Notes for Advanced Accounting Acct. 101 Dr.

Tim Kelley

Table of Contents
Business Combinations: Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Pages 1 - 2 Pages 3 - 10 Pages 11 - 14 Pages 15 - 23 Pages 24 - 28 Pages 29 - 34

International Operations: Chapter 12 Chapter 13 Pages 35 - 41 Pages 42 - 48

Partnerships: Chapter 15 Chapter 16 Pages 49 - 61 Pages 62 - 69

Fund Accounting: Chapter 17 Chapter 18 Pages 70 - 72 Pages 73 - 76

Chapter 1--Introduction to Business Combinations Business Combinations: Operations of two or more companies are brought under common control. Merger. 2. Statutory Consolidation. 3. Stock Acquisition.

Three Methods of Combining: 1.

1. Merger:

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

2. Statutory Consolidation:

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

2 3. Stock Acquisition: Acquiring Company acquires more than 50% of the voting (common--not preferred) stock of the acquired company. This can be a "friendly" or "hostile" takeover. (A + B = [A + b])

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

3 Chapter 2--Acquisition of Net Assets Before June 30, 2001: Two Methods of Recording the Initial Combination: A: Purchase Method (usually results in some goodwill being recognized. This goodwill is no longer subject to amortization, but is instead subject to an annual impairment test). Pooling of Interests Method (FASB no longer allows--as of June 30, 2001--the Pooling of Interests method). Poolings in effect before June 30, 2001 are grandfathered in. With a pooling, the two companies combining their interests simply added together their book values to form a new consolidated balance sheet. No goodwill was recorded in poolings. Note: Before June 30, 2001, you could use the pooling of interests method if you met 12 criteria (to establish that the business combination was a stock for stock swap of companies of similar size), otherwise you had to use the purchase method. Now you have to use the purchase method. The main concept behind the 12 conditions was that at least 90% of the acquired company's shares had to be obtained by the acquiring company in the stock swap and that the owners maintain their same "relative interest" in the combined business (i.e., nobody was bought out or is being set up to be bought out).

B:

4 Mechanics of Purchase Method (only method now allowed for business combinations): Method can be used for (1) mergers, (2) statutory consolidations, and (3) stock acquisitions. Recording Requirement #1: Record investment in acquired company at "total cost." Total cost = cash paid + present value of any future payments + direct expenses of merger (e.g., accounting fees) + FMV of any stock given up. Recording Requirement #2: Record assets and liabilities at FMV. Note: The difference between the "total cost" of the acquisition and the FMV of the net assets (assets minus liabilities) creates either a positive or negative differential. If positive differential:

If negative differential:

5 Merger: Acquisition of Net Assets (No contingent consideration) Cost > FMV of net assets (positive differential = goodwill) Cost < FMV of net assets (negative differential = reduction in the valuation of noncurrent assets other than long-term marketable securities).

Example: Negative Differential Facts: 1. "A" buys "B's" net assets for $9,000. 2. "B's" Balance Sheet (Date of Acquisition). BV $1,000 2,000 2,500 1,200 1,100 $7,800 $ 0 FMV $ 900 3,000 2,600 1,500 1,200 $9,200 $ 0

Accounts Receivable Inventory Long-Term Marketable Securities P,P,& E Patent Total Assets Liabilities Calculation of Differential: Total Cost $9,000 FMV of net assets (9,200) Negative Differential $ (200) Allocation of Negative Differential: FMV $1,500 1,200 $2,700

PPE Patents

Journal Entry:

6 Example: Positive Differential Facts: Same facts as previous example, except that "A" buys the net assets of "B" for $10,200. Total Cost FMV of net assets acquired Goodwill $10,200 9,200 $ 1,000

Journal entry on A's books:

7 Contingent Consideration Based on Earnings: Sometimes an acquiring company may agree to pay the acquired company's owner more $ if certain earnings are met (by the acquired net assets). In this case the TOTAL COST of the acquisition is not known until the end of the contingency period. Purchase Method: Purchase Date: Later Date:

Record purchase at known cost. Add EXTRA COST paid if earnings level is met. If COST > FMV of net assets Debit goodwill for additional cost (change in accounting estimate). If COST < FMV of net assets Increase noncurrent assets to FMV and, if necessary, debit goodwill (change in accounting estimate).

8 Example: Pepper Company acquired all the net assets of Salt Company on December 31, 2000 for $1,850,000 cash. The balance sheet of Salt Company immediately prior to the acquisition showed: Book Value Fair Value $ 800,000 $ 800,000 900,000 1,375,000 $1,700,000 $2,175,000 $ 150,000 400,000 500,000 650,000 $1,700,000 $ 190,000

Current assets Plant and Equipment Total Liabilities Common Stock Other Contributed Capital Retained Earnings Total

As part of the negotiations, Pepper agreed to pay the stockholders of Salt $500,000 cash if the post combination earnings of Pepper average $1,800,000 or more per year over the next two years. Required: A. Prepare the journal entries on the books of Pepper to record the acquisition on December 31, 2000. B. Assuming that the earnings contingency is met, prepare the journal entry on Pepper's books needed to settle the contingency on December 31, 2002.

Part A:

Part B:

9 Contingent Consideration Based on Security Price (No change in the "total cost" of the acquisition--only a change in the number of shares reflecting the total cost). Acquired Company shareholders may worry about a drop in the value of the acquiring company's shares (which they received when they gave up their shares in the acquired company). In response, the acquiring company may guarantee that its shares will maintain their value for a specified period of time after the date of acquisition. Facts: 1. The acquiring company issues 1,000,000 of its own shares to obtain all the $1,000,000 net assets of the acquired company. FMV per share of acquiring company was $1 at the date of acquisition (each share has a $.10 par value). 2. 3. Acquiring company guaranteed its stock price for one year. After 1 year, the stock price of the acquiring company has fallen to $.25 per share.

10 Chapter 3--Consolidated Financial Statements (Date of Acquisition) Note: With a stock acquisition, a parent-subsidiary relationship is formed. Both the parent and subsidiary maintain a set of books. With a merger, only one corporation survives (Chapter 2). We will now look at stock acquisitions with the purchase method (Chapters 3-6). We only look at the balance sheet in Chapter 3--we see the income statement in Chapters 4-6. If we buy more than 50% of another company's voting common stock (we prepare consolidated financial statements). Unless: (1) Control is temporary or (2) Control does not rest with the majority owners (e.g., company is effectively "nationalized.") Prior to FASB #94, we could exclude subsidiaries with a dramatically different business from the parent. For example, General Motors used to be able to exclude its finance subsidiary (General Motors Acceptance Corp.--GMAC) from consolidation and instead used the equity method. Why Stock Acquisitions? 1. Easier than a merger (and you don't have to buy 100% of the subs. net assets--you just need to buy more than 50% of the voting common stock to gain a controlling interest). 2. If a subsidiary (a legally separate corp.) defaults on a loan, the parent is oftentimes not liable--unlike with a merger. However: If the subsidiary was set up to commit a fraud on the creditors or if the parent siphoned off subsidiary assets in anticipation of subsidiary insolvency, then creditors can successfully sue the parent.

Problems with Consolidated Financial Statements 1. Sub. shareholders (minority interest) and sub. creditors learn little from consolidated financial statements (Remember that sub. creditors can only sue sub. assets). Solution: Subsidiary only financial statements can be prepared for minority shareholders and subsidiary creditors.

11 2. Ratio Analysis may be misleading. Auto Company-Parent 40% 60% 100% Finance Company-Subsidiary 90% 10% 100% Total

Debt Equity Total

65% 35% 100%

Note: The above analysis assumes that the parent and sub are the same size. Solution: Segment Reporting (However, segment reporting disclosures are somewhat limited).

3.

Consolidation of Foreign Sub. can lead to Interpretation Problems: Especially when there are: 1. significant currency value fluctuations. 2. hyperinflationary conditions Solution: See Chapter 13 (which we will cover).

12 Stock Acquisitions: Purchase Method (Date of Acquisition Only) Example 1: 100% Purchase---Cost of "S" = BV of "S" Example 2: 80% Purchase---Cost of "S" = BV of "S" Example 3: 80% Purchase---Cost of "S" > BV of "S" Example 4: 80% Purchase---Cost of "S" < BV of "S"

Adjustments:

Eliminations:

Example 1: 100% Purchase---Cost of "S" = BV of "S" Example 2: 80% Purchase---Cost of "S" = BV of "S" (For the facts for Examples 1 & 2See page 12.1)

13 Example 3: 80% Purchase---Cost of "S" > BV of "S" On January 2, 1993, Park Company acquired 80% of the outstanding common stock of Somer Company for $150,000 cash. Just after the acquisition, the balance sheets of the two companies were as follows: (For Example 3 facts, see worksheet on Page 13.1) The fair values of Somer Company's assets and liabilities were equal to their book values with the exception of land (assumption for all Chapter 3 problems). Required: A. Prepare the journal entry that Park prepared at the date of acquisition.

B.

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

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

Special Topic--Subsidiary Treasury Stock: P's share of "S" treasury stock must be eliminated in the investment elimination entry. Remaining debit balance in the treasury stock account reduces minority interest. Note: Be careful in determining P's ownership % of "S," when "S" has treasury stock in its balance sheet. P's ownership % = Shares of "S" common stock owned by "P" Shares of "S" common stock outstanding*** ***Shares of "S" common stock outstanding = Common shares issued minus treasury shares.

14 Special Topic--Subsidiary Treasury Stock: (continued) Example: Phillips Company purchased 26,600 shares of the outstanding common stock of Scott Company on December 31, 1999 for cash. At that time, the balance sheet of the Scott Company included the following stockholders' equity section: Common Stock (44,000 shares) APIC Retained Earnings Treasury Stock (6000 shares) Total Stockholders' Equity $ 880,000 440,000 170,000 (120,000) $1,370,000

Required: A. Prepare the elimination entry required for the preparation of a consolidated balance sheet workpaper on December 31, 1999, assuming: 1. The purchase price of the stock was $1,010,000.

2.

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

Assume further that any difference between the cost of the investment and the book value of the net assets acquired relates to subsidiary land. B. Compute the amount of minority interest that would appear on the December 31, 1999 consolidated balance sheet.

15 Chapter 4--Consolidated Financial Statements after Acquisition Part A: Investment Accounting Methods on P's Books (Cost Vs. Equity). Part B: Consolidations at the end of 1 full year since the date of acquisition. (The acquisition will be on Jan. 1 and the calendar year will be our fiscal year). Also covered will be consolidations after 1 full year since the date of acquisition. Part C: Mid-Year purchase of subsidiary stock. Part D: Consolidated statement of cash flows. __________________________________________________________________

Part A:

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

After an investment in a subsidiary is initially recorded, the parent's accountants must decide how to account for the investment over time. -----------------------------------------------------------------Recall the following from investment accounting in intermediate accounting: Method of recording and subsequent accounting for long-term investments in equities depends on the amount of voting stock you own. a) Cost Method - less than 20% (Voting Common Stock). Called a passive investment. Record at cost (later adjusted for changes in market value). To record the acquisition: Long-term Investment Cash To record dividends received: Cash (or Receivable) Dividend Revenue $ $ $cost $cost

16 b) Equity Method - 20% to 50% (Voting Common Stock). You are assumed to have "significant influence." (Investor company could manipulate the investee company's dividend policy to create dividend revenue--if investor company with significant influence was allowed to use the cost method--for itself anytime extra revenue was desired.) Investment account is kept at your share of the investee company's net worth (i.e., equity). At year-end, you must show a revenue for your share of the investee's net income and increase your investment account. L-T investment Equity in Subsidiary Income $ Your % share $

When dividends from the investee are received, you must reduce your investment. Cash or Div. L-T investment -------------------------------------------------------$ Dividends $

It does not matter what method the parent uses on its books to account for a subsidiary. The consolidation accountant must adjust the worksheet elimination entries to take into account whatever method the P accountants used on their books (cost, partial equity, or full equity). The consolidated F/Ss will be identical no matter what method P has used to account for the investment in S stock on its books. Therefore, we will concentrate on consolidations where the parent uses the cost method to account for the investment in S stock over time on their books. Example: Facts: 1. 2. 3. 4. Review of Cost and Equity Methods On Jan. 1, Year 1 the "P" Company buys 20% of "S" for $1000. During Year 1, "S" gives "P" $100 in dividends. "S" has $1,250 in net income in Year 1. The fair market value of "P's" stock investment in "S" has fallen to $950. "P" has no other long-term investments.

17 Cost Method (Securities Available for Sale) Journal Entries: 1. 1/1/Year 1 Equity Method

2.

During Year 1

3.

12/31/Year 1

4.

12/31/Year 1

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

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

Part B:

Consolidations at the End of 1 Full Year Since the Date of Acquisition (DOA = Jan. 1, Year 1). Also, Consolidations After 1 Year Since the Date of Acquisition

Assumptions in Part B: -we will use the purchase method of accounting. -we will use the cost method on P's books during the year (P could potentially also use partial equity or full equity methods). -"S" was purchased at the beginning of the year. -any differential is due to undervalued or overvalued land. Note: See page 124 of our textbook for an example of a consolidation worksheet format--one year since the date of acquisition. In the consolidated income statement, all the parent's earnings and the parent's share (in this case 80%) of the subsidiary earnings are reflected in consolidated earnings.

19 Example (Consolidations 1 Year Since the Date of Acquisition): Peace Company purchased 80% of the common stock of Shaw, Inc. on January 1, 2000 for $350,000. The trial balances at the end of 2000 for the companies were: Peace $62,816 216,000 69,360 350,000 301,604 30,000 303,000 37,082 14,888 $1,384,750 $84,478 12,800 200,000 300,000 222,352 549,120 16,000 $1,384,750 Shaw $68,000 208,520 19,680 0 213,274 20,000 162,800 19,334 12,796 $724,404 $32,540 14,286 100,000 150,000 134,998 292,580 0 $724,404

Cash Accounts and Notes Receivable Inventory, 1/1 Investment in Shaw, Inc. Other Assets Dividends Declared Purchases Selling Expenses Other Expenses Total Debits Accounts and Notes Payable Other Liabilities Common Stock Premium on Common Stock Retained Earnings Sales Dividend Income (From S) Total Credits

Inventory balances on December 31, 2000 were $22,520 for Peace and $12,300 for Shaw, Inc. Shaws accounts and notes payable contain a $5,000 note payable to Peace. Required: Prepare a workpaper for the preparation of consolidated financial statements on December 31, 2000. The difference between cost and book value of equity acquired relates to subsidiary land.

20 Example (Consolidations More Than 1 Year Since the Date of Acquisition): On January 1, 1997, Pair Company purchased 80% of the capital stock of Snap Company for $48,000. Snap Company had capital stock of $50,000 and retained earnings of $8,000 at that time. On December 31, 2000, the trial balances of the two companies were: Pair $8,000 22,000 14,000 4,000 48,000 50,000 8,000 10,000 84,000 10,000 $258,000 $6,000 8,000 0 100,000 40,000 96,000 8,000 $258,000 $20,000 Snap $14,000 16,000 8,000 0 0 40,000 6,000 10,000 20,000 8,000 $122,000 $6,000 0 4,000 50,000 20,000 42,000 0 $122,000 $10,000

Cash Accounts Receivable Inventory, 1/1 Advance to Snap Company Investment in Snap Company Plant and Equipment Land Dividends Declared Purchases Other expenses Total Debits Accounts Payable Other Liabilities Advance from Pair Company Capital Stock Retained Earnings Sales Dividend Income Total Credits Inventory, 12/31

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

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

Main Idea: Parent can only include in consolidated net income: 1. 2. Example: On May 1, 1999, Pace Company purchased 80% of the common stock of Senior Company for $45,000. Additional data concerning these two companies for the years 1999 and 2000 are: 1999 Pace $100,000 50,000 40,000 35,000 5,000 1999 Senior $25,000 10,000 10,000 15,000 2,000 2000 Pace $100,000 50,000 70,000 37,500 5,000 2000 Senior $25,000 10,000 23,000 (5,000) 0 Parent's independently earned net income. Parent's share of S net income since the date of acquisition.

Common Stock Other Contributed Capital Retained Earnings, 1/1 Net Income (Loss) Cash Dividends (11/30)

Required: A. Prepare the workpaper entries that would be made on a consolidated statements workpaper for the years December 31, 1999 and 2000 for Pace Company and its subsidiary, assuming that Senior Company's income is earned evenly throughout the year. B. Calculate consolidated net income and consolidated retained earnings for 1999 and 2000.

22 Part D: Consolidated Statement of Cash Flows Dividends paid by the sub to the parent need to be eliminated in consolidation (cash never leaves the consolidated entity). Noncontrolling Interest in Income (or Minority Interest) must be added to consolidated net income in order to compute consolidated cash provided by operations (of course, there will likely be other additions and subtractions to consolidated net income to compute consolidated cash provided by operations).

Key Concepts:

23 Example--Consolidated Statement of Cash Flows: A consolidated income statement and selected comparative balance sheet data for Prince Company and subsidiary follow: Prince Company and Subsidiary Consolidated Income Statement For the year Ended December 31, 2000 Sales Cost of Sales Gross Profit Operating Expenses: Depreciation Expense Selling Expenses Administrative Expenses Combined Income Less: Minority Interest Consolidated Net Income $628,000 247,000 381,000 $69,000 122,000 85,000

276,000 105,000 15,750 $89,250

----------------------------------------------------------------------------------------Selected comparative balance sheet data: 12/31/99 $264,000 194,000 26,000 99,000 72,000 56,000 12/31/00 $318,000 172,000 30,000 86,000 84,000 40,000

Accounts Receivable Inventory Prepaid Selling Expenses Accounts Payable Accrued Selling Expenses Accrued Administrative Expenses

Required: Prepare the cash flow from operating activities section of a consolidated statement of cash flows assuming use of the: A. B. Direct Method. Indirect Method.

24 Chapter 5 Allocation and Depreciation of Differences Between Cost and Book Values This chapter examines how a differential is: 1. Allocated during the consolidation process to increase or decrease the book value of S assets/liabilities, and 2. Amortized each year on the consolidation worksheet (Note: Some assets such as land and goodwill are not reduced in value over time, unless there is evidence of asset impairment). Terms: Differential = Difference between cost and book value of S net assets purchased by P. Goodwill = Excess of cost over FMV of S identifiable net assets purchased by P.

25 Example--Differential Relates to PPE and Inventory: On January 1, Year 1, Park Company purchased an 80% interest in Stream Company for $260,000. On this date, Stream Company had common stock of $207,000 and retained earnings of $130,500. An examination of Stream Companys balance sheet (at the date of acquisition) revealed the following comparisons between book and fair values. Book Value $30,000 50,000 300,000 200,000 Fair Value $35,000 55,000 350,000 200,000

Inventory Other Current Assets Equipment Land

Additional Facts: 1. Assume inventory of S is sold within one year (FIFO). 2. Other current assets are sold within one year. 3. S will depreciate equipment over a 10 year remaining life, using straight-line depreciation and no salvage value. Required: 1. Prepare the journal entry that P would make on its books on the date of acquisition. 2. Prepare elimination journal entries that would be made (1) on the date of acquisition, (2) one year after the date of acquisition, and (3) two years after the date of acquisition. Rules: 1. Any increase or decrease in S assets/liabilities are reflected in the consolidated worksheets and the consolidated financial statements, but have no impact on Ss books. 2. S will use its original cost figures to report its income. 3. Consolidated worksheets and financial statements will reflect the difference between the fair market value and book value of Ss assets at the date of acquisition. Specifically, we must (on the worksheet) adjust Ss depreciation and amortization etc., to reflect the difference between the fair market value and book value of Ss assets at the date of acquisition. Recall however that goodwill is not subject to amortization (but to an annual impairment test).

26 Special Problems Related to Treatment of the Difference Between Cost and Book Value: A. Book value of liabilities of S are not equal to the FMV of the liabilities of S. B. Show accum. depr. separately--not PPE (net). C. Early sale of land by S. -------------------------------------------------------------------------------------------------------A. Book value of liabilities of S are not equal to the FMV of the liabilities of S. Bonds Payable: premium. BV = Face value +/- unamortized discount or

FMV = Present value of future interest and principal payments as of the date of acquisition (not when bonds were issued). If FMV > BV (at Date of Acquisition): Worksheet bond premium amortization will decrease consolidated interest expense and increase consolidated net income. If FMV < BV (at Date of Acquisition): Worksheet bond discount amortization will increase consolidated interest expense and decrease consolidated net income.

Example--Bonds FMV is not equal to BV and Goodwill Recorded: On January 1, 1998, Point Corporation acquired an 80% interest in Sharp Company for $2,000,000. At that time Sharp Company had capital stock of $1,500,000 and retained earnings of $700,000. The book values of Sharp Company's assets and liabilities were equal to their fair values except for the bonds payable. The outstanding bonds were issued on January 1, 1993 (at face value with a 10% coupon rate) and mature on January 1, 2003. The bond principal is $500,000 and the current yield on similar bonds is 15%. Required: A. Assume interest is paid annually, prepare a schedule to assign the difference between cost and book value in the consolidated statements workpaper on the acquisition date. Prepare the workpaper entries necessary on December 31, 1998.

B.

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

Example: Pale Company acquires a 75% interest in Shadow Company on January 2, 2000. The resulting difference between cost and book value in the amount of $120,000 is entirely attributable to undervalued equipment with an original life of 15 years and a remaining life, on January 2, 2000, of 10 years. Required: Prepare the December 31 consolidated financial statements workpaper entries for 2000 and 2001 to assign and depreciate the difference between cost and book value, recording accumulated depreciation as a separate balance.

28 C. Early sale of land by S.

Formula for Computing Consolidated Net Income: P's income from independent operations (take out any dividends received from S). Add: P's share of S's reported net income Subtract: Amortization/Depreciation of differential assigned to expense this year Consolidated Net Income X X (X) X

Example--Early Sale of Land by S: Pender Company purchased 80% of the common stock of Sunderland Company in the open market on January 1, 1998, paying $31,000 more than the book value of the interest acquired. The difference between cost and book value is attributable to land. Required: A. B. What workpaper entry is required each year until the land is disposed of? Assume that the land is sold on January 1, 2001 and that Sunderland Company recognizes a $50,000 gain on its books. What amount of gain will be reflected on the 2001 consolidated income statement? In all years subsequent to the disposal of the land, what workpaper entry will be necessary?

C.

29 Chapter 6 Elimination of Unrealized Profit in Intercompany Sales of Inventory This chapter addresses what additional elimination entries are needed on the consolidated worksheet when P and S have had intercompany inventory transactions. TERMS: Upstream sale Sale from S to P. S recorded the profit, and P put the item in Inventory at the purchase price from S. Sale from P to S. P recorded the profit, and S put the item in Inventory at the purchase price from P.

Downstream sale

Unrealized Intercompany Profit The intercompany profit on the sale between P and S is considered unrealized until the inventory is sold to outside parties. Therefore, any profit that occurred between the parties this year AND remains in the ENDING INVENTORY of P or S must be eliminated. (This profit is really moved to the income statement in the year the item is sold to outsiders.) SUMMARY: Unrealized profit is eliminated from the consolidated income statement. Ending inventory is reduced to be at "cost to the consolidated entity."

30 Realized Intercompany Profit If inventory is sold to outsiders in the same year it is sold between P and S, the profit is considered realized. (Nothing special is done in the consolidation.) ALSO, intercompany profit in the BEGINNING INVENTORY of either P or S is considered realized (or confirmed) that year if the goods are sold to outsiders. NOTE: 100% of any unrealized profit is eliminated for both upstream and downstream sales!!!!! (This is true even though the minority shareholders consider any upstream profits on sales to P to be realized upon the sale from S to P.) Elimination Entries for Unrealized Intercompany Profits: 1. Eliminate all intercompany sales for the year at sale price (which includes profit). Sales Cost of goods sold (or Purchases) X X (no income statement effect)

Note: The credit to cost of goods sold is for the full sales price (this overstatement is corrected in the next elimination entry). Note: 100% of upstream & downstream sales are eliminated in this manner.

2.

Eliminate unrealized intercompany profit in ending inventory. Cost of goods sold Inventory X X (income statement effect)

Note: This elimination entry reduces income by the amount of the intercompany profit that was imbedded in the parent's and/or subsidiary's ending inventory.

31 Example--Unrealized Ending Inventory Profit--Upstream Sale: 1. 2. 3. 4. Jan. 1, 2000 purchase transaction (80% purchase). In 2000, there was a $1,000 upstream sale of 4 units of inventory ($250 * 4 units) (S >>>>> P). The cost of goods sold on these units was $800 ($200 * 4 units). P still has all this inventory at 12/31/00.

32 Note: Previous Example did not have any beginning inventory. If we had beginning inventory: Worksheet Entry: (Downstream sale: P >>>>>>>>> S) X X

Beginning R/E - P * Cost of Sales ** *

Reduces opening balance in R/E (we eliminated this ending inventory unrealized profit last year, but only on a worksheet basis--On the Parent's books the profit is still reflected in retained earnings--so we reflect last year's unrealized profit elimination by reducing the opening balance in the parent's R/E). Assuming FIFO, the beginning inventory will be sold this year. The credit here to "cost of sales" increases earnings and shows that the consolidated entity has realized the profits by selling to some party outside the consolidated entity. Also, note that the subsidiary books will reflect overstated "cost of sales" since the subsidiary's cost of sales includes the "stepped-up" cost when the inventory was sold by the parent to the subsidiary at a profit last year. This overstated subsidiary cost of sales is "backed-out" in the above elimination entry.

**

Worksheet Entry:

Upstream Sale (P <<<<<<<<<<<<< S)

Note: Elimination of the last year's unrealized profit is apportioned between the parent and minority interests. Beg R/E - P Beg R/E - S Cost of Sales *** X X X 40*** 10**** 50

(P% * last year's unrealized profit or 80% * $50 = $40). (MI% * last year's unrealized profit or 20% * $50 = $10).

****

Note: Chapter 5 adjustments permanently reduce (sometimes increase) consolidated income and R/E. On the other hand, Chapter 6 adjustments of intercompany profits simply delay the recognition of consolidated income (consolidated R/E should not be affected in the long run).

33 CALCULATING MINORITY INTEREST IN N.I.: 1. DOWNSTREAM SALE: (P >>>>>>>>>>>> S) the profit is on P's income statement and, hence, S's net income does NOT need to be adjusted. S reported net income * M.I. % = M.I. in net income

2.

UPSTREAM SALE: (P <<<<<<<<<<<< S) M.I. in S's net income must be adjusted to: a. b. subtract out any unrealized profit on the subsidiary income statement and/or add in any realized (i.e., confirmed) S profit not on the Sub. income statement this year.

Formula to compute M.I. in S's net income: Subsidiary reported net income Less: Unrealized profit reported in P ending inventory for sales that occurred this year. Add: Realized profit from Ps beginning inventory Adjusted S net income * MI % M.I. in net income XX (XX) XX XX ??% XX

Note: Combined income Less: M.I. Share in "S" net income (see above) Consolidated Net income XX (XX) XX

34 Example--Ending and Beginning Inventory Intercompany Profits--Upstream Sale: Webster Corporation owns 90% of the common stock of Clark Company. The stock was purchased for $540,000 on January 1, 1995, when Clark Company's retained earnings were $100,000. Financial data for 1999 are presented below: Webster Corp. 1,100,000 54,000 1,154,000 150,000 850,000 1,000,000 140,000 860,000 207,000 1,067,000 87,000 541,000 87,000 (100,000) 528,000 80,000 213,000 140,000 540,000 500,000 1,473,000 70,000 75,000 800,000 528,000 1,473,000 Clark Company 530,000 0 530,000 110,000 350,000 460,000 115,000 345,000 137,500 482,500 47,500 120,000 47,500 (60,000) 107,500 50,000 112,500 115,000 400,000 677,500 30,000 40,000 500,000 107,500 677,500

Sales Dividend Income Total Revenue Cost of Goods Sold: Beginning Inventory Purchases Cost of Goods Available Less: Ending Inventory Cost of Goods Sold Other Expenses Total Costs and Expenses Net Income 1/1 Retained Earnings Net Income Dividends Declared 12/31 Retained Earnings Cash Accounts Receivable Inventory Investment in Clark Company Other Assets Total Assets Accounts Payable Other Current Liabilities Capital Stock Retained Earnings Total Liabilities and Equity

The January 1, 1999 inventory of Webster Corporation includes $30,000 of profit recorded by Clark Company on 1998 sales. During 1999, Clark Company made intercompany sales of $200,000 with a markup of 25% on cost. The ending inventory of Webster Corporation includes goods purchased in 1999 from Clark Company for $50,000. Required: Prepare the consolidated statements workpaper for the year ended December 31, 1999.

35 Chapter 12 Accounting for Foreign Currency Transactions and Hedging Foreign Currency Risk

I.

Transaction Gains and Losses (assuming that we have not hedged against a foreign exchange loss). Issues: With an export, we sell goods on credit and later receive foreign currency worth more (GOOD NEWS) or less (BAD NEWS) (in terms of dollars) than we had expected at the time of sale. With an import, we purchase goods on credit and later pay foreign currency worth more (BAD NEWS) or less (GOOD NEWS) (in terms of dollars) than we expected at the time of purchase.

Example #1: Importing Transaction (no hedge is made). Facts: 1. 2. On December 15th, the USA Company buys inventory from a Mexican Company for 75,000 pesos (n,30). The indirect exchange rates (expressed in units of foreign currency) at the following dates are as follows: Dec 15th Dec 31st Jan 15th 9.023 pesos = $1 8.945 pesos = $1 9.141 pesos = $1

Purchase date Year end Settlement date

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

Dec. 15:

Dec. 31:

Jan. 15:

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

36 Example #1 (cont.): Importing Transaction (no hedge is made) Journal Entries: Dec. 15:

Dec 31:

Jan 15:

Example #2: Exporting Transaction (assuming no hedge was made) Facts: 1. 2. USA Company sells equipment to a French Company on December 10th for 250,000 Euros (n,30). The direct exchange rates are as follows: Dec. 10 Dec. 31 Jan. 10 $.885 = 1 Euro $.892 = 1 Euro $.879 = 1 Euro

Sales date Year end Settlement date Journal Entries: Dec. 10:

Dec. 31:

Jan 10:

37

Import Increase in direct exchange rate Decrease in direct exchange rate Some Definitions: Hedging:

Export

Taking actions to protect your company from foreign exchange risk.

Forward Exchange Contracts: Agreement to buy or sell foreign currency at a future date at a set forward rate. Note: Forward exchange contracts can be used to hedge against the possibility of foreign currency exchange (or transaction) losses on credit sales and purchases--as we will soon see. Forward Rate: The exchange rate between currencies for a future date. For example, I agree today to buy 10 British pounds, 1 year from now, for $1.50 per pound. The $1.50 per pound is the forward rate and is set. Premium or Discount: The difference between the current spot rate and a forward rate. If Forward rate > Spot Rate (Difference = Premium) If Forward rate < Spot Rate (Difference = Discount) Note: The premium or discount is caused by differences in the interest rates (and expected future interest rates) and other economic factors (e.g., differential inflation rates). Three Important Dates to Consider: 1. Commitment Date (date we issue purchase order or receive sales order). 2. Sales/Purchase Date (date that title transfers and import purchase or export sale is made). 3. Settlement Date (date that cash is paid or received related to credit purchase or sale).

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

Time Period #1--Hedge of a Foreign Currency Commitment: This is the time between the commitment date and the sales/purchase date. Accounting rules: 1. 2. Exchange gains/losses will exactly offset each other. Firm Commitment account will be closed out to adjust the sales (for an export) or the inventory/purchases (for an import) so that on the sales/purchase date the sales or purchase recorded reflects the forward contract amount that was agreed to at the commitment date.

Time Period #2--Hedge of an Exposed A/R of A/P: This is the time between the sales/purchase date and the settlement date. Accounting rules: 1. Transaction gains/losses will not exactly offset each other (in the short run anyway). However, by the time we reach the end of the transaction at the settlement date, the sum total of the net transaction gains/losses will equal the original premium or discount on the forward exchange contract. The original credit to sales (for an export) or debit to inventory/purchases (for an import) will not be adjusted for subsequent transaction gains and losses.

2.

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

39 Example--Hedge of a Foreign Currency CommitmentSale (Export): (Time Period #1) On October 1, Year 1, Advanced Electronics, Inc., secured an order from a company located in France for a new computer to be delivered on April 1, Year 2. The sale price, which is payable in Euros, is 30,000 Euros. The 180-day delivery schedule allows for custom manufacture, delivery, and installation. Payment is due on delivery. The spot rate for Euros on October 1, Year 1 is $.88. In order to protect itself against foreign currency fluctuations, Advanced Electronics sold 30,000 Euros for delivery in 180 days at the forward rate of $.86 on October 1, Year 1. The following additional exchange rates prevailed: December 31, Year 1: Spot rate = $.84 Forward rate for 90-day delivery = $.81 Spot rate = $.80

April 1, Year 2:

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

40 Example--Hedge of a Foreign Currency CommitmentPurchase (Import): (Time Period #1) On April 1, Year 1, Hoover Co. committed to order 8,000 cameras from a Japanese firm at a price of 150,000,000 yen. The purchase will be recorded on June 1, Year 1 when the cameras will be delivered and paid for. On April 1, Year 1, Hoover enters into a forward exchange contract to receive 150,000,000 yen on June 1, Year 1 at a forward rate of 1 yen = $.00816. The spot rate on April 1, Year 1 is 1 yen = $.00829 and on June 1, Year 1 = $.00801. Required: Prepare the purchase and the forward contract related journal entries for April 1 and June 1, Year 1.

41 Example--Hedge of an Exposed Accounts ReceivableSale (Export): (Time Period #2) On December 1, 1999, Tyro Toy Company exported toys that had cost $170,000 to a British Company for 140,000 pounds. The account is to be settled on January 31, 2000. Tyro Toy Company is a calendar-year company and uses the perpetual inventory system. Direct exchange rates were as follows: December 1 = December 31 = January 31 = $1.4202 $1.4170 $1.4320

On December 1, 1999, Tyro Company entered into a forward contract to sell 140,000 pounds on January 31, 2000 for $1.4189 per pound. Note: The forward rate on Dec. 31 = $1.4151. Required: Prepare the journal entries needed in 1999 and 2000 to record the sale and forward contract and to settle the accounts.

42 Chapter 13 The Translation of Financial Statements of Foreign Affiliates Chapter 12 -- Import and Export Transactions Chapter 13 -- Foreign Affiliate 0-20%--Cost Method (Insignificant Influence) 20-50%--Equity Method (Significant Influence) 50-100%-Consolidated Financial Statements (Controlling Interest) After adjusting the foreign affiliates financial statements to reflect U.S. GAAP, two methods are specified in U.S. GAAP for translating the consolidated financial statements of foreign affiliates from the foreign currency to U.S. currency. a. b. Current Rate Method Temporal Method

If certain conditions exist, the U.S. Company must use the current rate method; if other conditions are met, the company must use the temporal rate method. We use the current rate method if the foreign currency is the functional currency of the foreign affiliate. This is true if the affiliate is fairly independent. a. affiliate obtains its own financing and doesn't pay significant dividends to the U.S. parent. affiliate does not have significant inter-company import/export transactions with the U.S. parent.

We use the temporal rate method if the U.S. dollar is the functional currency of the foreign affiliate. This is true if: a. there are significant dollars flowing in and out of the foreign affiliate--from and to the U.S parent. the foreign affiliate is essentially a branch of the U.S. parent's operations.

b. or

We use the temporal rate method if there has been significant inflation experienced in the foreign country where the affiliate is located. a. 100% inflation over the last three years (approximately 26% compounded annually) is considered to be significant inflation.

43 Current Rate Method: Assets & Liabilities Common Stock & APIC Retained Earnings Sales Expenses Depreciation Expense Dividends Current Exchange Rate Historical Exchange Rate (Exchange rate at time of stock issuance) From combined Income Statement & Statement of Retained Earnings Average Exchange Rate Average Exchange Rate Average Exchange Rate Historical Exchange Rate (Exchange rate when dividends were paid)

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

Temporal Method: Monetary Assets (Cash, A/R, Notes Rec.) (Assets expressed in terms of a fixed amount of cash to be realized). Inventory (Cost) Inventory (FMV--LCM Method) Property, Plant & Equipment Other Nonmonetary Assets Liabilities (most are monetary) Common Stock & APIC Retained Earnings Sales Cost of Sales Depreciation Expense Other Expenses Dividends Current Exchange Rate

Historical Exchange Rate Current Exchange Rate Historical Exchange Rate Historical Exchange Rate Current Exchange Rate Historical Exchange Rate From the Combined Income Statement and Statement of Retained Earnings Average Exchange Rate Historical Exchange Rate Historical Exchange Rate Average Exchange Rate Historical Exchange Rate

Note: Any translation gain or loss is run through the income statement. Companies generally do not like this and some enter into hedging transactions to avoid big losses on their books.

44 Overview of differences between the current rate and temporal methods.

Nonmonetary Assets Cost of Sales Depreciation Exp. Translation Gain or Loss

Current Rate Method Current Rate Average Rate Average Rate Stockholders' Equity Account

Temporal Method Historical Rate Historical Rate Historical Rate Income Statement

Example:

To demonstrate why the temporal method should be used in situations in which inflation is significant in the foreign country where affiliate is located. 20 years ago our foreign subsidiary purchased land for 1,000,000 foreign currency units (FCU) when the direct exchange rate was 1 FCU = $.10. The direct exchange rate is now 1 FCU = $.0004 (indirect rate: $1 = 2500 FCUs).

Facts: 1.

2.

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

45 Current Rate Method (Year 1) 1/1/Year 1 Euros 12/31/Year 1-Euros Ex. Rate Direct $

Cash A/R Land P, P, & E Total Assets Liabilities Com. Stk. R/E Translation Adjustment Total Liabs and S.E.

10,000 10,000 30,000 40,000 90,000 20,000 70,000 0

20,000 20,000 40,000 50,000 130,000 20,000 70,000 40,000

90,000

130,000 Year 1Euros 350,000 (290,000) 60,000 (20,000) 40,000 0 40,000

Revenues Expenses Net Income Less: Dividends Increase in R/E Beginning R/E Ending R/E
Additional Facts--Exchange Rates:

1/1/Year 1 -- 1 Euro = $.80 (Common Stock Issued) Avg. Year 1-- 1 Euro = $.82 9/30/Year 1-- 1 Euro = $.83 (Dividends Paid) 12/31/Year 1--1 Euro = $.84

46 Current Rate Method (Year 2)

Cash A/R Land P,P,& E Total Assets Liabs Com. Stk. R/E Translation Adjustment Total Liabs and SE

1/1/Year 2-- 12/31/Year 2-Euros Euros 20,000 25,000 20,000 35,000 40,000 40,000 50,000 70,000 130,000 170,000 20,000 70,000 40,000 10,000 70,000 90,000

Ex. Rate

Direct $

130,000

170,000 Year 2 Euros 450,000 (340,000) 110,000 (60,000) 50,000 40,000 90,000

Revenues Expenses Net Income Less: Dividends Increase in R/E Beginning R/E Ending R/E
Additional Facts--Exchange Rates:

1/1/Year 2 -- 1 Euro = $.84 Avg. Year 2-- 1 Euro = $.88 9/30/Year 2-- 1 Euro = $.90 (Dividends Paid) 12/31/Year 2--1 Euro = $.92

47 Temporal Method (Year 1)

Cash A/R Land P, P, & E Total Assets Liabs Com. Stk. R/E Total Liabs and SE Revenues Depreciation Expense ($40,000/4 Years) Other Expenses Translation Gain/Loss Net Income Less: Dividends Increase in R/E Beginning R/E Ending R/E

1/1/Year 1 Euros 10,000 10,000 30,000 40,000 90,000 20,000 70,000 0 90,000

12/31/Year 1 Euros 20,000 20,000 40,000 50,000 130,000 20,000 70,000 40,000 130,000 Year 1--Euros 350,000 (10,000) (280,000) 60,000 (20,000) 40,000 0 40,000

Ex. Rate

Direct $

Additional Facts--Exchange Rates: 1/1/Year 1 -- 1 Euro =$.80 (Common Stock Issued) (Land Purchased) (40,000 P, P, & E Purchased) Avg. Year 1-- 1 Euro =$.82 9/30/Year 1-- 1 Euro =$.83 (Dividends Paid) (10,000 Land Bought) 12/31/Year 1--1 Euro =$.84 (20,000 P, P, & E Purchased)

48 Temporal Method (Year 2)

Cash A/R Land P, P, & E Total Assets Liabs Com. Stk. R/E Total Liabs and SE Revenues Depreciation Expense (40,000/4)+(20,000/4) Other Expenses Translation Gain/Loss Net Income Less: Dividends Increase in R/E Beginning R/E Ending R/E

1/1/Year 2-Euros 20,000 20,000 40,000 50,000 130,000 20,000 70,000 40,000 130,000

12/31/Year 2 Euros 25,000 35,000 40,000 70,000 170,000 10,000 70,000 90,000 170,000 Year 2Euros 450,000 (15,000) (325,000) 110,000 (60,000) 50,000 40,000 90,000

Ex. Rate

Direct $

Additional Facts--Exchange Rates: 1/1/Year 2 -- 1 Euro =$.84 Avg. Year 2-- 1 Euro =$.88 9/30/Year 2-- 1 Euro =$.90 (Dividends Paid) 12/31/Year 2--1 Euro =$.92 (Bought 35,000 P, P,&E)

49 Chapter 15 Partnerships: Formation, Operation, and Ownership Changes Overview of Chapter 15 1. Types of Business Ownership and Definitions 2. Process of Forming a Partnership (simpler than a corporation). 3. Net Income Allocation 4. Admission of a New Partner --Buy out old partner (say 3 partners >>>> 3 partners) --Buy new ownership share (say 3 partners >>> 4 partners) 5. Withdrawal of a Partner --Bought out by partnership (say 3 partners >>> 2 partners) I. Three Types of Business Ownership: Sole Proprietorship Partnership (2 or more owners) Corporations Differences between: Partnerships and Corporations unlimited liability unlimited liability limited liability

50 Definitions: Mutual Agency: A partnership is bound by the actions of the individual partners (outsider can assume that each partner can act as an agent and bind the partnership). In other words, I am personally liable, if my partner signs a bad business deal without consulting me. Joint and Several Liability: Each Partner is individually responsible for all the partnership debts. For example, Partner "A" (with a "deep pocket") can be sued by partnership creditors for all partnership debts, even though Partners "B" and "C" are personally solvent. Partner "A" would try to recover from Partners "B" and "C." (Good luck trying to recover from your former partners!) Partnership Agreement: Good idea to have a written partnership agreement. Major Items: 1. Amount each partner is to contribute and the designated value if non-cash assets are contributed. 2. Basis for dividing profits. 3. Basis for dividing losses. 4. Basis for calculating equity of withdrawing partner. Note: The Uniform Partnership Act has default options if the partnership agreement is silent on certain points or if there is no partnership agreement. For example, in the absence of an agreement in writing, both profits and losses are shared equally by the partners.

II. Recording Formation of a Partnership: Financial Reporting: -normally we use the FMV of contributed assets to establish the partners' capital accounts. Tax Purposes: -normally we use the originating partners cost to establish the partnership tax basis for assets contributed and the resulting capital accounts.

51 Example--Formation of a Partnership: Carl, Edith, and Doris decided to engage in a real estate venture as a partnership. Carl invested $90,000 cash and Edith provided office equipment that is carried on her books at $82,000. The partners agree that the equipment has a fair value of $120,000. There is a $30,000 note payable remaining on the equipment to be assumed by the partnership. Although Doris has no physical assets to invest in the partnership, both Carl and Edith believe that her experience as a real estate appraiser is a valuable skill needed by the partnership and is a basis for granting her an equal capital interest in the partnership. Required: Assuming that each partner is to receive an equal capital interest in the partnership: A. B. C. Record the partnership formation under the bonus method. Record the partnership formation under the goodwill method, and assume a total goodwill of $90,000. Discuss the appropriateness of using either the bonus or goodwill methods to record the formation of the partnership.

52 III. Partnership Operations: Allocating Profits and Losses: --If partnership agreement is silent (or if there is no partnership agreement), then split profits and losses equally. --If agreement only specifies a profit ratio, courts assume that the loss ratio is the same. Common Profit/Loss Allocation Bases: 1. Specified ratio of profit/loss. 2. Specified ratio based on beginning, average, or ending capital balances. Note: A partner's capital account is increased by his or her share of the partnership profits and is decreased by partner withdrawals (partnerships do not pay dividends and do not make a distinction between contributed capital and earnings retained in the business). 3. 4. 5. "Interest" on beginning, average, or ending capital balances. "Salary" Allocation. "Bonus" Allocation. Note: Allocation of profit to the partners tells us how much of the "income summary" balance should be "closed out" to the partners' capital balances. The partnership does not record salary expense for any of the profits allocated to the partners (even if allocation bases #4 and/or #5 from the above list are used to allocate profits). Note: Be careful. Interest on loans made by a partner to the partnership is treated as an expense (but not interest on capital balances as a way to allocate profits--#3 above). Note: Usually, "Interest", "Salary" and/or "Bonus" are allocated first and then the remaining profit is allocated by the profit/loss ratio. or, of course, we can simply allocate profits by the P & L ratio. Allocation Base #1--Profit and Loss Ratio: For Example, the P & L ratio is 7:3 and total partnership profits are $100,000.

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

Allocation Base #3--Interest on Capital Balance: Used along with another basis when capital provided is an important factor to recognize in profit and loss allocation. Specify (in partnership agreement) 1. Interest rate. 2. Capital balance to use (beginning, average, or ending). 3. How remaining profits or losses should be allocated. Example: 1. 2. 3. 4. 10% interest rate on the beginning capital balances is allocated first. Remaining profits and losses are divided equally. "A" beginning capital = $100,000 "B" beginning capital = $ 50,000 This year's partnership profits = $12,000.

54 Allocation Base #4--Salary: -Recognized when "time spent" or "expertise" should be reflected in the profit allocation. (For example, to reward Partner "A" for spending much more time in partnership activities than the other partners.) After allocation of full salary, remaining profits or losses are usually divided based on the profit and loss ratio. 1. Salary allocation to Partner "A" is $20,000. 2. Remaining profits and losses are divided equally between Partner A and Partner B. 3. Total partnership profits were $30,000.

--

Example:

55 Allocation Base #5--Bonus: -Need to specify in the partnership agreement 1. bonus %. 2. what net income figure to use to calculate the bonus. a. Net Income before bonus allocation (easy to compute) or b. Net income after bonus (and after other profit and loss allocations). 1. Net Income before allocations =$10,000. 2. Beg. Capital ("A" = $10,000) ("B" = $30,000). 3. Profit and Loss allocation: a. 10% interest on beg. capital of "A" and "B." b. 20% bonus to "A" on net income after "interest" and bonus. c. Remaining profit or loss is to be divided equally.

Example:

56 IV. Changes in Partnership Ownership: (A) New partner buys out old partner (or buys out two or more partners' partnership interests). No cash to partnership (3P >>>>>> 3P) or (3P >>>>>>> 4P). (B) New partner buys new partnership interest from the partnership. $$$$ to Partnership (3P >>>>>>>> 4P). (C) Withdrawal, retirement, or death of an old partner. $$$$ from Partnership (3P >>>>>>>> 2P).

Steps to recording admission of new partner: Step #1: Adjust identifiable assets on the partnership books to FMV. (Can be justified because one partnership entity is ending and one is beginning). Determine if any "goodwill" is involved in the transaction (step not needed if bonus method is used). Record admission of new partner using the bonus method or the goodwill method.

Step #2:

Step #3:

57 Situation (A): New partner buys out old partner (or buys out two or more partners' partnership interests). No cash to partnership (3P >>>>>> 3P) or (3P >>>>>>> 4P). Example: 1. 2. Assets are increased to FMV and capital accounts of existing partners are increased based on profit and loss ratio. After journal entry in #1 is booked, capital accounts are as follows: Capital $10,000 (1/3) 20,000 (2/3) $30,000 P & L Ratio 30% 70%

X, Capital Y, Capital

3.

"N" pays the two partners $8,000 (1/3 = $2,666 to "X" and 2/3 = $5,333 to "Y") for a 20% interest.

Bonus Method:

Goodwill Method:

58 Situation (B): New partner buys new partnership interest from the partnership. $$$$ to Partnership (3P >>>>>>>> 4P). Example: The following balance sheet is for the partnership of Alice, Ben, and Kurt: Cash Other assets $ 60,000 640,000 $700,000 Liabilities Alice, Capital (40%) Ben, Capital (40%) Kurt, Capital (20%) $200,000 165,000 215,000 120,000 $700,000

Figures shown parenthetically reflect profit and loss ratios. Required: Prepare the necessary journal entries to record the admission of Dan in each of the following independent situations. Some situations may be recorded in more than one way (bonus and goodwill methods). 1. 2. Dan is to invest sufficient cash to receive a one-sixth interest. The parties agree that the admission is to be recorded without recording goodwill or bonus. Dan is to invest $175,000 for a 1/4th interest.

59 Situation B example continued: 3. Same facts as before except that Dan is to invest $175,000 for a 40% interest.

60 Situation (C): Withdrawal, Death, or Retirement of Partner $$$$ leaves the partnership (3P >>>>>>>> 2P) Possibility #1 (Good news for withdrawing partner). If: Amount paid by partnership > withdrawing partner's capital account

Then, we have 3 choices: 1. Bonus method 2. Partial goodwill method.*** 3. Total goodwill method.*** *** Don't use if goodwill relates to withdrawing partner. Example: (Possibility #1--Good news for withdrawing partner). Facts: 1. Partnership capital structure is as follows. P/L Ratio X, Capital = $60,000 1/3 Y, Capital = $70,000 1/3 Z, Capital = $50,000 1/3 2. Partnership pays $80,000 to buy out "X." Bonus Method

Partial Goodwill Method

Total Goodwill Method

61 Possibility #2 (Bad news for withdrawing partner). If instead: Amount paid by partnership < withdrawing partner's capital account

Then, we have 2 choices: 1. Bonus method (withdrawing partner may just "want out" for personal reasons). 2. Write down assets (if overvalued). Example: (Bad news for withdrawing partner). Facts: Same as previous example, except that "X" is paid $50,000 by the partnership. Bonus Method:

Asset Write-Down Method:

62 Chapter 16 Partnership Liquidation In this chapter we look at: Simple Liquidation I III Installment Liquidation II (not covered)

Solvent Partnership Insolvent Partnership

---------------------------------------------------------------------------------------------------Definitions: Simple Liquidations --All assets are sold before distributions are made to anyone. Installment Liquidations--Series of payments are made as assets are sold off. Solvent Partnership = (Positive Owners Equity) 1. All liabilities can be paid out of partnership assets. 2. We may need money from one partner to satisfy the debit balance in the capital account of another partner. Insolvent Partnership = (Negative Owners Equity) 1. Partners' personal assets are needed to pay off liabilities. ----------------------------------------------------------------------------------------------I. Simple Liquidation (Solvent Partnership): 1. Sell off all assets before distributions are made to anyone. 2. Gains/losses are distributed to the partners based on the profit and loss ratio. 3. Order of payment: a. outside creditors. b. partners' loans to partnership. c. partners' capital accounts. 4. However, if a partner has a credit loan balance and a debit capital balance, we have to offset these. 5. On the other hand, if a partner has a credit loan and credit capital balance (the loan must be paid off before any partner capital accounts are paid off). Note: Usually, liquidation expenses (liabilities) must be paid before other creditors. For example, accounting and legal fees related to the liquidation.

63 Example #1--Simple Liquidation of a Solvent Partnership: Balance Sheet Before Liquidation Cash Noncash Assets $11,000 100,000 $111,000 A/P 85,000 Loan from A 2,000 Loan from B 1,000 A, Capital (Cr) 5,000 B, Capital (Cr) 10,000 C, Capital (Cr) 8,000 $111,000

Additional Facts: The non-cash assets are sold for a net of $80,000. Profit/loss ratios: A = 50% B = 40% C = 10% No additional amounts can be contributed by any partner. (i.e., all are personally insolvent) Required: Prepare a Partnership Liquidation Schedule.

64 II. Installment Liquidation (Solvent Partnership): 1. Noncash assets will be converted to cash over time. 2 Distribution of cash to partners is made in installments. It is a good idea to prepare a Cash Distribution Plan. 1. This schedule indicates the order of the cash distributions as cash becomes available. 2. The partners and their personal creditors can use this schedule to estimate the amount of cash each partner may be getting from the partnership. 3. The Cash Distribution Plan is prepared before noncash assets are sold. We do not know if we have a solvent or insolvent partnership at this point. How to prepare a Cash Distribution Plan. 1. Combine capital balances with partner loans. 2. Find each partner's "loss absorption potential" (i.e., the maximum loss that would bring a given partner's combined capital balance to $0). 3. The partner with the highest "loss absorption potential" will be the first to receive a partnership distribution. 4. This process will eventually bring combined capital accounts in line with the profit and loss ratio. 5. After this point, any subsequent distributions will be based on the profit and loss ratio.

65 Example #2--Loss Absorption Schedule and Cash Distribution Plan: The Balance Sheet of the Oslo Company just prior to liquidation is as follows: Assets Assets $258,000 Equities Accounts payable Bates, loan Bates, capital (Cr) Hunt, capital (Cr) Riley, capital (Cr) $ 18,000 12,000 28,000 80,000 120,000 $ 258,000

Bates, Hunt, and Riley share profits and losses in the ratio 1:4:5, respectively. Required: Prepare a Loss Absorption Schedule and a Cash Distribution Plan.

66 II. Installment Liquidation (Solvent Partnership) (continued) In this situation we have two choices 1. Use a cash distribution plan (see Example 2 on previous page) or 2. Make a "schedule of safe payments" every time a distribution is to be made. Schedule of Safe Payments We assume the largest possible loss at each cash distribution point. Loss = book value of noncash assets (deemed to be worthless) + potential unrecorded liabilities. + remaining liquidation expenses

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

67 Example #3--Installment Liquidation (Solvent Partnership) with a Schedule of Safe Payments: The James, Allen, and Burk Partnership has not been successful; hence, the partners have sadly concluded that operations must be terminated and their partnership liquidated. Profits and losses are shared as follows: James, 45%; Allen, 35%; and Burk 20%. As the accountant placed in charge of this partnership, you have responsibility for the liquidation and distribution of assets. When you assume your responsibilities, the partnership balance sheet is as follows: Assets Cash Other assets $18,000 54,000 Equities Liabilities Loan from James James, capital (Cr) Allen, capital (Cr) Burk, capital (Cr) Total equities

Total assets

$72,000

$12,000 18,000 6,000 30,000 6,000 $72,000

During the first two months of your duties, the following events occur: 1. 2. 3. 4. Required: Assets having a book value of $40,000 are sold for $12,000 cash. Previously unrecorded liabilities of $1,000 are recognized. Before distributing available cash balances to creditors and partners, you conclude that a cash reserve of $1,000 should be set aside for future potential expenses. Remaining cash balances are distributed to creditors and partners. Prepare a schedule of partnership liquidation and a schedule of safe payments.

68 III. Insolvent Partnership (Simple or Installment Liquidation): In this unfortunate situation of an insolvent partnership, some partners will need to pay out of their personal assets to satisfy partnership creditors (if the payments are only to satisfy other partners, then this is not an insolvent partnership). Priorities of Partnership and Personal Creditors: Under the Uniform Partnership Act, we have the concept of the "Marshalling of Assets." (We divide --i.e., marshall-- the partnership and personal assets into categories). Priority to Partnership Assets: 1. Partnership creditors. 2. Personal creditors have a secondary claim on the appropriate partner's capital account. (For example, personal creditors of partner "A" can only have a secondary claim on partner "A's" capital account--not the other partners' capital accounts). Priority to Personal Assets: 1. Personal Creditors. 2. Partnership Creditors--for the full amount owed to them. The amount owed is not limited by the extent of the partner's capital account. 3. Claims of other partners due to a debit balance in our capital account.

69 Example #4--Partnership Liquidation (Insolvent Partnership): Mathis, Overton, and Downey are partners sharing profits in the ratio of 4:3:2, respectively. The partnership and two of the partners are currently unable to make full payment of their obligations to creditors. The balance sheet of the partnership and an enumeration of the assets and liabilities of the separate partners are as follows: MOD PARTNERSHIP Balance Sheet Assets Cash Other assets Equities 500 Accounts payable 60,500 Capital: Mathis Overton Downey Total Capital 61,000 Total equities

$37,000 (Cr) $10,000 (Cr) 6,000 (Cr) 8,000 24,000 $61,000

Total assets

Assets and Liabilities of Partners M, O, and D Excluding Partnership Interests Cash and Cash Value of Personal Assets

Partner Liabilities Mathis $20,000 Overton Downey

$31,000 9,450 4,000 11,900 5,000

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

70 Chapter 17 Introduction to Fund Accounting Objectives: Accounting for nonbusiness organizations (e.g., City of San Diego, United Way). 1. 2. Tracking inflows and outflows of funds (not revenues and expenses). Making sure that legal requirements are met.

Objectives: Business Accounting. 1. We try to measure profit (how well we did). We match efforts (expenses) with accomplishments (revenues).

With fund accounting it is hard to measure accomplishments (only efforts). How to measure better public schools or better fire departments? You can only develop imperfect measures of performance such as increased SAT scores and decreased response time for the fire department. Question: How to aggregate the accomplishments of the public schools, the fire department, etc.,? Answer: You can't. So if we dont have an income statement to see how weve done, what do we have instead? Operating Statement (also known as the Statement of Revenues, Expenditures, and Changes in Fund Balance--sort of a hybrid of the income statement and statement of cash flows) Inflows: 1. 2. 3. Outflows: 1. 2.

Revenues Transfers from other funds (to the general fund). Bond Issues Expenditures (includes expenses and asset purchases) Transfers to other funds (from the general fund).

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

Under Modified Accrual Accounting we recognize revenue when it is (a) measurable and (b) available to pay current obligations. Three Examples: Property Taxes: Property taxes, income taxes, and sales taxes and fines. Revenue is recognized when the taxes are levied--even if the collection will be in the next accounting period. Revenue is recorded when the tax return is filed.

Income Taxes:

Sales taxes and fines: Revenue is recorded when collected. Note: Proprietary funds (like a water district) use pure accrual accounting and record revenue when earned. Inflow #2: Bond issue proceeds = (not revenue because must be paid back)--inflow recorded upon receipt. Transfers from another fund = not revenue (does not increase the funds of the govt. entity as a whole). Expenditures = amounts that will flow out to pay for goods or services to an outside party. Note: Expenditures = (receipt of bill). Disbursement = (payment of bill). Outflow #2: Transfers to other funds = not an expenditure (does not decrease funds of a govt. entity as a whole).

Inflow #3:

Outflow #1:

72 Example--General Fund Journal Entries: The trial balance for the General Fund of the City of Centennial as of December 31, 2001 is presented below: DEBIT 300,000 75,000 CREDIT

Cash Supplies Inventory Unreserved Fund Balance Reserve for Supplies Inventory Totals

375,000

300,000 75,000 375,000

Transactions of the General fund for the year ended December 31, 2002, are summarized as follows: 1. The City Council adopted the following budget for 2002: Estimated Revenue Transfer from Trust Fund Appropriations Transfer to Debt Service Fund 2. 3. 4. 5. 6. 1,600,000 50,000 1,530,000 80,000

7. 8. 9. 10.

Property taxes of $1,500,000 were levied, of which it is estimated that $30,000 will not be collected. Purchase orders in the amount of $1,400,000 were placed with suppliers and other vendors. Property taxes in the amount of $1,450,000 were collected. $50,000 was received from the Trust Fund. Invoices in the amount of $1,380,000 were approved for payment. The amount originally encumbered for these invoices was $1,360,000. The invoices included $25,000 net of trade-in allowance for the purchase of a new minicomputer and $400,000 for supplies. The City received a trade-in allowance of $4,000 on its old minicomputer, which had been purchased three years earlier for $16,000. At the time the old minicomputer was purchased, it was estimated that it would have a useful life of four years. The new minicomputer is expected to last at least six years. Licenses and fees in the amount of $48,000 were collected. Vouchers in the amount of $1,300,000 were paid. Cash in the amount of $80,000 was transferred to the Debt Service Fund. Supplies on hand at the end of the year amount to $100,000. (Note: This is a $25,000 increase in supplies inventory.)

Required: A. Prepare entries in general journal form to record the transactions of the General Fund for the year ended December 31, 2002. The City of Centennial uses the purchase method to account for supplies inventory. B. Prepare a preclosing trial balance for the General Fund as of December 31, 2002. C. Prepare the necessary closing entries for the General Fund for the year ended December 31, 2002. D. Prepare a balance sheet and a statement of revenue, expenditures, and other changes in fund balance for the General Fund for the year ended December 31, 2002.

73 Chapter 18 Introduction to Accounting for State and Local Governmental Units Government units typically will have a number of fund and other accounting entities. These are listed below. After going over this list we will primarily focus on the journal entries for two funds: Capital Projects Funds and Debt Service Funds. LIST OF GOVERNMENTAL FUNDS (and related Account Groups) A. Governmental (or Expendable) Funds Main reporting emphasis in on inflow and outflow of expendable funds and the remaining fund balance. Balance Sheet: Current Assets = Current Liabilities + Fund Balance

Operating Statement: Inflows - Outflows = Change in Fund Balance 1. General Fund: Accounts for the inflows and outflows that a special governmental fund (see below) has not been set up to handle. This is the major fund for most governmental entities.

SPECIAL GOVERNMENTAL FUNDS: 2. Special Revenue Fund: Accounts for the inflows and outflows to finance the operation of a special facility (e.g., public park or museum). Likely inflows include (1) admission or usage charges, and (2) transfers in the from the general fund. Outflows go to pay for the operations of the special facility. 3. Capital Projects Fund: Accounts for the inflows and outflows for the acquisition of major capital facilities (e.g., roads or buildings). You could have one of these funds for each capital project. Likely inflows include (1) proceeds of L-T Debt issue, (2) special tax assessment, (3) transfers in from the general fund. Outflows go to pay for the capital project. Accounts for the inflows and outflows related to the accumulation of resources to pay off L-T Debt. Note the actual debt would not be accounted for in this fund -- just the collection of resources to pay off the L-T debt. (Like a sinking fund.) Accounts for resources where only interest on the funds can be used for a specific purpose (e.g., money for a special city library collection).

4. Debt Service Fund:

5. Permanent Funds:

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

6. General Fixed Assets Account Group: Any L-T Asset associated with any and all of the above governmental funds would be accounted for in this set of books. Note that there is only one General Fixed Assets Account Group set of books used for all of the above funds. Also, any cash flow related to the assets is accounted for in the funds above -- the account group ONLY shows the L-T assets and (possibility) related depreciation. 7. General L-T Obligation Account Group: Any L-T debt of any and all of the above governmental funds would be accounted for in this set of books. As with the fixed asset account group, there is only one General L-T Obligation Account Group set of books and only the debt is shown. Any cash flow is shown in the appropriate fund above.

B.

Proprietary (or Nonexpendable) Funds Accounts for the operations of a governmental unit that has been set up to be run like a profit-making business (e.g., public utility or bus service). Balance Sheet: Operating Statement: Assets = Liabilities + Fund Balance Revenues - Expenses = Net Income

Note:

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

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

C.

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

10. Fiduciary Funds:

75 Capital Projects Fund: The main thing to remember is that the Capital Projects Fund does not actually handle the debit for the capital project itself (the capital project itself is shown as an asset in the General LongTerm Fixed Assets Group of Accounts). The Capital Projects Fund only accounts for the money set aside the to pay for the Capital Project. Bond issue proceeds will increase the Fund Balance of the Capital Projects Fund and incurred expenditures will reduce this Fund Balance.

Example--Capital Projects Fund: The town on Billville authorized a municipal building to be constructed at a cost of $175,000. The construction will be financed from the proceeds of the issuance of $175,000 in 10% coupon rate bonds. Any difference between the par (face) value of the bonds and the proceeds from their sale is transferred to the Debt Service Fund. Transactions and events relating to this project include the following: 1. 2. 3. 4. 5. 6. 7. 8. The proceeds from the sale of the bonds were received and included a premium on the bond issue of $15,000. The premium was transferred to the Debt Service Fund. Encumbrances were recorded upon the signing of the construction contract in the amount of $175,000. Contract billings in the amount of $85,000 were approved for payment. Contract billings were paid in the amount of $85,000. All nominal accounts are closed and construction in progress was recorded in the appropriate account group in anticipation of the preparation of financial statements. Contract billings in the amount of $90,000 were approved on the completion of the municipal building. Contract billings of $90,000 less a retention of 5% were paid. The building was accepted, all construction liabilities were paid and the building was recorded as an asset in the appropriate account group.

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

76 Debt Service Funds: General Obligation Bonds may be serial bonds or term bonds. (A) Serial Bonds: The principal is repaid in a specified number of annual (and usually) equal installments. (B) Term Bonds: The principal is repaid in one lump sum at a specific maturity date.

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

Example--Debt Service Fund (Term Bonds): On January 1, 2000, the City of Cape May authorized and issued $200,000 of 5%, threeyear term bonds. Interest is payable annually on December 31. A debt service fund is established to accumulate the necessary resources to pay the annual interest on the bonds and to redeem the bonds when they mature. The required annual addition for principal and interest will be transferred annually to the debt service fund from the general fund. It is assumed that amounts received by the debt service fund for the payment of principal can be invested at an annual return of 8%. Required: A. Prepare a schedule to calculate the annual required additions and annual required earnings to repay the principal on the bonds assuming that the first installment for principal and interest is transferred to the debt service fund from the general fund on December 30, 2000. Prepare the entries to be recorded by the debt service fund for 2000, 2001, and 2002.

B.