CHAPTER 4

AGENCY & PRINCIPAL, HEAD OFFICE & BRANCH

4.1 Distinguishing Agency and Branch
An agency relationship refers a contract under which one or more
persons (the principals) engage another persons (the agents) to carry out
some service on their behalf that involves delegating some decision
making authority to the agent.
Branch is a business unit located at some distance from the home office.
This unit carries merchandise, makes sales, and makes collections from
its customers.
4.2 Accounting for Sales Agency
The term sales agency sometimes is applied to a business unit that
performs only a small portion of the functions traditionally associated
with a branch.
 A sales agency usually carries samples of products but does not
have inventory of merchandise
 Orders are taken from customers and transmitted to the home
office, which approves customers’ credit and ships the
merchandise directly to the customers
 Accounts receivables are managed by the home office
 An imprest cash fund is maintained at the sales agency for
payment of operating expenses
 Hence, no need for complete accounting records at a sales agency
other than a record of sales to customers and a summary of cash
payments supported by vouchers
 Separate revenue and expense accounts may be opened by the
home office for each sales agency so as to measure its profitability
 Subsidiary ledger accounts may be used to control fixed assets and
cost of goods sold by sales agencies

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Illustration: Journal Entries for a Sales Agency
Journal entries required at the home office in connection with a sales
agency (Shashemene Agency), assuming the perpetual inventory
system is used:
HOME OFFICE
JOURNAL ENTRIES FOR SHASHEMENE AGENCY TRANSACTIONS
Inventory Samples: Shashemene Agency 1,500
Inventories 1,500
To record merchandise shipped to sales agency for use as samples

Imprest Cash Fund: Shashemene Agency 1,000

Cash 1,000
To establish imprest cash fund for sales agency

Trade Accounts Receivable 50,000

Sales: Shashemene Agency 50,000
To record sales made by sales agency

Cost of Goods Sold: Shashemene Agency 35,000

Inventories 35,000
To record cost of merchandise sold by sales agency

Operating Expenses: Shashemene Agency 10,000

Cash 10,000
To replenish imprest cash fund (several checks during the period)

Sales: Shashemene Agency 50,000

Cost of Goods Sold: Shashemene Agency 35,000
Operating Expenses: Shashemene Agency 10,000
Income Summary: Shashemene Agency
5,000
To close revenue and expense accounts to a separate income
summary ledger account for a sales agency

Income Summary: Shashemene Agency 5,000

Income Summary 5,000
To close net income of sales agency to Income Summary ledger
account

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4.3 Accounting for Branch
The accounting work done at each branch depends upon the policy or
the accounting system of the enterprise which may provide for a
complete set of accounting records at each branch or keep all accounting
records in the home office.
A branch may, accordingly, maintain a complete set of accounting
records consisting of journals ledgers and chart of accounts similar to
those of an independent business enterprise, prepare financial
statements and periodically forward to the home office.
Transactions recorded by the branch should include all controllable
expenses and revenue for which the branch manager is responsible.
Expenses such as depreciation and branch plant assets are generally
maintained by the home office.
4.4 Reciprocal Accounts
The accounting records maintained by a branch include a Home Office
ledger account that is credited for all merchandise, cash, or other
resources provided by the home office; it is debited for all cash
merchandise or other asset sent to the home office or to other branches.
The Home Office account is a quasi-ownership equity account that shows
the net investment by the home office in the branch. At the end of the
accounting period when the branch closes its accounts, the Income
Summary account is closed to the Home Office account. A net income
increases the credit balance of the Home Office account; a net loss
decreases this balance.
In the home office accounting records, a reciprocal ledger account with a
title such as Investment in Branch is maintained. This non current asset
account is debited for cash, merchandise, and services provided to the
branch by the home office, and for net income reported by the branch. It
is credited for the cash or other assets received from the branch, and for

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any net loss reported by the branch. Thus, the Investment in Branch
account reflects the equity method of accounting. A separate investment
account is generally maintained by the home office for each branch.
At the end of an accounting period, the balance of the Investment in
Branch X ledger account in the accounting records of the home office
may not agree with the balance of the Home Office account in the records
of Branch X, because certain transactions may have been recorded by
one office but not by the other. These balances of the reciprocal accounts
must be brought into agreement before combined financial statements
are prepared.
4.5 Expenses Incurred by Home Office and Allocated to Branches
Some business enterprises follow a policy of notifying each branch of
expenses incurred by the home office on behalf of the branch. When
such a policy is adopted, an expense incurred by the home office and
allocated to a branch is recorded by the home office by a debit to
Investment in Branch and credit to an appropriate expense account; the
branch debits an expense account and credits Home Office. Expenses
paid by the home office and allocable to branches may be insurance,
property and other taxes, depreciation, and advertising.
Expenses of the home office may also be allocated to branches especially
if the home office does not make sales and functions only as accounting
and control center. The head office may also charge each branch interest
on the capital invested there in. such expenses would not appear in the
combined income statement as they would be offset against interest
revenue recorded by the home office.
4.6 Billings of Merchandise to Branches
Three alternative methods are available to the home office for billing
merchandise shipped to its branches:
 At cost
 At a percentage above cost

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  At the retail selling price
Shipment of merchandise to a branch does not constitute a sale as the
ownership does not change.
Billing at cost
 The simplest and widely used procedure
 Avoids complications of unrealized gross profits on inventories
 Attributes all gross profit to the branches even if some of the
merchandise may be manufactured by the home office
Billing at a percentage above cost
 Intended to allocate reasonable gross profit to the home office
 Under this method, the net income reported by the branch is
understated and the ending inventories are overstated for the
enterprise as a whole
 Adjustments must be made to eliminate intra company profits in
preparation of combined financial statements
Billing at Retail Selling Prices
 Based on a desire to strengthen internal control over inventories
 The home office record of shipments to a branch, when considered
along with sales reported with the branch, provide a perpetual
inventory stated at selling price
 Any difference with periodic physical count should be investigated
promptly
Illustrative Journal Entries of Operation of a Branch
Assume that S Company bills merchandise to Branch X at cost and the
branch maintains complete accounting records and prepares financial
statements.
Both the branch and home office use the perpetual inventory system.
Equipment used at the branch is carried in home office records.
Expenses such as advertising and insurance are incurred by the home
office and billed to the branch.

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Summarized transactions of year 1
1. Cash of 1,000 was forwarded to Branch X
2. Merchandise with cost of 60,000 was shipped to Branch X
3. Equipment of 500 acquired by Branch X, to be carried in home
office records
4. Credit sales by Branch X amounted to 80,000; the cost of
merchandise sold was 45,000.
5. Collections of trade accounts receivable of 62,000 made by Branch
X.
6. Payments for operating expenses by Branch X totaled 20,000
7. Cash of 37,500 remitted to home office by Branch X
8. Operating expenses charged to Branch X by home office totaled
3,000
When a branch obtains merchandise from outsiders also, the
merchandise acquired from the home office should be recorded in a
separate Inventories from Home Office account.

Home Office
1. Investment in Br X 1,000
Cash 1,000
Branch
Cash 1,000
2. Investment in Br X 60,000
Home Office 1,000
Inventories 60,000

Inventories 60,000
3. Equipment: Br X 500
Home Office 60,000
Investment in Br X 500

Home Office 500

4. None
Cash 500
Trade A/R 80,000

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CGS 45,000
Sales 80,000
Inventories 45,000

5. None
Cash 62,000
Trade A/R 62,000
6. None
Operating Exp 20,000
Cash 20,000
7. Cash 37,500
Inv. In Br X 37,500 Home Office 37,500
Cash 37,500
8. Inv in Br X 3,000
Operating Exp 3,000 Operating Exp 3,000
Cash 3,000

Adjusting and Closing Entries

None
Sales 80,000
CGS 45,000
Op. Exp 23,000
Income Sum 12,000
Investment in Br X 12,000
Income Br X 12,000 Income Summary 12,000
Home Office 12,000
Income Br X 12,000
Income Summary 12,000 None

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4.7 Transaction between Branches
Efficient operation may on occasion require that assets be transferred from one
branch to another. A branch does not carry a reciprocal account with another
branch but records the transfer in the Home Office account.
For example if Branch A transfers merchandise to Branch B, Branch A debits
Home Office and credits Inventories, while Branch B debits Inventories and
credit Home Office. The Home Office records the transfer by debiting
Investment in Branch B and crediting Investment in Branch A.
The additional freight cost due to the indirect routing does not justify increase
in the carrying amount of inventories. Only freight costs of the direct shipment
from the home office are included in inventory costs.
Illustration: The home office shipped merchandise costing 6,000 to Branch D
and paid freight costs of 400. Subsequently, the home office instructed Branch
D to transfer this merchandise to Branch E. Branch D paid 300 to carry out
this order. The cost of direct shipment from home office to E would have been
500. The journal entries in the three sets of records would be:
Home Office
Investment in Branch D 6,400
Inventories 6,000
Cash 400
To record shipment of merchandise and payment of freight costs

Investment in Branch E 6,500

Excess Freight Expense- Interbranch Transfers 200
Investment in Branch D 6,700
To record transfer of merchandise from Branch D to Branch E under
instruction of the home office

Branch D

Freight in 400
Inventories 6,000
Home Office 6,400

To record receipt of merchandise from home office with freight costs paid in
advance by home office
Home Office 6,700
Inventories 6,000
Freight in 400
Cash 300
To record transfer of merchandise to Branch E under instruction of home office
and payment of freight costs of 300

Branch E

Inventories 6,000
Freight in 500
Home Office 6,500
To record receipt of merchandise from Branch D transferred under instruction
of home office and normal freight billed by home office.

The excessive freight costs from such shipments generally result from
inefficient planning of original shipments and should not be included in
inventories. If branch managers are given authority to order transfer of
merchandise between branches, the excess freight costs should be recorded as
expenses attributable to the branches.

4.8 Combined Financial Statements

A balance sheet for distribution to external users the financial position of the
business enterprise as a single entity. A convenient starting point in the
preparation consists of the adjusted trial balances of the home office and the
branches.
The assets and liabilities of the branch are substituted for the Investment in
Branch ledger account included in the home office trial balance. Similar
accounts are combined to produce a single total amount for cash, trade
receivables, and other assets and liabilities of the enterprise as a whole.
Reciprocal accounts are eliminated as they have no significance when the
branch and home office report as a single entity. The balance of the Home
Office account is offset against the balance of the Investment in Branch
account.
The operating results of the enterprise (the home office and the branches) are
shown by an income statement in which the revenue and expenses of the
branch are combined with the revenue and expenses of the home office. Any
intracompany profits or losses are eliminated.

Working Paper for Combined Financial Statements

A working paper for combined financial statements has three purposes:
 To combine ledger account balances like assets and liabilities
 To eliminate any intra company profits or looses
 To eliminate the reciprocal accounts
Illustration: the same data is going to be used. Assuming that all the year end
routine adjustments are made, the working paper is begun with adjusted trial
balances of the home office and Branch X.
 S CORPORATION
Working Paper for Combined Financial Statements of Home Office and Branch X
For the Year Ended December 31, Year 1
(Perpetual Inventory System: Billing at Cost)

Adjusted TB Elimination Combined

Home Off Br X
Income statement
Sales (400,000) (80,000) (480,000)
Cost of Goods Sold 235,000 45,000 280,000
Operating expenses 90,000 23,000 113,000
Net income 75,000 12,000 87,000
Total 0 0

Statement of RE
Retained E Jan 1 (70,000) (70,000)
Net income (75,000) (12,000) (87,000)
Dividends 40,000 40,000
Retained E Dec 31 117,000

Balance sheet
Cash 25,000 5,000 30,000
Trade A\R (net) 39,000 18,000 57,000
Inventories 45,000 15,000 60,000
Investment in Br X 26,000 a (26,000)
Equipment 150,000 150,000
Acc Dep. (10,000) (10,000)
Trade A\P (20,000) (20,000)
Home Office (26,000) b 26,000
Common Stock (150,000) (150,000)
Retained earnings (117,000)
Total 0 0 0 0
In the elimination column, elimination (a) offsets the balance of Investment in
Branch X account against the balance of the Home Office account. This
elimination appears in the working paper only. Combined financial statements
of S Corporation prepared on the basis of the above working paper are:
S Corporation
Income Statement
For the Year Ended Dec 31, Year 1

Sales 480,000
Cost of goods sold 280,000
Gross profit 200,000
Operating expenses 113,000
Net income 87,000

Earning per share of common stock 5.80

S Corporation
Statement of Retained Earnings
For the Year Ended Dec 31, Year 1

Retained earnings, beginning of year 70,000

Add: Net income 87,000
Subtotal 157,000
Less: Dividends (2.67 per share) 40,000
Retained earnings, end of year 117,000
 S Corporation
Balance Sheet
Dec 31, Year 1

Assets
Cash 30,000
Trade A/R (net) 57,000
Inventories 60,000
Equipment 150,000
Less: Accumulated Depreciation 10,000 140,000
Total assets 287,000

Liabilities and Stockholders Equity

Liabilities
Trade A/P 20,000

Stockholders’ equity
Common stock (10 par) 150,000
Retained earnings 117,000 267,000
Total liabilities and stockholders’ equity 287,000

Shipping Merchandise to Branches at Price above Cost

As explained earlier, some businesses bill merchandise shipped to branches at
cost plus a markup percentage or retail selling prices. Because both methods
involve similar modification of accounts, a single example is used to illustrate
the key points.
Change one assumption of the former example to: the home office bills
merchandise shipped to branches at 50% above cost. The merchandise
shipment in the previous example is thus billed at 90,000 (60,000+50% mark
up of 30,000) and are recorded as follows:
Home Office
Investment in Br X 90,000
Inventories 60,000
Overvaluation of inv: Br X 30,000
Use of the allowance account enables the home office to maintain record of
unrealized gross profit on shipments.
Branch
Inventories 90,000
Home Office 90,000
The two reciprocal accounts at branch and head office viz. Home Office and
Investment in Branch X accounts will have balances of 56,000 before the
accounts are closed and net income or loss entered. This amount is 30,000
larger than the balance in the previous illustration as a result of change in
billing method.
At the end of the period the branch will report its inventories at billed prices of
22,500 (15,000*50%). In the records of the home office the required balance of
the Allowance for Overvaluation of Inventories: Branch X account is 7,500
(22,500-15,000); thus, this account balance must be reduced to 7,500 from the
present amount of 30,000 to represent the excess valuation contained in the
ending inventories of the branch.
Under the present assumption the branch reports a net loss of 10,500. The
adjustment of 22,500 is transferred as credit to Income: Branch X account,
because it represents additional gross profit over that reported by the branch.
Thus the actual net income for Branch X is 12,000, the same as the previous
illustration.
The following journal entries are passed in the home office records.
Income: Branch X 10,500
Investment in Branch X 10,500
To record net loss reported by branch
Allowance for Overvaluation of Inventories: Br X 22,500
Income: Branch X 22,500
To reduce allowance to amount by which ending inventories of branch exceed
cost
Income: Branch X 12,000
Income Summary 12,000
To close branch net income (as adjusted)

Working Paper when Billing to Branches at Price above Cost

S CORPORATION
Working Paper for Combined Financial Statements of Home Office and Branch X
For the Year Ended December 31, Year 1
(Perpetual Inventory System: Billing above Cost)

Adjusted TB Elimination Combined

Home Off Br X
Income statement
Sales (400,000) (80,000) (480,000)
Cost of Goods Sold 235,000 67,500 a (22,500) 280,000
Operating expenses 90,000 23,000 113,000
Net income 75,000 (10,500) b 22,500 87,000
Total 0 0
Statement of RE
Retained E Jan 1 (70,000) (70,000)
Net income (75,000) 10,500 b(22,500) (87,000)
Dividends 40,000 40,000
Retained E Dec 31 117,000
Balance sheet
Cash 25,000 5,000 30,000
Trade A\R (net) 39,000 18,000 57,000
Inventories 45,000 22,500 a(7,500) 60,000
Investment in Br X 56,000 c (56,000)
Allowance for over v (30,000) a 30,000
Equipment 150,000 150,000
Acc Dep. (10,000) (10,000)
Trade A\P (20,000) (20,000)
Home Office (56,000) b 56,000
Common Stock (150,000) (150,000)
Retained earnings (117,000)
Total 0 0 0 0
a) To reduce ending inventories and cost of goods sold of branch to cost,
and to eliminate balance in Allowance for Overvaluation of Inventories:
Branch X ledger account.
b) To increase net income of branch by portion of merchandise markup that
was realized.
c) To eliminate reciprocal ledger accounts.

Reconciliation of Reciprocal Accounts

In a previous section, the nature of reciprocal accounts and the necessity for
their reconciliation before the combined financial statements are prepared was
described. The situation is comparable to that of reconciling the ledger account
for Cash in Bank with the balance in the monthly bank statement.
Illustration: Assume the home office and the branch accounting records
contain the following data and the balances of the Home Office account and
Investment in Branch accounts on Dec 31 are 41,500 Cr. and 49,500 Dr.
respectively. Comparison of the two reciprocal accounts discloses four
reconciling items.
1. A debit of 8,000 in Investment in Branch account without a related credit
in Home Office account
Merchandise shipped to branch on Dec 29 but not received at year end.
Required journal in branch accounting records:
Inventories in Transit 8,000
Home Office 8,000
To record shipment of merchandise in transit from home office
The inventories in transit must be included in inventories in hand.
2. A credit of 1,000 in the Investment in Branch account without a related
debit in the Home Office account
The home office collected trade accounts receivable of the branch. The
journal entry required in the records of the branch on Dec 31:
Home Office 1,000
 Trade A/R 1,000
To record collection of accounts receivable by home office
3. A debit of 3,000 in the Home Office ledger account without a related
credit in Investment in Branch account
The branch acquired equipment for 3,000 on Dec 28 and debited Home
Office as equipment used by branch is carried in records of the home
office. The journal entry required in the records of the home office:
Equipment: Branch 3,000
Investment in Branch 3,000
To record equipment acquired by branch
4. A credit of 2,000 in the Home Office ledger account without a related
debit in the Investment in Branch account
Accounts receivable of the home office was collected on Dec 30 and
recorded as credit to Home Office. Journal entry required in the records
of the home office on Dec 31
Investment in Branch 2,000
Trade A/R 2,000
To record collection of receivable by branch
The effect of the foregoing end of year journal entries is to update the reciprocal
ledger accounts as shown below:
M COMPANY- HOME OFFICE AND A BRANCH
RECONCILIATION OF RECIPROCAL LEDGER ACCOUNTS
DEC 31, 19X9
Investment in Home Office
Branch
Balance before adjustment 49,500 Dr 41,500 Cr
Add: 1. Merchandise shipped 8,000
4. Home office A/R
collected by branch 2,000
Less: 2. Branch A/R
Colleted by H.O. (1,000)
3. Equipment acquired
By branch (3,000)
Adjusted balances 48,500 48,500