Definition of business combination

PFRS 3 defines business combination as a “a transaction or other event in which an acquire obtains
control of one or more businesses.” Transaction sometimes referred to as ‘mergers of equals’ are also
business combination as that term is used in PFRS 3.

Essential elements in the definition of a business combination

1. Control
2. Business

Control- an investor controls an investee when the investor is exposed, or has rights, to variable
returns from its involvement with the investee and has the ability to affect those returns through its
power over the investee.

An acquirer might obtain control of an acquiree in a variety of ways, for example:

a. By transferring cash, cash equivalents or other assets (including net assets that constitute a
business);
b. By incurring liabilities:
c. By issuing equity interest;
d. By providing more than one type of consideration; or
e. Without transferring consideration, including by contract alone.

Control is normally presumed to exist when the ownership interest acquired in the voting rights of
the acquiree is more than 50% ( or 51% or more). However, this is only a presumption because
control may still be obtained without necessarily acquiring more than half of the acquiree’s voting
rights, such as in the following instances:
a. The acquirer has the power to appoint or remove the majority of the board of directors of the
acquiree; or
b. The acquirer has the power to cast the majority of votes at board meetings or equivalent bodies
within the acquiree; or
c. The acquirer has power over more than half of the voting rights of the acquiree because of an
agreement with other investors; or
d. The acquirer has power to control the financial and operating policies of the acquiree because of a
law or an agreement.

Business is an integrated set of activities and assets that is capable of being conducted and managed
for the purpose of providing a return in the form of dividends; lower costs or other economic benefits
directly to investors or other owners, member or participants.

The three elements of a business are defined as follows:

a. Input: Any economic resource that result to an output when one or more processes are
applied to it, e.g., non-current assets, intellectual property, the ability to obtain access to
necessary materials or rights and employees.

b. Process: Any system, standard, protocol, convention or rule that when applied to an input or
inputs, creates or has the ability to create outputs, e.g., strategic management processes,
operational processes and resource management processes. Accounting, billing, payroll and
other administrative systems typically are not processes used to create outputs.

c. Output: The result of inputs and processes applied to those inputs that provide or have the
ability to provide a return in the form of dividends, lower costs or other economic benefits
directly to investors or the owners, members or participants.
Accounting Requirements

A business combination occurs when one company acquires another or when two or more companies
merge into one. After the combination, one company gains control over the other.

Business combinations are carried out either through:

1. Asset acquisition; or
2. Stock acquisition

Asset acquisition - the acquirer purchases the assets and assumes the liabilities of the acquiree in
exchange for cash or other non-cash consideration (which may be the acquirer’s own shares). After
the acquisition, the acquired entity normally ceases to exist as a separate legal or accounting entity.
The acquirer records the assets acquired and liabilities assumed in the business combination in its
accounting books.

Under the Corporation Code of the Philippines, a business combination effected through asset
acquisition may be either:

a. Merger - occurs when two or more companies merge into a single entity which shall be one
of the combining companies. For example: A Co. + B Co. = A Co. or B Co.
b. Consolidation - occurs when two or more companies consolidate into a single entity which
shall be the consolidated company. For example: A Co. + B Co. = C Co.

Stock acquisition - instead of acquiring the assets and assuming the liabilities of the acquiree, the
acquirer obtains control over the acquiree by acquiring a majority ownership interest (e.g., more than
50%) in the voting rights of the acquiree.

In a stock acquisition, the acquirer is known as the parent while the acquiree is known as the
subsidiary. After the business combination the parent and the subsidiary retain their separate legal
existence. However, for financial reporting purposes, both the parent and the subsidiary shall be
viewed as a single reporting entity.

After the business combination, the parent and subsidiary continue to maintain their own separate
accounting books, recording separately their assets, liabilities and the transactions they enter into.

The parent records the ownership interest acquired as “investment in subsidiary” in its separate
accounting books. However, the investment is eliminated when the group prepares consolidated
financial statements.

A business combination may also be described as:

1. Horizontal combination - a business combination of two or more entities with similar businesses,
e.g., bank acquires another bank.
2. Vertical combination - a business combination of two or more entities operating at different levels
in a marketing chain, e.g., a manufacturer acquires its supplier of raw materials.
3. Conglomerate - a business combination of two or more entities with dissimilar businesses, e.g., a
real estate developer acquires a bank.

The advantages of a business combination may include any of a combination of the following:

a. Competition is eliminated or lessened - competition between the combining constituents

with similar businesses is eliminated while the treat of competition from other market
participants is lessened.

b. Synergy - synergy occurs when the collaboration of two or more entities results to greater
productivity than the sum of the productivity of each constituent working independently.
Synergy is most commonly described as “the whole is greater than the sum of its parts.” It can
be simplified by the expression “1 plus 1 = 3.”
 c. Increased business opportunities and earnings potential - business opportunity and earnings
potential may be increased through:
i. An increased variety of products or services available and a decreased dependency on limited
number of products and services;
ii. Widened dispersion of products or services and better access to new markets;
iii. Access to either of the acquirer’s or acquiree’s technological know-hows, research and
development, secret processes, and other information;
iv. Increased investment opportunities due to increased capital; or
v. Appreciation in worth due to an established trade name by either one of the combining
constituents.

d. Reduction of operating costs - operating costs of the combined entity may be reduced.
i. Under a horizontal combination, operating costs may be reduced by the elimination of
unnecessary duplication of costs (e.g., cost of information system, registration and licenses,
some employee benefits and costs of outsourced services).
ii. Under a vertical combination, operation costs may be reduced by the elimination of costs of
negotiation and coordination between the companies and mark-ups on purchases.

e. Combination utilize economies of scale - economies of scale refer to the increase in

productive efficiency resulting from the increase in the scale of production. An entity that
achieves economies of scale decrease its average cost per unit as production is increased
because fixed costs are allocated over an increased number of units produced.

f. Cost savings on business expansion - the cost of business expansion may be lessened when a
company acquires another company instead of putting up a branch. There may be various
regulation (e.g., in the case of banks) which may restrict the company from branching out, such
as required minimum capitalization, level of liquidity and other requirements.

Some business combinations are affected through exchange of equity instruments rather than
transfer of cash or other resources. Such business combinations also protect the interests of
shareholders because they become either the shareholders of the acquirer or the new combined
entity.

g. Favorable tax implications - deferred tax assets may be transferred in a business combination.
Also, business combinations effected without transfers of considerations may not be subjected
to taxation.

The disadvantages of a business combination may include any or combination of the following:

a. Business combination brings monopoly in the market which may have a negative impact to the
society. This could result to impediment to healthy competition between market participants.

b. The identity of one or both of the combining constituents may cease leading loss of sense of
identity for existing employees and loss of goodwill.

c. Management of the combined entity may become difficult due to incompatible internal cultures,
system , and policies.

d. Business combination may result in over-capitalization which may result to diffusion in the market
price per share and attractiveness of the combined entity’s equity instruments to potential investors.

e. The combined entity may be subjected to stricter regulation and scrutiny by the government, most
especially if the business combination poses threat to consumers’ interests.

Business combinations are accounted for under PFRS 3 Business Combination.

Objective
The objective of PFRS 3 is to improve the relevance, reliability and comparability of financial reporting
of an entity in relation to a business combination by establishing the recognition and measurement
principles and disclosures requirements for the acquirer.

Scope
PFRS 3 applies to transactions that meet the definition of a business combination. It does not apply to
the following:

a. The formation of a joint venture.

b. The acquisition of an asset or a group of assets that does not constitute a business. In such cases
the acquirer shall identify and recognize the individual identifiable assets acquired and liabilities
assumed. The cost of the group shall be allocated to the individual identifiable assets and liabilities on
the basis of their relative fair values at the date of purchase. Such transaction does not give rise to
goodwill.

c. A combination of entities or businesses under common control.

ACQUISITION METHOD OF ACCOUNTING FOR BUSINESS COMBINATIONS

IFRS 3 requires that all business combinations be accounted for by applying the acquisition method
(called the “purchase method” in the 2004 version of IFRS 3). To determine whether a transaction or
other event is a business combination, four steps in the application of the acquisition method are to
be used as follows:

(1) Identify the acquirer.

(2) Determine the acquisition date.
(3) Determine the consideration given (price paid) by the acquirer.
(4) Recognize and measure the identifiable assets acquired, the liabilities assumed and any
non-controlling interest (formerly called minority interest) in the acquiree. Any resulting goodwill or
gain from a bargain purchase should be recognized.

Illustration 1

P Company acquires S Company on January 1, 2017. Included in the purchase consideration is an

amount of P5 million payable on January 1, 2019. P Company’s borrowing cost on acquisition date is
8% per annum.

The fair value of the deferred consideration that should be included in the cost of combination is
computed below.

Present value = P5,000,000/(1+0.08)= P4,286,694

The journal entry to be recorded on the date of acquisition is given below:

Cost of combination 4,286,694
Deferred liability 4,286,694

For the next two years, this liability amount should be increased to P5,000,000 and the accretion
should be recognized as a finance cost in profit and loss. The journal entries are as follows:

At the end of the 1st year:

Finance cost (8% x 4,286,694) 342,936

Deferred liability 342,936
At end of the 2nd year:

Finance cost [8% x (4,286,692 + 342,936) 370,370

Deferred liability 370,370

Upon payment

Deferred liability 5,000,000

Cash 5,000,000

Illustration 2

P Ltd acquires 1 100% interest in the equity shares of S Ltd from two controlling shareholders on
January 1, 2017. The terms of the business combination include:

(i) P Ltd shall pay an amount of P10 million to the two controlling shareholders of S Ltd;
(ii) P Ltd shall inject property into S Ltd. The carrying amount of the property in the accounts of P Ltd
at acquisition date is P20 million. The fair market value of the property at acquisition date is P30
million;
(iii) P Ltd shall assume the bank loans of P5million taken by the two controlling shareholders when
they invested in S Ltd; and
(iv) P Ltd shall bear the future losses and future restructuring costs of S Ltd, estimated at P6million.

The cost of combination is computed as follows:

Cash consideration P10 million

Liabilities assumed 5 million
Property transferred at carrying amount 20 million
Cost of combination 35 million

APPLYING THE ACQUISITION METHOD

As mentioned earlier, control of another company may be achieved either by the acquisition of net
assets or by acquisition of stocks.

ACQUISITION OF NET ASSETS

Let us assume that the company to be acquired by Acquirer, Inc., has the following Statement of
Financial Position of June 30,2017:

J&J Company
Statement of Financial Position
June 30,2017

Cash P 200,000 Current liabilities P 125,000

Marketable securities 300,000 Bonds payable 500,000
Inventory 500,000
Land 150,000 Common stock(P1 par) 50,000
Building(net) 750,000 Additional paid in capital 700,000
Equipment(net) 400,000 Retained earnings 925,000
Total assets P 2,300,000 Total liabilities and equity P 2,300,000
Fair values for all accounts have been measured as of June 30,2017 as follows:

Cash P 200,000
Marketable securities 330,000
Inventory 550,000
Land 360,000
Building 900,000
Equipment 700,000
Unrecognized receivables 225,000 P 3,265,000

Current liabilities P 125,000

Bonds payable 500,000
Premium on bonds payable 20,000 P 645,000
Fair value of net identifiable assets P 2,620,000

BOOKS OF THE ACQUIRER

Accounting Procedures in Recording the Acquisitions

The basic accounting procedures to record the acquisition of net asset are as follows:

 All accounts identified are measured at estimated fair value. This is always the case even if the
consideration given for a company is less than the sum of the fair values of the net assets
acquired (assets less liabilities assumed, P2,620,000 in the illustration).
 If the total consideration given for a company exceeds the fair value of its net identifiable assets
(P2,620,000), the excess price paid is recorded as goodwill.
 If the total consideration given for a company is less than the fair value of its net identifiable
assets (P2,620,000), the excess of net asset over the price paid is recorded as gain on acquisition
(bargain purchase) in the period of the purchase.
 All acquisition- related cost are expense in the period in which the costs are incurred, with one
exception. The costs to issue equity securities are recognized as a reduction from the value
assigned to additional paid in capital account.

Before recording the acquisition, the acquirer should calculated the difference between the price paid
and the fair value of the net assets acquired.

Case 1: Price paid exceeds the fair value of net identifiable assets acquired.

Acquired, Inc., issues 80,000 shares of its P10 par value common stock with a market value of P40
each for J&J Company’s net assets. Acquirer, Inc. pays professional fees of P50,000 to accomplish the
acquisition and stock issuance costs of P30,000.

Analysis:

Price paid (consideration given), 80,000 shares x P40 market value P3,200,000
Fair value of net identifiable assets acquired from J&J ( 2,620,000 )
Goodwill P 580,000
Professional fees (expense) P 50,000
Stock issue costs ( reduction from additional paid-in capital) 30,000

Entries recorded by the Acquirer, Inc. are as follows:

(1) To record the net assets acquired including the new goodwill:
Cash 200,000
Marketable securities 330,000
Inventory 550,000
Land 360,000
 Building 900,000
Equipment 700,000
Receivables -trade 225,000
Goodwill 580,000
Current liabilities 125,000
Bonds payable 500,000
Premium on bonds payable 20,000
Common stocks (P10 par, 80,000 shares issued) 800,000
Additional paid in capital (P30 x 800,000 shares) 2,400,000

(2) To record acquisition- related costs:

Acquisition expense 50,000

Additional paid in capital 30,000
Cash 80,000

Case 2: Price paid is less than fair value of net identifiable assets acquired:

Acquired, Inc. issues 20,000 shares of its P115 par value common stock with a market value of P120
each for J&J Company’s net assets. Acquirer, Inc. pays professional fees of P50,000 to accomplish the
acquisition and stock issuance costs of P130,000.

Analysis:

Price paid (consideration given), 20,000 shares x P120 market value P2,400,000
Fair value of net identifiable assets acquired from J&J Company ( 2,620,000 )
Gain on acquisition (bargain purchase) P(220,000)
Professional fees (expense) P 50,000
Stock issuance costs (reduction from additional paid in capital) 130,000

Entries recorded by Acquirer, Inc. to record the acquisition and related costs are as follows:

(1) To record the acquisition of net assets:

Cash 200,000
Marketable securities 330,000
Inventory 550,000
Land 360,000
Building 900,000
Equipment 700,000
Receivables- trade 225,000
Current liabilities 125,000
Bonds payable 500,000
Premium on bonds payable 20,000
Common stock (20,000 shares x P115 par) 2,300,000
Additional paid in capital (20,000 shares x P5) 100,000
Gain on acquisition 220,000

(2) To record acquisition-related costs:

Acquisition expense 50,000

Additional paid in capital 100,000
Stock issuance costs 30,000
Cash 180,000
ACQUISITION OF STOCK

In a stock acquisition, the acquiring company deals only with existing shareholders of the acquired
company not the company itself. To illustrate, assume that on December 31, 2017, P Company
acquired all 10,000 issued and outstanding shares of S Company’s P100 par value common stocks for
P2,000,000 cash. In addition, P Company paid professional fees to accomplish the combination of
P100,000. The journal entries to record the acquisition of stocks and the acquisition-related cost in
the books of P Company on December 31, 2017 are as follows:

(1) To record the acquisition of stock from S Company:

Investment in subsidiary S Company 2,000,000
Cash 2,000,000

(2) To record the acquisition-related costs:

Acquisition expense 100,000
Cash 100,000

Recognizing and Measuring Goodwill or a Gain from a Bargain Purchase

IFRS 3 prescribes that “the acquirer shall recognize goodwill as of the acquisition date measured as
the excess of (a) over (b) below:

(a) the aggregate of:

(i) the consideration transferred measured in accordance with this IFRS, which generally requires
acquisition- date fair value;
(ii) the amount of any non-controlling interest in the acquiree measured in accordance with this
IFRS (which in either based on fair value or proportionate share of net assets); and
(iii) in a business combination achieved in stages (step acquisition), the acquisition date fair value
of the acquirer’s previously held equity interest in the acquire.

(b) the net of the acquisition- date amounts of the identifiable assets acquired and liabilities assumed
measured in accordance with this IFRS.

Illustration 1

On January 1, 2017, PP Inc acquires a 75% equity interest in SS Inc, paying cash consideration of
P50million new ordinary shares of PP Inc valued at P2 each to the former owners of SS Inc. On this
date, the net fair of the identifiable assets and liabilities of SS Inc is P100million.

The issued share capital of SS Inc consists of 50 million ordinary shares of P1 each. On acquisition date,
the shares are quoted on the stock exchange at P4 per share. Both PP Inc and SS Inc agree that the
market value is representative of the fair value of SS Inc as a whole.

Required:
Compute the goodwill on combination and the non-controlling interest in accordance with:
(1) The original IFRS 3, and
(2) The revised IFRS 3 with (a) non-controlling interest measured at fair value and (b) non-controlling
interest measured at its proportionate share of net assets.

Solution 1

(1) Original IFRS 3

Cost of combination:
Cash consideration 50m
Ordinary shares issued 50m x P2 100m
Fair value of consideration transferred 150m
 Share of net assets acquired 75% x 100m 75m
Goodwill on combination 75m
Non-controlling interest at acquisition date: 25% xP100m 25m

(2) Revised IFRS 3

NCI Measured at
Shares of net asset Fair value
Fair value of consideration transferred 150m 150m
Non- controlling interests; share of net assets:
25% x 100m 25m -
Fair value of non-controlling interest
25% x 200m - 50m
Carrying/Fair value of SS Inc as a whole 175m 200m
Fair value of net assets 100m 100m
Goodwill on combination 75m 100m

Non-controlling interest:
25% x 100m
25% x (100m + 100m) 25m -
50m

Note that if non-controlling interest is measured based on its proportionate share of the net assets,
rather that at fair value, effect would be the same as the original IFRS 3.

Impairment Test for Goodwill

After initial recognition, the acquirer shall measure goodwill acquired in a business combination at
cost less any accumulated impairment losses in accordance with PAS 36, Impairment of Assets. This
standard prohibits amortization of goodwill but it requires that goodwill must be tested for
impairment annually, or more frequently if events or changes in circumstances indicate a possible
impairment.
Business Combination 2

Learning Objectives
1. Account for business combinations (a) accomplish through share-for-share exchanges, (b) achieved
in stages, and (c) achieve without transfer of consideration.
2. Explain the “measurement period” in relation to business combinations.
3. Distinguish what is part of a business combination and what is part of a “separate transaction.”
4. Account for settlement of pre-existing relationship between an acquirer and an acquiree.

Share-for-share exchanges
In a business combination accomplished through a mere exchange of equity interests between the
acquirer and the acquiree (or its former owners), the acquisition-date fair value of the acquiree’s
equity interests may be more reliably measurable than the acquisition-date fair value of the
acquirer’s equity interests.

In such case, the acquirer shall determine the amount of goodwill by using the acquisition-date fair
value of the acquiree’s equity interests instead of the acquisition-date fair value of the equity
interests transferred.

The use of the fair value of the acquiree’s equity interests in this situation, as an alternative to
measuring the fair value of consideration transferred by the acquirer, is on grounds of reliable
measurement only.

Illustration 1: Fair value pf acquiree’s share is more reliably determinable

XYZ, Inc., an unlisted company, acquires ABC Co., a publicly listed entity, through an exchange of
equity instruments.

In this case, the published price of the quoted equity instruments of ABC (acquiree) at acquisition
date is likely to provide a more reliable indicator of fair value than the valuation methods used to
measure the fair value of XYZ’s (acquirer) equity instruments.

Illustration 2: Fair value of acquirer’s shares is reliably determinable

On January 1, 20x1, ABC Co. acquired all of the identifiable assets and assumed all of the liabilities of
XYZ, Inc. by issuing its own ordinary shares. Information at acquisition date is shown below:
ABC Co. XYZ Co. Combined entity
(carrying amounts) (fair values)
Identifiable assets 2,400,000 1,600,000 4,000,000
Goodwill - - ?

Total assets 2,400,000 1,600,000 ?

Liabilities 700,000 900,000 1,600,000
Share capital 600,000 300,000 700,000
Share premium 300,000 250,000 1,200,000
Retained earnings 800,000 150,000 ?
Total liabilities and equity 2,400,00 1,600,000 ?

Additional information:

 ABC’s share capital consists of 60,000 ordinary shares with par value of P10 per share.
 XYZ’s share capital consists of 3,000 ordinary shares with par value of P100 per share.

Requirements: compute for the following

a. Fair value of consideration transferred on the business combination, including the number of
shares issued and their acquisition-date fair value per share.
b. Goodwill recognized on acquisition date.
c. Retained earnings of the combined entity immediately after the business combination.
Requirement (a): Fair value of consideration transferred
Because the consideration transferred is in the form of ABC’s own shares, the fair value of the
consideration transferred is computed by determining the increase in ABC’s share capital and share
premium accounts as shown below:

ABC Co. Combined entity Increase

Share capital 600,000 700,000 100,000

Share premium 300,000 1,200,000 900,000
Totals 900,000 1,900,000 1,000,000

The fair value of the shares transferred as consideration for the business combination is P1,000,000
(i.e., total increase in ABC’s share capital and share premium accounts).

The number of shares issued in the business combination is computed as follows:

Increase in ABC’s share capital account(see table above) 100,000
Divide by: ABC’s par value per share 10
Number of shares issued 10,000

The acquisition-date fair value per share of the shares issued is computed as follows:
Fair value of consideration transferred 1,000,000
Divide by: number of shares issued 10,000
Acquisition-date fair value per share 100

Notice that XYZ’s share capital accounts are ignored in the computations above because the business
combination was accomplished through “asset acquisition.” XYZ’s assets and liabilities shall be
recorded in ABC’s books and XYZ’s share capital accounts including retained earnings will be
eliminated. Non-controlling interest will not arise because ABC acquired 100% interest.

Journal entry
The entry in the books of ABC Co. To record the issuance of the shares is as follows:
Jan. 1, 20x2 Investment in subsidiary (fair value) 1,000,000
Ordinary share capital (10k x P10) 100,000
Share premium 900,000
to recognize the investment in subsidiary

Requirement (b): Goodwill

Goodwill (gain on bargain purchase) is computed as follows:
Consideration transferred 1,000,000
Non-controlling interest in the acquiree -
Previously held equity interest in the acquiree -
Total 1,000,000
Fair value of net identifiable assets acquired (1.6M - .9M) ( 700,000)
Goodwill 300,000

Requirement (c): Retained earnings of the combined entity

Because XYZ’s retained earnings will be eliminated after the business combination, the retained
earnings of the combined entity immediately after the business combination is equal to ABC’s
acquisition-date retained earnings (i.e., P800,000)

The statement of financial position of the combined entity immediately after the business
combination is shown below:
Combined entity
Identifiable assets 4,000,000
 Goodwill 300,000
Total assets 4,300,000

Liabilities 1,600,000
Share capital 700,000
Share premium 1,200,000
Retained earnings 800,000
Total liabilities and equity 4,300,000

Business combination achieved in stages

A business combination achieved in stages occurs when an investors acquires additional shares from
an investee which it had previously held equity interest and the additional shares purchased results to
the investor obtaining control over the investee. In other words, controlling interest is obtained
through two or more separate transactions. A business combination achieved in stages is also
referred to as “step acquisition.”

Illustration 1: Business combination achieved in stages- PAS 28

On January 1, 20x1, ABC Co. acquired 30% ownership interest in XYZ, Inc. For P100,000. Because the
investment gave ABC significant influence over XYZ, the investment was accounted for under the
equity method in accordance with PAS 28 Investments in Associates and Joint Ventures.

From 20x1 to the end of 20x3, ABC recognized P50,000 net share in the profits of the associate and
P10,000 share in dividends. Therefore, the carrying amount of the investment in associate account on
January 1 ,20x3, is P140,000.
On January 1,20x4, ABC acquired additional 60% ownership interest in XYZ, Inc. for P800,000. As of
this date, ABC has identified the following:
a. The previously held 30% interest has a fair value of P180,000.
b. XYZ’s net identifiable assets have a fair value of P1,000,000.
c. ABC elected to measure non-controlling interests at the non-controlling interest’s proportionate
share of XYZ’s identifiable net assets.

Requirement: Compute for goodwill.

Solution:
Consideration transferred 800,000
Non-controlling interest in the acquiree (1M x 10%*) 100,000
Previously held equity interest in the acquiree 180,000
Total 1,080,000
Fair value of net identifiable assets acquired (1,000,000)
Goodwill 80,000

The pertinent entries are:

Jan. 1, 20x4 Investment in associate (180K-140K) 40,000
Gain on remeasurement - P/L 40,000
Jan. 1, 20x4 Investment in subsidiary (800K +180K) 980,000
Cash in bank 800,000
Investment in associate 180,000

Business combination achieved without transfer of consideration

The acquirer shall nevertheless apply the acquisition method to business combinations in which the
acquirer obtains control over an acquiree without transferring consideration.

The reason why the “purchase method” previously used for the business combinations has been
replaced with the “acquisition method” is to emphasize that a business combination may occur even
when a purchase transaction is not involved.

Examples of circumstances where the acquirer obtains control without transferring consideration:
 a. The acquiree repurchases a sufficient number of its own shares from other investors so that
acquirer will be able to obtain control.
For example, ABC Co. holds 40,000 ordinary shares representing a 40% ownership interest in XYZ,
Inc.’s 100,000 outstanding ordinary shares. Subsequently, XYZ repurchases 25,000 shares from other
investors to be held as treasury shares. After the treasury shares transaction,ABC’s ownership interest
will be increased to 53.33% (40,000 ÷ 75,000).

b. Minority veto rights lapse that previously kept the acquirer from controlling an acquiree in
which the acquirer held the majority voting rights.

c. The acquirer and acquiree agree to combine their businesses by contract alone. The acquirer
transfers no consideration in exchange for control of an acquiree and holds no equity interests in
the acquiree, either on the acquisition date or previously. Examples of business combinations
achieved by contract alone include bringing two businesses together in a stapling arrangement
or forming a dual listed corporation.

In a business combination in which no consideration is transferred, the acquirer substitutes the

acquisition-date fair value of its interest in the acquiree for the acquisition-date fair value of the
consideration transferred to measure goodwill or a gain on a bargain purchase.

In a business combination achieved by contract alone the acquirer attributes to the owners of the
acquiree the amount of the acquiree’s net asset measured either at fair value or at the
non-controlling interest’s proportionate share of the acquiree’s net identifiable assets. In other words,
the equity interests in the acquiree held by parties other than the acquirer are a non-controlling
interest in the acquirer’s post-combination financial statements even if the result is that all of the
equity interests in the acquiree are attributed to the non-controlling interest.

Illustration 1: Business combination - w/o transfer of consideration

ABC Co. owns 36,000 shares representing 40% ownership interest in XYZ, Inc.’s 90,000 outstanding
ordinary shares. ABC accounts for the investment under the equity method.

On January 1, 20x1, XYZ reacquired 30,000 of its own shares from other investors so that ABC shall
obtain control over XYZ. The following were determined as of acquisition date:
a. The previously held 40% interest has a fair value of P180,000.
b. XYZ’s net identifiable assets have a fair value of P1,000,000.
c. ABC elected to measure non-controlling interest at the non-controlling interest’s proportionate
share of XYZ’s net identifiable assets.

Requirement: Compute for goodwill.

Solution:
Consideration transferred (1M x 60%*) 600,000
Non-controlling interest in the acquiree (1M x 40%*) 400,000
Previously held equity interest in the acquiree -
Total 1,000,000
Fair value of net identifiable assets acquired (1,000,000)
Goodwill -

*After the business combination , ABC’s ownership interest is increased to 60% (i.e., 36,000+60,000).
Consequently, the non-controlling interest is 40%.

Notice that the acquisition-date fair value of ABC’s interest in XYZ is substituted for the
acquisition-date fair value of the consideration transferred to measure goodwill or a gain or bargain
purchase.

Since there is no change in the actual number of shares held by ABC before and after the business
combination, no amount is attributed to the previously held equity interest in the acquiree when
computing for goodwill or gain on bargain purchase. However, a remeasurement gain or loss shall be
recognized on the reclassification of the previously held equity interest in the acquiree.
The entry for the business combination is:
Jan. 1, 20x4 Investment in subsidiary 600,000
Investment in associate 180,000
Gain on measurement- P/L 420,000

Measurement period
If the initial accounting for a business combination is incomplete by the end of the reporting period in
which the combination occurs, the acquirer shall report in its financial statements provisional
amounts for the items for which the accounting is incomplete.

If new information is obtained during the measurement period which provides evidence of facts and
circumstances that existed as of the acquisition date that, if known, would have affected the
measurement of the amounts recognized as of that date, the acquirer shall retrospectively adjust the
provisional amounts recognized at the acquisition date.

Additional assets or liabilities may also be recognized during the measurement period if new
information is obtained about facts and circumstances that existed as of the acquisition date that, if
known, would have resulted in the recognition of those assets and liabilities as of that date.

The measurement periods ends as soon as the acquirer receives the information it was seeking about
facts and circumstances that existed as of the acquisition date or learns that more information is not
obtained.

However, the measurement period shall not exceed one year from the acquisition date.

The measurement period is the period after the acquisition date during which the acquirer may adjust
the provisional amounts recognized for a business combination. The measurement period provides
the acquirer with a reasonable time to obtain the information necessary to identify and measure the
following as of the acquisition date in accordance with the requirements of PFRS 3:
a. The consideration transferred;
b. Any non-controlling interest in the acquiree:
c. Previously held equity interest in the acquiree, in the case of a business combination achieved in
stages;
d. The identifiable assets acquired and liabilities assumed; and
e. The resulting goodwill or gain on a bargain purchase.

The acquirer recognizes an increase (decrease) in the provisional amount recognized for an
identifiable asset (liability) by means of a decrease (increase) in goodwill.

During the measurement period, the acquirer shall recognize adjustments to the provisional amounts
as if the accounting for the business combination had been complete at the acquisition date. Thus,
the acquirer shall restate comparative information for prior periods presented in financial statements
as needed.

After the measurement period ends, any revision on the accounting for a business combination shall
be treated as correction of error that is accounted for under PAS 8 Accounting Policies, Changes in
Accounting Estimates and Errors.

Illustration1: Provisional amounts - identifiable assets acquired

Fact pattern
On September 30, 20x1, ABC Co. acquired all of the identifiable assets and assumed all of the
liabilities of XYZ, Inc. By paying cash of P1,000,000. On this date, the identifiable assets acquired and
liabilities assumed have fair values of P1,600,000 and P900,000, respectively.
Case #1: Identifiable asset recognized at provisional amount
ABC engaged an independent valuer to appraise a building acquired from XYZ. However, the valuation
report was not received by the time ABC authorized for issue its financial statements for the year
ended December 31,20x1. As such the building was assigned a provisional amount of P700,000. Also,
the building was tentatively assigned an estimate useful life of 10 years from acquisition date. ABC
uses the straight line method of depreciation and recognized three months’ depreciation on the
building in 20x1.

On July 1, 20x2, ABC finally received the valuation report from the independent valuer which shows
that the fair value of the building on September 30,20x1 is P500,000 and the remaining useful from
that date is 5 years.

Question:How should ABC account for the new information obtained?

Answer: ABC should retrospectively adjust the provisional amount assigned to the building. The
adjustment shall be charged to the goodwill recognized on acquisition date. Depreciation expense
shall also be retrospectively adjusted as necessary. ABC shall then restate its 20x1 financial
statements and provide the disclosures required under PFRS 3.

The measurement period adjustments are computed as follows:

The unadjusted goodwill is computed as follows:

Consideration transferred 1,000,000
Non-controlling interest in the acquiree -
Previously held equity interest in the acquiree -
Total 1,000,000
Fair value of net identifiable assets acquired (1.6M - .9M) (700,000)
Goodwill (recognized on Sept. 30, 20x1) 300,000

The adjusted fair value of net identifiable assets acquired is computed as follows:
Fair value of identifiable assets acquired 1,600,000
Provisional amount assigned to building ( 700,000 )
Fair value of building per appraisal 500,000
Adjusted fair value of identifiable assets acquired 1,400,000
Fair value of liabilities assumed ( 900,000 )
Adjusted fair value of net identifiable assets acquired 500,000

The adjusted goodwill is computed as follows:

Consideration transferred 1,000,000
Non-controlling interest in the acquiree -
Previously held equity interest in the acquiree -
Total 1,000,000
Fair value of net identifiable assets acquired (500,000)
Goodwill 500,000

The adjustment to goodwill is computed as follows:

Goodwill recognized on September 30,20x1 300,000
Adjusted goodwill 500,000
Increase in goodwill 200,000

The adjustment to depreciation expense recognized in 20x1 is computed as follows:

Depreciation recognized(P700,000 ÷ 10 years x 3/12) 17,500
Adjusted depreciation (P500,000 ÷ 5 years x 3/12) 25,000
Additional depreciation expense for 20x1 7,500
The measurement period adjusting entries are as follows:
July 1, 20x2 Goodwill 200,000
Building 200,000
To record the adjustment to the provisional amount assigned to
the building
July 1, 20x2 Retained earnings 7,500
Accumulated depreciation 7,500
To record the adjustment to 20x1 depreciation
If monthly depreciation expenses were recognized during January to June 30, 20x2, the recognized
depreciation expenses shall also be adjusted accordingly.

Case#3: Information obtained beyond the measurement period

On November 1,20x2, the internal auditors of ABC discovered an error on the recorded identifiable
assets acquired from the business combination. A patent with fair value of P100,000 and remaining
useful life of 4years as of September 30,20x1 was omitted from the valuation listing.

Question: How should ABC account for the new information obtained?

Answer: Because the new information is obtained after the measurement period (i.e., beyond one
year from September 30, 20x1), ABC should account for the new information in accordance with PAS
8 as correction of a prior period error. PAS 8 requires the correction of a prior period error to be
accounted for retrospectively and for the financial statements to be presented as if the error had
never occurred by correcting the prior period’s information.

The correcting entries on the 20x1 financial statements are as follows:

Nov. 1, 20x2 Patent 100,000
Goodwill 100,000
Nov. 1, 20x2 Retained earnings (100K ÷ 4x 3/12) 6,250
Accumulated amortization 6,250

The unrecorded patent in nonetheless recognized, but this time not as a measurement period
adjustment but rather as correction of error. Goodwill is charged for the correction of error because if
ABC had known the existence and value of the unrecorded patent on September 30, 20x1, the
amount of goodwill that should have been recognized on that date is P200,000.

Determining what is part of the business combination transaction

Before the business combination, the acquirer and the acquiree may have pre-existing relationship or
they may enter into transaction during the negotiation period that are separate from the business
combination.

In such cases, the acquirer shall identify amounts that are not part of the consideration transferred
on the business combination. In applying the acquisition method, the acquirer shall recognize only the
consideration transferred on the business combination. Separate transaction shall be excluded from
the consideration transferred and accounted for under other relevant PFRSs.

A transaction that is arranged primarily for the benefit of the acquirer or the combined entity rather
than primarily for the benefit of the acquiree or its former owners before the combination is likely to
be a separate transaction. Thus, the portion of the transaction price shall be excluded from the
consideration transferred when applying the acquisition method.

PFRS 3 provides the following guidance when determining whether a transaction is part of a business
combination or a separate transaction:
a. Reasons for the transaction
A transaction that is arranged primarily for the benefit of the acquirer or the combined entity rather
than primarily for the benefit of the acquirer or the combined entity rather than primarily for the
benefit of the acquiree or its former owner before the combination is more likely to be a separate
transaction. Thus, the portion of the transaction price shall be excluded from the consideration
transferred when applying the acquisition method.

On the other hand, a transaction that is arranged primarily for the benefit of the acquiree or its
former owners before the combinations more likely to be a part of the business combination
transaction.

b. Party initiating the transaction

A transaction initiated by the acquiree is more likely for the benefits of the acquirer or the combined
entity and, therefore , is more likely a separate transaction.

On the other hand, a transaction initiated by the acquiree or its former owners is more likely a part of
the business combination transaction.

c. Timing of the transaction

A transaction between the acquirer and the acquiree that takes place during the negotiations of the
terms of a business combinations is more likely to have been entered into in contemplation of the
business combination.

The following are examples of separate transactions that are not to be included in applying the
acquisition method:

a. Settlement of pre-existing relationships between the acquirer and acquiree;

b. Remuneration to employees or former owners of the acquiree for future services; and
c. Reimbursement to the acquiree or its former owners for paying the acquirer’s acquisition-related
costs.
 Business Combination ( Part 3)

Special accounting topics for business combination

1. Goodwill
2. Reverse acquisition
3. Combination of mutual entities

Goodwill
Only goodwill that arises from a business combination is recognized as an asset. Goodwill arising from
other sources (e.g., internally generated) is not recognized. The amount recognized as goodwill is
determined on the acquisition date of a business combination. Subsequent expenditures on maintaining
goodwill are expensed immediately.

Subsequent to initial recognition, goodwill is not amortized but rather tested for impairment at least
annually.

For this purpose, goodwill shall be allocated to each of the acquirer’s cash-generating units (CGU) in the
year of business combination. If the allocation is not completed by the end of the year of business
combination, it must be completed before the end of the immediately following year.

Cash-generating unit (CGU) is the smallest identifiable group of assets that generates cash inflows that are largely
independent of the cash inflows from other assets or groups of assets.

Goodwill shall be allocated to the CGUs expected to benefit from the synergies of the business
combination. The methodology used to assign goodwill must be reasonable, supportable, and applied in
a consistent manner. For example, goodwill may be allocated based on the relative fair values of the
CGUs.

Illustration 1: Applications of the Direct valuation method

ABC Co. is contemplating on acquiring XYZ, Inc. The following information was gathered through a
diligence audit:

 The actual earnings of XYZ, Inc. The following information was gathered through a diligence audit:
Year Earnings
20x1 1,200,000
20x2 1,300,000
20x3 1,350,000
20x4 1,250,000
20x5 1,800,000
Total 6, 900,000

 Earnings in 20x5 include an expropriation gain of P400,000.

 The fair value of XYZ’s net assets as of the end of 20x5 is P10,000,000.
 The industry average rate of return is 12%.
 Probable duration of “excess earnings” is 5 years.

Method #1: Multiples of average excess earnings

Under this, method, goodwill is measured at the average excess earnings multiplied by the probable
duration of excess earnings.

Total earnings for the last 5 years 6,900,000

Less: Expropriation gain ( 400,000 )
Normalized earnings for the last 5 years 6,500,000
Divide by: 5
(a) Average annual earnings 1,300,000

Fair value of acquiree’s net assets 10,000,000

Multiply by: Normal rate of return 12%
(b) Normal earnings 1,200,000
Excess earnings (a) - (b) 100,000
Multiply by: Probable duration of excess earnings 5
Goodwill 500,000
Method #2: Capitalization of average excess earnings
Under this method, goodwill is measured at the average excess earnings divided by a pre-determined
capitalization rate. ( Assume a capitalization rate 25%).
Average earnings (6.9M - .4M expropriation gain) ÷ 5years 1,300,000
Normal earnings in the industry (10M x 12%) ( 1,200,000 )
Excess earnings 100,000
Divide by: Capitalization rate 25%
Goodwill 400,000

Method #3: Capitalization of average earnings

Under this method, the average earnings are divided by a pre-determined capitalization rate to estimate
the purchase price of the business combination. The excess of the estimated purchase price over the fair
value of the acquiree’s nt assets represents the goodwill. (Assume a capitalization rate of 12.5%).

Average earnings (6.9M - .4M expropriation gain) ÷ 5 years 1,300,000

Divide by: Capitalization rate 12.5%
Estimate purchase price 10,400,000
Fair value of XYZ’s net assets ( 10,000,000 )
Goodwill 400,000

Notice that if the “excess earnings” is used in the computations, the amount directly computed is
goodwill. On the other hand, if the “average earnings” is used, the amount directly computed is the
estimated purchase price.

Method #4: Presented value of average excess earnings

Under this method, goodwill is measured at the present value of average excess earnings discounted at a
pre-determined discount rate over the probable duration of excess earnings. (Assume a discount rate of
10%).

Average earnings (6.9M - .4M expropriation gain) ÷5 years 1,300,000

Normal earnings in the industry (10M x 12%) ( 1,200,000 )
Excess earnings 100,000
Multiply by: PV of an ordinary annuity @10%, n=5 3.79079
Goodwill 379,079

Reverse acquisition
In a business combination accomplished through exchange of equity interests, the acquirer is usually the
entity that issues its equity interests. However, the opposite is true for reverse acquisitions.

In a reverse acquisition, the entity that issues securities ( the legal acquirer ) is identified as the acquiree
for accounting purposes while the entity whose equity interests are acquired ( the legal acquiree ) is the
acquirer for accounting purposes

For example , ABC Co., a private entity, wants to become a public entity but does not want to register
its shares. To accomplish this, ABC will arrange for a public entity to acquire its equity interests in
exchange for public entity’s equity interests.

In the example above , the public entity is the legal acquirer because it issued its equity interests, and the
private entity is the legal acquiree because its equity interests were acquired.
However,when applying the guidance provided under PFRS 3:
a. The public entity is identified as the acquiree for accounting purposes (the accounting acquiree); and
b. The private entity (ABC Co.) is identified as the acquirer for accounting purposes (the accounting
acquirer).

Measuring the consideration transferred

In substance, the accounting acquirer usually issues no consideration to the acquiree. Instead, the
accounting acquiree issues its equity shares to the owners of the accounting acquirer to enable the
accounting acquirer to obtain control over the accounting acquiree.

As such, the acquisition-date fair value of the consideration transferred by the accounting acquirer shall
be measured as an amount based on the number of equity interest the legal subsidiary (accounting
acquirer) would have had to issue to give the owners of the legal parent (accounting acquirer) would
have had to issue to give the owners of the legal parent (accounting acquiree) the same percentage of
equity interest in the combined entity that results from the reverse acquisition.
Conventional acquisition vs. Reverse acquisition
Conventional Reverse
acquisition acquisition
Issuer of shares as The issuer of shares is the The issuer of shares is the
consideration transferred accounting acquirer. accounting acquiree.
Reference to combining - Accounting acquirer/ - Accounting acquirer/ Legal
constituents Legal parent subsidiary
- Accounting acquiree/ Legal - Accounting acquiree/ Legal
subsidiary parent

Measurement of consideration Fair value of consideration Fair value of the notional

transferred transferred by the accounting number of equity instruments
acquirer. that the accounting acquirer
(legal subsidiary) would have
had to issue to the accounting
acquiree (legal parent) to give
the owners of the accounting
acquiree (legal parent) the
same percentage ownership in
the combined entity.

Illustration: Reverse acquisition

On January 1, 20x1, XYZ, Inc ., an unlisted company, acquires ABC Co., a publicly listed entity, through an
exchange of equity instruments. ABC Co. issues 5 shares in exchange for each ordinary share of XYZ, Inc,
All of XYZ’s shareholders exchange their shares in ABC Co. Therefore, ABC Co. issues 40,000 ordinary
shares in exchange for all 8,000 ordinary shares of XYZ, Inc.

The fair value of each ordinary share of XYZ on January 1, 20x1 is P200. The quoted market price of ABC’s
ordinary shares at that date is P40.

The statements of financial position of the combining entities immediately before combination are
shown below:

ABC Co. XYZ, Inc

(legal parent,accounting acquiree ) (legal subsidiary, accounting acquirer )
Identifiable assets 1,600,000 2,400,000
Total assets 1,600,000 2,400,000
Liabilities 1, 300,000 700,000
Share capital:
10,000 ordinary
shares, P10 par 100,000
8,000 ordinary
shares, P100 par 800,000
Retained earnings 200,000 900,000
Total liabilities and equity 1,600,000 2,400,000

The fair values of ABC’s identifiable assets and liabilities on January 1,20x1 are the same as their carrying
amounts.

Requirements: Compute for goodwill (gain on bargain purchase).

Solution:
Analyses:
 XYZ, Inc lets itself acquired (legal form) for it to gain control over the legal acquirer (substance).

Combination of mutual entities

PFRS 3 defines a mutual entity as “An entity, other than an investor-owned entity, that provides
dividends, lower costs or other economic benefits directly to its owners, members or participants.”
Examples: a mutual insurance company, a credit union, and a cooperative entity.

Mutual entities may be differentiated from other types of businesses on the basis that members of
mutual entities are both customers and owners. Members generally expect to receive benefits from their
membership, normally in the form of reduced fees charged for goods and services or patronage dividends.
The portion of patronage dividends allocated to each members is often based on the amount of business
the members did with the mutual entity during the year.

When two mutual entities combine, the acquirer gives member or equity interests in itself in exchange
for the member interest in the acquiree. Consideration is transferred but its fair value is not readily
determinable by reference to a market.

In such case, the acquirer determines the amount of goodwill by using the acquisition-date fair value of
the acquiree’s- equity interests instead of the acquisition-date fair value of the acquirer’s equity interest
transferred as consideration.

Illustration: Combination of mutual entities

ABC Coop. and XYZ Coop. are cooperative institutions. On January 1, 20x1, the two entities combined,
with ABC identified as the acquirer. ABC shall issue member interests to XYZ. As a result, members of XYZ
become members of ABC. An estimated cash flow models indicates an acquisition-date fair valuation of
XYZ, as an entity, at P1,000,000. The fair value of XYZ’s identifiable net assets is P800,000.

Requirements: Compute for goodwill and provide the acquisition-date journal entry.
Solution:
Consideration transferred 1,000,000
Non-controlling interest in the acquiree -
Previously held equity interest in the acquiree -
Total 1,000,000
Fair value of net identifiable assets acquired (800,000)
Goodwill 200,000

ABC records its acquisition of XYZ in its consolidated financial statements as follows:
Jan. 1, Identifiable assets acquired 800,000
20x1 Goodwill 200,000
Member interests issued 1,000,000
NATURE OF CONSOLIDATED STATEMENTS

IFRS 10 requires that an entity that is a parent must present consolidated financial statements that
include all subsidiaries of the patent. Only three exceptions to this rule are available and these are:

(1) a parent need not present consolidated financial statements if all the following criteria are met:

(a) The parent itself is a wholly-owned subsidiary or it is a partially-owned subsidiary of another

entity and all of its owners, including those not normally entitled to vote, have been informed
about, and do not object to, the parent not presenting consolidated financial statements;
(b) Its debt and equity instruments are not traded in a public market;
(c) It did not file, nor is it in the process of filing, its financial statements with a securities
exchange commissions; and
(d) Its ultimate or intermediate parent produces consolidated financial statements that are
available for public use and comply with IFRS.

(2) Post-employment benefit plans or other long-term employee benefits plans to which IAS 10,
Employee Benefits, apply are excluded from the scope of IFRS 10.

(3) An investment entity need not present consolidated financial statements if it is required to measure
those subsidiaries at fair value through profit or loss in accordance with IFRS 9, Financial instruments (or
IAS 39, Financial Instruments: Recognition and Measurement until IFRS 9 comes into effect).

CONDITIONS FOR CONSOLIDATED STATEMENTS

Generally, statements are to be consolidated when a parent company owns over 50% of the voting
common stock of another company thereby having a controlling interest. However, control may be
achieved even with less than 51% of the voting common stock is owned by the parent. In such case, the
consolidated statements may be prepared in view of the unified managerial control.

CONTROL

IFRS 10 introduces a new single control model to identify a parent-subsidiary relationship by specifying
that “an investor controls an investee when the investor is exposed, or has rights, to variable returns
from its involvement with the investee and has the ability to affect those returns through its power over
the investee”.

In this new control model, an investor controls an investee if and only if the investor has all of the
following three elements:

(a) Power over the investee (the Power);

(b) Exposure, or rights, to variable returns from its involvement with the investee (the Returns); and
(c) The ability to use its power over the investee to effect the amount of the investor’s returns (the Link
between Power and Returns).
Illustration 1
P Company and Subsidiary
Consolidation Working Paper
December 1, 2017

P Company S Company Elimination Consolidated

Debit Credit
Assets

Cash P130,000 P-0- P130,000

Accounts receivable 40,000 32,000 72,000
Inventory 50,000 20,000 70,000
Equipment -net 180,000 158,000 338,000
Investment in S Company 100,000 -
(1) 100,000
Total assets P500,000 P210,000 P610,000

Liabilities and Equity

Accounts payable P280,000 110,000 P390,000
Common stocks:
P Company 100,000 100,000
S Company 50,000 (1) 50,000
Additional paid-in capital:
P Company 80,000 P80,000
S Company 30,000 (1) 30,000
Retained earnings:
P Company 40,000 P40,000
S Company 20,000 (1 )20,000

Total Liabilities and Equity P500,000 P210,000 P100,000 P610,000

P100,000

Illustration 2
P Company and Subsidiary
Consolidated Statement of Financial Position
December 1, 2017

Assets
Current assets
Cash P 130,000
Accounts receivable 72,000
Inventory 70,000
Total Current Assets 272,000

Non-current Assets
Equipment 338,000

Total Assets P 610,000

Liabilities and Equity

Current liabilities
Accounts payable P 390,000

Stockholders’ Equity
Common stock 100,000
Additional paid-in capital 80,000
Retained earnings 40,000 220,000

Total Liabilities and Equity P 610,000

Illustration 3
P Company and Subsidiary
Consolidation Working Paper
December 1, 2017

P Company S Company Elimination Consolidated

Debit Credit
Assets
Cash P120,000 P-0- P120,000
Accounts receivable 40,000 32,000 72,000
Inventory 50,000 20,000 70,000
Equipment-net 180,000 158,000 338,000
Goodwill (1)10,000 10,000
Investment in S Company 110,000 (1)110,000
Total assets P500,000 P210,000 P610,000

Liabilities and Equity

Accounts payable P280,000 P110,000 P390,000
Common stock
P Company 100,000 100,000
S Company 50,000 (1)50,000
Additional paid-in capital
P Company 80,000 80,000
S Company 30,000 (1)30,000
Retained earnings
P Company 40,000 40,000
S Company 20,000 (1)20,000
Total Liabilities & Equity P500,000 P210,000 P110,000 P610,000

Consolidated Statement of Financial Position. The formal consolidated statement of financial position
resulting from the 100% acquisition of S Company taken from the consolidated column of the
consolidation working paper is presented below:

P Company and Subsidiary

Consolidated Statement of Financial Position
December 1, 2017

Assets
Current assets
Cash P 120,000
Accounts receivable 72,000
Inventory 70,000
Total Current Assets 262,000
Non-current assets
Equipment 338,000
Goodwill 10,000
Total non-current assets 348,000
Total assets P 610,000

Liabilities and Equity

Accounts payable P 390,000

Stockholders’ Equity
Common stock 100,000
Additional paid in capital 80,000
Retained earnings 40,000
Total stockholders’ equity 220,000
Total liabilities and equity P 610,000
Illustration 4
P Company and Subsidiary
Consolidation Working Paper
December 1, 2017

P S Eliminations Consolidated
Company Company Debit Credit
Assets
Cash P150,000 P -0- P150,000
Account receivable 40,000 32,000 72,000
Inventory 50,000 20,000 70,000
Equipment 180,000 158,000 338,000
Investment in S Company 80,000 (1)P80,000
Total Assets P500,000 P210,000 P630,000

Liabilities and Equity

Accounts payable P280,000 P110,000 P390,000
Common stock:
P Company 100,000 100,000
S Company 50,000 (1)50,000
Additional paid-in capital
P Company 80,000 80,000
S Company 30,000 (1)30,000
Retained earnings
P Company 40,000 (1)20,000 60,000
S Company 20,000 (1)20,000
Total liabilities and equity P500,000 P210,000 P100,000 P100,000 P630,000

Illustration 5
P Company and Subsidiary
Consolidation Working Paper
December 1, 2017

P S Elimination and Adjustments Consolidated

Company Company Debit Credit
Assets
Cash P168,000 P-0- P168,000
Accounts receivable 144,000 40,000 184,000
Inventory 160,000 100,000 (2)10,000 270,000
Land 200,000 80,000 (2)50,000 330,000
Building 840,000 300,000 (2)200,000 1,340,000
Equipment 400,000 80,000 (2)40,000 520,000
Investment in S Company 800,000 (1)256,000
(2)544,000
Goodwill (2)350,000 350,000
Total P2,712,000 P600,000 P3162,000

Liabilities and Equity

Accounts payable P160,000 P80,000 P240,000
Bonds payable 400,000 200,000 600,000
Common stock:
P Company 560,000 560,000
S Company 20,000 (1)20,000
Additional paid- in capital:
P Company 1,140,000 1,140,000
S Company 180,000 (1)180,000
Retained earnings:
P Company 452,000 452,000
S Company 120,000 (1)120,000
NCI to consolidated (1)64,000 170,000
(2)106,000
Total P2,712,000 P600,000 P1,970,000 P970,000 P3,162,000
Consolidated Statement of Financial Position. The formal consolidated statement of financial position resulting from
80% acquisition of S Company in exchange for 16,000 parent’s share has been taken from the consolidated column of
consolidation working paper (Illustration 5).

P Company and Subsidiary

Consolidated Statement of Financial Position
December 1, 2017

Assets
Current assets
Cash P 168,000
Accounts receivable 184,000
Inventory 270,000
Total 622,000
Non-current assets
Land 330,000
Building 1,340,000
Equipment 520,000
Goodwill 350,000
Total 2,540,000
Total assets P3,162,000

Liabilities and Equity

Liabilities
Accounts payable P 240,000
Bonds payable 600,000
Total liabilities 840,000

Stockholder’s Equity
Common stock 560,000
Additional paid in capital 1,140,000
Retained earnings 452,000
Total controlling equity 2,152,000
Non-controlling interest 170,000
Total equity 2,322,000
Total liabilities and equity P3,162,000

Illustration 6
P Company and Subsidiary
Consolidation Working Paper
December 1, 2017
P Company S Company Elimination & Adjustments Consolidated
Debit Credit
Assets
Cash P168,000 P-0- P168,000
Accounts receivable 144,000 40,000 184,000
Inventory 160,000 100,000 (2)10,000 270,000
Land 200,000 80,000 (2)50,000 330,000
Building 840,000 300,000 (2)200,000 1,340,000
Equipment 400,000 80,000 (2)40,000 520,000
Investment in S Company 400,000 (1)256,000
(2)144,000
Total P2,312,000 P600,000 P2,812,000

Liabilities and Equity P240,000

Accounts payable P160,000 P80,000 600,000
Bonds payable 400,000 200,000
Common stock: 480,000
P Company 480,000 (1)20,000
S Company 20,000
Additional paid-in capital 820,000
P Company 820,000
S Company (1)180,000
Retained earnings: 180,000 (2)96,000 548,000
P Company 452,000 (1)120,000
S Company 120,000 (1)64,000 124,000
NCI to consolidated (2)60,000
P620,000 P620,000 P2,812,000
Total P2,312,000 P600,000
TECHNIQUES IN THE CALCULATION AND ALLOCATION OF GOODWILL AND/OR GAIN ON
ACQUISITION

The following are the steps that will always work if used in the order shown below:

WITH GOODWILL: Assume the price paid by the parent is P600,000.

Step 1: Enter the value for column A2 (sum of fair values of company’s net identifiable assets). Then the appropriate
percentage of that value into column B2 and C2. These amounts are fixed regardless of the price paid by the parent.

(A) (B) (C)

Company Parent Price NCI Value
Implied FV (80%) (20%)
1. Company fair value
2. Fair value of net assets excluding goodwill 620,000 496,000 124,000
3. Goodwill

Step 2: Enter the price paid by the parent for the controlling interest in B1.
(A) (B) (C)
Company Parent Price NCI Value
Implied FV (80%) (20%)
1. Company fair value P600,000
2. Fair value of net assets excluding goodwill 620,000 496,000 124,000
3. Goodwill

Step 3: Compare B1, the price paid by the parent, and B2, the parent’s share of the fair value of the company’s net
identifiable assets. If B1 is more the B2, enter B3 the difference, which is the goodwill applicable to the parent. Then
complete C1. Normally, this amount will be proportionate to B1. It can be a different amount (based on estimated
fair value) but never less than C2. In this case it is assessed to be P180,000 even though the proportionate value
would be P150,000 for this example. Compute now the value of C3 and complete the remaining columns.

(A) (B) (C)

Company Parent Price NCI Value
Implied FV (80%) (20%)
1. Company fair value P780,000 P600,000 P180,000*
2. Fair value of net assets excluding goodwill 620,000 496,000 124,000
3. Goodwill P160,000 P104,000 P56,000

WITH GAIN ON A ACQUISITION: Assume the price paid by the parent is P450,000.

Step 1: Enter and allocate fair values.

(B) (B) (C)

Company Parent Price NCI Value
Implied FV (80%) (20%)
1. Company fair value
2. Fair value of net assets excluding goodwill 620,000 496,000 124,000
3. Gain on acquisition

Step 2: Enter the price paid by the parent.

(A) (B) (C)
Company Parent Price NCI Value
Implied FV (80%) (20%)
1. Company fair value P450,000
2. Fair value of net assets excluding goodwill 620,000 496,000 124,000
3. Gain on acquisition

Step 3: Calculate the gain applicable to the parent (B2 is more than B1) and complete the remaining columns.
(A) (B) (C)
Company Parent Price NCI Value
Implied FV (80%) (20%)
1. Company fair value P574,000 P450,000 P124,000
2. Fair value of net assets excluding goodwill 620,000 496,000 124,000
3. Gain on acquisition P(46,000) P(46,000) P -0-
Take note that C1 cannot be less than C2.
If the fair value of the NCI exceeded P124,000, the excess would be an offset to the gain on the controlling interest.
To illustrate, assume that NCI has a fair value of P130,000.

(A) (B) (C)

Company Parent Price NCI Value
Implied FV (80%) (20%)
1. Company fair value P580,000 P450,000 P130,00
2. Fair value of net assets excluding goodwill 620,000 496,000 124,000
3. Gain on acquisition P(40,000) P(46,000) P6,000

The working paper elimination entry to allocate the excess would be:
Investment in S Company 46,000
NCI 6,000
Retained earnings - P Company (gain on acquisition) 40,000

SUBSIDIARY’S PREEXISTING GOODWILL

If the acquired subsidiary has goodwill on its books at time of acquisition, that goodwill is ignored in the computation
and allocation of excess.

Illustration:

Assume the same example involving the 80% acquisition of S Company in Case 4 on page 78.Assume further that S
Company in its statement of financial position on page 77 (Illustration 14-8) has a goodwill of P50,000 and the
retained earnings balance is P170,000.

The revised statement of financial position of S Company on the date of acquisition would be as follows:

S Company
Statement of Financial Position
December 1, 2017

Assets Book Value Fair Value

Accounts receivable P 40,000 P 40,000
Inventory 100,000 110,000
Land 80,000 130,000
Building 300,000 500,000
Equipment 80,000 120,000
Goodwill 50,000
Total assets P650,000 P900,000

Liabilities and Equity

Accounts payable P 80,000 P 80,000
Bonds payable 200,000 200,000
Total liabilities P280,000 P280,000
Stockholders’ Equity:
Common stock, P1 par P 20,000
Additional paid in capital 180,000
Retained earnings 170,000
Total equity P370,000

Net assets P370,000 P620,000

Assume that P Company issued 16,000 shares of its P10 par value common stock for 80% (16,000 shares) of the
outstanding shares of S Company. The fair value of P Company’s stock is P50 and the fair value of the 20% NCI is
assessed to be P200,000. P Company also pays P50,000 in professional fees to accomplish the acquisition. P Company
would make the following entries:
(1) To record the acquisition of S Company stock:
Investment in S Company (16,000 shares x P50) 800,000
Common stock (16,000 shares x P10) 160,000
Additional paid in capital 640,000

(2) To record acquisition-related costs:

Retained earnings - P Co. (acquisition expense) 50,000
Cash 50,000
Computation and allocation of the goodwill:
Total Parent Price NCI Value
Fair Value (80%) (20%)
Company fair value P1,000,000 P800,000 P200,000
Fair value of net assets excluding goodwill 620,000 496,000 124,000
Goodwill P 380,000 P304,000 P 76,000

The Determination and Allocation of Excess Schedule is as follows:

Total Parent Price NCI Value
Fair Value (80%) (20%)
Fair value of subsidiary P1,000,000 P800,000 P200,000
Less book value of interest acquired:
Common stock P 20,000
Additional paid in capital 180,000
Retained earnings 170,000
Total equity P 370,000 P370,000 P370,000
Interest acquired 80% 20%
Book value P296,000 P 74,000
Excess P 630,000 P504,000 P126,000
Adjustment of identifiable accounts:
Inventory P110,000 FV - P100,000 BV P (10,000)
Land (P130,000 FV - P80,000 BV) (50,000)
Buildings (P500,000 FV - P300,000 BV) (200,000)
Equipment (P120,000 FV - P80,000 BV) (40,000)
Total P(300,000)
Goodwill P330,000

The working paper elimination entries based on the D & A of excess schedule are:
E (1) Common stock - S Company 20,000
Additional paid in capital - S Company 180,000
Retained earnings - S Company 170,000
Investment in S Company 296,000
Non- controlling interest (NCI) 74,000
E (2) Inventory 10,000
Land 50,000
Building 200,000
Equipment 40,000
Goodwill (P380,000 - P50,000) 330,000
Investment in S Company 504,000
Non- controlling interest (NCI) 126,000

The consolidation working paper with the corresponding changes is as follows:

P Company and Subsidiary
Consolidation Working Paper
December 1, 2017
P Company S Company Debit Credit Consolidated
Assets
Cash P168,000 P -0- P168,000
Accounts receivable 144,000 40,000 184,000
Inventory 160,000 100,000 (2)10,000 270,000
Land 200,000 80,000 (2)50,000 330,000
Building 840,000 300,000 (2)200,000 1,340,000
Equipment 400,000 80,000 (2)40,000 520,000
Investment in S Company 800,000 (1)296,000
(2)504,000 -
Goodwill 50,000 (2)330,000 380,000
Total P2,712,000 P650,000 P3,192,000

Liabilities and Equity

Accounts payable P160,000 P80,000 P240,000
Bonds payable 400,000 200,000 600,000
Common stock:
P Company 560,000 560,000
S Company 20,000 (1)20,000
Additional Paid in Capital
P Company 1,140,000 1,140,000
S Company 180,000 (1)180,000
Retained earnings
P Company 452,000 452,000
S Company 170,000 (1)170,000
NCI to consolidated (1)74,000
(2)126,000 380,000
Total P2,712,000 P650,000 P1,000,000 P1,000,000 P3,192,000
Consolidation subsequent to date of acquisition
The consolidation procedures subsequent to the acquisition date involve the same procedures of (a)
eliminating the investment in subsidiary account and (b) adding, line by line, similar items of assets,
liabilities, income and expenses of the parent and the subsidiary. However, this time, we need to
consider also the changes in the subsidiary’s net assets since the acquisition date.

Accordingly, we will expand our consolidation procedures to reflect the accounting computations and
analyses that we will be making. We will be observing the following steps in the succeeding illustrations:
Step 1: Analysis of effects of intercompany transaction.
Step 2: Analysis of net assets
Step 3: Goodwill computation
Step 4: NCI in net assets computation
Step 5: Consolidated retained earnings computation
Step 6: Consolidated profit or loss computation
Step 7: Computation for profit or loss attributable to the owners of the parent and to NCI

Step 1: Analysis of effects of intercompany transaction

This is relevant when the parent and subsidiary had intercompany transactions during the period or in
the previous periods. This is discussed in the next chapter.

Step 2: Analysis of net assets

We will use of the following formula to facilitate this analysis:
Subsidiary Acquisition Consolidation Net
date date change
Share capital (&share premium) xx xx
Retained earnings xx xx
Other components of equity xx xx
Totals at carrying amounts xx xx
Fair value adjustments at
acquisition date xx xx
Subsequent depreciation
of fair value adjustments NIL (xx)
Unrealized profits NIL (xx)
Net assets at fair value xx(a) xx(b) xx(c)

Notes:
(a) This amount is used for computing goodwill in ‘Step 3’.
(b) This amount is used for computing non-controlling interest in net assets in ‘Step 4’
(c) This difference represents the net change in the subsidiary’s net assets since acquisition date. This is
used for computing consolidated retained earnings in ‘Step 5’.

Step 3: Goodwill computation

The goodwill that will be presented in the post-combination financial statements is the goodwill
determined at the acquisition date less accumulated impairment losses since acquisition date.

Goodwill is computed as follows:

Formula #1: NCI is measured at NCI’s proportionate share
Consideration transferred xx
Non-controlling interest in the acquiree xx
Previously held equity interest in the acquiree xx
Total xx
Fair value of net identifiable assets acquired (xx)
Goodwill at acquisition date xx
Accumulated impairment losses since acquisition date (xx)
Goodwill , net - current year xx

Formula #2: NCI is measured at fair value

Consideration transferred xx
Previously held equity interest in the acquiree xx
Total xx
Less: Parent’s proportionate share in the net assets of subsidiary (xx)
Goodwill attributable to owner of parent- acquisition date xx
Less: Parent’s share in goodwill impairment (xx)
Goodwill attributable to owners of parent - current year (a) xx
Fair value of NCI xx
Less: NCI’s proportionate share in net assets of subsidiary (xx)
Goodwill attributable to NCI - acquisition date xx
Less: NCI’s share in goodwill impairment (xx)
Goodwill attributable to NCI - current year (b) xx

Goodwill, net - current year (a) + (b) xx

Formula #2 is used for the following purposes:

1. Allocation of goodwill impairment to the owner of the parent and to NCI; and
2. Computation of NCI in assets when the parent elected to measure NCI at fair value on business
combination date.

Step 4: Non-controlling interest in net assets

The non-controlling interest in net assets is computed as follows:

Subsidiary’s net assets at fair value - current year xx

Multiply by: NCI percentage x%
Total xx
Add: Goodwill to NCI net of accumulated impairment losses (xx)*
Non-controlling interest in net assets- current year xx

*this amount is zero if NCI is measured at proportionate share. Goodwill is attributed to NCI only if NCI is measured at fair value.

Step 5: Consolidated retained earnings

The consolidated retained earnings is computed as follows:

Parent’s retained earnings in current year-end xx

Consolidation adjustments:
Parent’s share in the net change in subsidiary’s net assets xx
Unrealized profits (downstream only) (xx)
Gain or loss on extinguishment of bonds (xx)
Impairment loss on goodwill attributable to Parent (xx)
Net consolidation adjustments xx
Consolidated retained earnings xx

Step 6: Consolidated profit or loss

The consolidated profit or loss is computed as follows:
Parent Subsidiary Consolidated
Profits before adjustments xx xx xx
Consolidation adjustments:
Unrealized profits (xx) (xx) (xx)
Dividend income from subsidiary (xx) N/A (xx)
Gain or loss on extinguishment
of bonds (xx) (xx) (xx)
Net consolidation adjustments (xx) (xx) (xx)
Profits before fair value adjustment xx xx xx
Depreciation of fair value
adjustments (xx) (xx) (xx)
Impairment loss on goodwill (xx) (xx) (xx)
Consolidated profit or loss xx xx xx

Step 7: Profit or loss attributable to owners of parent and NCI

The consolidated profit and loss is attributed to the owners of parent and NCI as follows:
Owners of parent NCI Consolidated
Parent’s profit before FVA* xx xx xx
Share in the subsidiary’s profit before FVA xx xx xx
Depreciation of fair value adjustments (xx) (xx) (xx)
Share in impairment loss on goodwill (xx) (xx) (xx)
Total xx xx xx

The last step in the drafting of the consolidated financial statements. These include amounts determined in the
previous steps as follows:
Statement of financial position
a. Goodwill
b. NCI in net assets of the subsidiary (step 4); and
c. Consolidated retained earnings (step 5).

Statement of profit or loss and other comprehensive income

a. Consolidated profit and loss and comprehensive income (step 6).
b. Profit or loss and comprehensive income attributable to (a) owners of the parent and (b) NCI (step 7).

Illustration 1: Consolidation - Subsequent to date of acquisition

On January 1, 20x1, ABC Co. acquired 80% interest in XYZ, Inc. by issuing 5,000 shares with fair value of P15 per share
and par value of P10 per share. On acquisition date, ABC Co. elected to measure non-controlling interest at the NCI’s
proportionate share in XYZ, Inc.’s net identifiable assets.

XYZ’s shareholders’ equity as of January 1, 20x1 comprises the following:

(at carrying amounts)
Share capital 50,000
Retained earnings 24,000
Total equity 74,000

The fair values of XYZ’s assets and liabilities on January 1, 20x1 are as follows:
XYZ, Inc Carrying Fair Fair value
amounts value adjustments (FVA)
Cash 5,000 5,000 -
Account receivable 12,000 12,000 -
Inventory 23,000 31,000 8,000
Equipment 50,000 60,000 10,000
Accumulated depreciation (10,000) (12,000) (2,000)
Accounts payable (6,000) (6,000) -
Net assets 74,000 90,000 16,000

The remaining useful life of the equipment is 4years.

During 20x1, no dividends were declared by either ABC or XYZ. There were also no intercompany
transactions. The group determined that there is no goodwill impairment.

ABC’s and XYZ’s individual financial statements at year-end are shown below:

Statement of financial position

As at December 31, 20x1
ABC Co. XYZ, Inc.
ASSETS
Cash 23,000 57,000
Accounts receivable 75,000 22,000
Inventory 105,000 15,000
Investment in subsidiary(at cost) 75,000
Equipment 200,000 50,000
Accumulated depreciation (60,000) (20,000)
TOTAL ASSETS 418,000 124,000

LIABILITIES AND EQUITY

Accounts payable 43,000 30,000
Bonds payable 30,000 -
Total liabilities 73,000 30,000
Share capital 170,000 50,000
Share premium 65,000 -
Retained earnings 110,000 44,000
Total equity 345,000 94,000
TOTAL LIABILITIES AND EQUITY 418,000 124,000
Statements of profit or loss
For the year ended December 31, 20x1
ABC Co. XYZ, Inc.
Sales 300,000 120,000
Costs of goods sold (165,000) (72,000)
Gross profit 135,000 48,000
Depreciation expense (40,000) (10,000)
Distribution costs (32,000) (18,000)
Interest expense (3,000) -
Profit for the year 60,000 20,000

Requirement: Prepare the consolidated financial statements as at December 31, 20x1.

Solutions:
Step 1: Analysis of effects of intercompany transaction
We can leave this out because there are no intercompany transactions in the problem.

Step2: Analysis of net assets

XYZ, Inc Acquisition Consolidation Net
date date change
Share capital 50,000 50,000
Retained earnings 24,000 44,000
Other components of equity - -
Totals at carrying amounts 74,000 94,000
Fair value adjustments at acquisition date 16,000 16,000
Subsequent depreciation of FVA NIL (10,000)*
Unrealized profits (Upstream only) NIL -
Subsidiary’s net assets at fair value 90,000 100,000 10,000

*The subsequent depreciation of fair value adjustment(FVA) is determined as follows:

Fair value Divide by Subsequent
adjustments useful life depreciation
Inventory 8,000 N/A 8,000
Equipment 10,000
Accumulated depreciation (2,000)
Equipment - net 8,000 4 2,000
Totals 16,000 10,000
(a) The entire inventory is assumed to have been sold during the year.

Step 3: Goodwill computation

We will use ‘Formula #1’ because ABC elected to measure NCI at proportionate share.

Formula #1: NCI is measured at NCI’s proportionate share

Consideration transferred (5,000 sh. X P15) 75,000
Non-controlling interest in the acquiree (90K x 20%)-(step2) 18,000
Previously held equity interest in the acquiree -
Total 93,000
Fair value of net identifiable assets acquired (step2) (90,000)
Goodwill at acquisition date 3,000
Accumulated impairment losses since acquisition date -
Goodwill,net -current year 3,000

Step 4: Non-controlling interest in net assets

XYZ’s net assets at fair value - Dec. 31, 20x1(step2) 100,000
Multiply by: NCI percentage 20%
Total 20,000
Add: Goodwill to NCI net of accumulated impairment losses -**
Non-controlling interest in net assets - Dec.31, 20x1 20,000
*(100% minus 80% interest of ABC Co.)
**No goodwill is attributed to NCI is measured at proportionate share. Goodwill is attributed to NCI only if NCI is measured at fair
value.
Step 5: Consolidated retained earnings
ABC’s retained earnings -Dec. 31, 20x1 110,000
Consolidation adjustments:
ABC’s share in the net change is XYZ’s net assets 8,000
Unrealized profits (Downstream only) -
Gain or loss on extinguishment of bonds -
Impairment loss on goodwill attributable to Parent -
Net consolidation adjustments 8,000
Consolidated retained earnings - Dec. 31,20x1 118,000

(a) ABC’s share in the net change in XYZ’s net assets is computed as follows:
Net change in XYZ’s net assets (step2) 10,000
Multiply by: ABC’s interest in XYZ 80%
ABC’s share in the net change in XYZ’s net assets 8,000

Step 6: Consolidated profit or loss

Parent Subsidiary Consolidated
Profits before adjustments 60,000 20,000 80,000
Consolidation adjustments:
Unrealized profits ( - ) ( - ) ( - )
Dividend income from subsidiary ( - ) N/A ( - )
Gain or loss on extinguishment
of bonds ( - ) ( - ) ( - )
Net consolidated adjustments ( - ) ( - ) ( - )
Profit before FVA 60,000 20,000 80,000
Depreciation of FVA (8,000) (2,000) (10,000)
Impairment loss on goodwill ( - ) ( - ) ( - )
Consolidated profit 52,000 18,000 70,000

The shares in the depreciation of fair value adjustments (FVA) are computed as follows:
Total subsequent depreciation of fair value (step 2) 10,000
Allocation:
Parent’s share in depreciation of fair value (10,000 x 80%) 8,000
NCI’s share in depreciation of fair value (10,000 x 20%) 2,000
As allocated 10,000

Step 7: Profit or loss attributable to owners of parent and NCI

Owners NCI Consolidated
of parent
ABC’s profit before FVA (step 6) 60,000 N/A 60,000
Share in XYZ’s profit before FVA 16,000 4,000 20,000
Depreciation of FVA (step 6) (8,000) (2,000) (10,000)
Share in impairment loss on goodwill ( - ) ( - ) ( - )
Total 68,000 2,000 70,000
The share in XYZ’s profit before FVA are computed as follows:
Profit of XYZ before fair value adjustment (step 6) 20,000
Allocation:
ABC’s share (20,000 x 80%) 16,000
NCI’s share (20,000 x 20%) 4,000
As allocated: 20,000

The consolidated journal entries (CJEs) are as follows:

CJE #1: To eliminate investment in subsidiary and recognize goodwill
Dec. 31 Inventory 8,000
20x1 Equipment 10,000
Share capital - XYZ, Inc 50,000
Retained earnings - XYZ, Inc. 24,000
Goodwill 3,000
Investment in subsidiary 75,000
Non-controlling interest 18,000
Accumulated depreciation 2,000
to adjust the subsidiary’s assets to acquisition -date fair values, to eliminate
the investment in subsidiary and subsidiary’s pre-combination equity, and to
recognize goodwill and non-controlling interest in the consolidated financial
statements.
The entry above is exactly the same CJE #1 made at the acquisition-date consolidation. Notice that all
amounts pertain to the acquisition date. (see previous ‘Illustration: Consolidation - Date of acquisition; Case #1).

CJE #2: To recognize depreciation of fair value adjustments assigned to XYZ’s net identifiable assets at
acquisition date
Dec. 31, Cost of sales (dep’n of FVA on inventory) 8,000
20x1 Depreciation expense* 2,000
Inventory 8,000
Accumulated depreciation 2,000
*(P8,000 FVA on equipment ÷ 4 yrs.=P2,000)

Subsequent to 20x1, the accounts debited for the depreciation of fair value adjustments (FVA) recognized
in are the “retained earnings” of both the parent and the subsidiary for their respective shares.For
example, in the December 31, 20x2 consolidated, the subsequent depreciation of FVA is recorded as:
Dec. 31, Retained earnings - ABC (10K* x 80%) 8,000
20x1 Retained earnings - XYZ (10K* x 20%) 2,000
Depreciation expense 2,000
Inventory 8,000
Accumulated depreciation 4,000
*This amount pertains to the depreciation of FVA recognized in the preceding year.

CJE #3: To adjust the Parent’s and Subsidiary’s retained earnings for the depreciation of FVA during the
year
Dec. 31, Retained earnings - ABC [(8K + 2K) x 80%] 8,000
20x1 Retained earnings - XYZ [(8K + 2K) x 20%] 2,000
Income summary - working paper 10,000

CJE #4: To eliminate the post -acquisition change in XYZ’s net assets and to recognize NCI in
post-acquisition change in net assets
Dec. 31, Retained earnings - XYZ 18,000
20x1 Retained earnings - ABC 16,000
NCI (post - acquisition) 2,000

This amount can be simply “squeeze” after determining (e) and (f) or it can also be computed as follows:
Retained earnings - XYZ, Dec. 31, 20x1 44,000
Elimination of XYZ’s acquisition date retained earnings (CJE #1) (24,000)
NCI’s share in FVA (CJE#3) ( 2,000)
Remaining balance to be eliminated 18,000

This represents the parent’s share in the profit and loss of the subsidiary before FVA (‘step 7’).

This represents the profit or loss attributable to NCI (‘step 7’).

The sum of NCI’s in CJE’s #1 and #4 represents the NCI to be shown in the consolidated statement of
financial position.
Non-controlling interest in acquisition-date net assets (CJE#1) 18,000
Non-controlling interest in post- acquisition net assets (CJE#4) 2,000
Non-controlling interest in net assets - Dec. 31, 20x1 20,000

Notice that the amount of NCI in net asset above tallies with the amount computed in’ Step 4’.

We will now prepare the consolidation worksheet using the following guideline:
Statement of financial position:

Parent’s Subsidiary’s Consolidated

Assets & Assets & Assets &
Liabilities Liabilities Liabilities
(after
consolidation
adjustment )

Parent ‘s
Equity
Consolidated
Equity
Subsidiary’s a. Owners of
Equity parent
(eliminated and b. NCI (other
allocated)
owners of
subsidiary

Statement of profit or loss:

Parent’s Subsidiary’s Consolidated

Income & Income & Income &
Expense Expense Expense
(after
consolidation
adjustments)
The consolidated
profit is then
attributed to
both the owners
of the parent
and NCI.

ABC Co. XZY, Inc. CJE ref # Consolidation adjustments CJE ref. # Consolidated
ASSETS Dr. Cr.
Cash 23,000 57,000 80,000
Accounts
receivable 75,000 22,000 97,000
Inventory 105,000 15,000 1 8,000 8,000 2 120,000
Investment
in subsidiary 75,000 - 75,000 1 -
Equipment 200,000 50,000 1 10,000 260,000
Accumulated
Depreciation (60,000) (20,000) 4,000 1&2 (84,000)
Goodwill - - 1 3,000 3,000
TOTAL ASSET 418,000 124,000 476,000
LIABILITIES & EQUITY
Account payable 43,000 30,000 73,000
Bonds payable 30,000 - 30,000
Total liabilities 73,000 30,000 103,000
Share capital 170,000 50,000 1 50,000 170,000
Share premium 65,000 - 65,000
Retained earnings 110,000 44,000 1,3,&4 52,000 16,000 4 118,000
Non-controlling
interest - - 20,000 1&4 20,000
Total equity 345,000 94,000 373,000
TOTAL LIAB. & EQTY. 418,000 124,000 123,000 123,000 476,000
Sales 300,000 120,000 420,000
Cost of goods sold (165,000) (72,000) 2 8,000 (245,000)
Gross profit 135,000 48,000 175,000
Depreciation exp. (40,000) (10,000) 2 2,000 (52,000)
Distribution cost (32,000) (18,000) (50,000)
Interest exp. (3,000) - (3,000)
Profit of the year 60,000 20,000 70,000
The consolidated statement of financial position is shown below:
ABC Group
Consolidated statement of financial position
As of December 31, 20x1
ASSETS
Cash 80,000
Accounts receivable 97,000
Inventory 120,000
Equipment 260,000
Accumulated depreciation (84,000)
Goodwill 3,000
TOTAL ASSETS 476,000
LIABILITIES AND EQUITY
Accounts payable 73,000
Bonds payable 30,000
Total liabilities 103,000
Share capital 170,000
Share premium 65,000
Retained earnings 118,000
Owners of parent 353,000
Non-controlling interest 20,000
Total equity 373,000
TOTAL LIABILITIES & EQUITY 476,000

The consolidated statement of profit or loss is shown below:

ABC Group
Statement of profit or loss
For the year ended December 31, 20x1
Sales 420,000
Cost of goods sold (245,000)
Gross profit 175,000
Depreciation expense (52,000)
Distribution costs (50,000)
Interest expense (3,000)
Profit for the year 70,000
Profit attributable to:
Owner of the parents 68,000
Non-controlling interests 2,000
70,000

The following formulas may provide guidance in solving multiple choice problems as given in the CPA
board exams.

Consolidated total assets

Total assets of parent xx
Total assets of subsidiary xx
Investment in subsidiary (xx)
Fair value adjustments- net xx
Goodwill- net xx
Effect of intercompany transaction xx
Consolidated total assets xx

Consolidated total liabilities

Total liabilities of parent xx
Total liabilities of subsidiary xx
Fair value adjustments - net xx
Effect of intercompany transaction xx
Consolidated total liabilities xx

Consolidated total equity

Share capital of parent xx
Share premium of parent xx
Consolidated retained earnings xx
Equity attributable to owners of the parent xx
Non-controlling interests xx
Consolidated total equity xx
Using the formulas above, let us re-compute the totals in the consolidated financial statements.

Consolidated total assets

Total assets of parent 418,000
Total asset of subsidiary 124,000
Investment in subsidiary (75,000)
Fair value adjustments - net (16K -10K) 6,000
Goodwill - net (step 2) 3,000
Effect of intercompany transactions -
Consolidated total assets 476,000

Consolidated total liabilities

Total liabilities of parent 73,000
Total liabilities of subsidiary 30,000
Fair value adjustments - net -
Effect of intercompany transaction -
Consolidated total liabilities 103,000

Consolidated total equity

Share capital of parent 170,000
Share premium of parent 65,000
Consolidated retained earnings (step 5) 118,000
Equity attributable to owners of the parent 353,000
Non-controlling interest (step 4) 20,000
Consolidated total equity 373,000

SHORTCUTS
It is possible to prepare consolidated financial statements without preparing a detailed consolidation
worksheet (although this is not advisable). Analyze the computation below:
ASSETS Consolidated
Cash (23,000 +57,000) 80,000
Accounts receivable (75,000 + 22,000) 97,000
Inventory (105,000 + 15,000) 120,000
Investment in subsidiary (eliminated) -
Equipment (200,000 +50,000 + 10,000 FVA)(step 2) 260,000
Acc. depn. (60K +20K + 2K FVA + 2K dep’n. of FVA)(step 2) (84,000)
Goodwill (step 3) 3,000
TOTAL ASSETS 476,000

LIABILITIES AND EQUITY

Accounts payable(43,000 + 30,000) 73,000
Bonds payable (30,000 + 0 ) 30,000
Total liabilities 103,000
Share capital (Parent only) 170,000
Share premium (Parent only) 65,000
Retained earnings (step 5) 118,000
Equity attributable to owner of the parent 353,000
NCI in net assets (step 4) 20,000
Total equity 373,000
TOTAL LIABILITIES & EQUITY 476,000

Consolidated
Sales (300,000 + 120,000) 420,000
COGS (165K + 72K + 8K dep’n: of FVA on invty.)(step 2) (245,000)
Gross profit 175,000
Depn. Exp. (40K + 10K +2K dep’n. of FVA on equipt.)(step 2) (52,000)
Distribution costs (32,000 + 18,000) (50,000)
Interest expense ( 3,000)
Profit for the year 70,000
Intercompany Sales of Inventories

The intercompany profit in inventory transfer between affiliates is computed by multiplying the
inventory held by the buying affiliate which was acquired from the selling affiliate by the gross profit
rate based on sales of the selling affiliate.

The working paper elimination entries used in preparing consolidated financial statements must
eliminate fully the effects of all transactions between related companies. When there are intercompany
inventory transactons, eliminating entries are needed to remove the revenue and expenses related to the
intercompany transfers recorded by the individual companies. The elimination ensures that only the
historical cost of the inventory still on hands is included in the consolidated Statement of Financial
Position.

Intercompany Sales at Cost

Merchandise sometimes is sold to related affiliates at the seller’s cost. When an intercompany sales
include no profit or loss, the inventory amounts at the end of the period require no adjustment for
consolidation. At the time the inventory is resold to outsiders, the amount recognized as cost of goods
sold by the affiliate is the cost to the consolidated entity.

However, even when the intercompany sales includes no profit or loss, an eliminating entry is needed to
remove the intercompany sale and the related cost of goods sold recorded by the seller. This avoids
overstating these two accounts. Consolidated comprehensive income is not affected by the eliminating
entry when the intercompany sale is made at cost because both sales revenue and cost of goods sold are
reduced by the same amount.

Intercompany Sales at a Profit or Loss

Sale of inventory to affiliates are usually marked-up by a certain percentage of cost. For example, a
company may mark-up 50% of its inventory sales to its affiliates. Hence, inventory costing P2,000 will be
sold for P3,000. The elimination process will remove the effects of such sales in the consolidated
statements.

When intercompany sales include profits or losses, the working paper eliminations needed for
consolidation have two goals:
1. Elimination of the effects in the statement of CI of the intercompany sales by removing the sales
revenue from the intercompany sale and the related costs of goods sold recorded by the selling affiliate.
2. Elimination from the inventory on the Statement of Financial Position of any profit or loss on the
intercompany sales that has not been confirmed or realized by resale of the inventory to outsiders.

Inventory reported in the consolidated statement of financial position must be reported at cost to the
consolidated entity. Any profits or losses arising from intercompany sales must be eliminated.

DOWNSTREAM SALE OF INVENTORY

Downstream intercompany sales of merchandise are those made from a parent company to its
subsidiaries. For consolodation purposes, profits recorded on an intercompany inventory sale are realized
in the period in which the inventory is resold to outsiders. Until the point of resale, all intercompany
profits must be deferred. Consolidated CI must be based on the realized income of the selling affiliate. If
the intercompany sales of merchandise are made by the parent company or by wholly owned subsidiary,
there is no effect on any NCI in IC or loss, because the selling affiliates does not have NCI.

Parent and Subsidiary Companies entries

The journal entries to record the above transactions are as follows:

Books of Pete Corporation:

2016
April 1 (1) Cash 10,000
Sales 10,000
To record sale of merchandise of Sake Co.

(2) Cost of goods sold 8,000

Inventory 8,000
To record cost of inventory sold.
Books of Sake Company
2016
April 1 (3) Inventory 10,000
Cash 10,000
To record purchase of inventory from Pete Company.

Nov. 7 (4) Cash 15,000

Sales 15,000
To record sale of inventory to outsiders.

(5) Cost of goods sold 10,000

Inventory 10,000
To record cost of inventory sold to outsiders.

Illustration 1

Item Pete Sake Unadjusted Consolidated

Corporation Company Balances Amounts
Sales P10,000 P15,000 P25,000 P15,000
Cost of good sold ( 8,000) ( 10,000) ( 18,000) ( 8,000)
Gross profit P 2,000 P 5,000 P 7,000 P 7,000

Illustration. Assume again that Pete Corporation on April 1, 2016 sold merchandise to Sake Company
costing P8,000 for P10,000 or at a gross profit of 20%, out of which P4,000 remained unsold by Sake
Company on December 31, 2016.

Parent and Subsidiary Companies Entries

The above transaction are recorded in summary form by the two companies as follows:
Books of Pete Corporation. Journal entries (1) and (2), given previously for the sale of merchandise.
Books of Pete Company. For the purchase of merchandising journal entry (3). The sales of inventory to
outsiders is recorded as follows:

(6) Cash 7,500

Sales 7,500
To record sales to outsiders

(7) Cost of good sold 6,000

Inventory 6,000
To record cost of goods sold

The intercompany gross profit in Pete Corporation’s sales to Sake Company during the year ended
December 31, 2016, is analyzed as follows:

Illustration 2
Selling Price Cost Gross profit
( 20% of Selling Price )
Beginning inventory - - -
Add: Sales P10,000 P8,000 P2,000
Totals P10,000 P8,000 P2,000
Less: Ending inventory 4,000 3,200 800
Cost of goods sold P 6,000 P4,800 P1,200

Illustration 3
Selling Price Cost Gross profit
( 20% of Selling Price )
Beginning inventory P 4,000 P 3,200 P 800
Add: Sales 25,000 20,000 5,000
Totals 29,000 23,200 5,800
Less: Ending inventory 6,000 4,800 1,200
Cost of goods sold P23,000 P18,400 P4,600
UPSTREAM SALE OF INVENTORY

Upstream intercompany sales are those sales from subsidiaries to the parent company. When an
upstream sale of inventory occurs and the inventory is resold by the parent to outsiders during the same
period, all the parent entries and the eliminating entries in the consolidated working paper are identical
to those in the downstream case.

When the inventory is not resold to outsiders before the end of the period, working paper eliminating
entries are different from the downstream case only by the apportionment of the unrealized
intercompany to both the controlling and NCI. The intercompany profit in an upstream sale is recognized
by the subsidiary and shared between the controlling interest and NCI. Therefore, the elimination of the
unrealized intercompany profit will reduce the interests of both ownership groups until the profit is
realized by resale of the inventory to outsiders.

SUMMARY COMPARISON OF WORKING PAPER ELIMINATION ENTRIES

Illustration 4 below shows the elimination entries in 2016 and 2017 for both downstream and upstream
sales under the perpetual system.

2016
Downstream Sale Upstream Sale
Sales 10,000 Sales 10,000
Cost of goods sold 10,000 Cost of goods sold 10,000

Cost of goods sold 800 Cost of goods sold 800

Inventory 800 Inventory 800
2017
Downstream Sale Upstream Sale
Sales 25,000 Sales 25,000
Cost of goods sold 25,000 Cost of goods sold 25,000

Cost of goods sold 1,200 Cost of goods sold 1,200

Inventory 1,200 Inventory 1,200

Retained earnings , 1/1- Pete Retained earnings , 1/1- Pete

Corporation 800 Corporation 640
Cost of goods sold 800 NCI 160
Cost of goods sold 800
INTERCOMPANY SALE OF PROPERTY, PLANT AND EQUIPMENT

Intercompany sales of property, plant, and equipment are also identified as either downstream or
upstream because only upstream sales affect non-controlling interests.

Accounting procedures:
A. Any gain or loss is deferred and
a. Amortized over the asset’s remaining life, if the asset is depreciable.
b. Recognized only when the asset is sold to an unrelated party or otherwise derecognized, if the
asset is non-depreciable:
B. If the asset is subsequently sold to an unrelated party, the unamortized balance of the deferred gain
or loss is recognized in profit or loss.
C. In a downstream sale, the gain or loss is adjusted to the controlling interest only. Therefore, NCI is not
affected.
D. In an upstream sale, the adjustments for gain or loss are shared between the controlling interest and
NCI. Therefore, NCI is affected.
E. In any case, the unamortized balance of the deferred gain or loss is eliminated when the consolidated
financial statements are prepared.

Illustration: Consolidation - Intercompany PPE transaction

On January 1, 20x1, ABC Co. acquired 80% interest in XYZ, Inc. The business combination resulted to
goodwill of P3,000. On this date, XYZ’s equity comprised of P50,000 share capital and P24,000 retained
earnings. NCI was measured at its proportionate share in XYZ’s net identifiable assets.

XYZ’s assets and liabilities on January 1, 20x1 approximately their fair values except for the following:

XYZ, Inc Carrying Fair Fair value

amounts values adjustments (FVA)
Inventory 23,000 31,000 8,000
Equipment (4yrs. remaining life) 50,000 60,000 10,000
Accumulated depreciation (10,000) (12,000) (2,000)
Totals 63,000 79,000 16,000

On January 1, 20x1, ABC Co. sells equipment with a historical cost of P10,000 and accumulated
depreciation of P2,000 to XYZ, Inc. for P12,000, on cash basis. The equipment has a remaining useful life 4
years.

The year-end individual financial statements are shown below:

Statement of financial position
As at December 31, 20x1
ABC Co. XYZ, Inc
ASSETS
Cash 35,000 45,000
Accounts receivable 75,000 22,000
Inventory 105,000 15,000
Investment in subsidiary (at cost) 75,000
Equipment 190,000 62,000
Accumulated depreciation (56,000) (23,000)
TOTAL ASSETS 424,000 121,000

LIABILITIES AND EQUITY

Accounts payable 43,000 30,000
Bonds payable 30,000 -
Total liabilities 73,000 30,000
Share capital 170,000 50,000
Share premium 65,000 -
Retained earnings 116,000 41,000
Total equity 351,000 91,000
TOTAL LIABILITIES AND EQUITY 424,000 121,000
Statements of profit or loss
For the year ended December 31, 20x1

ABC Co. XYZ, Inc

Sales 300,000 120,000
Costs of goods sold (165,000) ( 72,000)
Gross profit 135,000 48,000
Depreciation exp. ( 38,000) ( 13,000)
Distribution costs ( 32,000) ( 18,000)
Interest expense ( 3,000) -
Gain on sale of equipment 4,000 -
Profit for the year 66,000 17,000

Requirements: Prepare the December 31, 20x1 consolidated financial statements:

Solutions:
Step 1: Analysis of effects of intercompany transaction
The intercompany sale is downstream because the seller is the parent (ABC Co.)

Let us analyze the effects of the intercompany sale having in mind the concept that it is as if the
intercompany sale never occurred:
Because of the sale Had there been no sale Effect on combined financial
statements before adjustments
a. ABC Co. recognized gain on a. No gain should have been a. Profit is overstated by
sale of P4,000 [P12,000 - recognized. P4,000.
P10,000 - P2,000)]
b. The equipment’s new cost b. The equipment’s historical b. The equipment’s cost is
is P12,000 the purchase cost is P10,000 overstated by P2,000.
price
c. The equipment’s c. The equipment’s c. Accumulated depreciation
accumulated depreciation accumulated depreciation on Jan. 1, 20x1 is
on Jan. 1,20x1 is zero on Jan. 1, 20x1 is P2,000 understated by P2,000.
because it has been
derecognized.
d. XYZ recognized d. ABC should have recognized d. Depreciation is overstated
depreciation of P3,000 in depreciation of P2,000 in by P1,000. Therefore, profit
20x1 (P12,000 purchase 20x1 (P8,000 carrying is understated by P1,000.
price ÷ 4yrs.). amount ÷ 4yrs.).
e. The equipment ‘s e. The equipment’s e. Accumulated depreciation
accumulated depreciation accumulated depreciation on Dec. 31, 20x1 is
on Dec. 31, 20x1 is P3,000 on Dec. 31, 20x1 should understated by P1,000.
(P0 beg. + P3,000 have been P4,000 (P2,000
depreciation). beg. + P2,000 depreciation).

CJE #1: To eliminate the gain on the intercompany sale

Dec. 31, Gain on sale of equipment (a)* 4,000
20x1 Equipment (b) 2,000
Accumulated depreciation- Jan. 1 (c) 2,000
*The letters are references to the analyses above.

CJE #2: To eliminate the overstatement in depreciation

Dec. 31, Accumulated depreciation (e) 1,000
20x1 Depreciation expense (d) 1,000

As stated earlier, the gain or loss on an intercompany sale of depreciable asset is initially deferred and
subsequently amortized over the remaining life of the asset. The amortization is done by eliminating
only the unamortized balance of the deferred gain as of the consolidation date. The amortized portion
remains.

The unamortized balance of the deferred gain is computed as follows:

Deferred gain on sale - Jan 1, 20x1 4,000
Multiply by: (3 yrs. remaining as of Dec. 31, 20x1 over 4 yrs.) 3/4
Deferred gain on sale - Dec. 31, 20x1 3,000
Notice from analysis (a) and (d) above that the net effect of the transaction is an overstatement in profit
for P3,000 (P4,000 overstatement - P1,000 understatement), equal to the unamortized balance of the
deferred gain. Only this amount should be eliminated. That is why the net effect of CJE’s #1 and #2 is a
decrease in profit for P3,000 (i.e., Dr. to gain of P4,000 and Cr. to depreciation expense of P1,000). The
P1,000 amortized portion remains in the accounts.

By year-end, the gain would have been closed to the seller’s retained earnings. Therefore, ABC’s retained
earnings shall be adjusted for the unamortized balance of the deferred gain.

CJE #3: To adjust the year-end retained earnings of the seller:

Dec. 31, Retained earnings - ABC Co. (downstream) 3,000
20x1 Income summary - working paper 3,000

Step 2: Analysis of net assets

XYZ, Inc. Acquisition Consolidation Net
date date change
Share capital 50,000 50,000
Retained earnings 24,000 41,000
Other components of equity - -
Totals at carrying amounts 74,000 91,000
Fair value adjustments at acquisition date 16,000 16,000
Subsequent depreciation of FVA NIL (10,000)*
Unrealized profits (upstream only) NIL -
Subsidiary’s net assets at fair value 90,000 97,000 7,000

*P8,000 dep’n. of FVA on inventory + P2,000 [(P10,000 - P2,000) ÷ 4 yrs.] dep’n. of FVA on equipment =
P10,000

Notice that the intercompany sales does not affect XYZ’s equity (and consequently NCI) because the sale
is downstream.

Step 3: Goodwill computation

The problem states that goodwill on acquisition date was P3,000. This is also the amount at year-end
because there is no impairment of goodwill during the year.

CJE #4: To eliminate investment in subsidiary and recognize goodwill

Dec.31, Inventory 8,000
20x1 Equipment 10,000
Share capital -XYZ, Inc. 50,000
Retained earnings - XYZ, Inc. 24,000
Goodwill 3,000
Investment in subsidiary 75,000
Accumulated depreciation 2,000
NCI at acquisition date (90K x 20%) 18,000

CJE #5: To recognized the depreciation of FVA during the year:

Dec. 31, Cost of sales (dep’n of FVA on inventory) 8,000
20x1 Depreciation expense* 2,000
Inventory 8,000
Accumulated depreciation 2,000
*(P10,000 - P2,000= P8,000 net FVA on equipment ÷ 4yrs. = P2,000)

CJE #6: To adjust the retained earnings accounts for FVA depreciation:
Dec. 31, Retained earnings - ABC [(8K + 2K) x80%] 8,000
20x1 Retained earnings -XYZ [(8K + 2K) x 20%] 2,000
Income summary - working paper 10,000

Step 4: Non-controlling interest in net assets

XYZ’s net assets at fair value - Dec. 31,20x1 (step 2) 97,000
Multiply by: NCI percentage 20%
Total 19,400
Add: Goodwill to NCI net of accumulated impairment losses -*
Non-controlling interest in net assets - Dec. 31,20x1 19,400
*No goodwill is attributed to NCI is measured at proportionate share.
Step 5: Consolidated retained earnings
ABC’s retained earnings - Dec. 31, 20x1 116,000
Consolidation adjustments:
ABC’s share in the net change in XYZ’s net assets 5,600
Unamortized deferred gain (downstream only) - (step 1) (3,000)
Gain or loss on extinguishment on bonds -
Impairment loss on goodwill attributable to Parent -
Net consolidation adjustments 2,600
Consolidated retained earnings - Dec. 31, 20x1 118,600

Net change in XYZ’s net assets (step 2) of P7,000 x 80% = P5,600

Step 6: Consolidated profit or loss

Parent Subsidiary Consolidated
Profits before adjustments 66,000 17,000 83,000
Consolidation adjustments:
Unamortized def. gain - (step 1) (3,000) ( - ) (3,000)
Dividend income from subsidiary ( - ) N/A ( - )
Gain or loss on extinguishment of bonds ( - ) ( - ) ( - )
Net consolidated adjustments (3,000) ( - ) (3,000)
Profits before FVA 63,000 17,000 80,000
Depreciation of FVA (8,000) (2,000) (10,000)
Impairment loss on goodwill ( - ) ( - ) ( - )
Consolidated profit 55,000 15,000 70,000

Shares in the depreciation of FVA: (10,000 x 80%); (10,000 x 20%)

Step 7: Profit or loss attributable to owners of parent and NCI

Owners NCI Consolidated
ABC’s profit before FVA (step 6) 63,000 N/A 63,000
Share in XYZ’s profit before FVA 13,600 3,400 17,000
Depreciation of FVA (step 6) (8,000) (2,000) (10,000)
Share in impairment loss on goodwill ( - ) ( - ) ( - )
Totals 68,600 1,400 70,000

Shares in XYZ’s profit before FVA (step 6): (17,000 x 80%); (17,000 x 20%)

CJE #7: To eliminate the post- acquisition change in XYZ’s net assets and to recognized NCI in
post-acquisition change in net assets

Dec. 31, Retained earnings - XYZ (squeeze) 15,000

20x1 Retained earnings - ABC 13,600
NCI ( post- acquisition) 1,400
This is the parent’s share in XYZ’s profit before FVA (step 7)
This is the profit attributable to NCI (step 7)
 ABC Co. XYZ, Inc CJE ref.# Consolidation adjustments CJE ref. # Consolidated
ASSET Dr. Cr.
Cash 35,000 45,000 80,000
Accounts
receivable 75,000 22,000 97,000
Inventory 105,000 15,000 4 8,000 8,000 5 120,000
Investment in
subsidiary 75,000 - 75,000 4 -
Equipment 190,000 62,000 4 10,000 2,000 1 260,000
Accumulated
depreciation (56,000) (23,000) 2 1,000 6,000 1,4,&5 (84,000)
Goodwill - - 4 3,000 3,000
TOTAL ASSETS 424,000 121,000 476,000
LIABILITIES & EQUITY
Accounts
Payable 43,000 30,000 73,000
Bonds pay. 30,000 - 30,000
Total liab. 73,000 30,000 103,000
Share capital 170,000 50,000 4 50,000 170,000
Share premium 65,000 - 65,000
Retained earnings 116,000 41,000 3,4,6,6,&7 52,000 13,600 7 118,600
Non-controlling
interest - - 19,400 4&7 19,400
Total equity 351,000 91,000 373,000
TOTAL LIAB & EQTY 424,000 121,000 124,000 124,000 476,000
Sales 300,000 120,000 420,000
Cost of goods sold (165,000) (72,000) 5 8,000 (245,000)
Gross profit 135,000 48,000 175,000
Depreciation exp. (38,000) (13,000) 5 2,000 1,000 2 (52,000)
Distribution cost (32,000) (18,000) (50,000)
Interest exp. ( 3,000) - (3,000)
Gain on saleof equip. 4,000 1 4,000 -
Profit for the year 66,000 17,000 70,000

The consolidated statement of financial position is shown below:

ABC Group
Consolidated statement of financial position
As of December 31, 20x1
ASSETS
Cash 80,000
Accounts receivable 97,000
Inventory 120,000
Equipment 260,000
Accumulated depreciation (84,000)
Goodwill 3,000
TOTAL ASSETS 476,000
LIABILITIES AND EQUITY
Accounts payable 73,000
Bonds payable 30,000
Total liabilities 103,000
Share capital 170,000
Share premium 65,000
Retained earnings 118,000
Owners of parent 353,600
Non-controlling interest 19,400
Total equity 373,000
TOTAL LIABILITIES AND EQUITY 476,000
The consolidated statement of profit or loss is shown below:
ABC Group
Statement of profit or loss
For the year ended December 31, 20x1
Sales 420,000
Cost of goods sold (245,000)
Gross profit 175,000
Depreciation expense (52,000)
Distribution cost (50,000)
Interest expense (3,000)
Profit for the year 70,000
Profit attributable to:
Owners of the parent 68,600
Non-controlling interests 1,400
70,000

Reconciliation using formulas:

Total assets of ABC Co. 424,000
Total assets of XYZ, Inc. 121,000
Investment in subsidiary (72,000)
Fair value adjustments - net (16K - 10K) 6,000
Goodwill -net 3,000
Effect of interco. transaction - unamortized deferred gain (3,000)
Consolidated total assets 476,000

Total liabilities of ABC Co. 73,000

Total liabilities of XYZ, Inc 30,000
Fair value adjustments - net -
Effect of intercompany transactions -
Consolidated total liabilities 103,000

Share capital of ABC Co. 170,000

Share premium of ABC Co. 65,000
Consolidated retained earnings 118,000
Equity attributable to owners of the parent 353,600
Non-controlling interests 19,400
Consolidated total equity 373,000
Intercompany dividends

When the investments in subsidiary is measured at cost or in accordance with PFRS 9, the dividends
received from the subsidiary is recognized in profit or loss when the parent’s right to receive the
dividends is established.

When the investment in subsidiary is measured using the equity method, the dividends received from
the subsidiary is recognized as reduction to the carrying amount of the investment.

In any case, the dividends must be eliminated when the consolidated financial statements are
prepared. It is as if the parent never received the dividends. Therefore:
a. If the dividends were recognized in profit or loss, eliminated the dividend income in the
consolidated statement of profit or loss.
b. If the dividends were recognized as reduction to the investment account, add back the dividends to
the investment account.

Illustration: Consolidation - Intercompany dividend transaction

On January 1, 20x1, ABC Co. acquired 80% interest in XYZ, Inc. by issuing 5,000 shares with fair value
of P15 per share. On this date, XYZ’s equity comprised of P50,000 share capital and P24,000 retained
earnings. NCI was measured at its proportionate share in XYZ’s net identifiable assets.

XYZ’s assets and liabilities on January 1, 20x1 approximate their fair value except for the following:

XYZ, Inc Carrying Fair Fair value

Amounts values adjustments (FVA)
Inventory 23,000 31,000 8,000
Equipment (4yrs. remaining life) 50,000 60,000 10,000
Accumulated depreciation (10,000) (12,000) (2,000)
Totals 63,000 79,000 16,000

XYZ, Inc. Declared and paid dividends of P6,000 during 20x1. There was no impairment in goodwill.
The year-end individual financial statements are shown below:

Statements of financial position

As at December 31, 20x1
ABC Co. XYZ, Inc.
ASSETS
Cash 27,800 51,000
Accounts receivable 75,000 22,000
Inventory 105,000 15,000
Investment in subsidiary (at cost) 75,000
Equipment 200,000 50,000
Accumulated depreciation (60,000) (20,000)
TOTAL ASSETS 422,800 118,000

LIABILITIES AND EQUITY

Accounts payable 43,000 30,000
Bonds payable 30,000 -
Total liabilities 73,000 30,000
Share capital 170,000 50,000
Share premium 65,000 -
Retained earnings 114,800 38,000
Total equity 349,000 88,000
TOTAL LIABILITIES AND EQUITY 422,800 118,000
Statements of profit or loss
For the year ended December 31, 20x1
ABC Co. XYZ, Inc.
Sales 300,000 120,000
Costs of goods sold (165,000) (72,000)
Gross profit 135,000 48,000
Depreciation expense (40,000) (10,000)
Distribution costs (32,000) (18,000)
Interest expense ( 3,000 ) -
Dividend income 4,800 -
Profit for the year 64,800 20,000

Requirements: Prepare the December 31, 20x1 consolidated financial statements.

Solution:

Step 1: Analysis of effects of intercompany transaction

The dividends declared by XYZ are allocated as follows:
Total dividends declared P6,000
Allocation:
Owners of the parent (6,000 x 80%) 4,800
Non-controlling interest (6,000 x 20%) 1,200
As allocated P6,000

Since the investment in subsidiary is measured at cost, ABC must have recognized the dividends as
dividend income (see statement of profit or loss above). This is eliminated as follows:
CJE #1: To eliminate the dividend income recognized by the parent.

Dec. 31, Dividend income 4,800

20x1 Income summary 4,800

By year-end, the dividend income would have been closed to ABC’s retained earnings. This shall be
reverted back to XYZ’s retained earnings. It is as if the parent never received the dividends.

CJE #2: To adjust retained earnings for the dividend transaction

Dec.31, Retained earnings - ABC Co. 4,800
20x1 Retained earnings - XYZ, Inc 4,800

If the dividends were declared but not yet paid, an additional CJE shall be made to eliminate the
“Dividends receivable” accounts.

Step 2: Analysis of net assets

XYZ, Inc Acquisition Consolidation Net
date date change
Share capital 50,000 50,000
Retained earnings 24,000 38,000
Other components of equity - -
Totals at carrying amounts 74,000 88,000
Fair value adjustments at acquisition date 16,000 16,000
Subsequent depreciation of FVA NIL (10,000)*
Unrealized profits (Upstream only) NIL -
Subsidiary’s net assets at fair value 90,000 94,000 4,000
*P8,000 dep’n. of FVA on inventory + P2,000 [(P10,000 - P2,000) ÷ 4 yrs.]
dep’n. of FVA on equipment = P10,000
Step 3: Goodwill computation
We will use ‘Formula #1’ because NCI is measured at proportionate share.

Consideration transferred (5,000 sh. x P15) 75,000

Non-controlling interest in the acquiree (90K x 20%) - (step 2) 18,000
Previously held equity interest in the acquiree -
Total 93,000
Fair value of net identifiable assets acquired (step 2) (90,000)
Goodwill at acquisition date 3,000
Accumulated impairment losses since acquisition date -
Goodwill , net - current year 3,000

CJE #3: To eliminate investment in subsidiary and recognized goodwill

Dec. 31, Inventory 8,000
20x1 Equipment 10,000
Share capital - XYZ, Inc. 50,000
Retained earnings - XYZ , Inc. 24,000
Goodwill 3,000
Investment in subsidiary 75,000
NCI (acquisition date) 18,000
Accumulated depreciation 2,000

CJE #4: to recognize the depreciation of FVA during the year:

Dec. 31, Cost of sales (dep’n. of FVA on inventory) 8,000
20x1 Depreciation expense* 2,000
Inventory 8,000
Accumulated depreciation 2,000
*(P10,000 - P2,000= P8,000 net FVA on equipment ÷ 4yrs. = P2,000)

CJE #5: To adjust the retained earnings accounts for FVA depreciation:
Dec. 31, Retained earnings - ABC [(8K + 2K) x80%] 8,000
20x1 Retained earnings -XYZ [(8K + 2K) x 20%] 2,000
Income summary - working paper 10,000

Step 4: Non-controlling interest in net assets

XYZ’s net assets at fair value - Dec. 31,20x1 (step 2) 94,000
Multiply by: NCI percentage 20%
Total 18,800
Add: Goodwill to NCI net of accumulated impairment losses -*
Non-controlling interest in net assets - Dec. 31,20x1 18,800

Step 5: Consolidated retained earnings

ABC’s retained earnings - Dec. 31, 20x1 114,800
Consolidation adjustments:
ABC’s share in the net change in XYZ’s net assets 3,200
Unrealized profits (Downstream only) -
Gain or loss on extinguishment on bonds -
Impairment loss on goodwill attributable to Parent -
Net consolidation adjustments 3,200
Consolidated retained earnings - Dec. 31, 20x1 118,000
P4,000 net change in XYZ’s assets (step 2) x 80%
The dividends received from the subsidiary are not separately adjusted in the formula above because
their effects is automatically eliminated by including only the parent’s share in the net change in the
subsidiary’s net assets.
Step 6: Consolidated profit or loss
Parent Subsidiary Consolidated
Profits before adjustments 64,800 20,000 84,800
Consolidation adjustments:
Unrealized profits - - -
Dividend income from subsidiary ( 4,800) N/A (4,800)
Gain or loss on extinguishment of bonds - - -
Net consolidated adjustments (4,800) - (4,800)
Profits before FVA 60,000 20,000 80,000
Depreciation of FVA (8,000) (2,000) (10,000)
Impairment loss on goodwill ( - ) ( - ) ( - )
Consolidated profit 52,000 18,000 70,000
Shares in the depreciation of FVA: (10,000 x 80%); (10,000 x 20%)

Step 7: Profit or loss attributable to owners of parent and NCI

Owners NCI Consolidated
ABC’s profit before FVA (step 6) 60,000 N/A 60,000
Share in XYZ’s profit before FVA 16,000 4,000 20,000
Depreciation of FVA (step 6) (8,000) (2,000) (10,000)
Share in impairment loss on goodwill ( - ) ( - ) ( - )
Totals 68,000 2,000 70,000
Shares in XYZ’s profit before FVA (step 6): (20,000 x 80%); (20,000 x 20%)

CJE #6: To eliminate the post- acquisition change in XYZ’s net assets and to recognized NCI in
post-acquisition change in net assets

Dec. 31, Retained earnings - XYZ (squeeze) 16,800

20x1 Retained earnings - ABC 16,000
NCI ( post- acquisition) 800
This is the parent’s share in XYZ’s profit before FVA (step 7)
This is the profit attributable to NCI (step 7) minus the dividend to NCI

Profit attributable to NCI (step 7) 2,000

Less: NCI dividend (P6,000 x 20%) (1,200)
NCI in post-acquisition change in net assets 800

This can be reconciled as follows:

NCI net assets

18,000 NCI at acquisition date (step 3)
800 NCI post- acquisition
Dec. 31, 20x1 (step 4) 18,800

or

NCI net assets

18,000 NCI at acquisition date (step 3)
NCI in dividends (step 1) 1,200 2,000 NCI Profit attributable to NCI (step 7)
Dec. 31, 20x1 (step 4) 18,800

We will now prepare the consolidation worksheet

 ABC Co. XYZ, Inc CJE ref.# Consolidation adjustments CJE ref. # Consolidated
ASSET Dr. Cr.
Cash 27,000 51,000 78,800
Accounts
receivable 75,000 22,000 97,000
Inventory 105,000 15,000 3 8,000 8,000 4 120,000
Investment in
subsidiary 75,000 - 75,000 3 -
Equipment 200,000 50,000 3 10,000 260,000
Accumulated
depreciation (60,000) (20,000) 4,000 3&4 (84,000)
Goodwill - - 3 3,000 3,000
TOTAL ASSETS 422,800 118,000 474,800
LIABILITIES & EQUITY
Accounts payable 43,000 30,000 73,000
Bonds pay. 30,000 - 30,000
Total liab. 73,000 30,000 103,000
Share capital 170,000 50,000 50,000 3 170,000
Share premium 65,000 - 65,000
Retained earnings 114,800 38,000 2,3,5,5&6 55,600 20,800 2&6 118,000
Non-controlling
interest - - 18,800 3 18,800
Total equity 349,800 88,000 371,800
TOTAL LIAB & EQTY 422,800 118,000 126,600 126,600 474,800
Sales 300,000 120,000 420,000
Cost of goods sold (165,000) (72,000) 4 8,000 (245,000)
Gross profit 135,000 48,000 175,000
Depreciation exp. (40,000) (10,000) 4 2,000 (52,000)
Distribution cost (32,000) (18,000) (50,000)
Interest exp. ( 3,000) - (3,000)
Gain on saleof equip. 4,800 1 4,000 -
Profit for the year 64,800 20,000 70,000

The consolidated statement of financial position is shown below:

ABC Group
Consolidated statement of financial position
As of December 31, 20x1
ASSETS Dec. 31 Jan. 1
Cash 78,800 15,000
Accounts receivable 97,000 42,000
Inventory 120,000 71,000
Equipment 260,000 260,000
Accumulated depreciation (84,000) (32,000)
Goodwill 3,000 3,000
TOTAL ASSETS 474,800 359,000
LIABILITIES AND EQUITY
Accounts payable 73,000 26,000
Bonds payable 30,000 30,000
Total liabilities 103,000 56,000
Share capital 170,000 170,000
Share premium 65,000 65,000
Retained earnings 118,000 50,000
Owners of parent 353,000 285,000
Non-controlling interest 18,800 18,000
Total equity 371,800 303,000
TOTAL LIABILITIES AND EQUITY 474,800 359,000
The consolidated statement of profit or loss is shown below:
ABC Group
Statement of profit or loss
For the year ended December 31, 20x1
Sales 420,000
Cost of goods sold (245,000)
Gross profit 175,000
Depreciation expense (52,000)
Distribution cost (50,000)
Interest expense (3,000)
Profit for the year 70,000
Profit attributable to:
Owners of the parent 68,000
Non-controlling interests 2,000
70,000

Optional reconciliations:
Instead of using the previous formulas, we can also reconcile some of the amounts computed using
T-accounts:
Consolidated retained earnings
50,000 beg. (see comparative info)
Profit attributable to
Dividend declared by Parent - 68,000 owners of parent (step 7)
Dec. 31, 20x1 (step 5) 118,000

Consolidated Total equity

303,000 beg. (see comparative info.)
Dividends declared by Parent - 70,000 Consolidated profit (step 6)
NCI in dividends (step 1) 1,200
Dec. 31, 20x1 371,800
Translation of Foreign Financial Statement (IAS 21)

ACCOUNTING PROCEDURES

Accountants of the Philippines company usually perform the following steps in the translation and
consolidation of the foreign entity financial statements:

1. Receivable foreign entity’s financial statements, which are reported in foreign currency.
2. Translate the statements in eign currency to Philippine peso. Each foreign entity account balance must
be individually transforlated into its Philippine peso equivalent, as follows:
Accounts Appropriate Account in
in foreign + exchange = Philippine peso
currency units rate equivalent value
3. Consolidated the translated foreign entity’s accounts, which are now stated in Philippine Peso, with
the Philippine company’s accounts.

DEFINITION OF KEY TERMS (in accordance with IAS 21)

The following term are usually used in the translation of foreign financial statements:
 Functional currency. The currency of the primary economic environment in which the entity
operates.
 Exchange difference. The difference resulting from translating a given number of units of one
currency into another currency at different exchange rates.
 Foreign operation. A subsidiary, associate, joint venture, or branch whose activities are based or
conducted in a country or currency other than that of the reporting entity.
 Closing rate. The spot exchange rate at the balance sheet date.
 Spot rate. The exchange rate for immediate delivery.
 Presentation currency. The currency that is used to present the financial statements.

Functional Currency
The functional currency should be determined by looking at several factors. This currency should be the
one in which the entity normally generates and spends cash and in which transactions are normally
denominated. All transactions in currencies other than the functional currency are treated as
transactions in foreign currencies . Five factors can be considered in making this decision: the currency.
(1) That mainly influences the price at which goods and services are sold.
(2) Of the country whose competitive forces and regulations mainly influence the entity’s pricing
structure.
(3) That influences the costs of equity
(4) In which funds are generated.
(5) In which receipts from operating activities are retained.
The first three items are generally considered to be the most influential in deciding the functional
currency.

TRANSLATION OF FINANCIAL STATEMENTS OF FOREIGN OPERATIONS

A foreign operation is an entity that is a subsidiary, associate, joint venture, or a branch of the reporting
entity, the activities of which are based or conducted in a country or currency other than those of the
reporting entity. For a local parent entity, it is not necessary that its foreign operation must be located
in another country. It may own a subsidiary that is incorporated and located in Singapore, but if that
subsidiary conducts its business in a functional currency ( the primary currency of the foreign entity’s
operating environment) other than that of the parent, that subsidiary located in another country, but if
that subsidiary conducts its business in the same functional currency as that of the parent, that subsidiary,
although a foreign operation, is considered to be an integral part of the parent’s operations.

With respect to the translation to be used, IAS 21 changes the requirements of the original IAS 21 by not
distinguishing between integral foreign operations and foreign entities. Instead, all overseas subsidiaries,
branches, associates and joint ventures are now classified as foreign operations. As a result of applying
the functional currency concept,
(a) There is no longer a distinction between integral operations and foreign entities.
Instead, an entity that was previously classified as an integral foreign operation will have the
same functional currency as the reporting entity (the need to translate to the functional currency
will not arise); and
(b) Only one translation method is prescribed for foreign operations, i.e., the closing or the current
rate method, that was applied to foreign entities under the original IAS 21 .
The Closing Rate Method

When the Closing rate method is used, exchange difference can arise from three sources, as follows:

(i) Translating the opening net assets in the foreign operation at an exchange rate different from
that at which it was previously reported;
(ii) Translating the income and expenses items (net retained earnings for the period) at the rates at
the dates of transactions ( or at a rate that approximates the actual rates, such as the average rate)
but assets and liabilities at the closing rate; and
(iii) Other changes to equity in the foreign entity, such as an asset revaluation.
If the financial statements of the entity are not in the functional currency of a hyperinflationary economy,
then IAS 21 prescribes the following procedures to translate foreign entity’s statements from its
functional currency into the presentation currency:
(a) Translate all items of financial position, including the allocated goodwill, at the closing rate,
except for share capital and pre-acquisition surplus which should be translated at their historical rate.
Post-acquisition profits are derived based on the balances in their year-to-year translations. Exchange
surplus are derived as the balancing figure.
(b) Translate all items of income and expenses in profit or loss at the average rate or as the
accounting policy requires. Translate items of other comprehensive income at the average rate (e.g. fair
value gain of financial assets) or rate ruling at valuation date (e.g. revaluation surplus).
(c) Retained earnings brought forward should be based on the prior year’s post-acquisition profits
in the presentation currency (e.g. in the local peso). Interim dividend paid is translated at the actual rate
ruling at the date of payment while dividend payable, if any, is translated at the closing rate.
(d) Prepare the consolidated financial statements using the normal consolidation procedures.
(e) Prove the total exchange differences as follows:

(i) Net assets and goodwill at acquisition date translated at closing rate minus net assets
and goodwill at acquisition date translated at their historical rate;
(ii) Year-to-year increase in net assets (i.e.., retained earnings for each year) translated at
closing rate minus their year-to-year reported amounted in Philippine Peso;
(iii) Any revaluation surplus arising during the year translated at the closing rate minus the
amount translated at the date of the revaluation.

Note that the above proof is for the total exchange differences. If movements in exchange surplus
(reserves) are required, then the proof should be as follows:
(i) Obtain the prove the exchange difference as at the end of the prior year (using the same
technique as described above but applying it to the position as at the end of the prior year);
(ii) Retranslate the opening net assets and goodwill of the subsidiary at the current year’s closing
rate;
(iii) If the average rate is used to translate the items in the statement of profit or loss and other
comprehensive income, retranslate the retained earnings and items of other comprehensive income for
the year at the closing rate;
(iv) If there has been a revaluation of property,plant and equipment during the year, retranslate the
surplus at the closing rate;
(v) Allocate the exchange difference between parent and non-controlling interest and produce the
consolidated statement of changes in equity.

Translation of Foreign Financial Statements under Hyperinflationary Economy

Determine whether an economy is hyperinflationary in accordance with IAS 29 requires judgment. The
standard does not establish an absolute rule at which hyperinflation is deemed to arise. However, when
cumulative inflation over three years approaches or exceeds 100%, it must be conceded that the
economy is suffering from hyperinflation.

Accounting for Hyperinflation

Financial statements of entities whose functional currency is that of a hyperinflationary economy first
have to be restated and then translated under IAS 21 if their parent has a different presentation
currency, in order that they can be incorporated in the consolidated financial statements of the parent
company.
APPENDIX

Accounting Records Not Kept in the Functional Currency - Remeasurement

Complications may arise if an overseas subsidiary, keeps its accounting records in its local currency
(normally required for compliance with the local statues), which is not its functional currency. IAS 21
clarifies that “when an entity keeps its books and records in a currency other than its functional currency,
at the time the entity prepares its financial statements all amounts are translated into the functional
currency, so as to produce the same amounts in the functional currency as would have occurred had the
item been recorded initially in the functional currency”.

In this case, re-measurement procedures of the items in the entity’s accounts is required. Such
translating procedures for re-measurement are often known as the “temporal method “ in the
accounting literature.

The re-measurement process begins by classifying assets and liabilities as either monetary or
nonmonetary items and then applying the appropriate exchange rate depending on whether the items in
monetary or nonmonetary. The following rules apply to the re-measurement process:

(a) Monetary assets and monetary liabilities are re-measured using the current rate at the balance sheet
date (closing rate).
(b) Nonmonetary assets and liabilities (e.g., land, building) which have historical cost balances are
re-measured using historical exchange rate at the date the item entered the subsidiary.
(c) Owner’s equity accounts such as common stock and additional paid in capital are translated using
historical rates.
(d) Dividends is translated at the historical rate at the date of declaration.
(e) Retained earnings is brought forward from the translated statement of the previous year.
(f) Revenues and most expenses that occur during a period are re-measured, for practical purposes,
using the weighted-average exchange rate for the period. However, revenues and expenses that
represent allocations of historical balances (e.g., depreciation) are re-measured using the same historical
exchanges rates as used for those items on the balance sheet.
(g) The re-measurement loss is reported on the consolidated statement of comprehensive income. The
loss is the result of a re-measurement process which assumes that the Philippine peso is the functional
currency.
(h) The calculation of the re-measurement loss is the result of the rules employed in the
re-measurement process. In mechanical terms, the re-measurement loss is the amount needed to make
the debits equal the credits in the foreign company’s Philippine peso trial balance.

The re-measurement and the translation processes are illustrated in the following illustrative problem.
 Liquidation - is the termination of business operations or the winding up of affairs. It is
process by which the assets of the business are converted into cash, the liabilities of the
business are settled, and any remaining amount is distributed to the owners.
 Entities undergoing liquidation measure their assets and liabilities in the statement of affairs at
realizable value.
 Liquidating entities usually prepare the following classes of financial reports: (a) Statement of
Affairs and (b) Statement of realization and liquidation. Additional statements such as note
disclosures and summary of cash receipts and disbursements may also be prepared.
 The statement of affairs is the initial report prepared at the start of the liquidating process.it
shows the financial position of the liquidating entity - the assets that are available for sale,
the claims of creditors to be settled, and the claims of the owners.
 Assets in the statement if affairs are classified into the following: (1) Assets pledged to fully
secured creditors; (2) Assets pledged to partially secured creditors; and (3) Free assets.
 Liabilities in the statement of affairs are classified into the following: (1) Unsecured liabilities
with priority; (2) Fully secured creditors; (3) Partially secured creditors; and (4) Unsecured
liabilities without priority.
 Assets pledged to fully secured creditors - assets with realizable values equal to or greater than
the realizable values of the related liabilities for which these assets have been pledge as
security.
 Assets pledged to partially secured creditors - assets with realizable value less than the
realizable values of the related liabilities for which these assets have been pledged as security.
 Free assets - assets that have not been pledged as security of liabilities. These also include the
excess of realizable values of assets pledged to fully secured creditors over the realizable values
of related liabilities for which these assets have been pledged.
 Unsecured liabilities with priority - liabilities that, although not secured by any assets, are
mandated by law to be paid first before any other unsecured liabilities, e.g., administrative
expenses, unpaid employee salaries and other benefits, and taxes and assessment.
 Fully secured creditors - liabilities secured by assets with realizable value equal to or greater
than the realizable values of such liabilities.
 Partially secured creditors - liabilities secured by assets with realizable value less than the
realizable values of such liabilities.
 Unsecured liabilities without priority - all other liabilities.

 The estimate deficiency to unsecured creditors without priority can be computed using the
formula below:

Estimated deficiency = Assets at realizable value less Liabilities at realized value

 The estimated recovery percentage of unsecured creditors without priority can computed using
the formula below:

Estimated recovery percentage Net free assets

of unsecured creditors without = Total unsecured liabilities
priority without priority

 The net free assets can be computed as follows:

Total assets at realizable values xx
Less: Unsecured creditors with priority (xx)
Fully secured creditors (xx)
Realizable value of asset pledged to partially
secured creditors (xx)
Net free assets xx
 The total unsecured liabilities without priority can be computed as follows:
Unsecured creditor without priority xx
Plus: Deficiency of assets pledged to partially secured
creditors (partially secured liability less realizable value of asset xx
pledged to partially secured creditors)
Total unsecured liabilities without priority xx

 The estimated recovery of partially secured creditors is equal to the realizable value of the assets
pledged plus the excess amount multiplied by the estimated recovery percentage.
 The estimated recovery of unsecured creditors without priority is equal to their claims multiplied
by the estimated recovery percentage.
 The statement of realization and liquidation is a periodic report, normally prepared by a
receiver, which shows information on the progress of the liquidation process. It is depicted like
the following T-account.

Debits Credits
Assets to be realized, excluding cash Assets realized
Assets acquired Assets not realized

Liabilities liquidated Liabilities to be liquidated

Liabilities not liquidated Liabilities assumed

Supplementary expenses Supplementary income

 Assets to be realized, excluding cash - represents the total non-cash assets available for disposal
as of the beginning of the period. This is measured at book value.
 Asset acquired - represents previously unrecorded assets that were recognized during the
period.
 Assets realized - represents the actual net proceeds received from the sale of non-cash assets
during the period.
 Assets not realized - represents the total cash available for disposal at the end of the period. This
is measured at book value.
 Liabilities to be liquidated - represents the total liabilities to be settled as of the beginning of the
period. This is measured at book value.
 Liabilities assumed - represents previously unrecorded liabilities that were recognized during the
period.
 Supplementary expenses / income - items of income and expenses realized/incurred during the
period.

There is net gain if total credits exceeds total debits; there is net loss if total debits exceeds total
credits.

 Reorganization - in its broadest sense, means the implementation of a business plan to

restructure or rehabilitate a corporation with the hopes of increasing company value. In most
cases, reorganization involves changing the entity’s capital structure.
 The following are some of the types or corporate reorganization: (a) group reorganization, (b)
recapitalization, (c) quasi-reorganization, (d) corporate rehabilitation, and (e) troubled debt
restructuring.
INVESTMENT IN JOINT ARRANGEMENTS

A joint arrangement as defined is an arrangement of which two or more parties have joint control.
Despite the diverse forms and structures, all joint arrangements have two characteristics in common,
and they are:
(a) The parties are bound by a contractual arrangement; and
(b) The contractual arrangement gives two or more of those parties joint control of the
arrangement.

The first characteristics of contractual arrangement is usually (though not necessarily) evidenced in
writing, e.g., by a formal contract amongst the parties or by the articles or by-laws of the joint
arrangement. Statutory mechanism can also relate enforceable arrangement, either on their own or
in conjunction with contracts between the parties. When the arrangements are structured through a
separate vehicle, the contractual arrangement, or some aspects of the contractual arrangement, will
in some cases be incorporated in the articles, characters or by-laws of the separate vehicle.

The second characteristics requires that all parties must collectively control the arrangement. No
single party is in a position to control unilaterally the joint arrangement.

A “party to a joint arrangement” is an “entity that participants in a joint arrangement”, regardless of

whether that entity has joint control of the arrangement.

A separate vehicle is a separately identifiable financial structure, including separate legal entities or
entities recognized by statue. Separate vehicle maybe in the form of a corporation.

CONTRACTUAL ARRANGEMENTS
The contractual arrangement sets outs the term upon which parties participates in the activity that is
the subject of the arrangement. Contractual arrangements generally specify the following:
 Purpose, activity and duration of the joint arrangement
 Appointment of members of the board of directors (or equivalent governing body)
 Decision-making processes:
 Matters requiring decisions from the parties
 Voting rights of the parties
 Required level of agreement for those matter
 Capital or other contributions requirements
 Sharing of assets, liabilities, revenues, expenses or profit or loss relating to the joint
arrangement.

ACCOUNTING FOR JOINT OPERATION

For a joint operator recognizes its:
 Assets, including its share of any assets held jointly
 Liabilities, including its share of any liabilities incurred jointly
 Revenue from the sales of its share of the output arising from the joint operation
 Share of the revenue from the sales of the output by the joint operation
 Expenses, including its share of any expenses incurred jointly.

For joint arrangement not structured through a separate vehicle, the contractual arrangement
establishes the parties’ rights to the assets, and obligations for the liabilities , and the parties’ rights to
the corresponding revenues and obligations for the corresponding expenses.

For joint operations that are structured through a separate vehicle, IFRS 11 does not provide any
explicit guidance, but where the classification as a joint operation has been based on contractual
terms, the guidance above would be relevant.
ACCOUNTING FOR JOINT VENTURES

A joint venturer shall recognize its interest in a joint venture as an investment and shall account for
that investment using the equity method. The proportionate consolidation as an option is eliminated.

Under the equity method, the investment in joint venture is initially recognized at cost, and adjusted
thereafter for the post-acquisition change in the venturer’s share of the joint venture’s net assets. The
venturer’s profit or loss includes its share of the joint venture’s profit or loss and the venturer’s other
comprehensive income includes its share of the joint venture’s other comprehensive income.

Equity Method of Accounting for an Associate

An entity recognizes its interest in an associate by applying the equity method. Under the equity
method, the investment is initially recorded at cost and the carrying amount is increased or decreased
by the investor’s share of the profits or losses of the joint venture or associate after the date of
acquisition. The investors takes its share of post-acquisition profit or losses irrespective of whether
dividends are distributed. Dividends received from a joint venture or an associate merely reduce the
carrying amount of the investment.

The carrying amount of the investments must also be adjusted for changes in the investor’s share of
the components of other comprehensive income (OCI) of the joint venture or associate after the
acquisition date. Examples of those changes includes those arising from the revaluation of property,
plant and equipment and intangible assets, from foreign exchange transaction differences, from the
remeasurement of the net defined benefit liability (assets), and from changes arising of fair valuing
available-for-sale investments. The investor’s share of those changes is recognized in the OCI of the
investor, and presented separately,as a one-line item of “share of OCI of a joint venture or associate
for items that would never be recycled to profit and loss” and as a one-line item for “share of OCI of a
joint venture or an associate for items that may be recycled to profit or loss” when the specified
conditions are met.

Under the equity method, the investors recognizes its share of an investee’s other net asset changes
(other than profit or loss or other comprehensive income and dividend received) directly in the
investor’s equity.

Components of Carrying Amount of Investment

In the consolidated financial statements of the investor, the carrying amount of the investment in
associate or joint venture is not eliminated but shown as a separate item as investment in joint
venture or associate, which may consist of the following components:

Cost of investment xxx

Add: Share of post-acquisition changes in net assets:
Post-acquisition retained earnings xxx
Post-acquisition other OCI (Revaluation surplus) xxx
Other net asset changes xxx
Carrying amount in the consolidated financial position xxx

TRANSACTIONS WITH AN ASSOCIATE OR JOINT VENTURE

In the case of intercompany (intragroup) transactions between a parent and its subsidiaries, full
elimination of such transactions and their unrealized profit or losses is required. The rationale
underlying this full elimination is the group of companies, being viewed as a single economic units,
cannot possibly generate results by transacting with itself.
The principle of Partial eliminations

IAS 28 requires that unrealized profits or losses resulting from “upstream” and “downstream”
transactions between an investing group and its associates or joint ventures which are included in the
carrying amount of the related assets should be eliminated partially to the extent of the investment
group’s interest in the associates or joint ventures. The rationale underlying the partial elimination is
that an investor, when transacting with its associates or joint venture, is considered to be transacting
partly with itself to the extent of its interest in the associate or joint venture, and partly with third
parties to the extent of their interests in the associates or joint venture.

Intercompany Sales if Inventories with an Associate or Joint Venture

Where intercompany sales of inventories with an associate or a joint venture occur at all the
inventories have subsequent been sold to third parties within the relevant accounting period, no
unrealized profit or loss arises. Accordingly, no consolidation adjustments (eliminations) for those
transactions are required, as the investor’s share of the profits or losses would have been realized
insofar as the group is concerned. This non-adjustment applies even if the transactions are
downstream sales by the investors to its associate or joint venture. In such cases, it is conceptually
wrong to eliminate partially the downstream sales, because such sales have been realized
subsequently by the associate or joint venture and the associate’s or joint venture’s sales are not
consolidated in the group accounts. As such, any elimination of the downstream sales to the associate
or joint venture will result in an understatement of the group’s revenue.

If some of the inventories from these intercompany sales with an associate or joint venture are still
held by the buyer, unrealized profit or losses arise. Accordingly, consolidation adjustments are
required to eliminate the investor’s share of these profits or losses. The consolidation adjustment
(eliminations), however, differ depending upon the direction of the transactions.

Remeasurement and Realization of OCI Reserve

If the investments becomes a subsidiary, the investor shall account for its investment in accordance
with IFRS 3 Business Combinations, and IFRS 10 Consolidated Financial Statements. In such cases, the
investors needs to apply the step acquisition requirements of IFRS 3 and the consolidation
requirements of IFRS 10 thereafter.

When there is a loss of joint control or significant influence (as in a partial disposal) and where the
retained interest in the former associate or joint venture is a financial asset, the investor shall
measure the retained interest fair-value. The fair value of the retained interest shall be regarded at its
value on initial recognition as a financial asset in accordance with IFRS 9. The investors shall recognize
in profit or loss any difference between:

(a) The fair value of any retained interest and any proceeds from disposing of a part interest in the
associate or joint venture; and
(b) The carrying amount of the investment at the date the equity method was discontinued.

When the use of the equity method is discontinued, the investor shall account for all amounts
previously recognized in other comprehensive income in relation to that investments as if the
investee had directly disposed of the related assets or liabilities. This means that if there are
previously recognized components of other comprehensive income in the former associate or joint
venture, the related reserves shall be reclassified to profit or loss or transferred to retained profits
directly at the date the equity method ceases.

Thus, exchange translation reserve of foreign operations, fair value reserve of AFS investments and
cash flow hedge reserve in the former associate or joint venture shall be reclassified to profit or loss.
On the other hand, any realization of revaluation reserve of property, plant and equipment shall be
directly transferred to retained profits in the statement of changes in equity. Similarly, for a financial
asset designated at fair value through other comprehensive income in accordance with IFRS 9, no
reclassification adjustment is allowed, and hence, the realization is by a direct transfer to retained
profits.

Other Intercompany Balances with an Associate or a Joint Venture

Apart from the equity investment, other intercompany balances with an associates or a joint venture
may include:
(a) Loans to or from the associate or joint venture
(b) Amounts due to or due from the associate or joint venture (balance arising from unsettled normal
trading transactions); and
(c) Dividends receivable from the associate or joint venture.

These balances must not be eliminated on consolidation simply because the items in the statement of
financial position of the associate or joint venture are not consolidated. They should be separately
disclosed in the consolidated financial statements under their respective classifications, such as
long-term loans to or from the associate or joint venture and amount due from or due to the
associates or joint venture under current assets or current liabilities respectively.

It should also be noted that no attempt should be made to adjust, in the group accounts, for interest
income or expense arising out of loans to or from the associate or joint venture, as such interest has
rightfully been earned or incurred (realized) between the investor and its associates or joint venture.
Accounting for Foreign Currency Transaction

Measured versus Denominated

It is useful to have an understanding of these two terms used in accounting of foreign currency
transactions. Assets and liabilities are denominated in one currency if their amount is fixed in terms of
that currency. However, they must be measured (for financial reporting purposes) in another currency.

When a transaction is to be settled by the receipt or payment of a specific currency, the receivable or
payable is said to be denominated in that currency. Regardless of the currency in which a transaction is
denominated, the party to the transaction measures and records the transaction in the currency (local
currency) in which the party is located. For example, a Philippine importer purchases goods on credit
from a U.S exporter who is to be paid in U.S dollars. The transaction is denominated in US dollars ($) but
measured and recorded by the Philippine importer in Philippine pesos (₱). However, the U.S exporter’s
transaction is both denominated and measured in US dollars.

Conversion and Translation

It is important to know the distinction between the conversion and translation of foreign currencies. In
the case of the example above, the Philippine importer converts Philippine pesos on the date of payment
into US dollars at the prevailing rate of exchange.

On the other hand, the assets, liabilities, and operating items of a foreign branch or subsidiary are
translated into Philippine pesos to consolidate them into the financial statements of the Philippine hone
office or parent company. No actual exchange of currencies is involved, only a translation into a single
currency.

Currency Exchange Rate

The exchange rate is the rate in which the currencies of two countries are exchanged at a particular time.
The buying and selling of foreign currencies as though they were commodities result in variation in the
exchange rate between the currencies of two countries. For example, a daily newspaper might quote
exchange rates for the US dollars ($) as follows, based on the prior day’s transactions in the Philippines
Stock Exchange:

ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS

A transaction that requires settlement or payment in a foreign currency is called a foreign currency
transaction. A transaction with a foreign company that is to be pain in Philippine peso is not a foreign
currency transaction to a Philippine company, because the amount of peso to be received or paid to
settle the account is fixed and is not affected by subsequent changes in the exchange rate. Thus, a
transaction of a Philippine company with a foreign company to be settled in pesos is accounted for in the
same manner s if it transaction had been with a company in the Philippines.

Often, however, the transaction described is negotiated and settled in terms of the foreign company’s
local currency unit. In such cases, the Philippine company must account for the transaction denominated
in foreign currency in terms of Philippines pesos. This accounting, described as foreign currency
translation, is accomplished by applying the appropriate exchange rate between the foreign currency
and the Philippine pesos.

Some of the more common foreign currency transactions are:

1. Importing and exporting goods on credit with the receivable or payable denominated in foreign
currency.
2. Borrowing or lending denominated in foreign currency.
3. Entering into a forward exchange contract to buy and sell foreign currency.

Importing and Exporting of Goods

This is the most common form of foreign currency transaction. In each unsettled foreign currency
transaction, there are three (3) issues of concern to the accountant. These issues and the appropriate
exchange rate to be used in translating accounts denominated in units of foreign currency (except for
forward exchange contracts) are as follows:

1. At the date the transaction is first recognized, Each asset, liability, revenue, gain or loss arising from
the transaction is measured and recorded in Philippine pesos by multiplying the units of foreign exchange
by the closing exchange rate, that is, the spot rate in effect on a given date.

2. At each balance sheet date that occurs between the transaction date and the settlement date.
Recorded balances that are denominated in a foreign currency are adjusted to reflect the closing
exchange rate in effect at the date o the statement of financial position. Foreign exchange (forex) gain or
loss is recognized for the difference in the exchange rate between the transaction date and the balance
sheet date.

3. At the settlement date. In the case of a foreign currency payable, a Philippine company must convert
Philippine pesos into foreign currency units to settle the account, while foreign currency units received to
settle a foreign currency receivable will be converted into pesos. Although translation is not required, a
foreign exchange (forex) gain or loss is recognized if the amount of peso paid or received upon
conversion does not equal the carrying value of the related payable or receivable.

Marginal Deposit on Letter of Credit (LC). Some banks may require importers to make a marginal deposit
upon opening of LC. As an example, let us assume that BPI required Manila Corporation to give a 25%
marginal deposit on the $10,000 letter of credit. The exchange rate given by the bank on November 15,
2017 is P50.00 to US$1. The entry to record this transaction is:

2017
Nov. 15: Marginal deposit on LC 125,000
Cash 125,000
To record marginal cost on LC
25% x ($10,000 x P50.00).

On the date of settlement of the LC, this marginal deposit is applied as payments.

Two- Transaction Perspective and One- Transaction Perspective

The journal entries above reflect the two-transaction perspective for recording foreign trade transaction.
Under the concept, Manila’s transaction with the US supplier basically were two-separate transactions.
One transaction was the purchase of the merchandise; the second transaction was the acquisition of the
foreign currency required to pay the LC for the merchandise purchased.

Under the one-transaction perspective, Manila’s total foreign exchange loss of P4,000 on its purchase
from the US supplier should be applied to increase the cost of merchandise purchased. Under the
approach, Manila would not prepare a journal entry on December 31, 2016, but would prepare the
following entry on January 10, 2017.

2017
Jan. 10: Acceptance payable 505,000
Purchases 4,000
Cash 509,000
To record payment of LC for P509,000
($10,000 x P50.90), and increase purchase for resulting forex loss.

In effect, the one-transaction perspective considers the original amount recorded for the purchase of
foreign merchandise as an estimate, subject to adjustment when the exact cash outlay required for the
purchase is known.

The authors supports the two-transaction perspective for foreign trade transactions and for loans
receivable and payable denominated in foreign currency.

Foreign Exchange (forex) Gains and Losses

From the foregoing illustrations, it shows that increases in the selling spot rate for a foreign currency
required by a Philippine Company to settle a liability denominated in that currency generate foreign
exchange (forex) losses to the company because more Philippine pesos are required to obtain the foreign
currency. Conversely, decreases in the selling spot rate produce foreign exchange (forex) gains to the
company because fewer Philippine pesos are required to obtain the foreign currency. In contrast,
increases in the buying spot rate for a foreign currency to be received by a Philippine company in
settlement of receivable denominated in that currency generate foreign exchange (forex) gains to the
company; decreases in the buying spot rate produce foreign exchange (forex) losses. These relationships
are summarized below:
 Statement of FP Effect on balance Statement
account affected reported of CI effect
Increase in exchange rate:
Importing transaction Payable Increase Loss
Exporting transaction Receivable Decrease Gain

Decrease in exchange rate:

Importing transaction Payable Decease Gain
Exporting transaction Receivable Decrease Loss

Foreign exchange gains and losses are included in the measurement of net income for the accounting
period in which the exchange rate (spot rate) changes (PAS 21).
Home office, Branch and Agency Accounting

Branch and Agency distinguished

New sales outlets may be organized as sales agencies or branches. A sales agency is not a self- contained
business but rather acts only on behalf of the home office. On the other hand, a branch is a
self-contained business which acts independently, but within the bounds of company policy and subject
to the control of the home office.

The following further differentiate these two:

Sales agency Branch
 Displays merchandise and takes customers’  Carries stock of merchandise used to fill
order but does not carry stock of customers’ orders (or provides services
merchandise to fill customers’ orders. similar to those provided by the home
office).
 Customers’ orders are sent to the home  Grants credit in accordance with the
office for approval of credit. Customers company’s policies, makes normal
remit payments directly to the home office. warranties, fill customers’ order, and makes
collections on sales.
 Holds revolving cash fund provided by the  Has its own assets and liabilities and
home office that is replenished when generates its own revenues and incurs its
depleted. Not other cash funds are held. own expenses. Makes periodic remittances
to home office subject to company policy.
 Not a separate accounting entity. The only  A separate accounting entity for internal
accounting records maintained are cash reporting. It maintains its own complete set
receipts and cash disbursement books of accounting records.
necessarily to account for the revolving
fund. The main office maintains records of For external reporting, the branch’s
sales made through the agency and the financial statements are combined with the
expenses it incur. home office’s financial statements.

Accounting for an agency

Since an agency does not maintain its own separate accounting books, all of its transactions are recorded
in the books of the home office. The agency maintains a simple records (e.g., a log book) to record its
cash receipts and cash disbursements, similarly to a petty cash system.

In order to identity the transactions of the agency from other transactions, the home office may set up
specific account codes and accounts titles for the agency.

For example, the revolving fund of a certain may be an account title “Cash - Agency #1,” and designated a
code similar to the following: <101 - 103> - where the 1st digit (1) refers to assets the 2nd and 3rd digits
refer to the agency (01), the 4th digit (1) refers to “cash” and the last two digits refer to “revolving fund”
(03).

Illustration: Accounting for agency

Agency transactions Home office books
Jan. 1
Receipt of revolving fund from home office. Cash - Agency #1 1,000
Cash on hand 1,000
Jan. 1 - 31
Orders sent by agency to home office. Accounts receivable 200
Sales - Agency #1 200

Cost of sales - Agency 120

Inventory 120

Collection by home office of agency sales Cash on hand 200

Accounts receivable 200
Jan. 1 - 31 No entry
Disbursements from the revolving fund
Jan. 31
Replenishment of revolving fund Various expenses - Agency #1 50
Cash on hand 50
To determine the profit attributable to the Sales - Agency #1 200
agency, the following closing entry shall be Cost of sales 120
made: Various expenses- Agency#1 50
Income summary - Agency #1 30
Accounting for branch operations
A branch is accounted for as a separate business unit, but subject to the control of the home office. The
home office determines the degree of self-management exercised by the branch.

The branch maintains its own records and prepares its own financial statements. However, the branch’s
financial statements are combined with the home office’s financial statements when preparing general
purpose financial statements.

Combined financial statements are prepared by:

1. Adding together similar items of assets, liabilities, income and expenses, and
2. Eliminating reciprocal accounts.

Reciprocal accounts (Interoffice or Intra-company accounts)

Transactions of either the home office or the branch with external parties are recorded in the normal
way.Thus, the PFRSs apply when recording these transactions.

However, for internal reporting purposes, transactions between a home office and its branch are
recorded in reciprocal accounts, namely:
1. “Investment in branch” account (or ‘Branch current’ account)
- the home office maintains this account in its books to account for its investments in the branch.
2. “Home office” account (or ‘Home office current’ account)
- the branch maintains this account in its books to account for investments received from the home
office.

The “Investment in branch” is an asset account in the home office’s individual financial statements; while
the “Home office” is an equity account in the branch’s individual financial statements. These accounted
are eliminated when combined financial statements are prepared.

A branch is treated as a separate accounting entity for internal reporting. However, when preparing
financial statements for external reporting, the home office and its branch are viewed as a single
reporting entity. Moreover, the branch does not have a separate legal existence.

The reciprocal accounts are debited (credited) for the following:

Home Office’s books:

Investment in branch
(a) Asset transfers to
branch xx
(b) Assets received
xx from branch
(c) Profit of branch xx
(d) Loss on branch
(e) Liabilities and
expenses incurred or
paid by home office
on behalf of branch xx

Branch’s books
Home office
(a) Assets received from home
xx office
(b) Asset transfers to
home office xx
xx (c) Profit
(d) Loss xx
(e) Liabilities and expenses
incurred or paid by home
xx office on behalf of branch
Notice that for every debit in an account, there is a corresponding credit on the other account. Therefore,
these accounts must be equal at any given point of time. For instance, if the “investment in branch”
account in the home office books has a P20,000 debit balance, the “Home office” account in the branch
books must also have a corresponding P20,000 credit balance.

In case these accounts do not balance, reconciliation procedures similar to bank reconciliation, must be
performed. Adjusting entries should be made first before combined financial statements are prepared.

This is normally the case in actual practice. During your analytical procedures later on when auditing, do
check immediately if these account balance - this will save you time (not to mention from
embarrassment and sleepless nights if you commit oversight errors). Accounting for branches is very
common when auditing banks.

When an entity has more than one branch, a separate investment account for each branch is maintained
in the home office books.

Allocation of expenses
Expenses incurred and paid by the branch are recorded in the normal way. However, expenses incurred
by the home on behalf of the branch are recorded similarly to an investment (i.e., debit to investment
account and credit to home office account).
For instance, costs which are incurred centrally are allocated to the various business units within a single
company in order to have proper financial performance measurement for each of the business units. The
following are examples of costs which may be allocated to the branch:
a. Cost of maintaining information systems
b. Cost of contracts signed on a company level, e.g., security, pest control, insurance, advertising, and
the like
c. Depreciation computed under the group or composite method of depreciation
d. Other general overhead costs

Combined financial statements are prepared simply by: adding together similar items of assets, liabilities,
income and expenses, and eliminating the reciprocal accounts.

Illustration: Combined financial statements

The trial balances of ABC Co.’s home office and branch are shown below:
ABC CO.
Trial balance
December 31, 20x1
Home office Branch
Dr. (Cr.) Dr. (Cr.)
Cash 1,100,000 417,000
Account receivable 180,000 100,000
Inventory, beg. 650,000 -
Shipments from home office 230,000
Purchases 72,000 40,000
Freight-in 22,000 18,000
Shipments to branch (230,000)
Investment in branch 827,000
Equipment 720,000 400,000
Accumulated depreciation -equipment (72,000) (40,000)
Furniture 90,000 50,000
Accumulated depreciation -furniture (9,000) (5,000)
Accounts payable (72,000) (40,000)
Accrued expenses (45,000) (25,000)
Share capital (2,000,000)
Share premium (500,000)
Retained earnings-beg. (206,000)
Home office (827,000)
Sales (900,000) (500,000)
Depreciation expense 168,000 68,000
Utilities expense 18,000 10,000
General overhead expense 7,200 4,000
Various operating expenses 180,000 100,000
TOTAL - -
The home office and the branch have ending inventories of P270,000 and P150,000, respectively:
Requirement: Prepare the combined
a. Statement of financial position; and
b. Statement of profit or loss.
The reconciliation of reciprocal accounts
As of any given point of time, the “Investment in branch” and the “Home office” accounts must have
equal balances. If these accounts do not balance, reconciliation procedures must be performed.

Reconciling the reciprocal accounts is similar to bank reconciliation procedures. Reconciliation items can
be broadly classified into the following:

a. Transfers in-transit - at the time financial statements are prepared, there may be asset transfers
between the home office and the branch which were not yet recorded by the supposedly recipient.

For instance, there may be shipments of inventory made by home office which were not yet received
recorded by the branch by the end of reporting period. The adjusting entry would be simply a debit to
“Shipments from home office,” and probably to “Freight-in” also, and a corresponding credit to “Home
office” account.

b. Unrecorded Debit and Credit memos

A debit memo sent by the home office to the branch means that the home office has debited (increased)
the “Investment in branch” account. Therefore the corresponding entry to be made in the branch books
is a credit (increase) to the “Home office” account. The opposite applies to a credit memo.

For example, when the hone office collects account receivable on behalf of the branch, the home office
would record the transaction as a debit to cash and a credit to the “Investment in branch” account.
Therefore, to notify the branch of the transaction,the home office will send a credit memo to the branch.
The branch will in turn record the credit memo as a debit to the “Home office” account and a credit to
account receivable.

A debit memo sent by the branch to the home office means that the branch has debited (decreased) the
“Home office” account. Therefore, the corresponding entry to be made in the home office books is a
credit (decrease) to the “Investment in branch” account. The opposite applies to a credit memo.

For example, when the branch returns damaged merchandise received from the home office, the branch
would record the transaction as a debit to “Home office” account and a credit to “Shipments from home
office” account. Therefore, to notify the home office of the transaction, the branch will send a debit
memo to the home office. The home office will in turn record the debit memo as a debit to “Shipments to
branch” account and a credit to the “Investment in branch” account.

A lag in the recording of debit and credit memos can result to imbalance in the reciprocal accounts on
cut-off date.

c. Errors
Errors such as omissions in recording, double recording, mathematical mistakes, and the like can result to
imbalance in the reciprocal accounts.

Home office with several branches

As mentioned earlier, when an entity has more than one branch, separate investment accounts for each
of the branches shall be maintained in the home office books. Each branch shall maintain its own home
office account and shall record is own transaction with the home office. Transactions between a branch
and the home office will not affect the records of the other branches.

However, errors may arise if a transaction between a certain branch and the home office was
erroneously recorded by the home office to another branch’s investment account or a branch
erroneously records a transaction of another branch with the home office.

Special problems in Accounting for branch operations

In addition to the general procedures discussed earlier, the home office and branch may enter into some
transactions that would create special accounting problems. Such transactions are the following:
1. Merchandise shipments to branch billed at a price above cost
2. Inter-branch transactions

Although these transactions do not affect general purpose financial statements, they require some
special accounting for internal reporting purposes.
Shipments to branch billed at a price above cost
Billing to the branch may be made at amounts above cost, or cost plus an arbitrary percentage, also
known as the “billed price.” Information on actual costs is withheld from the branch. Thus, upon receipt
of shipments the branch records the merchandise received at the billed price, rather than at cost.

This is solely for internal reporting purposes. So that when comparing the profitability of the business
units within the company, the home office’s contribution to the company’s profit through procurement,
manufacturing, and other functions made centrally are not disregarded.

When shipments are billed at cost, the entire gross profit earned by the branch is attributed solely to the
branch. On the other hand, when shipments are billed at above cost, a portion of the gross profit earned
by the branch is attributed to the home office.

For example, let us say your mama gives you and your little sister allowance based on your respective
grades in school. However, you are obligated to tutor little sister, help her in her home works, fetch her
from school, cook dinner, wash the dishes, do the laundry, and many more! Now, would it be fair if
mama gives you a little mark up on your allowance to compensate for your extra hard work? Yes, of
course, right? Same is true with the home office (you), the branch (little sister), and the company (the
mama).

It should be noted that a shipment to the branch, even at billed price, is not a sale. Shipments are
recognized as sale only when they are sold to external parties. Therefore, any markup on shipments
made to the branch must be eliminated when combined financial statements are prepared. This is
necessary to restate the cost of goods sold and ending inventory of the branch to their original costs.

Combined financial statements - Shipments at billed price

When combined financial statements are prepared, the markups on shipments are eliminated in order to
restate cost of goods sold and ending inventory to their original costs. This is performed by eliminating
the “shipments to branch (from home office)” accounts, together with the related “allowance” account.
The “Investment in branch” and “Home office” accounts are also eliminated.
Installment Sales Method

Applicability
The “installment sales method” is a special case of revenue recognition which deviates from the revenue
recognition principles of PFRS 15.

The installment sales method may be used:

a. When the entity uses the “income tax basis” of accounting (National Internal Revenue Code ‘NIRC’ Sec.
49). The “Income tax basis” of accounting may be used for external reporting if the reporting entity is
used for external reporting if the reporting entity is a “micro entity”
b. When the entity makes a departure from the provision of the PFRSs under circumstances described in
PAS 1 Presentation of Financial Statements.

PAS 1.19 states that, “In the extremely rare circumstances in which management concludes that
compliance with a requirement in a PRFS would be so misleading that it would conflict with the objective
of financial statements set out in the Framework, the entity shall depart from that requirement (in the
manner set out in paragraph 20) if the relevant regulatory framework requires, or otherwise does not
prohibit, such a departure.”

In the case of (b) above, the entity shall provide the necessary disclosures required under PAS 1.

PAS 1.18 also states that, “An entity cannot rectify inappropriate accounting policies either by disclosure
of the accounting policies used or by notes or explanatory material.

Accounting procedures
Under the “installment sales method,” gross profit from an installment sale is initially deferred and
periodically recognized as the installment payments are received by multiplying the gross profit rate by
the installments received. This is exemplified by the formula below:

Realized gross profit = Gross profit rate x Collection on sale

On initial transaction date, the installment sale is recorded in the normal manner by debiting a receivable
account and crediting sales (and by debiting cost of sales and crediting inventory - in the case of a
‘perpetual inventory system.’)

However, the gross profit on the sale is deferred through a credit to a “deferred gross profit” account.
This account will then be adjusted for any realized gross profit as installment payments are received. The
deferred gross profit account is presented in the statement of financial position under noncurrent
liabilities.

Repossession
As protection for the collectability of the consideration receivable, the seller in installment sales normally
reserves his right to repossess the property sold in case of default by the buyer.

The repossessed property is accounted for as follows:

1. The repossessed property is debited to an inventory account at “fair value”

For purposes of applying the installment sales method, “fair value” is either:
A. The appraised value of the repossessed property; or
B. The estimate selling price of the repossessed property less reconditioning costs and normal profit
margin , at date of repossession.
C.
2. The balances in the related installment receivable and deferred gross profit accounts are
derecognized.

3. The difference between (1) and (2) is recognized in profit or loss as gain or loss on repossession.

Trade- ins
Seller often accept merchandise traded- in by buyers as part of down payment for sale of new
merchandise.

The merchandise traded-in is accounted for as follows:

1. The merchandise received is debited to an inventory account at “fair value”
 For purposes of applying the “installment sales method,” “fair value” is either:
A. The appraised value of the traded-in merchandise; or
B. The estimated selling price of the traded-in merchandise less reconditioning costs and normal profit
margin, at date of trade-in.

2. The seller gives the buyer a trade-in value for the traded -in merchandise. The trade-in value is
normally equal to the traded-in merchandise’s fair value. However, there may be bases where the
trade-in value given to the buyer is not equal to the fair value of the traded-in merchandise.

3. In cases where the trade-in value given to the buyer is not equal to the fair value of the trade-in
merchandise, the difference between the trade-in value and fair value is accounted for as follows:

A. If the trade-in value is greater than the fair value, the resulting difference is debited to an “Over
allowance on trade-in” account. The “over allowance” is treated as reduction to the installment sale
price of the new merchandise sold when computing for the gross profit and gross profit rate.
B. If the trade-in value is less than the fair value, the resulting difference is credited to an “Under
allowance on trade-in” account. The “under price” is treated as addition to the installment sale price
of the new merchandise sold when computing for the gross profit and gross profit rate.

Cost recovery method

Under the “cost recovery method,” the initial collections on the sale are treated as recovery of the cost of
the inventory sold. Thus, no gross profit or interest income is recognized until total collections from the
sale exceed the cost of inventory sold.

This method is different from the “cost-recovery approach” under PFRS 15 Revenue from Contracts
with Customers. Under the “cost-recovery approach” of PFRS 15, when the outcome of a performance
obligation that is satisfied over time cannot be reasonably measured revenue is recognized only to the
extent of costs incurred that the entity expects to recover.

PFRS 15 does not state that revenue recognition should be based on actual collection.Rather, revenue is
recognized only up to extent of costs that are expected to be collected. Costs incurred that are not
expected to be recovered are recognized immediately as expense.

Just like “installment sales method,” the “cost recovery method” (not the ‘cost-recovery approach’ of
PFRS 15) is also a deviation from the principles of PFRS.
Consignment Sales

Consignment arrangements
Under a consignment arrangement, an entity (called the ‘consignor’) delivers goods to another party
(called the ‘consignee’) who undertakes to sell the goods to end customers on behalf of the consignor.

The consignor recognizes revenue only when the consignee sells the consigned goods to end customers
because it is only at this point that the control of the asset is transferred to the customer.

Accordingly, the consigned goods are included in the consignor’s inventory until they are sold to the end
customer. The consignee records the consigned goods through memo entries only.

Freight and other incidental costs of transferring consigned good to the consignee (e.g., transportation
and insurance) form part of the cost of the consigned goods. Repair costs for damages during the
shipment and storage and other maintenance costs are charges as expense.

If the consignee shoulders the freight and other costs necessary in bringing the inventory to the
consignee’s location and condition for sale,

In a typical consignment, the consignee is entitled to commission based on sales. In other arrangements,
the consignee “purchases” the goods simultaneously with the sale of the goods to the final customer. In
effect, the consignee’s commission is based on the mark-up he made on the final selling price.
Commissions are accounted for as expense by the consignor and as income by the consignee. Accordingly,
commissions do not affect the cost of consigned goods.

Commissions earned by the consignee are normally deducted from the amount to be remitted to the
consignor. In cases where commission is given to the consignee in advance, the consignor records the
advanced commission as receivable and not cost of inventory. When the related goods are sold to the
end customer, the consignor derecognizes the receivable and recognizes commission expense.

When the consignor goods are sold to end customers,

 The consignor recognizes revenue at the gross amount of consideration, i.e., the sale price agreed
with the consignee.
 The consignee recognizes revenue at the commission or fee to which it is entitled.

Principal versus Agent considerations

When another party is involved in providing goods or services to a customer, the entity shall determine
whether it is acting as principal or an agent.

The entity is an principal if it controls the goods or service before the goods and services is transferred to
the customer. However, the entity is not necessary is principal if it obtains legal entity titled of a product
only momentarily before legal title is transferred to the customer.

A principal may personally satisfy a performance obligation or it may engage another party (for example,
a subcontractor) to satisfy some or all of a performance obligation on its behalf. When the performance
obligation is satisfied, the principal recognizes revenue at the gross amount of consideration.

The entity is an agent if its performance obligation is to arrange the provision of goods or services by
another party. When the performance obligation is satisfied, the agent recognizes revenue at the
commission or fee to which it is entitled.

The following are indicators that an entity is an agent (and therefore does not control the good or service
before it is provided to a customers):

a. Another party is primarily responsible for fulfilling the contract;

b. The entity does not have inventory risk before or after the goods have been ordered by a customer,
during shipping or on return;
c. The entity does not have discretion in establishing prices for the other party’s goods or services and,
therefore, the benefit that the entity can receive from those goods or services is limited;
d. The entity’s consideration is in the form of a commission; and
e. The entity is not exposed to credit risk for the amount receivable from a customer in exchange for the
other party’s goods or services.
Insurance contract
PFRS 4 defines an insurance contract as “a contract under which one party (the insurer) accepts
significant insurance risk from another party (the policyholder) by agreeing to compensate the
policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder.”

PFRS 4 provides the definitions for the following term:

 Insurer - the party that has an obligation under an insurance contract to compensate a policy if
an insured event occurs.
 Policyholder - a party that has a right to compensation under an insurance contract if an
insured event occurs.
 Insured event - an uncertain future event that is covered by an insurance contract and creates
insurance risk.

The definition of an insurance contract determines which contracts are within the scope of PFRS 4 rather
than other PFRSs. Thus, an entity shall apply PFRS 4 to all policies it issues or holds that falls within the
definition of “insurance contract” as provided under PFRS 4.

Essential elements in the definition of an insurance contract

1. Transfer of significant insurance risk - there is transfer of significant insurance risk from the insured
(policy holder) to the insurer (insurance provider).
2. Payment from the insured (premium) - generally, the insured pays to a common fund from which
losses are paid. However, not all insurance contracts have explicit premiums (e.g., insurance cover
bundled with some credit card contracts).
3. Indemnification against loss - the insurer agrees to indemnify the insured or other beneficiaries
against loss or liability from specified events circumstances (called as ‘insured event’ that may occur or be
discovered during a specified period.

Significant insurance risk

Risk (or uncertainty) is a fundamental element of an insurance contract. At least one of the following is
uncertain at the inception of an insurance contract:
a. The occurrence of an insured event;
b. The timing of the event; or
c. The level of indemnification that the insurer will need to pay the insured if the event occurs.

Risk - is the possibility of loss or injury when an uncertain future event occurs. Risk can be:

a. Speculative risk - a risk that can result in either gain or loss, e.g., fluctuation in the prices of
commodities, or
b. Pure risk - a risk that can produce a loss only.

Insurance risk - is risk, other than financial risk transferred from the holder of a contract to the issuer.

The risk must be pre-existing at the time the insurance contract was executed. A new risk created by the
contract is not insurance risk.

Insurance risk is significant if an insured event could cause an insurer to pay significant additional benefits
in any scenario, excluding scenarios that lack commercial substance.

Additional benefits refer to amounts that exceed those that would be payable if no insured event
occurred.

A contract that transfers only an insignificant insurance risk may not be accounted for under PFRS 4. Such
contract shall be accounted for under other relevant PFRSs.

Financial risk - is the risk of a possible future change in one or more of a special interest rate, financial
instrument price, commodity price, foreign exchange rate , index of prices or rates, credit rating or credit
risk or other variable, provided in the case of a non-financial variable that the variable is not specific to a
party to the contract.

A contract that exposes the issuer to financial risk without significant insurance risk is not an insurance
contract. From the definitions above, insurance risk includes only “pure risk”.

If both significant insurance risk and financial risk are present, the contract will be classified as an
insurance contract.
In addition of financial risk, the following risks are also not insurance risk:

A. Lapse or persistency risk - the risk that the counterpart will cancel the contract earlier or later than
the issuer had expected in pricing the contract earlier or later than the issuer had expected in pricing the
contract. This is not insurance risk because the payment to the counterparty is not contingent on an
uncertain future event that adversely affects the counterparty.

B. Expense risk - the risk of unexpected increases in the administrative costs associated with the
servicing of a contract , rather than in costs associated with insured events. This is not insurance risk
because an unexpected increase in expenses does not adversely affect the counterparty.

Legal principles of insurance

The principal objective of every insurance contract is to provide financial protection to the insured in case
of occurrence of an uncertain future event. Neither the “insured” nor the “insurer” shall misuse an
insurance contract to unjustly enrich himself at the expense of the other.

1. Principle of Insurance Interest

2. Principle of Utmost Good Faith (Ubrrimae fidei)
3. Principle of Indemnity
4. Principle of Contribution

Types of insurers

1. Governments insurance - operated and regulated by the government (e.g, Government Service
Insurance System( GSIS) which extends life insurance to government employees and Social Security
System (SSS) which extends life insurance to employees or employers in the private sector and other
voluntary members.

2. Propriety insurance - owned by stockholders and operated for profit. Policyholders are not among the
owners of the business.

3. Mutual insurance - owned by the policyholders themselves, who elect the board of directors, e.g.,
cooperative insurance.

Types of insurance contracts

For purpose of applying PFRS 4, insurance contracts may be classified as:

1. Direct insurance contract - an insurance contracts where the insurer directly accepts risk from the
insured and assumes the sole obligation to compensate the insured and assumes the sole obligations to
compensate the insured in case of a loss event. PFRS 4 defines a direct insurance contract as “an
insurance contracts that is not a reinsurance contracts.”

2. Reinsurance contract - an insurance contract issued by one insurer (the insurer) to compensate
another insurer (the cedant) for losses on or more contracts issued by the cedant.

Relevant items:
1. Reinsurer - the party that has an obligation under a reinsurance contract to compensate a cedant if an
insured event occurs.
2. Cedant - the policyholder under a reinsurance contract.

Types of reinsurance contracts

a. Proportional - the cedant and the reinsurer share on the premiums and claims in proportion to the
risk assumed.
Proportional reinsurance contracts may be either:
i. Treaty (Obligatory) - the reinsurer shares in all risk arising from all the insurance policies issued
by the cedant that are within the scope of the reinsurance contracts.
ii. Facultative (Specific) - the reinsurer shares only on specific risks on individual insurance policies
ceded by the cedant.

b. Non proportional (Excess of loss reinsurance) - in cases of loss events, the reinsurer is obliged to pay
only for claims exceeding a predetermined amount (also known as the cedant’s ‘retention limit’ or ‘net
retention’).
Liability adequacy test
At each reporting period, an insurer shall assess whether its recognized liabilities are adequate using
current estimates of future cash flows, and related items such as handling costs, arising under the
insurance contracts.

If the assessment shows that the carrying amount of the insurance liabilities (less related deferred
acquisition costs and related intangible assets) is inadequate compared to the current estimate, the
deficiency is recognized in profit or loss.

Carrying amount of Deficiency of

insurance liability (less related Current estimate of insurance
deferred acquisition costs Less than on insurance liability at = liability recognized
and related intangible assets. end of reporting period. on profit or loss

If the insurer’s accounting policies do not required a liability adequacy test to be carried out, as described
above, than an assessment is still required of the potential net liability (i.e.,the relevant insurance
liabilities less any related deferred acquisition costs). in these circumstances the insurer is required to
recognize at least the amount that would be required to be recognized as a provision under PAS 37
Provisions, Contingent Liabilities and Contingent Assets. Any deficiency in insurance liability is also
recognized in profit and loss.

PFRS 4 provides the following definitions:

 Insurance liability - an insurer’s net contractual obligations under an insurance contract.
 Insurance asset - an insurer’s net contractual rights under an insurance contract.
 Reinsurance assets - a cedant’s net contractual rights under a reinsurance contracts.
PARTNERSHIP

Accounting for partnerships

The Conceptual Framework for Financial Reporting and the Standard (or PFRS for SMEs, when
appropriate) are applicable to all reporting entities regardless of the type of organization. Thus, most
accounting procedures used for other types of business organizations are also applicable to partnerships.
The main distinction lies on the accounting for equity. In addition, the accounting for partnerships should
also comply with relevant provisions of the Civil Code of the Philippines.

The following are the major considerations in the accounting for the equity of a partnership:

a. Formation - accounting for initial investments to the partnership

b. Operation - division of profit or losses
c. Dissolution - admission of a new partner and withdrawal, retirement or death of a partner
d. Liquidation - winding- up of affairs

Formation
A contract of partnership is consensual. It is created by the agreement of the partnership which may be
constituted in any form, such as oral or written.

Division of profits and losses

The partner shall share in the profits or losses of a partnership in accordance with the partnership
agreement.

Art 1797 of the Philippine Civil Code provides the following additional rules in the profit or loss sharing of
partners:
If only the share of each partner in the profits has been agreed upon, the share of each in the
losses shall be in proportion to what he may have contributed. but the industrial partner shall
not be liable for the losses. As for the profits, the industrial partner shall receive such share as
may be just and equitable under the circumstances. If besides his service he has contributed
capital, he shall also receive a share in the profits in proportion to his capital.

The designation of losses and profits cannot be entrusted to one of the partners (Art. 1798). A stipulation
which excludes one or more partners from any share in the profits or losses is void (Art 1799).

In addition the partnership agreement may also stipulate the following:

a. Salaries - normally, an industrial partner receives salary in addition to his share in the partnership’s
office as compensation for his services to the partnership.

b. Bonuses - the managing partner may be entitled to a bonus for excellent management performance.
Unlike for salaries, a partner is entitled to a bonus only if the partnership earns profit. The partner is not
entitled to any bonus if the partnership incurs loss.

c. Interest on capital contributions - the partnership agreement may stipulate that each partner is
entitled to a per annum interest computed on his capital contributions.

Dissolution
As mentioned earlier, one of the characteristics of a partnership is that is has a “limited life,” in the sense
that the partnership agreement can be easily dissolve.

Dissolution is different from liquidation. Dissolution is the change in the relation of the partners cause by
any partner ceasing to be associated in the carrying on of the business. Liquidation is the termination of
business operations or the winding up of affairs.

Partnership dissolution does not necessarily terminate the business. The business continues until the
remaining partners decide to liquidate the business. If the business is continued after dissolution, new
articles of partnership should be drawn up.

The following are the major considerations in the accounting for partnership dissolutions.
a. Admission of a partner.
b. Withdrawal, retirement or death of a partner
c. Incorporation of a partnership
The admission of a new partner or the withdrawal, retirement or death of an existing partner dissolves
the original partnership agreement because it creates a change in the relation of the partners (e.g., a
change in the number of the partners in a partnership).

It should be noted that the admission of a new partner requires the consent of all the existing partners.

Admission of partner
The admission of a new partner may be effected either through:
a Purchase of interest in the partnership, or
b Investment in the partnership.

Purchase of interest
A new partner may be admitted when he purchases part or all the interest of one or more of the existing
partners.

This transaction is a personal transaction between and among the partners. As such, any consideration
paid or received is not recorded in the partnership books. The only entry to be made in the partnership
books is a transfer within equity. A new capital account is established for the new partner and a
corresponding decease is made on the capital account(s) of the selling partner(s). No gain or loss shall is
recognized in the partnership books.

Revaluation of asset
When a partnership is dissolve but not liquidated, a new partnership is created. The asset and liabilities
carried over to the new partnership are restated to fair values.

Any adjustments to the asset and liabilities is allocated first to the existing partners before recording the
admission of the new partner.

Investment in the partnership

Instead of purchasing interest from the existing partners, a new partner may be admitted by investing
directly in the business.

This transaction is a transaction between the new partner and the partnership. As such, any
consideration paid by the incoming partner shall be recorded in the partnership books. However, since
this is a transaction with an owner, no gain or loss shall be recognized.

Two things may happen when a new partner invests in a partnership:

1. The new partner’s capital account is credited at an amount equal to the fair value of his investment;
or
2. The new partner’s capital account is credited at an amount greater than or less than the fair value of
his investment.

Incorporation of partnership
There are various reasons for incorporating a partnership, which may include the following:
a. Limited liability of shareholders - shareholders are not liable to corporate creditors beyond their
investment in the corporation.
b. Ease of raising additional capital - greater capital can be raised from an increased number of owners.
Also, it is easier for a corporation to generate external financing, as lenders need not worry about the
death of the partners.
c. Privacy and confidentially - unlike in partnerships, the owners of a corporate are not agents of the
corporation.
d. Dispersion of risk - the risk of loss is dispersed to more owners.
e. Unlimited life - changes in the relationship of the owners of a corporation do not dissolve the
corporation.
f. Transferability of ownership - transferring an ownership in a corporation is made simply by selling
one’s share stocks. The corporation need not to be dissolved when a shareholder sells his interest in the
business.
g. Better public relations - many believes that wider ownership of a business results to better public
relations.

When a partnership is converted into a corporation, the corporation acquires and assumes the assets and
liabilities of the partnership in exchange for shares of stocks which shall be issued in settlement of the
partners’ respective interests.
Liquidation
Liquidation is the termination of business operations or the winding up of affairs. It is a process by which
1 the assets of the business are converted into cash,
2 the liabilities of the business are settled, and
3 any remaining amount is distributed to the owners.

Liquidation may either be voluntary (e.g., per agreement of partners of a solvent partnership) or
involuntary (e.g., per government mandate or bankruptcy).

Conversion of non-cash assets into cash

The conversion of assets into cash is referred to as “realization” while the settlement of claims or
creditors and owners is referred to as “liquidation”. However, the term liquidation is used in a broader
sense to include the entire winding up process.

The winding up process starts with the conversion of non-cash assets into cash. As such, the timing of the
“realization” of non-cash assets determines the manner on which the “liquidation” (i.e., payment of
claims) is carried out.

Methods of liquidation
Liquidation may be accomplished either through.
1. Lump-sum liquidation- all of the non-cash assets of the partnership are sold simultaneously or
within a very short period of time. The proceeds are then used to settle all of the liabilities first, and any
remaining amount is paid to the partners under a single, lump-sum payments.

Lump-sum liquidation is possible when there is a contracted buyer of all of the non-cash assets of
the partnership or the assets are sold on a “package deal” basis.

2. Installment liquidation - is most cases, it would take some time before all of the assets of a
business are converted into cash. In such case, the partners’ claims are settled on installment basis as
cash becomes available, but only after all partnership liabilities are fully settled.

Settlement of claims
The available cash of the partnership is used to settle claims in the following descending order:
1. First, to outside creditors;
2. Second, to inside creditors (e.g., payables to partners);
3. Third, to owners’ interests

Right of off-set
As shown above, a loan payable to a partner has a higher priority over the partner’s capital balance but a
lower priority over the claims of outside creditors. However, the legal right of offset allows a deficit in a
partner’s capital account to be offset by a loan payable to that partner.

Lump-sum liquidation vs. Installment liquidation

The following procedures shall be observed when accounting for lump-sum liquidation or installment
liquidation:
Lump-sum Installment
1. All of the non-cash assets are converted to cash. 1. Some of the non-cash assets are converted to cash.
2. The total gain or loss on the sale is allocated to the 2. The carrying amount of any unsold non-cash assets is
partner’s capital balances based on their profit or loss considered as a loss. This is allocated to the partners’
ratios. capital balances based on their profit and loss ratios.
3. Actual liquidation expenses are allocated to the 3. Actual and estimated future liquidation expenses are
partners’ capital balances based on their profit or loss allocated to the partners’ capital balances based on their
ratios. profit or loss ratios.
4. The liabilities to outside creditors are fully settled. 4. The liabilities to outside creditors are partially or fully
settled.
5. The liabilities to inside creditors are fully settled. 5. The liabilities to inside creditors are partially or fully
settled but only after settlement of the liabilities to
outside creditors.
6. Any remaining cash is distributed to the owners in full 6. If both the liabilities to outside and inside creditors
settlement of their interests. are fully settled, any remaining cash less cash set aside
for future liquidation expenses is distributed to the
owners as partial settlement of their interest.
Marshalling of assets

As mentioned earlier, one of the characteristics of a partnership is ‘unlimited liability”. This is because the
personal assets of the general partners are subject to the claims of partnership’s creditors in case of
partnership insolvency.

The legal doctrine of marshalling of assets is applied when the partnership and some of the partners are
insolvent. The following are the rules when applying this doctrine:
1. First, any available assets of the partnership is used to settle the partnership’s liabilities.
2. Second, in case the assets of the partnership are insufficient to pay all liabilities (i.e., insolvency), the
solvent general partners are required to provide additional funds their personal assets.
The claims to the personal assets of a partner shall rank in the following order:
a. Those owing to separate creditors.
b. Those owing to partnership creditors.
c. Those owing to partners by way of contribution.
3. Third, in case some partners are insolvent (or limited partners), their capital deficiency shall be offset
to the capital balances of the other partners. If after allocating the capital deficiency of an insolvent (or
limited) partner, a solvent partner’s capital balance result to a negative results to a negative amount, the
solvent partner is required to provide additional contribution.

Cash priority program

Another method of ensuring that there are no overpayments to partners is by preparing a “cash priority
program” or “cash distribution program.” This schedule determines which partner shall be paid first and
which partner shall be paid last, after all liabilities are settled. This schedule can be prepared even prior
to the sale of any asset.

The preparation of this schedule requires the application of the same concepts as those we have applied
earlier, namely:
a. Unsold non-cash assets are treated as loss; and
b. Expected future liquidation costs and potential unrecorded liabilities are recognized immediately as
losses.

An additional procedure when preparing a cash priority program is to rank the partners in accordance to
their maximum loss absorption capacity. The partner with the highest maximum loss absorption capacity
shall be paid first. The partner with the lowest maximum loss absorption capacity shall be paid last. The
formula in computing for the maximum loss absorption capacity is as follows:

Maximum loss Total partner’s interest in the partnership

absorption = Partner’s profit or loss share percentage
capacity
 An entity shall apply the principles in PFRS 15 in accounting for revenues from franchise
contracts.
 A construction contract is a contract specifically negotiated for the construction of an asset or a
combination of assets that are closely interdependent in terms of their design, technology and
function or their ultimate purpose or use.
 PFRS 15 requires the following steps when recognizing revenue from construction contracts:
Step 1: Identify the contract with the customer
Step 2: Identify the performance obligations in the contract
Step 3: Determine the transaction price
Step 4: Allocate the transaction price to the performance obligations
Step 5: Recognize revenue when (or as) a performance obligations is satisfied

Step 1: (a) The contract must be approved and the contracting parties are committed to it; (b) rights
and payments terms are identifiable; (c) has commercial substance; and (d) the consideration is
probable of collection. No revenue is recognized if the contract does not meet the criteria above.
Any consideration received is recognized as liability.

Step 2: Each promise in a contract to transfer a distinct good or service is treated as a separate
performance obligation.
 A good or service is distinct if:
(a) The customer can benefit from it, either on its own or together with other resources that are
readily available to the customer (e.g., the good or service is regularly sold separately); and
(b) The good or service is separately identifiable (i.e., not an input to a combined output, does
not significantly modify the other promises, or not highly interrelated with the other promises).

 The entity shall determine whether a performance obligation is satisfied over time or a point in
time.
 A performance obligation is satisfied over time or at a point in time.
 A performance obligation is satisfied over time if one of the following criteria is met:
a. The customer simultaneously receives and consumes the benefits provided by the entity’s
performance as the entity performs.
b. The entity’s performance creates or enhances an asset (e.g., work in progress) that the
customer control as the asset is created or enhanced.
c. The entity’s performance does not create an asset with an alternative use to the entity and
the entity has an enforceable right to payment for performance completed to date.
 If the entity cannot demonstrate that a performance obligation is satisfied over time, it is
presumed that the performance obligation is satisfied at a point in time.
 If the performance obligation is satisfied overtime , the entity shall determine a measure of
progress that best depicts its performance.

 Under the “cost-t-cost” method (an application of the inputs method), the entity’s measure of
progress is determined using any of the following formulas:

Percentage of completion = ( Total costs incurred to date ÷ Estimated total contract costs)
OR
Percentage of completion = Total costs incurred to date ÷ (Total cost incurred to date +
Estimated costs to complete)
 If the outcome of a performance obligation that is satisfied over time cannot be measured
reasonably, the entity shall recognize revenue only to the extent of costs incurred that are
expected to be recovered (i.e., zero-profit method).
 Changes in measure of progress are accounted for prospectively.
 When a construction contract becomes onerous (e.g., the expected contact costs exceed the
transaction price), the entity shall recognize a provision in accordance with PAS 37.
 An entity shall apply the principles in PFRS 15 in accounting for revenues from franchise
contracts.
 PFRS 15 defines a license as one that “establishes a customer’s right to the intellectual property
on an entity.” Franchise is an example of a license.
 PFRS 15 requires the following steps when recognizing revenue from franchise contracts:
Step 1: Identify the contract with the customer
Step 2: Identify the performance obligations in the contract
Step 3: Determine the transaction price
Step 4: Allocate the transaction price to the performance obligations
Step 5: Recognize revenue when ( or as ) a performance obligation is satisfied

 In addition to the general principles, PFRS 15 requires an entity to apply some specific principles
when determining whether a promise to transfer a license is satisfied over time or at a point in
time.
 If the performance obligation in a franchise contract is satisfied over time, revenue is recognized
over the duration of the franchise contract as the performance obligation is satisfied. The
entity shall determine an appropriate method of measurement of its progress towards the
complete satisfaction of the performance obligation.
 If the performance obligation in a franchise contract is satisfied at a point is satisfied.
 Revenue from sales- based or usage-based royalties is recognized when those sales or usage
occur.
 Traditionally, infrastructure for public services, are constructed, operated and maintained by the
public sector. However, there may be service concession arrangements whereby a public sector
entity grants a private entity the right to conduct, operate and or maintain an infrastructure
for public services. Such arrangements are called “build-operate-transfer” (BOT).
 Other terms for BOT arrangements are “service concession arrangement,”
“rehabilitate-operate-transfer,” public-to private service concession” and “private-public
partnership (PPP).
 IFRIC 12 applies to BOT contracts whereby the grantor controls or regulates what services the
operation must provide using the assets, to whom, and at what price, and also controls any
significant residual interest in the assets at the end of the term of the arrangement.
 IFRIS 12 applies to both (a) infrastructure that is yet to be constructed or acquired by the
operator and (b) existing infrastructure that the operator undertakes to operate and maintain.
 The outsourcing of the operation of a governmental units internal services is not a service
concession arrangement within the scope of IFRIC 12 or SIC 29.
 The infrastructure in a BOT contract is not recognized as an item of PPE by the operator.
 The operator in a BOT contract acts as service provider. The operator shall recognize revenue
from the service concession arrangement using PFRS 15 for both construction or upgrade
services and operation services.
 The common characteristics of all service concession arrangements is that the operator both
receives right and incurs an obligation to provide public services.
 The operator recognizes a financial assets if it has a contractual right to receive cash or other
financial assets from the grantor.
 The operator recognizes an intangible assets if the operation has a contractual right to charge
users of the public services.
 An operator capitalizes borrowing costs in accordance with PAS 23 Borrowing Costs if the
consideration in a service concession arrangement is an intangible asset.
 Financial assets and intangible assets received as consideration from a BOT contract are
subsequently accounted for under PFRS 9 and PAS 38, respectively.

Relevant provision of the PFRS for SMEs

Section 34 Specialized Activities

Service concession arrangements

A service concession arrangement is as arrangement whereby a government or other public sector body
(the grantor) contracts with a private operator to develop (or upgrade), operate and maintain the
grantor’s infrastructure assets such as roads, bridges, tunnels, airports, energy distribution networks,
prisons or hospitals.

In those arrangements, the grantor controls or regulates what services the operator must provide using
the assets, to whom, and at what price, and also controls any significant residual interest in the assets at
the end of the term of the arrangement.

Two principal categories of service concession arrangements

There are two principal categories of service concession arrangements:
A. In one , the operator receives a financial asset - an unconditional contractual right receive a
specific or determinable amount of cash or another financial asset from the government in return
for constructing or upgrading a public sector asset, and then operating and maintaining the asset for a
specified period of time. This category includes guarantees by the government to pay for any shortfall
between amounts received from users of the public service and specified or determinable amounts.
B. In the other, the operator receives an intangible asset - a right to charge for use of a public sector
asset that it constructs or upgrades and then operates and maintain for a specified period of time. A right
to charge users is not an unconditional right to receive cash because the amounts are contingent on the
extent to which the public uses the service.

Sometimes, a single contract may contain both types: to the extent that the government has given an
unconditional guarantee of payment for the construction of the public sector asset, the operator has a
financial asset; to the extent that the operator has to rely on the public using the services in order to
obtain payment, the operator has an intangible asset.

Accounting - financial asset model

The operator shall recognize a financial asset to the extent that is has an unconditional contractual right
to receive cash or another financial asset from or at the direction grantor for the construction services.
The operation shall measure the financial asset at fair value. Thereafter, it shall follow Section 11 Basic
Financial Instruments and Section 12 Other Financial Instruments Issues in accounting for the financial
asset.

Accounting - intangible asset model

The operator shall recognize an intangible asset to the extent that it receives a right (a license) to
charge users of the public service. The operator shall initially measure the intangible asset at fair value.
Thereafter, if shall follow Section 18 in accounting for the intangible asset.

Operating revenue
The operator of a service concession arrangement shall recognize, measure and disclose revenue in
accordance with Section 23 Revenue for the services it performs.