adv act notes

7/28/2019 Adv Act Notes

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Notes for Advanced AccountingAcct. 101

Dr. Tim Kelley

Table of Contents

Business Combinations:

Chapter 1 Pages 1 - 2






International Operations:

Chapter 12 Pages 35 - 41Chapter 13 Pages 42 - 48

Partnerships:



Fund Accounting:




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Chapter 1--Introduction to Business Combinations

Business Combinations: Operations of two or more companies are brought under commoncontrol.

Three Methods of Combining: 1. Merger.2. Statutory Consolidation.3. Stock Acquisition.

1. Merger: One company acquires the net assets of another.(A + B = A)

2. Statutory Consolidation: New Corporation is formed through an exchange of voting stock.(A + B = C)


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3. Stock Acquisition: Acquiring Company acquires more than 50% of the voting (common--notpreferred) stock of the acquired company. This can be a "friendly" or"hostile" takeover.

(A + B = [A + b])

Note: Business Combination Types #1 & #2 (Mergers and Statutory Consolidations) are discussedin Chapter 2, while Business Combination Type #3 (Stock Acquisitions) is discussed inChapters 3-6.


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Chapter 2--Acquisition of Net Assets

Before June 30, 2001: Two Methods of Recording the Initial Combination:

A: Purchase Method (usually results in some goodwill being recognized. This goodwillis no longer subject to amortization, but is instead subject to an annual impairmenttest).

B: Pooling of Interests Method (FASB no longer allows--as of June 30, 2001--thePooling of Interests method). Poolings in effect before June 30, 2001 aregrandfathered in. With a pooling, the two companies combining their interestssimply added together their book values to form a new consolidated balance sheet.No goodwill was recorded in poolings.

Note: Before June 30, 2001, you could use the pooling of interests method if you

met 12 criteria (to establish that the business combination was a stock for stock swapof companies of similar size), otherwise you had to use the purchase method. Nowyou have to use the purchase method.

The main concept behind the 12 conditions was that at least 90% of the acquiredcompany's shares had to be obtained by the acquiring company in the stock swapand that the owners maintain their same "relative interest" in the combined business(i.e., nobody was bought out or is being set up to be bought out).


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Mechanics of Purchase Method (only method now allowed for business combinations):

Method can be used for (1) mergers, (2) statutory consolidations, and (3) stock acquisitions.

Recording Requirement #1: Record investment in acquired company at "total cost."

Total cost = cash paid + present value of any future payments + directexpenses of merger (e.g., accounting fees) + FMV of any stock givenup.

Recording Requirement #2: Record assets and liabilities at FMV.

Note: The difference between the "total cost" of the acquisition and theFMV of the net assets (assets minus liabilities) creates either apositive or negative differential.

If positive differential:

If negative differential:


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Merger: Acquisition of Net Assets (No contingent consideration)

Cost > FMV of net assets (positive differential = goodwill)

Cost < FMV of net assets (negative differential = reduction in the valuation ofnoncurrent assets other than long-term marketable securities).

Example: Negative DifferentialFacts:1. "A" buys "B's" net assets for $9,000.2. "B's" Balance Sheet (Date of Acquisition).

BV FMVAccounts Receivable $1,000 $ 900Inventory 2,000 3,000

Long-Term MarketableSecurities

2,500 2,600

P,P,& E 1,200 1,500Patent 1,100 1,200

Total Assets $7,800 $9,200

Liabilities $ 0 $ 0

Calculation of Differential:

Total Cost $9,000FMV of net assets (9,200)

Negative Differential $ (200)

Allocation of Negative Differential:

FMVPPE $1,500Patents 1,200

$2,700

Journal Entry:


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Example: Positive Differential

Facts: Same facts as previous example, except that "A" buys the net assets of "B" for $10,200.

Total Cost $10,200FMV of net assets acquired 9,200

Goodwill $ 1,000

Journal entry on A's books:


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Contingent Consideration Based on Earnings:

Sometimes an acquiring company may agree to pay the acquired company's owner more $ ifcertain earnings are met (by the acquired net assets). In this case the TOTAL COST of theacquisition is not known until the end of the contingency period.

Purchase Method:Purchase Date: Record purchase at known cost.

Later Date: Add EXTRA COST paid if earnings level is met.

If COST > FMV of net assets

Debit goodwill for additional cost (change inaccounting estimate).

If COST < FMV of net assets

Increase noncurrent assets to FMV and, ifnecessary, debit goodwill (change inaccounting estimate).


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Example:

Pepper Company acquired all the net assets of Salt Company on December 31, 2000 for $1,850,000cash. The balance sheet of Salt Company immediately prior to the acquisition showed:

Book Value Fair ValueCurrent assets $ 800,000 $ 800,000Plant and Equipment 900,000 1,375,000

Total $1,700,000 $2,175,000

Liabilities $ 150,000 $ 190,000Common Stock 400,000Other ContributedCapital

500,000

Retained Earnings 650,000

Total $1,700,000

As part of the negotiations, Pepper agreed to pay the stockholders of Salt $500,000 cash if the postcombination earnings of Pepper average $1,800,000 or more per year over the next two years.

Required:A. Prepare the journal entries on the books of Pepper to record the acquisition on December 31,

2000.

B. Assuming that the earnings contingency is met, prepare the journal entry on Pepper's booksneeded to settle the contingency on December 31, 2002.

Part A:

Part B:


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Contingent Consideration Based on Security Price(No change in the "total cost" of the acquisition--only a change in the number of sharesreflecting the total cost).

Acquired Company shareholders may worry about a drop in the value of the acquiringcompany's shares (which they received when they gave up their shares in the acquiredcompany). In response, the acquiring company may guarantee that its shares will maintaintheir value for a specified period of time after the date of acquisition.

Facts:1. The acquiring company issues 1,000,000 of its own shares to obtain all the $1,000,000 net

assets of the acquired company. FMV per share of acquiring company was $1 at the date ofacquisition (each share has a $.10 par value).

2. Acquiring company guaranteed its stock price for one year.

3. After 1 year, the stock price of the acquiring company has fallen to $.25 per share.


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Chapter 3--Consolidated Financial Statements (Date of Acquisition)

Note: With a stock acquisition, a parent-subsidiary relationship is formed. Both the parent andsubsidiary maintain a set of books. With a merger, only one corporation survives (Chapter 2). Wewill now look at stock acquisitions with the purchase method (Chapters 3-6). We only look at thebalance sheet in Chapter 3--we see the income statement in Chapters 4-6.

If we buy more than 50% of another company's voting common stock (we prepare consolidatedfinancial statements).

Unless:(1) Control is temporary or(2) Control does not rest with the majority owners (e.g., company is effectively

"nationalized.")

Prior to FASB #94, we could exclude subsidiaries with a dramatically different business from theparent. For example, General Motors used to be able to exclude its finance subsidiary (GeneralMotors Acceptance Corp.--GMAC) from consolidation and instead used the equity method.

Why Stock Acquisitions?1. Easier than a merger (and you don't have to buy 100% of the subs. net assets--you

just need to buy more than 50% of the voting common stock to gain a controllinginterest).

2. If a subsidiary (a legally separate corp.) defaults on a loan, the parent is oftentimesnot liable--unlike with a merger. However: If the subsidiary was set up to commit a

fraud on the creditors or if the parent siphoned off subsidiary assets in anticipation ofsubsidiary insolvency, then creditors can successfully sue the parent.

Problems with Consolidated Financial Statements

1. Sub. shareholders (minority interest) and sub. creditors learn little from consolidatedfinancial statements (Remember that sub. creditors can only sue sub. assets).

Solution: Subsidiary only financial statements can be prepared for minorityshareholders and subsidiary creditors.


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2. Ratio Analysis may be misleading.

AutoCompany--

Parent

Finance Company--Subsidiary

Total

Debt 40% 90% 65%

Equity 60% 10% 35%

Total 100% 100% 100%

Note: The above analysis assumes that the parent and sub are the same size.

Solution: Segment Reporting (However, segment reporting disclosures aresomewhat limited).

3. Consolidation of Foreign Sub. can lead to Interpretation Problems:

Especially when there are:1. significant currency value fluctuations.2. hyperinflationary conditions

Solution: See Chapter 13 (which we will cover).


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Stock Acquisitions:Purchase Method (Date of Acquisition Only)

Example 1: 100% Purchase---Cost of "S" = BV of "S"Example 2: 80% Purchase---Cost of "S" = BV of "S"Example 3: 80% Purchase---Cost of "S" > BV of "S"Example 4: 80% Purchase---Cost of "S" < BV of "S"

Adjustments:

Eliminations:

Example 1: 100% Purchase---Cost of "S" = BV of "S"

Example 2: 80% Purchase---Cost of "S" = BV of "S"

(For the facts for Examples 1 & 2See page 12.1)


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Example 3: 80% Purchase---Cost of "S" > BV of "S"

On January 2, 1993, Park Company acquired 80% of the outstanding common stock of SomerCompany for $150,000 cash. Just after the acquisition, the balance sheets of the two companieswere as follows:

(For Example 3 facts, see worksheet on Page 13.1)The fair values of Somer Company's assets and liabilities were equal to their book values with theexception of land (assumption for all Chapter 3 problems).

Required:A. Prepare the journal entry that Park prepared at the date of acquisition.

B. Prepare a consolidated balance sheet at the date of acquisition (see Page 13.1).

Example 4: 80% Purchase---Cost of "S" < BV of "S"Same facts as Example 3, except that say we paid $130,000 (instead of $150,000) for 80% of thevoting common stock of Somer Company.

Special Topic--Subsidiary Treasury Stock:

P's share of "S" treasury stock must be eliminated in the investment elimination entry. Remainingdebit balance in the treasury stock account reduces minority interest.

Note: Be careful in determining P's ownership % of "S," when "S" has treasury stock in its balance

sheet.

P's ownership % = Shares of "S" common stock owned by "P"Shares of "S" common stock outstanding***

***Shares of "S" common stock outstanding = Common shares issued minus treasury shares.


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Special Topic--Subsidiary Treasury Stock: (continued)

Example:Phillips Company purchased 26,600 shares of the outstanding common stock of Scott Company onDecember 31, 1999 for cash. At that time, the balance sheet of the Scott Company included thefollowing stockholders' equity section:

Common Stock (44,000 shares) $ 880,000APIC 440,000Retained Earnings 170,000Treasury Stock (6000 shares) (120,000)

Total Stockholders' Equity $1,370,000

Required:A. Prepare the elimination entry required for the preparation of a consolidated balance sheet

workpaper on December 31, 1999, assuming:

1. The purchase price of the stock was $1,010,000.

2. The purchase price of the stock was $920,000.

Assume further that any difference between the cost of the investment and the book value of

the net assets acquired relates to subsidiary land.

B. Compute the amount of minority interest that would appear on the December 31, 1999consolidated balance sheet.


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Chapter 4--Consolidated Financial Statements after Acquisition

Part A: Investment Accounting Methods on P's Books (Cost Vs. Equity).

Part B: Consolidations at the end of 1 full year since the date of acquisition. (The acquisition will beon Jan. 1 and the calendar year will be our fiscal year). Also covered will be consolidationsafter 1 full year since the date of acquisition.

Part C: Mid-Year purchase of subsidiary stock.

Part D: Consolidated statement of cash flows.

__________________________________________________________________

Part A: Investment Accounting Methods on P's Books (Cost Vs. Equity).

After an investment in a subsidiary is initially recorded, the parent's accountants must decide how toaccount for the investment over time.

------------------------------------------------------------------

Recall the following from investment accounting in intermediate accounting:

Method of recording and subsequent accounting for long-term investments in equitiesdepends on the amount of voting stock you own.

a) Cost Method - less than 20% (Voting Common Stock).

Called a passive investment.Record at cost (later adjusted for changes in market value).

To record the acquisition:

Long-term Investment $cost

Cash $cost

To record dividends received:

Cash (or Receivable) $Dividend Revenue $


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b) Equity Method - 20% to 50% (Voting Common Stock).

You are assumed to have "significant influence." (Investor company couldmanipulate the investee company's dividend policy to create dividendrevenue--if investor company with significant influence was allowed touse the cost method--for itself anytime extra revenue was desired.)

Investment account is kept at your share of the investee company's net worth(i.e., equity).

At year-end, you must show a revenue for your share of the investee's netincome and increase your investment account.

L-T investment $ Your % share

Equity in Subsidiary Income $

When dividends from the investee are received, you must reduce yourinvestment.

Cash or Div. $ Dividends

L-T investment $

--------------------------------------------------------

It does not matter what method the parent uses on its books to account for a subsidiary. Theconsolidation accountant must adjust the worksheet elimination entries to take into accountwhatever method the P accountants used on their books (cost, partial equity, or full equity).

The consolidated F/Ss will be identical no matter what method P has used to account for the

investment in S stock on its books. Therefore, we will concentrate on consolidations where theparent uses the cost method to account for the investment in S stock over time on their books.

Example: Review of Cost and Equity Methods

Facts: 1. On Jan. 1, Year 1 the "P" Company buys 20% of "S" for $1000.2. During Year 1, "S" gives "P" $100 in dividends.3. "S" has $1,250 in net income in Year 1.4. The fair market value of "P's" stock investment in "S" has fallen to $950. "P" has no

other long-term investments.


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Cost Method Equity Method(Securities Available for Sale)

Journal Entries:

1. 1/1/Year 1

2. During Year 1

3. 12/31/Year 1

4. 12/31/Year 1

Note: With the cost method, the "Investment in S" account stays the same--but our portfolio oflong-term securities is adjusted upward or downward using a valuation account and anowners' equity account is correspondingly adjusted upward or downward (securitiesavailable for sale approach). The only time that the "Investment in S" account is adjusteddownward is the case of a liquidating dividend.


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Note: With the equity method, the "Investment in S" account would always show P's equity claimon S's net assets.

Part B: Consolidations at the End of 1 Full Year Since the Date of Acquisition

(DOA = Jan. 1, Year 1). Also, Consolidations After 1 Year Since the Date ofAcquisition

Assumptions in Part B:-- we will use the purchase method of accounting.-- we will use the cost method on P's books during the year (P could

potentially also use partial equity or full equity methods).-- "S" was purchased at the beginning of the year.-- any differential is due to undervalued or overvalued land.

Note: See page 124 of our textbook for an example of a consolidation worksheet format--one year

since the date of acquisition. In the consolidated income statement, all the parent's earningsand the parent's share (in this case 80%) of the subsidiary earnings are reflected inconsolidated earnings.


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Example (Consolidations 1 Year Since the Date of Acquisition):

Peace Company purchased 80% of the common stock of Shaw, Inc. on January 1, 2000 for$350,000. The trial balances at the end of 2000 for the companies were:

Peace Shaw

Cash $62,816 $68,000Accounts and Notes Receivable 216,000 208,520Inventory, 1/1 69,360 19,680Investment in Shaw, Inc. 350,000 0Other Assets 301,604 213,274Dividends Declared 30,000 20,000Purchases 303,000 162,800Selling Expenses 37,082 19,334Other Expenses 14,888 12,796

Total Debits $1,384,750 $724,404

Accounts and Notes Payable $84,478 $32,540Other Liabilities 12,800 14,286Common Stock 200,000 100,000Premium on Common Stock 300,000 150,000Retained Earnings 222,352 134,998Sales 549,120 292,580Dividend Income (From S) 16,000 0Total Credits $1,384,750 $724,404

Inventory balances on December 31, 2000 were $22,520 for Peace and $12,300 for Shaw, Inc.Shaws accounts and notes payable contain a $5,000 note payable to Peace.

Required:

Prepare a workpaper for the preparation of consolidated financial statements on December 31,2000. The difference between cost and book value of equity acquired relates to subsidiary land.


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Example (Consolidations More Than 1 Year Since the Date of Acquisition):

On January 1, 1997, Pair Company purchased 80% of the capital stock of Snap Company for$48,000. Snap Company had capital stock of $50,000 and retained earnings of $8,000 at thattime. On December 31, 2000, the trial balances of the two companies were:

Pair Snap

Cash $8,000 $14,000Accounts Receivable 22,000 16,000Inventory, 1/1 14,000 8,000Advance to Snap Company 4,000 0Investment in Snap Company 48,000 0Plant and Equipment 50,000 40,000Land 8,000 6,000Dividends Declared 10,000 10,000

Purchases 84,000 20,000Other expenses 10,000 8,000Total Debits $258,000 $122,000

Accounts Payable $6,000 $6,000Other Liabilities 8,000 0Advance from Pair Company 0 4,000Capital Stock 100,000 50,000Retained Earnings 40,000 20,000Sales 96,000 42,000Dividend Income 8,000 0

Total Credits $258,000 $122,000

Inventory, 12/31 $20,000 $10,000

Any difference between cost and book value relates to subsidiary land.

Required:

Prepare a workpaper for the preparation of consolidated financial statements on December 31,2000.


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Part C: Interim (Mid-Year) Acquisitions of Subsidiary Stock

Main Idea:

Parent can only include in consolidated net income:

1. Parent's independently earned net income.2. Parent's share of S net income since the date of acquisition.

Example:

On May 1, 1999, Pace Company purchased 80% of the common stock of Senior Company for$45,000. Additional data concerning these two companies for the years 1999 and 2000 are:

1999 1999 2000 2000

Pace Senior Pace Senior

Common Stock $100,000 $25,000 $100,000 $25,000

Other ContributedCapital

50,000 10,000 50,000 10,000

Retained Earnings, 1/1 40,000 10,000 70,000 23,000

Net Income (Loss) 35,000 15,000 37,500 (5,000)

Cash Dividends (11/30) 5,000 2,000 5,000 0

Required:A. Prepare the workpaper entries that would be made on a consolidated statements

workpaper for the years December 31, 1999 and 2000 for Pace Company and itssubsidiary, assuming that Senior Company's income is earned evenly throughout the year.

B. Calculate consolidated net incomeand consolidated retained earningsfor 1999 and 2000.


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Part D: Consolidated Statement of Cash Flows

Key Concepts: Dividends paid by the sub to the parent need to be eliminated inconsolidation (cash never leaves the consolidated entity).

Noncontrolling Interest in Income (or Minority Interest) mustbe added to consolidated net income in order to compute consolidated cashprovided by operations (of course, there will likely be other additions andsubtractions to consolidated net income to compute consolidated cashprovided by operations).


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Example--Consolidated Statement of Cash Flows:

A consolidated income statement and selected comparative balance sheet data for PrinceCompany and subsidiary follow:

Prince Company and Subsidiary

Consolidated Income Statement

For the year Ended December 31, 2000

Sales $628,000Cost of Sales 247,000Gross Profit 381,000Operating Expenses:Depreciation Expense $69,000Selling Expenses 122,000

Administrative Expenses 85,000 276,000Combined Income 105,000Less: Minority Interest 15,750Consolidated Net Income $89,250

-----------------------------------------------------------------------------------------

Selected comparative balance sheet data:

12/31/99 12/31/00

Accounts Receivable $264,000 $318,000Inventory 194,000 172,000

Prepaid Selling Expenses 26,000 30,000Accounts Payable 99,000 86,000Accrued Selling Expenses 72,000 84,000Accrued Administrative Expenses 56,000 40,000

Required:

Prepare the cash flow from operating activities section of a consolidated statement of cash flowsassuming use of the:

A. Direct Method.B. Indirect Method.


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Chapter 5

Allocation and Depreciation of Differences Between Cost and Book Values

This chapter examines how a differential is:

1. Allocated during the consolidation process to increase or decrease the bookvalue of S assets/liabilities, and

2. Amortized each year on the consolidation worksheet (Note: Some assetssuch as land and goodwill are not reduced in value over time, unless there isevidence of asset impairment).

Terms:

Differential = Difference between cost and book value of S net assets purchased by

P.Goodwill = Excess of cost over FMV of S identifiable net assets purchased by P.


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Example--Differential Relates to PPE and Inventory:

On January 1, Year 1, Park Company purchased an 80% interest in Stream Company for $260,000.On this date, Stream Company had common stock of $207,000 and retained earnings of $130,500.An examination of Stream Companys balance sheet (at the date of acquisition) revealed thefollowing comparisons between book and fair values.

Book Value Fair ValueInventory $30,000 $35,000Other Current Assets 50,000 55,000Equipment 300,000 350,000Land 200,000 200,000

Additional Facts:1. Assume inventory of S is sold within one year (FIFO).

2. Other current assets are sold within one year.3. S will depreciate equipment over a 10 year remaining life, using straight-line depreciation

and no salvage value.

Required:1. Prepare the journal entry that P would make on its books on the date of acquisition.2. Prepare elimination journal entries that would be made (1) on the date of acquisition, (2) one

year after the date of acquisition, and (3) two years after the date of acquisition.

Rules:1. Any increase or decrease in S assets/liabilities are reflected in the consolidated worksheets

and the consolidated financial statements, but have no impact on Ss books.2. S will use its original cost figures to report its income.3. Consolidated worksheets and financial statements will reflect the difference between the fair

market value and book value of Ss assets at the date of acquisition. Specifically, we must(on the worksheet) adjust Ss depreciation and amortization etc., to reflect the differencebetween the fair market value and book value of Ss assets at the date of acquisition. Recallhowever that goodwill is not subject to amortization (but to an annual impairment test).


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Special Problems Related to Treatment of the Difference Between Cost and Book

Value:

A. Book value of liabilities of S are not equal to the FMV of the liabilities of S.B. Show accum. depr. separately--not PPE (net).C. Early sale of land by S.--------------------------------------------------------------------------------------------------------

A. Book value of liabilities of S are not equal to the FMV of the liabilities of

S.

Bonds Payable: BV = Face value +/- unamortized discount orpremium.

FMV = Present value of future interest andprincipal payments as of the date of acquisition (not when bonds

were issued).

If FMV > BV (at Date of Acquisition):Worksheet bond premium amortization will decrease consolidated interest expense andincrease consolidated net income.

If FMV < BV (at Date of Acquisition):Worksheet bond discount amortization will increase consolidated interest expense anddecrease consolidated net income.

Example--Bonds FMV is not equal to BV and Goodwill Recorded:

On January 1, 1998, Point Corporation acquired an 80% interest in Sharp Company for$2,000,000. At that time Sharp Company had capital stock of $1,500,000 and retained earningsof $700,000. The book values of Sharp Company's assets and liabilities were equal to their fairvalues except for the bonds payable. The outstanding bonds were issued on January 1, 1993 (atface value with a 10% coupon rate) and mature on January 1, 2003. The bond principal is$500,000 and the current yield on similar bonds is 15%.

Required:

A. Assume interest is paid annually, prepare a schedule to assign the difference between costand book value in the consolidated statements workpaper on the acquisition date.

B. Prepare the workpaper entries necessary on December 31, 1998.


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B. Show accum. depr. separately--not PPE (net).

Example:

Pale Company acquires a 75% interest in Shadow Company on January 2, 2000. The resultingdifference between cost and book value in the amount of $120,000 is entirely attributable toundervalued equipment with an original life of 15 years and a remaining life, on January 2, 2000,of 10 years.

Required:

Prepare the December 31 consolidated financial statements workpaper entries for 2000 and 2001to assign and depreciate the difference between cost and book value, recording accumulateddepreciation as a separate balance.


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C. Early sale of land by S.

Formula for Computing Consolidated Net Income:

P's income from independent operations (take out any dividends received from S). X

Add: P's share of S's reported net income X

Subtract: Amortization/Depreciation of differential assigned to expense this year (X)

Consolidated Net Income X

Example--Early Sale of Land by S:

Pender Company purchased 80% of the common stock of Sunderland Company in the openmarket on January 1, 1998, paying $31,000 more than the book value of the interest acquired.The difference between cost and book value is attributable to land.

Required:

A. What workpaper entry is required each year until the land is disposed of?B. Assume that the land is sold on January 1, 2001 and that Sunderland Company

recognizes a $50,000 gain on its books. What amount of gain will be reflected on the2001 consolidated income statement?

C. In all years subsequent to the disposal of the land, what workpaper entry will benecessary?


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Chapter 6

Elimination of Unrealized Profit in Intercompany

Sales of Inventory

This chapter addresses what additional elimination entries are needed on the consolidated worksheetwhen P and S have had intercompany inventory transactions.

TERMS:

Upstream sale Sale from S to P.S recorded the profit, andP put the item in Inventory at the purchase price from S.

Downstream sale Sale from P to S.P recorded the profit, and

S put the item in Inventory at the purchase price from P.

Unrealized Intercompany

ProfitThe intercompany profit on the sale between P and S is consideredunrealized until the inventory is sold to outside parties.

Therefore, any profit that occurred between the parties this yearAND remains in the ENDING INVENTORY of P or S must beeliminated.

(This profit is really moved to the income statement in theyear the item is sold to outsiders.)

SUMMARY:Unrealized profit is eliminated from the consolidated incomestatement.

Ending inventory is reduced to be at "cost to the consolidatedentity."


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Realized Intercompany

ProfitIf inventory is sold to outsiders in the same year it is sold between Pand S, the profit is considered realized. (Nothing special is done inthe consolidation.)

ALSO, intercompany profit in the BEGINNING INVENTORY ofeither P or S is considered realized (or confirmed) that year if thegoods are sold to outsiders.

NOTE: 100% of any unrealized profit is eliminated for both upstream and

downstream sales!!!!!

(This is true even though the minority shareholders consider anyupstream profits on sales to P to be realized upon the sale from S to

P.)

Elimination Entries for Unrealized Intercompany Profits:

1. Eliminate all intercompany sales for the year at sale price (which includes profit).

Sales X (no income statement

Cost of goods sold X effect)

(or Purchases)

Note: The credit to cost of goods sold is for the full sales price (this overstatement is

corrected in the next elimination entry).

Note: 100% of upstream & downstream sales are eliminated in this manner.

2. Eliminate unrealized intercompany profit in ending inventory.

Cost of goods sold X (income statement

Inventory X effect)

Note: This elimination entry reduces income by the amount of the intercompany

profit that was imbedded in the parent's and/or subsidiary's ending inventory.


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Example--Unrealized Ending Inventory Profit--Upstream Sale:

1. Jan. 1, 2000 purchase transaction (80% purchase).

2. In 2000, there was a $1,000 upstream sale of 4 units of inventory ($250 * 4

units) (S >>>>> P).

3. The cost of goods sold on these units was $800 ($200 * 4 units).

4. P still has all this inventory at 12/31/00.


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Note: Previous Example did not have any beginning inventory.

If we had beginning inventory:

Worksheet Entry: (Downstream sale: P >>>>>>>>> S)

Beginning R/E - P * XCost of Sales ** X

* Reduces opening balance in R/E (we eliminated this ending inventory unrealized profit lastyear, but only on a worksheet basis--On the Parent's books the profit is still reflected inretained earnings--so we reflect last year's unrealized profit elimination by reducing theopening balance in the parent's R/E).

** Assuming FIFO, the beginning inventory will be sold this year. The credit here to "cost of

sales" increases earnings and shows that the consolidated entity has realized the profits byselling to some party outside the consolidated entity. Also, note that the subsidiary bookswill reflect overstated "cost of sales" since the subsidiary's cost of sales includes the"stepped-up" cost when the inventory was sold by the parent to the subsidiary at a profit lastyear. This overstated subsidiary cost of sales is "backed-out" in the above elimination entry.

Worksheet Entry: Upstream Sale (P


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CALCULATING MINORITY INTEREST IN N.I.:

1. DOWNSTREAM SALE: (P >>>>>>>>>>>> S)

the profit is on P's income statement and, hence, S's net income does NOT need tobe adjusted.

S reported net income * M.I. % = M.I. in net income

2. UPSTREAM SALE: (P


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Example--Ending and Beginning Inventory Intercompany Profits--Upstream Sale:

Webster Corporation owns 90% of the common stock of Clark Company. The stock waspurchased for $540,000 on January 1, 1995, when Clark Company's retained earnings were$100,000. Financial data for 1999 are presented below:

Webster Corp. Clark Company

Sales 1,100,000 530,000Dividend Income 54,000 0Total Revenue 1,154,000 530,000

Cost of Goods Sold:Beginning Inventory 150,000 110,000Purchases 850,000 350,000Cost of Goods Available 1,000,000 460,000Less: Ending Inventory 140,000 115,000

Cost of Goods Sold 860,000 345,000Other Expenses 207,000 137,500Total Costs and Expenses 1,067,000 482,500

Net Income 87,000 47,500

1/1 Retained Earnings 541,000 120,000Net Income 87,000 47,500Dividends Declared (100,000) (60,000)12/31 Retained Earnings 528,000 107,500

Cash 80,000 50,000

Accounts Receivable 213,000 112,500Inventory 140,000 115,000Investment in Clark Company 540,000Other Assets 500,000 400,000Total Assets 1,473,000 677,500

Accounts Payable 70,000 30,000Other Current Liabilities 75,000 40,000Capital Stock 800,000 500,000Retained Earnings 528,000 107,500Total Liabilities and Equity 1,473,000 677,500

The January 1, 1999 inventory of Webster Corporation includes $30,000 of profit recorded byClark Company on 1998 sales. During 1999, Clark Company made intercompany sales of$200,000 with a markup of 25% on cost. The ending inventory of Webster Corporation includesgoods purchased in 1999 from Clark Company for $50,000.

Required: Prepare the consolidated statements workpaper for the year ended December 31,1999.


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Chapter 12

Accounting for Foreign Currency Transactions

and Hedging Foreign Currency Risk

I. Transaction Gains and Losses (assuming that we have not hedged against a foreignexchange loss).

Issues: With an export, we sell goods on credit and later receive foreign currency worthmore (GOOD NEWS) or less (BAD NEWS) (in terms of dollars) than we hadexpected at the time of sale.

With an import, we purchase goods on credit and later pay foreign currency worthmore (BAD NEWS) or less (GOOD NEWS) (in terms of dollars) than we expectedat the time of purchase.

Example #1: Importing Transaction (no hedge is made).

Facts: 1. On December 15th, the USA Company buys inventory from a MexicanCompany for 75,000 pesos (n,30).

2. The indirect exchange rates (expressed in units of foreign currency) at thefollowing dates are as follows:

Purchase date Dec 15th 9.023 pesos = $1

Year end Dec 31st 8.945 pesos = $1

Settlement

date

Jan 15th 9.141 pesos = $1

Direct Exchange Rates (Expressed in units of U.S. Currency)

Dec. 15:

Dec. 31:

Jan. 15:

Note: If the U.S. Company paid the Mexican Company in U.S. dollars, there would be no foreigncurrency risk.


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Example #1 (cont.): Importing Transaction (no hedge is made)

Journal Entries:Dec. 15:

Dec 31:

Jan 15:

Example #2: Exporting Transaction (assuming no hedge was made)

Facts: 1. USA Company sells equipment to a French Company on December 10th for250,000 Euros (n,30).

2. The direct exchange rates are as follows:

Sales date Dec. 10 $.885 = 1 Euro

Year end Dec. 31 $.892 = 1 Euro

Settlementdate

Jan. 10 $.879 = 1 Euro

Journal Entries:

Dec. 10:

Dec. 31:

Jan 10:


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Import Export

Increase in direct exchange rate

Decrease in direct exchange rate

Some Definitions:

Hedging: Taking actions to protect your company from foreign exchange risk.

Forward Exchange Contracts: Agreement to buy or sell foreign currency at a future date at a setforward rate.

Note: Forward exchange contracts can be used to hedge against the possibility of foreigncurrency exchange (or transaction) losses on credit sales and purchases--as we willsoon see.

Forward Rate: The exchange rate between currencies for a future date. For example, I agree todayto buy 10 British pounds, 1 year from now, for $1.50 per pound. The $1.50 perpound is the forward rate and is set.

Premium or Discount: The difference between the current spot rate and a forward rate.

If Forward rate > Spot Rate (Difference = Premium)

If Forward rate < Spot Rate (Difference = Discount)

Note: The premium or discount is caused by differences in the interest rates (and expectedfuture interest rates) and other economic factors (e.g., differential inflation rates).

Three Important Dates to Consider:

1. Commitment Date (date we issue purchase order or receive sales order).2. Sales/Purchase Date (date that title transfers and import purchase or export sale is made).3. Settlement Date (date that cash is paid or received related to credit purchase or sale).


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Important Point: The accounting for forward exchange contracts is different depending onwhich of two time periods (see below) you are in.

Time Period #1--Hedge of a Foreign Currency Commitment:This is the time between the commitment date and the sales/purchase date.

Accounting rules: 1. Exchange gains/losses will exactly offset each other.2. Firm Commitment account will be closed out to adjust

the sales (for an export) or the inventory/purchases (for animport) so that on the sales/purchase date the sales orpurchase recorded reflects the forward contract amount thatwas agreed to at the commitment date.

Time Period #2--Hedge of an Exposed A/R of A/P:

This is the time between the sales/purchase date and the settlement date.

Accounting rules: 1. Transaction gains/losses will not exactly offset each other(in the short run anyway). However, by the time we reach theend of the transaction at the settlement date, the sum total ofthe net transaction gains/losses will equal the originalpremium or discount on the forward exchange contract.

2. The original credit to sales (for an export) or debit toinventory/purchases (for an import) will not be adjusted forsubsequent transaction gains and losses.

Note: We will be skipping Pages 587 to 596, starting with cash flow hedges (bottom of Page 586).


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Example--Hedge of a Foreign Currency CommitmentSale (Export):

(Time Period #1)

On October 1, Year 1, Advanced Electronics, Inc., secured an order from a company located inFrance for a new computer to be delivered on April 1, Year 2. The sale price, which is payablein Euros, is 30,000 Euros. The 180-day delivery schedule allows for custom manufacture,delivery, and installation. Payment is due on delivery.

The spot rate for Euros on October 1, Year 1 is $.88. In order to protect itself against foreigncurrency fluctuations, Advanced Electronics sold 30,000 Euros for delivery in 180 days at theforward rate of $.86 on October 1, Year 1.

The following additional exchange rates prevailed:

December 31, Year 1: Spot rate = $.84

Forward rate for 90-day delivery = $.81

April 1, Year 2: Spot rate = $.80

Required:

Prepare the journal entries that would be made by Advanced Electronics for the transactions onOctober 1, Year 1, December 31, Year 1 (year end), and April 1, Year 2.


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Example--Hedge of a Foreign Currency CommitmentPurchase (Import):

(Time Period #1)

On April 1, Year 1, Hoover Co. committed to order 8,000 cameras from a Japanese firm at aprice of 150,000,000 yen. The purchase will be recorded on June 1, Year 1 when the cameraswill be delivered and paid for. On April 1, Year 1, Hoover enters into a forward exchangecontract to receive 150,000,000 yen on June 1, Year 1 at a forward rate of 1 yen = $.00816. Thespot rate on April 1, Year 1 is 1 yen = $.00829 and on June 1, Year 1 = $.00801.

Required:

Prepare the purchase and the forward contract related journal entries for April 1 and June 1, Year1.


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Example--Hedge of an Exposed Accounts ReceivableSale (Export):

(Time Period #2)

On December 1, 1999, Tyro Toy Company exported toys that had cost $170,000 to a BritishCompany for 140,000 pounds. The account is to be settled on January 31, 2000. Tyro ToyCompany is a calendar-year company and uses the perpetual inventory system. Direct exchangerates were as follows:

December 1 = $1.4202December 31 = $1.4170January 31 = $1.4320

On December 1, 1999, Tyro Company entered into a forward contract to sell 140,000 pounds onJanuary 31, 2000 for $1.4189 per pound. Note: The forward rate on Dec. 31 = $1.4151.

Required:Prepare the journal entries needed in 1999 and 2000 to record the sale and forward contract andto settle the accounts.


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Chapter 13

The Translation of Financial Statements of Foreign Affiliates

Chapter 12 -- Import and Export TransactionsChapter 13 -- Foreign Affiliate

0-20%--Cost Method (Insignificant Influence)20-50%--Equity Method (Significant Influence)50-100%-Consolidated Financial Statements

(Controlling Interest)

After adjusting the foreign affiliates financial statements to reflect U.S. GAAP, two methods arespecified in U.S. GAAP for translating the consolidated financial statements of foreign affiliatesfrom the foreign currency to U.S. currency.

a. Current Rate Method

b. Temporal Method

If certain conditions exist, the U.S. Company must use the current rate method; if other conditionsare met, the company must use the temporal rate method.

We use the current rate method if the foreign currency is the functional currency of the foreignaffiliate. This is true if the affiliate is fairly independent.

a. affiliate obtains its own financing and doesn't pay significant dividends to the U.S.parent.

b affiliate does not have significant inter-company import/export transactions with theU.S. parent.

We use the temporal rate method if the U.S. dollar is the functional currency of the foreignaffiliate. This is true if:

a. there are significant dollars flowing in and out of the foreign affiliate--from and tothe U.S parent.

b. the foreign affiliate is essentially a branch of the U.S. parent's operations.

or

We use the temporal rate method if there has been significant inflation experienced in the foreigncountry where the affiliate is located.

a. 100% inflation over the last three years (approximately 26% compounded annually)is considered to be significant inflation.


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Current Rate Method:

Assets & Liabilities Current Exchange Rate

Common Stock & APIC Historical Exchange Rate (Exchange rate at time of stock issuance)

Retained Earnings From combined Income Statement & Statement of Retained Earnings

Sales Average Exchange Rate

Expenses Average Exchange Rate

Depreciation Expense Average Exchange Rate

Dividends Historical Exchange Rate (Exchange rate when dividends were paid)

Note: Any translation gain/loss only affects stockholders' equity (no income statement effect).Since the functional currency is not the U.S. dollar, translation gains and losses in any givenyear are not likely to have much of an immediate affect on the U.S. parent.

Temporal Method:

Monetary Assets(Cash, A/R, Notes Rec.)(Assets expressed in termsof a fixed amount of cashto be realized).

Current Exchange Rate

Inventory (Cost) Historical Exchange Rate

Inventory (FMV--LCM Method) Current Exchange Rate

Property, Plant & Equipment Historical Exchange Rate

Other Nonmonetary Assets Historical Exchange RateLiabilities (most are monetary) Current Exchange Rate

Common Stock & APIC Historical Exchange Rate

Retained Earnings From the Combined Income Statement andStatement of Retained Earnings

Sales Average Exchange Rate

Cost of Sales Historical Exchange Rate

Depreciation Expense Historical Exchange Rate

Other Expenses Average Exchange Rate

Dividends Historical Exchange Rate

Note: Any translation gain or loss is run through the income statement. Companies generally donot like this and some enter into hedging transactions to avoid big losses on their books.


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Overview of differences between the current rate and temporal methods.

Current Rate Method Temporal Method

Nonmonetary Assets Current Rate Historical Rate

Cost of Sales Average Rate Historical Rate

Depreciation Exp. Average Rate Historical Rate

Translation Gain or Loss Stockholders' Equity Account Income Statement

Example: To demonstrate why the temporal method should be used in situations in whichinflation is significant in the foreign country where affiliate is located.

Facts: 1. 20 years ago our foreign subsidiary purchased land for 1,000,000 foreigncurrency units (FCU) when the direct exchange rate was1 FCU = $.10.

2. The direct exchange rate is now 1 FCU = $.0004(indirect rate: $1 = 2500 FCUs).

Note: The next four pages illustrate how the current rate and temporal methods differ. Theexample uses the same facts for the current rate and temporal methods over a two-yearperiod.


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Current Rate Method (Year 1)

1/1/Year 1

Euros

12/31/Year 1--

Euros

Ex. Rate Direct $

Cash 10,000 20,000A/R 10,000 20,000Land 30,000

40,000

P, P, & E 40,000

50,000

Total Assets 90,000 130,000

Liabilities 20,000 20,000

Com. Stk. 70,000

70,000

R/E 0 40,000TranslationAdjustmentTotal Liabsand S.E.

90,000 130,000

Year 1-

Euros

Revenues 350,000Expenses (290,000)

Net Income 60,000Less: Dividends (20,000)Increase in R/E 40,000Beginning R/E 0Ending R/E 40,000

Additional Facts--Exchange Rates:

1/1/Year 1 -- 1 Euro = $.80 (Common Stock Issued)

Avg. Year 1-- 1 Euro = $.829/30/Year 1-- 1 Euro = $.83 (Dividends Paid)12/31/Year 1--1 Euro = $.84


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Current Rate Method (Year 2)

1/1/Year 2--

Euros

12/31/Year 2--

Euros

Ex. Rate Direct $

Cash 20,000 25,000A/R 20,000 35,000Land 40,000 40,000P,P,& E 50,000 70,000Total Assets 130,000 170,000

Liabs 20,000 10,000Com. Stk. 70,000 70,000R/E 40,000 90,000

TranslationAdjustmentTotal Liabs andSE

130,000 170,000

Year 2

Euros

Revenues 450,000Expenses (340,000)

Net Income 110,000

Less: Dividends (60,000)Increase in R/E 50,000Beginning R/E 40,000Ending R/E 90,000

Additional Facts--Exchange Rates:

1/1/Year 2 -- 1 Euro = $.84Avg. Year 2-- 1 Euro = $.889/30/Year 2-- 1 Euro = $.90 (Dividends Paid)

12/31/Year 2--1 Euro = $.92


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Temporal Method (Year 1)

1/1/Year 1

Euros

12/31/Year 1

Euros

Ex. Rate Direct $

Cash 10,000 20,000A/R 10,000 20,000Land 30,000 40,000P, P, & E 40,000 50,000Total Assets 90,000 130,000

Liabs 20,000 20,000Com. Stk. 70,000 70,000R/E 0 40,000

Total Liabs and SE 90,000 130,000Year 1--Euros

Revenues 350,000Depreciation Expense($40,000/4 Years)

(10,000)

Other Expenses (280,000)Translation Gain/Loss -Net Income 60,000

Less: Dividends (20,000)

Increase in R/E 40,000Beginning R/E 0Ending R/E 40,000

Additional Facts--Exchange Rates:1/1/Year 1 -- 1 Euro =$.80 (Common Stock Issued)

(Land Purchased)(40,000 P, P, & E Purchased)

Avg. Year 1-- 1 Euro =$.829/30/Year 1-- 1 Euro =$.83 (Dividends Paid)

(10,000 Land Bought)

12/31/Year 1--1 Euro =$.84 (20,000 P, P, & E Purchased)


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Temporal Method (Year 2)

1/1/Year 2--

Euros

12/31/Year 2

Euros

Ex.

Rate

Direct $

Cash 20,000 25,000A/R 20,000 35,000Land 40,000 40,000P, P, & E 50,000 70,000Total Assets 130,000 170,000

Liabs 20,000 10,000Com. Stk. 70,000 70,000R/E 40,000 90,000

Total Liabs and SE 130,000 170,000Year 2Euros

Revenues 450,000Depreciation Expense(40,000/4)+(20,000/4)

(15,000)

Other Expenses (325,000)Translation Gain/Loss -Net Income 110,000

Less: Dividends (60,000)

Increase in R/E 50,000Beginning R/E 40,000Ending R/E 90,000

Additional Facts--Exchange Rates:1/1/Year 2 -- 1 Euro =$.84Avg. Year 2-- 1 Euro =$.889/30/Year 2-- 1 Euro =$.90 (Dividends Paid)12/31/Year 2--1 Euro =$.92 (Bought 35,000 P, P,&E)


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Chapter 15

Partnerships: Formation, Operation, and Ownership Changes

Overview of Chapter 151. Types of Business Ownership and Definitions2. Process of Forming a Partnership (simpler than a corporation).3. Net Income Allocation4. Admission of a New Partner

--Buy out old partner (say 3 partners >>>> 3 partners)--Buy new ownership share (say 3 partners >>> 4 partners)

5. Withdrawal of a Partner--Bought out by partnership (say 3 partners >>> 2 partners)

I. Three Types of Business Ownership:

Sole Proprietorship unlimited liabilityPartnership (2 or more owners) unlimited liability

Corporations limited liability

Differences between:Partnerships and Corporations


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Definitions:

Mutual Agency:A partnership is bound by the actions of the individual partners (outsider can assume thateach partner can act as an agent and bind the partnership). In other words, I am personallyliable, if my partner signs a bad business deal without consulting me.

Joint and Several Liability:Each Partner is individually responsible for all the partnership debts. For example, Partner"A" (with a "deep pocket") can be sued by partnership creditors for all partnership debts,even though Partners "B" and "C" are personally solvent. Partner "A" would try to recoverfrom Partners "B" and "C." (Good luck trying to recover from your former partners!)

Partnership Agreement:Good idea to have a written partnership agreement.

Major Items:1. Amount each partner is to contribute and the designated value if non-cash

assets are contributed.2. Basis for dividing profits.3. Basis for dividing losses.4. Basis for calculating equity of withdrawing partner.

Note: The Uniform Partnership Act has default options if the partnership agreement issilent on certain points or if there is no partnership agreement.

For example, in the absence of an agreement in writing, both profits andlosses are shared equally by the partners.

II. Recording Formation of a Partnership:

Financial Reporting:-- normally we use the FMV of contributed assets to establish the partners'

capital accounts.

Tax Purposes:

-- normally we use the originating partners cost to establish the partnership taxbasis for assets contributed and the resulting capital accounts.


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Example--Formation of a Partnership:

Carl, Edith, and Doris decided to engage in a real estate venture as a partnership. Carl invested$90,000 cash and Edith provided office equipment that is carried on her books at $82,000. Thepartners agree that the equipment has a fair value of $120,000. There is a $30,000 note payableremaining on the equipment to be assumed by the partnership. Although Doris has no physicalassets to invest in the partnership, both Carl and Edith believe that her experience as a real estateappraiser is a valuable skill needed by the partnership and is a basis for granting her an equal capitalinterest in the partnership.

Required:Assuming that each partner is to receive an equal capital interest in the partnership:

A. Record the partnership formation under the bonus method.B. Record the partnership formation under the goodwill method, and assume a total goodwill of

$90,000.C. Discuss the appropriateness of using either the bonus or goodwill methods to record the

formation of the partnership.


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III. Partnership Operations: Allocating Profits and Losses:--If partnership agreement is silent (or if there is no partnership agreement), then splitprofits and losses equally.

--If agreement only specifies a profit ratio, courts assume that the loss ratio is the same.

Common Profit/Loss Allocation Bases:1. Specified ratio of profit/loss.2. Specified ratio based on beginning, average, or ending capital balances.

Note: A partner's capital account is increased by his or her share of the partnershipprofits and is decreased by partner withdrawals (partnerships do not pay dividendsand do not make a distinction between contributed capital and earnings retained inthe business).

3. "Interest" on beginning, average, or ending capital balances.

4. "Salary" Allocation.5. "Bonus" Allocation.

Note: Allocation of profit to the partners tells us how much of the "income summary"balance should be "closed out" to the partners' capital balances. The partnershipdoes not record salary expense for any of the profits allocated to the partners (even ifallocation bases #4 and/or #5 from the above list are used to allocate profits).

Note: Be careful. Interest on loans made by a partner to the partnership is treated as anexpense (but not interest on capital balances as a way to allocate profits--#3above).

Note: Usually, "Interest", "Salary" and/or "Bonus" are allocated first and then theremaining profit is allocated by the profit/loss ratio.

or, of course, we can simply allocate profits by the P & L ratio.

Allocation Base #1--Profit and Loss Ratio:For Example, the P & L ratio is 7:3 and total partnership profits are $100,000.


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Allocation Base #2--Ratio Based on Capital Balances:For Example, lets say that Partner As beginning capital is $10,000 and her ending capitalis $20,000 and Partner Bs beginning capital is $20,000 and her ending capital is $30,000and the partners use average capital balances (beginning and ending capital balances areother options) to compute the profit/loss allocation and this year the partnership earned$100,000 in net income.

Allocation Base #3--Interest on Capital Balance:Used along with another basis when capital provided is an important factor to recognize inprofit and loss allocation.

Specify (in partnership agreement)1. Interest rate.2. Capital balance to use (beginning, average, or ending).

3. How remaining profits or losses should be allocated.

Example: 1. 10% interest rate on the beginning capital balances is allocated first.2. Remaining profits and losses are divided equally.3. "A" beginning capital = $100,000

"B" beginning capital = $ 50,0004. This year's partnership profits = $12,000.


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Allocation Base #4--Salary:

-- Recognized when "time spent" or "expertise" should be reflected in the profitallocation. (For example, to reward Partner "A" for spending much more time inpartnership activities than the other partners.)

-- After allocation of full salary, remaining profits or losses are usually divided basedon the profit and loss ratio.

Example: 1. Salary allocation to Partner "A" is $20,000.2. Remaining profits and losses are divided equally between Partner A and PartnerB.3. Total partnership profits were $30,000.


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Allocation Base #5--Bonus:

-- Need to specify in the partnership agreement1. bonus %.2. what net income figure to use to calculate the bonus.

a. Net Income before bonus allocation (easy tocompute) or

b. Net income after bonus (and after other profit andloss allocations).

Example: 1. Net Income before allocations =$10,000.2. Beg. Capital ("A" = $10,000) ("B" = $30,000).3. Profit and Loss allocation:

a. 10% interest on beg. capital of "A" and "B."b. 20% bonus to "A" on net income after "interest" and bonus.

c. Remaining profit or loss is to be divided equally.


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IV. Changes in Partnership Ownership:

(A) New partner buys out old partner (or buys out two or more partners' partnershipinterests).

No cash to partnership (3P >>>>>> 3P) or (3P >>>>>>> 4P).

(B) New partner buys new partnership interest from the partnership.

$$$$ to Partnership (3P >>>>>>>> 4P).

(C) Withdrawal, retirement, or death of an old partner.$$$$ from Partnership (3P >>>>>>>> 2P).

Steps to recording admission of new partner:

Step #1: Adjust identifiable assets on the partnership books to FMV. (Can be justifiedbecause one partnership entity is ending and one is beginning).

Step #2: Determine if any "goodwill" is involved in the transaction (step not needed if bonusmethod is used).

Step #3: Record admission of new partner using the bonus method or the goodwill method.


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Situation (A):

New partner buys out old partner (or buys out two or more partners' partnership

interests).

No cash to partnership (3P >>>>>> 3P) or (3P >>>>>>> 4P).

Example: 1. Assets are increased to FMV and capital accounts of existing partners areincreased based on profit and loss ratio.

2. After journal entry in #1 is booked, capital accounts are as follows:

Capital P & L RatioX, Capital $10,000 (1/3) 30%Y, Capital 20,000 (2/3) 70%

$30,000

3. "N" pays the two partners $8,000 (1/3 = $2,666 to "X" and 2/3 = $5,333 to

"Y") for a 20% interest.

Bonus Method:

Goodwill Method:


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Situation (B):

New partner buys new partnership interest from the partnership.$$$$ to Partnership (3P >>>>>>>> 4P).

Example:The following balance sheet is for the partnership of Alice, Ben, and Kurt:

Cash $ 60,000 Liabilities $200,000Other assets 640,000 Alice, Capital (40%) 165,000

$700,000 Ben, Capital (40%) 215,000Kurt, Capital (20%) 120,000

$700,000

Figures shown parenthetically reflect profit and loss ratios.

Required:Prepare the necessary journal entries to record the admission of Dan in each of the followingindependent situations. Some situations may be recorded in more than one way (bonus andgoodwill methods).

1. Dan is to invest sufficient cash to receive a one-sixth interest. The parties agree that theadmission is to be recorded without recording goodwill or bonus.

2. Dan is to invest $175,000 for a 1/4th interest.


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Situation B example continued:

3. Same facts as before except that Dan is to invest $175,000 for a 40% interest.


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Situation (C):

Withdrawal, Death, or Retirement of Partner$$$$ leaves the partnership (3P >>>>>>>> 2P)

Possibility #1 (Good news for withdrawing partner).

If: Amount paid by partnership > withdrawing partner's capital account

Then, we have 3 choices:1. Bonus method2. Partial goodwill method.***3. Total goodwill method.***

*** Don't use if goodwill relates to withdrawing partner.

Example: (Possibility #1--Good news for withdrawing partner).

Facts: 1. Partnership capital structure is as follows.P/L Ratio

X, Capital = $60,000 1/3Y, Capital = $70,000 1/3Z, Capital = $50,000 1/3

2. Partnership pays $80,000 to buy out "X."

Bonus Method

Partial Goodwill Method

Total Goodwill Method


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Possibility #2 (Bad news for withdrawing partner).

If instead: Amount paid by partnership < withdrawing partner's capital account

Then, we have 2 choices:1. Bonus method (withdrawing partner may just "want out" for personal reasons).2. Write down assets (if overvalued).

Example: (Bad news for withdrawing partner).

Facts: Same as previous example, except that "X" is paid $50,000 by the partnership.

Bonus Method:

Asset Write-Down Method:


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Chapter 16

Partnership Liquidation

In this chapter we look at:

Simple Liquidation Installment Liquidation

Solvent Partnership I II

Insolvent Partnership III (not covered)

---------------------------------------------------------------------------------------------------- Definitions:

Simple Liquidations --All assets are sold before distributions are made to anyone.

Installment Liquidations--Series of payments are made as assets are sold off.

Solvent Partnership= (Positive Owners Equity)1. All liabilities can be paid out of partnership assets.2. We may need money from one partner to satisfy the debit balance in the capital

account of another partner.

Insolvent Partnership= (Negative Owners Equity)1. Partners' personal assets are needed to pay off liabilities.

-----------------------------------------------------------------------------------------------

I. Simple Liquidation (Solvent Partnership):1. Sell off all assets before distributions are made to anyone.2. Gains/losses are distributed to the partners based on the profit and loss ratio.3. Order of payment:

a. outside creditors.b. partners' loans to partnership.c. partners' capital accounts.

4. However, if a partner has a credit loan balance and a debit capital balance, we haveto offset these.

5. On the other hand, if a partner has a credit loan and credit capital balance (the loanmust be paid off before any partner capital accounts are paid off).

Note: Usually, liquidation expenses (liabilities) must be paid before other creditors. For example,accounting and legal fees related to the liquidation.


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Example #1--Simple Liquidation of a Solvent Partnership:

Balance Sheet Before Liquidation

Cash $11,000 A/P 85,000Noncash Assets 100,000 Loan from A 2,000

$111,000 Loan from B 1,000A, Capital (Cr) 5,000B, Capital (Cr) 10,000C, Capital (Cr) 8,000

$111,000

Additional Facts:The non-cash assets are sold for a net of $80,000.Profit/loss ratios: A = 50% B = 40% C = 10%

No additional amounts can be contributed by any partner.(i.e., all are personally insolvent)

Required: Prepare a Partnership Liquidation Schedule.


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II. Installment Liquidation (Solvent Partnership):

1. Noncash assets will be converted to cash over time.2 Distribution of cash to partners is made in installments.

It is a good idea to prepare a Cash Distribution Plan.1. This schedule indicates the order of the cash distributions as cash becomes available.2. The partners and their personal creditors can use this schedule to estimate the

amount of cash each partner may be getting from the partnership.3. The Cash Distribution Plan is prepared before noncash assets are sold. We do not

know if we have a solvent or insolvent partnership at this point.

How to prepare a Cash Distribution Plan.1. Combine capital balances with partner loans.2. Find each partner's "loss absorption potential" (i.e., the maximum loss that would

bring a given partner's combined capital balance to $0).

3. The partner with the highest "loss absorption potential" will be the first to receive apartnership distribution.

4. This process will eventually bring combined capital accounts in line with the profitand loss ratio.

5. After this point, any subsequent distributions will be based on the profit and lossratio.


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Example #2--Loss Absorption Schedule and Cash Distribution Plan:

The Balance Sheet of the Oslo Company just prior to liquidation is as follows:

Assets Equities

Assets $258,000 Accounts payable $ 18,000Bates, loan 12,000Bates, capital (Cr) 28,000Hunt, capital (Cr) 80,000Riley, capital (Cr) 120,000

$ 258,000

Bates, Hunt, and Riley share profits and losses in the ratio 1:4:5, respectively.

Required: Prepare a Loss Absorption Schedule and a Cash Distribution Plan.


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II. Installment Liquidation (Solvent Partnership) (continued)

In this situation we have two choices1. Use a cash distribution plan (see Example 2 on previous page) or2. Make a "schedule of safe payments" every time a distribution is to be made.

Schedule of Safe PaymentsWe assume the largest possible loss at each cash distribution point.

Loss = book value of noncash assets (deemed to be worthless)+ potential unrecorded liabilities.+ remaining liquidation expenses

Note: With this very conservative approach, it should be impossible to give cash to apartner who eventually winds up with a debit capital balance.


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Example #3--Installment Liquidation (Solvent Partnership) with a Schedule of Safe

Payments:

The James, Allen, and Burk Partnership has not been successful; hence, the partners havesadly concluded that operations must be terminated and their partnership liquidated. Profitsand losses are shared as follows: James, 45%; Allen, 35%; and Burk 20%. As the accountantplaced in charge of this partnership, you have responsibility for the liquidation anddistribution of assets. When you assume your responsibilities, the partnership balance sheetis as follows:

Assets EquitiesCash $18,000 Liabilities $12,000Other assets 54,000 Loan from James 18,000

James, capital (Cr) 6,000Allen, capital (Cr) 30,000

Burk, capital (Cr) 6,000Total assets $72,000 Total equities $72,000

During the first two months of your duties, the following events occur:

1. Assets having a book value of $40,000 are sold for $12,000 cash.2. Previously unrecorded liabilities of $1,000 are recognized.

3. Before distributing available cash balances to creditors and partners, you concludethat a cash reserve of $1,000 should be set aside for future potential expenses.

4. Remaining cash balances are distributed to creditors and partners.

Required: Prepare a schedule of partnership liquidation and a schedule of safe payments.


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III. Insolvent Partnership (Simple or Installment Liquidation):In this unfortunate situation of an insolvent partnership, some partners will need to pay outof their personal assets to satisfy partnership creditors (if the payments are only to satisfyother partners, then this is not an insolvent partnership).

Priorities of Partnership and Personal Creditors:Under the Uniform Partnership Act, we have the concept of the "Marshalling of Assets."(We divide --i.e., marshall-- the partnership and personal assets into categories).

Priority to Partnership Assets:1. Partnership creditors.2. Personal creditors have a secondary claim on the appropriate partner's capital

account. (For example, personal creditors of partner "A" can only have a secondaryclaim on partner "A's" capital account--not the other partners' capital accounts).

Priority to Personal Assets:1. Personal Creditors.2. Partnership Creditors--for the full amount owed to them. The amount owed is not

limited by the extent of the partner's capital account.3. Claims of other partners due to a debit balance in our capital account.


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Example #4--Partnership Liquidation (Insolvent Partnership):

Mathis, Overton, and Downey are partners sharing profits in the ratio of 4:3:2, respectively. Thepartnership and two of the partners are currently unable to make full payment of their obligations tocreditors. The balance sheet of the partnership and an enumeration of the assets and liabilities of theseparate partners are as follows:

MOD PARTNERSHIP

Balance Sheet

Assets Equities

Cash $ 500 Accounts payable $37,000Other assets 60,500 Capital:

Mathis (Cr) $10,000Overton (Cr) 6,000

Downey (Cr) 8,000Total Capital 24,000

Total assets 61,000 Total equities $61,000

Assets and Liabilities of Partners M, O, and D

Excluding Partnership Interests

Cash and Cash ValuePartner of Personal Assets

Liabilities

Mathis $31,000$20,000Overton 9,450 11,900Downey 4,000 5,000

Required: Assuming that other assets are converted into $33,500 cash, prepare apartnership liquidation schedule and a complementary schedule indicating the distributionof partners personal assets according to the provisions of the Uniform Partnership Act.


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Chapter 17

Introduction to Fund Accounting

Objectives: Accounting for nonbusiness organizations (e.g., City of San Diego, United Way).

1. Tracking inflows and outflows of funds (not revenues and expenses).2. Making sure that legal requirements are met.

Objectives: Business Accounting.

1. We try to measure profit (how well we did). We match efforts (expenses) withaccomplishments (revenues).

With fund accounting it is hard to measure accomplishments (only efforts).

How to measure better public schools or better fire departments? You can only developimperfect measures of performance such as increased SAT scores and decreased responsetime for the fire department.

Question: How to aggregate the accomplishments of the public schools, the fire department,etc.,?

Answer: You can't.

So if we donthave an income statement to see how weve done, what do we have instead?

Operating Statement (also known as the Statement of Revenues, Expenditures, and Changes inFund Balance--sort of a hybrid of the income statement and statement ofcash flows)

Inflows:1. Revenues2. Transfers from other funds (to the general fund).3. Bond Issues

Outflows:1. Expenditures (includes expenses and asset purchases)

2. Transfers to other funds (from the general fund).


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Inflow #1: Revenues = Inflows from external parties that do not have to be repaid.

Under Modified Accrual Accounting we recognize revenue when it is (a)measurable and (b) available to pay current obligations.

Three Examples: Property taxes, income taxes, and sales taxes and fines.

Property Taxes: Revenue is recognized when the taxes are levied--even if thecollection will be in the next accounting period.

Income Taxes: Revenue is recorded when the tax return is filed.

Sales taxes and fines: Revenue is recorded when collected.

Note: Proprietary funds (like a water district) use pure accrual accounting and record

revenue when earned.

Inflow #2: Bond issue proceeds = (not revenue because must be paid back)--inflow recordedupon receipt.

Inflow #3: Transfers from another fund = not revenue (does not increase the funds of the govt.entity as a whole).

Outflow #1: Expenditures = amounts that will flow out to pay for goods or services to an outsideparty.

Note: Expenditures = (receipt of bill).Disbursement = (payment of bill).

Outflow #2: Transfers to other funds = not an expenditure (does not decrease funds of a govt.entity as a whole).


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Example--General Fund Journal Entries:The trial balance for the General Fund of the City of Centennial as of December 31, 2001 ispresented below:

DEBIT CREDIT

Cash 300,000Supplies Inventory 75,000

Unreserved Fund Balance 300,000

Reserve for Supplies Inventory 75,000

Totals 375,000 375,000

Transactions of the General fund for the year ended December 31, 2002, are summarized asfollows:

1. The City Council adopted the following budget for 2002:

Estimated Revenue 1,600,000Transfer from Trust Fund 50,000

Appropriations 1,530,000

Transfer to Debt Service Fund 80,000

2. Property taxes of $1,500,000 were levied, of which it is estimated that $30,000 willnot be collected.

3. Purchase orders in the amount of $1,400,000 were placed with suppliers and othervendors.

4. Property taxes in the amount of $1,450,000 were collected.5. $50,000 was received from the Trust Fund.

6. Invoices in the amount of $1,380,000 were approved for payment. The amountoriginally encumbered for these invoices was $1,360,000. The invoices included$25,000 net of trade-in allowance for the purchase of a new minicomputer and$400,000 for supplies. The City received a trade-in allowance of $4,000 on its oldminicomputer, which had been purchased three years earlier for $16,000. At thetime the old minicomputer was purchased, it was estimated that it would have auseful life of four years. The new minicomputer is expected to last at least six years.

7. Licenses and fees in the amount of $48,000 were collected.8. Vouchers in the amount of $1,300,000 were paid.9. Cash in the amount of $80,000 was transferred to the Debt Service Fund.10. Supplies on hand at the end of the year amount to $100,000. (Note: This is a

$25,000 increase in supplies inventory.)

Required:A. Prepare entries in general journal form to record the transactions of the General Fund

for the year ended December 31, 2002. The City of Centennial uses the purchasemethod to account for supplies inventory.

B. Prepare a preclosing trial balance for the General Fund as of December 31, 2002.C. Prepare the necessary closing entries for the General Fund for the year ended

December 31, 2002.D. Prepare a balance sheet and a statement of revenue, expenditures, and other changes

in fund balance for the General Fund for the year ended December 31, 2002.


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Chapter 18

Introduction to Accounting for State and Local Governmental Units

Government units typically will have a number of fund and other accounting entities. These arelisted below. After going over this list we will primarily focus on the journal entries for two

funds: Capital Projects Funds and Debt Service Funds.

LIST OF GOVERNMENTAL FUNDS

(and related Account Groups)

A. Governmental (or Expendable) Funds

Main reporting emphasis in on inflow and outflow of expendable funds and the remainingfund balance.

Balance Sheet: Current Assets = Current Liabilities + Fund Balance

Operating Statement: Inflows - Outflows = Change in Fund Balance

1. General Fund: Accounts for the inflows and outflows that a special governmental fund (seebelow) has not been set up to handle. This is the major fund for mostgovernmental entities.

SPECIAL GOVERNMENTAL FUNDS:

2. Special Revenue Fund: Accounts for the inflows and outflows to finance the operation of aspecial facility (e.g., public park or museum). Likely inflows include

(1) admission or usage charges, and (2) transfers in the from thegeneral fund. Outflows go to pay for the operations of the specialfacility.

3. Capital Projects Fund: Accounts for the inflows and outflows for the acquisition of majorcapital facilities (e.g., roads or buildings). You could have one ofthese funds for each capital project. Likely inflows include (1)proceeds of L-T Debt issue, (2) special tax assessment, (3) transfersin from the general fund. Outflows go to pay for the capital project.

4. Debt Service Fund: Accounts for the inflows and outflows related to the accumulation of

resources to pay off L-T Debt. Note the actual debt would not beaccounted for in this fund -- just the collection of resources to pay offthe L-T debt. (Like a sinking fund.)

5. Permanent Funds: Accounts for resources where only interest on the funds canbe used for a specific purpose (e.g., money for a special city librarycollection).


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ACCOUNT GROUPS: Since the governmental funds shown above do not carry L-T Assetsor L-T Liabilities on their Balance Sheets, any of those items wouldbe accounted for in the following account groups:

6. General Fixed Assets Account Group:

Any L-T Asset associated with any and all of the above governmental funds would beaccounted for in this set of books. Note that there is only one General Fixed Assets AccountGroup set of books used for all of the above funds. Also, any cash flow related to the assetsis accounted for in the funds above -- the account group ONLY shows the L-T assets and(possibility) related depreciation.

7. General L-T Obligation Account Group:

Any L-T debt of any and all of the above governmental funds would be accounted for in thisset of books. As with the fixed asset account group, there is only one General L-T

Obligation Account Group set of books and only the debt is shown. Any cash flow is shownin the appropriate fund above.

B. Proprietary (or Nonexpendable) Funds

Accounts for the operations of a governmental unit that has been set up to be run like aprofit-making business (e.g., public utility or bus service).

Balance Sheet: Assets = Liabilities + Fund Balance

Operating Statement: Revenues - Expenses= Net Income

Note: There is no need for account groups since all assets and liabilities are shown on the fund'sbalance sheet!!

8. Enterprise Fund: Exists to provide service to the public.

9. Internal Service Fund: Exists to give service to other governmental departments (e.g.,central purchasing department).

C. Fiduciary Funds

10. Fiduciary Funds: Exists to account for assets held by the governmental agencyin trust, or as an agent, for another person or organization.


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Capital Projects Fund:

The main thing to remember is that the Capital Projects Fund does not actually handle the debitfor the capital project itself (the capital project itself is shown as an asset in the General Long-Term Fixed Assets Group of Accounts). The Capital Projects Fund only accounts for the money

set aside the to pay for the Capital Project. Bond issue proceeds will increase the Fund Balanceof the Capital Projects Fund and incurred expenditures will reduce this Fund Balance.

Example--Capital Projects Fund:

The town on Billville authorized a municipal building to be constructed at a cost of $175,000.The construction will be financed from the proceeds of the issuance of $175,000 in 10% couponrate bonds. Any difference between the par (face) value of the bonds and the proceeds from theirsale is transferred to the Debt Service Fund.

Transactions and events relating to this project include the following:

1. The proceeds from the sale of the bonds were received and included a premium on thebond issue of $15,000. The premium was transferred to the Debt Service Fund.

2. Encumbrances were recorded upon the signing of the construction contract in the amountof $175,000.

3. Contract billings in the amount of $85,000 were approved for payment.4. Contract billings were paid in the amount of $85,000.5. All nominal accounts are closed and construction in progress was recorded in the

appropriate account group in anticipation of the preparation of financial statements.6. Contract billings in the amount of $90,000 were approved on the completion of the

municipal building.7. Contract billings of $90,000 less a retention of 5% were paid.8. The building was accepted, all construction liabilities were paid and the building was

recorded as an asset in the appropriate account group.

Required:

Prepare the journal entries related to the Capital Projects Fund and corresponding entries, if any,relating to the General Fixed Assets Account Group, the General Long-term Obligation AccountGroup, and the Debt Service Fund for the transactions and events described above. Clearlyidentify the fund or account group in which each entry is recorded.


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Debt Service Funds:

General Obligation Bonds may be serial bonds orterm bonds.

(A) Serial Bonds: The principal is repaid in a specified number

of annual (and usually) equal installments.

(B) Term Bonds: The principal is repaid in one lump sum at a specific maturity date.

Note: The Debt Service Fund does not actually record any long-term debt (which is insteadreflected in the General Long-Term Obligation Account Group. The Debt Service Fundis more like a Bond Sinking Fund (funds set aside to pay off the bonds).

Example--Debt Service Fund (Term Bonds):

On January 1, 2000, the City of Cape May authorized and issued $200,000 of 5%, three-year term bonds. Interest is payable annually on December 31. A debt service fund isestablished to accumulate the necessary resources to pay the annual interest on the bondsand to redeem the bonds when they mature. The required annual addition for principal andinterest will be transferred annually to the debt service fund from the general fund. It isassumed that amounts received by the debt service fund for the payment of principal can beinvested at an annual return of 8%.

Required:

A. Prepare a schedule to calculate the annual required additions and annual required

earnings to repay the principal on the bonds assuming that the first installment forprincipal and interest is transferred to the debt service fund from the general fund onDecember 30, 2000.

B. Prepare the entries to be recorded by the debt service fund for 2000, 2001, and 2002.

adv act notes

Documents