UNIT 1: SEGMENT REPORTING

1.1 INTRODUCTION

It is customary for many companies to diversify their operations into a variety of related and
unrelated industry areas. Financial analysts and other users of financial statements face
difficulty in analyzing and interpreting financial statements prepared for diversified companies.
The reason is that different industry segments can have differing growth potentials, capital
requirements, and profitability characteristics. Some segments operate in a stable industry, and
others in highly cyclical, or high demand industry.

In terms of capital requirements, the segment may operate in labor-intensive, modest capital
requirements, or high capital intensive industry. As a result, it is not sound to combine all
segments and evaluate the company’s growth potential and profitability. In order to make
meaningful analysis, the total company financial data should be disaggregated into segments.

1.2 OBJECTIVES OF SEGMENT REPORTING AND APPLICABLE ACCOUNTING

STANDARDS

According to FASB (statement No. 14), diversified companies should separately prepare
reporting for each segment. In the view of the FASB, financial information about business
segments will assist financial statement users in analyzing and understanding the financial
statements of the enterprise by permitting better assessment of the company’s past performance
and future prospects.

Generally, segment information is based on the totals of consolidated financial statements.

Thus, the principles governing consolidations are used for segment reporting. In segment
reporting, transactions between segments are not eliminated for purposes of segment
disclosures with the exception of inter segment loans, advances and related interest. These
items are generally excluded from segment assets and revenues.

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1.3 COVERAGE OF SEGMENTAL REPORTING

According to Financial Accounting Standard Board (statement No. 14), an enterprise may have
to disclose data for one or more of the following areas:
1. Operations in different industries
2. Domestic and foreign operations
3. Export sales
4. Major customer
Each of these is explained in subsequent sections.

1.3.1 Operations in different industries

A company may have segments in different industries. The company may not be required to
report its operations in different industries. In order to determine whether the company must
report its operations in different industries, several factors may be considered. The first factor is
to identify the industry segments in which it operates. The aim is to identify a reportable
segment. A reportable segment is a significant component of a company that provides related
products and services primarily to unaffiliated customers. Besides, in order to be reportable, a
segment has to meet one of the three tests  revenue test, operating profit test, and asset test.

1. 3.1.1 Revenue test

An industry segment is reportable if it meets the revenue test. The revenue test is met when an
industry segment’s revenue is 10% or more of the combined revenue of all industry segments.
Revenue includes inter segment sales and transfers. Interest is included in the revenue test if the
assets on which the interest is earned are included in that segment’s identifiable assets. The
interest includes interest on inter segment trade receivables, but does not include interest on
intersegment loans and advances.

To illustrate, assume that Amtex company has 4 segments; namely, A, B, C, and D. tTeir sales
are shown below:

Segments Total


FASB  Financial Accounting Standard Board

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 A B C D Eliminati Consoli
on dated
Sales to unaffiliated outsiders - $40,000 20,000 50,000 1,000 125,000 - 125,00
Inter segments sales ---
10,000 10,000 20,000 - 40,000 (40,000) 0
Total sales

50,000 30,000 70,000 15,000 165,000 (40,000) 125,00

0
The benchmark for a 10% revenue test is $16500 (i.e. 10% of 165,000).
= 10% of total sales

Since the sales of segments A, B, and C are greater than the benchmark sales amount, they are
considered segments Segment D is not a reportable segment because its revenue is less than
10% of the total sales of all segments (i.e 15,000).

1.3.1.2 Operating profit test

Operating profit is defined as an industry segment’s revenue minus all operating expenses.
Operating profit includes expenses that relate to inter segment sales or transfers and expenses
allocated among segments on a reasonable basis. Operating profit should not include revenues
earned at the corporate level, general corporate expenses, interest expense (except for financial
segments), domestic and foreign income taxes, income or loss from equity, investors, gain or
loss on discontinued operations, extraordinary items, minority interest, and the cumulative
effect of an accounting change. Intersegment interest expenses and revenues of an industry
segment that is primarily financial in nature are included in determining the operating profit or
loss of the segment.

The operating profit test is met when an industry segment absolute amount of its operating
profit or loss is 10% or more of the greater, in absolute amount of (1) the combined operating
profits of all industry segments that do not incur operating loss, or (2) the combined operating
loss of all industry segments that did incur an operating loss.

To illustrate, assume that XYZ company has four segments; namely W, X, Y, & Z. Their
operating profits/losses are shown below:

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 Segments Corporate Consolidat
W X Y Z Administration ed
Operating profit (Loss) Br(50,000) Br(10,000) Br. 90,000 Br. 70,000 – Br. 100,000
Equity investment income 15,000 - - - 25,000 ---------- 40,000
Corporate expenses _ _ _ _ (12,000) (12,000)
Interest (5,000) (5,000)
Totals Br (35,000) (10,000) 90,000 70,000 8,000 123,000

In order to determine the reportable segment using the operating profit test, the following steps
can be followed:

Step 1: Add the profits of all segments that reported a profit. In this case, segment Y and Z
reported a profit and their total operating profits are Br. 160,000 (i.e. 90,000 + 70,000
= Br. 160,00).
Step 2. Add the losses of all segments that reported a loss. In the forgoing example, segments
W and X have reported a loss. The total losses of both segments are Br. 60,000 (i.e
50,000 + 10,000 = 60,000).
Step 3. Determine the benchmark to identify reportable segment
Benchmark = 10% of total operating profit, or
= 10% of total operating losses, i.e.
= 10% x 160,000 = 16,000
= 10% x 60,000 = 6,000
Step 4. Identify the reportable segment
The greater of the benchmark determined in step 3 is Br. 16,000. Thus, a segment
whose operating profit is 10% or more is reportable. As a result, segment W, Y, and Z
are reportable because their operating profits or losses are greater than Br. 16,000.

1.3.1.3 Asset test

The asset test is met when an industry segment’s identifiable assets are 10% or more of the
combined identifiable assets of all industry segments. Identifiable assets include tangible and
intangible assets (including good will) used exclusively by an industry segment and an
allocated portion of assets used jointly by two or more industry segments. In the determination

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of segment’s identifiable assets, asset valuation allowances should be taken into account. Asset
valuation allowances include allowance for doubtful accounts, accumulated depreciation,
marketable securities valuation allowance, and inventories valuation allowances.

The identifiable assets of the segment should not include assets maintained for general
corporate purposes and inter segment loans, advances, or investments, except for those of a
financial segment.

To illustrate, suppose that the identifiable assets of XYZ company’s segments are shown below
(in thousands):

Segments Elimi Consolid

W X Y Z Corporate Total nations ated
Identifiable assets Br 40 50 300 90 – 480 - 480
Investments (inter segment) - - 20 – 60 80 – 80
Corporate _ _ _ _ 10 10 – 10
Loans (inter segment) 5 4 - - 8 17 (17) –
Totals 45 54 320 90 78 587 (17) 570

Besides, it is assumed that none of the segments is financial segment.

To identify reportable segment, the following steps can be followed:

Step 1. Compute the total identifiable assets of all segment
Total identifiable assets = 480,000
Step 2. Determine the benchmark
Benchmark = 10% of total identifiable assets
= 10% x 480,000
= 48,000
Step 3. Identify a reportable segment
A reportable segment is one whose identifiable assets are 10% or more of total identifiable
assets of all segments. Since their identifiable assets are grater than Br. 48,000, segments X, Y,
and Z are reportable segments.

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Evaluation of reportable segments
According to statement No. 14 of FASB, an industry segment is considered reportable if it
meets either revenue test, operating profit test, or asset test. However, the statement also
specified additional rules and criteria for a final determination of a reportable segment. These
rules and criteria include:
1. The segment should not be considered reportable when it meets only one of tests but is
not expected to meet the test in the future.
2. A segment that does not meet any of tests may be considered reportable if it has been
reportable in prior years and is expected to meet one or more of the tests in the future.
3. The combined reportable segments must represent a substantial portions (at least 75%)
of the total operations of the enterprise. For example, if the total revenue of reportable
segment is less than 75% of the total revenues of all industry segments, additional
segment must be identified as reportable segment.
4. If the number of reportable segments exceeds 10, it may be appropriate to combine the
most closely related industry segments in to broader reportable segments with a view of
reducing their numbers.

1.3.2 Foreign operations

According to FASB statement No. 14, multinational companies are required to disclose
domestic as well as significant foreign operations. Multinational companies are those
companies that establish their own plants in different countries over the world. Foreign
operations (for multinational companies) include those operations that are located outside a
“home country” and which produce revenue either:
- by unaffiliated customer sales
- by inter company sales

Foreign operations do not include the operation of unconsolidated subsidiaries and investees.
Multinational companies may group operations in individual foreign countries. The basis of
grouping may be:
- proximity
- economic affinity, or

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 - similarity in business environment

As indicated above, multinational companies are required to disclose only significant foreign
operations. Foreign operation is said to be significant if it meets either of the following two
tests:

1. Revenue test
Revenue from sales to unaffiliated customers is 10% or more of consolidated revenue. In this
case, if the revenue from sales to unaffiliated customers is 10% or more of consolidated
revenue, the operation should be reported separately.

Example
Intel Telecommunication Company has subsidiaries in three different African countries. The
sales results of domestic and foreign operations are shown below (in thousands)

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 Domestic Kenya Uganda Togo Combined Elim Consoli
nations dated
Sales to unaffiliated
Customers 4000 1500 5000 700 11,200 – 11200
Inter area sales 500 – 200 – 700 (700) –
Total revenue 4500 1500 5200 700 11,900 (700) 11,200

Revenue test benchmark = 10% of consolidated revenues

= 10% x 11,200 = 1120

Domestic operations, Kenya operation, and Uganda operation are reportable operations because
their revenue from sales to unaffiliated customers is greater than 10% of consolidated revenue.
Togo’s operation is not reportable because its sales ($700) are less than 10% of consolidated
revenue.

2. Asset test
If asset test is followed, the operation’s identifiable assets should be 10% or more of
consolidated assets in order to be reportable.

Example
Intel Telecommunication Company has subsidiaries in three different African countries. The
assets of domestic and three foreign operations are shown below: (in thousands)

Domestic Kenya Uganda Togo Combined Eliminations Consolidated

Identifiable assets $20,000 5000 10,000 3000 38,000 – 38,000
Investments Affiliates 7000 – 2000 9,000 – 9000
General corporate assets 12,000 12,000 – 12,000
Inter area advances 4000 1000 - - 5,000 (5000) –
Total assets 43,000 6000 12000 3000 64,000 (5000) 59000

Assets test benchmark = 10% of consolidated assets

= 10% x 59000 = 5900

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On the basis of asset test, only domestic Kenya and Uganda operations are reportable because
their identifiable assets are greater than the asset test benchmark of $5900. Togo operation is
not separately reported.

Generally, for all separately reportable operations as well as for the combined areas, revenues,
profitability information, and identifiable assets must be disclosed.

1.3.3 Export sales

Are foreign operations and export sales the same? No. Foreign operations and export sales are
not the same although it is not easy to identify the boundary between them. In general, as
defined earlier, foreign operations are those operations that are located outside a “home
country” and which produce revenue from either sale to unaffiliated customers or to members
of a group of companies. On the other hand, export sales represent revenues generated aboard
from services provided by domestic offices. Export sales is said to occur if the company’s
domestic operations sell to unaffiliated foreign customers. Export sales should be disclosed in
total and when appropriate by geographic area if such sales are at least 10% of the company’s
consolidated revenue.

1.3.4 Major customer

According to Statement of Financial Accounting Standard (SFAS No. 30), a major customer is
one that provides a firm with 10% or more of the company’s revenue. Major customer could be
business concerns, domestic government entity, or foreign government entity. According to the
statement, the company has to disclose sales to major customers.

1.4 THE POSITION OF SECURITY AND EXCHANGE COMMISSION (SEC) ON

SEGMENT REPORTING

With respect to segment reporting, Financial Accounting Standard Board and SEC agreed in
most cases except the following:
a. FASB requires segmental data only for those years for which a complete set of financial
statements is prepared, where as SEC requires segmental data for three years historical
period.

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 b. FASB requires the reporting of major customers if sales represent 10% or more of total
revenue, where as SEC requires identification of major customer or customers if the
loss of such a customer or customers would have a materially adverse effect on the
enterprise.

1.5 SUMMARY

The users of financial statements are interested in segment reporting in order to analyze and
interpret the firm’s past performance and to make predictions regarding the firm’s future
prospects. Given certain guidelines, most firms (except closely held companies) are required to
report segment information.

All segments are not reportable. In order to determine the reportable segment, the firm’s profit
centers are the focus. There are three types of tests in identifying a reportable segment; namely,
revenue test, operating profit test, and asset test. If the revenue of the segment is 10% or more
of the combined revenue of all industry segments, it is reportable.

According to profit test, a segment is said to be reportable if its operating profit or loss is 10%
or more of the combined if its operating profit or loss of all segments. On the other hand, using
asset test, if the segment’s identifiable assets are 10% or more of the combined identifiable
assets of all segments, the segment is reportable.

A segment is said to be dominant if its revenues, operating profit, and assets comprise more
than 90% of the firm’s revenues, operating profits, and assets. In this case, only dominant
segment is reportable.

Firm’s operating on multinational basis are required to disclose their foreign operations and
export sales if they constitute 10% or more of the total revenues of the firm.
If a customer provides 10% or more revenue to the firm, it is called a major customer, and
should be disclosed.

UNIT 2: INTERIM FINANCIAL REPORTING

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2.1 INTRODUCTION

Stakeholders, like investors, creditors, suppliers, and others, need information about the
financial performance of the enterprise. These users cannot wait for the end of the year to do
so. They need financial information periodically, at the end of either a month, quarter, or
semiannually. This chapter deals with important issues like accounting principles and practices
used in the preparation of interim financial statements, and approaches to preparing interim
financial statements.

2.2 THE NEED FOR INTERIM REPORTS

Interim financial reports are defined as reports prepared for a period of less than a year. The
purpose of preparing interim financial reports is to meet the needs of decision makers. Decision
makers are interested in frequent and timely information about the firm’s financial position and
results of operations. Among decision makers lenders are the common users. They need to
closely monitor the progress of borrowers so that problems can be identified as early as
possible. Another reason for the interest in interim financial reports is to use such reports as a
basis for projecting annual results.

An interim financial report may include either a

a. Selected financial data
b. Complete set of financial statements

Although there is greater need for interim financial reports, there are problems associated in
their preparation. Some of them include the following:
1. It is difficult to make estimates and judgments as accurately as possible. When the
accounting period gets shorter, estimates and judgments cannot be accurately made.
2. The treatment of seasonal expenses. i.e. expenses that relate to a full year’s activity but
that occur randomly during the year.

2.3 APPROACHES TO INTERIM REPORTING

This relates to the view accountants hold about interim period. Accountants hold two views
about interim period. There are:

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1. Discrete period approach
It is the approach in which each interim period is treated as a distinct accounting period. Alike
annual financial results, the same principles and processes are used in determining interim net
income. Under this approach, any outlay such as for advertising, repairs and maintenance
would be expensed in the interim period in which the outlay occurs.

2. Integral period approach

It is an approach in which an interim period is considered as an integral part of the annual
period. Under this approach, accruals, deferrals, estimates, and allocations depend on overall
estimates of the relationship between estimated annual revenues and expenses. Expenses, such
as advertising and research and development costs will be deferred so that a proper allocation
between interim periods within one year can be achieved.

According to Accounting Principles Board (APB) opinion No. 28, interims financial
statements are based on integral period approach. APB opinion No. 28 also stressed that interim
financial statements should be based on the same accounting principles and practices that are
used in the preparation of annual financial statements.

2.4 STANDARDS FOR INTERIM REPORTING OF REVENUES, COSTS, AND

EXPENSES

1. Revenues
Revenues should be recognized as earned during the interim period on the same basis as
followed for the full year. Seasonal variations in revenue should be disclosed by issuing data
for the latest 12 months in addition to the interim data.

2. Costs and expense

a. Direct costs and expenses

Costs and expenses may be classified into direct costs, and indirect costs. Direct costs and
expenses are those that can be associated with revenues, or directly associated with the products
or services provided. They are also called allocated product costs, and include all inventoriable
direct costs (i.e. materials, labor, and manufacturing overhead).

APB – Accounting Principles Board

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For interim periods, direct/allocated costs are treated in the same way as full year. However,
APB opinion No. 28 provided the following exceptions with respect to the determination of
cost of goods sold for interim financial statements.

a. Enterprises that use the gross profit method at interim dates to estimate cost of goods
sold should disclose their practice in the interim financial statements.
b. Enterprises using the LIFO method of inventory may dig into LIFO layers temporarily
during an interim period because LIFO is an annual concept.
c. Inventory losses resulting from market declines should not be deferred beyond the
interim period in which they occur. If losses are recovered in a subsequent interim
period, gains should be recognized to the extent of losses previously recognized. To
illustrate, assume that the costs and market value of inventory in the 1st quarter are Br.
10,000 and Br. 7000 respectively. Inventory loss to be reported in the 1 st quarter would
be Br. 3000 (i.e 10,000 – 7000 = 3000). If inventory value (market value) is Br. 14,000
in the 2nd quarter, gain is Br. 4000, but only Br. 3000 is recognized because loss was Br.
3000 in the 1st quarter.

Inventory losses due to temporary inventory market decline should not be recognized in interim
period. (Temporary inventory market decline is a market value decline in one interim period
with an expected market recovery in a subsequent interim period within the same fiscal year.

To illustrate, the application of the lower-of-cost or market rule to interim reporting, let’s
consider the following data. Grace Company accounts for its single merchandise item on the
FIFO basis by applying the lower-of-cost or market method. The company has 15000 units in
stock with a cost of Br. 60,000 or Br. 4 per unit. For simplicity of illustration, we assume that
no purchases were made during the year (2003). Quarterly sales and end-of-quarter
replacement costs for inventory during the year were as follows:

Quarter Quarterly End of quarter

ended sales (units) Replacement cost/per unit
March 31 -----------------3000 --------------------------------.--Br. 5
June 30 -------------------2000 ---------------------------------------3
September 30 -----------3500 ---------------------------------------6

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 December 31 -----------2500 ----------------------------------------2

Assume that the replacement cost decline in the second was not considered to be temporarily.

Grace Company’s cost of goods sold for four quarters, including the second quarter is
computed as follows:

Cost of goods sold

Quarter ended Computation for quarter For quarter Cumulative
March 31 ------------------3000 x 4------------------------- 12,000 12,000
June 30 --------------------(2000 x 4) + (10,000 x 1)a -----18,000 30,000
September 30 -------------(3500 x 3) – (6500 x 1)b --------4,000 34,000
December 31 --------------(2500 x 4) + (4000 x 2)c ------18,000 52,000

a. 10,000 units remaining in inventory multiplied by Br. 1 write down to lower

replacement cost
b. 6500 units in inventory multiplied by Br. 1 write-up to original FIFO cost.
c. 4000 units remaining in inventory multiplied by Br. 2 write-down to lower replacement
cost.
The Br. 52,000 cumulative cost of goods sold for Grace Company for 2003 may be verified as
follows:

Alternative 1:
11000 units sold during 2003, at Br. 4.00 FIFO cost
per unit (4 x 11,000) -------------------------------------------------------------44,000
Add: write-down of 2003 ending inventory to
replacement cost (4000 units x Br. 2.00) ------------------------------------------8,000
------------------------------------------8,000
Cost of goods sold for 2003 ---------------------------------------------------------------52,000
---------------------------------------------------------------52,000

Alternative 2
Cost of goods available for sale (15000 units x Br. 4) --------------------------------60,000
Less: Ending inventory, at lower of FIFO cost, or market
(4000 units x Br. 2) ------------------------------------------------------------------8,000
------------------------------------------------------------------8,000
Cost of goods sold for 2003 --------------------------------------------------------------52,000
--------------------------------------------------------------52,000

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Therefore, if interim reports are prepared for the 2 nd quarter, cost of goods sold is reported at
Br. 18,000.

b. Indirect costs
Indirect costs represent those costs and expenses other than product cost (direct, or
allocated costs). APB opinion No. 28 has indicated the following standards with respect to
costs and expenses other than product costs:
(i) They should be charged to income in interim period as incurred or be
allocated among interim period based on an estimate of time expired, benefit
received, or activity associated with the periods. The same procedures
should be used as annual reporting dates.
(ii) Those costs and expenses that cannot be readily identified with the activities
or benefits of other interim periods should be charged to the interim period
in which incurred, and disclosures should be made.
(iii) Arbitrary assignment of the amount of indirect costs and expenses to an
interim period should not be made.
(iv) Gains and losses that arise in any interim period similar to those that would
not be deferred at year-end, should not be deferred to later interim periods
within the same fiscal year.

N.B
1. The above standards apply to such items as major repairs, quantity discounts, property
taxes, and advertising costs.
2. The above standards encourage enterprises to avoid year-end adjustments as much as
possible may making quarterly estimates of items, such as inventory shortages, bad
debt expense, and contract adjustments.

2.5 INCOME TAXES IN INTERIM FINANCIAL STATEMENTS

The determination of interim operating results requires the estimation of income tax provision
for the interim periods. According to APB opinion No. 28, the amount of income tax charged to
an interim period should be related to the expected annual income tax provision. To estimate

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interim income tax, we need to determine the effective tax rate for the entire current fiscal
period at the end of each interim period. This effective tax rate is applied into interim income.
Interim income tax expense (or benefit) is computed as follows:

Year-to-date tax expense or benefit ----------------------------------------------------------- xxx

Less: cumulative amounts of tax reported in the
previous interim period ----------------------------------------------------------------- xxx
Interim income tax expense or benefit ------------------------------------------------------- xxx

The effect of permanent tax differences should be estimated in determining the estimated
effective annual tax rate. Permanent tax differences include:
- Percentage of depletion
- Nontaxable income
- Non taxable expense

In determining the estimated effective annual tax rate, we need to exclude the tax effect of non-
ordinary items of income or loss because they are sold net of income tax effect. Non ordinary
item of income or expense include:
- Extra ordinary items
- Discontinued operations
- Cumulative effect of changes in accounting principles

Illustration
Suppose that Stars Company has pretax income of Br. 130,000 at the end of the first quarter.
Assume further that at the end of the first quarter, Stars estimated that effective annual tax rate
is 59%. What is income tax provision for the first quarter?
Tax provision for the 1st quarter is equal to pretax income times estimated effective income tax
rate. i.e.

Income tax provision = Pretax income x Estimated effective tax rate

= 130,000 x 59%
= 76,700

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To illustrate further, Stars Company had a pretax income of Br. 180,000 for second quarter. Its
estimated combined effective tax rate is 55% at the end of the second year. Income tax
provision for the second quarter is the difference between year to date tax expense (or benefit)
and cumulative amounts of tax reported in the previous interim period. i.e

Cumulative pretax income year-to-date (130,000 + 180,000) -----------------310,000

Tax at estimated combined rate of 55% ------------------------------------------170,500
Less: Income tax accrued first-in the 1st quarter --------------------------------- 76,700
Income tax provision for the second quarter --------------------------------------93,800
--------------------------------------93,800

The above process is repeated for the third and fourth quarters. The effect of a change in the
estimated full year tax rate is included in the tax provision of the second quarter. As a result,
retroactive revision is not undertaken.

Journal Entries
1. To record Stars’ 1st quarter income tax provision
Income taxes expense ------------------------76,700
Income taxes payable -------------------------76,700
2. To record Stars’ 2nd quarter income tax provision
Income taxes expense -------------------------93,800
Income taxes payable --------------------------93,800

Tax benefit arises when operating result for the quarter turned to be a loss and the realization of
tax benefit is assured reasonably. If income tax benefit resulting from operating loss is not
reasonably assured, it is not realized.

To illustrate, consider the following data for Stars Company in year 3.

Pretax income Estimated

Quarter Current Year to date tax rate for year
First -----------------Br. (40,000) Br. (40,000) 70%
Second -------------------30,000 (10,000) 70%
Third ---------------------70,000 60,000 70%
Fourth --------------------90,000 150,000 65%

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Assume that tax benefits that arise from loss are not assured beyond a reasonable doubt.
Based on the above data, income tax provision for each quarter can be determined as follows:

Tax provision for quarter three:

Cumulative pretax income year to date ------------------------------------------------- 60,000
Tax at estimated combined rate (70% x 60,000) ---------------------------------------42,000
Less: Income tax accrued for the 1st and 2nd quarters -------------------------------------0
-------------------------------------0
Income tax provision for the 3rd quarter ------------------------------------------------ 42,000

Tax provision for 4th quarter:

Cumulative pretax income ---------------------------------------------------------------150,000
---------------------------------------------------------------150,000
Tax at estimated combined rate of 65% --------------------------------------------------97500
Less: Tax accrued for 1st, 2nd, & 3rd quarters -------------------------------------------42,000
-------------------------------------------42,000
Income tax provision ---------------------------------------------------------------------- 55,500

The manner in which tax provisions (tax benefits) are determined differs if tax benefits arising
from loss are assured reasonably. To illustrate, consider the above data for Stars Company
assuming that the realization of tax benefits from the 1st quarter was assured reasonably. Then
tax benefits or expense for each quarter can be determined as follows:

First Quarter
Cumulative pretax income ------------------------------------------------------ (40,000)
Tax at estimated effective rate of 70% (40,000 x 0.70)---------------------- (28,000)

Quarter two
Cumulative pretax income ----------------------------------------------------- (10,000)
Tax at estimated combined rate of 70% (10,000 x 0.70)-------------------- (7000)
Less: Tax benefit accrued for 1st quarter ------------------------------------ (28,000)
Tax benefit in 2nd quarter ------------------------------------------------------- 21000

3rd quarter
Cumulative pretax income ------------------------------------------------------ 60,000
Tax at estimated combined rate of 70% (60,000 x 0.70)-------------------- 42,000
Less: Tax benefits accrued for 1st & 2nd quarters ----------------------------(7,000)
----------------------------(7,000)

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Tax provision for 3rd quarter --------------------------------------------------- 49,000

4th quarter
Cumulative pretax income -------------------------------------------------------150,000
-------------------------------------------------------150,000
Tax at estimated combined rate of 65% (150,000 x 0.65)- --------------------97500
Less: Tax accrued for three quarters -------------------------------------------- 42,000
Income tax provision for 4th quarter ---------------------------------------------55,500
---------------------------------------------55,500

2.6 REPORTING OF ACCOUNTING CHANGES AND EXTRA ORDINARY AND

OTHER NON OPERATING ITEMS

2.6.1 Reporting extra ordinary and other non operating items

Extra ordinary items are events or transactions that are distinguished by their unusual nature
and by the infrequency of their occurrence. Any loss arising from extra ordinary events are
shown in the income statement, net of income taxes. Extraordinary and unusual items are
reported in full as they occur so that their impact is immediately known i.e. they are shown in
the income statement in the interim period in which they occur.

2.6.2 Reporting gains or losses from disposal of business segment

Business segment is a component of a business enterprise whose activities represent a separate

major line of business or class of customer. Any gain or loss on the disposal of the segment is
reported separately in the income statement, net of the related income tax effects. In interim
reports, any gain or loss resulting from disposal of segment is reported in full in the interim
period it arises.

2.6.3 Reporting accounting changes in interim periods

Business enterprises are required to use accounting principles consistently so that the financial
performance of two periods can be compared. However, management of a business enterprise

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may justify a change in accounting principles on grounds that it is preferable. There are three
types of accounting changes. These are changes in accounting principles, a change in
accounting estimates, and a change in reporting entity.

A change in accounting principles generally requires the inclusion of the cumulative effect of
change to a new principle in net income of the accounting period in which the change is made.
Change in accounting estimates affect only the current and future periods’ financial statements.
With regards to reporting accounting changes in interim period, there are two principal
provisions.

1. Accounting changes in the First interim period

If a change of accounting principles is made during the first interim period of an enterprise’s
fiscal year, the cumulative effect of the change on retained earnings at the beginning of that
fiscal year shall be include in net income of the first interim period.

2. Accounting changes in other than the first interim period of an enterprise.

If a change of accounting principle is made in other than the first interim period no cumulative
effect of the change shall be included in net income of the period of the change. Instead,
financial information for the pre-change interim periods of the fiscal year in which the change
is made shall be stated by applying the newly adopted accounting principle to those prechance
interim periods. The cumulative effect of the change on retained earnings at the beginning of
that fiscal year shall be included in restated net income of the first interim period of the fiscal
year in which the change is made.

2.7 DISCLOSURE OF SUMMARIZED INTERIM FINANCIAL DATA

In order to be timely, interim financial reports may not be as detail as annual financial reports.
However they should contain at minimum the following information: for the current quarter,
the current year-to date, or the last 12 months to date.
1. Sales (or gross revenue),
2. Provision for income taxes
3. Extra ordinary items
4. Cumulative effect of change in accounting principles

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 5. Net income
6. Earning per share data
7. Seasonal revenue, costs, or expenses
8. Significant changes in estimates or provision for income taxes
9. Disposal of a business segment
10. Contingent items
11. Significant changes in financial position

Note that interim reports may not be prepared for the 4th quarter of the fiscal year. In such case,
annual financial reports should disclose the effects of the following for the fourth quarter:
- Disposal of a segment
- Extraordinary items
- Changes in accounting principles
- The aggregate effect of year-end adjustments that are material to the 4th quarter
results.

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2.8 SUMMARY

Annual financial statements normally do not provide decision makers with the timely data
needed to make decisions. Thus, external decision makers need financial data for shorter
intervals of time. Interim financial statements are provided to external users to meet their needs.

Interim financial statements may be prepared using the discrete period approach, and integral
period approach. The integral period approach is presently used for interim reporting purposes.
Revenues in interim reports are recognized on the same basis used for annual reports. Costs and
expenses that are associated with revenue are allocated to the products or service rendered.
Another costs and expenses are charged to the interim period based on time expired, benefits
received, or activities associated with the interim period.

The income tax provision for an interim period should use an effective annualized tax rate.
Extraordinary and other non-operating items should be recognized in the interim period in
which they occur.

2.10 GLOSSARY

1. Interim financial statements. Financial statements prepared for a period of less than a
year.
2. Discrete period approach. The approach in which each interim period is treated as a
distinct accounting period.
3. Integral period approach. The approach in which an interim period is considered as an
integral part of the annual period.
4. Temporary inventory market decline. A market value decline of inventory in one
interim period with an expected market recovery in a subsequent interim period within
the same fiscal year.
5. Extraordinary items. Events or transactions that are distinguished by their unusual
nature and by the infrequency of their occurrence.
6. Business segment. A component of a business enterprise whose activities represent a
separate major line of business or class of customer.

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UNIT 3: ACCOUNTING FOR ESTATES AND TRUSTS

3.1 INTRODUCTION

Estate accounting is concerned with accounting for the administration and distribution of the
decedent’s property. In effect, this unit explores the legal and accounting aspects of estate
administration and trust.

3.2 LEGAL ASPECTS OF ESTATE ADMINISTRATION

According to Oxford current English dictionary, estate refers to person’s assets and liabilities at
death. The estates of deceased persons (decedents), or missing person should be administered
distributed, and accounted by certain laws. The deceased person may or may not leave his will
about the estates.

If a person died with a valid will, he/she is considered to have died testate. This person is called
testator.

The disposition of such person’s real and personal property is governed by the will of the
testator.

On the other hand, a person may not leave his will in part/wholly about the real and personal
proprieties. He/she is considered to have died (in testate). In this case, the distribution of such
person is governed by the provisions of certain laws (laws of intestacy).

The administration of estate involves marshaling the estate’s assets, paying the debts of the
decedent, and the distribution of the remaining in accordance with the testator’s wishes or the
laws of intestacy. If the deceased left the will, the validity of the will should be validated. The
process by which the validity of a will is established is called probating the will. Once a will
has been admitted to probate, the court will proceed to appoint a personal representative of the
deceased whose function is to administer the estate. This person is called an executor
(executrix). An executor is a male fiduciary named in the will be the decedent to administer the
estate. An executrix is a female fiduciary named in the will of the decedent to administer the
estate.

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If the decreased dies intestate, the court will appoint a personal representative who can
administer the estate. This person is called an administrator (adiminstiratrix). An administrator
is a male fiduciary appointed by a court to administer the estate of an in testate decedent. An
administratrix is a female fiduciary appointed by a court to administer the estate of an intestate
decedent. The appointed person is issued letters of administration as evidence of that
individual’s authority to act as a fiduciary to administer the estate of the intestate decedent.

Once appointed, the personal representative will take the possession and control of the
decedent’s property. If it is a business enterprise, the representative may continue to operate a
business for some time (no longer than four months in USA) with the specified period (three
months in USA), the personal representative must submit to the court an inventory of property
owned by the decedent on the date of death. He/she also submits a list of any leins that exist
against the property. If additional assets of the decedent are discovered after the filing of the
inventory with the court, supplementary inventory reports must be filed with the court.

Claims against the estate

Once appointed, the representative must give public notice in a newspaper of general
circulation at sometime interval. The purpose of the notice is to request that those who have
claims against the estate present them within the specified time, or be forever barred from
asserting such claims.

Some allowances and exemptions precede all claims against estate. These are described as
follows:

1. Homestead allowance
It refers to an allowance of certain amount ($500 in USA) to a surviving spouse or surviving
minor children of the decedent. This allowance is additional to any other share of the estate that
passes to the spouse or children by the will.

2. Family allowance
It refers to a reasonable cash allowance (not to exceed $6000 for the 1st 12 months after death in
USA) to the decedent’s surviving spouse and dependent children. Except homestead allowance,
family allowance has priority over all claims against the estate.

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3. Exempt property
It is a decedent’s household furnishings, automobile and other personal effects up to a value of
certain amount ($3500 in USA) and not available to creditors of the estate to the surviving
spouse and children.

After the above allowances are excluded, the representative pays in the claims in the following
order:

1. The expense of administering the estate

2. The funeral expense as well as the hospital and medical expense of the decedent’s
last illness.
3. Debts and taxes that have preference under federal or state laws.
4. All remaining claims

The settlement of an estate

Once the claims against the estate have been established and paid, the personal representative
has the duty to distribute the remaining assets of the estate to persons entitled to it.

Distribution of Intestate
When a person has died intestate, his/her estate will be distributed in accordance with the
applicable law. This is generally distributed to a spouse or blood relative. Real property is
distributed to heirs under the laws of the state where the property is located (in USA). Personal
property is distributed to next of kin under the laws of the state in which the decedent was
domiciled.

Distribution of Testate
If a person dies testate, the distribution of the decedent’s property is mostly governed by the
terms of the will. In such a situation, the gift of real property is called a devise. The recipient
(beneficiary) is called a devisee. Testamentary gifts of personal property are called bequests or
legacies. The recipient (beneficiary) is called legatee.

3.3 THE CLASSIFICATION OF LEGACIES

As defined above, legacy refers to the testamentary gifts of personal property. There are various
types of legacies. They are described below:

25
a. A specific legacy
It is a gift of personal property specifically identified in the will such as a specific piece of
Jewelry.

26
b. A demonstrative legacy
It is a testamentary gift payable out of a source specified in the will such as a specific amount
of money to be paid out of a specific bank account or the proceeds from a specific insurance
policy.

c. A general legacy
It is a gift of an indicated amount of money or quantity of something without designation as to
source.

d. Residual legacy
It is a testamentary gift of property remaining in an estate after all debts have been satisfied and
all other legacies have been distributed, or otherwise provided for.

3.4 ACCOUNTING ASPECTS OF ESTATE ADMINISTRATION

Facilitating the reporting by the personal representative, called fiduciary to the court is the
major purpose of estate accounting. The reporting involves two aspects. There are:

1. Accountability
Accountability emphasizes that the personal representative is responsible for the assets of the
deceased and for their administration and disposition. In this case, estate accounting reflects the
assets for which the fiduciary is charged with responsibility and the distributions and payments
to creditors and beneficiaries. The fiduciary is credited with the distributions and payments to
creditors and beneficiaries.

2. The distinction between principal and income

The distinction between principal and income is the basic to estate accounting. Principal, also
called corpus, is defined as the property set aside by the owner (or the person legally entitled to
do so) so that it is held in trust for eventual delivery to remainderman. Remainderman is a
person named to receive the principal of an estate at the conclusion of the income beneficiary’s
interest. Principal consists of the net assets of the estate on the date of death.

Net Assets = Gross Assets – Liabilities

Principal includes

27
 - Proceeds of insurance on property forming part of the principal
- Stock dividends and liquidating corporate distributions
- Rents or other types of revenues which already accrued at the date of death of the
testator
- All proceeds from the sale or redemption of bonds
- Cash dividends declared prior to a decedent’s death.

Charges against estate principal include:

- All expenses incurred in connection with the settlement of an estate. These include
funeral expenses, debts, estate taxes, interest on taxes, penalties on taxes, and family
allowances.
- Part of court costs and accountant’s fees, attorneys’ fees, personal representatives
fees, and trustees’ fees. The remaining part of these costs should be charged against
income.
- Costs incurred in preparing principal property for sale or rent.
- Cost of investing and reinvesting principal assets
- Major repairs to principal assets
- Income taxes on receipts or gains allocable to principal
- Rental expenses payable at the date of death of the decedent.

Income
Income is defined as the return in money, or property derived from the use of principal. Income
represents the earnings on the net assets of the estate. Income includes
- Rent
- Interest
- Cash dividend
- Receipts from business and farming operations
- Any revenue earned during the administration of a decedent’s estate.

Income may be charged with the following items:

- Ordinary expenses incurred in the management and preservation of estate or trust
property. This includes regularly recurring taxes assessed on the principal
- Water charges

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 - Insurance premiums
- Interest
- Ordinary repairs
- Depletion and depreciation depending on the expressed intention of the testator with
respect to the preservation of the principal of the estate
- Expenditures required to preserve the normal operating efficiency of depreciable
assets.

Depending on the testator’s will, the income of the estate (or a portion of it) accrues for the
benefit of one party for a stipulated period of time. The party who is entitled for the income of
the estate is called income beneficiary for a limited period of time after which the principal is
to be distributed to another party, called remainderman. Remainderman was defined earlier. To
illustrate the difference between income beneficiary and remainderman, assume that Ato
Bulcha has a business enterprise called Bulcha Company. W/ro Biftu is the spouse of Ato
Bulcha. Ato Bulcha has also three children. Assume further that Ato Bulcha has died on May
10,2004, at which time the net asset of his business is Br. 200,000. Before his death, he
expressed that income from his business is to be used by his spouse, and after her death the Br.
200,000 would be used by his children.

From the above description, the Br. 200,000 represents the principal. W/ro Biftu is called
income beneficiary, Ato Bulcha’s children are called remaindermen.

3.5 ACCOUNTING AND REPORTING FOR ESTATES

As indicated earlier, the major focus of estate accounting is on the accountability for estate
assets and for their proper administration and distribution. Therefore, regarding fiduciaries, the
fundamental accounting equation is shown below:
Assets = Accountability

The accounts are primarily designed to maintain the distinction between principal (capital, or
corpus), and income.

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3.5.1 Accounts relating to principal

The following accounts are used in relation to principal

1. Individual asset accounts

The accounting for an estate begins when the fiduciary files an inventory of the decedent’s
property with the court. At that time each asset account is debited at the asset’s fair market
value. For example, if the decedent has cash of Br. 10,000 and inventory with a market value of
Br. 15000 on the date of death, cash account is debited for Br. 10,000, and inventory account is
debited for Br. 15,000.

2. Estate principal account

Estate principal account is credited when asset accounts are debited. In the above example,
estate capital account is credited for Br. 25,000 (i.e 10,000 Br. 15,000 – 25,000) if the decedent
had no liability. Estate principal account is the basic equity of the estate.

3. Assets Subsequently Discovered account

Assets Subsequently Discovered account is used to record assets that were not inventoried of
the date of death of the estate. This account is credited when the market value of the asset
discovered is debited to an appropriate asset account.

4. Gain (loss) on realization

This account is used to record any gain or loss upon the disposal of the deceased person’s
assets. Loss on realization account is debited if loss arises on disposal of assets. On the other
hand, if the disposal of assets results in gain, gain on realization account is credited.

5. Debts of Decedent Paid account

This account is used by the personal representative to indicate reduction of accountability for
estate assets in the form of payment of debts and legacies. Legacy refers to a testamentary gift
of personal property.

3.5.2 Accounts relating to income

The following accounts may be used in relation to income:

1. Estate Income account

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Estate Income account is used to record income collections.
2. Expense accounts
They are used to record expenses allocable against the interests of income beneficiaries.

3. Distributions to Income Beneficiaries accounts

It is used to record the distribution of income to income beneficiary.

3.5.3 Reporting for estates

The personal representative is required to prepare reports for estates and submits to the court.
He/she is required to prepare two types of reports. There are:
1. Charge and discharge statement - principal
2. Charge and discharge statement – income

Illustration for Estate Accounting

Assume that Ato Tadege died testate on April 5, 2003. His estate consisted of the following as
prepared by the executor on April 27, 2003.
Cash in bank Br. 90,000
Household Effects 20,000
Investment in Dashen bank stock 50,000
Investment in government bonds 60,000
Dividend declared on April 2, 2003
On Dashen Bank stock 5,000
Accrued interest on government bonds 8,000

According to the terms of the will, Ato Kassa Tadege is appointed to be executor. This will also
provided that general legacies of Br. 7000 (in cash) be paid to Meskerm (Decedent’s grand
daughter), and the decedent’s household effects to go to Ato Kassa Tadege. After payments of
debts and proper charges and distribution of legacies, the remainder of the estate property will
be distributed to Ato Kassa Tadege.

The following transactions and events occurred relating to the estate.

1. Public notice was given that creditors of the estate should make a presentment of their
claims.

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 2. Paid funeral expense Br. 3000
3. Collected interest on government bonds, Br. 8,000
4. Collected dividend on Dashen Bank stock, Br. 5000
5. Discovered rare coin collection and sold it for Br. 12000 cash.
6. Interest earned subsequent to date of death on cash in bank account Br. 2000.
7. Paid debts of the decedent Br. 6000
8. Paid attorney’s fees, Br. 2000, and other administration expenses of Br. 5000 of which
Br. 1000 relate to income.
9. Sold Dashen Bank stock for Br. 48000.
10. Paid cash legacies provided for in the will
11. Deliver the household effects to Ato Kassa Tadege
12. Interest accrued on government bonds, Br. 1500
13. Distributed remaining assets to residuary beneficiaries

Instructions
a. Prepare journal entries of the fiduciary
b. Prepare charge and discharge statement of Ato Kassa Tadege as to principal and
income as of Dec. 31, 2003.
c. Prepare closing entries reflecting the distribution of remaining assets to residual
beneficiaries and closing the fiduciary books.

Solution
a. Journal entries

April 27, 2003 (To record inventory of Ato Tadege’s estate)

Cash – principal 90,000
Household effects 20,000
Investment in Dashen bank stock 50,000
Investment in government bonds 60,000
Dividend receivable 5,000
Interest receivable 8,000
Estate principal 233,000

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1. No entry is needed
2. Funeral and administration expense 3000
Cash – principal 3000
To record funeral expense paid
3. Cash – principal 8000
Interest receivable 8000
To record interest collected on government bonds
4. Cash – principal 5000
Dividend receivable 5000
To record dividend collected on Dashen bank stock
5. Cash – principal 12000
Assets subsequently discovered 12000
To record the value of coins discovered
6. Cash – Income 2000
Estate income 2000
To record interest earned on bank account
7. Debts of decedent paid 6000
Cash-principal 6000
To record the payment of decedent’s debts
8. Funeral and administration expense 6000
Expenses-income 1000
Cash – principal 6000
Cash – income 1000
To record the payment of attorney’s fees and administration expense
9. Cash – principal 48,000
Loss on realization 2,000
Investment in Dashen bank stock 50,000
To record the disposal of Dashen bank stock
10. Legacy – Meskerem 7000
Cash-principal 7000
To record the payment of legacy

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11. Legacy – Kassa 20,000
Household effects 20,000
To record the delivery of household effect as per will
12. Interest receivable 1500
Estate income 1500
To record accrued interest on government bonds
b. Charge and discharge statement – principal

Estate of Ato Tadege, Deceased

Kassa Tadege, Executor
Charge and Discharge statement
April 27 to December 31,2003

I charge myself with:

Assets per original inventory $ 233,000
Assets subsequently discovered 12,000
Total 245, 000

I credit myself with:

Loss on realization of assets 2000
Funeral and administration expenses 9000
Debts of decedent paid 6000
Legacies paid/distributed
Mesekerm (cash) 7000
Kassu (household effects) 20,000 44,000
Balance as to principal $201,000
Which consists of:
Cash 141,000
Investment in government bonds 60,000
$ 201,000

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 Cash – principal
Bal. 90,000 3000 (2)
(3) 8000 6000 (7)
(4) 5000 6000 (8)
(5) 12,000 7000 (10)
(9) 48,000
Bal. 141,000

Charge and discharge statement – income

Estate of Ato Tadege, Deceased
Kassa Tadege, Executor
April 27 to December 31, 2003

I charge myself with:

Income collected/Accrued@ $ 3500
I credit myself with:
Expenses chargeable to income 1000
Balance as to income $ 2500
Which consists of:
Cash $ 1000
Interest receivable (government bonds) 1500
$ 2500
Estate income cash – income expense – income
2000 (6) (6) 2000 1000 (8) (8) 1000
1500 (12) Ba. 1000
Bal. 3500

Interest – receivable
(12) 1500

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c. Closing entries reflecting the distribution of estate assets.
13. Legacy – Kassa 201,000
Cash – principal 141,000
Investment in government bonds 60,000
To close the distribution of residual assets to residuary beneficiary
14. Estate principal 233,000
Assets subsequently discovered 12,000
Loss on realization 2000
Debts of decedent paid 6000
Legacy – Meskerem 7000
Legacy – Kassa 221,000
Funeral & administration expenses 9000
To close open accounts as to estate principal
15. Distribution to Kassa 2500
Cash – income 1000
Interest receivable 1500
To record the distribution of remaining cash and interest receivable to income beneficiary.
16. Estate income 3500
Expense – income 1000
Distribution to income beneficiary – Kassa 2500
To close open accounts as to income.

3.6 LEGAL AND ACCOUNTING ASPECTS OF TRUSTS

Estate administration Vs Trust administration

Estate administration is generally a short-term process that aims at the expeditious distribution
of estate assets. On the other hand, trust administration consists of the prudent management of
funds over longer period of time.

A trust may be created by a living grantor who transfer property for the benefit of another
person (beneficiary) to a trustee. The trustee is responsible to hold assets for the beneficiary.
The income from a trust is ordinarily distributed periodically to an income beneficiary. The

36
principal of the trust ultimately goes to a remainderman. The income beneficiary and the
remainderman may be the same person.

The trust may be testate or instate. When a trust is created by a will, it is called a testamentary
trust.

Trust accounting
The accounting procedures for a trust are very similar to those of an estate. With respect to
reporting, the trustee is required to fill an accounting with the court concerning events of the
previous period, specifying the accounting period, and giving the names and addresses of the
living beneficiaries. The trustee must give a statement of unpaid claims and reasons for non-
payment within the reporting period. Besides, the trustee must render final accounting covering
the period since the last intermediate accounting at the termination of the trust. He/she must
also prepare the plan for the distribution of trust assets still on hand. To conclude, the function
of the trustee is the administration of the trust, preservation of the assets, the discharging of
liabilities, and the equitable distribution of principal and income to those entitled to them in
accordance with applicable laws and the intent of legal requirements.

3.7 SUMMARY

The planning for and the administration of estates and trusts involves accounting skills, and
knowledge of tax and other specialized areas of law. The focus of estate and trust accounting is
not on compliance with generally accepted accounting principles, rather on specialized
bookkeeping practices and accounting statements that aim at carrying out the intent of the law
and the intent of those who leave estates or create trusts.

A decedent died with testate leaves a will directing the distribution and administration of
his/her property. Whether the decedent had died testate or intestate, the administration of the
estate is normally under the jurisdiction of a court handling probate matters. The court issues
lesser of testamentary if the decedent died testate, and letters of administration if the decedent
died intestate.

Claims against estate are in the order of allowances and exemptions (homestead allowance,
family allowance, and exempt property) and followed by creditors.

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If the estate is sufficient to liquidate all of the debts of the decedents with some estate property
remaining, the fiduciary may proceed with the distribution of the estate’s real property and its
personal property. The gift of real property is called a devise and the recipient is a devisee. A
gift of personal property is called a bequest or legacy and the recipient is a legatee. A legacy
may be any of the following:
1. Specific legacy – legacy specifically identified
2. Demonstrative legacy – a sum of money payable out of a particular bank account
3. General legacy – sum of money without naming the source of the funds
4. Residual legacy – balance in the estate after paying all debts and other legacies.

The fiduciary has to classify the estate assets in to principal and income because income
beneficiary is different from principal beneficiary. Accounts used in principal accounting and
income accounting are different. Ultimately two separate statements are prepared by the
fiduciary – charge and discharge statement – principal, and charge and discharge statement –
income.

Finally, the administration of trusts is similar to that of estates – the administrator of a trust is
called a trustee and the recipient of a trust’s benefits is a beneficiary.

UNIT 4: BANKRUPTCY LIQUIDATION AND REORGANIZATION

4.1 INTRODUCTION

Changes in business environment are common. If they are not properly managed, they may
cause business failures. More specifically, the causes of business failures include poor
management, excessive debt, and inadequate accounting. These result in the inability of firms
to pay their liabilities when they become due. This would bring about bankruptcy.
This chapter is concerned with bankruptcy liquidation and reorganization.

4.2 INSOLVENCY VS BANKRUPTCY

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The term insolvent and bankrupt are often used interchangeably. Such usage is technically
incorrect. Insolvent refers to the financial condition of a person or business enterprise whereby
the sum of debts is greater than all of the fair value of its property. On the other hand, bankrupt
refers to a legal state.

4.3 BANKRUPTCY LIQUIDATION

Bankruptcy liquidation refers to the process that involves the realization (sale) of the assets of
an individual or a business enterprise and the distribution of the cash proceeds to the creditors
of the individual or enterprise. There are four classes of creditors in bankruptcy liquidation.
There are:
a. Fully secured creditors.
creditors. They are entitled to obtain satisfaction of all or part of
their claims from the assets pledged as collateral.
b. Partially secured creditors.
creditors.
c. Unsecured creditors with priority.
priority. The claims of these creditors are satisfied
in full from proceeds of realization of the debtor’s noncollateralized assets.
d. Unsecured creditors without priority.
priority. This class of creditors receive cash
from proceeds available from the realization of the debtor’s assets.

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4.3.1 Debtor’s petition (voluntary petition)

According to bankruptcy code, any person may file a petition in a court for voluntary
liquidation. The debtor’s bankruptcy petition must be accompanied by supporting exhibits of
the debts and property of the petitioner. The debts are classified into three. There are:
i. Creditors having priority
ii. Creditors holding security
iii. Creditors having unsecured claims without priority
The property of the debtor is reported into three categories
i. Real property
ii. Personal property
iii. Property claimed as exempt

N.B
i. Valuation of property are at market or current fair value
ii. A statement of financial affairs also accompanies the debtor’s bankruptcy petition.

4.3.2 Creditors’ petition (Involuntary petition)

If the debtor owes unpaid amounts to 12 or more unsecured creditors who are not employees,
relatives, stockholders, or other insiders, three or more of the creditors who have unsecured
claims totaling $10,000 or more may file in a federal bankruptcy court a creditors’ petition for
bankruptcy. The creditors’ petition is also called involuntary petition. If the number of
unsecured creditors is less than 10, one or more creditors having unsecured claims of $10,000
or more may file the petition. The petition of the creditors for bankruptcy may claim anyone of
the following:
i. The debtor is not paying debts as they come due
ii. The debtor is not paying debts within 120 days prior to the date of the petition

4.3.3 Unsecured creditors with priority

Unsecured creditors may be classified into unsecured creditors with priority and unsecured
creditors without priority. If adequate cash is not available for all unsecured creditors, the

40
available cash needs to be paid in full to the unsecured creditors with priority. Debts which are
found in this category include:
- Administrative costs
- Claims arising in the course of the debtors business or financial affairs after the
commencement of a creditors’ bankruptcy proceeding but before the appointment of a
trustee or order for relief.
- Claims for wages, salaries, and commissions (including vacation, severance, and sick
leave pay not in excess of $4000 per claimant) earned within 90 days before the date
of filing petition for bankruptcy or cessation of the debtor’s business.
- Claims for contributions to employee benefit plans arising within 180 days before the
date of filing the petition for bankruptcy cessation of the debtor’s business.
- Claims by producers of grain against a grain storage facility or by fisherman against a
fish storage or processing facility not in excess of $4000 per claimant
- Claims for cash deposited for goods/ services for the personal, family, or household
use of the depositor, not in excess of $1800 per claimant.
- Claims for alimony, maintenance, or support of a spouse, former spouse or child of
the debtor, under a separation agreement, divorce decree, or court order.
- Claims or government entities for various taxes or duties, subject to varying time
limitations.
Note that settlement of the above debts would be in the order specified.

4.3.4 Property claimed as exempt

Certain property of a bankruptcy petitioner is not included in the debtors’ estate. These include:
- Residential property exemptions provided by homestead laws.
- Exemptions for life insurance policies payable on death to the spouse or a relative of
the debtor.

4.3.5 Role of court in liquidation

All aspects of the bankruptcy proceedings are dealt with by the Federal Bankruptcy Court
(USA) with respect to a debtor’s and creditor’s petition for bankruptcy liquidation. The roles of
the court include:

41
 i. Dismiss the debtor’s or creditor’s bankruptcy petition or to grant an order for relief.
An order for relief is given for the filling of a debtor’s petition in bankruptcy. The
court also gives order for relief in a creditor’s petition after a hearing at which the
debtor may attempt to refuse the creditors’ allegations that the debtor was not pay
debtors as they came due. Thus, the creditors’ petition may be dismissed or order for
relief be given by the court.

Any suits that are pending against a debtor for whom a debtor’s or creditors’ bankruptcy
petition is filed are stayed until order for relief or dismissal of the petition after order for relief,
such suits are further stayed until the question of the debtor’s discharge is determined by the
court.
ii. The court appoints an interim trustee to serve permanently or until the trustee is
elected by the creditors. This is done after the court granted the order for relief.
iii. The court calls a meeting of the creditors after the order for relief within 10 to 30
days.

4.3.6 Role of creditors

As indicated above, within a period of 10 to 30 days after order for relief, the court calls a
meeting of the creditors. One of the responsibility of the creditors is to appoint a trustee to
manage the debtor’s estate. A majority vote is required for actions by creditors in appointing
the trustee.

4.3.7 Role of the Trustee

The trustee may be appointed by the court or elected by the creditors. The trustee is required to
assume the custody of the non-exempt property of the debtor. The principal duties of the trustee
are:
i. Continue to operate the debtor’s business (if directed by court)
ii. Realize the free assets of the debtor’s estate
iii. Pay cash to unsecured creditors
iv. Keep accounting records to enable the filing of a final report with the court
v. Invalidate a preference

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Preference is defined as the transfer of cash or property to an “outsider” creditor for an existing
debt made while the debtor was insolvent and within 90 days of filing of the bankruptcy
petition. This is the case if the transfer caused the creditor to receive more cash or property than
would be received in the bankruptcy liquidation. In this case, the trustee may recover from the
creditor the cash or property constituting the reference and include it in the debtor’s estate.

4.3.8 Discharge of Debtor

Discharge refers to the release of the debtor from all unliquidated debts. It is the court that
determines the debtor’s discharge. The role of the trustee is to liquidate the debtor’s property
and pay the necessary claims.

After all properties have been liquidated, all secured and priority creditor claims have been
paid, and all remaining cash has been paid to unsecured, nonprority creditors.
Discharge of the debtor does not include:
1. taxes payable by the debtor
2. debts resulting from the debtor’s obtaining money or property under false
representations, or willful conversion of the property of others.
3. debts not scheduled by the debtor in support of the bankruptcy petition.
4. debts arising from embezzlement or other fraudulent acts by the debtor acting in
a fiduciary capacity.
5. amounts payable for alimony, maintenance, or child support
6. debts for willful and malicious injuries to the persons or property of others
7. Debts for fines, penalties, or forfeitures payable to government entities, other
than for tax penalties
8. Debts for educational loans made, insured or guaranteed by governmental
entities, or by nonprofit universities or colleges.

Note that a debtor will not be discharge if:

! The debtor for commits any crimes, misstatements, or other malicious acts that are in
connection with the court proceedings.
!! The current bankruptcy petition was fined within six years of a previous bankruptcy
discharge to the same debtor.

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4.3.9 Role of Accountant in Bankruptcy Liquidation

The role of the accountant in liquidation proceedings is concerned with proper reporting of the
financial condition of the debtor and adequate accounting and reporting for the trustee for the
debtor. There are

1. The statement of affairs.

The statement of Affairs is prepared to present the financial condition of the debtor enterprise.
The statement is prepared on the assumption of quitting concern. This is due to the fact that a
business enterprise that enters bankruptcy liquidation proceedings is a quitting concern and not
a going concern. As a result, the balance sheet is not appropriate for an enterprise in
liquidation. Thus, Statement of Affairs is the financial statement designed for a business
enterprise entering liquidation.

The purpose of the Statement of Affairs is to display the assets and liabilities of the debtor
enterprise from the point of liquidation. The assets of the debtor enterprise are valued at current
fair values and the carrying values are presented on a memorandum basis. Besides, assets and
liabilities are classified according to the rankings and priorities. They are not prevented
according to the current classification used in the traditional balance sheet.

2. Statement of Realization and liquidation

Liquidation involves realization of the assets of the debtor’s estate. Statement of Realization
and liquidation is based on the assumed activities of the trustee for the estate of the bankrupt
firm. This statement is accompanied by the statement of cash receipts and cash payments.

4.4 BANKRUPTCY REORGANIZATION

When a business becomes insolvent, it does not have enough cash to meet its interest and
principal payments. Then the decision must be made whether to dissolve the firm through
liquidation or to permit it to reorganize and thus stay alive. The decision to force a firm to
liquidate versus permit it to reorganize depends on whether the value of the reorganized firm is
likely to be greater than the value of the firm’s assets if they are sold off piecemeal. The issue
of liquidation was discussed earlier.

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In a reorganization, a committee of unsecured creditors is appointed by the court to negotiate
with the management on the terms of a potential reorganization., the reorganization may call
for a restructuring of the firm’s debt. The restructuring of debts involve:
1. Reduce interests rate
2. Lengthen the term to maturity
3. Exchange some debts for equity

The purpose of restructuring is to reduce the financial charges to a level that the firm’s cash
flows can support.

In addition to committee, the court may appoint trustee to oversee the reorganization.

4.4.1 Appointment of trustee or examiner

The management or owners of the business enterprises may continue to operate the enterprise
as debtor in possession. Alternatively, the court may appoint a trustee to manage the enterprise.

The purposes of appointing the trustee are

1. To reduce fraud, dishonesty, incompetence or gross management by current
owners or managers
2. To protect the interest of the creditors or stockholders of the enterprise.

Where the reorganization involves the trustee, examiner may be appointed to investigate
possible fraud or mismanagement by the current managers or owners of the enterprise.

The powers and duties of the trustee include:

1. Prepare and file a list of creditors in court. The list includes class of creditors and their
claims and lest of stockholder of each class.
2. Investigate the acts, conduct, property, liabilities, and business operations on the
enterprise. The trustee indicates the desirability of continuing operations.
3. Report to the bankruptcy judge any facts ascertained as to fraud against or
mismanagement of the debtor enterprise.

4.4.2 Plan of reorganization

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The management or trustee is required to submit the plan of the organization to the bankruptcy
court. The same plan may also be given to the creditors and stockholders of the enterprise. The
purpose of submitting the plan of reorganization is for confirmation by the bankrutpcy court.
Before the plan of reorganization is confirmed by the court, the plan must be accepted by the
following parties:
1. Majority of the creditors, whose claims must account for two thirds of the total
liabilities.
2. Stockholder owning at least two thirds of the outstanding capital stuck of each
class.

If one or more classes of stockholders or creditors has accepted a plan, the bankruptcy court
may conform if the plan is fair and equitable to the nonacceptors. If the plan of reorganization
is confirmed by the bankruptcy court, it becomes binding on the debtor enterprise, on all
creditors and owners of the enterprise, and on any other enterprise issuing securities or
acquiring property user the plan.

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4.4.3 Accounting for a Reorganization

Accounting for reorganization involves journal entries for the following adjustments:
a) Carrying amounts of assets
b) Reduction of par or sated value of capital stock
c) Extensions of due dates and revisions of interest rates of notes payable
d) Exchanges of debt securities for equity securities (debt securities include notes
payable, bond, etc. Equity securities primarily include common stock and preferred
stock).
e) The elimination of a retained earnings deficit.

The reorganized enterprise is essentially a new enterprise whose assets and liabilities should be
valued at current fair values and whose shareholders’ equity consists only of paid in capital.

To illustrate accounting for reorganization, suppose Topcon Company has the following assets.
Liabilities, owners equity before bankruptcy petition by the debtors.

Topcon Company
Balance sheet
December 31,2003.
Assets:
Current Assets: Br. 95,000
Faded assets 180,000
Total cossets 275,000
Liabilities and stockholders’ Equity:
Liabilities:
Current liabilities:
Notes payable (due December 31,2004) 40,000
Notes payable (due September 30,2004) 50,000
Trade Accounts payable 20,000
Salaries and wages payable 10,000
Employee Income taxes payable 25,000
Total current liabilities 145,000

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 Bonds payable 100,000
Total liabilities 245,000
Stockholders’ Equity:
Common stock, Br.100 par, 600 shares authorized issued
and outstanding 60,000
Deficit (30,000)
Total liabilities and stockholders’ equity 275,000

Stockholders and all unsecured creditors have approved the plan of reorganization and the
bankruptcy court has conformed it.

The plan of reorganization is described below

1. Deposit Br 40,000 with escrow agent, to cover liabilities with priority and costs of
reorganization proceedings (Br. 7000). Salaries and wages and employee income taxes
payable are liabilities with priorities.
2. Amend articles of incorporation to provide for 10,000 shares of authorized common
stock of Br.1 par. The new common stock is to be exchanged on a share for share basis
for the 600 shares of outstanding Br.100 par common stock.
3. Extend due date of unsecured notes payable to suppliers totaling Br. 50,000 for three
years until December 31,2007. Increase the interest rate on te notes from the stated rate
of 10% to 12%.
4. Exchange 2000 shares of new Br.1 par common stock (at current fair value of Br.20 a
share) for unsecured notes payable to suppliers totaling Br. 40,000.
5. Pay suppliers 60 cents per dollar of trade accounts payable owed.

The journal entries to record the reorganization are shown below:

1) (a) To record deposit of cash with escrow agent
Cash with escrow Agent 40,000
Cash 40,000
(b) To record escrow agent’s payment of liabilities with priority
Salaries and wages payable 10,000
Employee income taxes payable 25,000
Cash with Escrow Agent 35,000

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(c) To record payment for cost of bankruptcy proceedings
Costs of Bankruptcy proceedings 7000
Cash with escrow agent 7000
(2) To record issuance of 600 shares of Br. 1 common stock in exchange for 600 shares of Br.
100 par common stock
Common stock, Br. 100 par 60,000
Common stock, Br. 1 par 600
Paid in capital in excess of par 59400
(3) To record extension of due dates on Notes Payable
10% Notes Payable to suppliers, due date Dec. 31, 2004 50,000
12% Notes Payable to suppliers, due date Dec. 31, 2007 50,000
(4) To record exchange of 2000 shares of Br. 1 par common stock for Notes Payable
Notes payable to suppliers 40,000
Common stock, Br. 1 par 2000
Paid in capital in excess of par 38,000
(5) To record payment of Br. 0.60 per Birr of Accounts payable to suppliers
Trade accounts payable 20,000
Cash (20,000 x 0.60) 12000
Gain from discharge of indebtedness in Bankruptcy 8000

Assuming that fresh start reporting is appropriate for the company under consideration after the
plan of organization has been carried out. The following journal entry is made to eliminate
retained earnings deficit.

Paid in capital in excess of par 29000

Gain from discharge of indebtedness in Bankruptcy 8000
Costs of Bankruptcy proceedings 7000
Retained earnings 30,000

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4.4.4 Disclosure of reorganization

Notes to the financial statements are used to present the complex issues that are involved in
bankruptcy reorganization. The disclosure should include for the period in which the plan of
reorganization was carried out.

4.5 SUMMARY

The failed business may be liquidated or reorganized. In the case of bankruptcy liquidation
non-cash assets are sold and the claims of the various parties be satisfied, usually beginning
with creditors. The quest for liquidation may be initiated b y the debtors or creditors. The court,
creditors, trustee and accountants are among the major parties involved in liquidation.

On the other hand, a firm in failure state may be reorganized if the value of the reorganized
firm is likely to be greater than the value of the firm’s assets if they are sold off piecemeal.

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