Advanced Financial Accounting-I

CHAPTER 4
ACCOUNTING FOR BRANCHES AND HEAD OFFICE
Introduction
Accounting for the operation of a business can become complicated whenever geographical
separation is encountered between the various facets of the organization. This chapter discusses
the special procedures necessary to record transactions occurring at significant distances from a
central office.
Branch accounting is analyzed with illustrative examples.The accounting and reporting for
segments of a business enterprise-primarily branches and divisions-are dealt with in this chapter.
Although branches of an enterprise are not separate legal entities, they are separate economic and
accounting entities whose special features necessitate accounting procedures tailored for those
features, such as reciprocal ledger accounts.
Objectives and Aims:
After completing this chapter, you would be able:
 Account for sales agency transactions
 Account for segments of a business enterprise, primarily branches and divisions
 Prepare working paper for combined financial statements
 Prepare combined financial statements for Home Office and Branches
 Comprehend the basic procedures for reconciliation of reciprocal accounts
 Record transactions between branches
2.1) Distinguishing Sales Agency, Branch, and Division
2.1.1. Sales Agency:
Sales agency is a term applied to a business unit that performs only a small portion of the
functions associated branch. A sales agency usually carries samples of products but does not
have an inventory of merchandise and usually lesser degree of autonomy.
2.1.2. Branch:
The term Branch is used to describe a business unit located at some distance from the Home
Office. Branches are economic and accounting entities. However, branches are not legal entity.
Branches may carry merchandise obtained from Home Office, make sales, approve customers’
credit, and make collections from its customers.
2.1.3. Division:
Division is a business segment or a business enterprise which generally has more autonomy than
a branch. Division may be as separate company or may not be a separate company. If the
division is not a separate company, the accounting procedures are the same as Branch. If the
division is a separate company (subsidiary company), the financial accounting requires
consolidation, which will be discussed in later topics.
Differences between Sales Agency, Branch and Division
Characteristics Sales Agency Branch Division
Degree of Autonomy Low Moderate High
Accounting Entity No Yes Yes
Legal Entity No No Possible
Economic Entity No No Possible
2.2. Accounting for Operation of Branch

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As a business enterprise grows, it may establish one or more branches to market its products over
a large territory. The term Branch is used to describe a business unit located at some distance
from the Home Office. The Accounting system, each maintains a fully set of books with a
complete self-balancing set of accounts and records its transactions with external parties in its
own accounting system. These transactions are recorded in the normal manner, and no special
treatment is needed. In addition, the home office and branch both must record transactions with
one another in their respective accounting systems. Even though the home office and each
branch maintain separate books, all accounts are combined for external reporting in such a way
that the external financial statements represent the company as a single economic entity.
This unit carries merchandise obtained from the Home Office, makes sales, approves customers’
credit, and makes collections from its customers. A branch may obtain merchandise solely from
the Home Office, or a portion may be purchased from outside suppliers. The cash receipts of the
branch often are deposited in a bank account belonging to Home Office; the branch expenses
then are paid from an imprest cash fund or a bank account provided by the Home Office. As the
imprest cash fund is depleted, the branch submits a list of cash payments supported by vouchers
and receives a check for a transfer from the Home Office to replenish the fund.
The use of an imprest cash fund gives the Home Office considerable control over the cash
transactions of the branch. However, it is common practice for a large branch to maintain its own
bank accounts. The extent of autonomy and responsibility of a branch varies, even among
different branches of the same business enterprise.
A segment of a business enterprise also may be operated as division, which generally has more
autonomy than a branch. The accounting procedures for a division not organized as Separate
Corporation (subsidiary company) are similar to those used for branches. When a business
segment is operated as a separate corporation, consolidated financial statements generally are
required.

Start-Up Costs of Opening New Branches

The establishment of a branch often requires the incurring of considerable costs before
significant revenue may be generated. Operating losses in the first few months are likely. In the
past, some business enterprises would capitalized and amortize such start-up costs on the
grounds that such costs are necessary to successful operation at a new location. However, most
enterprise recognized start-up costs in connection with the opening of a branch as expenses the
accounting period in which the costs are incurred. The decision should be based on the principle
that net income is measured by matching expired costs with realized revenue. Costs that benefit
future accounting periods are deferred and allocated to those periods. Seldom is there complete
certainty that a new branch will achieve a profitable level of operations in later years. Reporting
on the Costs of Start-Up Activities,” which required expensing of all start-up costs, including
those associated with organizing a new entity such as a branch or division.

Accounting System for a Branch and Home Office

The accounting system of one business enterprise having branches may provide for a complete set of
accounting records at each branch; policies of another such enterprise may keep all accounting records in
the Home Office. For example, branches of drug and grocery chain stores submit daily reports and
business documents to the Home Office, which enters all transactions by branches in computerized

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accounting records kept in a central location. The Home Office may not even conduct operations of its
own; it may serve only as an accounting and control center for the branches.
A branch may maintain a complete set of accounting records consisting of journals, ledgers, and a chart of
accounts similar to those of an independent business enterprise. Financial statements are prepared by the
branch accountant and forwarded to the Home Office. The number and types of ledger accounts, the
internal control structure, the form and content of the financial statements, and the accounting policies
generally are prescribed by the Home Office.
This section focuses on a branch operation that maintains a complete set of accounting records.
Transactions recorded by a branch should include all controllable expenses and revenue for which the
branch manager is responsible. If the branch manager has responsibility over all branch assets, liabilities,
revenue, and expenses, the branch accounting records should reflect this responsibility. Expenses such as
depreciation often are not subject to control by a branch manager; therefore, both the branch plant assets
and the related depreciation ledger accounts generally are maintained by the Home Office.
2.3. Reciprocal Ledger Accounts
Reciprocal accounts have equal and offsetting balances on both the home office and branch
books. They are used by both business units to record those transactions between the units or
made on behalf of one unit by the other. Transactions with external parties are recorded in the
normal manner. Transactions between the home office and a branch also are treated in the
normal manner except that they are recorded in intra-company accounts. these accounts are
reciprocal accounts between the home office and the branch. When the books of both the home
office and the branch are completely up to date, the balance in an intra-company account on the
home office books will be equal but opposite that of the related intra-company account on the
branch books. The balances of the two reciprocal accounts are adjusted for the same transactions.
The account balances are increased for asset transfers from the home office to branch and
reduced for asset transfers from the branch to the home office. Adjustments to the accounts also
are made for profits and losses of the branch, with branch profit leading to an increase in the
account balances and branch losses leading to a decrease. Note that the accounting records
maintained by a branch include a Home Office ledger account.
 Home Office account is credited for all merchandise, cash, or other assets provided by
the Home Office;
 Home Office account is debited for all cash, merchandise, or other assets sent by the
branch 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 an accounting period when the branch closes it
accounting records, the Income Summery 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.Investment in Branch is a non-current asset account, which
is debited for cash, merchandise, and services provided to the branch by the Home Office, and
for net income reported by the branch.Investment in Branch is credited for cash or other assets
received from the branch, and for net losses reported by the branch.
Thus, the Investment in Branch account reflects the equity method of accounting. A separate
investment account generally is maintained by the Home Office for each branch. If there is only

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one branch, the account title is likely to be Investment in Branch; if there are numerous branches,
each account title includes a name or number to identify each branch.
2.3.2 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 the branch’s behalf. Plant assets located at a branch generally are carried in the
Home Office accounting records. If a plant asset is acquired by the Home Office for the branch,
the journal entry for the acquisition is a debit to an appropriate asset account such as Equipment:
Branch and a credit to Cash or an appropriate liability account. If the branch acquires a plant
asset, it debits the Home Office ledger account and credits Cash or an appropriate liability
account. The Home Office debits an asset account such as Equipment: Branch and credits
Investment in Branch.
The Home Office also usually acquires insurance, pays property and other taxes, and arranges for
advertising that benefits all branches. Clearly, such expenses as depreciation, property taxes,
insurance, and advertising must be considered in determining the profitability of a branch. A
policy decision must be made as to whether these expense data are to be retained at the Home
Office or are to be reported to the branches so that the income statement prepared for each
branch will give a complete picture of its operations. 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 a Credit to an appropriate expense ledger account; the branch debits an expense account
and credits Home Office.
If the Home Office does not make sales, but functions only as an accounting and control center,
most or all of its expenses may be allocated to the branches. To facilitate comparison of the
operating results of the various branches, the Home Office may charge each branch interest on
the capital invested in that branch. Such interest expense recognized by the branches would be
offset by interest revenue recognized by the Home Office and would not be displayed in the
combined income statement of the business enterprise as a whole.
2.4.Billing of Merchandise Shipments to Branches
Three alternative methods area available to the Home Office for billing merchandise shipped to
its branches. The shipments may be billed:
1. At Home Office cost,
2. At a percentage above Home Office cost, or
3. At the branch’s retail selling price
The shipment of merchandise to a branch does not constitute a sale, because ownership of the
merchandise does not change.
1. Billing shipments to a branch at Home Office cost
This is the simplest procedure and is widely used. It avoids the complication of unrealized gross
profit in inventories and permits the financial statements of branches to give a meaningful picture
of operations. However, billing merchandise to branches at Home Office cost attributes all gross
profits of the enterprise to the branches, even though some of the merchandise may be
manufactured by the Home Office. Under these circumstances, Home Office cost may be the
most realistic basis for billing shipment to branches.

2. Billing shipments at a percentage above Home Office cost (such as 110% of cost)

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This may be intended to allocate a reasonable gross profit to the Home Office. When
merchandise is billed to a branch at a price above Home Office cost, the net income reported by
the branch is understated and the ending inventories are over-stated for the enterprise as a
whole.Adjustments must be made by the Home Office to eliminate the excess of billed prices
over cost (intracompany profits) in the preparation of combined financial statements for the
Home Office and the branch.

3. Billing shipments to a branch at branch retail selling prices

Thismay be based on a desire to strengthen internal control over inventories. The inventories
ledger account of the branch shows the merchandise received and sold at retail selling prices.
Consequently, the account will show the ending inventories that should be on hand at retail
prices. The Home Office record of shipments to a branch, when considered along with sales
reported by the branch, provides a perpetual inventory stated at selling prices. If the physical
inventories taken periodically at the branch do not agree with the amounts thus computed, an
error or theft may be indicated and should be investigated promptly.
2.1. Transactions between Branches
Efficient operations may on occasion require that merchandise or other assets be transferred from
one branch to another. Generally, a branch does not carry a reciprocal ledger account with
another branch but records the transfer in the Home Office ledger account. For example, if
MODJO Branch ships merchandise to ADAMA Branch, MODJO Branch debits Home Office
and credits Inventories (assuming that the perpetual inventory system is used). On receipt of the
merchandise, ADAMABranch debits Inventories and credits Home Office. The Home Office
records the transfer between branches by a debit to Investment in ADAMA Branch and a credit
to Investment in MODJO Branch.

The transfer of merchandise form one to another does not justify increasing the carrying amount
of inventories by the freight costs incurred because of the indirect routing. The amount of freight
costs properly included in inventories at a branch is limited to the cost of shipping the
merchandise directly from the Home Office to its present location. Excess freight costs are
recognized as expenses of the Home Office.
Illustration 2.4:
To illustrate the accounting for excess freight costs on inter-branch transfers of merchandise, assume the
following for excess freight costs on interbranch transfers of merchandise, assume the following data. The
Home Office shipped merchandise costing Br 6,000 to Dana Branch and paid freight costs of Br 400.
Subsequently, the Home Office instructed Dana Branch to transfer this merchandise to Evan Branch.
Freight costs of Br 300 were paid by Dana Branch to carry out this order. If the merchandise had been
shipped directly from the Home Office to Evan Branch, the freight costs would have been Br 500. The
journal entries required in the three sets of accounting records (assuming that the perpetual inventory
system is used) as follows:
1. In the Accounting Records of Home Office:
Investment in Dana Branch 6,400

Inventories 6,000

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Cash 400

To record shipment of merchandise and payment of freight costs

Investment in Evan Branch 6,500
Excess Freight Cost–Interbranch Transfer Expense 200
Investment in Dana Branch 6,700
To record transfer of merchandise from Dana Branch to Evan Branch under instruction of Home Office

Interbranch freight of Br 300 paid by Dana Branch caused total freight costs on this merchandise to
exceed direct shipment cost by Br 200 (Br 400 + Br 300 – Br 500 = Br 200).
2. In the Accounting Records of Dana Branch:
Inventories 6,000

Freight-In 400

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 Evan Branch under instruction of Home Office and payment of
freight costs of Br 300.
3. In Accounting Records of Evan Branch:
Inventories 6,000

Freight In 500

Home Office 6,500

To record transfer of merchandise to Evan Branch under instruction of Home Office and Normal freight
costs billed by Home Office.
Recognized excess freight costs on merchandise transferred from one branch to another as expenses of the
Home Office is an example of the accounting principle that expense and losses should be given prompt
recognition. The excess freight costs from such shipments generally result from inefficient planning of
original shipments and should not be included in inventories.
In recognizing excess freight costs of interbranch transfer as expenses attributable to the Home Office, the
assumption was that the Home Office makes the decisions directing all shipments. If branch managers are
given authority to order transfers of merchandise between branches, the excess freight costs are
recognized as expenses attributable to the branches whose managers authorized the transfers.

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2.6. Combined Financial Statement

2.3.4 Separate Financial Statements for Branch and for Home Office
A separate income statement and balance sheet should be prepared for a branch so management of the
enterprise may review the operating results and financial position of the branch. The branch’s income
statement has no usual features if merchandise is billed to the branch at Home Office cost. However, if
merchandise is billed to the branch at branch retail selling prices, the branch’s income statement will
show a net loss approximating the amount of operating expenses. The only unusual aspect of the balance
sheet for a branch is use of the Home Office ledger account in lieu of the ownership equity accounts for a
separate business enterprise. The separate financial statements prepared for a branch may be revised at the
Home Office to include expenses incurred by the Home Office allocable to the branch and to show the
results of branch operations after elimination of any intracompany profits on merchandise shipments.
Separate financial statements also may be prepared for the Home Office so that management will be able
to appraise the results of its operations and its financial position. However, it is important to emphasize
that separate financial statements of the Home Office and of the branch are prepared for internal use
only; they do not meet the needs of investors or other external users of financial statements.
2.3.5 Combined Financial Statements for Home Office and Branch
A balance sheet for distribution to creditors, stockholders, and government agencies must show the
financial position of a business enterprise having branches as a single entity. A convenient starting point
in the preparation of a combined balance sheet consists of the adjusted trial balances of the Home Office
and the Branch.
 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 accounts receivable, and other assets and liabilities of the
enterprise as a whole.
 In the preparation of a combined balance sheet, reciprocal ledger accounts are eliminated
because 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; also,
 Any receivables and payables between the Home Office and the branch (or between two
branches) are eliminated.
The operating results of the enterprise (the Home Office and all branches) are shown by an income
statement in which the revenue and expenses of the branches are combined with corresponding revenue
and expenses for the Home Office. Any intracompany profits or losses are eliminated.
2.4) Illustrative Transactions and Financial Statements for the Branch and HO
Illustration 2.2: Assume JIMMA TRADING Company bills merchandise to AGARO Branchat Home
Office cost and that AGAROBranch maintains complete accounting records and prepares financial
statements. Both the Home Office and the branch use the perpetual inventory system. Equipment used at
the branch is carried in the Home Office accounting records. Certain expenses, such as advertising and
insurance, incurred by the Home Office on behalf of the branch, are billed to the branch. Transactions and
events during the first year (2005) of operations of AGARO Branch are summarized below (start-up costs
are disregarded):
1. Cash of Br 1,000 was forwarded by the Home Office to AGARO Branch.
2. Merchandise with a Home Office cost of Br 60,000 was shipped by the Home Office to AGARO
Branch.
3. Equipment was acquired by AGARO Branch for Br 500, to be carried in the Home Office
accounting records. (Other plant assets for AGARO Branch generally are acquired by the Home
Office.)

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4. Credit sales by AGARO Branch amounted to Br 80,000; the branch’s cost of the merchandise
sold was Br 45,000.
5. Collections of trade accounts receivable by AGARO Branch amounted to Br 62,000.
6. Payments for operating expenses by AGARO Branch totaled Br 20,000.
7. Cash of Br 37,500 was remitted by AGARO Branch to the Home Office.
8. Operating expenses incurred by the Home Office and charged to AGARO Branch totaled Br
3,000.
These transactions and events are recorded by the Home Office and by AGARO Branch as follows
(explanations for the journal entries are omitted):

Typical Home Office and Branch Transactions and Events under Perpetual Inventory System
Home Office Accounting Records AGARO Branch Accounting Records
Journal Entries Journal Entries
1. Investment in AGARO Branch 1,000 Cash 1,000
Cash 1,000 Home Office a/c 1,000
2. Investment in AGARO Branch 60,000 Inventories 60,000
Inventories 60,000 Home Office 60,000
3. Equipment: AGARO Branch 500 Home Office 500
Investment in AGARO Branch 500 Cash 500
4. None Trade Accounts Receivables 80,000
Sales 80,000
Cost of Goods Sold 45,000
Inventories 45,000
5. None Cash 62,000
T/Accounts Receivables 62,000
6. None Operating Expenses 20,000
Cash 20,000
7. Cash 37,500 Home Office 37,500
Investment in AGARO Branch 37,500 Cash 37,500
8. Investment in AGARO Branch 3,000 Operating Expenses 3,000
Operating Expenses 3,000 Home Office 3,000

If a branch obtains merchandise from outsiders as well as from the Home Office, the
merchandise acquired from the Home Office may be recorded in a separate Inventory account
from Home Office ledger account. In the Home Office accounting records, the Investment in
AGARO Branch ledger account has a debit balance of Br 26,000 before the accounting records
are closed and the branch net income of Br 12,000 (Br 80,000 – Br 45,000 – Br 20,000 – Br
3,000 = Br 12,000) is transferred to the Investment in AGARO Branch ledger account, as
illustrated below:

Investment in AGARO Branch Account

Date Explanation Debit Credit Balance
2005 Cash sent to branch 1,000 1,000 Dr
Merchandise billed to branch at Home Office cost 60,000 61,000 Dr
Equipment acquired by branch, account by HO 500 60,500 Dr
Cash received from branch 37,500 23,000 Dr

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Operating expenses billed to branch 3,000 26,000 Dr

In the accounting records of AGARO Branch, the Home Office ledger account has a credit balance of
Br 26,000 (before the accounting records are closed and the net income of Br 12,000 is transferred to the
Home Office account), as shown bellow:
Home Office Account
Date Explanation Debit Credit Balance
2005 Cash received from the office 1,000 1,000 Cr
Merchandise received from Home Office 60,000 61,000 Cr
Equipment Acquired 500 60,500 Cr
Cash Sent to Home Office 37,500 23,000 Cr
Operating expenses billed by Home Office 3,000 26,000 Cr

2.5) Working Paper for Combined Financial Statements

A working paper for combined financial statements has three purposes:
1. To combine ledger account balances for like revenue, expenses, assets, and liabilities,
2. To eliminate any intracompany profits or losses, and
3. To eliminate the reciprocal accounts
Assume that the perpetual inventories of Br 15,000 (Br 60,000 – Br 45,000 = Br 15,000) at the
end of 2005 for AGARO Branch had been verified by a physical count. The working paper for
JIMMA TRADINGCompany is based on the transactions and events shown in the above
illustration and additional assumed data for the Home Office trial balance. All the routine year-
end adjusting entries are assumed to have been made, and the working paper is begun with the
adjusted trial balances of the Home Office and AGARO Branch. Income taxes are disregarded in
this illustration.
Note that the Br 26,000 debit balance of the Investment in AGARO Branch ledger account and
the Br 26,000 credit balance of the Home Office account are the balances before the respective
accounting records are closed, that is, before the Br 12,000 net income of AGARO Branch is
entered in these two reciprocal accounts. In the Eliminations column, elimination (a) offsets the
balance of the Investment in AGARO Branch account against the balance of the Home Office
account. This elimination appears in the working paper only; it is not entered in the accounting
records of either the Home Office or AGARO Branch because the sole purpose of the working
paper is to facilitate the preparation of combined financial statements.
2.5.1 Illustration on Combined Financial Statements
The following working paper provides the information for the combined financial statements (excluding a
statement of cash flows) of JIMMA TRADINGCompany below.

JIMMA TRADING COMPANY

WORKING PAPER FOR COMBINED FINANCIAL STATEMENTS OF HO AND AGARO BRANCH
FOR YEAR ENDED DECEMBER 31, 2005
(PERPETUAL INVENTORY SYSTEM: BILLINGS AT COST)
Adjusted Trial Balance
Home Office Branch Elimination Combined
Dr (Cr) Dr (Cr) Dr (Cr) Dr (Cr)
Income Statement

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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
Totals -0- -0- -0- -0-
Statement of Retained Earnings
Retained Earnings, Jan.1, 2005 (70,000) (70,000)
Net Income from above (75,000) (12,000) (87,000)
Dividends Declared 40,000 40,000
Retained Earnings, Dec.31,2005 (117,000)
Totals -0-
Balance Sheet
Cash 25,000 5,000 30,000
Trade Accounts Receivables 39,000 18,000 57,000
Inventories 45,000 15,000 60,000
Investment in AGARO Branch 26,000 a (26,000)
Equipment 150,000 150,000
Accumulated Depreciation (10,000) (10,000)
Trade Accounts Payable (20,000) (20,000)
Home Office (26,000) a 26,000
Common Stock, Br 10 par (150,000) (150,000)
Retained Earnings from above (117,000)
Totals -0- -0- -0- -0-
(a) To eliminate reciprocal ledger account balances
Combined Income Statement
JIMMA TRADING COMPANY
Combined Income Statement
For Year Ended December 31, 2005
Sales Br 480,000
Cost of goods sold 280,000
Gross margin on sale Br 200,000
Operating expenses 113,000
Net income Br 87,000
Basic earnings per share of common stock Br 5.80
Statement of Retained Earnings
JIMMA TRADING COMPANY
Statement of Retained Earnings
For Year Ended December 31, 2005
Retained earnings, beginning of year Br 70,000
Add: Net income 87,000
Subtotal Br 157,000
Less: Dividends (Br 2.67 per share) 40,000
Retained earnings, end of year Br117,000
Balance Sheet
JIMMA TRADING COMPANY
Balance Sheet
December 31, 2005

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Assets:
Cash Br 30,000
Trade accounts receivable (net) 57,000
Inventories 60,000
Equipment.........................................................................................Br150,000
Less: Accumulated depreciation.......................................................10,000 140,000
Total assets Br 287,000
Liabilities & Stockholders’ Equity:
Liabilities
Trade accounts payable Br 20,000
Stockholders’ equity
Common Stock, Br 10 par, 15,000 shares authorized,
issued, and outstanding..................................................................... Br150,000
Retained earnings.............................................................................117,000 267,000
Total liabilities & stockholders’ equity Br 287,000

2.5.2 Home Office Adjusting and Closing Entries and Branch Closing Entries
The Home Office’s equity-method adjusting and closing entries for branch operating results and the
branch’s closing entries on December 31, 2005, are shown below (explanations for the entries are
omitted):
Home Office Accounting Records AGARO Branch Accounting Records
Adjusting and Closing Entries Closing Entries
None Sales 80,000
Cost of Goods sold 45,000
Operating Expenses 23,000
Income Summary 12,000
Investment in AGARO Branch 12,000 Income Summary. 12,000
Income: AGARO Branch 12,000 Home Office 12,000
Income: AGARO Branch 12,000 None
Income Summary 12,000

2.6) Billing of Merchandise to Branches at Prices above Home Office Cost

The Home Offices of some business enterprises bill merchandise shipped to branches at Home
Office cost plus a markup percentage (or alternatively at branch retail selling prices). Because
both these methods involve similar modifications of accounting procedures, a single example
illustrates the key points involved, using the illustration for JIMMA TRADING Company one
changed assumption: the Home Office bill merchandise shipped to AGARO Branch at a markup
of 50% above Home Office cost, or 33 1/3 % of billed price.
Under this assumption, the journal entries for the first year’s events and transactions by the
Home Office and AGARO Branch are the same as those presented on the journal entries for
shipments of merchandise from the Home Office to AGARO Branch. These shipments (Br
60,000 Cost + 50% markup on cost = Br 90,000) are recorded under the perpetual inventory
system as follows:
Home Office Accounting Records AGARO Branch Accounting Records
Journal Entries Journal Entries
Investment in AGARO Branch 90,000 Inventories 90,000
Inventories 60,000 Home Office 90,000

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AFOVI 30,000

In the accounting records of the Home Office, the Investment in AGARO Branch ledger account
below now has a debit balance of Br 56,000 before the accounting records are closed and the
branch net income or loss is entered in the Investment in AGARO Branch account. This account
is Br 30,000 larger than the Br 26,000 balance in the prior illustration. The increase represents
the 50% markup over cost (Br 60,000) of the merchandise shipped to the AGARO Branch.
Investment in AGARO Branch a/c

Date Explanation Debit Credit Balance

2005 Cash sent to branch 1,000 1,000 Dr
Merchandise billed to branch at 50% over cost 90,000 91,000 Dr
Equipment acquired by branch, carried in HO 500 90,500 Dr
Cash received from branch 37,500 53,000 Dr
Operating expenses billed to branch 3,000 56,000 Dr

In the accounting records of AGARO Branch, the Home Office ledger account now has a credit
balance of $56,000; before the accounting records are closed and the branch net income or loss is
entered in the Home Office account, as illustrated below:
Home Office a/c
Date Explanation Debit Credit Balance
2005 Cash received from the office 1,000 1,000 Cr
Merchandise received from Home Office 90,000 91,000 Cr
Equipment Acquired 500 90,500 Cr
Cash Sent to Home Office 37,500 53,000 Cr
Operating expenses billed by Home Office 3,000 56,000 Cr

AGARO Branch recorded the merchandise received from the Home Office at billed prices of Br
90,000; the Home Office recorded the shipment by credits of Br 60,000 to Inventories and Br
30,000 to Allowance for Overvaluation of Inventories (AFOVI): AGARO Branch. Use of the
allowance account enables the Home Office to maintain a record of the cost of merchandise
shipped to AGARO Branch as well as the amount of the unrealized gross profit on the
shipments.
At the end of the accounting period, AGARO Branch reports its inventories (at billed prices) at
Br 22,500. The cost of these inventories is Br 15,000 (Br 22,500.1.50 = Br 15,000). In the Home
Office accounting records, the required balance of the Allowance for Overvaluation of
Inventories: AGARO Branch ledger account is Br 7,500 (Br 22,500 – Br 15,000 = Br 7,500);
thus, this account balance must be reduced from its present amount of Br 30,000 to Br 7,500.
The reason for this reduction is that the 50% markup of billed prices over cost has become
realized gross profit to the Home Office with respect to the merchandise sold by the branch.
Consequently, at the end of the year the Home Office reduces its allowance for overvaluation of
the branch inventories to the Br 7,500 excess valuation contained in the ending inventories. The
debit adjustment of Br 22,500 in the allowance account is offset by a credit to the Realized Gross
Profit: AGARO Branch Sales account, because it represents additional gross profit of the Home
Office resulting from sales by the branch.

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Working Paper When Billings to Branches Are at Prices above Cost

When a Home Office bills merchandise shipments to branches at prices above Home Office cost,
preparation of the working paper for combined financial statements is facilitated by any analysis
of the flow of merchandise to a branch, such as the following for AGARO Branch of JIMMA
TRADING Company:
JIMMA TRADING COMPANY
Flow of Merchandise for AGARO Branch
During 2005

Billed HO Markup
Price Cost (50% of Cost)
Beginning Inventories -0- -0- -0-
Add: Shipments from Home Office Br 90,000 Br 60,000 Br 30,000
Available for Sale Br 90,000 Br 60,000 Br 30,000
Less: Ending Inventories 22,500 15,000 7,500
Cost of Goods Sold Br 67,500 Br 45,000 Br 22,500

The foregoing analysis provides in the Markup column the information needed for the
Eliminations column in the working paper for combined financial statements below:

JIMMA TRADING COMPANY AND AGARO BRANCH

Working Paper for Combined Financial Statements
For The Year Ended December 31, 2005
(Perpetual Inventory System and Billings Above Cost)
Adjusted Trial Balances
Home Office Branch Elimination Combined
Dr (Cr) Dr (Cr) Dr (Cr) Dr (Cr)
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 (loss) 75,000 (10,500) b 22,500 87,000
Totals -0- -0- -0- -0-
Statement of Retained Earnings
Retained Earnings, Jan.1, 2005 (70,000) (70,000)
Net Income from above (75,000) 10,500 b (22,500) (87,000)
Dividends Declared 40,000 40,000
Retained Earnings, Dec.31,2005 (117,000)
Totals -0-
Balance Sheet
Cash 25,000 5,000 30,000
Trade Accounts Receivables 39,000 18,000 57,000
Inventories 45,000 22,500 a (7,500) 60,000

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AFOVI (30,000) a 30,000

Investment in AGARO Branch 56,000 c (56,000)
Equipment 150,000 150,000
Accumulated Depreciation (10,000) (10,000)
Trade Accounts Payable (20,000) (20,000)
Home Office (56,000) c 56,000
Common Stock, Br 10 par (150,000) (150,000)
Retained Earnings from above (117,000)
Totals -0- -0- -0- -0-

Elimination Journal Entries:

a) To reduce ending inventories and cost of goods sold of branch to cost, and to eliminate
unadjusted balance of Allowance of Overvaluation of Inventories: AGARO Branch ledger
account.
AFOVI 30,000
Cost of Goods Sold 22,500
Inventory 7,500

(b) To increase income of Home Office by portion of merchandise markup that was realized by branch
sales.
Unrealized Gross Profit 22,500

Realized Income: AGARO Branch 22,500

(c) To eliminate reciprocal ledger account balances

Home Office 56,000

Investment in AGARO Branch 56,000

The working paper above differs from the working paper when merchandise shipped at Home
Office cost by the inclusion of an elimination to restate the ending inventories of the branch to
cost. Also, the income reported by the Home Office is adjusted by the Br 22,500 of merchandise
markup that was realized as a result of sales by the branch. This amount in the Eliminations
column appears only in the working paper. The amounts represent a mechanical step to aid the
preparation of combined financial statements and are not entered in the accounting records of
either the Home Office or the branch.

Combined Financial Statements

Because the amounts in the Combined column of the working paper are the same as in the
working paper prepared when the merchandise shipments to the branch were billed at Home
Office cost, the combined financial statements are identical to those illustrated when
merchandise is shipped at Home Office cost.
Home Office Adjusting and Closing Entries and Branch Closing Entries
The adjusting and closing entries are different. The December 31, 2005, adjusting and closing
entries of the Home Office are illustrated below assuming the merchandise is shipped 50% above
Home Office cost:

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 Advanced Financial Accounting-I

Home Office Accounting Records

Adjusting and Closing Entries
1. Income: AGARO Branch (loss) 10,500
Investment in AGARO Branch 10,500
To record net loss reported by branch
2. AFOVI: AGARO Branch 22,500
Realized Gross Profit 22,500
To reduce allowance to amount by which ending inventories of branch exceed cost
3. Realized Gross Profit: AGARO Branch Sales 22,500
Income: AGARO Branch 10,500
Income Summary 12,000
To close branch net loss and realized gross profit to Income Summary account
After the forgoing journal entries have been posted, the ledger accounts in the Home Office
general ledger used to record branch operations are as follows:

Investment in AGARO Branch a/c

Date Explanation Debit Credit Balance
2005 Cash sent to branch 1,000 1,000 Dr
Merchandise billed to branch at 50% markup over cost 90,000 91,000 Dr
Equipment acquired by branch, carried in HO 500 90,500 Dr
Cash received from branch 37,500 53,000 Dr
Operating expenses billed to branch 3,000 56,000 Dr
Net loss for 2005 reported by branch 10,500 45,500 Dr

End-of-Period Balance in Accounting Records of the Home Office

Allowance for Overvaluation of Inventories: AGARO Branch
Date Explanation Debit Credit Balance
2005 Markup on merchandise shipped to branch During 2005 (50% of cost)
30,000 30,000 Cr
Realization of 50% markup on merchandise Sold by branch during 2005
22,500 7,500 Cr

Realized Gross Profit: AGARO Branch Sales

Date Explanation Debit Credit Balance
2005 Realization of 50% markup on merchandise sold by branch
during 2005 22,500 22,500 Cr
Closing Entries 22,500 -0-

Income: AGARO Branch

Date Explanation Debit Credit Balance
2005 Net loss for 2005 reported by branch 10,500 10,500 Dr
Closing Entries 10,500 -0-.

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 Advanced Financial Accounting-I

In the separate balance sheet for the Home Office, the Br 7,500 credit balance of the Allowance
for Overvaluation of Inventories: AGARO Branch ledger account is deducted from the Br 45,000
debit balance of the Investment in AGARO Branch account, thus reducing the carrying amount
of the investment account to a cost basis with respect to shipments of merchandise to the branch.
In the separate income statement for the Home Office, the Br 22,500 realized gross profit on
AGARO Branch sales may be displayed following gross margin on sales, Br 165,000 (Br
400,000 sales – Br 235,000 cost of goods sold = Br 165,000).
The closing entries for the branch at the end of 2005 are as follows:
AGARO Branch Accounting Records
Closing Entries
Sales 80,000
Income Summary 10,500
Cost of Goods Sold 67,500
Operating Expenses 23,000
To close revenue and expense ledger accounts
Home Office 10,500
Income Summary 10,500
To close the net loss in the Income Summary account to the HO account.

After these closing entries have been posted by the branch, the following Home Office ledger
account in the accounting records of AGARO Branch has a credit balance of Br 45,500, the same
as the debit balance of the Investment in AGARO Branch account in the accounting records of
the Home Office:
Home Office
Date Explanation Debit Credit Balance
2005 Cash received from the office 1,000 1,000 Cr
Merchandise received from Home Office cost 90,000 91,000 Cr
Equipment acquired 500 90,500 Cr
Cash sent to Home Office 37,000 53,000 Cr
Operating expenses billed to branch 3,000 56,000 Cr
Net loss for 2005 10,500 45,500 Cr

2.7) Treatment of Beginning Inventories Priced above Cost

The working paper shows how the ending inventories and the related allowance for
overvaluation of inventories were handled. However, because 2005 was the first year of
operations for AGARO Branch, no beginning inventories were involved.
Perpetual Inventory System
Under the perpetual inventory system, no special problems arise when the beginning inventories
of the branch include an element of unrealized gross profit.
Periodic Inventory System
To continue the illustration for JIMMA TRADING Company for a second year of operations
(2006) to demonstrate the handling of beginning inventories carried by AGARO Branch at an
amount above Home Office cost, assume that both the Home Office and AGARO Branch

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 Advanced Financial Accounting-I

adopted the periodic inventory system in 2006. When the periodic inventory system is used, the
Home Office credits Shipments to Branch (an offset account to Purchases) for the Home
Office cost of merchandise shipped and Allowance for Overvaluation of Inventories for the
Markup over Home Office cost. The branch debits Shipments from Home Office (analogous
to a Purchase account) for the billed price of merchandise received.
The beginning inventories for year 2006 were carried by AGARO Branch at Br 22,500, or 150%
of the cost of Br 15,000 (Br 15,000 @ 1.50 = Br 22,500). Assume that during 2006 the Home
Office shipped merchandise to AGARO Branch that cost Br 80,000 and was billed at Br
120,000, and that AGARO Branch sold for Br 150,000 merchandise that was billed at Br
112,500. The journal entries to record the shipments and sales under the periodic inventory
system are illustrated below:
Home Office Accounting Records AGARO Branch Accounting Records
Journal Entries Journal Entries
Investment in AGARO Branch 120,000 Shipments from HO 120,000
Shipment to Mete Branch 80,000 Home Office 120,000
AFOVI: AGARO Branch 40,000
None Cash or Trade Accounts Rec. 150,000
Sales 150,000

The inventories in a branch at the end of 2006 amounted to Br 30,000 at billed prices,
representing cost of Br 20,000 plus a 50% markup on cost (Br 20,000 @ 1.5 = Br 30,000). The
flow of merchandise for AGARO Branch during 2000 is summarized below:
JIMMA TRADING COMPANY
Flow of Merchandise for AGARO Branch
During 2006

Billed Price HO Markup (50% of cost;

Cost 33.33% of Billed Price)

Beginning inventories Br 22,5000 Br 15,000 Br 7,500

Add: Shipments from HO 120,000 80,000 40,000
Available for sale Br 142,500 95,000 Br 47,500
Less: Ending inventories (30,000) (20,000) (10,000)
Cost of goods sold Br 112,500 Br 75,000 Br 37,500

The activities of the branch for 2006 and end-of-period adjusting and closing entries are reflected
in the four Home Office ledger accounts below.

 Investment in Branch Account

Investment in AGARO Branch Account
Date Explanation Debit Credit Balance
2006 Balance, Dec. 31, 2005 45,500 Dr
Merchandise billed to branch at markup of 50% 120,000 165,500 Dr
Cash received from branch 113,000 52,500 Dr
Operating expenses billed to branch 4,500 57,000 Dr

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Net income for 2006 reported by branch 10,000 67,000 Dr

 Allowance for Over Valuation of Inventories

Allowance for Overvaluation of Inventories: AGARO Branch
Date Explanation Debit Credit Balance
2006 Balance, Dec. 31, 2005 7,500 Cr
Markup on merchandise shipped to branch During 2005 (50%
of cost) 40,000 47,500 Cr
Realization of 50% markup on merchandise Sold by branch
during 2006 37,500 10,000 Cr

 Realized Gross Profit

Realized Gross Profit: AGARO Branch Sales
Date Explanation Debit Credit Balance
2006 Realization of 50% markup on merchandise sold by branch
during 2005 37,500 37,500 Cr
Closing Entries 37,500 -0-
 Investment Income
Investment Income: AGARO Branch
Date Explanation Debit Credit Balance
2006 Net income for 200 reported by branch 10,000 10,000 Cr
Closing Entries 10,000 -0-

In the accounting records of the Home Office at the end of 2006, the balance required in the
Allowance for Overvaluation of Inventories: AGARO Branch ledger account it Br 10,000, that
is, the billed price of Br 30,000 less cost of Br 20,000 for merchandise in the branch’s ending
inventories. Therefore, the allowance account balance is reduced from Br 47,500 to Br 10,000.
This reduction of Br 37,500 represents the 50% markup on merchandise above cost that was
realized by AGARO Branch during 2006 and is credited to the Realized Gross Profit: AGARO
Branch Sales account.
Home Office a/c
Date Explanation Debit Credit Balance
2005 Balance, Dec. 31, 2005 45,500 Cr
Merchandise received from HO 120,000 165,500 Cr
Cash sent to Home Office 113,000 52,500 Cr
Operating expenses billed by HO 4,500 57,000 Cr
Net income for 2006 10,000 67,000 Cr

The working paper for combined financial statements under the periodic inventory system,
which reflects pre-adjusting and pre-closing balances for the reciprocal ledger accounts and the
Allowance for Overvaluation of Inventories are as follows:

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 Advanced Financial Accounting-I

JIMMA TRADING COMPANY

Working Paper for Combined Financial Statements of Home Office and AGARO Branch
For Year Ended December 31, 2006
(Periodic Inventory System: Billings above Cost)
Adjusted Trial Balance
Home Office Branch Elimination Combined
Dr (Cr) Dr (Cr) Dr (Cr) Dr (Cr)
Income Statement
Sales (500,000) (150,000) (650,000)
Inventories, Dec.31, 2005 45,000 22,500 b (7,500) 60,000
Purchases 400,000 400,000
Shipments to AGARO Branch (80,000) a 80,000
Shipments from Home Office 120,000 a (120,000)
Inventories, Dec.31, 2006 (70,000) (30,000) c 10,000 (90,000)
Operating Expenses 120,000 27,500 147,500
Net Income (loss) 85,000 10,000 d 37,500 132,500
Totals -0- -0- -0- -0-
Statement of Retained Earnings
Retained Earnings, Dec.31, 2005 (117,000) (117,000)
Net Income from above (85,000) (10,000) d (37,500) (132,500)
Dividends Declared 60,000 60,000
Retained Earnings, Dec.31,2005 (189,500)
Totals -0-
Balance Sheet
Cash 30,000 9,000 39,000
Trade Accounts Receivables(net) 64,000 28,000 92,000
Inventories (Dec.31, 2006) 70,000 30,000 c (10,000) 90,000
AFOVI: AGARO Branch (47,500) a 40,000
b 7,500
Investment in AGARO Branch 57,000 e (57,000)
Equipment 158,000 158,000
Accumulated Depreciation (15,000) (15,000)
Trade Accounts Payable (24,500) (24,500)
Home Office (57,000) e 57,000
Common Stock, Br 10 par (150,000) (150,000)
Retained Earnings from above (189,500)
Totals -0- -0- -0- -0-
(a) To eliminate reciprocal ledger accounts for merchandise shipments
(b) To reduce beginning inventories of branch to cost
(c) To reduce ending inventories of branch to cost
(d) To increase HO income of by portion of merchandise markup that was realized by branch sales

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(e) To eliminate reciprocal ledger account balances

2.8) Reconciliation of Reciprocal Ledger Accounts
At the end of an accounting period, the balance of the Investment in Branch ledger account in the
accounting records of the Home Office may not agree with the balance of the Home Office
account in the accounting records of the branch because certain transactions may have been
recorded by one office but not by the otheroffice. The situation is comparable to that of
reconciling the ledger account for Cash in Bank with the balance in the Monthly Bank Statement.
The lack of agreement between the reciprocal ledger account balances causes no difficulty
during an accounting period, but at the end of each period the reciprocal account balances must
be brought into agreement before combined financial statements are prepared.
Illustration 2.3:
As an illustration of the procedure for reconciling reciprocal ledger account balances at year-end,
assume that the Home Office and branch accounting records of Mercy Company and its branch
Arvin Branch contain the following data on December 31, 2003:
Accounting Records of Home Office
Investment in Arvin Branch
Date Explanation Debit Credit Balance
2003
Nov. 30 Balance (BBF) 62,500 Dr
Dec. 10 Cash received from branch 20,000 42,500 Dr
27 Collection of branch trade accounts receivable 1,000 41,500 Dr
29 Merchandise shipped to branch 8,000 49,500 Dr
Accounting Records of Arvin Branch
Home Office Account
Date Explanation Debit Credit Balance
2003
Nov. 30 Balance (BBF) 62,500 Cr
Dec. 10 Cash sent to Home Office 20,000 42,500 Cr
27 Acquired equipment 3,000 39,500 Cr
29 Collection of HO trade accounts receivable 2,000 41,500 Cr

There might be a number of reconciling items between Investment in Branch and Home Office
accounts. These are: -
 Inventories may be in-transit
 Trade Accounts Receivables of Branch may be collected by Home Office
 Branches may acquire plant assets to be maintained by HO without the knowledge of HO
 Trade Accounts Receivables of the Home Office may be collected by the Branches
Comparison of the two reciprocal ledger accounts discloses four reconciling items, describing as
follows:
1. A debit of Br 8,000 in the Investment in Arvin Branch ledger account without a related
credit in the Home Office account.
On December 29, the Home Office shipped merchandise costing Br 8,000 to the branch. The
Home Office debits its reciprocal ledger account with the branch on the date merchandise is

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 Advanced Financial Accounting-I

shipped, but the branch credits its reciprocal ledger account with the branch on the date
merchandise is shipped, but the branch credits it reciprocal account with the Home Office when
the merchandise is received a few days later. The required journey entry on December 31, 2003,
in the branch accounting records, assuming use of the perpetual inventory system, appears
below:
Inventories in Transit 8,000

Home Office 8,000

To record shipment of merchandise in transit from Home Office

In taking a physical inventory on December 31, 2003, the branch must add to the inventories on
hand the Br 8000 of merchandise in transit. When the merchandise is received in 2004, the
branch debits Inventories and credits Inventories in Transit.
2. A credit of Br 1,000 in the Investment in Arvin Branch ledger account without a related
debit in the Home Office account.
On December 27, trade accounts receivables of the branch were collected by the Home Office.
The collection was recorded by the Home Office by a debit to Cash and a credit to Investment in
Arvin Branch. No journal entry was made by Arvin Branch; therefore, the following journal
entry is required in the accounting records of Arvin Branch on December 31, 2003:
Home Office 1,000

Trade Accounts Receivable 1,000

To record collection of account receivable by Home Office

3. A debit of Br 3,000 in the Home Office ledger account without a related credit in the
Investment in Arvin Branch account.
On December 28, the branch acquired equipment for Br 3,000. Because the equipment used by
the branch is carried in the accounting records of the Home Office. The journal entry made by
the branch was a debit to Home Office and a credit to Cash. No journal entry was made by the
Home Office; therefore, the following journal entry is required on December 31, 2003, in the
accounting records of the Home Office:
Equipment: Arvin Branch 3,000
Investment in Arvin Branch 3,000
To record equipment acquired by branch.

4. A credit of Br 2,000 in the Home Office ledger account without a related debit in the Investment
in Arvin Branch account.
On December 30, trade accounts receivables of the Home Office were collected by Arvin Branch. The
collection was recorded by Arvin Branch by a debit to Cash and a credit to Home Office. No journal entry
was made by the Home Office; therefore, the following journal entry is required in the accounting
records of the Home Office on December 31, 2003:
Investment in Arvin Branch 2,000
Trade Accounts Receivable 2,000
To record collection of accounts receivable by Arvin Branch.

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The effect of the foregoing end-of-period journal is to update the reciprocal ledger accounts, as shown by
the following reconciliation:

MERCY COMPANY-HOME OFFICE AND ARVIN BRANCH

Reconciliation of Reciprocal Ledger Accounts
December 31, 2003
Investment in Arvin Home Office
Branch Account Account
Balances before adjustments Br 49,500 Dr Br 41,500 Cr
Add: (1) Merchandise shipped to branch by HO 8,000
(4) HO trade A/Rec collected by Branch 2,000
Less: (2) Branch A/Rec collected by HO (1,000)
(3) Equipment acquired by branch (3,000)
Adjusted balances Br 48,500 Dr Br 48,500 Cr

Summary
Many businesses have operating units in more than one location. These units may be separate
corporations, and a parent-subsidiary relationship exists between the parent company and its
affiliated companies. In other cases the operating units are not incorporated but are part of one
legal entity. In such an arrangement, each unit may be an agency of the main location (the home
office) or it may be a branch office.
A branch office may have its bookkeeping done at the home office based on transmittal forms
summarizing the daily activities of the branch. Alternatively, a branch may keep its own books
and accounts.
Shipments to a branch may be made at the home office’s cost or at an amount above its cost.

Chapter 4 Accounting for Branches & Head Office Page 22