Branch Accounting including Foreign Branches
Weightage: Chapter 15 of ICAI's Paper 1 syllabus, roughly 10 marks. The last chapter of the paper and the one candidates most often meet unprepared, though it is among the most mechanical once the four systems are separated.
The question a branch poses
A business operates from more than one place. The branches trade, hold stock, incur expenses and collect cash. At the year end the enterprise must produce one set of financial statements covering all of it.
The difficulty is that a branch is not a separate entity. It has no capital of its own, it owes nothing to the head office in law, and its assets belong to the same legal person. Everything between head office and branch is internal, and internal balances must ultimately cancel.
So branch accounting is the problem of recording internal transfers so that the enterprise's real position emerges when they are eliminated.
Which method is used depends on one thing: how much bookkeeping the branch does for itself. That is the classification to establish first, every time.
The four systems
Debtors system — for a small branch that keeps no books. The head office maintains a single Branch Account which functions as a memorandum of everything sent to and received from the branch. The balancing figure is the branch's profit.
Stock and debtors system — for a slightly larger branch, still keeping no books, where the head office wants more information than a single figure. Instead of one account, the head office maintains several: Branch Stock, Branch Debtors, Branch Expenses, Branch Adjustment and Branch Profit and Loss. The additional accounts make stock losses and shortages visible, which the debtors system conceals inside the profit figure.
Final accounts system — the head office prepares a Branch Trading and Profit and Loss Account in the ordinary way from the branch's returns, and the profit so computed is taken into the Branch Account.
Independent branch — the branch keeps a full double entry set of books, including its own trial balance. Head office and branch each maintain a current account with the other, and at the year end the two are reconciled and eliminated on incorporation.
The debtors system
The Branch Account is a personal account of the branch, debited with what the branch receives and credited with what it gives up.
Debit side: opening branch stock, opening branch debtors, opening petty cash and other assets; goods sent to branch; expenses paid by head office on the branch's behalf — rent, salaries, insurance, advertising.
Credit side: goods returned by the branch; cash received from the branch, whether from cash sales or from debtors; closing branch stock, closing branch debtors, closing petty cash and other assets.
The balancing figure is the branch's profit or loss, transferred to the general profit and loss account.
The logic is worth stating, because it makes the method reconstructible rather than memorised. The account opens with what the branch held at the start, adds what was sent during the year, and closes with what the branch holds at the end plus what it remitted. Anything left over was generated by trading.
Goods sent to branch at cost is the simple case. Where goods are invoiced at selling price — which head offices do to control branch pricing and to make pilferage visible — the loading must be removed, and this is where the questions are set.
The loading adjustment
If goods costing ₹100 are invoiced to the branch at ₹125, the loading is ₹25, or twenty per cent of invoice price and twenty-five per cent of cost. Reading which base a question uses is half the battle: "goods invoiced at cost plus 25%" and "goods invoiced so that loading is 25% of invoice price" describe different numbers.
Under the debtors system with invoice pricing, the adjustments are:
- Opening stock reserve — the loading in the opening stock, credited to the Branch Account (or debited to Stock Reserve and credited to Branch Account, depending on presentation);
- Loading on goods sent — removed;
- Loading on goods returned — removed;
- Closing stock reserve — the loading in the closing stock, carried forward.
The Stock Reserve Account exists because unsold stock invoiced at selling price contains unrealised profit. The enterprise has not sold to anyone outside itself, so the loading must be eliminated from closing stock exactly as intra-group profit is eliminated on consolidation. The principle is identical.
The stock and debtors system
Where the head office wants to know not merely how much profit the branch made but where the goods went, the single Branch Account is replaced by a set.
Branch Stock Account is maintained at invoice price. Debited with opening stock and goods sent; credited with cash sales, credit sales, goods returned to head office, and closing stock. The balancing figure is a surplus or shortage of stock.
That balancing figure is the whole point of the system. Under the debtors system a shortage disappears into the profit figure and nobody knows it occurred. Here it appears as a separate number, which is exactly what a head office wants from a branch it cannot supervise directly.
Branch Adjustment Account carries the loading. Credited with the loading on opening stock and on goods sent; debited with loading on returns and on closing stock; and the surplus or shortage from the Branch Stock Account is adjusted here at its loading element. The balance represents the gross profit of the branch.
Branch Profit and Loss Account takes the gross profit from the Branch Adjustment Account, deducts branch expenses and the cost element of any shortage, and yields the branch's net profit.
Branch Debtors Account runs in the ordinary way: opening balance and credit sales on the debit side; cash received, returns, discount allowed, bad debts and closing balance on the credit side.
A normal loss — evaporation, natural wastage — is absorbed in the cost of goods sold and is adjusted through the Branch Adjustment Account only for its loading. An abnormal loss — theft, fire, accident — is charged separately to the Branch Profit and Loss Account at cost, with its loading removed through the Branch Adjustment Account.
Independent branches
Here the branch keeps a full set of double entry books and prepares its own trial balance, which the head office then incorporates.
The current accounts. The head office maintains a Branch Account in its books; the branch maintains a Head Office Account in its own. The two are reciprocal: a debit in one corresponds to a credit in the other. When everything has been recorded on both sides, the balances are equal and opposite.
Reconciliation is required because at any given date they usually are not equal, and for a reason that is entirely ordinary: transactions in transit. Goods dispatched by the head office and not yet received by the branch; cash remitted by the branch and not yet received by the head office; expenses charged by the head office of which the branch has not been advised; depreciation charged by the head office on branch assets.
The convention is that the branch's books are brought up to date — the branch records the in-transit items — and then the two balances agree. Alternatively, for incorporation purposes, adjustment entries are passed in the head office books for items in transit.
Incorporation. The head office incorporates the branch trial balance line by line, and then eliminates:
- the Branch Account against the Head Office Account;
- goods sent to branch against goods received from head office;
- any unrealised profit in branch stock, where goods were invoiced above cost.
The parallel with consolidation is exact and worth naming: internal balances cancel, internal transfers cancel, and unrealised profit on internal transfers is eliminated.
Foreign branches
A foreign branch is an independent branch whose books are in another currency. The additional work is translation, governed by AS 11, and the whole question turns on a classification.
Integral versus non-integral
An integral foreign operation carries on its business as though it were an extension of the reporting enterprise's operations. A branch that merely sells goods imported from the head office, remits proceeds promptly, and depends on the head office for financing is integral. A change in the exchange rate affects the head office almost immediately, because the branch's cash flows are the head office's cash flows in another currency.
A non-integral foreign operation accumulates cash and other monetary items, incurs expenses, generates income and arranges borrowings substantially in its local currency. It may operate with a significant degree of autonomy. A change in the exchange rate affects the head office's net investment in the operation, rather than its individual monetary items.
AS 11 lists indicators pointing to non-integral status: activities carried on with a significant degree of autonomy; transactions with the reporting enterprise forming a low proportion of the operation's activities; financing mainly from its own operations or local borrowings rather than from the reporting enterprise; costs of labour, material and other components settled primarily in local currency; sales mainly in currencies other than the reporting currency; and cash flows insulated from the day-to-day activities of the reporting enterprise.
Translation of an integral operation
The financial statements are translated as if the transactions had been those of the reporting enterprise itself:
- Monetary items at the closing rate;
- Non-monetary items carried at historical cost at the rate on the date of the transaction;
- Non-monetary items carried at fair value at the rate when the value was determined;
- Income and expense items at the rates on the dates of the transactions, or an average rate where it approximates;
- Exchange differences recognised in profit and loss for the period.
Translation of a non-integral operation
- All assets and liabilities, both monetary and non-monetary, at the closing rate;
- Income and expense items at the rates on the dates of the transactions, or an average rate;
- Resulting exchange differences accumulated in a Foreign Currency Translation Reserve, not recognised in profit, until the disposal of the net investment, at which point the accumulated amount is recognised as income or expense.
The reason for the difference is worth understanding rather than memorising. An integral operation's exchange exposure is a real, immediate exposure on transactions the head office is effectively conducting, so it belongs in profit. A non-integral operation's exchange movement affects only the rupee value of a net investment the head office is not currently realising, so recognising it in profit would report gains and losses on a position that has not changed in any commercial sense. It is parked in a reserve until the investment is actually disposed of.
Change of classification
Where a foreign operation is reclassified, the translation procedures applicable to the new classification are applied from the date of the change.
On a change from integral to non-integral, exchange differences arising on translation of non-monetary assets at the date of reclassification are accumulated in the foreign currency translation reserve.
On a change from non-integral to integral, the translated amounts for non-monetary items at the date of the change are treated as their historical cost in the period of change and subsequent periods, and the exchange differences already accumulated in the reserve are not recognised as income or expense until disposal.
A worked debtors system problem
A head office invoices goods to its branch at cost plus 25 per cent. At the start of the year the branch held stock at invoice price of ₹50,000 and debtors of ₹30,000. During the year goods invoiced at ₹4,00,000 were sent; the branch returned goods invoiced at ₹20,000; credit sales were ₹3,10,000 and cash sales ₹90,000; ₹2,95,000 was collected from debtors; branch expenses of ₹48,000 were paid by the head office. Closing stock at invoice price was ₹60,000 and closing debtors ₹45,000.
First, fix the loading base. Cost plus 25 per cent means ₹100 of cost is invoiced at ₹125, so loading is ₹25 on an invoice value of ₹125 — that is one fifth of invoice price, not one quarter. Mistaking this is the commonest error in the chapter, and it corrupts every subsequent figure.
The Branch Account. Debit: opening stock 50,000; opening debtors 30,000; goods sent 4,00,000; expenses 48,000. Credit: goods returned 20,000; cash from debtors 2,95,000; cash sales 90,000; closing stock 60,000; closing debtors 45,000.
Debits total 5,28,000 and credits 5,10,000, so on invoice values the account shows a debit balance of 18,000 — which is not the profit, because the invoice figures still carry loading.
Now remove the loading. On goods sent, one fifth of 4,00,000 is 80,000, credited. On goods returned, one fifth of 20,000 is 4,000, debited. On opening stock, one fifth of 50,000 is 10,000, credited. On closing stock, one fifth of 60,000 is 12,000, debited as a stock reserve carried forward.
The branch profit emerges once these are applied, and the closing stock reserve of ₹12,000 remains on the balance sheet as a deduction from branch stock — because that stock has not been sold to anybody outside the enterprise, and its loading is unrealised profit exactly as intra-group profit is on consolidation.
The check worth doing. Gross profit should be reconcilable independently: total sales of 4,00,000 at a gross margin of one fifth of selling price gives 80,000, less any shortage, less expenses of 48,000. If your Branch Account profit and this rough figure diverge widely, the loading base is the first thing to re-examine.
Choosing the system in an examination
Questions do not usually announce which system to use, so the classification must be read out of the facts, and three cues settle it almost always.
If the question gives you a branch trial balance, the branch keeps full books and it is an independent branch: incorporate and eliminate.
If the question asks you to compute a shortage or surplus of stock, or gives figures that only make sense if such a figure is to emerge, it is the stock and debtors system, because that is the only system in which a shortage appears as a separate number rather than disappearing into profit.
Otherwise, if the branch keeps no books and you are given opening and closing assets, goods sent, remittances and expenses, it is the debtors system, and a single Branch Account will do.
Write which system you are using and why in one line before you start. It costs ten seconds, it forces the classification to be conscious rather than assumed, and where a candidate has chosen wrongly an examiner can still see the method was understood.
