1

CONTROL ACCOUNTS
We all know what bank reconciliation statement is, it actually is a check of two statements or two balances one which is maintaining by you second which is been maintained by bank for you. Control accounts are another accounting control type which is used in manual accounting system as to check the errors, a control account contains the totals of all postings made to the account for which it is been prepared. Like if I say I m using control account to reconcile my sales account, it means I am controlling my businesss sales account balance by putting all the information regarding (accounts receivable, sales returns, sales discounts, credit sales) which affects its total in it. Let me take an example by adding some ledgers A business made total credit sales for the whole year of 80000 to 3 different customers x, y and z, and business has recovered accounts receivable from x and y but z still have to pay the accounts receivable. Total sales returns business had were of 2000 from x, 5000 from y and 3000 from z. total sales discounts business allowed to these customers were, to x 500 to y 1000 and to z 2000. Keeping in mind the information lets prepare some normal ledgers first Sales Account A/R x A/R y A/R z 20000 30000 30000

Balance X Account Sales 20000 sales return 2000 sales

80000 Y Account 30000 sales return 5000

Sales discount 500 Cash 17500

sales discount 1000 cash 24000

0 Z Account Sales

0 sales return 3000 x y z 2000 5000 3000

30000 sales return

Sales discount 2000 Balance C/D 25000

Balance 25000

bal.

10000

2 We got 6 different ledger accounts related to one main account which is sales. One thing we actually are controlling credit sales because these are the one which are to be checked, as their balance is been recovered or not. Ne effect of these ledgers on sales is that accounts receivable of value 25000 are still to recover from z this net amount can be proved by control account sales ledger control account. It will start with debit balance because of a/r as I said we actually are checking receivables

Sales discount X Y Z 500 1000 2000

Bal.

3500

Sales ledger control account Total of credit sales 80000 sales returns total Sales discount total Total receipts/cash 10000 3500 41500

Balance receivable

25000

Calculation: 80000-10000-3500-41500 = 25000 *41500 is total payments received from both x and y (17500+24000) Here you can see control accounts when preparing for sales actually deals with accounts receivables rather by sales, this is why it is also called total debtors account, or receivable controls. What I actually did I recorded total sales as total accounts receivable in sales ledger control account as debit balance of 80000. Than further accounts receivables were decreased by receiving cash 41500, by sales discount 3500 by sales return 10000, leaving the net accounts receivable of 25000 This example might have cleared the image of control account. These accounts are maintained for two main accounts, purchase and sales, sales ledger control account we just been through the example and for purchase ledger control account or total creditors account or payable control account is: A business made a total credit purchase of 70000 which means it has 70000 to pay in form of accounts payable, to 2 different suppliers, 25000 to supplier A and 45000 to supplier B. purchases return to supplier A were of 8000 and to supplier B of 5000. Purchases discounts received from supplier A were of 1500 and from supplier B 3000. Total cash payment made to supplier A is of 13000 and to supplier B 20000 remaining still payable.

A Account Purchase return Purchase Discount Cash 8000 1500 13000 Balance 2500 purchase 25000 purchase return purchase discount cash

B Account 5000 3000 20000 balance 17000 purchase 45000

3 Purchase return A account B account 8000 5000 purchase discount B Account A account 3000 1500

Balance

13000

balance

4500

Purchase Account A account B account 25000 45000

Balance

70000

Here we are to prepare purchase control account, which actually will be payable control account, according to this information net payable due on the business are 17000 of b and 2500 of a which in total are 19500, through purchase ledger control account we will prove or check that the information is correct or not. It will start by a credit balance which actually is credit purchase, accounts payable balance

Purchase ledger Control Account Cash payments Purchase return Purchase discount 33000 Total Credit purchases 70000 13000 4500

Balance

19500

Control accounts, actually deals in totals, total of purchase return, total of purchase discount, total payments through cash or bank to credit suppliers, must say all those transaction which effect credit purchases should be recorded in control accounts. In case of sales ledger control accounts, total credit sales, total of sales return, total of sales discount, total of receipts from credit customers, all the information related to credit sales should be recorded in sales ledger control account Bad debts expenses and Recovered Bad Debts Bad debts are those amounts which are not recoverable from customers, irrecoverable accounts receivables. You know that accounts receivables are assets, which arises when business sold goods on credit to customers, the amounts these customer could not pay due to any reason are bad debts, and are losses/expenses in nature for business, they reduces accounts receivable in balance sheet, and reduces revenue in income statement Recovered bad debts are those bad debts which were been written off (treated as loss), but customer of whom these were written off is somehow managed to pay the due amount, these are called recovered bad debts, both of these elements effect sales ledger control account. As when bad debts occurs they reduces accounts receivable and is why they will be added to the credit side of sales ledger control account, and bad debts recovered which increases the value which was written of, will be added to the debit side of sales ledger control account.

4 Other transfer to control account Suppose my business is dealing with a person named Raheem & sons who is supplying goods to the business at same he also is the customer for business, same person is buying and selling goods to same business, and recently business made following transactions with him Purchased goods of value 30000 from Raheem & sons on credit Sold goods to Raheem & sons of value 25000 on credit Raheem & sons suggested setting off his accounts receivable 25000 with the amount payable 30000 to him This leaves the balance of accounts payable of 5000, here is the ledgers for these transactions Purchase ledger / a/p Raheem & sons sales ledger / A/R Raheem & sons

Purchase

30000

sales

25000

After setting off the ledgers are like this: Purchase ledger / a/p Raheem & sons sales ledger / A/R Raheem & sons

Set-off sales

25000 Purchase Balance

30000 5000

sales 0

25000 set-off purchase 0

25000

This is how the adjustment will be made, both accounts set-off sales and set-off purchase are contra accounts and they will be added in purchase ledger control account and sales ledger control account. Set-off sales account will be added to the credit side of sales ledger control account as it decreases accounts receivables. Set-off purchase account will be added to the credit side of purchase ledger control account as it decreases accounts payable. Some other accounts may be, dishonor cheques etc must also be included in sales ledger control account and purchase ledger control account

INVENTORY/STOCK ACCOUNTING
Inventory consists of goods a business own and store to sales as it is, or to use it in manufacturing of products and than sale it. Simple words inventory or stock is businesss real product, for which it is doing business. Business buy it store it sell it, as it is or by adding some material on it in both of the ways merchandising or manufacturing inventory is the same asset. A business sold computers and furniture; both these assets are inventories for the business. Machinery and equipment which are operational assets for the business who buys them, but the business who actually selling them these machinery and equipment is inventory. Inventories can be classified as: Merchandise inventory: which are the goods on hand purchased for resale by a retailer or a trading company as it is, mean in the same condition in which they are purchased. Generally these goods are not been altered because they already are in finished goods form, or ready to use form. How ever in some cases parts of a specific item may be acquired and further assembled into finished products. For example a computer shop, the owner purchases mouse, key boards, monitors,

5 systems and further assemble it in complete computer and sale it, he still does not alter it but he just join the parts of it which already are in finished form. Manufacturing inventory: which are goods consisting several categories, raw material inventory, work in process inventory, finished goods inventory and manufacturing supplies inventory. Lets assume a business which assembles men suits/clothing. At first it purchases raw materials, cloth, button, thread, zippers or any other item which is required. Second, items transferred from raw materials to be used in the production of men suits. Employees are hired to cut cloth, operates swing machines, sweep and clean up the shop area, power and heat is used, this is work in process inventory. Third suits are completed, inspected, cost of each unit is determined and transferred to ware house for sales. Miscellaneous inventories: are the goods such as office supplies, office stationary etc. inventories of this type are typically used in near future and are treated as selling and administrative expenses. Whatever inventory or I must say whatever the business is; there is a proper need to value its inventory

Items included in inventory

All the inventory goods a business owned on the closing date of valuing the stock, or preparation of income statement or balance sheet for which closing inventory value is required. Thing is business should report or value all the inventory goods it own, those which are been stored at business and those which are property of business but are not stored by it, are sold but with special treatments, or purchased with special treatments like, goods in transit, consignment goods, sales with buy back agreement, installment sales etc. Goods in transit Assuming I m in the business of selling computers, and I bought those computers from a supplier located in Karachi. I have placed an order for 100 computers 5 days ago, which for sure will take time in documentation and for the goods to deliver here in Bahawalpur, or lets say computers are on the way through a truck but I still did not received the inventory, these are the goods in transit. These goods will belong to my business when I will receive them by signing receipt note, until than even I have bought still these goods are not my businesss property and is why I cannot report them or value them as inventory/closing stock, if I have to prepare income statement or balance sheet today, or just have to value stock in hand. Goods on Consignment Goods held by branches, or agents of the business which are not on hand, are not stored at business ware house but are at the consigners (agent) ware house are still the property of business, business still have the ownership and will include those in valuing inventory unless the sales are not been reported by the agent. Consignment basically is an agreement between business/consigner and agent/consignee to sale goods for commission. Consigner sends goods to its agent to sale purpose; consignee makes his efforts to sell these goods for which he will get commission after deducting selling expenses. Sales with buyback agreements Some companies enter into a contract of selling goods, and to purchase them back if not sold, on a prearranged price. Business does this kind of contracts in order to avoid taxes on inventory holdings, and to avoid finance expenses that would be incurred if the inventory stayed in house. Buyer pays all or most of the retail price for these goods, and business buy them back when needed on the rate which already been arranged between both parties. For example a car assembling company may have to pay big amount of taxes for this kind of inventory items, and they sell their product for a while with an agreement of buying them back after the tax calculations just to avoid taxes, in other words we can say business has just parked its inventory for a while and will drive it back to own location. This kind of inventory should also be reported by the selling company in their inventory not by the buying company.

6 Special sales agreements There are some special sales agreements, in which business return the goods which are not sold as agreement. Suppose subhan book shop located at university chowk, purchases all of its books from Lahore book depot with a promise to return back those books which are not been sold after the specified time. In this case one should be careful, as when the Lahore book depot will be valuing their inventory they must make it clear from subhan book shop of the books they are going to return or all of them are been sold, if they are to be returned than they should be included in Lahore book depot inventory account. Installment Sales As name tells, an agreement in which goods are sold on installment, when company sold its goods on installment, goods remains the property of business which sells it. Owner ship remains to the business until the buyer pays all the installment payments. These goods should also be valued as inventory because the ownership even after selling them still is in hand; these sales can be included in revenue if the reasonable estimate can be made for uncollectable accounts.

COMPONENTS OF INVENTORY COST

Inventory cost is measured by the total cash outlay made to acquire the goods and to prepare them for sales, these costs include the purchase cost and any other cost which is paid in addition to purchase cost to make goods ready to use or to sale. Like freight in is the amount business pay in addition to purchase cost and this cost is added to inventory, when these are incidental to the goods purchased. If the cost of freight is not identical, than these should be charged to cost of goods sold or inventory or to both with some defined portion

INVENTORY RECORDING METHODS

There are two methods of recording inventory, or measuring physical quantities in inventory either by perpetual inventory system or periodic inventory system Perpetual Inventory Method It is a method where the inventory record/accounting is kept continuously up-to-date. It involves the record of every transaction which includes the receipts and issue of inventory by keeping a balance after every transaction. Under this method inventory balance can be seen at any time, and inventory ledger is been maintained in this method. At first when stock is purchased entry to record the transaction is debit inventory account and credit cash or accounts payable. Notice purchase account is not been debited but inventory is moved in the inventory account, from where all the records will be maintained of issuing it for sale or manufacturing purpose. When stock is been returned, entry at that time is debit supplier account credit inventory account. If business paid freight charges and to add these expenses to cost of inventory, entry is to debit inventory account and credit cash account. When goods are sold under this method, two entries are been made, first to record cash or accounts receivable which is debit cash/accounts receivable and credit sales account. Second entry is to record cost of goods sold by the entry; debit cost of goods sold and credit inventory account. When goods are returned from customer again two entries are been made. First debit sales return account and credit accounts receivable, second entry is debit inventory account and credit cost of goods sold account. In short perpetual inventory system keeps an up to date record of inventory on daily bases. Periodic inventory Method The method where physical inventory is taken only after the year end or after specific time period/accounting periods, just like in income statement , when we prepare income statement we calculate cost of goods sold and inventory in it, not before the income statement not after it. It starts from opening inventory; add purchase of inventory during the year, less inventory at the end of year/closing inventory. Under this method inventory acquisition and sales are recorded by debiting

7 purchase account and crediting cash or accounts payable account when inventory is purchased. When inventory is returned, debits suppliers account and credit purchase return. Freight if added it is added by debiting freight account and crediting cash account, when inventory is sold, debit accounts receivable or cash and credit sales account. When goods are returned from customer, debit sales return account and credit accounts receivable account. This method is used in books while studying accounting, preparing income statement where in income statement inventory is been physically viewed. To understand both of these methods lets do the comparison through making entries under both methods Entries at the time of purchase Perpetual inventory method Debit inventory account Credit 5000 5000 periodic inventory method debit purchase account credit 5000 5000

cash/vendor account Entries at the date of sales

cash/vendor account

Debit cash/debtor account Credit sales account

7000 7000 4000 4000

debit cash/debtor account credit sales account

7000 7000

Debit cost of goods sold Credit inventory

In perpetual inventory method at the time of sales 2 entries are been made, cost of goods sold is been calculated. Entries at the time of purchase return Debit vendor account Credit 200 200 debit vendor account credit 200 200

inventory account

purchase returns

Entries at the time of sales return Debit sales return Credit debtor account 300 In 300 300 debit sales return credit debtor account 300 300

Debit inventory account

Credit cost of goods sold 300 perpetual inventory method 2 entries will be made for sales return, including one to reduce cost of goods sold Entries at the time of purchase discount

There are two methods for recording purchase discounts, one is gross method (purchase-discount) and another is net method. In the periodic inventory system companies report their purchases and accounts payable at gross amounts, it reports purchase discount as a deduction from purchases on the income statement. Under net method companies report their purchases and accounts payable on net amount (after deducting discounts), so this is why in this method purchase discounts which are been lost are also been reported in a separate account called purchase discount lost account, which in nature is a loss for business and it reflect managements inefficiency that discount is not been taken. This purchase discount lost account is added under other expenses and losses on the income statement. Take an example to clear the concept

8 A business purchased goods of value 10000 with terms 2/10 net in 30 days, which means if payment is made in 10 days than 2% of total amount will be given as discount. Entries under gross method in both perpetual and periodic inventory methods Perpetual inventory method Debit Credit inventory account 10000 10000 periodic inventory method debit credit purchase account 10000 10000

accounts payable

accounts payable

If discount is taken mean payment is made in 10 days with discount which is 2% of 10000 = 200 entries are Debit Credit Credit accounts payable 10000 200 9800 debit credit credit accounts payable 10000 200 9800

inventory account cash

purchase discount cash

In perpetual inventory system inventory account is been reduced by 200 and in periodic system this discount is recorded in a separate account called purchase discount account If discount is not been taken than entries will be same under both methods Debit Credit accounts payable cash 10000 10000 debit credit accounts payable cash 10000 10000

Entries under net method in both perpetual and periodic inventory methods Debit Credit inventory account 9800 9800 debit credit purchase account 9800 9800

accounts payable

accounts payable

If discount is been taken Debit Credit accounts payable cash 9800 9800 debit credit accounts payable cash 9800 9800

When discount is not been taken Debit Debit Credit accounts payable 9800 debit debit 10000 credit accounts payable 9800

purchase discount lost 200 cash

purchase discount lost 200 cash 10000

Calculation of inventory value/cost, for cost of goods sold and ending inventory A merchandising business in the year 2008 had the following transactions, regarding its inventory balance/value July 1 Opening inventory 20pcs of computers @3000 per piece Sep 20 sold 30pcs computers @5000 per piece Nov 4 sold 5pcs computers @5200 per piece Oct 25 sold 10pcs computers @5200 per piece

July 20 purchased 30pcs computers @3500 per piece Sep 7 Oct 9 purchased 10pcs computers @3700 per piece purchased 5pcs computers @4000 per piece

9 It is quite simple that a business with an opening balance of 200 computers and in the year it purchased and sold above mentioned quantities, if one asks to calculate its inventory and cost of sales anyone of you can do so right?. Well it is not that easy, problem is inventory is been purchased on different costs, @3500, @3700 and @4000, and inventory at the opening of the year is valued @3000. In calculating ending inventory and cost of goods sold problem is how would I know the computers business sold at the date Sep 20 were been bought on which cost or were out of which purchase? The sales on Sep 20 were through opening balances at the cost 3000 per computer? Or from the purchase of July 1 which were at cost of 3500 per unit or Sep 7 purchase or through next purchase? May be business had made the sales through both, opening balance and from July 20 purchase by having quantity of 20pcs from opening balance and remaining 10pcs from the purchase. May be business had made that sales only from the purchase of 30 computers. It is a bit confusing before calculating ending inventory or cost of sales one should know which items are been sold, because different items at different times are holding different costs. Solution for this problem is that there are different inventory costing methods, which business uses to calculate their ending inventory and cost of sales. Those methods are: FIFO First in First out LIFO Last in First out and Average method

The main issue of these methods is to the order in which the actual unit costs incurred are assigned to the ending inventory and cost of sales. Under FIFO method which is first unit of inventory in is the first unit of inventory out, mean the unit we have purchased first is the unit which we are going to sale first. Under LIFO which is last unit of inventory in is the first unit of inventory out, mean the latest purchase unit is the one which we are going to sale first. AVERAGE method is quite simple to calculate the average of all the units (total value of inventory / total quantity) and sale any of them because all of them are been averaged to same cost. Before explaining all these methods first see another inventory valuation method which is Specific cost identification method This method requires that each item stocked should be specifically marked so that its cost can be identified at any time. This method is useful when the item is large, expensive or only small quantities are handled. Businesses may tag the items manufactured or purchased so that every item should have an identity regarding its cost. Valuation of the cost of inventory on hand and cost of goods sold only is possible when the items are tagged or got their own identity so that when they are sold one should know what cost it holds. Other feature of this method is the opportunity to change income of the business, for example two identical motor bikes are for sale that costs, 40000 and 39000. When one is sold for 45000 the cost of goods sold and income reported will be based on what item business select, both of the bikes are same if company selects the one with cost 40000 than income is 5000 if it selects the one with cost 39000 than income is 6000. First in First out Method This method as it named is, the first item purchased is the first item sold, all the inventories are sold in the order they were acquired. Oldest stock is to sell first which goes into cost of goods sold and remaining on hand stock is based on most recent cost on which they were purchased or manufactured. On next page we will value the inventory in the example we early stated by this method July 1 Opening inventory 20pcs of computers @3000 per piece Sep 20 sold 30pcs computers @5000 per piece Nov 4 sold 5pcs computers @5200 per piece Oct 25 sold 10pcs computers @5200 per piece

July 20 purchased 30pcs computers @3500 per piece Sep 7 Oct 9 purchased 10pcs computers @3700 per piece purchased 5pcs computers @4000 per piece

Based on FIFO method under periodic inventory system cost of goods sold and ending inventory will be calculated as

10 Cost assigned to the sale of computers on Sep 20 which is of 30pcs computers is July 1 opening inventory 20pcs @3000 Remaining 10 will be of July 20 @3500 60000 35000

Cost assigned to the sale on October 25 which is 10pcs computers is Of July 20 purchase 10pcs @3500 35000 Under FIFO method as you can see is on first sale first business will sell those items which it had in the opening inventory and which it purchased first. At Sep 20 sales 30pcs computers were sold 20 from opening inventory and 10 from first purchase of July 1, which leaves a balance of 20 computers in July 1 purchase. If the business is manufacturing business than under FIFO same cost flow will be used for material issued to work in process. Oldest material purchased will be issued first to production and will be sold first

Cost assigned to the sale on Nov 4 which is of 5pcs computers is Of July 20 purchase 5pcs @3500 Total cost of sales is Closing inventory after all the sales 5pcs computers from July 20 purchase @3500 17500 10pcs computers from Sep 7 purchase @3700 37000 5pcs computers from Oct 9 purchase @4000 Closing stock 20000 74500 17500 147500

On next page we will see the FIFO method under perpetual inventory system. FIFO method gives equal answer under both periodic and perpetual inventory system FIFO method under perpetual inventory system Date Purchased/Receipt Quantity Rate Value Sold/Issue Quantity Rate Balance Quantity Rate 20 20 30 20 30 10 20 10 5 4000 20000 3000 3500 60000 35000 3000 3000 3500 3000 3500 3700

Value

Value 60000 60000 105000 60000 105000 37000 0 70000 37000 70000 37000 20000 35000 37000 20000 17500 37000 20000 74500

1-Jul 20-Jul 7-Sep

30 10

3500 3700

105000 37000

20-Sep

9-Oct

25-Oct

10

3500

35000

4-Nov

3500

17500

cost of goods sold

147500

20 3500 10 3700 20 3500 10 3700 5 4000 10 3500 10 3700 5 4000 5 3500 10 3700 5 4000 closing stock

11 See under both FIFO perpetual and FIFO periodic inventory methods cost of sales and closing stock is equal AVERAGE method for the same example In periodic average method what business will do is to calculate an average rat for each of the item on hand and for which is been sold. Total purchases and opening stock were 65pcs computers with total cost of *222000, with average rate of 3415 approximately ** 20 3000 60000 30 3500 105000 10 3700 37000 5 4000 20000 65 222000 All the units for whole year will be calculated for cost of goods sold at the average rate which is been calculated, without caring which item business should sale first because now every item is averaged and any of them can be sold without caring the flow of inventory. On next page we will see the average perpetual method, in average perpetual method a new average rate is been calculated every time when stock is been purchased Average method under perpetual inventory system Date Purchased/Receipt Quantity Rate Value Sold/Issue Quantity Rate Balance Rate 3000 3300 3366.667 3366.667

Value

Quantity 20 50 60

Value 60000 165000 202000 101000

1-Jul 20-Jul 7-Sep 20-Sep

30 3500 105000 10 3700 37000 30 3366.667 101000

30

9-Oct

5 4000

20000

35

3457.143

121000

25-Oct 4-Nov

10 5

3457.143 3457.143

34571.43 17285.72 152857.2

25 20

3457.143 86428.58 3457.143 69142.86 69142.86

cost of goods sold

closing stock

In average perpetual method a new average rate is been calculated every time when stock is been purchased LIFO-Last in First out Method with same data Last in first out method as defined earlier is when goods purchased most recently are the goods to sale out first. Under LIFO periodic inventory method closing stock and cost of goods sold will be valued as:

12 For Sep 20 sold 30pcs computers @5000 per piece, flow of inventory will be Sep 7 purchased 10pcs computers @3700 per piece July 20 purchased 30pcs computers @3500 per piece 37000 (10*3700) 70000 (20*3500) 107000

10pcs from 20pcs from

For

Oct 25 sold 10pcs computers @5200 per piece, flow of inventory cost is Oct 9 purchased 5pcs computers @4000 per piece 20000 (5*4000) 17500 (5*3500) 37500

5pcs from 5pcs from

July 20 purchased 30pcs computers @3500 per piece

For

Nov 4 sold 5pcs computers @5200 per piece, flow of inventory cost is July 20 purchased 30pcs computers @3500 per piece total cost of sales 17500 (5*3500) 162000

5pcs from

Closing inventory is the same opening balance of 20pcs @3000 as it is the oldest purchase of the year and is why is still in stock, because under LIFO newest item is to be sold first. Under this method cost of sales are high because they are calculated at recent unit cost and is why company will report less revenue than it will under FIFO method. LIFO perpetual Method LIFO method under perpetual inventory system Date Purchased/Receipt Qty Rate Value Sold/Issue Rate Value Balance Rate Value 3000 3000 3500 3000 3500 3700 3000 3500 3000 3500 4000 60000 60000 105000 60000 105000 37000 0 60000 35000 60000 35000 20000 0 60000 17500 60000 60000

Qty

Qty 20 20 30 20 30 10

1-Jul 20-Jul 7-Sep

30 10

3500 3700

105000 37000

20-Sep

10 20 5 4000 20000

3700 3500

9-Oct

37000 70000 0 0 0 0 20000 17500 0 17500 162000

20 10 20 10 5

25-Oct

5 5

4000 3500

4-Nov

5 3500 total cost of sales

20 3000 5 3500 20 3000 closing stock

This data was according to merchandising business if the business is of manufacturing than the inventory flow in shape of raw material issued will be assumed as it did under these methods. Under FIFO method raw material oldest purchased will be issued for manufacturing and latest purchase will remain in ending raw material. Under LIFO latest purchase of raw material will be issued for production and oldest will remain in material on hand. And in average method average rate will be calculated and material will be issued to production

13 Exercise-1 July 2 July 9 a business in the month of July 2009 had following transactions related to inventory July 8 purchased 3000 units @12 per unit

opening balance 500 units @10 per unit issued 3000 units to production

July 17 purchased 5000 units @11 per unit

July 24 issued 5200 units to production Calculate cost of inventory under FIFO LIFO and AVERAGE Perpetual and Periodic method Exercies-2 Sep 1 Sep 9 a business in the month of September 2009 had following transactions related to inventory Sep 4 purchased 1500kgs @110 per kg

opening stock 1000kgs @100 per kg issued 1700kgs

Sep 13 issued 100kgs Sep 28 issued 200kgs

Sep 22 purchased 500kgs @115 per kg

Calculate cost of inventory under FIFO LIFO and AVERAGE Perpetual and Periodic method Lower of cost and net realizable value Inventory valuation is not just to calculate the cost flow; it is to value inventory on fair manners. Suppose a business buys and sells paintings, recently they have purchased 5 paintings costing 5000 each. Soon they discovered that 1 painting is fake and its value is of 500 only in the market. Now business is facing a loss of 4500 and is why regardless of which inventory method is been used (FIFO, LIFO or AVERAGE) this painting will be reported on its market value which is 500. This 500 is the net realizable value of the painting. The items which are damaged, cannot be sold without alteration (additional cost is to be added and than they will be sold), or items with low selling price than their cost must be reported at lower of cost and net realizable value. Cost is the cost you pay for the inventory item plus cost of conversion and other costs incurred in bringing the inventories to their present location and condition. Net realizable value is the estimated selling price of inventory item less estimated cost of completing the product if it is damaged, and estimated costs necessary to make the sales. For example a business of motor bikes got 3 different motor bikes in stock with cost and net realizable value of
Motor Bike Cost Net realizable value Honda 70 45000 50000 Honda 125 60000 65000 Honda 100 51000 49000 Total 156000 164000

Now according to the rule inventory will be reported on lower of cost and net realizable value in balance sheet, and will be 45000 for Honda 70, 60000 for Honda 125 and 49000 for Honda 100. Total inventory will not be 156000, it will be 154000 (45000+60000+49000). Example Xyz Company has an item of stock which is no more useful for its production, this item had cost of 20000. This item cannot be sold and cannot be used, business found a way to utilize this stock item by adding 5000 of alteration cost and than this item can be used as a substitute product which cost 15000 to purchase. Mean this item can be used after adding 5000 as another product which is of 15000 in market, in this case net realizable value will be 15000 5000 = 10000. And cost is 20000, so in balance sheet item will be reported on 10000 which is lower of cost and net realizable value Example Xyz Company has an item of stock with a cost of 40000; this item is no more useful for business, and can be sold for 25000, with a trade discount of 2000, cash discount of 500 and cost of disposing the item 1000. In this case net realizable value is sales-trade discount-cost of disposing the item, which is (25000-2000-1000) 22000. Cost of the item is 40000 and is why the balance sheet value of this item is 22000.

14 NOTE: cash discount will not be adjusted in net realizable value it is an income statement item Example Xyz Company at 31 December 2009 had stock with cost of 10000 and net realizable value of 12000, this stock includes 3 different items with following data
DVD Player 3000 4200 Stereo System 2500 3500 Computer 4500 4300 Total 10000 12000

Cost Net realizable value

NOTE: inventory value should be calculated on item-by-item basis mean every item should separately be valued on lower of cost and net realizable value which will be in this example

Value to Take
Example

DVD Player 3000

Stereo System 2500

Computer 4300

Total 9800

Xyz Company has raw material stock of fabric 1000 meter with a cost of 10 per meter, which is to be used in the production of shirts. Assume per meter price of fabric is reduced from 10 to 7 in the market, and is why company has also decreased the price of finished goods (shirts) from 50 to 45. In this case what will be the lower of cost and net realizable value of fabric at the end of accounting period? Answer is, according to accounting standards; raw materials and other supplies held for use in the production of inventories are not written down below cost if the finished goods in which they are consumed are to be sold at or above their cost. In this case though per meter fabric is reduced from 10 to 7 but shirts are to be sold above than the cost, this is why 10 per meter will be reported in balance sheet not 7 even if the rate is been decreased. Example Grace computer shop asks your advice about a stereo system which they have imported in 2005 from America with a cost 10000 Pakistani rupees plus import cost of 3000. Soon they discovered this item is not useful in Pakistan due to the complexity of usage and only way of selling this item is to export it back in America. This stereo got a market value of 4000 in America now. They are asking your opinion about the value of this item to report in balance sheet under 2 cases, first that export cost of item is 3200, and second is export cost of this item is 4100. Answer is under first case value of stereo is 40003200=800, under second case stock value is 0 because cost is 11000+3000=14000 and net realizable value is negative 40004100= -100, this is why item should be reported on 0 value in balance sheet in second case. Example Xyz Company prints and sells books of accounting. The stock of books included in the closing inventory at 31 December 2008, at a cost of 200 per book. During audit auditor noted that the sale price for this inventory item is 170 per book as on 10 January 2009. Furthermore he was informed that during physical stock take a water leakage has created damage to the books and their bindings. And for that company spent a total of 20 per book for repairing and binding the books. Under this situation what is net realizable value and inventory write-down (loss) amount? Net realizable value in this case is 170-20=150, 170 is the market price each unit and 20 which added to repair each unit, leaving net realizable value of 150 each unit. Inventory write-down amount is the inventory loss amount, the difference between cost and net realizable value which is 200-150= 50. Company is facing 50 each unit loss on this inventory, and it will report the item at 150 each unit in the balance sheet

15

DEPRECIATION ACCOUNTING
Depreciation means expiration of cost of the fixed asset in the period for which accounting statements are being prepared. It represents a fall in quality or value of any fixed asset. In other words it means the cost of fixed asset used up through the use of asset. It is an attempt to spread the cost of a long-lived asset as an expense over its useful life. Assume a business purchased furniture of value rs.50000 with intension to use it in the business for years, as furniture is the item which exist in the business for many years unless it is been retired or sold out or wasted. Now concept is, if the furniture is to remain in the business for more than one year than why to charge whole of its cost rs.50000 in one accounting period in which it is been purchased. According to matching principle expenses of an accounting period should be matched with the revenue of same period. When the asset is to be used in generating revenue for more than one year, its cost will also be spread as depreciation expense for more than one year. When we say that the furniture is one year old, we actually are saying we have used it for one year and is why the furniture loosed its value. Through depreciation we actually are expiring the portion of the cost of fixed asset which is been used up during an accounting period. Reason for doing this is fixed assets excluding land loose their value with the passage of time due to wear and tear and obsolescence (change in technology). Before further proceeding lets look at fixed assets Fixed Assets Fixed asset is an asset held to use for producing goods or providing services for more than one year, and is not for sale in the normal course of business Determination of cost Cost of fixed asset should include all the costs necessary for bringing the asset to its working condition. In other words any directly attributable cost should be added to purchase price of the asset. For example installation costs, professional fees, legal fees, initial delivery and handling cost, site preparation, any duties and taxes paid for asset all these costs should be included in the cost of an asset. Example Xyz Company purchased a car for manager use. Purchase invoice of car contain following information; cost rs.500000, charges for number plates rs.5000, delivery charges rs.1000, alarm system rs.4000 and petrol rs.500. Calculate cost to be depreciated As explained earlier all directly attributable costs will be added to fixed asset so, cost to be depreciation is rs.510000 (500000+5000+1000+4000) delivery charges, alarm system charges and number plate charges will be added for capitalization but 500 for petrol will be ignored. Example Xyz Company purchased an asset by paying these amounts; 100000 to supplier of asset, delivery charges of 500, maintenance charges of 3000, additional component to increase capacity 4000, replacement cost 3000. Company also gets a cash discount of 10000. Calculate cost to be capitalized and depreciated Total cost to be capitalized will be calculated as:

listed Cost Cash discount additional component to increase capacity delivery charges Total cost to be capitalized

100000 -10000 4000 500 94500

16 Replacement which does not increase the capacity of the asset is not capitalized so is the maintenance charges which are to be added as revenue expenses. Those costs which increase revenue earning capability of asset should be capitalized Example Xyz Company purchases new equipment on 1/1/2009 by paying 890000 to vendor, 51000 for transporting the equipment, 8000 for insurance during transportation. Company also estimated that maintenance will cost 4,000 in the first year, and will rise by about 20% annually for 10 years. What cost should be capitalized or depreciated in this case? As described earlier maintenance cost will not be added in the cost of asset but will be treated as revenue expense, so the cost to be capitalized is 949000 (890000+8000+51000). Self constructed assets Where the asset is self constructed the cost of the asset should comprise those costs that directly relate to specific asset (material cost, labor cost, and factory overheads) or any other construction cost which is attributable to the construction activity and can be allocated to specific asset Example Xyz Company constructed its own machinery for production; cost related to construction is, direct material 200000, direct labor 70000, fixed overhead 50000, variable overhead 30000. Under this what cost should be capitalized? As described earlier all the costs directly attributable to constructed asset will be added to its cost, here cost to be capitalized is 300000 (200000+30000+70000). Fixed overheads (building rent, salary of administration staff) remains same even if the asset is not been constructed, this is why is not been added in the cost Asset brought in by exchange or part exchange by another asset When assets are been exchanged wholly or partially, rule is to record the acquired asset either on its fair value (market value) or the net book value (cost-accumulated depreciation) of the asset given up, adjusting by any cash payment given or received Example Xyz Company exchanged a used machine for a similar machine, used machine had cost of 12000, been depreciated for 4000 and fair value of machine is 6000. In addition cash payment of 7000 also paid for the exchange. In this case what is the capitalization cost of new machine? As rule describe here we dont have fair value of new machine so we will record new machine for the assets fair value (6000) which is given in exchange and cash 7000, which will be 13000. Journal entry to record this transaction will be
Detail new machinery accumulated depreciation loss on disposal old machinery cash Debit 13000 4000 2000 Credit

12000 7000

Example Xyz Company exchanges 4 used trucks to acquire land. Trucks had cost of 100000, were been depreciated by 20000, and fair value of these trucks were 130000 at the date of exchange. Xyz Company also paid cash payment of 10000 in addition. What is total cost to be capitalized for land?

17 Net book value of trucks is 80000 (100000-20000) with fair value of 130000, which represents a gain of 50000 at the time of disposal/exchange. Total cost of land which will be capitalized is fair value of trucks 130000 plus cash payment of 10000, in total 140000. Journal entry in this case is
Detail land accumulated depreciation trucks gain on disposal of trucks cash Debit 140000 20000 Credit

100000 50000 10000

When assets are acquired in exchange of shares When asset is acquired in exchange of shares of a company than the cost to be capitalized either will be, fair value of asset acquired or fair market value of shares issued whichever is clear Example: Xyz Company acquired equipment and in exchange issued 1000 shares with par/face value of 10 each share. These shares have fair market value of 12 each share. Under this case what will be the cost of equipment to be capitalized? Two choices are there, first to record the equipment on its fair market value if it is clear; if not than fair value of shares issued will be recorded as cost. In our case we dont know the fair market value of equipment but we do know the fair market value of shares so cost to be capitalized will be 12000 (1000*12). Journal entry for this transaction is

Detail equipment (1000*12) shares stock (1000*10) additional paid in capital

Debit 12000

Credit 10000 2000

So much with the cost to be capitalized, now we will see the depreciation portion. As described earlier depreciation is a method of allocating/spreading cost of fixed asset over its useful life. Factors to be considered while calculating depreciation are: Cost (listed price + any other cost directly attributable to asset), as we have discussed cost in detail Salvage value/Residual value/Scrap value is the value of asset which will be recovered when asset will be retired/sold; it is estimated value of asset after its useful life which can be recovered. Assume a company purchased machinery with a cost of 10000 having useful life of 5 years, management estimated that machinery will be sold for 2000 after its useful life 5 years, in this case total amount to be calculated for depreciation will be cost-scrap value (10000-2000) 8000. This 8000 will be considered for depreciation because it is assumed that 2000 will be recovered so that 2000 will not be expired Useful life of the asset is its service life which can be defined as number of years/accounting periods during which the asset will be useful for business. In above example as assumed the useful life of the asset is 5 years it actually means the asset will benefit the business for 5 years or the asset can be used in business for 5 years. There are several methods of calculating depreciation; most common among them are straight line method and declining balance method. Straight-line Method This is most popular and simple method of calculating depreciation. It requires allocation of equal or fixed amount each period as depreciation, and asset is written down by same amount each year. Formula for calculating depreciation through this method is cost-scrap value / useful life.

18 Example Xyz Company purchased machinery for 50000, with useful life of 5 years and scrap value of 5000. In this case what will be the depreciable cost and annual depreciation of machinery? Total depreciable cost is 50000-5000 (cost scrap value) 45000, and annual depreciation is 9000 (45000/5) depreciable cost useful life of asset. So asset will be depreciated with 9000 each year till 5 years. Example Xyz Company acquired plant for listed price of 100000, delivery charges rs.10000, installation charges rs.5000. This plant has a useful life of 10 years with a scrap value of 10000. In this case what is depreciable cost and annual depreciation? Depreciable cost is 105000 (listed price + delivery charges + installation charges scrap value) and annual depreciation of 10500 (depreciable cost / useful life) 105000/10. So far with calculating depreciation, now we will discuss the accounting treatment for this Under first example when asset is been purchased/acquired journal entry is debit asset account credit cash/bank/vendor account. Now after calculating depreciation as we did in example one which is 9000 annually, journal entry is
Detail Depreciation Expense Accumulated Depreciation Debit 9000 Credit 9000

Each year up to 5 years the same entry will be passed. Depreciation expense account is profit & loss account and will be added in operating expenses in income statement and accumulated depreciation account will be subtracted from asset account in balance sheet every year with 9000 to record net book value of asset each year till 5 years. First year
Assets Machine Accumulated depreciation Amount 50000 -9000 41000

Second Year
Assets Machine Accumulated depreciation Amount 50000 -18000 32000

Third year
Assets Machine Accumulated depreciation Amount 50000 -27000 23000

Fourth Year
Assets Machine Accumulated depreciation Amount 50000 -36000 14000

Fifth Year
Assets Machine Accumulated depreciation Amount 50000 -45000 5000

Notice that every year asset will be reported at total cost and than total of accumulated will be subtracted from it. First year it was 9000, 2nd year it was, 18000, third year it was, 27000 and so on

As explained this is how asset will be treated in balance sheet every year till 5 years and see the results that after five years assets net book value or carrying amount is 5000 as estimated in example 1 that scrap value of 5000. Asset will not further depreciate after 5 years. Now it is not necessary that machine will not be in use after the depreciation is completed, regardless of how many years after completion of useful life the asset is to be used no further depreciation will be charged as asset is totally depreciated

19 Exercise ABC Company purchased a building costing 500000, legal fee charges 5000 and repair charges to improve capacity of building 70000. Management assumes that building has a useful life of 20 years, with scrap value of 100000. Calculate depreciable cost and depreciation amount under straight-line method pass journal entries and show effect in balance sheet Reducing/Declining Balance Method of Depreciation Under this method a fixed percentage of net book value is taken every year for depreciation. As fix percentage is charged to book value, the depreciation charge every year decreases over the life of asset. Under this method different amounts are charged as depreciation and these amounts are also charged on net book value (cost-acc. Depreciation) of the asset. Concept is that this method should be used as assets earning power reduced as asset gets older Example Xyz Company purchased equipment at cost 50000 with useful life of 5 years; this equipment is to be depreciated by declining balance method with 30% annual rate of depreciation First year depreciation will be 30% of total cost which is 50000 = 15000. In second year depreciation will be calculated on net book value not on cost, net book value in this case after first year depreciation is (50000-15000) 35000 and depreciation for 2nd year is (35000*25%) 10500. In third year again asset will be written down to its net book value by subtracting accumulated depreciation 15000 of first year 10500 of second year (50000-15000-10500) 24500, and for 3rd year depreciation will be calculated 30% of 24500 which is 7350 here is the table for five years
years 1 2 3 4 5 calculation 50000*30% 35000*30% 24500*30% 17150*30% 12005*30% annual depreciation 15000 10500 7350 5145 3601.5 accumulated depreciation 15000 25500 32850 37995 41596.5 net book value 35000 24500 17150 12005 8403.5

First year journal entry and balance sheet affect

Detail Depreciation Expense Accumulated Depreciation Balance Sheet Assets Machine Accumulated depreciation Debit 15000 Credit 15000 Amount 50000 -15000 35000

Second Year
Detail Depreciation Expense Accumulated Depreciation Balance Sheet Assets Machine Accumulated depreciation Debit 10500 Credit 10500 Amount 50000 -25500 24500

Third year
Detail Depreciation Expense Accumulated Depreciation Balance Sheet Assets Machine Accumulated depreciation Debit 7350 Credit 7350 Amount 50000 -32850 17150

fourth year
Detail Depreciation Expense Accumulated Depreciation Balance Sheet Assets Machine Accumulated depreciation Debit 5145 Credit 5145 Amount 50000 -37995 12005

This is how every year the asset will be treated till 5 years. The percentage rate for annual depreciation is calculated through a formula which will be discussed on next page

20 This formula is applied when asset has a scrap value if it does not than percentage rate will not be calculated by formula. Formula for the %age rate is R= 1-(S/C) 1/N R is the rate of depreciation, S is scrap value of asset, C is the cost of asset, and N represents the useful life of any asset. After finding the percentage rate remaining will be done according to above mentioned example Exercise Xyz Company acquired machinery at cost 50000, delivery charges 5000 and installation charges 1000, with useful life of 10 years. Calculate depreciable value and annual depreciation for 5 years using declining balance method with rate 30% Sum of Year Digit Method of Depreciation This method assumes that the depreciation charge should be the heaviest in the early years of the life of the fixed asset. It allocates annual depreciation in proportion to the number of years of an assets useful life which remains at the commencement of an accounting year. Sum of digits is taken as in case of 5 years useful life (1+2+3+4+5=15) and following formula is formed to calculate depreciation every year (Number of years of life remaining/Total of digits of years of life) x Cost less residual value A machine cost 30,000 which have an estimated life of 5 years. Life expectancy from year 1 to year 5 is 1st year 5 2 year4 3 year 3 4 year 2 5 year 1
th th rd nd

Year 1: Depreciation is 5/15 x 30,000 = 10,000 Year 2: Depreciation is 4/15 x 30,000 = 8,000 Year 3: Depreciation is 3/15 x 30,000 = 6,000 Year 4: Depreciation is 2/15 x 30,000 = 4,000 Year 5: Depreciation is 1/15 x 30,000 = 2,000

Sum of digits is 15 (1+2+3+4+5) so by putting values in formula depreciation is calculated for every year up to 5 years Exercise Xyz Company purchased an asset with cost 80000, having scrap value of 10000 after 5 years. What will be the depreciation every year under sum of year digit method of depreciation? Unit of Output or Machine Hour Rate Method of Depreciation This method allocates the depreciable base over the units of output (e.g., machine hours) rather than years of use. This approach is useful under such cases where the life is best measured by identifiable units of machine consumption. Example a printing machine may produce 400000 copies over its total useful life, and its useful life is assumed to be 4 years, this machine has no scrap value, further assumed first year 150000 copies will be printed through it, 2nd year 75000, 3rd year 75000 and 4th year 100000. Machine costs 50000, calculate depreciation. Depreciation charge per copy will be Cost of machine-scrap value/total copies which is 50000/400000 = 0.125, and depreciation 1st year will be 150000*0.125 = 18750, 2nd year depreciation will be 75000*0.125 = 9375, 3rd year depreciation is 75000*0.125 = 9375, 4th year depreciation is 100000*0.125 = 12500 which after 4 years cause a total depreciation of 50000 (18750+9375+9375+12500). If per copy depreciation rate is not calculated than another formula can be prints in first year/total print copies * cost, for first year it will be 150000/400000*50000 = 18750, 2nd year 75000/400000*50000 = 9375 and so on. Under both answers will be same Exercise Xyz Company purchased a machine at cost 50000, with scrap value 10000; useful life of this machine is 5 years company assumed total working hours of this machine over its useful life are 30000. Machine worked first year for 8000 hours, 2nd year 8000 hours, 3rd year 5000 hours, 4th year 5000 hours, and last year 4000 hours. Calculate depreciation

21

SALES TAX
Is a tax charged on sales of goods, some countries instead of sales tax use value added tax, it actually is an indirect tax which is charged not to the person selling but the final consumer of the product for which sales tax is been charges. For example I m in a business of soap, when I sale it I actually charge tax to customers, final consumers of soap. By doing this I am collecting the amount of sales tax on behalf of state/government and will submit the amount to state. Sales tax is liability for the business, as this amount is to be paid to government. This tax is charged on different rates in different countries, in Pakistan now a days it is charges at 16% of total sales. For example a company made a sale of 10000 it will charge 16% on it as sales tax, total amount of invoice will be 11600 (10000+1600). Journal entry to record this transaction is Detail cash/A.R Sales Sales Tax Debit 11600 10000 1600 Credit

Sales tax as I told earlier is a liability account, when amount is remitted to govt. simple journal entry is been passed as business does for reducing any liability debit sales tax account credit cash account. Another thing regarding this tax is, on one side if a business is charging/collecting sales tax on other side business also is paying tax on the purchase of goods in case of merchandise business, and in case of manufacturing business it pays sales tax for the purchase of raw materials. Now real concept of sales tax is business adjust the tax it pays (sales tax on purchase) against the tax it collects (sales tax on sales). For example a business purchased raw material for 5000 and paid tax on it 16% which is 800 and further sells finished goods for 10000 and charge sales tax 16% which is 1600, now at the time of paying the tax to government business will adjust 800 against 1600 and will pay only 800 (1600-800). If the same business had paid taxes of 1600 and collected 800 by sales, it will get a refund of tax of 800 in coming months. Working example: Xyz Company in July 2009 purchased total goods of value 50000 with tax 16% on 50000; total sales of the month are 70000 with 16% sales tax, prepare journal entries and calculate any sales tax refund/payable Journal entries to record these are: Detail Purchases Sales Tax Cash/Accounts Payable SALES TAX TAX 8000 TAX BAL In case of Discount Sales tax in case of discount is calculated on the price/cost after deducting discount, i.e. Xyz Company sold goods of value 10000 with trade discount of 5%, and sales tax of 16% also charged on sales, show invoice and journal entries 11200 3200 Debit 50000 8000 58000 Credit Detail Cash/Accounts Receivable Sales Tax Sales Debit 81200 11200 70000 Credit

In this case as you can see Xyz Company has collected 11200 and paid 8000 for tax, so will pay to state amount of balance, we debit sales tax account in case of purchase as receivable because we owe govt. /state this amount of tax, in case of sales we credit sales tax as liability because we have to pay this amount to govt. /state

Goods Discount Net Sales Sales Tax

10000 -500 9500 1520

Cash/A.R Sales Sales Tax

11020 9500 1520

22 In case of return of goods/debit & credit Notes Sales tax in case of purchase and sales return is also adjusted, i.e. in previous example by assume that goods of value 1000 were been returned by customer for this sales tax account will also be adjusted by passing this journal entry

Sales Return Sales Tax Cash/A.R

1000 160 1160

Working problem: Xyz Company is in the business of manufacturing fruit juices; during March 2010 company made total sales of 500pcs juices @15, with trade discount of 2%. Total sales returns of the month were 7pcs juices @15 record journal entries and maintain sales tax account for the month First we will find out net sales (sales-discount), (7500-2% of 7500 which is 150) 7350. Second is to find sales tax on net sales which will be (7350*16%) 1176, now journal entry will be debit cash or A.R by (7350+1176), credit sales by 7350 and sales tax 1176. For sales return of 7pcs first to find amount including sales tax for 7pcs which is (7*15 which is 105+16% of 105 which is 16.8) 121.8

Cash/A.R Sales Tax Sales Tax

Tax Fraction

8526 1176 7350

Sales Return Sales Tax Cash/A.R

105 16.8 121.8

In above example instead of giving net sales what if data is including sales tax, i.e. xyz company during March 2010 made total sales of 8526 including sales tax, you are required to find sales tax amount, for this purpose tax fraction is been used tax fraction is a/100+a, a is rate of sales tax. Now for 8526 sales tax is 8526* .16/116, which will be same amount 1176 as calculated above So much for accounting treatment now have a look on sales tax in Pakistan In Pakistan sales tax currently is been charged at 16% as mentioned earlier, federal board of revenue is the authority to collect this tax and to define rules and regulations for sales tax according to sales tax act1990. Businesses/persons get register to concerned tax authority under sales tax act1990; sales tax act also had defined a criterion under which registration of sales tax is compulsory. In detail following are the conditions for business/person to get register under sales tax act A manufacturer excluding cottage industry, cottage industry means a manufacturer whose annual turnover for last 12 month for taxable supplies is less than 50,00000 or whose annual utility bills (electricity, gas, telephone) during last 12 months is less than 700000 A retailer whose value of supplies exceeds rupees 50, 00000 in any period during last 12 months, an importer, a wholesaler, dealer and distributor Distributor is the person appointed by the manufacturer, importer or any other person for a specified area to purchase goods from him for further supply Retailer is the person supplying goods to general public for the purpose of consumption Wholesaler means the sale of goods or merchandise to retailers, to industrial, commercial, institutional, or other professional business users, or to other wholesalers and related subordinated services. In general, it is the sale of goods to anyone other than a standard consumer; wholesaler sells goods in large quantities

23 Coming back to the topic in Pakistan every individual/business file sales tax return on monthly basis, exactly in same manner as described in accounting for sales tax section. While computing sales tax liability of a person there are three different elements, first goods charged at regular tax 16% or some special cases higher than this, second is exempted goods (goods on which no sales tax is paid), third is zero rated tax (goods taxable at 0%), goods charged by 0 percent are mainly goods exported out of Pakistan. Example: a manufacturer exports goods of value 5000, on which sales tax is to be charged at 0 percent but the manufacturer had paid 1000 sales tax on the purchase of goods, in this case manufacturer can get a benefit of refund of 1000 which he did paid on purchase Another thing while calculating sales tax is there are two different categories register dealers and unregister dealers, tax refund can be claimed by register dealers only, tax invoices can be recorded by register dealers not by unregister dealer, unregister manufacturer cannot collect sales tax as they does not charge tax invoice for sales they do charge commercial invoice on which they cannot charge tax Example: Xyz Company is registered under sales tax act, 1990 it has following transactions during March 2010, Purchase from registered persons 400000, purchase from non registered person 250000, import of raw material 300000, sales of goods 1500000 When we are to calculate sales tax we first have to calculate input tax and output tax, input tax is tax paid on purchase of goods and output tax is tax collected by the sale of goods if the output tax is larger than input tax than company pay it to state, if input tax is more than output tax company claim a refund Output tax for Xyz Company Sales of goods 1500000 *.16 = 240000 NOTE: unregistered person cannot charge sales tax to his customer, cannot charge tax invoice, so Xyz Company cannot claim refund for the purchase of 250000 Input tax for xyz company purchase from registered person 400000*.16= 64000 Import of goods 300000*.16= Total input tax 48000 112000

Total tax liability for Xyz Company is output tax-input tax (240000-112000) 128000 Example: Xyz Company is registered manufacturer you are to calculate its tax liability from following information; Total sales/supplies are of 500000 out of which 300000 are normal taxable supplies, 100000 are 0 rated supplies and 100000 are exempt supplies. Exempted supplies will not be included for tax computation other details are Normal taxable supplies are to charge at 16% so 300000*.16 0 rated supplies are to charge at 0% so Total tax payable for company is 48000 Where goods are imported in Pakistan, value of goods is calculated as invoice price + custom duty on goods + excise duty on goods = value of goods for sales tax purpose. In case if value is determined for customer duty than invoice price will also be ignored and formula will be, value determined for custom duty + customs duty on goods + excise duty on goods Example: Xyz Company is registered manufacturer; you are to calculate its tax liability for following transactions Purchases from registered persons 5000000, goods imported (invoice value in Pakistani rupees) 1500000, customs duty paid 350000, federal excise duty paid 60000. Sales to registered person 9000000, sales to non registered persons 1000000, and goods exported out of Pakistan 1500000 100000*0 = 48000 =0

24 Output tax Sales to registered persons Sales to unregistered persons Exports Total output tax Input tax Purchase from registered persons Imports (1500000+350000+60000) Total input tax Total tax payable is (1600000-1105600) 5000000 & 16% = 1910000 * 16% = 800000 305600 1105600 494400 9000000 * 16% = 1000000 * 16% = 1500000 * 0% = 1440000 160000 0 1600000 NOTE: in this case value of imported goods was been calculated by adding invoice price + customs paid on it + excise paid on it * 16%. There is sometimes a value is determined for customs duty and while calculating sales tax that determined value of goods will be added while ignoring invoice price of goods . Suppose in following case value was determined for customs as 1800000 instead of invoice value of 1500000, than total input tax on imports will be 1800000 +350000+ 60000) 2210000 and sales tax will be 353600 (2210000*.16)

There are some goods specified in third schedule of sales tax which are to be taxed @16% of retail price, those goods are fruit juices, and vegetable juices; ice cream; aerated waters or beverages; syrups and squashes; cigarettes; toilet soap; detergents; shampoo; tooth-paste; shaving cream; perfumery and cosmetics; tea; powder drinks; milky drinks; toilet paper and tissue paper; spices sold in retail packing bearing brand name and trade marks; shoe polish and shoe cream. It is required by law that retail price and the amount of sales tax should be printed by manufacturer of following products on each article, packet, container, etc. Retail price is the price fixed by the manufacturer inclusive of any charges and taxes other than sales tax at which any particular product is to be sold to general consumer. Example: Xyz Company is in the business of manufacturing and supplying fruit juices, during a tax period it supplied juices worth rs.5000000 to retailer to sell them to final consumer. As per normal business practice the company sells the goods at a discount of 25% of the retail price. Calculate output tax of Xyz Company Sales price of goods Discount allowed 25% Retail price (sales price + discount allowed) Total output tax will be (6250000*16%) 5000000 1250000 6250000 1000000 NOTE: under this case sales tax will be charged at price on which juices are to be sold to general consumer not at the price at which juices are sold to retailer. For this discounted amount is added back to sales price for tax purpose

Sales tax is also been paid on utility bills (electricity, gas, etc), registered businesses which uses electricity for manufacturing the product which is taxable , can claim refund of input tax paid on electricity or gas bill. Point to be noted in this case is this refund is only available if and only the electricity is been consumed for manufacturing such goods which are to charge sales tax. Another thing when business is making both taxable as well as exempt supplies than credit of input tax is allowed in respect of taxable supplies only. Input tax allowed will be calculated by following formula; total input tax *taxable supplies / total supplies. Total supplies included (taxable sales + exempt sales) Example: Xyz Company which is making taxable and exempt goods, calculate its tax liability in case of following transactions Purchases from registered persons 500000, purchases from non registered persons 300000, manufacturing and other costs 200000

25 Sales to registered persons 1500000, sales to non-registered persons 300000, sales of exempted supplies 200000, sales tax on electricity bill 10000 Out put tax Sales to registered person Sales to non-registered person Sales of exempted goods (200000) Total out put tax Input tax Purchases from registered persons Input tax paid on electric bill Total input tax Input tax allowed Total input tax* taxable supplies / total supplies so 95000*1800000/2000000 = 85500 so in this case instead of charging total input tax input tax allowed will be adjusted for sales tax liability so net tax payable is 288000-85500 = 202500 Change in tax rate If there is change in rate of tax than tax should be charged at the rate which is in force at the time of supply, and person is liable to file two returns for one tax period, one for the period prior to change and another for the period after change Example; xyz company while doing business in a tax period made total sales of 50000 with tax rate of 16% in earlier 10 days of tax period, during month sales tax rate is been changed from 16 to 17% and company further made sales of 80000. In this case two sales tax returns will be filed one of 50000 with tax rate of 16 and another for 80000 with tax rate of 17%. One thing to be noted is, if tax is not paid within 7 days of presenting the goods declaration than the tax shall be charged according to the rates in force at the date of actual payment. For example Xyz Company in above example had calculated total tax payable by 50000*.16=8000 + 80000*.17=13600 = 21600. And if for some reason company cannot manage to pay this amount for 7 days than the tax rate applied will be 17% for all the sales and will make sales tax liability of 22100 (80000+50000 * .17) Problem: xyz company purchased goods of value 1000000 at start of period, compute its tax liability assuming that company made total sales of 800000 at sales tax rate of 16% on 10th day of tax period, after that tax rate is been changed from 16 to 17% and company in further days made total sales of 900000, compute net tax liability of xyz company 500000*.16= 80000 15000 95000 1500000*.16 = 240000 300000*.16 = 48000 0 288000 NOTE: when business is selling both taxable goods and exempt goods, it cannot claim total input tax paid through purchase as refund, in this case business will adjust it by the formula specified Non-registered person cannot charge the sales tax on supplies made by him so his customer cannot claim credit of input tax There is no difference in registered person and non-registered person while calculating output tax (tax on sales)

26

CASH FLOW STATEMENT

Cash flow statement represents cash inflows (receipts) and cash outflows (payments) of any business in an accounting period. This statement provide information about negative cash flows (when payments are more than receipts) and positive cash flows (when receipts are more than payments), which is important for investors, management, shareholders. This statement has three sections: cash from operating activities, cash from investing activities, and cash from financing activities, lets see in detail about all three sections Cash from operating activities It shows net increase or decrease in cash resulting from a businesss operations. It includes cash inflows from sales of goods and services, interest income, mean all direct incomes or any other indirect income from operations of business, and cash outflows from payments for inventories, wages, taxes, interest, and other expenses. You can say cash flow from operating activities include item which comes in income statement for calculation of net profit. Difference between inflows and outflows result in net change in cash from operations Cash from investing activities Investing activities are the acquisition and disposal of long-term assets and other investments (making & collecting loan) other than investment in cash equivalents (short term with maturity life of maximum three months from date acquired, highly liquid investment, readily convertible with known amount of cash, no risk in change of value). These activities reflect all the transactions relating to the acquisition and sale of long-term assets and investments, like purchase or sale of land, building, equipment, purchase or sale of investments, receipt of interest/dividend. Cash from financing activities Involve liability and stockholders equity items of like, obtaining cash from creditors and repaying the amounts borrowed and obtaining capital from owners and providing them with return on and of their investment. These are transactions relating to the sources from where all the activities are initially financed including payment of interest and dividends
operating activities cash inflows sale of goods or services returns on loans (interest) and equity (dividends) operating activities cash outflows payments to suppliers for inventory payments to employees for services payments to government for taxes payments to lenders for interests payments to others for expenses investing activities cash inflows sale of property,land,building and equipment sale of debt or equity securities collection of principal on loans to other businesses investing activities cash outflows purchase of property, land, equipment purchase of debt or equity securities providing loan to other businesses financing activities cash inflows from sale of equity from issuance of debt (bonds, notes) financing activities cash outflows to stockholders as dividends to redeem long-term debt or reacquire of capital

The information to prepare cash flow statement usually comes from three sources. First one is comparative balance sheet; which provide the amount of changes in assets, liabilities, and equities from beginning to the end of period. Second; current income statement data help determine the amount of cash provided by or used by operations during the period. Third; selected transaction data which provide additional detail information needed to determine how the company provided or used cash during period

Preparing cash flow statement from three sources explained above required three steps. First; determine the change in cash, second; determine the net flow from operating activities, third; determine net cash flows from investing and financing activities

27 Example: Xyz Company started on its operation from Jan 1 2005 at the end of accounting period data about business is: xyz company Balance sheet 31.dec.05 1.jan.05 49000 0 36000 0 85000 0 xyz company income statement revenues 125000 operating expenses -85000 income before taxes 40000 tax expense -6000 net income 34000

Assets Cash A/r Total Liability & equity

changes 49000 increase 36000 increase

Exp. Payable 5000 0 5000 increase Common stock 60000 0 60000 increase Retained earning 20000 0 20000 increase Total 85000 0 Additional information: a dividend of 14000 was been declared and paid during the year as said earlier first step is to determine the change in cash which is opening balance of cash and ending balance of cash you can get from balance sheet, so balance is 49000 as net cash at beginning was 0 Second step is to calculate net cash flow from operating activities which is important and complicated a bit. There are two methods to determine net cash flow from operating activities first is direct method second is indirect method Cash flow from operating activities using direct method (income statement method) One thing should be noted before preparing cash flow from operating activities, for this statement transactions will be reported at cash based accounting system, like in income statement of xyz company you can see there is revenue of 125000 at same in balance sheet of the company there are accounts receivable of 36000 mean company collected cash 89000 (125000-36000), and for operating expenses which are in total 85000 cash payments are made for 80000 as you can see from balance sheet 5000 are still there, and tax expense is also been paid as there is no tax payable in balance sheet so: cash collected from revenue cash paid for expenses income before taxes cash payments for income tax 89000 -80000 9000 -6000

net cash provided by operating activity 3000 Cash flow from operating activities using indirect method (reconciliation method) This method actually reconciles net profit, it starts from net income and convert it to net cash flow from operating expenses. Under this method cash flow from operating activities will be calculated as: net income adjustments to reconcile net income increase in accounts receivable increase in expenses payable 34000 -36000 5000

net cash provided by operating activities 3000 Why increase in accounts receivable is been deducted? Reason is increase in accounts receivable mean revenue is been realized but not been earned under cash base accounting system, these 36000 are not been collected from customers so the amount should be deducted from net profit to provide information about cash inflows and outflows. Same is for expenses payable, increase in expenses payable mean the amount of cash is not yet been paid even if expenses are been occurred so to add back payable as no cash outflow is been made for these.

28 Third step is to determine net cash flow from financing and investing activities for xyz company 2 financing activities are there first issuance of common stock (inflow of cash) payment of dividend (outflow of cash). So cash flow statement for Xyz Company using both direct and indirect method is

xyz company statement of cash flow for the year ended on 31, deck 2005 cash flows from operating activities net income 34000 adjustments to reconcile net income increase in accounts receivable -36000 increase in expenses payable 5000 net cash provided by operating activites cash flows from financing activities issuance of common stock 60000 payment of cash dividends -14000 net cash provided by financing activities net increase in cash cash at january 1 2005 cash at december 31 2005
Second year of Xyz Company

3000

46000 49000 0 49000

xyz company statement of cash flow for the year ended on 31, deck 2005 cash flows from operating activities cash collected from revenue 89000 cash paid for expenses -80000 income before taxes 9000 cash payments for income tax -6000 net cash provided by operating activites cash flows from financing activities issuance of common stock 60000 payment of cash dividends -14000 net cash provided by financing activities net increase in cash cash at january 1 2005 cash at december 31 2005

3000

46000 49000 0 49000

After the completion of second year of business 2006 company got following balances xyz company comparative Balance sheet Assets 31.dec.06 1.jan.05 Cash 37000 49000 A/r 26000 36000 Prepaid expenses 6000 0 Land 70000 0 Building Acc. Depreciation building Equipment Acc. Depreciation equipment Total Liability & equity Exp. Payable Common stock Retained earning Bonds payable Total Additional information 200000 -11000 68000 -10000 386000 40000 60000 136000 150000 386000 0 0 0 0 85000 5000 60000 20000 0 85000 xyz company income statement Revenues 492000 Operating expenses -290000 Income before taxes 202000 Tax expense -68000 Net income 134000

Changes 12000 decrease 10000 decrease 6000 increase 70000 increase 200000 increase 11000 increase 68000 increase 10000 increase

35000 increase 0 116000 increase 150000 increase

Company declared and paid cash dividend of 18000 Company obtained 150000 cash through the issuance of long-term bonds Land equipment and building were acquired for cash Prepare cash flow statement of Xyz Company First to determine change in cash, which is 12000 decreases (49000-37000) you can see from comparative balance sheet of company

29 Step 2 is to calculate net cash flow from operating activities using both direct and indirect method Direct Method CASH FLOW FROM OPERATING ACTIVITIES REVENUE OPERATING EXPENSES INCOME TAX EXPENSE CASH PROVIDED BY OPERATING ACTIVITIES
Only accrual bases of accounting is converted into cash bases of accounting, under which revenue was collected 502000 (492000+ decrease in a/r 10000). Operating expenses are of 240000 (269000-35000+6000) 35000 is amount of expenses still payable 6000 is amount paid in advance is why added in operating expenses. To understand the concept, make clear understanding of cash base accounting system

502000 -240000 -68000 194000

Indirect Method Indirect method is a bit complex than direct method, under this method a reconciliation process is been gone through to determine net cash from operating activities. Here is a list of items to be reconciled against net income Items to add back in net income Depreciation expense Amortization expense of intangible assets Loss on sale of plan assets or investments Decrease in accounts receivable Decrease in merchandise inventory Decrease in prepaid expenses Increase in accounts payable Increase in accrued liabilities Items to deduct from net income Gain on sale of plant assets or investments Increase in accounts receivable Increase in inventory Increase in prepaid expenses Decrease in accounts payable Decrease in accrued liabilities

Cash flow from operating activities for Xyz Company is NET INCOME INCREASE IN PREPAID EXPENSES DECREASE IN A/R INCREASE IN ACCRUED EXPENSES DEPRECIATION EXPENSE NET CASH PROVIDED BY OPERATING ACTIVITIES 134000 -6000 10000 35000 21000 194000

All non cash expenses gains affect net income but does not affect net cash, as net income goes down by depreciation expense but business does not pay cash for depreciation expense is why added back to net income. Decrease in accounts receivable, inventory, prepaid expenses, and increase in accounts payable and accrued liabilities under go by cash inflows is why they added back to net income. Increase in inventory, accounts receivable, prepaid expenses, and decease in accounts payable and accrued liabilities under go cash outflows is why they are deducted from net income

Third step is to include investing and financing activities Investing activities for Xyz Company are increase in land 70000 means land purchased and cash paid against it so is an outflow of cash in investing activity, increase in building and equipment indicate that company purchased them paying cash 200000, 68000 respectively and made outflow of cash from investing activity. Increase in bonds payable account increased cash 150000 which is an inflow of cash from financing activity, dividend paid is also financing activity making outflow of cash On next page we will see the cash flow statement of Xyz Company for 2006

30 XYZ COMPANY CASH FLOW STATEMENT CASH FLOW FROM OPERATING ACTIVITIES NET INCOME INCREASE IN PREPAID EXPENSES DECREASE IN A/R INCREASE IN ACCRUED EXPENSES DEPRECIATION EXPENSE NET CASH PROVIDED BY OPERATING ACTIVITIES CASH FLOW FROM INVESTING ACTIVITIES PURCHASE OF LAND PURCHASE OF BUILDING PURCHASE OF EQUIPMENT NET CASH FLOW FROM INVESTING ACTIVITIES CASH FLOW FROM FINANCING ACTIVITIES ISSUANCE OF BONDS CASH DIVIDENDS PAID BY CASH NET CASH FLOW FROM FINANCING ACTIVITIES NET DECREASE IN CASH CASH AT JANUARY 1 CASH AT DECEMBER 31

134000 -6000 10000 35000 21000

60000 194000

-70000 -200000 -68000 -338000

150000 -18000 132000 -12000 49000 37000

Xyz Company 3rd year of operation 1st January 2007 to 31st December 2007 xyz company comparative Balance sheet assets 31.Dec.07 1.jan.07 changes cash 54000 37000 17000 increase a/r 68000 26000 42000 increase prepaid expenses 4000 6000 2000 decrease inventories land building acc. Depreciation building equipment acc. depreciation equipment Total liability & equity exp. Payable common stock retained earning bonds payable Total Additional information: 54000 45000 200000 -21000 193000 -28000 569000 33000 220000 206000 110000 569000 0 70000 200000 -11000 68000 -10000 386000 40000 60000 136000 150000 236000 54000 increase 25000 decrease 0 10000 increase 125000 increase 18000 increase xyz company income statement revenues 890000 cost of sales -465000 operating expenses -221000 interest expense -12000 loss on sale of equipment -2000 operating income 190000 income tax expense -65000 net income 125000

7000 decrease 160000 increase 70000 increase 40000 decrease

Operating expenses include depreciation of 33000 and amortization of prepaid expenses 2000 Land was sold at its book value for cash Cash dividends of 55000 were declared and paid

31 Interest expense of 12000 was paid in cash Equipment with a cost of 166000 was purchased for cash and equipment of cost 41000; book value 36000 was sold for 34000 cash Bonds were redeemed at their book value for cash Common stock (1 par) was issued for cash Change in cash is 17000, can be seen from comparative balance sheet XYZ COMPANY CASH FLOW STATEMENT CASH FLOW FROM OPERATING ACTIVITIES NET INCOME DECREASE IN PREPAID EXPENSES INCREASE IN ACCOUNTS RECEIVABLE INCREASE IN INVENTORIES DEPRECIATION EXPENSE LOSS ON SALE OF EQUIPMENT INCREASE IN ACCOUNTS PAYABLE NET CASH PROVIDED BY OPERATING ACTIVITIES CASH FLOW FROM INVESTING ACTIVITIES SALE OF LAND SALES OF EQUIPMENT PURCHASE OF EQUIPMENT NET CASH FLOW FROM INVESTING ACTIVITIES CASH FLOW FROM FINANCING ACTIVITIES REDEMPTION OF BONDS COMMON STOCK ISSUED CASH DIVIDENDS PAID BY CASH NET CASH FLOW FROM FINANCING ACTIVITIES NET INCREASE IN CASH CASH AT JANUARY 1 CASH AT DECEMBER 31 Exercise 1 Partial Balance sheet of ABC Company 31.Dec.07 31.Dec.08 A/r 10000 8000 Inventory 700 600 Prepaid Insurance 900 400 Accounts Payable 350 500 Dividends Payable 80 100 Wages Payable 400 850 Taxes Payable 200 375

125000 2000 -42000 -54000 33000 2000 -7000

-66000 59000

25000 34000 -166000 -107000

-40000 160000 -55000 65000 17000 37000 54000

ABC company income statement Net Income 5000 Depreciation Expense -2000 loss on sale of equipment -1000 Amortization of Patent -400

Prepare net cash flow from operating activities for ABC Company

32 Exercise 2 Partial Balance sheet of DEF Company 31.Dec.07 31.Dec.08 A/r 5000 7000 Inventory 2000 4000 Prepaid Insurance 7000 3000 Accounts Payable 1500 2000 Supplies 1000 3000 Utilities Payable 2000 1400 Prepare net cash flow from operating activities for DEF Company Exercise 3 Xyz Company engaged in following investment activities during year 2008 Purchased equipment for 10000 cash, sold land for 4000 cash, sold its investment in stock for 9000 cash, collected 5000 on a loan, collected 250 interest on a loan, lent 1500 to company ABC. Calculate net cash flow from investment for Xyz Company Exercise 4 ABC Companys beginning balance in land account was 10000, its ending balance was 17000, and during the period it sold land with a cost of 7000 for 11000. How much cash did the company spend for the purchase of new land? How do we treat the gain of 4000 on the sale of land? Define what will be the treatment of these events on net cash flow from financing activities and operating activities Exercise 5 Xyz Company had following finance and investing activities during 2008 Bought treasury stock for 9000, sold a machine for 18000, bought general motors stock for 15000, lent 3000 to ABC Company, issued 4000 of its own stock at 4500 cash, paid up a bond for 10000 cash, issued 100 shares at 50 per common stock as stock dividend, paid cash dividends of 2000. Compute both net flows from financing and investing activities Exercise 6 Partial Balance sheet of DEF Company 31.Dec.07 31.Dec.08
Cash

DEF Company income statement Net Income 2000 Depreciation Expense -400 Gain on Sale of Land 900 Amortization of Patent -200

30000 50000 63000 115000 -40000 30000 248000 52000 150000 0 46000 248000

60000 60000 81000 155000 -55000 45000 346000 60000 200000 10000 76000 346000

No building or land was disposed during the year, stock issuance was for cash, retained earning entries were for net income 55000 and dividends paid of 25000. Prepare cash flow statement for DEF Company using partial balance sheet data

A/r Inventory Building Accumulated Depreciation Land Total Assets Accounts Payable Common Stock Debentures Retained Earnings Total Equities

33

INTRODUCTION TO CONSOLIDATED FINANCIAL STATEMENT

Owners of a company are its shareholders, usually holder of ordinary shares (common stock). Anyone who buys ordinary shares in a company is usually given three rights; the right to vote at shareholders meetings, right to an interest in the net assets of the company, right to an interest in profits earned by the company. By using their voting rights at shareholders meeting, they are able to show their approval and disapproval of electing of directors and any proposals the directors make at such meetings. Directors manage the affairs of the company, any group of shareholders who between them own more than 50% or more than 50% of voting shares of a company, can control the election of directors and policies of the company through directors. One company may hold shares in another company, therefore to control another company one should obtain more than 50% of voting shares of the company to whom holders want to control. Parent and Subsidiaries X Company has an issued share capital of 50000 of ordinary shares of 100 each, on 1 January 2006, Y Company buys 25001 shares from a shareholder of X Company for 260000, Y Company will now control X Ltd because it has more than 50% of voting shares and is why Y Ltd is now called parent company and X Ltd is now called subsidiary of Y Ltd Even after acquiring the control of another company both of the companies will keep on maintaining their accounts separately, only difference which will and can be seen in balance sheet of Y Company will be a decrease in cash/bank account and an increase in another asset account called investment in subsidiary, at the time of acquisition following journal entry will be passed, Debit investment in subsidiary 260000 and Credit cash or bank 260000 Consolidated Statements Now imagine that you are shareholder of Y Company and each year you receive a set of financial statements of the company and after acquisition of shares in X Company an amount of 260000 would appear as an asset in balance sheet of Y Company and in income statement dividend received from X Company, these two items are all you can see by seeing the set of financial reports. Now issue is you have invested in Y Company and because of its majority shareholding in X Company, you have, in effect, also invested in X Company, and when you want to know how assets and liabilities in Y Company change over years, you will also like to know exactly the same for X Company. But as you are not directly are shareholder of X Company is why you will not be sent a copy of its financial statements. This is even bad when Y Company is not just controlling X Company but 10 companies in line and they are trading with each other, they owe money to one another or be owed money by them, and you will not be having any idea about what is going on in the business you have invested instead of some limited view. To overcome this situation parent company must distribute to their shareholders a set of consolidated financial statements, which is called consolidated accounting. These bring together all of the financial statements for the parent and its subsidiaries in such a way that shareholders can get an over all view of their investments. Different Methods of Acquiring control of One Company by Another One company can acquire control of another company by the way company Y did, another way is when X Company issues new shares to Y amounting to over 50% of voting shares, and Y Company pays for the shares in cash. Another method is Y Company could purchase over 50% voting shares of X Company on the open market by exchanging for them newly issued shares of Y Company. This control can also be obtained by acting through another company, for example, Y Company purchase over 50% of voting rights of X Company, and X Company further purchase 100% of voting shares of Z Company. Z Company would now be a sub-subsidiary of Y Company

34 Consolidation of Balance Sheet Consolidated balance sheet as described is the balance sheet of parent and subsidiaries as one financial statement. As there are many transaction under a group of companies when companies buy and sell goods to each other, they borrow and lend money to each other, sometime an item which is accounts receivable for one company is accounts payable in another i.e. y company sold goods to x company its subsidiary, and x company has not yet paid for the goods so while preparing balance sheet same item is accounts receivable in y companys balance sheet and is accounts payable in x companys balance sheet, these kinds of accounts should be canceled against each other while preparing consolidated financial statement. Consolidated statements should show how groups as a whole have dealt with the world outside; transactions which are between group entities do not represent dealings with outside world. This is why such transactions should be deleted and this called principle of cancellation. For example, balance sheets of both x and y companies at January 1 2006 are: company x cash inventory accounts receivable total assets accounts payable share capital (2700*10) equity and liabilities 30000 5000 3000 38000 11000 27000 38000 cash inventory furniture total assets accounts payable share capital (740*100) equity and liabilities company y 50000 12000 15000 77000 3000 74000 77000

Further assume that Y Company purchased 100% of voting rights of x company all 2700 shares for 27000 cash. This even will change the balance sheet of company y as in assets account cash account will be reduced by 27000 and a new asset account will be increase by 27000 investments in subsidiary, but there will be no effect on x companies balance sheet company y cash inventory investment in subsidiary furniture total assets accounts payable share capital (740*100) equity and liabilities 23000 12000 27000 15000 77000 3000 74000 77000 y & x consolidated balance sheet cash (30000+23000) 53000 inventory (5000+12000) 17000 accounts receivable 3000 furniture 15000 total assets 88000 accounts payable (11000+3000) share capital (740*100) equity and liabilities 14000 74000 88000

Can be seen that items same in nature are canceled out in each other and items with different natures are reported in balance sheet like furniture and accounts receivable

When 100% shares are acquired by paying more than book value There is sometimes a situation when companies buy shares of another company by paying more than their book value, for example in above example company y instead of paying 27000 of shares had paid 30000 to acquire the control of something of value 27000. Why companies pay more than book value? Answer is for goodwill, companies acquire the control by paying more than the book value of assets or shares of any company. This goodwill account now will be added while preparing consolidated financial statement. Original value of shares are 27000, by paying 30000 company y is actually paying extra 3000 for goodwill, in consolidated balance sheet investment in subsidiary account will be canceled with x share capital account but this difference of 3000 will be added on asset side as goodwill, by taking above data just considering that company y had paid 30000 for shares consolidated balance sheet will be

35 company y cash inventory investment in subsidiary furniture total assets accounts payable share capital (740*100) equity and liabilities 20000 12000 30000 15000 77000 3000 74000 77000 y & x consolidated balance sheet cash (30000+20000) 50000 Goodwill 3000 inventory (5000+12000) 17000 accounts receivable 3000 Furniture 15000 total assets accounts payable (11000+3000) share capital (740*100) equity and liabilities 88000 14000 74000 88000

Investment in subsidiary account is been canceled out by share capital of x company and difference is placed as goodwill in asset side

NOTE: In practice accounting standards require that fair values should be used rather than book values while preparing consolidated statement for consideration paid. Where 100% shares are acquired by paying less than book value If companies pay more than book value/fair value of assets acquired than they also sometime pay less than the fair value of assets. Again taking data from above example and considering that Y Company had paid 24000 for 2700 shares of 10 each, by leading a negative goodwill of 3000, a person without conceptual knowledge may say that this 3000 is profit, but it is not the case because one cannot pay cash divided by such amount. NOTE: Under IFRS 3 business combination, negative goodwill must be eliminated by reassessing the fair values of the net assets acquired. If doing so fails to eliminate all the negative goodwill the remainder must be written off immediately as a gain to profit or loss account. With above data considering company y had paid 24000 for 100% shares of company x consolidated balance sheet will be: company y cash inventory investment in subsidiary furniture total assets accounts payable share capital (740*100) equity and liabilities y & x consolidated balance sheet cash (30000+26000) 56000 17000 inventory (5000+12000) accounts receivable 3000 Furniture 15000 total assets 91000 accounts payable (11000+3000) share capital (740*100) retained profit equity and liabilities 14000 74000 3000 91000

26000 12000 24000 15000 77000 3000 74000 77000

Investment in subsidiary account is been canceled out by share capital of x company and difference is placed as retained profit

NOTE: This is the case when assets are not reassessed and negative good will is been recorded as retained profit If the case is to reduce fair value of net assets of company instead of placing negative goodwill in balance sheet as retained profit, balance will be different. Suppose in above example x companys net assets were reassessed and was found that fair value of inventory of company x is 2000. This will cause net value of x company 24000 and consideration paid by company y 24000 will be equaled and there will not be any negative goodwill, and balance sheet will be:

36 company y cash inventory investment in subsidiary furniture total assets accounts payable share capital (740*100) equity and liabilities 26000 12000 24000 15000 77000 3000 74000 77000 y & x consolidated balance sheet cash (30000+26000) 56000 inventory (2000+12000) 14000 accounts receivable 3000 furniture 15000 total assets 88000 accounts payable (11000+3000) share capital (740*100) equity and liabilities 14000 74000 88000

x company balance sheet revised cash 30000 inventory 2000 accounts receivable 3000 total assets 35000 accounts payable 11000 share capital (2700*10) 27000 reserve -3000 equity and liabilities 35000

See here no negative goodwill is been arises, when inventory is reduced. This is preferable by accounting standards to reassess and try not to leave any negative goodwill, if in case negative goodwill is still there it should be charged to profit & loss account as gain on consolidation Where less than 100% of shares are acquired Sometimes companies buy less than 100% of voting shares of another company, or can say less than 100% of control on another company either on equal to fair value, less than fair value and more than fair value of net assets of acquired company. Now what happened is a portion of another company is in control of parent company and another portion (the control not acquired) is in control of outsiders called minority interest or non controlling interest. For example Y Company purchased 70% of net shares of x company, which gives Y Company a control on x companys assets of 70% not on complete 100%; the remaining 30% assets will be controlled by outsiders not by Y Company. 70% of x company will be (cash +inventory + accounts receivable - accounts payable) 30000 + 5000 + 3000 = 38000 11000 = 27000, and 70% of 27000 is 18900 and control of outsider on x company is 30% of 27000 which is 8100. Now there are two methods to report this in consolidated balance sheet, under first method only acquired assets are reported in balance sheet and there is not anything about non controlling interest. Balance sheet using this method can be prepared as under, first both companies balance sheet company x cash inventory accounts receivable total assets accounts payable share capital (2700*10) equity and liabilities company y 30000 5000 3000 38000 11000 27000 38000 cash inventory furniture total assets 50000 12000 15000 77000

accounts payable 3000 share capital (740*100) 74000 equity and liabilities 77000 Consolidated balance sheet when Y Company purchased 70% of shares of x company by paying 18900 cash, and under first method consolidated balance sheet is: company y cash (50000-18900) inventory investment in subsidiary furniture total assets accounts payable share capital (740*100) equity and liabilities y & x consolidated balance sheet cash 31100 inventory 12000 furniture 15000 net assets of x company 70% 18900 total assets accounts payable share capital (740*100) equity and liabilities 77000 3000 74000 77000

31100 12000 18900 15000 77000 3000 74000 77000

37 Second method which is recommended by international GAAP is where all 100% of assets of acquired company are presented in balance sheet and also the control interest of outsiders. By taking above data consolidated balance sheet of y & x company is as follows under second method y & x consolidated balance sheet cash (31100+30000) inventory (12000+5000) accounts receivable furniture total assets accounts payable (3000+11000) share capital (740*100) minority interest 30% equity and liabilities

61100 17000 3000 15000 96100 14000 74000 8100 96100

Can be seen that under this method clear picture is been presented by providing information about the portion of control by y company 70% and portion of control by outsiders 30%, as this is preferred method we will be using this method

Where less than 100% interest is acquired by paying more than fair value of net assets y & x consolidated balance sheet cash (28000+30000) goodwill inventory (12000+5000) accounts receivable furniture total assets accounts payable (3000+11000) share capital (740*100) minority interest 30% equity and liabilities

58000 3100 17000 3000 15000 96100 14000 74000 8100 96100

In above presented example assume that y company instead of paying 18900 for 70% shares had paid 22000, as described earlier it will cause an increase in goodwill in consolidated financial statement. As company y had paid 3100 more than book value of 70% assets of company x this 3100 will be added in the assets side of consolidated balance sheet as positive goodwill and balance sheet with minority interest can be drawn like the one drawn on left

Where less than 100% interest is acquired by paying less than fair value of net assets y & x consolidated balance sheet cash (34200+30000) 64200 inventory (12000+5000) 17000 accounts receivable 3000 furniture 15000 total assets accounts payable (3000+11000) share capital (740*100) retained profit minority interest 30% equity and liabilities 99200 14000 74000 3100 8100 99200

In above presented example assume that y company instead of paying 18900 for 70% shares had paid 15800, as described earlier it will cause negative goodwill in consolidated financial statement. As company y had paid 3100 less than book value of 70% assets of company x this 3100 first should be adjusted by reassessing fair value of net asset of company x if it cannot be adjusted than should be charged to profit & loss account as gain from consolidation, and is what we did

On next page we will see what is the effect of consolidation when company which is been acquired has retained profit and reserve

38 Acquisition of Subsidiaries When Reserves and Retained Profits Exist Reserves and profits as you know belong to ordinary shareholders. When there is a situation these reserve and retained profit exist at the time of acquisition than company has to pay for those reserves and retained profits as well. Suppose x company purchased 100% shares of y company which were 100 shares @10 for 1500, and at that time y company also got reserve of 200 and retained profit of 300 than in this case the amount paid 1500 will be adjusted against share capital + reserve + retained profit which is 1000+200+300 = 1500 so there will not be any negative or positive goodwill in this case. Reserves and profits will be canceled out against investment account and will not be shown in consolidated balance sheet. When 100% of shares are bought at book value when subsidiary has reserves COMPANY X Cash Inventory Accounts receivable Total share capital (1000*10) Accounts payable General reserve retained profit Total COMPANY Y Cash Inventory Accounts receivable Total share capital (5000*10) Accounts payable General reserve retained profit Total

5000 15000 10000 30000 10000 7000 5000 8000 30000

50000 20000 30000 100000 50000 7000 15000 28000 100000

Above is the balance sheets of two companies, assuming company acquired company X by paying cash 23000 for 100% interest in company X, in this case how this investment will be seen is, 23000 is been paid for share capital of 10000 + reserve of 5000 + profit of 8000 which in total is 23000, and leaving no goodwill consolidated balance sheet will be as: 1. y & x Consolidated balance sheet Cash 32000 Inventory 35000 Accounts receivable 40000 Total 107000 Capital 50000 Accounts payable 14000 reserve 15000 retained profit 28000 Total 107000 when paid more than fair value of net assets y & x Consolidated balance sheet Cash 28000 Goodwill 4000 Inventory 35000 Accounts receivable 40000 Total 107000 Capital 50000 Accounts payable 14000 reserve 15000 retained profit 28000 Total 107000 company y has paid 27000 to acquire 100% interest in x 2.

3. when paid less than fair value of net assets y & x Consolidated balance sheet Cash 35000 Inventory 35000 Accounts receivable 40000 Total 110000 Capital 50000 Accounts payable 14000 reserve 15000 retained profit 31000 Total 110000 company y has paid 20000 to acquire 100% interest in x

Here you can see in second balance sheet when there is goodwill it is been adjusted in asset side, and as described earlier when business has reserves it pays for reserves too not just for share capital. Net assets total were 23000, leaving 4000 for goodwill. In third balance sheet again net assets were of value 23000 but company y after paying 20000 gets a gain of 3000 which was been adjusted in retained profits in consolidated balance sheet

39 Example of consolidated balance sheets with pre and post acquisition profits using control charts ASSETS Land Building Stock Sundry debtors Investments : 8000 shares of s ltd Cash in hand TOTAL H LTD 100000 100000 90000 40000 125000 120000 575000 S LTD 40000 50000 30000 30000 ---25000 175000 LIABILITIES 5000 equity shares of rs.100 each 10000 equity shares of rs.10 each Profit & loss a/c Sundry creditors H LTD 500000 ---55000 20000 S LTD 100000 40000 35000

TOTAL

575000

175000

H ltd acquired shares in S ltd on 1.1.2001 when S ltd had rs.25000 in profit & loss account. No dividend has been declared by S ltd in 2001. You are required to prepare a consolidated balance sheet of H & S ltd as on 31.12.2001 Solution: first step is to find out degree of control which is = acquired shares by parent /total shares of subsidiary = 8000/10000 = 4/5th and minority interest is 1/5th. Or can be calculated by = 8000/10000*100 = 80% control is acquired by parent company which is 80000 and 20% is of minority interest which is 20000 (excluding profits) Second step is to calculate control chart A from the balance sheet of S ltd for calculating pre-acquisition profit and reserves, post acquisition profit, and minority interest. DETAIL Pre-acquisition profit Post-acquisition profit - Pre-acquisition profit Share Capital - Minority interest Minority interest Notes Total PKR 25,000 PKR 40,000 (PKR 25,000) PKR 15,000 PKR 100,000 (PKR 20,000) PKR 80,000 PKR 28,000 Parent's share PKR 20,000 Minority Interest PKR 5,000

PKR 12,000

PKR 3,000 PKR 20,000

Control char B: for calculating goodwill Cost of Investment - pre-acquisition profit - face value of shares Goodwill PKR 125,000.00 (PKR 20,000.00) (PKR 80,000.00) (PKR 100,000.00) PKR 25,000.00

Control chart C: Other Assets and Liabilities Land 100000 40000 140000 Building 100000 50000 150000 Stock 90000 30000 120000 A/Rec 40000 30000 70000 Cash 120000 25000 145000 A/Pay 20000 35000 55000 P&L A/C 55000 12000 67000

H ltd S ltd

40 Assets Current Assets cash stock A/Rec Fixed Assets Goodwill Land Building TOTAL Liabilities 145000 120000 70000 25000 140000 150000 650000 A/Pay 55000

Equity share Capital P&L account Minority Interest TOTAL

500000 67000 28000 650000

Exercise: when H ltd acquired 2000 shares in S ltd which had reserves amounting 5000 none of which has been distributed since than. Further details of both the companies: ASSETS Building Plant & machinery -Depreciation Investments : 2000 shares in s ltd Stock Bank A/rec H LTD 72000 40000 -10000 25000 18000 5000 22000 172000 S LTD 25000 15000 -5000 ---3000 5000 7000 50000 LIABILITIES Share capital of rs.10 each Reserves Profit & loss a/c Sundry creditors H LTD 120000 25000 12000 15000 S LTD 30000 6000 9000 5000

172000

50000

Intra-Group Debts it is often happened when subsidiaries owe money to another subsidiary or parent company, or parent company owe money to subsidiary, which up to separate balance sheets of parent company and subsidiary is allowed to be recorded separately but when consolidated balance sheet is to be prepared it seems same, it is like a person is your supplier and your customer and what you do is cancel out the payables with receivables. For example if a parent company sells goods to its subsidiary on credit, or provides a loan to subsidiary company of 10000, how it will appear in balance sheets of both companies separately is that it will be accounts receivable or loan receivable on parent companys balance sheet and accounts payable or loan payable on subsidiary companys balance sheet. When we prepare consolidated balance sheet we assume the whole parent and subsidiary companies one company and we prepare single balance sheet by adding all the assets and liabilities of parent and subsidiary companies. Doing so under above example will increase assets of the company by 10000 and liabilities at same by 10000 even though it is inner debt or dealing. So companies must cancel this amount by each other to present fair picture of consolidated balance sheet. Unrealized profit in inventory There is often a situation when one company sells goods on cost or on profit to another company under same group of companies. For example company A is parent company of company B, and sells goods to company B for 1200 which cost company A 1000. Now up to this point it seems company A had made a profit of 200, further assuming company B have not yet sold these goods and goods are still in stock of company B. now problem occurs that within a group or under consolidated balance sheet whole group is assumed one single business than how is this possible to declare 200 profit when goods are not yet sold?. It is like, a business buys goods for 1000 and sells them to itself for 1200 and claim a profit of 200 it does not make sense. This is why adjustment is needed while preparing consolidated balance sheet if one company had sold stock to another company for profit and that stock is not yet been sold. In consolidated balance sheet inventory will be reduced of company B from 200 and profit will be reduced from company A 200 (will be canceled out with each other). If goods were sold at cost in that case there is not any profit and so is not any need to make the adjustment.

41 Further there is situation when some of the goods are sold to third party/outsiders and some still is in stock. Assume in previous example company B had sold 80% of the goods for 1100 and remaining 20% are still in stock. 80% goods cost company B = 1200*.80 = 960 so profit is 1100-960 = 140, and closing stock is 1200*.20= 240. Now what is happening company A is reporting a profit of 200 and company B is reporting a profit of 140 both these profits are 200+140 = 340. But when we look at it by the group point of view does this profit really is of 340? By seeing it as a group as a single company, these 80% goods which were sold cost company 800 (1000*.80), and by selling it for 1100 real profit group had earn is of 300 (1100-800). And closing stock for group at cost is 200 (1000*.20). So adjustment still is needed to reduce both profit and inventory by 40 Lets put this above explanation in an example Assets investment:100 shares @100 each inventory bank A LTD B LTD Liabilities & Equity 10000 0 share capital @100 each 2400 2000 A/Pay 6000 12000 18400 14000 A LTD B LTD 15000 10000 3400 4000 18400 14000

Above balance sheets are dated 31.12.2001, company A acquired 100% interest in company B by paying 10000 for 100 shares, further company A had sold inventory costing 1000 for 1200 to company B in the year. You are to prepare consolidated balance sheet under both cases explained in above example, when none of stock is sold and when 80% of stock is sold. Assets bank (7000+11000) inventory (1400+3000) Liabilities & Equity 18000 share capital @100 each 4400 A/Pay (3400+4000)

15000 7400

22400 22400 Cash is decreased by 1000 for company B and increased by 1000 for company A assuming goods were sold on cash Under second case where 80% of goods were sold balance sheet is Liabilities & Equity 19100 share capital @100 each 15000 3600 A/Pay (3400+4000) 7400 PROFIT 300 22700 22700 Here goods are sold for 1100 and we assumed that sales were made by cash, and profit is of 300 as defined above in the example and remaining stock is 3600 Unrealized Profit on Fixed Assets A member company may sell fixed asset or stock which becomes fixed asset of another company at profit, under following situation same adjustment is needed as we did in unrealized profit in inventory section. This time value of profit and value of fixed assets both will be reduced by extra (profit) amount on cost. Assets bank (6000+12000+1100) inventory (4400-800)

42 Revaluation of Assets If the fixed assets of the subsidiary company are revalued at the time of acquisition of the controlling shares of the subsidiary company by the holding company, the effect of profit or loss on revaluation should be reflected in the consolidated balance sheet. The assets are to appear at their revalued figures in the consolidated balance sheet. If revaluation is upward causing an increase in book value of asset and at same an increase in pre-acquisition profit. If asset is revalued, accumulated depreciation adjustment is also to be considered. If revaluation result in an increase than depreciation that has already been charged seems to be undercharged and the amount of extra depreciation is treated as revenue loss, and will be deducted from subsidiarys profit & loss account. If revaluation results in a decrease than depreciation that has already been charged is overcharged and is why amount of extra depreciation is treated as revenue profit and will be written back to profit & loss account (will be added in profit & loss account of subsidiary) Example: following are the balance sheets of X LTD and YLTD Balance sheet dated 31.12.2001 ASSETS EQUIPMENT

X LTD 250000

Y LTD 95000

LIABILITIES SHARE CAPITAL OF RS.10 EACH

X LTD Y LTD 400000 100000

PROFIT & LOSS A/C 50000 20000 140000 ---SUNDRY CREDITORS 85000 2000 50000 0 80000 20000 15000 7000 535000 122000 535000 122000 On January 1, 2001 profit and loss account of Y Ltd showed a credit balance of 8000 and equipment of Y Ltd was revalued by X Ltd at 20% above its book value of rs.100000 (but no such adjustment was effected in the books of Y Ltd) INVESTMENTS : 9000 SHARES IN Y LTD STOCK BANK A/Rec Pre and Post Acquisition profits: 90% shares are bought by X LTD and 10% are of minority interest. Pre-acquisition profit is 8000 of profit & loss account on January 1 and 20000 from revaluation of equipment (100000*.20), in total 28000 out of which 90% is of X Ltd (25200) and 10% is of minority interest (2800) Post-acquisition profit from Y Ltd balance sheet is 20000-8000 = 12000 and minus 1000 for the increase in depreciation charge so post-acquisition profit is 11000 out of which 90% (9900) for X LTD and 10% (1100) for minority interest Working Note for depreciation: depreciation as can be seen by balance sheet that book value of asset was 100000 but at balance sheet date equipment is reduced by 5000 mean depreciation percentage is 5% (5000/100000*100). But after valuation value of equipment is 120000 and 5% is 6000 so extra 1000 will be charged to profit & loss account of Y Ltd Computation of Goodwill: Company X has paid 14000 for (9000 shares of 10 each) 90000 plus a pre-acquisition profit of 25200 = 115200. So amount paid for goodwill is 140000-115200 = 24800 While preparing consolidated balance sheet equipment will now be reported for 12000 and minority interest is 1000 shares for 10000 plus 2800 of pre-acquisition profit and 1100 of post acquisition profit (10000+1100+2800) 13900 Assets Current Assets BAND (80000+20000) A/REC (7000+15000) STOCK Fixed Assets Goodwill EQUIPMENT (250000+120000) -DEPRECIATION TOTAL Liabilities 100000 22000 50000 24800 370000 -6000 560800 A/Pay (85000+2000) 87000

Equity share Capital P&L account (50000+9900) Minority Interest TOTAL

400000 59900 13900 560800

43 Example: prepare consolidated balance sheet from following Following are balance sheets of parent and subsidiary company at 31st March 2006 shares of both the companies are of 10each PARENT SUBSIDIARY PARENT ASSETS LTD LTD LIABILITIES LTD INVESTMENTS : 5000 SHARE CAPITAL OF RS.10 SHARES 105000 ----EACH 200000 Non Current Assets 140000 104000 Profit at 31st March 45000 Profit for 2006 50000 STOCK 26000 19000 General Reserve 7000 BANK 4000 6000 Accounts Payable 3000 Accounts Receivable 30000 14000 305000 143000 305000

SUBSIDIARY LTD 50000 35000 51000 ----7000 143000

Note: During the year parent sold goods which had cost 1100 to subsidiary for 1800 none of these goods had been sold by the balance sheet date. Al the balance sheet date parent owes subsidiary 2000 Acquisition of shares in subsidiaries at different dates In our above discussion we assumed that shares were bought on a single date, however it is a fact that shares are often bought at different times and that earlier purchase of share may not give buyer controlling interest, this is known as piecemeal acquisition. Why controlling interest is not been availed? Is due to the fact we studied at the start of this topic that One company may hold shares in another company, therefore to control another company one should obtain more than 50% of voting shares of the company to whom holders want to control. Now if a company had purchased only 20% shares in a month and 20% after 4 months and 20% after another 4 months than the control it had is at last purchase (after 8 months of first purchase). So is the reason that consolidated balance sheet will be prepared after 3rd purchase after 8 months of first purchase and is why there are some adjustments regarding goodwill is to be made. IFRS 3 requires that consolidation be based on the fair values at the date the undertaking actually becomes a subsidiary. However goodwill arising on each transaction must also be calculated Example: S company has an issued share capital of 100 ordinary shares of 1 each. Only reserve S has is the balance of retained profits 50 on 31st December 2004, and 2 years later at 31st December 2006 that reserve balance is of 80. Company P bought 20 shares on 31st December 2004 for 36 and further 40 shares on 31st December 2006 for 79. Now from above data the date company S becomes the subsidiary and consolidated balance sheet is to be prepared is 31st December 2006, because up to this date only 20 shares were bought by company P. Now calculation of goodwill will be: COST 115 at 31.12.2004 36 at.31.12.2006 79 Shares Bought (20+40) 60 Retained Profit 60% of 80 48 -108 Goodwill on Acquisition 7 31.12.04: 36-30 (20% of 100 + 50) = 6 31.12.06: 79-72 (40% of 100 + 80) = 7 Post-first purchase profit is 20% of (80-50) = 6 so if even if we calculate goodwill separately it is 6+7 = 13 and by subtracting the post-first purchase profit of 6 it is 7 Post-first purchase profit is also the amount of goodwill avoided by delaying acquisition until 31.12.2006. If we calculate goodwill at 31.12.2004 is 6 but this goodwill cannot be recognized reason is at that date company P dont have controlling interest in company S and consolidation statement cannot be prepared NOTE: when the real acquisition is occurred (one company buys 50% or more shares) only than the goodwill can be recognized.

44 Shares Bought During an Accounting Period Another thing you might have noticed is we have assumed so far that shares are purchased at the end of an accounting period, however most of the time there are situations when shares are bought within accounting period. In this situation calculation of pre-acquisition profit needs a little attention. The approach adopted under this situation is that the reserves balance according to the last balance sheet before the acquisition of shares is taken, and to add the profit or deduct the loss of current year in which acquisition is taken place, before acquisition date. Lets say company A had in its balance sheet of year ending 2004 a retained profit of 10000, during year 2005 company B acquired 60% shares of it at the end of 8th month of the accounting period from January 1 2005 to December 31st 2005. Further assume that company A earned a profit of 5000 in year 2005 which can be figured out from its income statement. Now here is the point, pre-acquisition profit will be 10000 and 8 months profit out of 5000 which is 5000*8/12 = 3333 approximately. Pre-acquisition profit will be 13333 (10000+3333). Reason is 5000 was earned for whole year but acquisition was made at the end of 8th month and the profit earned after 8th month is post acquisition profit. Example: company p bought 20 of the 30 issued ordinary shares of s for 49 on 30th September 2005. Financial statements for s are drawn up annually to 31st December. Balance sheet of s as at 31st December 2004 showed a balance of retained profits of 24, and income statement of s for the year ending 31st December 2005 showed a profit of 12. Now from above example it can be seen that acquisition is made at the end of 9th month so profit for year 2005 will be taken as pre-acquisition for 9 months which is 12*9/12 = 9. 3 months profit is post acquisition profit which cannot be included for the calculation of goodwill. P paid 20 for 20 shares and pre-acquisition profit up to 30th September is 24 + 9 = 33 and company p had purchased 20 out of 30 share so 20/30*33 = 22 is the pre-acquisition profit for company. So company p had paid 49 for 20+22 = 42, so goodwill is 49 42 = 7 Exercise: on 31st March 2003, A LTD had issued share capital of 50000 ordinary share of rs.1 each, and reserves of 30000. Two years later, the reserves had risen to 45000 but share capital was unchanged. B LTD purchased 12500 shares in A LTD first on 31st March 2003 for 32000, and 18000 shares on 31st March 2005 for 29000. Calculate the figure of goodwill that will appear in the consolidated balance sheet as at 31st March 2005. Exercise: A LTD bought 120000 of the 200000 issued ordinary shares of 1 each in company B for 300000 on 31 st July 2004. Bs financial statements are drawn up annually to 31st December. Balance sheet of B showed retained profit of 62000 at 31st December 2003, and income statement of company B showed a profit of 69000 for the year ended 31 st December 2004. No other reserves appear in either balance sheet. Calculate the figure for goodwill to be shown in consolidated balance sheet at 31st December 2004

45 Consolidated Income Statement When business prepares consolidated statement, they prepare all the statements even the consolidated income statement as well. Consolidated income statement is drawn up to show the overall profit or loss of the companies in the group, treating the group as a single entity. If all of the subsidiaries are owned 100% and there are no unrealized profits in inventory, then consolidated income statement is just adding together all the amounts contained in each of the individual company income statements to form consolidated income statement. However there always are some adjustments rather than the situation we discussed. Example: where the subsidiary is wholly owned P LTD owns 100% of the share capital of S LTD. The income statements of these companies for the year ending 31 December 2004 are: INCOME STATEMENTS Revenue Cost of Sales Gross Profit Distribution Cost Administrative Expenses Profit Before Tax Tax Profit for the Year

P LTD 400000 -270000 130 20000 30000 -50000 80000 -17000 63000

S LTD 280000 -190000 90 10000 15000 -25000 65000 -11000 54000

NOTE: P LTD had sold goods which cost 10000 to S LTD for 15000 At the balance sheet date, 40% of goods in (a) had not been sold by S LTD Of the 7000 retained profits from last year for S LTD, 3000 is in respect of post-acquisition profits. CONSOLIDATED INCOME STATEMENT Revenue Cost of Sales Gross Profit Distribution Cost Administrative Expenses Profit Before Tax Tax Profit for the Year 665000 -447000 218000 30000 45000 -75000 143000 -128000 115000

Workings: Revenue is calculated as P 400000 + S 280000 15000 intercompany sales so is = 665000 Gross Profit = P 270000 + S 190000 15000 intercompany purchase + unrealized profit in inventory (40% of 5000) 2000

46 Example: Where there is minority interest in subsidiary P LTP owns 80% of shares in S LTD. Income statements of the companies for the year ending 31st December 2002 are: INCOME STATEMENTS Revenue Cost of Sales Gross Profit Distribution Cost Administrative Expenses Profit Before Tax Tax Profit for the Year 35000 70000 P LTD 640000 -410000 230000 -105000 125000 -26000 99000 20000 55000 S LTD 330000 -200000 130000 -75000 55000 -10000 45000

NOTES: S LTD had sold goods which cost 20000 to P LTD for 30000 At balance sheet date 30% of goods had not been sold by P LTD Of the 35000 retained profits of S LTD brought forward, 15000 is post-acquisition profits. CONSOLIDATED INCOME STATEMENT Revenue Cost of Sales Gross Profit Distribution Cost Administrative Expenses Profit Before Tax Tax Profit After Taxation Minority Interest Profit for the year 940000 -583000 357000 55000 125000 -180000 177000 -36000 141000 -9000 123000

Workings: Revenue = P LTD 640000 + S LTD 330000 30000 intercompany sales = 940 Cost of Sales = P LTD 410000 + S LTD 200000 - intercompany purchase 30000 + unrealized profit in inventory (30% of 10000) 3000 = 583000 Minority Interest = 20% of 45000 profit in S LTD = 9000

47

Long Term Liabilities (Bonds Payables)

Long term liabilities are liabilities that will be paid after one year or in the time period of more than one year. In this chapter we will discuss bonds and notes payables which are the long term liabilities of any business Bonds Payable Concept and Definition Bond is an instrument business uses to borrow money from others. It is a written promise by some business to pay back the amount of principal and interest on it. When we buy a bond from any business/corporation, we actually are lending money to them and receiving an evidence of this transaction written on a piece of paper containing a promise to pay back the loan plus interest. Its is based on a contract called indenture, which explains different characteristics of a bond such as maturity date, rate of interest, and call provisions. There are some types of bonds, such as: Secured bonds which are backed by collateral such as real estate or any other asset, unsecured bonds which does not require any collateral these are high risk bonds, and they pay high interest. Term bonds pay the principal amount on one date, the maturity date. Serial bonds which pays the principal in installments, Convertible bonds which may be exchanged for stock of issuing corporation, Commodity-backed bonds (Zero coupon bonds) do not pay interest but are sold at discount thus there is interest effect at maturity when the buyer receives the full par value. Callable bonds give the issuer the right to pay up the bonds before maturity date. Issuance of Bonds Par, Discounts and Premium At every bond there is an amount of principal which is to be paid back at maturity date, this amount is called face value or par value. The rate of interest specifies on it is called contract rate or nominal rate. If the contract rate is equal to the rate currently flowing in the market the bond will be issued at par value Xyz Company issues a bond with par value of rs.1000 and contract rate of 10% payable annually. If the market rate is also 10% the selling price of this bond will be its par value. Assume company issues the bond at January 1 2001 and paid interest on it at every December 31 up to 4years of bonds life. Journal entries will be as follows
On January 1 2001 when bond is issued Cash Bonds Payable On every Dec 31 up to 4 years entry for interest Interest Expense Cash On 31st Dec after 4 years when principal is paid back Bond Payable Cash 1000 1000 1000 1000 100 100

Discount situation why normally it happens that company sell their bonds at a discount price Market rates due to economical conditions are not stable, they often changes. Now a corporation who got some bonds printed with 10% interest and market rate changes to 12% than no one will be willing to buy the bond of 10% interest rate as market is providing 12%. Here companies got two choices, one to tear up old bonds with 10% interest and print the new one with 12% but it is not easy. Company will suffer cost of printing and old prints will be wasted, is why companies choose second method which is to sell the bond at a discount price (price lower than the par value). By selling a bond with par value 1000 at a price 900 means company is receiving 900 in cash and will have to pay 1000 principal and interest will also be paid on 1000 not on 900. Through this company pays the buyer additional interest not just 10% specified on bond. Assume the data from previous example is same but this time bond is issued on a discount of 100 (1000-100 = 900) so entries will be:
On January 1 2001 when bond is issued Cash Bond Discount Bonds Payable 900 100 1000 100 Cash 100

On every Dec 31 up to 4 years entry for interest

Interest Expense

48 Bond discount account is contra liability account which will be subtracted from bonds payable account in balance sheet to report a more clear view of bonds. Bond discount account will also be amortized (a method just like depreciation through which value of an intangible is spread over its use full life). In this case amortization will be calculated using straight line method so bond discount / bond life = 100 / 4 = 25 per year. Every year bond discount account will be reduced with 25 up to 4years against the interest expense account. As explained earlier the discount is additional interest to the buyer and for the company (issuer). So entry will be Up to 4 years of bonds life this entry will be made every year to reduce
Interest Expense Bond Discount Cash 25 25

the bond discount account until it is 0. And after 4 years bonds payable will be equal to 1000 as there will be no discount left

Premium situation why normally it happens that company sell their bonds with premium Premium is the situation when bonds of a company are sold at a price more than the par value. Normally it happens when market rate goes down due to economic condition. Now assuming the same data of Xyz Company consider that market rate is now 8% and companys bond is offering 10% which means company will pay more than what market is offering to the buyer. Here what businesses do is they sell their bonds at a price more than what is the par value of the bonds to compensate them. Xyz Company might sell the bond at 1100, and at maturity date company will payback 1000. 100 extra is called bond premium which is not a contra account but is only an addition to bond payable account which will be amortized same is bond discount account we studied earlier. Assuming the same journal entries for this will be:
On January 1 2001 when bond is issued Cash Bond Premium Bonds Payable On every Dec 31 up to 4 years entry for interest Interest Expense Cash 1100 100 1000 100 100

As for bond premium account it will be amortized in the same manner we did in bond discount account and 25 per year will be reduced from it, and remaining amount will be added back in bond payable account to show a more clear view.

Bond Premium Interest Expense Cash

25 25

Up to 4 years of bonds life this entry will be made every year to reduce the bond premium account until it is 0. And after 4 years bonds payable will be equal to 1000 as there will be no premium left

Semiannually and Quarterly Interest Payments There are cases when bonds pay interest in semiannually (twice a year) and quarterly (four times a year). Under such conditions not only the interest is calculated two or four time a year but the discount and premium accounts are also been amortized under the same manner. Interest is always mentioned on yearly basis is why when we say semiannually than we mean company will pay the interest two times and after every 6 months a year and is why for 6 month half of the interest will be charged 5% if we continue with our above example. For whole year interest was 10% and for half year it is 5% (10%/2) and if company pays quarterly interest which means 4 times a years than interest will be 2.5% (10%/4). Same will be the procedure for discount and premium as in above cases premium and bond was 25 a year and if company pays interest semiannually than we will also divide this 25 with two which is 12.5 (25/2) and if company pays quarterly than 6.25 (25/4). And journal entries will also be made with these values after every six or three month a year. Issuance of Bonds between Interest Dates In the bond indenture there is all the detail about the bond including the interest dates which specifies at which date interest will be paid and at the same date usually a bond is been sold. But it often happened that sale is made due to some reason at a later date or sale is delayed until a later date. Remember whenever the sale is made interest will be paid from

49 the date which is specifies in the indenture. If the interest date is January 1 and bond is sold on April 1 due to some reason, interest will still be paid from January 1 not from April. As company receives the bond amount on April and pays interest from January, it is to pay the interest from January to March period even though company did not received any money. To avoid such situation or we can say to recover the wasted interest companies raise the price of the bond by the amount of interest which is been wasted before the sale of bond. Assume Xyz Company sold a bond on April 1 with par value of 1000 and interest rate of 10%, furthermore bonds interest date is from January 1. Which means company is receiving 1000 at April 1 and paying interest from January 1. 3 months interest is wasted which company is to adjust in the price of the bond and rather then selling it for 1000 the 3 months interest amount will be added in the price of the bond. Interest for the year is 100 and 3 months interest is (100*3/12) 25, and this 25 belongs to the time period in which company did not had the amount mean sale was not been made. So these 25 will be added to the price and company will sell the bond for 1025 to recover the wasted interest. Journal entries are:
On April 1 when bond is issued Cash 1025 Bond Payable Interest Expense Interest Expense Cash 1000 25 100 100

On Dec 31 when interest is to be paid

Original interest paid at 30 December is 75 (100 debit balance of interest account 25 credit balance of the account). If a premium or discount is there than it should be amortized from the date of sale not from the date specified in indenture Exercise 1 Xyz Company sold a bond on January 1 2001 with par value of 10000 and contract/interest rate is 10% with a life of 3 years. You are to calculate the journal entries of issuance, interest payments and payment for every year and maturity 2. Assume the same data in above exercise but bond is sold on a discount of 500 (at 95) and a premium of 500 (at 105) and complete the journal entries for interest, amortization of premium and discount, and payment at maturity. 3. Assume the same data in exercise 1 but company pays interest semiannually and quarterly 4. Assume the same data in exercise 2 but company pays interest semiannually and quarterly 5. Assume the same data in exercise 1 but assume that company made the sales at June 1 2001 6. Assume the same data in exercise 2 but assume that company made the sales at June 1 2001 Bond Issuance Cost When companies issue bonds they incur some cost associated to those bonds. These costs can be printing costs, legal and accounting fees, and commission/promotion costs. According to the accounting rule these costs should be debited to an asset account (a deferred charge account) and than be amortized over the life of the bond using straight-line method (normally). For example Xyz Company issued a bond with face value of 10000 and interest rate of 10% with 4 years life of the bond. Company also incurred a cost of 1000 on the printing of these bonds, under such situation entries will be:
For the Issuance of Bond Cash Bond Payable To record the cost of printing 10000 10000 2000 Cash 2000

Bond Issue Cost

Bond issuance cost will be debited at the time bonds are been sold. And will be amortized over the life of bond using straight-line method. Under above case per year amortization will be 500 (2000/4) for which general entry every year will be
Bond Issue Expense 500 Bond Issue Cost Cash

500

50 Early Retirement of Bonds Some bonds contain a provision of early retirement in their indenture. Early retirement of a bond mean to pay the amount of bond before its maturity. The amount paid to retire the bond is already been specified to the buyer of bond. If the price paid to retire/cancel the bond is greater than the book value (bond payable bond discount + bond premium) of the bond than the difference between book value and amount paid is a loss. If it is less than the book value, than it is a gain. The general entry to retire a bond closes bond payable account and any discount or premium related to it, and credits cash, and realize gain and loss if any. Xyz Company issued a 10000 bond of 4 year maturity at face value. After 2 years company retired the bond by paying 11000 a discount situation and 9000 a gain situation. General entries under both situations at the retirement are: Entry for gain on retirement Bond Payable 10000 Cash Gain on Retirement Entry for loss on retirement Bond Payable Loss on Retirement Cash Account

9000 1000

10000 1000 11000

Xyz Company on January 1 2001 issued a 100000 bond with 5year life at 103000. After 2 years it retired the bond at 104000 as specified in indenture. General entries at this time are: Book value of the bond is (bond payable + bond premium (after amortization of 2years)) 100000+3000-1200 = 101800. And retirement price is 104000 so 104000-101800 = 2200 is a loss. Journal entry under such situation will be: Bond Payable Bond Premium Loss on Retirement 100000 1800 2200 Cash 104000 Amortization per year for bond premium of 3000 is 600 and for 2 years it is 1200, remaining value in bond premium is 1800 is why bonds book value after 2 years is 101800 (100000+1800) so bond premium account will be closed by 1800 debit

Xyz Company issued a 50,000 year bond on January 1 2001 at 95 (5% discount). Related issue costs of the bond were 1000, after 3 years bond was retired at 90 (10%discount) at that moment balances of accounts were: Bond Discount 2500 500 500 500 Bal. 1000 Bond Payable 50000 Bond issue Cost 1000 200 200 200 Bal. 400 Book value of the bond is 49000 and the retirement price is 45000 leaving 4000 in gain. But this 4000 gain will be reduced by the remaining bond issue cost which is not been amortized yet. So real gain is 4000-400 = 3600

Exercise: on January 1 2001 Xyz Company issued a 10 year 40000 bond at 103. Five years later it retired the bond at 102. Prepare journal entry and show account balances after 5 years. Exercise: a bond is retired at 97. Its related accounts appear as follows: Bond Discount 2000 200 200 200 1400 Bond Payable 70000 Bond issue Cost 900 90 90 90 630

Prepare the entry for retirement

51