $36,506

The journal entries of Palm Corporation and Starr Company for Year 2007, the first year
of the lease, are on page 340, and selected ledger accounts for both companies relative to
the lease are shown on pages 341–343.

3
Accounting for leases is discussed and illustrated in intermediate accounting textbooks.
340 Part Two Business Combinations and Consolidated Financial Statements

Parent Company’s PALM CORPORATION

(Lessor’s) Journal Journal Entries
Entries for First Year
of Intercompany Sales- 2007
Type Lease Jan. 2 Intercompany Lease Receivables
[($10,000 4) $1,000] 41,000
Intercompany Cost of Goods Sold 30,000
Intercompany Sales 36,506
Unearned Intercompany Interest Revenue
($41,000 $36,506) 4,494
Inventories 30,000
To record sales-type lease with Starr Company at inception
and cost of leased equipment.

2 Cash 10,000
Intercompany Lease Receivables 10,000
To record receipt of first payment on intercompany lease.

Dec. 31 Unearned Intercompany Interest Revenue

[($31,000 $4,494) 0.08] 2,120
Intercompany Interest Revenue 2,120
To recognize interest earned for first year of intercompany
sales-type lease.

Subsidiary’s (Lessee’s) STARR COMPANY

Journal Entries for Journal Entries
First Year of
Intercompany Capital 2007
Lease Jan. 2 Leased Equipment—Capital Lease 36,506
Intercompany Liability under Capital Lease (net) 36,506
To record intercompany capital lease at inception.

2 Intercompany Liability under Capital Lease (net) 10,000

Cash 10,000
To record lease payment for first year of intercompany lease.

Dec. 31 Intercompany Interest Expense

[($36,506 $10,000) 0.08] 2,120
Intercompany Interest Payable 2,120
To record accrued interest on intercompany lease
obligation on Dec. 31, 2007.

31 Depreciation Expense ($36,506 6) 6,084

Leased Equipment—Capital Lease 6,084
To record depreciation expense (straight-line method) for first
year of intercompany lease. (Six-year economic life of
leased equipment is used because lease contains a bargain
purchase option.)
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 341

Parent Company’s PALM CORPORATION

(Lessor’s) Ledger Ledger Accounts
Accounts for
Intercompany Sales- Intercompany Lease Receivables
Type Lease Date Explanation Debit Credit Balance
2007
Jan. 2 Inception of lease 41,000 41,000 dr
2 Receipt of first payment 10,000 31,000 dr
2008
Jan. 2 Receipt of second payment 10,000 21,000 dr
2009
Jan. 2 Receipt of third payment 10,000 11,000 dr
2010
Jan. 2 Receipt of fourth payment 10,000 1,000 dr
2011
Jan. 2 Receipt of purchase option 1,000 -0-

Unearned Intercompany Interest Revenue

Date Explanation Debit Credit Balance
2007
Jan. 2 Inception of lease ($41,000 $36,506) 4,494 4,494 cr
Dec. 31 Interest for year
[($31,000 $4,494) 0.08] 2,120 2,374 cr
2008
Dec. 31 Interest for year
[($21,000 $2,374) 0.08] 1,490 884 cr
2009
Dec. 31 Interest for year
[($11,000 $884) 0.08] 809 75 cr
2010
Dec. 31 Interest for year [($1,000 $75) 0.08] 75* -0-

*Adjusted $1 for rounding.

Intercompany Interest Revenue

Date Explanation Debit Credit Balance
2007
Dec. 31 Interest for Year 2007 2,120 2,120 cr
31 Closing entry 2,120 -0-
2008
Dec. 31 Interest for Year 2008 1,490 1,490 cr
31 Closing entry 1,490 -0-
2009
Dec. 31 Interest for Year 2009 809 809 cr
31 Closing entry 809 -0-
2010
Dec. 31 Interest for Year 2010 75* 75 cr
31 Closing entry 75 -0-

*Adjusted $1 for rounding.

342 Part Two Business Combinations and Consolidated Financial Statements

Subsidiary’s (Lessee’s) STARR COMPANY

Ledger Accounts for Ledger Accounts
Intercompany Capital
Lease Leased Equipment—Capital Lease
Date Explanation Debit Credit Balance
2007
Jan. 2 Capital lease at inception 36,506 36,506 dr
Dec. 31 Depreciation for Year 2007 6,084 30,422 dr
2008
Dec. 31 Depreciation for Year 2008 6,084 24,338 dr
2009
Dec. 31 Depreciation for Year 2009 6,084 18,254 dr
2010
Dec. 31 Depreciation for Year 2010 6,084 12,170 dr
2011
Dec. 31 Depreciation for Year 2011 6,085* 6,085 dr
2012
Dec. 31 Depreciation for Year 2012 6,085* -0-

*Adjusted $1 for rounding.

Intercompany Liability under Capital Lease

Date Explanation Debit Credit Balance
2007
Jan. 2 Capital lease at inception 36,506 36,506 cr
2 First lease payment 10,000 26,506 cr
2008
Jan. 2 ($10,000 $2,120 interest) 7,880 18,626 cr
2009
Jan. 2 ($10,000 $1,490 interest) 8,510 10,116 cr
2010
Jan. 2 ($10,000 $809 interest) 9,191 925 cr
2011
Jan. 2 ($1,000 $77 interest) 925 -0-

Intercompany Interest Expense

Date Explanation Debit Credit Balance
2007
Dec. 31 ($26,506 0.08) 2,120 2,120 dr
31 Closing entry 2,120 -0-
2008
Dec. 31 ($18,626 0.08) 1,490 1,490 dr
31 Closing entry 1,490 -0-
2009
Dec. 31 ($10,116 0.08) 809 809 dr
31 Closing entry 809 -0-
2010
Dec. 31 ($925 0.08) 75* 75 dr
31 Closing entry 75 -0-

*Adjusted $1 for rounding.

 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 343

Depreciation Expense
Date Explanation Debit Credit Balance
2007
Dec. 31 ($36,506 6) 6,084 6,084 dr
31 Closing entry 6,084 -0-
2008
Dec. 31 ($36,506 6) 6,084 6,084 dr
31 Closing entry 6,084 -0-
2009
Dec. 31 ($36,506 6) 6,084 6,084 dr
31 Closing entry 6,084 -0-
2010
Dec. 31 ($36,506 6) 6,084 6,084 dr
31 Closing entry 6,084 -0-
2011
Dec. 31 ($36,506 6) 6,085* 6,085 dr
31 Closing entry 6,085 -0-
2012
Dec. 31 ($36,506 6) 6,085* 6,085 dr
31 Closing entry 6,085 -0-

*Adjusted $1 for rounding.

Working paper eliminations (in journal entry format) for Palm Corporation and sub-
sidiary for the first two years of the intercompany lease are as follows (intercompany inter-
est revenue and intercompany interest expense self-eliminate on the same line of the
income statement section of the working paper for consolidated fianancial statements):

Working Paper PALM CORPORATION AND SUBSIDIARY

Elimination for First Partial Working Paper Eliminations
Year of Intercompany December 31, 2007
Sales-Type/Capital
Lease (b) Intercompany Liability under Capital Lease—Starr 26,506
Intercompany Interest Payable—Starr 2,120
Unearned Intercompany Interest Revenue—Palm 2,374
Intercompany Sales—Palm 36,506
Intercompany Cost of Goods Sold—Palm 30,000
Intercompany Lease Receivables—Palm 31,000
Leased Equipment—Capital Lease—Starr
($36,506 $30,000 $1,084) 5,422
Depreciation Expense—Starr
[($36,506 $30,000) 6] 1,084
To eliminate intercompany accounts associated with intercompany
lease and to defer unrealized portion of intercompany gross profit
on sales-type lease. (Income tax effects are disregarded.)
344 Part Two Business Combinations and Consolidated Financial Statements

Working Paper PALM CORPORATION AND SUBSIDIARY

Elimination for Second Partial Working Paper Eliminations
Year of Intercompany December 31, 2008
Sales-Type/Capital
Lease (b) Intercompany Liability under Capital Lease—Starr 18,626
Intercompany Interest Payable—Starr 1,490
Unearned Intercompany Interest Revenue—Palm 884
Retained Earnings—Palm [($36,506 $30,000) $1,084] 5,422
Intercompany Lease Receivables—Palm 21,000
Leased Equipment—Capital Lease—Starr
($5,422 $1,084) 4,338
Depreciation Expense—Starr 1,084
To eliminate intercompany accounts associated with intercompany lease
and to defer unrealized portion of intercompany gross profit on
sales-type lease. (Income tax effects are disregarded.)

The foregoing eliminations have features comparable with both eliminations for inter-
company sales of merchandise (page 332) and eliminations for intercompany sales of plant
assets (page 338). For example, the elimination of December 31, 2007, removes the parent
company’s intercompany sales ($36,506) and cost of goods sold ($30,000), because the
leased equipment had been carried in the parent’s Inventories ledger account and the sales-
type lease (from the parent’s viewpoint) occurred during Year 2007. The subsidiary’s
(lessee’s) depreciation expense of $1,084 for Year 2007 represents the realization of a por-
tion of the parent’s gross profit margin on the intercompany sale. In the Year 2008 elimi-
nation, the original $6,506 ($36,506 $30,000 $6,506) unrealized gross profit element
in the subsidiary’s leased equipment has been reduced by the $1,084 reduction of the sub-
sidiary’s Year 2008 depreciation expense.

INTERCOMPANY SALES OF INTANGIBLE ASSETS

The working paper eliminations for intercompany gains on sales of intangible assets are
similar to those for intercompany gains in depreciable plant assets, except that no accumu-
lated amortization ledger account may be involved. The unrealized intercompany gain of
the selling affiliate is realized through periodic amortization expense recognized by the ac-
quiring affiliate.
To illustrate, assume that on January 2, 2008, Palm Corporation sold to Starr Company,
its wholly owned subsidiary, for $40,000 a patent carried in Palm’s accounting records at
$32,000. The patent had a remaining economic life of four years on January 2, 2008, and
was amortized by the straight-line method. The appropriate working paper elimination (in
journal entry format) on December 31, 2008, follows:

Working Paper PALM CORPORATION AND SUBSIDIARY

Elimination for Year of Partial Working Paper Eliminations
Intercompany Sale of December 31, 2008
Patent at a Gain
(c) Intercompany Gain on Sale of Patent—Palm ($40,000 $32,000) 8,000
Amortization Expense—Starr ($8,000 4) 2,000
Patent—Starr ($8,000 $2,000) 6,000
To eliminate unrealized intercompany gain in patent and related
amortization. (Income tax effects are disregarded.)
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 345

The working paper elimination (in journal entry format) for December 31, 2009, is as
follows:

Working Paper PALM CORPORATION AND SUBSIDIARY

Elimination for Year Partial Working Paper Eliminations
Following Year of December 31, 2009
Intercompany Sale of
Patent at a Gain (c) Retained Earnings—Palm ($8,000 $2,000) 6,000
Amortization Expense—Starr ($8,000 4) 2,000
Patent—Starr ($6,000 $2,000) 4,000
To eliminate unrealized intercompany gain in patent and related
amortization. (Income tax effects are disregarded.)

ACQUISITION OF AFFILIATE’S BONDS

The intercompany profits (gains) or losses on intercompany sales of merchandise, plant
assets, and intangible assets and on leases of property under capital/sales-type leases are,
on the date of sale, unrealized gains or losses resulting from business transactions between
two affiliated corporations. Intercompany gains and losses may be realized by the consoli-
dated entity when one affiliate acquires, in the open market, outstanding bonds of another
affiliate. The gain or loss on such a transaction is imputed, because the transaction is not
consummated between the two affiliates. No realized or unrealized intercompany gain or
loss would result from the direct acquisition of one affiliate’s bonds by another affiliate, be-
cause the cost of the investment to the acquirer would be exactly offset by the proceeds of
the debt to the issuer.

Illustration of Acquisition of Affiliate’s Bonds

Assume that on January 2, 2007, Sage Company (the partially owned subsidiary) issued to
the public $500,000 face amount of five-year, 10% bonds due January 1, 2012. The bonds
were issued at a price to yield a 12% return to investors. Interest was payable annually on
January 1. Bond issue costs are disregarded in this example.
The net proceeds of the bond issue to Sage were $463,952, computed as follows:4

Computation of Present value of $500,000 in five years at 12%, with interest

Proceeds of Bonds paid annually ($500,000 0.567427) $283,713
Issued by Partially Add: Present value of $50,000 each year for five years at 12%
Owned Subsidiary ($50,000 3.604776) 180,239
Proceeds of bond issue $463,952

During the year ended December 31, 2007, Sage prepared the following journal entries
for the bonds, including the amortization of bond discount by the interest method:

4
Intermediate accounting textbooks generally contain a discussion of computations of bond issuance
proceeds using calculators or present value tables. (Annual interest payments are assumed to simplify the
illustration; bonds typically pay interest semiannually.)
346 Part Two Business Combinations and Consolidated Financial Statements

Partially Owned 2007

Subsidiary’s Journal Jan. 2 Cash 463,952
Entries for Issuance of Discount on Bonds Payable 36,048
Bonds Payable and Bonds Payable 500,000
Accrual of Interest To record issuance of 10% bonds due Jan. 1, 2009, at
a discount to yield 12%.

Dec. 31 Interest Expense ($463,952 0.12) 55,674

Interest Payable ($500,000 0.10) 50,000
Discount on Bonds Payable 5,674
To record accrual of annual interest on 10% bonds.

On December 31, 2007, the balance of Sage’s Discount on Bonds Payable ledger ac-
count was $30,374 ($36,048 $5,674 $30,374).
Assume that on December 31, 2007, Post Corporation (the parent company) had cash
available for investment. With a market yield rate of 15% on that date, Sage Company’s
10% bonds might be acquired at a substantial discount. Consequently, Post acquired in the
open market on December 31, 2007, $300,000 face amount (or 60% of the total issue of
$500,000) of the bonds for $257,175 plus $30,000 accrued interest for one year
($300,000 0.10 $30,000). The $257,175 acquisition cost is computed as follows:

Computation of Parent Present value of $300,000 in four years at 15%, with interest paid
Company’s Acquisition annually ($300,000 0.571753) $171,526
Cost for Bonds of Add: Present value of $30,000 each year for four years at 15%
Partially Owned ($30,000 2.854978) 85,649
Subsidiary Cost to Post Corporation of $300,000 face amount of bonds $257,175

Post prepared the following journal entry on December 31, 2007, to record the acquisi-
tion of Sage’s bonds:

Parent Company’s Investment in Sage Company Bonds 257,175

Journal Entry to Intercompany Interest Receivable 30,000
Record Open-Market Cash 287,175
Acquisition of Bonds To record acquisition of $300,000 face amount of Sage Company’s 10%
of Partially Owned bonds due Jan. 1, 2012, and accrued interest for one year.
Subsidiary

Upon receiving notification of the parent company’s acquisition of the bonds, Sage
Company prepared the following journal entry on December 31, 2007, to record the inter-
company status of a portion of its bonds payable:
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 347

Partially Owned Bonds Payable 300,000

Subsidiary’s Journal Discount on Intercompany Bonds Payable ($30,374 0.60) 18,224
Entry to Record Parent Interest Payable ($50,000 0.60) 30,000
Company’s Open- Intercompany Bonds Payable 300,000
Market Acquisition of Discount on Bonds Payable 18,224
Subsidiary’s
Intercompany Interest Payable 30,000
Outstanding Bonds
To transfer to intercompany accounts all amounts attributable to bonds
acquired by parent company in open market.

From the standpoint of the consolidated entity, Post Corporation’s acquisition of Sage
Company’s bonds is equivalent to the extinguishment of the bonds at a realized gain of
$24,601, computed as follows:

Computation of Carrying amount of Sage Company’s bonds acquired by Post

Realized Gain on Corporation on Dec. 31, 2007 ($300,000 $18,224) $281,776
Parent Company’s Less: Cost of Post Corporation’s investment 257,175
Open-Market Realized gain on extinguishment of bonds $ 24,601
Acquisition of
Subsidiary’s
Outstanding Bonds The $24,601 realized gain is not recorded in the accounting records of either the parent
company or the subsidiary. Instead, it is recognized in the working paper elimination (in
journal entry format) on December 31, 2007, shown below.

Working Paper POST CORPORATION AND SUBSIDIARY

Elimination to Partial Working Paper Eliminations
Recognize Gain on December 31, 2007
Intercompany
Extinguishment of (e) Intercompany Bonds Payable—Sage 300,000
Bonds Payable Discount on Intercompany Bonds Payable—Sage 18,224
Investment in Sage Company Bonds—Post 257,175
Gain on Extinguishment of Bonds—Sage 24,601
To eliminate subsidiary’s bonds acquired by parent and to recognize
gain on the extinguishment of the bonds. (Income tax effects are
disregarded.)

Disposition of Gain on Extinguishment of Bonds

The foregoing working paper elimination attributes the gain on Post Corporation’s acquisi-
tion of its subsidiary’s bonds to Sage Company—the subsidiary. This treatment of the gain
follows from the assumption that the parent company’s open-market acquisition of the sub-
sidiary’s bonds was, in substance, the extinguishment of the bonds by the subsidiary. The
parent company acted as agent for the subsidiary in the open-market transaction; thus,
the gain is attributed to the subsidiary. Under this approach, the accounting for the gain on
the acquisition of the subsidiary’s bonds is the same as if the subsidiary itself had acquired
and retired the bonds.
The entire realized gain of $24,601 is displayed in the consolidated income statement of
Post Corporation and subsidiary for the year ended December 31, 2007.5

5
APB Opinion No. 26, “Early Extinguishment of Debt” (New York: AICPA, 1973), par. 20.
348 Part Two Business Combinations and Consolidated Financial Statements

Minority Interest in Gain on Extinguishment of Bonds

As discussed in the preceding section, the gain on Post Corporation’s acquisition of its
subsidiary’s bonds is attributed to the partially owned subsidiary. It follows that the gain
should be considered in the computation of the minority interest in the subsidiary’s
net income for the year ended December 31, 2007. Also, the gain is included in the
computation of the amount of the subsidiary’s retained earnings to be included in con-
solidated retained earnings on December 31, 2007. These procedures are illustrated on
page 354.

Accounting for Gain in Subsequent Years

In the four years following Post Corporation’s acquisition of Sage Company’s bonds,
the gain realized but unrecorded on the date of acquisition is in effect recorded by the con-
solidated entity through the differences in the two affiliates’ amortization and accumulation
of bond discount. (It is essential that the affiliate that acquired the bonds at a discount un-
dertake an accumulation program consistent with that of the affiliate that issued the bonds;
thus, Post Corporation should adopt the interest method of amortization used by Sage.) To
illustrate this concept, the journal entries for the bond interest by the two companies for the
year ended December 31, 2008, are below, and the ledger accounts of both companies rel-
Affiliated Companies’ ative to the intercompany bonds are illustrated on pages 349 and 350 for the four years the
Journal Entries for bonds remain outstanding.
Bonds for Year after
Intercompany
Acquisition of the
Bonds

Date Post Corporation Journal Entries Sage Company Journal Entries

2008
Jan. 2 Cash 30,000 Intercompany Interest Payable 30,000
Intercompany Interest Interest Payable 20,000
Receivable 30,000 Cash 50,000
To record receipt of To record payment of accrued
accrued interest on interest on 10% bonds.
Sage Company’s
10% bonds. Intercompany Interest Expense 33,813
Interest Expense 22,542
Dec. 31 Intercompany Interest
Intercompany Interest
Receivable 30,000
Payable 30,000
Investment in Sage
Company Bonds 8,576 Interest Payable 20,000
Discount on Intercom-
Intercompany
pany Bonds Payable 3,813
Interest Revenue 38,576
Discount on Bonds
To accrue annual interest
Payable 2,542
on Sage Company’s
10% bonds To accrue annual interest on 10%
($257,175 bonds. Interest is computed as
0.15 $38,576). follows:
Intercompany ($300,000
$18,224) 0.12 $33,813
Other ($200,000
$12,150) 0.12 $22,542
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 349

Parent Company’s POST CORPORATION

Ledger Accounts for Ledger Accounts
Intercompany Bonds
Investment in Sage Company Bonds
Date Explanation Debit Credit Balance
2007
Dec. 31 Acquisition of $300,000 face
amount of bonds 257,175 257,175 dr
2008
Dec. 31 Accumulation of discount
($38,576 $30,000) 8,576 265,751 dr
2009
Dec. 31 Accumulation of discount
($39,863 $30,000) 9,863 275,614 dr
2010
Dec. 31 Accumulation of discount
($41,342 $30,000) 11,342 286,956 dr
2011
Dec. 31 Accumulation of discount
($43,044 $30,000) 13,044 300,000 dr

Intercompany Interest Revenue

Date Explanation Debit Credit Balance
2008
Dec. 31 ($257,175 0.15) 38,576 38,576 cr
31 Closing entry 38,576 -0-
2009
Dec. 31 ($265,751 0.15). 39,863 39,863 cr
31 Closing entry 39,863 -0-
2010
Dec. 31 ($275,614 0.15) 41,342 41,342 cr
31 Closing entry 41,342 -0-
2011
Dec. 31 ($286,956 0.15) 43,044* 43,044 cr
31 Closing entry 43,044 -0-

*Adjusted $1 for rounding.

Subsidiary’s Ledger SAGE COMPANY

Accounts for Ledger Accounts
Intercompany Bonds
Intercompany Bonds Payable
Date Explanation Debit Credit Balance
2007
Dec. 31 Bonds acquired by parent company 300,000 300,000 cr
(continued)
350 Part Two Business Combinations and Consolidated Financial Statements

SAGE COMPANY
Ledger Accounts (concluded)

Discount on Intercompany Bonds Payable

Date Explanation Debit Credit Balance
2007
Dec. 31 Bonds acquired by parent company 18,224 18,224 dr
2008
Dec. 31 Amortization ($33,813 $30,000) 3,813 14,411 dr
2009
Dec. 31 Amortization ($34,271 $30,000) 4,271 10,140 dr
2010
Dec. 31 Amortization ($34,783 $30,000) 4,783 5,357 dr
2011
Dec. 31 Amortization ($35,357 $30,000) 5,357 -0-

Intercompany Interest Expense

Date Explanation Debit Credit Balance
2008
Dec. 31 [($300,000 $18,224) 0.12] 33,813 33,813 dr
31 Closing entry 33,813 -0-
2009
Dec. 31 [($300,000 $14,411) 0.12] 34,271 34,271 dr
31 Closing entry 34,271 -0-
2010
Dec. 31 [($300,000 $10,140) 0.12] 34,783 34,783 dr
31 Closing entry 34,783 -0-
2011
Dec. 31 [($300,000 $5,357) 0.12] 35,357 35,537 dr
31 Closing entry 35,357 -0-

A comparison of the yearly journal entries to Post Corporation’s Intercompany Interest

Revenue ledger account and Sage Company’s Intercompany Interest Expense account
demonstrates that the difference between the annual entries in the two accounts represents the
recording, in the separate companies’ accounting records, of the $24,601 gain realized but
unrecorded when the parent company acquired the subsidiary’s bonds in the open market. A
summary of the differences between the two intercompany interest amounts is as follows:

Total of Differences
Post Corporation’s Sage Company’s Difference—Repre-
between Parent’s
Year Ended Intercompany Intercompany senting Recording
Intercompany Interest
Dec. 31, Interest Revenue Interest Expense of Realized Gain
Revenue and
Subsidiary’s 2008 $ 38,576 $ 33,813 $ 4,763
Intercompany Interest 2009 39,863 34,271 5,592
Expense Is Equal to 2010 41,342 34,783 6,559
Realized Gain on 2011 43,044 35,357 7,687
Parent’s Acquisition of Totals $162,825 $138,224 $24,601
Subsidiary’s Bonds
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 351

Working Paper Elimination on December 31, 2008

The working paper elimination (in journal entry format) for the bonds and interest on
December 31, 2008, is as follows:

Working Paper POST CORPORATION AND SUBSIDIARY

Elimination for First Partial Working Paper Eliminations
Year Subsequent to December 31, 2008
Intercompany
Acquisition of Bonds (e) Intercompany Interest Revenue—Post 38,576
Intercompany Bonds Payable—Sage 300,000
Discount on Intercompany Bonds Payable—Sage 14,411
Investment in Sage Company Bonds—Post 265,751
Intercompany Interest Expense—Sage 33,813
Retained Earnings—Sage ($24,601 0.95) 23,371
Minority Interest in Net Assets of Subsidiary
($24,601 0.05) 1,230
To eliminate subsidiary’s bonds owned by parent company, and
related interest revenue and expense; and to increase
subsidiary’s beginning retained earnings by amount of
unamortized realized gain on the exitinguishment of the bonds.
(Income tax effects are disregarded.)

The foregoing working paper elimination effectively reduces consolidated net income
(before minority interest) by $4,763 ($38,576 $33,813 $4,763). As shown on
page 350, the $4,763 is the difference between the eliminated intercompany interest
revenue of the parent company and the eliminated intercompany interest expense of
the subsidiary. Failure to eliminate intercompany interest in this manner would result
in a $4,763 overstatement of pre-minority interest consolidated net income for Year
2008, because the entire $24,601 realized gain on the parent company’s acquisition of
the subsidiary’s bonds was recognized in the consolidated income statement for Year
2007—the year the bonds were acquired—as evidenced by the $24,601 credited to
Retained Earnings—Sage and to Minority Interest in Net Assets of Subsidiary in the
elimination.
The $4,763 reduction of consolidated net income (before minority interest) is attrib-
utable to the subsidiary, because the original realized gain to which the $4,763 relates
was allocated to the subsidiary. Consequently, the $4,763 must be considered in the
computation of minority interest in net income of the subsidiary for the year ended
December 31, 2008. The $4,763 also enters into the computation of the amount of
the subsidiary’s retained earnings included in consolidated retained earnings. These
amounts associated with Sage Company’s bonds are reflected in the working paper for
consolidated financial statements for the year ended December 31, 2008, as illustrated
on pages 357 and 358.

Working Paper Elimination on December 31, 2009

The working paper elimination (in journal entry format) on December 31, 2009, is as
follows:
352 Part Two Business Combinations and Consolidated Financial Statements

Working Paper POST CORPORATION AND SUBSIDIARY

Elimination for Second Partial Working Paper Eliminations
Year Subsequent to December 31, 2009
Intercompany
Acquisition of Bonds (e) Intercompany Interest Revenue—Post 39,863
Intercompany Bonds Payable—Sage 300,000
Discount on Intercompany Bonds Payable—Sage 10,140
Investment in Sage Company Bonds—Post 275,614
Intercompany Interest Expense—Sage 34,271
Retained Earnings—Sage
[($24,601 $4,763) 0.95] 18,846
Minority Interest in Net Assets of Subsidiary
[($24,601 $4,763) 0.05] 992
To eliminate subsidiary’s bonds owned by parent company, and
related interest revenue and expense; and to increase
subsidiary’s beginning retained earnings by amount of
unamortized realized gain on the extinguishment of the bonds.
(Income tax effects are disregarded.)

Comparable working paper eliminations are appropriate for Years 2010 and 2011. After
Sage Company paid the bonds in full on maturity (January 2, 2012), no further working
paper eliminations for the bonds would be required.

Reissuance of Intercompany Bonds

The orderly amortization of a realized gain on the acquisition of an affiliate’s bonds is dis-
rupted if the acquiring affiliate sells the bonds to outsiders before they mature. A transac-
tion gain or loss on such a sale is not realized by the consolidated entity. Logic requires that
a working paper elimination be prepared to treat the transaction gain or loss as premium or
discount on the reissued bonds, as appropriate. These complex issues are rarely encoun-
tered; thus, they are not illustrated here.

ILLUSTRATION OF EFFECT OF INTERCOMPANY PROFITS

(GAINS) ON MINORITY INTEREST
To illustrate the effect of intercompany profits (gains) on the computation of minor-
ity interest in the net income of a partially owned subsidiary, return to the example
of Post Corporation and its 95%-owned purchased subsidiary, Sage Company. The
following working paper eliminations for Post Corporation and subsidiary (in journal
entry format) are taken from page 289 of Chapter 7, and from pages 330, 334, 336,
and 347 of this chapter. These eliminations are followed by a revised elimination (which
differs from the one on page 289 of Chapter 7) for minority interest in net income of
subsidiary.
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 353

POST CORPORATION AND SUBSIDIARY

Working Paper Eliminations
December 31, 2007

(a) Common Stock—Sage 400,000

Additional Paid-in Capital—Sage 235,000
Retained Earnings—Sage ($384,000 $4,750) 379,250
Retained Earnings of Subsidiary—Post 4,750
Intercompany Investment Income—Post 81,700
Plant Assets (net)—Sage ($176,000 $14,000) 162,000
Leasehold—Sage ($25,000 $5,000) 20,000
Goodwill—Post 38,000
Cost of Goods Sold—Sage 17,000
Operating Expenses—Sage 2,000
Investment in Sage Company Common Stock—Post 1,231,200
Dividends Declared—Sage 50,000
Minority Interest in Net Assets of Subsidiary
($61,000 $2,500) 58,500
To carry out the following:
(1) Eliminate intercompany investment and equity accounts of
subsidiary at beginning of year, and subsidiary dividends.
(2) Provide for Year 2007 depreciation and amortization on
differences between current fair values and carrying amounts
of Sage’s identifiable net assets as follows:

Cost of
Goods Operating
Sold Expenses
Building depreciation $ 2,000 $2,000
Machinery depreciation 10,000
Leasehold amortization 5,000 $2,000
Totals $17,000 $2,000

(3) Allocate unamortized differences between combination date

current fair values and carrying amounts to appropriate assets.
(4) Establish minority interest in net assets of subsidiary at beginning
of year ($61,000), less minority interest in dividends declared
by subsidiary during year ($50,000 0.05 $2,500)
(Income tax effects are disregarded.)

(b) Intercompany Sales—Sage 120,000

Intercompany Cost of Goods Sold—Sage 96,000
Cost of Goods Sold—Post 16,000
Inventories—Post 8,000
To eliminate intercompany sales, cost of goods sold, and unrealized
profit in inventories. (Income tax effects are disregarded.)

(c) Intercompany Gain on Sale of Land—Post 50,000

Land—Sage 50,000
To eliminate unrealized intercompany gain on sale of land.
(Income tax effects are disregarded.)

(continued)
354 Part Two Business Combinations and Consolidated Financial Statements

POST CORPORATION AND SUBSIDIARY

Working Paper Eliminations (concluded)
December 31, 2007

(d) Intercompany Gain on Sale of Machinery—Sage 23,800

Machinery—Post 23,800
To eliminate unrealized intercompany gain on sale of machinery.
(Income tax effects are disregarded.)
(e) Intercompany Bonds Payable—Sage 300,000
Discount on Intercompany Bonds Payable—Sage 18,224
Investment in Sage Company Bonds—Post 257,175
Gain on Extinguishment of Bonds—Sage 24,601
To eliminate subsidiary’s bonds acquired by parent, and to
recognize gain on the extinguishment of the bonds. (Income
tax effects are disregarded.)
(f) Minority Interest in Net Income of Subsidiary 3,940
Minority Interest in Net Assets of Subsidiary 3,940
To establish minority interest in subsidiary’s adjusted net income
for Year 2007 as follows:
Net income of subsidiary $105,000
Adjustments for working paper eliminations:
(a) ($17,000 $2,000) (19,000)
(b) (8,000)
(d) (23,800)
(e) 24,601
Adjusted net income of subsidiary $ 78,801
Minority interest share ($78,801 0.05) $ 3,940

In elimination ( f ) above, the effects of the other eliminations on the subsidiary’s net in-
come are applied to compute the adjusted net income of the subsidiary, for consolidation
purposes. The minority interest percentage then is applied to compute the minority interest
in net income of the subsidiary. The rationale for these procedures follows:
• Elimination (a) increases costs and expenses of the subsidiary, thus decreasing the sub-
sidiary’s net income, a total of $19,000.
• Elimination (b) reduces the subsidiary’s gross profit margin on sales by $24,000
($120,000 $96,000 $24,000); however, $16,000 of the gross profit margin was re-
alized by the parent company in its sales to outsiders. The net effect on the subsidiary’s
net income is a decrease of $8,000 ($24,000 $16,000 $8,000).
• Elimination (c) removes a gain of the parent company; it does not affect the subsidiary’s
net income.
• Elimination (d) removes a gain of the subsidiary and reduces the subsidiary’s net in-
come by $23,800.
• Elimination (e) attributes a gain on extinguishment of bonds to the subsidiary, thus in-
creasing the subsidiary’s net income by $24,601.
Working Paper for Consolidated Financial Statements
A partial working paper for consolidated financial statements for Post Corporation and sub-
sidiary for the year ended December 31, 2007, is on page 355. The amounts for Post Cor-
poration and Sage Company are the same as in the illustration on page 290 of Chapter 7.
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 355

Equity Method: Partially Owned Subsidiary Subsequent to Date of Business Combination

POST CORPORATION AND SUBSIDIARY

Partial Working Paper for Consolidated Financial Statements
For Year Ended December 31, 2007

Eliminations
Post Sage Increase
Corporation Company (Decrease) Consolidated
Statement of Retained Earnings
Retained earnings, beginning of year 1,349,450 384,000 (a) (379,250) 1,354,200
Net income 353,550 105,000 (161,839)* 296,711
Subtotals 1,703,000 489,000 (541,089) 1,650,911
Dividends declared 158,550 50,000 (a) (50,000)† 158,550
Retained earnings, end of year 1,544,450 439,000 (491,089) 1,492,361

Balance Sheet
Liabilities and Stockholders’ Equity
Total liabilities x,xxx,xxx xxx,xxx xxx,xxx x,xxx,xxx
Common stock, $1 par 1,057,000 1,057,000
Common stock, $10 par 400,000 (a) (400,000)
Additional paid-in capital 1,560,250 235,000 (a) (235,000) 1,560,250
b r
Minority interest in net assets (a) 58,500 62,440
of subsidiary (f) 3,940
Retained earnings 1,544,450 439,000 (491,089) 1,492,361
Retained earnings of subsidiary 4,750 (a) (4,750)
Total stockholders’ equity 4,166,450 1,074,000 (1,068,399) 4,172,051
Total liabilities and stockholders’ equity x,xxx,xxx x,xxx,xxx (1,068,399) x,xxx,xxx

*
Net decrease in revenue (and gains): $81,700 $120,000 $50,000 $23,800 $24,601 $250,899
Less: Net decrease in costs and expenses: $96,000 $16,000 $19,000 $3,940 89,060
Decrease in combined net incomes to compute consolidated net income $161,839
†
A decrease in dividends and an increase in retained earnings.

The foregoing working paper demonstrates that, when intercompany profits exist,
consolidated net income is not the same as the parent company’s net income under the
equity method of accounting for the subsidiary’s operations; nor is consolidated retained
earnings the same as the total of the parent company’s two retained earnings amounts.
($1,544,450 $4,750 $1,549,200; consolidated retained earnings is $1,492,361.) In the
comprehensive illustration that follows, I demonstrate how consolidated net income and
consolidated retained earnings may be verified when intercompany profits (gains) are
involved in the consolidation process.

COMPREHENSIVE ILLUSTRATION OF WORKING PAPER FOR

CONSOLIDATED FINANCIAL STATEMENTS
Chapters 6 through 8 explain and illustrate a number of aspects of working papers for con-
solidated financial statements. The comprehensive illustration that follows incorporates
most of these aspects. The illustration is for Post Corporation and its partially owned sub-
sidiary, Sage Company, for the year ended December 31, 2008.
The ledger accounts for Post Corporation’s Investment in Sage Company Common
Stock, Retained Earnings, and Retained Earnings of Subsidiary, and for Sage Company’s
Retained Earnings, are as follows. Closing entries for Year 2008 are not yet recorded in the
retained earnings accounts. Review of these accounts should aid in understanding the
356 Part Two Business Combinations and Consolidated Financial Statements

illustrative working paper for consolidated financial statements on pages 357 and 358 and
the related working paper eliminations (in journal entry format) on pages 359 and 360.
Consolidated goodwill was unimpaired throughout the three-year period.

POST CORPORATION LEDGER ACCOUNTS

Investment in Sage Company Common Stock

Date Explanation Debit Credit Balance
2005
Dec. 31 Total cost of business
combination 1,192,250 1,192,250 dr
2006
Nov. 24 Dividend declared by Sage 38,000 1,154,250 dr
Dec. 31 Net income of Sage 85,500 1,239,750 dr
31 Amortization of differences 42,750 1,197,000 dr
2007
Nov. 22 Dividend declared by Sage 47,500 1,149,500 dr
Dec. 31 Net income of Sage 99,750 1,249,250 dr
31 Amortization of differences 18,050 1,231,200 dr
2008
Nov. 25 Dividend declared by Sage 57,000 1,174,200 dr
Dec. 31 Net income of Sage 109,250 1,283,450 dr
31 Amortization of differences 18,050 1,265,400 dr

Retained Earnings
Date Explanation Debit Credit Balance
2005
Dec. 31 Balance 1,050,000 cr
2006
Dec. 31 Close net income available
for dividends 458,000 1,508,000 cr
31 Close Dividends Declared
account 158,550 1,349,450 cr
2007
Dec. 31 Close net income available
for dividends 319,350 1,668,800 cr
31 Close Dividends Declared
account 158,550 1,510,250 cr

Retained Earnings of Subsidiary

Date Explanation Debit Credit Balance
2006
Dec. 31 Close net income not available
for dividends 4,750 4,750 cr
2007
Dec. 31 Close net income not available
for dividends 34,200 38,950 cr
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 357

SAGE COMPANY LEDGER ACCOUNT

Retained Earnings
Date Explanation Debit Credit Balance
2005
Dec. 31 Balance 334,000 334,000 cr
2006
Dec. 31 Close net income 90,000 424,000 cr
31 Close Dividends Declared
account 40,000 384,000 cr
2007
Dec. 31 Close net income 105,000 489,000 cr
31 Close Dividends Declared
account 50,000 439,000 cr

Equity Method: Partially

Owned Subsidiary Subsequent
to Business Combination

POST CORPORATION AND SUBSIDIARY

Working Paper for Consolidated Financial Statements
For Year Ended December 31, 2008

Eliminations
Post Sage Increase
Corporation Company (Decrease) Consolidated
Income Statement
Revenue:
Net sales 5,900,000 1,400,000 7,300,000
Intercompany sales 150,000 (b) (150,000)
Intercompany interest revenue 38,576 (e) (38,576)
Intercompany investment income 91,200 (a) (91,200)
Intercompany revenue (expenses) 14,000 (14,000)

e(b) (26,000) f
Total revenue 6,043,776 1,536,000) (279,776) 7,300,000
Costs and expenses: (a) 17,000

Cost of goods sold 4,300,000 950,000 (d) (4,760) 5,236,240

Intercompany cost of goods sold 120,000 (b) (120,000)
Operating expenses 985,108 217,978 (a) 2,000 1,205,086
Intercompany interest expense 33,813 (e) (33,813)
Interest expense 51,518 22,542 74,060
Income taxes expense 246,000 76,667 322,667
Minority interest in net
income of subsidiary (f) 4,600 4,600
Total costs and expenses and
minority interest 5,582,626 1,421,000 (160,973)* 6,842,653
Net income 461,150 115,000 (118,803) 457,347

*A decrease in total costs and expenses and an increase in net income. (continued)
358 Part Two Business Combinations and Consolidated Financial Statements

POST CORPORATION AND SUBSIDIARY

Working Paper for Consolidated Financial Statements (concluded)
For Year Ended December 31, 2008

Eliminations
Post Sage Increase
Corporation Company (Decrease) Consolidated
Statement of Retained Earnings
(a) (400,050)

µ(c) (50,000) ∂
(b) (7,600)
Retained earnings, beginning of year 1,510,250 439,000 1,492,361
(d) (22,610)
(e) 23,371)
Net income 461,150 115,000 (118,803) 457,347
Subtotal 1,971,400 554,000 (575,692) 1,949,708
Dividends declared 158,550 60,000 (a) (60,000)* 158,550
Retained earnings, end of year 1,812,850 494,000 (515,692) 1,791,158

Balance Sheet
Assets
Intercompany receivables (payables) (3,500) 3,500
Inventories 950,000 500,000 (b) (12,000) 1,438,000
Other current assets 760,000 428,992 1,188,992
Investment in Sage Company
stock 1,265,400 (a) (1,265,400)
Investment in Sage Company
bonds 265,751 (e) (265,751)
(a) 148,000
b
Plant assets (net) 3,700,000 1,300,000 (d) (19,040) r 5,128,960
Land (for building site) 175,000 (c) (50,000) 125,000
Leasehold (net) (a) 15,000 15,000
Goodwill 85,000 (a) 38,000 123,000
Total assets 7,022,651 2,407,492 (1,411,191) 8,018,952

Liabilities and Stockholders’ Equity

Bonds payable 200,000 200,000
Intercompany bonds payable 300,000 (e) (300,000)
Discount on bonds payable (9,608) (9,608)
Discount on intercompany
bonds payable (14,411) (e) (14,411)†
Other liabilities 2,553,601 802,511 3,356,112
Common stock, $1 par 1,057,000 1,057,000
Common stock, $10 par 400,000 (a) (400,000)
Additional paid-in capital 1,560,250 235,000 (a) (235,000) 1,560,250

µ(d) (1,190) ∂
(a) 59,800
Minority interest in net assets (b) (400)
of subsidiary 64,040
(e) 1,230
(f) 4,600
Retained earnings 1,812,850 494,000 (515,692) 1,791,158
Retained earnings of subsidiary 38,950 (a) (38,950)
Total liabilities and stockholders’
equity 7,022,651 2,407,492 (1,411,191) 8,018,952

*A decrease in dividends and an increase in retained earnings.

†A decrease in discount on intercompany bonds payable and an increase in total liabilities and stockholders’ equity.
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 359

POST CORPORATION AND SUBSIDIARY

Working Paper Eliminations
December 31, 2008

(a) Common Stock—Sage 400,000

Additional Paid-in Capital—Sage 235,000
Retained Earnings—Sage ($439,000 $38,950) 400,050
Retained Earnings of Subsidiary—Post 38,950
Intercompany Investment Income—Post 91,200
Plant Assets (net)—Sage ($162,000 $14,000) 148,000
Leasehold (net)—Sage ($20,000 $5,000) 15,000
Goodwill—Post 38,000
Cost of Goods Sold—Sage 17,000
Operating Expenses—Sage 2,000
Investment in Sage Company Common Stock—Post 1,265,400
Dividends Declared—Sage 60,000
Minority Interest in Net Assets of Subsidiary 59,800
To carry out the following:
(1) Eliminate intercompany investment and equity accounts of
subsidiary at beginning of year, and subsidiary dividend.
(2) Provide for Year 2008 depreciation and amortization on
differences between current fair values and carrying amount
of Sage’s identifiable net assets as follows:

Cost of
Goods Operating
Sold Expenses
Building depreciation $ 2,000 $2,000
Machinery depreciation 10,000
Leasehold amortization 5,000
Totals $17,000 $2,000

(3) Allocate unamortized differences between combination date

current fair values and carrying amounts to appropriate assets.
(4) Establish minority interest in net assets of subsidiary at beginning
of year, excluding intercompany profits effects ($62,800), less
minority interest in dividends declared by subsidiary during
year ($60,000 0.05 $3,000).
(Income tax effects are disregarded.)

(b) Retained Earnings—Sage 7,600

Minority Interest in Net Assets of Subsidiary 400
Intercompany Sales—Sage 150,000
Intercompany Cost of Goods Sold—Sage 120,000
Cost of Goods Sold—Post 26,000
Inventories—Post 12,000
To eliminate intercompany sales, cost of goods sold, and unrealized
profits in inventories. (Income tax effects are disregarded.)

(c) Retained Earnings—Post 50,000

Land—Sage 50,000
To eliminate unrealized intercompany gain in land. (Income tax
effects are disregarded.)

(continued)
360 Part Two Business Combinations and Consolidated Financial Statements

POST CORPORATION AND SUBSIDIARY

Working Paper Eliminations (concluded)
December 31, 2008

(d) Retained Earnings—Sage 22,610

Minority Interest in Net Assets of Subsidiary 1,190
Accumulated Depreciation—Post 4,760
Machinery—Post 23,800
Depreciation Expense—Post 4,760
To eliminate unrealized intercompany gain in machinery and in
related depreciation. (Income tax effects are disregarded.)

(e) Intercompany Interest Revenue—Post 38,576

Intercompany Bonds Payable—Sage 300,000
Discount on Intercompany Bonds Payable—Sage 14,411
Investment in Sage Company Bonds—Post 265,751
Intercompany Interest Expense—Sage 33,813
Retained Earnings—Sage 23,371
Minority Interest in Net Assets of Subsidiary 1,230
To eliminate subsidiary’s bonds owned by parent company,
and related interest revenue and expense; and to increase
subsidiary’s beginning retained earnings by amount of
unamortized realized gain on the extinguishment of
the bonds. (Income tax effects are disregarded.)

(f) Minority Interest in Net Income of Subsidiary 4,600

Minority Interest in Net Assets of Subsidiary 4,600
To establish minority interest in subsidiary’s adjusted net income
for Year 2008, as follows:
Net income of subsidiary $115,000
Adjustments for working paper eliminations:
(a) ($17,000 $2,000) (19,000)
(b) ($150,000 $120,000 $26,000) (4,000)
(d) 4,760
(e) ($38,576 $33,813) (4,763)
Adjusted net income of subsidiary $ 91,997
Minority interest share ($91,997 0.05) $ 4,600

Following are 12 important features of the working paper for consolidated financial
statements and related working paper eliminations for Post Corporation and subsidiary for
the year ended December 31, 2008:
1. Intercompany investment income of Post Corporation for Year 2008 is computed as
follows:

Computation of $115,000 (Sage Company’s net income for Year 2008) 0.95 $109,250
Intercompany Less: $19,000 [(Year 2008 amortization of differences between current
Investment Income fair values and carrying amounts of Sage Company’s identifiable net
assets on date of business combination) 0.95] 18,050
Intercompany investment income of Post Corporation for Year 2008 $ 91,200
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 361

2. Post Corporation’s intercompany revenue of $14,000 is a management fee from

Sage Company, computed as 1% of Sage’s $1,400,000 net sales for Year 2008
($1,400,000 0.01 $14,000).
3. The income tax effects of Post Corporation’s use of the equity method of accounting
for its subsidiary’s operations are not reflected in Post’s income taxes expense for
Year 2008. Income tax effects associated with the equity method of accounting are
considered in Chapter 9.
4. Consolidated retained earnings of Post Corporation and subsidiary at the beginning
of Year 2008 ($1,492,361) is identical to consolidated retained earnings at the end of
Year 2007 (see page 355).
5. The net intercompany payable of Post Corporation on December 31, 2008, is com-
puted as follows:

Computation of Net Accounts payable to Sage Company for merchandise purchases $47,500
Intercompany Payable Less: Interest receivable from Sage Company (page 348) $30,000
of Parent Company Management fee receivable from Sage Company 14,000 44,000
Net intercompany payable $ 3,500

6. Elimination (a) continues the amortization of differences between current fair values
and carrying amounts of the subsidiary’s net assets on the date of the business combi-
nation of Post Corporation and Sage Company (see Chapter 7, page 288).
7. The $62,800 minority interest at the beginning of the year, excluding intercompany
profits (gains) effects, as set forth in the explanation for elimination (a)(4), is com-
puted as follows:

Computation of Stockholders’ equity of Sage Company, Dec. 31, 2007:

Minority Interest at Common stock, $10 par $ 400,000
Beginning of Year Additional paid-in capital 235,000
Retained earnings 439,000
Total stockholders’ equity $1,074,000
Add: Unamortized differences between current fair values
and carrying amounts of Sage’s identifiable net assets,
Dec. 31, 2007 (see page 353):
Plant assets $162,000
Leasehold 20,000 182,000
Total adjusted net assets of Sage, Dec. 31, 2007 $1,256,000
Minority interest therein ($1,256,000 0.05) $ 62,800

8. Eliminations ( b), (c), (d), and (e) are identical to the eliminations illustrated in this
chapter on pages 332, 335, 337, and 351, respectively. For posting to the working paper
for consolidated financial statements, elimination (d) was condensed. The credit to
Depreciation Expense in elimination (d) is posted to Cost of Goods Sold in the income
statement section of the working paper.
9. The effects of eliminations (a) through (e) on the computation of the minority interest
in net income of the subsidiary, in elimination (f ), are analyzed as follows:
• Elimination (a) increases costs and expenses of the subsidiary, thus decreasing the
subsidiary’s net income, a total of $19,000.
362 Part Two Business Combinations and Consolidated Financial Statements

• Elimination (b) reduces the subsidiary’s gross profit margin on sales by $30,000
($150,000 $120,000 $30,000); however, $26,000 of gross profit margin was re-
alized by the parent company in its sales to outsiders. The net effect on the sub-
sidiary’s net income is a decrease of $4,000 ($30,000 $26,000 $4,000).
• Elimination (c) does not affect the net income of the subsidiary.
• Elimination (d) includes a $4,760 credit to the parent company’s depreciation ex-
pense, which in effect is a realization of a portion of the intercompany profit on the
subsidiary’s sale of machinery to the parent company (see page 338). Thus, the sub-
sidiary’s net income is increased by $4,760.
• Elimination (e) decreases intercompany interest revenue by $38,576 and decreases
intercompany interest expense by $33,813. The difference, $4,763 ($38,576
$33,813 $4,763), is a reduction of the subsidiary’s net income, to avoid double
counting of the realized but unrecorded gain on the extinguishment of the sub-
sidiary’s bonds in the prior year (see page 351).
10. Because of the elimination of intercompany profits (gains), consolidated net income
for the year ended December 31, 2008, does not equal the parent company’s equity-
method net income. Consolidated net income may be verified as shown below:

Verification of Net income of Post Corporation $461,150

Consolidated Net Less: Post’s share of adjustments to subsidiary’s net
Income income for intercompany profits (gains):
Elimination (b) ($150,000 $120,000 $26,000) $(4,000)
Elimination (d) 4,760
Elimination (e) ($38,576 $33,813) (4,763)
Total $(4,003)
Post’s share [$(4,003) 0.95] (3,803)
Consolidated net income $457,347

11. Similarly, consolidated retained earnings on December 31, 2008, does not equal the
total of the two parent company retained earnings amounts in the working paper for
consolidated financial statements. Consolidated retained earnings may be verified as
follows:

Verification of Total of Post Corporation’s two retained earnings amounts

Consolidated Retained ($1,812,850 $38,950) $1,851,800
Earnings Adjustments:
Post’s share of adjustments to subsidiary’s net income
(see above) (3,803)
Intercompany gain in Post’s retained earnings—
elimination (c) (50,000)
Post’s share of adjustments to subsidiary’s beginning
retained earnings for intercompany profits (gains):
Elimination (b) $ (7,600)
Elimination (d) (22,610)
Elimination (e) 23,371 (6,839)
Consolidated retained earnings $1,791,158
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 363

12. The consolidated amounts in the working paper for consolidated financial statements
represent the financial position and operating results of Post Corporation and sub-
sidiary resulting from the consolidated entity’s transactions with outsiders. All inter-
company transactions, profits (gains), and balances have been eliminated in the
computation of the consolidated amounts.

SEC ENFORCEMENT ACTION DEALING WITH WRONGFUL

ACCOUNTING FOR AN INTERCOMPANY ACCOUNT
AAER 992
“In the Matter of Robert Gossett and Ronald Langos, Respondents,” reported in AAER 992
(December 1, 1997), described the SEC’s discovery of a number of egregious misstate-
ments of the quarterly and fiscal year consolidated financial statements of a company and
its subsidiaries that provided corrosion control engineering, monitoring services, systems,
and equipment to the infrastructure, environmental, and energy markets. Among these mis-
statements, perpetrated primarily by the parent company’s president and chief operating of-
ficer and its vice president of finance, chief financial officer, and treasurer, was an improper
debit balance in the parent’s Intercompany Account. Instead of being eliminated in consol-
idation, the Intercompany Account’s debit balance included $601,000 of subcontract
expenses and $700,000 attributable to the parent company’s failure to record certain inter-
company transfers of inventory.

Review 1. How should a parent company and subsidiary account for related party transactions
Questions and balances to assure their correct elimination in the preparation of consolidated fi-
nancial statements? Explain.
2. Identify five common related party transactions between a parent company and its sub-
sidiary.
3. Primak Corporation rents a sales office to its wholly owned subsidiary under an oper-
ating lease requiring rent of $2,000 a month, payable the first day of the month. What
are the income tax effects of the elimination of Primak’s $24,000 rent revenue and the
subsidiary’s $24,000 rent expense in the preparation of a consolidated income state-
ment? Explain.
4. Is an intercompany note receivable that has been discounted by a bank eliminated in
the preparation of a consolidated balance sheet? Explain.
5. How are consolidated financial statements affected if unrealized intercompany profits
(gains) resulting from transactions between a parent company and its subsidiaries are
not eliminated? Explain.
6. What consolidated financial statement categories are affected by intercompany sales of
merchandise at a profit? Explain.
7. How is the unrealized intercompany profit in a subsidiary’s beginning inventories re-
sulting from the parent company’s sales of merchandise to the subsidiary accounted for
in a working paper elimination (in journal entry format)? Explain.
8. How is the minority interest in net income of a partially owned subsidiary affected by
working paper eliminations for intercompany profits? Explain.
9. Some accountants have advocated the elimination of intercompany profit in the parent
company’s ending inventories only to the extent of the parent’s ownership interest in
364 Part Two Business Combinations and Consolidated Financial Statements

the partially owned selling subsidiary. What is an argument in opposition to this treat-
ment of intercompany profit in the parent company’s ending inventories?
10. How do intercompany sales of plant assets and intangible assets differ from intercom-
pany sales of merchandise?
11. Is an intercompany gain on the sale of land ever realized? Explain.
12. Sayles Company, a 90%-owned subsidiary of Partin Corporation, sold to Partin for
$10,000 a machine with a carrying amount of $8,000, no residual value, and an eco-
nomic life of four years. Explain how the intercompany gain element of Partin Corpo-
ration’s annual depreciation expense for the machine is accounted for in the working
paper for consolidated financial statements.
13. In what ways do working paper eliminations (in journal entry format) for intercom-
pany leases of property under capital/sales-type leases resemble eliminations for inter-
company sales of plant assets and intangible assets? Explain.
14. “No intercompany gain or loss should be recognized when a parent company acquires
in the open market outstanding bonds of its subsidiary, because the transaction is not
an intercompany transaction.” Do you agree with this statement? Explain.
15. What accounting problems result from the reissuance by a subsidiary of parent com-
pany bonds that had been acquired in the open market by the subsidiary? Explain.
16. Intercompany profits (gains) or losses in inventories, plant assets, intangible assets, or
bonds result in consolidated net income that differs from the parent company’s equity-
method net income. Why is this true? Explain.

Exercises
(Exercise 8.1) Select the best answer for each of the following multiple-choice questions:
1. On October 31, 2005, Sol Company, the wholly owned subsidiary of Pan Corporation,
borrowed $50,000 from Pan on a 90-day, 8% promissory note. On November 30, 2005,
Pan discounted the note at Western National Bank at a 10% discount rate. In Pan’s
journal entry to record the discounting of the note, the amount of the debit to the Cash
account is:
a. $50,000.
b. $50,150.
c. $50,333.
d. $51,000.
e. Some other amount.
2. On February 28, 2005, Pylon Corporation discounted at Bank of Los Angeles at a 15%
discount rate a $120,000, 60-day, 12% note receivable dated February 19, 2005, made
by Sullivan Company, a wholly owned subsidiary of Pylon. In its journal entry to
record the discounting of the note, Pylon:
a. Debits Cash, $119,799 ($122,400 $2,601).
b. Credits Discount on Intercompany Notes Receivable, $2,601 ($122,400
0.15 51⁄360).
c. Credits Intercompany Interest Revenue, $2,400 ($120,000 0.12 60⁄360).
d. Credits Notes Receivable, $120,000.
e. Prepares none of the foregoing debits or credits.
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 365

3. Intercompany loans, operating leases of property, and rendering of services do not include
an element of intercompany profit (gain) or loss for the consolidated entity because:
a. The affiliated companies do not profit at each other’s expense.
b. The revenue of one affiliate exactly offsets the expense of the other affiliate.
c. The transactions are not with outsiders.
d. The intercompany amounts are eliminated in the working paper for consolidated
financial statements.
4. A subsidiary’s journal entry to record the parent company’s discounting of a note
receivable from the subsidiary at a bank includes:

Debit Credit
a. Notes Payable Interest Payable
b. Intercompany Notes Payable Interest Payable
c. Intercompany Notes Payable Intercompany Interest Payable
d. Notes Payable Intercompany Interest Payable

5. A working paper elimination (in journal entry format) for intercompany sales of mer-
chandise generally includes a credit to:
a. Intercompany Cost of Goods Sold only.
b. Cost of Goods Sold only.
c. Both Intercompany Cost of Goods Sold and Cost of Goods Sold.
d. Neither Intercompany Cost of Goods Sold nor Cost of Goods Sold.
6. Does a parent company’s open-market acquisition of its subsidiary’s bonds at a cost
less than their carrying amount result, from a consolidated viewpoint on the date of ac-
quisition, in:

A Realized Gain? An Unrealized Gain?

a. Yes Yes
b. Yes No
c. No Yes
d. No No

7. This sentence appears in ARB No. 51, “Consolidated Financial Statements”: “The
amount of intercompany profit or loss to be eliminated . . . is not affected by the exis-
tence of a minority interest.” The foregoing statement is consistent with the:
a. Parent company concept.
b. Economic unit concept.
c. Equity method of accounting.
d. Purchase method of accounting.
8. In a working paper elimination (in journal entry format) dated March 31, 2006, for the
elimination of intercompany sales, cost of goods sold, and intercompany profit in in-
ventories resulting from a parent company’s sales of merchandise to its partially owned
subsidiary, the intercompany profit in the April 1, 2005 (beginning-of-year) inventories
of the subsidiary is:
a. Debited to Inventories—Subsidiary.
b. Credited to Inventories—Subsidiary.
c. Debited to Retained Earnings—Parent.
d. Debited to Retained Earnings—Subsidiary and Minority Interest in Net Assets of
Subsidiary.
366 Part Two Business Combinations and Consolidated Financial Statements

9. During the fiscal year ended March 31, 2006, Puritan Corporation sold merchandise
costing $120,000 to its 75%-owned subsidiary, Separatist Company, at a gross profit
rate of 40%. In the relevant working paper elimination (in journal entry format) on
March 31, 2006, Intercompany Sales—Puritan is debited for:
a. $156,000.
b. $168,000.
c. $180,000.
d. $200,000.
e. Some other amount.
10. A debit to Minority Interest in Net Assets of Subsidiary is inappropriate in a working
paper elimination (in journal entry format) for intercompany sales of merchandise by a:
a. Parent company to a partially owned subsidiary.
b. Partially owned subsidiary to another partially owned subsidiary.
c. Partially owned subsidiary to a wholly owned subsidiary.
d. Partially owned subsidiary to the parent company.
11. On August 31, 2005, Polanski Corporation acquired for $84,115 (a 14% yield),
$100,000 face amount of 10%, 20-year bonds (interest payable semiannually) due
August 31, 2011, of Skowalksi Company, its wholly owned subsidiary. The bonds had
been issued by Skowalksi to yield 12%. In a working paper elimination (in journal en-
try format) for the fiscal year ended February 28, 2006, Polanski debits the Intercom-
pany Interest Revenue ledger account for:
a. $5,000.
b. $5,888.
c. $6,000.
d. $8,412.
e. Some other amount.
12. A working paper elimination (in journal entry format) debiting Retained Earnings—
Parent and crediting Land—Subsidiary is prepared in the accounting period or periods:
a. Of the sale of the land only.
b. Following the period of the sale of the land only.
c. Both of the sale of the land and following the period of the sale of the land.
d. Neither of the sale of the land nor following the period of the sale of the land.
13. If a machine is sold by a wholly owned subsidiary to the parent company at a gain at
the end of the affiliates’ fiscal year, the appropriate working paper elimination (in jour-
nal entry format) will not include a(n):
a. Debit to Retained Earnings—Subsidiary.
b. Debit to Intercompany Gain on Sale of Machinery—Subsidiary.
c. Credit to Machinery—Parent.
d. Explanation.
14. If there is a $60,000 intercompany gain on the sale of machinery by a parent company
to its subsidiary, and the subsidiary establishes a five-year economic life, straight-line
depreciation, and no residual value for the machinery, the amount of the debit to
Retained Earnings—Parent in the working paper elimination at the end of the third
year of the machinery’s economic life is:
a. $24,000.
b. $36,000.
c. $48,000.
d. $60,000.
e. An indeterminable amount.
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 367

(Exercise 8.2) On March 13, 2006, Parker Corporation loaned $100,000 to its subsidiary, Sark Company,
on a 90-day, 8% promissory note. On April 12, 2006, Parker discounted the Sark note at
CHECK FIGURE First National Bank at a 10% discount rate.
Discount, $1,700. Prepare a working paper to compute the debit to the Cash ledger account in Parker Cor-
poration’s April 12, 2006, journal entry to record the discounting of the Sark Company
note. Round to the nearest dollar.
(Exercise 8.3) On March 1, 2006, Payton Corporation loaned $10,000 to its subsidiary, Slagle Company,
on a 90-day, 7% promissory note. On March 31, 2006, Payton discounted the Slagle note at
CHECK FIGURE a bank at a 9% discount rate.
Debit interest expense, Prepare Payton Corporation’s journal entry on March 31, 2006, to record the discount-
$36.
ing of the Slagle Company note. Round all amounts to the nearest dollar.
(Exercise 8.4) On March 31, 2006, Scully Company, the wholly owned subsidiary of Planke Corporation,
prepared the following journal entry at the instruction of Planke:

CHECK FIGURE
Debit interest expense, Intercompany Notes Payable 18,000
$17. Intercompany Interest Expense 135
Notes Payable 18,000
Interest Payable 135
To transfer 9%, 60-day note payable to Planke Corporation
dated March 1, 2006, from intercompany notes to outsider
notes. Action is necessary because Planke discounted the
note at 10% on this date.

Prepare a journal entry for Planke Corporation on March 31, 2006, to record the dis-
counting of the Scully Company note with the bank. Use a 360-day year.
(Exercise 8.5) Palos Verdes Corporation had the following events and transactions with its 90%-owned
subsidiary, South Gate Company, during the fiscal year ended May 31, 2006:
CHECK FIGURE 2005
July 1, debit interest June 1 Palos Verdes loaned South Gate $120,000 on a 90-day, 12% promissory
expense, $690. note.
July 1 Palos Verdes discounted the South Gate note at a bank at a 15% discount
rate.
2006
May 1 South Gate declared a dividend totaling $80,000.
May 10 South Gate paid the dividend declared May 1, 2006.
May 31 South Gate reported a net income of $200,000 for the year ended
May 31, 2006.
Prepare journal entries for Palos Verdes Corporation (omit explanations) for the forego-
ing transactions and events. Use the equity method of accounting where appropriate. (Dis-
regard income taxes.)
(Exercise 8.6) Peggy Corporation supplies all the merchandise sold by its wholly owned subsidiary, Sally
Company. Both Peggy and Sally use the perpetual inventory system. Peggy bills merchan-
CHECK FIGURE dise to Sally at a price 25% in excess of Peggy’s cost. For the fiscal year ended Novem-
Gross profit in cost of ber 30, 2006, Peggy’s sales to Sally were $120,000 at billed prices. At billed prices, Sally’s
goods sold, $22,800. December 1, 2005, inventories were $18,000, and its November 30, 2006, inventories were
$24,000.
368 Part Two Business Combinations and Consolidated Financial Statements

Prepare for Peggy Corporation and subsidiary an analysis of intercompany sales, cost of
goods sold, and gross profit in inventories for the year ended November 30, 2006. Your analy-
sis should show selling price, cost, and gross profit for each of the three intercompany items.
(Exercise 8.7) The intercompany sales of merchandise by Patter Corporation to its wholly owned sub-
sidiary, Smatter Company, for the fiscal year ended February 28, 2006, may be analyzed as
follows:

CHECK FIGURE
Selling Gross
Credit cost of goods
Price Cost Profit
sold—Smatter,
$187,500. Beginning inventories $100,000 $ 75,000 $ 25,000
Add: Sales 800,000 600,000 200,000
Subtotals $900,000 $675,000 $225,000
Less: Ending inventories 150,000 112,500 37,500
Cost of goods sold $750,000 $562,500 $187,500

Prepare a working paper elimination for Patter Corporation and subsidiary on February
28, 2006. Omit explanation and disregard income taxes.
(Exercise 8.8) Pele Corporation acquired 70% of the outstanding common stock of Shad Company on
August 1, 2005. During the fiscal year ended July 31, 2006, Pele sold merchandise to Shad
CHECK FIGURE in the amount of $120,000; the merchandise was priced at 20% above Pele’s cost. Shad had
Credit intercompany 30% of this merchandise in inventories on July 31, 2006.
cost of goods sold— Prepare a working paper elimination (in journal entry format) for Pele Corporation and
Pele, $100,000. subsidiary on July 31, 2006. (Disregard income taxes.)
(Exercise 8.9) During the fiscal year ended December 31, 2006, Spring Company, a 75%-owned subsidiary
of Polydom Corporation, sold merchandise costing $600,000 to Solano Company, a 90%-
CHECK FIGURE owned subsidiary of Polydom, at a markup of 25% on selling price. Included in Solano’s
Debit minority December 31, 2006, inventories were goods acquired from Spring at a billed price of $200,000,
interest, $10,000. representing a $40,000 increase over the comparable inventories on December 31, 2005.
Prepare a working paper elimination (in journal entry format) for Polydom Corporation
and subsidiaries on December 31, 2006. (Disregard income taxes.)
(Exercise 8.10) Polar Corporation entered into business combinations with Solar Company, an 80%-owned
subsidiary, and Stellar Company, a 70%-owned subsidiary, on September 30, 2005. During
CHECK FIGURE the fiscal year ended September 30, 2006, intercompany sales of merchandise by the two
Credit cost of goods subsidiaries were as follows:
sold—Solar, $45,000.

Solar Sales to Stellar Sales

Stellar to Solar
Cost of merchandise sold $120,000 $180,000
Markup on selling price 20% 25%
Selling price of merchandise (cost to purchaser) in
Sept. 30, 2006, inventories of purchaser $ 40,000 $ 60,000

Prepare working paper eliminations (in journal entry format; omit explanations) for
Polar Corporation and subsidiaries on September 30, 2006. (Disregard income taxes.)
(Exercise 8.11) Among the working paper eliminations (in journal entry format) of Parke Corporation and
subsidiary on December 31, 2006, was the following (explanation omitted):
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 369

CHECK FIGURE
b. Two years. Retained Earnings—Selma ($18,750 0.90) 16,875
Minority Interest in Net Assets of Subsidiary ($18,750 0.10) 1,875
Accumulated Depreciation—Parke 12,500
Machinery—Parke 25,000
Depreciation Expense (straight-line)—Parke ($25,000 4) 6,250

Answer the following questions:

a. What is the probable explanation of the foregoing elimination?
b. How many years have elapsed since the underlying intercompany transaction? Explain.
c. How does the credit to Depreciation Expense—Parke enter into the measurement of con-
solidated net income for Parke Corporation and subsidiary for the year ended December 31,
2006? Explain.
(Exercise 8.12) On October 1, 2006, the beginning of a fiscal year, Patria Corporation acquired equipment
for $14,500 from its 90%-owned subsidiary, Selena Company. The equipment was carried
at $9,000 in Selena’s accounting records and had an economic life of 10 years on October 1,
CHECK FIGURE 2006. Patria uses the sum-of-the-years’ digits depreciation method.
Debit minority Prepare a working paper elimination (in journal entry format) for Patria Corporation and
interest, $450. subsidiary on September 30, 2008. (Disregard income taxes.)
(Exercise 8.13) On January 2, 2006, Steve Company, an 80%-owned subsidiary of Paulo Corporation, sold
to its parent company for $20,000 a machine with a carrying amount of $16,000, a five-year
CHECK FIGURE economic life, and no residual value. Both Paulo and Steve use the straight-line method of
(4) $160. depreciation for all machinery.
Compute the missing amounts in the working paper eliminations (in journal entry for-
mat) for Paulo Corporation and subsidiary that follow. Use the identifying numbers for the
missing amounts in your solution.

December 31, December 31,

2008 2010
Minority Interest in Net Assets of Subsidiary (1) (4)
Retained Earnings—Steve (2) (5)
Accumulated Depreciation—Paulo (3) (6)
Machinery—Paulo 4,000 4,000
Depreciation Expense—Paulo 800 800
To eliminate unrealized intercompany gain in
machinery and in related depreciation.
(Income tax effects are disregarded.)

(Exercise 8.14) The working paper elimination (in journal entry format) on December 31, 2006, the date
that Pelion Corporation entered into a sales-type lease with its subsidiary, Styron Company,
was as shown below:
CHECK FIGURE
Credit depreciation Intercompany Liability under Capital Lease—Styron 15,849
expense, $385. Unearned Intercompany Interest Revenue—Pelion 4,151
Intercompany Sales—Pelion 20,849
Intercompany Cost of Goods Sold—Pelion 17,000
Intercompany Lease Receivables—Pelion 20,000
Leased Equipment—Capital Lease—Styron ($20,849 $17,000) 3,849
To eliminate intercompany accounts associated with intercompany lease
and to defer unrealized portion of intercompany gross profit on sales-type
lease. (Income tax effects are disregarded.)
370 Part Two Business Combinations and Consolidated Financial Statements

Pelion’s (the lessor’s) implicit interest rate, known to Styron (the lessee) and less than
Stryon’s incremental borrowing rate, was 10%, and the leased equipment had a 10-year
economic life with no residual value. Five lease payments of $5,000 each, beginning on
December 31, 2006, were required under the lease. Styron uses the straight-line method of
depreciation.
Prepare a working paper elimination (in journal entry format) for Pelion Corporation
and subsidiary on December 31, 2007. (Disregard income taxes.)
(Exercise 8.15) On March 1, 2006, the beginning of a fiscal year, Smart Company, the wholly owned sub-
sidiary of Pawley Corporation, sold to Pawley for $80,000 a patent with a carrying amount
of $60,000 and a four-year remaining economic life. Pawley credits amortization directly
to intangible asset ledger accounts and includes amortization with operating expenses.
Prepare a working paper elimination for Pawley Corporation and subsidiary on Febru-
ary 28, 2007. (Omit explanation and disregard income taxes.)
(Exercise 8.16) Solaw Company, the wholly owned subsidiary of Polka Corporation, issued 10%, five-year
bonds on May 1, 2006, at their face amount of $100,000. Interest is payable annually each
CHECK FIGURE May 1, beginning Year 2007. On April 30, 2007, the end of a fiscal year, Polka acquired in
Gain on the open market 40% of Solaw’s outstanding bonds at a 12% yield, plus accrued interest for
extinguishment, one year.
$2,430. Prepare a working paper to compute the amount of cash paid by Polka Corporation for
Solaw Company’s bonds on April 30, 2007, and the gain on the extinguishment of the
bonds. Round all computations to the nearest dollar. (Disregard income taxes.)
(Exercise 8.17) On November 1, 2006, the beginning of a fiscal year, Sinn Company, the 90%-owned sub-
sidiary of Parr Corporation, issued to the public $100,000 face amount of five-year,
9% bonds, interest payable each November 1, beginning Year 2007, for $103,993—an 8%
yield. Bond issue costs may be disregarded. On October 31, 2007, Parr acquired in the open
CHECK FIGURE market $60,000 face amount of Sinn’s 9% bonds for $58,098—a 10% yield. The realized
(3) $58,508. gain on the transaction displayed in the October 31, 2007, consolidated income statement
of Parr Corporation and subsidiary was $3,889. Sinn and Parr use the interest method of
amortization of bond premium and accumulation of bond discount.
Prepare a working paper to compute the missing amounts in the working paper elimina-
tion (in journal entry format) below. Round all amounts to the nearest dollar. (Disregard
income taxes.)

PARR CORPORATION AND SUBSIDIARY

Partial Working Paper Eliminations
October 31, 2008

Intercompany Interest Revenue—Parr (1)

Intercompany Bonds Payable—Sinn 60,000
Premium on Intercompany Bonds Payable—Sinn (2)
Investment in Sinn Company Bonds—Parr (3)
Intercompany Interest Expense—Sinn (4)
Retained Earnings—Sinn (5)
Minority Interest in Net Assets of Subsidiary 389
To eliminate subsidiary’s bonds owned by parent company, and related
interest revenue and expense; and to increase subsidiary’s beginning
retained earnings by amount of unamortized realized gain on the
extinguishment of the bonds. (Income tax effects are disregarded.)
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 371

(Exercise 8.18) Palimino Corporation acquired a 70% interest in Sokal Company in 2005. For the fiscal years
ended December 31, 2006 and 2007, Sokal had a net income of $80,000 and $90,000, respec-
tively. During Year 2006, Sokal sold merchandise to Palimino for $10,000 at a gross profit of
$2,000. The merchandise was resold during Year 2007 by Palimino to outsiders for $15,000.
Compute the minority interest in Sokal Company’s net income for the years ended De-
cember 31, 2006 and 2007. (Disregard income taxes.)

Cases
(Case 8.1) Powell Corporation has begun selling idle machinery from a discontinued product line to a
wholly owned subsidiary, Seeley Company, which needs the machinery in its operations.
Powell had transferred the machinery from the Machinery ledger account to an Idle Ma-
chinery account, had written down the machinery to current fair value based on quotations
from used machinery dealers, and had terminated depreciation of the idle machinery when
the product line was discontinued.
During the fiscal year ended December 31, 2006, Powell’s sales of idle machinery to
Seeley totaled $50,000 and were accounted for by Powell and Seeley in the following
aggregate journal entries:

POWELL CORPORATION
Journal Entries

Cash 50,000
Sales of Idle Machinery 50,000
To record sales of idle machinery to Seeley Company.

Cost of Idle Machinery Sold 40,000

Idle Machinery 40,000
To write off idle machinery sold to Seeley Company.

SEELEY COMPANY
Journal Entries

Machinery 50,000
Cash 50,000
To record acquisition of used machinery from Powell Corporation.

Depreciation Expense 5,000

Accumulated Depreciation of Machinery 5,000
To provide, in accordance with regular policy, depreciation for one-half
year in year of acquisition of machinery, based on economic life of five
years and no residual value.

On December 31, 2006, the accountant for Powell Corporation prepared the following
working paper elimination (in journal entry format):

Retained Earnings—Powell 10,000

Machinery—Seeley 10,000
To eliminate unrealized intercompany gain in machinery.
372 Part Two Business Combinations and Consolidated Financial Statements

Instructions
Evaluate the foregoing journal entries and working paper elimination.

(Case 8.2) Sawhill Company, one of two wholly owned subsidiaries of Peasley Corporation, is in liq-
uidation under Chapter 7 of the U.S. Bankruptcy Code. On October 31, 2006, the close of
a fiscal year, Sawhill sold trade accounts receivable with a carrying amount of $50,000 to
Shelton Company, the other wholly owned subsidiary of Peasley Corporation, for a gain of
$10,000. Shelton debited the $10,000 to a deferred charge ledger account, which was to be
amortized to expense in proportion to the amounts collected on the trade accounts receiv-
able Shelton had acquired from Sawhill. The $10,000 gain was displayed in the consoli-
dated income statement of Peasley Corporation and Shelton Company for the fiscal year
ended October 31, 2006; Sawhill Company was not included in the consolidated financial
statements on that date because it was in liquidation. Peasley used the equity method of ac-
counting for its investments in both Shelton and Sawhill.

Instructions
Evaluate the accounting described above.

(Case 8.3) You are the newly hired controller of Winston Corporation, whose founder and sole
owner, Harold Winston, engaged you to “straighten out the books” in anticipation of the
company’s “going public” in about three years. In reviewing the accounting records of
Winston Corporation and its wholly owned subsidiary, Cranston Company, you find that
both companies have used the periodic inventory system, but neither company had kept
adequate records of Winston’s sales of its only product to Cranston, which sold that prod-
uct and other products obtained from unrelated suppliers to Cranston customers. You
learned from Harold Winston that no uniform markup had been applied to products sold
to Cranston; the markups varied from 15% to 25% of Winston’s production costs. You
also learn that the two companies had filed separate income tax returns, prepared by a lo-
cal CPA firm, in past years. Your initial investigation indicates that, on the advice of the
engagement partner of the local CPA firm, both Winston and Cranston had taken accu-
rate physical inventories in past years.

Instructions
Is it possible for you to prepare fairly presented consolidated financial statements for
Winston Corporation and subsidiary as of the end of the first fiscal year of your controller-
ship? Explain.

(Case 8.4) As independent auditor of a new client, Aqua Water Corporation, you are reviewing the
working paper for consolidated financial statements prepared by Arthur Brady, Aqua
Water’s accountant. Aqua Water distributes water to homeowners in a suburb of a large
city. Aqua Water purchases the water from its subsidiary, Aqua Well Company. Aqua
Water organized Aqua Well five years ago and acquired all its common stock for cash on
that date.
During the course of your audit, you have learned the following:
1. Both Aqua Water and Aqua Well are public utilities subject to the jurisdiction of the
state’s Public Utilities Commission.
2. Aqua Well charges Aqua Water for the transmission of water from wells to consumers.
The transmission charge, at the customary utility rate, was approved by the state’s Pub-
lic Utilities Commission.
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 373

3. Aqua Well charges Aqua Water separately for the volume of water delivered to Aqua
Water’s customers.
4. Your audit working papers show the following audited amounts for the two companies’
separate financial statements:

Aqua Water Aqua Well

Corporation Company
Total revenue $3,500,000 $ 300,000
Net income 300,000 50,000
Total assets 5,700,000 1,000,000
Stockholders’ equity 2,500,000 600,000

The working paper for consolidated financial statements prepared by Aqua Water Cor-
poration’s accountant appears in order, except that Aqua Well’s Transmission Revenue
amount of $60,000 is not offset against Aqua Water’s Transmission Expense amount of
$60,000. The accountant explained that, because the transmission charge by Aqua Well is
at the customary utility rate approved by the state’s Public Utilities Commission, the
charge should not be treated as intercompany revenue and expense. Furthermore, Brady
points out, the working paper for consolidated financial statements does offset Aqua
Well’s Water Sales amount of $200,000 against Aqua Water’s Purchases amount of
$200,000.

Instructions
Do you concur with the accountant’s (Brady’s) position? Explain.
(Case 8.5) You are a sole practitioner CPA specializing in forensic (investigative) accounting. The
audit committee of Padgett Corporation, a nonpublic enterprise with ten shareholders,
has requested you to investigate possible misstatements in the following condensed con-
solidated financial statements of Padgett and its wholly owned subsidiary, Seacoast
Company:

PADGETT CORPORATION AND SUBSIDIARY

Consolidated Income Statement
For Year Ended December 31, 2006

Revenue and gains:

Net sales $2,000,000
Gain on sale of land 200,000
Total revenue and gains $2,200,000
Costs and expenses:
Cost of goods sold $1,400,000
Selling, general, and administrative expenses 300,000
Income taxes expense 170,000
Total costs and expenses 1,870,000
Net income $ 330,000
Basic earnings per share $5.50
374 Part Two Business Combinations and Consolidated Financial Statements

PADGETT CORPORATION AND SUBSIDIARY

Consolidated Balance Sheet
December 31, 2006

Assets
Current assets $ 3,000,000
Property, plant, and equipment (net) 7,000,000
Total assets $10,000,000

Liabilities and Stockholders’ Equity

Current liabilities $ 2,000,000
Long-term debt 5,000,000
Total liabilities $ 7,000,000

Stockholders’ equity:
Common stock, no par or stated value; 60,000
shares authorized, issued and outstanding
(no change during year) $1,200,000
Retained earnings (no dividends during year) 1,800,000
Total stockholders’ equity 3,000,000
Total liabilities and stockholders’ equity $10,000,000

Your investigation disclosed the following:

1. The majority stockholder, chairman of the board, and president of Padgett had autho-
rized the sale of part of Padgett’s land, having a carrying amount of $800,000, to Sea-
coast in 2006 for a $1,000,000, five-year, non-interest-bearing, unsecured promissory
note. A fair rate of interest on the note is 8%. The $200,000 intercompany gain
($1,000,000 $800,000 $200,000) had not been eliminated in the preparation of the
consolidated income statement of Padgett and Seacoast.
2. On December 31, 2006, Padgett had sold to Seacoast finished goods with a cost of
$500,000, at Padgett’s usual markup of 30% on cost. Neither the intercompany sales nor
the intercompany cost of goods sold had been eliminated in the preparation of the con-
solidated income statement of Padgett and Seacoast. None of the finished goods had
been sold by Seacoast to outsiders on December 31, 2006.

Instructions
Write a letter to the audit committee of Padgett Corporation’s board of directors, describ-
ing your findings and their impact on the assets, liabilities, stockholders’ equity, revenue
and gains, expenses, and basic earnings per share of Padgett Corporation and subsidiary.
Do not prepare revised financial statements.

Problems
(Problem 8.1) On October 21, 2006, Prentiss Corporation loaned to its 92%-owned subsidiary, Scopes
Company, $100,000 on a 90-day, 71⁄2% promissory note. On October 31, 2006, Prentiss dis-
CHECK FIGURE counted the Scopes note at City Bank, at a discount rate of 9% a year.
a. Intercompany
interest revenue, $208.
Instructions
Prepare journal entries for the foregoing business transactions and events:
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 375

a. In the accounting records of Prentiss Corporation.

b. In the accounting records of Scopes Company.
Round all amounts to the nearest dollar.
(Problem 8.2) Pillsbury Corporation has begun making working capital loans to its wholly owned sub-
sidiary, Sarpy Company, on 71⁄2% promissory notes. The following 120-day loans were
made prior to June 30, 2006, the close of the fiscal year:

May 1, 2006 $15,000

May 31, 2006 20,000

On June 6, 2006, Pillsbury discounted the May 1 note at a bank, at a 9% discount rate. The
CHECK FIGURE bank used a 360-day year and based the discount on the maturity value of the note.
a. June 6, credit
intercompany interest Instructions
revenue, $113. Prepare journal entries to record the note transactions and related June 30, 2006,
adjustments:
a. In the accounting records of Pillsbury Corporation.
b. In the accounting records of Sarpy Company.
Round all amounts to the nearest dollar.
(Problem 8.3) Pittsburgh Corporation completed a business combination with Syracuse Company on
April 30, 2005. Immediately thereafter, Pittsburgh began making cash advances to Syra-
CHECK FIGURE cuse at a 10% annual interest rate. In addition, Syracuse agreed to pay a monthly manage-
c. Intercompany ment fee to Pittsburgh of 2% of monthly net sales. Payment was to be made no later than
revenue (expenses), the tenth day of the month following Syracuse’s accrual of the fee.
$6,911. During your audit of the financial statements of Pittsburgh Corporation and Syracuse
Company as of July 31, 2005, the end of the fiscal year, you discovered that each
company has set up only one ledger account—entitled Intercompany Account—to record
all intercompany transactions. Details of the two accounts on July 31, 2005, are as
follows:

PITTSBURGH CORPORATION LEDGER

Intercompany Account—Syracuse Company

Date Explanation Debit Credit Balance
2005
May 2 Cash advance paid 4,500 4,500 dr
May 27 Cash advance paid 9,000 13,500 dr
June 11 Management fee received 2,000 11,500 dr
June 12 Repayment of May 2 advance and
interest 4,550 6,950 dr
June 21 Cash advance paid 10,000 16,950 dr
July 11 Management fee received 2,200 14,750 dr
July 27 Repayment of May 27 advance and
interest 9,150 5,600 dr
July 31 Cash advance paid 5,000 10,600 dr
376 Part Two Business Combinations and Consolidated Financial Statements

SYRACUSE COMPANY LEDGER

Intercompany Account—Pittsburgh Corporation

Date Explanation Debit Credit Balance
2005
May 3 Cash advance received 4,500 4,500 cr
May 28 Cash advance received 9,000 13,500 cr
June 10 Management fee paid
($100,000 0.02) 2,000 11,500 cr
June 11 Repayment of May 2 advance
and interest 4,550 6,950 cr
June 22 Cash advance received 10,000 16,950 cr
July 10 Management fee paid
($110,000 0.02) 2,200 14,750 cr
July 26 Repayment of May 27 advance
and interest 9,150 5,600 cr

Your audit working papers show audited net sales of $330,000 for Syracuse Company
for the three months ended July 31, 2005. You agreed to the companies’ use of a 360-day
year for computing interest.

Instructions
a. Prepare correcting entries for Pittsburgh Corporation on July 31, 2005. Establish appro-
priate separate intercompany accounts in the journal entries.
b. Prepare correcting entries for Syracuse Company on July 31, 2005. Establish appropri-
ate separate intercompany accounts in the journal entries.
c. Prepare a partial working paper for consolidated financial statements to include the
intercompany accounts established in (a) and (b).
(Problem 8.4) Parley Corporation owns 90% of the outstanding common stock of Silton Company. Both
Parley and Silton have a February 28 (or 29) fiscal year-end. On March 1, 2006, Silton sold
CHECK FIGURE to Parley for $100,000 a warehouse carried in Silton’s Leasehold Improvements ledger ac-
Credit gain on count on that date at a net amount of $80,000. Parley was amortizing the warehouse on the
extinguishment, straight-line basis over the remaining term of the operating lease, which was to expire
$1,736. February 28, 2016.
On March 1, 2007, Parley acquired in the open market for $48,264 cash (a 10% yield)
one-half of Silton’s $100,000 face amount 8% bonds due February 28, 2009. The bonds had
been issued at their face amount on March 1, 2004, with interest payable annually on
February 28, beginning in 2005. Both Silton and Parley use the interest method of amorti-
zation and accumulation of bond discount.

Instructions
Prepare working paper eliminations (in journal entry format) on February 28, 2008, for
Parley Corporation and subsidiary. (Disregard income taxes.)
(Problem 8.5) Peke Corporation sells merchandise to its 75%-owned subsidiary, Stoke Company, at a
CHECK FIGURE markup of 25% on cost. Stoke sells merchandise to Peke at a markup of 25% on selling
Debit minority interest price. Merchandise transactions between the two companies for the fiscal year ended
in net assets, $1,875. June 30, 2007, were as follows, at selling prices:
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 377

Peke Stoke
Sales to Sales to
Stoke Peke
July 1, 2006, inventories of purchaser $ 48,000 $ 30,000
Sales during year 600,000 800,000
Subtotals $648,000 $830,000
Less: June 30, 2007, inventories of purchaser 60,000 40,000
Cost of goods sold during year $588,000 $790,000

Instructions
Prepare working paper eliminations (in journal entry format) on June 30, 2007, for Peke
Corporation and subsidiary. (Disregard income taxes.)

(Problem 8.6) For the fiscal year ended April 30, 2006, Scala Company, the 90%-owned subsidiary of
Padua Corporation, had a net income of $120,000. During the year ended April 30, 2006,
the following intercompany transactions and events occurred:
CHECK FIGURE 1. Padua sold merchandise to Scala for $180,000, at a markup of 20% on Padua’s cost.
Debit minority interest Merchandise acquired from Padua in Scala’s inventories totaled $54,000 on May 1,
in net income, 2005, and $84,000 on April 30, 2006, at billed prices.
$11,803.
2. On May 1, 2005, Scala sold to Padua for $80,000 a machine with a carrying amount to
Scala of $56,000. Padua established a remaining economic life of eight years, no resid-
ual value, and the straight-line method of depreciation for the machine.
3. On April 30, 2006, Padua acquired in the open market $200,000 face amount of Scala’s
10%, ten-year bonds for $158,658, a yield rate of 14%. Scala had issued $400,000 face
amount of the bonds on October 31, 2005, for $354,120, a yield rate of 12%. The bonds
paid interest each April 30 and October 31; Padua acquired its bond investment after the
interest for April 30, 2006, had been paid to the previous bondholders. Both Scala and
Padua use the interest method of amortization or accumulation of bond discount.

Instructions
Prepare working paper eliminations (in journal entry format) for Padua Corporation and
subsidiary on April 30, 2006, including the minority interest in net income of subsidiary.
Disregard the elimination for the intercompany investment in the subsidiary’s common
stock; also disregard income taxes.

(Problem 8.7) On July 1, 2005, the beginning of a fiscal year, Pacific Corporation and its wholly owned
subsidiary, Sommer Company, entered into the following intercompany transactions and
CHECK FIGURE events:
b. Credit gain on
extinguishment, 1. Pacific sold to Sommer for $16,000 a machine with a carrying amount of $12,000
$18,533. ($30,000 cost less $18,000 accumulated depreciation). Sommer estimated a remaining
economic life of eight years and no residual value for the machine. Sommer uses the
straight-line method of depreciation for all plant assets.
2. Pacific acquired in the open market for $361,571 (a 12% yield) four-fifths of Sommer’s
outstanding 8% bonds due June 30, 2008 (after June 30, 2005, interest had been paid on
the bonds). Sommer’s accounting records on July 1, 2005, included the following ledger
account balances:
378 Part Two Business Combinations and Consolidated Financial Statements

8% bonds payable, due June 30, 2008 $500,000 cr

Discount on 8% bonds payable 24,870 dr

The 8% bonds (interest payable each June 30) had been issued by Sommer July 1, 2003, to
yield 10%. Bond issue costs may be disregarded. Interest expense recognized by Sommer
through Year 2005 was as follows:

Year ended June 30, 2004 $46,209

Year ended June 30, 2005 46,830

Both Sommer and Pacific use the interest method of amortization or accumulation of bond
discount.
Instructions
a. Prepare journal entries for Pacific Corporation to record the two transactions or events
with Sommer Company on July 1, 2005, and intercompany interest revenue for the year
ended June 30, 2006. (Disregard income taxes.)
b. Prepare working paper eliminations (in journal entry format) for Pacific Corporation
and subsidiary on June 30, 2006. (Disregard income taxes.)
(Problem 8.8) On August 31, 2006, the end of a fiscal year, Silver Company, a wholly owned subsidiary
of Pollard Corporation, issued to the public, at a yield rate of 11%, $800,000 face amount of
CHECK FIGURE 10%, ten-year bonds with interest payable each February 28 and August 31. Bond issue
b. Aug. 31, 2007, costs may be disregarded. On August 31, 2007, after Silver’s interest payment, Pollard ac-
credit gain on quired in the open market $600,000 face amount of Silver’s 10% bonds for $535,034, at a
extinguishment, yield rate of 12%. On that date, Silver’s Discount on Bonds Payable account had a debit
$31,227. balance of $44,985. Both companies use the interest method of amortization or accumula-
tion of bond discount, and both companies close their accounting records only at the end of
the fiscal year.
Instructions
a. Set up three-column ledger accounts for Pollard Corporation’s Investment in Silver
Company Bonds and Intercompany Interest Revenue and for Silver Company’s Inter-
company Bonds Payable, Discount on Intercompany Bonds Payable, and Intercompany
Interest Expense. Record in the ledger accounts all transactions involving Silver’s 10%
bonds from August 31, 2007, through August 31, 2008. Round all amounts to the near-
est dollar. Disregard income taxes, and do not prepare closing entries.
b. Prepare working paper eliminations (in journal entry format) for Pollard Corporation
and subsidiary on August 31, 2007, and August 31, 2008. (Disregard income taxes.)
(Problem 8.9) On December 31, 2006, Procus Corporation entered into a three-year sales-type lease with
its 90%-owned subsidiary, Stoffer Company, for equipment having an economic life of six
CHECK FIGURES years, no residual value, and a cost in Procus’s Inventories ledger account of $32,000. The
b. Credit leased lease required Stoffer to pay Procus $20,000 on December 31, 2006, 2007, and 2008, and
equipment: Dec. 31, $5,000 (a bargain purchase option) on December 31, 2009. Procus’s implicit interest rate
2006, $28,242; (known to Stoffer and less than Stoffer’s incremental borrowing rate) was 7%, and Stoffer
Dec. 31, 2007, $23,535. uses the straight-line method of depreciation. The present value of the minimum lease pay-
ments was $60,242.
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 379

Instructions
a. Set up three-column ledger accounts for Procus Corporation’s Intercompany Lease Re-
ceivables, Unearned Intercompany Interest Revenue, and Intercompany Interest Rev-
enue ledger accounts and for Stoffer Company’s Leased Equipment—Capital Lease,
Intercompany Liability under Capital Lease, and Intercompany Interest Expense ac-
counts; record in the accounts all transactions and events related to the leased property
for the six years ended December 31, 2012. (Round all amounts to the nearest dollar;
disregard income taxes.)
b. Prepare working paper eliminations (in journal entry format) for Procus Corporation
and subsidiary on December 31, 2006, and December 31, 2007. (Disregard income
taxes.)
(Problem 8.10) Patrick Corporation issued 100,000 shares of its $10 par common stock (current fair value
$2,205,000) to acquire all the outstanding $10 par common stock of Shannon Company on
CHECK FIGURE December 31, 2005, the end of a fiscal year, in a business combination. In addition, Patrick
Consolidated retained acquired for $220,424, at a 12% yield rate, $250,000 face amount of Shannon’s 9%, ten-year
earnings, $4,799,576. bonds due June 30, 2011, with interest payable each June 30 and December 31. (The current
fair values of Shannon’s net assets equaled their carrying amounts.) After completion of the
business combination and journal entries to transfer merchandise transactions between
Patrick and Shannon prior to the business combination to appropriate intercompany ledger
accounts, the separate financial statements of the two companies were as follows:

PATRICK CORPORATION AND SHANNON COMPANY

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

Patrick Shannon
Corporation Company
Income Statements
Revenue:
Net sales $15,000,000 $10,000,000
Intercompany sales (prior to business
combination) 600,000
Total revenue $15,000,000 $10,600,000
Costs and expenses:
Cost of goods sold $ 6,000,000 $ 6,000,000
Intercompany cost of goods sold (prior to
business combination) 480,000
Operating expenses 5,350,000 2,137,000
Interest expense 150,000 108,000
Income taxes expense 1,400,000 750,000
Total costs and expenses $12,900,000 $ 9,475,000
Net income $ 2,100,000 $ 1,125,000

Statements of Retained Earnings

Retained earnings, beginning of year $ 3,530,000 $ 275,000
Add: Net income 2,100,000 1,125,000
Subtotals $ 5,630,000 $ 1,400,000
Less: Dividends declared 800,000 270,000
Retained earnings, end of year $ 4,830,000 $ 1,130,000

(continued)
380 Part Two Business Combinations and Consolidated Financial Statements

PATRICK CORPORATION AND SHANNON COMPANY

Separate Financial Statements (following business combination) (concluded)
For Year Ended December 31, 2005

Patrick Shannon
Corporation Company
Balance Sheets
Assets
Cash $ 750,000 $ 300,000
Trade accounts receivable (net) 1,950,000 450,000
Intercompany accounts receivable
(prior to business combination) 300,000
Inventories 2,100,000 950,000
Investment in Shannon Company common stock 2,205,000
Investment in Shannon Company bonds 220,424
Plant assets (net) 4,660,000 2,000,000
Other assets 564,576 350,000
Total assets $12,450,000 $ 4,350,000

Liabilities and Stockholders’ Equity

Intercompany accounts payable $ 300,000
Other current liabilities 1,450,000 $ 945,000
Bonds payable 1,500,000 950,000
Intercompany bonds payable 250,000
Common stock, $10 par 3,000,000 900,000
Additional paid-in capital 1,370,000 175,000
Retained earnings 4,830,000 1,130,000
Total liabilities and stockholders’ equity $12,450,000 $ 4,350,000

On December 31, 2005, one-half of the merchandise acquired by Patrick from Shannon
prior to the business combination remained unsold.
Instructions
Prepare a working paper for a consolidated balance sheet and related working paper elimi-
nations (in journal entry format) for Patrick Corporation and subsidiary on December 31,
2005. (Disregard income taxes.)
(Problem 8.11) Power Corporation acquired 80% of Snyder Company’s 1,250 shares of outstanding $100
par common stock on July 1, 2005, for $158,600, including out-of-pocket costs of the busi-
ness combination. The excess of the current fair value of Snyder’s identifiable net assets
over their carrying amounts on July 1, 2005, was attributable as follows:

To inventories $3,000
To equipment (five-year remaning economic life on July 1, 2005) 4,000
To goodwill 3,400

In addition, on July 1, 2005, Power acquired in the open market at face amount $40,000
of Snyder Company’s 6% bonds payable. Interest is payable by Snyder each July 1 and
January 1.
Separate financial statements for Power Corporation and Snyder Company for the peri-
ods ended December 31, 2005, were as follows:
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 381

CHECK FIGURES POWER CORPORATION AND SNYDER COMPANY

Minority interest in net
Separate Financial Statements
income, $2,320; For Periods Ended December 31, 2005
minority interest in
net assets, $39,320. Power Snyder
Corporation Company
(Year Ended (Six Months
Dec. 31, 2005) Ended Dec. 31, 2005)
Income Statements
Revenue:
Net sales $ 902,000 $400,000
Intercompany sales 60,000 105,000
Intercompany interest revenue (expense) 1,200 (1,200)
Intercompany investment income 13,280
Intercompany loss on sale of equipment (2,000)
Total revenue $ 974,480 $503,800
Costs and expenses:
Cost of goods sold $ 720,000 $300,000
Intercompany cost of goods sold 50,000 84,000
Operating expenses and income taxes expense 124,140 99,800
Total costs and expenses $ 894,140 $483,800
Net income $ 80,340 $ 20,000

Statements of Retained Earnings

Retained earnings, beginning of period $ 220,000 $ 50,000
Add: Net income 80,340 20,000
Subtotals $ 300,340 $ 70,000
Less: Dividends declared 36,000 9,000
Retained earnings, end of period $ 264,340 $ 61,000

Balance Sheets
Assets
Intercompany receivables (payables) $ 100 $ (100)
Inventories, at first-in, first-out cost 300,000 75,000
Investment in Snyder Company common stock 164,680
Investment in Snyder Company bonds 40,000
Plant assets 794,000 280,600
Accumulated depreciation of plant assets (260,000) (30,000)
Other assets 610,900 73,400
Total assets $1,649,680 $398,900

Liabilities and Stockholders’ Equity

Dividends payable $ 1,600
Bonds payable $ 600,000 45,000
Intercompany bonds payable 40,000
Other liabilities 376,340 114,300
Common stock, $100 par 360,000 125,000
Additional paid-in capital 49,000 12,000
Retained earnings 264,340 61,000
Total liabilities and stockholders’ equity $1,649,680 $398,900
382 Part Two Business Combinations and Consolidated Financial Statements

Additional Information
1. Intercompany sales data for the six months ended December 31, 2005, are:

Power Snyder
Corporation Company
Intercompany accounts payable, Dec. 31, 2005 $13,000 $ 5,500
Intercompany purchases in inventories, Dec. 31, 2005 25,000 18,000

2. On October 1, 2005, Power had sold to Snyder for $ 12,000 equipment having a carry-
ing amount of $ 14,000 on that date. Snyder established a five-year remaining economic
life, no residual value, and the straight-line method of depreciation for the equipment.
Snyder includes depreciation expense in operating expenses.
3. Dividends were declared by Snyder as follows:

Sept. 30, 2005 $1,000

Dec. 31, 2005 8,000
Total dividends declared $9,000

4. Consolidated goodwill was unimpaired as of December 31, 2005.

Instructions
Prepare a working paper for consolidated financial statements and related working paper
eliminations (in journal entry format) for Power Corporation and subsidiary for the year
ended December 31, 2005. (Disregard income taxes.)
(Problem 8.12) On January 2, 2005, Pritchard Corporation issued 5,000 shares of its $10 par common
stock having a current fair value equal to the current fair value (and carrying amount) of the
combinee’s net assets in exchange for all 3,000 shares of Spangler Company’s $20 par com-
mon stock outstanding on that date. Out-of-pocket costs of the business combination may
be disregarded. Separate financial statements of the two companies for the year ended
December 31, 2005, follow:

PRITCHARD CORPORATION AND SPANGLER COMPANY

Separate Financial Statements
For Year Ended December 31, 2005

Pritchard Spangler
Corporation Company
Income Statements
Revenue:
Net sales $499,850 $298,240
Intercompany sales 40,000 6,000
Intercompany interest revenue (expense) 300 (480)
Intercompany investment income 10,200
Intercompany gain on sale of equipment 2,000
Total revenue $550,350 $305,760
Costs and expenses:
Cost of goods sold $400,000 $225,000
Intercompany cost of goods sold 30,000 4,800
Operating expenses and income taxes expense 88,450 65,760
Total costs and expenses $518,450 $295,560
Net income $ 31,900 $ 10,200

(continued)
 Chapter 8 Consolidated Financial Statements: Intercompany Transactions 383

CHECK FIGURES PRITCHARD CORPORATION AND SPANGLER COMPANY

b. Consolidated net
Separate Financial Statements (concluded)
income, $26,300; For Year Ended December 31, 2005
consolidated ending
retained earnings, Pritchard Spangler
$115,400. Corporation Company
Statements of Retained Earnings
Retained earnings, beginning of year $ 89,100 $ 22,100
Add: Net income 31,900 10,200
Subtotals $121,000 $ 32,300
Less: Dividends declared 4,500
Retained earnings, end of year $121,000 $ 27,800

Balance Sheets
Assets
Intercompany receivables (payables) $ 21,300 $ (22,980)
Inventories 81,050 49,840
Investment in Spangler Company common stock 112,300
Plant assets 83,200 43,500
Accumulated depreciation of plant assets (12,800) (9,300)
Other assets 71,150 56,200
Total assets $356,200 $117,260

Liabilities and Stockholders’ Equity

Liabilities $ 56,700 $ 9,460
Common stock, $10 par 120,000
Common stock, $20 par 60,000
Additional paid-in capital 58,500 20,000
Retained earnings 121,000 27,800
Total liabilities and stockholders’ equity $356,200 $117,260

Additional Information
1. On December 31, 2005, Spangler owed Pritchard $16,000 on open account and $8,000
on 12% demand notes dated July 1, 2005 (interest payable at maturity). Pritchard had
discounted $3,000 of the notes received from Spangler with a bank on July 1, 2005,
without notifying Spangler of this action.
2. During 2005, Pritchard sold to Spangler for $40,000 merchandise that cost $30,000.
Spangler’s December 31, 2005, inventories included $10,000 of this merchandise priced
at Spangler’s cost.
3. On July 1, 2005, Spangler had sold equipment with a carrying amount of $15,000 to
Pritchard for $17,000. Pritchard recognized depreciation on the equipment in the amount
of $850 for 2005. The remaining economic life of the equipment on the date of sale was
10 years. Pritchard includes depreciation expense in operating expenses.
4. Spangler had shipped merchandise to Pritchard on December 31, 2005, and recorded an
intercompany account receivable of $6,000 for the sale. Spangler’s cost for the mer-
chandise was $4,800. Because the merchandise was in transit, Pritchard did not record
the transaction. The terms of the sale were FOB shipping point.
5. Spangler declared a dividend of $1.50 a share on December 31, 2005, payable on Janu-
ary 10, 2006. Pritchard made no journal entry for the dividend declaration.
384 Part Two Business Combinations and Consolidated Financial Statements

Instructions
a. Prepare adjusting entries for Pritchard Corporation and Spangler Company on Decem-
ber 31, 2005.
b. Prepare a working paper for consolidated financial statements and related working paper
eliminations (in journal entry format) for Pritchard Corporation and subsidiary on De-
cember 31, 2005. Amounts in the working paper should reflect the adjusting entries
in (a). (Disregard income taxes.)
Chapter Nine

Consolidated Financial
Statements: Income
Taxes, Cash Flows, and
Installment Acquisitions
Scope of Chapter
This chapter considers two topics that have relevance for every business combination and
parent company–subsidiary relationship: (1) income taxes and (2) the consolidated state-
ment of cash flows. In addition, this chapter deals with accounting for installment acquisi-
tions of a subsidiary in a business combination.

INCOME TAXES IN BUSINESS COMBINATIONS

AND CONSOLIDATIONS
Accounting for income taxes for business combinations and for a consolidated entity has
received considerable attention from accountants in recent years, primarily because of the
emphasis on interperiod income tax allocation and disclosure in financial statements.
Accounting for income taxes in business combinations and consolidated financial state-
ments may be subdivided into three sections: (1) income taxes attributable to current fair
values of a combinee’s identifiable net assets, (2) income taxes attributable to undistributed
earnings of subsidiaries, and (3) income taxes attributable to unrealized and realized inter-
company profits (gains).

Income Taxes Attributable to Current Fair Values of

a Combinee’s Identifiable Net Assets
Income tax accounting requirements for business combinations often differ from financial
accounting requirements. A business combination, which in accordance with financial
accounting requires a revaluation of the combinee’s identifiable net assets, may meet the
requirements for a “tax-free corporate reorganization” under the Internal Revenue Code, in
which a new income tax basis may not be required for the combinee’s net assets. In such
situations, a temporary difference may result between provisions for depreciation and
amortization in the combinee’s financial statements and income tax returns.
385
386 Part Two Business Combinations and Consolidated Financial Statements

In recognition of this problem, the Financial Accounting Standards Board made the fol-
lowing provision for income tax considerations in the valuation of a combinee’s net assets:
A deferred tax liability or asset shall be recognized in accordance with the requirements
of this Statement for differences between the assigned values and the tax bases of the assets
and liabilities (except the portion of goodwill for which amortization is not deductible
for tax purposes, unallocated “negative goodwill,” leveraged leases, . . .) recognized in
a . . . business combination.1

To illustrate the application of the above, assume that the business combination of Regal
Corporation and the combinee, Thorne Company, completed on June 1, 2005, met the
requirements for a “tax-free corporate reorganization” for income tax purposes. Regal paid
$800,000 (including direct out-of-pocket costs of the business combination) for all of
Thorne’s identifiable net assets except cash. The current fair values of Thorne’s identifiable
net assets were equal to their carrying amounts, except for the following assets:

Differing Current Fair Tax Bases/

Values and Carrying Current Carrying Current Fair Economic
Amounts of Assets Assets Fair Values Amounts Value Excess Life
Inventories (first-in,
first-out cost) $ 100,000 $ 80,000 $ 20,000
Land 250,000 220,000 30,000
Building 640,000 500,000 140,000 20 years
Machinery 120,000 100,000 20,000 5 years
Totals $1,110,000 $900,000 $210,000

If the carrying amounts (equal to current fair values) of Thorne’s other identifiable assets
and liabilities were $390,000 and $650,000, respectively, and the income tax rate is 40%,
Regal’s journal entries to record the business combination with Thorne Company on June 1,
2005, would be as follows:

Journal Entries for Investment in Net Assets of Thorne Company 800,000

Business Combination Cash 800,000
Including Deferred To record acquisition of net assets of Thorne Company except cash,
Income Tax Liability and direct out-of-pocket costs of the business combination.

Inventories 100,000
Land 250,000
Building 640,000
Machinery 120,000
Other Identifiable Assets 390,000
Goodwill 5$800,000 3 ($1,110,000 $390,000) ($84,000
$650,000)4 6 34,000
Deferred Income Tax Liability ($210,000 0.40) 84,000
Other Liabilities 650,000
Investment in Net Assets of Thorne Company 800,000
To allocate cost of Thorne’s net assets to identifiable net assets;
to establish liability for deferred income tax attributable to
differences between current fair values and tax bases of
assets; and to allocate remainder of cost to goodwill.

1
FASB Statement No. 109, “Accounting for Income Taxes” (Norwalk: FASB, 1992), par. 30.
 Chapter 9 Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions 387

The deferred income tax liability established in the foregoing journal entry will be ex-
tinguished when the temporary differences between current fair values and tax bases of the
inventories and plant assets reverse through sale or depreciation. For example, assuming the
inventories were sold during the fiscal year ended May 31, 2006, the deferred tax liability
would be reduced by $12,400, computed as follows:

Income Tax Effect of Cost of goods sold (inventories current fair value excess) $20,000
Reversing Temporary Building depreciation attributable to current fair value excess
Differences ($140,000 20) 7,000
Machinery depreciation attributable to current fair value excess
($20,000 5) 4,000
Total reversing temporary differences $31,000
Income tax effect ($31,000 0.40) $12,400

Assuming that business combination goodwill was not impaired as of May 31, 2006, and
that Regal Corporation had pretax financial income of $420,000 (excluding tax-deductible
goodwill amortization of $2,267) for the year ended May 31, 2006, and there were no tem-
porary differences between pretax financial income and taxable income other than those
resulting from the business combination with Thorne Company, Regal’s journal entry for
income taxes on May 31, 2006, is as follows:

Journal Entry for Income Taxes Expense ($420,000 0.40) 168,000

Income Taxes Deferred Income Tax Liability 12,400
Income Taxes Payable [($420,000 $31,000) 0.40] 180,400
To record income taxes expense for 2006.

In the foregoing journal entry, tax-deductible goodwill amortization expense of $2,267

is not included in the measurement of pretax financial income, because it is based on
the 15-year amortization period required by Section 197 of the Internal Revenue Code
($34,000 15 $2,267).

Income Taxes Attributable to Undistributed

Earnings of Subsidiaries
In 1992, the FASB revised prior accounting standards for income taxes attributable to
undistributed earnings of subsidiaries in the following provisions:2
1. A deferred income tax liability is to be recognized for an excess of the financial report-
ing carrying amount of an investment in a domestic subsidiary over its tax basis if the
excess arose in fiscal years beginning after December 15, 1992.
2. A deferred income tax liability need not be recognized for an excess of the financial
reporting carrying amount over the tax basis of an investment in a foreign subsidiary if
the excess essentially is permanent in duration.
The substance of the foregoing is that currently a deferred income tax liability must be pro-
vided by the parent company for the undistributed earnings of its domestic subsidiaries.

2
Ibid., pars. 32(a) and 31(a).
388 Part Two Business Combinations and Consolidated Financial Statements

Illustration of Income Tax Allocation for Undistributed Earnings of Subsidiaries

Pinkley Corporation owns 75% of the outstanding common stock of Seabright Company,
which it acquired for cash on April 1, 2005. Goodwill acquired by Pinkley in the business
combination was $30,000 and was to be amortized for income tax purposes over 15 years;
Seabright’s identifiable net assets were fairly valued at their carrying amounts. For the fis-
cal year ended March 31, 2006, Pinkley had pretax financial income, exclusive of tax-
deductible goodwill amortization and intercompany investment income under the equity
method of accounting, of $100,000. Seabright’s pretax financial income was $50,000, and
dividends declared and paid by Seabright during Fiscal Year 2006 totaled $10,000. The in-
come tax rate for both companies is 40%. Income tax laws provide for a dividend-received
deduction rate of 80% on dividends from less-than-80%-owned domestic corporations.
Neither Pinkley nor Seabright had any temporary differences; neither had any income sub-
ject to preference income tax rates; and there were no intercompany profits resulting from
transactions between Pinkley and Seabright. Consolidated goodwill was not impaired as of
March 31, 2006.
Seabright’s journal entry to accrue income taxes on March 31, 2006, is as follows:

Subsidiary’s Journal Income Taxes Expense 20,000

Entry for Accrual of Income Taxes Payable 20,000
Income Taxes To record income taxes expense for Fiscal Year 2006 ($50,000 0.40
$20,000).

On March 31, 2006, Pinkley prepares the following journal entries for income taxes
payable, the subsidiary’s operating results, and deferred income tax liability:

PINKLEY CORPORATION
Journal Entries
March 31, 2006

Income Taxes Expense 39,200

Income Taxes Payable 39,200
To record income taxes expense for Fiscal Year 2006 on income
exclusive of intercompany investment income ($100,000 $2,000
tax-deductible goodwill amortization) 0.40 $39,200.

Cash 7,500
Investment in Seabright Company Common Stock 7,500
To record dividend declared and paid by subsidiary ($10,000 0.75
$7,500).

Investment in Seabright Company Common Stock 22,500

Intercompany Investment Income 22,500
To accrue share of subsidiary’s net income for Fiscal Year 2006
($30,000* 0.75 $22,500).

Income Taxes Expense 1,800

Income Taxes Payable 600
Deferred Income Tax Liability 1,200

(continued)
 Chapter 9 Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions 389

PINKLEY CORPORATION
Journal Entries (concluded)
March 31, 2006

To provide for income taxes on intercompany investment income

from subsidiary as follows:
Net income of subsidiary $30,000
Less: Depreciation and amortization attributable to
differences between current fair values and carrying
amounts of subsidiary’s net assets -0-
Income of subsidiary subject to income taxes $30,000
Parent company’s share ($30,000 0.75) $22,500
Less: Dividend-received deduction ($22,500 0.80) 18,000
Amount subject to income taxes $ 4,500
Income taxes expense ($4,500 0.40) $ 1,800
Taxes currently payable based on dividend received
($7,500 0.20 0.40) $ 600
Taxes deferred until earnings remitted by subsidiary 1,200
Income taxes expense $ 1,800

*$50,000 $20,000 $30,000.

Income Taxes Attributable to Intercompany Profits (Gains)

Federal income tax laws permit an affiliated group of corporations to file a consolidated in-
come tax return rather than separate returns. Intercompany profits (gains) and losses are
eliminated in a consolidated income tax return just as they are in consolidated financial
statements. An “affiliated group” for federal income tax purposes is defined as follows:
The term “affiliated group” means one or more chains of includible corporations connected
through stock ownership with a common parent corporation which is an includible corpora-
tion if—
(1) Stock possessing at least 80 percent of the voting power of all classes of stock and at
least 80 percent of each class of the nonvoting stock of each of the includible corporations
(except the common parent corporation) is owned directly by one or more of the other
includible corporations; and
(2) The common parent corporation owns directly stock possessing at least 80 percent of
the voting power of all classes of stock and at least 80 percent of each class of the nonvoting
stock of at least one of the other includible corporations.
As used in this subsection, the term “stock” does not include nonvoting stock which is
limited and preferred as to dividends.3

If a parent company and its subsidiaries do not qualify for the “affiliated group” status, or
if they otherwise elect to file separate income tax returns, the provisions of FASB Statement
No. 109, “Accounting for Income Taxes,” for the recognition of deferred tax assets and lia-
bilities apply.4 (Accounting for income taxes is discussed in depth in intermediate accounting
textbooks.) The deferral of income taxes accrued or paid on unrealized intercompany profits
is best illustrated by returning to the intercompany profits examples in Chapter 8.5

3
United States, Internal Revenue Code of 1986, sec. 1504(a).
4
FASB Statement No. 109, pars. 9(e), 121 through 124.
5
In the examples that follow, it is assumed that the provisions of FASB Statement No. 109, “Accounting
for Income Taxes,” for recognizing deferred tax assets without a valuation allowance are met.
390 Part Two Business Combinations and Consolidated Financial Statements

Income Taxes Attributable to Unrealized Intercompany Profits in Inventories

For unrealized intercompany profits in inventories at the end of the first year of an affiliated
group’s operations, return to the working paper elimination (in journal entry format) on
page 330 for Post Corporation and Sage Company on December 31, 2007, which is as
follows:

Elimination of Intercompany Sales—Sage 120,000

Unrealized Intercompany Cost of Goods Sold—Sage 96,000
Intercompany Profit in Cost of Goods Sold—Post 16,000
Ending Inventories Inventories—Post 8,000
To eliminate intercompany sales, cost of goods sold, and unrealized
intercompany profit in inventories.

If Post and Sage file separate income tax returns for Year 2007 and the income tax
rate is 40%, the following additional elimination (in journal entry format) is required on
December 31, 2007:

Elimination for Deferred Income Tax Asset—Sage 3,200

Income Taxes Income Taxes Expense—Sage 3,200
Attributable to To defer income taxes provided on separate income tax returns of
Unrealized subsidiary applicable to unrealized intercompany profits in parent
Intercompany Profit company’s inventories on Dec. 31, 2007 ($8,000 0.40 $3,200).
in Ending Inventories

The $3,200 reduction in the income taxes expense of Sage Company (the partially
owned subsidiary) enters into the computation of the minority interest in net income of the
subsidiary for the year ended December 31, 2007.
With regard to unrealized intercompany profits in beginning and ending inventories, I
refer to the working paper elimination (in journal entry format, on page 332) for the year
ended December 31, 2008, which follows:

Elimination of Retained Earnings—Sage ($8,000 0.95) 7,600

Intercompany Profits Minority Interest in Net Assets of Subsidiary ($8,000 0.05) 400
in Beginning and Intercompany Sales—Sage 150,000
Ending Inventories Intercompany Cost of Goods Sold—Sage 120,000
Cost of Goods Sold—Post 26,000
Inventories—Post 12,000
To eliminate intercompany sales, cost of goods sold, and unrealized
intercompany profit in inventories.

Assuming separate income tax returns for Post Corporation and Sage Company for
Year 2008 and an income tax rate of 40%, the following additional eliminations (in journal
entry format) are appropriate on December 31, 2008:
 Chapter 9 Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions 391

Eliminations for Deferred Income Tax Asset—Sage 4,800

Income Taxes Income Taxes Expense—Sage 4,800
Attributable to To defer income taxes provided on separate income tax returns of
Intercompany Profits subsidiary applicable to unrealized intercompany profits in parent
in Ending and company’s inventories on Dec. 31, 2008 ($12,000 0.40 $4,800).
Beginning Inventories
Income Taxes Expense—Sage 3,200
Retained Earnings—Sage ($3,200 0.95; or
$7,600 0.40) 3,040
Minority Interest in Net Assets of Subsidiary ($3,200 0.05; or
$400 0.40) 160
To provide for income taxes attributable to realized intercompany
profits in parent company’s inventories on Dec. 31, 2007
($8,000 0.40 $3,200).

The second of the foregoing eliminations reflects the income tax effects of the realization
by the consolidated group, on a first-in, first-out basis, of the intercompany profits in the
parent company’s beginning inventories.

Income Taxes Attributable to Unrealized Intercompany Gain in Land

Under generally accepted accounting principles, gains and losses from sales of plant assets
are not extraordinary items.6 Thus, intraperiod income tax allocation is not appropriate for
such gains and losses.
The intercompany gain on Post Corporation’s sale of land to Sage Company during Year
2007 is eliminated by the following December 31, 2007, working paper elimination (in
journal entry format, from page 334):

Elimination of Intercompany Gain on Sale of Land—Post 50,000

Unrealized Land—Sage 50,000
Intercompany Gain To eliminate unrealized intercompany gain on sale of land.
in Land

If Post and Sage filed separate income tax returns for Year 2007, the following elimi-
nation (in journal entry format) accompanies the one illustrated above, assuming an income
tax rate of 40%:

Elimination for Income Deferred Income Tax Asset—Post 20,000

Taxes Attributable Income Taxes Expense—Post 20,000
to Unrealized To defer income taxes provided on separate income tax returns of parent
Intercompany Gain in company applicable to unrealized intercompany gain in subsidiary’s land
Land—for Accounting on Dec. 31, 2007 ($50,000 0.40 $20,000).
Period of Sale

6
APB Opinion No. 30, “Reporting the Results of Operations” (New York: AICPA, 1973), pars. 10
and 23(d).
392 Part Two Business Combinations and Consolidated Financial Statements

In years subsequent to Year 2007, as long as the subsidiary owns the land, the following
elimination (in journal entry format) accompanies the elimination that debits Retained
Earnings—Post and credits Land—Sage for $50,000:

Elimination for Income Deferred Income Tax Asset—Post 20,000

Taxes Attributable Retained Earnings—Post 20,000
to Unrealized To defer income taxes attributable to unrealized intercompany gain in
Intercompany Gain in subsidiary’s land.
Land—for Accounting
Periods Subsequent
to Sale
In a period in which the subsidiary resold the land to an outsider, the appropriate elimi-
nation would be a debit to Income Taxes Expense—Post and a credit to Retained Earnings—
Post, in the amount of $20,000, because the $50,000 gain that previously was unrealized
would be realized on behalf of Post by Sage, the seller of the land to an outsider.

Income Taxes Attributable to Unrealized Intercompany Gain in a

Depreciable Plant Asset
As pointed out in Chapter 8, the intercompany gain on the sale of a depreciable plant asset
is realized through the periodic depreciation of the asset. Therefore, the related deferred in-
come taxes reverse as depreciation expense is taken on the asset.
To illustrate, refer to the illustration in Chapter 8, page 336, of the December 31, 2007,
working paper elimination (in journal entry format) for the unrealized intercompany gain
in Post Corporation’s machinery, which is reproduced below:

Elimination of Intercompany Gain on Sale of Machinery—Sage 23,800

Unrealized Machinery—Post 23,800
Intercompany Gain To eliminate unrealized intercompany gain on sale of machinery.
in Machinery

Assuming separate income tax returns and an income tax rate of 40%, the tax- deferral
elimination on December 31, 2007 (the date of the intercompany sale of machinery), is as
follows:

Elimination for Income Deferred Income Tax Asset—Sage 9,520

Taxes Attributable Income Taxes Expense—Sage 9,520
to Unrealized To defer income taxes provided on separate income tax returns of
Intercompany Gain in subsidiary applicable to unrealized intercompany gain in parent company’s
Machinery—for machinery on Dec. 31, 2007 ($23,800 0.40 $9,520).
Accounting Period
of Sale

The $9,520 increase in the subsidiary’s net income is included in the computation of the
minority interest in the subsidiary’s net income for Year 2007. For the year ended December 31,
2008, the elimination (in journal entry format) of the intercompany gain (see page 337) is
as follows:
 Chapter 9 Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions 393

Elimination of Retained Earnings—Sage ($23,800 0.95) 22,610

Intercompany Gain in Minority Interest in Net Assets of Subsidiary ($23,800 0.05) 1,190
Machinery and in Accumulated Depreciation—Post 4,760
Related Depreciation Machinery—Post 23,800
Depreciation Expense—Post 4,760
To eliminate unrealized intercompany gain in machinery and in related
depreciation. Gain element in depreciation computed as $23,800
0.20 $4,760, based on five-year economic life.

For the year ended December 31, 2008, the elimination (in journal entry format) for in-
come taxes attributable to the intercompany gain is as follows:

Elimination for Income Income Taxes Expense—Sage 1,904

Taxes Attributable to Deferred Income Tax Asset—Sage ($9,520 $1,904) 7,616
Intercompany Gain in Retained Earnings—Sage ($9,520 0.95; or $22,610 0.40) 9,044
Machinery—for First Minority Interest in Net Assets of Subsidiary ($9,520 0.05; or
Year Subsequent $1,190 0.40) 476
to Sale To provide for income taxes expense on intercompany gain realized through
parent company’s depreciation ($4,760 0.40 $1,904); and to defer
income taxes attributable to remainder of unrealized gain.

Comparable working paper eliminations would be necessary on December 31, Years

2009, 2010, 2011, and 2012.

Income Taxes Attributable to Intercompany Gain on Extinguishment of Bonds

As pointed out in Chapter 8, a gain or loss is recognized in consolidated financial state-
ments for one affiliate’s open-market acquisition of another affiliate’s bonds. Thus, in-
come taxes attributable to the gain or loss should be provided for in a working paper
elimination.
Referring to Post Corporation’s December 31, 2007, open-market acquisition of Sage
Company’s bonds (see page 347), there is the following working paper elimination (in jour-
nal entry format) on December 31, 2007:

Elimination for Intercompany Bonds Payable—Sage 300,000

Realized Gain on Discount on Intercompany Bonds Payable—Sage 18,224
Extinguishment of Investment in Sage Company Bonds—Post 257,175
Affiliate’s Bonds Gain on Extinguishment of Bonds—Sage 24,601
To eliminate subsidiary’s bonds acquired by parent; and to recognize gain
on the extinguishment of the bonds.

The appropriate elimination (in journal entry format) to accompany the foregoing one is as
follows, assuming that (1) the income tax rate is 40%, and (2) separate income tax returns
are filed:
394 Part Two Business Combinations and Consolidated Financial Statements

Elimination for Income Income Taxes Expense—Sage 9,840

Taxes Attributable to Deferred Income Tax Liability—Sage 9,840
Realized Gain on To provide for income taxes attributable to subsidiary’s realized gain on
Extinguishment of parent company’s acquisition of the subsidiary’s bonds ($24,601
Affiliate’s Bonds—for 0.40 $9,840).
Accounting Period of
Extinguishment
The additional expense of the subsidiary recognized in the foregoing elimination enters into
the computation of the minority interest in net income of the subsidiary for Year 2007.
In periods subsequent to the date of the acquisition of the bonds, the actual income
taxes expense of both the parent company and the subsidiary reflect the effects of the in-
tercompany interest revenue and intercompany interest expense. The income tax effects
of the difference between intercompany interest revenue and expense represent the re-
versal of the $9,840 deferred income tax liability recorded in the foregoing elimination.
For example, the working paper elimination (in journal entry format) for intercompany
bonds of Post Corporation and subsidiary on December 31, 2008 (see page 351), is re-
peated below:

Elimination for Intercompany Interest Revenue—Post 38,576

Intercompany Bonds Intercompany Bonds Payable—Sage 300,000
One Year after Discount on Intercompany Bonds Payable—Sage 14,411
Acquisition Investment in Sage Company Bonds—Post 265,751
Intercompany Interest Expense—Sage 33,813
Retained Earnings—Sage ($24,601 0.95) 23,371
Minority Interest in Net Assets of Subsidiary ($24,601 0.05) 1,230
To eliminate subsidiary’s bonds owned by parent company, and related
interest revenue and expense; and to increase subsidiary’s beginning
related earnings by the amount of unamortized realized gain on the
extinguishment of the bonds.

The foregoing elimination is accompanied by the following additional elimination (in

journal entry format) on December 31, 2008:

Elimination for Income Retained Earnings—Sage ($9,840 0.95; or $23,371 0.40) 9,348
Taxes Attributable to Minority Interest in Net Assets of Subsidiary ($9,840 0.05; or
Gain on Acquisition of $1,230 0.40) 492
Affiliate’s Bonds—for Income Taxes Expense—Sage 3 ($38,576 $33,813) 0.40 4 1,905
First Year Subsequent Deferred Income Tax Liability—Sage ($9,840 $1,905) 7,935
to Acquisition To reduce the subsidiary’s income taxes expense for amount attributable to
recorded intercompany gain (for consolidation purposes) on subsidiary’s
bonds; and to provide for remaining deferred income taxes on unrecorded
portion of gain.

Summary: Income Taxes Attributable to Intercompany Profits (Gains)

This section illustrates the interperiod allocation of income taxes attributable to inter-
company profits (gains) of affiliated companies that file separate income tax returns.
 Chapter 9 Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions 395

The elimination of unrealized intercompany profits (gains) causes a temporary differ-

ence in which taxable income exceeds pre-tax financial income in the accounting period
of the intercompany gain; thus, assuming provisions of FASB Statement No. 109, “Ac-
counting for Income Taxes,” for recognizing deferred tax assets without a valuation al-
lowance are met, deferred income tax assets must be accounted for in working paper
eliminations that accompany the profit (gain) eliminations. In the case of intercompany
bonds, pretax financial income exceeds taxable income of the accounting period of the
realized gain; thus, a deferred income tax liability must be provided in a working paper
elimination.
The illustrative working paper eliminations for Post Corporation and subsidiary for
the year ended December 31, 2008, outlined in the preceding pages, are summarized as
follows:

POST CORPORATION AND SUBSIDIARY

Partial Working Paper Eliminations
December 31, 2008

(b) Retained Earnings—Sage ($8,000 0.95) 7,600

Minority Interest in Net Assets of Subsidiary ($8,000 0.05) 400
Intercompany Sales—Sage 150,000
Intercompany Cost of Goods Sold—Sage 120,000
Cost of Goods Sold—Post 26,000
Inventories—Post 12,000
To eliminate intercompany sales, cost of goods sold, and unrealized
intercompany profits in inventories.

(c) Deferred Income Tax Asset—Sage 4,800

Income Taxes Expense—Sage 4,800
To defer income taxes provided on separate income tax returns of
subsidiary applicable to unrealized intercompany profits in parent
company’s inventories on Dec. 31, 2008 ($12,000 0.40 $4,800).

Income Taxes Expense—Sage 3,200

Retained Earnings—Sage ($3,200 0.95; or $7,600 0.40) 3,040
Minority Interest in Net Assets of Subsidiary
($3,200 0.05; or $400 0.40) 160
To provide for income taxes attributable to realized intercompany
profits in parent company’s inventories on Dec. 31, 2007
($8,000 0.40 $3,200).

(d) Retained Earnings—Post 50,000

Land—Sage 50,000
To eliminate unrealized intercompany gain in land.

(e) Deferred Income Tax Asset—Post 20,000

Retained Earnings—Post 20,000
To defer income taxes attributable to unrealized intercompany gain
in subsidiary’s land ($50,000 0.40 $20,000).

(continued)
396 Part Two Business Combinations and Consolidated Financial Statements

POST CORPORATION AND SUBSIDIARY

Partial Working Paper Eliminations (concluded)
December 31, 2008

(f) Retained Earnings—Sage ($23,800 0.95) 22,610

Minority Interest in Net Assets of Subsidiary ($23,800 0.05) 1,190
Accumulated Depreciation—Post 4,760
Machinery—Post 23,800
Depreciation Expense—Post 4,760
To eliminate unrealized intercompany gain in machinery and
in related depreciation. Gain element in depreciation computed
as $23,800 0.20 $4,760, based on five-year economic life.

(g) Income Taxes Expense—Sage 1,904

Deferred Income Tax Asset—Sage ($9,520 $1,904) 7,616
Retained Earnings—Sage ($9,520 0.95; or $22,610 0.40) 9,044
Minority Interest in Net Assets of Subsidiary
($9,520 0.05; or $1,190 0.40) 476
To provide for income taxes expense on intercompany gain realized
through parent company’s depreciation ($4,760 0.40 $1,904);
and to defer income taxes attributable to remainder of unrealized
gain.

(h) Intercompany Interest Revenue—Post 38,576

Intercompany Bonds Payable—Sage 300,000
Discount on Intercompany Bonds Payable—Sage 14,411
Investment in Sage Company Bonds—Post 265,751
Intercompany Interest Expense—Sage 33,813
Retained Earnings—Sage ($24,601 0.95) 23,371
Minority Interest in Net Assets of Subsidiary ($24,601 0.05) 1,230
To eliminate subsidiary’s bonds owned by parent company, and
related interest revenue and expense; and to increase subsidiary’s
beginning retained earnings by amount of unamortized realized
gain on the extinguishment of the bonds.

(i) Retained Earnings—Sage ($9,840 0.95; or $23,371 0.40) 9,348

Minority Interest in Net Assets of Subsidiary ($9,840 0.05;
or $1,230 0.40) 492
Income Taxes Expense—Sage 3 ($38,576 $33,813) 0.40 4 1,905
Deferred Income Tax Liability—Sage ($9,840 $1,905) 7,935
To reduce the subsidiary’s income taxes expense for amount attrib-
utable to recorded intercompany gain (for consolidation purposes)
on subsidiary’s bonds; and to provide for remaining deferred income
taxes on unrecorded portion of gain.

All the foregoing eliminations except (d) and (e) affect the net income of Sage
Company, the partially owned subsidiary. The appropriate amounts in those eliminations
are included in the computation of minority interest in net income of subsidiary for
Year 2008.
 Chapter 9 Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions 397

CONSOLIDATED STATEMENT OF CASH FLOWS

The consolidated financial statements issued by publicly owned companies include a state-
ment of cash flows. This statement may be prepared as described in intermediate account-
ing textbooks; however, when the statement is prepared on a consolidated basis, a number
of problems arise. Some of these are described below:
1. Depreciation and amortization expense, as reported in the consolidated income state-
ment, is added to total consolidated income, which includes minority interest in net
income of subsidiary, in a consolidated statement of cash flows. The depreciation and
amortization expense in a business combination is based on the current fair values of the
identifiable assets of subsidiaries on the date of the business combination. Net income
applicable to minority interest is included in the computation of net cash provided by
operating activities because 100% of the cash of all subsidiaries is included in a consol-
idated balance sheet.
2. Only cash dividends paid by the parent company and cash dividends paid by partially
owned subsidiary companies to minority stockholders are reported as cash flows from
financing activities. Cash dividends paid by subsidiaries to the parent company have no
effect on consolidated cash because cash is transferred entirely within the affiliated
group of companies. Dividends paid to minority stockholders that are material in
amount may be listed separately or disclosed parenthetically in a consolidated statement
of cash flows.
3. A cash acquisition by the parent company of additional shares of common stock directly
from a subsidiary does not change the amount of consolidated cash and thus is not
reported in a consolidated statement of cash flows.
4. A cash acquisition by the parent company of additional shares of common stock from
minority stockholders reduces consolidated cash. Consequently, such an acquisition is
reported in a consolidated statement of cash flows in the cash flows from investing
activities section.
5. A cash sale of part of the investment in a subsidiary company increases consolidated
cash (and the amount of minority interest) and thus is reported with cash flows from
investing activities in a consolidated statement of cash flows. A gain or loss from such a
sale represents an adjustment to consolidated net income of the parent company and its
subsidiaries in the measurement of net cash flow from operating activities.

Illustration of Consolidated Statement of Cash Flows

Parent Corporation has owned 100% of the common stock of Sub Company for several
years. Sub has outstanding only one class of common stock, and its total stockholders’
equity on December 31, 2005, was $500,000. On January 2, 2006, Parent sold 30% of its
investment in Sub’s common stock to outsiders for $205,000, which was $55,000 more
than the carrying amount of the stock in Parent’s accounting records. Sub had a net
income of $100,000 for Year 2006 and paid cash dividends of $60,000 near the end of Year
2006. During Year 2006, Parent issued additional common stock and cash of $290,000 in
exchange for plant assets with a current fair value of $490,000. The consolidated entity
had additional long-term borrowings of $93,000 during Year 2006, and interest payments
during the year totaled $62,000, none of which was capitalized. Income tax payments to-
taled $234,000.
The consolidated income statement for Year 2006, the consolidated statement of
stockholders’ equity for Year 2006, and the comparative consolidated balance sheets on
December 31, 2006 and 2005, for Parent Corporation and subsidiary are on pages 398–399;
398 Part Two Business Combinations and Consolidated Financial Statements

the working paper for consolidated statement of cash flows for Year 2006 is on pages 399–
400, and the consolidated statement of cash flows (indirect method) for Parent Corporation
and subsidiary for Year 2006 is on page 400.

PARENT CORPORATION AND SUBSIDIARY

Consolidated Income Statement
For Year Ended December 31, 2006

Sales and other revenue (including gain of $55,000 on sale of

investment in Sub Company common stock) $2,450,000
Costs and expenses:
Costs of goods sold $1,500,000
Depreciation and amortization expense 210,000
Other operating expenses 190,000 1,900,000
Income before income taxes $ 550,000
Income taxes expense 250,000
Total consolidated income $ 300,000
Less: Minority interest in net income of subsidiary 30,000
Net income $ 270,000
Basic earnings per share of common stock $ 5.14

PARENT CORPORATION AND SUBSIDIARY

Consolidated Statement of Stockholders’ Equity
For Year Ended December 31, 2006

Common Additional Retained

Stock, $10 Par Paid-in Capital Earnings Total
Balances, beginning of year $500,000 $300,000 $670,000 $1,470,000
Issuance of 5,000 shares of common
stock for plant assets 50,000 150,000 200,000
Net income 270,000 270,000
Cash dividends declared and paid
($2.91 a share) (160,000) (160,000)
Balances, end of year $550,000 $450,000 $780,000 $1,780,000

PARENT CORPORATION AND SUBSIDIARY

Consolidated Balance Sheets
December 31, 2006 and 2005

December 31,
2006 2005
Assets
Cash $ 300,000 $ 240,000
Other current assets 900,000 660,000
Plant assets 3,000,000 2,510,000
Less: Accumulated depreciation of plant assets (1,300,000) (1,100,000)
Intangible assets (net) 240,000 250,000
Total assets $3,140,000 $2,560,000

(continued)
 Chapter 9 Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions 399

PARENT CORPORATION AND SUBSIDIARY

Consolidated Balance Sheets (concluded)
December 31, 2006 and 2005

December 31,
2006 2005
Liabilities and Stockholders’ Equity
Current liabilities (no notes payable) $ 505,000 $ 490,000
Long-term debt 693,000 600,000
Common stock, $10 par 550,000 500,000
Additional paid-in capital 450,000 300,000
Minority interest in net assets of subsidiary 162,000
Retained earnings 780,000 670,000
Total liabilities and stockholders’ equity $3,140,000 $2,560,000

PARENT CORPORATION AND SUBSIDIARY

Working Paper for Consolidated Statement of Cash Flows (indirect method)
For Year Ended December 31, 2006

Transactions for Year 2006

Balances Balances
Dec. 31, 2005 Debit Credit Dec. 31, 2006
Cash 240,000 (x) 60,000 300,000
Other current assets less current liabilities 170,000 (5) 225,000 395,000
Plant assets 2,510,000 (6) 290,000 3,000,000
b r
(9) 200,000
Intangible assets (net) 250,000 (3) 10,000 240,000
Totals 3,170,000 3,935,000
Accumulated depreciation 1,100,000 (3) 200,000 1,300,000
Long-term debt 600,000 (7) 93,000 693,000
Common stock, $10 par 500,000 (9) 50,000 550,000
Additional paid-in capital 300,000 (9) 150,000 450,000
Minority interest in net assets of subsidiary (2) 30,000
b r
(8) 18,000 (4) 150,000 162,000
Retained earnings 670,000 (8) 160,000 (1) 270,000 780,000
Totals 3,170,000 953,000 953,000 3,935,000

Operating Activities
Net income (1) 270,000
Minority interest in net income of subsidiary (2) 30,000
From operating
Add: Depreciation and amortization expense f (3) 210,000 v activities
Less: Gain on sale of investment in
$230,000
Sub Company common stock (4) 55,000
Net increase in net current assets (5) 225,000

Investing Activities
Sale of investment in Sub Company
From investing
common stock (4) 205,000
b r activities
Acquisition of plant assets (6) 290,000
($85,000)
(continued)
400 Part Two Business Combinations and Consolidated Financial Statements

PARENT CORPORATION AND SUBSIDIARY

Working Paper for Consolidated Statement of Cash Flows (indirect method) (concluded)
For Year Ended December 31, 2006

Transactions for Year 2006

Balances Balances
Dec. 31, 2005 Debit Credit Dec. 31, 2006
Financing Activities
Long-term borrowings (7) 93,000 From financing
Payment of dividends, including $18,000 to c s activities
minority stockholders of Sub Company (8) 178,000 ($85,000)
Subtotals 808,000 748,000
Increase in cash (x) 60,000
Totals 808,000 808,000

PARENT COMPANY AND SUBSIDIARY

Consolidated Statement of Cash Flows (indirect method)
For Year Ended December 31, 2006

Net cash provided by operating activities (Exhibit 1) $230,000

Cash Flows from Investing Activities:
Disposal of investment in Sub Company common stock $205,000
Acquisition of plant assets (290,000)
Net cash used in investing activities (85,000)
Cash Flows from Financing Activities:
Long-term borrowings $ 93,000
Dividends paid, including $18,000 to minority stock-
holders of Sub Company (178,000)
Net cash used in financing activities (85,000)
Net increase in cash $ 60,000
Cash, beginning of year 240,000
Cash, end of year $300,000
Exhibit 1 Cash flows from operating activities:
Net income $270,000
Adjustments to reconcile net income to net cash provided by
operating activities:
Minority interest in net income of subsidiary 30,000
Depreciation and amortization expense 210,000
Gain on disposal of investment in Sub Company
common stock (55,000)
Net increase in net current assets (225,000)*
Net cash provided by operating activities $230,000
Exhibit 2 Supplemental disclosure of cash flow information:
Cash paid during the year for:
Interest (none capitalized) $ 62,000
Income taxes 234,000
Exhibit 3 Noncash investing and financing activities:
Common stock issued for plant assets $200,000

* This amount was aggregated to condense the illustration; FASB Statement No. 95, “Statement of Cash Flows” (Stamford: FASB, 1987),
par. 29, requires disclosure, as a minimum, of changes in receivables and payables pertaining to operating activities and in inventories.
 Chapter 9 Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions 401

The following four items in the consolidated statement of cash flows warrant emphasis:
1. Net cash provided by operating activities includes the minority interest in net income of
Sub Company.
2. Net cash provided by operating activities excludes the gain of $55,000 from sale of the
investment in Sub Company common stock; thus, the proceeds of $205,000 are reported
as a component of cash flows from investing activities in the consolidated statement of
cash flows.
3. Only the dividends paid to stockholders of Parent Corporation ($160,000) and to
minority stockholders of Sub Company ($18,000) are reported as cash flows from
financing activities.
4. The issuance of common stock by Parent Corporation to acquire plant assets is a non-
cash transaction [coded (9) in the working paper on page 399] that is reported in
Exhibit 3 at the bottom of the consolidated statement of cash flows on page 400.

INSTALLMENT ACQUISITION OF SUBSIDIARY

A parent company may obtain control of a subsidiary in a series of installment acquisi-
tions of the subsidiary’s common stock, rather than in a single transaction constituting a
business combination. The installment acquisitions necessitate application of accounting
standards applicable to both influenced investees and controlled subsidiaries.
In accounting for installment acquisitions of common stock of the eventual subsidiary,
accountants are faced with a difficult question: At what point in the installment acquisition
sequence should current fair values be determined for the subsidiary’s identifiable net
assets, in accordance with accounting for business combinations? A practical answer is:
Current fair values for the subsidiary’s net assets should be ascertained on the date when
the parent company attains control of the subsidiary. On that date, the business combina-
tion is completed.
However, this answer is not completely satisfactory, because generally accepted ac-
counting principles require use of the equity method of accounting for investments in com-
mon stock sufficient to enable the investor to influence significantly the operating and
financial policies of the investee.7 A 20% common stock investment is presumed, in the ab-
sence of contrary evidence, to be the minimum ownership interest for exercising significant
operating and financial influence over the investee. APB Opinion No. 18, “The Equity
Method of Accounting for Investments in Common Stock,” requires retroactive application
of the equity method of accounting when an investor’s ownership interest reaches 20%. The
following example illustrates these points.

Illustration of Installment Acquisition of Parent Company’s

Controlling Interest
Prinz Corporation, which has a February 28 or 29 fiscal year-end, acquired 9,500 shares
of Scarp Company’s closely held 10,000 shares of outstanding $5 par common stock in
installments as follows (out-of-pocket costs are disregarded):

7
APB Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock”
(New York: AICPA, 1971), par. 17.
402 Part Two Business Combinations and Consolidated Financial Statements

Parent Company’s Number of Carrying

Installment Shares of Scarp Method of Amount of Scarp
Acquisition of Company Com- Payment by Company’s
Controlling Interest mon Stock Prinz Identifiable Net
in Subsidiary Date Acquired Corporation Assets
Mar. 1, 2005 1,000 $ 10,000 cash $80,000
Mar. 1, 2006 2,000 22,000 cash 85,000
Mar. 1, 2007 6,500 28,000 cash 90,000
t 50,000, 15%
5-year
promissory note
Totals 9,500 $110,000

The foregoing analysis indicates that Prinz made investments at a cost of $10, $11, and
$12 a share in Scarp’s common stock on dates when the stockholders’ equity (book value)
per share of Scarp’s common stock was $8, $8.50, and $9, respectively. The practicality of
ascertaining current fair values for Scarp’s identifiable net assets on March 1, 2007, the date
Prinz attained control of Scarp, is apparent.
In addition to the Common Stock ledger account with a balance of $50,000 (10,000
$5 $50,000) and a Paid-in Capital in Excess of Par account with a balance of $10,000,
Scarp had a Retained Earnings account that showed the following changes:

Retained Earnings Retained Earnings

Account of Investee
Date Explanation Debit Credit Balance
2005
Mar. 1 Balance 20,000 cr
2006
Feb. 10 Dividends declared ($1 a share) 10,000 10,000 cr
28 Net income 15,000 25,000 cr
2007
Feb. 17 Dividends declared ($1 a share) 10,000 15,000 cr
28 Net income 15,000 30,000 cr

Parent Company’s Journal Entries for Installment Acquisition

Prinz prepares the following journal entries (in addition to the usual end-of-period adjust-
ing and closing entries) to record its investments in Scarp’s common stock. (All dividends
declared by Scarp are assumed to have been paid in cash on the declaration date, and in-
come tax effects are disregarded.)

PRINZ CORPORATION
Journal Entries

2005
Mar. 1 Investment in Scarp Company Common Stock 10,000
Cash 10,000
To record acquisition of 1,000 shares of Scarp Company’s
outstanding common stock.

(continued)
 Chapter 9 Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions 403

PRINZ CORPORATION
Journal Entries (concluded)

2006
Feb. 10 Cash 1,000
Dividend Revenue 1,000
To record receipt of $1 a share cash dividend declared this
date on 1,000 shares of Scarp Company common stock.

Mar. 1 Investment in Scarp Company Common Stock 22,000

Cash 22,000
To record acquisition of 2,000 shares of Scarp Company’s
outstanding common stock.

1 Investment in Scarp Company Common Stock 500

Retained Earnings of Investee 500
To change retroactively accounting for investment in
Scarp Company to equity method from cost method;
and to record retroactively 10% share of Scarp Company’s net
income for year ended Feb. 28, 2003, as follows:
Share of Scarp’s net income, Fiscal Year 2006
($15,000 0.10) $1,500
Less: Dividend revenue recognized in Year 2006 1,000
Prior period adjustment to Retained Earnings of
Investee ledger account $ 500

2007
Feb. 17 Cash 3,000
Investment in Scarp Company Common Stock 3,000
To record receipt of $1 a share cash dividend declared this
date on 3,000 shares of Scarp Company’s common stock.

28 Investment in Scarp Company Common Stock 4,500

Investment Income 4,500
To record share of Scarp Company’s net income for year
ended Feb. 28, 2007 ($15,000 0.30 $4,500).

Mar. 1 Investment in Scarp Company Common Stock 78,000

Cash 28,000
Notes Payable 50,000
To record acquisition of 6,500 shares of Scarp Company’s
outstanding common stock for cash and a 15%, five-year
promissory note.

Prinz’s acquisition of 6,500 shares of Scarp’s outstanding common stock on March 1,

2007, constitutes a business combination. Accordingly, on that date Prinz should apply the
principles of purchase accounting described in Chapters 5 and 6, including the valuation of
Scarp’s identifiable net assets at their current fair values. Any excess of the $78,000 cost of
Prinz’s investment over Prinz’s 65% share of the current fair value of Scarp’s identifiable
net assets is assigned to goodwill.

Criticism of Foregoing Approach

The foregoing illustration of accounting for the installment acquisition of an eventual sub-
sidiary’s common stock may be criticized for its handling of goodwill. On three separate
404 Part Two Business Combinations and Consolidated Financial Statements

dates spanning two years, goodwill was recognized in Prinz’s three acquisitions of out-
standing common stock of Scarp.
The FASB has suggested that the current fair values of Scarp’s identifiable net assets
should be determined on each of the three dates Prinz acquired Scarp common stock. How-
ever, such a theoretically precise application of accounting principles for long-term invest-
ments in common stock appears unwarranted in terms of cost-benefit analysis. Until Prinz
attained control of Scarp, the amortization elements of Prinz’s investment income presum-
ably would not be material. Thus, the goodwill approach illustrated in the preceding section
of this chapter appears to be practical and consistent with the following passage from APB
Opinion No. 18:
The carrying amount of an investment in common stock of an investee that qualifies for the
equity method of accounting . . . may differ from the underlying equity in net assets of the
investee . . . if the investor is unable to relate the difference to specific accounts of the
investee, the difference should be considered to be goodwill. . . .8

Working Paper for Consolidated Financial Statements

The working paper for consolidated financial statements and related working paper elimi-
nations for Prinz Corporation and subsidiary on March 1, 2007, and for subsequent
accounting periods are prepared in accordance with the procedures outlined in prior chap-
ters. Prinz’s retroactive application of the equity method of accounting for its investment in
Scarp’s common stock results in the Investment in Scarp Company Common Stock and
Retained Earnings of Subsidiary (Investee) ledger accounts on March 1, 2007, that follow:

Selected Ledger Investment in Scarp Company Common Stock

Accounts of Parent
Date Explanation Debit Credit Balance
Company
2005
Mar. 1 Acquisition of 1,000 shares 10,000 10,000 dr
2006
Mar. 1 Acquisition of 2,000 shares 22,000 32,000 dr
1 Retroactive application of equity
method of accounting 500 32,500 dr
2007
Feb. 17 Dividends received ($1 a share) 3,000 29,500 dr
28 Share of net income 4,500 34,000 dr
Mar. 1 Acquisition of 6,500 shares 78,000 112,000 dr

Retained Earnings of Subsidiary (Investee)

Date Explanation Debit Credit Balance
2006
Mar. 1 Retroactive application of equity
method of accounting 500 500 cr
2007
Feb. 29 Closing entry—share of Scarp
Company adjusted net income
not declared as a dividend
($4,500 $3,000) 1,500 2,000 cr

8
Ibid., par. 19(n).
 Chapter 9 Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions 405

If the current fair value of Scarp’s identifiable net assets on March 1, 2007, was $90,000,
the same as the carrying amount of the net assets on that date, the working paper elimina-
tion (in journal entry format) for Prinz and subsidiary on March 1, 2007, is as illustrated
below. Goodwill of $26,500 recognized in the working paper elimination comprises the
three components shown following the elimination. (The goodwill was unimpaired as of
February 28, 2007.)

Working Paper PRINZ CORPORATION AND SUBSIDIARY

Elimination on Date of Working Paper Elimination
Business Combination March 1, 2007
for Partially Owned
Subsidiary Acquired in (a) Common Stock, $5 par—Scarp 50,000
Installments Additional Paid-in Capital—Scarp 10,000
Retained Earnings—Scarp ($30,000 $2,000) 28,000
Retained Earnings of Subsidiary (Investee)—Prinz 2,000
Goodwill—Prinz ($2,000 $5,000 $19,500) 26,500
Investment in Scarp Company Common Stock—Prinz 112,000
Minority Interest in Net Assets of Subsidiary 4,500
To eliminate intercompany investment and equity accounts of
subsidiary on date of business combination; to allocate
excess of cost over current fair value (equal to carrying amounts) of
identifiable net assets acquired to goodwill; and to establish minority
interest in net assets of subsidiary on date of business combination
($90,000 0.05 $4,500).

Components of Net Installment Acquisition of: Mar. 1, 2005 Mar. 1, 2006 Mar. 1, 2007
Goodwill on Date of Cost of Scarp Company common
Business Combination stock acquired $10,000 $22,000 $78,000
Accomplished in Less: Share of carrying amount of
Installments Scarp’s identifiable net assets
acquired:
Mar. 1, 2005 ($80,000 0.10) 8,000
Mar. 1, 2006 ($85,000 0.20) 17,000
Mar. 1, 2007 ($90,000 0.65) 58,500
Goodwill $ 2,000 $ 5,000 $19,500

The $2,000 portion of Scarp’s retained earnings attributable to Prinz’s 30% ownership
of Scarp common stock prior to the business combination is not eliminated. Thus,
consolidated retained earnings on March 1, 2007, the date of the business combination,
includes the $2,000 amount plus Prinz’s own retained earnings of $210,000, for a total
of $212,000.
For fiscal years subsequent to March 1, 2007, Prinz recognizes intercompany investment
income equal to 95% of the operating results of Scarp. In addition, Prinz recognizes any
impairment losses attributable to consolidated goodwill if they occur.
On March 1, 2007, the date the business combination of Prinz Corporation and Scarp
Company was completed, only a consolidated balance sheet is appropriate, for reasons dis-
cussed in Chapter 6. On page 406 is the working paper for consolidated balance sheet of
Prinz and Scarp on March 1, 2007, that reflects the working paper elimination on this page.
406 Part Two Business Combinations and Consolidated Financial Statements

Amounts for Prinz and Scarp other than those illustrated in the elimination are assumed.
Also, there were no intercompany transactions between the two companies prior to March 1,
2007.

Partially Owned PRINZ CORPORATION AND SUBSIDIARY

Subsidiary on Date of Working Paper for Consolidated Balance Sheet
Business Combination March 1, 2007
Accomplished in
Elimination
Installments
Prinz Scarp Increase
Corporation Company (Decrease) Consolidated
Assets
Current assets 400,000 140,000 540,000
Investment in Scarp
Company common
stock 112,000 (a) (112,000)
Plant assets (net) 1,200,000 160,000 1,360,000
Goodwill (a) 26,500 26,500
Total assets 1,712,000 300,000 (85,500) 1,926,500

Liabilities and
Stockholders’ Equity
Current liabilities 200,000 60,000 260,000
Long-term debt 800,000 150,000 950,000
Common stock, $1 par 150,000 150,000
Common stock, $5 par 50,000 (a) (50,000)
Additional paid-in capital 350,000 10,000 (a) (10,000) 350,000
Minority interest in net
assets of subsidiary (a) 4,500 4,500
Retained earnings 210,000 30,000 (a) (28,000) 212,000
Retained earnings of
subsidiary 2,000 (a) (2,000)
Total liabilities and
stockholders’ equity 1,712,000 300,000 (85,500) 1,926,500

Review 1. Under what circumstances do income taxes enter into the measurement of current fair
values of a combinee’s identifiable net assets in a business combination?
Questions
2. What standards were established in FASB Statement No. 109, “Accounting for Income
Taxes,” for income taxes attributable to undistributed earnings of subsidiaries?
3. Are interperiod income tax allocation procedures necessary in working paper elimina-
tions for a parent company and subsidiaries that file consolidated income tax returns?
Explain.
4. A parent company and its subsidiary file separate income tax returns. How does the con-
solidated deferred income tax asset associated with the intercompany gain on the parent
company’s sale of a depreciable plant asset to its subsidiary reverse? Explain.
5. Are cash dividends declared to minority stockholders displayed in a consolidated state-
ment of cash flows? Explain.
6. How is the equity method of accounting applied when a parent company attains control
of a subsidiary in a series of common stock acquisitions? Explain.
 Chapter 9 Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions 407

7. Logically, at what stage in the installment acquisition of an eventual subsidiary’s out-

standing common stock should the parent company ascertain the current fair values of the
subsidiary’s identifiable net assets? Explain.
8. What amounts comprise consolidated retained earnings on the date of a business combina-
tion that involved installment acquisitions of the subsidiary’s outstanding common stock?

Exercises
(Exercise 9.1) Select the best answer for each of the following multiple-choice questions:
1. If a business combination (for financial accounting) is a “tax-free corporate reorgani-
zation” for income tax purposes, in the journal entry to record the business combina-
tion, the current fair value excesses of the combinee’s identifiable net assets are:
a. Disregarded.
b. The basis for a credit to Deferred Income Tax Liability.
c. Credited to the affected asset accounts.
d. Credited to retained earnings of the combinor.
2. In a business combination that is a “tax-free corporate reorganization” for income tax
purpose, may the temporary differences between current fair values and tax bases of
the combinee’s inventories and plant assets be realized through the assets’:

Sale? Depreciation?
a. Yes Yes
b. Yes No
c. No Yes
d. No No

3. Under the provisions of FASB Statement No. 109, “Accounting for Income Taxes,” a
debit to Deferred Income Tax Assets is required in a working paper elimination ac-
companying an elimination for all of the following except an:
a. Intercompany profit on merchandise.
b. Intercompany bondholding (open-market acquisition; bonds originally issued at
face amount).
c. Intercompany gain on a plant asset.
d. Intercompany gain on an intangible asset.
4. Is a deferred income tax liability typically recognized by a combinor/parent company for:

Differences between Current Fair

Values and Carrying Amounts of Undistributed Earnings of a
the Identifiable Net Assets 65%-Owned Domestic
of a Subsidiary? Subsidiary?
a. Yes Yes
b. Yes No
c. No Yes
d. No No

5. The appropriate format for a parent company’s journal entry to provide for income
taxes on intercompany investment income from a 65%-owned domestic subsidiary that
declared and paid dividends less than the amount of that income is:
408 Part Two Business Combinations and Consolidated Financial Statements

a. Deferred Income Tax Asset XXX

Income Taxes Expense XXX
Income Taxes Payable XXX
b. Deferred Income Tax Liability XXX
Income Taxes Expense XXX
Income Taxes Payable XXX
c. Deferred Income Tax Asset XXX
Income Taxes Expense XXX
Income Taxes Payable XXX
d. Income Taxes Expense XXX
Income Taxes Payable XXX
Deferred Income Tax Liability XXX
6. If a parent company and its subsidiary file separate income tax returns, a deferred
income tax liability is recognized in working paper eliminations for a:
a. Parent company’s open-market acquisition of its subsidiary’s outstanding bonds.
b. Subsidiary’s sale of merchandise to its parent company.
c. Wholly owned subsidiary’s sale of land to a partially owned subsidiary.
d. Partially owned subsidiary’s sale of an intangible asset to a wholly owned subsidiary.
7. In a consolidated statement of cash flows, cash flows from financing activities include,
for a partially owned subsidiary:
a. Cash dividends paid to the parent company only.
b. Cash dividends paid to minority stockholders only.
c. Both cash dividends paid to the parent company and cash dividends paid to minority
stockholders.
d. Neither cash dividends paid to the parent company nor cash dividends paid to
minority stockholders.
8. How is the parent company’s cash acquisition of additional shares of previously unis-
sued common stock directly from a subsidiary displayed in a consolidated statement of
cash flows?
a. As an operating cash flow.
b. As an investing cash flow.
c. As a financing cash flow.
d. It is not reported.
9. In a consolidated statement of cash flows (indirect method), a gain on the parent com-
pany’s disposal of a portion of its investment in the subsidiary for cash is displayed with:
a. Cash flows from investing activities.
b. Cash flows from financing activities.
c. Noncash investing and financing activities (exhibit).
d. Cash flows from operating activities (exhibit).
10. In a consolidated statement of cash flows under the indirect method, the parent company’s
investment income from an influenced investee that paid no dividends is displayed in:
a. Cash flows from investing activities.
b. Cash flows from operating activities.
c. The exhibit reconciling net income to net cash flows from operating activities.
d. None of the foregoing sections.
11. In a consolidated statement of cash flows prepared under the indirect method, minority
interest in net income of subsidiary is added to consolidated net income for the com-
putation of net cash provided by operating activities because:
a. Cash dividends paid to minority stockholders by a partially owned subsidiary are
excluded from cash flows from financing activities.
 Chapter 9 Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions 409

b. An increase in minority interest in net assets of subsidiary is displayed with cash

flows from investing activities.
c. A decrease in minority interest in net assets of subsidiary is displayed with cash
flows from financing activities.
d. 100% of the cash of all subsidiaries is included in a consolidated balance sheet.
12. In an installment acquisition of a controlling interest in a subsidiary, the investor uses
a Retained Earnings of Investee/Subsidiary ledger account:
a. Beginning with the date of the first investment, regardless of amount.
b. Beginning when the investment aggregates at least 20%.
c. Beginning when the controlling interest is acquired.
d. In none of the foregoing circumstances.
13. If a parent company applies the equity method of accounting retroactively during the
course of its installment acquisition of a controlling interest in its subsidiary, con-
solidated retained earnings on the date that the business combination is completed
includes:
a. The parent company’s retained earnings only.
b. Both the parent company’s retained earnings and 100% of the subsidiary’s retained
earnings.
c. The parent company’s retained earnings plus a portion of the subsidiary’s earnings
equal to the balance of the parent’s Retained Earnings of Subsidiary (Investee) ledger
account.
d. The parent company’s retained earnings plus a percentage of the subsidiary’s re-
tained earnings equal to the percentage of the subsidiary’s outstanding common
stock acquired by the parent company to complete the business combination.
(Exercise 9.2) Salvo Corporation merged with Mango Company in a business combination. As a result,
goodwill was recognized. For income tax purposes, the business combination was consid-
ered to be a tax-free corporate reorganization. One of Mango’s assets was a building with
an appraised value of $150,000 on the date of the business combination. The building had
CHECK FIGURE a carrying amount of $90,000, net of accumulated depreciation based on the double-
Deferred income tax declining-balance method of depreciation, for financial accounting. Current fair values of
liability, $24,000. other assets were equal to carrying amounts.
Assuming a 40% income tax rate, prepare a working paper to compute the amount of the
deferred income tax liability that Salvo Corporation recognizes with respect to the building
as a result of the business combination.
(Exercise 9.3) On May 31, 2005, Combinor Corporation acquired for $560,000 cash all the net assets
except cash of Combinee Company, and paid $60,000 cash to a law firm for legal services
in connection with the business combination. The balance sheet of Combinee Company on
May 31, 2005, was as follows:

CHECK FIGURE
COMBINEE COMPANY
Debit goodwill,
Balance Sheet (prior to business combination)
$50,000. May 31, 2005

Assets Liabilities and Stockholders’ Equity

Cash $ 40,000 Liabilities $ 620,000
Other current assets (net) 280,000 Common stock, $1 par 250,000
Plant assets (net) 760,000 Retained earnings 330,000
Intangible assets (net) 120,000 Total liabilities and
Total assets $1,200,000 stockholders’ equity $1,200,000
410 Part Two Business Combinations and Consolidated Financial Statements

The present value of Combinee’s liabilities on May 31, 2005, was $620,000. The current
fair values of its noncash assets were as follows on that date:

Other current assets $300,000

Plant assets 780,000
Intangible assets 130,000

The income tax rate is 40%, and the business combination was a “tax-free corporate reor-
ganization” for income tax purposes.
Prepare journal entries (omit explanations) for Combinor Corporation on May 31, 2005,
to record the acquisition of the net assets of Combinee Company except cash, but includ-
ing a deferred income tax liability.
(Exercise 9.4) On November 1, 2005, the date of the business combination of Prudence Corporation and
its 70%-owned subsidiary, Sagacity Company, the current fair values of Sagacity’s identifi-
able net assets equaled their carrying amounts, and goodwill amortizable over 15 years for
income tax purposes was recognized in the amount of $60,000 in the working paper elimi-
CHECK FIGURE nation for the consolidated balance sheet of Prudence Corporation and subsidiary on that
Credit deferred income date. For the fiscal year ended October 31, 2006, Sagacity had a net income of $140,000
tax liability, $1,920. and declared and paid dividends of $50,000 on that date.
Assuming that the income tax rate is 40% and Prudence qualifies for the 80% dividend-
received deduction, prepare journal entries (omit explanations) for Prudence Corporation,
under the equity method of accounting, for the operations of Sagacity Company for the
year ended October 31, 2006, including income tax allocation.
(Exercise 9.5) During the fiscal year ended October 31, 2006, Shipp Company, a wholly owned subsidiary
of Ponte Corporation, sold merchandise to Stack Company, an 80%-owned subsidiary of
CHECK FIGURE Ponte, at billed prices totaling $630,000, representing Shipp’s usual 40% markup on cost.
Debit deferred income Stack’s beginning and ending inventories for the year included merchandise purchased
tax asset—Shipp, from Shipp at the following total billed prices:
$8,800.

Nov. 1, 2005 $35,000

Oct. 31, 2006 77,000

Ponte, Shipp, and Stack file separate income tax returns, and each has an income tax rate
of 40%.
Prepare October 31, 2006, working paper eliminations in journal entry format (explana-
tions omitted), for Ponte Corporation and subsidiaries, including income tax allocation, as-
suming that the provisions of FASB Statement No. 109, “Accounting for Income Taxes,”
for recognizing a deferred tax asset without a valuation allowance are met.
(Exercise 9.6) During the fiscal year ended November 30, 2006, Pederson Corporation sold merchandise
costing $100,000 to its 80%-owned subsidiary, Solomon Company, at a gross profit rate of
CHECK FIGURE 20%. On November 30, 2006, Solomon’s inventories included merchandise acquired from
Debit deferred income Pederson at a billed price of $30,000—a $10,000 increase over the comparable amount in
tax asset—Pederson, Solomon’s November 30, 2005, inventories. Both Pederson and Solomon file separate in-
$2,400. come tax returns, and both are subject to an income tax rate of 40%.
 Chapter 9 Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions 411

Prepare working paper eliminations (in journal entry format) for merchandise transactions
and related income tax allocation for Pederson Corporation and subsidiary on November 30,
2006, assuming that the provisions of FASB Statement No. 109, “Accounting for Income
Taxes,” for recognizing a deferred tax asset without a valuation allowance are met.
(Exercise 9.7) The sales of merchandise by Sol Company, 80%-owned subsidiary of Pol Corporation, to
Stu Company, 70%-owned subsidiary of Pol, during the fiscal year ended October 31, 2006,
may be analyzed as follows:

CHECK FIGURE
Selling Price Cost Gross Profit
Debit income taxes
expense—Sol, $8,000. Beginning inventories $ 80,000 $ 60,000 $ 20,000
Sales 400,000 300,000 100,000
Subtotals $480,000 $360,000 $120,000
Ending inventories 90,000 67,500 22,500
Cost of goods sold $390,000 $292,500 $ 97,500

Pol, Sol, and Stu file separate income tax returns, and each has an income tax rate of 40%.
Prepare working paper eliminations, including income taxes allocation, in journal entry
format (omit explanations) for Pol Corporation and subsidiaries on October 31, 2006, as-
suming that the provisions of FASB Statement No. 109, “Accounting for Income Taxes,”
for recognizing a deferred tax asset without a valuation allowance are met.
(Exercise 9.8) The following working paper eliminations (in journal entry format) were prepared by the
accountant for Purdue Corporation on February 28, 2006, the end of a fiscal year:

CHECK FIGURE
PURDUE CORPORATION AND SUBSIDIARY
Debit income taxes
Working Paper Eliminations
expense—Purdue, February 28, 2006
$800.
Intercompany Gain on Sale of Machinery—Purdue 12,000
Machinery—Scarsdale 12,000
To eliminate unrealized intercompany gain on February 28, 2006, sale
of machine with a six-year economic life, no residual value, and
straight-line depreciation method.

Deferred Income Tax Asset—Purdue ($12,000 0.40) 4,800

Income Taxes Expense—Purdue 4,800
To defer income taxes provided in separate income tax returns of
parent company applicable to unrealized intercompany gain in
subsidiary’s machinery on February 28, 2006.

Prepare working paper eliminations (in journal entry format, explanations omitted) for
Purdue Corporation and subsidiary on February 28, 2007, assuming that the provisions of
FASB Statement No. 109, “Accounting for Income Taxes,” for recognizing a deferred tax
asset without a valuation allowance are met.
(Exercise 9.9) The working paper eliminations (in journal entry format) of Pegler Corporation and its
wholly owned subsidiary, Stang Company, on October 31, 2006, included the following:
412 Part Two Business Combinations and Consolidated Financial Statements

CHECK FIGURE
Credit retained (b) Retained Earnings—Stang 10,000
earnings—Pegler, Intercompany Sales—Stang 240,000
$16,000. Intercompany Cost of Goods Sold—Stang 120,000
Cost of Goods Sold—Pegler 60,000
Inventories—Pegler 70,000
To eliminate intercompany sales, cost of goods sold, and
unrealized intercompany profit in inventories.

(c) Retained Earnings—Pegler 40,000

Accumulated Depreciation—Stang 60,000
Machinery—Stang 80,000
Depreciation Expense—Stang 20,000
To eliminate unrealized intercompany gain in machinery
and in related depreciation. Gain element in depreciation
computed as $80,000 4 $20,000, based on four-year
economic life of machinery.

Both Pegler and Stang file separate tax returns, and both have an income tax rate of 40%.
Prepare required additional working paper eliminations (in journal entry format; omit
explanations) for Pegler Corporation and subsidiary on October 31, 2006, assuming that
the provisions of FASB Statement No. 109, “Accounting for Income Taxes,” for recogniz-
ing a deferred tax asset without a valuation allowance are met.
(Exercise 9.10) On October 31, 2006, Salvador Company, 80%-owned subsidiary of Panama Corporation,
sold to its parent company for $20,000 a patent with a carrying amount of $15,000 on that
CHECK FIGURE date. Remaining legal life of the patent on October 31, 2006, was five years; the patent was
b. Credit amortization expected to produce revenue for Panama during the entire five-year period. Panama and
expense—Panama, Salvador file separate income tax returns; their income tax rate is 40%. Panama uses an
$1,000. Accumulated Amortization of Patent ledger account.
Assuming that the provisions of FASB Statement No. 109, “Accounting for Income
Taxes,” for recognizing a deferred tax asset without a valuation allowance are met, prepare
working paper eliminations (in journal entry format), including income tax allocation, for
Panama Corporation and subsidiary with respect to the patent: (a) on October 31, 2006,
and (b) on October 31, 2007.
(Exercise 9.11) The following working paper elimination (in journal entry format) was prepared for Plumm
Corporation and subsidiary on March 31, 2006:

CHECK FIGURE
Credit deferred income Intercompany Interest Revenue—Plumm ($456,447 0.10) 45,645
tax liability—Sam, Intercompany 8% Bonds Payable—Sam 500,000
$7,384. Discount on Intercompany 8% Bonds Payable—Sam
($22,429 $2,981) 19,448
Investment in Sam Company Bonds—Plumm
($456,447 $5,645) 462,092
Intercompany Interest Expense—Sam ($477,571 0.09) 42,981
Retained Earnings—Sam ($477,571 $456,447) 21,124
To eliminate subsidiary’s bonds owned by parent company, and related
interest revenue and expense; and to increase subsidiary’s beginning
retained earnings by amount of unamortized realized gain on the
extinguishment of the bonds.
 Chapter 9 Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions 413

Plumm and Sam file separate income tax returns, and both are subject to a 40% income tax rate.
Prepare a working paper elimination (in journal entry format) for Plumm Corporation
and subsidiary on March 31, 2006, for the income tax effects of the foregoing elimination.
Omit the explanation for the elimination.
(Exercise 9.12) On October 31, 2006, Pom Corporation acquired in the open market $500,000 face amount of
the 10%, ten-year bonds due October 31, 2015, of its wholly owned subsidiary, Sepp Company.
CHECK FIGURE The bonds had been issued by Sepp on October 31, 2005, to yield 12%. Pom’s investment was
(4) $1,420. at a 15% yield rate. Both Pom and Sepp file separate income tax returns, both companies are
subject to an income tax rate of 40%, and neither company has any items requiring interperiod
or intraperiod income tax allocation other than the Sepp Company bonds, on which interest is
payable each October 31. Working paper eliminations (in journal entry format) related to the
bonds on October 31, 2006, and October 31, 2007, with certain amounts omitted, are as follows:

POM CORPORATION AND SUBSIDIARY

Partial Working Paper Eliminations
October 31, 2006

Intercompany Bonds Payable—Sepp 500,000

Discount on Intercompany Bonds Payable—Sepp 53,283
Investment in Sepp Company Bonds—Pom 380,710
Gain on Extinguishment of Bonds—Sepp 66,007
To eliminate subsidiary’s bonds acquired by parent, and to
recognize gain on the extinguishment of the bonds.

Income Taxes Expense—Sepp (1)

Deferred Income Tax Liability—Sepp (2)
To provide for income taxes attributable to subsidiary’s realized
gain on parent company’s acquisition of the subsidiary’s bonds.

POM CORPORATION AND SUBSIDIARY

Partial Working Paper Eliminations
October 31, 2007

Intercompany Interest Revenue—Pom 57,107

Intercompany Bonds Payable—Sepp 500,000
Discount on Intercompany Bonds Payable—Sepp 49,725
Investment in Sepp Company Bonds—Pom 387,817
Intercompany Interest Expense—Sepp 53,558
Retained Earnings—Sepp 66,007
To eliminate subsidiary’s bonds owned by parent company, and
related interest revenue and expense; and to increase subsidiary’s
beginning retained earnings by amount of unamortized realized
gain on the extinguishment of the bonds.

Retained Earnings—Sepp (3)

Income Taxes Expense—Sepp (4)
Deferred Income Tax Liability—Sepp (5)
To reduce the subsidiary’s income taxes expense for amount
attributable to recorded intercompany gain (for consolidation
purposes) on subsidiary’s bonds; and to provide for remaining
deferred income taxes on unrecorded portion of gain.
414 Part Two Business Combinations and Consolidated Financial Statements

Prepare a working paper to compute the five missing amounts in the foregoing working
paper eliminations.

(Exercise 9.13) Prieto Corporation declared and paid cash dividends of $250,000 on its common stock and dis-
tributed a 5% common stock dividend in 2006. The current fair value of the shares distributed
pursuant to the 5% stock dividend was $600,000. Prieto owns 100% of the common stock of
Sora Company and 75% of the common stock of Sano Company. In 2006, Sora declared and
CHECK FIGURE paid cash dividends of $100,000 on its common stock and $25,000 on its $5 cumulative pre-
Total cash flows, ferred stock. None of the preferred stock is owned by Prieto. In 2006, Sano declared and paid
$286,000. cash dividends of $44,000 on its common stock, the only class of capital stock issued.
Prepare a working paper to compute the amount to be displayed as cash flows for the
payment of dividends in the Year 2006 consolidated statement of cash flows for Prieto
Corporation and subsidiaries.

(Exercise 9.14) The consolidated statement of cash flows (indirect method) for Paradise Corporation and
its partially owned subsidiaries is to be prepared for Year 2006. Using the following letters,
indicate how each of the 13 items listed below should be displayed in the statement.
A O Add to combined net income in the computation of net cash provided by
operating activities
D O Deduct from combined net income in the computation of net cash provided
by operating activities
IA A cash flow from investing activities
FA A cash flow from financing activities
N Not included or separately displayed in the consolidated statement of cash
flows, but possibly disclosed in a separate exhibit
1. The minority interest in net income of subsidiaries is $37,500.
2. Paradise issued a note payable to a subsidiary company in exchange for plant assets
with a current fair value of $180,000.
3. Paradise distributed a 10% stock dividend; the additional shares of common stock is-
sued had a current fair value of $675,000.
4. Paradise declared and paid a cash dividend of $200,000.
5. Long-term debt of Paradise in the amount of $2 million was converted to its common
stock.
6. A subsidiary sold plant assets to outsiders at the carrying amount of $80,000.
7. Paradise’s share of the net income of an influenced investee totaled $28,000. The in-
vestee did not declare or pay cash dividends in 2006.
8. Consolidated depreciation and amortization expense totaled $285,000.
9. A subsidiary amortized $3,000 of premium on bonds payable owned by outsiders.
10. Paradise sold its entire holdings in an 80%-owned subsidiary for $3 million.
11. Paradise merged with Sun Company in a business combination; 150,000 shares of
common stock with a current fair value of $4.5 million were issued by Paradise for all
of Sun’s outstanding common stock.
12. Paradise received cash dividends of $117,000 from its subsidiaries.
13. The subsidiaries of Paradise declared and paid cash dividends of $21,500 to minority
stockholders.

(Exercise 9.15) On August 1, 2005, Packard Corporation acquired 1,000 of the 10,000 outstanding shares
of Stenn Company’s $1 par common stock for $5,000. Stenn’s identifiable net assets had a
 Chapter 9 Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions 415

current fair value and carrying amount of $40,000 on that date. Stenn had a net income of
CHECK FIGURE $3,000 and declared and paid dividends of the same amount for the fiscal year ended July
July 31, 2007, credit 31, 2006. On August 1, 2006, Packard acquired 4,500 more shares of Stenn’s outstanding
Intercompany common stock for $22,500. The current fair values and carrying amounts of Stenn’s iden-
Investment Income, tifiable net assets were still $40,000 on that date. Stenn had a net income of $7,500 and de-
$4,125. clared no dividends for the fiscal year ended July 31, 2007.
Prepare journal entries for Packard Corporation for the foregoing business transactions
and events for the two years ended July 31, 2007. (Omit explanations and disregard income
tax effects.) Consolidated goodwill was unimpaired at July 31, 2007.

Cases
(Case 9.1) In a classroom discussion of accounting standards established in FASB Statement No. 109,
“Accounting for Income Taxes,” student Laura was critical of the requirement to establish a de-
ferred tax asset or liability for differences between the assigned values and the tax bases of
most assets and liabilities recognized in a business combination (see page 386). Laura pointed
out that, in the usual situation of assigned values in excess of tax bases, the recognition of a de-
ferred tax liability for the resultant differences has the effect of increasing goodwill (or de-
creasing “bargain-purchase excess”) otherwise recognized in the business combination. Laura
questions whether, on the date of the business combination, the so-called deferred income tax
liability is really a liability, as defined in paragraph 35 of FASB Concepts Statement No. 6,
“Elements of Financial Statements.” Student Jason responds that in paragraphs 75 through 79
of FASB Statement No. 109, the FASB dealt with the issue raised by Laura and concluded that
deferred income tax liabilities resulting from business combinations are indeed liabilities.
Instructions
Do you agree with student Jason that the FASB’s conclusion should put to rest criticisms of
FASB Statement No. 109 such as that expressed by student Laura? Explain.
(Case 9.2) On April 1, 2005, the beginning of a fiscal year, Paddock Corporation acquired 70% of the
outstanding common stock of domestic subsidiary Serge Company in a business combina-
tion. In your audit of the consolidated financial statements of Paddock Corporation and
subsidiary for the year ended March 31, 2006, you discover that Serge had a net income of
$50,000 for the year but did not declare or pay any cash dividends. Nonetheless, Paddock
did not record a deferred income tax liability applicable to Serge’s undistributed earnings,
net of the 80% dividend-received deduction, despite Paddock’s having adopted the equity
method of accounting for Serge’s operating results.
In response to your inquiries, the controller of Paddock pointed out that Serge’s severe
cash shortage made the declaration and payment of cash dividends by Serge doubtful for
the next several years. Therefore, stated the controller, a provision for deferred income
taxes on Serge’s undistributed earnings for the year ended March 31, 2006, is inappropriate
under generally accepted accounting principles.
Instructions
Do you agree with the controller’s interpretation of generally accepted accounting princi-
ples for the undistributed earnings of Serge Company? Explain.
(Case 9.3) The recognition of goodwill on a residual basis in business combinations has been criti-
cized by some accountants (see page 182). In the accounting for business combinations
accomplished in installments, described on pages 401–406, more than one amount of good-
will may be recognized.
416 Part Two Business Combinations and Consolidated Financial Statements

Instructions
Assume that you are asked to advise the Financial Accounting Standards Board on alterna-
tives to recognizing multiple amounts of goodwill in business combinations accomplished
in installments. What alternatives would you recommend? Explain.
(Case 9.4) As controller of Pantheon Corporation, a publicly owned enterprise that has a wholly
owned subsidiary, Synthesis Company, you are considering whether a valuation allowance,
as discussed in paragraph 17(e) of FASB Statement No. 109, “Accounting for Income
Taxes,” is required for the $400,000 deferred income tax asset related to the $1,000,000 un-
realized intercompany gain from Pantheon’s sale of part of its land to Synthesis as the site
for a new factory building for Synthesis. For valid reasons, Pantheon and Synthesis file sep-
arate income tax returns; therefore, Pantheon has paid the $400,000 amount as part of its
overall federal and state income tax obligations. You are aware that, unless Synthesis sells
the land to an outsider in the future, the $1,000,000 gain will not be realized by the consol-
idated entity. Nonetheless, you know that land values are increasing in the area surround-
ing Synthesis’s land, and that it is more likely than not that Synthesis would realize a gain
if it did sell the land to an outsider. You also are aware that valuation allowances for de-
ferred tax assets based on future taxable income were included in the AICPA’s Statement of
Position 94-6, “Disclosure of Certain Significant Risks and Uncertainties,” especially in
paragraphs A-43 through A-45 of Appendix A thereof.
Instructions
Do you consider a valuation allowance necessary for the $400,000 deferred tax asset of
Pantheon Corporation and subsidiary? Explain.

Problems
(Problem 9.1) This problem consists of two unrelated parts.
a. The merchandise sales by Pro Corporation’s wholly owned subsidiary, Spa Company, to
Pro’s 80%-owned subsidiary, Sol Company, may be analyzed as follows for the year
ended October 31, 2006:

CHECK FIGURE Gross Profit

b. Credit deferred
(331⁄3 of Cost; 25%
income tax liability,
Selling Price Cost of Selling Price)
$40,923.
Beginning inventories $ 100,000 $ 75,000 $ 25,000
Sales 2,000,000 1,500,000 500,000
Subtotals $2,100,000 $1,575,000 $525,000
Ending inventories 300,000 225,000 75,000
Cost of goods sold $1,800,000 $1,350,000 $450,000

Pro, Spa, and Sol use the perpetual inventory system, file separate income tax returns, and
have an income tax rate of 40%.
Instructions
Prepare working paper eliminations (in journal entry format), including income taxes allo-
cation, for Pro Corporation and subsidiaries on October 31, 2006.
 Chapter 9 Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions 417

b. The following working paper eliminations (in journal entry format) were prepared by
the accountant for Primrose Corporation, which had a single wholly owned subsidiary:

PRIMROSE CORPORATION AND SUBSIDIARY

Partial Working Paper Eliminations
April 30, 2006

Intercompany 8% Bonds Payable—Safflower 1,000,000

Discount on Intercompany 8% Bonds Payable—Safflower 124,622
Investment in Safflower Company 8% Bonds—Primrose 770,602
Gain on Extinguishment of Bonds—Safflower 104,776
To eliminate subsidiary’s bonds (interest payable Apr. 30 and
Oct. 31), which had been issued to yield 10% and were
acquired by parent company at a 12% yield; and to recognize
gain on the extinguishment of the bonds.

Income Taxes Expense—Safflower ($104,776 0.40) 41,910

Deferred Income Tax Liability—Safflower 41,910
To provide for income taxes attributable to subsidiary’s realized
gain on parent company’s acquisition of the subsidiary’s bonds.

Instructions
Prepare comparable working paper eliminations for Primrose Corporation and subsidiary
on October 31, 2006.
(Problem 9.2) The working paper eliminations (in journal entry format) for intercompany bonds of Pullet
Corporation and its wholly owned subsidiary on November 30, 2006, the end of a fiscal
year, follow. The bonds, which had been issued by Sagehen Company for a five-year term
on November 30, 2005, to yield 10%, were acquired in the open market by Pullet on
November 30, 2006, to yield 12%. Interest on the bonds is payable at the rate of 8% each
November 30, 2007 through 2009. Both companies use the interest method of amortization
or accumulation of bond premium or discount.

CHECK FIGURE
PULLET CORPORATION AND SUBSIDIARY
b. Credit deferred
Partial Working Paper Eliminations
income tax liability, November 30, 2006
$1,112.
Intercompany Bonds Payable—Sagehen 60,000
Discount on Intercompany Bonds Payable—Sagehen 3,804
Investment in Sagehen Company Bonds—Pullet 52,710
Gain on Extinguishment of Bonds—Sagehen 3,486
To eliminate subsidiary’s bonds acquired by parent; and to
recognize gain on the extinguishment of the bonds.

Income Taxes Expense—Sagehen ($3,486 0.40) 1,394

Deferred Income Tax Liability—Sagehen 1,394
To provide for income taxes attributable to subsidiary’s realized
gain on parent company’s acquisition of the subsidiary’s bonds.
418 Part Two Business Combinations and Consolidated Financial Statements

Instructions
a. Prepare journal entries for both Pullet Corporation and Sagehen Company to recognize
intercompany interest revenue and expense, respectively, on November 30, 2007. Dis-
regard Sagehen’s bonds owned by outsiders.
b. Prepare working paper eliminations (in journal entry format) for Pullet Corporation and
subsidiary on November 30, 2007, including allocation of income taxes.
(Problem 9.3) On January 2, 2005, Presto Corporation issued 10,000 shares of its $1 par (current fair
value $40) common stock for all 50,000 shares of Shuey Company’s outstanding common
stock in a statutory merger that qualified as a business combination. Out-of-pocket costs in
connection with the combination, paid by Presto on January 2, 2005, were as follows:

Finder’s fee, accounting fees, and legal fees relating to the business
combination $60,000
Costs associated with SEC registration statement for securities issued to
complete the business combination 30,000
Total out-of-pocket costs of business combination $90,000

For income tax purposes, the business combination qualified as a “Type A tax-free cor-
porate reorganization.” The balance sheet of Shuey Company on January 2, 2005, with as-
sociated current fair values of assets and liabilities, was as follows:

CHECK FIGURE
SHUEY COMPANY
Credit deferred income
Balance Sheet (prior to business combination)
tax liability, $54,000. January 2, 2005

Carrying Current
Amounts Fair Values
Assets
Cash $ 20,000 $ 20,000
Trade accounts receivable (net) 80,000 80,000
Inventories 120,000 160,000
Short-term prepayments 10,000 10,000
Investments in held-to-maturity debt securities 30,000 45,000
Plant assets (net) 430,000 490,000
Intangible assets (net) 110,000 130,000
Total assets $800,000 $935,000

Liabilities and Stockholders’ Equity

Liabilities:
Notes payable $ 60,000 $ 60,000
Trade accounts payable 90,000 90,000
Income taxes payable 30,000 30,000
Long-term debt 300,000 300,000
Total liabilities $480,000 $480,000
Stockholders’ equity:
Common stock, $2 par $100,000
Additional paid-in capital 100,000
Retained earnings 120,000
Total stockholders’ equity $320,000
Total liabilities and stockholders’ equity $800,000
 Chapter 9 Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions 419

The income tax rate for both Presto and Shuey is 40%.

Instructions
Prepare journal entries for Presto Corporation to record the business combination with
Shuey Company on January 2, 2005, including deferred income taxes.

(Problem 9.4) Separate balance sheets of Pellerin Corporation and its subsidiary, Sigmund Company,
on the dates indicated, are as follows. Both companies have a December 31 fiscal year-
end.

PELLERIN CORPORATION AND SIGMUND COMPANY

Separate Balance Sheets
Various Dates, Year 2005

Pellerin
Corporation Sigmund Company
Dec. 31, Jan. 2, Sept. 30, Dec. 31,
2005 2005 2005 2005
Assets
Cash $ 400,000 $ 550,000 $ 650,000 $ 425,000
Fees and royalties
receivable 250,000 450,000 500,000
Investment in
Sigmund Company
common stock 2,240,000
Patents (net) 1,000,000 850,000 800,000
Other assets (net) 4,360,000 200,000
Total assets $7,000,000 $1,800,000 $1,950,000 $1,925,000

Liabilities and
Stockholders’
Equity
Liabilities $ 400,000 $ 200,000 $ 150,000 $ 275,000
Common stock, $10 par 5,000,000 1,000,000 1,000,000 1,000,000
Retained earnings 1,600,000 600,000 800,000 650,000
Total liabilities and
stockholders’ equity $7,000,000 $1,800,000 $1,950,000 $1,925,000

Additional Information
1. Pellerin had acquired 30,000 shares of Sigmund’s outstanding common stock on Jan-
uary 2, 2005, at a cost of $480,000; and 60,000 shares on September 30, 2005, at a cost
of $1,760,000. Pellerin obtained control over Sigmund because of the valuable patents
owned by Sigmund.
2. Sigmund amortizes the cost of patents on a straight-line basis. Any amount allocated to
patents as a result of the business combination is to be amortized over the five-year re-
maining economic life of the patents from January 2, 2005.
3. Sigmund declared and paid a cash dividend of $300,000 on December 31, 2005. Pellerin
had not recorded either the declaration or the receipt of the dividend.
420 Part Two Business Combinations and Consolidated Financial Statements

Instructions
Prepare journal entries for Pellerin Corporation on December 31, 2005, to account for its
investments in Sigmund Company under the equity method of accounting. Disregard in-
come taxes, and do not prepare journal entries for Pellerin’s acquisition of the investments
in Sigmund.
(Problem 9.5) Consolidated financial statements of Porcelain Corporation and its 80%-owned subsidiary,
Skinner Company, for the year ended December 31, 2006, including comparative consoli-
dated balance sheets on December 31, 2005, are as follows:

CHECK FIGURE
PORCELAIN CORPORATION AND SUBSIDIARY
Net cash provided by
Consolidated Income Statement
operating activities,
For Year Ended December 31, 2006
$135,000.
Revenue:
Net sales $1,200,000
Gain on disposal of plant assets 50,000
Total revenue $1,250,000
Costs and expenses and minority interest:
Cost of goods sold $700,000
Depreciation expense 40,000
Goodwill impairment loss 20,000
Other operating expenses 120,000
Interest expense 50,000
Income taxes expense 192,000
Minority interest in net income of subsidiary 10,000 1,132,000
Net income $ 118,000
Basic earnings per share of common stock $ 1.97

PORCELAIN CORPORATION AND SUBSIDIARY

Consolidated Statement of Stockholders’ Equity
For Year Ended December 31, 2006

Common Stock, Additional Retained

$1 par Paid-in Capital Earnings Total
Balances,
beginning of year $ 60,000 $30,000 $180,000 $270,000
Issuance of
40,000 shares of
common stock
at $1.75 a share 40,000 30,000 70,000
Net income 118,000 118,000
Cash dividends
declared and paid
($1 a share) (60,000) (60,000)
Balances, end of year $100,000 $60,000 $238,000 $398,000
 Chapter 9 Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions 421

PORCELAIN CORPORATION AND SUBSIDIARY

Consolidated Balance Sheets
December 31, 2006 and 2005

2006 2005
Assets
Cash $ 70,000 $ 50,000
Other current assets 230,000 150,000
Plant assets (net) 680,000 600,000
Goodwill 140,000 160,000
Total assets $1,120,000 $960,000

Liabilities and Stockholders’ Equity

Liabilities:
Current liabilities, including current portion of
note payable $ 187,000 $110,000
Note payable, due $50,000 annually, plus interest at 10% 450,000 500,000
Total liabilities $ 637,000 $610,000
Stockholders’ equity:
Common stock, $1 par $ 100,000 $ 60,000
Additional paid-in capital 60,000 30,000
Minority interest in net assets of subsidiary 85,000 80,000
Retained earnings 238,000 180,000
Total stockholders’ equity $ 483,000 $350,000
Total liabilities and stockholders’ equity $1,120,000 $960,000

Additional Information
1. The affiliated companies acquired plant assets for $220,000 cash during the year ended
December 31, 2006. Also during the year, Skinner Company, the 80%-owned subsidiary
of Porcelain, sold plant assets with a carrying amount of $100,000 to an outsider for
$150,000 cash.
2. Skinner declared and paid dividends totaling $25,000 during the year ended December
31, 2006.
Instructions
Prepare a consolidated statement of cash flows (indirect method) for Porcelain Corporation
and subsidiary for the year ended December 31, 2006, without using a working paper. Dis-
regard disclosure of cash paid for interest and income taxes.
(Problem 9.6) The following transactions took place between Parkhurst Corporation and its wholly owned
subsidiary, Sandland Company, which file separate income tax returns, during the fiscal
year ended March 31, 2006:
1. Parkhurst sold to Sandland at a 30% gross profit rate merchandise with a total sale price of
$200,000. Sandland’s March 31, 2006, inventories included $40,000 (billed prices) of the
merchandise obtained from Parkhurst—a $20,000 increase from the related April 1, 2005,
inventories amount. Both Parkhurst and Sandland use the perpetual inventory system.
2. On April 1, 2005, Sandland sold to Parkhurst for $50,000 a machine with a carrying
amount of $30,000 on that date. The economic life of the machine to Parkhurst was five
years, with no residual value. Parkhurst uses the straight-line method of depreciation for
all plant assets.
422 Part Two Business Combinations and Consolidated Financial Statements

3. On February 28, 2006, Parkhurst sold land for a plant site to Sandland for $480,000. The
land had a carrying amount to Parkhurst of $360,000.
4. On March 31, 2006, following Sandland’s payment of interest to bondholders, Parkhurst
acquired in the open market for $487,537, a 16% yield, 60% of Sandland’s 12%, ten-
year bonds dated March 31, 2005. The bonds had been issued to the public by Sandland
on March 31, 2005, to yield 14%. On March 31, 2006, after the payment of interest,
Sandland’s accounting records included the following ledger account balances relative
to the bonds:

12% bonds payable $1,000,000 cr

Discount on 12% bonds payable 100,590 dr

Both Parkhurst and Sandland use the interest method of amortization or accumulation of
bond discount. The income tax rate for both affiliated companies, which file separate in-
come tax returns, is 40%.
Instructions
Prepare working paper eliminations (in journal entry format), including income taxes allo-
cation, for Parkhurst Corporation and subsidiary on March 31, 2006. Round all amounts to
the nearest dollar.
(Problem 9.7) Paine Corporation owns 99% of the outstanding common stock of Spilberg Company, ac-
quired July 1, 2005, in a business combination that did not involve goodwill; and 90% of
CHECK FIGURES the outstanding common stock of Sykes Company, acquired July 1, 2005, in a business
a. Credit deferred
combination that reflected goodwill of $52,200. All identifiable net assets of both Spilberg
income tax liability
(other liabilities),
and Sykes were fairly valued at their carrying amounts on July 1, 2005. Goodwill is amor-
$11,520; tized over 15 years for income tax purposes.
b. Consolidated net Separate financial statements of Paine, Spilberg, and Sykes for the fiscal year ended
income, $119,940; June 30, 2006, prior to income tax provisions and equity-method accruals in the account-
consolidated ending ing records of Paine, are below and on page 423.
retained earnings,
$466,460; minority
interest in net assets, PAINE CORPORATION AND SUBSIDIARIES
$69,200. Separate Financial Statements
For Year Ended June 30, 2006

Paine Spilberg Sykes

Corporation Company Company

Income Statements
Revenue:
Net sales $1,000,000 $ 550,000 $ 220,000
Intercompany sales 100,000
Total revenue $1,100,000 $ 550,000 $ 220,000
Costs and expenses:
Cost of goods sold $ 700,000 $ 357,500 $ 143,000
Intercompany cost of goods sold 70,000
Operating expenses 130,000 125,833 43,667
Interest expense 46,520
Income taxes expense 26,667 13,333
Total costs and expenses $ 946,520 $ 510,000 $ 200,000
Net income $ 153,480 $ 40,000 $ 20,000
(continued)
 Chapter 9 Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions 423

PAINE CORPORATION AND SUBSIDIARIES

Separate Financial Statements (concluded)
For Year Ended June 30, 2006

Paine Spilberg Sykes

Corporation Company Company
Statements of Retained Earnings
Retained earnings, beginning of year $ 396,520 $ 300,000 $ 150,000
Add: Net income 153,480 40,000 20,000
Subtotals $ 550,000 $ 340,000 $ 170,000
Less: Dividends 50,000 20,000 10,000
Retained earnings, end of year $ 500,000 $ 320,000 $ 160,000

Balance Sheets
Assets
Inventories $1,000,000 $ 800,000 $ 700,000
Investment in Spilberg Company
common stock 990,000
Investment in Sykes Company
common stock 574,200
Other assets 1,501,300 1,260,000 790,000
Total assets $4,065,500 $2,060,000 $1,490,000

Liabilities and Stockholders’ Equity

Intercompany dividends payable $ 19,800 $ 9,000
Other liabilities $1,965,500 1,020,200 891,000
Common stock, $1 par 1,000,000 500,000 300,000
Additional paid-in capital 600,000 200,000 130,000
Retained earnings 500,000 320,000 160,000
Total liabilities and stockholders’ equity $4,065,500 $2,060,000 $1,490,000

Additional Information
1. Intercompany profits in June 30, 2006, inventories resulting from Paine’s sales to its sub-
sidiaries during the year ended June 30, 2006, are as follows:

In Spilberg Company’s inventories—$6,000

In Sykes Company’s inventories—$7,500

2. Consolidated goodwill was unimpaired as of June 30, 2006.

Instructions
a. Prepare Paine Corporation’s June 30, 2006, journal entries for income taxes and equity-
method accruals. The income tax rate for all three companies is 40%. All three compa-
nies declared dividends on June 30, 2006. Disregard the dividend-received deduction.
b. Prepare a working paper for consolidated financial statements and related working pa-
per eliminations (in journal entry format), including income taxes allocation, for Paine
Corporation and subsidiaries for the year ended June 30, 2006. The three affiliated com-
panies file separate income tax returns. Amounts for Paine Corporation should reflect
the journal entries in (a).
(Problem 9.8) The separate financial statements of Pickens Corporation and subsidiary for the year ended
December 31, 2005, are as follows:
424 Part Two Business Combinations and Consolidated Financial Statements

CHECK FIGURES PICKENS CORPORATION AND SUBSIDIARY

Consolidated net
Separate Financial Statements
income, $60,326; For Year Ended December 31, 2005
consolidated ending
retained earnings, Pickens Skiffen
$638,826; minority Corporation Company
interest in net assets,
$91,341. Income Statements
Revenue:
Net sales $ 840,000 $360,000
Intercompany sales 80,600 65,000
Intercompany gain on sale of equipment 9,500
Intercompany interest revenue 2,702
Intercompany investment income 44,800
Total revenue $ 977,602 $425,000
Costs and expenses:
Cost of goods sold $ 546,000 $252,000
Intercompany cost of goods sold 56,420 48,750
Interest expense 32,000 9,106
Intercompany interest expense 2,276
Other operating expenses and income taxes expense 270,752 56,868
Total costs and expenses $ 905,172 $369,000
Net income $ 72,430 $ 56,000
Statements of Retained Earnings
Retained earnings, beginning of year $ 595,000 $136,000
Add: Net income 72,430 56,000
Subtotals $ 667,430 $192,000
Less: Dividends 20,000 11,000
Retained earnings, end of year $ 647,430 $181,000
Balance Sheets
Assets
Intercompany receivables (payables) $ 35,800 $ (35,800)
Inventories 180,000 96,000
Investment in Skiffen Company common stock 393,200
Investment in Skiffen Company bonds 27,918
Plant assets (net) 781,500 510,000
Accumulated depreciation of plant assets (87,000) (85,000)
Other assets 333,782 146,500
Total assets $1,665,200 $631,700
Liabilities and Stockholders’ Equity
Dividends payable $ 20,000 $ 2,200
Bonds payable 400,000 120,000
Intercompany bonds payable 30,000
Discount on bonds payable (4,281)
Discount on intercompany bonds payable (1,070)
Deferred income tax liability 15,800
Other liabilities 164,470 24,851
Common stock, $2.50 par 400,000 250,000
Additional paid-in capital 14,000 29,000
Retained earnings 647,430 181,000
Retained earnings of subsidiary 3,500
Total liabilities and stockholders’ equity $1,665,200 $631,700
 Chapter 9 Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions 425

Pickens had acquired 10% of the 100,000 outstanding shares of $2.50 par common
stock of Skiffen Company on December 31, 2003, for $38,000. An additional 70,000 shares
were acquired for $315,700 on January 2, 2005 (at which time there was no difference
between the current fair values and carrying amounts of Skiffen’s identifiable net assets).
Out-of-pocket costs of the business combination may be disregarded.
Additional Information
1. Pickens Corporation’s ledger accounts for Investment in Skiffen Company Common
Stock, Deferred Income Tax Liability, Retained Earnings, and Retained Earnings of
Subsidiary were as follows (before December 31, 2005, closing entries):

Investment in Skiffen Company Common Stock

Date Explanation Debit Credit Balance
2003
Dec. 31 Acquisition of 10,000 shares 38,000 38,000 dr
2005
Jan. 2 Acquisition of 70,000 shares 315,700 353,700 dr
2 Retroactive application of equity
method of accounting
3 ($40,000 $5,000) 0.10 4 3,500 357,200 dr
Dec. 15 Dividend declared by Skiffen
($11,000 0.80) 8,800 348,400 dr
31 Net income of Skiffen
($56,000 0.80) 44,800 393,200 dr

Deferred Income Tax Liability

Date Explanation Debit Credit Balance
2005
Jan. 2 Income taxes applicable to
undistributed earnings of
subsidiary ($3,500 0.40)* 1,400 1,400 cr
Dec. 31 Income taxes applicable to
undistributed earnings of
subsidiary 3 ($44,800
3 $8,800) 0.40 4 * 14,400 15,800 cr

*Dividend received deduction is disregarded.

Retained Earnings
Date Explanation Debit Credit Balance
2003
Dec. 31 Balance 540,000 cr
2004
Dec. 31 Close net income 55,000 595,000 cr
426 Part Two Business Combinations and Consolidated Financial Statements

Retained Earnings of Subsidiary

Date Explanation Debit Credit Balance
2005
Jan. 2 Retroactive application of equity
method of accounting 3,500 3,500 cr

2. Skiffen Company’s Retained Earnings ledger account was as follows:

Retained Earnings
Date Explanation Debit Credit Balance
2003
Dec. 31 Balance 101,000 cr
2004
Dec. 31 Close net income 40,000 141,000 cr
31 Close Dividends Declared account 5,000 136,000 cr

3. Information relating to intercompany sales for 2005:

Pickens Skiffen
Corporation Company
Dec. 31, 2005, inventory of intercompany merchandise
purchases, on first-in, first-out basis $26,000 $22,000
Intercompany payables, Dec. 31, 2005 12,000 7,000

4. Pickens acquired $30,000 face amount of Skiffen’s 6% bonds in the open market on Jan-
uary 2, 2005, for $27,016—a 10% yield. Skiffen had issued the bonds on January 2,
2003, to yield 8% and had been paying the interest each December 31.
5. On September 1, 2005, Pickens sold equipment with a cost of $40,000 and accumulated
depreciation of $9,300 to Skiffen for $40,200. On September 1, 2005, the equipment
had an economic life of 10 years and no residual value. Skiffen includes depreciation ex-
pense (straight-line method) in other operating expenses.
6. Skiffen owed Pickens $32,000 on December 31, 2005, for non-interest-bearing cash
advances.
7. Pickens and Skiffen file separate income tax returns. The income tax rate is 40%. The
dividend-received deduction is disregarded, as is the $1,680 ($25,200 15 $1,680)
unimpaired goodwill amortization for income tax purposes.
8. Consolidated goodwill was unimpaired as of December 31, 2005.
Instructions
Prepare a working paper for consolidated financial statements and related working paper
eliminations (in journal entry format) for Pickens Corporation and subsidiary on Decem-
ber 31, 2005, including income taxes allocation other than for goodwill. Round all amounts
to the nearest dollar.
(Problem 9.9) On January 2, 2005, Plummer Corporation acquired a controlling interest of 75% in the
outstanding common stock of Sinclair Company for $96,000, including direct out-of-
pocket costs of the business combination. Separate financial statements for the two compa-
nies for the fiscal year ended December 31, 2005, are as follows:
 Chapter 9 Consolidated Financial Statements: Income Taxes, Cash Flows, and Installment Acquisitions 427

CHECK FIGURE PLUMMER CORPORATION AND SINCLAIR COMPANY

a. Credit income taxes
Separate Financial Statements
payable, $240; For Year Ended December 31, 2005
b. Consolidated net
income, $76,454; Plummer Sinclair
consolidated ending Corporation Company
retained earnings,
$446,954; minority Income Statements
Revenue:
interest in net assets,
$43,258. Net sales $772,000 $426,000
Intercompany sales 78,000 104,000
Dividend revenue 750
Intercompany gain on sale of machinery 800
Intercompany investment income 31,163
Other revenue 9,000 2,900
Total revenue $890,163 $534,450
Costs and expenses:
Cost of goods sold $445,000 $301,200
Intercompany cost of goods sold 65,000 72,800
Depreciation expense 65,600 11,200
Other operating expenses 195,338 84,667
Income taxes expense 35,225 25,833
Total costs and expenses $806,163 $495,700
Net income $ 84,000 $ 38,750

Statements of Retained Earnings

Retained earnings, beginning of year $378,000 $112,000
Add: Net income 84,000 38,750
Subtotals $462,000 $150,750
Less: Dividends 7,500 4,000
Retained earnings, end of year $454,500 $146,750

Balance Sheets
Assets
Short-term investments in trading securities $ 18,000
Intercompany receivables (payables) $ 16,000 (16,000)
Inventories 275,000 135,000
Other current assets 309,100 106,750
Investment in Sinclair Company common stock 124,163
Plant assets 518,000 279,000
Accumulated depreciation (298,200) (196,700)
Total assets $944,063 $326,050

Liabilities and Stockholders’ Equity

Dividends payable $ 7,500
Income taxes payable 35,225 $ 25,833
Other current liabilities 260,838 123,467
Common stock, $10 par 150,000
Common stock, $5 par 20,000
Additional paid-in capital 36,000 10,000
Retained earnings 454,500 146,750
Total liabilities and stockholders’ equity $944,063 $326,050
428 Part Two Business Combinations and Consolidated Financial Statements

Additional Information
1. Sinclair sold machinery with a carrying amount of $4,000, no residual value, and a
remaining economic life of five years to Plummer for $4,800 on December 31, 2005.
2. Sinclair’s depreciable plant assets had a composite estimated remaining economic life of
five years on January 2, 2005; Sinclair uses the straight-line method of depreciation for
all plant assets.
3. Data on intercompany sales of merchandise follow:

In Purchaser’s Amount Payable

Inventory, by Purchaser,
Dec. 31, 2005 Dec. 31, 2005
Plummer Corporation to Sinclair Company $24,300 $24,000
Sinclair Company to Plummer Corporation 18,000 8,000

4. Both companies are subject to an income tax rate of 40%. Plummer is entitled to a dividend-
received deduction of 80%. Each company will file separate income tax returns for Year
2005. Except for Plummer’s Intercompany Investment Income ledger account, there are no
temporary differences for either company.
5. Plummer’s ledger accounts for Investment in Sinclair Company Common Stock and
Intercompany Investment Income were as follows (before December 31, 2005, closing
entries):

Investment in Sinclair Company Common Stock

Date Explanation Debit Credit Balance
2005
Jan. 2 Acquisition of 3,000 shares 96,000 96,000 dr
Dec. 31 Net income of Sinclair
($38,750 0.75) 29,063 125,063 dr
31 Amortization of bargain-purchase
excess 5 3 ($142,000
0.75) $96,000 4 56 2,100 127,163 dr
31 Dividend declared by Sinclair
($4,000 0.75) 3,000 124,163 dr

Intercompany Investment Income

Date Explanation Debit Credit Balance
2005
Dec. 31 Net income of Sinclair 29,063 29,063 cr
31 Amortization of bargain-purchase
excess 2,100 31,163 cr

Instructions
a. Prepare a December 31, 2005, adjusting entry for Plummer Corporation to provide for
income tax allocation resulting from Plummer’s use of the equity method of accounting
for the subsidiary’s operating results. Round all amounts to the nearest dollar.
b. Prepare a working paper for consolidated financial statements and related working paper
elimination (in journal entry format), including income tax allocation, for Plummer
Corporation and subsidiary on December 31, 2005. Amounts for Plummer should reflect
the journal entries in (a).
Chapter Ten

Consolidated Financial
Statements: Special
Problems

Scope of Chapter
In this chapter, the following special problems that might arise in the preparation of con-
solidated financial statements are discussed:
Changes in parent company’s ownership interest in a subsidiary
Subsidiary with preferred stock outstanding
Stock dividends distributed by a subsidiary
Treasury stock transactions of a subsidiary
Indirect shareholdings and parent company’s common stock owned by a
subsidiary

CHANGES IN PARENT COMPANY’S OWNERSHIP

INTEREST IN A SUBSIDIARY
Subsequent to the date of a business combination, a parent company might acquire
stockholdings of the subsidiary’s minority stockholders; or the parent company might
sell some of its shares of subsidiary common stock to outsiders. Also, the subsidiary
itself might issue additional shares of common stock to the public, or to the parent com-
pany. The accounting treatment for each of these situations is discussed in the following
sections.

Parent Company Acquisition of Minority Interest

Purchase accounting is applied to the parent company’s or the subsidiary’s acquisition of all
or part of the minority interest in net assets of the subsidiary. To illustrate the acquisition of
429
430 Part Two Business Combinations and Consolidated Financial Statements

a subsidiary’s minority interest, return to the Prinz Corporation–Scarp Company illustra-

tion in Chapter 9 (pages 401–406) and assume that Scarp had a net income of $25,000 for
the year ended February 29, 2008, and declared and paid dividends totaling $15,000 on
February 14, 2008. Under the equity method of accounting, given that consolidated good-
will was not impaired as of February 29, 2008, Prinz Corporation’s Investment in Scarp
Company Common Stock and Retained Earnings of Subsidiary ledger accounts, and
Scarp Company’s Retained Earnings account, are as follows (before February 29, 2008,
closing entries). The working paper eliminations (in journal entry format) for the year
ended February 29, 2008, are on page 431 (disregarding income taxes).

Selected Ledger PRINZ CORPORATION LEDGER

Accounts of Parent
Company One Year Investment in Scarp Company Common Stock
after Business Date Explanation Debit Credit Balance
Combination
2005
Mar. 1 Acquisition of 1,000 shares 10,000 10,000 dr
2006
Mar. 1 Acquisition of 2,000 shares 22,000 32,000 dr
1 Retroactive application of equity
method of accounting 500 32,500 dr
2007
Feb. 17 Dividends received: $1 a share
(3,000 $1) 3,000 29,500 dr
28 Share of net income ($15,000 0.30) 4,500 34,000 dr
Mar. 1 Acquisition of 6,500 shares 78,000 112,000 dr
2008
Feb. 14 Dividends received: $1.50 a share
(9,500 $1.50) 14,250 97,750 dr
29 Share of net income ($25,000 0.95) 23,750 121,500 dr

Retained Earnings of Subsidiary

Date Explanation Debit Credit Balance
2006
Mar. 1 Retroactive application of equity method
of accounting 500 500 cr
2007
Feb. 28 Closing entry—share of Scarp Company’s
adjusted net income not declared as a
dividend ($4,500 $3,000) 1,500 2,000 cr
 Chapter 10 Consolidated Financial Statements: Special Problems 431

Retained Earnings SCARP COMPANY LEDGER

Ledger Account of
Subsidiary One Year Retained Earnings
after Business Date Explanation Debit Credit Balance
Combination
2005
Mar. 1 Balance 20,000 cr
2006
Feb. 10 Dividends declared: $1 a share 10,000 10,000 cr
28 Net income 15,000 25,000 cr
2007
Feb. 17 Dividends declared: $1 a share 10,000 15,000 cr
28 Net income 15,000 30,000 cr

Working Paper PRINZ CORPORATION AND SUBSIDIARY

Eliminations for First Working Paper Eliminations
Year following February 29, 2008
Business Combination
(a) Common Stock, $5 par—Scarp 50,000
Additional Paid-in Capital—Scarp 10,000
Retained Earnings—Scarp ($30,000 $2,000) 28,000
Retained Earnings of Subsidiary—Prinz 2,000
Intercompany Investment Income—Prinz 23,750
Goodwill—Prinz 26,500
Investment in Scarp Company Common Stock—Prinz 121,500
Dividends Declared—Scarp 15,000
Minority Interest in Net Assets of Subsidiary ($4,500 $750) 3,750
To eliminate intercompany investment and equity accounts of
subsidiary at beginning of year; to allocate excess of cost over
current fair values (equal to carrying amounts) of identifiable net
assets acquired to goodwill; and to establish minority interest in
net assets of subsidiary at beginning of year ($4,500—see page 406),
less minority interest in dividends ($15,000 0.05 $750).

(b) Minority Interest in Net Income of Subsidiary ($25,000 0.05) 1,250

Minority Interest in Net Assets of Subsidiary 1,250
To establish minority interest in net income of subsidiary for year
ended February 29, 2008.

Assume further that on March 1, 2008, Prinz acquired for $6,000 the 500 shares of
Scarp’s common stock owned by minority stockholders; the following journal entry is
appropriate:

Parent Company’s Investment in Scarp Company Common Stock 6,000

Journal Entry for Cash 6,000
Acquisition of To record acquisition of 500 shares of subsidiary’s common stock from
Minority Interest minority stockholders.
432 Part Two Business Combinations and Consolidated Financial Statements

Because the minority interest in net assets of subsidiary in the consolidated balance sheet
of Prinz and subsidiary on February 29, 2008, totaled $5,000 ($3,750 $1,250), an addi-
tional $1,000 ($6,000 $5,000) of goodwill must be recognized and subsequently tested
for impairment. Under the equity method of accounting, Prinz accrues 100% of Scarp’s net
income subsequent to March 1, 2008, and there is no minority interest to be accounted for
in consolidation.
If Prinz paid less than the carrying amount of the minority interest acquired, the
appropriate accounting treatment of the difference is not clear. Presumably, the excess
of minority interest carrying amount over Prinz’s cost should be allocated pro rata to re-
duce the carrying amounts of selected assets of Scarp. This approach would be consistent
with the theory of purchase accounting set forth in Chapter 5 (page 171). However, as-
suming that the difference between carrying amount and cost is immaterial, it may be
treated as an offset to any goodwill arising from earlier acquisitions of Scarp’s common
stock that remains unimpaired.

Parent Company Sale of a Portion of Its Subsidiary

Common Stockholdings
A parent company with a substantial ownership interest in a subsidiary may sell a portion
of that interest for several reasons. Perhaps the parent company is short of cash, or the
earnings of the subsidiary are unsatisfactory. The parent company may recognize that a
subsidiary may be controlled effectively with less than a total ownership of its outstand-
ing common stock and that an 80% or 90% ownership of a subsidiary may tie up exces-
sive amounts of capital. Some corporations in past years have sold a portion of a newly
acquired subsidiary’s common stock in order to generate cash for additional business
combinations.
Sale of all or part of the net assets of a subsidiary often involves accounting for and in-
come statement display of the disposal of an operating segment. This topic is considered in
Chapter 13.
Accounting for a parent company’s sale of its investment in a subsidiary is similar to the
accounting for disposal of any noncurrent asset. The carrying amount of the subsidiary
common stock sold is removed from the parent company’s Investment in Subsidiary Com-
mon Stock ledger account, and the difference between that carrying amount and the cash or
current fair value of other consideration received is recognized as a gain or loss on disposal
of the stock. Under generally accepted accounting principles, the gain or loss is not an
extraordinary item for consolidated income statement display.1
Unless the business combination had resulted from an installment acquisition of the
subsidiary’s common stock, there is no significant change in the working paper elimina-
tions after the parent’s sale of part of its ownership interest in the subsidiary. However, the
minority interest in the subsidiary’s net income and net assets increases. The parent com-
pany’s equity-method journal entries for the subsidiary’s operations are changed only for
the decrease in the percentage of the parent’s ownership interest in the subsidiary.
When control was acquired by installment purchases of the subsidiary’s common stock,
specific identification should be used to account for the carrying amount of the subsidiary
stock sold. There must be an accompanying adjustment in the parent company’s application
of the equity method of accounting for the subsidiary’s operating results. For example, pur-
chased goodwill should no longer be accounted for in the working paper for consolidated
financial statements if the block of subsidiary common stock to which it applies was sold
by the parent company; the goodwill is impaired.

1
APB Opinion No. 30, “Reporting the Results of Operations” (New York: AICPA, 1973), par. 23(d).
 Chapter 10 Consolidated Financial Statements: Special Problems 433

Illustration of Parent Company Sale of Subsidiary Stockholding

Returning to the Prinz Corporation–Scarp Company affiliation, assume that Scarp declared
and paid a $15,000 dividend to Prinz on February 12, 2009, and had a net income of
$35,000 for the year ended February 28, 2009. Under these circumstances, Prinz’s Invest-
ment ledger account and Retained Earnings of Subsidiary account, and Scarp Company’s
Retained Earnings account (before February 28, 2009, closing entries), are as follows,
given that consolidated goodwill was unimpaired as of February 28, 2009:

Selected Ledger PRINZ CORPORATION LEDGER

Accounts of Parent
Company Two Years Investment in Scarp Company Common Stock
after Business Date Explanation Debit Credit Balance
Combination
2005
Mar. 1 Acquisition of 1,000 shares 10,000 10,000 dr
2006
Mar. 1 Acquisition of 2,000 shares 22,000 32,000 dr
1 Retroactive application of equity
method of accounting 500 32,500 dr
2007
Feb. 17 Dividends received: $1 a share
(3,000 $1) 3,000 29,500 dr
28 Share of net income ($15,000 0.30) 4,500 34,000 dr
Mar. 1 Acquisition of 6,500 shares 78,000 112,000 dr
2008
Feb. 14 Dividends received: $1.50 a share
(9,500 $1.50) 14,250 97,750 dr
29 Share of net income ($25,000 0.95) 23,750 121,500 dr
Mar. 1 Acquisition of 500 shares 6,000 127,500 dr
2009
Feb. 12 Dividends received: $1.50 a share
(10,000 $1.50) 15,000 112,500 dr
28 Share of net income ($35,000 1.00) 35,000 147,500 dr

Retained Earnings of Subsidiary

Date Explanation Debit Credit Balance
2006
Mar. 1 Retroactive application of equity
method of accounting 500 500 cr
2007
Feb. 28 Closing entry—share of Scarp
Company adjusted net income
not paid as a dividend
($4,500 $3,000) 1,500 2,000 cr
2008
Feb. 29 Closing entry—share of subsidiary’s
net income not declared as a
dividend ($23,750 $14,250) 9,500 11,500 cr
434 Part Two Business Combinations and Consolidated Financial Statements

Retained Earnings SCARP COMPANY LEDGER

Ledger Account of
Subsidiary Two Years Retained Earnings
after Business Date Explanation Debit Credit Balance
Combination
2005
Mar. 1 Balance 20,000 cr
2006
Feb. 10 Dividends declared: $1 a share 10,000 10,000 cr
28 Net income 15,000 25,000 cr
2007
Feb. 17 Dividends declared: $1 a share 10,000 15,000 cr
28 Net income 15,000 30,000 cr
2008
Feb. 14 Dividends declared: $1.50 a share 15,000 15,000 cr
29 Net income 25,000 40,000 cr

Under these circumstances, the working paper elimination (in journal entry format) for
Prinz Corporation and subsidiary on February 28, 2009, is as shown below (disregarding
income taxes):

Working Paper PRINZ CORPORATION AND SUBSIDIARY

Elimination for Second Working Paper Elimination
Year following February 28, 2009
Business Combination
(a) Common Stock, $5 par—Scarp 50,000
Additional Paid-in Capital—Scarp 10,000
Retained Earnings—Scarp ($40,000 $11,500) 28,500
Retained Earnings of Subsidiary—Prinz 11,500
Intercompany Investment Income—Prinz 35,000
Goodwill—Prinz ($26,500 $1,000) 27,500
Investment in Scarp Company Common Stock—Prinz 147,500
Dividends Declared—Scarp 15,000
To eliminate intercompany investment and equity accounts of
subsidiary at beginning of year; and to allocate excess of cost
over current fair values (equal to carrying amounts) of identifiable
net assets acquired to goodwill.

Continuing the illustration, assume that, in order to raise cash for additional busi-
ness combinations, Prinz on March 1, 2008, sold in the open market the 1,000 and
2,000 shares of Scarp common stock acquired March 1, 2005, and March 1, 2006,
respectively, for $55,000. The sale resulted in a gain of $12,000, computed as follows:
 Chapter 10 Consolidated Financial Statements: Special Problems 435

Computation of Gain Proceeds of sale $ 55,000

on Parent Company’s Less: Carrying amount of 1,000 shares of Scarp common
Sale of Portion of stock acquired Mar. 1, 2005:
Subsidiary Cost $10,000
Stockholdings Add: Share of Scarp’s net income, Years 2006–2009
($90,000 0.10) 9,000
Less: Share of Scarp’s dividends, Years 2006–2009
($50,000 0.10) (5,000) (14,000)
Carrying amount of 2,000 shares of Scarp common
stock acquired Mar. 1, 2006:
Cost $22,000
Add: Share of Scarp’s net income, Years 2007–2009
($75,000 0.20) 15,000
Less: Share of Scarp’s dividends, Years 2007–2009
($40,000 0.20) (8,000) (29,000)
Gain on sale of portion of subsidiary stockholdings $ 12,000

The following journal entry is prepared by Prinz Corporation on March 1, 2009, to

record the sale of part of its investment in Scarp Company common stock:

Parent Company’s Cash 55,000

Journal Entry to Investment in Scarp Company Common Stock
Record Sale of Portion ($14,000 $29,000) 43,000
of Investment in Realized Gain on Disposal of Investment in Subsidiary 12,000
Subsidiary To record sale of 3,000 shares of Scarp Company common stock at a gain.

The $12,000 realized gain in the foregoing journal entry is displayed in the consolidated in-
come statement of Prinz Corporation and subsidiary for the year ending February 28, 2010,
because it was realized in a transaction with outsiders.
For a consolidated balance sheet of Prinz Corporation and subsidiary on March 1, 2009,
following Prinz’s sale of Scarp common stock, the following working paper elimination (in
journal entry format) is required:

Working Paper PRINZ CORPORATION AND SUBSIDIARY

Elimination on Date Working Paper Elimination
of Parent Company’s March 1, 2009
Disposal of a Portion
of Its Subsidiary’s (a) Common Stock, $5 par—Scarp 50,000
Stockholdings Additional Paid-in Capital—Scarp 10,000
Retained Earnings—Scarp ($40,000 $20,000 $31,500) 28,500
Retained Earnings of Subsidiary—Prinz
($11,500 $35,000 $15,000) 31,500
Goodwill—Prinz ($27,500 $2,000 $5,000) 20,500
Investment in Scarp Company Common Stock
($147,500 $43,000) 104,500
Minority Interest in Net Assets of Subsidiary
[($50,000 $10,000 $60,000) 0.30] 36,000
To eliminate intercompany investment and equity accounts of subsidiary;
to allocate excess of cost over current fair values (equal to carrying
amounts) of identifiable net assets acquired to goodwill; and to
establish minority interest in net assets of subsidiary.
436 Part Two Business Combinations and Consolidated Financial Statements

The foregoing elimination recognizes only the goodwill applicable to Prinz Corpora-
tion’s March 1, 2007, and March 1, 2008, acquisitions of Scarp Company common stock.
The total goodwill of $20,500 comprises the following:

Computation of Mar. 1, 2007, acquisition $19,500

Goodwill, March 1, Mar. 1, 2008, acquisition 1,000
2009 Total goodwill, Mar. 1, 2009 $20,500

Also reflected in the foregoing elimination is the minority interest in net assets of sub-
sidiary that resulted from Prinz’s disposal of 30% of its investment in Scarp’s common
stock. The amount of the minority interest is developed from the carrying amount
of Scarp’s identifiable net assets of $120,000 ($50,000 $10,000 $60.000
$120,000) on March 1, 2009.

Subsidiary’s Issuance of Additional Shares of Common Stock

to the Public
Instead of obtaining funds by selling a portion of its ownership interest in a subsidiary, the par-
ent company may instruct the subsidiary to issue additional shares of common stock to the
public, with the parent company and minority stockholders of the subsidiary waiving their pre-
emptive right to acquire part of the common stock. The cash obtained would be available to the
consolidated group through intercompany transactions. Because the parent company does not
acquire shares of common stock on a pro rata basis along with present minority stockholders
in the subsidiary’s stock issuance, as in a stock rights offering, the parent’s percentage owner-
ship interest in the subsidiary changes. In addition, unless the subsidiary issues additional com-
mon stock to the public at a price per share equal to the per-share carrying amount of the
subsidiary’s outstanding common stock, there generally is a realized nonoperating gain or loss
to the parent company.2 These two points are illustrated in the following section.

Illustration of Subsidiary’s Issuance of Additional Common Stock to the Public

On January 2, 2005, Paulson Corporation acquired 80% of the outstanding common stock of
Spaulding Company for $240,000. Out-of-pocket costs of the business combination are disre-
garded in this illustration. Spaulding’s stockholders’ equity on January 2, 2005, was as follows:

Stockholders’ Equity Common stock, $5 par $ 50,000

of Subsidiary on Additional paid-in capital 75,000
Date of Business Retained earnings 100,000
Combination Total stockholders’ equity $225,000

The current fair values of Spaulding’s identifiable net assets on January 2, 2005, were
equal to their carrying amounts. Thus, the $60,000 excess of the cost of Paulson’s invest-
ment ($240,000) over 80% of the $225,000 current fair value of Spaulding’s identifiable net
assets ($225,000 0.80 $180,000) was attributable to goodwill, which was unimpaired
on December 31, 2005.
For the year ended December 31, 2005, Spaulding had a net income of $20,000 and
declared and paid cash dividends of $10,000 ($1 a share). On December 31, 2005, Spauld-
ing issued 2,000 shares of common stock in a public offering at $33 a share, net of costs of
issuing the stock, for a total of $66,000. (Both Paulson and the existing minority stockholders

2
Staff Accounting Bulletin 51, Securities and Exchange Commission (Washington, 1983), as amended by
Staff Accounting Bulletin 84.
 Chapter 10 Consolidated Financial Statements: Special Problems 437

of Spaulding waived their preemptive right to acquire additional shares of Spaulding’s common
stock.) Thus, after the closing process, Spaulding’s stockholders’ equity on December 31,
2005, amounted to $301,000 ($225,000 $20,000 $10,000 $66,000) and consisted
of the following amounts:

Stockholders’ Equity Common stock, $5 par ($50,000 $10,000) $ 60,000

of Subsidiary after Its Additional paid-in capital ($75,000 $56,000) 131,000
Issuance of Common Retained earnings ($100,000 $20,000 $10,000) 110,000
Stock to Public Total stockholders’ equity $301,000

Paulson’s Investment ledger account under the equity method of accounting is as follows
after the subsidiary’s issuance of common stock:

Parent Company’s Investment in Spaulding Company Common Stock

Investment Account
Date Explanation Debit Credit Balance
after Subsidiary’s
Issuance of Common 2005
Stock to Public Jan. 2 Acquisition of 8,000 shares in business
combination 240,000 240,000 dr
Dec. 31 Dividends received ($10,000 0.80) 8,000 232,000 dr
31 Share of net income ($20,000 0.80) 16,000 248,000 dr
31 Nonoperating gain on subsidiary’s
issuance of common stock to public 12,667 260,667 dr

The December 31, 2005, increase of $12,667 in Paulson’s Investment ledger account is
offset by a credit to a nonoperating gain account. The $12,667 is Paulson’s share (for which
Paulson paid nothing) of the increase in Spaulding’s net assets resulting from Spaulding’s
issuance of common stock to the public at $33 a share. The $33 a share issuance price ex-
ceeds the $31 carrying amount ($248,000 8,000 shares) per share of Paulson’s Invest-
ment account prior to Spaulding’s common stock issuance. The $12,667 debit to Paulson’s
Investment ledger account is computed as follows:

Computation of Gain Paulson’s Minority’s

to Parent Company Total Share Share
Resulting from
Carrying amount of Spaulding
Subsidiary’s Issuance
Company’s identifiable net
of Common Stock
assets after common stock
to Public
issuance to public $301,000 (662⁄3%)† $200,667 (331⁄3%) $100,333
Carrying amount of Spaulding
Company’s identifiable net
assets before common stock
issuance to public 235,000* (80%) 188,000‡ (20%) 47,000
Difference $ 66,000 $ 12,667§ $ 53,333

*
$225,000 $20,000 $10,000 $235,000.
†8,000 (10,000 2,000) 662⁄3%.
‡
Paulson’s share of Spaulding’s identifiable net assets 3($225,000 $20,000 $10,000) 0.80 4 $188,000
Add: Unimpaired goodwill 60,000
Balance of Paulson’s Investment in Spaulding Company Common Stock ledger account $248,000
§
Nonoperating gain to parent company; Paulson’s journal entry (explanation omitted) is as follows:
Investment in Spaulding Company Common Stock 12,667
Gain from Subsidiary’s Issuance of Common Stock 12,667
438 Part Two Business Combinations and Consolidated Financial Statements

The foregoing analysis reflects the effect of the decrease of Paulson’s percentage interest
in Spaulding’s outstanding common stock from 80% before the public stock issuance to
66 2⁄3% after the issuance. Nevertheless, the issuance price of $33 a share exceeded the $31
carrying amount per share of Paulson’s original investment in Spaulding, thus resulting in
the $12,667 nonoperating gain to Paulson.
The following working paper eliminations (in journal entry format) are appropriate for
Paulson Corporation and subsidiary following Spaulding’s common stock issuance on
December 31, 2005, assuming that consolidated goodwill was unimpaired as of that date
and there were no other intercompany transactions or profits for Year 2005.

Working Paper PAULSON CORPORATION AND SUBSIDIARY

Eliminations on Date Working Paper Eliminations
of Subsidiary’s December 31, 2005
Issuance of Common
Stock to Public (a) Common Stock—Spaulding 60,000
Additional Paid-in Capital—Spaulding 131,000
Retained Earnings—Spaulding 100,000
Goodwill—Paulson 60,000
Intercompany Investment Income—Paulson ($20,000 0.80) 16,000
Investment in Spaulding Company Common Stock—Paulson 260,667
Dividends Declared—Spaulding 10,000
Minority Interest in Net Assets of Subsidiary
($45,000 $2,000 $53,333) 96,333
To eliminate intercompany investment and related equity accounts of
subsidiary (retained earnings of subsidiary at the beginning of year);
to eliminate subsidiary’s dividends declared; to record unimpaired
goodwill on Dec. 31, 2005; and to provide for minority
interest in net assets of subsidiary at beginning of year ($225,000 ,
0.20 $45,000), less dividends to minority stockholders ($10,000
0.20 $2,000), plus minority interest’s share of proceeds of public
stock issuance ($66,000 $12,667 $53,333).

(b) Minority Interest in Net Income of Subsidiary 4,000

Minority Interest in Net Assets of Subsidiary 4,000
To provide for minority interest in subsidiary’s Year 2005 net income as
follows: $20,000 0.20 interest throughout Year 2005 $4,000.

Note that Paulson’s $12,667 nonoperating gain is not eliminated in the foregoing elimi-
nations; it was realized through the subsidiary’s transaction with outsiders.

Subsidiary’s Issuance of Additional Shares of Common Stock

to Parent Company
Instead of issuing additional common stock to the public, a subsidiary might issue the ad-
ditional stock to the parent company. This eventuality might occur if the parent company
desired to increase its total investment in the subsidiary, or if the parent wished to reduce
the influence of minority stockholders of the subsidiary.
To illustrate, return to the Paulson Corporation–Spaulding Company illustration and as-
sume that on December 31, 2005, Spaulding had issued 2,000 shares of common stock to
Paulson, rather than to the public, at $33 a share, for a total of $66,000, and that the minor-
ity stockholders waived their preemptive rights to acquire additional common stock.
Under these circumstances, Paulson’s Investment account increases to a balance of
$310,833 ($248,000 $66,000 cost of common stock acquired $3,167 nonoperating
loss). The nonoperating loss of $3,167 is computed as follows:
 Chapter 10 Consolidated Financial Statements: Special Problems 439

Computation of Loss Paulson’s Minority’s

to Parent Company Total Share Share
Resulting from
Carrying amount of Spaulding
Subsidiary’s Issuance
Company’s identifiable net
of Common Stock to
assets after common stock
Parent Company
issuance to parent $301,000 (831⁄3%)* $250,833 (162⁄3%) $50,167
Carrying amount of Spaulding
Company’s identifiable net
assets before common stock
issuance to parent 235,000 (80%) 188,000† (20%) 47,000
Difference $ 66,000 $ 62,833 $ 3,167‡

*(8,000 2,000) (10,000 2,000) 831⁄3%

†
Paulson’s share of Spaulding’s identifiable net assets $188,000
Add: Unimpaired goodwill 60,000
Balance of Paulson’s Investment in Spaulding Company Common Stock ledger account $248,000
‡
Nonoperating loss to parent company; Paulson’s journal entry (explanation omitted) is as follows:
Loss from Subsidiary’s Issuance of Common Stock 3,167
Investment in Spaulding Company Common Stock 3,167

Paulson’s $3,167 loss is realized because, although it arose in a transaction with Spauld-
ing, Paulson paid $66,000 for an investment valued at $62,833; the minority stockholders
were the beneficiaries of the $3,167 difference. Thus, Paulson’s $3,167 loss is displayed in
the consolidated income statement of Paulson Corporation and subsidiary for the year
ended December 31, 2005.
The working paper eliminations (in journal entry format) for Paulson Corporation and sub-
sidiary following Spaulding’s common stock issuance on December 31, 2005, are as follows:

Working Paper PAULSON CORPORATION AND SUBSIDIARY

Eliminations on Date Working Paper Eliminations
of Subsidiary’s December 31, 2005
Issuance of Common
Stock to Parent (a) Common Stock—Spaulding 60,000
Company Additional Paid-In Capital—Spaulding 131,000
Retained Earnings—Spaulding 100,000
Goodwill—Paulson 60,000
Intercompany Investment Income—Paulson ($20,000 0.80) 16,000
Investment in Spaulding Company Common Stock—
Paulson ($250,833 $60,000) 310,833
Dividends Declared—Spaulding 10,000
Minority Interest in Net Assets of Subsidiary
($45,000 $2,000 $3,167) 46,167
To eliminate intercompany investment and related equity accounts
of subsidiary (retained earnings of subsidiary at the beginning
of year); to eliminate subsidiary’s dividends declared; to record
unimpaired goodwill on Dec. 31, 2005; and to provide for
minority interest in net assets of subsidiary at beginning of year
($225,000 0.20 $45,000), less dividends to minority
stockholders ($10,000 0.20 $2,000), plus minority interest’s share
of proceeds of common stock issuance to parent company ($3,167).
(b) Minority Interest in Net Income of Subsidiary 4,000
Minority Interest in Net Assets of Subsidiary 4,000
To provide for minority interest in subsidiary’s Year 2005 net income as
follows: $20,000 0.20 interest throughout Year 2005 $4,000.
440 Part Two Business Combinations and Consolidated Financial Statements

The recognition of nonoperating gains or losses on a subsidiary’s issuance of additional

shares of stock was tentatively opposed by the FASB, which supported instead reporting a
change in a parent company’s proportionate interest in a subsidiary as an increase or a de-
crease, as appropriate, in the parent’s additional paid-in capital.3

SUBSIDIARY WITH PREFERRED STOCK OUTSTANDING

Some combinees in a business combination have outstanding preferred stock. If a parent
company acquires all of a subsidiary’s preferred stock, together with all or a majority of its
common stock, the working paper for consolidated financial statements and working paper
eliminations are similar to those illustrated in Chapters 6 through 9. If less than 100% of
the subsidiary’s preferred stock is acquired by the parent company, the preferences associ-
ated with the preferred stock must be considered in the computation of the minority inter-
est in the net assets and net income of the subsidiary.

Illustration of Minority Interest in Subsidiary

with Preferred Stock
Suppose, for example, that on July 1, 2005, Praeger Corporation paid $200,000 (including
direct out-of-pocket costs of the business combination) for 60% of Simmon Company’s
10,000 shares of outstanding $1 par, 6% cumulative preferred stock and 80% of Simmon’s
50,000 shares of outstanding $2 par common stock, which were owned pro rata by the same
stockholders. The preferred stock had a liquidation preference of $1.10 a share and was
callable at $1.20 a share plus cumulative preferred dividends in arrears. The stockholders’
equity of Simmon on July 1, 2005, was:

Stockholders’ Equity of 6% cumulative preferred stock, $1 par; 10,000 shares outstanding $ 10,000
Subsidiary on Date of Common stock, $2 par; 50,000 shares outstanding 100,000
Business Combination Additional paid-in capital 30,000
Retained earnings 50,000
Total stockholders’ equity $190,000

There were no cumulative preferred dividends in arrears on July 1, 2005. The current fair
values of Simmon’s identifiable net assets on July 1, 2005, were equal to their carrying
amounts on that date.
The presence of the preferred stock raises two questions:
1. What part, if any, does the preferred stock play in the measurement of the goodwill rec-
ognized in the business combination?
2. Which per-share amount—$1 par, $1.10 liquidation preference, or $1.20 call price—
should be used to measure the minority interest in Simmon’s net assets on July 1, 2005?
The following are logical answers to the two questions:
1. The preferred stock does not enter into the measurement of the goodwill recognized in
the business combination. Typically, preferred stockholders have no voting rights; thus,
in a business combination, preferred stock may in substance be considered debt rather

3
Proposed Statement of Financial Accounting Standards, “Consolidated Financial Statements: Policy and
Procedures” (Norwalk: FASB, 1995), par. 29.
 Chapter 10 Consolidated Financial Statements: Special Problems 441

than owners’ equity. Accordingly, the amount paid by the combinor for the subsidiary’s
common stock should be the basis for computation of the goodwill.
2. The call price plus any cumulative preferred dividends in arrears should be used to mea-
sure the minority interest of the preferred stockholders in Simmon’s net assets on July 1,
2005. The call price generally is the maximum claim on net assets imposed by the pre-
ferred stock contract. Furthermore, the call price is the amount that Simmon would pay,
on a going-concern basis, to extinguish the preferred stock. Use of the preferred stock’s
liquidation value in the computation of the stockholders’ interest in the subsidiary’s net
assets would stress a quitting-concern approach, rather than the going-concern princi-
ple. Finally, the par of the preferred stock has no significance as a measure of value for
the preferred stock.
In accordance with the foregoing discussion, Praeger prepares the following journal
entry to record the business combination with Simmon on July 1, 2005. (Out-of-pocket
costs of the combination are not accounted for separately in this illustration.)

Parent Company’s Investment in Simmon Company Preferred Stock (6,000 $1.20) 7,200
Journal Entry for Investment in Simmon Company Common Stock ($200,000 $7,200) 192,800
Business Combination Cash 200,000
Involving Subsidiary’s To record business combination with Simmon Company.
Preferred Stock

The working paper elimination (in journal entry format) for Praeger and subsidiary on
July 1, 2005, is as follows:

Working Paper PRAEGER CORPORATION AND SUBSIDIARY

Elimination on Date of Working Paper Elimination
Business Combination July 1, 2005
Involving Partially
Owned Subsidiary Cumulative Preferred Stock—Simmon 10,000
Having Preferred Common Stock—Simmon 100,000
Stock Outstanding Additional Paid-in Capital—Simmon 30,000
Retained Earnings—Simmon 50,000
Goodwill—Praeger 5$192,800 3 ($190,000 $12,000 call price
of preferred stock) 0.80]6 50,400
Investment in Simmon Company Preferred Stock—
Praeger 7,200
Investment in Simmon Company Common Stock—
Praeger 192,800
Minority Interest in Net Assets of Subsidiary—Preferred
(4,000 $1.20) 4,800
Minority Interest in Net Assets of Subsidiary—Common
($178,000 0.20) 35,600
To eliminate intercompany investment and related equity accounts of
subsidiary on date of business combination; to record excess of cost
attributable to common stock over 80% share of current fair value of
subsidiary’s identifiable net assets as goodwill; and to provide for
minority interest in subsidiary’s preferred stock and in net assets
applicable to common stock on date of business combination.
442 Part Two Business Combinations and Consolidated Financial Statements

The following aspects of the foregoing elimination should be emphasized:

1. Simmon’s goodwill is measured as the difference between the cost assigned to Praeger’s
investment in Simmon’s common stock and Praeger’s share of the current fair value of
Simmon’s net assets applicable to common stock; Simmon’s preferred stock does not en-
ter the measurement of the goodwill.
2. The minority interest in the subsidiary’s preferred stock is measured as the 4,000 shares
of preferred stock owned by stockholders other than Praeger multiplied by the $1.20 call
price per share.
3. The minority interest in the subsidiary’s common stock is measured as 20% of the
$178,000 ($190,000 $12,000 net asset value of Simmon’s common stock.

Preferred Stock Considerations subsequent to Date

of Business Combination
Regardless of whether Simmon’s preferred dividend is paid or omitted in years subsequent
to July 1, 2005, the preferred dividend affects the measurement of the minority interest of
common stockholders in the net income of Simmon. For example, assume that Simmon
had a net income of $50,000 for the fiscal year ended June 30, 2006, and declared and paid
the preferred dividend of $0.06 a share and a common dividend of $0.50 a share on June 30,
2006; and that consolidated goodwill was unimpaired as of June 30, 2006. Praeger records
these elements of Simmon’s operating results on June 30, 2006, under the equity method of
accounting, as follows:

Parent Company’s PRAEGER CORPORATION

Journal Entries, Journal Entries
June 30, 2006
Cash 20,360
Investment in Simmon Company Common Stock 20,000
Intercompany Dividend Revenue 360
To record receipt of dividends declared and paid by Simmon Company as
follows:
Preferred stock (6,000 $0.06) $ 360
Common stock (40,000 $0.50) 20,000
Total cash received $20,360

Investment in Simmon Company Common Stock 39,520

Intercompany Investment Income 39,520
To record share of Simmon Company’s net income applicable to common
stock as follows:
Simmon Company’s net income $50,000
Less: Preferred dividend (10,000 $0.06) 600
Net income attributable to common stock $49,400
Parent company’s share ($49,400 0.80) $39,520
(Income tax effects are disregarded.)

After the foregoing journal entries are posted, Praeger’s Investment in Simmon Com-
pany Common Stock ledger account is as follows:
 Chapter 10 Consolidated Financial Statements: Special Problems 443

Investment Account of Investment in Simmon Company Common Stock

Parent Company One
Date Explanation Debit Credit Balance
Year subsequent to
Business Combination 2005
July 1 Acquisition of 40,000 shares 192,800 192,800 dr
2006
June 30 Dividends received: $0.50 a share 20,000 172,800 dr
30 Share of net income 39,520 212,320 dr

If there are no other intercompany transactions or profits, the June 30, 2006, working paper
eliminations (in journal entry format) for Praeger Corporation and subsidiary are as follows:

Working Paper PRAEGER CORPORATION AND SUBSIDIARY

Eliminations One Year Working Paper Eliminations
subsequent to Business June 30, 2006
Combination Involving
Partially Owned (a) Cumulative Preferred Stock—Simmon 10,000
Subsidiary Having Common Stock—Simmon 100,000
Preferred Stock Additional Paid-in Capital—Simmon 30,000
Outstanding Retained Earnings—Simmon 50,000
Intercompany Dividend Revenue—Praeger 360
Intercompany Investment Income—Praeger 39,520
Goodwill—Praeger 50,400
Investment in Simmon Company Preferred Stock—
Praeger 7,200
Investment in Simmon Company Common Stock—
Praeger 212,320
Dividends Declared—Simmon
[(10,000 $0.06) (50,000 $0.50)] 25,600
Minority Interest in Net Assets of Subsidiary—
Preferred ($4,800 $240) 4,560
Minority Interest in Net Assets of Subsidiary—
Common [$35,600 ($25,000 0.20)] 30,600
To eliminate intercompany investment and related equity accounts of
subsidiary at beginning of year; to eliminate subsidiary’s dividends
declared; to record unimpaired goodwill on June 30, 2006;
and to provide for minority interest in subsidiary’s preferred stock
and common stock at beginning of year, less dividends to minority
stockholders.

(b) Minority Interest in Net Income of Subsidiary 10,120

Minority Interest in Net Assets of Subsidiary—
Preferred 240
Minority Interest in Net Assets of Subsidiary—
Common [($50,000 $600) 0.20] 9,880
To provide for minority interest in net income of subsidiary for Fiscal
Year 2006.

In the review of the June 30, 2006, journal entries of Praeger and the working paper
eliminations on that date, the following points should be noted:
1. Praeger Corporation’s accounting for its investment in the subsidiary’s preferred stock es-
sentially is the cost method. This method is appropriate as long as the subsidiary declares
444 Part Two Business Combinations and Consolidated Financial Statements

and pays the cumulative preferred dividend annually. If the subsidiary had passed the
preferred dividend of $600 for the year ended June 30, 2006, Praeger would have recorded
the passed preferred dividend under the equity method of accounting as follows:

Parent Company’s Investment in Simmon Company Preferred Stock 360

Journal Entry for Intercompany Investment Income 360
Passed Cumulative To accrue cumulative preferred dividend passed by subsidiary’s board
Preferred Dividend of of directors ($600 0.60 $360).
Subsidiary

The working paper eliminations in the year of a passed cumulative preferred dividend
would be the same as those illustrated on page 443, except that the minority interest in the
subsidiary’s preferred stock would be $240 ($600 0.40 $240) larger because of
the effect of the passed dividend. (Of course, no common dividend could be declared if
the cumulative preferred dividend were passed.)
2. The net result of the foregoing journal entries and working paper eliminations is that the
subsidiary’s Fiscal Year 2006 net income of $50,000 is allocated as follows:

Allocation of Consolidated Minority

Subsidiary’s Net Total Net Income Interest
Income to Preferred
To preferred stockholders: 10,000
and Common
shares $0.06, in 60:40 ratio $ 600 $ 360 $ 240
Stockholders
To common stockholders in
80:20 ratio 49,400 39,520 9,880
Net income of subsidiary $50,000 $39,880 $10,120

Other Types of Preferred Stock

Treatment similar to that illustrated in the foregoing section is appropriate for the minority
interest in a subsidiary having other types of outstanding preferred stock. If the preferred
stock were noncumulative, there would be no parent company accrual of passed dividends.
If the preferred stock were participating (which seldom is the case), the subsidiary’s re-
tained earnings would be allocated to the minority interests in preferred stock and common
stock according to the term of the participation clause.

STOCK DIVIDENDS DISTRIBUTED BY A SUBSIDIARY

If a parent company uses the equity method of accounting for the operating results of a sub-
sidiary, the subsidiary’s declaration and issuance of a common stock dividend has no effect
on the parent’s Investment in Subsidiary Common Stock ledger account. As emphasized in
intermediate accounting textbooks, receipt of a stock dividend does not represent dividend
revenue to the investor.
After the declaration of a common stock dividend not exceeding 20 to 25%, the sub-
sidiary’s retained earnings is reduced by an amount equal to the current fair value of the
stock issued as a dividend. This reduction and the offsetting increase in the subsidiary’s
paid-in capital ledger accounts are incorporated in the working paper eliminations subse-
quent to the issuance of the stock dividend, and there is no specific elimination for the stock
dividend itself. Thus, the amount of consolidated retained earnings is not affected by a sub-
sidiary’s stock dividend. As stated by the AICPA:
 Chapter 10 Consolidated Financial Statements: Special Problems 445

the retained earnings in the consolidated financial statements should reflect the accumulated
earnings of the consolidated group not distributed to the shareholders of, or capitalized by,
the parent company.4

Illustration of Subsidiary Stock Dividend

On June 30, 2005, the date of the business combination of Pasco Corporation and its
wholly owned subsidiary, Salvo Company, the working paper elimination (in journal entry
format) was as follows, because the current fair values of Salvo’s identifiable net assets
were equal to their carrying amounts and no goodwill was involved in the combination:

Working Paper PASCO CORPORATION AND SUBSIDIARY

Elimination on Date of Working Paper Elimination
Business Combination June 30, 2005
with Wholly Owned
Subsidiary (a) Common Stock, $1 par—Salvo 150,000
Additional Paid-in Capital—Salvo 200,000
Retained Earnings—Salvo 250,000
Investment in Salvo Company Common Stock—Pasco 600,000
To eliminate intercompany investment and related accounts for
stockholders’ equity of subsidiary on date of business combination.

On June 18, 2006, Salvo distributed 15,000 shares of its $1 par common stock to Pasco
as a 10% stock dividend. Salvo debited the Dividends Declared ledger account for
$75,000 (15,000 $5), the current fair value of the common stock distributed as a divi-
dend. Pasco prepared no journal entry for the stock dividend, but it did record the sub-
sidiary’s net income of $180,000 for the fiscal year ended June 30, 2006, under the equity
method of accounting as follows:

Parent Company’s Investment in Salvo Company Common Stock 180,000

Equity-Method Journal Intercompany Investment Income 180,000
Entry to Record Net To record 100% of Salvo Company’s net income for the year ended
Income of Wholly June 30, 2003. (Income tax effects are disregarded.)
Owned Subsidiary

On June 30, 2006, the working paper elimination (in journal entry format) for Pasco
Corporation and subsidiary is as follows:

Working Paper PASCO CORPORATION AND SUBSIDIARY

Elimination following Working Paper Elimination
Wholly Owned June 30, 2006
Subsidiary’s
Distribution of a Stock (a) Common Stock, $1 par—Salvo ($150,000 $15,000) 165,000
Dividend Additional Paid-in Capital—Salvo ($200,000 $60,000) 260,000
Retained Earnings—Salvo 250,000
Intercompany Investment Income—Pasco 180,000
Investment in Salvo Company Common Stock—
Pasco ($600,000 $180,000) 780,000
Dividends Declared—Salvo 75,000
To eliminate intercompany investment, related accounts for stockholders’
equity of subsidiary, and investment income from subsidiary.

4
ARB No. 51, “Consolidated Financial Statements” (New York: AICPA, 1959), p. 46.
446 Part Two Business Combinations and Consolidated Financial Statements

In its closing entries on June 30, 2006, Pasco credits its Retained Earnings of Sub-
sidiary ledger account for $105,000, the amount of the undistributed earnings of the
subsidiary ($180,000 $75,000 $105,000), which of course differs from the after-
closing balance of Salvo’s Retained Earnings ledger account ($250,000 $180,000
$75,000 $355,000). However, because $75,000 of Pasco’s intercompany investment
income is closed with the remainder of Pasco’s net income to its Retained Earnings ledger
account, consolidated retained earnings of Pasco Corporation and subsidiary includes
$430,000 of retained earnings attributable to the subsidiary ($355,000 $75,000).

TREASURY STOCK TRANSACTIONS OF A SUBSIDIARY

Treasury stock owned by a subsidiary on the date of a business combination is treated as
retired stock in the preparation of consolidated financial statements because the treasury
stock is not outstanding and thus was not acquired by the parent company. A working pa-
per elimination is prepared to account for the “retirement” of the treasury stock by the par
or stated value method, which is described in intermediate accounting textbooks.

Illustration of Treasury Stock Owned by Subsidiary on Date

of Business Combination
Palance Corporation acquired all 49,000 shares of the outstanding common stock of
Sizemore Company on March 1, 2005, for $147,000, including direct out-of-pocket costs.
Sizemore’s stockholders’ equity on that date was as follows:

Stockholders’ Equity Common stock, $1 par $ 50,000

of Subsidiary with Additional paid-in capital 25,000
Treasury Stock on Retained earnings 50,000
Date of Business Total paid-in capital and retained earnings $125,000
Combination Less: 1,000 shares of treasury stock, at cost 2,000
Total stockholders’ equity $123,000

On the date of the combination, the current fair values of Sizemore’s identifiable net as-
sets equaled their carrying amounts.
The working paper eliminations (in journal entry format) for Palance Corporation and
subsidiary on March 1, 2005, are as follows:

Working Paper PALANCE CORPORATION AND SUBSIDIARY

Eliminations on Date Working Paper Eliminations
of Business March 1, 2005
Combination with
Wholly Owned (a) Common Stock—Sizemore (1,000 $1) 1,000
Subsidiary Having Additional Paid-in Capital—Sizemore (1,000 $0.50) 500
Treasury Stock Retained Earnings—Sizemore (1,000 $0.50) 500
Treasury Stock—Sizemore (1,000 $2) 2,000
To account for subsidiary’s treasury stock as though it had been retired.

(continued)
 Chapter 10 Consolidated Financial Statements: Special Problems 447

PALANCE CORPORATION AND SUBSIDIARY

Working Paper Eliminations (concluded)
March 1, 2005

(b) Common Stock—Sizemore ($50,000 $1,000) 49,000

Additional Paid-in Capital—Sizemore ($25,000 $500) 24,500
Retained Earnings—Sizemore ($50,000 $500) 49,500
Goodwill—Sizemore ($147,000 $123,000) 24,000
Investment in Sizemore Company Common Stock—Palance 147,000
To eliminate intercompany investment and equity accounts of subsidiary
on date of business combination; and to allocate excess of cost over
current fair values (and carrying amounts) of identifiable net assets
acquired to goodwill.

In the first elimination, additional paid-in capital of the subsidiary is reduced by the pro rata
portion ($25,000 50,000 shares $0.50 a share) applicable to the treasury stock. The re-
mainder of the cost of the treasury stock is allocated to the subsidiary’s retained earnings.
As indicated on page 429, if, subsequent to the date of a business combination, a sub-
sidiary acquires for its treasury some or all of the shares of its common stock owned by mi-
nority stockholders, purchase accounting is applied. Thus, in the working paper elimination
that accounts for the treasury stock as though it had been retired, current fair value differ-
ences and goodwill may be recognized. [It should be emphasized that, in a greenmail (de-
fined on page 165) acquisition of treasury stock, the excess of the cost of the treasury stock
over its current fair value typically is recognized as a loss.5]

Illustration of Treasury Stock Acquired by Subsidiary

subsequent to Business Combination
On December 31, 2005, Portola Corporation acquired 80% of the outstanding common
stock of Stanley Company for $44,000, including direct out-of-pocket costs of the business
combination. Stanley’s stockholders’ equity on December 31, 2005, was as follows, with
current fair values of identifiable net assets equal to carrying amounts:

Stockholders’ Equity Common stock, $10 par $ 10,000

of Subsidiary on Additional paid-in capital 15,000
Date of Business Retained earnings 25,000
Combination Total stockholders’ equity $ 50,000

For the fiscal year ended December 31, 2006, Stanley declared dividends of $4,000 and
had a net income of $10,000. Portola’s investment ledger account appeared as follows on
December 31, 2006, assuming consolidated goodwill of $4,000 3 $44,000 ($50,000
0.80) 4 was unimpaired as of December 31, 2006:

5
FASB Technical Bulletin No. 85–6, “Accounting for a Purchase of Treasury Shares at a Price Significantly
in Excess of the Current Market Price of the Shares . . . ” (Stamford: FASB, 1985), p. 2.
448 Part Two Business Combinations and Consolidated Financial Statements

Investment Ledger Investment in Stanley Company Common Stock

Account of Parent
Date Explanation Debit Credit Balance
Company One Year
subsequent to Business 2005
Combination Dec. 31 Acquisition of 800 shares 44,000 44,000 dr
2006
Dec. 28 Dividends received: $4 a share
($4,000 0.80) 3,200 40,800 dr
31 Share of net income ($10,000 0.80) 8,000 48,800 dr

The working paper eliminations (in journal entry format) for Portola Corporation and
subsidiary on December 31, 2006, are as follows:

Working Paper PORTOLA CORPORATION AND SUBSIDIARY

Eliminations One Year Working Paper Eliminations
subsequent to Business December 31, 2006
Combination Involving
Partially Owned (a) Common Stock, $10 par—Stanley 10,000
Subsidiary Additional Paid-in Capital—Stanley 15,000
Retained Earnings—Stanley 25,000
Intercompany Investment Income—Portola 8,000
Goodwill—Portola 4,000
Investment in Stanley Company Common Stock—Portola 48,800
Dividends Declared—Stanley 4,000
Minority Interest in Net Assets of Subsidiary
($10,000 $800) 9,200
To eliminate intercompany investment and equity accounts of
subsidiary at beginning of year; to allocate excess of cost
over current fair values (and carrying amounts) of identifiable
net assets acquired to unimpaired goodwill; and to establish
minority interest in net assets of subsidiary at beginning of year
($50,000 0.20 $10,000), less minority interest in dividends
declared by subsidiary during year ($4,000 0.20 $800).

(b) Minority Interest in Net Income of Subsidiary ($10,000 0.20) 2,000

Minority Interest in Net Assets of Subsidiary 2,000
To establish minority interest in subsidiary’s net income for Year 2006.

On January 2, 2007, Stanley paid $7,400 (current fair value) to acquire 100 shares of its
common stock from a minority stockholder. Stanley’s journal entry to record the acquisi-
tion of treasury stock was as follows:

Subsidiary’s Journal Treasury Stock (100 $74) 7,400

Entry for Acquisition Cash 7,400
of Treasury Stock To record acquisition of common stock from a minority stockholder.
subsequent to Business
Combination
The $74 a share acquisition cost of the treasury stock exceeds the $56 a share
($11,200 200) carrying amount of the minority interest in net assets of subsidiary by
$18 ($74 $56). Thus, assuming that the current fair values of Stanley’s identifiable net
 Chapter 10 Consolidated Financial Statements: Special Problems 449

assets were equal to their carrying amounts on January 2, 2007, Stanley’s acquisition of
goodwill of $1,800 (100 $18) is recognized in the first of the following working paper
eliminations (in journal entry format) on that date:

Working Paper PORTOLA CORPORATION AND SUBSIDIARY

Eliminations following Working Paper Eliminations
Partially Owned January 2, 2007
Subsidiary’s
Acquisition of (a) Common Stock, $10 par—Stanley (100 $10) 1,000
Treasury Stock Additional Paid-in Capital—Stanley (100 $15) 1,500
Retained Earnings—Stanley (100 $31) 3,100
Goodwill—Stanley (100 $18) 1,800
Treasury Stock—Stanley 7,400
To account for subsidiary’s treasury stock as though it had been retired.

(b) Common Stock, $10 par—Stanley ($10,000 $1,000) 9,000

Additional Paid-in Capital—Stanley ($15,000 $1,500) 13,500
Retained Earnings—Stanley ($25,000 $10,000 $4,000
$3,100 $4,800) 23,100
Retained Earnings of Subsidiary—Portola ($8,000 $3,200) 4,800
Goodwill—Portola 4,000
Investment in Stanley Company Common Stock—Portola 48,800
Minority Interest in Net Assets of Subsidiary
($11,200 $5,600) 5,600
To eliminate intercompany investment and equity accounts of subsidiary;
to allocate excess of cost over current values of identifiable net assets
acquired to goodwill; and to establish minority interest in net assets
of subsidiary (100 $56 $5,600).

INDIRECT SHAREHOLDINGS AND PARENT COMPANY’S

COMMON STOCK OWNED BY A SUBSIDIARY
In the early years of business combinations resulting in parent company–subsidiary rela-
tionships, complex indirect or reciprocal shareholdings frequently were involved. Indirect
shareholdings are those involving such relationships as one subsidiary and the parent com-
pany jointly owning a controlling interest in another subsidiary, or a subsidiary company
itself being the parent company of its own subsidiary. Reciprocal shareholdings involve
subsidiary ownership of shares of the parent company’s common stock.

Indirect Shareholdings
Business combinations in recent years generally have been far less complex than those de-
scribed above. There usually has been a single parent company and one or more subsidiaries,
and indirect shareholdings have been the exception rather than the rule. Accountants faced
with the problems of preparing a working paper for consolidated financial statements for
parent company–subsidiary relationships involving indirect shareholdings must follow
carefully the common stock ownership percentages and apply the equity method of ac-
counting for the operating results of the various subsidiaries.
450 Part Two Business Combinations and Consolidated Financial Statements

Illustration of Indirect Shareholdings

On December 31, 2005, Placer Corporation acquired 160,000 shares (80%) of the out-
standing common stock of Shabot Company for $476,240, and 36,000 shares (45%) of Sur
Company’s outstanding common stock for $182,000. Both amounts included direct out-of-
pocket costs of the common stock acquisitions. On December 31, 2005, Shabot owned
20,000 shares (25%) of Sur’s outstanding common stock; accordingly, Placer acquired
indirect control of Sur as well as direct control of Shabot in the business combination, as
illustrated in the following diagram:

Illustration of Indirect
Shareholdings Placer
Corporation

45 rsh
ow
ne %
ip
rsh
ow 80

% ip
ne
Shabot 25% Sur
Company ownership Company

Because Shabot was able to exercise significant influence over the financing and operating
policies of Sur, it applied the equity method of accounting for its investment in Sur.
Separate balance sheets of Shabot and Sur on December 31, 2005, prior to the business
combination, follow:

SHABOT COMPANY AND SUR COMPANY

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

Shabot Sur
Company Company
Assets
Current assets $ 360,400 $190,600
Investment in Sur Company common stock 91,950
Plant assets (net) 640,650 639,400
Total assets $1,093,000 $830,000

Liabilities and Stockholders’ Equity

Current liabilities $ 210,200 $ 80,500
Long-term debt 300,000 389,500
Common stock, $1 par 200,000 80,000
Additional paid-in capital 150,000 120,000
Retained earnings 222,850 160,000
Retained earnings of investee 9,950
Total liabilities and stockholders’ equity $1,093,000 $830,000

Shabot’s Investment in Sur Company Common Stock and Retained Earnings of Investee
ledger accounts were as follows on December 31, 2005:
 Chapter 10 Consolidated Financial Statements: Special Problems 451

Selected Ledger Investment in Sur Company Common Stock

Accounts of
Date Explanation Debit Credit Balance
Subsidiary-Investor
on Date of Business 2004
Combination Dec. 31 Acquisition of 20,000 shares 82,000 82,000 dr
2005
Dec. 6 Dividends received: $0.25 a share 5,000 77,000 dr
31 Share of net income ($60,000 0.25) 15,000 92,000 dr
31 Impairment of goodwill 50 91,950 dr

Retained Earnings of Investee

Date Explanation Debit Credit Balance
2005
Dec. 31 Closing entry—share of Sur Company
adjusted net income not paid as a
dividend ($15,000 $50 $5,000) 9,950 9,950 cr

The foregoing ledger accounts of Shabot indicate that Shabot had applied the equity
method of accounting for its investment in the influenced investee, Sur, and that the $2,000
excess of the cost of Shabot’s investment over the underlying equity of Sur’s identifiable net
assets was allocated to goodwill that had been slightly impaired.
The current fair values of the identifiable net assets of both Shabot and Sur
equaled their carrying amounts on December 31, 2005. Accordingly, goodwill ac-
quired by Placer in the business combination with Shabot and Sur was measured as
follows:

Computation of Shabot Sur

Goodwill Acquired Company Company
by Parent Company
Cost of investment $476,240 $182,000
Less: Current fair value of identifiable net assets acquired:
Shabot ($582,800 0.80) 466,240
Sur ($360,000 0.45) 162,000
Goodwill $ 10,000 $ 20,000

Working Paper for Consolidated Balance Sheet on Date

of Business Combination
The working paper for consolidated balance sheet of Placer Corporation and subsidiaries
on December 31, 2005, the date of the business combination, and the related working paper
eliminations (in journal entry format) are as follows:
452 Part Two Business Combinations and Consolidated Financial Statements

Partially Owned Subsidiaries on Date of Business Combination

PLACER CORPORATION AND SUBSIDIARIES

Working Paper for Consolidated Balance Sheet
December 31, 2005

Eliminations
Placer Shabot Sur Increase
Corporation Company Company (Decrease) Consolidated
Assets
Current assets 1,400,000 360,400 190,600 1,951,000
Investment in Shabot Company
common stock 476,240 (a) (476,240)
Investment in Sur Company
r
r
common stock 182,000 91,950 (b) (91,950)
(b) (182,000)
Plant assets (net) 3,800,000 640,650 639,400 5,080,050
r
r
Goodwill (a) 10,000
31,950
(b) 21,950
Total assets 5,858,240 1,093,000 830,000 (718,240) 7,063,000

Liabilities and
Stockholders’ Equity
Current liabilities 600,000 210,200 80,500 890,700
Long-term debt 3,000,000 300,000 389,500 3,689,500
Common stock, $1 par 1,200,000 200,000 80,000 r (a) (200,000) r 1,200,000
(b) (80,000)
r
r
Additional paid-in capital 500,000 150,000 120,000 (a) (150,000) 500,000
(b) (120,000)
Minority interest in net assets of
r
r
subsidiaries (a) 116,560
(b) 108,000 224,560
r
r
Retained earnings 558,240 222,850 160,000 (a) (222,850)
(b) (160,000) 558,240
Retained earnings of investee 9,950 (a) (9,950)
Total liabilities and stockholders’
equity 5,858,240 1,093,000 830,000 (718,240) 7,063,000

Working Paper PLACER CORPORATION AND SUBSIDIARIES

Eliminations on Working Paper Eliminations
Date of Business December 31, 2005
Combination Involving
Indirect Shareholdings (a) Common Stock, $1 par—Shabot 200,000
Additional Paid-in Capital—Shabot 150,000
Retained Earnings—Shabot 222,850
Retained Earnings of Investee—Shabot 9,950
Goodwill—Placer 10,000
Investment in Shabot Company Common Stock—Placer 476,240
Minority Interest in Net Assets of Subsidiaries
($582,800 0.20) 116,560
To eliminate intercompany investment and equity accounts of Shabot
Company on date of business combination; to allocate excess of
cost over current fair values (and carrying amounts) of identifiable
net assets acquired to goodwill; and to establish minority interest
in net assets of Shabot on date of business combination.

(continued)
 Chapter 10 Consolidated Financial Statements: Special Problems 453

PLACER CORPORATION AND SUBSIDIARIES

Working Paper Eliminations (concluded)
December 31, 2005

(b) Common Stock, $1 par—Sur 80,000

Additional Paid-in Capital—Sur 120,000
Retained Earnings—Sur 160,000
Goodwill — Placer ($1,950 $20,000) 21,950
Investment in Sur Company Common Stock—Placer 182,000
Investment in Sur Company Common Stock—Shabot 91,950
Minority Interest in Net Assets of Subsidiaries
($360,000 0.30) 108,000
To eliminate intercompany investments and equity accounts of Sur
Company on date of business combination; to allocate excess of
cost over current fair values (and carrying amounts) of identifiable
net assets acquired to goodwill; and to establish minority interest
in net assets of Sur on date of business combination.

The following two aspects of the working paper eliminations warrant emphasis:
1. In elimination (a), Shabot Company’s retained earnings of investee amount on the date of
the business combination is reduced to zero. Because Placer Corporation is the parent
company in the Placer–Shabot–Sur business combination, Shabot’s ownership of 20,000
shares of Sur’s outstanding common stock on the date of the combination is not construed
as an installment acquisition by Placer; thus, consolidated retained earnings on the date
of the combination does not include Shabot’s share of Sur’s retained earnings.
2. In elimination (b), both the $20,000 goodwill acquired by Placer (see page 451) and the
unimpaired goodwill implicit in Shabot’s investment in Sur ($2,000 $50 $1,950) are
included in consolidated goodwill, because the current fair values of Sur’s identifiable net
assets equaled their carrying amounts on the date of combination. The entire goodwill is
attributable to Placer because of the existence of minority interests in both Shabot and Sur.

Working Paper Eliminations Subsequent to Business Combination

For the fiscal year ended December 31, 2006, Shabot Company had an income of $150,000
(exclusive of investment income from Sur) and declared dividends of $60,000; Sur Com-
pany had a net income of $80,000 and declared dividends of $20,000. These operating re-
sults are recorded in the investment accounts of Placer and Shabot below and on page 454,
under the equity method of accounting assuming that consolidated goodwill was unim-
paired as of December 31, 2006; the working paper eliminations (in journal entry format)
for Placer Corporation and subsidiaries on December 31, 2006, follow those accounts.

Investment Accounts PLACER CORPORATION LEDGER

of Parent Company
and Subsidiary One Investment in Shabot Company Common Stock
Year subsequent to Date Explanation Debit Credit Balance
Business Combination
2005
Dec. 31 Acquisition of 160,000 shares 476,240 476,240 dr
2006
Dec. 6 Dividends received: $0.30 a share 48,000 428,240 dr
31 Share of net income
[($150,000 $20,000) 0.80] 136,000 564,240 dr
454 Part Two Business Combinations and Consolidated Financial Statements

Investment in Sur Company Common Stock

Date Explanation Debit Credit Balance
2005
Dec. 31 Acquisition of 36,000 shares 182,000 182,000 dr
2006
Dec. 6 Dividends received: $0.25 a share 9,000 173,000 dr
31 Share of net income ($80,000 0.45) 36,000 209,000 dr

SHABOT COMPANY LEDGER

Investment in Sur Company Common Stock

Date Explanation Debit Credit Balance
2004
Dec. 31 Acquisition of 20,000 shares 82,000 82,000 dr
2005
Dec. 6 Dividends received: $0.25 a share 5,000 77,000 dr
31 Share of net income
($60,000 0.25) 15,000 92,000 dr
31 Impairment of goodwill 50 91,950 dr
2006
Dec. 6 Dividends received: $0.25 a share 5,000 86,950 dr
31 Share of net income
($80,000 0.25) 20,000 106,950 dr

Working Paper PLACER CORPORATION AND SUBSIDIARIES

Eliminations for First Working Paper Eliminations
Year following December 31, 2006
Business Combination
Involving Indirect (a) Common Stock, $1 par—Shabot 200,000
Shareholdings Additional Paid-in Capital—Shabot 150,000
Retained Earnings—Shabot 222,850
Retained Earnings of Investee—Shabot 9,950
Intercompany Investment Income—Placer 136,000
Goodwill—Placer 10,000
Investment in Shabot Company Common Stock—Placer 564,240
Dividends Declared—Shabot 60,000
Minority Interest in Net Assets of Subsidiaries
($116,560 $12,000) 104,560
To eliminate intercompany investment and equity accounts of Shabot
Company at beginning of year, and subsidiary dividends; to
allocate unamortized excess of cost over current fair values of
identifiable net assets to unimpaired goodwill; and to establish
minority interest in net assets of Shabot at beginning of year
($116,560), less minority interest in dividends ($60,000 0.20 .
$12,000).

(continued)
 Chapter 10 Consolidated Financial Statements: Special Problems 455

PLACER CORPORATION AND SUBSIDIARIES

Working Paper Eliminations (concluded)
December 31, 2006

(b) Common Stock, $1 par—Sur 80,000

Additional Paid-in Capital—Sur 120,000
Retained Earnings—Sur 160,000
Intercompany Investment Income—Placer 36,000
Intercompany Investment Income—Shabot 20,000
Goodwill—Placer ($1,950 $20,000) 21,950
Investment in Sur Company Common Stock—Placer 209,000
Investment in Sur Company Common Stock—Shabot 106,950
Dividends Declared—Sur 20,000
Minority Interest in Net Assets of Subsidiaries ($108,000 $6,000) 102,000
To eliminate intercompany investment and equity accounts of Sur
Company at beginning of year, and subsidiary dividends; to
allocate unamortized excess of cost over current fair values of
identifiable net assets to unimpaired goodwill; and to establish
minority interest in net assets of Sur at beginning of year ($108,000),
less minority interest in dividends ($20,000 0.30 $6,000).

(c) Minority Interest in Net Income of Subsidiaries

[($170,000 0.20) ($80,000 0.30)] 58,000
Minority Interest in Net Assets of Subsidiaries 58,000
To establish minority interest in subsidiaries’ net income for Year 2006.

Parent Company’s Common Stock Owned by a Subsidiary

The traditional approach by accountants to problems of reciprocal shareholdings involved
complex mathematical allocations of the individual affiliated companies’ net income or loss
to consolidated net income or loss and to minority interest. These allocations typically in-
volved matrices or simultaneous equations.
Accountants have come to question the traditional approach to reciprocal shareholdings.
The principal criticism is that strict application of mathematical allocations for reciprocal
shareholdings violates the going-concern aspect of consolidated financial statements in fa-
vor of a liquidation approach. A related criticism is the emphasis of the traditional ap-
proach on legal form of the reciprocal shareholdings, rather than on economic substance.
When a subsidiary acquires outstanding common stock of the parent company, it has been
argued, the shares of parent company common stock owned by the subsidiary are in essence
treasury stock to the consolidated entity. The treasury stock treatment for reciprocal share-
holdings was sanctioned by the American Accounting Association and by the AICPA as
follows:
Shares of the controlling company’s capital stock owned by a subsidiary before the date of
acquisition of control should be treated in consolidation as treasury stock. Any subsequent
acquisition or sale by a subsidiary should likewise by treated in the consolidated statements
as though it had been the act of the controlling company.6

6
Accounting and Reporting Standards for Corporate Financial Statements, “Consolidated Financial
Statements” (Madison: AAA, 1957), p. 44.
456 Part Two Business Combinations and Consolidated Financial Statements

. . . shares of the parent held by a subsidiary should not be treated as outstanding stock
in the consolidated balance sheet.7

The material in this text is consistent with the view that a subsidiary’s shareholdings of
parent company common stock in essence are treasury stock to the consolidated entity. This
position is analogous to that set forth in Chapter 8 for intercompany bondholdings. There
the point is made that a subsidiary acquiring the parent company’s bonds payable in the
open market is acting on behalf of the parent in the acquisition of the bonds for the consol-
idated entity’s treasury.
To illustrate the accounting and working paper eliminations for parent company’s com-
mon stock owned by a subsidiary, assume that on May 1, 2005, the beginning of a fiscal
year, Springer Company, the wholly owned subsidiary of Prospect Corporation, acquired
for $50,000 in the open market 5,000 shares, or 5%, of the outstanding $1 par common
stock of Prospect. On April 30, 2006, Prospect declared and paid a cash dividend of $1.20
a share.
Springer prepares the following journal entries for its investment in Prospect’s common
stock, under the appropriate cost method of accounting:

Subsidiary’s Journal 2005

Entries for Investment May 1 Investment in Prospect Corporation Common Stock 50,000
in Parent Company’s Cash 50,000
Common Stock To record acquisition of 5,000 shares of parent company’s
outstanding common stock at $10 a share.

2006
Apr. 30 Cash 6,000
Intercompany Dividend Revenue 6,000
To record dividend of $1.20 a share on 5,000 shares of parent
company’s common stock.

The working paper eliminations (in journal entry format) for Prospect Corporation and
subsidiary on April 30, 2006, include the following:

Working Paper PROSPECT CORPORATION AND SUBSIDIARY

Eliminations for Parent Partial Working Paper Eliminations
Company Common April 30, 2006
Stock Owned by
Subsidiary (b) Treasury Stock—Prospect 50,000
Investment in Prospect Corporation Common Stock—Springer 50,000
To transfer subsidiary’s investment in parent company’s common stock
to treasury stock category.

(c) Intercompany Dividend Revenue—Springer 6,000

Dividends Declared—Prospect 6,000
To eliminate parent company dividends received by subsidiary.

7
ARB No. 51, par. 13.
 Chapter 10 Consolidated Financial Statements: Special Problems 457

The effect of the second elimination is to remove the parent company dividends ap-
plicable to the consolidated treasury stock. The result is that, in the consolidated state-
ment of retained earnings, dividends are in the amount of $114,000 ($120,000
$6,000 $114,000), representing the $1.20 a share dividend on 95,000 shares of parent
company common stock that are outstanding from the viewpoint of the consolidated entity.

Concluding Comments on Special Problems

This chapter presents a number of special problems that might arise in the preparation of
consolidated financial statements. Not discussed are basic or diluted earnings per share
computations for a consolidated entity, because in most circumstances the standards for
earnings per share computations described in intermediate accounting textbooks apply to
the computation of consolidated earnings per share. The problems that arise in earnings per
share computations when a subsidiary owns shares of the parent company’s common stock
or the parent owns potentially dilutive financial instruments of the subsidiary are highly
technical and too specialized to warrant inclusion in a discussion of basic concepts relating
to consolidated financial statements. The FASB has dealt with such matters in FASB State-
ment No. 128, “Earnings per Share.”8

Review 1. FASB Statement No. 141, “Business Combinations,” requires use of the purchase
method of accounting for a parent company’s or a subsidiary’s acquisition of all or part
Questions of the minority interest in net assets of the subsidiary. Discuss the reasoning in support
of this requirement.
2. If a parent company acquires the minority interest in net assets of a subsidiary at less
than carrying amount, what accounting treatment is appropriate for the difference?
Explain.
3. Why does a parent company recognize a nonoperating gain or loss when a subsidiary
issues common stock to the public at a price per share that differs from the carrying
amount per share of the parent company’s investment in the subsidiary’s common stock?
Explain.
4. Is a gain or a loss that is recognized by a parent company on the disposal of part of its
investment in common stock of a subsidiary eliminated in the preparation of consoli-
dated financial statements? Explain.
5. Explain how the minority interest in net assets of a subsidiary is affected by the parent
company’s ownership of 70% of the subsidiary’s outstanding common stock and 60% of
the subsidiary’s outstanding 7%, cumulative, fully participating preferred stock.
6. Does the declaration of a stock dividend by a subsidiary necessitate any special treat-
ment in working paper eliminations? Explain.
7. Describe how a subsidiary’s ledger accounts are affected when it acquires for its treasury
all or part of its outstanding common stock owned by minority stockholders.
8. “The treasury stock treatment for shares of parent company common stock owned by a
subsidiary overstates consolidated net income and understates the minority interest in
net income of the subsidiary.” Do you agree? Explain.

8
FASB Statement No. 128, “Earnings per Share” (NorwalK: FASB, 1997), pars. 62, 156.
458 Part Two Business Combinations and Consolidated Financial Statements

9. Shares of its common stock held by a corporation in its treasury are not entitled to divi-
dends. However, a subsidiary receives dividends on shares of its parent company’s com-
mon stock owned by the subsidiary. For consolidated financial statements, these parent
company shares are considered equivalent to treasury stock of the consolidated entity. Is
there an inconsistency in this treatment? Explain.

Exercises
(Exercise 10.1) Select the best answer for each of the following multiple-choice questions:
1. The minority interest of preferred stockholders in the net assets of a partially owned
subsidiary preferably is measured by the preferred stock’s
a. Cash dividend per share.
b. Call price per share.
c. Liquidation preference per share.
d. Par or stated value per share.
2. Shares of a parent company’s common stock owned by the parent’s subsidiary are ac-
counted for in consolidated financial statements of the parent company and its sub-
sidiary as:
a. Retired parent company stock.
b. Reissued parent company stock.
c. Consolidated short-term investments.
d. Consolidated treasury stock.
3. Do the following business transactions or events of a subsidiary generally result in a
nonoperating gain or loss to the parent company?

Subsidiary’s Issuance Subsidiary’s Acquisition

Subsidiary’s Issuance of Unissued Common of Part of
of Unissued Common Stock to Parent Minority Stockholdings
Stock to Public? Company? for Treasury?
a. No No No
b. Yes Yes No
c. Yes No Yes
d. Yes Yes Yes

4. If a parent company acquires for cash all the common stock owned by minority stock-
holders of a partially owned subsidiary, the excess of the cash paid over the minority
interest in net assets of the subsidiary generally is recognized as:
a. An expense in a parent company journal entry.
b. Goodwill in a working paper elimination.
c. An increase in the current fair values of the subsidiary’s identifiable net assets in a
working paper elimination.
d. A reduction of an additional paid-in capital ledger account balance in a parent com-
pany journal entry.
5. Parsell Corporation disposed of a 20% interest in the outstanding common stock of its
previously wholly owned subsidiary, Sorbell Company, on May 31, 2006, to an outside
entity at a substantial gain. A result of this event is:
a. A decrease in consolidated goodwill of Parsell Corporation and subsidiary on
May 31, 2006.
 Chapter 10 Consolidated Financial Statements: Special Problems 459

b. The elimination of the gain in the working paper for consolidated financial state-
ments of Parsell Corporation and subsidiary for the year ended May 31, 2006.
c. An increase in minority interest in net income of subsidiary in the consolidated income
statement of Parsell Corporation and subsidiary for the year ended May 31, 2006.
d. All of the foregoing.
e. None of the foregoing.
6. Is a parent company’s gain on disposal of a portion of its investment in the subsidiary
displayed as realized in the:

Parent Company’s Consolidated Income

Unconsolidated Income Statement of Parent
Statement? Company and Subsidiary?
a. Yes Yes
b. Yes No
c. No Yes
d. No No

7. The appropriate recording (explanation omitted) for a parent company to reflect a loss
on its subsidiary’s issuance of additional shares of common stock to the public is:
a. A working paper elimination debiting Nonoperating Loss from Subsidiary’s Issuance
of Common Stock and crediting Investment in Subsidiary Company Common Stock.
b. A parent company journal entry debiting Nonoperating Loss from Subsidiary’s
Issuance of Common Stock and crediting Investment in Subsidiary Company Com-
mon Stock.
c. A subsidiary journal entry debiting an additional paid-in capital ledger account and
crediting Payable to Parent Company.
d. A note to the consolidated financial statements only.
8. If a parent company acquires additional shares of previously unissued common stock
from its subsidiary, with minority stockholders of the subsidiary waiving their pre-
emptive rights, a resultant gain or loss is:
a. Recognized by the parent company and eliminated in the preparation of consoli-
dated financial statements.
b. Recognized by the parent company and not eliminated in the preparation of consol-
idated financial statements.
c. Recognized by the subsidiary and eliminated in the preparation of consolidated
financial statements.
d. Recognized in a working paper elimination for the preparation of consolidated
financial statements.
9. A parent company realizes a gain or loss on its acquisition of additional common stock
from a subsidiary, with the minority stockholders waiving their preemptive rights,
because:
a. The minority stockholders are owners under the economic unit concept.
b. The minority stockholders are creditors under the economic unit concept.
c. The subsidiary will pay more dividends to the parent company subsequent to its
acquisition of additional common stock of the subsidiary.
d. The parent company will recognize more intercompany investment income or loss
subsequent to its acquisition of additional common stock of the subsidiary.
e. Of none of the foregoing reasons.
460 Part Two Business Combinations and Consolidated Financial Statements

10. Is a gain or loss realized by the parent company when a subsidiary issues additional
shares of common stock to:

The Public? The Parent Company?

a. No No
b. No Yes
c. Yes No
d. Yes Yes

11. When a parent company acquires both preferred stock and common stock of the sub-
sidiary in a business combination, goodwill recognized in the combination is com-
puted based on:
a. Cost allocated to preferred stock only.
b. Cost allocated to common stock only.
c. Cost allocated to both preferred stock and common stock.
d. Some other measure.
12. Is goodwill attributable to a subsidiary recognized in a working paper elimination for
treasury stock of the subsidiary:

Owned on the Date of the Acquired subsequent to the Date

Business Combination? of the Business Combination?
a. Yes Yes
b. Yes No
c. No Yes
d. No No

13. Treasury stock acquired by a subsidiary from minority stockholders of the subsidiary
is accounted for in consolidated financial statements as:
a. Treasury stock of the subsidiary.
b. Treasury stock of the parent company.
c. Treasury stock of the consolidated entity.
d. Retired stock of the subsidiary.
14. Shares of the parent company’s issued common stock that are owned by the subsidiary
are treated in the consolidated balance sheet as being:
a. Outstanding.
b. In the treasury.
c. Retired.
d. Part of the minority interest.
(Exercise 10.2) On March 31, 2006, the consolidated balance sheet of Polberg Corporation and its 85%-
owned subsidiary, Serrano Company, showed goodwill of $65,400 and minority interest in
CHECK FIGURE net assets of subsidiary of $22,800. On April 1, 2006, Polberg paid $10,000 to minority
Minority interest, stockholders who owned 500 of Serrano’s 10,000 shares of issued common stock.
$15,200. Prepare a working paper to compute goodwill and minority interest in net assets of sub-
sidiary for display in the consolidated balance sheet of Polberg Corporation and subsidiary
on April 1, 2006.
(Exercise 10.3) On January 2, 2005, Prester Corporation organized Shire Company, paying $40,000 for
CHECK FIGURE 10,000 shares of Shire’s $1 par common stock. On January 3, 2005, before beginning op-
Nonoperating gain to erations, Shire issued 2,000 shares of its $1 par common stock to the public for net pro-
Prester, $2,500. ceeds of $11,000; Prester did not exercise its preemptive right.
 Chapter 10 Consolidated Financial Statements: Special Problems 461

Prepare a working paper to compute the change in Prester’s Investment ledger account
balance that resulted from Shire’s issuance of common stock to the public.
(Exercise 10.4) On October 31, 2006, when the balance of Pinto Corporation’s Investment in Sorrel Com-
pany Common Stock ledger account was $540,000 and the minority interest in net assets of
CHECK FIGURE subsidiary was $135,000, Sorrel Company, of whose 10,000 shares of outstanding common
a. Nonoperating loss to stock Pinto owned 8,000 shares, issued 2,000 shares of unissued common stock to Pinto at
Pinto, $1,500. $72 a share. (Minority stockholders did not exercise their preemptive rights.) Prior to is-
suance of the 2,000 shares of common stock, the stockholders’ equity of Sorrel, which had
been organized by Pinto, totaled $675,000; after issuance of the 2,000 shares, Sorrel’s
stockholders’ equity totaled $819,000.
a. Prepare a three-column working paper to compute the change in the Investment ledger
account balance of Pinto Corporation resulting from Sorrel Company’s issuance of
2,000 shares of common stock to Pinto on October 31, 2006. Use the following column
headings: “Total,” “Pinto’s Share,” and “Minority Interest Share.”
b. Prepare a journal entry for Pinto Corporation on October 31, 2006, to record the change
in Pinto’s Investment ledger account balance resulting from Sorrel Company’s issuance
of 2,000 shares of common stock to Pinto.
(Exercise 10.5) The stockholders’ equity section of Stegg Company’s August 31, 2005, balance sheet was
as follows:

CHECK FIGURE
8% cumulative preferred stock, $1 par, dividends in arrears two years;
b. $63,000.
authorized, issued, and outstanding 100,000 shares, callable at
$1.10 a share plus dividends in arrears $ 100,000
Common stock, $2 par; authorized, issued, and outstanding
100,000 shares 200,000
Additional paid-in capital—common stock 150,000
Retained earnings 750,000
Total stockholders’ equity $1,200,000

On August 31, 2005, Panay Corporation acquired 50,000 shares of Stegg’s outstanding
preferred stock and 75,000 shares of Stegg’s outstanding common stock for a total cost—
including out-of-pocket costs—of $1,030,500. The current fair values of Stegg’s identifi-
able net assets were equal to their carrying amounts on August 31, 2005.
Answer the following questions (show supporting computations):
a. What amount of the $1,030,500 total cost is assignable to Stegg’s preferred stock?
b. What is the minority interest of preferred stockholders in Stegg’s net assets on August
31, 2005?
c. What is the amount of goodwill acquired by Panay August 31, 2005?
d. What is the minority interest of common stockholders in Stegg’s net assets on August
31, 2005?
(Exercise 10.6) Simplex Company, the partially owned subsidiary of Polyglot Corporation, had a net in-
come of $342,800 for the fiscal year ended May 31, 2006, during which Simplex declared
a dividend of $12 a share on its 10,000 shares of outstanding 12%, $100 par, cumulative
CHECK FIGURE preferred stock, and a dividend of $8 a share on its 80,000 shares of outstanding $1 par
Net income to parent, common stock. Polyglot owned 7,000 shares of preferred stock and 60,000 shares of com-
$251,100. mon stock of Simplex. There were no dividends in arrears on the preferred stock.
462 Part Two Business Combinations and Consolidated Financial Statements

Prepare a working paper (as on page 444) to show the allocation of Simplex Company’s
$342,800 net income for the year ended May 31, 2006, to consolidated net income and to
the minority interest in net income of subsidiary.
(Exercise 10.7) On September 30, 2006, prior to the declaration of a 15% stock dividend by its subsidiary,
Sabro Company, on that date, Placard Corporation’s accountant prepared the following ten-
tative working paper elimination (in journal entry format):
CHECK FIGURE
b. Credit retained (a) Common Stock, $2 par—Sabro 80,000
earnings of subsidiary, Additional Paid-in Capital—Sabro 40,000
$40,000. Retained Earnings—Sabro ($130,000 $10,000) 120,000
Retained Earnings of Subsidiary—Placard 10,000
Intercompany Investment Income—Placard 70,000
Goodwill—Sabro 20,000
Investment in Sabro Company Common Stock—Placard 340,000
To eliminate intercompany investment and equity accounts of
subsidiary at beginning of year, and investment income
from subsidiary; and to allocate excess of cost over current
fair values (and carrying amounts) of identifiable net assets
acquired to goodwill.

The current fair value of the dividend shares issued by Sabro was $5 a share. Placard had
net sales of $840,200 and total costs and expenses of $668,500 for the fiscal year ended
September 30, 2006.
a. Prepare a revised working paper elimination (in journal entry format) for Placard Cor-
poration and subsidiary on September 30, 2006, to reflect the effects of Sabro’s stock
dividend. Omit explanation, but show supporting computations.
b. Prepare a single closing entry (forgoing use of the Income Summary ledger account) for
Placard Corporation on September 30, 2006. Omit explanation, but show supporting
computations.
(Exercise 10.8) On December 31, 2005, the date of the business combination of Portland Corporation and
Salem Company, Salem had 50,000 shares of $5 par common stock authorized, 20,000
shares issued (total net issue proceeds were $160,000), and 500 shares in the treasury, with
a total cost of $5,500. The balance of Salem’s Retained Earnings ledger account was
$240,000 on December 31, 2005.
Prepare a working paper elimination (in journal entry format) for Portland Corporation
and subsidiary on December 31, 2005, to account for the subsidiary’s treasury stock as
though it had been retired.
(Exercise 10.9) On February 28, 2005, the stockholders’ equity of Stocker Company was as follows:
CHECK FIGURE
Common stock, no par or stated value; 50,000 shares issued,
Debit goodwill—
48,000 shares outstanding $250,000
Stocker, $66,000.
Retained earnings 600,000
Total paid-in capital and retained earnings $850,000
Less: 2,000 shares of treasury stock, at cost 16,000
Total stockholders’ equity $834,000

On February 28, 2005, Priam Corporation paid $900,000 for all 48,000 shares of outstand-
ing common stock of Stocker; on that date, current fair values of Stocker’s identifiable net
assets were equal to their carrying amounts. Out-of-pocket costs of the business combina-
tion may be disregarded.
 Chapter 10 Consolidated Financial Statements: Special Problems 463

Prepare working paper eliminations (in journal entry format; omit explanations) for
Priam Corporation and subsidiary on February 28, 2005.
(Exercise 10.10) The stockholders’ equity section of the balance sheet of Sergeant Company, the wholly
owned subsidiary of Private Corporation, on May 31, 2005, the date of the business com-
bination, which did not involve a current fair value excess or goodwill, was as follows:

Common stock, $10 par $100,000

Additional paid-in capital 50,000
Retained earnings 150,000
Total paid-in capital and retained earnings $300,000
Less: 500 shares of treasury stock, at cost 7,500
Total stockholders’ equity. $292,500

Prepare working paper eliminations, in journal entry format (omit explanations), for
Private Corporation and subsidiary on May 31, 2005.
(Exercise 10.11) The stockholders’ equity of Sibley Company on February 28, 2005, was as follows:

CHECK FIGURE Common stock, no par or stated value; 100,000 shares

Total debits to
authorized, 80,000 shares issued $160,000
Goodwill—Sibley,
Retained earnings 640,000
$50,000.
Total stockholders’ equity $800,000

On February 28, 2005, Parson Corporation acquired 75,000 shares of Sibley’s outstanding
common stock for $790,000, including direct out-of-pocket costs of the business combi-
nation. Simultaneously, Sibley acquired for the treasury the remaining 5,000 shares of its
outstanding common stock for $60,000, a fair price. The current fair values of Sibley’s
identifiable net assets were equal to their carrying amounts on February 28, 2005.
Prepare working paper eliminations, in journal entry format (omit explanations), for
Parson Corporation and subsidiary on February 28, 2005.
(Exercise 10.12) On January 2, 2005, Prince Corporation organized Sabine Company with authorized com-
mon stock of 10,000 shares, $5 par. Prince acquired 4,000 shares of Sabine’s common stock
at $8 a share, and Samnite Company, a wholly owned subsidiary of Prince, acquired the
6,000 remaining authorized shares of Sabine’s common stock at $8 a share. For the fiscal
year ended December 31, 2005, Sabine had a net income of $80,000 and declared divi-
dends of $2 a share on December 28, 2005, payable on January 25, 2006.
Prepare journal entries under the equity method of accounting to record the operating re-
sults of Sabine Company for Year 2005 in the accounting records of (a) Prince Corporation,
and (b) Samnite Company. (Omit explanations; disregard income taxes.)
(Exercise 10.13) During the fiscal year ended May 31, 2007, Sugar Company, the wholly owned subsidiary
of Peaches Corporation, prepared the following journal entries:

2006
June 1 Investment in Peaches Corporation Common Stock 100,000
Cash 100,000
To record acquisition of 100 shares (1%) of parent company’s
outstanding common stock at $1,000 a share.
464 Part Two Business Combinations and Consolidated Financial Statements

2007
May 31 Cash 5,000
Intercompany Dividends Revenue 5,000
To record dividend of $50 a share on 100 shares of parent
company’s common stock.

Prepare working paper eliminations (in journal entry format, omitting explanations) for
Peaches Corporation and subsidiary on May 31, 2007.
(Exercise 10.14) On August 1, 2005, the beginning of a fiscal year, Pressman Corporation acquired 95% of
the outstanding common stock of Sycamore Company in a business combination. Among
the intercompany transactions and events between Pressman and Sycamore subsequent to
August 1, 2005, were the following:
1. On May 31, 2006, Sycamore declared a 10% stock dividend on its 10,000 outstanding
shares of $10 par common stock having a current fair value of $18 a share. The 1,000
shares of the stock dividend were issued June 18, 2006.
2. On July 28, 2006, Sycamore acquired in the open market for $15,000, 1,000 of the
100,000 outstanding shares of Pressman’s $1 par common stock. Pressman declared no
dividends during the fiscal year ended July 31, 2006.
Prepare working paper eliminations (in journal entry format) on July 31, 2006, for
Pressman Corporation and subsidiary, required for the foregoing intercompany trans-
actions.

Cases
(Case 10.1) Wilma Reynolds, CPA, a member of the American Institute of Certified Public Accountants
(AICPA), is controller of Premium Corporation, a publicly owned enterprise with a now-
60%-owned subsidiary, Service Company. Reynolds has informed Premium’s chief finan-
cial officer, Wayne Cartwright, that the $150,000 increase in Premium’s investment in
Service, which resulted from Service’s just-completed issuance of additional common
stock to the public, should be recognized as an increase in Premium’s additional paid-in
capital, in accordance with a proposed standard of the FASB. Cartwright countered that
Topic 5-H of the SEC Staff Accounting Bulletins (SAB), which is based on SAB 51 and
SAB 84, sanctions recognition of the $150,000 increase as nonoperating income of Pre-
mium. Cartwright expressed the belief that because the SEC has statutory authority to es-
tablish accounting standards, its pronouncements should prevail over those proposed or
issued by the FASB.

Instructions
Do you agree with Wayne Cartwright? In formulating your answer, consider the following:
Sections 101 and 103 of the SEC’s Codification of Financial Reporting Policies.
FASB Statement No. 111, “Recession of FASB Statement No. 32 and Technical
Corrections,” par. 25.
AICPA Code of Professional Conduct, Rule 203 “Accounting Principles” and
Appendix A.
 Chapter 10 Consolidated Financial Statements: Special Problems 465

(Case 10.2) The board of directors of Banking Enterprises, Inc., a holding company with 25 subsidiary
federally chartered banks, has offered $2,500,000 to Mary Phillips, the 40% minority
stockholder of Bank of Provence, for the entire 40% interest, which has a carrying amount
of $1,800,000 in the consolidated balance sheet of Banking Enterprises, Inc. and sub-
sidiaries. In a discussion of the appropriate accounting for the $700,000 difference
($2,500,000 $1,800,000) between the amount offered and the carrying amount, Bank-
ing’s chief financial officer, Wendell Casey, supports recognition of goodwill. However,
controller John Winston of Banking Enterprises, Inc., believes that some of the $700,000
represents a greenmail-type loss, and should be recognized as such. In an appearance be-
fore Banking’s board, both Casey and Winston argue their positions forcefully. The board
instructs the two men to consult with the engagement partner of Banking’s independent au-
diting firm, Crandall & Lowe, CPAs, to resolve the matter.

Instructions
Assume you are the above-described partner of Crandall & Lowe, CPAs. How would you
resolve the dispute between Wendell Casey and John Winston? Explain, including mention
of the additional information you would need.
(Case 10.3) In a classroom discussion of the display, in a consolidated balance sheet, of the minor-
ity interest of preferred stockholders in the net assets of a subsidiary, student Ross sug-
gested that such a minority interest differs from the minority interest of common
stockholders, and thus possibly warrants display in the “mezzanine” section between li-
abilities and stockholders’ equity. Student Kerry disagrees; she maintains that the term
minority applies to preferred stockholders as well as common stockholders other than
the parent company; both minority interests are part of consolidated stockholders’
equity.

Instructions
Do you support the position of student Ross or of student Kerry? Explain.

Problems
(Problem 10.1) Scrip Company, the 80%-owned subsidiary of Pinch Corporation, had 10,000 shares of
$5 par common stock outstanding on March 31, 2005, the date of the Pinch-Scrip busi-
ness combination, with total stockholders’ equity of $300,000 and total paid-in capital
equal in amount to retained earnings on that date. Goodwill in the amount of $40,000
and minority interest in net assets of subsidiary of $60,000 were displayed in the con-
CHECK FIGURE solidated balance sheet of Pinch Corporation and subsidiary on March 31, 2005. The
Debit goodwill— current fair values of Scrip’s identifiable net assets equaled their carrying amounts on
Pinch, $54,000. March 31, 2005.
On April 1, 2005, Pinch paid $44,000 (the current fair value) to a minority stockholder
for 1,000 shares of Scrip common stock. For the fiscal year ended March 31, 2006, Scrip
had a net income of $90,000 and declared and paid dividends of $3 a share in March, Year
2006. Consolidated goodwill was unimpaired as of March 31, 2006.

Instructions
Prepare working paper eliminations (in journal entry format) for Pinch Corporation and
subsidiary on March 31, 2006. (Disregard income taxes.)
466 Part Two Business Combinations and Consolidated Financial Statements

(Problem 10.2) On January 2, 2005, Prime Corporation issued 50,000 shares of $10 par (current fair value
$25 a share) common stock and paid $140,000 out-of-pocket costs for all the outstanding
CHECK FIGURE common stock of Showboat Company in a business combination that did not involve good-
b. Debit retained will or current fair value excess. On the date of the combination, Showboat’s stockholders’
earnings—Showboat, equity consists of the following:
$235,000.

Common stock, $1 par $400,000

Additional paid-in capital 300,000
Retained earnings 250,000
Total paid-in capital and retained earnings $950,000
Less: 20,000 shares of treasury stock, at cost 50,000
Total stockholders’ equity $900,000

On December 29, 2005, Showboat declared a dividend of $0.10 a share, payable in Year
2006. For the fiscal year ended December 31, 2005, Showboat had a net income of $90,000.
Instructions
a. Prepare journal entries for Prime Corporation to record the operating results of Show-
boat Company for Year 2005, under the equity method of accounting. (Disregard income
taxes.)
b. Prepare working paper eliminations (in journal entry format) for Prime Corporation and
subsidiary on December 31, 2005. (Disregard income taxes.)
(Problem 10.3) The working paper eliminations (in journal entry format) for Pumble Corporation and its
subsidiary (established by Pumble on November 1, 2004, with a 2% minority interest) on
October 31, 2006, are as follows:

PUMBLE CORPORATION AND SUBSIDIARY

Working Paper Eliminations
October 31, 2006

(a) Common Stock—Salton 10,000

Additional Paid-in Capital—Salton 60,000
Retained Earnings—Salton ($80,000 0.02) 1,600
Retained Earnings of Subsidiary—Pumble ($80,000 0.98) 78,400
Intercompany Investment Income—Pumble ($40,000 0.98) 39,200
Investment in Salton Company Common Stock—
Pumble ($180,000 0.98) 176,400
Dividends Declared—Salton 10,000
Minority Interest in Net Assets of Subsidiary ($3,000 $200) 2,800
CHECK FIGURES To eliminate intercompany investment and related accounts for
a. Credit intercompany stockholders’ equity of subsidiary at beginning of year, and
investment income, investment income from subsidiary; and to establish minority
interest in net assets of subsidiary at beginning of year
$34,363; b. Debit
($150,000 0.02 $3,000), less minority interest in
minority interest in net dividends ($10,000 0.02 $200).
income, $637.
(b) Minority Interest in Net Income of Subsidiary ($40,000 0.02) 800
Minority Interest in Net Assets of Subsidiary 800
To establish minority interest in net income of subsidiary for year
ended October 31, 2006.
 Chapter 10 Consolidated Financial Statements: Special Problems 467

On November 1, 2006, Salton issued 1,000 additional shares of $1 par common stock to
Pumble for $20 a share (Salton’s minority stockholders did not exercise their preemptive
rights). (Out-of-pocket costs of the stock issuance may be disregarded.) On October 31,
2007, Salton declared a dividend of $2 a share, and for the fiscal year ended October 31,
2007, Salton had a net income of $35,000.
Instructions
a. Prepare journal entries for Pumble Corporation to record the operating results of Salton
Company for the fiscal year ended October 31, 2007, under the equity method of ac-
counting. Round Pumble’s new percentage interest in Salton to two decimal places, and
all dollar amounts to the nearest dollar. (Disregard income taxes.)
b. Prepare working paper eliminations (in journal entry format) for Pumble Corporation
and subsidiary on October 31, 2007. Round all amounts to the nearest dollar. (Disregard
income taxes.)
(Problem 10.4) On February 28, 2006, the end of a fiscal year, the balance of Pronto Corporation’s
Retained Earnings of Subsidiary ledger account (after closing) was $9,000, and the balance
of Pronto’s Investment in Speedy Company Common Stock ledger account was $75,000,
which was analyzed as follows:

CHECK FIGURE
Share of identifiable net assets of Speedy (current fair values equaled
b. $103,000.
carrying amounts on date of business combination) ($100,000 0.60) $60,000
Goodwill (unimpaired) 15,000
Balance of Pronto’s investment account, Feb. 28, 2006 $75,000

The minority interest in net assets of subsidiary in the consolidated balance sheet of Pronto
Corporation and subsidiary on February 28, 2006, was $40,000 ($100,000 0.40). The
stockholders’ equity of Speedy Company on February 28, 2006, consisted of the following:

Common stock, $1 par $ 10,000

Additional paid-in capital 30,000
Retained earnings 60,000
Total stockholders’ equity $100,000

On March 1, 2006, in order to reduce the minority interest in the net assets of Speedy
Company, Pronto Corporation paid $32,000 to Speedy for 2,000 shares of Speedy’s un-
issued common stock, thus increasing Pronto’s ownership interest in Speedy to
66 2 3 % 3 (6,000 2,000) (10,000 2,000) 4 . (The minority stockholders of Speedy did
not exercise their preemptive rights.)
Instructions
a. Prepare a journal entry for Speedy Company to record the issuance of 2,000 shares of
common stock to Pronto Corporation on March 1, 2006.
b. Prepare a working paper to compute the balance of Pronto Corporation’s Investment in
Speedy Company Common Stock ledger account on March 1, 2006, following the ac-
quisition of 2,000 shares of Speedy’s unissued common stock. (Include the nonoperat-
ing gain or loss resulting from Speedy’s issuance of common stock to Pronto.)
c. Prepare a working paper elimination (in journal entry format) for the consolidated
balance sheet of Pronto Corporation and subsidiary on March 1, 2006, following
468 Part Two Business Combinations and Consolidated Financial Statements

Speedy’s issuance of 2,000 shares of common stock to Pronto. Disregard Speedy’s

operations for March 1, 2006, and disregard income taxes.
(Problem 10.5) On October 31, 2005, Pun Corporation acquired 80% of the outstanding common stock of
Sim Company for $960,000, including goodwill of $80,000. On that date, the carrying
amount (equal to current fair value) of Sim’s identifiable net assets was $1,100,000, repre-
sented by the following stockholders’ equity:

CHECK FIGURE Common stock, no par or stated value; 10,000 shares authorized,
Debit goodwill—Sim,
issued, and outstanding $ 500,000
$54,000.
Retained earnings 600,000
Total stockholders’ equity $1,100,000

Additional Information
1. For the fiscal year ended October 31, 2006, Sim had a net income of $100,000 and de-
clared and paid dividends of $40,000. Thus, because consolidated goodwill was unim-
paired as of October 31, 2006, the balance of Pun’s Investment in Sim Company
Common Stock ledger account under the equity method of accounting on October 31,
2006, was $1,008,000, computed as follows:

Cost of 8,000 shares acquired Oct. 31, 2005 $ 960,000

Add: Share of net income ($100,000 0.80) 80,000
Subtotal $1,040,000
Less: Share of dividends ($40,000 0.80) 32,000
Balance, Oct. 31, 2006 $1,008,000

2. The after-closing balance of Pun’s Retained Earnings of Subsidiary ledger account on

October 31, 2006, was $48,000 ($80,000 $32,000).
3. On November 1, 2006, at Pun’s direction, Sim paid $170,000 (the current fair value) to
a dissident minority stockholder for 1,000 shares of Sim’s outstanding common stock,
preparing the following journal entry:

Treasury Stock (1,000 $170) 170,000

Cash 170,000
To record acquisition of 1,000 shares of outstanding common
stock from a minority stockholder for the treasury.

The current fair values of Sim’s identifiable net assets were the same as their carrying
amounts on November 1, 2006.
Instructions
Prepare working paper eliminations (in journal entry format) for Pun Corporation and sub-
sidiary on November 1, 2006, to account for Sim Company’s treasury stock as though it had
been retired and to eliminate the intercompany investment and equity accounts of the sub-
sidiary. Disregard Sim’s operations for November 1, 2006, and disregard income taxes.
(Problem 10.6) Separate and consolidated financial statements of Peterson Corporation and its wholly owned
subsidiary, Swanson Company, for the fiscal year ended May 31, 2007, are on page 469.
The two companies used intercompany ledger accounts only for receivables and payables.
 Chapter 10 Consolidated Financial Statements: Special Problems 469

PETERSON CORPORATION AND SUBSIDIARY

Separate and Consolidated Financial Statements
For Year Ended May 31, 2007

Peterson Swanson
Corporation Company Consolidated
Income Statements
Revenue:
Net sales $10,000,000 $4,600,000 $12,900,000
Other revenue 270,000 20,000 37,000
Total revenue $10,270,000 $4,620,000 $12,937,000
Costs and expenses:
Cost of goods sold $ 6,700,000 $3,082,000 $ 8,085,300
Operating expenses and income
taxes expense 2,918,750 1,288,000 4,206,750
Total costs and expenses $ 9,618,750 $4,370,000 $12,292,050
Net income $ 651,250 $ 250,000 $ 644,950

Statements of Retained Earnings

Retained earnings, beginning of year $ 2,421,250 $ 825,000 $ 2,530,550
Add: Net income 651,250 250,000 644,950
Subtotals $ 3,072,500 $1,075,000 $ 3,175,500
Less: Dividends 300,000 175,000 297,000
Retained earnings, end of year $ 2,772,500 $ 900,000 $ 2,878,500

Balance Sheets
Assets
Intercompany receivables (payable) $ 520,000 $ (520,000)
Short-term investments* 400,000 150,000 $ 530,000
Inventories 1,100,000 610,000 1,693,500
Investment in Swanson Company
common stock 1,100,000
Other assets 2,800,000 1,370,000 4,170,000
Goodwill 50,000
Total assets $ 5,920,000 $1,610,000 $ 6,443,500

Liabilities and Stockholders’ Equity

Liabilities $ 2,075,000 $ 560,000 $ 2,635,000
Common stock, $10 par 1,000,000 150,000 1,000,000
Retained earnings 2,772,500 900,000 2,878,500
Retained earnings of subsidiary 122,500
Treasury stock (50,000) (70,000)
Total liabilities and stockholders’ equity $ 5,920,000 $1,610,000 $ 6,443,500

*Fair values same as carrying amounts

Additional Information
1. All of Swanson’s identifiable net assets were fairly valued at their carrying amounts
on May 31, 2005–the date of the Peterson–Swanson business combination. Thus, the
$50,000 excess of Peterson’s investment in Swanson over the carrying amounts of
Swanson’s identifiable net assets was attributable to goodwill, which was unimpaired as
of May 31, 2007.
470 Part Two Business Combinations and Consolidated Financial Statements

2. During the year ended May 31, 2007, Peterson sold merchandise to Swanson at
Peterson’s regular markup.
3. Swanson had acquired 1,000 shares of Peterson’s common stock on June 10, 2006, and
Peterson had acquired its treasury stock on May 26, 2007.
Instructions
Reconstruct the working paper eliminations (in journal entry format) for Peterson Corpo-
ration and subsidiary on May 31, 2007. (Disregard income taxes; omit explanations for
eliminations.)
(Problem 10.7) Separate financial statements of Pomerania Corporation and its two subsidiaries for the year
ended December 31, 2005, are as follows:

CHECK FIGURES
POMERANIA CORPORATION AND SUBSIDIARIES
a. Credit intercompany
Separate Financial Statements
investment income,
For Year Ended December 31, 2005
$11,600;
b. Consolidated net Pomerania Slovakia Sylvania
income, $110,960; Corporation Company Company
consolidated ending
Income Statements
retained earnings,
Revenue
$215,160; minority
Net sales $1,120,000 $900,000 $700,000
interest in net assets,
$232,240. Intercompany sales 140,000
Intercompany investment income 44,000
Total revenue $1,304,000 $900,000 $700,000
Cost and expenses:
Cost of goods sold $ 800,000 $650,000 $550,000
Intercompany cost of goods sold 100,000
Operating expenses and income taxes
expense 300,000 150,000 130,000
Total costs and expenses $1,200,000 $800,000 $680,000
Net income $ 104,000 $100,000 $ 20,000

Statements of Retained Earnings

Retained earnings, beginning of year $ 126,200 $107,000 $100,000
Add: Net income 104,000 100,000 20,000
Subtotals $ 230,200 $207,000 $120,000
Less: Dividends 22,000 75,000
Retained earnings, end of year $ 208,200 $132,000 $120,000

Balance Sheets
Assets
Intercompany receivables (payables) $ 63,400 $ (41,000) $ (22,400)
Inventories 290,000 90,000 115,000
Investment in Slovakia Company
common stock 305,600
Investment in Slovakia Company bonds 20,800
Investment in Sylvania Company
preferred stock 7,000
Investment in Sylvania Company
common stock 196,000
Other assets 836,400 555,000 510,000
Total assets $1,719,200 $604,000 $602,600

(continued)
 Chapter 10 Consolidated Financial Statements: Special Problems 471

POMERANIA CORPORATION AND SUBSIDIARIES

Separate Financial Statements (concluded)
For Year Ended December 31, 2005

Pomerania Slovakia Sylvania

Corporation Company Company
Liabilities and Stockholders’ Equity
Dividends payable $ 22,000 $ 6,000
Bonds payable 285,000 125,000 $125,000
Intercompany bonds payable 25,000
Discount on bonds payable (8,000) (10,000)
Discount on intercompany bonds payable (2,000)
Other liabilities 212,000 78,000 107,600
Preferred stock, $20 par 400,000 50,000
Common stock, $10 par 600,000 250,000 200,000
Retained earnings 208,200 132,000 120,000
Total liabilities and stockholders’ equity $1,719,200 $604,000 $602,600

Additional Information
1. Pomerania Corporation’s Investment in Slovakia Company Common Stock ledger ac-
count is shown below:

Investments in Slovakia Company Common Stock

Date Explanation Debit Credit Balance
2005
Jan. 2 Cost of 5,000 shares 71,400 71,400 dr
June 30 20% of dividend declared 9,000 62,400 dr
30 20% of net income for
Jan. 2–June 30 12,000 74,400 dr
July 1 Cost of 15,000 shares 223,200 297,600 dr
Dec. 31 80% of dividend declared 24,000 273,600 dr
31 80% of net income for
July 1–Dec. 31 32,000 305,600 dr

2. The accountant for Pomerania made no equity-method journal entries for Pomerania’s
investments in Sylvania’s preferred stock and common stock. Pomerania had acquired
250 shares of Sylvania’s fully participating noncumulative preferred stock for $7,000
and 14,000 shares of Sylvania’s common stock for $196,000 on January 2, 2005. Out-
of-pocket costs of the business combination may be disregarded.
3. Sylvania’s December 31, 2005, inventories included $22,400 of merchandise purchased
from Pomerania for which no payment had been made.
4. Pomerania had acquired in the open market twenty-five $1,000 face amount 6% bonds
of Slovakia for $20,800 on December 31, 2005. The bonds had a December 31 interest
payment date, and a maturity date of December 31, 2007.
5. Slovakia owed Pomerania $17,000 on December 31, 2005, for a non-interest-bearing
cash advance.
472 Part Two Business Combinations and Consolidated Financial Statements

Instructions
a. Prepare adjusting entries for Pomerania Corporation on December 31, 2005, to account
for the investments in Sylvania Company preferred stock and common stock under the
equity method. (Disregard income taxes.)
b. Prepare a working paper for consolidated financial statements and related working pa-
per eliminations (in journal entry format) for Pomerania Corporation and subsidiaries
on December 31, 2005. (Disregard income taxes.)
(Problem 10.8) Plover Corporation acquired for $151,000, including direct out-of-pocket costs of the busi-
ness combination, 100% of the common stock and 20% of the preferred stock of Starling
CHECK FIGURES Company on June 30, 2005. On that date, Starling’s retained earnings balance was $41,000.
c. Consolidated net The current fair values of Starling’s identifiable assets and liabilities and preferred stock
income, $144,525; were the same as their carrying amounts on June 30, 2005.
consolidated ending The separate financial statements of Plover and Starling for the fiscal year ended
retained earnings, December 31, 2006, are as follows:
$292,336; minority
interest in net assets,
$40,000. PLOVER CORPORATION AND SUBSIDIARY
Separate Financial Statements
For Year Ended December 31, 2006

Plover Starling
Corporation Company
Income Statements
Revenue:
Net sales $1,562,000
Intercompany sales 238,000
Contract revenue $1,210,000
Intercompany contract revenue 79,000
Interest revenue 19,149
Intercompany investment income 42,500
Intercompany dividend revenue 500
Intercompany gain on sale of land 4,000
Intercompany interest revenue (expense) 851 (851)
Total revenue $1,867,000 $1,288,149
Costs and expenses:
Cost of goods sold $ 942,500
Intercompany cost of goods sold 212,500
Cost of contract revenue $ 789,500
Intercompany cost of contract revenue 62,500
Operating expenses and income taxes expense 497,000 360,000
Interest expense 49,000 31,149
Total costs and expenses $1,701,000 $1,243,149
Net income $ 166,000 $ 45,000

Statements of Retained Earnings

Retained earnings, beginning of year $ 139,311 $ 49,500
Add: Net income 166,000 45,000
Subtotals $ 305,311 $ 94,500
Less: Dividends 2,500
Retained earnings, end of year $ 305,311 $ 92,000

(continued)
 Chapter 10 Consolidated Financial Statements: Special Problems 473

PLOVER CORPORATION AND SUBSIDIARY

Separate Financial Statements (concluded)
For Year Ended December 31, 2006

Plover Starling
Corporation Company
Balance Sheets
Assets
Intercompany receivables (payables) $ 35,811 $ 21,189
Costs and estimated earnings in excess of billings on
uncompleted contracts 30,100
Inventories 217,000 117,500
Investment in Starling Company preferred and
common stock 202,000
Land 34,000 42,000
Other plant assets (net) 717,000 408,000
Other assets 153,000 84,211
Total assets $1,358,811 $703,000

Liabilities and Stockholders’ Equity

Dividends payable $ 2,000
Mortgage notes payable $ 592,000 389,000
Other liabilities 203,000 70,000
5% noncumulative, nonparticipating preferred stock,
$1 par 50,000
Common stock, no par or stated value 250,000 100,000
Retained earnings 305,311 92,000
Retained earnings of subsidiary 8,500
Total liabilities and stockholders’ equity $1,358,811 $703,000

Transactions between Plover and Starling during the fiscal year ended December 31, 2006,
were as follows:
1. On January 2, 2006, Plover sold land with an $11,000 carrying amount to Starling for
$15,000. Starling made a $3,000 down payment and signed an 8% mortgage note pay-
able in 12 equal quarterly payments of $1,135, including interest, beginning March 31,
2006. 8% was a fair interest rate.
2. Starling produced equipment for Plover under two separate construction-type contracts.
The first contract, which was for office equipment, was begun and completed during
Year 2006 at a cost to Starling of $17,500. Plover paid $22,000 cash for the equipment
on April 17, 2006. The second contract was begun on February 15, 2006, but will not be
completed until May 2007. Starling had incurred $45,000 costs under the second con-
tract as of December 31, 2006, and anticipated additional costs of $30,000 to complete
the $95,000 contract. Starling accounts for all construction-type contracts under the
percentage-of-completion method of accounting. Plover had made no journal entry in its
accounting records for the uncompleted contract as of December 31, 2006. Plover
depreciates all its equipment by the straight-line method over a 10-year estimated eco-
nomic life with no residual value, takes a half year’s depreciation in the year of acquisi-
tion of plant assets, and includes depreciation in operating expenses.
474 Part Two Business Combinations and Consolidated Financial Statements

3. On December 1, 2006, Starling declared a 5% cash dividend on its preferred stock,

payable January 15, 2007, to stockholders of record December 14, 2006.
4. Plover sold merchandise to Starling at an average markup of 12% of cost. During the
year, Plover billed Starling $238,000 for merchandise shipped, for which Starling had
paid $211,000 by December 31, 2006. Starling had $11,200 (at billed price) of this mer-
chandise on hand on December 31, 2006.

Instructions
a. Prepare an analysis of the Intercompany Receivables (Payables) ledger accounts of the
affiliates on December 31, 2006.
b. Prepare the adjusting entry or entries for December 31, 2006, based on your analysis
in (a) above.
c. Prepare a working paper for consolidated financial statements and related working paper
eliminations (in journal entry format) for Plover Corporation and subsidiary for the year
ended December 31, 2006. Round all computations to the nearest dollar. The working
paper should reflect the adjusting entries in (b). (Disregard income taxes.)
(Problem 10.9) On February 1, 2005, Pullard Corporation acquired all the outstanding common stock of
Staley Company for $5,850,000, including direct out-of-pocket costs of the business com-
CHECK FIGURES bination, and 20% of Staley’s preferred stock for $150,000. On the date of the combination,
Consolidated net the carrying amounts and current fair values of Staley’s identifiable assets and liabilities
income, $2,848,450; were as shown below:
consolidated ending
retained earnings,
$15,531,950; minority
interest in net assets, STALEY COMPANY
$600,000. Identifiable Assets and Liabilities
February 1, 2005

Carrying Current
Amounts Fair Values
Cash $ 200,000 $ 200,000
Notes receivable 85,000 85,000
Trade accounts receivable (net) 980,000 980,000
Inventories 828,000 700,000
Land 1,560,000 2,100,000
Other plant assets 7,850,000 10,600,000
Accumulated depreciation (3,250,000) (4,000,000)
Other assets 140,000 50,000
Total assets $8,393,000 $10,715,000
Notes payable $ 115,000 $115,000
Trade accounts payable 400,000 400,000
7% bonds payable 5,000,000 5,000,000
Total liabilities $5,515,000 $ 5,515,000
Preferred stock, noncumulative, nonparticipating,
$5 par and call price per share; authorized, issued,
and outstanding 150,000 shares $ 750,000
Common stock, $10 par; authorized, issued, and
outstanding 100,000 shares 1,000,000
Additional paid-in capital—common stock 122,000
Retained earnings 1,006,000
Total stockholders’ equity $2,878,000
Total liabilities and stockholders’ equity $8,393,000
 Chapter 10 Consolidated Financial Statements: Special Problems 475

Separate financial statements of Pullard and Staley for the period ended October 31,
2005, are as follows:

PULLARD CORPORATION AND STALEY COMPANY

Separate Financial Statements
For Period Ended October 31, 2005

Pullard Staley
Corporation Company
(year ended (9 months
10/31/05) ended 10/31/05)
Income Statements
Revenue:
Net sales $18,042,000 $ 5,530,000
Intercompany sales 158,000 230,000
Intercompany investment income 505,150
Interest revenue 26,250 1,700
Intercompany interest revenue 78,750
Total revenue $18,810,150 $ 5,761,700
Costs and expenses:
Cost of goods sold $10,442,000 $ 3,010,500
Intercompany cost of goods sold 158,000 149,500
Depreciation expense 1,103,000 588,750
Operating expenses and income taxes expense 3,448,500 1,063,900
Interest expense 806,000 190,650
Intercompany interest expense 78,750
Total costs and expenses $15,957,500 $ 5,082,050
Net income $ 2,852,650 $ 679,650

Statements of Retained Earnings

Retained earnings, beginning of period $12,683,500 $ 1,006,000
Add: Net income 2,852,650 679,650
Retained earnings, end of period $15,536,150 $ 1,685,650

Balance Sheets
Assets
Cash $ 822,000 $ 530,000
Notes receivable 85,000
Trade accounts receivable (net) 2,723,700 1,346,400
Intercompany receivables 12,300
Inventories 3,204,000 1,182,000
Investment in Staley Company common stock 6,355,150
Investment in Staley Company preferred stock 150,000
Investment in Staley Company bonds 1,500,000
Land 4,000,000 1,560,000
Other plant assets 17,161,000 7,850,000
Accumulated depreciation (6,673,000) (3,838,750)
Other assets 263,000 140,000
Total assets $29,518,150 $ 8,854,650

(continued)
476 Part Two Business Combinations and Consolidated Financial Statements

PULLARD CORPORATION AND STALEY COMPANY

Separate Financial Statements (concluded)
For Period Ended October 31, 2005

Pullard Staley
Corporation Company
(year ended (9 months
10/31/05) ended 10/31/05)
Liabilities and Stockholders’ Equity
Notes payable $ 115,000
Trade accounts payable $ 1,342,000 169,700
Intercompany payables 12,300
7% bonds payable 3,500,000
Intercompany 7% bonds payable 1,500,000
Long-term debt 10,000,000
Preferred stock, $5 par 750,000
Common stock, $10 par 2,400,000 1,000,000
Additional paid-in capital 240,000 122,000
Retained earnings 15,536,150 1,685,650
Total liabilities and stockholders’ equity $29,518,150 $8,854,650

By the fiscal year-end, October 31, 2005, the following transactions and events had
taken place:
1. The balance of Staley’s net trade accounts receivable on February 1, 2005, had been
collected.
2. Staley’s inventories on February 1, 2005, had been debited to cost of goods sold under
the perpetual inventory system.
3. Prior to February 1, 2003, Pullard had acquired in the open market, at face amount,
$1,500,000 of Staley’s 7% bonds payable. The bonds mature on August 31, 2011, with
interest payable annually each August 31.
4. As of February 1, 2005, Staley’s other plant assets had a composite remaining economic
life of six years. Staley used the straight-line method of depreciation, with no residual
value. Staley’s depreciation expense for the nine months ended October 31, 2005, was
based on the former depreciation rates in effect prior to the business combination.
5. The other assets consist entirely of long-term investments in held-to-maturity debt se-
curities made by Staley and do not include any investment in Pullard.
6. During the nine months ended October 31, 2005, the following intercompany sales of
merchandise had occurred:

Pullard Staley
to Staley to Pullard
Net sales $158,000 $230,000
Included in purchaser’s inventories, Oct. 31, 2005 36,000 12,000
Balance unpaid, Oct. 31, 2005 16,800 22,000
 Chapter 10 Consolidated Financial Statements: Special Problems 477

Pullard sold merchandise to Staley at cost. Staley sold merchandise to Pullard at selling
prices that included a gross profit margin of 35%. There had been no intercompany sales
prior to February 1, 2005.
7. Neither company had declared dividends during the period covered by the separate
financial statements.
8. Staley’s goodwill recognized in the business combination was $1,400,000. The goodwill
was 3.75% impaired as of October 31, 2005.
9. The $505,150 balance of Pullard’s Intercompany Investment Income ledger account is
computed as follows:

Net income of Staley for nine months ended Oct. 31, 2005 $679,650
Less: Amortization and adjustment of differences between
current fair values and carrying amounts of Staley’s
identifiable net assets on Feb. 1, 2005:
Inventories—to cost of goods sold $(128,000)
Other plant assets—depreciation {[($6,600,000
$4,600,000) 6] 3⁄4} 250,000
Goodwill—impairment loss ($1,400,000 0.0375) 52,500 174,500
Balance, Oct. 31, 2005 $505,150

Instructions
Prepare a working paper for consolidated financial statements and related working paper
eliminations (in journal entry format) for Pullard Corporation and subsidiary on October
31, 2005. Round all amounts to the nearest dollar. (Disregard income taxes.)
Chapter Eleven

International
Accounting Standards;
Accounting for Foreign
Currency Transactions

Scope of Chapter
In 2002, the Financial Accounting Standards Board joined with the International Account-
ing Standards Board in a short-term convergence project whose goal was to compare the
two boards’ existing standards and conform the two sets of standards into the higher-quality
solution.1 In 2003, the FASB reported that it had issued four exposure drafts (dealing with
voluntary changes in accounting policy, calculation of earnings per share, recognition of
gains and losses on asset exchanges, and expensing of abnormal amounts of idle capacity
and spoilange costs) as part of that convergence project, with another exposure draft deal-
ing with the balance sheet classification of certain liabilities to be issued shortly thereafter.2
These actions by the FASB and the IASB are clear evidence of the pressing need for a
single set of generally accepted accounting principles to be used by business enterprises
internationally. For example, the SEC’s Division of Corporate Finance has observed that
more than 1,300 companies from 58 countries have registered their securities with the
SEC.3 Further, nearly 21 percent of the investments of the College Retirement Equities
Fund Stock Account, a major pension fund in the United States, are in the stocks of com-
panies in 28 foreign countries.4
This chapter first discusses the work of the International Accounting Standards Board
(IASB) and, later, describes and illustrates accounting for a multinational enterprise’s busi-
ness transactions denominated in a foreign currency.

1
The CPA Letter, American Institute of Certified Public Accountants (New York, February 2004), p. 6.
2
Ibid.; The FASB Report (Norwalk, January 30, 2004), p. 9.
3
PCAOB (Public Company Accounting Oversight Board) Reporter, Commerce Clearing House
(Washington, March 1, 2004), p. 2.
4
2003 Annual Report of College Retirement Equities Fund, p. ST-3.

478
 Chapter 11 International Accounting Standards; Accounting for Foreign Currency Transactions 479

INTERNATIONAL ACCOUNTING STANDARDS BOARD

The IASB, headquartered in London, began operations in 2001 under the guidance of the
International Accounting Standards Committee Foundation. With 12 full-time and 2 part-
time members, the IASB issues International Financial Reporting Standards, the first of
which comprised the International Accounting Standards (IASs) that had been issued by
a predecessor committee. For convenience, the remainder of this chapter refers to indivi-
dual IASs.
The IASB promotes the use of IASs in countries of the world; it has no authority to
mandate their use.
Through 2001 the IASB or its predecessor committee issued or revised 41 IASs, deal-
ing with such accounting issues as consolidated financial statements, depreciation, segment
reporting, leases, revenue recognition, business combinations, and related-party disclo-
sures. To promote adoption of the Standards, the IASB had in the past accommodated al-
ternative accounting treatments in several of its pronouncements. However, in 1993 the
IASB revised 11 of its previously issued standards to eliminate some accounting alterna-
tives completely and to establish benchmark, or preferred, accounting treatments with per-
missible alternatives. For example, International Accounting Standard (IAS) 2, “Inventories,”
designates first-in, first-out or weighted average as benchmark methods of applying in-
ventory cost flows; in addition, last-in, first-out is an allowed alternative treatment for
inventory cost flows, provided a reconciliation of last-in, first-out inventories to average
or first-in, first-out cost is included.
Among the International Accounting Standards issued by the IASB are four that deal
with topics covered elsewhere in this book: joint ventures, business combinations, consol-
idated financial statements, and influenced investees. A fifth standard dealing with changes
in foreign exchange rates is dealt with elsewhere in this chapter and in Chapter 12. The fol-
lowing section draws on AICPA Professional Standards, “International Volume,” as of
June 1, 2003, to describe briefly the four standards listed above.

IAS 31, “Financial Reporting of Interests in Joint Ventures”

In this pronouncement, the IASB permitted either the proportionate consolidation method
(proportionate share method in Chapter 3, pages 99–100) or the equity method for a ven-
turer’s investment in a jointly controlled entity, which might be a corporation or a partner-
ship. As pointed out in Chapter 3, U.S. accounting standards require the equity method of
accounting for investments in corporate joint ventures but permit either the equity method
or the proportionate share method of accounting for investments in unincorporated joint
ventures.

IFRS 3, “Business Combinations”

The IASB required purchase-type accounting for all business combinations in Interna-
tional Financial Reporting Standard No. 3, issued in March 2004. In so doing, the
IASB forbade use of a previously sanctioned accounting technique for certain business
combinations termed uniting of interests combinations. Further, the IASB requires that
goodwill, recognized in business combinations be tested periodically for potential im-
pairment losses. Thus, the IASB standards are the same as those of the FASB, as de-
scribed in Chapter 5.
480 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

IAS 27, “Consolidated Financial Statements and Accounting

for Investments in Subsidiaries”
Among the provisions of IAS 27 are the following:
1. Consolidation policy is based on control rather than solely on ownership (see Chapter 6,
pages 208–211).
2. Intercompany transactions, profits or gains, and losses are eliminated in full, regardless
of an existing minority interest.
3. The minority interest in net income of subsidiary is displayed separately in the consoli-
dated income statement. The minority interest in net assets of subsidiary is displayed
separately from liabilities and stockholders’ equity in the consolidated balance sheet.
Thus, the IASB rejected both the parent company concept and the economic unit con-
cept (see Chapter 6, pages 228–229).
4. In the unconsolidated financial statements of a parent company, investments in sub-
sidiaries that are included in the consolidated statements may be accounted for by either
the equity method, as required by the SEC (see Chapter 7, page 292), or the cost method.

IAS 28, “Accounting for Investments in Associates”

Apart from using the term associate for an influenced investee, as that U.S. terminology is
applied (see Chapter 9, page 401), the provisions of IAS 28 resemble those of APB Opin-
ion No. 18, “The Equity Method of Accounting for Investments in Common Stock.”

ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS

In most countries, a foreign country’s currency is treated as though it were a commodity, or
a money-market instrument. In the United States, for example, foreign currencies are
bought and sold by the international banking departments of commercial banks. These for-
eign currency transactions are entered into on behalf of the banks’ multinational enterprise
customers, and for the banks’ own account.
The buying and selling of foreign currencies as though they were commodities result in
variations in the exchange rate between the currencies of two countries. For example, a
daily newspaper might quote exchange rates for the British pound (£) as follows, based on
the prior day’s transactions in the pound:

Foreign Currency Dollars in

in Dollars Foreign Currency
Britain (pound) 1.6065 0.6225

The first column indicates that £1 could be exchanged for approximately $1.61; the second
column indicates that $1 could be exchanged for approximately £0.62. Note that the two
exchange rates are reciprocals (1 1.6065 0.6225).
The exchange rate illustrated above is the selling spot rate charged by the bank for cur-
rent sales of the foreign currency. The bank’s buying spot rate for the currency typically is
less than the selling spot rate; the agio (or spread) between the selling and buying spot rates
represents gross profit to a trader in foreign currency. In addition to spot rates, there are for-
ward rates, which apply to foreign currency transactions to be consummated on a future
date. Forward rates apply to forward contracts, which are derivative instruments discussed
in a subsequent section of this chapter.
 Chapter 11 International Accounting Standards; Accounting for Foreign Currency Transactions 481

To illustrate the application of exchange rates, assume that a U.S. business enterprise
required £10,000 (10,000 British pounds) to pay for merchandise acquired from a British
supplier. At the $1.6065 selling spot rate, the U.S. multinational enterprise would pay
$16,065 (£10,000 $1.6065 $16,065) for the 10,000 British pounds.
Factors influencing fluctuations in exchange rates include a nation’s balance of payments
surplus or deficit, differing global rates of inflation, money-market variations (such as in-
terest rates) in individual countries, capital investments levels, and monetary actions of cen-
tral banks of various nations.

FASB Statements No. 52 and No. 133

In December 1981, the FASB issued FASB Statement No. 52, “Foreign Currency Transla-
tion,” in which it established accounting standards for matters involving foreign currencies,
and in 1998 it issued FASB Statement No. 133, “Accounting for Derivative Instruments
and Hedging Activities.” The accounting standards established by the FASB for foreign cur-
rency transactions such as purchases and sales of merchandise, loans, and related derivative
instruments are discussed in the following sections.

Transactions Involving Foreign Currencies

A multinational (or transnational) enterprise is a business enterprise that carries on oper-
ations in more than one nation, through a network of branches, divisions, influenced in-
vestees, joint ventures, and subsidiaries. Multinational enterprises obtain material and
capital in countries where such resources are plentiful. Multinational enterprises manufac-
ture their products in nations where wages and other operating costs are low, and they sell
their products in countries that provide profitable markets. Many of the largest multina-
tional enterprises are headquartered in the United States.
A multinational enterprise headquartered in the United States engages in sales, pur-
chases, and loans with independent foreign enterprises as well as with its branches, divi-
sions, influenced investees, or subsidiaries in other countries. If the transactions with
independent foreign enterprises are denominated (or expressed) in terms of the U.S. dollar,
no accounting problems arise for the U.S. multinational enterprise. The sale, purchase, or
loan transaction is recorded in dollars in the accounting records of the U.S. enterprise; the
independent foreign enterprise must obtain or dispose of the dollars necessary to complete
the transaction through the foreign exchange department of its bank.
Often, however, the transactions described above are negotiated and settled in terms of
the foreign enterprise’s local currency unit (LCU). In such circumstances, the U.S. enter-
prise must account for the transaction denominated in foreign currency in terms of U.S.
dollars. This accounting, described as foreign currency translation, is accomplished by ap-
plying the appropriate exchange rate between the foreign currency and the U.S. dollar.

Purchase of Merchandise from a Foreign Supplier

To illustrate a purchase of merchandise from a foreign supplier, assume that on April 18,
2005, Worldwide Corporation purchased merchandise from a German supplier at a cost of
100,000 euros, the common currency of most member countries of the European Union.
The April 18, 2005, selling spot rate was –C1 $1.05.5 Because Worldwide was a customer
of good credit standing, the German supplier made the sale on 30-day open account.

5
Exchange rates fluctuate significantly over time; thus, the exchange rates illustrated in this chapter may
differ significantly from current exchange rates.
482 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

Assuming that Worldwide uses the perpetual inventory system, it records the April 18,
2005, purchase as follows:

Journal Entry for Inventories 105,000

Purchase of Trade Accounts Payable 105,000
Merchandise from To record purchase on 30-day open account from German supplier for
German Supplier, –C100,000, translated at selling spot rate of –C1 $1.05
Payment to Be Made – 100,000 $1.05 $105,000).
(C
in Euros

The selling spot was used in the journal entry, because it was the rate at which the lia-
bility to the German supplier could have been settled on April 18, 2005.

Foreign Currency Transaction Gains and Losses

During the period that the trade account payable to the German supplier remains unpaid, the
selling spot rate for the euro may change. If the selling spot rate decreases (the euro weakens
against the dollar), Worldwide will realize a foreign currency transaction gain; if the selling
spot rate increases (the euro strengthens against the dollar), Worldwide will incur a foreign
currency transaction loss. Foreign currency transaction gains and losses are included in the
measurement of net income for the accounting period in which the spot rate changes.6
To illustrate, assume that on April 30, 2005, the selling spot rate for the euro was –C1
$1.04 and Worldwide prepares financial statements monthly. The accountant for Worldwide
records the following journal entry with respect to the trade account payable to the German
supplier:

Journal Entry to Trade Accounts Payable 1,000

Recognize Foreign Foreign Currency Transaction Gains 1,000
Currency Transaction To recognize foreign currency transaction gain applicable to April 18, 2005,
Gain on Date Financial purchase from German supplier, as follows:
Statements are Liability recorded on Apr. 18, 2005 $105,000
Prepared Less: Liability translated at Apr. 30, 2005, selling spot rate:
–C1 $1.04 (C – 100,000 $1.04 $104,000) 104,000
Foreign currency transaction gain $ 1,000

Assume further that the selling spot rate on May 18, 2005, was –C1 $1.02. The May 18,
2005, journal entry for Worldwide’s payment of the liability to the German supplier is
shown below:

Journal Entry for Trade Accounts Payable 104,000

Payment of Liability Foreign Currency Transaction Gains 2,000
to German Supplier Cash 102,000
Denominated in the To record payment for –C100,000 draft to settle liability to German
Euro – 100,000 $1.02
supplier, and recognition of transaction gain (C
$102,000).

Two-Transaction Perspective and One-Transaction Perspective

The journal entries above reflect the two-transaction perspective for interpreting a foreign
trade transaction. Under this concept, which was sanctioned by the FASB in FASB
Statement No. 52, Worldwide’s dealings with the German supplier essentially were two

6
FASB Statement No. 52, “Foreign Currency Translation” (Stamford: FASB, 1981), par. 15.
 Chapter 11 International Accounting Standards; Accounting for Foreign Currency Transactions 483

separate transactions. One transaction was the purchase of the merchandise; the second
transaction was the acquisition of the foreign currency required to pay the liability for the
merchandise purchased. Supporters of the two-transaction perspective argue that an im-
porter’s or exporter’s assumption of a risk of fluctuations in the exchange rate for a foreign
currency is a financing decision, not a merchandising decision.
Advocates of an opposing viewpoint, the one-transaction perspective, maintain that
Worldwide’s total foreign currency transaction gain of $3,000 ($1,000 $2,000) on its
purchase from the German supplier should be applied to reduce the cost of the merchandise
purchased. Under this approach, Worldwide would not prepare a journal entry on April 30,
2005, but would prepare the following journal entry on May 18, 2005 (assuming that all the
merchandise purchased on April 18 had been sold by May 18):

Journal Entry under Trade Accounts Payable 105,000

One-Transaction Cost of Goods Sold 3,000
Perspective Cash 102,000
To record payment for –C100,000 (C – 100,000 $1.02 $102,000) to
settle liability to German supplier, and offset of resultant transaction
gain against cost of goods sold.

In effect, supporters of the one-transaction perspective for foreign trade activities con-
sider the original amount recorded for a foreign merchandise purchase as an estimate, sub-
ject to adjustment when the exact cash outlay required for the purchase is known. Thus, the
one-transaction proponents emphasize the cash-payment aspect, rather than the bargained-
price aspect, of the transaction.
The author concurs with the FASB’s support for the two-transaction perspective for foreign
trade transactions and for loans receivable and payable denominated in a foreign currency.
The separability of the merchandising and financing aspects of a foreign trade transaction is
an undeniable fact. In delaying payment of a foreign trade purchase transaction, an importer
has made a decision to assume the risk of exchange rate fluctuations. This risk assumption is
measured by the foreign currency transaction gain or loss recorded at the time of payment for
the purchase of merchandise (or on the dates of intervening financial statements).

Sale of Merchandise to a Foreign Customer

Assume that on May 17, 2005, Worldwide Corporation, which uses the perpetual inventory
system, sold merchandise acquired from a U.S. supplier for $12,000 to a French customer
for –C15,000, with payment due June 16, 2005. On May 17, 2005, the buying spot rate for the
euro was –C1 $1.01. Worldwide prepares the following journal entries on May 17, 2005:

Journal Entries for Trade Accounts Receivable 15,150

Sale of Merchandise Sales 15,150
to French Customer, To record sale on 30-day open account to French customer for –C15,000,
Payment to Be translated at buying spot rate of –C1 $1.01 (C
– 15,000 $1.01
Received in Euros $15,150).

Cost of Goods Sold 12,000

Inventories 12,000
To record cost of merchandise sold to French customer.

Assuming that the buying spot rate for the euro was –C1 $0.99 (the euro weakened
against the dollar) on May 31, 2005, when Worldwide prepared its customary monthly
financial statements, the following journal entry is appropriate:
484 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

Journal Entry to Foreign Currency Transaction Losses 300

Record Foreign Trade Accounts Receivable 300
Currency Transaction To recognize transaction loss applicable to May 17, 2002, sale to French
Loss on Date Financial customer as follows:
Statements Are Asset recorded on May 17, 2005 $15,150
Prepared Less: Asset translated at May 31, 2005, buying spot rate:
–C1 $0.99 (–C15,000 $0.99 $14,850) 14,850
Foreign currency transaction loss $ 300

If on June 16, 2005, the date when Worldwide received a draft for –C 15,000 from the
French customer, the euro had strengthened against the dollar to a buying spot rate of
–C1 $0.995, Worldwide’s journal entry would be as follows:

Journal Entry for Cash 14,925

Receipt from Trade Accounts Receivable 14,850
French Customer Foreign Currency Transaction Gains 75
Denominated in the To record receipt and conversion to dollars of –C15,000 draft in
Euro payment of receivable from French customer, and recognition of
– 15,000 $0.995 $14,925).
foreign currency transaction gain (C

Loan Payable Denominated in a Foreign Currency

If a U.S. multinational enterprise elects to borrow a foreign currency to pay for merchan-
dise acquired from a foreign supplier, the following journal entries would be illustrative
(Sfr is the symbol for the Swiss franc):

Journal Entries for 2005

Loan Payable in Apr. 30 Inventories 69,000
a Foreign Currency Trade Accounts Payable 69,000
To record purchase from Swiss supplier for Sfr100,000,
translated at selling spot rate of Sfr1 $0.69
(Sfr100,000 $0.69 $69,000).

30 Trade Accounts Payable 69,000

Notes Payable 69,000
To record borrowing of Sfr100,000 from bank on 30-day, 6%
loan to be repaid in Swiss francs, and payment of liability to
Swiss supplier.

May 30 Notes Payable 69,000

Interest Expense ($69,000 0.06 30 360) 345
Foreign Currency Transaction Losses 201
Cash 69,546
To record payment for Sfr100,500 draft to settle Sfr100,000,
30-day, 6% note, together with Sfr500 interest
(Sfr100,000 0.06 30 360 Sfr500) at selling spot rate
of Sfr1 $0.692(Sfr100,500 0.692 $69,546), and
recognition of foreign currency transaction loss.
 Chapter 11 International Accounting Standards; Accounting for Foreign Currency Transactions 485

Loan Receivable Denominated in a Foreign Currency

A U.S. multinational enterprise’s receipt of a promissory note denominated in a foreign cur-
rency might be illustrated by the following journal entries:

Journal Entries for 2005

Loan Receivable in a May 31 Notes Receivable 980,000
Foreign Currency Sales 980,000
To record sale to Belgian customer for 60-day, 9%
promissory note for –C1,000,000, translated at
buying spot rate of –C1 $0.98 (C– 1,000,000
$0.98 $980,000).

31 Cost of Goods Sold 820,000

Inventories 820,000
To record cost of merchandise sold to Belgian customer.

June 30 Notes Receivable 30,000

Interest Receivable ($1,010,000 0.09 30 360) 7,575
Interest Revenue 7,575
Foreign Currency Transaction Gains 30,000
To recognize foreign currency transaction gain applicable
to May 31, 2005, sale to Belgian customer and to
accrue interest on note receivable from the customer,
valued at the buying spot rate of –C1 $1.01.
Transaction gain is computed as follows:
Receivable translated at June 30, 2005
– 1,000,000 $1.01)
buying spot rate (C $1,010,000
Receivable recorded on May 31, 2005 980,000
Transaction gain $ 30,000

July 30 Cash (C– 1,015,000 $0.99) 1,004,850

Foreign Currency Transaction Losses 20,150
Notes Receivable 1,010,000
Interest Receivable 7,575
– 1,000,000 $0.99)
Interest Revenue [(C
0.09 30 360] 7,425
To record receipt and conversion to dollars of –C1,015,000
draft to settle 60-day, 9% note, together with –C15,000
– 1,000,000 0.09 60 360 –C15,000),
interest (C
and recognition of foreign currency transaction loss of
$20,150 [(C – 1,000,000 –C7,500) ($1.01 $0.99)
$20,150].

Conclusions regarding Transactions Involving

Foreign Currencies
From the foregoing examples, it is evident that increases in the selling spot rate for a for-
eign currency required by a U.S. multinational enterprise to settle a liability denominated
in that currency generate foreign currency transaction losses to the enterprise because
more U.S. dollars are required to obtain the foreign currency. Conversely, decreases in the
486 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

selling spot rate produce foreign currency transaction gains to the enterprise because
fewer U.S. dollars are required to obtain the foreign currency. In contrast, increases in the
buying spot rate for a foreign currency to be received by a U.S. multinational enterprise in
settlement of a receivable denominated in that currency generate foreign currency trans-
action gains to the enterprise; decreases in the buying spot rate produce foreign currency
transaction losses. Mastery of these relationships assures a clearer understanding of the
effects of changes in exchange rates for foreign currencies.

Forward Contracts
Forward contracts are another type of transaction involving foreign currencies. A forward
contract is an agreement to exchange currencies of different countries on a specified fu-
ture date at the forward rate in effect when the contract was made. Forward rates may be
larger or smaller than spot rates for a foreign currency, depending on the foreign currency
dealer’s expectations regarding fluctuations in exchange rates for the currency. For exam-
ple, a newspaper had the following data regarding the British pound (£) and the Swiss
franc (Sfr):

£1 Sfr 1
Spot rate $1.6365 $0.6752
1 month forward rate 1.6338 0.6775
3 months forward rate 1.6284 0.6817
6 months forward rate 1.6207 0.6879

Forward contracts are derivative instruments, defined by the FASB as follows:

A derivative instrument is a financial instrument or other contract with all three of the
following characteristics:
a. It has (1) one or more underlyings and (2) one or more notional amounts or payment
provisions or both. Those terms determine the amount of the settlement or settlements,
and, in some cases, whether or not a settlement is required.
b. It requires no initial net investment or an initial net investment that is smaller than would
be required for other types of contracts that would be expected to have a similar response
to changes in market factors.
c. Its terms require or permit net settlement, it can readily be settled net by a means outside
the contract, or it provides for delivery of an asset that puts the recipient in a position not
substantially different from net settlement.
Underlying, notional amount, and payment provision. An underlying is a specified inter-
est rate, security price, commodity price, foreign exchange rate, index of prices or rates, or
other variable (including the occurrence or nonoccurrence of a specified event such as a
scheduled payment under a contract). An underlying may be a price or rate of an asset or lia-
bility but is not the asset or liability itself. A notional amount is a number of currency units,
shares, bushels, pounds, or other units specified in the contract. The settlement of a derivative
instrument with a notional amount is determined by interaction of that notional amount with
the underlying. The interaction may be simple multiplication, or it may involve a formula
with leverage factors or other constants. A payment provision specifies a fixed or deter-
minable settlement to be made if the underlying behaves in a specified manner. (Emphasis
added.)7

7
FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities” (Norwalk:
FASB, 1998), pars. 6 and 7, as amended 2003 by FASB Statement No. 149, par, 4.
 Chapter 11 International Accounting Standards; Accounting for Foreign Currency Transactions 487

In accordance with the foregoing, the underlying for a forward contract is the contracted
forward rate, and the notional amount is the number of foreign currency units specified in
the forward contract.
FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activi-
ties,” established accounting standards for the following types of forward contracts:8
1. Forward contract not designated as a hedge.
2. Forward contract designated as a hedge of a foreign-currency–denominated firm
commitment.
3. Forward contract designated as a hedge of an investment in an available-for-sale
security.
4. Forward contract designated as a hedge of a forecasted foreign-currency–denominated
transaction.
5. Forward contract designated as a hedge of a net investment in a foreign operation.
The table on page 488 summarizes the accounting for gains and losses and the financial
statement effects of the foregoing derivative instruments.
Forward contracts of the first two types listed above are discussed and illustrated in this
chapter; the fifth type is dealt with in Chapter 12. (The complexity of the third and fourth
types renders them inappropriate for illustration in a textbook dealing with fundamental
issues. An illustration of the fourth type of forward contract, termed a cash flow hedge, can
be found in Example 10, paragraphs 165 through 172, of FASB Statement No. 133,
“Accounting for Derivative Instruments and Hedging Activities.”) The FASB required that
all derivative instruments, including the forward contracts categorized above, be recognized
as assets or liabilities, as appropriate, and measured at fair value.9 Fair value was defined
in part by the FASB as the amount at which the asset or liability could be bought or sold
in a current transaction between willing parties, that is, other than in a forced liquidation
or sale.10

Forward Contract Not Designated as a Hedge

To hedge is to take measures to reduce or eliminate a potential unfavorable outcome of a
future event. For an illustration of a forward contract not designated as a hedge, assume
that, in anticipation of a possible trip for its marketing executives to several countries of the
European Union for potential customers of its products, on May 1, 2005, Carthay Company
entered into a 60-day forward contract to acquire –C100,000 on June 30, 2005, at a forward
rate of –C1 $1.09. (The selling spot rate of the euro on May 1, 2005, was $1.04.) Because
Carthay’s purpose of entering into the forward contract did not involve designating the con-
tract as one of the types of hedges described at the top of this page, any gain or loss on the
forward contract during its 60-day term must be recognized currently in the measurement
of Carthay’s net income for a financial reporting period.11
Assuming forward rates for euro contracts maturing on June 30, 2005, were –C1 $1.07
on May 31 and –C1 $1.06 on June 30 of that year, and that Carthay prepared financial
statements on May 31 and June 30, Carthay’s journal entries for the forward contract not
designated as a hedge are on page 489.

8
Ibid., par. 18.
9
Ibid., par. 17.
10
Ibid., par. 540.
11
Ibid., par. 18a.
488 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

Statement of Financial Accounting Standards No. 133, “Accounting

for Derivative Instruments . . .”

Accounting Financial
Type for Gains (Losses) Statements Effects
Not Designated as a Recognized immediately in
Hedge earnings
(paragraph 18a)
Foreign Currency
Hedge:
Of exposure of Same as for fair value Same as for fair value
unrecognized firm hedge (see below) hedge
commitment or (paragraphs 37, 38,
available-for-sale 18d1, 18d2)
security

Of exposure of foreign Same as for cash flow Same as for cash flow
currency–denominated hedge (see below) hedge
forecasted transaction (paragraphs 40, 41,
18d3)
Of net investment in Not applicable Reported in accumulated
foreign operation other comprehensive
income as accumulated
foreign currency
translation adjustments
(paragraph 42 and FAS
52, paragraph 20a,
18d4)
Fair Value Hedge Recognized in earnings in Net loss (if any) in income
Of exposure to the period of change in statement is measure of
changes in fair value of fair value, together with hedge ineffectiveness
recognized asset or offsetting gain or loss on (paragraph 22)
liability or a firm hedged item attributable
commitment to risk being hedged
(paragraphs 20–21) (paragraph 22)
(paragraph 18b)
Cash Flow Hedge Effective portion reported in Overall earnings impact of
Of exposure to other comprehensive hedge may be reported
variability in expected income; ineffective in more than one period
future cash flow portion reported in (paragraph 31)
attributable to a earnings (paragraph 30)
particular risk Amounts in other
(paragraphs 28–29) comprehensive income
reclassified into earnings
in the period(s) that the
hedged forecasted
transaction affects
earnings (paragraph 31)
(paragraph 18c)
 Chapter 11 International Accounting Standards; Accounting for Foreign Currency Transactions 489

Journal Entries for 2005

Forward Contract Not May 1 Investment in Forward Contract 109,00012
Designated as a Hedge Forward Contract Payable 109,000
To record forward contract for –C100,000, at forward
rate of –C1 $1.09 (C– 100,000 $1.09 $109,000).

31 Foreign Currency Transaction Losses 1,990

Investment in Forward Contract 1,990
To recognize fair value of forward contract investment
and resultant transaction loss, as follows:
Forward price of contract:
May 1 $109,000
May 31 (C– 100,000 $1.07) 107,000
Difference $ 2,000
Less: Discount to maturity
(30 days) at 6% rate
($2,000 0.06 30 360) 1013
Transaction loss $ 1,990

June 30 Investment in Euros (C– 100,000 $1.06) 106,000

Forward Contract Payable 109,000
Foreign Currency Transaction Losses 1,010
Cash 109,000
Investment in Forward Contract
($109,000 $1,990) 107,010
To recognize settlement of forward contract, fair value
of investment in euros, and transaction loss as follows:
Carrying amount of contract May 31 $107,010
Fair value of contract
– 100,000 $1.06)
June 30 (C 106,000
Transaction loss $ 1,010

Presumably, the selling spot rate for the euro on June 30, 2005, is –C1 $1.06, the same as
the forward rate for a forward contract maturing on that date. Thus, the investment in euros
is valued at current fair value on that date. On subsequent financial statement preparation
dates, foreign currency transaction gains or losses would be recognized for changes in the
selling spot rate for the euro, as long as Carthay Company maintained its investment
therein.

Forward Contract Designated as a Hedge of a Foreign-Currency–Denominated

Firm Commitment
FASB Statement No. 133 defined a firm commitment as follows:14
An agreement with an unrelated party, binding on both parties and usually legally enforce-
able, with the following characteristics:

12
See ibid., par. 17a, re recognition of asset and liability.
13
See ibid., par. 478, re effects of discounting in determination of fair value.
14
Ibid., par. 540.
490 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

a. The agreement specifies all significant terms, including the quantity to be exchanged, the
fixed price, and the timing of the transaction. The fixed price may be expressed as a speci-
fied amount of an entity’s functional currency or of a foreign currency. It may also be
expressed as a specified interest rate or specified effective yield.
b. The agreement includes a disincentive for nonperformance that is sufficiently large to
make performance probable.

The FASB characterized a forward contract designated as a hedge of a foreign-

currency–denominated firm commitment as a fair value hedge,15 for which it set forth a
number of complex criteria not enumerated here.16 Gains or losses on the hedging instru-
ment (in this case, the forward contract) and on the hedged item to be acquired or disposed
of under the firm commitment are to be recognized in the measurement of net income and
of the carrying amount of the hedged item.17
To illustrate, assume that on August 1, 2005, Carthay Company entered into a firm
commitment with a Japanese manufacturer to acquire a machine, delivery and passage of
title on October 30, 2005, at a price of 10,000,000 yen (¥). To hedge against unfavorable
changes in the exchange rate for the yen, the selling spot rate for which was ¥1 $0.006958
on August 1, on that date Carthay entered into a 90-day forward contract for ¥10,000,000 at
a forward rate of ¥1 $0.007051. Forward rates for yen-denominated forward contracts
maturing on October 30, 2005, were ¥1 $0.007030 on August 31, 2005, ¥1 $0.007019
on September 30, 2005, and ¥1 $0.007010 on October 30, 2005, on all of which dates
Carthay prepared financial statements. Carthay’s journal entries on August 1 and 31, Septem-
ber 30, and October 30, 2005, are as follows:

Journal Entries for 2005

Forward Contract Aug. 1 Investment in Forward Contract 70,510
Designated as a Hedge Forward Contract Payable 70,510
of a Foreign- To record forward contract for ¥10,000,000 at forward rate of
Currency–Denominated ¥1 $0.007051 (¥10,000,000 $0.007051 $70,510).
Firm Commitment
(Fair Value Hedge) 31 Foreign Currency Transaction Losses 208
Firm Commitment for Machinery 208
Investment in Forward Contract 208
Foreign Currency Transaction Gains 208
To recognize fair value of forward contract investment, resultant
transaction loss, increase in fair value of commitment to
acquire machine, and resultant transaction gain, as follows:
Forward price of contract:
Aug. 1 $70,510
Aug. 31 (¥10,000,000 $0.007030) 70,300
Difference $ 210
Less: Discount to maturity (60 days) at 6%
rate ($210 0.06 60 360 $2) 2
Transaction loss and gain $ 208

(continued)

15
Ibid., par. 4.
16
Ibid., par. 20, 21.
17
Ibid., par. 22.
 Chapter 11 International Accounting Standards; Accounting for Foreign Currency Transactions 491

2005
Sept. 30 Foreign Currency Transaction Losses 110
Firm Commitment for Machinery 110
Investment in Forward Contract 110
Foreign Currency Transaction Gains 110
To recognize fair value of forward contract investment, resultant
transaction loss, increase in fair value of commitment to
acquire machine, and resultant transaction gain, as follows:
Forward price of contract:
Aug. 1 $70,510
Sept. 30 (¥10,000,000 $0.007019) 70,190
Difference $ 320
Less: Discount to maturity (30 days) at 6%
rate ($320 0.06 30 360) 2
Total change in fair value of forward
contract (60 days) $ 318
Less: Change recognized Aug. 31, 2002 208
Transaction loss and gain $ 110

Oct. 30 Foreign Currency Transaction Losses 92

Firm Commitment for Machinery 92
Investment in Forward Contract 92
Foreign Currency Transaction Gains 92
To recognize fair value of forward contract investment, resultant
transaction loss, increase in fair value of commitment to
acquire machine, and resultant transaction gain, as follows:
Forward price of contract:
Aug. 1 $70,510
Oct. 30 (¥10,000,000 $0.007010) 70,100
Total change in fair value of
forward contract (90 days) $ 410
Less: Changes in fair value
recognized Aug. 31 and
Sept. 30 ($208 $110) 318
Transaction loss and gain $ 92

Oct. 30 Investment in Yen (¥10,000,000 $0.007010) 70,100

Forward Contract Payable 70,510
Investment in Forward Contract
($70,510 $208 $110 $92) 70,100
Cash 70,510
To recognize settlement of forward contract and fair value of
investment in yen.

30 Machinery ($70,100 $410) 70,510

Investment in Yen 70,100
Firm Commitment for Machinery ($208 $110 $92) 410
To record acquisition of machinery from Japanese manufacturer.
492 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

Because Carthay Company had acquired a forward contract for the same amount of the
same currency in which the firm commitment was denominated, the hedge was “perfect,”
in that it fully covered the risk of unfavorable changes in the exchange rate for the yen. Ac-
cordingly, the cost of the machine acquired from the Japanese manufacturer was the U.S.
dollar amount of the forward contract.

International Accounting Standards 21 and 39

The provisions of IAS 21, “The Effects of Changes in Foreign Exchange Rates,” dealing
with foreign-currency–denominated transactions are essentially the same as those of FASB
Statement No. 52, “Foreign Currency Translation.” However, IAS 21 has no coverage of
forward contracts, which are dealt with in IAS 39, “Financial Instruments: Recognition and
Measurement,” with standards similar to those of FASB Statement No. 133.

Disclosures regarding Foreign Currency Transactions

For transactions denominated in a foreign currency, FASB Statement No. 52 requires dis-
closure, in the financial statements or notes thereto, of the aggregate foreign currency trans-
action gains and losses included in the measurement of net income.18 For example, under
the caption “Other Expense (Income)” in its income statements for the three fiscal years
ended September 27, 1997, Tyson Foods, Inc., a publicly owned company, displayed “For-
eign currency exchange” [losses] of $15.6 million for 1995 and $9.0 million for 1996, but
none for 1997.
FASB Statement No. 133, effective for fiscal years beginning after June 15, 2000, re-
quires numerous quantitative and qualitative disclosures regarding all derivative instru-
ments, including those designated as hedges of foreign currency exchange risks. (Presumably,
such disclosures are to be in the financial statements and the notes thereto.)19 Further, the
SEC requires disclosure, outside the financial statements and the notes thereto, of both
qualitative and quantitative information about market risk inherent in derivative instru-
ments.20 (Market risk is the risk of a decline in value or an increase in onerousness of a
derivative instrument resulting from future changes in market prices.)

Review 1. What is the U.S. term for the IASB’s jointly controlled entity?
Questions 2. How does IFRS 3, “Business Combinations,” compare with current U.S. accounting
standards for business combinations? Explain.
3. In IAS 27, “Consolidated Financial Statements . . . ,” did the IAS adopt the parent
company concept or the economic unit concept for display of the minority interest in
net income and net assets of subsidiaries in consolidated financial statements? Explain.
4. Define the following terms associated with foreign currencies:
a. Exchange rate
b. Forward rate
c. Selling spot rate
d. Spot rate

18
FASB Statement No. 52, par. 30.
19
FASB Statement No. 133, par. 45.
20
Codification of Financial Reporting Policies (Washington: SEC, 1997), sec. 507.
 Chapter 11 International Accounting Standards; Accounting for Foreign Currency Transactions 493

5. A newspaper listed spot exchange rates for the Japanese yen (¥) as follows:
Buying rate: ¥1 $0.0039
Selling rate: ¥1 $0.0043
How many U.S. dollars does a U.S. enterprise have to exchange for ¥50,000 at the above
rates to settle a trade account payable denominated in that amount to a Japanese sup-
plier? Explain.
6. What is a multinational enterprise?
7. On March 27, 2005, a U.S. multinational enterprise purchased merchandise on 30-day
credit terms from a Philippines exporter at an invoice cost of =p 80,000. (=
p is the sym-
bol of the Philippine peso.) What U.S. dollar amount does the U.S. enterprise credit to
Trade Accounts Payable if the March 27, 2005, spot rates for the Philippine peso are as
follows?
Buying rate: = p 1 $0.11
Selling rate: =p 1 $0.12
8. Are foreign currency transaction gains or losses entered in the accounting records prior
to collection of a trade account receivable or payment of a trade account payable de-
nominated in a foreign currency? Explain.
9. Explain the one-transaction perspective regarding the nature of a foreign currency
transaction gain or loss.
10. What arguments are advanced in support of the two-transaction perspective for for-
eign currency transaction gains and losses? Explain.
11. What is a forward contract?
12. How may a U.S. multinational enterprise hedge against the risk of fluctuations in ex-
change rates for foreign currencies? Explain.
13. What is market risk with respect to derivative instruments?

Exercises
(Exercise 11.1) Select the best answer for each of the following multiple-choice questions:
1. Export Company had a trade account receivable from a foreign customer stated in the
local currency of the foreign customer. The trade account receivable for 900,000 local
currency units (LCU) had been restated to $315,000 in Export’s June 30, 2005, balance
sheet. On July 26, 2005, the account receivable was collected in full when the ex-
change rate was LCU1 $0.331⁄3. The journal entry (explanation omitted) that Export
prepares to record the collection of this trade account receivable is:
a. Cash 300,000
Trade Accounts Receivable 300,000
b. Cash 300,000
Foreign Currency Transaction Gains and Losses 15,000
Trade Accounts Receivable 315,000
c. Cash 300,000
Foreign Currency Translation Adjustments 15,000
Trade Accounts Receivable 315,000
d. Cash 315,000
Trade Accounts Receivable 315,000
494 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

2. If the exchange rate for one British pound is $1.55, $1.00 may be exchanged for:
a. 0.45 pound.
b. 0.65 pound.
c. 0.78 pound.
d. An indeterminate fraction of a pound.
3. If $1.9672 is required to acquire one British pound, the amount of pound(s) required to
acquire $1 is:
a. £0.5083
b. £5.0834
c. £3.8702
d. £0.2584
4. Vermont Corporation, a U.S. enterprise, purchased merchandise from a New Zealand
supplier on November 5, 2005, for $NZ50,000, when the selling spot rate was
$NZ1 $0.4295. On Vermont’s December 31, 2005, year-end the selling spot rate
was $0.4245. On January 15, 2006, Vermont acquired $NZ50,000 at the selling spot of
$0.4345 and paid the invoice. What amounts does Vermont report in its income state-
ments for years 2005 and 2006 as foreign currency transaction gains or (losses)?
a. $250 $(500)
b. (250) -0-
c. -0- (250)
d. -0- -0-
e. Some other amounts
5. On April 30, 2005, the buying spot rate for the local currency unit (LCU) was $0.15,
the selling spot rate was $0.17, and the 30-day forward rate was $0.19. If on that date
a U.S. multinational enterprise received a LCU100,000 draft from a foreign customer
in settlement of a purchase made by the customer on March 31, 2005, the U.S. enter-
prise may convert the LCU100,000 draft to:
a. $15,000 b. $17,000 c. $19,000 d. Some other amount
6. A U.S. multinational enterprise has an account receivable from a German customer and
an account payable to an unrelated German supplier, both of which are denominated in
the euro. If the exchange rate for the euro decreases, the result to the enterprise will be
realization of foreign currency transaction gains or losses as follows:

On Account Receivable On Account Payable

a. Transaction gain Transaction gain
b. Transaction loss Transaction loss
c. Transaction loss Transaction gain
d. Transaction gain Transaction loss

7. In FASB Statement No. 52, “Foreign Currency Translation,” did the FASB sanction,
for interpreting a foreign trade transaction, the:

Two-Transaction Perspective? One-Transaction Perspective?

a. No Yes
b. No No
c. Yes Yes
d. Yes No
 Chapter 11 International Accounting Standards; Accounting for Foreign Currency Transactions 495

8. The International Accounting Standards Board has designated as preferable the inven-
tory cost flow valuation method(s):
a. First-in, first-out or weighted average.
b. First-in, first-out or last-in, first-out.
c. Last-in, first-out or weighted average.
d. First-in, first-out only.
e. Weighted average only.
9. A forward contract is a derivative instrument because:
a. It has an underlying: the contracted foreign exchange rate.
b. It has a notional amount: the number of foreign currency units.
c. It requires no initial net investment.
d. Of all the foregoing reasons.
10. The FASB required that forward contracts:
a. Be recognized as assets or liabilities, as appropriate.
b. Be valued at fair value.
c. Be valued at their notional amount.
d. Be treated in the manner described in both a and b.
e. Be treated in the manner described in both a and c.

(Exercise 11.2) On June 26, 2005, L.A. Company purchased merchandise from Brit Company for £10,000,
terms net 30 days. On June 30, 2005, L.A. Company prepared financial statements. On
July 26, 2005, L.A. Company electronically transferred £10,000 to Brit Company. Relevant
spot exchange rates for the pound sterling (£) were as follows:

£1
Buying Selling
Rate Rate
June 26, 2005 $1.63 $1.67
June 30, 2005 1.64 1.68
July 26, 2005 1.62 1.66

Prepare journal entries (omit explanations) for L.A. Company on June 26 and 30 and
July 26, 2005. L.A. Company uses the perpetual inventory system.
(Exercise 11.3) Walker, Inc., a U.S. corporation that prepares annual financial statements, ordered a ma-
chine (plant asset) from Pfau Company of Germany on July 15, 2005, for –C100,000 when
the selling spot rate for the euro was $1.065. Pfau shipped the machine on September 1,
2005, and billed Walker for –C100,000. The selling spot rate for the euro was $1.070 on that
date. Walker acquired a draft for –C100,000 and paid the invoice on October 25, 2005, when
the selling spot rate for the euro was $1.065.
Prepare journal entries for Walker, Inc., to record the foregoing business transactions
and events.
(Exercise 11.4) On November 18, 2005, U.S. Company, which uses the perpetual inventory system and pre-
CHECK FIGURE pares financial statements monthly, shipped merchandise costing $1,000 to France Com-
Nov. 30, credit foreign pany for –C1,500, terms n/30. On December 18, 2005, U.S. Company received from France
currency transaction Company a draft for –C1,500, which U.S. converted to U.S. dollars immediately. Spot rates
gains, $8. for the euro were as follows:
496 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

–C 1
Buying Rate Selling Rate
Nov. 18, 2005 $1.055 $1.060
Nov. 30, 2005 1.060 1.050
Dec. 18, 2005 1.050 1.055

Prepare journal entries for U.S. Company on November 18 and 30 and December 18,
2005. Omit explanations for the journal entries.
(Exercise 11.5) On March 25, 2005, Lincoln Company, a U.S. multinational enterprise, sold merchandise
costing $260,000 to Svenska Company, a Swedish enterprise, for 2,000,000 krona (Kr) on
CHECK FIGURE 30-day open account. On April 24, 2005, Lincoln received a Kr2,000,000 draft from Sven-
Mar. 31, credit foreign ska and converted it to U.S. dollars. Lincoln prepares monthly financial statements and uses
currency transaction the perpetual inventory system. Exchange rates for the krona were as follows:
gains, $20,000.

Kr1
Buying Selling Forward
Mar. 25, 2005 $0.19 $0.20 $0.22
Mar. 31, 2005 0.20 0.22 0.24
Apr. 24, 2005 0.18 0.19 0.20

Prepare journal entries (omit explanations) for Lincoln Company on March 25, March 31,
and April 24, 2005.
(Exercise 11.6) On March 1, 2005, Yankee Company sold merchandise with a cost of $100,000 to a foreign
customer in its local currency unit (LCU) for a LCU600,000, 60-day promissory note bear-
CHECK FIGURE ing interest of 18% a year. On April 30, 2005, Yankee received a draft for LCU618,000, in
Apr. 30, credit foreign settlement of the note receivable from the foreign customer, and converted it to U.S. dollars
currency transaction immediately. Relevant exchange rates for the LCU were as follows:
gains, $18,540.

LCU1
Mar. 1, 2005 Apr. 30, 2005
Spot rates:
Buying $0.30 $0.33
Selling 0.32 0.34
30-day forward rate 0.40 0.44

Prepare journal entries for Yankee Company on March 1, 2005, and April 30, 2005, for
the foregoing information. Yankee uses the periodic inventory system and prepares end-of-
period adjustments only on June 30, the end of its fiscal year.
(Exercise 11.7) The accountant for Transglobal Company is a proponent of the one-transaction perspective
of accounting for foreign trade transactions. On November 19, 2005, Transglobal’s ac-
countant prepared the following journal entry:
 Chapter 11 International Accounting Standards; Accounting for Foreign Currency Transactions 497

Trade Accounts Payable 60,000

Cost of Goods Sold ($3,000 3313%) 1,000
Inventories ($3,000 662 3%) 2,000
Cash 63,000
To record payment for –C60,000 draft (C – 60,000 $1.05 $63,000)
to settle liability to French supplier, and allocation of resultant foreign
currency transaction loss to cost of goods sold and to inventories.

Prepare a journal entry for Transglobal Company on November 19, 2005, to correct the
foregoing journal entry. Do not reverse the foregoing entry.
(Exercise 11.8) On March 31, 2005, Kingston Company acquired a 30-day forward contract for 100,000
local currency units (LCU) of a foreign country. The contract was not designated to hedge.
CHECK FIGURE On April 30, 2005, Kingston paid cash to settle the contract and obtain the LCU100,000
Apr. 30, debit foreign draft. Kingston prepares adjusting entries and financial statements only at the end of its
currency transaction fiscal year, April 30. Relevant exchange rates for one unit of the local currency were as
losses, $3,000. follows:

LCU1
Mar. 31, 2005 Apr. 30, 2005
Spot rates:
Buying $0.18 $0.19
Selling 0.20 0.22
Forward rates:
Contracts maturing April 30, 2005 0.25 0.22

The discount rate is 6%.

Prepare journal entries for Kingston Company on March 31, 2005, and April 30, 2005.
(Exercise 11.9) On August 6, 2005, Concordia Company, a U.S. multinational enterprise that uses the per-
petual inventory system, purchased from a Belgium supplier on 30-day open account goods
CHECK FIGURE costing –C80,000. On that date, various exchange rates for the euro were as follows:
Sept. 5, credit
investment in forward
contract, $87,200.
Spot rates:
Buying: –C1 $1.07
Selling: –C1 $1.08
30-day forward rate: –C1 $1.10

Also on August 6, 2005, Concordia acquired a 30-day forward contract for –C80,000, des-
ignated to hedge the euro commitment.
Prepare journal entries to record the August 6, 2005, transactions of Concordia Com-
pany, as well as the related transactions on September 5, 2005, on which date the forward
rate for forward contracts maturing that date was –C1 $1.09. Concordia does not close its
accounting records monthly or prepare monthly financial statements. None of the mer-
chandise had been sold.
498 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

Cases
(Case 11.1) Both the International Accounting Standards Board (IASB) and the U.S. Financial Ac-
counting Standards Board were essentially established in 1973. Since that time, the IASB
has issued 41 International Accounting Standards, but the FASB has issued more than 140
Statements of Financial Accounting Standards.

Instructions
Do you favor the FASB’s continued outpouring of Statements, most of which differ at least
in some respects from IASB Standards? Alternatively, should the FASB encourage the
IASB to join it in expanding their convergence project described on page 478? Base your
answer on your perception of which course of action would best enhance the adoption of
uniform accounting standards throughout the world.
(Case 11.2) Many accountants believe that generally accepted accounting principles in the United
States, especially those developed by the Financial Accounting Standards Board, are su-
perior to International Accounting Standards or to the accounting standards of other
countries. In their view, foreign enterprises wanting to have their securities traded on U.S.
stock exchanges should prepare financial reports that comply with U.S. accounting stan-
dards. However, the U.S. Securities and Exchange Commission is a member of the Inter-
national Organization of Securities Commissions (IOSCO), which has considered the
possibility of allowing foreign enterprises to prepare financial reports that incorporate
International Accounting Standards in requesting permission to have their securities
traded in any country.

Instructions
Do you support or oppose the SEC’s participation in the work of the IOSCO? Should or
should not foreign enterprises meet financial reporting standards applicable to U.S. enter-
prises if the foreign enterprises want their securities to be traded on U.S. stock exchanges?
Explain.
(Case 11.3) FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities,”
which is effective for fiscal years beginning after June 15, 2000, requires (in paragraphs 44
and 45) numerous disclosures regarding derivative instruments.

Instructions
Obtain the annual report of a publicly owned enterprise that has forward contract derivative
instruments, make a copy of the note to financial statements that deals with such instru-
ments, and analyze the note for compliance with paragraphs 44 and 45 of FASB Statement
No. 133. Attach the copy of the note to your solution to the case.

Problems
(Problem 11.1) On August 1, 2005, Caribbean Company, a U.S. multinational enterprise that prepares fi-
nancial statements monthly, acquired a 60-day forward contract for £50,000. Exchange
rates for the British pound (£) on various dates in 2005 were as follows:
 Chapter 11 International Accounting Standards; Accounting for Foreign Currency Transactions 499

CHECK FIGURE £1
a. Aug. 31, debit
foreign currency Aug. 1 Aug. 31 Sept. 30
transaction losses, Spot rates:
$995; b. Sept. 30, Buying $1.80 $1.82 $1.83
credit foreign currency Selling 1.90 1.91 1.92
transaction gains, Forward rates:
$505. Contracts maturing Sept. 30, 2005 1.95 1.93 1.92

Instructions
Prepare journal entries (omit explanations) for Caribbean Company’s forward contract dur-
ing its 60-day term under the following assumptions:
a. The contract was not designated as a hedge.
b. The contract was designated as a hedge of a £50,000 purchase order issued by Caribbean
on August 1, 2005, to a British supplier for merchandise to be delivered and paid for on
September 30, 2005.
Use a 6% discount rate.
(Problem 11.2) The following problem consists of two unrelated parts.
a. On June 27, 2005, U.S. Company, which uses the perpetual inventory system, purchased
from French Company, for 100,000 euros (C– ), merchandise to be shipped by air that date
CHECK FIGURE directly to Canadian Company at a selling price of 180,000 Canadian dollars ($C). On
b. Apr. 30, debit July 27, 2005, U.S. Company obtained for U.S. dollars and sent to French Company a
foreign currency draft for –C100,000 and received from Canadian Company a draft for $C180,000, which
transaction losses, U.S. immediately converted to U.S. dollars. U.S. Company does not prepare monthly fi-
$2,010. nancial statements. Relevant spot exchange rates were as follows:

–C1 $C1
Buying Selling Buying Selling
June 27, 2005 $1.03 $1.05 $0.84 $0.86
July 27, 2005 1.04 1.06 0.85 0.87

Instructions
Prepare journal entries (omit explanations) for U.S. Company on June 27, 2005, to record
the purchase and sale of merchandise and on July 27, 2005, to record the payment to French
Company and the receipt from Canadian Company.
b. On March 1, 2005, Spheric Company prepared the following journal entry:

Investment in Forward Contract (Singapore dollars) 35,000

Forward Contract Payable (S$100,000 $0.35) 35,000
To record acquisition of forward contract, not designated as
a hedge, for 60 days at forward rate of S$1 $0.35.
500 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

The forward rates for the Singapore dollar for forward contracts maturing April 30,
2005, were as follows:

Date S$1
Mar. 31, 2005 $0.33
Apr. 30, 2005 0.31

Instructions
Prepare journal entries (omit explanations) for Spheric Company on March 31 and April
30, 2005. Spheric prepares monthly financial statements. The discount rate is 6%.
(Problem 11.3) The following problem consists of two unrelated parts.
a. Zonal Corporation is a multinational company that sells merchandise to Stacey, Ltd., a
CHECK FIGURE customer in the United Kingdom. On November 19, 2005, Zonal sold to Stacey mer-
b. Aug. 29, credit chandise costing $40,000 for £38,000. On December 19, 2005, Zonal received from
foreign currency Stacey a draft for £38,000, which Zonal immediately converted to U.S. dollars. Zonal
transaction gains, uses the perpetual inventory system and prepares monthly financial statements. Selected
$15,300. exchange rates for the British pound were as follows:

£1
Nov. 19, 2005 Nov. 30, 2005 Dec. 19, 2005
Spot rates:
Buying $1.45 $1.44 $1.43
Selling 1.48 1.47 1.46
Forward rate:
30-day contract 1.50 1.49 1.48

Instructions
Prepare journal entries (omit explanations) for Zonal Corporation on November 19,
November 30, and December 19, 2005.
b. On June 30, 2005, Iberia Company, a U.S. multinational enterprise that does not prepare
monthly financial statements, sold merchandise costing $75,000 to a foreign customer,
and received in exchange a 60-day, 12% note for 7,500,000 local currency units
(LCU). The buying spot rate for the LCU on June 30, 2005, was LCU1 $0.014. On
August 29, 2005, Iberia received from the foreign customer a draft for LCU7,650,000,
which Iberia converted on that date to U.S. dollars at the buying spot rate of
LCU1 $0.016.

Instructions
Prepare journal entries (omit explanations) for Iberia Company to record the June 30, 2005,
sale, under the perpetual inventory system, and the August 29, 2005, conversion of the for-
eign customer’s LCU7,650,000 draft to U.S. dollars.
(Problem 11.4) Imex Company, a U.S. multinational enterprise with an April 30 fiscal year, had the fol-
lowing transactions and events, among others, during March and April 2005:
 Chapter 11 International Accounting Standards; Accounting for Foreign Currency Transactions 501

CHECK FIGURE Exchange Rates

a. Apr. 5, debit
inventories, $100. Spot
Date Explanation of Transactions and Events Buying Selling Forward
2005
Mar. 6 Received merchandise purchased from
Venezuelan supplier on 30-day open account,
cost 100,000 bolivars (B). Acquired 30-day
forward contract for B100,000 as hedge. $0.006 $0.007 $0.008
18 Received merchandise purchased from Danish
supplier on 30-day open account, cost
75,000 euros (–C ). 1.04 1.06 1.10
25 Sold merchandise to Swiss customer on 30-day
open account for 50,000 francs (Sfr). Cost of
goods sold $15,000. 0.52 0.53 0.54
Apr. 4 Received merchandise purchased from Spanish
supplier on 30-day open account for 150,000
euros (–C ). 1.05 1.07 1.11
5 Settled B100,000 forward contract, and paid
Venezuelan supplier for Mar. 6 purchase,
none of which had been sold. 0.006 0.007 0.007
17 Acquired draft for –C 75,000 for payment to Danish
supplier for Mar. 18 purchase. 1.03 1.05 1.08
Apr. 24 Received draft for Sfr50,000 from Swiss customer
for sale of Mar. 25. Exchanged draft for U.S.
dollar credit to bank checking account. 0.53 0.54 0.55
30 Obtained exchange rates quotation for euro. 1.03 1.05 1.07

Instructions
a. Prepare journal entries (omit explanations) for Imex Company to record the foregoing
transactions and events in U.S. dollars, under the perpetual inventory system.
b. Prepare an adjusting entry (omit explanation) for Imex Company on April 30, 2005. Imex
does not prepare monthly financial statements.
(Problem 11.5) On June 30, 2005, Impo Company, which prepares monthly financial statements, acquired
from Japanese Company for 500,000 yen (¥) a machine with an economic life of five years
CHECK FIGURE and no residual value. To pay Japanese Company, Impo borrowed ¥500,000 from Japanese
Aug. 29, debit foreign Bank on a 12%, 60-day promissory note. Impo acquired a ¥510,000 draft from U.S. Bank
currency transaction on August 29, 2005, to pay the maturity value of the note to Japanese Bank. Relevant spot
losses, $153. rates for the yen were as follows:

¥1
Buying Rate Selling Rate
June 30, 2005 $0.0081 $0.0084
July 31, 2005 0.0080 0.0082
Aug. 29, 2005 0.0082 0.0085

Instructions
Prepare journal entries (omit explanations) for Impo Company on June 30, July 31, and
August 29, 2005, including interest accrual and depreciation of the machine. Use 30-day
months for July and August interest.
502 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

(Problem 11.6) During your first-time audit of the financial statements of Allison Company, a closely held
corporation, you review the following ledger account:

CHECK FIGURE
Forward Contracts
Debit foreign currency
transaction losses, $15. Date Explanation Debit Credit Balance
2005
Apr. 30 Payment for 60-day contract for
¥100,000 at ¥1 $0.00801 801 801 dr
Sept. 30 Payment of 60-day contract for
–C50,000 at –C1 $1.04 52,000 52,801 dr

Your study of underlying records discloses the following:

1. Allison, as a nonpublic company, prepares financial statements at the end of its Septem-
ber 30 fiscal year only.
2. The offsetting credits for the debits to Forward Contracts were to Cash.
3. No other journal entries had been prepared by Allison for the forward contracts.
4. The contract for Japanese yen (¥) was not designated as a hedge. The yen were used for
travel expenses in Japan prior to September 30, 2005.
– ) hedged a –C50,000 purchase commitment to a French supplier
5. The contract for euros (C
for merchandise received and paid for September 30, 2005, all of which was on hand on
that date.
6. Forward rates for forward contracts payable on the indicated dates were as follows:
¥1: Mar. 1, 2005, $0.00801; Apr. 30, 2005, $0.00786
–C1: Aug. 1, 2005, $1.04; Sept. 30, 2005, $1.01
Instructions
Prepare two journal entries, one for each forward contract, for Allison Company on Septem-
ber 30, 2005, to correct the accounting for the two contracts. Show supporting computa-
tions in the explanations for the entries.
Chapter Twelve

Translation of Foreign
Currency Financial
Statements
Scope of Chapter
When a U.S. multinational enterprise prepares consolidated or combined financial state-
ments that include the operating results, financial position, and cash flows of foreign sub-
sidiaries or branches, the U.S. enterprise must translate the amounts in the financial
statements of the foreign entities from the entities’ functional currency to the U.S. dollar,
the reporting currency. Similar treatment must be given to investments in other foreign in-
vestees for which the U.S. enterprise uses the equity method of accounting. In addition, if
the 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 remeasured to the functional currency from the local currency. Both remeasure-
ment and translation are described and illustrated in this chapter, together with other issues
involving foreign currency restatements.

FUNCTIONAL CURRENCY
The FASB defined the functional currency of a foreign entity as follows:
An entity’s functional currency is the currency of the primary economic environment in
which the entity operates; normally, that is the currency of the environment in which an en-
tity primarily generates and expends cash. . . .
For an entity with operations that are relatively self-contained and integrated within a par-
ticular country, the functional currency generally would be the currency of that country.
However, a foreign entity’s functional currency might not be the currency of the country in
which the entity is located. For example, the parent’s currency generally would be the func-
tional currency for operations that are a direct and integral component or extension of the
parent company’s operations.1

To assist in the determination of the functional currency of a foreign entity, the FASB
provided the following guidelines:2

1
FASB Statement No. 52, “Foreign Currency Translation” (Stamford: FASB, 1981), pars. 5–6.
2
Ibid., par. 42.

503
504 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

The salient economic factors set forth below, and possibly others, should be considered both
individually and collectively when determining the functional currency.

a. Cash flow indicators

(1) Foreign Currency—Cash flows related to the foreign entity’s individual assets and lia-
bilities are primarily in the foreign currency and do not directly impact the parent
company’s cash flows.
(2) Parent’s Currency—Cash flows related to the foreign entity’s individual assets and li-
abilities directly impact the parent’s cash flows on a current basis and are readily
available for remittance to the parent company.
b. Sales price indicators
(1) Foreign Currency—Sales prices for the foreign entity’s products are not primarily re-
sponsive on a short-term basis to changes in exchange rates but are determined more
by local competition or local government regulation.
(2) Parent’s Currency—Sales prices for the foreign entity’s products are primarily re-
sponsive on a short-term basis to changes in exchange rates; for example, sales prices
are determined more by worldwide competition or by international prices.
c. Sales market indicators
(1) Foreign Currency—There is an active local sales market for the foreign entity’s prod-
ucts, although there also might be significant amounts of exports.
(2) Parent’s Currency—The sales market is mostly in the parent’s country, or sales con-
tracts are denominated in the parent’s currency.
d. Expense indicators
(1) Foreign Currency—Labor, materials, and other costs for the foreign entity’s products
or services are primarily local costs, even though there also might be imports from
other countries.
(2) Parent’s Currency—Labor, materials, and other costs for the foreign entity’s products
or services, on a continuing basis, are primarily costs for components obtained from
the country in which the parent company is located.
e. Financing indicators
(1) Foreign Currency—Financing is primarily denominated in foreign currency, and
funds generated by the foreign entity’s operations are sufficient to service existing
and normally expected debt obligations.
(2) Parent’s Currency—Financing is primarily from the parent or other dollar-denominated
obligations, or funds generated by the foreign entity’s operations are not sufficient to
service existing and normally expected debt obligations without the infusion of addi-
tional funds from the parent company. Infusion of additional funds from the parent
company for expansion is not a factor, provided funds generated by the foreign en-
tity’s expanded operations are expected to be sufficient to service that additional
financing.
f. Intercompany transactions and arrangements indicators
(1) Foreign Currency—There is a low volume of intercompany transactions, and there is
not an extensive interrelationship between the operations of the foreign entity and the
parent company. However, the foreign entity’s operations may rely on the parent’s or
affiliates’ competitive advantages, such as patents and trademarks.
(2) Parent’s Currency—There is a high volume of intercompany transactions and there is
an extensive interrelationship between the operations of the foreign entity and the
parent company. Additionally, the parent’s currency generally would be the functional
currency if the foreign entity is a device or shell corporation for holding investments,
obligations, intangible assets, etc., that could readily be carried on the parent’s or an
affiliate’s books.

The foregoing guidelines indicate the importance of determining the appropriate func-
tional currency for a foreign entity. The functional currency of the foreign entity underlies
the application of the monetary principle (discussed in intermediate accounting textbooks)
for the entity.
 Chapter 12 Translation of Foreign Currency Financial Statements 505

Alternative Methods for Translating Foreign Entities’

Financial Statements
If the exchange rate for the functional currency of a foreign subsidiary or branch remained
constant instead of fluctuating, translation of the foreign entity’s financial statements to
U.S. dollars would be simple. All financial statement amounts would be translated to U.S.
dollars at the constant exchange rate. However, exchange rates fluctuate frequently. Thus,
accountants charged with translating amounts in a foreign entity’s financial statements to
U.S. dollars face a problem similar to that involving inventory valuation during a period
of purchase price fluctuations: Which exchange rate or rates should be used to translate the
foreign entity’s financial statements? A number of answers were proposed for this question
prior to the issuance of FASB Statement No. 52, “Foreign Currency Translation.” The
several methods for foreign currency translation may be grouped into three basic classes:
current/noncurrent, monetary/nonmonetary, and current rate. (A fourth method, the
temporal method, essentially is the same as the monetary/nonmonetary method.) The
three classes differ principally in translation techniques for balance sheet amounts.

Current/Noncurrent Method
In the current/noncurrent method of translation, current assets and current liabilities are
translated at the exchange rate in effect on the balance sheet date of the foreign entity (the
current rate). All other assets and liabilities, and the elements of owners’ equity, are trans-
lated at the historical rates in effect at the time the assets, liabilities, and equities first were
recognized in the foreign entity’s accounting records. In the income statement, depreciation
expense and amortization expense are translated at historical rates applicable to the related
assets, while all other revenue and expenses are translated at an average exchange rate for
the accounting period.
The current/noncurrent method of translating foreign investees’ financial statements was
sanctioned by the AICPA for many years. This method supposedly best reflected the
liquidity aspects of the foreign entity’s financial position by showing the current U.S. dollar
equivalents of its working capital components. Today, the current/noncurrent method has
few supporters. The principal theoretical objection to the current/noncurrent method is that,
with respect to inventories, it represents a departure from historical cost. Inventories are
translated at the 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.

Monetary/Nonmonetary Method
The monetary/nonmonetary method of translating foreign currencies focuses on the char-
acteristics of assets and liabilities of the foreign entity, rather than on their balance sheet
classifications. This method is founded on the same monetary/nonmonetary aspects of assets
and liabilities that are employed in historical-cost/constant-purchasing-power accounting,
described in intermediate accounting textbooks. Monetary assets and liabilities— those
representing claims or obligations expressed in a fixed monetary amount—are translated at
the current exchange rate. All other assets, liabilities, and owners’ equity amounts are trans-
lated at appropriate historical rates. In the income statement, average exchange rates are
applied to all revenue and expenses except depreciation expense, amortization expense, and
cost of goods sold, which are translated at appropriate historical rates.
Supporters of the monetary/nonmonetary method emphasized its retention of the
historical-cost principle in the foreign entity’s financial statements. Because the foreign en-
tity’s financial statements are consolidated or combined with those of the U.S. multinational
enterprise, consistent accounting principles are applied in the consolidated or combined
506 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

financial statements. The monetary/nonmonetary method essentially was sanctioned by the

FASB prior to the issuance of FASB Statement No. 52.
Critics of the monetary/nonmonetary method point out that this method emphasizes the
parent company aspects of a foreign entity’s financial position and operating results. By
reflecting the foreign entity’s changes in assets and liabilities, and operating results, as
though they were made in the parent company’s reporting currency, the monetary/non-
monetary method misstates the actual financial position and operating results of the
foreign entity.

Current Rate Method

Critics of the monetary/nonmonetary method of foreign currency translation generally have
supported the current rate method. Under the current rate method, all balance sheet amounts
other than owners’ equity are translated at the current exchange rate. Owners’ equity amounts
are translated at historical rates.
To emphasize the functional currency aspects of the foreign entity’s operations, all rev-
enue and expenses may be translated at the current rate on the respective transaction dates,
if practical. Otherwise, an average exchange rate is used for all revenue and expenses.

Standards for Translation Established by the Financial

Accounting Standards Board
FASB Statement No. 52 adopted the current rate method, as described in the preceding
section of this chapter, for translating a foreign entity’s financial statements from the en-
tity’s functional currency to the reporting currency of the parent company, which for a
U.S. enterprise is the U.S. dollar.3 If a foreign entity’s accounting records are maintained
in a currency other than its functional currency, account balances must be remeasured to
the functional currency before the foreign entity’s financial statements may be translated.4
Remeasurement essentially is accomplished by the monetary/nonmonetary method of
translation described above. If a foreign entity’s functional currency is the U.S. dollar,
remeasurement eliminates the need for translation of the entity’s financial statements.
Because remeasurement, if required, must precede translation, remeasurement techniques
are illustrated in the next section.

REMEASUREMENT OF A FOREIGN ENTITY’S ACCOUNTS

The FASB provided the following guidelines for remeasurement:
The remeasurement process should produce the same result as if the entity’s books of record
had been initially recorded in the functional currency. To accomplish that result, it is necessary
to use historical exchange rates between the functional currency and another currency in the
remeasurement process for certain accounts (the current rate will be used for all others), . . .
it is also necessary to recognize currently in income all . . . gains and losses from remeasure-
ment of monetary assets and liabilities that are not denominated in the functional currency
(for example, assets and liabilities that are not denominated in dollars if the dollar is the func-
tional currency).5

The following list includes the nonmonetary balance sheet items and related revenue
and expense amounts that should be remeasured using historical rates to produce the same

3
Ibid., par. 12.
4
Ibid., par. 10.
5
Ibid., par. 47.
 Chapter 12 Translation of Foreign Currency Financial Statements 507

result in terms of the functional currency that would have occurred if those items had been
recorded initially in the functional currency. (All other items are remeasured using the
current rate.)
Marketable securities carried at cost:
Equity securities
Debt securities not intended to be held until maturity
Inventories carried at cost
Short-term prepayments such as insurance, advertising, and rent
Plant assets and accumulated depreciation of plant assets
Patents, trademarks, licenses, formulas, goodwill, other tangible assets, and
accumulated amortization of intangible assets
Deferred charges and credits
Deferred revenue
Common stock
Preferred stock carried at issuance price
Examples of revenue and expenses related to nonmonetary items:
Cost of goods sold
Depreciation of plant assets
Amortization of intangible assets such as patents and licenses
Amortization of deferred charges or credits
The appropriate historical or current exchange rate generally is the rate applicable to
conversion of the foreign currency for dividend remittances.6 Accordingly, a U.S. multina-
tional enterprise having foreign branches, investees, or subsidiaries typically uses the buy-
ing spot rate on the balance sheet date or applicable historical date to remeasure the foreign
currency financial statements.

Illustration of Remeasurement of a Foreign Entity’s

Account Balances
To illustrate the remeasurement of a foreign entity’s account balances to the entity’s func-
tional currency from another currency, return to the Smaldino Company illustration in
Chapter 4, with merchandise shipments by the home office to Mason Branch in excess of
home office cost. Assume that both the home office and Mason Branch use the perpetual in-
ventory system, that Mason Branch is located in France, and that the functional currency of
Mason Branch is the U.S. dollar, although the branch maintains its accounting records in
– ), the local currency.
the euro (C
Year 2005 transactions and events of Smaldino’s home office and branch illustrated
in Chapter 4 are repeated below, with appropriate revisions of monetary amounts. Fol-
lowing each transaction is the exchange rate for the euro on the date of the transaction
or event.

Transactions or Events for Year 2005

1. Cash of $1,000 was sent by the home office to Mason Branch (C– 1 $1.065).
2. Merchandise with a cost of $60,000 was shipped by the home office to Mason Branch at
– 1 $1.065).
a billed price of $90,000 (C

6
Ibid., par. 27(b).
508 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

3. Equipment was acquired by Mason Branch for –C500, to be carried in the home office
– 1 $1.054).
accounting records (C
4. Sales by Mason Branch on credit amounted to –C92,500 (C
– 1 $1.058). Cost of goods
sold was –C64,818.
5. Collections of trade accounts receivable by Mason Branch amounted to –C 68,400
– 1 $1.055).
(C
6. Payments for operating expenses by Mason Branch totaled –C6,414 (C
– 1 $1.060).
– –
7. Cash of C37,500 was remitted by Mason Branch to home office (C1 $1.060).
8. Operating expenses incurred by the home office charged to Mason Branch totaled
– 1 $1.063).
$3,000 (C
The exchange rate on December 31, 2005, was –C1 $1.058.
The foregoing transactions or events are recorded by the home office and by Mason
Branch with the following journal entries (explanations omitted):

SMALDINO COMPANY
Home Office and Mason Branch Journal Entries
For Year 2005

Home Office Mason Branch

Accounting Records (U.S. Dollar) Accounting Records (Euro)

(1) Investment in Mason Branch 1,000 Cash ($1,000 $1.065) 939

Cash 1,000 Home Office 939

(2) Investment in Mason Branch 90,000 Inventories ($90,000 $1.065) 84,507

Inventories 60,000 Home Office 84,507
Allowance for Overvaluation of
Inventories: Mason Branch 30,000

(3) Equipment: Mason Branch

– 500 $1.054)
(C 527 Home Office 500
Investment in Mason Branch 527 Cash 500

(4) None Trade Accounts Receivable 92,500

Cost of Goods Sold 64,818
Sales 92,500
Inventories 64,818

(5) None Cash 68,400

Trade Accounts Receivable 68,400

(6) None Operating Expenses 6,414

Cash 6,414

– 37,500 $1.060)
(7) Cash (C 39,750 Home Office 37,500
Investment in Mason Branch 39,750 Cash 37,500

(8) Investment in Mason Branch 3,000 Operating Expenses ($3,000 $1.063) 2,822
Operating Expenses 3,000 Home Office 2,822
 Chapter 12 Translation of Foreign Currency Financial Statements 509

In the home office accounting records, the Investment in Mason Branch ledger account
(in dollars, before the accounts are closed) is as shown below:

Home Office Investment in Mason Branch

Reciprocal Ledger
Date Explanation Debit Credit Balance
Account with Branch
(in Dollars) 2005 Cash sent to branch $ 1,000 $ 1,000 dr
Merchandise shipped to branch 90,000 91,000 dr
Equipment acquired by branch, carried
in home office accounting records $ 527 90,473 dr
Cash received from branch 39,750 50,723 dr
Operating expenses billed to branch 3,000 53,723 dr

In the Mason Branch accounting records, the Home Office ledger account (in euros, be-
fore the accounts are closed) is as follows:

Branch Reciprocal Home Office

Ledger Account with
Date Explanation Debit Credit Balance
Home Office (in Euros)
2005 Cash received from home office –C 939 –C 939 cr
Merchandise received from home office 84,507 85,446 cr
Equipment acquired by branch –C 500 84,946 cr
Cash sent to home office 37,500 47,446 cr
Operating expenses billed by home office 2,822 50,268 cr

Following is the Mason Branch trial balance (in euros) on December 31, 2005:

SMALDINO COMPANY
Mason Branch Trial Balance
December 31, 2005

Debit Credit
Cash –C 24,925
Trade accounts receivable 24,100
Inventories 19,689
Home office –C 50,268
Sales 92,500
Cost of goods sold 64,818
Operating expenses 9,236
Totals –C142,768 –C142,768

Remeasurement of Branch Trial Balance

Remeasurement of the Mason Branch trial balance on December 31, 2005, is illustrated on
page 510.
510 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

Working Paper for SMALDINO COMPANY

Remeasurement of Remeasurement of Mason Branch Trial Balance to U.S. Dollars
Branch Trial Balance December 31, 2005
to U.S. Dollar
Balance Balance
Functional Currency
(Euros) Exchange (U.S. Dollars)
from Euros
dr (cr) Rates dr (cr)
Cash –C 24,925 $1.058 (1) $ 26,371
Trade accounts receivable 24,100 1.058 (1) 25,498
Inventories 19,689 1.065 (2) 20,969
Home office (50,268) (3) (53,723)
Sales (92,500) 1.0615 (4) (98,189)
Cost of goods sold 64,818 1.065 (2) 69,031
Operating expenses 9,236 1.0615 (4) 9,804
Subtotals –C -0- $ (239)
Foreign currency transaction loss 239
Totals –C -0- $ -0-

(1) Current rate (on Dec. 31, 2005)

(2) Historical rate (when goods were shipped to branch by home office)
(3) Balance of Investment in Branch ledger account in home office accounting records
(4) Average of beginning (C
– 1 $1.065) and ending (C – 1 $1.058 ) exchange rates for euro

In a review of the remeasurement of the Mason Branch trial balance, the following four
features should be noted:
1. Monetary assets are remeasured at the current rate; the single nonmonetary asset—
inventories—is remeasured at the appropriate historical rate.
2. To achieve the same result as remeasurement of the Home Office ledger account trans-
actions at appropriate historical rates, the balance of the home office’s Investment in
Mason Branch account (in dollars) is substituted for the branch’s Home Office account
(in euros). All equity ledger accounts—regardless of legal form of the investee—are
remeasured 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 remea-
sured at the appropriate historical rate. 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 remea-
sured trial balance. This transaction loss is included in the measurement of the branch’s
net income for 2005, because it results from the branch’s transactions’ having been
recorded in euros, the branch’s local currency, rather than in dollars, the branch’s func-
tional currency.7
After the trial balance of the Mason Branch has been remeasured from euros to U.S.
dollars, combined financial statements for home office and branch may be prepared as
illustrated in Chapter 4, because the branch’s functional currency is the U.S. dollar.

7
Ibid., par. 47.
 Chapter 12 Translation of Foreign Currency Financial Statements 511

TRANSLATION OF A FOREIGN ENTITY’S FINANCIAL STATEMENTS

As indicated on page 506, if a foreign entity’s financial statement amounts are expressed in a
functional currency other than the U.S. dollar, those amounts must be translated to dollars (the
U.S. reporting currency) by the current rate method. The following sections illustrate transla-
tion of the financial statements of a foreign influenced investee and a foreign subsidiary.

Translation of Financial Statements of Foreign

Influenced Investee
To illustrate the translation of the financial statements of a foreign investee whose func-
tional currency is its local currency, assume that on May 31, 2005, the end of a fiscal year,
Colossus Company, a U.S. multinational company, acquired 30% of the outstanding com-
mon 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 Venezuela Investee for B600,000, 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, 2005, was as follows:

Stockholders’ Equity Common stock B 500,000

of Foreign Investee on Additional paid-in capital 600,000
Date of Investment Retained earnings 900,000
Total stockholders’ equity B2,000,000

There was no difference between the cost of Colossus Company’s investment and its equity
in the net assets of Venezuela Investee (B2,000,000 0.30 B600,000, the cost of the
investment).
The exchange rates for the bolivar were as follows:

Exchange Rates for May 31, 2005 $0.25

Venezuelan Bolivar May 31, 2006 0.27
Average for year ended May 31, 2006 0.26

Translation of Venezuela Investee’s financial statements from the functional currency to the
U.S. dollar reporting currency for the fiscal year ended May 31, 2006, is illustrated as follows:

Working Paper for VENEZUELA INVESTEE

Translation of Investee Translation of Financial Statements to U.S. Dollars
Financial Statements For Year Ended May 31, 2006
to U.S. Dollar
Venezuelan Exchange
Reporting Currency
Bolivars Rates U.S. Dollars
from Bolivar
Functional Currency Income Statement
Net sales B6,000,000 $0.26 (1) $1,560,000
Costs and expenses 4,000,000 0.26 (1) 1,040,000
Net income B2,000,000 $ 520,000

(continued)
512 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

VENEZUELA INVESTEE
Translation of Financial Statements to U.S. Dollars (concluded)
For Year Ended May 31, 2006

Venezuelan Exchange
Bolivars Rates U.S. Dollars
Statement of Retained Earnings
Retained earnings, beginning of year B 900,000 0.25 (2) $ 225,000
Add: Net income 2,000,000 520,000
Subtotals B2,900,000 $ 745,000
Less: Dividends* 600,000 0.27 (3) 162,000
Retained earnings, end of year B2,300,000 $ 583,000

Balance Sheet
Assets
Current assets B 200,000 0.27 (3) $ 54,000
Plant assets (net) 4,500,000 0.27 (3) 1,215,000
Other assets 300,000 0.27 (3) 81,000
Total assets B5,000,000 $1,350,000

Liabilities and Stockholders’ Equity

Current liabilities B 100,000 0.27 (3) $ 27,000
Long-term debt 1,500,000 0.27 (3) 405,000
Common stock 500,000 0.25 (2) 125,000
Additional paid-in capital 600,000 0.25 (2) 150,000
Retained earnings 2,300,000 583,000
Foreign currency translation adjustments 60,000†
Total liabilities and stockholders’ equity B5,000,000 $1,350,000

*Dividends were declared on May 31, 2006.

†Income tax effects are disregarded.
(1) Average rate for year ended May 31, 2006
(2) Historical rate (on May 31, 2005, date of Colossus Company’s investment)
(3) Current rate (on May 31, 2006)

In a review of the translation of the foreign investee’s financial statements illustrated on

page 511 and 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, 2006, 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.8
8
Ibid., par. 13, as amended by FASB Statement No. 130, “Reporting Comprehensive Income” (Norwalk:
FASB, 1997), par. 29.
 Chapter 12 Translation of Foreign Currency Financial Statements 513

Following the translation of Venezuela Investee’s financial statements from bolivars

(the functional currency of Venezuela Investee) to U.S. dollars (the reporting currency
of Colossus Company), on May 31, 2006, Colossus prepares the following journal
entries in U.S. dollars under the equity method of accounting for an investment in
common stock:

Investor Company’s Investment in Venezuela Investee Common Stock ($520,000 0.30) 156,000
Journal Entries under Investment income 156,000
Equity Method of To record 30% of net income of Venezuela Investee. (Income tax
Accounting effects are disregarded.)

Investment in Venezuela Investee Common Stock ($60,000 0.30) 18,000

Foreign Currency Translation Adjustments 18,000
To record 30% of other comprehensive income component of Venezuela
Investee’s stockholders’ equity. (Income tax effects are disregarded.)

Dividends Receivable ($162,000 0.30) 48,600

Investment in Venezuela Investee Common Stock 48,600
To record dividends receivable from Venezuela Investee.

After the foregoing journal entries are posted, the Investment ledger account of Colossus
Company (in U.S. dollars) is as follows:

Investment Ledger Investment in Venezuela Investee Common Stock

Account of Investor
Date Explanation Debit Credit Balance
2005
May 31 Acquisition of 30% of common stock 150,000 150,000 dr
2006
May 31 Share of net income 156,000 306,000 dr
31 Share of other comprehensive income 18,000 324,000 dr
31 Share of dividends 48,600 275,400 dr

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 3($125,000 $150,000 $583,000
$60,000) 0.30 $275,400 4. 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 Investee; however, the investor’s share of
the translation adjustments is reflected in the investor’s Investment ledger account as other
comprehensive income.9 Foreign currency translation adjustments are displayed in accu-
mulated other comprehensive income in the stockholders’ equity section of Venezuela

9
FASB Statement No. 130, par. 121.
514 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

Investee’s translated balance sheet until sale or liquidation of all or part of Colossus Com-
pany’s investment in Venezuela Investee. At that time, the appropriate amount of the foreign
currency translation adjustments is included in the measurement of the gain or loss on sale
or liquidation of the investment in Venezuela Investee.10

Translation and Consolidation of Financial Statements of

Foreign Subsidiary
To illustrate the translation and consolidation of financial statements of a foreign subsidiary
whose functional currency is its local currency, assume that on August 31, 2005, the end of
a fiscal year, SoPac Corporation, a U.S. enterprise with no other subsidiaries, acquired at
the selling spot rate of $NZ1 $0.52 a draft for 500,000 New Zealand dollars ($NZ),
which it used to acquire all 10,000 authorized shares of $NZ50 par common stock of newly
organized Anzac, Ltd., a New Zealand enterprise. The out-of-pocket costs of the acquisi-
tion were immaterial and thus recognized as expense by SoPac, which prepared the follow-
ing journal entry for the investment:

Journal Entry for 2005

Investment in Foreign Aug. 31 Investment in Anzac, Ltd., Common Stock
Subsidiary ($NZ500,000 $0.52) 260,000
Cash 260,000
To record acquisition of 10,000 shares of $NZ50 par common
stock of Anzac, Ltd.

Anzac, Ltd., was self-contained in New Zealand, where it conducted all its operations.
Thus, the functional currency of Anzac was the New Zealand dollar. Further, to enhance
Anzac’s growth, the board of directors of SoPac decided that Anzac should pay no divi-
dends to SoPac in the foreseeable future.
For the fiscal year ended August 31, 2006, Anzac prepared the following income state-
ment and balance sheet (a statement of cash flows is disregarded):

ANZAC, LTD.
Income Statement
For Year Ended August 31, 2006

Revenue:
Net sales $NZ240,000
Other 60,000
Total revenue $NZ300,000
Costs and expenses:
Cost of goods sold $NZ180,000
Operating expenses and income taxes expense 96,000
Total costs and expenses 276,000
Net income (retained earnings, end of year) $NZ 24,000

10
FASB Statement No. 52, par. 14; FASB Interpretation No. 37, “Accounting for Translation Adjustments
upon Sale of Part of an Investment in a Foreign Entity” (Stamford: FASB, 1983), par. 2.
 Chapter 12 Translation of Foreign Currency Financial Statements 515

ANZAC, LTD.
Balance Sheet
August 31, 2006

Assets
Cash $NZ 10,000
Trade accounts receivable (net) 40,000
Inventories 180,000
Short-term prepayments 4,000
Plant assets (net) 320,000
Intangible assets (net) 20,000
Total assets $NZ574,000

Liabilities and Stockholder’s Equity

Notes payable $NZ 20,000
Trade accounts payable 30,000
Total liabilities $NZ 50,000
Common stock, $NZ50 par $NZ500,000
Retained earnings 24,000
Total stockholder’s equity $NZ524,000
Total liabilities and stockholder’s equity $NZ574,000

The exchange rates for the New Zealand dollar were as follows:

Aug. 31, 2005 $0.52

Aug. 31, 2006 0.50
Average for year ended Aug. 31, 2006 0.51

Translation of the financial statements of Anzac, Ltd., from the functional currency to
the U.S. dollar reporting currency for the fiscal year ended August 31, 2006, is illustrated
below and on page 516.

Working Paper for ANZAC, LTD.

Translation of Translation of Financial Statements to U.S. Dollars
Subsidiary Financial For Year Ended August 31, 2006
Statements to U.S.
New Zealand Exchange U.S.
Dollar Reporting
Dollars Rate Dollars
Currency from
New Zealand Dollar Income Statement
Functional Currency Net sales $NZ240,000 $0.51 (1) $122,400
Other revenue 60,000 0.51 (1) 30,600
Total revenue $NZ300,000 $153,000
Cost of goods sold $NZ180,000 0.51 (1) $ 91,800
Operating expenses and income
taxes expense 96,000 0.51 (1) 48,960
Total costs and expenses $NZ276,000 $140,760
Net income (retained earnings,
end of year) $NZ 24,000 $ 12,240

(continued)
516 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

ANZAC, LTD.
Translation of Financial Statements to U.S. Dollars (concluded)
For Year Ended August 31, 2006

New Zealand Exchange U.S.

Dollars Rate Dollars
Balance Sheet
Cash $NZ 10,000 0.50 (2) $ 5,000
Trade accounts receivable (net) 40,000 0.50 (2) 20,000
Inventories 180,000 0.50 (2) 90,000
Short-term prepayments 4,000 0.50 (2) 2,000
Plant assets (net) 320,000 0.50 (2) 160,000
Intangible assets (net) 20,000 0.50 (2) 10,000
Total assets $NZ574,000 $287,000
Notes payable $NZ 20,000 0.50 (2) $ 10,000
Trade accounts payable 30,000 0.50 (2) 15,000
Common stock 500,000 0.52 (3) 260,000
Retained earnings 24,000 12,240
Foreign currency translation
adjustments (10,240)*
Total liabilities and
stockholder’s equity $NZ574,000 $287,000

*Income tax effects are disregarded.

(1) Average for year ended Aug. 31, 2006
(2) Current rate (on Aug. 31, 2006)
(3) Historical rate (on Aug. 31, 2005, date of SoPac Corporation’s investment)

Following the translation of the financial statements of Anzac, Ltd., from New Zealand
dollars (the functional currency of Anzac) to U.S. dollars (the reporting currency of SoPac
Corporation), SoPac prepares the following journal entries in U.S. dollars under the equity
method of accounting for an investment in common stock:

Parent Company’s 2006

Journal Entry under Aug. 31 Investment in Anzac, Ltd., Common Stock 12,240
Equity Method of Intercompany Investment Income 12,240
Accounting To record 100% of net income of Anzac, Ltd. (Income tax
effects are disregarded.)

31 Foreign Currency Translation Adjustments 10,240

Investment in Anzac, Ltd. Common Stock 10,240
To record 100% of other comprehensive income component
of Anzac Ltd.’s stockholder’s equity. (Income tax effects
are disregarded.)

After the foregoing journal entries are posted, the balance of SoPac’s Investment in
Anzac, Ltd., Common Stock ledger account is $262,000 ($260,000 $12,240 $10,240),
which is equal to the total stockholder’s equity of Anzac, Ltd., including foreign currency
translation adjustments, in the translated balance sheet of Anzac ($260,000 $12,240
$10,240 $262,000). SoPac is now enabled to prepare the following working paper elim-
ination (in journal entry format) and working paper for consolidated financial statements,
 Chapter 12 Translation of Foreign Currency Financial Statements 517

as well as the consolidated financial statements on pages 518 and 519 (other amounts for
SoPac are assumed).

SOPAC CORPORATION AND SUBSIDIARY

Working Paper Elimination
August 31, 2006

(a) Common Stock—Anzac 260,000

Intercompany Investment Income—SoPac 12,240
Investment in Anzac, Ltd., Common Stock—SoPac 262,000
Foreign Currency Translation Adjustments—SoPac 10,240
To eliminate intercompany investment and equity accounts of
subsidiary.
(Income tax effects are disregarded.)

Equity Method: Wholly Owned Subsidiary Subsequent to Date of Business Combination

SOPAC CORPORATION AND SUBSIDIARY

Working Paper for Consolidated Financial Statements
For Year Ended August 31, 2006

Eliminations
SoPac Increase
Corporation Anzac, Ltd. (Decrease) Consolidated
Income Statement
Revenue:
Net sales 840,000 122,400 962,400
Intercompany investment income 12,240 (a) (12,240)
Other 120,000 30,600 150,600
Total revenue 972,240 153,000 (12,240) 1,113,000
Costs and expenses:
Cost of goods sold 720,000 91,800 811,800
Operating expenses and income
taxes expense 160,000 48,960 208,960
Total costs and expenses 880,000 140,760 1,020,760
Net income 92,240 12,240 (12,240) 92,240

Statement of Retained Earnings

Retained earnings, beginning of year 480,000 480,000
Net income 92,240 12,240 (12,240) 92,240
Subtotal 572,240 12,240 (12,240) 572,240
Dividends declared 30,000 30,000
Retained earnings, end of year 542,240 12,240 (12,240) 542,240

Balance Sheet
Assets
Cash 80,000 5,000 85,000
Trade accounts receivable (net) 270,000 20,000 290,000
Inventories 340,000 90,000 430,000
Short-term prepayments 12,000 2,000 14,000
Investment in Anzac, Ltd., common stock 262,000 (a) (262,000)
Plant assets (net) 618,000 160,000 778,000
Intangible assets (net) 80,000 10,000 90,000
Total assets 1,662,000 287,000 (262,000) 1,687,000
(continued)
518 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

Equity Method: Wholly Owned Subsidiary Subsequent to Date of Business Combination

SOPAC CORPORATION AND SUBSIDIARY

Working Paper for Consolidated Financial Statements (concluded)
For Year Ended August 31, 2006

Eliminations
SoPac Increase
Corporation Anzac, Ltd. (Decrease) Consolidated
Liabilities and
Stockholders’ Equity
Notes payable 50,000 10,000 60,000
Trade accounts payable 80,000 15,000 95,000
Long-term debt 400,000 400,000
Common stock 600,000 260,000 (a) (260,000) 600,000
Retained earnings 542,240 12,240 (12,240) 542,240
Foreign currency translation
adjustments (10,240) (10,240) (a) (10,240)* (10,240)†
Total liabilities and stockholders’
equity 1,662,000 287,000 (262,000) 1,687,000

*
A decrease in foreign currency translation adjustments and an increase in equity.
†
Income tax effects are disregarded.

SOPAC CORPORATION AND SUBSIDIARY

Consolidated Income Statement
For Year Ended August 31, 2006

Revenue:
Net sales $ 962,400
Other 150,600
Total revenue $1,113,000
Costs and expenses:
Cost of goods sold $811,800
Operating expenses and income taxes expense 208,960
Total costs and expenses 1,020,760
Net income $ 92,240
Basic earnings per share of common stock
(60,000 shares outstanding) $ 1.54

SOPAC CORPORATION AND SUBSIDIARY

Consolidated Statement of Comprehensive Income
For Year Ended August 31, 2006

Net income $ 92,240

Other comprehensive income: Foreign currency translation adjustments
(disregarding income tax effects) (10,240)
Comprehensive income $ 82,000
 Chapter 12 Translation of Foreign Currency Financial Statements 519

SOPAC CORPORATION AND SUBSIDIARY

Consolidated Statement of Changes in Equity
For Year Ended August 31, 2006

Accumulated
Other
Common Retained Comprehensive
Stock Earnings Income Total
Balances, beginning of year $600,000 $480,000 $1,080,000
Add: Net income 92,240 92,240
Other comprehensive
income:
Foreign currency
translation adjustments $(10,240) (10,240)
Comprehensive income $ 82,000
Dividends declared (30,000) (30,000)
Balances, end of year $600,000 $542,240 $(10,240) $1,132,000

SOPAC CORPORATION AND SUBSIDIARY

Consolidated Balance Sheet
August 31, 2006

Assets
Current assets:
Cash $ 85,000
Trade accounts receivable (net) 290,000
Inventories 430,000
Short-term prepayments 14,000
Total current assets $ 819,000
Plant assets (net) 778,000
Intangible assets (net) 90,000
Total assets $1,687,000

Liabilities and Stockholders’ Equity

Current liabilities:
Notes payable $ 60,000
Trade accounts payable 95,000
Total current liabilities $ 155,000
Long-term debt 400,000
Total liabilities $ 555,000
Stockholders’ equity:
Common stock, $10 par $600,000
Retained earnings 542,240
Accumulated other comprehensive income (10,240)
Total stockholders’ equity 1,132,000
Total liabilities and stockholders’ equity $1,687,000

The foregoing consolidated financial statements are in the formats required by the
FASB.11
11
FASB Statement No. 130, pars. 14, 22, 23, 26.
520 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

Summary: Remeasurement and Translation

Principal features of the foregoing discussion of remeasurement of a foreign entity’s ac-
counts and translation of a foreign entity’s financial statements are summarized in the fol-
lowing table:

Comparison of Remeasurement and Translation

Feature Remeasurement Translation
Underlying concept Foreign entity’s accounts should Foreign entity’s financial
reflect transactions and events statements should reflect
as though recorded in the financial results and
functional currency rather relationships created in
than the local currency. the economic environment
of the foreign operations.
When required (1) Foreign entity’s accounts are Foreign entity’s functional
maintained in the local currency is not the
currency instead of the reporting currency.
functional currency.
(2) Foreign entity is operating in
a highly inflationary
economy (see page 521).
Method used Monetary/nonmonetary method Current rate method
Display of balancing In income statement as In balance sheet, stockholders’
amount transaction gain or loss equity section, as part of
accumulated other
comprehensive income

Other Aspects of Foreign Currency Translation

In addition to the topics discussed thus far, the four topics described in the following sec-
tions are included in FASB Statement No. 52.

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 adjustments.12
1. Foreign currency transactions that are designated as, and are effective as, economic
hedges of a net investment in a foreign entity, commencing as of the designation date
2. Intercompany foreign currency transactions that are of a long-term investment nature
(that is, settlement is not planned or anticipated in the foreseeable future), when the enti-
ties to the transaction are consolidated, combined, or accounted for by the equity
method. . . .

12
FASB Statement No. 52, par. 20, as reaffirmed by FASB Statement No. 133, “Accounting for Derivative
Instruments and Hedging Activities” (Norwalk: FASB, 1998), pars. 42, 474–478, which deals also with
forward contracts designated as a hedge of the net investment in a foreign operation.
 Chapter 12 Translation of Foreign Currency Financial Statements 521

To illustrate an economic hedge of a net investment in a foreign entity, return to the

Venezuela Investee illustration on pages 512–513 and assume that, to hedge its investment,
Colossus Company borrowed B1,020,000 from a Venezuela bank on May 31, 2006.
B1,020,000 is equal to the carrying amount, in bolivars, of Colossus Company’s investment
on May 31, 2006 3 (B500,000 B600,000 B2,300,000) 0.30 B1,020,000 4 . If the
exchange rate for the bolivar was B1 $0.28 on May 31, 2007, Colossus had a foreign
currency transaction loss of $10,200 3 B1,020,000 ($0.28 $0.27) 4 during the fiscal
year ended May 31, 2007, on the loan payable to the Venezuela bank. Disregarding income
taxes, no part of the $10,200 transaction loss is recognized by Colossus if foreign currency
translation adjustments in the May 31, 2007, translated balance sheet of Venezuela In-
vestee are at least $70,200, which is a $10,200 increase ($70,200 $60,000) over the
May 31, 2006, balance. If however, foreign currency translation adjustments are less than
$70,200 on May 31, 2007, Colossus Company recognizes an appropriate part of the trans-
action loss. For example, if foreign currency translation adjustments in the May 31, 2007,
translated balance sheet are $64,500, Colossus prepares the following journal entry on
May 31, 2007:

Investor Company’s Foreign Currency Transaction Losses 5,700

Journal Entry for Loan Payable to Venezuela Bank 5,700
Foreign Currency To recognize foreign currency transaction loss on loan obtained to hedge
Transaction Loss on investment in Venezuela Investee as follows:
Hedging Loan Liability recorded on May 31, 2006 (B1,020,000 $0.27) $275,400
Less: Liability translated at May 31, 2007, spot rate
B1 $0.28 (B1,020,000 $0.28) 285,600
Difference $ (10,200)
Less: Increase in foreign currency translation
adjustments of investee ($64,500 $60,000) 4,500
Foreign currency transaction loss recognized $ (5,700)

Functional Currency in Highly Inflationary Economies

The FASB required that the functional currency of a foreign entity in a highly inflation-
ary economy be identified as the reporting currency (the U.S. dollar for a U.S. multina-
tional enterprise). The FASB defined a highly inflationary economy as one having
cumulative inflation of 100% or more over a three-year period.13 Thus, financial state-
ments of a foreign entity in a country experiencing severe inflation are remeasured in U.S.
dollars, regardless of the criteria for determination of the functional currency described
on pages 503–504.

Income Taxes Related to Foreign Currency Translation

Conventional interperiod and intraperiod income tax allocation procedures were pre-
scribed by the FASB for the income tax effects of foreign currency translation, as
follows:14

13
Ibid., par. 11.
14
Ibid., pars. 22–24.
522 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

1. Interperiod tax allocation for temporary differences associated with foreign currency
transaction gains and losses that are reported in different accounting periods for finan-
cial accounting and income taxes. [Interperiod tax allocation is discussed in intermedi-
ate accounting textbooks.]
2. Interperiod tax allocation for temporary differences associated with foreign currency
translation adjustments that do not meet the criteria for nonrecognition of deferred tax
liabilities for undistributed earnings of foreign subsidiaries. (See Chapter 9, page 387.)
3. Intraperiod tax allocation for foreign currency translation adjustments included in the
stockholders’ equity section of the balance sheet. (Intraperiod tax allocation is discussed
in intermediate accounting textbooks.)

Disclosure of Foreign Currency Translation

The FASB required disclosure, in the income statement or in a note to the financial state-
ments, of the aggregate foreign currency transaction gains or losses of an accounting pe-
riod. Further, as illustrated on page 519, the FASB required disclosure of changes in foreign
currency translation adjustments (as well as other components of accumulated other com-
prehensive income) during an accounting period. The FASB also has specified additional
disclosures for forward contracts or other financial instruments designated as hedges of the
foreign currency exposure of a net investment in a foreign operation.15

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 comparable with those of
FASB No. 52, “Foreign Currency Translation.” A difference is that IAS 21 states a prefer-
ence for applying price-level adjustments (a topic discussed in intermediate accounting
textbooks and covered in IAS 29, “Financial Reporting in Hyperinflationary Economies”)
prior to the translation of financial statements of foreign entities operating in highly infla-
tionary economies.

Appraisal of Accounting Standards for Foreign

Currency Translation
FASB Statement No. 52 was approved by the FASB by a bare four-to-three majority, which
indicates the degree of dissatisfaction with the standards it established for foreign currency
translation. Among the criticisms of FASB Statement No. 52 are the following:
1. It established an identifiable distinction between transaction gains and losses arising
from remeasurement and translation adjustments resulting from translation. Both
remeasurement and translation involve comparable activities—the restatement of
amounts in a foreign currency to another currency—thus, they should be accounted for
in the same manner.
2. It abandoned the historical-cost principle by sanctioning use of the current rate 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, “Accounting for the Translation of Foreign Currency Transac-
tions and Foreign Currency Financial Statements,” which was superseded by FASB
Statement No. 52, was in effect for little more than six years, during which time it was

15
Ibid., pars. 30–31; FASB Statement No. 130, par. 26; FASB Statement No. 133, par. 45c.
 Chapter 12 Translation of Foreign Currency Financial Statements 523

the subject of continuous controversy. FASB Statement No. 8 was criticized for its re-
quirements that translation adjustments be included in the measurement of net income
and that the monetary/nonmonetary method be used to translate a foreign entity’s finan-
cial statements.

Review 1. What is the functional currency of a foreign entity?

Questions 2. Differentiate between the current/noncurrent method and the current rate method of
translating foreign currency financial statements.
3. What exchange rate is used to remeasure to U.S. dollars (the functional currency) the
balance of the Intercompany Accounts Payable ledger account of a foreign subsidiary of
a U.S. parent company? Explain.
4. Differentiate remeasurement to functional currency from foreign currency translation.
5. Differentiate between foreign currency transaction gains and losses and foreign cur-
rency translation adjustments.
6. What foreign currency transaction gains and losses are excluded from the measure-
ment of net income?
7. What is the functional currency of a foreign investee in a highly inflationary economy?
8. What disclosures relating to foreign currency matters are required in the financial state-
ments or in a note to the financial statements of U.S. multinational enterprises?
9. What criticisms of FASB Statement No. 52, “Foreign Currency Translation,” have been
made?

Exercises
(Exercise 12.1) Select the best answer for each of the following multiple-choice questions:
1. The functional currency of a foreign subsidiary might be any of the following except the:
a. Local currency.
b. Reporting currency.
c. Supplemental Drawing Rights of the International Monetary Fund.
d. Currency in which the subsidiary maintains its accounting records.
2. If a foreign subsidiary of a U.S. multinational enterprise has a functional currency other
than its local currency and the U.S. dollar, the subsidiary’s financial statements must be:
a. Remeasured to the U.S. dollar only.
b. Translated to the U.S. dollar only.
c. Remeasured to the functional currency and translated to the U.S. dollar.
d. Translated to the functional currency and remeasured to the U.S. dollar.
3. Gains and losses resulting from remeasurement of foreign currency financial state-
ments to the functional currency are displayed as a(n):
a. Part of equity in the balance sheet.
b. Extraordinary item in the income statement for the accounting period in which
remeasurement takes place.
c. Ordinary item in the income statement for losses but deferred for gains.
d. Ordinary item in the income statement for the accounting period in which remea-
surement takes place.
524 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

4. According to FASB Statement No. 52, “Foreign Currency Translation,” remeasure-

ment of a foreign subsidiary’s accounting records to the subsidiary’s functional cur-
rency should be accomplished by the:
a. Monetary/nonmonetary method.
b. Current rate method.
c. Current/noncurrent method.
d. Functional currency method.
5. The monetary/nonmonetary method of foreign currency translation currently is
used for:
a. Remeasurement but not for translation.
b. Translation but not for remeasurement.
c. Both remeasurement and translation.
d. Neither remeasurement nor translation.
6. According to FASB Statement No. 52, “Foreign Currency Translation,” the appro-
priate method of restatement from a foreign currency to the U.S. dollar for each of
the following is:

Remeasurement Translation
a. Current rate Monetary/nonmonetary
b. Monetary/nonmonetary Current rate
c. Monetary/nonmonetary Monetary/nonmonetary
d. Current rate Current rate

7. Currently displayed in the income statement of a U.S. multinational enterprise are:

a. Foreign currency transaction gains and losses only.
b. Foreign currency translation adjustments only.
c. Both foreign currency gains and losses and foreign currency translation adjustments.
d. Neither foreign currency transaction gains and losses nor foreign currency transla-
tion adjustments.
8. With respect to a foreign subsidiary’s financial statements, are foreign currency trans-
action gains and losses recognized in:

Remeasurement from Translation from Functional

Local Currency to Currency to Reporting
Functional Currency? Currency?
a. Yes Yes
b. Yes No
c. No Yes
d. No No

9. Do foreign currency translation adjustments result from:

Remeasurement of a Translation of a Foreign

Branch’s Trial Investee’s Financial
Balance? Statements?
a. Yes No
b. No Yes
c. No No
d. Yes Yes
 Chapter 12 Translation of Foreign Currency Financial Statements 525

10. Foreign currency translation adjustments arising from translation of the financial state-
ments of a foreign subsidiary are currently reported in:
a. Stockholders’ equity of the foreign subsidiary.
b. Revenue or expenses of the foreign subsidiary.
c. Consolidated net income of the parent company and the foreign subsidiary.
d. Paid-in capital of the parent company.
11. Foreign currency translation adjustments is a:
a. Parent company ledger account.
b. Foreign subsidiary ledger account.
c. Balancing amount for translation.
d. Balancing amount for remeasurement.
(Exercise 12.2) Among the journal entries of the foreign branch of Logan Company for the month of
April 2006 were the following, denominated in the local currency unit (LCU):

2006
Apr. 4 Cash LCU10,000
Home Office LCU10,000
To record receipt and conversion to LCU of $2,400
draft sent by the home office on Apr. 1, 2006.

16 Home Office LCU50,000

Cash LCU50,000
To record payment for equipment to be carried
in the home office accounting records.

28 Home Office LCU4,000

Cash LCU4,000
To record dispatch of LCU4,000 draft to home office.

Spot exchange rates for the LCU during April 2006 were as follows:

LCU1
Buying Selling
Apr. 1 $0.22 $0.24
4 0.23 0.25
16 0.21 0.22
28 0.23 0.24
30 0.22 0.23

The home office of Logan Company received and converted the LCU4,000 draft to U.S.
dollars on April 30, 2006.
Prepare journal entries, denominated in U.S. dollars, for the home office of Logan Com-
pany to reflect appropriately the foregoing transactions and events of the foreign branch.
(Exercise 12.3) A wholly owned foreign subsidiary of Multiverse Company had selected expense accounts
stated in local currency units (LCU) for the fiscal year ended November 30, 2006, as follows:

Doubtful accounts expense LCU 60,000

Patent amortization expense (patent acquired Dec. 1, 2003) 40,000
Rent expense 100,000
526 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

The functional currency of the foreign subsidiary is the U.S. dollar. The exchange rates for
the LCU for various dates or periods were as follows:

Dec. 1, 2005 $0.25

Nov. 30, 2006 0.20
Average for year ended Nov. 30, 2006 0.22

Prepare a working paper to compute the total dollar amount to be included in the re-
measured income statement of Multiverse Company’s foreign subsidiary for the year ended
November 30, 2006, for the foregoing expense accounts.
(Exercise 12.4) The foreign subsidiary of Paloma Company, a U.S. multinational enterprise, had plant as-
sets on December 31, 2006, with a cost of 3,600,000 local currency units (LCU). Of this
CHECK FIGURE amount, plant assets with a cost of LCU2,400,000 were acquired in 2004, when the
Depreciation expense exchange rate was LCU1 $0.625; and plant assets with a cost of LCU1,200,000 were
for 2006, $216,720. acquired in 2005, when the exchange rate was LCU1 $0.556. The exchange rate on
December 31, 2006, was LCU1 $0.500, and the weighted-average exchange rate for
2006 was LCU1 $0.521. The foreign subsidiary depreciated plant assets by the straight-
line method over a 10-year economic life with no residual value. The U.S. dollar was the
functional currency of the foreign subsidiary.
Prepare a working paper to compute for 2006 the depreciation expense for Paloma Com-
pany’s foreign subsidiary, in U.S. dollars, for the remeasured income statement.
(Exercise 12.5) Following is the euro-denominated trial balance of the French Branch of USA Corporation
on June 30, 2005, the end of the first month of the branch’s operations:

CHECK FIGURE
USA CORPORATION
Foreign currency
French Branch Trial Balance
transaction gain,
June 30, 2005
$12,150.
Cash –C 15,000
Trade accounts receivable 250,000
Inventories 115,000
Home office –C360,000
Sales 450,000
Cost of goods sold 340,000
Operating expenses 90,000
Totals –C810,000 –C810,000

Additional Information
1. All the merchandise in the branch’s inventories on June 30, 2005, had been shipped by
the home office on June 1, 2005, when the exchange rate was –C1 $1.05.
2. The balance of the home office’s Investment in French Branch ledger account on June
30, 2005, was $365,000.
3. The exchange rate on June 30, 2005, was –C1 $1.04.
Prepare a working paper to remeasure the June 30, 2005, trial balance of French Branch
of USA Corporation to U.S. dollars, the branch’s functional currency. Round all remeasured
amounts to the nearest dollar.
 Chapter 12 Translation of Foreign Currency Financial Statements 527

(Exercise 12.6) The trial balance of the German Branch of Global Company, a U.S. multinational enter-
prise, on April 30, 2005, the end of the first month of the branch’s operations, was as fol-
lows [denominated in the euro (C– )]:

CHECK FIGURE
GLOBAL COMPANY
Foreign currency
German Branch Trial Balance
transaction loss,
April 30, 2005
$5,850.
Debit Credit
Cash –C 15,000
Trade accounts receivable 260,000
Inventories 120,000
Home office –C280,000
Sales 550,000
Cost of goods sold 340,000
Operating expenses 95,000
Totals –C830,000 –C830,000

The balance of Global Company’s home office’s Investment in German Branch ledger account
on April 30, 2005, was $298,000. Relevant exchange rates for the euro were as follows:

–C 1
April 1, 2005 (date of Global’s home office’s only shipment of merchandise
to the branch) $1.04
Apr. 30, 2005 1.06
Average for April 2005 1.05

Prepare a working paper to remeasure the April 30, 2005, trial balance of the German
Branch of Global Company to U.S. dollars, its functional currency, from euros. Round all
amounts to the nearest dollar. Use the following columns in your working paper:

Balance (C–) Exchange Balance ($)

dr (cr) Rates dr (cr)

(Exercise 12.7) The translated balance sheet items of Spanish Company, wholly owned foreign subsidiary of
U.S. corporation, which owned all of Spanish’s authorized common stock, were as follows
on November 30, 2006:

CHECK FIGURE
Additional paid-in capital $100,000
Foreign currency
Common stock 50,000
translation
Foreign currency translation adjustments (credit balance) 30,000
adjustments, $30,000
Current assets 180,000
credit balance.
Current liabilities 80,000
Long-term debt 120,000
Other assets 60,000
Plant assets (net) 260,000
Retained earnings 120,000

Prepare a balance sheet for Spanish Company on November 30, 2006.

528 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

(Exercise 12.8) For the year ended December 31, 2005, its first year of operations after its establishment
by Stateside Corporation, its parent company, wholly owned Overseas Company had the
CHECK FIGURE following financial statement amounts, denominated in its functional currency, the local
Foreign currency currency unit (LCU):
translation
adjustments, $12,000
credit balance. Total revenue LCU800,000
Total expenses 600,000
Total assets 900,000
Total liabilities 500,000
Stockholder’s equity:
Common stock, LCU1 par 200,000
Retained earnings (no dividends declared) 200,000

Exchange rates for the LCU were as follows:

Jan. 2, 2005 (date Overseas was established) LCU1 $0.44

Dec. 31, 2005 LCU1 $0.48
Average for 2005 LCU1 $0.46

Prepare a working paper to compute the foreign currency translation adjustments to be

displayed in the translated balance sheet, stockholder’s equity section, of Overseas Com-
pany on December 31, 2005.
(Exercise 12.9) On December 31, 2006, Investor Corporation, a U.S. multinational enterprise, had a 20%
influencing investment in the common stock of Foreign Investee Company, whose stock-
CHECK FIGURE holders’ equity totaled 1,500,000 local currency units (LCU), its functional currency, on
Foreign currency that date. The translated balance sheet of Foreign Investee on December 31, 2006, included
transaction loss, $9,300. in stockholders’ equity foreign currency translation adjustments of $47,600 (credit bal-
ance). On January 2, 2007, to hedge its net investment in Foreign Investee, Investor bor-
rowed LCU300,000 when the exchange rate was LCU1 $0.20, which was the same
exchange rate in effect on December 31, 2006. On December 31, 2007, the exchange rate
for the local currency unit was LCU1 $0.24, and foreign currency translation adjust-
ments in Foreign Investee’s translated balance sheet amounted to $50,300 (credit balance).
Prepare a journal entry for Investor Corporation on December 31, 2007, to recognize the
change in the exchange rate for the LCU from LCU1 $0.20 on December 31, 2006, to
LCU1 $0.24 on December 31, 2007.

Cases
(Case 12.1) Ostmark Company, a U.S. multinational enterprise, has a subsidiary in Austria. On April 1,
2006, Ostmark acquired for $550,000 a draft for 500,000 euros (C – ) and remitted it to the
Austrian subsidiary as a long-term, non-interest-bearing advance. The advance was to be
repaid ultimately in U.S. dollars. The euro is the functional currency of the subsidiary.
You were engaged as independent auditor for the audit of the March 31, 2007, consoli-
dated financial statements of Ostmark Company and subsidiaries (including the Austrian
subsidiary). On March 31, 2007, the selling spot rate for the euro was –C 1 $1.05.
Ostmark’s controller translated the Payable to Ostmark Company liability in the Austrian
subsidiary’s balance sheet from –C500,000 to $525,000 (C – 500,000 $1.05 $525,000).
 Chapter 12 Translation of Foreign Currency Financial Statements 529

Because the $525,000 translated balance of the subsidiary’s Payable to Ostmark Company
liability did not offset the $550,000 balance of Ostmark’s Receivable from Austrian Sub-
sidiary ledger account on March 31, 2007, Ostmark’s controller prepared the following
working paper elimination (in journal entry format) on March 31, 2007:

Foreign Currency Translation Adjustments—Austrian Subsidiary 25,000

Receivable from Austrian Subsidiary—Ostmark 25,000
To record translation adjustment resulting from decline in exchange rate
for the euro to –C1 $1.05 on March 31, 2007, from –C1 $1.10 on
April 1, 2006.

Instructions
Evaluate the accounting treatment described above.
(Case 12.2) Suppose that the following resolution were to be debated in your accounting class:
RESOLVED, that FASB No. 52, “Foreign Currency Translation,” established an indefensible
distinction between transaction gains and losses arising from remeasurement and translation
adjustments arising from translation.

Instructions
Which side—affirmative or negative—would you support in the debate? Explain.
(Case 12.3) FASB No. 52, “Foreign Currency Translation,” essentially gives to management of a U.S.
multinational enterprise the responsibility for determining the functional currency of the
enterprise’s foreign branches, divisions, influenced investees, joint ventures, and sub-
sidiaries, except for foreign entities that operate in highly inflationary economies, which
must use the reporting currency as the functional currency.
Instructions
Given that remeasurement from a local currency to the functional currency produces for-
eign currency transaction gains and losses displayed in the enterprise’s income statement,
while translation from the functional currency to the reporting currency generates foreign
currency translation adjustments currently displayed in the stockholders’ equity section of
the balance sheet, is there any incentive for management to determine that the local cur-
rency of a foreign entity is not its functional currency? Explain.

Problems
(Problem 12.1) On March 1, 2005, Transcontinent Company, a U.S. multinational enterprise, established a
branch in Mideastia, a foreign country. Transcontinent’s home office sent cash and mer-
chandise (billed at cost) to the Mideastia Branch only on March 1, 2005, and the branch
CHECK FIGURE made sales and incurred rent and other operating expenses in Mideastia during the month
Foreign currency of March 2005. Transcontinent’s home office maintained accounts in its ledger for the
transaction loss, $140. branch’s plant assets. Because the Mideastia Branch’s operations were an integral compo-
nent of Transcontinent’s home office’s operations, the U.S. dollar was the functional cur-
rency of the Mideastia Branch; however, the branch maintained its accounting records in
the local currency unit (LCU).
The trial balance of the Mideastia Branch on March 31, 2005, was as follows:
530 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

TRANSCONTINENT COMPANY
Mideastia Branch Trial Balance
March 31, 2005

Debit Credit
Cash LCU 2,000
Trade accounts receivable 58,000
Allowance for doubtful accounts LCU 1,000
Inventories 126,000
Home office 220,000
Sales 184,000
Cost of goods sold 160,000
Operating expenses 59,000
Totals LCU405,000 LCU405,000

Relevant exchange rates for the Mideastia Branch’s local currency unit were as follows:

Mar. 1, 2005 $0.60

Mar. 31, 2005 0.64
Average for March 2005 0.62

Instructions
Prepare a working paper to remeasure the March 31, 2005, trial balance of Mideastia
Branch of Transcontinent Company to U.S. dollars, the branch’s functional currency, from
local currency units. The March 31, 2005, balance (before closing entries) of the Invest-
ment in Mideastia Branch ledger account in Transcontinent’s home office’s ledger was
$132,000. Use the following headings for your working paper:

Balance Balance
(LCUs) Exchange (U.S. Dollars)
Account Title dr (cr) Rates dr (cr)

(Problem 12.2) The trial balance in local currency units (LCU) of Foreign Branch of Sarasota Company on
April 30, 2005, the end of the branch’s first month of operations, is as follows. The func-
tional currency of Foreign Branch is the U.S. dollar.

CHECK FIGURE
SARASOTA COMPANY
Foreign currency
Foreign Branch Trial Balance
transaction loss, $9,479.
April 30, 2005

Balance
dr (cr)
Cash LCU 10,000
Trade accounts receivable 50,000
Inventories (1,600 units at first-in, first-out cost) 124,375
Home office (104,565)
Sales (2,100 units at LCU133) (279,300)
Cost of goods sold 152,289
Operating expenses 47,201
Total LCU -0-
 Chapter 12 Translation of Foreign Currency Financial Statements 531

Additional Information
1. Foreign Branch sells a single product, which it acquires from the home office of Sarasota
Company.
2. The Investment in Foreign Branch ledger account in the accounting records of the home
office of Sarasota Company (prior to end-of-period adjusting and closing entries) is
shown below:

Investment in Foreign Branch ($)

Date Explanation Debit Credit Balance
2005
Apr. 1 Cash sent to branch 10,000 10,000 dr
1 1,000 units of merchandise
shipped to branch $80 a unit 80,000 90,000 dr
3 Equipment acquired by branch
(recorded in Home Office
accounting records) 5,500 84,500 dr
10 1,200 units of merchandise
shipped to branch $81 a unit 97,200 181,700 dr
20 1,500 units of merchandise
shipped to branch $82 a unit 123,000 304,700 dr
29 Cash received from branch 210,000 94,700 dr
30 Operating expenses billed to branch 25,000 119,700 dr

3. The Home Office ledger account in the accounting records of the Foreign Branch of
Sarasota Company (prior to end-of-period closing entries) is shown below:

Home Office (LCU)

Date Explanation Debit Credit Balance
2005
Apr. 2 Cash received from home office 9,091 9,091 cr
2 1,000 units of merchandise
received from home office
LCU72.73 72,730 81,821 cr
2 Equipment acquired by branch 5,000 76,821 cr
11 1,200 units of merchandise received
from home office LCU72.32 86,784 163,605 cr
21 1,500 units of merchandise received
from home office LCU78.10 117,150 280,755 cr
28 Cash sent to home office 200,000 80,755 cr
30 Operating expenses billed by
home office 23,810 104,565 cr

4. Exchange rates for the local currency unit (LCU) of the country in which Foreign
Branch operates were as follows during April 2005:

Apr. 1–Apr. 6 $1.10

Apr. 7–Apr. 18 1.12
Apr. 19–Apr. 30 1.05
532 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

Instructions
Prepare a working paper to remeasure the April 30, 2005, trial balance of Foreign Branch
of Sarasota Company to U.S. dollars, its functional currency, from local currency units.
Compute all exchange rates to the nearest cent.
(Problem 12.3) On December 1, 2005, the beginning of a fiscal year, Pan-Europe Corporation, a U.S.
multinational enterprise, formed a foreign subsidiary, which issued all of its currently out-
CHECK FIGURE standing common stock to Pan-Europe on that date. Selected items from the subsidiary’s
Accumulated trial balances, all of which are shown in local currency units (LCU), are as follows:
depreciation, Nov. 30,
2007, $16,010.
Nov. 30, Nov. 30,
2007 2006
Trade accounts receivable (net of allowance for
doubtful accounts of LCU2,200 on Nov. 30, 2007,
and LCU2,000 on Nov. 30, 2006) LCU 40,000 LCU 35,000
Inventories, at first-in, first-out cost 80,000 75,000
Plant assets (net of accumulated depreciation of
LCU31,000 on Nov. 30, 2007, and LCU14,000
on Nov. 30, 2006) 163,000 150,000
Long-term debt 100,000 120,000
Common stock, authorized 10,000 shares, LCU10 par;
issued and outstanding 5,000 shares on Nov. 30, 2007,
and Nov. 30, 2006 50,000 50,000

Additional Information
1. Relevant exchange rates were as follows:

Dec. 1, 2005–June 30, 2006 2LCU to $1

July 1, 2006–Sept. 30, 2006 1.8LCU to $1
Oct. 1, 2006–May 31, 2007 1.7LCU to $1
June 1, 2007–Nov. 30, 2007 1.5LCU to $1
Average monthly rate for year ended Nov. 30, 2006 1.9LCU to $1
Average monthly rate for year ended Nov. 30, 2007 1.6LCU to $1

2. Analysis of the trade accounts receivable (net) balances follows:

Year Ended November 30,

2007 2006
Trade Accounts Receivable:
Balances, beginning of year LCU 37,000
Sales (LCU36,000 a month in 2007 and
LCU31,000 a month in 2006) 432,000 LCU 372,000
Collections (423,600) (334,000)
Write-offs (April 2007 and November 2006) (3,200) (1,000)
Balances, end of year LCU 42,200 LCU 37,000

Allowance for Doubtful Accounts:

Balances, beginning of year LCU 2,000
Doubtful accounts expense 3,400 LCU 3,000
Write-offs (April 2007 and November 2006) (3,200) (1,000)
Balances, end of year LCU 2,200 LCU 2,000
 Chapter 12 Translation of Foreign Currency Financial Statements 533

3. An analysis of inventories, for which the first-in, first-out inventory method is used, follows:

Year Ended November 30,

2007 2006
Inventories, beginning of year LCU 75,000
Purchases (May 2007 and May 2006) 335,000 LCU375,000
Goods available for sale LCU410,000 LCU375,000
Inventories, end of year 80,000 75,000
Cost of goods sold LCU330,000 LCU300,000

4. On December 1, 2005, Pan-Europe’s foreign subsidiary had acquired land for

LCU24,000 and depreciable plant assets for LCU140,000. On June 4, 2007, additional
depreciable plant assets were acquired for LCU30,000. Plant assets are being depreci-
ated by the straight-line method over a 10-year economic life with no residual value. A
full year’s depreciation is taken in the year of acquisition of plant assets.
5. On December 15, 2005, 14% serial bonds with a face amount of LCU120,000 were is-
sued. The bonds were to mature serially each year through December 15, 2011, and in-
terest was payable semiannually on June 15 and December 15. The first principal
payment was made on December 15, 2006.

Instructions
Prepare a working paper to remeasure the foregoing items to U.S. dollars, the functional
currency of Pan-Europe Corporation’s foreign subsidiary, on November 30, 2007, and
November 30, 2006, respectively. Show supporting computations. Round all exchange rates
to the nearest cent.
(Problem 12.4) On August 1, 2005, Westpac Corporation, a U.S. multinational enterprise, established a
sales branch in Singapore. The transactions and events of Westpac’s home office with the
Singapore branch, and the branch’s own transactions and events, during August 2005, are
described below. Following each transaction or event is the appropriate spot exchange rate
for the Singapore dollar (S$).
(1) Cash of $50,000 sent to branch (S$1 $0.45).
(2) Merchandise with a cost of $75,000 shipped to branch at a billed price of $100,000
(S$1 $0.45).
(3) Rent of leased premises for August paid by branch, S$1,000 (S$1 $0.45).
(4) Store and office equipment acquired by branch for S$5,000, to be carried in home
office accounting records (S$1 $0.45).
(5) Sales by branch on credit, S$25,000 (S$1 $0.46). Cost of goods sold, S$15,000.
(6) Collections of trade accounts receivable by branch, S$20,000 (S$1 $0.455).
(7) Payment of operating expenses by branch, S$5,000 (S$1 $0.47).
(8) Cash remitted to home office by branch, S$10,000 (S$1 $0.44).
(9) Operating expenses incurred by home office charged to branch, $2,000 (S$1
$0.445).
(10) Uncollectible account receivable written off by branch, S$1,000 (S$1 $0.44).
Instructions
Prepare journal entries for the home office of Westpac Corporation in U.S. dollars, and for
the Singapore branch in Singapore dollars, to record the foregoing transactions or events.
Both home office and branch use the perpetual inventory system and the direct write-off
534 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

method of accounting for uncollectible accounts. Round all amounts to the nearest dollar.
Omit journal entry explanations.
(Problem 12.5) Portero Corporation, a U.S. multinational enterprise, combined with Sudamerica Company
on January 2, 2005, by the acquisition at carrying amount of all of Sudamerica’s outstand-
CHECK FIGURE ing common stock. Sudamerica is located in Nicaduras, whose monetary unit, the local cur-
Foreign currency rency of Sudamerica, is the peso ($N). Sudamerica’s functional currency is the U.S. dollar.
transaction loss, Sudamerica’s accounting records were continued without change. A trial balance, in
$13,720. Nicaduran pesos, on January 2, 2005, follows:

SUDAMERICA COMPANY
Trial Balance (Nicaduran Pesos)
January 2, 2005

Debit Credit
Cash $N 3,000
Trade accounts receivable 5,000
Inventories (first-in, first-out cost) 32,000
Plant assets 204,000
Accumulated depreciation of plant assets $N 42,000
Trade accounts payable 81,400
Common stock 50,000
Retained earnings 70,600
Totals $N244,000 $N244,000

Sudamerica’s trial balance, in Nicaduran pesos, on December 31, 2006, follows:

SUDAMERICA COMPANY
Trial Balance (Nicaduran Pesos)
December 31, 2006

Debit Credit
Cash $N 25,000
Trade accounts receivable 20,000
Allowance for doubtful accounts $N 500
Receivable from Portero Corporation 33,000
Inventories (first-in, first-out cost) 110,000
Plant assets 210,000
Accumulated depreciation of plant assets 79,900
Notes payable 60,000
Trade accounts payable 22,000
Income taxes payable 40,000
Common stock 50,000
Retained earnings 100,600
Sales—local 170,000
Sales—foreign 200,000
Cost of goods sold 207,600
Depreciation expense 22,400
Other operating expenses 60,000
Income taxes expense 40,000
Gain on disposal of plant assets 5,000
Totals $N728,000 $N728,000
 Chapter 12 Translation of Foreign Currency Financial Statements 535

Additional Information
1. All of Sudamerica’s foreign sales are made to Portero and are accumulated in the
Sales—Foreign ledger account. The balance of the Receivable from Portero Corporation
account (a current asset) is the total of unpaid invoices. All foreign sales are billed in
U.S. dollars. The reciprocal accounts in Portero’s accounting records show total Year
2006 purchases as $471,000 and the total of unpaid invoices as $70,500 (before end-of-
period adjusting entries). Portero remits pesos to pay for the purchases.
2. Depreciation is computed by the straight-line method over a 10-year economic life
with no residual value for all depreciable assets. Machinery costing $N20,000 was ac-
quired by Sudamerica on December 31, 2005, and no depreciation was recorded for
this machinery in 2005. There have been no other depreciable plant assets acquired
since January 2, 2005, and no assets are fully depreciated.
3. No journal entries have been made in the Retained Earnings ledger account of
Sudamerica since its acquisition other than the net income for 2005.
4. The exchange rates for the Nicaduran peso follow:

Jan. 2, 2005 $2.00

Year 2005 average 2.10
Dec. 31, 2005 2.20
Year 2006 average 2.30
Dec. 31, 2006 2.40

Instructions
Prepare a working paper to remeasure the trial balance of Sudamerica Company for the
year ended December 31, 2006, from Nicaduran pesos to U.S. dollars, Sudamerica’s func-
tional currency. The working paper should show the trial balance amounts in pesos, the ex-
change rates, and the amounts in dollars.
(Problem 12.6) Hightower Company, a U.S. multinational enterprise, established a branch in Brazentina in
1998. The branch carried its accounting records in the Brazentina peso (BP), although its
CHECK FIGURE functional currency was the U.S. dollar.
b. Foreign currency You were engaged to audit Hightower’s combined financial statements for the year ended
transaction gain, December 31, 2005. You retained a licensed professional accounting firm in Brazentina to
$20,113. audit the branch accounts. The firm reported that the branch accounts were fairly stated in
pesos, except that a Brazentina franchise fee and any possible adjustments required by
home office accounting procedures were not recorded. Trial balances for the home office
and branch office of Hightower Company on December 31, 2005, are on page 536.
Additional Information
1. The Brazentina peso was devalued July 1, 2005, from BP1 $0.25 to BP1 $0.20.
The former exchange rate had been in effect since 1997.
2. Included in the balance of the home office’s Investment in Brazentina Branch ledger ac-
count was a $4,000 billing for merchandise shipped during 2005. The branch did not re-
ceive the shipment during 2005. Home office sales to the branch are marked up 331 3 %
on home office cost and shipped FOB home office. Branch sales to home office are
made at branch cost. There were no seasonal fluctuations in branch sales to outsiders
during the year.
3. The branch had beginning and ending inventories valued at first-in, first-out cost of
BP80,000 [exclusive of the amount in (2), above], of which one-half on each date had
been acquired from the home office. The home office had December 31, 2005, invento-
ries valued at first-in, first-out cost of $520,000.
536 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

HIGHTOWER COMPANY
Home Office and Branch
Trial Balances
December 31, 2005

Home
Office Branch
(U.S. Dollars) (Brazentina
dr (cr) Pesos) dr (cr)
Cash $ 90,000 BP 110,000
Trade accounts receivable (net) 160,000 150,000
Inventories, beginning of year 510,000 80,000
Short-term prepayments 18,000
Investment in Brazentina Branch 10,000
Branch market research 12,000
Plant assets 750,000 1,000,000
Accumulated depreciation of plant assets (350,000) (650,000)
Current liabilities (240,000) (220,000)
Long-term debt (200,000) (230,000)
Home office (30,000)
Common stock (300,000)
Retained earnings (145,000)
Sales (4,035,000) (1,680,000)
Intracompany sales (160,000)
Purchases 3,010,000 1,180,000
Intracompany purchases 140,000
Depreciation expense 50,000 100,000
Other operating expenses and income
taxes expense 680,000 190,000
Totals $ -0- BP -0-

4. The Branch Market Research ledger account balance is the unamortized portion of a
$15,000 fee paid by the home office in January 2003 to a U.S. firm for market research
for the branch. Currency restrictions prevented the branch from paying the fee. The
home office agreed to accept merchandise from the branch over a five-year period, dur-
ing which the market research fee was to be amortized.
5. There were no changes in the branch’s plant assets during 2005.
6. The government of Brazentina imposes a franchise fee of 10 pesos per 100 pesos of
income before franchise fee of the branch, in exchange for certain exclusive trading
rights granted to the branch. The fee is payable each May 1 for the preceding calen-
dar year’s trading rights; it had not been recorded by the branch on December 31,
2005.

Instructions
a. Prepare journal entries on December 31, 2005, to correct the accounting records of:
(1) The home office of Hightower Company
(2) The Brazentina branch of Hightower Company
b. Prepare a working paper to combine the financial statements of Hightower Company’s
home office and Brazentina branch for Year 2005, with all amounts stated in U.S. dol-
lars. Formal combined financial statements are not required. Do not prepare formal
 Chapter 12 Translation of Foreign Currency Financial Statements 537

combination eliminations; instead, explain the eliminations, including supporting com-

putations, at the bottom of the working paper. Disregard income taxes. Assume that the
branch purchases occurred evenly throughout 2005.
The following column headings are suggested for the working paper:

Home Office Adjusted Trial Balance—dr (cr)

Branch Adjusted Trial Balance:
In Brazentina Pesos—dr (cr)
Exchange Rates (remeasurement)
In Dollars—dr (cr)
Eliminations—dr (cr)
Home Office and Branch Combined—dr (cr)

(Problem 12.7) The financial statements of Eagle Corporation, a U.S. multinational enterprise, and its
wholly owned Canadian subsidiary, Mapleleaf Company, at the end of the first year fol-
CHECK FIGURE lowing Eagle’s establishment of Mapleleaf, were as follows ($C is the symbol for the
a. Foreign currency Canadian dollar, the functional currency of Mapleleaf ):
translation adjustments,
$5,000 debit.
EAGLE CORPORATION AND MAPLELEAF COMPANY
Separate Financial Statements
For Year Ended December 31, 2005

Eagle Mapleleaf
Corporation Company
Income Statements
Total revenue $1,200,000 $C800,000
Total costs and expenses 900,000 700,000
Net income $ 300,000 $C100,000

Statements of Retained Earnings

Retained earnings, beginning of year $ 500,000
Net income 300,000 $C100,000
Subtotal $ 800,000 $C100,000
Dividends declared 200,000
Retained earnings, end of year $ 600,000 $C100,000

Balance Sheets
Assets
Current assets $ 700,000 $C400,000
Investment in Mapleleaf Company common stock 160,000
Plant assets (net) 1,600,000 500,000
Intangible assets (net) 240,000
Total assets $2,700,000 $C900,000

Liabilities and Stockholders’ Equity

Current liabilities $ 400,000 $C200,000
Long-term debt 500,000 400,000
Common stock 1,200,000 200,000
Retained earnings 600,000 100,000
Total liabilities and stockholders’ equity $2,700,000 $C900,000
538 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

Exchange rates for the Canadian dollar were as follows during 2005:

$C1
Jan. 2, 2005 (date Mapleleaf Company was established) $0.80
Dec. 31, 2005 0.78
Average for 2005 0.79

Instructions
a. Prepare a working paper to translate the financial statements of Mapleleaf Company for
the year ended December 31, 2005, from Canadian dollars, its functional currency, to
U.S. dollars, the reporting currency.
b. Prepare journal entries for Eagle Corporation on December 31, 2005, to account for its
investment in Mapleleaf Company under the equity method of accounting. (Disregard
income taxes.)
c. Prepare a working paper for consolidated financial statements of Eagle Corporation and
subsidiary on December 31, 2005, and a related working paper elimination (in journal
entry format). (Disregard income taxes.)
(Problem 12.8) Separate financial statements of Panamer Corporation, a U.S. multinational enterprise, and
its two subsidiaries for the year ended December 31, 2006, are as follows (IN is the symbol
CHECK FIGURE for the Itican peso):
a. Foreign currency
translation adjustments,
$4,420 debit. PANAMER CORPORATION AND SUBSIDIARIES
Separate Financial Statements
For Year Ended December 31, 2006

Panamer U.S. Itican

Corporation Subsidiary Subsidiary
(Dollars) (Dollars) (Pesos)
Income Statements
Revenue:
Sales $400,000 $21,000 IN381,000
Intercompany sales to U.S. Subsidiary 10,000
Total revenue $410,000 $21,000 IN381,000
Costs and expenses:
Cost of goods sold $300,000 $15,000 IN300,000
Intercompany cost of goods sold 7,500
Depreciation expense 3,000 550 17,500
Selling expenses 34,500 2,400 16,500
Other operating expenses 40,000 1,383 23,667
Income taxes expense 10,000 667 9,333
Total costs and expenses $395,000 $20,000 IN367,000
Net income $ 15,000 $ 1,000 IN 14,000

Statements of Retained Earnings

Retained earnings, beginning of year $ 25,000 $ 2,000 IN 7,000
Net income 15,000 1,000 14,000
Subtotals $ 40,000 $ 3,000 IN 21,000
Dividends declared 1,000
Retained earnings, end of year $ 40,000 $ 2,000 IN 21,000
(continued)
 Chapter 12 Translation of Foreign Currency Financial Statements 539

PANAMER CORPORATION AND SUBSIDIARIES

Separate Financial Statements (concluded)
For Year Ended December 31, 2006

Panamer U.S. Itican

Corporation Subsidiary Subsidiary
(Dollars) (Dollars) (Pesos)
Balance Sheets
Assets
Cash $ 10,000 $ 1,500 IN 10,000
Trade accounts receivable (net) 30,000 8,000 35,000
Intercompany receivables (payables) 4,000 (900)
Inventories 20,000 83,000
Investment in U.S. Subsidiary common stock 9,000
Investment in Itican Subsidiary common stock 12,000
Plant assets 45,000 5,500 175,000
Accumulated depreciation of plant assets (15,000) (2,000) (75,000)
Total assets $115,000 $12,100 IN228,000

Liabilities and Stockholders’ Equity

Trade accounts payable $ 25,000 IN 7,000
Dividends payable $ 100
Long-term debt 100,000
Common stock, 1,000 shares 50,000 10,000 100,000
Retained earnings 40,000 2,000 21,000
Total liabilities and stockholders’ equity $115,000 $12,100 IN228,000

Additional Information
1. On December 31, 2005, Panamer had acquired 900 of the 1,000 outstanding shares
of common stock of U.S. Subsidiary for $9,000, and all 1,000 shares of the out-
standing common stock of Itican Subsidiary for $12,000. The identifiable net assets
of both combinees were fairly valued at their carrying amounts on December 31,
2005. Panamer adopted the equity method of accounting for its investments in both
subsidiaries.
2. Both of Panamer’s subsidiaries depreciate plant assets by the straight-line method over
10-year economic lives, with no residual values. None of the subsidiaries’ plant assets
was fully depreciated on December 31, 2005, or on December 31, 2006. There were no
additions to or retirements of Itican Subsidiary’s plant assets during 2006.
3. On December 31, 2006, Panamer shipped merchandise billed at $4,000 to U.S. Subsidiary.
There were no intercompany sales to Itican Subsidiary.
4. On December 18, 2006, U.S. Subsidiary declared a dividend of $1 a share, payable
January 16, 2007, to stockholders of record January 10, 2007.
5. Relevant exchange rates for the Itican peso, which is the functional currency of Itican
Subsidiary, were as follows:

Dec. 31, 2005, through Mar. 31, 2006 $0.12

Apr. 1, 2006, through Dec. 31, 2006 0.08
540 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

Instructions
a. Prepare a working paper to translate Itican Subsidiary’s financial statements for the year
ended December 31, 2006, from Itican pesos, its functional currency, to U.S. dollars.
Use weighted-average exchange rates where appropriate.
b. Prepare correcting entries for Panamer Corporation and for U.S. Subsidiary on Decem-
ber 31, 2006.
c. Prepare a working paper for consolidated financial statements and working paper elim-
inations (in journal entry format) for Panamer Corporation and subsidiaries on Decem-
ber 31, 2006. The working papers should reflect the translated balances in a and the
adjustments in b. (Disregard income taxes.)
Chapter Thirteen

Reporting for
Components; Interim
Reports; Reporting for
the SEC
Scope of Chapter
This chapter deals with three topics that have received considerable attention from accoun-
tants. Reporting for components of an entity and interim reports have been the subjects of
pronouncements of the Financial Accounting Standards Board, the American Institute of Cer-
tified Public Accountants, and the Securities and Exchange Commission (SEC). In addition,
the specialized requirements of accounting and reporting for the SEC by enterprises subject
to its jurisdiction have undergone substantial modifications in recent years. All three topics are
of considerable significance for accountants who deal with publicly owned corporations.

REPORTING FOR COMPONENTS OF AN ENTITY

The FASB has stated that a component of an entity comprises operations and cash flows
that can be clearly distinguished, operationally and for financial reporting purposes, from
the rest of the entity.1 The FASB further pointed out that the foregoing definition includes
operating segments and reportable segments of an entity, as discussed in the following
sections.2

Background of Components Reporting

The wave of conglomerate business combinations in past years, involving companies in
different industries or markets, led to consideration of appropriate methods for reporting
disaggregated financial data for business components. Financial analysts and others inter-
ested in comparing one diversified business enterprise with another found that consolidated
financial statements did not supply enough information for meaningful comparative statis-
tics regarding operations of the diversified enterprises in specific industries.

1
FASB Statement No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (Norwalk:
FASB, 2001), par. 41.
2
Ibid.

541
542 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

The FASB has traced the history of components reporting from the start of hearings in
1964 before the U.S. Senate Judiciary Committee’s Subcommittee on Antitrust and
Monopoly. The subcommittee was considering economic concentration in American industry,
especially in the so-called conglomerate (diversified) business enterprises.
Out of these hearings came discussions and debate among academicians, members of
Congress, SEC officials, financial analysts, business executives, and AICPA representatives
regarding the propriety of disaggregated financial reporting for components of a business
enterprise. The concept of components reporting was controversial because it was opposed
to the philosophy that consolidated financial statements, rather than separate financial state-
ments, fairly present the financial position and operating results of an economic entity, re-
gardless of the legal or operating segment structure of the entity.
In 1976, the FASB issued FASB Statement No. 14 “Financial Reporting for Segments
of a Business Enterprise.” Defining an industry segment as “a component of an enterprise
engaged in providing a product or service or a group of related products and services pri-
marily to unaffiliated customers (i.e., customers outside the enterprise) for a profit,” 3 the
FASB required business enterprises having industry segments to disclose certain informa-
tion regarding their operations in different industries, their foreign operations and export
sales, and their major customers. Comparable information was required to be disclosed for
an enterprise’s operations in individual foreign countries or groups of countries, its export
sales, and its major customers. Both maximum and minimum limitations were placed on
the number of segments or foreign areas for which the information was to be provided, and
enterprise management was given considerable latitude in identifying enterprise industry
segments and allocating nontraceable expenses to segments, and in the method of disclo-
sure of the required information; that is, within the enterprise’s financial statements, in the
notes to the financial statements, or in a separate exhibit.

Proposal to Improve Segment Reporting

In 1994, the AICPA’s Special Committee on Financial Reporting issued a report that ad-
dressed concerns about the relevance and usefulness of business enterprise reporting.
Among the committee’s recommendations for improvements in disclosures of operating
segment information were the following:
Segment reporting should be improved by better aligning the information in business report-
ing with the segment information that companies report internally to senior management or
the board [of directors].

*****
[W]hen reporting about each segment, companies should avoid arbitrary allocations made
solely for purposes of business reporting. Instead, companies should report information in
the same way they determine it for internal reporting and disclose the methods used. Compa-
nies also should disclose more detailed financial information about each investment in, or
affiliation with, an unconsolidated entity that is individually significant.4

Reacting to the foregoing, in 1997 the FASB issued Statement No. 131 “Disclosures
about Segments of an Enterprise and Related Information.” Adopting the management
approach to segment reporting, which requires segmentation of business activities based

3
FASB Statement No. 14, “Financial Reporting for Segments of a Business Enterprise” (Stamford: FASB,
1976), par. 10a.
4
The AICPA Special Committee on Financial Reporting, Improving Business Reporting—A Customer
Focus, AICPA (New York: 1994), pp. 11–12.
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 543

on the way a business enterprise is managed, the FASB replaced the term industry segment
as used in FASB Statement No. 14 with the term operating segment, determined as
follows:
An operating segment is a component of an enterprise:
(a) That engages in business activities from which it may earn revenues and incur expenses
(including revenues and expenses relating to transactions with other components of the
same enterprise),
(b) Whose operating results are regularly reviewed by the enterprise’s chief operating deci-
sion maker to make decisions about resources to be allocated to the segment and assess
its performance, and
(c) For which discrete financial information is available.5

For reportable operating segments of a business enterprise as specified by the FASB, it

mandated several disclosures, including the following:
(1) Factors used to identify reportable segments
(2) Types of products and services from which each reportable segment derives its revenue
(3) Segment profit or loss and segment total assets, as measured by the internal financial
reporting system
(4) Selected components of revenues and expenses included in the measurement of re-
portable segment profit or loss, such as interest revenue and interest expense
(5) Reconciliation of total reportable segments’ profit or loss to the enterprise’s pre-tax in-
come from continuing operations
(6) Explanation of how segment profit or loss is measured
(7) Reconciliation of total of reportable segments’ assets to total assets
(8) Investments in influenced investees included in segment assets
(9) Total expenditures for additions to long-lived segment assets
(10) In certain cases, selected information about reportable segments that operate in more
than one country
(11) Information about the enterprise’s reliance on major customers: those who provide
10 percent or more of the enterprise’s total revenues.6

In addition to the foregoing information required to be provided in annual financial

reports, the FASB required selected comparable information to be disclosed in interim re-
ports that include condensed financial statements.7 Interim reports are discussed in another
section of this chapter (pages 547–556).
It is clear from a comparison of the foregoing with the disclosures required under FASB
Statement No. 14 (see page 542) that, under FASB Statement No. 131, enterprise manage-
ments will have a great deal of flexibility in complying with the requirements thereof,
which will provide far more information to users of financial reports than was required by
FASB Statement No. 14.
Following are examples of disclosures required by the FASB for reportable segment
profit or loss and components thereof; segment assets and liabilities; and reconciliations of
segment totals to pretax income from continuing operations and to consolidated total assets
and total liabilities.

5
FASB Statement No. 131, “Disclosures about Segments of an Enterprise and Related Information”
(Norwalk: FASB, 1997), par. 10.
6
Ibid., pars. 26–39, as amended 1999 by FASB Statement No. 135.
7
Ibid., par. 33, as amended 1999 by FASB Statement No. 135.
544 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

VARIEGATED COMPANY
Information about Segment Profit or Loss and Segment Assets and Liabilities
For Year Ended March 31, 2006
(amounts in thousands)

Operating Segment
No. 1 No. 2 Total
Revenues from external customers $8,100 $7,400 $15,500
Intersegment revenues 100 200 300
Segment profit 200 1,300 1,500
Interest expense 400 300 700
Depreciation and amortization expense 1,800 900 2,700
Income taxes expense 300 800 1,100
Segment assets 9,600 8,400 18,000
Additions to plant and intangible assets 700 400 1,100

VARIEGATED COMPANY
Reconciliation of Operating Segment Totals to Consolidated Totals
For Year Ended March 31, 2006
(amounts in thousands)

Revenues Profit Assets

Segment totals $15,800 $1,500 $18,000
Elimination of intersegment items (400) (200) (2,000)
Unallocated expenses (300)
Consolidated amounts $15,400 $1,000* $16,000

*Pretax income from continuing operations.

The financial statements of The McGraw-Hill Companies, Inc., in Appendix 1 to this

chapter, illustrate the first of the foregoing methods of disclosure of segment information
under FASB Statement No. 131. The segment information is included in Note 4 on pages
571–573.

Allocation of Nontraceable Expenses to Operating Segments

The FASB required a reasonable basis for allocations such as nontraceable expenses—
those enterprise expenses not identifiable with operations of a specific operating segment—
to those segments in the measurement of reportable segment profit or loss.8 Accordingly,
enterprise management must devise an appropriate method for apportioning nontraceable
expenses to the operating segments. Methods that have been used for such allocations in-
clude ratios based on operating segment revenues, payroll totals, average plant assets and
inventories, or a combination thereof. For example, assume the following data for Multi-
product Corporation:

8
Ibid., par. 29.
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 545

Data for Company Operating Segments

and Its Two Operating
Chemical Food
Segments
Company Products Products Total
(1) Net sales (operating segment revenues) $550,000 $ 450,000 $1,000,000
Traceable expenses $300,000 $ 350,000 $ 650,000
Nontraceable expenses $200,000 200,000
Total expenses $200,000 $300,000 $ 350,000 $ 850,000
Income before income taxes $ 150,000
Income taxes expense 60,000
Net income $ 90,000
(2) Payroll totals $ 60,000 $160,000 $ 240,000 $ 460,000
(3) Average plant assets and inventories $ 80,000 $620,000 $1,380,000 $2,080,000

Computation of a ratio for allocating nontraceable expenses to operating segments based

on the three factors described on page 544 is as follows:

Computations of Chemical Food

Three-Factor Ratio Products Products
$ 550,000 $ 450,000
(1) Ratio of operating segment revenue 55% 45%
$1,000,000 $1,000,000
$ 160,000 $ 240,000
(2) Ratio of segment payroll totals 40% 60%
$ 400,000 $ 400,000
(3) Ratio of average plant assets and
$ 620,000 $1,380,000
inventories 31% 69%
$2,000,000 $2,000,000
Totals 126% 174%
Arithmetic averages (divide by 3) 42% 58%

The $200,000 amount of nontraceable expenses of the home office of Multiproduct

Corporation is allocated to the two operating segments as follows:

Allocation of To Chemical Products segment ($200,000 0.42) $ 84,000

Nontraceable To Food Products segment ($200,000 0.58) 116,000
Expenses Total nontraceable expenses $200,000

Segment profit (loss) for the two operating segments of Multiproduct Corporation is
computed as follows:

Segment Profit (Loss) Chemical Food

of Two Operating Products Products Total
Segments
Net sales $550,000 $450,000 $1,000,000
Traceable expenses $300,000 $350,000 $ 650,000
Nontraceable expenses 84,000 116,000 200,000
Total expenses $384,000 $466,000 $ 850,000
Segment profit (loss) $166,000 $ (16,000) $ 150,000
546 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

SEC Requirements for Segment Information

The requirements of the Securities and Exchange Commission for reporting of segment in-
formation are in Regulation S-K, which outlines nonfinancial statement information that
must be included in reports to the SEC. The SEC disclosure requirements for operating seg-
ments, in addition to the requirements of the FASB, are as follows:9
1. Amount or percentage of total revenue contributed by any class of product or services
that accounted for 10% or more of total revenue during the past three years.
2. The name of a major customer (see page 543), together with its relationship to the re-
porting enterprise, if loss of the customer would have a material adverse effect on the
enterprise.
3. Information about foreign operations or export sales that are expected to be material in
the future.
Regulation S-K is discussed in a subsequent section of this chapter.

Reporting the Disposal of a Business Component

To this point, accounting standards developed by the FASB for financial reporting for ex-
isting operating segments have been discussed. The consideration of segment reporting is
concluded with the reporting for effects of the disposal of an operating segment.
In 2001, the FASB significantly simplified the complex reporting that had been required
for more than 28 years for a disposal of a component of a business such as an operating
segment. The suggested disclosure for such reporting is as follows:10

Income from continuing operations before income taxes $XXXX

Provision for income taxes XXX
Income from continuing operations $XXXX
Discontinued operations (Note ______)
Income (loss) from operations of discontinued Division X, including
$XXX loss on disposal (less applicable income taxes of $______) XXXX
Net income $XXXX

The contents of discontinued operations are discussed in the following sections.

Income from Continuing Operations

The purpose of the income from continuing operations amount is to provide a basis of
comparison in the comparative income statements of a business enterprise that has discon-
tinued an operating segment. In order for the income from continuing operations amounts
to be comparable, the operating results of the discontinued segment of the enterprise must
be excluded from income from continuing operations for all accounting periods pre-
sented in comparative income statements. For example, in comparative income statements
for the three years ended December 31, 2007, for Wexler Company, a diversified enterprise
with five operating segments, which disposed of one of the segments during 2007, the income

9
Codification of Financial Reporting Policies, Securities and Exchange Commission (Washington: 1982),
Sec. 503.02.
10
FASB Statement No. 144, par. 43.
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 547

from continuing operations amounts for 2005 and 2006, as well as for 2007, exclude the
operating results of the discontinued segment.

Income (Loss) from Discontinued Operations

The operating income or loss, net of applicable income taxes, of Wexler Company’s dis-
continued segment is included in its entirety in this section of Wexler’s income statement
for 2005 and 2006. For 2007, the net-of-tax income or loss of the discontinued segment in-
cludes the gain or loss on the disposal of the net assets of the segment, whether by sale or
abandonment.
An example of income statement presentation of of discontinued components is on
page 562 (page 55 of the 2003 annual report of The McGraw-Hill Companies, Inc.) Related
disclosures in Note 2 to the financial statements are on pages 570 and 571 (pages 64 and 65
of the annual report).

International Accounting Standard 14

In 1997, the International Accounting Standards Board issued a revised IAS 14, “Segment
Reporting,” which, although similar in many respects to FASB Statement No. 131, differed
significantly in the method of identifying reportable segments.

SEC Enforcement Action Dealing with Wrongful Application

of Accounting Standards for Operating Segments
AAER 1061
In AAER 1061, “In the Matter of Sony Corporation and Sumio Sano, . . .” (August 5,
1998), the SEC reported that Sony Corporation, a Japanese enterprise that operated
through subsidiaries in the United States, inappropriately reported two distinct operating
segments—music and motion pictures—as a single “entertainment” segment. Through this
device, Sony was able to conceal the substantial operating losses of the motion picture seg-
ment through offsets against the profitable music segment. Further, according to the SEC,
Sony did not disclose those losses in the Management Discussion and Analysis section of
its annual report to shareholders. Further compounding the inadequate reporting was the
lack of a vice president of finance to oversee such reporting; the individual responsible was
a director and the general manager of Sony’s Capital Market and Investor Relations Divi-
sion. In addition to complying with FASB Statement No. 131, “Disclosures about Seg-
ments of an Enterprise and Related Information,” Sony was ordered by the SEC to have an
independent auditor examine and express an opinion on the Management Discussion and
Analysis section of Sony’s fiscal year 1999 annual report to stockholders and to take mea-
sures to ensure that its chief financial officer would be responsible for Sony’s financial
reporting.

INTERIM FINANCIAL REPORTS

Generally, financial statements are issued for the full fiscal year of a business enterprise.
In addition, many enterprises issue complete financial statements for interim accounting
periods during the course of a fiscal year. For example, a closely held company with out-
standing bank loans may be required to provide monthly or quarterly financial state-
ments to the lending bank. However, interim financial statements usually are associated
with the quarterly reports issued by publicly owned companies to their stockholders,
the Securities and Exchange Commission, and the stock exchanges that list their capital
548 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

stock. The New York Stock Exchange’s listing agreement requires listed companies to
publish quarterly financial reports. Companies subject to the periodic reporting require-
ments of the SEC must file Form 10-Q with the SEC no later than 40 days after the end
of each of the first three quarters of their fiscal years. In addition, the SEC requires
disclosure of operating results for each quarter of the two most recent fiscal years in a
“supplementary financial information” section of the annual report of a business
enterprise.11

Problems in Interim Financial Reports

Except for 10-Q quarterly reports filed with the SEC, the form, content, and accounting
practices for interim financial reports were left to the discretion of business enterprises until
1973. In that year, the Accounting Principles Board issued Opinion No. 28, “Interim
Financial Reporting.” Prior to the issuance of Opinion No. 28, there were unresolved prob-
lems regarding interim financial reports, including the following:
1. Enterprises employed a wider variety of accounting practices and estimating techniques
for interim financial reports than they used in the annual financial statements audited by
independent CPAs. The enterprises’ implicit view was that any misstatements in interim
financial reports would be corrected by auditors’ proposed adjustments for the annual
financial statements.
2. Seasonal fluctuations in revenue and irregular incurrence of costs and expenses during
the course of a business enterprise’s fiscal year limited the comparability of operating
results for interim periods of the fiscal year. Further, time constraints in the issuance of
interim statements limited the available time to accumulate end-of-period data for in-
ventories, payables, and related expenses.
3. Accountants held two divergent views on the theoretical issues underlying interim fi-
nancial statements. These differing views are described below:
a. Under the discrete theory, each interim period is considered a basic accounting
period; thus, the results of operations for each interim period are measured in essen-
tially the same manner as for an annual accounting period. Under this theory, defer-
rals, accruals, and estimations at the end of each interim period are determined by
following essentially the same principles and estimates or judgments that apply to
annual periods.
b. Under the integral theory, each interim period is considered an integral part of the
annual period. Under this theory, deferrals, accruals, and estimates at the end of each
interim period are affected by judgments made at the interim date as to results of op-
erations for the remainder of the annual period. Thus, an expense item that might be
considered as falling entirely within an annual period (no fiscal year-end accrual or
deferral) might be allocated among interim periods based on estimated time, sales
volume, production volume, or some other basis.12
The problems discussed in the preceding section led to a number of published interim
income statements with substantial quarterly earnings, and income statements for the year
with a substantial net loss.

11
Regulation S-K, Item 302(a), Securities and Exchange Commission (Washington). See page 584 (page
81 of the 2003 annual report of The McGraw-Hill Companies, Inc.).
12
APB Opinion No. 28, “Interim Financial Reporting” (New York: AICPA, 1973), par. 5.
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 549

APB Opinion No. 28

The stated objectives for APB Opinion No. 28 were to provide guidance on accounting is-
sues peculiar to interim reporting and to set forth minimum disclosure requirements for in-
terim financial reports of publicly owned enterprises.13 One part of the Opinion dealt with
standards for measuring interim financial information and another covered disclosure of
summarized interim financial data by publicly owned enterprises. In APB Opinion No. 28,
the APB adopted the integral theory that interim periods should be considered as integral
parts of the annual accounting period.
The APB established guidelines for the following components of interim financial re-
ports: revenue, costs associated with revenue, all other costs and expenses, and income taxes
expense. These guidelines are discussed in the following sections.

Revenue
Revenue from products sold or services rendered should be recognized for an interim
period on the same basis as followed for the full year. Further, business enterprises having
significant seasonal variations in revenue should disclose the seasonal nature of their
activities.14

Costs Associated with Revenue

Costs and expenses associated directly with or allocated to products sold or services
rendered include costs of material, direct labor, and factory overhead. APB Opinion No. 28
required the same accounting for these costs and expenses in interim financial reports
as in fiscal-year financial statements. However, the Opinion provided the following
exceptions with respect to the measurement of cost of goods sold for interim financial
reports:15
1. Enterprises that use the gross margin method at interim dates to estimate cost of goods
sold should disclose this fact in interim financial reports. In addition, any material ad-
justments reconciling estimated interim inventories with annual physical inventories
should be disclosed.
2. Enterprises that use the last-in, first-out (lifo) inventory method and temporarily deplete
a base layer of inventories during an interim reporting period should include in cost of
goods sold for the interim period the estimated cost of replacing the depleted lifo base
layer.
To illustrate, assume that Megan Company, which uses the last-in, first-out inventory
valuation method, temporarily depleted a base layer of inventories with a cost of $80,000
during the second quarter of the fiscal year ending December 31, 2006. Replacement cost
of the depleted base layer was $100,000 on June 30, 2006. In addition to the usual debit to
Cost of Goods Sold and credit to Inventories for the quarter ended June 30, 2006, which
would include the $80,000 amount from the base layer, Megan prepares the following jour-
nal entry on June 30, 2006:

13
Ibid., par. 6.
14
Ibid., pars. 11 and 18.
15
Ibid., pars. 13–14.
550 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

Journal Entry for Cost of Goods Sold ($100,000 $80,000) 20,000

Temporary Depletion Liability Arising from Depletion of Base Layer of Lifo Inventories 20,000
of Base Layer of Lifo To record obligation to replenish temporarily depleted base
Inventories layer of last-in, first-out inventories.

Assuming merchandise with a total cost of $172,000 was purchased by Megan on July 6,
2006, the following journal entry is required:

Journal Entry for Inventories ($172,000 $20,000) 152,000

Restoration of Base Liability Arising from Depletion of Base Layer of Lifo Inventories 20,000
Layer Trade Accounts Payable 172,000
To record purchase of merchandise and restoration of depleted base
layer of last-in, first-out inventories.

3. Lower-of-cost-or-market write-downs of inventories should be provided for interim

periods as for complete fiscal years, unless the interim date market declines in inven-
tory are considered temporary, and not applicable at the end of the fiscal year. If an in-
ventory market write-down in one interim period is offset by an inventory market
price increase in a subsequent interim period, a gain is recognized in the subsequent
period to the extent of the loss recognized in preceding interim periods of the fiscal
year.
For example, assume that Reynolds Company, which uses lower-of-cost-or-market,
first-in, first-out cost, for valuing its single merchandise item, had 10,000 units of mer-
chandise with first-in, first-out cost of $50,000, or $5 a unit, in inventory on January 1,
2006. Assume further for simplicity that Reynolds made no purchases during 2006.
Quarterly sales and end-of-quarter replacement costs for inventory during 2006 were as
follows:

Quarterly Sales and Quarterly End-of-Quarter

End-of-Quarter Quarter Ended Sales (Units) Inventory Replacement Costs (Per Unit)
Replacement Costs
Mar. 31 2,000 $6
for Inventory
June 30 1,500 4
Sept. 30 2,000 7
Dec. 31 1,200 3

If the replacement cost (market) decline in the second quarter was not considered to be
temporary, Reynolds Company’s cost of goods sold for the four quarters of 2006 would
be computed as follows:
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 551

Computation of Cost of Goods Sold

Quarterly Cost of
Quarter Ended Computation for Quarter For Quarter Cumulative
Goods Sold
Mar. 31 2,000 $5 $10,000 $10,000
June 30 (1,500 $5) (6,500 $1)* 14,000 24,000
Sept. 30 (2,000 $4) (4,500 $1)† 3,500 27,500
Dec. 31 (1,200 $5) (3,300 $2)‡ 12,600 40,100
*
6,500 units remaining in inventory multiplied by $1 write-down to lower replacement cost.
†
4,500 units in inventory multiplied by $1 write-up to original first-in, first-out cost.
‡
3,300 units remaining in inventory multiplied by $2 write-down to lower replacement cost.

The $40,100 cumulative cost of goods sold for Reynolds Company for 2006 may be ver-
ified as follows:

Verification of 6,700 units sold during 2006, at $5 first-in, first-out cost per unit $33,500
Cumulative Cost Write-down of 2006 ending inventory to replacement cost (3,000
of Goods Sold units $2) 6,600
Cost of goods sold for 2006 $40,100

Alternative Verification:
Cost of goods available for sale (10,000 $5) $50,000
Less: Ending inventory, at lower of first-in, first-out cost or market
(3,300 $3) 9,900
Cost of goods sold for 2006 $40,100

4. Enterprises using standard costs for inventories and cost of goods sold generally should
report standard cost variances for interim periods as they do for fiscal years. Planned
variances in materials prices, volume, or capacity should be deferred at the end of in-
terim periods if the variances are expected to be absorbed by the end of the fiscal year.

All Other Costs and Expenses

The following guidelines for all costs and expenses other than those associated with rev-
enue are set forth in APB Opinion No. 28:
Costs and expenses other than product costs should be charged to income in interim periods
as incurred, or be allocated among interim periods based on an estimate of time expired,
benefit received or activity associated with the periods. Procedures adopted for assigning
specific cost and expense items to an interim period should be consistent with the bases fol-
lowed by the company in reporting results of operations at annual reporting dates. However,
when a specific cost or expense item charged to expense for annual reporting purposes bene-
fits more than one interim period, the cost or expense item may be allocated to those interim
periods. . . .
The amounts of certain costs and expenses are frequently subjected to year-end adjust-
ments even though they can be reasonably approximated at interim dates. To the extent possi-
ble such adjustments should be estimated and the estimated costs and expenses assigned to
interim periods so that the interim periods bear a reasonable portion of the anticipated annual
amount. Examples of such items include inventory shrinkage, allowance for uncollectible ac-
counts, allowance for quantity discounts, and discretionary year-end bonuses.16

16
Ibid., pars. 15a and 17.
552 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

APB Opinion No. 28 includes a number of specific applications of the foregoing

guidelines.

Income Taxes Expense

The techniques for recognizing income taxes expense in interim financial reports were
described as follows:
At the end of each interim period the company should make its best estimate of the effective
tax rate expected to be applicable for the full fiscal year. The rate so determined should be
used in providing for income taxes on a current year-to-date basis. The effective tax rate
should reflect anticipated . . . foreign tax rates, percentage depletion, . . . and other available
tax planning alternatives. However, in arriving at this effective tax rate no effect should be in-
cluded for the tax related to significant unusual or extraordinary items that will be separately
reported or reported net of their related tax effect in reports for the interim period or for the
fiscal year.17

To illustrate, assume that on March 31, 2006, the end of the first quarter of Fiscal Year
2006, Carter Company’s actual first quarter and forecasted fiscal year operating results were
as follows:

Actual First Quarter First Quarter Fiscal Year

and Forecasted Fiscal (Actual) (Estimated)
Year Pretax Financial
Revenue $400,000 $1,800,000
Income
Less: Costs and expenses other than income taxes 300,000 1,500,000
Income before income taxes $100,000 $ 300,000

Assume further that there were no temporary differences between Carter’s pretax finan-
cial income and taxable income, but that Carter had the following estimated permanent dif-
ferences between pretax financial income and federal and state taxable income for the 2006
fiscal year:

Estimated Permanent Dividend received deduction $17,000

Differences Premiums on officers’ life insurance 5,000

If Carter’s nominal federal and state income tax rates total 40%, Carter estimates its
effective combined income tax rate for 2006 as follows:

Computation of Estimated income before income taxes $300,000

Estimated Effective Add: Nondeductible premiums on officers’ life insurance 5,000
Income Tax Rate Less: Dividend received deduction (17,000)
Estimated taxable income $288,000
Estimated combined federal and state income taxes ($288,000 0.40) $115,200
Estimated effective combined federal and state income tax rate for 2006
($115,200 $300,000) 38.4%

17
Ibid., par. 19.
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 553

Carter’s journal entry for income taxes on March 31, 2006, is as follows:

Journal Entry for Income Taxes Expense 38,400

Income Taxes for First Income Taxes Payable 38,400
Quarter of Fiscal Year To provide for estimated federal and state income taxes for the first
quarter of 2006 ($100,000 0.384 $38,400).

For the second quarter of 2006, Carter again estimates an effective combined federal
and state income tax rate based on more current projections for permanent differences
between pretax financial income and taxable income for the entire year. However, the
new effective rate is not applied retroactively to restate the first quarter’s income taxes
expense. For example, assume that Carter’s second-quarter estimate of the effective com-
bined federal and state income tax rate was 39.2% and that Carter’s pretax financial in-
come for the second quarter was $120,000 (or $220,000 for first two quarters). Carter
prepares the following journal entry on June 30, 2006, for income taxes expense for the
second quarter of 2006:

Journal Entry for Income Taxes Expense 47,840

Income Taxes for Income Taxes Payable 47,840
Second Quarter To provide for estimated federal and state income taxes for the second
of Fiscal Year quarter of 2006 as follows:
Cumulative income taxes expense ($220,000 0.392) $86,240
Less: Income taxes expense for first quarter 38,400
Income taxes expense for second quarter $47,840

The foregoing computation of income taxes expense for interim periods is a highly sim-
plified example. Many complex aspects of income taxes, such as net operating loss carry-
backs and carryforwards, complicate the computations of income taxes for interim periods.
FASB Interpretation No. 18, “Accounting for Income Taxes in Interim Periods,” provides
guidance for complex interim period income tax computations.

Reporting Accounting Changes in Interim Periods

In 1974, the FASB issued FASB Statement No. 3, “Reporting Accounting Changes in In-
terim Financial Statements,” as an amendment to APB Opinion No. 28. Following are the
two principal provisions of FASB Statement No. 3:
If a cumulative effect type accounting change is made during the first interim period of an
enterprise’s fiscal year, the cumulative effect of the change on retained earnings at the begin-
ning of that fiscal year shall be included in net income of the first interim period (and in last-
twelve-months-to-date financial reports that include that first interim period).
If a cumulative effect type accounting change is made in other than the first interim pe-
riod of an enterprise’s fiscal year, no cumulative effect of the change shall be included in net
income of the period of the change. Instead, financial information for the pre-change interim
periods of the fiscal year in which the change is made shall be restated by applying the newly
adopted accounting principle to those pre-change interim periods. The cumulative effect of
the change on retained earnings at the beginning of that fiscal year shall be included in re-
stated net income of the first interim period of the fiscal year in which the change is made
(and in any year-to-date or last-twelve-months-to-date financial reports that include the first
554 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

interim period). Whenever financial information that includes those pre-change interim peri-
ods is presented, it shall be presented on the restated basis.18

Disclosure of Interim Financial Data

As minimum disclosure, APB Opinion No. 28 provided that the following data should be
included in publicly owned enterprises’ interim financial reports to stockholders. The data
are to be reported for the most recent quarter and the year to date, or 12 months to date of
the quarter’s end.19
1. Sales or gross revenue, income taxes expense, extraordinary items (including related in-
come tax effects), cumulative effect of a change in accounting principle or practice, and
net income.
2. Basic and diluted earnings per share data for each period presented (as amended by
FASB Statement No. 128, “Earnings per Share”).
3. Seasonal revenue, costs, or expenses.
4. Significant changes in estimates or provisions for income taxes.
5. Disposal of an operating segment and extraordinary, unusual, or infrequently occurring
items.
6. Contingent items.
7. Changes in accounting principle or estimate.
8. Significant changes in financial position.
For enterprises that complete a material business combination in an interim period, the
FASB requires disclosure of the following through the most recent interim period of the rel-
evant fiscal year:20
1. The name and a brief description of the acquired entity and the percentage of voting
equity interests acquired.
2. The primary reasons for the acquisition, including a description of the factors that con-
tributed to a purchase price that results in recognition of goodwill.
3. The period for which the results of operations of the acquired entity are included in the
income statement of the combined entity.
4. The cost of the acquired entity and, if applicable, the number of shares of equity in-
terests (such as common shares, preferred shares, or partnership interests) issued or
issuable, the value assigned to those interests, and the basis for determining that
value.
5. Supplemental pro forma information that discloses the results of operations for the
current interim period and the current year up to the date of the most recent interim
statement of financial position presented (and for the corresponding periods in the
preceding year) as though the business combination had been completed as of the be-
ginning of the period being reported on. That pro forma information shall display, at
a minimum, revenue, income before extraordinary items and the cumulative effect of
accounting changes (including those on an interim basis), net income, and earnings
per share.
6. The nature and amount of any material, nonrecurring items included in the reported pro
forma results of operations.

18
FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements” (Stamford:
FASB, 1974), pars. 9–10.
19
APB Opinion No. 28, par. 30.
20
FASB Statement No. 141, “Business Combinations” (Norwalk: FASB, 2001, pars, 51, 58.
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 555

The FASB also has required the following additional disclosures for reportable operat-
ing segments in interim reports: revenues from external customers; intersegment revenues;
segment profit or loss; segment assets if material changes have occurred since the most re-
cent 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 pretax income from continu-
ing operations.21
Disclosure of interim financial data is illustrated in the excerpts from the 2003 annual
report of The McGraw-Hill Companies, Inc., presented in the appendix to this chapter
(page 584).

Conclusions on Interim Financial Reports

APB Opinion No. 28, FASB Statement No. 3, and FASB Interpretation No. 18 represented
a substantial effort to upgrade the quality of interim financial reports. However, controversy
continues on the subject of interim financial reporting—especially concerning the APB’s
premise that an interim period should be accounted for as an integral part of the applicable
annual period. In recognition of this controversy and other problems of interim financial re-
porting, the FASB undertook a comprehensive study of the topic, and issued a Discussion
Memorandum entitled “Interim Financial Accounting and Reporting.” However, because
of more pressing matters on its agenda, the FASB abandoned the project a few years later.

IAS 34, “Interim Financial Reporting”

In IAS 34, the International Accounting Standards Board specified the condensed financial
statements and other data to be included in quarterly or semiannual reports: comparative
balance sheets, income statements, cash flows statements, and equity changes statements,
together with basic and diluted earnings per share and selected notes to financial state-
ments. Presumably the IASB provided more specificity than is present in APB Opinion No. 28
because of the detailed requirements for financial statements included in the SEC’s
Form 10-Q and the instructions thereto.

SEC Enforcement Actions Dealing with Wrongful Application

of Accounting Standards for Interim Financial Reports
Numerous SEC enforcement actions have addressed overstatements of quarterly earnings
reported in Form 10-Q. Among 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 costs that should be recognized as expenses;
and overstatement of percentage of completion on construction-type contracts. Examples
of SEC enforcement actions involving interim financial reports follow:

AAER 170
AAER 170, “Securities and Exchange Commission v. Kaypro Corporation and Andrew F.
Kay” (November 6, 1987), deals with a federal court’s entry of a permanent injunction
against a corporation that developed, manufactured, and marketed microcomputers, and
against its CEO/CFO. According to the SEC, the latter was responsible for the corporation’s
issuance of misleading interim reports to the SEC in Form 10-Q because he sanctioned

21
FASB Statement No. 131, par. 33.
556 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

misuse of the gross margin method for estimating quarterly ending inventories. The SEC
found that quarterly cost of goods sold amounts had been estimated at 57% of sales instead
of the actual 74% of sales determined by the corporation’s independent auditors at the end
of the fiscal year that included the subject quarters.

AAER 207 and 208

AAER 207, “. . . In the Matter of Matrix Science Corp., et al.,” and AAER 208, “Securities
and Exchange Commission v. Ronald A. Hammond, John H. MacQueen and Thomas
Fleming, Jr.” (November 1, 1988), report SEC enforcement actions against a corporation
engaged in the design, manufacture, and sale of electrical connectors, and against 10 of its
senior and middle-management executives, including its CFO. The SEC found that, among
other misstatements, the corporation’s quarterly sales, reported to the SEC in Form 10-Q,
were overstated because sales journals had been held open for up to two days after the end
of each quarter, to enable the corporation to report net sales amounts that approximated
preestablished sales quotas for the quarter.

AAER 389
AAER 389, “Securities and Exchange Commission v. Albert Barette and Michael Strauss,”
(June 17, 1992) reported a permanent injunction and fines of $50,000 and $10,000, re-
spectively, against the former CEO and former CFO of a wholly owned subsidiary of a pub-
licly owned company. The SEC alleged that the two officials misstated the subsidiary’s
quarterly operating results reported to the parent company, in order to conceal the sub-
sidiary’s failure to meet internal budgetary targets. The SEC charged that because of the
overstatements of some quarterly results and the understatements of others, the following
pattern emerged with respect to the parent company’s earnings reported to the SEC on
Form 10-Q:

Quarter Ended (000 Omitted)

9/30/89 12/31/89 3/31/90 9/30/90 12/31/90
Pretax income:
As reported $2,611 $ 2,723 $ 4,100 $3,677 $3,231
Actual 2,262 2,974 4,529 3,165 2,569
Overstatement (understatement) $ 349 $( 251) $( 429) $ 512 $ 662

AAER 1275
AAER 1275, “In the Matter of Mary Sattler Polverari, CPA,” describes the fraud perpe-
trated by the supervisor of financial reporting for a controller of franchise brand names
in the hotel, real estate brokerage, and car rental businesses. According to the SEC, the
supervisor, after preparing conventional interim consolidating financial statements for
the enterprise’s business units, using electronic spreadsheets, made unsupported changes
in the consolidated amounts as directed by her supervisors. The purpose of the changes was
to inflate the enterprise’s interim earnings reports to meet expectations of Wall Street
financial analysts. The SEC denied the supervisor’s privilege of practicing before it as an
accountant, with the provision that, after meeting certain requirements, she might apply for
reinstatement after a period of three years.
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 557

REPORTING FOR THE SEC

The Securities and Exchange Commission (SEC) is an agency of the U.S. government cre-
ated in 1934 to oversee the interstate issuances and trading of securities. Since its creation,
the SEC’s functions have expanded to include administration of the following statutes,
among others:
• Securities Act of 1933, governing interstate issuances of securities to the public.
• Securities Exchange Act of 1934, governing trading of securities on national securities
exchanges and over the counter.
• Public Utility Holding Company Act of 1935, governing interstate public utility holding
company systems for electricity and gas.
• Trust Indenture Act of 1939, governing the issuance of bonds, debentures, and similar
debt securities under an indenture meeting the requirements of the Act.
• Investment Company Act of 1940 and Investment Advisers Act of 1940, governing op-
erations of investment companies and investment advisers.
This section focuses on SEC administration of the Securities Act of 1933 (the 1933 Act)
and the Securities Exchange Act of 1934 (the 1934 Act).

Nature of Reporting to the SEC

Most publicly owned companies are subject to either or both the 1933 Act and the 1934 Act.
Companies planning to issue securities interstate to the public generally must file a regis-
tration statement with the SEC. Companies whose securities are traded on national stock
exchanges also must file a registration statement; in addition, periodic reports must be
made to the SEC by such companies. Most large companies whose securities are traded
over the counter also must report periodically to the SEC.

Registration of Securities
The SEC has developed a series of forms for the registration of securities. Forms S-1, S-2,
S-3, S-4, F-1, F-2, F-3, and F-4 are used by large companies to register securities to be is-
sued to the public; Form SB-1 and Form SB-2 are used by small business issuers, as de-
fined in the 1933 Act. The principal form for registering securities for trading on a national
exchange or over the counter is Form 10. The various forms are not a series of blanks to be
filled in; they are guides for the format of information to be included in the registration
statements.

Periodic Reporting
The principal forms established by the SEC for reporting by companies whose stock is
traded on national exchanges or over the counter are Form 10-K, Form 10-Q, and Form
8-K. Form 10-K is an annual report to the SEC, which must be filed within 60 days follow-
ing the close of the company’s fiscal year. Much of the information required by Form 10-K
may be incorporated by reference to the annual report to stockholders, which also must be
filed with the SEC.
Form 10-Q is a quarterly report to the SEC that is due within 40 days after the end of
each of the first three quarters of the company’s fiscal year; a quarterly report for the fourth
quarter of the fiscal year is not required. The condensed financial statements that must be
included in Form 10-Q are more extensive than the minimum disclosure requirements of
APB Opinion No. 28, “Interim Financial Reporting” (see page 554), but the 10-Q financial
statements need not be audited.
558 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

Form 8-K is a current report that must be filed with the SEC within four business days
after the occurrence of events such as the following:
1. Change in control of the reporting company, or in the company’s fiscal year.
2. Acquisition or disposal of assets by the reporting company, including business
combinations.
3. Bankruptcy or receivership of the reporting company.
4. Change of independent auditors for the reporting company.
5. Resignation and other changes of directors of the reporting company.
6. Changes in the reporting company’s bylaws.
In addition, a company may choose to report to the SEC in Form 8-K any other event that
it considers important to stockholders.
Another important periodic report to the SEC is a proxy statement, which must be filed
by companies that solicit proxies for annual meetings of their stockholders. If matters other
than election of directors, selection of independent auditors, and consideration of stock-
holder proposals are to take place at an annual meeting, a preliminary proxy statement
must be filed with the SEC for review and comment prior to distribution of the definitive
proxy statement to stockholders. Essentially, the proxy statement includes disclosure of all
matters to be voted on at the forthcoming meeting of stockholders whose proxies are so-
licited. If the stockholders are to vote on authorization or issuances of securities, modifica-
tion or exchanges of securities, or business combinations, the proxy statement must include
financial statements of the company and of any proposed combinee.

Organization and Functions of the SEC

The SEC is administered by five commissioners appointed for five-year terms by the President
and confirmed by the Senate of the United States. No more than three commissioners may be
members of the same political party. Headquartered in Washington, D.C., the SEC has nine re-
gional offices and six branch offices. In the following sections, three segments of the SEC are
discussed: chief accountant, Division of Corporation Finance, and Division of Enforcement.

Chief Accountant
The chief accountant of the SEC, as an expert in accounting, is responsible for issuing pro-
nouncements that establish the SEC’s position on matters affecting accounting and audit-
ing. The chief accountant also supervises disciplinary proceedings against accountants
charged with violating the SEC’s Rules of Practice. The chief accountant cooperates with
the FASB and other private organizations interested in research and standards setting in
accounting and auditing.

Division of Corporation Finance

The staff of the SEC’s Division of Corporation Finance reviews the Forms and proxy state-
ments filed with the SEC under the 1933 Act and the 1934 Act. The extent of the reviews
varies, depending on whether the filing company has a history of acceptable reporting to
the SEC or is “unseasoned.” Division of Corporation Finance personnel consult with the
chief accountant on the propriety of accounting presentations in filings with the SEC.
Changes in the various Forms and in Regulation S-X and Regulation S-K are the respon-
sibility of the Division of Corporation Finance.

Division of Enforcement
The duties of the SEC’s Division of Enforcement involve monitoring the compliance of
companies subject to the SEC’s jurisdiction with the 1933 Act and the 1934 Act. When
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 559

noncompliance is ascertained, the Division of Enforcement often will request and obtain
federal court injunctions prohibiting the company and its management from further
violations of the two Acts. Many of the criminal indictments involving management
fraud in recent years have been obtained through the efforts of the SEC’s Division of
Enforcement.

Interaction between SEC and FASB

Both the 1933 Act and the 1934 Act empower the SEC to establish rules for the accounting
principles underlying financial statements and schedules included in reports filed with the
SEC. The SEC rarely has used this authority directly. Instead, it generally has endorsed ac-
tions on accounting principles by organizations in the private sector (currently the FASB),
while reserving the right to issue its own pronouncements when necessary. This posture of
the SEC has been described as follows:
In ASR [Accounting Series Release] 4, the Commission stated its policy that financial state-
ments prepared in accordance with accounting practices for which there was no substantial
authoritative support were presumed to be misleading and that footnote or other disclosure
would not avoid this presumption. It also stated that, where there was a difference of opinion
between the Commission and a registrant as to the proper accounting to be followed in a par-
ticular case, disclosure would be accepted in lieu of correction of the financial statements
themselves only if substantial authoritative support existed for the accounting practices fol-
lowed by the registrant and the position of the Commission had not been expressed in rules,
regulations or other official releases. For purposes of this policy, principles, standards and
practices promulgated by the FASB in its Statements and Interpretations will be considered
by the Commission as having substantial authoritative support, and those contrary to such
FASB promulgations will be considered to have no such support.
. . . Information in addition to that included in financial statements conforming to gener-
ally accepted accounting principles is also necessary. Such additional disclosures are re-
quired to be made in various fashions, such as in financial statements and schedules reported
on by independent public accountants or as textual statements required by items in the ap-
plicable forms and reports filed with the Commission. The Commission will continue to
identify areas where investor information needs exist and will determine the appropriate
methods of disclosure to meet these needs.22

Thus, the SEC differentiated between generally accepted accounting principles and
disclosures in financial statements and schedules, and expressed an intention to concentrate
on pronouncements on disclosures. The SEC subsequently supplemented its relationship
with the FASB as follows:
The Securities and Exchange Commission has determined that the Financial Accounting
Standards Board (FASB or Board) and its parent organization, the Financial Accounting
Foundation (FAF), satisfy the criteria in section 108 of the Sarbanes-Oxley Act of 2002 and,
accordingly, FASB’s financial accounting and reporting standards are recognized as “gener-
ally accepted” for purposes of the federal securities laws. As a result, registrants are required
to continue to comply with those standards in preparing financial statements filed with the
Commission, unless the Commission directs otherwise. Our determination is premised on an
expectation that the FASB, and any organization affiliated with it, will address the issues set
forth in this statement and any future amendments to this statement, and will continue to
serve investors and protect the public interest. This policy statement updates Accounting
Series Release No. 150, issued on December 20, 1973, which expressed the Commission’s
intent to continue to look to the private sector for leadership in establishing and improving

22
Codification of Financial Reporting Policies, Securities and Exchange Commission (Washington: 1982),
Sec. 101.
560 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

accounting principles and standards through the FASB with the expectation that the body’s
conclusions will promote the interests of investors.23

The principal devices used by the SEC to communicate its requirements for accounting
principles and disclosures have been Regulation S-X, Regulation S-K, Accounting Series
Releases, Financial Reporting Releases, and Staff Accounting Bulletins.

Regulation S-X
The SEC issued Regulation S-X to provide guidance for the form and content of financial
statements and schedules required to be filed with the SEC under the laws that it adminis-
ters. Since the adoption of Regulation S-X in 1940, the SEC has amended the document
extensively, including a thorough overhaul in 1980 (Accounting Series Release No. 280).
Regulation S-X consists of numerous rules subdivided into several articles. Among the
significant provisions of Regulation S-X are Rule 3-02, which requires audited income
statements and statements of cash flows for three fiscal years, and Article 12, which illus-
trates the form and content of schedules to be filed in support of various financial statement
items. Excerpts from the annual report of The McGraw-Hill Companies, Inc., in the ap-
pendix at the end of this chapter illustrate the required comparative financial statements.
At one time, numerous schedules were required to be included in some of the Forms filed
with the SEC. However, in 1994, the SEC terminated several of the required schedules, in
Financial Reporting Release No. 44. One of the few remaining schedules is “Schedule II—
Valuation and Qualifying Accounts,” the format and instructions for which are as follows:24

Column C—Additions
(2)—
Column B— (1)— Charged to
Balance at Charged to Other Column D— Column E—
Beginning of Costs and Accounts— Deductions— Balance at End
Column A—Description1 Period Expenses Describe Describe of Period
1
List, by major classes, all valuation and qualifying accounts and reserves not included in specific schedules. Identify each class of valuation and qualifying accounts and
reserves by descriptive title. Group (A) those valuation and qualifying accounts which are deducted in the balance sheet from the assets to which they apply and (B) those re-
serves which support the balance sheet caption, Reserves. Valuation and qualifying accounts and reserves as to which the additions, deductions, and balances were not individ-
ually significant may be grouped in one total and in such case the information called for under columns C and D need not be given.

Typically reported in Schedule II are asset valuation accounts such as Allowance for
Doubtful Accounts and Accumulated Depreciation.

Regulation S-K
The SEC issued Regulation S-K in 1977 to provide guidance for the completion of nonfinan-
cial statement disclosure requirements in the various Forms filed under the 1933 Act and the
1934 Act. As amended since its adoption, Regulation S-K contains several items of disclosure.

Accounting Series Releases (ASRs)

In 1937 the SEC initiated a program of pronouncements by the chief accountant designed to
contribute to the development of uniform standards and practice in major accounting ques-
tions. Through early 1982, 307 ASRs were issued, with more than half of them published
after January 1974. However, fewer than half of the ASRs dealt solely with accounting prin-
ciples and disclosures; the remainder covered auditing standards, independence of auditors,
and enforcement actions of the SEC involving accountants.

23
Financial Reporting Release No. 70, Securities and Exchange Commission (Washington: 2003).
24
Regulation S-X, Rule 12-09.
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 561

Two examples of ASRs dealing with accounting principles and disclosures are ASR
No. 142 and ASR No. 149. In ASR No. 142, “Reporting Cash Flow and Other Related
Data,” the SEC concluded that financial reports should not present cash flow (net income
adjusted for noncash expenses and revenue) per share and other comparable per-share
computations, other than those based on net income, dividends, or net assets. In ASR No.
149, “. . . Improved Disclosure of Income Tax Expense” (as amended by ASR No. 280), the
SEC mandated several disclosures concerning income taxes. Note 6 of the annual report of
The McGraw-Hill Companies, Inc., in the appendix (page 574) illustrates the requirements
of ASR No. 149, which later were incorporated in paragraph 47 of FASB Statement No.
109, “Accounting for Income Taxes.”

Financial Reporting Releases (FRRs)

In 1982, the SEC terminated the issuance of Accounting Series Releases and instituted
Financial Reporting Releases for stating its views on financial reporting matters. (En-
forcement actions of the SEC were to be publicized in Accounting and Auditing Enforce-
ment Releases.)

Staff Accounting Bulletins (SABs)

The following excerpt from ASR No. 180 describes the SABs issued by the SEC:
The Securities and Exchange Commission today announced the institution of a series of Staff
Accounting Bulletins intended to achieve a wider dissemination of the administrative interpre-
tations and practices utilized by the Commission’s staff in reviewing financial statements. The
Division of Corporation Finance and the Office of the Chief Accountant began the series today
with the publication of Bulletin No. 1. . . . The statements in the Bulletin are not rules or inter-
pretations of the Commission nor are they published as bearing the Commission’s official ap-
proval; they represent interpretations and practices followed by the Division and the Chief
Accountant in administering the disclosure requirements of the federal securities laws.

The following example from SAB No. 1 (subsequently superseded by SAB No. 40) illus-
trates the contents of a typical Bulletin:
Facts: Company E proposes to include in its registration statement a balance sheet show-
ing its subordinated debt as a portion of stockholders’ equity.
Question: Is this presentation appropriate?
Interpretive Response: Subordinated debt may not be included in the stockholders’ equity
section of the balance sheet. Any presentation describing such debt as a component of stock-
holders’ equity must be eliminated. Furthermore, any caption representing the combination
of stockholders’ equity and any subordinated debt must be deleted.

The SEC and the Public Company Accounting

Oversight Board (PCAOB)
As described in Chapter 1 (pages 1–2), the Sarbanes-Oxley Act of 2002 established the
PCAOB to provide oversight over companies subject to the jurisdiction of the SEC. The
SEC’s relationship with the PCAOB has been described as follows:
The [SEC] has the power of appointment [of PCAOB members] and can remove a member
for good cause. It must approve all Board rules before they become effective and can amend
the Board’s rules, adding to them or deleting from them. All disciplinary sanctions are sub-
ject to review by the Commission, which can modify or cancel them. The Board must file an
annual report with the Commission, which has the power to rescind elements of the Board’s
authority, censure it or its members, or limit its activities, if it determines that doing so would
be in the public interest.25

25
Sarbanes–Oxley: A Closer Look, KPMG LLP, 2003, p.1.
562 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

Appendix

Excerpts from the 2003 Annual Report of The McGraw-Hill

Companies, Inc.
CONSOLIDATED STATEMENT OF INCOME
Years ended December 31 (in thousands, except per-share data) 2003 2002 2001
Revenue (Notes 1, 2 and 4)
Product revenue $2,414,563 $2,389,770 $2,341,429
Service revenue 2,413,294 2,250,414 2,133,172
Total Revenue 4,827,857 4,640,184 4,474,601
Expenses (Note 5)
Operating related
Product 1,166,217 1,166,888 1,171,176
Service 840,248 814,423 838,202
Operating related expenses 2,006,465 1,981,311 2,009,378
Selling and general
Product 894,862 877,703 869,497
Service 844,881 756,830 764,789
Selling and general expenses 1,739,743 1,634,533 1,634,286
Depreciation (Note 1) 82,827 86,818 85,748
Amortization of intangibles (Note 13) 32,973 36,270 32,527
Goodwill amortization (Note 13) – – 51,581
Total expenses 3,862,008 3,738,932 3,813,520
Other income–net (Notes 2 and 14) 171,525 18,660 10,110
Income from operations 1,137,374 919,912 671,191
Interest expense 7,097 22,517 55,070
Income from continuing operations
Before taxes on income 1,130,277 897,395 616,121
Provision for taxes on income (Note 6) 442,466 325,429 238,436
Income from continuing operations 687,811 571,966 377,685
Discontinued operations (Note 2):
Earnings from operations of discontinued components:
ComStock (including gain on disposal of $86,953 in 2003) 87,490 8,827 8,853
Income tax expense 30,304 3,310 3,408
Earnings from discontinued operations 57,186 5,517 5,445
Juvenile retail publishing business
(including loss on planned 2004 disposition of $75,919) (81,058) (1,157) (9,916)
Income tax benefit (23,711) (434) (3,817)
Loss from discontinued operations (57,347) (723) (6,099)
(Loss)/earnings from discontinued operations (161) 4,794 (654)
Net income $ 687,650 $ 576,760 $ 377,031
Basic earnings per common share (Note 12)
Income from continuing operations $ 3.61 $ 2.97 $ 1.95
Net income $ 3.61 $ 2.99 $ 1.95
Diluted earnings per common share (Note 12)
Income from continuing operations $ 3.58 $ 2.94 $ 1.93
Net income $ 3.58 $ 2.96 $ 1.92

See accompanying notes.

 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 563

CONSOLIDATED BALANCE SHEET

December 31 (in thousands, except per-share data) 2003 2002

Assets
Current assets
Cash and equivalents (Note 1) $ 695,591 $ 58,186
Accounts receivable (net of allowances for doubtful accounts and
sales returns: 2003–$239,824; 2002–$241,061). (Note 1) 956,439 991,806
Inventories:
Finished goods 273,097 314,420
Work-in-process 12,944 18,128
Paper and other materials 15,146 28,209
Total inventories (Note 1) 301,187 360,757
Deferred income taxes (Note 6) 226,068 169,829
Prepaid and other current assets (Note 1) 76,867 93,729
Total current assets 2,256,152 1,674,307
Prepublication costs: (net of accumulated amortization:
2003–$1,037,142; 2002–$924,867) (Note 1) 463,635 534,835
Investments and other assets
Investments in Rock-McGraw, Inc.–at equity (Notes 1 and 14) – 119,442
Prepaid pension expense (Note 10) 288,244 261,243
Other 215,732 205,243
Total investments and other assets 503,976 585,928
Property and equipment–at cost
Land 13,658 13,252
Buildings and leasehold improvements 379,779 330,484
Equipment and furniture 737,989 728,217
Total property and equipment 1,131,426 1,071,953
Less–accumulated depreciation 664,098 640,493
Net property and equipment 467,328 431,460
Goodwill and other intangible assets (Notes 1 and 13)
Goodwill–net 1,239,877 1,294,831
Copyrights–net 244,869 272,243
Other intangible assets–net 218,231 238,578
Net goodwill and other intangible assets 1,702,977 1,805,652
Total assets $5,394,068 $5,032,182

See accompanying notes.

564 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

2003 2002
Liabilities and shareholders’ equity
Current liabilities
Notes payable (Note 3) $ 25,955 $ 119,414
Accounts payable 306,157 303,354
Accrued royalties 121,047 119,821
Accrued compensation and contributions to retirement plans 352,061 317,640
Income taxes currently payable 246,943 82,016
Unearned revenue (Note 1) 595,418 538,961
Deferred gain on sale leaseback (Note 14) 7,516 –
Other current liabilities (Note 1) 338,637 294,085
Total current liabilities 1,993,734 1,775,291
Other liabilities
Long-term debt (Note 3) 389 458,923
Deferred income taxes (Note 6) 200,485 200,114
Accrued postretirement healthcare and other benefits (Note 11) 168,051 172,067
Deferred gain on sale leaseback (Note 14) 204,783 –
Other non-current liabilities 269,575 259,965
Total other liabilities 843,283 1,091,069
Total liabilities 2,837,017 2,866,360

Commitments and contingencies (Note 7)

Shareholders’ equity (Notes 8 and 9)

Common stock, $1 par value: authorized – 300,000,000 shares;
issued – 205,854,086 shares in 2003 and 205,853,583 shares in
2002, respectively 205,854 205,853
Additional paid-in capital 86,501 79,410
Retained income 3,153,195 2,672,086
Accumulated other comprehensive income (69,524) (103,965)
Less – Common stock in treasury – at cost
(15,457,880 shares in 2003 and 14,021,056 shares in 2002) 801,062 669,499
Unearned compensation on restricted stock 17,913 18,063
Total shareholders’ equity 2,557,051 2,165,822
Total liabilities and shareholders’ equity $5,394,068 $5,032,182
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 565

CONSOLIDATED STATEMENT OF CASH FLOWS

Years ended December 31 (in thousands) 2003 2002 2001

Cash flow from operating activities
Net income $ 687,650 $ 576,760 $ 377,031
Dividend from Rock-McGraw, Inc. 103,500 – –
Restructuring and asset write-downs – – 158,962
Adjustments to reconcile net income to cash provided
by operating activities:
Depreciation 83,953 89,589 88,802
Amortization of goodwill and intangibles 33,739 38,789 91,555
Amortization of prepublication costs 285,487 280,393 240,241
Provision for losses on accounts receivable 29,839 33,024 55,254
Gain on sale of real estate – – (6,925)
Loss on sale of MMS International – 14,534 –
Gain on sale of S&P ComStock (86,953) – –
Loss on planned disposition of juvenile retail
publishing business primarily goodwill impairment 75,919 – –
Gain on sale of Rock-McGraw, Inc. (131,250) – –
Other (12,468) (9,618) (8,347)
Change in assets and liabilities net of effect of
acquisitions and dispositions:
Decrease in accounts receivable and inventory 77,055 61,623 23,308
Decrease in prepaid and other current assets 18,927 7,185 27,023
Increase in accounts payable and accrued expenses 32,692 4,373 42,202
Increase/(decrease) in unearned revenue and
other current liabilities 51,451 (56,149) (42,696)
Increase in interest and income taxes currently payable 169,935 18,475 42,618
Net change in deferred income taxes (50,017) 64,492 7,357
Net change in other assets and liabilities 12,886 18,921 3,196
Cash provided by operating activities 1,382,345 1,142,391 1,099,581
Investing activities
Investment in prepublication costs (218,049) (249,317) (294,538)
Purchase of property and equipment (114,984) (70,019) (116,895)
Acquisition of businesses and equity interests (3,678) (19,310) (333,234)
Proceeds from disposition of property, equipment and businesses 502,665 24,304 17,876
Additions to technology projects (28,145) (55,477) (28,840)
Other – 3,299 –
Cash provided by/(used for) investing activities 137,809 (366,520) (755,631)
Financing activities
Dividends paid to shareholders (206,543) (197,016) (189,834)
(Payments)/additions to commercial paper and
other short-term debt–net (552,719) (478,501) 12,137
Repayment of long-term debt – – (741)
Repurchase of treasury shares (216,356) (183,111) (176,468)
Exercise of stock options 79,162 77,465 63,917
Other (408) (575) (376)
Cash used for financing activities (896,864) (781,738) (291,365)
Effect of exchange rate changes on cash 14,115 10,518 (2,221)
Net change in cash and equivalents 637,405 4,651 50,364
Cash and equivalents at beginning of year 58,186 53,535 3,171
Cash and equivalents at end of year $ 695,591 $ 58,186 $ 53,535

See accompanying notes.

566 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

Less–
Years ended Accumulated Less– unearned
December 31, other common compen-
2003, 2002 and 2001 $1.20 Additional compre- stock in sation on
(in thousands, preference Common paid-in Retained hensive treasury restricted
except per-share data) $10 par $1 par capital income income at cost stock Total

Balance at
December 31, 2000 $13 $205,839 $44,176 $2,105,145 $(110,358) $470,903 $12,868 $1,761,044
Net income – – – 377,031 – – – 377,031
Other comprehensive
income (Note 1) – – – – (16,502) – – (16,502)
Comprehensive income 360,529
Dividends
($.98 per share) – – – (189,834) – – – (189,834)
Share repurchase – – – – – 176,468 – (176,468)
Employee stock plans – – 20,407 – – (80,070) 2,444 98,033
Other – – 55 – – (526) – 581
Balance at
December 31, 2001 13 205,839 64,638 2,292,342 (126,860) 566,775 15,312 1,853,885
Net income – – – 576,760 – – – 576,760
Other comprehensive
income (Note 1) – – – – 22,895 – – 22,895
Comprehensive income 599,655
Dividends
($1.02 per share) – – – (197,016) – – – (197,016)
Share repurchase – – – – 183,111 – (183,111)
Employee stock plans – – 14,737 – – (80,298) 2,751 92,284
Other (13) 14 35 – – (89) – 125
Balance at
December 31, 2002 – 205,853 79,410 2,672,086 (103,965) 669,499 18,063 2,165,822
Net income – – – 687,650 – – – 687,650
Other comprehensive
income (Note 1) – – – – 34,441 – – 34,441
Comprehensive income 722,091
Dividends
($1.08 per share) – – – (206,543) – – – (206,543)
Share repurchase – – – – – 230,837 – (230,837)
Employee stock plans – – 7,047 – – (99,176) (150) 106,373
Other – 1 44 2 – (98) – 145
Balance at
December 31, 2003 $– $205,854 $86,501 $3,153,195 $ (69,524) $801,062 $ 17,913 $2,557,051

See accompanying notes.

 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 567

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Accounting Policies Accounting for the impairment of long-lived

Principles of consolidation. The consolidated financial assets. The Company accounts for impairment of long-
statements include the accounts of all subsidiaries and lived assets in accordance with Statement of Financial
the Company’s share of earnings or losses of joint ven- Accounting Standards (SFAS) No. 144, “Accounting for
tures and affiliated companies under the equity method the Impairment or Disposal of Long-Lived Assets.” SFAS
of accounting. All significant intercompany accounts and No. 144 establishes a uniform accounting model for long-
transactions have been eliminated. lived assets to be disposed of. The Company evaluates
Use of estimates. The preparation of financial state- long-lived assets for impairment whenever events or
ments in conformity with generally accepted accounting changes in circumstances indicate that the carrying
principles requires management to make estimates and amount of an asset may not be recoverable. Upon such
assumptions that affect the amounts reported in the fi- an occurrence, recoverability of assets to be held and
nancial statements and accompanying notes. Actual re- used is measured by comparing the carrying amount of
sults could differ from those estimates. an asset to forecasted undiscounted future net cash flows
Cash equivalents. Cash and cash equivalents include expected to be generated by the asset. If the carrying
highly liquid investments with original maturities of three amount of the asset exceeds its estimated future cash
months or less and consist primarily of money market flows, an impairment charge is recognized by the amount
funds and time deposits at December 31, 2003 and by which the carrying amount of the asset exceeds the
2002. Such investments are stated at cost, which approxi- fair value of the asset. For long-lived assets held for sale,
mates market value and were $695.9 million and $41.9 assets are written down to fair value, less cost to sell. Fair
million in 2003 and 2002, respectively. These investments value is determined based on discounted cash flows, ap-
are not subject to significant market risk. praised values or management’s estimates, depending
Inventories. Inventories are stated at the lower of upon the nature of the assets. There were no impair-
cost (first-in, first-out) or market. A significant estimate in ments of long-lived assets, as of December 31, 2003,
the McGraw-Hill Education segment is the reserve for in- 2002 and 2001, with the exception of the Landoll, Frank
ventory obsolescence. The reserve is based upon manage- Schaffer and related juvenile retail publishing businesses
ment’s assessment of the marketplace of products in (juvenile retail publishing business), which was adjusted
demand as compared to the number of units currently on to fair value less cost to sell as a result of a planned dis-
hand. Should the estimate for inventory obsolescence for position. See Note 13.
the Company vary by one percentage point, it would Goodwill and other intangible assets. Goodwill
have an approximate $4.6 million impact on operating represents the excess of purchase price and related costs
profit. over the value assigned to the net tangible and identifi-
Prepublication costs. Prepublication costs, principally able intangible assets of businesses acquired. As of
outside preparation costs, are amortized from the year of December 31, 2003 and 2002, goodwill and other indefi-
publication over their estimated useful lives, one to five nite lived intangible assets that arose from acquisitions
years, using either an accelerated or the straight-line were $1.3 billion and $1.3 billion, respectively. On Janu-
method. The majority of the programs are amortized us- ary 1, 2002, the Company adopted SFAS No. 142,
ing an accelerated methodology. The Company periodi- “Goodwill and Other Intangible Assets.” Under SFAS No.
cally evaluates the remaining lives and recoverability of 142, goodwill and other intangible assets with indefinite
such costs, which is sometimes dependent upon program lives are not amortized, but instead are tested for impair-
acceptance by state adoption authorities, based on ex- ment annually, or if certain circumstances indicate a pos-
pected undiscounted cash flows. If the annual prepublica- sible impairment may exist, in accordance with the
tion amortization varied by one percentage point, the provisions of SFAS No. 142. The Company evaluates the
consolidated amortization expense would have increased recoverability of goodwill and indefinite lived intangible
by approximately $3.0 million. assets using a two-step impairment test approach at the
Investment in Rock-McGraw, Inc. Rock-McGraw reporting unit level. In the first step the fair value for
owns the Company’s headquarters building in New York the reporting unit is compared to its book value including
City. Rock-McGraw was owned 45% by the Company goodwill. In the case that the fair value of the reporting
and 55% by Rockefeller Groups, Inc. The Company ac- unit is less than the book value, a second step is per-
counted for this investment under the equity method formed which compares the implied fair value of the re-
of accounting. In December 2003, the Company sold its porting unit’s goodwill to the book value of the goodwill.
45% equity investment in Rock-McGraw, Inc. See The fair value for the goodwill is determined based on
Note 14. the difference between the fair values of the reporting
568 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

units and the net fair values of the identifiable assets and tively determinable, revenue is recorded as unearned and
liabilities of such reporting units. If the fair value of the recognized ratably over the service period. Fair value is
goodwill is less than the book value, the difference is rec- determined for each service component through a bifur-
ognized as an impairment. SFAS No. 142 also requires cation analysis which relies upon the pricing of similar
that intangible assets with estimable useful lives be amor- cash arrangements that are not part of the multi-element
tized over their respective estimated useful lives to the arrangement. Advertising revenue is recognized when the
estimated residual values, and reviewed for impairment in page is run or the spot is aired. Subscription income is
accordance with SFAS No. 144, “Accounting for the Im- recognized over the related subscription period.
pairment or Disposal of Long-Lived Assets.” See Note 13. Product revenue comprises the revenue from the
Beginning in January 2002, the Company did not McGraw-Hill Education segment and the circulation
amortize goodwill on its books in accordance with SFAS revenue from Information and Media Services, and repre-
No. 142. Prior to the adoption of SFAS No. 142, goodwill sents educational products, primarily books and maga-
was amortized on a straight-line basis over periods of up zines. Service revenue represents the revenue of the
to 40 years. The amount of goodwill amortization recog- Financial Services segment and the remaining revenue
nized was $0 million, $0 million and $56.6 million for of Information and Media Services, and represents
2003, 2002 and 2001. information-related services and advertising.
Receivable from/payable to broker-dealers and Depreciation. The costs of property and equipment
dealer banks. A subsidiary of J. J. Kenny Co. acts as an are depreciated using the straight-line method based
undisclosed agent in the purchase and sale of municipal upon the following estimated useful lives: Buildings and
securities for broker-dealers and dealer banks. The Com- leasehold improvements–15 to 40 years; Equipment and
pany had matched purchase and sale commitments of furniture–three to 10 years.
$109.1 million and $238.9 million at December 31, 2003 Advertising expense. The cost of advertising is ex-
and 2002, respectively. Only those transactions not pensed as incurred. The Company incurred $86 million,
closed at the settlement date are reflected in the balance $92 million and $107 million in advertising costs in 2003,
sheet as a component of other current assets and 2002 and 2001, respectively.
liabilities. Allowance for doubtful accounts and sales re-
Foreign currency translation. The Company has turns. The accounts receivable reserve methodology is
operations in various foreign countries. The functional based on historical analysis and a review of outstanding
currency is the local currency for all locations, except in balances. The impact on the operating profit for a 1%
the McGraw-Hill Education segment where operations change in the allowance for doubtful accounts is $12.0
that are extensions of the parent have the U.S. dollar as million. A significant estimate in the McGraw-Hill Educa-
functional currency. In the normal course of business tion segment, and particularly within the Higher Educa-
these operations are exposed to fluctuations in currency tion, Professional, and International Group, is the
values. Assets and liabilities are translated using current allowance for sales returns, which is based on the histori-
exchange rates, except certain accounts of units whose cal rate of return and current market conditions. The
functional currency is the U.S. dollar, and translation impact on the operating profit for a 1% change in the
adjustments are accumulated in a separate component of allowance for sales returns is $10.0 million.
shareholders’ equity. Revenue and expenses are Stock-based compensation. As permitted by SFAS
translated at average monthly exchange rates. Inventory, No. 123, “Accounting for Stock-Based Compensation,”
prepublication costs and property and equipment ac- the Company measures compensation expense for its
counts of units whose functional currency is the U.S. dol- stock-based employee compensation plans using the in-
lar are translated using historical exchange rates, and trinsic method prescribed by Accounting Principles Board
translation adjustments are charged and credited to Opinion No. 25 (APBO No. 25), “Accounting for Stock
income. Issued to Employees.”
Revenue. Revenue is recognized when goods are As required by SFAS No. 148, “Accounting for Stock-
shipped to customers or services are rendered. Units Based Compensation-Transition and Disclosure,” an
whose revenue is principally from service contracts record amendment to SFAS No. 123, the following table illus-
revenue as earned. Revenue relating to agreements that trates the effect on net income and earnings per share if
provide for more than one service is recognized based the Company had applied the fair value recognition pro-
upon the relative fair value to the customer of each ser- visions of SFAS No. 123 to stock-based employee com-
vice component and as each component is earned. If the pensation:
fair value to the customer for each service is not objec-
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 569

Recent accounting pronouncements. In January

Years ended December 31,
2003, the Financial Accounting Standards Board (FASB)
(in thousands except
issued Interpretation No. 46, “Consolidation of Variable
earnings per share) 2003 2002 2001
Interest Entities, an Interpretation of Accounting Research
Net income, Bulletin (ARB) No. 51” The interpretation introduces a
as reported $687,650 $576,760 $377,031 new consolidation model, the variable interests model,
Stock-based com- based on potential variability in gains and losses of the
pensation cost entity being evaluated for consolidation. It provides guid-
included in ance for determining whether an entity lacks sufficient
net income, equity or the entity’s equity holders lack adequate
net of tax $ 9,182 $ 12,984 $ 15,002 decision-making ability. These entities, variable interest
Fair value of stock- entities (VIEs), are evaluated for consolidation based on
based compen- their variable interests. Variable interests are contractual,
sation cost, net ownership or other interests in an entity that expose their
of tax $ (52,320) $ (63,113) $ (51,724) holders to the risks and rewards of the VIE. Application of
Pro forma the interpretation is required in financial statements that
net income $644,512 $526,631 $340,309 have interests in structures that are commonly referred to
as special purposes entities for periods ending after De-
Basic earnings per
cember 15, 2003. For all other types of variable interest
common share
entities the interpretation is required for periods ending
As reported $ 3.61 $ 2.99 $ 1.95
after March 15, 2004. Management does not believe that
Pro forma $ 3.38 $ 2.73 $ 1.76
this will have a material impact on the Company’s finan-
Diluted earnings
cial statements.
per common share
At its September 9, 2003 meeting, the Accounting
As reported $ 3.58 $ 2.96 $ 1.92
Standards Executive Committee (AcSEC) voted to approve
Pro forma $ 3.35 $ 2.71 $ 1.74
the Statement of Position (SOP), “Accounting for Certain
Basic weighted Costs and Activities Related to Property, Plant, and Equip-
average shares ment.” The SOP would provide guidance for certain costs
outstanding 190,492 192,888 193,888 and activities relating to property, plant, and equipment
Diluted weighted (PP&E). The proposal addresses which costs related to
average shares PP&E assets should be capitalized as improvements and
outstanding 192,005 194,573 195,873 which costs should be charged to expense as repairs and
maintenance and uses a project stage or timeline frame-
Beginning in 1997, participants who exercise an option work with PP&E assets accounted for at a component
by tendering previously owned shares of common stock of level. Under the SOP, enterprises would also be required
the Company may elect to receive a one-time restoration to select an accounting policy for post-adoption acquisi-
option covering the number of shares tendered. Restora- tion of assets that can differ from the componentization
tion options are granted at fair market value of the Com- policy for pre-adoption assets. AcSEC also concluded that
pany’s common stock on the date of the grant, have a companies be required to disclose meaningful ranges
maximum term equal to the remainder of the original op- with respect to PP&E depreciable lives. The final SOP will
tion term, and are subject to a six-month vesting period. require companies to segregate PP&E depreciable life dis-
Comprehensive income. The following table is a rec- closures into ranges, similar to the concept used by com-
onciliation of the Company’s net income to comprehen- panies when disclosing ranges of outstanding stock
sive income for the years ended December 31: option exercise prices. The final SOP is expected to be is-
sued in early 2004 and would be applicable for fiscal
(in thousands) 2003 2002 2001 years beginning after December 15, 2004. Management
is currently evaluating the impact of this pronouncement.
Net income $687,650 $ 576,760 $377,031 At the January 7, 2004 meeting, the FASB finalized its
Other comprehensive discussions of the proposed Financial Staff Position (FSP)
income: SFAS No. 106a, “Accounting and Disclosure Requirements
Foreign currency Related to the Medicare Prescription Drug, Improvement
translation and Modernization Act of 2003.” The proposed FSP was
adjustments 34,441 22,895 (16,502) issued for comment in December 2003 to address the ac-
Comprehensive counting and disclosure implications that are expected to
income $ 722,091 $599,655 $360,529 arise as a result of the Medicare Prescription Drug,
570 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

Improvement and Modernization Act of 2003 (the Act), Dispositions. In February 2003, the Company di-
which was enacted on December 8, 2003. The Act intro- vested S&P ComStock (ComStock), the real-time market
duces a prescription drug benefit under Medicare data unit of Standard & Poor’s. The sale resulted in a
(Medicare Part D) as well as a federal subsidy to sponsors $56.8 million after-tax gain (30 cents per diluted share),
of retiree healthcare benefit plans that provide a benefit $87.0 million pre-tax, recorded as discontinued opera-
that is at least actuarially equivalent to Medicare Part D. tion. ComStock was formerly part of the Financial Ser-
The issue is whether an employer that provides postretire- vices segment. The sale of ComStock to Interactive Data
ment prescription drug coverage (a plan) should recognize Corporation resulted in $115.0 million in cash, an after-
the effects of the Act on its accumulated postretirement tax cash flow impact of $78.7 million, and a reduction in
benefit obligation (APBO) and net postretirement benefit net assets of $28.0 million, which includes a reduction
costs and, if so, when and how those effects should be in net goodwill and intangible assets of $14.3 million.
accounted for. Specific authoritative guidance on the ac- The revenue recorded from ComStock for the twelve
counting for the federal subsidy is pending and the guid- months ended December 31, 2003, 2002 and 2001 was
ance, when issued, could require the Company to change $11.1 million, $65.4 million and $79.0 million, respectively.
previously reported information. ComStock provides market data to Institutional In-
The proposed FSP permits a sponsor of a postretire- vestors, Retail Brokers, Financial Advisors and other users.
ment health care plan that provides a prescription drug The decision to sell ComStock is consistent with the Fi-
benefit to make a one-time election to defer accounting nancial Services strategy of leveraging the strength of its
for the effects of the Act. The Company has elected to equity and fund research information to provide unique
postpone the election until a final FSP is issued. In accor- data and analysis to investment managers and investment
dance with this FSP, the net periodic postretirement bene- advisors. As a result of this refined strategy, the market
fit cost in Note 11 does not reflect the effects of the Act data ComStock provides fell outside the core capabilities
on the plan. Management is currently evaluating the im- that Financial Services is committed to growing.
pact of the Act on its financial statements. Juvenile retail publishing business: In January 2004,
Reclassification. Certain prior year amounts have the Company sold the juvenile retail publishing business
been reclassified for comparability purposes. which was part of the McGraw-Hill Education segment’s
2. Acquisitions and Dispositions School Education Group. The juvenile retail publishing
business produced consumer-oriented learning products
Acquisitions. In 2003, the Company had a small acquisi-
for sale through educational dealers, mass merchandisers,
tion and purchase price adjustments from its prior years’
bookstores, and e-commerce. As a result of this planned
acquisitions, totaling $3.7 million. In 2002, the Company
disposition, as of December 31, 2003, in accordance with
acquired seven companies, principally Open University
Statement of Financial Accounting Standards (SFAS) No.
Press. Reality Based Learning and Bredex Corporation, for
144, “Accounting for the Impairment or Disposal of
a total of $19.3 million. In 2001, the Company acquired
Long-Lived Assets,” the Company reviewed the carrying
eight companies, principally Financial Times Energy, Frank
value of the juvenile retail publishing business net assets
Schaffer Publications, Corporate Value Consulting and
and adjusted the net assets to their fair market value less
Mayfield Publishing Company, for $333.2 million, net of
cost to sell. Accordingly, during the fourth quarter, the
cash acquired. All of these acquisitions were accounted
Company recognized impairments to the carrying value
for under the purchase method. Intangible assets
of these net assets of approximately $75.9 million ($54.1
recorded for all current transactions are amortized using
million net of tax), $0.28 per diluted share in 2003. Ap-
the straight-line method for periods not exceeding
proximately $70.1 million of that charge was a write-off
15 years. In accordance with SFAS No. 142, no goodwill
of goodwill and intangibles.
amortization was recorded in 2003 or 2002.
As a result of the Company’s planned disposition of
Noncash Investing Activities. Liabilities assumed in
the juvenile retail publishing business, the Company re-
conjunction with the acquisition of businesses:
flected the results of these businesses as discontinued op-
erations for all periods presented. The disposition and
results of operations for the period resulted in a loss of
$81.1 million, $57.3 million after-tax, or 30 cents per di-
(in millions) 2003 2002 2001 luted share.
Fair value of This business was selected for divestiture as it no
assets acquired $4.1 $20.9 $369.9 longer fits within the Company’s strategic plans. The
Cash paid (net of market was considered to have limited future growth po-
cash acquired) 3.7 19.3 333.2 tential, possessed unique sales channels, had low profit
Liabilities assumed $0.4 $ 1.6 $ 36.7 margins and would have required significant investment
to achieve the limited growth potential.
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 571

In 2002, the Company sold MMS International and no backup facilities for these borrowings are required. As
recognized a pre-tax loss of $14.5 million ($2.0 million is the case with commercial paper, ECNs have no financial
after-tax benefit or 1 cent per diluted share). The variance covenants. There were no ECNs outstanding at December
between the pre-tax loss and the after-tax benefit is the 31, 2003 and 2002.
result of previous book write-downs and the inability of For 2002, eighty percent of the commercial paper bor-
the Company to take a tax benefit for the write-downs rowings outstanding were classified as long-term. This
until the unit was sold. In 2001, the Company sold DRI amount was determined based upon the Company’s de-
and recognized a pre-tax gain of $8.8 million ($26.3 mil- tailed financial budgets and cash flow forecasts and sup-
lion after-tax, or 13 cents per diluted share). The differ- ports the Company’s ability and intent to retain this debt
ence between the pre-tax gain on the sale of DRI of $8.8 level throughout the next year.
million and the after-tax benefit of $26.3 million is the re- Under a shelf registration that became effective with
sult of previous book write-downs and the inability of the the Securities and Exchange Commission in 1990, an ad-
Company to take a tax benefit for the write-downs until ditional $250 million of debt securities can be issued.
the unit was sold. A summary of long-term debt at December 31 follows:
3. Debt and Other Commitments
At December 31, 2003, the Company had total borrow- (in millions) 2003 2002
ings of $26.3 million, primarily representing domestic Commercial paper supported
commercial paper borrowings of $21.5 million maturing by bank revolving credit
during 2004. agreement $ – $458.5
The Company has two revolving credit facility agree- Other (primarily acquisition
ments, consisting of a $625 million, five-year revolving related notes) 0.4 0.4
credit facility (Five-year Facility) and a $575 million, 364- Total long-term debt $0.4 $458.9
day revolving credit facility. The Company’s $675 million,
364-day revolving facility agreement, entered into on July
The Company paid interest on its debt totaling $6.1
23, 2002, expired on July 22, 2003. On July 22, 2003,
million in 2003, $22.2 million in 2002 and $61.5 million
the Company replaced this credit facility with a new 364-
in 2001.
day, $575 million credit facility that allows it to borrow
The carrying amount of the Company’s commercial
until July 20, 2004, on which date the facility agreement
paper borrowings approximates fair value.
terminates and the maturity of such borrowings may not
As of December 31, 2003 the Company’s uncondi-
be later than July 20, 2005. The Company continues to
tional purchase obligation payments for each of the years
pay a facility fee of five basis points on the 364-day facil-
2004 through 2007 and thereafter are approximately
ity whether or not amounts have been borrowed and
$36.9 million, $28.8 million, $2.4 million, $1.7 million
borrowings may be made at 15 basis points above the
and $0.3 million, respectively.
prevailing LIBOR rates. The commercial paper borrowings
are also supported by a $625 million, five-year revolving 4. Segment Reporting and Geographic Information
credit facility, which expires August 15, 2005. The Com- The Company has three reportable segments: McGraw-
pany pays a facility fee of seven basis points on the five- Hill Education, Financial Services and Information and
year credit facility whether or not amounts have been Media Services. The McGraw-Hill Education segment is
borrowed, and borrowings may be made at 13 basis one of the premier global educational publishers and is
points above the prevailing LIBOR rates. All of the facili- the largest U.S.-owned educational publisher serving the
ties contain certain covenants, and the only financial elementary and high school (elhi), college and university,
covenant requires that the Company not exceed indebt- professional, and international markets. The segment
edness to cash flow ratio, as defined, of 4 to 1 at any comprises two operating groups: the School Education
time. This restriction has never been exceeded. At De- Group, and the Higher Education, Professional, and Inter-
cember 31, 2003 and 2002, there were no borrowings national Group. In January 2004, the Company divested
under any of the facilities. Landoll, Frank Schaffer and related juvenile retail publish-
The Company also has the capacity to issue Extendible ing businesses, which were part of the McGraw-Hill Edu-
Commercial Notes (ECNs) of up to $240 million. ECNs cation segment. As a result of the planned disposition as
replicate commercial paper, except that the Company has of December 31, 2003, in accordance with SFAS No. 144,
an option to extend the note beyond its initial redemp- the Company reflected the results of these businesses as
tion date to a maximum final maturity of 390 days. How- discontinued operations. See Note 2.
ever, if exercised, such an extension is at a higher reset The Financial Services segment operates under the
rate, which is at a predetermined spread over LIBOR, and Standard & Poor’s brand as one reporting unit and pro-
is related to the Company’s commercial paper rating at vides credit ratings, evaluation services, and analyses
the time of extension. As a result of the extension option, globally on corporations, financial institutions, securitized
572 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

and project financings, and local, state and sovereign The operating profit adjustments listed below relate to
governments. Financial Services provides a wide range of the operating results of the corporate entity, which is not
analytical and data services for investment managers and considered an operating segment, and includes all corpo-
investment advisors globally. The Financial Service seg- rate (income) expenses of $(38.2) million, $91.9 million
ment is also a leading provider of valuation and consulting and $93.1 million, respectively, for 2003, 2002 and 2001,
services. In February 2003, the Company divested S&P and interest expense of $7.1 million, $22.5 million, and
ComStock, which was formerly part of the Financial Ser- $55.1 million, respectively, of the Company. Included in
vices segment. S&P ComStock is reflected as a discontinued corporate income for 2003 is the gain from sale of Rock-
operation on the face of the income statement. See Note 2. McGraw, Inc. of $131.3 million, See Note 14. Corporate
The Information and Media Services segment com- assets consist principally of cash and equivalents, invest-
prises two operating groups, which include business and ment in Rock-McGraw, Inc., prepaid pension expense, de-
professional media offering information, insight and ferred income taxes and leasehold improvements related
analysis: the Business-to-Business Group (comprising the to subleased areas.
Brands BusinessWeek, McGraw-Hill Construction, Platts, Foreign operating profit from continuing businesses
Aviation Week and Healthcare Information) and the was $219.1 million, $188.5 million, and $111.4 million in
Broadcasting Group. 2003, 2002 and 2001, respectively. Foreign revenue, op-
Information as to the operations of the three seg- erating profit and long-lived assets include operations in
ments of the Company is set forth below based on the 36 countries. The Company does not have operations
nature of the products and services offered. The Executive in any foreign country that represents more than 5% of
Committee, comprising the Company’s principal corpo- its consolidated revenue. Transfers between geographic
rate executives, is the Company’s chief operating decision areas are recorded at agreed upon prices and intercom-
maker and evaluates performance based primarily on op- pany revenue and profit are eliminated.
erating profit. The accounting policies of the operating All income statement categories have been restated to
segments are the same as those described in the sum- exclude the results of discontinued operations. Segment
mary of significant accounting policies–refer to Note 1 information for the years ended December 31, 2003,
for the Company’s significant accounting policies. 2002, and 2001 was as follows:

Information
McGraw-Hill Financial and Media Segment Consolidated
(in millions) Education Services Services Totals Adjustments Total
2003
Operating revenue $2,286.2 $1,769.1 $772.6 $4,827.9 $ – $4,827.9
Operating profit 321.8 667.6 109.8 1,099.2 31.1 1,130.3*
Depreciation and amortization† 340.5 34.7 20.1 395.3 3.0 398.3
Assets 2,755.4 873.4 433.1 4,061.9 1,332.2 5,394.1
Capital expenditures‡ 258.7 57.5 15.1 331.3 1.7 333.0
Technology project additions 14.5 11.7 – 26.2 1.9 28.1
2002
Operating revenue $2,275.0 $1,555.7 $809.5 $4,640.2 $ – $4,640.2
Operating profit 333.0 560.8 118.0 1,011.8 (114.4) 897.4*
Depreciation and amortization† 340.4 32.9 21.8 395.1 5.1 400.2
Assets 3,024.5 819.6 446.5 4,290.6 741.6 5,032.2
Capital expenditures‡ 281.3 25.3 12.7 319.3 – 319.3
Technology project additions 47.3 2.4 4.4 54.1 1.4 55.5
2001
Operating revenue $2,230.2 $1,398.3 $846.1 $4,474.6 $ – $4,474.6
Operating profit 273.3 425.9 65.0 764.2 (148.1) 616.1*
Depreciation and amortization† 325.6 51.2 26.3 403.1 3.4 406.5
Assets 3,069.6 847.7 481.2 4,398.5 762.7 5,161.2
Capital expenditures‡ 354.4 29.1 27.9 411.4 – 411.4
Technology project additions 21.4 1.0 5.3 27.7 1.1 28.8

*Income from continuing operations before taxes on income.

†Includes amortization of goodwill and intangible assets and prepublication costs. Goodwill amortization of $0 million.
$0 million and $51.6 million for 2003, 2002 and 2001.
‡Includes purchase of property and equipment and investments in prepublication costs.
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 573

The following is a schedule of revenue and long-lived assets by geographic location:

(in millions) 2003 2002 2001

Long-lived Long-lived Long-lived
Revenue assets Revenue assets Revenue assets
United States $3,862.5 $2,591.1 $3,780.2 $2,848.8 $3,679.6 $2,830.5
European region 541.4 74.5 463.8 63.2 427.9 114.0
Rest of world 424.0 71.9 396.2 66.6 367.1 56.3
Total $4,827.9 $2,737.5 $4,640.2 $2,978.6 $4,474.6 $3,000.8

5. Restructuring restructuring and all employee severance and benefit

In the fourth quarter of 2001, the Company announced a costs were paid.
worldwide restructuring program that includes the exiting Asset impairment losses of $128.8 million include
of certain businesses, product lines and markets in each $36.6 million associated with the exiting of the McGraw-
of its operating segments. As part of the restructuring Hill Education’s business training coursework operation,
program, the Company is focusing its resources on those $37.2 million attributed to the disposing of non-strategic
businesses and products with higher profit margins and properties in the investment services area in Financial Ser-
improving the effectiveness of the organization. As a re- vices and costs associated with the disposal, $36.0 million
sult, the Company recorded a restructuring and asset im- primarily arising from losses on McGraw-Hill Construc-
pairment charge of $159.0 million pretax. This charge is tion’s e-commerce investments and emerging technology
comprised of $62.1 million for McGraw-Hill Education, investments in the venture fund, and $19.0 million on the
$43.1 million for Financial Services, $34.9 million for In- write-off of certain assets.
formation and Media Services and $18.9 million for Cor- Changes in the marketplace led to a shift to online
porate. The after-tax charge recorded is $112.0 million learning solutions which impacted McGraw-Hill Educa-
or 57 cents per diluted share. $123.0 million of the re- tion’s business training coursework operations. As a result
structuring expenses were classified as operating related and as part of the restructuring, the Company initiated
expenses on the Consolidated Statement of Income for an exiting of the business training coursework operations
the year ended December 31, 2001 and $36.0 million leading to a charge of approximately $36.6 million. This
were considered non-operating. The operating related charge is primarily comprised of write-offs of prepublica-
expenses consisted of $30.2 million in employee sever- tion costs and goodwill associated with the operation.
ance and benefit costs and $92.8 million in asset impair- As a result of the Company’s decision to dispose of
ment losses. The non-operating expenses consisted of the non-strategic properties in the investment services
$36.0 million related to the write-downs of certain area, losses of approximately $37.2 million were recog-
e-commerce and emerging technology investments. nized which comprised the complete write-off of certain
The restructuring that was recorded at December 31, investments and the write-down of goodwill associated
2001 consisted of the following: with properties to be sold. As part of the restructuring
plan, discussions were initiated with potential buyers and
the write-down of goodwill was determined based upon
the net realizable values. The remaining carrying values
(in millions) of these assets approximated $22 million and the dispos-
Employee severance and benefit costs $ 30.2 als were completed within one year.
Asset impairment losses 128.8 Also reflected in the total asset impairment losses is
Total $159.0 $36.0 million primarily arising from losses on McGraw-Hill
Construction’s e-commerce investments and the emerg-
ing technology investments in the venture fund as the
Company has decided to scale back on these initiatives.
Employee severance and benefit costs of $30.2 million These impairment losses reflect the permanent write-
includes a planned workforce reduction of approximately down of the investments to fair value that was deter-
925 people related to the exiting of certain business ac- mined based upon the earnings capability and expected
tivities, product lines and publishing programs to be dis- cash flow of the related investments.
continued or curtailed, and other efforts to improve the The $19.0 million is primarily attributed to the write-
effectiveness of the organization. At December 31, off of net assets associated with the programs and prod-
2002, all employees have been terminated under this uct lines to be discontinued.
574 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

At December 31, 2001, the remaining reserve of ap- The principal temporary differences between the
proximately $36.5 million was included in other current accounting for income and expenses for financial
liabilities. The restructuring was completed at December reporting and income tax purposes as of December 31
31, 2002. follow:
6. Taxes on Income
Income from continuing operations before taxes on in-
come resulted from domestic operations (including foreign (in millions) 2003 2002*
branches) and foreign subsidiaries’ operations as follows:
Fixed assets and intangible assets $224.3 $197.0
Prepaid pension and
(in millions) 2003 2002 2001 other expenses 199.7 176.0
Domestic operations $1,036.3 $836.0 $582.2 Unearned revenue 47.4 47.4
Foreign operations 94.0 61.4 33.9 Reserves and accruals (306.3) (284.1)
Postretirement and
Total income
postemployment benefits (84.5) (86.5)
before taxes $1,130.3 $897.4 $616.1
Deferred gain on sale leaseback (86.0) –
Other – net (20.2) (19.5)
A reconciliation of the U.S. statutory tax rate to the Deferred tax (asset)/liability
Company’s effective tax rate for financial reporting pur- – net $ (25.6) $ 30.3
poses follows:
*2002 reclassified for comparability purposes.

2003 2002 2001

U.S. statutory rate 35.0% 35.0% 35.0%
The Company made net income tax payments totaling
Goodwill amortization – – 1.4
$328.4 million in 2003, $246.0 million in 2002 and
Effect of state and local
$202.4 million in 2001.
income taxes 3.9 3.9 3.9
The Company has not recorded deferred income
Disposition of businesses 2.1 (1.2) (2.1)
taxes applicable to undistributed earnings of foreign
Restructuring and
subsidiaries that are indefinitely reinvested in foreign op-
asset impairment – – 2.3
erations. Undistributed earnings amounted to approxi-
Other–net (1.9) (1.4) (1.8)
mately $256 million at December 31, 2003, excluding
Effective tax rate 39.1% 36.3% 38.7% amounts that, if remitted, generally would not result in
any additional U.S. income taxes because of available
The provision for taxes on income consists of the foreign tax credits. If the earnings of such foreign sub-
following: sidiaries were not indefinitely reinvested, a deferred tax
liability of approximately $46 million would have been
required.
(in millions) 2003 2002 2001 7. Rental Expense and Lease Obligations
Federal: Rental expense for property and equipment under all op-
Current $343.4 $207.1 $196.9 erating lease agreements was as follows:
Deferred (35.1) 47.4 (8.1)
Total federal 308.3 254.5 188.8
Foreign:
Current 27.2 17.5 13.8 (in millions) 2003 2002 2001
Deferred (0.4) (0.5) (1.1) Gross rental expense $187.5 $173.2 $154.4
Total foreign 26.8 17.0 12.7 Less: sublease revenue 7.1 19.9 29.9
State and local: Net rental expense $180.4 $153.3 $124.5
Current 117.0 36.0 38.6
Deferred (9.6) 17.9 (1.7)
Total state and local 107.4 53.9 36.9
Total provision for taxes $442.5 $325.4 $238.4
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 575

The Company is committed under lease arrangements Plan, 296,840 and 298,812 common shares were re-
covering property, computer systems and office equip- served for issuance at December 31,2003 and 2002, re-
ment. Certain lease arrangements contain escalation spectively.
clauses covering increased costs for various defined real In the third quarter 2002, the Company redeemed all
estate taxes and operating services. of the outstanding shares of $1.20 convertible preference
Minimum rental commitments, including rent pay- stock. The redemption price of $40 per share, as provided
ments on the sale–leaseback described in Note 14, under by the terms of the preference stock, became payable to
existing non-cancelable leases with a remaining term of holders, who did not otherwise convert their shares into
more than one year, are shown in the following table. the Company’s common stock, on September 1, 2002.
The annual rental commitments for real estate were re- Most holders elected conversion prior to redemption.
duced by $7 million in 2004 and then by approximately None of the convertible preference shares provided a
$4 million a year thereafter through 2008 for sublease beneficial conversion feature at the time they were origi-
income. nally issued.
Two million shares of preferred stock, par value $1
per share, are authorized; none have been issued.
(in millions) 600,000 shares have been reserved for issuance under a
Preferred Share Purchase Rights Plan adopted by the
2004 $ 139.9 Company’s Board of Directors on July 29, 1998. Under
2005 130.0 the 1998 Rights Plan, one Right for each share of com-
2006 117.3 mon stock outstanding was issued to shareholders of
2007 109.5 record on August 14, 1998. These Rights will become
2008 108.8 exercisable only if a person or group acquires 20% or
2009 and beyond 1,426.9 more of the Company’s common stock or announces a
Total $2,032.4 tender offer that would result in the ownership of 20%
or more of the common stock. Each Right will then enti-
tle the holder to buy a 1/400th interest in a share of
8. Capital Stock Series A preferred stock at an exercise price of $150. The
Rights are redeemable by the Company’s Board of Direc-
On January 27, 1999, the Board of Directors ap- tors for one-quarter cent each prior to a 20% acquisition
proved a share repurchase program authorizing the by a third party. The 1998 Plan also gives the Board of
repurchase of up to 15 million shares, approximately Directors the option to exchange one share of common
7.5% of the Company’s outstanding common stock. stock of the Company for each Right (not owned by the
The Company completed the program in December acquirer) after an acquirer holds 20% but less than 50%
2003 after repurchasing 2.3 million shares for $135.9 of the outstanding shares of common stock. In the
million in 2003, for a total of 15 million shares totaling event, after a person or group acquires 20% or more of
$855.1 million at an average price of approximately the Company’s stock, that the Company is acquired in a
$57.01 per share. merger or other business combination transaction of
On January 29, 2003 the Board of Directors approved 50% or more of its consolidated assets or earnings
a new stock repurchase program authorizing the pur- power are sold, each Right becomes exercisable for com-
chase of up to 15 million additional shares, which was mon stock equivalent to two times the exercise price of
approximately 7.8% of the Company’s outstanding com- the Right.
mon stock. The Company repurchased 1.1 million shares In 2003, dividends were paid at the quarterly rate of
for $76.7 million in 2003 under this program at an aver- $0.27 per common share. Total dividends of $0.80 per
age price of approximately $68.26 per share. preference share were paid in 2002. All dividends on
The repurchased shares will be used for general corpo- preference stock are cumulative. Total dividends paid in
rate purposes, including the issuance of shares in connec- 2003, 2002 and 2001 were $206.5 million, $197.0 mil-
tion with the exercise of employee stock options for stock lion and $189.8 million, respectively.
compensation plans. In the event of a significant invest-
ment opportunity, the Company may slow the pace of re- 9. Stock Plan Awards
purchase activity. The Company applies the provisions of APBO No. 25,
The number of common shares reserved for issuance “Accounting for Stock Issued to Employees,” in
for employee stock plan awards was 25,520,427 at accounting for its stock-based awards. Accordingly,
December 31, 2003 and 28,348,251 at December no compensation cost has been recognized for its
31, 2002. Under the Director Deferred Stock Ownership stock option plans other than for its restricted stock
576 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

performance awards. The Company has three stock

Weighted
option plans: the 2002, 1993 and 1987 Employee Stock
average exer-
Incentive Plans.
(in thousands of shares) Shares cise price
The Plans provide for the granting of incentive
stock options, nonqualified stock options, stock appre- Outstanding at
ciation rights, restricted stock awards, deferred stock December 31, 2000 12,206 $42.97
(applicable to the 1987 Plan only) or other stock-based Options granted 4,806 60.16
awards to purchase a total of 47.3 million shares of the Options exercised (2,093) 36.65
Company’s common stock – 9.2 million shares under Options cancelled and expired (341) 51.35
the 1987 Plan, 28.6 million shares under the 1993 Plan Outstanding at
and 9.5 million shares under the 2002 Plan, as December 31, 2001 14,578 $49.34
amended. Options granted 4,987 67.06
Stock options, which may not be granted at a price Options exercised (1,703) 39.66
less than the fair market value of the Company’s com- Options cancelled and expired (341) 58.80
mon stock at date of grant, vest in two years in equal
Outstanding at
annual installments and have a maximum term of ten
December 31, 2002 17,521 $55.13
years.
The fair value of each option grant was estimated Options granted 5,100 56.98
on the date of grant using the Black-Scholes option- Options exercised (2,027) 45.93
pricing model with the following assumptions for Options cancelled and expired (584) 65.33
2003, 2002 and 2001, respectively: risk-free average Outstanding at
interest rate of 2.9%, 5.1% and 4.7%; dividend December 31, 2003 20,010 $56.32
yield of 1.8%, 1.6% and 1.7%; volatility of 22%,
29% and 28%; and expected life of five years for all At December 31, 2003, 2002 and 2001, options for
years. 12,920,000, 10,689,000 and 8,340,000 shares of common
A summary of the status of the Company’s stock op- stock were exercisable. The weighted average fair value
tion plans as of December 31 and activity during the year of options granted during 2003, 2002 and 2001 was
follows: $11.19, $19.87 and $16.76, respectively.

A summary of information about stock options outstanding and exercisable at December 31, 2003 follows:

(in thousands of shares) Options Outstanding Options Exercisable

Range of Weighted average Weighted average Weighted average
exercise prices Shares remaining term exercise price Shares exercise price
$16.78 to $24.97 691 2.12 years $21.03 691 $21.03
$25.41 to $38.06 1,113 4.08 years $36.29 1,113 $36.29
$38.47 to $57.63 8,089 7.51 years $53.28 3,947 $50.18
$57.72 to $70.41 10,117 7.72 years $63.37 7,169 $62.50
$16.78 to $70.41 20,010 7.24 years $56.32 12,920 $54.26

Under the Director Deferred Stock Ownership Plan, a rendering service. Shares will be delivered as of the date a
total of 296,840 shares of common stock was reserved as recipient ceases to be a member of the Board of Directors
of December 31, 2003, and may be credited to deferred or within five years thereafter, if so elected. The Plan will
stock accounts for eligible Directors. In general, the Plan remain in effect until terminated by the Board of Direc-
requires that 50% of eligible Directors’ annual compensa- tors or until no shares of stock remain available under the
tion plus dividend equivalents be credited to deferred Plan.
stock accounts. Each Director may also elect to defer all Restricted stock performance awards have been
or a portion of the remaining compensation and have an granted under the 2002, 1993 and 1987 Plans. These re-
equivalent number of shares credited to the deferred stricted stock awards will vest only if the Company achieves
stock account. Recipients under this Plan are not required certain financial goals over various vesting periods. Other
to provide consideration to the Company other than restricted stock awards have total vesting periods of up to
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 577

three years with vesting beginning on the first anniversary

(in millions) 2003 2002 2001
of the awards. Recipients are not required to provide
consideration to the Company other than rendering ser- Service cost $ 35.9 $ 29.2 $ 25.9
vice and have the right to vote the shares and to receive Interest cost 50.3 47.1 45.8
dividends. Expected return
A total of 294,876 restricted shares were issued at an on assets (96.3) (105.2) (99.5)
average market value of $56.42 in 2003, 274,875 shares Amortization of:
at an average market value of $66.73 in 2002 and Transition asset 0.2 0.2 0.2
264,213 shares at an average market value of $59.28 in Prior service cost 0.4 1.2 1.1
2001. The awards are recorded at the market value on Actuarial (gain) (3.8) (16.8) (20.1)
the date of grant. Initially, the total market value of the Net periodic
shares is treated as unearned compensation and is benefit (income) $(13.3) $ (44.3) $(46.6)
charged to expense over the respective vesting periods. U.S. weighted average
Under APBO No. 25, for performance incentive shares, assumptions used to
adjustments are also made to expense for changes in determine net cost –
market value and achievement of financial goals. Re- January 1:
stricted stock compensation charged to expense was Discount rate 63⁄4% 71⁄4% 71⁄2%
$14.6 million for 2003, $20.8 million for 2002 and $24.4 Compensation
million for 2001. Restricted shares outstanding at the end increase factor 51⁄2 51⁄2 51⁄2
of the year were 738,847 in 2003, 710,872 in 2002 and Return on assets 83⁄4 91⁄2 91⁄2
670,959 in 2001.
10. Retirement Plans
The Company and its subsidiaries have a number of
defined benefit pension plans and defined contribu-
tion plans covering substantially all employees. The The Company also has unfunded supplement bene-
Company’s primary pension plan is a noncontri- fit plans to provide senior management with supplemen-
butory plan under which benefits are based on employee tal retirement, disability and death benefits. Certain
career employment compensation. The Company also supplemental retirement benefits are based on final
sponsors voluntary 401 (k) plans under which the Com- monthly earnings. Pension cost was approximately $7.5
pany may match employee contributions up to certain million for 2003, $6.4 million for 2002 and $6.7 million
levels of compensation as well as profit-sharing plans for 2001. The accrued benefit obligation as of December
under which the Company contributes a percentage of 31, 2003 and 2002 was $46.1 million and $40.6 million,
eligible employees’ compensation to the employees’ respectively.
accounts. Total retirement plans cost was $68.6 million for 2003,
For purposes of determining annual pension cost, $33.7 million for 2002 and $23.1 million for 2001.
prior service costs are being amortized straight-line over The funded status of the defined benefit plans as of
the average remaining service period of employees ex- December 31 follows:
pected to receive benefits. For 2003, the assumed re-
turn on plan assets of 8.75% is based on a calculated
market-related value of assets, which recognizes
changes in market value over five years. The 2003 re-
turn assumption was reduced from 9.5% on January 1, (in millions) 2003 2002
2003, to reflect lower expected returns on investments Change in benefit obligation
due to expected long-term market weakness. Addition- Net benefit obligation at
ally, effective January 1, 2003, the Company changed its beginning of year $737.0 $ 660.0
discount rate assumption on its retirement plans to Service cost 35.9 29.2
6.75% from 7.25% utilized in 2002. Effective January 1, Plan amendments 0.6 1.1
2004, the Company changed its discount rate assump- Interest cost 50.3 47.1
tion on its retirement plans to 6.25% from 6.75% in Plan participants’ contributions 1.2 1.1
2003. There was no change in the 2004 expected return Actuarial loss 72.0 31.3
on plan asset assumption. Prior years balances have Gross benefits paid (40.2) (38.4)
been restated to include a non-U.S. plan previously not Currency effect 8.5 5.6
consolidated. Net benefit obligation at
A summary of net periodic benefit income for the end of year $865.3 $ 737.0
Company’s defined benefit plans are as follows:
578 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

The accumulated benefit obligation at the end of excess of the fair value of plan assets for the years ended
2003 and 2002 was $770.7 million and $613.8 million, in December 31, 2003 and 2002:
respectively.

Projected benefit
(in millions, except percentages) 2003 2002
obligation exceeds the
U.S. weighted average assumptions (in millions) fair value of plan assets
used to determine benefit
obligations – December 31: End of year 2003 2002
Discount rate 61⁄4% 63⁄4% Projected benefit obligation $173.7 $183.7
1
Compensation increase factor 5 ⁄2 51⁄2 Accumulated benefit obligation $126.6 $148.5
Change in plan assets Fair value of plan assets $ 75.0 $ 87.8
Fair value of plan assets at
beginning of year $ 821.1 $ 997.1
Actual return on plan assets 228.2 (149.6)
Employer contributions 11.7 6.3
Plan participants’ contributions 1.2 1.1 Accumulated benefit
Gross benefits paid (40.2) (38.4) obligation exceeds the
Currency effect 6.3 4.6 (in millions) fair value of plan assets
Fair value of plan assets at End of year 2003 2002
end of year $1,028.3 $ 821.1 Projected benefit obligation $75.3 $183.7
Accumulated benefit obligation $60.4 $148.5
Fair value of plan assets $ – $ 87.8

Benefits paid in the above table include only those

amounts contributed directly to or paid directly from
assets. Information about the expected cash flows for the de-
The funded status of the plans, reconciled to the fined benefit plans are as follows:
amount reported on the statement of financial position
follows:

Employer contributions (in millions)

2004 (expected) $ 12.8
End of year (in millions) 2003 2002
Funded status at end of year $163.0 $ 84.0
Unrecognized net actuarial loss 119.5 173.6
Unrecognized net Expected benefit payments (in millions)
transition obligation – 0.2 2004 $ 38.0
Unrecognized prior service costs 2.1 2.0 2005 39.2
Net amount recognized $284.6 $259.8 2006 40.7
2007 42.3
Pension Benefits
2008 44.4
End of year (in millions) 2003 2002 2009–2013 $262.0
Prepaid benefit cost $288.2 $261.2
Accrued benefit cost (3.6) (1.4)
Net amount recognized $284.6 $259.8 The above table reflects the total benefits expected to
be paid from the plans or from the Company’s assets in-
cluding both the Company’s share of the benefit cost and
the participants’ share of the cost.
The following tables reflect pension plans, primarily The asset allocation for the Company’s domestic de-
unfunded nonqualified plans and a non-U.S. plan, with a fined benefit plan at the end of 2003 and 2002 and the
projected benefit obligation in excess of the fair value of target allocation for 2004, by asset category, are as
plan assets and an accumulated benefit obligation in follows:
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 579

Target Percentage of plan Components of net periodic benefit cost

Asset category allocation assets at year end
(in millions) 2003 2002 2001
2004 2003 2002 Service cost $ 2.2 $ 2.5 $ 2.4
Domestic Equity securities 60% 62% 62% Interest cost 10.8 10.2 9.9
International Equity 20 18 16 Amortization of:
Debt securities 20 19 21 Prior service cost (3.5) (2.5) (2.5)
Actuarial (gain) – (1.1) (1.8)
Other - 1 1
Net periodic benefit cost $ 9.5 $ 9.1 $ 8.0
Total 100% 100% 100%

The defined benefit plan has no investment in the A summary of the components of the unfunded postre-
Company’s common stock. tirement benefit obligation as of December 31 follows:
The investment of assets on behalf of the Company’s
defined benefit plans focuses on both the opportunity for
capital growth and the reinvestment of income. The
growth potential is primarily from capital appreciation Change in benefit obligation
from stocks and secondarily from the reinvestment of in- (in millions) 2003 2002
come from fixed instruments. The mix of assets is estab-
Net benefit obligation at
lished after careful consideration of the long-term
beginning of year $167.2 $142.0
performances of asset classes and an analysis of future li-
Service cost 2.2 2.5
abilities. Investments are selected based on their potential
Interest cost 10.8 10.2
to enhance returns, preserve capital, and reduce overall
Plan participants’ contributions 2.5 2.0
volatility. Holdings are well diversified within each asset
Plan amendments (10.4) –
class, which includes U.S. and foreign stocks, high-quality
Actuarial loss 16.7 25.4
bonds, annuity contracts and cash.
Gross benefits paid (16.0) (14.9)
The Company has several foreign pension plans that
do not determine the accumulated benefits or net Net benefit obligation at
assets available for benefits as disclosed above. The end of year $173.0 $167.2
amounts involved are not material and are therefore not
included.
Assets of the defined contribution plan consist primar-
Weighted average assumption used to determine
ily of index funds, equity funds, debt instruments and
benefit obligations, end of year
McGraw-Hill common stock. The U.S. plan held approxi-
mately 1.8 million and 1.9 million shares of McGraw-Hill 2003 2002
common stock at December 31, 2003 and 2002, respec- Discount rate 6.25% 6.75%
tively, with market values of $124.1 million and $114.7
million, respectively. The plan received dividends on
McGraw-Hill common stock during 2003 and 2002 of
$2.0 million and $1.9 million, respectively. Change in plan assets

11. Postretirement Healthcare and Other Benefits (in millions) 2003 2002
The Company and some of its domestic subsidiaries pro- Fair value of plan assets at
vide certain medical, dental and life insurance benefits for beginning of year $ – $ –
retired employees and eligible dependents. The medical Employer contributions 13.5 12.9
and dental plans are contributory while the life insurance Plan participants’ contributions 2.5 2.0
plan is noncontributory. The Company currently does not Gross benefits paid (16.0) 14.9)
fund any of these plans. Fair value of plan assets at
Postretirement benefit cost was $9.5 million in 2003, end of year $ – $ –
$9.1 million in 2002 and $8.0 million in 2001.
The Company uses a measurement date of December
31 for its postretirement healthcare and other benefits. A Employer contribution and benefits paid in the above
summary of the components of the cost in 2003, 2002 table include only those amounts contributed directly to
and 2001 follows: or paid directly to the plan.
580 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

12. Earnings Per Share

(in millions) 2003 2002
A reconciliation of the number of shares used for calcu-
Funded status at end of year $(173.0) $(167.2)
lating basic earnings per common share and diluted earn-
Unrecognized net actuarial
ings per common share follows:
loss (gain) 12.4 (4.2)
Unrecognized prior service costs (7.5) (0.7)
Net amount recognized $(168.1) $(172.1)

(in thousands) 2003 2002 2001

Net income $687,650 $576,760 $377,031
Information about the expected cash flows for the Average number of
other postretirement benefit plans follows: common shares
outstanding 190,492 192,888 193,888
Effect of stock options
and other dilutive
Expected benefit payments (in millions)
securities 1,513 1,685 1,985
2004 $ 14.2 Average number of
2005 14.9 common shares
2006 15.5 outstanding
2007 16.1 including effect
2008 16.6 of dilutive securities 192,005 194,573 195,873
2009–2013 90.1

The above table reflects the total benefits expected to Restricted performance shares outstanding at Decem-
be paid from the Company’s assets. ber 31, 2003 of 739,000 were not included in the
The initial weighted average healthcare cost rates for computation of diluted earnings per common share
2003 and 2002 were 10.00% and 10.25%, respectively. because the necessary vesting conditions have not yet
The assumed weighted average healthcare cost trend rate been met.
will decrease ratably from 10.00% in 2003 to 5.5% in 13. Goodwill and Intangible Assets
2012 and remain at that level thereafter. The weighted
average discount rate used to measure expense was Effective as of January 1, 2002, the Company adopted
6.75% in 2003 and 7.25% in 2002. Assumed healthcare Statement of Financial Accounting Standards (SFAS) No.
cost trends have a significant effect on the amounts re- 142, “Goodwill and Other Intangible Assets.” Under
ported for the healthcare plans. A one-percentage point SFAS No. 142, goodwill and other intangible assets with
change in assumed healthcare cost trend creates the indefinite lives are no longer amortized but are reviewed
following effects: annually or more frequently if impairment indicators
arise. The Company performed the required transitional
impairment review of goodwill as of January 1, 2002. For
each of the reporting units, the estimated fair value was
One- One- determined utilizing the expected present value of the fu-
percentage percentage ture cash flows of the units. In all instances, the esti-
point point mated fair value of the reporting units exceeded their
(in millions) increase decrease book values and therefore no write-down of goodwill
Effect on total of service was required.
and interest cost $ 0.8 $ (0.8) The following table reflects unaudited pro forma
Effect on postretirement results of operations of the Company, giving effect
benefit obligation $13.0 $(12.1) to SFAS No. 142 as if it were adopted on January 1,
2001:
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 581

Twelve months ended December 31,

December 31, (in (in thousands) 2003 2002
thousands, except McGraw-Hill Education
earnings per share) 2003 2002 2001 Beginning balance $913,624 $853,829
Net income Additions (dispositions) (61,283) 15,271
as reported $687,650 $576,760 $377,031 Purchase price allocations – 39,146
Add back: amortiza- Other 6,436 5,378
tion expense, Total $858,777 $913,624
net of tax – – 34,831 Financial Services
Pro forma net income $687,650 $576,760 $411,862 Beginning balance $288,236 $288,400
Basic earnings per Additions/(dispositions) (12,327) (4,979)
common share: Other 11,496 4,815
As reported $ 3.61 $ 2.99 $ 1.95 Total $287,405 $288,236
Pro forma $ 3.61 $ 2.99 $ 2.12 Information and Media Services
Diluted earnings Beginning balance $ 92,971 $ 88,799
per common share: Additions/(dispositions) 875 (1,204)
As reported $ 3.58 $ 2.96 $ 1.92 Other (151) 5,376
Pro forma $ 3.58 $ 2.96 $ 2.10
Total $ 93,695 $ 92,971

There were no material acquisitions or dispositions

The following table summarizes the activity in good-
for the periods indicated both individually and in the
will for the periods indicated:
aggregate, and therefore pro forma financial infor-
mation is not required. Included in the McGraw-Hill Edu-
cation segment’s additions/dispositions is $61.3 million
December 31, of goodwill impairment associated with the planned
(in thousands) 2003 2002 disposition of the juvenile retail publishing business. See
Beginning balance $1,294,831 $ 1,231,028 Note 2.
Net change from The following table summarizes other intangibles sub-
acquisitions and ject to amortization at the dates indicated:
dispositions (72,735) 9,088
Purchase price December 31,
allocations – 39,146 (in thousands) 2003 2002
Other 17,781 15,569
Copyrights $ 465,031 $ 475,054
Total $1,239,877 $ 1,294,831 Accumulated amortization (220,162) (202,811)
Net copyrights 244,869 272,243
Other intangibles 306,088 308,179
The following table summarizes net goodwill by Accumulated amortization (125,922) (107,666)
segment:
Net other intangibles 180,166 200,513
Total gross intangible assets $ 771,119 $ 783,233
Total accumulated
December 31, amortization (346,084) (310,477)
(in thousands) 2003 2002
Total net intangible assets $ 425,035 $ 472,756
McGraw-Hill Education $ 858,777 $ 913,624
Financial Services 287,405 288,236
Information and In 2003 net intangibles have been adjusted $8.8 mil-
Media Services 93,695 92,971 lion for impairment due to the planned disposition of the
juvenile retail publishing business.
Total $1,239,877 $1,294,831
Intangible assets are being amortized on a straight-line
basis over periods of up to 40 years. Amortization ex-
pense for intangibles totaled $33.7 million, $38.8 million
The following table summarizes the activity in good- and $34.9 million for the twelve months ended Decem-
will for the periods indicated: ber 31, 2003, 2002 and 2001, respectively. The weighted
582 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

average life of the intangible assets at December 31, States and including amounts based on management’s
2003, is 16 years. The projected amortization expense for best estimates and judgments, present fairly The
intangible assets, assuming no further acquisitions or dis- McGraw-Hill Companies’ financial condition and the re-
positions, is approximately $27 million per year over the sults of the Company’s operations. Other financial infor-
next five years. mation given in this report is consistent with these
The following table summarizes other intangibles not statements.
subject to amortization at the dates indicated: The McGraw-Hill Companies’ management maintains
a system of internal accounting controls designed to pro-
vide reasonable assurance that the financial records accu-
December 31, rately reflect the Company’s operations and that the
(in thousands) 2003 2002 Company’s assets are protected against loss. Consistent
FCC Licenses $38,065 $38,065 with the concept of reasonable assurance, the Company
recognizes that the relative costs of these controls should
not exceed the expected benefits in maintaining these
14. Sale-Leaseback Transaction controls. It further assures the quality of the financial
In December 2003, the Company sold its 45% equity in- records in several ways: a program of internal audits, the
vestment in Rock-McGraw, Inc. Rock-McGraw, Inc. owns careful selection and training of management personnel,
the Company’s headquarters building in New York City. maintaining an organizational structure that provides an
The transaction, which was valued at $450.0 million, in- appropriate division of financial responsibilities, and com-
cluded assumed debt. Proceeds from disposition were municating financial and other relevant policies through-
$382.1 million. The sale resulted in a pre-tax gain of out the corporation. The financial statements in this
$131.3 million and an after-tax benefit of $58.4 million, report have been audited by Ernst & Young LLP, indepen-
30 cents per diluted share in 2003. dent auditors, in accordance with auditing standards gen-
The Company will remain an anchor tenant of what erally accepted in the United States. The independent
will continue to be known as The McGraw-Hill Compa- auditors were retained to express an opinion on the fi-
nies building and will continue to lease space from Rock- nancial statements, which appears on the next page.
McGraw, Inc., under an existing lease for approximately The McGraw-Hill Companies’ Board of Directors,
16 years. Currently, the Company leases approximately through its Audit Committee, composed entirely of out-
18% of the building space. The lease is being accounted side directors, is responsible for reviewing and monitoring
for as an operating lease. Pursuant to sale–leaseback ac- the Company’s financial reporting and accounting prac-
counting rules, as a result of the Company’s continued in- tices. The Audit Committee meets periodically with man-
volvement, a gain of approximately $212.3 million agement, the Company’s internal auditors and the
($126.3 million after-tax) was deferred and will be amor- independent auditors to ensure that each group is carry-
tized over the remaining lease term as a reduction in rent ing out its respective responsibilities. In addition, the in-
expense. The Company’s degree of involvement was de- dependent auditors have full and free access to the Audit
termined to be “more than minor,” since the present Committee and meet with it with no representatives from
value of future minimum lease payments under the cur- management present.
rent lease was greater than 10% of the fair value of the
property.
As of December 31, 2003, the minimum lease pay-
ments to be paid for each of the years 2004 through
2008 and in the aggregate thereafter are approximately
$17.2 million, $16.9 million, $16.9 million, $17.6 million,
and $18.4 million, respectively, and $218.6 million
thereafter.
Harold McGraw III
Chairman of the Board, President and
REPORT OF MANAGEMENT Chief Executive Officer
To the Shareholders of
The McGraw-Hill Companies, Inc.
The financial statements in this report were prepared by
the management of The McGraw-Hill Companies, Inc.,
which is responsible for their integrity and objectivity. Robert J. Bahash
These statements, prepared in conformity with ac- Executive Vice President and
counting principles generally accepted in the United Chief Financial Officer
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 583

REPORT OF INDEPENDENT well as evaluating the overall financial statement presen-

tation. We believe that our audits provide a reasonable
AUDITORS basis for our opinion.
In our opinion, the consolidated financial statements
The Board of Directors and Shareholders referred to above present fairly, in all material respects,
of The McGraw-Hill Companies, Inc. the consolidated financial position of The McGraw-Hill
We have audited the accompanying consolidated balance Companies, Inc. at December 31, 2003 and 2002,
sheets of The McGraw-Hill Companies, Inc. as of Decem- and the consolidated results of its operations and its cash
ber 31, 2003 and 2002, and the related consolidated flows for each of the three years in the period ended
statements of income, shareholders’ equity and cash December 31, 2003, in conformity with accounting prin-
flows for each of the three years in the period ended ciples generally accepted in the United States.
December 31, 2003. These financial statements are the As discussed in Note 13 to the consolidated financial
responsibility of the Company’s management. Our re- statements, the Company adopted Statement of Financial
sponsibility is to express an opinion on these financial Accounting Standards No. 142 in 2002.
statements based on our audits.
We conducted our audits in accordance with auditing
standards generally accepted in the United States. Those
standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements.
An audit also includes assessing the accounting principles New York, New York
used and significant estimates made by management, as January 27, 2004
SUPPLEMENTAL FINANCIAL INFORMATION
Quarterly Financial Information (Unaudited)*
(in thousands, except per-share data)(a) First quarter Second quarter Third quarter Fourth quarter Total year

2003
Operating revenue $830,814 $1,172,019 $1,602,667 $1,222,357 $4,827,857
Income from continuing operations
before taxes on income 63,273 226,658 459,206 381,140(b) 1,130,277
Income from continuing operations 39,863 142,795 289,299 215,854(b) 687,811
Earnings/(loss) from discontinued operations 55,532 (760) 997 (55,930) (161)
Net income 95,395 142,035 290,296 159,924(b) 687,650
Earnings per share:
Basic earnings per share
Income from continuing operations 0.21 0.75 1.52 1.13 3.61
Net income 0.50 0.75 1.52 0.84 3.61
Diluted earnings per share
Income from continuing operations 0.21 0.75 1.51 1.12 3.58
Net income 0.50 0.74 1.51 0.83 3.58
2002
Operating revenue $809,373 $1,149,353 $1,540,200 $1,141,258 $4,640,184
Income from continuing operations
before taxes on income 46,385 214,359 420,784(c) 215,867 897,395
Income from continuing operations 28,991 133,974 274,084(c) 134,917 571,966
Earnings/(loss) from discontinued operations 211 2,496 2,135 (48) 4,794
Net income 29,202 136,470 276,219(c) 134,869 576,760
Earnings per share:
Basic earnings per share
Income from continuing operations 0.15 0.69 1.42 0.70 2.97
Net income 0.15 0.71 1.43 0.70 2.99
Diluted earnings per share
Income from continuing operations 0.15 0.69 1.41 0.69 2.94
Net income 0.15 0.70 1.42 0.69 2.96
2001
Operating revenue $806,827 $1,104,055 $1,487,456 $1,076,263 $4,474,601
Income from continuing operations
before taxes on income 32,383(d) 173,794(e) 389,139 20,805(f) 616,121
Income from continuing operations 19,916(d) 119,852(e) 239,320 (1,403)(f) 377,685
Earnings/(loss) from discontinued operations 475 145 168 (1,442) (654)
Net income 20,391(d) 119,997(e) 239,488 (2,845)(f) 377,031
Earnings per share:
Basic earnings per share
Income from continuing operations 0.10 0.62 1.23 (0.01) 1.95
Net income 0.11 0.62 1.24 (0.01) 1.95
Diluted earnings per share
Income from continuing operations 0.10 0.61 1.22 (0.01) 1.93
Net income 0.10 0.61 1.22 (0.01) 1.92

*See page 84 for notes to the Quarterly Financial Information.

High and Low Sales Prices of The McGraw-Hill Companies Common Stock†
2003 2002 2001
First Quarter $62.58–51.74 $69.70–58.88 $64.74–54.09
Second Quarter 66.15–55.46 68.73–56.30 70.87–57.84
Third Quarter 64.51–58.60 65.98–50.71 67.95–50.55
Fourth Quarter 70.00–61.99 66.30–55.51 61.80–48.70
Year $70.00–51.74 $69.70–50.71 $70.87–18.70
†
The New York Stock Exchange is the principal market on which the Corporation’s shares are traded.
584
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 585

Notes to the Quarterly Financial Information on page 81.

Note: Earnings per share may not crossfoot due to (c) 2002 results reflect a pre-tax loss of $14.5 million
rounding. and an after-tax benefit of $2.0 million, 1 cent per
diluted share on the sale of MMS International. The vari-
(a) Operating revenue, income from continuing opera-
ance between the pre-tax loss on the sale of MMS Inter-
tions before taxes on income, and income from continu-
national and the after-tax benefit is the result of previous
ing operations for years 2003, 2002 and 2001 have been
book write-downs and the inability of the Company to
restated to exclude amounts associated with discontinued
take a tax benefit for the write-downs until the unit was
operations. In 2003 the Company adopted the Discontin-
sold.
ued Operations presentation, outlined in SFAS No. 144,
“Accounting for the Impairment or Disposal of Long- (d) Includes a $6.9 million pre-tax gain, 2 cents per diluted
Lived Assets.” Discontinued operating components, rev- share, on the sale of a building.
enue and operating profit of S&P ComStock and juvenile (e) Includes an $8.8 million pre-tax gain ($26.3 million
retail publishing business historically included in the Fi- after-tax gain, 13 cents per diluted share) on the disposi-
nancial Services and McGraw-Hill Education segments, re- tion of DRI; the variance between the pre-tax gain recog-
spectively, are restated in discontinued operations. 2003 nized on the sale of DRI of $8.8 million and the after-tax
discontinued operations include $87.5 million on the di- benefit of $26.3 million is the result of previous book
vestiture of S&P ComStock ($57.2 million after-tax gain or write-downs and the inability of the Company to take a
30 cents per diluted share), and an $81.1 million loss on tax benefit for the write-downs until the unit was sold. It
the planned disposition of the juvenile retail publishing also includes a $22.8 million pre-tax loss ($21.9 million
business ($57.3 million after-tax loss or 30 cents per di- after-tax charge, 11 cents per diluted share) on the clos-
luted share) which was subsequently sold on January 30, ing of Blue List the contribution of Rational Investors and
2004. Discontinued operations in years 2002 and 2001 the write-down of selected assets.
reflect net after-tax earnings/(loss) from the operations of (f) Includes a $159 million pre-tax charge ($112.0 million
S&P ComStock and juvenile retail publishing business. after-tax, 57 cents per diluted share) for the restructuring
(b) 2003 results include a pre-tax gain on sale of real and asset write-downs.
estate of $131.3 million ($58.4 million after-tax gain or
30 cents per diluted share.)

Notes to the 11-Year Financial Review on page 82.

(a) All income statement categories presented except for ($58.4 million after-tax gain, or 30 cents per diluted earn-
discontinued operations, have been restated to exclude ings per share).
amounts associated with discontinued operations. In (c) 2002 income from continuing operations before taxes
2003 the Company adopted the Discontinued Operations reflects a $14.5 million pre-tax loss ($2.0 million after-tax
presentation, outlined in SFAS No. 144, “Accounting for benefit, or 1 cent per diluted share) on the disposition of
the Impairment or Disposal of Long-Lived Assets.” Dis- MMS International.
continued operating components, revenue and operating (d) 2001 income from continuing operations before taxes
profit of S&P ComStock and juvenile retail publishing reflects the following items: a $159.0 million pre-tax charge
business historically included in the Financial Services and for restructuring and asset write-down; an $8.8 million pre-
McGraw-Hill Education segments, respectively, are re- tax gain on the disposition of DRI; a $22.8 million pre-tax
stated in discontinued operations. 2003 discontinued op- loss on the closing of Blue List, the contribution of Rational
erations include $87.5 million on the divestiture of S&P Investors and the write-down of selected assets; and a $6.9
ComStock ($57.2 million after-tax gain or 30 cents per di- million pre-tax gain on the sale of a building.
luted earnings per share), and an $81.1 million loss on
(e) 2000 income from continuing operations before taxes
the planned disposition of juvenile retail publishing busi-
reflects a $16.6 million gain on the sale of Tower Group.
ness ($57.3 million after-tax loss or 30 cents per diluted
earnings per share) which was subsequently sold on Janu- (f) 1999 income from continuing operations before taxes
ary 30, 2004. Discontinued operations in years 2002–2000 on income reflects a $39.7 million gain on the sale of the
reflect net after-tax earnings/(loss) from the operations of Petrochemical publications.
S&P ComStock and juvenile retail publishing business and (g) 1998 income from continuing operations before taxes
1999–1993 reflect net after-tax earnings/(loss) from the on income reflects a $26.7 million gain on sale of a build-
operations of S&P ComStock. ing and a $16.0 million charge at Continuing Education
(b) 2003 income from continuing operations includes a Center for write-down of assets due to a continuing de-
pre-tax gain on sale of real estate of $131.3 million cline in enrollments.
ELEVEN-YEAR FINANCIAL REVIEW
(in thousands, except per-share data, operating statistics and number of employees,
as restated) (a)* 2003 2002
Operating Results by Segment and Income Statistics
Operating Revenue
McGraw-Hill Education $2,286,161 $2,275,019
Financial Services 1,769,093 1,555,726
Information and Media Services 772,603 809,439
Total Operating Revenue 4,827,857 4,640,184
Operating Profit
McGraw-Hill Education 321,751 332,949
Financial Services 667,597 560,845
Information and Media Services 109,841 118,052
Operating Profit 1,099,189 1,011,846
Share of profit of Macmillan/McGraw-Hill School Publishing Company(k) – –
Unusual charges(i, l) – –
Gain on exchange of Shepard’s/McGraw-Hill(i) – –
General corporate income/(expense)(b) 38,185 (91,934)
Interest expense (7,097) (22,517)
Income From Continuing Operations Before Taxes On Income(a, b, c, d, e, f, g, h, j) 1,130,277 897,395
Provision for taxes on income 442,466 325,429
Income From Continuing Operations Before Extraordinary Item and
Cumulative Adjustment 687,811 571,966
Discontinued Operations:
Net earnings/(Loss) from discontinued operations(a) (161) 4,794
Income Before Extraordinary Item and Cumulative Adjustment 687,650 576,760
Early extinguishment of debt, net of tax(m) – –
Cumulative effect on prior years of changes in accounting(m) – –
Net Income $ 687,650 $ 576,760
Basic Earnings Per Share
Income from continuing operations before extraordinary item and
cumulative adjustment $ 3.61 $ 2.97
Discontinued operations – 0.02
Income before extraordinary item and cumulative adjustment $ 3.61 $ 2.99
Extraordinary item and cumulative adjustment(m) – –
Net income $ 3.61 $ 2.99
Diluted Earnings Per Share
Income from continuing operations before extraordinary item and
cumulative adjustment $ 3.58 $ 2.94
Discontinued operations – 0.02
Income before extraordinary item and cumulative adjustment $ 3.58 $ 2.96
Extraordinary item and cumulative adjustment(m) – –
Net income $ 3.58 $ 2.96
Dividends per share of common stock $ 1.08 $ 1.02
Operating statistics
Return on average shareholders’ equity 29.6% 29.4%
Income from continuing operations before taxes as a percent of revenue 23.4% 19.3%
Income before extraordinary item and cumulative adjustment as a
percent of operating revenue 14.2% 12.4%
Balance sheet data
Working capital $ 262,418 $ (100,984)
Total assets 5,394,068 5,032,182
Total debt 26,344 578,337
Shareholders’ equity $2,557,051 $2,165,822
Number of employees 16,068 16,505

*See page 84 for notes to the Eleven-Year Financial Review.

586
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 587

2001 2000 1999 1998 1997 1996 1995 1994 1993

$2,230,235 $1,979,308 $1,734,922 $1,620,343 $1,573,797 $1,277,895 $1,235,578 $1,162,157 $ 667,444
1,398,303 1,205,038 1,163,644 1,037,026 878,259 766,620 705,014 669,718 628,153
846,063 1,007,552 1,030,015 1,015,598 1,035,834 990,924 962,379 896,960 876,098

4,474,601 4,191,898 3,928,581 3,672,967 3,487,890 3,035,439 2,902,971 2,728,835 2,171,695

273,339 307,672 273,667 202,076 187,722 151,921 162,604 125,765 49,374

425,911 383,025 358,155 338,655 245,150 241,479 214,707 201,642 186,421
65,003 212,921 185,551 139,352 158,879 131,397 130,145 120,482 116,751

764,253 903,618 817,373 680,083 591,751 524,797 507,456 447,889 352,546

– – – – – – – – 28,376
– – – – – (25,000) – – (229,800)
– – – – – 418,731 – – –
(93,062) (91,380) (83,280) (80,685) (75,342) (62,073) (63,570) (54,134) (48,538)
(55,070) (52,841) (42,013) (47,961) (52,542) (47,656) (58,766) (51,746) (36,342)

616,121 759,397 692,080 551,437 463,867 808,799 385,120 342,009 66,242

238,436 292,367 269,911 215,061 177,610 316,687 158,669 140,908 54,696

377,685 467,030 422,169 336,376 286,257 492,112 226,451 201,101 11,546

(654) 4,886 3,405 2,935 2,442 1,432 360 656 (159)

377,031 471,916 425,574 339,311 288,699 493,544 226,811 201,757 11,387

– – – (8,716) – – – – –
– (68,122) – – – – – – –

$ 377,031 $ 403,794 $ 425,574 $ 330,595 $ 288,699 $ 493,544 $ 226,811 $ 201,757 $ 11,387

$ 1.95 $ 2.41 $ 2.15 $ 1.71 $ 1.45 $ 2.48 $ 1.14 $ 1.02 $ 0.06

– 0.02 0.02 0.01 0.01 – – – –

$ 1.95 $ 2.43 $ 2.17 $ 1.72 $ 1.46 $ 2.48 $ 1.14 $ 1.02 $ 0.06

– (0.35) – (0.04) – – – – –

$ 1.95 $ 2.08 $ 2.17 $ 1.68 $ 1.46 $ 2.48 $ 1.14 $ 1.02 $ 0.06

$ 1.93 $ 2.38 $ 2.13 $ 1.69 $ 1.43 $ 2.46 $ 1.14 $ 1.02 $ 0.06
(0.01) 0.03 0.01 0.01 0.02 0.01 – – –

$ 1.92 $ 2.41 $ 2.14 $ 1.70 $ 1.45 $ 2.47 $ 1.14 $ 1.02 $ 0.06

– (0.35) – (0.04) – – – – –

$ 1.92 $ 2.06 $ 2.14 $ 1.66 $ 1.45 $ 2.47 $ 1.14 $ 1.02 $ 0.06

$ 0.98 $ 0.94 $ 0.86 $ 0.78 $ 0.72 $ 0.66 $ 0.60 $ 0.58 $ 0.57

20.7% 23.5% 26.7% 22.9% 20.8% 41.4% 23.3% 23.4% 1.3%

13.8% 18.1% 17.6% 15.0% 13.3% 26.6% 13.3% 12.5% 3.1%
8.4% 11.3% 10.8% 9.2% 8.3% 16.3% 7.8% 7.4% 0.5%

$ (63,446) $ 20,905 $ (14,731) $ 94,497 $ 217,912 $ 92,629 $ 157,244 $ 94,486 $ 28,463

5,161,191 4,931,444 4,118,111 3,817,336 3,740,569 3,668,381 3,081,846 2,984,745 3,066,750
1,056,524 1,045,377 536,449 527,597 684,425 581,368 628,664 762,805 928,710
$1,853,885 $1,761,044 $1,648,490 $1,508,995 $1,394,384 $1,322,827 $ 998,964 $ 877,266 $ 788,584

17,135 16,761 16,376 15,897 15,690 16,220 15,452 15,339 15,661

588 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

(h) 1997 income from continuing operations before taxes Macmillan/McGraw-Hill results are consolidated
on income reflects a $33.2 million provision for the con- effective October 1, 1993 in the McGraw-Hill Education
solidation of office space in New York City and a $20.4 segment.
million gain on the sale of Datapro Information Services. (l) 1993 amount reflects unusual charges in connection
(i) 1996 operating profit excludes a net gain on the ex- with the acquisition of the additional 50% interest in
change of Shepard’s/McGraw-Hill for the Times Mirror Macmillan/McGraw-Hill.
Higher Education group comprising a $418.7 million gain (m) The cumulative adjustment in 2000 reflects the adop-
on the exchange and a $25 million one-time charge for tion of SAB 101, Revenue Recognition in Financial State-
integration costs. ments. The cumulative adjustment in 1992 reflects the
(j) 1995 income from continuing operations before taxes adoption of the provisions of SFAS No. 106, “Employers’
on income reflects a $26.8 million provision for best prac- Accounting for Postretirement Benefit Other Than Pen-
tices initiatives and a $23.8 million gain on sale of the sions,” and SFAS No. 112, “Employers’ Accounting for
topical publishing division of Shepard’s/McGraw-Hill. Postemployment Benefits.” The extraordinary item in
(k) Reflects The McGraw-Hill Companies’ share of profit 1998 relates to costs for the early extinguishment of
of Macmillan/McGraw-Hill School Publishing Company $155 million of the Company’s 9.43% Notes during the
through September 30, 1993. third quarter.

Review 1. What is an operating segment of a business enterprise?

Questions 2. Is the concept of segment reporting consistent with the theory of consolidated finan-
cial statements? Explain.
3. Describe the format established by the FASB for reporting the disposal of an operating
segment of an entity.
4. Discuss the provisions of APB Opinion No. 28, “Interim Financial Reporting,” deal-
ing with the accounting for costs associated with revenue in interim financial reports.
5. How is lower-of-cost-or-market accounting for inventories applied in interim financial
reports?
6. Explain the technique included in APB Opinion No. 28, “Interim Financial Report-
ing,” for the measurement of income taxes expense in interim financial reports.
7. Identify four U.S. statutes administered by the SEC.
8. Differentiate between Form 10-K and Form 8-K filed with the SEC under the Securi-
ties Exchange Act of 1934.
9. Under what circumstances must financial statements of a business enterprise be in-
cluded in a proxy statement issued to the enterprise’s stockholders under the provisions
of the Securities Exchange Act of 1934?
10. What position did the SEC take regarding its role in the establishment of accounting
principles?
11. How do accountants use Regulation S-X in filings with the SEC?
12. What is Regulation S-K of the SEC?
13. What are Financial Reporting Releases?
14. Does the SEC require the inclusion of financial forecasts in filings with the SEC?

Exercises
(Exercise 13.1) Select the best answer for each of the following multiple-choice questions:
1. In financial reporting for segments of a business enterprise, must the segment profit or
loss of an operating segment include:
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 589

Interest Expense? Income Taxes Expense?

a. Yes Yes
b. Yes No
c. No Yes
d. No No

2. Rawson Company is a diversified enterprise that discloses segment financial informa-

tion for its operating segments. The following information is available for 2006:

Traceable Nontraceable
Operating Segment Sales Expenses Expenses
Segment A $400,000 $225,000
Segment B 300,000 240,000
Segment C 200,000 135,000
Totals $900,000 $600,000 $150,000

Nontraceable expenses are allocated based on the ratio of a segment’s income before
nontraceable expenses to total income before nontraceable expenses. The segment
profit for Operating Segment B for 2006 is:
a. $0.
b. $10,000.
c. $30,000.
d. $50,000.
e. Some other amount.
3. Irving Company discloses operating segment information in its annual report. The fol-
lowing data were available for the year ended December 31, 2006:

Operating Traceable
Segment Sales Expenses
Chemicals $ 500,000 $300,000
Tools 400,000 250,000
Services 300,000 175,000
Totals $1,200,000 $725,000

Additional expenses for the year ended December 31, 2006, not included above, were
as follows:

Nontraceable operating expenses $180,000

Unallocated expenses 120,000

Appropriate common expenses are allocated to operating segments based on the ratio
of a segment’s sales to total sales. The segment profit for the Services operating seg-
ment for the year ended December 31, 2006, is:
a. $125,000
b. $80,000
c. $65,000
d. $50,000
e. Some other amount.
590 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

4. Revenue of an operating segment of a business enterprise includes:

a. Intersegment sales or transfers.
b. An appropriate portion of revenue earned solely at the corporate level.
c. Equity in net income of influenced investees.
d. All of the foregoing.
5. For the reporting of segment revenues for operating segments in interim reports, the
FASB requires that:
a. Sales to unaffiliated customers and intersegment sales or transfers be disclosed sep-
arately.
b. Sales to unaffiliated customers and intersegment sales or transfers be reported as a
single amount.
c. Intersegment sales or transfers be excluded.
d. None of the foregoing take place.
6. On September 15, 2006, the board of directors of Harte Company approved a plan to
dispose of an operating segment. It was expected that the disposal would be accom-
plished on June 1, 2007, for $1 million proceeds. Disposal costs of $150,000 were paid
by Harte during the fiscal year ended April 30, 2007, and it was estimated that the
carrying amount of the operating segment’s net assets on June 1, 2007, would be
$1,750,000. The operating segment had actual or estimated operating losses as follows:

May 1 through Sept. 14, 2006 $130,000

Sept. 15, 2006, through Apr. 30, 2007 50,000
May 1 through May 31, 2007 15,000

Disregarding income taxes, Harte Company displays in its income statement for the
fiscal year ended April 30, 2007, a loss on disposal of business segment of:
a. $0
b. $900,000
c. $915,000
d. $965,000
7. May a net-of-tax provision for operating losses of a discontinued operating segment be
included with:

Income (Loss) from Continuing Gain (Loss) on Disposal of the

Operations of the Discontinued Discontinued Business
Business Segment? Segment?
a. Yes Yes
b. Yes No
c. No Yes
d. No No

8. Trent Company had a net income of $700,000 for the fiscal year ended June 30, 2007,
after the following events or transactions that occurred during the year:
(1) The decision was made July 1, 2006, to discontinue the plastics operating segment.
(2) The plastics operating segment was sold December 31, 2006.
(3) Operating loss from July 1 to December 31, 2006, for the plastics operating seg-
ment amounted to $60,000 before income tax benefit.
(4) Plastics operating segment net assets with a carrying amount of $350,000 were
sold for $200,000.
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 591

Trent’s income tax rate was 40%. For the fiscal year ended June 30, 2007, Trent Com-
pany’s income from continuing operations was:
a. $574,000
b. $700,000
c. $784,000
d. $826,000
e. Some other amount
9. When an operating segment has been discontinued during the year, the segment’s
losses of the current period up to the disposal date are displayed in the:
a. Income statement as part of the income (loss) from operations of the discontinued
business segment.
b. Income statement as part of the loss on disposal of the discontinued business segment.
c. Income statement as part of the income (loss) from continuing operations.
d. Retained earnings statement as a direct decrease in beginning retained earnings.
10. APB Opinion No. 28, “Interim Financial Reporting,” provided special treatment for in-
terim periods’ cost of goods sold for:
a. Gross margin method.
b. Temporary depletions of base layers of last-in, first-out inventories.
c. Temporary market declines of inventories.
d. All of the foregoing.
11. In accordance with APB Opinion No. 28, “Interim Financial Reporting,” may costs
and expenses other than product costs be allocated among interim periods based on an
estimate of:

Activity Associated with

Time Expired? Benefit Received? the Periods?
a. Yes Yes Yes
b. Yes No Yes
c. No Yes No
d. No Yes Yes

12. In APB Opinion No. 28, “Interim Financial Reporting,” the APB adopted the:
a. Integral theory
b. Interim theory
c. Discrete theory
d. Unified theory
13. According to APB Opinion No. 28, “Interim Financial Reporting,” must lower-of-cost-
or-market writedowns of inventories be provided for interim periods if the interim date
market declines are considered:

Permanent? Temporary?
a. Yes Yes
b. Yes No
c. No Yes
d. No No

14. In interim financial reporting, year-end adjustments to which of the following item or
items must be estimated and assigned to interim periods?
a. Inventory shrinkage.
b. Doubtful accounts expense.
592 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

c. Discretionary year-end bonuses.

d. All of the foregoing.
15. According to APB Opinion No. 28, “Interim Financial Reporting,” income taxes ex-
pense in an income statement for the first interim period of an enterprise’s fiscal year
should be computed by applying the:
a. Estimated income tax rate for the full fiscal year to the pretax financial income for
the interim period.
b. Estimated income tax rate for the full fiscal year to the taxable income for the in-
terim period.
c. Statutory income tax rate to the pretax financial income for the interim period.
d. Statutory income tax rate to the taxable income for the interim period.
16. Wade Company, which has a fiscal year ending February 28 or 29, had the following
pretax financial income and estimated effective annual income tax rates for the first
three quarters of the year ended February 28, 2006:

Pretax Estimated Effective Annual

Quarter Financial Income Income Tax Rate at End of Quarter
First $60,000 40%
Second 70,000 40%
Third 40,000 45%

Wade’s income taxes expense in its interim income statement for the third quarter of
Fiscal Year 2006 is:
a. $18,000. b. $24,500. c. $25,500. d. $76,500. e. Some other amount
17. Which of the following SEC publications provides guidelines for the financial state-
ments required in reports to the SEC?
a. Regulation S-X
b. Regulation S-K
c. Staff Accounting Bulletins
d. Regulation C
18. Guidance for the completion of nonfinancial statement disclosure requirements in the
various Forms filed with the SEC is provided in:
a. Regulation S-X
b. Regulation S-K
c. ASR 142
d. SAB 1
19. Which of the following is not a registration statement filed with the SEC?
a. Form S-1 b. Form S-2 c. Form S-3 d. Form 10 e. Form 10-K
20. The current report form of the SEC is:
a. Form 10-K
b. Form 10-Q
c. Form 8-K
d. Proxy statement
21. The SEC’s present position with respect to the inclusion of financial forecasts in filings
with the SEC is that financial forecasts are:
a. Permissible
b. Mandatory
c. Forbidden
d. Unimportant
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 593

(Exercise 13.2) Data for the three operating segments of Polyglot Company for the fiscal year ended June
30, 2006, were as follows (amounts in thousands):

CHECK FIGURE Operating Segment

Alpha segment profit,
$150,000. Alpha Beta Gamma Total
Sales to unaffiliated customers $400 $500 $600 $1,500
Intersegment sales 50 40 30 120
Traceable expenses:
Intersegment purchases 60 20 40 120
Other 200 300 500 1,000
Nontraceable expenses 150

Prepare a working paper to compute the revenue and segment profit or loss of each of
the operating segments of Polyglot Company for the year ended June 30, 2006, assuming
that Polyglot allocates nontraceable expenses to operating segments in the ratio of segment
sales to unaffiliated customers.
(Exercise 13.3) Rinker Company operates in three different industries, each of which is appropriately re-
garded as an operating segment. Segment No. 1 contributed 60% of Rinker’s total sales
CHECK FIGURE in 2006. Sales for Segment No. 1 were $900,000 and traceable expenses were $400,000 in
Segment profit, 2006. Rinker’s total nontraceable expenses for 2006 were $600,000. Rinker allocates non-
$140,000. traceable expenses based on the ratio of a segment’s sales to total sales, an appropriate
method of allocation.
Prepare a working paper to compute the segment profit or loss for Rinker Company’s
Segment No. 1 for 2006.
(Exercise 13.4) The nontraceable expenses of Coopers Company for the fiscal year ended June 30, 2006,
totaled $310,000. The net sales, payroll totals, and average plant assets and inventories for
the two operating segments of Coopers were as follows:

CHECK FIGURE
Chemicals Sporting Goods
Nontraceable expenses
Segment Segment
to chemicals segment,
$207,700. Net sales $1,400,000 $600,000
Payroll totals 150,000 100,000
Average plant assets and inventories 710,000 290,000

Prepare a working paper to compute the amount of Coopers Company’s nontraceable ex-
penses to be allocated to the Chemicals segment and the Sporting Goods segment of Coop-
ers Company for the year ended June 30, 2006, assuming that such expenses are allocated
to the two segments on the basis of the arithmetic average of the percentage of net sales,
payroll taxes, and average plant assets and inventories applicable to each segment.
(Exercise 13.5) Canton Company allocates nontraceable expenses to its three operating segments in the
ratio of net sales to unaffiliated customers. For the fiscal year ended April 30, 2006, rele-
vant segment data were as follows:
594 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

CHECK FIGURE Operating Operating Operating

Operating segment A
Segment A Segment B Segment C
segment profit,
$100,000. Revenue:
Net sales to unaffiliated customers $500,000 $300,000 $200,000
Intersegment transfers out 80,000 40,000 20,000
Costs and expenses:
Traceable expenses 400,000 100,000 200,000
Intersegment transfers in 30,000 60,000 50,000

Nontraceable expenses of Canton Company for the year ended April 30, 2006, totaled
$100,000.
Prepare a working paper to compute for each operating segment of Canton Company the
following amounts for the year ended April 30, 2006: revenue, expenses, segment profit or
loss. Use a column for each operating segment, as shown above.
(Exercise 13.6) Crossley Company had a net income of $600,000 for the year ended December 31, 2006,
after inclusion of the following events or transactions that occurred during the year:
CHECK FIGURE (1) The decision was made on January 2 to dispose of the cinder block operating segment.
b. Total income taxes, (2) The cinder block operating segment was disposed of on July 1.
$400,000.
(3) Operating income from January 2 to June 30 for the cinder block operating segment
amounted to $90,000 before income taxes.
(4) Cinder block operating segment net assets with a carrying amount of $250,000 were
disposed of for $100,000.
Crossley was subject to income taxes at the rate of 40%.
a. Prepare a working paper to compute Crossley Company’s income from continuing op-
erations for the year ended December 31, 2006.
b. Prepare a working paper to compute Crossley Company’s total income taxes (expense
and allocated) for the year ended December 31, 2006.
(Exercise 13.7) Tovar Company’s accounting records for the fiscal year ended August 31, 2006, include the
following data with respect to its Wallis division, an operating segment. Sale of the net as-
CHECK FIGURE sets of that division to Expansive Enterprises, Inc., for $300,000 was authorized by Tovar’s
Income from board of directors on August 31, 2006. Closing date of the disposal was expected to be
continuing operations, February 28, 2007.
$384,000.

Wallis Division:
Net sales, year ended Aug. 31, 2006 $200,000
Costs and expenses, year ended Aug. 31, 2006 150,000
Estimated operating losses, six months ending Feb. 28, 2007 40,000
Estimated carrying amount of net assets, Feb. 29, 2007 330,000

Tovar’s income tax rate is 40%. For the year ended August 31, 2006, Tovar had a $640,000
income from continuing operations before income taxes.
Prepare a partial income statement for Tovar Company for the year ended August 31,
2006, to present the foregoing information. Disregard earnings per share data.
(Exercise 13.8) For the fiscal year ended June 30, 2006, Dispo Company, which has an income tax rate of
40%, had the following pretax amounts:
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 595

CHECK FIGURE
Income from continuing operations $1,000,000
Net income, $462,000.
Loss from disposal of net assets of discontinued Division
105 (an operating segment) 60,000
Loss from operations of Division 105 from July 1, 2005,
through the disposal date, May 31, 2006 170,000

Prepare a partial income statement for Dispo Company for the year ended June 30,
2006, beginning with income from continuing operations. Disregard basic earnings per
share.
(Exercise 13.9) The income tax rate for Downsize Company was 40%, and it had no differences between
pretax financial income and taxable income. For the fiscal year ended November 30, 2006,
pretax amounts in the bottom portion of Downsize’s income statement for the year then
ended were as follows:

CHECK FIGURE
Income from continuing operations (before income taxes) $500,000
Net income, $282,000.
Income from operations of discontinued Webb Division
(an operating segment) 10,000
(Loss) on disposal of Webb Division net assets (40,000)

Prepare a partial income statement, including intraperiod tax allocation, for Downsize
Company for the year ended November 30, 2006. Disregard earnings per share data.
(Exercise 13.10) Reducto Company had the following data for the fiscal year ended April 30, 2006, a year in
which its directors had resolved on February 28, 2006, to dispose of Woeful Division, an
operating segment, and completed the disposal on April 15, 2006:

CHECK FIGURE
Income tax rate 40%
Net income, $198,000.
Pretax:
Income from continuing operations $600,000
Loss from disposal of net assets of Woeful Division, Apr. 15, 2006 70,000
Operating losses of Woeful Division:
May 1, 2005 – Feb. 28, 2006 160,000
Mar. 1 – Apr. 15, 2006 40,000

Prepare the bottom portion of Reducto Company’s income statement for the year ended
April 30, 2006, beginning with income from continuing operations before income taxes.
Disregard basic earnings per share disclosures.
(Exercise 13.11) On January 2, 2006, Luigi Company paid property taxes of $40,000 on its plant assets for
2006. In March 2006, Luigi made customary annual major repairs to plant assets in the
amount of $120,000. The repairs will benefit the entire year ended December 31, 2006. In
April 2006, Luigi incurred a $420,000 loss from a replacement cost decline of inventories
that was considered to be permanent.
Prepare a working paper to show how the foregoing items are reported in Luigi Com-
pany’s quarterly income statements for the fiscal year ended December 31, 2006.
(Exercise 13.12) Lundy Company sells a single product, which it purchases from three different vendors. On
May 1, 2005, Lundy’s inventory of the product consisted of 1,000 units at first-in, first-out
cost of $7,500. Lundy’s merchandise transactions for the fiscal year ended April 30, 2006,
were as follows:
596 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

CHECK FIGURE End-of-Quarter

Cost of goods sold,
Quarter Units Cost per Unit Units Replacement
quarter ended Jan. 31,
Ended Purchased Purchased Sold Cost per Unit
$59,250.
July 31, 2005 5,000 $8.00 4,500 $8.50
Oct. 31, 2005 6,000 8.50 7,000 9.00
Jan. 31, 2006 8,000 9.00 6,500 8.50*
Apr. 30, 2006 6,000 8.50 5,500 9.50

*Decline not considered to be temporary.

Prepare a working paper to compute Lundy Company’s cost of goods sold for each of
the four quarters of the year ended April 30, 2006. Show computations.
(Exercise 13.13) Marmon Corporation’s statutory income tax rate is 40%. Marmon forecasts pretax financial
income of $100,000 for the fiscal year ending April 30, 2007, and no temporary differences
between pretax financial income and taxable income. Marmon forecasts the following per-
CHECK FIGURE manent differences between pretax financial income and taxable income for the year end-
Estimated tax rate,
ing April 30, 2007: dividend received deduction, $20,000; premiums expense for officers’
36%.
life insurance, $10,000.
Prepare a working paper to compute Marmon Corporation’s estimated effective income
tax rate for the year ending April 30, 2007.
(Exercise 13.14) Basey Company has a fiscal year ending April 30. On July 31, 2006, the end of the first
quarter of Fiscal Year 2007, Basey estimated an effective income tax rate of 55% for that
CHECK FIGURE year. On October 31, 2006, the end of the second quarter of Fiscal Year 2007, Basey esti-
Oct. 31, debit income mated an effective income tax rate of 52% for that year. Pretax financial income for Basey
taxes expense, was as follows:
$124, 000.

For three months ended July 31, 2006 $200,000

For three months ended October 31, 2006 250,000

Prepare journal entries for income taxes expense of Basey Company on July 31 and
October 31, 2006.
(Exercise 13.15) Public Company, which uses the perpetual inventory system and the last-in, first-out
method of valuing inventory, temporarily depleted a base layer of its inventories with a cost
CHECK FIGURE of $170,000 during the third quarter of its fiscal year ending February 28, 2007. Replace-
Dec. 18, debit ment cost of the depleted inventory was $210,000 on November 30, 2006. On December
inventories, $320,000. 18, 2006, Public made its first purchase of merchandise during the fourth quarter, at a total
cost of $360,000, on open account.
Prepare journal entries for Public Company on November 30 and December 18, 2006.
(Exercise 13.16) For its first two quarters of calendar year 2006, its fiscal year, Intero Company had the fol-
lowing data:

CHECK FIGURE Three Months Pretax Financial Estimated Effective

June 30, debit income Ended Income for Quarter Income Tax Rate for 2006
taxes expense,
$260,200. Mar. 31, 2006 $500,000 38.6%
June 30, 2006 600,000 41.2%
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 597

Prepare journal entries (omit explanations) for Intero Company to accrue income taxes
expense for the first two quarters of 2006.
(Exercise 13.17) On January 31, 2006, the end of the first quarter of its fiscal year ending October 31, 2006,
Cassidy Company had the following ledger account balances:

CHECK FIGURE Income taxes expense $160,000 dr

Feb. 1, debit
Liability arising from depletion of base layer of lifo inventories 30,000 cr
inventories, $80,000.

On February 1, 2006, Cassidy purchased merchandise costing $110,000 on account, and on

April 30, 2006, Cassidy estimated total income taxes expense of $340,000 for the six
months ended on that date. Cassidy uses the perpetual inventory system.
Prepare journal entries for Cassidy Company on February 1 and April 30, 2006, for the
foregoing facts.
(Exercise 13.18) Farber Company’s journal entry for income taxes on September 30, 2006, the end of its fis-
cal year, was as follows:

CHECK FIGURE
State income tax, net Income Taxes Expense ($31,960 $14,100) 46,060
of federal benefit, Income Taxes Payable 46,060
8.46%. To provide for income taxes for the year as follows:

Federal State
Pretax financial income $100,000 $100,000
Less: Nontaxable municipal bond interest (10,000) (10,000)
Add: Nondeductible expenses 4,000 4,000
Taxable income, state $ 94,000
State income tax at 15% $ 14,100
Less: State income tax (14,100)
Taxable income, federal $ 79,900
Federal income tax at 40% $ 31,960

Prepare a reconciliation, in percentages rounded to the nearest hundredth, between the

statutory federal income tax rate, 40%, and Farber Company’s effective income tax rate,
46.06% ($46,060 $100,000 0.4606), required by Regulation S-X, Rule 4-08(h)(2), for
a note to Farber’s September 30, 2006, financial statements filed with the SEC in Form 10-K.
Combine any reconciling items that individually are less than 5% of the statutory federal
income tax rate. Use the format on page 574.

Cases
(Case 13.1) Ellen Laughlin, CPA, controller of Electronics, Inc., a publicly owned enterprise, is prepar-
ing the company’s Form 10-Q Quarterly Report for the quarter ended May 31, 2006, the
first quarter of the fiscal year ending February 28, 2007. In the course of her work, Laughlin
is instructed by Wilbur Jackson, Electronics, Inc.’s chief financial officer, to include in first
598 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

quarter sales a $500,000 shipment delivered to the truck driver of long-time customer
Wilmont Company on June 1, 2006. Prior to the inclusion, first quarter sales of Electronics,
Inc., totaled $6,400,000. Jackson pointed out to Laughlin that (1) the goods had been man-
ufactured by Electronics to Wilmont’s specifications; (2) the goods were packaged and
invoiced to Wilmont in Electronics, Inc.’s shipping department on May 31, awaiting sched-
uled pickup by Wilmont’s truck driver on that date in accordance with the contract with
Wilmont; and (3) because Wilmont’s truck had been disabled in a traffic accident while en
route to Electronics on the afternoon of May 31, a substitute truck could not be obtained by
Wilmont until June 1.

Instructions
Can Ellen Laughlin ethically comply with Wilbur Jackson’s instructions? Explain, consid-
ering the provisions of paragraphs 83 and 84 of FASB Concepts Statement No. 5, “Recog-
nition and Measurement in Financial Statements of Business Enterprises,” and Chapters 4
and 5 of Division 2, “Sales,” of the Uniform Commercial Code.
(Case 13.2) In a classroom discussion of the provisions for reporting of operating segments of a busi-
ness enterprise, as set forth in FASB Statement No. 131, “Disclosures about Segments of
an Enterprise . . . ,” student Jeff asserts that the proposed changes are flawed in that they
give far too much latitude to managements of business enterprises in determining operating
segments, deciding what information is needed for management decisions regarding oper-
ating segments, and segment profit or loss of operating segments. The result of such lati-
tude, in Jeff ’s opinion, is noncompliance with the qualitative characteristic reliability,
established as a requirement for useful financial information in paragraph 33 of FASB Con-
cepts Statement No. 2, “Qualitative Characteristics of Accounting Information.” Jeff points
out that such management-determined information is neither verifiable nor neutral—two
ingredients of reliable financial information. Jeff admitted that, in taking this position, he
was influenced by the dissent of FASB member James J. Leisenring to the issuance of
FASB Statement No. 131.

Instructions
Do you agree with student Jeff ? Explain.
(Case 13.3) In APB Opinion No. 28, “Interim Financial Reporting,” the APB adopted the integral the-
ory, rather than the discrete theory, for interim financial statements.

Instructions
a. Present arguments in favor of the integral theory of interim financial reporting.
b. Present arguments in favor of the discrete theory of interim financial reporting.
c. Which theory do you prefer? Explain, disregarding the APB’s adoption of the integral
theory.
(Case 13.4) Critics have charged that the SEC, contrary to its position as stated on pages 559–560, es-
sentially establishes generally accepted accounting principles in its Financial Reporting
Releases and Staff Accounting Bulletins.

Instructions
Do you agree with the critics? Explain.
(Case 13.5) Nanson Company, a publicly owned corporation listed on a major stock exchange, fore-
casted operations for the fiscal year ending December 31, 2006, as shown on page 599.
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 599

NANSON COMPANY
Forecasted Income Statement
For Year Ending December 31, 2006

Net sales (1,000,000 units) $6,000,000

Cost of goods sold 3,600,000
Gross margin on sales $2,400,000
Operating expenses 1,400,000
Operating income $1,000,000
Nonoperating revenue and expenses -0-
Income before income taxes $1,000,000
Income taxes expense (current and deferred) 550,000
Net income $ 450,000
Basic earnings per share of common stock 4.50

Nanson has operated profitably for many years and has experienced a seasonal pattern of
sales volume and production similar to the following ones forecasted for 2006: Sales vol-
ume is expected to follow a quarterly pattern of 10%, 20%, 35%, 35%, respectively, be-
cause of the seasonality of the industry. Also, because of production and storage capacity
limitations, it is expected that production will follow a pattern of 20%, 25%, 30%, 25%, per
quarter, respectively.
At the conclusion of the first quarter of 2006, the controller of Nanson prepared and is-
sued the following interim income statement:

NANSON COMPANY
Income Statement
For Quarter Ended March 31, 2006

Net sales (100,000 units) $ 600,000

Cost of goods sold 360,000
Gross margin on sales $ 240,000
Operating expenses 275,000
Operating loss $ (35,000)
Loss from warehouse explosion (175,000)
Loss before income taxes $(210,000)
Income taxes expense -0-
Net loss $(210,000)
Basic loss per share of common stock $ (2.10)

Additional Information
The following additional information was available for the first quarter just completed, but
was not included in the information released by Nanson:
1. Nanson uses a standard cost system in which standards are set at currently attainable
levels on an annual basis. At the end of the first quarter, underapplied fixed factory over-
head (volume variance) of $50,000 was recognized as an asset. Production during the
first quarter was 200,000 units, of which 100,000 units were sold.
2. The operating expenses were forecasted on a basis of $900,000 fixed expenses for the
year plus $0.50 variable expenses per unit sold.
600 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

3. The warehouse explosion loss met the conditions of an extraordinary loss. The ware-
house had a carrying amount of $320,000; $145,000 was recovered from insurance on
the warehouse. No other gains or losses were anticipated during the year from similar
events or transactions, nor has Nanson had any similar losses in preceding years; thus,
the full loss will be deductible as an ordinary loss for income tax purposes.
4. The effective rate for federal and state income taxes combined was expected to average
55% of pretax financial income for. There were no permanent differences between pre-
tax financial income and taxable income.
5. Basic earnings per share of common stock was computed on the basis of 100,000 shares
of common stock outstanding. Nanson has only one class of common stock issued, no
long-term debt outstanding, no stock option plans, and no warrants to acquire common
stock outstanding.

Instructions
a. Identify the weaknesses in form and content of Nanson Company’s interim income
statement, without reference to the additional information.
b. For each of the five items of additional information, indicate the preferable treatment for
interim reports and explain why that treatment is preferable.

Problems
(Problem 13.1) Data with respect to the four operating segments of Wabash Company for the fiscal year
ended November 30, 2006, follow:

CHECK FIGURE
Operating Segment
a. Loss for Operating
Segment Delta, Alpha Beta Gamma Delta Total
$5,000. Net sales to outsiders $40,000 $20,000 $25,000 $ 5,000 $90,000
Intersegment transfers out 2,000 4,000 1,000 3,000 10,000
Intersegment transfers in 4,000 3,000 2,000 1,000 10,000
Other traceable expenses 9,000 6,000 5,000 10,000 30,000
Nontraceable expenses 20,000

Wabash allocated nontraceable expenses to operating segments by the following reasonable

method: Alpha—40%; Beta—30%; Gamma—20%; Delta—10%.

Instructions
Prepare a working paper to compute the segment profit or loss for Wabash Company’s four
operating segments for the year ended November 30, 2006.
(Problem 13.2) Cregar Company is “going public” early in Year 2007, and is preparing to file a Form S-1
CHECK FIGURE registration statement with the SEC to register the common stock it plans to issue to the
Net income, 2005, public. The accountant for Cregar prepared the following comparative income statements
$720,000. for inclusion in the Form S-1:
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 601

CREGAR COMPANY
Income Statements
For Three Years Ended December 31, 2006

2006 2005 2004

Net sales $10,000,000 $9,600,000 $8,800,000
Cost of goods sold 6,200,000 6,000,000 5,400,000
Gross margin on sales $ 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 operating segment 900,000
Income before income taxes $ 2,500,000 $1,200,000 $1,300,000
Income taxes expense 1,000,000 480,000 520,000
Net income $ 1,500,000 $ 720,000 $ 780,000

During your audit of the foregoing income statements, you discover that Cregar con-
tracted on January 2, 2006, to sell for $3,200,000 the assets and product line of one of its
operating segments. The sale was completed on December 31, 2006, for a gain of $900,000
before income taxes. The discontinued operations’ contribution to Cregar’s income before
income taxes for each year was as follows: 2006, $640,000 loss: 2005, $500,000 loss; 2004,
$200,000 income. Cregar’s income tax rate is 40%.
Instructions
Prepare corrected partial comparative income statements for Cregar Company for the three
years ended December 31, 2006. Disregard notes to financial statements and basic earnings
per share of common stock. Begin the income statements with income from continuing op-
erations before income taxes. Show supporting computations.
(Problem 13.3) For the fiscal year ending July 31, 2006, Lang Corporation forecasted pretax financial in-
come of $800,000. Lang did not anticipate any temporary differences between pretax
financial income and taxable income. However, the following permanent differences be-
tween financial and taxable income for Fiscal Year 2006 were forecasted:

CHECK FIGURES
Dividend received deduction $150,000
a. Effective income
Lobbying expenses 20,000
tax rate, first quarter,
Officers’ life insurance premium expense 15,000
34.3%; b. July 31,
debit income taxes
expense, $77,960.
Additional Information
1. Lang’s combined federal and state income tax rate is 40%, and federal and state laws co-
incide with respect to the computation of taxable income.
2. Lang’s quarterly pretax financial income for the year ended July 31, 2006, is summa-
rized below:

Quarter Ended
Oct. 31, 2005 $180,000
Jan. 31, 2006 230,000
Apr. 30, 2006 195,000
July 31, 2006 225,000
602 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

3. During Fiscal Year 2006, Lang did not alter its forecast of pretax financial income for the
year. However, effective January 31, 2006, Lang revised its permanent difference estimate
for the 2006 dividend received deduction to $180,000 from $150,000. The actual amounts
for the permanent differences computed by Lang on July 31, 2006, were as follows:

Dividend received deduction $175,000

Lobbying expenses 20,000
Officers’ life insurance premium expense 16,000

Instructions
a. Prepare a working paper to compute the effective combined federal and state income tax
rate that Lang Corporation should use for its quarterly interim financial reports for the
year ended July 31, 2006. Round all percentage computations to the nearest tenth.
b. Prepare Lang Corporation’s journal entries for income taxes on October 31, 2005, and
January 31, April 30, and July 31, 2006.
(Problem 13.4) Bixler Company, a diversified manufacturing enterprise that does not report to the SEC,
had four operating segments engaged in the manufacture of products in each of the follow-
ing industries: food products, health aids, textiles, and office equipment.
CHECK FIGURE Additional Information
Net income, 2006, 1. Financial data for the two years ended December 31, 2006, are shown below:
$1,152,000.

Net Sales Cost of Goods Sold Operating Expenses

Operating Segment 2006 2005 2006 2005 2006 2005
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 equipment 920,000 1,330,000 800,000 1,000,000 650,000 750,000
Totals $8,000,000 $7,000,000 $4,800,000 $4,400,000 $1,700,000 $1,300,000

2. On January 1, 2006, Bixler adopted a plan to dispose of the assets and product line
of the office equipment segment at an anticipated gain. On September 1, 2006, the idle
segment’s assets and product line were disposed of for $2,100,000 cash, at a gain of
$640,000.
3. Bixler’s textiles segment had six manufacturing plants that produced a variety of textile
products. In April 2006, Bixler sold one of these plants and realized a gain of $130,000.
After the sale, the operations at the plant that was sold were transferred to the remaining
five textile plants that Bixler continued to operate.
4. In August 2006, the main warehouse of the food products segment, located on the banks
of the Colton River, was flooded when the river overflowed. The resulting uninsured
damage of $420,000 is not included in the financial data in (1) above. Historical records
indicate that the Colton River normally overflows every four to five years, causing flood
damage to adjacent property.
5. For the two years ended December 31, 2006 and 2005, Bixler realized interest revenue
on investments of $70,000 and $40,000, respectively. For the two years ended Decem-
ber 31, 2006 and 2005, Bixler’s net income was $960,000 and $670,000, respectively.
Income taxes expense for each of the two years should be computed at a rate of 40%.
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 603

Instructions
Prepare comparative income statements for Bixler Company for the years ended December
31, 2006 and 2005. Notes to the financial statements and basic earnings per share of com-
mon stock disclosures are not required.
(Problem 13.5) The accounting records of Draco Company included the following amounts for the year
ended December 31, 2006:

CHECK FIGURE Cost of goods sold—continuing operations $ 8,000,000

a. Net income, Estimated loss on disposal of Southern Division (an operating segment),
$324,000. to be completed in first quarter of Year 2007 50,000
Income taxes payable ($540,000 0.40) 216,000
Interest expense 100,000
Judgment paid in lawsuit of Justin Company v. Draco Company,
initiated in 2004 80,000
Loss from bankruptcy liquidation of major customer 150,000
Loss from operations of Southern Division, discontinued effective
Dec. 31, 2006 120,000
Net sales—continuing operations 10,000,000
Operating expenses—continuing operations 800,000
Uninsured loss from earthquake at Northern Division 160,000

Draco’s income tax rate is 40%. Draco had no temporary differences or permanent
differences between pretax financial income and taxable income for 2006. Prior to 2006,
there had not been an earthquake in the Northern Division’s locality for more than 50
years.
Instructions
a. Prepare an income statement for Draco Company for the year ended December 31,
2006. Disregard earnings per share data and notes to financial statements.
b. Prepare a journal entry for Draco Company’s income taxes on December 31, 2006, with
appropriate intraperiod tax allocation.
(Problem 13.6) Principia Corporation was incorporated January 2, 2006, with a public issuance of 3 mil-
lion shares of $1 par common stock on that date for net proceeds of $5,750,000, net of out-
CHECK FIGURES of-pocket costs of the stock issuance. Immediately thereafter, Principia organized three
a. Principia operating wholly owned subsidiaries: Seattle Company and Boston Company in the United States,
segment profit, and London Company in the United Kingdom. Principia paid $1,500,000 cash for each
$17,000; b. Unallocated subsidiary’s 1,500,000 authorized shares of $1 par common stock.
interest revenue, The working paper for consolidated financial statements for Principia Corporation and
$20,000.
subsidiaries for the year ended December 31, 2006, is on pages 604–605.
Additional Information
1. Each of the affiliated companies constitutes an operating segment.
2. None of the companies declared or paid dividends in 2006.
3. Each of the companies files separate income tax returns at an effective income tax rate
of 40%.
4. Intercompany receivables and payables represent loans or advances. (Receivables and
payables arising from intercompany sales of merchandise had been paid in full on De-
cember 31, 2006.)
604 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

5. Of Principia’s operating expenses, $50,000 represents nontraceable expenses allocable

to each operating segment in the ratio of the average of each segment’s 2006 sales to
outsiders and December 31, 2006, plant asset amounts. The remainder of Principia’s op-
erating expenses represents general corporate expenses.
6. Cash not required for each operating segment’s current operations is forwarded to Prin-
cipia for the acquisition of short-term investments classified as trading securities. Inter-
est on the investments is not allocated to operating segments.

Instructions
Prepare for Principia Corporation and subsidiaries, in the format illustrated on page 544,
(a) information about segment profit or loss and segment assets, and (b) a reconciliation of
operating segment totals to consolidated totals. Disregard segment depreciation and amor-
tization expense, interest expense, and additions to plant assets.

PRINCIPIA CORPORATION AND SUBSIDIARIES

Working Paper for Consolidated Financial Statements
For Year Ended December 31, 2006
(000 omitted)

Eliminations
Principia Seattle Boston London Increase
Corporation Company Company Company* (Decrease) Consolidated
Income Statement
Revenue:
Net sales 500 400 300 200 1,400
Intercompany sales 40 30 20 10 (b) (100)
Intercompany investment
income 32 (a) (32)
Interest revenue 20 20
Total revenue 592 430 320 210 (132) 1,420
Costs and expenses:
Cost of goods sold 375 320 210 130 (b) (10) 1,025
Intercompany cost of goods
sold 32 24 16 8 (b) (80)
Operating expenses 133 60 40 50 283
Interest expense 6 9 7 22
Income taxes expense 15 12 27 9 (b) (6) 57
Total costs and expenses 555 422 302 204 (96) 1,387
Net income (and retained
earnings) 37 8 18 6 (36) 33

Balance Sheet
Assets
Short-term investments (trading) 80 80
Inventories 500 600 700 800 (b) (10) 2,590
Other current assets 700 800 600 500 2,600
Deferred income tax asset (b) 6 6
Intercompany receivables
(payables) 80 (60) 50 (70)
Investments in subsidiaries’
common stock 4,532 (a) (4,532)
Plant assets (net) 800 900 700 600 3,000
Intangible assets (net) 40 60 50 70 220
Total assets 6,732 2,300 2,100 1,900 (4,536) 8,496
(continued)
 Chapter 13 Reporting for Components; Interim Reports; Reporting for the SEC 605

PRINCIPIA CORPORATION AND SUBSIDIARIES

Working Paper for Consolidated Financial Statements (Concluded)
For Year Ended December 31, 2006
(000 omitted)

Eliminations
Principia Seattle Boston London Increase
Corporation Company Company Company* (Decrease) Consolidated
Liabilities and Stockholders’
Equity
Current liabilities 945 692 432 227 2,296
6% bonds payable 100 150 167 417
Common stock, $1 par 3,000 1,500 1,500 1,500 (a) (4,500) 3,000
Additional paid-in capital 2,750 2,750
Retained earnings 37 8 18 6 (36) 33
Total liabilities and
stockholders’ equity 6,732 2,300 2,100 1,900 (4,536) 8,496

Explanation of eliminations:
(a) To eliminate intercompany investments and related equity accounts of subsidiaries.
(b) To eliminate intercompany sales, cost of goods sold, and unrealized profits in inventories, and to defer income taxes applicable to unrealized profits.
*Amounts remeasured to U.S. dollars, London’s functional currency, from British pounds.

(Problem 13.7) This problem consists of three unrelated parts.

CHECK FIGURES a. For the fiscal year ended April 30, 2006, Lobeck Company had a net income of
a. Income from $600,000. Lobeck’s income tax rate is 40%, and there were no permanent differences or
continuing operations, temporary differences between pretax financial income and taxable income.
$702,000; b. Dec. 31,
On February 28, 2006, in accordance with a decision of Lobeck’s board of directors
debit income taxes
on December 31, 2005, Lobeck disposed of the net assets of its Texas Division, an op-
expense, $60,900.
erating segment, for a pretax loss of $50,000. The $120,000 pretax operating loss of
Texas Division for the 10 months ended February 28, 2006, was incurred as follows:

Eight months ended Dec. 31, 2005 $ 80,000

Two months ended Feb. 28, 2006 40,000
Total pretax operating loss $120,000

Instructions
Prepare the bottom portion of Lobeck Company’s income statement for the year ended
April 30, 2006, beginning with “Income from continuing operations before income taxes.”
Disregard basic earnings per share of common stock.
b. For the fiscal year ended December 31, 2006, Spratt Company had the following:

Pretax Financial Income Estimated Effective

Quarter Ended (and Taxable Income) Income Tax Rate for 2006
Mar. 31, 2006 $100,000 45%
June 30, 2006 120,000 46%
Sept. 30, 2006 140,000 44%
Dec. 31, 2006 150,000 43%
606 Part Three International Accounting: Reporting of Segments, for Interim Periods, and to the SEC

Instructions
Prepare journal entries for Spratt Company’s income taxes expense on March 31, June 30,
September 30, and December 31, 2006. Omit explanations for the journal entries.
c. During the three months ended March 31, 2006, the third quarter of its fiscal year ended
June 30, 2006, Jackson Company temporarily depleted its base layer of last-in, first-out
inventories having a lifo cost of $120,000 and a replacement cost on March 31, 2006, of
$210,000. On April 30, 2006, Jackson purchased replacement merchandise with a cost
of $370,000, on open account.
Instructions
Prepare journal entries for Jackson Company on March 31 and April 30, 2006, for the fore-
going business transactions and events. Omit explanations for the journal entries.
Chapter Fourteen

Bankruptcy:
Liquidation and
Reorganization

Scope of Chapter
Business failures are a common occurrence in the U.S. economy. Poor management, ex-
cessive debt, and inadequate accounting are the most commonly cited causes of business
failures. The situation that precedes the typical business failure is inability of a business
enterprise to pay liabilities as they become due. Unsecured creditors often resort to law-
suits to satisfy their unpaid claims against a business enterprise. Secured creditors may
force foreclosure proceedings for real property or may repossess personal property that
collateralizes a security agreement. The Internal Revenue Service may seize the assets
of a business enterprise that has failed to pay FICA and income taxes withheld from its
employees.
A business enterprise may be unable to pay its liabilities as they become due even
though the current fair values of its assets exceed its liabilities. For example, an enterprise
may experience a severe cash shortage in times of price inflation because of the lag between
the purchase or production of goods at inflated costs and the recovery of the inflated costs
through increased selling prices.
More typical of the failing business enterprise than the conditions described in the fore-
going paragraph is the state of insolvency. Insolvent is defined in the Bankruptcy Code as
follows:
“insolvent” means—
(A) with reference to an entity other than a partnership and a municipality, financial condi-
tion such that the sum of such entity’s debts is greater than all of such entity’s property, at a
fair valuation, exclusive of—
(i) property transferred, concealed, or removed with intent to hinder, delay, or defraud such
entity’s creditors; and
(ii) property that may be exempted from property of the estate under . . . this title; and
(B) with reference to a partnership, financial condition such that the sum of such partner-
ship’s debts is greater than the aggregate of, at a fair valuation—
(i) all of such partnership’s property, exclusive of property of the kind specified in subpara-
graph (A) (i) of this paragraph; and

607
608 Part Four Accounting for Fiduciaries

(ii) the sum of the excess of the value of each general partner’s nonpartnership property, ex-
clusive of property of the kind specified in subparagraph (A) (ii) of this paragraph, over
such partner’s nonpartnership debts;1

The terms insolvent and bankrupt often are used as interchangeable adjectives. Such
usage is technically incorrect; insolvent refers to the financial condition of a person or
business enterprise, and bankrupt refers to a legal state. In this chapter, various legal and
accounting issues associated with bankruptcy liquidations and reorganizations are dis-
cussed and illustrated.

THE BANKRUPTCY CODE

The U.S. Constitution (Article 1, Section 8) authorizes Congress to establish uniform laws
on the subject of bankruptcies throughout the United States. For the first 89 years under the
Constitution, the United States had a national bankruptcy law for a total of only 16 years.
During the periods in which national bankruptcy laws were not in effect, state laws on in-
solvency prevailed. In 1898 a Bankruptcy Act was enacted that, as amended, remained in
effect for 80 years. Enactment of the Bankruptcy Act caused state laws on insolvency to be
relatively dormant. In 1978 the Bankruptcy Reform Act established the present Bankruptcy
Code; in 1980 the Bankruptcy Tax Act established a uniform group of income tax rules for
bankruptcy and insolvency; and in 1994 the Bankruptcy Code was amended by the Bank-
ruptcy Reform Act of 1994.
The U.S. Supreme Court may prescribe by general rules the various legal practices and
procedures under the Bankruptcy Code. Thus, the Federal Rules of Bankruptcy Procedure
established by the Supreme Court constitute important interpretations of provisions of the
Bankruptcy Code.

BANKRUPTCY LIQUIDATION
The process of bankruptcy liquidation under Chapter 7 of the Bankruptcy Code involves
the realization (sale) of the assets of an individual or a business enterprise and the distrib-
ution of the cash proceeds to the creditors of the individual or enterprise. Creditors having
security interests collateralized by specific assets of the debtor generally are entitled to ob-
tain satisfaction of all or part of their claims from the assets pledged as collateral. The
Bankruptcy Code provides for priority treatment for certain unsecured creditors; their
claims are satisfied in full, if possible, from proceeds of realization of the debtor’s noncol-
lateralized assets. Unsecured creditors without priority receive cash, in proportion to the
amounts of their claims, from proceeds available from the realization of the debtor’s assets.
Thus, there are four classes of creditors in a bankruptcy liquidation: fully secured creditors,
partially secured creditors, unsecured creditors with priority, and unsecured creditors
without priority.

Debtor’s (Voluntary) Petition

The Bankruptcy Code provides that any “person,” except certain entities such as a rail-
road, an insurance company, a bank, a credit union, or a savings and loan association,

1
Bankruptcy Code, sec. 101 (32).
 Chapter 14 Bankruptcy: Liquidation and Reorganization 609

may file a petition in a federal bankruptcy court for voluntary liquidation under Chapter 7
of the Code. The official form for a debtor’s bankruptcy petition, also known as a vol-
untary petition, must be accompanied by supporting exhibits of the petitioner’s debts and
property. The debts are classified as follows: (1) creditors having priority; (2) creditors
holding security; and (3) creditors having unsecured claims without priority. The debtor’s
property is reported as follows: real property, personal property, and property claimed as
exempt. Valuations of property are at market or current fair values. Also accompanying
the debtor’s bankruptcy petition is a statement of financial affairs (not to be confused
with the accounting statement of affairs illustrated on page 614 of this chapter), which
contains a series of questions concerning all aspects of the debtor’s financial condition
and operations.

Creditors’ (Involuntary) Petition

If a debtor other than a farmer, a nonprofit organization, or one of the types precluded
from filing voluntary petitions owes unpaid amounts to 12 or more unsecured creditors
who are not employees, relatives, stockholders, or other “insiders,” three or more of the
creditors having unsecured claims totaling $10,000 or more may file in a federal bank-
ruptcy court a creditors’ petition for bankruptcy, also known as an involuntary petition.
If fewer than 12 creditors are involved, one or more creditors having unsecured claims of
$10,000 or more may file the petition. The creditors’ petition for bankruptcy must claim
either (1) the debtor is not paying debts as they come due or (2) within 120 days prior to
the date of the petition, a custodian was appointed for or had taken possession of the
debtor’s property.

Unsecured Creditors with Priority

The Bankruptcy Code provides that the following unsecured debts are to be paid in full, in
the order specified if adequate cash is not available for all, out of a debtor’s estate before
any cash is paid to other unsecured creditors:
1. Administrative costs.
2. Claims arising in the course of the debtor’s business or financial affairs after the com-
mencement of a creditors’ bankruptcy proceeding but before appointment of a trustee or
order for relief.
3. Claims for wages, salaries, and commissions, including vacation, severance, and sick
leave pay not in excess of $4,000 per claimant, earned within 90 days before the date of
filing the petition for bankruptcy or cessation of the debtor’s business.
4. Claims for contributions to employee benefit plans arising within 180 days
before the date of filing the petition for bankruptcy or cessation of the debtor’s busi-
ness. The limit of such claims is $4,000 times the number of employees covered by
the plans, less the aggregate amount paid to the covered employees under priority
3 above.
5. Claims by producers of grain against a grain storage facility or by fishermen against a
fish storage or processing facility, not in excess of $4,000 per claimant.
6. Claims for cash deposited for goods or services for the personal, family, or household
use of the depositor, not in excess of $1,800 per claimant.
7. Claims for alimony, maintenance, or support of a spouse, former spouse, or child of the
debtor, under a separation agreement, divorce decree, or court order.
8. Claims of governmental entities for various taxes or duties, subject to varying time
limitations.
610 Part Four Accounting for Fiduciaries

Property Claimed as Exempt

Certain property of a bankruptcy petitioner is not includable in the debtor’s estate. The
Bankruptcy Code excludes from coverage of the Code the various allowances provided in
the laws of either the United States or the state of the debtor’s residence, whichever is more
beneficial to the debtor. Typical of these allowances are residential property exemptions
provided by homestead laws and exemptions for life insurance policies payable on death to
the spouse or a relative of the debtor. (Bills introduced in Congress in 2001 would modify
these allowances.)

Role of Court in Liquidation

The federal bankruptcy court in which a debtor’s or creditors’ petition for bankruptcy liq-
uidation is filed oversees all aspects of the bankruptcy proceedings.
One of the first acts of the court is either to dismiss the debtor’s or creditors’ bank-
ruptcy petition or to grant an order for relief under the Bankruptcy Code. The filing
of a debtor’s petition in bankruptcy is in effect an order for relief; in a creditors’ petition,
order for relief is made by the court after a hearing at which the debtor may attempt
to refute the creditors’ allegations that the debtor was not paying debts as they came
due. Any suits that are pending against a debtor for whom a debtor’s or creditors’ bank-
ruptcy petition is filed generally are stayed until order for relief or dismissal of the
petition; after order for relief such suits are further stayed until the question of the
debtor’s discharge is determined by the court. Further, the court appoints an interim
trustee after the order for relief, to serve permanently or until a trustee is elected by
the creditors.

Role of Creditors
Within a period of 10 to 30 days after an order for relief, the bankruptcy court must call a
meeting of the creditors. At the meeting, the “outsider” creditors appoint a trustee to man-
age the debtor’s estate. A majority vote in number and amount of claims of all unsecured
and nonpriority creditors present is required for actions by creditors.

Role of Trustee
The trustee elected by the creditors or appointed by the court assumes custody of the debtor’s
nonexempt property. The principal duties of the trustee are to continue operating the debtor’s
business if directed by the court, realize the free assets of the debtor’s estate, and pay cash to
unsecured creditors. The trustee is responsible for keeping accounting records to enable the
filing of a final report with the bankruptcy court.
The Bankruptcy Code empowers the trustee to invalidate a preference, defined as the
transfer of cash or property to an “outsider” creditor for an existing debt, made while the
debtor was insolvent and within 90 days of filing of the bankruptcy petition, provided
the transfer caused the creditor to receive more cash or property than would be received in
the bankruptcy liquidation. The trustee may recover from the creditor the cash or property
constituting the preference and include it in the debtor’s estate.

Discharge of Debtor
Once the debtor’s property has been liquidated, all secured and priority creditor claims have
been paid, and all remaining cash has been paid to unsecured, nonpriority creditors, the
 Chapter 14 Bankruptcy: Liquidation and Reorganization 611

debtor may receive a discharge, defined as the release of the debtor from all unliquidated
debts except debts such as the following:
1. Taxes payable by the debtor to the United States or to any state or subdivision, including
taxes attributable to improper preparation of tax returns by the debtor.
2. Debts resulting from the debtor’s obtaining money or property under false pretenses or
representations, or willful conversion of the property of others.
3. Debts not scheduled by the debtor in support of the bankruptcy petition, such creditors
not being informed of the bankruptcy proceedings.
4. Debts arising from embezzlement or other fraudulent acts by the debtor acting in a fidu-
ciary capacity.
5. Amounts payable for alimony, maintenance, or child support.
6. Debts for willful and malicious injuries to the persons or property of others.
7. Debts for fines, penalties, or forfeitures payable to governmental entities, other than for
tax penalties.
8. With certain exceptions, debts for educational loans made, insured, or guaranteed by
governmental entities or by nonprofit universities or colleges. (In 1997, a National Bank-
ruptcy Review Commission recommended discharge of educational loans other than for
medical schools.)
A debtor will not be discharged if any crimes, misstatements, or other malicious acts
were committed by the debtor in connection with the court proceedings. In addition, a
debtor will not be discharged if the current bankruptcy petition was filed within six years
of a previous bankruptcy discharge to the same debtor.

Role of Accountant in Bankruptcy Liquidation

The accountant’s role in liquidation proceedings is concerned with proper reporting of the
financial condition of the debtor and adequate accounting and reporting for the trustee for
the debtor’s estate, as described in the following sections.

Financial Condition of Debtor Enterprise:

The Statement of Affairs
A business enterprise that enters bankruptcy liquidation proceedings is a quitting concern,
not a going concern. Consequently, a balance sheet, which reports the financial position of
a going concern, is inappropriate for an enterprise in liquidation.
The financial statement designed for a business enterprise entering liquidation is the
statement of affairs (not to be confused with the legal bankruptcy form with a similar title
described on page 609). The purpose of the statement of affairs is to display the assets and
liabilities of the debtor enterprise from a liquidation viewpoint, because liquidation is the
outcome of the Chapter 7 bankruptcy proceedings. Thus, assets displayed in the statement
of affairs are valued at current fair values; carrying amounts of the assets are presented on
a memorandum basis. In addition, assets and liabilities in the statement of affairs are clas-
sified according to the rankings and priorities set forth in the Bankruptcy Code; the cur-
rent/noncurrent classification used in a balance sheet for a going concern is not appropriate
for the statement of affairs.

Illustration of Statement of Affairs

The balance sheet of Sanders Company on June 30, 2006, the date that Sanders filed a
debtor’s (voluntary) bankruptcy petition, is as follows:
612 Part Four Accounting for Fiduciaries

SANDERS COMPANY
Balance Sheet
(prior to filing of debtor’s bankruptcy petition)
June 30, 2006

Assets
Current assets:
Cash $ 2,700
Notes receivable and accrued interest, less allowance
for doubtful notes, $6,000 13,300
Trade accounts receivable, less allowance for
doubtful accounts, $23,240 16,110
Inventories, at first-in, first-out cost:
Finished goods 12,000
Goods in process 35,100
Material 19,600
Factory supplies 6,450
Short-term prepayments 950
Total current assets $106,210
Plant assets, at cost:
Land $ 20,000
Buildings (net) 41,250
Machinery (net) 48,800
Tools (net) 14,700
Net plant assets 124,750
Total assets $230,960

Liabilities and Stockholders’ Equity

Current liabilities:
Notes payable:
Pacific National Bank, including accrued interest
(due June 30, 2007) $ 15,300
Suppliers, including accrued interest
(due May 31, 2007) 51,250
Trade accounts payable 52,000
Salaries and wages payable 8,850
Property taxes payable 2,900
Interest payable on first mortgage bonds 1,800
FICA and income taxes withheld and accrued 1,750
Total current liabilities $133,850
First mortgage bonds payable 90,000
Total liabilities $223,850
Stockholders’ equity:
Common stock, $100 par; 750 shares
authorized, issued, and outstanding $ 75,000
Deficit (67,890) 7,110
Total liabilities and stockholders’ equity $230,960
 Chapter 14 Bankruptcy: Liquidation and Reorganization 613

Other information available from notes to financial statements and from estimates of
current fair values of assets follows:
1. Notes receivable with a face amount plus accrued interest totaling $15,300, and a cur-
rent fair value of $13,300, collateralize the notes payable to Pacific National Bank.
2. Finished goods are expected to be sold at a markup of 331⁄3% over cost, with disposal
costs estimated at 20% of selling prices. Estimated cost to complete goods in process
is $15,400, of which $3,700 would be cost of material and factory supplies used. The
estimated selling price of goods in process when completed is $40,000, with disposal
costs estimated at 20% of selling prices. Estimated current fair values for material and
factory supplies not required to complete goods in process are $8,000 and $1,000, re-
spectively. All short-term prepayments are expected to be consumed in the course of
liquidation.
3. Land and buildings, which collateralize the first mortgage bonds payable, have a current
fair value of $95,000. Machinery with a carrying amount of $18,200 and current fair
value of $10,000 collateralizes notes payable to suppliers in the amount of $12,000, in-
cluding accrued interest. The current fair value of the remaining machinery is $9,000,
net of disposal costs of $1,000, and the current fair value of tools after the amounts used
to complete the goods in process inventory is $3,255.
4. Salaries and wages payable are debts having priority under the Bankruptcy Code.
5. Costs of administering the bankruptcy liquidation are estimated at $1,905.

The statement of affairs for Sanders Company on June 30, 2006, is as shown on
page 614.
The following points should be stressed in the review of the June 30, 2006, statement of
affairs for Sanders Company:
1. The “Carrying Amount” columns in the statement of affairs serve as a tie-in to the bal-
ance sheet of Sanders on June 30, 2006, as well as a basis for estimating expected losses
or gains on realization of assets.
2. Assets are assigned to one of three groups: pledged for fully secured liabilities, pledged
for partially secured liabilities, and free. This grouping of assets facilitates the compu-
tation of estimated amounts available for unsecured creditors—those with priority and
those without priority.
3. Liabilities are grouped in the categories reported by a debtor in the exhibits supporting
a debtor’s bankruptcy petition (see pages 608–609): unsecured with priority, fully se-
cured, partially secured, and unsecured without priority.
4. An offset technique used where the legal right of setoff exists. For example, amounts
due to fully secured creditors are deducted from the estimated current fair value of
the assets serving as collateral; and unsecured liabilities with priority are deducted
from estimated amounts available to unsecured creditors from the proceeds of free asset
realization.
5. An estimated settlement per dollar of unsecured liabilities without priority is computed
by dividing the estimated amount available for unsecured, nonpriority creditors by the
total unsecured liabilities, thus:

$60,960
64 cents on the dollar
$95,250

This computation enables the bankruptcy trustee to estimate the amount of cash that will
be available to unsecured, nonpriority creditors in a liquidation proceeding.
 614

SANDERS COMPANY
Statement of Affairs
June 30, 2006

Current Estimated Loss or

Carrying Fair Amount (Gain) on Carrying Amount
Amounts Assets Values Available Realization Amounts Liabilities and Stockholders’ Equity Unsecured
Assets Pledged for Fully Unsecured Liabilities with Priority:
Secured Liabilities: Estimated administrative costs $ 1,905
$ 20,000 Land f$ 95,000 $(33,750) $ 8,850 Salaries and wages payable 8,850
41,250 Buildings 2,900 Property taxes payable 2,900
Less: Fully secured liabilities 1,750 FICA and income taxes withheld and accrued 1,750
Part Four Accounting for Fiduciaries

(contra) 91,800 $ 3,200 Total (deducted contra) $15,405

Assets Pledged for Partially Fully Secured Liabilities:
Secured Liabilities: 90,000 First mortgage bonds payable $90,000
13,300 Notes and interest receivable 1,800 Accrued interest on first mortgage bonds
(deducted contra) $ 13,300 payable 1,800
18,200 Machinery (deducted contra) $ 10,000 8,200 Total (deducted contra) $91,800
Free Assets: Partially Secured Liabilities:
2,700 Cash $ 2,700 2,700 15,300 Notes and accrued interest payable to Pacific
16,110 Trade accounts receivable 16,110 16,110 National Bank $15,300
Inventories: Less: Net realizable value of notes receivable
12,000 Finished goods 12,800 12,800 (800) pledged as collateral (contra) 13,300 $ 2,000
35,100 Goods in process 20,300* 20,300* 14,800 12,000 Notes and accrued interest payable to
19,600 Material 8,000 8,000 11,600 suppliers $12,000
6,450 Factory supplies 1,000 1,000 5,450 Less: Estimated realizable value of machinery
950 Short-term prepayments -0- -0- 950 pledged as collateral (contra) 10,000 2,000
30,600 Machinery 9,000 9,000 21,600
14,700 Tools 3,255 3,255 11,445 Unsecured Liabilities without Priority:
Total estimated amount available $76,365 $ 39,495 39,250 Notes payable to suppliers 39,250
Less: Unsecured liabilities with priority (contra) 15,405 52,000 Trade accounts payable 52,000
Estimated amount available for unsecured, 7,110 Stockholders’ equity
nonpriority creditors (64¢ on the dollar) $60,960
Estimated deficiency to unsecured, nonpriority
creditors (36¢ on the dollar) 34,290
$230,960 $95,250 $ 230,960 $95,250

*Estimated selling price $ 40,000

Less: Estimated “out-of-pocket” completion costs ($15,400 $3,700) (11,700)
Estimated disposal costs ($40,000 0.20) (8,000)
Net realizable value $ 20,300
 Chapter 14 Bankruptcy: Liquidation and Reorganization 615

Estimated Amounts to Be Recovered by Each

Class of Creditors
By reference to the statement of affairs on page 614, the accountant for the trustee in bank-
ruptcy for Sanders Company may prepare the summary of estimated amounts to be recov-
ered by each class of Sanders’s creditors shown below:

SANDERS COMPANY
Estimated Amounts to Be Recovered by Creditors
June 30, 2006

Estimated
Class of Creditors Total Claims Computation Recovery
Unsecured with priority $ 15,405 100% $ 15,405
Fully secured 91,800 100% 91,800
Partially secured 27,300 $23,300 ($4,000 0.64) 25,860
Unsecured without priority 91,250 64% 58,400
Totals $225,755* $191,465†

*$15,405 $91,800 $15,300 $12,000 $39,250 $52,000 $225,755.

†$95,000 $13,300 $10,000 ($76,365 $3,200) $191,465.

Accounting and Reporting for Trustee

Traditionally, the accounting records and reports for trustees have been extremely detailed
and elaborate. However, the provisions of the applicable Federal Rule of Bankruptcy Pro-
cedure are general. Therefore, simple accounting records and reports such as the following
should be adequate.
1. The accounting records of the debtor should be used during the period that a trustee car-
ries on the operations of the debtor’s business.
2. An accountability technique should be used once the trustee begins realization of the
debtor’s assets. In the accountability method of accounting, the assets and liabilities for
which the trustee is responsible are entered in the accounting records of the trustee at
their statement of affairs valuations, with a balancing debit to a memorandum-type
ledger account with a title such as Estate Deficit. The amount of the debit to Estate
Deficit is equal to the estimated deficiency to unsecured creditors reported in the state-
ment of affairs. Appropriate cash receipts and cash payments journal entries are made
for the trustee’s realization of assets and payment of liabilities. No “gain” or “loss”
ledger account is necessary because a business enterprise in liquidation does not require
an income statement. Differences between cash amounts realized or paid and carrying
amounts of the related assets or liabilities are debited or credited to the Estate Deficit
ledger account.
3. The interim and final reports of the trustee to the bankruptcy court are a statement of
cash receipts and cash payments, a statement of realization and liquidation, and, for
interim reports, supporting exhibits of assets not yet realized and liabilities not yet
liquidated.

Illustration of Accountability Technique

Assume that Arline Wells, the trustee in the voluntary bankruptcy liquidation pro-
ceedings for Sanders Company (see page 612), took custody of the assets of Sanders on
616 Part Four Accounting for Fiduciaries

June 30, 2006. The accountant for the trustee prepared the following journal entry on
June 30, 2006.

Journal Entry for SANDERS COMPANY, IN BANKRUPTCY

Bankruptcy Trustee Arline Wells, Trustee
Journal Entry
June 30, 2006

Cash 2,700
Notes and Interest Receivable 13,300
Trade Accounts Receivable 16,110
Finished Goods Inventory 12,800
Goods in Process Inventory 20,300
Material Inventory 8,000
Factory Supplies 1,000
Land and Buildings 95,000
Machinery ($10,000 $9,000) 19,000
Tools 3,255
Estate Deficit 34,290 (1)
Estimated Administrative Costs 1,905
Notes and Interest Payable ($15,300 $12,000 $39,250) 66,550
Trade Accounts Payable 52,000
Salaries and Wages Payable 8,850
Property Taxes Payable 2,900
FICA and Income Taxes Withheld and Accrued 1,750
Interest Payable on First Mortgage Bonds 1,800
First Mortgage Bonds Payable 90,000
To record current fair values of assets and liabilities of Sanders Company,
in bankruptcy liquidation proceedings.

(1) Equal to estimated deficiency to unsecured, nonpriority creditors in the statement of affairs on page 614.

When the trustee realizes assets of Sanders, the appropriate journal entry is a debit
to Cash, credits to the asset ledger accounts, and a debit or credit to the Estate Deficit ac-
count for a loss or gain on realization, respectively. Costs of administering the estate that
exceed the $1,905 liability also are debited to the Estate Deficit ledger account.

Statement of Realization and Liquidation

The traditional statement of realization and liquidation was a complex and not too readable
accounting presentation. A form of realization and liquidation statement that should be
more useful to the bankruptcy court than the traditional statement is as follows. This finan-
cial statement is based on the assumed activities of the trustee for the estate of Sanders
Company during the month of July 2006, including operating the business long enough to
complete and sell the goods in process inventory.
 Chapter 14 Bankruptcy: Liquidation and Reorganization 617

Interim Statement of SANDERS COMPANY, IN BANKRUPTCY

Realization and Arline Wells, Trustee
Liquidation for Trustee Statement of Realization and Liquidation
in Bankruptcy For Month Ended July 31, 2006
Liquidation
Estate deficit, June 30, 2006 $34,290
Assets realized:

Current Fair
Values, Realization Loss or
June 30, 2006 Proceeds (Gain)
Trade accounts receivable $14,620 $12,807 $ 1,813
Finished goods inventory 12,800 11,772 1,028
Goods in process inventory 14,820 15,075 (255)
Totals $42,240 $39,654 2,586
Liabilities with priority liquidated
at carrying amounts:
Salaries and wages payable $ 8,850
Property taxes payable 2,900
FICA and income taxes
withheld and accrued 1,750
Total liabilities with priority
liquidated $13,500
Administrative costs paid, $1,867
($1,905 had been estimated) (38)
Estate deficit, July 31, 2006 $36,838

An accompanying statement of cash receipts and cash payments for the month ended
July 31, 2006, would show the sources of the $39,654 total realization proceeds, and the
dates, check numbers, payees, and amounts of the $13,500 paid for liabilities with priority
and the $1,867 paid for administrative costs. Supporting exhibits would summarize assets
not yet realized and liabilities not yet paid.
Liquidation involves realization of the assets of the debtor’s estate. In many cases, an in-
solvent debtor may be restored to a sound financial footing if it can defer payment of its
debts. Chapter 11 of the Bankruptcy Code, dealing with reorganization, enables a debtor to
continue operations under court protection from creditor lawsuits while it formulates a plan
to pay its debts. Reorganization is discussed in the next section.

BANKRUPTCY REORGANIZATION
Chapter 11 of the Bankruptcy Code provides for the court-supervised reorganization of a
debtor business enterprise. Typically, a reorganization involves the reduction of amounts
payable to some creditors, other creditors’ acceptance of equity securities of the debtor for
their claims, and a revision of the par or stated value of the common stock of the debtor.
A debtor’s (voluntary) petition for reorganization may be filed by a railroad or by any
“person” eligible to petition for liquidation (see pages 608–609) except a stockbroker or a
commodity broker. Requirements for a creditors’ (involuntary) petition for reorganization
are the same as the requirements for a liquidation petition (see page 609).
618 Part Four Accounting for Fiduciaries

Appointment of Trustee or Examiner

During the process of reorganization, management or owners of the business enterprise
may continue to operate the enterprise as debtor in possession. Alternatively, the bank-
ruptcy court may appoint a trustee to manage the enterprise. A trustee is appointed because
of fraud, dishonesty, incompetence, or gross mismanagement by current owners or man-
agers, or to protect the interests of creditors or stockholders of the enterprise. In some re-
organization cases not involving a trustee, the court may appoint an examiner to investigate
possible fraud or mismanagement by the current managers or owners of the enterprise; the
appointment of an examiner is limited to enterprises having unsecured liabilities, other than
payables for goods, services, or taxes, exceeding $5 million.
Among the powers and duties of the trustee are the following:
1. Prepare and file in court a list of creditors of each class and their claims and a list of
stockholders of each class.
2. Investigate the acts, conduct, property, liabilities, and business operations of the enter-
prise, consider the desirability of continuing operations, and formulate a plan for such
continuance for submission to the bankruptcy judge if management of the debtor has not
done so.
3. Report to the bankruptcy judge any facts ascertained as to fraud against or mismanage-
ment of the debtor enterprise.

Plan of Reorganization
The plan of reorganization submitted by the management or the trustee to the bank-
ruptcy court is given to the debtor enterprise’s creditors and stockholders, to the U.S.
Secretary of the Treasury, and possibly to the SEC. The plan must include provisions
altering or modifying the interests and rights of the creditors and stockholders of the
debtor enterprise, as well as a number of additional provisions. The SEC may review
the plan and may be heard in the bankruptcy court’s consideration of the plan. Before
a plan of reorganization is confirmed by the bankruptcy court, the plan must be ac-
cepted by a majority of the creditors, whose claims must account for two-thirds of the
total liabilities, and by stockholders owning at least two-thirds of the outstanding capi-
tal stock of each class. If one or more classes of stockholders or creditors has not
accepted a plan, the bankruptcy court may confirm the plan if the plan is fair and
equitable to the nonacceptors. Confirmation of the plan of reorganization by the bank-
ruptcy court makes the plan binding on the debtor enterprise, on all creditors and own-
ers of the enterprise, and on any other enterprise issuing securities or acquiring property
under the plan.

Accounting for a Reorganization

The accounting for a reorganization typically requires journal entries for adjustments
of carrying amounts of assets; reductions of par or stated value of capital stock (with
recognition of resultant paid-in capital in excess of par or stated value); extensions of due
dates and revisions of interest rates of notes payable; exchanges of equity securities for
debt securities; and the elimination of a retained earnings deficit. The latter entry is as-
sociated with fresh start reporting for a reorganized enterprise whose liabilities exceed
the reorganization value (essentially current fair value) of its assets.2 Because of

2
Statement of Position 90-7, “Financial Reporting by Entities in Reorganization under the Bankruptcy
Code” (New York: AICPA, 1990), par. 36.
 Chapter 14 Bankruptcy: Liquidation and Reorganization 619

changes in the ownership of common stock of such an enterprise as a result of the reor-
ganization, it is no longer controlled by its former stockholder group, and it essentially is
a new reporting enterprise whose assets and liabilities should be valued at current fair
values and whose stockholders’ equity consists only of paid-in capital.3
It is important for accountants to be thoroughly familiar with the plan of reorganiza-
tion, in order to account properly for its implementation. Accountants must be careful
to avoid charging post-reorganization operations with losses that arose before the reor-
ganization.
To illustrate the accounting for a reorganization, assume that Sanders Company (see
pages 611–615) filed a petition for reorganization, rather than for liquidation, on June 30,
2006, with Sanders management as debtor in possession. The plan of reorganization, which
was approved by stockholders and all unsecured creditors and confirmed by the bankruptcy
court, included the following:
1. Deposit $25,000 with escrow agent, as soon as cash becomes available, to cover liabili-
ties with priority and costs of reorganization proceedings.
2. Amend articles of incorporation to provide for 10,000 shares of authorized common
stock of $1 par. The new common stock is to be exchanged on a share-for-share basis for
the 750 shares of outstanding $100 par common stock.
3. Extend due date of unsecured notes payable to suppliers totaling $15,250 for four years,
until May 31, 2011. Increase the interest rate on the notes from the stated rate of 14% to
18%, the current fair rate of interest.
4. Exchange 1,600 shares of new $1 par common stock (at current fair value of $15 a
share) for unsecured notes payable to suppliers totaling $24,000.
5. Pay suppliers 70 cents per dollar of trade accounts payable owed.
The journal entries below and on page 620, numbered to correspond with the provisions
of the reorganization plan outlined above, were recorded by Sanders Company as cash be-
came available from operations. Assuming that fresh start reporting is appropriate for
Sanders Company after the plan of reorganization has been carried out, the last journal
entry on page 620 is appropriate for eliminating the $67,890 retained earnings deficit of
Sanders on June 30, 2006.

Journal Entries for SANDERS COMPANY

Bankruptcy Journal Entries
Reorganization
(1) Cash with Escrow Agent 25,000
Cash 25,000
To record deposit of cash with escrow agent under terms of bankruptcy
reorganization.
Salaries and Wages Payable 8,850
Property Taxes Payable 2,900
FICA and Income Taxes Withheld and Accrued 1,750
Cash with Escrow Agent 13,500
To record escrow agent’s payment of liabilities with priority.

(continued)

3
Ibid., par. 39.
620 Part Four Accounting for Fiduciaries

SANDERS COMPANY
Journal Entries (concluded)

Costs of Bankruptcy Proceedings 11,000

Cash with Escrow Agent 11,000
To record escrow agent’s payment of costs of bankruptcy proceedings.
(2) Common Stock, $100 par 75,000
Common Stock, $1 par 750
Paid-in Capital in Excess of Par 74,250
To record issuance of 750 shares of $1 par common stock in exchange
for 750 shares of $100 par common stock.
(3) 14% Notes Payable to Suppliers, due May 31, 2007 15,250
18% Notes Payable to Suppliers, due May 31, 2011 15,250
To record extension of due dates of notes payable to suppliers and
increase of interest rate to 18% from 14%.
(4) Notes Payable to Suppliers 24,000
Common Stock, $1 par 1,600
Paid-in Capital in Excess of Par 22,400
To record exchange of 1,600 shares of $1 par common stock
for $24,000 face amount of notes payable, at current fair value
of $15 a share.
(5) Trade Accounts Payable 52,000
Cash 36,400
Gain from Discharge of Indebtedness in Bankruptcy 15,600
To record payment of $0.70 per dollar of accounts payable to suppliers.

Journal Entry to Paid-in Capital in Excess of Par 63,290

Eliminate Deficit Gain from Discharge of Indebtedness in Bankruptcy 15,600
Costs of Bankruptcy Proceedings 11,000
Retained Earnings 67,890
To eliminate deficit on June 30, 2006, and close bankruptcy
gain and costs to Paid-in Capital in Excess of Par ledger account.

The effect of the foregoing journal entries is to show a “clean slate” for Sanders Com-
pany as a result of the approved bankruptcy reorganization and the write-off of the retained
earnings deficit existing on the date of the petition for reorganization. The extension of due
dates of some liabilities, conversion of other liabilities to common stock, and liquidation of
trade accounts payable at less than their face amount should enable Sanders to resume op-
erations as a going concern. For a reasonable number of years following the reorganization,
Sanders might “date” the retained earnings in its balance sheets to disclose that the earn-
ings were accumulated after the reorganization.

Disclosure of Reorganization
The elaborate and often complex issues involved in a bankruptcy reorganization are dis-
closed in a note to the financial statements for the period in which the plan of reorganiza-
tion was carried out. Examples of recent such disclosures are included in the AICPA’s 1994
publication Illustrations of Financial Reporting by Entities in Reorganization under the
 Chapter 14 Bankruptcy: Liquidation and Reorganization 621

Bankruptcy Code. In addition, the Summary of Significant Accounting Policies note to fi-

nancial statements of a reorganized enterprise might include disclosures such as the fol-
lowing for Wang Laboratories, Inc., a publicly owned enterprise:
Bankruptcy-Related Accounting
The Company has accounted for all transactions related to the Chapter 11 case in accordance
with Statement of Position 90-7 (“SOP 90-7”), “Financial Reporting by Entities in Reorgani-
zation under the Bankruptcy Code,” which was issued by the American Institute of Certified
Public Accountants in November 1990. Accordingly, liabilities subject to compromise under
the Chapter 11 case have been segregated on the Consolidated Balance Sheet and are recorded
for the amounts that have been or are expected to be allowed on known claims rather than esti-
mates of the amounts those claims are to receive under the Reorganization Plan. In addition,
the Consolidated Statements of Operations and Consolidated Statements of Cash Flows for
the year ended June 30, 1993 separately disclose expenses and cash transactions, respectively,
related to the Chapter 11 case (see Note C, Reorganization and Restructuring). In accordance
with SOP 90-7, no interest has been accrued on pre-petition, unsecured debt. Additionally, in-
terest income earned by WLI subsequent to the filing of Chapter 11 is reported as a reduction
of reorganization items. The reorganized Company will account for the Reorganization Plan
utilizing the “Fresh-Start” reporting principles contained in SOP 90-7.4

Review 1. Define insolvency as that term is used in the Bankruptcy Code for an entity other than
Questions a partnership.
2. What are Federal Rules of Bankruptcy Procedure?
3. Identify the various classes of creditors whose claims are dealt with in bankruptcy
liquidations.
4. Describe the process of liquidation under Chapter 7 of the Bankruptcy Code.
5. Differentiate between a debtor’s petition and a creditors’ petition.
6. May any business enterprise file a debtor’s bankruptcy petition for liquidation?
Explain.
7. Who may file a creditors’ petition for bankruptcy liquidation?
8. What is a statement of financial affairs under the Bankruptcy Code?
9. List the unsecured debts having priority over other unsecured debts under the provi-
sions of the Bankruptcy Code.
10. Describe the priority of claims for wages and salaries under the Bankruptcy Code.
11. Describe the authority of a bankruptcy trustee with respect to a preference.
12. What are the effects of a discharge in bankruptcy liquidation proceedings? Explain.
13. What use is made of the accounting financial statement known as a statement of
affairs? Explain.
14. Describe the accountability method of accounting used by a trustee in a bankruptcy
liquidation.
15. For what types of bankruptcy reorganizations might an examiner be appointed by the
bankruptcy court?
16. What is the role of the Securities and Exchange Commission in a bankruptcy reorga-
nization?

4
AICPA, Accounting Trends & Techniques, 48th ed. (New York: 1994), p. 35.
622 Part Four Accounting for Fiduciaries

17. Must all classes of creditors accept a reorganization plan before the plan may be con-
firmed by the bankruptcy court? Explain.
18. What is fresh-start reporting for a business enterprise reorganized under Chapter 11
of the Bankruptcy Code, and under what circumstances is it appropriate?

Exercises
(Exercise 14.1) Select the best answer for each of the following multiple-choice questions:
1. A category of assets that typically has zero in the Estimated Amount Available column
of a statement of affairs is:
a. Factory supplies inventory
b. Tools
c. Short-term prepayments
d. None of the foregoing
2. In a bankruptcy proceeding, the term statement of affairs refers to:
a. A document containing a series of questions concerning all aspects of the debtor’s
financial condition and operations.
b. A financial statement prepared in lieu of a balance sheet.
c. Both a and b.
d. Neither a nor b.
3. The number of classes of creditors in a bankruptcy liquidation is:
a. Two
b. Three
c. Four
d. Five
4. The Paid-in Capital in Excess of Par ledger account of a debtor corporation undergo-
ing bankruptcy reorganization typically is debited or credited for:
a. Costs of bankruptcy proceedings.
b. Gain from discharge of indebtedness in bankruptcy.
c. Retained earnings deficit.
d. All the foregoing items.
e. None of the foregoing items.
5. The bankruptcy trustee for Insolvent Company sold assets having a carrying amount
of $10,000 for $8,500 cash. The journal entry (explanation omitted) to record the
sale is:
a. Cash 8,500
Loss on Realization of Assets 1,500
Assets 10,000
b. Cash 8,500
Estate Administration Expenses 1,500
Assets 10,000
c. Cash 8,500
Cost of Goods Sold 10,000
Sales 8,500
Assets 10,000
 Chapter 14 Bankruptcy: Liquidation and Reorganization 623

d. Cash 8,500
Estate Deficit 1,500
Assets 10,000
6. In a statement of affairs (financial statement), assets pledged for partially secured lia-
bilities are:
a. Included with assets pledged for fully secured liabilities.
b. Offset against partially secured liabilities.
c. Included with free assets.
d. Disregarded.
7. Regis Company is being liquidated in bankruptcy. Unsecured creditors without prior-
ity are expected to be paid 50 cents on the dollar. Sardo Company is the payee of a note
receivable from Regis in the amount of $50,000 (including accrued interest), which is
collateralized by machinery with a current fair value of $10,000. The total amount ex-
pected to be realized by Sardo on its note receivable from Regis is:
a. $35,000
b. $30,000
c. $25,000
d. $10,000
e. Some other amount
8. In journal entries for a bankruptcy reorganization, the difference between the carrying
amount of a liability of the debtor and the amount accepted by the creditor in full set-
tlement of the liability is credited to:
a. Retained Earnings (Deficit).
b. Paid-in Capital in Excess of Par or Stated Value.
c. Paid-in Capital from Reorganization.
d. Cash with Escrow Agent.
e. Some other ledger account.
9. With respect to the terms bankrupt and insolvent as adjectives:
a. Bankrupt refers to a legal state; insolvent refers to the financial condition of a per-
son or a business enterprise.
b. Bankrupt refers to the financial condition of a person or a business enterprise;
insolvent refers to a legal state.
c. Both bankrupt and insolvent refer to the financial condition of a person or a busi-
ness enterprise.
d. Bankrupt and insolvent properly may be used as interchangeable adjectives.
10. The accounting records of a trustee in a bankruptcy liquidation are maintained:
a. Under the accrual basis of accounting.
b. Under the cost basis of accounting.
c. Under an accountability technique.
d. In accordance with the bankruptcy court’s instructions.
11. Under the Bankruptcy Code, are creditors having priority:

Secured Creditors? Unsecured Creditors?

a. Yes Yes
b. Yes No
c. No Yes
d. No No
624 Part Four Accounting for Fiduciaries

12. The period of time that must elapse before a debtor that has had a previous bankruptcy
discharge may again be discharged is:
a. Four years
b. Five years
c. Six years
d. Seven years
13. The sequence of listing (1) fully secured liabilities, (2) partially secured liabilities,
(3) unsecured liabilities with priority, and (4) unsecured liabilities without priority in
the liabilities and stockholders’ equity section of a statement of affairs is:
a. (1), (2), (3), (4)
b. (3), (1), (2), (4)
c. (1), (3), (2), (4)
d. (1), (3), (4), (2)
14. The following journal entry (explanation omitted) was prepared by an enterprise that
had filed a debtor’s petition in bankruptcy:

Cash with Escrow Agent 100,000

Cash 100,000

Such a journal entry generally is related to:

a. A liquidation only.
b. A reorganization only.
c. Either a liquidation or a reorganization.
d. Neither a liquidation nor a reorganization.
15. The estimated amount available for free assets in a statement of affairs for a business
enterprise undergoing bankruptcy liquidation is equal to the assets’:
a. Carrying amounts less current fair values.
b. Carrying amounts plus gain or less loss on realization.
c. Carrying amounts plus loss or less gain on realization.
d. Current fair values less carrying amounts.
16. A retained earnings deficit of a business enterprise undergoing bankruptcy reorgani-
zation typically is eliminated by its:
a. Offset against gain from discharge of indebtedness in bankruptcy.
b. Inclusion with costs of bankruptcy proceedings.
c. Offset against legal capital.
d. Offset against additional paid-in capital.
17. On April 30, 2006, Carson Welles, trustee in bankruptcy liquidation for Lyle Company,
paid $12,140 in full settlement of Lyle’s liability under product warranty, which had
been carried in Welles’s accounting records at $10,000. The appropriate journal entry
for Welles (explanation omitted) is:
a. Liability under Product Warranty 12,140
Cash 12,140
b. Liability under Product Warranty 10,000
Estate Deficit 2,140
Cash 12,140
c. Liability under Product Warranty 10,000
Product Warranty Expense 2,140
Cash 12,140
 Chapter 14 Bankruptcy: Liquidation and Reorganization 625

d. Liability under Product Warranty 10,000

Retained Earnings (Prior Period Adjustment) 2,140
Cash 12,140
(Exercise 14.2) The December 18, 2006, statement of affairs of Downside Company, which is in bankruptcy
liquidation, included the following:

CHECK FIGURE
Assets pledged for fully secured liabilities $100,000
To partially secured
Assets pledged for partially secured liabilities 40,000
liabilities, $48,000.
Free assets 120,000
Fully secured liabilities 80,000
Partially secured liabilities 50,000
Unsecured liabilities with priority 60,000
Unsecured liabilities without priority 90,000

Prepare a working paper to show the estimated amount of assets expected to be received
by each of the four classes of creditors of Downside Company in its bankruptcy liquidation.
(Exercise 14.3) Amounts related to the statement of affairs of Foldup Company, in bankruptcy liquidation
on April 30, 2006, were as follows:

CHECK FIGURE
Assets pledged for fully secured liabilities $ 80,000
Estimated deficiency,
Assets pledged for partially secured liabilities 50,000
$100,000.
Free assets 280,000
Fully secured liabilities 60,000
Partially secured liabilities 80,000
Unsecured liabilities with priority 40,000
Unsecured liabilities without priority 330,000

Prepare a working paper to compute the total estimated deficiency to unsecured, non-
priority creditors, and the cents per dollar that such creditors may expect to receive from
Foldup Company.
(Exercise 14.4) Data from the April 30, 2006, statement of affairs of Windup Company, which was under-
going bankruptcy liquidation, included the following:

CHECK FIGURE
Assets pledged for fully secured liabilities $70,000
To partially secured
Assets pledged for partially secured liabilities 30,000
liabilities, $35,000.
Free assets 50,000
Fully secured liabilities 60,000
Partially secured liabilities 40,000
Unsecured liabilities with priority 30,000
Unsecured liabilities without priority 50,000

Prepare a working paper to show how Windup Company’s assets on April 30, 2006, are
expected to be apportioned to Windup’s creditors’ claims on that date.
626 Part Four Accounting for Fiduciaries

(Exercise 14.5) Components of the December 17, 2006, statement of affairs of Liquo Company, which was
undergoing liquidation under Chapter 7 of the Bankruptcy Code, included the following:

CHECK FIGURE
Assets pledged for fully secured liabilities, at current fair value $150,000
To partially secured
Assets pledged for partially secured liabilities, at current fair value 104,000
liabilities, $114,400.
Free assets, at current fair value 80,000
Fully secured liabilities 60,000
Partially secured liabilities 120,000
Unsecured liabilities with priority 14,000
Unsecured liabilities without priority 224,000

Prepare a working paper dated December 17, 2006, to compute the amount expected to
be paid to each class of creditors of Liquo Company. The following column headings are
suggested: Class of Creditor, Total Claims, Computation, Estimated Amount. The total of
the Estimated Amount column should equal total assets, $334,000.
(Exercise 14.6) Scott Company filed a debtor’s bankruptcy petition on June 25, 2006, and its statement of
affairs included the following amounts:

CHECK FIGURE Carrying Current

Cash received by
Amounts Fair Values
partially secured
creditors, $84,000. Assets
Assets pledged for fully secured liabilities $160,000 $190,000
Assets pledged for partially secured liabilities 90,000 60,000
Free assets 200,000 140,000
Totals $450,000 $390,000

Liabilities
Unsecured liabilities with priority $ 20,000
Fully secured liabilities 130,000
Partially secured liabilities 100,000
Unsecured liabilities without priority 260,000
Total $510,000

Assuming that Scott Company’s assets realized cash at the current fair values and the
business was liquidated by the bankruptcy trustee, prepare a working paper to compute
the amount of cash that the partially secured creditors should receive.
(Exercise 14.7) The statement of affairs for Wick Corporation shows that approximately 78 cents on the
dollar probably will be paid to unsecured creditors without priority. Wick owes Stark Com-
CHECK FIGURE pany $23,000 on a promissory note, plus accrued interest of $940. Inventories with a cur-
Amount to Stark rent fair value of $19,200 collateralize the note payable.
Company, $22,897. Prepare a working paper to compute the amount that Stark Company should receive
from the trustee of Wick Corporation, assuming that actual payments to unsecured credi-
tors without priority amount to 78 cents on the dollar. Round all amounts to the nearest
dollar.
 Chapter 14 Bankruptcy: Liquidation and Reorganization 627

(Exercise 14.8) Decker Company filed a debtor’s bankruptcy petition on August 15, 2006, and its statement
of affairs included the following amounts:

CHECK FIGURE
Carrying Current
Cash available,
Amounts Fair Values
$180,000.
Assets
Assets pledged for fully secured liabilities $150,000 $185,000
Assets pledged for partially secured liabilities 90,000 60,000
Free assets 210,000 160,000
Totals $450,000 $405,000

Liabilities
Unsecured liabilities with priority $ 35,000
Fully secured liabilities 130,000
Partially secured liabilities 100,000
Unsecured liabilities without priority 270,000
Total $535,000

Assuming that Decker Company’s assets realized cash at the current fair values and the
business was liquidated by the bankruptcy trustee, prepare a working paper to compute
the amount of cash available to pay unsecured liabilities without priority.
(Exercise 14.9) Prepare a working paper to compute the estimated amount expected to be paid to each
class of creditors, using the following data taken from the statement of affairs for Kent
Corporation:

CHECK FIGURE Assets pledged for fully secured liabilities (current fair value, $75,000) $ 90,000
To partially secured
Assets pledged for partially secured liabilities (current fair value, $52,000) 74,000
creditors, $57,200.
Free assets (current fair value, $40,000) 70,000
Unsecured liabilities with priority 7,000
Fully secured liabilities 30,000
Partially secured liabilities 60,000
Unsecured liabilities without priority 112,000

(Exercise 14.10) The following information for Progress Book Company on May 31, 2006, was obtained by
an accountant retained by Progress Book’s creditors:
1. Furniture and fixtures: Carrying amount, $70,000; current fair value, $60,500; pledged
on a note payable of $42,000 on which unpaid interest of $800 has accrued.
2. Book manuscripts owned: Carrying amount, $15,000; current fair value, $7,200; pledged
on a note payable of $9,000; interest on the note is paid to date.
3. Books in process of production: Accumulated cost (direct material, direct labor, and
factory overhead), $37,500; estimated sales value on completion, $60,000; additional
out-of-pocket costs of $14,200 will be required to complete the books in process.
Prepare the headings for the asset side of a statement of affairs for Progress Book Com-
pany on May 31, 2006, and illustrate how each of the three items described is displayed in
the statement.
628 Part Four Accounting for Fiduciaries

(Exercise 14.11) Edward Ross, the trustee in bankruptcy for Winslow Company, set up accounting records
based on the April 30, 2006, statement of affairs for Winslow. The trustee completed the
following transactions and events early in May 2006:
May 2 Sold for $10,000 cash the finished goods inventory with a statement of affairs
valuation of $10,500.
3 Paid wages with a statement of affairs valuation of $8,000.
4 Collected $6,000 on trade accounts receivable with a statement of affairs valu-
ation of $6,200. The remainder was considered to be uncollectible.
7 Paid trustee fee for one week, $500. (Debit Estimated Administrative Costs.)
Prepare journal entries (omit explanations) for Edward Ross, trustee in bankruptcy for
Winslow Company, for the transactions and events described above.
(Exercise14.12) From the following traditional form of statement of realization and liquidation, prepare
a more concise statement of realization and liquidation similar to the one illustrated on
page 617.

CHECK FIGURE
REED COMPANY, IN BANKRUPTCY
Estate deficit, Jan. 31,
Selma Ross, Trustee
$7,150. Statement of Realization and Liquidation
For Month of January 2006

Assets to be realized: Liabilities to be liquidated:

Trade accounts receivable $ 7,500 Notes payable $ 5,000
Inventories 12,500 Trade accounts payable 30,000
Equipment 10,000 Interest payable 150
Subtotal $30,000 Subtotal $35,150
Supplementary charges: Liabilities assumed:
Administrative costs 2,950 Interest payable 50
Interest expense 50 Assets realized:
Liabilities liquidated: Trade accounts receivable 6,500
Trade accounts payable 6,000 Inventories 14,500
Liabilities not liquidated: Assets not realized:
Notes payable 5,000 Equipment 10,000
Trade accounts payable 24,000 Net loss 2,000
Interest payable 200
Total $68,200 Total $68,200

(Exercise 14.13) Following are selected provisions of the plan of reorganization for Kolb Company, which is
emerging from Bankruptcy Code Chapter 11 reorganization on July 27, 2006:
(1) Amended articles of incorporation to provide for 100,000 shares of authorized com-
mon stock, $5 par, to be exchanged on a share-for-share basis for 50,000 shares of out-
standing no-par, no-stated-value common stock with a carrying amount of $600,000.
(2) Exchanged 10,000 shares of the new $5 par common stock for trade accounts payable
totaling $70,000.
(3) Paid 80 cents per dollar for full settlement of other trade accounts payable totaling
$60,000.
 Chapter 14 Bankruptcy: Liquidation and Reorganization 629

Prepare journal entries (omit explanations) for Kolb Company on July 27, 2006, to re-
flect the foregoing elements of its plan of reorganization.

(Exercise 14.14) Among the provisions of the reorganization of Hayward Company under Chapter 11 of the
Bankruptcy Code were the following:
(1) Issued 1,000 shares of $5 par common stock in exchange for 1,000 shares of $100 par
common stock outstanding.
(2) Issued 200 shares of $5 par common stock (current fair value $10 a share) for notes
payable to suppliers with unpaid principal of $2,500 and accrued interest of $500.
(3) Paid $8,000 to suppliers in full settlement of trade accounts payable of $10,000.
Prepare journal entries (omit explanations) for Hayward Company for the foregoing pro-
visions, all of which were completed on January 20, 2006.

Cases
(Case 14.1) The January 29, 1994, balance sheet of Hills Stores Company, a publicly owned enterprise,
included the following asset:

Reorganization value in excess of amounts

allocable to identifiable assets, net $176,718,000

The Intangible Assets section of Hills’s Summary of Significant Accounting Policies note
to financial statements read in part as follows:
Reorganization value in excess of amounts allocable to identifiable assets is being amortized
over 20 years on a straight-line basis. Accumulated amortization was $29,395,000 at January
29, 1994.

The reorganization value accounted for more than 19% of Hills’s total assets of
$907,621,000 on January 29, 1994.

Instructions
What is your opinion of the foregoing balance sheet display and related note disclosures?
Explain, after researching the following:

AICPA Statement of Position 90-7, “Financial Reporting by Entities in Reorganization

under the Bankruptcy Code,” paragraphs 9, 38, 61, and 62.
FASB Statement of Financial Accounting Concepts No. 6, “Elements of Financial
Statements,” paragraphs 25 through 31 and 171 through 177.
FASB Statement of Financial Accounting Standards No. 142, “Goodwill and Other
Intangible Assets,” paragraphs 1, 5, and 10.
FASB Statement of Financial Accounting Standards No. 87, “Employers’ Accounting
for Pensions,” paragraphs 36, 37, and 38, and dissent of Robert T. Sprouse.
630 Part Four Accounting for Fiduciaries

(Case 14.2) In auditing the financial statements of Delbert Company for the six months ended Decem-
ber 31, 2006, you find items a through e below had been debited or credited to the Retained
Earnings ledger account during the six months immediately following a bankruptcy reor-
ganization, which was effective July 1, 2006:
a. Debit of $25,000 arising from an additional income tax assessment applicable to
2005.
b. Credit of $48,000 resulting from gain on disposal of equipment that was no longer
used in the business. This impaired equipment had been written down by a $50,000
increase in the Accumulated Depreciation ledger account on July 1, 2006.
c. Debit of $15,000 resulting from the loss on plant assets destroyed in a fire on November
2, 2006.
d. Debit of $32,000 representing cash dividends declared on preferred stock.
e. Credit of $60,400, the net income for the six-month period ended December 31,
2006.
Instructions
For each of the foregoing items, state whether it is correctly debited or credited to the
Retained Earnings ledger account. Give a brief reason for your conclusion.
(Case 14.3) You have been asked to conduct a training program explaining the preparation of a state-
ment of affairs (financial statement) for the staff of Bixby & Canfield, CPAs.
Instructions
Explain how each of the following is presented in a statement of affairs (financial state-
ment) for a corporation in bankruptcy liquidation proceedings:
a. Assets pledged for partially secured liabilities.
b. Unsecured liabilities with priority.
c. Stockholders’ equity.

Problems
(Problem 14.1) On July 24, 2006, the date the plan of reorganization of Re-Org Company was approved by
the bankruptcy court, Re-Org’s stockholders’ equity was as follows:

Common stock, no par or stated value; authorized 100,000

shares, issued and outstanding 60,000 shares $ 580,000
Deficit (260,000)
Total stockholders’ equity $ 320,000

Included in Re-Org’s plan of reorganization were the following:

1. Authorize payment of $50,000 unrecorded bankruptcy administrative costs by escrow
agent holding special Re-Org cash account.
2. Amend articles of incorporation to change common stock to $1 par from no-par, no-
stated-value stock.
 Chapter 14 Bankruptcy: Liquidation and Reorganization 631

3. Exchange 10% unsecured $120,000 promissory note payable to supplier (interest unpaid
for three months) for a 12%, two-year promissory note in the total amount of unpaid prin-
cipal and accrued interest on the 10% note.
4. Pay suppliers 80 cents on the dollar (from Re-Org cash account) for their claims total-
ing $100,000.
5. Eliminate deficit against paid-in capital resulting from (2) and gain resulting from (4).

Instructions
Assuming the foregoing were completed on July 24, 2006, prepare journal entries (omit
explanations) for Re-Org Company on that date. Use the following ledger account titles:

Cash Interest Payable

Cash with Escrow Agent 10% Note Payable
Common Stock, no par 12% Note Payable
Common Stock, $1 par Paid-in Capital in Excess of Par
Costs of Bankruptcy Proceedings Retained Earnings (Deficit)
Gain from Discharge of Indebtedness in Trade Accounts Payable
Bankruptcy

(Problem 14.2) The following information was available on October 31, 2006, for Dodge Company, which
cannot pay its liabilities when they are due:

CHECK FIGURE
Carrying
Estimated deficiency,
Amounts
$20,500.
Cash $ 4,000
Trade accounts receivable (net): Current fair value equal to carrying amount 46,000
Inventories: Net realizable value, $18,000; pledged on $21,000 of notes
payable 39,000
Plant assets: Current fair value, $67,400; pledged on mortgage note
payable 134,000
Accumulated depreciation of plant assets 27,000
Supplies: Current fair value, $1,500 2,000
Wages payable, all earned during October 2006 5,800
Property taxes payable 1,200
Trade accounts payable 60,000
Notes payable, $21,000 secured by inventories 40,000
Mortgage note payable, including accrued interest of $400 50,400
Common stock, $5 par 100,000
Deficit 59,400

Instructions
a. Prepare a statement of affairs for Dodge Company on October 31, 2006, in the form
illustrated on page 614.
b. Prepare a working paper to compute the estimated percentage of claims each group
of creditors should expect to receive if Dodge Company petitions for liquidation in
bankruptcy.

(Problem 14.3) Robaire Corporation was in financial difficulty because of declining sales and poor cost
controls. Its stockholders and principal creditors had asked for an estimate of the financial
632 Part Four Accounting for Fiduciaries

CHECK FIGURES results of the realization of the assets, the payment of liabilities, and the liquidation of
b. Estate deficit, Jan. Robaire. Thus, the accountant for Robaire prepared the statement of affairs shown on
31, $9,380; c. Trial page 633.
balance totals, On January 2, 2007, Robaire filed a debtor’s petition for liquidation under the Bank-
$31,850. ruptcy Code. Charles Stern was appointed as trustee by the bankruptcy court to take cus-
tody of the assets, make payments to creditors, and implement an orderly liquidation. The
trustee completed the following transactions and events during January, 2007:
Jan. 2 Recorded the assets and liabilities of Robaire Corporation in a separate set of
accounting records. The assets were recorded at current fair value, and all lia-
bilities were recorded at the estimated amounts payable to the various groups
of creditors.
7 Disposed of the land and buildings at an auction for $52,000 cash and paid
$42,550 to the mortgagee. The payment included interest of $50 that accrued
in January.
10 Made cash payments as follows:

Wages payable $1,500

FICA and income taxes withheld and accrued 800
Completion of inventories 400
Administrative costs of liquidation 600

31 Received cash from Jan. 8 to Jan. 31, 2007, as follows:

Collection of trade accounts receivable at carrying amount,

including $10,000 of assigned accounts $17,500
Sale of inventories 18,000
Disposal of Public Service Company bonds 920

31 Made additional cash payments as follows:

Administrative costs of liquidation $ 1,250

Note payable to bank (from proceeds of collection of assigned
accounts receivable) 10,000
Fifty cents on the dollar to unsecured creditors 30,500

Instructions
a. Prepare journal entries for the foregoing events and transactions of the trustee for
Robaire Corporation.
b. Prepare a statement of realization and liquidation for the trustee of Robaire Corporation
for the month of January 2007. Use the format illustrated on page 617.
c. Prepare a trial balance for the trustee of Robaire Corporation on January 31, 2007.
 ROBAIRE COMPANY
Statement of Affairs
December 31, 2006

Current Estimated Loss or

Carrying Fair Amount (Gain) on Carrying Liabilities and Amount
Amounts Assets Values Available Realization Amounts Stockholders’ Equity Unsecured

Assets Pledged for Fully Secured Unsecured Liabilities with Priority:

Liabilities: Estimated administrative
$ 4,000 Land $20,000 $(16,000) costs $ 3,200
25,000 Buildings 30,000 (5,000) $ 1,500 Wages payable 1,500
Total $50,000 800 FICA and income taxes
Less: Fully secured liabilities (contra) 42,500 $ 7,500 withheld and accrued 800
Total (deducted contra) $ 5,500
Assets Pledged for Partially Secured
Liabilities: Fully Secured Liabilities:
10,000 Trade accounts receivable 42,000 Mortgage note payable $42,000
(deducted contra) $10,000 500 Interest payable 500
Total (deducted contra) $42,500
Free Assets:
700 Cash $ 700 700 Partially Secured Liabilities:
10,450 Trade accounts receivable 10,450 10,450 25,000 Notes payable to bank $25,000
40,000 Inventories $19,350 Less: Assigned trade
Less: Cost to complete 400 18,950 18,950 21,050 accounts receivable 10,000 $ 15,000
9,100 Factory supplies -0- -0- 9,100
5,750 Public Service Company bonds 900 900 4,850 Unsecured Liabilities without
38,000 Machinery and equipment 18,000 18,000 20,000 Priority:
Total estimated amount available $56,500 $ 34,000 20,000 Notes payable to suppliers 20,000
Less: Unsecured liabilities with priority 26,000 Trade accounts payable 26,000
(contra) 5,500 27,200 Stockholders’ equity
Estimated amount available for
unsecured, nonpriority creditors $51,000
Estimated deficiency to unsecured,
nonpriority creditors 10,000
$143,000 $61,000 $143,000 $61,000
Chapter 14 Bankruptcy: Liquidation and Reorganization 633
634 Part Four Accounting for Fiduciaries

(Problem 14.4) Javits Corporation advised you that it is facing bankruptcy proceedings. As the independent
auditor for Javits, you knew of its financial condition.
The unaudited balance sheet of Javits on July 10, 2006, was as follows:

CHECK FIGURE
JAVITS CORPORATION
b. Estimated
Balance Sheet
deficiency, $22,500. July 10, 2006

Assets
Cash $ 12,000
Short-term investments, at cost 20,000
Trade accounts receivable, less allowance for doubtful accounts 90,000
Finished goods inventory 60,000
Material inventory 40,000
Short-term prepayments 5,000
Land 13,000
Buildings (net) 90,000
Machinery (net) 120,000
Goodwill (net) 20,000
Total assets $470,000
Liabilities and Stockholders’ Equity
Notes payable to banks $135,000
Trade accounts payable 94,200
Wages payable 15,000
Mortgage notes payable 130,000
Common stock 100,000
Retained earnings (deficit) (4,200)
Total liabilities and stockholders’ equity $470,000

Additional Information
1. Cash included a $500 travel advance that had been spent.
2. Trade accounts receivable of $40,000 had been pledged as collateral for notes payable
to banks in the amount of $30,000. Credit balances of $5,000 were netted in the ac-
counts receivable total. All accounts were expected to be collected except those for
which an allowance had been established.
3. Short-term investments (all acquired in May 2006), classified as trading, consisted
of U.S. government bonds costing $10,000 and 500 shares of Owens Company
common stock. The current fair value of the bonds was $10,000; the current fair
value of the stock was $18 a share. The bonds had accrued interest receivable of
$200. The short-term investments had been pledged as collateral for a $20,000 note
payable to bank.
4. Estimated realizable value of finished goods was $50,000 and of material was $30,000.
For additional out-of-pocket costs of $10,000 the material would realize $59,900 as
finished goods.
5. Short-term prepayments were expected to be consumed during the liquidation period.
6. The current fair values of plant assets were as follows: land, $25,000; buildings,
$110,000; impaired machinery, $65,000.
 Chapter 14 Bankruptcy: Liquidation and Reorganization 635

7. Trade accounts payable included $15,000 withheld FICA and income taxes and $6,000
payable to creditors who had been reassured by the president of Javits that they would
be paid. There were unrecorded employer’s FICA taxes in the amount of $500.
8. Wages payable were not subject to any limitations under the Bankruptcy Code.
9. Mortgage notes payable consisted of $100,000 secured by land and buildings, and a
$30,000 installment contract secured by machinery. Total unrecorded accrued interest
for these liabilities amounted to $2,400.
10. Probable judgment on a pending suit against Javits was estimated at $50,000.
11. Costs other than accounting fees to be incurred in connection with the liquidation were
estimated at $10,000.
12. You had not submitted an invoice for $5,000 for the April 30, 2006, annual audit of
Javits, and you estimate a $1,000 fee for liquidation work.
Instructions
a. Prepare correcting journal entries for Javits Corporation on July 10, 2006.
b. Prepare a statement of affairs for Javits Corporation on July 10, 2006. Amounts in the
statement should reflect the journal entries in a.

(Problem 14.5) The adjusted trial balance of Laurel Company on June 30, 2006, is as follows:

CHECK FIGURE
LAUREL COMPANY
Estimated deficiency,
Adjusted Trial Balance
$32,400.
June 30, 2006

Debit Credit
Cash $ 14,135
Notes receivable 29,000
Interest receivable 615
Trade accounts receivable 24,500
Allowance for doubtful accounts $ 800
Inventories 48,000
Land 10,000
Building 50,000
Accumulated depreciation of building 15,000
Machinery and equipment 33,000
Accumulated depreciation of machinery and equipment 19,000
Furniture and fixtures 21,000
Accumulated depreciation of furniture and fixtures 9,500
Goodwill 9,600
Note payable to City Bank 18,000
Notes payable to Municipal Trust Company 6,000
Notes payable to suppliers 24,000
Interest payable on notes 1,280
Trade accounts payable 80,520
Wages payable 1,400
FICA and income taxes withheld and accrued 430
Mortgage bonds payable 32,000
Interest payable on mortgage bonds 1,820
Common stock 70,000
Retained earnings—deficit 39,900
Totals $279,750 $279,750
636 Part Four Accounting for Fiduciaries

Additional Information
1. Notes receivable of $25,000 were pledged to collateralize the $18,000 note payable to
City Bank. Interest of $500 was accrued on the pledged notes receivable, and interest of
$600 was accrued on the $18,000 note payable to the bank. All the pledged notes re-
ceivable were considered collectible. Of the remaining notes receivable, a $1,000 non-
interest-bearing note was uncollectible. The note had been received for an unconditional
cash loan.
2. Trade accounts receivable included $7,000 from Boren Company, which currently was
being liquidated. Creditors were expected to realize 40 cents on the dollar. The al-
lowance for doubtful accounts was adequate to cover any other uncollectible accounts.
A total of $3,200 of the remaining collectible trade accounts receivable was pledged as
collateral for the notes payable to Municipal Trust Company of $6,000 with accrued in-
terest of $180 on June 30, 2006.
3. Inventories, valued at first-in, first-out cost, were expected to realize 25% of cost on a
forced liquidation sale after the write-off of $10,000 of obsolete stock.
4. Land and buildings, which had been appraised at 110% of their carrying amount, were
mortgaged as collateral for the bonds. Interest of $1,820 was accrued on the bonds on
June 30, 2006. Laurel expected to realize 20% of the cost of its impaired machinery and
equipment, and 50% of the cost of its impaired furniture and fixtures after incurring re-
finishing costs of $800.
5. Estimated costs of liquidation were $4,500. Depreciation and accruals had been adjusted
to June 30, 2006.
6. Laurel had net operating loss carryovers for income tax purposes of $22,000 for
the year ended June 30, 2005, and $28,000 for the year ended June 30, 2006. The
income tax rate expected to be in effect when the operating loss carryovers were used
was 40%.

Instructions
Prepare a statement of affairs for Laurel Company on June 30, 2006.
(Problem 14.6) Bilbo Corporation, which is in bankruptcy reorganization, had $105,000 of dividends in ar-
rears on its 7% cumulative preferred stock on March 31, 2006. While retained earnings were
adequate to permit the payment of accumulated dividends, Bilbo’s management did not
CHECK FIGURE want to weaken its working capital position. It also realized that a portion of the plant as-
b. Total assets, sets was no longer used by Bilbo. Therefore, management proposed the following plan of
$1,137,530. reorganization, which was accepted by stockholders and confirmed by the bankruptcy
court, to be effective on April 1, 2006:
1. The preferred stock was to be exchanged for $300,000 face amount and current fair
value of 15%, ten-year bonds. Dividends in arrears were to be settled by the issuance of
12,000 shares of $10 par, 15%, noncumulative preferred stock having a current fair
value equal to par.
2. Common stock was to be assigned a par of $50 a share.
3. Impaired goodwill was to be written off; impaired plant assets were to be written
down, based on appraisal and estimates of current fair value, by a total of $103,200,
consisting of a $85,400 increase in the Accumulated Depreciation ledger account bal-
ance and a $17,800 decrease in plant assets; other current assets were to be written
down by $10,460 to reduce trade accounts receivable and inventories to net realizable
values.
 Chapter 14 Bankruptcy: Liquidation and Reorganization 637

The balance sheet of Bilbo Corporation on March 31, 2006, follows:

BILBO CORPORATION
Balance Sheet
March 31, 2006

Assets
Cash $ 30,000
Other current assets 252,890
Plant assets $1,458,250
Less: Accumulated depreciation 512,000 946,250
Goodwill 50,000
Total assets $1,279,140

Liabilities and Stockholders’ Equity

Current liabilities $ 132,170
7% cumulative preferred stock, $100 par ($105,000
dividends in arrears); 3,000 shares authorized, issued,
and outstanding 300,000
Common stock, no par or stated value; 9,000 shares
authorized, issued, and outstanding 648,430
Additional paid-in capital: preferred stock 22,470
Retained earnings 176,070
Total liabilities & stockholders’ equity $1,279,140

Instructions
a. Prepare journal entries for Bilbo Corporation to give effect to the plan of reorganization
on April 1, 2006.
b. Prepare a balance sheet for Bilbo Corporation on April 30, 2006, assuming that net
income for April was $15,000. The operations resulted in $11,970 increase in cash,
$18,700 increase in other current assets, $7,050 increase in current liabilities, and
$8,620 increase in the Accumulated Depreciation ledger account.
Chapter Fifteen

Estates and Trusts

Scope of Chapter
Estates and trusts are accounting entities as well as taxable entities. The individuals or
business enterprises that manage the property in estates and trusts are fiduciaries; they
exercise stewardship for the property in accordance with the provisions of a will, a trust
document, or state laws.
This chapter deals first with the legal aspects of estates, including wills, and then
discusses and illustrates the accounting for estates; the last section covers the legal and
accounting aspects of trusts.

LEGAL AND ACCOUNTING ASPECTS OF ESTATES

State laws (generally termed probate codes) regulate the administration and distribution of
property in estates of decedents, missing persons, and other individuals subject to protec-
tion of courts. The many variations among the probate codes of the 50 states led to the
drafting of a Uniform Probate Code, developed by the National Conference of Commis-
sioners on Uniform State Laws and approved by the American Bar Association. Although
the Code has not yet been adopted in total by all states, it is used in this chapter to illustrate
the important legal issues underlying the accounting for estates.

Provisions of Uniform Probate Code Governing Estates

The Uniform Probate Code identifies an estate as all the property of a decedent, trust,
or other person whose affairs are subject to the Code. 1 Person is defined as an indi-
vidual or an organization. The Code also provides that the real and personal property
of a decedent is to be awarded to the persons specified in the decedent’s will. In the
absence of a will—a condition known as intestacy—the decedent’s property goes to
heirs, as described in the Code. Thus, the intentions of a testator (a person creating a
will) control the disposition of a decedent’s property.2

Wills
The Code provides that a will shall be in writing, signed by the testator, or in the testator’s
name by some other person in the testator’s presence and by the testator’s direction,
and also signed by at least two witnesses. The chief exception of these requirements is a
holographic will—a will having its essential provisions and signature in the handwriting
of the testator.

1
Uniform Probate Code, Sec. 1-201(14).
2
Ibid., Sec. 2-101.

638
 Chapter 15 Estates and Trusts 639

Probate of Wills
The probate of a will is action by the probate court (also known as surrogate or orphan’s
court) to validate the will. The Code provides for two types of probate—informal and
formal. Informal probate is initiated by the application of an interested party filed with a
court official known as a registrar. After thorough review of the completeness and propriety
of an application for informal probate, the registrar issues a written statement of informal
probate, thus making the will effective.
Formal probate (formal testacy proceedings) is litigation to determine whether a dece-
dent left a valid will; it is initiated by a petition filed by an interested party requesting the
probate court to order probate of the will. The petition also may request a finding that the
decedent died intestate (without a valid will). During the court hearings, any party to
the formal probate proceedings may oppose the will; however, the burden of proof that the
will is invalid is on the contestant of the will. After completion of the hearings, the court
enters an order for formal probate of a will found to be valid, or an order that the decedent
died intestate. Generally, no formal or informal probate proceedings may be undertaken
more than three years after the decedent’s death.

Appointment of Personal Representative

In both informal and formal probate proceedings, the probate court appoints a personal
representative of the decedent to administer the decedent’s estate. A personal representa-
tive named in the decedent’s will is called an executor. If the decedent died intestate, the
court-appointed personal representative is known as an administrator. The Code requires
the probate court to issue letters testamentary to the personal representative before admin-
istration of the estate may begin. Because personal representatives are fiduciaries, they
must observe standards of care in administering estates that prudent persons would observe
in dealing with the property of others. The personal representative is entitled to reasonable
compensation for services.

Powers and Duties of Personal Representative

The personal representative of a decedent is empowered to take possession and control of
the decedent’s property, and to have title to the property in trust for the benefit of creditors
and beneficiaries of the estate. The personal representative also has many additional pow-
ers, such as the right to continue any single proprietorship of the decedent for not more than
four months following the date of the personal representative’s appointment and the
authority to allocate items of revenue and expenses of the estate to either estate principal
(corpus) or estate income, as provided by the will or by law. Such allocations constitute the
chief accounting problem for an estate and are discussed in a subsequent section of this
chapter (pages 641–642).
Not later than 30 days after appointment, the personal representative must inform the
decedent’s devisees or heirs of the appointment. A devisee is any person or trust named in
a will to receive real or personal property of the decedent in a transfer known as a devise.
Within three months after appointment, the personal representative must prepare an in-
ventory of property owned by the decedent on the date of death, together with a list of any
liens against the property. The property in the inventory must be stated at current fair
value on the date of death. The personal representative may retain the services of an
appraiser to obtain the current fair values of property. The inventory of decedent’s prop-
erty is filed with the probate court. If other property of the decedent is discovered after the
filing of the original inventory, the personal representative must file a supplementary
inventory with the probate court.
640 Part Four Accounting for Fiduciaries

Exempt Property and Allowances

In a manner similar to the bankruptcy law discussed in Chapter 14, the Uniform Probate
Code provides for certain exemptions from claims against the estate property, even by
devisees. These exceptions are as follows:
1. Homestead allowance. The decedent’s surviving spouse, or surviving minor and
dependent children, are entitled to a homestead allowance of a specified amount. This
allowance is in addition to any share of the estate property passing to the spouse or chil-
dren pursuant to the provisions of the will.
2. Exempt property. The decedent’s surviving spouse or children are entitled to an ag-
gregate specified value of automobiles, household furniture and furnishings, appliances,
and personal effects.
3. Family allowance. The surviving spouse and minor children who were being sup-
ported by the decedent are entitled to a reasonable cash allowance, payable in a lump
sum not exceeding a specified amount, or in installments not exceeding one-twelfth of
the specified lump sum each month for one year, during the administration of the estate.
The family allowance has priority over all claims against the estate other than the home-
stead allowance.

Claims of Creditors against the Estate

The personal representative for an estate is required to publish a notice once a week for
three successive weeks, in a newspaper of general circulation, requesting creditors of
the estate to present their claims within four months after the date of the first publi-
cation, or be forever barred. If the estate property not exempt under the Code is insuffi-
cient to pay all creditors’ claims in full, the personal representative pays the claims in
the following order:
1. Costs of administering the estate.
2. Decedent’s reasonable funeral costs.
3. Debts and taxes with preference under federal law.
4. Reasonable and necessary medical and hospital costs of decedent’s last illness.
5. Debts and taxes with preference under state laws.
6. All other claims.
Four months after publication of the first notice to estate creditors, the personal representa-
tive initiates payment of claims in the order outlined above, after first providing for home-
stead, family, and exempt property allowances.

Distributions to Devisees
The personal representative also has the duty of distributing estate property to the devisees
named in the will. The property is to be distributed in kind to the extent possible, rather
than first being realized in cash and then distributed.
If estate property that is not exempt is insufficient to cover creditors’ claims as well as
all devises, the devises abate (are reduced) in the sequence provided for in the decedent’s
will. If the will is silent as to order of abatement, the Uniform Probate Code provides the
following abatement sequence:
1. Property not disposed of by the will.
2. Residuary devises, which are devises of all estate property remaining after general and
specific devises are satisfied.
 Chapter 15 Estates and Trusts 641

3. General devises, which are gifts of an amount of money or a number of countable

monetary items, such as 500 shares of Mercury Company common stock.
4. Specific devises, which are gifts of identified objects, such as named paintings, automo-
biles, stock certificates, or real property.
Devises may be granted to the devisees in trust, which requires the establishment of a
testamentary trust, that is, one provided for by a will. Trusts are discussed in a subsequent
section of this chapter.

Estate and Inheritance Taxes

The federal estate tax assessed against the net assets of an estate, and inheritance taxes as-
sessed by various states against devisees and heirs of a decedent, often called death taxes,
must be charged to the devisees as outlined in the will. If the will is silent on this point, the
Code provides that death taxes are to be apportioned to the devisees in the ratio of their
interests (equity) in the estate.

Closing the Estate

No earlier than six months after the date of appointment, a personal representative may
close an estate by filing a statement with the probate court. The written content of this state-
ment is described in the Uniform Probate Code; this legal statement usually is accompanied
by a financial statement known as a charge and discharge statement.

Provisions of Revised Uniform Principal and

Income Act Governing Estates
As noted on page 639, the primary accounting problem for an estate is the allocation
of revenue and expenses to principal and income. This allocation is important because
many wills provide that income of a testamentary trust is paid to an income benefi-
ciary, and that trust principal is paid to a different principal beneficiary (or remainder-
man). A proper accounting for principal and income is essential before the estate is
closed.
The Revised Uniform Principal and Income Act provides guidelines for allocation
in the absence of instructions in the will or trust instrument. Many states have adopted
all or part of the Act, often with modifications. The provisions of the Act include the
following:
1. Income is defined as the return in money or property derived from the use of principal,
including rent, interest, cash dividends, or any other revenue received during adminis-
tration of an estate.
2. Principal is defined as property set aside by its owner to be held in trust for eventual de-
livery to a remainderman. Principal includes proceeds of insurance on principal prop-
erty, stock dividends, and liquidating dividends. Any accrued revenue on the date of
death of the testator is included in the principal of the estate.
3. Premium or discount on investments in bonds included in principal is not amortized. All
proceeds from sale or redemption of bonds are principal.
4. Income is charged with a reasonable provision for depreciation, computed in accordance
with generally accepted accounting principles, on all depreciable property except prop-
erty used by a beneficiary, such as a residence or a personal automobile. Income also is
642 Part Four Accounting for Fiduciaries

charged with costs of administering and preserving income-producing property. Such

costs include property taxes, ordinary repairs, and property insurance.
5. Principal is charged with expenditures incurred in preparing principal property for sale
or rent, cost of investing and reinvesting principal property, major repairs to principal
property, and income taxes on receipts or gains allocable to principal.
6. Court costs, attorneys’ fees, trustees’ fees, and accountants’ fees for periodic reporting
to the probate court are allocated as appropriate to principal and to income.

Illustration of Accounting for an Estate

Now that certain legal issues involved in estates have been discussed, it is appropriate to
illustrate the accounting for estates, including the charge and discharge statement rendered
by the personal representative at the closing of the estate. Estate accounting is carried out
in accordance with the accountability technique illustrated in Chapter 14. The accounting
records of the personal representative include only those items for which the representative
is accountable, under the equation Assets Accountability.
The illustration on pages 644–646 of journal entries in accounting for an estate is based
on the following information for the estate of Jessica Davis:
1. Jessica Davis, a single woman, died March 18, 2006, after a brief illness that required
her to be hospitalized. Her will, approved for informal probate on March 25, 2006, con-
tained the following devises:
a. General devises of $10,000 cash to each of three household employees: Alice Martin,
Angelo Bari, and Nolan Ames. Devisees must waive claims for unpaid wages on date
of death.
b. Specific devise of all 200 shares of Preston Company common stock to Nancy
Grimes, a niece.
c. Specific devise of paintings, other art objects, clothing, jewelry, and personal effects
to Frances Davis Grimes, sister of Jessica Davis.
d. Specific devise of residence, furniture, and furnishings to Wallace Davis, brother of
Jessica Davis.
e. General devise of $5,000 cash to Universal Charities, a nonprofit organization.
f. Residue of estate in trust (First National Bank, Trustee) to Nancy Grimes; income to
be paid to her at the end of each calendar quarter until her twenty-first birthday on
October 1, 2011, at which time the principal also is to be paid to Nancy Grimes.
2. Paul Hasting, attorney for Jessica Davis and executor of her estate, published the
required newspaper notice to creditors on March 26, April 2, and April 9, 2006. The
following claims were received from creditors within the four-month statutory
period:

List of Claims against Funeral costs (Wade Mortuary) $ 810

Estate of Jessica Davis Hospital costs (Suburban Hospital) 1,928
Physician’s fees (Charles Carson, M.D.) 426
Morningside Department Store charge account 214
Various residence bills 87
Total claims against estate of Jessica Davis $3,465
 Chapter 15 Estates and Trusts 643

3. Hasting prepared final individual federal and state income tax returns for Jessica Davis
for the period January 1 to March 18, 2006. The federal return showed income tax due
in the amount of $457; the state return showed no tax due.
4. Hasting prepared the following inventory of property owned by Jessica Davis on March
18, 2006:

List of Property Current Fair Values,

Included in Estate of Description of Estate Property Mar. 18, 2006
Jessica Davis
Bank checking account $ 2,157
Bank savings account (including accrued interest) 30,477
Savings and loan association 2-year certificate of deposit
maturing June 30, 2006 (including accrued interest) 26,475
Salary earned for period Mar. 1 to Mar. 8, 2006 214
Claim against medical insurance carrier 1,526
Social security benefits receivable 14,820
Proceeds of life insurance policy (payable to estate) 25,000
Marketable securities:
Common stock of Preston Company, 200 shares 8,000
Common stock of Arthur Corporation, 100 shares 6,500
Residence 40,800*
Furniture and furnishings 2,517
Paintings and other art objects 16,522
Clothing, jewelry, personal effects 625
Automobile 2,187
Total current fair value of estate property $177,820

*Subject to unpaid mortgage note of $15,500, due $500 monthly on the last day of the month, plus interest at 10% a year on the unpaid
balance.

5. Subsequent to preparing the foregoing inventory, Hasting discovered a certificate for

600 shares of Campbell Company common stock with a fair value of $18,000.
6. Hasting prepared the federal estate tax return for the Estate of Jessica Davis, Deceased.
The return showed a tax due of $18,556. Hasting also prepared state inheritance tax re-
turns for the devisees showing taxes due of $5,020.
7. Hasting administered the estate, charging a fee of $2,500, and closed the estate by filing
the required legal documents and a charge and discharge statement prepared by a CPA
who was a member of Hasting’s law firm.
644 Part Four Accounting for Fiduciaries

Illustrative Journal PAUL HASTING, EXECUTOR

Entries for Estate Of the Will of Jessica Davis, Deceased
Journal Entries

2006
Mar. 18 Principal Cash (bank checking account) 2,157
Savings Account 30,477
Certificate of Deposit (including accrued interest) 26,475
Salary Receivable 214
Medical Insurance Claim Receivable 1,526
Social Security Benefits Receivable 14,820
Life Insurance Claim Receivable 25,000
Marketable Securities 14,500
Residence 40,800
Furniture and Furnishings 2,517
Paintings and Other Art Objects 16,522
Clothing, Jewelry, Personal Effects 625
Automobile 2,187
Mortgage Note Payable 15,500
Interest Payable ($15,500 0.10 18⁄360) 78
Estate Principal Balance ($177,820 $15,578) 162,242
To record inventory of property owned by decedent Jessica
Davis on date of death, net of lien against residence.

25 Marketable Securities 18,000

Property Discovered 18,000
To record property discovered subsequent to filing of
original inventory of property.

31 Principal Cash 70,511

Income Cash 55
Savings Account 30,477
Salary Receivable 214
Social Security Benefits Receivable 14,820
Life Insurance Claim Receivable 25,000
Interest Revenue 55
To record realization of various property, including $55
interest received on savings account for period Mar. 18
through 31, 2006.

31 Distributions to Income Beneficiaries 55

Income Cash 55
To distribute income cash to residuary devisee Nancy
Grimes, as required by the will.

Apr. 2 Principal Cash 2,050

Loss on Disposal of Principal Property 137
Automobile 2,187
To record disposal of automobile.

(continued)
 Chapter 15 Estates and Trusts 645

PAUL HASTING, EXECUTOR

Of the Will of Jessica Davis, Deceased (continued)
Journal Entries

2006
Apr. 4 Devises Distributed 5,000
Principal Cash 5,000
To record distribution of general devise to Universal
Charities.

16 Liabilities Paid 3,922

Principal Cash 3,922
To record following liabilities paid:
Funeral costs (Wade Mortuary) $ 810
Hospital costs (Suburban Hospital) 1,928
Physician’s fees (Charles Carson, M.D.) 426
Final federal income tax 457
Morningside Department Store charge account 214
Various residence bills 87
Total $ 3,922

19 Principal Cash 1,526

Medical Insurance Claim Receivable 1,526
To record collection of medical insurance claim.

24 Principal Cash 1,000

Income Cash 1,500
Payable to Devisees 1,000
Dividend Revenue 1,500
To record receipt of quarterly cash dividends on common
stock, as follows:
Preston Company (payable to Nancy Grimes) $ 1,000
Arthur Corporation 300
Campbell Company 1,200
Total $ 2,500

25 Receivable from Devisees 23,576

Principal Cash 23,576
To record payment of federal estate tax and state
inheritance taxes on behalf of devisees, as follows:
Federal estate tax $18,556
State inheritance taxes 5,020
Total $23,576

Apr. 26 Principal Cash 6,295

Receivable from Devisees 6,295
To record receipt of cash from specific devisees for their
shares of federal estate tax and state inheritance taxes
as follows:
Frances Davis Grimes ($23,576 0.102)* $ 2,405
Wallace Davis ($23,576 0.165)* 3,890
Total $ 6,295

*See explanation on pages 647–648. (continued)

646 Part Four Accounting for Fiduciaries

PAUL HASTING, EXECUTOR

Of the Will of Jessica Davis, Deceased (concluded)
Journal Entries

2006
Apr. 27 Devises Distributed 30,000
Receivable from Devisees 4,173
Principal Cash 25,827
To record payment of cash to general devisees, less
amounts receivable for their shares of federal estate
tax and state inheritance taxes, as follows:
$10,000 devises payable to Alice Martin,
Angelo Bari, Nolan Ames ($10,000 3) $30,000
Less: Share of death taxes ($23,576
0.059* 3) 4,173
Net cash paid $25,827
30 Mortgage Note Payable 15,500
Interest Payable 78
Devises Distributed 52,886
Payable to Devisees 1,000
Marketable Securities 8,000
Residence 40,800
Furniture and Furnishings 2,517
Paintings and Other Art Objects 16,522
Clothing, Jewelry, Personal Effects 625
Principal Cash 1,000
To transfer to devisee Nancy Grimes cash for dividend
received on Preston Company common stock; and to
record distribution of specific devises as follows:
Specific devise to Nancy Grimes:
200 shares of Preston Company common stock $ 8,000
Specific devise to Frances Davis Grimes:
Paintings, other art objects, clothing, jewelry,
personal effects 17,147
Specific devise to Wallace Davis:
Residence, net of mortgage note payable, with
furniture and furnishings 27,739
Total $52,886

May 1 Administrative Costs 2,500

Principal Cash 2,500
To record payment of executor’s fee.
3 Devises Distributed 85,797
Distributions to Income Beneficiaries 1,500
Principal Cash (balance of account) 21,714
Income Cash 1,500
Certificate of Deposit 26,475
Marketable Securities 24,500
Receivable from Devisees (balance of account) 13,108
To record distribution of residuary devise (principal and income)
to First National Bank, trustee for Nancy Grimes, devisee.

*See explanation on pages 647–648.

 Chapter 15 Estates and Trusts 647

The foregoing journal entries are entered in the accounting records for the Estate of
Jessica Davis, Deceased. (Dates for journal entries are assumed.) Comments relating to
specific journal entries that require particular emphasis follow:

March 18 Journal Entry

This entry records the executor’s inventory of estate property, including accrued inter-
est and unpaid salary on the date of death. Because the decedent was a single woman,
there was no homestead allowance, family allowance, or exempt property. The mort-
gage note payable (and any accrued interest) applicable to the residence is recognized as
a liability for accountability purposes. Claims of unsecured creditors are not recorded
as liabilities because the accounting records for an estate are not designed to record
all aspects of the estate’s financial position; accounting records for an estate re-
flect only the executor’s accountability for property and any direct claims against the
property.

March 31 Journal Entries

A separate ledger account, Income Cash, is used to record cash receipts attributable to in-
come. In accordance with provisions of the will of Jessica Davis, the income of $55 attrib-
utable to the residuary devise to Nancy Grimes is distributed to her at the end of the
calendar quarter.

April 2 Journal Entry

No depreciation was recognized on the automobile prior to its disposal, because it was not
a revenue-producing asset for the estate.

April 16 Journal Entry

The Liabilities Paid ledger account represents a reduction of the executor’s accountability
for estate property; it is neither an asset account nor an expense account, but rather an
account in which distributions to estate creditors are recorded.

April 24 Journal Entry

Dividends received on marketable securities required segregation in the accounting records,
because the securities are allocable to separate devises, as follows:
1. Preston Company common stock, $1,000: Allocable to specific devise to Nancy Grimes.
2. Arthur Corporation and Campbell Company common stocks, $1,500: Allocable to
residuary devise to Nancy Grimes.
Although Nancy Grimes is the recipient of both devises, the residuary devise ultimately
will be placed in a testamentary trust for the devisee.

April 25 Journal Entry

The will of Jessica Davis was silent regarding allocation of estate and inheritance taxes.
Consequently, in accordance with the provisions of the Uniform Probate Code, the federal
estate tax and state inheritance taxes are allocated in the ratio of interests of devisees, other
than the nontaxable nonprofit organization, in the estate. The following summary shows
this ratio:
648 Part Four Accounting for Fiduciaries

Ratio of Devisee PAUL HASTING, EXECUTOR

Interests in Estate of Of the Will of Jessica Davis, Deceased
Jessica Davis Ratio of Devisee Interests
April 25, 2006

Current Fair Value Ratio to Total of

Devisee of Estate Interest All Estate Interests
Alice Martin $ 10,000 5.9%
Angelo Bari 10,000 5.9
Nolan Ames 10,000 5.9
Nancy Grimes (specific devise) 8,000 4.7
Frances Davis Grimes 17,147 (1) 10.2
Wallace Davis 27,739 (2) 16.5
Nancy Grimes (residuary devise) 85,797 50.9
Totals $168,683 (3) 100.0%

(1) $16,522 $625 $17,147.

(2) ($40,800 $2,517) ($15,500 $78) $27,739.
(3) $162,242 $18,000 $137 $5,000 $3,922 $2,500 $168,683.

April 26 and April 27 Journal Entries

The executor requested the specific devisees to pay in cash their shares of the federal estate
tax and state inheritance taxes. The executor withheld the general devisees’ death taxes
from the cash payable to them.

May 1 Journal Entry

The entire fee of the executor was charged to estate principal because the time spent by
Paul Hasting on income property was insignificant. The allocation of fees is more appro-
priate for a trust than for an estate of relatively short duration.

May 3 Journal Entry

No adjusting entries are required for interest on the certificate of deposit or any declared
but unpaid dividends on the marketable securities. An accrual-basis cutoff for an estate is
appropriate only at the time the executor prepares the inventory of estate property in order
to facilitate the distinction between estate principal and estate income. If the will provides
that the accrual basis of accounting must be used, the executor must comply.
In the preceding illustration, federal and state income taxes on the estate were disre-
garded. In addition, it was assumed that devisee Wallace Davis immediately occupied the
decedent’s residence, so that depreciation on the residence was not required as it would
be if rent revenue were realized from a lease. A further assumption was that devisee Wallace
Davis paid the March 31 and April 30, 2006, installments on the mortgage note secured by
the residence.

Trial Balance
A trial balance of the ledger accounts of the Estate of Jessica Davis on May 3, 2006, is as
follows:
 Chapter 15 Estates and Trusts 649

PAUL HASTING, EXECUTOR

Of the Will of Jessica Davis, Deceased
Trial Balance
May 3, 2006

Dr (Cr)
Principal:
Estate principal balance $(162,242)
Property discovered (18,000)
Loss on disposal of principal property 137
Liabilities paid 3,922
Devises distributed 173,683
Administrative costs 2,500
Total $ -0-
Income:
Interest revenue $ (55)
Dividend revenue (1,500)
Distributions to income beneficiaries 1,555
Total $ -0-

Charge and Discharge Statement for Executor

The executor’s charge and discharge statement and supporting exhibits for the Estate of
Jessica Davis are below and on pages 650–651. The items in the statement were taken from
the trial balance above. Although the executor’s activities essentially ended May 3, the Uni-
form Probate Code precludes closing an estate earlier than six months after the issuance of
letters testamentary.

PAUL HASTING, EXECUTOR

Of the Will of Jessica Davis, Deceased
Charge and Discharge Statement
For Period March 18 through September 18, 2006

First, as to Principal
I charge myself as follows:
Inventory of estate property, Mar. 18, 2006 (Exhibit 1) $162,242
Property discovered (Exhibit 2) 18,000 $180,242
I credit myself as follows:
Loss on disposal of principal property (Exhibit 3) $ 137
Liabilities paid (Exhibit 4) 3,922
Devises distributed (Exhibit 5) 173,683
Administrative costs (Exhibit 6) 2,500 180,242
Balance, Sept. 18, 2006 $ -0-
Second, as to Income
I charge myself as follows:
Interest revenue (bank savings account) $ 55
Dividend revenue (Exhibit 7) 1,500 $ 1,555
I credit myself as follows:
Distributions of income (Exhibit 8) 1,555
Balance, Sept. 18, 2006 $ -0-
650 Part Four Accounting for Fiduciaries

PAUL HASTING, EXECUTOR

Of the Will of Jessica Davis, Deceased
Exhibits Supporting Charge and Discharge Statement
For Period March 18 through September 18, 2006

Exhibit 1—Inventory of Estate Property, Mar. 18, 2006:

Bank checking account $ 2,157
Bank savings account (including accrued interest) 30,477
Savings and loan association 2-year certificate
of deposit maturing June 30, 2006 (including
accrued interest) 26,475
Salary earned for period Mar. 1 to 8, 2006 214
Claim against medical insurance carrier 1,526
Social security benefits receivable 14,820
Proceeds of life insurance policy (payable to estate) 25,000
Marketable securities:
Common stock of Preston Company, 200 shares 8,000
Common stock of Arthur Corporation, 100 shares 6,500
Residence $ 40,800
Less: Balance of mortgage note payable, including
accrued interest of $78 15,578 25,222
Furniture and furnishings 2,517
Paintings and other art objects 16,522
Clothing, jewelry, personal effects 625
Automobile 2,187
Total inventory of estate property $162,242

Exhibit 2—Property Discovered:

On Mar. 25, 2006, a certificate for 600 shares of
Campbell Company common stock was discovered
among the decedent’s personal effects. All other
securities were located in the decedent’s safe deposit
box at First National Bank. (Valued at fair value on
date of Jessica Davis’s death.) $ 18,000

Exhibit 3—Loss on Disposal of Principal Property:

Disposal of automobile, Apr. 3, 2006
Carrying amount $ 2,187
Less: Cash proceeds 2,050
Loss on disposal of principal property $ 137

Exhibit 4—Liabilities Paid:

Wade Mortuary $ 810
Suburban Hospital 1,928
Charles Carson, M.D. 426
Final federal income tax 457
Morningdale Department Store 214
Various residence bills 87
Total liabilities paid $ 3,922

(continued)
 Chapter 15 Estates and Trusts 651

PAUL HASTING, EXECUTOR

Of the Will of Jessica Davis, Deceased
Exhibits Supporting Charge and Discharge Statement (concluded)
For Period March 18 through September 18, 2006

Exhibit 5—Devises Distributed:

General devise to Universal Charities: Cash $ 5,000
General devise to Alice Martin: Cash 10,000
General devise to Angelo Bari: Cash 10,000
General devise to Nolan Ames: Cash 10,000
Specific devise to Nancy Grimes: 200 shares of
Preston Company common stock 8,000
Specific devise to Frances Davis Grimes: Paintings, other
art objects, clothing, jewelry, personal effects 17,147
Specific devise to Wallace Davis: Residence, net of mortgage
note payable, with furniture and furnishings 27,739
Residuary devise to Nancy Grimes: Cash, certificate of deposit,
100 shares of Arthur Corporation common stock, and
600 shares of Campbell Company common stock (in trust) 85,797
Total devises distributed $173,683

Exhibit 6—Administrative Costs:

Fee of executor (charged entirely to principal because
income administration activities were nominal) $ 2,500

Exhibit 7—Dividend Revenue:

Arthur Corporation common stock $ 300
Campbell Company common stock 1,200
Total dividend revenue $ 1,500

Exhibit 8—Distributions of Income:

Mar. 31, 2006: To residuary devisee Nancy Grimes $ 55
May 3, 2006: To First National Bank, trustee for Nancy Grimes 1,500
Total distributions of income $ 1,555

The foregoing charge and discharge statement shows the executor’s accountability,
not the financial position or cash transactions of the estate. The statement discloses the
charges to the executor for estate principal and estate income property for which the
executor is accountable, and the credits to the executor for the dispositions made of
estate property.

Closing Entry for Estate

Once the executor’s closing statement and charge and discharge statement have been
accepted by the probate court, the accountant for the estate may prepare an appropriate
closing entry. The closing entry for the estate of Jessica Davis on September 18, 2006,
follows:
652 Part Four Accounting for Fiduciaries

Journal Entry to Close Estate Principal Balance 162,242

Estate of Jessica Davis Property Discovered 18,000
Interest Revenue 55
Dividend Revenue 1,500
Loss on Disposal of Principal Property 137
Liabilities Paid 3,922
Devises Distributed 173,683
Administrative Costs 2,500
Distributions to Income Beneficiaries 1,555
To close estate of Jessica Davis in accordance with probate
court authorization.

The example of estate accounting in this chapter was simplified in terms of details
and time required for the liquidation of the estate. In practice, many estates—especially
those involved in formal probate proceedings—take several months and sometimes
years to settle. For many estates, preparation of the federal estate tax return is a complex
task. Furthermore, the estate of an intestate decedent involves complicated legal issues.
An accountant involved in accounting for an estate must be familiar with provisions
of the decedent’s will and with appropriate state probate laws and principal and in-
come laws, and should work closely with the attorney and executor (or administrator)
for the estate.

LEGAL AND ACCOUNTING ASPECTS OF TRUSTS

A trust created by a will, as illustrated in the preceding section of this chapter, is a testa-
mentary trust. A trust created by the act of a living person or persons is an inter vivos, or
living, trust. The parties to a trust are (1) the settlor (also known as the donor or trustor)—
the individual creating the trust, (2) the trustee—the fiduciary individual or corporation
holding legal title to the trust property and carrying out the provisions of the trust docu-
ment for a fee, and (3) the beneficiary—the party for whose benefit the trust was estab-
lished. As noted on page 641, the income from trust property may be distributed to an
income beneficiary, but the principal of a trust ultimately goes to a principal beneficiary
(also known as the remainderman).

Provisions of Uniform Probate Code Governing Trusts

The Uniform Probate Code contains detailed sections dealing with trust registration, juris-
diction of courts concerning trusts, duties and liabilities of trustees, and powers of trustees.
The Code requires that a trustee of a trust must register the trust with the appropriate state
probate court. Registration subjects the trust to the jurisdiction of the court. The court’s ju-
risdiction may include appointing or removing a trustee, reviewing the trustee’s fees, and
reviewing or settling interim or final accountings of the trustee. The trustee is required by
the Code to administer the trust expeditiously for the benefit of the beneficiaries, and to use
standards of care appropriate for a prudent person in dealing with the property of others.
The trustee must keep the trust beneficiaries reasonably informed as to the administration
of the trust, and furnish the beneficiaries a statement of the trust accounts annually (or more
frequently if necessary) and at the termination of the trust.
 Chapter 15 Estates and Trusts 653

Provisions of Revised Uniform Principal and

Income Act Governing Trusts
The provisions for allocations between principal and income that are set forth in the
Revised Uniform Principal and Income Act (pages 641–642) are applicable to trusts as well
as to estates.

Illustration of Accounting for a Trust

The journal entries in the accounting records of a trust usually differ from those of an es-
tate because of the longer life of a trust. Whereas the personal representative for an estate
attempts to complete the administration of the estate as expeditiously as possible, the
trustee for a trust must comply with the provisions of the trust document during the stated
term of the trust. Accordingly, the trustee’s activities include investment of trust property
and maintenance of accounting records for both trust principal and trust income.
To illustrate the accounting issues for a trust, return to the testamentary trust provided
by the will of Jessica Davis (page 642). The trust was created by the residuary devise to
Nancy Grimes, which required the trustee to pay income from the trust to Grimes at the end
of each calendar quarter until her twenty-first birthday (October 1, 2011), at which time the
trust principal would be paid to Grimes. Thus, Grimes is both the income beneficiary and
the principal beneficiary.
The following journal entries illustrate the activities of First National Bank, trustee for
Nancy Grimes, during the quarter ended June 30, 2006. The journal entries for the Nancy
Grimes Trust are essentially cash-basis entries; there is no need to accrue interest or divi-
dends on trust investments at the end of a quarter because conventional financial statements
generally are not prepared for a trust.

NANCY GRIMES TRUST

First National Bank, Trustee
Journal Entries

2006
May 3 Principal Cash 21,714
Income Cash 1,500
Certificate of Deposit (including accrued interest) 26,475
Marketable Securities 24,500
Trust Principal Balance 72,689
Trust Income Balance 1,500
To record receipt of principal and income property in trust
from Paul Hasting, executor of estate of Jessica Davis.
May 6 Marketable Securities 19,900
Interest Receivable 180
Principal Cash 20,080
To record acquisition of the following securities:
$15,000 face amount of 12% bonds of
Warren Company, due Mar. 31, 2026 $15,000
Accrued interest 180
$5,000 face amount of commercial paper of
Modern Finance Company, due July 5, 2006
acquired at 12% discount 4,900
Total cash paid $20,080

(continued)
654 Part Four Accounting for Fiduciaries

NANCY GRIMES TRUST

First National Bank, Trustee (concluded)
Journal Entries

June 30 Principal Cash 26,475

Income Cash 612
Certificate of Deposit 26,475
Interest Revenue 612
To record proceeds of matured certificate of deposit and
interest since Mar. 18, 2006.

30 Administrative Costs 250

Expenses Chargeable to Income 250
Principal Cash 250
Income Cash 250
To record payment of trustee fee for period May 3–June 30,
2006, chargeable equally to principal and to income.

30 Marketable Securities 25,000

Principal Cash 25,000
To record acquisition of 14% U.S. Treasury notes due June 30,
2006, at face amount.

30 Distributions to Income Beneficiary 1,862

Income Cash 1,862
To record regular quarterly distribution to income beneficiary
Nancy Grimes.

The May 3, 2006, opening journal entry for the trust is the counterpart of the journal
entry for the Estate of Jessica Davis on the same date (page 646), except that the amount
receivable from the trust beneficiary for federal estate tax and state inheritance tax was off-
set against the gross amount of the devise, and the $72,689 difference ($85,797 $13,108)
was recorded as the trust principal balance.

Trial Balance
The trial balance of the Nancy Grimes Trust on June 30, 2006, is as follows:

NANCY GRIMES TRUST

First National Bank, Trustee
Trial Balance
June 30, 2006

Dr (Cr)
Principal:
Principal cash $ 2,859
Marketable securities 69,400
Interest receivable 180
Trust principal balance (72,689)
Administrative costs 250
Totals $ -0-
(continued)
 Chapter 15 Estates and Trusts 655

NANCY GRIMES TRUST

First National Bank, Trustee (concluded)
Trial Balance
June 30, 2006

Dr (Cr)
Income:
Trust income balance $ (1,500)
Interest revenue (612)
Expenses chargeable to income 250
Distributions to income beneficiary 1,862
Totals $ -0-

Charge and Discharge Statement for Trustee

A charge and discharge statement for the trustee of the Nancy Grimes Trust would resem-
ble the charge and discharge statement for an estate illustrated on pages 649–651. The ma-
jor difference would be an exhibit for the details of the $72,439 ($72,689 $250) trust
principal balance on June 30, 2006.

Periodic Closing Entry for Trust

A closing entry should be made for a trust at the end of each period for which a charge and
discharge statement is prepared to clear the nominal accounts for the next reporting period.
The closing entry for the Nancy Grimes Trust on June 30, 2006, is as illustrated below:

Periodic Closing Entry Trust Principal Balance 250

for a Trust Trust Income Balance 1,500
Interest Revenue 612
Administrative Costs 250
Expenses Chargeable to Income 250
Distributions to Income Beneficiary 1,862
To close nominal accounts of trust.

At the time specified in the trust document for transfer of the trust principal to the prin-
cipal beneficiary, a journal entry is made to debit the Distributions to Principal Beneficiary
ledger account and credit the various trust principal asset accounts. A closing entry for the
termination of the trust would then be required, in the form of the comparable estate jour-
nal entry illustrated on page 652.

Review 1. Is the Uniform Probate Code in effect throughout the United States?
Questions 2. Define the following terms:
a. Estate f. Letters testamentary
b. Intestacy g. Devise
c. Testator h. Remainderman
d. Executor i. Inter vivos trust
e. Administrator j. Settlor
3. Compare informal probate with formal probate of a will.
656 Part Four Accounting for Fiduciaries

4. Compare the standards of care required of a personal representative of a decedent with

the standards of care required of a trustee of a trust.
5. Why must there be a distinction between principal and income in the administration of
an estate?
6. Describe the exempt property and allowances provisions of the Uniform Probate
Code.
7. What type of devise is each of the following?
a. The beach house at 1411 Ocean Avenue, Long Beach, California.
b. $25,000 cash.
c. $60,000 face amount of U.S. Treasury bonds.
d. 1,000 shares of Rogers Corporation common stock represented by certificate
No. G-1472.
e. All my remaining property.
8. Is the accrual basis of accounting ever used for an estate or a trust? Explain.
9. Explain the requirements for depreciation accounting contained in the Revised Uni-
form Principal and Income Act.
10. Describe the use of the Property Discovered ledger account in accounting for an estate.
11. Compare a personal representative’s charge and discharge statement for an estate with
the financial statements issued by a business enterprise.
12. Discuss the similarities and differences in the journal entries for estates and for trusts.

Exercises
(Exercise 15.1) Select the best answer for each of the following multiple-choice questions:
1. In the accounting records of the executor of an estate, the Property Discovered ledger
account is:
a. An asset account.
b. A liability account.
c. An equity account.
d. An accountability account.
2. If estate property that is not exempt is insufficient to cover creditors’ claims as well as
all devises, and the will is silent as to abatement, the Uniform Probate Code provides
the following abatement sequence:
a. Property not specifically mentioned in the will, residuary devises, general devises,
specific devises.
b. Residuary devises, specific devises, property not specifically mentioned in the will,
general devises.
c. General devises, residuary devises, property not specifically mentioned in the will,
specific devises.
d. None of the above.
3. Which of the following ledger accounts of an executor of a decedent’s will typically
has a debit balance?
a. Assets Discovered
b. Liabilities Paid
c. Estate Principal Balance
d. None of the above.
 Chapter 15 Estates and Trusts 657

4. In the abatement sequence for devises established by the Uniform Probate Code, the
last devises to be abated are:
a. Specific devises
b. General devises
c. Residuary devises
d. Inter vivos devises
5. The Devises Distributed ledger account of a decedent’s estate is a(n):
a. Asset account
b. Liability account
c. Accountability account
d. Expense account
6. Devises distributed are displayed in the charge and discharge statement for the execu-
tor of a decedent’s will in the section:
a. First, as to principal, I charge myself as follows.
b. First, as to principal, I credit myself as follows.
c. Second, as to income, I charge myself as follows.
d. Second, as to income, I credit myself as follows.
7. The ranking, in order of priority of payment by the personal representative of a dece-
dent’s estate, of debts and taxes with preference under federal law is:
a. First
b. Second
c. Third
d. Fourth
8. The financial statement prepared periodically for the trustee of a trust is:
a. A charge and discharge statement.
b. A statement of realization and liquidation.
c. An income statement.
d. A statement of affairs.
9. The Liabilities Paid ledger account in the accounting records of the personal represen-
tative of an estate is a(n):
a. Asset account
b. Liability account
c. Accountability account
d. Expense account
10. In the charge and discharge statement for the executor of a will, property discovered is
displayed with:
a. Principal—I charge myself as follows.
b. Income—I charge myself as follows.
c. Principal—I credit myself as follows.
d. Income—I credit myself as follows.
11. Court costs, attorneys’ fees, trustees’ fees, and accountants’ fees for periodic reporting
to the probate court by a trustee are:
a. Charged entirely to principal.
b. Charged entirely to income.
c. Allocated to principal and income.
d. Charged as ordered by the court.
658 Part Four Accounting for Fiduciaries

12. A devise of 1,000 shares of The Walt Disney Company common stock is a(n):
a. Residuary devise
b. General devise
c. Specific devise
d. Abated devise
13. Which of the following journal entries (amounts and explanations omitted) is inappro-
priate for an estate?
a. Savings Account
Property Discovered
b. Receivable from Devisees
Principal Cash
c. Liabilities Paid
Principal Cash
d. Devises Distributed
Income Cash
e. None of the above.
14. A personal representative of an estate who is appointed by the probate court is a(n):
a. Executor
b. Administrator
c. Trustee
d. Devisee
(Exercise 15.2) Indicate whether each of the following items would be charged to trust principal or to trust
income of a testamentary trust, assuming that the Revised Uniform Principal and Income
Act is to be followed:
a. Depreciation of building.
b. Legal fees for managing trust property.
c. Special assessment tax levied on real property for street improvements.
d. Interest on mortgage note payable.
e. Loss on disposal of trust investments.
f. Major repairs to real property prior to disposal of the property.
(Exercise 15.3) After the payment of all estate liabilities, excepting the executor’s fee of $40,000, the
following property remained in the Estate of Allen Baker, deceased, on April 30, 2006:

CHECK FIGURE Amount % of Total

Residuary devise, $0.
Cash in checking account $13,860 21%
Bank certificate of deposit maturing April 30, 2007,
including accrued interest 21,120 32
100 shares of BBM Company common stock, at current
fair value on date of death 9,900 15
$20,000 face amount Southeastern Airlines 7% bonds
due 2008, at current fair value on date of death 21,120 32
Total estate property $66,000 100%

The following devises remained to be distributed by the executor:

1. Barbara Baker (wife)—certificate no. X4738 for $20,000 face amount of Southeastern
Airlines 7% bonds due 2008.
 Chapter 15 Estates and Trusts 659

2. Carl Baker (son)—50 shares of BBM Company common stock.

3. Danielle Baker (daughter)—50 shares of BBM Company common stock.
4. Edie Baker (niece)—residue of estate.
Prepare a working paper to show how total estate property should be distributed by the
executor on April 30, 2006.
(Exercise 15.4) After payment of all liabilities of the Estate of Rhoda Ross, deceased, and the completion
of distributions to income beneficiaries, the trial balance of the estate was as follows on
CHECK FIGURE December 17, 2006:
To Roberta Jones,
$17,500.

Dr (Cr)
Principal:
Principal cash $ 100,000
200 shares of Excel Corporation common stock, at current fair value 60,000
$50,000 face amount of 10% Engle Corporation bonds, plus accrued
interest at date of death, at current fair value 55,000
Estate principal balance (200,000)
Gain on disposal of principal property (15,000)
Total $ -0-

Remaining devises to be distributed were as follows:

1. All 200 shares of Excel Corporation common stock to Leah Ross, daughter.
2. $25,000 face amount of 10% Engle Corporation bonds to Ward Ross, son.
3. $60,000 checking account balance (included in principal cash) in acct. no. 6158 at Bank
of America to University of Carlin, a nonprofit organization.
4. $50,000 cash to Music Center Fund, a nonprofit organization.
5. Residue of estate to Roberta Jones, sister.
Prepare a working paper to show how the foregoing devices are to be distributed on
December 17, 2006. The following column headings are suggested: Devisee, Type of
Devise, Gross Devise Amount, Abated Amount, Net Devise Amount. The Net Devise Amount
column should total $215,000, the carrying amount (and current fair value) of the estate
principal property.
(Exercise 15.5) Prepare journal entries (omit explanations) for the following selected transactions of the ex-
ecutor of the will of Lincoln Johnson, deceased:
2006
Dec. 6 Executor Grant Hayes discovered a certificate for 1,000 shares of Coburn Com-
pany common stock with a current fair value of $6 a share. Hayes had filed the
inventory of estate property with the probate court on November 14, 2006.
14 Hayes distributed a general devise of $2,500 cash to Garfield Arthur, Johnson’s
nephew.
26 Hayes was authorized by the probate court to receive a fee of $1,000 (all
allocable to principal) for services to date. Hayes prepared the check.
31 Hayes paid liabilities of the Estate of Lincoln Johnson in the amount of
$9,200.
660 Part Four Accounting for Fiduciaries

(Exercise 15.6) Selected transactions and events completed by the executor of the will of D. C. Kane, who
died on October 15, 2006, are as follows:
Oct. 20 Inventory of estate property (at current fair value) was filed with the court as
follows:

Cash $ 88,800
Real property 148,000
Arriba Company common stock 60,000
Carter Corporation bonds ($40,000 face amount) 40,000
Accrued interest on Carter Corporation bonds 600
Personal and household effects 23,500

29 A certificate for 150 shares of Basin Corporation common stock valued at

$9,000 was found in the coat pocket of an old suit belonging to the decedent.
Nov. 10 A cash dividend of $520 was received on the Arriba Company common stock.
The stock had been willed as a specific devise to Edward Kane, son of
D. C. Kane.
15 Liabilities of D. C. Kane in the amount of $30,000 were paid.
22 Administrative costs of $3,240 were paid. All costs are chargeable to principal.
29 Bonds of Carter Corporation were sold at 94, plus accrued interest of $1,050.
30 Arriba Company common stock and the cash dividend of $520 received on
November 10 were transferred to Edward Kane.
Prepare journal entries to record the foregoing transactions and events in the accounting
records of the executor of the will of D. C. Kane, deceased. Omit explanations for the
journal entries.
(Exercise 15.7) The inexperienced accountant for Lillian Crane, executor of the will of Marion Wilson,
deceased, prepared the following journal entries, among others:

2006
Apr. 25 Marketable Securities 10,400
Estate Principal Balance 10,400
To record supplemental inventory for property discovered
subsequent to filing of original inventory.

30 Distribution Expense 800

Income Cash 800
To record distribution of income cash to residuary devise,
as required by the will.

May 27 Accounts Payable 7,400

Principal Cash 7,400
To record following liabilities paid:
Funeral costs $2,500
Hospital bills 3,800
Doctor’s fees 1,100
Total $7,400
 Chapter 15 Estates and Trusts 661

Prepare journal entries for Lillian Crane, executor of the will of Marion Wilson, de-
ceased, on May 31, 2006, to correct the foregoing journal entries. Do not reverse the fore-
going entries.
(Exercise 15.8) The accountant for the executor of the will of Howard Jones, deceased, prepared the
following trial balance on December 18, 2006, the date the estate was closed:

MARIAN SMITH, EXECUTOR

Of the Will of Howard Jones, Deceased
Trial Balance
December 18, 2006

Dr (Cr)
Principal:
Estate principal balance (June 18, 2006) $(150,000)
Property discovered (20,000)
Gain on disposal of principal property (1,000)
Liabilities paid 40,000
Devises distributed 125,000
Administrative costs 6,000
Total $ -0-
Income:
Interest revenue $ (10,000)
Dividend revenue (15,000)
Distributions to income beneficiaries 25,000
Total $ -0-

Prepare a charge and discharge statement for Marian Smith, executor of the will of
Howard Jones, deceased, on December 18, 2006. (Disregard supporting exhibits.)
(Exercise 15.9) Barbara Coleman, executor of the will of Robert Kaplan, who died on August 10, 2005,
prepared the following trial balance on February 10, 2006:

CHECK FIGURE
BARBARA COLEMAN, EXECUTOR
Estate principal
Of the Will of Robert Kaplan, Deceased
balance, Feb. 10, Trial Balance
$26,000. February 10, 2006

Dr (Cr)
Principal cash $ 26,000
Income cash 490
Estate principal balance (117,000)
Property discovered (1,800)
Gain on disposal of principal property (1,200)
Administrative costs 3,000
Liabilities paid 24,500
Devises distributed 66,500
Interest revenue (3,590)
Distributions to income beneficiaries 2,000
Expenses chargeable to income 1,100
Total $ -0-
662 Part Four Accounting for Fiduciaries

Prepare an interim charge and discharge statement for the period August 10, 2005,
through February 10, 2006. (Do not prepare supporting exhibits.)
(Exercise 15.10) The trial balance of Wanda Wardlow, executor of the will of William Wardlow, deceased,
on June 30, 2006, the filing date for the final charge and discharge statement, included the
following:

Administrative costs $ 5,000

Property discovered 36,000
Devises distributed 347,366
Distributions to income beneficiaries 3,110
Dividend revenue 3,000
Estate principal balance 324,484
Interest revenue 110
Liabilities paid 7,844
Loss on disposal of principal property 274

Prepare a closing entry for Wanda Wardlow, executor of the will of William Wardlow,
deceased, on June 30, 2006.
(Exercise 15.11) Pursuant to the will of Gina Adams, the residue of her estate after probate of the will is to
be transferred to a testamentary trust. The following trial balance was prepared from the
CHECK FIGURE ledger of the estate on June 30, 2006:
b. Credit trust principal
balance, $6,750.

Dr (Cr)
Principal cash $115,000
Income cash 6,750
Marketable securities 105,000
Estate principal balance (265,000)
Property discovered (13,000)
Gain on disposal of principal property (12,000)
Administrative costs 5,400
Liabilities paid 16,000
Devises distributed 48,600
Interest revenue (4,000)
Dividend revenue (4,500)
Expenses chargeable to income 1,750
Total $ -0-

a. Prepare journal entries to transfer the residuary devise to the trustee and to close the
accounting records of the estate.
b. Prepare a journal entry to open the accounting records of the trust.

(Exercise 15.12) The trial balance of the Wilson Woodrow Trust on April 30, 2006, a date on which the
trustee rendered a charge and discharge statement to the probate court, included the fol-
lowing items:
 Chapter 15 Estates and Trusts 663

Debit Credit
Administrative costs (chargeable to principal) $ 1,700
Distributions to income beneficiary 2,000
Expenses chargeable to income 800
Interest revenue $ 1,600
Marketable securities 80,000
Principal cash 30,000
Trust income balance 1,200
Trust principal balance 111,700
Totals $114,500 $114,500

Prepare a closing entry for the Wilson Woodrow Trust on April 30, 2006.

Cases
(Case 15.1) At a meeting in his office, Carl Roberts, managing partner of Roberts & Webb, LLP, CPAs,
is asked by Albert Hopp, a wealthy tax client, to approve Hopp’s naming Roberts as execu-
tor of his and his terminally ill wife’s wills and as trustee of their testamentary trusts. Hopp
tells Roberts that a bank trust department would not be as effective in the roles as Roberts
because of the complexities of Hopp’s investments, liabilities, and tax matters. Roberts in-
forms Hopp that, as a partner in his firm, Roberts would have to use firm personnel in ad-
ministering the estate and trust, and that such an arrangement might create a conflict of
interest between Roberts as trustee and Roberts as partner. Roberts explained to Hopp that,
under the quality control procedures established by Roberts & Webb, LLP, for the accep-
tance of new clients, he would have to consult with his three partners before accepting the
engagement as executor of the Hopp wills and testamentary trusts.

Instructions
If you were a partner in the Roberts & Webb, LLP, firm, would you approve Carl Roberts’s
acceptance of the proffered executor and trustee appointments by the Hopps? Explain.
(Case 15.2) The estate of Mary Carr included the following securities on the date of death, April 16,
2006 (all of which are a part of the residuary devise):
1. Sand Company 12% bonds due June 16, 2016, face amount $100,000; current fair value
on April 16, 2006 (excluding accrued interest), $103,500; interest payable June 16 and
December 16 of each year.
2. Palko Corporation common stock, 5,000 shares; current fair value on April 16, 2006,
$68,000; dividend of $1 a share declared April 1, 2006, payable May 1, 2006, to stock-
holders of record April 14, 2006.
3. Palko Corporation 8%, $100 par, cumulative preferred stock, 1,000 shares; current fair
value on April 16, 2006, $97,500. Dividends are paid semiannually January 1 and July 1,
and there are no dividends in arrears.

Instructions
a. Inform the executor of the will of Mary Carr, deceased, which of the foregoing items
constitute income and which constitute principal of the estate.
b. If the dividends were in arrears on the Palko Corporation 8%, $100 par, cumulative pre-
ferred stock, would your answer to a be any different? Explain.
664 Part Four Accounting for Fiduciaries

(Case 15.3) James Saliba transferred a manufacturing enterprise and 10,000 shares of MP Company
common stock to Fidelity Trust Company to be held in trust for the benefit of his son,
Robert, for life, with the remainder to go to Robert’s son, Edward. Fidelity Trust Company
insured the enterprise with Boston Insurance Company under two policies. One policy
was a standard fire insurance policy covering the buildings and equipment. The other pol-
icy covered any loss of income during periods when the enterprise was inoperable as a re-
sult of fire or other catastrophe. The buildings and equipment subsequently were destroyed
by fire, and Boston Insurance Company paid claims under both policies to Fidelity Trust
Company.
Shortly after the 10,000 shares of MP Company common stock had been transferred to
Fidelity Trust Company, MP Company declared a dividend of 10 shares of Monte Oil Cor-
poration common stock for each 100 shares of MP Company common stock held. The
Monte Oil common stock had been acquired as an investment by MP Company.
During the same year, MP Company directors split the common stock 2 for 1. After the
distribution of the new shares, Fidelity Trust Company disposed of 10,000 shares of MP
Company common stock.

Instructions
How should Fidelity Trust Company handle the events described above as to distribution
between the income beneficiary and the remainderman? State reasons for making the dis-
tribution in the manner that you recommend.
(Case 15.4) In reviewing the accounting records of Stanley Koyanagi, executor of the will of Edward
Dunn, who died January 16, 2006, you study the will and other documents, which reveal
that (1) Dunn’s son received a specific devise of the decedent’s only rental property and
12% bonds of Padre Corporation, $50,000 face amount, due March 1, 2016; (2) Dunn’s
daughter was the beneficiary of a life insurance policy (face amount $100,000) on which
the decedent had paid the premiums; and (3) Dunn’s widow had been left the remainder of
the estate in trust.
Your review also reveals the following transactions and events occurring from the time
of Dunn’s death to March 1, 2006:
(1) Jan. 17 $3,195 was received from the redemption of $3,000 face amount of
Camm Corporation 13% bonds that matured on January 15, 2006.
(2) Jan. 20 $500 was received from Pittson Corporation as a cash dividend of $1 a
share on common stock, declared December 1, 2005, payable January
15, 2006, to stockholders of record January 2, 2006.
(3) Jan. 20 $5,040 was paid to Witter & Company, stockbrokers, for the acquisi-
tion of five Seaboard, Inc., 14%, $1,000 bonds due June 30, 2017.
(4) Jan. 21 30 shares of common stock were received from Ragusa Company,
constituting a 2% stock dividend declared December 14, 2005, dis-
tributable January 20, 2006, to stockholders of record January 15,
2006.
(5) Feb. 1 $200 quarterly interest was paid by the executor on a promissory note
payable due January 31, 2007.
(6) Feb. 1 Dunn’s physician was paid $2,500 for services rendered during Dunn’s
last illness.
(7) Feb. 2 $600 was received from East Corporation as a cash dividend of $0.25
a share on common stock, declared January 18, 2006, payable January
30, 2006, to stockholders of record January 27, 2006.
(8) Feb. 3 $575 rent revenue for February was received and deposited in the bank.
 Chapter 15 Estates and Trusts 665

(9) Feb. 10 $890 was paid for property taxes covering the period from February 1
to July 31, 2006.
(10) Mar. 1 $1,802 was paid to the Internal Revenue Service as the remaining in-
come taxes owed by the decedent for 2005 taxable income.
Instructions
Indicate whether each transaction or event should be:
Allocated between principal and income.
Allocated between principal and beneficiaries (devisees).
Attributed solely to income.
Attributed solely to principal.
Attributed solely to beneficiaries (devisees).
State reasons supporting your conclusions as to how each transaction or event should be
handled.

Problems
(Problem 15.1) Mildred Young died on June 5, 2006. Michael Synn was named executor in the will that had
been prepared by Young’s attorney. On December 31, 2006, the accountant for the executor
prepared the following trial balance:

CHECK FIGURE MICHAEL SYNN, EXECUTOR

Estate principal Of the Will of Mildred Young, Deceased
balance, Dec. 31, Trial Balance
$557,800. December 31, 2006

Dr (Cr)
Principal cash $ 25,700
Income cash 13,000
Investments in bonds 268,300
Investments in common stocks 224,300
Household effects 39,500
Gains on disposal of principal property (2,200)
Property discovered (16,800)
Liabilities paid 36,200
Administrative costs 10,000
Devises distributed 15,000
Estate principal balance (600,000)
Dividend revenue (14,200)
Interest revenue (18,500)
Expenses chargeable to income 720
Distributions to income beneficiaries 18,980
Total $ -0-

Instructions
The amount in the Estate Principal Balance ledger account represents the inventory of es-
tate property on June 5, 2006. Prepare an interim charge and discharge statement for the
666 Part Four Accounting for Fiduciaries

executor of the will of Mildred Young for the period June 5 through December 31, 2006.
Supporting exhibits are not required for any items except the listing of property compris-
ing the estate principal balance on December 31, 2006.
(Problem 15.2) Pablo Garcia died on March 1, 2006, leaving a will in which he named Mark Castro as
executor and trustee pending final distribution of estate property to Manuel Montejano, a
CHECK FIGURE nephew. The will instructed the executor to transfer Garcia’s personal effects and automo-
c. Credit trust principal bile to the nephew, to pay estate taxes, outstanding liabilities, and administrative costs of
balance, $189,600. the estate, and to transfer the remaining estate property to a trust for the benefit of the
nephew. Income from the estate and the trust was to be paid to the nephew, who was to re-
ceive the principal (corpus) upon graduation from State University.
The inventory of estate property on March 1, 2006, consisted of the following:

Cash $ 44,440
Certificate of deposit at Standard Savings Bank (includes
accrued interest of $1,100) 101,100
Personal effects 13,200*
Automobile 2,800*
Investments in common stocks 77,000*

*At current fair value.

The following transactions or events were completed by the executor through De-
cember 10, 2006:
(1) Discovered a savings account of $6,290 in the name of Pablo Garcia. (Debit
Principal Cash.)
(2) Paid administrative costs for the estate, $5,200. All costs are chargeable to principal.
(3) Disposed of common stock with a carrying amount of $20,000 for $26,020, net of
commissions.
(4) Transferred personal effects and automobile to Manuel Montejano.
(5) Received income as follows (there were no expenses chargeable to income): Interest,
$5,200 (includes accrued interest on certificate of deposit on March 1, 2006);
dividends, $1,400.
(6) Distributed the income of the estate to Manuel Montejano.
(7) Paid liabilities of decedent, $8,050.
(8) Paid estate taxes, $32,000. (Debit Estate Taxes Paid.)
(9) Closed the accounting records of the estate and transferred property to the Manuel
Montejano Trust.

Instructions
a. Prepare journal entries to record the foregoing transactions or events and to close the
accounting records of the estate. Disregard homestead allowance, exempt property,
and family allowance.
b. Prepare a charge and discharge statement immediately after the transfer of estate
property to the Manuel Montejano Trust. Do not prepare any supporting exhibits.
c. Prepare a journal entry on December 10, 2006, to open the accounting records for the
testamentary trust: the Manuel Montejano Trust.
 Chapter 15 Estates and Trusts 667

(Problem 15.3) Janet Mann died on May 31, 2006. Her will provided that all liabilities and costs were to be
paid and that the property was to be distributed as follows:
CHECK FIGURE 1. Personal residence to George Mann, widower of Janet Mann.
Estate principal 2. U.S. Treasury 12% bonds and Permian Company common stock—to be placed in trust.
balance, July 1, All income to go to George Mann during his lifetime.
$291,700.
3. Sonar Corporation 9% bonds—devised to Eleanor Mann, daughter of Janet Mann.
4. Cash—a devise of $15,000 to Dudley Mann, son of Janet Mann.
5. Residue of estate—to be divided equally between the two children of Janet Mann:
Eleanor and Dudley.

Additional Information
1. The will further provided that during the administration period George Mann was to be
paid $1,500 a month from estate income. Estate and inheritance taxes were to be paid
from the principal of the estate. Dudley Mann was named as executor and trustee.
2. The following inventory of the decedent’s property was prepared (amounts are current
fair values):

Personal residence $245,000

Jewelry—diamond ring 14,600
City National Bank—checking account; balance May 31, 2006 43,000
$200,000 U.S. Treasury 12% bonds, due 2022, interest payable
Mar. 1 and Sept. 1 (includes accrued interest of $6,000) 206,000
$10,000 Sonar Corporation 9% bonds, due 2015, interest payable
May 31 and Nov. 30 9,900
Permian Company common stock, 800 shares 64,000
Dividends receivable on Permian Company common stock 800
Roe Company common stock, 700 shares 70,000

3. The executor opened an estate checking account and transferred the decedent’s check-
ing account balance to it. Other deposits in the estate checking account through July 1,
2007, were as follows:

Interest received on $200,000 U.S. Treasury 12% bonds:

Sept. 1, 2006 $12,000
Mar. 1, 2007 12,000
Dividends received on Permian Company common stock:
June 15, 2006, declared May 7, 2006, payable to holders of record
May 27, 2006 800
Sept. 15, 2006 800
Dec. 15, 2006 1,200
Mar. 15, 2007 1,500
June 15, 2007 1,500
Net proceeds of June 19, 2006, disposal of 700 shares of Roe Company
common stock 68,810
668 Part Four Accounting for Fiduciaries

4. Payments were made from the estate checking account through July 1, 2007, for the
following:

Liabilities of decedent paid (including funeral costs) $12,000

Additional prior years’ federal and state income taxes, plus interest to
May 31, 2006 1,810
Income taxes of Janet Mann for the period Jan. 1, 2006, through
May 31, 2006, in excess of amounts paid by the decedent on
declarations of estimated tax 9,100
Federal and state fiduciary income taxes, fiscal years ending June 30,
2006, and June 30, 2007 2,400
Estate and inheritance taxes 43,000
Monthly payments to George Mann, 13 payments of $1,500 19,500
Attorney’s and accountant’s fees (allocated entirely to principal) 25,000

5. The executor, Dudley Mann, waived a fee. However, he desired to receive his mother’s
diamond ring in lieu of the $15,000 cash devise. All parties agreed to this in writing, and
the probate court’s approval was secured. All devises other than the assets to be held in
trust and the residue of the estate were delivered on July 1, 2007.
Instructions
Prepare a charge and discharge statement as to principal and income, with supporting
exhibits, to accompany the formal court accounting on behalf of the executor of the
will of Janet Mann, deceased, for the period from May 31, 2006, through July 1, 2007.
In accordance with the will, the executor accrued the interest and dividends on the es-
tate investments to July 1, 2007. Disregard homestead allowance, exempt property, and
family allowance.
(Problem 15.4) The will of Frederick Doheny directed that the executor, Richard Cordes, liquidate the
entire estate within two years of the date of death and pay the net proceeds and income
CHECK FIGURE to United Charities. Frederick Doheny, a bachelor, died on February 1, 2006, after a
Estate principal brief illness.
balance, Dec. 31, An inventory of the decedent’s property was prepared, and the current fair value of all
$230,000. items was determined. The preliminary inventory, before the computation of any appropri-
ate income accruals on the property in inventory, follows:

Current
Fair Values
Union Bank checking account $ 33,500
$60,000 face amount Sun City bonds, interest rate 12%, payable
Jan. 1 and July 1, maturity date July 1, 2010 59,000
2,000 shares Ron Corp. common stock 220,000
Term life insurance: beneficiary, Estate of Frederick Doheny 20,000
Residence ($86,500) and furniture ($23,500) 110,000

During the remainder of 2006, the following transactions or events occurred:

1. The interest on the Sun City bonds was received. The bonds were disposed of on July 1,
for $59,000, and the proceeds and interest accrued on February 1 ($600), were paid to
United Charities.
 Chapter 15 Estates and Trusts 669

2. Ron Corp. paid cash dividends of $1 a share on March 1 and December 1, and distrib-
uted a 10% stock dividend on July 1. All dividends had been declared 45 days before
each payment date and were payable to holders of record as of 40 days before each pay-
ment date. In September, 1,000 shares of Ron Corp. common stock were disposed of for
$105 a share, and the proceeds were paid to United Charities.
3. The residence was rented furnished at $900 a month commencing April 1. The rent was
paid monthly, in advance. Property taxes of $1,200 for the calendar year 2006 were paid.
The house and furnishings had estimated economic lives of 40 years and 8 years, re-
spectively. The part-time gardener was paid four months’ wages totaling $500 on April
30 for services performed, and then was released.
4. The Union Bank checking account was closed, and the balance of $8,500 was trans-
ferred to a bank checking account for the estate.
5. The proceeds of the term life insurance were received on March 1 and deposited in the
bank checking account for the estate.
6. The following cash payments were made:
a. Funeral costs and costs of last illness, $3,500.
b. Amount due on 2005 income taxes of decedent, $700.
c. Attorney’s and accountant’s fees, $20,000, of which $3,025 was allocated to income.
7. On December 31, the balance of the undistributed income, except for $500, was paid to
United Charities. The balance of the cash on hand derived from the principal of the es-
tate was paid to United Charities on December 31. On December 31, the executor re-
signed and waived all fees.

Instructions
Prepare a charge and discharge statement, together with supporting exhibits, for the execu-
tor of the will of Frederick Doheny, deceased, for the period February 1 through December
31, 2006. Disregard depreciation.
Chapter Sixteen

Nonprofit
Organizations
Scope of Chapter
This chapter discusses and illustrates some of the accounting and financial statement
display issues for nonprofit organizations. A nonprofit (or not-for-profit) organization
is a legal and accounting entity that is operated for the benefit of society as a whole,
rather than for the benefit of an individual proprietor or a group of partners or stock-
holders. Thus, the concept of net income is not meaningful for a nonprofit organization.
Instead, as does the internal service fund of a governmental entity described in Chap-
ter 19, a nonprofit organization generally strives only to obtain revenues sufficient to
cover its expenses.
Nonprofit organizations constitute a significant segment of the U.S. economy. As pointed
out by the Financial Accounting Standards Board:
Not-for-profit organizations include cemetery organizations, civic organizations, colleges and
universities, cultural institutions, fraternal organizations, hospitals, labor unions, libraries,
museums, performing arts organizations, political parties, private and community founda-
tions, private elementary and secondary schools, professional associations, public broadcast-
ing stations, religious organizations, research and scientific organizations, social and country
clubs, trade associations, voluntary health and welfare organizations, and zoological and
botanical societies. They do not include governmental units.1

ACCOUNTING STANDARDS FOR NONPROFIT ORGANIZATIONS

For many years, the accounting standards and practices that constitute generally accepted
accounting principles were not considered to be entirely applicable to nonprofit organiza-
tions. The following quotation, which formerly appeared in various auditing publications of
the AICPA, outlines this situation:
The statements . . . of a not-for-profit organization . . . may reflect accounting practices
differing in some respects from those followed by enterprises organized for profit. In some
cases generally accepted accounting principles applicable to not-for-profit organizations have
not been clearly defined. In those areas where the independent auditor believes generally
accepted accounting principles have been clearly defined, he may state his opinion as to the

1
Invitation to Comment, “Financial Reporting by Not-for-Profit Organizations: Form and Content of
Financial Statements” (Norwalk: FASB, 1989), p. 17.

670
 Chapter 16 Nonprofit Organizations 671

conformity of the financial statements either with generally accepted accounting principles
or (less desirably) with accounting practices for not-for-profit organizations in the particular
field, and in such circumstances he may refer to financial position and results of operations.
In those areas where he believes generally accepted accounting principles have not been
clearly defined, the provisions covering special reports as discussed under cash basis and
modified accrual basis statements are applicable.2

In the period 1972 to 1974, the unsettled state of accounting for nonprofit organizations
was improved by the AICPA’s issuance of three Audit and Accounting Guides or Industry
Audit Guides: “Hospital Audit Guide,” “Audits of Colleges and Universities,” and “Audits
of Voluntary Health and Welfare Organizations.” All three were subsequently amended, and
the “Hospital Audit Guide” was superseded by “Health Care Organizations.” The status of
an Audit and Accounting Guide or an Industry Audit Guide is set forth in each guide; the
following language in “Health Care Organizations” is typical:
The AICPA Auditing Standards Board has found the descriptions of auditing standards,
procedures, and practices in this Audit and Accounting Guide to be consistent with existing
standards covered by rule 202 of the AICPA Code of Professional Conduct. Descriptions of
auditing standards, procedures, and practices in Audit and Accounting Guides are not as
authoritative as pronouncements of the Auditing Standards Board, but AICPA members should
be aware that they may have to justify a departure from such descriptions if the quality of
their work is questioned.3

The three Guides listed above dealt with only three types of nonprofit organizations.
Thus, in 1978, the AICPA issued Statement of Position 78-10, later incorporated in “Au-
dits of Certain Nonprofit Organizations,” which applied to at least 18 types of nonprofit or-
ganizations, ranging from cemetery societies to zoological and botanical societies.
The existence of four separate sources of authoritative support for generally accepted
accounting principles for nonprofit organizations led to many inconsistencies among the
accounting standards for such organizations. The FASB resolved several of these incon-
sistencies in four Statements of Financial Accounting Standards discussed in sub-
sequent sections of this chapter: No. 93, “Recognition of Depreciation by Not-for-Profit
Organizations”; No. 116, “Accounting for Contributions Received and Contributions
Made”; No. 117, “Financial Statements of Not-for-Profit Organizations”; and No. 124,
“Accounting for Certain Investments Held by Not-for-Profit Organizations.” Subsequently,
the AICPA issued an Audit and Accounting Guide, “Not-for-Profit Organizations,” that su-
perseded “Audits of Colleges and Universities,” “Audits of Voluntary Health and Welfare
Organizations,” and “Audits of Certain Nonprofit Organizations.” Taken together, the ac-
tions of the FASB and the AICPA brought order out of chaos with respect to accounting
standards for nonprofit organizations.

CHARACTERISTICS OF NONPROFIT ORGANIZATIONS

Nonprofit organizations are in certain respects hybrid because they have some characteris-
tics similar to those of governmental entities (which are discussed in Chapter 17) and other
characteristics similar to those of business enterprises.

2
Statement on Auditing Standards No. 1, “Codification of Auditing Standards and Procedures”
(New York: AICPA, 1973), par. 620.08.
3
Audit and Accounting Guide, “Health Care Organizations” (New York: AICPA, 1996), p. iii.
672 Part Five Accounting for Nonbusiness Organizations

Among the features of nonprofit organizations that resemble characteristics of govern-

mental entities are the following:
1. Service to society Nonprofit organizations often render services to society as a whole.
The members of this society may range from a limited number of citizens in a commu-
nity to almost the entire population of a city, state, or nation. Similar to the services ren-
dered by governmental entities, the services of nonprofit organizations are of benefit to
the many rather than the few.
2. No profit motivation Nonprofit organizations do not operate with the objective of
earning a profit. Consequently, nonprofit organizations generally are exempt from fed-
eral and state income taxes. Governmental entities, except for enterprise funds, have the
same characteristics. (As pointed out in Chapter 19, enterprise funds sometimes are as-
sessed an amount in lieu of property taxes by the legislative branch of the government.)
3. Financing by the citizenry As with governmental entities, most nonprofit organiza-
tions depend on the general population for a substantial portion of their support, because
revenues from charges for their services are not intended to cover all their operating
costs. Exceptions are professional societies and the philanthropic foundations estab-
lished by wealthy individuals or families. Whereas the citizenry’s contributions to gov-
ernment revenues are mostly involuntary taxes, their contributions to nonprofit
organizations are voluntary contributions.
4. Stewardship for resources Because a substantial portion of the resources of a non-
profit organization is donated, the organization must account for the resources on a stew-
ardship basis similar to that of governmental entities. The stewardship requirement
makes fund accounting appropriate for many nonprofit organizations, as it is for gov-
ernmental entities.
5. Importance of budget The four preceding characteristics of nonprofit organizations
cause their annual budget to be as important as for governmental entities.
Among the characteristics of nonprofit organizations that resemble those of business enter-
prises are the following:
1. Governance by board of directors As with a business corporation, a nonprofit corpo-
ration is governed by elected or appointed directors, trustees, or governors. In contrast,
the legislative and executive branches of a governmental entity share the responsibilities
for its governance.
2. Measurement of cost expirations Governance by a board of directors means that a
nonprofit organization does not answer to a lawmaking body as does a governmental entity.
One consequence is that cost expirations, or expenses, rather than expenditures, are re-
ported in the statement of activities (see pages 684–685) of most nonprofit organizations.
Allocation of expenses (including depreciation) and revenues to the appropriate accounting
period thus is a common characteristic of nonprofit organizations and business enterprises.
3. Use of accrual basis of accounting Nonprofit organizations employ the same accrual
basis of accounting used by business enterprises.

FUND ACCOUNTING BY NONPROFIT ORGANIZATIONS

The internal accounting unit for many nonprofit organizations is the fund, which is a fis-
cal and accounting entity with a self-balancing set of accounts recording cash and other
financial resources, together with all related liabilities and residual equities or balances,
and changes therein, which are segregated for the purpose of carrying on specific
 Chapter 16 Nonprofit Organizations 673

activities or attaining certain objectives in accordance with special regulations, restric-

tions, or limitations.4
Separate funds may be necessary to distinguish between assets that may be used as au-
thorized by the board of directors and assets whose use is restricted by donors. Funds com-
monly used by some of the nonprofit organizations covered in this chapter include the
following:
• Unrestricted fund (sometimes called unrestricted current fund, general fund, or unre-
stricted operating fund ).
• Restricted fund (sometimes called restricted specific-purpose fund or restricted oper-
ating fund).
• Endowment fund.
• Agency fund (sometimes called custodian fund ).
• Annuity fund and life income fund (sometimes called split-interest funds).
• Loan fund.
• Plant fund (sometimes called land, building, and equipment fund ).5

Unrestricted Fund
In many respects, an unrestricted fund is similar to the general fund of a governmental
entity, which is discussed in Chapter 17. The unrestricted fund includes all the assets of a
nonprofit organization that are available for use as authorized by the board of directors and
are not restricted for specific purposes. Thus, similar to the general fund of a governmental
entity, an unrestricted fund is residual in nature.

Revenues and Gains of Unrestricted Fund

The revenues and gains of an unrestricted fund are derived from a number of sources. For
example, a hospital derives general (unrestricted) fund revenues from patient services, ed-
ucational programs, research and other grants, unrestricted gifts, unrestricted income from
endowment funds, and miscellaneous sources such as contributed material and services.
A university’s sources of unrestricted fund revenues and gains include student tuition and
fees; governmental grants and contracts; gifts and private grants; unrestricted income from
endowment funds; and revenue from auxiliary activities such as student residences, food
services, and intercollegiate athletics. The principal revenue source of voluntary health
and welfare organizations’ unrestricted funds (and all other funds) is contributions. Rev-
enues may also include membership dues, interest, dividends, and realized and unrealized
gains on investments in debt and equity securities. A nonprofit professional society re-
ceives revenues from membership dues, fees for educational programs, advertising, and
sales of publications.

Revenues for Services

A nonprofit organization’s revenues for services are accrued at full rates, even though part
or all of the revenue is to be waived or reduced.6 Suppose, for example, that nonprofit Com-
munity Hospital’s patient service records for June 2006 include the following amounts:

4
Codification of Governmental Accounting and Financial Reporting Standards (Norwalk: Governmental
Accounting Standards Board, 2003), Sec. 1100.102.
5
Audit and Accounting Guide, “Not-for-Profit Organizations” (New York: AICPA, 2003), pars. 16.04,
16.06, 16.08, 16.11, 16.13, 16.17, 16.19.
6
FASB Statement No. 117, “Financial Statements of Not-for-Profit Organizations” (Norwalk: FASB, 1993),
par. 24.
674 Part Five Accounting for Nonbusiness Organizations

Patient Service Gross patient service revenues (before charity care or contractual
Revenues Components adjustments) $100,000
of a Nonprofit Hospital Charity care for indigent patients 8,000
Amount to be received from Civic Welfare, Inc., as a partial
reimbursement for charity care 3,000
Contractual adjustment allowed to Blue Cross 16,000
Provision for doubtful accounts 12,000

The following journal entries are appropriate for the Community Hospital General Fund
on June 30, 2006:

Journal Entries for Accounts Receivable 92,000

Patient Service Patient Service Revenues ($100,000 $8,000) 92,000
Revenues of General To record gross patient service revenues for month of June at full rates,
Fund of a Nonprofit exclusive of charity care.
Hospital
Accounts Receivable 3,000
Patient Service Revenues 3,000
To record amount receivable from Civic Welfare, Inc. ($3,000), as a partial
reimbursement for charity care.

Contractual Adjustments 16,000

Accounts receivable 16,000
To record contractual adjustments allowed to Blue Cross for June.

Doubtful Accounts Expense 12,000

Allowance for Doubtful Accounts 12,000
To provide for doubtful accounts receivable for June.

In the first journal entry for Community Hospital, the value of the charity care pro-
vided to indigent patients is not accrued as accounts receivable or revenues because the
underlying health care services provided by the hospital were never expected to result in
cash flows to the hospital.7 The account receivable in the second journal entry resulted
from a commitment by another nonprofit organization to contribute toward the cost of
charity care provided by Community Hospital. The contractual adjustments recorded in
the third journal entry above illustrate a unique feature of a hospital’s operations. Many
accounts receivable of a hospital are collectible from a third-party payor, rather than
from the patient receiving services. Among third-party payors are the U.S. government
(Medicare and Medicaid programs), state programs such as MediCal in California, Blue
Cross, and private medical insurance carriers. The hospital’s contractual agreements with
third-party payors generally provide for payments by the third parties at less than full
billing rates.
In the statement of activities of Community Hospital for June 2006, the balance of the
Contractual Adjustments ledger account on June 30, 2006, is deducted from the balance

7
“Health Care Organizations,” par. 10.03.
 Chapter 16 Nonprofit Organizations 675

of the Patient Service Revenues account to compute net patient service revenue for the
month. The balance of the Allowance for Doubtful Accounts ledger account is offset
against the balance of the Accounts Receivable account in the balance sheet, and write-
offs of accounts receivable are recorded in the customary fashion. For example, the
uncollectible accounts receivable of nonpaying patients who had been billed for services
would be written off by Community Hospital by the following journal entry in the Unre-
stricted Fund on June 30, 2006:

Journal Entry to Write Allowance for Doubtful Accounts 5,100

Off Uncollectible Accounts Receivable 5,100
Accounts Receivable To write off uncollectible accounts receivable of nonpaying patients,
of a Nonprofit Hospital as follows:
J.R. English $1,500
R.L. Knight 1,100
S.O. Newman 2,500
Total $5,100

In contrast to the offset presentation of contractual adjustments in the statement of ac-

tivities of a nonprofit hospital, the comparable tuition remissions or exemptions of a non-
profit university or college often are included with expenses for student aid in that entity’s
statement of activities.8

Contributed Material, Services, and Facilities

In addition to cash contributions, nonprofit organizations often receive contributions of
material, services, and facilities. For example, a hospital may receive free drugs, or a uni-
versity may receive free operating supplies. The contributed material is recorded in the In-
ventories ledger account at its current fair value, with a credit to a revenues account in an
unrestricted fund, as illustrated in the following journal entry for the General Fund of Com-
munity Hospital:

Journal Entry for Inventories 5,000

Material Contributed Contributions Revenue 5,000
to a Nonprofit Hospital To record contributed drugs at current fair value.

Contributed services are recorded in an unrestricted fund as salaries expense, with an

offset to a revenues account, if the services are rendered to the nonprofit organization by
skilled individuals. The value assigned to the services is the going rate for comparable em-
ployees or contractors of the entity, less any meals or other living costs absorbed for the
donor of the services by the nonprofit organization. The FASB established the following
requirements for recognizing contributed services in the accounting records of a nonprofit
organization:

8
“Not-for-Profit Organizations,” par. 13.07.
676 Part Five Accounting for Nonbusiness Organizations

Contributions of services shall be recognized if the services received (a) create or

enhance nonfinancial assets or (b) require specialized skills, are provided by individuals
possessing those skills, and would typically need to be purchased if not provided by
donation. Services requiring specialized skills are provided by architects, carpenters,
doctors, electricians, lawyers, nurses, plumbers, teachers, and other professionals and
craftsmen. Contributed services . . . that do not meet the above criteria shall not be
recognized.9

To illustrate the accounting for contributed services that meet the foregoing criteria, as-
sume that the services of volunteer nurses’ aides were valued at $26,400 for the month of
June 2006 by Community Hospital, and that the value of meals provided at no cost to the
volunteer during the month was $2,100. The following journal entry is appropriate for the
General Fund of Community Hospital on June 30, 2006:

Journal Entry for Salaries Expense 24,300

Services Contributed Contributions Revenue 24,300
to a Nonprofit Hospital To record contributed services at current fair value of $26,400 less $2,100
value of meals provided to donors.

Significant contributed facilities are recognized as revenue at their current fair value,
offset by a debit to an asset or an expense account, as appropriate. For example, if the fair
rental value of the building used by Archer School, a nonprofit private elementary school,
is $8,000 a month, but the building’s owner waives rental payments, Archer School pre-
pares the following journal entry each month in its Unrestricted Fund:

Journal Entry for Rent Expense 8,000

Contributed Facilities Contributions Revenue 8,000
To record current fair value of rental of school building whose use was
contributed.

Pledges
A pledge (or promise to give) is a commitment by a prospective donor to contribute a spe-
cific amount of cash or property to a nonprofit organization on a future date or in install-
ments. Because a pledge is in writing and signed by the pledgor, it resembles in form the
promissory note used in business. However, pledges often are not enforceable contracts.
Under the accrual basis of accounting, unconditional pledges are recognized as receiv-
ables and revenues in the unrestricted fund, with appropriate provision for doubtful
pledges.10 Pledges due in future accounting periods or having restrictions as to their use
generally are accounted for in a restricted fund (see pages 680–681).11
To illustrate the accounting for pledges, assume that Civic Welfare, Inc., a voluntary
health and welfare organization, received unconditional pledges totaling $200,000 in a
fund-raising drive. Based on past experience and current economic conditions, 15% of

9
FASB Statement No. 116, “Accounting for Contributions Received and Contributions Made” (Norwalk:
FASB, 1993), par. 9.
10
Ibid., par. 8.
11
Ibid., par. 15.
 Chapter 16 Nonprofit Organizations 677

the pledges are considered to be doubtful of collection. The journal entries below are
appropriate:

Journal Entries to Pledges Receivable 200,000

Recognize Receivable Contributions Revenue 200,000
for Pledges and To record receivable for pledges.
Doubtful Pledges of a
Nonprofit Voluntary Doubtful Pledges Expense 30,000
Health and Welfare
Allowance for Doubtful Pledges 30,000
Organization
To record provision for doubtful pledges ($200,000 0.15 $30,000).

Contributions revenue is displayed in the Statement of Activities, as is doubtful pledges

expense. Pledges receivable are displayed in the balance sheet net of the allowance for
doubtful pledges. The write-off of uncollectible pledges is recorded by a debt to the
Allowance for Doubtful Pledges ledger account and a credit to the Pledges Receivable
account.

Revenues and Gains from Pooled Investments

Many of the funds of nonprofit organizations have cash available for investments in securi-
ties and other money-market instruments. To provide greater efficiency and flexibility in in-
vestment programs, the investment resources of all funds of a nonprofit organization may
be pooled for investment by a single portfolio manager. The pooling technique requires a
careful allocation of investment revenues and realized and unrealized gains and losses to
each participating fund.
To illustrate the pooling of investments, assume that on January 2, 2006, four funds of
Civic Welfare, Inc., a nonprofit voluntary health and welfare organization, pooled their se-
curities investments (to be managed by the Unrestricted Fund), as follows:

Pooling of Investments Current Original

by Nonprofit Voluntary Cost Fair Values Equity, %
Health and Welfare
Unrestricted Fund $ 20,000 $ 18,000 15
Organization on Jan.
Restricted fund 15,000 21,600 18
2, 2006
Plant Fund 10,000 20,400 17
Wilson Endowment Fund 55,000 60,000 50
Totals $100,000 $120,000 100

The original equity percentages in the above tabulation are based on current fair val-
ues, not on cost. The current fair values of the pooled investments on January 2, 2006, rep-
resent a common “measuring rod” not available in the cost amounts, which represent
current fair values on various dates the investments were acquired by the respective funds.
Realized and unrealized gains (or losses) and interest and dividend revenue of the pooled
investments during 2006 are allocated to the four funds in the ratio of the original equity
percentages. For example, if $11,000 net realized gains of the investment pool during
2006 were reinvested, net unrealized gains amounted to $7,000, and interest and dividend
revenue of $9,000 was distributed by the pool during 2006, these amounts are allocated as
shown on page 678:
678 Part Five Accounting for Nonbusiness Organizations

Allocation of Year Original Net Realized Interest and

Revenue from Pooled Equity, and Unrealized Dividends
Investments to %* Gains Revenue
Respective Funds
Unrestricted Fund 15 $ 2,700 $1,350
Restricted Fund 18 3,240 1,620
Plant Fund 17 3,060 1,530
Wilson Endowment Fund 50 9,000 4,500
Totals 100 $18,000 $9,000

*The original equity percentages may be converted to units, with a per-unit value of $180 ($18,000 100 $180) allocated for net
gains, and a per-unit value of $90 ($9,000 100 $90) allocated for interest and dividends revenue.

Each of the funds participating in the investment pool debits Investments and credits
Gains on Investments or Investment Income for its share of the $18,000 net gains of the
pooled investments. However, assuming that all the interest and dividends revenue, regard-
less of the fund to which it is attributable, is available for unrestricted use by Civic Welfare,
Inc., the entire $9,000 interest and dividends revenue is recognized as revenue by the Un-
restricted Fund.
If another fund of Civic Welfare, Inc., entered the investment pool on December 31,
2006, the original equity percentages would be revised, based on the December 31, 2006,
current fair values of the investment portfolio. For example, if the Harris Endowment Fund
entered the Civic Welfare, Inc., investment pool (which had total investments with a current
fair value of $144,000) on December 31, 2006, with investments having a cost of $32,000
and a current fair value of $36,000 on that date, the equity percentages would be revised as
illustrated below:

Revision of Fund Current Revised

Equities in Pooled Cost* Fair Values† Equity, %
Investments on
Unrestricted Fund $ 22,700 $ 21,600 12.0
Dec. 31, 2006
Restricted Fund 18,240 25,920 14.4
Plant Fund 13,060 24,480 13.6
Wilson Endowment Fund 64,000 72,000 40.0
Subtotals $118,000 $144,000
Harris Endowment Fund 32,000 36,000 20.0
Totals $150,000 $180,000 100.0

*Cost for four original pool member funds includes $18,000 gains of 2006.
†
Current fair value of original pooled investments totaling $144,000 on December 31, 2006, allocated to original pool member funds
based on original equity percentages computed on page 677.

Gains (or losses) and interest and dividends revenue for accounting periods subsequent
to December 31, 2006, are allocated in the revised equity percentages. The revised equity
percentages are maintained until the membership of the investment pool changes again.

Expenses and Losses of Unrestricted Fund

A nonprofit organization typically recognizes all expenses in its unrestricted fund. As indi-
cated on page 677, losses may be recognized in other funds as well as in the unrestricted
fund.
Expenses of a nonprofit organization may be classified in two groups: program services
and supporting services. Program services are the organization’s activities that result in the
distribution of goods and services to beneficiaries, customers, or members that fulfill the
 Chapter 16 Nonprofit Organizations 679

purposes or mission of the organization. Supporting services are all activities of the orga-
nization other than program services, such as management and general, fund-raising, and
membership development activities.12

Depreciation Expense of Nonprofit Organizations

In FASB Statement No. 93, “Recognition of Depreciation by Not-for-Profit Organiza-
tions,” the FASB required recognition of depreciation on all long-lived tangible assets of
nonprofit organizations, except for individual works of art or historical treasures having
extraordinarily long economic lives, with disclosure of the following in a note to the
financial statements:13
1. Depreciation expense for the period.
2. Balances of major classes of depreciable assets, by nature or function, at the balance
sheet date.
3. Accumulated depreciation, either by major classes of depreciable assets or in total, at the
balance sheet date.
4. A general description of the method or methods used in computing depreciation for ma-
jor classes of depreciable assets.
Expenses that are unique to nonprofit organizations include fund-raising expense,
conditional pledges, and income taxes on certain unrelated business income.

Fund-Raising Expense
Although fund-raising costs may benefit future accounting periods of a nonprofit organiza-
tion, just as advertising costs of a business enterprise may benefit future periods, fund-
raising costs are recognized as an expense when incurred.14

Conditional Pledges
Some nonprofit organizations promise to make grants to individuals or to other organiza-
tions. For example, a nonprofit performing arts organization may promise to make grants
to theaters to help defray operating costs. Generally, grants are recognized as expense when
the governing board of the nonprofit organization unconditionally approves them. However,
unpaid amounts of pledges for grants that may be revoked by the nonprofit organization are
not recognized as expense until they become unconditional.15

Income Taxes
Some otherwise tax-exempt nonprofit organizations may be subject to federal and state in-
come taxes on their unrelated business income, which is derived from activities not sub-
stantially related to the educational, charitable, or other basis of the organization’s
tax-exempt status. For example, the income that a country club derives from staging pro-
fessional tennis tournaments on its tennis courts otherwise used by members might be sub-
ject to income taxes. Income taxes expense for such nonprofit organizations is subject to the
interperiod tax allocation requirements for business enterprises.16

12
FASB Statement No. 117, pars. 26–28.
13
FASB Statement No. 93, “Recognition of Depreciation by Not-for-Profit Organizations” (Stamford:
FASB, 1987), pars. 5–6.
14
“Not-for-Profit Organizations,” par. 13.06.
15
FASB Statement No. 116, par. 22.
16
FASB Statement No. 109, “Accounting for Income Taxes” (Norwalk: FASB, 1992), par. 3.
680 Part Five Accounting for Nonbusiness Organizations

Assets and Liabilities of Unrestricted Fund

Most assets and liabilities of a nonprofit organization’s unrestricted fund are similar to the
current assets and liabilities of a business enterprise. Cash, investments, accounts receiv-
able, receivables from other funds, inventories, and short-term prepayments are typical as-
sets of an unrestricted fund. Nonprofit organizations that use fund accounting generally
account for plant assets in a plant fund, although health care entities may account for such
assets in the general fund.17
With respect to nonexhaustible collections of museums, art galleries, botanical gardens,
libraries, and similar nonprofit organizations, the FASB waived recognition of such assets
in the organizations’ accounting records under specified conditions. However, the organi-
zation’s statement of activities and a note to the financial statements must include specified
disclosures regarding the collections.18
The liabilities of an unrestricted fund include payables, accruals, and deferred revenue
similar to those of a business enterprise, as well as amounts payable to other funds.

Fund Balance of Unrestricted Fund

Because most nonprofit organizations do not have owners, the net assets of the organiza-
tions’ unrestricted funds are represented by a fund balance similar to that of most funds of
a governmental entity, as discussed in Chapters 17 through 19.
The board of directors of a nonprofit organization may designate a portion of an unre-
stricted fund’s net assets for a specific purpose. The earmarked position is accounted for
as a segregation of the unrestricted fund balance, rather than as a separate restricted fund.
For example, if the board of directors of Civic Welfare, Inc., a voluntary health and wel-
fare organization, earmarks $25,000 of the unrestricted fund’s assets for the acquisition
of office equipment, the following journal entry is prepared for Civic Welfare, Inc., Unre-
stricted Fund:

Journal Entry for Undesignated Fund Balance 25,000

Designation of Portion Designated Fund Balance—Office Equipment 25,000
of Fund Balance of To record designation of portion of fund balance for acquisition of
Unrestricted Fund office equipment.

The Designated Fund Balance—Office Equipment ledger account is similar to a re-

tained earnings appropriation account of a corporation and is reported in the account-
ing records of Civic Welfare, Inc., as a portion of the fund balance of the Unrestricted
Fund.

Restricted Fund
Nonprofit organizations establish restricted funds to account for assets available for current
use but expendable only as authorized by the donor of the assets. Thus, a restricted fund of
a nonprofit organization resembles the special revenue fund of a governmental entity (as
described in Chapter 18), because the assets of both types of funds may be expended only
for specified purposes.
The assets of restricted funds are not derived from the operations of the nonprofit
organization. Instead, the assets are obtained from (1) restricted gifts or grants from individuals

17
“Health Care Organizations,” par. 1.12.
18
FASB Statement No. 116, pars. 11, 26–27.
 Chapter 16 Nonprofit Organizations 681

or governmental entities, (2) revenues from restricted fund investments, (3) realized and
unrealized gains or investments of the restricted funds, and (4) restricted income from
endowment funds. These assets are transferred to the unrestricted fund at the time the
designated expenditure is made, with a credit to an account with a title such as Net Assets
Released from Restrictions.
To illustrate, assume that on July 1, 2006, Robert King donated $50,000 to Community
Hospital, a nonprofit organization, for the acquisition of beds for a new wing of the hospi-
tal. On August 1, 2006, Community Hospital paid $51,250 for the beds. These transactions
and events are recorded by Community Hospital as shown below:

Journal Entries for In Robert King Restricted Fund:

Restricted Donation to
Nonprofit Hospital 2006
July 1 Cash 50,000
Contributions Revenue 50,000
To record receipt of gift from Robert King for acquisition of
beds for new wing.

Aug. 1 Net Assets Released from Restrictions 50,000

Payable to Unrestricted Fund 50,000
To record obligation to Unrestricted Fund for cost of beds
for new wing in accordance with Robert King’s gift.

In Unrestricted Fund:

2006
Aug. 1 Plant Assets 51,250
Cash 51,250
To record acquisition of beds for new wing.

1 Receivable from Robert King Restricted Fund 50,000

Net Assets Released from Restrictions 50,000
To record receivable from Robert King Restricted Fund for
reimbursement of expenditures for beds.

Endowment Fund
An endowment fund of a nonprofit organization is similar to a nonexpendable trust fund
of a governmental entity, which is described in Chapter 19. A permanent endowment fund
is one for which the principal must be maintained indefinitely in revenue-producing invest-
ments. Only the revenues from a permanent endowment fund’s investments may be
expended by the nonprofit organization. In contrast, the principal of a term endowment
fund may be expended after the passage of a period of time or the occurrence of an event
specified by the donor of the endowment principal. A quasi-endowment fund is established
by the board of directors of a nonprofit organization, rather than by an outside donor. At the
option of the board, the principal of a quasi-endowment fund later may be expended by the
entity that established the fund.
682 Part Five Accounting for Nonbusiness Organizations

The revenues of endowment funds are accounted for in accordance with the instruc-
tions of the donor or the board of directors. If there are no restrictions on the use of
endowment fund income, it is transferred to the nonprofit organization’s unrestricted
fund. Otherwise, the endowment fund revenues are transferred to an appropriate
restricted fund.

Agency Fund
An agency fund of a nonprofit organization is used to account for assets held by a nonprofit
organization as a custodian. The assets are disbursed only as instructed by their owner. For
example, a nonprofit university may act as custodian of cash of a student organization. The
university disburses the cash as directed by the appropriate officers of the student organi-
zation. The undistributed cash of the student organization is reported as a liability of the
university’s agency fund, rather than as a fund balance, because the university has no eq-
uity in the fund.

Annuity and Life Income Funds

Annuity Fund
Assets may be contributed to a nonprofit organization with the stipulation that the organi-
zation pay specified fixed amounts periodically to designated recipients, for a specified time
period. An annuity fund is established by the nonprofit organization to account for this
arrangement. At the end of the specified time period for the periodic payments, the unex-
pended assets of the annuity fund are transferred to the unrestricted fund or to a restricted
fund or endowment fund specified by the donor.
The following journal entries illustrate the accounting for the Ruth Collins Annuity
Fund of Ridgedale College, a nonprofit college, for the fund’s first fiscal year, ending
June 30, 2007:

Journal Entries for 2006

Annuity Fund of a July 1 Cash 50,000
Nonprofit College Annuity Payable 35,000
Contributions Revenue 15,000
To record receipt of cash from Andrea Collins for an annuity
of $6,000 a year each June 30 to Ruth Collins for her lifetime.
Liability is recorded at the actuarially computed present value
of the annuity, based on life expectancy of Ruth Collins.

1 Investments 45,000
Cash 45,000
To record acquisition of interest in Ridgedale College’s
investment pool.

2007
June 30 Cash 1,500
Investments 2,000
Annuity Payable 3,500
To record share of realized and unrealized revenues and
gains of Ridgedale College investment pool.

(continued)
 Chapter 16 Nonprofit Organizations 683

2007
June 30 Annuity Payable 6,000
Cash 6,000
To record payment of current year’s annuity to Ruth Collins.

30 Contributions Revenue 15,000

Annuity Payable 1,000
Fund Balance 14,000
To close revenue account and adjust annuity liability based on
revised actuarial valuation of Ruth Collins annuity.

Note that, in the first journal entry on June 30, 2007, the revenues and gains on the annuity
fund’s share of the investment pool are credited to the Annuity Payable ledger account. This
is necessary because the actuarial computation of the annuity on the date of establishment
of the annuity fund valued the annuity liability at its then present value.
Life Income Fund
A life income fund is used to account for stipulated payments to a named beneficiary (or
beneficiaries) during the beneficiary’s lifetime. In a life income fund, only the income is
paid to the beneficiary. Thus, payments to a life income fund’s beneficiary vary from one
accounting period to the next, but payments from an annuity fund are fixed in amount.

Loan Fund
A loan fund may be established by any nonprofit organization, but loan funds most fre-
quently are included in the accounting records of colleges and universities. Student loan
funds generally are revolving; that is, as old loans are repaid, new loans are made from the
receipts. Loans receivable are carried in the loan fund at estimated realizable value; provi-
sions for doubtful loans are debited directly to the Fund Balance ledger account, not to an
expense account. Interest on loans is credited to the Fund Balance account, ordinarily on
the cash basis of accounting.

Plant Fund
The components of plant funds vary among nonprofit organizations. In addition to plant as-
sets, plant funds may include cash and investments earmarked for additions to plant assets
and mortgage notes payable and other liabilities collateralized by the plant assets. Sinking-
fund assets set aside for retirement of debt incurred to acquire plant assets also may be in
plant funds.

FINANCIAL STATEMENTS OF NONPROFIT ORGANIZATIONS

The wide variety of nonprofit organizations described on page 670, together with the vari-
ous inconsistent pronouncements of the AICPA on accounting for nonprofit organizations,
contributed in the past to an assortment of form, content, display, and terminology tech-
niques for financial statements of such organizations. To lend more uniformity to financial
reporting by nonprofit organizations without imposing inflexible standards, the FASB is-
sued FASB Statement No. 117, “Financial Statements of Not-for-Profit Organizations.”
Among its provisions were the following:19

19
FASB Statement No. 117, passim.
684 Part Five Accounting for Nonbusiness Organizations

1. Financial statements of nonprofit organizations shall be a statement of financial posi-

tion, a statement of activities, a statement of cash flows, and notes to the financial
statements.
2. The statement of financial position shall report the amounts of the organization’s total
assets, total liabilities, and total net assets.
3. The statement of financial position shall report the amounts for each of the three classes
of the organization’s net assets: permanently restricted, temporarily restricted, and unre-
stricted.
4. The statement of activities shall report the amount of the change in the organization’s net
assets for the period with a caption such as changes in net assets or change in equity.
5. The statement of activities shall report the amount of the changes in each of the three
classes of the organization’s net assets: permanently restricted, temporarily restricted,
and unrestricted.
6. The statement of activities shall report gross amounts of revenues and expenses of the
organization, except that investment revenues may be reported net of expenses and gains
or losses on disposal of plant assets may be reported net.
7. The statement of activities or a note thereto shall report expenses by functional classifi-
cations such as program services and supporting services.
8. The statement of cash flows shall be similar in format—direct method or indirect
method—to one that is issued for a business enterprise.
The following financial statements illustrate a format that complies with the foregoing
standards:

NONPROFIT ORGANIZATION
Statement of Activities
For Year Ended June 30, 2006
(amounts in thousands)

Changes in unrestricted net assets:

Revenues and gains:
Contributions $ 9,000
Fees 6,000
Investment revenue 7,000
Net realized and unrealized gains on investments 8,000
Other 1,000
Total unrestricted revenue and gains $ 31,000
Net assets released from restrictions 16,000
Total unrestricted revenues, gains, and other support $ 47,000
Expenses:
Programs $ 28,000
Management and general 3,000
Fund raising 2,000
Total expenses $ 33,000
Increase in unrestricted net assets $ 14,000
(continued)
 Chapter 16 Nonprofit Organizations 685

NONPROFIT ORGANIZATION
Statement of Activities (concluded)
For Year Ended June 30, 2006
(amounts in thousands)

Changes in temporarily restricted net assets:

Contributions $ 9,000
Investment revenue 3,000
Net realized and unrealized gains on investments 3,000
Net assets released from restrictions (16,000)
Decrease in temporarily restricted net assets $ (1,000)
Changes in permanently restricted net assets:
Contributions $ 2,000
Investment revenue 10,000
Net realized and unrealized gains on investments 6,000
Increase in permanently restricted net assets $ 18,000
Increase in net assets $ 31,000
Net assets, beginning of year 252,200
Net assets, end of year $283,200

NONPROFIT ORGANIZATION
Statement of Financial Position
June 30, 2006
(amounts in thousands)

Assets
Cash and cash equivalents $ 100
Short-term investments in securities, at fair value 1,500
Accounts and interest receivable (net) 2,300
Pledges receivable (net) 3,000
Inventories and short-term prepayments 700
Long-term investments in securities, at fair value 220,000
Cash and investments in securities, restricted to acquisition of plant assets 5,300
Plant assets (net) 62,000
Total assets $294,900

Liabilities and Net Assets

Liabilities:
Accounts payable $ 3,000
Grants payable 1,000
Annuities payable 1,700
Long-term debt 6,000
Total liabilities $ 11,700
Net assets:
Unrestricted $ 92,000
Temporarily restricted 50,000
Permanently restricted 141,200
Total net assets $283,200
Total liabilities and net assets $294,900
686 Part Five Accounting for Nonbusiness Organizations

NONPROFIT ORGANIZATION
Statement of Cash Flows (indirect method)
For Year Ended June 30, 2006
(amounts in thousands)

Net cash provided by operating activities (Exhibit 1) $ 19,000

Cash flows from investing activities:
Acquisition of investments in securities $(29,000)
Acquisition of plant assets (2,000)
Disposal of plant assets 12,600
Net cash used in investing activities (18,400)
Cash flows from financing activities:
Contributions received $ 3,000
Interest and dividends received and reinvested 1,000
Payment of annuities payable (2,000)
Payment of long-term debt (3,000)
Net cash used in financing activities (1,000)
Net decrease in cash and cash equivalents $ (400)
Cash and cash equivalents, beginning of year 500
Cash and cash equivalents, end of year $ 100
Exhibit 1 Cash flows from operating activities:
Increase in net assets $ 31,000
Adjustments to reconcile increase in net assets to net cash
provided by operating activities:
Depreciation expense 7,000
Increase in accounts and interest receivable (1,000)
Increase in pledges receivable (1,000)
Decrease in inventories and short-term prepayments 2,000
Increase in accounts payable 2,000
Decrease in grants payable (4,000)
Net realized and unrealized gains on investments in securities $(17,000)
Net cash provided by operating activities $ 19,000
Exhibit 2 Cash paid during the year for interest (none capitalized) $ 400
Exhibit 3 Noncash investing and financing activities:
Plant assets acquired through contribution $ 2,200

The following features of the foregoing financial statements may be noted:

1. In the statement of activities, contributions, investment income, and gains or losses are
common to changes in all three categories of net assets: unrestricted, temporarily re-
stricted, and permanently restricted. Fees and other operating revenues and expenses are
associated with changes in unrestricted net assets only.
2. In the statement of financial position, restricted cash and investments are displayed
separately.
 Chapter 16 Nonprofit Organizations 687

3. As mandated by the FASB, current fair value is the basis of valuation for all securities
investments: short term, long term, and restricted.20
4. In the statement of cash flows (indirect method), the $17,000 of net realized and unre-
alized gains on investments is the total of the following in the statement of activities:

Net realized and unrealized gains on investments from:

Unrestricted net assets $ 8,000
Temporarily restricted net assets 3,000
Permanently restricted net assets 6,000
Total $17,000

5. For a nonprofit organization that uses fund accounting for internal purposes, unrestricted
net assets typically are those in the unrestricted (or general) fund. Temporarily restricted
net assets generally are those in restricted funds, loan funds, term and quasi-endowment
funds, annuity and life income funds, and plant funds. The most significant source of
permanently restricted net assets is permanent endowment funds.
An example of financial statements of a nonprofit organization is in the appendix to this
chapter.

Concluding Observations on Accounting for

Nonprofit Organizations
The FASB’s issuance of Statements No. 93, 116, 117, and 124 has supplanted many of the
previously accepted—but inconsistent—accounting standards for the numerous types of
nonprofit organizations listed on page 670. More reforms may be necessary, however, in the
form and content of financial statements issued by those organizations. For example, should
there be a caption, “Excess of revenues over expenses,” somewhere in a nonprofit organi-
zation’s statement of activities? Should budgeted amounts be compared with actual operat-
ing results in the statement of activities? May some measure of performance—for example,
effectiveness of use of contributions—be reported? Perhaps more research into the needs
of users of financial statements of nonprofit organizations may yield answers to these and
other questions.

20
FASB Statement No. 124, “Accounting for Certain Investments Held by Not-for-Profit Organizations”
(Norwalk: FASB, 1995), par. 7.
688 Part Five Accounting for Nonbusiness Organizations

Appendix

Excerpts from the 2003 Annual Report of

the Kenneth T. and Eileen L. Norris
Foundation

INDEPENDENT AUDITOR’S REPORT

Trustees
Kenneth T. and Eileen L. Norris Foundation
Long Beach, California

We have audited the accompanying statements of financial position of The Kenneth T. and Eileen L. Norris
Foundation (the “Foundation”) as of November 30, 2003 and 2002, and the related statements of activities and cash
flows for the years then ended. These financial statements are the responsibility of the Foundation’s management.
Our responsibility is to express an opinion on these financial statements based on our audit.

We conducted our audit in accordance with auditing standards generally accepted in the United States of America.
Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence sup-
porting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the November 30, 2003 and 2002, financial statements present fairly, in all material respects, the
financial position of the Foundation as of November 30, 2003 and 2002, and the changes in its net assets and its
cash flows for the years then ended in conformity with accounting principles generally accepted in the United
States of America.

Los Angeles, California

February 19, 2004
 Chapter 16 Nonprofit Organizations 689

THE KENNETH T. AND EILEEN L. NORRIS FOUNDATION

Statements of Financial Position
November 30, 2003 and 2002

2003 2002
Assets
Cash and cash equivalents $ 409,876 $ 1,801,845
Investments
Corporate stocks 79,813,338 62,334,083
Domestic corporate bonds 78,570,088 85,484,492
U.S. and state government obligations 85,312 748,588
Limited partnerships 5,005,794 4,883,155
Mutual funds 2,369,720 1,637,613
Trust deed notes receivable 360,000 492,939
Total investments 166,204,252 155,580,870
Interest receivable and other 1,588,210 1,496,207
Total $168,202,338 $158,878,922

Liabilities and Unrestricted Net Assets

Liabilities
Grants payable $ 7,341,959 $ 10,403,031
Accounts payable - 1,088,451
Federal excise taxes payable 78,767 57,497
Total liabilities 7,420,726 11,548,979
Unrestricted net assets 160,781,612 147,329,943
Total $168,202,338 $158,878,922

The accompanying Notes are an integral part of the financial statements.

THE KENNETH T. AND EILEEN L. NORRIS FOUNDATION

Statements of Activities
Years Ended November 30, 2003 and 2002

2003 2002
Revenues
Interest, net of amortization of bond premiums of
$109,065 and $141,475 in 2003 and 2002, respectively $ 5,092,850 $ 5,267,051
Dividends 1,325,807 1,041,635
Other income 65,398 121,812
Total revenues 6,484,055 6,430,498
(continued)
690 Part Five Accounting for Nonbusiness Organizations

THE KENNETH T. AND EILEEN L. NORRIS FOUNDATION

Statements of Activities (concluded)
Years Ended November 30, 2003 and 2002

2003 2002
Expenses
Grants 4,725,478 5,958,182
Administrative fees 838,604 809,520
Custodian fees 160,504 168,435
Federal excise tax 78,767 57,497
Rent 46,169 47,503
Foreign 22,725 16,993
Insurance 11,013 10,282
Depreciation - 362
Other expenses 153,213 205,127
Total expenses 6,036,473 7,273,901
Excess of revenues (expenses)
before realized and unrealized income (loss)
on investments 447,582 (843,403)
Realized and unrealized income (loss)
on investments, net 13,004,087 (19,882,911)
Increase (decrease) in unrestricted net assets 13,451,669 (20,726,314)
Unrestricted net assets, beginning of year 147,329,943 168,056,257
Unrestricted net assets, end of year $160,781,612 $147,329,943

THE KENNETH T. AND EILEEN L. NORRIS FOUNDATION

Statements of Cash Flows
Years Ended November 30, 2003 and 2002

2003 2002
Cash flows from (used in) operating activities:
Increase (decrease) in unrestricted net assets $ 13,451,669 $(20,726,314)
Adjustments to reconcile increase (decrease) in unrestricted net
assets to net cash used in operating activities:
Net realized and unrealized income (loss) on investments, net (12,990,241) 19,882,911
Amortization of premiums paid on investments 109,065 141,475
Depreciation - 362
Change in operating assets and liabilities:
Decrease in interest receivable and other (149,490) (101,421)
Decrease in grants payable (3,061,072) (2,317,645)
Increase (decrease) in accounts payable (1,088,451) 1,088,451
Increase (decrease) in federal excise taxes payable 78,757 (52,809)
Net cash used in operating activities (3,649,763) (2,084,990)

Cash flows from (used in) investing activities:

Proceeds from sale of investments 18,575,887 23,506,062
Purchase of investments (16,318,093) (20,048,065)
Net cash from investing activities 2,257,794 3,457,997
Net increase (decrease) in cash and cash equivalents (1,391,969) 1,373,007
Cash and cash equivalents—beginning of year 1,801,845 428,838
Cash and cash equivalents—end of year $ 409,876 $ 1,801,845
 Chapter 16 Nonprofit Organizations 691

THE KENNETH T. AND EILEEN L. NORRIS FOUNDATION

Notes to Financial Statements
November 30, 2003 and 2002

NOTE 1—TRUST AGREEMENT

The Kenneth T. and Eileen L. Norris Foundation (the “Foundation”), a charitable trust, was
created in September 1963 by gift of property from Kenneth T. and Eileen L. Norris. The
Foundation is a private foundation as defined in Section 509(a) of the Internal Revenue Code,
and accordingly, the Foundation and its trustees are subject to the provisions of the Internal
Revenue Code of 1986 and the laws of the State of California. The terms of the trust inden-
ture provide that, either directly or indirectly, the assets and income are to be applied exclu-
sively for charitable purposes.

NOTE 2—SIGNIFICANT ACCOUNTING POLICIES

Cash and Cash Equivalents—For purposes of reporting cash flows, cash and cash equiv-
alents include cash and investments in U.S. Treasury bills and commercial paper that
mature within 90 days at the time of purchase.

Investments—The Foundation records its investments in equity securities with readily

determinable fair values and all investments in debt securities at fair value. The fair
value of U.S. and state government obligations and mutual funds is determined on the
basis of quoted market values. Trust deed notes receivable bear interest at or near market
rates and approximate fair value. Limited partnerships which do not have readily deter-
minable market values as of November 30, 2003 and 2002 are valued based on the avail-
able partner capital account balances as reported by the partnerships to the Foundation,
adjusted for capital contributions and distributions from the partnerships through
November 30, 2003.

Purchases and sales of investments are recorded on the trade date. Dividend income is
recorded based on the payment date. Interest income is recorded as earned on an accrual
basis. Realized gains and losses are recorded upon disposition of securities. Investment
income and realized and unrealized gains and losses are recognized as unrestricted net
assets, unless their use is temporarily or permanently restricted by donors to a specified
purpose or future period.

Grants—Unconditional grants made by the Foundation are recognized as an expense in the

period in which they are approved. If these grants are paid over a period exceeding one year
they are recorded at the net present value of future cash payments, using an applicable U.S.
Treasury bill rate. Grants that are conditioned upon future events are expensed when those
conditions are substantially met.

Use of Estimates—The preparation of financial statements in conformity with accounting

principles generally accepted in the United States of America requires management to
make estimates and assumptions that affect the reported amounts of assets and liabilities as
well as the disclosure of contingent assets and liabilities at the date of the financial state-
ments and the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
692 Part Five Accounting for Nonbusiness Organizations

NOTE 3—INVESTMENTS
Investments comprised the following at November 30:

2003
Cost Fair Value
Corporate stocks $ 36,387,600 $ 79,813,338
Domestic corporate bonds 71,262,222 78,570,088
U.S. and state government obligations 79,130 85,312
Mutual funds 1,343,830 2,369,720
Trust deed note receivable 360,000 360,000
$109,432,782 161,198,458
Limited partnerships 5,005,794
Total investments $166,204,252

2002
Cost Fair Value
Corporate stocks $ 27,836,855 $ 62,334,083
Domestic corporate bonds 80,095,201 85,484,492
U.S. and state government obligations 500,000 748,588
Mutual funds 1,000,000 1,637,613
Trust deed notes receivable 492,939 492,939
$109,924,995 150,697,715
Limited partnerships 4,883,155
Total investments $155,580,870

NOTE 4—GRANTS PAYABLE

Grants payable include unconditional grants approved by the Foundation during the current
or previous years that will be paid in future years. As of November 30, 2003 and 2002, such
grants are expected to be paid as follows:

2003 2002
Less than one year $ 3,183,900 $ 3,933,000
One to five years 4,565,000 7,048,000
7,748,900 10,981,000
Less unamortized discount (406,941) (577,969)
Total grants payable at net present value $ 7,341,959 $10,403,031

Cash payments made on unconditional grants were $7,786,550 and $8,275,828 during the
years ended November 30, 2003 and 2002, respectively.

NOTE 5—RELATED PARTIES

Certain trustees of the Foundation are also officers of KTN Enterprises, Inc., which provide
all administrative and accounting services to the Foundation. The Foundation is charged an
administrative fee for these services. These annual administrative fees were $838,604 and
$809,520 for the years ending November 30, 2003 and 2002 respectively.
 Chapter 16 Nonprofit Organizations 693

NOTE 6—FEDERAL EXCISE TAXES

The Foundation qualifies as a tax-exempt organization under Section 501(c)(3) of the
Internal Revenue Code (the “Code”) but is subject to a federal excise tax at the rate of
two percent on its “net investment income” as defined by the Code. The excise tax may
be reduced to one percent should the amount of qualified distributions during the years
exceed a threshold amount, which is determined based on a formula provided by
the Code.
Federal income tax regulations require the Foundation to distribute, before the close
of the following year, five percent of the market value of its aggregate noncharitable
assets, reduced by federal excise taxes. The Foundation has undertaken to make timely
qualified distributions in order to satisfy the minimum distribution requirements of
the Trust.

Review 1. What is a nonprofit organization?

Questions 2. List four types of nonprofit organizations in the United States.
3. What role did the AICPA’s Accounting and Auditing Guides or Industry Audit Guides
play in the establishment of accounting standards for nonprofit organizations? Explain.
4. What are three characteristics of nonprofit organizations that resemble those of gov-
ernmental entities?
5. What characteristics of nonprofit organizations resemble those of business enterprises?
6. Nonprofit hospitals and universities often reduce their basic revenue charges to patients
and students, respectively. How are these reductions reflected in the revenue account-
ing for the two types of nonprofit organizations? Explain.
7. a. Does a nonprofit organization recognize contributed material in its accounting
records? Explain.
b. Does a nonprofit organization recognize contributed services in its accounting
records? Explain.
8. How are expenses classified in the statement of activities of a nonprofit organization
that receives significant support from the public? Explain.
9. Explain the accounting for pledges of grants that may be revoked by the board of
trustees of a nonprofit performing arts organization.
10. How are collections reported in the financial statements of a nonprofit museum?
Explain.
11. Differentiate between an annuity fund and a life income fund of a nonprofit organization.
12. Define the following terms applicable to nonprofit organizations:
a. Designated Fund Balance
b. Third-party payor
c. Pledge
d. Charity care
e. Term endowment fund
13. Identify the financial statements that are issued by a nonprofit organization.
694 Part Five Accounting for Nonbusiness Organizations

Exercises
(Exercise 16.1) Select the best answer for each of the following multiple-choice questions:
1. Are fund-raising expenses of a nonprofit organization displayed in the statement of
activity as:

Program Services Supporting Services

Expenses? Expenses?
a. Yes Yes
b. Yes No
c. No Yes
d. No No

2. Caddy School, a nonprofit private elementary school, occupies its school building
rent-free, as permitted by the building owner. The existence of rent-free facilities is
recognized in Caddy School’s Unrestricted Fund as:
a. Financial aid expense and other operating support.
b. Rent expense and an increase in fund balance.
c. Rent expense and contributions revenue.
d. An item requiring disclosure in a note to the financial statements.
3. Costs of fund-raising dinners by a nonprofit organization are:
a. Recognized as expense when incurred.
b. Deferred and recognized as expense over the accounting periods expected to bene-
fit from the fund-raising proceeds.
c. Offset against the revenue received from the dinners.
d. Offset against the undesignated fund balance of the organization’s unrestricted
fund.
4. The type of endowment fund that may be established only by the board of trustees of a
nonprofit university is a:
a. Permanent endowment fund.
b. Term endowment fund.
c. Quasi-endowment fund.
d. Trustee endowment fund.
5. The Contractual Adjustments ledger account of a nonprofit hospital is:
a. An expense account.
b. A revenue offset account.
c. A loss account.
d. An asset account.
6. With respect to a nonprofit organization’s payments to beneficiaries of annuity funds
and life income funds:
a. Annuity fund payments are fixed in amount; life income fund payments vary in
amount.
b. Annuity fund payments vary in amount; life income fund payments are fixed in
amount.
c. Payments from both annuity funds and life income funds are fixed in amount.
d. Payments from both annuity funds and life income funds vary in amount.
 Chapter 16 Nonprofit Organizations 695

7. One characteristic of nonprofit organizations that is comparable with characteristics of

governmental entities is:
a. Stewardship of resources.
b. Governance by board of directors.
c. Measurement of cost expirations.
d. None of the foregoing.
8. The plant assets of a nonprofit hospital are accounted for as part of:
a. The general fund.
b. A restricted fund.
c. A plant fund.
d. Other nonoperating funds.
9. Does the current funds group of a nonprofit university include:

Annuity Funds? Loan Funds?

a. Yes Yes
b. Yes No
c. No No
d. No Yes

10. The records of Rehab Hospital, a nonprofit organization, had the following amounts on
June 30, 2006:

Charity care $ 40,000

Contractual adjustments 80,000
Patient service revenues (gross) 620,000
Provision for doubtful accounts 70,000

Net patient service revenues for Rehab Hospital for the year ended June 30, 2006,
amount to:
a. $620,000. d. $430,000.
b. $550,000. e. Some other amount.
c. $500,000.
11. An annuity fund of a nonprofit organization resembles the organization’s:
a. Endowment funds
b. Restricted funds
c. Life income funds
d. Loan funds
12. The fund of a nonprofit university that is revolving is a(n):
a. Annuity fund
b. Life income fund
c. Loan fund
d. Endowment fund
13. The statement of financial position of a nonprofit organization displays the organiza-
tion’s assets, liabilities, and:
a. Fund balance.
b. Equity.
c. Excess of assets over liabilities.
d. Net assets.
696 Part Five Accounting for Nonbusiness Organizations

(Exercise 16.2) Gross patient service revenues of Neighborhood Hospital, a nonprofit organization, for the
month of May 2006, totaled $860,000. Charity care to indigent patients totaled $80,000, of
which $50,000 was to be received by Neighborhood Hospital from City Charities. Con-
tractual adjustments allowed to Blue Cross amounted to $140,000. Doubtful accounts ex-
pense was estimated at $20,000.
Prepare journal entries (omit explanations) for Neighborhood Hospital on May 31,
2006.
(Exercise 16.3) For the month of September 2006, its first month of operations, Redwood Hospital’s patient
service records included the following:

Amount to be received from United Way for indigent patients $ 16,500

Charity care for indigent patients 32,000
Contractual adjustments allowed for Medicare patients 18,500
Gross patient service revenues (excluding charity care
and contractual adjustments) 225,000
Doubtful accounts expense (no accounts were written off) 14,600

Prepare a working paper to show how the foregoing information is displayed in the fi-
nancial statements of nonprofit Redwood Hospital for the month of September 2006.
(Exercise 16.4) Selected ledger account balances for Recuperative Hospital, a nonprofit organization, on
October 31, 2006, the end of its first month of operations, were as follows:

Accounts receivable $174,000 dr

Allowance for doubtful accounts 24,000 cr
Contractual adjustments 32,000 dr
Doubtful accounts expense 24,000 dr
Patient service revenues 206,000 cr

In addition, Recuperative had charity care totaling $10,000, of which $6,000 was to be re-
imbursed by Local Services, a nonprofit organization. Because Recuperative billed patients
on October 31, 2006, it had not collected any accounts receivable as of that date.
Reconstruct the journal entries (omit explanations) prepared by Recuperative Hospital
on October 31, 2006.
(Exercise 16.5) The library of the nonprofit University of South Park (USP) received books with a current
fair value of $16,000 from various publishers at no cost on June 15, 2006. The library’s op-
erations are accounted for in USP’s Unrestricted Fund.
Prepare a journal entry for the Unrestricted Fund of University of South Park on June
15, 2006.
(Exercise 16.6) In your audit of the financial statements of Cordova Hospital, a nonprofit organization, for
the fiscal year ended March 31, 2006, you note the following journal entry in the General
Fund:

Inventories 200
Cash 200
To record purchase of medicine and drugs from manufacturer at nominal
cost. Current fair value of the items totaled $6,400.
 Chapter 16 Nonprofit Organizations 697

Prepare a journal entry to correct the accounting records of the General Fund of
Cordova Hospital on March 31, 2006.
(Exercise 16.7) During the month of October 2006, volunteer instructors’ aides rendered services at no
cost to Warner College, a nonprofit organization. Salary rates for comparable employ-
ees of Warner College, applied to the services, yielded a total value of $3,400. Compli-
mentary meals given to the volunteers at the Warner College cafeteria during October
2006 cost $180. The volunteer’s services met the specifications for donated services
in FASB Statement No. 116, “Accounting for Contributions Received and Contri-
butions Made.”
Prepare a journal entry for the Warner College Unrestricted Fund on October 31, 2006,
for the services donated to Warner College during the month of October 2006. (Disregard
income taxes and other withholdings.)
(Exercise 16.8) The value of services contributed by docents of Modern Museum, a nonprofit organization,
totaled $68,000 for the fiscal year ended June 30, 2006. Also during that year, Modern Mu-
seum used rent-free facilities for storage that would have been leased to a business enter-
prise by the owner for the rent of $96,000 a year.
Prepare journal entries dated June 30, 2006, for the foregoing support of Modern
Museum.
(Exercise 16.9) Community Welfare, Inc., accounts for pledges in accordance with FASB Statement
No. 116, “Accounting for Contributions Received and Contributions Made.” During the
month of November 2006, Community Welfare received unrestricted pledges totaling
$500,000, of which 20% was estimated to be uncollectible, and wrote off uncollectible
pledges totaling $30,000. During that month, $240,000 was collected on pledges.
Prepare journal entries (dated November 30, 2006) for Community Welfare, Inc., with
respect to pledges. (Omit explanations for the journal entries.)
(Exercise 16.10) The “Summary of Significant Accounting Policies” note to the financial statements pre-
pared by the controller of Wabash Hospital (a nonprofit organization) for the fiscal year
CHECK FIGURE ended June 30, 2006, included the following sentence: “Pledges for contributions are
Credit contributions recorded when the cash is received.” Another note read as follows:
revenue, $25,000.

Pledges Unrestricted pledges receivable, received, and collected during

the year ended June 30, 2006, were as follows:
Pledges receivable, July 1, 2005 (10% doubtful) $ 50,000
New pledges received during year ended June 30, 2006 300,000
Pledges receivable, July 1, 2005, determined to be uncollectible
during year (15,000)
Pledges collected in cash during year ended June 30, 2006 (275,000)
Pledges receivable, June 30, 2006 (12% doubtful) $ 60,000

All pledges are due six months from the date of the pledge. Pledge revenue is recorded in
the General Fund.
Assume that you are engaged in the first annual audit of the financial statements of
Wabash Hospital for the fiscal year ended June 30, 2006, and are satisfied with the propri-
ety of the amounts recorded in the hospital’s “Pledges” note. Prepare an adjusting entry for
the General Fund of Wabash Hospital on June 30, 2006.
(Exercise 16.11) On July 1, 2005, three funds of Wilmington College pooled their individual securities
investments, as follows:
698 Part Five Accounting for Nonbusiness Organizations

Current
Cost Fair Values
Restricted Fund $ 80,000 $ 90,000
Quasi-Endowment Fund 120,000 126,000
Annuity Fund 150,000 144,000
Totals $350,000 $360,000

During the fiscal year ended June 30, 2006, the Wilmington College investment pool, man-
aged by the Unrestricted Fund, reinvested realized gains of $3,000, had net unrealized gains
of $7,000, and received dividends and interest totaling $18,000.
Prepare journal entries on June 30, 2006, for each of the three Wilmington College
funds to record the results of the investment pool’s operations during Fiscal Year 2006. Do
not use Receivable from Unrestricted Fund ledger accounts.
(Exercise 16.12) Artistry Unlimited, a nonprofit performing arts organization, received a contribution of
$50,000 on July 1, 2006, the beginning of a fiscal year, to be awarded as grants to students
of ballet for the school year beginning in September 2006. On September 1, 2006, uncon-
ditional grants totaling $45,000 were awarded to nine students of ballet. Artistry Unlimited
does not use fund accounting.
Prepare journal entries for Artistry Unlimited on July 1 and September 1, 2006.
(Exercise 16.13) On July 1, 2006, the beginning of a fiscal year, Technology Specialists, a nonprofit research
and scientific organization, awarded a $30,000, three-year research grant to Martin Grey.
The grant was payable in three annual installments of $10,000, beginning July 1, 2006;
however, the governing board of Technology Specialists reserved the right to revoke the re-
maining unpaid amount of the grant on appropriate notice to Grey on June 30, 2007, or
June 30, 2008, if Grey’s research efforts were unproductive.
Prepare a journal entry for Technology Specialists on July 1, 2006.
(Exercise 16.14) From the following ledger account balances (amounts in thousands) of the General Fund of
No-Prof Hospital, a nonprofit organization, prepare a statement of financial position as of
June 30, 2006. No-Prof has only a general fund.

CHECK FIGURE Accounts with Debit Balances Accounts with Credit Balances
Total net assets,
$2,900,000 Accounts receivable (net) $ 900 Accounts payable and accrued
Cash and cash equivalents 100 liabilities $ 550
Cash restricted to acquisition of Advances from third-party
plant assets 200 payors 200
Investments restricted to Deferred revenues 100
acquisition of plant assets 400 Fund balance designated for
Inventory of supplies 200 plant assets 600
Plant assets (net) 3,100 Housing bonds payable 400
Short-term prepayments 50 Mortgage bonds payable 500
Notes payable (current) 300
Undesignated fund balance 2,300
Total $4,950 Total $4,950
 Chapter 16 Nonprofit Organizations 699

Cases
(Case 16.1) During the June 20, 2006, meeting of the board of directors of Roakdale Association, a
nonprofit voluntary health and welfare organization, the following discussion occurred:
Chair: We shall now hear the report from the controller.
Controller: Our unrestricted contributions are at an all-time high. I project
an increase in unrestricted net assets of $100,000 for the year
ending June 30, 2007.
Chair: That’s too large an amount for us to have a successful fund-
raising drive next year. I’ll entertain a motion that $80,000 of
unrestricted contributions be transferred to a Restricted Fund.
Director Walker: So moved.
Director Hastings: Second.
Chair: All those in favor say aye.
All Directors: Aye.
Chair: The chair directs the controller to prepare the necessary journal
entries for the Unrestricted Fund and a Restricted Fund.
Instructions
Do you concur with the action taken by the board of directors of Roakdale Association?
Explain.
(Case 16.2) The board of trustees of Toledo Day Care Center, a nonprofit organization, has asked you, as
independent auditor for the center, to attend a meeting of the board of trustees and participate
in the discussion of a proposal to create one or more endowment funds. At the meeting, the
board members ask you numerous questions regarding the operations and the accounting
treatment of endowment funds. Among the questions posed by trustees were the following:
1. Are only the revenues of an endowment fund expendable for current operations?
2. Under what circumstances, if any, may endowment fund principal be expended at the
discretion of the board?
3. Must a separate set of accounting records be established for each endowment fund, or
may all endowment fund operations be accounted for in a single restricted fund?
Instructions
Prepare a reply for each of the trustee’s questions. Number your replies to correspond with
the question numbers.
(Case 16.3) In your audit of the financial statements of Science Unlimited, a nonprofit research and sci-
entific organization, for the fiscal year ended June 30, 2006, you find that products created
by Science Unlimited are sold at prices less than production costs. Unsold products are car-
ried at an arbitrary amount in two sections of Science Unlimited’s statement of financial
position—$10,000 “base stock” as a plant asset and the remainder as a current asset. No
provision is made for distribution, handling, or storage costs.
Instructions
Do you concur with the way Science Unlimited presents unsold products in its statement of
financial position? Explain. (Adapted from AICPA Technical Practice Aids.)
(Case 16.4) Station KKLL, a nonprofit public broadcasting station, is authorized to acquire surplus
broadcasting equipment from the U.S. government at nominal prices. In your audit of the
700 Part Five Accounting for Nonbusiness Organizations

financial statements of Station KKLL for the fiscal year ended June 30, 2006, you discover
that a radio station tower antenna with a current fair value of $8,000 had been acquired
from the U.S. government for $500, which was the amount debited to the Broadcasting
Equipment ledger account. Under terms of the acquisition, Station KKLL is not permitted
to resell the antenna for a period of four years.
Instructions
Do you concur with Station KKLL’s accounting for the acquisition of the antenna? Explain.
(Adapted from AICPA Technical Practice Aids.)
(Case 16.5) The accountant for Nonprofit Religious Organization proposes to estimate the fair value of
services contributed by deacons, elders, ushers, and other volunteer laypersons and recog-
nize the amount as both expense and revenue in the organization’s statement of activities.
Instructions
Do you concur with the accountant’s proposal? Explain.
(Case 16.6) As a CPA, a member of the AICPA, and chief accountant of Vol-Wel, a nonprofit voluntary
health and welfare organization, you are engaged in preparing financial statements for Vol-
Wel for its first fiscal year, ended June 30, 2006. You have shown the following draft con-
densed statement of activities to Wells Conner, president of Vol-Wel and chairman of its
board of trustees:

VOL-WEL
Draft Condensed Statement of Activities
For Year Ended June 30, 2006

Changes in unrestricted net assets:

Total unrestricted revenues and gains $380,000
Net assets released from restrictions 25,000
Total unrestricted revenues, gains, and other support $405,000
Expenses:
Programs $ 80,000
Management and general 210,000
Fund raising 40,000
Total expenses $330,000
Increase in unrestricted net assets $ 75,000

Conner expresses concern about the amount of the management and general expenses,
which constitute nearly 64% ($210,000 $330,000 0.636) of total expenses and over
half ($210,000 $405,000 0.519) of total unrestricted revenues, gains, and other sup-
port. He fears that prospective donor users of the statement of activities will not be inclined
to make unrestricted contributions to Vol-Wel, given its substantial overhead expenses. He
therefore instructs you to do the following:
1. Recognize the $60,000 estimated value of services contributed by fund-raising volun-
teers, who do not have specialized skills.
2. Move a substantial part of Conner’s $100,000 annual salary from management and gen-
eral expenses to program expenses and fund-raising expenses, given his participation in
both programs and fund raising.
Instructions
Can you ethically comply with Wells Conner’s instructions? In forming your solution, con-
sider the following:
 Chapter 16 Nonprofit Organizations 701

FASB Statement No. 116, “Accounting for Contributions Received and Contributions
Made,” pars. 9–10 and 118–124.
FASB Statement No. 117, “Financial Statements of Not-for-Profit Organizations,”
pars. 26–28.
AICPA Professional Standards, vol. 2, ET Section 203.05, “Responsibility of
Employees for the Preparation of Financial Statements in Conformity with GAAP.”

Problems
(Problem 16.1) Ledger account balances (in alphabetical sequence) to be included in the statement of ac-
tivities for Seaside Hospital (a nonprofit organization that has only a general fund) for the
fiscal year ended June 30, 2006, are as follows:

CHECK FIGURE Debit Credit

Increase in unrestricted
(in thousands)
net assets, $200,000.
Administrative services expenses $280
Contractual adjustments 140
Depreciation expense 340
Doubtful accounts expense 80
Fiscal service expense 180
General services expense 360
Nursing services expense 560
Other operating revenue $ 180
Other professional services expense 260
Patient service revenue 1,560
Unrestricted contributions revenue 380
Unrestricted revenue from investments 280

Instructions
Prepare a statement of activities for Seaside Hospital (amounts in thousands) for the year
ended June 30, 2006, ending with increase (decrease) in unrestricted net assets.
(Problem 16.2) Among the transactions and events of Holley School, a nonprofit, private secondary school,
for the fiscal year ended June 30, 2006, were the following:
(1) Paid $50,000 from the Unrestricted Fund for classroom computers, to be carried in
the Plant Fund.
(2) Received an unrestricted cash gift of $200,000.
(3) Disposed of for $110,000 common stocks investments that had been carried in the
Quasi-Endowment Fund at $100,000. There were no restrictions on use of the pro-
ceeds attributable to the gain.
(4) Constructed a new school building at a total cost of $2 million. Payment was by
$250,000 cash from the Plant Fund and $1,750,000 obtained on a 5% mortgage note
payable.
Instructions
Prepare journal entries for the foregoing transactions and events of Holley School for the
year ended June 30, 2006. Use the following ledger account titles in the journal entries:
702 Part Five Accounting for Nonbusiness Organizations

Plant Fund
Buildings
Cash
Equipment
Fund Balance
Mortgage Note Payable
Quasi-Endowment Fund
Cash
Investments
Payable to Unrestricted Fund
Unrestricted Fund
Cash
Contributions revenue
Investment Income
Receivable from Quasi-Endowment Fund
Undesignated Fund Balance

(Problem 16.3) The adjusted trial balance of Nonprofit Trade Association, which does not use fund ac-
counting, for June 30, 2006, was as follows:

CHECK FIGURES
NONPROFIT TRADE ASSOCIATION
Ending net assets,
Adjusted Trial Balance
$312,000; total assets, June 30, 2006
$491,000.
Debit Credit
Cash $ 7,000
Short-term investments in securities 217,000
Accounts receivable 28,000
Allowance for doubtful accounts $ 3,000
Publications inventory 61,000
Long-term investments in securities 120,000
Plant assets 55,000
Accumulated depreciation of plant assets 22,000
Other assets 28,000
Accounts payable 36,000
Accrued liabilities 12,000
Deferred membership dues 131,000
Fund balance, July 1, 2005 285,000
Membership dues 184,000
Conferences and meetings revenue 321,000
Publications and advertising sales 143,000
Special assessments revenue 50,000
Investment revenue and net gains 11,000
Member services expense 56,000
Conferences and meetings expense 166,000
Technical services expense 218,000
Communications expense 61,000
General administration expenses 154,000
Membership development expense 27,000
Totals $1,198,000 $1,198,000
 Chapter 16 Nonprofit Organizations 703

Instructions
Prepare a statement of activities and a statement of financial position for Nonprofit Trade
Association for the fiscal year ended June 30, 2006.
(Problem 16.4) On July 1, 2005, the beginning of a fiscal year, the four funds of Suburban Welfare Ser-
vices, a nonprofit organization, formed an investment pool of securities managed by the
Unrestricted Fund. On that date, cost and current fair values of the investment pool securi-
ties were as follows:

CHECK FIGURE Current

a. Unrestricted fund
Fair
equity percentages: (1)
Cost Values
22.00%; (2) 18.33%.
Unrestricted Fund $ 50,000 $ 59,400
Restricted Fund 20,000 16,200
Plant Fund 80,000 89,100
Arnold Life Income Fund 100,000 105,300
Totals $250,000 $270,000

Additional Information
1. During the six months ended December 31, 2005, the investment pool, managed by the
Unrestricted Fund, reinvested gains totaling $5,000, had net unrealized gains of $10,000,
and received dividends and interest totaling $25,000, which was distributed to the partic-
ipating funds.
2. On December 31, 2005, the Restricted Fund withdrew from the pool and was awarded
securities in the amount of its share of the pool’s aggregate December 31, 2005, current
fair value of $300,000.
3. On January 2, 2006, the Edwards Endowment Fund entered the Suburban Welfare Services
investment pool with investments having a cost of $70,000 and a current fair value of
$78,000.
4. During the six months ended June 30, 2006, the investment pool reinvested gains total-
ing $40,000 and received dividends and interest totaling $60,000, which was distributed
to the participating funds.
Instructions
a. Prepare a working paper for the Suburban Welfare Services investment pool to compute
the following (round all percentages to two decimal places):
(1) Original equity percentages, July 1, 2005.
(2) Revised equity percentages, January 2, 2006.
b. Prepare journal entries to record the operations of the Suburban Welfare Services
investment pool in the accounting records of the Unrestricted Fund. Use Payable to
Restricted Fund, Payable to Plant Fund, and Payable to Arnold Life Income Fund ledger
accounts for amounts payable to other funds.
(Problem 16.5) Among the transactions and events of the General Fund of Harbor Hospital, a nonprofit
organization, for the month of October 2006, were the following:
1. Gross patient revenues of $80,000 were billed to patients. Indigent patient charity care
amounted to $4,000, of which amount $2,500 was receivable from Bovard Welfare
704 Part Five Accounting for Nonbusiness Organizations

Organization. Provision was made for contractual adjustments allowed to Medicaid of

$6,000, and doubtful accounts of $8,000.
2. Contributed services approximating $10,000 at going salary rates were received from
volunteer nurses. Meals costing $200 were served to the volunteer nurses at no charge
by the Harbor Hospital cafeteria.
3. New unrestricted pledges, due in three months, totaling $5,000 were received from var-
ious donors. Collections on pledges amounted to $3,500, and the provision for doubtful
pledges for October 2006 was $800.
4. The $500 monthly annuity established for Arline E. Walters by Walters’s contribution to
Harbor Hospital three years ago was paid on behalf of the Arline E. Walters Annuity
Fund.
5. The amount of $3,000, received from the Charles Watson Restricted Fund, was
expended for new surgical equipment, as authorized by the donor.

Instructions
a. Prepare journal entries for the October 2006 transactions and events of the Harbor
Hospital General Fund. Number each group of entries to correspond to the number of
each transactions or events group.
b. Prepare journal entries required for the Harbor Hospital Arline E. Walters Annuity Fund
and Charles Watson Restricted Fund as indicated by the transactions and events of the
General Fund.

(Problem 16.6) The statements of financial position of Wigstaff Foundation, a nonprofit research and
scientific organization that does not use fund accounting, on June 30, 2006 and 2005, were
as follows:

CHECK FIGURE WIGSTAFF FOUNDATION

Net cash provided by Statements of Financial Position
operating activities, June 30, 2006 and 2005
$266,000.
2006 2005
Assets
Current assets:
Cash $ 650,000 $ 630,000
Accounts receivable (net) 744,000 712,000
Unbilled contract revenue and reimbursable
grant costs 976,000 780,000
Short-term payments 80,000 76,000
Total current assets $2,450,000 $2,198,000
Long-term investments in securities $ 840,000 $ 780,000
Plant assets:
Land $ 440,000 $ 440,000
Building 958,000 958,000
Furniture and equipment 334,000 312,000
Subtotals $1,732,000 $1,710,000
Less: Accumulated depreciation 518,000 370,000
Net plant assets $1,214,000 $1,340,000
Total assets $4,504,000 $4,318,000

(continued)
 Chapter 16 Nonprofit Organizations 705

WIGSTAFF FOUNDATION
Statements of Financial Position (concluded)
June 30, 2006 and 2005

2006 2005
Liabilities and Net Assets
Current liabilities:
Accounts payable and accrued liabilities $ 836,000 $ 776,000
Restricted grant advances 522,000 420,000
Current portion of long-term debt 176,000 164,000
Total current liabilities $1,534,000 $1,360,000
Long-term debt (collateralized by plant assets) 618,000 794,000
Total liabilities $2,152,000 $2,154,000
Net assets:
Net equity in plant assets $ 596,000 $ 546,000
Undesignated 1,756,000 1,618,000
Total unrestricted net assets $2,352,000 $2,164,000
Total liabilities and net assets $4,504,000 $4,318,000

Additional Information for Fiscal Year Ended June 30, 2006:

1. The increase in unrestricted net assets was $188,000.
2. There were no disposals of plant assets or long-term securities investments. Furniture
and equipment was acquired for cash, as were long-term investments.
3. The “net equity in plant assets” designation of the fund balance represents the difference
between total plant assets and long-term debt collateralized by plant assets.
Instructions
Prepare a statement of cash flows (indirect method) for Wigstaff Foundation for the year
ended June 30, 2006. A working paper is not required. Disregard changes in current fair
values of securities investments.
(Problem 16.7) The post-closing trial balance of Mid-City Sports Club, a nonprofit social club, on June 30,
2005, was as follows:

CHECK FIGURE
MID-CITY SPORTS CLUB
b. Total assets,
Post-Closing Trial Balance
$122,000. June 30, 2005

Debit Credit
Cash $ 9,000
Investments in securities 58,000
Inventories 5,000
Land 10,000
Building 164,000
Accumulated depreciation of building $130,000
Furniture and equipment 54,000
Accumulated depreciation of furniture and equipment 46,000
Accounts payable 12,000
Membership certificates (100 $1,000) 100,000
Cumulative increase in net assets 12,000
Totals $300,000 $300,000
706 Part Five Accounting for Nonbusiness Organizations

Additional Information for Fiscal Year Ended June 30, 2006:

1. Dues revenue was $20,000.
2. Snack bar and soda fountain sales totaled $28,000.
3. Interest received on securities investments amounted to $6,000.
4. Amounts vouchered for payment were as follows:

Clubhouse expenses $17,000

Snack bar and soda fountain supplies (perpetual inventory system) 26,000
General and administrative expenses 11,000

5. Vouchers paid totaled $55,000.

6. The members were assessed $10,000 on June 30, 2006, payable within one year, for cap-
ital improvements to the clubhouse. All the assessments were considered collectible,
although none was collected on June 30, 2006. (Credit Contributions Revenue.)
7. An unrestricted gift of $5,000 was received.
8. Depreciation expense of $4,000 for the building and $8,000 for the furniture and equip-
ment was allocable as follows: $9,000 to clubhouse expense, $2,000 to snack bar and
soda fountain expense, and $1,000 to general and administrative expense.
9. The June 30, 2006, physical inventory of snack bar and soda fountain supplies totaled
$1,000.
Instructions
a. Prepare journal entries (omit explanations) for the events and transactions of Mid-City
Sports Club for the year ended June 30, 2006.
b. Prepare a statement of activities and a statement of financial position for Mid-City
Sports Club for the year ended June 30, 2006.
Disregard changes in current fair values of securities investments.
(Problem 16.8) Following is the post-closing trial balance of the unrestricted fund and the restricted fund
of State University, a nonprofit organization, on June 30, 2005:

STATE UNIVERSITY
Post-Closing Trial Balance
June 30, 2005
(amounts in thousands)

Unrestricted Restricted
Fund Fund
Cash and cash equivalents $210 $ 7
Accounts receivable (student tuition and fees) 350
Allowance for doubtful accounts (9)
State appropriation receivable 75
Investments in securities 60
Totals $626 $67
Accounts payable $ 45
Deferred revenues 66
Fund balance 515 $67
Totals $626 $67
 Chapter 16 Nonprofit Organizations 707

The following transactions and events occurred during the fiscal year ended June 30,
2006, at actual amounts:
1. On July 7, 2005, a gift of $100,000 was received from an alumnus. The alumnus
requested that one-half of the gift be used for the acquisition of books for the uni-
versity library and that the remainder be used for the establishment of a scholarship.
The alumnus further requested that the revenue generated by the scholarship fund be
used annually to award a scholarship to a qualified student, with the principal
remaining intact. On July 20, 2005, the board of trustees resolved that the cash of the
newly established scholarship (endowment) fund would be invested in bank certifi-
cates of deposit. On July 21, 2005, the certificates of deposit were acquired.
2. Revenues from student tuition and fees applicable to the year ended June 30, 2006,
amounted to $1,900,000. Of this amount, $66,000 had been collected in the prior year
and $1,686,000 had been collected during the year ended June 30, 2006. In addition,
on June 30, 2006, the university had received cash of $158,000, representing tuition
and fees for the session beginning July 1, 2006.
3. During the year ended June 30, 2006, State University had collected $349,000 of the
outstanding accounts receivable at the beginning of the year. The balance was deter-
mined to be uncollectible and was written off against the allowance ledger account. On
June 30, 2006, the allowance account was increased by $3,000.
4. During the year, interest of $6,000 was earned and collected on late student fee pay-
ments.
5. During the year, the state appropriation was received. An additional unrestricted
appropriation of $50,000 was made by the state, but had not been paid to State
University as of June 30, 2006.
6. Unrestricted cash gifts totaling $25,000 were received from alumni of the university.
7. During the year, restricted fund securities investments carried at $21,000 were sold for
$26,000. Investment earnings amounting to $1,900 were received. (Credit Fund
Balance.)
8. During the year, unrestricted operating expenses of $1,777,000 were recognized. On
June 30, 2006, $59,000 of these expenses remained unpaid.
9. Restricted cash of $13,000 was spent for authorized purposes during the year. An equal
amount was transferred from fund balance to revenues of the restricted fund.
10. The accounts payable on June 30, 2005, were paid during the year.
11. During the year, $7,000 interest was earned and received on the certificates of deposit
acquired in accordance with the board of trustees resolution discussed in item (1).
(Credit Fund Balance.)
Instructions
Prepare journal entries for State University to record the transactions or events for the
year ended June 30, 2006. Each journal entry should be numbered to correspond with the
transaction or event described above. (Omit explanations for the journal entries.)
The working paper should be organized as follows:

Unrestricted Restricted Endowment

Transaction Ledger Fund Fund Fund
Number Accounts dr(cr) dr(cr) dr(cr)
(1)
708 Part Five Accounting for Nonbusiness Organizations

Use the following ledger account titles in the journal entries:

Unrestricted Fund
Accounts Payable
Accounts Receivable
Allowance for Doubtful Accounts
Cash
Deferred Revenues
Expenses
Revenues
State Appropriation Receivable
Restricted Fund
Cash
Expenditures
Fund Balance
Investments
Revenues
Endowment Fund
Cash
Fund Balance
Investments

Disregard changes in current fair values of securities investments.

(Problem 16.9) Following is the post-closing trial balance of the three funds of Resthaven Hospital, a non-
profit organization, on December 31, 2005, the end of a fiscal year:

RESTHAVEN HOSPITAL
Post-Closing Trial Balance
December 31, 2005
(amounts in thousands)

Plant Replacement
General and Expansion Endowment
Fund Fund Fund
Cash $ 20 $ 54 $ 6
Accounts receivable 37
Allowance for doubtful accounts (7)
Inventory of supplies 14
Investments in securities 71 260
Land 370
Buildings 1,750
Accumulated depreciation of buildings (430)
Equipment 680
Accumulated depreciation of equipment (134)
Totals $2,300 $125 $266
Accounts payable $ 16
Accrued liabilities 6
Mortgage bonds payable 150
Fund balance designated for plant assets 2,116
Undesignated fund balance 12 $125 $266
Totals $2,300 $125 $266
 Chapter 16 Nonprofit Organizations 709

Additional Information for 2006:

1. Gross debits to Accounts Receivable for hospital services were as follows:

Room and board $ 780,000

Other professional services 321,000
Gross debits to Accounts Receivable $1,101,000

2. Deductions from gross revenues were contractual adjustments of $15,000. Doubtful

accounts expense was $30,000.
3. The General Fund paid $18,000 to retire mortgage bonds payable with that face
amount.
4. The General Fund received unrestricted gifts of $50,000 and revenues from Endow-
ment Fund securities investments of $6,500. The General Fund had been designated to
receive the revenues on Endowment Fund investments.
5. Equipment costing $26,000 was acquired. An x-ray machine that had cost $24,000 and
had a carrying amount of $2,400 was disposed of for $500.
6. Vouchers totaling $1,191,000 were issued for the following:

Administrative services expense $ 120,000

Interest expense 95,000
General services expense 225,000
Nursing services expense 520,000
Other professional services expense 165,000
Inventory of supplies 60,000
Accrued liabilities, Dec. 31, 2005 6,000
Total vouchers issued $1,191,000

7. Collections on accounts receivable totaled $985,000. Accounts receivable written off

as uncollectible amounted to $11,000.
8. Cash payments on accounts payable were $825,000.
9. Supplies of $37,000 were issued for nursing services.
10. On December 31, 2006, accrued interest on Plant Replacement and Expansion Fund
securities investments was $800.
11. Depreciation of buildings and equipment was as follows:

Buildings $ 44,000
Equipment 73,000
Total depreciation $117,000

12. On December 31, 2006, an accrual of $6,100 was made for interest on the mortgage
bonds payable.
710 Part Five Accounting for Nonbusiness Organizations

Instructions
For the period January 1 through December 31, 2006, prepare journal entries (omit expla-
nations) to record the transactions and events described above for the following funds of
Resthaven Hospital:

General Fund
Plant Replacement and Expansion Fund
Endowment Fund

Each journal entry should be numbered to correspond with the transactions or events
described on page 709.
The working paper should be organized as follows:

Plant
General Replacement Endowment
Transaction Ledger Fund and Expansion Fund
Number Accounts dr(cr) Fund dr(cr) dr(cr)
(1)

In addition to the ledger accounts included in the December 31, 2005, post-closing trial bal-
ance of Resthaven Hospital, the following accounts are pertinent:

Unrestricted Fund
Administrative Services Expense
Contractual Adjustments
Depreciation Expense
Doubtful Accounts Expense
General Services Expense
Interest Expense
Loss on Disposal of Plant Assets
Nursing Services Expense
Other Professional Services Expense
Patient Service Revenues
Unrestricted Gift Revenues
Unrestricted Revenues from Endowment Fund
Plant Replacement and Expansion Fund
Interest Receivable

Disregard changes in current fair values of securities investments.

(Problem 16.10) A partial statement of financial position for Libra College, a nonprofit organization, on June
30, 2005, follows:
 Chapter 16 Nonprofit Organizations 711

LIBRA COLLEGE
Partial Statement of Financial Position
June 30, 2005

Current Funds
Unrestricted Restricted
Assets
Cash $200,000 $ 10,000
Investments in securities 210,000
Accounts receivable, tuition and fees (net of $15,000
allowance for doubtful accounts) 360,000
Short-term prepayments 40,000
Total assets $600,000 $220,000

Liabilities and Net Assets

Accounts payable $100,000 $ 5,000
Payable to other funds 40,000
Deferred revenues 25,000
Net assets (fund balances) 435,000 215,000
Total liabilities and net assets $600,000 $220,000

Additional Information for Fiscal Year Ended June 30, 2006:

1. Cash collected from tuition and fees totaled $3 million, of which $362,000 was for
accounts receivable on June 30, 2005, $2,500,000 was for Fiscal Year 2006 tuition, and
$138,000 was for Fiscal Year 2007 tuition.
2. Deferred revenues (for tuition and fees) on June 30, 2005, were earned.
3. The balance of accounts receivable on June 30, 2005, was written off, and the required
June 30, 2006, balance of the Allowance for Doubtful Accounts ledger account was
estimated at $10,000.
4. On June 30, 2006, an unrestricted appropriation of $60,000 was received from the state
government.
5. Unrestricted cash gifts of $80,000 were received, of which $30,000 was transferred to
the Student Loan Fund by the board of trustees of Libra College.
6. Investment income of $18,000 was realized and collected; investments carried at
$25,000 were disposed of for $31,000; and the Restricted Fund acquired securities in-
vestments for $40,000.
7. Unrestricted general expenses of $2,500,000 were incurred; on June 30, 2006, unre-
stricted accounts payable totaled $75,000.
8. The restricted accounts payable balance on June 30, 2005, was paid.
9. The $40,000 payable to other funds was paid to the Plant Fund.
10. One-fourth of the June 30, 2005, short-term prepayments expired and pertained to gen-
eral expenses; there were no additional short-term prepayments made.

Instructions
For the year ended June 30, 2006, prepare journal entries (omit explanations) for the
transactions and events described above for the Unrestricted Fund and the Restricted
Fund of Libra College. Each journal entry should be numbered to correspond with the
712 Part Five Accounting for Nonbusiness Organizations

transactions of events described on page 711. Disregard changes in current fair values of
investment securities.
The working paper should be organized as follows:

Unrestricted Restricted
Transaction Fund Fund
Number Ledger Accounts dr(cr) dr(cr)

(1)

In addition to the ledger accounts included in the June 30, 2005, partial statement of finan-
cial position of Libra College, the following accounts are pertinent:

Unrestricted Fund
Education and General Expenses
Government Grants Revenues
Private Gifts Revenues
Provision for Doubtful Tuition and Fees
State Appropriation Receivable
Tuition and Fees Revenues

(Problem 16.11) The adjusted trial balances of the two funds of Disadvantaged Children Association, a non-
profit voluntary health and welfare organization, on June 30, 2006, the end of a fiscal year,
were as follows:

CHECK FIGURES
DISADVANTAGED CHILDREN ASSOCIATION CURRENT FUNDS
Ending unrestricted net
Adjusted Trial Balances
assets, $98,000; ending June 30, 2006
temporarily restricted
net assets, $13,000. Unrestricted Fund Restricted Fund
Debit Credit Debit Credit
Cash $ 40,000 $ 9,000
Pledges receivable 12,000
Bequest receivable 5,000
Allowance for doubtful pledges $ 3,000
Interest receivable 1,000
Investments in securities, at
fair value 100,000
Accounts payable and accrued
liabilities 50,000 $ 1,000
Deferred revenues 2,000
Restricted fund balance 3,000
Designated fund balance 12,000
Undesignated fund balance 26,000
Contributions revenue 320,000 15,000
Membership dues revenue 25,000
Program service fees revenue 30,000
Investment revenue and gains 10,000
(continued)
 Chapter 16 Nonprofit Organizations 713

DISADVANTAGED CHILDREN ASSOCIATION CURRENT FUNDS

Adjusted Trial Balances (concluded)
June 30, 2006

Unrestricted Fund Restricted Fund

Debit Credit Debit Credit
Hearing-impaired children’s program
expenses 120,000
Vision-impaired children’s program
expenses 150,000
Management and general expenses 45,000 4,000
Fund-raising expenses 8,000 1,000
Provision for doubtful pledges 2,000
Totals $478,000 $478,000 $19,000 $19,000

Instructions
Prepare financial statements, excluding a statement of cash flows, for Disadvantaged
Children Association for the fiscal year ended June 30, 2006.
Chapter Seventeen

Governmental Entities:
General Fund
Scope of Chapter
In 1999, the governmental Accounting Standards Board (GASB), whose establishment in 1984
is described on page 717, issued GASB Statement No. 34, “Basic Financial Statements—
and Management’s Discussion and Analysis—for State and Local Governments.” That pro-
nouncement was a major milestone in the upgrading of the financial accounting and
reporting by governmental entities other than the United States government and sparked
renewed interest in a somewhat arcane area of accounting: state and local governmental
entities.
This chapter deals with the following aspects of state and local governmental entities:
their nature; their financial reporting objectives; their accounting and reporting standards;
and accounting for a governmental entity’s general fund. Accounting and reporting for
other funds and account groups of governmental entities are covered in Chapters 18 and 19.
However, it must be emphasized that Chapters 17 through 19 do not discuss accounting
standards for the United States federal government.

NATURE OF GOVERNMENTAL ENTITIES

Students beginning the study of accounting for governmental entities temporarily must set
aside many of the familiar accounting principles for business enterprises. Such fundamen-
tal concepts of accounting theory for business enterprises as the nature of the accounting
entity and the primacy of the income statement have limited relevance in accounting for
governmental entities. Consequently, the following discussion identifies the features of gov-
ernmental entities that give rise to unique accounting concepts.
When thinking of governmental entities of the United States, one tends to focus on the
federal government or on the governments of the 50 states. However, in addition to those ma-
jor governmental entities and the governments of the several U.S. territories, there are the
following governmental entities in the United States:1
• More than 3,000 counties.
• Nearly 17,000 townships.

1
Local Governmental Accounting Trends & Techniques—1990 Third Edition (New York: AICPA,
1990), p. 1–1.

714
 Chapter 17 Governmental Entities: General Fund 715

• Over 19,000 municipalities.

• Nearly 15,000 school districts.
• Over 28,000 special districts (port authorities, airports, public buildings, libraries, and
others).
Despite the wide range in size and scope of governance, the governmental entities listed
above have a number of characteristics in common. Among these characteristics are the
following:
1. Organization to serve the citizenry. A basic tenet of governmental philosophy in the
United States is that governmental entities exist to serve the citizens subject to their ju-
risdiction. Thus, the citizens as a whole establish governmental entities through the con-
stitutional and charter process. In contrast, business enterprises are created by only a
limited number of individuals.
2. General absence of the profit motive. With few exceptions, governmental entities ren-
der services to the citizenry without the objective of profiting from those services. Busi-
ness enterprises are motivated to earn profits.
3. Taxation as the principal source of revenue. The citizens subject to a governmental
entity’s jurisdiction provide resources to the governmental entity principally through tax-
ation. Many of these taxes are paid on a self-assessment basis. There is no comparable
revenue for business enterprises.
4. Impact of the legislative process. Operations of governmental entities are for the most
part initiated by various legislative enactments, such as operating budgets, borrowing
authorizations, and tax levies. Business enterprises also are affected by federal, state,
and local laws and regulations, but not to such a direct extent.
5. Stewardship for resources. A primary responsibility of governmental entities in fi-
nancial reporting is to demonstrate adequate stewardship for resources provided by their
citizenry (“other people’s money”). Business enterprises have a comparable responsi-
bility to their owners, but not to the same extent as governmental entities.
The five foregoing characteristics of governmental entities are major determinants of ac-
counting standards for such entities.

OBJECTIVES OF FINANCIAL REPORTING FOR

GOVERNMENTAL ENTITIES
Shortly after its establishment (as described on page 717) the Governmental Accounting
Standards Board (GASB) issued Concepts Statement No. 1, “Objectives of Financial Re-
porting,” in which it established the following reporting objectives for state and local gov-
ernmental entities:
1. Financial reporting should assist in fulfilling government’s duty to be publicly accountable
and should enable users to assess that accountability.
a. Financial reporting should provide information to determine whether current-year rev-
enues were sufficient to pay for current-year services. This also implies that financial re-
porting should show whether current-year citizens received services but shifted part of
the payment burden to future-year citizens; whether previously accumulated resources
were used up in providing services to current-year citizens; or, conversely, whether
current-year revenues were not only sufficient to pay for current-year services, but also
increased accumulated resources.
716 Part Five Accounting for Nonbusiness Organizations

b. Financial reporting should demonstrate whether resources were obtained and used in
accordance with the entity’s legally adopted budget; it should also demonstrate compli-
ance with other finance-related legal or contractual requirements.
c. Financial reporting should provide information to assist users in assessing the service
efforts, costs, and accomplishments of the governmental entity. This information, when
combined with information from other sources, helps users assess the economy, effi-
ciency, and effectiveness of government and may help form a basis for voting or fund-
ing decisions. The information should be based on objective criteria to aid interperiod
analysis within an entity and comparisons among similar entities. Information about
physical resources (as discussed in paragraph 3b) should also assist in determining cost
of services.
2. Financial reporting should assist users in evaluating the operating results of the govern-
mental entity for the year.
a. Financial reporting should provide information about sources and uses of financial re-
sources. Financial reporting should account for all outflows by function and purpose, all
inflows by source and type, and the extent to which inflows met outflows. Financial re-
porting should identify material nonrecurring financial transactions.
b. Financial reporting should provide information about how the governmental entity fi-
nanced its activities and met its cash requirements.
c. Financial reporting should provide information necessary to determine whether the en-
tity’s financial position improved or deteriorated as a result of the year’s operations.
3. Financial reporting should assist users in assessing the level of services that can be pro-
vided by the governmental entity and its ability to meet its obligations as they become due.
a. Financial reporting should provide information about the financial position and condi-
tion of a governmental entity. Financial reporting should provide information about re-
sources and obligations, both actual and contingent, current and noncurrent. The major
financial resources of most governmental entities are derived from the ability to tax and
issue debt. As a result, financial reporting should provide information about tax sources,
tax limitations, tax burdens, and debt limitations.
b. Financial reporting should provide information about a governmental entity’s physical
and other nonfinancial resources having useful lives that extend beyond the current
year, including information that can be used to assess the service potential of those re-
sources. This information should be presented to help users assess long- and short-term
capital needs.
c. Financial reporting should disclose legal or contractual restrictions on resources and
risks of potential loss of resources.2
The foregoing objectives provide the framework within which the GASB develops
standards of financial reporting for governmental entities3 (as described in the following
section).

ACCOUNTING AND REPORTING STANDARDS FOR

GOVERNMENTAL ENTITIES
For many years, accounting and reporting standards for governmental entities were es-
tablished by the National Council on Governmental Accounting, a 21-member organ-
ization composed primarily of local, state, and national finance officers, including two

2
Codification of Governmental Accounting and Financial Reporting Standards (Norwalk: GASB, 2003),
App. B, pars. 77-79 (footnote omitted).
3
Ibid., p. B-5.
 Chapter 17 Governmental Entities: General Fund 717

Canadian finance officers. In 1984, the Governmental Accounting Standards Board was
established as an arm of the Financial Accounting Foundation, which also oversees the
Financial Accounting Standards Board. The GASB issues Statements of Governmental
Accounting Standards for financial accounting and reporting of state and local gov-
ernmental entities.
One of the first acts of the GASB was to codify governmental accounting and financial
reporting standards in effect in 1984. Subsequently, the GASB has issued a number of
Statements that superseded, modified, or supplemented the standards set forth in the Codifi-
cation; and the Codification was frequently revised. This chapter and Chapters 18 and 19
discuss and illustrate many of the governmental accounting and financial reporting standards
currently in effect.

The Governmental Financial Reporting Entity

A significant question to be resolved in accounting for governmental entities is what
agencies, institutions, commissions, public authorities, or other governmental organiza-
tions are to constitute the financial reporting entity for a governmental entity. The Cod-
ification provided that the governmental financial reporting entity is to consist of the
following:4
1. The primary government—a state government, a municipality or county, or a special-
purpose government such as a school district or a park district meeting specified
criteria.
2. Organizations for which the primary government is financially accountable by reason
of appointing a voting majority of the governing bodies and thus either imposing its will
on the organizations or being responsible to provide financial benefits to, or financial
burdens on, the organizations.
3. Other organizations whose relationship with the primary government necessitates their
inclusion in the financial reporting entity.
The organizations described in 2 and 3 above are termed component units. The Codifica-
tion provided several nonauthoritative illustrative examples of governmental financial re-
porting entities.5

Funds: The Principal Accounting Unit for

Governmental Entities
Accounting for business enterprises emphasizes the economic entity as an accounting
unit. Thus, a partnership is considered to be an accounting entity separate from the part-
ners; and consolidated financial statements are issued for a group of affiliated—but
legally separate—corporations that constitute a single economic entity under common
control.
There is generally no single accounting entity for a specific governmental entity, such as
a city or a county. Instead, the principal accounting unit for governmental entities is the
fund. The Codification defined fund as follows:
Governmental accounting systems should be organized and operated on a fund basis. A fund
is defined as a fiscal and accounting entity with a self-balancing set of accounts recording
cash and other financial resources, together with all related liabilities and residual equities or

4
Ibid., Sec. 2100.111 ff.
5
Ibid., Sec. 2100.902 ff.
718 Part Five Accounting for Nonbusiness Organizations

balances, and changes therein, which are segregated for the purpose of carrying on specific acti-
vities or attaining certain objectives in accordance with special regulations, restrictions, or
limitations. [Emphasis added.]6

GASB Statement No. 34 identified the following 11 types of funds:7

Governmental Funds
1. The General Fund—to account for all financial resources except those required to be ac-
counted for in another fund.
2. Special Revenue Funds—to account for the proceeds of specific revenue sources
(other than trusts for individuals, private organizations, or other governments or for
major capital projects) that are legally restricted to expenditure for specified pur-
poses.
3. Capital Projects Funds—to account for financial resources to be used for the acqui-
sition or construction of major capital facilities (other than those financed by pro-
prietary funds or in trust funds for individuals, private organizations, or other
governments).
4. Debt Service Funds—to account for the accumulation of resources for, and the payment
of, general long-term debt principal and interest.
5. Permanent Funds—to report resources that are legally restricted to the extent
that only earnings, and not principal, may be used for purposes that support the
governmental entity’s programs, that is, for the benefit of the government or its
citizenry.

Proprietary Funds
1. Enterprise Funds—to report any activity for which a fee is charged to external users for
goods or services.
2. Internal Service Funds—to report any activity that provides goods or services to other
funds, departments, or agencies of the governmental entity, or to other governments on
a cost-reimbursement basis.

Fiduciary Funds
1. Pension (and other Employee Benefit) Trust Funds—to report resources required to be
held in trust for the members and beneficiaries of pension, other postemployment bene-
fit, and other employee benefit plans.
2. Investment Trust Funds—to report the external portion of investment pools reported by
the sponsoring government.
3. Private-Purpose Trust Funds—to report all other trust arrangements under which prin-
cipal and income benefit individuals, private organizations, or other governments.
4. Agency Funds—to report resources held by the governmental entity in a purely custo-
dial capacity (assets equal liabilities).
The governmental funds account for financial resources of a governmental entity that
are used in day-to-day operations. The proprietary funds carry out governmental entity
activities that closely resemble the operations of a business enterprise. Fiduciary funds

6
Ibid., Sec. 1100.102.
7
Ibid., Secs. 1300.104–1300.114.
 Chapter 17 Governmental Entities: General Fund 719

account for resources that are not owned by a governmental entity, but are administered by
the entity as a custodian or fiduciary.
Every governmental entity has a general fund. According to the Codification, any ad-
ditional funds should be established as required by law and sound financial administration.8
Accounting and reporting for the general fund are discussed in a subsequent section of this
chapter; accounting and reporting for other funds are explained in Chapters 18 and 19.
At this point, it is appropriate to emphasize that a governmental entity does not have a
single accounting unit to account for its financial resources, obligations, revenues, and
expenditures.

The Modified Accrual Basis of Accounting

The governmental funds of a governmental entity have used a modified accrual basis of ac-
counting, in which revenues are recognized only when they became both measurable and
available to finance expenditures of a fiscal period. Expenditures are recognized when the
related liabilities are incurred, and short-term prepayments are not recognized as assets.
The conventional accrual basis of accounting is used for other funds.9

Recording the Budget

GASB Statement No. 34 provided the following statement regarding budgets of govern-
mental entities:10
1. An annual budget(s) should be adopted by every governmental entity.
2. The accounting system should provide the basis for appropriate budgetary control.
3. Budgetary comparison schedules should be presented as required supplementary infor-
mation for the general fund and for each major special revenue fund that has a legally
adopted annual budget.
Budgets are key elements of legislative control over governmental entities. The executive
branch of a governmental entity proposes the budgets; the legislative branch reviews, mod-
ifies, and enacts the budgets; and finally the executive branch approves the budgets and car-
ries out their provisions.
The two basic classifications of budgets for governmental entities are the same as those
for business enterprises—annual budgets and long-term or capital budgets. Annual bud-
gets include the estimated revenues and appropriations for expenditures for a specific fis-
cal year of the governmental entity. Annual budgets are appropriate for the general fund and
special revenue funds; they sometimes are used for other governmental funds. Capital bud-
gets, which are used to control the expenditures for construction projects or other plant
asset acquisitions, may be appropriate for capital projects funds. The annual or capital bud-
gets often are recorded in the accounts of all these funds, to aid in accounting for compli-
ance with legislative authorizations.
The operations of the two proprietary funds (enterprise funds and internal service funds)
are similar to those of business enterprises. Consequently, annual budgets are used by these
funds as a managerial planning and control device rather than as a legislative control tool.

8
Codification, Sec. 1100.104.
9
Ibid., Secs. 1600.105–1600.106, 1600.116, 1600.127.
10
Ibid., Sec. 1700 Statement of Principle.
720 Part Five Accounting for Nonbusiness Organizations

Thus, annual budgets of enterprise funds and internal service funds generally are not
recorded in ledger accounts by those funds.

Types of Annual Budgets

Several types of annual budgets may be used by a governmental entity.11 An object budget
emphasizes, by department, the object of each authorized expenditure. For example, under
the legislative activity of the general government function, the object budget may include
authorized expenditures for salaries, services, supplies, and equipment.
A program budget stresses measurement of total cost of a specific governmental entity
program, regardless of how many departments of the governmental entity are involved in
the program. Object of expenditure information is of secondary importance in a program
budget.
In a performance budget, there is an attempt to relate the input of governmental re-
sources to the output of governmental services. For example, the total estimated expendi-
tures of the enforcement section of the taxation department might be compared with the
aggregate collections of additional tax assessments budgeted for the fiscal year.
Regardless of which types of annual budgets are used by a governmental entity, the
final annual budget adopted by the governmental entity’s legislative body will include
estimated revenues for the fiscal year and the appropriations for expenditures autho-
rized for that year. If the estimated revenues of the budget exceed appropriations (as re-
quired by law for many governmental entities), there will be a budgetary surplus; if
appropriations exceed estimated revenues, there will be a budgetary deficit in the deficit
budget.

Journal Entry for a General Fund Budget

To illustrate the recording of an annual budget in the accounts of a general fund, assume
that the Town of Verdant Glen in June 2005 adopted the following condensed annual bud-
get for its General Fund for the fiscal year ending June 30, 2006:

Budget of General Estimated revenues:

Fund of a General property taxes $700,000
Governmental Entity Other 140,000
Total estimated revenues $840,000
Add: Estimated other financing sources (transfer from
Enterprise Fund) 10,000
Subtotal $850,000
Less: Appropriations:
General government $470,000
Other 340,000
Total appropriations $810,000
Estimated other financing uses (transfer to Debt
Service Fund) 10,000 820,000
Excess of estimated revenues and other financing
sources over appropriations and other financing
uses (budgetary surplus) $ 30,000

11
Audit and Accounting Guide, “Audits of State and Local Governmental Units” (New York: AICPA,
2003), pars. 11.05–11.07.
 Chapter 17 Governmental Entities: General Fund 721

The journal entry to record the annual budget on July 1, 2005, follows:

Journal Entry for Estimated Revenues 840,000

Budget of General Estimated Other Financing Sources 10,000
Fund of a Appropriations 810,000
Governmental Entity Estimated Other Financing Uses 10,000
Budgetary Fund Balance 30,000
To record annual budget adopted for fiscal year ending June 30, 2006.

An analysis of each of the ledger accounts in the foregoing journal entry follows:
1. The Estimated Revenues and Estimated Other Financing Sources ledger accounts may
be considered pseudo asset controlling accounts because they reflect resources expected
to be received by the General Fund during the fiscal year. These accounts are not actual
assets, because they do not fit the accounting definition of an asset as a probable future
economic benefit obtained or controlled by a particular entity as a result of past transac-
tions or events.12 Thus, the two accounts in substance are memorandum accounts,
useful for control purposes only, that will be closed after the issuance of financial state-
ments for the General Fund for the fiscal year ending June 30, 2006.
2. The Estimated Other Financing Sources ledger account includes the budgeted amounts
of such items as proceeds from the disposal of plant assets (which also may be recog-
nized as revenue) and transfers in from other funds.
3. The Appropriations and Estimated Other Financing Uses ledger accounts may be con-
sidered pseudo liability controlling accounts because they reflect the legislative body’s
commitments to expend General Fund resources as authorized in the annual budget.
These accounts are not genuine liabilities because they do not fit the definition of a lia-
bility as a probable future sacrifice of economic benefits arising from present obligations
of a particular entity to transfer assets or provide services to other entities in the future
as a result of past transactions or events.13 The Appropriations and Estimated Other Fi-
nancing Uses accounts are memorandum accounts, useful for control purposes only,
that will be closed after issuance of year-end financial statements for the General
Fund.
4. The Estimated Other Financing Uses account includes budgeted amounts of transfers
out to other funds, which are not expenditures.
5. The Budgetary Fund Balance ledger account, as its title implies, is an account that bal-
ances the debit and credit entries to accounts of a budget journal entry. Although simi-
lar to the owners’ equity accounts of a business enterprise in this balancing feature, the
Budgetary Fund Balance account does not purport to show an ownership interest in a
general fund’s assets. At the end of the fiscal year, the Budgetary Fund Balance account
is closed by a journal entry that reverses the original entry for the budget.
The journal entry to record the Town of Verdant Glen General Fund’s annual budget for
the year ending June 30, 2006, is accompanied by detailed entries to subsidiary ledgers for
estimated revenues, estimated other financing sources, appropriations, and estimated other

12
Statement of Financial Accounting Concepts No. 6, “Elements of Financial Statements” (Stamford:
FASB, 1985), par. 25.
13
Ibid., par. 35.
722 Part Five Accounting for Nonbusiness Organizations

financing uses. The budget of the Town of Verdant Glen General Fund purposely was con-
densed; in practice, the general fund’s estimated revenues and appropriations would be de-
tailed by source and function, respectively, into one or more of the following widely used
subsidiary ledger categories:

Estimated revenues: Appropriations:

Taxes General government
Licenses and permits Public safety
Intergovernmental revenues Public works
Charges for services Health and welfare
Fines and forfeits Culture—recreation
Miscellaneous Conservation of natural resources
Debt service
Intergovernmental expenditures
Miscellaneous

In summary, budgets of a governmental entity generally are recorded in the accounts

of the general fund and special revenue funds; they may also be recorded in the accounts of
capital projects funds. The recording of the budget initiates the accounting cycle for each
of the funds. Recording the budget also facilitates the preparation of financial statements
that compare actual amounts of revenues and expenditures with budgeted amounts.

Encumbrances and Budgetary Control

Because of the need for the expenditures of governmental entities to be in accord with ap-
propriations of governing legislative bodies, an encumbrance accounting technique often
is used for the general fund and special revenue funds and sometimes for capital projects
funds.14 When a purchase order for goods or services is issued to a supplier by one of those
funds, a journal entry similar to the following is prepared for the fund:

Journal Entry for Encumbrances 18,413

Encumbrances Fund Balance Reserved for Encumbrances 18,413
To record encumbrance for purchase order No. 1685 issued to Wilson
Company.

When the supplier’s invoice for the ordered merchandise or services is received by the gov-
ernmental entity, it is recorded and the related encumbrance is reversed as illustrated below:

Journal Entries for Expenditures 18,507

Receipt of Invoice Vouchers payable 18,507
and Reversal of To record invoice No. 348J received from Wilson Company under
Encumbrance purchase order No. 1685.

Fund Balance Reserved for Encumbrances 18,413

Encumbrances 18,413
To reverse encumbrance for purchase order No. 1685 issued to Wilson
Company.

14
Codification, Sec. 1700.128.
 Chapter 17 Governmental Entities: General Fund 723

As indicated by the example on page 722, the invoice amount may differ from the amount
of the governmental entity’s purchase order because of such items as shipping charges,
sales taxes, and price changes.
The controls inherent in the encumbrance technique may be illustrated by assuming,
with respect to the foregoing journal entries, that they applied to a purchase order for sup-
plies (not available from the governmental entity’s internal service fund) for the general
government, the general fund fiscal year appropriation for which totaled $85,000. The sub-
sidiary ledger record for general government supplies would include the following infor-
mation (dates are assumed):
Subsidiary Ledger
Account for Supplies

General Government—Supplies
Unexpended,
Appropriation, Encumbrance, Expenditure, Unencumbered
Date Credit Debit Debit Balance, Credit
2005
July 1 Budgeted appropriation 85,000 85,000
2 P.O. 1685 to Wilson Company 18,413 66,587
6 Inv. 348J from Wilson Company (18,413) 18,507 66,493

The posting of the $18,413 encumbrance on July 2 reduces the balance of the appropri-
ation by that amount and protects against the issuance of one or more purchase orders in ex-
cess of the unexpended, unencumbered balance of $66,587. Receipt of the invoice for
$18,507 and reversal of the related encumbrance of $18,413 reduces the unexpended, un-
encumbered balance by $94 ($18,507 $18,413).
Thus, the encumbrance technique is a memorandum method for ensuring that total ex-
penditures for a fiscal year do not exceed appropriations. Encumbrance journal entries are
not necessary for normal recurring expenditures such as salaries and wages, utilities,
and rent. The encumbrance technique used in accounting for governmental entities has no
counterpart in accounting for business enterprises.

ACCOUNTING AND REPORTING FOR A GOVERNMENTAL

ENTITY’S GENERAL FUND
As indicated on page 718, a general fund is used to account for all transactions and events
of a governmental entity not accounted for in one of the other 10 types of funds. Thus, the
general fund as an accounting unit serves the same residual purpose that the general jour-
nal provides as an accounting record. Although the general fund is residual, it generally ac-
counts for the largest aggregate dollar amounts of the governmental entity’s revenues and
expenditures.
In illustrating the accounting for a general fund, the example of the Town of Verdant
Glen used in the preceding section is continued.

Illustration of Accounting for a General Fund

Assume that the balance sheet of the Town of Verdant Glen General Fund on June 30, 2005
(prior to the journal entry for the Fiscal Year 2006 budget illustrated on page 721), was as
shown on page 724.
724 Part Five Accounting for Nonbusiness Organizations

Balance Sheet of a TOWN OF VERDANT GLEN GENERAL FUND

Governmental Entity’s Balance Sheet
General Fund at End June 30, 2005
of Preceding Fiscal
Assets
Year
Cash $160,000
Inventory of supplies 40,000
Total assets $200,000

Liabilities and Fund Balance

Vouchers payable $ 80,000
Fund balance:
Reserved for inventory of supplies $40,000
Unreserved and undesignated 80,000 120,000
Total liabilities and fund balance $200,000

The fund balance reserved for inventory of supplies is analogous to a mandatory re-
striction of retained earnings in a business enterprise. It represents a reservation of the Gen-
eral Fund’s fund balance, so that the $40,000 nonexpendable portion of the General Fund’s
total assets will not be appropriated for expenditures in the legislative body’s adoption of
the annual budget for the General Fund for the year ending June 30, 2006.
Assume that, in addition to the budget illustrated on page 720 and recorded on page 721,
the Town of Verdant Glen General Fund had the summarized transactions and events for the
fiscal year ended June 30, 2006, that follow. For simplicity, income taxes, sales taxes, short-
term prepayments, and short-term loans are disregarded in this illustration.
1. Property taxes were billed in the amount of $720,000, of which $14,000 was of doubt-
ful collectibility.
2. Property taxes collected in cash totaled $650,000; revenues from licenses and permits
fees collected totaled $102,000.
3. Property taxes in the amount of $13,000 were determined to be uncollectible.
4. Purchase orders for nonrecurring expenditures were issued to outside suppliers in the
total amount of $360,000.
5. Expenditures for the year totaled $760,000, of which $90,000 applied to additions to
inventory of supplies, and $350,000 applied to $355,000 of the purchase orders in the
total amount of $360,000 issued during the year.
6. Billings for services and supplies received from the Enterprise Fund and the Internal
Service Fund totaled $30,000 and $20,000, respectively.
7. Cash payments on vouchers payable totaled $770,000. Cash payments to the Enter-
prise Fund and the Internal Service Fund were $25,000 and $14,000, respectively.
8. Transfers of cash to the Debt Service Fund for maturing principal and interest on gen-
eral obligation serial bonds totaled $11,000.
9. A payment of $40,000 in lieu of property taxes and a subsidy of $10,000 were received
from the Enterprise Fund.
10. Supplies with a cost of $80,000 were used during the year.
11. All uncollected property taxes on June 30, 2006, were delinquent.
12. The Town Council designated $25,000 of the unreserved and undesignated fund bal-
ance for the replacement of equipment during the year ending June 30, 2007.
 Chapter 17 Governmental Entities: General Fund 725

After the journal entry for the budget is recorded, as illustrated on page 721, the
following journal entries, numbered to correspond to the foregoing transactions or
events, are prepared for the Town of Verdant Glen General Fund during the year ended
June 30, 2006:

Journal Entries for 1 Taxes Receivable—Current 720,000

General Fund of a Allowance for Uncollectible Current Taxes 14,000
Governmental Entity Revenues 706,000
To accrue property taxes billed and to provide for estimated
uncollectible portion.

As indicated on page 719, the modified accrual basis of accounting for a general fund
requires the accrual of property taxes because they are billed to the property owners by
the Town of Verdant Glen and are thus measurable and available as collected. The estimated
uncollectible property taxes are offset against the total taxes billed in order to measure
actual revenues from property taxes for the year.

2 Cash 752,000
Taxes Receivable—Current 650,000
Revenues 102,000
To record collections of property taxes and licenses and permits
fees revenues for the year.

Under the modified accrual basis of accounting, revenues from licenses and permits fees
are recognized on the cash basis. However, any taxes or other revenues collected in advance
of the fiscal year to which they apply are credited to a liability ledger account.
If a governmental entity’s general fund has a cash shortage prior to collection
of property taxes, it may issue short-term tax anticipation notes to borrow cash. Typi-
cally, tax anticipation notes payable are repaid from proceeds of the subsequent tax
collections.

3 Allowance for Uncollectible Current Taxes 13,000

Taxes Receivable—Current 13,000
To write off receivables for property taxes that are uncollectible.

The foregoing journal entry represents a shortcut approach. In an actual situation, un-
collectible property taxes first would be transferred, together with estimated uncollectible
amounts, to the Taxes Receivable—Delinquent ledger account from the Taxes Receivable—
Current account. Any amounts collected on these delinquent taxes would include
revenues for interest and penalties required by law. Uncollected delinquent taxes would
726 Part Five Accounting for Nonbusiness Organizations

be transferred, together with estimated uncollectible amounts, to the Tax Liens Receiv-
able ledger account. After the passage of an appropriate statutory period, the govern-
mental entity might satisfy its tax lien by selling the property on which the delinquent
taxes were levied.

4 Encumbrances 360,000
Fund Balance Reserved for Encumbrances 360,000
To record purchase orders for nonrecurring expenditures issued
during the year.

As explained on page 722, encumbrance journal entries often are used to prevent the
overexpending of an appropriated amount in the budget. The journal entry to the Encum-
brances ledger account is posted in detail to reduce the unexpended balances of each ap-
plicable appropriation in the subsidiary ledger for appropriations. The unexpended balance
of each appropriation thus is reduced for the amount committed by the issuance of purchase
orders.

5a Expenditures 670,000
Inventory of Supplies 90,000
Vouchers Payable 760,000
To record expenditures for the year.

The Expenditures ledger account is debited with all expenditures, regardless of purpose,
except for additions to the inventory of supplies. Principal and interest payments on long-
term debt, additions to the governmental entity’s plant assets not accounted for in other
funds, payments for goods or services to be received in the future—all are debited to
Expenditures or to Other Financing Uses rather than to asset or liability ledger accounts.
(Expenditures for long-term debt principal and plant asset additions often are recorded on
a memorandum basis in the general long-term debt and general capital (plant) assets
account groups, respectively, as explained and illustrated in Chapter 18.)
The accounting for general fund expenditures described above emphasizes once again
the importance of the annual budget in the accounting for a general fund. Expenditures are
chargeable to amounts appropriated by the legislative body of the governmental entity. De-
tailed items making up the $670,000 total debit to the Expenditures ledger account in the
foregoing journal entry are posted to the appropriations subsidiary ledger as reductions of
unexpended balances of each appropriation.

5b Fund Balance Reserved for Encumbrances 355,000

Encumbrances 355,000
To reverse encumbrances applicable to vouchered expenditures
totaling $350,000.
 Chapter 17 Governmental Entities: General Fund 727

Recording actual expenditures of $350,000 (included in the $670,000 total in entry 5a

on page 726) applicable to purchase orders totaling $355,000 makes this amount of the pre-
viously recorded encumbrances no longer necessary. Accordingly, $355,000 of encum-
brances is reversed; the reversal is posted to the detailed appropriations subsidiary ledger
as well as to the general ledger. Encumbrances of $5,000 ($360,000 $355,000 $5,000)
remain outstanding on June 30, 2006, the fiscal year-end.

6 Expenditures 50,000
Payable to Enterprise Fund 30,000
Payable to Internal Service Fund 20,000
To record billings for services and supplies received from other funds.

Billings from other funds of the governmental entity are not subject to encumbrance or
vouchered for payment, as are billings from outside suppliers. Instead, billings from other
funds are recorded in separate liability ledger accounts. The related debit is to the Expen-
ditures account if the billings are for quasi-external transactions, such as providing ser-
vices and supplies.

7 Vouchers Payable 770,000

Payable to Enterprise Fund 25,000
Payable to Internal Service Fund 14,000
Cash 809,000
To record payment of liabilities during the year.

8 Other Financing Uses 11,000

Cash 11,000
To record transfer to Debt Service Fund for maturing principal and
interest on long-term general-obligation serial bonds.

The Other Financing Uses ledger account is debited because the payment to the Debt
Service Fund is a transfer out rather than a quasi-external transaction. (The correspond-
ing journal entry in the Debit Service Fund is shown in Chapter 18.)

9 Cash 50,000
Revenues 40,000
Other Financing Sources 10,000
To record payment in lieu of property taxes ($40,000) and subsidy
($10,000) received from Enterprise Fund.

Amounts transferred in to the General Fund from other funds are recognized as revenues
if they are quasi-external transactions, such as payments in lieu of property taxes; other-
wise, they are recognized as other financing sources if they are transfers in, such as subsi-
dies. (The financial statement display of the foregoing transfers out of the Enterprise Fund
is illustrated in Chapter 19.)
728 Part Five Accounting for Nonbusiness Organizations

10a Expenditures 80,000

Inventory of Supplies 80,000
To record cost of supplies used during the year.

10b Unreserved and Undesignated Fund Balance 10,000

Fund Balance Reserved for Inventory of Supplies 10,000
To increase inventory of supplies reserve to $50,000 to agree with
balance of inventory of Supplies ledger account at end of year
($50,000 $40,000 $10,000).

The immediately preceding journal entry represents a restriction of a portion of the Fund
Balance account to prevent its being appropriated improperly to finance a deficit annual
budget for the General Fund for the year ending June 30, 2007. Only cash and other mon-
etary assets of a general fund are available for appropriation to finance authorized expendi-
tures of the succeeding fiscal year.

11 Taxes Receivable—Delinquent 57,000

Allowance for Uncollectible Current Taxes 1,000
Taxes Receivable—Current 57,000
Allowance for Uncollectible Delinquent Taxes 1,000
To transfer delinquent taxes and related estimated uncollectible
amounts from the current classification.

The foregoing journal entry clears the Taxes Receivable—Current ledger account and
the related valuation account for uncollectible amounts so that they will be available for ac-
crual of property taxes for the fiscal year ending June 30, 2007.

12 Unreserved and Undesignated Fund Balance 25,000

Fund Balance Designated for Replacement of Equipment 25,000
To designate a portion of the fund balance for the replacement of
equipment during the year ending June 30, 2007.

The Fund Balance Designated for Replacement of Equipment ledger account is similar
to a voluntary retained earnings appropriation of a business enterprise. It indicates that the
annual budget for the Town of Verdant Glen General Fund for the year ending June 30,
2007, must include an appropriation of $25,000 for new equipment and estimated revenues
for the proceeds from disposal of the replaced equipment. The designated fund balance of
$25,000 will be closed to the Unreserved and Undesignated Fund Balance ledger account
on July 1, 2006, when the annual budget for the year ending June 30, 2007, is recorded.

Trial Balance at End of Fiscal Year for a General Fund

After all the foregoing journal entries (including the budget entry on page 721) have been
posted to the general ledger of the Town of Verdant Glen General Fund, the trial balance on
June 30, 2006, is as follows:
 Chapter 17 Governmental Entities: General Fund 729

Trial Balance of a TOWN OF VERDANT GLEN GENERAL FUND

Governmental Entity’s Trial Balance
General Fund at End June 30, 2006
of Current Fiscal Year
Debit Credit
Cash $ 142,000
Taxes receivable—delinquent 57,000
Allowance for uncollectible delinquent taxes $ 1,000
Inventory of supplies 50,000
Vouchers payable 70,000
Payable to Enterprise Fund 5,000
Payable to Internal Service Fund 6,000
Fund balance reserved for encumbrances 5,000
Fund balance reserved for inventory of supplies 50,000
Fund balance designated for replacement of equipment 25,000
Unreserved and undesignated fund balance 45,000
Budgetary fund balance 30,000
Estimated revenues 840,000
Estimated other financing sources 10,000
Appropriations 810,000
Estimated other financing uses 10,000
Revenues 848,000
Other financing sources 10,000
Expenditures 800,000
Other financing uses 11,000
Encumbrances 5,000
Totals $1,915,000 $1,915,000

Financial Statements for a General Fund

The results of operations (that is, net income or net loss) is not relevant for a general fund.
Instead, two financial statements—a statement of revenues, expenditures, and changes in
fund balance, and a balance sheet—are appropriate.15 These two financial statements are
shown below and on page 730 for the Town of Verdant Glen’s General Fund for the year
ended June 30, 2006.

Financial Statements TOWN OF VERDANT GLEN GENERAL FUND

of a Governmental Statement of Revenues, Expenditures, and Changes in Fund Balance
Entity’s General Fund For Year Ended June 30, 2006
at End of Current
Fiscal Year Variance
Favorable
Budget Actual (Unfavorable)
Revenues:
Taxes $700,000 $706,000 $ 6,000
Other 140,000 142,000 2,000
Total revenues $840,000 $848,000 $ 8,000
(continued)

15
Ibid., Secs. 2200.153, 2200.156.
730 Part Five Accounting for Nonbusiness Organizations

Financial Statements TOWN OF VERDANT GLEN GENERAL FUND

of a Governmental Statement of Revenues, Expenditures, and Changes in Fund Balance (concluded)
Entity’s General Fund For Year Ended June 30, 2006
at End of Current
Fiscal Year (concluded) Variance
Favorable
Budget Actual (Unfavorable)
Expenditures:*
General government $470,000 $459,000 $11,000
Other 340,000 341,000 (1,000)
Total expenditures $810,000 $800,000 $10,000
Excess of revenues over expenditures $ 30,000 $ 48,000 $18,000
Other financing sources (uses):
Transfers in 10,000 10,000
Transfers out (10,000) (11,000) (1,000)
Net change in fund balance $ 30,000 $ 47,000 $17,000
Fund balance, beginning of year 120,000 120,000
Fund balance, end of year $150,000 $167,000 $17,000

*Breakdown of actual amounts between general government and other categories is assumed.

TOWN OF VERDANT GLEN GENERAL FUND

Balance Sheet
June 30, 2006

Assets
Cash $142,000
Taxes receivable, net of allowance for estimated
uncollectible amounts, $1,000 56,000
Inventory of supplies 50,000
Total assets $248,000

Liabilities and Fund Balance

Liabilities:
Vouchers payable $ 70,000
Payable to other funds 11,000
Total liabilities $ 81,000
Fund balance:
Reserved for encumbrances $ 5,000
Reserved for inventory of supplies 50,000
Designated for replacement of equipment 25,000
Unreserved and undesignated 87,000 167,000
Total liabilities and fund balance $248,000

The following aspects of the Town of Verdant Glen General Fund financial statements
are significant:
1. The statement of revenues, expenditures, and changes in fund balance compares
budgeted with actual amounts. This comparison aids in the appraisal of the stewardship
for the General Fund’s resources and the compliance with legislative appropriations.
 Chapter 17 Governmental Entities: General Fund 731

(Expenditures in excess of appropriated amounts generally are not permitted unless a

supplementary appropriation is made by the legislative body and approved by the exec-
utive of the governmental entity.)
2. The amounts received from and paid to other funds of the Town of Verdant Glen are
termed transfers in and transfers out, respectively, to distinguish them from other types of
financing sources and uses that might have been received or paid by the General Fund.
3. The assets of the General Fund include only current financial resources assets—cash,
some short-term investments, receivables, and inventories. Expenditures for plant assets
are not recognized as assets in the General Fund; they might be recorded in the General
Capital Assets Account Group.
4. The unreserved and undesignated fund balance in the balance sheet, $87,000, is a bal-
ancing amount to make the total of the reserved, designated, and unreserved and undes-
ignated fund balance amounts equal to $167,000, the final amount in the statement of
revenues, expenditures, and changes in fund balance. After the posting of the closing en-
tries illustrated in the next section, the ending balance of the Unreserved and Undesig-
nated Fund Balance ledger account is $87,000 (see page 732).

Closing Entries for a General Fund

After financial statements have been prepared for the Town of Verdant Glen General Fund,
the budgetary and actual revenues, expenditures, and encumbrances ledger accounts must
be closed, to clear them for the next fiscal year’s activities. The closing entries below are
appropriate for the Town of Verdant Glen General Fund on June 30, 2006:

Closing Entries for a Unreserved and Undesignated Fund Balance 5,000

Governmental Entity’s Encumbrances 5,000
General Fund at End To close Encumbrances ledger account.
of Current Fiscal Year
Appropriations 810,000
Estimated Other Financing Uses 10,000
Budgetary Fund Balance 30,000
Estimated Revenues 840,000
Estimated Other Financing Sources 10,000
To close budgetary ledger accounts. (See page 721.)

Revenues 848,000
Other Financing Sources 10,000
Expenditures 800,000
Other Financing Uses 11,000
Unreserved and Undesignated Fund Balance 47,000
To close revenues, expenditures, and other financing sources and
uses ledger accounts.

The foregoing journal entries do not close the Fund Balance Reserved for Encum-
brances ledger account. Thus, the reserve represents a mandatory restriction of the fund
balance on June 30, 2006, because the Town of Verdant Glen General Fund is committed
in Fiscal Year 2007 to make estimated expenditures of $5,000 attributable to budgetary
appropriations carried over from Fiscal Year 2006. If the Fund Balance Reserved for
Encumbrances account had been closed, the Unreserved and Undesignated Fund Balance
732 Part Five Accounting for Nonbusiness Organizations

account would have been overstated by $5,000. The Unreserved and Undesignated Fund
Balance ledger account balance must represent the amount of the General Fund’s net assets
that is available for appropriation for a deficit budget in Fiscal Year 2007. When expendi-
tures applicable to the $5,000 outstanding encumbrances on June 30, 2006, are vouchered
for payment in the succeeding fiscal year, the Fund Balance Reserved for Encumbrances
ledger account is debited for $5,000, the Vouchers Payable account is credited for the
amount to be paid, and the balancing debit or credit is entered in the Unreserved and
Undesignated Fund Balance account. In this way, the Expenditures ledger account is not
improperly debited in Fiscal Year 2007 for an amount attributable to Fiscal Year 2006.
The budgetary accounts are closed at the end of the fiscal year because they are no
longer required for control over revenues, expenditures, and other financing sources and
uses. The amounts in the journal entry that closed the budgetary accounts were taken from
the journal entry to record the budget (page 721).
After the June 30, 2006, closing entries for the Town of Verdant Glen General Fund are
posted, the Unreserved and Undesignated Fund Balance ledger account is as follows:

Unreserved and Unreserved and Undesignated Fund Balance

Undesignated Fund
Date Explanation Debit Credit Balance
Balance Ledger
Account of a 2005
Government Entity’s June 30 Balance 80,000 cr
General Fund at End 2006
of Current fiscal year June 30 Increase in amount reserved for inventory
of supplies (page 728) 10,000 70,000 cr
30 Designation for replacement of equipment
(page 728) 25,000 45,000 cr
30 Close Encumbrances account (page 731) 5,000 40,000 cr
30 Close excess of revenues and other
financing sources over expenditures
and other financing uses (page 731) 47,000 87,000 cr

Review 1. Does the Financial Accounting Standards Board establish accounting standards for
governmental entities? Explain.
Questions
2. What characteristics of governmental entities have a significant influence on the ac-
counting for governmental entities? Explain.
3. What is a fund in accounting for governmental entities?
4. What is the support for each of the following accounting standards for general funds
of governmental entities?
a. The modified accrual basis of accounting.
b. The encumbrance accounting technique.
c. Recording the budget in the accounting records.
5. a. Differentiate between a program budget and a performance budget.
b. Differentiate between a budgetary deficit and a deficit budget.
6. The Estimated Revenues ledger account of a governmental entity’s general fund may
be considered a pseudo asset, and the Appropriations account may be considered a
pseudo liability. Why is this true?
 Chapter 17 Governmental Entities: General Fund 733

7. What is the function of the Budgetary Fund Balance ledger account for a governmen-
tal entity’s general fund?
8. What does the reference to a governmental entity’s general fund as residual mean?
Explain.
9. What revenues of a governmental entity’s general fund generally are accrued? Explain.
10. Distinguish between the Expenditures ledger account of a governmental entity’s gen-
eral fund and the expense accounts of a business enterprise.
11. Explain the purpose of the Other Financing Sources and Other Financing Uses ledger
accounts of a governmental entity’s general fund.
12. The accounting records for the City of Worthington General Fund include a ledger ac-
count titled Fund Balance Reserved for Inventory of Supplies. Explain the purpose of
this account.
13. Differentiate between a reservation and a designation of the fund balance of a gov-
ernmental entity’s general fund.
14. a. What are the financial statements issued for a governmental entity’s general fund?
b. What are the principal differences between the financial statements of a govern-
mental entity’s general fund and the financial statements of a business enterprise?

Exercises Select the best answer for each of the following multiple-choice questions:
(Exercise 17.1) 1. The Estimated Revenues ledger account of a governmental entity’s general fund is deb-
ited when:
a. The budgetary accounts are closed at the end of the fiscal year.
b. The budget is recorded.
c. Actual revenues are recognized under the modified accrual basis of accounting.
d. Actual revenues are received in cash.
2. Which of the following ledger accounts is debited by a governmental entity’s general
fund that uses the encumbrances accounting technique when a purchase order is issued?
a. Appropriations.
b. Vouchers Payable.
c. Fund Balance Reserved for Encumbrances.
d. Encumbrances.
e. None of the foregoing.
3. GASB Statement No. 34, “Basic Financial Statements . . . for State and Local Gov-
ernments,” identified:
a. Eleven types of funds.
b. Seven types of funds and two account groups.
c. Two types of funds and seven account groups.
d. Eight types of funds and two account groups.
4. Is a fund of a governmental entity:

A Fiscal Unit? An Accounting Unit?

a. Yes Yes
b. Yes No
c. No Yes
d. No No
734 Part Five Accounting for Nonbusiness Organizations

5. In the journal entry to record the annual budget of a governmental entity’s general
fund, appropriate entries to the following general fund ledger accounts are:

Estimated Other
Estimated Revenues Appropriations Financing Uses
a. Debit Debit Credit
b. Debit Credit Credit
c. Credit Debit Debit
d. Credit Debit Credit

6. Which of the following is a budgetary ledger account of a governmental entity’s gen-

eral fund?
a. Encumbrances.
b. Other Financing Sources.
c. Unreserved and Undesignated Fund Balance.
d. Appropriations.
7. Which of the following ledger accounts of a governmental entity’s general fund is cred-
ited when previously ordered supplies are received?
a. Fund Balance Reserved for Encumbrances.
b. Encumbrances.
c. Expenditures.
d. Appropriations.
e. None of the foregoing.
8. In a governmental entity’s general fund journal entry on the date an invoice is received
for a nonrecurring procurement under a purchase order for which encumbrance ac-
counting was used, the appropriate entries to the following ledger accounts are:

Encumbrances Expenditures
a. Debit Debit
b. Debit Credit
c. Credit Debit
d. Credit Credit

9. The ledger account debited in the journal entry of a governmental entity’s general fund
crediting the Allowance for Uncollectible Current Taxes ledger account is:
a. Doubtful Current Taxes Expense.
b. Unreserved and Undesignated Fund Balance.
c. Revenues.
d. Taxes Receivable—Current.
e. Some other account.
10. Repairs that have been made for a governmental entity’s general fund, and for which an
invoice has been received, are recorded in the general fund with a debit to:
a. Expenditures.
b. Encumbrances.
c. Repairs Expense.
d. Appropriations.
e. Some other ledger account.
11. The appropriate ledger accounts to be credited by a governmental entity’s general fund
for cash received from the entity’s enterprise fund are:
 Chapter 17 Governmental Entities: General Fund 735

Payments in Lieu
of Property Taxes Subsidies
a. Revenues Other Financing Sources
b. Revenues Revenues
c. Other Financing Sources Revenues
d. Other Financing Sources Other Financing Sources

12. The appropriate format of the end-of-fiscal-year journal entry (explanation omitted) to
close the Encumbrances ledger account of a governmental entity’s general fund is:
a. Unreserved and Undesignated Fund Balance
Encumbrances
b. Fund Balance Reserved for Encumbrances
Encumbrances
c. Expenditures
Encumbrances
d. Encumbrances
Appropriations

(Exercise 17.2) The activity with respect to the General Government—Supplies subsidiary ledger account
of the Ridge City General Fund included the following for the first part of the July 1,
2005–June 30, 2006, fiscal year:
CHECK FIGURE 2005
July 8 unexpended,
unencumbered July 1 The appropriation in the fiscal year budget was $100,000.
balance, $62,520 2 Purchase order 4-1 for $20,000 was issued to Crosby Company; encumbrance
credit. accounting is used.
3 Supplies were received from Crosby Company under purchase order 4-1, in-
voice 6392 for $20,120.
5 Defective supplies with an invoice 6392 cost of $640 were returned to Crosby
Company, accompanied by debit memorandum 4-6.
8 Purchase order 4-14 for $18,000 was issued to Lassen Company.
Prepare a subsidiary ledger account for General Government—Supplies for Ridge City
General Fund and post entries for the foregoing events or transactions. Your ledger account
should have the following columns: Date; Explanation; Appropriation, credit; Encumbrance,
debit; Expenditure, debit; Unexpended, unencumbered balance, credit.
(Exercise 17.3) The post-closing trial balance of the Winston County General Fund included the following
ledger account balances on June 30, 2005:

Taxes receivable—delinquent $30,200 dr

Allowance for uncollectible delinquent taxes 1,300 cr

The property taxes assessment for the fiscal year ending June 30, 2006, totaled $640,000; 4%
of Winston County’s property taxes assessments has been uncollectible in past fiscal years.
Prepare a journal entry for the property taxes of Winston County’s General Fund on July 1,
2005, the date on which the property taxes for the fiscal year ending June 30, 2006, were
billed to taxpayers.
(Exercise 17.4) On July 25, 2005, office supplies estimated to cost $2,390 were ordered from a vendor for
delivery to the office of the city manager of Gaskill. The City of Gaskill maintains a perpetual
736 Part Five Accounting for Nonbusiness Organizations

inventory system and encumbrance accounting for such supplies. The supplies ordered
July 25 were received on August 9, 2005, accompanied by an invoice for $2,500.
Prepare journal entries to record the foregoing transactions in the City of Gaskill Gen-
eral Fund.
(Exercise 17.5) The Glengarry School District General Fund had an inventory of supplies (and related re-
serve) of $60,200 on July 1, 2005. For the fiscal year ended June 30, 2006, supplies costing
$170,900 were acquired; related purchase orders totaled $168,400. The physical inventory
of unused supplies on June 30, 2006, totaled $78,300. The perpetual inventory system and
encumbrance accounting is used to account for the inventory of supplies.
Prepare journal entries for the foregoing facts for the year ended June 30, 2006. Omit
explanations for the journal entries.
(Exercise 17.6) Among the journal entries prepared by the inexperienced accountant of Rainbow County
General Fund for the fiscal year ended June 30, 2006, were the following:

2005
July 1 Accounts Receivable 800,000
Cash 800,000
To record nonreturnable transfer of cash to Internal Service
Fund to provide working capital for that fund.

Sept. 1 Equipment 120,000

Vouchers Payable 120,000
To record acquisition of equipment having a 10-year
economic life and no residual value.

Prepare correcting journal entries on June 30, 2006, for Rainbow County General Fund.
(Exercise 17.7) From the following ledger account balances for the Town of Irving General Fund on June
30, 2006, the end of the town’s fiscal year, prepare closing entries:

Appropriations $1,520,000
Encumbrances 10,000
Estimated revenues 1,600,000
Expenditures 1,500,000
Fund balance reserved for encumbrances 10,000
Revenues 1,616,000

(Exercise 17.8) Selected ledger account balances of Bixby Village General Fund on June 30, 2006, were as
follows:

Debit Credit
Appropriations $400,000
Budgetary fund balance 30,000
Encumbrances $ 1,000
Estimated other financing sources 10,000
Estimated other financing uses 6,000
Estimated revenues 426,000
Expenditures 395,000
Fund balance reserved for encumbrances 1,000
Other financing sources 14,000
Other financing uses 5,000
Revenues 440,000
Unreserved and undesignated fund balance 80,000
 Chapter 17 Governmental Entities: General Fund 737

Prepare closing entries (omit explanations) for Bixby Village General Fund on June 30,
2006.
(Exercise 17.9) Following is the statement of revenues, expenditures, and changes in fund balance for the
Village of Mortimer General Fund for the year ended June 30, 2006. The village did not
have any other financing sources or uses for the year. Unfilled purchase orders on June 30,
2006, for which the village used encumbrance accounting, totaled $11,400.

VILLAGE OF MORTIMER GENERAL FUND

Statement of Revenues, Expenditures, and Changes in Fund Balance
For Year Ended June 30, 2006

Variance
Favorable
Budget Actual (Unfavorable)
Revenues:
Taxes $820,000 $814,200 $(5,800)
Other 160,000 162,500 2,500
Total revenues $980,000 $976,700 $(3,300)
Expenditures:
General government $615,000 $618,800 $(3,800)
Other 275,000 277,400 (2,400)
Total expenditures $890,000 $896,200 $(6,200)
Net change in fund balance $ 90,000 $ 80,500 $(9,500)
Fund balance, beginning of year 280,400 280,400
Fund balance, end of year $370,400 $360,900 $(9,500)

Prepare closing entries for the Village of Mortimer General Fund on June 30, 2006.
(Exercise 17.10) The post-closing trial balance of the Town of Parkside General Fund on June 30, 2006, was
as follows:

CHECK FIGURE TOWN OF PARKSIDE GENERAL FUND

Unreserved and
Post-Closing Trial Balance
undesignated fund June 30, 2006
balance, $91,000.
Debit Credit
Cash $150,000
Taxes receivable—delinquent 50,000
Allowance for uncollectible delinquent taxes $ 5,000
Inventory of supplies 60,000
Vouchers payable 80,000
Payable to Town of Parkside Enterprise Fund 20,000
Fund balance reserved for encumbrances 4,000
Fund balance reserved for inventory of supplies 60,000
Unreserved and undesignated fund balance 91,000
Totals $260,000 $260,000

Prepare a balance sheet for the Town of Parkside General Fund on June 30, 2006.
(Exercise 17.11) On July 1, 2005, the general ledger of the City of Winkle General Fund had the following
fund balance ledger accounts:
738 Part Five Accounting for Nonbusiness Organizations

CHECK FIGURE
Balance
$248,000.
July 1, 2005
Reserved for inventory of supplies $ 80,600
Reserved for encumbrances 18,100
Unreserved and undesignated 214,700

The budget for the fiscal year ending June 30, 2006, showed a budgetary surplus of $20,400.
Revenues for the year ended June 30, 2006, exceeded expenditures by $37,600. There were
no other financing sources or uses for the year. The physical inventory of supplies on June 30,
2003, was $88,200, and outstanding encumbrances on June 30, 2006, totaled $14,800.
Prepare a working paper to compute the balance of the Unreserved and Undesignated
Fund Balance ledger account (after posting of closing entries) for the City of Winkle Gen-
eral Fund on June 30, 2006.
(Exercise 17.12) The Unreserved and Undesignated Fund Balance ledger account of the Town of Oldberry
General Fund was as follows on June 30, 2006. The Town of Oldberry did not have any
other financing sources or uses during the year ended June 30, 2006.

Unreserved and Undesignated Fund Balance

Date Explanation Debit Credit Balance
2005
June 30 Balance 62,400 cr
2006
June 30 Decrease in amount reserved for
inventory of supplies 3,700 66,100 cr
30 Close Encumbrances ledger account 6,200 59,900 cr
30 Close excess of revenues ($840,200)
over expenditures ($764,800) 75,400 135,300 cr
30 Designation for replacement of
equipment 60,000 75,300 cr

Reconstruct the journal entries of the Town of Oldberry General Fund indicated by the
foregoing information.

Cases
(Case 17.1) The inexperienced accountant of Corbin City prepared the following financial statements
for the city’s general fund:

CORBIN CITY GENERAL FUND

Income Statement
For Year Ended June 30, 2006

Revenues:
Taxes $640,000
Other 180,000
Total revenues $820,000
(continued)
 Chapter 17 Governmental Entities: General Fund 739

CORBIN CITY GENERAL FUND

Income Statement
For Year Ended June 30, 2006 (concluded)

Expenses:
General government $600,000
Depreciation 60,000
Other 120,000 780,000
Net income $ 40,000

CORBIN CITY GENERAL FUND

Statement of Changes in Fund Balance
For Year Ended June 30, 2006

Fund balance, beginning of year $4,850,000

Add: Net income 40,000
Fund balance, end of year $4,890,000

CORBIN CITY GENERAL FUND

Balance Sheet
June 30, 2006

Assets
Cash $ 260,000
Property taxes receivable—delinquent 80,000
Inventory of supplies 110,000
Plant assets (net) 4,620,000
Total assets $5,070,000

Liabilities, Reserves, and Fund Balance

Vouchers payable $ 160,000
Reserve for delinquent property taxes 20,000
Fund balance 4,890,000
Total liabilities, reserves, and fund balance $5,070,000

Instructions
Identify the deficiencies in each of the foregoing financial statements of Corbin City Gen-
eral Fund. There are no arithmetic errors in the statements. Disregard notes to the financial
statements.
(Case 17.2) In a classroom discussion of the modified accrual basis of accounting for general funds of
governmental entities, student Ella questioned the propriety of accruing self-assessed taxes
such as income taxes and sales taxes. She pointed out that until the taxes are paid, the
governmental entity has no liability-paying ability and no knowledge of the amount of taxes
ultimately to be collected. Student Janice disagreed with Ella, stating that the budget-
preparation process entails estimation of total fiscal year revenues, including revenues from
sales taxes and income taxes. Janice concluded by asserting that the currently required
modified accrual basis of accounting for governmental entities’ general fund revenues is
overly conservative and fails to provide meaningful budget-to-actual comparisons in gen-
eral funds’ statements of revenues, expenditures, and changes in fund balance.
740 Part Five Accounting for Nonbusiness Organizations

Instructions
Do you support the views of student Ella or student Janice? Explain.
(Case 17.3) You have been assigned by your CPA firm, in which you are an audit manager, to conduct
a staff training program in accounting for governmental entities. In preparing for the pro-
gram, you have decided to anticipate questions about the reasons governmental entities
must use a maximum of 11 separate funds, rather than a single accounting unit, to account
for the governmental entity’s transactions and events.
Instructions
Prepare a brief essay on the reasons for the use of fund accounting by governmental entities.

Problems
(Problem 17.1) The trial balance of Weedpatch County General Fund on June 30, 2006, was as follows
(amounts in thousands):

CHECK FIGURE
Debit Credit
Total assets, $200,000.
Cash $ 100
Taxes receivable—delinquent 60
Allowance for uncollectible delinquent taxes $ 10
Inventory of supplies 50
Vouchers payable 40
Payable to other funds 12
Fund balance reserved for encumbrances 4
Fund balance reserved for inventory of supplies 50
Unreserved and undesignated fund balance 18
Budgetary fund balance 20
Estimated revenues 800
Appropriations 780
Revenues 830
Expenditures 750
Encumbrances 4
Totals $1,764 $1,764

The balance of the Unreserved and Undesignated Fund Balance ledger account on July 1,
2005, was $22,000; there were balances of $6,000 and $40,000, respectively, in the Fund
Balance Reserved for Encumbrances and the Fund Balance Reserved for Inventory of Sup-
plies accounts on that date.
Instructions
Prepare a statement of revenues, expenditures, and changes in fund balance and a balance
sheet (amounts in thousands) for Weedpatch County General Fund for the year ended June
30, 2006.
(Problem 17.2) The following information was taken from the accounting records of the General Fund of
the City of Lory after the ledger accounts had been closed for the fiscal year ended June 30,
2006. The budget for the fiscal year ended June 30, 2006, included estimated revenues of
$2,000,000 and appropriations of $1,940,000. There were no estimated or actual other fi-
nancing sources or other financing uses.
 Chapter 17 Governmental Entities: General Fund 741

City of Lory General Fund

Transactions, Events, and

Closing Entries, July 1,
Post-Closing 2005, through Post-Closing
Trial Balance, June 30, 2006 Trial Balance,
June 30, June 30,
2005 Debit Credit 2006
Debits
Cash $700,000 $1,820,000 $1,852,000 $668,000
Taxes receivable 40,000 1,870,000 1,828,000 82,000
Total debits $740,000 $750,000

Credits
Allowance for uncollectible
taxes $ 8,000 8,000 10,000 $ 10,000
Vouchers payable 132,000 1,852,000 1,840,000 120,000
Fund balance:
Reserved for
encumbrances 1,000,000 1,070,000 70,000
Unreserved and
undesignated 600,000 70,000 20,000 550,000
Total credits $740,000 $6,620,000 $6,620,000 $750,000

Instructions
Prepare journal entries to record the budgeted and actual transactions and events of the City
of Lory General Fund for the fiscal year ended June 30, 2006. Also, prepare closing entries.
Do not differentiate between current and delinquent taxes receivable.
(Problem 17.3) At the start of your audit of the financial statements of the City of Riverdale, you discov-
ered that the city’s accountant failed to maintain separate funds. The trial balance of the
City of Riverdale General Fund for the fiscal year ended December 31, 2006, is as follows:

CITY OF RIVERDALE GENERAL FUND

Trial Balance
December 31, 2006

Debit Credit
Cash $ 207,500
Taxes receivable—current 148,500
Allowance for uncollectible current taxes $ 6,000
Revenues 992,500
Expenditures 760,000
Donated land 190,000
Construction in progress—River Bridge 130,000
River Bridge bonds payable 100,000
Contracts payable—River Bridge 30,000
Vouchers payable 7,500
Unreserved and undesignated fund balance 300,000
Totals $1,436,000 $1,436,000
742 Part Five Accounting for Nonbusiness Organizations

Additional Information
1. The budget for Year 2006, not recorded in the accounting records, was as follows: esti-
mated revenues, $815,000; appropriations, $775,000. There were no estimated or actual
other financing sources or other financing uses.
2. Outstanding purchase orders on December 31, 2006, for expenditures not recognized in
the accounting records, totaled $2,500. Riverdale uses encumbrance accounting.
3. Included in the Revenues ledger account balance was a credit of $190,000 representing the
current fair value of land donated by the state as a site for construction of the River Bridge.
4. The taxes receivable became delinquent on December 31, 2006.
Instructions
Prepare correcting journal entries on December 31, 2006, for the City of Riverdale General
Fund. Correcting entries for other funds or account groups and closing entries are not required.
(Problem 17.4) The following transactions and events affecting Canning County General Fund took place
during the fiscal year ended June 30, 2006:
(1) The following annual budget was adopted:

Estimated revenues:
Property taxes $4,500,000
Licenses and permits 300,000
Fines 200,000
Total estimated revenues $5,000,000
Appropriations:
General government $1,500,000
Police services 1,200,000
Fire department services 900,000
Public works services 800,000
Acquisition of fire engines 400,000
Total appropriations $4,800,000

There were no other financing sources or other financing uses budgeted.

(2) Property tax bills totaling $4,650,000 were issued; it was estimated that $150,000 of
this amount would be uncollectible. Fines of $200,000 were assessed.
(3) Property taxes totaling $3,900,000 were collected. The $150,000 previously estimated
to be uncollectible remained unchanged, but $630,000 of uncollected property taxes
was reclassified as delinquent. It was known that delinquent taxes would be collected
soon enough after June 30, 2006, to make these taxes available to finance obligations
incurred during the year ended June 30, 2006. (There was no balance of uncollected
taxes on July 1, 2005.)
(4) Other cash collections were as follows:

Licenses and permits $270,000

Fines 200,000
Disposal of public works equipment (carrying amount in the General
Capital Assets Account Group was $5,000) 15,000
Total other cash collections $485,000

(5) No encumbrances were outstanding on June 30, 2005. The following purchase orders
were executed:
 Chapter 17 Governmental Entities: General Fund 743

Total Outstanding
Amount June 30, 2006
General government $1,050,000 $ 60,000
Police services 300,000 30,000
Fire department services 150,000 15,000
Public works services 250,000 10,000
Fire engines 400,000
Totals $2,150,000 $115,000

(6) The following vouchers were approved for payment:

General government $1,440,000

Police services 1,155,000
Fire department services 870,000
Public works services 700,000
Fire engines 400,000
Total vouchers approved $4,565,000

(7) Vouchers totaling $4,600,000 were paid.

Instructions
Prepare journal entries to record the foregoing transactions and events of Canning County
General Fund for the year ended June 30, 2006. Do not prepare closing entries.
(Problem 17.5) The trial balance of Arden School District General Fund is as follows:

CHECK FIGURES
ARDEN SCHOOL DISTRICT GENERAL FUND
a. (1) Favorable ending
Trial Balance
fund balance variance, December 31, 2006
$1,000; (2) Total fund
balance, $78,850. Debit Credit
Cash $ 47,250
Short-term investments 11,300
Taxes receivable—delinquent 30,000
Inventory of supplies 11,450
Vouchers payable $ 20,200
Payable to Internal Service Fund 950
Fund balance reserved for encumbrances 2,800
Fund balance reserved for inventory of supplies 11,450
Unreserved and undesignated fund balance 59,400
Budgetary fund balance 7,000
Estimated revenues 1,007,000
Appropriations 985,000
Estimated other financing uses 15,000
Revenues 1,008,200
Expenditures 990,200
Other financing uses 10,000
Encumbrances 2,800
Totals $2,110,000 $2,110,000

The balance of the Fund Balance Reserved for Inventory of Supplies ledger account on
December 31, 2005, was $9,500.
744 Part Five Accounting for Nonbusiness Organizations

Instructions
a. Prepare the following financial statements for Arden School District General Fund for
the year ended December 31, 2006:
(1) Statement of revenues, expenditures, and changes in fund balance.
(2) Balance sheet.
b. Prepare closing entries for Arden School District General Fund on December 31, 2006.

(Problem 17.6) The following summary of transactions and events was taken from the accounting records
of Melton School District General Fund before the accounting records had been closed for
the fiscal year ended June 30, 2006:
CHECK FIGURE
MELTON SCHOOL DISTRICT GENERAL FUND
c. Trial balance totals,
Summary of Transactions and Events
$870,000.
For Year Ended June 30, 2006

Post-Closing Pre-Closing
Balances, Balances,
June 30, 2005 June 30, 2006
Ledger accounts with debit balances:
Cash $400,000 $ 700,000
Taxes receivable 150,000 170,000
Estimated revenues 3,000,000
Expenditures 2,700,000
Other financing uses 142,000
Encumbrances 91,000
Totals $550,000 $6,803,000
Ledger accounts with credit balances:
Allowance for uncollectible taxes $ 40,000 $ 70,000
Vouchers payable 80,000 408,000
Payable to other funds 210,000 142,000
Fund balance reserved for encumbrances 60,000 91,000
Unreserved and undesignated fund balance 160,000 162,000
Revenues from taxes 2,800,000
Other revenues 130,000
Budgetary fund balance 20,000
Appropriations 2,810,000
Estimated other financing uses 170,000
Totals $550,000 $6,803,000

Additional Information
1. The estimated taxes receivable for the year ended June 30, 2006, were $2,870,000, and
taxes collected during the year totaled $2,810,000.
2. An analysis of the transactions in the Vouchers Payable ledger account for the year
ended June 30, 2006, follows:

Debit (Credit)
Current year expenditures (all subject to encumbrances) $(2,700,000)
Expenditures applicable to June 30, 2005, outstanding encumbrances (58,000)
Vouchers for payments to other funds (210,000)
Cash payments 2,640,000
Net change $ (328,000)
 Chapter 17 Governmental Entities: General Fund 745

3. During Fiscal Year 2006, the General Fund was billed $142,000 for services furnished
by other funds of Melton School District.
4. On May 2, 2006, purchase orders were issued for new textbooks at an estimated cost of
$91,000. The books were to be delivered in August 2006.
Instructions
a. Using the foregoing data, reconstruct the journal entries to record all transactions and
events of Melton School District General Fund for the year ended June 30, 2006, includ-
ing the recording of the budget for the year. Disregard current and delinquent taxes re-
ceivable. (Hint: The $2,000 difference between the $60,000 fund balance reserved for
encumbrances on June 30, 2005, and the $58,000 amount vouchered for the related ex-
penditures is credited to the Unreserved and Undesignated Fund Balance ledger account.)
b. Prepare closing entries for Melton School District General Fund on June 30, 2006.
c. Prepare a post-closing trial balance for Melton School District General Fund on June 30,
2006.
(Problem 17.7) Because the controller of the City of Romaine had resigned, the assistant controller attempted
to compute the cash required to be derived from property taxes for the General Fund for the
fiscal year ending June 30, 2006. The computation was made as of January 1, 2005, to serve
CHECK FIGURE as a basis for establishing the property tax rate for the fiscal year ending June 30, 2006. The
Property tax levy mayor of Romaine has requested you to review the assistant controller’s computations and ob-
required, $3,361,000. tain other necessary information to prepare for the City of Romaine General Fund a formal
estimate of the cash required to be derived from property taxes for the fiscal year ending June
30, 2006. Following are the computations prepared by the assistant controller:

City resources other than proposed property tax levy:

Estimated General Fund cash balance, Jan. 1, 2005 $ 352,000
Estimated cash receipts from property taxes, Jan. 1 to June 30, 2005 2,222,000
Estimated cash revenues from investments, Jan. 1, 2005, to June 30,
2006 442,000
Estimated proceeds from issuance of general obligation bonds in
August 2005 3,000,000
Total City resources $6,016,000
General Fund requirements:
Estimated expenditures, Jan. 1 to June 30, 2005 $1,900,000
Proposed appropriations, July 1, 2005, to June 30, 2006 4,300,000
Total General Fund requirements $6,200,000

Additional Information
1. The General Fund cash balance required for July 1, 2006, is $175,000.
2. Property tax collections are due in March and September of each year. You note that during
February 2005 estimated expenditures will exceed available cash by $200,000. Pending col-
lection of property taxes in March 2005, this deficiency will have to be met by the issuance
of 30-day tax-anticipation notes of $200,000 at an estimated interest rate of 12% a year.
3. The proposed general-obligation bonds will be issued by the City of Romaine Enterprise
Fund to finance the construction of a new water pumping station.
Instructions
Prepare a working paper as of January 1, 2005, to compute the property tax levy required
for the City of Romaine General Fund for the fiscal year ending June 30, 2006.
(Problem 17.8) The following data were taken from the accounting records of the Town of Tosca General
Fund after the ledger accounts had been closed for the fiscal year ended June 30, 2006:
746 Part Five Accounting for Nonbusiness Organizations

TOWN OF TOSCA GENERAL FUND

Data from Accounting Records
For Year Ended June 30, 2006

Balances Fiscal Year 2006 Changes Balances

July 1, June 30,
2005 Debit Credit 2006
Assets
Cash $180,000 $ 955,000 $ 880,000 $255,000
Taxes receivable 20,000 809,000 781,000 48,000
Allowance for uncollectible taxes (4,000) 6,000 9,000 (7,000)
Total assets $196,000 $296,000

Liabilities and Fund Balance

Vouchers payable $ 44,000 880,000 889,000 $ 53,000
Payable to Internal Service Fund 2,000 7,000 10,000 5,000
Payable to Enterprise Fund 10,000 60,000 100,000 50,000
Fund balance reserved for
encumbrances 40,000 40,000 47,000 47,000
Unreserved and undesignated
fund balance 100,000 47,000 88,000 141,000
Total liabilities and fund balance $196,000 $2,804,000 $2,804,000 $296,000

Additional Information
1. The budget for Fiscal Year 2006 provided for estimated revenues of $1,000,000 and ap-
propriations of $965,000. There were no other financing sources or other financing uses
budgeted.
2. Expenditures totaling $895,000, in addition to those chargeable against the Fund Bal-
ance Reserved for Encumbrances ledger account, were made.
3. The actual expenditure chargeable against the July 1, 2005, Fund Balance Reserved for
Encumbrances ledger account was $37,000.
Instructions
Reconstruct the journal entries, including closing entries, for the Town of Tosca General
Fund indicated by the foregoing data for the year ended June 30, 2006. Do not attempt to
differentiate between current and delinquent taxes receivable.
(Problem 17.9) The post-closing trial balance of the City of Douglas General Fund on June 30, 2005, was
as follows:

CITY OF DOUGLAS GENERAL FUND

Post-Closing Trial Balance
June 30, 2005

Debit Credit
Cash $ 62,000
Taxes receivable—delinquent 46,000*
Allowance for uncollectible delinquent taxes $ 8,000
Inventory of supplies 18,000
Vouchers payable 28,000
Fund balance reserved for inventory of supplies 18,000
Fund balance reserved for encumbrances 12,000
Unreserved and undesignated fund balance 60,000
Totals $126,000 $126,000

*Collectible delinquent taxes were expected to be collected by Aug. 31, 2005.

 Chapter 17 Governmental Entities: General Fund 747

Additional Information
1. The annual budget for the fiscal year ending June 30, 2006, was as follows:

Estimated revenues $400,000

Estimated other financing sources 200,000
Subtotal $600,000
Less: Appropriations $560,000
Estimated other financing uses 20,000 580,000
Budgetary surplus $ 20,000

2. Property taxes were levied for the year ending June 30, 2006, in an amount to provide
revenues of $220,800, after estimated uncollectible taxes of 4% of total taxes receivable.
3. Purchase orders issued during the year ended June 30, 2006, totaled $518,000. Encum-
brance accounting is used.
4. Cash receipts for the year ended June 30, 2006, were as follows:

Delinquent property taxes $ 38,000

Current property taxes 226,000
Refund from vendor for overpayment of Fiscal Year 2006 invoice for
acquisition of equipment 4,000
Other revenues (licenses and permits fees) 196,000
Other financing sources 200,000
Total cash receipts $664,000

5. Vouchers were prepared as follows for the year ended June 30, 2006:

Encumbrance outstanding, June 30, 2005 $ 10,000

Expenditures for year ended June 30, 2006 (including supplies,
$80,000; related encumbrances totaled $292,000) 298,000
Other expenditures (no encumbrances) 244,000
Other financing uses (payable to Capital Projects Fund) 20,000
Total vouchers $572,000

6. Cash payments for vouchers payable during the year ended June 30, 2006, totaled
$580,000.
7. The physical inventory of supplies on June 30, 2006, amounted to $12,000. Supplies are
accounted for under the perpetual inventory system.
8. On June 30, 2006, $20,000 of the unreserved and undesignated fund balance was desig-
nated for the acquisition of equipment during the fiscal year ending June 30, 2007.

Instructions
Prepare journal entries for the foregoing transactions and events of the City of Douglas
General Fund for the year ended June 30, 2006, and closing entries on June 30, 2006.
Chapter Eighteen

Governmental Entities:
Other Governmental
Funds and Account
Groups

Scope of Chapter
This chapter presents a discussion and illustration of accounting and reporting for a gov-
ernmental entity’s governmental funds other than the general fund, and for voluntarily
maintained general capital assets and general long-term debt account groups.

OTHER GOVERNMENTAL FUNDS

Accounting and reporting for the four governmental funds (special revenue funds, capital
projects funds, debt service funds, and permanent funds) other than the general fund incor-
porates many of the accounting standards discussed in Chapter 17. For example, the mod-
ified accrual basis of accounting is appropriate for all governmental funds, and recording
the budget (together with encumbrance accounting) is appropriate for special revenue funds
and may be useful for debt service funds and capital projects funds.

Accounting and Reporting for Special Revenue Funds

As indicated on page 719, separate special revenue funds are established by govern-
mental entities, as required by law and sound financial administrations, to account for the
receipts and expenditures associated with specialized revenue sources that are earmarked
by law or regulation to finance specified governmental operations. Fees for rubbish col-
lection, state gasoline taxes, “sin taxes” on tobacco products and alcoholic beverages,
and traffic violation fines are examples of governmental entity revenues that may be
accounted for in separate special revenue funds. Ledger account titles, budgetary pro-
cesses, and financial statements for special revenue funds are similar to those for the general
fund.
748
 Chapter 18 Governmental Entities: Other Governmental Funds and Account Groups 749

To illustrate the accounting for a special revenue fund, assume that on July 1, 2006, the
Town Council of the Town of Verdant Glen authorized the establishment of a special
revenue fund—its first such fund—to account for special assessments levied on certain
residents of the neighboring Village of Arbor. Those residents had requested the Town
Council to provide street cleaning and streetlight maintenance services, which could not be
furnished by the Village of Arbor. Because the property tax revenues of the Town of Ver-
dant Glen, which among other services financed street cleaning and streetlight maintenance
for residents of the town only, could not be used for such services elsewhere, the Town
Council authorized the special assessment to finance comparable services for the request-
ing residents of the Village of Arbor. The Town Council adopted a budget for the Special
Revenue Fund for the fiscal year ending June 30, 2007, providing for estimated revenues of
$80,000 (from the special assessments) and appropriations of $75,000 (for reimbursements
to the General Fund for expenditures made by that fund for the services provided to the
Village of Arbor residents). Following are additional transactions or events of the Town of
Verdant Glen Special Revenue Fund for the fiscal year ended June 30, 2007:
1. Special assessments totaling $82,000 were levied on the appropriate residents of the Vil-
lage of Arbor, to be paid in full in 60 days. All the special assessments were expected to
be collected.
2. Cash receipts from the special assessments were collected in full, $82,000.
3. Of the cash receipts, $63,000 was invested in U.S. Treasury bills with a face amount of
$65,000. The U.S. Treasury bills matured on June 30, 2007, and were redeemed in full
on that date.
4. Billings from the Town of Verdant Glen General Fund, requesting reimbursement of ex-
penditures of that fund, totaled $76,000; $62,000 of that amount was paid to the General
Fund by June 30, 2007.
5. On June 30, 2007, the Town Council of the Town of Verdant Glen designated the fund
balance ($8,000) of the Special Revenue Fund for reimbursement of the General Fund
during the fiscal year ending June 30, 2008.

Journal Entries for Special Revenue Fund

Journal entries of the Town of Verdant Glen Special Revenue Fund to record the foregoing
events and transactions and to close the accounts for the fiscal year ended June 30, 2007,
are shown on page 750. Note that the encumbrances technique is not used by this special
revenue fund because it does not issue purchase orders for goods or services from
outsiders.
Because the $76,000 billings of the Town of Verdant Glen General Fund to the Special
Revenue Fund were for reimbursement of General Fund expenditures, the General Fund
credits its Expenditures ledger account in the journal entry in which it debits Receivable
from Special Revenue Fund.
750 Part Five Accounting for Nonbusiness Organizations

Journal Entries for TOWN OF VERDANT GLEN SPECIAL REVENUE FUND

Special Revenue Fund Journal Entries
of a Governmental
Entity Estimated Revenues: 80,000
Appropriations 75,000
Budgetary Fund Balance 5,000
To record annual budget adopted for fiscal year ending June 30, 2007.

Special Assessments Receivable—Current 82,000

Revenues 82,000
To record special assessments billed, all of which are estimated to be
collectible.

Cash 82,000
Special Assessments Receivable—Current 82,000
To record collection of special assessments in full during the year.

Investments 63,000
Cash 63,000
To record acquisition of $65,000 face amount of U.S. Treasury bills,
maturity June 30, 2007.

Cash 65,000
Investments 63,000
Revenues 2,000
To record receipt of cash for matured U.S. Treasury bills.

Expenditures 76,000
Payable to General Fund 76,000
To record billings from General Fund for reimbursement of expenditures
for street cleaning and streetlight maintenance for residents of the
Village of Arbor.

Payable to General Fund 62,000

Cash 62,000
To record payments to General Fund during the year.

Appropriations 75,000
Budgetary Fund Balance 5,000
Estimated Revenues 80,000
To close budgetary ledger accounts.

Revenues ($82,000 $2,000) 84,000

Expenditures 76,000
Unreserved and Undesignated Fund Balance 8,000
To close Revenues and Expenditures ledger accounts.

Unreserved and Undesignated Fund Balance 8,000

Fund Balance Designated for Reimbursement of General Fund 8,000
To designate entire fund balance for reimbursement of the General Fund
during the fiscal year ending June 30, 2008.
 Chapter 18 Governmental Entities: Other Governmental Funds and Account Groups 751

Financial Statements for Special Revenue Fund

The financial statements for a special revenue fund are the same as those for the general
fund: a statement of revenues, expenditures, and changes in fund balance, and a balance
sheet. Financial statements for the Town of Verdant Glen Special Revenue Fund for the fis-
cal year ended June 30, 2007, are as follows:

Financial Statements TOWN OF VERDANT GLEN SPECIAL REVENUE FUND

of a Governmental Statement of Revenues, Expenditures, and Changes in Fund Balance
Entity’s Special For Year Ended June 30, 2007
Revenue Fund
Variance
Favorable
Budget Actual (Unfavorable)
Revenues:
Special assessments $80,000 $82,000 $ 2,000
Other 2,000 2,000
Total revenues $80,000 $84,000 $ 4,000
Expenditures:
Reimbursement of General
Fund expenditures $75,000 $76,000 $(1,000)
Excess of revenues over expenditures
(fund balance, end of year) $ 5,000 $ 8,000 $ 3,000

TOWN OF VERDANT GLEN SPECIAL REVENUE FUND

Balance Sheet
June 30, 2007

Assets
Cash $22,000

Liabilities and Fund Balance

Payable to General Fund $14,000
Fund balance designated for reimbursement of General Fund 8,000
Total liabilities and fund balance $22,000

Accounting and Reporting for Capital Projects Funds

Capital projects funds of a governmental entity record the receipt and payment of cash
for the construction or acquisition of the governmental entity’s plant assets other than
those financed by proprietary funds (enterprise funds and internal service funds) or
trust funds. The resources for a capital projects fund generally are derived from pro-
ceeds of general obligation bonds, but the resources also may come from current tax
revenues of the general fund or from grants or shared revenues of other governmental
entities.
752 Part Five Accounting for Nonbusiness Organizations

A capital budget, rather than an annual budget, is the control device appropriate for a
capital projects fund. The capital budget deals with both the authorized expenditures for the
project and the bond proceeds or other financing sources for the project.

Journal Entries for Capital Projects Fund

On July 1, 2005, the Town of Verdant Glen authorized a $500,000, 20-year, 7% general
obligation bond issue to finance an addition to the town’s high school. A capital budget was
approved for the amount of the bonds, but was not to be integrated in the accounting re-
cords of the capital projects fund authorized for the project. The following journal entries
illustrate receipt of proceeds of the bonds and other activities of the Town of Verdant Glen
Capital Projects Fund for the fiscal year ended June 30, 2006:

Journal Entries for TOWN OF VERDANT GLEN CAPITAL PROJECTS FUND

Capital Project Fund Journal Entries
of a Governmental
Entity Cash 450,518
Other Financing Uses: Discount on Bonds Issued 49,482
Other Financing Sources: Bonds Issued 500,000
To record proceeds of 20-year, 7% general obligation term bonds due
July 1, 2025, interest payable Jan. 1 and July 1, to yield 8%, face
amount $500,000. (Bond issue costs are disregarded.)

Investments 335,000
Cash 335,000
To record acquisition of $350,000 face amount of U.S. Treasury bills,
maturity 26 weeks.

Encumbrances 482,000
Fund Balance Reserved for Encumbrances 482,000
To record contracts with architect and construction contractor and
issuance of purchase orders.

Cash 350,000
Investments 335,000
Revenues 15,000
To record receipt of cash for matured U.S. Treasury bills.

Expenditures 378,000
Vouchers Payable 378,000
To record expenditures for the year.

Fund Balance Reserved for Encumbrances 368,200

Encumbrances 368,200
To reverse encumbrances applicable to vouchered expenditures.

Vouchers Payable 327,500

Cash 327,500
To record payment of vouchers during the year.

(continued)
 Chapter 18 Governmental Entities: Other Governmental Funds and Account Groups 753

TOWN OF VERDANT GLEN CAPITAL PROJECTS FUND

Journal Entries (concluded)

Unreserved and Undesignated Fund Balance ($482,000 $368,200) 113,800

Encumbrances 113,800
To close Encumbrances ledger account.

Revenues 15,000
Other Financing Sources: Bonds Issued 500,000
Expenditures 378,000
Other Financing Uses: Discount on Bonds Issued 49,482
Unreserved and Undesignated Fund Balance 87,518
To close Revenues, Expenditures, and Other Financing Sources and
Uses ledger accounts.

The following features of the foregoing journal entries should be noted:

1. The capital budget for the high school addition was not entered in the accounting
records of the Capital Projects Fund. The indenture for the 20-year, 7% general obliga-
tion bonds (general long-term capital debt) provided adequate control.
2. The liability applicable to the 20-year general obligation bonds was not recorded in the
Capital Projects Fund. The liability for the bonds is recorded at face amount in the vol-
untarily maintained general long-term debt account group (see page 761).
3. The face amount of the general obligation bonds is another financing source of the
Capital Projects Fund; the discount on the bonds is another financing use.1 The interest
earned on the short-term investment in U.S. Treasury bills represents revenues to the
Capital Projects Fund.
4. The encumbrances and expenditures accounting for the Capital Projects Fund is similar
to that for the General Fund illustrated in Chapter 17. Also, the closing entries for the
two types of governmental funds are similar.
Expenditures for construction recorded in the Town of Verdant Glen Capital Projects
Fund are accompanied in the voluntarily maintained general fixed assets account group by
a journal entry at the end of the fiscal year with a debit to Construction in Progress and a
credit to Investment in Capital Assets from Capital Projects Funds (see page 759).
At the end of each fiscal year prior to completion of a capital project, the Revenues,
Other Financing Sources, Expenditures, and Encumbrances ledger accounts of the Capi-
tal Projects Fund are closed to the Unreserved and Undesignated Fund Balance account.
On completion of the project, the Capital Projects Fund is terminated by a transfer of any
unused cash to the Debt Service Fund or the General Fund, as appropriate; the Unre-
served and Undesignated Fund Balance ledger account of the receiving fund would be
credited for this transfer. Any cash deficiency in the Capital Projects Fund (a possibility
suggested by the deficit fund balance in the balance sheet on page 754) probably would
be made up by the General Fund; this transfer would be credited to the Other Financing

1
Codification of Governmental Accounting and Financial Reporting Standards (Norwalk: GASB, 2003),
Sec. 1800.108.
754 Part Five Accounting for Nonbusiness Organizations

Sources ledger account of the Capital Projects Fund and debited to the Other Financing
Uses account of the General Fund.

Financial Statements for Capital Projects Fund

A capital projects fund issues the same financial statements as a general fund: a statement
of revenues, expenditures, and changes in fund balance, and a balance sheet. For the Town
of Verdant Glen Capital Projects Fund, these financial statements are as follows for the year
ended June 30, 2006:

Financial Statements TOWN OF VERDANT GLEN CAPITAL PROJECTS FUND

of a Governmental Statement of Revenues, Expenditures, and Changes in Fund Balance
Entity’s Capital For Year Ended June 30, 2006.
Projects Fund
Revenues:
Miscellaneous $ 15,000
Expenditures:*
Construction contracts $ 287,600
Engineering and other 90,400
Total expenditures $ 378,000
Excess (deficiency) of revenues over expenditures $(363,000)
Other financing sources (uses):
Face amount of general obligation bonds $ 500,000
Discount on general obligation bonds (49,482)
Excess of revenues and other sources over expenditures and other uses
(fund balance, end of year) $ 87,518

*
Breakdown of expenditures is assumed.

TOWN OF VERDANT GLEN CAPITAL PROJECTS FUND

Balance Sheet
June 30, 2006.

Assets
Cash $138,018

Liabilities and Fund Balance

Liabilities:
Vouchers payable $ 50,500
Fund balance:
Reserved for encumbrances $113,800
Unreserved and undesignated (26,282) 87,518
Total liabilities and fund balance $138,018

To reiterate, the plant assets constructed with resources of the Capital Projects Fund
are not displayed in that fund’s balance sheet. The constructed plant assets might be
recorded in the governmental entity’s voluntarily maintained general capital assets
account group. Furthermore, the general obligation bonds issued to finance the Capital
 Chapter 18 Governmental Entities: Other Governmental Funds and Account Groups 755

Projects Fund are not a liability of that fund. Prior to the maturity date or dates of the
bonds, the liability is carried in the voluntarily maintained general long-term debt account
group, (see page 761). On the date the bonds mature, the related liability is transferred to a
debt service fund or to the general fund, as appropriate, from the general long-term debt
account group.

Accounting and Reporting for Debt Service Funds

Payments of principal and interest on long-term bonds and other long-term debt of a gov-
ernmental entity, other than special assessment bonds, revenue bonds, and general obliga-
tion bonds serviced by an enterprise fund, are accounted for either in the general fund or in
debt service funds. Special assessment bonds are repaid from the proceeds of special as-
sessment levies against specific properties receiving benefits from the special assessment
improvements; if these bonds finance construction projects for an enterprise fund, they are
accounted for in that enterprise fund. Revenue bonds are payable from the earnings of a
governmental entity’s enterprise and are accounted for in the appropriate enterprise fund.
In some cases, general obligation bonds, which are backed by the full faith and credit of
the issuing governmental entity, will be repaid from the resources of a governmental entity
enterprise. These general obligation bonds are displayed as liabilities of the appropriate en-
terprise fund.
The liability for bonds payable from resources of the general fund or a debt service fund
is not recorded in that fund until the debt matures. Prior to maturity date, the bond liability is
carried in the voluntarily maintained general long-term debt account group.
The two customary types of general obligation bonds whose servicing is recorded in
debt service funds are the following:
• Serial bonds, with principal payable in annual installments over the term of the bond
issue.
• Term bonds, with principal payable in total on a fixed maturity date, generally from pro-
ceeds of an accumulated sinking fund.
Generally, legal requirements govern the establishment of debt service funds. In the
absence of legal requirements or of a formal plan for accumulation of a sinking fund for
repayment of a general obligation term bond, there may be no need to establish a debt ser-
vice fund.

Journal Entries for Debt Service Fund

To illustrate the journal entries that are typical for a debt service fund, assume that the
Town of Verdant Glen had only two general obligation bond issues outstanding during
the fiscal year ended June 30, 2006: A $100,000, 10% serial bond issue whose final
annual installment of $10,000 was payable on January 1, 2006, and a $500,000, 7%
term bond issue due July 1, 2025 (see page 752). The Town Council had authorized
establishment of a debt service fund for the serial bonds. However, sinking fund accu-
mulations on the term bonds were not required to begin until July 1, 2008; therefore,
a debt service fund for those bonds was unnecessary during the fiscal year ended June
30, 2006.
Interest on both general obligation bond issues was payable each January 1 and July 1.
Interest payments on the term bonds were recorded in the General Fund during the fiscal
year ended June 30, 2006, and were included in expenditures of that fund, as illustrated on
page 727. Interest payments on the serial bonds were made from the Debt Service Fund to
a fiscal agent, for transfer to the bondholders.
756 Part Five Accounting for Nonbusiness Organizations

The June 30, 2005, balance sheet of the Town of Verdant Glen Debt Service Fund for the
serial bonds was as follows:

TOWN OF VERDANT GLEN DEBT SERVICE FUND

Balance Sheet
June 30, 2005

Assets
Cash $342

Liabilities and Fund Balance

Fund balance reserved for debt service $342

Aggregate journal entries for the Town of Verdant Glen Debt Service Fund for the year
ended June 30, 2006, are as follows:

Aggregate Journal TOWN OF VERDANT GLEN DEBT SERVICE FUND

Entries for Debt Journal Entries
Service Fund of a
Governmental Entity Cash 11,000
Other Financing Sources—Transfers In 11,000
To record receipt of cash from General Fund for payment of serial bond
principal ($10,000) and interest ($1,000) maturing on July 1, 2005, and
Jan. 1, 2006.

Cash with Fiscal Agent 11,000

Cash 11,000
To record payment of cash to bank trust department acting as fiscal
agent for payment of serial bond principal and interest.

Expenditures 11,000
Matured Bonds Payable 10,000
Matured Interest Payable 1,000
To record expenditures for interest due July 1, 2005, and principal and
interest due Jan. 1, 2006.

Matured Bonds Payable 10,000

Matured Interest Payable 1,000
Cash with Fiscal Agent 11,000
To record fiscal agent’s payments of bond principal and interest.

Expenditures 342
Cash 342
To record payment of fiscal agent for services during year ended
June 30, 2006.

Other Financing Sources—Transfers In 11,000

Fund Balance Reserved for Debt Service 342
Expenditures 11,342
To close fund on extinguishment of related serial bonds.
 Chapter 18 Governmental Entities: Other Governmental Funds and Account Groups 757

Following are significant aspects of these journal entries.

1. There was no journal entry to record an annual budget. Generally, indentures for general
obligation bonds provide sufficient safeguards (such as restricting the fund balance
of the debt service fund solely for the payment of debt and related servicing costs), so
that recording the budget in the Debt Service Fund is unnecessary. (Note, however, on
page 720 of Chapter 17 that the General Fund’s estimated other financing use for pay-
ment of $10,000 to the Debt Service Fund had been included in the General Fund’s an-
nual budget.)
2. The first journal entry is the counterpart of the General Fund journal entry no. 8 on
page 727 in Chapter 17.
3. Expenditures for principal and interest payments of the Debt Service Fund are recorded
only on the maturity dates of the obligations. Prior to the maturity dates, the liability for
the bonds’ principal is carried in the voluntarily maintained general long-term debt
account group (see page 761). Because a debt service fund generally does not issue
purchase orders, encumbrance accounting is not required.
4. The closing entry extinguishes all remaining ledger account balances of the Debt Ser-
vice Fund, because the final serial principal payment had been made.
The modified accrual basis of accounting is appropriate for revenues of a debt
service fund. Thus, any property taxes specifically earmarked for servicing of a gov-
ernmental entity’s general obligation bonds may be accrued as revenues in the debt
service fund. The accounting for such a tax accrual is the same as that for the general
fund.
For a term bond issue that requires the accumulation of a sinking fund, the journal en-
tries for a debt service fund include the investment of cash in interest-bearing securities and
the collection of interest. Under the modified accrual basis of accounting, interest revenue
accrued on sinking fund investments at the end of the governmental entity’s fiscal year is
recognized in the accounting records of the debt service fund.

Financial Statements for Debt Service Fund

A balance sheet for a debt service fund is illustrated on page 755. There is no balance sheet
for the Town of Verdant Glen Debt Service Fund on June 30, 2006, because the fund had
been extinguished. The statement of revenues, expenditures, and changes in fund balance
for the Town of Verdant Glen Debt Service Fund for the year ended June 30, 2006, is as
follows:

Statement of TOWN OF VERDANT GLEN DEBT SERVICE FUND

Revenues, Statement of Revenues, Expenditures, and Changes in Fund Balance
Expenditures, and For Year Ended June 30, 2006
Changes in Fund
Expenditures:
Balance of a
Governmental Entity’s Principal retirement $ 10,000
Debt Service Fund Interest and charges by fiscal agent 1,342
Total expenditures $ 11,342
Excess (deficiency) of revenues over expenditures $(11,342)
(continued)
758 Part Five Accounting for Nonbusiness Organizations

TOWN OF VERDANT GLEN DEBT SERVICE FUND

Statement of Revenues, Expenditures, and Changes in Fund Balance (concluded)
For Year Ended June 30, 2006

Other financing sources:

Transfers in 11,000
Net change in fund balance $ (342)
Fund balance, beginning of year 342
Fund balance, end of year -0-

Permanent Funds
As indicated on page 718 of Chapter 17, permanent funds of a governmental entity report
resources that are legally restricted so that principal cannot be used for programs such as
ongoing maintenance of a public cemetery.2 Because of their limited application, account-
ing and reporting for permanent funds are not illustrated in this chapter.

GENERAL CAPITAL ASSETS AND GENERAL LONG-TERM

DEBT ACCOUNT GROUPS
The accounting standards for state and local governmental entities described in Chapter 17
(page 719) might make it advisable for governmental entities to use account groups to
record capital (plant) assets (including infrastructure: streets, sidewalks, bridges, and the
like) and long-term debt of a governmental entity not recorded in a fund. A governmental
entity’s voluntarily maintained general capital assets and general long-term debt account
groups are not funds; they are memorandum accounting entities. Their purpose is to pro-
vide in one record the governmental entity’s plant assets and long-term liabilities that are
not recorded in one of the governmental entity’s funds. Plant assets are recorded in enter-
prise, trust, and internal service funds; bonds payable and other long-term liabilities are
also recorded in these funds.

Accounting and Reporting for General Capital Assets

Account Group
Plant assets in the general capital assets account group are recorded at their cost to the gov-
ernmental entity or at their current fair value if donated to the governmental entity. The off-
setting credit is to a memorandum ledger account such as Investment in General Capital
Assets from (the source of the asset).
According to the Governmental Accounting Standards Board, except for certain infra-
structure and inexhaustible (land and certain works of art) assets, depreciation must be
recorded in the general capital assets account group, with a debit to the appropriate Invest-
ment in General Capital Assets ledger account and a credit to an Accumulated Depreciation
account.3 When a plant asset carried in the general capital assets account group is disposed

2
Ibid., Sec. 1300.108.
3
Ibid., Sec. 1400.104.
 Chapter 18 Governmental Entities: Other Governmental Funds and Account Groups 759

of by the governmental entity, the carrying amount of the asset is removed from the appro-
priate memorandum ledger accounts in the general capital assets account group; any
proceeds are recognized as miscellaneous revenue or as other financing sources in the
general fund. Impairment losses of general capital assets should be recognized as they are
for plant assets of a business enterprise.4

Journal Entries for General Capital Assets Account Group

The following journal entries for the Town of Verdant Glen are typical of those for a gov-
ernmental entity’s general capital assets account group:

Journal Entries for TOWN OF VERDANT GLEN GENERAL CAPITAL ASSETS ACCOUNT GROUP
General Capital Assets Journal Entries
Account Group of a
Governmental Entity Machinery and Equipment 126,400
Investment in General Capital Assets from General Fund Revenues 126,400
To record acquisition of equipment by General Fund.

Construction in Progress 378,000

Investment in General Capital Assets from Capital Projects Funds 378,000
To record construction work in progress on high school addition.

Land 500,000
Buildings 800,000
Investment in General Capital Assets from Gifts 1,300,000
To record, at current fair value, private citizen’s gift of land and a
building to be used as a public library.

Investment in General Capital Assets from General Fund Revenues 20,000

Accumulated Depreciation of Machinery and Equipment 70,000
Machinery and Equipment 90,000
To record disposal of machinery and equipment.

Investment in General Capital Assets from General Fund Revenues 40,000

Investment in General Capital Assets from Capital Projects Funds 1,280,000
Investment in General Capital Assets from Gifts 60,000
Accumulated Depreciation of Infrastructure 1,000,000
Accumulated Depreciation of Buildings 240,000
Accumulated Depreciation of Machinery and Equipment 140,000
To recognize depreciation of infrastructure, buildings, and machinery
and equipment for the year ended June 30, 2006.

The first of the foregoing journal entries incorporates the assumption that equipment ac-
quisitions were included in the expenditures of the Town of Verdant Glen General Fund for
the year ended June 30, 2006 (see page 726); the second journal entry was made on June 30,
2006, to record accumulated cost of the construction project of the Town of Verdant Glen

4
GASB Statement No. 42, “Accounting and Financial Reporting for Impairment of Capital Assets . . .
(Norwalk: GASB, 2003), par. 17.
760 Part Five Accounting for Nonbusiness Organizations

Capital Projects Fund (page 752); and the third journal entry incorporates the assumption
that proceeds of disposal of machinery and equipment were included in revenues of the
Town of Verdant Glen General Fund for the year ended June 30, 2006.

Required Disclosures for General Capital Assets

The Governmental Accounting Standards Board requires presentation of an analysis of
changes in general capital assets of a governmental entity in a note to the financial state-
ments discussed in Chapter 19.5 The analysis of changes in general capital assets for the
Town of Verdant Glen for the fiscal year ended June 30, 2006, is as follows (beginning-of-
year and end-of-year balances are assumed):

CHANGES IN TOWN OF VERDANT GLEN GENERAL CAPITAL ASSETS

For Year Ended June 30, 2006

Balances, Balances,
July 1, June 30,
2005 Additions Disposals* 2006
General Capital Assets
Infrastructure $50,000,000 $50,000,000
Land 6,200,000 $ 500,000 6,700,000
Buildings 18,700,000 800,000 19,500,000
Machinery and equipment 720,000 126,400 90,000 756,400
Construction in progress 378,000 378,000
Totals $75,620,000 $1,804,400 $ 90,000 $77,334,400

Accumulated Depreciation
Infrastructure $ 7,000,000 $1,000,000 $ 8,000,000
Buildings 1,460,000 240,000 1,700,000
Machinery and equipment 216,000 140,000 $ 70,000 286,000
Totals $ 8,676,000 $1,380,000† $ 70,000 $ 9,986,000

Investment in General Capital Assets

From General Fund revenues $10,424,000 $ 126,400 $ 60,000 $10,490,400
From Capital Projects Funds 52,618,000 378,000 1,280,000 51,716,000
From gifts 3,902,000 1,300,000 60,000 5,142,000
Totals $66,944,000 $1,804,400 $1,400,000 $67,348,400

*
For investment in general capital assets section, includes depreciation.
†
Broken down by function in the statement of activities described in Chapter 19.

Accounting and Reporting for General Long-Term

Debt Account Group
General obligation bonds of a governmental entity, both serial and term, and other long-term
liabilities that are not recorded in an enterprise fund might be, at the election of the entity,
recorded as memorandum credits in the general long-term debt account group. The offset-
ting memorandum debit entry is to the Amount to Be Provided ledger account. When cash
and other assets for the ultimate payment of a bond issue or other long-term liabilities have
been accumulated in a debt service fund, the Amount Available in Debt Service Fund ledger
account is debited and the Amount to Be Provided account is credited. When the bonds or

5
Codification, Sec. 2300.112.
 Chapter 18 Governmental Entities: Other Governmental Funds and Account Groups 761

other liabilities are paid by the debt service fund, the memorandum accounts are reversed in
the general long-term debt account group in a closing entry at the end of the fiscal year.

Journal Entries for Long-Term Debt Account Group

The following journal entries for the Town of Verdant Glen General Long-Term Debt Ac-
count Group parallel the corresponding journal entries in the Debt Service Fund (page 756)
and the Capital Projects Fund (page 752), respectively:

Journal Entries for TOWN OF VERDANT GLEN GENERAL LONG-TERM DEBT ACCOUNT GROUP
General Long-Term Journal Entries
Debt Account Group
of a Governmental Amount Available in Debt Service Fund 10,000
Entity Amount to Be Provided 10,000
To record amount received by Debt Service Fund from General Fund for
retirement of principal of general obligation serial bonds.

Serial Bonds Payable 10,000

Amount Available in Debt Service Fund 10,000
To record Debt Service Fund payment of 10% serial bonds on
January 1, 2006.

Amount to Be Provided 500,000

Term Bonds Payable 500,000
To record issuance of 7% general obligation term bonds for construction
of addition to high school.

Required Disclosures for General Long-Term Debt

The Governmental Accounting Standards Board requires presentation of an analysis of
changes in general long-term debt of a governmental entity in a note to the financial state-
ments discussed in Chapter 19.6 Following is an analysis of changes in general long-term
debt of the Town of Verdant Glen for the year ended June 30, 2006:

CHANGES IN TOWN OF VERDANT GLEN GENERAL LONG-TERM DEBT

For Year Ended June 30, 2006

Balances, Balances,
July 1, June 30,
2005 Additions Payments 2006
Term Bonds
7%, 20-year general obligation
bonds due July 1, 2025 $500,000 $500,000
Serial Bonds
10%, 10-year general obligation
bonds, final installment due
January 1, 2006 $10,000 $10,000
Totals $10,000 $500,000 $10,000 $500,000

6
Ibid., Sec. 2300.114.
762 Part Five Accounting for Nonbusiness Organizations

Capital Leases of Governmental Entities

If a capital lease is executed by a governmental entity for property not recorded in a pro-
prietary fund (internal service fund or enterprise fund), the property is recorded in the vol-
untarily maintained general capital assets account group and the lease liability is recorded
in the voluntarily maintained general long-term debt account group, valued in accordance
with the provisions of FASB Statement No. 13, “Accounting for Leases” (as amended and
interpreted).7 The periodic lease payments typically are included in expenditures of the
general fund.
To illustrate accounting for a capital lease by a governmental entity, assume that on July
1, 2006, the Town of Verdant Glen entered into a three-year capital lease for furniture and
equipment for the library building donated to the town (see page 759). The minimum lease
payments were $10,000, payable each July 1, 2006 through 2008. Title to the furniture and
equipment was to be vested in the town on July 1, 2009. The town adopted the straight-line
method of depreciation, a 10-year economic life, and no residual value for the furniture and
equipment. The interest rate implicit in the lease, known to the town and less than the
town’s incremental borrowing rate, was 8%.
The following journal entries would be required for the capital lease for the three-year
lease term:

Journal Entries for TOWN OF VERDANT GLEN

Governmental Entity’s Journal Entries for Capital Lease
Capital Lease
In General Fund
2006
July 1 Expenditures 10,000
Cash 10,000
To record first lease payment on three-year capital lease for
library furniture and equipment.

2007
July 1 Expenditures ($1,427 interest $8,573 principal) 10,000
Cash 10,000
To record second lease payment on three-year capital lease for
library furniture and equipment.

2008
July 1 Expenditures ($740 interest $9,260 principal) 10,000
Cash 10,000
To record third lease payment on three-year capital lease for
library furniture and equipment.

In General Long-Term Debt Account Group

2006
July 1 Amount to Be Provided ($10,000 2.783265*) 27,833
Liability under Capital Lease (net) 27,833
To record liability under three-year capital lease for
library furniture and equipment.

*
Present value of annuity due of l for three periods at 8%.
(continued)
7
Ibid., Sec. L20.110.
 Chapter 18 Governmental Entities: Other Governmental Funds and Account Groups 763

TOWN OF VERDANT GLEN

Journal Entries for Capital Lease (concluded)

2006
July 1 Liability under Capital Lease (net) 10,000
Amount to Be Provided 10,000
To record General Fund payment of first lease payment on
three-year capital lease for library furniture and equipment.

2007
July 1 Liability under Capital Lease (net) 8,573
Amount to Be Provided 8,573
To record General Fund payment of second lease payment
on three-year capital lease for library furniture and equipment.

2008
July 1 Liability under Capital Lease (net) 9,260
Amount to Be Provided 9,260
To record General Fund payment of third lease payment on
three-year capital lease for library furniture and equipment.

In General Capital Assets Account Group

2006
July 1 Leased Furniture and Equipment—Capital Lease 27,833
Investment in General Capital Assets from
General Fund Revenues 27,833
To record acquisition of library furniture and equipment under
three-year capital lease.

2007
June 30 Investment in General Capital Assets from General Fund
Revenues ($27,833 10) 2,783
Accumulated Depreciation—Leased Furniture and
Equipment—Capital Lease 2,783
To recognize depreciation of leased library furniture and
equipment for the year ended June 30, 2007.
(The same depreciation journal entries would be prepared on June 30, 2008, through June 30, 2016.)

Accounting for Special Assessment Bonds

In GASB Statement No. 6, “Accounting and Financial Reporting for Special Assessments,”
the Governmental Accounting Standards Board terminated the use of special assessment
funds to account for the construction of public improvements financed by special assess-
ments against selected property owners and by related special assessment bonds.8 Instead,
special revenue funds, capital projects funds, and debt service funds are to be used, as ap-
propriate, for the transactions and events related to such construction projects.
With respect to special assessment bonds, which sometimes are issued by a governmen-
tal entity to finance construction projects pending the receipt of special assessments payable
in annual installments, the GASB provided the following standards:

8
Ibid., Sec. S40.113.
764 Part Five Accounting for Nonbusiness Organizations

b. Special assessment debt for which the government is obligated in some manner . . .
should be reported as general long-term liabilities in the government-wide statement of
net assets, except for the portion, if any, that is directly related to and expected to be paid
from proprietary funds.
(1) The portion of the special assessment debt that will be repaid from property owner
assessments should be reported as “special assessment debt with governmental com-
mitment.”
(2) The portion of special assessment debt that will be repaid from general resources of
the government (the public benefit portion, or the amount assessed against government-
owned property) should be reported like other general long-term liabilities.
(3) The portion of special assessment debt that is directly related to and expected to be
paid from proprietary funds should be reported as liabilities of those funds in the
proprietary fund statement of net assets. Liabilities directly related to and expected to
be repaid from proprietary funds should also be reported in the government-wide
statement of net assets.
c. Special assessment debt for which the government is not obligated in any manner should
not be displayed in the government’s financial statements.9

To illustrate application of the foregoing standards, assume that on July 1, 2006, the
Town Council of Verdant Glen enacted a special assessment for paving streets and in-
stalling sidewalks in a section of the town. The total assessment was $250,000, payable
by the assessed property owners in five annual installments, beginning July 1, 2006. In-
terest on unpaid balances at 10% a year was payable annually by the assessed property
owners, beginning July 1, 2007. To help finance the cost of the construction project, the
Town Council authorized the issuance on July 1, 2006, of $200,000 face amount, four-
year, 8% special assessment bonds, payable $50,000 a year plus interest payable annually,
beginning July 1, 2007. The Town Council authorized the establishment of a special rev-
enue fund and a capital projects fund to account for the construction project. Under the
terms of the bond indenture for the special assessment bonds, the Town of Verdant Glen
was obligated to pay the special assessment bonds at maturity if the property owners de-
faulted on their special assessments and proceeds of lien foreclosures on the property
were insufficient.
The following journal entries are required on July 1, 2006, the date of the special
assessment:

Journal Entries for TOWN OF VERDANT GLEN

Governmental Entity Journal Entries for Construction Project Financed by Special Assessment
Construction Project
Financed by Special In Special Revenue Fund (different from that illustrated on
Assessment pages 748–751):
Special Assessments Receivable—Current 50,000
Special Assessments Receivable—Deferred 200,000
Revenues 50,000
Deferred Revenues 200,000
To record special assessment levied on property owners benefited by
paving and sidewalk project; special assessments receivable and related
revenues applicable to year ended June 30, 2006, are current, and the
balance is deferred.

(continued)

9
Ibid., Sec. S40.116 b,c.
 Chapter 18 Governmental Entities: Other Governmental Funds and Account Groups 765

TOWN OF VERDANT GLEN

Journal Entries for Construction Project Financed by Special Assessment (concluded)

Cash 50,000
Special Assessments Receivable—Current 50,000
To record receipt of current special assessment payments.

Other Financing Uses—Transfers Out 50,000

Cash 50,000
To record transfer of cash for financing of paving and sidewalk project
to Capital Projects Fund established for that purpose.

In Capital Projects Fund (different from that illustrated on

pages 751–755):
Cash 50,000
Other Financing Sources—Transfers In 50,000
To record receipt of cash from Special Revenue Fund for proceeds of
current installment of special assessments.

Cash 195,776
Other Financing Uses: Discount on Bonds Issued 4,224
Other Financing Sources: Bonds Issued 200,000
To record proceeds of $200,000 face amount of four-year, 8% special
assessment bonds to yield 9%.

In General Long-Term Debt Account Group (same as that

illustrated on pages 760–761):
Amount to Be Provided 200,000
Special Assessment Bonds Payable 200,000
To record issuance of 8% special assessment bonds for paving and
sidewalk project; the town is obligated to honor deficiencies on
payment of the bonds.

Some significant features of the foregoing journal entries are as follows:

1. The capital budget for the paving and sidewalks project is not entered in the accounting
records of either the Special Revenue Fund or the Capital Projects Fund. The Town Coun-
cil’s approval of the special assessment and the related bonds provides adequate control.
2. Because the Special Revenue Fund will collect the special assessments as they become cur-
rent, that fund also will service the special assessment bonds as they become payable. Fur-
ther, the Special Revenue Fund will accrue interest receivable (at 10%) on the unpaid special
assessments receivable, and interest payable (at 8%) on the special assessment bonds.
3. On June 30, 2007, 2008, 2009, and 2010, the Special Revenue Fund will prepare the fol-
lowing journal entry:

Special Assessments Receivable—Current 50,000

Deferred Revenues 50,000
Special Assessments Receivable—Deferred 50,000
Revenues 50,000
To transfer special assessment installment receivable in next fiscal year
and related revenues to the current category from the deferred category.
766 Part Five Accounting for Nonbusiness Organizations

4. The special assessment bonds and related interest are payable serially over a four-year
period by the Special Revenue Fund, from proceeds of the annual collections of special
assessments and related interest. Accordingly, the present value of the 8% special as-
sessment bonds ($195,776) at the 9% yield rate is computed as follows:

Computation of Principal and interest due July 1, 2007 [($50,000 $16,000) 0.917431*] $ 60,550
Present Value of Principal and interest due July 1, 2008 [($50,000 $12,000) 0.841680*] 52,184
Special Assessment Principal and interest due July 1, 2009 [($50,000 $8,000) 0.772183*] 44,787
Bonds Principal and interest due July 1, 2010 [($50,000 $4,000) 0.708425*] 38,255
Present value (proceeds) of 8% special assessment
bonds at 9% yield rate $195,776

*
From present value tables.

Review 1. Describe the taxes, fees, or other revenues of a governmental entity that often are ac-
counted for in special revenue funds.
Questions
2. The following journal entry was prepared for the Town of Groman Special Revenue
Fund, established to account for special assessments on selected property owners of the
nearby Village of Angelus:

Expenditures 42,000
Payable to General Fund 42,000
To record billings from General Fund for reimbursement of
expenditures for street cleaning and streetlight maintenance for
residents of the Village of Angelus.

What ledger account does the Town of Groman General Fund credit to offset the
$42,000 debit to Receivable from Special Revenue Fund? Explain.
3. How are proceeds of general obligation bonds issued at face amount by a governmental
entity to finance a construction project accounted for in a capital projects fund? Explain.
4. Is a separate debt service fund established for every issue of general obligation bonds
issued by a governmental entity? Explain.
5. The following journal entry (explanation omitted) appeared in the Charter County
Debt Service Fund:

Cash with Fiscal Agent 83,000

Cash 83,000

What is the probable explanation for this journal entry? Explain.

6. Is the recognition of depreciation of plant assets appropriate for a governmental entity’s
voluntarily maintained general capital assets account group? Explain.
7. Explain the use of the Investment in General Capital Assets from Gifts ledger account
of a governmental entity’s general capital assets account group.
8. Is a balance sheet issued for a governmental entity’s voluntarily maintained general
capital assets account group? Explain.
9. The following journal entry appeared in the accounting records of the Village of Marvell
voluntarily maintained General Long-Term Debt Account Group:
 Chapter 18 Governmental Entities: Other Governmental Funds and Account Groups 767

Amount to Be Provided 25,000

Amount Available in Debt Service Fund 25,000
To record amount received by Debt Service Fund from General Fund
for retirement of principal of general obligation serial bonds.

Is the foregoing journal entry prepared correctly? Explain.

10. Explain how each of the following accounting units of a governmental entity is af-
fected by a capital lease for fire engines of the fire department: general fund, voluntar-
ily maintained general long-term debt account group, voluntarily maintained general
capital assets account group.
11. Under what circumstances, if any, is a liability for special assessment bonds recorded
in a governmental entity’s voluntarily maintained general long-term debt account group?
Explain.

Exercises
(Exercise 18.1) Select the best answer for each of the following multiple-choice questions:
1. May funds other than the general fund be established by a governmental entity in re-
sponse to:

Legislative Action? Executive Action?

a. Yes Yes
b. Yes No
c. No Yes
d. No No

2. The governmental funds of a governmental entity include all the following except:
a. Special revenue funds
b. Agency funds
c. Debt service funds
d. Capital projects funds
3. An example of a governmental fund of a governmental entity is:
a. An enterprise fund
b. A special revenue fund
c. An agency fund
d. None of the foregoing
4. The type of governmental fund of a governmental entity whose accounting most re-
sembles that of the entity’s general fund is a:
a. Capital projects fund
b. Debt service fund
c. Special revenue fund
d. Special expenditures fund
768 Part Five Accounting for Nonbusiness Organizations

5. The governmental funds of a governmental entity for which the statement of revenues,
expenditures, and changes in fund balance typically displays both budgeted and actual
amounts are:
a. Special revenue funds
b. Capital projects funds
c. Debt service funds
d. None of the foregoing
6. A capital projects fund of a governmental entity is:
a. A governmental fund
b. A proprietary fund
c. A fiduciary fund
d. An account group
7. A Fund Balance Reserved for Encumbrances ledger account most likely is appropriate
for a governmental entity’s:
a. Special revenue fund
b. Capital projects fund
c. Debt service fund
d. Three foregoing governmental funds
8. To record the issuance of general obligation bonds at face amount to finance a govern-
mental entity’s capital project fund, the accountant for that fund credits:
a. Revenues
b. Other Financing Sources
c. Unreserved and Undesignated Fund Balance
d. General Obligation Bonds Payable
9. Is an annual budget always recorded by a governmental entity’s:

Special Revenue Capital Projects Debt Service

Funds? Funds? Funds?
a. Yes Yes Yes
b. Yes No Yes
c. Yes Yes No
d. Yes No No

10. A governmental entity’s voluntarily maintained general capital assets account group
may be used for all plant assets of the governmental entity not recorded in:
a. Capital projects funds
b. Trust funds
c. The general fund
d. Plant asset funds
11. Are plant assets of a governmental entity accounted for in the entity’s:

General Fund? Capital Projects Funds?

a. Yes Yes
b. Yes No
c. No Yes
d. No No
 Chapter 18 Governmental Entities: Other Governmental Funds and Account Groups 769

12. Excluded from the voluntarily maintained general capital assets account group of a
governmental entity are:
a. Donated plant assets.
b. Plant assets constructed with resources of capital projects funds.
c. Infrastructure.
d. None of the foregoing.
13. A governmental entity’s Amount to Be Provided ledger account is included in the ac-
counting records of the entity’s:
a. Debt service funds.
b. Capital projects funds.
c. General long-term debt account group.
d. General capital assets account group.
14. The typical balances of the following ledger accounts of a governmental entity’s gen-
eral long-term debt account group are:

Amount Available
in Debt Service Fund Amount to Be Provided
a. Debit Credit
b. Credit Debit
c. Debit Debit
d. Credit Credit

15. Are journal entries for a capital lease (for property not recorded in a proprietary fund)
entered into by a governmental entity typically required in the entity’s:

General Long-Term General Capital Assets

General Fund? Debt Account Group? Account Group?
a. No Yes Yes
b. Yes No Yes
c. Yes Yes No
d. Yes Yes Yes

16. For the transactions and events related to construction of public improvements financed
by special assessments, does a governmental entity use a:

Special Revenue Capital Projects Debt Service

Fund? Fund? Fund?
a. Yes Yes Yes
b. Yes Yes No
c. No Yes No
d. No Yes Yes

(Exercise 18.2) On July 1, 2005, property taxes totaling $480,000, of which 11⁄2% was estimated to be un-
collectible, were levied by the County of Larchmont Special Revenue Fund. Property taxes
collected by the Special Revenue Fund during July 2005 totaled $142,700.
Prepare journal entries for the County of Larchmont Special Revenue Fund for the fore-
going transactions and events.
(Exercise 18.3) On July 1, 2005, the City of Garbo Capital Projects Fund received the proceeds of a $1 mil-
lion face amount, 6% five-year serial bond issue, $200,000 principal plus interest payable
770 Part Five Accounting for Nonbusiness Organizations

CHECK FIGURE annually, to finance the construction of a new elementary school. The bonds were issued to
Present value of bonds, yield 8%.
$949,636. Prepare a working paper to compute the proceeds (present value) of the City of Garbo
6% serial bonds on July 1, 2005.
(Exercise 18.4) On July 1, 2005, the County of Pinecrest issued at face amount $1,200,000 of 30-year, 5%
general obligation term bonds, interest payable each January 1 and July 1, to finance the
construction of a public health center.
Prepare journal entries on July 1, 2005, to record the foregoing transaction for all
County of Pinecrest funds or voluntarily maintained account groups affected. Identify the
funds or account groups.
(Exercise 18.5) On April 30, 2006, the fiscal agent for the Town of Wallen Debt Service Fund paid the final
serial payment of $50,000 on the town’s 8% general obligation bonds, together with semi-
annual interest. The Debt Service Fund had provided sufficient cash to the fiscal agent a few
days earlier.
Prepare a journal entry for the Town of Wallen Debt Service Fund to record the fiscal
agent’s payment of bond principal and interest on April 30, 2006.
(Exercise 18.6) On March 18, 2006, the Bucolic Township General Fund transferred $140,000 to the Debt
Service Fund for the semiannual $100,000 serial maturity (payable March 31, 2006) on
$800,000 face amount of outstanding 10% general obligation bonds, plus interest of
$40,000.
Prepare journal entries (omit explanations) on March 18, 2006 only, for the appropriate
funds and voluntarily maintained account group of Bucolic Township.
(Exercise 18.7) Among the activities of Nemo County for the fiscal year beginning July 1, 2005, and end-
ing June 30, 2006, was the following:
Sept. 1, 2005 Acquired for cash, from proceeds of general tax revenues, equipment
costing $80,000 (the related purchase order was for $79,600). The equip-
ment was to be used by the general government of Nemo County. The
county uses encumbrance accounting.
Prepare journal entries (omit explanations) for the foregoing activity of Nemo County.
Identify by initials the funds or voluntarily maintained account groups (for example, GF,
SRF, CPF, GCAAG) in which the journal entries are recorded.
(Exercise 18.8) On March 24, 2006, Wildwood Village sold to a scrap dealer for $40,000 an old fire engine
with a cost of $200,000 and carrying amount of $20,000 in Wildwood’s general capital as-
sets account group. The $40,000 cash was received by Wildwood’s general fund, which si-
multaneously acquired another fire engine for $450,000 cash, compared with the $446,000
amount of the purchase order that had been issued on February 10, 2006. The village uses
encumbrance accounting and a general capital assets account group.
Prepare journal entries (omit explanations) for Wildwood Village’s general fund and
general capital assets account group on March 24, 2006 only.
(Exercise 18.9) On June 30, 2006, the end of the fiscal year, the following journal entry was prepared by
the accountant for the Town of Backwoods Town Hall Capital Projects Fund:

Expenditures 950,000
Vouchers Payable 950,000
To record first progress billings of architect and contractor for town hall
under construction.
 Chapter 18 Governmental Entities: Other Governmental Funds and Account Groups 771

Prepare a journal entry on June 30, 2006, for the Town of Backwoods voluntarily main-
tained General Capital Assets Account Group.
(Exercise 18.10) A citizen of Hays City donated 10 acres of undeveloped land to the city for a future school
site. The donor’s cost of the land was $555,000. The current fair value of the land was
$850,000 on the date of the gift.
Prepare a journal entry for the appropriate fund or account group of Hays City to record
the gift. Identify the fund or account group.
(Exercise 18.11) On April 30, 2006, the Town of Noblisse General Fund received the $30,000 proceeds from
disposal of a computer that had a carrying amount of $40,000. The General Fund had ac-
quired the computer three years earlier at a cost of $100,000.
Prepare journal entries on April 30, 2006, to record the foregoing transaction for all
Town of Noblisse funds or voluntarily maintained account groups affected. Identify the funds
or account groups.
(Exercise 18.12) On July 1, 2005, the City of Rogell entered into a five-year capital lease for fire-fighting
equipment, with lease payments of $20,000 due each July 1, 2005 through 2009. Title to the
CHECK FIGURE equipment was to pass to the City of Rogell on June 30, 2010. The interest rate implicit in
In general long-term the lease, known to Rogell and less than Rogell’s incremental borrowing rate, was 8%.
debt account group, Prepare journal entries on July 1, 2005, to record the foregoing transaction for all City
debit amount to be of Rogell funds or voluntarily maintained account groups affected. Identify the funds or ac-
provided, $86,243. count groups.
(Exercise 18.13) On July 1, 2005, the Town of Warren issued $600,000 face amount of three-year, 9% spe-
cial assessment bonds, payable $200,000 a year plus interest, at a 10% yield rate, to finance
CHECK FIGURE a street improvement project. The town was “obligated in some manner” for the bonds.
In capital projects Prepare journal entries on July 1, 2005, to record the foregoing transaction for all Town
fund, debit cash, of Warren funds or voluntarily maintained account groups affected. Identify the funds or
$589,737. account groups.
(Exercise 18.14) The ledger accounts listed below are included frequently in the accounting records of gov-
ernmental entities.

Ledger Account Fund or Account Group

1 Bonds Payable a General fund
2 Fund Balance Reserved for Encumbrances b Special revenue fund
3 Amount to Be Provided c Capital projects fund
4 Equipment d Debt service fund
5 Appropriations e General capital assets account group
6 Estimated Revenues f General long-term debt account group
7 Taxes Receivable—Current

Select the appropriate identifying letter to indicate the governmental entity fund or ac-
count group in which these ledger accounts might properly appear. An account might ap-
pear in more than one fund or account group.

Cases
(Case 18.1) The controller of the city of Darby has asked your advice on the accounting for an install-
ment contract payable by the city. The contract covers the cost of installing automatic
gates, currency receptacles, and ticket dispensers for the 20 city-owned parking lots in the
772 Part Five Accounting for Nonbusiness Organizations

downtown district. Installation of the self-parking equipment resulted in a decrease in the

required number of parking attendants for the city-owned parking lots and a reduction in
the salaries and related expenditures of the City of Darby General Fund.
The contract is payable monthly in amounts equal to 40% of the month’s total parking
revenue for the 20 lots. Because no legal or contractual provisions require the City of Darby
to establish an enterprise fund for the parking lots, both parking revenue and parking-lot
maintenance and repairs expenditures are to be recorded in the City of Darby General
Fund. The parking-lot sites are to be carried at cost in the City of Darby voluntarily main-
tained General Capital Assets Account Group.
The city controller describes the plans for accounting for payments on the contract as
follows: Monthly payments under the contract are to be debited to the Expenditures ledger
account of the General Fund and to the debt service section of the expenditures subsidiary
ledger. The payments also will be recorded in the General Capital Assets Account Group as
additions to the Improvements Other than Buildings ledger account. A note to the General
Fund balance sheet will disclose the unpaid balance of the installment contract at the end
of each fiscal year. The unpaid balance of the contract will not be included in the voluntar-
ily maintained General Long-Term Debt Account Group because the contract does not rep-
resent a liability for borrowing of cash, as do the bond and other long-term debt liabilities
of the City of Darby.
Instructions
What is your advice to the controller of the City of Darby? Explain.
(Case 18.2) The chief accountant of the City of DelVille requests your advice on how to account for
two special assessments, which the city has never before enacted. One special assessment
was to finance street lighting and maintenance services to selected residents of the nearby
Town of Minimus; the other was to finance construction of a new city hall for the City of
DelVille. Special assessment bonds were not to be issued.
Instructions
What is your advice to the chief accountant of the City of DelVille? Explain.
(Case 18.3) James Milton, the newly elected controller of Wilburtown, a municipality with a population
of approximately 120,000, is astonished that Wilburtown’s accounting records include 25
special revenue funds. He asks you, a member of the newly appointed independent auditors
of Wilburtown, which had never before been audited, for assistance in determining which—
if any—of the special revenue funds might be closed, with their revenues and related ex-
penditures to be accounted for in the Wilburtown General Fund. Before responding to
Milton, you decide to consult Section 1300.105 of Codification of Governmental Ac-
counting and Financial Reporting Standards (Norwalk: GASB, 2003).
Instructions
After undertaking the consulting described above, prepare a memorandum to James Milton
in answer to his question.
(Case 18.4) In a classroom discussion of accounting procedures for the general long-term debt account
group of a governmental entity, Professor Lisa Newton posed the following question to her
students:
In the journal entry to provide for the liability under a general obligation term bond payable
in the voluntarily maintained general long-term debt account group, should there also be a
debit to Amount to Be Provided and a credit to Interest to Be Paid for the total interest oblig-
ation under the bonds? Explain your views.

Instructions
If you were a student in Professor Newton’s class, how would you answer her question?
 Chapter 18 Governmental Entities: Other Governmental Funds and Account Groups 773

(Case 18.5) The City Council of Martinburg has asked you, the engagement manager of the CPA firm
that has just concluded the audit of the city’s financial statements for the fiscal year ended
June 30, 2006, to explain the negative balance of the unreserved and undesignated fund bal-
ance in the following balance sheet:

CITY OF MARTINBURG CLINIC CAPITAL PROJECTS FUND

Balance Sheet
June 30, 2006

Assets
Cash $ 24,000
Investments, at fair value 382,000
Total assets $406,000

Liabilities and Fund Balance

Liabilities:
Vouchers payable $ 10,000
Contracts payable 60,000
Total liabilities $ 70,000
Fund balance:
Reserved for encumbrances $480,000
Unreserved and undesignated (144,000) 336,000
Total liabilities and fund balance $406,000

Your firm’s audit working papers show that the clinic was 80% complete on June 30, 2006.
Instructions
How would you respond to the City Council’s request? Explain.

Problems
(Problem 18.1) During the fiscal year ended June 30, 2006, Ridge City had the following plant asset trans-
actions and events, among others:
2005
Oct. 31 General Fund acquired for cash equipment costing $20,000.
Dec. 10 A citizen donated land and a building with current fair values of $100,000
and $500,000, respectively.
2006
June 30 Construction in progress expenditures in the Capital Projects Fund totaled
$970,000 at fiscal year-end.
30 Depreciation of buildings—$250,000—and of equipment—$40,000—was
attributable to plant assets acquired as follows: From General Fund revenues—
$60,000; from Capital Projects Funds—$140,000; from gifts—$90,000.
30 Depreciation of infrastructure—$850,000—was attributable to assets ac-
quired from capital projects funds.

Instructions
Prepare journal entries for the Ridge City voluntarily maintained General Capital Assets
Account Group for the foregoing transactions and events.
774 Part Five Accounting for Nonbusiness Organizations

(Problem 18.2) Shown below is the trial balance of the Town of Dilbey Capital Projects Fund at the end of
its first year of operations.

CHECK FIGURE
TOWN OF DILBEY CAPITAL PROJECTS FUND
Total liabilities & fund
Trial Balance
balance, $276,036.
June 30, 2006

Debit Credit
Cash $ 276,036
Vouchers payable $ 101,000
Fund balance reserved for encumbrances 227,600
Revenues (interest on investments) 30,000
Other financing sources: Bonds issued 1,000,000
Expenditures: Construction contracts 575,200
Expenditures: Engineering and other 180,800
Other financing uses: Discount on bonds issued 98,964
Encumbrances 227,600
Totals $1,358,600 $1,358,600

Instructions
Prepare financial statements for the Town of Dilbey Capital Projects Fund for the fiscal year
ended June 30, 2006.
(Problem 18.3) On July 1, 2005, the Town of Logan began two construction projects: (1) an addition to the
town hall and (2) a curbing construction project financed with a special assessment. The
special assessment totaled $400,000, payable by the assessed citizens in five annual install-
ments of $80,000 beginning July 1, 2005, together with interest at 8% a year on the unpaid
assessments. Other details for the fiscal year ended June 30, 2006, were as follows:

Curbing Construction
Addition to Town Hall Project
Bonds issued July 1, 2005, $600,000 face amount, $320,000 face amount
at face amount 7%, 20-year general 71⁄2%, 4-year special
obligation term bonds, assessment bonds,
interest payable Jan. 1 $80,000 principal and
and July 1 interest payable each
July 1
Total encumbrances $530,200 $384,600
Total expenditures $380,600 $360,300
Encumbrances applicable
to expenditures $382,100 $354,700
Total cash paid on
vouchers payable $322,700 $347,600

Instructions
Prepare journal entries for the fiscal year ended June 30, 2006, including year-end accruals
but excluding closing entries, for (a) the Town of Logan Town Hall Capital Projects Fund
and (b) the Town of Logan Special Revenue Fund (established to account for the proceeds
of the special assessment). Do not prepare journal entries for the Town of Logan Curbing
Construction Capital Projects Fund.
 Chapter 18 Governmental Entities: Other Governmental Funds and Account Groups 775

(Problem 18.4) Among the journal entries of the General Fund of Webster Village for the fiscal year ended
June 30, 2006, were the following:

2005
July 3 Other Financing Uses—Transfers Out 15,000
Payable to Capital Projects Fund 15,000
To record liability to Capital Projects Fund for
transfer to make up that fund’s cash deficiency.

Aug. 31 Other Financing Uses—Transfers Out 210,000

Cash 210,000
To record transfer to Debt Service Fund for maturing
principal and final six-months’ interest payment on $200,000
face amount, 20-year, 10% general obligation term bonds
issued Aug. 31, 1985.

Nov. 30 Expenditures 60,000

Vouchers Payable 60,000
To record expenditure for new computer for village.
Straight-line depreciation to be used; economic life is five
years, with no residual value.

30 Fund Balance Reserved for Encumbrances 58,800

Encumbrances 58,800
To reverse encumbrance applicable to computer.

2006
Jan. 2 Other Financing Uses—Transfers Out 20,000
Cash 20,000
To record transfer to Special Revenue Fund for
village’s share of street-paving project cost in Westside
section; remaining $180,000 estimated cost is to be financed
by a special assessment.

Instructions
Prepare journal entries for the fiscal year ended June 30, 2006, in the other funds or volun-
tarily maintained account groups affected by the foregoing transactions or events of the
General Fund of Webster Village. Identify the affected funds or account groups. Include a
journal entry for depreciation of the computer.
(Problem 18.5) Among the activities of Calabash County for the fiscal year beginning July 1, 2005, and
ending June 30, 2006, were the following:
2005
July 1 Approved the annual budget for the Gasoline Tax Special Revenue Fund as fol-
lows: Appropriations, $600,000; estimated revenues, $640,000.
5 Executed a contract for the construction of a new public library at a total cost
of $5 million.
Aug. 1 Authorized a special assessment of $400,000 on residents of the North Sub-
division for construction of sidewalks. The special assessment, which was
payable in five annual installments of $80,000 beginning October 1, 2005, with
interest at 9% a year on the unpaid installments, was to be accounted for in the
Special Assessment Special Revenue Fund.
776 Part Five Accounting for Nonbusiness Organizations

Sept. 1 Acquired from proceeds of general tax revenues equipment costing $20,000
(the related purchase order was for $19,600). The equipment was to be used by
the general government of Calabash County, which does not depreciate plant
assets, in the voluntarily maintained General Capital Assets Account Group.
The county uses encumbrance accounting.

Instructions
Prepare journal entries for the fiscal year ended June 30, 2006, for the foregoing transac-
tions or events of Calabash County. Identify the funds or account groups in which the jour-
nal entries are recorded.
(Problem 18.6) On July 1, 2005, the City of Arlette, which records depreciation on plant assets in the vol-
untarily maintained General Capital Assets Account Group, leased under a three-year term
CHECK FIGURE capital lease a computer with a four-year economic life and no residual value. Lease pay-
July 1, 2005, credit ments of $3,000 were payable by the General Fund on July 1, 2005, 2006, and 2007; a bar-
liability under capital gain purchase option of $500 was payable on June 30, 2008. The interest rate implicit in the
lease (net), $8,663. lease, 9%, was less than the city’s incremental borrowing rate and was known to the City
Council.

Instructions
Prepare journal entries with respect to the capital lease for the City of Arlette for the three
fiscal years ended June 30, 2008, in all affected funds and account groups. Identify the af-
fected funds or account groups. The City of Arlette depreciates plant assets by the straight-
line method.
(Problem 18.7) The City of Ordway’s fiscal year ends on June 30. During the year ended June 30, 2006, the
city authorized the construction of a new library and the issuance of general obligation term
CHECK FIGURE bonds to finance the construction of the library. The authorization imposed the following
b. Total assets, restrictions:
$2,500,000.
1. Construction cost was not to exceed $5 million.
2. Annual interest rate was not to exceed 10%.
The city does not record capital budgets, but other appropriate ledger accounts, included
for encumbrance accounting, are maintained. The following transactions or events relating
to the financing and constructing of the library occurred during the fiscal year ended June
30, 2007:
(1) On July 1, 2006, the city issued $5 million of 30-year, 9% general obligation term
bonds for $5,100,000. The semiannual interest dates were June 30 and December 31.
(2) On July 3, 2006, the Library Capital Projects Fund invested $4,900,000 in short-term
notes. This investment was at face amount, with no accrued interest. Interest on cash
invested by the Library Capital Projects Fund must be transferred to the Library Debt
Service Fund. During the year ending June 30, 2007, estimated interest to be earned
was $140,000.
(3) On July 5, 2006, the City signed a construction-type contract with Premier Construc-
tion Company to build the library for $4,980,000.
(4) On January 15, 2007, the Library Capital Projects Fund received $3,040,000, from
the maturity of short-term notes acquired on July 3, 2006. The cost of these notes
was $3 million. The interest of $40,000 was transferred to the Library Debt Service
Fund.
(5) On January 20, 2007, Premier Construction Company billed the City $3 million for
work performed on the new library. The contract calls for 10% retention until final
 Chapter 18 Governmental Entities: Other Governmental Funds and Account Groups 777

inspection and acceptance of the building. The Library Capital Projects Fund paid
$2,700,000 to Premier.
(6) On June 30, 2007, the accountant for the Library Capital Projects Fund prepared ad-
justing and closing entries.

Instructions
a. Prepare journal entries for the fiscal year ended June 30, 2007, for the foregoing trans-
actions or events of the City of Ordway Library Capital Projects Fund. Use the follow-
ing ledger account titles:
Cash
Encumbrances
Expenditures
Fund Balance Reserved for Encumbrances
Interest Receivable
Investments
Other Financing Sources
Payable to Library Debt Service Fund
Unreserved and Undesignated Fund Balance
Vouchers Payable
Do not record journal entries in any other fund or account group.
b. Prepare a balance sheet for the City of Ordway Library Capital Projects Fund on June
30, 2007.
(Problem 18.8) In a special election held on May 1, 2005, the citizens of the City of Wilmont approved a $10
million issue of 20-year, 8% general obligation term bonds maturing in 2025. The proceeds
of the bonds will be used to help finance the construction of a new civic center. The total cost
of the project was estimated at $15 million. The remaining $5 million was to be financed by
an irrevocable state grant, which has been awarded. A capital projects fund was established
to account for this project and was designated the Civic Center Capital Projects Fund.
The following transactions and events occurred during the fiscal year beginning July 1,
2005, and ending June 30, 2006:
(1) On July 1, the General Fund loaned $500,000 (non-interest-bearing) to the Civic Cen-
ter Capital Projects Fund for defraying engineering and other costs.
(2) Preliminary engineering and planning costs of $320,000 were paid to Akron Company.
There had been no encumbrance for this cost.
(3) On December 1, the bonds were issued to yield 9%. Interest was payable each June 1
and December 1, through 2025.
(4) On March 15, a contract for $12 million was entered into with Carlson Construction
Company for the major part of the project.
(5) Purchase orders were placed for material estimated to cost $55,000. Encumbrance ac-
counting was used.
(6) On April 1, a partial payment of $2,500,000 was received from the state government.
(7) The material that was ordered previously was received at a cost of $51,000 and paid for.
(8) On June 15, a progress billing of $2 million was received from Carlson Construction
Company for work done on the project. In accordance with the contract, the city with-
held 6% of any billing until the project was completed.
(9) The General Fund was repaid the $500,000 previously loaned.
778 Part Five Accounting for Nonbusiness Organizations

Instructions
Prepare general journal entries to record the foregoing transactions and events of the Civic
Center Capital Projects Fund for the period July 1, 2005, through June 30, 2006, and the
closing entries on June 30, 2006. Omit explanations for the journal entries. Use the follow-
ing ledger account titles in the journal entries:
Cash Other Financing Uses
Encumbrances Payable to General Fund
Expenditures Receivable from State Government
Fund Balance Reserved for Revenues
Encumbrances Unreserved and Undesignated Fund Balance
Other Financing Sources Vouchers Payable
(Problem 18.9) The following deficit budget was proposed for 2005 for the Angelus School District Gen-
eral Fund:

ANGELUS SCHOOL DISTRICT GENERAL FUND

Annual Budget
For Year Ending December 31, 2005

Fund balance, Jan. 1, 2005 $128,000

Revenues:
Property taxes 112,000
Investment interest 4,000
Total $244,000
Expenditures:
Operating $120,000
County treasurer’s fees 1,120
Bond interest 50,000
Projected fund balance, Dec. 31, 2005 72,880
Total $244,000

A general obligation bond issue of the School District had been proposed in 2004. The
proceeds were to be used for a new school. There are no other outstanding bond issues. In-
formation about the bond issue follows:

Principal amount $1,000,000

Interest rate 71⁄2%
Bonds dated Jan. 1, 2005
Interest payable Jan. 1 and July 1, beginning July 1, 2005
Maturity Serially at the rate of $1,000,000 a year, starting Jan. 1, 2007.

The School District uses a separate bank account for each fund. The General Fund trial
balance on December 31, 2004, follows:
 Chapter 18 Governmental Entities: Other Governmental Funds and Account Groups 779

ANGELUS SCHOOL DISTRICT GENERAL FUND

Trial Balance
December 31, 2004

Debit Credit
Cash $ 28,000
Short-term investments—U.S. Treasury 6% bonds,
interest payable on May 1 and Nov. 1 100,000
Unreserved and undesignated fund balance $128,000
Totals $128,000 $128,000

The county treasurer collects the property taxes and withholds a fee of 1% on all col-
lections. The transactions and events for 2005 were as follows:
Jan. 1 The proposed budget was adopted, the general obligation bond issue was au-
thorized, and the property taxes were levied.
Feb. 28 Net property tax receipts from county treasurer, $49,500, were deposited.
Apr. 1 General obligation bonds were issued at 101 plus accrued interest. It was di-
rected that the premium be used for payment of interest by the General Fund.
2 The School District paid $147,000 for the new school site.
3 A contract for $850,000 for the new school was approved. Encumbrance ac-
counting was used.
May 1 Interest was received on short-term investments.
July 1 Interest was paid on bonds.
Aug. 31 Net property tax receipts from county treasurer, $59,400, were deposited.
Nov. 1 Payment on new school construction contract, $200,000, was made.
1 Interest was received on short-term investments.
Dec. 31 Operating expenditures during the year were $115,000. (Disregard voucher-
ing and encumbrances.)

Instructions
Prepare journal entries for Angelus School District to record the foregoing Year 2005 trans-
actions and events in the following funds or voluntarily maintained account groups. (Clos-
ing entries are not required.)
a. General Fund.
b. Capital Projects Fund.
c. General Capital Assets Account Group.
d. General Long-Term Debt Account Group.
Angelus School District does not use a Debt Service Fund.
Chapter Nineteen

Governmental Entities:
Proprietary Funds,
Fiduciary Funds, and
Comprehensive
Annual Financial
Report
Scope of Chapter
In this chapter, the coverage of accounting and reporting for governmental entities is com-
pleted with the discussion and illustration of (1) accounting and reporting for proprietary
funds and fiduciary funds, and (2) the comprehensive annual financial report (CAFR) cur-
rently published by governmental entities other than the federal government.

PROPRIETARY FUNDS
Enterprise funds and internal service funds constitute the proprietary funds of govern-
mental entities. These funds are more similar to business enterprises than are govern-
mental funds or fiduciary funds (trust funds and agency funds). Enterprise funds sell
services to the citizens, and sometimes to other funds, of the governmental entity, for
amounts designed to produce a net income. Internal service funds, as their title indicates,
sell goods or services to other funds of the governmental entity, but not to the public. Ac-
cordingly, earning significant amounts of net income is not an objective of an internal
service fund.
Both enterprise funds and internal service funds use the accrual basis of accounting and
issue financial statements similar to those for a nonprofit organization—a statement of rev-
enues, expenses, and changes in net assets [which includes an amount labeled increase (de-
crease) in net assets], a statement of net assets, and a statement of cash flows.
780
 Chapter 19 Governmental Entities: Proprietary and Fiduciary Funds, CAFR 781

The statements of net assets of both types of proprietary funds are classified into current
and noncurrent sections. The plant assets of the two types of proprietary funds are recorded
in their accounting records, and depreciation and amortization expenses are recognized by
each proprietary fund.
Because of the many similarities in the accounting cycle and the financial statements of
business enterprises and proprietary funds, journal entries for proprietary funds are not il-
lustrated in this section. Instead, the unique features of proprietary funds, including differ-
ences from features of business enterprises, are emphasized, and financial statements for
proprietary funds are illustrated.

Accounting and Reporting for Enterprise Funds

Enterprise funds account for the operations of commercial-type activities of a governmen-
tal entity, such as utilities, airports, seaports, and recreational facilities. These commercial-
type enterprises sell services to the public (and sometimes to other activities of the gov-
ernmental entity) at a profit. Consequently, the accounting for enterprise funds is more akin
to business enterprise accounting than the accounting for any other governmental entity
fund. For example, the accrual basis of accounting is used for an enterprise fund, with
short-term prepayments, depreciation expense, and doubtful accounts expense recognized
in the fund’s accounting records. The enterprise fund’s accounting records also include the
plant assets owned by the fund, as well as the liabilities for revenue bonds and any general
obligation bonds payable by the fund. (General obligation bonds are a liability of an enter-
prise fund if their proceeds were used by the enterprise fund for construction of plant assets
or other purposes.) Encumbrance accounting is not used for enterprise funds, and their an-
nual budgets generally are not entered in the accounting records. The net assets of an en-
terprise fund may be debited with cash remittances for transfers to the general fund, similar
to dividends declared and paid by a corporate enterprise.
However, there are several differences between accounting for an enterprise fund and ac-
counting for a business enterprise. Among these differences are the following:
1. Enterprise funds are not subject to federal and state income taxes. However, an enter-
prise fund may make payments in lieu of property or franchise taxes to the general fund
and display the payments as expenses in the statement of revenues, expenses, and changes
in net assets. (See page 727 of Chapter 17.)
2. There is no capital stock in an enterprise fund’s statement of net assets.
3. An enterprise fund has restricted assets, which are segregated from current assets in the
balance sheet. Cash deposits made by customers of a utility enterprise fund, which are
to help assure the customers’ payment for utility services, are restricted for cash or
interest-bearing investments to offset the enterprise fund’s liability for the customers’ de-
posits. Cash received from proceeds of revenue bonds issued by the enterprise fund is
restricted to payments for construction of plant assets financed by issuance of the bonds.
Part of the cash generated by the enterprise fund’s operations must be segregated and
invested for payment of interest and principal of the revenue bonds issued by the enter-
prise fund.
4. Current liabilities payable from restricted assets are segregated from other current lia-
bilities of an enterprise fund in a section of the balance sheet that precedes long-term
liabilities.
5. A restricted net assets amount generally is displayed in the statement of net assets of an
enterprise fund. The amount is equal to the total of cash and investments restricted to
payment of revenue bond interest and principal.
782 Part Five Accounting for Nonbusiness Organizations

6. Subsidy-type transfers from an enterprise fund to the general fund are displayed below
nonoperating revenues and expenses of the enterprise fund’s statement of revenues, ex-
penses, and changes in net assets.
7. The form of the statement of cash flows for proprietary funds of governmental entities
was set forth in GASB Statement No. 9, “Reporting Cash Flows of Proprietary and
Nonexpendable Trust Funds and Governmental Entities That Use Proprietary Fund Ac-
counting,” issued in 1989 by the Governmental Accounting Standards Board.1 Among
the features of an enterprise fund’s statement of cash flows are the following:
a. There are four categories of cash flows: from operating activities, from noncapital fi-
nancing activities, from capital and related financing activities, and from investing
activities. (The statement of cash flows for a business enterprise has three categories
of cash flows.)
b. In the direct method, operating income, rather than increase (decrease) in net assets,
is reconciled to net cash provided by operating activities. The direct method is
required.
c. Noncapital financing activities cash flows include operating grants from other gov-
ernmental entities and transfers to or from other funds of the governmental entity.
d. Temporary investments of cash received from borrowings for plant assets construc-
tion are reported with cash flows from capital and related financing activities, rather
than with cash flows from investing activities.

Financial Statements for Enterprise Fund

Some of the foregoing discussion is illustrated in the following financial statements of the
Town of Verdant Glen Enterprise Fund (for the town’s water utility):

Financial Statements TOWN OF VERDANT GLEN ENTERPRISE FUND

of a Governmental Statement of Revenues, Expenses, and Changes in Net Assets
Entity’s Enterprise For Year Ended June 30, 2006
Fund
Operating revenues:
Charges for services $520,000
Operating expenses:
Personal services $ 82,000
Contractual services 94,000
Supplies 21,000
Material 75,000
Heat, light, and power 14,000
Depreciation 45,000
Payment in lieu of property taxes 40,000
Total operating expenses 371,000
Operating income $149,000
Nonoperating revenues (expenses):
Operating grants $ 43,000
Investment revenue and net gains 12,000
Interest expense (46,000)
Fiscal agent fees (14,000)
Total nonoperating revenues (expenses) (5,000)
(continued)

1
Codification of Governmental Accounting and Financial Reporting Standards (Norwalk: GASB, 2003),
Sec. 2450.
 Chapter 19 Governmental Entities: Proprietary and Fiduciary Funds, CAFR 783

TOWN OF VERDANT GLEN ENTERPRISE FUND

Statement of Revenues, Expenses, and Changes in Net Assets (concluded)
For Year Ended June 30, 2006

Income before transfers $144,000

Transfer (out) to General Fund (10,000)
Increase in net assets $134,000
Net assets, beginning of year 532,000
Net assets, end of year $666,000

TOWN OF VERDANT GLEN ENTERPRISE FUND

Statement of Net Assets
June 30, 2006

Assets
Current assets:
Cash $ 62,000
Short-term investments, at fair value 120,000
Accounts receivable (net) 56,000
Receivable from General Fund 5,000
Inventory of supplies, at first-in, first-out cost 18,000
Short-term prepayments 2,000
Total current assets $ 263,000
Restricted assets:
Cash $ 22,000
Short-term investments, at fair value 145,000
Total restricted assets $ 167,000
Capital assets:
Land $ 192,000
Buildings 1,285,000
Machinery and equipment 347,000
Subtotal 1,824,000
Less: Accumulated depreciation 748,000
Net capital assets 1,076,000
Total assets $1,506,000
Liabilities
Current liabilities:
Vouchers payable $ 144,000
Accrued liabilities 82,000
Total current liabilities $ 226,000
Liabilities payable from restricted assets:
Interest payable $ 20,000
Current portion of revenue bonds 50,000
Customers’ deposits 44,000
Total liabilities payable from restricted assets $ 114,000
Long-term debt:
Revenue bonds, less current portion 500,000
Total liabilities $ 840,000
(continued)
784 Part Five Accounting for Nonbusiness Organizations

TOWN OF VERDANT GLEN ENTERPRISE FUND

Statement of Net Assets (concluded)
June 30, 2006

Net Assets
Net assets:
Invested in capital assets, net of related debt $526,000 (a)
Restricted for debt service 103,000 (b)
Unrestricted 37,000 (c)
Total net assets $666,000

(a) $1,076,000 $50,000 $500,000

(b) $167,000 $20,000 $44,000
(c) $1,506,000 $840,000 $526,000 $103,000, OR $263,000 $226,000

TOWN OF VERDANT GLEN ENTERPRISE FUND

Statement of Cash Flows
For Year Ended June 30, 2006

Net cash provided by operating activities (Exhibit 1):

Cash receipts from customers $782,000
Cash receipts from interfund services provided 87,000
Total cash receipts $869,000
Cash payments to employees for services $314,000
Cash payments to other suppliers of goods or services 203,000
Cash payment in lieu of property taxes to General Fund 40,000
Other operating cash payments 108,000
Total cash payments 665,000
Net cash provided by operating activities $204,000
Cash flows from noncapital financing activities:
Payment of principal ($50,000) and interest ($2,000) of
note payable to bank $ (52,000)
Operating grants from state government 43,000
Transfer (out) to General Fund (10,000)
Net cash used in noncapital financing activities (19,000)
Cash flows from capital and related financing activities:
Acquisition of machinery and equipment $ (41,000)
Payment of serial maturity of revenue bonds ($50,000) and
annual interest on the bonds ($44,000) (94,000)
Payment of fiscal agent fees (14,000)
Deposits received from customers 10,000
Net cash used in capital and related financing activities (139,000)
Cash flows from investing activities:
Revenue and net gains from short-term investments 12,000
Increase in cash and cash equivalents $ 58,000
Cash and cash equivalents, beginning of year 291,000
Cash and cash equivalents, end of year $349,000

(continued)
 Chapter 19 Governmental Entities: Proprietary and Fiduciary Funds, CAFR 785

TOWN OF VERDANT GLEN ENTERPRISE FUND

Statement of Cash Flows (concluded)
For Year Ended June 30, 2006

Exhibit 1 Cash flows from operating activities:

Operating income $149,000
Adjustments to reconcile operating income to net cash
provided by operating activities:
Depreciation expense 45,000
Decrease in accounts receivable (net) 3,000
Increase in receivable from General Fund (5,000)
Increase in inventory of supplies (4,000)
Decrease in short-term prepayments 1,000
Increase in vouchers payable 21,000
Decrease in accrued liabilities (6,000)
Net cash provided by operating activities $204,000

The following four aspects of the financial statements for the Town of Verdant Glen
Enterprise Fund should be noted:
1. The payment in lieu of property taxes, $40,000, and the transfer out, $10,000, in the
statement of revenues, expenses, and changes in net assets are counterparts of the
amounts recorded by the Town of Verdant Glen General Fund in journal entry no. 9 on
page 727 of Chapter 17.
2. The receivable from General Fund, $5,000, in the statement of net assets is the counter-
part of the related payable to Enterprise Fund in the General Fund trial balance on
page 729 of Chapter 17.
3. The $103,000 net assets restricted for revenue bonds retirement in the statement of net
assets may be verified as follows:

Total restricted assets $167,000

Less: Total liabilities payable from restricted assets other than long-term debt 64,000
Net assets restricted for revenue bonds retirement $103,000

4. Short-term investments, both current and restricted, in the statement of net assets are cash
equivalents. Thus, the end-of-year amount of cash and cash equivalents in the statement
of cash flows is computed as follows: $62,000 $120,000 $22,000 $145,000
$349,000.

Accounting and Reporting for Internal Service Funds

An internal service fund is established to sell supplies and services to other funds of the gov-
ernmental entity, but not to the public. This type of fund is created to ensure uniformity and
economies in the procurement of supplies and services for the governmental entity as a whole,
such as computer and stationery supplies and the maintenance and repairs of motor vehicles.
The operations of internal service funds resemble those of a business enterprise, except
that internal service funds are not profit-motivated. The revenues of internal service funds
should be sufficient to cover all their operating costs and expenses, with perhaps a modest
profit margin. In this way, the resources of internal service funds are “revolving”; the orig-
inal contribution from the general fund of the governmental entity to establish an internal
786 Part Five Accounting for Nonbusiness Organizations

service fund is expended for supplies, operating equipment, employees’ salaries or wages,
and other operating expenses, and the amounts expended then are recouped through billings
to other funds of the governmental entity.
Although an internal service fund should use an annual budget for managerial plan-
ning and control purposes, the budget need not be entered in the accounting records of
the fund. The accrual basis of accounting, including the perpetual inventory system and
depreciation of plant assets, is appropriate for an internal service fund. Encumbrance
accounting may be useful in controlling nonrecurring purchase orders of an internal
service fund.
Because internal service funds do not issue revenue bonds and do not receive contribu-
tions or deposits from customers, the financial statements of internal service funds are
nearly identical in form and content to those of business enterprises. However, similar to
enterprise funds, internal service funds do not have owners’ equity in their statements of net
assets. A net assets ledger account balance typically supports that amount in the net assets
section of the statement of net assets for an internal service fund.

Financial Statements for Internal Service Fund

The following financial statements for the Town of Verdant Glen Internal Service Fund are
illustrative of the statements for such a fund. The receivable from General Fund, $6,000, in
the statement of net assets below is the counterpart of the related payable to Internal Ser-
vice Fund in the General Fund trial balance on page 729 of Chapter 17.

Financial Statements TOWN OF VERDANT GLEN INTERNAL SERVICE FUND

of a Governmental Statement of Revenues, Expenses, and Changes in Net Assets
Entity’s Internal For Year Ended June 30, 2006
Service Fund
Operating revenues:
Charges for services $162,400
Operating expenses:
Personal services $21,200
Supplies 84,300
Heat, light, and power 20,500
Depreciation 34,000
Total operating expenses 160,000
Increase in net assets $ 2,400
Net assets, beginning of year 636,800
Net assets, end of year $639,200

TOWN OF VERDANT GLEN INTERNAL SERVICE FUND

Statement of Net Assets
June 30, 2006

Assets
Current assets:
Cash $ 8,600
Receivable from General Fund 6,000
Inventory of supplies, at first-in, first-out cost 64,300
Total current assets $ 78,900
(continued)
 Chapter 19 Governmental Entities: Proprietary and Fiduciary Funds, CAFR 787

TOWN OF VERDANT GLEN INTERNAL SERVICE FUND

Statement of Net Assets (concluded)
June 30, 2006

Capital assets:
Land $ 142,100
Building 627,500
Machinery and equipment 132,800
Subtotal 902,400
Less: Accumulated depreciation 327,800
Net capital assets 574,600
Total assets $ 653,500

Liabilities
Current liabilities:
Vouchers payable $ 14,300
Total liabilities $ 14,300
Net Assets
Net assets:
Invested in capital assets, net of related debt $ 574,600
Unrestricted 64,600 (a)
Total net assets $ 639,200

(a) $78,900 $14,300

TOWN OF VERDANT GLEN INTERNAL SERVICE FUND

Statement of Cash Flows
For Year Ended June 30, 2006

Net cash provided by operating activities (Exhibit 1):

Cash receipts from interfund services provided $370,300
Cash payments to employees for services $ 76,000
Cash payments to other suppliers of goods or services 212,000
Other operating cash payments 53,600
Total cash payments 341,600
Net cash provided by operating activities $ 28,700
Cash flows from capital and related financing activities:
Acquisition of machinery and equipment (23,400)
Increase in cash $ 5,300
Cash, beginning of year 3,300
Cash, end of year $ 8,600

Exhibit 1 Cash flows from operating activities:

Increase in net assets $ 2,400
Adjustments to reconcile increase in net assets to net cash
provided by operating activities:
Depreciation expense 34,000
Decrease in receivable from General Fund 1,000
Increase in inventory of supplies (11,300)
Increase in vouchers payable 2,600
Net cash provided by operating activities $ 28,700
788 Part Five Accounting for Nonbusiness Organizations

Applicability of FASB Pronouncements to Proprietary Funds

In GASB Statement No. 20, “Accounting and Financial Reporting for Proprietary Funds . . . ,”
the GASB addressed the troublesome issue of which—if any—pronouncements of the
FASB should apply to proprietary funds of governmental entities.2 As an interim measure,
the GASB provided that proprietary funds should apply all Accounting Research Bulletins,
Accounting Principles Board Opinions, and Financial Accounting Standards Board State-
ments and Interpretations issued as of November 30, 1989, unless those pronouncements
conflicted with or contradicted GASB pronouncements. In addition, proprietary funds might
elect to apply all (not some) FASB Statements and Interpretations issued after November
30, 1989, as long as they do not conflict with or contradict GASB pronouncements. Thus,
GASB Statement No. 20 provided temporary guidance to governmental entities for apply-
ing business enterprise-type accounting standards, as appropriate, to their proprietary funds.
In GASB Statement No. 34, “Basic Financial Statements . . . ,” paragraphs 93 through 95,
the GASB reaffirmed the foregoing provisions of GASB Statement No. 20.

FIDUCIARY FUNDS
Private-purpose trust funds, pension trust funds, agency funds, and investment trust funds
constitute the fiduciary funds of a governmental entity. The position of the governmental
entity with respect to such funds is one of a custodian or a trustee, rather than an owner.
For fiduciary funds, the Governmental Accounting Standards Board has mandated use
of the accrual basis of accounting and preparation of a statement of fiduciary net assets and
a statement of changes in fiduciary net assets.3 The following sections of this chapter de-
scribe and illustrate accounting and reporting for fiduciary funds.
Accounting and Reporting for Agency Funds
Agency funds are of short duration. Typically, agency funds are used to account for sales
taxes collected by a state government on behalf of the municipalities and townships of the
state, and for payroll taxes and other deductions withheld from salaries and wages payable
to employees of a governmental entity. The amounts withheld subsequently are paid to a
federal or state collection unit.
Agency funds do not have operations during a fiscal year; thus, the only financial statements
for an agency fund are a statement of fiduciary assets showing the cash or receivables of the
fund and the amounts payable to other funds or governmental entities or to outsiders, and a
statement of changes in fiduciary assets, illustrated as follows for the Town of Verdant Glen:

Financial Statements TOWN OF VERDANT GLEN AGENCY FUND

of a Governmental Statement of Fiduciary Assets
Entity’s Agency Fund June 30, 2006

Assets
Cash $12,600

Liabilities
Vouchers payable $12,600

2
Ibid., Sec. P80.104 and P80.105.
3
Ibid., Sec. 1600, “Fund Financial Statements, C, and Sec. 2200.172–Sec. 2200.174.
 Chapter 19 Governmental Entities: Proprietary and Fiduciary Funds, CAFR 789

TOWN OF VERDANT GLEN AGENCY FUND

Statement of Changes in Assets and Liabilities
For Year Ended June 30, 2006

Balances, Balances,
July 1, 2005 Additions Deductions June 30, 2006
Assets
Cash $14,200 $49,000 $50,600 $12,600

Liabilities
Vouchers payable $14,200 $49,000 $50,600 $12,600

Accounting and Reporting for Private-Purpose Trust Funds

Private-purpose trust funds of a governmental entity are longer-lived than agency funds.
An expendable trust fund is one whose principal and income both may be expended
to achieve the objectives of the trust. A nonexpendable trust fund is one whose rev-
enues are expended to carry out the objectives of the trust; the principal remains in-
tact. For example, an endowment established by the grantor of a trust may specify that the
revenues from the endowment are to be expended by the governmental entity for
student scholarships, but the endowment principal is not to be expended. A nonexpend-
able trust fund requires two separate trust fund accounting entities—one for principal and
one for revenues. Accounting for the two separate trust funds requires a careful distinction
between transactions affecting the principal—such as changes in the investment portfolio—
and transactions affecting revenues—such as cash dividends and interest on the investment
portfolio. The trust indenture, which is the legal document establishing the trust, should
specify distinctions between principal and revenues. If the trust indenture is silent with
respect to such distinctions, the trust law of the governmental entity governs separation of
principal trust fund and revenues trust fund transactions.
Because the governmental entity serves as a custodian for a trust fund, accounting for a
trust fund should comply with the trust indenture under which the fund was established.
Among the provisions that might affect the accounting for a trust fund are requirements that
the annual budget for the trust fund be entered in its accounting records and that deprecia-
tion be recognized for an endowment principal trust fund that includes depreciable plant
assets.
To illustrate accounting for private-purpose trust funds, assume that Karl and Mabel
Root, residents of the Town of Verdant Glen, contributed marketable securities with a cur-
rent fair value of $100,000 on July 1, 2005, to a trust to be administered by the Town of
Verdant Glen as trustee. Principal of the gift was to be maintained in an Endowment Prin-
cipal Nonexpendable Trust Fund. Revenues from the marketable securities were to be used
for scholarships for qualified students to attend Verdant Glen College; the revenues and
expenditures for scholarships were to be accounted for in an Endowment Revenues Ex-
pendable Trust Fund. The Bank of Verdant Glen trust department was to receive an an-
nual trustee’s fee of $500 for administering the two trust funds on behalf of the Town of
Verdant Glen.
Journal entries for the two trust funds for the year ended June 30, 2006, are sum-
marized on page 790 (changes in current fair value of the marketable securities are dis-
regarded).
 790

Journal Entries for Nonexpendable Trust Fund and Expendable Trust Fund of a Governmental Entity

Endowment Endowment
Principal Revenues
Nonexpendable Expendable
Explanation of Transactions and Events Account Titles Trust Fund Trust Fund
Receipt of marketable securities in trust Investments 100,000
Revenues 100,000
Accrual of revenues on marketable Interest Receivable 5,000
securities Dividends Receivable 8,000
Revenues 13,000
Receipt of interest and dividends Cash 13,000
Part Five Accounting for Nonbusiness Organizations

Interest Receivable 5,000

Dividends Receivable 8,000
Recording of liability to Revenues Trust Other Financing Uses 13,000
Fund for interest and dividends Payable to Revenues Trust Fund 13,000
Receivable from Principal Trust Fund 13,000
•
Other Financing Sources 13,000
Transfer of cash from Principal Trust Fund to Payable to Revenues Trust Fund 13,000
Revenues Trust Fund Cash 13,000
Cash 13,000
•
Receivable from Principal Trust Fund 13,000
Payment of scholarships to students James Expenditures 12,000
Rich and Janet Wells Cash 12,000
Payment of trustee’s fee Expenditures 500
Cash 500
Closing entries Revenues 113,000
Other Financing Uses 13,000
Net assets Reserved for Endowment 100,000
Other Financing Sources 13,000
Expenditures 12,500
Net assets Reserved for Scholarships 500
 Chapter 19 Governmental Entities: Proprietary and Fiduciary Funds, CAFR 791

Financial Statements of Nonexpendable Trust Fund

Financial statements of the Town of Verdant Glen Endowment Principal Nonexpendable
Trust Fund are shown below for the year ended June 30, 2006:

Financial Statements TOWN OF VERDANT GLEN ENDOWMENT PRINCIPAL

of a Governmental NONEXPENDABLE TRUST FUND
Entity’s Nonexpendable Statement of Changes in Fiduciary Net Assets
Trust Fund For Year Ended June 30, 2006

Operating revenues:
Interest $ 5,000
Dividends 8,000
Gifts 100,000
Total operating revenues $113,000
Transfers out 13,000
Increase in net assets $100,000
Net assets, beginning of year -0-
Net assets, end of year $100,000

TOWN OF VERDANT GLEN ENDOWMENT PRINCIPAL

NONEXPENDABLE TRUST FUND
Statement of Fiduciary Net Assets
June 30, 2006

Assets
Investments, at fair value $100,000

Net Assets
Net assets reserved for endowment $100,000

Financial Statements of Expendable Trust Fund

For the Town of Verdant Glen Endowment Revenues Expendable Trust Fund, financial
statements for the year ended June 30, 2006, are as follows:

Financial Statements TOWN OF VERDANT GLEN ENDOWMENT REVENUES

of a Governmental EXPENDABLE TRUST FUND
Entity’s Expendable Statement of Changes in Fiduciary Net Assets
Trust Fund For Year Ended June 30, 2006

Revenues $ -0-
Expenditures:
Education $ 12,000
Administration 500
Total expenditures $ 12,500
Excess (deficiency) of revenues over expenditures $(12,500)
Transfers in 13,000
Increase in net assets $ 500
Net assets, beginning of year -0-
Net assets, end of year $ 500
792 Part Five Accounting for Nonbusiness Organizations

TOWN OF VERDANT GLEN ENDOWMENT REVENUES

EXPENDABLE TRUST FUND
Statement of Fiduciary Net Assets
June 30, 2006

Assets
Cash $500
Net Assets
Net assets $500

There is no unreserved and undesignated net assets balance for either of the Town of
Verdant Glen trust funds, because the trust indenture required the reservation of the entire
net assets of each fund to achieve the purpose of the trust.
Accounting and Reporting for Pension Trust Funds
The GASB has defined a pension trust fund as follows:
A fund used by a governmental entity to report resources that are required to be held in trust
for the members and beneficiaries of defined benefit pension plans, defined contribution
plans, other postemployment benefit plans, or other employee benefit plans. They are used to
account for the accumulation of assets for the purpose of paying benefits when they become
due in accordance with the terms of the plan: a pension plan included in the financial report-
ing entity of the plan sponsor or a participating employer.4
Pension trust funds are accounted for in essentially the same manner as proprietary
funds. Thus, the accounting records of pension trust funds are maintained under the accrual
basis of accounting and include all assets, liabilities, revenues, and expenses of the fund.
Because of the complexities of pension trust funds, illustrative journal entries for a pen-
sion trust fund are beyond the scope of this discussion. The following financial statements
for the Town of Verdant Glen Employees’ Retirement System Pension Trust Fund for the
year ended June 30, 2006, which exclude a statement of cash flows (which is optional)
illustrate some of the accounting concepts involved.5

TOWN OF VERDANT GLEN PENSION TRUST FUND

Statement of Changes in Fiduciary Net Assets
For Year Ended June 30, 2006

Additions:
Employee contributions $131,600
Employer contributions 247,300
Investment net gains and revenues, net of investment expenses 146,200
Total additions $525,100
Deductions:
Annuity and disability benefits $222,000
Refunds of contributions 38,300
Administrative expenses 187,200
Total deductions 447,500
Increase in net assets $ 77,600
Net assets held in trust for pension benefits, beginning of year 842,300
Net assets held in trust for pension benefits, end of year $919,900

4
Ibid., Sec. P20.551.
5
Ibid., Sec. Pe5.901.
 Chapter 19 Governmental Entities: Proprietary and Fiduciary Funds, CAFR 793

TOWN OF VERDANT GLEN PENSION TRUST FUND

Statement of Fiduciary Net Assets
June 30, 2006

Assets
Cash and short-term investments, at fair value $ 21,200
Receivables 34,800
Long-term investments, at fair value 884,600
Capital assets, less accumulated depreciation 82,100
Total assets $1,022,700
Liabilities
Refunds payable and other 102,800
Net assets held in trust for pension benefits $ 919,900

In addition to the foregoing financial statements, the pension trust fund of a govern-
mental entity must provide two schedules as required supplementary information following
the notes to the pension fund’s financial statements:
A schedule of funding progress that includes historical trend information about the actuari-
ally determined funded status of the pension plan and the progress made in accumulating
sufficient assets to pay benefits when due
A schedule of employer contributions that includes historical trend information about the
annual required contributions compared with the actual contributions6

Following is a discussion of important features of the financial statements for the Town
of Verdant Glen Pension Trust Fund:
1. The defined benefit pension plan of the Town of Verdant Glen is a contributory pension
plan, to which both covered employees and the town make contributions. (In a noncon-
tributory pension plan, only the town would make contributions.)
2. Investment revenues of the Pension Trust Fund include realized and unrealized gains and
losses on investments as well as interest and dividends.
3. Annuity benefits are pension payments to retired former employees of the Town of
Verdant Glen. Disability benefits are payments to former employees whose disabilities
precluded their working until scheduled retirement dates.
4. All pension payments to retired employees had been made through June 30, 2006; oth-
erwise, the liabilities in the Pension Trust Fund statement of fiduciary net assets would
include an amount for annuities payable.
5. Not illustrated for the Town of Verdant Glen Pension Trust Fund are the extensive dis-
closures required in notes to the financial statements of the Pension Trust Fund. These
required disclosures are set forth in GASB Statement No. 25, “Financial Reporting for
Defined Benefit Pension Plans and Note Disclosures for Defined Contribution Plans,”
paragraph 32.

Accounting and Reporting for Investment Trust Funds

Governmental entities such as counties and states often maintain external investment
pools, similar to the pooled investments of the various funds of nonprofit organizations
discussed in Chapter 16. Smaller governmental entities, such as towns and villages located

6
Ibid.
794 Part Five Accounting for Nonbusiness Organizations

in the same county or state, may achieve higher returns by pooling their investments with
those of other small entities. The investments are managed by the treasurer or chief finan-
cial officer of the state or county sponsoring government. In GASB Statement No. 31,
“Accounting and Financial Reporting for Certain Investments and for External Investment
Pools,” the GASB required sponsoring governments to establish investment trust funds for
external investment pools. Financial statements for the investment pools would be the same
as for pension trust funds: a statement of fiduciary net assets and a statement of changes in
fiduciary net assets.7
To illustrate, assume that Riparian County maintains an external investment pool for the
Town of Verdant Glen and other towns and villages within its borders. Following are hypo-
thetical financial statements for the Riparian County Investment Trust Fund:

RIPARIAN COUNTY INVESTMENT TRUST FUND

Statement of Changes in Fiduciary Net Assets
For Year Ended June 30, 2006

Additions:
Participants’ contributions $ 1,800,000
Investment net realized and unrealized gains and revenues,
net of investment expenses 1,140,000
Total additions $ 2,940,000
Deductions:
Administrative expenses 460,000
Net increase $ 2,480,000
Net assets held in trust for pool participants, beginning of year 65,820,000
Net assets held in trust for pool participants, end of year $68,300,000

RIPARIAN COUNTY INVESTMENT TRUST FUND

Statement of Fiduciary Net Assets
June 30, 2006

Assets
Cash and short-term investments, at fair value $26,200,000
Long-term investments at, fair value 42,180,000
Total assets $68,380,000
Liabilities
Payable to Treasurer of Riparian County 80,000
Net assets held in trust for pool participants $68,300,000

COMPREHENSIVE ANNUAL FINANCIAL REPORT

OF GOVERNMENTAL ENTITIES
As pointed out in Chapter 17 (page 714), the Governmental Accounting Standards Board’s
issuance in 1999 of GASB Statement No. 34, created renewed interest in financial report-
ing by state and local governmental entities. The GASB reported its objective in issuing
GASB Statement No. 34, as follows:

7
Ibid., Sec. I50.116.
 Chapter 19 Governmental Entities: Proprietary and Fiduciary Funds, CAFR 795

The Board’s objective with this Statement is to establish a basic financial reporting model
that will result in greater accountability by state and local governments by providing more use-
ful information to a wider range of users than did the previous model. The new model also
improves on earlier standards and proposals for modifying the previous model, . . . . 8

GASB Statement No. 33—A Preliminary Step

Before issuing GASB Statement No. 34, the GASB resolved the pressing issue of account-
ing for a governmental entity’s nonexchange transactions, such as most taxes, grants, and
private donations. The four classes of nonexchange transactions and their recognitions es-
tablished by the GASB are summarized in the following chart:9

Classes and Timing of Recognition of Nonexchange Transactions

Class Recognition
Derived tax revenues Assets*
Examples: sales taxes, Period when underlying exchange has occurred or when
personal and corporate resources are received, whichever is first.
income taxes, motor fuel
Revenues
taxes, and similar taxes
Period when underlying exchange has occurred. (Report ad-
on earnings or
vance receipts as deferred revenues.) When modified accrual
consumption
accounting is used, resources also should be “available.”
Imposed nonexchange Assets*
revenues Period when an enforceable legal claim has arisen or when
Examples: property taxes, resources are received, whichever is first.
most fines and
Revenues
forfeitures
Period when resources are required to be used or first period
that use is permitted (for example, for property taxes, the
period for which levied). When modified accrual accounting
is used, resources also should be “available.” (For property
taxes, apply NCGA Interpretation 3, as amended.)
Government-mandated Assets* and liabilities
nonexchange Period when all eligibility requirements have been met or
transactions (for asset recognition) when resources are received,
Examples: federal whichever is first.
government mandates
Revenues and expenses or expenditures
on state and local
Period when all eligibility requirements have have been met.
governments
Report advance receipts or payments for use in the following
Voluntary period as deferred revenues or advances, respectively.
nonexchange However, when a provider precludes the sale, disbursement,
transactions or consumption or resources for a specified number of
Examples: certain grants years, until a specified event has occurred, or permanently
and entitlements, most [for example, permanent and term endowments], report
donations revenues and expenses or expenditures when the resources
are, respectively, received or paid and report resulting net
assets, equity, of fund balance as restricted. When modified
accrual accounting is used for revenue recognition,
resources also should be “available.”

*If there are purpose restrictions, report restricted net assets (or equity or fund balance) or, for governmental funds, a reservation of fund
balance.

8
GASB Statement No. 34, par. 183.
9
Codification, Sec. N50.901.
796 Part Five Accounting for Nonbusiness Organizations

Subsequent to its issuance, GASB Statement No. 33 was modified with respect to ac-
counting for a governmental entity’s derived tax revenues or imposed nonexchange rev-
enues shared with other governmental entities.10

Subsequent Steps—GASB Statements No. 35, 37, 38, and 41

Subsequent to the issuance of GASB Statement No. 34, the GASB issued four additional
statements that either modified or supplemented Statement No. 34, as follows:
1. GASB Statement No. 35, “Basic Financial Statements—and Management’s Discussion
and Analysis—for Public Colleges and Universities.” This statement merely amended
Statement No. 34 to include public colleges and universities within its scope.11
2. GASB Statement No. 37, “Basic Financial Statements—and Management’s Discussion
and Analysis—for State and Local Governments: Omnibus.” This statement’s purpose
was to encourage financial managers of governmental entities to report management
discussion and analysis items that have the most relevance and to avoid boilerplate
language.12
3. GASB Statement No. 38, “Certain Financial Statement Note Disclosures.” Following
a general disclosure principle that disclosure in the notes to the financial statements of a
governmental entity is needed only when the information required to be disclosed is not
displayed on the face of the financial statements, GASB Statement No. 38 established
and modified disclosure requirements related to the following:
Summary of significant accounting policies
Violations of finance-related legal or contractual provisions
Debt and lease obligations
Short-term debt
Disaggregation of receivable and payable balances
Interfund balances and transfers13
4. GASB Statement No. 41, “Budgetary Comparison Schedules—Perspective Differ-
ences.” This statement requires a governmental entity that, because of perspective dif-
ferences, is unable to present budgetary comparisons for the general fund and major
special revenue funds to present, as required supplementary information, budgetary
comparison schedules based on the fund, organization, or program structure that the
entity uses for its legally adopted budget.14

Composition of a Governmental Entity’s Comprehensive

Annual Financial Report
The Governmental Accounting Standards Board provided the following general guidelines
for a governmental entity’s comprehensive annual financial report:
a. A comprehensive annual financial report should be prepared and published, covering all
activities of the primary government (including its blended component units*) and provid-
ing an overview of all discretely presented component units* of the reporting entity—

10
Codification, Sec. N50.125.
11
Ibid., Sec. Co.5.
12
Ibid., Sec. 2200.109.
13
Ibid., Secs. 2300.103, 2300.106, 2300.118–2300.121.
14
Ibid., Sec. 2400.102.
* The term component units is defined on page 717 of Chapter 17.
 Chapter 19 Governmental Entities: Proprietary and Fiduciary Funds, CAFR 797

including introductory section, management’s discussion and analysis (MD&A), basic finan-
cial statements, required supplementary information other than MD&A, appropriate com-
bining and individual fund statements, schedules, narrative explanations, and statistical
section. The reporting entity is the primary government (including its blended component
units) and all discretely presented component units . . . .
b. The minimum requirements for MD&A, basic financial statements, and required supple-
mentary information other than MD&A are:
(1) Management’s discussion and analysis.
(2) Basic financial statements. The basic financial statements should include:
(a) Government-wide financial statements.
(b) Fund financial statements.
(c) Notes to the financial statements.
(3) Required supplementary information other than MD&A.15

The GASB diagrammed the foregoing features of a comprehensive annual financial report
as follows:16

Management’s discussion
and analysis

Government-wide Fund financial

financial statements statements

Notes to the financial statements

Required supplementary information

(other than MD&A)

The GASB provided general guidance for the sections of a comprehensive annual financial
report as follows:
1. Management’s Discussion and Analysis should discuss the current-year results in
comparison with the prior year, with emphasis on the current year. This fact-based
analysis should discuss the positive and negative aspects of the comparison with the
prior year.17

15
Ibid., Sec. 2200 Statement of Principle, b and c.
16
Ibid., Sec. 2200.103.
17
Ibid., Sec. 2200.107.
798 Part Five Accounting for Nonbusiness Organizations

2. The government-wide financial statements consist of a statement of net assets and a

statement of activities. Those statements should:
a. Report information about the overall government without displaying individual funds
or fund types
b. Exclude information about fiduciary activities, including component units that are
fiduciary in nature (such as certain public employee retirement systems)
c. Distinguish between the primary government and its discretely presented component
units
d. Distinguish between governmental activities and business-type activities of the pri-
mary government
e. Measure and report all assets (both financial and capital), liabilities, revenues, ex-
penses, gains, and losses using the . . . accrual basis of accounting.18
3. Separate financial statements should be presented for the primary government’s govern-
mental and proprietary funds.19
4. The notes to the financial statements should communicate information essential for
fair presentation of the financial statements that is not displayed on the face of the
financial statements. As such, the notes are an integral part of the basic financial state-
ments. The notes should focus on the primary government—specifically, its govern-
mental activities, business-type activities, major funds, and nonmajor funds in the
aggregate.20
5. Required supplementary information consists of schedules, statistical data, and other in-
formation that the GASB has determined are an essential part of financial reporting and
should be presented with, but are not part of, the basic financial statements of a govern-
mental entity.21
The foregoing discussion regarding the comprehensive annual financial report of a gov-
ernmental entity suggests that such a report may be a complex, voluminous disclosure
instrument. The statement of net assets and the statement of activities of the City of
Alexandria, Virginia, for the fiscal year ended June 30, 2000, are clear evidence of such
complexity.22

SEC ENFORCEMENT ACTION DEALING WITH WRONGFUL

APPLICATION OF ACCOUNTING AND REPORTING
STANDARDS FOR GOVERNMENTAL ENTITY
AAER 970
In AAER 970, “In the Matter of The City of Syracuse, New York, Warren D. Simpson, and
Edward D. Polgreen” (September 30, 1997), the SEC reported that official statements pro-
duced by the City of Syracuse in connection with the issuance of $23,000,000 face amount
of one-year bond anticipation notes were materially false and misleading. According to the
SEC, the combined statements of revenue, expenditures, and changes in fund balances for
the City’s general and debt service funds reported a $400,000 excess of revenues over

18
Ibid., Sec. 2200.110.
19
Ibid., Sec. 2200.148.
20
Ibid., Sec. 2300.102.
21
Ibid., Sec. 2200.178.
22
Bruce W. Chase and Laura B. Iriggs, “How to Implement GASB Statement No. 34,” Journal of Accoun-
tancy, November 2001 (Jersey City: American Institute of Certified Public Accountants, Inc.), pp. 77–79.
 Chapter 19 Governmental Entities: Proprietary and Fiduciary Funds, CAFR 799

expenditures instead of the actual $9,400,000 excess of expenditures over revenues. In

addition, the combined ending fund balances of the general and debt service funds were
overstated by $24,200,000. According to the SEC, the primary cause of the misstatements
was the preparation of the combined financial statements before the City’s accounting
records had been closed for the relevant fiscal year and the premature recognition of prop-
erty tax revenues. The City, its most senior accountant in its Finance Department, and its
First Deputy Commissioner of Finance agreed to cease and desist from violating the Secu-
rities Act of 1933 and the Securities and Exchange Act of 1934.

Review 1. Under what circumstances are general obligation bonds payable of a governmental en-
Questions tity recorded in the governmental entity’s enterprise fund? Explain.
2. The accounting for a governmental entity’s enterprise fund in many respects is similar
to the accounting for a business enterprise; yet there are a number of differences be-
tween the two types of accounting. Identify at least three of the differences.
3. Why does a governmental entity’s enterprise fund have restricted assets in its statement
of net assets? Explain.
4. What are the four categories of cash flows in the statement of cash flows for a govern-
mental entity’s enterprise fund?
5. How is the excess of total assets over total liabilities displayed in the financial state-
ments of a governmental entity’s internal service fund? Explain.
6. How does the statement of net assets of a governmental entity’s internal service fund
differ from the statement of net assets of the governmental entity’s enterprise fund?
Explain.
7. Is a statement of revenues, expenses, and changes in fiduciary net assets issued for an
agency fund of a governmental entity? Explain.
8. Accounting for a nonexpendable trust for which a governmental entity acts as custo-
dian requires the establishment of two separate private-purpose trust funds. Why is this
true?
9. Explain the nature of the contributions in the statement of changes in fiduciary net as-
sets of a governmental entity’s pension trust fund.
10. Are fund financial statements the only financial statements included in the compre-
hensive annual financial report of a governmental entity? Explain.
11. Does the management’s discussion and analysis section of a governmental entity’s
comprehensive annual financial report include required supplementary financial infor-
mation? Explain.

Exercises
(Exercise 19.1) Select the best answer for each of the following multiple-choice questions:
1. An agency fund of a governmental entity is an example of which of the following type
of fund?
a. Fiduciary b. Governmental c. Proprietary d. Internal service
800 Part Five Accounting for Nonbusiness Organizations

2. Is a Contributed Capital from General Fund amount displayed in the statement of net
assets of a governmental entity’s:

Enterprise Fund? Internal Service Fund?

a. Yes No
b. No Yes
c. No No
d. Yes Yes

3. The following transactions were among those reported by the Scobey County Water
and Power Enterprise Fund for the fiscal year ended June 30, 2006:

Proceeds from issuance of revenue bonds $5,000,000

Cash deposits received from customer households 3,000,000
Cash contributed by subdividers 1,000,000

In the water and power enterprise fund’s statement of cash flows for the year ended
June 30, 2006, the amount to be reported as cash flows from capital and related fi-
nancing activities is:
a. $9,000,000
b. $8,000,000
c. $6,000,000
d. $5,000,000
4. Does a governmental entity’s agency fund issue a:

Statement of Fiduciary Statement of Changes

Assets in Fiduciary Net Assets?
a. Yes Yes
b. Yes No
c. No Yes
d. No No

5. Slade City Internal Service Fund received a transfer in of $50,000 cash from the Gen-
eral Fund. This $50,000 transfer is accounted for in the Internal Service Fund with a
credit to:
a. Revenues.
b. Other Financing Sources.
c. Accounts Payable.
d. Transfers In
6. Is the entire fund balance reserved in:

A Nonexpendable An Expendable
Private-Purpose Trust Fund? Private-Purpose Trust Fund?
a. Yes Yes
b. Yes No
c. No Yes
d. No No
 Chapter 19 Governmental Entities: Proprietary and Fiduciary Funds, CAFR 801

7. Which of the following funds of a governmental entity uses the same basis of
accounting as an enterprise fund?
a. Special revenue funds.
b. Internal service funds.
c. Permanent funds.
d. Capital projects funds.
8. Restricted assets are displayed in a governmental entity statement of net assets for:
a. Both an enterprise fund and an internal service fund.
b. Neither an enterprise fund nor an internal service fund.
c. An enterprise fund only.
d. An internal service fund only.
9. Which of the following funds of a governmental entity may account for expendable or
nonexpendable resources?
a. Debt service funds.
b. Enterprise funds.
c. Private-purpose trust funds.
d. Special revenue funds.
e. None of the foregoing funds.
10. Customers’ deposits that may not be spent for operating purposes are displayed in the
statement of net assets of the enterprise fund of a governmental entity as:
a. Restricted cash or investments.
b. Nonrestricted cash or investments.
c. Payable to general fund.
d. Payable to special revenue fund.
11. Does an agency fund for a governmental entity issue:

A Statement of A Statement of Changes A Statement of

Fiduciary Assets in Fiduciary Net Assets Cash Flows?
a. Yes Yes Yes
b. Yes No Yes
c. Yes Yes No
d. Yes No No

12. A Net Assets Reserved for Endowment ledger account is appropriate for:
a. An endowment principal nonexpendable trust fund only.
b. An endowment revenues expendable trust fund only.
c. Either an endowment principal nonexpendable trust fund or an endowment rev-
enues expendable trust fund.
d. Neither an endowment principal nonexpendable trust fund nor an endowment rev-
enues expendable trust fund.
13. Which of the following taxes is not a tax revenue of a governmental entity that is clas-
sified as derived under GASB Statement No. 33, “Accounting and Financial Reporting
for Nonexchange Transactions”?
a. Sales tax b. Personal income tax c. Motor fuel tax d. Property tax
(Exercise 19.2) The Enterprise Fund of Orchard City billed the Orchard City General Fund $16,400 for
utility services on May 31, 2006.
Prepare journal entries for the May 31, 2006, billing for both the Orchard City General
Fund and the Orchard City Enterprise Fund.
802 Part Five Accounting for Nonbusiness Organizations

(Exercise 19.3) Selected ledger accounts of the Town of Goland Enterprise Fund had the following bal-
ances on June 30, 2006:
CHECK FIGURE
Liabilities payable from restricted assets:
Restricted fund
Interest payable $ 24,400
balance, $43,400.
Current portion of revenue bonds 80,000
Customers’ deposits 62,600
Restricted assets:
Cash 42,300
Short-term investments, at fair value 168,100

Prepare a working paper to compute the required balance of the Net Assets Restricted
for Revenue Bonds Retirement ledger account of the Town of Goland Enterprise Fund on
June 30, 2006.
(Exercise 19.4) On June 18, 2006, the Wilbert Township Enterprise Fund made a $120,000 payment in lieu
of property taxes to the Wilbert Township General Fund.
Prepare journal entries on June 18, 2006, for Wilbert Township’s General Fund and En-
terprise Fund.
(Exercise 19.5) Selected items taken from comparative financial statements of the Town of Liddell Enter-
prise Fund were as follows for the fiscal year ended June 30, 2006:
CHECK FIGURE
Decrease in inventory of supplies $ 42,600
Net cash provided by
Decrease in receivable from General Fund 21,700
operating activities,
Decrease in vouchers payable 12,200
$218,900.
Depreciation expense 81,700
Increase in accounts receivable 36,800
Increase in accrued liabilities 8,100
Increase in short-term prepayments 11,600
Net income 94,200
Operating income 125,400
Transfer out to General Fund 18,600
Payment in lieu of property taxes to General Fund 46,800

Prepare the cash flows from operating activities exhibit for the statement of cash flows
(direct method) for the Town of Liddell Enterprise Fund for the year ended June 30, 2006.
(Exercise 19.6) From the following trial balance, prepare appropriate financial statements (excluding a
statement of cash flows):
CHECK FIGURE
TOWN OF DILBEY INTERNAL SERVICE FUND
Ending net assets,
Trial Balance
$1,278,400. June 30, 2006

Debit Credit
Cash $ 17,200
Receivable from General Fund 12,000
Inventory of supplies 128,600
Capital assets 1,804,800
Accumulated depreciation of capital assets $ 655,600
Vouchers payable 28,600
Net assets, July 1, 2005 1,273,600
Charges for services 324,800
Operating expenses 320,000
Totals $2,282,600 $2,282,600
 Chapter 19 Governmental Entities: Proprietary and Fiduciary Funds, CAFR 803

(Exercise 19.7) Agatha Morris, a citizen of Roark City, donated common stock with a current fair value of
$620,000 to the city under a trust indenture dated July 1, 2005. Under the terms of the in-
denture, the principal amount is to be kept intact; use of dividends revenues from the com-
mon stock is restricted to financing academic scholarships for college students. On
December 14, 2005, dividends of $42,000 were received on the common stock donated by
Morris.
Prepare journal entries for Roark City to record the foregoing transactions and events in
the appropriate funds. Identify the funds. Disregard entries for accrual of dividends and for
unrealized gains or losses on investments. Omit explanations for the journal entries.
(Exercise 19.8) Ledger account balances on June 30, 2006, applicable to the City of Carvell Pension Trust
Fund statement of changes in pension plan net assets for the fiscal year ended on that date,
were as follows:

CHECK FIGURE
Administrative expenses $294,600
Ending net assets,
Annuity benefits 284,300
$841,700.
Disability benefits 52,800
Employer contributions 318,500
Net assets held in trust for pension benefits, July 1, 2005 841,000
Investment revenues (net) 163,900
Employee contributions 211,600
Refunds of contributions 61,600

Prepare a statement of changes in fiduciary net assets for the City of Carvell Pension
Trust Fund for the year ended June 30, 2006.
(Exercise 19.9) Among the transactions or events of Local Town for the month of November, 2005, were
the following:
Nov. 3 Issued at face amount $1 million of general obligation bonds, the proceeds of
which were to finance construction of a new water treatment plant for water
sold to residents of the town.
5 Received an invoice of $25,000 in the General Fund for equipment for which
a purchase order in the amount of $24,700 had been issued earlier. The town
uses encumbrance accounting.
7 Acquired for $50,000 cash supplies for the central warehouse, to be issued to
various departments of the town. The perpetual inventory system is used for
supplies.
30 Issued bills totaling $80,000 to consumers of the water utility, for water con-
sumption for the 30 days ended November 30, 2005.
Prepare journal entries (omit explanations) for the foregoing transactions or events of
Local Town for the month of November 2005. Identify the fund or voluntarily maintained
account group in which each journal entry is recorded.

Cases
(Case 19.1) You have been requested to audit the financial statements of the funds and voluntarily main-
tained account groups of Ashburn City for the fiscal year ended June 30, 2006. During the
course of your audit, you learned that on July 1, 2005, the city had issued at face amount
804 Part Five Accounting for Nonbusiness Organizations

$1 million, 20-year, 8% general obligation serial bonds to finance additional power-generating

facilities for the Ashburn City electric utility. Principal and interest on the bonds were
payable by the Ashburn City Electric Utility Enterprise Fund. However, for the first five
years of the serial maturities of the bonds—July 1, 2006, through July 1, 2010—a special
tax levy accounted for in the Ashburn City Special Revenue Fund was to contribute to the
payment of 80% of the interest and principal of the general obligation bonds. At the end of
the five-year period, revenues from the electric utility’s new power-generating facilities are
expected to produce cash flows for the Ashburn City Electric Utility Enterprise Fund suffi-
cient to pay all the serial maturities and interest of the general obligation bonds during the
period July 1, 2011, through July 1, 2025.
You found that the accounting records of the Ashburn City Electric Utility Enterprise
Fund included the following ledger account balances relative to the general obligation
bonds on June 30, 2006:

8% general obligation serial bonds payable ($50,000 due July 1, 2006) $1,000,000 cr
Interest payable (interest on the bonds is payable annually each July 1) 80,000 cr
Interest expense 80,000 dr

The statement of revenues, expenses, and changes in net assets for the year ended
June 30, 2006, prepared by the accountant for the Ashburn City Electric Utility Enterprise
Fund showed a decrease in net assets of $40,000. You also learned that on July 1, 2006,
the Ashburn City Special Revenue Fund paid $104,000 ($130,000 0.80 $104,000)
and the Ashburn City Electric Utility Enterprise Fund paid the remaining $26,000
($130,000 0.20 $26,000) to the fiscal agent for the 8% general obligation serial
bonds. The $130,000 was the total of the $50,000 principal and $80,000 interest due on the
bonds July 1, 2006. In the Enterprise Fund’s journal entry to record payment of the bond
principal and interest, the amount of $104,000 was credited to the Transfer In ledger
account.

Instructions
Do you concur with the Ashburn City Electric Utility Enterprise Fund’s accounting and re-
porting treatment for the 8% general obligation serial bonds? Discuss.
(Case 19.2) Wallace and Brenda Stuart, residents of Colby City, have donated their historic man-
sion, “Greystone,” in trust to Colby City to serve as a tourist attraction. For a nominal
charge, tourists will be guided through Greystone to observe the paintings, sculptures,
antiques, and other art objects collected by the Stuarts, as well as the mansion’s unique
architecture.
The trust indenture executed by the Stuarts provided that the admissions charges to
Greystone (which was appraised at $5 million on the date of the trust indenture) are to
cover the operating expenditures associated with the tours, as well as maintenance and
repairs costs for Greystone. Any excess of admissions revenues over the foregoing expen-
ditures and costs was to be donated to Colby University for scholarships to art and archi-
tecture students. The trust indenture requires depreciation of Greystone.

Instructions
Discuss the fund accounting issues, and related accounting matters such as deprecia-
tion, that should be considered by officials of Colby City with respect to the Stuart
Trust.
 Chapter 19 Governmental Entities: Proprietary and Fiduciary Funds, CAFR 805

Problems
(Problem 19.1) Among the transactions and events of Kaspar City for the first four months of the fiscal year
ending June 30, 2006, were the following:
CHECK FIGURE 2005
Aug. 1, debit cash in July 1 Billed general property taxes, $1,600,000, of which 5% was estimated to be
Enterprise Fund, uncollectible.
$1,115,574.
Aug. 1 Issued $1 million, 20-year, 7% general obligation bonds to yield 6%, interest
payable February 1 and August 1, to finance construction of a power-generating
facility for the electricity utility.
Sept. 1 Received invoice in General Fund for a new computer for governmental ac-
counting. Cost of the computer and related software was $10,000; the related
purchase order had been issued for $10,200.
Oct. 1 Received invoice in General Fund for supplies received from Internal Service
Fund, $1,200. The amount had not been subject to encumbrance.

Instructions
Prepare journal entries for the foregoing transactions or events of Kaspar City for the first
four months of the fiscal year ended June 30, 2006, in all affected funds or voluntarily
maintained account groups. Identify the funds or account groups. The Internal Service
Fund uses the periodic inventory system.
(Problem 19.2) The adjusted trial balance of the Town of Tolliver Enterprise Fund on June 30, 2006, was as
follows:

CHECK FIGURES
TOWN OF TOLLIVER ENTERPRISE FUND
Increase in net assets,
Adjusted Trial Balance
$57,000; total assets June 30, 2006
$1,361,000.
Debit Credit
Cash—unrestricted $ 22,000
Cash—restricted 38,000
Short-term investments, at fair value—unrestricted 64,000
Short-term investments, at fair value—restricted 97,000
Accounts receivable 64,000
Allowance for doubtful accounts $ 12,000
Receivable from General Fund 26,000
Receivable from Internal Service Fund 18,000
Inventory of supplies, at average cost 47,000
Short-term prepayments 8,000
Land 160,000
Buildings 830,000
Accumulated depreciation of buildings 186,000
Machinery and equipment 247,000
Accumulated depreciation of machinery and equipment 62,000
Vouchers payable 38,000
Contracts payable 27,000
(continued)
806 Part Five Accounting for Nonbusiness Organizations

TOWN OF TOLLIVER ENTERPRISE FUND

Adjusted Trial Balance (concluded)
June 30, 2006

Debit Credit
Accrued liabilities 18,000
Interest payable 24,000
Customers’ deposits 38,000
6% revenue bonds, payable $40,000 a year 400,000
Net assets restricted for revenue bonds retirement 33,000
Unrestricted net assets, beginning of year 726,000
Charges for services 643,000
Operating grants 50,000
Investment revenue and net gains 12,000
Personal services 281,000
Contractual services 143,000
Material and supplies 46,000
Heat, light, and power 38,000
Depreciation expense 57,000
Interest expense and fiscal agent’s fees 83,000
Totals $2,269,000 $2,269,000

Instructions
Prepare a statement of revenues, expenses, and changes in net assets and a statement of net
assets for the Town of Tolliver Enterprise Fund for the fiscal year ended June 30, 2006.
(Problem 19.3) In compliance with a newly enacted state law, Diggs County assumed the responsibility of
collecting all property taxes levied within its boundaries as of July 1, 2005. A composite
property tax rate per $100 of net assessed valuation was developed for the fiscal year end-
ing June 30, 2006, and is presented below:

Diggs County General Fund $ 6.00

Evans City General Fund 3.00
Hickman Township General Fund 1.00
Total $10.00

All property taxes were due in quarterly installments. After collection, taxes were to be
distributed to the governmental entities represented in the composite rate. In order to ad-
minister collection and distribution of such taxes, Diggs County established a Tax Agency
Fund.
Additional Information
1. In order to reimburse Diggs County for estimated costs of administering the Tax Agency
Fund, the Tax Agency Fund was to deduct 2% from the tax collections each quarter for
Evans City and Hickman Township. The total amount deducted was to be remitted to the
Diggs County General Fund.
2. Current year tax levies to be collected by the Tax Agency Fund were as follows:
 Chapter 19 Governmental Entities: Proprietary and Fiduciary Funds, CAFR 807

Gross Estimated Amount

Levy to Be Collected
Diggs County $3,600,000 $3,500,000
Evans City 1,800,000 1,740,000
Hickman Township 600,000 560,000
Totals $6,000,000 $5,800,000

3. As of September 30, 2005, the Diggs County Tax Agency Fund had received $1,440,000
in first-quarter payments. On October 1, 2005, the Diggs County Tax Agency Fund made
a distribution to the three governmental entities.
Instructions
For the period July 1, 2005, through October 1, 2005, prepare journal entries (explanations
omitted) to record the foregoing transactions and events for the following funds:
Diggs County Tax Agency Fund Evans City General Fund
Diggs County General Fund Hickman Township General Fund
Your working paper should be organized as follows:

Diggs Diggs Hickman

County County Evans City Township
Tax Agency General General General
Fund Fund Fund Fund
Account Titles dr(cr) dr(cr) dr(cr) dr(cr)

(Problem 19.4) The Town of Northville was incorporated and began operations on July 1, 2005. The
following transactions and events occurred during the first fiscal year, July 1, 2005, to June
30, 2006:
(1) The town council adopted a budget for general operations during the year ending
June 30, 2006. Revenues were estimated at $400,000. Legal authorizations for bud-
geted expenditures were $394,000. There were no other financing sources or uses.
(2) Property taxes were levied in the amount of $390,000; it was estimated that 2% of this
amount would be uncollectible. These taxes were available on the date of levy to fi-
nance current expenditures.
(3) During the year a resident of the town donated marketable securities with a current
fair value of $50,000 to the town under a trust. The terms of the trust indenture spec-
ified that the principal amount was to be kept intact; use of revenues generated by the
securities was restricted to financing college scholarships for students. Revenues
earned and received on these marketable securities amounted to $5,500 through
June 30, 2006.
(4) A General Fund transfer of $55,000 was made to establish an Internal Service Fund
to provide for an inventory of supplies.
(5) The town council decided to install lighting in the Town Park, and a special assessment
project was authorized to install the lighting at a cost of $75,000. The assessments were
levied for $72,000, with the town contributing $3,000 from the General Fund. All as-
sessments were collected during the year, as was the General Fund contribution.
808 Part Five Accounting for Nonbusiness Organizations

(6) A contract for $75,000 was approved for the installation of the lighting. On June 30,
2006, the lighting was completed but not approved. The contractor was paid all but
5%, which was retained to ensure compliance with the terms of the contract. Encum-
brances accounts are maintained.
(7) During the year, the Internal Service Fund purchased supplies at a cost of $41,900.
(8) Cash collections recorded by the General Fund during the year were as follows:

Property taxes $386,000

Licenses and permits fees 7,000

(9) The town council decided to build a town hall at an estimated cost of $500,000 to re-
place space occupied in rented facilities. The town does not record project authoriza-
tions. General obligation term bonds bearing interest at 6% were to be issued. On June
30, 2006, the bonds were issued at their face amount of $500,000, payable June 30,
2026. No contracts had been signed for this project and no expenditures had been made.
(10) A fire truck was acquired for $16,000, and the voucher was approved and paid by the
General Fund. This expenditure previously had been encumbered for $15,000.

Instructions
Prepare journal entries for the Town of Northville to record each of the foregoing transac-
tions and events in the appropriate fund or account group. Omit explanations for the journal
entries. Do not prepare closing entries for any fund. Organize your working paper as follows:

Transaction or Fund or Account

Event No. Account Group Titles Debit Credit

Number each journal entry to correspond with the transactions or events described on
page 807 and above. Use the following funds (show fund symbol in working paper) and ac-
count titles:

Endowment Principal Private-Purpose Trust Fund (EPF)

Cash
Investments
Other Financing Uses—Transfers Out
Payable to Endowment Revenues Private-Purpose Trust Fund
Revenues
Endowment Revenues Private-Purpose Trust Fund (ERF)
Cash
Other Financing Sources—Transfers In
Receivable from Endowment Principal Private-Purpose Trust Fund
General Capital Assets Account Group (GCA) (voluntarily maintained)
Improvements (Other than Buildings)
Investment in General Capital Assets from Capital Projects Funds
Investment in General Capital Assets from General Fund Revenues
Machinery and Equipment
General Fund (GF)
Allowance for Uncollectible Current Taxes
Appropriations
Budgetary Fund Balance
Cash
(continued)
 Chapter 19 Governmental Entities: Proprietary and Fiduciary Funds, CAFR 809

Encumbrances
Estimated Revenues
Expenditures
Fund Balance Reserved for Encumbrances
Other Financing Uses
Payable to Special Revenue Fund
Revenues
Taxes Receivable—Current
Vouchers Payable
General Long-Term Debt Account Group (GLTD) (voluntarily maintained)
Amount to Be Provided
Term Bonds Payable
Internal Service Fund (ISF)
Cash
Other Financing Sources
Inventory of Supplies
Special Revenue Fund (SRF)
Cash
Other Financing Sources
Receivable from General Fund
Revenues
Special Assessments Receivable—Current
Town Hall Capital Projects Fund (TH)
Cash
Other Financing Sources
Town Park Lighting Capital Projects Fund (TPL)
Cash
Encumbrances
Expenditures
Fund Balance Reserved for Encumbrances
Vouchers Payable

(Problem 19.5) The City of Cavendish operates a central garage in an Internal Service Fund to provide
garage space and repairs for all city-owned and -operated vehicles. The Internal Service
Fund was established by a contribution of $200,000 from the General Fund on July 1, 2003,
at which time the building was acquired. The post-closing trial balance of the Internal Ser-
vice Fund on June 30, 2005, was as follows:

CITY OF CAVENDISH INTERNAL SERVICE FUND

Post-Closing Trial Balance
June 30, 2005

Debit Credit
Cash $150,000
Receivable from General Fund 20,000
Inventory of material and supplies 80,000
Land 60,000
Building 200,000
Accumulated depreciation of building $ 10,000
Machinery and equipment 56,000
Accumulated depreciation of machinery and equipment 12,000
Vouchers payable 38,000
Net assets, beginning of year 506,000
Totals $566,000 $566,000
810 Part Five Accounting for Nonbusiness Organizations

Additional Information for the Fiscal Year Ended June 30, 2006:
(1) Material and supplies were purchased on account for $74,000.
(2) The perpetual inventory balance of material and supplies on June 30, 2006, was
$58,000, which agreed with the physical count on that date.
(3) Salaries and wages paid to employees totaled $230,000, including related fringe benefits.
(4) A billing was received from the Enterprise Fund for utility charges totaling $30,000,
and was paid.
(5) Depreciation of the building was recognized in the amount of $5,000. Depreciation of
the machinery and equipment amounted to $8,000.
(6) Billings to other funds for services rendered to them were as follows:

General Fund $262,000

Enterprise Fund 84,000
Special Revenue Fund 32,000

(7) Unpaid interfund receivable balances on June 30, 2006, were as follows:

General Fund $ 6,000

Special Revenue Fund 16,000

(8) Vouchers payable on June 30, 2006, were $14,000.

Instructions
For the fiscal year July 1, 2005, through June 30, 2006, prepare journal entries to record all
the transactions and events for the City of Cavendish Internal Service Fund. Omit explana-
tions for the entries. Use the following account titles, in addition to those included in the
June 30, 2006, post-closing trial balance:
Charges for Services Payable to Enterprise Fund
Operating Expenses Receivable from Enterprise Fund
(controlling account) Receivable from Special Revenue Fund
(Problem 19.6) Your audit of the financial statements of the Town of Novis for the fiscal year ended June 30,
2006, disclosed that the town’s inexperienced accountant was uninformed regarding govern-
CHECK FIGURE mental accounting standards and recorded all transactions and events in the General Fund.
b. Trial balance totals, The following Town of Novis General Fund trial balance was prepared by the accountant:
$34,200.

TOWN OF NOVIS GENERAL FUND

Trial Balance
June 30, 2006

Debit Credit
Cash $ 12,900
Accounts receivable 1,200
Taxes receivable—current 8,000
Town property 16,100
Vouchers payable $ 15,000
Bonds payable 48,000
(continued)
 Chapter 19 Governmental Entities: Proprietary and Fiduciary Funds, CAFR 811

TOWN OF NOVIS GENERAL FUND

Trial Balance (concluded)
June 30, 2006

Debit Credit
Unreserved and undesignated fund balance 23,200
Appropriations 350,000
Expenditures 332,000
Estimated revenues 290,000
Revenues $320,000
Totals $708,200 $708,200

Your audit disclosed the following:

1. The accounts receivable balance was due from the town’s water utility for the sale of ob-
solete equipment on behalf of the General Fund. Accounts for the water utility operated
by the town are maintained in the Water Utility Enterprise Fund.
2. The total property tax levy for the year was $270,000. The town’s tax collection experi-
ence in recent years indicates an average loss of 3% of the total property tax levy for un-
collectible taxes.
3. On June 30, 2006, the town retired at face amount 12% general obligation serial bonds
totaling $30,000. The bonds had been issued on July 1, 2001, in the total amount of
$150,000. Interest paid during the year also was recorded in the Bonds Payable ledger
account. There was no debt service fund for the serial bonds.
4. On July 1, 2005, to service various departments the town council authorized a supply
room with an inventory not to exceed $10,000. During the year supplies totaling
$12,300 were purchased and debited to Expenditures. The physical inventory taken on
June 30, 2006, disclosed that supplies totaling $8,400 had been used. No internal service
fund was authorized by the town council.
5. Expenditures for Fiscal Year 2006 included $2,600 applicable to purchase orders issued
in the prior year. Outstanding purchase orders on June 30, 2006, not entered as encum-
brances in the accounting records, amounted to $4,100.
6. The amount of $8,200, receivable from the state during Fiscal Year 2006 for the town’s
share of state gasoline taxes, had not been entered in the accounting records, because the
state was late in remitting the $8,200.
7. Equipment costing $7,500, which had been acquired by the General Fund, was removed
from service and sold for $900 during the year, and new equipment costing $17,000 was
acquired. These transactions were recorded in the Town Property ledger account. The
town does not recognize depreciation in the General Capital Assets Account Group.
Instructions
a. Prepare adjusting and closing entries for the Town of Novis General Fund on June 30,
2006.
b. Prepare a post-closing trial balance for the Town of Novis General Fund for the year
ended June 30, 2006.
c. Prepare adjusting entries for any other funds or account groups of the Town of Novis.
(The town’s accountant had recorded all the foregoing transactions or events in the Gen-
eral Fund, and had prepared no journal entries for other funds or voluntarily maintained
account groups.)
812 Part Five Accounting for Nonbusiness Organizations

(Problem 19.7) Selected financial statements of the Village of Rosner Enterprise Fund are as follows:

CHECK FIGURE
VILLAGE OF ROSNER ENTERPRISE FUND
Net cash provided by
Statement of Revenues, Expenses, and Changes in Net Assets
operating activities,
For Year Ended June 30, 2006
$146,000.
Operating revenues:
Charges for services $282,000
Operating expenses:
Personal services $ 41,000
Contractual services 26,000
Material and supplies 37,000
Heat, light, and power 11,000
Depreciation 36,000
Payment in lieu of property taxes 15,000
Total operating expenses 166,000
Operating income $116,000
Nonoperating revenues (expenses):
Operating grant $ 20,000
Investment revenue and net gains 8,000
Interest expense (40,000)
Total nonoperating revenues (expenses) (12,000)
Income before transfers $104,000
Transfer (out) to General Fund (55,000)
Increase in net assets $ 49,000
Net assets, beginning of year 282,000
Net assets, end of year $331,000

VILLAGE OF ROSNER ENTERPRISE FUND

Statements of Net Assets
June 30, 2006 and 2005

June 30,
2006 2005
Assets
Current assets:
Cash and short-term investments $ 41,000 $ 32,000
Accounts receivable (net) 82,000 76,000
Receivable from General Fund 12,000 8,000
Inventory of supplies 21,000 23,000
Short-term prepayments 4,000 5,000
Total current assets $160,000 $144,000
Restricted assets:
Cash and short-term investments 118,000 106,000
Capital assets (net) 641,000 614,000
Total assets $919,000 $864,000

(continued)
 Chapter 19 Governmental Entities: Proprietary and Fiduciary Funds, CAFR 813

VILLAGE OF ROSNER ENTERPRISE FUND

Statements of Net Assets (concluded)
June 30, 2006 and 2005

June 30,
2006 2005
Liabilities
Current liabilities:
Vouchers payable $ 67,000 $ 73,000
Accrued liabilities 46,000 39,000
Total current liabilities $113,000 $112,000
Liabilities payable from restricted assets:
Interest payable $ 20,000 $ 20,000
Current portion of revenue bonds $ 50,000 -0-
Customers’ deposits 55,000 50,000
Total liabilities payable from restricted assets $125,000 $ 70,000
Long-term debt:
10% revenue bonds payable $350,000 $400,000
Total liabilities $588,000 $582,000

Net Assets
Net assets:
Invested in capital assets, net of related debt $241,000 $214,000
Restricted for revenue bonds retirement 43,000 36,000
Unrestricted 47,000 32,000
Total net assets $331,000 $282,000

Additional Information for the Fiscal Year Ended June 30, 2006
(1) The 10% revenue bonds, which pay interest January 1 and July 1, are due serially
$50,000 a year beginning July 1, 2006.
(2) New customers’ deposits totaled $7,000; refunds of customers’ deposits amounted to
$2,000.
(3) Capital assets with a carrying amount of $22,000 were disposed of for that amount;
new capital assets were acquired for cash.
(4) A $55,000 transfer of net assets was made to the General Fund.
(5) The short-term investments are cash equivalents.
Instructions
Prepare a statement of cash flows (indirect method) for the Village of Rosner Enterprise
Fund for the fiscal year ended June 30, 2006.
Glossary
A American Institute of Certified Public Accountants
(AICPA) The national professional organization of certified
abatement sequence The order of reduction of devises in public accountants licensed by the states and territories of
the will of a decedent whose estate property is insufficient to the United States
pay all the decedent’s liabilities and cover all devises; the annual budget A budget prepared for the general fund
order is as follows: property not specifically mentioned in and special revenue funds of a governmental entity; includes
the will, residuary devises, general devises, specific devises estimated revenues, estimated other financing sources, ap-
account group A set of memorandum ledger accounts propriations, and estimated other financing uses for a fiscal
established voluntarily by a governmental entity to account year
for plant assets (general capital assets account group) and annuity fund A fund established by a nonprofit organization
long-term debt (general long-term debt account group) not to account for assets contributed to the organization, the
recorded in a fund of the governmental entity income from which is the source of fixed periodic payments
accountability method The method of accounting used to designated recipients for a specified time period
by a trustee in bankruptcy or by the personal representative appropriations Authorized expenditures of a governmental
of a decedent’s estate, evidenced by the equation Assets entity’s general fund and special revenue funds, as approved
Accountability by the legislative and executive authorities of the entity and
Accounting and Auditing Enforcement Releases (AAERs) set forth in the annual budget
A series of pronouncements initiated by the Securities and associate The International Accounting Standards Board’s
Exchange Commission (SEC) in 1982 to report its enforce- term for influenced investee
ment actions involving accountants and accounting issues
Accounting Series Releases (ASRs) Pronouncements of B
the chief accountants of the SEC from 1937 to 1982 de-
signed to contribute to the development of uniform standards bankrupt A legal state in which an insolvent debtor is
and practice in major accounting questions given protection from creditors’ claims by the Bankruptcy
acquisition of assets A business combination in which Court
one business enterprise acquires the gross or net assets of Bankruptcy Code The federal law governing bankruptcies
another enterprise by paying cash or issuing equity or debt in the United States
securities bankruptcy liquidation The procedure under Chapter 7 of
acquisition of common stock A business combination in the Bankruptcy Code in which a trustee realizes the debtor’s
which an investor enterprise issues cash or equity or debt nonexempt assets and pays creditors as specified in the
securities to acquire a controlling interest in the outstanding Bankruptcy Code
common stock of an investee enterprise, which is not bankruptcy reorganization The procedure under Chap-
liquidated but becomes a subsidiary of the investor parent ter 11 of the Bankruptcy Code in which a business enterprise
company is protected from creditor’s claims while it develops a plan
administrator An intestate decedent’s personal represen- for restructuring its liabilities and stockholders’ equity
tative, who is appointed by the probate court bargain-purchase excess The excess of the current fair
affiliate A business enterprise that is controlled or signifi- value of the combinee’s identifiable net assets in a business
cantly influenced by another enterprise combination over the cost to the combinor
agency funds Fiduciary funds of a governmental entity, of beneficiary The party for whose benefit a trust is established
short duration, that account for sales taxes, payroll taxes, branch A unit of a business enterprise, located at some
and other such amounts collected by the governmental entity distance from the home office, that carries merchandise
for later payment to other governmental entities entitled to obtained from the home office, makes sales, approves
the taxes and other amounts; also, funds of nonprofit customers’ credit, and makes collections from its customers
organizations used for assets held by the organizations as budgetary deficit An excess of appropriations and
custodian estimated other financing uses over estimated revenues and
agio (spread) The difference between the selling spot rate estimated other financing sources in the annual budget of a
and the buying spot rate of a foreign currency governmental entity’s general fund

814
 Glossary 815

budgetary surplus An excess of estimated revenues and collections Nonexhaustible resources of nonprofit muse-
estimated other financing sources over appropriations and ums, art galleries, botanical gardens, libraries, and similar
estimated other financing uses in the annual budget of a nonprofit organizations, for which a determination of fair
governmental entity’s general fund and special revenue value is impracticable and depreciation is inappropriate
funds combined enterprise The accounting entity that results
business combination An entity’s acquisition of net assets from a business combination
that constitute a business or of equity interests in one or combinee A constituent company other than the combinor
more entities and obtains control over that entity or entities in a business combination
buying spot rate The exchange rate paid by a foreign combinor A constituent company entering into a business
currency dealer “on the spot” combination whose owners as a group end up with control
of the ownership interests in the combined enterprise
component of an entity Operations and cash flows that
C can be clearly distinguished, operationally and for financial
reporting purposes, from the rest of the entity
capital budget A budget prepared for a capital projects
fund of a governmental entity; includes the estimated component unit An organization included in a govern-
resources available for a capital project and the estimated mental financial reporting entity because the primary
costs of completion of the project government is financially accountable for the organization or
because of the relationship of the organization to the primary
capital expenditures Expenditures for capital (plant)
government
assets of a governmental entity
comprehensive annual financial report (CAFR) The
capital lease A lease that, from the viewpoint of the lessee,
annual report required by the Governmental Accounting
is equivalent to the acquisition, rather than the rental, of
Standards Board to be prepared by every governmental
property from the lessor
entity as a matter of public record
capital projects funds Governmental funds that record
comprehensive income The change in equity of a
the receipt and payment of cash for the construction or
business enterprise during a period from transactions and
acquisition of the governmental entity’s capital (plant) assets
other events and circumstances from nonowner sources
other than those accounted for in proprietary funds or trust
funds conflict of interest A situation in which an individual
reaps an inappropriate personal benefit from his or her acts
cash distribution program A plan prepared for a liqui-
in an official capacity
dating partnership to show the appropriate sequence for
paying cash as it becomes available to partnership creditors conglomerate A group of affiliated business enterprises in
and to partners unrelated industries or markets
cash equivalents Short-term investments that are readily conglomerate combination A business combination
marketable and have maturity dates no longer than three between enterprises in unrelated industries or markets
months consolidated financial statements Financial statements of
certificate A document evidencing formation of a limited a single economic entity composed of several legal entities
partnership, filed with the county recorder of the principal (parent company and subsidiaries)
place of business of the limited partnership constituent companies The business enterprises that enter
change in the reporting entity A type of accounting into a business combination
change, dealt with in APB Opinion No. 20, “Accounting contingent consideration Additional cash, other assets, or
Changes,” that requires an adjustment to beginning-of- securities that may be issuable in the future, contingent on
period retained earnings future events such as a specified level of earnings or a
channel stuffing Artificially accelerating product delivery designated market price for a security that had been issued
schedules at the end of an accounting period to complete a business combination
charge and discharge statement The financial statement contractual adjustments Discounts from full billing rates
prepared on behalf of the personal representative of a dece- of nonprofit hospitals provided in contracts with third-party
dent’s estate, submitted to the probate court; a comparable payors such as Medicare and Medicaid
financial statement prepared on behalf of the trustee of a contributory pension plan A pension plan that requires
trust contributions from employees as well as employers
charity care Health services provided by nonprofit convergence project A joint activity of the Financial
hospitals to indigent patients, there being no expectation of Accounting Standards Board and the International Account-
resultant cash flows to the hospital ing Standards Board, the goal of which is to compare the
816 Glossary

two boards’ existing standards and conform the two sets of special assessment bonds, revenue bonds, and general ob-
standards into the higher-quality solution ligation bonds serviced by an enterprise fund
“cookie jar reserves” A “cooking the books” technique debtor in possession Management of a business enterprise
that involves establishing fictitious liabilities for bogus ex- undergoing reorganization under Chapter 11 of the Bankruptcy
penses or revenue in a highly profitable period, and revers- Code that continues to operate the enterprise during the
ing the liabilities in subsequent low earnings periods reorganization
“cooking the books” Fraudulent financial reporting debtor’s (voluntary) petition A bankruptcy petition in-
cost method The method of accounting for an investment itiated by an insolvent debtor
in a subsidiary that recognizes parent company revenue only defined benefit pension plan A pension plan under which
to the extent the subsidiary declares dividends from retained the basis of computation of pension benefits for retired
earnings accumulated after the date of the business com- employees usually involves employee compensation, years
bination of service, and age on date of retirement
credit risk The risk of nonperformance by a party to a derivative instrument A financial instrument or other
financial instrument or derivative instrument contract contract that has (1) one or more underlyings and (2) one or
more notional amounts or payment provisions or both;
creditors’ (involuntary) petition A bankruptcy petition
requires no initial net investment or a smaller-than-expected
initiated by creditors of an insolvent debtor in accordance
initial net investment; and has terms requiring or permitting
with provisions of the Bankruptcy Code
net settlement or related settlement options
cumulative preferred stock Preferred stock that requires
designated fund balance A segregated amount of the
dividends “passed” in one year to be declared and paid in a
fund balance of a nonprofit organization’s unrestricted fund
subsequent year, together with that year’s regular dividends,
or of the general fund of a governmental entity that
to preferred stockholders before dividends may be declared
evidences the earmarking of the fund’s net assets for a
and paid to common stockholders
purpose specified by the organization’s governing board or
current/noncurrent method A method of translating legislative body
foreign currency financial statements in which current
devise A transfer of real or personal property in a will
assets and liabilities are translated at the current exchange
rate on the balance sheet date, while other assets, other devisee The recipient of a devise
liabilities, and owners’ equity elements are translated at direct out-of-pocket costs Some legal fees, some
historical rates. Depreciation and amortization expenses accounting fees, and finder’s fee incurred specifically to
are translated at historical rates; all other revenue and accomplish a business combination
expenses are translated at an average rate for the discharge Forgiveness of all except specified unpaid lia-
accounting period bilities of a debtor that underwent liquidation under Chap-
current rate method A method of translating foreign ter 7 of the Bankruptcy Code
currency financial statements in which all balance sheet discontinued operations Operations of a component
amounts other than owners’ equity are translated at the (operating segment) that has been sold, abandoned, spun off,
current exchange rate, while owners’ equity elements are or otherwise disposed of, or, although still operating, is the
translated at historical rates. All revenue and expense items subject of a formal plan for disposal by a business enterprise
are translated at the appropriate current rate or at an average discrete theory A theory of interim financial reporting
of current rates that considers each interim period a basic accounting period
“cute accounting” Stretching the form of accounting whose operating results are measured in essentially the same
standards to the limit, regardless of the substance of the un- manner as for an annual accounting period
derlying business transaction or events dissolution A change in the relationship among partners
of a partnership, caused by any partner’s ceasing to be
associated in the carrying on of the partnership business
D division A segment of a business enterprise that generally
death taxes Federal estate taxes on the principal of has more autonomy than a branch; a segment that often was
a decedent’s estate and state inheritance taxes on devisees formerly an independent enterprise, but subsequently was a
receiving devises constituent company—typically the combinee—in a busi-
debt service expenditures Expenditures for interest on ness combination
operating debt of a governmental entity, such as short-term downstream intercompany sales Sales of merchandise by
loans a parent company to a subsidiary of the parent
debt service funds Governmental funds that account for drawing A partner’s withdrawal of cash or other assets
payments of principal and interest on long-term bonds and from a partnership in accordance with terms of the partnership
other long-term debt of a governmental entity other than contract
 Glossary 817

external investment pools Pooled investments of small

E governmental units such as towns and villages, maintained
economic unit concept A concept of consolidated by larger governmental entities such as counties and states,
financial statements of a parent company and one or more the object being the realization of a larger return on the
partially owned subsidiaries that views the consolidated investments than would be possible apart from the pool
enterprise as a single entity with ownership by parent
company stockholders and subsidiary minority stock- F
holders
family allowance A reasonable cash allowance, payable in a
EDGAR The Electronic Data Gathering, Analysis, and
lump sum not exceeding a specified amount, to the decedent’s
Retrieval project of the SEC, designed to permit “paperless”
spouse or children during the administration of an estate
filings with the SEC over telephone lines, on diskettes, or on
magnetic tapes fiduciaries The individuals or business enterprises that
manage the property in estates and trusts
encumbrance accounting An accounting method for
governmental funds of a governmental entity that entails a fiduciary funds Private-purpose and other trust funds, and
debit to Encumbrances and a credit to Fund Balance Reserved agency funds, of a governmental entity that account for
for Encumbrances when purchase orders or contracts for resources that are not owned by the entity but are adminis-
nonrecurring expenditures are issued by the funds tered by the entity as a custodian or fiduciary
endowment A gift placed in trust that generally requires financial accountability A situation in which a primary
the principal of the gift to be maintained intact, with revenues government appoints a majority of the governing body of
from the investment of the gift used for the purposes another organization and thus imposes its will on the
specified by the donor of the gift organization or is responsible for providing financial benefits
to, or financial burdens on, the other organization
endowment fund A nonprofit organization’s fund whose
principal must be maintained intact permanently or tem- Financial Executives International (FEI) The profes-
porarily and whose income is expendable by the organization sional organization of financial vice presidents, controllers,
for a specified or elective purpose and treasurers of business enterprises
enterprise funds Proprietary funds of a governmental financial forecast Prospective financial statements that
entity that account for any activity for which a fee is charged present an entity’s expected financial position, results of
to external users for goods or services operations, and cash flows
equity method The method of accounting for an investment financial instrument Cash, evidence of an ownership
in a corporate or an unincorporated joint venture that in- interest in an entity, or a contract that imposes both a right
creases the venturer’s Investment account balance for the on one entity and an obligation on another entity to
venturer’s share of venture net income and decreases the exchange cash or other financial instruments
account balance for the venturer’s share of venture net losses, financial reporting entity The primary government and
dividends, or other cash remittances; also, the method of other component units that comprise the governmental entity
accounting for an investment in a subsidiary that increases that issues financial reports
the parent company’s Investment account balance for the Financial Reporting Releases (FRRs) A series of pro-
parent’s share of subsidiary net income and decreases the nouncements initiated by the SEC in 1982 to state its views
account balance for the parent’s share of subsidiary net on financial reporting matters
losses and dividends financial resources Cash, claims to cash such as receivables
estate All the property of a decedent, trust, or other person and investments, inventories, and short-term prepayments of
whose affairs are subject to the Uniform Probate Code governmental funds of a governmental entity
exchange rate The ratio between one unit of each of two finder’s fee A fee paid to an investment banker or other
foreign currencies organization or individuals that investigated the combinee,
executor The personal representative of a decedent, named assisted in determining the price, and otherwise rendered
in the decedent’s will services to bring about a business combination
exempt property Property of a decedent excluded from foreign currency transaction A transaction of a business
claims of the decedent’s creditors and devisees, including enterprise that is denominated in a currency other than the
aggregate specified value of automobiles, household furniture local currency of the enterprise
and furnishings, and personal effects foreign currency transaction gains (losses) Gains and
expendable private-purpose trust funds Fiduciary funds losses recognized on transactions denominated in a foreign
of a governmental entity, of long duration, that account for currency or in the remeasurement to the functional currency
the receipt and expenditure of revenues produced by the of foreign entities’ financial statements maintained in the
principal of the trust, which is nonexpendable local currency
818 Glossary

foreign currency translation Restating a transaction together with all related liabilities and residual equities or
denominated in a foreign currency to the local currency of balances, and changes therein, which are segregated for the
the transacting enterprise purpose of carrying on specific activities or attaining certain
foreign currency translation adjustments A balancing objectives in accordance with special regulations, restrictions,
amount resulting from the translation of a foreign entity’s or limitations
financial statements from the entity’s functional currency to
the reporting currency of the parent company or investor
enterprise G
Form 8-K A current report filed by a publicly owned general capital assets account group The memorandum
company with the SEC within a specified number of days set of accounts of a governmental entity in which are recorded
following the occurrence of specified events or events plant assets that are not in a fund
elected to be reported by the company
general devise A decedent’s gift of an amount of money
Form 10 A registration statement filed by a publicly owned or a number of countable monetary items
company with the SEC in connection with trading of the
general long-term capital debt Liabilities expected to be
company’s securities on a national exchange or over the
paid from the financial resources of governmental funds and
counter
that provide long-term financing to acquire a governmental
Form 10-K The annual report filed by a publicly owned entity’s capital assets, including infrastructure, or for nonre-
company with the SEC within 60 days following the close of curring projects or activities that have long-term economic
the company’s fiscal year benefit
Form 10-Q A quarterly report filed by a publicly owned general long-term debt account group The memorandum
company with the SEC within 40 days following the close of set of accounts of a governmental entity in which are recorded
each of the company’s first three fiscal-year quarters long-term liabilities that are not recorded in a fund
formal probate Litigation to determine whether a decedent general obligation bonds Bonds issued by a governmental
left a valid will entity that are backed by the full faith and credit of the entity
Forms S-1 through S-4 and F-1 through F-4 Registration and supported by its taxation power
statements filed with the SEC by companies that issue secu- general partnership A partnership in which all the partners
rities to the public interstate are responsible for unpaid liabilities of the firm and all have
forward contract An agreement to exchange currencies authority to act for the firm
of different countries on a specified future date at the forward goodwill In general, an unidentifiable intangible asset
rate in effect when the contract was made whose cost measures the value of excess earnings of an
forward rate The rate of exchange between foreign cur- acquired business enterprise; in a business combination, the
rencies to be exchanged on a future date excess of the combinor’s cost over the current fair values of
fresh start reporting A method of financial reporting the combinee’s identifiable net assets
applied to certain business enterprises emerging from governmental funds The general fund, special revenue
reorganization under Chapter 11 of the Bankruptcy Code in funds, capital projects funds, debt service funds, and perma-
which assets and liabilities are stated at current fair values nent funds of a governmental entity that account for financial
and retained earnings deficits are written off against resources of the entity used in day-to-day operations
additional paid-in capital grant A contribution of cash or other assets received by a
friendly takeover A business combination in which the governmental entity from another government to be used or
boards of directors of the constituent companies generally expended for a specific purpose, activity, or facility
work out the terms of the combination amicably and submit greenmail A tactic used to resist a hostile takeover
the proposal to stockholders of all constituent companies for business combination in which the target combinee acquires
approval its common stock presently owned by the prospective
fully secured creditors Creditors of a debtor in bankruptcy combinor at a price substantially in excess of the prospective
whose claims are collateralized by debtor’s assets having combinor’s cost, with the stock thus acquired placed in the
current fair values in excess of the amount of the claims treasury or retired
functional currency The currency of the primary eco-
nomic environment in which the entity operates; normally,
that is the currency of the environment in which the entity
H
primarily generates and expends cash hedge Measures taken to reduce or eliminate a potential
fund In governmental and nonprofit organization account- unfavorable outcome of a future event
ing, a fiscal and accounting entity with a self-balancing set heirs Recipients of property of an intestate decedent, as
of accounts recording cash and other financial resources, specified by state probate codes
 Glossary 819

highly inflationary economy An economy having cumu- International Financial Reporting Standards Pro-
lative inflation of 100% or more over a three-year period nouncements of the International Accounting Standards
holographic will A will having its essential provisions and Board
signature in the handwriting of the testator intestacy The absence of a will for a decedent
home office The principal business unit of an enterprise intestate Without a valid will
that has branches or divisions investment trust funds Fiduciary funds of a governmental
homestead allowance A specified amount of a decedent’s agency that account for external investment pools for which
property allocated to a decedent’s spouse or surviving minor the entity is the sponsoring government
or dependent children, in addition to property passing to
those persons by devises
horizontal combination A business combination between J
enterprises in the same industry joint venture A partnership of limited duration and with
hostile takeover A prospective business combination in limited projects or other activities
which the target company resists the proposed takeover jointly controlled entity The International Accounting
Standards Board term for joint venture

I
income beneficiary The recipient of income of a testa- L
mentary trust lateral intercompany sales Sales of merchandise by one
informal probate A proceeding by the registrar of a subsidiary of a parent company to another subsidiary of that
probate court that results in the registrar’s making a decedent’s parent
will effective by means of a written statement letters testamentary Authorization document for the
infrastructure Streets, sidewalks, bridges, and the like of personal representative of an estate to begin administration
a governmental entity of the estate
insider trading Purchasing or selling a security while in life income fund A fund established by a nonprofit organi-
possession of material, nonpublic information or commu- zation to account for assets contributed to the organization,
nicating such information in connection with a securities the income from which, in whatever amount, is distributed
transaction in periodic payments to designated recipients for a specified
insolvent Unable to pay liabilities when due because of time period
insufficient assets and poor borrowing potential limited liability company (LLC) An entity that combines
Institute of Management Accountants (IMA) The national features of both partnerships (for federal income tax pro-
professional organization of accountants in industry poses) and corporations (for protection of owners from
integral theory A theory of interim financial reporting personal liability for entity debts)1
that considers each interim period an integral part of the limited liability partnership (LLP) A partnership whose
annual period partners are liable for their own actions and the actions of
inter vivos (living) trust A trust created by a living person partnership employees under their supervision, but not for
interest method A technique for computing interest the actions of other partners; further, an LLP is responsible
revenue or expense that applies the yield rate of bonds to for the actions of all partners and employees
their present value at the beginning of the period for which limited partnership A partnership having, in addition to
interest is to be measured one or more general partners, one or more partners with
internal service funds Proprietary funds of a governmental no responsibility for unpaid liabilities of the partnership
entity that provide supplies and services to other funds, and with restrictions on activities related to the partnership
departments, or agencies of the governmental entity on a liquidation (of partnership) The winding up of part-
cost-reimbursement basis nership activities, usually by selling assets, paying liabilities,
International Accounting Standards Board (IASB) An and distributing any remaining cash to partners
organization of up to 17 members that conducts the business loan fund A fund typically established by a nonprofit
of the International Accounting Standards Committee school, college, or university for loans to students
International Accounting Standards Committee (IASC) local currency unit The unit of currency of the country in
An organization of accounting groups from more than 100 which a business enterprise is located
countries, headquartered in London, whose mission is to
develop accounting standards for potential adoption in the 1
Coopers & Lybrand, Choosing a Business Entity in the 1990’s
countries of the member accounting groups (Washington: Coopers & Lybrand LLP, 1994), p. 27.
820 Glossary

London Interbank Offered Rate (LIBOR) The inter- nonbusiness organizations Governmental entities and
national interest rate banks charge each other for loans nonprofit organizations
noncontributory pension plan A pension plan that
M requires contributions from the employer but not from
management approach The method of operating segment employees
designation that is based on the way a segmented business noncumulative preferred stock Preferred stock whose
enterprise is managed owners have no future claim for dividends “passed” in any
market risk The risk of a decline in value or an increase year
in onerousness of a financial instrument or derivative instru- nonexpendable private-purpose trust funds Fiduciary
ment resulting from future changes in market prices funds of a governmental entity, of long duration, that ac-
marshaling of assets A provision of the Uniform count for the principal of a trust, which must be maintained
Partnership Act that specifies the respective rights of intact
partnership creditors and partners’ personal creditors to nonprofit organization A legal and accounting entity
partnership assets and to partners’ personal assets that generally is operated for the benefit of society as a
master limited partnership A large limited partnership whole, rather than for the benefit of an individual pro-
engaged in ventures such as oil and gas exploration and real prietor or a group of partners or stockholders
estate development that issues units registered with the notional amount A number of currency units, shares, or
Securities and Exchange Commission other units specified in a contract supporting a derivative
minority (noncontrolling) interest The claim of stock- instrument
holders other than the parent company to the net assets and
net income or losses of a partially owned subsidiary O
modified accrual basis of accounting An accounting operating debt Short-term loans obtained by the general
method applied to the governmental funds of a govern- fund of a governmental entity
mental entity in which revenues are recognized only when operating expenditures Expenditures for day-to-day
they are measurable and available operations of the governmental funds of a governmental
monetary assets Cash and other assets representing claims entity, such as for salaries and wages, utilities, and con-
expressed in a fixed monetary amount sumption of short-term prepayments and inventories of
monetary liabilities Liabilities representing obligations ex- supplies
pressed in a fixed monetary amount operating segment A component of a business enterprise
monetary/nonmonetary method A method of translating that engages in business activities for which it earns rev-
foreign currency financial statements in which monetary enues and incurs expenses, whose operations are regularly
assets and monetary liabilities are translated at the current reviewed by the enterprise’s chief operating decision maker
exchange rate on the balance sheet date; nonmonetary for purposes of evaluating past performance and making
assets and liabilities and owners’ equity elements are trans- decisions about future allocation of resources, and for which
lated at historical rates. Depreciation and amortization discrete financial information, generated by or based on the
expenses and cost of goods sold are translated at historical internal financial reporting system, is available
rates; all other revenue and expenses are translated at an order for relief Action by the Bankruptcy Court to protect
average rate for the accounting period the debtor from creditors’ claims during the bankruptcy
monetary principle The principle that money is assumed proceedings
to be a useful standard measuring unit for reporting the other financing sources Sources of financial resources of
effects of business transactions and events a governmental fund other than revenues, such as transfers
multinational (transnational) enterprise A business in and gains on disposals of plant assets
enterprise that carries on operations in more than one other financing uses Uses of financial resources of a gov-
nation, through a network of branches, divisions, influenced ernmental fund other than expenditures, such as transfers out
investees, joint ventures, and subsidiaries and losses on disposals of plant assets

N P
negative goodwill The remainder of a bargain-purchase pac-man defense A tactic used to resist a hostile takeover
excess that cannot be apportioned to reduce the amounts business combination in which the target company itself
assigned to the combinee’s qualifying assets threatens a takeover of the prospective combinor
net assets Total assets less total liabilities; equal to par value method A method of accounting for the retire-
stockholders’ equity of a corporation ment of treasury stock in which the cost of the treasury
 Glossary 821

stock is allocated pro rata to reduce (1) the Common Stock personal representative The executor or administrator of
ledger account balance by the par or stated value, if any, of a decedent’s estate
the treasury shares; (2) an appropriate additional paid-in plant fund A fund of a nonprofit organization that accounts
capital account for the excess over par or stated value attrib- for plant assets, and often for cash and investments ear-
utable to the original issuance of the treasury shares; and marked for additions to plant assets as well as mortgage notes
(3) Retained Earnings for any unallocated cost remaining payable and other liabilities collateralized by the organization’s
parent company An investor enterprise that obtains plant assets
control of an investee (subsidiary) pledge A commitment by a prospective donor to contribute
parent company concept A concept of consolidated a specific amount of cash or property to a nonprofit orga-
financial statements of a parent company and one or more nization on a future date or in installments
partially owned subsidiaries that views the consolidated pledgor The maker of a pledge
entity as an extension of the parent company, with the minority
poison pill A tactic used to resist a hostile takeover
interest in the net assets of subsidiary considered to be a
business combination in which the target company amends
liability, and the minority interest in net income of sub-
its articles of incorporation or bylaws to make it more
sidiary an expense, of the consolidated entity
difficult to obtain stockholder approval for a takeover
partially secured creditors Creditors of a debtor in
preacquisition contingencies Contingent assets (other
bankruptcy whose claims are collateralized by debtor’s
than potential income tax benefits of a loss carryforward),
assets having current fair values less than the amount of the
contingent liabilities, or contingent impairments of assets
claims
that existed prior to completion of a business combination
participating preferred stock Preferred stock whose
preference The transfer of cash or property to a creditor
owners, after receiving the specified dividend on the pre-
by an insolvent debtor within 90 days of the filing of a
ferred stock, may receive an additional dividend if the
bankruptcy petition by or on behalf of the debtor, provided
common stockholders are paid dividends in excess of the
that the transfer caused the creditor to receive more cash or
specified preferred dividend
property than would be received in the bankruptcy
partnership An association of two or more persons to liquidation
carry on, as co-owners, a business for profit
primary government A state government, a municipality
pension trust funds Fiduciary funds of a governmental or county, or a special-purpose government such as a school
entity that account for the receipt and expenditure of amounts district or a park district meeting specified criteria
contributed by employer and employees to provide resources
principal beneficiary (remainderman) The recipient of
for post-retirement pensions and other such benefits to for-
the principal of a trust
mer employees
prior period adjustment In a statement of partners’ capital,
performance budget An annual budget of a governmental
an adjustment to partners’ beginning capital balances to
entity’s general fund that attempts to relate the input of
correct an error in the financial statements of a prior period
governmental resources to the output of governmental
services private-purpose trust funds Fiduciary funds of a govern-
periodic inventory system The method of accounting for mental entity that account for trust arrangements under
inventory in which the Inventories ledger account is used which principal and income benefit individuals, private
only at the end of an accounting period to reflect the value organizations, or other governments
of the ending inventory of merchandise or manufactured probate Action by the probate court to validate a decedent’s
products will
permanent difference A difference between pretax finan- probate (orphan’s, surrogate) court The state court es-
cial income and taxable income that does not reverse in one tablished to probate decedents’ wills
or more subsequent accounting periods professional corporation A form of corporation authorized
permanent endowment fund An endowment fund whose by some states, having various requirements as to profes-
principal never may be disbursed by the nonprofit organization sional licensing of stockholders, transfers of stock ownership,
and malpractice insurance coverage
permanent funds Governmental funds that account for
resources that are legally restricted to the extent that only program services Activities of a nonprofit organization
earnings, and not principal, may be used for purposes that that result in the distribution of goods and services to benefi-
support the governmental entity’s programs ciaries, customers, or members that fulfill the purposes or
mission of the organization
perpetual inventory system The method of accounting
for inventory in which the Inventories ledger account is projected benefits The amount of all benefits under a de-
debited for purchases of merchandise or the cost of goods fined benefit pension plant attributable to employee services
manufactured and credited for the cost of goods sold to the date of computation of the actuarial present value
822 Glossary

promissory note An unconditional promise in writing, Regulation S-K A pronouncement of the SEC that pro-
signed by the maker, to pay a certain sum of money on de- vides guidance for the completion of nonfinancial statement
mand or at a fixed or determinable future time to order of a disclosure requirements in the various Forms filed with the
payee or to bearer SEC
proportionate consolidation method The International Regulation S-X A pronouncement of the SEC that pro-
Accounting Standards Board term for the proportionate vides guidance on the form and content of financial state-
share method of accounting for an investment in a joint ments included in the various Forms filed with the SEC
venture remeasurement Restatement of account balances of
proportionate share method The method of accounting a foreign entity to its functional currency from its local
for an investment in an unincorporated joint venture that currency
allocates to the venturer’s assets, liabilities, revenue, gains, reorganization value The current fair value of the total
expenses, and losses the venturer’s pro rata share of the assets of a business enterprise undergoing reorganization
venture’s comparable items under Chapter 11 of the Bankruptcy Code
proprietary funds Enterprise funds and internal services reportable segments Operating segments of a business
funds of a governmental entity that carry out governmental enterprise for which numerous disclosures are required by
activities closely resembling the operations of a business the Financial Accounting Standards Board
enterprise reporting currency The currency of the parent company,
proxy statement A statement filed by a publicly owned home office, or investor enterprise of a foreign entity
company with the SEC prior to the company’s solicitation of residuary devise A devise of all property of a decedent
proxies from stockholders prior to a meeting of stockholders remaining after specific and general devises are distributed
Public Company Accounting Oversight Board An restricted fund A fund established by a nonprofit organi-
organization established under the Sarbanes-Oxley Act of zation to account for contributed assets available for current
2002 to oversee financial reporting of publicly owned busi- use but expendable only as authorized by the donor of the
ness enterprises and their independent auditors assets
push-down accounting Accounting for net assets of a revenue bonds Bonds issued by an enterprise fund of a
subsidiary at their current fair values as established in the governmental entity to finance a construction project of the
business combination, rather than at carrying amounts, in entity; the bonds’ principal and interest are paid from revenues
separate financial statements of the subsidiary generated by the construction project
Revised Uniform Principal and Income Act A law in
Q effect in part or in full in many states, which provides for
allocation of transactions of the personal representative
quasi-endowment fund An endowment fund established
of an estate or trust between principal and income, in the
by the governing board of a nonprofit organization, the
absence of appropriate instructions in the will or trust
principal of which may be expended at the direction of the
document
board
right of offset A legal doctrine that permits offsetting of a
quasi-external transactions Transactions of the general
loan receivable from or payable to a partner of a liquidating
fund of a governmental entity with proprietary funds of the
partnership against that partner’s capital account balance
entity, such as for goods and services provided by the
proprietary funds
S
R sales-type lease A lease that, from the viewpoint of the
realization Conversion of noncash assets of a liquidating lessor, is equivalent to the sale, rather than the rental, of
partnership or debtor in bankruptcy to cash property to the lessee
reciprocal accounts The Investment in Branch ledger Sarbanes-Oxley Act of 2002 A federal law enacted to re-
account in the home office accounting records and the Home form financial reporting by publicly owned business enter-
Office account in the branch accounting records; also, the prises and their independent auditors
Investment in Subsidiary Common Stock ledger account in scorched earth A tactic used to resist a hostile takeover
the parent company’s accounting records and the stockholders’ business combination in which the target company sells or
equity accounts in the subsidiary’s accounting records spins off to stockholders one or more profitable business
registrar The officer of a probate court authorized to carry segments
out informal probate of decedents’ wills Securities and Exchange Commission (SEC) The federal
registration statement A document filed with the SEC by agency charged with overseeing issuance and trading of
a company that issues securities to the public interstate securities interstate by publicly owned companies
 Glossary 823

security interest A legal claim of a secured creditor of a statement of financial affairs (legal document) A docu-
debtor to designated personal property of the debtor ment accompanying a debtor’s petition that contains a series
selling spot rate The exchange rate charged by a foreign of questions concerning all aspects of the debtor’s financial
currency dealer “on the spot” position and operations
settlor (donor, trustor) The creator of a trust statement of financial position A financial statement that
shared revenues Revenues received by a governmental displays the assets, liabilities, and net assets—permanently
entity from another government that had levied the taxes or restricted, temporarily restricted, and unrestricted—of a
fees to be shared nonprofit organization
shark repellent A tactic used to resist a hostile takeover statement of partners’ capital The financial statement
business combination in which the target company ac- issued by a partnership to display changes in partners’ capital
quires substantial amounts of its outstanding common from investments, net income or loss, and drawings during
stock for the treasury or for retirement or incurs substantial an accounting period
long-term debt in exchange for its outstanding common statement of realization and liquidation A financial
stock statement prepared for a liquidating partnership that displays
special assessment bonds Bonds issued by a govern- realization of noncash assets, allocation of resultant gains or
mental entity, principal and interest of which are paid from losses to partners, payment of partnership liabilities, and
special assessments on specific taxpayers benefited by the distribution of any remaining cash to partners; also, a finan-
construction project financed in part by the bonds cial statement prepared on behalf of a trustee in a bank-
ruptcy liquidation that sets forth assets realized and liabilities
special assessments Taxes levied by a governmental entity
paid, with “gains” and “losses” thereon applied to the estate
on specific taxpayers to be benefited by the construction
deficit
project financed in part by the assessments
statutory consolidation A business combination in which
special purpose entities Entities created for a limited
a new corporation issues common stock for all outstanding
purpose, with a limited life and limited activities, and designed
common stock of two or more other corporations that are
to benefit a single company
then dissolved and liquidated, with their net assets owned by
special revenue funds Governmental funds that account the new corporation
for receipts and expenditures associated with specialized statutory merger A business combination in which one
revenue sources that are earmarked by law or regulation to corporation (the survivor) acquires all the outstanding
finance specified government operations common stock of one or more other corporations that are
specific devise A decedent’s gift of identified objects, such then dissolved and liquidated, with their net assets owned by
as named paintings, automobiles, stock certificates, or real the survivor
property subsidiary An investee enterprise controlled by an investor
sponsoring government A governmental entity that man- enterprise (parent company)
ages external investment pools support Resources obtained by nonprofit organizations
spot rate The rate of exchange between two foreign cur- through contributions from individuals, governmental entities,
rencies to be exchanged “on the spot” and other organizations
Staff Accounting Bulletins (SABs) Pronouncements of the supporting services All activities of a nonprofit organi-
SEC staff regarding administrative interpretations and prac- zation other than program services, such as management and
tices used by the staff in reviewing Forms and financial general, fund-raising, and membership development
statements filed with the SEC activities
statement of activities A financial statement that displays survivor The constituent company in a statutory merger
the changes in net assets—unrestricted, temporarily res- that is not dissolved and liquidated
tricted, and permanently restricted—of a nonprofit organi-
zation
statement of affairs (financial statement) A “quitting
T
concern” financial statement prepared on behalf of a debtor temporary difference A difference between the tax basis
undergoing bankruptcy liquidation that classifies nonexempt of an asset or a liability and its reported amount in the
assets and liabilities of the debtor according to provisions of financial statements that will result in taxable or deductible
the Bankruptcy Code amounts in future years when the reported amount of the
statement of cash flows A financial statement that asset or liability is recovered or settled, respectively; a
displays the cash flows from operating activities, investing difference between pretax financial income and taxable
activities, and financing activities of a business enterprise, income that reverses in one or more subsequent accounting
governmental entity, or nonprofit organization periods
824 Glossary

term endowment fund An endowment fund whose princi- units Securities evidencing ownership interests in a limited
pal may be expended after a specified time period or the partnership
occurrence of a specified event unrelated business income Income derived by a nonprofit
testamentary trust A trust created by a will organization from activities not substantially related to the
testator The maker of a will educational, charitable, or other basis of the organization’s
third-party payor An organization such as Medicare or tax-exempt status
Medicaid that pays for services rendered by a nonprofit unrestricted fund A nonprofit organization’s fund that
hospital to patients includes all assets of the organization available for use as
transfers Transfers of financial resources among funds authorized by the governing board and not restricted for
of a governmental entity for other than quasi-external specific purposes
transactions unsecured creditors with priority Creditors of a debtor
translation Restatement of financial statement amounts of in a bankruptcy proceeding whose unsecured claims are paid
a foreign entity from its functional currency to the reporting in accordance with provisions of the Bankruptcy Code prior
currency of the parent company or investor enterprise to the payment of claims of other unsecured creditors
trust document The document establishing a trust unsecured creditors without priority Creditors of a
debtor in a bankruptcy proceeding whose unsecured claims
trust indenture The legal document that creates a trust
do not have priority under the Bankruptcy Code
trustee The fiduciary individual or corporation holding
upstream intercompany sales Sales of merchandise by a
title to trust property and carrying out provisions of the trust
subsidiary to its parent company
document

U V
variable interest entity An entity subject to consolidation
underlying A specified interest rate, security price, foreign
with a parent company under terms of an Interpretation of
exchange rate, index of prices or rates, or other variable; it
the Financial Accounting Standards Board
may be a price or rate of an asset or liability but not the asset
or liability itself vertical combination A business combination between an
enterprise and its customers or suppliers
undistributed earnings of subsidiary The parent com-
pany’s share, under the equity method of accounting, of the
adjusted net income less dividends of the subsidiary
W
Uniform Probate Code A law in effect in part or in full in white knight A tactic used to resist a hostile takeover
many states, which provides for procedures used in probating business combination in which the target company seeks out
wills a candidate to be the combinor in a friendly takeover
uniting of interests The International Accounting Stan- will A document that awards a testator’s property to devisees
dards Board formerly used term for a business combination following the testator’s death
not construed as a purchase of the combinee by the combiner
Index
A Industry Audit Guide, 671 Branches and divisions
interpretation of APB Opinion No. 18, accounting overview, 121–122
Accounting and Auditing Enforcement 99 accounting systems for, 122–143
Releases. See also Securities and on nonprofit organizations, 670–671 billing for merchandise, 124, 130
Exchange Commission (SEC) Statement of Position 78-10, 671 definitions, 121
AAER 34, 234–235 Annuity fund, 682–683 expense allocations, 123
AAER 35, 143 APB. See Accounting Principles Board financial statements, 123–135
AAER 38, 182–183 (APB) inventories, 136–138
AAER 39, 182–183 ASR. See Accounting Series Releases reciprocal ledger accounts, 123,
AAER 40, 101 Assets 138–141
AAER 78, 101 distribution of, 76 SEC and, 143
AAER 102, 101 general capital assets, 758–760 start-up costs, 122
AAER 170, 555–556 intangible assets and, 344–345 transactions between branches, 142–143
AAER 202, 50 marshaling of assets, 83 Budgets, 719–723
AAER 207, 556 Attest engagement, definition of, 15 Business, definition of, 164
AAER 208, 556 Attest engagement team, definition of, 15 Business combinations. See also Consoli-
AAER 214, 50–51 Audit and Accounting Guides (AICPA), dated financial statements
AAER 220, 51 671 antitrust considerations, 166
AAER 275, 183 Auditor’s report sample, 688–693 appraisal of accounting standards
AAER 344, 6 for, 182
AAER 389, 556 bargain purchases, 171
AAER 598, 183 B conglomerate combinations, 166
AAER 601, 183 contingent consideration, 169–170,
AAER 606, 183 Bankruptcies, 7 178–179
AAER 607, 183 Bankruptcy definitions for, 164–165
AAER 923, 2 bankruptcy liquidation, 608–617 financial statements for, 180–182
AAER 970, 798–799 bankruptcy reorganization, 617–621 finder’s fees, 169
AAER 992, 363 insolvency defined, 607 goodwill and, 171, 179, 217,
AAER 1061, 547 Internal Revenue Service and, 607 227–229, 451
AAER 1275, 556 overview of, 607–608 horizontal combinations, 166
AAER 1762, 235 security agreements and, 607 “negative goodwill,” 171
Accounting Principles Board (APB) Bankruptcy Act of 1898, 608 purchase method of accounting for,
APB Opinion No. 18, 97, 99, 101, Bankruptcy Code, 608 168–182
401–406 Bankruptcy liquidation reasons for, 165–168
APB Opinion No. 28, 548, 549–554, accounting in, 611, 615–617 SEC enforcement actions for, 182–183
555, 557 court’s role in, 610 statutory mergers and consolidations,
Accounting Series Releases. See also creditor role in, 610 166–167, 175–178
Securities and Exchange Commission creditor’s petition, 609 tender offers and, 167
(SEC) debtor’s petition, 608–609 vertical combinations, 166
ASR No. 4, 559 discharge of debtor, 610–611 Buying spot rate, 480
ASR No. 142, 561 process of, 608
ASR No. 149, 561 property claimed as exempt, 610
ASR No. 280, 560, 561 reporting for trustees, 615–617 C
overview of, 560–561 statement of affairs, 611–614
Administrator, definition of, 639 trustee role in, 610–611 Capital leases, 762–763
Agency funds, 718, 788–789 unsecured creditors with priority, 609 Capital projects funds, 718, 751–755
AICPA. See American Institute of Certified Bankruptcy Reform Act of 1978, 608 Cash flow hedges, 488
Public Accountants (AICPA) Bankruptcy Reform Act of 1994, 608 Channel stuffing, definition of, 2
Allocation periods, 171 Bankruptcy reorganization, 617–621 Client, definition of, 15–16
American Institute of Certified Public Bankruptcy Tax Act, 608 Close relative, definition of, 16
Accountants (AICPA) Bargain purchases, 171 Codification, 717, 719
AICPA Professional Standards, 479 Beneficiaries, of trusts, 652 College Retirement Equities Fund Stock
Audit and Accounting Guides, 671 Bonds, 755, 763–766 Account, 478
code of ethics, 3–6, 11–20 Bonuses, 35–36, 42–43, 46 Combined enterprise, definition of, 164

825
826 Index

Combined income statements, 123 FASB Proposed Statement of Redefini- Derivative instruments, 486
Commodities, 480 tion of Control, 209–210 Devise, definition of, 639
Common stock, consolidated financial goodwill and, 217, 227–229 Devisee, definition of, 639
statements and, 432–440 IAS 27 and, 231–232 Disaggregated financial data, 541
Competence, ethics and, 9 minority interests, 208, 220, 223, Disclosures
Component units. See Segment reporting 225–227 interim reports and, 554–555
Conbinee, definition of, 164 nature of, 207–208 regarding foreign currency transactions,
Conbinors, 164, 165 parent company–subsidiary relation- 492
Confidentiality, ethics and, 9, 18 ships, 207–211 reorganization disclosure, 620–621
Conglomerate business combinations, 166 partially owned subsidiaries and, SEC and, 559
Consolidated financial statements. See also 220–234 segment reporting and, 543–544
Business combinations; Financial Ac- push-down accounting for subsidiaries, Discrete theory, 548
counting Standards Board; Financial 232–234 Dissolution of limited liability partnership
statements SEC enforcement actions concerning, (LLP), 26, 39–40
changes in parent company’s ownership 234–235 Distribution, of assets, 76
interest in subsidiary, 429–440 shortcomings of, 232 Due care, 14–15
common stock and, 432–440 variable interest entities and, 210–211
example of, 562–588 wholly owned subsidiaries and,
extraordinary items, 432 211–226 E
going-concern aspect, 445 working paper, 215–220, 223–226, 233
income taxes, 385–396 Consolidated financial statements, subse- Economic substance, 27, 40, 209, 235, 455
indirect shareholdings and parent com- quent to date of business combination Encumbrances, 722–723
pany’s common stock owned by closing entries, 271–273, 276, Endowment fund, 681–682
subsidiary, 449–454 286–287, 296 Enterprise funds, 718, 780–785
installment acquisition of subsidiary, cost method and, 262, 292–298 Entity, definition of, 164
401–406 equity method and, 262–292 Equity Funding fraud of 1973, 4
parent company acquisition of minority partially owned subsidiaries and, Equity method of accounting, joint ventures
interst, 429–432 276–277 and, 99
preferred stock and, 440–444 wholly owned subsidiaries and, 261–262 Estates
quitting–concern approach, 441 working paper, 268–270, 275, 281–287, creditor claims, 640
statement of cash flows, 397–401 289–291, 293–298 definition of, 638
stock dividends and, 444–445 Constituent companies, definition of, 164 distributions to devisees, 640–641
treasury stock transactions and, Contingent consideration, 169–170, estate and inheritance taxes, 641
446–449, 455 178–179 example of accounting for, 642–652
working paper, 441, 443, 445, 448–449, Contingent fees, 18–19 Uniform Probate Code and, 638–641
451–454 Continuing education, 5 wills, 538–639
Consolidated financial statements, inter- Contracts, partnership contract, 27–28 Ethics
company transactions Control AICPA and, 3–6, 11–20
bond acquisitions and, 345–352 controlling interests, 208–211, 220 competence and, 9
capital/sales-type leases and, 339–344 definition of, 164, 209 confidentiality and, 9, 18
income taxes and, 325–326 FASB and, 209–210 contingent fees and, 18–19
intangible assets and, 344–345 Cooking the books definitions of terms, 15–16
intercompany profits (gains) and minor- bank failures and, 7 due care and, 14–15
ity interests, 353–355 definition of, 1 Equity Funding fraud of 1973 and, 4
intercompany sales of merchandise, Corporate joint ventures, 97 FEI and, 3–6, 10–11
327–333 Corporations, LLP compared with, 26 financial reporting and, 2–8
inventories and, 331–333 Covered member, definition of, 16 fraudulent financial reporting, 2–3
involving profit (gain) or loss, 326 Creditor’s petition, 609 IMA and, 3, 4, 6, 8–10
not involving profit (gain) or loss, Current/noncurrent method of translation insider trading and, 6
322–326 of foreign currency financial statements, integrity and, 9–10, 13, 17
plant asset sales and, 333–339 504 National Commission on Fraudulent
SEC enforcement actions and, 363 Current rate method of translation of for- Financial Reporting (Treadway
working paper, 332, 351–363 eign currency financial statements, 506 Commission) and, 4–5
Consolidated financial statements, on date Cute accounting, definition of, 1 objectivity and, 10, 13–14, 17
of business combination overview of, 1–2
advantages of, 232 responsibilities and, 3, 12–13
bargain-purchase excess in consoli- D Exchange rates, 480, 505, 506–507
dated balance sheet, 229–231 Executor, definition of, 639
controlling interests and, 208–211, Debt service funds, 718, 755–758 Expense, expense allocations from home
220 Debtor’s petition, 608–609 office to branches, 123
disclosure of consolidation policy, 231 Denominated transactions, 481 Extraordinary items, 432
 Index 827

F for business combinations, 180–182 Form S-1, 557

combined financial statements, 123, Form S-2, 557
Fair value hedges, 488, 490 125, 128–130, 133–135 Form S-3, 557
Family allowance, definition of, 640 definition of, 16 Form S-4, 557
FEI. See Financial Executives International fraudulent financial reporting, 2–6 Form SB-1, 557
(FEI) income statements, 123 Form SB-2, 557
Fiduciary funds, 788–794 for LLPs, 36–38 Forward contracts in foreign currency
Financial Accounting Standards Board. See for nonprofit organizations, 683–687 transactions, 480, 486–492
also Consolidated financial statements partnership liquidation and, 79–80 Forward rates, 480
Discussion Memorandum on push- statement of affairs in bankruptcy, Fraudulent financial reporting
down accounting, 233 611–614 bank failures and, 7
FASB Statement No. 2, 170 working paper for, 127–130, 132–133, definition of, 4–5
FASB Statement No. 3, 553, 555 215–220 overview of, 2–3
FASB Statement No. 8, 522–523 Finder’s fees, 169 Friendly takeover, definition of, 164
FASB Statement No. 13, 762–763 Firm, definition of, 16 FRRs. See Financial Reporting Release
FASB Statement No. 14, 542, 543 Foreign currency hedges, 488 (FRRs)
FASB Statement No. 18, 555 Foreign currency transaction losses, 510 Functional currency, 502–506, 512
FASB Statement No. 52, 481, 482–483, Foreign currency transactions. See also Fund, definition of, 717
503n, 505, 506, 514n, 520, 520n, 522 International Accounting Standards Fund accounting
FASB Statement No. 93, 671, 679, 687 Board agency fund, 682
FASB Statement No. 94, 208 accounting for, 480–481 annuity fund, 682–683
FASB Statement No. 109, 389, denominated transactions, 481 capital projects funds, 718, 751–755
395, 561 disclosures, 492, 522 contributions, 675–676
FASB Statement No. 116, 671, 687 FASB 52 and, 481, 482–483 debt service funds, 755–758
FASB Statement No. 117, 671, 687 FASB 133 and, 481, 487, 489–490, 492 endowment fund, 681–682
FASB Statement No. 124, 671, 687 foreign currency gains, 482–483, expenses, 678–679
FASB Statement No. 128, 554 486, 522 fiduciary funds, 788–794
FASB Statement No. 130, 519n foreign currency losses, 482–483, general fund, 673, 718, 720–732
FASB Statement No. 131, 181, 542, 485, 522 government entities and, 717–719
543, 544, 547 foreign currency translations, 481 income taxes, 679
FASB Statement No. 133, 481, 487, forward contracts, 480, 486–492 loan fund, 683
489–490, 492, 520n hedges, 487–488, 490, 521 overview of, 672–673
FASB Statement No. 141, 168, 171, 182 IAS 21 and, 492 plant fund, 683
FASB Statement No. 142, 179 IAS 27 and, 480 pledges, 676–677, 679
FASB Technical Bulletin No. 85–6, IAS 28 and, 480 proprietary funds, 718–719, 780–788
447n IAS 39 and, 492 restricted fund, 680–681
functional currency defined by, 503 income taxes and, 521–522 revenues, 673–675, 677–678
International Accounting Standards International Accounting Standards special revenue funds, 718, 748–751
Board convergence project with, 478 (IASs) and, 479–480 unrestricted fund, 673–680
Interpretation No. 46, 210 inventories and, 479
Proposed Interpretation of FIN 46, loans payable denominated in foreign
210–211 currency, 484 G
Proposed Statement on Redefinition loans receivable denominated in foreign
of Control and, 209–210 currency, 485 GASB. See Governmental Accounting
SEC and, 559–561 local currency units (LCUs) and, 481 Standards Board (GASB)
Financial Analysts Federation, 4 merchandise purchase from foreign General capital assets, 758–760
Financial Executives International (FEI) supplier, 481–482 General devises, definition of, 640
code of ethics, 3–5, 10–11 merchandise sale to foreign customer, General funds, 673, 718, 720–732
continuing education and, 5 483–484 General long-term debt, 760–761
Financial institution, definition of, 16 multinational enterprises and, 481 General partnership, overview of, 25
Financial Reporting Release (FRRs). one-transaction perspective, 483 Going concern, 611
See also Securities and Exchange two-transaction perspective, 482–483 Goodwill
Commission (SEC) Foreign currency translations, 481 in business combinations, 171, 179,
FRR No. 25, 209 Foreign exchange rates, 486 217, 227–229, 451
FRR No. 44, 560 Form 8-K, 557–558 consolidated financial statements and,
Financial statements. See also Consoli- Form 10-K, 50–51, 557 217, 227–229, 451
dated financial statements; Translation of Form 10-Q, 101, 548, 555, 557 “negative goodwill,” 171
foreign currency financial statements Form F-1, 557 partnerships and, 43, 45
adjusting and closing entries, 133–135 Form F-2, 557 Government entities
auditor’s responsibility, 3 Form F-3, 557 bonds and, 763–766
for branches and divisions, 123–135 Form F-4, 557 capital leases of, 762–763
828 Index

Government entities—cont. I International Accounting Standards Board.

comprehensive annual financial reports See also Foreign currency transactions
of, 794–798 IMA. See Institute of Management Financial Accounting Standards Board
debt service funds, 718, 755–758 Accountants (IMA) convergence project with, 478
fiduciary funds, 788–794 Imprest cash fund, 121 IAS 14, 547
financial statements for, 724, 729–731, In kind, definition of, 76 IAS 21, 492, 522
754–755, 757–758, 782, 786–787, Income, definition of, 641 IAS 22, 179, 479
791–792 Income-sharing plans, 29–39 IAS 27, 480
general capital assets, 758–760 Income statements, 123 IAS 28, 480
general long-term debt, 760–761 Income taxes IAS 31, 101, 479
permanent funds, 718, 758 assets current fair value and, 385–387 IAS 34, 555
proprietary funds, 718–719, 780–788 consolidated financial statements and, IAS 39, 492
special revenue funds, 718, 748–751 385–396 International Financial Reporting Stan-
Governmental Accounting Standards Board FASB Statement No. 109 and, 389 dards, 479
(GASB) foreign currency translations and, Interpretation of rules of conduct, defini-
Codification and, 717, 719 521–522 tion of, 17
Concepts Statement No. 1, 715 intercompany profits (gains) and, Intestacy, definition of, 638–639
GASB Statement No. 6, 763–766 389–396 Inventories
GASB Statement No. 9, 782 interim reports and, 552–553 branches and divisions and, 136–138
GASB Statement No. 20, 788 nonprofit organizations and, 672, 679 foreign currency transactions and, 479
GASB Statement No. 33, 795–796 undistributed earnings of subsidiaries periodic inventory systems, 136–138
GASB Statement No. 34, 714, 788, and, 387–389 perpetual inventory systems, 136
794–795 working paper, 396 Investment Advisers Act of 1940, 557
GASB Statement No. 35, 796 Incorporation of limited liability partner- Investment Company Act of 1940, 557
GASB Statement No. 37, 796 ship (LLP), 93–96 Investment trust funds, 718, 793–794
GASB Statement No. 38, 796 Independent auditor’s report sample,
GASB Statement No. 41, 796 688–693
GASB Statement No. 42, 759n Indirect shareholdings, 449–454 J
Governmental entities Industry Audit Guide (AICPA), 671
accounting and reporting for, Information returns, 26 Joint ventures, 97–101
723–732 Inheritance taxes, 641
accounting and reporting standards Insider trading, ethics and, 6
for, 716–723 Insolvency, 81–85 L
budgets and, 719–723 definition of, 607
capital projects funds, 751–755 Institute of Management Accountants Last-in, first-out (lifo) inventory method,
fund as principal accounting unit (IMA) 549
for, 717–719 code of ethics, 3, 4, 6, 8–10 Legal form, 27, 40, 209, 235, 445
general fund and, 673, 718, 720–732 continuing education and, 5 Lifo. See Last-in, first-out (lifo) inventory
modified accrual basis of accounting Integral theory, 548 method
and, 719, 725 Integrity, ethics and, 9–10, 13, 18 Limited liability company (LLC), 98
nature of, 714–715 Interim financial reports. See also Financial Limited liability partnership (LLP), 26–29,
SEC enforcement actions and, statements 93–96
798–799 APB Opinion 28 and, 548, 549–555 Limited partnership, 47–48
special revenue funds, 748–751 disclosures, 554–555 Liquidation, definition of, 75
Greenmail, definition of, 165 discrete theory, 548 Liquidation in installments, 85–93
Gross margin, 549 example of, 584 Liquidation of partnership
Form 10-Q and, 548, 555 insolvency and, 81–85
gross margin and, 549 in installments, 85–93
H income taxes and, 552–553 marshaling of assets, 83
integral theory, 548 overview, 75–76
Hedges inventory methods and, 549 payments to partners, 77–85
cash flow hedges, 488 overview of, 547–548 Living trusts, 652
definition of, 487 problems in, 548 LLC. See Limited liability company (LLC)
fair value hedges, 488, 490 quarterly reports, 547–548 LLP. See Limited liability partnership (LLP)
foreign currency hedges, 488 reporting accounting changes, Local currency units (LCUs), 481
illustration of, 521 553–555
High inflationary economy, 521 revenues and, 549
Holographic wills, 638 SEC enforcement actions, 555–556 M
Homestead allowance, definition of, 640 Internal Revenue Service, 607
Horizontal business combinations, 166 Internal service funds, 718, 780–781, Market risk, definition of, 492
Hostile takeover, definition of, 165 785–788 Marshaling of assets, 83
 Index 829

Minority interests, 208, 220, 223, 225–227 ledger accounts, 28 Related party transactions, 29
Modified accrual basis of accounting, legal form and, 26, 40 Remeasurement of foreign entity’s
719, 725 limited liability partnership (LLP), accounts, 506–510, 520, 522
Monetary/nonmonetary method of trans- 26–29 Residuary devises, definition of, 640
lation of foreign currency financial state- limited partnership, 47–48 Revised Uniform Principal and Income
ments, 505–506 liquidation of, 75–85 Act, 641, 653
Money-market instruments, 480 loans to/from partners, 28–29 Robert Morris Associates, 4
Multinational enterprise, definition of, 481 new partner admissions, 40–42
overview, 25
ownership changes, 39–40 S
N partner retirement, 45–47
related party transactions, 29 SAB. See Staff Accounting Bulletin (SAB)
National Commission on Fraudulent Finan- SEC and, 50–51 Sarbanes-Oxley Act of 2002, 1, 559
cial Reporting (Treadway Commission), PCAOB. See Public Company Accounting Scorched earth, definition of, 165
4–5 Oversight Board (PCAOB) Seaview Symposium of 1970, 4
National Council on Governmental Pension trust funds, 792–793 SEC enforcement actions
Accounting, 716–717 Pensions, 718 branches and divisions and, 143
“Negative goodwill,” 171 Periodic inventory systems, 136–138 business combinations and, 182–183
New York Stock Exchange, 548 Permanent endowment fund, definition consolidated financial statements, on
Nonprofit organizations of, 681 date of business combination and,
accounting standards for, 670–671 Permanent funds, 718, 758 234–235
board of directors and, 672 Perpetual inventory systems, 136 foreign companies and, 478
budgets, 672 Person, definition of, 638 government entities and, 798–799
characteristics of, 671–672 Pledges, 676–677, 679 interim reports and, 555–556
definition of, 670 Poison pill, definition of, 165 segment reporting and, 546
financial statements, 683–687 Practice of public accounting, definition Securities Act of 1933, 557–558
fund accounting, 672–683 of, 17 Securities and Exchange Commission
income taxes and, 672, 679 Preacquisition contingencies, 171 (SEC). See also Accounting and Auditing
independent auditor’s report sample, Preferred stock, consolidated financial Enforcement Releases; Financial Report-
688–693 statements and, 440–444 ing Release (FRRs)
stewardship of, 672 Principal, definition of, 641 Accounting Series Releases (ASRs),
Notional amounts, 486 Private-purpose trust funds, 718, 789–792 559, 560–561
Number of currency units, 486 Professional services, definition of, 17 disclosures and, 559
Proportionate share method of accounting, enforcement division, 558–559
joint ventures and, 99, 100, 101 example of financial reports, 562–588
O Proprietary funds, 718–719, 780–788 FASB and, 559–561
Public business enterprises, 181 Form 8-K, 557–558
Objectivity, ethics and, 10, 13–14, 17 Public Company Accounting Oversight Form 10-K, 50–51, 557
One-transaction perspective in foreign Board (PCAOB), 1, 561 Form 10-Q, 101, 548, 555, 557
currency transactions, 483 Public Utility Holding Company Act of Form F-1, 557
Ordinary net income, LLP and, 26 1935, 557 Form F-2, 557
Push-down accounting, 232–234 Form F-3, 557
Form F-4, 557
P Form S-1, 557
Q Form S-2, 557
Pac-man defense, definition of, 165 Form S-3, 557
Parent company–subsidiary relationships, Quarterly reports, 547–548 Form S-4, 557
207–211 Quasi-endowment fund, 681 Form SB-1, 557
Partnerships Quitting concern, 611 Form SB-2, 557
bonuses, 35–36, 42–43, 46 legislation concerning, 557
contracts, 27–28 limited partnerships and, 48
death of partner, 47 R organization and functions of, 558–559
definition of, 25 partnerships and, 50–51
dissolution of, 26, 39–40 Realization Public Company Accounting Oversight
drawings, 28 definition of, 75 Board (PCAOB) and, 561
economic substance and, 27, 40 distribution and, 78–81 registration statements, 557
financial statements for, 36–38 financial statements and, 79–80 Regulation S-K, 558, 560
goodwill, 43, 45 Reciprocal ledger accounts, 123, 138–141 Regulation S-X, 558, 560
income-sharing plans, 29–39 Registration statements, 557 reporting requirements, 557–559
incorporation of, 93–96 Regulation S-K, 558, 560 Staff Accounting Bulletin 40, 48–50
insolvency and, 81–85 Regulation S-X, 558, 560 Staff Accounting Bulletin 51, 436n
830 Index

Securities Exchange Act of 1934, 102, 557 T Treadway Commission. See National
Segment reporting Commission on Fraudulent Financial Re-
background of component reporting, Tender offers, 167 porting (Treadway Commission)
541–542 Term endowment fund, definition of, 681 Treasury stock, 446–449, 455
disclosure examples, 543–544 Testamentary trusts, definition of, 641 Trust Indenture Act of 1939, 557
disposal of business component, Testator, definition of, 638 Trustees, 652
546–547 Third-party payors, 674 Trusts
example of, 572–574 Translation of foreign currency financial example of accounting for, 653–655
IAS 14 and, 547 statements living trusts, 652
management approach to, 542–543 adjustments, 520–521, 522 overview of, 652
nontraceable expense allocation to alternative methods for translation, Revised Uniform Principal and Income
operating segments, 544–545 505–506 Act governance of, 653
proposal for improvement of, 542–543 cash flow indicators, 504 testamentary trusts, 641
SEC requirements for, 546 current/noncurrent method of transla- Uniform Probate Code governance
Selling spot rate, 480, 482 tion, 505 over, 652
Senate Judiciary Committee’s Subcommit- current rate method, 506 Two-transaction perspective in foreign
tee on Antitrust and Monopoly, 542 expense indicators, 504 currency transactions, 482–483
Settlors, 652 financing indicators, 504
Shark repellent, definition of, 165 foreign currency transaction gains, 522
Single accounting entities, 207 foreign currency transaction losses, U
Single economic entities, 207 510, 522
Special revenue funds, 718, 748–751 foreign currency translation adjust- Underlyings, 486
Specific devises, definition of, 640 ments, 512 Uniform Limited Partnership Act, 47
Staff Accounting Bulletin (SAB) functional currency, 502–506, 512 Uniform Partnership Act, 25
SAB No. 40, 48–50 intercompany transactions and arrange- Uniform Probate Code, 638–641, 652
SAB No. 54, 233 ments indicators, 504
Standard of Ethical Conduct for Members monetary/nonmonetary method of
(IMA), 3 translation, 505–506 V
Start-up costs, 122 overview of, 503
Statement of affairs in bankruptcy, remeasurement of foreign entity’s Vertical business combinations, 166
611–614 accounts, 506–510, 520, 522 Vouchers, 121
Statutory mergers and consolidations, sales market indicators, 504
166–167, 175–178 sales price indicators, 504
Stock dividends, 444–445 translation of foreign entity’s financial W
Subchapter S Corporations, 26 statements, 511–523
Subsidiary companies, 121, 207–211, working paper, 510, 511–512, White knight, definition of, 165
211–226, 232–234 515–518 Wills, 638–639