Chapter 3 Branch Accounting PDF

Chapter 3 AGENCY & PRINCIPAL, HEAD OFFICE & BRANCH Distinguishing Agency and Branch An agency relationship refers a contract under which on or more persons (the principals) engage another persons (the agents) to carry out some service on their behalf that involves delegating some decision making aut...

Chapter 3 AGENCY & PRINCIPAL, HEAD OFFICE & BRANCH Distinguishing Agency and Branch An agency relationship refers a contract under which on or more persons (the principals) engage another persons (the agents) to carry out some service on their behalf that involves delegating some decision making authority to the agent. Branch is a business unit located at some distance from the home office. This unit carries merchandise, makes sales, and makes collections from its customers. Accounting for Sales Agency The term sales agency sometimes is applied to a business unit that performs only a small portion of the functions traditionally associated with a branch.  A sales agency usually carries samples of products but does not have inventory of merchandise  Orders are taken from customers and transmitted to the home office, which approves customers’ credit and ships the merchandise directly to the customers  Accounts receivables are managed by the home office  An imprest cash fund is maintained at the sales agency for payment of operating expenses  Hence, no need for complete accounting records at a sales agency other than a record of sales to customers and a summary of cash payments supported by vouchers  Separate revenue and expense accounts may be opened by the home office for each sales agency so as to measure its profitability  Subsidiary ledger accounts may be used to control fixed assets and cost of goods sold by sales agencies 1 Illustration: Journal Entries for a Sales Agency Journal entries required at the home office in connection with a sales agency (Adama Agency), assuming the perpetual inventory system is used: HOME OFFICE JOURNAL ENTRIES FOR ADAMA AGENCY TRANSACTIONS Inventory Samples: Adama Agency 1,500 Inventories 1,500 To record merchandise shipped to sales agency for use as samples Imprest Cash Fund: Adama Agency 10,000 Cash 10,000 To establish imprest cash fund for sales agency Trade Accounts Receivable 50,000 Sales: Adama Agency 50,000 To record sales made by sales agency Cost of Goods Sold: Adama Agency 35,000 Inventories 35,000 To record cost of merchandise sold by sales agency Operating Expenses: Adama Agency 10,000 Cash 10,000 To replenish imprest cash fund (several checks during the period) Sales: Adama Agency 50,000 Cost of Goods Sold: Adama Agency 35,000 Operating Expenses: Adama Agency 10,000 Income Summary: Adama Agency 5,000 To close revenue and expense accounts to a separate income summary ledger account for a sales agency Income Summary: Adama Agency 5,000 Income Summary 5,000 To close net income of sales agency to Income Summary ledger account 2 Accounting for Branch The accounting work done at each branch depends upon the policy or the accounting system of the enterprise which may provide for a complete set of accounting records at each branch or keep all accounting records in the home office. A branch may, accordingly, maintain a complete set of accounting records consisting of journals ledgers and chart of accounts similar to those of an independent business enterprise, prepare financial statements and periodically forward to the home office. Transactions recorded by the branch should include all controllable expenses and revenue for which the branch manager is responsible. Expenses such as depreciation and branch plant assets are generally maintained by the home office. Reciprocal Accounts The accounting records maintained by a branch include a Home Office ledger account that is credited for all merchandise, cash, or other resources provided by the home office; it is debited for all cash merchandise or other asset sent to the home office or to other branches. The Home Office account is a quasi-ownership equity account that shows the net investment by the home office in the branch. At the end of the accounting period when the branch closes its accounts, the Income Summary account is closed to the Home Office account. A net income increases the credit balance of the Home Office account; a net loss decreases this balance. In the home office accounting records, a reciprocal ledger account with a title such as Investment in Branch is maintained. This non current asset account is debited for cash, merchandise, and services provided to the branch by the home office, and for net income reported by the branch. It is credited for the cash or other assets received from the branch, and for any net loss reported by the branch. Thus, the Investment in Branch 3 account reflects the equity method of accounting. A separate investment account is generally maintained by the home office for each branch. At the end of an accounting period, the balance of the Investment in Branch X ledger account in the accounting records of the home office may not agree with the balance of the Home Office account in the records of Branch X, because certain transactions may have been recorded by one office but not by the other. These balances of the reciprocal accounts must be brought into agreement before combined financial statements are prepared. Expenses Incurred by Home Office and Allocated to Branches Some business enterprises follow a policy of notifying each branch of expenses incurred by the home office on behalf of the branch. When such a policy is adopted, an expense incurred by the home office and allocated to a branch is recorded by the home office by a debit to Investment in Branch and credit to an appropriate expense account; the branch debits an expense account and credits Home Office. Expenses paid by the home office and allocable to branches may be insurance, property and other taxes, depreciation, and advertising. Expenses of the home office may also be allocated to branches especially if the home office does not make sales and functions only as accounting and control center. The head office may also charge each branch interest on the capital invested there in. such expenses would not appear in the combined income statement as they would be offset against interest revenue recorded by the home office. Billings of Merchandise to Branches Three alternative methods are available to the home office for billing merchandise shipped to its branches:  At cost  At a percentage above cost  At the retail selling price 4 Shipment of merchandise to a branch does not constitute a sale as the ownership does not change. Billing at cost  The simplest and widely used procedure  Avoids complications of unrealized gross profits on inventories  Attributes all gross profit to the branches even if some of the merchandise may be manufactured by the home office Billing at a percentage above cost  Intended to allocate reasonable gross profit to the home office  Under this method, the net income reported by the branch is understated and the ending inventories are overstated for the enterprise as a whole  Adjustments must be made to eliminate intra company profits in preparation of combined financial statements Billing at Retail Selling Prices  Based on a desire to strengthen internal control over inventories  The home office record of shipments to a branch, when considered along with sales reported with the branch, provide a perpetual inventory stated at selling price  Any difference with periodic physical count should be investigated promptly Illustrative Journal Entries of Operation of a Branch Assume that S Company bills merchandise to Branch X at cost and the branch maintains complete accounting records and prepares financial statements. Both the branch and home office use the perpetual inventory system. Equipment used at the branch is carried in home office records. Expenses such as advertising and insurance are incurred by the home office and billed to the branch. 5 Summarized transactions of year 1 1. Cash of 1,000 was forwarded to Branch X 2. Merchandise with cost of 60,000 was shipped to Branch X 3. Equipment of 500 acquired by Branch X, to be carried in home office records 4. Credit sales by Branch X amounted to 80,000; the cost of merchandise sold was 45,000. 5. Collections of trade accounts receivable pf 62,000 made by Branch X. 6. Payments for operating expenses by Branch X totaled 20,000 7. Cash of 37,500 remitted to home office by Branch X 8. Operating expenses charged to Branch X by home office totaled 3,000 When a branch obtains merchandise from outsiders also, the merchandise acquired from the home office should be recorded in a separate Inventories from Home Office account. Home Office 1. Investment in Br X 1,000 Branch Cash 1,000 Cash 1,000 Home Office 1,000 2. Investment in Br X 60,000 Inventories 60,000 Inventories 60,000 Home Office 60,000 3. Equipment: Br X 500 Investment in Br X 500 Home Office 500 Cash 500 4. None Trade A/R 80,000 CGS 45,000 Sales 80,000 Inventories 45,000 6 5. None Cash 62,000 Trade A/R 62,000 6. None Operating Exp 20,000 Cash 20,000 7. Cash 37,500 Home Office 37,500 Inv. In Br X 37,500 Cash 37,500 8. Inv in Br X 3,000 Operating Exp 3,000 Operating Exp 3,000 HO 3,000 Adjusting and Closing Entries None Sales 80,000 CGS 45,000 Op. Exp 23,000 Income Sum 12,000 Investment in Br X 12,000 Income Summary 12,000 Income Br X 12,000 Home Office 12,000 Income Br X 12,000 None Income Summary 12,000 7 Transaction between Branches Efficient operation may on occasion require that assets be transferred from one branch to another. A branch does not carry a reciprocal account with another branch but records the transfer in the Home Office account. For example if Branch A transfers merchandise to Branch B, Branch A debits Home Office and credits Inventories, while Branch B debits Inventories and credit Home Office. The Home Office records the transfer by debiting Investment in Branch B and crediting Investment in Branch A. The additional freight cost due to the indirect routing does not justify increase in the carrying amount of inventories. Only freight costs of the direct shipment from the home office are included in inventory costs. Illustration: The home office shipped merchandise costing 6,000 to Branch D and paid freight costs of 400. Subsequently, the home office instructed Branch D to transfer this merchandise to Branch E. Branch D paid 300 to carry out this order. The cost of direct shipment from home office to E would have been 500. The journal entries in the three sets of records would be: Home Office Investment in Branch D 6,400 Inventories 6,000 Cash 400 To record shipment of merchandise and payment of freight costs Investment in Branch E 6,500 Excess Freight Expense- Interbranch Transfers 200 Investment in Branch D 6,700 To record transfer of merchandise from Branch D to Branch E under instruction of the home office 8 Branch D Freight in 400 Inventories 6,000 Home Office 6,400 To record receipt of merchandise from home office with freight costs paid in advance by home office Home Office 6,700 Inventories 6,000 Freight in 400 Cash 300 To record transfer of merchandise to Branch E under instruction of home office and payment of freight costs of 300 Branch E Inventories 6,000 Freight in 500 Home Office 6,500 To record receipt of merchandise from Branch D transferred under instruction of home office and normal freight billed by home office. The excessive freight costs from such shipments generally result from inefficient planning of original shipments and should not be included in inventories. If branch managers are given authority to order transfer of merchandise between branches, the excess freight costs should be recorded as expenses attributable to the branches. Combined Financial Statements A balance sheet for distribution to external users the financial position of the business enterprise as a single entity. A convenient starting point in the preparation consists of the adjusted trial balances of the home office and the branches. The assets and liabilities of the branch are substituted for the Investment in Branch ledger account included in the home office trial balance. Similar accounts are combined to produce a single total amount for cash, trade receivables, and other assets and liabilities of the enterprise as a whole. 9 Reciprocal accounts are eliminated as they have no significance when the branch and home office report as a single entity. The balance of the Home Office account is offset against the balance of the Investment in Branch account. The operating results of the enterprise (the home office and the branches) are shown by an income statement in which the revenue and expenses of the branch are combined with the revenue and expenses of the home office. Any intracompany profits or losses are eliminated. Working Paper for Combined Financial Statements A working paper for combined financial statements has three purposes:  To combine ledger account balances like assets and liabilities  To eliminate any intra company profits or looses  To eliminate the reciprocal accounts Illustration: the same data is going to be used. Assuming that all the year end routine adjustments are made, the working paper is begun with adjusted trial balances of the home office and Branch X. 10  S CORPORATION Working Paper for Combined Financial Statements of Home Office and Branch X For the Year Ended December 31, Year 1 (Perpetual Inventory System: Billing at Cost) Adjusted TB Elimination Combined Home Off Br X Income statement Sales (400,000) (80,000) (480,000) Cost of Goods Sold 235,000 45,000 280,000 Operating expenses 90,000 23,000 113,000 Net income 75,000 12,000 87,000 Total 0 0 Statement of RE Retained E Jan 1 (70,000) (70,000) Net income (75,000) (12,000) (87,000) Dividends 40,000 40,000 Retained E Dec 31 117,000 Balance sheet Cash 25,000 5,000 30,000 Trade A\R (net) 39,000 18,000 57,000 Inventories 45,000 15,000 60,000 Investment in Br X 26,000 a (26,000) Equipment 150,000 150,000 Acc Dep. (10,000) (10,000) Trade A\P (20,000) (20,000) Home Office (26,000) b 26,000 Common Stock (150,000) (150,000) Retained earnings (117,000) Total 0 0 0 0 11 In the elimination column, elimination (a) offsets the balance of Investment in Branch X account against the balance of the Home Office account. This elimination appears in the working paper only. Combined financial statements of S Corporation prepared on the basis of the above working paper are: S Corporation Income Statement For the Year Ended Dec 31, Year 1 Sales 480,000 Cost of goods sold 280,000 Gross profit 200,000 Operating expenses 113,000 Net income 87,000 Earning per share of common stock 5.80 S Corporation Statement of Retained Earnings For the Year Ended Dec 31, Year 1 Retained earnings, beginning of year 70,000 Add: Net income 87,000 Subtotal 157,000 Less: Dividends (2.67 per share) 40,000 Retained earnings, end of year 117,000 12  S Corporation Balance Sheet Dec 31, Year 1 Assets Cash 30,000 Trade A/R (net) 57,000 Inventories 60,000 Equipment 150,000 Less: Accumulated Depreciation 10,000 140,000 Total assets 287,000 Liabilities and Stockholders Equity Liabilities Trade A/P 20,000 Stockholders’ equity Common stock (10 par) 150,000 Retained earnings 117,000 267,000 Total liabilities and stockholders’ equity 287,000 Shipping Merchandise to Branches at Price above Cost As explained earlier, some businesses bill merchandise shipped to branches at cost plus a markup percentage or retail selling prices. Because both methods involve similar modification of accounts, a single example is used to illustrate the key points. Change one assumption of the former example to: the home office bills merchandise shipped to branches at 50% above cost. The merchandise shipment in the previous example is thus billed at 90,000 (60,000+50% mark up of 30,000) and are recorded as follows: Home Office Investment in Br X 90,000 Inventories 60,000 Overvaluation of inv: Br X 30,000 Use of the allowance account enables the home office to maintain record of unrealized gross profit on shipments. 13 Branch Inventories 90,000 Home Office 90,000 The two reciprocal accounts at branch and head office viz. Home Office and Investment in Branch X accounts will have balances of 56,000 before the accounts are closed and net income or loss entered. This amount is 30,000 larger than the balance in the previous illustration as a result of change in billing method. At the end of the period the branch will report its inventories at billed prices of 22,500 (15,000*50%). In the records of the home office the required balance of the Allowance for Overvaluation of Inventories: Branch X account is 7,500 (22,500-15,000); thus, this account balance must be reduced to 7,500 from the present amount of 30,000 to represent the excess valuation contained in the ending inventories of the branch. Under the present assumption the branch reports a net loss of 10,500. The adjustment of 22,500 is transferred as credit to Income: Branch X account, because it represents additional gross profit over that reported by the branch. Thus the actual net income for Branch X is 12,000, the same as the previous illustration. The following journal entries are passed in the home office records. Income: Branch X 10,500 Investment in Branch X 10,500 To record net loss reported by branch Allowance for Overvaluation of Inventories: Br X 22,500 Income: Branch X 22,500 To reduce allowance to amount by which ending inventories of branch exceed cost Income: Branch X 12,000 Income Summary 12,000 To close branch net income (as adjusted) 14 Working Paper when Billing to Branches at Price above Cost S CORPORATION Working Paper for Combined Financial Statements of Home Office and Branch X For the Year Ended December 31, Year 1 (Perpetual Inventory System: Billing above Cost) Adjusted TB Elimination Combined Home Off Br X Income statement Sales (400,000) (80,000) (480,000) Cost of Goods Sold 235,000 67,500 a (22,500) 280,000 Operating expenses 90,000 23,000 113,000 Net income 75,000 (10,500) b 22,500 87,000 Total 0 0 Statement of RE Retained E Jan 1 (70,000) (70,000) Net income (75,000) 10,500 b(22,500) (87,000) Dividends 40,000 40,000 Retained E Dec 31 117,000 Balance sheet Cash 25,000 5,000 30,000 Trade A\R (net) 39,000 18,000 57,000 Inventories 45,000 22,500 a(7,500) 60,000 Investment in Br X 56,000 c (56,000) Allowance for over v (30,000) a 30,000 Equipment 150,000 150,000 Acc Dep. (10,000) (10,000) Trade A\P (20,000) (20,000) Home Office (56,000) b 56,000 Common Stock (150,000) (150,000) Retained earnings (117,000) Total 0 0 0 0 15  a) To reduce ending inventories and cost of goods sold of branch to cost, and to eliminate balance in Allowance for Overvaluation of Inventories: Branch X ledger account. b) To increase net income of branch by portion of merchandise markup that was realized. c) To eliminate reciprocal ledger accounts. Reconciliation of Reciprocal Accounts In a previous section, the nature of reciprocal accounts and the necessity for their reconciliation before the combined financial statements are prepared was described. The situation is comparable to that of reconciling the ledger account for Cash in Bank with the balance in the monthly bank statement. Illustration: Assume the home office and the branch accounting records contain the following data and the balances of the Home Office account and Investment in Branch accounts on Dec 31 are 41,500 Cr. and 49,500 Dr. respectively. Comparison of the two reciprocal accounts discloses four reconciling items. 1. A debit of 8,000 in Investment in Branch account without a related credit in Home Office account Merchandise shipped to branch on Dec 29 but not received at year end. Required journal in branch accounting records: Inventories in Transit 8,000 Home Office 8,000 To record shipment of merchandise in transit from home office The inventories in transit must be included in inventories in hand. 2. A credit of 1,000 in the Investment in Branch account without a related debit in the Home Office account The home office collected trade accounts receivable of the branch. The journal entry required in the records of the branch on Dec 31: 16  Home Office 1,000 Trade A/R 1,000 To record collection of accounts receivable by home office 3. A debit of 3,000 in the Home Office ledger account without a related credit in Investment in Branch account The branch acquired equipment for 3,000 on Dec 28 and debited Home Office as equipment used by branch is carried in records of the home office. The journal entry required in the records of the home office: Equipment: Branch 3,000 Investment in Branch 3,000 To record equipment acquired by branch 4. A credit of 2,000 in the Home Office ledger account without a related debit in the Investment in Branch account Accounts receivable of the home office was collected on Dec 30 and recorded as credit to Home Office. Journal entry required in the records of the home office on Dec 31 Investment in Branch 2,000 Trade A/R 2,000 To record collection of receivable by branch The effect of the foregoing end of year journal entries is to update the reciprocal ledger accounts as shown below: 17  M COMPANY- HOME OFFICE AND A BRANCH RECONCILIATION OF RECIPROCAL LEDGER ACCOUNTS DEC 31, 19X9 Investment in Home Office Branch Balance before adjustment 49,500 Dr 41,500 Cr Add: 1. Merchandise shipped 8,000 4. Home office A/R collected by branch 2,000 Less: 2. Branch A/R Colleted by H.O. (1,000) 3. Equipment acquired By branch (3,000) Adjusted balances 48,500 48,500 18