Branch Accounting including Foreign Branches — Practice

Question 1

Goods are invoiced to a branch at cost plus 25%. Closing branch stock at invoice price is ₹90,000. Compute the stock reserve. A candidate computes ₹22,500. Identify and explain the error.

Accepted Answer

Cost plus 25 per cent means that goods costing 100 are invoiced at 125, so the loading of 25 is a quarter of cost but one fifth of invoice price. Closing stock is given at invoice price, so the loading in it is one fifth of 90,000, that is 18,000, and the stock reserve is 18,000. The candidate has computed 22,500, which is 25 per cent of the invoice price, applying the cost-based percentage to an invoice-based figure. The error corrupts every subsequent number in a branch question, since the same conversion is needed for goods sent, goods returned and both opening and closing stock, and it is the single most common mistake in the chapter. The safeguard is to write the conversion explicitly before starting: loading at cost plus x per cent equals x over 100 plus x of invoice price, so cost plus 25 per cent is 25 over 125, that is one fifth. Read the question's wording carefully too, because loading of 25 per cent of invoice price is a different instruction, equivalent to cost plus one third, and questions do use both formulations.

Question 2

Set out the cues by which you decide which branch accounting system a question requires, and explain why writing your choice down before starting is worth doing.

Accepted Answer

Three cues settle it in almost every question. If the question supplies a branch trial balance, the branch keeps a full set of double entry books and it is an independent branch: the task is to reconcile the current accounts for items in transit, incorporate the trial balance line by line, and eliminate the internal balances and any unrealised profit in branch stock. If the question asks for 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 being absorbed silently into the profit figure. Otherwise, where 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 suffices. The final accounts system appears where the question asks for a Branch Trading and Profit and Loss Account. Writing the choice down in one line before starting costs ten seconds, forces the classification to be conscious rather than assumed, and means that a candidate who has chosen wrongly can still be seen by the examiner to have understood the method, which protects part of the mark.

Question 3

A head office invoices goods at cost plus 25%. Opening branch stock at invoice price ₹50,000; opening debtors ₹30,000; goods sent ₹4,00,000; goods returned ₹20,000; credit sales ₹3,10,000; cash sales ₹90,000; collected from debtors ₹2,95,000; branch expenses paid by head office ₹48,000; closing stock at invoice price ₹60,000; closing debtors ₹45,000. Set out the Branch Account entries and the loading adjustments.

Accepted Answer

The loading is one fifth of invoice price, since cost plus 25 per cent gives 25 on 125. The Branch Account is debited with opening stock 50,000, opening debtors 30,000, goods sent 4,00,000 and expenses 48,000, totalling 5,28,000. It is credited with goods returned 20,000, cash received from debtors 2,95,000, cash sales 90,000, closing stock 60,000 and closing debtors 45,000, totalling 5,10,000. On invoice values the account shows a debit balance of 18,000, which is not the profit because the invoice figures still contain loading. Four loading adjustments follow. Loading on goods sent, one fifth of 4,00,000, that is 80,000, is credited. Loading on goods returned, one fifth of 20,000, that is 4,000, is debited. Loading on opening stock, one fifth of 50,000, that is 10,000, is credited. Loading on closing stock, one fifth of 60,000, that is 12,000, is debited and carried forward as a stock reserve. 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 anyone outside the enterprise and its loading is unrealised profit, eliminated on exactly the principle that removes intra-group profit on consolidation. A useful independent check is that sales of 4,00,000 at a margin of one fifth of selling price give a gross profit of 80,000, against which expenses of 48,000 are set.

Question 4

Explain why a stock reserve is created when goods are invoiced to a branch above cost, and connect the treatment to a principle met elsewhere in the paper.

Accepted Answer

A head office that invoices goods to its branch at selling price does so for control reasons: it fixes the branch's pricing, and it makes pilferage visible because the branch is accountable for stock at the value it is expected to sell for. But the invoice price contains a profit element, and at the year end any of those goods still unsold sit in the enterprise's balance sheet carrying that profit. No sale has occurred to anybody outside the enterprise, since a head office cannot make a profit by selling to itself, so the loading in closing stock is unrealised. Carrying it would overstate both closing stock and reported profit, and would recognise income in the year the goods were transferred internally rather than in the year they were actually sold. The stock reserve removes it, so that branch stock appears in the balance sheet at cost to the enterprise. The principle is identical to the elimination of unrealised profit on intra-group transactions when consolidating under AS 21, where goods sold by a parent to a subsidiary and still held at the year end carry profit that the group as a whole has not earned. In both cases the entity boundary is what determines whether a profit is real, and in both cases the answer is that transfers within the boundary earn nothing.

Question 5

Explain the purpose of each of the four accounts in the stock and debtors system, and identify what the balancing figure of each represents. Why would a head office prefer this system to the debtors system?

Accepted Answer

The Branch Stock Account is maintained at invoice price, debited with opening stock and goods sent, and credited with cash sales, credit sales, goods returned to head office and closing stock. Its balancing figure is a surplus or shortage of stock, and isolating that figure is the entire purpose of the system. The Branch Adjustment Account carries the loading: it is credited with the loading on opening stock and on goods sent, debited with the loading on returns and on closing stock, and adjusted for the loading element of any surplus or shortage; its balance represents the branch's gross profit. The Branch Profit and Loss Account takes that gross profit, deducts branch expenses and the cost element of any abnormal shortage, and yields the branch's net profit. The Branch Debtors Account runs conventionally, with opening balance and credit sales on the debit side and cash received, returns inwards, discount allowed, bad debts and the closing balance on the credit side. A head office prefers this system because the debtors system tells it only how much profit the branch made, and a shortage of stock disappears inside that single figure without anyone learning that it occurred. A branch that cannot be supervised directly is exactly the case where management needs to know whether goods went missing, and the stock and debtors system produces that number as a separate, visible item.

Question 6

Distinguish normal from abnormal loss at a branch and state the accounting treatment of each where goods are invoiced above cost.

Accepted Answer

A normal loss is one inherent in the nature of the goods or the handling process and expected to occur in the ordinary course — evaporation, natural wastage, breakage within customary limits. Because it is expected, it is treated as part of the cost of the goods that survive: no separate charge is made, the loss is absorbed in the cost of goods sold, and the only entry required is an adjustment through the Branch Adjustment Account to remove the loading element, so that the loading account is not left carrying profit on goods that no longer exist. An abnormal loss is one not expected in the ordinary course — theft, fire, accident, damage in transit beyond normal limits. It is not a cost of trading and must not be buried in the cost of goods sold, because doing so would conceal it and would distort the gross margin. It is therefore charged separately at cost to the Branch Profit and Loss Account, with its loading removed through the Branch Adjustment Account so that the two elements of the invoice value are dealt with in the right places. The distinction matters commercially as well as in the accounts: an abnormal loss is a management failure or an insured event, and either way it needs to be visible to someone who can act on it.

Question 7

At the year end the head office's Branch Account shows ₹8,40,000 debit and the branch's Head Office Account shows ₹7,55,000 credit. Explain why the two differ, list the usual causes, and state the convention for reconciling them.

Accepted Answer

The two accounts are reciprocal: every entry in one has a corresponding entry in the other, so when all transactions have been recorded on both sides the balances are equal and opposite. A difference means that some transactions have been recorded by one party and not yet by the other, and the ordinary explanation is items in transit at the year end rather than error. The usual causes are four. Goods dispatched by the head office and not yet received or recorded by the branch. Cash or cheques remitted by the branch and not yet received or recorded by the head office. Expenses incurred by the head office on the branch's behalf, such as insurance or advertising, of which the branch has not yet been advised. And depreciation charged by the head office on branch fixed assets whose accounts it maintains. Here the head office balance exceeds the branch balance by 85,000, which will be accounted for by items the head office has recorded and the branch has not, most typically goods in transit and unadvised expenses. The convention is that the branch's books are brought up to date by recording the in-transit items, after which the two balances agree and can be eliminated against each other on incorporation. Alternatively, for incorporation purposes, adjustment entries may be passed in the head office books to bring the in-transit items into account.

Question 8

State what is eliminated when an independent branch's trial balance is incorporated in the head office books, and explain the parallel with consolidation.

Accepted Answer

Three eliminations are required. First, the Branch Account in the head office books is eliminated against the Head Office Account in the branch books, the two having been reconciled and made equal and opposite; they represent an internal claim of the enterprise on itself, which cannot appear in financial statements of a single legal person. Second, goods sent to branch in the head office books are eliminated against goods received from head office in the branch books, since the transfer moved nothing outside the enterprise and leaving both would double count the same goods once as a despatch and once as a purchase. Third, any unrealised profit in branch stock is eliminated where goods were invoiced above cost, so that stock is carried at cost to the enterprise. The parallel with consolidation under AS 21 is exact and worth stating in an answer. There, intra-group balances are eliminated, intra-group transactions are eliminated, and unrealised profits resulting from intra-group transactions are eliminated in full. Here the same three steps are applied to a structure that is not a group at all but a single legal entity operating in two places. In both cases the reason is the same: the financial statements report on a defined reporting entity, and transactions that do not cross that entity's boundary earn nothing and create nothing.

Question 9

Classify each as integral or non-integral, with reasons: (a) a Dubai branch that sells goods imported from the Indian head office, remits proceeds weekly and is funded entirely by head office; (b) a Kenya branch that manufactures locally, sells locally in shillings, borrows from Kenyan banks and remits a dividend annually.

Accepted Answer

The Dubai branch is an integral foreign operation. AS 11 describes an integral foreign operation as one that carries on its business as though it were an extension of the reporting enterprise's operations, and every feature here points that way: it sells goods supplied by the head office rather than goods it produces, it remits proceeds weekly rather than accumulating them, and it depends on the head office for financing rather than raising its own. The consequence is that a movement in the exchange rate affects the head office almost immediately, because the branch's cash flows are in substance the head office's cash flows denominated in another currency. The Kenya branch is non-integral. It accumulates cash and other monetary items, incurs expenses, generates income and arranges borrowings substantially in its local currency, and it operates with a significant degree of autonomy. AS 11's indicators are satisfied: activities carried on autonomously, transactions with the reporting enterprise forming a low proportion of its activities, financing mainly from its own operations and local borrowings, costs settled primarily in local currency, sales mainly in a currency other than the reporting currency, and cash flows insulated from the day-to-day activities of the reporting enterprise. A rate movement affects the head office's net investment in the operation rather than its individual monetary items. Note that geography decides nothing; both branches are abroad and they are classified differently.

Question 10

Set out the translation rules for an integral and a non-integral foreign operation, and explain from first principles why exchange differences are treated differently in the two cases.

Accepted Answer

For an integral foreign 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 exchange rate on the date of the transaction, so they do not move; non-monetary items carried at fair value at the rates when those values were determined; income and expense items at the rates on the dates of the transactions, or at an average rate where it approximates them; and the resulting exchange differences recognised as income or expense in the profit and loss account for the period. For a non-integral foreign operation the rules are simpler and different: all assets and liabilities, both monetary and non-monetary, are translated at the closing rate; income and expense items at the rates on the dates of the transactions or an average; and the resulting exchange differences are accumulated in a foreign currency translation reserve rather than 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 economic rather than technical. An integral operation's exchange exposure is real and immediate, on transactions the head office is effectively conducting itself, so it belongs in profit as it arises. A non-integral operation's exchange movement affects only the rupee value of a net investment the head office is not currently realising and has no intention of realising; recognising it in profit would report gains and losses on a position that has not changed in any commercial sense and would make earnings swing with a rate the enterprise is not exposed to in cash terms. It is therefore parked in a reserve until disposal actually crystallises it.

Question 11

A foreign branch previously classified as non-integral becomes integral following a restructuring. State the accounting on the change, and state the position on the reverse change.

Accepted Answer

AS 11 provides that when there is a change in the classification of a foreign operation, the translation procedures applicable to the revised classification are applied from the date of the change, and not retrospectively. On a change from non-integral to integral, the translated amounts for non-monetary items at the date of the change are treated as the historical cost for those items in the period of change and in subsequent periods, so the closing rate applied on the last day of non-integral status becomes the fixed rate at which those items are thereafter carried. The exchange differences already accumulated in the foreign currency translation reserve are not recognised as income or expense until the disposal of the operation, so the reserve is simply frozen rather than released; the reasoning is that a reclassification is not a disposal and nothing has been realised. On the reverse change, from integral to non-integral, exchange differences arising on the translation of non-monetary assets at the date of the reclassification are accumulated in the foreign currency translation reserve, since from that date the operation's assets are translated at the closing rate and the resulting differences belong in the reserve rather than in profit. In both directions the principle is the same: the change is prospective, and amounts already in the reserve stay there until the net investment is actually disposed of.

Question 12

Describe the final accounts system of branch accounting, and say when a head office would use it in preference to the debtors system.

Accepted Answer

Under the final accounts system the head office prepares a Branch Trading and Profit and Loss Account in the ordinary way, using the returns the branch submits: opening stock, goods sent, purchases made locally by the branch, sales, closing stock, and the branch's expenses. The profit so computed is then taken into the Branch Account in the head office books. The branch itself still keeps no double entry books; it merely reports figures. A head office prefers this to the debtors system where it wants a conventional profit statement for the branch rather than a single balancing figure, and particularly where the branch makes some purchases of its own or incurs expenses locally, because those transactions are awkward to present within a single Branch Account and natural within a trading and profit and loss account. It also gives management a gross margin for the branch, which the debtors system does not, and gross margin is usually the more diagnostic number: a falling gross margin points to pricing or stock loss, while a falling net profit could be either that or expense creep. Where goods are invoiced above cost, the same loading adjustments and closing stock reserve are required as under the debtors system, since the reason for them is unaffected by the choice of presentation.

Question 13

Explain why branch accounting exists as a distinct problem at all, given that a branch is not a separate legal entity.

Accepted Answer

The fact that a branch is not a separate legal entity is precisely what creates the problem rather than removing it. A branch has no capital of its own, owes the head office nothing that a court would enforce, and holds assets that belong to the same legal person as the head office's assets. Everything passing between them is therefore internal, and none of it can appear in the enterprise's financial statements: goods sent to branch is not a sale, the branch current account is not a receivable, and profit on goods invoiced to the branch is not profit. Yet the enterprise still needs to record those transfers, because a branch trades independently day to day, holds stock, collects cash and incurs expenses, and management cannot control what it cannot measure. Branch accounting is the set of techniques for recording internal transfers in a way that gives management the information it needs while ensuring that the enterprise's real position emerges once the internal items are eliminated. That is why every system in the chapter ends in the same two operations: measure the branch, then cancel the internal balances and remove the unrealised profit.

Question 14

Goods are invoiced to a branch such that the loading is 20% of invoice price. Express this as a percentage on cost, and compute the stock reserve on closing stock of ₹1,50,000 at invoice price and the loading on goods sent of ₹9,00,000 at invoice price.

Accepted Answer

If loading is 20 per cent of invoice price, then on an invoice value of 100 the loading is 20 and the cost is 80, so the loading expressed on cost is 20 over 80, that is 25 per cent. The goods are therefore invoiced at cost plus 25 per cent, which is the same arrangement as the more common formulation but stated from the other side. The general conversions are worth writing out once: a loading of y per cent of invoice price equals y over 100 minus y as a percentage of cost, and a loading of x per cent on cost equals x over 100 plus x of invoice price. Both figures in this question are given at invoice price, so the invoice-based percentage applies directly to each without conversion. The stock reserve on closing stock is 20 per cent of 1,50,000, that is 30,000. The loading on goods sent is 20 per cent of 9,00,000, that is 1,80,000. The trap the question sets is the temptation to convert to 25 per cent and then apply that to figures already expressed at invoice price, which would give 37,500 and 2,25,000 and would be wrong; the conversion is needed only when a figure is stated at cost and the percentage at invoice price, or the reverse.

Question 15

A head office maintains a Dubai branch whose accounts are in dirhams. It has been treated as integral. The branch holds fixed assets bought three years ago, inventory bought during the year, cash, and a payable to a local supplier. State the rate applied to each and the destination of the exchange difference, then state how each answer changes if the branch were non-integral.

Accepted Answer

As an integral operation the branch is translated as though its transactions were the head office's own. Fixed assets bought three years ago are non-monetary items carried at historical cost and are translated at the exchange rate on the date of the transaction, so they are carried at the three-year-old rate and do not move with the currency. Inventory bought during the year is likewise non-monetary at historical cost and is translated at the rate on its transaction date, subject to the ordinary lower of cost and net realisable value test. Cash and the payable to the local supplier are both monetary items and are translated at the closing rate. The exchange differences arising are recognised as income or expense in the profit and loss account for the period. If the branch were non-integral, three of the four answers change. All assets and liabilities, monetary and non-monetary alike, are translated at the closing rate, so the fixed assets and the inventory move to the closing rate along with the cash and the payable; income and expense items are translated at the rates on the dates of the transactions or an average approximating them. And the resulting exchange difference is not recognised in profit at all but accumulated in a foreign currency translation reserve, remaining there until the net investment in the operation is disposed of, when it is recognised as income or expense.

Practice — Branch Accounting including Foreign Branches

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