In AS 14 we were taught an adjustment that when prior to absorption the purchasing company sells some goods to the vendor company it has to create a stock reserve to reducve the value of inventory by adjusting goodwill or capital reserve after the absorption is completed
we were also taught that the 2 conditions necessarry for making stock reserve are
1) the seller should earn some profit on the goods sold 2) the goods must be returned back to the seller
however when a vendor company sells goods to purchasing company at some profit prior to absorption the profit is distributed among its equity holders at the time of absorption and as far as purchasing company is concerned
1) neither it earns something on such purchase 2) neither the goods are returned by it to anyone
still in our study material module ICAI has advised us to create a stock reserve in the books of the purchasing company
please guide for the rationale followed by ICAI behind this adjustment
06 July 2024
The adjustment you're referring to regarding the creation of a stock reserve in the context of AS 14 (Accounting for Amalgamations) typically addresses the scenario where the purchasing company (acquirer) sells goods to the vendor company (acquiree) before the amalgamation (absorption) process is completed. Here’s the rationale and conditions typically considered for creating such a stock reserve, as advised by ICAI (Institute of Chartered Accountants of India):
### Rationale Behind the Adjustment:
1. **Ensuring Fair Representation:** - The creation of a stock reserve aims to ensure that the inventory of the purchasing company reflects its true economic position post-amalgamation. - Before amalgamation, if the purchasing company sells goods to the vendor company, it might record a profit on these sales. This profit is treated as a liability because it is to be distributed among the equity holders of the vendor company upon amalgamation.
2. **Matching Principle:** - The adjustment follows the principle of matching expenses to revenues. If the purchasing company has recorded a profit on the sale of goods to the vendor company before amalgamation, but those goods remain in the inventory of the purchasing company after amalgamation, the profit recognized should be adjusted against the inventory value.
### Conditions for Creating a Stock Reserve:
1. **Profit on Sale:** - The purchasing company should have recognized a profit on the sale of goods to the vendor company before amalgamation. This profit represents an economic benefit that needs to be adjusted post-amalgamation.
2. **Goods Not Returned:** - The goods sold by the purchasing company to the vendor company are not physically returned to the purchasing company after amalgamation. This means the profit recognized on these sales remains embedded in the value of the inventory of the purchasing company.
### Practical Application:
- **Accounting Treatment:** The profit recognized on the sale of goods to the vendor company is adjusted by creating a stock reserve in the books of the purchasing company. This reserve reduces the value of inventory in the purchasing company's books, thereby aligning the financial statements with the economic reality post-amalgamation.
- **ICAI Guidance:** The guidance from ICAI emphasizes the need for transparency and accuracy in financial reporting, ensuring that the effects of transactions leading up to amalgamation are appropriately accounted for to present a true and fair view of the financial position.
### Conclusion:
The rationale behind creating a stock reserve in the context of AS 14 is to adjust for any profits recognized on sales of goods to the vendor company before amalgamation, ensuring that the inventory value accurately reflects the economic reality post-amalgamation. This adjustment aligns with accounting principles of fairness, transparency, and matching of revenues and expenses. It’s essential to follow such guidelines to maintain consistency and accuracy in financial reporting during amalgamations and similar corporate transactions.
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