Calamba Review Center - Laguna (LCRC)

2F MMCO Building, 8000 Lakeview Ph3 Angela Street, Halang, Calamba City Laguna, Philippines
Tel No. (02) 330-8617, (049) 523-6031; (02) 330-6057
CPA REVIEW (May 2020 Batch)
AFAR Marc Oliver Castañeda, CPA MBA

INSTALLMENT ACCOUNTING

THE REVENUE RECOGNITION PRINCIPLE

The revenue recognition principle dictates that revenue be recognized when the earning process is complete or virtually
complete and an exchanged transaction has taken place. Revenue is therefore typically recognized when the firm delivers
goods, performs services, or as time passes (as in the case of interest revenue or rent revenue). There are other points in the
operating cycle where revenue could be recognized. Revenue could be recognized as production takes place, when production is
completed, or as cash is collected from the customer. The following exhibit shows these possibilities. Although the revenue
recognition principle sets the general rule, there are circumstances where revenue is recognized prior to or after delivery. These
exceptional situations are depicted as follows:

EXHIBIT - REVENUE RECOGNITION TIME LINE

Production Production Sale Full Price

Begins Complete Delivery Collected
 PRODUCTION PERIOD  INVENTORY PERIOD  COLLECTION PERIOD 
I------------------------------------------------------------------------------------------------I
    
Percentage of Completed Accretion Revenue Instalment Sales
Completion Contract Basis Recognition Method and
Method Method Principle Cost Recovery
Revenue Recognition (General Rule) Method
for Special Products
with Immediate Marketability

RECOGNITION OF REVENUE AFTER DELIVERY

Revenue is generally recognized when goods are delivered or services performed at the point of the sale. In some
circumstances, recognition of revenue at the point of sale would be premature because collection of the account receivable is
highly uncertain and a reasonable estimate of uncollectibles cannot be made. The instalment sales or cost recovery method is
used to determine when revenue is recognized from such sales. It should be noted that there are few situations where both of
the above mentioned criteria are met. Generally, a firm will refuse credit to those who are unlikely to pay and past experience
will provide a means of estimating uncollectibles.

A. The instalment sales method may be used when collectibility is uncertain and it is impossible to estimate
bad debt loss.
The instalment sales method recognizes gross profit on sales as cash is collected. The method is acceptable for financial
accounting purposes when collection is highly uncertain and estimation of bad debts is not possible. Under certain circumstances
real estate sales firms and franchise operations are required to use this method. While the instalment method has limited
applicability for financial reporting purposes it is used frequently for taxes.
1. Under the instalment sales method proportionate amounts of gross profit are recognized as cash is collected. Credit
sales are recorded in the usual way, but adjusting entries at the end of each period defer gross profit to the extent that
cash is yet to be collected. The gross profit is recognized as the cash is collected. The steps in using the instalment
method are summarized below.
• Step One: Record credit sale in usual manner debiting Instalment Accounts Receivable and crediting
Instalment Sales. Each period’s instalment sales will be kept in a separate account.
• Step Two: Cash collections are recorded in the usual manner debiting Cash and crediting Instalment Accounts
Receivable.
• Step Three: At the end of each period, the cost of goods sold on instalment is removed from the books. The
gross profit on the instalment sales is set up as a deferred gross profit account. The deferred gross profit is
recognized as cash is collected. The entry to defer gross profit on instalment sales for the period is
Instalment Sales xxx
Cost of Instalment Sales xxx
Deferred Gross Profit xxx
The Deferred Gross Profit account should be reported as a contra accounts receivable account on the balance
sheet. In practice, however, it is generally shown as unearned revenue and appears in the liability section of the
balance sheet.
• Step Four: Compute the gross profit percentage for the year’s instalment sales.
Instalment Sales – Cost of Instalment Sales
Gross Profit Percentage = -------------------------------------------------
Instalment Sales
This percentage is calculated every year that instalment sales are made.

• Step Five: Apply the gross profit percentage for each year’s instalment sales to cash collected from accounts
relating to that year to determine the amount of realized gross profit to be recognized.
Gross Profit Recognized For Year 20xx

Page 1 of 22
 = Gross Profit Percentage For Year X Cash Collected From Instalment Accounts
Receivable From Year xx

The entry to recognize gross profit earned debits Deferred Gross Profit for Year xx and credits Realized Gross Profit
on instalment sales.

2. The seller can generally repossess merchandise sold on instalment, if payments are stopped. Repossession signals
uncollectibility of the related account. The account receivable and related deferred gross profit must be written off. The
repossessed merchandise should be recorded at it resale or fair market value. There may be a gain or loss on
repossession.

3. Interest included in instalment payments should be separated from repayment of the account when interest is charged.
Deferred gross profit is realized only on the portion of each payment that is a repayment of the principal amount. Any
interest included in the cash collections must be accounted for separately. Interest should be accounted for under the
effective interest method.

B. The cost recovery method recognizes no gross profit until the full cost of goods sold has been recovered.

The cost recovery method is used when there is a very high degree of uncertainty about collectibility of the account.
No gross profit is recognized on the sale until the full cost of goods sold has been recovered. Thereafter, all cash received is
reported as gross profit. The cost recovery system is rarely used for financial statement purposes and is not allowed for
income taxes.

QUIZZER
1. CRC-ACE started operations on January 1, 20X4 selling home appliances and furniture on installment basis. For 20X4 and
20X5, the following represented operational details:
In thousand Pesos
20X4 20X5
Installment sales 1,200 1,500
Cost of installment sales 720 1,050
Collections
2014 installment sales 630 450
2015 installment sales 900

On January 7, 20X6 an installment sale account in 20X4 defaulted and the merchandise with a market value of P15,000
was repossessed. The related installment receivable balance as of date of default and repossession was P24,000. The
balance of the unrealized gross profit as of the end 2015:
A. P228,000 B. P360,000 C. P192,000 D. P275,000

Items 2 to 4 are based on the following:

The following information is taken from the unadjusted trial balance as of December 31, 20X6 for ACE Corporation:
Cash P 15,000
Accounts receivable 60,000
Installment receivable – 20X4 15,000
Installment receivable – 20X5 45,000
Installment receivable – 20X6 240,000
Merchandise inventory 52,600
Repossessed goods 15,000
Purchases 493,000
Operating expenses 76,300
Repossession loss 24,000
Cash sales P 90,000
Charged sales 180,000
Installment sales 446,400
Other revenue 8,840
Deferred gross profit – 20X4 22,200
Deferred gross profit – 20X5 39,360
The rates of gross profit on installment sales were: 30% in 20X4 and 32% in 20X5. During 20X6, the installment sales price
exceeded the cash price be 24%, while the charge sales price exceeded the cash sales price by 20%. The repossession in
2016 related to 2014 account balances of P14,000 and 2015 account balances of P25,000. The inventory of new and
repossessed merchandise at December 31, 20X6 amounted to P77,000.

2. Total realized gross profit on installment sales in 20X6 amounted to:

A. P102,700 B. P156,240 C. P179,260 D. P232,800
3. The repossession loss was:
A. P9,000 B. P11,800 C. P23,200 D. P24,000
4. The net income for 20X6 was:
A. P100,000 B. P115,000 C. P179,260 D. P195,000

Page 2 of 22
5. The Alaska Company uses the installment method of reporting for accounting purposes. The following data were obtained
for the years 20X4 to 20X6.
20X4 20X5 20X6
Installment sales P600,000 P810,000 P990,000
Cost of installment sales 420,000 486,000 643,500
Gross profit P180,000 P324,000 P346,500

Installment contracts receivable balances, December 31:

20X4 20X5 20X6
20X4 sales P360,000 P270,000 P120,000
20X5 sales 600,000 390,000
20X6 sales 780,000

In 20X6, one of the customers defaulted in his payment and the company repossessed the merchandise with an estimated
market value of P30,000. The sales were in 20X4 and the unpaid balance on the date of repossession was P45,000.
Compute for 20X6 (1) The gain or (loss) on repossession; (2) Total realized gross profit, and (3) The deferred gross profit
A. (1) P (1,500); (2) P189,000; (3) P451,500
B. (1) (1,500); (2) 189,000; (3) 465,000
C. (1) 750; (2) 129,000; (3) 465,000
D. (1) 1,500; (2) 73,500; (3) 273,000

Items 6 to 7 are based on the following:

The Abenson Appliances accounts for its sales on the installment basis. As the beginning of 20X6, ledger accounts include
the following balances:
Installment contracts receivable, 20X4 P30,000
Installment contracts receivable, 20X5 96,000
Deferred gross profit, 20X4 12,600
Deferred gross profit, 20X5 36,000

At the end of 2016 account balances before adjustment for realized gross profit on installment sales are:
Installment contracts receivable, 20X4 P --0--
Installment contracts receivable, 20X5 24,000
Installment contracts receivable, 20X6 130,000
Deferred gross profit, 20X4 12,600
Deferred gross profit, 20X5 34,350
Deferred gross profit, 20X6 60,000
Installment sales in 20X6 are made at 25% above the cost of merchandise sold. During 20X6 upon default in payment by
the customer, the company repossessed the merchandise with an estimated market value of P2,000. The sales was in 20X5
for P10,800, and P6,400 had been collected prior to repossession.
6. Compute the gain or (loss) on repossession assuming that:
Profit is Recognized when the sale is made Profit is Recognized in proportion to
(Point of Sale) Periodic Collections (I/Sales M)
a. P(2,400) P(1,520)
b. 750 ( 750)
c. –0-- (1,520)
d. (2,400) ( 750)
7. The realized gross profit on December 31, 20X6 is:
A. P73,600 B. 71,950 C. P34,000 D. 70,000

Items 8 through 11 are based on the following:

The following trial balance was prepared for the DR Sales Corp. on December 31, 20X6.
Cash 25,000
Installment accounts receivable, 20X6 80,000
Installment accounts receivable, 20X5 20,000
Installment accounts receivable, 20X4 5,000
Accounts receivable 40,000
Inventory, December 31, 20X5 30,000
Other assets 52,000
Accounts payable 75,000
Deferred gross profit, 20X5 96,000
Deferred gross profit, 20X4 22,500
Capital stock 100,000
Retained earnings 44,500
Sales 192,000
Installment sales 500,000
Purchases 455,000
Repossessed merchandise 10,000
Cost of installment sales 310,000
Shipments on installment sales 310,000
Loss on repossessions 13,000
Operating expenses 300,000
1,340,000 1,340,000
Page 3 of 22
 The following account balances were found in the post-closing trial balance prepared at the beginning of 20X6:
Installment accounts receivable, 20X5 P 240,000
Installment accounts receivable, 20X4 50,000
Deferred gross profit, 20X5 96,000
Deferred gross profit, 20X4 22,500

The inventory of new and repossessed merchandise on Dec. 31, 20X6 was P35,000. At the end of December, before
preparing the trial balance, the bookkeeper made the following incomplete entry:
Repossessed merchandise 10,000
Loss on repossessions 13,000
Installment accounts receivable, 20X6 5,000
Installment accounts receivable, 20X5 10,000
Installment accounts receivable, 20X4 8,000

8. The total realized gross profit in 20X6 must be:

A. P232,000 B. P199,700 C. P300,350 D. P258,350
9. The total deferred gross profit in 20X6 must be:
A. P50,150 B. P40,650 C. P82,650 D. P0
10. The correct loss on repossession must be:
A. P13,000 B. P0 C. P3,500 D. P9,500
11. The correct net income (loss) for 20X6 must be:
A. P350 loss B. P3,150 loss C. P45,150 loss D. P54,650 loss
12. The correct total assets for 20X6 must be:
A. P257,000 B. P252,000 C. P211,350 D. P216,350

Items 13 through 16 are based on the following::

The following account balances appear on the books of Macy Co. as of December 31, 20X6:
Cash P 60,000 Capital Stock P200,000
Accounts receivable 320,000 Retained earnings 19,500
Merchandise inventory 30,000 Sales 500,000
Accounts payable 12,000 Purchases 258,000
Unrealized gross profit, 2015 104,500 Expenses 170,000
The accounts receivable account is a controlling account for three subsidiary ledgers which show the following totals:
20X5 installment contracts P 60,000
20X6 installment contracts 240,000
Charge accounts (terms, 30 days net) 20,000
The gross profit on installment contracts for 20X5 was 55% of sales price: on installment contracts for 2016, 50% with the
gross profit on regular charge sales being somewhat below 50%. Collections on installment contracts for 20X5 total P120,000
for the year just closed; on installment contracts for 20X6, P160,000; on charge accounts, P96,000. The charge accounts on the
books at the beginning of the year amounted to P16,000. Repossession for the year were on installment contracts for 20X5, on
which the uncollected balances at the time of repossession amounted to P10,000. Merchandise repossessed was charged to
Purchases at the amount of the uncollected balance. Appraisal reports show that this repossessed merchandise actually was
worth P8,000 at the time of repossession. The final inventory of merchandise valued at cost amounted to P26,000, including the
repossessed merchandise of P8,000.
13. The total realized gross profit before gain or loss on repossession in 20X6 is:
A. P178,000 B. P188,000 C. P186,000 D. P146,000

14. The total deferred gross profit as of December 31, 20X6 is

A. P153,000 B. P120,000 C. P157,200 D. P158,500

15. The gain (loss) on repossession is:

A. P(3,500) B. P3,500 C. P2,000 D. P2,500

Items 16 and 17 are based on the following:

Love Corporation has been using the cash method to account for income since its first year of operations in 20X5. All sales
are made on credit with notes receivable given by the customers. The income statements for 20X5 and 20X6 included the
following amounts:
20X5 20X6
Revenues - collection on principal P32,000 P50,000
Revenues - interest 3,600 5,500
Cost of goods purchased* 45,200 52,020

*Includes increase in inventory of goods on hand of P2,000 in 20X5 and P8,000 in 20X6

The balances due on the notes at the end of each year were as follows:
20X5 20X6
Notes receivable – 20X5 P62,000 P36,000
Notes receivable – 20X6 60,000
Unearned interest revenue – 20X5 7,167 5,579
Unearned interest revenue – 20X6 8,043
Page 4 of 22
16. Under the installment method, how much is the realized gross profit in 20X5?
A. P16,080 B. P32,000 C. P17,889 D. P14,164

17. Under the installment method, how much is the realized gross profit in 20X6?
A. P12,267 B. P11,062 C. P23,329 D. P21,615

Page 5 of 22
 LONG-TERM CONSTRUCTION CONTRACTS

THE REVENUE RECOGNITION PRINCIPLE

The revenue recognition principle dictates that revenue be recognized when the earning process is complete or virtually
complete and an exchanged transaction has taken place. Revenue is therefore typically recognized when the firm delivers
goods, performs services, or as time passes (as in the case of interest revenue or rent revenue). There are other points in the
operating cycle where revenue could be recognized. Revenue could be recognized as production takes place, when production
is completed, or as cash is collected from the customer. The following exhibit shows these possibilities. Although the revenue
recognition principle sets the general rule, there are circumstances where revenue is recognized prior to or after delivery.
These exceptional situations are depicted as follows:

EXHIBIT - REVENUE RECOGNITION TIME LINE

Production Production Sale Full Price
Begins Complete Delivery Collected
 PRODUCTION PERIOD  INVENTORY PERIOD  COLLECTION PERIOD  I--------------------------------------------------
------------------------------------------I
    
Percentage of Completed Accretion Revenue InstalmentSales
Completion Contract Basis Recognition Method and
Method Method Principle Cost Recovery
Revenue Recognition (General Rule) Method
for Special Products
with Immediate Marketability

REVENUE RECOGNITION PRIOR TO DELIVERY

Firms may justify recognizing revenue prior to delivery when the selling price of the product has been reasonably
assured, the firm has a reasonable basis for knowing or estimating the cost of the product, and there is good reason to expect
that the price will be collected. Revenue from long-term construction products may be recognized as production takes place
(percentage of completion method) or when production is completed (completed-contract method). Revenue is often
recognized upon completion of production for special products with immediate marketability (gold, certain agricultural crops).
Some accountants argue that revenue should be recognized as products requiring long aging period such as wine, increase in
value while in the inventory (accretion basis).

Revenue earned on long-term construction projects may be recognized under the percentage of completion or completed-
contract methods.
Revenue is recognized prior to delivery for many long-term construction products. A signed contract sets the price for
the product, the construction company generally has good estimates of the cost of construction, and there should normally
be reasonable assurance that the contract price will be collected. There are two methods in use for recognizing revenue
from long-term construction contracts - the percentage of completion method and the completed contract method. The
general use is the percentage of completion method.

1. Under the percentage of completion method, revenue is recognized as production takes place. At the end of each
accounting period, the construction company will determine the percentage of completion of the product based upon
costs to date and estimated total costs. An estimate of final gross profit (contract price minus estimated total
construction costs) is made. Gross profit recognized for the period is the difference between total gross profit earned to
date and gross profit already recognized in previous periods. Construction costs to date plus the part of the total gross
profit earned to date are accumulated in the inventory account called Construction in Process/Progress. The steps in
using the percentage of completion method are described below.

*Step One. Actual construction costs are accumulated in the inventory account, Construction in Process/Progress.

*Step Two. Accounts Receivable is debited and Billings on Contracts is credited when the firm bills the customer for
progress payments. The billing account is a contra construction in process account and is subtracted from that account
when reporting construction in process in excess of billings on the balance sheet.

*Step Three. Cash collected is credited to Accounts Receivable and debited to Cash.

*Step Four. At the end of each period the cumulative amount of gross profit earned to date on the contract is
estimated.

Costs incurred to Date

P ercentage of Com pletion = --------------------------------
Estimated Total Costs
Gross profit Earned To Date = Percentage of completion X (Contract Price - Estimated Total Costs)

*Step Five. Gross profit to be recognized for the accounting period equals to gross profit earned to date minus gross
profit recognized in previous periods. The gross profit for the period is debited to Construction in Process/Progress and
credited to Contract Revenue. The balance in Construction in Process/Progress equal to total construction costs to date
plus recognized profit earned to date. The current period construction costs are recognized as expenses. Contract
revenue equals current period construction costs plus gross profit recognized for the period.
Page 6 of 22
 *Step Six. When the contract is completed and fully billed, the debit balance in Construction in Process/Progress will
be identical to the credit balance in Billings on Contracts. The entry to close out the project debits the billings account
and credit the construction in process/progress account
2. The completed contract method recognizes all revenue when construction is completed. The completed contract method
is similar to recognizing revenue at the point of sale because when a contract exists there should be a very limited
holding period after construction is completed. Under the completed contract method, no revenue is recognized until
construction is completed. The Construction in Process/Progress account will contain costs to date. It will not contain
gross profit earned to date. Gross profit earned over the life of the contract will be the same as under the percentage of
completion method.
4. The percentage of completion method is the preferable method for accounting for long term contracts. The accounting
profession considers the percentage of completion method to be preferable when reasonable cost estimates are
available. The completed contract method is used when such estimates cannot be made. The percentage of completion
method is considered at present by the profession as GAAP.
4. Estimated losses on long-term contracts must always be recognized fully in the accounting period when the loss
estimate is made. This is true under both the percentage of completion and completed contract methods. Any gross
profit previously recognized under the percentage of completion method must be removed from the Construction in
Process/Progress account.

QUIZZER
1. The following information pertain to the building contract of Orlando Construction Company, wherein the fixed contract
price is P80 million.

20X4 20X5 20X6

Estimated costs P20.1 million P30.15 million P16.75 million
Progress billings 10 million 25 million 45 million
Cash collection 8 million 23 million 49 million

Assume that all costs are incurred, all billings to customers are made, and all collections from customers are received within
30 days of billing, as planned. Under the percentage-of- completion method of revenue recognition is used, how much is the
income from construction for the year 20X6?
A. P3,900,0000 B. P3,250,000 C. P9,750,000 D. P5,850,000

2. Jethro Construction Company began operations in 20X5. Construction activity for the first year is shown below. All contracts
are with different customers, and any work remaining at December 31, 20X5, is expected to be completed in 20X6.
Cash Contract Estimated
Total Billings Collections Costs Incurred Additional
Contract through through through Costs to
Project Price 12/31/X5 12/31/X5 12/31/X5 Complete

1 P 560,000 P 360,000 P340,000 P450,000 P140,000

2 670,000 220,000 22016,000 126,000 504,000
3 500,000 500,000 440,000 330,000 -0-
P1,730,000 P1,20140,000 P990,000 P906,000 P644,000
Determine the income from construction to be reported in the income statement for the year 20X5.
A. P90,000 B. P60,000 C. P86,000 D. P148,000

3. Philip Construction Company started a project with a contract price of P80 million. The cost incurred to date is P12 million
and the estimated cost to complete is still P48 million. Under the cost to cost basis, how much is the income from
construction?
A. P4 million B. P8 million C. P20 million D. P32 million

4. The Stonerich Construction had two projects for which it reported the following as of the end of 20X6.
Quezon City Mandaluyong
Contract Price P 4,800,000 P 960,000
20X5: Costs incurred 3,500,000 -
Percent completed 75% -
20X6: Costs incurred 1,240,000 140,000
Percent completed 100% 15%
The company used the percentage of completion method of accounting revenue.

How much is income from construction for 20X6?

A. P51,000 loss B. P40,000 loss C. P36,000 loss D. P100,000 income

5. Villar’s Construction is in its fourth year of business. Villar performs long-term construction projects and accounts for them
using the percentage of completion method. Villar built an apartment building at a price of P1,000,000. The costs and
billings for this contract for the first three years are as follows:

20X4 20X5 20X6

Cost incurred to date P320,000 P600,000 P790,000
Estimated costs yet to be incurred 480,000 200,000 -0-
Customer billings to date 150,000 410,000 1,000,000

Page 7 of 22
 Collections of billings to date 120,000 340,000 950,000

Determine the income from construction in 20X5?

A. P150,000 B. P80,000 C. P70,000 D. P60,000

6. Jessica Construction has consistently used the percentage-of-completion method. On January 10, 20X5, Jessica began work
on P3,000,000 construction contract. At the inception date, the estimated cost of construction was P2,250,000. The
following data relate to the progress of the contract:

Income recognized at December 31, 20X5 P 300,000

Costs incurred January 10, 2015 through Dec. 31, 20X6 1,800,000
Estimated cost to complete, December 31, 20X6 600,000

What percent was completed in 20X6?

A. 75% B. 40% C. 35% D. cannot be determined

7. On July 1, 20X4, Mean Construction Company Inc. contracted to build an office building for Terence Corporation for a total
contract price of P19.5 million. On July 1, Mean estimated that it would take between 2 to 3 years to complete the building.
On December 31, 20X6, the building was deemed substantially completed. Following are accumulated contract costs
incurred, total estimated costs, and accumulated billings to Terence for 20X4, 20X5, and 20X6.

At 12/31/20X4 At 12/31/20X5 At 12/31/20X6

Contract costs incurred to date P 1,500,000 P12,000,000 P21,000,000
Total estimated costs 15,000,000 20,000,000 -0-
Billings to Terence 3,000,000 11,000,000 18,500,000

Using the percentage of completion method, determine the correct income (loss) from construction to be presented in the
income statement of the company for the years 20X4, 20X5, and 20X6, respectively.
A. P450,000; (P500,000); (P1,000,000)
B. P450,000; (P450,000); (P1,500,000)
C. P450,000; (P950,000); (P1,000,000)
D. P450,000; P500,000; (P1,500,000)

8. In 20X6, Carmela Construction Company was contracted to do private road network of Courtney Corporation for P100
million. The project was estimated to be complete in two years.
The construction contract provided among other things the following:
a. 5% mobilization fee (to be deducted from the last billing) payable within 15 days after the signing of the contract;
b. Retention provision of 10% on all billings;
c. Progress billings on construction are payable within seven days from date of acceptance.
Carmela estimated its gross margin on the project at 25% and used the percentage of completion method of accounting. By
the end of the year, Carmela presented progress billings corresponding to 50% completion. Courtney Corp. accepted all the
bills presented except the last one for 10% which was accepted on 10 January . With the exception of the last billing of 8%
accepted in 20X6, which was due on 3 January 20X6 all accepted billings were settled in 20X6.
The gross profit recognized by Carmela Construction Company for 20X6 is:
a. P50 million b. P25 million c. P12.5 million d. Not determinable

9. Cameron Company entered into a contract to build a small bridge for Agdao. The contract price for the bridge was
P7,500,000 and Cameron estimated a total costs of P6,900,000 in 20X5. The company incurred P2,300,000 of costs during
20X5. By the end of 2016 it was apparent that Cameron had underestimated the real costs. The estimated total cost of
project skyrocketed to P7,800,000. Construction cost incurred in 20X6 totalled P4,000,000. The project was completed in
20X6 at a final costs of P7,800,000. No progress billings were made under the contract and no cash was collected by the
end of 20X6.

The amount of gross profit (loss) that must be recognized in 20X6 must be:
a. P300,000 loss b. P200,000 profit c. P500,000 loss d. P100,000 loss

10. Clarence Construction has consistently used the percentage-of-completion method. On January 10, 20X5, Clarence began
work on P3,000,000 construction contract. At the inception date, the estimated cost of construction was P2,250,000. The
following data relate to the progress of the contract:
Income recognized at December 31, 20X5 P 300,000
Costs incurred January 10, 20X5 through Dec. 31, 20X6 1,800,000
Estimated cost to complete, December 31, 20X6 600,000

In its income statement for the year ended Dec. 31, 20X6, what amount of gross profit should Clarence report?
a. P450,000 b. P300,000 c. P262,500 d. P150,000

11. Jason Construction, Inc. has consistently used the percentage-of-completion method of recognizing income. During 20X6
Jason started work on a P3,000,000 fixed-price construction contract. The accounting records disclosed the following data
for the year ended December 31, 20X6:
Cost incurred P 930,000
Estimated cost to complete 2,170,000
Page 8 of 22
 Progress billings 1,100,000
Collections 700,000
How much loss should Jason have recognized in 20X6?
a. P230,000 b. P100,000 c. P30,000 d. P0

FRANCHISE ACCOUNTING
FRANCHISING: ACCOUNTING BY FRANCHISOR
Franchise companies derive their revenue from one or both of two sources:
1. From sale of initial franchises and related assets or services, and
2. From continuing fees based on the operations of franchises.
Franchisor - the party who grants business rights under the franchise.
Franchisee - the party who operates the franchised business.
Normal services performed by franchisor:
1. Assistance in site selection.
a. Analyzing location.
b. Negotiating lease.
2. Evaluating potential income.
3. Supervision of construction activity.
a. Obtaining financing.
b. Designing building.
c. Supervising contractor while building.
4. Assistance in the acquisition of signs, fixtures, and equipment.
5. Bookkeeping and advisory services.
a. Setting up franchisee’s records.
b. Advising on income, real estate, and other taxes.
c. Advising on local regulations of the franchisee’s business.
6. Employee and management training.
7. Quality control.
8. Advertising and promotion.

INITIAL FRANCHISE FEES

The initial franchise fee is consideration for establishing the franchise relationship and providing some initial services. Initial
franchise fees are to be recorded as revenue only when and as the franchisor makes “substantial performance” of the services it
is obligated to perform and collection of the fee is reasonably assured.

SUBSTANTIAL PERFORMANCE
Substantial performance occurs when the franchisor has no remaining obligation to refund any cash received or excuse any
nonpayment of a note and has performed all the initial services required under the contract. Commencement of operations by
the franchisee shall be presumed to be the earliest point at which substantial performance has occurred, unless it can be
demonstrated that

substantial performance of all obligations, including services rendered voluntarily, has occurred before that time.

CONTINUING FRANCHISE FEES

Continuing franchise fees are received in return for the continuing rights granted by the franchise agreement and for
providing such services as management training, advertising and promotion, legal assistance, and other support. Continuing
fees should be reported as revenue when they are earned and receivable from the franchisee, unless a portion of them has
been designated for a particular purpose, such as providing a specified amount for building maintenance or local advertising. In
that case, the portion deferred shall be an amount sufficient to cover the estimated cost in excess of continuing franchise fees
and provide a reasonable profit on the continuing services.

BARGAIN PURCHASES
In addition to paying continuing franchise fees, franchisees frequently purchase some or all of their equipment and
supplies from the franchisor. The franchisor would account for these sales as it would for any other product sales. Sometimes,
however, the franchise agreements, grants the franchisee the right to make bargain purchases of equipment or supplies after
the initial franchise fee is paid. If the bargain price is lower than the normal selling price of the same product, or if it does not
provide the franchisor a reasonable profit, then a portion of the initial franchise fee should be deferred. The deferred portion
would be accounted for as an adjustment of the selling price when the franchisee subsequently purchases the equipment or
supplies.
OPTIONS TO PURCHASE
A franchise agreement may give the franchisor an option to purchase the franchisee’s business. As a matter of
management policy, the franchisor may reserve the right to purchase a profitable franchised outlet, or to purchase one that is in
financial difficulty. If it is probable at the time the option is given that the franchisor will ultimately purchase the outlet, then the
initial franchisee fee should not be recognized as revenue but should be recorded as a liability. When the option is exercised, the
liability would reduce the franchisor’s investment in the outlet.
FRANCHISOR’S COSTS
Franchise accounting also involved proper accounting for the franchisor’s costs. The objective is to match related costs
and revenues by reporting them as components of income in the same accounting period. Franchisors should ordinarily

Page 9 of 22
defer direct costs (usually incremental costs) relating to specific franchise sales for which revenue has not yet been recognized.
Costs should not be deferred, however, without reference to anticipated revenue and its realizability. Indirect costs of a regular
and recurring nature such as selling and administrative expenses that are incurred irrespective of the level of franchise sales
should be expensed as incurred.
DISCLOSURES OF FRANCHISORS
Disclosure of all significant commitments and obligations resulting from franchise agreements, including a description of
services that have not yet been substantially performed, is required. Any resolution of uncertainties regarding the collectibility of
franchise fees should be disclosed. Initial franchise fees should be segregated from other franchise fee revenue if they are
significant. Where possible, revenues and costs related to franchisor-owned outlets should be distinguished from those related
to franchised outlets.
ILLUSTRATION OF ENTRIES FOR INITIAL FRANCHISE FEE
Assume that Jollibee Inc. charges an initial franchise fee of P5,000,000 for the right to operate a franchisee of Jollibee. Of
this amount, P1,000,000 is payable when the agreement is signed and the balance is payable in five annual payments of
P800,000 each. In return for the initial franchise fee, the franchisor will help locate the site, negotiate the lease or purchase of
the site supervise the construction activity, and provide the bookkeeping services. The credit rating of the franchisee indicates
that money can be borrowed at 24%.
1. If there is reasonable expectation that the down payment may be refunded and if substantial future services remain to be
performed by Jollibee Inc., the entry should be:
Cash 1,000,000
Notes Receivable 4,000,000
Discount on Notes Receivable 1,803,680
Unearned Franchise Fee 3,196,320

2. If the probability of refunding the initial franchise fee is extremely low, the amount of future services to be provided to the
franchisee is minimal, collectibility of the note is reasonably assured, and substantial performance has occurred, the entry
should be:
Cash 1,000,000
Notes Receivable 5,000,000
Discount on Notes Receivable 1,803,680
Revenue from Franchise Fee 3,196,320

3. If the initial down payment is not refundable, represents a fair measure of the services already provided, with a significant
amount of services still to be performed by the franchisor in future periods, and collectibility of the note is reasonably
assured, the entry should be:
Cash 1,000,000
Notes Receivable 4,000,000
Discount on Notes Receivable 1,803,680
Revenue from Franchise Fee 1,000,000
Unearned Franchise Fees 2,196,320

4. If the initial down payment is not refundable and no future services are required by the franchisor, but collection of the note
is so uncertain that recognition of the note as an asset is unwarranted, the entry should be:
Cash 1,000,000
Revenue from Franchise Fees 1,000,000
5. Under the same conditions as those listed under 4 except that the down payment is refundable or substantial services are
yet to be performed, the entry should be:
Cash 1,000,000
Unearned Franchise Fees 1,000,000
In cases 4 and 5, where collection of the note is extremely uncertain, cash collections may be recognized using the
installment method or the cost recovery method.

ILLUSTRATIVE PROBLEMS
1. VIKINGS’s Inc. franchises its name to different enterprise throughout the country. The franchise agreement requires the
franchisee to make an initial payment of P80,000 on the agreement date and the balance, covered by a P160,000
noninteresting – bearing note, in four equal annual payments beginning one year from the agreement date. The
franchisor agrees to make market studies, find a location, train the employees, and perform a few other minor related
services. The initial payment is refundable until the date of opening. The following describe the relationship with a newly
appointed franchisee: (assume an interest rate of 10%).
July 01, 20X6: Entered into franchise agreement.
Aug. 15, 20X6: Completed market study at cost of P25,000.
Nov. 10, 20X6: Found suitable location; service cost, P10,000.
Jan. 10, 20X7: Completed training of employees; cost, P35,000.
Jan. 15, 20X7: Franchise outlet is opened.

Required:
Give the journal entries in 20X6 and 20X7 record the above transactions, including any adjusting entry/entries at the 20X6
year-end.

July 01, 20X6: Cash 80,000

Notes receivable 160,000
Page 10 of 22
 Discount on notes receivable 33,200
Deposit on franchise or Unearned Franchise Fees
P80,000 + (P40,000 x 3.17) 206,800

Aug. 15, 20X6: Deferred franchise costs 25,000

Cash 25,000

Nov. 10, 20X6: Deferred franchise costs 10,000

Cash 10,000

Dec. 31, 20X6: Discount on notes receivable 6,340

Interest revenue (40,000 x 3.17) 6,340

Jan. 10, 20X7: Deferred franchise costs 35,000

Cash 35,000

Jan. 15, 20X7: Deposit on franchise 206,800

Franchise revenue 206,800

Franchise costs 70,000

Deferred franchise costs 70,000

July 1, 20X7 Cash 40,000

Notes receivable 40,000

Dec. 31, 20X7 Discount on notes receivable 14,314

Interest income 14,314

2. Triple V Enterprises, a franchisor, charges new franchisees a “franchise fee” of P500,000. Of this amount, P200,000 is
payable at the time the agreement is signed and the balance in P100,000 non- interest bearing notes due every year
thereafter. Triple V agrees to assists in locating a suitable business site, conduct a market study, supervise construction of
facilities, and provide initial training for employees.
Required:
Assuming an implicit interest rate of 12%, prepare first year entries relating to each of the following assumptions:
1. Down payment is refundable, but no services have been rendered so far; collection of notes is reasonably assured.
2. Down payment is nonrefundable, and substantial services, costing P250,000, have been performed; collections of notes
is certain.
3. Down payment is nonrefundable, and substantial services, costing P300,000 have been performed; collection of notes is
doubtful.
4. Same as #3, except cost recovery method will be used.

Case 1: Deposit Method

Cash 200,000
Note receivable 300,000
Discount on notes 59,800
receivable
Deposit on franchise 440,200

Case 2: Full Accrual Method

Cash 200,000
Notes receivable 300,000
Discount on notes receivable 59,800
Deposit on franchise 440,200

Deferred franchise costs 250,000

Cash 250,000

Cost of franchise fee revenue 250,000

Deposit on franchise 440,200
Deferred franchise costs 250,000
Franchise fee revenue 440,200

Case 3: Installment Method

Cash 200,000
Notes receivable 300,000
Discount on notes receivable 59,800
Deposit on franchise 440,200

Deferred on franchise 300,000

Cash 300,000

Deposit on franchise 440,000

Page 11 of 22
 Deferred franchise costs 300,000
Deferred gross profit on 140,000
franchise

Deferred gross profit on franchise 63,700

Realized gross profit on 63,700
franchise

Case 4: Cost Recovery Method

First 3 entries in case 3 are also the entries in this method. However, since cash received (P200,000) is less
than the costs incurred (P300,000), no profit will be realized in this period.

QUIZZER
1. On December 31, 20X6, Chowqueen, Inc. authorized Mr. Chun to operate as a franchisee for an initial franchise fee of
P150,000. Of this amount, P60,000 was received upon signing the agreement and the balance represented by a note due in
three annual payments of P30,000 each beginning December 31, 20X5. The present value on December 31, 20X6, for three
annual payment appropriately discounted is P72,000. According to the agreement, the non- refundable down payment
represents a fair measure of the services already performed by Chowqueen and substantial future services are still to be
rendered. However, the collectibility of the note is not reasonably assured. Chowqueen’s December 31, 20X6, balance sheet
unearned franchise fee from Mr. Chun’s franchise should report as:
A. P132,000 B. P100,000 C. P - 0 - D. P72,000

2. On December 31, 20X6, Shabu-Shabu Inc. signed an agreement authorizing Alrene Company to operate as a franchise for
an initial franchise fee of P50,000. Of this amount, P20,000 was received upon signing of the agreement and the balance is
due in three annual payment of P10,000 each, beginning December 31, 20X10. No future services are required to be
performed. Alrene Company’s credit rating is such that collection of the note is reasonably assured. The present value at
December 31, 8 of the three annual payments discounted at 14% (the implicit rate for a loan of this type) is P23,220. On
December 31, 20X6, Shabu-Shabu should record earned franchise fees of:
A. P23,220 B. P43,220 C. P30,000 D. P 0

3. On December 31, 20X5, Da Girl Company signed an agreement to operate as franchisee of Wendy’s for a franchise fee of
P80,000. Of this amount, P30,000 was paid upon signing of the agreement and the balance is payable in five annual
payments of P10,000 each beginning December 31, 20X6. The present value of the five payment, at an appropriate rate of
interest, is P56,000 at December 31, 20X5. The agreement provides that the down payment is not refundable and no future
services are required of the franchisor. The collection of note receivable is reasonably certain. Wendy’s Company should
report unearned revenue from franchise fee in its December 31, 20X6 balance sheet at:
A. P80,000 B. P30,000 C. P66,000 D. P 0

4. Each of the Yellowwich Pizza Company’s 21 new franchisees contracted to pay an initial franchise fee of P30,000. By
December 31, 20X5, each franchise had paid a nonrefundable P10,000 fee and signed a note to pay P10,000 principal plus
the market rate of interest on December 31, 20X6, and December 31, 20X7. Experience indicates that five franchisees will
default on the additional payments. What amount of earned franchise fees would Yellowwich Pizza Company report at
December 31, 20X5:
A. P400,000 B. P610,000 C. P600,000 D. P530,000

5. Mel’s Pizza Hot, Inc. grants a franchise to Mr. AA for an initial franchise fee of P1,000,000. The agreement provides that
Mel’s Pizza Hot, Inc. has the option within the one year to acquire franchisee’s business and its seems certain that Pizza Hot,
Inc. will exercise the option. On Pizza Hot, Inc. books, how should the initial franchise fee be recognized?
A. Deferred revenue and to be amortized.
B. Realized revenue.
C. Extraordinary revenue.
D. Deferred revenue and treated as a reduction from Pizza’s investment when the option is exercise.

6. On Dec. 29, 20X6, FIESTA HAT signed a franchising agreement for the operation of an outlet in Dagupan City by Sombrero
Co. The franchising agreement required the franchisee, Sombrero Co., to make an initial payment of P200,000 upon signing
of the contract and three payments each of P100,000 beginning one year from the agreement date and yearly thereafter.
The franchisor agrees to prepare market studies, find a suitable location, train employees, and perform some other related
services. The location, train employees, and perform some other related services. The initial payment is refundable until
substantial performance is effected. In 20X6, FIESTA HAT should report franchise fee revenue of:
A. P-0- B. P200,000 C. P125,000 D. P500,000

7. Jollibee, franchisor, entered into a franchising agreement with Jo Levy, franchisee, on October 31, 20X6. The total franchise
fee is P500,000, of which P100,000 is payable upon signing of the agreement with the balance payable in four equal annual
installments. The down payment is refundable in the event the franchisor fails to render stipulated services and, thus far,
none has been performed. When Jollibee prepares its October 31, 20X6 financial statements, the franchise fee revenue to
be reported is:
Page 12 of 22
 A. - 0 - B. P400,000 C. P100,000 D. P500,000

8. The franchise agreement between Jolly-R and Mr. Chris which was signed at the beginning of the year required a P500,000
franchise fee payable P100,000 upon signing of the franchise and the balance in four annual installments starting the end of
the current year. At the time of the granting of the franchise, the present value using 12% as discount rate of the four
installments would approximate P199,650. The fees once paid are not refundable. The franchise may be cancelled subject
to the provisions of the agreement. Should there be unpaid franchise fee attributed to the balance of main fee (P500,000),
same would become due and demanable upon cancellation. Further, the franchisor is entitled to a 5% fee on gross sale
payable monthly within the first ten days of the following month. The Credit Investigation Bureau rated Mr. Chris as AAA
credit rating. Further the balance of the franchise fee was guaranteed by a commercial bank. The first year of operations
yielded gross sales of P9 million. As of the signing of the franchise agreement, Jolly-R’s unearned franchise fee amounted to
A. P649,650 B. P400,000 C. zero D. P199,650

9. Croley Snack granted a franchise to Eat N Eat for the Ortigas area. Eat N Eat was to pay franchise fee of P100,000 payable
in five equal annual installments starting with the payment upon signing of the agreement. The franchise was to pay
monthly 1% of gross sales of the preceding month. Should the operations of the outlet prove to be unprofitable, the
franchise may be cancelled with whatever obligations owing Croley Snack in connection with the P100,000 franchise fee
waived. The first year generated a gross sales of P500,000. Croley Snack earned franchise fee for the first year amounted to
A. P5,000 B. P25,000 C. P105,000 D. P20,000
10. Kitchenics Inc. awarded its franchise to Wings Co. in Cebu for a total fee of P100,000. Of said amount, P50,000 was payable
upon the signing of the franchise agreement and the balance, payable in two annual payments of P25,000 each. Kitchenics
had been very successful in Metro Manila with 100 franchisees but Cebu was the first outside Metro Manila. Kitchenics’
agreement with Wings provided that in the event the first year of operations would result to an operating loss, the
franchising agreement may be cancelled without need of returning any portion of paid franchise fee and there would be no
need to pay any balance of the unpaid franchise fee. The entry to record the granting of the franchise to Wings was

A. Cash P50,000
Notes receivable 50,000
Unearned franchise fee P100,000
B. Cash 50,000
Notes receivable 50,000
Revenue from franchise fee 50,000
Unearned franchise fee 50,000
C. No entry
D. Cash 50,000
Notes receivable 50,000
Revenue from franchise fee 100,000

11. On December 31, 20X5, Mc Dowell Inc. signed an agreement authorizing MN Co. to operate as a franchise for an initial
franchise fee of P50,000. Of this amount, P20,000 was received upon signing of the agreement and the balance is due in 3
equals annual payments beginning December 31, 20X6. The agreement provides that the down payment (representing a
fair measure of services already performed by Mc Dowell) is not refundable and no substantial future services are required
to be performed. MN Co.’s credit rating is such that collection of the note is reasonably assured. The implicit interest rate on
this type of loan is 14%. On December 31, 20X5, Mc Dowell should record unearned franchise fees of
A. P23,220 B. P42,220 C. P30,000 D. -- 0 --

12. Coney Island Inc. sells franchises for ice cream outlets in Metro Manila. One contract has been signed on January 15, 20X5.
The agreement calls for an initial franchise fee of P6,000,000 to be paid by the franchise upon signing of the contract. The
franchisor initial cost of services is P2,250,000 to be incurred uniformly over the 6 month period / prior to the scheduled
opening date of July 15, 20X6. No return payments are to be made by the franchisor, although there will be continuing
costs of P180,000 per year for services rendered during the 10 year term of contract. The normal return for the franchisor
on continuing operation involving franchise outlets is 10%. How much net income would be recognized by the franchisor on
July 15, 20X6?
A. P3,750,000 B. P6,000,000 C. P5,750,000 D. P1,750,000

13. On January 1, 20X6 Dokito Inc. authorized Mr. T to operate as franchise for an initial franchise fee of P150,000. Of this
amount, P60,000 was received upon signing the agreement and the balance, represented by a note, is due in a 3 annual
payments of P30,000 each beginning December 31, 20X6. The present value on January 1, 2016, for three annual payments
appropriately discounted is P72,000. According to the agreement, the non-refundable down payment represents a fair
measure services already performed by Dokito and substantial future services are still to be rendered. However, collectibility
of the note is reasonably certain. Dokito’s December 31, 20X6 balance sheet, unearned franchise fees from Mr. X franchise
should be reported as
A. P132,000 B. -- 0 -- C. P100,000 D. P72,000

Page 13 of 22
14. Each of Potter Pie Co’s. 21 new franchisees contracted to pay an initial franchise fee of P30,000. By December 31, 20X5,
each franchise had paid a non- refundable P10,000 fee and signed a note to pay P10,000 principal plus the market rate of
interest on December 31, 20X6 and 20X7. Experience indicates that one franchise will default on the additional payments.
Services for the initial fee will be performed in 20X5. What amount of net unearned franchise fees would Potter report at
Dec. 31, 20X5?
A. P400,00 B. P600,000 C. P610,000 D. P630,000
15. PIZZA HOT, franchisor, entered into a franchising agreement with Jo Levy, franchisee, on October 31, 20X6. The total
franchise fee is P500,000, of which P100,000 is payable upon signing of the agreement with the balance payable in four
equal annual installments. The down payment is refundable in the event the franchisor fails to render stipulated services
and, thus far, none has been performed. When PIZZA HOT prepares its Oct. 31, 20X6 financial statements, the franchise fee
revenue to be reported is:
A. -- 0 -- B. P400,000 C. P100,000 D. P500,000

16. At the beginning of the year, Zita Eat Haus got the franchise of Max, a known steak house of upscale patronage. The
franchise agreement required a P500,000 franchise fee payable P100,000 upon signing of the franchise and the balance in
four annual installments starting the end of the current year. At present value using 12% as discount rate, the four
installments would approximate P303,735. The fees once paid are not refundable. The franchise may be canceled subject to
the provisions of the agreement. Should there be unpaid franchise fee attributed to the balance of main fee (P500,000), the
same would become due and demandable upon cancellation. Further, the franchiser is entitled to a 5% fee on gross sales
payable monthly within the first ten days of the following month. The Credit Investigation Bureau rated Zita as AAA credit
rating. The balance of the franchise fee was guaranteed by a commercial bank. The first year of operations yielded gross
sales of P9 million. Max’s earned franchise fees from Zita for the first year of operation, amounted:
A. P950,000 B. P853,735 C. P500,000 D. P403,735

17. Domino Pizza grants a franchise to KM for an initial fee of P1,000,000. The agreement provides that Domino has the option
within one year to acquire franchisee business, and it seems certain that Domino will exercise this option. On Domino’s
books, how should the initial fee be recorded?
A. realized revenue
B. deferred revenue to be amortized.
C. extraordinary revenue
D. deferred and treated as reduction in Domino’s investment.

18. Year-Round Golf sells franchises for indoor golf driving ranges and putting greens. For each franchise, the company charges
a non-refundable initial franchise fee of P400,000. The franchise agreement requires a down payment of P100,000, with
balance covered by the issuance of a P300,000, 10% note, payable by the franchisee at the end of 5 years. Interest does
not begin to accrue until the franchise opens, and first interest payment is required 12 months after the franchise opens.
The company only sells to qualified buyers so the collectibility of the note is always reasonably assured. The services
required for the initial franchise fee are completed 6 months after the agreement is signed. How much franchise revenue
earned must be recognized upon signing of the agreement by Year-Round?
A. P400,000 B. P100,000 C. P286,276 D. P0

Page 14 of 22
 HOME & BRANCH ACCOUNTING

1. Accounting for branches

Branches are identifiable locations within a business entity for which separate accounting records are maintained.
Branches are extensions of home office. Branches are separate accounting entities, but they are not separate
legal entities, and their financial statements are used only for internal reporting purposes. Financial statements for the
business entity are prepared by combining the financial statements of the branches with those of the central reporting unit
of the business. Branch operations stocks merchandise, makes sales to customers, passes on customer credit, collects
receivables, incurs expenses, and performs other functions normally associated with the operations of a separate business
enterprise. Such activities are accounted for through separate branch accounting systems that parallel the systems of
independent businesses except in the manner of accounting for ownership equities and in recording
transactions between branches and the main office of the enterprise.

2. Home and branch transactions

Transactions of the home office with external entities are recorded in the home office accounting records in the
usual manner. Similarly, transactions between a branch and unrelated entities are recorded on the branch books in
accordance with established accounting procedures. Thus, the unique feature of home office and branch accounting
lies in the manner of recording transactions between the home office and its branches. Therefore, home and
branch accounting is basically accounting inter-office transactions.

3. Reciprocal branch and home office account

The branch account on the home office books is an asset account representing the investment of the home office
in branch net assets. The home office account in the branch books is an equity account that represents the equity of
the home office in the branch net assets. Thus, the branch and home office accounts are reciprocal, each
representing the net assets of the branch. This reciprocal relationship between home office and branch accounts is a
continuous relationship. Whenever the home office increases (debits) its branch account, the branch should increase (credit)
its home office account. Similarly, any decrease (debit) in the home office account on the branch book should be
accompanied by a decrease (credit) in the branch
account on the home office books. The only reasons that differences between home office and branch accounts
occur are time lags (timing difference) in recording information on the two sets of books and home office or
branch errors.

4. Merchandise shipment in excess of cost

Home office transfers prices in excess of cost for internal shipments to their branches. Sometimes home office set
transfer prices at sales prices, or set standard mark-ups. Reasons commonly cited for internal transfer of merchandise above
cost include equitable allocation of income between the various units of the enterprise, efficiency in pricing inventories, and
concealment of the true profit margins from branch personnel.
When the home office ships merchandise to its branches at transfer prices in excess of cost, the accounting records of
the home office are adjusted to permit measurement of actual cost of merchandise transferred. This is usually done through
an inventory “loading” or unrealised profit account, which is normally recorded at the end of the accounting period.
The adjustment is made to reflect the correct net income of the branch on the home office books. The other term used to
describe the loading or unrealised account is “allowance for overvaluation in branch inventory” account.
Entries to record transfer of merchandise at prices in excess of cost do not change the reciprocal relationship between
the home office and branch accounts, but they do affect the relationship between home office and branch shipment
accounts, because the “shipments to branch” account is credited at cost and the “shipments from home office” account is
debited at the transfer price. The difference between the shipments account lies in the mark-up that is reflected in the
loading in branch inventories account. This loading account is frequently designated “unrealised profit in branch
inventories.”
When a branch receives merchandise at transfer prices that include a loading factor and sells that merchandise, its cost
of goods sold is overstated and its income is understated. The home office increases its branch account and records branch
profit or loss on the basis of income reported by the branch, so any branch profit recorded by the home office is similarly
understated. As mentioned above, this understatement of branch profit on home office books is corrected by a year-end
adjusting entry that reduces the loading account to reflect amounts realized during the period through branch sales to
outside entities.

This method is illustrated below in no. 10.

5. Shipments to Branch Recorded at Billing Prices
Sometimes home office ships to their branches at billing prices and adjust the loading account at the end of the
accounting period. When this approach is used, the balance of the loading account during an accounting period will reflect
unrealised profit in branch beginning inventories, and the shipments to branch account will include the loading factor on
shipments for the current period. The shipments to branch account (home office books) and the shipments from home
office account (branch books) are reciprocals under this method. Under this method, adjustment of shipments to branch
account is made at the end of the accounting period to reflect the branch loading on inventories and the loading account
will be adjusted to record the realized profit on shipments sold.
To further explain the above discussion, we will use the information given in no. 10 below.

Home Office Books Cebu Branch Books

a) Entry to record the shipments during the year.
Cebu branch 50,000 Shipments from home office 50,000
Shipments to Cebu branch 50,000 Home office 50,000

Page 15 of 22
 The above shipments account on home office and branch books are recorded both at billed prices.

b) Entry to adjust the loading - branch inventory account and the Cebu branch profit.
Shipments to Cebu branch 10,000
Loading – branch inventory 600
Cebu branch profit 10,600

The shipments to Cebu branch account decreased by P10,000 to adjust the amount of shipments to its correct cost of
P40,000. The loading – branch inventory account decreased by P600, because the beginning balance on the home books
shows P1,600 but the correct ending balance per branch ending inventory from home office should only be P1,000 (P10,000
x ½ x 25%/12%).

6. Freight costs on shipments

Freight costs on merchandise shipped between home office and branch locations should be included in branch
inventory and cost goods sold measurements.
Merchandise cost should not include excessive freight charges from the transfer of merchandise between a home
office and its branches or between branch locations. If the branch returns half the merchandise received from the home
office because it is defective, or because of a shortage of inventory at the home office location, the home office cost of the
merchandise should not include the freight charges to or from the branch. Total unnecessary freight charges on the
merchandise are charged to a home office “loss on excessive freight charges” account because the freight charges
represent management mistakes or inefficiencies. Therefore, they are not considered normal operating or freight expenses.

The same is true for errors committed by the home office in transferring merchandise to branches. The difference
between the correct freight directly from the home office to the branch and the actual freight incurred from home office to
the branch must be chargeable to the home office and considered by the home office as loss on excessive freight charges.

7. Home office – Branch expenses allocation

The allocation of expenses among home office and branch operations is frequently necessary to provide an accurate
measurement of income for the separate units of the enterprise. Advertising expense, for example, may relate to sales
efforts of the home office and one or more branches. If such advertising is paid by the home office, that part related to
branch sales should be allocated to the branches. Pension costs paid by the home office and home office general and
administrative expenses may also be allocated to branch operations in order to provide complete profit information for
each business unit. Another situation that requires expense allocation of complete profit information arises when plant
asset records are centralized in the home office accounting system. The home office normally will record the entire
depreciation for all plant assets and just allocate the depreciation to branches for those that pertain to branch plant assets.

8. Reconciliation of home office and branch accounts

Reciprocity between home office and branch accounts will not exist at year-end if errors have been made in recording
reciprocal transactions either on the home office or the branch books, or if transactions have been recorded on one set of
books but not on the other. The approach for reconciling home office and branch account at year-end is similar to the
approach used for bank reconciliations. Only, the most commonly used method is the approach of bringing the two
reciprocal accounts to their adjusted balances.
Errors committed by the home office or branch office require adjusting entry(s) on their corresponding books, whereas
timing differences does not require adjustments.
9. Sales agencies
Sales agencies are established to display merchandise and to take customers’ orders, but they do not stock merchandise
to fill customers’ orders or pass on customer credit. The sales agency is not a separate accounting or business entity.
Ordinarily, the only account records required for sales agencies are for cash receipts and disbursements, which are handled
in essentially the same manner as petty cash systems. The central accounting system of the business maintains records of
sales made through agency operations and related cost of sales and other expenses.

10. ILLUSTRATION OF HOME OFFICE AND BRANCH ACCOUNTING

REH Corporation of Manila has operated a sales branch in Baguio, for a number of years. All merchandise shipped to the
Baguio branch is transferred at normal sales prices, which are 125% of home office cost. The Baguio branch also purchases
merchandise from outside suppliers. This merchandise is sold by Baguio at a 25% markup based on invoice cost. Balance
sheets for Danny Corporation’s home office and its Baguio branch at December 31, 2015 are as follows:

REH CORPORATION HOME OFFICE AND BAGUIO BRANCH

BALANCE SHEETS AT DECEMBER 31, 2015
Home office Branch
Assets
Cash P 25,000 P11,000
Accounts receivable – net 42,000 23,000
Inventory 20,000 16,000
Plant assets – net 70,000 -
Baguio branch 43,000 - .
Total assets P200,000 P50,000
Liabilities and Equity
Accounts payable P 14,000 P 5,000
Other liabilities 10,000 2,000

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 Loading – branch inventory 1,600 -
Home office 43,000
Capital stock 150,000 -
Retained earnings 24,400 - .
Total liabilities and equity P200,000 P50,000
All plant asset records for REH’s home office and Baguio branch are maintained on the home office books. Half of the
P16,000 branch inventory at December 31, 2015 was received from local suppliers, and the remaining P8,000 was received
from the home office at established transfer prices. A summary of the transactions of REH’s home office and Baguio branch
for 2016 follows:

1. REH’s sales for 2016 were P281,750, of which P200,000 were home office sales and P81,750 were sales made by
the Baguio branch. All sales were on account.
2. Home office and branch purchases on account for 2016 were P205,000 and P20,000, respectively. The home office
shipped P40,000 of merchandise to Baguio branch at a transfer price of P50,000.
3. The home office collected P195,000 on account during 2016, and Baguio branch collected P79,750.
4. The Baguio branch transferred P55,000 cash to the home office during 2016.
5. Payments on account were home office, P210,000; Baguio branch, P21,000.
6. During 2016, the home office paid operating expenses of P20,000, and Baguio branch paid operating expenses of
P2,000. Of the operating expenses paid by the home office, P1,000 was allocated to Baguio branch.
7. Total depreciation for the year was P8,000, of which P1,500 was allocated to branch operations.
Year-end inventories are P25,000 for the home office, and P10,000 for Baguio branch, with half of the branch inventory
consisting of merchandise acquired from the home office.
Required:
1. Prepare the journal entries for the year 2016 on the books of the home office and branch office.
2. Prepare the adjusting and closing entries on the home office books and the closing entry on the books of the branch.
3. Prepare the unadjusted trial balance of the home office and the branch for the year 2016.
4. Prepare the individual financial statements of the home office and the branch.
5. Prepare the combined financial statements of REH Corporation for the year 2016.

REH CORPORATION
HOME OFFICE AND BAGUIO BRANCH JOURNAL ENTRIES
FOR THE YEAR 20X6
Number Home Office Books Baguio Branch Books
1 Accounts receivable 200,000 Accounts receivable 81,750
Sales 200,000 Sales 81,750
To record sales on account. To record sales on account.

2 Purchases 205,000 Purchases 20,000

Accounts payable 205,000 Accounts payable 20,000
To record purchases on account. To record purchases on account.

Baguio branch 50,000 Shipments from home office 50,000

Shipments to Baguio branch 40,000 Home office 50,000
Loading branch inventory 10,000 To record receipt of merchandise
To transfer merchandise to Baguio from home office.
Branch at 125% of cost.

3 Cash 195,000 Cash 79,750

Accounts receivable 195,000 Accounts receivable 79,750
To record collection on accounts receivable. To record collection on accounts
Receivable.
4 Cash 55,000 Home office 55,000
Baguio branch 55,000 Cash 55,000
To record receipt of cash from Baguio branch. To record cash remittance to
home office.
5 Accounts payable 210,000 Accounts payable 21,000
Cash 210,000 Cash 21,000
To record payments on account. To record payments on account.

6 Operating expenses 20,000 Operating expenses 2,000

Cash 20,000 Cash 2,000
To record payment of expenses. To record payment of expenses.
Baguio branch 1,000 Operating expenses 1,000
Operating expenses 1,000 Home office 1,000
To record allocation of expenses to To record expenses allocated from
Baguio branch. home office.

7 Baguio branch 1,500 Operating expenses 1,500

Operating expenses 6,500 Home office 1,500
Page 17 of 22
 Accumulated depreciation 8,000 To record allocation of depreciation
To record depreciation and allocation to from home office.
Baguio branch.

REH CORPORATION
HOME OFFICE AND BAGUIO BRANCH ADJUSTING & CLOSING JOURNAL ENTRIES
DECEMBER 31, 20X6
Home Office Books Baguio Branch Books
Adjusting Entries Closing Entry

(1) To record branch reported net income. To close the nominal accounts and to
Baguio branch 1,250 record the net income.
Baguio branch profit 1,250 Sales 81,750
Inventory, Dec 31, 14 10,000
(2) To adjust the net income of the branch Inventory, Jan 1, 14 16,000
and to record the realized loading. Purchases 20,000
Loading in branch inventory 10,600 Shipments from home office 50,000
Baguio branch profit 10,600 Operating expenses 4,500
Unrealized profit per books of P11,600, Home office 1,250
Less P1,000 unrealized profit in
branch ending Inventory = P10,600
adjustment.

Closing Entry
To close the nominal accounts and to record
the combined net income.
Sales 200,000
Inventory, December 31, 20X6 25,000
Shipments to Baguio branch 40,000
Baguio branch profit 11,850
Inventory, January 1, 20X6 20,000
Purchases 205,000 Branch profit = 1,850
Operating expenses 25,500
Retained earnings 26,350 Home office profit = 14,500

REH CORPORATION
HOME OFFICE AND BAGUIO BRANCH UNADJUSTED TRIAL BALANCE
FOR THE YEAR ENDED, DECEMBER 31, 20X6

Home Office Baguio Branch

Debit Credit Debit Credit
Cash P 45,000 P 12,750
Accounts receivable – net 47,000 25,000
Inventories 20,000 16,000
Plant assets – net 62,000 -
Baguio branch 40,500 -
Accounts payable P 9,000 P 4,000
Other liabilities 10,000 2,000
Loading - branch inventory 11,600 -
Home office - 40,500
Capital stock 150,000 -
Retained earnings 24,400 -
Sales 200,000 81,750
Purchasea 205,000 20,000
Shipments from home office 50,000
Shipments to Baguio branch 40,000
Operating expenses 25,500 4,500 .____
Total P445,000 P 445,000 P 128,250 P128,250

REH CORPORATION
HOME OFFICE INCOME STATEMENT
FOR THE YEAR ENDED, DECEMBER 31, 20X6

Sales P200,000
Cost of sales:
Inventory, January 1, 20X6 P 20,000
Add: Purchases 205,000
Available for sale P225,000
Less: Shipments to branch ( 40,000)

Page 18 of 22
 Inventory, December 31, 2016 ( 25,000) 160,000
Gross profit P 40,000
Less: Operating expenses 25,500
Income from own operations 14,500
Add: Baguio branch profit 11,850
Combined net income P 26,350

REH CORPORATION
HOME OFFICE BALANCE SHEET
AS OF DECEMBER 31, 20X6

Assets Liabilities and Equity

Cash P 45,000 Accounts payable P 9,000
Accounts receivable – net 47,000 Other liabilities 10,000
Inventories 25,000 Loading in branch inventory 1,000
Plant assets – net 62,000 Capital stock 150,000
Baguio branch 41,750 Retained earnings 50,750
Total P220,750 Total P220,750

REH CORPORATION
BAGUIO BRANCH INCOME STATEMENT
FOR THE YEAR ENDED, DECEMBER 31, 20X6

Sales P81,750
Cost of sales:
Inventory, January 1, 20X6 P16,000
Add: Purchases 20,000
Shipments from home office 50,000
Available for sale P86,000
Less: Inventory, December 31, 20X6( 10,000) 76,000
Gross profit P 5,750
Less: Operating expenses 4,500
Net income P 1,250
REH CORPORATION
BAGUIO BRANCH BALANCE SHEET
AS OF DECEMBER 31, 20X6

Assets Liabilities and Equity

Cash P12,750 Accounts payable P 4,000
Accounts receivable – net 25,000 Other liabilities 2,000
Inventories 10,000 Home office 41,750
Total P 47,750 Total P 47,750

REH CORPORATION
COMBINED INCOME STATEMENT
FOR THE YEAR ENDED, DECEMBER 31, 20X6

Sales P281,750
Cost of sales:
Inventory, January 1, 20X6 P 34,400
Add: Purchases 225,000
Available for sale P259,400
Less: Inventory, December 31, 2016( 34,000) 225,400
Gross profit P 56,350
Less: Operating expenses 30,000
Combined net income P 26,350

REH CORPORATION
COMBINED BALANCE SHEET
AS OF DECEMBER 31, 20X6
Assets
Liabilities and Equity
Cash P 57,750 Accounts payable P 13,00
Accounts receivable – net 72,000 Other liabilities 12,000
Inventories 34,000 Capital stock 150,000
Plant assets – net 62,000 Retained earnings 50,750
Total P 225,750 Total 225,750

QUIZZER
Questions 1 through 5 are based on the following:

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 Comparative trial balances of the home office and the two branches of Norway Corporation at December 31, 20X6 were as
follows:

Home office Branch No. 1 Branch No. 2

Cash P 5,000 P 15,000 P 22,000
Accounts receivable (net) 80,000 30,000 40,000
Inventories 150,000 60,000 48,000
Branch No. 1 170,000
Branch No. 2 165,000
Plant assets (net) 730,000 250,000 200,000
Purchases 900,000
Shipments from home office 300,000 240,000
Expenses 300,000 75,000 50,000
Total P2,500,000 P730,000 P600,000

Accounts payable P 100,000 P 45,000 P 30,000

Other liabilities 80,000 15,000 5,000
Loading in branch inventories 108,000
Capital stock, P10 par 500,000
Retained earnings 262,000
Home office 170,000 165,000
Sales 1,000,000 500,000 400,000
Shipments to branches 450,000 0 0
Total P2,500,000 P730,000 P600,000

Additional information:
Home office and Branch inventories at December 31, 2016 were:
Home office (at cost) P120,000
Branch No. 1 (at billed price) 72,000
Branch No. 2(at billed price) 96,000

1. What is the mark-up rate on merchandise transfers to branch?

A. 20 percent of billed price C. 16-2/3 percent of billed price
B. 25 percent of cost. D. 25 percent of billed price

2. How much is the beginning inventory of Norway Corporation?

A. P150,000 B. P258,000 C. P240,000 D. P90,000

3. How much is the ending inventory of Branch No. 1 at cost?

A. P72,000 B. P57,600 C. P60,000 D. P54,000

4. How much is the correct net income of Branch No. 2 as far as home office is concerned?
A. P190,000 B. P158,000 C. P185,000 D. P94,000

5. How much net income will the home office report in its separate income statement?
A. P220,000 B. P595,000 C. P494,000 D. P100,000

Questions 6 and 7 are based on the following:

The Dagupan City branch of Andy Enterprises, Manila was billed for merchandise shipments from home office at cost plus
25% in 20X5 and cost plus 20% in 20X6. Other pertinent data for 20X6:
Dagupan branch Home office
Sales P63,000 P212,000
Inventory beginning 8,900 (at billed price) 23,000 (at cost)
Purchases 164,000
Inventory transfers 50,400 (at billed price) 42,000 (at cost)
Inventory, end 11,700 (at billed price 28,500 (at cost)
Expenses 20,300 76,400
6. What will be the combined cost of sales of Dagupan branch and Andy’s home office that must be shown in the combined
income statement?
A. P22,430 B. P155,815 C. P155,870 D. P22,040
7. What will be the combined net income of Dagupan branch and Andy’s home office?
A. P22,430 B. P22,600 C. P22,133 D. P22,040

Question 8 and 9 are based on the following:

The following information came from the books and records of Lowe Corporation and its branch. The balances are as of
December 31, 20X6.
Home Office Branch
Dr. (Cr.) Dr. (Cr.)
Sales P(500,000)
Expenses 150,000
Shipments to branch P(240,000)
Unrealized profit in branch inventory ( 74,000)
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 The branch purchases all of its merchandise from the home office. The home office ships this merchandise at 125 percent of
its cost. The ending inventory of the branch is P60,000 at the billed price. There are no shipments in transit between the
home office and the branch.

8. The beginning inventory of the branch per GAAP must be:

A. P64,000 B. P70,000 C. P60,000 D. P56,000
9. The correct net income of the branch must be:
A. P40,000 B. P102,000 C. P50,000 D. P62,000

10. The home office sells merchandise to its branch at 120% of cost. The branch was established several years ago with policy
that all its merchandise would be acquired from the home office. The branch reported inventory beginning of P3,600 and
inventory ending of P6,000. The home office showed in its trial balance an unrealized profit on inventory account balance of
P4,600. The cost of merchandise sold by the branch that came from the home office is:
A. P21,600
B. P18,000
C. P21,000
D. Cannot be determined

11. Given:
Home Office Control (Branch Books)
Jan. 1, 20X6 Balance 60,000
Jan. 3, 20X6 Cash remitted to home office 80,000
Jan. 5, 20X6 Shipments from home office 120,000
Jan. 28, 20X6 Expenses from home office 45,200
Jan. 28, 20X6 Cash remitted to home office 30,000
Jan. 28, 20X6 Merchandise returned to home office 12,000
Branch Control (Home Office Books)
Jan. 1, 20X6 Balance 60,000
Jan. 3, 20X6 Cash received from branch 80,000
Jan. 4, 20X6 Shipments to branch 120,000
Jan. 28, 20X6 Expense allocation 52,400
Jan. 28, 20X6 Shipments to branch 24,000
Jan. 28, 20X6 Collection from branch customer 18,000
Jan. 28, 20X6 Supplies purchased for branch and
shipped directly to branch 8,000

Except for the error by the branch in recording its share of allocated expenses, all differences are timing differences.

The adjusted balance of reciprocal accounts is:

A. P103,200 B. P166,400 C. P117,200 D. P124,400

Items 12 through 16 are based on the following:

The preclosing general ledger trial balances at December 31, 20X6, for the G Wholesale Company and its Quezon City
branch office are shown below:
Trial Balance
Home Office Branch Office
Dr. (Cr.) Dr. (Cr.)
Cash P 360,000 P 80,000
Accounts receivable 350,000 120,000
Inventory 700,000 150,000
Plant assets - net 900,000
Branch office 200,000
Accounts payable (360,000) (135,000)
Accrued expenses (140,000) ( 25,000)
Home office ( 90,000)
Capital stock (500,000)
Retained earnings (450,000)
Sales ( 4,400,000) (950,000)
Purchases 2,900,000 240,000
Purchases from Home office 450,000
Expenses 440,000 160,000

Your audit disclosed the following data:

1. On December 23 the branch office manager purchased P40,000 of furniture and fixtures but failed to notify the home
office. The bookkeeper, knowing that all fixed assets are carried on the home office recorded the proper entry on the
branch office records. It is the company’s policy not to take any depreciation on assets acquired in the last half of a
year.
2. On December 27 a branch office customer erroneously paid his account of P20,000 to the home office. The
bookkeeper made the correct entry on the home office books but did not notify the branch office.
3. On December 30 the branch office remitted cash of P50,000, which was received by the home office in January,
20X7.

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 4. On December 31 the branch office erroneously recorded the December allocated expenses from the home office as
P5,000 instead of P15,000..
5. On December 31 the home office shipped merchandise billed at P30,000 to the branch office, which was received in
January, 20X7.
6. The entire opening inventory of the branch office had been purchased from the home office. Home office 2016
shipments to the branch office were purchased by the home office in 2016. The physical inventories at December 31,
20X6, excluding the shipment in transit, are:
Home office - P550,000 (at cost)
Branch office - P200,000 (comprised of P180,000 from home office and P20,000 from outside vendors.)
7. The home office consistently bills shipments to the branch office at 20% above cost. The sales account is credited for
the invoice price.

12. How much is the correct ending inventory of G Wholesale Company?

A. P750,000 B. P720,000 C. P745,000 D. P738,000

13. How much is the adjusted balance of reciprocal account before net income of branch?
A. P110,000 B. P190,000 C. P80,000 D. P130,000

14. How much is the correct net income of the branch?

A. P220,000 B. P210,000 C. P234,000 D. P224,000

15. How much is the correct cost of sales of the G Wholesale Company?
A. P3,665,000 B. P3,595,000 C. 3,290,000 D. P3,220,000

16. How much is the correct sales of G Wholesale Company?

A. P5,350,000 B. P4,900,000 C. P4,870,000 D. P4,975,000

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