MODULE 1 - Partnership Accounting

→ Loan to and Loan from partners

-​ A withdrawal by a partner of a substantial amount with the
1.0 Partnership Accounting assumption of its repayment to the firm may be debited to a
→ Partnership Receivable from partner account rather than to the partner's
-​ Partnerships are a popular form of business because they are drawing account. On the other hand, an advance to the
easy to form and because they allow several individuals to partnership by a partner with the assumption of its ultimate
combine their talents and skills in a particular business repayment by the partnership is viewed as a loan rather than
venture. In addition, partnerships provide a means of as an increase in the capital account. This type of transaction
obtaining more capital than a single individual can obtain and is credited to the Loan's payable or Notes payable if the loan
allow the sharing of risks for rapidly growing businesses. is evidence by a note duly signed in the name of the
Partnerships are particularly common in the service partnership
professions, especially law, medicine and accounting.
1.1 Formation
→ Partner's Ledger Accounts → Accounting for the Formation of a Partnership
-​ In a partnership, although it is possible to operate with one -​ A partnership may be formed in several ways namely:
equity account for each partner, it is desirable that the 1.​ Formation of a partnership for the first time
following partner's accounts be maintained: 2.​ Conversion of a sole proprietorship to a partnership
a.​ Capital accounts a.​ A sole proprietor allows an individual, who has no
b.​ Drawing or personal accounts business of his own to join his business.
c.​ Account for loans to or from partners b.​ Two or more sole proprietors form a partnership
3.​ Admission of a new partner
→ Capital and Drawing accounts
-​ The original investment of each partner is recorded by → Partnership formation for the First Time
debiting the fair value of the assets invested, crediting the a.​ Cash Investments
liabilities assumed by the firm and crediting the partner's
Initial cash investments in a partnership are recorded in the
capital account for the net assets contributed. Subsequent to
capital accounts maintained for each partner. For example
the original investments, transactions between the partnership
Aldous and Baxia each invests P100,000 cash in a new
and the partners will result in changes in the respective
partnership. The entry to record the investments would be:
partner's ownership interest. These changes are summarized
in the respective partner's capital and drawing accounts.
Cash 200,000
-​ A partner's equity is increased by the additional investment of Aldous, capital 100,000
cash or other property and by a share in the partnership profit. Baxia, capital 100,000
A partner's equity is decreased by the withdrawal of cash or
other assets and by a share in the partnership loss. b.​ Non-cash investments
-​ Normally, increases or decreases in capital that are When property other than cash is invested in a partnership, the
interpreted as permanent capital changes are recorded non-cash property is recorded at the current fair value of the
directly in the capital account. Withdrawals, which are property at the time of the investment. The fair value on
considered equivalent to salaries, made by the partner in non-cash assets is determined by agreement of the partners.
anticipation of profits and other increases or decreases of The amounts involved should be specified in the written
relatively minor amounts are recorded in the drawing account. partnership agreement.
At the end of the accounting period, the debit and credit
balances in the drawing account are then closed to the
respective partner's capital account. Also, during this period, 1.2 Operation
the profit or loss as shown by the Income Summary account → Accounting for Partnership Operations
is distributed in accordance with the profit and loss sharing -​ Net income is computed in the usual manner that is matching
agreement, The share of each partner in the profit or loss is revenues and expenses then credited to the individual capital
recorded in their respective capital account. Individual accounts. However, the treatment becomes more complex
partner's capital and drawing balances are combined to report because of the differences in capital contributions, abilities
each partner's interest in the statement of financial position. and talents of individual partners, and in time spent on
partnership duties by the individual partners,
-​ The Capital account is credited for:
a.​ Original Investment → Division of Profits and Losses
b.​ Additional Investment -​ The partnership law provides that profits and losses of the
c.​ Partner's share in the profits partnership are to be divided in accordance with the partners
agreement. If no agreement is made between and among the
-​ The Capital account is debited for: partners, profits and losses are to be divided according to
a.​ Permanent withdrawal of capital their original capital contributions. Should the partners agree
b.​ Debit balance of the drawing account at the end of the to divide the profits only, losses, if any, are to be divided in the
period same manner as that of dividing profits. However, should the
c.​ Partner's share in the losses partners agree to divide losses only, profits, if any, shall be
divided by the partners according to capital contributions.
-​ The Drawing account is credited for:
a.​ Partnership obligations assumed or paid by the partner -​ The ratio in which the partnership profits and losses are
b.​ Personal funds or claims of partner collected and divided is known as the profit and loss ratio. The many
retained by the partnership possible methods of dividing net income or loss among
c.​ Periodic partner's salaries depending on the accounting partners can be summarized as follows:
and disbursement procedures agreed upon. 1.​ Equally
2.​ In an unequal or arbitrary ratio
3.​ In the ratio of partners capital account balances on a
-​ The Drawing account is debited for: particular date, or in the ratio of average capital account
a.​ Withdrawal of assets by the partners in anticipation of balances during the year.
net income 4.​ Allowing interest on partners' capital account balances
b.​ Partner's personal indebtedness paid or assumed by and dividing the remaining net income or loss in a
the partnership specified ratio.
c.​ Funds or claims of partnership collected and retained 5.​ Allowing salaries to partners and dividing the remaining
by the partner net income or loss in a specified ratio
6.​ Bonus to managing partners based on net income.
1.3 Dissolution / Changes in Ownership Interest -​ A new partner may acquire interest in the partnership by
→ Partnership Dissolution/Changes in Ownership Interest investing in the business. In this case, the partnership
-​ A partnership rests upon a contractual foundation, therefore, receives the cash or other assets, thereby increasing its total
the life span of a partnership may be somewhat uncertain assets as well as the total capital. This method of admission
since it depends on the moods and relationships of the is a transaction between the partnership and the incoming
partners. Any circumstances which cause the technical partner. Three cases may exist when a new partner invests in
termination of a partnership may lead to the partnership's partnership:
permanent dissolution and liquidation, if the partners so 1.​ Case 1: The new partner's investment (contributed
agree, Dissolution and liquidation in relation to the partnership capital) equals the new partner's proportion of the
are not synonymous. A partnership is said to be dissolved partnership's book value (agreed value)
when the original association for the purposes of carrying on 2.​
activities has ended. A partnership is said to be liquidated 3.​ Case 2: The new partner's investment is more than the
when the business is terminated. Thus, a partnership may be new partner's agreed capital. This indicates that the
dissolved without being liquidated. While dissolution may partnership's prior net assets are undervalued on the
result in the liquidation of a partnership, liquidation always books.
results in dissolution. 4.​
5.​ Case 3: The new partner's investment is less than the
-​ Partnership dissolution due to changes in ownership interests new partner's agreed capital. This suggests that the
occurs for a variety of reasons. These can be summarized as partnership's prior net assets are overvalued on its books.
follows:
a.​ Admission of a partner -​ The following steps/procedures may be used in determining
b.​ Retirement of a partner how to account for the admission of a new partner:
c.​ Death of a partner
d.​ Incorporation of a partnership 1.​ Compute the new partner's proportion of the
partnership's book value (agreed capital) as follows:
-​ In most cases, when a change in ownership occurs, the
market values of individual partnership assets and liabilities Agreed capital = Prior capital of old partners + Investment of
are different from their book values. These differences can be the new partner X % of capital to new partner
accounted for by recording them on the partnership books
either by adjusting the assets and liabilities - in many cases, 2.​ Compare the new partner's contributed capital with his
by adjusting the partners' capital accounts. or her agreed capital to determine the procedures to
be followed in accounting for his or her admission.
1.3.1 Admission of a New Partner
→ Admission of a new partner a.​ Case 1: Investment = Agreed Capital
-​ An existing partnership may admit a new partner with the ●​No revaluation or bonus
consent of all the partners. When a new partner is admitted,
the partnership is dissolved and a new partnership is formed. b.​ Case 2: Investment cost > Agreed Capital
Upon the admission of a new partner, a new agreement ●​Revalue net assets up to fair value and
covering partners' interests, profit and loss sharing and other allocate to old partners.
considerations should be drawn because the dissolution of ●​Allocate bonus to old partners.
the original partnership would cancel the original agreement.
c.​ Case 3: Investment cost < Agreed Capital
-​ The admission of a new partner may occur in either of two ●​Revalue net assets down to fair value and
ways, namely: allocate to old partners.
1.​ Purchase of all or part of the interest of one or more of ●​Assign bonus to new partner
the existing partners.
2.​ Investment of assets in the partnership by the incoming
3. Determine the specific admission method.
partner.

1.3.1.1 By Purchase of Interest 1.3.2 Withdrawal, Retirement or Death of a New Partner

→ Purchase of Interest from One or More Partners → Withdrawal or Retirement of a partner
-​ One or more partners may sell their portion of the business to -​ When a partner retires or withdraws from the partnership, the
an outside party. This type of transaction is common in partnership is dissolved but the remaining partners may
operations that rely primarily on monetary capital rather than continue operating the business. The existing partners may
on the business expertise of the partners. buy out the retiring partner either by making a direct
acquisition or by having the partnership acquire the retiring
-​ The partner in making the transfer of ownership can actually partner's interest. If the present partner directly acquires the
convey the following rights: retiring partner's interest, the only entry on the partnership's
1.​ The right of co-ownership in the business property. This books is to record the transfer of capital from the retiring
right justifies the partnership drawings from the partner to the remaining partner. If the partnership acquires
business as well as the settlement paid at liquidation or the interest of the retiring partner, the partnership must pay
at the time of partners' withdrawal. the retiring partner an amount equal to his interest, more than
2.​ The right to share in profits and losses. his interest or less than his interest.
3.​ The right to participate in the management of the
business. -​ The interest of the retiring partner is usually measured by his
capital balance, increased or decreased by his share in the
-​ When an incoming partner purchases a portion or all of the following adjustment:
interests of one or more of the original partners, the 1.​ Profit or loss from the partnership operations from the
partnership assets remain unchanged and no cash or other last closing date to the date of his/her retirement.
assets flow from the new partner to the partnership. This 2.​ Changes in the valuation of all assets and liabilities
transaction is recorded by opening a capital account for the (book values to fair values)
new partner and decreasing the capital accounts of the selling
partners by the same amount. The cash paid by the buyer is → Death of a partner
not recorded in the books of the partnership for this is a -​ In the event of the death of a partner, the estate of the
personal transaction between the selling partners and the deceased partner is entitled to receive the amount of his
buyer. The gain or loss arising from the sale of interest is not interest in the partnership at the date of his death, The
to be recorded in the partnership books. deceased partner's capital is adjusted using his profit and loss
share percentage for changes in asset values arising from
1.3.1.2 By Investment revaluation of assets and for the profit from the date the
→ New partner invests in partnership
 books were last closed. The balance of his capital account -​ A debit balance in the partner's capital account may be
after considering the necessary adjustments should be caused by losses incurred in the realization of assets or by
transferred to a liability account pending settlement. pro rata absorption of an uncollectible deficit of a partner
whose combined capital and loan accounts is not enough to
1.3.3 Incorporation of a Partnership absorb the partner's share of total losses.
→ Incorporation of a Partnership
-​ When a partnership is converted into a corporation, the → Methods of Partnership Liquidation
corporation takes over the assets and assumes the liabilities -​ When a partnership is to be liquidated by the sale of assets,
of the partnership in exchange for shares of stocks. The the following methods may be used:
stocks received by the partnership are distributed in 1.​ Lump-Sum Liquidation, otherwise called Total
settlement of their interest. The partners now become Liquidation or Single Distribution.
stockholders of the newly formed corporation. 2.​ Installment Liquidation, otherwise called Installment
Distribution.
-​ The accounting procedures in recording the incorporation of
the partnership will depend on whether the original books of 1.4.1 Lump-Sum Method
the partnership will be continued by the corporation or new → Lump-sum Liquidation
books will be opened. -​ A lump-sum liquidation of a partnership is one in which all the
assets are converted into cash within a very short time,
→ Partnership Books Retained outside creditors are paid, and single lump-sum payment is
-​ If the partnership book are retained, the steps to be taken are made to the partners for their total interests.
as follows:
1.​ Revalue the assets → Realization of Assets
2.​ Close the partner's capital accounts to the corporate -​ Typically a partnership will experience losses on the sale of its
capital accounts assets. A partnership may have a "Going Out of Business"
sale in which its inventory is marked down well below normal
→ New Books Opened for the Corporation selling price to encourage immediate sale. The partnership's
-​ If new books are to be opened, the old partnership books fixed assets may also be offered at a reduced price. The
must be closed. The accounting procedures may be outlined accounts receivable are actually collected by the partnership.
as follows in the book of partnerships: Sometimes the partnership offers a large cash discount for
1.​ Revalue the assets (and any other items agreed on) in prompt payment of any remaining receivables whose
accordance with the agreed transfer values. collection may otherwise delay the termination of the
2.​ Record the transfer of assets and liabilities to the partnership. Alternatively, the receivables may be sold to a
corporation and the receipt of capital stocks by the factor. A factor is a business that specializes in acquiring
partnership. accounts receivables and immediately paying cash to the
3.​ Record the distribution of stocks to the partners in seller of the receivables. The partnership records the sale of
settlement of the balances of their capital accounts. the receivables, as it would any other asset.

1.4 Liquidation -​ Before any distribution may be made to the partners, either
→ Liquidation liabilities to outside creditors must be paid in full or the
-​ The basic objectives of a partnership during the liquidation necessary funds may be placed in an escrow account. The
process are to convert the partnership assets to cash (called escrow agent, usually a bank, uses the funds only for
realization of assets), to pay off partnership obligations and to payment of the partnership liabilities.
distribute cash and any unrealized assets to the individual
partners. The purpose of accounting during this period is to → Expenses of Liquidation
have an equitable distribution of partnership cash to creditors -​ During the liquidation process, expenses are usually incurred,
and partners. Hence, it is no longer income determination that such as legal and accounting expenses and advertising cost
is the focus of accounting but rather, the computation of gains of selling the assets. These expenses are allocated to
or losses on realization of assets which are to be partners' capital accounts in their profit and loss ratio.
subsequently allocated among the partners, the payment of
liabilities in accordance with law and the final distribution of → Liquidation Procedures
cash to partners. -​ The following procedure may be used in lump-sum liquidation.
1.​ Realization of assets and distribution of gain or loss on
-​ There are certain rules that should be followed in the realization among the partners based on the profit and
liquidation of the partnership namely: loss ratio.
1.​ Always allocate and close gains or losses to the 2.​ Payment of expenses
partners' capital accounts prior to distribution of any 3.​ Payment of liabilities
cash to partners. 4.​ Elimination of partner's capital deficiencies. If after the
2.​ When the business is liquidated, the partner is entitled distribution of loss on realization, a partner incurs a
to an amount depending upon his capital contribution, capital deficiency (i.e. partner's share of realization loss
his drawing, his share in the net income or loss from exceeds his capital credit) this deficiency must be
operations before liquidation, gains and losses on eliminated by using one of the following methods, in
realization and the balance of his loan account, if any. order of priority.
a.​ If the deficient partner has a loan balance,
-​ Each partner will receive in the final settlement the amount of exercise the right of offset,
his equity in the business, The amount of a partner's equity is b.​ If the deficient partner is solvent, make him
increased by the positive factors such as investment of capital invest cash to eliminate his deficiency.
and share in the profits. It is decreased by the negative c.​ the deficient partner is insolvent, let the other
factors such as withdrawals and share in the losses. If the partners absorb his deficiency
negative factors are greater than positive factors, the partners 5.​ Payment to partners (in order of priority)
will have a deficiency (debit balance) and he must pay the a.​ Loan accounts
partnership the amount of such deficiency, Failure to do so b.​ Capital accounts
would mean that his fellow partners would bear more than
their contractual share in losses and they will consequently 1.4.2 Installment Method
receive less than their equities in the business. → Installment Liquidation
-​ Involves the selling of some assets, paying liabilities of the
-​ As a general rule, the cash should be distributed as follows: partnership, dividing the available cash to the partners, selling
1.​ First, to outside creditors additional assets and making further payments to partners.
2.​ Second, to partners for loan accounts. This process continues until all the assets have been sold and
3.​ Third, to partners for capital accounts. all cash has been distributed to the creditors and to partners.
→ Procedures for Liquidation by Installment → Admission of a New Partner
-​ The following are the accounting procedures that may be 1.​ Admission by Purchase Interest
followed in liquidating a partnership by installments
1.​ Record the realization of assets and distribute the Case 1: Purchase of interest for one partner
realized gains or losses among the partners using profit A, Capital xx
and loss ratio. B, Capital xx
2.​ Pay liquidation expense and unrecorded liabilities, if
there are any and distribute these among the partners Case 2: Purchase of interest from all partners
using the profit and loss ratio. -​ Assumption 1 – Purchase at Book Value
3.​ Pay the liabilities to outsiders.
4.​ Distribute cash to partners after possible future losses -​ Assumption 2 – Purchase at more than Book Value
have been apportioned to partners or in accordance -​ Alternative 1: BOOK VALUE APPROACH
with a cash distribution program.
Amount Paid xx
-​ Eliminate any capital deficiency only before final payments to Less: Book Value of interest Acquires xx
partners. Excess xx

→ Periodic Computation of Safe Payments to partners

-​ The Statement of partnership liquidation is usually supported -​ Alternative 2: REVALUATION APPROACH
by a schedule of safe installment payments to partners, -​ Good will xx
simply called Schedule of Safe Payments, prepared -​ A, Capital xx
periodically. According to the schedule, each installment of -​ B, Capital xx
cash is distributed as if no more cash is forthcoming, either
from sale of assets or from collection of deficiencies from
partners. Cash is therefore distributed to a partner only if he Amount Paid xx
has an excess credit balance in his partnership interest (i.e. Less: Book Value Acquired xx
capital account or capital and loan account combined) after Excess xx
absorption of his share of the maximum possible loss that Divided by: Interest Acquired xx
may occur. The possible loss (hypothetical loss) consists of Revaluation of Asset Upward xx
the following:
1.​ Total value of remaining non-cash assets. These assets -​ A, Capital (old+goodwill*interest acquires) xx
are assumed unrealizable (they cannot be sold), hence, -​ B, Capital (old+goodwill*interest acquires) xx
they are considered loss chargeable to the partners. -​ F, Capital xx
2.​ Cash withheld to pay for anticipated liquidation
expenses and unrecorded liabilities that may arise. The -​ Assumption 3 – Purchase at less than Book Value
said expenses and liabilities represent possible loss to -​ In Book Value approach, same format but it is a loss,
the partners because upon their payment, the amount while, in Revaluation approach, same format but it is
paid is to be correspondingly absorbed by the partners. downward.
-​ Additional loss may also accrue to the partners when a debit -​ Prefer Book Value if Profit and Loss interest > capital
balance in any of the capital accounts results from the interest, otherwise, use revaluation approach.
foregoing allocations of possible loss. The deficiency of any of
the partners is absorbed by the other partners as additional
possible loss to them because he is presumed unable to pay 2.​ Admission by Investment
anything to the firm. -​ Any gain or loss recognized on sales subsequent to
recording the admission will be allocated on the basis of
→ Cash Withheld the new profit and loss ratio.
-​ The cash set aside in a separate fund is not a factor in
computing possible loss. It is the cash set aside to insure ●​TCC=TAC- No Adjustment
payments of potential liquidation expenses, which may be ●​TCC>TAC- overstatement of the asset or diminution
incurred and unrecorded liabilities may be discovered. This in partner’s capital
cash withheld is added to the total remaining non-cash assets ●​TCC<TAC- unrecorded net assets or the required
to obtain the maximum possible loss needed in the additional investment in partner’s capital
computation of safe installment payment. Also cash available
for distribution to the partners for the period is net of the cash ●​CC=AC- No transfer of capital
withheld. ●​CC>AC- Capital transfer or bonus to old partners
●​CC<AC- Additional Capital credit (either bonus or
-​ Unrecorded liabilities are obligations which are discovered or goodwill) from the old partners.
incurred during the liquidation. These are allocable to the
-​ In bonus, if there’s a revaluation of assets, they cannot be
partners according to their profit and loss sharing agreement.
recognized. But if a revaluation method is used, they
affect the partner’s capital account.
1.5 Summary
-​ In the absence of an approach to be used, a bonus
→ Capital interest vs. Profit and Loss Interest
approach should be applied.
-​ Capital Interest is a claim against the net assets of the
partnership as shown by the balance in the partner’s capital
→ Incorporation of a Partnership
account, while Interest in Profit or Loss determines how the
●​Partnership books are retained
partner’s capital interest will increase or decrease as a result
1.​ Change in assets and liability values in the partner’s
of subsequent operations.
interest prior to corporation
2.​ The change in the form of proprietorship. A revaluation
→ Assignment of an interest to a Third Party
account may be debited to losses and credited with
a.​ Revaluation Approach
gains from revaluation, and the balance may
-​ The use of fair values provides an equitable measure of
subsequently be closed into the capital accounts in the
each partner’s capital interest in the partnership.
Profit and Loss Ratio.
-​ Basis of valuation is fair value
-​ Results in a marked departure from the historical principle
●​New books for the corporation.
-​ In accounting record of partnership
b.​ Absence of Revaluation
1.​ Prepare J.E. for revaluation of assets, including
-​ This approach would retain the historical cost/changing
recognition of goodwill.
value (BOOK VALUE APPROACH).
 2.​ Record any cash withdrawal necessary to adjust portion is the maximum potential loss on
parties capital account balances to round amounts non-cash assets.
3.​ Record the transfer of assets and liabilities to the ●​Any capital deficiencies that may result in
corporation, the receipt of the corporation’s other partners as a result of a maximum loss
common stock by partnership, and the distribution on non-cash assets.
of the common stock to the partners in settlement ●​Schedule of Safe Payments is an effective
of the balances of their capital accounts. method of computing the amount of safe
payments to partners and preventing
-​ In the accounting records of the corporation excessive payments on any partners.
1.​ Record the acquisition of assets and liabilities from ●​It is inefficient, if numerous installment
the partnership at current fair values. distributions are made to partners.
2.​ Record the issuance of common stock at current ●​It is deficient as a planning device because it
fair value in payment of the obligation to the does provide information, but it can be
partnership. overcome by preparing a cash distribution
plan at the start of the liquidation process.

→ Partnership Liquidation 2.​ Cash Priority Program

-​ The phase of partnership operations which begins after a.​ Ranking the Partners
dissolution and ends with the termination of a partnership b.​ Reflects only the order in which cash
activities referred to as "winding up the affairs." distribution to partners will be made if cash is
available to distribute
-​ Basic Procedures in Liquidation (Procedures for Minimizing c.​ Loss Absorption Power / Abilities / Potential /
Inequities Among Partners) Maximum Loss Absorbable = Total interest
1.​ Sharing Gains and Losses. When a partnership is account/Profit and Loss assigned ratio
liquidated, the books should be adjusted and have
closed the net profit or loss for the period in the manner -​ Vulnerability Rankings
they have agreed in the partnership agreement. -​ Lowest absorption abilities is the most
2.​ Advance planning when the partnership is formed. vulnerable to partnership losses
3.​ Rules on setoff- Partnership Loans (Receivable) to the
partners -​ Limitation of Cash Priority Program
4.​ Rules on set off- Partner (Payable) loans to the 1.​ The program is operable only after outside
partnership—depends upon the situation. creditors have been paid in full
-​ Legal doctrine of setoff – whereby a deficit 2.​ Reflects only the order in which cash
balance in a partner's capital account may be set distribution to partners will be made if cash is
off against any balance existing in his/her loan available to distribute
account. 3.​ The sequence of distribution of cash in the
5.​ Liquidation expenses. Certain costs incurred during the program coincides with the sequence that
liquidation process should be treated as a reduction of would result if cash were distributed using the
the proceeds from the sale of non-cash assets. Other schedule of safe payments
liquidation costs should be treated as expenses.
6.​ Marshaling of assets. This doctrine is applied when the
partnership and/or one or more of the partners are
insolvent.
7.​ Distribution of cash or other assets to partners.

→ Lump-sum Liquidation
-​ Is one in which all assets are converted into cash within a
very short time, creditors are paid, and a single, lump-sum
payment is made to the partner’s for their capital interest.
1.​ Realization and distribution of gain or loss to all
partners on the basis of profit and loss ratio.
2.​ Payment of expenses
3.​ Payment of liabilities
4.​ Elimination of partner's capital deficiencies.
5.​ Payment to partners (in order)
a.​ Loan accounts
b.​ Capital accounts

→ Installment Liquidation
-​ Is a process of realizing some assets, paying creditors,
paying the remaining available cash to partners, realizing
additional assets, and making additional cash payment to
partners.
1.​ Schedule of Sales Payment
a.​ Assume total loss on all remaining non-cash
assets. Provide all possible losses, including
potential liquidation cost and unrecorded
liabilities.
-​ Possible Loss= amount of unrealized
non-cash assets + amount of cash withheld
(i.e. unrecorded unpaid expenses, and
anticipated liquidation expenses)

b.​ Assume that partners with a potential capital

deficit will be unable to pay anything to the
partnership (assume to be personally insolvent)
●​Hypothetical or assumed deficit balance is
allocated to the partners who have credit
balances using profit and loss ratio. This
MODULE 2 - Corporate Liquidation
3.​ Free Assets – Assets that are not pledged as security
for any particular liability, and thus available to meet
2.0 Corporate Liquidation the claims of priority liabilities and unsecured creditors.
→ Corporations get into financial difficulty for a large variety of Free assets also include the value of assets pledged to
reasons. A company may suffer from continued losses from fully secured creditors in excess of the related liability.
operations, overextended credit to customers, poor management or -​ Example: The P1,000,000 of the value of the building
working capital, failure to react to changes in economic conditions, is included as free assets
inadequate financing and a host of other reasons for not sustaining
a viable

→ Insolvency
-​ A debtor corporation is considered insolvent when it is unable
to pay its debts as they come due. In the legal sense, a
business enterprise is insolvent when its financial condition is
such that the sum of all its debt is greater than all of its assets
at fair valuation. Thus, a corporation remains solvent as long
as the fair value of its assets exceeds its liabilities, even if it
cannot meet its current obligation because of an insufficiency
of liquid resources. Debtor Corporations that are insolvent
have a large number of alternatives, such as liquidation,
reorganization or debt restructuring.

→ Corporate Liquidation
-​ This process can be initiated by the company by filing a
voluntary petition with the Securities and Exchange
Commission (SEC). The corporation is given three years from
the date of approval within which to wind up its affairs.

-​ The Securities and Exchange Commission may appoint a

receiver or a trustee following the filing of a petition for
liquidation or bankruptcy. The duties of the receiver in a
liquidation focuses on the realization of assets and the
payment of liabilities rather than on the preservation and
continuation of the business. In the course of the liquidation,
the receiver may continue business activity if that is in the
interest of an orderly liquidation. 2.1.1 Illustrative Problem
→ To illustrate the preparation of this statement, assume that X
-​ Financial Report Company has experienced severe financial difficulties in recent
-​ Corporation in liquidation usually prepares two classes of times and is currently insolvent.
financial reports. First, the initial report shows the
available asset values and debts of the debtor X Company
corporation. This report is known as the Statement of
Affairs. The second, is the periodic report of the receiver ASSETS
known as the Statement of Realization and Current Assets
Liquidation, this shows how the receiver managed the Cash 2,000
assets of the debtor corporation on behalf of the creditors. Marketable Securities 15,000
Accounts Receivable 23,000
2.1 Statement of Affairs Inventory 41,000
→ Statement of Affairs Prepaid Expenses 3,000
-​ Normally, at the start of the liquidation, a statement of affairs Property and Equipment (net) 84,000
is prepared for the corporation to provide information about Land
the current financial position of the company. The Statement Building 100,000
of Affairs is not a going concern report, it is an important Equipment 110,000
planning report for the anticipated liquidation of a company. 80,000
Thus, historical cost figures are not relevant. The various Intangible Assets 290,000
parties concerned desire information that reflects: Total Assets
a.​ the net realizable value of the debtor's assets and 15,000
b.​ the ultimate application of these proceeds to specific 389,000
liabilities.
LIABILITIES AND STOCKHOLDERS
-​ The assets and liabilities are reported according to the EQUITY
classifications relevant to liquidation. Consequently, assets Current Liabilities 75,000
are classified into three categories as follows: Notes Payable (secured by inventory) 60,000
1.​ Assets pledged to fully secured creditors – Certain Accounts Payable 18,000
assets can be pledged as security for a particular Accrued Expenses 153,000
liability and the estimated realizable value of the assets
equals or exceeds the amount of the liability. Such Long Term Liabilities
assets may also yield resources to cover unsecured Notes Payable (secured by lien on land
liabilities. and building) 200,000
2.​ Assets pledged to partially secured creditors – Stockholders Equity
Other assets that are pledged as security for a Capital Stock 100,000
particular liability. Partial payment of the liability will Retained earnings (Deficit) (64,000)
utilize the entire asset value; nothing will be left for the Total Liabilities and Stockholders equity 36,000
unsecured liabilities. 389,000
-​ Example: The P1,000,000 of the value of the
building is included as free assets. → Before the preparation of a statement of affairs, additional data
must be ascertained concerning the insolvent company and its
assets and liabilities. Hence, the following information has been in this category since such expenses will be necessary
accumulated about the X Company: for liquidation.
1.​ The marketable securities reported on the balance sheet e.​ According to this statement, if liquidation occurs, X
have appreciated in value since being acquired and are Company expects to have only P57,000 in free assets
now worth P20,000. Dividends of P500 are currently due remaining after settling all liabilities with priority.
from this investment. Unfortunately, the liability section shows unsecured
2.​ P12,000 of the company's accounts receivable can still be claims with a total of P95,000. These creditors, therefore,
collected. face a P38,000 loss (P95,000-P57,000) if the company is
3.​ The inventory held by the company can be sold for liquidated. This final distribution is often converted into an
P43,000. expected recovery percentage computed as follows.
4.​ A refund of P I ,000 will be received from the various -​ Expected Recovery Percentage = Net Free Assets /
prepaid expenses but the company's intangible assets Unsecured Claims
have no resale value. -​ P57,000 / P95,000 = 60%
5.​ The land and building can still be sold for P231,000.
While the equipment can only be sold for P32,000. -​ Thus, unsecured creditors can anticipate receiving only
6.​ Administrative expenses of P21 ,500 are estimated if 60 percent of their claims. Unsecured creditor, for
liquidation of the company does occur. example, who is owed P1,000 by this company should
7.​ Accrued expenses include salaries of P12,000 and payroll anticipate collecting only P600 (P1,000 X 60%)
taxes from wages but not yet paid to the government total following liquidation. Fully secured creditors, of course,
P3 ,000. will receive the full amount owed to them, as well as
8.​ Interest of P5,000 on the company's long-term liabilities those creditors with priority claims.
has not been accrued for the first six months of 2020.

2.2 Statement of Deficiency

→ The balances of the Stockholders equity account depends on the
amount of free assets available. If there is a deficiency of assets to
satisfy unsecured creditors, all claims of equity holders are
extinguished. Only if there are free assets in excess of unsecured
liabilities can stockholders share any distributions.

2.3 Statement of Realization and Liquidation

→ Statement of Realization and Liquidation
-​ This statement shows a complete record of the transaction of
the receiver for a period of time. Its structure is similar to a T
account and is composed of three elements: asset
transactions, and income/loss transactions.

-​ The first duty of the receiver is to realize the assets, that is to

convert the non-cash assets into cash so that the creditors
can be paid. The process of realization may be done in
several ways, some assets may be realized by normal
operations, such as the continuing collections of receivables
from customers. Other assets can be realized by sale. During
realization, gains and losses on asset sales may occur,
expenses may be incurred and revenues can be earned. The
realization activities may be presented in T account format.

-​ The second task of the receiver is to liquidate the liabilities,

that is to make full or partial settlement with the creditors.
Again, gains or losses may occur in the process of liquidation,
as may expenses or revenues. The liquidation activities may
also be presented in T account format.
→ From the above data, the statement of affairs for X Company can
be prepared and the following should be specifically noted in the
statement of affairs: Assets to be Realized Assets Realized
a.​ The current and non current classifications usually -​ Identifies the individual -​ Identifies proceeds
applied to assets and liabilities are omitted. Since the assets to which the trustee received from the
company is on the verge of going out of business. Such has taken title from the conversion of specific
classification is meaningless. Instead, the statement is debtor assets
designed to separate the secured and unsecured
balances. Assets Acquired
b.​ Book values are presented on the left side of the -​ Itemizes the assets Assets not Realized
schedule but only for informational purposes. These discovered from operating -​ Identifies the assets
figures are not relevant. All assets are reported at net activities during the period remaining with the trustee
realizable value, whereas liabilities are shown at the at the end of the reporting
amount required for settlement. period
c.​ The dividends receivable and the interest payable are
both included in the statement, although neither has been Liabilities Liquidated Liabilities to be Liquidated
recorded on the balance sheet. Currently updated figures -​ Identifies specific liabilities -​ Identifies the liabilities that
must be disclosed within the statement of affairs. paid by the trustee the trustee took
d.​ Liabilities having priority are individually identified with the responsibility at the date of
liability section because these claims will be paid before the appointment
other unsecured creditors, the P35,500 total also is
deducted directly from the free assets. Although not yet Liabilities not Liquidated Liabilities Incurred
incurred, estimated administrative expenses are included
 which the sum of all debts is greater than all of its assets at a
-​ Reflects those that remain -​ Reflects those that remain fair valuation.
to be paid by the trustee to be paid by the trustee
1.​ Assets
Statement of Realization and Liquidation a.​ Assets pledged with fully secured creditors –
expected to realize an amount at least sufficient
Supplementary Charges Supplementary Credits to satisfy the related debt.
-​ Excluding assets losses -​ Revenue excluding gains b.​ Assets pledged with partially secured
and write-offs on assets realization and creditors – expected to realize an amount below
liability settlements the related debt.
c.​ Free assets – not pledged and are available to
satisfy the claims of creditors with priority, partially
secured creditors, and unsecured creditors.
2.4 Determination of the order of priority of claimants of
company assets subject to liquidation 2.​ Liabilities
→ The liabilities of the company are classified into four categories a.​ Fully Secured Liabilities – expect to be paid in
as follows: full as a result of their having sufficient collateral
1.​ Unsecured Liabilities with priority – When the creditor to satisfy the indebtedness.
has no lien on any specific assets of the debtor corporation b.​ Partially Secured Liabilities – have collateral,
but its claims rank ahead of other unsecured liabilities in the the proceeds of which are expected to be
order of payment, the claims are considered unsecured insufficient to satisfy the indebtedness.
liabilities with priority. These liabilities, in order to priority c.​ Unsecured Liabilities with Priority – have
are: priority under the law (Section 50 Insolvency Law)
a.​ Administrative expenses of the receiver d.​ Unsecured Liabilities (General Controls) –
b.​ Unpaid employee’s salaries and wages, and benefit have no collateral relating to their indebtedness.
plans
c.​ Taxes 3.​ Estimated Recovery % or Dividend to General
Unsecured Creditors = Net Free Assets / Total
2.​ Fully secured creditors – For these liabilities, the creditor Unsecured Creditors
has a lien on specific assets, whose estimated realizable
value equals or exceeds the amount of the liability. → Statement of Realization and Liquidation
-​ Example: A bank holds a P2,000,000 mortgage on a -​ An activity statement progresses toward the liquidation of a
building of a debtor corporation and the building has an debtor’s state. It shows the actual transactions that transpired
estimated realizable value of P3,000,000. The during the period covered
mortgage is therefore fully secured and the bank is
referred to as a fully secured creditor.

3.​ Partially secured creditors – In some cases, the creditor

has a lien on specific assets but the estimated realizable
value of those assets is less than the amount of the liability.
-​ Example: A finance company holds a P50,000 note
secured by equipment of a debtor corporation, but the
equipment has an estimated realizable value of only
P30,000. This note is partially secured and the finance
company is referred to as a partially secured creditor.

4.​ Unsecured creditors – All other liabilities for which the

creditor has no lien on any specific assets of the debtor
corporation are unsecured. This includes the unsecured
portion of the liability to partially secured creditors.
-​ Example: There is a note payable to the finance
company for P50,000 secured by the equipment worth
P30,000, the difference of P20,000 is added to the
unsecured liabilities.

2.5 Summary
→ Insolvency
-​ it is an inability to pay off its liabilities as they become due and
demandable. In Legal View, it is a financial condition in which
the sum of all debts is greater than all of its assets at a fair
valuation.

1.​ Role of Creditors

●​outside creditors appoint a trustee to manage the
debtor’s state

2.​ Roles of Trustees

●​Continue operating the debtor’s business if directed
by the account
●​Realizes free assets of the debtor’s expenses
●​Pay cash to unsecured creditors

3.​ Role of Accountants

●​Concerned with proper reporting of the financial
condition of the debtor and adequate accounting
and reporting for the trustee

→ Statement of Affairs
-​ It is an inability to pay off its liabilities as they become due
and demandable. In Legal View, it is a financial condition in
MODULE 3 - Revenue from contracts
●​Each party’s rights in relation to the goods or services to be
transferred can be identified;
●​The payment terms for the goods or services to be
with customers transferred can be identified;
3.0 Revenue from contracts with customers ●​The contract has commercial substance; and
→ Revenue from contracts with customers ●​It is probable that the consideration to which the entity is
-​ An installment sales contract is a special type of credit entitled to in exchange for the goods or services will be
arrangement which provides for a series of payments over a collected.
period of months or years. Installment sales are widely used
by dealers in real estate, home appliances and cars. Since -​ If a contract with a customer does not yet meet all of the above
the seller must wait for a considerable period of time to collect criteria, the entity will continue to re-assess the contract going
the full amount it exposes the seller to a greater risk of forward to determine whether it subsequently meets the above
non-collection considering that customers who avail of this criteria.
plan are generally weaker in financial condition. Furthermore,
the credit standing of a customer may change significantly -​ The standard provides detailed guidance on how to account for
during the period covered by an installment contract. approved contract modifications. If certain conditions are met, a
contract modification will be accounted for as a separate
-​ In view of this greater risk of non-collection, the seller should contract with the customer. If not, it will be accounted for by
protect himself by adopting a form of contract which enables modifying the accounting for the current contract with the
him to repossess the property if the buyer fails to make all the customer. Whether the latter type of modification is accounted
agreed installment payments. for prospectively or retrospectively depends on whether the
remaining goods or services to be delivered after the
→ Methods of Gross Profit Recognition on Installment Sales modification are distinct from those delivered prior to the
-​ The determination of the net income on installment sales is modification.
one of the more complicated problems because the amounts
of recoveries and the related costs and expenses are seldom 3.1.2 Step 2: Identify the performance obligations in the
known in the period when the sale is made. Two general contract
approaches may be used in the recognition of gross profit on → Step 2: Identify the performance obligation in the contract
installment sales: -​ At the inception of the contract, the entity should assess the
a.​ The gross profit (excess of sales price over cost of goods or services that have been promised to the customer,
sales) is recognized at the time of sale and and identify as a performance obligation: a good or service (or
b.​ The gross profit is recognized in installments over the bundle of goods or services) that is distinct; or a series of
period of the contract on the basis of cash collection. distinct goods or services that are substantially the same and
that have the same pattern of transfer to the customer.
→ Gross Profit is Recognized at the Time of Sale
-​ Many companies treat a sale on installment in exactly the -​ A series of distinct goods or services is transferred to the
same way as they treat any other sale on account. The customer in the same pattern if both of the following criteria
Account Receivable account is debited and the Sales account are met:
is credited for the full price when the sale is made. The ●​Each distinct good or service in the series that the entity
treatment is not different from that employed for regular sales promises to transfer consecutively to the customer would
on credit. Gross profit is recognized at the period of sale, the be a performance obligation that is satisfied over time
point at which goods have been delivered to the customers (see below); and
and a definite amount of receivables have been acquired. ●​A single method of measuring progress would be used to
measure the entity’s progress towards complete
→ Gross Profit is Recognized in the Period in which Cash is satisfaction of the performance obligation to transfer each
Collected distinct good or service in the series to the customer.
-​ This is a special method of accounting for installment sales
whereby gross profit is recognized in the periods in which the -​ A good or service is distinct if both of the following criteria are
installment receivables are collected instead of in the periods met:
in which receivables are created. The amount of cash ●​The customer can benefit from the good or services on its
collections then become the basis for gross profit recognition. own or in conjunction with other readily available
resources; and
3.1 Five-Steps Model Framework ●​The entity’s promise to transfer the good or service to the
→ Accounting Requirements for Revenue customer is separately identifiable from other promises in
-​ The core principle is that an entity will recognize revenue to the contract.
depict the transfer of promised goods or services to
customers in an amount that reflects the consideration to -​ Factors for consideration as to whether a promise to transfer
which the entity expects to be entitled in exchange for those goods or services to the customer is not separately
goods or services. This core principle is delivered in a identifiable include, but are not limited to:
five-step model framework: ●​The entity does provide a significant service of integrating
1.​ Identify the contract(s) with the customer the goods or services with other goods or services
2.​ Identify the performance of obligations in the contract promised in the contract;
3.​ Determine the transaction price ●​The goods or services significantly modify or customize
4.​ Allocate the transaction price to the performance other goods or services promised in the contract;
obligations in the contracts ●​The goods or services are highly interrelated or highly
5.​ Recognize revenue when (or as) the entity satisfies a interdependent.
performance obligation
3.1.3 Step 3: Determine the transaction price
-​ Application of this guidance will depend on the facts and → Step 3: Determine the transaction price
circumstances present in a contract with a customer and will -​ The transaction price is the amount to which an entity expects
require the exercise of judgment. to be entitled in exchange for the transfer of goods and
services. When making this determination, an entity will
3.1.1 Step 1: Identify the contract with the customer consider past customary business practices.
→ Step 1: Identify the contract with the customer
-​ A contract with a customer will be within the scope if all the -​ Where a contract contains elements of variable consideration,
following conditions are met: the entity will estimate the amount of variable consideration to
●​The contract has been approved by the parties to the which it will be entitled under the contract. Variable
contract; consideration can arise, for example, as a result of discounts,
rebates, refunds, credits, price concessions, incentives,
performance bonuses, penalties or other similar items.
 Variable consideration is also present if an entity’s right to Factors that may indicate the point in time at which control
consideration is contingent on the occurrence of a future passes include, but are not limited to:
event. ●​the entity has a present right to payment for the asset;
●​the customer has legal title to the asset;
-​ The standard deals with the uncertainty relating to variable ●​the entity has transferred physical possession of the
consideration by limiting the amount of variable consideration asset;
that can be recognized. Specifically, variable consideration is ●​the customer has the significant risks and rewards related
only included in the transaction price if, and to the extent that, to the ownership of the asset; and
it is highly probable that its inclusion will not result in a ●​the customer has accepted the asset.
significant revenue reversal in the future when the uncertainty
has been subsequently resolved.

-​ However, a different, more restrictive approach is applied in 3.2 Other Revenue Recognition Issues
respect of sales or usage-based royalty revenue arising from
license of intellectual property. Such revenue is recognized
only when the underlying sales or usage occur.

3.1.4 Step 4: Allocate the transaction price to the performance

obligations in the contracts
→ Step 4: Allocate the transaction price to the performance
obligations in the contracts
-​ Where a contract has multiple performance obligations, an
entity will allocate the transaction price to the performance
obligations in the contract by reference to their relative
standalone selling prices. If a standalone selling price is not
directly observable, the entity will need to estimate it.
●​Adjusted market assessment approach
●​Expected cost plus a margin approach
●​Residual approach (only permissible in limited
circumstances)

-​ Any overall discount compared to the aggregate of

standalone selling prices is allocated between performance
obligations on a relative standalone selling price basis. In
certain circumstances, it may be appropriate to allocate such
a discount to some but not all of the performance obligations.

-​ Where consideration is paid in advance or in arrears, the

entity will need to consider whether the contract includes a
significant financing arrangement and, if so, adjust for the
time value of money. A practical expedient is available where 3.2.1 Sales with a Right of Return
the interval between transfer of the promised goods or → Sales with a right of return
services and payment by the customer is expected to be less -​ Under the standard, when an entity makes a sale with a right
than 12 months. of return, it recognizes revenue at the amount to which it
expects to be entitled by applying the variable consideration
3.1.5 Step 5: Recognize revenue when (or as) the entity and constraint guidelines set out in Step 3 of the Five-Steps
satisfies a performance obligation Model Framework. The entity also recognizes a refund liability
→ Step 5: Recognize revenue when (or as) the entity satisfies a and an asset for any goods or services that it expects to be
performance obligation returned.
-​ Revenue is recognized as control is passed, either over time
or at a point in time. -​ An entity applies the accounting guidance for a sale with right
-​ Control of an asset is defined as the ability to direct the use of of return when a customer has a right to:
and obtain substantially all of the remaining benefits from the ●​A full or partial refund of any consideration period
asset. This includes the ability to prevent others from directing ●​A credit that can be applied against amount owed, or that
the use of and obtaining the benefits from the asset. The will be owed, to the entity; or
benefits related to the asset are the potential cash flows that ●​Another product in exchange (unless it is another product
may be obtained directly or indirectly. These include, but are of the same type, quality, condition and price - e.g.
not limited to: exchanging a red sweater for a white sweater)
●​Using the asset to produce goods or provide services;
●​Using the asset to enhance the value of other assets; -​ An entity does not account for its stand-ready obligation to
●​Using the asset to settle liabilities or to reduce expenses; accept returns as a performance obligation. In addition to
●​Selling or exchanging the asset; product returns, the guidance also applies to services that are
●​Pledging the asset to secure a loan; and provided subject to a refund.
●​Holding the asset.
-​ The guidance does not apply to:
-​ An entity recognizes revenue over time if one of the following ●​Exchanges by a customer of one product for another of
criteria is met: the same type, quality, condition and price; and
●​the customer simultaneously receives and consumes all ●​Returns of faulty goods or replacements, which are
of the benefits provided by the entity as the entity instead evaluated under the guidance on warranties.
performs;
●​the entity’s performance creates or enhances an asset -​ The entity updates its measurement of the refund liability and
that the customer controls as the asset is created; or return asset at each reporting date for changes in
●​the entity’s performance does not create an asset with an expectations about the amount of the refunds. It recognizes
alternative use to the entity and the entity has an adjustments to the:
enforceable right to payment for performance completed ●​Refund liability as revenue;
to date. ●​Return asset as an expense
Example: Retailer B sells 100 products at a price of 100 each
-​ If an entity does not satisfy its performance obligation over
and receives a payment of 10,000. The sales contract allows the
time, it satisfies it at a point in time. Revenue will therefore be
recognized when control is passed at a certain point in time.
 customer has an option to purchase the good or service with
customer to return any undamaged products within 30 days and or without warranty, then the warranty is a distinct service. If
receive a full refund in cash. The cost of each product is 60. B the warranty includes a service beyond assuring that the
estimates that three products will be returned and a subsequent goods complies with agreed specifications, then it is distinct.
change in the estimate will not result in a significant revenue
reversal. -​ When a warranty is not sold separately, the warranty or option
of it may still be a performance obligation if it provides the
B estimates that the cost of recovering the products will not be customer with a service in addition to the assurance that the
significant and expects that the products can be resold at a product complies with agreed specifications. A warranty that
profit. covers only a product's compliance with agreed specifications
(an assurance warranty) is accounted for under the provisions
Within 30 days, two products were returned. standard.

B recorded the following entries on: -​ If the warranty - or part of it - is considered to be a

-​ Transfer of products to the customer to reflect its performance obligation, then the entity allocates a portion of
expectation that three products will be returned the transaction price to the service performance obligation by
-​ Return of the two products; and applying the requirements in Step 4 model.
-​ Expiry of the right to return products
-​ If an entity provides a warranty that includes both an
Sale assurance element and a service element and the entity
cannot reasonably account for them separately, then it
Cash 10,000 accounts for both of the warranties together as a single
Refund Liability (1) 300 performance obligation.
Revenue 9,700 Example: Manufacturer M grants its customer a standard
To recognize sale excluding the revenue warranty with the purchase of its product. Under this warranty,
on product expected to be returned M provides assurance that the product complies with the agreed
specifications and will operate as promise for three years from
Return Asset (2) 180 the date of purchase,
Cost of Sales 5,820
Inventory 6,000 Customer C also chooses to purchase an extended warranty for
To recognize cost of sales and right to two additional years.
recover products from customers
In this example, M concludes that there are two performance
Two Products Returned obligations in the contract.

Refund Liability (3) 200

Cash (3) 200
To recognize the refund for product
returned

Inventory (4) 120

Returned Asset (4) 120
To recognize product returned as
inventory

Right of Returned Expires

Refund Liability 100 -​ The extended warranty is a performance obligation because it

Revenue 100 can be purchased separately and distinct based on the Step 2
To recognize revenue on expiry of right of criteria.
return
-​ The component of the standard warranty that provides
assurance that the product complies with stated specifications
Cost of Sales 60
is an assurance-type warranty, and therefore is not a
Return Asset 60
performance obligation. As a consequence, M accounts for
To recognize cost of sales on expiry of
the standard warranty under the provisions standard when
right to recover products from customers
control of the product transfers to the customer.

Notes 3.2.3 Principal vs. Agent Consideration

1.​ 100 x 3 (the price of the product expected to be returned) → Principal vs. Agent Consideration
2.​ 60 x 3 (the cost of the products expected to be returned) -​ When another party is involved in providing goods or services
3.​ 100 x 2 (the price of the products returned) to a customer, an entity evaluates the nature of its promise to
4.​ 60 x 2 (the cost of the products returned) the customer. If an entity obtains control of another party's
goods or services before transferring control to the customer,
3.2.2 Warranties then the entity's promise is to provide the goods or services
→ Warranties itself. Therefore the entity is acting as a principal.
-​ Under the standard, an entity accounts for a warranty (or part
of a warranty) as a performance obligation if the warranty is -​ However, if the entity does not control the good or service
distinct, including: before it is transferred to the customer, then the entity is
●​The customer has an option to purchase the warranty acting as an agent and arranges for that good or service to be
separately; or provided by another party.
●​Additional services are provided as part of the warranty.
-​ Otherwise, warranties are accounted for under the provisions -​ An entity identifies each specified good or service to be
standard. transferred to the customer and determines whether it is a
principal or agent for each one. An entity may be a principal
→ Applying guidance on warranties for some goods and services and an agent for others in a
-​ Under the standard a warranty is considered a performance contract to transfer multiple goods or services
obligation if it is distinct under the Step 2 criteria. If the
 Example 1: Specific good or service is the underlying product renew the contract beyond the stated contract term to avoid the
ordered up-front fee. If the incentive is important to Z’s decision to enter
into the contract, then there is a material right.
Company V operates a website from which it sells Company T’s
products. Customers place orders directly on the website. V First, C compares the up-front fee of 50 with the total transaction
passes orders on to T, which ships the products directly to price of 1,250 (the up-front fee of 50 plus the service fee of
customers. 1,200 (12 x 100)). It concludes that the refundable up-front fee is
not quantitatively material.
In this case, the specified good or service is the underlying
product ordered rather than a right to that product. Second, C considers the qualitative reasons that Z might renew.
These include, but are not limited to, the overall quality of the
service provided, the services and related ricing provided by
Example 2: Specified good or service is a right to a specified
competitors and the inconvenience to Z of changing service
good of services
providers (e.g. returning equipment to C, scheduling installation
by the new provider)
Company V is a ticket-selling agent that sells airline tickets. The
tickets give customers the right to travel with a specific airline. C concludes that although avoidance of the up-front fee on
renewal is a consideration to Z, this factor alone does not
In this case, the specified good or service is the right to the flight. influence Z’s decision over whether to renew the service. C
As such, the principal-agent assessment focuses on who concludes based on its customer satisfaction research data that
controls that right rather than the underlying fight itself. In these the quality of service provided and its competitive pricing are the
cases, the fact that Y will not provide the underlying service is key factors underpinning the average customer life of three
not determinative. years.

3.2.4 Non-refundable up-Front Fees 3.2.5 Licensing

→ Non-refundable up-Front Fees → Licensing
-​ Some contracts include non-refundable up-front fees that are -​ A license of IP establishes a customer’s rights to the IP of
paid at or near contract inception - e.g. joining fees for health another entity. Examples of IP include:
club membership, activation fees for telecommunication ●​Software and Technology
contracts and set-up fees for outsourcing contracts. The ●​Franchises
standard provides guidance on determining the timing or ●​Patents, Trademarks, and Copyrights
recognition for these fees. ●​Films, Music and Video Games; and
●​Scientific Compounds
-​ An entity assesses whether the non-refundable up-front fees
relate to the transfer of a promised good or service to the Example 1: Promise is a service, not a license
customer.
Streaming Service S provides a music streaming service to
-​ In many cases, even though a non-refundable up-front fee customers. S enters into a one-year contract via the internet on
relates to an activity that the entity is required to undertake to C’s personal devices. However, C does ot have the ability to
fulfill the contract, that activity does not result in the transfer of download the music content during the contract term and it can
a promised good or service to the customer. Instead, it is an listen only to the music only through the internet.
administrative task.
S evaluates whether it is providing C with a service or a license
-​ If the activity does not result in the transfer of a promised to its content. S concludes that the contract does not include a
good or service to the customer, then the up-front fee is an license because C does not have the ability to download the
advance payment for performance obligations to be satisfied music during the contract term and use it without accessing S’s
in the future and is recognized as revenue when those future site. As a result, the license guidance does not apply.
goods or services are provided.
Example 2: Promise is a license
-​ If the up-front fee gives rise to a material right for future goods
or services, then the entity attributes all of it to the goods and
services to be transferred, including the material right Production COmpany P produces music content. P enters into a
associated with the up-front payment. three-year license agreement to provide an initial music library
and rights to future content to Customer C. The terms of the
-​ The non-refundable up-front fee results in a contract that license allow C to play, stream, and broadcast the content to
includes a customer option that is a material right if it would other parties.
probably impact the customer's decision on whether to
exercise the option to continue buying the entity's product or P evaluates whether it is providing C with a service or a license
service (e.g. to renew a membership or service contract or to its content. P concludes that the contract includes a license of
order an additional product). IP because C takes delivery of the music library that it can use
without further services from P.
Example: Non-refundable up-front fees: Annual Contract
As a result, the licensing guidance applies and P needs to
Cable Company C enters into a one-year contract to provide evaluate whether the license related to the initial music library is
cable television to customer Z. In addition to a monthly service distinct from the rights to future content.
fee of 100, C charges a one-time up-front fee of 50. C has
determined that its set-up activity does not transfer a promised 3.2.6 Repurchase Agreements
good or services to Z, but is instead an administrative task. → Repurchase Agreements
-​ An entity has executed a repurchase agreement if it sells an
At the end of the year, Z can renew the contract on a asset to a customer and promises, or has the option, to
month-to-month basis at the then-current month rate or can repurchase it. If the repurchase agreement meets the
commit to another one-year contract at the then-current annual definition of a financial instrument, then it is outside the scope
rate. In either case, Z will not be charged another fee on of the standard. If not, then the repurchase agreement is in
renewal. The average customer life for customers entering into the scope of the standard and the accounting for it depends
similar contracts is three years. on its type, e g. a forward, call option or put option and on the
repurchase price.
C considers both quantitative and qualitative factors to
determine whether the up-front fee provides an incentive for Z to
 3.3 Financial Statement Presentation
→ Financial Statement Presentation
-​ Contracts with customers will be presented in an entity’s
statement of financial position as a contract liability, a contract
asset, or a receivable, depending on the relationship between
3.2.7 Consignment Arrangements the entity’s performance and the customer’s payment.
→ Consignment Arrangements
-​ An entity may deliver goods to another party but retain control -​ A contract liability is presented in the statement of financial
of the goods, e.g. it may deliver a product to a dealer or position where a customer has paid an amount of
distributor for sale to an end customer. These types of consideration prior to the entity performing by transferring the
arrangements are called "consignment arrangements" and do related goods or service to the customer.
not allow the entity to recognize revenue on delivery of the
products to the intermediary. -​ Where the entity has performed by transferring a good or
service to the customer and the customer has not yet paid the
related consideration, a contract asset or a receivable is
presented in the statement of financial position, depending on
the nature of the entity’s right to consideration. A contract
asset is recognized when the entity’s right to consideration is
conditional on something other than the passage of time, for
example future performance of the entity. A receivable is
recognized when the entity’s right to consideration is
unconditional except for the passage of time.

-​ Contract assets and receivables shall be accounted for in

accordance with the standard. Any impairment relating to
contracts with customers should be measured, presented and
disclosed in accordance with the standard. Any difference
between the initial recognition of a receivable and the
corresponding amount of revenue recognized should also be
presented as an expense, for example, an impairment loss.

→ Disclosures
-​ The disclosure objective stated is for an entity to disclose
3.2.8 Bill and Hold-Arrangements
sufficient information to enable users of financial statements
→ Bill and Hold-Arrangements
to understand the nature, amount, timing and uncertainty of
-​ When an entity bills a customer for a product that it transfers
revenue and cash flows arising from contracts with
at a point in time, but retains physical possession of the
customers. Therefore, an entity should disclose qualitative
product until it is transferred to the customer at a future point
and quantitative information about all of the following:
in time. This might occur to accommodate a customer's lack
●​Its contracts with customers
of available space for the product or delays in production
●​the significant judgments, and changes in the judgments,
schedules.
made in applying the guidance to those contracts; and
●​any assets recognized from the costs to obtain or fulfill a
-​ To determine when to recognize revenue, an entity needs to
contract with a customer.
determine when the customer obtains control of the product.
Generally, this occurs at shipment or delivery to the customer,
-​ Entities will need to consider the level of detail necessary to
depending on the contract terms,
satisfy the disclosure objective and how much emphasis to
place on each of the requirements. An entity should
aggregate or disaggregate disclosures to ensure that useful
information is not obscured.
3.4 Summary -​ When a perpetual inventory system is maintained, the
→ Related Terms account repossessed merchandise should be debited to
-​ Revenue – gross inflow of economic benefits during the Merchandise Inventory-Repossessed
period.
-​ Trade-in – is recorded at the value allowed.
– arises in the course of the ordinary-including
sales, fees, interest, dividends, royalties, and rent -​ Over-allowance – a reduction in sales price
-​ Gain – represent increases in economic benefit and such Pro Forma
are no different in nature from revenue. Trade-in Allowance xx
-​ Ordinary Activities – core business operations Less: Market Value before Reconditioning Cost
– Revenue is realized when goods and Estimated Resale Price After Reconditioning
services are exchanged for cash or Costs xx
claims to cash (receivables). Less: Reconditioning Costs (xx)
– "Revenue is earned when the entity Cost to Sell (xx)
has substantially accomplished what it Normal Profit (xx)
must do to be entitled to the benefits Over-Allowance xx
represented by the revenue." xx
-​ Regular Sales – either cash sales or credit sales.
-​ Installment Sales – payment of periodic installment.
Uncollectible Allowance Accounts Written-off:
→ Method of Gross Profit Ratio
-​ Time of Sale/ Sale Basis (Accrual Basis) – profit is Doubtful Account Expense xx
recognized in the period in which the sale is made. Deferred Gross Profit xx
-​ Time of Collection – profit is recognized in the period in Installment Accounts Receivable xx
which cash is collected. The gross profit is deferred, then it is
-​ Interest on Installment Sales Contracts
realized when collections are made.
1.​ Long-end interest – interest is computed based on the
balance of the unpaid principal balance between
installment period
2.​ Short-end interest – interest is computed on the
installment due, from the date the contract was entered
into until the date of the installment payment

-​ Computation of Realized Gross Profit

●​Current Year Sales: Gross Profit/ Installment Sales
●​Prior year’s Sales: Deferred-Gross Profit-Beg. Of Current
Year/Installment AR - beginning of the current year

-​ The installment sales method of accounting normally implies

the deferral gross profit but the recognition of selling and
administrative expenses in the period of their incurred.

-​ Allocation of Cost of Goods Sold

●​Use lump-sum is usually used for any cases
●​NRV= Estimated Selling Price - (Recondition + cost to
sell)

-​ Guidelines in Repossession
1.​ Repossession may also be recorded as an estimated
cash purchase.
2.​ When published prices are not available, NRV less
normal profit may be used.
→ Journal Entries

Repossessed Merchandise xx
Deferred Gross Profit xx

Loss on Repossession xx
Installment Accounts Receivable xx

Pro Forma
Estimated Selling Price after Reconditioning Cost xx
Less: Reconditioning Cost xx
Cost to Sell xx
Normal Profit xx
Market Value before Reconditioning Cost xx
Less: Unrecovered Cost xx
Installment Accounts Receivable xx
Less: Deferred Gross Profit xx
Loss/Gain on Repossession (xx)
xx
xx
MODULE 4 - Long Term Construction
costs that are expected to be recovered if the
contract is accepted. Contract costs incurred after
the acceptance of the contract are costs incurred
Contracts toward the completion of the project and are also
4.0 Long Term Construction Contracts capitalized in the Construction in Progress (CIP)
→ Contract Revenue account. The contract does not have to be identified
-​ Revenue from long-term construction contracts is measured before the capitalization; it is only necessary that
at the fair value of the consideration received or receivable. there be an expectation of the recovery of the
This includes the initial amount of revenue agreed in the costs. Once the contract has been accepted, the
contract. This amount may increase or decrease from one pre-contract costs become contract costs incurred
period to the next. to date. However, if the pre-contract costs are
-​ Example: already recognized as an expense in the period in
a.​ A contractor and customer may agree to change the which they are incurred, they are not included in
scope of the work to be performed under the contract. contract costs when the contract is obtained in a
Such as, changes in the specifications design of the subsequent period.
asset and changes in the duration of the contract.
b.​ The amount of revenue agreed may increase as a 2.​ Estimated cost to Complete
result of cost escalation clauses. -​ These are the anticipated cost of materials, labor,
c.​ The amount of contract revenue may decrease as a subcontracting costs and indirect costs (overhead)
result of penalties arising from delays caused by the required to complete a project at a scheduled time.
contractor in the completion of the contract; or They are composed of the same elements as the
d.​ When the contract price involves a fixed price per unit original total estimated contract costs and would be
of output, contract revenue increases as the number of based on prices expected to be in effect when the
units is increased. costs are incurred. The latest estimates should be
-​ Construction revenue may also include incentive payments to used to determine the progress toward completion.
the contractor for early completion of the contract when the
contract is sufficiently advanced that it is probable that the -​ Accounting for contract costs is similar to
specified performance standards will be met or exceeds; and accounting for inventory. Costs as incurred would
the amount of the incentive payment can be measured be recorded in the Construction in Progress
reliably. account. Construction in Progress account would
include both direct and indirect costs but would
→ Contract Costs usually not include general and administrative
-​ Contract costs are costs that relate directly to the specific expenses or selling expenses since they are not
contract; are attributable to contract activity in general and normally identifiable with a particular contract and
can be allocated to the contract; and are specifically should therefore be expensed.
chargeable to the customer under the terms of the contract.
Examples of contract costs are: → Methods of Construction Accounting
a.​ Site labor costs, including site supervision 1.​ Percentage of Completion Method
b.​ Costs of materials used in construction -​ This method is to be used when the outcome of the
c.​ Depreciation of plant and equipment used on the construction contract can be estimated reliably, that
contract is, the estimate of costs to complete and the extent of
d.​ Costs of moving plant, equipment and materials to and progress toward completion of long-term contracts
from the contract site are reasonably dependable
e.​ Costs of hiring plant and equipment
f.​ Costs of design and technical assistance -​ Measuring the Percentage of Completion
g.​ The estimated costs of rectification and guarantee ●​The stage of completion of a contract may be
work, including expected warranty costs determined in a variety of ways. The enterprise
h.​ Claims from third parties uses the method that measures the work
i.​ Insurance performed. Depending on the nature of the
j.​ Construction overheads contract, the methods may include:
k.​ General administrative costs and development costs for a.​ Input Measures (Cost to Cost Method)
which reimbursement is specified in the terms of the -​ This method is used if the contract calls
contract for one large project rather than several
separate projects. Under this method
-​ Construction revenue may also include incentive payments to the degree of completion is determined
the contractor for early completion of the contract when the by computing the ratio of the costs
contract is sufficiently advanced that it is probable that the already incurred to the total estimated
specified performance standards will be met or exceeds; and costs to complete the project. The
the amount of the incentive payment can be measured percentage of completion is then
reliably. applied to the estimated gross profit
(contract price less total estimated
→ Type of Contract Costs costs) to determine the gross profit to
-​ Contract costs can be broken down into two categories: cost be recognized to date. Some of the
incurred to date and estimated costs to complete costs incurred, particularly in the early
1.​ Cost incurred to date stages of the contract should be
-​ These include pre-contract costs and costs incurred excluded in using this method, because
after contract acceptance. Pre-contract costs are they do not relate directly to the work
costs incurred before a contract has been entered performed on the contract. These
into, with the expectation that the contract will be include such items as payments to
accepted and these costs will hereby be subcontractors in advance for work that
recoverable through billings. The criteria for has been set to be performed,
recognition of such costs are: fabricated materials that have been
a.​ They are capable of being identified delivered to the contract site but not yet
separately installed, used or applied during the
b.​ They can be measured reliably contract performance, unless the
c.​ It is probable that the contract will be obtained material has been made specifically for
the contract. However, this estimation is
-​ Pre-contract costs include costs of architectural required in reporting income, regardless
designs, cost of securing the contract and any other of how the percentage of completion is
computed.
 b.​ Output Measures (Units of Delivery) Building xx
-​ The progress is based on the results Construction in Progress (CIP) xx
achieved. Under this method revenue is
recognized when certain phases of the 6.​Turnover to Client
project are completed and accepted by Construction in Progress (CIP) xx
the buyer. This method is useful in Building xx
contracts for the construction of several
condominium units. Income is
recognized when a particular unit is Pro Forma 20x1 20x2 20x
completed and delivered and accepted 3
by the buyer although the entire project
is not yet finished. Thus, if a Contract Price
construction company signs a contract Initial Amount of Contract
for ten condominium units and Variation
completes three units at the end of the Total Contract Price
first year and accepted by the buyers, Cost Incurred Each Year
then 30% of the total revenue provided Add: Cost Incurred to Date
under the contract should be Actual Cost Incurred to Date
recognized. Add: Estimated Cost to Complete
Total Estimated Cost (3)
2.​ Zero Profit Method (Cost Recovery Method) Estimated Gross Profit
-​ This method is described as the percentage of % of Completion (1)/(3)
completion method based on a zero profit margin. Gross Profit to Date
Under this method, revenue is recognized in an Less: Gross Profit in Prior Years
amount exactly equal to costs incurred until Gross Profit Current Years
reasonable objective estimates of the percentage of
completion are available.
4.1.1 Overtime
-​ Performance during the period is included in the → Recognizing Revenue at a Point in Time or Over a Period of
Statement of Comprehensive Income, although the Time
method does not affect net income because revenue -​ The last step of the Five-Steps Model Framework addresses
and costs recognized are equal. The zero profit at what time revenue from contracts with customers should be
margin approach indicates to financial statement recognized. One of the principal considerations used in this
users the volume of the company's business while determination is whether the performance obligation is
deferring the recognition of gross profit until more satisfied at a point in time (when) or over a period of time (as).
reliable estimates of the degree of completion can be This determination should be made for each performance
made. obligation at the inception of a contract and is determined
based on the method the entity transfers control of the
4.1 Journal Entries and Determination of Revenue, Costs, and promised goods or services to a customer. The guidance
Gross Profit assumes the performance obligation is satisfied at a point in
→ Journal Entries time, unless any one of the following criteria are met:
●​The customer simultaneously receives and consumes the
1.​Billing of Clients benefits provided by the entity’s performance as the entity
Accounts Receivable xx performs.
Cash xx ●​The entity’s performance creates or enhances an asset
that the customer controls as the asset is created or
2.​Payment from Clients enhanced.
Cash xx ●​The entity’s performance does not create an asset with an
Accounts Receivable xx alternative use to the entity, and the entity has an
enforceable right to payment for performance completed
3.​Construction Costs to date.
Raw Materials xx
Salaries/Wages Expense xx -​ Whereas the first condition is primarily focused on delivery of
Utilities Expense xx services, the next two are focused on the creation or
Cash xx enhancement of goods, although the criteria could be applied
to either in certain circumstances.
4.​End Of Year
A.​ Percentage of Completion -​ To clarify, customers simultaneously receive and consume
Construction in Progress (CIP) xx benefits generally if the asset is transferred in intervals where
Raw Material xx the delivery of individual service is distinct and identifiable.
Salaries/Wages Expense xx The specific example in the guidance is a cleaning service.
Utilities Expense xx The second condition relates primarily to work-in-process
assets and if/when the rights to the asset are controlled by the
Construction in Progress (CIP) xx customer throughout the process. In this case the asset would
Construction Costs xx have value to the customer at some point during the creation
Revenue xx or enhancement process. An example might be software
development where the customer may have control of the
B.​ Zero Profit Method related asset even though the development process is not
Construction in Progress (CIP) xx complete. The final condition could be determined either by
Raw Material xx the product itself or the contract terms. For example, the
Salaries/Wages Expense xx contract terms could specifically exclude the vendor from
Utilities Expense xx using the asset elsewhere, as in a trademark. Alternatively,
the product itself could simply have no alternative use, such
Construction Costs xx as a custom-built machine.
Revenue xx
→ Period of Time
-​ If any one of the above criteria are met, the performance
5.​Project Completion
obligation is considered to be satisfied over a period of time.
For performance obligations satisfied over a period of time,
 states that revenue should be recognized “by measuring the a.​ Costs incurred plus recognized profits; less
progress toward complete satisfaction of that performance b.​ The sum of recognized losses and progress billings for all
obligation.” Further, the guidance describes two methods for contracts in progress for which progress billings exceed
measuring such progress, the “input method” and the “output costs incurred plus recognized profits (less recognized
method.” The entity should only measure satisfaction of the losses).
performance obligation over a period of time if the entity has
reliable information from which to reasonably measure its 4.3 Financial Statement Presentation
progress toward completing the performance obligation under → Financial Statement Presentation
one of these methods. -​ An enterprise should present:
a.​ The gross amount due from customers for contract
4.1.1.1 Input Method work as an asset; and
→ Input Method b.​ The gross amount due to customers for contract work
-​ As indicated by the title, this method measures the level of as a liability
effort the entity has put into satisfying the performance
obligation in relation to the total. Examples include resources → Disclosure
consumed, labor hours expended, costs incurred, time 1.​ Disclosures relating to all contracts:
elapsed, or machine hours used. Costs included in this a.​ Aggregate amount of contract revenue
method should be tailored to exclude those costs that are not recognized in the period.
incurred directly in satisfaction of the performance obligation. b.​ Methods used in determination of contract
revenue recognized in the period.
-​ The entity should elect the measurement method that most 2.​ Disclosure relating to contracts in progress:
accurately reflects its progress toward satisfaction of the a.​ Methods used in determination of stage of
performance obligation. Once elected, the entity should apply completion (of contracts in progress)
that method in measuring the satisfaction of similar b.​ Aggregate amount of costs incurred and
performance obligations in similar circumstances. recognized profits (net of recognized losses) to
date
4.1.1.2 Output Method c.​ Amounts of advances received (at statement of
→ Output Method financial position date)
-​ Under this method, the entity would measure completion of d.​ Amount of retentions (at statement of financial
the total performance obligation either in relation to the total position date)
obligation that has been satisfied or in relation to what
remains to be satisfied. Examples provided include surveys of 4.4 Summary
performance completed to date, appraisals of results → Long Term Contracts
achieved, milestones reached, time elapsed, and units -​ A construction contract is a contract specifically negotiated for
produced or units delivered. the construction of an asset or a combination of an asset that
are closely interrelated or interdependent in terms of their
4.1.2 Point in Time design technology, and function or their ultimate use or
→ Point in Time purpose.
-​ Once the determination has been made that the performance
obligation has been satisfied at a point in time, the next step → Types of Construction Costs
is to determine at what point in time the obligation is satisfied. 1.​ Fixed Price Contract
The guidance does not provide a distinct set of criteria for ●​Agreed to a Fixed Price
when the performance obligation is satisfied but does provide ●​Subject to Cost Escalation Clauses
the following factors to be considered in this determination; 2.​ Cost Plus Contract
●​The entity has a present right to payment for the asset ●​Reimbursed for allowed or otherwise defined costs
●​The customer has legal title to the asset plus a % of these costs or a fixed rate
●​The entity has transferred physical possession of the
asset → Related Terms
●​The customer has the significant risks and rewards of -​ Construction Revenue – total amount of consideration
ownership of the asset receivable under the contract.
●​The customer has accepted the asset -​ Variation – instruction by the customers for a change in the
scope of the work to be performed under the contract.
-​ These factors are points of consideration in determining when -​ Incentive Payment – additional amounts paid to the
control of the related asset passes to the customer. Transfer contractor are met or exceeded.
of control could result from a combination of factors -​ Claims – an amount that the contractor seeks to collect from
depending on the facts and circumstances of the contract. the customers or another party as reimbursement for costs
Alternatively, a number of these factors could be present but if not included in the contract price.
the customer still did not have control of the asset, the -​ Construction Contracts
performance obligation may not be satisfied. For example, in ●​Relate directly to the specific contract
consignment arrangements the customer may have accepted ●​Are attributable to contract activity in general and can be
and taken physical possession of the goods but control is not allocated to the contract.
deemed to have been transferred until the goods are sold by ●​Chargeable to the customers
the consignor.
→ Costs that relate directly:
-​ In determining when control has been transferred, the entity a.​ Site labor costs
should consider the assets at which point in time the b.​ Materials used
customer has the ability to direct the use of—and obtain c.​ Depreciation
substantially all the benefits of—that asset. d.​ Moving PPE
e.​ Hiring PPE
4.2 Gross Amount Due from / to Customers f.​ Design and technical assistance
→ The gross amount due from customers for contract work is g.​ Rectification and guarantee work
the net amount of: h.​ Claims from third parties
a.​ Costs incurred plus recognized profits; less
b.​ The sum of recognized losses and progress billings for all
contracts in progress for which costs incurred plus
recognized profits (less recognized losses) exceeds
progress billings.

→ The gross amount due to customers for contract work is the

net amount;
→ Percentage of Completion Method
-​ An application of the accrual assumption
-​ Avoids the mismatch between costs being recognized as they
are incurred and revenue only being recognized when the
contract is completed.

a.​ Input Measures

-​ Based on an established or assumed relationship
between a unit of input and productivity.
i.​ Cost-to-Cost Method – degree of completion is
determined by comparing costs already incurred
with the most recent estimates of total costs
expected to complete the project.
ii.​ Effort-Expended Method – based on some
measure of work performed.

b.​ Output Measures – are measured in terms of results

achieved. It was based on units produced.

→ Cost-Recovery Method
1.​ Recognize Revenue only to the extent of contract costs
incurred in which are expected to be recoverable;
2.​ Recognize contract costs as an expense in the period they
are incurred.

→ Financial Statements Presentations

1.​ Current Assets – Total costs incurred on the contract, less
progress billings
2.​ Current Liability – Progress Billings less total cost incurred
on the contract
3.​ General Administrative Expense – charge to income in
the period when they occur.
4.​ Contract Retention – guarantee the completion of the
contract in satisfying manner (Current Assets)
MODULE 5 - Franchise Operations –
-​ The following accounting principle and procedures are to be
Franchisor’s Point of View used in the recognition of revenue from the initial franchise
5.0 Franchise Operations fee:
→ Franchise Operations 1.​ Revenue from the initial franchise fee should be
-​ A franchise generally involves the grant from one party recognized on the consummation of the transaction,
(franchisor) to another party (franchisee), the right to sell the which occurs when all material services or conditions of
granting party's goods or services. Each party contributes the sale have been substantially performed.
resources. Substantial performance by the franchisor occurs when
the following conditions are met:
-​ The franchisor contributes his trade name, products, a.​ The franchisor is not obligated in any way (trade
company's reputation and trademarks. He also imparts his practice, law, intent or agreement) to refund
expertise and on a continuing basis provides guidance and cash already received or forgive unpaid debt.
duties on the manner in which the franchisee must operate b.​ The initial services required of the franchisor by
his establishment. The franchisee on the other hand, provides contract or otherwise have been substantially
operational capital and managerial operational resources performed.
required for the operation of the franchised business. c.​ No other material conditions or obligation exist

-​ The relation of these parties is covered by a franchise 2.​ Direct franchise costs of initial services rendered by the
agreement which outlines the rights and responsibilities of franchisor shall be deferred until related revenue is
each party, describes the marketing practices to be followed, recognized. These costs should not exceed anticipated
details the contribution of each party and sets certain related revenue. Indirect costs that occur on a regular
standards of operating procedures which both parties agree basis should be expensed when incurred.
to perform.
-​ It is assumed that substantial performance occurs when the
-​ Franchising gives the franchisor the opportunity to distribute franchisee actually commences operations of the franchise.
his product and or services with minimum investment in the Once substantial performance is achieved, revenue from the
franchised outlet. Franchisee is able to own his business, initial franchise fee should be recognized using the following
reap financial rewards and benefit from the agreement by way methods:
of assistance and guidance from the franchisor. The 1.​ Accrual basis – This method is used when the initial
franchisee, however, must pay for these services and must be franchise fee is collectible over an extended period of
willing to accept the franchisor's control over operations. time and the collectibility of the unpaid portion of the
franchise fee is reasonably assured.
5.1 Journal Entries and Determination of Revenue Costs and 2.​ Gross Profit Method – If the collectibility of the unpaid
Gross Profits portion of the franchise fee is not reasonably assured.
→ Journal Entries 3.​ Cost Recovery Method – This method should be used
in exceptional cases that is when the initial franchise
1.​To record the receipt of initial franchise fee fee is collectible over an extended period and the
Cash xx collectibility of the unpaid portion of the initial franchise
Deferred revenue from IFF xx fee is uncertain.

2.​To record payment of franchise cost xx → Revenue Recognition - Continuing Franchise Fees
Deferred cost of franchise revenue xx -​ Continuing franchise fee is usually collected from the
Franchise Expense xx franchisee at the end of each month based on a certain
Cash percentage of their monthly sales. Continuing franchise fees
are recognized as revenue when actually earned and
3.​To record continuing franchise fee receivable from the franchisee.
Cash xx
Revenue from CFF xx → Franchise Fee
-​ Franchise agreement usually requires franchisees to make
payments, called the franchise fee to the franchisor in
4.​End Of Year
consideration for the reputation, skill products and services
A.​ To adjust cost of franchise revenue
contributed by the franchisor. There are two types of franchise
Cost of franchise revenue xx
fees, namely;
Deferred cost of franchise revenue xx
1.​ Initial Franchise Fee
2.​ Continuing Franchise Fee
B.​ To recognize fully as revenue the initial franchise
fee
5.1.1 Initial Franchise Fee
Deferred revenue from IFF xx
→ Initial Franchise Fee
Revenue from IFF xx
-​ This represents initial payment for establishing the franchise
agreement and for providing certain initial services associated
with the agreement. The initial franchise fee may be payable
Statement of Comprehensive Income of the Franchisor immediately in cash or for an extended period of time. The
initial services rendered by the franchisor prior to the opening
Revenue from franchise fee xx of the franchisee's operations usually include the following:
Cost of franchise revenue (xx) a.​ Assistance in site selection for the construction of the
Gross Profit xx building
Operating Expenses (xx) b.​ Supervision of the construction activity, which
Continuing Franchise Fee xx involves obtaining financing, designing building and
Interest Income xx supervising contractor
Net Income/ Net Loss xx/(xx) c.​ Assistance in the acquisition of signs, fixtures and
equipment
→ Revenue Recognition - Initial Franchise Fees d.​ Provision of bookkeeping and advisory services
-​ The problem of recognizing revenue with regard to initial e.​ Provision of employee and management training
franchise fees, generally results from two issue: f.​ Provision of quality control
1.​ The point at which the fee is to be considered earned; g.​ Provision of advertising and promotion
and
2.​ The assurance of collectibility of any unpaid portion of 5.1.2 Continuing Franchise Fee, Bargain Purchase Option,
the fee, if the total initial franchise fee is not paid in full. and Commingled Revenue
→ Continuing Franchise Fee accounting for the initial franchise fee. If at the time the option
-​ This represents continued payment to the franchisor for is given, an understanding exists that the option will be
providing specific future services, such as advertising and for exercised or it is probable that the franchisor ultimately will
the continued use of intangible rights by the franchisee. acquire the franchised outlet, the initial franchise fee shall not
These fees are usually based on the operations of franchises. be recognized as revenue but shall be deferred. When the
option is exercised, the deferred amount shall reduce the
→ Commingled Revenue franchisor's investment in the outlet.
-​ The franchise agreement ordinarily establishes a single initial
franchise fee as consideration for the franchise rights and the 5.2 Consignment Sales
initial services to be performed by the franchisor. Sometimes, → Consignment Sales
however, the fee also may cover tangible property, such as -​ In some arrangements the delivery of the goods by the
signs, equipment, inventory, and land and building. In those manufacturer (wholesaler) to the dealer (retailer) is not
circumstances, the portion of the fee applicable to the tangible considered to be full performance and a sale because the
assets shall be based on the fair value of the assets and may manufacturer retains title to the goods. This specialized
be recognized before or after recognizing the portion method of marketing certain types of products make use of a
applicable to the initial services. For example, when the device known as a consignment. Under this arrangement, the
portion of the fee relating to the sale of specific tangible consignor (manufacturer) ships merchandise to the consignee
assets is objectively determinable, it would be appropriate to (dealer), who is to act as an agent for the consignor in selling
recognize that portion when their titles pass, even though the the merchandise. Both consignor and consignee are
balance of the fee relating to services is recognized when the interested in selling - the former to make a profit or develop a
remaining services or conditions in the franchise agreement market, the latter to make a commission on the sales.
have been substantially performed or satisfied
→ Accounting for Consignment Sales
-​ Although a franchise agreement may specify portions of the -​ A modified version of the sales basis (regular sales) of
total fee that relate to specific services to be provided by the revenue recognition is used by the consignor. That is,
franchisor, the services usually are interrelated to such an revenue is recognized only after the consignor receives
extent that the amount applicable to each service cannot be notification of sale and the cash remittance from the
segregated objectively. The fee shall not be allocated among consignee.
the different services as a means of recognizing any part of
the fee for services as revenue before all the services have -​ The merchandise is carried throughout the consignment as
been substantially performed unless actual transaction prices the inventory of the consignor, separately classified as
are available for individual services; for example, through Merchandise inventory on Consignment. It is not recorded as
recent sales of the separate specific services. an asset on the consignee's books. Upon sale of the
merchandise, the consignee has liability for the net amount.
→ Bargain Purchase Option The consignor periodically receives from the consignee an
-​ The franchisee may purchase some or all of the equipment or account sales that shows the merchandise received,
supplies necessary for its operations from the franchisor. merchandise sold, expenses chargeable to the consignment
Sometimes, the franchisee is given the right to make bargain and the cash remitted. Revenue then is recognized by the
purchases of equipment or supplies for a specified period or consignor.
up to a specified amount, when the initial franchise fee is
paid. If the bargain price is lower than the selling price of the -​ The following are procedures in consignment sales
same product to other customers or if the price does not transaction
provide the franchisor a reasonable profit on the equipment or 1.​ Consignor
supply sales, then a portion of the initial franchise fee shall be a.​ Consignment transactions recorded separately -
deferred and accounted for as an adjustment of the selling this method determines consignment profit
price when the franchisee purchases the equipment or separate from regular sales. An inventory
supplies. The portion deferred shall be either (a) the account called as inventory on Consignment is
difference between the selling price to other customers and used to record transactions in relation to
the bargain purchase price or (b) an amount sufficient to consignment.
cover any cost in excess of the bargain purchase price and i.​ Inventory on Consignment account is
provide a reasonable profit on the sale, as appropriate debited for:
●​Cost of goods shipped on
5.1.1 Repossessed Franchise consignment
→ Repossessed Franchise ●​Expenses related to consignment
-​ A franchisor may recover franchise rights through incurred by the consignor
repossession if a franchisee decides not to open an outlet. If, ●​Reimbursable expenses related to
for any reason, the franchisor refunds the consideration consignment paid by the consignee
received, the original sale is canceled, and revenue
previously recognized shall be accounted for as a reduction in ii.​ Inventory on Consignment account is
revenue in the period the franchise is repossessed. If credited for:
franchise rights are repossessed but no refund is made; ●​Cost of goods returned by the
a.​ The transaction shall not be regarded as a sale consignee
cancellation, ●​Cost of consignment sales and
b.​ No adjustment shall be made to any previously expenses relating to consignment
recognized revenue,
c.​ Any estimated uncollectible amounts resulting from b.​ Consignment transactions not recorded
unpaid receivables shall be provided for, and separately - consignment transactions are
d.​ Any consideration retained for which revenue was not treated like a regular type of sales.
previously recognized shall be reported as revenue. Determination of consignment profit is not
required since it is already part of the profit of
5.1.1 Option to Purchase the Franchise Outlet the entire entity.
→ Option to Purchase the Franchise Outlet
-​ A franchise agreement may give the franchisor an option to 2.​ Consignee
purchase the franchisee's business. For example, a franchisor a.​ Consignment transactions recorded separately -
may purchase a profitable franchised outlet as a matter of under this method, two accounts are needed to
management policy, or purchase a franchised outlet that is in be maintained in relation to consignment
financial difficulty or unable to continue in business to transactions:
preserve the reputation and goodwill of the franchise system. i.​ Consignor receivable account is:
If such an option exists, the likelihood of the franchisor
acquiring the franchised outlet shall be considered in
 ●​Debited for expenses paid by the
consignee but chargeable to the Notes Receivable xx
consignor Franchise Revenue
●​Credited when remittance is made to b.​ Refund has expired and collectability of the note is
the consignor reasonably assured, not substantially performing all
material services
ii.​ Consignor payable account is: Cash xx
●​Credited for the sales by the Notes Receivable xx
consignee Unearned Franchise Revenue
●​Debited when remittance is made by
the consignor -​ Subsequently, when it is performed all services;

b.​ Consignment transactions not recorded Unearned Franchise Revenue xx

separately - consignment transactions are Franchise Revenue xx
treated like a regular type of sales.
Determination of consignment profit is not c.​ Substantially performed all services and the
required since it is already part of the profit of collectability of the note is reasonably assured, but
the entire entity. the refund period has not expired.
5.3 Summary Unearned Franchise Revenue xx
→ Related terms Revenue from Franchise xx
-​ Franchise agreement – involves the granting business
rights by the franchisor to a franchisee that will operate the -​ Subsequently, the refund period has expires:
franchise outlet in a certain geographical location Unearned Franchise Revenue xx
-​ Initial Franchise Fee – recorded as revenue only when and Revenue from Franchise xx
as the franchisor makes “substantial performance” of the
services it is obligated to perform and collection of the fee is
reasonably assured d.​ Substantially Performed all services, refund period
-​ Franchisor’s Costs – match related costs and revenues by has expired, but the collectability of the note is not
reporting them as a component of income in the same reasonably assured - use installment method
accounting period.
– Ordinarily defer direct cost Cash xx
– Indirect cost should be expensed Notes Receivable xx
immediately Franchise Revenue xx
-​ Continuing Franchise Fee – received in continuing rights Unearned Franchise Revenue xx
granted by the franchise agreement and for providing such
-​ Subsequently, it recognizes it over period of time:
service
– It should be reported as Unearned Franchise Revenue xx
revenue when they are earned and receivable from the franchisee, Franchise Revenue xx
unless a portion of them has been designated for a particular
purpose
e.​ Refund has expired, Substantially performed all
→ Summary services, no basis for estimating the collectability of
-​ The franchisor provides the franchisee with the following the note (uncertain) - use cost-recovery method.
services: Cash xx
1.​ Assistance in site location Unearned Franchise Revenue xx
a.​ Analyzing the location
b.​ Negotiating the lease -​ Subsequently, collectability is assured
2.​ Evaluation of potential income
3.​ Supervision of construction income Unearned Franchise Revenue xx
4.​ Supervision of construction activity Franchise Revenue xx
a.​ Obtaining financing
b.​ Designing building 2.​ Initial Franchise Revenue – Non-Interesting Fee
c.​ Supervising contractor while building a.​ Reasonable expectation that the down payment may
5.​ Provision of bookkeeping and advisory services be refunded, substantial future services remain to be
a.​ Setting up franchisee’s records performed
b.​ Advising on income, real estate, and other taxes
c.​ Advising on local regulations of the franchisee Cash xx
business Notes Receivable xx
6.​ Provision of employee and management training Unearned Interest Income (Discount on N/R) xx
7.​ Provision of quality control Franchise Revenue xx

-​ Substantial Performance – no remaining obligation to

refund any cash received or excuse any non-payment of a b.​ If the probability of refunding the initial franchise fee is
note performed all the initial services required under the extremely low, future services to be provided to the
contract franchisee is minimal, collectability of the note is
-​ General Rule: 90% or more of the services required reasonably is assured, substantial performance has
occurred
-​ 3 Conditions to recognize initial franchise fee Cash xx
a.​ Service Notes Receivable xx
b.​ Period of refund Unearned Interest Income xx
c.​ Collectibility Franchise Revenue xx
→ Journal Entries
1.​ Initial Franchise Fee – Interest Bearing Note c.​ Initial down payment is not refundable, represents a
a.​ Performed all material services, the refund has fair measure of the services already provided,
expired, collectability is assured significant amount of services still to be performed,
collectability of the note is reasonably assured.
Cash xx
 -​ The balance of the Investment in Branch account shows the
Cash xx extent of the home office's investment in a particular branch.
Notes Receivable xx The reciprocal Home Office account on the books of the
Unearned Interest Income xx branch represents the home office's equity in the separate
Franchise Revenue xx financial statements of the branch.
Unearned Franchise Revenue xx
-​ The balances of the two reciprocal accounts are adjusted for
d.​ Initial down payment is not refundable, and no future the same inter-company transactions. The account balances
services are required by the franchisor, collection of are increased for asset transfers from the home office to the
the note is uncertain branch and decreased for asset transfers from the branch to
the home office. Adjustments to the accounts are also made
Cash xx for profits and losses of the branch, with branch profits
Franchise Revenue xx increasing the account balances and branch losses leading to
the decrease. Note that increases in the home office's
-​ When the collection of the note is extremely Investment in Branch account are accomplished with debit
uncertain, revenue through gross profit is entries and decreases with credit entries. The opposite is true
recognized by means of cash collection using the with respect to the Branch Home Office account.
cost recovery method.
6.2 Reconciliation of reciprocal accounts
e.​ Same case in #4 but the initial down payment is → Reconciliation of Reciprocal Accounts
refundable or substantial services are yet to be -​ The Investment in Branch account on the home office books
performed. and the Home Office account on the branch books are
Cash xx reciprocal accounts and theoretically, should have the same
Unearned Franchise Revenue xx balance at the end of the accounting period. However, this
condition seldom exists in practice because of bookkeeping or
mechanical errors such as duplication of entries, slides and

MODULE 6 -Accounting for Home Office, transpositions on either set of books that have occurred or
certain transactions may already have been recorded by one
office and not yet by the other or there is a time lag between
Branch, and Agency Transactions the recording of the same transaction on the home office and
6.0 Home Office, Branch, and Agency Transactions branch books.
→ Sales Agency and Branch Distinguished
-​ While both the sales agency and the branch office are -​ The home office, for example, debits an Investment in Branch
vehicles for enlarging sales volume, they exhibit a number of account immediately upon the shipment of merchandise to
significant operational differences. A sales agency usually the branch. The branch, on the other hand, credits the Home
carries a line of samples or displays merchandise but does Office account only at a later time when the merchandise is
not carry stocks of it. Orders are taken from customers and received, which can be several days after the shipment by the
sent to the home office for approval of credit. The home office home office. Another example of a transaction which causes
then ships that merchandise directly to customers. The different balances in the two accounts is the remittance of
receivable accounts are maintained in the home office which cash by the branch to the home office. Entry on the branch
also performs the collection function. A working fund for sales books of the cash remittance is not recorded by the home
agency expenses is provided by the home office and office while the cash is still in transit. The lack of agreement
replenished when exhausted. No other cash is handled by the between the reciprocal accounts poses no problem during the
sales agency. accounting period. However, at the end of the accounting
period, the reciprocal accounts must be brought into
-​ On the other hand, the branch office normally carries stocks agreement before combined financial statements are
of merchandise, which may be obtained solely from the home prepared.
office or a portion may be purchased from outside suppliers.
The branch makes usual warranties with respect to quality, -​ The data to be considered in reconciling the two accounts
makes collections of accounts receivable and functions in may be classified as follows:
most respects as an independent business unit. 1.​ Debits in the Investment in Branch account without
corresponding credits in the Home Office account.
-​ A branch may be restricted until it is a little more than a sales 2.​ Credits in the Investment in Branch account without
agency. A sales agency can be expanded until it resembles a corresponding debits in the Home Office account.
branch. 3.​ Debits in the Home Office account without
corresponding credits in the Investment in Branch
6.1 Transactions on the books of the home office and the account.
branch 4.​ Credits in the Home Office account without
→ Reciprocal (Intracompany) Accounts corresponding debits in the Investment in Branch
-​ Transactions with outside parties are recorded in the usual account.
manner. Transactions between the home office and a branch 5.​ Bookkeeping or mechanical errors on either set of
are recorded in intracompany accounts. These accounts are books.
reciprocal accounts between the home office and the branch.
When the books of both the home office and the branch are 6.3 Preparation of individual and combined financial
completely up to date, the balance in a reciprocal account on statements
the home office books will be equal but opposite that of the → Separate Financial Statement
related reciprocal account on the branch books. For example, -​ Normally the branch prepares its own financial statements so
if a reciprocal account on the home office books has a that the management of the home office can review and
P50,000 debit balance, the related reciprocal account on the evaluate the operating results and financial position of the
branch books should have a credit balance on the same branch. The home office also prepares its own financial
amount. statements so that it may appraise independently the results
of its own operation and its own financial position.
-​ The reciprocal account on the books of the home office often
is called Investment in Branch or Branch Current, while the → Combined Financial Statement
reciprocal account on the branch books may be labeled Home -​ In the preparation of combined financial statements for the
Office or Home Office Current. When a company has several company, the accounts of the home office and its branches
branches, a separate investment account for each branch is are combined. Reciprocal or intracompany account balances
maintained on the home office books. must be eliminated because they relate to activities within the
company rather than activities between the company and
outside parties.
 typically does not stock inventory, but only displays
-​ To facilitate the preparation of combined financial statements, merchandise, takes orders and arranges for delivery of the
a working paper normally is used to combine the accounts of merchandise. In other words, the agency merely acts on
the home office and its branches, and to eliminate the behalf of the home office (H.O.), with the latter handling the
reciprocal accounts. All eliminations are only made in the other aspects of operations such as purchase of
working paper, not on the separate books of the units being merchandise, advertising, and granting of credit
combined .
-​ The branch, however, has a greater degree of autonomy and
6.4 Special procedures in home office and branch transactions thus operates more independently of the home office than the
(inter – branch transfer of cash and merchandise at cost or at agency, primarily in the following aspects
billed price) ●​:Provision of a wider range of services to customers or
→ Merchandise Shipments to Branch - Billed at a price in clientele
Excess of Cost ●​Exercise of greater management decision-making
-​ The home office may prefer to bill merchandise to branches at ●​Handling of more aspects of business operations, such
cost plus an arbitrary percentage, otherwise known as billed as stocking of inventory, filling of customers’ orders, credit
price. Under this method, the branch manager is not given and collection
complete information concerning the actual cost of ●​Maintenance of a separate accounting system
merchandise shipped. Hence, upon receipt of merchandise
from the home office, the branch records the charges that are → Separate Branch Accounting Systems
listed on the invoice accompanying the goods. -​ Reflecting this greater degree of autonomy, the branch
typically maintains its own separate accounting system, while
-​ When billings to the branch exceed cost, the profits the agency does not. In fact, it is the home office which
determined by the branch will be less than actual profits. The records all agency transactions in the former’s accounting
inventories reported by the branch are overstated as much as system.
they were valued based on the billed price, not at their cost.
-​ Such maintenance of separate accounting records by the
6.5 Accounting for agency transactions branch and the home office facilitates more effective control
→ Accounting for Agencies over operations and enables top management to better
-​ The accounting process for the operation of a sales agency assess branch performance and make strategic business
does not introduce any new accounting problem because a decisions for the company.
sales agency is simply an extension of existing sales
territories. A sales agency neither keeps a complete set of → Accounting for Branch Operations
books nor uses a double entry system of accounts. Ordinarily, -​ The accounting transactions recorded by the branch are
a record of sales to customers and a list of cash payments generally of the following types:
supported by vouchers are sufficient. An imprest system is ●​External transactions or transactions with parties external
usually adopted by the home office for the working fund of the to the company as a legal entity (e.g. customers,
sales agency. suppliers, creditors, utility companies)
●​Internal transactions
-​ The entries made by the home office depend on whether ○​ Within the branch
sales agency net income is determined separately or not ○​ With other branches of the company
separately. If the home office wants to determine the net ○​ With home office
income of each of its sales agencies separately, it must
maintain in the general ledger distinct revenue and expense -​ The recording by the branch of its external transactions and
accounts in the name of the sales agency. For example, those which by nature affect only the branch (i.e. internal
Sales - Sales Agency, Rent Expense - Sales Agency. The transactions within the branch) is done using the regular
cost of goods sold by each agency must also be determined. accounts and journal entries. However, in recording the
If the perpetual inventory system is used, shipments to branch’s transactions with the H.O., certain intra-company
customers of the sales agencies are debited to Cost of Goods accounts will have to be created and used. Likewise,
Sold - Sales Agency and credited to Merchandise Inventory. inter-branch transactions or transactions of the branch with
On the other hand, if the periodic inventory system is another branch are usually caused or cleared through the
maintained, shipments to sales agency customers are H.O. using intra-company accounts.
recorded by debiting Cost of Goods Sold - Sales agency and
crediting Shipment of Merchandise - Sales Agency. At the end → Intra-Company Accounts
of the accounting period, the account Shipments of -​ At the time of the establishment of the branch, the following
Merchandise - Sales Agency is deducted from the total typical intra-company accounts are created in the books of
beginning inventory and purchases to determine the cost of accounts or records of the branch and home office:
goods available for sale by the home office for its own ●​Branch Book of Accounts
operations. ○​ “Home Office” Account
●​Home Office Book of Accounts
-​ If the home office elects not to determine separately the sales ○​ “Investment in Branch” account (one account for each
agency net income, the transactions of the sales agency are branch)
recorded in the home office's own revenue and expense
accounts. Upon closing the books, the Income summary -​ The intra-company accounts “Home Office” and “Investment
shows the results of both operations. in Branch” are reciprocal accounts, meaning they are
inversely related to or opposite each other. The “Home Office”
-​ When the home office transfers fixed assets to sales agencies account has a normal credit balance, while the “Investment in
the home office debits an appropriate asset account identified Branch” account has a normal debit balance. Whatever
with the sales agency (Ex. Furniture and Fixtures - Sales authorized transaction is recorded in one account should also
Agency) and credits the appropriate asset account. be recorded in the other account. Provided all transactions
are recorded, both accounts should have the same or equal
6.5 Summary balance.
→ Branch or Agency
-​ Depending on its objectives, the enterprise may adopt the -​ The “Home Office” account appears in the equity section of
form of either a branch or an agency. Both are part of a the branch balance sheet, while the “Investment in Branch”
central organization and while they conduct operations away account is shown in the asset section of the H.O. balance
from their home office, they are not a separate legal entity sheet. However, in the preparation of the financial statements
from the latter. of the company as a whole, these intra-company accounts
are eliminated since they pertain to internal activities which do
-​ The key difference between the two lies in their degree of not concern the external users of the reports.
autonomy or independence. For instance, a sales agency
→ Common Intra-Company
-​ The following are the most common transactions between the
branch and H.O. which are recorded by both, using the
intra-company accounts mentioned above:
●​Transfer of assets from H.O. to the branch and vice versa
(e.g. cash, fixed assets, merchandise inventory)
●​Recognition of branch income or loss (after closing of
revenue and expense accounts by the branch to its
“Income Summary” account)
●​Recording of expenses incurred by the branch but billed
to and paid by the H.O. (e.g. purchase of office supplies
by the H.O. for the branch)
●​Allocation of expenses by the H.O. which are chargeable
to the branch (e.g. branch’s share of the cost of
advertising undertaken by H.O. for the company)
●​Inter-branch transactions (e.g. personal accounts of
branch employees for collection, transfers of fixed assets,
authorized expenses incurred by a branch employee in
another branch)

→ Reconciliation of Investment in Branch and Home Office

Accounts
-​ As discussed above, the balances of the “Home Office” and
“Investment in Branch” accounts should be equal or the
same. In reality, however, because of timing differences and
recording errors, these two accounts rarely balance. There is
therefore a need to periodically prepare a reconciliation of
these two accounts to determine the reconciling items and
record the necessary adjustments through appropriate journal
entries in either or both of the books of the branch and H.O.