CruxFinancial Accounting

A branch is a unit of the business set up at another place to sell close to the customers. It does the same kind of work as the head office (H.O.) and is controlled by it. Branch accounting records each branch's dealings with the head office, with other branches and with customers, so that each branch's profit or loss is known.

A dependent branch is a selling outlet: it sells only what the head office gives it. Its books are kept by the head office in one of four ways: the Debtors System, the Stock and Debtors System, the Final Accounts System and the Wholesale Branch System. The syllabus asks for the first two.

Debtors System. The head office opens one Branch Account for each branch. It is a nominal account: it collects everything sent to the branch on the debit side and everything received from it, plus the closing assets, on the credit side. The balance is the branch's profit or loss.

Stock and Debtors System. The head office opens several accounts for each branch: Branch Stock, Branch Debtors, Branch Expenses, Branch Adjustment, Branch Profit and Loss and Goods Sent to Branch (and, where needed, Branch Cash and Branch Fixed Assets). It was adopted because the Debtors System has three weaknesses: it cannot split profit into gross and net, it gives no control over stock, and it does not show losses of stock.

The head office may send goods to the branch at cost, or at a higher price called the invoice price (IP). It invoices above cost to keep the cost secret from the branch, or to control the branch's selling price. The difference between invoice price and cost is the loading. Loading is not profit until the goods are sold to outsiders, so every invoice-price figure in the head office's books must be brought back to cost before profit is struck.

The question states the mark-up in one of two ways. Turn it into a fraction of invoice price:

How the figures in a question are read.

1. Goods sent to the branch and branch stocks are taken at invoice price unless the question says otherwise.
2. Stock "at cost to branch" or stock "at its cost" (the branch's cost) means invoice price, because the branch's cost is what it was invoiced. Enter it as given.
3. Stock "at cost", "at cost price" or "at cost to H.O." means the head office's cost. Gross it up to invoice price (for cost plus 25%, multiply by 5/4) before entering it in an invoice-price account.

List price. Some questions add a third price. The head office fixes a list (catalogue) price, invoices the branch at a discount on it, and tells the branch to sell for cash at invoice price and on credit at list price. Turn everything into invoice price first. Credit sales at list price are then above invoice price, and the excess is a surplus that belongs to gross profit (sub-topic 5).

Under the Debtors System the Branch Account is charged with everything the branch starts with and everything sent to it, and credited with everything received from it and everything it holds at the end.

The main journal entries in the head office's books:

What does not pass through the Branch Account. Sales of either kind, money the branch collects from its debtors, discounts and bad debts written off, allowances to customers, and expenses the branch pays out of its own cash never appear in it. They have already changed the branch's cash, debtors or stock, and those reach the Branch Account through the remittances and the closing balances. Entering them again would count them twice.

Goods at invoice price. When the Branch Account carries goods and stock at invoice price, three adjusting entries take the loading out:

1. Loading on the net goods sent (goods sent less returns to the head office): Goods Sent to Branch A/c Dr, To Branch A/c.
2. Loading on closing stock: Branch A/c Dr, To Branch Stock Reserve A/c.
3. Loading on opening stock (last year's reserve released): Branch Stock Reserve A/c Dr, To Branch A/c.

The Goods Sent to Branch Account is credited with all goods sent and debited with returns and with the loading on net goods sent. Its balance is the cost of net goods sent, which is transferred to Purchases or Trading Account so that the head office's own Trading Account does not count them as goods still in hand.

Losses under the Debtors System. A normal loss (wastage or spoilage the question calls normal) needs no entry: it simply leaves less closing stock, so the profit already bears it. An abnormal loss, such as goods lost in transit, is taken out of the branch result: the Branch Account is credited with its cost and General Profit and Loss Account debited (its loading is already inside the loading on net goods sent). A gap that the memorandum Branch Stock Account leaves with no cause given is shown there as goods unaccounted for, but it needs no entry in the Branch Account: that account takes the closing stock as counted, so the profit already bears the gap.

Prepaid and outstanding items. Expenses paid by the head office are debited in full; a part paid in advance for a later period (rent, insurance, salary advance) is a closing asset on the credit side. An expense outstanding at the start is an opening liability; one outstanding at the end is a closing liability. Depreciation is never entered as such: the asset is carried down at its value less depreciation.

Debtors System questions often leave out credit sales, cash collected, the cash remitted or the closing stock. Find each one in a memorandum account: a working account kept outside the double entry, whose balancing figure is the missing amount.

Petty cash on the imprest system. The branch keeps a fixed float and is reimbursed what it spends. If the head office sends the amount spent, debit the Branch Account with it; the float at the end is a closing asset. If the reimbursement comes out of branch cash, the remittance is lower by that amount instead. Either way the profit is the same.

Purchases by the branch. Goods a branch buys locally with the head office's permission carry no loading. Their cost reaches the Branch Account through the cash or creditors paid, and their stock at the end is shown at cost.

Each account has one job:

The journal entries in the head office's books:

The losses of stock (normal and abnormal) have their own entries in sub-topic 6.

Work a Stock and Debtors question in this order:

1. Fix the loading fraction of invoice price, and convert every figure to invoice price.
2. Write Branch Debtors and find its missing figure.
3. Write Branch Stock; a gap left after every stated item is a shortage or surplus.
4. Write Branch Adjustment: loading in, loading out, gross profit as the balance.
5. Write Branch Expenses and Branch Profit and Loss; net profit as the balance.
6. Write Goods Sent to Branch and prove the gross profit on cost.

A normal loss arises from the nature of the goods: evaporation, breaking of bulk, ordinary wastage, pilferage the question calls normal. It is a cost of doing business, so the sale price of the good units carries it. An abnormal loss arises from an unusual event: fire, flood, theft, an accident in transit. It is not a cost of trading and must be kept out of gross profit.

An unexplained shortage. When Branch Stock does not balance after every stated item, the gap is a shortage (the books show more than was counted). If the question names a normal loss and that is already entered, or says nothing about the gap, treat the shortage as abnormal and split it. Treat it as normal only when the question calls it normal (for example, "any stock unaccounted for is normal wastage").

A loss stated at cost. A normal loss "at cost to H.O." is grossed up to invoice price before it is credited to Branch Stock. A loss stated at list price is converted to invoice price.

Inter-branch transfers. A transfer is recorded as if it went through the head office. Goods sent to another branch are treated like goods returned to the head office (the sending branch's Branch Account or Branch Stock is credited); goods received from another branch are treated like goods received from the head office (debited). Transfers "at its cost" are at invoice price. The loading on the net goods moved is removed through Goods Sent to Branch (or the other branch's account) in the usual way.

Goods in transit. Goods invoiced by the head office and not received by the branch by the year end belong to the branch's closing stock. Two layouts give the same profit:

1. Debit Branch Stock (or the Branch Account) with all goods sent and carry the transit goods down as a separate closing balance, "stock in transit".
2. Debit Branch Stock only with goods received and carry the transit goods as a balance in Goods Sent to Branch.

Either way, raise a stock reserve on goods in transit too: they are at invoice price.

Allowance off the selling price. An allowance to customers already deducted when the sale was recorded means the goods left the stock at full invoice price but were sold for less. Credit Branch Stock and debit Branch Adjustment with it. Under the Debtors System it needs no entry.

Branch manager's commission. The commission is a branch expense charged before net profit. Read the base carefully:

Under the Debtors System the commission is debited to the Branch Account; any part not yet paid at the year end is a closing liability. Under the Stock and Debtors System it is debited to Branch Profit and Loss.

A department is a section of a business, such as one counter of a large store, that sells its own kind of goods under the same roof as the others. Each usually has its own manager. Departmental accounting keeps accounts that show the result of each department, so that the owners can see how the business as a whole and each department is doing.

Objectives (advantages).

1. Individual results. The gross and net profit of each department are known and can be compared.
2. Decisions. Management can decide whether to expand, change or close a department.
3. Planning. Each department's figures help plan its purchases, staff and space for the future.
4. Motivation. Comparing results spurs the staff of each department and builds healthy competition between them.

Methods.

Exam questions use the columnar method.

The account has the usual two sides, with one money column for each department (and, if useful, a total column).

The departmental net profits are carried to a General Profit and Loss Account, which also takes the items not shared, the stock reserve on goods passed between departments (sub-topic 5), and gives the net profit of the business.

Some expenses belong to one department and are charged straight to it. Others serve every department and must be apportioned (shared out). There is no single correct basis: pick the one that best measures how much each department uses the expense. Where the question prints a ratio, use it.

Adjust each common expense for amounts prepaid or outstanding first, then share the corrected figure. An item such as a provision for bad debts on each department's own debtors is charged directly, not shared.

When one department's output is another department's input, the transfer is recorded in both columns: the giving department is credited (like a sale) and the receiving department is debited (like a purchase). The question states the price.

That profit is unrealised. It is removed through a stock reserve in the General Profit and Loss Account (or the business-as-a-whole column): the reserve on closing stock is debited, and last year's reserve on opening stock is released (credited). The departmental profits are left as they are, so each department is still judged on its own transfers.

The giving department's rate is its gross profit divided by its turnover, transfers included. If the transfer is at cost plus 25%, the profit is 25/125 (one-fifth) of the transfer price. If the question gives last year's rate, use it for the opening stock and this year's rate for the closing stock.

Some questions give each department's units (bought, sold, in stock) and selling price per unit, but only the total cost of purchases. They add that every department earns the same rate of gross profit on sales. Then cost is the same fraction of selling price in every department, and that fraction can be found.

1. Value each department's purchased units at its selling price, and add them.
2. Cost ratio = total cost of purchases ÷ that total at selling price. Gross profit rate = 1 − cost ratio.
3. Cost per unit of each department = its selling price × cost ratio.
4. Opening stock in units = units sold + closing units − units purchased (unless given). Value opening and closing stock at the cost per unit.
5. Prepare the Departmental Trading Account. Each gross profit must equal the common rate × that department's sales.

When the question gives a trial balance with departmental columns for some items:

1. Put every departmental item (stock, purchases, sales, wages, own expenses) in its own column.
2. Adjust the common items for prepayments, outstandings and depreciation, then share them on the printed or suitable bases.
3. Strike each department's gross and net profit.
4. Carry the net profits to a General Profit and Loss Account with the items not shared and any stock reserve; find the business's net profit.
5. Prepare one Balance Sheet for the whole business. Closing stocks of all departments are added together (less any stock reserve); prepaid expenses are assets and outstanding expenses liabilities; the net profit (less drawings) goes to capital.

A lease is an agreement by which the owner of an asset, the lessor, gives another party, the lessee, the right to use the asset for an agreed period in return for one payment or a series of payments (AS 19, para 3.1). The lessee gets the use of the asset without buying it and pays for it out of what the asset earns; this is why leasing is called lease financing. An agreement to hire an asset with an option to acquire it later (a hire purchase agreement) also counts as a lease (para 4).

Elements. An agreement signed by both parties; two parties, the lessor and the lessee; and the lease rent, which pays the lessor interest on its investment, the asset's depreciation and any charges it bears (repairs, insurance).

What AS 19 does not cover (para 1): leases to explore for or use natural resources (oil, gas, timber, minerals); licences for films, video recordings, plays, manuscripts, patents and copyrights; and leases of land. It covers an agreement that gives the right to use an asset even if the lessor also provides substantial services, but not a pure service contract (para 2).

Key terms (AS 19, para 3, in plain words):

Advantages of leasing to the lessee.

1. Capital is saved: the asset is used without paying its full price at once.
2. Less initial investment is needed, which suits a new business.
3. Fewer formalities than a loan from a financial institution.
4. The lessor may give technical support.
5. Under an operating lease the lessor bears the risk that the asset becomes out of date, which suits fast-changing technology.
6. The rent is fixed for the period even if the asset's value changes.
7. Tax benefits for both parties, and a sale and leaseback can release cash tied up in assets.

Disadvantages. The lessee cannot alter the asset or the terms without the lessor's consent; a finance lease cannot be cancelled except at heavy cost, even if the asset becomes useless; the lessee gains nothing if the asset rises in value; and leasing usually costs more than borrowing.

A finance lease passes to the lessee substantially all the risks and rewards that go with owning the asset. Legal title may or may not pass in the end. An operating lease is every lease that is not a finance lease (AS 19, paras 3.2, 3.3 and 6). The risks are losses from idle capacity, from the asset going out of date and from changes in economic conditions; the rewards are profitable use over the asset's economic life, a rise in its value and what it fetches at the end (para 5).

The decision rests on the substance of the deal, not its form (para 8). Any of these situations would normally make it a finance lease (para 8):

1. Ownership passes to the lessee by the end of the lease term.
2. The lessee has an option to buy the asset at a price expected to be well below its fair value at the date the option can be used, so that at inception it is reasonably certain the option will be used.
3. The lease term covers the major part of the asset's economic life, even if title never passes.
4. At inception, the present value of the minimum lease payments comes to at least substantially all of the asset's fair value.
5. The asset is so specialised that only the lessee can use it without major changes.

These indicators, alone or together, can also point to a finance lease (para 9):

1. If the lessee may cancel, the lessee bears the lessor's losses from the cancellation.
2. Gains or losses from changes in the residual's fair value fall on the lessee (for example, a rent rebate equal to most of the sale proceeds at the end).
3. The lessee can continue for a secondary period at a rent well below the market rent.

The lease is classified at inception (para 10). A later change in an estimate (of the economic life or the residual value) or in circumstances (the lessee defaults) does not reclassify it. Only a change in the terms that would have given a different class at inception makes it a new agreement over its revised term. The lessor and the lessee may, on their different facts, classify the same lease differently (para 7).

The two compared.

Kinds of finance lease in the syllabus sources:

1. An ordinary finance lease, where a leasing company or financier buys the asset and leases it out to earn finance income.
2. A finance lease by a manufacturer or dealer. A maker or dealer offers customers the choice of buying or leasing. Such a lease earns two incomes (paras 32 to 36):
   • a selling profit, equal to the profit on an outright sale at normal selling prices: sales revenue is the asset's fair value (or the present value of the minimum lease payments at a commercial rate, if lower); cost of sale is the asset's cost (or carrying amount) less the present value of the unguaranteed residual value; and
   • finance income over the lease term. If the dealer quotes an artificially low interest rate, the selling profit is cut down to what a commercial rate would give. Its initial direct costs are an expense at the start of the lease.
3. A finance leaseback: a sale and leaseback in which the leaseback passes substantially all the risks and rewards.

A manufacturer or dealer earns no selling profit on an operating lease, because that is not equal to a sale (para 45).

Sale and leaseback. The owner sells an asset and leases the same asset back from the buyer. The sale price and the rents are agreed as one package. The treatment depends on what kind of lease the leaseback is (paras 47 to 53):

In law the lessee does not own the asset, but in substance it has bought the use of it for most of its life and taken on a debt for it. So it shows both (paras 11 to 20).

1. At inception, record the asset and a liability at the same amount: the fair value of the asset, or the present value of the minimum lease payments (lessee's view, with the residual value the lessee guarantees) if that is lower. Discount at the interest rate implicit in the lease if it can be found; otherwise at the lessee's incremental borrowing rate.
2. Initial direct costs of arranging the lease are added to the asset.
3. Each payment is split into a finance charge and a repayment of the liability. The finance charge is spread so that it gives a constant rate of interest on the balance of the liability still outstanding (a little rounding in the last year is normal).
4. Depreciate the asset on the lessee's usual policy for owned assets (AS 10). If it is reasonably certain the lessee will own the asset at the end, depreciate over its useful life; if not, over the lease term or the useful life, whichever is shorter.
5. In the Balance Sheet, show the asset among fixed assets (separately from owned assets) and the liability separately as a current or long-term liability. Never deduct the liability from the asset.

Under a finance lease the lessor has, in substance, sold the asset on credit. Each rent it receives is partly a repayment of its investment and partly finance income for financing the lessee (paras 26 to 29).

1. Gross investment = lessor's minimum lease payments (rents + guaranteed residual value) + unguaranteed residual value.
2. Net investment = present value of the gross investment at the interest rate implicit in the lease. At the implicit rate it equals the asset's fair value.
3. Unearned finance income = gross investment − net investment. It is the total interest the lessor will earn over the lease.
4. At inception the lessor shows a receivable equal to the net investment, not the asset.
5. Each year's finance income = net investment outstanding × implicit rate, so the return on the investment is constant. Each rent (leaving out charges for services) reduces both the principal and the unearned finance income.
6. The unguaranteed residual value is reviewed regularly. If the estimate falls, the income for the remaining term is reworked and the part already taken that is now too high is reversed at once; an estimate that rises is ignored (para 30).
7. Initial direct costs of arranging the lease (commission, legal fees) are either expensed at once or spread against the finance income over the term (para 31).

Finding the annual rent. When the question says the rents are set so that their present value plus that of the residual value equals the asset's cost (or fair value), work backwards: annual rent = (cost − present value of the residual value) ÷ the sum of the annual factors.

Disclosure in brief (paras 22 and 37). The lessee shows leased assets apart from owned ones and, for each class, their net carrying amount, with the future minimum lease payments and their present value. The lessor shows its gross investment and the present value of the payments receivable, the unearned finance income and the unguaranteed residual values. Both split the future amounts into not later than one year, later than one year and not later than five years, and later than five years.

Under an operating lease nothing is bought or financed: the lessee hires the asset and the lessor hires it out.

Companies that follow Indian Accounting Standards (Ind AS) account for leases under Ind AS 116, Leases, which applies to accounting periods beginning on or after 1 April 2019. It replaced Ind AS 17 and is based on IFRS 16. Its main change is for the lessee: the lessee no longer sorts leases into finance and operating, but follows one model, recording a right-of-use asset and a lease liability for its leases. Short leases of up to 12 months and leases of low-value assets are the exceptions. The lessor still classifies its leases as finance or operating.