Accounting 2

3
Accounting II
Editor
Prof.Dr. Saime ÖNCE
Authors
CHAPTER 1, 2 Assoc.Prof.Dr. Arman Aziz KARAGÜL
CHAPTER 3, 4
Assoc.Prof.Dr. Mustafa Gürol DURAK
CHAPTER 5
Prof.Dr. Nazlı KEPÇE
CHAPTER 6, 7
Asst.Prof.Dr. Sezen ULUDAĞ
CHAPTER 8
Prof.Dr. Ayşe Banu BAŞAR
T.C. ANADOLU UNIVERSITY PUBLICATION NO: 3878
OPEN EDUCATION FACULTY PUBLICATION NO: 2680
Copyright © 2019 by Anadolu University

All rights reserved.
This publication is designed and produced based on “Distance Teaching” techniques. No part of this
book may be reproduced or stored in a retrieval system, or transmitted in any form or by any means
of mechanical, electronic, photocopy, magnetic tape, or otherwise, without the written permission of
Anadolu University.
Graphic and Cover Design

Prof.Dr. Halit Turgay Ünalan
Assessment Editor
Lecturer Gamze Erşen
Graphic Designers
Ayşegül Dibek
Gülşah Karabulut
Özlem Çayırlı
Typesetting and Composition

Yasin Özkır
Cansu Ersoy
Burcu Semiz
Murat Tambova
Dilek Özbek
Kağan Küçük
Halil Kaya
Saner Coşkun
ACCOUNTING II
E-ISBN
978-975-06-3498-7
All rights of this book belong to Anadolu University.
ESKİŞEHİR, March 2019
3276-0-0-0-1902-V01
Contents
Intangible
Property, Plant Assets and
CHAPTER 1 CHAPTER 2
and Equipment Natural
Resources
Introduction ................................................... 3 Introduction ................................................... 33
Property, Plant and Equıpment ................... 3 Intangible Assets ........................................... 33
Acquisition of Property, Plant and Acquisition of Intangible Assets ................... 34
Equipment ...................................................... 4 Rights ..................................................... 35
Cost of Land and Land Improvements..... 5 Goodwill ................................................. 40
Cost of Buildings ................................... 6 Pre-operating Costs .............................. 42
Cost of Machinery and Equipment ..... 9 Research and Development Costs ....... 43
Cost of Furniture and Fixtures ............. 11 Leasehold Improvements ..................... 43
Cost of Vehicles ..................................... 12 Natural Resources ......................................... 45
Depreciation .................................................. 13 Financial Reporting for Intangible
Measuring Depreciation ....................... 13 Assets and Natural Resources ...................... 47
Disposing of Property, Plant and
Equipment Assets .......................................... 21
Discarding Property, Plant and
Equipment Assets ................................. 21
Selling Property, Plant and Equipment
Assets for Cash ...................................... 22
Exchange of Property, Plant and
Current
CHAPTER 3 Investments CHAPTER 4 Liabilities and
Payroll
Introduction .................................................. 59 Introduction ................................................... 91
Why Companies Invest ................................. 59 Accountıng for Current Liabilities ............... 91
Investments in Debt Securities ................... 60 Accounts Payable .................................. 92
Held-To-Maturity (Htm) Securities .... 61 Notes Payable ........................................ 93
Available For Sale Securities ................ 66 Short-Term Bank Loans ........................ 95
Trading Securities ................................. 68 Current Portion of Long-Term Bank
Investments in Equity Securities ................. 69 Loans ...................................................... 96
Holdings Of Less Than 20 Percent Accruals .................................................. 98
(Minority, Passive investments) ........ 70 Unearned Revenues .............................. 98
Holdings Between 20 Percent And 50 Tax Payables .......................................... 100
Percent (Minority, Value Added Tax (VAT) ........................ 101
Active investments) ............................. 74 Payroll Accounting ........................................ 103
Holdings Of More Than 50 Percent Estimated Liabilities (Provisions) ................ 104
(Majority, Active Investments) .......... 76 Contingent Liabilities .................................... 107
Derivatives as Contractual Investments ..... 77 Reporting Current Liabilities and
Transfers Between Categories ...................... 77 Liquidity ......................................................... 108
iii
Long Term Shareholders’
CHAPTER 5 CHAPTER 6 Equity:
Liabilities Paid-in Capital
Introduction ................................................... 121 Introduction.................................................... 157

Nature of Long Term Liabilities.................... 121 Characteristics of a Corporations and
Bonds and Types of Bonds............................. 122 Other Types of Entities.................................. 157
Secured And Unsecured Bonds............. 123 Characteristics of Different
Term, Serial Bonds, And Callable Types of Entities ................................... 157
Characteristics of a Corporations ........ 158
Bonds...................................................... 123
Issuance of Shares ......................................... 164
Registered And Bearer (Coupon)
Issuing Common Shares at
Bonds...................................................... 124
Par Value ................................................ 165
Accounting for Bond Issues........................... 124 Issuing Common Shares over
Bonds Issued At Face Value Par Value................................................. 166
(At Par Value) ....................................... 125 Issuing No-par Common Shares .......... 167
Bonds Issued At Premium..................... 126 Issuing Stated Value-Common
Bonds Issued At Discount...................... 128 Shares ..................................................... 167
Amortization of Bond Discounts and Differences and Issuance of
Premiums........................................................ 129 Preferred Shares ............................................ 168
Amortization Of Bonds Issued At Basic Differences Between a Preferred
Premium................................................. 130 Share and a Common Share.................. 169
Amortization Of Bonds Issued At Issuing of Preferred Shares................... 169
Treasury Shares.............................................. 170
Discount.................................................. 134
Definition and Characteristics of
Long Term Notes Payable ............................ 137
Treasury Shares...................................... 170
Accounting for Treasury Shares........... 171
Shareholders’
Equity: Retained Statement of
CHAPTER 7 Earnings and CHAPTER 8
Cash Flows
Dividends
Introduction.................................................... 185 Introduction ................................................... 211
Retained Earnings.......................................... 185 The Statement of Cash Flows: Purpose and
Accounting for Cash Dividends..................... 187 Format ............................................................ 211
The Dividend on Preferred Shares ....... 190 Importance of Cash Flows .................... 211
Recording Declaration and Payment Reporting Cash Flows Information:
of Cash Dividends.................................. 190 Statement of Cash Flows ...................... 212
Accounting for Share Dividends and Clasification of Cash Flows ........................... 214
Share Splits ..................................................... 192 Operating Activities .............................. 215
Share Dividends ..................................... 192 Investing Activities ............................... 215
Share Splits ............................................ 195 Financing Activities .............................. 215
Restrictions on Retained Earnings ............... 196 Cash Flows From Operating Activities ........ 216
Changes in Shareholders’ Equity................... 196 Reporting Operating Cash Flows:
Earnings and Evaluating Ratios ................... 199 Indirect Method ................................... 217
Reporting Operating Cash Flows:
Direct Method ....................................... 220
Cash Flows From Investing Activities .......... 223
Cash Flows From Financing Activities ......... 223
iv
Preface
Dear reader,
In “Accounting I” book, we emphasized the This book that you are reading now has been
rationale for, and implications of, accounting written in a collaborative team work. Many
concepts. Both of “Accounting I” and people, such as authors, proof readers, and
“Accounting II” books are intended to be an editorial and design team, helped to make this
introductory and fundamental sources for book possible. We thank all the people who
business students at all levels with a desire to put efforts into this book.
learn about the fundamentals of accounting.
These two books are complementary to Hopefully, this book will be beneficial for you
each other. While Accounting I covers the to understand that the accounting is a holistic
Environment of Business and Accounting, process of recording all financial transactions
the Recording Process, Accrual Accounting of a company and reporting via financial
and Adjusting Process, Completing the statements.
Accounting Cycle, Merchandising Operations Good luck in this course! Read on and enjoy!
and Inventory, Internal Control, Cash and
Receivables, “Accounting II” covers the
recording processes for “Property, Plant and The Book Team
Equipment”, “Intangible Assets and Natural
Resources”, “Investments”, “Long Term Editor
Liabilities”, and “Shareholders’ Equity: Paid in Prof.Dr. Saime ÖNCE
Capital and Retained Earnings”. Additionally,
in the final chapter, the book has also
examined “Cash Flows Statement” which is
one of the basic financial statements.

v
Contents
Intangible
Property, Plant Assets and
CHAPTER 1 CHAPTER 2
and Equipment Natural
Resources
Introduction ................................................... 3 Introduction ................................................... 33
Property, Plant and Equıpment ................... 3 Intangible Assets ........................................... 33
Acquisition of Property, Plant and Acquisition of Intangible Assets ................... 34
Equipment ...................................................... 4 Rights ..................................................... 35
Cost of Land and Land Improvements..... 5 Goodwill ................................................. 40
Cost of Buildings ................................... 6 Pre-operating Costs .............................. 42
Cost of Machinery and Equipment ..... 9 Research and Development Costs ....... 43
Cost of Furniture and Fixtures ............. 11 Leasehold Improvements ..................... 43
Cost of Vehicles ..................................... 12 Natural Resources ......................................... 45
Depreciation .................................................. 13 Financial Reporting for Intangible
Measuring Depreciation ....................... 13 Assets and Natural Resources ...................... 47
Disposing of Property, Plant and
Equipment Assets .......................................... 21
Discarding Property, Plant and
Selling Property, Plant and Equipment
Assets for Cash ...................................... 22
Exchange of Property, Plant and
Current
CHAPTER 3 Investments CHAPTER 4 Liabilities and
Payroll
Introduction .................................................. 59 Introduction ................................................... 91
Why Companies Invest ................................. 59 Accountıng for Current Liabilities ............... 91
Investments in Debt Securities ................... 60 Accounts Payable .................................. 92
Held-To-Maturity (Htm) Securities .... 61 Notes Payable ........................................ 93
Available For Sale Securities ................ 66 Short-Term Bank Loans ........................ 95
Trading Securities ................................. 68 Current Portion of Long-Term Bank
Investments in Equity Securities ................. 69 Loans ...................................................... 96
Holdings Of Less Than 20 Percent Accruals .................................................. 98
(Minority, Passive investments) ........ 70 Unearned Revenues .............................. 98
Holdings Between 20 Percent And 50 Tax Payables .......................................... 100
Percent (Minority, Value Added Tax (VAT) ........................ 101
Active investments) ............................. 74 Payroll Accounting ........................................ 103
Holdings Of More Than 50 Percent Estimated Liabilities (Provisions) ................ 104
(Majority, Active Investments) .......... 76 Contingent Liabilities .................................... 107
Derivatives as Contractual Investments ..... 77 Reporting Current Liabilities and
Transfers Between Categories ...................... 77 Liquidity ......................................................... 108
iii
Long Term Shareholders’
CHAPTER 5 CHAPTER 6 Equity:
Liabilities Paid-in Capital
Introduction ................................................... 121 Introduction.................................................... 157

Nature of Long Term Liabilities.................... 121 Characteristics of a Corporations and
Bonds and Types of Bonds............................. 122 Other Types of Entities.................................. 157
Secured And Unsecured Bonds............. 123 Characteristics of Different
Term, Serial Bonds, And Callable Types of Entities ................................... 157
Characteristics of a Corporations ........ 158
Bonds...................................................... 123
Issuance of Shares ......................................... 164
Registered And Bearer (Coupon)
Issuing Common Shares at
Bonds...................................................... 124
Par Value ................................................ 165
Accounting for Bond Issues........................... 124 Issuing Common Shares over
Bonds Issued At Face Value Par Value................................................. 166
(At Par Value) ....................................... 125 Issuing No-par Common Shares .......... 167
Bonds Issued At Premium..................... 126 Issuing Stated Value-Common
Bonds Issued At Discount...................... 128 Shares ..................................................... 167
Amortization of Bond Discounts and Differences and Issuance of
Premiums........................................................ 129 Preferred Shares ............................................ 168
Amortization Of Bonds Issued At Basic Differences Between a Preferred
Premium................................................. 130 Share and a Common Share.................. 169
Amortization Of Bonds Issued At Issuing of Preferred Shares................... 169
Treasury Shares.............................................. 170
Discount.................................................. 134
Long Term Notes Payable ............................ 137
Treasury Shares...................................... 170
Accounting for Treasury Shares........... 171
Shareholders’
Equity: Retained Statement of
CHAPTER 7 Earnings and CHAPTER 8
Cash Flows
Dividends
Introduction.................................................... 185 Introduction ................................................... 211
Retained Earnings.......................................... 185 The Statement of Cash Flows: Purpose and
Accounting for Cash Dividends..................... 187 Format ............................................................ 211
The Dividend on Preferred Shares ....... 190 Importance of Cash Flows .................... 211
Recording Declaration and Payment Reporting Cash Flows Information:
of Cash Dividends.................................. 190 Statement of Cash Flows ...................... 212
Accounting for Share Dividends and Clasification of Cash Flows ........................... 214
Share Splits ..................................................... 192 Operating Activities .............................. 215
Share Dividends ..................................... 192 Investing Activities ............................... 215
Share Splits ............................................ 195 Financing Activities .............................. 215
Restrictions on Retained Earnings ............... 196 Cash Flows From Operating Activities ........ 216
Changes in Shareholders’ Equity................... 196 Reporting Operating Cash Flows:
Earnings and Evaluating Ratios ................... 199 Indirect Method ................................... 217
Reporting Operating Cash Flows:
Direct Method ....................................... 220
Cash Flows From Investing Activities .......... 223
Cash Flows From Financing Activities ......... 223
iv
Preface
Dear reader,
In “Accounting I” book, we emphasized the This book that you are reading now has been
rationale for, and implications of, accounting written in a collaborative team work. Many
concepts. Both of “Accounting I” and people, such as authors, proof readers, and
“Accounting II” books are intended to be an editorial and design team, helped to make this
introductory and fundamental sources for book possible. We thank all the people who
business students at all levels with a desire to put efforts into this book.
learn about the fundamentals of accounting.
These two books are complementary to Hopefully, this book will be beneficial for you
each other. While Accounting I covers the to understand that the accounting is a holistic
Environment of Business and Accounting, process of recording all financial transactions
the Recording Process, Accrual Accounting of a company and reporting via financial
and Adjusting Process, Completing the statements.
Accounting Cycle, Merchandising Operations Good luck in this course! Read on and enjoy!
and Inventory, Internal Control, Cash and
Receivables, “Accounting II” covers the
recording processes for “Property, Plant and The Book Team
Equipment”, “Intangible Assets and Natural
Resources”, “Investments”, “Long Term Editor
Liabilities”, and “Shareholders’ Equity: Paid in Prof.Dr. Saime ÖNCE
Capital and Retained Earnings”. Additionally,
in the final chapter, the book has also
examined “Cash Flows Statement” which is
one of the basic financial statements.

v
Chapter 1 Property, Plant and Equipment
After completing this chapter, you will be able to;
1
Learning Outcomes
Explain the Properties of Property, Plant and Understand the concepts underlying the
Equipment
2 measurement of acquisition cost and measure
the cost of Property, Plant and Equipment
3 Explain the concept of depreciation and apply

depreciation methods
4 Explain how to account for the disposal of
Property, Plant and Equipment
Key Terms
Capitalized Cost
Depreciation
Chapter Outline Depreciable Cost
Introduction
Depreciation Methods
Double-Declining Balance Depreciation
Acquisition of Property, Plant and Equipment
Economic Life
Depreciation
Fixed Assets
Disposing of Property, Plant and Equipment Asset
Partial-year Depreciation
Residual Value
Straight-Line Depreciation
Units-of-production Depreciation
Useful Life
2
Accounting II
INTRODUCTION company called as “lessee” takes over the property

As you can remember from the previous book of the asset from the owner (lessor) company.
Accounting I, assets are defined as the economic During the rental period, lessee makes the rental
resources acquired by the business in order to payments. Though a leasing transaction seems as
benefit from them in the future. In fact, there is if it is a rental transaction, because the ownership
an expectation for the businesses to use the assets of the asset is handed over to the user company,
in their operations. Some of these assets can be according to the substance over legal form concept
converted into cash, sold, collected and consumed of accounting. The legal form of this transaction is
within one year or operation cycle which is shorter a rental transaction but as the asset is going to be
but some of the assets will be used in operations taken over from the owner at the end of the rental
for more than a year. The first group of assets are agreement, economic substance of the transaction
called current assets whereas the latter is called steps forward and the economic resource acquired
non-current assets (long-term assets). by a leasing transaction recognized as an asset.
Non-current assets are the assets that are
acquired to use in the operations of the business for
several years. Besides these assets, receivables that
have due dates of more than one year will also be
reported under non-current assets. In this chapter
we will focus on Property, Plant and Equipment
which generally holds the largest portion in non-
current assets.
PROPERTY, PLANT AND

EQUIPMENT
Businesses must have some long-lived assets
(property, plant and equipment) in order to carry
out their operations. For example, the business
needs managerial building, factory building, lands,
equipment, furniture, machineries, vehicles, etc. Picture 1.1
You may think that the business can operate without Property, Plant, and Equipment assets are long-
acquiring a building, it can be rented for example. lived and tangible assets used in the operations of
Well, in this case it is important to remember the a business. Property, Plant, and Equipment assets
properties of the assets1. First of all, for an economic are called in various names such as Plant Assets or
resource to be recognized as an asset, it must have Fixed Assets. By whatever name, these assets are
a capacity of providing future benefit. Secondly, it expected to provide benefit to the company for a
must be controlled by the business and lastly the long term. Property, Plant, and Equipment assets
transaction that caused future benefit and control are critical to a company’s success because they play
must occur in the past. The control property here a key role in ongoing operations and determine
indicates that an economic resource must be fully the company’s capacity and therefore its ability to
under control of a business but other parties don’t satisfy customers.2
have a right of providing benefit from it. When the Property, plant and equipment assets have the
business rents a building to use in the operations, following major characteristics:3
it cannot be recognized as an asset because the – They are acquired for use in operations and not
business doesn’t have full control on building. For for resale: Because those assets are acquired
example, the business cannot sell the building to for use in operations for several years, they
anyone. But there is one exception at this point. are recognized under non-current assets.
Leasing transactions provides companies use the Otherwise, they would either be reported
property, plant and equipment assets within a rental under merchandise inventory or reported
agreement. At the end of the agreement the user
3
as an expense. For example, Presta Co.

company sells various kinds of electronic
Property, plant and equipment assets
devices such as laptops, cell phones,
are economic resources that have physical
TVs, etc. Let’s assume that the company
substance (tangible), are used in the
purchased 25 laptops with the exact brand
operations of a business, and are not intended
and specifications. The company will use
for sale to customers.
five of the laptops in its operations and 20
of them will be sold. How will the company
recognize this transaction? 20 laptops will
be recognized as merchandise inventory.
Long-lived assets such as land, buildings,
Because the intention of the company
and equipment, are acquired to use in the
when acquiring these laptops is resale. But
operations of a business.
for the five laptops they will be recognized
as equipment, because the intention of
acquiring them is to use in operations.
Here a question may occur. What happens ACQUISITION OF PROPERTY,
if the company sells the laptops which were PLANT AND EQUIPMENT
recognized as equipment? Recognizing as The decision to acquire a long-term asset is
fixed asset does not mean that the company a complex process. The historical cost principle
cannot sell those assets. Of course the requires that companies record property, plant and
company has a right to sell it but it doesn’t equipment assets at their actual cost. So, what is
change the initial recognition of the asset. cost? Cost consists of all expenditures necessary to
The company purchased it to use in the acquire the asset and make it ready for its intended
operations. use.4 According to the historical cost principle, cost
– They are in long-term in nature and usually is the cash or cash equivalent price of obtaining the
depreciated: Property, plant and equipment asset and bringing it to the location and condition
assets provide economic benefit for several necessary for its intended use5. So, pay attention
years. This means that within the revenue to the expression “bringing it to the location and
the company earned these assets have condition necessary for its intended use”. This means
contributions. In other words, by using that the cost of the property, plant, and equipment
these assets their benefits are consumed. assets does not only consist of the purchase price
As you remember, the matching principle of the asset. Added to the purchase price cash or
indicates that the revenues of a period must cash equivalent prices for transferring, installment,
be matched with the expenses of the same assembling, insurance during transfer, permits, etc.
period for calculating the profit/loss of the must be included.
period. So the cost of the long-lived assets
should be divided into their useful lives.
This allocation of a long-lived asset’s cost Property, plant and equipment assets are
over its useful life is called depreciation. recognized with their actual costs.
Their whole costs must not be recognized
Cost is the cash or cash equivalent price of
as an expense for the year they are acquired.
obtaining the asset plus all necessary taxes,
– They possess physical substance: Property, plant purchase commissions and all other amounts
and equipment have physical existences. paid to ready the asset for its intended use.
They are also called tangible assets because
of this characteristic.
For example, Schrader Co. produces heat
insulating bricks for industrial furnaces. Powder-
like insulating material are compressed into
brick shapes by using 2,500 tons of forging press
machines. These kinds of press machines cannot
4
Accounting II
be installed on a regular floor. The floor must be

strengthened in order to resist the 2,500 tons of
force the machine applied. So, when calculating
the cost of the machine, the cost of strengthening
operation must be added to the purchase price of
the machine. Because, without that operation the
machine cannot be used. Assume that the purchase
price of the machine is 250,000 TL and the
strengthening operation costed 12,500 TL. Then
the total cost of the machine will be 262,500 TL.
Now, let’s have a look at the different categories
of property, plant, and equipment assets. Picture 1.2
Cost of Land and Land Improvements

All expenditures made to acquire land and Land improvements are structural additions
ready it for intended use are considered as the part made to land, such as driveways, parking
of the land cost6. The cost of the land includes the lots, fences, landscaping, and underground
following items7; sprinklers.
– purchase price
– brokerage commission
– survey and legal fees
– property taxes in arrears 1
– taxes assessed to transfer the ownership on Why are the costs of land improvements not
the land added to the cost of the land?
– cost of clearing the land and removing
unwanted buildings. Example 1:Mount Co. purchases land for
For example, Bar Co. purchases a land for 400,000 TL with a note payable. Mount Co. also
constructing a warehouse. On the land, there is a paid 10,000 TL for removing the old ruins present
ruined old mansion. In order to use the land for on the land and sold the debris for 2,000 TL in
its intended use, the ruined old mansion must cash. For the clearing of the land Mount Co. paid
be removed and the land must be cleared for 3,000 TL in cash. Mount Co. paid 30,000 TL for
pavements, lighting and signs from bank account to
construction. The cost of removing and clearing
the construction company.
operations must also be added to the cost of land.
After the removal, the debris were sold. The receipt In this example, the company has to separate the
will be a reduction in the cost of the land. Bar Co. cost of the land and cost of the land improvements.
installs paving from and to the warehouse. Also, First of all, let’s calculate the cost of the land.
installs signs and street lights. These installments Purchase Price 400,000 TL
are not included in the cost of the land. These (+) Additional Costs 13,000 TL
type of separate long-lived assets are called land
Removal of Ruins 10,000 TL
improvements.
Clearing of the land 3,000 TL
(-) Reduction in Cost (2,000) TL
Selling of the debris (2,000)TL
411,000
Total Cost of the Land
TL
5
All necessary costs incurred in making land ready for its intended use increase (debit) the Land account.
Land account is debited for 413,000 TL because of the costs of removal of ruins and clearing the land added
over to the purchase price of the land. In the second journal entry Land account was credited because selling
of the debris reduces the cost of the land. In order to reduce the cost, Land account is credited.
Date Account Titles and Short Explanation Debit Credit

Land 413,000
Notes Payable 400,000
Cash 13,000
To record the purchase of land

Cash 2,000
Land 2,000
To record the selling of the debris
LAND
413,000 2,000
The cost of land improvements includes all expenditures necessary to make the improvements ready
for their intended use. In this journal entry, cash paid for installing pavements, lighting and signs are
recognized as Land Improvements. The cost of the land improvements is indicated as 30.000 TL. Thus,
Land Improvements account is debited and Cash account is credited.

Land Improvements 30,000
Cash 30,000
To record the payment for Land Improvements
LAND IMPROVEMENTS
30,000
2
E-tap Co. purchases land for 500,000 TL in cash. E-tap Co. also paid 15,000 TL for removing the ruins
present on the land and sold the debris for 5,000 TL in cash. For the clearing of the land E-tap Co. paid
5,000 TL in cash. E-tap Co. paid 20,000 TL for pavements, lighting and signs from bank account to
the construction company.
Cost of Buildings
Buildings are facilities used in operations, such as stores, offices, factories, warehouses, and so forth.
Cost of the building may vary according to its acquisition method. The company may purchase a ready-
made building or construct one. In either case, the cost of the building should include all the expenditures
6
Accounting II
related to their acquisition or construction. When a building is purchased, the costs will be the purchase
price and plus the costs to renovate the building to ready it for use8. When a new building is constructed,
its cost consists of the contract price plus payments made by the owner for architects’ fees, building
permits, excavation costs, payments for material, labor and overhead costs incurred during construction.
Example 2: Tube Co. purchased a building to use for managerial purposes for 7,500,000 TL and also paid
title deed fees for 225,000 TL.
Here in this example, the cost of the building consists of the sum of purchase price and the title deed
fee. It is a necessary payment for the company in order to acquire the building. Thus, title deed fee should
be added to the cost of the building.

Building 7,725,000
Cash 7,725,000
To record the purchase of building
There are also some regular maintenance operations during the life of property, plants and equipment.
As for the building, it may be the inside paintwork, some repairs, etc. These expenditures will not be
added to the cost of the building, because they do not extend the useful life or increase the capacity of the
asset. These kinds of expenditures will be recognized as a period expense and are debited to Repairs and
Maintenance Expense account.
The ordinary repairs are called revenue expenditures (income statement expenditures). Revenue
expenditures do not increase the capacity or efficiency of an asset or extend its useful life and are reported
on the income statement as an expense in the period incurred.
Example 3: Velo Co. have the exterior and interior of the building painted to a construction company for
30,000 TL and paid the amount in cash.

Administrative Expenses 30,000
Cash 30,000
To record the painting expense for the building
There are also some expenditures made for building and these expenditures yielded as extending the
useful life of the asset and/or increasing the capacity of the asset. These kinds of expenditures must be
capitalized. Capitalization means recording as an asset. In this context, if an expenditure extends the useful
life and/or increases the capacity of an asset, it must be added to the cost of the related asset.
A capital expenditure (balance sheet expenditure) is debited to an asset account because it increases
the asset’s capacity or efficiency or extends the asset’s useful life. A capital expenditure is reported on
the balance sheet as an asset.
7
Capitalization means recording the expenditure as an asset.
Example 4: Peloton Co. renovated the building for 250,000 TL and paid the amount.
Building 250,000
Cash 250,000
To capitalize the renovation expense
In this example, renovation operation brought the building to its intended use. This expenditure is
added to the cost of the building.
Sometimes companies sign construction contracts with
construction companies in order to construct a building.
During the construction, company makes payments as
progress payments to contractor for the construction process.
These payments are recorded to Construction-in-Progress
account until the construction is finished. Construction-in-
Progress account is also a long-lived asset account. When the
construction is finished and the contractor hands over the
building, the balance of the Construction-in-Progress account
is transferred to Building account. For example, the company
may have signed three construction contracts and each of them
must be separately monitored in order to identify their costs.
Picture 1.3
Example 5: Pedal Co. signs construction contract with two construction companies on September, 1.
Contractor A is liable for constructing the headquarter building while Contractor B is liable for constructing
pavements of the campus. From the progress payment reports received from the contractors, Pedal Co. pays
4,300,000 TL to Contractor A and 80,000 TL to Contractor B.

Construction-in-Progress 4,380,000
September, 1 -Headquarter Building 4,300,000*
-Pavements 80,000*
Cash 4,380,000
To journalize Construction-in-Progress
*: Those accounts are subsidiary accounts. They will be
reported on the Subsidiary Ledgers, not on the General
Ledgers
CONSTRUCTION-IN-PROGRESS Headquarters Building Pavements

4,380,000 4,300,000 80,000
The second progress payment reports were received on November, 1. Based on the progress payment reports,
Pedal Co. pays 2,000,000 TL to Contractor A and 220,000 TL to Contractor B. Upon the payments
Contractor A and Contractor B complete the headquarters and the pavement. Pedal Co. also pays 50.000 TL
for title deed fee.
8
Accounting II

November, 1 -Headquarter Building 2,000,000
-Pavements 220,000
Cash 2,220,000
To journalize Construction-in-Progress

4,380,000 4,300,000 80,000
2,220,000 2,000,000 220,000

Building
-Headquarters 6,300,000

-Pavements
To journalize the finished constructions

4,380,000 6,600,000 4,300,000 6,300,000 80,000 300,000
2,220,000 2,000,000 220,000
BUILDING LAND IMPROVEMENTS

6,300,000 300,000

Building 50,000
Cash 50,000
To journalize paying of title deed fee
BUILDING
6,300,000
50,000
Title deed fee is an expenditure that increases the cost of the building. It is incurred in order to be the
owner of the building. Therefore, building account is debited in the journal entry.
Cost of Machinery and Equipment

Like the other long-lived assets, the cost of machinery and equipment includes all the necessary
expenditures for the machines and equipment to become available for their intended use. In addition to
purchase price, transportation charges, insurance while in transit, installation costs and the cost of testing
9
before using are included in the cost of machinery and

equipment9. Assume that the test results are perfect. When
the test product sold, the earned revenue will decrease the
cost of the machine.
These costs incur only at the initial recognition of
machinery and equipment. In other words, for the first
recognition of these assets, expenditures made for bringing
them to their initial use are capitalized. Assume that the
machinery has been installed and the company is using
them. After three years of using, the company needs to move
and settle to a new location. In this case, the expenditure
for disassembling and reassembling the machinery,
transportation charges, insurance during transportation,
etc. will not be capitalized. They will be recorded as period
expenses. Picture 1.4
Example 6: Chain Co. purchases a ceramic furnace for 250,000 TL. As for the transportation charge Chain
Co. pays 10,000 TL, for the insurance 2,500 TL and 11,500 TL for the customs fee. Chain Co. also pays
26,500 TL for assembling the machinery.
First of all, we need to calculate the cost of the machine. Chain Co. made some expenditures for the
machine. The important point is to choose which expenditures will be included in the cost. Main criteria
here is whether the expenditure is necessary for the asset to bring it for its intended use or not. If yes, then
the expenditure will be included in the cost of the asset.
The cost of the machinery is;
- Purchase price : 250,000 TL
- Transportation Chr. : 10,000 TL
- Insurance : 2,500 TL
- Customs Fee : 11,500 TL
- Assembly : 26,500 TL
TOTAL COST : 300,500 TL

Machinery and Equipment 300,500
Cash 300,500
To journalize the cost of machinery
Example 7: Fork Co. made an expenditure for 12,500 TL for the machine in order to increase the production
capacity of the machine.

Machinery and Equipment 12,500
Cash 12,500
To journalize the cost of machinery
As you remember, if the expenditure increases the capacity or productivity of the asset and/or extends
the useful life then this expenditure will be added to the cost of the asset. Therefore, Machinery and
Equipment account is debited in this transaction.
10
Accounting II
Example 8: Hub Co. paid 1,500 TL for the annual maintenance of the machine.
Repair and Maintenance Expense 1,500
Cash 1,500
To journalize the repair and maintenance expense
Apart from Example 7, in this transaction, the expenditure does neither extend the useful life of the
machine nor increases the capacity or productivity. So, these kinds of expenditures will not be added to
the cost of the machine. They will be recorded as period expense.
Example 9: QR Co. is a tire manufacturing company. To shorten the distance between suppliers, QR Co.
decides to move the factory to Organized Industrial Zone. For disassembling and reassembling of the machines
QR Co. pays 150,000 TL and for the transportation QR co. pays 100.000 TL.

Assembling Expenses 150,000
Transportation Expense 100,000
Cash 250,000
To journalize the period expenses
Even though the expenditures are made for the assets to bring them to their intended uses, they will be
recorded as period expenses; because this criterion is applied just for the initial recognition of the assets.
When the assets are ready to use, only the expenditure that will affect their useful lives and capacity will be
added to the cost. Otherwise they will be recorded as a period expense.
Cost of Furniture and Fixtures

Desks, chairs, sofas, file cabinets, sheles and so forth are all examples for furniture and fixtures. They
are the assets that utilize the company by easing the operations. Like all other long-lived assets, their costs
consist of purchase price and other necessary expenditures made to bring them to their intended use.
Example 10: On September 1, Saddle Co. makes an advance payment for 7,500 TL in order to purchase
a seating group for welcoming guests.

September 1 Advances Paid 7,500
Cash 7,500
To journalize the advances paid
On December 1, Saddle Co. receives the seating group for 16,500 TL. 7,500 TL advance is paid earlier
for this seating group purchase.

December 1 Furniture 16,500
Advances Paid 7,500

Cash 9,000
To journalize the purchasing of furniture
11
Cost of Vehicles
The cost of the vehicles include the purchase price and other necessary expenditures made to bring
them to their intended uses. If the expenditure made for vehicles extends the useful life of the vehicle and/
or increases the capacity, like modification or engine renewal, then these expenditures will be capitalized.
But the regular maintenance expenditures such as oil change or minor engine repairs will be recorded as
period expenses.
Example 11: Rim Co. purchases a minivan to use in marketing department for 140,000 TL and an official
car for CEO for 525,000 TL.

Vehicles 665,000
-Minivan 140,000*
-Official Car 525,000*
Cash 665,000
To journalize the purchasing of vehicles

*Those accounts are subsidiary accounts. They will be reported
on the Subsidiary Ledgers, not on the General Ledgers
VEHICLES Minivan Official Car

665,000 140,000 525,000
Rim Co. signs a contract with a car-design company and renovates the interior of the minivan for the
customers. Rim Co. pays 60,000 for renovation.
The renovation expenditure brought a large transformation in minivan. Thus, the expenditure will be
capitalized.

Vehicles
60,000
-Minivan
Cash 60,000
To journalize renovation expense of minivan
VEHICLES Minivan Official Car

665,000 140,000 525,000
60,000 60,000
Rim Co. pays 2,350 TL for regular service maintenance expense for official car of the CEO.

General and Administrative Expenses 2,350
Cash 2,350
To journalize the maintenance expense
12
Accounting II
DEPRECIATION
As mentioned previously in this chapter, Depreciation is the allocation of the long-
depreciation is the allocation of long-term asset’s lived assets’ cost to their useful lives in
cost to expense over its useful life. All assets, systematic and rational manner.
except land, lose their ability to provide services
and wear out as they are used. Thus, the costs of Depreciation also acts as a hidden fund source
long-lived assets should be recorded as an expense for a company. At the end of the long-lived asset’s
over their useful lives. This periodic recording of useful life, the accumulated depreciation will be
the cost of long-lived assets as an expense is called equal to the cost or the depreciable cost of the
depreciation. long-lived asset. This means that the depreciation
Property, Plant and Equipment assets include expenses recorded throughout the asset’s useful life
the assets that the company will use for more than will reduce the profit of the company and this will
a year. During the usage of these assets, they will lead less tax expense and this will result as a hidden
wear out and lose their ability to provide services. fund at the end of asset’s useful life. This is sort
In accounting words, their future benefits will of legal encouragement for the companies to make
decrease. This may occur from either technological new investments.
issues or obsolescence or productivity issues etc.
The company will benefit by using them and they Measuring Depreciation
have direct or indirect contribution in the revenue. In order to measure the depreciation, three
For example, the machines in the production line elements must be known;
have direct effect on the revenue but the furniture
have indirect effect. Even their effects are direct or - The cost of the long-lived asset
indirect on the revenue, their future benefits will - The estimated residual value of the long-
decrease through the years. Here the matching lived asset
principle comes. According to the matching - The estimated useful life of the long-lived
principle, the operation results (profit or loss) will asset
be calculated by matching the revenues of a specific The cost of the long-lived asset is a known issue
period with the expenses of the same period. So for the company. The capitalized cost of the asset is
the whole cost of the long-lived asset should not the main factor here. As you know that the cost of
be recorded as a “period expense” in the year it was the asset is not just only the purchase price paid for
purchased. The cost of the long-lived asset should acquiring it, it a very important issue to calculate
be allocated throughout its useful life so its yearly the actual cost of the asset. As you know, actual
depreciation expenses will be matched with yearly cost of the long lived asset includes all items paid
revenues of the company. for the asset to perform its intended function.
The residual value (also called salvage value)
and the useful life of the asset are estimations. The
company should estimate the cash value of the
asset at the end of its useful life. In other words,
residual value is the amount that the company will
receive when it is sold at the end of its useful life.
By considering together, the company will find out
the depreciable cost of the asset. Depreciable cost
is the cost when residual value is subtracted from
capitalized cost of the asset.
Depreciable Cost = Capitalized Cost of the Asset –

Estimated Residual Value
Picture 1.5
13
Depreciation Methods
Capitalized cost minus estimated residual Depreciation allocates the cost of the asset to
value is called depreciable cost. its useful life. But how? You may think that the
company may divide the cost of the asset to its
The useful life of an asset is an estimation, useful life in years. For example, the company
too. The company will estimate for how long the has a building that costs 1,000,000 TL, has no
company will get benefit by using that asset. A residual value and its useful life is 10 years. Then
company’s useful life estimation might be shorter depreciation expense per year might be calculated
than the economic life or physical life of the in the following way:
asset. Economic life is the life of the asset that its
manufacturer indicated. But the useful life of the 1,000,000
asset is related to the time that the company will = 100,000 TL annual depreciation expense
10
benefit for. For example, the company purchases
a truck for transportation. The company estimates This may be an option. But the main idea of
to use the truck (benefit from it) for five years depreciation is that it must be systematic and
(useful life) but the manufacturer company of the rational. This means that the method chosen must
truck indicates that it has a life span of 15 years reflect the way the asset wears off over its useful life.
(economic life). Assume that the company purchased a machine.
Now, let’s take a look at the depreciation Because it is brand new, the company wants to use
methods and see how the cost of the asset, residual it heavily for the first year and for the following
value of the asset and useful life of the asset interact years the company will reduce its use gradually.
with each other. In this case cost/useful life will not exactly reflect
the asset’s consumption over the years, because this
method represents the equal consumption over the
years.
3
To overcome these kinds of problems, there are
Rec Co. purchases a machinery for 4,500,000 TL various depreciation methods for the companies to
on November 12, 2018. Just before the assembly apply but three are used most commonly:
of the machine, Rec Co. learns that the assembly
- Straight-line Depreciation Method
company has bankrupted. So Rec Co. gets in touch
with the supplier and the supplier told Rec Co. - Double Declining Balance Depreciation
that a team of assembly will assemble the machine Method
in 4 months. During these 4 months Rec Co. can’t - Units-of-production Depreciation Method
benefit from the machine. In February 2019 the Each method is appropriate in certain
assembly team assembles the machine and readied circumstances. These methods work differently on
it for use. Though the machine is purchased in how they achieve the annual depreciation amount,
November 2018, when does the depreciation date but they all result in the same total depreciation
begins? over the total life of the asset.
Straight-line Depreciation Method

Straight-line depreciation method allocates the depreciable cost of the asset equally to its useful life and
is calculated as follows:
Depreciable Cost = Cost of the asset – Residual value
1
Straight − line depreciation = DepreciableCost x
Useful life
14
Accounting II
Example 12: FTP Co. purchases a machinery on January 1st 2018 for 340,000 TL. FTP Co. also pays
15,000 TL for transportation and insurance during transportation. Upon the receiving of machinery FTP Co.
pays 5,000 TL for assembling and testing of the machinery. FTP Co. estimates to use the machine for 5 years and
at the end of it useful life it is estimated to be sold at 45,000 TL. Company will apply straight-line depreciation
method for the machinery.
First of all, depreciable cost must be calculated;
Purchase Price 340,000 TL

(+) Additional Costs 20,000 TL
Transportation & Ins. 15,000 TL
Assembly & Testing 5,000 TL
Cost of the machine 360,000 TL
(-) Residual Value (45,000) TL
Depreciable Cost 315,000 TL
1
Straight − line depreciation = 315,000x = 63,000TL
5 years
The annual depreciation expense is 63,000 TL for the machinery. Over the useful life of the machinery,
every year the company will record 63,000 TL depreciation expense.

December, 31 2018 Depreciation Expense 63,000
Accumulated Depreciation 63,000
To journalize the depreciation expense
ACCUMULATED DEPRECIATION
63,000 (2018)
Depreciation Expense is reported on the income statement. Accumulated Depreciation account is

a contra-asset account which is reported as a deduction under Property, Plant and Equipment on the
balance sheet.
FTP Co.
Dec. 31, 2018
Balance Sheet
CURRENT ASSETS XX
:
:
NON-CURRENT ASSETS 297,000
Property, Plant & Equipment 297,000
Machinery 360,000
(-)Accumulated Depreciation (63,000)
15
“Cost of the asset – Accumulated Depreciation” is called the “Book Value” of the asset. In this example,
book value of the asset is 297,000 TL on December 31, 2018.
At the end of the second year (December 31, 2019) FTP Co. will make the same journal entry, because
in the straight-line depreciation method the depreciation expense amount doesn’t change but some
exceptions.

63,000 (2018)
63,000 (2019)
On the balance sheet (December 31, 2019) the Property, Plant&Equipment will be seen as follows;
FTP Co.
Dec. 31, 2019
Balance Sheet
CURRENT ASSETS XX
:
:
Machinery 360,000
The book value of the asset will be 234,000 TL on December 31, 2019.
Now, let’s examine the total depreciation schedule of the machinery through its useful life. A straight-
line depreciation schedule for this machinery is shown in Exhibit 1.1.
Exhibit 1.1 Straight-Line Depreciation Schedule

Depreciable D e p r e c i a t i o n Depreciation A c c u m u l a t e d
Year Book Value
Cost Rate Expense Depreciation
2018 315,000 1/5=0,20 63,000 63,000 297,000
2019 315,000 1/5=0,20 63,000 126,000 234,000
2020 315,000 1/5=0,20 63,000 189,000 171,000
2021 315,000 1/5=0,20 63,000 252,000 108,000
2022 315,000 1/5=0,20 63,000 315,000 45,000*
45,000* is residual value of the machinery
As seen from the schedule, depreciation expense amount is the same every year and the accumulated
depreciation is the sum of all depreciation expenses recorded to date for the depreciable asset. Notice that
the accumulated depreciation at the end of the asset’s useful life is equal to the depreciable cost. Also the
net book value at the end of the asset’s useful life is the residual value. Because the company estimates to
sell it to that price.
16
Accounting II
Now you may think that what happens if the useful life of an asset extends or the capacity of the
asset increases due to some expenditures made during the useful life of the asset? As you remember some
expenses extends the useful life of the asset and/or increases the capacity or performance of the asset. These
expenses are capitalized so it increases the depreciable cost of the asset. Thus, it affects the depreciation
expense. So, the company recalculates the depreciation expense of the asset for its rest of useful life. Let’s
make a simple example.
Example 13: Spoke Co. purchases a machinery in 2016 for 400,000 TL. In 2018, the crank shaft of the
machine is replaced due to the corrosion for 60,000 TL. The changing of the part extends the useful life of the
machine for two more years. Normally, the company estimates to use the machine for five years.
A straight-line depreciation schedule for this machinery is shown in Exhibit 1.2.

Depreciable Accumulated
Year Depreciation Expense Book Value
Cost Depreciation
2016 400,000 80,000 80,000 320,000
2017 400,000 80,000 160,000 240,000
2018 460,000 92,000 252,000 208,000
2019 460,000 92,000 344,000 116,000
2020 460,000 92,000 436,000 24,000
2021 60,000 12,000 448,000 12,000
2022 60,000 12,000 460,000 0
For the first two years, the machine’s depreciation expense is 80,000 TL over the amount of depreciable
cost. After the replacement of the part, the capitalized cost of the machine increases to 460,000 TL so
the depreciation cost to 92,000 TL. Until the pre-estimated useful life of the machine (5 years) ends, the
depreciation expense will be 92,000 TL. For the extended time of the useful life only the latter cost will
be depreciated.
Let’s assume that the Spoke Co. replaces the part of the machine but it doesn’t have any effect on the
useful life of the machine. It just increases the performance of the machine. The machine has still five
years of useful life. Does the depreciation expense change in this situation? Yes, it changes because the
replacement expenditure is capitalized so it increases the cost of the machine so does the depreciable cost.
Here is the depreciation schedule;
A straight-line depreciation schedule for this machinery is shown in Exhibit 1.3.
Depreciable Depreciation A c c u m u l a t e d
Year Book Value
Cost Expense Depreciation
2016 400,000 80,000 80,000 320,000
2017 400,000 80,000 160,000 240,000
2018 460,000 100,000 260,000 200,000
2019 460,000 100,000 360,000 100,000
2020 460,000 100,000 460,000 0
In this example, for the first two years, the depreciation expense is calculated over the initial cost
(400,000 TL). After the replacement of the part, the cost of the machine increases to 460,000 TL and the
depreciation expense to 100,000 TL. 80,000 TL of the 100,000 TL is from the initial cost (400,000), the
remaining 20,000 TL is the depreciation expense for the replaced part for the remaining useful life of the
machine (60,000/3 years=20,000).
17
Double-Declining Balance Depreciation Method

Double-declining balance depreciation method produces a decreasing annual depreciation expense
over the asset’s useful life. Double-declining balance depreciation method expenses more of the asset’s cost
near the start of an asset’s life and less at the end of its useful life. In other words, the depreciation expense
gradually decreases through the following years of the asset. This method is used by companies when the
asset is estimated to be used more in early years of its useful life. The method is so named because the
periodic depreciation expense amount is based on a declining book value of the asset.
There are some differences between double-declining balance depreciation method and straight-line
depreciation method. These are;
- Residual value of the asset will be ignored when calculating depreciable cost. Residual value is
included at the end of the useful life of the asset.
- Depreciation rate is the twice of the straight-line depreciation rate.
The double-declining-balance method multiplies an asset’s book value (the asset’s cost minus its
accumulated depreciation) by a constant percentage that is twice the straight-line depreciation rate. The
straight-line depreciation rate is calculated as 1/useful life. Therefore, the double-declining-balance method
rate will be 2 × (1/useful life).
Double-declining-balance depreciation expense amounts can be computed using the following formula:
2
Double − Declining Balance Depreciation = (Cost − Accumulated Depreciation)x
Useful Life
Now let’s solve Example 12 by double-declining balance depreciation method.

Example 14: FTP Co. purchases a machinery on January 1, 2018 for 340,000 TL. FTP Co. also pays
15,000 TL for transportation and insurance during transportation. Upon the receiving of machinery, FTP Co.
pays 5,000 TL for assembling and testing of the machinery. FTP Co. estimates to use the machine for 5 years and
at the end of it useful life it is estimated to be sold at 45,000 TL. Company will apply double-declining balance
depreciation method for the machinery.

Transportation & Ins. 15,000 TL
Assembly & Testing 5,000 TL
Cost of the machine 360,000 TL
Residual Value 45,000 TL
2
Double - Declining Balance Depreciation 1st Year= (360,000 − 0)x = 144,000TL
5
2
Double - Declining Balance Depreciation 2nd Year= (360,000 −144,000)x = 86,400TL
5
The double-declining-balance method depreciation schedule for this machinery is shown in

Exhibit 1.4.
18
Accounting II
Exhibit 1.4 The Double-Declining-Balance Method Depreciation Schedule
Depreciable D epre c ia tion Depreciation A c c u m u l a t e d

Year Book Value
2018 (360,000-0)=360,000 2/5=0,40 144,000 144,000 216,000
2019 (360,000-144,000)=216,000 2/5=0,40 86,400 230,400 129,600
2020 (360,000-230,400)=129,600 2/5=0,40 51,840 282,240 77,760
2021 (360,000-282,240)=77,760 2/5=0,40 31,104 313,344 46,656
2022 - - 1,656 315,000 45,000
You must have noticed that in the last year of the asset’s useful life depreciation expense amount is the
amount that brings the book value to the residual value.

144,000 (2018)
FTP Co.
Dec. 31, 2018
Balance Sheet
CURRENT ASSETS XX
:
:
Machinery 360,000
Units-of-Production Depreciation Method

The Units-of-Production (also called as Units-of-Use, Units-of-Output or, Units-of-Activity) method
is based on the assumption that depreciation is only the result of use and that the passage of time does
not play a role in this process. Under the units-of-production method, useful life is expressed in terms of
the total units of production or use expected from the asset,
rather than as a time period.
The units-of-production method provides the same
Units-of-production depreciation method
amount of depreciation expense for each unit of output of
depreciates by units rather than by years.
the asset. Depending on the asset, the units of output can
be expressed in terms of hours, miles driven, or quantity
produced. When a plant asset’s usage varies every year, the units-of-production method does a better job
of matching expenses with revenues.10
Let’s assume that the machinery purchased by FTP Co. in the previous examples is estimated to be used
to produce 100,000 parts of products. For the first year, the machine produces 40,000 parts, second year
15,000 parts, third year 20,000 parts, fourth year 15,000 parts and fifth year 10,000 parts. The company
will calculate depreciation expense for each year as follows;
19
1
Units − of − Production = (Cost − ResidualValue)x
Total Production
(TotalUse)
1
Units − of − Production = (360,000 − 45,000)x = 3.15 TL / part
100,000
After calculating the unit-of-production depreciation per unit, the depreciation schedule will be as
follows (Exhibit 1.5);
Exhibit 1.5 The Units-of-Production Method Depreciation Schedule
Depreciation Depreciation A c c u m u l a t e d
Year Units Produced Book Value
Per Unit Expense Depreciation
2018 3.15 TL/part 40,000 126,000 126,000 234,000
2019 3.15 TL/part 15,000 47,250 173,250 186,750
2020 3.15 TL/part 20,000 63,000 236,250 123,750
2021 3.15 TL/part 15,000 47,250 283,500 76,500
2022 3.15 TL/part 10,000 31,500 315,000 45,000
As you can follow from the schedule, the depreciation expense through the years varies according to the
usage weigh of the asset. The more the asset is used the more depreciation expense will occur.
Partial-Year Depreciation Method

In the previous examples, we calculated depreciation
for the entire year. What would happen if the business In Turkey, partial-year depreciation is applied
placed the machinery in service on October 1, 2018, only for vehicles. All the other depreciable
instead of January 1, 2018? Would the depreciation for long lived assets except vehicles are depreciated
any of the methods change? Yes, but only the methods that according to yearly basis. Regardless of the
are calculated based on a time period, which means only date the asset is purchased, the depreciation
straight-line and double-declining balance would change. expense for the first year is calculated as if
Units-of-production does not consider years in its formula; the asset were used for the whole year whole
thus, that calculation remains the same.11 year. For example, if the company purchases
Monthly depreciation expense must be calculated for a building on October 3, 2018, the first year’s
the depreciation expense of vehicles within the first year. depreciation expense is calculated as if the asset
For the following years of the asset’s useful life, yearly were used for the whole year whole year not
depreciation will be calculated as usual. At the end of its for three months. But for the vehicles, there is
useful life, the excess depreciation expense from the first an exception of depreciation application.
year will be added to last year’s depreciation expense.
1 monthsused
Partial − Year Depreciation = (Cost − ResidualValue)x x
Useful Life 12
Example 15: Stem Co, purchases a vehicle for 120,000 TL on September 10,2018. The useful life of the
vehicle is five years and straight-line depreciation method will be applied.
The day of the purchase is not important for the calculation. The depreciation expense is calculated on
monthly basis. So, in the first year the depreciation expense will be just for 4 months.
1 4
Partial − Year Depreciation = (120,000 − 0)x x = 8,000TL
5 12
Now let’s prepare the depreciation schedule for the vehicle (Exhibit 1.6);
20
Accounting II
Exhibit 1.6 The Partial-Year Depreciation Schedule

Depreciable D e p r e c i a t i o n Depreciation A c c u m u l a t e d
Year Book Value
1 4
Sept, 2018 120,000 x 8,000 8,000 112,000
5 12
2019 120,000 1/5 24,000 32,000 88,000
2020 120,000 1/5 24,000 56,000 64,000
2021 120,000 1/5 24,000 80,000 40,000
2022 - - 40,000 120,000 -
Pay attention to the last year of the vehicle’s depreciation expense. It is calculated as 40,000 TL. 24,000
TL of it comes from the yearly depreciation expense (120,000 x 1/5), the remaining 16,000 TL is the
amount that cannot be recorded as depreciation expense from the first year. Normally, for the first year
the asset should have a depreciation expense of 24,000 TL but according to the partial-year depreciation
method, only 8,000 TL of it can be recorded as depreciation expense. The difference (24,000 - 8,000 =
16,000 TL) is added to the last year’s depreciation expense.
DISPOSING OF PROPERTY, PLANT AND EQUIPMENT ASSETS

Property, Plant and Equipment assets remain on the business’s accounting books until they are
disposed of. Companies dispose of property, plant and equipment assets which are no longer useful for
the company. Eventually, a long-lived asset wears out or becomes obsolete. When plant assets are no
longer useful because they have physically deteriorated or become obsolete, a company can dispose them
by discarding, selling them for cash, or exchanging them for a new long-lived asset. The disposal of
property, plant and equipment assets can take one of three forms:
• Discard (retire) the long-lived asset.
• Sell the long-lived asset for cash.
• Exchange the long-lived asset for another long-lived asset.
Regardless of the type of disposal, the company must determine the book value of the long-lived asset
at the disposal date to determine the gain or loss on disposal. As you remember, the book value is the
difference between the cost of the long-lived asset and the accumulated depreciation to date.
If the long-lived asset is no longer useful, it is disposed. In such a case, the company will remove the
asset and associated accumulated depreciation from the accounts. Regardless of the type of disposal, there
are four steps:12
1. Bring the depreciation up to date.
2. Remove the old, disposed-of asset and associated accumulated depreciation from the accounts.
3. Record the value of any cash received (or paid) in the disposal of the asset.
4. Finally, determine the amount of any gain or loss. Gain or loss is determined by comparing the cash
received and the market value of any other assets received with the book value of the asset disposed of.
Discarding Property, Plant and Equipment Assets

Discarding (retiring) of property, plant and equipment assets involve disposing of the asset for no cash.
If an asset is disposed of when it is fully depreciated and has no residual value, then the original cost and
accumulated depreciation of the long-lived asset are simply written off the accounting books. There is no
need to bring the depreciation up to date because the asset is already fully depreciated. In addition, no
gain or loss is recognized because no cash was received or paid. A loss is recognized if a company retires a
long-lived asset before it is fully depreciated and no cash is received for residual or salvage value.
21
If a Property, Plant and Equipment is still being used, its cost and accumulated depreciation should
remain in the ledger even if the asset is fully depreciated until the company discard the asset. The company
may continue to report it on balance sheet even though no additional depreciation expense is recorded.
Selling Property, Plant and Equipment Assets

for Cash
Accounting for the sale of a long-lived asset is essentially the
same as accounting for its discarding except that cash is received
in the exchange. In a disposal by sale for cash, the company
compares the book value of the asset with the cash received
from the sale. If the cash received from the sale exceed the book
value of the long-lived asset, a gain on disposal occurs. If the
cash received from the sale is less than the book value of the
long-lived asset sold, a loss on disposal occurs.
The following entries on Example 16 show how to record
the sale of a machine under three assumptions about the selling
Picture 1.6
price.
Example 16: Rack Co. sells its machine for 120,000 TL. When the machinery was purchased three years ago
the capitalized cost of the machinery was 300,000 TL (The machine is estimated to have been used used for 5
years). Rack Co. applies straight-line depreciation method and the machinery has an accumulated depreciation
of 180,000 TL.
It has a cost of 300,000 TL. But during three years, company has depreciated 180,000 TL of the asset.
So, book value of the asset is 120,000 TL (300,000 - 180,000) at the time of sale.
Example 16-1: Selling a Long-Lived Asset at Book Value: In the first case, Rack Co. sells its machine for
120,000 TL. Rack Co. receives 120,000 TL and this amount is exactly equal to the book value of the machine
(120,000 TL); therefore, no gain or loss occurs.

Cash 120,000
Machinery&Equipment 300,000
To journalize the sale of machine for cash
Example 16-2: Selling a Long-Lived Asset Above Book Value: In the second case, Rack Co. sells its
machine for 135,000 TL. Rack Co. receives 135,000 TL cash and it exceeds the book value of 120,000 TL.
Thus, a gain of 15,000 TL is recorded:

Cash 135,000
Gain on Sale of Machinery&Equipment 15,000
22
Accounting II
Example 16-3: Selling a Long-Lived Asset Below Book Value: In the third case, Rack Co. sells its
machine for 100,000 TL. Rack Co. receives 100,000 TL cash and it is less than the book value of 120,000 TL.
Thus, a loss of 20,000 TL is recorded:

Cash 100,000
Loss on Sale of Machinery&Equipment 20,000
Machinery&Equipment account is credited when it is sold. When the machinery is sold, its
accumulated depreciation must be removed from accounting books. Hence there is no more machinery so
there shouldn’t be any accumulated depreciation related to it. Thus, accumulated depreciation account is
debited in order to remove from the accounting books.
Exchange of Property, Plant and Equipment Assets

As we have noted, companies can dispose of long-lived assets by exchanging (trading) them for another
long-lived asset such as an old machine for a new one. Basically, accounting for exchanges of long-lived
assets is similar to accounting for sales of long-lived assets for cash. But there are some special rules for
exchange of long-lived assets such as deciding about the commercial substance of exchange. In accounting
for such exchanges of non-monetary assets, we need to find out if the transaction has commercial substance.
An exchange has commercial substance if the future cash flows change as a result of the exchange.13
In other words, an exchange has commercial substance if the future cash flows (receipts of revenue or
payment of expenses) of the company will change because of the exchange.14 For example, when exchange
of an older machinery for a new machinery will increase productivity and thereby create more revenue for
the company, this exchange has commercial substance.
If exchanges have commercial substance (which is when there is a change in cash flow resulting from
the transaction), the parties should recognize a gain or loss on the exchange. The old asset will be removed
from the accounting books, and the new asset will be recorded at its market value. Most of the exchanges
have commercial substance (even when similar assets are exchanged).
If exchanges do not have commercial substance, ignore any gain or loss on the transaction (there are
a few exceptional situations) and record the acquired asset at the book value of the asset given up in the
exchange plus cash paid and minus cash received instead of at market value.
23
Further Reading
Source: Hagen Ackermann, Martin Fochmann and Nadja Wolf, The Effect of Straight-Line
and Accelerated Depreciation Rules on Risky Investment Decisions- An Experimental Study,
International Journal of Financial Studies, 2016, vol. 4, issue 4, p.1-26
24
Accounting II
In Practice
25
Source: http://www.vestelinvestorrelations.com/en/_assets/pdf/AnnualReport_2017.pdf
Discuss:
1. Partial balance sheet and footnotes of Vestel Elektronik Sanayi ve Ticaret Anonim Şirketi is
given. What do you think about depreciation methods of Vestel Elektronik Sanayi ve Ticaret
Anonim Şirketi?
2. Look at the other companies’ financial statements and compare the depreciation methods of
them.
26
Accounting II
Explain the Properties of

LO 1 Property, Plant and Equipment
Property, plant and equipment assets are acquired in order to be used in business operations. They have
some distinctive characteristics from other assets. First of all, they are not acquired for resale. Their main
characteristic is to be used in business operations. Secondly, they are acquired to be used for more than a
year, so most of them are subjected to depreciation, and lastly they have a physical substance.
Summary
Understand the concepts underlying
the measurement of acquisition cost
LO 2 and measure the cost of Property, Plant
and Equipment
Property, plant and equipment assets are recorded with their actual costs. Cost is the cash or cash equivalent
price of obtaining the asset and bringing it to the location and condition necessary for its intended use. In
this manner, in addition to to the purchase price of the asset, expenditure made for the asset to be used in
business operations must be added to the cost of the asset.
Explain the concept of

LO 3 depreciation and apply
depreciation methods
Depreciation is the allocation of the asset’s cost to its useful years. As the asset is worn off during its usage,
its benefit will be consumed. In this manner, every year for its useful life depreciation expense will incur.
There are some methods to calculate the depreciation expense amount. Most commonly used depreciation
methods are straight-line depreciation method, double-declining balance depreciation method, and
units-of-production depreciation method. In straight-line depreciation method, the cost of the asset is
allocated equally over its useful life. In double-declining balance depreciation method, the cost of the
asset is allocated to its useful life from more depreciation expense to less depreciation expense. In units-
of-production depreciation method, the cost of the asset is allocated according to the asset’s actual usage
over the years.
Explain how to account for the

LO 4 disposal of Property, Plant and
Equipment
The disposal of property, plant and equipment assets can take one of three forms:
• Discard (retire) the long-lived asset.
• Sell the long-lived asset for cash.
• Exchange the long-lived asset for another long-lived asset.
Regardless of the type of disposal, the company must determine the book value of the long-lived asset at
the disposal date to determine the gain or loss on disposal.
27
1 Which of the following economic resource 6 “RVY Co. purchases a machine for 525,000
cannot be recognized as an asset? TL. RVY Co. also pays 37,500 TL for customs and
A. Rented buildings transportation. Upon the receiving of machinery RVY
B. Financial leased machines Co. pays 12,500 TL for assembling and testing of the
machinery. The product produced at the end of the
Test Yourself
C. Purchased vehicles
testing is sold for 4,500 TL. RVY Co. estimates to
D. Constructed land improvements use the machine for 5 years and at the end of it useful
E. Lands life it is estimated to be sold at 55,000 TL. RVY Co.
will apply straight-line depreciation method for the
2 Which of the following long-lived asset is not machine.”
subject to depreciation? What is the depreciable cost of the machine?
A. Vehicles A. 579,500 B. 575,000
B. Office buildings C. 525,500 D. 525,000
C. Land improvements E. 530,000
D. Lands
E. Factory building
7 “Slime Co., purchases a vehicle for 380,000 TL
on October 11,2018. The useful life of the vehicle is
3 Allen Co. pays 40,000 TL of customs fee for the five years and straight-line depreciation method will
purchased machine from abroad. How will Allen be applied.” What will be the depreciation expense
Co. record this customs fee in the journal? of the vehicle in 2018?
A. Records as an expense A. 19,000 B. 38,000
B. Adds to the cost of the machine C. 76,000 D. 95,000
C. Records as purchase expense E. 361,000
D. Records as Cost of Goods Sold
E. Records as Sales Allowances 8 “Tire Co., makes an expense of 75,000 TL
in the third year of the machine that increases its
4 VO2 Co. makes an expenditure for 1,500 TL performance. The initial cost of the machine was
for the regular service maintenance of the vehicle 475,000 TL and the company estimates to use it for 5
used in marketing department. How will VO2 Co. years and company applies straight-line depreciation
record this expenditure in the journal? method.” What is the depreciation expense for the
machine in the third year of its useful life?
A. Adds to the cost of the car
A. 380,000 B. 120,000
B. Records as an asset
C. 110,000 D. 95,000
C. Records as a period expense
E. 25,000
D. Records as an inventory
E. Records as a depreciation
9 What is the book value of the asset in the
third year of its useful life for the Question 8?
5 ZWF Co. purchases a machine for 4,000,000
TL and estimates to use it for 10 years. According A. 310,0000 B. 285,000
to the double-declining balance depreciation C. 265,000 D. 215,000
method, what will be the depreciation expense for E. 190,000
the second year?
A. 160,000 10 How can we define the difference between
B. 640,000 the cost of the asset and accumulated depreciation?
C. 800,000 A. Net Book Value B. Book Value
D. 1,440,000 C. Cost D. Asset
E. 3,200,000 E. Period expense
28
Accounting II
If your answer is wrong, please review

1. A If your answer is wrong, please review the 6. C
the “Cost of Machinery and Equipment”
“Property, Plant and Equipment” section.
section.
Answer Key for “Test Yourself” Suggested answers for “Your turn”
If your answer is wrong, please review the If your answer is wrong, please review
2. D 7. A
“Cost of Land and Land Improvements” the “Straight-line Depreciation Method”
section. section.
If your answer is wrong, please review If your answer is wrong, please review
3. B 8. B
the “Cost of Machinery and Equipment” the “Straight-line Depreciation Method”
section. section.

4. C If your answer is wrong, please review the 9. A
the “Straight-line Depreciation Method”
“Cost of Vehicles” section.
section.
5. B “Double-declining Depreciation Method”
10. B
the “Straight-line Depreciation Method”
section. section.
Why are the costs of land improvements not added to the

cost of the land?
All long-lived assets but except the land wear out as they are used. Land does
not wear out. So it is not subject to depreciation. But the improvements such
your turn 1 as pavements, signs, fences, etc. have limited lives. Thus, they are subject to
depreciation. Their costs must be allocated through their useful lives. That is
why they are recognized under land improvements.
29
E-tap Co. purchases land for 500,000 TL in cash. E-tap

Co. also pays 15,000 TL for removing the ruins present
on the land and sells the debris for 5,000 TL in cash. For
the clearing of the land E-tap Co. paid 5,000 TL in cash.
Suggested answers for “Your turn”
E-tap Co. pays 20,000 TL for pavements, lighting and

signs from bank account to the construction company.
First of all, let’s calculate the cost of the land.

Removal of Ruins 15,000 TL
Clearing of the land 5,000 TL
(-) Reduction in Cost (5,000) TL
Selling of the debris (5,000) TL
Total Cost of the Land 515,000 TL
The cost of the land improvements is indicated as 20.000 TL. So, the company
will record land improvement from the cost of 20.000 TL.

Land 520,000
Cash 520,000
To record the purchase of land
your turn 2 Date Account Titles and Short Explanation Debit Credit
Cash 5,000
Land 5,000
To record the selling of the debris
LAND
520,000 5,000

Cash 20,000
To record the payment for Land
Improvements
Rec Co. purchases a machinery for 4,500,000 TL on

November 12, 2018. Just before the assembly of the
machine, Rec Co. learns that the assembly company has
bankrupted. So Rec Co. gets in touch with the supplier
and the supplier tells Rec Co. that a team of assembly will
assemble the machine in 4 months. During these 4 months
Rec Co. can’t benefit from the machine. In February 2019,
the assembly team assesmbles the machine and readies
it for use. Though the machine is purchased in November
2018 when does the depreciation date begin?
Depreciation occurs due to the usage of the asset. For the time asset is being
used, it contributes to the revenue of the company. So the depreciation begins
your turn 3 on the date that the company begins to use the asset. In this example, the
depreciation beginning date will be February 2019.
30
Accounting II
Endnotes
1
Cemalcılar, Ö, Önce, S. (1999). Muhasebenin 8
Horngren, C.T., Harrison Jr.,W.T. and Oliver, M.S.
Kuramsal Yapısı, T.C. Anadolu Üniversitesi (2012). Accounting, 9th Edition, Pearson Publ.,
Yayınları No:1093, p.84. p.479.
2
Kimmel Paul D., Weygandt Jerry J., Kieso Donald E. 9
Horngren, C.T., Harrison Jr.,W.T. and Oliver, M.S.
(2009) Financial Accounting Tools for Business (2012). Accounting, 9th Edition, Pearson Publ.,
Decision Making, 5th edition, John Wiley & p.479.
Sons, Inc., p.434. 10
Miller-Nobles, Tracie L., Mattison, Brenda L. and
3
Kieso, D.E., Weygant, J.J., & Warfield, T.D. (2011). Matsumurato, Ella Mae (2016) Horngren’s
Intermediate Accounting, Vol. I, John Wiley Financial & Managerial Accounting, The
and Sons, IFRS Edition, p.512. Financial Chapters, 5th edition, Pearson
Education Limited, p.507.
4
Weygandt Jerry J., Kimmel Paul D., Kieso Donald
E. (2015) Accounting Principles, 12th edition, 11
John Wiley & Sons, Inc., p.444. Matsumurato, Ella Mae, p.511.
5
Kieso, D.E., Weygant, J.J., & Warfield, T.D. (2011). 12
Intermediate Accounting, Vol. I, John Wiley Matsumurato, Ella Mae, p.514.
and Sons, IFRS Edition, p.512. 13
Weygandt Jerry J., Kimmel Paul D., Kieso Donald
6
Kieso, D.E., Weygant, J.J., & Warfield, T.D. (2011). E. (2015) Principles of Accounting, 12th edition,
Intermediate Accounting, Vol. I, John Wiley John Wiley & Sons, Inc p.465.
and Sons, IFRS Edition, p.513. 14
7
Horngren, C.T., Harrison Jr.,W.T. and Oliver, M.S. Matsumurato, Ella Mae, p.526.
(2012). Accounting, 9th Edition, Pearson Publ.,
p.478.
31
Intangible Assets and
Chapter 2 Natural Resources
Learning Outcomes
1 Explain and identify the intangible assets 2 Describe and illustrate how to account for
intangible assets
3 Describe and illustrate how to account for

natural resources 4 Describe how natural resource and intangible
assets are reported and analyzed
Key Terms
Amortization
Copyrights
Chapter Outline Depletion
Introduction Franchises & Leases
Intangible Assets Goodwill
Acquisition of Intangible Assets Intangible Assets
Natural Resources Leasehold Improvements
Financial Reporting for Intangible Assets and Natural Resources
Natural Resources Patents
Pre-operating Costs
Research & Development Costs
Rights
Trademarks
32
Accounting II
INTRODUCTION
Long-term (non-current) assets include An intangible asset is both long term and
property, plant and equipment assets such as land, nonphysical.
buildings, and machinery; intangible assets such as
patents and copyrights; and natural resources such
as timberland, mineral deposits and oil-and-gas
Not having a physical substance brings
fields. These assets represent a company’s strategic
confusion with receivables. Receivables also don’t
commitments well into the future and help create
the revenue of the business. We discussed property, have a physical substance but they give a right of
plant and equipment assets in Chapter 1, and in a demand from other parties apart from intangible
this chapter, we will focus on the intangible assets assets.2 Intangible asset’s value comes from the
and natural resources. long-term rights or advantages it provides to its
owner.
The judgments related to their acquisition,
operation, and disposal, and to the allocation of Intangible assets are long-lived assets that are
their costs will affect a company’s performance and used in the operations of a business for more than a
will have important implications for a company’s year and are not held for sale. So, they are reported
reported results for years. As a matter of being under non-current assets section of balance sheet.
a non-current asset, both intangible assets and Intangible assets generally arise from the following
natural resources provide benefit to the company sources:3
for more than a year. Throughout their useful lives, • Exclusive privileges granted by
they contribute to the profitability of the company. governmental authority such as patents,
In this chapter, we will examine how to record the copyrights, franchises, trademarks, and
purchase, cost allocation, and disposal of intangible tradenames.
assets and natural resources. • Private monopolistic arrangements arising
from contractual agreements such as
INTANGIBLE ASSETS franchises and leases.
In the first chapter of this book, we discussed • Acquisition of another business, in which
property, plant and equipment assets as the main part the purchase price includes a payment for
of non-current assets. Non-current assets not just only goodwill (Superior entrepreneurial capacity
include property, plant and equipment assets (fixed or management know-how and customer
assets, tangible assets) but they also include various loyalty is related to goodwill.)
kinds of long-lived assets with their own characteristics. Intangible assets have distinctive qualifications
Intangible assets are a unique kind of non-current from other assets that require them to be recorded
assets that provide certain legal rights, privileges, and as intangible asset. These are4;
competitive advantages to the business1. Intangible • They have a value for a specific company
assets don’t have a physical substance or form unlike • Some of them have unlimited life
property, plant and equipment assets. Instead,
• Their values fluctuate highly because their
intangible assets convey special rights from patents,
copyrights, licenses, trademarks, etc. and other benefits are based on competition.
inventive works. Besides these, intangible assets also Intangible assets are qualified by rights,
include pre-operating costs, research and development privileges, and advantages of possession rather than
costs and leasehold improvements. physical existence.
33
Intangible Assets and Natural Resources
ACQUISITION OF INTANGIBLE attorney’s fee.7 When a company develops its own

ASSETS intangible assets, it should record those types of
costs as period expenses.8
Purchased intangible assets are recorded at their
acquisition cost that is the amount that a company
paid for them. In other words, the initial cost for
an intangible asset includes only the purchase
price. As you can realize, there is a difference Intangible assets are recorded at their cost and
between intangible assets and property, plant, the initial cost of a purchased intangible asset
and equipment assets in determining the cost. includes only the purchase price.
For property, plant, and equipment assets, cost
includes both the purchase price of the asset and
the costs incurred in designing and constructing Intangibles are categorized as having either
the asset. Companies expense any costs incurred in a limited life (definite life) or an indefinite life. A
developing an intangible asset.5 limited (definite) life means the useful life is subject
Some types of intangible assets are not to a legal limit or can be reasonably estimated. If an
purchased; they can be internally developed. When intangible asset has a limited life, it will be expensed
an intangible asset is internally developed, it may through amortization. The company allocates this
be very difficult to evaluate it. If an intangible asset type of intangible asset’s cost to expense over their
is not purchased, only some limited costs can be useful life. The process of allocating the cost of
capitalized.6 The costs of these intangible assets an intangible asset to expense over its useful life
can be measured by costs like registration fees and is referred to amortization. Amortization applies
34
Accounting II
to intangibles exactly as depreciation applies to and benefiting the powers that the governmental
property, plant, and equipment. Amortization authorities provided to the company.10 When the
occurs due to the passage of time or a decline in the right is acquired, the related account is debited and
usefulness of the intangible asset. Intangible assets they are amortized according to contract durations.
are typically amortized on a straight-line basis. If there are no contracts for the right, then the
amortization duration will be five years by default.
The accounting for the purchase and
Most purchased intangibles are expensed amortization of each asset is similar.
through amortization which is the allocation
of the cost of an intangible asset to expense
over its useful life.
Rights consist of patents, licenses,
trademarks, franchises and copyrights
Only intangible assets that have a definite

life are amortized. Intangible assets with
indefinite lives should not be amortized.
Intangible assets with indefinite life do not

have legal, contractual, regulatory, economic,
or competitive factors that limit the usage of
the intangible asset9. Intangible assets with an
indefinite life, nevertheless, are subject to an
impairment test that should be performed at least
annually. Impairment occurs when the fair value
of an asset is lower than the book value. In other
words, there has been a permanent decline in the
value of the asset. If it is determined that they
have lost some or all of their value in generating
future cash flows (if an impairment occurs), they
should be written down to their fair value; and the
company records a loss in the period in which the
decline is identified. Patents
Companies may acquire exclusive rights to
produce and sell goods with one or more unique
features. Such rights are granted by patents, which
All intangible assets are subject to an annual
the federal government issues to inventors. Patents
impairment test to determine if the assets
are government grants given to the holder for
justify their value on the balance sheet.
invention in all fields of technology providing that
the invention is new, involves an inventive step and
Now let’s have look at the types of intangible is applicable to industry.11
assets.
Rights internet
Rights consist of patents, licenses, trademarks, You can check the following web site for further
franchises and copyrights that are purchased by information. www.turkpatent.gov.tr
paying their prices and expenditures made for using
35
The recognition of patent depends on how it is acquired. If it is purchased, then the cost is capitalized
and recognized in Patents account. The initial cost of a patent is the cash or cash equivalent price paid to
acquire the patent.
If patent is internally developed through research and development, the expenditures made throughout
the research and development process are recorded as current operating expense in the period in which
they are incurred.12
Example 1: ORB Co. paid 4,500,000 TL to acquire a patent on January 1, 2018. The useful life of the
patent is 10 years.
In this example, the cost of the patent for the company is 4,500,000 TL. So, the Patents account will
be debited.

Jan. 1, 2018 Patents 4,500,000
Cash 4,500,000
To record the purchase of patent
The acquired patent will be reported as Intangible Assets in the non-current assets section of the balance sheet.
The cost of the purchased patent is capitalized in Patents account as an intangible asset. This cost is
amortized over the years of the patent’s expected useful life. Intangible assets are generally amortized by
straight-line method. The cost of the intangible asset is distributed to its useful life equally. In the first
example, the useful life of the patent is 10 years. So the amortization rate will be;
1 1
Amortization Rate= =
Patent’ s Useful Life 10
Amortization Expense = Capitalized Cost x Amortization Rate
1
Amortization Expense = 4,500,000 x = = 450,000 TL
10
The amortization is recorded by debiting an amortization expense account and crediting the patents
account. A separate contra asset account is usually not used for intangible assets.

December, 31 2018 Amortization Expense 450,000
Patents 450,000
To journalize the amortization expense
“Companies frequently choose credit entry directly to the asset account instead of using an Accumulated
Amortization account, because the residual value is generally zero and there is no physical asset to dispose of at the
end of its useful life, so the asset essentially removes itself from the books through the process of amortization.”13
At the end of the first year (December 31, 2018), ORB Co. will report this patent at 4,050,000 TL
(4,500,000 TL cost minus first-year’s amortization of 450,000 TL), the next year at 3,600,000 TL, and so
forth. Each year the value of the patent will be reduced until to the end of its ten-year life, at which point
its book value will be 0 TL.
36
Accounting II
Now let’s give an example for the internally developed patent.

Example 2: ORB Co. applied for a patent for its newly developed product. For the development process, the
company spent 375,000 TL.

Research and Development Costs 375,000
Cash 375,000
To record the patent development cost
Copyrights
A copyright is an exclusive right granted by the
1
government to publish, reproduce and sell a book,
HR Co. purchased a patent for 5 years for musical composition, film, other art works, computer
1,000,000 TL in cash. Make the journal entry for programs, or intellectual property. Government
acquisition and the adjusting entry as of December grants copyrights to authors, composers, sculptors
31. and other artists for their creations and works.14
Copyright belongs to the person who creates it.15
When a company pays the producer/author/
composer, etc. to purchase the rights for reproducing,
selling or composing the work, Copyrights account
is debited.
Example 3: QR Co. is the country’s one of the
most popular book and magazine publisher. QR Co.,
purchased the rights of writer Stelvio Alp d’Huez’s last
book for 1,500,000 TL for 5 years.

Copyrights 1,500,000
Cash 1,500,000
To record the purchase of copyright
Amortizations of the copyrights are as same as the amortization of the patents. At the end of the year,
the company will calculate the amortization rate and then the amortization expense.
1 1
Copyright’s Useful Life 5
1
5

December, 31 20xx Amortization Expense 300,000
Copyrights 300,000
37
Trademarks
Trademarks (also called trade name) are assets that represent distinctive identifications of products
or services. Trademarks may consist of any signs like words including personal names, figures, colors,
letters, numbers, sounds and the shape of goods or their packages, providing that such signs are capable
of distinguishing the goods or services of one undertaking from those of other undertakings and being
represented on the register in a manner to determine clear and precise matter of protection afforded to its
proprietor.16
When a company purchased the right of usage of a trademark, then Trademarks account is debited for
the related amount. The cost of a trademark or trade name is amortized over its useful life.
Example 4: RIM Co., paid 1,000,000 TL for its new product’s trademark “AERO” for 10 years.

Trademarks 1,000,000
Cash 1,000,000
To record the purchase of trademark
In this example, Trademarks account is debited because of acquiring a trademark. The company will
use this trademark and apply amortization for 10 years.
Example 5: QRK Co. paid 2,500,000 TL to LNB Co. in order to purchase the right of usage of LNB Co.’s
trademark “Fondo” for 5 years.

Trademarks 2,500,000
Cash 2,500,000
To record the purchase of trademark
Trademarks account in this example is related to the purchase of a right. It’s the right to use a trademark
of another company. The amount paid for the right is recognized in Trademarks account. Thus, the
Trademarks account is debited. For the useful life of the trademark, which is 5 years in this example, QRK
Co. will apply amortization.
1
5

Trademarks 500,000
Franchises and Licenses

A franchise is a contractual arrangement between a franchisor and a franchisee. Franchises are
privileges granted by a business to sell goods or services under specified conditions. The franchisor grants
the franchisee the right to sell certain products, perform specific services, or use certain trademarks or trade
names, usually within a designated geographic area.17
38
Accounting II
Licenses are privileges granted by a government Competition and some other regulations regulate
to use public property in performing services.18 A franchise applications in Turkey. The judicial
license granted by a governmental body permits a opinion of Turkish Court of Appeals define
company to use public property in performing its franchise as, “a long-term and continuous business
services.19 relationship arising from the concession given to the
second party to conduct commercial affairs subject
to the concession rights by providing information
Franchises and licenses are privileges granted and support to the management and organization
by a business or a government to sell product of the business within a certain period of time and
or service under specified conditions. limitations of a product or service that is formed from
the contractual relationship between two independent
parties.”20
There is no specific definition for franchise. Example 6: Finestre Co., signed franchising
Turkish Code of Obligations, Industrial Property contract with Zoncolan Co. in order to use Zoncolan
Law, Turkish Commercial Code, Intellectual Co. brand “Monte” for 10 years and paid 2,000,000
Property Rights Law, Law on The Protection of TL.

Franchises & Licenses 2,000,000
Cash 2,000,000
To record the purchase of franchise
In this example, Franchises & Licenses account is debited because of signing the franchising contract
and acquiring the right of using the brand. Amortization of franchise is based on the contract useful
life that is 10 years according to this example. At the end of the year, Finestre Co., will journalize the
amortization expense for the franchise.
1
10

Franchises & Licenses 200,000
Example 7: Zip Co. paid 3,000,000 TL in order to get solar energy plant license from Energy Market
Regulatory Authority and Meteorological Service.

Franchises & Licenses 3,000,000
Cash 3,000,000
To record the purchase of license
The acquired licenses are also recognized in Franchises and Licenses account. The account is debited
when a license is acquired. Like the other intangible assets, the amortization of the license is based on
the useful life of the license. If the useful life of the license is unlimited or unknown, then the capitalized
amount will be amortized within 5 years by default.
39
In this example, there is no information given about the useful life of the license. So, the company will
apply amortization for 5 years.
1
5

and liabilities.21 Goodwill is unique. Unlike assets

such as investments and plant assets, which can be
sold individually in the marketplace, goodwill can
2
be identified only with the business as a whole.22
AER Co. paid 3,000,000 TL for a 10-year Therefore, companies record goodwill only when
franchise that will expire on December 31, 2028. there is an exchange transaction that involves the
Make the journal entries for the purchasing of the purchase of an entire business.23 Thus, goodwill is
franchise and the adjusting entry for the first year. only recorded when purchasing another company.
When an entire business is purchased, goodwill is
the excess of cost over the fair market value of the
Goodwill net assets (total assets less total liabilities) acquired.
Goodwill means different things to different
people. Generally, it refers to a company’s good
Goodwill is the value paid above the net
reputation and intangible assets of a business that
worth of the company’s assets and liabilities.
is created from favorable attributes that relate to
a company and are not attributable to any other
specific asset. These include managerial skills,
desirable location, good customer relations, skilled
employees, high-quality products, and good
If acquiring company purchases another
relations with labor unions. A good reputation may
company and pays more for that company
create goodwill, but that company cannot record
than the market value of the net assets
goodwill for its own business.
acquired, the difference is goodwill. Goodwill
From an accounting standpoint, goodwill is the is recorded only by an acquiring company.
excess of the cost to purchase another company
over the market value of business’s net assets (total
Example 8: Mür Co. purchased Chain Co. for
assets minus total liabilities). Goodwill is the value
7,500,000 TL that has assets and liabilities shown below.
paid above the net worth of the company’s assets
40
Accounting II
Chain Co.
Balance Sheet
31/12/20xx
Cash 100,000 Bank Loans 2,000,000
Cheques Received 150,000 Notes Payable 350,000
Accounts Receivable 200,000
Merchandise Inventory 1,900,000 Owner’s Equity 6,000,000
Building 2,500,000
Machinery & Equipment 3,900,000
(-) Accumulated Depreciation (400,000)
8,350,000 8,350,000
Purchase Price to acquire Chain Co. 7,500,000 TL.

Total Assets of Chain Co. 8,350,000
Total Liabilities of Chain Co. 2,350,000
(Less) Net Asset amount of Chain Co. 6,000,000 TL.
Goodwill 1,500,000 TL
When the goodwill is calculated, Mür Co. will journalize the transaction as follows;

Cash 100,000
Cheques Received 150,000
Accounts Receivable 200,000
Merchandise Inventory 1,900,000
Building 2,500,000
Machinery & Depreciation 3,900,000
Goodwill 1,500,000
Bank Loans 2,000,000
Cash 7,500,000
To record the goodwill
In recording the purchase of a business, the company debits (increases) the identifiable acquired assets,
credits liabilities at their fair values, credits cash for the purchase price, and records the difference as
goodwill.
Unlike patents and copyrights, goodwill is not amortized because it is considered to have an indefinite
life. Instead, the acquiring company measures the fair value of its acquired goodwill each year. If the
goodwill has increased in fair value, there is nothing to record such as a gain on goodwill. However, if
goodwill’s fair value has decreased, then the company records an impairment loss and goodwill must be
written down.
41
3
Shift Co. purchased Let Co. for 9,000,000 TL that has assets and liabilities given below.
Cash 250,000
Trade Receivables 500,000
Trade Payables 100,000
Building 3,250,000
Merchandise Inventory 750,000
Bank Loans 450,000
Accumulated Amortization 100,000
Calculate the goodwill amount and journalize the acquisition transaction.
Pre-operating Costs
Companies make preoperating expenditures when establishing a new business or founding a new
branch or continuously expanding of the operations but in return there is no gain obtained. These kinds
of expenditures are capitalized as an intangible asset named Preoperating Costs. Because the life of the
company is assumed infinite, Preoperating cost are generally amortized within 5 years.
Example 9: KERT Co. was established by six shareholders. During the establishment one of the shareholders
paid 50,000 TL in cash for the notary and registration fee.

Pre-operating Costs 50,000
Payables to Shareholders 50,000
To record the preoperating costs
In this transaction, the expenditures for notary and registration fees are capitalized under Pre-Operating
Costs account. Payables to Shareholders account is credited because one of the shareholders paid the fees
from his/her own assets (personal assets). So, the company owed to the shareholder.
At the end of the period KERT Co. will amortize Preoperating Costs over 5-year basis.
1
Amortization Expense = 50,000 x = = 10,000 TL
5

Pre-operating Costs 10,000
42
Accounting II
Research and Development Costs

Research and Development expenditures are capitalized when the company makes expenditures for
developing new technologies or products, or improves the current ones or expenditures made for similar
aims. Related expenditures are capitalized by debiting in Research and Development Costs account.
Example 10: ROC Co. operates in the field of aerodynamics. The company works on antifriction materials.
For the development of new antifriction materials, the company spent 12,000,000 TL.

Research & Development Costs 12,000,000
Cash 12,000,000
To record the Research & Development costs
Research & Development Costs are generally amortized within 5 years. So, the amortization expense
will be;
1
Amortization Expense = 12,000,000 x = = 2,400,000 TL
5

December, 31 20xx Amortization Expense 2,400,000
Research & Development Costs 2,400,000
Leasehold Improvements
Leasehold improvements account is capitalized when the company makes expenditures in order to
improve the rented fixed assets or to continuously increase the economic value of the fixed asset that will
be left to the owner at the end of the rental period. The expenditures made for regular maintenance of the
rented fixed assets are not included in capitalization. They will be recorded as term expenses.
Example 11: Pedal Co. paid 45,000 TL for the decoration of new sales office that has been rented for 10
years.

Leasehold Improvements 45,000
Cash 45,000
To record the Leasehold Improvements
The leasehold improvements account is capitalized because the expenditure made is for the rented
estate to bring it to its intended use and also it increases the value of the estate.
Leasehold Improvements account amortized according
to the rental period. For this example, the amortization
expense will be calculated over 10 years. If the rental period Leasehold Improvements account is only
is unknown or there is no rental contract between the used for rented assets
parties, then the amortization expense will be calculated
over 5 years by default.
43
1
Amortization Rate=
10
1
Amortization Expense = 45,000 x = = 4,500 TL
10

As mentioned above, regular repair and maintenance expenditures will not be capitalized. They are
recorded as term expenses.
Example 12: Pedal Co., had the interior of the rented office painted for 5,000 TL and paid the amount in
cash.

Marketing, Sales and Distribution Expenses 5,000
Cash 5,000
To record the Marketing, Sales and Distribution Expense
In this transaction, Marketing, Sales and Distribution Expense account, which is an expense account,
is debited because the expenditure was made for the sales office. If it were made for the management
purposes, then the company should have recorded it to Administrative Expenses account.
One important issue for the Leasehold Improvements is that the improvements and/or changes made
to rented estate will be left to the owner at the end of the period. If it is a reversible improvement and/or
change then the expenditures made must be recorded in fixed assets. For example;
Example 13: HC Co., had the factory building insulated for 25,000 TL that has been rented for 10 years.
The company also installed removable elevators inside to use in the operations for 10,000 TL.

Machinery & Equipment 10,000
Cash 35,000
To record the Leasehold Improvements and fixed asset
In this transaction, the expenditure made for the insulation is capitalized in Leasehold Improvements
account because the value increasing change made for the rented building will be left to the owner at the
end of the rental period. But the expenditure made for the removable elevators will not be capitalized
in Leasehold Improvements account. Because the elevators are removable the company will take them
44
Accounting II
and may install to the new rented or owned factory

All mineral resources are exclusively owned by the
building. In other words, the company is the
state. They are not subject to private ownership
owner of the elevators and they will not be left at rights. The right to explore and extract from
the end of the rental period. So, they are capitalized mines is granted through mining licenses issued
in a fixed asset account, that is Machinery & by the state under the Mining Law. (Article 4,
Equipment account. Turkish Mining Law No. 3213, of 4 June 1985)
NATURAL RESOURCES Extracting out the natural resources requires

Natural resources are long-term assets that some preparations. First of all, the company must
come from the earth that are consumed such as make do research to investigate if the ore deposit is
Timberlands, Oil and Gas Reserves, and Mineral eligible for processing later and for determining the
Deposits.24 These long-lived productive assets have entrance and exit locations for the mine. Maybe,
two distinguishing characteristics:25 the company had the drilling tests made in order
to examine the geological structure of the area. As
(1) they are physically extracted in operations a result of these research activities, it may be found
(such as mining, cutting, or pumping), and out that the mine will not be operable or vice versa.
(2) they are replaceable only by an act of nature. If the deposit is operable then the expenditures will
be capitalized and be subjected to depletion. If the
deposit is not operable then the expenditures made
will be recorded as term expenses. After the research
Natural resources come from earth, they are operations, the company will make operations for
not created by human beings.
preparing and developing the ore deposit. In order
to remove the earth from the top of the ore deposit
or dig tunnels for entrances and exits and install
These assets are converted to inventory by ventilation systems, lay down rails for carrying out
extracted minerals and make roads for the in-mine
cutting, pumping, mining, or other extraction
vehicles, etc., the company makes expenditures.
methods.26 They are recorded at acquisition cost.
These expenditures are also capitalized. Now let’s
The acquisition cost of a natural resource is the
give examples about the explanations given above.
price needed to acquire the resource and prepare
it for its intended use. For an already-discovered Example 14: Dig Co., paid 100,000 TL to
resource, such as an existing coal mine, cost is the Mineral Research and Exploration Co. for researching
price paid for the property.27 the ore deposit in the field. As the result of the research
operation, it is found out that there is 30,000,000
Especially mining companies deal with these tons of coal ore available for extraction. Dig Co. paid
kinds of assets. In fact, the company doesn’t 2,000,000 TL in order the mine to be readied for
really own the natural resources. The state owns extraction. In this manner, the company had the
the natural resources and the company pays for railroads laid down, ventilation systems installed and
the license and privileges in order to operate the entrance and exit halls dug.
mining activities.

Ore Deposits 2,100,000
-Research operation 100,000
-Preparations 2,000,000
Cash 2,100,000
To record the Ore Deposits
45
In this transaction, the expenditures made for the research and preparation operations are capitalized
in Ore Deposits account, which is a natural resource asset. The reason is the ore deposit found is suitable
for operating. If there were no available ore deposit found or it was not worth operating it, then it would
be recorded to an expense account, for example, Research Expenses. Also, the company wouldn’t spend
2,000,000 TL on a worthless ore. Assume that the ore deposit in the field is not worth operating. In this
case, the company will record this transaction as;

Research Expenses 100,000
Cash 100,000
To record the research expense for ore deposit
As a natural resource is extracted, harvested, or mined and then sold, its asset account must be
proportionally reduced. For example, the carrying value of oil reserves on the balance sheet is reduced by
the proportional cost of the barrels pumped during the period.28 As a result, the company is using up the
oil reserves such that at some point in time, there is nothing left to extract.
The allocation of the natural resources’ cost to expense in a
rational and systematic manner over the resource’s useful life is
Depletion is to natural resources as called depletion.
depreciation is to plant assets and The depletion in natural resources is calculated different than
amortization to intangible assets. fixed assets and intangible assets. Depletion refers not only to
the exhaustion of a natural resource but also to the proportional
allocation of the cost of a natural resource to the units extracted.29
The cost of a natural resource allocated closely resembles the units-of-production method (learned earlier in
Chapter 1) because depletion generally is a function of the units extracted during the year. The depletion
expense is calculated within the interaction between total reserve, yearly extraction quantity and the capitalized
cost. When a natural resource is purchased or developed, the total units that will be available, such as barrels
of oil, tons of coal, or board-feet of lumber, must be estimated. The depletion cost per unit is determined by
dividing the cost of the natural resource (less residual value, if any) by the number of units estimated to be in
the resource. The amount of the depletion cost for each accounting period is then computed by multiplying
the depletion cost per unit by the number of units extracted and sold.
Cost- Residual Value

Depletion per Unit=
Total Estimated Units Available
Depletion Expense=Depletion per Unit x Yearly Extracted Quantity
Example 15: In the first year of the coal mine, Dig Co. dug out 2,400,000 tons of coal. Let’s now calculate
the depletion expense of the first year.
Cost of mine : 2,100,000 TL
Estimated total units of resource : 30,000,000 tons
Tons mined during year : 2,400,000 tons
Residual value : 0 TL
The depletion expense of 168,000 TL for the year is computed as shown below.
2,100,000-0
Depletion per unit= =0.07 TL per Ton
30,000,000 tons
Depletion Expense = 0.07 x 2,400,000 tons=168,000 TL
46
Accounting II

December, 31 20xx Depletion Expense 168,000
Accumulated Depletion 168,000
To journalize the depletion expense
4
Merc Co. purchased a coal mine by paying 22,500,000 TL. Estimated reserves are 90,000,000
tons of coal. In the first year, the company extracted 3,000,000 tons of coal. Make the
journal entry to record the depletion expense at the end of the first year.
FINANCIAL REPORTING FOR INTANGIBLE ASSETS AND NATURAL

RESOURCES
In the balance sheet, each class of long term assets (non-current assets) should be disclosed on the main
body of the statement or in the notes. Companies disclose the balances of the major classes of tangible and
intangible long term assets either in the face of the statement or in the notes of financial statements. In
addition, they should describe the depreciation, amortization, and depletion methods that were used, as
well as disclose the amount of depreciation, amortization, and depletion expense for the period.
Intangible assets are usually reported in the balance sheet in a separate section following Property, Plant
and Equipment assets. The balance of each class of intangible assets should be disclosed on the balance
sheet at their book value (cost less accumulated depreciation) either in the face of the statement or the
notes. Intangibles do not usually use a contra asset account like the contra asset account Accumulated
Depreciation used for plant assets. Instead, companies record amortization of intangibles as a direct
decrease (credit) to the asset account. Amortization expense is reported on the income statement as part
of operations.
The balance sheet (Statement of Financial Position) presentation for Arçelik Company’s tangible and
intangible assets is shown below. The notes to Arçelik’s financial statements present greater details about
the accounting for its long-term intangible assets.
47
48
Accounting II
Source: http://www.arcelikas.com/UserFiles/file/AnnualReport2017.pdf
49
Further Reading
Source: BP Annual Report and Form, 2017. https://www.bp.com/content/dam/bp/en/corporate/pdf/

investors/bp-annual-report-and-form-20f-2017.pdf
50
Accounting II
Explain and identify the

LO 1 intangible assets
Intangible assets are unique kinds of non-current assets that

provide certain legal rights and competitive advantages to the
business. These assets don’t have a physical substance unlike
fixed assets but without intangible assets the company may not
be able to carry out its operations. Patents, copyrights, licenses,
Summary
trademarks, etc. can be given as examples of intangible assets.
Besides these assets intangible assets, include pre-operating
expenses, research and development expenses and leasehold
improvements.
Goodwill is the excess of the amount paid for an entity over
the fair market value of the net assets and usually relates to the
superior earning potential of the entity. Goodwill should be
recorded only when a company purchases an entire business.
Goodwill should be reviewed for possible impairment on an
annual basis.
Describe and illustrate how to

LO 2 account for intangible assets
The purchase of an intangible asset should be treated as a

capital expenditure and recorded at acquisition cost. In other
words, the cost of intangible asset includes all acquiring
expenditures and the necessary expenditures to bring the asset
to its intended use. Some types of intangible assets can also be
internally developed. The costs of these intangible assets can
be measured by costs like registration fees and attorney’s fee.
When an intangible asset is internally developed, it may be
very difficult to evaluate it. These types of costs are generally
recorded as a period expense.
If an intangible asset has a limited life, its cost should be
allocated (amortized) over its useful life. Intangible assets with
indefinite lives should not be amortized. Companies normally
use the straight-line method for amortizing intangible assets.
51

LO 3 account for natural resources
Natural resources consist of standing timber and underground

deposits of oil, gas and minerals. Especially mining companies
deal with these kinds of assets.
Extracting out the natural resources require some preparations.
First of all, the company must do research to investigate if
Summary
research if the ore deposit is eligible for processing later and for
determining the entrance and exit locations for the mine. As a
result of these research activities, it may be found out that the
mine will not be operable or vice versa. If the deposit is operable
then the expenditures will be capitalized and be subjected to
depletion. If the deposit is not operable then the expenditures
made will be recorded as term expenses. After the research
operations, the company will make operations for preparing
and developing the ore deposit. In order to remove the earth
from the top of the ore deposit or dig tunnels for entrances and
exits and install ventilation systems, lay down rails for carrying
out extracted minerals and make roads for the in-mine vehicles,
etc., the company makes expenditures. These expenditures are
also capitalized.
The amount of periodic depletion is computed by multiplying
the quantity of minerals extracted during the period by a
depletion rate. The depletion rate is computed by dividing
the cost of the mineral deposit by its estimated total units of
resource.
Describe How Natural Resources,

LO 4 And İntangible Assets Are
Reported And Analyzed
In the balance sheet, each class of long term assets (non-current

assets) should be disclosed on the main body of the statement
or in the notes.
Intangible assets are usually reported in the balance sheet in
a separate section following Property, Plant and Equipment
assets. The balance of each class of intangible assets should be
disclosed on the balance sheet at their book value either in the
face of the statement or the notes. Intangibles do not usually use
a contra asset account like the contra asset account Accumulated
Depreciation used for plant assets. Instead, companies record
amortization of intangibles as a direct decrease (credit) to the
asset account. Amortization expense is reported on the income
statement as part of operations.
52
Accounting II
1 Which of the following transactions can be 6 Mex Co. applied for a patent for its newly
recognized as an intangible asset? developed product. The company spent 1,000,000 TL
for the development process? Which account will be
A. Improvements made on rented warehouse debited in this transaction?
B. Improvements made on lands
Test Yourself
C. Regular maintenance operations made on A. Research and Development Costs
rented building B. Patents
D. Financial leased machineries C. Licenses
E. Gas expense for the vehicles D. Merchandise Inventory
E. Bank
2 Which of the following cannot be considered 7 Vox Co. signed a contract on October 1,2018
as a right?
with Leo Co. in order to use Leo Co.’s brand for 10
A. Licenses years and paid 1,500,000 TL. What will be the
B. Franchises amortization expense in 2018?
C. Goodwill A. 37,500 B. 75,000 C. 112,500
D. Trademarks D. 150,000 E. 1,500,000
E. Copyrights
8 Lux Co. had the power sockets changed in the
3 Which of the following methods shows the office rooms for 3,000 TL. The company has rented
right way of amortizing the intangible assets? the building for 10 years and the office is being used
for managerial purposes. Which account will be
A. Double-declining balance method debited in this transaction?
B. Straight-line method
A. Administrative expenses
C. Units-of-production method
B. Leasehold improvements
D. FIFO method
C. Buildings
E. Accelerated amortization method
D. Amortization expense
E. Accumulated amortization
4 ULTE Co. made an expense for 15,250 TL for
the regular maintenance of the office store used in 9 UCI Co. paid 4,500,000 TL for the ore mine
marketing department. How will ULTE Co. record to be ready for the intended use. Also the company
this expense in the journal? previously paid 500,000 TL for the research
A. Adds to the cost of the office store operations. It is found out that there is 25,000,000
B. Records as an asset m3 of crude oil. At the end of the first year the
company had drilled out 3,400,000 m3 of oil. What
C. Records as inventory
is the depletion expense for the year?
D. Records as term expense
E. Records as amortization A. 215,000 B. 500,000 C.
680,000
D. 785,000 E. 3,400,000
5 Gear Co. purchased Link Co. for 9,500,000 TL
that has assets of 11,500,000 TL and liabilities of 10 TOC Co. operates in the field of nano-
3,500,000 TL. What will be the Goodwill amount technology. For the development of new material, the
that Gear Co. will report on its balance sheet? company spent 5,000,000 TL. Which account will
be debited in this transaction?
A. 1,500,000
A. Research and Development Costs
B. 2,000,000 B. Copyrights
C. 8,000,000 C. Trademarks
D. 9,500,000 D. Natural Resources
E. 14,500,000 E. Amortization expense
53
1. A If your answer is wrong, please review the 6. A If your answer is wrong, please review the
“Intangible Assets” section. “Patents” section.
Answer Key for “Test Yourself”
2. C If your answer is wrong, please review the 7. D If your answer is wrong, please review the
“Intangible Assets” section. “Franchises and Licenses” section.
3. B If your answer is wrong, please review the 8. A If your answer is wrong, please review the
“Intangible Assets” section. “Leasehold Improvements” section.
4. D If your answer is wrong, please review the 9. C If your answer is wrong, please review the
“Leasehold Improvements” section. “Natural Resources” section.
“Goodwill” section. “Research and Development Costs” section.
HR Co. purchased acquired a patent for 5 years

for 1,000,000 TL in cash. Make the journal entry for
acquisition and the adjusting entry as of December 31.

Jan. 1, 20xx Patents 1,000,000
Cash 1,000,000
To record the purchase of patent
1 1
Patent’ s Useful Life 5

your turn 1 Amortization Expense = Capitalized Cost x Amortization Rate
1
5

Patents 200,000
54
Accounting II
AER Co. paid 3,000,000 TL for a 10-year franchise that will expire
on December 31, 2028. Make the journal entries for the purchasing
of the franchise and the adjusting entry for the first year.

Jan. 1, 2018 Franchises & Licenses 3,000,000
Cash 3,000,000
To record the purchase of franchise
your turn 2 1
10

December, 31 2018 Amortization Expense 300,000
55
Shift Co. purchased Let Co. for 9,000,000 TL that has assets and
liabilities given below.
Cash 250,000

Trade Payables 100,000
Building 3,250,000
Bank Loans 450,000
Calculate the goodwill amount and journalize the acquisition transaction.
First of all, we need to arrange the accounts into order that are given randomly
above and calculate the amount of Owner’s Equity.
Let Co.
Balance Sheet
31/12/20xx
Cash 250,000 Bank Loans 450,000
Trade Receivables 500,000 Trades Payable 100,000
Building 3,250,000 Owner’s Equity 8,375,000
(-) Accumulated Depreciation (725,000)
(-) Accumulated Amortization (100,000)
8,925,000 8,925,000
your turn 3 Goodwill = 9,000,000 – 8,375,000

= 625,000 TL
As the goodwill is calculated, Shift Co. will journalize the transaction as follows;

Cash 250,000
Building 3,250,000
Goodwill 625,000
Bank Loans 450,000
Trades Payable 100,000
Bank 9,000,000
To record the goodwill
56
Accounting II
Merc Co. purchased a coal mine by paying 22,500,000 TL. Estimated

reserves are 90,000,000 tons of coal. In the first year, the company
extracted 3,000,000 tons of coal. Make the journal entry to record the

depletion expense at the end of first year.
Capitalized Cost
Depletion Expense= x Yearly Extraction
Total Reserve

22,500,000 TL
Depletion Expense= x 3,000,000 tons = 750,000 TL
90,000,000 tons

your turn 4 Date Account Titles and Short Explanation Debit Credit
December, 31 Depletion Expense 750,000
20xx
Accumulated Deplation 750,000
To journalize the depletion expense
Endnotes
1 Cemalcılar, Ö., Önce, S. (1999). Muhasebenin Kuramsal 14 Cemalcılar, Ö., Önce, S., p.432.
Yapısı, T.C. Anadolu Üniversitesi Yayınları No:1093, 15
p.419. Law on Intellectual and Artistic Works., No:5846
amended by Law No:6552, Official Gazette 10/09/2014.
2 Cemalcılar, Ö., Önce, S., p.420. 16 Industrial Property Code, Law Number:6769,
3 Weygandt, Jerry J., Kimmel, Paul D., Kieso, Donald E. Accepted:22/12/2016, Official Gazette 10/01/2017.
(2015) Accounting Principles 12th Edition, John Wiley No:29944. Book One: Trademarks, Section One, Article 4.
& Sons, p. 460; Edwards, J.D., Hermanson, R.H. (2010). 17
Accounting Principles: A Business Perspective, Vol.1 Weygandt, Jerry J., Kimmel, Paul D., Kieso, Donald E., p.
Eight Edition, Endeavour International Corp., Houston, 462; Miller-Nobles, Tracie L., Mattison, Brenda L., and
p. 492. Matsumurato, Ella Mae, p. 523.
18 Horngren, C.T., Harrison Jr.,W.T. and Oliver, M.S. (2012).
4 Cemalcılar, Ö., Önce, S., p.420.
Accounting, 9th Edition, Pearson Publ., p.498.
5 Weygandt, Jerry J., Kimmel, Paul D., Kieso, Donald E., p. 19 Weygandt, Jerry J., Kimmel, Paul D., Kieso, Donald E., p. 462.
460.
20 Turkish Court of Appeals, Judicial Opinion Text,
6 Miller-Nobles, Tracie L., Mattison, Brenda L., and
Matsumurato, Ella Mae (2016) Horngren’s Financial & Merits No:2001/819 - Decree No:2001/4917. Date of
Managerial Accounting, The Financial Chapters, 5th Judgement:25/06/2001.
edition, Pearson Education, p. 521. 21 Horngren, C.T., Harrison Jr.,W.T. and Oliver, M.S., p.498.
7 Cemalcılar, Ö., Önce, S., p.426. 22 Weygandt, Jerry J., Kimmel, Paul D., Kieso, Donald E., p. 462.
8 Cemalcılar, Ö., Önce, S., p.426. 23 Weygant, J.J., Kimmel, P.D., & Kieso, D.E., (2009)
9 Miller-Nobles, Tracie L., Mattison, Brenda L., and Financial Accounting, Tools for Business Decision
Matsumurato, Ella Mae, p. 521. Making, 5th edition, John Wiley & Sons, Inc., p.455.
24 Miller-Nobles, Tracie L., Mattison, Brenda L., and
10 General Communiqué on Accounting System
Implementation, Issued by Ministery of Finance, Official Matsumurato, Ella Mae, p. 520.
Gazette 21/12/1992. 25 Weygandt, Jerry J., Kimmel, Paul D., Kieso, Donald E., p.
11 Industrial Property Code, Law Number:6769, 458.
Accepted:22/12/2016, Official Gazette 10/01/2017. 26 Needles, B., Powers, M., Crosson, S., (2011) Principles of
No:29944. Accounting, Eleventh Edition, Cengage Learning, p.494.
12 Cemalcılar, Ö., Önce, S., p.431; Warren, Carl S., Reeve, James 27 Weygandt, Jerry J., Kimmel, Paul D., Kieso, Donald E., p. 458.
M., Duchac, Jonathan E., (2014) Financial and Managerial 28
Accounting, 12e, South-Western, Cengage Learning, p.423. Needles, B., Powers, M., Crosson, S., p.494.
13 29 Needles, B., Powers, M., Crosson, S., p.494.
Miller-Nobles, Tracie L., Mattison, Brenda L., and
Matsumurato, Ella Mae, p. 522. 57
Chapter 3 Investments
1 2
Learning Outcomes
Explain why companies invest in debt and Describe and illustrate how to account for
equity securities and classify investments investments in debt securities
3 Define and clarify how to account for

investments in equity securities 4 Identify and categorize derivatives
5 Determine how to transfer between categories
Key Terms
Affiliate
Amortization
Available-for-sale Security
Call Option
Capital (Holding) Gain
Chapter Outline Consolidation
Introduction Debt Security
Why Companies Invest Derivatives
Investment in Debt Securities Discount
Effective Interest Rate
Investment in Equity Securities Face Value
Derivatives as Contractual Investments Futures
Transfers between Categories Held-to-maturity
Mark-to-Market
Options
Parent
Premium
Put Option
Security
Subsidiary
Trading Security
58
Accounting II
INTRODUCTION
It is a known fact that the main objective of Companies may direct their idle or excess
companies is to maximize the shareholders’ wealth and cash into either debt securities or equity
it becomes possible through income maximization. securities, as the two main groups of
Although the major part of income arises from investment alternatives.
main operations, investments also generate a part of
net income. In order to maximize income through
investments, companies must choose the best A “security” represents the issuer’s share,
alternative among many different ones. participation or other interest in an entity or
Companies normally generate cash from their issuer’s obligation that: (a) either is represented by
own operations and this cash can be used for the an instrument issued in bearer or registered from;
following purposes:1 or (b) dealt in on securities exchanges or used as a
1. Investing in current operations medium for investment; or (c) divisible into a class
of shares, participations or obligations3.
2. Investing in temporary (short-term)
investments to earn additional revenue
3. Investing in long-term investments in stock
of other companies for strategic reasons A “security” represents the issuer’s share,
participation or other interest in an entity
Cash is often used to support the current
or issuer’s obligation that: (a) either is
operating activities of a company such as to pay
represented by an instrument issued in
daily expenses, to buy merchandise inventory, or
bearer or registered from; or (b) dealt in on
to replace worn-out equipment with more efficient
securities exchanges or used as a medium for
and productive equipment etc. You already learned
investment; or (c) divisible into a class of
how to account the use of cash in current operations
shares, participations or obligations.
and the use of it for purchasing property, plant
and equipment. In this chapter, we are going to
describe and illustrate the use of cash for investing in
A company may also invest cash in the debt
temporary investments and long term investments.
or equity securities of another company for the
long term purposes. The purpose of investment
WHY COMPANIES INVEST (temporary or long term) might be different, but
A company may temporarily have excess the same debt or equity securities will be used in
cash that is not needed for use in its current both temporary and long term investments.
operations. This is often the case when a company The primary objective of temporary investments
has a seasonal operating cycle. At the end of an is to:4
operating cycle, many companies may have cash 1. earn interest revenue.
on hand that is temporarily idle until the start of 2. receive dividends.
another operating cycle. Instead of letting excess
3. realize gains from increases in the market
cash remain idle, these companies may invest the
price of the securities.
excess funds temporarily to earn a greater return
than they would get by just holding the cash in the However, a company may also invest in the
bank. In doing so, companies may invest their idle other companies for the purpose of partnering
or excess funds in securities such as:2 with or controlling them in the long-term. Long-
term investments often involve the purchase of
1. Debt securities, which are notes and bonds
a significant portion of the equity securities of
that pay interest and have a fixed maturity
another company. Such investments usually have
date.
a strategic purpose, such as reduction of costs,
2. Equity securities, which are preferred and expansion, or integration etc...5
common stock that represent ownership in a
A possible income opportunity arises in terms
company and do not have a fixed maturity date.
of interest or dividend, depending on which
59
Investments
alternative is preferred. On the other hand, companies securities, available-for-sale securities, or held-to-
may also prefer alternatives that create income to the maturity securities.
company indirectly. For example, if a company invests • Trading securities are debt or equity securities
high enough to another company’s common stocks bought and held principally for the purpose
as to have control over it, this may help the investor of being sold in the near term to generate
company use the other company’s resources with income on short-term price differences.
better conditions and/or secure certain arrangements,
• Available-for-sale securities are debt or
as well. For instance, holding a high rate of ownership
equity securities that do not meet the
in the supplier company may provide an investor
criteria for either trading or held-to-
company to get high quality and low priced raw
maturity securities. They are held with
materials. Thus, this enables the company to generate
the intent of selling them sometime in the
income indirectly, by using the other company as an
future. Therfore, they may be short-term or
asset used in operations.
long-term depending on what management
Investments in debt and equity securities are intends to do with them.
classified as either temporary (short-term) or long-
• Held-to-maturity securities are debt securities
term. For purposes of valuation and reporting at a
that the investor has an intend and ability
financial statement date, short-term and long-term
to hold until their maturity date.
investments must be further classified as trading
INVESTMENTS
SHORT-TERM LONG-TERM
AVAILABLE- INFLUENTIAL BUT

TRADING CONTROLLING
FOR-SALE NONCONTROLLING
Figure 3.1 illustrates the classification of short-term and long-term investments.

Source: Belverd Needles, Marian Powers, and Susan Crosson, Principles of Accounting, Eleventh Edition, 2011,
Cengage Learning, p. 1263.
How to account for investments depends on both the chosen alternative and intention of management.
The intention of management significantly determines the classification of an investment instrument
(security), and this may cause different accounting treatments for the same instrument.
INVESTMENTS IN DEBT SECURITIES

The security that represents a credit relationship with another entity upon issuance is called debt
security. By investing in a debt security issued by another enterprise, a company plays the creditor role in
the market. Treasury bonds, corporate bonds, convertible debt instruments are some of the examples of
debt securities. The clauses to these securities, such as the interest rate, maturity etc., are mostly declared
on the face.
60
Accounting II
Figure 3.2
Debt securities are classified in three groups When a debt security is issued, an investor
based on the intention of a company on investing purchases it for a price and receives two types
on investing6: of cash flows in exchange; (i) interest, and (ii)
1. Held-to-maturity Securities face (nominal or par) value to be received at the
maturity. The investor classifies the HTM security
2. Available for sale Securities
as either current or non-current asset depending
3. Trading Securities on its maturity. Interest revenue is accrued by the
investor for every fiscal year until the maturity and
Held-to-Maturity (HTM) Securities finally security is converted into cash with the face
value upon delivery to the issuer. Face value is the
A security is recorded as held-to-maturity
amount written on a debt security to be paid by
when the investor company has both intention
issuer upon delivery at maturity date.
and ability to keep it until the maturity date.
Therefore, only the debt securities can be classified
as held-to-maturity because equity securities do not
have a maturity (consistent with going concern Face value is the amount written on a debt
assumption). The intention of a company is the key security to be paid by issuer upon delivery at
point in classification. If a company has no definite maturity date.
time-period to keep the security, then investment
cannot be recorded as held-to-maturity because this
type of investment does not reflect any intention by If the price paid for security is equal to the face
management to hold until maturity. Similarly, if the value, then the security is told to be sold at par.
security is kept ready to be converted into cash in However, the purchase price generally differs from
case of a liquidity problem or when an opportunity face value. If the security is sold at a price below
occurs in the market, it is not appropriate to record the face value, it is sold at a discount. On the other
the security in this class again. hand, if the price exceeds the face value, security
is sold at a premium7. What determines whether
it will be sold at par, at discount or at premium
Held-to-maturity securities include only is usually the difference between the interest rate
debt securities because equity securities do offered by security and the rate of return available
not have a maturity (consistent with going in the market. A security that offers an interest rate,
concern assumption). which is higher than the market return, is sold at
61
Investments
premium; whereas lower-than-market interest rate An investor should use effective interest rate in
requires a discounted price for the security to be order to calculate the amount of amortization for
sold. the period9. The effective interest rate is the interest
The amounts of premium or discount represent rate that makes the present value of all future
the difference between the face value and the cash receipts (interest plus face value) equal to the
purchase price. These amounts are amortized purchase price of security10. In other words, it is the
during the life of security (until maturity), so that real rate of return that a company gathers from debt
the total initial profit or loss (difference between security taking into account the purchase price.
purchase price paid and face value to be received
at the end) is allocated to each period. Therefore,
these securities are reported with their amortized
costs in the financial statements instead of their
fair (market) values. Besides, the fair value does
not provide useful information since the company
does not intent to terminate the investment until
it matures and the amount to receive at the end
of maturity is already determined on the face of
security. In other words, there is no holding gain
or loss incurred in held-to-maturity securities.
Additionally, the irrelevance of market value
during the life of security prevents the companies
face with highly volatile profit or losses in their
financial statements arising from the changes in
market conditions.
Fair Value is defined as the price that would

be received to sell an asset or paid to transfer
a liability in an orderly transaction between Figure 3.3
market participants at the measurement
date.8
The effective interest rate is the interest rate
that makes the present value of all future
cash receipts equal to the purchase price of
security.
1
Why does an investor amortize the discount or
premium?
2
Please, comment on the relationship among
Held-to-maturity securities are recorded the meanings of the terms “prepaid expense”,
using the amortized cost instead of fair “unearned revenue”, “discount on bond” and
values. Therefore, there is no holding gain or “premium on bond”.
loss to recognize in financial statements.
62
Accounting II
Example (Bond purchased at discount): On 1 January 2018, Investor Company has purchased the bonds
of Debtor Company by paying 187,580 TL. The bonds have 200,000 TL face value with 4 years maturity and
10% interest rate declared on it. The interest will be paid semiannually. On January 1, market interest rate is
12%.
On the date of transaction, Investor Co. paid 187,580 TL and purchased a security that will pay
200,000 TL 4 years later, in addition to 10,000 TL [(200,000 x 10%) x 6/12] interest for every six
months. Thus, ignoring the interest amount, company seems to have 12,420 TL profit (187,580 is paid
and 200,000 TL will be collected back at maturity) for this 4-years period. Then, on January 1, the entry
will be as follows:
Date Account Title and Description Debit Credit

January 1, 2018 Held-to-Maturity Securities 200,000
Cash 187,580
Discount on HTM Security 12,420*
To record the purchase of Held-to-Maturity (HTM) security at discount
* Discount amount to amortize in 4 years: 200,000 – 187,580
With the above entry, the balance sheet of Investor Company will seem like (only for relevant items):
Table 3.1 Partial Balance Sheet of Investor Company

Investor Company
Balance Sheet (TL)
January 1, 2018
Non-Current Assest
Held-to-Maturity Securities 200,000
(-) Discounts on HTM Security (12,420)
Discount on bond is a contra-asset account, which is represented to disclose asset at amortized value.
To allocate this 12,420 TL to each period, amortization is required. Table 3.2 represents the amortization
of discount amount together with interest revenue and interest collected for each payment period.
63
Investments
Table 3.2 Amortization Schedule for Discount of Bond of Debtor Co.
Date Interest Revenue Interest Amortization Amortized Value
01.01.2018 187,580
30.06.2018 11,255 10,000 1,255 188,835
31.12.2018 11,330 10,000 1,330 190,165
30.06.2019 11,410 10,000 1,410 191,575
31.12.2019 11,495 10,000 1,495 193,070
30.06.2020 11,584 10,000 1,584 194,654
31.12.2020 11,679 10,000 1,679 196,333
30.06.2021 11,780 10,000 1,780 198,113
31.12.2021 11,887 10,000 1,887 200,000
TOTAL 92,420 80,000 12,420
On June 30, 2018, Investor Company will record 11,255 TL interest revenue against the cash collection
of 10,000 TL and increase in the carrying value of security by 1,255 TL (by decreasing the discount
amount). Thus, at the end of the first six months the following entry should be prepared:

June 30, 2018 Cash 10,000
Discount on HTM Security 1,255
Interest Revenue 11,255*
To record the collection of interest on bond
* Interest revenue accrued: 10,000 TL interest on face value +1,255 TL amortization of discount
After this entry, balance sheet and income statement of Investor Company at the end of June 30, 2018
will be as follows:
Table 3.3 Financial Statements of Investor Company
Investor Company
Investor Company
Income Statement
Balance Sheet (TL)
For the period between january 1 - June 30, 2018
June 30, 2018
...
Current Assest Other Reveneus and Gains
Cash 10,000 Interest Revenue 11,255
...
Non-Current Assest
...
Held-to-Maturity Securities 200,000
(-) Discounts on HTM Security (11,165)
The following example is derived from this example to represent how to treat the bonds purchased at
a premium.
Example (Bond purchased at premium): On January 1, 2018, Investor Company has purchased the bonds
of Premium Company by paying 213,465 TL. The bonds have 200,000 TL face value with 4 years maturity and
10% interest rate declared on it; the interest to be paid semiannually. On January 1, market interest rate is 8%.
64
Accounting II
In this case, Investor Company has paid 213,465 TL to receive 10,000 TL every 6-months and an
additional 200,000 TL at the end of 4th year. The journal entry to represent the purchase of bond on
January 1 is as follows:
January 1, 2018 Held-to-Maturity Securities 200,000

Premium on HTM Security 13,465
Cash 213,465
To record the purchase of Held-to-Maturity (HTM) security at premium
* Premium amount to amortize in 4 years: 213,465– 200,000
Since Investor Company has paid 13,465 TL, more than what will be received at maturity, this premium
amount can be regarded as a kind of prepaid loss to be amortized in 4 years period. As seen in Table 3.4,
as time passes amortized value approaches the face value.
Table 3.4 Amortization Schedule for Premium of Bond of Premium Co.

Amortized
Date Interest Revenue Interest Amortization
Value
01.01.2018 213,465
30.06.2018 8,539 10,000 1,461 212,004
31.12.2018 8,480 10,000 1,520 210,484
30.06.2019 8,419 10,000 1,581 208,904
31.12.2019 8,356 10,000 1,644 207,260
30.06.2020 8,290 10,000 1,710 205,550
31.12.2020 8,222 10,000 1,778 203,772
30.06.2021 8,151 10,000 1,849 201,923
31.12.2021 8,077 10,000 1,923 200,000
TOTAL 66,535 80,000 13,465
The amortization will be done by offsetting to interest revenue as follows:
June 30, 2018 Cash 10,000

Interest Revenue 8,539*
Premium on HTM Security 1,461
To record the purchase of Held-to-Maturity(HTM) security at premium
* Interest revenue: 10,000 TL interest on face value - 1,461 TL amortization of premium
Although the bond incurs 10,000 TL interest for the first 6 months, because 1,461 TL of premium is
amortized in this period, the amount to recognize as interest revenue is 8,539 TL.
65
Investments
Available for Sale Securities

Companies may invest in debt securities, which Available for sale securities are measured
are held to be terminated in case of a cash need in with their fair values. Any change in value
the future. These securities are initially designated is reflected in balance sheets with the help
as available for sale securities, depending on the of unrealized holding gain or loss accounts.
intention of the management to keep them. Mostly
non-financial companies invest in these securities.
Available for sale securities are usually recognized Periodically received interest is recorded as
as non-current asset in balance sheet with their fair interest revenue of the period in income statement.
values (market prices). When the fair value of the Additionally, cumulative amount of unrealized
security changes, the value of investment changes, gains or losses existing in equity section are
too. Therefore, company records “unrealized transferred to income statement at the time the
holding gain” account for an increase in value available for sale debt security is terminated. In
and “unrealized holding loss” account in case of a other words, gains or losses incurred because of
decrease in value. Since these losses and gains are changes in fair value during the holding period, are
not realized yet, they are not reported as a revenue reported in income statement only when they are
or expense item in income statement. Instead, they realized.
are recorded as an item of equity in balance sheet11. Example: On January 1, 2018, Investor Company
has purchased the bonds of Debtor Company by paying
116,042 TL with the intention to get interest income
as well as protecting the company from a possible
illiquidity problem in following years. The bonds have
120,000 TL face value with 4 years maturity and
8% interest rate declared on it. The interest will be
paid semiannually. On January 1, market interest
rate is 9%.
Figure 3.4
Table 3.5 Amortization Schedule for Discount of Bond of Debtor Co.
Date Interest Revenue Interest Amortization Amortized Value
01.01.2018 116,042
30.06.2018 5,222 4,800 422 116,464
31.12.2018 5,241 4,800 441 116,905
30.06.2019 5,261 4,800 461 117,366
31.12.2019 5,281 4,800 481 117,847
30.06.2020 5,303 4,800 503 118,351
31.12.2020 5,326 4,800 526 118,876
30.06.2021 5,349 4,800 549 119,426
31.12.2021 5,374 4,800 574 120,000
TOTAL 42,358 38,400 3,958
66
Accounting II
Initial purchase and subsequent amortization records are the same as held-to-maturity securities;
therefore, they will not be repeated in this part. The difference in measurement of HTM securities and
available for sale securities is that available for sale securities are measured and reported with their fair
values, although the premium/discount is still amortized in periods. To illustrate how the change in fair
value is reflected in accounting records, assume that at the end of 2018 the market interest rate has
increased to 11% resulting in a fair value of 111,008 TL (present value of future cash flows with 11%
discount rate).
It is shown in Table 5 that the carrying value (amortized value) of the bond as of 31.12.2018 is 116,905
TL. Since the fair value of bond has decreased below the carrying value, there should be an adjustment on
the value of available for sale security. The required entry is as follows:
31.12.2018 Unrealized Holding Loss 5,897
Available for Sale Securities 5,897*
To adjust amortized value of Available for Sale Security to Fair Value
* Adjustment in Value: Amortized Value (116,905 TL) – Fair Value (111,008 TL)
Sale of Available for Sale Debt Securities

Assume that Investor Company sold the bond on 31 December, 2020 (before maturity) for 120,000
TL. On the same day, amortized value of the bond is 112,889 TL (114,103 TL value after adjustment –
1,124 TL Discount on Bond) as represented in T accounts below.
Available For Sale Security

01.01.18 Purchase 120,000 31.12.18 Decrease in Fair Value 5,897
Balance 114,103
Discount on A.F.S. Securities

30.06.18 Amortization 422 01.01.18 Discount 3,958
31.12.18 Amortization 526
Balance 1,124
The sale of bond for 120,000 TL seems to generate a total gain of 7,111 TL for Investor Company.
However, this amount arises, in some part, because of the reversal of the previously recognized decreases
in fair value of the bond by 5,897 TL. In this case, the entry to record the sale of bond on 31 December,
2020 is as follows:
67
Investments

December 31, 2020 Cash 120,000
Discount on A.F.S. Securities 1,124
Gain on Sale of Securities 1,214*
Unrealized Holding Loss 5,897
Available for Sale Securities 114,103
To record the sale of Available for Sale Security
* Gain = 120,000 TL Sales – 114,103 TL Carrying Value – 5,897 TL Closing holding loss account
Trading Securities
Trading refers to the purchase and resale of an
item. Therefore, when a company purchases a debt
security with an aim of reselling for a higher price,
this security is classified as trading security. In other
words, companies invest in debt securities to have
return on them in terms of capital gains, as well as
interest revenue. Capital (holding) gain is the profit
generated from an investment arising from the
change in value.
When a company purchases a debt security

with the aim of reselling for a higher price,
this security is classified as trading security.
Companies invest in trading securities with the Figure 3.5

aim of reselling in the market in one-year period
(similar to inventories). Thus, trading securities are
classified as current asset. In the representation of Trading securities are reported in current assets
these items, companies use fair (market) values. In at fair value, with any change in value being
other words, any change in market value is reflected considered in the calculation of net income.
in the carrying value of trading security. At the same No discount or premium is amortized.
time, an item for unrealized holding gains or losses
is recognized in the income statement. Valuation
of trading security differs from available for sale Example: On 5 May, 2018 Investor Company
securities at this point that changes in value are not have purchased a Treasury bill for 130,000 TL. The
reflected in income statement for available for sale Treasury bill has 180 days maturity and a face value
securities. Additionally, since the trading securities of 150,000 TL.
are hold to be sold in short-term period (similar to • On 30 June, 2018 which is a financial
inventories), there is no need to amortize a discount reporting day for Investor Company, the
or premium for these securities, opposite to other market value of the bond has increased to
equity securities. 138,000 TL.
• Company has sold the bond for 145,000 TL
on 20 August, 2018.
68
Accounting II
The initial journal entry to record the purchase of Treasury Bill is prepared as follows:

May 5 Trading Securities (T-bills) 130,000
Cash 130,000
To record the purchase of 180 days Treasury Bill as trading security
According to the case, the aforementioned Company makes semiannual adjustment on June 30. The
treasury bill under question is a trading security; thus, the value of T-bill should be adjusted to up-to-date
market value of 138,000 TL. The required adjusting entry is presented below:

June 30 Trading Security (T-bills) 8,000*
Unrealized Holding Gain 8,000
To record the adjustment of the value of Trading Security to Fair Value
*Adjustment amount: 138,000 TL fair value – 130,000 TL carrying value before adjustment
As of July 1, the T-bills will be represented in the balance sheet of Investor Company as 138,000TL by an increase
of 8,000 TL in fair value. With the above entry, Investor Company also recognizes 8,000 TL gain in income statement.
When Investor Company sells the T-bill for 145,000 TL, the amount to record as profit is not 15,000
TL (145,000 TL – 130,000 TL) because 8,000 TL of this increase in value has already been recognized
until the last adjustment date of June 30. Therefore, company will record only 7,000 TL gain on sale of
trading security, with the following journal entry:

August 20 Cash 145,000
Trading Security (T-bills) 138,000
Gain on Sale of Trading Securities 7,000*
To record the sale of Trading Security
*Gain on Sale to record in unadjusted period: 145,000 TL sales – 138,000 TL carrying value
INVESTMENTS IN EQUITY SECURITIES

Another option for companies to invest their excess funds in is equity securities. Equity securities are the
instruments representing the ownership interest in an entity, such as common stocks, preferred stocks, etc. The
initial value of security to record in balance sheet includes purchase price and other incidental expenditures
such as brokerage commission and taxes. However, the subsequent accounting treatment for equity investment
changes depending on the rate of ownership and influence acquired by investor on investee. The name by which
an equity investment is represented in balance sheet depends on the percentage of ownership of the investor:
• Ownership Percentage is less than 20% “Available
for Sale” or “Trading Security”.
In an investment process, the investing party
• Ownership Percentage is between 20% and 50%
is called “investor” while invested company
“Affiliate”.
is called as “investee”.
• Ownership Percentage is more than 50%
“Subsidiary”.
69
Investments
Figure 3.6
Holdings of less than 20 Percent (Minority, Passive Investments)

When a company invests in another corporation up to 20% of total outstanding shares, it is assumed
that the investor company does not possess an important role in determination of company policies. In other
words, this investment does not represent a managerial role in invested company. In this case, depending on
the intention of management, the security can be reported either as trading security or available for sale security.
Trading Securities
If the aim of management is to generate profit from price changes in short term, the security is recorded
as trading security (same as in debt securities). Trading securities are initially recorded with their acquisition
costs (purchase price plus other costs related to purchase). However, subsequent measurement is done
using the fair (market) values. Any change in
fair values of trading securities are reflected
in income statement as Unrealized Holding
Gains or Losses, while decreasing the value of
security in the balance sheet.
Example: On 12 November, 2018 Investor
Company purchased 1,200 shares of Equitor
Corporation by paying 1.50 TL/share. Investor
also paid an additional 120 TL as brokerage
commission for this transaction. On the balance
sheet date, market price for each Equitor share
is 2.00 TL.
On November 12, 2018 Investor Company
prepares the following journal entry to record
Figure 3.7
the purchase of this trading security:

November 12, 2018 Trading Security (Common Stock) 1,920*
Cash 1,920
To record the purchase of Trading Security (Common Stock)
* Acquisition Cost: (1,200 shares x 1.50 TL/share) + 120 TL Brokerage Fee
70
Accounting II
At the balance sheet date, the market value of Equitor share is 2.00 TL. This means that value of
investment should be adjusted to 2.00 TL/ share. To do that, the following entry is recorded:

December 31, 2018 Trading Security (Common Stock) 480*
Unrealized Holding Gain 480
* Adjustment Amount: (1,200 shares x 2 TL/share) – 1,920 TL carrying value before adjustment
After this adjusting entry at the balance sheet date, the ledger of Trading Securities account will seem as:
Trading Securities
12.11.18 Purchase 1,920

31.12.18 Fair Value Adjustment 480
Balence 2,400
Besides capital gain, investing companies may also incur dividends revenue in the period they hold
the security. However, dividend revenue is not a regularly recurring revenue that occurs every year. The
occurrence of dividend revenue depends on the dividend payout decision of the investee. If an investee
decides to distribute dividend from net income and declares this decision to the public, then investors can
recognize dividend revenue in their income statements, concurrently with Dividend Receivable account
in the balance sheet.
Suppose that on December 15, Equitor Corp. has decided to distribute 0.50 TL for each outstanding share
for the year 2018. In this situation, Investor Company has earned dividends revenue of 600 TL (0.50 TL
x 1,200 shares owned). The required entry will be as follows:

December 15 Dividends Receivable 600
Dividends Revenue 600
To record the dividends declared by investee
When the investor sells the shares, any gain or loss from this sales transaction is calculated based on the
carrying value determined after the last adjustment. Suppose that Investor Company sold half of the stocks
for 1,320 TL on 18 January 2019.

January 18, 2019 Cash 1,320
Trading Security (Common Stock) 1,200
Gain on Sale of Trading Security 120
To record the sale of Trading Security (Common Stock)
Investor Company generated 120 TL profit from this sale because the total fair value of Equitor
Company shares after the last adjustment was 2,400 TL and Investor Company sold half of these stocks
for 1,320 TL.
71
Investments
Since 600 shares are sold in the market for 1,320 TL, this means the market value of Equitor Corp.
shares is 2.20TL/share. Investor Company still owns 600 shares of Equitor Corp. Therefore, company
adjusts the remaining values of shares with the following entry:

January 18 2019 Trading Security (Common Stock) 120*
Unrealized Holding Gain 120
* Adjustment amount: (2.20 TL/share – 2.00 TL/share) x 600 shares
After the sales and adjustment records, the ending ledger for Trading Security is as follows:
Trading Securities
12.11.18 Purchase 1,920 18.01.19 Sold 1,200

31.12.18 Fair Value Adjustment 480
18.01.19 Fair Value Adjust. 120
Balance 1,320
Available for Sale Securities

When an investor company purchases less than 20% of another company without an initial intention
to generate profit from price changes in short-term, the security is classified as Available for Sale Security.
Very similar to trading securities, available for sale securities are recognized with their acquisition costs
and are subsequently measured by the fair (market) value. The main difference arises in where the changes
in fair value are recorded. As stated in trading securities, any change in fair value is directly reflected in
income statement. However, changes in fair value for available for sale securities are not recognized as a
part of net income, rather they are recorded to equity with the account name “Unrealized Holding Gains
or Losses”.
Although the accounting treatment is quite similar to that of available for sale debt securities, an
example is provided below just to remind.
Example: On December 12, Investor Company has purchased 2,000 shares of Equitor Corp. by paying
3.00 TL for each share. Additionally, the company paid 600 TL for brokerage fees, taxes and other fees, as well.
• On December 19, Equitor Corporation declared to pay 0.10 TL dividend for each outstanding share.
• On December 31, the market value for Equitor Corporation shares was 2.80 TL/share.
• On January 5, Equitor Corporation has paid the dividends.
• On January 15, Investor converted each share into cash, when the market value of an Equitor share
drastically increased to 4.00 TL/share.
When the shares are purchased on December 12, Investor Company will prepare the record presented
below:

December 12 Available for Sale Securities (Common Stock) 6,600*
Cash 6,600
To record the purchase of Available for Sale Security (Common Stock)
* Cost of Share: Purchase price (2,000 shares x 3.00 TL) + Other Purchase related Fees (600 TL)
72
Accounting II
Declaration of 0.10 TL/share dividend means that Investor Company has a dividend revenue incurred
in the period by 200 TL (2,000 shares x 0.10 TL/share). However, the amount will be received in the
future. Therefore, the company prepares the following entry:

December 19 Dividends Receivable 200
Dividends Revenue 200
To record the dividend revenue from Equitor Corp.
On the balance sheet date, the carrying value of common

stocks must be adjusted to the market value according
to mark-to-market rule. Mark-to-market rule states that
Mark-to-market rule states that marketable
marketable securities should be represented in financial
securities should be represented in financial
statements with their market values as of the reporting date12.
statements with their market values as of the
reporting date. Therefore, the carrying value of Equitor shares must be
decreased to 2.80 TL/share in the balance sheet of Investor
Company with the following adjustment:

December 31 Unrealized Holding Loss 1,000*
To record unrealized holding gain for Equitor Corp. shares
* Adjustment amount: Carrying Value (6,600 TL) - Market Value of Shares (2.80 TL x 2,000 shares)
Since Investor Company reports its investment in Equitor Corporation shares as Available for Sale
securities, the unrealized loss of 1,000 TL will be recorded as an item of Equity, rather than an item of
income statement.
On January 5, when Equitor Corporation pays the dividends that were declared on December 19,
Investor Company collects 200 TL in cash and has no remaining dividends receivable any more.

January 5 Cash 200
Dividends Receivable 200
To record the cash collection from dividends.
When the shares are sold for 4.00 TL/share on January 15, company recognizes a realized gain on sale
of these shares. The required entry is:

January 15 Cash 8,000*
Unrealized Holding Loss 1,000

Gain on Sale of Marketable Sec. 1,400
To record sale of Available for Sale Securities
* Proceeds from Sales: 4.00 TL/share x 2,000 shares
73
Investments
Investor Company has generated a revenue

of 8,000 TL by selling the shares, which were
purchased from 6,600 TL. In other words, company
has generated 1,400 TL capital gain from this
investment. Available for Sales Securities account
is closed by crediting 5,600 TL because of the last
adjustment made on December 31 (carrying value
of Equitor shares was decreased to 5,600 TL from
6,600 TL). The amount of loss (1,000 TL) that
was recognized (but not realized) in Equity section
with last adjustment is also closed, resulting in an
increase in equity by 1,000 TL. As seen, although
Figure 3.8
Investor Company seems to make 2,400 TL profit
by selling shares with a carrying value of 5,600 TL When an investor owns more than 20% but less
for 8,000 TL, 1,000 TL of this profit is reflected as than 50% of invested company providing a significant
an increase in equity in order to reverse the decrease influence, the investee is reported as “affiliate” in the
recognized in the previous period. balance sheet. In this case, investors should initially
recognize the affiliate with acquisition cost and use
Holdings between 20 Percent and 50 “equity method” 13 for subsequent valuation for this
Percent (Minority, Active Investments) investment, instead of fair value method used for
the equity investments representing lower than 20%
Companies may invest in other in the shares of
ownership. The underlying logic in using this kind of
the other companies’ shares at such a percentage
an accounting method in affiliates is that the investor
that is enough to join policy determination process
company is also a part of success or failure of investee,
but not to control the entity. Generally, it is
as it participates in financial and operational decisions
assumed that having at least 20% of the shares of
to be applied. Therefore, any change in equity of the
a company gives an investor the right and power
investee should also be reflected in investor’s financial
to participate in policy determination process;
statements proportionately with the rate of ownership.
however, some possible exceptional situations may
For example, if an investor owns 40% of a company,
exist. For example, a company owning 35% of a
40% of that company’s income is recorded as income
company may not possess significant influence
of the period in investor’s income statement, too. On
in decision making if another investor has more
the other hand, dividend distributions cause decreases
than 50%. Significant influence can be defined as
in equity of the investee concurrently with the carrying
the power to participate and have affect on policy
value of affiliates account in investor’s balance sheet.
determination process of investee.
Investors should use equity method as the

Significant influence can be defined as the
accounting treatment for affiliates because
power to participate and have affect on
an investor. Because, investor has significant
policy determination process of investee.
influence on decisions that result in success
or failure of investee’s operations.
3
4
If the investor owns only 10% of investee, but
What happens if the share of investor in investee’s
60% of investee’s total sales is generated from the
loss exceeds the carrying value of Affiliates? Do you
investor, how should the investor account for this
think that the investor should recognize additional
investment?
losses? Why/why not?
74
Accounting II
Example: On 23 February, 2018 Investor Company paid 135,000 TL including brokerage commissions,
taxes and other fees and bought 35% of Equitor Corporation.
• On December 31, Equitor Corp. has reported 200,000 TL net income for 2018.
• On 31 March, 2019 Equitor Corp declared and paid 10,000 TL dividend.
• In 2019, Equitor Corp. had 50,000 TL loss reported at the bottom line of income statement.
• On 27 May, 2020 Investor Company sold the shares for 204,000 TL and received cash.
The initial journal entry to record on the time of purchase on 23 February, 2018 is as follows:

February 23 Affiliates 135,000
Cash 135,000
To record the investment in 35% of Equitor Corp.
Income statement of Equitor Corp. (investee) represents 200,000 TL net income for 2018, meaning
an increase in equity by 200,000 TL. Since Investor Company owns 35% of Equitor Corp., the value of
affiliate account in balance sheet of Investor Company has also increased by 70,000 TL (35% x 200,000
TL). Then, the required entry is:

December 31 Affiliates 70,000
Revenue from Affiliates 70,000
To record the revenue from affiliate (Equitor Corp.)
Declaration of 10,000 TL dividend causes the equity of Equitor Corp. decrease by 10,000 TL, resulting
in a parallel decrease in the carrying value of affiliates account by 3,500 TL (35% x 10,000 TL). The entry
for collection of dividend and adjustment of the carrying value is as follows:

March 2019 Cash 3,500
Affiliates 3,500
To record the dividend received from affiliate (Equitor Corp.)
Financial results show that Equitor has 50,000 TL loss for the year 2019. The effect of this loss to
financial statements of Investor Company is reflected with the following entry:

December 31 Loss from Affiliates 17,500*
Affiliates 17,500
To record the loss from affiliate (Equitor Corp.)
* Loss from affiliates = 50,000 TL Total Loss in Affiliate x 35% share in Affiliate
Because losses decrease the net asset of a company, the investors’ wealth is also negatively affected by
investees’ losses. To represent the decrease in investor’s assets, affiliates account is credited, while the loss is
recognized in income statement to reflect a decrease in equity, as well.
75
Investments
On 27 May, 2020 Investor Company terminated the investment in Equitor Corp. in exchange for
204,000 TL cash. The ledger of Affiliates account shows that the carrying value at this date is 184,000 TL.
Affiliates
23.02.18 Purchase 135,000 31.03.2019 Dividends 3,500

31.12.2018 Revenue from 70,000 31.12.2018 Revenue from 17,500
Affiliates Affiliates
Balance 184,000
The required journal entry to represent the sale of Equitor Corp. shares on May 27 is:

May 27 Cash 204,000
Affiliates 184,000
Gain on Sale of Affiliates 20,000
To record the loss from affiliate (Equitor Corp.)
Holdings of more than 50 Percent (Majority, Active Investments)

When the rate of ownership in invested company exceeds 50 percent, the investor is assumed to
have control over the investee because in any case the decision is taken by the investor as more than
half of the shares belongs to him. The investor company is called parent and the investee is subsidiary.
In case of investments over 50%, parent company consolidates the financial statements of subsidiary.
Consolidation means that parent company adds all financial statement items of the subsidiary to his own
financial statements (after some eliminations and adjustments) and prepares a joint financial statement set
combining the financial values of the both of the companies. In other words, parent and the subsidiary
are considered together as a single company and are required to prepare a single financial statement set.14
Claims of other owners are represented in the consolidated financial statement as “minority interest”.
Consolidation means that parent company

adds all financial statement items of the
subsidiary to his own financial statements
The investor company is called parent and (after some eliminations and adjustments)
the investee is subsidiary. and prepares a joint financial statement set
combining the financial values of the both of
the companies.
Figure 3.9
76
Accounting II
DERIVATIVES AS CONTRACTUAL promises to deliver a specified quantity of stocks

INVESTMENTS or commodities at a specified price at maturity for
an agreed-upon price.16 If the price of asset goes in
Derivatives are the contracts that provide payoffs
the expected direction an investor generates profit,
to investors depending on the values of other assets
if the price moves in the opposite direction an
that they are derived15 from. A derivative is not an
investor makes loss.
asset itself, it is a contract produced on assets, such
as shares, commodities, etc. In other words, what is In accounting for derivatives, it should be
bought by a derivative is the promise to buy or sell considered that since derivative contracts refer
an asset in the future upon execution of contract. In to the rights or obligations to be exercised in the
the initiation of a derivative investment, an investor future, they should be recognized as assets or
makes only a margin investment to purchase the liabilities. They should be recognized at their fair
promise. The profitability on derivative depends on values in the balance sheet, and any profit realized
the accuracy in prediction of the price movement from price changes should be recognized in the
of share or commodity. income statement as profit / loss from derivatives17.
Derivatives are recognized in balance

Derivatives are the contracts that provide
sheet with their fair values. Profit/Loss
payoffs to investors depending on the values
from derivatives is reported in the income
of other assets that they are derived from.
statement.
Companies may invest in derivatives as a

hedging instrument, as well as an investment
tool. Investors protect themselves from having
huge amounts of losses resulting from unexpected
volatility (in amount or direction) by investing their
cash in derivatives, instead of direct investments. If
the derivative contracts are purchased as hedging
tools, then the accounting treatment for them
differs from derivatives as investment instrument.
However, the subject of accounting for hedging
instruments is out of scope of this chapter.
Figure 3.10
TRANSFERS BETWEEN
CATEGORIES
The two most common types of derivative Independent from which investment alternative
instruments are options and forwards or futures is initially chosen, companies may change their
contracts. Investing in an option contract gives the intentions to keep the securities. This change in
investor the right, but not obligation, to buy or sell intention may result in change in classification,
a predetermined quantity of financial instruments too. Whichever pair of investment categories is
in future at a specified price. While a call option considered (among all investment alternatives)
gives right to buy instruments, a put option does not matter, transfers between categories are
provides the selling right. If the price of asset does accounted for at fair value on the date of transfer.
not move in the expected direction, an investor For example, if an investor decides to keep the
does not exercise the promise and loss is limited to investment, which is previously recorded as
initial margin invested to buy the contract. In the available for sale security until it matures, then
forward contracts, on the other hand, an investor the security should be reclassified and accounted
77
Investments
for as a held to maturity security. To transfer the When a company reclassifies an investment,
security into HTM category, the fair value should other securities in the same category should be
be determined. Once the fair value is known, reviewed, too. However, an investor is allowed
it will be the basis for all calculations (regarding to reclassify only some part of a category when
the discounts or premiums etc.). Additionally, needed.
the amount of unrealized holding gains or losses, When securities are reclassified between the
which were reported as a separate item in equity available for sale and trading categories, the
before, will be amortized over the remaining life unrealized holding gains or losses that incur at the
of security. transfer date are recognized in income statement
and the securities are valued at fair value as the new
cost basis.
5
Please, comment on the following case in terms of the
In Turkey, it is forbidden to reclassify a
required accounting treatment: What happens if the
security from trading securities to any other
investor changes the category from held-to-maturity
form.
to available for sale category?
78
Accounting II
Further Reading
“Recent decades have witnessed a dramatic shift in the nature of risk in global financial markets
and increased volatility of many asset classes…”
As investors are continuously exposed to a broad range of dynamic risks, derivatives have become a valuable
tool in the risk management practices of institutions. Despite the potential for derivative instruments to effectively
manage the risks faced by institutions, public opinion concerning these securities suggests the general public
view derivative securities as inherently dangerous (McGough 1995). Anecdotes such as Long-Term Capital
Management (LTCM) in the US, Barings Bank in the UK, and the foreign exchange episode occurring at
National Australia Bank in 2004, highlight the potential hazards of derivative use, and have attracted the close
attention of risk management executives, investors, governments, market regulators, as well as the media.
Regulators attempting to prevent corporate failure associated with derivatives usage have relied on mandated
disclosure. In contrast, regulation of derivative use in the Australian investment management industry has not
required quantitative disclosure, but rather design features, implementation of risk management policies, and
constraints placed on the use of derivatives. The Australian Prudential Regulation Authority (APRA) prescribes
that derivatives may not be used for speculative purposes, and managed funds cannot hold uncovered positions
in derivatives. Derivative use must also be conducted within the confines of the trust deed.
Theoretical literature proposes that derivatives provide users with efficiency benefits in the form of reduced
transaction costs and improved risk control (Merton 1995). The extant literature on derivative usage focuses on
corporate hedging rather than derivative use within the investment management industry. There are only a few
studies, which directly analyze the use of derivatives by investment managers.
Despite these alleged benefits, several studies from both the corporate and investment management literature
have found that the risk and return characteristics of derivative users are indeed similar to those of non-users.
Specifically, Koski and Pontiff (1999) examine mutual fund return distributions of derivative users and non-
users, and they conclude that derivatives do not lead to significant differences in fund performance or risk.
Pinnuck (2004) shows that Australian equity managers utilize options to both increase or decrease exposure to
underlying stocks held in the fund. However, Pinnuck does not attempt to infer the motivation for derivative use
by portfolio managers.
Source: Kingsley FONG, David R. GALLAGHER and Aaron NG “The Use of Derivatives by
Investment Managers and Implications for Portfolio Performance and Risk” International Review of
Finance. Vol. 5 No: 1–2, 2005: pp. 1–29
79
Investments
Inside Practice
The Best Investment Strategies

The best investing strategies are the ones that work best for the investors’ objectives and risk tolerance
patterns; rather than those providing the highest historical return. The best investment strategy is the one
that works best for the characteristics and objectives of an investor. Some strategies for determining the
investment habits are provided below18:
Fundamental Analysis: Fundamental analysis is one of the oldest and most basic forms of investing
styles. In this strategy, before deciding on which stocks to invest in, an investor should analyze the financial
statements of possible investees in order to select quality stocks19. Data gathered from the financial
statements can be used in evaluating the financial position and performance of the company compared
to previous years’ results as well as results of other companies in the same industry. By considering all the
evaluations, an investor may arrive at reasonable prices for the available stocks.
Technical Analysis: In technical analysis, investors consider recent trends and price patterns that a
share represents in the market as a way to predict future price movements. In other words, investors use
some indicators that provide signals on the direction of price movement. Usually charts are preferred,
and there are predetermined shapes that refer to patterns that the price of a share is expected to follow,
and these patterns arise from past experiences on that share. Fundamental data, such as P/E ratio, is not
considered in technical analysis where trends and patterns are prioritized overvaluation measures.
Value Investing: In this strategy, investors look for stocks selling at a “discount”. Index funds or
actively-managed funds that hold value stocks are also good alternatives for investors because investors save
both time and energy by not analyzing the financial statements and looking for value stocks.
Growth Investing: Growing shares perform best when an economy grows at an healthy rate. In a
growing economy, all market participants have higher expectations and spend more funds to survive the
growth. Even if a company is highly valued, the positive expectations on the market may incur expectations
on continuation of growth in that share, with a growing economic structure.
Buy and Hold: The main logic of this strategy is that a share can provide a reasonable return by just
holding for a longer period, despite the volatility characteristic of short-term periods. By applying a more
stable holding strategy, rather than more frequently buying at low and reselling for higher prices, an
investor may generate less return; however, less frequent trading minimizes trading costs, that results in an
increase in the overall net return of the investment portfolio.
Modern Portfolio Theory: By applying this theory as an investing method, an investor attempts to take
a minimal level of market risk to capture maximum-level returns. The key to achieve maximum income
with least risk is diversification20, which means investing in a security that is high in risk individually, but
when combined with several other investments, the whole portfolio can be balanced in such a way that its
risk is lower than some of the underlying assets or investments.
Post-Modern Portfolio Theory (PMPT): This theory refers to a part of behavioral finance literature,
as it suggests that investors perceive the risk asymmetrically21. This means that investors reactions to losses
are not the same as their reactions to gains, and investors do not always act rationally. Therefore, behavioral
patterns of investors should also be considered rather than only the mathematical model that Modern
Portfolio Theory follows.
Tactical Asset Allocation: Tactical asset allocation is an investment strategy that is based on forming
a balanced portfolio from both debt and equity securities and adjusting with the intention of maximizing
portfolio returns and minimizing risk compared to a benchmark. The first focus is on asset allocation,
and then the investment selection comes in this type of investment strategy, different from the technical
analysis and fundamental analysis.
Discuss:
1) What is the key point in deciding on an investment strategy to apply?
2) What is the relationship between risk and return?
3) Is it better to invest in only one security or to form a portfolio of securities with different specifications?
4) How long should it take to provide the required return from an investment; 3 months, 1 year, or more?
80
Accounting II
Explain why companies invest

LO 1 in debt and equity securities and
classify investments
In order to maximize the income through investments, companies have to choose the best alternative
among many different ones. Management intention significantly determines the classification of an
investment instrument (security), and this may cause different accounting treatments for the same
instrument. Companies may direct their excess funds into two main groups of alternatives. In a very
general classification, investors can direct their funds into two different types of securities:
Summary
a. Debt Securities
b. Equity Securities
Investments in debt and equity securities are classified as either temporary (short-term) or long-term. For
purposes of valuation and reporting at a financial statement date, short-term and long-term investments
must be further classified as trading securities, available-for-sale securities, or held-to-maturity securities.
Describe and illustrate how to account

LO 2 for investments in debt securities
The security that represents a credit relationship with another entity upon issuance is called debt security.
Measurement and accounting treatment for a debt security differs among the categories. Recognition and
subsequent treatment for the three categories are explained below:
1. Held-to-maturity Securities: An investor classifies the HTM security as either current or non-current
asset depending on its maturity. Interest revenue is accrued by an investor for every fiscal year until
the maturity, and finally security is converted into cash with the face value upon delivery to the issuer.
During the life of security amortization is applied to the premium or discount incurred at the time of
purchase and the amount of amortization for the period is offset/added to interest revenue.
2. Available for Sale Securities: The term “avaliable for sale securities” is usually recognized as non-current
asset in balance sheet with their fair values (market prices). When the fair value of the security changes,
the value of investment changes, too. Therefore, company records “unrealized holding gain” account
for an increase in value and “unrealized holding loss” account in case of a decrease in value. Since these
losses and gains are not realized yet, they are not reported as a revenue or expense item in income
statement. Instead, they are recorded as an item of equity in balance sheet.
3. Trading Securities: Trading securities are classified as current asset. In the representation of these items,
companies use fair (market) values. In other words, any change in market value is reflected in the
carrying value of trading security. At the same time, an item for unrealized holding gains or losses
is recognized in the income statement. Valuation of trading security differs from available for sale
securities at this point that changes in value are not reflected in income statement for available for sale
securities. Additionally, since the trading securities are hold to be sold in short-term period (similar to
inventories), there is no need to amortize a discount or premium for these securities, opposite to the
other equity securities.
81
Investments
Define and clarify how to

LO 3 account for investments in equity
securities
Equity Securities are the instruments representing the ownership interest in an entity, such as common
stocks, preferred stocks, etc. The name by which an equity investment is represented in balance sheet
depends on the percentage of ownership together with the management intention to invest:
Percentage Owned by Investor Category
Summary
1. 0 < Ownership Percentage < 20% “Available for Sale” or “Trading Security”
2. 20 < Ownership Percentage < 50% “Affiliate”
3. 50 < Ownership Percentage “Subsidiary”
1. Available for Sale or Trading Security: Up to 20% ownership the management intention and definition
(in the main frame) is the same as in their definitions in debt securities.
2. Affiliate: From 20% up to 50% of ownership, an investor is accepted to have significant influence in
an investee, meaning that an investor has right and power to participate in financial and operational
decisions and strategy determination process of an investee. The investee is recorded in financial
statements of the investor company as “Affiliate”.
3. Subsidiary: When the rate of ownership exceeds 50%, an investor is suggested to have right to possess
control over the investee. This investor is known as “parent” and the investee as “subsidiary” in this
kind of investments.
The initial value of security to record in balance sheet includes purchase price, and the other incidental
expenditures such as brokerage commission and taxes. However, the subsequent accounting treatment for
equity investment changes depending on the rate of ownership and influence acquired by investor on an
investee. The accounting treatments for all categories of equity investments are presented below:
1. Investments up to 20%
a. Available for Sale Securities: These securities are recorded at acquisition cost when they are
purchased. Although amortization is applied for discounts and premiums on purchase, subsequent
measurement is done using the market value. The increases or decreases in their value are recorded
as “Unrealized Holding Gains” or “Unrealized Holding Loss” in equity and are not included in
calculation of net income for the period.
b. Trading Securities: Trading securities are recorded at acquisition cost when they are purchased.
Subsequent measurement is done by using the market value. The increases or decreases in their
value are included in net income with items of “Unrealized Holding Gains” or “Unrealized
Holding Loss” reflected in income statement.
2. Investments between 20% and 50%
Investors use an equity method to account for affiliates. In this method, an investment is initially recognized
with the acquisition cost, and afterwards the changes in an investee’s equity is proportionately reflected
in an investor’s financial statements, too. The income generated by an investee is recorded in income
statement as “Revenue from Affiliates” or “Losses from Affiliates”. Any dividend that the investee declares,
cause a decrease in Affiliate account proportionately with the extent of ownership.
3. Investments more than 50%,
When the investor buys more than 50% of total shares of investee, the accounting treatment is
consolidation. By consolidating the financial statement of investee, the investor prepares a single set of
financial statements combining two separate statement sets of both the investor and investee together.
82
Accounting II
Identify and categorize

LO 4 derivatives
Derivatives are the contracts that provide payoffs to investors depending on the values of the other assets
that they are derived. A derivative is not an asset itself, it is a contract produced on assets, such as shares,
commodities, etc. In other words, what is bought by a derivative is the promise to buy or sell an asset in
the future upon execution of contract. In the initiation of a derivative investment, an investor makes only
a margin investment to purchase the promise.
Summary
The two most common types of derivative instruments are options and forwards or futures contracts.
Investing in an option contract gives the investor the right, but not obligation, to buy or sell a
predetermined quantity of financial instruments in future at a specified price. While call option gives
right to buy instruments, a put option provides the selling right. In the forward contracts, on the other
hand, the investor promises to deliver a specified quantity of stocks or commodities at a specified price
at maturity for an agreed-upon price.
Determine how to transfer

LO 5 between categories
Independent from which investment alternative is initially chosen, companies may change their intentions
to keep the securities. This change in intention may result in change in classification, too. Whichever
pair of investment categories is considered (among all investment alternatives) does not matter, transfers
between categories are accounted for at fair value on the date of transfer. When a company reclassifies an
investment, the other securities in the same category should be reviewed, too. However, investor is allowed
to reclassify only some part of a category when needed.
When securities are reclassified between the available for sale and trading categories, the unrealized holding
gains or losses that incur at the transfer date are recognized in income statement and the securities are
valued at fair value as the new cost basis.
83
Investments
1 Which of the following instruments is a debt 6 If the bond with 100,000 TL fair value is
security? sold for 95,000 TL, the bond is sold
A. Common Stock A. at par
B. Preferred Stock B. at premium
Test Yourself
C. Cash C. at maturity
D. Treasury Bond D. at Profit
E. Accounts Payable E. at discount
2 Which of the following instruments is an 7 In Available for Sale Debt Securities, amount
equity security? of amortization of a premium on the bond is
A. Common Stock recorded in
B. Corporate Bond A. income Statement as increase in Sales Revenue
C. Cash B. equity as Amortization Surplus
D. Notes Payable C. income Statement as an increase in Interest
E. Accounts Receivable Revenue
D. income Statement as a decrease in Interest
3 What is the main motivation for investors to Revenue
invest? E. available for Sale Securities as an increase in
A. Provide financing carrying value
B. Use excess inventories
C. Establish new partnerships On November 6, ÖzSer Company has bo-
D. Increase Sales Volume ught 12,000,000 shares of Satlık Corporation,
E. Generate Income which has 40,000,000 outstanding shares in to-
tal, by paying 1,200,000 TL cash. Satlık Corp.
4 Which of the following securities cannot be reported a net income of 100,000 TL at the end
represented as equity investment? of year. The market value of Satlık Corp. shares
is 0.13 TL per share at the balance sheet date.
A. Held to Maturity Securities
Please answer the questions 8 - 10 using the
B. Affiliates
information presented above.
C. Subsidiaries
D. Available for Sale Securities
E. Trading Securities
8 ÖzSer Company will make the following
record on November 6:
5
Held-to-Maturity Securities are accounted by A. Debit Subsidiaries by 1,200,000 TL; Credit
using: Cash by 1,200,000 TL
B. Debit Affiliates by1,200,000 TL; Credit Cash
A. Equity Method by 1,200,000 TL
B. Amortized Value C. Debit Marketable Securities by 1,200,000 TL;
C. Fair Value Credit Cash by 1,200,000 TL
D. Cost D. Debit Available for Sale Securities by 1,200,000
E. Revalued Cost TL; Credit Cash by 1,200,000 TL
E. Debit Affiliates by 30,000TL; Credit Revenues
from Affiliates by 30,000TL
84
Accounting II
9 At the balance sheet date, investment will be 10 If Satlık Corporation had 80,000,000
valued by outstanding shares in total and main aim of ÖzSer
A. Cost of 1,200,000 TL Company was to have profit from increase in the
value of shares in 2 months, investment would be
B. Fair Value of 1,560,000 TL (Increase reported
valued at the balance sheet date by
in Equity)
C. Carrying Value of 1,300,000 TL (by adding A. Cost of 1,200,000 TL
Test Yourself
100,000 TL Income) B. Fair Value of 1,560,000 TL (Increase reported
D. Fair Value of 1,560,000 TL (Increase reported in Equity)
in Income Statement) C. Carrying Value of 1,300,000 TL (by adding
E. Carrying Value of 1,230,000 TL (by adding 100,000 TL Income)
30,000 TL Income) D. Fair Value of 1,560,000 TL (Increase reported
in Income Statement)
E. Carrying Value of 1,230,000 TL (by adding
30,000 TL Income)
85
Investments
If your answer is wrong, please review the

1. D If your answer is wrong, please review the 6. E
“Investment in Debt Securities – Held to
“Investment in Debt Securities” section.
Maturity Securities” section.

2. A If your answer is wrong, please review the 7. D
“Investment in Debt Securities – Available
“Investment in Equity Securities” section.
for Sales Securities” section.

3. E If your answer is wrong, please review the 8. B
“Investment in Equity Securities – Holding
“Introduction” section.
between 20% and 50%” section.
If your answer is wrong, please review the If your answer is wrong, please review the
4. A 9. E
“Investment in Debt Securities – Held to “Investment in Equity Securities – Holding
Maturity Securities” section. between 20% and 50%” section.
5. B “Investment in Debt Securities – Held to
10. D
“Investment in Equity Securities – Holdings of less
Maturity Securities” section. than 20 Percent – Trading Securities” section.
Why does an investor amortize the discount or premium?
The discount or premium amount reflects the difference between what the
investors pay for a bond on purchase, and what they receive on maturity
date. In other words, discount or premium can be considered as pre-received
revenue or pre-paid loss for the duration of bond, respectively. In order to
calculate the yield on bond investment, investors should also allocate these
your turn 1 amounts to each period next to the interest revenue earned for the period.
In summary, “discount or premium” represents the initial profit / loss an
investor faces at the time of purchase. Then, in calculating the periodic return
these amounts should be considered, too.
Please, comment on the relationship among the meanings

meanings of the terms “prepaid expense”, “unearned
revenue”, “discount on bond” and “premium on bond”.
When a bond is purchased with a lower-than-face value, an investor previously

records a gain (discount) to allocate to each period during the life of bond. As
the time passes, an increase in value of bond will be recognized in the income
statement. From this perspective, discounts are similar to unearned interest
revenue, in that a total amount is recognized in advance, and as it is partially
your turn 2 realized, it is recorded in the income statement.
Similarly, when the bond is purchased for a higher-than-face value, a company
initially records a premium to amortize during the life of the bond. The excess
amount paid to the bond is similar to prepaid interest expense in that as the
time passes value of bond decreases, resulting in a decrease in interest revenue
(like an interest expense accruing).
86
Accounting II
If the investor owns only 10% of investee, but 60% of

investee’s total sales is generated from the investor, how
should the investor account for this investment?

Even if an investor owns less than 20% of total shares, a significant influence
may exist. An example to this case is being the major customer of investee. If
the investor has such a huge share in total sales of investee, he may possess a
your turn 3 significant influence on the decisions of investee. Therefore, the investment
should be reported as Affiliate in balance sheet and equity method should be
used to account for it.
What happens if the share of investor in investee’s loss

exceeds the carrying value of Affiliates? Do you think that the
investor should recognize additional losses? Why/why not?
The investee may have such a high loss that terminates all the investment in
investor’s balance sheet and still incur some losses. If this is the case, investors
should report all the losses, even after closing the affiliate account with
your turn 4 some part of loss because the investor is responsible from for total loss (in
proportion to his rate of ownership) as he participates in the decision-making
process. The investor recognizes all loss in income statement and the excess-
of-carrying value should be reported in equity as impairment on investment.
Please, comment on the following case in terms of the

required accounting treatment: What happens if the
investor changes the category from held-to-maturity to
available for sale category?
Held to maturity (HTM) securities are kept with their amortized values,
whereas available for sale (AFS) securities are valued with their fair values. If a
HTM security is transferred to AFS security category, the fair value of security
your turn 5 will be the new carrying value to be recorded as Available for Sale Security.
If the fair value on transfer date differs from amortized value of HTM, the
amount of difference is reported in equity as “Unrealized Holding Gain” or
“Unrealized Holding Loss”. The amount, reported in equity with this way,
will be amortized until the maturity of security.
87
Investments
Endnotes
1
Warren, Carl S., Reeve, James M., and Duchac, International Financial Reporting Standards Board,
8
Jonathan E. (2014) Financial and Managerial IFRS 13: Fair Value Measurement, par. 9.
Accounting, 12th Edition, South-Western,
Özerhan, Y. and Yanık S. (2015) Türkiye Finansal
9
Cengage Learning, p. 584.
Raporlama Standartları (TFRS), Ankara:
2
Demir, V. (2015) TFRS/UFRS Kapsamında TURMOB Publishing, p. 203; Demir, V. op cit.
Finansal Araçlar: Sunum/Muhasebeleştirme p. 96.
ve Ölçme/Açıklamalar, 2nd Edition, Ankara: 10
Demir, V. and Bahadır, O. (2018) Türkiye Finansal
Nobel Publishing, p.64; Karan, M. B. (2011)
Raporlama Standartları (TFRS): Açıklamalar ve
Yatırım Analizi ve Portföy Yönetimi, 3rd Edition,
Uygulamalar, Istanbul: ISMMMO Publishing,
Ankara: Gazi Publishing, p.88; Simga-Mugan,
p.555; Karan, M. B. (2011), op cit. p.133.
F. N. C. and Akman, N. H. (2012) Principles
of Financial Accounting Based on IFRS, Fifth 11
Kieso et al., op cit. p.840.
Edition, McGraw-Hill, p. 262. 12
Bodie et al., op cit. p. 800.
3
Kieso, D. E., Weygandt J. J. and Warfield, T. D. 13
Simga-Mugan and Akman, op cit. p.273.
(2004) Intermediate Accounting, 11th Edition,
John Wiley and Sons Ltd., p.836. 14
Simga-Mugan and Akman, op cit. p. 274; Kieso et
al., op cit., p. 851.
4
Warren, Carl S., Reeve, James M., and Duchac,
Jonathan E., p. 585. 15
Kieso et al., op cit., p. 861
5
Warren, Carl S., Reeve, James M., and Duchac, 16
Simga-Mugan and Akman, op cit. p. 272; Kieso et
Jonathan E., p. 585; Weygandt, Jerry J., Kimmel, al., op cit., p. 861; Bodie et al. op cit. p.57.
Paul D., and Kieso, Donald E. (2015) Accounting 17
Kieso et al., op cit., p. 862.
Principles, 12th Edition, John Wiley & Sons,
Inc., p.692.
18
Kent Thune (2018, November 8) The Best
Investment Strategies. https://www.thebalance.
6
Örten, R., Kaval, H. and Karapınar, S. (2018) Türkiye com/top-investing-strategies-2466844
Muhasebe – Finansal Raporlama Standartları
Uygulama ve Yorumları, 11th Edition, Ankara:
19
Akgüç, Ö. (2013) Mali Tablolar Analizi, 15th
Gazi Publishing, p.332; Needles, Belverd, Powers, Edition, Arayış Publishing, Istanbul. p.435.
Marian, and Crosson, Susan (2011) Principles 20
Bodie at al. op cit. p 226.
of Accounting, Eleventh Edition, Cengage
Learning, p. 1263.
21
F. Brigham and J.F. Houston (2014) Fundamentals
of Financial Management, (N. Aypek, Trans.)
7
Bodie, Z., Kane, A. and Marcus, A.J. (2005) Ankara: Nobel Yayıncılık.
Investments (6th Edition) Singapore: McGraw
Hill, p. 462
88
Chapter 4 Current Liabilities and Payroll
After completing this chapter, you will be able to:
1 2
Learning Outcomes
Explain and illustrate current liabilities, and

Compute and record basic payroll transactions
identify the major types of current liabilities
3 Account for current liabilities that must be

estimated 4 Account for contingent liabilities
5 Explain the financial statement presentation of

current liabilities and liquidity
Key Terms
Accounts Payable
Accrual
Bank Loan
Contingent Liability
Chapter Outline Current Liability
Introduction Income Tax
Accounting for Current Liabilities Liability
Payroll Accounting Liquidity
Estimated Liabilities (Provisions) Notes Payable
Contingent Liabilities Payroll
Reporting Current Liabilities and Liquidity Provisions
Social Security Premiums
Unearned Revenue
Unemployment Insurance Premiums
Value Added Tax
VAT Deductible
VAT Payable
90
Accounting II
INTRODUCTION ACCOUNTING FOR CURRENT

In order to finance the acquisition of assets, LIABILITIES
companies have two types of financing options: debt Current liabilities must be paid either with
financing and equity financing. The right side of cash or with goods and services within one year
the balance sheet represents the financing structure or within the entity’s normal operating cycle if the
of a company. Debt financing is represented on operating cycle is longer than a year. If it takes more
“Liabilities” section whereas equity financing is than 12 months after the purchase of raw materials
represented on the “Equity” section of a balance to produce and sell products and collect the
sheet. As you have learned, equity is the “owners’ receivables in return, this means that the operating
claims in business”. Liabilities are “creditors’ cycle is more than 12 months for that company.
claims on total assets” and as “existing debts and In other words, the time needed by the company
obligations of company.” Companies must settle to provide funds from its operations and fulfill its
or pay these claims, debts, and obligations at some liabilities is more than 12 months; thus, the term
time in the future by transferring assets or services. “current” is proxies for the operating cycle.
Liability is defined as the present obligation of a

company arising from past events and fulfillment Operating cycle of a merchandising company
of which causes the outflow of economic benefits begins with the purchase of merchandise
in terms of payments of cash, transfer of assets or inventory and ends when the cash from sales
rendering of services. is collected from customers.
Liabilities have three main characteristics: The current liabilities are obligations that will be
• They occur because of a past transaction or paid out of current assets and are due within a short
event. time, usually within one year. Current liabilities
• They create a present obligation for future represent the nature and amounts of outflow of
payment of cash or services. economic benefits from the company in order to
fulfill existing obligations in the following fiscal
• They are an unavoidable obligation.
year (one year or operating cycle). Current liabilities
Debt financing will help a company acquire include short-term bank loans, current portions
the things it needs to grow, but companies must of long-term bank loans, accounts payable, notes
be careful about the amount of debts. When the payable, accruals etc. Current liabilities are listed on
company is unable to pay its bills at the maturity the balance sheet in the order in which they are due.
dates, its creditors step in and take over because
providers of debt financing are the creditors.
However, the providers of equity financing are the Current liabilities represent the existing obligations
owner or owners of a company. Consistent with whose fulfillment are expected to result in outflow
the going concern principle of accounting, equity of economic benefits in the following fiscal year.
has no maturity as it represents the company’s
ownership. On the other hand, every liability
eventually matures with varying dates. Some
liabilities are to be settled in the same reporting
period while some others remain into following 1
periods. If the company incurs an obligation in December
Depending on their maturities, liabilities can be to be paid 5 months later, is this obligation
split into two main categories as “current liabilities treated as a current liability or will it be a non-
(short term liabilities)” and “non-current liabilities current liability, just because it will be paid in the
(long term liabilities)”. In this chapter, we discuss following year?
current liabilities.
91
Current Liabilities and Payroll
Accounts Payable
Accounts payable arise from purchasing goods or
services for use in a company’s operations. Amounts
owed for goods or services purchased on account
are accounts payable. Accounts payable are debts
incurred in the normal course of a business, resulting
from acquisition of inventories and supplies. In
these kind of payables, there is no formal document
stating the amount or the date of payment except the
invoice that supplier issues1. Besides, the maturity
of accounts payable is usually very close to issuance
date, such as up to three months period.
Accounts Payable are typically short term as credit

Picture 4.1 terms are usually between 30 and 90 days.
Keeping in mind that they change depending

We have described and illustrated accounts
on the laws and regulations applied in each country, payable transactions in earlier chapters. Most of
we will begin our discussion with current liabilities the businesses make the majority of their purchases
of a known amount. on account. Thus, for most businesses, this is often
the largest current liability.
Example: On May 1, Lakers Company, a retailer of sports equipment, purchased 200 pairs of basketball
shoes at different sizes and models from BNA Corporation from 250 TL/shoe on account. The payment is due
on July 1.
The journal entry for purchase of shoes for 50,000 TL (200 shoes x 250 TL/shoe) on May 1 is as follows:

May 1 Merchandise Inventory 50,000
Accounts Payable 50,000
Recording the purchase of inventories on account
Accounts payable occur on May 1 because Lakers Company receives the goods (shoes) before payment
has been made.
Lakers Company will pay this debt on July 1 because the due date is July 1. When Lakers Company
pays on July 1, the entry to record is:

July 1 Accounts Payable 50,000
Cash 50,000
Recording the payment of debt for purchase of inventories on May 1
When Lakers Company makes payment, its cash and debts are decreased.
92
Accounting II
Notes Payable
In cases of purchases on credit or borrowings, companies may issue promissory notes as an arrangement
to formalize the repayment of a certain amount of cash at a certain date to a third party. If it is expected
to be paid in the following fiscal year, these promissory notes are recorded as notes payable in current
liabilities section of balance sheet2.
Example: On 31 March 2018, Spurs Company purchased equipment for 100,000 TL. Spurs issued a note
for the amount. The note has 6 months maturity and 10% interest rate, and total interest and principal amount
is due on maturity.
The first journal entry to record the purchase of equipment:

March 31, 2018 Equipment 100,000
Recording the purchase of equipment by issuing a note payable
At the end of maturity, Spurs will make payment for both the principal and interest accrued on notes
payable with the following entry:
From March 31 to September 30, 2018 (6 months period), the accrued interest can be calculated as:
100,000 x 0.10 x 6
Interest = = 5,000TL
12

September 30, 2018 Interest Expense 5,000
Cash 105,000
Recording the payment of notes payable and interest at maturity
Example: On 30 September 2018, Spurs Company purchased a vehicle for 140,000 TL. Spurs paid 20,000
TL in cash and issued a note for the remaining amount. The note has 6 months maturity and 10% interest rate,
and total interest and principal amount is due on maturity.
The first journal entry to record the purchase of vehicle is:

September 30, 2018 Vehicle 140,000
Cash 20,000
Recording the purchase of vehicle
From September 30 to December 31, 2018 (3 months period), the accrued interest (monthly interest
expense) can be calculated as:
120,000 x 0.10 x 3
Interest = = 3,000TL
12
93
To record the interest expense in the period it incurs, the adjusting entry to record at balance sheet date
is as follows:

December 31, 2018 Interest Expense 3,000
Interest Payable 3,000
Recording the interest incurred on promissory note
At the end of maturity, Spurs will make payment for both the principal and interest accrued on notes
payable with the following entry:

March 31, 2019 Interest Expense* 3,000
Cash 126,000
Recording the payment of notes payable and interest at maturity
* Interest accrued for the period January 1 – March 31, 2019 (3 months).
Additionally, in cases that companies do not have enough funds to close their existing payables, they
may issue notes in order to extend the maturity. These notes are also recorded as current liabilities unless
their extended maturities end after the fiscal year.
Example: Raptors Company had purchased inventories for 10,000 TL on account due June 15. However, on
June 15, the company did not have enough cash to meet its obligations, so they requested a one-month extension
in maturity, in exchange of 1,000 TL interest and issued one-month promissory note. In this case, Raptors
Company will have to pay 11,000 TL on July 15.
Company exchanged its payable with a new one in order to extend the maturity by paying an additional
1,000 TL just because of its insufficient funds. In other words, company settled its accounts payable by
creating another liability with an additional interest.
The journal entry to record the new liability with extended maturity is:

June 15 Accounts Payable 10,000
Interest Expense 1,000
Recording the liability with extended maturity
At the end of maturity, Raptors will make payment for both the principal and interest accrued on notes
payable in the following entry:

July 15 Notes Payable 11,000
Cash 11,000
Recording the payment for notes payable at maturity
94
Accounting II
Short-Term Bank Loans

Companies generally need short term financing
in order to use in their normal operations and they
borrow these funds from banks with short-term
maturities. These borrowings from banks to be fully
repaid in the same fiscal year is classified as Short-Term
Bank Loans. This type of loans are borrowed with the
intention to repay from the collections of receivables
that will be generated by the sales of goods3.
A very common form of short-term bank loans is
the “line of credit”. A line of credit is offered by banks,
or credit unions, to companies up to a maximum
amount. It gives the companies access to a set
amount of cash in exchange of interest payments4.
It differentiates from bank loans in that it does not
incur any interest unless it is actually borrowed.
Companies can choose when to take out the funds,
pay back and repeat again as long as they stick to the
Picture 4.2
terms, such as payment on time and in full.
Example: On November 1, Mr. Blum, the owner of Blum Company, borrowed 100,000 TL from the
bank with 12% interest rate and 10 months maturity. Both the interest and principal will be paid at the end
of maturity.
The initial journal entry to be recorded on November 1 is as follows:

November 1 Cash 100,000
Bank Loans 100,000
Recording the borrowing from bank
Interest expense (interest expense is calculated on daily basis) to record for the period between November
1 - December 31 is calculated as:
Interest =
(100,000 x 60 x12) = 2,000TL
36,000
Assuming that Blum Company adjusts its accounts annually, the adjusting entry to record at year-end
will be as:
December 31 Interest Expense 2,000
Recording the interest expense at year-end
95
The journal entry for the company to record the payment at maturity date is as follows:

August 31 Interest Expense 8,000*
Bank Loan 100,000
Cash 110,000
Recording the payment of bank loan at maturity
*Interest for the period between January 1 – August 31 calculated as [(100,000x12x240) / 36000]
As the above entry states, the payment at maturity includes interest expense (for the period between
January 1 and August 31), interest payable (interest remaining from previous period) and the principal
amount.
Current Portion of Long-Term Bank Loans

Companies may prefer long-term borrowings more than the short-term loans, depending on the amount
of funds to borrow. In case of borrowings with high amounts, companies prefer longer maturities, so that
it is expected to be easier to pay the loan back and protect the liquidity of company at the same time.
Companies pay these loans in installments, which include some part of principal and accrued interest
together. Therefore, even long-term borrowings have repayment obligations in short term. In other words,
some part of the long-term loan matures within one year (or operating cycle length) as of balance sheet date.
This part to be paid in the next financial statement term is classified as Current Portion of Long Term Loan.
Long-term liabilities are often paid back in periodic payments, called installments.
Long-term liability installments that are due within the coming year must be classified as a current
liability as Current Portion of Long Term Loan.
Example: On 31 October 2018, Bulls Corporation borrowed 400,000 TL from Dollar Bank with 2 years
maturity and 15% interest rate with semiannual payments. The payment schedule for Bulls Corp.’s bank
loan is as follows:
Payment Date Installment Principal Interest

30 April 2019 130,000 TL 100,000 TL 30,000 TL*
31 October 2019 130,000 TL 100,000 TL 30,000 TL
30 April 2020 130,000 TL 100,000 TL 30,000 TL
31 October 2020 130,000 TL 100,000 TL 30,000 TL
Total 520,000 TL 400,000 TL 120,000 TL
* Interest accrued semiannually; calculated as [(400,000 x 15 x 180) / 30,000]
96
Accounting II
On the date of borrowing, Bulls Corp. should record the loan as long-term bank loans. When the
balance sheet date comes, the amount to be paid in the following fiscal year is recorded as current portion
of long-term loans.
The journal entry to record the initial recognition of bank loan on October 31 is as follows:

October 31, 2018 Cash 400,000
Long-term Bank Loans 400,000
Recording the long-term bank loan
On 31 December 2018, the first entry is prepared to transfer the amount of long-term bank loans that
will be paid within 1 year to current portions of long-term loans account.

December 31, 2018 Long-term Bank Loans 100,000
Current Portion of Long-term Loan 100,000
Transferring the amount of long-term bank loan to be paid in short term
Then company calculates the accrued interest and adds the amount to long-term bank loan with the
following entry:

December 31, 2018 Interest Expense 10,000*
Recording and add the accrued interest to long term loan
* Interest accrued for the period between October 31 – December 31, calculated as [(400,000 x 15 x 60)/36,000]
Accrued interest is then transferred to current portion of long-term loans as it will be paid within a year.

December 31, 2018 Long-term Bank Loans 10,000
Transferring accrued interest from long-term loans to current liability
For the period between December 31 and April 30, 2019, interest accrues on bank loan. To record the
interest expense for the period and transfer it to the “Current Portion of Long-Term Loans” account, the
following entries are required:
97

April 30, 2019 Interest Expense 20,000
Recording the accrued interest on long-term loan

April 30, 2019 Long-term Bank Loans 20,000
Transferring accrued interest from long-term loans to current liability
On 30 April 2019, the journal entry to record the payment of 130,000 TL for current portion of long-
term loan is as follows:

April 30, 2019 Current Portion of Long-term Loan 130,000
Cash 130,000
Recording the payment for Current Portion of Long-term Loan
The payment of 130,000TL includes both interest and principal amounts allocated as:
i. A part of principal 100,000
ii. Interest accrued for October 31 – December 31, 2018 10,000
iii. Interest accrued for December 31 – April 30, 2019 20,000
Accruals can be defined as liabilities for unpaid

2 expenses.
Why is the Current Portion of Long-Term Loans
account is required for information users?
Unearned Revenues
Customers may make advanced payments
Accruals for the goods or services they will receive in the
Matching principle requires the recognition future. When the company receives an advanced
of expenses in the period in which they incur payment, an obligation occurs for delivering
to generate revenues. Therefore, as of the end the goods or rendering the service for which the
of period, all expenses should be recorded customer has made payment. Therefore, company
independent from whether they are paid or not. must record a liability in its financial statements
When an expense incurs but is not paid yet, it and this liability is named unearned revenue. In this
should be recorded as accrued expense. In other context, unearned revenues can be defined as the
words, accruals can be defined as liabilities for payments received in advance for the products or
unpaid expenses. The most common examples services being provided. Unearned revenue should
of accrued expenses are interest payable, salaries be converted into earned revenue as consistent
payable, income taxes payable etc. with the matching principle. In other words, the
unearned revenue must be closed and revenue must
be recognized in the income statement to the extent
the goods are delivered or the service is rendered.
98
Accounting II
The unearned revenue must be closed and revenue

Unearned revenues are payments received in
be recognized in the income statement to the extent
advance of the product or service being provided.
the goods are delivered or service is rendered.
3
How does the customer record the amount, which is reported as unearned revenue by seller?
Example: On December 25, to get prepared for the final exams, Mrs. Hardworking has agreed with Coursery
Education to take private courses for 25 hours from 200 TL/hour and paid 5,000 TL in advance. Until the end
of the year, Company has lectured 10 hours with Mrs. Hardworking and the last course is given as of January 10.
In this case, the Coursery Company has to report a liability of 5,000 TL upon the collection of cash in
advance, on December 25.

December 25 Cash 5,000
Unearned Revenue 5,000
Recording the collection in advance for the un-rendered service.
CASH UNEARNED REVENUE

Dec.25 5,000 5,000 Dec.25
At the end of the year, some parts of unearned revenue must be recorded as revenue, as the company
has rendered the service in some parts. Until the end of the year 10 hours of lectures are given, so company
earned revenue of 2,000 TL (200 TL/hour x 10 hours). This also means that company does not have a
liability of 25 hours any more, only 15 hours of lectures left.

December 31 Unearned Revenue 2,000
Revenue 2,000
Recording the payment of salaries
UNEARNED REVENUE REVENUE

Dec.31 2,000 5,000 Dec.25 2,000 Dec.31
Balance 3,000 Balance 2,000
99
On January 10, the last course is given and all the service is rendered. As of January 31, (assuming the
company adjusts monthly) the entry to record is:

January 31 Unearned Revenue 3,000
Revenue 3,000
Recording the payment of salaries
By recording this way, company reports the revenues in the period they are earned, providing a better
performance evaluation consistent with the periodicity principle.
Tax Payables
When a company reports positive income in the income statement, it becomes subject to taxation. The
amount of tax that the company must remit to the government is determined by using the reported net
income and income tax rate applied in the country.
In some countries, profitable companies are

required to remit income tax installments to the
government on a monthly or quarterly basis. For 4
example, in Turkey, companies pay prepaid tax
What happens if the accumulated prepaid tax
on their quarterly income, these payments are
amount is higher than the annual income tax?
accumulated in an account named prepaid tax and
at the end of the fiscal year, total prepaid amount is
deducted from annual corporate income tax.
Example: Bucks Company is a manufacturer of coffee tables and operates only in local market. Company
has reported 1,200,000 TL taxable income for the year ended December 31, 2018. The income tax rate in the
country is 20% and company has already prepaid 196,000TL tax for the first three quarters.
In this case, the total income tax liability is calculated by applying the tax rate on taxable income. Total
income tax to pay government is 240,000 TL (1,200,000 x 0.20). Since 196,000 TL of this amount is
already paid during the year, company has a remaining tax liability of 44,000 TL (240,000 – 196,000).
The entry to record remaining liability balance as well as income tax expense is as follows:

December 31 Income Tax Expense 240,000
Prepaid Tax 196,000
Income Tax Payable 44,000
Recording the tax expense and related liabilities
In the taxation system, the company pays income tax and then the company’s shareholders must pay
a second and separate tax on dividends they receive from the distribution of after-tax income by the
company. By doing this, companies and their owners are treated as being legally separate for tax purposes5.
Additionally, as a result of differences between the taxation rules and financial reporting rules, taxable
income (income on which the tax liability is calculated) may differ from accounting income (income
100
Accounting II
represented in income statement). Therefore, tax authorities request some adjustments from companies
before calculating their tax liabilities. After these adjustments are completed, accounting income may be
higher or lower than taxable income.
internet
Tax authorities do not allow some expenses to be
International Tax Turkey Highlights 2018
used as a deduction in taxable income. Thus, these
https://www2.deloitte.com/content/dam/
expenses in general are called “non-deductible
Deloitte/global/Documents/Tax/dttl-tax-
expenses”.
turkeyhighlights-2018.pdf
Value Added Tax (VAT)

Whenever a good or service is delivered, Value Added Tax (VAT) occurs. VAT is a kind of sales tax.
The tax amount is calculated from the revenue (not income as in income tax) by using VAT rates on
the delivered product or service. In a sales transaction, the seller receives an amount including both the
sales price and VAT. VAT is not included in revenue because the seller collects the value added tax from
customers on behalf of the government. On the other hand, the seller also pays VAT to the suppliers
while purchasing goods. When the goods and services are delivered, the amount of tax is recorded as VAT
received, and in cases of purchases, it is VAT paid account that the amount is recorded in.
At the end of each fiscal year, these two accounts on VAT are considered. If VAT received exceeds the
VAT paid, this means the seller company has collected more than what it has already paid to government
as VAT. Then at year-end, a liability account should be recorded: VAT Payable. Company has to pay
this amount to tax office. In opposite case, where VAT paid is more than VAT received, this means that
the company has paid more tax. Then, it collected from customers on behalf of government. The excess
amount is recorded in an asset account; VAT Deductible. This amount represents a tax receivable from
government and is carried forward to the next year in order to be deducted from VAT tax liability.
VAT received is the amount that the seller receives from customers in order to pay to government at
year-end, whereas VAT paid is the amount paid to the government with the intermediary of suppliers.
Example: Wolves Company manufactures and sells special design furniture on demand. On November 13,
company purchased 32 kg. of lumber on account to use in manufacturing the special design office-table that a
customer has ordered. Company and the customer have agreed on a sales price of 12,000 TL + 18% VAT for this
special table. Wolves Company purchased the lumbers from 100 TL/kg + 18% VAT. On November 25, company
completed and delivered the table to the customer and received cash.
The journal entries for the company’s purchase and sales transactions are presented below (omit the
cost of the sales):

November 13 Raw Materials Inventory 3,200
VAT Paid 576*
Accounts Payable** 3,776
Recording the purchase of raw materials (lumber)
* VAT Paid = 3,200 x 0.18 = 576 TL
** In some cases, companies pay the VAT in cash and obligation stands for the remaining part
101

November 25 Cash 14,160
Revenue 12,000
VAT Received 2,160*
Recording the revenue from sales of office-table
* VAT Received = 12,000 x 0.18 = 2,160 TL
VAT paid is not a part of product cost while VAT received is not a part of company’s revenue. They refer
to payments to and collections on behalf of tax office respectively.
Example:
a. The end-of-year balances of VAT paid and VAT received accounts for Wolves Company is presented below.
VAT Paid VAT Received

112,460 138,640
Closing the VAT paid and VAT received accounts with each other, it is obvious that received VAT
exceeds paid VAT by 26,180 TL (138,640 – 112,460), meaning that Wolves Company has collected
on behalf of government, 26,180 TL more than what it has paid to government. In this case, company
has a VAT liability to government by 26,180 TL to be recorded as VAT payable. The entry to close VAT
accounts and record this excess amount is as follows:

December 31 VAT Received 138,640
VAT Paid 112,160
VAT Payable 26,180
Closing the VAT accounts and record excess amount
b. The end-of-year balances of VAT paid and VAT received accounts for Wolves Company is presented below.
VAT Paid VAT Received

138,640 112,160
In the above case, in which VAT paid exceeds VAT received, Wolves Company should report a receivable
for the excess amount (26,480 TL) to be deducted from the following year’s VAT. The account to record
is called VAT deductible. In other words, when the company closes its VAT accounts with each other, a
receivable is recorded as VAT deductible. Then, the required entry is as follows:

December 31 VAT Received 112,160
VAT Deductible 26,480
VAT Paid 138,640
Closing the VAT accounts and record excess amount
102
Accounting II
PAYROLL ACCOUNTING
As employees work for the company, the employers incur obligations to pay as either salaries or wages.
Included in these salaries and wages, there are some additional obligations that the employers have to
pay on behalf of employees, such as personal income taxes, employment insurance, pension and health
insurance contributions, and union dues. These items are withheld from employees’ paychecks at the end
of each period. The amount of salaries or wages before any deduction is called “gross pay” and the net
amount of cash that the employers receive after all deductions are made is called “net (take-home) pay”6.
There are two types of deductions from the gross pay7:
1. Required (Mandatory) deductions, which are the withholdings, stated by laws and regulations, such
as income taxes and social security premiums etc.
2. Optional (Voluntary) deductions, which the employees desire to pay additionally for special purposes,
such as health insurance and pension plan payments etc.
“Salaries” are monthly payments to employees

whereas “wages” are the payments to employees on
an hourly basis.
These deductions withheld from the employees’

salaries or wages do not represent the taxes on
employers. They represent the portions of salaries/
wages expense that the employers must pay directly
to tax authorities, instead of paying to employees. In
other words, the employer plays an intermediary or
tax collector role by law by collecting money from
employees and passing it on to third parties. As of the
balance sheet date, these deductions are recorded in Picture 4.3
current liabilities, to be remitted to various agencies
in a few weeks.
Employers play an intermediary or tax collector role by law by collecting money from employees and
passing it on to third parties.
Additionally, employers have payroll related liabilities on themselves, too. For instance, all employers
must pay social security premiums and unemployment insurance premiums on salaries and wages to
each employee. Many employers also pay premiums for health insurance of their employees as well as
contributing to their pension plans8.
103
Example: Rockets Corporation has 12 employees. In March, the gross amount of payment for these employees
is 240,000 TL. Social Security Premiums (SSP), employee income taxes, stamp duty and Unemployment
Insurance Premiums (UIP) are represented below as well as the employer’s deductions on himself.
Gross Pay 240,000

(-) Employees’ Share of SSP (14% of gross pay) (33,600)
(-) Employees’ Share of UIP (1% of gross pay) (2,400)
Income Tax Base 204,000
(-) Employee Income Tax (15% of tax base) (30,600)
(-) Stamp Duty (0.66% of gross pay) (1,584)
Net Pay 171,816
Employer’s Share of SSP (20% of gross pay) 48,000

Employer’s Share of UIP (2% of gross pay) 4,800
With the data above, the journal entry to record the salaries and related liabilities is as follows:

March 31 Salaries Expense 240,000
SSP-Employer’s Share 48,000
UIP-Employer’s Share 4,800
Cash 171,816
Taxes Payable 32,184*
Premiums Payable 88,800**
Recording the payment of salaries and related liabilities
* Taxes Payable = Employee Income Tax + Stamp Duty
** Premiums Payable = Employer’s Share of SSP and UIP + Employees’ Share of SSP and UIP
ESTIMATED LIABILITIES (PROVISIONS)

Companies may present obligations that the amounts or timing (or both) are not certainly known9.
According to conservatism principle, these obligations must be reported in the balance sheet as liability,
at an amount dependent on managements’ best estimations. These kinds of liabilities are called estimated
liabilities or provisions. Some examples of provisions are provisions for employee benefits (severance
allowance), provisions for warranties, restructuring provisions, etc.
The term “estimated liabilities” is defined as the present obligations with uncertain amounts to settle.
That amount is the best estimate of the amount that an entity would rationally pay to settle the obligation
at the balance sheet date.
104
Accounting II
In order to inform the users on time, management may use estimations and assumptions. The use of
estimates is an essential part of reporting and it does not undermine the reliability of financial reports.
However, according to the recognition criteria, if the uncertainty in amount is so great that reliable
measurement is not provided, then that item is not reported directly in financial statements and it is
reported in footnotes to financial statements.
A common example of estimated liabilities is the product warranty liabilities. In warranty liabilities,
expected values should be used to determine the amount of the provision10. Present obligation reveals
when the sales occur with a warranty clause and there is a probability that the customer will return the
defective product with the intention of either replacement or repair. In this case, company has to estimate
the amount of possible warranty costs (usually as a percentage of sales) depending on past experiences
and record a liability and an expense for warranties. By doing this, sales revenues and relevant warranty
expenses are recorded in the same period, consistent with matching principle. Since the warranties are
provided for a limited time, it is assumed to occur in one-year period following the sales. Therefore,
warranty obligations are considered as current liabilities, unless stated otherwise.
The seller does not know exactly which product(s) will require replacement or repair, when it may occur
or how much dollar it costs to the company. Thus, seller uses its experience to make the best estimate of
probable future warranty cost.
Example: Cavaliers Company produces and sells led-

screen TVs and provides customers the warranty to either
repair or replace the product depending on the nature
of defects detected. During the year 2018, company has
sold 1,200 led-screen TVs. The past experiences show
that, on average 5% of sold products are brought back to
be repaired and another 3% to be replaced. The average
cost of repairing the led-screen TVs was 3,000 TL and
replacement costs were 10,000 TL on average.
Since the company provides warranty to repair
or replace the defective TVs, at the end of each year
it should estimate an amount to incur as warranty
expense and a liability for it. For the valuation of this
Picture 4.4 liability, the expected value should be used as follows:
Expected Average Cost

Total Expected Cost
No. of Units per unit
Possible cost to incur for repairs 1,200 x 5% 3,000 TL 180,000 TL
Possible cost to incur for replacement 1,200 x 3% 10,000 TL 360,000 TL
Total expected (estimated) warranty cost 540,000 TL
The adjusting entry to record the warranty expense to the same period with its relevant sales revenue is:
105

December 31 Warranty Expense 540,000
Estimated Warranty Payable 540,000
Recording the expected warranty expense as provision
With the above entry, the company matches the sales revenue with warranty expense that will incur as
a result of same sales transactions. During the following fiscal year, when a repair or replacement occurs in
the context of warranty given, the company decreases the warranty liability and credits the related accounts
(such as labor and materials) used in repair or replacement.
Example - Cont.’: On 20 February 2019, a customer brought the TV back for repair. This repair required
a replacement of screen surface and the new screen costed 1,200 TL to Cavaliers Company. Which company
should prepare the following entry:

February 20 Estimated Warranty Payable 1,200
Materials 1,200
Recording the cost of repair under warranty
If the actual cost for warranties during the year is more than the estimated liability, additional warranty
expense should be recorded. However, if the actual warranty cost does not meet the estimated amount of
liability, the unused part of the liability is closed against previous year’s gains/losses.
Example: Assuming that in the year 2019, Cavaliers Company incurred total repair cost for labor and spare parts:
a. 620,000 TL
b. 480,000 TL.
The journal entries to adjust expected liability with actual costs are as follows:
a. Actual Warranty Cost > Expected Warranty Liability

December 31 Warranty Expense 80,000*
Estimated Warranty Payable 540,000
Related Items (Labor, Materials) 620,000
Closing the warranty liability with actual cost incurred
* 620,000 – 540,000 = 80,000 TL excess amount
b. Actual Warranty Cost < Expected Warranty Liability

December 31 Estimated Warranty Payable 540,000*
Related Items (Labor, Materials) 480,000
Gains of Previous Years 60,000
Closing the warranty liability with actual cost incurred
* 540,000 – 480,000 = 60,000 TL excess amount
106
Accounting II
CONTINGENT LIABILITIES
A contingent liability is a potential liability because it depends on a future event. If a possible obligation
arises from past events but its existence can only be confirmed depending on the occurrence of one or more
future events, the obligation under question is a contingent liability. Alternatively, if a present obligation
exists but it is not probable that an outflow of economic benefits will be required or even if it is probable,
the amount to settle the obligation cannot be measured reliably, the obligation is disclosed as contingent
liability11. In other words, existence and disclosure of contingent liability depend on two probabilities:
a. Probability of Occurrence: Probable, reasonably possible, or remote (almost impossible)
b. Measurement: Estimable or not estimable
If the existence of an obligation is dependent on

the occurrence of one or more future events, the If a present obligation exists but the amount to
obligation is a contingent liability. In other words, settle the obligation cannot be estimated reliably,
the probability of occurrence determines the the obligation is a contingent liability.
existence of a liability.
The two general recognition criterion for liabilities are the possibility of economic benefit outflow and
reliably measurement of the amount.
Since recognizing this kind of a liability is contingent on the occurrence of an event in the future,
the probability of occurrence is the first point to consider. Once the future event is possible, then the
recognition depends on whether the amount can be reliably measured or not. If the amount can be
measured reliably, a contingent liability is disclosed in footnotes12. However, if the contingency is almost
impossible to occur, no liability is reported in neither financial statements nor footnotes.
5
Please explain what distinguishes among liabilities, provisions and contingent liabilities.
Contingent liabilities are similar to estimated liabilities in nature, as both of them represent possible
future liabilities arising from past events. However, they differ in terms of the level of uncertainty included.
The estimated liabilities can be reported in financial statements to the extent they are reliably measured,
whereas the contingent liabilities are reported just in footnotes because of the high level of uncertainty
included in their measurement or existence.
Contingent liabilities are reported just in footnotes because of the uncertainty included in its
measurement or existence.
107
Example: Heat Corporation is a construction

company that builds apartments. On June 25, after the
end of working day, workers forgot to lock the entrance to
the construction area. The children in the neighborhood
entered the area and started to play with hoist. One of the
children felt down and broke his arm. His parents filed
a lawsuit against the company for damages claiming an
indemnity of 100,000 TL.
In this case, Heat Corporation should, at first,
examine the probability of losing the lawsuit. If it is
probable, then the second criteria of measurement
reliability is considered. There are three possible cases
and three treatments by Heat Corporation;
a. Almost impossible to lose the lawsuit; so does not
pay any indemnity – No Liability Reported
b. Probably will lose the lawsuit, however the
Picture 4.4 amount of indemnity cannot be estimated reliably
– Liability Disclosed in Footnotes
c. Probably will lose the lawsuit and the amount of indemnity can be estimated reliably – Journalized
and Reported in Financial Statements
Suppose that the third option occurs and the experiences from other cases signals that company will
pay approximately 30,000 TL as indemnity. Then company must record a liability of 30,000 TL in its
balance sheet as well as an expense (for probable loss) in income statement by recording the following
journal entry:

December 31 Expenses From Other Ordinary Activities 30,000
Contingent Liability 30,000
Recording the probable loss from ongoing lawsuit
6
What if the company was the filing party? Would they report an asset for each of these three options?
REPORTING CURRENT LIABILITIES AND LIQUIDITY

As explained previously, a current liability is a debt that a company reasonably expects to pay (1) from
existing current assets or through the creation of other current liabilities, and (2) within one year or the
operating cycle, whichever is longer. Debts that do not meet both criteria are non-current (long-term)
liabilities.
Financial statement users want to know whether a company’s obligations are current or long-term. It
is important for a company to pay all of its liabilities (solvency); however, it is vitally important to pay its
current liabilities (liquidity). A company that has more current liabilities than current assets often lacks
liquidity, or short-term debt-paying ability. What is called “current” is either the benefits to be received
(for assets), or obligations to be met (for liabilities), in one-year period. Combining these two definitions,
108
Accounting II
companies care about the ability of current assets to meet current liabilities. If the current assets cannot
match current liabilities, companies will have to either convert their non-current assets, which are usually
used in providing capacity for operations, into current assets (in most cases cash) or will have to extend the
maturities to longer terms with an additional amount of interest. In addition, users want to know the types
of liabilities a company has. If a company declares bankruptcy, a specific, predetermined order of payment
to creditors exists13. Thus, the amount and type of liabilities are of critical importance.
Liquidity, which is defined as the ability to meet short-term liabilities, is one of the most important
points that all users of accounting information, especially investors and creditors, consider. If the
company cannot pay its obligations, it may go
bankrupt. Therefore, liquidity is an indicator for
investors showing the going concern of company Liquidity is an indicator of reliability level for a
and an indicator for creditors representing the company in terms of either survival or credibility.
probability that they will be able to collect their
funds back (with an interest or at least the principal
amount).
Let’s summarize which types of current liabilities we have covered thus far. A company can report its
current liabilities on the balance sheet as follows:
Considering the fact that companies use their assets to

generate income and pay their liabilities with this income,
internet creditors are also interested in the financial performance
To see the financial statements of companies as well as financial position of the company. Assessing
check https://www.kap.org.tr/en/ the interest coverage power of income becomes another
important point of view for the creditors.
Picture 4.5
109
Since the liabilities are usually paid by using cash as an intermediary, companies’ cash generating
ability becomes another critical point to consider. As the third financial statement, after the balance sheet
for financial position and income statement for financial performance, the statement of cash flows helps
users to evaluate the cash generating ability of the company. For example, despite having a good balance
between current assets and current liabilities, if a company has a poor level of operating cash flow, this may
point some problems with its debt payment performance.
In order to assess the company from these perspectives, investors and creditors generally imply ratio
analysis, as well as other financial statement analysis methods. Ratios, which are calculated by dividing a
financial statement item with another, help users with analyzing the company from different perspectives.
Ratios (such as current ratio, acid-test ratio, operating cash flows ratio, net working capital ratio, interest
coverage ratio) represent the riskiness and creditworthiness of companies to investors and creditors.
Ratios represent the relationships between financial statement items to make it possible to assess the
financial position and performance of companies.
Further Reading
Affects of Working Capital Management on Firm’s Performance: Evidence from Turkey

“… Working capital management decisions are very important and strategic because they affect the
firm profitability and firm value. Working capital management involves managing current assets and
current liabilities of firms. The current assets are cash and cash equivalents, marketable securities,
accounts receivable and inventories. The current liabilities are accounts payable, expenses payable,
including accrued wages and taxes and notes payable. A narrower definition for the working capital is
inventory + accounts receivable – accounts payable. Thus, according to this definition, working capital
management is managing inventory, accounts receivable and accounts payable. The effective working
capital management is very important because it affects the performance and liquidity of the firms
(Taleb et al., 2010). The main objective of working capital management is to reach optimal balance
between working capital management components (Gill, 2011). The efficient management of working
capital is a fundamental part of the overall corporate strategy to create shareholders” value (Nazir and
Afza, 2008). Therefore, firms try to keep an optimal level of working capital that maximizes their value
(Deloof, 2003). The most popular measurement of working capital management is cash conversion cycle
(CCC) which is the time lag between purchase of raw materials or render of services and the collection
of cash from the sale of goods or services rendered. If the time lag is longer, it means greater investment
to working capital components and this causes greater financing needs. Hence, interest expenses will be
higher which leads to higher default risk and lower profitability. The use of profitability as an indicator
of firm performance, there can be a reverse relationship between CCC and firm performance...”
Source: Gamze VURAL, Ahmet G. SÖKMEN and Emin H. ÇETENAK Affects of Working Capital
Management on Firm’s Performance: Evidence from Turkey International Journal of Economics and
Financial Issues, Vol. 2, No. 4, 2012, pp.488-495.
110
Accounting II
Inside Practice
How Much Current Liability Should a Company Have?

Approaching the subject from managers’ perspective, decisions on two points are important in
financing operations:
(i) level of debt financing, and
(ii) conditions of debt financing (such as the interest rate and maturity).
The level of debt financing determines the capital structure of company, which represents the
combination of debt and equity in total financing. If the debt and equity percentages are not balanced
accurately, this makes the company become either very risky (with too much debt used) or too much
conservative (with too much equity used). Therefore, borrowing decision is like a two-sided sworn.
Increasing the debt usage, on one hand, causes an increase in company’s risk of losing its ability to pay
for debts, and as a result decrease its creditworthiness. On the other hand, it gives managers opportunity
to generate a higher return on equity and to allocate unused equity to different projects. The creation of
higher return on equity as a result of higher debt usage is called “financial leverage”.
As the second decision to take, managers must prefer the borrowing option with most appropriate
conditions. Minimum interest with longer maturity is usually the preferred form for debt clauses.
However, even if the minimum interest cannot be obtained, the interest rate, at least, must be less than
the rate of return that company generates using those borrowed funds (usually considered as return on
asset).
Maturity of debt is also as important as the interest rate. If the maturity of payments does not fit
with the timing of collections from assets, liabilities fail to be met and this may result the company
even to bankrupt. Therefore, management considers collection periods to determine an appropriate
borrowing policy. In terms of financial management, the fundamental rule of finance says that only
current assets should be acquired using short-term liabilities, while non-current assets should totally be
financed through the use of long-term capital (long-term liabilities + equity). In other words, the time
period required to generate benefits from assets should be shorter than (or equal to) the time period
required to pay the obligations in order to keep the companies safe.
Discuss:
1. What is the relationship between cash conversion cycle and current liability management?
2. When should a company use short-term liabilities instead of long term financing options and why?
3. Explain the relationship between interest and taxation.
111
Explain and illustrate current

LO 1 liabilities, and identify the major
types of current liabilities
“Liability” is defined as the present obligation of a company arising from past events and fulfillment of
which causes outflow of economic benefits in terms of payments of cash, transfer of assets or rendering
of services. From another perspective, with a very basic level definition, liability represents the part of
financing that a company provides from resources other than claims of its equity owners.
Depending on their maturities, liabilities are classified as “current liabilities” and “non-current liabilities”.
Summary
The term “current” means “in the same period”, which stands for either “the same 12-months period” or
“the same operating cycle”, whichever is longer. If it takes more than 12-months after the purchase of raw
materials to produce and sell products and collect the receivables in return, this means that the operating
cycle is more than 12 months for that company. In other words, the time needed by the company to
provide funds from its operations and fulfill its liabilities is more than 12 months; thus, the term “current”
proxies for the operating cycle.
All expenses should be recorded in the periods they incur; so that the performance of the company can be
assessed accurately, as its income statement covers all revenues and expenses for that period. Recognition
of expenses do not require a cash outflow. Therefore, expenses are recognized in income statement even if
they are not paid yet. When an expense incurs but the payment will be made in other periods, companies
should also record a liability to be settled in future periods. That liability is called “accrued expenses”.
Completely opposite situation, in which the company collects cash in advance but the goods or service
will be delivered in other periods, also required the company to recognize a liability. However, this time
the name of liability is “unearned revenue”.
In short, the term “accrual” refers to expenses that are incurred but unpaid, while “unearned revenue”
refers to future revenues that are collected but not delivered yet.
Income statement that companies prepare at the end of each year represents whether the company has
increased its equity during period by generating income or not. If the company reports a positive income
number at the end, it should pay the government an income tax before adding the income to its equity.
The income tax rate is determined by the governments. However, some kinds of expenses are not accepted
as tax-deductible by some governments, meaning that before calculating the income tax obligation, these
non-deductible items should be added back and then the tax rate should be applied on the new taxable
income calculated. In other words, taxation rules and rules of financial reporting may differ from each
other.
In addition, in some countries like Turkey, companies make advance tax payments that they calculate
over their quarterly income numbers. These payments accumulate in an account to be deducted from
end-of-year income tax obligation. If the prepaid taxes exceed income tax obligation of the entire year,
the exceeding amount remains as a receivable in the balance sheet to be deducted from following year’s
tax obligations.
When the goods and services are delivered, the amount of tax is recorded as VAT received, and in cases of
purchases it is VAT paid account that the amount is recorded in. At the end of each fiscal year, these two
accounts on VAT are considered. If VAT received exceeds the VAT paid, this means the seller company
has collected more than what it has already paid to government as VAT. Then at year-end, a liability
account should be recorded; VAT Payable. Company has to pay this amount to tax office. In opposite
case, where VAT paid is more than VAT received, this means that the company has paid more tax than
it collected from customers on behalf of government. The excess amount is recorded in an asset account;
VAT Deductible. This amount represents a tax receivable from government and is carried forward to the
next year in order to be deducted from VAT tax liability.
112
Accounting II
Compute and record basic payroll

LO 2 transactions
There are some obligations that the employers have to pay on behalf of employees, such as personal
income taxes, employment insurance, pension and health insurance contributions, and union dues. These
items are withheld from employees’ paychecks at the end of each period. There are two types of deductions
from the gross pay:
- Required (Mandatory) deductions, which are the withholdings, stated by laws and regulations, such as
Summary
income taxes and social security premiums etc.
- Optional (Voluntary) deductions, which the employees desire to pay additionally for special purposes,
such as health insurance and pension plan payments etc.
Account for current liabilities that

LO 3 must be estimated
Companies may have present obligations that the amounts or timing (or both) are not certainly known.
According to conservatism principle, these obligations must be reported in the balance sheet as liability,
at an amount dependent on managements’ best estimations. These kinds of liabilities are called estimated
liabilities or provisions.
Provisions arise from present obligations and recognition of a provision means the outflow of economic
benefits is probable and it can be measured reliably. Stipulating a present liability, in case it is not probable
that obligation will end up with outflow of economic benefits from the company or if the amount of
outflow cannot be measured reliably, possible provision turns into a contingent liability. Additionally,
provisions are existing liabilities with uncertain timing or amount; however, contingent liabilities require
one or more future events to occur.
LO 4 Account for contingent liabilities
A contingent liability is a potential liability because it depends on a future event. If a possible obligation
arises from past events but its existence can only be confirmed depending on the occurrence of one
or more future events, the obligation under question is a contingent liability. The form of liability to
recognize in financial statements or disclose in footnotes depends on two probabilities:
a. Probability of Occurrence
b. Probability of Measurement Reliability
Once a company has an obligation, if timing and amount of settlement are certain, a liability is recognized
in the balance sheet. If the amount can be reliably estimated but has some uncertainty included at the
same time, it is recognized as a provision instead of an ordinary liability. If, on the other hand, the amount
cannot be estimated reliably it becomes a contingent liability to be disclosed in footnotes only.
113
Explain the financial statement

LO 5 presentation of current liabilities
and liquidity
It is vitally important for a company to pay its current liabilities. What is called “current” is either the
benefits to be received, or obligations to be met in one-year period. Combining these two definitions,
companies care about the ability of current assets to meet current liabilities. If the current assets cannot
match current liabilities, companies will have to either convert their non-current assets, which are usually
used in providing capacity for operations, into current assets (in most cases cash) or will have to extend
Summary
the maturities to longer terms with an additional amount of interest. Therefore, companies operating
with too much share of current liability in total financing is usually accepted as too much risky to either
invest or lend.
On the other hand, if the company finances its operations mostly by using long-term financing options,
the cost of financing will incur more compared to short-term financing, in terms of either interest or
dividends.
114
Accounting II
1 Which of the followings is a liability? 5 On December 1, company borrowed 120,000

A. The vehicle that company purchases TL from the bank and will make semiannual
B. Depreciation on machinery payments of 30,000 TL (20,000 TL Principal +
10,000 TL Interest) during 3 years. The entry to
C. Salaries paid to employees
record at the balance sheet date is:
Test Yourself
D. Unpaid electricity expense
E. Issued shares of company A. Debit Cash by 120,000TL; credit Bank Loans
by 120,000 TL
B. Debit Interest Expense by 10,000 TL; credit
2 Which of the followings can be recorded as Cash by 10,000 TL
current liability? C. Debit Current Portion of Long-term Loans
A. Bank credit with 2 years maturity by 60,000; credit Long-term Bank Loans by
B. A received check with 2 months maturity 60,000 TL
C. Amount of cash paid for purchase of inventory D. Debit Long-term Loans by 20,000 TL; credit
D. Possible decrease in sales by 100,000 TL next year Cash by 20,000 TL
E. Indemnity to be paid to fired employees next E. Debit Long-term Loans by 60,000; credit
year Current Portion of Long-term Bank Loans by
60,000 TL
3 …. is a kind of credit which is offered by

banks but does not incur any interest until being 6 The additional amount that a company
used. accepts to pay in order to extend the maturity of
an existing liability is called:
A. Check
A. Cash
B. Line of Credit
B. Interest
C. Letter of Credit
C. Principal
D. Short-term Loan
D. Premium
E. Paycheck
E. Installment
4 On November1, NoCash Company borrowed

60,000 TL from Bank Lender with the conditions 7 On February 25, User Company has received
of 10% annual interest and 3 months maturity. an electricity bill of 12,000 TL for February to be
All principal and interest will be paid at the end paid in March. The electricity bill is recorded in
of maturity. The debit and credit records for the company’s financial statements as;
relevant items at the maturity date are: A. Electricity Expense in income statement and
A. Debit Cash by 60,000TL; credit Short-term Accrued Electricity Payable in balance sheet
Bank Loans by 60,000 TL B. Electricity Expense in balance sheet and
B. Debit Interest Expense by 500 TL; credit Short- Accrued Electricity Payable in Income
term Bank Loans by 500 TL Statement
C. Debit Interest Expense by 500 TL, Interest C. Unearned Revenue in balance sheet and
Payable by 1,000 TL, Short-term Bank Loans Accrued Electricity Payable in Income
by 60,000 TL; credit Cash by 61,500 TL Statement
D. Debit Interest Expense by 500 TL, Interest D. Unearned Revenue in balance sheet and
Payable by 1,000 TL; Short-term Bank Loans Electricity Expense in Income Statement
by 1,500 TL E. Electricity Expense in income statement and
E. Debit Short-Term Bank Loans by 1,000 TL; Accounts Payable in balance sheet
credit Current Portion of Long – term Loans
by 1,000 TL
115
Please answer the questions 8 and 9 using the

information presented below.
9 How will Courty Company record this
“On 15 December 2018, Courty Company agreed 10,000 TL on 31 January 2019?
with famous attorney Mr. Lawier to defend the
company against the labor-union in a case on 15 A. by recording a provision in the balance sheet
March 2019. The labors claimed the company to B. by recording a contingent liability in the
pay 230,000 TL in total. As of the beginning of balance sheet
Test Yourself
January 2019, another company has lost a similar C. by disclosing a contingent liability in the
(almost identical) case against the same labor union footnotes
and paid 150,000 TL (a very different amount D. by recording as accrued consultancy expense
than that was concluded in another court; 15,000 E. by not recording anything
TL). If Courty Company loses the case, Mr. Lawier
will collect 10,000 TL from the company. This
prevents the indemnity to be measured reliably.” 10 The analyses of Value Added Tax (VAT)
accounts of Tax-Max Company show that, during
the year company has collected 145,000 TL VAT
8 How will Mr. Lawier record this 10,000 TL for the sales generated and paid 162,000 TL VAT
on 15 December 2018 (the date of agreement)? in total for the purchases of raw materials. The
entry to record at the end of year includes;
A. by recording as unearned revenue
A. VAT payable of 17,000 TL
B. by recording as accounts receivable
B. VAT received of 162,000 TL
C. by recording as cash inflow C. VAT deductible of 17,000 TL
D. by recording as accrued consultancy expense D. VAT collected of 162,000 TL
E. VAT paid of 17,000 TL
E. by not recording anything
116
Accounting II

1. D If your answer is wrong, please review the 6. B
“Accounting for Current Liabilities – Notes
“Accounting for Current Liabilities” section.
Payable” section.

2. E If your answer is wrong, please review the 7. A
the “Accounting for Current Liabilities –
“Accounting for Current Liabilities” section.
Accruals” section.
3. D 8. E
“Accounting for Current Liabilities – Short the “Accounting for Current Liabilities –
Term Bank Loans” section. Unearned Revenue” section.

4. C 9. C If your answer is wrong, please review the
“Accounting for Current Liabilities – Short
“Contingent Liabilities” section.
Term Bank Loans” section.
If your answer is wrong, please review If your answer is wrong, please review the
5. E the “Accounting for Current Liabilities – 10. C
“Accounting for Current Liabilities – Value
Current Portion of Long-Term Bank Loans” Added Tax” section.
section.

If the company incurs an obligation in December to be paid 5 months
later, is this obligation treated as a current liability or will it be a non-
current liability, just because it will be paid in the following year?
The obligation under question will be recorded as a current liability, because

the current-noncurrent distinction is made using the balance sheet date as
the starting point. A balance sheet can be prepared on any day desired, as
your turn 1 it represents the financial position of a company at a specific point in time.
Therefore, if a balance sheet is prepared on December 31, this obligation falls
in short-term payables class.
Why is the Current Portion of Long-Term Loans account is

required for information users?
According to periodicity principle, companies must divide their unlimited

life (according to going concern assumption) to periods and prepare their
financial statements for each period (fiscal year) separately. This enables users
your turn 2
of accounting information opportunity to assess the riskiness of companies
(such as liquidity) as well as their financial performances. Even if the payment
is due in many years, the partial payments that fall in short-term period must
be reported separately than the remaining lump sum to be paid in long-term,
so that investors and creditors can better evaluate whether the company can
meet its obligations in short term or not. In summary, to provide a complete
picture of current liabilities, partial payments of long-term loans should be
reported in short-term obligations.
117
How does the customer record the amount, which is

reported as unearned revenue by seller?
What is recorded as unearned revenue by the seller is the advanced payment of

customer for the goods and services that will be received in the future. From
the perspective of customers, this kind of prepayments are treated as “prepaid
your turn 3 expenses” or “deposits given” depending on the source of prepayment.
What happens if the accumulated prepaid tax amount is

higher than the annual income tax?
If the prepaid amount of tax is higher than the year-end income tax amount, a
your turn 4 receivable is recorded in balance sheet to represent the amount to be deducted
from next year’s first prepaid tax obligation, just like it is in VAT.
Please explain what distinguishes provisions

and contingent liabilities from other liabilities.
When a company has no reasonable alternative but to settle the obligation, this
means company has a present obligation. Once a company has an obligation,
your turn 5 if timing and amount of settlement are certain, an ordinary liability (the word
“ordinary” is used only to differentiate from provisions and contingent ones) is
recognized in the balance sheet. If the amount can be reliably estimated but has
some uncertainty included at the same time, it is recognized as a provision instead
of an ordinary liability. If, on the other hand, the amount cannot be estimated
reliably, it becomes a contingent liability to be disclosed in footnotes only.
118
Accounting II
What if the company was the filing party? Would

they report an asset for each of these three
options?

If the company were the filing party, it would have an economic benefit inflow
as the indemnity upon winning the case. However, because of conservatism
your turn 6 principle, company cannot recognize any asset in its financial statements
unless they receive the right to collect a certain amount of indemnity. If the
amount is both probable to inflow and can be estimated reliably, company
discloses a contingent asset in footnotes for it.
Endnotes
1Simga-Mugan, F. N.C. and Akman, N.H. (2012) 9Mirza, A. A., Holt, G. J. and Orrell, M. (2008)
Principles of Financial Accounting Based on IFRS International Financial Reporting Standards:
(Fifth Edition). McGraw-Hill, p.244. Workbook and Guide (Second Edition). John Wiley
2Simga-Mugan and Sons Inc. p. 277.
and Akman, op cit. p.244; Dauderis,
H. and Annand, D. (2014) Introduction to 10Elliott and Elliott, op cit. p. 291.
Financial Accounting (Second Edition), Valley 11Alfredson, K., Leo K., Picker, R., Loftus, J., Clark,
Educational Services Ltd. p. 453.
K. and Wise, V. (2009) Applying International
3Marshall, D.H., McManus, W. W. and Viele, D.F. Financial Reporting Standards (Second Edition)
(2002) Accounting: What the Numbers Mean (Fifth John Wiley and Sons Inc. p. ; Mirza et al., op cit.
Edition). McGraw-Hill, p. 234. p. 276.
4Simga-Mugan and Akman, op cit. p. 243. 12Dick, W. and Missionier-Piera, F. (2010) Financial
5Elliott, Reporting Under IFRS: A Topic Based Approach.
B. and Elliott, J. (2011) Financial Accounting
John Wiley and Sons Inc. p. 96.
and Reporting (Fourteenth Edition) Pearson
Education Limited, p.377. 13Kimmel P.D., Weygandt J. J. and Kieso D. E.
6Dauderis (2009) Financial Accounting: Tools for Business
and Annand, op cit. p. 448.
Decision Making, 5th Edition, John Wiley &
7Simga-Mugan and Akman, op cit. p. 247. Sons, Inc., p. 488.
8Williams, J.R., Haka, S.F., Bettner, M. S. and
Meigs, R.F. (2003) Financial Accounting (Eleventh
Edition). New York: McGraw-Hill, p.
119
Chapter 5 Long Term Liabilities
After completing this chapter, you will be able to:
Describe the major characteristics of long term
1
Learning Outcomes
liabilities and distinguish long term liabilities

from short term liabilities
2 Describe the major characteristics of bonds
and identify various types of bond issues
3 Record bonds issued at par value and at a

discount or premium
4 Amortize bond discounts and bond premiums
using the effective interest methods.
5 Explain the accounting for long term notes

payable
Chapter Outline Key Terms

Introduction Bond Indenture
Nature of Long Term Liabilities Bonds
Bonds and Types of Bonds Bonds Issued at Discount
Accounting for Bond Issues Bonds Issued at Par
Amortization of Bond Discounts and Premiums Bonds Issued at Premium
Long Term Notes Payable Effective Interest Rate Method
Effective Yield
External Financing
Long Term Liabilities
Long Term Notes Payable
120
5
Accounting II
INTRODUCTION
In order to finance and expand their operations Short term liabilities consist of an expected
companies need funds. Although some of the outflow of resources arising from present
necessary funding can be provided by their own obligations that are not payable within a
operations, companies usually have to raise some year or the operating cycle of the company
of the funds from external sources. Therefore, whichever is longer.
these companies are required to obtain long-
term financing from banks and other financial
institutions and we call this process as “external
financing”. Long term liabilities consist of an expected
External financing includes some combination outflow of resources arising from present
of debt and equity financing. Corporations obtain obligations that are not payable within a
cash for recurring business operations from stock year or the operating cycle of the company
issuances, profitable operations, and short-term whichever is longer.
borrowing (current liabilities). However, when
situations arise that require large amounts of
cash, such as the purchase of a land, building, or Long-term liabilities are the most common way
equipment, corporations also raise cash from long- to finance the expansion of a business. Growth
term borrowing (obligations arising from debt usually requires investment in long-term assets and
financing is called as “long term liabilities”). in research and development and other activities
Short-term debts, including the purchase of that will generate income in coming years. To
goods and services on account and the issuance finance these assets and activities, a company needs
of short-term notes payable, were discussed in long-term funds. The management issues related
Chapter 4. Issuing equity in the form of common to long-term debt financing are whether to take
or preferred stock will be discussed in Chapter on long-term debt, how much long-term debt to
6. This chapter focuses on the use of long-term carry, and what types of long-term debt to incur.1
debt such as bonds and notes payable to finance Generally, long term liabilities have various
a company’s operations. In this chapter, first covenants or restrictions for the protection of both
the nature of long term liabilities and then the lenders and borrowers. The covenants and other
measurement, valuation and financial reporting of terms of the agreement between the borrower and
the most common types of long term liabilities will the lender are stated in the bond indenture or note
be explained. agreement.
NATURE OF LONG TERM

LIABILITIES
Long term debt has various covenants or
In a balance sheet, obligations related with
restrictions for the protection of both lenders
external financing sources named as “liabilities”.
and borrowers.
Liabilities are first classified as “Current (Short-
Term) Liabilities” and “Non-Current (Long-
Term) Liabilities” based on the time period in
which expected debt will be paid back. Short To structure long-term financing to the best
term liabilities consist of an expected outflow of advantage of their companies, managers should
resources arising from present obligations that are know the characteristics of the various long-term
payable within a year or the operating cycle of debts. Bonds payable, long-term notes payable,
the company whichever is longer. Whereas long mortgages payable, pension liabilities and lease
term liabilities consist of an expected outflow of liabilities can be given as the example to long term
resources arising from present obligations that are liabilities. In this chapter accounting, valuation
not payable within a year or the operating cycle of and financial reporting of bonds and long term
the company whichever is longer. notes payable will be explained in detail.
121
5
Each bondholder receives a bond certificate

showing the name of the company that borrowed
the money, exactly like a note payable. The
certificate specifies the face value, which is the
amount of the bond issue. The bond’s face value is
also called maturity value, principal, or par value.
A bond arises from a contract known as a bond
indenture and represents a promise to pay:
1. a sum of money at a designated maturity
rate, plus
2. periodic interest at a specified rate on the
maturity amount (face value)
The bond indenture is a contract or loan

agreement under which the bonds are
BONDS AND TYPES OF BONDS
issued. A bond indenture deals with matters
A bond is the most common type of long-term such as the interest rate, maturity date and
debt. Bond is a form of interest-bearing notes maturity amount, possible restrictions on
payable issued by corporations and governmental dividends, repayment plans, and other
agencies. Like a note, a bond requires a promise provisions relating to the debt.
to pay a sum of money at a designated maturity
date, plus periodic interest at a specified rate on the
maturity amount (face value). Bonds payable are The interest rate written in the terms of the
the most common type of long term debts issued bond indenture (an ordinarily printed on the
to multiple lenders called bondholders. bond certificate) is known as the stated, coupon or
nominal rate and this rate is set by the issuer and
expressed as a percentage of the face value.
Bond is a form of interest-bearing notes
payable issued by corporations and
governmental agencies. A bond is a debt or The interest rate written in terms of the
liability of the issuer. bond indenture is known as the stated
interest rate.
The main purpose of issuing bonds is to borrow

for the long term when the amount of capital
needed is too large for one lender to supply. In
other words, by issuing bonds, a company can
divide a large amount of long-term indebtedness Stated interest rate is also called as coupon
into many small investing units, thus enabling or nominal rate.
more than one lender to participate in the loan.
Each investor can buy a specified amount of the
company’s bonds. For example, a company seeking
to borrow 1,000,000 TL would issue one thousand
1,000 TL bonds (1,000 TL x 1,000) rather than one The interest rate written in terms of the
1,000,000 TL bond or note. This practice enables bond indenture is set by the bond issuer.
investors with less cash to invest to purchase some
of the bonds.
122
5
Accounting II
payment. For example, mortgage bonds are

secured by a claim on real estate. A mortgage is
a legal claim (lien) on specific property that gives
Face value is also called as the par value,
the bondholder the right to possess the pledged
principal amount or maturity value of the
property if the company fails to make required
bonds
payments.2 Bonds not backed by collateral are
called “unsecured bonds” (also called debenture
bonds). They are very risky and offer a high
interest rate.3
internet
Handbook of Turkish Capital Markets
Secured bonds are backed by a pledge of
2018 https://www.tspb.org.tr/wp-content/
some collaterals, unsecured bonds are not.
uploads/2015/07/TCMA_Handbook_of_
the_Turkish_Capital_Markets_2018-1.pdf
http://cbonds.com/countries/Turkey-bond
Unsecured bonds offer high interest rate,

they are not backed by a collateral and very
risky.
Term, Serial Bonds, and Callable

Bonds
With respect to the way they mature, bonds are
classified as term bonds, serial bonds and callable
bonds. Bond issues that mature on a single date are
called “term bonds”. Bond issues that mature in
installments are called “serial bonds”. Bond issues
that give the issuer the right to call and retire the
bonds prior to maturity is called “callable bonds”.4
Bonds can be classified into different categories

When all bonds of an issue mature at the
depending on different face amount, interest
same time, they are called term bonds. If the
rates, interest payment dates, and maturity dates.
bonds mature over several dates, they are
Some of the most common types of bonds will be
called serial bonds.
discussed in this part of the chapter.
Secured and Unsecured Bonds

With respect to whether they are backed by Bond issues that mature on a single date are
a pledge of some collateral or not, bonds are called term bonds, bond issues that mature
classified as secured and unsecured bonds. A in installments are called serial bonds.
secured bond is a bond for which a company
has pledged specific property to ensure its
123
5
Registered and Bearer (Coupon) rate and principal (the face value). In other words,
Bonds selling price of a bond can be calculated as the
present value of the face value plus the present
Bonds issued in the name of the owner are
value of periodic interest payments.
called “registered bonds” and require surrender of
the certificate and issuance of a new certificate to
complete a sale. Bonds re not recorded in the name
of the owner are called “bearer (coupon) bonds”
and they can be transferred from one owner to
another by mere delivery. The bondholder detaches
the coupons from the bonds on the interest payment
dates and submits them to a bank for collection.5
Bonds issued in the name of the owner are

called registered bonds, bonds not issued
in the name of the owner are called bearer
The interest rate used to compute the present
(coupon) bonds.
value of these cash flows is the market interest rate
that provides an acceptable return on investment
commensurate with the issuer’s risk characteristics.
Income and Revenue Bonds To calculate the selling price of bonds we need
Bonds which pay no interest unless the issuing to know the face value of the bond (the principal
company is profitable are called “income bonds”. amount borrowed), the interest payment pattern
Bonds which pay interest from specified revenue (annually, semiannually, etc.), the market interest
sources are called “revenue bonds”. They are rate per period and number of periods to maturity.
usually issued by airports, toll-road authorities and
Based on the relationship between stated and
governmental bodies.
market interest rates we can easily understand
whether bonds should be sold at its face value (at
par), or should be sold at a price different from
Bonds which pay interest from the profit their face value before making any calculations.
of issuing company are called “income
If stated interest rate is equal to market interest
bonds”, bonds which pay interest from
specified revenue sources are called rate then the bonds will be sold at their face value,
“revenue bonds”. because company is exactly offering the same
return what the market is offering. So we can say
that bond is sold at face value (at par).
Income bonds pay no interest unless the

issuing company is profitable.
When selling price of a bond is equal to its
face value that means it is sold at face value
(at par).
ACCOUNTING FOR BOND
ISSUES
A bond can be issued at any price agreed upon
by the issuer and the bondholders. The issue price
of a bond is considered as the present value of its
future cash flows which is calculated by interest
124
5
Accounting II
If stated interest rate is different from the market interest rate then bonds will be sold at a price different
from their face value, because company is offering a different return from what the market is offering. So
we can say bond is either sold at a premium or a discount.
When selling price of a bond is different from its face value that means it is sold either
at premium or discount.
Bonds Issued at Face Value (at Par Value)

Bonds issued at face value (at par value) means
stated interest rate is equal to market interest rate and
no premium and discount exists.
To illustrate assume that on January 2, 2018 Balstad
Company issues bonds for $100,000, due in 5 years with
10 percent interest payable annually at year end. At the
time of issue market rate for such bonds is 10 percent.
Without making any calculations we can say that
bonds are issued at face value (at par) because the
stated interest rate is equal to the market interest rate.
First we have to list all the data we have to calculate
the selling price of the bonds issued:
Face Value : $100,000

Stated Interest Rate : 10%
Market Interest Rate : 10%
Interest Payment Pattern : Annually
The Principal Payment Pattern : At Maturity
Number of Interest Payments to Maturity : 5
Interest to be paid at the end of each period is $10,000 ($100,000 x 10%)
Present Value $ 100,000 Principal
=10%
$10,000 $10,000 $10,000 $10,000 $10,000 Interest
0 1 2 3 4 5
As a result of this calculation we understand that Balstad has to pay $10,000 interest at the end of each
year end for 5 years and at the end of the fifth year also has to pay back the principal amount borrowed.
Now we have all the information we need to calculate the present value of the future cash flows related
with bonds issued.
125
5
Present Value of the Principal

$100,000 x 0.62092 (Appendix A, Table 1, n: 5, i: 10%)* $62,092
Present Value of the Interest Payments
$10,000 x 3.79079(Appendix A, Table 2, n: 5, i: 10% )** $37,908
Present value (selling price) of the bonds $100,000
*, **In order to simplify our solution we directly use the already calculated present value factors from time value
of money tables which are given in Appendix A. Interest rate used is the market interest rate. We simply find
the intersection point of total period and interest rate and use that value.
This sale can be journalized as follows:

January 2 Cash 100,000
Long Term Bonds Payable 100,000
To record sale of 5-year bonds at face value (at par).
Partial impact of this sale regarding to liabilities on Balance Sheet as of the date of the sale as follows:
Balstad Company
Balance Sheet (Partial)
as of January 2, 2018
.... ....
Long Term Bonds Payable $100,000
1
On January 3, 2018 Malibu Corporation issued bonds for $100,000 due in 5 years with
12 percent interest payable annually. At the time of issue market rate for such bonds is
12 percent. The principal amount borrowed will be paid back once at maturity.
Required: a) Calculate the selling price of bonds and make the necessary journal entry
as of the issue date. b) Make the necessary journal entry as of December 31, 2018 and
January 3, 2019.
Bonds Issued at Premium

Bonds issued at premium means, market interest rate is less than the stated interest rate of the bond
issued. In other words, since the stated interest rate is more than the interest rate offered by any other
investment instrument in the market, investors will pay more than the face value of the bond.
To illustrate assume that on January 2, 2018 Balstad Company issues $100.000 in bonds, due in 5
years with 10 percent interest payable annually at year end. At the time of issue market rate for such bonds
is 8 percent.
126
5
Accounting II
First we have to list all the data we have to calculate the selling price of the bonds issued:


=8%
$10,000 $10,000 $10,000 $10,000 $10,000 Interest
0 1 2 3 4 5
with bonds issued.

$100,000 x 0.68058 (Appendix A, Table 1, n: 5, i: 8%) $68,058
By paying $107,985 at the date of issue, the investors will realize an effective rate or yield of 8 percent
over the 5-year term of bonds. These bonds would sell at a premium of $7,985 ($107,985 - $100,000).

Premium on Long Term Bonds Payable 7,985
To record sale of bonds at premium
Balstad Company
.... ....

Premium on LTBonds Payable 7,985
127
5
2
On January 3, 2018 Melrose Corporation issued bonds for $100,000 due in 5 years with 12 per-
cent interest payable annually. At the time of issue market rate for such bonds is 10 percent. The
principal amount borrowed will be paid back once at maturity.
Required: Calculate the selling price of bonds and make the necessary journal entry as of the
issue date.
Bonds Issued at Discount

Bonds issued at discount means, market
interest rate is more than the stated interest rate
of the bond issued. In other words, since the
stated interest rate is less than the interest rate
offered by any other investment instrument in
the market, investors will pay less than the face
value of the bond.
To illustrate the calculation of the selling price
of bonds issued assume that on January 2, 2018
Balstad Company issues $100.000 in bonds,
due in 5 years with 8 percent interest payable
annually at year end. At the time of issue market
rate for such bonds is 10 percent.
Before making any calculation we can say that these bonds are sold at discount because similar
instruments in the market are offering a higher return (interest) than the return that Balstad offers. As a
result, Balstad has to do something to make its bonds attractive and ensure investors that they are going
to get the same return. So if Balstad sells bonds at a discount in return investors are going to realize
an effective yield of 10 percent over the investment period. First we have to list all the data we have to
calculate the selling price of the bonds issued:

=10%
$8,000 $8,000 $8,000 $8,000 $8,000 Interest
0 1 2 3 4 5
128
5
Accounting II
with bonds issued.

over the 5-year term of bonds. These bonds would sell at a discount of $7,582 ($100,000 - $92,418).

Discount on Long Term Bonds Payable 7,582
Balstad Company
.... ....

(-) Discount on LTBonds Payable (7,582)
3
On January 3, 2018 California Corporation issued bonds for $100,000 due in 5 years with 10
percent interest payable semiannually (twice a year). At the time of issue market rate for such
bonds is 12 percent. The principal amount borrowed will be paid back once at maturity.
Required: Calculate the selling price of bonds and make the necessary journal entry as of the
issue date.
AMORTIZATION OF BOND DISCOUNTS AND PREMIUMS

As it has been already mentioned, by paying more or less at the issuance, investors earn a rate different
than the stated rate on the bond. Remember that, the issuing company pays the stated interest rate over
the term of the bonds but also must pay the face value at maturity. If the bond is issued at a discount, the
amount paid at maturity is more than the selling price. If issued at premium, the company pays less at
maturity relative to the selling price.
129
5
The company records this adjustment to the cost as bond interest expense over the life of the bonds
through a process called amortization. Amortization of a discount increases bond interest expense.
Amortization of a premium decreases bond interest expense.
Amortization of a discount increases bond interest Adjustment process to the cost as bond interest
expense, amortization of a premium decreases bond expense over the life of bonds called amortization.
interest expense.
The method used for amortization of a discount or

premium is called effective interest method.
Amortization method used for discount or

premium is called effective interest method.
Under effective-interest method, we have to do the followings:

1. Compute bond interest expense:
Bond Interest Expense = Carrying Value of Bonds x Effective Interest Rate at The Beginning of Period
The carrying value is the face amount

minus any unamortized discount or plus The term carrying value is synonymous with book value.
any unamortized premium.
2. Determine the bond discount or premium amortization:

Bond
Interest Paid = Face Amount of Bonds x Stated Interest Rate
Amortization Amount = Bond Interest Expense – Bond Interest Paid
Amortization of Bonds Issued at Premium

As we have already mentioned before if bond issuer offers more interest rate than the market interest
rate, they have to sell at premium to offer the same effective interest return to their investors.
To illustrate amortization of premium under the effective-interest method, Montana Corporation issued
$100,000 of 8 percent term bonds on January 1, 2018, due on January 2023, with interest payable each July
1 and January 1 (semiannually). Market interest rate was 6 percent.6
130
5
Accounting II

Interest Payment Pattern : Semiannually
Number of Interest Payments to Maturity : 10 (5yrs x 2)
Interest to be paid at the end of each period is:
$100,000 x 8% = $8,000 annually

$8,000 ÷ 2 = $4,000 semiannually
As a result of this calculation we understand that Montana has to pay $4,000 interest at July 1 and
January 1 for 5 years and at the end of the fifth year also has to pay back the principal amount borrowed.
with bonds issued.

$100,000 x 0.74726 (Appendix A, Table 1, n: 10, i:3%) $74,409
over the 5-year term of bonds. These bonds would sell at a premium of $8,530 ($108,530 - $100,000).

Premium on Long Term Bonds Payable 8,530
Balstad Company
.... ....

131
5
The five-year bond-premium amortization schedule can be prepared as follows:
Schedule of Bond Premium Amortization

Effective Interest Method-Semiannual Interest Payments
Cash Interest Discount
Period Carrying Amount of Bonds
Paid Expense Amortized
Issue Date $108,530
1 $4,000 $3,256a $744$b 107,786c
2 $4,000 3,234 766 107,020
3 $4,000 3,211 789 106,231
4 $4,000 3,187 813 105,418
5 $4,000 3,162 838 104,580
6 $4,000 3,137 863 103,717
7 $4,000 3,112 888 102,829
8 $4,000 3,085 915 101,914
9 $4,000 3,057 943 100,971
10 $4,000 3,029 971 100,000
$40,000 $31,470 $8,530
a $108,530 x 6% ÷ 2=3,256 c $108,530 - 614 = $107,786

b $4,000 - $3,256 = $ 744

July 1, 2018 Interest Expense 3,256
Premium on Bonds Payable 744
Cash 4,000
To record 1st Interest Payment
Partial impact of this sale to financial statements:

Montana Corporation
Income Statement (Partial)
as of July 1, 2018
Interest Expense $3,256

Montana Corporation
as of July 1, 2018
.... ....

132
5
Accounting II
Montana Corporation journalizes the interest expense accrued at December 31, 2018 (year-end)

Premium on Bonds Payable 766
To record adjustment at year end
Partial impact of this entry to financial statements:

Montana Corporation
For 2018
Interest Expense $6,490*

*$3,256 + $3,234 = $6,490 (for 2018)
Montana Corporation
as of December 31, 2018
.... ....

Montana Corporation journalizes the payment of interest expense accrued at January 1, 2019 as below:

January 1, 2019 Interest Payable 4,000
Cash 4,000
To record 2nd Interest Payment
4
On January 2, 2018 Miami Corporation issued bonds for $100,000 due in 3 years with 6 percent
interest payable semiannually (twice a year). At the time of issue market rate for such bonds is 4
percent. The principal amount borrowed will be paid back once at maturity.
Required: a) Calculate the selling price of bonds and make the necessary journal entry as of the
issue date. b) Make necessary journal entry for the first interest payment.
133
5
Amortization of Bonds Issued at

Discount
Recall that if bond issuer offers less interest rate
than the market interest rate, they have to sell at
premium to offer the same effective interest return
to their investors.
To illustrate amortization of premium under the
effective-interest method. Jacksonville Corporation
issued $100,000 of 8 percent term bonds on January
1, 2018, due on January 2023, with interest payable
each July 1 and January 1 (semiannually). Market
interest rate was 10 percent.7

Number of Interest Payments to Maturity : 10 (5yrs. x 2)

$100,000 x 8% = $8,000 annually
$8,000 ÷ 2 = $4,000 semiannually
As a result of this calculation we understand that Jacksonville has to pay $4,000 interest at July 1 and
January 1 for 5 years and at the end of the fifth year also has to pay back the principal amount borrowed.
with bonds issued.

over the 5-year term of bonds. These bonds would sell at a discount of $7,722 ($100,000 - $92,278).

To record sale of bonds discount
134
5
Accounting II
Jacksonville Corporation
.... ....

The five-year bond-discount amortization schedule can be prepared as follows:
Schedule of Bond Premium Amortization

Effective Interest Method-Semiannual Interest Payments
Cash Interest Discount
Period Carrying Amount of Bonds
Paid Expense Amortized
Issue Date $92,278
1 $4,000 $4,614a $614b 92,892c
2 $4,000 4,645 645 93,537
3 $4,000 4,677 677 94,214
4 $4,000 4,711 711 94,925
5 $4,000 4,746 746 95,671
6 $4,000 4,783 783 96,454
7 $4,000 4,823 823 97,277
8 $4,000 4,864 864 98,141
9 $4,000 4,907 907 99,048
10 $4,000 4,952 952 100,000
$40,000 $47,722 $7,722
a $92,278 x 8% ÷ 2 = $4,614 c $92,278 + 614 = $92,892

b $4,614 - $4,000 = $614

July 1,2018 Interest Expense 4,614
Discount on Bonds Payable 614
Cash 4,000
Partial impact of this sale to financial statements:
For the first 6 months of 2018
135
5
as of July 1, 2018
.... ....
.... Long Term Bonds Payable $100,000

Discount on Bonds Payable 645
To record adjustment at year end

For 2018
Interest Expense $9.259
* $4,614 + $4,645= $9,259 (for 2018)
.... ....

Jacksonville Corporation journalizes the payment of interest expense accrued at January 1, 2019 as
below:

January 1, 2019 Interest Payable. 4,000
Cash 4,000
To record 2nd Interest Payment
5
On January 2, 2018 Texas Corporation issued bonds for $100,000 due in 4 years with 14 percent
interest payable semiannually (twice a year). At the time of issue market rate for such bonds is 16
percent. The principal amount borrowed will be paid back once at maturity.
Required: a) Calculate the selling price of bonds and make the necessary journal entry as of the
issue date. b) Make necessary journal entry for the first interest payment
136
5
Accounting II
LONG TERM NOTES PAYABLE

You learned about the short term notes payable in a Chapter 4. A long-term note is a promissory note
that represents a loan from a bank or other creditor. Long-term notes payable is similar to short-term
notes payable except that the term of the notes exceeds one year. The basic difference between short term
notes payable and long-term notes payable is the maturity date. As we have already mentioned before long
term liabilities consist of an expected outflow of resources arising from present obligations that are not
payable within a year or the operating cycle of the company whichever is longer. Long-term notes payable
is typically reported in the long-term liabilities section of the balance sheet.8
Most of the long-term notes payable are paid in
installments which include some part of principal
and accrued interest together.
To illustrate Smart Bulls Company signed $20,000
note payable on December 1, 2018. The note will be
paid over four years with payments of $5,000 plus 12%
interest due each December 31, beginning December
31, 2019. Remember that the current portion of the
note, the amount due December 31, 2019, $5,000, is
considered a current liability at December 31, 2018.
We record the issuance of the note on December 31,
2018, in the following journal entry:

December 1, 2018 Cash 4,000
Notes Payable 4,000
Received cash in exchange for a 4-year, 12% note
On December 31, 2019, Smart Bulls Company will make a $5,000 principal payment plus 12%
interest. Using the calculation for interest that you have already learned, Smart Bulls Company will
calculate interest expense as follows:
Beginning Balance × Interest Rate × Time
The total cash payment is the principal payment plus interest expense. The principal portion of the
payment is then computed as the difference between the total installment note payment (cash paid) and
the interest component. These computations are illustrated in the following table.
Beginning Principal Interest Total Ending

Balance Payment Expense Payment Balance
December 31, 2018 $20,000
December 31, 2019 $20,000 $5,000 $2,400 $7,400 $15,000
December 31, 2020 $15,000 $5,000 $1,800 $6,800 $10,000
December 31, 2021 $10,000 $5,000 $1,200 $6,200 $5,000
December 31, 2022 $5,000 $5,000 $600 $5,600 0
---------- --------- ----------
Total $20,000 $6,000 $26,000
137
5
Notice that at the end of the four years, Smart Bulls Company will have paid total interest of $6,000.
Also notice that the interest expense decreases each year, as this expense is based on the principal, which is
decreasing with each installment payment.
Assume it’s now December 31, 2019, and Smart Bulls Company must make its first installment
payment of $5,000 principal plus interest on the note. The entry to record the first payment on December
31, 2019, is as follows:

Notes Payable 5,000
Cash 7,400
Paid principal and interest on installment note
After the final payment, the carrying amount on the note is zero, indicating that the note has been
paid in full.
Installment notes are generally used to purchase specific assets such as equipment, and typically secured
by the purchased asset. When a note is secured by an asset, it is called a mortgage note. If the borrower
cannot pay the mortgage note, the lender has the right to take ownership of the pledged asset and sell it to
pay back the debt.9 Mortgages payable are very similar to long-term notes payable. The main difference is the
mortgages payable is secured with specific assets, whereas long-term notes are not secured with specific assets.
The nature of long term notes payable is quite similar in substance to bonds. A long-term note is
a promissory note that represents a loan from a bank or other creditor, while a bond is usually a more
complex financial instrument that represent a debt to many creditors.10 Additionally, notes do not trade
as readily as bonds in the organized public securities markets.
Accounting for notes and bonds are also similar. Companies, compute the present value of bonds
by calculating present value of its future interest and principal cash flows and amortizes any discount or
premium over the life of the note. Inevitably accounting and financial reporting of long term notes payable
are quite similar to bonds payable.
To illustrate Seattle Company borrowed $10,000 from Boston Company as of January 2, 2018, in return
signed a three year, 10 percent annually interest bearing note. The market rate for a note of similar risk is 12
percent.
$10,000 x 10% = $1,000 annually

=12%
$1,000 $1,000 $1,000
0 1 2 3
As a result of this calculation we understand that Seattle has to pay $1,000 interest at the end of each
year for 3 years and at the end of the third year also has to pay back the principal amount borrowed. Now
we have all the information we need to calculate the present value of the future cash flows related with
bonds issued.
138
5
Accounting II

The issuance of notes payable can be journalized as follows:

January 2,2016 Cash 9,520
Discount on Long Term Notes Payable 480
Long Term Notes Payable 10,000
To record sale of notes issued at discount
Seattle Company
.... ....

(-) Discount on LTBonds Payable (480)
The five-year bond-discount amortization schedule can be prepared as follows:

Period Cash Interest Discount Carrying
Paid Expense Amortized Amount of Bonds
Issue Date $92,278
31.12.2018 $1,000 $1,142a $142b 9,662c
31.12.2019 1,000 1,159 159 9,821
31.12.2020 1,000 1,179 179 10,000
$3,000 $3,480 $480

a $ 9,520 x 12% = $1,142
b $ 1,142 - $ 1,000 = $ 142
c $ 9,520 + $ 142 = $ 9,662
Seattle Corporation makes the following journal entry for the first year end payment:

Discount on Long Term Notes Payable 142
Cash 1,000
To record the first year end interest payment
139
5
Seattle Company
For 2018
Seattle Company
.... ....

6
On January 3, 2018 Manhattan Corporation borrowed $50,000 from Dexter Company, in return
signed a six year, 8 percent annually interest bearing note. The market rate for a note of similar risk
is 10 percent. Required: Make necessary journal entry for the issuance of the note.
Further Reading
HANDBOOK OF THE TURKISH CAPITAL MARKETS 2017

…
C. Debt Securities Market
1. Markets
Banks and brokerage firms are allowed to operate in the Debt Securities Market. Government bonds,
T-bills, corporate bonds, Islamic bonds (sukuk) and asset backed securities are traded in these markets.
In addition to organized markets, debt securities can be traded in the OTC market. However, OTC
market transactions must be reported to Borsa Istanbul. The settlement of OTC transactions is con-
ducted through banks’ accounts at the Central Bank, or brokerage firms’ accounts at Takas bank, or
through the system of MKK, CSD of Turkey….
Source: https://www.tspb.org.tr/wp-content/uploads/2015/08/Handbook_of_the_Turkish_Capital_
Markets_2017.pdf
140
5
Accounting II
Inside Practice
Source: http://cbonds.com/emissions/issue/36317
Discuss:
1. What do you think about Arçelik’s bonds types?
2. What is the effects of issuing bonds?
3. What is the importance of long term financing for Arçelik and look at the other companies
external financing activities?
141
5
Describe the major characteristics of long term liabilities and

LO 1 distinguish long term liabilities from short term liabilities
Short term liabilities consist of an expected outflow or resources arising from present obligations that
are payable within a year or the operating cycle of the company whichever is longer. Whereas long term
liabilities consist of an expected outflow of resources arising from present obligations that are not payable
within a year or the operating cycle of the company whichever is longer.
Short term liabilities consist of an expected outflow of resources arising from present obligations that
are payable within a year or the operating cycle of the company whichever is longer. Whereas long term
Summary
liabilities consist of an expected outflow of resources arising from present obligations that are not payable
within a year or the operating cycle of the company whichever is longer. Long-term liabilities are the most
common way to finance the expansion of a business. Generally, long term liabilities have various cove-
nants or restrictions for the protection of both lenders and borrowers. The covenants and other terms of
the agreement between the borrower and the lender are stated in the bond indenture or note agreement.
Describe the major characteristics of bonds

LO 2 and identify various types of bond issues
Bond is a form of interest-bearing notes payable issued by corporations and governmental agencies. Like a
note, a bond requires a promise to pay a sum of money at a designated maturity date, plus periodic interest
at a specified rate on the maturity amount (face value). The main purpose of issuing bonds is to borrow
for the long term when the amount of capital needed is too large for one lender to supply.
Types of bond issues are (1) secured and unsecured bonds; (2) term, serial and callable bonds; (3) registe-
red and bearer bonds; (4) income and revenue bonds.
Record bonds issued at par value and at a

LO 3 discount or premium
A bond can be issued at any price agreed upon by the issuer and the bondholders. The issue price of a bond
is considered as the present value of its future cash flows which is calculated by interest rate and principal
(the face value).
To calculate the selling price of bonds we need to know the face value of the bond (the principal amount
borrowed), the interest payment pattern (annually, semiannually, etc.), the market interest rate per period
and number of periods to maturity.
Based on the relationship between stated and market interest rates we can easily understand whether
bonds should be sold at its face value (at par), or should be sold at a price different from their face value
before making any calculations.
Investors value a bond at the present value of its future cash flows, which is composed of interest and
principal amount. The interest rate used to calculate the present value is the market interest rate offered
by similar investment instruments in the market. A bond’s interest rate is named as stated interest rate. If
a bond is issued with a stated interest rate which is equal to market interest rate than it is called “sold at
face value (at par)”. However, sometimes the stated interest rate is different from the market interest rate.
If stated interest rate is greater than the market interest rate than it is called “sold at premium”; if stated
interest rate is less than market interest rate than it is called “sold at discount”.
142
5
Accounting II
Amortize bond discounts and bond premiums

LO 4 using the effective interest methods
The discount (premium) is amortized and charged to interest expense over the life of the bonds. Amorti-
zation of discount increases bond interest expense, whereas amortization of premium decreases bond inte-
rest expense. Effective-interest method is the name given to amortization of discount (premium) of bonds.
In this method (1) bond interest expense is computed by multiplying the carrying value of the bonds at
the beginning of the period by the effective interest rate; (2) the bond discount (premium) amortization
is determined by comparing the bond interest expense with the interest to be paid.
Summary
Explain the accounting for long term
LO 5 notes payable
A long-term note is a promissory note that represents a loan from a bank or other creditor. Long-term no-
tes payable is similar to short-term notes payable except that the term of the notes exceeds one year. Most
of the long-term notes payable are paid in installments which include some part of principal and accrued
interest together. Installment notes are generally used to purchase specific assets such as equipment, and
typically secured by the purchased asset. When a note is secured by an asset, it is called a mortgage note.
Accounting for long term notes payable and bonds are quite similar. Notes are also valued at present
value of their future cash flows (interest plus principal amount). Any discount or premium is amortized
similarly over the life of the note.
143
5
1 Which of the following statements is wrong? 5 Which of the following statements is true?
A. Long term debt has various covenants or restric- A. If stated interest rate is less than market interest
tions for the protection of lenders. rate the bond is sold at discount.
B. Long term debt has various covenants or rest- B. If stated interest rate is equal to market interest
rictions for the protection of both lenders and
Test Yourself
rate, the bond is sold at discount.

borrowers. C. If stated interest rate is more than market inte-
C. Short term liabilities consist of an expected outf- rest rate, the bond is sold at discount.
low of resources arising from present obligations d) If stated interest rate is equal to market interest
that are not payable within a year or the opera- rate, the bond is sold at premium.
ting cycle of the company whichever is longer.
e) If stated interest rate is less than market interest
D. Long term liabilities consist of an expected outf- rate, the bond is sold at premium.
low of resources arising from present obligations
that are not payable within a year or the opera-
ting cycle of the company whichever is longer. 6 Miramar Company issued $400,000 of 10%
E. The covenants and other terms of the agreement 10 year bonds on January 1, 2017, interest is pa-
between the borrower and the lender are stated yable annually. Market interest rate was 8%. What
in the bond indenture is the selling price of the bond as of January 1,
2017? (Round to nearest dollar amount if needed)
2 Which of the following cannot be classified A. $185,276 B. $268,403
as long term liabilities? C. $350,842 D. $400,000
A. Bonds B. Lease liabilities E. $453,679
C. Prepaid expenses D. Mortgages payable
E. Pension liabilities 7 On June 30, 2017 Yellowstone Company
issued $5,000,000 face value of 10%, 10 year
3 Which of the following statements is wrong? bonds. The bonds pay annual interest. If market
interest rate was 12%, what is the selling price of
A. A bond indenture is a contract from which a the bonds as of June 30, 2017? (Round to nearest
bond arises. dollar amount if needed)
B. The interest rate written in terms of bond inden-
A. $4,434,960 B. $4,500,000
ture is known as market interest rate.
C. $5,000,000 D. $5,500,000
C. Stated interest is also called as nominal rate.
E. $5,614,442
D. The interest rate written in terms of bond inden-
ture is set by the bond issuer.
E. Face value is also called as par value. 8 On January 1, 2017, Medieval Company
sold 5 year bonds having a face value of $800,000.
The stated interest rate of the bonds was 6%, in-
4 Which of the following cannot be classified terest payable semiannually. If market interest rate
as one of the types of bonds? was %8, what is the selling price of the bonds as of
A. Secured Bonds January 1, 2017? (Round to nearest dollar amount
B. Revenue Bonds if needed)
C. Registered Bonds A. $732,603 B. $735,110
D. Operating Bonds C. $739,126 D. $800,000
E. Callable Bonds E. $833,331
144
5
Accounting II
9 On January 1, 2017, Century Company sold 10 Georgia Company borrowed $250,000 from
10 year bonds having a face value of $1,200,000. Boston Company as of January 2, 2018, in return
The stated interest rate was 14%, interest payable signed a three year, 6 percent annually interest bea-
semiannually. If market interest rate was 12%, what ring note. The market rate for a note of similar risk
is the selling price of the bonds as of January 1, is 8 percent. What is the total amount borrowed
Test Yourself
2017? (Round to nearest dollar amount if needed) as of January 2, 2018? (Round to nearest dollar
A. $1,115,000 amount if needed)
B. $1,200,000 A. $198,458
C. $1,212,198 B. $209,905
D. $1,337,633 C. $237,115
E. $1,349,837 D. $250,000
E. $263,365
145
5
1. A If your answer is wrong, please review the 6. E If your answer is wrong, please review the
“Nature of Long Term Liabilities” section. “Accounting for Bond Issues” section.
2. C If your answer is wrong, please review the 7. A If your answer is wrong, please review the
“Nature of Long Term Liabilities” section. “Accounting for Bond Issues” section.
3. B If your answer is wrong, please review the 8. B If your answer is wrong, please review the
“Bonds and Types of Bonds” section. “Accounting for Bond Issues” section.
4. D If your answer is wrong, please review the 9. D If your answer is wrong, please review the
“Bonds and Types of Bonds” section. “Accounting for Bond Issues” section.
5. A If your answer is wrong, please review the 10. C If your answer is wrong, please review the
“Accounting for Bond Issues” section. “Long Term Notes Payable” section.
146
5
Accounting II
On January 3, 2018 Malibu Corporation issued bonds for $100,000

due in 5 years with 12 percent interest payable annually. At the
time of issue market rate for such bonds is 12 percent. The principal
amount borrowed will be paid back once at maturity.

Required: a) Calculate the selling price of bonds and make the
necessary journal entry as of the issue date. b) Make the necessary
journal entry as of December 31, 2018 and January 3, 2019.
a. First we have to list all the data we have to calculate the selling price of the
bonds issued:

Number of Interest Payments to Maturity :5
Interest to be paid at the end of each period is $ 12,000 ($100,000 x 12%)

As a result of this calculation we understand that Malibu has to pay $12,000
interest at the end of each year end for 5 years and at the end of the fifth year
your turn 1 also has to pay back the principal amount borrowed.
Now we have all the information we need to calculate the present value of the
future cash flows related with bonds issued.

$12,000 x 3.60478 (Appendix A, Table 2, n: 5, i: 12% ) $43,257

January 3, 2018 Cash 100,000
To record sale of bonds at par
147
5
On January 3, 2018 Malibu Corporation issued bonds for $100,000

due in 5 years with 12 percent interest payable annually. At the
time of issue market rate for such bonds is 12 percent. The principal
necessary journal entry as of the issue date. b) Make the necessary
journal entry as of December 31, 2018 and January 3, 2019.
b.
your turn 1 To record year end adjustment for interest

January 3, 2019 Interest Payable 12,000
Cash 12,000
To record payment of interest accrued
On January 3, 2018 Melrose Corporation issued bonds for $100,000

due in 5 years with 12 percent interest payable annually. At the time
of issue market rate for such bonds is 10 percent. The principal
Required: Calculate the selling price of bonds and make the
necessary journal entry as of the issue date.
First we have to list all the data we have to calculate the selling price of the
bonds issued:

Interest to be paid at the end of each period is $ 12,000 ($100,000 x 12%)

As a result of this calculation we understand that Melrose has to pay $12,000
also has to pay back the principal amount borrowed.
your turn 2
By paying $107,582 at the date of issue, the investors will realize an ef-
fective rate or yield of 10 percent over the 5-year term of bonds. These bonds
would sell at a premium of $7,582 ($107,582 - $100,000).

January 3, Cash 107,582
Premium on LT Bonds Payable 7,582
148
5
Accounting II
On January 3, 2018 California Corporation issued bonds for

$100,000 due in 5 years with 10 percent interest payable
semiannually (twice a year). At the time of issue market rate for such
bonds is 12 percent. The principal amount borrowed will be paid
back once at maturity.

Required: Calculate the selling price of bonds and make the
necessary journal entry as of the issue date.
First we have to list all the data we have to calculate the selling price of the
bonds issued:

Interest to be paid at the end of each period is $ 10,000 ($100,000 x 10%) As

a result of this calculation we understand that California has to pay $10,000
also has to pay back the principal amount borrowed.
your turn 3
By paying $92,791 at the date of issue, the investors will realize an effective
rate or yield of 12 percent over the 5-year term of bonds. These bonds would
sell at a discount of $7,209 ($100,000 - $92,791).

149
5
On January 2, 2018 Miami Corporation issued bonds for $100,000

due in 3 years with 6 percent interest payable semiannually (twice a
year). At the time of issue market rate for such bonds is 4 percent.
The principal amount borrowed will be paid back once at maturity.
necessary journal entry as of the issue date. b) Make necessary

journal entry for the first interest payment.
bonds issued:

$100,000 x 6% = $6,000 annually

$6,000 ÷ 2 = $3,000 semiannually
As a result of this calculation we understand that Miami has to pay $3,000

interest at July 1 and January 1 for 3 years and at the end of the third year
also has to pay back the principal amount borrowed. Now we have all the
information we need to calculate the present value of the future cash flows
related with bonds issued.

your turn 4 Present Value of the Interest Payments
sell at a premium of $2,754 ($102,754 - $ 100,000).

January 2, 2018 Cash 102,754
Premium on LT Bonds Payable 2,754
b.

July 1,2018 Interest Expense 2,055a
Premium on Bonds Payable 945b
Cash 3,000
a$102,754 x 4% ÷ 2 = $2,055 b$3,000 - $2,055 = $945
150
5
Accounting II
On January 2, 2018 Texas Corporation issued bonds for $100,000

due in 4 years with 14 percent interest payable semiannually (twice a
year). At the time of issue market rate for such bonds is 16 percent.
The principal amount borrowed will be paid back once at maturity.

necessary journal entry as of the issue date. b) Make necessary
journal entry for the first interest payment
bonds issued:

$100,000 x 14% = $14,000 annually

$14,000 ÷ 2 = $7,000 semiannually
As a result of this calculation we understand that Texas has to pay $7,000
interest at July 1 and January 1 for 4 years and at the end of the fifth year also
has to pay back the principal amount borrowed. Now we have all the infor-
mation we need to calculate the present value of the future cash flows related
with bonds issued.

sell at a discount of $5,746 ($100,000 - $94,254).

b.

July 1,2018 Interest Expense 7,540a
Discount on Bonds Payable 540b
Cash 7,000
a$94,254 x 16% ÷ 2 = $7,540 b$7,540 - $7,000 = $540
151
5
On January 3, 2018 Manhattan Corporation borrowed $50,000 from

Dexter Company, in return signed a six year, 8 percent annually
interest bearing note. The market rate for a note of similar risk is 10
percent.
Required: Make necessary journal entry for the issuance of the note.

$50,000 x 8 % = $4,000 annually
As a result of this calculation we understand that Manhattan has to pay
$4,000 interest at the end of each year for 6 years and at the end of the sixth
year also has to pay back the principal amount borrowed. Now we have all
the information we need to calculate the present value of the future cash flows
related with bonds issued.

The issuance of notes payable can be journalized as follows:

Discount on Long Term Notes Payable 4,355
Long Term Notes Payable 50,000
To record of notes issued at discount
Endnotes
1Needles,B. E. Jr., Powers M., and Crosson S. V., 5Kieso, Weygandt and Warfield, p.524.
(2011) Principals of Accounting 11th Edition, 6Kieso, Weygandt, Warfield, (2011) Intermediate
Cengage Learning, p.564.
Accounting, IFRS Edition Volume I, John
2Edwards, j. D. and Hermanson, R.H. Accounting Wiley&Sons Publications, p.727.
Principles: A Business Perspective, First Global 7Kieso, Weygandt, Warfield, p.726.
Text Edition, Volume 1 Financial Accounting,
Endeavour International Corporation, Houston, 8Kieso, Weygandt, Warfield, p.734.
Texas, USA, p.636. 9Warren, Carl S., James M. Reeve, Jonathan E. Duchac
3Kieso, Weygandt and Warfield, (2006) Fundamentals (2014) Financial and Managerial Accounting, 12
of Intermediate Accounting, John Wiley&Sons Edition, Cengage Learning, p. 552.
Publication, p.523. 10Needles, Powers, and Crosson, p.567.
4Kieso, Weygandt and Warfield, p.524.
152
5
Accounting II
153
5
154
Shareholders’ Equity:
Chapter 6 Paid-in Capital
1
Learning Outcomes
Identify and discuss the major

characteristics of a corporation, 2 Journalize the issuance of shares,
3
Differentiate preferred shares from common
shares, 4 Explain how to account for treasury share.
Chapter Outline
Introduction Key Terms
Characteristics of a Corporation and other Common share
Types of Entities Corporation
Issuance of Shares Paid-in capital
Differences and Issuance of Preferred Shares Par value
Treasury Shares Preferred share
Shareholders’ equity
Treasury shares
156
6
Accounting II
INTRODUCTION In this part of the chapter, you will first learn

Entities can be organized in different forms. major characteristics of these type of entities and
Hence it is important to understand the major then distinguish characteristics of the corporations.
characteristics of different types of entities to
organize their accounting information systems Characteristics of Different Types
successfully. Different forms of entities can be of Entities
classified as sole proprietorships, partnerships,
While starting a new entity, the question
and corporations. In this chapter, you will firstly
about the type of the entity should be considered
get general information about different forms of
carefully. Hence, the decision about the type of
entities. Among these, the corporation which has
the entity will affect almost all of the processes in
special characteristics is examined in detail and
an entity. As it is explained above, there are three
the advantages and disadvantages of corporations
common types of entities. In the following parts
will be discussed. After that, the components of
of this chapter, you will find general information
shareholders’ equity are explained. Subsequently,
about these common types.
the meaning of common shares, preferred shares,
and treasury shares will be explained. You will also The first one is proprietorship which is owned by
learn how to account different types of shares. a single owner. This type of entity is the smallest and
simplest one among the different types of entities.
CHARACTERISTICS OF A
CORPORATIONS AND OTHER Proprietorship is an entity owned by a single
TYPES OF ENTITIES owner.
An entity can be organized in different forms in
accordance with several aims. Thus, entities may be
classified in different ways because of the different The owner of proprietorship is called as
types of entities. In compliance with accounting proprietor and his or her equity can be seen as only
perspective, types of entities are based on their one item in owner’s equity section of the balance
ownership, taxation, life, the personal liability of sheet.1
the owners particularly. In accordance with this
perspective the followings are examples of the most
common types of entities: Proprietor is the owner of a sole
• Sole proprietorship proprietorship.
• Partnership
• Corporation
The expiration of a proprietorship is caused
either by the proprietor’s death or his/her choice of
ending it. Also, the proprietor is personally liable
for the proprietorship’s liabilities. However, the
Most common types of entities are accounting process of the proprietorship is separate
sole proprietorships, partnerships, and from the personal records of the proprietor.
corporations Another important characteristic is about
taxation. A proprietorship is not a separate taxable
entity. The proprietor pays tax on the income of
proprietorship2.
157
6
Shareholders’ Equity: Paid-in Capital
Partnership (LLP) occurs. The owner/owners of

the limited liability partnership are called member/
members.4 In a Limited Liability Partnerships,
all of the members have limited liability. Thus, a
Limited Liability Partnership can protect other
members from negative possibilities like unethical
behaviors that result from some members.
internet
You can visit the following web site to get
information about Establishing a Business in
Turkey.
http://www.invest.gov.tr/en-US/
investmentguide/investorsguide/Pages/
EstablishingABusinessInTR.aspx
Picture 6.1 Proprietorship is an entity owned by a single
owner.
Characteristics of a Corporations
The second type of entity is a partnership which We will discuss the third type of the entity
has at least two or more owners. In a partnership, that is corporation in detail. A corporation is
the owners are called as partners. Partnerships are a legal entity which is organized under state law
organized as small or medium size entities. and owned by shareholders. Thus, the owners in
a corporation are called shareholders. A person
or an organization may own some certificate that
Partnership is an entity owned by two or
represents the ownership in a corporation named
more owners.
shares of a corporation and called shareholders.
Generally, corporations are organized as very
Partners are the owners of a partnership
large entities and sometimes their shares can be
purchased on an organized stock exchange market.
These are called publicly held corporations. In this
Similar to proprietorship, the cancellation of case, a corporation may have many shareholders.
the partnership may be caused either by one of the
partners’ death or choice of cancelling it and the
partners are personally liable for the partnership’s
liabilities. Surely, based on the entity concept the internet
accounting process of a partnership is separate from Borsa İstanbul was founded for the purpose
the personal records of the partners. Partnerships of serving as a securities exchange and brings
are not separate taxable entities.3 together all the exchanges operating in the
Being responsible for the partnership’s liability Turkish capital markets under a single roof.
is an important disadvantage for the partners. https://www.borsaistanbul.com/en/home-page
Especially if the number of the partners are high,
it may be riskier. If a partner commits fraud or
if there is a black hole because of a failure of one
partner in the partnership, the result of these all
negative possibilities may affect all of the partners.
To eliminate this disadvantage Limited Liability
158
6
Accounting II
subject is called cash dividend. This term “Cash

dividend” is an individual share of the income
A corporation is an entity organized under
distributed to the shareholders. The details related
state law and owned by shareholders.
to dividends will be discussed in Chapter 7.
Contrary to the other types of entities, a
As an important characteristic, shareholders corporation is a legal entity separate from its
are not personally responsible for the corporation’s owners.
liabilities. This means that shareholders’ possible
loss is limited with their capital investment.
Hence, the creditors cannot make any claim on
shareholders’ personal assets. This characteristic
As an alternative terminology the term
of corporation is essential for the shareholders
“stock” may be used instead of the term
because their personal assets are protected and
“share” and similarly, the term “stockholder”
the corporation may raise may raise more capital
may be used instead of the term
from shareholders. Also, the government and
“shareholder”.
related regulators design more regulations and try
to monitor corporations to protect shareholders’
and creditors’ claims. Another characteristic is the
transferability of the shares. This characteristic is
essential for shareholders since it is flexible. They
can transfer corporation’s shares to another one.
Shareholders have limited liability for

business debts and losses. The shareholders’
assets are protected from the debts and
liabilities of the corporation.
The cancellation of the corporation does

not depend on the death of any shareholder or Picture 6.2 Corporations are organized as very large
their choices to cancel it. In other words, the entities and they can supply shares to the public.
corporation is a permanent organization. The
transfer of the shares, anyone’s death or withdrawal
do not put an end to the corporation. Another The shareholders have a crucial role in the
distinguishing difference of a corporation is decision-making process of a corporation. Therefore,
about taxation. Corporations are taxable entities.6 it is important to understand the requisitions of the
All of the corporations have to pay tax. Besides, shareholders and maintain a healthy relationship
when corporations make cash payments to the with them to achieve the common goal of the
shareholders, double taxation may occur. The corporation. With this perspective, technological
imposed taxation is paid by the corporation and issues may become more of an issue in some cases.
the cash received by the shareholders is reported The box below shows the news about technological
on the income tax return of the shareholder. This issues of the shareholders.8
159
6
Further Reading
Delaware, Blockchain Technology & the Future limited to cryptocurrencies. The blockchain is a
By Brett Melson Monday, July 30, 2018 decentralized, widely-distributed digital ledger
technology in which transactions are recorded
Stock represents ownership in a corporate
across many computers worldwide.
entity and is given in exchange for a paid-in
capital contribution to a business. Ownership As a result, recorded transactions cannot be
of stock does not entitle the holder to specific changed after the fact without the alteration of
property or assets of the company but rather the record stored on the various systems which
provides the holder with a portion of the entity’s received the distributed ledger.
profits and gains, normally through the receipt of Using blockchain technology to maintain
dividends paid to the shareholder. a stock ledger could help to ensure the
The specific benefits or advantages of the accuracy of the ledger and the appropriate
stock can vary depending upon a company’s documentation of transactions. Often, ledgers
Articles of Incorporation and the terms governing in smaller corporations, particularly closely-held
specific classes or stock. corporations, are loosely maintained in an Excel
spreadsheet, and a failure to maintain the ledger
Corporations in Delaware are required to
in a timely way or catch inaccuracies in data entry
keep a stock ledger. This ledger is not filed with
can often lead to errors or omissions.
the state of Delaware and is not part of the public
record. Delaware corporations are required to An automated ledger recorded and verified in
record the stockholder’s name; the stockholder’s a distributed ledger creates the promise of an easier
address; the number of shares registered to the way to maintain a reliable and up-to-date ledger.
stockholder; and all issuances and transfers of Errors in a stock ledger can create significant
stock. issues under the securities laws and the Delaware
Recent changes to the Delaware General General Corporate Law. These errors or omissions
Corporate Law expressly permit the keeping can create significant legal ramifications for
of corporate records in the form of electronic a company. For instance, errors in ownership
networks and databases. These changes permit amounts or outdated rosters of stock ownership
a corporation to maintain the required stock can lead to failures to comply with voting rights
ledger using distributed-ledger technology, more and the required delivery of corporate materials
popularly referred to as blockchain technology. to shareholders.
As recently discussed in the news, the various The Delaware Division of Corporations has
potential applications of blockchain technology embraced the many benefits of the Blockchain
are said to potentially disrupt a wide array of technology by exploring the use of the technology
established markets and business methods. The relating to the ownership. Blockchain technology
blockchain is most commonly examined in the may bring enormous benefits to the industry, but
context of the creation, documentation, and only time will tell.”
trading of cryptocurrencies such as Bitcoin,
Litecoin and Ethereum. Internet Source: https://www.delawareinc.
While all cryptocurrencies involve the use com/blog/delaware-blockchain-technology-and-
of blockchain, blockchain applications are not the-future/
160
6
Accounting II
As it is explained above, corporations have many special characteristics. Therefore, corporations differ
from other types of entities in many aspects. The comparable characteristics of corporations and other
types of entities can be summarized in the simplest way as follow in Table 6.1:9
Table 6.1 Comparison of basic characteristics of corporations and other types of entities.
Name of the Personal responsibility

Life of entity Taxation
owner(s) of owner(s)
ends with death Personally responsible

Sole Not a separate
Proprietor or choice of for the proprietorship’s
Proprietorship taxable entity
proprietor liabilities
ends with death Personally liable for
Not a separate
Partnership Partners or choice of the proprietorship’s
taxable entity
proprietor liabilities
Not personally
responsible from
Corporation Shareholders Indefinite Taxable entity
the corporation’s
liabilities
Advantages and Disadvantages of a Shareholders’ Rights in Corporations

Corporation Having shares of a corporation provides some
Based on the different characteristics of rights to the shareholders. The general rights of
corporations, the advantages and disadvantages shareholders in a corporation are summarized:11
may be summarized as follows10 • Vote: Coequal shareholders legally own the
Advantages corporation. They can manage the corpora-
• Corporations are separate legal entities. tion indirectly through a board of directors
They are organized independently of their they elect. Shareholders vote on some mat-
shareholders. ters at shareholders’ meetings. In normal
• Shareholders have limited liability in cor- conditions, each share carries one vote.
porations. • Dividends: When declared, shareholders
• Corporations have continuous lives. receive a proportionate of some dividend.
• Transferability of ownership is easy in cor- Generally, each share receives an equal
porations in comparison to other types of amount of dividend.
entities. • Liquidation: When a corporation goes out,
• Raising more capital can be easy in cor- shareholders may receive their proportion-
porations in comparison to other types of ate share of any asset that still remains.
entities. • Preemption: Shareholders have the right to
Disadvantages maintain their proportionate ownership in
corporations.
There are greater regulations for corporations in
• Receiving Information: Shareholders have
comparison to other types of entities.
the right to access information related to
Corporations may be subject to double taxation. the corporation.
Because of some legal procedures, the start-up
costs may be higher in the corporations comparing
to the other types of entities. Shareholders’ rights in corporations are
vote, dividend, liquidation preemption and
receiving information.
161
6
Shareholders’ Equity in Corporations Transferable units that represent the ownership

Shareholders’ equity of corporations is defined of a corporation are named as “capital share”.13
with some special terms. In this part of the chapter, Corporations’ capital shares may be composed of
special terms for corporations will be introduced. a different type of shares. It is possible to classify
A corporation starts with some legal procedures. types of shares in different ways according to the
Then, the state authorizes the corporation and different regulations in different countries. As
grants a charter or articles of incorporation. a general classification according to the shares’
Afterwards, the corporation should prepare some accounting process, the classes of shares may be
special rules and procedure to operate.12 divided into two basic groups:
A share certificate is an evidence that represents
the ownership of a corporation. Share certificates
Common share - Preferred Share
may be printed or they may be in electronic format.
Side note: A share certificate is an evidence that
represents the ownership of a corporation. Par Value Share - No-par Value Share-Stated Value Share
In charter, also the maximum number shares

that the corporation may issue is determined. This
This number in total which is allowed by charter
is named as “Authorized Share”. The number of
authorized shares includes all issued and unissued
Capital share means the transferable units that
shares. Thus, the share that has been issued by the
represent the ownership of a corporation.
corporation is called “Issued Share”. Besides this,
“Outstanding Shares’ are the shares that have
already been issued and held by shareholders.
Common Share and Preferred Share
The basic unit of a capital share is a “common
share”. It is a share that represents the ownership of
Authorized share is the share number in a corporation. But a “preferred share” is a special
total that a corporation that a corporation is share that provides its owner some advantages
authorized to sell as indicated in its charter. more than a common share does. For example,
Issued share is the share that has been issued preferred shareholders can receive dividends
by the corporation. before the others or in a liquidation, preferred
shareholders can receive remaining assets before
Outstanding shares are the shares that
the others. Corporations issue common share and
have already been issued and held by
according to their preference, they may also issue
shareholders.
some preferred shares. In this case, share capital
consists of common and preferred shares.
Common share is a share that represents the ownership of a corporation.
Preferred share is a special share that provides its owner some advantages more than a common share does.
Par Value Share and No-par Value Share

“Par value” is the nominal value assigned by a corporation to its shares in the charter. It is different
than the market value of shares. Most corporations prefer to set par value low enough to protect their
corporation to issue shares below par value.14”
162
6
Accounting II
Par value is the nominal value assigned by a

corporation to its shares in the charter.
“Par value for a share refers to the nominal

value stated in the corporate charter. On the
contrary, “no-par value” for a share refers to the
no-par value stated in the corporate charter. It is
possible to assign a value of the par value close
to the no-par value. This is called “stated value
share”. Picture 6.3 A corporation may issue a par value or no
par value or stated value share iStock-97503255.
Par value share is the capital share that has a

As it is said, types of shares may be classified
par value.
in some different ways according to the different
regulations in different countries. You can find
No-par value share is the capital share that
some explanation about Turkey from the web site
has no par value assigned to it.
of Borsa İstanbul:15
Stated value share is a share that assigned to
an amount similar to par value.
Further Reading
“Equity Types” to the capital from the company’s internal resources.

Registered and Bearer Equity It does not lead to an inflow of outside funds. Shares
issued for these transactions are free shares.
Bearer equities are transferred upon delivery
whereas registered equities are transferred upon A rights issue is the sales of “paid-up” shares
endorsement and delivery. Bearer equities and issued by a company to supply new funds at their
registered equities may be traded on Borsa nominal value or a higher price. Paid-up shares
İstanbul if only the company’s board of directors can be sold to existing shareholders (pre-emptive
authorizes transfer through blank endorsement. right) as well as to other investors.
Common and Preferred Equities Premium and Non-Premium Stocks
Common equities grant equal rights to their Equities issued at par (nominal value) are
holders. Unless otherwise stipulated in the articles called non-premium equities, whereas equities
of association, equities are common equities. issued at a price higher than the nominal value
are called premium-equities.
Preferred equities provide their holders
with a set of preferential rights with regard to Companies listed on Borsa İstanbul are
the sharing in the profit and casting votes at the subject to the authorized capital system and
general assembly. can issue premium equities provided that it is
permitted in their articles of association and
Bonus and Paid-up Shares
there is a decision of the board of directors to
A bonus issue is a distribution of free shares to that effect.
shareholders in exchange of an amount which is added
163
6
Founder Shares and Dividend Shares

Founder shares are shares that entitle the holder to participate in part of the company’s capital in
consideration of the foundation services as per the provisions of the articles of association, and that is
always registered in the names of the founders. Founder shares neither represent a certain capital interest
nor vest any right to participate in the company’s management.
Dividend shares are given in consideration of certain services and receivables to certain people,
depending on the decision of the company’s general assembly and do not represent any capital interest”
Internet Source: http://www.borsaistanbul.com/en/products-and-markets/products/equities/

hisse-senedi-cesitleri .
Sources of Shareholders’ Equity

As it is known, owners’ equity means
shareholders’ equity in a corporation. The structure
of the shareholders’ equity is very important for a As an alternative terminology the term
corporation. There may be two different sources for “contributed capital” may be used instead of
a shareholders’ equity: First one is “Paid-in Capital the term “paid-in capital”.
(or contributed capital)” which represents the
total amount of contribution to the corporation by
shareholders. In other words, it represents the total
amount of assets received from shareholders. Thus,
it is generated from external parties. 1
What is the relation between
authorized shares, issued
Paid-in capital represents the total amount shares, and outstanding shares?
of contribution to the corporation by
shareholders.
ISSUANCE OF SHARES
The second source of shareholders’ equity Corporations are operating on a large scale,
is “Retained Earnings (or earned capital)”. therefore; they almost always have financing
Retained earnings are the amount earned through requirements. Hence, corporations prefer to raise
profitable operations of a corporation that is kept more capital by issuing their shares. The first time
in the corporation. In other words, it is the earned of offering shares to the public is called as initial
amount which is not distributed to the shareholders public offering (IPO).
as dividends. Thus it is generated internally from There are two ways for corporations to offer
the corporation’s operation. It is based on the and sell their shares to the investors. They may
decision of retaining some amount of net income sell their shares directly to the shareholders or
in a corporation. they may prefer to use the service of underwriter
such as investment banking firm that specializes in
bringing securities to the attention of an investor.16
After selling their issues to the shareholders,
Retained earnings is the amount earned corporations receive an amount for shares. The
through profitable operations of a amount that is received from issuing shares is called
corporation that is kep in the corporation issue price. Usually, the issue price will be higher
than the par value.17
164
6
Accounting II
Issuing Common Shares at Par

Value
Issue price is the amount that is received
As a legal procedure, a corporation should
from issuing shares.
authorize some amount of common share at the
charter. But authorized share is presenting just the
In this part of the chapter, you will learn how total amount of shares which is allowed by charter
to record while issuing common shares in different as explained before. There is no effect on any of the
conditions. financial statement item. Therefore, determining
authorized share will not require any journal entry
in the accounting process. After determining the
number of authorized shares, a corporation will
issue some of the shares and record this amount.
To record issuance of common share at par
value, an asset account, and a new equity account
will be used.
Assume that on January 31, 2018, (A) Inc.
authorizes 500,000,000 common shares and then
issues 200,000 common shares. The common shares
of (A) Inc. carry a par value of 1 TL per share. The
journal entry, then, is as follows:
Picture 6.4 A corporation can raise capital by issuing
its share

Jan 31 Cash 200,000
Common Share 200,000

(1 TL x 200,000)
To issue common share at par
In this situation, the first part of Shareholders’ Equity section of the Balance Sheet could be seen as follows:
Table 6.2 Partial Balance Sheet after Issuance of Common Share

(A) Inc.
January 31, 2018
Paid-in Capital
Common Share – 1 TL par value; 500,000,000 shares are authorized, 200,000 shares are 200,000 TL
issued and outstanding
In some cases, it may be possible to receive some other type of assets –such as a building, some furniture
etc.- and also some service -such as some advisory services- instead of cash while issuing common shares.
In this case, to record this transaction, related accounts should be used instead of cash. But at that time,
the value should be considered carefully. If a corporation issues shares for any asset other than cash or for
some type of services, this transaction should be recognized at market value. This means there may be a
possibility to face with an ethical challenge.
165
6
Issuing Common Shares over Par Common”. This premium amount is also called an
Value additional paid-in capital. Because of the Paid-in
Capital in Excess of Par-Common account, total
Corporations usually set par value low (usually
amount of common shares and premium could be
1 TL) to avoid issuing their stock below par. For
seen separately in the shareholders’ equity section
this reason, usually, most of the corporations issue
of the balance sheet.19
common shares above par value. A “premium” is
the total amount above par value at which a share
is issued (sold). A premium on the issue of stock
is not a gain, income, or profit for the corporation “Paid-in Capital in Excess of Par-Common”
because the company is dealing with its own account represents the total amount
stock.18 received from shareholders above par value
at which common shares are issued.
Premium is the total amount above the par

Assume that on February 28, 2018, (B) Inc. issues an
value of shares at which a share is issued.
additional 100,000 common shares of the 1 TL par
value common share for cash at 3 TL per share.
Common shares should be recorded at par value The amount received above the par value, in
even if they have already issued with a different this case 2 TL (3 TL – 1 TL), is credited to Paid-in
amount. Then a premium should be recorded in Capital in Excess of Par—Common. The journal
an equity account different than Common Share entry, then, is as follows:
account is named “Paid-in Capital in Excess of Par-

Feb 28 Cash (3 TL x 100,000) 300,000
Common Share- 100,000
(1 TL x 100,000)
Paid-in Capital in Excess of 200,000
Par Common
(300,000-100,000)
To issue common share at a premium
In this situation, the first part of Shareholders’ Equity section of the Balance Sheet could be seen as
follows:
Table 6.3 Partial Balance Sheet after issuing common share over par value
(B) Inc.
February 28, 2018
Paid-in Capital
Common Share – 1 TL par value; 100,000 shares issued and outstanding TL 100,000
Paid-in Capital in Excess of Par-Common 200,000
In very rare cases, shares might be issued below par value. If this seldom transaction occurs, another
separate account entitled “Discount on Capital Share” should be debited. This account represents the
differences between the issue price and Par Value.20
166
6
Accounting II
Issuing No-par Common Shares

As explained before, no-par value share is the capital share that has no par value assigned to it. If there
is no par or stated value while issuing common share, total selling price should be debited to the cash or
any other asset account and common share should be credited.
Assume that on March 31, 2018, (C) Inc. issues 500,000 no-par common shares per share for cash at 2 TL
per share. The journal entry, then, is as follows:

March 31 Cash 1,000,000
Common Share- 1,000,000
(2 TL x 500,000)
To issue no-par common share
In this position, the first part of Shareholders’ Equity section of the Balance Sheet could be seen as
follows:
Table 6.4 Partial Balance Sheet after issuing no-par common share
(C) Inc.
March 31, 2018
Paid-in Capital
Common Share – no-par value; 500,000 issued and outstanding TL 1,000,000
While issuing no-par common share, there is no premium or discount because there is no par or stated
value for shares to compare. It means if a corporation issues no-par common shares, “Paid-in Capital in
Excess of Par” and “Discount on Capital Share” accounts are not used.
Issuing Stated Value-Common Shares

Stated value share is a share that is assigned to an amount In the issuance of no-par common shares,
similar to par value as it is explained. There is no par value the total issue price should be recorded in
at first, but the corporation assigns a stated value to the common share account directly.
shares issued. After determination of the stated value of the
common shares, the recording process of issuance will be similar with common share at par value. In other
words, a premium and in some rare cases a discount may occur.
Assume that on April 30, 2018, (D) Inc. issues 10,000 common shares that carry 1 TL stated value per share
for cash at 5 TL per share. The journal entry, then, is as follows:
167
6

Apr 30 Cash
(5 TL x 10,000) 50,000
Common Share- 10,000
(1 TL x 10,000)
Paid-in Capital in Excess of Stated (50,000-10,000) 40,000
To issue stated value common share at a premium
To issue stated value common share at a premium in the same way with issuance par value common
share at a premium, the name of the equity account should be changed. In this situation, “Paid-in Capital
in Excess of Stated” account should be used to record the transaction.
“Paid-in Capital in Excess of Stated” In the issuance of common shares overstated,

account represents the total amount common share account is debited just by
received from shareholders above stated the stated value of the total issued common
value while issuing shares. shares without premium.

In this position, the first part of Shareholders’ Equity section of the Balance Sheet could be seen as
follows:
Table 6.5 Partial Balance Sheet after issuing common share overstated value
(D) Inc.
April 30, 2018
Paid-in Capital
Common Share – 1 TL stated value; 10,000 shares issued and out- TL 10,000
standing
Paid-in Capital in Excess of Stated 40,000
DIFFERENCES AND ISSUANCE

2 OF PREFERRED SHARES
What are the basic types of A preferred share is already defined as a type
shares in a corporation? of capital share that provides some advantages to
its owner over a common share. Actually, the way
of the accounting process in issuing for preferred
shares is similar with common share’s accounting
168
6
Accounting II
process. But different accounts should be used and common shareholders. Declaring and distributing
common share and preferred share part should be dividends depend on many factors, such as
presented separately on the balance sheet. Beyond adequate retained earnings and the availability of
these differences related to recording and reporting cash. Therefore, having a dividend preference is
procedures, the most important differences an important advantage. Besides a preferred share
between a common and a preferred share are may sometimes provide a cumulative dividend
about their reasons. In other words, priorities and according to the regulations. This advantage means
privileges which are provided by a preferred share that preferred shareholders must be paid both
are the most important differences between them. current-year dividends and any unpaid prior-year
According to the agreements, a preferred share dividends before common shareholders receive
may provide some other priorities and privileges dividends.23
such as convertibility.21 But the most important The second important advantage of a preferred
priorities of a preferred share are “dividends” and share is liquidation preference. Most preferred
“assets in the event of liquidation”.22 In below, shares have a preference on corporations’ assets
these basic characteristics and then issuance of if the corporation fails. This advantage provides
preferred shares are explained. effective security for the shareholders who have
preferred shares.24 Thus, liquidation preference is
another important advantage of preferred shares
for shareholders.
The most important priorities of a preferred
share are “dividends” and “assets in the
event of liquidation”. Issuing of Preferred Shares
Accounting processes for issuing of common
and preferred shares are similar. The possible
situations in issuance are that some preferred share
would be the same with common share issuance.
But, as it is emphasized above, different accounts
should be used and common share and preferred
share part should be presented separately on the
balance sheet. The reason for these different
applications is the different characteristics of
preferred and common share that have already
been discussed.
With this perspective, for the transactions about
the issuance, instead of Common Share account,
“Preferred Share” account should be used while
recording preferred shares. Besides, if a corporation
issues both common and preferred share, the type
of the share should be indicated in the recording of
Picture 6.5 A preferred share can provide some premium. Therefore, “Paid-in capital in excess of
additional benefits to shareholders. par- Preferred” account should be used.
In previous examples, while explaining
issuance of common shares over par value, (B) Inc.
Basic Differences Between a
illustrated and on February 28, 2018; (B) Inc. has
Preferred Share and a Common already issued 100,000 common shares that carry
Share 1 TL par value per share for cash at 3 TL per share.
The first important advantage of a preferred The transaction is journalized. Now assume that
share is dividend preference. As it is mentioned on May 31, 2018, (B) Inc. decides to issue 50,000
before, preferred shareholders have the right to share preferred shares of its 15 TL par at 20 TL per share.
in the distribution of corporation’s income before The journal entry, then, is as follows:
169
6

May 31 Cash 1,000,000
(20 TL x 50,000)
Preferred Share- 750,000
(15 TL x 50,000)
Paid-in Capital in Excess of Par 250,000

Preferred (1,000,000-750,000)
To issue preferred share at a premium
In this situation, the first part of Shareholders’ Equity section of the Balance Sheet could be seen as
follows:
Table 6.6 Partial Balance Sheet after issuing the preferred share over par value
(B) Inc.
May 31, 2018
Paid-in Capital
Preferred Share – 15 TL par value; 50,000 shares issued and outstanding 750,000
Paid-in Capital in Excess of Par-Preferred 250,000
Common Share – 1 TL par value; 100,000 shares issued and outstanding 100,000
Paid-in Capital in Excess of Par-Common 200,000
“Paid-in Capital in Excess of Par-Common”

account represents the total amount Common share part and preferred share
received from shareholders above par value part should be presented separately on the
while issuing common shares. balance full stop is necessary


Treasury Shares
3 Treasury share is a corporation’s own share that
What is the importance of the has been repurchased and is being held for future
dividend right to a shareholder? use.25 In other words, treasury shares are previously
issued shares which have been reacquired by the
corporation later. The corporation repurchases its
TREASURY SHARES own shares from the shareholders. In the future,
A corporation may repurchase its own shares treasury shares may be resold or held for an
in some cases abide by the legal boundaries. These indefinite time by the corporation.
shares are named as Treasury Shares. In this part of
the chapter, firstly the term treasury share is defined
and the basic characteristics of it are explained and Treasury share is a corporation’s own share
then accounting for treasury shares are illustrated. that has been repurchased and is being held
for future use.
170
6
Accounting II
Remember that outstanding shares are defined On the other hand, a corporation may want to
as the shares that have already been issued and also retire its shares at the beginning by canceling. This is
held by shareholders before. If a corporation has called the retirement of shares. In this circumstance,
treasury shares they should be subtracted from the common share account should be debited and
the number of outstanding shares because of the cash account should be credited. After this
treasury shares are held by the corporation not by cancellation, these shares cannot be reissued and
shareholders. With this perspective, treasury shares the number of outstanding shares is permanently
don’t have the right to vote and receive dividends as reduced. In the following paragraph, the accounting
they are not outstanding shares. process for treasury shares is discussed.
Accounting for Treasury Shares

While a corporation has some treasury share
Outstanding shares represent the differences transaction, a new account will be required entitled
between issued share and treasury share. “Treasury Share”. When the treasury shares are
resold they may be sold at cost, above or below
cost, which may require another new account. You
will find some illustrations for these transactions.
Treasury Share account is a contra shareholders’
equity account. Hence, it is a debit-balance account.
Treasury shares should be reported after retained
earnings section of the corporation’s balance sheet
to show a decrease in shareholders’ equity because
the number of the issued share that could be seen
on the paid-in the capital section does not change.
Treasury Share account is a contra

shareholders’ equity account.
Picture 6.6 Treasury share is a corporation’s own share
that has been reacquired iStock- 99009582
There may be several reasons for a corporation Treasury Share is reported as a negative
to repurchase its own shares, but the main possible amount on the balance sheet.
reasons may be summarized as follows:26
The management of the corporation may want; Another important point about the accounting
• to avoid a takeover and be cautious about of the treasury shares is recording the value of it.
outsiders. There may be some other methods but the most
• to reissue the shares to employees and common is the cost method. In the other words,
reward them. treasury shares should be recorded with the “at
• to promote the price of the shares by in- cost” price that the corporation paid to reacquire
it.27 Recording treasury shares with cost will be
creasing the trading of the shares.
illustrated below.
• to resell its own shares with a higher price.
• to reduce the number of outstanding
shares for some ratio analysis. Purchasing of Treasury Share
As it is explained, for these possible reasons As it is explained above, while recording a
above, a corporation may reacquire its own shares. purchase, the shares’ cost should be debited to
Hence, these treasury shares should be recorded Treasury Shares account.
separately.
171
6
To illustrate, assume that on June 24, 2018, (A) Inc. purchased 20,000 previously issued common share. (A)
Inc. is paying 2 TL per share for this transaction. The journal entry, then, is as follows:

June 24 Treasury Share 40,000
(2 TL x 20,000)
Cash 40,000
To purchase treasury share
In the journal entry, to purchase treasury share, “Treasury Share” account is debited at the cost (2 TL
per share). It is a contra account and shows a decrease in the equity part. To repurchase its own shares, the
corporation is paying, so cash is credited to show that it is decreasing.
Selling of Treasury Share at Cost

After reacquiring the treasury shares, the corporation may resell these shares. If treasury share is resold
with the same amount of cost, there won’t be any differences to record. Because in this case, the cost is
equal to the sale price.
To illustrate in conjunction with the previous example, assume that on August 10, 2018, (A) Inc. resold
5,000 of treasury shares for 2 TL per share. The journal entry, then, is as follows:

August 10 Cash 10,000
Treasury Share 10,000
(2 TL x 5,000)
To sell treasury share at the cost

In the journal entry to sell treasury share, “Treasury Share” account is credited at the cost (2 TL per
share). It is a contra shareholders’ equity account and with this transaction, it is decreasing because of sale.
At the same time, cash is debited to show that it is increasing while receiving money in selling.
Selling of Treasury Share Above Cost

As a second possibility in a sale, treasury share may be resold above cost. In this case, there will be a
difference between the cost and the sale price of the treasury share. If the sale price is higher than the cost
of treasury share, this positive difference should be recorded in a new shareholders’ equity account named
“Paid-in Capital from Treasury Share”. Paid-in Capital from Treasury Share is reported in the Paid-in
Capital section of a corporation’s balance sheet.
Paid-in Capital from Treasury Share account Selling of treasury share above cost has no
is a shareholders’ equity account. effect on the net income/net loss.

To illustrate in conjunction with the previous example, assume that on September 15, 2018, (A) Inc. resold
172
6
Accounting II
5,000 of treasury shares again but this time for 5 TL per share while the cost per share was 2 TL. The journal
entry, then, is as follows:

Sep 15 Cash 25,000
(2 TL x 5,000)
Paid-in Capital from Treasury Share 15,000
(25,000 -10,000)
To sell treasury share above cost

In the journal entry to sell treasury share above cost, “Treasury Share” account is credited at the cost (2
TL per share) again. It is a contra shareholders’ equity account and with this transaction, it is decreasing
because of sale. At the same time, Paid-in Capital from Treasury Share account which is a shareholders’
equity account is also credited with the total amount of differences between the total sale price and total
cost. On the other side, cash is debited with the sale price (5 TL per share) to show that, it is increasing
while receiving money in the selling.
Selling of Treasury Share Below Cost

As another possibility in a sale, treasury share may be resold below cost. In this case, again there will
be a difference between the cost and the sale price of treasury share. When the sale price is lower than the
cost of treasury share, this negative difference should be recorded “Paid-in Capital from Treasury Share”
if Paid-in Capital from Treasury Share account has enough credit balance. But, if Paid-in Capital from
Treasury Share account has no or less credit balance than the amount that should be recorded on its debit
side -because of the difference about sale-, in this case, the total or remaining amount should be recorded
on the debit side of the retained earnings account. (Retained
earnings account is explained in Chapter 7) Because, as it is
emphasized, Paid-in Capital from Treasury Share account
is a shareholders’ equity account, in other words, a credit Selling of treasury share below cost has no
effect on the net income/net loss.
balance account and it is impossible to see a debit balance.
To illustrate in conjunction with the previous example, assume that on November 18, 2018, (A) Inc. resold
5,000 of treasury shares again but this time for 1 TL per share while the cost per share was 2 TL. The journal
entry, then, as follows:

Nov 18 Cash 5,000
Paid in Capital from Treasury Share (10,000 – 5,000) 5,000

(2 TL x 5,000)
To sell treasury share below cost

173
6
In the journal entry to sell treasury share below

cost, “Treasury Share” account is credited with the PAID-IN CAPITAL FROM
cost (2 TL per share) again. With this transaction, TREASURY SHARE
Treasury Shares is decreasing because of sale. On Nov 18 5,000 Sep 15 15,000
the other side, cash is debited with the sale price (1
TL per share) to show that, it is decreasing while Balance 10,000
receiving money in selling. At the same time, Paid-
in Capital from Treasury Share account which is a
shareholders’ equity account is also debited with
the total amount of negative differences between
the total sale price and total cost because in the 4
previous example (about Selling of treasury share What is the effect of the
above cost) 15,000 TL is credited to Paid-in Capital treasury shares on shareholders’
from Treasury Share. Thus, it has a credit balance equity part of the balance
of more than 5,000 TL. The t-account of Paid-in sheet?
Capital from Treasury Share, then, is as follows:
Further Reading
Serving Shareholders Doesn’t Mean Put- This intuition is borne out by recent share-
ting Profit Above All Else holder behavior. Until a few years ago corporate
“Is the only responsibility of business to maxi- managers heard only two complaints from insti-
mize profits, as Milton Friedman famously argued tutional investors: that executive pay was exces-
in 1970? Many scholars and business people have sive and that the company had an insufficient
criticized this idea on the grounds that companies number of independent directors. Not anymore.
should cater to employees and the community, not The new mantra, especially in Europe, is ESG:
just to shareholders. But the law seems to support Companies should care about the environmental
shareholder primacy: Under Delaware law, which and social impact of their investments. In fact,
controls the vast majority of corporate America, research has shown that the majority of sharehol-
directors are elected by shareholders, and, accor- der proposals in the U.S. now concern ESG.
ding to Leo Strine Jr., a Delaware judge, directors Friedman acknowledged that shareholders
owe their loyalty to those who elect them. might have ethical concerns, but he implicitly as-
In a recent paper, we offer a different pers- sumed that a company’s profit and social objecti-
pective, one that we believe is perfectly consistent ves are separable. This is true for the example he
with the fiduciary duties of corporate directors: used in his article: corporate charity. One dollar
Companies should maximize shareholder welfare, donated by the corporation is not worth more
not value. than one dollar donated by shareholders. Why
should corporate boards decide about charitable
Our starting point is that shareholders care
giving when they can distribute the profits to be
about more than just money. Many shareholders
donated as dividends and let the shareholders de-
pay more for fair-trade coffee or buy electric cars
cide directly?
rather than cheaper gas guzzlers, because, using
the current economic lingo, they are prosocial. We agree with Friedman on this point. But
They care, at least to some degree, about the he- we are interested in situations where profit and
alth of society at large. Why would they not want social consequences are inextricably connec-
the companies they invest in to behave similarly? ted…..Therefore, if investors have some objecti-
ves other than money, there is no reason why a
174
6
Accounting II
company’s board should ignore them and pursue We propose the same for companies. On deci-
only profit maximization. The fiduciary duty a sions with major social consequences, referenda
board has to a company’s shareholders is to ma- should be used to elicit shareholders’ preferences.
ximize their welfare, not just the value of their If shareholders care only about money, the
pocketbook. This raises an important question: system will produce the same result that we ob-
How can a board do that? serve today. But if many shareholders do have
Can Boards Incorporate Shareholder Welfare? social objectives, as both data and intuition sug-
It may seem an impossible task: Should gest, the system will allow them to achieve these
a board stop before every decision and poll its objectives and increase their utility…..”
shareholders? The answer is no. In all represen- Source: Oliver Hart and J. Luigi Zingales
tative democracies, most decisions are delegated (2017). Social Responsibility-Serving Sharehol-
to representatives, who are elected on the basis ders Doesn’t Mean Putting Profit Above All Else.
of their stated preferences about important so- Harvard Business Review, October 12, 2017
cial issues. Shareholders elect directors to pursue Follow this and additional articles at: https://
their interests, which can include nonmonetary hbr.org/2017/10/serving-shareholders-doesnt-
considerations. mean-putting-profit-above-all-else
Occasionally, on very important matters the
citizens are polled directly, through a referendum.
Inside Practice
REGULATIONS ABOUT TREASURY “The Turkish Commercial Code permits the

SHARES acquisition of treasury shares only up to 10% of
In many countries, there are some regulati- the share or paid-in capital if the acquisition is
ons about the restrictions of treasury share. Ge- made for consideration. Only fully paid-in sha-
nerally, to realize the restrictions, a limit for retai- res can be acquired for a consideration.”
ned earnings is determined by the state. In Turkey Similar with the Turkish Commercial Code,
also there are some restrictions for treasury shares main regulations of Communiqué on Buy-
as in many countries. The Turkish Commercial Backed Shares about the treasury shares can be
Code numbered 6102 has published on Febru- express as follows:
ary 2, 2011, and it is in force since July 1, 2012. “Nominal value of shares of corporations
There are important regulations about treasury buy-backed cannot exceed 10% of paid or issued
shares in the Turkish Commercial Code. Besides capital of corporations, also including the previ-
Capital Markets Law has adopted a regulation ous acquisitions. The buy-backed shares which
for the treasury shares by a Communiqué named are disposed of during the program are not taken
Communiqué on Buy-Backed Shares on January into account.”
3, 2014.
Discuss:
The most important part of the regulations
1) What can be the possible effects of a large
in the Turkish Commercial Code that explained
number of buyback programs?
in Article 379 can summarize as follows:
2) What can be the reasons for the restrictions of
treasury shares?
175
6
Identify and discuss the major

LO 1 characteristics of a corporation.
Most common types of entities are sole proprietorships, part-

nerships, and corporations. The first one is proprietorship
which is owned by a single owner. This type of entity is the
smallest and simplest one among the different types of entities.
The owner is called proprietor. Also, the expiration of a prop-
rietorship is caused either by the proprietor’s death or his/her
Summary
choice of ending it. The proprietor is personally responsible for

the proprietorship’s liabilities. A proprietorship is not a separate
taxable entity. The second type of entity is a partnership which
has at least two or more owners. In a partnership, the owners
are called partners. Partnerships are organized as small or medi-
um size entities. The expiration of a partnership is caused either
by the partners’ death or their choice of ending it. The partners
are personally responsible for the partnership’s liabilities. Part-
nerships are not separate taxable entities. To eliminate liability,
Limited Liability Partnership (LLP) occurs. The owner/owners
of the limited liability partnership are called member/members.
A corporation which is organized under state law and is owned
by shareholders. Thus, in a corporation the name of the owners
are shareholders. Shareholders are not personally responsible
for the corporation’s liabilities. They can transfer corporation’s
shares to another one. The expiration of a corporation is caused
either by the shareholders’ death or their choice of ending it.
Corporations are taxable entities. Shareholders’ right in corpo-
rations are vote, dividend, liquidation pre-emption and recei-
ving information. A share certificate is evidence that represents
the ownership of a corporation. Authorized share is the total
number of shares which is allowed by charter. Issued share is
that has been issued by the corporation. Outstanding shares
are that have already been issued and also held by shareholders.
Shares may be classified in some different ways according to the
different regulations in different countries. As a general classi-
fication according to the shares’ accounting process, the classes
of shares may be divided into two basic groups: 1) Preferred
Share-Common Share 2) Par value share-No-par value share-
Stated value share
176
6
Accounting II
LO 2 Journalize the issuance of shares.
In the issuing process at first as a legal procedure, a corporation

should authorize some number of common share in the charter.
While issuing them, the transaction should be recorded in the re-
lated capital share account named common share. It is possible to
issue at par, over the par, below the par. The total amount above par
value while issuing shares are named premium. Then a premium
Summary
should be recorded in an equity account different than Common
Share account named “Paid-in Capital in Excess of Par-Common”.
In some rare cases, shares may be issued below par value. But this
situation is permitted or limited in most states. While issuing a no-
par common share, total issue price should be recorded in common
share account directly. Issuing stated value common share process is
similar to the issuing a par value common shares.
Differentiate preferred shares

LO 3 from common shares.
A preferred share has already been defined as a type of capital

share that provides its owner some advantages over a common
share. The most important priorities of a preferred share are
“dividends” and “assets in the event of liquidation. Accoun-
ting processes for issuing of common and preferred shares are
similar. The possible situations while issuance some preferred
share would be the same with common share issuance. For the
issuance transactions,“Preferred Share” account should be used
while recording preferred shares instead of Common Share ac-
count. Besides, if a corporation issue both common and pre-
ferred shares, the type of the share should be indicated in the
recording of premium. Therefore, “Paid-in capital in excess of
par- Preferred” account should be used.
177
6
Explain how to account for

LO 4 treasury shares.
Treasury share is a corporation’s own share that has been re-

purchased and is being held for future use.
There may be several reasons for a corporation to repurchase
its own shares, but the main possible reasons are: To avoid a ta-
keover and be cautious about outsiders, to reissue the shares to
employees and reward them, to promote the price of the shares
Summary
by increasing the trading of the shares, to resell its own shares

with a higher price or to reduce the number of outstanding sha-
res for some ratio analysis. In recording this transaction, contra
shareholders’ equity account named treasury shares is used. Af-
terward, they can resell. In a sale, treasury share may be resold
above cost. In this case, there will be a difference between the
cost and the sale price of treasury share. The positive difference
should be recorded in a new shareholders’ equity account na-
med “Paid-in Capital from Treasury Share”. In some cases, tre-
asury share may be resold below cost. This negative difference
should be recorded in “Paid-in Capital from Treasury Share” if
Paid-in Capital from Treasury Share account has enough credit
balance. But, if Paid-in Capital from Treasury Share account
has no or less credit balance, the remaining amount should be
recorded on the debit side of the retained earnings account.
178
6
Accounting II
1 Which of the following expressions related to 5 What is the name of the shares that have
the characteristics of different types of entities is already been issued and also held by shareholders?
correct?
A. Preferred share
A. The proprietor is personally responsible for the B. Authorized share
proprietorship’s liabilities.
Test Yourself
C. Treasury share
B. The partnership is a type of entity which has at
D. Outstanding shares
most two owners.
E. Issued share
C. A proprietorship is a separate taxable entity.
D. The cancellation of a partnership does not
depend on the death or choice of any partner. 6 Which of the expressions related to the
shareholders’ equity in corporations is incorrect?
E. The owner/owners of the limited liability
partnership is/are called partners. A. A share certificate is an evidence that represents
the ownership of a corporation
2 Which of the following expressions is a B. Transferable units that represent the ownership
disadvantage of a corporation? of a corporation are named capital share
C. Preferred share is a special share that provides its owner
A. Corporations are permanent entities.
some advantages more than a common share does.
B. Corporations may be subject to double taxation.
D. Stated value share is a share that is assigned a
C. Transferability of ownership is easy. value amount similar to par value.
D. Shareholders have just limited liability in E. Paid-in capital is the amount earned through
corporations. profitable operations of a corporation that is
E. Raising more capital can be easy. kept in the corporation
3 Which of the following is presenting the 7 While issuing some common shares that
shareholders’ right to maintain their proportionate carry 1 TL par value per share for cash at 5 TL per
ownership in corporations? share, which account should be debited?
A. Vote A. Cash
B. Dividends B. Common Share
C. Liquidation C. Retained Earnings
D. Receiving information D. Paid-in Capital in Excess of Par
E. Pre-emption E. Paid-in Capital in Excess of Stated
4 What is the total number of shares that is 8 Which of the expressions related to the
allowed in the charter called? preferred share is incorrect?
A. Outstanding share A. The par value in the issuance of the preferred
B. Treasury share share should be credited on the preferred share.
C. Authorized share B. The premium from the issuance of the preferred
D. Issued share share should be debited on paid-in capital in
E. Preferred share excess of par- Preferred
C. One of the most important advantages of a
preferred share is dividend preference
D. Liquidation preference is one of the important
advantages of a preferred share that provides
effective security for the shareholders.
E. Common share part and preferred share part
should be presented separately on the balance
sheet
179
6
9 What is the corporation’s own share that has 10 Which account should be credited while
been repurchased and being held for future use selling treasury share below cost?
called?
A. Cash
A. Outstanding shares B. Paid-in Capital from Treasury Share
B. Preferred shares C. Paid-in Capital Excess of Par
Test Yourself
C. Common shares D. Common share

D. Treasury shares E. Treasury share
E. Issued share
180
6
Accounting II
1. A 6. E
“Characteristics of Different Types of Enti- “Shareholders’ equity in corporations” sec-
ties”. section. tion.
2. B 7. A
Answer Key for “Test Yourself” Suggested answers for “Your turn”
“Advantages and disadvantages of a corpo- “Issuing Common Shares over Par Value”
ration” section. section.
3. E 8. B
“Shareholders’ rights in corporations” sec- “Differences and Issuance of Preferred
tion. Shares” section.

4. C 9. D If your answer is wrong, please review the
“Shareholders’ equity in corporations” sec-
“Treasury Shares” section.
tion.

5. D “Shareholders’ equity in corporations” sec-
10. E If your answer is wrong, please review the
“Treasury Shares” section.
tion.
What is the relation between authorized shares,

issued shares and outstanding shares?
The maximum number of shares that the corporation may issue is called
“Authorized Share”. The number of authorized shares includes all issued and
your turn 1 unissued shares. Therefore, it is defined as the total number of shares which
is allowed by charter. Inside this maximum number-authorized share, shares
that have been already issued by the corporation are called “Issued Share”.
Some part of issued shares would be held by the shareholders and named as,
“Outstanding Share”. Briefly, the largest number is authorized shares. Some
part of authorized share is issued share. Lastly, some part of issued share that
has already been issued and also held by shareholders is outstanding shares.
What are the basic types of shares in a

corporation?
As a general classification according to the shares’ accounting process, the

classes of shares may be divided into two basic groups. The first group is
your turn 2 “Common Share – Preferred Share”, Par Value Share – No Par Value Share
Stated Value Share. Common share is a share that represents the ownership
of a corporation. Preferred share is a special share that provides its owner
some advantages more than a common share does. According to the second
classification, par value share is the capital share that has a par value. On the
contrary, no-par value share is the capital share that has no par value assigned
to it. Finally stated value share is defined as a share that is assigned to a value
similar to par value.
181
6
What is the importance of the dividend right to a

shareholder?
A preferred share has already been defined as a type of capital share that pro-
vides its owner some advantages over a common share. According to the ag-
your turn 3 reements, a preferred share may provide some other priorities and privileges
such as convertibility. But the most important priorities of a preferred share
are “dividends” and “assets” in the event of liquidation. Investors want to
have shares to earn money. Thus they want to receive some part of earnings
proportionally. In other words, the most common aim to invest money in a
corporation is to receive dividends.
What is the effect of the treasury shares on

shareholders’ equity part of the balance sheet?
Treasury share is a corporation’s own share that has been repurchased and is
being held for future use. It should be recorded on Treasury Share account
your turn 4 which is a contra shareholders’ equity account. Hence, it is a debit-balance
account. Treasury shares should be reported after retained earnings section
of the corporation’s balance sheet to show a decrease in shareholders because
the number of the issued share that could be seen on the paid-in the capital
section does not change. To find the total number of shareholders’ equity on
a balance sheet, treasury share balance should be subtracted from the total
amount.
182
6
Accounting II
Endnotes
1Williams, Haka, Nettner, Megis (2002) Financial 14Miller-Nobles T., Mattison, B., Matsumara, E.M.,
& Managerial Accounting (12th ed.), McGraw- p.701.
Hill, p.61. 15http://www.borsaistanbul.com/en/products-and-
2Miller-NoblesT., Mattison, B., Matsumara, E.M. markets/products/equities/hisse-senedi-cesitleri
(2016). Horngren’s Accounting: The financial 16Paul D. Kimmel, Jerry J. Weygandt, Donald E.
chapters (11th ed.), Global Edition. London,
Kieso, (2009) Financial Accounting, (5th ed.)
Pearson Educated Limited, p.31.
John Wiley & Sons, Inc. p.556.
3Miller-Nobles T., Mattison, B., Matsumara, E.M., 17Miller-Nobles T., Mattison, B., Matsumara, E.M.,
p.31.
p.702
4Horngren C.T., Harrison W.T., Oliver S. (2012) 18Miller-Nobles T., Mattison, B., Matsumara, E.M.,
Accounting, (9th ed.) Pearson Education
p. 675.
Limited, p.30
19Miller-Nobles T., Mattison, B., Matsumara, E.M.,
p.703.
p.696.
20Williams, Haka, Nettner, Megis, p.462.
6Miller-Nobles T., Mattison, B., Matsumara, E.M,
p.31. 21Williams, Haka, Nettner, Megis, p.463.
7Miller-Nobles T., Mattison, B., Matsumara, E.M., 22Paul D. Kimmel, Jerry J. Weygandt, Donald E.
p.696. Kieso, p.561.
8 https://www.delawareinc.com/blog/delaware- 23Paul D. Kimmel, Jerry J. Weygandt, Donald E.
blockchain-technology-and-the-future/ Kieso, p.562.
9Derivedfrom: Miller-Nobles T., Mattison, B., 24Paul D. Kimmel, Jerry J. Weygandt, Donald E.
Matsumara, E.M., p.31. Kieso, p.563.
10Miller-Nobles T., Mattison, B., Matsumara, E.M., 25Paul D. Kimmel, Jerry J. Weygandt, Donald E.
p.699. Kieso, p.559.
11 http://www.borsaistanbul.com/en/products- 26Miller-Nobles T., Mattison, B., Matsumara, E.M.,
and-markets/products/equities/hisse-senedi- p.707.
sahibinin-haklari Miller-Nobles T., Mattison, B., 27Miller-Nobles T., Mattison, B., Matsumara, E.M.,
Matsumara, E.M, p.699. p.707.
12Miller-Nobles T., Mattison, B., Matsumara, E.M., 28 https://hbr.org/2017/10/serving-shareholders-
p.699. doesnt-mean-putting-profit-above-all-else
13Williams, Haka, Nettner, Megis (2002) (12th ed.) 29 http://www.mevzuat.gov.tr/
Financial & Managerial Accounting, McGraw- MevzuatMetin/1.5.6102.pdf
Hill, p.454.
30http://www.cmb.gov.tr/SiteApps/Teblig/File/483
183
Shareholders’ Equity:
Retained Earnings and
Chapter 7 Dividends
1 2
Learning Outcomes
Describe and illustrate how to account for cash

Explain the retained earnings dividends
3 Describe and illustrate how to account for

share dividends and share splits 4 Report restrictions on retained earnings
5 Describe and illustrate shareholders’ equity

section 6 Define comprehensive income and calculate
the return on equity, earnings per share and
book value per share
Chapter Outline Key Terms

Introduction Book value per share
Retained Earnings Cash dividend
Accounting for Cash Dividends Comprehensive income
Accounting for Share Dividends and Share Dividend
Splits Earnings per share
Restrictions on Retained Earnings Retained earnings
Changes in Shareholders’ Equity Return on equity
Earnings and Evaluating Ratios Share dividend
Share splits
184
7
Accounting II
INTRODUCTION corporate decisions to retain net income to be used

The first source of shareholders’ equity part in future operations or for expansion. Retained
is Paid-in Capital which was discussed in the earnings is an item of shareholders’ equity and it
previous chapter. The second one is Retained represents the shareholders’ claims on assets and
Earnings that represents the amount earned are shown on the shareholders’ equity part of the
through profitable operations of a corporation and balance sheet.
that is kept in the corporation. In other words, it is
the earned amount which is not distributed to the Retained earnings is the amount earned
shareholders as dividends as it is briefly mentioned through profitable operations of corporations
before. On the other hand, the distributions and that is kept in the corporation
from the earnings to the shareholders is named
as dividends. In this chapter, basically the details
about retained earnings and dividends will be At this point, it should be emphasized that the
discussed. At first, the general information about retained earnings are not the assets themselves and
retained earnings are introduced and then different it is not related to the corporation’s cash account.
types of dividends and share splits are explained. In other words, it is possible to see enough balance
Afterward, restrictions on retained earnings are on retained earnings while there isn’t enough
mentioned. Then, preparing a shareholders’ equity amount on cash account. Hence, retained earnings
section of the balance sheet is illustrated. Lastly, the and cash are separate accounts. Retained earnings
distinction between net income and comprehensive account’s credit balance (it is an equity account)
income is explained and return on equity, earnings indicates a company’s profits since its inception,
per share, and book value per share are introduced. minus any losses, dividends to shareholders, or
transfers to contributed capital.1
Retained earnings account’s credit balance

indicates that the corporation’s lifetime
earnings exceed lifetime losses and dividends
To understand the retained earnings account,

recall the closing process at the end of the
accounting period. A corporation closes its revenue
accounts and expense accounts. To close all the
revenue accounts, they should be debited while
Income Summary account is credited with the total
amount of the revenues. Thus, the total amount of
revenues for an accounting period could be seen on
Picture 7.1 It is important to understand the meaning
the credit side of the Income Summary account.
of the terms retained earnings and dividends.
Contrarily, to close all the expense accounts they
should be credited while the Income Summary
account is debited with the total amount of the
RETAINED EARNINGS expenses. Thus, the total amount of expenses for
Retained earnings represents the amount of an accounting period could be seen on the debit
the assets that are generated through profitable side of the Income Summary account. In the end,
operations of corporations and are not distributed the financial result of the corporation (net income
to the shareholders in the form of dividend. It or net loss) for a specific accounting period could
means corporations retain some part of their net be seen on the balance of the Income Summary
income in the corporation. Retained earnings is account as illustrated below:
internally generated equity because it results from
185
7
Shareholders’ Equity: Retained Earnings and Dividends
INCOME SUMMARY
Total expenses Total revenues

for an accounting period for an accounting period
Finally, the balance of the Income Summary account is close to the Retained Earnings account. Thus, it
means a net income increases the retained earnings but net loss decreases the retained earnings. If there is a
debit balance in Retained Earnings, this is called a deficit (debit balance) in Retained Earnings. A deficit is
shown in the shareholder’s equity part of the balance sheet as a deduction from contributed capital. There
is an illustration for the closing process when there is a net income at the end of the accounting period:
Assume that ABC Inc. has following revenues and expenses on December 31, 2018:
• Sales Revenue 800,000 TL
• Gain on Sale of Plant Assets 10,000 TL
• Cost of Goods Sold 500,000 TL
• Selling Expenses 25,000 TL
• Operating Expenses 20,000 TL
The journal entry for the closing process is as follows:

Sales Revenue 800,000
Dec 31
Gain on Sale of Plant Asets 10,000
Income Summary 810,000
Dec 31 Income Summary 545,000

Cost of Goods Sold 500,000
Selling Expenses 25,000
Operating Expenses 20,000
To close expenses
After posting these two journal entries in the closing process, the revenue and expense accounts of
the period would be closed and the total amount of all revenues and expenses would be seen on Income
Summary account, as follow:
INCOME SUMMARY
Dec 31 545,000 Dec 31 810,000
Balance ….. 265,000
Finally, the balance of the Income Summary account 265,000 TL (810,000 – 545,000) is Net Income
amount of the period and it will be closed by the Retained Earnings account. Thus, net income will
increase the retained earnings. The journal entry is as follow:
186
7
Accounting II
Dec 31 Income Summary 265,000

Retained Earnings 265,000
To close net income to Retained Earnings
As illustrated above, the balance of Income Summary account is transferred to the Retained Earnings
account at the end of the accounting period. After that, if the management decides to distribute some of
the income as dividends, that amount will reduce the retained earnings. When the company distributes
dividends, the Retained Earnings account will be debited. Accounting for dividends will be discussed in
the following part of this chapter.
Retained Earnings account represents a cumulative balance on the shareholders’ equity part of the
Balance Sheet. Therefore, the retained earnings account balance is important for the financial strength of
a corporation over its life.
1
Explain the importance of retained earnings for a corporation.
ACCOUNTING FOR CASH DIVIDENDS

Profitable corporations may make distributions to their shareholders in the form of dividends.
Dividends are distributions of cash, other property, or share of the business to the shareholders of a
corporation on a pro rata (proportional to ownership) basis. In other words, a dividend is a distribution
of some portion of earnings to the shareholders by a corporation. Distribution of dividends is based
on the decision of the board of the directors. In considering whether to declare dividends, managers
must conclude that declaring dividends is both legally (both in accordance with the law and contract)
and financially desirable. Thus, it is obvious that dividend policies of companies are very important to
shareholders. They want to earn return or premium on their investments.
A dividend is a distribution of some portion of earnings to the shareholders by

a corporation.
There is an example about dividend policy of Turkish Airlines which can be found on their website.
“The Incorporation aims to distribute at least 20% of the net distributable profit as cash and/or bonus
shares under the provisions of the Turkish Commercial Code, Capital Markets Law, Turkish Tax Procedure
Law, other related legislation and its Articles of Association. The minimum payout ratio is to be revie-
wed every year by the Board of Directors while considering global and national economic conditions, the
Incorporation’s medium and long term growth strategies along with the investment strategies and cash re-
quirements at the time. Dividend distribution shall be started at the date set forth in the General Assembly
provided that the start date of the dividend distribution is no later than the relevant fiscal year end in
which the General Assembly is held. The Incorporation can distribute advance dividend under the provisi-
ons of the legislation in effect and can distribute the dividend as equal or unequal amounted installments”
Source: http://investor.turkishairlines.com/en/governance/dividend-policy
187
7
Corporations distribute dividends on a pro rata paid-in capital is prohibited but payment of
(proportional to ownership) basis to shareholders dividends from paid-in capital in excess of par
regarding the portion of shares they have. Usually, is legal in some states.2 Dividends will be paid
a corporation may pay dividends in cash, other from retained earnings. Payment of dividends
assets, or shares of its common stock. Cash from retained earnings is legal in all states. This is
Dividends and Share Dividends are the common why a corporation has to have retained earnings
ways of distributions and they will be discussed. at first while planning to pay cash dividends.
A cash dividend is a cash distribution of Secondly, a corporation has to have an adequate
earnings by a corporation to its shareholders. amount of cash to pay cash dividends. The legality
Although dividends may be paid in other assets or of dividends and the ability to pay dividends are
properties, cash dividends are the most common two different things. Recall that as it is explained
types of dividends. before, cash and retained earnings are separate
from each other. Sometimes it may be possible to
If a corporation wants to pay cash dividends,
see enough balance on retained earning while there
three conditions required are as follows:
isn’t enough amount on the cash account. Thus the
1. Sufficient retained earnings amount of cash is an important factor to make a
2. Adequate cash decision about the payment of cash dividends.
3. Declared dividends by the board of direc-
Afterward, the board of the directors which has
tors
the authority to determine the policy of payment of
the dividends, should make a decision and declare
it. While making this decision they have to think
A cash dividend is a cash distribution of about both shareholders’ and the corporation’s
earnings by a corporation to its shareholders. interest. As explained before, shareholders are
waiting for reasonable returns but in some cases
payment of dividends may cause some liquidity
problems in the corporation. Thus the board of
directors should evaluate all possible results of
dividend distribution.
After the decision of paying dividends, three
dates are important for a corporation. These are
Declaration date, the Record date, and Payment
date. At first, on the declaration date a liability
occurs for a corporation, thus, a journal entry is
required at that time. Secondly, the corporation
determines the shareholders who receive dividends
separately on the record date. In this case, a
new journal entry is not required because this
determination has no financial effect. Finally, the
corporation pays the dividend that is determined
for the shareholders on the payment date and a new
journal entry should be prepared because while
Picture 7.2 Shareholders are expecting to receive some paying dividends, corporation’s assets (cash) and
cash dividends. also equity (retained earnings) are both decreasing.
Briefly, on the declaration date and payment
The legality of a cash dividend depends on date journal entries are required in the process of
the laws of the country in which the company accounting for cash dividends.
is incorporated. Payment of dividends from
188
7
Accounting II
Further Reading
The details about dividends should be explained in the footnotes of the financial statements. In the following
you can examine Koç Holding’s dividend distribution in the footnotes on a Balance Sheet:3
“KOÇ HOLDİNG A.Ş.
NOTE 22 - EQUITY
Dividend Distribution
Listed companies in BIST are subject to dividend regulations of CMB as follows:
According to the Article 19 of the Capital Market Law, numbered 6362 and effective from 30 December 2012, and
Dividend Communiqué of CMB, numbered II-19.1 and effective from 1 February 2015, listed companies shall distribute
their profits within the framework of the profit distribution policies to be determined by their general assemblies and in
accordance with the prevailing regulations. Regarding the profit distribution policies of the listed companies, CMB may set
different principles on companies with similar qualifications.
In accordance with the Turkish Commercial Code, unless the required reserves and the dividend for shareholders as
determined in the Articles of Association or in the dividend distribution policy of the company are set aside; no decision
may be taken to set up other reserves, to transfer profits to the subsequent year or to distribute dividends to the holders of
usufruct shares, to the members of the board of directors or to the employees; and no dividend can be distributed to these
people unless the determined dividend for shareholders is paid in cash.
For the listed companies, dividend distribution is made evenly to all existing shares as of the date of dividend
distribution without considering the dates of issuance and acquisition of the shares.
Companies shall distribute their profits through general assembly decisions in accordance with the profit distribution
policies to be determined by their general assemblies as well as the related provisions of the prevailing regulations. A minimum
distribution rate has not been determined in these regulations. The companies pay dividends as determined in their articles
of associations or profit distribution policies. Furthermore, dividends may be paid in installments with the same or different
amounts and profit share advances may be distributed over the profit in the interim financial statements.
In accordance with Article 32 of the Company’s Articles of Association, a contribution of a maximum 2% (according
to the decision of the General Assembly) of the amount remaining after the first legal reserves set aside over income before
tax, financial obligations and first level dividends, is paid to Koç Holding Emekli ve Yardım Sandığı Vakfı. In addition,
save for the first level dividend determined according to the Capital Markets Law, 3% of the amount remaining after
the first legal reserves, financial obligations and 5% of the paid-in capital, is deducted from the income before tax,
is allocated to holders of dividend-right certificates. However, the amount to be paid to the holders of dividend-right
certificates may not exceed 1/10 of the amount remaining after the first legal reserves and first level dividend calculated
according to CMB regulations are deducted from the net profit.
As of 31 December 2017, the total amount of reserves that can be subject to dividend distribution wit-
hout creating additional corporate tax burden is 5.871.787 TL thousand.
At the Ordinary General Assembly Meeting of Koç Holding A.Ş. held on 30 March 2017, it was resolved;
• to distribute 826.449.174,50 TL consisting the first level dividend amounting to 169.902.993,53
TL and the second level dividend amounting to 656.546.180,97 TL in cash;
• A dividend payment of 826.449.174,50 TL and 98.031.981,14 TL payment allocated to usufruct
shareholders amounting to a total of 924.481.155,64 TL will be paid in cash and 2.250.398,33 TL
of this amount will be sourced from current year tax-exempt earnings and 922.230.757,31 TL will be
sourced from a current year other taxable earnings. 10.500.000 TL allocated to Koç Holding Emekli
ve Yardım Sandığı Vakfı, will be paid in cash and sourced from a current year other taxable earnings.
Cash dividend payments were completed as of 10 April 2017.”
Source: https://www.koc.com.tr/en-us/investor-relations/financial-statements-and-statistics/Annual%20
Reports/Ko%C3%A7%20Holding%202017%20Annual%20Report.pdf
189
7
The Dividend on Preferred Shares

If a corporation has already issued both common and preferred shares, the shareholders who have
preferred shares should receive dividends at first. After the preferred shareholders receive cash dividends,
the common shareholders may receive cash if there is still any remaining amount from the total amount of
dividends. Because preferred shares have some priorities over the common shares.
Usually, the dividend rate on preferred shares is expressed as a percentage of preferred share par value
(such as 5%) on the certificate. The preferred dividend is calculated as follow:
The preferred dividend = Outstanding preferred shares x Par value x Preferred dividend rate
Assume that (A) Inc has 40,000 outstanding preferred shares of 8%, 20 TL par preferred share. In this
case, the preferred dividend is calculated as follows:
4,000 x 20 x 8% = 64,000 TL
If the total dividend amount which is determined by the board of directors is large enough to cover
both preferred and common shares, the preferred shareholders will receive their dividends at first and
then common shareholders will receive the remaining amount. If the total dividend amount less than the
required preferred dividend amount, preferred shareholders receive the total amount but, the common
shareholders will not receive any dividend for this period.4
Assume that (A) Inc. has already determined the total dividend of 100,000 TL. Then the common
dividend amount is calculated just by subtracting the preferred dividend. Then the remaining amount will
be the common share dividend amount:
100,000 TL – 64,000 TL = 36,000 TL common share dividend
Unfortunately, preferred share cannot guarantee that a corporation will pay a dividend equal to the
preferred amount and sometimes a corporation may fail to pay any dividends. If a corporation cannot pay
any dividends, the preferred share is called dividend in arrears. But, generally preferred shares are issued
as cumulative preferred shares and preferred shareholders can receive all the dividends in arrears before
the common shareholders receive any dividend in the next period.
A cumulative preferred share is a preferred

A preferred dividend is in arrears if it has share that can also receive all dividends
not been paid for the period. in arrears while receiving a new preferred
dividend.
Recording Declaration and Payment of Cash Dividends

Firstly, on the date of the declaration, the corporation’s liability amount is determined and it should be
recorded. If a corporation has already issued both common and preferred shares, the liabilities about the
preferred dividend and common dividend should be recorded in separate accounts after being declared.
To illustrate, assume that (B) Inc. on January 15, 2018, declares 200,000 TL cash dividends of preferred
shares, 250,000 TL cash dividends of common shares.
190
7
Accounting II
On the date of the declaration, the journal entry is as follows:

Jan 15 Retained Earnings 450,000
Dividends payable-preferred 200,000
Dividends payable-common 250,000
To declare a cash dividend
Dividend Payable accounts are current liability accounts in which debts about the preferred
dividend and common dividend should be recorded.
With the journal entry above, liabilities increased with two separate current liability accounts and at the
same time shareholders’ equity decreased with the debited retained earnings. In some different practices, it
is possible to use Cash Dividends account instead of Retained earnings, but debiting Retained Earnings
is the most common practice.5 In this way, at the end of the accounting period cash dividends should be
closed to Retained earnings. The journal entries, then are as follows:

Jan 15 Cash Dividends 450,000
Dividends payable-preferred 200,000
Dividends payable-common 250,000
To declare a cash dividend

Dec 31 Retained Earnings 450,000
Cash Dividends 450,000
To close Cash dividends
Finally, on the date of payment, liabilities are decreasing and also assets - cash is decreasing while paying
dividends to shareholders.
In conjunction with the previous example, assume that (B) Inc. on January 22, 2018, pays preferred
and common dividends. The journal entry is as follows:

Jan 22 Dividends Payable –Preferred 200,000
Dividends Payable -Common 250,000
Cash 450,000
To pay cash dividends
191
7
2
Just on the declaration date and payment
Which dates are important for the
date journal entries are required. No journal
transactions about the distribution of cash
entry is required in the recording date.
dividends for a corporation?
ACCOUNTING FOR SHARE

DIVIDENDS AND SHARE SPLITS
Another popular way to distributing dividends to the shareholders is to share dividends. In this part
of this chapter firstly the characteristics of share dividends are introduced and recording share dividends
transactions is explained. Hence, the differences between cash dividends and share dividends will be
emphasized. Afterward ,another important transaction for corporations named share splits and its effects
are explained.
Share Dividends
The second popular way to distributing dividends
to the shareholders is to share dividends. In this case,
the distributed item is different than cash dividends.
Share dividend is a distribution of a corporation’s
own shares to the shareholders as dividends. It
must be an effective alternative to conserve cash
while continuing to distribute a dividend to the
shareholders and reward them. Besides distributions
of share, dividends may provide some advantages by
reducing the market price of shares. Thanks to low
market price, a corporation’s shares may be seen more
attractive by the investors.6 For whatever reason it
might be, it is important to understand the effects
and differences of share dividends. Picture 7.3 Distributions of share dividends to the
shareholders.
Share dividend is a distribution of a corporation’s If a corporation decides to distribute share

own shares to the shareholders as dividends. dividends, assets, liabilities the total shareholders’ equity
will not change. On the contrary, while recording cash
dividends, assets and total shareholders’ equity are decreasing because of the decrease in cash and retained
earnings. When the company distributes share dividends, asset amount of company will not change. Items
of the shareholders’ equity will be affected. In other words, the amount of issued and outstanding shares are
also increasing and retained earnings are decreasing. All of the shareholders receive a proportional amount of
additional shares. Therefore, the percentage of total ownership will not change. After the decision of paying
share dividends, similar to the cash dividends distributions, three dates are important for a corporation. These
are: Declaration date, Record date and Distribution date. At first, on the declaration date, the corporation
has declared its intention to distribute its shares. A journal entry is required to show the change between
shareholders’ equity items. Secondly, the corporation determines the shareholders who receive share dividends
separately on the record date. In this case, a new journal entry is not required. Because this determination has
no financial effect. Finally, the corporation distributes the dividend that is determined to the shareholders
on the distribution date and a new journal entry should be prepared. Briefly, on the declaration date and
distribution date journal entries are required in the process of accounting for cash dividends.7
192
7
Accounting II
Further Reading
There is some explanation about dividend payments in Turkey:

“The dividend distribution principles for public Joint stock corporations are regulated by the CMB’s Communiqué on
Dividends (No: II-19.1). Hence, public Joint stock corporations distribute dividends in accordance with the regulations
and via the decision of their respective General Assemblies. Within the framework of their dividend distribution policies,
corporations are obliged to at least include the following fundamental considerations:
a. Whether an actual dividend distribution will be materialized or not, and the dividend distribution
rate for the common partners and other people, which bears the legal right to take part in a dividend
distribution, should such a distribution be realized.
b. The date of the actual dividend distribution, with the condition that the distribution will be
commenced at the General Assembly, which convenes after the end of the last fiscal year.
c. A form of payment of the dividend (i.e. in cash, shares or both in predetermined proportions)
d. Whether an advance payment of the dividend distribution will be carried out or not, and the
principles of such a distribution, should there be any.
The dividends are to be distributed equally proportionate all existing shares, at the appointed date regardless of their
issuance and acquisition dates. Joint stock corporations, whose equities are traded on the Exchange are free to:
• distribute the dividend entirely in cash,
• distribute the dividend entirely as equity,
• distribute a certain part of it in cash and a certain part of it as equity, and retain the remainder;
• choose to not to distribute it in either cash or as equity, and retain it within the corporation.
Pending the approval from their respective General Assemblies. However, unless an allocation has been made for the
mandatory legal reserves and the distribution of the dividends assigned by the Articles of Association of the company to
the shareholders is completed, a decision could not be taken:
to allocate further legal reserves,
• to carry the profits forward to the next year,
• or
• to distribute profits to:
• preferred stockholders,
• holders of participating certificates,
• founders and common dividend shares,
• members of the board of directors,
Other parties.”
Source: http://www.borsaistanbul.com/en/companies/companies-liabilities/equity-market/dividend-payments
The recording process for the transactions about the distribution of share dividends is based on the
number of dividends. According to the size of the dividends, share dividends transactions are usually
divided into two groups:8
• Small share dividends: These are the dividends which are less than 20%–25% of the corpora-
tion’s issued shares. To record small share dividends fair market value should be used. This prac-
tice is based on the assumption that a small share dividend will have little effect on the market
price of the shares previously outstanding.
193
7
• Large share dividends: These are the dividends which are greater than 20%–25% of the corpora-
tion’s issued shares. These types of dividends are rare. But, if a corporation decides on a large share
dividend, par value or stated value should be used to record related transactions instead of market
value because of the possible important effect of this transaction on the market price of the shares.
Share dividends are categorized into two groups as small share

dividends and large share dividends.
To record the declaration of a small share dividend with its market value, the Retained Earnings
account should be debited for market value. A shareholders’ equity account named Common Share
Dividend Distributable is credited with the par or stated value and Paid-in Capital in Excess of Par is
credited with the remaining amount.
Similar to cash dividends, it is possible to use Share Dividends account

instead of Retained Earnings at first. If Share Dividends is used, it should
be closed to Retained Earnings at the end of the accounting period.
Afterward, to record the distribution of a small share dividend, Common Share Dividend Distributable
is credited with the par or stated value while the Common Share is credited.
To illustrate, assume that (D) Inc. declares 3% common share dividend on 4,000,000 shares outstanding.
Their market value is 3 TL per share while their par value is 1 TL on November 1, 2018.
The (D) Inc. will issue 120,000 (4,000,000 shares x 3%) common shares to shareholders. The journal
entry, then, is as follows:
Nov 1 Retained Earnings 360,000
(3 TL x 4,000,000 shares x %3)
Common Share Dividend 120,000
Distributable
(1 TL x 4,000,000 shares x %3)
Paid-in Capital in Excess of
240,000
Par-Common
(360,000-120,000)
To declare share dividends

After the declaration of share dividends, the shareholders who receive share dividends are determined
on the record date. But no record is required on the record date. Then on distribution date, one more
journal entry is required to record the issuance of a common share in this transaction.
Assume that, (D) Inc. issues common shares for 120,000 TL on November 15, 2018, to distribute share
dividends that are declared.
194
7
Accounting II
The journal entry is as follow:

Nov 15 Common Shares Dividend Distributable 120,000

To issue share dividends

As explained before, large share dividends are rare. But, when there is a decision about large share
dividends, it should be recorded at par value or stated value on declaration date.
To illustrate, assume that (ABC) Inc. declares a share dividend of 40% on 1,000,000 shares outstanding.
Their market value is 15 TL per share while their par value is 1 TL on December 1, 2018.
Dec 1 Retained Earnings 400,000
(1 TL x 1,000,000 share x 40%)
Common Share Dividend Distributable 400,000
(1 TL x 1,000,000 share x 40%)
To declare share dividends
Assume that, (ABC) Inc. issues common shares for 400,000 TL on December 15, 2018, to distribute share
dividends that are declared.
Dec 15 Common Shares Dividend Distributable 400,000

To issue share dividends
Share Splits
A share split is increasing the number of issued and
outstanding shares of a corporation that results in decreasing
of shares’ par value.
A share split is increasing the number of issued

and outstanding shares of a corporation that
results in decreasing of shares’ par value.
It is significantly different than Share Dividends. If a

corporation decides to split its common shares 2 for 1, it has Picture 7.4 Share Splits increases the issued
twice shares after the split and par value of per share is cut in and outstanding shares
195
7
half. Usually, the reason for share splits is to decrease the market price and make the shares more appropriate
and attractive for the investors. But share splits have no financial effect on any account balance. Thus no
classical journal entry is required. It should be recorded in a memorandum entry that represents a note
without any balance.9
Briefly, the number of outstanding shares are increasing while the par values are decreasing in the same
proportiona with a share split.
In a share split the par value per share is 3

decreasing in the determined proportion. Explain the account called
But recall that in a share dividend the par Common Share Dividend
value per share doesn’t change. Distributable
RESTRICTIONS ON RETAINED EARNINGS

To reserve cash or to be conservative about possible risks or some specific reasons such as loan
agreements, to distribute the regular amount of dividends etc. there may be some restrictions on retained
earnings. Thus, some amount of retained earnings may be defined as restricted retained earnings. Restricted
retained earnings amount presents the amount of that is unavailable for distribution to the shareholders.
In other words, restricted retained earnings show a reduction from a possible amount of dividends. On the
footnotes of the financial statements, all of the details should be explained clearly.
A restriction on retained earnings is an amount of retained

earnings that is unavailable for dividends.
Usually, the restrictions may occur in three different types: Legal

restrictions, contractual restrictions, and voluntary restrictions.
Regulations in different countries may require legal restrictions to
4
protect the capital of the corporations. Long term liabilities agreement
may require to restrict the retained earnings. Other than these Discuss the possible reasons
restrictions, the board of the directors may require some restrictions on to restrict retained earnings.
retained earnings for specific proposes.10
CHANGES IN SHAREHOLDERS’ EQUITY

Because of some transactions that have been already discussed until this part of the chapter, shareholders’
equity may change over time. For shareholders, it is very important to understand the changes in
shareholders’ equity to decide on their investment plans. Besides, these changes are important for other
financial statement users to analyze the financial strength, performance, and position of the corporation.
Hence, the requirements for the information about the change in the shareholders’ equity could be changed
according to different parties. For this reason, on the balance sheet, the most basic and general information
should be represented as a summary. Then on the footnotes of the balance sheet, the financial statement
users who need some more information can find many details about different items of the balance sheet.
Most important types of transactions that may affect the shareholders’ equity are explained in Chapter
6 and Chapter 7. These are the issuance of shares, purchase, and sale of treasury sales, cash dividends, share
dividends and share splits. The effects of these transactions have been already discussed. Just to summarize
their effects, you can examine Figure 7.1.11
196
7
Accounting II
Figure 7.1 Effects on Assets, Liabilities, and Equity

EFFECTS ON TOTAL
TRANSACTION
ASSETS LIABILITIES SHAREHOLDERS’EQUITY
Issuance of share Increase No effect Increase
Purchase of treasury share Decrease No effect Decrease
Sale of treasury share Increase No effect Increase
Declaration of the cash dividend No effect Increase Decrease
Payment of cash dividend Decrease Decrease No effect
Share dividend No effect No effect No effect*
Share split No effect No effect No effect
* The share capital account increases and retained earnings decreases by offsetting amounts that net to zero.
Source: Harrison, W. T., Horngren, C. T., Thomas, W., & Suwardy, T. (2014). Financial Accounting: International
Financial Reporting Standards (9th ed.), Global Edition, London, Pearson Educated Limited, p. 630.
To represent the shareholders’ equity on a balance sheet, firstly the total amount of Paid-in Capital
accounts balances then –if any- Additional Paid-in Capital Accounts are presented. Afterward, the Retained
Earnings is presented. Finally, if the corporation has Treasury Shares, its amount should be subtracted
from the subtotal to calculate total shareholders’ equity. At least this information should be presented on
a Balance Sheet. In real life, it is possible to see some more details. Actually, for the details, the footnotes
of the Balance Sheet are very comprehensive and important. For example, usually, components of share
capital and dividend distribution are explained on the footnotes of the balance sheet.
In Figure 7.2, a general view of the form of a Shareholders’ Equity section on a Balance Sheet is
illustrated.
Figure 7.2 Illustration for the Shareholders’ Equity section on a Balance Sheet
(….) Inc.
Date
Paid-in Capital …………
Preferred Share ………
Common Share ………
Additional Paid-in Capital ……….
Paid-in Capital in Excess of Par-Preferred ………
Paid-in Capital in Excess of Par-Common ………
Paid-in Capital from Treasury Share ……….

Retained Earnings ………...
Less: Treasury Share (……….)

Total Shareholders’ Equity
197
7
Because of the importance of the information

about the changes in shareholders’ equity especially
for the investors, another specific financial
statement named Statement of Shareholder’s
Equity is prepared by the corporations.
Corporations prepare the statement of equity
to provide more information about the change in
the shareholders’ equity. This statement starts with
the beginning balances of different components of
Shareholders’ Equity, and additions and subtractions.
Statement of shareholders’ equity is a

financial report that represents the details Picture 7.5 Statement of Changes in Shareholders’ Equity-
about the changes in shareholders’ equity for Koç Holding
a period of time.
In Figure 7.3, you can examine Koç Holding’s
Statement of Changes in Shareholders’ Equity.12 Below,
you will see the term comprehensive income which is used for explaining the details of the change in the
shareholders’ equity. Comprehensive income is explained in the following part.
Figure 7.3 Statement of Changes in Shareholders’ Equity-Koç Holding
Source: https://www.koc.com.tr/en-us/investor-relations/financial-statements-and-statistics/Annual%20Reports/
Ko%C3%A7%20Holding%202017%20Annual%20Report.pdf
5
Explain the importance of the information related to shareholders’ equity.
198
7
Accounting II
EARNINGS AND EVALUATING RATIOS

Corporations should give accurate, reliable, comparable information to the users of financial statements
about their financial performance. As it is explained while discussing the other types of entities, all of them
should explain all the revenues and expenses. Similarly, corporations should explain their net income or net
loss as financial results. Recall that financial result could be calculated just comparing all of the revenues
and expenses for a service entity. To prepare a multi-step format income statement for merchandising
operations, firstly gross profit/ loss section should be prepared to present the result from main operation
issues. Secondly the operating income/loss section should be prepared to show the result from ordinary
transactions. Lastly, other revenues and expenses should be presented in the third section to see the result
of a corporation. If there is a net income as a result, the tax should be calculated for a corporation. Income
before tax expense minus tax expense can give net results of a corporation.
In reporting the components of net income in the traditional way, which is explained above, some
gains and losses are not included. These are components of the Comprehensive Income. Comprehensive
income is all changes in the shareholders’ equity from all sources except owners’ investments and dividends.
To calculate other comprehensive income components should be added or subtracted. To report a
comprehensive income there are two alternatives. In the first alternative, two separate statements may be
prepared for net income and comprehensive income. As a second alternative, just a combined statement
may be prepared.13 Comprehensive income components are as follows:14
• Unrealized gains or losses
• Foreign-currency translation adjustments
• Gains (losses) from post-retirement benefit plans A Comprehensive income is all changes in
• Deferred gains (losses) derivatives. the shareholders’ equity from all sources
except owners’ investments and dividends.
Picture 7.6 Calculating comprehensive income
The importance of accurate, reliable, comparable information about the corporations for different
parties is emphasized before. This why different presentations occur to provide more information to the
financial statement users. The financial statement users also want to analyze this information to see the
relevant meaning of them that will be used in their decision making. As it is known, using financial ratios
are very practical, beneficial and pervasive ways of analyzing financial statements. By some ratios, the
relationship between shareholders’ equity items, their positions, results, and effects can be understood
clearly. Thus the information on the financial statements can be used in some decision making processes.
199
7
One of the ratios that is used for analysis is the Return on Equity (ROE). It measures a corporation’s
profitability by presenting how much profit it generates with each item (TL) of shareholders’ equity. It can
be calculated as follows:
Average shareholders’ equity can be calculated as an average amount of beginning and ending balance
of shareholders’ equity.
Return on Equity is a measure of a corporation’s profitability

that presents how much profit it generates with each item (TL)
of shareholders’ equity.
It is expressed as a percentage. In many industries, 15% is considered a good return on equity.15

Another ratio is Earnings Per Share (EPS) that presents how much income is earned for each common
share. It can be calculated as follows:
An average number of common shares outstanding can be calculated as an average amount of beginning
and ending number of common shares outstanding for a period.
Earnings Per Share presents how much income is earned by a

corporation for each common share.
Another ratio that may be considered is book value per share. This ratio is used to calculate the per share
value of a corporation. In other words, it represents the amount of the owner’s equity on the corporation’s
books for each common share. Some investors want to have shares whose market price is below book value.16
Therefore, it may be important information for some decision making processes. It can be calculated as follows:
Book value per share represents the amount 6

of the owner’s equity on the corporation’s Explain the differences between net income and
books for each common share. comprehensive income.
200
7
Accounting II
Further Reading
Why companies do not pay cash dividends: The tively younger (in the earlier stage of their life cycle)
Turkish experience with high-growth opportunities, or with a low level
“This study uses a survey approach to examine the of profitability (or even loss) and small (negative) ear-
views of corporate managers of non-dividend-paying nings. Second, the findings show some evidence that
firms listed on the Borsa Istanbul (BIST) in order to Turkish firms consider their shareholders’ preferences
identify the factors leading to the decision not to pay in setting a no cash dividends policy. Third, we find
cash dividends in Turkey. Our survey results show that that non-dividend-paying BIST managers do not
cash constraints, growth opportunities, low profitabi- perceive taxes as an important reason for paying no
lity and earnings, and the cost of raising external funds dividends, although differences exist between the tax
(debt) are the major reasons inducing BIST firms not rate on capital gains and cash dividends as well as in
to pay dividends. Additionally, non-dividend-paying the taxation of dividends among investors in Turkey.
firms consider their shareholder preferences when set- Fourth, our survey findings indicate strong agreement
ting a policy of paying no cash dividends. Yet, they to that a firm would not distribute dividends if it fa-
neither view taxes as an important factor for paying no ces high flotation costs of raising new external capital.
dividends nor perceive that stock repurchases are subs- Yet, the results are inconclusive about how managers
titutes for cash dividends. Statistical analysis using view the relation between paying a no cash dividend,
secondary data of publicly-traded BIST firms reveals and even distributing dividends, and stock prices, and
whether the actual corporate actions are consistent the potential signaling role of dividend policy. Finally,
with the managerial views revealed by our survey re- contrary to the argument that firms use share repurc-
search. These tests show that growth opportunities hases as substitutes for cash dividends, managers of
and debt level have a negative effect on the dividend non-dividend-paying BIST firms rank the preferen-
payment decisions of BIST firms. Also, large block ces to distribute cash using stock repurchases instead
holders and the existence of multiple large sharehol- of dividends as the lowest among 18 factors that may
ders reduce the likelihood and intensity of paying a lead to paying no dividends. Furthermore, we supple-
cash dividend in the Turkish market. Overall, the evi- ment our survey findings by statistical analysis using
dence suggests that non-dividend-paying companies secondary (published) data of publicly-traded BIST
are likely to be smaller in size, relatively younger (in firms in order to determine whether actual corporate
the earlier stage of their life cycle) with high-growth actions are consistent with the managerial views reve-
opportunities or with a low level of profitability (or aled by our survey research…”17
even loss) and small (negative) earnings. By contrast,
highly-profitable, mature and large-size corporations Source: H. Kent Baker and Erhan Kilincarslan
are more likely to pay cash dividends. Accordingly, (2018). “Why companies do not pay cash dividends: The
the findings of our survey of non-dividend-paying Turkish experience”, Global Finance Journal, Febru-
managers of BIST firms lead to several important ary 2018.
conclusions. First, our survey results reveal that major
Follow this and additional articles at https://
reasons behind BIST-listed firms’ decision not to pay
ac.els-cdn.com/S1044028317304659/1-
dividends are cash constraints, availability of profitab-
s2.0-S1044028317304659-main.
le investment opportunities, poor profitability and
pdf?_tid=2c15521d-c4a1-495c-87e3-
earnings, and cost of raising external funds. The sur-
3bcdeb5f0714&acdnat=1542099259_f9e-
vey results generally suggest that non-dividend-paying
1661c909e99d0b162caac565c6c9e
BIST companies are likely to be smaller in size, rela-
201
7
Inside Practice
STATUTORY AND DISCRETIONARY RE- • After the payment of 5% of the net profits to
SERVES UNDER THE TERMS OF THE TUR- shareholders as a first dividend distribution, 10%
KISH COMMERCIAL CODE of the amount that is decided to be distributed
The new Turkish Commercial Code numbered among persons having shares in the profits “se-
6102 was published on February 2, 2011, and it is in cond statutory legal reserves” is added to the ge-
force since July 1, 2012. Reserves which are impor- neral statutory reserves after it reaches the legal
tant for the calculation of the distributable amount limit”
of dividends are regulated in the Turkish Commercial • The second type of reserve named voluntary re-
Code. Reserves may be defined as some parts of pro- serves are “voluntary reserves in general” and “re-
fits which are set aside for specific proposes. Accor- serves to be appropriated in favor of employees
ding to the Turkish Commercial Code, corporations and workers”
have to set aside statutory reserves in some cases. Be- • The corporation may decide on and indicate in
sides, corporations can set aside voluntary reserves in the article; to set aside voluntary reserves in an
order to perform some specific aims and strengthen amount exceeding 5% of the annual net income
the financial structure of the corporation. There are or to approve general reserves which may exceed
detailed regulations related to statutory and voluntary 20% of the paid-in capital or to set aside some
reserves in Article 519, 520, 521, 522, 523 of the Tur- other reserves.
kish Commercial Code. Some important parts of the-
se regulations may be summarized as follows:18
Discuss:
• Statutory reserves are classified into two groups
the “general statutory reserves” and “reserves to 1. Explain the differences between the retained
set aside with respect to the corporation’s own earnings and reserves.
shares acquired and revaluation funds”. 2. How can these regulations affect the distri-
butions of dividends?
• Every year corporations have to set aside 5% of
the annual profit as general statutory reserves un-
til the total amount of this reserve reaches 20%
of the corporations’ paid-in capital.
202
7
Accounting II
LO 1 Explain the retained earnings
Retained earnings which are a component of the shareholders’

equity, represent the amount earned through profitable opera-
tions of a corporation and that keeps in the corporation. There
may be some different reasons to retain earnings in the corpo-
ration such as to fulfill the legal obligations, to be cautious, to
grow etc. Retained earnings account’s credit balance indicates
that the corporation’s lifetime earnings exceed lifetime losses
Summary
and dividends. But, the retained earnings account has no di-
rect relation with the cash account of the corporation. In the
closing process, a corporation closes all its revenue and expense
accounts to income summary account. Then income summary
account is closed to retained earnings. A net income increases
the retained earnings but net loss decreases the retained ear-
nings. If there is a debit balance in Retained Earnings this is
called a deficit. Retained Earnings account represents a cumu-
lative balance on the shareholders’ equity part of the Balance
Sheet at the end of the accounting period.

LO 2 account for cash dividends.
A dividend is a distribution of some portion of earnings to the

shareholders by a corporation. Therefore, shareholders give a
lot of importance to corporations’ dividend policies. Corpo-
rations distribute dividends in a proportional basis to share-
holders regarding the portion of shares they have. A cash divi-
dend is distributions of some portion of earnings as cash to the
shareholders by a corporation. If a corporation wants to pay
cash dividends, it has to have some retained earnings and an
adequate amount of cash at first. Then the corporation should
make a decision to declare cash dividends. After the decision
of paying dividends, three dates are important for a corpora-
tion. These are Declaration date, Record date, and Payment
date. Besides, the type of shareholders are important. The sha-
reholders who have preferred shares should receive dividends
at first. After the preferred shareholders receive cash dividends,
the common shareholders may receive cash if there is still any
remaining amount from the total amount of dividends because
preferred shares have some priorities over the common shares.
On the declaration date and payment date journal entries are
required in the process of accounting and then on the balance
sheet, the details about dividends should be explained in the
footnotes of the financial statements.
203
7

LO 3 account for share dividends and
share splits.
Share dividend is a distribution of a corporation’s own shares

to the shareholders as dividends. It must be an effective alter-
native to conserve cash while continuing to distribute a divi-
dend to the shareholders and reward them. If a corporation
decides to distribute share dividends, assets, liabilities and total
shareholders’ equity will not change. On the contrary, while
recording cash dividends, assets and total shareholders’ equity
Summary
are decreasing. Because of the decrease in cash and retained

earnings. After the decision of paying share dividends, similar
with the cash dividends distributions, Declaration date, Record
date and Distribution date are important and on the declarati-
on date and distribution date journal entries are required in the
process of accounting for cash dividends The recording process
for the transactions about distribution of share dividends is ba-
sed on the number of dividends. Different types are illustrated
in the chapter. A share split is increasing the number of issued
and outstanding shares of a corporation that results in decrea-
sing of shares’ par value. Usually, the of each share the market
price and make the shares more appropriate and attractive for
the investors. But share splits have no financial effect on any
account balance. Thus, no classical journal entry is required.
Report restrictions on retained

LO 4 earnings.
A restriction on retained earnings is an amount of retained

earnings that is unavailable for dividends. There may be some
different reasons. Maybe to reserve cash or to be conservative
about possible risks or some specific reasons such as loan agree-
ments, to distribute the regular amount of dividends etc. Usu-
ally, the restrictions may occur in three different types: Legal
restrictions, contractual restrictions, and voluntary restrictions.
Restricted retained earnings show a reduction from a possible
amount of dividends. On the footnotes of the financial state-
ments, all of the details should be explained clearly.
204
7
Accounting II
Describe and illustrate

LO 5 shareholders’ equity section.
Shareholders’ equity may change over time. This change may

be caused by different reasons such as the issuance of shares,
purchase, and sale of treasury sales, cash dividends, share divi-
dends and share splits. All the changes are important for other
financial statement users to analyze the financial strength, per-
formance and position of the corporation. Hence it is critical
for decision makers to find related information. To represent
Summary
the shareholders’ equity on a balance sheet, firstly the total
amount of Paid-in Capital accounts balances then –if any- Ad-
ditional Paid-in Capital Accounts are presented. Afterward the
Retained Earnings is presented. Finally, if the corporation has
Treasury Shares, its amount should be subtracted from the sub-
total to calculate total shareholders’ equity. At least this infor-
mation should be presented on a Balance Sheet whereusually
components of share capital, dividend distribution, and all ot-
her details are explained on the footnotes of the balance sheet.
Define comprehensive income and

LO 6 calculate the return on equity,
earnings per share and book value
per share.
Corporations should give accurate, reliable, comparable infor-

mation to the users of financial statements about their financial
performance. Recall that financial result could be calculated
just comparing all of the revenues and expenses for a service
entity. In reporting the components of net income in the tra-
ditional way which is explained above, some gains and losses
are not included. These are components of the Comprehensive
Income. Comprehensive income is all changes in the sharehol-
ders’ equity from all sources except owners’ investments and di-
vidends. With including comprehensive income components, a
comprehensive statement could be prepared. Besides this detai-
led information, financial statement users are required to analy-
ze this information. To analyze especially the profitability on
shareholders’ equity, three ratios are very useful and important:
return on equity measures of a corporation’s profitability that
presents how much profit it generates with each item (TL) of
shareholders’ equity; earnings per share present how much in-
come is earned by a corporation for each common share; book
value per share represents the amount of the owner’s equity on
the corporation’s books for each common share.
205
7
1 What is the amount earned through profitable 6 What is increasing the number of issued and
operations and that keeps in the corporation called? outstanding shares of a corporation that results in
decreasing of shares’ par value called?
A. Retained earnings
B. Dividend A. Share splits
C. Deficit B. Share dividends
Test Yourself
D. Share split C. Restrictions

E. Restrictions D. Retained earnings
E. Cash dividends
2 Which of the following expression is incorrect?
7 What is are the dividends less than 20%-25%
A. At the end of the accounting period, the Income of the corporations’ issued shares called?
Summary is closed to Retained Earnings.
B. A credit balance in Retained Earnings is called a A. Deficit
deficit. B. Small share dividends
C. Retained earnings account is not a reservoir for C. Share splits
possible cash dividends. D. Restrictions
D. Retained Earnings account represents a cumulati- E. Large share dividends
ve balance.
E. Retained earnings account is reported on the sha- 8 Which of the following transaction has no ef-
reholders’ equity part of the Balance Sheet. fect on assets?
A. Issuance of share
3 What is the distribution of some portion of ear- B. Payment of cash dividends
nings to shareholders by a corporation called?
C. Sale of treasury sale
A. Investment D. Declaration of share dividends
B. Retained earnings E. Purchase of treasury share
C. Share split
D. Deficit 9 Which of the following is not a component of
E. Dividend the comprehensive income?
A. Foreign- currency translation adjustment
4 On which date is a journal entry required in the B. Unrealized gains or losses
accounting process of the cash dividends?
C. Deferred gains derivatives
A. Decision date D. Losses from post-retirement benefit plans
B. Record date E. Preferred share
C. Declaration date
D. Communicating date 10 What is the measure of a corporation’s profita-
E. Dividend date bility that presents how much profit it generates with
each item (TL) of shareholders’ equity called?
5 (A) Inc. has 100,000 outstanding preferred sha- A. Deficit
res of 10%, 50 TL par preferred share. What is the B. Book value per share
total preferred dividend amount for (A) Inc.?
C. Return on equity
A. 100,000 D. Preferred share
B. 10,000 E. Earnings per share
C. 5,000,000
D. 500,000
E. 20,000
206
7
Accounting II
“Retained Earnings” section. “Share Splits” section.

2. B If your answer is wrong, please review the 7. B If your answer is wrong, please review the
“Retained Earnings” section. “Share Dividends” section.
3. E If your answer is wrong, please review the 8. D If your answer is wrong, please review the
“Accounting for Cash Dividends” section. “Changes in Shareholders’ Equity” section.
4. C If your answer is wrong, please review the 9. E If your answer is wrong, please review the
“Accounting for Cash Dividends” section. “Earnings and Evaluating Ratios” section.
5. D If your answer is wrong, please review the 10. C If your answer is wrong, please review the
“Dividend on Preferred Shares” section. “Earnings and Evaluating Ratios” section.
Explain the importance of retained earnings for a

corporation.

Retained Earnings account represents a cumulative balance of companies’
earnings since its inception, minus any losses, dividends to stockholders, or
transfers to contributed capital on the Balance Sheet. It is an equity account;
thus it can be seen on the shareholders’ equity section of a corporation’s balan-
ce sheet. There may be some different reasons to retain some part of earnings
in the corporation such as to fulfill the legal obligations, to be cautious, to
your turn 1 grow, to be sustainable, to invest in new areas etc. For each different reason, it
represents the shareholders’ claim on assets and is shown on the shareholders’
equity part of the balance sheet. Hence, retained earnings account indicates
that the corporation’s lifetime earnings exceed lifetime losses and dividends.
Therefore, the retained earnings account balance is important especially for
the financial strength of a corporation over its life.
Which dates are important for the transactions about the

distribution of cash dividends for a corporation?
The board of the directors has the authority to determine the policy of pay-
ment of the dividends. They should make a decision and declare it. After the
decision of paying dividends, three dates are important for a corporation:
Declaration date, Record date, and Payment date. At first, on the declaration
your turn 2 date a liability occurs for a corporation thus a journal entry is required at
that time. Secondly, the corporation determines the shareholders who receive
dividends separately on the record date. In this case, a new journal entry is
not required. Finally, the corporation pays the dividend that is determined
for the shareholders on the payment date and a new journal entry should be
prepared. Briefly, on the declaration date and payment date journal entries
are required in the process of accounting for cash dividends.
207
7
Explain the account called Common Share Dividend

Distributable
Common Share Dividend Distributable account is a shareholders’ equity account

that can be seen on the balance sheet. If there is an increase in the Common Share
Dividend Distributable account it should be credited. On the contrary, if there is
a decrease in Common Share Dividend Distributable account is should be debi-
ted. Therefore, on declaration date, it should be credited while Retained Earnings
your turn 3 should be debited for market value. Common Share Dividend Distributable is
credited with the par or stated value and if there is a difference Paid-in Capital in
Excess of Par it is also credited with the remaining amount.
Afterward, to record the distribution of a dividend, Common Share Dividend
Distributable is credited with the par or stated value while the Common Share
is credited.
Discuss the possible reasons to restrict retained

earnings.
Usually, the restrictions may occur in three different types such as Legal
restrictions, contractual restrictions, and voluntary restrictions. Regulations
in different countries may require legal restrictions to protect the capital of
your turn 4 the corporations. Hence the first main reason may be legal obligations. As a
second possibility, long term liability agreement may require to restrict the
retained earnings. Other than these restrictions, the board of the directors
may require some restrictions on retained earnings for specific proposes. For
example, to be cautious, to grow, to be sustainable, to invest in new areas etc.
Explain the importance of the information related to

shareholders’ equity.
Information related to shareholders’ equity is very important for all the types
of financial statement users to analyze the financial strength, performance,
and position of the corporation. Especially for shareholders, it is very critical
to understand the changes in shareholders’ equity to decide on their invest-
ment plans. For this reason, on the balance sheet the most basic and general
your turn 5
information should be represented as a summary and on the footnotes of
the financial statements, many details are presented because all the types of
financial statement users require different types of accurate, reliable and com-
parable information to manage their own decision-making process.
208
7
Accounting II
Explain the differences between a net income

and a comprehensive income.
While calculating and reporting the net income in a traditional way some
gains and losses are not included. Including these gains and losses the compre-
your turn 6 hensive income is calculated. A Comprehensive income defined as all changes
in the shareholders’ equity from all sources except owners’ investments and
dividends Comprehensive income components are: Unrealized gains or losses,
foreign currency translation adjustments, gains (losses) from post-retirement
benefit plans, deferred gains (losses) derivatives. Thus, the extend and the
components of a net income and a comprehensive income is different from
each other.
Endnotes
1Needles, B., Powers, M., Crosson, S. (2011) 11Harrison, W. T., Horngren, C. T., Thomas, W., &
Principles of Accounting, Eleventh Edition, Suwardy, T., p. 630.
Cengage Learning, p. 629. 12https://www.koc.com.tr/en-us/investor-relations/
2Kimmel, Paul D., Weygandt, Jerry J., Kieso, Donald financial-statements-and-statistics/Annual%20
E. (2009) Financial Accounting (5th ed.), John Reports/Ko%C3%A7%20Holding%20
Wiley & Sons, Inc. p.564. 2017%20Annual%20Report.pdf
3https://www.koc.com.tr/en-us/investor-relations/ 13Miller-Nobles T., Mattison, B., Matsumara, E.M.,
financial-statements-and-statistics/Annual%20 p.813.
Reports/Ko%C3%A7%20Holding%20 14Miller-Nobles T., Mattison, B., Matsumara, E.M.,
2017%20Annual%20Report.pdf
p.813.
4Miller-NoblesT., Mattison, B., Matsumara, E.M. 15Harrison, W. T., Horngren, C. T., Thomas, W., &
(2016). Horngren’s Accounting: The financial
Suwardy, T., p. 633.
chapters (11th ed.), Global Edition, London,
Pearson Educated Limited, p.712-713. 16Harrison, W. T., Horngren, C. T., Thomas, W., &
5Harrison, Suwardy, T., p. 631.
W. T., Horngren, C. T., Thomas, W.,
& Suwardy, T. (2014). Financial Accounting: 17https://ac.els-cdn.com/S1044028317304659/1-
International Financial Reporting Standards (9th s2.0-S1044028317304659-main.
ed.), Global Edition, London, Pearson Educated pdf?_tid=2c15521d-c4a1-495c-87e3-
Limited, p. 625. 3bcdeb5f0714&acdnat=1542099259_
6Miller-Nobles f9e1661c909e99d0b162caac565c6c9e
T., Mattison, B., Matsumara, E.M.,
p.714 18 http://www.mevzuat.gov.tr/
7Miller-Nobles MevzuatMetin/1.5.6102.pdf
T., Mattison, B., Matsumara, E.M.,
p.714-715
8Kimmel, Paul D., Weygandt, Jerry J., Kieso, Donald
E., p.566.
p.718.
10Weygandt, Jerry J., Kieso, Donald E., Kimmel, Paul
D. (1999) Accounting Principles (5th ed.), John
Wiley & Sons, Inc. p.643.
209
Chapter 8 Statement of Cash Flows
Learning Outcomes
1 Discuss the principal purposes and format of

the statement of cash ﬂows, 2 Classify cash flows from operating, investing,
and financing activities,
3 Identify cash flows from operating activities

using direct and indirect method, 4 Determine cash flows from investing activities,
5 Determine cash flows from financing activities.
Key Terms
Cash
Chapter Outline Direct Method
Introduction
Financing Activities
The Statement of Cash Flows: Purpose and Format
Financing Cash Flows
Classification of Cash Flows
Indirect Method
Cash Flows from Operating Activities
Investing Cash Flows
Cash Flows from Investing Activities
Investment Activities
Cash Flows from Financing Activities
Operating Activities
Operating Cash Flows
Statement of Cash Flow
210
Accounting II
INTRODUCTION
Each business aims to get more profit and to ensure the continuity of its operations. However, even
the most profitable company can face the bankruptcy if it is faced with a constant cash deficit and failure
to pay. In this case, it is important to know cash resources and payments to assure the profitability and
continuity of operations.
Unlike balance sheet and income statement that you have studied in previous chapters, Statement
of Cash Flows (or Cash Flows Statement) focuses on cash, cash providing activities and cash spending
activities during one period.
THE STATEMENT OF CASH FLOWS: PURPOSE AND FORMAT

Cash flows can be defined as cash inflows and cash outflows in a certain period of time. Every company
needs cash to pay its bills, business expenses and to pay off scheduled liabilities on time. Cash generally
comes from the sources that mentioned below:
• Capital — setting up business, or getting new partners;
• Borrowing — customers, vendors, employees, and financial institutions;
• Conversion of assets to cash — selling inventory, equipment, plant, property or collection of
accounts receivable.
internet
IAS 7 Statement of Cash Flows requires an entity to present a statement of cash flows as an integral part
of its primary financial statements. https://www.iasplus.com/en/standards/ias/ias7
Importance of Cash Flows

A successful business must get more cash than it spends
to produce its goods or services. However, due to timing
differences, profit and cash flows act differently. If the profit Profit and cash flows may not move in the
is insufficient but the cash flows are sufficient, the business same direction.
can carry out its activities in the short term, but might face
problems in the long term. Therefore, business must have
strong cash flows as well as the net profit. In addition, positive cash surplus serves as a buffer against
unforeseen crises and management errors. Cash is also necessary for the growth and operation of an
enterprise. Business bankruptcies often derive from lack of cash, not lack of profit.1
For example, you will find some financial items for Company (X) below:
Income Statement 20XX

Sales Revenue 150,000
Operating Expenses 25,000
Financial Expenses 30,000
Net Profit 25,000
211
Statement of Cash Flows
Balance Sheet 20XX

Cash 5,000 Current Liabilities 140,000
Receivables 100,000 Long Term Liabilities 60,000
Inventory 80.000 Shareholders’ Equity 80,000
Property, Plant and Equipment, Net 95,000
Total Assets 280,000 Total Liabilities and Equity 280,000
As you can see from the financial statements:

• Company (X) has 25,000 TL net profit and net profit is approximately 17% of sales revenue.
But the current liabilities of the company are 90,000 TL so it is clear that the company has to sell
inventory and collect receivables fast enough in order to get cash.
• If we calculate inventory turnover, it is 0.875; this means that the company cannot sell its inventory
fast enough and it will take too long time to sell its inventory and this will delay cash collections.
The inventory turnover ratio shows how effectively inventory is managed by comparing cost of
goods sold with average inventory for a period. Also, it measures how many times a company sold
its total average inventory amount during the year. The equation for inventory turnover equals the
cost of goods sold divided by the average inventory.
• Additionally, if we calculate the days’ sales in accounts receivable ratio, it is 1.5; then the days’ sales
in accounts receivable is 240 days. This means the company will wait too long to collect receivables
from customers.
The days’ sales in accounts receivable ratio also known as the number of days of receivables tells you
the average number of days it takes to collect an account receivable. The calculation for the days’ sales
in accounts receivable is the number of days in the year (usually 360 or 365 days is used) divided by
the accounts receivable turnover ratio for a specific year. Receivables turnover ratio can be calculated
by dividing the net value of sales (if possible credit sales) during a given period by the average
accounts receivable during the same period.
From the analysis given above Company (X) has profit,

but there will be some problems to pay liabilities due to
internet
long time wait to collect cash from receivables and to make
sales. Therefore, so it is important to have both income https://www.accountingcoach.com/blog/
and sufficient cash flow to succeed in business. receivables-turnover-ratio
Reporting Cash Flows Information: Statement of Cash Flows

None of the financial statements that you have learned until now reports changes in cash. When you
compare the balance sheets for two periods, you can only see either the cash is increased or decreased. But
the balance sheet does not show why cash is increased or decreased. The statement of cash flows reports
cash receipts (where the cash came from) and cash payments (how cash was spent) for a period.2
212
Accounting II
credit sales, accrued but not yet collected revenues,

depreciation expenses, provision expenses are
included in the income statement and they are not
included in the cash flows statement.4
In the income statement, income and

expense items are taken into consideration
both on accrual and cash basis.
Statement of cash flows relies on only cash

The statement of cash flows reports: basis.
• Where cash came from (receipts) and
how cash was spent (payments)
• Why cash increased or decreased during On the other hand, the cash flows statement
period takes into account the transactions that require
• Covers a span of time and is dated the cash, related to the activities whether or not they
same as the income statement provide income. For example, transactions such
as the collection of receivables, payment of debts
and the prepayment of fixed assets are not reported
The statement of cash flows reports cash in the income statement, but they are considered
inflows and outflows related to operating activities, in the cash flow statement because they cause
investment activities and financing activities that cash flow. In addition, income and expense items
occur in an operating period. This statement enables included in the income statement on a cash basis
to monitor the sources of cash collections and the are also included in the statement of cash flows.5
usage of cash payments. Thus, it is possible to see
the reasons of decrease and increase in cash values.
This information is used to predict future cash
needs, to check the accuracy of past assessments of Cash flows statement takes into account the
cash flows, and to assess the relationship between transactions that require cash, related to the
profitability, net cash flows and the effects of price activities whether or not they provide income.
changes.3
Cash and profit are different concepts and Income statement takes into account expenses
reflect different amounts. Thus, so increase/ or revenues whether or not they create cash
decrease amount of profit isn’t equal to movements.
increase/decrease amount of cash and cash
equivalents.
The statement of cash flows helps to do the
following:
The statement of cash flows explains the • Predict future cash flows,
inequality of cash and profit. The reason of
• Evaluate management,
the difference between cash and profit is the
application of different rules for income statement • Predict ability to pay debts and dividends.
and the statement of cash flows. Income statement As it can be understood the cash flow statement
takes into account expenses or revenues whether covers only cash inflows and outflows that occurred
or not they create cash movements. Items such in business. Also, it does not include transactions
213
that do not directly affect cash collection and

payment transactions. The main purpose
of this statement is to focus on cash flows
1
from operating, investment and financing
activities. What is cash and cash equivalents? Explain components in
defining cash and cash equivalents.
CLASIFICATION OF CASH FLOWS

In the statement of cash flows, there are three basic types of cash flow activities. These activities have
a separate section which reports cash inflows and cash outflows in the statement of cash flows. These
activities are:
• Operating activities
• Investing activities
• Financing activities
Samples for these three activities are shown in Figure 8.1. Cash flows must be reported to give
information about these three activities described above.
Figure 8.1: Sections of Statement of Cash Flows
Cash Flows from Cash inflows

Operating Activities (CFO) • From customers for the sales of merchandise inventory and services
• For interest and dividend income
Cash outflows
• For the purchase of merchandise inventory and payment of operating
expenses
• For the interest expense and income tax expense

Investing Activities (CFI) • From the sale of property, plant, equipment, and investments
• From the collection of long term notes receivable
Cash outflows
• To purchase property, plant, equipment, and investments
• For loans made to borrowers

Financing Activities (CFF) • From issuance of share and selling treasury share
• From receipt of borrowing money
Cash outflows
• For payment of dividends and buying treasury share
• For repayments of loans
214
Accounting II
Operating Activities Financing Activities

The most important part of the statement of Financing activities are the activities that
cash flows is operating cash flows as they reflect the increase or decrease long term liabilities and equity.
basis of the business. A successful business must So in the cash flow statement, financing activities
generate most of its cash from operating activities. include cash inflows and outflows involved in long
Operating activities create revenues, expenses, gains, term liabilities and equity such as issuing shares,
and losses net income, which is a product of accrual paying dividends and buying and selling treasury
basis accounting. Operating activities reflects day to shares, borrowing money and paying off long term
day operations of the business such as cash receipts liabilities such as notes payable, bonds payable.8
form customers for sales of merchandise inventory
and services and cash outflows for purchases of
merchandise inventory or payment of operating Financing activities relate to noncurrent
expenses. This section also includes cash receipts for liabilities and shareholders’ equity. These
interest and dividend income and cash payments activities may include to obtain cash and
for interest expense and income tax expense.6 pay cash to investors and creditors. Issuing
shares, borrowing money, buying and selling
treasury shares, paying cash dividends are
Operating activities create revenue or expense financing activities.
in entity’s business and these activities affect
the income statement.
Each section of the cash flow statement affects
a different part of balance sheet. Figure 8.2 shows
how operating, investing and financing activities
typically relate to the various parts of the balance
Only the activities that involve receipt of sheet.
cash or payment of cash are reported in
Cash Flows Statement. Any transaction that
doesn’t involve cash will not be reported in Figure 8.2: How Operating, Investing and Financing
any section of Cash Flows Statement. Cash Flows Affect the Balance Sheet
Operating Current Assets Current Liabilities Operating

Investing Activities Cash Flow
Non-Current Liabilities
Investing activities are the activities that Operating
Non-Current Assets Financing
Cash Flow Cash Flow
increase or decrease long term assets such as Shareholder’s Equity
property, plant, equipment, notes receivable and

investments. This section of statement of cash Source: Harrison, Walter, T., Horngren Charles T.,
flows shows cash inflows from selling long term Thomas C. William, Suwardy Themin, (2014) Financial
assets and collecting of long term notes receivable Accounting: International Financial Reporting
and cash outflows for the purchase of long term Standards, 9th ed., Pearson Education Limited, p. 677.
assets and loaning long term notes receivable.7
Cash flows from operating activities affect

current assets and current liabilities. Cash flows
Investing activities are purchases and sales of
from investing activities affect the long term assets
non-current assets, which are important for
and finally, cash flows from financing activities
an entity’s medium and long term operations.
affect long term liabilities and equity.
215
2
Company (X) borrows 20,000 TL from Zeta Bank for 3 years. Company (X) will make
payment amounting 34,000 TL, including interest. How will the cash outflow of 34,000 TL
be reported on Company (X)’s cash flow statement?
CASH FLOWS FROM OPERATING ACTIVITIES

Two different methods can be used for reporting operating cash flows. These are;
• Indirect Method
• Direct Method
These two methods differ in the calculation manner Indirect or direct methods are only used
for reporting operating cash flows. The indirect method in the operating cash flows section. These
adjusts accrual basis net profit or loss for the effects of methods use different computations but
non-cash transactions. Indirect method relies on necessary produce the same amount of cash from
additions and subtractions from net profit to find operating operating activities.
cash flows. Indirect method starts with net income and
reconciles to net cash provided by operating activities. The
direct method shows each major class of gross cash receipts
and gross cash payments. The direct method shows all cash
receipts and cash payments from operating activities. It Both the direct and indirect methods require
shows cash inflows and outflows more clearly, and it is more cash flows to be classified according to
comprehensible than indirect method. operating, investing and financing activities.
Indirect method starts with net income and

reconciles to net cash provided by operating
activities.
The direct method shows each major class of

gross cash receipts and gross cash payments.
Below, Figure 8.3 summarizes the differences between direct and indirect method. Note that two
methods compute the same amount for operating cash flows.
216
Accounting II
Figure 8.3: A Brief Summary of Direct and Indirect Method.

INDIRECT METHOD DIRECT METHOD
Net Income 900 Collections from Customers 2,700
Adjustments: Deductions:
Depreciation 200 Payment to employees 1,600
Net Cash from Operations 1,100 Net Cash from Operations 1,100
Source: Harrison, Walter, T., Horngren Charles T., Thomas C. William, Suwardy Themin, (2014) Financial Accounting:
International Financial Reporting Standards, 9th ed., Pearson Education Limited, p. 677.
Reporting Operating Cash Flows: Indirect Method

Indirect method is based on the harmonization of accrual base by reconciliation of net income to
net cash provided by operating activities. The additions or subtractions may not have a symmetrical
relationship with the timing of cash movements in the income statement.
Figure 8.4 shows a framework for computing operating cash flows by indirect method.
Figure 8.4: Framework for Calculating Operating Cash Flows

FRAMEWORK FOR OPERATING CASH FLOWS: INDIRECT METHOD
Net Income
Adjustments to reconcile net income to net cash provided by operating activities
+ Depreciation expense
+Loss on sale of long term assets
- Gain on sale of long term assets
- Increases in current assets other than cash
+ Decreases in current assets other than cash
+Increases in current liabilities
- Decrease in current liabilities
Net Cash provided by (used for) operating activities
Depreciation Expenses: As you can remember from previous chapters, depreciation has no effect on cash,
but like all other expenses decreases net income. So in order to reconcile net income to net cash flows from
operations we have to add depreciation back to net income.9
Gains and Losses on the Sale of Long Term Assets: Selling out of long term assets such as buildings and
lands are investing activities and this create gain or loss. But this gain or loss is included in determining
net income. This gain or loss must be removed from net income on the statement of cash flows to avoid
double counting. So the total cash receipts from the sale of the long term asset can be reported in the
investing section.10
Changes in the Current Asset and Current Liabilities: Most of the current assets and the current liabilities
result from operating activities. Changes in current assets and current liabilities create adjustments to
net income on the cash flow statement. Below you will find some explanations about the changes in the
current assets and current liability accounts that create adjustments to net income:11
217
• An increase in a current asset other than • A decrease in a current liability decreases cash:
cash causes a decrease in cash: If a current Payment of a current liability decreases cash
asset other than cash (like Accounts and also liability. So we subtract decreases
Receivable, Inventory, Prepaid Expenses) in current liabilities from net income to get
increases compared to previous year this net cash from operating activities.
shows an increase in current asset, then • An increase in a current liability increases cash:
cash decreases. For example, if Accounts If Accounts Payable increases compared to
Receivable increases over last year, this previous year this means that cash was not
means that there are more sales on account spent at the time the expense was incurred,
than cash collections and company made but it will be paid later. Also, cash will be
more sales on credit than cash collections reduced later when firm pays its liability. So
from customers. This is reported as a an increase in a current liability is added to
decrease in cash on statement of cash flows. net income in cash flow statement.
• A decrease in a current asset other than cash To develop the statement of cash flows let’s
causes an increase in cash: If inventory has begin with Beta Inc example. Its balance sheet
decreased compared to previous year this and income statement are shown below. (The
means that the firm has sold some inventory sample given below is based on Harrison, Walter,
and collected cash. Similarly, if Accounts T., Horngren Charles T., Thomas C. William,
Receivable balance decreases compared to Suwardy Themin, (2014) Financial Accounting:
the previous year, this means that firm has International Financial Reporting Standards, 9th
collected its receivables. So we add decreases ed., Pearson Education Limited)
current assets to net income.
Direct method identify actual cash flows;

indirect method reconciles net income to
cash flow from operations.
Beta Inc.
Income Statement
Year Ended December 31, 20X9
Sales Revenue 909
Interest Revenue 6
Gain on Sale PPE 24
Total Revenue and Gains 939
Cost of Goods Sold 450
Salary and Wage Expenses 168
Depreciation Expense 54
Interest Expense 21
Other Operating Expense 51
Income Tax Expense 45
Total Expenses 789
Net Income 150
218
Accounting II
Beta Inc.
Comparative Balance Sheets
December 31, 20X8 and 20X9
Increase
20X8 20X9
(Decrease)
ASSETS
Current:
Cash 126 102 (24)
Account Receivable 243 288 45
Inventory 114 105 (9)
Prepaid Expenses 21 24 3
Notes Receivable (long term) - 63 63
PPE, Net 657 1029 372
Total 1,161 1,611 450
LIABILITIES
Current:
Accounts Payable 171 273 102
Accrued Liabilities 9 3 (6)
Salary and Wage Payable 18 12 (6)
Long Term Debt 231 480 249
Share Capital 474 486 12
Retained Earnings 258 357 99
Total 1,161 1,611 450
We can calculate cash flows from operations according to indirect method using the framework given
in Figure 8.4 above.
Beta Inc.
Statement of Cash Flows (CFFO Part, Indirect Method)
For the Year Ended December 31, 20X9
Cash flows from operating activities:
Net Income 150
Adjustments to reconcile net income to net cash provided by operating activitees
+ Depreciation expense 54
- Gain on sale of long term assets (24)
- Increases in current assets other cash (accounts receivable and prepaid expenses) (45+3)
+ Decreases in current assets other cash (inventory) 9
+ Increases in current liabilities (accounts payable) 102
- Decreases in current liabilities (salary/wage payable and accrued liabilities) (6+6)
Net Cash provided by operating activities 231
219
Reporting Operating Cash Flows: Direct Method

In this method, cash flow items and amounts are reported. This method clearly demonstrates cash
amounts paid and collected for business activities. This method is easy to apply. This method requires
more computations than indirect method. To compute operating cash flows, we use income statement and
changes in balance sheet accounts.
Figure 8.5: Framework for Computing Receipts and Payments According to Direct Method
Receipts/ Income Statement

Change in Related Balance Sheet Account
Payments Account
Receipts:
From + Decrease in Accounts Receivable
Sales Revenue
Customers - Increase in Accounts Receivable
+Decrease in Interest Receivable
Of interest Interest Revenue
- Increase in Interest Receivable
Payments:
Cost of + Increase in Inventory + Decrease in Accounts Payable
To suppliers
Goods Sold - Decrease in Inventory - Increase in Accounts Payable
Operating + Increase in Prepaid +Decrease in Accrued Liabilities
Expense - Decrease in Prepaid - Increase in Accrued Liabilities
Salary + Decrease in Salary (wage) Payable

To employees
(Wage) Expense - Increase in Salary (wage) Payable
+ Decrease in Interest Payable

For interest Interest Expense
- Increase in Interest Payable
Income + Decrease in Income Tax Payable

For Income tax
Tax Expense - Increase in Income Tax Payable
Source: Harrison, Walter, T., Horngren Charles T., Thomas C. William, Suwardy Themin, (2014) Financial Accounting:
International Financial Reporting Standards, 9th ed., Pearson Education Limited, p. 695.
To calculate operating cash flows for the direct method we will use income statement and the changes
in the balance sheet accounts for the same company - Beta Inc. To make easier computation you can follow
the steps given below:
Calculate Calculate Calculate

cash Calculate Calculate
payments payments of
collections payments to payments to
for operating interest and
from suppliers employees
expenses income taxes
customers
220
Accounting II
Calculating Cash Collections from Customers: Beginning balance of Prepaid Expenses 21

To calculate cash collections from customers you
+ Payments ?
will need sales revenue (from income statement)
and beginning and ending balance of accounts - Expiration of Prepaid Expense 21
receivable. To find collections it will be appropriate Ending balance of Prepaid Expenses 24
to use the equation given below:
From the equation given above, we can find
Beginning balance of Accounts Receivable 243 payments as 24 TL.
+ Sales 909
- Collections ? Fundamental assumption for the
= Ending balance of Accounts Receivable 288 prepayments is beginning prepayments will
be used in period, and ending prepayment is
From the equation given above, we can find the payment that we made during the year.
collections from customers as 864 TL.
Calculating Payments to Suppliers: This part
includes two separate computations. Beginning balance of Accrued Liabilities 9
• Payments for operating expenses. + Accrual expense at year end 3
• Payments for inventory. - Payments ?
To calculate payments for inventory you will = Ending balance of Accrued Liabilities 3
need cost of goods sold (from income statement),
Inventory and Accounts Payable (from balance From the equation given above, we can find
sheet). This computation will convert cost of goods payments as 9 TL.
sold to cash basis.
Beginning Inventory 114 Fundamental assumption is beginning

+ Purchases ? accrued liabilities will be paid for during
year, ending balance will remain owing.
- Ending Inventory 105
= Cost of Goods Sold 450
From the equation given above, we can find Accrual of Expense at Year End 3
purchases as 441 TL. +Expiration of Prepaid Expense 21
Now we can calculate cash payments for inventory. - Payments ?
Ending Balance of Other Operating Expenses 51
Beginning balance of Accounts Payable 171
+ Purchases 441 From the equation given above, we can find
total payments for operating expenses as 27 TL.
- Payment for inventory ?
Now we can find total payments for operating
= Ending balance of Accounts Payable 273
expenses as 9+27+24=60 TL
From the equation given above, we can find
cash payments for inventory as 339 TL.
Calculating Payments for Operating
Total payments for operating expenses is
Expenses: These payments will exclude interest and
the sum of payments for prepaid expenses,
income tax. To compute payments for operating
payments for accrued liabilities and payments
expenses you will need Prepaid Expenses, Accrued
for other operating expenses.
Liabilities, and Other Operating Expenses.
221
Payments for Inventory 339

+ Payments for Operating Expenses 60
= Payments to Suppliers 399 Payments to suppliers is the sum of payments
for inventory and payments for operating
Calculating Payments to Employees: These payments expenses.
include salary and wage expenses.
Beginning balance of Salary and Wage Payable 18

+ Salary and wage expense 168
- Payments ?
= Ending balance of Salary and Wage Payable 12
From the equation given above, we can find total payments for employees as 174 TL.
Calculating Payments of Interest and Income Taxes: For Beta Inc., the interest payable and tax
payable balances are zero, so we will not make any analysis. If there were any balances, we would make
computations as shown in Figure 8.5.
Beta Inc.
Statement of Cash Flows (CFFO Part, Direct Method)
Receipts:
Collections from Customers 864
Interest Received 6
Total Cash Receipts 870
Payments:
To Suppliers (399)
To Employeas (174)
For Income tax (45)
For Interest (21)
Total cash payments (639)
Net cash provided by operating activities 231
3
Below you will find some financials for Company (X):
20X8 20X9
Note that the two methods for reporting Net Receivables 4,000 3,500
operating cash flows calculate the same Inventory 7,000 9,500
amount.
Accounts Payable 2,000 1,200
Sales 35,000
How much cash has been collected from customers during 20X9?
How much cash was paid for inventory during 20X9?
222
Accounting II
CASH FLOWS FROM INVESTING In the statement of cash flows, 177 TL will be
ACTIVITIES reported as cash inflows (because of selling PPE)
from investing activity.
Investing activities affect long term assets such as
Investments in Property, Plant and Equipment (PPE) As for the long term receivables, we can
assets, and etc. Thus, so investing cash flows is about determine cash flows from loan transactions on
cash inflows and cash outflows related with long notes receivable as follows:
term assets. Cash inflows from investing activities
include sales of plant assets, long term investments, Beginning balance of Notes Receivable -
collections of loans to others and etc. Cash outflows + New Loans ?
from operations include purchase of plant assets, long - Collections -
term investments, making loans to others, and etc.
= Ending Balance of Notes Receivable 63
As from the equation above we can determine

new loans as 63 TL.
Beta Inc.
Statement of Cash Flows (CFI Part)
Cash flows from investing activities:
Acquisition of PPE (579)
Loan to another company (63)
Calculating Purchase and Sales of PPE: To
Proceeds from sale of PPE 177
compute purchases and sales of PPE, you will need
balance sheet (PPE, accumulated depreciation) Net cash used for investing activities: (465)
income statement (depreciation expense, gain/loss
on sale of PPE).
In order to calculate purchase and sale of PPE,
we must calculate the book value of assets sold. 4
Beginning balance of PPE, net is 255,000 TL
Beginning Balance of Net PPE 657 and ending balance of PPE, net is 220,000 TL.
Depreciation for the period is 35,000 and the new
+ Acquisitions of PPE 579*
purchases of PPE is 45,000 TL. If the loss from
- Depreciation 54
PPE sold 10,000 TL, calculate the cash proceeds
- Book value of assets sold ? of sale.
= Ending Balance of Net PPE 1,029
* Suppose as data
CASH FLOWS FROM FINANCING
ACTIVITIES
From the equation given above, we can calculate
Financing activities affect the long term liability
book value of assets sold as 153 TL.
and equity accounts. So cash flows from financing
As a further step we can calculate sale activities is about the firm’s capital structure and
proceeds as follows: owners of the entity. Cash inflows from finance
activities include issuance of shares, proceeds from
Book value of assets sold 153 selling treasury shares, loans and borrowings. Cash
+ Gain 24 outflows include repurchase of shares, repayment
of loans and borrowings.12
- Loss -
= Sale Proceeds 177
223
Let’s calculate financing cash flows for Beta Inc.

Calculate Issuances and Payments of Long
Term Debt: To calculate payments of long term
debt you will need balance sheet (New issuances-
if known, Beginning and ending balances of Long
Term Debt, Notes Payable, Bonds Payable).
Beginning Balance of Long Term Debt 231

+ Issuance of new debt 627*
- payments of debt ?
= Ending Balance of Long Term Debt 480
* Suppose as data
We can find payments of debt as 429 TL.

If Beta Inc. have proceeds from issuance of shares as 12 TL (suppose as data), we can calculate receipts
from issuance of share as 474 + 12 = 486
We can also calculate receipts from issuance of

share and payments to purchase treasury share
Remember the beginning balance of share and payments of dividends. These calculations
capital is 474 and ending balance is 486. can be made on the rationale that we made above
about beginning and ending balances of related
accounts.
Beta Inc.
Statement of Cash Flows (CFF Part)
Cash flows from financing activities:
Proceeds from issuance of long term debt 627
Proceeds from issuance of share 12
Payment of long term debt (429)
Net cash provided by financing activities 210
After preparing operating, finance and investment cash flows sections, the net change and its effect on
the beginning cash balance must be shown at the bottom of the statement. Net increase or decrease in cash
is computed by combining the cash provided by your used for operating, investing and financing activities.

Net cash used for investing activities (465)
Net (decrease) in cash (24)
Cash balance, December 31, 20X8 126
224
Accounting II
If there are any non-cash investing and financing activities, the last step in preparing statement of cash
flows is to report non cash investing and financing transactions. Acquiring a building by issuing common
share, acquiring a land by issuing notes payable and retiring notes payable by issuing common share are the
examples for non-cash investing and financing activities. These transactions don’t create a cash activity, but
they are important. For this reason, non-cash investing and financing activities are reported in a separate
part of the statement of cash flows.
Figure 8.6 shows the whole statement of cash flows.
Figure 8.6: The whole Statement of Cash Flows for Beta Inc.
Beta Inc.
Statement of Cash Flows (CFFO Part, Direct Method)
Receipts:
Collections from Customers 864
Interest Received 6
Payments:
To suppliers (399)
To employees (174)
For income tax (45)
For interest (21)
Cash flows from investing activities:
Acquisition of PPE (579)
Loan to another company (63)
Proceeds from sale of PPE 177
Net cash used for investing activities (465)
Cash flows from financing activities:
Proceeds from issuance of long term debt 627
Proceeds from issuance of share 12
Payment of long term debt (429)
Net (decrease) in cash (24)
5
Note that the sum of cash from operating, 20X8 20X9
investing and financing activities must be Shareholders’ Equity 40,000 85,000
equal to the difference between beginning
Net income 7,000 9,500
cash balance and ending balance of cash
Dividends 2,000 1,200
balance.
Calculate cash inflows from new insurance of capital share for the year 20X9.
225
Further Reading
An Analysis of Patterns from the Statement the pattern to be transitory as well, for the cash “treasure
of Cash Flows1 chest” is likely to be used in the near future to finance
The Statement of Cash Flows (SCF) provides a share repurchase, to repay long-term debt principal,
information about a firm’s cash flows that is intended to purchase a large investment
to complement the information appearing in the In Pattern 2 (+, -, -), the firm is generating
accrual basis income statement and balance sheet. enough positive operating cash flow to invest in long-
The SCF also indicates why and how the cash term assets and to reduce its debt or pay dividends.
amount changed: what generated cash and how cash This pattern reflects a mature, successful firm.
was used. Gup and his colleagues described the eight Pattern 3 (+, +, -), the operating and investing
possible cash flow patterns from the Statement of cash flows are positive while financing cash flow
Cash Flow, and then they analyzed selected financial is negative. The pattern is unusual because firms’
characteristics of firms within each pattern. While investing activities typically produce outflows
they take a “naive” approach by considering the signs, rather than inflows.
either positive or negative, of cash flow amounts
In Pattern 4 (+, -, +), they expect that the firm’s
within each pattern, this approach is but one step in
operating cash flow is not sufficient to support its
understanding the usefulness of the SCF. Obviously,
investing activities. As a result, a portion of the
the magnitudes and the relative magnitudes of the
investing outflow is financed by the proceeds from
cash flow amounts, as well as their composition
the issuance of new debt or equity. Researchers
within each pattern change from period to period,
believe that this pattern reflects a growing firm.
and may prove to be more useful and informative.
Pattern 5 (-, +, +), also appears unusual: a firm
Cash Flows with a net outflow of cash from operating activities
may make up that deficit by selling long-term assets
Operating Investing Financing and also by issuing debt or equity capital.
Activities Activities Activities
Pattern 6 (-, -, +), even though the firm has
PATTERN 1 + + + a negative operating cash flow, it is investing in
long-term assets. Six suggests that the negative
PATTERN 2 + - -
operating cash flow is temporary, perhaps because
PATTERN 3 + + - a young, fast-growing company is expanding such
PATTERN 4 + - + components of working capital as receivables
PATTERN 5 - + + and inventory, or paying off current liabilities, to
PATTERN 6 - - + support rapidly increasing sales.
PATTERN 7 - + - Pattern 7 (-, +, -), the firm has a deficit
in operating cash flow and is shrinking by
PATTERN 8 - - -
distributing cash to shareholders and/or repaying
Determining the profile of financial debtholders. Pattern 7 suggests that the firm may
characteristics typical of the firms in each cash be showing losses on its income statement that are
flow pattern may enable the user to gain insights contributing to a net operating cash outflow
simply by identifying a firm’s particular cash flow In Pattern 8 (-, -, -), all activities have negative cash
pattern. Such insights may help in deciding what flows. This situation can occur only when previously
other financial information should be examined accumulated cash balances are being consumed to
and what other analyses should be performed. offset negative cash flows. Like Patterns One, Five, and
In Pattern 1 (+, +, +) the firm is generating a Seven, Pattern Eight is unusual
positive net cash flow from operating activities, and 1This Inside Practice section is brief summary
also selling its long-term assets (e.g., depreciable assets, of a research work “An Analysis of Patterns from
long-term investments, etc.), and raising additional the Statement of Cash Flows” by Benton E. Gup,
debt and/or equity capital. Pattern 1 is unusual in that William D. Samson, Michael T. Dugan, MyungJ.
the firm is accumulating cash from all three activities Kim, and Thawatchai Jittrapanun.
226
Accounting II
Inside Practice
Source: https://tprstaticfilessa.blob.core.windows.net/assets/uploads/faaliyet-raporlari/TUPRAS2017ENG2018.pdf
Discuss:
1) Which method did the entity use to report operating cash flows?
2) From which activity did the entity get/use the most cash flows?
227
Discuss the principal purposes and

LO 1 format of the statement of cash
ﬂows
The statement of cash flows reports a business’s cash receipts (where the cash came from) and cash payments
(how cash was spent) for a period. This statement also explains why net income as reported on the income
statement is no equal the change in cash balance. The statement of cash flows is the link between accrual
based income statement and the cash reported on the balance sheet. The statement of cash flows reports
cash inflows and outflows related to operating activities, investment activities and financing activities that
Summary
occur in an operating period. This statement enables to monitor the sources of cash collections and the
usage of cash payments. Thus, it is possible to see the reasons of decrease and increase cash values.
Classify cash flows from

LO 2 operating, investing, and
financing activities
Cash flow statement includes three basic types of cash flow activities. These activities have a separate
section which reports cash inflows and cash outflows in statement of cash flows. These activities are
operating activities, investing activities, financing activities. Operating activities create revenues, expenses,
gains, and losses net income, which is a product of accrual basis accounting. Operating activities reflect
day to day operations of the business such as cash receipts form customers for sales of merchandise
inventory and services and cash outflows for purchases of merchandise inventory or payment of operating
expenses. Investing activities are the activities that increase or decrease long term assets such as property,
plant, equipment, notes receivable and investments. Financing activities are the activities that increase or
decrease long term liabilities and equity.
Identify cash flows from

LO 3 operating activities using direct
and indirect method
An entity has to report its operating cash flows using one of two methods: Indirect method and direct
method. Although these methods use different computations, they produce the same amount for
operating activities. Indirect method begins with income and some adjustments are made to reconcile
net income to net cash provided by operating activities. Direct method calculates net cash provided by
operating activities as collections minus operating disbursements. This method shows all the cash receipts
and payments from operating activities.
228
Accounting II
Determine cash flows from

LO 4 investing activities
Investing cash flows include cash inflows and outflows related to long term assets of entity. Cash receipts
include sale of PPE and other noncurrent assets, sale of long term investments and collections of loans
to others; outflows include acquisition of PPE and other noncurrent assets, purchase of long term
investments, and making loans to others.
Summary
Determine cash flows from
LO 5 financing activities
Financing cash flows are related to the capital structure and owners of the entity and affect long term
liabilities and equity accounts. Cash receipts include issuance of shares, proceeds from selling treasury shares,
loans and borrowings; outflows include repayment of loans and borrowings, and repurchase of shares.
229
1 Which of the following is not a purpose of 6 Net income 50,000

cash flow statements? Loss on sale of land 10,000
A. Predict future cash flows. Depreciation expense 7,000
B. Evaluate management. Decrease in current liabilities 25,000
Test Yourself
C. Predict ability to pay debts Increase in current assets other than cash 35,000
D. Predict ability to pay dividends What is cash flows from operating activities by the
E. Evaluate profitability indirect method?
A. 87,000 B. 7,000 C. 67,000
2 Under indirect method, operating cash flows D. 127,000 E. 93,000
begin with:
A. Cash balance 7 Cost of goods sold 150,000
B. Sales revenue Beginning inventory 100,000
C. Net income/loss Ending inventory 40,000
D. Accounts payable Beginning accounts payable 25,000
Ending accounts payable 55,000
E. Accounts receivable
What is the amount of cash paid for inventory?
3 Which of the following is a financing activity? A. 140,000 B. 90,000 C. 115,000
D. 60,000 E. 100,000
A. Selling of a property
B. Payment of salaries
C. Loans made to borrowers
8 Which of the following activities affect long
term assets?
D. Buying merchandise inventory
E. Payment for dividend A. Financing activities B. Operating activities
C. Investing activities D. Marketing activities
E. Sales activities
4 Toys Inc. has net income of 60,000 TL,
depreciation 5,000 TL. Current assets decreased by
8,000 and current liabilities increased by 10,000. 9 Which of the following activities affect long
By using indirect method, how much operating term liabilities?
cash flows will Toys Inc. report? A. Financing activities
A. 83,000 B. Operating activities
B. 73,000 C. Investing activities
C. 63,000 D. Marketing activities
D. 37,000 E. Sales activities
E. 57,000
10 Beginning accounts receivables 60,000
5 Which of the following is not included in Ending accounts receivable 50,000
computing payments to suppliers? Sales 200,000
Beginning inventory 100,000
A. Cost of goods sold Ending inventory 40,000
B. Merchandise inventory
What is the cash collected from customers?
C. Operating expenses
D. Income taxes A. 200,000 B. 210,000 C. 250,000
E. Accrued liabilities D. 100,000 E. 170,000
230
Accounting II
If your answer is incorrect, review “The

1. E 6. B If your answer is incorrect, review “Cash
Statement of Cash Flows: Purposes and
Flows from Operating Activities”.
Format”.

2. C If your answer is incorrect, review 7. D If your answer is incorrect, review “Cash
“Classification of Cash Flows”. Flows from Operating Activities”.
3. E If your answer is incorrect, review 8. C If your answer is incorrect, review “Cash

“Classification of Cash Flows”. Flows from Investing Activities”.
4. A If your answer is incorrect, review “Cash 9. A If your answer is incorrect, review “Cash
Flows from Operating Activities”. Flows from Financing Activities”.
5. D If your answer is incorrect, review “Cash 10. B If your answer is incorrect, review “Cash
Flows from Operating Activities”. Flows from Operating Activities”.
Suggested Answers for “Your turn”

What is cash and cash equivalents? Explain
components in defining cash and cash equivalents.
Cash and cash equivalents are defined in International Accounting Standards

(IAS-7 Statement of Cash Flows). Cash and cash equivalents refer to the item
on the balance sheet that reports the value of a company’s assets that are cash
your turn 1 or can be converted into cash immediately. These include bank accounts,
marketable securities, commercial paper, Treasury bills, and short-term
government bonds with a maturity date of three months or less. Marketable
securities and money market holdings are considered cash equivalents because
they are liquid and not subject to material fluctuations in value.
Company (X) borrows 20,000 TL from Zeta Bank for

3 years. Company (X) will make payment amounting
34,000 TL, including interest. How will the cash
outflow of 34,000 TL be reported on Company (X)’s
cash flow statement?
The 34,000 TL outflow has two components; 20,000 for the loan principal
repayment and 14,000 TL for the interest payment. Company will report
your turn 2
cash outflow for loan principal payment under cash flows from financing
activities; and, interest payment outflow under cash flows from operations.
231
Below you will find some financials for Company (X):

20X8 20X9
Net Receivables 4,000 3,500
Inventory 7,000 9,500

Accounts Payable 2,000 1,200
Sales 35,000
How much cash has been collected from customers during 20X9?
How much cash was paid for inventory during 20X9?
Beginning Balance of Receivables + Sales – Collections = Ending Balance of

Receivables
Collections = 4,000 + 35,000 – 3,500
= 35,500
Payments for inventory:
Beginning Inventory 7,000
+ Purchases ?
- Ending Inventory 9,500
your turn 3 = Cost of Goods Sold 23,500
We can calculate purchases as 26,000
Beginning balance of Accounts Payable 2,000

+ Purchases 26,000
- Payment for inventory ?
= Ending balance of Accounts Payable 1,200
Payments for inventory is 26,800 TL
Beginning balance of PPE, net is 255,000 TL and ending

balance of PPE, net is 220,000 TL. Depreciation for the
period is 35,000 and the new purchases of PPE is 45,000
TL. If the loss from PPE sold 10,000 TL, calculate the cash
proceeds of sale.
Beginning Balance of Net PPE 225,000

+ Acquisitions of PPE 45,000
- Depreciation 35,000
- Book value of assets sold ?
= Ending Balance of Net PPE 220,000
your turn 4
Book value of assets Sold is 45,000
Book value of assets sold 45,000
+ Gain -
- Loss 10,000
= Sale Proceeds 35,000
We can calculate sales proceeds as 35,000 TL.
232
Accounting II
20X8 20X9
Shareholders’ Equity 40,000 85,000

Calculate cash inflows from new insurance of capital share

for the year 20X9
20X8 20X9
Shareholders’ Equity 40,000 85,000
There is 45,000 TL (85,000 – 40,000) increase in shareholders’ equity. This

increase can be explained by
your turn 3
• issuance of share
• net income (or loss)
• dividends.
Increase in shareholders’ equity = New issuance + net income – Dividends
45,000 = ? 9,500 – 1,200
Cash inflows from new issuance = 36,700 TL.
Endnotes
1Reider,R. and HEYLER P. B. (2003) Managing 7Miller-Nobles, Mattison, Matsumura, p. 835.
Cash Flow: An Operational Focus, John Wiley 8Mulford, Charles W. (2005), Creative Cash Flow
and Sons Inc, New Jersey, p. 12-13.
Reporting: Uncovering Sustainable Financial
2Miller-Nobles,Tracie L., Mattison, Brenda L. and Performance, New Jersey: John Wiley & Sons, p.
Matsumurato, Ella Mae (2016) Horngren’s 64-65.
Financial & Managerial Accounting, The 9Harrison, Walter, T., Horngren Charles T., Thomas
Financial Chapters, 5th edition, Pearson
C. William, Suwardy Themin, (2014) Financial
Education Limited, p.834.
Accounting: International Financial Reporting
3Akdoğan N. and Tenker N., (2001) Finansal Standards, 9th ed., Pearson Education Limited,
Tablolar ve Mali Analiz Teknikleri, Gazi p. 681.
Kitabevi, 7. Baskı, p. 284-285. 10Miller-Nobles, Mattison, Matsumura, p. 841.
4Akdoğan N. and Tenker N., p. 284-285. 11Miller-Nobles, Mattison, Matsumura, p. 835.
5Akdoğan N. and Tenker N., p. 284-285. 12Harrison, Horngren, Thomas, Suwardy, p. 686.
6Miller-Nobles, Mattison, Matsumura, p. 835.
233

Accounting 2

Uploaded by

Document Information

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

Accounting 2

Uploaded by

Copyright:

Available Formats

3

Prof.Dr. Saime ÖNCE

CHAPTER 1, 2 Assoc.Prof.Dr. Arman Aziz KARAGÜL

Copyright © 2019 by Anadolu University

Graphic and Cover Design

Typesetting and Composition

All rights of this book belong to Anadolu University.

ESKİŞEHİR, March 2019

Introduction ................................................... 121 Introduction.................................................... 157

Introduction ................................................... 121 Introduction.................................................... 157

3 Explain the concept of depreciation and apply

INTRODUCTION company called as “lessee” takes over the property

PROPERTY, PLANT AND

as an expense. For example, Presta Co.

be installed on a regular floor. The floor must be

Cost of Land and Land Improvements

Date Account Titles and Short Explanation Debit Credit

Date Account Titles and Short Explanation Debit Credit

Date Account Titles and Short Explanation Debit Credit

Date Account Titles and Short Explanation Debit Credit

Date Account Titles and Short Explanation Debit Credit

To record the painting expense for the building

Capitalization means recording the expenditure as an asset.

Date Account Titles and Short Explanation Debit Credit

CONSTRUCTION-IN-PROGRESS Headquarters Building Pavements

Date Account Titles and Short Explanation Debit Credit

CONSTRUCTION-IN-PROGRESS Headquarters Building Pavements

Date Account Titles and Short Explanation Debit Credit

Land Improvements 300,000

To journalize the finished constructions

CONSTRUCTION-IN-PROGRESS Headquarters Building Pavements

BUILDING LAND IMPROVEMENTS

Date Account Titles and Short Explanation Debit Credit

Cost of Machinery and Equipment

before using are included in the cost of machinery and

Date Account Titles and Short Explanation Debit Credit

Date Account Titles and Short Explanation Debit Credit

Date Account Titles and Short Explanation Debit Credit

Cost of Furniture and Fixtures

Date Account Titles and Short Explanation Debit Credit

Date Account Titles and Short Explanation Debit Credit

Advances Paid 7,500

To journalize the purchasing of furniture

Date Account Titles and Short Explanation Debit Credit

To journalize the purchasing of vehicles

VEHICLES Minivan Official Car

Date Account Titles and Short Explanation Debit Credit

VEHICLES Minivan Official Car

Date Account Titles and Short Explanation Debit Credit

Depreciable Cost = Capitalized Cost of the Asset –

Straight-line Depreciation Method

Purchase Price 340,000 TL

Date Account Titles and Short Explanation Debit Credit

Depreciation Expense is reported on the income statement. Accumulated Depreciation account is

Date Account Titles and Short Explanation Debit Credit

Exhibit 1.1 Straight-Line Depreciation Schedule

Exhibit 1.2 Straight-Line Depreciation Schedule

Exhibit 1.3 Straight-Line Depreciation Schedule

Double-Declining Balance Depreciation Method

Now let’s solve Example 12 by double-declining balance depreciation method.

Purchase Price 340,000 TL

The double-declining-balance method depreciation schedule for this machinery is shown in

Exhibit 1.4 The Double-Declining-Balance Method Depreciation Schedule

Depreciable D epre c ia tion Depreciation A c c u m u l a t e d