Modul PAII

WOLLEGA UNIVERSITY
COLLEGE OF BUSINESS AND ECONOMICS
DEPARTMENT OF ACCOUNTING AND FINANCE
DISTANCE STUDIES
PRINCIPLE OF ACCOUNTING PART II
PREPARED BY: Adamu Terfa

Debela Yohanis
Adugna Megenasa
EDITED BY: Adugna Megenasa

Adamu Terfa
Debela Yohanis
NEKEMTE
ETHIOPIA
July, 2013
Principles of Accounting II (AcFn 1032)
Table of Contents
UNIT ONE: CASH AND RECEIVABLES..............................................................................1
1.0 AIMS & OBJECTIVES....................................................................................................1
1.1 INTRODUCTION.............................................................................................................2
1.2 INTERNAL CONTROL OF CASH...............................................................................3
1.3 BANK RECONCILIATION...........................................................................................4
1.4 PETTY CASH AND CHANGE FUNDS.....................................................................11
1.5. CLASSIFICATION OF RECEIVABLES.....................................................................16
1.6 INTERNAL CONTROL OF RECEIVABLES...............................................................17
1.7 ACCOUNTING FOR UNCOLLECTIBLE ACCOUNTS.............................................18
1.8 ACCOUNTING FOR NOTES RECEIVABLE..............................................................26
1.9. FACTORING RECEIVABLES.....................................................................................30
1.10. PRESENTATION OF CASH AND RECEIVABLES ON THE BALANCE SHEET
...............................................................................................................................................33
1.11 ANSWER TO CHECK YOUR PROGRESS EXERCISES.........................................36
UNIT TWO: INVENTORIES.................................................................................................43
2.0 AIMS AND OBJECTIVES.............................................................................................43
2.1 INTRODUCTION...........................................................................................................44
2.2 INTERNAL CONTROL OF INVENTORIES...............................................................44
2.3 THE EFFECTS OF INVENTORY ERRORS ON THE FINANTIAL STATEMENTS47
2.4 INVENTORY COST FLOW ASSUMPTIONS.............................................................49
2.5 INVENTORY COSTING METHODS UNDER A PERPETUAL & PERIODIC
INVENTORY SYSTEM.......................................................................................................50
2.6 VALUATION OF INVENTORY AT OTHER THAN COST.......................................57
2.7 ESTIMATING INVENTORY COST.............................................................................59
2.8 PRESENTATION OF MERCHANDISE INVENTORY ON THE BALANCE SHEET
...............................................................................................................................................62
2.9 ANSWERS TO CHECK YOUR PROGRESS AND EXERCISES..........................63
UNIT THREE: PLANT ASSETS AND INTANGIBLE ASSETS..........................................69
3.0. INTRODUCTION..........................................................................................................70
i
3.1 NATURE
N AND MEANING OF PLANT ASSETS........................................................70
3.2 ACCOUNTING FOR DEPRECIATION........................................................................74
3.3 DEPRECIATION OF PARTIAL YEARS......................................................................87
3.4 CAPITAL AND REVENUE EXPENDITURES............................................................88
3.5 DISPOSAL OF PLANT ASSETS..................................................................................90
3.6 LEASING FIXED ASSETS............................................................................................97
3.7 INTERNAL CONTROL OF FIXED ASSETS...............................................................98
3.8 NATURAL RESOURCES..............................................................................................99
3.9 INTANGIBLE ASSETS...............................................................................................100
3.10 PRESENTATION OF PLANT ASSETS AND INTANGIBLE ASSETS ON THE
BALANCE SHEET.............................................................................................................103
3.11 ANSWERS TO CHECK YOUR PROGRESS AND EXERCISES...........................105
UNIT FOUR: CURRENT LIABILITIES...............................................................................114
4.0 AIMS AND OBJECTIVES.........................................................................................114
4.1 INTRODUCTION.........................................................................................................114
4.2 THE NATURE OF CURRENT LIABILITIES............................................................115
4.3 SHORT-TERM NOTES PAYABLE..........................................................................115
4.4 ETHIOPIAN PAYROLL SYSTEM.............................................................................118
4.5 PRESENTATION OF CURRENT LIABILITIES ON THE BALANCE SHEET.......122
4.6 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS:.....................................124
UNIT FIVE: ACCOUNTING FOR PARTNERSHIPS..........................................................127
5.0 AIMS AND OBJECTIVE.............................................................................................127
5.1 INTRODUCTION.........................................................................................................128
5.2 BASIC CHARACTERSTICS PARTNERSHIPS.........................................................128
5.3 EQUITY REPORTING FOR PARTNERSHIP............................................................131
5.4. FORMATION OF PARTNERSHIPS..........................................................................132
5.5 DIVIDING PARTNERSHIP NET INCOME AND NET LOSS................................134
5.6 DISSOLUTION OF A PARTNERSHIP.......................................................................137
5.7 LIQUIDATION OF A PARTNERSHIP.......................................................................143
5.8 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS......................................152
UNIT SIX: ACCOUNTING FOR CORPORATIONS...........................................................159
ii
6.0 INTRODUCTION.........................................................................................................160
6.1 NATURE OF A CORPORATION...............................................................................160
6.2. CHARACTERISTICS OF A CORPORATION..........................................................161
6.3. CLASSES OF STOCK.................................................................................................165
6.4 ACCOUNTING FOR ISSUANCE OF STOCKS.........................................................168
6.6 TREASURY STOCK TRANSACTIONS....................................................................172
6.7 ACCOUNTING FOR DIVIDENDS.............................................................................173
6.8 REPORTING STOCKHOLDERS’ EQUITY.............................................................178
6.9 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS......................................181
iii
COURSE DESCRIPTION
This course is a continuation of principles of accounting I. the course is designed to introduce

students to the application of accounting principles and concepts to major balance sheet items.
the specific topics includes internal control over cash, accounting for receivables, accounting
for inventories, accounting for current liabilities, accounting for plant asset, natural resources
and intangibles and accounting for businesses organized as partnerships and companies as per
Ethiopian commercial code.
code
COURSE OBJECTIVES
The course has the general objective of introducing students to the accounting basics of
recognizing, measuring, and reporting common balance sheet items.
Upon the successful completion of this course, the students will be expected to:
 Apply accounting principles and control of cash and receivables

 Analyze and record payroll transactions in Ethiopian context.
 Utilize and identify the implication of the various methods of valuation respect to
accounts and notes receivable, inventories, depreciation, tangible and intangible assets,
and natural resources.
 Analyze, record and report transactions for businesses organized as partnerships,
private limited companies, and share companies
iv
UNIT ONE: CASH AND RECEIVABLES
CONTENTS
1.0 Aims & Objectives
1.1 Introduction
1.2 Internal Control of Cash
1.3 Bank Reconciliation
1.4 Petty Cash and change funds
1.5 Classification of Receivables
1.6 Internal Control over Receivables
1.7 Accounting for Notes Receivable
1.8 Factoring Receivables
1.9 Presentation of cash and receivables on the balance sheet
1.10 Summary
1.11 Answer to Check your Progress Exercises
1.12 Model Examination Questions
1.0 AIMS & OBJECTIVES
In this unit, internal control of cash, the accounting for cash transactions and receivables will
be discussed. After you have studied this unit, you should be able to:
 define cash
 Describe the nature of cash and the importance of internal control over cash.
cash
 prepare a bank reconciliation
 understand the internal control of cash
 list the common classification of Receivables
 explain internal Control procedures that apply to receivables
 describe the nature of and the accounting for uncollectible and,
 Explain how receivables can be converted to cash before maturity.
 Summarize how cash and receivables are presented on the balance sheet.
1
1.1 INTRODUCTION
Since cash is the asset most likely to be used improperly by employees, exposed for
embezzlement and many business transactions either directly or indirectly affect it, it is
therefore necessary to have effective control of cash. We also emphasize on how companies
account for and report receivables. We will discuss the importance of estimating uncollectable
in order to determine the reasonable balance of receivables on the balance sheet.
Most of the companies sell goods and services on credit in order to earn more profits.
Receivables represent claims for money, goods, services, and non-cash assets from other
firms. Receivables may be current or non-current depending on the expected collection date.
Meaning and Characteristics of Cash
Cash includes coins, currency (paper money), checks, money orders, and money on deposit
that is available for unrestricted withdrawal from banks and other financial institutions.
Normally, you can think of cash as anything that a bank would accept for deposit in your
account. For example, a check made payable to you could normally be deposited in a bank
and thus is considered cash. Other items such as ordinary checks received from customers,
money orders, coins and currency and petty cash also are included as cash. Banks do not
accept postage stamps, travel advances to employees, notes receivable or post-dated checks as
cash.
The following are some of the characteristics of cash:

cash:
a) Cash is used as medium of exchange

b) Cash is the most liquid asset
c) Cash is mostly affected by business transactions
d) Cash is used to measure the value of other assets
e) Cash is mostly exposed to embezzlements
2
Exercise 1.1: Check Your Progress;
1. Define cash as it is used for accounting purpose.

…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………
2. Which of the following items should not be included as cash?

a) Ordinary checks
b) Post-dated checks
c) Cash deposited in saving accounts
d) Postage stamps
e) Deposits in checking accounts
1.2 INTERNAL CONTROL OF CASH
The need to safeguard cash is crucial in most businesses because cash is mostly exposed to
embezzlement.
embezzlement. Firms address this problem through the internal control system. An internal
control system is a set of policies and procedures designed to protect assets, provide accurate
accounting records and evaluate performances.
A sound internal control system for cash increases the likely hood that the reported values for
cash are accurate.
Internal control for cash should include the following procedures:
 The individuals who receive cash should not also disburse (pay) cash
 The individuals who handle cash should not access accounting records
 Cash receipts are immediately recorded and deposited and are not used directly to
make payments.
 Disbursements are made by serially numbered checks, only upon proper authorization
by someone other than the person writing the check
 Bank accounts are reconciled monthly.
3
The following are the most common elements of cash control and managements: Bank
Reconciliation, petty cash fund, voucher system, change fund, and cash short and over.
1.3 BANK RECONCILIATION
For effective control, the reasons for the difference between the cash balance on the bank
statement and the cash balance in the accounting records should be determined by preparing
bank reconciliation. Bank reconciliation is a listing of the items and amounts that because
the cash balance reported in the bank statement to differ from the balance of the cash account
in the ledger.
Bank accounts are one of the most important means of controlling cash that provide several
advantages such as:
 Cash is physically protected by the bank,

 A separate record of cash is maintained by the bank,
 And customers may remit payments directly to the bank.
A business often maintains several bank accounts. The forms used with each bank account are
a signature card,
card, deposit ticket,
ticket, check,
check, and record of checks drawn.
drawn.
When you open a checking account, you sign a signature card.

card. This card is used by the bank
to verify the signature on checks that are submitted for payment. Also, when you open an
account, the bank assigns an identifying number to the account. The details of a deposit are
listed by the depositor on a printed deposit ticket supplied by the bank. These forms are often
prepared in duplicate. The bank teller stamps or initials a copy of the deposit ticket and gives
it to the depositor as a receipt. Other types of receipts may also be used to give the depositor
written proof of the date and the total amount of the deposit.
A check is a written document signed by the depositor, ordering the bank to pay a sum of
money to an individual or entity. There are three parties to a check:
o The drawer: the one who signs the check, ordering payment by the bank
o The drawee: the bank on which the check is drawn
o The payee: The payee is the party to whom payment is to be made.
4
Bank statement
If a company uses a bank account, monthly statements are received from the bank showing
beginning and ending balances and transactions occurring during the month including checks
paid, deposits received, and service charges. These monthly statements (reports) received
from the bank are called bank statements.
statements. Bank statements generally are accompanied by
checks paid and charged to the accounts during the month, debit and credited memos, which
inform the company about changes in the cash accounts. For a bank, the depositor’s cash
balance is a liability, the amount the bank owes to the firm. Therefore, a debit memo describes
the amount and nature of decrease is the company’s cash accounts. A credits memo indicates
an increase in the cash balance of the depositor that it has with the bank.
Reconciliation of Bank and Book Cash Balances
Monthly reconciling of the bank balance with the depositor’s cash accounts balance is
essential cash control procedure. To reconcile a bank statement means to verify that the bank
balance and the accounting records of the depositor are consistent. The balance shown in a
monthly bank statement seldom equals the balance appearing in the depositor’s accounting
records. Certain transactions recorded by the depositor may not have been recorded by the
bank and vice versa.
The most common examples that cause disparity between the two balances are:
1) Outstanding checks:
checks: Checks issued and recorded by the company, but not yet
presented to the bank for Payment.
2) Deposits in transit:
transit: Cash receipts recorded by the depositor, but not reached the bank
to be included in the bank statement for the current month.
3) Service charges:
charges: Banks often charge a fee for handling checking accounts. The amount
of this charge is deducted by the bank form bank balance and debit memo is issued for
the depositor.
5
4) Charges for depositing NSF- checks:

checks: NSF stands for “Not Sufficient Funds.” When checks
are deposited in an account, the bank generally gives the depositor immediate credit.
On occasion, one of these checks may prove to be uncollectible because the maker of
the check does not have sufficient funds in his or her account. In such a case, the bank
will reduce the depositor’s account by the amount of this uncollectible item and return
the check to the depositor marked “NSF”.
5) Notes collected by bank:
bank: If the bank collects a note receivable on behalf of the
depositor, it credits the depositor’s account and issues a credit memorandum for the
depositor.
When the depositor prepares bank reconciliation, the balances shown in the bank statement
and in the accounting records both are adjusted for any unrecorded transactions. Additional
adjustments may be required to correct any errors discovered in the bank statements or in the
accounting records.
Steps in Preparing Bank Reconciliation
Bank reconciliation is a schedule prepared by the depositor to bring the balance shown in the
bank statement and the balance shown in the depositor’s accounting into agreement.
The steps to prepare bank reconciliation are:
1. Compare each deposit listed on the bank statement with unrecorded deposits appearing in
the preceding period’s reconciliation and with deposit receipts or other records of
deposits. Add deposits not recorded by the bank to the balance according to the bank
statement.
2. Compare paid checks with outstanding checks appearing on the preceding period’s
reconciliation and with recorded checks. Deduct checks outstanding that have not been
paid by the bank from the balance according to the bank statement.
3. Compare bank credit memorandums to entries in the journal. For example, a bank would
issue a credit memorandum for a note receivable and interest that it collected for a
depositor. Add credit memorandums that have not been recorded to the balance according
to the depositor’s records.
6
4. Compare bank debit memorandums to entries recording cash payments. For example, a
bank normally issues debit memorandums for service charges and check printing charges.
A bank also issues debit memorandums for not-sufficient-funds checks. A not-sufficient-
funds (NSF) check is a customer’s check that was recorded and deposited but was not paid
when it was presented to the customer’s bank for payment. NSF checks are normally
charged back to the customer as an account receivable. Deduct debit memorandums that
have not been recorded from the balance according to the depositor’s records.
5. List any errors discovered during the preceding steps. For example, if an amount has been
recorded incorrectly by the depositor, the amount of the error should be added to or
deducted from the cash balance according to the depositor’s records. Similarly, errors by
the bank should be added to or deducted from the cash balance according to the bank
statement.
6. The equality of adjusted balance of statement and adjusted balance of the depositor’s
record is compared.
7. Journal entries are prepared to record any items delayed by the depositor.
Bank reconciliation is usually divided into two sections. The first section begins with the cash
balance according to the bank statement and ends with the adjusted balance. The second
section begins with the cash balance according to the depositor’s records and ends with the
adjusted balance. The two amounts designated as the adjusted balance must be equal. The
content of the bank reconciliation is shown below.
7
Cash balance according to bank statement . . …………………………………. $XXX

Add: Additions by depositor not on bank statement . . . . . . . . . .. . . . $XX
Bank errors . . . . . . . . . . . . . . . . . . . ……………………………….. . . XX XX
$XXX
Deduct: Deductions by depositor not on bank statement . . . . . . . . . . $XX
Bank errors . . . . . . . . . . . . ……………………………………. . . . . . . XX XX
Adjusted balance . . . . . . . . . . . . . . . . . ………………………………… . . . . . $XXX
$XXX
Cash balance according to depositor’s records……………………..……………. $XXX

Add: Additions by bank not recorded by depositor . . . . . .. . . . . . . . $XX
Depositor errors . . . . . . . . . . . ……………………………. …. . . . . . . XX XX
$XXX
Deduct: Deductions by bank not recorded by depositor . . . …. . . . . . $XX
Depositor errors . . . . . . . . . . . . . . . …………………………………... XX XX
Adjusted balance . . . . . . . . . . …………………………………… . . . . . . . . . . . . $XXX
$XXX
Illustration of Bank Reconciliation
Bank statement for Power Networking Company shows a balance of $3,359.78 as of July
31, 2012. The cash balance in Power Networking’s ledger as of the same date is $2,549.99.
The following reconciling items are revealed by using the steps outlined above:
o Deposit of July 31, not recorded on bank statement . . . . . . . . . . . . . . . . . . ……. . $ 816.20

o Checks outstanding: No. 812, $1,061.00; No. 878, $435.39; No. 883, $48.60. .. . 1,544.99
o Note plus interest of $8 collected by bank (credit memorandum), not
Recorded in the journal . . . . . . . . . . . . . . . . . . . . . . . . . . …………. . . . . . . . . . . . . 408.00
8
o Check from customer (Nuuf) returned by bank because of

Insufficient funds (NSF) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ….... …. . . . 300.00
o Bank service charges (debit memorandum), not recorded in the journal. . …..….. . 18.00
o Check No. 879 for $732.26 to Siif Co. on account, recorded in the
Journal as $723.26 . . . . . . ……………. . . . . . . . . . . . . . . . . . . . . . . . . . . ….. . . . . . 9.00
Power Networking
Bank Reconciliation
July 31, 2012
Cash balance according to bank statement $3 3 5 9 .78
Add; Deposit of July 31, not recorded by bank 8 1 6. 20
$4 1 7 5. 98
Deduct: Outstanding checks:
No. 812 $1 0 6 1.00
No. 878 4 3 5 .39
No. 883 4 8. 60 1 5 4 4 .99
Adjusted balance $2 6 3 0 .99
Cash balance according to depositor’s records $2 5 4 9 .99

Add :Note and interest collected by bank 4 0 8. 00
$2 9 5 7. 99
Deduct: Check returned because of insufficient funds $ 3 0 0 .00
Bank service charges 1 8 .00
Error in recording Check No. 879 9 .00 3 2 7. 00
Adjusted balance $2 6 3 0 .99
Note: No entries are necessary on the depositor’s records as a result of the information
included in the first section of the bank reconciliation. This section begins with the cash
9
balance according to the bank statement. However, the bank should be notified of any errors
that need to be corrected on its records.
Any items in the second section of the bank reconciliation must be recorded in the depositor’s
accounts. This section begins with the cash balance according to the depositor’s records. For
example, journal entries should be made for any unrecorded bank memorandums and any
depositor’s errors.
The journal entries for Power Networking, based on the preceding bank reconciliation, are as
follows:
July 31 Cash 408 .00

Notes Receivable 400 .00
Interest Revenue 8.00
 Note collected by bank.
July 31 Accounts Receivable––Nuuf 300.00
Miscellaneous Administrative Expense 18.00
Accounts Payable––Siif Co. 9.00
Cash 327.00
 NSF check, bank service charges, and error in recording Check No. 879. 327.00
After these entries have been posted, the cash account will have a debit balance of $2,630.99.
This balance agrees with the adjusted cash balance shown on the bank reconciliation. This is
the amount of cash available as of July 31 and the amount that would be reported on Power
Networking’s July 31 balance sheet.
Although businesses may reconcile their bank accounts in a slightly different format from
what we described above, the objective is the same: to control cash by reconciling the
company’s records to the records of an independent outside source, the bank. In doing so, any
errors or misuse of cash may be detected.
1. Briefly explain the basic purpose of bank reconciliation.
10
…………………………………………………………………………………………………
…………………………………………………………………………………………………
……………………
2. Define the following terms related to the accounting for cash:
a) Outstanding checks
………………………………………………………………………………………………
………………………………………………………………………………………………
b) Deposit in transit
………………………………………………………………………………………………
………………………………………………………………………………………………
c) NSF- check
………………………………………………………………………………………………
………………………………………………………………………………………………
3. Which of the reconciling items necessitate an entry in the depositor’s accounts?

a) Deposit in transit
b) Outstanding checks
c) Note collected by bank
d) Bank service charge
4. Assume that the bank recorded a deposit of $4,100 as $1,400. How would this bank error
be shown on the bank reconciliation?
1.4 PETTY CASH AND CHANGE FUNDS
Petty Cash
As in your own day-to-day life, it is usually not practical for a business to write checks to pay
small amounts, such as postage. Yet, these small payments may occur often enough to add up
to a significant total amount. Thus, it is desirable to control such payments. For this purpose, a
special cash fund, called a petty cash fund, is used. It is used to handle many types of small
payments such as employee transportation costs, purchase of office supplies, purchase of
postage stamps, and delivery charges. Many businesses find it convenient to make minor
11
expenditures instead of writing checks. The petty cash amount various from Br. 50 or less to
more than Br. 1,000, which will cover small expenditures for a period of two or three weeks.
It is established by first estimating the amount of cash needed for payments from the fund
during a period, such as a week or a month. After necessary approvals, a check is written and
cashed for this amount. The money obtained from cashing the check is then given to an
employee, called the petty cash custodian, who is authorized to disburse monies from the
fund. For control purposes, the company may place restrictions on the maximum amount and
the types of payments that can be made from the fund.
Each time monies are paid from petty cash, the custodian records the details of the payment
on a petty cash receipt form. The petty cash fund is normally replenished at periodic intervals,
or when it is depleted or reaches a minimum amount. When a petty cash fund is replenished,
the accounts debited are determined by summarizing the petty cash receipts. A check is then
written for this amount, payable to the petty cash custodian.
Establishment of Petty Cash
To establish a petty cash fund a check is issued to a bank. This check is cashed and the money
is kept on hand in a petty cash box. One employee is designated as custodian of the fund. The
issuance of the check for establishment is recorded by debiting petty cash account and
crediting cash.
To illustrate normal petty cash fund entries, assume that a petty cash fund of $100 is
established on August 1.
1. The entry to record this transaction is as follows:
follows
Aug. 1 Petty Cash 100.00

Cash 100.00
 Established petty cash fund.
Replenishment of Petty Cash
During the period, the custodian makes small payments from the petty cash fund and obtains a
receipt or prepares a petty cash voucher. This petty cash voucher explains the nature and
amount of every expenditure and is kept with the fund. When the fund runs low or at the end
12
of the company’s fiscal period, a check is issued to reimburse the fund for the expenditures
made during the period. The issuance of this check is recorded by debiting the appropriate
expense accounts and crediting cash or vouchers payable.
Replenishing the petty cash fund restores it to its original amount of $100. You should note
that there is no entry in Petty Cash when the fund is replenished. Petty Cash is debited only
when the fund is initially set up or when the amount of the fund is increased at a later time.
Petty Cash is credited if it is being decreased.
At the end of August, the petty cash receipts indicate expenditures for the following items:
office supplies, $28; postage (office supplies), $22; store supplies, $35; and daily newspapers
(miscellaneous administrative expense), $3. The entry to replenish the petty cash fund on
August 31 is as follows
Aug. 31 Office Supplies 50.00

Store Supplies 35.00
Miscellaneous Administrative Expense 3.00
Cash 88.00
 Replenished petty cash fund.

Change Fund
Some businesses that receive cash directly from customers should maintain a fund of currency
and coins in order to make change (Amharic=>”zirzir”). This fund, which is part of the total
cash balance, is called change fund. A change fund is established by issuing a check to the
bank and transferring the cash to the custodian. The issuance of a check to establish a change
fund is recorded by debiting cash on hand and crediting cash or voucher payable.
Once a change fund is established, there will be no change in its balance unless there is a
decision by management to increase or decrease the fund balance.
Cash Short and Over
13
Regardless of the source of cash receipts, every business must properly safeguard and record
its cash receipts. One of the most important controls to protect cash received in over-the-
counter sales is a cash register. You may have noticed that when a clerk (cashier) enters the
amount of a sale, the cash register normally displays the amount. This is a control to ensure
that the clerk has charged you the correct amount. You also receive a receipt to verify the
accuracy of the amount.
At the beginning of a work shift, each cash register clerk is given a cash drawer that contains
a predetermined amount of cash for making change for customers. The amount in each drawer
is called a change fund. At the end of the work shift, each clerk and the supervisor count the
cash in the clerk’s cash drawer. The amount of cash in each drawer should equal the
beginning amount of cash plus the cash sales for the day. However, errors in recording cash
sales or errors in making change cause the amount of actual cash on hand to differ from this
amount. Such differences are recorded in cash short and over account. The account cash
short and over is debited if there is shortage and credited if there is overage. At the end of the
period if the account had a debit balance, it appears in the Income statement as miscellaneous
expense; if it has a credit balance, it is shown as miscellaneous revenue.
revenue. For example, the
following entry records a clerk’s cash sales of $3,150 when the actual cash on hand is $3,142:
Cash 3,142.00
Cash Short and Over 8.00
Sales 3,150.00
 To record cash sales and actual cash on hand.
1. If the petty cash account has a balance of $200, the cash in the fund totals $20, and the
petty cash receipts total $180 at the end of a period, what account is credited and what is
the amount of the credit in the entry to replenish the fund?
------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------
14
2. The petty cash account has a debit balance of Br. 200. At the end of the accounting period,
there is Br. 160 in the petty cash fund along with petty cash receipts totaling Br. 40.
Should the fund be replenished as of the last day of the period? Why?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
3. In what order are vouchers ordinarily filed

A) In the unpaid voucher file
B) In the paid voucher file
4. In which section of the Income statement would a credit balance in cash short and over be
reported?
Voucher System
One method to control cash disbursements is a voucher system. A voucher is a special form,
which contains relevant data about a liability and its payment.
A voucher system is a set of procedures for authorizing and recording liabilities and cash
payments. A voucher system normally uses (1) vouchers, (2) a file for unpaid vouchers, and
(3) a file for paid vouchers. Generally, a voucher is any document that serves as proof of
authority to pay cash. For example, an invoice properly approved for payment could be
considered a voucher. In many businesses, however, a voucher is a special form for recording
relevant data about a liability and the details of its payment.
Each voucher includes the creditor’s invoice number and the amount and terms of the invoice.
The accounts used in recording the purchases (or transaction) are listed in the account
distribution.
A voucher is normally prepared in the Accounting Department; after all necessary supporting
documents have been received. For example, when a voucher is prepared for the purchase of
goods, the voucher should be supported by the supplier’s invoice, a purchase order, and a
receiving report. In preparing the voucher, an accounts payable clerk verifies the quantity,
15
price, and mathematical accuracy of the supporting documents. This provides assurance that
the payment is for goods that were properly ordered and received.
After a voucher is prepared, the voucher and its supporting documents are given to the proper
official for approval. After it has been approved, the voucher is returned to the Accounting
Department, where it is recorded in the accounts. It is then filed in an unpaid voucher file by
its due date so that all available purchase discounts are taken. On its due date, the voucher is
removed from the unpaid voucher file. The date, the number, and the amount of the check
written in payment are listed on the back of the voucher. The payment of the voucher is
recorded in the same manner as the payment of an account payable.
After payment, vouchers are marked “Paid” and are usually filed in numerical order in a paid
voucher file. They are then readily available for examination by employees needing
information about past payments. A voucher system may be either manual or computerized.
In a computerized system, properly approved supporting documents (such as purchase orders

and receiving reports)
1.5. CLASSIFICATION OF RECEIVABLES
Receivables can be broadly classified into Trade Receivables and Non-trade Receivables.
Receivables.
Trade Receivables: describe amounts owed to the company for goods and services sold in the
normal course of business. Non-trade Receivable arise from many other sources, such as
advance to employees, interest receivables, rent receivables and loan to affiliated companies.
Unless we indicate otherwise, we will assume that all receivables in this unit are trade
receivables.
Based on the above broad classification, receivables can be further classified into Account
Receivable and Notes Receivables.
Account Receivable: refers to amounts due from customers for credit sales. These
receivables are supported by sales invoices or other documents rather than any formal written
promises. Such Account Receivables are normally expected to be collected within relatively
short period, such as 30 or 60 days. They are classified on the balance sheet as a current asset.
16
Notes Receivable: refers to amounts that customers owe, for which a formal, written
instrument of credit has been issued. Notes are usually used for credit periods of more than
sixty days and for transactions of relatively large value. Notes may also be used in settlement
of an open account and in borrowing or lending money.
Other Receivables: Other receivables are normally listed separately on the balance sheet. If
they are expected to be collected within one year, they are classified as current assets. If
collection is expected beyond one year, they are classified as noncurrent assets and reported
under the caption Investments. Other receivables include interest receivable, taxes receivable,
and receivables from officers or employees.
employees
1.6 INTERNAL CONTROL OF RECEIVABLES
The principles of internal control that we discussed under cash can be used to establish
controls to safeguard receivables. The control procedures should be applied on receivables
because they are one of the asset elements for the organization For example, the four
functions of credit approval, sales, accounting, and collections should be separated. The
individuals responsible for sales should be separate from the individuals accounting for the
receivables and approving credit. By doing so, the accounting and credit approval functions
serve as independent checks on sales. The employee who handles the accounting for
receivables should not be involved with collecting receivables. Separating these functions
reduces the possibility of errors and misuse of funds.
Adequate control over Accounts Receivable begins with the approval of the sales by a
responsible company official or the credit department, after the customer’s credit rating has
been reviewed. Likewise, adjustments of Account Receivable, such as for sales return and
allowance, and sales discount, should be authorized or reviewed by a responsible party.
Effective collection procedure should also be established to ensure timely collection of
receivables and to minimize losses from uncollectible accounts.
1. List the common classifications of receivables
17
………………………………………………………………………………………………
………………………………………………………………………………………………
…...……………………………………
2. Why is Account Receivable classified as a current asset?

………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………
3. Why is segregation of duties required for related activities related to receivables?
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………
1.7 ACCOUNTING FOR UNCOLLECTIBLE ACCOUNTS
When credit is extended, some amount of uncollectible receivables is generally inevitable

regardless of the care taken in granting credit and the control procedures used. The operating
expense incurred because of the failure to collect receivables is called Uncollectible
Accounts Expense or Bad Debts Expense or Doubtful Accounts Expense.
Expense.
When does an account as a note become uncollectible? There is no general rule for
determining when an account receivable becomes uncollectible. The fact that a debtor fails to
pay an account receivable according to a sales contract or fails to pay a note on the due date
does not necessarily mean that the account receivable will be uncollectible. The debtor’s
bankruptcy is one of the most significant indications of partial or complete uncollectibility.
Other indications include the closing of the customer’s business and the failure of repeated
attempts to collect.
There are two methods of accounting for uncollectible receivables.
1) The allowance method,

method, which provides an expense for uncollectible receivables in
advance of their write-off (removal from the ledger) and
18
2) The direct write-off method,

method, which recognizes the expense only when accounts
receivable are judged to be worthless. We will discuss each of these methods next.
1) Allowance Method of Accounting for Uncollectible
Most large businesses use the allowance method to estimate the uncollectible portion of their
trade receivables. To illustrate this method, assume yadani Company began a new business on
August and chose to use the calendar year as its fiscal year. The accounts receivable account
has a balance of $105,000 at the end of December. The customer accounts making up the
$105,000 balance in Accounts Receivable include some that are past due. However, Yadani
doesn’t know which specific accounts will be uncollectible at this time. It is likely that some
accounts will be collected only in part and that others will become worthless. Based on a
careful study, Yadani estimates that a total of $4,000 will eventually be uncollectible. The
following adjusting entry at the end of the fiscal period records this estimate:
Adjusting Entry
Dec. 31 Uncollectible Accounts Expense 4000.00

Allowance for Doubtful Accounts 4000.00
Note: The adjusting entry reduces receivables to their net realizable value and matches the
uncollectible expense with revenues
Because the $4,000 reduction in accounts receivable is an estimate, it cannot be credited to

specific customer accounts or to the accounts receivable controlling account. Instead, a contra
asset account entitled Allowance for Doubtful Accounts is credited. As with all periodic
adjustments, the entry above serves two purposes. First, it reduces the value of the receivables
to the amount of cash expected to be realized in the future. This amount, which is $101,000
($105,000 _ $4,000), is called the net realizable value of the receivables. Second, the
adjusting entry matches the $4,000 expense of uncollectible accounts with the related
revenues of the period. After the adjusting entry has been posted, as shown in the following T
19
accounts, Accounts Receivable still has a debit balance of $105,000. This balance is the
amount of the total claims against customers on account. The credit balance of $4,000 in
Allowance for Doubtful Accounts is the amount to be deducted from Accounts Receivable to
determine the net realizable value. The balance of the Uncollectible Accounts Expense is
reported in the current period income statement, normally as an administrative expense. This
classification is used because the credit-granting and collection duties are the responsibilities
of departments within the administrative area.
Accounts Receivable Allowance for Doubtful Accounts
Aug. 31 20,000 Sept. 30 15,000 Dec. 31 Adj. 4,000

Sept. 30 25,000 Oct. 31 25,000
Oct. 31 40,000 Nov. 30 23,000 Uncollectible Accounts Expense
Nov. 30 38,000 Dec. 31 30,000 Dec. 31 Adj. 4,000
Dec. 31 75,000 ------------
198,000 93,000
Bal. 105,000
Write-Offs to the Allowance Account
When a customer’s account is identified as uncollectible, it is written off against the

allowance account as follows:
Jan. 21 Allowance for Doubtful Accounts 610.00

Accounts Receivable– Bekam 610.00
 To write off the uncollectible account.
The authorization to support this entry should come from a designated manager. It should
normally be in writing. The total amount written off against the allowance account during a
period will rarely be equal to the amount in the account at the beginning of the period. The
allowance account will have a credit balance at the end of the period if the write-offs during
the period are less than the beginning balance. It will have a debit balance if the write-offs
20
exceed the beginning balance. However, after the year-end adjusting entry is recorded, the
allowance account should have a credit balance.
An account receivable that has been written off against the allowance account may later be
collected. In such cases, the account should be reinstated by an entry that reverses the write-
off entry. The cash received in payment should then be recorded as a receipt on account. For
example, assume that the account of $610 written off in the preceding entry is later collected
on June 10. The entry to reinstate the account and the entry to record its collection are as
follows:
June 10 Accounts Receivable––Bekam 610

Allowance for Doubtful Accounts 610
 To reinstate account written off earlier in the year.
Cash 610
Accounts Receivable–– Bekam 610
 To record collection on account.
Estimating Uncollectibles
How is the amount of uncollectible accounts estimated?
The estimate of uncollectibles at the end of a fiscal period is based on past experience and
forecasts of the future. When the general economy is doing well, the amount of uncollectible
expense is normally less than it would be when the economy is doing poorly. The estimate of
uncollectibles is usually based on either:
a) The amount of sales,

sales, as shown on the income statement for the period, or
b) The amount of the receivables,
receivables, as shown on the balance sheet at the end of the period,
and the age of the receivable accounts.
a) Estimate Based on Sales
Accounts receivable are created by credit sales. The amount of credit sales during the period
may therefore be used to estimate the amount of uncollectible accounts expense. The amount
of this estimate is added to whatever balance exists in Allowance for Doubtful Accounts. For
example, assume that the allowance account has a credit balance of $700 before adjustment. It
21
is estimated from past experience that 1% of credit sales will be uncollectible. If credit sales
for the period are $300,000, the adjusting entry for uncollectible accounts at the end of the
period is as follows:
Adjusting entry
Dec. 31 Uncollectible Accounts Expense 3000.00

Allowance for Doubtful Accounts 3000.00
After the adjusting entry has been posted, the balance of the allowance account is $3,700. If
there had been a debit balance of $200 in the allowance account before the year-end
adjustment, the amount of the adjustment would still have been $3,000. The balance in the
allowance account would have been $2,800 ($3,000 _ $200).
The estimate-based-on-sales method emphasizes the matching of uncollectible accounts

expense with the related sales of the period. Thus, this method places more emphasis on the
income statement than on the balance sheet.
Note: The estimate based on sales is added to any balance in Allowance for Doubtful
Accounts
b) Estimate Based on Analysis of Receivables
The longer an account receivable remains outstanding, the less likely that it will be collected.
Thus, we can base the estimate of uncollectible accounts on how long the accounts have been
outstanding. For this purpose, we can use a process called aging the receivables.
In aging the receivables, an aging schedule is prepared by classifying each receivable by its
due date. The number of days an account is past due is determined from the due date of the
account to the date the aging schedule is prepared.
Example
22
An aging summary of trade receivable for NATNAEL Company on December 31, 2002 is
illustrated below: Note that the number of different age classes to be used, and the estimate of
average collection for each age group of class depends on actual practice and experience of an
enterprise.
Assume that NATNAEL uses the calendar year as fiscal period.
NATNAEL Company
Aging trade account receivable
December 31, 2002
Balance in each Estimated Estimated
Age interval category Uncollectible Uncollectible
percentage Amount
Not yet due Birr 2,400,000.00 1% Birr 24,000.00
Under 30 days past due Birr 416,000.00 3% Birr 12,480.00
30 –60 days past due Birr 208,000.00 5% Birr 10,000.00
61-120 days past due Birr 96,000.00 10% Birr 9,600.00
121 –180 days past due Birr 48,000.00 30% Birr 14,400.00
Over 180 days past due Birr 32,000.00 75% Birr 24,000.00
Total Birr 3,200,000.00 Birr 94,880.00
The amount Birr 94,880.00 is the amount that should be deducted from account receivable
balance of the year, in order to identify the net realizable amount. These means that the Birr
94,880.00 is the desired balance of allowance account after adjustment. The excess of this
amount over the balance of the allowance account before adjustment is the amount of the
current provision to be made for uncollectible account expense.
The allowance account of NATNAEL Company is shown below using the T-account; the
adjustment amount to determine the Uncollectible expense is shown bellow.
Adjusting amount = Desired amount + current balance of allowance account
= 94,880.00
23
The adjustment amount is determined after considering the existing balance of allowance
account before adjustment.
 If the balance of allowance account is zero before adjustment, the adjustment amount
will be Br. 94,880.
 If the allowance account has debit balance it is added on the desired balance to find
the adjustment amount.
 If the allowance account has credit balance it is deducted from the desired balance to
obtain the adjustment amount.
2) Direct Write-Off Method Of Accounting for Uncollectibles
The allowance method emphasizes reporting uncollectible accounts expense in the period in
which the related sales occur. This emphasis on matching expenses with related revenue is the
preferred method of accounting for uncollectible receivables. There are situations, however,
where it is impossible to estimate, with reasonable accuracy, the uncollectibles at the end of
the period. Also, if a business sells most of its goods or services on a cash basis, the amount
of its expense from uncollectible accounts is usually small. In such cases, the amount of
receivables is also likely to represent a small part of the current assets. Examples of such a
business are a restaurant, an attorney’s office, and a small retail store such as a hardware
store. In such cases, the direct write-off method of recording uncollectible expense may be
used.
Under the direct write-off method, uncollectible accounts expense is not recorded until an
account has been determined to be worthless. Thus, an allowance account and an adjusting
entry are not needed at the end of the period.
Illustration
Seman Enterprise uses direct write off method of accounting for Uncollectible. On February
27, 2012 it was known that the account receivable from ABC Company for the Amount of
Birr 10,000.00 was Uncollectible since ABC was bankrupted. The entry to record the direct
write off of the receivable would be:
24
February 27, 2002 Uncollectible account expense Br 10,000.00

Account receivable –ABC co. Br 10,000.00
On October 15, 2012 Seman enterprise collected Birr 3,000.00 from ABC Company in
settlement of the account receivable, which was written off on February 27, 2002. In order to
record the collection 1st we have to reinstate the receivable account for the amount collected.
1st to reinstate the account receivable written-off

October 15, 2012 Account receivable – ABC Company Br 3,000.00
Uncollectible account Expense Br 3,000.00
2nd to record the collection
15, 2012 Cash Br 3,000.00
Account Receivable – ABC Company Br 3,000.00
After the fiscal period is over on January 07, 2013, ABC Company paid Birr 5,000.00 in
settlement of the remaining unsettled balance of receivable, which was written off on
February 27, 2012. When collecting account receivable, which was written off in a previous
accounting period, it is recorded by a credit to doubtful account recovered. The doubtful
account recovered account is a miscellaneous revenue item, which is reported in the income
statement as miscellaneous revenue. Therefore the transaction will be:
January 07, 2013 Cash Br 5,000.00

Doubtful Account recovered Br 5,000.00
1. Describe the nature of and the accounting for uncollectible receivables.

------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------
2. If the balance of accounts receivable is $380,000 and the balance of the allowance for
doubtful accounts is $56,000, what is the net realizable value of the receivables?
receivables
------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------
25
3. Record the following transactions in the accounts of Dashen P/c., which uses the
allowance method of accounting for uncollectibles receivables.
Sep. 5- Sold merchandise on account to Hirut Co. Br. 5000
Oct. 20- Received Br. 3000 from, Hirut Co. and Writes-off the remainder owed on the sale of
September 5 as uncollectibles.
Dec. 10- reinstated the account of Hirut Co. that had been written-off on October-20 and
received Br. 2000 cash in full payment.
4. Before the year-end adjustment, Allowance for Doubtful Accounts has a credit balance of
$45,000. Uncollectible accounts are estimated as 2% of credit sales of $1,200,000. The
accounts receivable balance before adjustment is $290,000. What are (1) the uncollectible
expense for the period, (2) the balance of Allowance for Doubtful Accounts after
adjustment, and (3) the net realizable value of the receivables after adjustment?
adjustment
1.8 ACCOUNTING FOR NOTES RECEIVABLE
Notes Receivable is usually recorded in a single note Receivable account to simplify record
keeping. We need only one account because the original notes are kept on file. This means the
maker; rate of interest, due date, and other information can be learned by examining the actual
note.
Illustration
Assume that on Jannuary-10, Leqa Co. sales merchandise on account to Qellam Co. and
receive a Br. 5,000, 90-day, 12% promissory note.
This transaction is recorded as: -

Jan. 10. Notes Receivable ------------------------5000
Sales--------------------------------------5000
The maker of the note usually honors the note and pays it in full. The entry required to record
the receipt of cash by Leqa Co. from Qellam Co. is as follows:
April-10 Cash------------------------------5150
Notes Receivable----------------------------------5000
26
Interest Revenue (500 X 12/100 X 90/360) ----150

Companies can sometimes accept a note for an overdue customer as a way of granting a time
extension on a past-due account Receivable. To illustrate, assume that a 60-day, 10% note
dated September 5, 20x1 is accepted by Awash Co. in settlement of the account of Happy co,
which is past due and has a balance of 10,000. The entry to record the transaction is as
follows:
September 5 Note Receivable ---------------------------------------------10, 000
Account Receivable ----------------------------------------------10,000
 Received a note to settle account
Recording a dishonored note
When a note’s maker is unable or refuses to pay at maturity, the note is dishonored. The act of
dishonoring a note doesn’t relieve the maker of the obligation to pay. The payee should use
every legitimate means to collect. But how do companies report this event? The balance of the
Notes Receivable account normally includes only those notes that have not matured. When a
note is dishonored, we therefore remove the amount of this note from the Notes Receivable
account and charge it back to an Accounts Receivable from its maker. Assume for instance
Leqa Co., holds a Br. 1000, 12%, 30-day note of Ato Alemu. At maturity, Alemu dishonored
the note. Leqa Co. records this dishonoring of its Note Receivable, on Oct. 25, as follows:
Oct.25, Account Receivable-- Ato Alemu --------------- 1010

Note Receivable---------------------------------------1000
Int. Revenue. --------------------------------------------10
 To record dishonored note & interest of 1000 X 12% X 30/360 =10
The above entry records interest of Br. 10, which has been earned, even though the note has
been dishonored.
End-Of-Period interest Adjustment

When notes receivable are outstanding at the end of an accounting period, accrued interest is
computed and recorded. For example, on December 20, 20x1, Leqa Co. accepted a Br. 2000,
60-day, 12% note from a customer in granting an extension of a past-due account. Assuming
27
that the accounting period ends on Dec. 31, the entries to record the receipt of the note,
accrued interest, and payment of the note at maturity are shown below: -
Dec. 19. Note Receivable -------------------------------------2000

A/R- customer-X ---------------------------------------2000
 Received note in settlement of A\R
Dec. 31. Interest Receivable-------------------------8

Int. Revenue------------------------------------8
 Adjusting entry for accrued Interest, Br. 2000 X 12% X 12/360 = 8
Feb. 17. Cash----------------------------------2040

N/R---------------------------------------------2000
Int. Receivable. ----------------------------------8
Int. Revenue-------------------------------------32
 Received pyt of note & interest at maturity
The adjusting entry above on Dec. 31, 20X1, was required to show the interest earned for the
period on the Income Statement.
Characteristics of Notes Receivable
A claim supported by a note has some advantages over a claim in the form of an Account
Receivable. By signing a note, the debtor recognizes the debt and agrees to pay according to
the terms listed. A note is therefore a strong legal claim if there is a court action.
A promissory note is a written promise to pay a sum of money on demand or at a definite

time. It is payable to the order of a person or firm or to the bearer or holder of the note. The
person or firm that makes the promise signs it. The one to whose order the note is payable is
called the payee,
payee, and the one making the promise is called the maker.
maker.
Notes have several characteristics that affect how they are recorded and reported in the
financial statements. The characteristics are described in the following paragraphs: -
28
 Due Date
The date a note is to be paid is called the Due Date or Maturity date.
date. The period of time
between the issuance date and the due date of a short-term note may be stated in either days or
months. When the term on a note is expressed in days, the maturity date is the specified
number of days after the note’s date. As an example, a five-day note dated January-1 matures
and is due on Jannuary-6. A 90-day notes dated March-10, matures on Jun-8. This due date,
June-8, is computed as below: -
Term of the Note--------------------------------------------90

Days in March---------------------------31
Minus the date of the note-------------10
Days remaining in March------------------------21
Add days in April---------------------------------30
Add days in May----------------------------------31
May----------------------------------31
82
Number of days remaining to equal 90-days
(90 – 82 = 8)------------------------------------------------8
Therefore, Due date is June-8.
The period of a note is sometimes expressed in months. When months are used, the note
matures and is payable in the month of its maturity on the same date of the month as its
original date
A three-month note dated March-10, for instance, is payable on June-10.
 Interest Computation
Interest is the cost of borrowing money for the borrower. It is the profit from lending money
for the lender. The interest rate on notes is normally stated in terms of per year, regardless of
the actual period of time involved.
The formula for computing interest is as follows: -
29
Interest = Principal X Annual X Time

(Face Amount interest Rate
of the Note)
To illustrate the formula, the interest on a Br. 10,000, 12%, 60 day note is computed as:-
Br. 10,000 X 12% X 60/360 = 200
N.B. To simplify interest computations for notes with periods expressed in days, it is common
to treat a year as having 360 days.
 Maturity Value
The amount that is due at the maturity or due date is called the maturity value. The maturity
value of a note is the sum of the face amount and the interest. In the above example, the
maturity value is Br. 10,200 (which is Br. 10,000 face amount plus Br. 200 interest)
Where MV= Maturity value
i.e. MV = FV + I FV = Face value
I = Interest
1.9. FACTORING RECEIVABLES
Companies often sell their receivables to other companies. This transaction is called factoring
the receivables, and the buyer of the receivables is called a factor.
factor. An advantage of factoring
is that the company selling its receivables receives immediate cash for operating and other
needs. In addition, depending upon the factoring agreement, some of the risk of uncollectible
accounts may be shifted to the factor.
Converting receivable is usually done either (1) by selling them, or (2) by using them as
security for a loan. The topic of using notes as security for a loan will be discussed in future
courses. Notes Receivable can be converted to cash by discounting them at a financial
institution such as a Bank. The process has three steps as indicated in the following diagram.
In the first step, the maker receives goods, service or cash from the payee in exchange for the
note. In the second step, the payee discounts the note with a bank and receives the maturity
30
value of the note less a discount (a fee) charged by the bank. In the third step, the maker pays
the bank at the maturity of the note.
Maker Goods (1) Payee
Note (2)
Cash (3) cash less discount
Bank
Note (2)
Notes Receivable are discounted with or without recourse.

recourse. When a note is discounted without
recourse, the bank assumes the risk of a bad debt loss and the original payee doesn’t have a
contingent liability. A contingent liability is an obligation to make a future payment if and
only if an uncertain future event occurs. A note discounted without recourse is like an outright
sale of an asset. If a note is discounted with recourse and the original maker of the note fails
to pay the bank when it matures, the payee of the note must pay for it. This means a company
discounting a note (an endorser) with recourse has a contingent liability until the bank is paid.
A Co. should disclose contingent liabilities in the accompanying notes to its financial
statements.
To illustrate, assume that a 90-day, 12%, Br. 20,000 N/R from Ilfu Co. dated Jan.1, 20x2 is
discounted at the payee’s bank on February 12, 20x2 at the discount rate of 15%. The steps to
determine the proceeds (-the amount to be received by the payee from the bank upon
discounting) are as follows:
31
Step 1 – Determine the maturity date & maturity value.
MD = April –1 & MV = FV + I = 20,000 + [20,000 X 12% X 90/360]
= 20,600
Step 2 – Determine the Bank Discount (Bank

(Bank discount is an interest that is charged by
the bank and is computed based on the maturity value of the note for the discount
period. Discount Period is the time the bank must hold the note) before it becomes
due.
 Bank Discount = MV X DR X DP where MV = Maturity value ( 20,600)
DR = Discount Rate (15%)
DP= Discount period (from Feb.12
to April 1)
Discount = 20,600 X 15% X 48/360
= 412
Step 3-
3- Determine proceed (proceed is the amount of cash paid to the endorser after
deducting discount)
i.e. proceed = MV – D
= 20,600 – 412 = 20188
Step 4 – Record the necessary journal entry at the date of discount. (Here, record interest
revenue which is the excess of proceeds from the face value or record interest
expense when the proceed is less than the face value of the note)
Feb 12. Cash---------------------------------20,188

N/R -----------------------------------------20,000
I. Rev. --------------------------------------188.00
Discounted Br. 20,000, 90-day, 12% note at 15%
The length of the discount period and the difference between the interest rate and the discount
rate determine whether interest expense or interest revenue will result from discounting.
32
When a discounted Notes Receivable is dishonored, the bank notifies the endorser and asks
for payment if there is no statement that limits the responsibility of the endorser. In some
cases, the bank may charge a protest fee of notifying the endorser that a note has been
dishonored. The entire amount paid to the bank by the endorser, including the interest and
protest fee, should be debited to the A/R of the maker.
Example: Assume that the maker, Ilfu Co, dishonored the above discounted note at maturity.
The bank charges a protest fee of Br. 25. The endorser’s entry to record the payment to the
bank is as follows:
April 2. Account Receivable- Ilfu Co----------------- 20,625

Cash-----------------------------------20, 625
Paid dishonored, discounted note
1.Chilallo Co. issued a 60-day, 12% note for Br. 40,000, dated February-12, to Garra Muleta
Co. an account.
a. Determine the due date of the note

b. Determine the maturity value of the note
c. Present entries required to record the following
 Receipt of the note by the payee.
 Receipt by payee of payment of the note at maturity.
2.. Record the following transaction in the account of Axumite Co.
May-1. Received a Br. 15,000, 60-day, 12% note from Adama Co. on account.
May-21. Discounted the note at Mekele Bank at 14%
June-30. The note is dishonored, paid the bank the amount due on the note plus a
protest fee of Br. 30.
July-20. Received the amount due on the dishonored note plus interest for 20-days, at
12% on the amount charged to Adama Co. on April-30.
33
1.10. PRESENTATION OF CASH AND RECEIVABLES ON THE BALANCE

SHEET
Cash On the Balance Sheet
Cash is the most liquid asset, and therefore it is listed as the first asset in the Current Assets
section of the balance sheet. Most companies present only a single cash amount on the
balance sheet by combining all their bank and cash fund accounts. A company may have cash
in excess of its operating needs. In such cases, the company normally invests in highly liquid
investments in order to earn interest.
interest These investments are called cash equivalents.
equivalents.
Examples of cash equivalents include U.S. Treasury Bills, notes issued by major corporations
(referred to as commercial paper), and money market funds. Companies that have invested
excess cash in cash equivalents usually report Cash and cash equivalents as one amount on the
balance sheet. Banks may require depositors to maintain minimum cash balances in their bank
accounts. Such a balance is called a compensating balance.
balance. This requirement is often
imposed by the bank as a part of a loan agreement or line of credit. A line of credit is a
preapproved amount the bank is willing to lend to a customer upon request. Compensating
balance requirements should be disclosed in notes to the financial statements. An example of
the presentation of Cash is shown in the partial balance sheet for Koortu Co. as of June 30,
2012 as follows.
Balance Sheet
June 30, 2002
(In millions)
Assets
Current assets:
Cash and equivalents $ 3,016
Short-term investments 35,636
Total cash and short-term investments $38,652
Receivables on the Balance Sheet
34
All receivables that are expected to be realized in cash within a year are presented in the
Current Assets section of the balance sheet. It is normal to list the assets in the order of their
liquidity. This is the order in which they are expected to be converted to cash during normal
operations. An example of the presentation of receivables is shown in the partial balance sheet
for Hibretfree Co. as follows.
Hibretree Co.
Balance Sheet
December 31, 2011
Assets
Current assets:
Cash$ 119, 500.00
Notes receivable 250, 000.00
Accounts receivable 445, 000.00
Less allowance for doubtful accounts 15,000.00 430,000.00
Interest receivable $14,500.00
The balance of Hibretfree’s notes receivable, accounts receivable, and interest receivable
accounts are reported on balance sheet above. The allowance for doubtful accounts is
subtracted from the accounts receivable. Alternatively, the accounts receivable may be listed
on the balance sheet at its net realizable value of $430,000, with a note showing the amount of
the allowance. If the allowance account includes provisions for doubtful notes as well as
accounts, it should be deducted from the total of Notes Receivable and Accounts Receivable.
Other disclosures related to receivables are presented either on the face of the financial
statements or in the accompanying notes. Such disclosures include the market (fair) value of
the receivables.6 In addition, if unusual credit risks exist within the receivables, the nature of
35
the risks should be disclosed. For example, if the majority of the receivables are due from one
customer or are due from customers located in one area of the country or one industry, these
facts should be disclosed
SUMMARY
1. Cash includes only those items immediately available to pay obligations.

2. The objectives of cash management are accurate accounting for cash transactions, the
prevention of losses through theft or fraud, and maintaining adequate cash balances.
3. The bank reconciliation adjusts the cash balance per book and the cash balance per bank
statement for any unrecorded items such as outstanding checks and bank service charges.
4. Bank reconciliation produces the correct amount of cash to be included in the balance
sheet at the end of the month.
5. A company may use a petty cash fund to make small payments that occur frequently, as
payment by check would cause delay and excessive expense of maintaining records.
6. One of the best systems for establishing control of cash payments is the use of a voucher
system. A voucher system uses vouchers, a voucher register, a file for unpaid vouchers, a
check register and a file for paid vouchers.
7. Receivables are money claims against other entities, including people, business firms and
other organizations. These receivables as other assets of the business organization need to
be properly handled otherwise they might be exposed for different type of error and fraud.
8. Based on the nature of the account, there are different accountings treatments required for
recording transactions made on credit and for the related risk of uncollectibles that arise
when customers default to make payment according to their agreement. The common
methods used to treat uncollectibles accounts in the book of the payee are the allowance
method and the direct-write-off method.
9. If a company selects the allowance method to treat uncollectibles, estimation is required
either based on sales or analysis of receivables.
1.11 ANSWER TO CHECK YOUR PROGRESS EXERCISES
36
1. Cash includes all the items that are accepted for deposit by a bank, notably paper
money and coins, money orders, and checks.
2. a) Post-dated checks
b) Postage stamps
1. The basic purpose of a bank reconciliation is to achieve the control inherent in the
maintenance of two independent records of cash transactions; one record maintained
by the depositor and the other by the bank. When these two records are reconciled
(brought into agreement), we gain assurance of a correct accounting for cash
transactions.
2. a) Checks issued that have not been paid by the bank.
b) Deposits not recorded by the bank.
c) A customer’s check which was deposited but returned because of a lack of funds in
the account on which the check was drawn (in the customer’s bank account).
3. d) Note collected by bank

e) Bank service charge
4. The error of $2,700 would be added to the cash balance according to the
bank
bank statement
1. Cash is credited for $180

2. Yes. To record the unrecorded expenditures of Br. 40 at least by the end of the fiscal
period
3. a) According to the earliest date
b) In numerical order
4. In miscellaneous revenue section of Income statement

37
1. The term receivables includes all money claims against other entities, including
people, business firms, and other organizations. They are normally classified as
accounts receivable, notes receivable, or other receivables.
2. Account Receivable is classified as current asset because it is normally expected to be
collected within a relatively short period or time.
3. Segregation of duties for related activities is required in order to decrease the
possibility of inefficiency, error and fraud.
The two methods of accounting for uncollectible receivables are the allowance method and
the direct write-off method. The allowance method provides in advance for uncollectible
receivables. The direct write-off method recognizes the expense only when the account is
judged to be uncollectible
1. $324,000 ($380,000 _ $56,000)
2.
Sep. 5 A/R-Hirut Co. 5000
Sale 5000
Oct.20 Cash 3000

A/R-Hiruit Co. 3000
Allowance for Doubtful account 2000
A/R-Hirut Co. 2000
Dec. 10 A/R-Hiruit Co. 2000

Allowance for D.a/c 2000
Cash 2000
A/R Hiruit Co. 2000
3. (1) $24,000 (2% _ $1,200,000);
(2) $69,000 ($24,000 _ $45,000); and
(3) $221,000 ($290,000 _ $69,000)
38
a. April-13
b. Br. 40,800 MV = FV + I = [40,000 + (40,000 X 12/100 X 60/360 )]
c. 1- Notes Receivables----------------40,000
A/R- Garra Muleta Co.----------------40,000
2- Cash-----------------------40,800
N/R------------------------------40,000
Interest Revenue-------------------800
1.
May-1. Note Receivable 15,000
A/R-Adama Co. 15, 000
May-21. Cash (15300 – 238) 15062

N/R 15,000
Interest Revenue 62
June-30. A/R-Adama Co. (15300 + 30) 15330

Cash 15330
July-20. Cash 15432.20
A/R-Adama Co. 15,330
Interest Revenue (15330 x 12/100 x 20/360) 102.20
MODEL EXAMINATION QUESTIONS
Part I. Short answer questions
1. In general terms, in which section does cash, appear on the balance sheet?
2. Explain some measures that strengthen internal control over cash receipts and payments.
3. What is the basic control feature in a voucher system?
39
4. List two items often encountered in reconciling a bank account that may cause cash per the
bank statement to be larger than the balance of cash shown in the depositor’s accounting
records.
Part II. Work Out Questions
1. Shown below is the information needed to prepare a bank reconciliation for MITE
company at December 31.
a) At December 31, cash per the bank statement was $ 15,981; cash per the
company’s records was $ 17,445.
b) Two-debit memorandum accompanied the bank statement: service charges for
December of $ 24, and a $ 600 check drawn by FACTI marked ‘NSF’.
c) Cash receipts of $ 4,353 on December 31 were not deposited until January.
d) The following checks had been issued in December but were not included
among the paid checks returned by the bank: no. 620 for $ 978, no. 630 for $
2,052, and no. 641 for $ 483.
Required:
i) Prepare bank reconciliation at December 31
ii) Prepare the necessary journal entry or entries to update the accounting records
based on the reconciliation.
2. FACT Company maintains its checking account with the Commercial Bank. The company
is ready to prepare its December 31 bank reconciliation. The following data are available:
a) The November 30 bank reconciliation showed the following:
1) Cash on hand (held by FACT company for day to day minor
expenses), Br. 400 (included in FACT’s cash account)
2) Deposit in transit, Br. 2,000, and
3) Checks outstanding: N0. 121 Br. 1,000
No. 130 2,000
No. 142 3,000
b) Bank Statement, December 31:
40
 Balance, December 31 Br. 67,600

 Deposits: 188,500
 Checks: No. 130, Br. 2,000; N0. 142, Br. 3,000;
N0. 143 – 176, Br. 191,000 (196,000)
 Note collected for FACT company (including

Br. 720 interest) 16,720
 NSF check, customer Binda (250)

 Bank service charges (20)
 Balance, December 31 Br. 76,550
Required:
i) Determine deposit in transit and checks outstanding

ii) Prepare the December 31 Bank reconciliation
iii) Based on your bank reconciliation, give all journal entries that should be made at
December 31.
3. Prepare journal entries to record the following transactions entered in to by Meskel

Company during the year 20X2.
September 1- Received a Br. 10,000, 12%, 60-day note from Yasin Co. as full
settlement of his open account.
October 20- Sold merchandise on account to Heaven Co. for B.r 25,000 by receiving a
90-day, 10% note.
October 31- Received full payment from Yasin Co. for notes received on September 1.
December 31- Record the adjusting entry required for accrued interest from October 20.
Transaction. (assume that the Accounting period ends on December 31.)
4. Nazareth cosmetics Co. is undecided about which base to use in estimating uncollectibles
accounts. On December 31, 20X2, the balance in Account Receivable was Br. 800,000
and net credit sales amounted to Br. 1,500,000 during 20X2. An aging analysis of the
account receivable indicated that Br. 12,000 in accounts receivable are expected to be
41
uncollectible. Past experience has shown that about ½ of 1% of net credit sales eventually
are uncollectibles.
Prepare the adjusting entries to record estimated bad debt expense using the
a. Percentage of sales basis, and

b. The percentage of receivable basis under each of the following independent
assumptions
i. Allowance for Doubtful Accounts has a credit balance of Br. 2000
before adjustment.
ii. Allowance for Doubtful Account has a debit balance of Br. 600 before
adjustment
5. The Lasta Co. uses the allowance method for estimating uncollectibles accounts. Prepare
journal entries to record the following transactions.
January 02- Sold merchandise to Leqa Co. for Br. 30,000, term n/15.
February 15- Received Br. 20,000 from Leqa Co. on account.
April 20- Written-off as uncollectible the remaining balance of Leqa Co. account when the
business declared bankruptcy.
June 1- unexpectedly received a check for Br. 6000 from Leqa Co.
6. Compute the missing amounts for each of the following notes.

Principal Interest Rate Time Total Interest
(a) Br. 60,000 10 % 1.5 years ?
(b) Br. 200,000 ? 9 months Br. 17,250
(c) ? 12 % 60 days Br. 1,500
(d) Br. 85,000 7% ? 1,487.50
7. Meskerem Co. holds a 90-day, 10% note for Br. 100,000 dated June-12, that was received
from a customer on account. On June 30, the note is discounted at Borena Bank at the rate of
12.5 %.
42
a) Determine the maturity value of the note.

b) Determine the number of days in the discount period
c) Determine the amount of the discount.
d) Determine the amount of the proceeds
e) Present the journal entry required to record the discounting of the note on June 30.
UNIT TWO: INVENTORIES

Contents:
2.0 Aims and Objectives
2.1 Introduction
2.2 Internal control of Inventories
2.3 The effects of inventory errors on the financial statements
2.4 Inventory cost flow assumptions
2.5 Inventory costing methods under a perpetual and periodic inventory system
2.7 Valuation of inventory at other than cost
2.7 Estimating inventory costs
2.8 Presentation of merchandise inventory on the balance sheet
2.9 Summary
2.10 Answers to check your progress
2.11 Model examination questions
43
2.0 AIMS AND OBJECTIVES
The unit discusses the meaning, internal control over inventory, and effects of inventory
errors on financial statements. It also discusses the inventory costing methods and estimating
inventory costs. After studying this unit, you will be able to:
 Summarize and provide examples of internal control procedures that apply to
inventories.
 Describe the effect of inventory errors on the financial statements.
 Describe three inventory cost flow assumptions and how they impact the income
statement and balance sheet.
 Compute the cost of inventory under the perpetual inventory system, using the following
costing methods: first-in, first-out; last-in, first-out; and average cost.
 Compute the cost of inventory under the periodic inventory system, using the following
costing methods: first-in, first out; last-in, first-out; and average cost.
 Compare and contrast the use of the three inventory costing methods.
 Compute the proper valuation of inventory at other than cost, using the lower-of-cost-or-
market and net realizable value concepts.
 Prepare a balance sheet presentation of merchandise inventory.
 Estimate the cost of inventory, using the retail method and the gross profit method
2.1 INTRODUCTION
Inventory is any form of asset item held for sale in the ordinary course of business or goods
that will be used in the production of goods to be sold. They are mainly divided into two
major categories:
 Inventories of manufacturing businesses.
 Inventories of merchandising businesses.
a) Inventories of manufacturing businesses: - manufacturing businesses are
businesses that produce physical output. They normally have three types of
inventories. namely:
 Raw material inventory
 Work in process inventory
44
 Finished goods inventory

Raw material inventory -is the cost assigned to goods and materials on hand but not yet
placed into production. Raw materials include the wood to make a chair or other office
furniture’s, the steel to make a car etc.
Work in process inventory-

inventory- is the cost of raw material on which production has been started
but not completed, plus the direct labor cost applied specifically to this material and allocated
manufacturing overhead costs.
Finished goods inventory- is the cost identified with the completed but unsold units on hand
at the end of each period.
b) Inventories of merchandising businesses are merchandise purchased for resale in

the normal course of business. These types of inventories are called merchandise
inventories and the unit focuses on it.
2.2 INTERNAL CONTROL OF INVENTORIES
The cost of inventory is a significant item in many businesses’ financial statements. What do
we mean by the term inventory? Inventory is used to indicate (1) merchandise held for sale in
the normal course of business and (2) materials in the process of production or held for
production. In this chapter, we focus primarily on inventory of merchandise purchased for
resale. What costs should be included in inventory? the cost of merchandise is its purchase
price, less any purchases discounts. These costs are usually the largest portion of the
inventory cost. Merchandise inventory also includes other costs, such as transportation,
import duties, and insurance against losses in transit. Not only must the cost inventory be
determined, but good internal control over inventory must also be maintained. Two primary
objectives of internal control over inventory are safeguarding the inventory and properly
reporting it in the financial statements. These internal controls can be either preventive or
detective in nature.
 A preventive control is designed to prevent errors or misstatements from occurring.

 A detective control is designed to detect an error or misstatement after it has
occurred. Control over inventory should begin as soon as the inventory is received.
45
Pre-numbered receiving reports should be completed by the company’s receiving

department in order to establish the initial accountability for the inventory. To make
sure the inventory received is what was ordered, each receiving report should agree
with the company’s original purchase order for the merchandise. Likewise, the price at
which the inventory was ordered, as shown on the purchase order, should be compared
to the price at which the vendor billed the company, as shown on the vendor’s invoice.
After the receiving report, purchase order, and vendor’s invoice have been reconciled,
the company should record the inventory and related account payable in the
accounting records; as:-
Inventory ----------------------------xxx
A/payable----------------------------xxx
Controls for safeguarding inventory include developing and using security measures to
prevent inventory damage or employee theft. For example, inventory should be stored in a
warehouse or other area to which access is restricted to authorized employees, only. The
removal of merchandise from the warehouse should be controlled by using requisition forms,
which should be properly authorized. The storage area should also be climate controlled to
prevent damage from heat or cold. Further, when the business is not operating or is not open,
the storage area should be locked.
When shopping, you may have noticed how retail stores protect inventory from customer
theft. Retail stores often use such devices as two-way mirrors, cameras, and security guards.
High priced items are often displayed in locked cabinets. Retail clothing stores often place
plastic alarm tags on valuable items such as leather coats. Sensors at the exit doors set off
alarms if the tags have not been removed by the clerk. These controls are designed to prevent
customers from shoplifting.
Using a perpetual inventory system for merchandise also provides an effective means of
control over inventory. The amount of each type of merchandise is always readily available in
a subsidiary inventory ledger.
ledger. In addition, the subsidiary ledger can be an aid in maintaining
inventory quantities at proper levels. Frequently comparing balances with predetermined
minimum and maximum levels allows for timely reordering and prevents ordering excess
inventory.
46
To ensure the accuracy of the amount of inventory reported in the financial statements, a
merchandising business should take a physical inventory (i.e., count the merchandise). In a
perpetual inventory system, the physical inventory is compared to the recorded inventory in
order to determine the amount of shrinkage or shortage. If the inventory shrinkage is
unusually large, management can investigate further and take any necessary corrective action.
Knowledge that a physical inventory will be taken also helps prevent employee thefts or
misuses of inventory. How does a business “take” a physical inventory? The first step in this
process is to determine the quantity of each kind of merchandise owned by the business. A
common practice is to use teams of two persons. One person determines the quantity, and the
other lists the quantity and description on inventory count sheets. Quantities of high-cost
items are usually verified by supervisors or a second count team.
What merchandise should be included in inventory? All the merchandise owned by the
business on the inventory date should be included. For merchandise in transit, the party (the
seller or the buyer) who has title to the merchandise on the inventory date is the owner. To
determine who has title, it may be necessary to examine purchases and sales invoices of the
last few days of the current period and the first few days of the following period. As we
discussed in an earlier chapter, shipping terms determine when title passes. When goods are
purchased or sold FOB shipping point, title passes to the buyer when the goods are shipped.
When the terms are FOB destination, title passes to the buyer when the goods are delivered.
To illustrate, assume that Keraj Co. orders birr 25,000 of merchandise on December 28, 2010.
The merchandise is shipped FOB shipping point by the seller on December 30 and arrives at
Keraj Co.’s warehouse on January 4, 2011. As a result, the merchandise is not counted by the
inventory crew on December 31, the end of Keraj Co.’s fiscal year. However, the birr 25,000
of merchandise should be included in Keraj’s inventory because title has passed. Keraj Co.
should record the merchandise in transit on December 31, debiting Merchandise Inventory
and crediting Accounts Payable for birr 25,000. Manufacturers sometimes ship merchandise
to retailers who act as the manufacturer’s agent when selling the merchandise. The
manufacturer retains title until the goods are sold. Such merchandise is said to be shipped on
consignment to the retailers. The unsold merchandise is a part of the manufacturer’s
47
(consignor’s) inventory, even though the merchandise is in the hands of the retailers. The
consigned merchandise should not be included in the retailer’s (consignee’s) inventory.
2.3 THE EFFECTS OF INVENTORY ERRORS ON THE FINANTIAL

STATEMENTS
Any errors in the inventory count will affect both the balance sheet and the income statement.
For example, an error in the physical inventory will misstate the ending inventory, current
assets, and total assets on the balance sheet. This is because the physical inventory is the basis
for recording the adjusting entry for inventory shrinkage. Also, an error in taking the physical
inventory misstates the cost of goods sold, gross profit, and net income on the income
statement. In addition, because net income is closed to the owner’s equity at the end of the
period, owner’s equity will also be misstated on the balance sheet. This misstatement of
owner’s equity will equal the misstatement of the ending inventory, current assets, and total
assets. To illustrate, assume that in taking the physical inventory on December 31, 2010,
Keraj Company incorrectly recorded its physical inventory as birr 115,000 instead of the
correct amount of birr 125,000. As a result, the merchandise inventory, current assets, and
total assets reported on the December 31, 2010 balance sheet would be understated by birr
10,000 (birr 125,000 _ birr 115,000). Because the ending physical inventory is understated,
the inventory shrinkage and the cost of merchandise sold will be overstated by birr 10,000.
Thus, the gross profit and the net income for the year will be understated by birr 10,000. Since
the net income is closed to owner’s equity at the end of the period, the owner’s equity on the
December 31, 2010 balance sheet will also be understated by birr 10,000. The effects on
Keraj Company’s financial statements are summarized as follows:
Amount of
Misstatement
Balance Sheet:
Sheet:
Merchandise inventory understated br (10,000)
Current assets understated (10,000)
Total assets understated (10,000)
Owner’s equity understated (10,000)
Income Statement:
48
Cost of merchandise sold overstated br 10,000

Gross profit understated (10,000)
Net income understated (10,000)
Now assume that in the preceding example the physical inventory had been overstated on
December 31, 2010, by br 10,000. That is, Keraj Company erroneously recorded its inventory
as br 135,000. In this case, the effects on the balance sheet and income statement would be
just the opposite of those indicated above. Errors in the physical inventory are normally
detected in the period after they occur. In such cases, the financial statements of the prior year
must be corrected.
If the inventory shrinkage at the end of the year is overstated by br 7,500, the error will cause
an:
-----------------------------------------------------------------------------------------------------------------
------------
A. understatement of cost of merchandise sold for the year by br7,500.

B. overstatement of gross profit for the year by Br 7,500.
C. overstatement of merchandise inventory for the year by br 7,500.
D. understatement of net income for the year by 7,500.
2.4 INVENTORY COST FLOW ASSUMPTIONS
A major accounting issue arises when identical units of merchandise are acquired at different
unit costs during a period. In such cases, when an item is sold, it is necessary to determine its
unit cost so that the proper accounting entry can be recorded. To illustrate, assume that three
identical units of Item CC are purchased during May, as shown below:
Item CC Units Cost

May 10 Purchase 1 br 9
18 Purchase 1 13
49
24 Purchase 1 14
Total 3 br 36
Average cost per unit br 12
Assume that one unit is sold on May 30 for br 20. If this unit can be identified with a specific
purchase, the specific identification method can be used to determine the cost of the unit sold.
For example, if the unit sold was purchased on May 18, the cost assigned to the unit is br 13
and the gross profit is br 7 (br 20 _ br 13). If, however, the unit sold was purchased on May
10, the cost assigned to the unit is br 9 and the gross profit is br 11 (br20 _ br9).
The specific identification method is not practical unless each unit can be identified
accurately. An automobile dealer, for example, may be able to use this method, since each
automobile has a unique serial number. For many businesses, however, identical units cannot
be separately identified, and a cost flow must be assumed. That is, which units have been sold
and which units are still in inventory must be assumed. There are three common cost flow
assumptions used in business. Each of these assumptions is identified with an inventory
costing method, as shown below:-
Cost Flow Assumption Inventory Costing Method
 Cost flow is in the order : First-in, first-out (FIFO)

in which the costs were incurred.
 Cost flow is in the reverse : Last-in, first-out (LIFO)
order in which the costs were incurred.
 Cost flow is an average of the costs. : Average cost
2.5. INVENTORY COSTING METHODS UNDER A PERPETUAL &

PERIODIC INVENTORY SYSTEM
One of the most important decisions in accounting for inventory is determining the per unit
costs assigned to inventory items. When all units are purchased at the same unit cost, this
process is simple since the same unit cost is applied to determine the cost of goods sold and
ending inventory. But when identical items are purchased at different costs, a question arises
50
as to what amounts are included in the cost of merchandise sold and what amounts remain in
inventory. In this topic we will give look at the perpetual and periodic inventory system one
after the other.
2.5.1. A Perpetual Inventory System :- In a perpetual inventory system, as we
discussed in a previous chapter, all merchandise increases and decreases are
recorded in a manner similar to recording increases and decreases in cash. The
merchandise inventory account at the beginning of an accounting period
indicates the merchandise in stock on that date. Purchases are recorded by
debiting Merchandise Inventory and crediting Cash or Accounts Payable. On the
date of each sale, the cost of the merchandise sold is recorded by debiting Cost of
Merchandise Sold and crediting Merchandise Inventory. As we illustrated in the
preceding section, when identical units of an item are purchased at different unit
costs during a period, a cost flow must be assumed. In such cases, the FIFO, LIFO,
or average cost method is used. We illustrate each of these methods, using the
data for Item CB1, shown below.
Item CB1 Units Cost
Jan. 1 Inventory 10 br 20
4 Sale 7
10 Purchase 8 21
22 Sale 4
28 Sale 2
30 Purchase 10 22
First-In, First-Out Method:-
51
Most businesses dispose of goods in the order in which the goods are purchased. This
would be especially true of perishables and goods whose styles or models often change.
For example, grocery stores shelve their milk products by expiration dates. Likewise,
men’s and women’s clothing stores display clothes by season. At the end of a season, they
often have sales to clear their stores of off-season or out-of-style clothing. Thus, the FIFO
method is often consistent with the physical flow or movement of merchandise. To the
extent that this is the case, the FIFO method provides results that are about the same as
those obtained by identifying the specific costs of each item sold and in inventory. When
the FIFO method of costing inventory is used, costs are included in the cost of
merchandise sold in the order in which they were incurred. To illustrate, the following
table 2.1 shows the journal entries for purchases and sales and the inventory subsidiary
ledger account for Item CB1. The number of units in inventory after each transaction,
together with total costs and unit costs, are shown in the account. We assume that the units
are sold for Br 30 each on account.
Table 2.1: Perpetual Inventory Account (FIFO)
ITEM CB1
Purchase Cost of merchandise sold Inventory

Date Quantity Unit Total Quantity Unit Total Quantity Unit Total
cost cost cost cost cost cost
Jan. 1 10 20 200
4 7 20 140 3 20 60
52
10 8 21 168 3 20 60
8 21 168
22 3 20 60
1 21 21 7 21 147
28 2 21 42 5 21 105
30 10 22 220 5 21 105
10 22 220
The journal entries:
Jan. 4 Accounts Receivable 210

Sales 210
4 Cost of Merchandise Sold 140
Merchandise Inventory 140
10 Merchandise Inventory 168
Accounts Payable 168
22 Accounts Receivable 120
Sales 120
Sales 60

You should note that after the 7 units were sold on January 4, there was an inventory of 3
units at br 20 each. The 8 units purchased on January 10 were acquired at a unit cost of br 21,
instead of br 20. Therefore, the inventory after the January 10 purchase is reported on two
lines, 3 units at br 20 each and 8 units at br 21 each. Next, note that the br 81 cost of the 4
53
units sold on January 22 is made up of the remaining 3 units at br 20 each and 1 unit at br 21.
At this point, 7 units are in inventory at a cost of br21 per unit.
Last-In, First-Out Method:-
When the lifo method is used in a perpetual inventory system, the cost of the units sold is the
cost of the most recent purchases. To illustrate, table 2.2 shows the journal entries for
purchases and sales and the subsidiary ledger account for Item 127B, prepared on a lifo basis.
Table 2.2 : Perpetual inventory accounting LIFO
ITEM CB1
Purchase Cost of merchandise sold Inventory
cost cost cost cost cost cost
Jan. 1 10 20 200
4 7 20 140 3 20 60
10 8 21 168 3 20 60
8 21 168
22 4 21 84 3 20 60
4 21 84
28 2 21 42 3 20 60
2 21 42
30 10 22 220 3 20 60
2 21 42
10 22 220
The journal entries-under LIFO
Jan. 4 Accounts Receivable 210

Sales 210
54


Sales 120

Sales 60


If you compare the ledger accounts for the FIFO perpetual system and the LIFO perpetual
system, you should discover that the accounts are the same through the January 10 purchase.
Using LIFO, however, the cost of the 4 units sold on January 22 is the cost of the units from
the January 10 purchase (br21 per unit). The cost of the 7 units in inventory after the sale on
January 22 is the cost of the 3 units remaining from the beginning inventory and the cost of
the 4 units remaining from the January 10 purchase.
When the LIFO method is used, the inventory ledger is sometimes maintained in units only.
The units are converted to dollars when the financial statements are prepared at the end of the
period.
The following units of a particular item were purchased and sold during the period:
55
Beginning inventory 40 units at br 20

First purchase 50 units at br 21
Second purchase 50 units at br 22
First sale 110 units
Third purchase 50 units at br 23
Second sale 45 units
What is the cost of the 35 units on hand at the end of the period as determined under the
perpetual inventory system by the LIFO costing method?
A.br 715 B. br 705 C. br 700 D. br 805
Average Cost Method: - When the average cost method is used in a perpetual inventory
system, an average unit cost for each type of item is computed each time a purchase is made.
This unit cost is then used to determine the cost of each sale until another purchase is made
and a new average is computed. This averaging technique is called a moving average. Since
the average cost method is rarely used in a perpetual inventory system, we do not illustrate it
in this unit.
2.5.2 A Periodic inventory system: - When the periodic inventory system is used, only
revenue is recorded each time a sale is made. No entry is made at the time of the sale to record
the cost of the merchandise sold. At the end of the accounting period, a physical inventory is
taken to determine the cost of the inventory and the cost of the merchandise sold. Like the
perpetual inventory system, a cost flow assumption must be made when identical units are
acquired at different unit costs during a period. In such cases, the FIFO, LIFO, or average cost
method is used.
First-In, First-Out Method: - To illustrate the use of the FIFO method in a periodic inventory
system, we assume the following data:
Jan. 1 Inventory: 200 units at br 9 br 1,800

Mar. 10 Purchase: 300 units 10 3,000
Sept. 21 Purchase: 400 units 11 4,400
Nov. 18 Purchase: 100 units 12 1,200
56
Available for sale during year 1,000 br10, 400
The physical count on December 31 shows that 300 units have not been sold. Using the FIFO
method, the cost of the 700 units sold is determined as follows:
Earliest costs, Jan. 1: 200 units at br 9 br1,800

Next earliest costs, Mar. 10: 300 units 10 3,000
Next earliest costs, Sept. 21: 200 units 11 2,200
Cost of merchandise sold: 700 br7,000
The following units of a particular item were available for sale during the period:
Beginning inventory 40 units at br 20

First purchase 50 units br 21
Second purchase 50 units br22
Third purchase 50 units br 23
What is the unit cost of the 35 units on hand at the end of the period as determined under the
periodic inventory system by the fifo costing method?
A. br 20 B. br 21 C. br 22 D. br 23
Last-In, First-Out Method:- When the LIFO method is used, the cost of merchandise sold is
made up of the most recent costs. Based on the data in the FIFO example, the cost of the 700
units of inventory is determined as follows:
Most recent costs, Nov. 18: 100 units at br12 br1,200

Next most recent costs, Sept. 21: 400 units 11 4,400
Next most recent costs, Mar. 10: 200 units 10 2,000
Cost of merchandise sold: 700 br7,600
57
Deducting the cost of merchandise sold of br7,600 from the br10,400 of merchandise
available for sale yields br2,800 as the cost of the inventory at December 31. The br2,800
inventory is made up of the earliest costs incurred for this item.
Average Cost Method:- The average cost method is sometimes called the weighted average
method.
method. When this method is used, costs are matched against revenue according to an
average of the unit costs of the goods sold. The same weighted average unit costs are used in
determining the cost of the merchandise inventory at the end of the period. For businesses in
which merchandise sales may be made up of various purchases of identical units, the average
method approximates the physical flow of goods.
The weighted average unit cost is determined by dividing the total cost of the units of each
item available for sale during the period by the related number of units of that item. Using the
same cost data as in the FIFO and LIFO examples, the average cost of the 1,000 units, $10.40,
and the cost of the 700 units, $7,280, are determined as follows:
Average unit cost: br10, 400/1,000 units = br10.40

Cost of merchandise sold: 700 units at $10.40 = br7,280
Deducting the cost of merchandise sold of br7,280 from the br10,400 of merchandise
available for sale yields br3,120 as the cost of the inventory at December 31.
2.6 VALUATION OF INVENTORY AT OTHER THAN COST
Cost is the primary basis for valuing inventories. In some cases, however, inventory is valued
at other than cost. Two such cases arise when (1) the cost of replacing items in inventory is
below the recorded cost and (2) the inventory is not salable at normal sales prices. This latter
case may be due to imperfections, shop wear, style changes, or other causes.
2.6.1 Valuation at Lower of Cost or Market: - If the cost of replacing an item in inventory
is lower than the original purchase cost, the lower-of-cost-or-market (LCM) method is used to
value the inventory. Market, as used in lower of cost or market, is the cost to replace the
merchandise on the inventory date. This market value is based on quantities normally
purchased from the usual source of supply. In businesses where inflation is the norm, market
prices rarely decline. In businesses where technology changes rapidly (e.g., microcomputers
58
and televisions), market declines are common. The primary advantage of the lower-of-cost-or-
market method is that gross profit (and net income) is reduced in the period in which the
market decline occurred. In applying the lower-of-cost-or-market method, the cost and
replacement cost can be determined in one of three ways. Cost and replacement cost can be
determined for (1) each item in the inventory, (2) major classes or categories of inventory, or
(3) the inventory as a whole. In practice, the cost and replacement cost of each item are
usually determined.
To illustrate, assume that there are 400 identical units of Item A in inventory, acquired at a
unit cost of br10.25 each. If at the inventory date the item would cost br10.50 to replace, the
cost price of br10.25 would be multiplied by 400 to determine the inventory value. On the
other hand, if the item could be replaced at br9.50 a unit, the replacement cost of br9.50
would be used for valuation purposes. The following table shows a method of organizing
inventory data and applying the lower-of-cost-or-market method to each inventory item. The
amount of the market decline, br450 (br15,520 - br15,070), may be reported as a separate item
on the income statement or included in the cost of merchandise sold. Regardless, net income
will be reduced by the amount of the market decline.
Determining Inventory at Lower of Cost or Market
Commodity Inventory Unit cost Unit Total

quantity price market
Cost market Lower of C
price
or M
A 400 Br 10.25 Br 9.50 Br 4,100 Br 3,800 Br3,800
B 120 22.5 24.10 2,700 2,892 2,700
C 600 8 7.75 4,800 4,650 4,650
D 280 14 14.75 3,920 4,130 3,920
Total 15,520 15,472 15,070
2.6.2 Valuation at Net Realizable Value:- As you would expect, merchandise that is out of
date, spoiled, or damaged or that can be sold only at prices below cost should be written
down. Such merchandise should be valued at net realizable value. Net realizable value is the
estimated selling price less any direct cost of disposal, such as sales commissions. For
59
example, assume that damaged merchandise costing br 1,000 can be sold for only br 800, and
direct selling expenses are estimated to be br 150. This inventory should be valued at br650
(br800 - br150), which is its net realizable value.
2.7 ESTIMATING INVENTORY COST
It may be necessary for a business to know the amount of inventory when perpetual inventory
records are not maintained and it is impractical to take a physical inventory. For example, a
business that uses a periodic inventory system may need monthly income statements, but
taking a physical inventory each month may be too costly. Moreover, when a disaster such as
a fire has destroyed the inventory, the amount of the loss must be determined. In this case,
taking a physical inventory is impossible, and even if perpetual inventory records have been
kept, the accounting records may also have been destroyed. In such cases, the inventory cost
can be estimated by using (1) the retail method or (2) the gross profit method.
1) Retail Method of Inventory Costing:- The retail inventory method of estimating

inventory cost is based on the relationship of the cost of merchandise available for sale
to the retail price of the same merchandise. To use this method, the retail prices of all
merchandise are maintained and totaled. Next, the inventory at retail is determined by
deducting sales for the period from the retail price of the goods that were available for
sale during the period. The estimated inventory cost is then computed by multiplying
the inventory at retail by the ratio of cost to selling (retail) price for the merchandise
available for sale. The illustrative computation follows:
Determining Inventory by the Retail Method
60
Cost Retail
Merchandise inventory, January 1 . . . . . . . . ……… ……19,400 br 36,000

Purchases in January (net) . . . . . . . . . . . . . . . ……………42,600
……………42,600 64,000
Merchandise available for sale . . . . . . . . . . . . 62,000 100,000
Ratio of cost to retail price: br 62,000/ br100,000 =62%
Sales for January (net) . . . . . . . . . . . . . . . . . . . . . . . . …………………………………70,000
Merchandise inventory, January 31, at retail . . . . . . . . …. …………………………br 30,000
Merchandise inventory, January 31, at estimated cost
(br 30,000 X 62%) . . . . . . . . . . . . . . . . . . . . . . . . ……. ………………………….br18,600
2) Gross Profit Method of Estimating Inventories: - The gross profit method uses the
estimated gross profit for the period to estimate the inventory at the end of the period. The
gross profit is usually estimated from the actual rate for the preceding year, adjusted for any
changes made in the cost and sales prices during the current period. By using the gross profit
rate, the dollar amount of sales for a period can be divided into its two components:
1/ gross profit and

2/ cost of merchandise sold.
The latter amount may then be deducted from the cost of merchandise available for sale to
yield the estimated cost of the inventory. The forth coming computation illustrates the gross
profit method for estimating a company’s inventory on January 31. In this example, the
inventory on January 1 is assumed to be br 57,000, the net purchases during the month are br
180,000, and the net sales during the month are br 250,000. In addition, the historical gross
profit was 30% of net sales.
Estimating Inventory by Gross Profit Method
61
Merchandise inventory, January 1 . . . . . . . . . . . . . . . ………..br 57,000

Purchases in January (net) . . . . . . . . . . . . . . . . . . . . …………. 180,000
Merchandise available for sale . . . . . . . . . . . . . . . . ................ br237,000
Sales in January (net) . . . . . . . . . . . . . . . . . . . . . ...br 250,000
Less estimated gross profit (br250,000 X 30%) . . . . ..75,000
Estimated cost of merchandise sold . . . . . . . . . . . . . ……………175,000
Estimated merchandise inventory, January 31 . . . . . . . ……..br 62,000
The gross profit method is useful for estimating inventories for monthly or quarterly financial
statements in a periodic inventory system. It is also useful in estimating the cost of
merchandise destroyed by fire or other disasters.
Keraj Co.’s beginning inventory and purchases during the year ended December 31, 2012,
were as follows:
Units Unit cost Total cost
January 1 Inventory 1,000 br 50.00 br 50,000

March 10 Purchase 1,200 52.50 63,000
June 25 Sold 800 units
August 30 Purchase 800 55.00 44,000
October 5 Sold 1,500 units
November 26 Purchase 2,000 56.00 112,000
December 31 Sold 1,000 units
Total 5,000 br 269,000
F Instructions:
1. Determine the cost of inventory on December 31, 2012, using the perpetual inventory
system and each of the following inventory costing methods:
a. first-in, first-out
62
b. last-in, first-out
2. Determine the cost of inventory on December 31, 2012, using the periodic inventory
system and each of the following inventory costing methods:
A. First-In, First-Out
B. Last-In, First-Out
C. Average Cost
4.3. Assume that during the fiscal year ended December 31, 2012, sales were br 290,000 and
the estimated gross profit rate was 40%. Estimate the ending inventory at December 31, 2012,
using the gross profit method.
2.8 PRESENTATION OF MERCHANDISE INVENTORY ON THE BALANCE

SHEET
Merchandise inventory is usually presented in the Current Assets section of the balance sheet,
following receivables. Both the method of determining the cost of the inventory (FIFO, LIFO,
or average) and the method of valuing the inventory (cost or the lower of cost or market)
should be shown. It is not unusual for large businesses with varied activities to use different
costing methods for different segments of their inventories. The details may be disclosed in
parentheses on the balance sheet or in a footnote to the financial statements. The following
prototype of balance sheet attempts to brief the presentation:
3C Merchandizing PLC
Balance Sheet
Assets:
Current Assets:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 00
Account receivables . . . . . . . . 40,000
Less : allowance for doubtfull account 2,500 37,500 00
Merchandise inventory. . . . . . . . . . . . . . . . . . .. . 30,000 00
Sene 30, 2005
63
2.9 ANSWERS TO CHECK YOUR PROGRESS AND EXERCISES
Solution To Check Your Progress: 2.1
1) D The overstatement of inventory shrinkage by Br7,500 at the end of the year will cause
the cost of merchandise sold for the year to be overstated by Br 7,500, the gross profit for
the year to be understated by br7,500, the merchandise inventory to be understated by br
7,500, and the net income for the year to be understated by br 7,500 (answer D).
2) A The lifo method of costing is based on the assumption that costs should be charged
against revenue in the reverse order in which costs were incurred. Thus, the oldest costs
are assigned to inventory. Thirty of the 35 units would be assigned a unit cost of $20
(since 110 of the beginning inventory units were sold on the first sale), and the remaining
5 units would be assigned a cost of $23, for a total of $715 (answer A).
3) D The FIFO method of costing is based on the assumption that costs should be charged
against revenue in the order in which they were incurred (first-in, first-out). Thus, the
most recent costs are assigned to inventory. The 35 units would be assigned a unit cost of
br 23 (answer D).
Solution tocheck your progress- Exercise/s 2-2
2.1.a
a) First-in, first-out method: br 95,200

Purchases Cost of Merchandise Inventory
Sold
Date2012 Quantity Unit Total Quantity Unit Total Quantity Unit Total
Cost Cost Cost Cost Cost Cost
Jan.1 1,000 50.00 50,000
Mar.10 1,200 52.50 63,000 1,000 50.00 50,000
1,200 52.50 63,000
June 25 800 50.00 40,000 200 50.00 10,000
1,200 52.50 63,000
Aug.30 800 55.00 44,000 200 50.00 10,000
64
1,200 52.50 63,000

800 55.00 44,000
Oct.5 200 50.00 10,000 700 55.00 38,500
1,200 52.50 63,000
100 55.00 5,500
Nov.26 2,000 56.00 112,000 700 55.00 38,500
2,000 56.00 112,000
Dec.31 700 55.00 38,500 1,700 56.00 95,200
300 6.00 16,800
2.1.b.
b.) Last-in, first-out method: br 91,000 (br35,000 + br56,000)
Purchases Cost of Merchandise Sold Inventory
Cost Cost Cost Cost Cost Cost
Jan.1 1,000 50.00 50,000
Mar.10 1,200 52.50 63,000 1,000 50.00 50,000
1,200 52.50 63,000
June 800 52.50 42,000 1,000 50.00 50,000
25 400 52.50 21,000
Aug.30 800 55.00 44,000 1,000 50.00 50,000
400 52.50 21,000
800 55.00 44,000
Oct.5 800 55.00 44,000 700 50.00 35,000
400 52.50 21,000
300 50.00 15,000
Nov.26 2,000 56.00 112,000 700 50.00 35,000
2,000 56.00 112,000
Dec.31 1,000 56.00 56,000 700 50.00 35,000
1,000 56.00 56,000
65
2.2. a) First-in, first-out method: 1,700

,700 units at br 56 = br 95,200
b) Last-in, first-out method:

1,000 units at br 50.00 = br50,000
700 units at br52.50 = 36,750
1,700 units br 86,750
c) Average cost method:

Average cost per unit: br 269,000 ÷ 5,000 units = br 53.80
Inventory, December 31, 2012: 1,700 units at br 53.80 = br 91,460
2.3. Gross profit method: / Answer = br 95,000 /
Merchandise inventory, January 1, 2012 . . . . . . . . . . . . . . . . . . . ……… . . . . . . . br 50,000

Purchases (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ………… . . . . . . . 219,000
Merchandise available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . ………. . . . . . . . . 269,000
Sales (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .br290,000
Less estimated gross profit (br 290,000 _ 40%) . . . . . . . . . . . . . . 116,000
Estimated cost of merchandise sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174,000
Estimated merchandise inventory, December 31, 2012 . . . . . . . . . . . . . . . . . . . br 95,000
PART-I: Discussion Questions
1. Which inventory system provides the more effective means of controlling inventories
(perpetual or periodic)? Why?
2. Why is it important to periodically take a physical inventory if the perpetual system is
used?
3. Yacob Co. sold merchandise to Dawit Company on December 31, FOB shipping point. If
the merchandise is in transit on December 31, the end of the fiscal year, which company
would report it in its financial statements? Explain.
66
4. A manufacturer shipped merchandise to a retailer on a consignment basis. If the

merchandise is unsold at the end of the period, in whose inventory should the merchandise
be included?
5. Do the terms fifo and lifo refer to techniques used in determining quantities of the
various classes of merchandise on hand? Explain.
6. Which of the three methods of inventory costing—fifo, lifo, or average cost— will in
general yield an inventory cost most nearly approximating current replacement cost?
7. If inventory is being valued at cost and the price level is steadily rising, which of the three
methods of costing—fifo, lifo, or average cost—will yield the lowest annual income tax
expense? Explain
8. How is the method of determining the cost of the inventory and the method of valuing it
disclosed in the financial statements?
9. What uses can be made of the estimate of the cost of inventory determined by the gross
profit method?
ART- II: WORK OUT
1. DURETTI Co. engaged in the following transactions in Ekatit 1995:
Ekatit 1- Sold merchandise to Belew Co. on credit, terms n/30, FOB shipping point, Br.
2100 (cost br. 1260)
3 – Purchased merchandise on credit from Semi Co., terms n/30, FOB shipping
point, Br. 3800
5 – Paid Express Transit for freight charges on merchandise received, Br. 290
6 – Purchased store supplies on credit from Hadiya Trading, terms n/20, Br.
636
8 – Purchase merchandise on credit from Semi Co., terms n/30, FOB shipping
point, Br. 3600, which includes Br. 200 freight costs paid by Semi Co.
12 – Returned some of the merchandise received on Ekatit 3 for credit, Br. 600
15 – Sold merchandise on credit to MERON Trading, terms n/30, FOB
shipping point, Br. 1200 (cost Br. 720)
16 – Returned some of the store supplies purchased in Ekatit 6 for credit, Br. 200
67
17 – Sold merchandise for cash Br. 1000 (cost, Br. 600)

18 – Accepted for full credit a return from Belew Company and returned
merchandised to inventory, Br. 200 (Cost Br. 120)
24 – Paid Semi Company for purchase of Ekatit 3 loss return of Ekatit 12
25 – Received full payment from Belew Company for his Ekatit 1 purchase less the
return on Ekatit 18
Required:
1. Prepare general journal entries to record the transactions, assuming use of the periodic
inventory system.
2. Prepare general journal entries to record the transactions, assuming use of the periodic
inventory system.
3. Compute the cost of goods sold and net sales during Ekatit.
4. Compute the Gross Profit on sale for the month of Ekatit.
2. Refer to the following exercise in order to answer questions a – f.
The following information is related to the business for three consecutive fiscal years.
19 x 3 19 x 2 19 x 1
Net sales Br. 430,000 Br. 425,000 Br. 400,000
Cost of goods sold 240,000 243,000 240,000
Gross Profit 189,200 182,000 160,000
Operating Expenses 96,800 92,400 86,500
Assume that you have found everything in order except for the following:
i. The ending inventory was understated by Br. 15,000 and Br. 3000 at the end of 19 x 1
and 19 x 2 respectively.
ii. The ending inventory was overstated by Br. 20,200 at the end of 19 x 3
The business enterprise uses the periodic inventory system and the above errors had not been
brought to attention prior to your investigation.
68
a. What was the correct amount of cost of goods sold for 19 x 1?

b. What was the correct amount of cost of goods sold for 19 x 2?
c. What was the correct amount of cost of goods sold for 19 x 3?
d. What was the correct amount of Net income for 19 x 2?
e. What was the correct amount of Net income for 19 x 3?
f. Compute the correct gross profit percentage for 19 x 1?
3. The beginning inventory of drift boats at Heritage Float Co. and data on purchases and
sales for a three-month period are as follows:
Number Per
Date Transaction of Units Unit Total
August 1 Inventory 22 $2,200 $ 48,400

8 Purchase 18 2,250 40,500
11 Sale 12 4,800 57,600
22 Sale 11 4,800 52,800
September 3 Purchase 16 2,300 36,800
10 Sale 10 5,000 50,000
21 Sale 5 5,000 25,000
30 Purchase 20 2,350 47,000
October 5 Sale 20 5,250 105,000
13 Sale 12 5,250 63,000
21 Purchase 30 2,400 72,000
28 Sale 15 5,400 81,000
Instructions
1. Record the inventory, purchases, and cost of merchandise sold data in a perpetual
inventory record similar to the one illustrated in Exhibit 3, using the first-in, first-out
method.
2. Determine the total sales and the total cost of drift boats sold for the period. Journalize the
entries in the sales and cost of merchandise sold accounts. Assume that all sales were on
account.
3. Determine the gross profit from sales of drift boats for the period.
4. Determine the ending inventory cost.
69
UNIT THREE: PLANT ASSETS AND INTANGIBLE ASSETS
3.0 Introduction
3.1 Nature of plant assets
3.2 Accounting for depreciation
3.3 Capital expenditures and revenue expenditures
3.4 Disposal of plant assets
3.5 Leasing of plant assets
3.6 Internal controls of plant assets
3.7 Intangible Assets
3.8 Natural resources
3.9 Presentation of fixed assets and intangible assets on the balance sheet
 Summary
 Answer to Check Your Progress
 Model Examination Questions
 Reference Books
 Glossary
Objectives:
Objectives: After studying this chapter, you will be able to:
 Define plant assets and describe the accounting for their cost.
 Compute and account for depreciation of plant assets
 Classify fixed asset costs as either capital expenditures or revenue expenditures.
 Journalize entries for the disposal of plant assets.
 Define a lease and summarize the accounting rules related to the leasing of plant
assets.
 Describe internal controls over plant assets.
 Describe the accounting for intangible assets, such as patents, copyrights, and
goodwill.
 Account for depletion of natural resources.
 Prepare a balance sheet that includes fixed assets and intangible assets.
70
3.0. INTRODUCTION
In previous two chapters of this module, you have discussed three important items of the
balance sheet of a firm: cash, receivables and inventories, by stressing on importance of such
assets to the successful functioning of businesses and accounting treatment of these assets. In
this chapter, you will learn the nature and the accounting principles and practices surrounding
plant assets and intangible assets. Together, plant and intangible assets make up a significant
part of a firm’s balance sheets because they represent major investments of resources. The
future of many business enterprises depends heavily on their investment in plant and
intangible assets.
Hence, this chapter aims at discussing the meaning and nature of plant assets, acquisition
costs, and the related cost allocation (depreciation) of plant assets. The units also discuss
different methods of computing depreciation and the accounting procedures involved in
recording the transactions relating to acquisition, depreciation, and disposal of plant assets. In
the last section of the chapter, you will discuss the nature and accounting treatment of
intangible assets.
3.1 NATURE
N AND MEANING OF PLANT ASSETS
Activity 3.1: what are long-lived assets? What makes it different from current assets that you
have studied in previous chapters?
Long-lived assets are expected to be used for more than one year or one operating cycle
whatever the operating cycle is long. Long-lived assets are placed into two major categories:
plant assets and intangible assets. Under this section we discuss about plant asset while
intangible assets will be discussed under its respective topic.
Plant assets are long-term or relatively permanent assets. They are tangible assets because
they exist physically; you can touch them. They are owned and used by the business and are
not offered for sale as part of normal operations. Other descriptive titles for these assets are
fixed assets or property, and equipment. So in this module fixed assets and plant assets are
used interchangeably.
71
If the purchased item is long-lived, then it should be capitalized, which means it should
appear on the balance sheet as an asset. Otherwise, the cost should be reported as an expense
on the income statement. Capitalized costs are normally expected to last more than a year. If
the asset is also used for a productive purpose, which involves a repeated use or benefit, then
it should be classified as a fixed asset, such as land, buildings, or equipment. An asset need
not actually be used on an ongoing basis or even often. For example, standby equipment for
use in the event of a breakdown of regular equipment or for use only during peak periods is
included in fixed assets.
Plant assets are owned and used by the business and are not offered for resale. Long-lived
assets held for resale are not classified as fixed assets, but should be listed on the balance
sheet in a section entitled investments. For example, undeveloped land acquired as an
investment for resale would be classified as an investment, not land. The above concept could
be visualized with the following chart for more understanding.
Is the purchased
item long-lived?
Yes No
Is the asset used in a Expense
Yes No
Plant/intangible Asset Investment
3.1.1 ACQUISITION COST OF A PLANT ASSET
Activity 3.2:
3.2: Dear student, what is cost of a plant asset? How do you determine the amount of
cost that incurred to acquire plant assets? What items are included to determine the cost of an
asset? Is it only the invoice purchase price paid or to be paid that is considered as the cost of
a plant asset? How this cost is captured or recorded in the journal? Try to judge or estimate
72
the possible answer to these guiding questions before you proceed to read the following. Then
compare your trying with the existing principles and practices after thoroughly reading.
Acquisition cost of a plant asset includes more than its purchase price. It is the sum of all
necessary costs to get the asset and make it ready for intended use. For example, expenditures
related to the acquisition of a plant asset such as freight, insurance while in transit and
installation are included in the cost of the asset because they are necessary if the asset is to
function. According to the matching principle, therefore, such costs are allocated to the
economic life of the asset rather than charged as expenses during the acquisition period.
Of course, only costs necessary for preparing a long-lived asset for use should be included as
a cost of the asset. Unnecessary costs that do not increase the asset’s usefulness are recorded
as an expense. For example, the following costs are included as an expense: vandalism,
mistake in installation, uninsured theft, and fines for not obtaining proper permits from
governmental agencies.
3.1.1.1 Determining the Cost of Land
The acquisition cost of land includes Purchase price, commissions, survey and legal costs,
razing or removing unwanted buildings less any salvage proceeds, grading and leveling,,
paving a public street bordering, delinquent real estate taxes( if any), and any other costs that
require to acquire and make ready it. Under the historical cost assumption, land is reported in
the balance sheet at its original cost. Land is not subjected to depreciation because land does
not have a limited useful life. As of the acquisition date land is debited and cash or liability is
credited.
Land -----------------------------xx
Cash/liability ----------------------- xx
(to record the acquisition of Land)
To illustrate assume that a business signs Br, 300,000 note payable to purchase land for a new
store site on January 1, 2011. It pays Br.10, 000 in back property tax, Br.8, 000 in transfer
taxes, Br. 5,000 for removal of an old building, a Br.1, 000 survey fee, and Br.260, 000 to
pave the parking lot. Then, the cost of the land is determined as follows:
73
Purchase price of land Br.300, 000
Add related costs:

Back property taxes Br.10, 000
Transfer taxes 8,000
Removal of buildings (net) 5,000
Survey fees 1,000 24,000
Total cost of land Br.324, 000
Journal entry:
2011
Jan1 Land --------------------------------------------------------------- 324,000
Notes payable ---------------------------------------------------------------- 300,000
Cash --------------------------------------------------------------------- 24,000
( to record acquisition of land )
Note that land improvements are items placed on the land. Land improvements include
fencing, paving, driveways, security systems and outdoor lighting. These costs are not
considered as the cost of land. Hence, the amount paid for paving the parking lot, Br,
260,000 is not included in the cost of the land. It is treated as the cost of the land
improvements.
3.1.1.2 Determining the Cost of Buildings
An organization may acquire buildings through purchase or by self construction. Cost of

buildings acquired through purchase includes purchase price, brokerage commissions, sales
and other taxes, repairing or renovating building, while self constructed costs of building
includes: architects’ fees, engineers’ fees, insurance costs incurred during construction,,
interest on money borrowed to finance construction,, walkways to and around the building
and any other costs incurred to complete the construction of the building. Either acquired
through purchase or construction the cost of buildings like any other assets, it consists of all
expenditures (costs) that are reasonable and necessary to get and make it ready for use.
74
3.1.1.3. Determining the Cost of Machinery and Equipment
Machinery and equipment costs include sales taxes, freight, installation, repairs (purchase of
used equipment), reconditioning (purchase of used equipment), insurance while in transit,
assembly, modifying for use, testing for use, and permits from government agencies. Sales tax
is not an expense, but rather a cost of purchasing the machine.
1. State the general statement that guides you to determine acquisition cost of plant asset.
2. Assume that an asset is dropped and damaged resulted from carelessness of the laborers
while it is being unloaded. How do you treat the cost requires to repair this asset? (It should
be expensed, or it should be added to the cost of asset). Give your justification.
3. A business enterprise acquires a piece of land for future site. It pays a cash price of Br.
310,000, pays brokerage fees of Br. 8500 and title fees of Br. 4000, pays Br. 6000 to have
unwanted building removed, and pays, Br. 2500 to have the site graded. The business
receives Br. 3000 salvage from the old building.
Required:
a. Determine the cost of this land.
b. Pass journal entry to record acquisition of the land.
3.2 ACCOUNTING FOR DEPRECIATION
Plant assets (except land) wear out over time or lose their ability, over time, to provide
services. As a result, the costs of equipment, buildings, land improvements and other plant
assets’ cost should be transferred to expense accounts in a systematic manner during their
expected useful lives. This periodic transfer of cost to expense is called depreciation. Land
has an unlimited life and therefore, depreciation is not determined for it.
The adjusting entry to record depreciation is usually made at the end of each month or at the
end of the year. This entry debits Depreciation Expense and credits a contra asset account
75
entitled Accumulated Depreciation or Allowance for Depreciation. The use of a contra asset
account allows the original cost to remain unchanged in the fixed asset account. That is the
historical cost for plant assets are reported on the balance sheet.
Factors that cause a decline in the ability of a fixed asset to provide services may be identified
as physical depreciation or functional depreciation. Physical depreciation occurs from wear
and tear while in use and from the action of the weather. Functional depreciation occurs when
a fixed asset is no longer able to provide services at the level for which it was intended. For
example, a personal computer made in the 1980s would not be able to provide an Internet
connection. Such advances in technology during this century have made functional
depreciation an increasingly important cause of depreciation. Depreciation is neither the
indication of market value decline nor a method of setting aside cash to replace assets. Rather
it is the systematic way of transferring the expired portion of costs to expense. That is the
market value of a plant asset could be above or below the carrying value of the asset and cash
account is neither increased nor decreased by the periodic entries of depreciation.
3.2.1 Determining and Accounting For Depreciation
Activity 3. 3: Dear students, it is believed that you have got clear meaning of depreciation
from the discussion made above. Still some questions may come to your mind regarding
depreciation. These might be; what are the factors considered in determining depreciation
expense?, How much would be the amount of deprecation for each period? How it is
determined and recorded. Such and other similar questions might be made clear in the
following discussions. But before you proceed to read the section, guess the possible answers
for these questions; of course you are not obliged to get the exact answer.
Three factors are considered in determining the amount of depreciation expense to be

recognized each period. These three factors are:
76
a. The fixed asset’s initial cost- is the acquisition cost of the asset.
b. Expected useful life of the asset- is the expected years or services the asset is used in the
operation of the business. This can be expressed in terms of years or volume of activities
or outputs of the assets.
c. Estimated value of the asset at the end of its useful life. This estimated value is called the
residual value, scrap value, salvage value, or trade-in value.
A fixed asset’s residual value at the end of its expected useful life must be estimated at the
time the asset is placed in service. If a fixed asset is expected to have little or no residual
value when it is taken out of service, then its initial cost should be spread over its expected
useful life as depreciation expense. If, however, a fixed asset is expected to have a significant
residual value, the difference between its initial cost and its residual value, called the asset’s
depreciable cost, is the amount that is spread over the asset’s useful life as depreciation
expense.
Exhibit 3.1 shows the relationship among the three factors and the depreciable cost
Cost Salvage Value Equals

Minus Depreciable Cost
3.2.2 Methods of Determining Periodic Depreciation
The Following Methods are the most common methods used to determine periodic
depreciation expense.
 Straight Line Method

 Units of Production Method
 Declining Balance Method
 Sum of years digits method
77
a. Straight Line Method (S/L)
Straight-line is the easiest method. It results an equal amount of depreciation each period. It
allocates the cost of the asset evenly over its useful life. The depreciable cost (cost – residual)
is divided by the useful life in years.
S/L
Cost – salvage value
Depreciation expense =
Economic Life∈ years
Remember, the entry to record depreciation is the same regardless of the method.
Depreciation expense is debited and will appear on the income statement. Accumulated
depreciation, a contra-asset is credited and will appear on the balance sheet. It will be
deducted from the cost of the plant asset to determine its book value.
 Book value = Cost minus accumulated depreciation

 At the end of the asset’s life: Book value = residual value
The word “accumulated” means that this account will grow each year as depreciation is added
to it over the life of the plant asset. Since accumulated depreciation is subtracted from the
cost of the asset, as it increases, the book value decreases. At the end of the asset’s useful life,
the book value will equal its residual.
For example, assume that equipment was acquired on January 1, 2011 for Br. 24,000; its
estimated residual value is Br.2, 000, and its estimated life is 5 years. The annual depreciation
is computed and recorded as follows for the year ended on December 31, 2011:
cost – salvage value

Depreciation expense =
economic life ∈ years
24,000 – 2,000
=
5
= Br.4, 400
78
Journal entry:
2011
Dec.31 Depreciation expense ------------------------------------------ 4,400
Accumulated depreciation- equipment----------------------- 4,400
(To record depreciation expense for the period)
Activity 3.4: Based on the information given in the example above, attempt the following
questions. Do not check the given answer before you try it.
a. What is the book value of the equipment as of December 31, 2011?

b. Determine depreciation expense for the year ended 2012, 2013, 2014 and 2015
respectively.
c. What is the balance of accumulated depreciation as of December 31, 2015?
d. What is the book value of the equipment as of December 31, 2015?
 Check your answer with given below for this specific activity and again read the
explanation given above under straight line method if your answer is different.
Whena. an asset is used
Br.19600 for only part
b) Br.4,400 of 22000
c) Br. a year, the annual
d. Br. 2000-depreciation is prorated.
which is equal For
to the salvage
example,value
assume that the asset in the above example is placed in service on October 1. The
depreciation for the first fiscal year of use would be Br. 1,100 (Br. 4,400 x 3/12) instead of
Br.4, 400 and hence the entry will be:
2011
Dec.31 Depreciation expense ------------------------------------------ 1,100
Accumulated depreciation- equipment----------------------- 1,100
(To record depreciation expense for the period)
b. Units of Production Method (UOP)
Units-of-production (UOP) is similar to straight line depreciation. Cost less residual is

divided by the useful life. Only with this method, the life is expressed in units, not years. The
result is depreciation expense per unit. Units can be measured in any input or output of an
asset. For example, for a vehicle, a company could use miles driven or for a copy machine,
79
number of copies made. The depreciation per unit is then multiplied by the units produced
during the year. This method results in varying amounts of depreciation each period,
depending on the use of the asset. Mathematically these statements can be expressed as
follows:
UOP
Cost – residual
 Depreciation expense per unit =
Usefullife ∈units
 Depreciation expense for the year = Depreciation expense per unit x units produced
during the period
For example, assume that a machine with a cost of Br. 24,000 and an estimated residual value
of Br. 2,000 is expected to have an estimated life of 10,000 operating hours. Besides assume
that the machine was in operation for 2,100 hours during a year. Then depreciation for a unit
of one hour and depreciation for that year would be computed as follows:
 Depreciation expense per unit = (Br.24, 000 – Br. 2,000)/10,000 hours

= Br.2.20
Then, depreciation expense for that year would be:
 Depreciation expense = 2,100 hours x Br.2.20/hour
= Br. 4,620
c. Declining Balance Method
The declining-balance method provides for a declining periodic expense over the estimated
useful life of the asset. To apply this method, the annual straight-line depreciation rate is
doubled and hence also called double-declining-balance method. It is an accelerated method
since in the early life of an asset large depreciation amounts are expensed and later in the life
of the asset, the amounts are smaller.
This method does not use residual value until towards the end of the asset’s life. Steps to use
this method:
1. Compute double declining balance (DDB) rate. This is found by dividing two by the
useful life or 100 divided by the useful life and multiply by 2. This is often referred to
80
as twice-the-straight-line rate and usually expressed as a percent. For example, the

declining-balance rate for an asset with an estimated life of 5 years is 40%, which is
double the straight-line rate of 20%* 2 or (100%/5 * 2).
2. The DDB rate is multiplied by the book value (at the beginning of the year) of the
asset (not cost minus residual). In the first year, the book value will equal the asset’s
cost. However, each year as accumulated increases, book value decreases, and thus,
so does depreciation expense. You need to be careful with this method not to
depreciate below residual. The formula is not set up to “stop” when depreciable cost
equals residual value. In the last year, or earlier in some cases, the depreciation
expense is “forced” so that ending book value equals residual.
To illustrate the application of the method, refer the above information given under straight
line method for equipment. For this specific example, depreciation schedule can be shown as
follows for double declining balance method of computing depreciation.
Depreciation schedule- Declining Balance Method
Year Cost Accumulated depreciation Book value at Rate Depreciation Book value at
at the beginning of the beginning of year for year end of year
(a) year (c) (d) (c)* (d) = (e) (c) - (e)*
(b)
1 Br. 24,000 0 Br. 24,000 40% Br. 9,600 Br.14,400
2 24,000 Br,9,600 14,400 40% 5,760 8,640
3 24,000 15,360 8,640 40% 3,456 5,184
4 24,000 18,816 5,184 40% 2,073.60 3,110.40
5 24,000 20,889.60 3,110.40 - 1,110.40* 2,000
Note that for the last year depreciation we would not apply the rate to the book value since a
plant asset should not depreciate below its residual value; in this case Br. 2,000. Therefore,
81
last year depreciation is obtained simply by subtracting residual value from the beginning
book value of the asset that is Br, 3,110.40 minus Br.2, 000 equals Br. 1,110.40. Book value
at end of year can be calculated as indicated in the last column above (c – e), or (a) – (b + e)
for each year.
For the plant asset put in operation after some months were elapsed, the same approach is
used as indicated under straight line method; that is we compute depreciation only for the
number of months a plant asset was used.
d. The Sum-of- the Years-Digits Method (SYD )
Sum-of-the-years' digits, or SYD, is a form of accelerated depreciation that pro duces large amount of
depreciation expense results at the early life of the assets and a decline depreciation expense
thereafter because a successively smaller fraction is applied each year to the depreciable cost of the
asset. Of course the amount is not as large as to that of double declining method. Computation of
depreciation expense using this method is the most complex of the other methods-especially when
partial years are involved. As indicated in different accounting books, because of its complexity SYD
is rarely used in today's business world.
Steps to use the method:

1. Determine the denominator of the fraction:
fraction: is the sum of the digits representing
the years of life. For less number of assets’ life of years getting this sum is become
very simple. However, in the case of very long life of assets, example more than 20
years; getting this sum is time taking and tedious without using formula to get the
sum. Hence; one can apply the following arithmetic formula to get the sum easily for
any number of years.
S = n [(n + 1)/2]
Where; S- Sum of the years digits (example of digits 1, 2,3,4,5 for an asset with 5
years Economic life)
n- Years of life of an asset
2. Determine the fraction:

fraction: the numerator of the fraction for the first year would be the
remaining life of an asset at the beginning of the year. Likewise, it continuous for the
82
next years. The denominator of the fraction is unchanged for every year. Therefore,
fraction is changed because of changes in numerator which declines as the years of life
of an asset increases. For example for an asset with 5 years economic life; the fraction
would be: 5/15, 4/15, 3/15, 2/15, and 1/15 for 1st, 2nd, 3rd, 4th, and 5th year respectively.
3. Apply the fraction to the depreciable cost.

To illustrate how to apply the method, reconsider the information given above under
straight line method for equipment and the following depreciation schedule under sum
of the year’s digits method.
Depreciation Schedule- Sum - of - the - Years - Digits Method
Year Cost Depreciable Rate Yearly Accumulated Book Value
Cost (b) Depreciation Depreciation
(a) (c) (a)-(d)
(b)*(c)= (d) (e)
1 Br. 24,000 Br. 22,000 5/15 Br. 7333.33 Br. 7333.33 Br. 16,667.67
2 24,000 22,000 4/15 5866.67 13,200 10,800
3 24,000 22,000 3/15 4,400 17,600 6400
4 24,000 22,000 2/15 2933.33 20533,33 3466.67
5 24,000 22,000 1/15 1466.67 22,000 2000
Note that the complexity of this method comes when an asset is purchased and put in service for
partial year. In that case we have to consider that a given fraction should be used for full year ( 12
consecutive months).
For example, assume that the equipment given in the above example was acquired and put in
service on October 1, 2011 instead of January 1, 2011 for the year ended December 31, 2011.
83
Then; Depreciation for first year equals (5/15 * 22,000) * 3/12; for 2nd year equals ( 5/15*
22,000 ) *9/12 + ( 4/15 * 22,000 ) * 3/12; likewise you compute depreciation expense for 3rd,
4th, and 5th years. What you have to remember is that a given fraction has to be used for 12
consecutive months as explained above for such cases.
3.2.3 Comparing Depreciation Methods
The amount of depreciation expense will vary according to the depreciation method used by a
Company. Straight-line is by far the most commonly used depreciation method because it is
the simplest to apply and makes intuitive sense.
The straight-line method provides for the same periodic amounts of depreciation expense over
the life of the asset. The units-of-production method provides for periodic amounts of
depreciation expense that vary, depending upon the amount the asset is used. The declining-
balance method provides for a higher depreciation amount in the first year of the asset’s use,
followed by a gradually declining amount. For this reason, the declining-balance method is
called an accelerated depreciation method.
It is most appropriate when the decline in an asset’s productivity or earning power is greater
in the early years of its use than in later years. Further, using this method is often justified
because repairs tend to increase with the age of an asset. The reduced amounts of depreciation
in later years are thus offset to some extent by increased repair expenses.
Like declining balance method, sum of year’s digits method provides for a higher
depreciation amount in the first year of the asset’s use and declining for the next years
because of declining in fraction used in computation. Therefore, it is a form of accelerated
depreciation. Of course its accelerated speed is not as that of double declining balance.
Graphical Comparison of the most three Common Methods of Depreciation
8000
84
7000
5000
4000
3000 S/L
2000
UOP
1000
DDB
0
Year 1 Year 2 Year 3
In the above graph that shows yearly depreciation, straight-line depreciation is uniform at Birr
3000 per year over three years period. However, the declining balance method begins at an
amount greater than straight line (Br.3000) and decreases each year to amounts that are less
than straight line. The production method does not generate a regular pattern because of the
random fluctuation of the depreciation from year to year.
In general, companies use different methods of deprecation for good reason. The straight-line
method can be advantageous for financial reporting because it can produce the highest net
income, and the accelerated depreciation method can be beneficial for tax purposes because it
can result in lower income taxes.
This Exercise helps you to evaluate your progress

85 regarding computation of depreciation by
applying different methods discussed above.
1. One can determine depreciation for all plant assets except land. Why land is considered as
3.2.4. Revising Depreciation Estimates
From the three factors, cost residual value and useful life that affect depreciation residual
value and useful life are estimated at the acquisition of an asset. They are not actual values.
Hence, revising the estimates of the residual value and the useful life is normal. When these
estimates are revised, they are used to determine the depreciation expense in future periods.
They do not affect the amounts of depreciation expense recorded in earlier years.
To illustrate, assume that a fixed asset purchased for Br. 130,000 was originally estimated to
have a useful life of 30 years and a residual value of Br. 10,000. The asset has been
86
depreciated at Br. 4,000 per year [(Br. 130,000 _ Br.10, 000)/30 years] for 10 years by the
straight-line method. At the end of ten years, the asset’s book value (undercoated cost) is
Br.90,000, determined as follows:
Asset cost Br.130, 000
Less accumulated depreciation (Br. 4,000 per year * 10 years) 40,000
Book value (unexpired cost), end of tenth year Br. 90,000
During the eleventh year, it is estimated that the remaining useful life is 25 years (instead of
20) and that the residual value is Br.5, 000 (instead of Br.10, 000). The depreciation expense
for each of the remaining 25 years is Br.3, 400, computed as follows:
Book value (unexpired cost), end of tenth year Br. 90,000

Less revised estimated residual value 5,000
Revised remaining depreciable cost Br.85,
Br.85, 000
Divide by remaining years 25
Revised annual depreciation expense Br. 3,400
1. Assume that Matador Company acquired a plant asset for Br. 120,000 on January 1,
2004 and estimate its economic life and salvage value 10 years and Br. 20,000
respectively. Matador decides on January 1, 2011, to extend the useful life of the
truck one year and estimate its salvage value for Br. 25,000 because of its excellent
condition. The company has used the straight-line method to depreciate the asset to
date.
Required:
a. Calculate the depreciation expense on Dec31, 2011 and pass journal entry for the
same.
b. What is the book value at the end of December 31, 2011?
c. Determine the book value at the end of its economic life. .
87
3.3 DEPRECIATION OF PARTIAL YEARS
So far, depreciation expense has been calculated on the basis of a full year. Businesses
purchase assets at all times during the year, however, so partial-year depreciation calculations
are often required.
1. To compute depreciation expense for less than a full year, first calculate the
depreciation
2. Expense for the year and then distribute it evenly over the number of months the asset
is held during the year.
To illustrate assume that a piece of equipment is purchased for Br. 10,000 and that it has an
estimated useful life of five years, and an estimated residual value of Br. 1,000. Assume
further that the equipment is purchased on October 2 and that the yearly accounting period
ends on December 31. Depreciation must be recorded for three months, October through
December, or 3/12 of a year. This factor is applied to the calculated depreciation for the entire
year. The three months’ depreciation under the straight-line method is calculated as follows:
Solution:
Annual depreciation = Original cost – Estimated Salvage value
Estimated useful life
= Br. 10,000 – Br. 1,000 = Birr 1,800
5 years
Depreciation for partial year (Oct – Dec. 31) is therefore, Br. 1800 x 3/12 = Br. 450
If the company used the double declining balance method on the above equipment, the
depreciation on the asset would be: Br. 10,000 x 40/100 x 3/12, = Br. 1,000, depreciation for
three months, If the company used the sum-of-years-digits method, the depreciation on the
asset would be:
Birr (10,000 – 1000) x 5/15 x 3/12 = Birr 450, and the depreciation for the second year would
be:
88
(10,000 – 1000) x 5/15 x 9/12 = Br. 2250

(10000 – 1000) x 4/15 x 3/12 = 600
Therefore, total 2nd year depreciation Br. 1850
Note that in this specific example depreciation was recorded from the beginning of
October. If the equipment had been purchased on October 16, or thereafter, depreciation
would be calculated beginning November 1 ( only for 2 months ), as if the equipment were
purchased on that date.
3.4 CAPITAL AND REVENUE EXPENDITURES
The costs of acquiring fixed assets, adding to a fixed asset, improving a fixed asset, or
extending a fixed asset’s useful life are called capital expenditures. That is costs incurred for
additions and improvements to increase the operating efficiency, productive capacity, or
useful life of a plant asset are categorized as capital expenditure. Such expenditures are
recorded by either debiting the asset account or its related accumulated depreciation account.
Whereas, costs that benefit only the current period or costs incurred for normal maintenance
and repairs are called revenue expenditures. They are meant for ordinary repairs and therefore
such expenditures are debited to maintenance or repair expense accounts. For example, the
cost of replacing spark plugs in an automobile or the cost of repainting a building should be
debited to an expense account.
To properly match revenues and expenses, it is important to distinguish between capital and
revenue expenditures. Capital expenditures will affect the depreciation expense of more than
one period, while revenue expenditures will affect the expenses of only the current period.
Revenue Expenditure reduces profit through an expense account (e.g., repair expense) in the
current year where as a capital expenditure reduces profit at a (through depreciation expense
over time) much slower rate
89
To illustrate suppose for example, a machine costing Br. 70,000 had no estimated residual
value and an original estimated useful life of ten years, has been depreciated for 7 years. At
the very beginning of the 8th year, the machine was given a major overhaul costing Br. 6,000.
This expenditure extended the useful life of the machine 3 years beyond the original estimate.
The computation of the new book value and the entry for the extraordinary repair would be as
follows:
Jan. 4. Accumulated Depreciation – Machinery……………6,000
Cash …………………………………………………………6,000
Extraordinary repair to machinery
( to record extraordinary repair )
The revised annual depreciation for each of the six years remaining in the machine’s useful
life would be calculated as follows:
Cost of Machine……………………………………… Birr 70,000
Accum. Depreciation before extraordinary repair Br. 49,000
Less: extraordinary repair (Debited to Accum. Depr.)….6000 43,000
Book value (carrying value) after extraordinary repair… Br.27,000
Revised Annual periodic depreciation= 27000………………………. 4,500
6 years
Exercise 3.4: Check your progress.
1. Describe general statement that guides to categorize costs incurred related to plant
assets as capital and revenue expenditures.
--------------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------------------
--------------------------------------
2. Assume that Matador Company purchased and installed an alarm system for its retail
store on January 1, 1999, at a cost of Br. 50,000. The alarm system was estimated to
have a ten year life with no salvage value. On January 1, 2006, the alarm system was
replaced with a system having more advanced technology. The removal of the old
alarm system cost Br.2, 000. The new system cost Br. 120,000 and is estimated to
90
have a ten-year life, with no residual value. Matador Co. uses the straight-line
depreciation method.
a. Determine the total depreciation expense for 2006 related to the alarm system.
b. Determine the total expense reported in the income statement in 2006 from these
transactions.
3.5 DISPOSAL OF PLANT ASSETS
Plant assets that are no longer useful would be discarded, sold, or traded for other fixed assets.
The details of the entry to record a disposal will vary. In all cases, however, the book value of
the asset must be removed from the accounts. In doing that the general entry for this purpose
debits the asset’s accumulated depreciation account for its balance on the date of disposal and
credits the asset account for the cost of the asset and other balancing accounts such as loss on
disposal or gain on disposal would be used to keep the balance of an entry if any difference is
there between debits and credits. Of course the included accounts in an entry are based on the
methods of disposal mentioned above (through discarding, selling and exchanging for other
fixed assets).
a) Discarding Fixed Assets
When fixed assets are no longer useful to the business and have no residual or market value,
they are discarded. A plant asset that will be discarded may be fully depreciated (book value
equals zero) or not fully depreciated (book value is different from zero). In the first case
(when Book value = 0) no gain or loss is recognized. But when book value is different from
zero, loss on disposal would be recognized. If an asset has not been fully depreciated,
depreciation should be recorded prior to removing it from service and from the accounting
records.
To illustrate:
a) Assume that an item of equipment acquired at a cost of Br. 30,000 is fully depreciated at
December 31, the end of the preceding fiscal year. On February 14, the equipment is
discarded. The entry to record this disposal is as follows:
91
Feb 14 Accumulated Depreciation—Equipment ------------------------- 30,000

Equipment --------------------------------------------------------------30,000
( To write off equipment discarded.)
b) Assume that equipment costing Br.12, 000 is depreciated at an annual straight-line rate
of 20%. In addition, assume that on December 31 of the preceding fiscal year, the
accumulated depreciation balance, after adjusting entries, is Br.9, 500. Finally, assume
that the asset is removed from service on the following March 24. Here two entries have
to be passed to settle the removal of this asset.
1. Updating accumulated depreciation account: In this example the entry to record the
depreciation for the three months of the current period prior to the asset’s removal from
service is as follows:
Mar 24 Depreciation Expense—Equipment --------------------------------- Br. 600

Accumulated Depreciation—Equipment ----------------------------- 600
(To record current depreciation on equipment discarded (Br.2400 * 3/12).
2. To write off asset discarded: In this example recorded as follows:

Mar 24 Accumulated Depreciation - Equipment ------------------ Br. 10,100
Loss on disposal ------------------- 1,900
Equipment ----------------------------- 12,000
(To write off equipment discarded).
The loss of Br, 1,900 is recorded because the balance of the accumulated depreciation account
(Br10, 100) is less than the balance in the equipment account (Br 12,000). Losses on the
discarding of fixed assets are non operating items and are normally reported in the Other
Expense section of the income statement.
b) Selling Fixed Assets
The entry to record the sale of a fixed asset is similar to the entries illustrated above, except
that the cash or other asset received must also be recorded. Three conditions can be
92
recognized based up on the relation between book value and the market price of an asset that
has been sold.
 If the selling price is more than the book value of the asset, the transaction results in a
gain.
 If the selling price is less than the book value, there is a loss.
 If the selling price is equals the book value, there is no gain and no loss.
From the above you can conclude that gain or loss will equal the difference between the cash
received and the book value of the asset.
To illustrate, assume that equipment costing Br.20, 000 is depreciated at an annual straight-
line rate of 10%. In addition, assume that on December 31 of the preceding fiscal year, the
accumulated depreciation balance, after adjusting entries, is Br.14, 000. Finally, assume that
the asset is removed from service on the following July, 5. As in the case of under discarding
two entries would be passed:
a) To update depreciation account

July 5 Depreciation Expense—Equipment --------------------------------- Br. 1000
Accumulated Depreciation—Equipment ----------------------------- 1000
(To record current depreciation on equipment sold (Br.20, 000 * 10% * 1/2).
b) To record sales of the plant asset: As indicated above, one of the three conditions
would occur when we sell a fixed asset that has been used in service. Hence let us
determine the book value before we proceed to record the entry.
Book value = Cost – Accumulated depreciation
Br.20, 000 – (Br, 14,000 + Br. 1,000)
= Br.5, 000
Now let us assume possible conditions that could be occurred:
i. When sold at book value- no gain or loss
July 5 Cash ----------------------------------------------------------------Br. 5,000
Accumulated Depreciation - Equipment -------------------- 15,000
Equipment ----------------------------- 20,000
93
(To write off equipment sold).

ii. When sold at below book value for Br. 4,000 loss of Br, 1000
July 5 Cash ------------------------------------------------------------- Br. 4,000

Loss on Disposal of fixed asset --------------------------- 1,000
Equipment ----------------------------- 20,000
iii. When sold at more than book value for Br. 5,500 gain of Br, 500
July 5 Cash ------------------------------------------------------------- Br. 5,500

Equipment ----------------------------- 20,000
Gain on Disposal of Fixed Asset ----------------------------- 500
Didericksen Company sold a truck with a historical cost of $50,000 and accumulated
depreciation of $24,000 for $30,000 cash. Make the journal entry necessary to record the sale
of the truck.
Solution
The journal entry to record the sale of the truck for $30,000 cash is as follows:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000
Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000
Gain on Sale of Truck . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000
Truck . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
c) Exchanging plant Assets

A third way of disposing of plant assets is to exchange it for another asset. Such exchanges
may occur with cars, trucks, machines, and other types of large equipment. Exchanges may
involve similar assets, such as an old machine exchanged for a new machine model, or
dissimilar assets, , such as a truck for a computer,
94
When dissimilar assets are exchanged the transaction is accounted for exactly as outlined
previously: the acquired asset is recorded in the books at its fair market value, and a gain or
loss may be recognized depending on the difference between this market value and the book
value of the asset that was disposed of.
In this Module we focus on recording for similar plant asset exchange except comparison may
be made how gain or loss is treated under each. Old equipment is often traded in for new
equipment having a similar use. In such cases, the seller allows the buyer an amount for the
old equipment traded in. This amount, called the trade-in allowance, may be either greater or
less than the book value of the old equipment. The remaining balance—the amount owed—is
either paid in cash or recorded as a liability. It is normally called boot.
 Exchanging Similar Plant Assets

a) Gain Treatment on Exchanges
Gains on exchanges of similar fixed assets are not recognized for financial reporting purposes.
This is based on the theory that revenue occurs from the production and sale of goods
produced by fixed assets and not from the exchange of similar fixed assets. Gains on
exchanges of similar fixed assets are also not recognized for income tax purposes ( of course
this is based on the tax laws of a country). To illustrate, assume the following exchange data
taken from seller and buyer , Biqila Computer Center:
Similar equipment acquired (new) by Biqila Computer Center:
List price of new equipment . . . . . . . . . . . . . . . . . . . . . . -------------------------------Br.5, 000

Trade-in allowance on old equipment ( value given by the seller . . . . . . . . . . . . . . . 1, 100
Cash paid at June 19, date of exchange – boot (given by Biqila ). . . . . . . . . . . . . 3,900
Equipment traded in (old):
Cost of old equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . --------------Br.4, 000
Accumulated depreciation at date of exchange (June 19 ) . . . . . . . . 3,200
Book value at June 19, date of exchange . . . . . . . . . . . . . 800
95
Based on the above given data, when the trade-in allowance exceeds the book value of an
asset traded in and no gain is recognized, the cost recorded for the new asset can be
determined in either of two ways as follows:
Method One:
List price of new equipment . . . . . . . . . . . . . . . . . . . . . . Br. 5,000
Trade-in allowance . . . . . . . . . . . . . . . . . . . Br.1,100
Book value of old equipment . . . . . . . . . . . . . . 800
Unrecognized gain on exchange . . . . . . . . . . . . . . . . . . . (300)
Cost of new equipment . . . . . . . . . . . . . . . . . . . . . . . . . . Br. 4,700
Method Two:
Book value of old equipment . . . . . . . . . . . . . . . . . . . . . Br.800
Cash paid at date of exchange . . . . . . . . . . . . . . . . . . . . . 3,900
Cost of new equipment . . . . . . . . . . . . . . . . . . . . . . .Br.4, 700
Now the entry will be made as follows:

June 19 accumulated depreciation (old) ------------------- 3,200
Equipment (new) ---------------------------- 4,700
Equipment (old) -------------------------------------------- 4000
Cash (boot given) ------------------------------------------ 3900
(To record write off old equipment through exchange)
Not recognizing the Br.300 gain (Br.1, 100 trade-in allowance minus Br. 800 book value) at
the time of the exchange reduces future depreciation expense. That is, the depreciation
expense for the new asset is based on a cost of Br. 4,700 rather than on the list price of Br.
5,000. In effect, the unrecognized gain of Br.300 reduces the total amount of depreciation
taken during the life of the equipment by Br.300.
b) Loss Treatment on Exchanges
For financial reporting purposes, losses are recognized on exchanges of similar fixed assets.
Losses on exchanges of similar fixed assets are also not recognized for l income tax purposes.
Loss occurred when the trade-in allowance is less than the book value of the old equipment.
96
When there is a loss, the cost recorded for the new asset should be the market (list) price. To
illustrate, assume the following exchange data for Biqila Computer Center
List (market) price of new equipment --------------------------------------- Br. 20,000

Trade-in allowance on old equipment -------------------------------------------- 4,000
Cost of old equipment ----------------------------------------------------------------- 14,000
Accumulated depreciation of old equipment at date of exchange, June 10 ---- 9,200

Based on this data cost, loss and cash given (boot) is computed as follows and recorded in the
book of Biqila Computer center.
Similar equipment acquired (new):

List price of new equipment . . . . . . . . . . . . . . . . . . . . . . Br.20, 000
Less:Trade-in allowance on old equipment . . . . . . . . . . . . . . . 4,000
Cash paid at June 10, date of exchange . . . . . . . . Br. 16,000
Equipment traded in (old):

Cost of old equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . Br. 14,000
Accumulated depreciation at date of exchange . . . . . . . . 9,200
Book value at June 10, date of exchange . . . . . . . . . 4,800
Trade-in allowance on old equipment . . . . . . . . . . . . . . . 4,000
Loss on exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Br. 800
Journal entry
June 10 Equipment (new) ------------------------------------------ 20000
Accumulated depreciation –equipment (old ) 9,200
Loss on Disposal (exchange) ---------------------- 800
Equipment (Old) ------------------------------------- 14000
Cash ----------------------------------- 16,000
(to write off old plant asset exchanged for similar asset )
From the above example and explanation you can recognize that there are special rules for
recognizing these gains and losses, depending on the nature of the assets exchanged. You may
see the similarities and differences from the following:
97
Exchange Losses Gains

Recognized Recognized
For Financial Reporting Purposes:
 Of similar assets………………………… Yes……………………………….No
 Of Dissimilar assets………………………. Yes…………………………….. Yes
For Income Tax purposes:

 Of similar assets…………………………… No………………………….. No
 Of dissimilar assets………………………… Yes……………………… Yes
1. Assume that the business exchange a machine with a cost of Br. 11,000, and accumulated
depreciation of Br. 9000 for a newer more modern machine on the following terms:
Cost of new machine ………………………Birr 12000.

Trade-in Allowance for old machine…………… (1500)
Cash payment required (Boot)……………..Birr 10500.
The journal entry required to record the exchange of assets would be
-----------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------------
--------------------------
2. What is the justification for the non-recognition of gains that result from the exchange of
similar assets?
3.6 LEASING FIXED ASSETS
You are probably familiar with leases. A lease is a contract for the use of an asset for a stated
period of time. Leases are frequently used in business. For example, automobiles, computers,
medical equipment, buildings, and airplanes are often leased. The two parties to a lease
contract are the lessor and the lessee. The lessor is the party who owns the asset. The lessee is
the party to whom the rights to use the asset are granted by the lessor. The lessee is obligated
98
to make periodic rent payments for the lease term. All leases are classified by the lessee as
either capital leases or operating leases.
A capital lease is accounted for as if the lessee has, in fact, purchased the asset. The lessee
debits an asset account for the fair market value of the asset and credits a long-term lease
liability account. The asset is then written off as expense (amortized) over the life of the
capital lease. The accounting for capital leases and the criteria that a capital lease must satisfy
are discussed in more advanced accounting texts. A lease that is not classified as a capital
lease for accounting purposes is classified as an operating lease. The lessee records the
payments under an operating lease by debiting Rent Expense and crediting Cash. Neither
future lease obligations nor the future rights to use the leased asset are recognized in the
accounts. However, the lessee must disclose future lease commitments in notes to the
financial statements.
3.7 INTERNAL CONTROL OF FIXED ASSETS
Because of their dollar value and long-term nature, it is important to design and apply
effective internal controls over fixed assets. Such controls should begin with authorization and
approval procedures for the purchase of fixed assets. Controls should also exist to ensure that
fixed assets are acquired at the lowest possible costs. One procedure to achieve this objective
is to require competitive bids from preapproved vendors.
As soon as a fixed asset is received, it should be inspected and tagged for control purposes
and recorded in a subsidiary ledger. This establishes the initial accountability for the asset.
Subsidiary ledgers for fixed assets are also useful in determining depreciation expense and
recording disposals. Operating data that may be recorded in the subsidiary ledger, such as
number of breakdowns, length of time out of service, and cost of repairs, are useful in
deciding whether to replace the asset. A company that maintains a computerized subsidiary
ledger may use bar-coded tags, similar to the one on the back of this textbook, so that fixed
asset data can be directly scanned into computer records.
Fixed assets should be insured against theft, fire, flooding, or other disasters. They should also
be safeguarded from theft, misuse, or other damage. For example, fixed assets that are highly
99
open to theft, such as computers, should be locked or otherwise protected when not in use. For
computers, safeguarding also includes climate controls and special fire-extinguishing
equipment. Procedures should also exist for training employees to properly operate fixed
assets such as equipment and machinery.
A physical inventory of fixed assets should be taken periodically in order to verify the
accuracy of the accounting records. Such an inventory would detect missing, obsolete, or idle
fixed assets. In addition, fixed assets should be inspected periodically in order to determine
their condition.
Careful control should also be exercised over the disposal of fixed assets. All disposals should
be properly authorized and approved. Fully depreciated assets should be retained in the
accounting records until disposal has been authorized and they are removed from service.
3.8 NATURAL RESOURCES
The fixed assets of some businesses include timber, metal ores, minerals, or other natural
resources. As these businesses harvest or mine and then sell these resources, a portion of the
cost of acquiring them must be debited to an expense account. This process of transferring the
cost of natural resources to an expense account is called depletion. The amount of depletion is
determined by multiplying the quantity extracted during the period by the depletion rate. This
rate is computed by dividing the cost of the mineral deposit by its estimated size. Computing
depletion is similar to computing units-of-production depreciation.
To illustrate, assume that a business paid Br.800, 000 for the mining rights to a mineral
Deposit estimated at 2,000,000 tons of ore. The depletion rate is B.0.40 per ton (Br.800,
000/2,000,000 tons). If 100,000 tons are mined during the year, the periodic depletion is
Br.40, 000 (100,000 tons * Br.0.40). The entry to record the depletion is shown below.
Dec.31 Depletion Expense -------------------------------- 40,000

Accumulated Depletion -------------------------------- 40,000
(to record adjusting for resources used during the period)
100
Like the accumulated depreciation account, Accumulated Depletion is a contra asset account.
It is reported on the balance sheet as a deduction from the cost of the mineral deposit.
3.9 INTANGIBLE ASSETS
Intangible assets are rights and privileges that are long-lived, are not held for resale, have no
physical substance, and usually provide their owner with competitive advantages over other
fi rms. Familiar examples are patents, copyrights, trademarks, franchises, licenses, and
goodwill. In today’s information-driven society, intangibles can be a company’s largest asset.
The basic principles of accounting for intangible assets are like those described earlier for
plant assets. The major concerns are determining:
 the initial cost and

 the amortization—the amount of cost to transfer to expense for intangible assets.
Amortization results from the passage of time or a decline in the usefulness of the intangible
asset. Some of the intangible assets are discussed as follows:
a) Patents
Manufacturers may acquire exclusive rights to produce and sell goods with one or more
unique features. Such rights are granted by patents, which the government issues to inventors.
These rights continue in effect for about 20 years which can be different among countries. A
business may purchase patent rights from others, or it may obtain patents developed by its
own research and development efforts. The initial cost of a purchased patent, including any
related legal fees, is debited to an asset account. This cost is written off, or amortized, over the
years of the patent’s expected usefulness. This period of time may be less than the remaining
legal life of the patent. The estimated useful life of the patent may also change as technology
or consumer tastes change.
The straight-line method is normally used to determine the periodic amortization. When the
amortization is recorded, it is debited to an expense account and credited directly to the
patents account. A separate contra asset account is usually not used for intangible assets.
101
To illustrate, assume that at the beginning of its fiscal year, a business acquires patent rights
for Br.200, 000. The patent had been granted 6 years earlier by the government Patent Office.
Although the patent will not expire for 14 years, its remaining useful life is estimated as 5
years. The adjusting entry to amortize the patent at the end of the fiscal year is as follows:
Dec 31 Amortization Expense—Patents --------------------------- 40,000

Patents ------------------------------------------------ 40,000
Rather than purchase patent rights, a business may incur significant costs in developing
Patents through its own research and development efforts. Such research and development
costs are usually accounted for as current operating expenses in the period in which they are
incurred. Expensing research and development costs is justified because the future benefits
from research and development efforts are highly uncertain.
b) Copyrights and Trademarks
The exclusive right to publish and sell a literary, artistic or musical composition is granted by
a copyright office. Copyrights are issued by the government and extend for 70 years beyond
the author’s death. The costs of a copyright include all costs of creating the work plus any
administrative or legal costs of obtaining the copyright. A copyright that is purchased from
another should be recorded at the price paid for it. Copyrights are amortized over their
estimated useful lives. Intangibles, which mainly consist of artist contracts and music
catalogs, are being amortized on a straight-line basis principally over 16 years and 21 years,
respectively.
A trademark is a name, term, or symbol used to identify a business and its products. It is
distinctive identification of product or service; a logo or catch phrase. Under law, businesses
can protect against others using their trademarks by registering them. Like a copyright, the
legal costs of registering a trademark with the government are recorded as an asset. Thus,
even though the Coca-Cola trademarks are extremely valuable, they are not shown on the
balance sheet, because the legal costs for establishing these trademarks are immaterial.
If, however, a trademark is purchased from another business, the cost of its purchase is
recorded as an asset. The cost of a trademark is in most cases considered to have an indefinite
102
useful life. Thus, trademarks are not amortized over a useful life, as are the previously
discussed intangible assets. Rather, trademarks should be tested periodically for impaired
value. When a trademark is impaired from competitive threats or other circumstances, the
trademark should be written down and a loss recognized.
Franchise operations have become so common in everyday life that we often don’t realize we
are dealing with them. When a business obtains a franchise, the recorded cost of the franchise
includes any sum paid specifically for the franchise right as well as legal fees and other costs
incurred in obtaining it. Although the value of a franchise at the time of its acquisition may be
substantially in excess of its cost, the amount recorded should be limited to actual outlays. For
example, approximately 80% of McDonald’s locations are operated under franchise
agreements. A McDonald’s franchisee must contribute an initial cash amount of $300,000,
which is used to buy some of the equipment and signs and also to pay the initial franchise fee.
The value of a McDonald’s franchise alone is much more than $300,000, but the franchisee
would only record a franchise asset in his or her financial statements equal to the cost (not
value) of the franchise. However, if a franchise right is included when one company
purchases another company, presumably the entire value is included in the purchase price, and
the fair value attributable to the franchise right is recorded as an intangible asset in the
acquirer’s books.
c) Goodwill
In business, goodwill refers to an intangible asset of a business that is created from such
favorable factors as location, product quality, reputation, and managerial skill. Goodwill
allows a business to earn a rate of return on its investment that is often in excess of the normal
rate for other firms in the same business.
Generally accepted accounting principles permit goodwill to be recorded in the accounts only
if it is objectively determined by a transaction. An example of such a transaction is the
purchase of a business at a price in excess of the net assets (assets _ liabilities) of the acquired
business. The excess is recorded as goodwill and reported as an intangible asset. Unlike
patents and copyrights, goodwill is not amortized. However, a loss should be recorded if the
103
business prospects of the acquired firm become significantly impaired. Accounting treatment
will be detailed in financial courses when the acquisitions of other businesses are common.
Exercise 3.6: Check Your Progress

1. Assume that on Jan 5, 2010 Coca Cola Soft Drink Bottling Company purchased a
patent on a unique bottle cap for Br. 120,000. Assume that Coca Cola’s management
determines that, although the patent for the bottle cap will last for seventeen years, the
product using the cap will be sold only for the next 5 years.
Required:
a) Record the purchase of the patent
b) Record the annual amortization
2. Assume that MIDROC Construction has acquired the right to use 100,000 acres of
land in in Western Region of Oromia, Qelem Zone (Wollega ) to mine for gold at a
total cost of, Br. 100,000.000 and zero salvage value. The Company estimated that the
mine will; provide approximately 800,000 grams of gold.
Required
a. Compute depletion rate
b. Compute the amount of depletion for the first year and second year assuming
200,000grams and 250,000 grams are extracted respectively.
3. Explain the difference among depreciation, amortization and depletion.
3.10 PRESENTATION OF PLANT ASSETS AND INTANGIBLE ASSETS ON THE

BALANCE SHEET
Activity: Dear student, how would plant assets and intangible assets be reported in the
financial statements? Try to guess the answer before you proceed reading the following
section.
The amount of depreciation and amortization expense of a period should be reported

separately in the income statement or disclosed in a note. A general description of the method
or methods used in computing depreciation should also be reported. The amount of each
major class of plant assets should be disclosed in the balance sheet or in notes. The related
104
accumulated depreciation should also be disclosed, either by major class or in total. The fixed
assets may be shown at their book value (cost less accumulated depreciation), which can also
be described as their net amount. If there are too many classes of fixed assets, a single amount
may be presented in the balance sheet, supported by a separate detailed listing. Fixed assets
are normally presented under the more descriptive caption of property, plant, and equipment.
The cost of mineral rights or ore deposits is normally shown as part of the fixed assets section
of the balance sheet. The related accumulated depletion should also be disclosed. In some
cases, the mineral rights are shown net of depletion on the face of the balance sheet,
accompanied by a note that discloses the amount of the accumulated depletion.
Intangible assets are usually reported in the balance sheet in a separate section immediately
following fixed assets. The balance of each major class of intangible assets should be
disclosed at an amount net of amortization taken to date. Following is a partial balance sheet
that shows the reporting of fixed assets and intangible assets (hypothetical data) for Matador
Company.
Matador Company
Balance Sheet
December 31, 2011
Assets:
Total Current assets --------------------------------------------- Br. 500,000
Property, plant, and Equipment:
Office Equipment ----------------------------------------------------Br. 350,000
Less accumulated depreciation --------------------------------- 102,000 248,000
Buildings ------------------------------------------- Br. 2, 650,000
Less accumulated depreciation -------------- 420,000 2,230,000
Land ---------------------------------------------------- 1,850,000
Total property, plant, and equipment ---------------- Br.4, 328,000
Intangible assets:
Patents ------------------------------------------------------- 140,000
Total assets ------------------------------------------------- Br.4,968,000
Br.4,968,000
105
3.11 ANSWERS TO CHECK YOUR PROGRESS AND EXERCISES
1. The cost of a plant asset includes all expenditures that are reasonable and necessary for
getting the asset to the desired location and ready for use.
2. The cost of repairing this damage should be recognized as an expense of the current
period, not added to the cost of the machine. Although it is necessary to repair the
machine, it was not necessary to drop it-and that's what brought about the need for the
repairs
3. The cost of the land is determined as follows:
a. Cash prices (negotiated price)…………………………………… Br. 310,000
Title Fees……………………………………………………………………..4,000
Brokerage Fees………………………………………………………………...8,500
Cost of Grading…………………………………………………………….. 2,500
Cost of removing (demolition) unwanted building Br. 6000
Less: Salvage received……………………………….(3000)…………………3,000
Total cost of land…………………………………………………… .….Br.
.….Br. 328,000
b. Land ------------------------------------------------- 328,000
Notes payable --------------------------------- 310,000
Cash ---------------------------------------- 18,000
1. Because it is very difficult to estimate economic life of the land. Land has unlimited life.
2. A) 20,000 cost – Br. 2,000 residual value = Br. 18,000 to be depreciated
a)
 Straight-Line
Depreciation = Cost – Residual Value
Life in years
= Br.20,000 – Br,2,000
5 years
= Br. 3,600
106
 Note that the same amount of depreciation expense is recognized for remaining
economic life of the asset under this method.
 Units-of-Production Depreciation
Depreciation expense per unit = Cost – Residual Value
Life in Units
= Br.20,000 – Br,2,000
18,000
= Br.1.00 per unit
In the statement of the problem indicated that the total expected production is
uniformly prorated over the economic life of the asset. Hence, each year units of
production is 3600 (18,000/5). This implies each year depreciation is also uniform
and computed as follows:
3600 units * Br. 1.00 per unit = Br. 3,600.
 Double-Declining-Balance Depreciation
DDB Rate = (100%/Useful

Useful Life) × 2
= (100%/5 Years) × 2
= 40%
Book Value at Book Value at
Year Rate Beginning of Year Depreciation End of Year
2007 40% Br.20,000 Br. 8,000 Br. 12,000
2008 40 12,000 4,800 7,200
2009 40 7,200 2,880 4,320
2010 40 4,320 1,728 2,592
2011 40 2,592 592 2,000
Br. 18,000
107
 Sum- of- Years digits Method
Book Value
Year Fraction Depreciable cost Depreciation End of Year
2007 5/15 Br.18, 000 Br. 6,000 Br. 14,000
2008 4/15 18,000 4,800 9,200
2009 3/15 18,000 3,600 5,600
2010 2/15 18,000 2,400 3,200
2011 1/15 18,000 1,200 2,000
Br. 18,000
3. Journal Entries:
Method Date Dr. Cr.

s
S/L 2008 Depreciation expense ---------------- 3,600
Dec. 3 Acc. Depreciation ---------------- 3,600

1
UOP 2008 Depreciation expense ---------------- 3,600

1
DDB 2008 Depreciation expense ---------------- 8,000

1
SYD 2008 Depreciation expense ---------------- 4,800

1
DDB 2012 Depreciation expense --------------- 592

( yr5)
Dec.
Note that Final 3 Acc.= Depreciation
year’s depreciation ----------------
amount needed 592
to equate book value with
1
salvage value under double declining method. That means asset should not
depreciate for its book value less than salvage value. That means maximum
108
accumulated depreciation balance is equal to the depreciable cost of an asset.
4. Comparison and reasons for Choosing the depreciation method
Years Straight Line Declining Balance
1 Br. 3,600 Br. 8,000
2 3,600 4,800
3 3,600 2,880
4 3,600 1,728
5 3,600 592
 Reasons for for choosing the depreciation method
F Simplicity
F Reporting to stockholders
FComparability
 Reasons for Choosing Accelerated Methods
F Result in better matching of revenue and expenses for some assets, particularly
those becoming obsolete quickly.
F Minimize taxable income (but companies usually use one method for tax purpose
and another for financial reporting purpose
F Most companies use straight-line depreciation for external reporting. It provides

an equal amount each year. However, companies can choose different methods
for tax purposes than they do for accounting purposes.
109
a)
Book value (unexpired cost), Jan 1, 2011 Br. 50,000
Revised estimated residual value 25,000
Revised remaining depreciable cost Br.25, 000
Divide by remaining years /4____
Revised annual depreciation expense Br. 6,250
On Dec 31, 2011, BV = Br. 120,000 – Br.( 70,000 + 6,250 )
= Br. 43, 750
Or
Br. 50,000 – 6,250 = Br. 43,750
It must be equal to salvage value which is Br. 25,000, verify through computation
1. In general, costs incurred to achieve greater future benefits should be capitalized,

whereas expenditures that simply maintain a given level of services should be
expensed. To capitalize costs, one of three conditions must be present:
 Useful life of the asset must be increased.
 Quantity of units produced from asset must be increased.
 Quality of units produced must be enhanced.
2.
a. Determine the total depreciation expense for 2006 related to the alarm system.
b. Determine the total expense reported in the income statement in 2006 from these
transactions.
2.a) Total cost = Book value of removed alarm system plus cost incurred during
110
2006 to remove the old system plus depreciation expense of the

new system at the end of 2006
= Br. 15,000 (cost – Acc.depn. of old system) + Br. 12,000 ( depn.
Expense Of new system)
= Br. 27,000
Total expense = Book value of removed alarm system plus cost incurred during
2006 to remove the old system plus depreciation expense of the
new system at the end of 2006
= Br.15,000 + Br.12,000 + Br.2,000
= Br. 29,000
1. The trade-in allowance (1500) is less than the carrying value (Br. 2000) of the old
machine. The loss on the exchange is Br. 500, (Br. 2000 – Br. 1500). Therefore, the
journal entry required to record the exchange of assets would be as follows:
July 5. Equipment (New)……………………..12,000.00

Accum. Depreciation-Equip…………………...9,000.00
Loss on Exchange of plant assets………………. 500.00
Equipment (old)……………………………………11,000.00
Cash…………………………….…………………. 10,500.00
2. Gains on exchanges of similar assets are not recognized for financial reporting
purposes because the earning lives of the asset surrendered are not considered to be
completed
1) Total cost – Salvage value = Depletion cost per unit.

Total estimated units available
Br. 100,000,000 = Br. 125 per gram

800,000 grams
2)
111
Year 1; 200,000 * Br. 125 = Br. 25,000,000

Journal entry
Depletion Expense…………………..25,000,000
Accumulated Depletion……………………….25, 000,000
Year 2 ; 250,000 * Br. 125 = Br. 2,500,000
Journal entry
Depletion Expense…………………..31,250,000
Accumulated Depletion……………………….31,250,000
(To record Depletion)
3. The purpose of these terms is almost the same. But they differ to what they are
pertaining.
o Depreciation is the cost allocation of the plant assets to the period the used to
generate revenue ( used in the operation )
o Amortization: is the cost allocation of intangible assets to the period they
benefit. Where as
o Depletion is the periodic cost allocation of the natural resources.
(You may explain in detail their difference)
Part I: True or False
1. When partially depreciated (not fully depreciated) plant asset is disposed by means of
discarding, the amount of loss from plant asset is the same as the book value of the
disposed plant asset.
2. Sum-of-years-digits method of computing depreciation is the simplest method of all
and hence has used by most companies.
3. Depreciation is the means of determining the mark value of the plant assets.
Part II: Matching type
A B
112
1. Depletion Q. allocation of costs of Intangible assets
2. Straight-line depreciation method R. Yearly depreciation is based on the activity of

the year
3. Double declining balance depreciation S. Fraction of the years digit is used to compute
yearly depreciation
method
4. Amortization T. allocation of costs of natural resources
5. Units of production depreciation method U. allocation of costs of plant assets
V. rate is applied on the beginning book value of

each year to compute the yearly depreciation
Part III: Multiple Choice Types
1. One of the following is not an example of intangible assets.

A) patents B) Franchise C) Trademarks
D) Goodwill E) None
2. Which of the following expenditures incurred in connection with acquiring machinery is a
proper charge to the asset account?
A. Freight B. Installation costs C. Both A and B D. Neither A nor B E. None
2. What is the amount of depreciation, using the declining-balance method (twice the straight-
line rate) for the second year of use for equipment costing Br.9,000, with an estimated
residual value of Br.600 and an estimated life of 3 years?
A. Br.6, 000 B. Br.2, 000 C. Br.3, 000 D. Br.400 E. None
3. An example of an accelerated depreciation method is:
A. Straight-line B. Declining-balance C. Units-of-production D. Depletion E.None

4. A fixed asset priced at $100,000 is acquired by trading in a similar asset that has a book
value of Br.25, 000. Assuming that the trade-in allowance is Br. 30,000 and that Br.
70,000 cash is paid for the new asset, what is the cost of the new asset for financial
reporting purposes?
A. Br.100, 000 B. Br.95,000 C. Br.70,000 D. Br.30,000 E. None
113
5. Which of the following is an example of an intangible asset?
A. Patents B. Goodwill C. Copyrights D. All of the above E, None
Part IV. Short Answer
1. Assume that Matador Co. acquired an adjacent vacant lot with the hope of selling it in
the future at a gain. The lot is not intended to be used in Company’s business
operations. Where such real estate should be listed in the balance sheet?
2. What is meant by Intangible Asset?

3. Explain the entries required in selling a plant asset for cash.
Part V. Work out Part
1. Assume that Matador Company purchased a small delivery truck on October 1, 2011
for Br.130, 000 expected to be used for 5 years and its estimated service is 1,000,000
miles. Its expected salvage value is Br.10, 000.
Required:
a. Compute depreciation of the machine for years 1 through 5 using the straight-line,
units-of-production, double-declining-balance and sum of the year’s digits
depreciation methods.
b. Pass journal entry to record depreciation for year 1 under each method.
2. Sold a truck for Br. 1,800.00. The truck had been purchased two years ago on January
2 for Br. 2300.00.The amount of depreciation is Br. 800.00 a year. Accumulated
depreciation for that amount was recorded at the end of the two previous years.
a. Record the depreciation for the current year to June 30.
b. Record the sale of the truck.
3. Discarded office equipments for which there was no further use and which could not
be sold. The office equipment cost Br. 320.00 and had a book value of Br. 20.00 at the
time was discarded.
114
UNIT FOUR: CURRENT LIABILITIES
CONTENTS:
4.0 Aims and Objectives
4.1 Introduction
4.2 The nature of Liabilities
4.3 Short- term notes payable
4.4 Ethiopian Payroll system
4.5 Presentation of Liabilities on the Balance Sheet
4.0 AIMS AND OBJECTIVES

The unit discusses the meaning, nature of current Liabilities, the Ethiopian payroll system and
Presentation of Liabilities on the Balance Sheet. After studying this unit, you will be able to:
 Define and give examples of current liabilities.
 Prepare journal entries for short-term notes payable and the disclosure for the
current portion of long-term debt.
 Describe the accounting treatment for contingent liabilities
 Determine employer liabilities for payroll, including liabilities arising from
employee earnings and deductions from earnings.
 Describe payroll accounting systems of Ethiopia.
4.1 INTRODUCTION
Current liabilities are obligations that are to be paid out of current assets and are due within a
short time, usually within one year. This are caused either by receiving goods or services prior
to making payment ( Account payables) , receiving payment prior to delivering goods or
services, deductions and withholding from employee’s salary maturing portions of the long-
term liabilities and Taxes payable, Interest payable, Wages payable , so on .
115
4.2 THE NATURE OF CURRENT LIABILITIES
Liabilities that are to be paid out of current assets and are due within a short time, usually
within one year, are called current liabilities.
liabilities. Most current liabilities arise from two basic
transactions:
I. Receiving goods or services prior to making payment.

II. Receiving payment prior to delivering goods or services.
An example of the first type of transaction is accounts payable arising from purchases of
merchandise for resale. An example of the second type of transaction is unearned rent arising
from the receipt of rent in advance. In this chapter, we will introduce some other common
current liabilities. These include short-term notes payable, contingencies, payroll liabilities,
and employee fringe benefits.
4.3 SHORT-TERM NOTES PAYABLE
The current liability section of the balance sheet contain items that are used to finance
business operations, such as short-term notes payable and the portion of long-term debt that is
due within the coming period. Notes may be issued when merchandise or other assets are
purchased. They may also be issued to creditors to temporarily satisfy an account payable
created earlier. For example, assume that Keraj co. issues a 90-day, 12% note for br 1,000,
dated August 1, 2012, to WALMART Co. for the br1,000 overdue account. The entry to
record the issuance of the note is as follows:
Aug.1 Accounts payable-WALMART.CO. . . . . . . . . . . . . . . . . . . . . . . . .1,000

Notes payable-WALMART CO. . . . . . . . . . . . . . . . . . . . . . . . . . . .1,000
(A 90-day,12% notes on account of br 1,000)
When the note matures, the entry to record the payment of br 1,000 principal plus br 30
interest (br 1,000 _ 12% _ 90/360) is as follows:
Oct. 30. Notes payable-Walmart c. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1,000

Interest expense( 12% x 1,000 x 90/360). . . . . . . . . . . . .. . . . . 30
Cash. . . . . . . . . . . … . . . . . . . . . . . . . . . . . . . . . . . .. . . . . ..1,030
(Payed principal plus notes against due notes)
116
Current Portion of Long-Term Debt:

Long-term liabilities are often paid back in periodic payments, called installments, such as
building, car and like long time loan . Long-term liability installments that are due within the
coming year must be classified as a current liability. The total amount of the installments due
after the coming year is classified as a long-term liability. To illustrate, Keraj Marchandizing
Co. reported the following scheduled debt payments in the notes to its Sene 30, 2005 annual
report to shareholders:
Fiscal year ending
2006 br 600,000
2007 100,000
2008 150,000
2009 300,000
2010 500,000
After 5yrs 6,000,000
Total principal payments br 2,250,000
The debt of br 600,000 due in 2006 (coming year) would be reported as a current liability on
the Sene30, 2005(end of year) balance sheet. The remaining debt of br 1,650,000 (br
2,250,000 - br 600,000) would be reported as a long-term liability on the balance sheet.
A business issued a $5,000, 60-day, 12% note to the bank. What is the amount due at
maturity? -
___________________________________________________________________________
_____________________________________________.
Contingent Liabilities:-
Some past transactions will result in liabilities if certain events occur in the future. These
potential obligations are called contingent liabilities. For example, Bishoftu co. would have a
contingent liability for the estimated costs associated with warranty work on new car sales.
117
The obligation is contingent upon a future event, namely, a customer requiring warranty work
on a vehicle. The obligation is the result of a past transaction, which is the original sale of the
vehicle. If a contingent liability is probable and the amount of the liability can be reasonably
estimated, it should be recorded in the accounts. Bishoftu Car co.’s vehicle warranty costs are
an example of a recordable contingent liability. The warranty costs are probable because it is
known that warranty repairs will be required on some vehicles. In addition, the costs can be
estimated from past warranty experience. To illustrate, assume that during June of 2004,
Bishoftu Car co. sells a double cabine vehicle for br 600,000 on which there is a 24-month
warranty for repairing defects. Past experience indicates that the average cost to repair defects
is 3.5% of the sales price over the warranty period. The entry to record the estimated product
warranty expense for June is as follows:
June,30 Product Warranty Expense . . . . . . . . . . . . . . . . . . . . . . . . . .21,000

Product Warranty Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000
(Warranty expense for June, 3.5% x br 600,000)
This transaction matches revenues and expenses properly by recording warranty costs in the
same period in which the sale is recorded. When the defective product is repaired, the repair
costs are recorded by debiting Product Warranty Payable and crediting Cash, Supplies, or
other appropriate accounts. For example, if the customer required a br 6,000 part replacement
on May 10,2005 ( 11 months later ) , the entry would be:
May 10,2005 Product Warranty Payable . . . . . . . . . . . . . . . . . . . . . . . .6,000

Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6,000
(Replaced defective part under warranty)
Note:- If a contingent liability is probable but cannot be reasonably estimated or is only

possible, then the nature of the contingent liability should be disclosed in the foot-notes to the
financial statements. Professional judgment is required in distinguishing between contingent
liabilities that are probable versus those that are only possible.
118
4.4 ETHIOPIAN PAYROLL SYSTEM
The term payroll refers to the amount paid to employees for the services they provide during a
period. A business’s payroll is usually significant for several reasons. First, employees are
sensitive to payroll errors and irregularities. Maintaining good employee morale requires that
the payroll be paid on a timely, accurate basis. Second, the payroll is subject to various federal
and state regulations and the third is that the proceeds from payroll taxes are the largest source
of revenue for the government- so required a serious attention both from tax with-holding and
tax administrative sides. Various federal, state, and local laws require employers to keep
accurate payroll records and to prepare reports and submit to the appropriate units. The law
also requires employers to remit the amounts withheld from its employees and the payroll
taxes imposed on itself. / For more detail regarding the Ethiopian tax laws, regulations and
proclamations please go through: the council of ministers regulation No. 78 / 2002. And
Article 33 or proclamation No. 64 / 1975, Proclamation No. 286 / 2002 and the other related
issues on Negarit Gazeta/.
 Definition of payroll related terms:-

Salary and Wages:- Salaries and wages paid to employees are an employer’s labor expenses.
The term salary usually refers to payment for managerial, administrative, or similar services.
The rate of salary is normally expressed in terms of a month or a year. The term wages
usually refers to payment for manual labor, both skilled and unskilled. The rate of wages is
normally stated on an hourly or weekly basis. In practice, the terms salary and wages are often
used interchangeably.
The Pay Day:- is the day on which wages or salaries are paid to employees. This is usually
on the last day of the pay period.
The Pay Period: A pay period refers to the length of time covered by each payroll payment.
A Payroll Register (sheet): is the list of employees of a business along with each employee’s
gross earnings; deductions and net pay (take home pay) for a particular pay period. The
payroll register (sheet) is prepared based on attendance sheets, punched (clock) cards or time
cards.
119
Pay Check: A business can pay payroll by writing a check for the amount of the net pay. A
check is prepared in the name of each employee and handed to employees. Alternatively a
check for the total net pay can be prepared for employees to be paid by cash at the
organization.
Gross Earnings:
Earnings: are taxes collected from the earnings of employees by t he employer
organization as per the regulations of the government. These have to be submitted (paid) to
the government because3d employer organization is only acting as an agent of the
government in collecting these taxes from employees.
Payroll Deductions: are deductions from the gross earnings of an employee such as
employment income taxes (withholding taxes), labor union dues, fines, credit association pays
etc.
Net Pay: Net Pay is the earning of an employee after all deductions have been deducted. This
is the take home pay amount collected by an employee on the payday.
Pension Contribution:- currently, employees / working for more than 45 days,both in

government and Ngo’s/ in Ethiopia is expected to pay or contribute 7% of their basic salary to
the governments’ pension trust fund. This amount is withheld by the employer from each
employee on every payroll and later be paid to the respective government body. The employer
is also expected to contribute towards this same fund 8% of the basic salary of every
permanent government employee.
Therefore, the total contribution to the pension fund of the Ethiopian government is equal to
15% of the basic salary of employees. That is, 7% comes from the employees and 8% comes
from the employer. This enables the employee to be entitled to the pension pay when retiring
provided the employee satisfies the minimum requirements to enjoy the benefits.
 Exemptions
The tax proclamation also provides some exemptions. Exemption, in this context, refers to
income, which is not subject to tax. The following categories of income are exempted from
employment income tax:
120
 Casual employees (who do not work under the same employer for more than one month
in a year)
 Pension, provident fund and all other retirement benefit (up to 15% of the monthly
salary of employee)
 Income of diplomats or consular representatives
 Foreign personnel employed in Embassy, Legation, Consulate or mission who are
bearers of diplomatic passport
 Income specifically exempted by law or international treaty or an agreement approved
by Minister
 Consumption paid for personal injury
 Gratitude in relation to the death of another person
 Deductions
The following payments, made to an employee by an employer, are allowed to be deducted to
determine taxable income.
 Reimbursed medical expenses

 Transportation allowance
 Hardship allowance
 Reimbursed traveling expense (incurred on duty)
 Traveling expenses from the place of recruitment to the place of employment and on
completion of employment from the place of employment to the place of recruitment
 Allowances paid to the members and secretaries of the board of public enterprises and
of study groups set by federal or regional government.
 Income of persons employed for domestic duties
 Special Provision
The following category of employees shall declare and pay taxable income themselves.
 Those who are work for more than one employer

 Those who work in International Organization-Embassies, etc (who are not exempted)
121
 Penalties
For no filling or late filing:
 Birr 1,000 for the first 30 days

 Birr 2,000 for the next 30 days
 Birr 1,500 for each 30 days thereafter For non-payment:
 5% of tax unpaid on the first day after due date
 2%additional tax on the first day of each month thereafter For failure to withhold:
Withholding agent shall personally be liable to pay the amount due plus Br 1,000 and
Br 1,000 will be imposed on the chief accountant or officer who is in charge of
supervision.
A tax rate is applied to the taxable income to determine the tax that must be paid. Article 11
of the Income Tax Proclamation sets out the tax rate schedule that lists the tax rates that must
be applied to determine the tax liability of an employee. This schedule called Schedule “A” is
shown below. The total tax payable on employment income can be determined using a
simplest method.
Tax Liability = (Taxable Income X Tax Rate for the Bracket) -Deduction. If “I” is taxable
income, income tax on different brackets can be calculated as follows:
Income Bracket Rate Deduction
0 - 150 0 0
151 – 650 I X 10% 150
651 – 1,400 I X 15% 47.50
1,401 – 2,350 I X 20% 117.50
2,351 – 3,550 I X 25% 235.50
3,551 – 5,000 I X 30% 412.50
5001 & above I X 35% 662.50
122
Determine the total amount expected as income tax from an employee who earns a basic
monthly salary of Br. 3,200, a monthly allowance of Br. 600, and an overtime earning of
Br. 700?
________________________________________________________________________
________________________________________________?
4.5 PRESENTATION OF CURRENT LIABILITIES ON THE BALANCE SHEET
Current liability is usually presented in the Capital and liability section of the balance sheet,
preceding the owners equity and capital items. On the balance sheet the current liabilities
should be kept separate from long and medium term notes that are to mature within a year,
possibly in chronology of maturity.
 POSSIBLE COMPONENTS OF A PAYROLL REGISTER

1 Employee Number:-Number
Number:-Number assigned to employees for identification purpose when a
relatively large number of employees are involved in a payroll register.
2 Name of Employees:- full name of the employees
3 Earnings
Money earned by an employee from various sources,. This may include.
a. Basic Salary-
Salary- a flat monthly salary of an employee for carrying out the normal work
of employment and subject to change when the employee is promoted.
b. Allowances- money paid monthly to an employee for special reasons, like:
- Position allowance-
allowance- a monthly paid to an employee of earning a particular office
responsibility.
- Housing allowance- a monthly allowance given to cover housing costs of the
individual employee when the employment contract requires the employer to
provide housing but the employer fails to do so.
123
- Hardship allowance-
allowance- a sum of money given to an employee to compensate for
an inconvenient circumstance caused by the employer. For instance, unexpected
transfer to aw different and distant work area or location.
- Desert allowance- a monthly allowance given to an employee because of
assignment to a relatively hot region.
- Transportation (fuel) allowance- a monthly allowance to an employee to cover
cost of transportation up to her workplace if the employer has committed itself to
provide transportation service.
C. Overtime Earning: Overtime work is the work performed by an employee beyond the
regular working hours. Overtime earnings are the amount paid to an employee for
overtime work performed.
Article 33 of proclamation No. 64/1975 discussed the following about how overtime work
should be paid:
A worker shall be entitled to be paid at a rate of
i. one and one-quarter (1 ¼) times his ordinary hourly rate for overtime work performed
before 10:00 P.M in the evening.
ii. One and one half (1 ½) times his ordinary hourly rate for overtime work performed
between 10:00 P.M and six (6:00 A.M) in the morning.
iii. Two times the ordinary hourly rate for overtime work performed on weekly rest days
iv. two and one half (2 ½ ) times the ordinary hourly rate for overtime work performed on
a public holiday.
All in all, the gross earnings of an employee may include the basic salary, allowance and
overtime earnings.
Illustration:
Ato Ahmed is an employee of Nile Travel co. and his monthly basic salary is Br 4,700. In
addition he is getting Br 100 monthly house allowance.
Required: Determine his taxable income and income tax liability.
124
Solution:
Taxable income = Br 4,700 + Br 100 = Br4,800

Tax liability = (Taxable income X Tax rate for the Bracket) – Deduction
= (4,800 X 30%) – 412.50
= Br 1,027.50
Recordings of both the with-held tax and payroll tax liabilities, as follows:
F To record payment of salary to the employee:

Salary Expense ( basic + housing allo ) . . . . . . . .. . . . . . . . . . . . . . . . . . . 4,800
Payroll expense( 8%x4700) . . . . . . . . . . . . . . . …. . . . . . . . . . . . . . . . . . . . .376
Employment Income Tax Payable…. . . . . ………………………………1,027.50
Pension contribution payable ( 7% + 8% of the basic slry ) . . . . . . . . . . . . 705
Cash ( 4800 -329- 1,027.5) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 3,443.5
F To record the payment of withhold tax to Federal Inland Revenue Authority and the
pensions contribution to pension trust fund:
Employment Income Tax Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. .1,027.50
Pension contribution payable ( 7% + 8% of the basic slry ) . . . . . . . . . . . . . . . . . . . 705
Cash . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. .. . . . . . . . . . . . . . . . . . . . . . . . 1,732.5
4.6 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS:
Q1) The maturity value is br 5,100, determined as follows:
Face amount of note = br 5,000

Plus interest (br5,000 x 12% x 60/360) 100
Maturity value br 5,100
Q2) Gross Earnings of the employee = Basic Salary + Allowance + Overtime earning
Gross total Earnings = br. 3,200 + br. 600 + br. 700

Gross Total Earnings = br. 4,500
Taxable Income of the employee = br. 4,500
Total Employee Income Tax is therefore, br.4,500 x 30% - 412.5 = 937.5
125

Problems:
1) Keraj merchandizing .co, pays its employee’s salarie according to the Ethiopian
calendar Month. The following data relate to the month of Miazia, 2005 E.C.
S.No Employee Name Basic Salary

001 Tigist Regasa birr 3,500
002 Fatima Kemal birr 4500
003 Ojulu Narang birr 3,480
04 Abdalla Farah birr 2,500
Additional information
 All workers are expected to work 40 hours per week .

 Ojulu Narang has worked 15 hours of overtime during the month: out of which 5
hours on a public holy day and the remainingbetween 10 p.m to 6:00 a.m.
 Fatima Kemal has also worked 10 hours of overtime: 5 hours public holy days and 5
before10 p.m.
 Fatima Kemal reported to make a monthly deduction of br. 400 for Hidase Dam.
 All workers are permanent except Abdalla Farah.
Required:
 Compute the total deductions and net pay for each employee.
 Compute (calculate) the total:
a) Withholding Taxes
b) Payroll Tax
c) Record the payment of salary as of Miazia 30,2005.
 prepare the entry to pay the withholding taxes to the appropriate government unit.
2) Famly furniture plc.. a family held business, pays the salary to its employees according
to the Ethiopian calendar month. The following data relates to the month of Sene, 2005.
126
Name Basic Salary
Shumet Alamirew br. 5,350

Delelegn Bosoka 3,500
Ayana Baati 3,800
Raji Ahmed 4,650
Goitom Guish 3,670
Additional information
 The PLC. Wanted the worker to work 40 hours in a week .

 Ato Ayana Baati have worked 10 hours of overtime during 10:00pm to 6:00a.m.
 Ato, Delelegn Bosoka and Goitom Guish earn a monthly allowance of birr 900 and
br. 750 respectively.
Required: based on the information given above:
 Compute the income tax for each employee.

 Compute the total deductions for each employee.
 Determine the net pay (take-home-pay) for each employee.
 Compute the total withholding tax for the month.
 Compute the total payroll tax expense.
 Pass the journal entry to record the payment of salary as of Sene 30,2005.
127
UNIT FIVE: ACCOUNTING FOR PARTNERSHIPS

Contents
5.0 Aims & Objectives

5.1 Introduction
5.2 Basic Characteristics of partnerships
5.3 Equity reporting for partnerships
5.4 Formation of Partnership
5.5 Division of Partnership Income And Losses
5.6 Dissolution of A Partnership
5.6.1. Admission of A New Partner
5.6.2. Withdrawal or Death of partner
5.7 Liquidation of A Partnership
5.8 Financial Statements For A Partnership
5.9 Summary
5.10 Answers To Check Your Progress
5.11 Model Examination Questions
5.12 Reference Books
5.13 Glossary
5.0 AIMS AND OBJECTIVE
The unit aims at discussing the accounting for partnerships such as Equity reporting for
partnerships , computing each partner’s share of income or losses using different techniques,
and recording them to the respective capital accounts. Also, the accounting implications of
dissolution and liquidation of a partnership will be described. Having studied and worked
through this chapter you would be able to:
Define partnerships and explain their characteristics.
 Describe the basic characteristics of partnerships

 describe the advantages and disadvantages of a partnership
 Describe and illustrate the equity reporting for partnerships
128
 Describe and illustrate the accounting for forming a partnership.

partnership
 Understand and apply the various methods of dividing the income or loss of a
partnership.
 Record the admission and withdrawal of a partner(s)
 Understand and apply the steps in the liquidation of a partnership.
5.1 INTRODUCTION
In your previous course you have studied the three most dominant forms of business
organization: sole proprietorship, partnership, and corporation. For accounting purposes, each
form should be viewed as an economic unit separate from its Owners, though legally only the
corporation is considered separate from its Owners. The accounting for corporate form of
businesses will be explained in the next chapter. The main focus of this chapter is to acquaint
the learners with the basics of accounting for partnerships. As will be explained later in this
section, the same accounting principles that are used in accounting for a sole proprietorship
are applied in partnership form of businesses. However, there are accounting practices that
are unique to partnerships. These unique accounting features relate to the partners’ capital
and drawing accounts, division of income (or loss), and changes in Ownership of the
partnership.
A partnership is an association of two or more persons to carry-on as co-Owners of a

business for profit. This association is based on a partnership agreement or contract known as
the articles of a partnership. The partnership agreement should specify the name location,
and purpose of the business; the capital contributions and duties of each partner; the methods
of income and loss division; the rights of each partner upon liquidation (winding up) of a
partnership, etc. The partnership agreement should be in writing to avoid any
misunderstandings about the formation, operation, and liquidation of a partnership
5.2 BASIC CHARACTERSTICS PARTNERSHIPS
For purposes of accounting, partnerships are treated as separate economic entities. The next
paragraphs describe some of the important features of a partnership.
129
A) Voluntary Association
A partnership is a voluntary association of individuals rather than a legal entity in itself.

Therefore, a partner is responsible under the law for his or her partner’s business actions
within the scope of the partnership. A partner also has unlimited liability for the debts of the
partnership. Because of these potential liabilities, an individual must be allowed to choose the
people who join the partnership.
B) Limited Life
Because a partnership is formed by the consent of two or more partners, it has a limited life.
This means that, anything that ends the contract dissolves the partnership. A partnership can
be dissolved when (1) a new partner is admitted; (2) a partner withdraws, retires, dies or
becomes bankrupt. At this point, the remaining partners should sign a new contractual
agreement to continue the affairs of the business. In place of the old partnership a new
partnership is formed. Thus, a partnership is said to have a limited life.
C) Unlimited Liability
Each partner is liable for all the debts of the partnership. When and if the partnership fails to
pay its debts, creditors can seize (take) each partner’s personal assets to satisfy their claims.
Therefore, a partnership creditor’s claims are not limited to the assets of the business, but is
extends to the personal property of the partners. Each partner, then, could be required by law
to pay all the obligations (debts) of the partnership. Suppose, for example, the liabilities of
ABC company (a partnership business) as of a certain date is birr 600,000, however, the total
properties (assets) of ABC company could only be sold for birr 450,000. Thus, to settle
creditors’ claims fully, the house or personal assets of the partners may have to be sold.
D) Mutual Agency
Each partner is an agent of the partnership within the scope of the business. This means that
partner’s act to any contract is binding on the remaining partners as long as it is within the
apparent scope of the business’ operations.
130
For example, a partner in a public accounting firm can bind the partnership through the
delivery of accounting services. But this partner cannot bind the partnership to a contract for
delivering (or providing) cars because it is out of the scope of the business.
E) Co Ownership of partnership property
Once invested, the properties contributed by the partners become the property of the
partnership and is owned jointly by all the partners. Upon liquidation of the partnership and
distribution of assets, the partner’s claim on the assets is measured by the amount of the
balance in his/her capital account.
F) Participation in income of the partnership. Net income and net loss are distributed among
the partners according to their agreement.
agreement Each partner has the right to participate in sharing
the net income or net loss of the partnership
G) Non-taxable entity
A partnership, like a proprietorship, is a nontaxable entity and thus does not pay federal
income taxes. However, revenue and expense and other results of partnership operations must
be reported annually to the Internal Revenue Service. The partners must, in turn, report their
share of partnership income on their personal tax returns.
returns
ADVANTAGES AND DISADVANTAGES OF PARTNERSHIP

Advantages:
A partnership form of business Ownership has the following advantages:
1. Easy and inexpensive to form than a corporation. A partnership is easy to form. It only
requires the consent of two or more parties. Two or more competent persons simply agree
to be partners in some common business purpose.
2. Advantageous to raise a large amount of capital and managerial skill (talent) than a sole
proprietorship. Because a partnership is formed by two or more persons, it is possible to
raise a large amount of capital and managerial skill than a single owner.
3. Not subject to separate taxation as a case in a corporation because each partner reports
his/her own share of partnership income and is individually taxed, and
131
4. Not required to observe on many restrictive laws unlike a corporation.
Disadvantages
Partnership has the following disadvantages:
1. Partners assume unlimited liability. The liability of the partners is not limited to what
they have in the partnership, but it goes to the extent of their personal properties (assets).
2. Disadvantageous if each partner does not exercise his/her good judgment because one
partner’s act can bind a partnership into a contract.
3. Limited life. Partnerships are subject to possible termination due to many uncontrollable
circumstances such as the death of a partner.
4. The transfer of Ownership from one partner to another person is difficult unless the
remaining partners approve of this.
5.3 EQUITY REPORTING FOR PARTNERSHIP
Reporting changes in partnership capital accounts is similar to that for a proprietorship, except
that there is an owner’s capital account for each partner. The change in the owners’ capital
accounts for a period of time is reported in a statement of partnership equity.
equity. The statement
of partnership equity discloses each partner’s capital account in the columns and the reasons
for the change in capital in the rows. An example of statement of partnership Equity for
Hundaaf partnership of Yilma and Girma is given as follows.
132
Hundaaf partnership
Statement of Partnership Equity
For the Year Ended December 31, 2012
Yilma, Girma, Total
partnership
Capital Capital Capital
Balance, January 1, 2012 $245.00 365.00 610.00
Capital additions 50.00 50.00
Net income for the year 40.00 80.00 120.00
Less partner withdrawals (5.00) (45.00) (50.00)
Balance, December 31, 2006 330.00 400.00 730.00
5.4. FORMATION OF PARTNERSHIPS
In forming a partnership, the investments of each partner are recorded in separate entries. The
assets contributed by a partner are debited to the partnership asset accounts. If liabilities are
assumed by the partnership, the partnership liability accounts are credited. The partner’s
capital account is credited for the net amount.
Illustration
Hawi and Habte decided to form a partnership business, which would provide medical
services. They have been in business separately before they form the partnership. The
partnership assumed the liabilities of their separate business. The assets were valued and
recorded at their current fair market value.
Shown below are the assets contributed and the liabilities assumed by the partnership at their
fair market value.
Hawi Habte
Cash Birr 6.500 Cash Birr 3,300

Accounts Receivable 8,600 Accounts Receivable 4,300
Supplies 21,000 Supplies 12,000
Medical Equipment 3,000 Medical Equipment 150,000
133
Accounts Payable (2,300) Accounts Payable (3,200)
The journal entry on January 1, 2012 to record the investment of each partner and the
formation of the partnership would be:
2012, Jan.1. Cash 6,500

Account Receivable 8,600
Supplies 21,000
Medical Equipment 3,000
Account payable 2,300
Hawi, Capital 36,800
2012, Jan.1. Cash 3,300

Account Receivable 4,300
Supplies 12,000
Building 150,000
Accounts Payable 3,200
Habte, Capital 166,400
1. On February 2, 2012, Hawi and Habte made additional investments of cash Birr 4,200 and
4300 respectively. Show the entry to record the investments by the Owners.
-----------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
2. Describe and illustrate the accounting for forming a partnership
-----------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
3. What characteristics of a partnership could be interpreted as disadvantages?
134
-----------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------------
5.5 DIVIDING PARTNERSHIP NET INCOME AND NET LOSS
A partnership’s income and losses can be distributed according to whatever method the
partner’s specifies in the partnership agreement. The agreement should be specific and clear,
to avoid later disputes.
If a partnership agreement does not mention the distribution of income and losses, the law
requires that they be shared equally by all partners. Also, if a partnership agreement specifies
only the distribution of income, but is silent as to losses, the law requires that losses be
distributed in the same ratio as income.
The Income of a partnership normally has three components:
(1) return to the partners for the use of their capital – called interest on partners’ capital,
(2) compensation for direct services the partners have rendered – called partners’ salaries,
and
(3) Other income for any special characteristics individual partners may bring to the
partnership or risks they may take.
The breakdown of total income into its three components helps clarify how much each partner
has contributed to the firm.
Income can be shared among the partners in one of the following ways:
1. Net income divided in a stated ratio such as:

A) equally
B) agreed upon ratio (other than equally)
C) ratio based on beginning capital balances
2. Net Income divided by allowing interest on the capital investments, salaries, or both
with the remaining net income divided in an agreed ratio.
135
Example
Assume that Hawi and Habte partnership had a net income of Birr 60,000
1) A. Assume that the articles of a partnership provides equal share of Net Income or Loss.
- In this case the capital accounts of each partner will be credited for Birr. 30,000
Income Summary-------------------------------60,000
Hawi capital------------------------------------30,000
Habte capital------------------------------------30,000
B. Net income is divided in ratio of 3.2 to Hawi and Habte respectively.
- Income summary-------------------------------------60,000
Hawi capital (3/5 X 60,000) ---------------------------36,000
Habte capital (2/5 X 60,000) ---------------------------24,000
C. Net income is divided in a ratio of partners’ capital account balances at
the
the beginning of the fiscal period.
Income summary ------------------------------- 60,000
[
36800
203200 ]
×60,000 ¿ ¿ ¿¿
Hawi capital ¿ ------------------------------10,866
Habte capital [ ]
166400
×60 , 000
203200 --------------------------- 49,134
 36800 + 166400 = 203200

2. Net income is divided by allowing 5% interest on their beginning capital balances, a
salary of Birr. 5,000 to Hawi and the remainder is divide equally.
136
Net Income Division
Income to be
Hawi Habte Total Distributed
Net income Birr, 60,000
Interest (5%) 1,840 8,320 10,160 49,840
Salary 5,000 -- 5,000 44,840
Remainder 22,420 22,420 44,840 -- 0 –
Distribution 29,260 30,740 60,000
Journal entry
Income summary ---------------------------- 60,000

Hawi capital --------------------------------- 29,260
Habte capital --------------------------------- 30,740
1. Assume the same agreement as in number “2” above but the net income for the year was
Birr. 10,000. Determine the amount to be distributed to each partner and record the
distribution in journal entry form
------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------
2. Raha and Sifan agreed to form a partnership. Raha contributed Br. 200,000 in cash , and
Sifan contributed assets with a fair market value of Br. 400,000. The partnership, in its
initial year, reported net income of Br. 120,000.
Prepare the journal entry to distribute the first year’s income to the partners under each of the
following condition.
 Raha and Sifan failed to include stated ratio in the partnership agreement.
137
 Raha and Sifan agreed to share income and losses in a 3:2 ratio.
 Raha and Sifan agreed to share income and losses in the ratio of their original
investments.
 Raha and Sifan agreed to share income and losses by allowing 10 percent interest on
their original investments and sharing any remainder equally
3. What accounts are debited and credited to record the division of net income at the
end of the fiscal period?
------------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------
4. What accounts are debited and credited to record the division of net loss among the
partners’ at the end of the fiscal period?
------------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------
5.6 DISSOLUTION OF A PARTNERSHIP
Dissolution of a partnership occurs whenever there is change in the original association of

partners. When a partnership is dissolved, the partners lose their authority to continue the
business as a going concern. This does not mean that the business operation necessarily is
ended or interrupted, but it does mean – from a legal and accounting standpoint – that the
separate entity stops to exist.
The remaining partners can act for the partnership in finishing the affairs of the business or in
forming a new partnership that will be a new accounting entity.
A partnership is legally dissolved (terminated) when a new partner is admitted or an existing

partner withdraws.
5.6.1. Admission of a New Partner:
A person may be admitted to a partnership only with the consent of all the current partners by:
138
1. Purchasing an interest from one or more of the current partners.

2. Contributing assets to the partnership.
When the first method is used, the equity of the incoming partner is obtained from current
partners, and neither the total assets nor the total owner’s equity of the business is affected.
When the second method is used, both the total assets and the total owner’s equity of the
business are increased. In the following paragraphs, we discuss each of these methods.
1. Admission by Purchase of Ownership Right
When an individual is admitted to a firm by purchasing Ownership right from an old partner,
each partner must agree to the change. A journal entry is needed in the partnership to transfer
the Ownership right purchased from the capital account of the selling partner to the capital
account of the new partner. The partnership’s assets and liabilities remain unchanged.
Suppose, for example, Sister Damme joins the partnership of Hawi and Habte by buying
Ownership right of Br. 8000 from Habte. The entry to record the admission of Sister Damme
and the transfer of the Ownership right from the capital account of Habte to the capital
account of Sister Damme in the partnership books shown below
Journal entry
Habte---------------------------------- 8,000
Sr. Damme --------------------------------------8,000
The price that sister Damme paid to Habte can be more or less than Br. 8,000 but that is
irrelevant as it wouldn’t be reflected in the record (books) of the partnership.
2. Admission by Investing Assets
Assume that instead of purchasing Ownership right from the existing partners, Sister Damme
invested cash of Br. 80,000 into the partnership. In this case both partnership assets and total
Owners’ equity are increase. The journal entry must record such an investment and the
increase in partnership assets.
Consider the following scenarios as an example:
139
1. Sister Damme receives a 50% Ownership right in the partnership. Assume also that
Hawi and Habte’s capital balance were Br. 25,000 and Br. 55,000 respectively. Hawi
and Habte share income in a ratio of 2:1 respectively.
Journal Entry
Sister Damme’s capital account would be credited for Br. 80,000 i.e., (55,000 + 25,000 +
80,000) X ½.
Cash------------------------------------------80,000
Sister Damme, Capital------------------------80,000
2. Sister Damme receives a one –fourth Ownership right upon admission. Assume
everything else as above. In this case Sister Damme’s capital account would be
credited for birr 40,000 i.e. (Birr 25,000 + Birr 80,000) X ¼.
The difference Br. 40,000, (80,000 – 40,000) would be shared between the remaining two
partners with the income-sharing ratio.
Journal entry
Cash----------------------------80,000
Damme capital -------------------40,000
Hawi capital --------------------- 26,667
Habte capital --------------------- 13,333
1. Assume the same as above except that sister Damme received ¾ Ownership right upon
admission as she was thought to bring goodwill to the partnership. Record the admission.
-----------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------------
Revaluation of Assets
A partnership’s asset account balances should be stated at current values when a new partner
is admitted. If the accounts do not approximate current market values the accounts should be
140
adjusted. The net adjustment (increase or decrease) in asset values is divided among the
capital accounts of the existing partners according to their income-sharing ratio. Failure to
adjust the accounts for current values may result in the new partner sharing in asset gains or
losses that arose in prior periods
To illustrate, assume that in the preceding example for the Hawi and Habte partnership, the
balance of the merchandise inventory account is $14,000 and the current replacement value is
$17,000. Assuming that Hawi and Habte share net income equally, the revaluation is recorded
as follows
Merchandize inventory 3000.00

Hawi, capital 1500.00
Habte, capita 1500.00
5.6.2. Withdrawal or Death of Partner
When a partner retires or withdraws from a partnership, one or more of the remaining
partners may buy the withdrawing partner’s interest. The firm may then continue its
operations uninterrupted. In such cases, the purchase and sale of the partnership interest is
between the partners as individuals. The only entry on the partnership’s records is to debit the
capital account of the partner withdrawing and to credit the capital account of the partner or
partners buying the additional interest. If the withdrawing partner sells the interest directly to
the partnership, both the assets and the owner’s equity of the partnership are reduced. Before
the sale, the asset accounts should be adjusted to current values, so that the withdrawing
partner’s equity may be accurately determined. The net amount of the adjustment should be
divided among the capital accounts of the partners according to their income sharing ratio. If
not enough partnership cash or other assets are available to pay the withdrawing partner, a
liability may be created (credited) for the amount owed the withdrawing partner. When an
existing partner withdraws he/she can sell his/her Ownership right or he/she can withdraw
assets from the partnership. Both options are considered below:
141
1. Sale of Ownership Right to the Existing Partner
When Ownership right is sold by a withdrawing partner to an existing partner, the entry on the
partnership’s books transfers the retiring partner’s capital balance to the buyer’s capital
account.
Example:
Habte withdraws from the partnership because of a disagreement. He sells his Br. 38,333
Ownership right to Hawi.
Journal entry
Habte Capital----------------------------- 38,333

Hawi Capital ----------------------------- 38,333
The amount paid by Hawi is not recorded on the partnership books, because the transaction
involves no flow of assets to or from the partnership.
2. Withdrawal of Assets From the Partnership

When a partner withdraws he/she may be paid above or below the amount shown in his/her
capital balances.
Example:
a. Assume Habte was paid Br. 50,000 cash when he withdraws from the partnership of
H,H&D. The capital balances of each partner were as follows as of that date:
Hawi capital -------------------------------Br. 100,000

Habte capital ------------------------------ --- 50,000
Sister Damme capital ----------------------------35,000
----------------------------35,000
Total Equities Birr 185,000
Journal entry
Habte capital -------------------------------- 50,000

Cash -----------------------------------------------------------50,000
142
b. Assume Habte was paid Br. 56,000 instead of Br. 50,000, the excess amount of Birr 6,000
is charged to the remaining partner’s capital accounts based on the income- sharing ratio.
(Assume a 3:2:1 income-sharing ratio between Hawi, Habte and Sister Damme
respectively).
Journal entry
Habte capital ------------------------------------50,000

Sister Damme capital ------------------------- 1,500
Hawi capital ----------------------------------- 4,500
Cash ----------------------------------------------------56,000
1. The Birr 6,000 excess is shared on the basis of a 3:1 ratio, i.e., Hawi would be charged for
6,000 X c/4 = birr 4500, and Sister Damme would be charged for Birr 6000 X ¼= Birr
1500.
Death of a Partner
When a partner dies, the accounts should be closed as of the date of death. The net income for
the current year should be determined and divided among the partners’ capital accounts. The
balance in the capital account of the deceased partner is then transferred to a liability account
with the deceased’s estate. The remaining partner or partners may continue the business or
terminate it. If the partnership continues in business, the procedures for settling with the estate
are the same as those discussed for the withdrawal of a partner.
1. Assume everything else as in # b above except that Habte was paid Br. 45,000 upon
withdrawal. Record the dissolution.
-----------------------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------------------------
Attempt the following questions:
143
1. The partnership agreement for Dawit and Totoba partnership does not disclose how they
will share income and losses. How would the income and losses be shared in this
partnership?
2. In January 2011, Hailu and Jalene agreed to produce and sell Soaps. Hailu contributed br.
240,000 in cash to the business. Jalene contributed the building and equipment, valued at
Br. 220,000 and Birr. 140,000, respectively. The partnership had an income of Birr
84,000 during 2011 but was less successful during 2012, when income was only Br.
40,000.
(a) Prepare the journal entry to record the investment of both partners in the partnership
(b) Determine the share of income for each partner in 2011 under each of the following
conditions:
 The partners agreed to share income equally.
 The partners failed to agree on an income- sharing arrangement.
 The partners agreed to share income according to the ratio of their capital investments
 The partners agreed to share income by allowing interest of 10% on their original
investments and dividing the remainder equally.
 The partners agreed to share income by allowing salaries of Birr 40,000 for Hailu and
Br. 28,000 for Jalene, and dividing the remainder equally.
3. Hamdiya, Hasaniya, and Famiya have equity in a partnership of Birr 80,000, Birr 80,000,
and Birr 120,000, respectively, and they share income and losses in a ratio of 20%, 20%,
and 60%. The partners have agreed to admit Alawiya to the partnership.
Instruction:
Instruction: prepare journal entries to record the admission of Alawiya to the partnership
under the following conditions:
(a) Alawiya invests Birr 50,000 for 20% interest in the partnership, and a bonus is
recorded for the original partners.
(b) Alawiya invests Birr 60,000 for a 40% interest in the partnership, and a bonus is
recorded for Alawiya.
144
5.7 LIQUIDATION OF A PARTNERSHIP
Liquidation of a partnership is the process of ending the business, of selling enough assets to
pay the partnership’s liabilities and distributing any remaining assets among the partners.
Liquidation is a special form of dissolution. When a partnership is liquidated, the business

will not continue.
 A partnership may be liquidated if:

A. The objectives sought in forming the partnership has been achieved.
B. the time period for which the partnership was formed expires (ends)
C. newly enacted laws have made the partnerships activities illegal,
D. the partnership becomes bankrupt.
The partnership agreement should indicate the procedures to be followed in case of
liquidation. Usually, the books (records) are adjusted and closed, with the income or loss
distributed to the partners and the assets are sold.
The sale of the assets at the time of liquidation of a partnership is known as realization.
As the assets of the business are sold, any gain or loss should be distributed to the partners
according to the income and loss sharing ratio.
As cash is realized, it must be applied first to outside creditors. Finally, the remaining cash is
distributed to the partners in accordance with the balance of their capital accounts.
Illustration
The partnership of Ajebush, Fandisha, and Diga is liquidated on September 1,2012. The
income and loss sharing ratio of the partners is: Ajebush 40%, Fandisha 35%, and Diga 25%.
After discontinuing the ordinary business operations of their partnership and closing the
accounts, the following summary of a trial balance is prepared:
A, F and D
Trial Balance
Septamber 1, 2012
Debit Credit
Cash 10,000
145
Other assets 90.000

Liabilities 10,000
R. Capital 30,000
S. Capital 30,000
T. Capital ________ 30,000
Total 100,000 100,000
Based on the information on the trial balance, accounting for liquidation of A,F,
A,F, and D
partnership will be illustrated using different selling prices for the non cash assets.
Case One: Gain on Realization
Assume that Ajebush, Fandisha, and Diga sell all noncash assets for Birr 95,000, realizing a
gain of birr 5000, (Birr 95,000 – Birr 90,000). The gain is divided among Ajebush, Fandisha
and Diga in the income and loss sharing ratio of 40% 35%, and 25% respectively. Then, the
liabilities are paid, and the remaining cash is distributed to the partners according to the
balances in their capital accounts. The entries to record the steps in the liquidation of a
business are as follows:
Cash………………………………95,000
Other assets………………………….90,000
Gain on sale of assets……………….. 5,000
Entry to record the sale of non cash asset and the recognition of gain on realization
- Gain on sale of assets…………… 5,000

A Cap. (5,000 X 40%)………………… 2.000
F Cap. (5,000 X 35%)…………………. 1,750
D Cap. (5000 X 25%)…………………...1,250
To distribute gain on realization
- Liabilities……………………….10,000
Cash………………………………..10,000
To record the settlement of partnership liabilities
146
After the above entries are posted, the partners’ capital accounts shows:
A’s Beg Bal. 30,000 + 2,000 = Birr 32,000

F’s Beg Bal. 30,000 + 1,750 = Birr 31,750
D’s Beg Bal. 30,000 + 1,250 = Birr 31,250
The cash account now shows a balance of Birr 95,000 (10,000 + 95,000 – 10,000). The entry
recorded upon distribution of this cash among the partners would, therefore, be
A, capital……………………… Birr 32,000

F, capital……………………… Birr 31,750
D, capital……………………… Birr 31,250
Cash------------------------------------------95,000
To record the distribution of cash among the partners
A, F, D partnership
Statement of Partnership Liquidation
For period Sept. 1-15, 2012
Cash + Non cash = Liabilities + Capital

Asset
A(40%) F(35% D(25%
Bal.before realization Birr 10,000 90,000 10,000 30,000 30,000 30,000

Sales of Assets &
Division of gain +95,000 -90,000 --- 2000 1750 1250
Bal.after realization 105,000 -0- 10,000 32,000 31,750 31,250
Payment of Liab. – 10,000 --- -10.000

-10.000 --- --- ---
Bal. After payment

Of liab. 95,000 -0- -0- 32,000 31,750 31,250
Dist.of cash (95,000
(95,000 ) --- --- (32,000) (31,750) (31,250)
Balance after Dist.of cash 0 0 0 0 0 0
147
Case two: Loss on Realization: No capital Deficiencies
Assume that Ajebush, Fandisha, and Diga sell all non cash assets for Birr 70,000, instead of
Birr 95,000, incurred a loss of birr 20, 000 (Birr 90,000 – Birr 70,000)
Journal entry
Cash --------------------------------------70,000
Loss on realization-----------------------20,00
Other Assets-------------------------------------90,000
To record the sale of the assets
A capital---------------------- (40% X 20,000) -----------------8,000

F capital----------------------- (35,000 X 20,000) --------------7,000
D capital ---------------------- (25% X 20,000) --------------- 5,000
Loss on Realization ------------------------------------- 20,000
To distribute the loss on realization
Liabilities ---------------------------------- 10,000
Cash -----------------------------------10,000
To record the settlement of partnership liabilities
After the above entries have been posted; the accounts show cash 70,000 A, cap. Birr22, 000
F,cap. Birr 23,000 and D, cap. Birr 25,000. The entry to record the cash distribution to the
partners would, therefore, be as follows:
A cap --------------------------------- 22,000

F cap ----------------------------------23,000
D cap --------------------------------- 25, 000
Cash -------------------------------------- 70,000
Entry to record the distribution of cash to partners
148
A, F, D partnership

Asset
A(40%) F(35% D(25%

Sales of Assets &
Division of loss +70,000 -90,000 --- 8000 7000 5000
Bal.after realization 80,000 -0- 10,000 38,000 37,000 35,000

Payment of Liab. – 10,000 --- -10.000
-10.000 --- --- ---
Bal. After payment
Of liab. 70,000 -0- -0- 38,000 37,000 35,000
Dist.of cash (70,000
(70,000 ) --- --- (38,000) (37,000) (35,000)
Balance after Dist.of cash 0 0 0 0 0 0
Case three: Loss on Realization with Deficiency in one Partner Capital
- Assume the non-cash assets of A,F and D partnership are sold for only Birr 10,200,
incurring a loss of Birr 79,800,( Birr 90,000 – Birr 10,200). The entries to record the
division of loss among the partners and the liquidation to this point are shown below:
Cash -------------------------------- 10,200
Loss on sale of Assets ----------- 79,800
Other Assets-------------------------- 90,000
149
To record the sale of assets
A capital (79800 X 40%) ----------------------31,920

F capital (79800 X 35%) ---------------------- 27,930
D capital (79800 X 25%) ---------------------- 19,950
Loss on sale of Assets ---------------------------- 79,800
To distribute loss on realization
Liabilities ----------------------------------- 10,000

Cash ------------------------------------------------10,000
To record settlement of liabilities
At this stage of the liquidation the capital accounts of the partners have the following balances
A capital = 30,000 – 31920 = 1,920

F capital = 30,000 – 27930 = 2,070
D capital = 30,000 – 19950 = 10,050
Only Birr 10,200 cash is available (10,000 + 10200 – 10,000) for distribution to F and D
while the combined balances of their capital accounts is Birr 12,120. Therefore, additional
Birr 1,920, (12120 – 10200) is needed which is the amount owed by A to the partnership.
Therefore, either A will have to pay this amount first and the cash will be distributed to F and
D, or F and D will have to share the Birr 1920 loss in their income and loss-sharing ratio of
35:25.
Let’s assume, the loss was distributed since A couldn’t pay the amount immediately.
Journal Entries
F capital (35/60 X 1920) -------------- 1,120

D capital (25/60 X 1920) ---------------- 800
A capital ------------------------------------------1,920
To charge A’s capital deficiency to S and T
F, capital -----------------------------------950.00
150
D, capital -----------------------------------9,250.00
Cash ----------------------------------------------10,200
To record the final cash distribution to partners
The various entries in the liquidation of A, F, and D partnership are summarized in the
following statement.
A, F, D partnership

Asset
A(40%) F(35% D(25%

Sales of Assets &
Division of loss +10,200 -90,000 --- -31,920 -27,930
-27,930 19,950
Bal.after realization 20,000 -0- 10,000 (1920) 2,070 10,050
Payment of Liab. – 10,000 --- -10.000
-10.000 --- --- ---
Bal. After payment
Of liab. 10,200 -0- -0- (1920) 2,070 10,050
Division of deficiency --- --- --- 1920 (1120) 800
Bal. After division of
Deficiency – 10,200 -0- -0- -0- 950 9,250
Dist.of cash 10,000 --- --- --- -950 -9250
Balance -0- -0- -0- -0- -0- -0 -
SUMMARY
A partnership is an association of two or more persons to carry on as co-Owners of a business

for profit. This association is based on a partnership agreement or contract known as the
articles of a partnership.
151
A partnership form of business Ownership has several characteristics. From among them are:
voluntary association, limited life, unlimited liability, mutual agency, and co- Ownership of
partnership property.
The advantages of partnerships include: easy of formation, possible to raise large amount of
capital than a single owner, not subject to separate taxation, and the absence of many
restrictive laws unlike a corporation, etc.
Partnerships have also the following disadvantages: unlimited liability, mutual agency,
limited life, etc.
In accounting for partners’ investment, it is necessary to maintain separate capital and

withdrawals accounts for each partner and to divide the income and losses of the company
among the partners. When recording the investments of the partners, all noncash assets must
be recorded at their fair market value at the time they are transferred to the partnership.
A partnership income and losses can be distributed according to whatever method the partner
specifies in the partnership agreement. The agreement should be specific and clear, to avoid
later disputes.
If a partnership agreement does not mention the distribution of income and losses, the law
requires that they be shared equally by all partners. If a partnership agreement specifies only
the distribution of income, but is silent as to losses, the law requires that losses be distributed
in the same ratio as income.
The income of a partnership normally has three components: (1) return to the partners for the
use of their capital, (2) compensation for direct services the partners have rendered, and (3)
other income for any special characteristics individual partners may bring to the partnership or
risks they may take.
At the end of each fiscal period financial statements are prepared for a partnership business.
Most of the financial statements of a partnership are the same as that of a sole proprietorship
with the exception of the Owners equity section of a balance sheet.
152
Dissolution of a partnership occurs whenever there is a change in the original association of

partners. When a partnership is dissolved, the partners lose their authority to continue the
business as a going concern. This does not mean that the business operation necessarily is
ended or interrupted, but it does mean - from a legal and accounting stand point - that the
separate entity stops to exist. A partnership is legally dissolved when a new partner is
admitted or an existing partner withdraws.
Liquidation of a partnership is the process of ending the business, of selling enough assets to
pay the partnership’s liabilities and distributing any remaining assets among the partners.
Liquidation is a special from of dissolution. When a partnership is liquidated, the business
will not continue.
A partnership may be liquidated if: (a) the objectives sought in forming the partnership has
been achieved, (b) the time period for which the partnership was formed expires (or ends), (c)
newly enacted laws have made the partnership’s activities illegal, (d) the partnership becomes
bankrupt.
The partnership agreement should indicate the procedures to be followed incase of

liquidation. Usually, the records are adjusted and closed, with the income or loss distributed
to the partners, and the assets are sold. The sale of the assets at the time of liquidation of a
partnership is known as realization. As the assets of the business are sold, any gain or loss
should be distributed to the partners according to the income and loss sharing ratio. As cash
is realized it must be applied first to outside creditors. Finally, the remaining cash is
distributed to the partners in accordance with the balance of their capital accounts.
5.8 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS
1. Journal entry
Cash-----------------------------8500
Hawi capital-------------------------- 4200
Habte capital--------------------------- 4300
153
2. When a partnership is formed, accounts are debited for the assets contributed,
accounts are credited for the liabilities assumed, and the partners’ capital accounts are
credited for their respective net amounts. Noncash assets are recorded at amounts
agreed upon by the partners.
partners
3. Unlimited liability, mutual agency, limited life.
Net income division
Income to be
Hawi Habte Total Distributed
Net income 10,000
Interest (5%) 1,840 8,320 10,160
Salary 5,000 ------- 5,000
Total 6,840 8,320 15,160
Excess of allowance
Over net income 2,580 2,580 5,580
Net income 4,260 5,740, 10,000

Journal entry
Income summary 10,000
Hawi capital 4,260
Habte capital 5,580
2.
a) If the partners failed to include the ratio in their agreement or if they remain silent in
how to share net income or net loss the law provide that any income or loss should
be shared equally.
b)
Division of net income
154
income to be
Raha Sifan Total distributed
Net income 120,000

Division of income 72,000 48,000 120,000 0
Journal entry

Raha, capital 72,000
Sifan, capital 48,000
c) Division of net income
Income to be
Net income 120,000
Division of income 80,000 40,000 120,000 0
Journal entry

d) Division of net income
Income to be
Net income 120,000
Interest (10%) 20,000 40,000 60,000 60,000
Remainder Equally 30, 000 30,000 60,000 0
Net income 50,000 70,000 120,000
Journal entry
155
2) Income summary account is debited and the partner’s capital account is credited to record
division of net income.
3) Income summary account is credited and the partner’s capital account is debited to record
division of net loss.
Journal entry
Cash----------------------------80,000
Good will ----------------------40,000
Damme, capital -------------------120,000
Journal entry
Habte capital ------------------------------------50,000
Sister Damme capital ------------------------ 1.250
Hawi capital ----------------------------------- 3,750
Cash --------------------------------------------45,000
PART I.
I. Choose The Best Answer:
_____ 1. The term unlimited liability when used in connection with a partnership refers to the
fact that:
1. A contract entered into by one partner is binding on all partners.

2. Creditors can look beyond the partnership assets to the individual assets of the
partners for satisfaction.
3. The partnership has an unlimited obligation to provide professional services.
4. The partnership is liable for all actions of the partners even when conducting
personal business.
5. All except D.
156
______2. A and B agree to form a partnership. A is to contribute birr 60,000 in cash and to
spent one – half time to the partnership. Bi is agreed to contribute birr 40,000 and to devote
full time to the partnership. How will A and B share in the division of net income or net loss?
a. 1:2 d. 1:1
b. 2:1 e. None of the above
c. 3:2
Refer to the following information which is related to XYZ partnership and answer questions
3 and 4. The capital account and income sharing ratios of the three partners after realization of
non – cash assets and settlement of all liabilities are as follows:
Partner Balance in Capital Income – Sharing

Account Ratio
X Birr 45,000 2
Y (15,000) 3
Z 36,000 3
______3. If partner Y is unable to pay any part of his deficiency to the partnership, how
much cash will be given to partner Z from the liquidation?
A) Birr 30,375 C) Birr 13,500 E) None of the above.

B) Birr 27,000 D) Birr 30,000
_____ 4. If partner Y pays two – third of the deficiency to the partnership, how much
cash will be given to partner X?
A) Birr 33,000 C) Birr 43,000 E) None of the above.
B) Birr 47,000 D) Birr 45,000
______5. Which of the following is not a characteristic of a partnership?
A) each partner can act as an agent of a partnership

B) Unlimited life.
C) Easy of formation
D) It is not legally separate from its Owners.
157
E) None of the above

PART II – Attempt the Following Questions
1. What are the disadvantages of the partnership over the corporation as a form of
organization for a profit making business enterprise?
2. Explain the difference between the admission of a new partner to a partnership (a) by
purchase of an interest from another partner and (b) by contribution of assets to the
partnership.
3. When a new partner is admitted to a partnership and goodwill is attributable to the old
partnership, how should the amount of the goodwill be allocated to the capital accounts of
the original partners?
4. Why might partnership attribute goodwill to a newly admitted partner?
5. Paulos, Dawit, and Abeje are partners sharing income 3:2:1. After the firm’s loss from
liquidation is distributed, Paulos’s capital account has a debit balance of Birr 30,000. If
Paulos is personally bankrupt and unable to pay any of the birr 30,000, how will the loss
be divided between Dawit and Abeje?
Exercise
Dagnachew and Firdu formed a partnership. Dagnachew invested Birr 90,000 and Firdu
invested Birr 60,000. Dagnachew is to devote one-half time to the business while Firdu is to
devote full time.
The following plans for the division of income are being considered:
1. equally
2. in the ratio of original investments
3. in the ratio of time devoted to the business
4. Interest of 12% on original investments and the reminder equally.
5. Interest of 12% on original investments, salaries of Birr 10,000 to Dagnachew and Birr
20,000 to Firdu, and the remainder equally.
6. The same as in #5 except that Dagnachew is also to be allowed a bonus equal to 25% of
the amount by which net income exceeds salary allowances.
Required:
158
Determine the division of income to Dagnachew and Firdu under each plan assuming the
partnership of Danagnachew and Firdu earned a net income of:
a) Birr 32,000
b) Birr 150,000
Problem 1
The following balance sheet is related to GAROMA partnership
GAROMA Partnership
Balance sheet
Meskerm 10,1995
Assets: Liabilities and Capital

Cash-------------------------Birr 20,000 Liabilities--------------Birr 30,000
Other assets--------------------- 80,000 Capital:
Y.capital-------------------- 40,000
G. capital------------------- 21,000
_______ A. capital------------------- 9,000
Total Liabilities and
Total Assets----------------
Assets---------------- Birr 100,000 Capital-----------------------
Capital-----------------------100,000
100,000
The partners agreed to liquidate the business enterprise by selling other assets and dividing
any remaining cash available in the partnership after settling the debt of the partnership as of
the date of liquidation. All the partners are general partners. Partner Y, G and A share
income or loss in the ratio of 20%, 40%, and 40% respectively.
Required:
A. prepare a liquidation statement assuming that the other assets were realized for:
i) Birr 80,000
159
ii) Birr 100,000

iii) Birr 60,000
iv) Birr 50,000
B. Journalize the necessary entries for the business enterprise on the basis of the
liquidation statement prepared for each case.
UNIT SIX: ACCOUNTING FOR CORPORATIONS
Contents:
6.0 Introduction
6.1 Nature of a Corporation
6.2 Basic characteristics of Corporations
6.3 Classes of Stocks
6.4 Issuing shares
6.5 Treasury stock transactions
6.6 Accounting for dividends
6.7 Earnings per common share
6.8 Reporting shareholders’ equity on the balance sheet
Objectives: After studying this chapter, you will able to:

 Describe the nature of the corporate form of organization.
 List the two main sources of stockholders’ equity.
 List the major sources of paid-in capital, including the various classes of stock.
 Journalize the entries for issuing stock.
 Journalize the entries for treasury stock transactions.
 State the effect of stock splits on corporate financial statements.
 Journalize the entries for cash dividends and stock dividends.
 Describe and illustrate the reporting of stockholders’ equity.
160
6.0 INTRODUCTION
Activity 6.0: Dear learner, from your study in previous chapters, could you list and
explain different forms of businesses? Try to list and explain them before you proceed to
read the following section.
Identifying the nature and characteristics of different forms of business type enables an
individual to make decision on various issues regarding the business such as whether to invest
in or not, working as employees, giving credits, and others. For example if you own stock in
a corporation, you are interested in how the stock is doing in the market. If you are
considering buying stocks, you are interested in your rights as a stockholder and returns that
you can expect from the stock.
Although you may not own any stocks, you probably buy services or products from
corporations, and you may work for a corporation. Understanding the corporate form of
organization will help you in your role as a stockholder, a consumer, or an employee. In this
chapter, we discuss the characteristics of corporations that make similar and different from
other forms of businesses, as well as how corporations account for stocks.
stocks
6.1 NATURE OF A CORPORATION
A corporation is a legal entity, distinct and separate from the individuals who create and
operate it. It is created by obtaining charter from the state in which the company is to be
incorporated. The charter/ articles of incorporation are given from the states in which the
corporation is to be incorporated. Once the charter is given, the stockholders control a
161
corporation by electing a board of directors. This board meets periodically to establish

corporate policies.
As a legal entity, a corporation may acquire, own, and dispose of property in its own name. It
may also incur liabilities and enter into contracts. Legal rights are given to corporation
separately as entity or individual. Therefore, a corporation is legally entertained as a person,
so it is called artificial person. Most importantly, it can sell shares of ownership, called stock.
This characteristic gives corporations the ability to raise large amounts of capital. The
stockholders or shareholders who own the stock own the corporation. They can buy and sell
stock without affecting the corporation’s operations or continued existence. Corporations
whose shares of stock are traded in public markets are called public corporations.
Corporations whose shares are not traded publicly are usually owned by a small group of
investors and are called nonpublic or private Corporations. In this material our discussion
focuses on public corporation.
6.2. CHARACTERISTICS OF A CORPORATION
Dear learner do you remember some characteristics of a partnership. Recall these

characteristics and compare and contrast with the corporation’s characteristics listed and
explained below.
 Separate Legal Existence: Corporation acts under its own name rather than in the
name of its stockholders.
 Limited liability of stockholders: Limited to their investment. Unlike partnership
and sole proprietorship owners are not personally liable for liabilities of the
corporation. They are liable to the maximum of their investment.
investment
 Transferable ownership rights: Shareholders may sell their stock.
stock
 Ability to acquire capital: Corporation can easily obtain capital through the
issuance of stock when compared other business forms.
for
 Continuous life: Continuance as a going concern is not affected by the
withdrawal, death, or incapacity of a stockholder, employee, or officer.
office
 Government Regulations: since a corporation comes into existence according to
the law of the state, the law may provide for considerable rules and regulation of
162
the corporation’s activities. For example, the withdrawal of funds from a

corporation is subjects to certain limits sets by law.
 Additional Taxes: Corporations pay income taxes as a separate legal entity and in
addition, stockholders pay taxes on cash dividends.
Advantages of a Corporation
A corporation has several advantages over the sole proprietorship and the partnership form of
businesses. The major advantages are:
 limited liability,
 ease in transferring ownership
 continuity, and
 Ease in raising money.
Disadvantages of a Corporation
• Double taxation
• Greater regulation
• Cost of formation
Rights of Stockholders
The owners of the corporation are called stockholders.

stockholders. Each stockholder receives from the
corporation a stock certificate indicating the number of shares s/he owns. The following are
some major rights pertaining to ownership of capital stock:
stock
1. To vote for directors and on other key issues. A stockholder has one vote for each share
owned those who have more percent have more controlling power (usually with more than
50%). Stockholders have managerial authority to the extent of their voting rights unless they
are appointed to management functions by the board.
2. To participate in any dividends declared by the board of directors . Some or all of the
earnings of the period could be declared and distributed for the shareholders. This kind of
distribution is called dividends. Dividends are distributed only after declared by board of
directors. Dividends are distributed to the shareholders in proportion of share owned.
163
3. To share in the distribution of assets if the corporation is liquidated. The residual

assets (assets minus liabilities) would be distributed to the shareholders in proportion to the
number of shares owned.
4. Pre-emptive rights: the current stockholders has the right to purchase the shares of the
corporation on a prorate basis when new stocks are offered for sale. These preemptive rights
are designed to provide each stockholder the opportunity to maintain a proportional
ownership in the corporation.
Exercise 6.1: Check your progress
1. Discuss some advantages of having a business in the form of corporation versus

having in the form of partnership.
2. Explain the meaning of pre-emptive right as one of the rights of stockholders.
stockholders
Stockholders’ Equity
 Activity 6.2: Dear learner, what does stockholders' equity mean? Is it synonyms to
capital used as in the case of other forms of business that you have already studied? Is
there any difference between owners’ equity and Paid-In Capital of a corporation?
Guess the answer before you proceed to read the following section.
The owners’ equity in a corporation is commonly called stockholders’ equity,

equity, shareholders’
equity,
equity, shareholders’ investment,
investment, or capital.
capital. In a corporation balance sheet, the
Stockholders’ Equity section reports the amount of each of the two main sources of
stockholders’ equity.
 The first source is capital contributed to the corporation by the stockholders and
others,
others called paid-in capital or contributed capital.
 The second source is net income retained in the business, called retained earnings.
earnings.
The paid-in capital contributed by the stockholders is recorded in separate accounts for each
class of stock. If there is only one class of stock, the account is entitled Common Stock or
Capital Stock.
Stock.
164
Retained earnings are generated from operations. Net income increases retained earnings,
while dividends decrease retained earnings. Thus, retained earnings represent a corporation’s
accumulated net income that has not been distributed to stockholders as dividends. The
balance of the retained earnings account at the end of the fiscal year is created by closing
entries. First, the balance in the income summary account (the net income or net loss) is
transferred to Retained Earnings. Second, the balance of the dividends account, which is
similar to the drawing account for a proprietorship, is transferred to Retained Earnings. Other
terms that may be used to identify retained earnings in the financial statements include
earnings retained for use in the business and earnings reinvested in the business.
business
A debit balance in Retained Earnings is called a deficit.

deficit. Such a balance results from
accumulated net losses. In the Stockholders’ Equity section, a deficit is deducted from paid-in
capital in determining total stockholders’ equity.
equity
Sources of Paid-In Capital
The main source of paid-in capital is from issuing stock. The number of shares of stock that a
corporation is authorized to issue is stated in its charter and is known as authorized
stocks/shares. The term issued refers to the shares issued to the stockholders. The stocks that
are issued and remaining in the hands of stockholders are called outstanding stocks. The
phrase, ‘remaining in the hands of stockholders” is used in this statement because sometimes
a corporation repurchases its own stock which is called Treasury stock for different purposes.
This will be detailed latter in the module. The relationship between authorized, issued, and
outstanding stock is shown in the in the following chart..
Authorized Share (A ) Key: The relation of these

three variables can be
explained as follows using
the substituted letters.
Issued Shares ( B )
A= B+C
B – C = Treasury
Outstanding stock ( if any )
Shares 165
Or
(C) A – B = Unissued
shares
Shares of stock are often assigned a monetary amount, called par. Corporations may issue
stock certificates to stockholders to document their ownership. Printed on a stock certificate is
the par value of the stock, the name of the stockholder, and the number of shares owned.
Stock may also be issued without par, in which case it is called no-par stock.
stock. A government
may require the board of directors to assign a stated value to no-par stock.
stock. Because
corporations have limited liability, creditors have no claim against the personal assets of
stockholders. And hence, the government requires corporations maintain a minimum
stockholder contribution to protect public.
public This minimum amount is called legal capital.
capital. The
amount of required legal capital varies among the states, but it usually includes the amount of
par or stated value of the shares of stock issued.
1. On its balance sheet, a corporation reports the following three numbers related to its
common stock: 200,000 shares; 150,000 shares; and 138,000 shares. What is the
number of shares authorized, issued, outstanding, and reacquired?
reacquired?
2. What are the major rights that accompany ownership of a share of stock?
6.3. CLASSES OF STOCK
a) Common Stock: When only one class of stock is issued, it is called common stock. It is the
basic types of stock issued by every corporation. Common rights pertaining to common stock
include: voting rights, participating in dividends, residual claims to assets up on liquidation
and Pre-emptive rights.
166
b) Preferred Stock: a corporation may issue one or more classes of stock with various
preference rights. A common example of such a right is the preference to dividends. Such a
stock is generally called a preferred stock. The dividend rights of preferred stock are usually
stated in monetary terms or as a percent of par. For example, Br. 4 preferred stock has a right
to an annual Br. 4 per share dividend. If the par value of the preferred stock were Br. 50, the
same right to dividends could be stated as 8% (Br. 4/Br. 50) preferred stock.
Basic characteristics of preferred stock include:

 preference as to dividends
 Cumulative dividend rights ( in case of cumulative types of preferred stock)
 Preference in liquidation: In addition to dividend preference, preferred stock may be
given preferences to assets if the corporation goes out of business and is liquidated.
However, claims of creditors must be satisfied first. Preferred stockholders are next in
line to receive any remaining assets, followed by the common stockholders.
 No voting power
6.3.1 Types of preferred stocks
a) Cumulative vs. Non-cumulative preferred stock
Cumulative preferred stock : is the preferred stock for which dividend payment is
accumulated for the omitted year (called arrears) and be paid in a year declaration is made
before any distribution is made for common stockholders. Arrears should be disclosed,
normally in a note to the financial statements.
To illustrate assume that a corporation has 1,000 shares of Br. 4 cumulative preferred stock
and 4,000 shares of common stock outstanding. Also assume that the net income, amount of
earnings retained, and the amount of earnings distributed during year threat as follows:
2008 2009 2010
Net income Br. 20,000 Br. 55,000 Br. 62,000
Amount retained 20,000 55,000 40,000
167
Amount distributed Br.0 Br,0 Br. 22,000
Now Br. 22,000 dividends paid in 2010 are distributed between the preferred and common
stockholders as follows:
Preferred stock dividends Dividends paid in 2010

A Preferred stock Common stock
rr
No
ea
any
2008 arrears --------------------------------------------------- Br. 4,000
payme
2009 arrears ------------------------------------------------------ 4,000 nt
2010 ( current dividends ) ---------------------------------- 4,000 Br. 10,000
Total -------------------------------------- Br. 12.000 Br. 10,000
Non cumulative preferred stock: For which dividends is not accumulated. Dividends are
paid only for the year it is declared. Therefore, any unpaid dividend is lost forever for this
type of preferred stock.
To illustrate consider the above example given under cumulative preferred stock. When the
type of preferred stock is non cumulative it is distributed between preferred stock and
common stock as follows;
Years
Dividends paid in 2010
Preferred stock Common
stock
2008 -------------------------------------------------------- Br. 0
2009 -------------------------------------------------------- -0-
2010 (current dividends) --------------------------------------- 4,000 Br. 18,000
Total ------------------------------------------- Br. 4.000 Br. 18,000
168
b) Participating versus Nonparticipating preferred stock

Preferred stockholders’ dividend rights are usually limited to a certain amount. Such stock is
said to be nonparticipating preferred stock. To illustrate consider the above example with a
minor modification on dividend distributed amount during each year.
2008 2009 2010

Net income Br. 20,000 Br. 55,000 Br. 62,000
Amount retained 15,000 30,000 40,000
Amount distributed Br.5, 000 Br,.25,000 Br. 22,000
Now the distribution is made as follows between common stock and non participating
preferred stock:
Years Dividends paid in 2010
Preferre stock Common stock
2008 ----------------------------------------------------------- Br. 4.000 Br. 1,000
2009 ----------------------------------------------------------------- 4,000

21,000
2010 (current dividends ) ----------------------------------------- 4,000 Br.
18,000
Total -------------------------------------------- Br. 12.000 Br.
40,000
Participating Preferred Stock: In some cases, preferred stock may receive additional
dividends if certain conditions are met. Such stock is called participating preferred stock.
Since it is rarely used now days as indicated in different books, we may not detail this type of
preferred stock.
1. Roman Corporation has 50,000 shares of $2, cumulative preferred stock outstanding.
Preferred dividends are three years in arrears (not including the current year). What
amount of preferred dividends must be paid before any dividends on common shares
can be paid?
paid?
169
2. If a corporation has outstanding 1,000 shares of Br. 9 cumulative preferred stock of Br.
100 par and dividends have been passed for the preceding three years, what is their
amount of preferred dividends that must be declared is the current year before a
dividend can be declared on common stock?
a) Br. 9,000 c) Br. 36,000
b) Br. 27,000 d) None
6.4 ACCOUNTING FOR ISSUANCE OF STOCKS

High light conceptual note ( Optional to read or skip on )
Dear learner, do you remember the recording aspects of accounting for the other forms of business
that you have gone done for. In partnership form of business, for example, you have learnt the
accounting treatment for formation (initial investment), for distribution of income or loss from
operation, accounting for dissolution and accounting for liquidation. Accounting principles and
concepts that you have studied for other forms of these businesses works equally for a corporate
form.
The source of accounting difference may come because of their nature discussed above. For
example, a corporation raises funds by issuing stocks which is not the case in other forms of
businesses. Hence, the difference of using account names will be different from others. Otherwise,
accounting for investments (contributed by owners), accounting for operation, and for other business
transactions are principally the same. Therefore, for corporation we also discuss the accounting
issues of issuance of stock (contribution by owners), accounting for dividends and for any other
business transactions
A separate accountthat could
is used foroccur in thethe
recording corporation.
amount of each class of stock issued to investors
in a corporation. Stock is often issued by a corporation at a price of its par or a price other
than its par. This is because the par value of a stock is simply its legal capital. When stock is
issued for a price that is more than its par, the stock has sold at a premium.
premium. When stock is
issued for a price that is less than its par, the stock has sold at a discount.
discount.
a) Issuance of Stock at Par

To illustrate assume that a corporation is authorized to issue 10,000 shares of preferred stock,
Br. 100 par, and 100,000 shares of common stock, Br. 20 par. One-half of each class of
authorized shares is issued at par
Entry:
170
Cash ------------------------------------------------------- 1,500.000

Preferred stock ------------------------------------------------ 500,000
Common stock ----------------------------------------------- 1,000,000
(To record the issuance of stocks at par)
b) Issuance of stock at Premium

When stock is issued at a premium, Cash or other asset accounts are debited for the amount
received. Common Stock or Preferred Stock is then credited for the paramount. The excess of
the amount paid over par is a part of the total investment of the stockholders in the
corporation. Therefore, such an amount in excess of par should be classified as a part of the
paid-in capital. An account entitled Paid-In Capital in Excess of Par is usually credited for this
amount. To illustrate, assume that Matador Company issues 2,000 shares of Br. 60 par
common stock for cash at Br. 70. The entry to record this transaction is as follows:
follows:
Cash………………………………………………………140.000
Common Stock…………………………………..120,000
Paid-in-capital is excess of par………………… 20,000
c) Issuance of Stock at Discount

Under unfavorable conditions stocks can be issued at less than par value. Following given
activity specifies this condition. Try to pass the entry and check your answer with similar
information given in exercise.
Activity 6.3: Assumes that Matador Company issues 2,000 shares of Br. 60 par common
stock for cash at Br. 50. Pass entry for the issuance of these shares.
d) Stock Issued on a Subscription Basis
During the start-up of a corporation, prospective investors may sign a contract to purchase a
specified number of shares on credits with payments due at one or more specified future
dates. One reason for this procedure is to attract small investors. Another reason is to appeal
to investors who prefer not to invest cash until the corporation is ready to start business
operations. A corporation may also sell its capital stock on credit after incorporation.
171
When stock is subscribed, the company debits stock subscription receivable for the
subscription price, credits capital stock subscribed for the par value of the subscribed shares,
and credits paid in capital in excess of the subscription price over par value. Later, as cash is
collected, the entry is a debit to cash and a credit to stock subscription receivable. When the
entire subscription price is collected, the stock certificates are issued for the subscribers. The
issuance of stock is recorded by debiting capital stock subscribed and crediting capital stock.
The following illustration demonstrates the accounting procedures for stock subscriptions.
Assume that 100,000 shares of Matador corporation common stock, par Br. 10, are subscribed
for at Br. 20 by Sifan. The total is payable in three installments. The following entries are
processed by Matador Corporation.
Common stock subscription Receivable 2,000,000

Common stock subscribed 1,000,000
Paid-in-capital in excess of par 1,000,000
(To
(To record receipt of subscription for 100,000 shares )
Cash 500,000
Common stock subscription receivable 500,000
(To record receipt of 1st payment)
Cash 500,000
Common stock subscription Receivable 500,000
(To record receipt of 2nd payment)
Cash 500,000
( To record receipt of 3rd payment)
Cash 500,000
( To record receipt of 4th (final ) payment )
172

Common stock 1,000,000
( To record issuance of stock at the final receipt )
d) Non Cash Issuance of Capital Stock
When Stocks are exchanged for non cash assets Cost of non cash asset would be either the fair
market value of the consideration given up, or the fair market value of the consideration
received, whichever is more clearly determinable. To illustrate assume that Matador co’s
Br.10 par value common stock is actively traded at a market value of Br.15 per share.
Matador issues 5,000 shares to purchase land advertised for sale at Br. 85,000. Journalize the
issuance of the stock in acquiring the land.
Land (5,000 x Br, 15) -------------------------------------- 75,000

Common stock (5,000 x Br.10) -------------------------------------- 50,000
Paid-in capital in excess of par --------------------------------------- 25,000
e) Issuing No-Par Stock
When no-par stock is issued, the entire proceeds are credited to the stock account. This is true
even though the issue price varies from time to time. For example, assume that a corporation
issues 10,000 shares of no-par common stock at Br. 40 a share and at a later date issues 1,000
additional shares at Br. 36. The entries to record the no-par stock are as follows:
Cash………………………………… 400.000
Common Stock…………………………………..400,000
(To record Issued 10,000 shares of no-par common stock at Br 40 each)
Another issuance of no- par stock
Cash……………………………………………………… 36.000
Common Stock………………………………….. 36,000
(To record Issued 1,000 shares of no-par common stock at Br 36 each)
Note that if the board of directors state value for the no par stock, issuing such stock is
recorded similar to that of with par stock.
173
6.6 TREASURY STOCK TRANSACTIONS
As explained in the introductory part a corporation may buy its own stock to provide shares
for resale to employees, for reissuing as a bonus to employees, or for supporting the market
price of the stock or for any other management supportive reasons. Such stock that a
corporation has once issued and then reacquires is called treasury stock.
stock
There are several methods of accounting for the purchase and the resale of treasure stock. A
commonly used method of accounting for the purchase and resale of treasury stock is the cost
method.8 when the stock is purchased by the corporation; paid in capital is reduced by
debiting Treasury Stock for its cost (the price paid for it). The par value and the price at which
the stock was originally issued are ignored. When the stock is resold, Treasury Stock is
credited for its cost, and any difference between the cost and the selling price is normally
debited or credited to Paid-In Capital from Sale of Treasury Stock.
Note that no gain or loss is recognized on treasury stock transactions, even when the shares are
reissued at a price above or below cost. Any change in stockholders’ equity resulting from treasury
stock is not included in computing net income of the period. Rather it is regarded as changes in
paid-in- capital.
To illustrate assume that Matador Company originally issued 15,000 shares of Br.1 par,
common stock for Br. 25 per share. If the company reacquired 1,000 shares for Br, 28 per
share, the following entry will be passed:
Treasury stock (1,000 x Br.28) ----------------------- 28,000

Cash ---------------------------------------------------- 28,000
(To repurchase stocks those have been already issued)
If the company sells 500 shares of this treasury stock for Br. 30 each, the entry would be:
Cash (500 * Br. 30) 15,000

Treasury stock 14,000
Paid in capital from sale of 1.000
Treasury stock
Note that paid in capital from sale of treasury stock is reported in the paid in capital section
of the balance sheet. Treasury stock is deducted
174 from the total of the paid in capital and
Retained earnings.
1. Assume that 120,000 shares of RAM corporation common stock, par br. 10, are
subscribed for at Br. 12 by Misrak Binda. The total is payable in three installments.
Pass the entries that are processed by RAM Corporation
2. Assume that Haromaya Corporation had 50,000 shares of Br. 10 par common stock
outstanding at the beginning of the current year. The company purchased 500 shares
for cash and received 500 shares in settlement of a debt from stockholders. The
markets price of stocks was Br. 30/share. Pass the entry involving the transactions.
6.7 ACCOUNTING FOR DIVIDENDS
The board of directors of a corporation has the sole authority to distribute dividends to the
stockholders. When such action is taken, the directors are said to declare a dividend. Since
dividends are normally based on earnings, a corporation cannot guarantee dividends even to
preferred stockholders. However, because they have first rights to any dividends, the preferred
Stockholders have a greater chance of receiving regular dividends than do the common
stockholders.
A board of directors may declare either cash dividends or stock dividends or both. When a
board of directors declares a cash dividend, it authorizes the distribution of a portion of the
corporation’s cash to stockholders. When a board of directors declares a stock dividend, it
authorizes the distribution of a portion of its stock. In both cases, the declaration of a dividend
reduces the retained earnings of the corporation.
a) Accounting for Cash Dividends
A cash distribution of earnings by a corporation to its shareholders is called a cash dividend.
dividend.
Although dividends may be paid in the form of other assets, cash dividends are the most
common form. There are usually three conditions that a corporation must meet to pay a cash
dividend:
 Sufficient retained earnings
 Sufficient cash
175
 Formal action by the board of directors

A large amount of retained earnings does not always mean that a corporation is able to pay
dividends since the balances of the cash and retained earnings accounts are often unrelated.
Thus, a large retained earnings account does not necessarily mean that there is cash available
to pay dividends.
A corporation’s board of directors has the right to declare dividends or not to declare. If
declared the following are the important dividend dates:
Date of Declaration: on this date, the corporation’s board of directors formally approves and
announces the dividend to be distributed. The declaration is recorded on this date as a debit to
dividends and a credit to dividends payable.
Date of Record:
Record: no entry is made on this date. It specifies who will receive the dividends. It
is the date on which the eligible individuals to dividends are determined.
Date of payment: this date is determined by the board of directors and is usually stated is
declaration. At the date of payment the liability recorded at the date of declaration is debited
and the appropriate asset account is credited.
To illustrate, assume that on December 20 the board of directors of Matador Corporation

declares the following yearly cash dividends. The date of record is December 25, and the date
of payment is January 2.
Dividend Total
per Share
Dividends
Preferred stock, Br.100 par, 5,000 shares outstanding . . . Br. 2.50 Br.12,
500
Common stock, Br. 10 par, 100,000 shares outstanding. . 0.30
30,000
176
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Br.
42,500
Now based on the above information Matador Corporation records the Br.42,500 liability for
the dividends on December 20, the declaration date, as follows:
Dividends ----------------------------------------- 42, 500
Cash Dividends Payable ------------------------------------------------------- 42,500
(To record declared cash dividend.)
No entry is required on the date of record, December 25, since this date merely determines
which stockholders will receive the dividend. On the date of payment, January 2, the
corporation records the Br. 42,500 payment of the dividends as follows:
Cash Dividends Payable -------------------------------------------- 42,500

Cash ----------------------------------------------------------------------------- 42,500
( to record payments of cash dividends )
If Matador Corporation’s fiscal year ends December 31, the balance in Cash Dividends
(simply dividends) will be transferred to Retained Earnings as a part of the closing process by
debiting Retained Earnings and crediting Cash Dividends. Cash Dividends Payable will be
listed on the December 31 balance sheet as a current liability. If a corporation that holds
treasury stock declares a cash dividend, the dividends are not paid on the treasury shares.
Dividends are not reported on the income statement. They would be found in a statement of
retained earnings or statement of stockholders’ equity once declared and statement of cash
flows when paid.
b) Stock Dividends
A distribution of shares of stock to stockholders is called a stock dividend. Usually, such

distributions are in common stock and are issued to holders of common stock. Stock
dividends are different from cash dividends in that there is no distribution of cash or other
assets to stockholders. The effect of a stock dividend on the stockholders’ equity of the
issuing corporation is to transfer retained earnings to paid-in capital. For public corporations,
177
the amount transferred from retained earnings to paid-in capital is normally the fair value
(market price) of the shares issued in the stock dividend.
To illustrate, assume that the stockholders’ equity accounts of Matador Corporation as of
December 15 are as follows:
Common Stock, Br.20 par (2,000,000 shares issued) ------------------------- Br.40, 000,000
Paid-In Capital in Excess of Par—Common Stock ----------------------------- 9,000,000
Retained Earnings ---------------------------------------------------------- 26,600,000
Assume that on December 15, the board of directors declares a stock dividend of 5% or
100,000 Shares (2,000,000 shares* 5%) to be issued on January 10 to stockholders of record
on December 31. The market price of the stock on the declaration date is Br. 31 a share. The
entry to record the declaration is as follows:
Dec 15 Stock Dividends (100,000 * Br. 31 market price) -----------------3,100 000

Stock Dividends Distributable (100,000*20 Par)
2,000,000
Paid-In Capital in Excess of Par––Common Stock -----
1,100,000
(To
(To record declared stock dividend.)
The Br. 3,100,000 balance in Stock Dividends is closed to Retained Earnings on December
31. The stock dividends distributable account is listed in the Paid-In Capital section of the
balance sheet. Thus, the effect of the stock dividend is to transfer Br. 3,100,000 of retained
earnings to paid-in capital.
On January 10, the number of shares outstanding is increased by 100,000 by the following
entry:
Jan10 Stock Dividends Distributable -------------------------2,000 000

Common Stock ------------------------------------------ 2,000,000
(To
(To record distributed stock for the stock dividends)
A stock dividend does not change the assets, liabilities, or total stockholders’ equity of the
corporation. Likewise, it does not change a stockholder’s proportionate interest (equity) in the
corporation. For example, if a stockholder owned 1,000 of a corporation’s 10,000 shares
178
outstanding, the stockholder owns 10% (1,000/10,000) of the corporation. For example, after
declaring a 6% stock dividend, the corporation will issue 600 additional shares (10,000 shares
* 6%), and the total shares outstanding will be 10,600. The stockholder of 1,000 shares will
receive 60 additional shares and will now own 1,060 shares, which is still a 10% equity
interest.
C) Stock Splits
Corporations sometimes reduce the par or stated value of their common stock and issue a
proportionate number of additional shares. When this is done, a corporation is said to have
split its stock, and the process is called a stock split. When stock is split, the reduction in par
or stated value applies to all shares, including the unissued, issued, and treasury shares. A
major objective of a stock split is to reduce the market price per share of the stock. This, in
turn, should attract more investors to enter the market for the stock and broaden the types and
numbers of stockholders.
To illustrate a stock split, assume that Matador Corporation has 10,000 shares of Br. 100 par
common stock outstanding with a current market price of Br. 150 per share. The board of
directors declares a 5-for- 1 stock split, reduces the par to Br. 20, and increases the number of
shares to 50,000. The amount of common stock outstanding is Br.1, 000,000 both before and
after the stock split. Only the number of shares and the par per share are changed. Each
Matador Corporation shareholder owns the same total par amount of stock before and after
the stock split.
For example, a stockholder who owned 4 shares of Br. 100 par stock before the split (total par
of Br. 400) would own 20 shares of Br. 20 par stock after the split (total par of Br.400). Since
there are more shares outstanding after the stock split, we would expect that the market price
of the stock would fall. For example, in the preceding example, there would be 5 times as
many shares outstanding after the split. Thus, we would expect the market price of the stock
to fall from Br.150 to approximately Br.30 (Br.150/5). Since a stock split changes only the par
or stated value and the number of shares outstanding, it is not recorded by a journal entry.
179
Although the accounts are not affected, the details of stock splits are normally disclosed in the
notes to the financial
1. State the effect of stock splits on corporate financial statements.

2. LTM Corporation announced a 4-for-1 stock split of its $50 par value common stock,
which is currently trading for $120 per share. What is the new par value and the
estimated market price of the stock after the split?
6.8 REPORTING STOCKHOLDERS’ EQUITY
Various formats may be used in reporting stockholders’ equity. The significant changes in the
sources of stockholders’ equity—paid-in capital and retained earnings— may be reported in
separate statements or notes that support the balance sheet presentation.
a) Balance Sheet Presentation
Preferred stock, common stock, additional paid-in-capital, retained earnings, and treasury
stock are all reported on the balance sheet in the stockholders' equity section. Information
regarding the par value, authorized shares, issued shares, and outstanding shares must be
disclosed for each type of stock. If a company has preferred stock, it is listed first in the
stockholders' equity section due to its preference in dividends and during liquidation.
liquidation
Stockholders’ section of Balance sheet is presented as follows; (Hypothetical values)

• Stockholders’ equity:
• 9%cumulative Ps, Br100 by, authorized
100,000 shares, issued 50,000 shares --- --------------- Br.5, 000,000
Common stock, Br.5 pv authorized 3 million
shares, issued 2 million shares– --------------------------- 10,000,000
Additional paid in capital:
Preferred stock ----------------------------------------------- 500,000
Common stock -------------------------------------------- 20,000,000
Treasury stock --------------------------------------------------25,000
Total paid-in capital ---------------------------------------- Br. 35,525,000
Retained earnings --------------------------------------------- 14,000,000
180
Subtotal ---------------------------------------------- 49,525,000

Less: Treasury stock -------------------------------------------- 125,000
Total stockholders’ equity --------------------------- Br. 49, 400,000
b) Reporting Retained Earnings

A corporation may report changes in retained earnings by preparing a separate retained
earnings statement, a combined income and retained earnings statement, or a statement of
stockholders’ equity. When a separate retained earnings statement is prepared, the beginning
balance of retained earnings is reported. The net income is then added (or net loss is
subtracted) and any dividends are subtracted to arrive at the ending retained earnings for the
period.
period
Using hypothetical number an example of such a statement is shown as follows.
follows
Matador Corporation
Retained Earnings Statement
For the Year Ended Dec 31, 2010
Retained earnings, January 1, 2010 . . . . . . . . . . . . . . . . . . . . . Br.350, 000
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280,000
Less: dividends declared . . . . . . . . . . . . . . . . . . . . . . . . . . . 75,000
Increase in retained earnings . . . . . . . . . . . . . . . . . . . . . . . 205,000
Retained earnings, Dec 31, 2010 . . . . . . . . . . . . . . . . . . . Br. 555,000
Describe and illustrate the reporting of stockholders’ equity.
Summary
Corporations have a separate legal existence, transferable units of stock, and limited
stockholders’ liability. Corporations may be either public or private corporations, and they are
subject to federal income taxes. The documents included in forming a corporation include an
application of incorporation, articles of incorporation, and bylaws. Costs often incurred in
181
organizing a corporation include legal fees, taxes, state incorporation fees, and promotional
costs. Such costs are debited to an expense account entitled Organizational Expenses.
The two main sources of stockholders’ equity are:
capital contributed by the stockholders and others, called paid-in capital, and net income
retained in the business, called retained earnings. Stockholders’ equity is reported in a
corporation balance sheet according to these two sources.
The main source of paid-in capital is from issuing stock. The two primary classes of stock are
common stock and preferred stock. Preferred stock is normally nonparticipating and may be
cumulative or noncumulative. In addition to the issuance of stock, paid-in capital may arise
from treasury stock transactions.
When a corporation issues stock at par for cash, the cash account is debited and the class of
stock issued is credited for its par amount. When a corporation issues stock at more than par,
Paid-In Capital in Excess of Par is credited for the difference between the cash received and
the par value of the stock. When stock is issued in exchange for assets other than cash, the
assets acquired should be recorded at their fair market value. When no-par stock is issued, the
entire proceeds are credited to the stock account. No-par stock may be assigned a stated value
per share, and the excess of the proceeds over the stated value may be credited to Paid-In
Capital in Excess of Stated Value.
When a corporation buys its own stock, the cost method of accounting is normally used.
Treasury Stock is debited for its cost, and Cash is credited. If the stock is resold, Treasury
Stock is credited for its cost and any difference between the cost and the selling price is
normally debited or credited to Paid-In Capital from Sale of Treasury Stock.
The entry to record a declaration of cash dividends debits Dividends and credits Dividends
Payable for each class of stock. The payment of dividends is recorded in the normal manner.
When a stock dividend is declared, Stock Dividends is debited for the fair value of the stock
to be issued. Stock Dividends Distributable is credited for the par or stated value of the
common stock to be issued. The difference between the fair value of the stock and its par or
stated value is credited to Paid-In Capital in Excess of Par—Common Stock. When the stock
182
is issued on the date of payment, Stock Dividends Distributable is debited and Common Stock
is credited for the par or stated value of the stock issued.
When a corporation reduces the par or stated value of its common stock and issues a
proportionate number of additional shares, a stock split has occurred. There are no changes in
the balances of any corporation accounts, and no entry is required for a stock split
Significant changes in the sources of stockholders’ equity—paid-in capital and retained

earnings—may be reported in separate statements or notes that support the balance sheet
presentation. Changes in retained earnings may be reported by preparing a separate retained
earnings statement.
6.9 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS

1)
 Limited liability: Since a corporation is a separate legal entity, the creditors of a
corporation have a claim against the assets of the corporation, not the personal
property of the owners.
 Ease in transferring ownership: ownership of a corporation is evidenced by
transferable shares of stocks. These shares of stocks may be sold by one investor to
another without dissolving or disrupting the business organization.
organization.
 Continuity: A corporation has perpetual existence in that its continuous existence
is not dissolved by the death on retirements of any of its members
 Ease in raising money:
2. The current stockholders has the right to purchase the shares of the corporation on a prorate
basis when new stocks are offered for sale. These preemptive rights are designed to provide
each stockholder the opportunity to maintain a proportional ownership in the corporation.
corporation.
1. $400,000 [3 years in arrears (50,000 _ $2 _ 3) plus the current year’s dividend of

$100,000]
183
2. C
1) Common stock subscription Receivable 1,440,000

Paid-in-capital in excess of par 240,000
To record receipt of subscription for 120,000 shares
Cash 480,000
Common stock subscription receivable 480,000
To record receipt of 1st payment
Cash 480,000
To record receipt of final payment
Cash 480,000
To record receipt of final payment
Common stock 1,200,000
To record issuance of stock
2) Treasury stock 30,000

Cash 15,000
Notes Receivable 15,000
If the company sells 600 shares of the treasury stock for Br. 31 each, the entry would be:
Cash 18,600
Treasury stock 18,000
Paid in capital from sale of 600
Treasury stock
184
1. When a corporation reduces the par or stated value of its common stock and issues a
proportionate number of additional shares, a stock split has occurred. There are no
changes in the balances of any corporation accounts, and no entry is required for a stock
split.
2. $12.50 ($50/4) par value; $30 ($120/4) estimated market price.
Significant changes in the sources of stockholders’ equity—paid-in capital and retained

earnings—may be reported in separate statements or notes that support the balance sheet
presentation. Changes in retained earnings may be reported by preparing a separate retained
earnings statement, a combined income and retained earnings statement, or a statement of
stockholders’ equity. Restrictions to retained earnings must be disclosed, usually in the notes
to the financial statements. Material errors in a prior period’s net income, called prior period
adjustments, are reported in the retained earnings statement
PART-I: Short answer questions
1. Why are most large businesses organized as corporations?

2. Of two corporations organized at approximately the same time and engaged in
businesses, one issued $75 par common stock, and the other issued $1 par common
stock. Do the par designations provide any indication as to which stock is preferable as
an investment? Explain.
3. A corporation reacquires 10,000 shares of its own $25 par common stock for
$420,000, recording it at cost. (a) What effect does this transaction have on revenue or
expense of the period? (b) What effect does it have on stockholders’ equity?
4. What is the primary purpose of a stock split?
5. (a) What are the three conditions for the declaration and the payment of a cash
dividend? (b) The dates in connection with the declaration of a cash dividend are July
1, August 15, and September 1. Identify each date.
PART-II: Choose the correct answer
185
1) If a corporation has outstanding 1,000 shares of 9% cumulative preferred stock of $100

par and dividends have been passed for the preceding three years, what is the amount of
preferred dividends that must be declared in the current year before a dividend can be
declared on common stock?
A. $ 9,000 C. $36,000
B. $27,000 D. $45,000
2) 2. Paid-in capital for a corporation may arise from which of the following sources?
A. Issuing cumulative preferred stock C. Selling the corporation’s treasury
B. Receiving donations of real estate stock
D. All of the above
3) The Stockholders’ Equity section of the balance sheet may include:
A. Common Stock C. Preferred Stock
B. Stock Dividends Distributable D. All of the above
4) If a corporation reacquires its own stock, the stock is listed on the balance sheet in the:
A. Current Assets section. C. Stockholders’ Equity section.
B. Long-Term Liabilities section. D. Investments section
.
5) A corporation has issued 25,000 shares of $100 par common stock and holds 3,000 of
these shares as treasury stock. If the corporation declares a $2 per share cash dividend,
what amount will be recorded as cash dividends?
A. $22,000 B. $25,000
C. $44,000 D. $50,000
PART-III: PROBLEMS
1. Abay River Corporation sells and services pipe welding equipment in Wyoming. The
following selected accounts appear in the ledger of Abay River Corporation on January 1,
2006, the beginning of the current fiscal year:
Preferred 2% Stock, $100 par (80,000 shares authorized,
18,000 shares issued) . . . . . . . . . . . . . . . . . . . . . . . . ….. . . . . . . $1,800,000
Paid-In Capital in Excess of Par—Preferred Stock . . . . . . . . . . . . 172,500
186
Common Stock, $10 par (800,000 shares authorized,

500,000 shares issued) . . . . . . . . . . . . . . . . . . . . …… . . . . . . . . . 5,000,000
Paid-In Capital in Excess of Par—Common Stock . . . . . . . . . . . . 1,236,000
Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . …... . . . . . . . 6,450,000
During the year, the corporation completed a number of transactions affecting the
stockholders’ equity. They are summarized as follows:
a. Purchased 60,000 shares of treasury common for $1,080,000.

b. Sold 20,000 shares of treasury common for $420,000.
c. Sold 7,000 shares of preferred 2% stock at $108.
d. Issued 40,000 shares of common stock at $23, receiving cash.
e. Sold 35,000 shares of treasury common for $595,000.
f. Declared cash dividends of $2 per share on preferred stock and $0.16 per share on common
stock.
g. Paid the cash dividends.
Instructions
Journalize the entries to record the transactions. Identify each entry by letter.
2. IMX Enterprises Inc. produces aeronautical navigation equipment. The stockholders’

equity accounts of IMX Enterprises Inc., with balances on January 1, 2006, are as follows:
Common Stock, $10 stated value (100,000 shares authorized,

60,000 shares issued) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600,000
Paid-In Capital in Excess of Stated Value . . . . . . . . . . . . . . . . . . . . . . 150,000
Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 497,750
Treasury Stock (7,500 shares, at cost) . . . . . . . . . . . . . . . . . . . . . . . . . 120,000
The following selected transactions occurred during the year:

Jan. 19.
19. Paid cash dividends of $0.60 per share on the common stock. The dividend had been
properly recorded when declared on December 28 of the preceding fiscal year for $31,500.
Feb. 2.
2. Sold all of the treasury stock for $150,000.
187
Mar. 15.
15. Issued 20,000 shares of common stock for $480,000.
July 30.
30. Declared a 2% stock dividend on common stock, to be capitalized at the market price
of the stock, which is $25 a share.
Aug. 30.
30. Issued the certificates for the dividend declared on July 30.
Oct. 10.
10. Purchased 5,000 shares of treasury stock for $105,000.
Dec. 30.
30. Declared a $0.50-per-share dividend on common stock.
31. Closed the credit balance of the income summary account, $182,500.
31. Closed the two dividends accounts to Retained Earnings.
Instructions
1. Enter the January 1 balances in T accounts for the stockholders’ equity accounts listed.
Also prepare T accounts for the following: Paid-In Capital from Sale of Treasury Stock; Stock
Dividends Distributable; Stock Dividends; Cash Dividends.
2. Journalize the entries to record the transactions, and post to the eight selected accounts.
3. Prepare a retained earnings statement for the year ended December 31, 2006.
4. Prepare the stockholders’ equity
188
GLOSSARY
 Account Receivable: - A claim against a customer for services rendered or goods sold
on credit.
 Accumulated Depreciation: The cumulative sum of all depreciation recognized since
the date of acquisition of the particular assets.
 Aging the receivable: - The process of analyzing the account receivable and
classifying them according to various age groupings, with the due date being the base
point for determine age.
 Allowance method: - A method of accounting for uncollectible receivables, whereby
advance provision for the uncollectibles is made
 Amortization: When referring to long-lived assets, it usually means the allocation of
the costs of intangible assets to the periods that benefit from these intangible assets.
 APB Opinions:
Opinions: A series of thirty-one opinions of the accounting principles Board,
many of which are still the “accounting law of the land.”
 Bank reconciliation: a schedule that explains the difference between the balance of
cash shown in the bank statement and the balance of cash shown in the depositor’s
records.
189
 Book Value, (net book value): The balance of an account shown on the book, net of
any contra accounts. For example the book value of equipment is its acquisition cost
minus accumulated depreciation
 Board of directors: Persons elected by common stockholders to direct the affairs of a
corporation
 Capital stock: A transferable unit of ownership of a corporation. A broad term, which
may refer to common stock, preferred stock, or both.
 Capitalized: A cost that is added to an asset account, as distinguished from being
expensed immediately
 Cash:
Cash: money on deposit in banks and other items that a bank will accept for
immediate deposit.
 Cash management: planning, controlling, and accounting for cash transactions and
cash balances.
 Common stock: A type of capital stock, which possesses the basic rights of ownership
including the rights to vote.
 Contra account: A separate but related account that offsets or is a deduction from a
companion account. An example is accumulated depreciation.
 Corporation: A business organized as a legal entity separate from its owners.
 Cost of merchandise sold-
sold- The cost of the merchandise purchased by a merchandise
enterprise and sold
 Current asset: - Cash or other assets that are expected to be converted to cash or
sold or used up, usually within a year or less, through the normal operations of
business.
business
 Depletion: The process of allocating the cost of natural resources to the periods in
which the resources are used
 Depreciable Value: The amount of the acquisition cost to be allocated as depreciation
over the total useful life of an asset. It is the difference between the total acquisition
cost and the predicted residual value
190
 Direct write-off method: - A method of accounting for uncollectibles receivables,

whereby an expense is recognized only when specific accounts are judged to be
uncollectible.
 Dishonored note receivable: - A note that the maker fails to pay on its due date.
 Dissolution:
Dissolution: formation of a new partnership because of the retirement’s admission
or death of a partner.
 Finished goods inventory-
inventory- The cost of finished products on hand that have not been
sold
 First-in, First-out (FIFO) method- method of inventory costing based on the
assumption that the costs of merchandise sold should be charged against revenue in
the order in which the costs were incurred
 FOB destination-
destination- Terms of agreement between buyer and seller where by ownership
passes when merchandise is received by the buyer, and the seller absorbs the
transportation costs.
 FOB shipping, point-Terms
point-Terms of agreement between buyer and seller, whereby
ownership passes when merchandise is delivered to the shipper, and the buyer
absorbs the transportation costs
 Franchises (Licenses): Privileges granted by a government, manufacturer, or
distributor to sell a product or service in accordance with specified conditions.
 Goodwill: The excess of the cost of an acquired company over the sum of the fair
market value of its identifiable individual assets less the liability.
 Gross profit-
profit- The excess of net revenue from sales over the cost of merchandise sold.
 Last-in, First-out (LIFO) method- a method of inventory costing based on the
assumption that the most recent merchandise costs should be cha
 Leasehold:
Leasehold: The right to use a fixed asset for a specified period of time, typically
beyond one year.
 Leasehold Improvement: Investments by a lessee in items that are not permitted to

be removed from the premises when a lease expires, such as installation of new
fixtures, panels, walls and air-condition equipment.
191
 Legal capital: Equal to the par value or stated value of capital stock issued. This
amount cannot be removed without special legal
action
 Liquidation:
Liquidation: the winding up of operation and sale of business assets.
 Net income-
income- The final figure in the income statement when revenues exceed expenses.
 Notes Receivable: - A written promise to pay by the maker, representing an amount
to be received by the payee.
 Purchases returns and allowances-
allowances- Reduction in purchase, resulting from
merchandise returned to the vendor or from the vendor’s reduction in the original
purchase price; a contra account to purchases.
 Patents: Granted by the federal government to an invent bestowing (in the united
states) the exclusive right for 17 years to produce and sell the in invention.
 Payroll: total amount paid to employees for a certain period.
 Paid in capital: the amounts invested in a corporation by its stockholders.
 Payroll Register (sheet): a list of employees of a business along with their earnings,
deductions and net pay.
pay
 Partnership : a business owned by two or more individuals as co-owners based on
a partnership agreement
 Partners : owners of a partnership
 Par value (or stated Value): the minimum amount per share to be invested is the
corporation by its own owners and cannot be withdrawn except by special legal action.
 Petty cash: small amount of cash, which is used to make small payments that occur
frequently.
 Preferred stock: a class of capital stock usually having preferences as to dividends
and in the distribution of assets inevents of liquid action
 Realization : sale of business assets for cash
 Salary: amount paid to work performed for skilled labor
 Stock certificate: a document issued by a corporation as evidence of the ownership
of the number of shares stated on the certificate.
192
 Subscriptions to Capital stock: formal promises to buy shares of stock from a

corporation with payment at a later date.
 Trademarks: Distinctive identification of a manufactured product or of a service
taking the form of a name, a sign, a slogan, a logo, or an emblem
 Uncollectibles accounts Expense: - The operating expense incurred because of the
failure to collect receivables.
 Voucher: a written authorization used in approving a transaction for recording and
payment.
 Voucher system: an accounting system designed to provide strong internal control
over cash disbursements.
 Wages : amount paid to a piece of work by unskilled labor
 Work in process inventory-
inventory- The direct materials costs, the direct labor costs, and the
factory overhead costs, which have entered into the manufacturing process, but are
associated with products that have not been finished
REFERENCE BOOKS
 Fees and warren, Accounting Principles, 16th edition, South Western publishing
Company. / Any recent edition/
 Smith, Keith & Stephens, Accounting Principles, 3rd edition and above, McGraw
Hill book Company.1989 and beyond.
 Hermanson, Edwards and Salmonson, Accounting Principles, 4th ed., Richard D.
Irwin, Inc. 1989.
 Larson, Kermit D., Fundamental Accounting Principles, 12th edition and above,
Richard Irwin Inc., 1990 and beyond.
 Meigs Walter B., Accounting, The Basis for Business Decisions, 6th Ed and above,
McGraw-Hill International Book Company, 1984 and beyond.
193
 Niswonger and Fees, Accounting Principles, South Western Publishing Company

10th – 13th Ed.
194

Modul PAII

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Modul PAII

Uploaded by

Copyright:

Available Formats

WOLLEGA UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ACCOUNTING AND FINANCE

PRINCIPLE OF ACCOUNTING PART II

PREPARED BY: Adamu Terfa

EDITED BY: Adugna Megenasa

This course is a continuation of principles of accounting I. the course is designed to introduce

 Apply accounting principles and control of cash and receivables

UNIT ONE: CASH AND RECEIVABLES

1.0 AIMS & OBJECTIVES

Meaning and Characteristics of Cash

The following are some of the characteristics of cash:

a) Cash is used as medium of exchange

Exercise 1.1: Check Your Progress;

1. Define cash as it is used for accounting purpose.

2. Which of the following items should not be included as cash?

1.2 INTERNAL CONTROL OF CASH

Internal control for cash should include the following procedures:

1.3 BANK RECONCILIATION

 Cash is physically protected by the bank,

When you open a checking account, you sign a signature card.

Reconciliation of Bank and Book Cash Balances

4) Charges for depositing NSF- checks:

Steps in Preparing Bank Reconciliation

The steps to prepare bank reconciliation are:

Cash balance according to bank statement . . …………………………………. $XXX

Cash balance according to depositor’s records……………………..……………. $XXX

o Deposit of July 31, not recorded on bank statement . . . . . . . . . . . . . . . . . . ……. . $ 816.20

o Check from customer (Nuuf) returned by bank because of

Cash balance according to depositor’s records $2 5 4 9 .99

July 31 Cash 408 .00

Exercise 1.2: Check Your Progress;

1. Briefly explain the basic purpose of bank reconciliation.

3. Which of the reconciling items necessitate an entry in the depositor’s accounts?

1.4 PETTY CASH AND CHANGE FUNDS

Establishment of Petty Cash

Aug. 1 Petty Cash 100.00

Replenishment of Petty Cash

Aug. 31 Office Supplies 50.00

 Replenished petty cash fund.

Cash Short and Over

3. In what order are vouchers ordinarily filed

In a computerized system, properly approved supporting documents (such as purchase orders

1.5. CLASSIFICATION OF RECEIVABLES

1.6 INTERNAL CONTROL OF RECEIVABLES

Exercise 1.4: Check Your Progress;

1. List the common classifications of receivables

2. Why is Account Receivable classified as a current asset?

3. Why is segregation of duties required for related activities related to receivables?

1.7 ACCOUNTING FOR UNCOLLECTIBLE ACCOUNTS

When credit is extended, some amount of uncollectible receivables is generally inevitable

There are two methods of accounting for uncollectible receivables.

1) The allowance method,

2) The direct write-off method,

1) Allowance Method of Accounting for Uncollectible

Dec. 31 Uncollectible Accounts Expense 4000.00

Because the $4,000 reduction in accounts receivable is an estimate, it cannot be credited to

Accounts Receivable Allowance for Doubtful Accounts

Aug. 31 20,000 Sept. 30 15,000 Dec. 31 Adj. 4,000

Write-Offs to the Allowance Account

When a customer’s account is identified as uncollectible, it is written off against the

Jan. 21 Allowance for Doubtful Accounts 610.00

June 10 Accounts Receivable––Bekam 610