Principles of Accounting II (ACFN 202

Table of Contents

Content Page

UNIT ONE: ACCOUNTING FOR RECEIVABLES………………………..2

UNIT TWO: ACCOUNTING FOR INVENTORIES………………………..25

UNIT THREE: ACCOUNTING FOR PLANT ASSETS…………………….35

UNIT FOUR: ACCOUNTING FOR PARTNERSHIPS……………………..55

CHAPTER FIVE: ACCOUNTING FOR CORPORATIONS…………….76

CHAPTER SIX: ACCOUNTING FOR PAYROLL…………………………87

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UNIT ONE
1. ACCOUNTING FOR RECEIVABLES

Learning Objectives
After studying this chapter, you should be able to:
1. Identify the different types of receivables.
2. Explain how companies recognize accounts receivable.
3. Distinguish between the methods and bases companies use to value accounts receivable.
4. Describe the entries to record the disposition of accounts receivable.
5. Compute the maturity date of and interest on notes receivable.
6. Explain how companies recognize notes receivable.
7. Describe how company’s value notes receivable.
8. Describe the entries to record the disposition of notes receivable.
9. Explain the statement presentation and analysis of receivables.

As indicated in the Feature Story, receivables are a significant asset for banks. Because a large
portion of sales are credit sales, receivables are important to companies in other industries as
well. As a consequence, companies must pay close attention to their receivables and manage
them carefully. In this chapter, you will learn what journal entries companies make when they
sell products, when they collect cash from those sales, and when they write off accounts they
cannot collect.
The content and organization of the chapter are as follows.

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 1.1 Trade as receivable

The term receivables refer to amounts due from individuals and companies. Receivables are
claims that are expected to be collected in cash. The management of receivables is a very
important activity for any company that sells goods or services on credit.
Receivables are important because they represent one of a company’s most liquid assets. For
many companies, receivables are also one of the largest assets.

Notes and accounts receivable that result from sales transactions are often called trade
receivables
The relative significance of a company’s receivables as a percentage of its assets depends on
various factors: its industry, the time of year, whether it extends long-term financing, and its
credit policies.

1.2 Classification of Receivables

To reflect important differences among receivables, they are frequently classified as
(A) Accounts receivable,
(B) Notes receivable, and
(C) Other receivables.

A. Accounts receivable

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Account receivables are amounts customers owe on account. They result from the sale of goods
and services. Companies generally expect to collect accounts receivable within 30 to 60 days.
They are usually the most significant type of claim held by a company.
B. Notes receivable 
Notes receivable are a written promise (as evidenced by a formal instrument) for amounts to be
received. The note normally requires the collection of interest and extends for time periods of
60–90 days or longer.
C. Other receivables
It include non-trade receivables such as interest receivable, loans to company officers, advances
to employees, and income taxes refundable. These do not generally result from the operations of
the business. Therefore, they are generally classified and reported as separate items in the
statement of financial position.
1.2.1 Accounts Receivable
i) Recognizing Accounts Receivable
Recognizing accounts receivable is relatively straightforward. A service organization records a
receivable when it performs a service on account. A merchandiser records accounts receivable at
the point of sale of merchandise on account. When a merchandiser sells goods, it increases
(debits) Accounts Receivable and increases (credits) Sales Revenue.

The seller may offer terms that encourage early payment by providing a discount. Sales returns
also reduce receivables. The buyer might find some of the goods unacceptable and choose to
return the unwanted goods.
To review, assume that Hennes&Mauritz (SWE) on July 1, 2017, sells merchandise on account to
Polo Company for $1,000, terms 2/10, n/30. On July 5, Polo returns merchandise with a sales
price of $100 to Hennes&Mauritz. On July 11, Hennes&Mauritz receives payment from Polo
Company for the balance due. The journal entries to record these transactions on the books of
Hennes&Mauritz are as follows. (Cost of goods sold entries are omitted.)

To illustrate, assume that you use your JCPenney credit card to purchase clothing with a sales
price of $300 on June 1, 2017. JCPenney will increase (debit) Accounts Receivable for $300 and
increase (credit) Sales Revenue for $300 (cost of goods sold entry omitted) as follows.

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To illustrate, assuming that you owe $300 at the end of the month, and JCPenney charges 1.5%
per month on the balance due, the adjusting entry that JCPenney makes to record interest revenue
of $4.50 ($300×1.5%) on June 30 is as follows.

On May 1, Wilton sold merchandise on account to Bates for €50,000 terms 3/15, net 45. On May
4, Bates returns merchandise with a sales price of €2,000. On May 16, Wilton receives payment
from Bates for the balance due. Prepare journal entries to record the May transactions on
Wilton’s books. (You may ignore cost of goods sold entries and explanations.)
Solution

ii) Valuing Accounts Receivable

Once companies record receivables in the accounts, the next question is: How should they report
receivables in the financial statements? Companies report accounts receivable on the statement
of financial position as an asset. But determining the amount to report is sometimes difficult
because some receivables will become uncollectible.

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Each customer must satisfy the credit requirements of the seller before the credit sale is
approved. Inevitably, though, some accounts receivable become uncollectible. For example, a
customer may not be able to pay because of a decline in its sales revenue due to a downturn in
the economy. Similarly, individuals may be laid off from their jobs or faced with unexpected
hospital bills. Companies record credit losses as debits to Bad Debt Expense (or Uncollectible
Accounts Expense). Such losses are a normal and necessary risk of doing business on a credit
basis. Recently, when home prices in many parts of the world fell, home foreclosures rose and
lenders experienced huge increases in their bad debt expense.

Two methods are used in accounting for uncollectible accounts: (A) the direct write-off method
and (B) the allowance method. The following sections explain these methods.

A. Direct Write-Off Method for Uncollectible Accounts

Under the direct write-off method, when a company determines a particular account to be

uncollectible, it charges the loss to Bad Debt Expense.

Assume, for example, that Warden Ltd. writes off as uncollectible M. E. Doran’s HK$1,600
balance on December 12. Warden’s entry is as follows.

Under this method, Bad Debt Expense will show only actual losses from uncollectables. The
company will report accounts receivable at its gross amount.

Although this method is simple, its use can reduce the usefulness of both the income statement
and statement of financial position.
Consider the following example. Assume that in 2017, Quick Buck Computer Ltd. decided it
could increase its revenues by offering computers to college students without requiring any
money down and with no credit-approval process. On campuses across the country, it distributed
one million computers with a selling price of HK$6,400 each. This increased Quick Buck’s
revenues and receivables by HK$6,400 million. The promotion was a huge success! The 2017
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statement of financial position and income statement looked great. Unfortunately, during 2018,
nearly 40% of the customers defaulted on their loans. This made the 2018 income statement and
statement of financial position look terrible. Illustration 8-2 shows the effects of these events on
the financial statements if the direct write-off method is used.

Illustration 8-2 Effects of direct write-off method

Under the direct write-off method, companies often record bad debt expense in a period different
from the period in which they record the revenue. The method does not attempt to match bad
debt expense to sales revenue in the income statement. Nor does the direct write-off method
show accounts receivable in the statement of financial position at the amount the company
actually expects to receive. Consequently, unless bad debt losses are insignificant, the direct
write-off method is not acceptable for financial reporting purposes.

B. Allowance Method for Uncollectible Accounts

The allowance method of accounting for bad debts involves estimating uncollectible accounts at
the end of each period. This provides better matching on the income statement. It also ensures
that companies state receivables on the statement of financial position at their cash (net)
realizable value. Cash (net) realizable value is the net amount the company expects to receive
in cash.1

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IFRS requires the allowance method for financial reporting purposes when bad debts are
material in amount. This method has three essential features:

HELPFUL HINT: In this context, material means significant or important to financial statement

users.
 Companies estimate uncollectible accounts receivable. They match this estimated
expense against revenues in the same accounting period in which they record the
revenues.
 Companies debit estimated uncollectible to Bad Debt Expense and credit them to
Allowance for Doubtful Accounts through an adjusting entry at the end of each period.
Allowance for Doubtful Accounts is a contra account to Accounts Receivable.
When companies write off a specific account, they debit actual uncollectible to Allowance for
Doubtful Accounts and credit that amount to Accounts Receivable
Recording Estimated Uncollectible 

To illustrate the allowance method, assume that Hampson Furniture has credit sales of
€1,200,000 in 2017. Of this amount, €200,000 remains uncollected at December 31. The credit
manager estimates that €12,000 of these sales will be uncollectible. The adjusting entry to record
the estimated uncollectable increases (debits) Bad Debt Expense and increases (credits)
Allowance for Doubtful Accounts, as follows.

Hampson reports Bad Debt Expense in the income statement as an operating expense (usually as
a selling expense). Thus, the estimated uncollectable are matched with sales in 2017. Hampson
records the expense in the same year it made the sales.

Allowance for Doubtful Accounts shows the estimated amount of claims on customers that the
company expects will become uncollectible in the future. Companies use a contra account
instead of a direct credit to Accounts Receivable because they do not know which customers will
not pay. The credit balance in the allowance account will absorb the specific write-offs when
they occur.

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As Illustration 8-3 shows, the company deducts the allowance account from accounts receivable
in the current assets section of the statement of financial position.

Illustration 8-3 Presentation of allowance for doubtful accounts

HAMPSON FURNITURE
Statement of Financial Position (partial)

Current assets

Supplies   € 25,000

Inventory   310,000

Accounts receivable €200,000

Less: Allowance for doubtful accounts 12,000 188,000   

Cash 14,800   

Total current assets   €537,800

The amount of €188,000 in Illustration 8-3 represents the expected cash realizable value of the
accounts receivable at the statement date. Companies do not close Allowance for Doubtful
Accounts at the end of the fiscal year.

 HELPFUL HINT: Cash realizable value is sometimes referred to as accounts

receivable (net).

Recording the Write-Off of an Uncollectible Account 

Companies use various methods of collecting past-due accounts, such as letters, calls, and legal
action. When they have exhausted all means of collecting a past-due account and collection
appears impossible, the company should write off the account. In the credit card industry, for
example, it is standard practice to write off accounts that are 210 days past due. To prevent
premature or unauthorized write-offs, authorized management personnel should formally

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approve each write-off. To maintain segregation of duties, the employee authorized to write off
accounts should not have daily responsibilities related to cash or receivables.

To illustrate a receivables write-off, assume that the financial vice president of Hampson
Furniture authorizes a write-off of the €500 balance owed by R. A. Ware on March 1, 2018. The
entry to record the write-off is as follows.

Bad Debt Expense does not increase when the write-off occurs. Under the allowance method,
companies debit every bad debt write-off to the allowance account rather than to Bad Debt
Expense. A debit to Bad Debt Expense would be incorrect because the company has already
recognized the expense when it made the adjusting entry for estimated bad debts. Instead, the
entry to record the write-off of an uncollectible account reduces both Accounts Receivable and
Allowance for Doubtful Accounts. After posting, the general ledger accounts appear as shown in
Illustration 8-4.

Illustration 8-4 General ledger balances after write-off

A write-off affects only statement of financial position accounts—not income statement

accounts. The write-off of the account reduces both Accounts Receivable and Allowance for
Doubtful Accounts. Cash realizable value in the statement of financial position, therefore,
remains the same, as Illustration 8-5 shows.
Illustration 8-5 Cash realizable value comparison
Before Write-Off After Write-Off

Accounts receivable € 200,000 € 199,500

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Less: Allowance for doubtful accounts 12,000 11,500

Cash realizable value €188,000 €188,000

                   

Recovery of an Uncollectible Account 

Occasionally, a company collects from a customer after it has written off the account as
uncollectible. The company makes two entries to record the recovery of a bad debt. (1) It
reverses the entry made in writing off the account. This reinstates the customer’s account. (2) It
journalizes the collection in the usual manner.

To illustrate, assume that on July 1, R. A. Ware pays the €500 amount that Hampson had written
off on March 1. Hampson makes the following entries.

Note that the recovery of a bad debt, like the write-off of a bad debt, affects only statement of
financial position accounts. The net effect of the two entries above is a debit to Cash and a
credit to Allowance for Doubtful Accounts for €500. Accounts Receivable and the Allowance for
Doubtful Accounts both increase in entry (1) for two reasons. First, the company made an error
in judgment when it wrote off the account receivable. Second, after R. A. Ware did pay, Accounts
Receivable in the general ledger and Ware’s account in the subsidiary ledger should show the
collection for possible future credit purposes.

Estimating the Allowance 

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For Hampson Furniture in Illustration 8-3, the amount of the expected uncollectable was given.
However, in “real life,” companies must estimate that amount when they use the allowance
method. One of two bases is used to determine this amount: (1) percentage of sales or (2)
percentage of receivables. Both bases are generally accepted. The choice is a management
decision. It depends on the relative emphasis that management wishes to give to expenses and
revenues on the one hand or to cash realizable value of the accounts receivable on the other. The
choice is whether to emphasize income statement or statement of financial position
relationships. Illustration 8-6 compares the two bases.

Illustration 8-6 Comparison of bases for estimating uncollectible

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The percentage-of-sales basis results in a better matching of expenses with revenues—an income
statement viewpoint. The percentage-of-receivables basis produces the better estimate of cash
realizable value—a statement of financial position viewpoint. Under both bases, the company
must determine its past experience with bad debt losses.

Percentage-of-Sales 
In the percentage-of-sales basis, management estimates what percentage of credit sales will be
uncollectible. This percentage is based on past experience and anticipated credit policy. The
company applies this percentage to either total credit sales or net credit sales of the current year.

To illustrate, assume that Gonzalez SA elects to use the percentage-of-sales basis. It concludes
that 1% of net credit sales will become uncollectible. If net credit sales for 2017 are €800,000,
the estimated bad debt expense is €8,000 (1%×€800,000). The adjusting entry is as follows.

After the adjusting entry is posted, assuming the allowance account already has a credit balance
of €1,723, the accounts of Gonzalez SA will show the following.
Illustration 8-7 Bad debt accounts after posting

This basis of estimating uncollectables emphasizes the matching of expenses with

revenues. As a result, Bad Debt Expense will show a direct percentage relationship to the sales
base on which it is computed. When the company makes the adjusting entry, it disregards
the existing balance in Allowance for Doubtful Accounts. The adjusted balance in this account
when netted against accounts receivable should be a reasonable approximation of the realizable
value of the receivables. If actual write-offs differ significantly from the amount estimated, the
company should modify the percentage for future years.

Percentage-of-Receivables
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Under the percentage-of-receivables basis, management estimates what percentage of
receivables will result in losses from uncollectible accounts. The company prepares an aging
schedule, in which it classifies customer balances by the length of time they have been unpaid.
Because of its emphasis on time, the analysis is often called aging the accounts receivable.

Total estimated bad debts for Dart ( 2,228,000) represent the amount of existing customer
claims the company expects will become uncollectible in the future. This amount represents
the required balance in Allowance for Doubtful Accounts at the statement of financial position
date. The amount of the bad debt adjusting entry is the difference between the required
balance and the existing balance in the allowance account. If the trial balance shows
Allowance for Doubtful Accounts with a credit balance of  528,000, the company will make an
adjusting entry for  1,700,000 ( 2,228,000 −  528,000), as shown here (  in thousands).

Illustration 8-8 Aging schedule

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  HELPFUL HINT: The older categories have higher percentages because the longer an
account is past due, the less likely it is to be collected.

After Dart posts its adjusting entry, its accounts will appear as follows (  in thousands).

Illustration 8-9 Bad debt accounts after posting

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Occasionally, the allowance account will have a debit balance prior to adjustment. This occurs
when write-offs during the year have exceeded previous provisions for bad debts. In such a case,
the company adds the debit balance to the required balance when it makes the adjusting entry.
Thus, if there had been a  500,000 debit balance in the allowance account before adjustment,
the adjusting entry would have been for  2,728,000 ( 2,228,000 +  500,000) to arrive at a
credit balance of  2,228,000. The percentage-of-receivables basis will normally result in the
better approximation of cash realizable value.
> DO IT!

Uncollectible Accounts Receivable

Brule Co. has been in business for five years. The unadjusted trial balance at the end of the
current year shows:
Accounts Receivable $30,000 Dr.

Sales Revenue $180,000 Cr.

Allowance for Doubtful Accounts $2,000 Dr.

Bad debts are estimated to be 10% of receivables. Prepare the entry to adjust Allowance for
Doubtful Accounts.

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Solution
The following entry should be made to bring the balance in Allowance for Doubtful Accounts up
to a normal credit balance of $3,000 (10%×$30,000):

iii. Disposing of Accounts Receivable

In the normal course of events, companies collect accounts receivable in cash and remove the
receivables from the books. However, as credit sales and receivables have grown in significance,
the “normal course of events” has changed. Companies now frequently sell their receivables to
another company for cash, thereby shortening the cash-to-cash operating cycle.

Companies sell receivables for two major reasons. First, they may be the only reasonable
source of cash. When money is tight, companies may not be able to borrow money in the usual
credit markets. Or, if money is available, the cost of borrowing may be prohibitive.

A second reason for selling receivables is that billing and collection are often time-consuming
and costly. It is often easier for a retailer to sell the receivables to another party with expertise in
billing and collection matters.

Sale of Receivables

A common sale of receivables is a sale to a factor. A factor is a finance company or bank that
buys receivables from businesses and then collects the payments directly from the customers.
Factoring is a multibillion dollar business.

Factoring arrangements vary widely. Typically, the factor charges a commission to the company
that is selling the receivables. This fee ranges from 1–3% of the amount of receivables
purchased. To illustrate, assume that Tsai Furniture factors NT$600,000 of receivables to Federal
Factors. Federal Factors assesses a service charge of 2% of the amount of receivables sold. The
journal entry to record the sale by Tsai Furniture on April 2, 2017, is as follows.

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If the company often sells its receivables, it records the service charge expense (such as that
incurred by Tsai) as a selling expense. If the company infrequently sells receivables, it may
report this amount in the “Other income and expense” section of the income statement.

Credit Card Sales

Credit card use is becoming widespread around the world. ICBC is among the largest credit card
issuers in the world. Visaand MasterCard are the credit cards that most individuals use. Three
parties are involved when credit cards are used in retail sales: (1) the credit card issuer, who is
independent of the retailer; (2) the retailer; and (3) the customer. A retailer’s acceptance of a
national credit card is another form of selling (factoring) the receivable.

Illustration 8-10 shows the major advantages of credit cards to the retailer. In exchange for these
advantages, the retailer pays the credit card issuer a fee of 2–6% of the invoice price for its
services.

Accounting for Credit Card Sales 

The retailer generally considers sales from the use of credit card sales as cash sales. The retailer
must pay to the bank that issues the card a fee for processing the transactions. The retailer
records the credit card slips in a similar manner as checks deposited from a cash sale.

To illustrate, Lee Co. Ltd. purchases NT$6,000 of music downloads for its restaurant from Yang
Music, using a Visa First Bank Card. First Bank charges a service fee of 3%. The entry to record
this transaction by Yang Music on March 22, 2018, is as follows.

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> DO IT!

iv. Disposition of Accounts Receivable

Mehl Wholesalers NV has been expanding faster than it can raise capital. According to its local
banker, the company has reached its debt ceiling. Mehl’s suppliers (creditors) are demanding
payment within 30 days of the invoice date for goods acquired, but Mehl’s customers are slow in
paying (60–90 days). As a result, Mehl has a cash flow problem.
Mehl needs €120,000 in cash to safely cover next Friday’s payroll. Its balance of outstanding
accounts receivables totals €750,000. To alleviate this cash crunch, the company sells €125,000
of its receivables on September 7, 2017. Mehl is charged a 1% service charge on this sale.
Record the entry that Mehl would make when it raises the needed cash.

Solution
If Mehl Wholesalers factors €125,000 of its accounts receivable at a 1% service charge, it would
make the following entry.

1.2.2 Note receivables

Companies may also grant credit in exchange for a formal credit instrument known as a
promissory note. A promissory note is a written promise to pay a specified amount of money on
demand or at a definite time. Promissory notes may be used (1) when individuals and companies

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lend or borrow money, (2) when the amount of the transaction and the credit period exceed
normal limits, or (3) in settlement of accounts receivable.

In a promissory note, the party making the promise to pay is called the maker. The party to
whom payment is to be made is called the payee. The note may specifically identify the payee by
name or may designate the payee simply as the bearer of the note. In the note shown
in Illustration 8-11, Calhoun plc is the maker, and Wilma Ltd. is the payee. To Wilma Ltd., the
promissory note is a note receivable. To Calhoun plc, it is a note payable.
Illustration 8-11 Promissory note

 HELPFUL HINT: For this note, the maker, Calhoun plc, debits Cash and credits Notes
Payable. The payee, Wilma Ltd., debits Notes Receivable and credits Cash.

Notes receivable give the holder a stronger legal claim to assets than do accounts receivable.
Like accounts receivable, notes receivable can be readily sold to another party. Promissory notes
are negotiable instruments (as are checks), which means that they can be transferred to another
party by endorsement.

Companies frequently accept notes receivable from customers who need to extend the payment
of an outstanding account receivable. They often require such notes from high-risk customers. In
some industries (such as the pleasure and sport boat industry), all credit sales are supported by
notes. The majority of notes, however, originate from loans.The basic issues in accounting for
notes receivable are the same as those for accounts receivable:
1. Recognizing notes receivable.
2. Valuing notes receivable.
3. Disposing of notes receivable.
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On the following pages, we look at these issues. Before we do, however, we need to consider two
issues that do not apply to accounts receivable: determining the maturity date and computing
interest.

Determining the Maturity Date

When the life of a note is expressed in terms of months, you find the date when it matures by
counting the months from the date of issue. For example, the maturity date of a three-month note
dated May 1 is August 1. A note drawn on the last day of a month matures on the last day of a
subsequent month. That is, a July 31 note due in two months matures on September 30.When the
due date is stated in terms of days, you need to count the exact number of days to determine the
maturity date. In counting, omit the date the note is issued but include the due date. For
example, the maturity date of a 60-day note dated July 17 is September 15, computed as follows.

Illustration 8-12 Computation of maturity date

Term of note 60 days

July (31–17) 14

August 31 45

Maturity date: September 15

   

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Illustration 8-13 Maturity date of different notes

Computing Interest
Illustration 8-14 gives the basic formula for computing interest on an interest-bearing note.
Illustration 8-14 Formula for computing interest

The interest rate specified in a note is an annual rate of interest. The time factor in the formula
in Illustration 8-14expresses the fraction of a year that the note is outstanding. When the maturity
date is stated in days, the time factor is often the number of days divided by 360. When counting
days, omit the date that the note is issued but include the due date. When the due date is stated in
months, the time factor is the number of months divided by 12. Illustration 8-15shows
computation of interest for various time periods. 
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  HELPFUL HINT: The interest rate specified is the annual rate.

Illustration 8-15 Computation of interest

There are different ways to calculate interest. For example, the computation in Illustration 8-
15 assumes 360 days for the length of the year. Most financial instruments use 365 days to
compute interest. For homework problems, assume 360 days to simplify computations.
i) Recognizing Notes Receivable

To illustrate the basic entry for notes receivable, we will use Calhoun plc’s £1,000, two-month,
12% promissory note dated May 1. Assuming that Calhoun plc wrote the note to settle an open
account, Wilma Ltd. makes the following entry for the receipt of the note.

The company records the note receivable at its face value, the amount shown on the face of the
note. No interest revenue is reported when the note is accepted because the revenue recognition
principle does not recognize revenue until the performance obligation is satisfied. Interest is
earned (accrued) as time passes.
If a company lends money using a note, the entry is a debit to Notes Receivable and a credit to
Cash in the amount of the loan.

ii) Valuing Notes Receivable

Valuing short-term notes receivable is the same as valuing accounts receivable. Like accounts
receivable, companies report short-term notes receivable at their cash (net) realizable value.
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The notes receivable allowance account is Allowance for Doubtful Accounts. The estimations
involved in determining cash realizable value and in recording bad debt expense and the related
allowance are done similarly to accounts receivable.

iii) Disposing of Notes Receivable

Notes may be held to their maturity date, at which time the face value plus accrued interest is
due. In some situations, the maker of the note defaults, and the payee must make an appropriate
adjustment. In other situations, similar to accounts receivable, the holder of the note speeds up
the conversion to cash by selling the receivables. The accounting entries for the sale of notes
receivable are left for a more advanced class.

a. Honor of Notes Receivable

A note is honored when its maker pays in full at its maturity date. For each interest-bearing note,
the amount due at maturity is the face value of the note plus interest for the length of time
specified on the note.

To illustrate, assume that Wolder Co. lends Higley Co. €10,000 on June 1, accepting a five-
month, 9% interest note. In this situation, interest is €375 (€10,000×9%×512). The amount
due, the maturity value, is €10,375 (€10,000+€375). To obtain payment, Wolder (the payee)
must present the note either to Higley Co. (the maker) or to the maker’s agent, such as a bank. If
Wolder presents the note to Higley Co. on November 1, the maturity date, Wolder’s entry to
record the collection is as follows.

Accrual of Interest Receivable

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Suppose instead that Wolder Co. prepares financial statements as of September 30. The timeline
in Illustration 8-16presents this situation.
Illustration 8-16 Timeline of interest earned

To reflect interest earned but not yet received, Wolder must accrue interest on September 30. In
this case, the adjusting entry by Wolder is for four months of interest, or €300, as shown below.

Sept. 30 Interest Receivable 300

Interest Revenue 300
(€10,000 x 9% x 4/12 = € 300)

At the note’s maturity on November 1, Wolder receives €10,375. This amount represents
repayment of the €10,000 note as well as five months of interest, or $375, as shown below. The
€375 is comprised of the €300 Interest Receivable accrued on September 30 plus €75 earned
during October. Wolder’s entry to record the honoring of the Higley note on November 1 is as
follows.

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In this case, Wolder credits Interest Receivable because the receivable was established in the
adjusting entry on September 30.
b. Dishonor of Notes Receivable
A dishonored (defaulted) note is a note that is not paid in full at maturity. A dishonored note
receivable is no longer negotiable. However, the payee still has a claim against the maker of the
note for both the note and the interest. Therefore, the note holder usually transfers the Notes
Receivable account to an Accounts Receivable account.
To illustrate, assume that Higley Co. on November 1 indicates that it cannot pay at the present
time. The entry to record the dishonor of the note depends on whether Wolder Co. expects
eventual collection. If it does expect eventual collection, Wolder Co. debits the amount due (face
value and interest) on the note to Accounts Receivable. It would make the following entry at the
time the note is dishonored (assuming no previous accrual of interest).

If instead on November 1 there is no hope of collection, the note holder would write off the face
value of the note by debiting Allowance for Doubtful Accounts. No interest revenue would be
recorded because collection will not occur.

c. Discounting Note Receivable

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A company may endorse a note receivable and transfer it to a bank in return for cash. Notes
Receivable can be converted to cash before they mature. This can be done by discounting notes
receivable at a financial institution or bank.

To illustrate, assume that ABC co hold a Birr 3,000, 90 days 12% note, dated May 15 .On July 4,
the note is discounted at DASHEN BANK at the rate of 12% ABC’s co proceeds from the bank
are computed as follows:
Principal of the note - - - - - - - - - - - - - - - - - - - Br. 3,000
(+) Interest from the note (3000 x 12% x 90/360) - - - - 75
= Maturity value - - - - - - - - - - - - - - - - - - - - -- - - - 3075
(-) Bank discount (3075 x 12% x 40/360)* - - - - - - - 41
= Proceeds - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 3,034

ABC Company held the note for 50 of the 90 days before discounting.

The entry to record discounting of he note is

A u gu st 1 4 C ash 3034
In te re s t R e v e n u e 34
N o te s R e c e iv a b le 3000
It should be observed that the proceeds from discounting a note receivable might be less than the
face value. When this situation occurs, the excess of the face value over the proceeds is recorded
as interest expense. Notes receivable are discounted with recourse or without recourse. When a
note is discounted without recourse, the bank assumes the risk of a bad debt loss and the
original payee doesn’t have a contingent liability. A contingent liability is an obligation to make a
future payment if, and only if an uncertain future event occurs. If a note is discounted with
recourse and the original maker of the note fails to pay the bank when it matures, the original
payee of the note must pay for it. This means a company discounting a note with recourse has a
contingent liability until the bank is paid. A company should disclose contingent liabilities in
notes to its financial statements.

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Summery
The term receivables refer to amounts due from individuals and companies. Receivables are
claims that are expected to be collected in cash. The management of receivables is a very
important activity for any company that sells goods or services on credit. Receivables are
important because they represent one of a company’s most liquid assets. For many companies,
receivables are also one of the largest assets. To reflect important differences among receivables,
they are frequently classified as Accounts receivable, notes receivable, and other receivables.
Companies report accounts receivable on the statement of financial position as an asset. But
determining the amount to report is sometimes difficult because some receivables will become
uncollectible. If the amounts are not collectable there are two methods to recognize the
uncollectable amounts such as the direct write-off method and the allowance method. The
following sections explain these methods. Companies may also grant credit in exchange for a
formal credit instrument known as a promissory note. A promissory note is a written promise to
pay a specified amount of money on demand or at a definite time. Promissory notes may be used
(1) when individuals and companies lend or borrow money, (2) when the amount of the
transaction and the credit period exceed normal limits, or (3) in settlement of accounts
receivable. The basic issues in accounting for notes receivable are the same as those for accounts
receivable recognizing notes receivable, valuing notes receivable. anddisposing of notes
receivable.

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Exercise

1. The ledger of ABC Co at the end of the current year shows Accounts Receivable of Br. 92,500.
The analysis of the accounts in the customers’ ledger indicates uncollectible accounts of Br.8010.
(the company uses the percentage of receivable method) Record the adjusting entry under the
following assumptions.
A. The allowance for doubtful account before adjustment has zero balance.
B. The allowance for doubtful account before adjustment has a debit balance of Br. 510
C. The allowance for doubtful account before adjustment has a credit balance of Br. 800

2. Assume DDB Co. determines on January 23 it can’t collect Br. 520 owed to it by its customer
AKK. Co. Record the adjusting entry using the direct write-off method.

3.XYZ Company has accepted a Br. 12, 000, 60 day, non – interest bearing not dated Oct. 18 in
settlement of open account. Assuming that the cash is collected in the due date. Record the
acceptance of Notes receivable and collection of cash.

4. ABC Company has accepted a Br. 11, 000, 60 – day, 12% note dated September 28 in
settlement of open account. Fiscal period ends on December 31. Show the entry to record:
* A. If the cash is collected at maturity (honored)
* B. If the note is dishonored
* EFG co. holds a 120-day, 10% not for a Br. 20,000, dated September 5, is discounted at
WEGAGEN BANK on October 8 at the rate of 15%. Determine the proceeds and record
discounting of the note.

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 UNIT TWO

2. ACCOUNTING FOR INVENTORIES

2.1 Importance of Inventories
2.2 Inventory systems
As you have learned in principles of accounting, companies use one of two systems to account
for inventory: a perpetual inventory system or a periodic inventory system.
2.1.1 Perpetual inventory system
In a perpetual inventory system, companies keep detailed records of the cost of each inventory
purchase and sale. These records continuously-perpetually-show the inventory that should be on
hand for every item. For example, a Ford dealership has separate inventory records for each
automobile, truck, and van on its lot and showroom floor.at the end of the physical period
companies count the ending inventory forchecking the inventory balance rather than knowing.
2.1.2 Periodic System
In a periodic inventory system, companies do not keep detailed inventory records of the goods
on hand throughout the period. Instead, they determine the cost of goods sold only at the end of
the accounting period-that is, periodically. At that point, the company takes a physical
inventory count to determine the cost of goods on hand.

2.3 Determining actual quantity of inventory on hand

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No matter whether they are using a periodic or perpetual inventory system, all companies need to
determine inventory quantities at the end of the accounting period. When using a perpetual
system, companies take a physical inventory for two purposes: The first purpose is to check the
accuracy of their perpetual inventory records. The second is to determine the amount of
inventory lost due to wasted raw materials, shoplifting, or employee theft. Companies using a
periodic inventory system must take a physical inventory for two different purposes: to determine
the inventory on hand at the balance sheet date and to determine the cost of goods sold for the
period.
Determining inventory quantities involves two steps: (1) taking a physical inventory of goods on
hand and (2) determining the ownership of goods.
i. Taking a Physical Inventory
Taking a physical inventory involves actually counting, weighing, or measuring each kind of
inventory on hand. In many companies, taking an inventory is a formidable task. Retailers such
as Target, True Value Hardware, or Home Depot have thousands of different inventory items. An
inventory count is generally more accurate when goods are not being sold or received during the
counting. Consequently, companies often “take inventory” when the business is closed or when
business is slow. Many retailers close early on a chosen day in January-after the holiday sales
and returns, when inventories are at their lowest level-to count inventory. Companies take the
physical inventory at the endof the accounting period.
ii. Determining Ownership of Goods
One challenge in computing inventory quantities is determining what inventory company owns.
To determine ownership of goods, two questions must be answered: Do all of the goods included
in the count belong to the company? Does the company own any goods that were not included in
the count?
One challenge in computing inventory quantities is determining what inventory a company
owns. To determine ownership of goods, two questions must be answered: Do all of the goods
included in the count belong to the company? Does the company own any goods that were not
included in the count?
Goods in Transit
A complication in determining ownership is goods in transit (on board a truck, train, ship, or
plane) at the end of the period. The company may have purchased goods that have not yet been
received, or it may have sold goods that have not yet been delivered. To arrive at an accurate
count, the company must determine ownership of these goods. Goods in transit should be
included in the inventory of the company that has legal title to the goods.

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1. When the terms are FOB (free on board) shipping point, ownership of the goods passes to
the buyer when the public carrier accepts the goods from the seller.
2. When the terms are FOB destination, ownership of the goods remains with the seller until the
goods reach the buyer. If goods in transit at the statement date are ignored, inventory quantities
may be seriously miscounted.
Assume, for example, that Hargrove Company has 20,000 units of inventory on hand on
December 31. It also has the following goods in transit: (1) sales of 1,500 units shipped
December 31 FOB destination, and (2) purchases of 2,500 units shipped FOB shipping point by
the seller on December 31. Hargrove has legal title to both the 1,500 units sold and the 2,500
units purchased. If the company ignores the units in transit, it would understate inventory
quantities by 4,000 units (1,500 -2,500).
As we will see later in the chapter, inaccurate inventory counts affect not only the inventory
amount shown on the balance sheet but also the cost of goods sold calculation on the income
statement.
Consigned Goods
In some lines of business, it is common to hold the goods of other parties and try to sell the
goods for them for a fee, but without taking ownership of the goods. These are called consigned
goods.
For example, you might have a used car that you would like to sell. If you take the item to a
dealer, the dealer might be willing to put the car on its lot and charge you a commission if it is
sold. Under this agreement the dealer wouldnot take ownership of the car, which would still
belong to you. Therefore, if an inventory count were taken, the car would not be included in the
dealer’s inventory.
Many car, boat, and antique dealers sell goods on consignment to keep their inventory costs
down and to avoid the risk of purchasing an item that they won’t be able to sell. Today even
some manufacturers are making consignment agreements with their suppliers in order to keep
their inventory levels low.

2.4 Methods of inventory costing

After a company has determined the quantity of units of inventory, it applies unit costs to the
quantities to compute the total cost of the inventory and the cost of goods sold. This process can
be complicated if a company has purchased inventory items at different times and at different
prices.

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For example, assume that Crivitz TV Company purchases three identical 46- inch TVs on
different dates at costs of Br700, Br 750, and Br800. During the year Crivitz sold two sets at Br
1,200 each.
Purchases
February 3 1 TV at Br.700
March 5 1 TV at Br 750
May 22 1 TV at Br 800
Sales
June 1 2 TVs forBr 2,400 ($1,200 _ 2)
Cost of goods sold will differ depending on which two TVs the company sold. For example, it
might be Br 1,450 (Br 700-Br 750), or Br 1,500 (Br 700- Br 800), or Br 1,550 (Br 750 -Br 800).
In this section we discuss alternative costing methods available to Crivitz.
1) Specific Identification
If Crivitz sold the TVs it purchased on February 3 and May 22, then its cost of goods sold is
$1,500 ($700 _ $800), and its ending inventory is $750. If Crivitz can positively identify which
particular units it sold and which are still in ending inventory, it can use the specific
identification method of inventory costing (see Illustration ). Using this method, companies can
accurately determine ending inventory and cost of goods sold.
Specific identification requires that companies keep records of the original cost of each
individual inventory item. Historically, specific identification was possible only when a company
sold a limited variety of high-unit-cost items that could be identified clearly from the time of
purchase through the time of sale. Examples of such products are cars, pianos, or expensive
antiques. Today, bar coding, electronic product codes, and radio frequency identification make it
theoretically possible to do specific identification with nearly any type of product.
The reality is, however, that this practice is still relatively rare. Instead, rather than Specific
identification requires that companies keep records of the original cost of each individual
inventory item. Historically, specific identification was possible only when a company sold a
limited variety of high-unit-cost items that could be identified clearly from the time of purchase
through the time of sale. Examples of such products are cars, pianos, or expensive antiques.
Today, bar coding, electronic product codes, and radio frequency identification make it
theoretically possible to do specific identification with nearly any type of product. The reality is,
however, that this practice is still relatively rare. Instead, rather than keep track of the cost of
each particular item sold, most companies make assumptions, called cost flow assumptions,
about which units were sold.
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 2.5 Estimating inventory cost /Cost Flow Assumptions
Because specific identification is often impractical, other cost flow methods are permitted. These
differ from specific identification in that they assume flows of costs that may be unrelated to the
physical flow of goods. There are three assumed cost flow methods:
I. First-in, first-out (FIFO)
II. Last-in, first-out (LIFO) : this methods are prohibited in IFRS
III. Average-cost

There is no accounting requirement that the cost flow assumption be consistent with the
physical movement of the goods. Company management selects theappropriate cost flow
method.
To illustrate these three inventory cost flow methods, we will assume thatHouston Electronics
uses a periodic inventory system. The information for itsAstrocondensors is shown in
Illustration.

HOUSTON ELECTRONICS
Astro Condensers
DateExplanationUnits Unit CostTotal Cost
Jan. 1 Beginning inventory 100Br 10 Br1, 000
Apr. 15 Purchase 200 Br 11Br 2,200
Aug. 24Purchase 300 Br 12 Br 3,600
Nov. 27 Purchase 400 Br 13 Br 5,200
Total 1,000Br12, 000
The company had a total of 1,000 units available that it could have sold during the period. The
total cost of these units was $12,000.A physical inventory at the end of the year determined that
during the year Houston sold 550 units and had 450 units in inventory at December 31. The
question then is how to determine what prices to use to value the goods sold and the ending
inventory. The sum of the cost allocated to the units sold plus the cost of the units in inventory
must be $12,000, the total cost of all goods available for sale.
I) FIRST-IN, FIRST-OUT (FIFO)
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The FIFO (first-in, first-out) method assumes that the earliest goods purchased are the first to
be sold. FIFO often parallels the actual physical flow of merchandise; it generally is good
business practice to sell the oldest units first. Under the FIFO method, therefore, the costs of the
earliest goods purchased are the first to be recognized. In determining cost of goods sold. (This
does not necessarily mean that the oldest units are sold first, but that the costs of the oldest units
are recognized first. In a bin of picture hangers at the hardware store, for example, no one really
knows, nor would it matter, which hangers are sold first.) Illustration shows the allocation of the
cost of goods available for sale at Houston Electronics under FIFO.
COST OF GOODS AVAILABLE FOR SALE
Date Explanation Units Unit Cost Total Cost
Jan. 1 Beginning inventory 100 Br 10 Br 1,000
Apr. 15 Purchase 200 11 2,200
Aug. 24 Purchase 300 12 3,600
Nov. 27 Purchase 400 13 5,200
Total 1,000 $12,000
STEP 1: ENDING INVENTORY STEP 2: COST OF GOODS SOLD
Date Units Unit Cost Total cost
Nov. 27 400 $13 $5,200 Cost of goods available for sale Br12, 000
Aug. 24 50 12600less: Ending inventory (5,800)
Total 450$5,800 Cost of goods sold Br. 6,200

Under FIFO, since it is assumed that the first goods purchased were the first goods sold, ending
inventory is based on the prices of the most recent units purchased. That is, under FIFO,
companies obtain the cost of the ending inventory bytaking the unit cost of the most recent
purchase and working backward until allunits of inventory have been costed. In this
example, Houston Electronics prices the 450 units of ending inventory using the most recent
prices. The last purchase was 400 units at $13 on November 27.The remaining 50 units are
priced using the unit cost of the second most recent purchase, $12, on August 24. Next, Houston
Electronics calculates cost of goods sold by subtracting the cost of the units notsold (ending
inventory) from the cost of all goods available for sale.

Illustration 6-6 demonstrates that companies also can calculate cost of goods sold by pricing the
550 units sold using the prices of the first 550 units acquired.

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Note that of the 300 units purchased on August 24, only 250 units are assumed sold. This agrees
with our calculation of the cost of ending inventory, where 50 of these units were assumed
unsold and thus included in ending inventory.

Date Units Unit Cost Total Cost

Jan. 1 100 $10 $1,000
Apr. 15 200 11 2,200
Aug. 24 250 12 3,000
Total 550 $6,200

II. AVERAGE-COST
The average-cost method allocates the cost of goods available for sale on the basis of the weighted average
unit cost incurred. The average-cost method assumes that goods are similar in nature. Illustration presents the
formula and a sample computation of the weighted-average unit cost.

Goods available for sale = weighted average unit cost

Total unit available for sale

The company then applies the weighted average unit cost to the units on hand to determine the
cost of the ending inventory. Illustration 6-10 shows the allocation of the cost of goods available
for sale at Houston Electronics using average cost.
We can verify the cost of goods sold under this method by multiplying the units sold times the
weighted average unit cost (550 _ $12 _ $6,600). Note that this method does not use the average
of the unit costs. That average is $11.50 ($10 _ $11 _ $12 _ $13 _ $46; $46 _ 4). The average
cost method instead uses the average weighted by the quantities purchased at each unit cost.
COST OF GOODS AVAILABLE FOR SALE
Date Explanation Units Unit Cost Total Cost
Jan. 1 Beginning inventory 100 $10 $ 1,000
Apr. 15 Purchase 200 11 2,200
Aug. 24 Purchase 300 12 3,600
Nov. 27 Purchase 400 13 5,200
Total 1,000 $12,000
STEP 1: ENDING INVENTORY STEP2: COST OF GOODS SOLD

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$12,000/ 1,000 =$12.00 Cost of goods available for sale $12,000
Less: Ending inventory 5,400
Units Unit Cost Total Cost Cost of goods sold $ 6,600
450 $12.00 $5,400

2.6 Presentation of merchandise inventory on the balance sheet

In the balance sheet, merchandising companies report merchandise inventory as a current asset
immediately below accounts receivable. Recall from accounting for merchandizing inventory
chapter that companies generally list current asset items in the order of their closeness to cash
(liquidity). Merchandise inventory is less close to cash than accounts receivable, because the
goods must first be sold and then collection made from the customer.
Sample format

PW AUDIO SUPPLY
Balance Sheet (Partial)
December 31, 2010
Assets
Current assets
Cash $ 9,500
Accounts receivable 16,100
Merchandise inventory 40,000
Prepaid insurance 1,800
Total current assets 67,400
Property, plant, and equipment
Store equipment $80,000
Less: Accumulated depreciation—store equipment 24,000 56,000
Total assets $123,400

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 Summery
Companies use one of two systems to account for inventory: a perpetual inventory
system (companies keep detailed records of the cost of each inventory purchase and
sale) or a periodic inventory system (companies do not keep detailed inventory records
of the goods on hand throughout the period. Instead, they determine the cost of goods
sold only at the end of the accounting period-that is, periodically). No matter whether
they are using a periodic or perpetual inventory system, all companies need to determine
inventory quantities at the end of the accounting period. Determining inventory

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 quantities involves two steps: taking a physical inventory of goods on hand and
determining the ownership of goods. After a company has determined the quantity of
units of inventory, it applies unit costs to the quantities to compute the total cost of the
inventory and the cost of goods sold. This process can be complicated if a company has
purchased inventory items at different times and at different prices. The inventory
costing methods are Specific Identification methods, First-in, first-out (FIFO), and
average-cost

Exercise

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1. The beginning inventory of Beta company consisted of  100 units @ $60 each. The following
transactions occurred during the month of March 2013.

 Mar. 05: Purchased 300 units @ $60 each.

 Mar. 06: Out of 300 units purchased on March 05, 10 units were returned to supplier.
 Mar: 28: Sold 250 units @ $100 each.

On March 31, 2013, 140 units were found by a physical count.

Required: Make journal entries for the month of June assuming the Beta company uses:

a. Perpetual inventory system.

b. Periodic inventory system.

2. The Delta Company uses a periodic inventory system The beginning balance of inventory
and purchases made by the company during the month of July, 2016 are given below:

 July 01: Beginning inventory, 500 units @ $20 per unit.

 July 18: Inventory purchased 800 units @ $24 per unit.
 July 25: Inventory purchased 700 units @ $26 per unit.

The Delta Company sold 1,400 units during the month of July.

Required: Compute inventory on July 31, 2016 and cost of goods sold for the month of July
using following inventory costing methods:

A. First in, first out (FIFO) method

B. Average cost method

3. The Alpha merchandising company purchases product DX-5 directly from manufacturers and
sells it to small retailers as well as customers. The following transactions occurred during the
last month of  2016:

 Dec. 01: 800 units on hand @ $40 each.

 Dec. 08: 600 units sold @ $76 each.
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  Dec. 14: 1,200 units purchased @ $50 each.
 Dec. 18: 1,080 units sold @ $76 each.
 Dec. 30: 800 units purchased @ $60 each.

Required:

Assuming the Alpha merchandising company uses periodic inventory method, compute the cost
of inventory on hand at December 31, 2016 under the following cost flow assumptions:

A. First in, first out (FIFO)

B. Weighted average
C. specific identification method
4. Assuming the Alpha merchandising company uses a perpetual inventory method, compute
the cost of inventory on hand at December 31, 2016 under the following cost flow
assumptions:
A. First in, first out (FIFO)
B. Weighted average
C. specific identification method

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 UNIT THREE

3. ACCOUNTING FOR PLANT ASSETS

Chapters’ objectives

At the end of this chapter the student should:

 able to understand nature of plant assets
 able to understand acquisition cost of plant, property and equipment
 able to understand economic life and salvage value
 able to understand depreciation methods
 able to understand composite rate depreciation method
 able to understand disposal of depreciable assets
 able to understand depletion – meaning and accounting treatment
 able to understand intangible assets

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 3.1 Nature of plant assets
Plant assets are resources that have three characteristics: they have a physical substance (a
definite size and shape), are used in the operations of a business, and are not intended for sale to
customers. They are also called property, plant, and equipment;plant and equipment; and
fixed assets. These assets are expected to provide services to the company for a number of years.
Except for land, plant assets decline in service potential over their useful lives. Because plant
assets play a key role in ongoing operations, companies keep plant assets in good operating
condition. They also replace worn-out or outdated plant assets, and expand productive resources
as needed. Many companies have substantial investments in plant assets.
Acquisition cost of plant, property and equipment
The cost principle requires that companies record plant assets at cost. Thus Rent-A-Wreck
records its vehicles at cost. Cost consists of all expendituresnecessary to acquire the asset and
make it ready for its intended use.
For example, the cost of factory machinery includes the purchase price, freight costs paid by the
purchaser, and installation costs. Once cost is established, the company uses that amount as the
basis of accounting for the plant asset over its useful life.
In the following sections, we explain the application of the cost principle to each of the major
classes of plant assets.
Land
Companies acquire land for use as a site upon which to build a manufacturing plant or office.
The cost of land includes (1) the cash purchase price, (2) closing costs such as title and attorney’s
fees, (3) real estate brokers’ commissions, and (4) accrued property taxes and other liens
assumed by the purchaser. For example, if the cash price is $50,000 and the purchaser agrees to
pay accrued taxes of $5,000, the cost of the land is $55,000.

Companies record as debits (increases) to the Land account all necessary costs incurred to make
land ready for its intended use. When a company acquires vacant land, these costs include
expenditures for clearing, draining, filling, and grading. Sometimes the land has a building on it
that must be removed before construction of a new building. In this case, the company debits to
the Land account all demolition and removal costs, less any proceeds from salvaged materials.
To illustrate, assume that Hayes Manufacturing Company acquires real estate at a cash cost of
$100,000.The property contains an old warehouse that is razed at a net cost of $6,000 ($7,500 in

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costs less $1,500 proceeds from salvaged materials). Additional expenditures are the attorney’s
fee, $1,000, and the real estate broker’s commission, $8,000.The cost of the land is $115,000,
computed as follows.

Land
Cash price of property $100,000
Net removal cost of warehouse 6,000
Attorney’s fee 1,000
Real estate broker’s commission 8,000
Cost of land $115,000
When Hayes records the acquisition, it debits Land for $115,000 and credits Cash for $115,000.
Land Improvements
Land improvements are structural additions made to land. Examples are driveways, parking
lots, fences, landscaping, and underground sprinklers. The cost of land improvements includes
all expenditures necessary to make the improvements ready for their intended use. For example,
the cost of a new parking lot for Home Depot includes the amount paid for paving, fencing, and
lighting. Thus Home Depot debits to Land Improvements the total of all of these costs. Land
improvements have limited useful lives, and their maintenance and replacement are the
responsibility of the company. Because of their limited useful life, companies expense
(depreciate) the cost of land improvements over their useful lives.
Buildings
Buildings are facilities used in operations, such as stores, offices, factories, warehouses, and
airplane hangars. Companies debit to the Buildings account all necessary expenditures related to
the purchase or construction of a building. When a building is purchased, such costs include the
purchase price, closing costs (attorney’s fees, title insurance, etc.) and real estate broker’s
commission. Costs to make the building ready for its intended use include expenditures for
remodeling and replacing or repairing the roof, floors, electrical wiring, and plumbing.When a
new building is constructed, cost consists of the contract price plus payments for architects’
fees, building permits, and excavation costs.
In addition, companies charge certain interest costs to the Buildings account: Interest costs
incurred to finance the project are included in the cost of the building when a significant period
of time is required to get the building ready for use. In these circumstances, interest costs are
considered as necessary as materials and labor. However, the inclusion of interest costs in the
cost of a constructed building is limited to the construction period. When construction has
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been completed, the company records subsequent interest payments on funds borrowed to
finance the construction as debits (increases) to Interest Expense.
Equipment
Equipment includes assets used in operations, such as store check-out counters, office furniture,
factory machinery, delivery trucks, and airplanes. The cost of equipment, such as Rent-A-Wreck
vehicles, consists of the cash purchase price, salestaxes, freight charges, and insurance
during transit paid by the purchaser. It also includes expenditures required in assembling,
installing, and testing the unit. However, Rent-A-Wreck does not include motor vehicle licenses
and accident insurance on company vehicles in the cost of equipment. These costs represent
annual recurring expenditures and do not benefit future periods. Thus, they are treated as
expenses as they are incurred.
To illustrate, assume Merten Company purchases factory machinery at a cash price of $50,000.
Related expenditures are for sales taxes $3,000, insurance during shipping $500, and installation
and testing $1,000.The cost of the factory machinery is $54,500, computed as follows.
Factory Machinery
Cash price $50,000
Sales taxes 3,000
Insurance during shipping 500
Installation and testing 1,000
Cost of factory machinery $54,500

Merten makes the following summary entry to record the purchase and related expenditures:
Factory Machinery ……………………..54,500
Cash……………………………………… 54,500
(To record purchase of factory machine)
For another example, assume that Lenard Company purchases a delivery truck at a cash price of
$22,000. Related expenditures consist of sales taxes $1,320, painting and lettering $500, motor
vehicle license $80, and a three-year accident insurance policy $1,600. The cost of the delivery
truck is $23,820, computed as follows.
Delivery Truck
Cash price $22,000
Sales taxes 1,320
Painting and lettering 500
Cost of delivery truck $23,820

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Lenard treats the cost of the motor vehicle license as an expense, and the cost of the insurance
policy as a prepaid asset. Thus, Lenard makes the following entry to record the purchase of the
truck and related expenditures:
Delivery Truck………………………………… 23,820
License Expense ………………………………..80
Prepaid Insurance ……………………………….1, 600
Cash ……………………………………………………25,500
(To record purchase of delivery truck and related expenditures)

3.2Economic life and salvage value

Useful life: is an estimate of the expected productive life, also called service life, of the asset.
Useful life may be expressed in terms of time, units of activity (such as machine hours), or units
of output. Useful life is an estimate. In making the estimate, management considers such factors
as the intended use of the asset, its expected repair and maintenance, and its vulnerability to
obsolescence. Past experience with similar assets is often helpful in deciding on expected useful
life. We might reasonably expect Rent-A-Wreck and Avis to use different estimated useful lives
for their vehicles.
Salvage value: is an estimate of the asset’s value at the end of its useful life. This value may be
based on the asset’s worth as scrap or on its expected trade-in value. Like useful life, salvage
value is an estimate. In making the estimate, management considers how it plans to dispose of
the asset and its experience with similar assets.
3.3 Capital expenditures Vs revenue expenditure
3.4Depreciation methods
Depreciation is the process of allocating to expense the cost of a plant asset over its useful
(service) life in a rational and systematic manner.
It is important to understand that depreciation is a process of cost allocation. It is not a
process of asset valuation. No attempt is made to measure thechange in an asset’s market value
during ownership. So, the book value (costless accumulated depreciation) of a plant asset may
be quite differentfrom its market value.
Depreciation applies to three classes of plant assets: land improvements, buildings, and
equipment. Each asset in these classes is considered to be a depreciable asset.Why? Because the
usefulness to the company and revenue-producing ability of each asset will decline over the
asset’s useful life. Depreciation does not apply to land because its usefulness and revenue-
producing ability generally remain intact over time. In fact, in many cases, the usefulness of
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landis greater over time because of the scarcity of good land sites. Thus, land is not a
depreciable asset.
During a depreciable asset’s useful life its revenue-producing ability declines because of wear
and tear. A delivery truck that has been driven 100,000 miles will be less useful to a company
than one driven only 800 miles.
Revenue-producing ability may also decline because of obsolescence. Obsolescence is the
process of becoming out of date before the asset physically wears out. For example, major
airlines moved from Chicago’s Midway Airport to Chicago-O’Hare International Airport because
Midway’s runways were too short for jumbo jets. Similarly, many companies replace their
computers long before they originally planned to do so because improvements in new computing
technology make the old computers obsolete.
Recognizing depreciation on an asset does not result in an accumulation of cash for
replacement of the asset. The balance in Accumulated Depreciation representsthe total amount
of the asset’s cost that the company has charged to expense.It is not a cash fund.
Note that the concept of depreciation is consistent with the going-concern assumption. The
going-concern assumption states that the company will continue in operation for the
foreseeable future. If a company does not use a going-concern assumption, then plant assets
should be stated at their market value. In that case, depreciation of these assets is not needed.
Factors in Computing Depreciation
Three factors affect the computation of depreciation:
1. Cost. Earlier, we explained the issues affecting the cost of a depreciable asset. Recall that
companies record plant assets at cost, in accordance with the cost principle.
2. Useful life: is an estimate of the expected productive life, also called service life, of the asset.
Useful life may be expressed in terms of time, units of activity (such as machine hours), or units
of output. Useful life is an estimate.
In making the estimate, management considers such factors as the intended use of the asset, its
expected repair and maintenance, and its vulnerability to obsolescence. Past experience with
similar assets is often helpful in deciding on expected useful life. We might reasonably expect
Rent-A-Wreck and Avis to use different estimated useful lives for their vehicles.
3. Salvage value: is an estimate of the asset’s value at the end of its useful life. This value may
be based on the asset’s worth as scrap or on its expected trade-in value. Like useful life, salvage
value is an estimate. In making the estimate, management considers how it plans to dispose of
the asset and its experience with similar assets.

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Depreciation is generally computed using one of the following methods:
A. Straight-line
B. Units-of-activity
C. Declining-balance
Each method is acceptable under generally accepted accounting principles. Management selects
the method(s) it believes to be appropriate.The objective is to select the method that best
measures an asset’s contribution to revenue over its useful life. Once a company chooses a
method, it should apply it consistently over the useful life of the asset. Consistency enhances the
comparability of financial statements. Depreciation affects the balance sheet through
accumulated depreciation and the income statement through depreciation expense.
We will compare the three depreciation methods using the following data for a small delivery
truck purchased by Barb’s Florists on January 1, 2010.
Cost $13,000
Expected salvage value $ 1,000
Estimated useful life in years 5
Estimated useful life in miles 100,000
Illustration 10-8 (in the margin) shows the use of the primary depreciation methods in 600 of the
largest companies in the United States.

A. STRAIGHT-LINE
Under the straight-line method, companies expense the same amount of depreciation for each
year of the asset’s useful life. It is measured solely by the passage of time.
In order to compute depreciation expense under the straight-line method, companies need to
determine depreciable cost. Depreciable cost is the cost of the asset less its salvage value. It
represents the total amount subject to depreciation.
Under the straight-line method, to determine annual depreciation expense, we divide depreciable
cost by the asset’s useful life. Illustration 10-9 shows the computation of the first year’s
depreciation expense for Barb’s Florists.

Cost –salvage value=depreciable asset

Br 13,000-br 1,000= Br 12,000

Depreciable cost/useful life=Annual depreciable expense

Br 12,000/5=Br 2,400
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Alternatively, we also can compute an annual rate of depreciation. In this case, the rate is 20%
(100%/ 5 years).When a company uses an annual straight-line rate; it applies the percentage rate
to the depreciable cost of the asset. Illustration shows a depreciation schedule using an annual
rate.
BARB’S FLORISTS
Computation End of Year
Year depreciable * deprecation = annual dep. expense accumulate dep. BV
Cost rate

2010 $12,000 20% $2,400 $ 2,400 $10,600*

2011 12,000 20 2,400 4,800 8,200
2012 12,000 20 2,400 7,200 5,800
2013 12,000 20 2,400 9,600 3,400
2014 12,000 20 2,400 12,000 1,000

Book Value= Cost-Accumulated depreciation =($13,000 - $2,400).

2. UNITS-OF-ACTIVITY
Under the units-of-activity 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-activity
method is ideally suited to factory machinery. Manufacturing companies can measure production
in units of output or in machine hours. This method can also be used for such assets as delivery
equipment (miles driven) and airplanes (hours in use).The units-of-activity method is generally
not suitable for buildings or furniture, because depreciation for these assets is more a function of
time than of use.
To use this method, companies estimate the total units of activity for the entire useful life, and
then divide these units into depreciable cost. The resulting number represents the depreciation
cost per unit. The depreciation cost per unit is then applied to the units of activity during the year
to determine the annual depreciation expense.

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To illustrate, assume that Barb’s Florists drives its delivery truck 15,000 miles in the first year.
Illustration shows the units-of-activity formula and the computation of the first year’s
depreciation expense.

Depreciable cost = depreciable cost per unit Br12, 000 = Br 0.12

Total units of activity 100,000 miles

Depreciable cost per unit * Units activity during the year =annual depreciation expense
Br 0.12 *15,000 miles= Br 1,800
3.DECLINING-BALANCE
The declining-balance method produces a decreasing annual depreciation expense over the
asset’s useful life. The method is so named because the periodic depreciation is based on a
declining book value (cost less accumulated depreciation) of the asset. With this method,
companies compute annual depreciation expense by multiplying the book value at the beginning
of the year by the declining-balance depreciation rate. The depreciation rate remains constant
from year to year, but thebook value to which the rate is applied declines each year.
At the beginning of the first year, book value is the cost of the asset. This is so because the
balance in accumulated depreciation at the beginning of the asset’s useful life is zero. In
subsequent years, book value is the difference between cost and accumulated depreciation to
date. Unlike the other depreciation methods, the declining-balance method does not use
depreciable cost. That is, it ignores salvage value in determining the amount to which the
declining-balance rate is applied.
Salvage value, however, does limit the total depreciation that can be taken. Depreciation stops
when the asset’s book value equals expected salvage value. A common declining-balance rate is
double the straight-line rate. The method is often called the double-declining-balance method.
If Barb’s Florists uses the double-declining-balance method, it uses a depreciation rate of 40% (2
X the straight-line rate of 20%). Illustration shows the declining-balance formula and the
computation of the first year’s depreciation on the delivery truck.

Book value beginning the year * decline balance rate =Annual depreciation expense
Br 13,000 * 40% = Br 5,200
The depreciation schedule under this method is as follows
Computation End of the year
Year Book value begs. Depreciation Annual Accumulated Book value

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 the year X rate = depreciation deprecation
expense
2010 Br 13,000 40% Br 5,200 Br 5,200 Br 7,800
2011 7,800 40 3,120 8,320 4,680
2012 4,680 40 1,872 10,192 2,808
2013 2,808 40 1.123 11,315 1685
2014 1,685 40 685 12,000 1,000

Computation of $674 ($1,685 * 40%) is adjusted to $685 in order for book value to equal salvage
value.
The delivery equipment is 69% depreciated ($8,320 _ $12,000) at the end of the second year.
Under the straight-line method, the truck would be depreciated 40% ($4,800 _ $12,000) at that
time. Because the declining-balance method produces higher depreciation expense in the early
years than in the later years, it is considered an accelerated-depreciation method. The
declining-balance method is compatible with the matching principle. It matches the higher
depreciation expense in early years with the higher benefits received in these years. It also
recognizes lower depreciation expense in later years, when the asset’s contribution to revenue is
less. Some assets lose usefulness rapidly because of obsolescence. In these cases, the declining-
balance method provides the most appropriate depreciation amount.
When a company purchases an asset during the year, it must prorate the first year’s declining-
balance depreciation on a time basis. For example, if Barb’s Florists had purchased the truck on
April 1, 2010, depreciation for 2010 would become
$3,900 ($13,000 * 40% * 9/12). The book value at the beginning of 2011 is then $9,100 ($13,000
- $3,900), and the 2011 depreciation is $3,640 ($9,100 * 40%). Subsequent computations would
follow from those amounts.
COMPARISON OF METHODS
Illustration compares annual and total depreciation expense under each of the three methods for
Barb’s Florists.
HELPFULHINT
The method recommended for an asset that is expected to be significantly more productive in the
first half of its useful life is the declining-balance method.
Year Straight line Units of activity Decline balance
2010 Br 2,400 Br 1,800 Br 5,200
2011 2,400 3,600 3,120

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2012 2,400 2,400 1,872
2013 2,400 3,000 1,123
2014 2,400 1,2000 685
Br 12,000 Br 12,000 Br 12,000

3.5Disposal of depreciable assets

Companies dispose of plant assets in three ways—retirement, sale, orexchange shows.Whatever
the method, at the time of disposal the company must determine the book value of the plant
asset.As noted earlier, book value is the difference between the cost of a plantasset and the
accumulated depreciation to date.
At the time of disposal, the company records depreciation for the fraction ofthe year to the date
of disposal. The book value is then eliminated by (1) debiting(decreasing) Accumulated
Depreciation for the total depreciation to date, and(2) crediting (decreasing) the asset account for
the cost of the asset. In this chapterwe examine the accounting for the retirement and sale of
plant assets. In this chapter we discuss and illustrate the accounting for exchanges ofplant assets.
1. Retirement of Plant Assets
To illustrate the retirement of plant assets, assume that Hobart Enterprises retires its computer
printers, which cost $32,000. The accumulated depreciation on these printers is $32,000. The
equipment, therefore, is fully depreciated (zero book value).The entry to record this retirement is
as follows.
Accumulated Depreciation—Printing Equipment ………32,000
Printing Equipment…………………………………… 32,000
(To record retirement of fully depreciated equipment)

What happens if a fully depreciated plant asset is still useful to the company? In this case, the
asset and its accumulated depreciation continue to be reported on the balance sheet, without
further depreciation adjustment, until the company retires the asset. Reporting the asset and
related accumulated depreciation on the balance sheet informs the financial statement reader that
the asset is still in use.
Once fully depreciated, no additional depreciation should be taken, even if an asset is still being
used. In no situation can the accumulated depreciation on a plant asset exceed its cost.
If a company retires a plant asset before it is fully depreciated, and no cash is received for scrap
or salvage value, a loss on disposal occurs. For example, assume that Sunset Company discards
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delivery equipment that cost $18,000 and has accumulated depreciation of $14,000.The entry is
as follows.
Accumulated Depreciation—Delivery Equipment…………. 14,000
Loss on Disposal…………………………………………….. 4,000
Delivery Equipment……………………………………….18,000
(To record retirement of delivery equipment at a loss)

Companies report a loss on disposal in the “Other expenses and losses” section of the income
statement.
3.6 Depletion – meaning and accounting treatment
Natural resources consist of standing timber and underground deposits of oil, gas,and minerals.
These long-lived productive assets have two distinguishing characteristics:(1) They are
physically extracted in operations (such as mining, cutting, orpumping). (2) They are replaceable
only by an act of nature.
The acquisition cost of a natural resource is the price needed to acquire the resource and prepare
it for its intended use. For an already-discovered resource, such as an existing coal mine, cost is
the price paid for the property. The allocation of the cost of natural resources to expense in a
rational and systematic manner over the resource’s useful life is called depletion. (That is,
depletion is to natural resources as depreciation is to plant assets.) Companies generally usethe
units-of-activity method (learned earlier in the chapter) to compute depletion.The reason is
that depletion generally is a function of the units extracted during theyear.

Under the units-of-activity method, companies divide the total cost of the natural resource minus
salvage value by the number of units estimated to be in the resource. The result is a depletion
cost per unit of product. They then multiply the depletion cost per unit by the number of units
extracted and sold. The result is the annual depletion expense. Illustration shows the formula to
compute depletion expense.

Total cost minus salvage value = depletion cost per unit

Total estimated units
Depletion cost per unit * number of units extracted and sold = Annual depletion expense
To illustrate, assume that Lane Coal Company invests $5 million in a mine estimated to have 10
million tons of coal and no salvage value. In the first year, Lane extracts and sells 800,000 tons
of coal. Using the formulas above, Lane computes the depletion expense as follows:
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$5,000,000 *10,000,000 = $0.50 depletion cost per ton
$0.50 * 800,000 =$400,000 annual depletion expense

Lane records depletion expense for the first year of operation as follows.
Dec. 31 Depletion Expense …………………………400,000
Accumulated Depletion…………………………… 400,000
(To record depletion expense on coal deposits)
The company reports the account Depletion Expense as a part of the cost of producing the
product. Accumulated Depletion is a contra-asset account, similar to accumulated depreciation. It
is deducted from the cost of the natural resource in the balance sheet, as Illustration 10-22 shows.
LANE COAL COMPANY
Balance Sheet (partial)

Coal mine…………………………………………….. $5,000,000

Less: Accumulated depletion ………………………400,000 $4,600,000

Many companies do not use an Accumulated Depletion account. In such cases, the company
credits the amount of depletion directly to the natural resources account.
Sometimes, a company will extract natural resources in one accounting period but not sell them
until a later period. In this case, the company does not expense the depletion until it sells the
resource. It reports the amount not sold as inventory in the current assets section.

3.8 Intangible assets

Intangible asset: an identifiable non-monetary asset without physical substance. An asset is a

resource that is controlled by the entity as a result of past events (for example, purchase or self-
creation) and from which future economic benefits (inflows of cash or other assets) are expected.
[IAS 38.8] Thus, the three critical attributes of an intangible asset are:

 Identifiability
 control (power to obtain benefits from the asset)
 future economic benefits (such as revenues or reduced future costs

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Identifiability: an intangible asset is identifiable when it: [IAS 38.12]

 is separable (capable of being separated and sold, transferred, licensed, rented, or

exchanged, either individually or together with a related contract) or
 arises from contractual or other legal rights, regardless of whether those rights are
transferable or separable from the entity or from other rights and obligations
 patented technology, computer software, databases and trade secrets

 trademarks, trade dress, newspaper mastheads, internet domains

 video and audiovisual material (e.g. motion pictures, television programmes)
 customer lists
 mortgage servicing rights
 licensing, royalty and standstill agreements
 import quotas
 franchise agreements
 customer and supplier relationships (including customer lists)
 marketing rights

Intangibles can be acquired:

 by separate purchase
 as part of a business combination
 by a government grant
 by exchange of assets
 by self-creation (internal generation)

3.8.1 Recognition

Recognition criteria: IAS 38 requires an entity to recognise an intangible asset, whether

purchased or self-created (at cost) if, and only if: [IAS 38.21]

 it is probable that the future economic benefits that are attributable to the asset will flow
to the entity; and
 The cost of the asset can be measured reliably.
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This requirement applies whether an intangible asset is acquired externally or generated
internally. IAS 38 includes additional recognition criteria for internally generated intangible
assets (see below).

The probability of future economic benefits must be based on reasonable and supportable
assumptions about conditions that will exist over the life of the asset. [IAS 38.22] The
probability recognition criterion is always considered to be satisfied for intangible assets that are
acquired separately or in a business combination. [IAS 38.33]

If recognition criteria not met: If an intangible item does not meet both the definition of and
the criteria for recognition as an intangible asset, IAS 38 requires the expenditure on this item to
be recognised as an expense when it is incurred. [IAS 38.68]

Business combinations. There is a presumption that the fair value (and therefore the cost) of an
intangible asset acquired in a business combination can be measured reliably. [IAS 38.35] An
expenditure (included in the cost of acquisition) on an intangible item that does not meet both the
definition of and recognition criteria for an intangible asset should form part of the amount
attributed to the goodwill recognised at the acquisition date.

Reinstatement. The Standard also prohibits an entity from subsequently reinstating as an

intangible asset, at a later date, an expenditure that was originally charged to expense. [IAS
38.71]

Initial recognition: research and development costs

 Charge all research cost to expense. [IAS 38.54]

 Development costs are capitalised only after technical and commercial feasibility of the
asset for sale or use have been established. This means that the entity must intend and be
able to complete the intangible asset and either use it or sell it and be able to demonstrate
how the asset will generate future economic benefits. [IAS 38.57]

If an entity cannot distinguish the research phase of an internal project to create an intangible
asset from the development phase, the entity treats the expenditure for that project as if it were
incurred in the research phase only.

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Initial recognition: in-process research and development acquired in a business
combination

A research and development project acquired in a business combination is recognised as an asset

at cost, even if a component is research. Subsequent expenditure on that project is accounted for
as any other research and development cost (expensed except to the extent that the expenditure
satisfies the criteria in IAS 38 for recognising such expenditure as an intangible asset). [IAS
38.34]

Initial recognition: internally generated brands, mastheads, titles, lists

Brands, mastheads, publishing titles, customer lists and items similar in substance that are
internally generated should not be recognised as assets. [IAS 38.63]

Initial recognition: computer software

 Purchased: capitalise
 Operating system for hardware: include in hardware cost
 Internally developed (whether for use or sale): charge to expense until technological
feasibility, probable future benefits, intent and ability to use or sell the software,
resources to complete the software, and ability to measure cost.
 Amortisation: over useful life, based on pattern of benefits (straight-line is the default).

Initial recognition: certain other defined types of costs

The following items must be charged to expense when incurred:

 internally generated goodwill [IAS 38.48]

 start-up, pre-opening, and pre-operating costs [IAS 38.69]
 training cost [IAS 38.69]
 advertising and promotional cost, including mail order catalogues [IAS 38.69]
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  relocation costs [IAS 38.69]

For this purpose, 'when incurred' means when the entity receives the related goods or services. If
the entity has made a prepayment for the above items, that prepayment is recognised as an asset
until the entity receives the related goods or services.

3.8.2 Initial measurement

Intangible assets are initially measured at cost.

Measurement subsequent to acquisition: cost model and revaluation models allowed

An entity must choose either the cost model or the revaluation model for each class of intangible
asset.

Cost model. After initial recognition intangible assets should be carried at cost less accumulated
amortisation and impairment losses.

Revaluation model. Intangible assets may be carried at a revalued amount (based on fair value)
less any subsequent amortisation and impairment losses only if fair value can be determined by
reference to an active market. [IAS 38.75] Such active markets are expected to be uncommon for
intangible assets. [IAS 38.78] Examples where they might exist:

 production quotas
 fishing licences
 taxi licences

Under the revaluation model, revaluation increases are recognised in other comprehensive
income and accumulated in the "revaluation surplus" within equity except to the extent that they
reverse a revaluation decrease previously recognised in profit and loss. If the revalued intangible
has a finite life and is, therefore, being amortised (see below) the revalued amount is amortised.
[IAS 38.85]

Classification of intangible assets based on useful life

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Intangible assets are classified as: [IAS 38.88]

 Indefinite life: no foreseeable limit to the period over which the asset is expected to
generate net cash inflows for the entity.
 Finite life: a limited period of benefit to the entity.

3.8.2.1 Measurement subsequent to acquisition: intangible assets with finite lives

The cost less residual value of an intangible asset with a finite useful life should be amortised on
a systematic basis over that life: [IAS 38.97]

 The amortisation method should reflect the pattern of benefits.

 If the pattern cannot be determined reliably, amortise by the straight-line method.
 The amortisation charge is recognised in profit or loss unless another IFRS requires that it
be included in the cost of another asset.
 The amortisation period should be reviewed at least annually. [IAS 38.104]

Expected future reductions in selling prices could be indicative of a higher rate of consumption
of the future economic benefits embodied in an asset. [IAS 18.92]

The standard contains a rebuttable presumption that a revenue-based amortisation method for
intangible assets is inappropriate. However, there are limited circumstances when the
presumption can be overcome:

 The intangible asset is expressed as a measure of revenue; and

 it can be demonstrated that revenue and the consumption of economic benefits of the
intangible asset are highly correlated. [IAS 38.98A]

Note: The guidance on expected future reductions in selling prices and the clarification regarding
the revenue-based depreciation method were introduced by Clarification of Acceptable Methods
of Depreciation and Amortisation, which applies to annual periods beginning on or after 1
January 2016.

Examples where revenue based amortisation may be appropriate

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IAS 38 notes that in the circumstance in which the predominant limiting factor that is inherent in
an intangible asset is the achievement of a revenue threshold, the revenue to be generated can be
an appropriate basis for amortisation of the asset. The standard provides the following examples
where revenue to be generated might be an appropriate basis for amortisation: [IAS 38.98C]

 A concession to explore and extract gold from a gold mine which is limited to a fixed
amount of revenue generated from the extraction of gold
 A right to operate a toll road that is based on a fixed amount of revenue generation from
cumulative tolls charged.

The asset should also be assessed for impairment in accordance with IAS 36. [IAS 38.111]

3.8.2.2 Measurement subsequent to acquisition: intangible assets with indefinite useful lives

An intangible asset with an indefinite useful life should not be amortised. [IAS 38.107]

Its useful life should be reviewed each reporting period to determine whether events and
circumstances continue to support an indefinite useful life assessment for that asset. If they do
not, the change in the useful life assessment from indefinite to finite should be accounted for as a
change in an accounting estimate. [IAS 38.109]

The asset should also be assessed for impairment in accordance with IAS 36. [IAS 38.111]

Subsequent expenditure

Due to the nature of intangible assets, subsequent expenditure will only rarely meet the criteria
for being recognised in the carrying amount of an asset. [IAS 38.20] Subsequent expenditure on
brands, mastheads, publishing titles, customer lists and similar items must always be recognised
in profit or loss as incurred. [IAS 38.63]

3.8.3 Disclosure

For each class of intangible asset, disclose: [IAS 38.118 and 38.122]

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  Useful life or amortisation rate
 Amortisation method
 Gross carrying amount
 Accumulated amortisation and impairment losses
 Line items in the income statement in which amortisation is included
 Reconciliation of the carrying amount at the beginning and the end of the period
showing:
o additions (business combinations separately)
o assets held for sale
o retirements and other disposals
o revaluations
o impairments
o reversals of impairments
o amortisation
o foreign exchange differences
o other changes
 Basis for determining that an intangible has an indefinite life
 Description and carrying amount of individually material intangible assets
 Certain special disclosures about intangible assets acquired by way of government grants
 Information about intangible assets whose title is restricted
 Contractual commitments to acquire intangible assets

Additional disclosures are required about:

 intangible assets carried at revalued amounts

 the amount of research and development expenditure recognised as an expense in the
current period

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 Summery

The cost of plant assets includes all expenditures necessary to acquire the asset and make it ready
for its intended use. Cost is measured by the cash or cash equivalent price paid. After the passage
of time or use most of the plant assets are exposed for depreciation. Depreciation is the allocation
of the cost of a plant asset to expense over its useful (service) life in a rational and systematic
manner. The allocation of the cost of natural resources to expense in a rational and systematic
manner over the resource’s useful life is called depletion. Depreciation is not a process of
valuation, nor is it a process that results in an accumulation of cash. Deprecation can be
computed in Straight-line method, units-of- Varying Depreciation cost per activity amount unit,
Units of activity method and Declining- Decreasing methods. Companies make revisions of
periodic depreciation in present and future periods, not retroactively. They determine the new

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annual depreciation by dividing the depreciable cost at the time of the revision by the remaining
useful life. Companies dispose of plant assets in three ways—retirement, sale, or exchange
shows. Whatever the method, at the time of disposal the company must determine the book value
of the plant asset. At the time of disposal, the company records depreciation for the fraction of
the year to the date of disposal. The book value is then eliminated by (1) debiting (decreasing)
Accumulated Depreciation for the total depreciation to date, and (2) crediting (decreasing) the
asset account for the cost of the asset. The other issue of this chapter is intangible asset.
Intangible asset is an identifiable non-monetary asset without physical substance. An asset is a
resource that is controlled by the entity as a result of past events (for example, purchase or self-
creation) and from which future economic benefits (inflows of cash or other assets) are expected.
Thus, the three critical attributes of an intangible asset are identifiability, control (power to obtain
benefits from the asset) and future economic benefits (such as revenues or reduced future costs).
Patented technology, computer software, databases and trade secrets trademarks, trade dress,
newspaper mastheads, internet domains etc. are the examples of intangible asset.

Self-checked questions

Match the statement with the term most directly associated with it.
Copyright Depletion
Intangible asset Franchise
Research and development costs
1. _______ the allocation of the cost of a natural resource to expense in a rational and systematic
manner.

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2. _______ rights, privileges, and competitive advantages that result from the ownership of long-
lived assets that do not possess physical substance.
3. _______ an exclusive right granted by the federal government to reproduce and sell an artistic
or published work.
4. ______________A right to sell certain products or services or to use certain trademarks
or trade names within a designated geographic area.
5. ________ Costs incurred by a company that often lead to patents or new products. These costs
must be expensed as incurred.
Multiple choices
1. Erin Danielle Company purchased equipment and incurred the following costs.
Cash price …………………………$24,000
Sales taxes ………………………….1,200
Insurance during transit ……………….200
Installation and testing………………. 400
Total costs………………… $25,800
2. What amount should be recorded as the cost of theequipment?
a. $24,000.
b. $25,200.
c. $25,400.
d. $25,800.
3. Depreciation is a process of:
a. valuation.
b. cost allocation.
c. cash accumulation.
d. appraisal
4. Micah Bartlett Company purchased equipment on January 1, 2009, at a total invoice cost of
$400,000.The equipment has an estimated salvage value of $10,000 and an estimated useful life
of 5 years. The amount of accumulated depreciation at December 31, 2010, if the straight-line
method of depreciation is used, is:
a. $80,000.
b. $160,000.
c. $78,000.
d. $156,000.

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4. Ann Torbert purchased a truck for $11,000 on January 1, 2009. The truck will have an
estimated salvage value of $1,000 at the end of 5 years. Using the units-of-activity method, the
balance in accumulated depreciation at December 31, 2010, can be computed by the following
formula:
a. ($11,000 _Total estimated activity) _ Units of activity for 2010.
b. ($10,000 _Total estimated activity) _ Units of activity for 2010.
c. ($11,000 _Total estimated activity) _ Units of activity for 2009 and 2010.
d. ($10,000 _Total estimated activity) _ Units of activity for 2009 and 2010.

5. When there is a change in estimated depreciation:

a. previous depreciation should be corrected.
b. current and future years’ depreciation should be revised.
c. only future years’ depreciation should be revised.
d. None of the above.
6. Able Towing Company purchased a tow truck for $60,000 on January 1, 2010. It was
originally depreciated on a straight-line basis over 10 years with an assumed salvage value of
$12,000. On December 31, 2012, before adjusting entries had been made, the company decided
to change the remaining estimated life to 4 years (including 2012) and the salvage value to
$2,000.What was the depreciation expense for 2012?
a. $6,000.
b. $4,800.
c. $15,000.
d. $12,100.
Workout question
On January 1, 2010, Skyline Limousine Co. purchased a limo at an acquisition cost of $28,000.
The vehicle has been depreciated by the straight-line method using a 4-year service life and a
$4,000 salvages value. The company’s fiscal year ends on December 31.
Instructions
Prepare the journal entry or entries to record the disposal of the limousine assuming that
it was:
(a) Retired and scrapped with no salvage value on January 1, 2014.
(b) Sold for $5,000 on July 1, 2013.

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 UNIT FOUR

4. ACCOUNTING FOR PARTNERSHIPS

Chapter objectives
At the end of the chapter the student should
 Identify the Partnership characteristics
 Identify the advantages and disadvantages of a partnership
 Able to recording investments of partners
 Able to distribution of partnership income and losses
 Able to understand Revaluation of assets
 Able to understand Admission of a new partner

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4.0 Definition:

A partnership is a voluntary association of two or more people to pursue a business for a profit as
a co-owner. Partnerships are common especially in small retail and service business. Many
professional practitioners, including physicians, lawyers, and accountants, also organize their
practices as a partnerships.

4.1 Characteristics of partnerships

Partnerships are an important type of organization because they offer certain advantages with
their unique characteristics.

 Limited Life: A partnership legally ceases to exist upon the withdrawal, bankruptcy or
death of an existing partner, the admission of a new partner, or the voluntary dissolution
of the entity.

 Mutual Agency: Each partner is a fully authorized agent of the partnership. As its agent,
a partner can commit or bind the partnership to any contract within the scope of the
partnership business on its behalf. Thus the acts of each partner bind the partnership and
become the responsibility of all partners.

 Co-ownership of partnership property: partnership assets are owned jointly by all

partners. Any investment by a partner becomes the joint property of all partners. Partners
have a claim on partnership assets based on their capital account and the partnership
contract.

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  Unlimited Liability: In case of insolvency, each partner is individually responsible for
the liabilities of the partnership, regardless of the amount of equity that the partner has in
the partnership. Thus, if a partnership becomes insolvent, the partners must contribute
sufficient personal assets to settle the debts of the partnership. This feature is one of the
major differences between partnerships and the corporate form of organization, where
shareholders are not personally liable for the company’s debts. This major disadvantage
of unlimited liability can be circumvented by the formation of a limited partnership, but
the acts that allow this type of partnership require that at least one partner be a general
partner and that the partnership name not contain any of the names of the limited
partners.

 Nontaxable entity: a partnership has the same tax status as a sole proprietorship and is
not subject to federal income taxes on its income. The individual partners must report
their distributive share of partnership income on their personal tax returns. It paid a single
tax
4.2 Advantages and Disadvantages of Partnerships

Advantages: a partnership is relatively easy and inexpensive to organize, requiring only an

agreement between two or more persons. A partnership has the advantage of being able to bring
more capital, more managerial skills, and more experiences than would a sole proprietorship.
Because the partnership is a nontaxable entity, the combined income taxes paid by the individual
partners may be lower than the net income taxes that would be paid by a corporation, which is a
taxable entity.

Disadvantages: the disadvantages of a partnership are that its life is limited, each partner has
unlimited liability and one partner can bind the partnership to contracts. Also, raising large
amounts of capital is more difficult for a partnership than for a corporation.

4.3 Accounting for Partnership :Recording Initial Investments:

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A separate entry is made for the investments of each partner in a partnership. The various assets
contributed by a partner are debited to the proper asset accounts. In each entry, the monetary
amounts at which the non-cash assets are stated are those agreed upon by the partners. In arriving
at an appropriate amount for such assets, consideration should be given to their market values at
the time the partnership is formed. If liabilities are assumed by the partnership, the appropriate
liability accounts are credited. The partner’s capital account is credited for the net amount.

Illustration:

A, B, and C formed a partnership; A contributed $50,000 in cash and inventory with a fair market
value of $100,000 in the partnership; B contributed equipment with a fair market value of
$180,000 and a building with a fair market value of $150,000 in the partnership; C contributed
$100,000 in cash and equipment with a fair market value of $90,000 and in addition to this ‘C’
transferred a liability of $30,000 to the partnership. The entry to record the assets contributed and
the liabilities transferred by ‘A’, ‘B’, and ‘C’.

Cash--------------------------------------$150,000

Inventory---------------------------------100,000

Equipment--------------------------------270,000

Building-----------------------------------150,000

Accounts Payable---------- 30,000

A, Capital-------------------- 150,000

B, Capital--------------------- 330,000

C, Capital--------------------- 160,000

4.4 Division of Net income or Net loss

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As in the case of a sole proprietorship, the net income of a partnership may be said to include a
return for the services of the owners, for the capital invested, and for economic or pure profit. It
should be noted that division of the net income or net loss among the partners in exact
accordance with their partnership agreement is of the utmost importance. If the agreement is
silent on the matter, the law provides that all partners share equally, regardless of differences in
amounts of capital contributed, of special skills possessed, or of time devoted to the business.
The partners may, however, make any agreement they wish in regard to the division of net
income and net loss.

 Income Division Recognizing Services of Partners

As a means of recognizing differences in ability and amount of time devoted to the business,
articles of partnership often provide for the division of a portion of net income to the partners in
the form of a salary allowances.

Illustration:

Assume that the articles of partnership of Abebe and Emebet provide for monthly salary
allowances of Birr 2,500 and Birr 2,000 respectively, with the balances of the net income to be
divided equally, and that the net income for the year is Birr 75,000.

Net income---------------------------------------------------------------------Birr 75,000

Division of net income: Abebe Emebet Total

Salary allowance------------------- Birr 2500 Birr 2000 Birr 4500

Remaining income---------------- 35,250 35,250 71,500

Net income---------------------- Birr 37,750 Birr 37,250 Birr 75,000

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The division of net income is recorded as a closing entry, regardless of whether the partners
actually withdraw the amounts of their salary allowances. The entry for the division of net
income is as follows:

December 31:

Income summary----------------------------75,000

Abebe, Capital-----------------------------------37,750

Emebet, Capital----------------------------------37,250

If Abebe and Emebet had withdrawn their salary allowances monthly, the withdrawals would
have accumulated as debits in the drawing accounts during the year. At the end of the year, the
debit balances of Birr 30,000 and Birr 24,000 in their drawing accounts would be transferred to
their respective capital accounts.

 Income Division Recognizing Services of Partners and Investment

Partners may agree the most equitable plan of income sharing is to allow salaries based on the
services rendered and also to allow interest on the capital investments. The remainder is then
shared in an arbitrary ratio.

Illustration:

Assume that Abebe and Emebet (1) are allowed monthly salaries of Birr 2,500 and Birr 2,000
respectively; (2) are allowed interest at 12% on capital balances at January 1 of the current fiscal
year, which amounted to Birr 80,000 and Birr 60,000 respectively; and (3) divide the remainder
of net income equally.

Net income----------------------------------------------------------------------------------Birr 75,000

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Division of net income: Abebe Emebet Total

Salary allowance-------------------Birr 30,000 Birr 24,000 Birr 54,000

Interest allowance-----------------Birr 9,600 Birr 7,200 Birr 16,800

Remaining income---------------- 2,100 2,100 4,200

Net income-------------------------Birr 41,700 Birr 33,300 Birr 75,000

 Income Division-Allowances Exceed Net Income

In the illustration presented above, the net income has exceeded the sum of the allowances for
salary and interest. If the net income is less than the total of the special allowances, the
“remaining balance” will be a negative figure that must be divided among the partners as though
it were a net loss.

Illustration:

Take the above example but change the net income as though it were Birr 50,000.

Net income------------------------------------------------------------------------Birr 50,000

Division of net income: Abebe Emebet Total

Salary allowance-----------------Birr 30,000 Birr 24,000 Birr 54,000

Interest allowance---------------Birr 9,600 Birr 7,200 Birr 16,800

Excess of allow. Over income-- -(10,400) (10,400) (20,800)

Net income---------------------Birr 29,200 Birr 20,800 Birr 50,000

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 Partnership Dissolution

One of the basic characteristics of the partnership form of organization is its limited life. Any
change in the personnel of the ownership results in the dissolution of the partnership. Thus,
admission of a new partner dissolves the old firm. Similarly, death, bankruptcy, or withdrawal of
a partner causes dissolution. Dissolution of partnership is not necessary followed by the winding
up of the affairs of the business. For example, a partnership composed of two partners may admit
an additional partner. Or if one of three partners in a business withdraws, the remaining partners
may continue to operate the business. In all such cases, a new partnership is formed and new
articles of partnership should be prepared.

4.5 Revaluation of Assets:

If the partnership assets are not fairly stated in terms of current market value at the time a new
partner is admitted, the accounts may be adjusted accordingly. The net amount of the increases
and decreases in asset values are then allocated to the capital accounts of the old partners
according to their income-sharing ratio.

Illustration:Assume that in the above illustration for the Donald and Gerald partnership the
balance of the merchandise inventory account had been $14,000 and the current replacement
price had been $17,000. Prior to Sharon’s admission, the revaluation would be recorded as
follows, assuming that Donald and Gerald share net income equally.

Merchandise inventory----------------3,000

Donald, Capital------------------ 1,500

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 Gerald, Capital------------------- 1,500

Goodwill:When a new partner is admitted to a partnership, goodwill attributable either to the old
partnership or to the incoming partner may be recognized. Although there are various methods of
estimating goodwill, such factors are the respective shares owned by the partners and the relative
bargaining abilities of the partners will influence the final determination. The amount of
goodwill agreed upon is recorded as an asset, with a corresponding credit to the appropriate
capital accounts.

Illustration 1: Assume that on March 1 the partnership of Marsha and Helen admits William
who is to contribute cash of $15,000. After the tangible assets of the old partnership have been
adjusted to market value prices, the capital balances of Marsha and Helen are $20,000 and
$24,000. The parties agree, however, that the enterprise is worth $50,000. The excess of $50,000
over the capital balances of $44,000 ($20,000 + $24,000) indicates the existence of $6,000 of
goodwill. This $6,000 should be divided between the capital accounts of the original partners
according to their income sharing agreement.

The entries to record the goodwill and the admission of the new partner, assuming that the
original partners share equally in net income, are as follows:

1. To record the recognition of goodwill to the old partners

Goodwill-------------------------------------6,000

Marsha, Capital-------------------- 3,000

Helen, Capital---------------------- 3,000

2. To record the admission of a new partner

Cash-------------------------------------15,000

William, Capital---------------- 15,000

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Illustration 2: Assume that Sandra is to be admitted to the partnership of Cowen and Dodd for
an investment of $30,000. If the parties agree to recognize $5,000 of goodwill attributable to
Sandra, the entry to record her admission is as follows:

Cash-----------------------30,000

Goodwill------------------5,000

Sandra, Capital----- 35,000

4.6 Admission of a Partner:

An additional person may be admitted to a partnership enterprise only with the consent of the
current partners. An additional person may be admitted to a partnership through either of two
procedures.

1. Purchase of an interest from one or more of the current partners.

2. Contribution of assets to the partnership.

Admission by purchase of an interest from one or more of the current

partners: when an additional person may be admitted to a partnership by purchasing an
interest from one or more of the existing partners, the capital interest of the incoming partner is
obtained from current partners, and neither the total asset nor the total owner’s equity of the
business is affected. The purchase price is paid directly to the selling partners. Payment is for
partnership equity owned by the partners as individuals, and hence the cash or other
consideration paid is not recorded in the accounts of the partnership. The only entry needed is the
transfer of the proper amounts of owner’s equity from the capital accounts of the selling partners
to the capital account established for the incoming partner.

Example: assume that partners Tom and Nathan have capital balances of $50,000 each. On June
1, each sells one fifth of his respective equity to Joe for $10,000 in cash. The exchange of cash is
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not a partnership transaction and thus is not recorded by the partnership. The only entry required
in the partnership accounts is as follows

Tom, Capital------------------------10,000

Nathan, Capital--------------------10,000

Joe, Capital------------------ 20,000

Admission by Contribution of Assets: - Instead of buying an interest from the current partners,
the incoming partner may contribute assets to the partnership. In this case both the assets and the
owner’s equity of the firm are increased.

Illustration: - Assume that Donald and Gerald are partners with capital accounts of $35,000 and
$25,000 respectively. On June 1, Sharon invests $20,000 cash in the business, for which she is to
receive ownership equity of $20,000. The entry to record this transaction is as follows:

Cash----------------------------------------20,000

Sharon, Capital----------------- 20,000

With the admission of Sharon, the total owners’ equity of the new partnership becomes
$80,0000.

Withdrawal of a Partner

When a partner retires or for some reason wishes to withdraw from the firm, one or more of the
remaining partners may purchase the withdrawing partner’s interest and the business may be
continued without apparent interruption. In such cases, settlement for the purchase and sale is
made between the partners as individuals, in a manner similar to the admission of a new partner
by purchase of an interest, and thus is not recorded by the partnership. The only entry required by

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the partnership is a debit to the capital account of the partner withdrawing and a credit to the
capital account of the partner or partner’s acquiring the interest.

Illustration 1: Alan is to retire/withdraw from the partnership of Theodor, Alan, and Smith. The
capital balances of the partners are as follows: Alan, $ 200,000; Theodor, $100,000; and Smith, $
100,000. Alan has sold his interest to Theodor for $200,000. Hence, the only entry required by
the partnership to record the withdrawal of Alan is follows:

Alan, Capital-------------------------------200,000

Theodor, Capital------------------- 200,000

N.B: when a partner withdraws him/her from the partnership by selling his/her interest to one or
more of the existing partners, the capital interest of the outgoing partner is given to the current
partners purchasing the interest, and the total asset nor the total owner’s equity of the business is
affected.

However, if the settlement with the withdrawing partner is made by the partnership, the effect is
to reduce the assets and the owner’s equity of the firm. To determine the ownership equity of the
withdrawing partner, the asset accounts should be adjusted to current market prices. The net
amount of the adjustments should be divided among the capital accounts of the partners
according to the income sharing ratio. In the event that the cash or the other available assets are
insufficient to make complete payment at the time of withdrawal, a liability account should be
credited for the balance owed to the withdrawing partner.

Illustration 2:

Alan is to retire/withdraw from the partnership of Alan, Theodor, and Smith. The capital balances
of the partners are as follows: Alan, $ 200,000; Theodor, $100,000; and Smith, $ 100,000. Their

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net income/net loss sharing ratio is 2:1:1 respectively. At the time of the valuation of assets at
their market prices, the partners agreed that the merchandise inventory should be increased by
$10,500 and the allowance for doubtful accounts should be increased by $2,100.

Required: - Present entries to record;

1. The adjustment of the assets to bring them into agreement with market prices.
2. The withdrawal of Alan from the partnership if (a) Alan receives the full amount in cash
(b) Alan agreed to accept an interest bearing note of $150,000 in partial settlement of his
ownership equity and the remainder of his claim to receive in cash.

Solution:

1. Merchandise inventory--------------------------------10,500
Alan, Capital------------------------------------ 4,200
Theodor, Capital------------------------------- 2,100
Smith, Capital---------------------------------- 2,100
Allowance for doubtful accounts--------- 2,100

2. (a) Alan, Capital-----------------------------204,200

Cash---------------------------------- 204,200
(b) Alan, Capital--------------------------204,200
Notes payable------------------ 150,000
Cash------------------------------- 54,200

Death of a Partner

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The death of a partner dissolves the partnership. In the absence of any contrary agreement, the
accounts should be closed as of the date of death, and the net income for the fractional part of the
year should be transferred to the capital accounts. The balance in the capital account of the
deceased partner is then transferred to a liability account until the law orders to whom should the
deceased capital should be given.

Liquidation of Partnership

Liquidation is refers to the process of a wind-up of a business firm. When a partnership goes out
of business, it usually sells the assets (i.e. non cash assets). The sale of non-cash assets is called
realization. During the process of realization, any gain or loss resulted from the sale of non-cash
assets is shared among the partners based on their income sharing agreement. As cash is realized,
it is applied first to the payment of the claims of creditors. After all liabilities have been paid, the
remaining cash is distributed to the partners, based on their ownership equities as indicated by
their capital accounts.

Illustration:-

The partnership of Dawit, Alemu, and Almaz share income in a ratio of 5:3:2, after discontinuing
the ordinary business operations of their partnership and closing the accounts, the following
summary of the general ledger is prepared:

Cash-------------------------------------$11,000

Non cash assets----------------------- 64,000

Liabilities------------------------------- $9,000

Dawit, Capital------------------------- 22,000

Alemu, Capital------------------------ 22,000

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Almaz, Capital------------------------22,000

Total-------------------------------$75,000 $75,000

Based on these facts, accounting for the liabilities of the partnership will be illustrated using
three different selling prices for the non-cash assets.

Gain on Realization

Dawit, Alemu, and Almaz sell all non-cash assets for $72,000, realizing a gain of $8,000
($72,000 - $64,000). The gain is divided among the capital accounts of the partners in the income
sharing ratio of 5:3:2. The liabilities are paid, and the remaining cash is distributed to the
partners according to the balances in their capital accounts. A statement of partnership
liquidation, which summarizes the liquidation process, is presented hereunder:

Dawit, Alemu, and Almaz

Statement of Partnership Liquidation

For period of xxxx

Capital

Non cash DawitAlemuAlmaz

CashAssets = Liab. + (50%) + (30%) + (20%)

Balance before realization.. 11,000 64,000 9,000 22,000 22,000 22,000

Sale of non-cash assets &

Division of gain………….. +72,000 -64,000 - +4,000 +2,400 +1,600

Balance after realization… 83,000 -0- 9,000 26,000 24,400 23,600

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Payment of liabilities…….. -9,000 - -9,000 - - -

Bal. after payment of liab.. 74,000 -0- -0- 26,000 24,400 23,600

Distrib.of cash to part…... -74,000 - - -26,000 -24,400 -23,600

Final balances……………. -0- -0- -0- -0- -0- -0-

The entries to record the several steps in the liquidation procedure are as follows:

1. To record the sale of non-cash assets

Cash-------------------------------------72,000
Non cash assets------------------ 64,000
Loss & gain on realization--- 8,000
2. To record the division of gain
Loss & gain on realization-------8,000
Dawit, Capital------------------- 4,000
Alemu, Capital------------------ 2,400
Almaz, Capital------------------ 1,600
3. To record the payment of liabilities
Liabilities------------------------------9,000
Cash------------------------------- 9,000
4. To record the distribution of cash to partners
Dawit, Capital-----------------------26,000
Alemu, Capital----------------------24,400
Almaz, Capital----------------------23,600
Cash-------------------------- 74,000

Loss on Realization; No Capital Deficiencies

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Assume that the foregoing example, Dawit, Alemu, and Almaz dispose all of non-cash assets for
$44,000, incurring a loss of $20,000 ($64,000 - $74,000). The various steps in the statement of
partnership liquidation are presented hereunder:

Dawit, Alemu, and Almaz

Statement of Partnership Liquidation

For period of xxxx

Capital

Non cash Dawit Alemu Almaz

CashAssets = Liab. + (50%) + (30%) + (20%)

Balance before realization.. 11,000 64,000 9,000 22,000 22,000 22,000

Sale of non cash assets &

Division of loss.………….. +44,000 -64,000 - -10,000 -6,000 -

4,000

Balance after realization… 55,000 -0- 9,000 12,000 16,000 18,000

Payment of liabilities…….. -9,000 - -9,000 - - -

Bal. after payment of liab.. 46,000 -0- -0- 12,000 16,000 18,000

Distrib.of cash to part…... -46,000 - - -12,000 -16,000 -18,000

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Final balances……………. -0- -0- -0- -0- -0- -0-

The entries to record the several steps in the liquidation procedure are as follows:

1. To record the sale of non-cash assets

Cash-------------------------------------44,000
Loss & gain on realization--------20,000
Non cash assets------------------ 64,000
2. To record the division of gain
Dawit, Capital------------------- 10,000
Alemu, Capital------------------ 6,000
Almaz, Capital------------------ 4,000
Loss & gain on realization-------20,000

3. To record the payment of liabilities

Liabilities------------------------------9,000
Cash------------------------------- 9,000
4. To record the distribution of cash to partners
Dawit, Capital-----------------------12,000
Alemu, Capital----------------------16,000
Almaz, Capital----------------------18,000
Cash-------------------------- 46,000

Loss on Realization; Capital Deficiency

Assume that the foregoing example, Dawit, Alemu, and Almaz dispose all of non cash assets for
$10,000, incurring a loss of $54,000 ($64,000 - $10,000). The various steps in the statement of
partnership liquidation are presented hereunder:

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Dawit, Alemu, and Almaz

Statement of Partnership Liquidation

For period of xxxx

Capital

Non cash Dawit Alemu Almaz

CashAssets = Liab. + (50%) + (30%) + (20%)

Balance before realization.. 11,000 64,000 9,000 22,000 22,000 22,000

Sale of non cash assets &

Division of loss………….. +10,000 -64,000 - -27,000 -16,200 -10,800

Balance after realization… 21,000 -0- 9,000 -5,000 5,800 11,200

Payment of liabilities…….. -9,000 - -9,000 - - -

Bal. after payment of liab.. 12,000 -0- -0- -5,000 5,800 11,200

Distrib.of cash to part…... -12,000 - - - -2,800 -9,200

Final balances……………. -0- -0- -0- -5,000 3,000 2,000

The entries to record the liquidation to this point are as follows:

1. To record the sale of non-cash assets

Cash-------------------------------------10,000
Loss & gain on realization--------54,000
Non cash assets------------------ 64,000
2. To record the division of gain

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 Dawit, Capital------------------- 27,000
Alemu, Capital------------------ 16,200
Almaz, Capital------------------ 10,800
Loss & gain on realization-------54,000
3. To record the payment of liabilities
Liabilities------------------------------9,000
Cash------------------------------- 9,000
4. To record the distribution of cash to partners
Alemu, Capital----------------------2,800
Almaz, Capital----------------------9,200
Cash-------------------------- 12,000

N.B: The affairs of the partnership are not completely wound up until the claims among the
partners are settled. Payments to firm by the deficient partner are credited to that partner’s capital
account. Any uncollectible deficiency becomes a loss to the partnership and is written off against
the balances of the remaining partners. Finally, the cash received from the deficient partner is
distributed to the other partners according to their ownership claims.

Assumption 1: Dawit pays the entire amount of the $5,000 deficiency to the partnership (no
loss).

The receipt of the $5,000 paid by Dawit to the partnership and the distribution of the $5,000 to
the partners are indicated in the following statement of partnership liquidation.

Dawit, Alemu, and Almaz

Statement of Partnership Liquidation

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 For period of xxxx

Capital

Non cash DawitAlemuAlmaz

CashAssets = Liab. + (50%) + (30%) + (20%)

Balance…………………….. -0- -0- -0- -5,000 3,000 2,000

Receipt of deficiency…… +5,000 -0- - +5,000 - -

Balance………………..… 5,000 -0- -0- -0- 3,000 2,000

Distrib.of cash to part…... -5,000 - - - -3,000 -2,000

Final balances……………. -0- -0- -0- -0- -0- -0-

The entries to record the final settlement are as follows:

1. To record the receipt of deficiency

Cash--------------------------------------5,000
Dawit, Capital--------------------- 5,000
2. To record the distribution of cash to partners
Alemu, Capital---------------------------3,000
Almaz, Capital---------------------------2,000
Cash----------------------------------- 5,000

Assumption 2:Dawit pays $3,000 of the deficiency to the partnership, and the remainder is
considered to be uncollectible ($2,000 loss)

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The receipt of the $3,000 paid by Dawit to the partnership, the division of the $2,000 loss, and
the distribution of the $3,000 to the partners are indicated in the following statement of
partnership liquidation.

Dawit, Alemu, and Almaz

Statement of Partnership Liquidation

For period of xxxx

Capital

Non cash Dawit Alemu Almaz

CashAssets = Liab. + (50%) + (30%) + (20%)

Balance…………………….. -0- -0- -0- -5,000 3,000 2,000

Receipt of deficiency…… +3,000 -0- - +3,000 - -

Balance………………..… 3,000 -0- -0- -2,000 3,000 2,000

Division of loss………… - - - +2,000 -1,200 -800

Balance----------------------- 3,000 -0- -0- -0- 1,800 1,200

Distrib.of cash to part…... -3,000 - - - -1,800 -1,200

Final balances……………. -0- -0- -0- -0- -0- -0-

It should be noted that the $2,000 loss was divided between Alemu and Almaz in their income
sharing ratio of 3:2. The entries to record the final settlement are as follows:

1. To record the receipt of part of deficiency

Cash--------------------------------------3,000

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 Dawit, Capital--------------------- 3,000
2. To record the division of loss
Alemu, Capital---------------------------1,200
Almaz, Capital---------------------------800
Dawit, Capital---------------------- 2,000

3. To record the distribution of cash to partners

Alemu, Capital---------------------------1,800
Almaz, Capital---------------------------1,200
Cash----------------------------------- 3,000

Assumption 3: Dawit is unable to pay any part of the $5,000 deficiency (5,000 loss)

The division of the $5,000 loss indicated in the following statement of partnership liquidation.

Dawit, Alemu, and Almaz

Statement of Partnership Liquidation

For period of xxxx

Capital

Non cash DawitAlemuAlmaz

CashAssets = Liab. + (50%) + (30%) + (20%)

Balance…………………….. -0- -0- -0- -5,000 3,000 2,000

Division of loss………… - - - +5,000 -3,000 -2,000

Final balances……………. -0- -0- -0- -0- -0- -0-

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It should be noted that the $5,000 loss was divided between Alemu and Almaz in their income
sharing ratio of 3:2. The entries to record the final settlement is as follows:

1. To record the division of loss

Alemu, Capital---------------------------3,000
Almaz, Capital---------------------------2,000
Dawit, Capital-----------------------------5,000

Summery

A partnership is a voluntary association of two or more people to pursue a business for a profit as
a co-owner. Partnerships are common especially in small retail and service business. Many
professional practitioners, including physicians, lawyers, and accountants, also organize their
practices as a partnerships. Partnership has a certain common characteristics such as limited life,
mutual agency, and co-ownership of partnership property, unlimited liability and nontaxable
entity. The advantages of a partnership are relatively easy and inexpensive to organize, requiring
only an agreement between two or more persons. A partnership has the advantage of being able
to bring more capital, more managerial skills, and more experiences than would a sole
proprietorship. On the other hand there is a disadvantages such as the disadvantages of a

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partnership are that its life is limited, each partner has unlimited liability and one partner can
bind the partnership to contracts. Also, raising large amounts of capital is more difficult for a
partnership than for a corporation. The accounting treatments of partnership in initial investment
is a separate entry is made for the investments of each partner in a partnership. The various assets
contributed by a partner are debited to the proper asset accounts. In each entry, the monetary
amounts at which the non-cash assets are stated are those agreed upon by the partners at the time
of the division of the net income or net loss among the partners in exact accordance with their
partnership agreement is of the utmost importance. If the agreement is silent on the matter, the
law provides that all partners share equally, regardless of differences in amounts of capital
contributed, of special skills possessed, or of time devoted to the business. Any change in the
personnel of the ownership results in the dissolution of the partnership. Thus, admission of a new
partner dissolves the old firm. If the partnership assets are not fairly stated in terms of current
market value at the time a new partner is admitted, the accounts may be adjusted accordingly.
The net amount of the increases and decreases in asset values are then allocated to the capital
accounts of the old partners according to their income-sharing ratio.

Self-checked question

Part one: True /false questions

1. A partnership is a voluntary association of two or more people to pursue a business for a

profit as a co-owner.
2. Liquidation is refers to the process of a wind-up of a business firm.
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 3. The balance in the capital account of the deceased partner is then transferred to a liability
account until the law orders to whom should the deceased capital should be given.
4. When a new partner is admitted to a partnership, goodwill attributable either to the old
partnership or to the incoming partner may be recognized
5. The advantages of a partnership are that its life is limited, each partner has limited
liability and one partner can bind the partnership to contracts.

Part two: Workout Question

1. X, Y, and Z formed a partnership; A contributed $5000 in cash and inventory with a

fair market value of $10,000 in the partnership; Y contributed equipment with a fair
market value of $18,000 and a building with a fair market value of $15,000 in the
partnership; Z contributed $10, 000 in cash and equipment with a fair market value of
$9000 and in addition to this ‘Z’ transferred a liability of $3000 to the partnership.
Required pass the entry to record the assets contributed and the liabilities transferred
by ‘X’,Y and ‘Z’.
2. Assume that the articles of partnership of Temesgen and Aklilu provide for monthly
salary allowances of Birr 4500 and Birr 2,000 respectively, with the balances of the
net income to be divided equally, and that the net income for the year is Birr 75,000.
Required : A) Distribute the net income to the partner & Pass the journal entry

3. Assume that in the above illustration for the Wonde and Alemu partnership the balance
of the merchandise inventory account had been $140,000 and the current replacement
price had been $170,000. Prior to Sharon’s admission, the revaluation would be recorded
as follows, assuming that Wonde and Alemu share net income equally.

Required: pass the necessary entry

CHAPTER FIVE
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 5. ACCOUNTING FOR CORPORATIONS
Chapter objectives
At the end of this chapter the student should:

 Able to know the concepts of corporation

 Recognize characteristics of corporation
 understands the components of stock
 understand issuance of stock
 Recognize characteristics of preferred stock

Corporation – an entity created by law that is separate from its owners, with its own powers,
responsibilities, and liabilities.

5.1 Characteristics of Corporations

Advantages
 Separate legal entity: corporation that conducts its affairs with the same rights, duties,
and responsibilities of a person.
 Limited liability of stockholders: Stockholders are neither liable for corporate acts nor
corporate debt.
 Transferable ownership rights: The transfer of shares from one stockholder to another,
usually with no effect on the corporation or its operations.
 Continuous life: A corporation’s life continues indefinitely because it is not tied to the
physical lives of its owners.
 Lack of mutual agency for stockholders: A corporation acts through its agents, who are
its officers and managers.
 Ease of capital accumulation: Buying stock is attractive to investors because
stockholders aren’t liable for the corporation’s acts and debts, stocks usually are

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 transferred easily, the life of the corporation is unlimited, and stockholders aren’t
corporate agents.

Disadvantages
 Government regulation: A corporation must meet requirements of a state’s
incorporation law.
 Corporate taxation: Corporations are subject to the same property and payroll taxes as
proprietorships and partnerships plus additional taxes.
5.2 Components of stock:
The following are the two general categories of contributed capital (stock):
A. Common stock
 votes to elect officers, establish governing rules
 often more than one class
B. Preferred stock: - Shares/ Stocks which enjoy the preferential rights as to dividend and
repayment of capital in the event of winding up of the company over the equity shares are
called preference shares. The holder of preference shares will get a fixed rate of dividend.

Number of shares of stock:

 Authorized: maximum shares corporation will be allowed to issue.
 Issued: shares which have been sold or transferred to stockholders, however this does not
necessarily mean the number of shares currently outstanding. The number of issued shares
is often considerably less than the number of authorized shares.
 Outstanding: shares actually in the hands of stockholders
 sometimes a company repurchases shares and holds them as treasury stock
 not counted as outstanding shares

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 For example, if a corporation initially sells 2,000 shares of its stock to investors, and if
the corporation did not reacquire any of this stock, this corporation is said to have 2,000
shares of stock outstanding. The number of outstanding shares is always less than or
equal to the number of issued shares. The number of issued shares is always less than (or
equal to) the authorized number of shares.
 Treasury: shares which have been repurchased by the corporation, it is not part of the
number of shares outstanding
Par value is an arbitrary amount stated on the face of the stock certificate and represents the
legal capital of the corporation.
 Generally very low, fulfills legal requirements.
 Not the value of the stock, or the issue price
 Legal requirements depend on state of incorporation
 Some states do not require corporations to indicate a par value
 Some states require stated value instead of par value
 Will record in Capital Stock account as the number of shares issued multiplied by par
value per share
Additional paid-in capital is the amount received for stock in addition to par value; may also be
called:
 Paid-in capital in excess of par
 Premium on stock
 Often recorded on the balance sheet on a single line, for all classes of stock
Retained earnings is the amount of net income over the life of the company not paid out as
dividends.
 Not the amount available to the stockholders
 Does not represent a pool of liquid assets
5.3 Issuance of Stock

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A corporation can issue common stock directly to investors. Alternatively, it can issue the stock
indirectly through an investment banking firm that specialize in bringing securities to the
attention of prospective investors. Direct issue is typical in closely held companies. Indirect issue
is customary for a publicly held corporation. In an indirect issue, the investment banking firm
may agree to underwrite the entire stock issue. In this arrangement, the investment banker buys
the stock from the corporation at a stipulated price and resells the shares to investors. The
corporation thus avoids any risk of being unable to sell the shares. Also, it obtains immediate use
of the cash received from the underwriter. The investment banking firm, in turn, assumes the risk
of reselling the shares, in return for an underwriting fee.

For example, Google (the world’s number-one Internet search engine) used underwriters when it
issued a highly successful initial public offering, raising $1.67 billion. The underwriters charged
a 3% underwriting fee (approximately $50 million) on Google’s stock offering.
How does a corporation set the price for a new issue of stock? Among the factors to be
considered are (1) the company’s anticipated future earnings, (2) its expected dividend rate per
share, (3) its current financial position, (4) the current state of the economy, and (5) the current
state of the securities market. The calculation can be complex and is properly the subject of a
finance course.
5.4 Characteristics of Preferred Stock
Preferred stock is flexible, with provisions tailored to company's needs.
Cumulative feature: if no dividend is declared in one year, dividend on preferred stock
is considered to be in arrears
 before any subsequent common dividends can be paid, dividends in arrears on
preferred stock must be paid
 does NOT guarantee a preferred dividend, only says that IF ANY dividend is paid,
preferred dividend must be satisfied first, including amounts in arrears if any

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 Non‐cumulative feature – confers no right to prior periods’ unpaid dividends if they
were not declared in those prior periods
Participating feature – In addition to a fixed dividend, balance of profit (after meeting
equity dividend) shared by some preference shareholders. Such shares are participating
preference shares.
Non‐participating feature – These shares get only a fixed rate of dividend. These do not
get share in the surplus profit.
Convertible feature: allows preferred shareholders to convert their shares to common
stock within a specified period or at a specified date according to the terms of issue.
Callable feature: gives the issuing corporation the right to purchase this stock from its
holders at specified future prices (call premium) and dates.
Call price: amount paid to call and retire a preferred share
Difference between equity shares and preference shares
Equity shares Preference shares
1. It is an ownership security 1. It is a hybrid security
2. Dividend rate is not fixed 2. Dividend rate is fixed
3. Capital is repaid only in winding up 3. Capital is repaid after a stipulated
4. These shares have voting rights period
5. Face value is lower 4. These shares generally do not have
voting rights
5. Face value is higher

5.5 Forming a Corporation

Illustration

On January 5, the firm paid the organization costs of $8,500. This amount includes legal
fees, taxes and licenses, promotion costs, etc.
Jan.5 Organization Costs……………… 8 500

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 Cash…………………………………………… 8 500
Paid cost of organizing the corporation

5.5.1 Issue of Share/ or Stock

The shares can be issued either at par, premium or at discount. Shares are said to be issued at par
when a shareholder is required to pay the face value of the shares to the company. Shares are said
to be issued at premium when a shareholder is required to pay more than the face value to the
company. Shares are said to be issued at discount when the shareholder is required to pay less
amount than the face value to the company. For example, a company issues the shares having the
face value of $10 at $10; it is the issue at par. If it is issued at $ 12, the issue is at premium. If it
is issued at $8, the issue is at discount.
Example

A corporation is authorized to issue 10,000 shares of preferred stock, $100 par, and 100,000
shares of common stock, $20 par. On April 1, one-half of each class of authorized stock is issued
at par for cash.
Apr. 1 Cash………………………. 1,500,000

Preferred Stock………………………. 500 000

Common Stock……………………….. 1,000,000

( Issued preferred stock and common stock at par.)

5.5.2 Issuing Stock at a Premium

Illustration#1

On March 15, Caldwell Company issues 2,000 shares of $50 par preferred stock for cash
at $55.
Mar. 15 Cash…………………………………………… 110,000

Preferred Stock………………………………………………..100,000

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 Paid-in Capital in Excess of Par--

Preferred Stock………………………………………………….10, 000

(Issued 2,000 shares of $50 par preferred stock at $55.)

 The $10,000 excess is recorded in a separate account because some states do not consider
this to be part of legal capital and may be used for dividends.

Illustration#2

On Nov. 12, a corporation acquired land for which the fair market value cannot be
determined. The corporation issued 10,000 shares of $10 par common that has a current
market value of $12 in exchange for the land.

Nov. 12 Land……………………………………….. 120 000

Common Stock………………………………………………… 100 000

Paid-in Capital in Excess of Par……………………………… 20 000

Issued $10 par common stock valued at $12 per share, for land.

Stock issued for assets other than cash should be recorded at the fair market value of the
asset or fair market value of the stock, whichever can be more clearly determined.
5.5.3 Issuing Stock at No-Par
Illustration#1

On February 23, a corporation issues 10,000 shares of no-par common stock at $40 a
share.

Feb. 23 Cash………………………………….400 000

Common Stock………………………………………..400 000

Issued 10,000 shares of no-par common stock at $40.

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Illustration#2

Later, on March 9, the corporation issues 1,000 additional shares at $36.

Mar. 9 Cash …………………………36 000

Common Stock …………………………………..36 000

Issued 1,000 shares of no-par common stock at $36.

 Some states require that the entire proceeds from the sale of no-par stock be treated as
legal capital.
 Also, no-par stock may be assigned a stated value per share. The stated value is recorded
similar to a par value.

5.5.4 Issuing Stock with a Stated Value

On March 30, issued 1,000 shares of no-par common stock at $40; stated value, $25.

Mar. 30 Cash………………………………………..40 000

Common Stock…………………………………………. 25 000

Paid-in Capital in Excess of

Stated Value…………………………………………..15 000 00

Issued 1,000 shares of no-par common stock at $36; stated value, $25.

5.5.5 Treasury Stock Transactions

Occasionally, a corporation buys back its own stock for the purpose of later reissuing it. This
stock is referred to as treasury stock.

Treasury stock is stock that:

1. Has been issued as fully paid.

2. Has been reacquired by the corporation.
3. Has not been canceled or reissued.
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  A commonly used method of accounting for treasury stock is the cost method.

Illustration#1

On January 5, a firm purchased 1,000 shares of treasury stock (common stock, $25 par) at
$45 per share.

Jan. 5 Treasury Stock ………………….. 45, 000

Cash ………………………………………………. 45, 000

Purchased 1,000 shares of treasury stock at $45.

Illustration#2

On June 2, sold 200 shares of treasury stock at $60 per share.

June 2 Cash ………………………………….. 12 000

Treasury Stock ………………………………………… 9 000

Paid-in Capital from sale of

Treasury Stock ……………………………………... 3 000

Sold 200 shares of treasury stock at $60.

Illustration#3

On September 3, sold 200 shares of treasury stock at $40 per share.

Sep. 3 Cash ……………………………………… 8 000

Paid-in Capital from Sale of

Treasury Stock ………………………….. 1 000

Treasury Stock …………………………………………… 9 000

Sold 200 shares of treasury stock at $60.

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5.6 Cash Dividends for Preferred and Common Stock

When more than one class of stock is outstanding, cash dividends must be allocated between
them.

 Calculate amount due preferred shareholders first, per the terms of the stock
 noncumulative preferred stock receives only this year's dividend
 cumulative preferred shareholders must also receive all dividends in arrears,
that is, dividends from any previous year in which the company did not pay or
distribute dividends
 calculate dividends in arrears on preferred stock
 add the current year's preferred dividend
 subtract this subtotal from the total dividend to be paid to find the amount
available for distribution to common stockholders
 For cumulative and participating preferred stock
 calculate dividends in arrears and current preferred dividend as above
 distribute an equal percentage to common at agreed-on rate
 divide remainder of dividend monies between preferred and common
stockholders, based on agreed algorithm, for example, the proportion of
each type of stock to total par value
 Subtract preferred stockholders' share from total dividends available to find total amount
due common shareholders
 Calculate per share amount for common and preferred shares
 Cumulative and participating features make preferred stock more attractive to investors, but
company must avoid diminishing the attractiveness of their common stock when investors
see less dividend money available to common shareholders after preferred stockholders
receive their allocation

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 Summery

Corporation is an entity created by law that is separate from its owners, with its own
powers, responsibilities, and liabilities. Like partnership corporation has own
characteristics. Such as Separate legal entity, Limited liability of stockholders,
transferable ownership rights, continuous life, lack of mutual agency for stockholders and

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 ease of capital accumulation. Stocks of the corporations can be categories in to two such
as common stock and preferred stock. A corporation can issue common stock directly to
investors. Alternatively, it can issue the stock indirectly through an investment banking
firm that specialize in bringing securities to the attention of prospective investors. Direct
issue is typical in closely held companies. Indirect issue is customary for a publicly held
corporation. In an indirect issue, the investment banking firm may agree to underwrite
the entire stock issue. Generally common stock are is an ownership security, dividend
rate is not fixed, capital is repaid only in winding up, these shares have voting rights and
face value is lower. Whereas in case of preferred stocks is a hybrid security, dividend rate
is fixed, capital is repaid after a stipulated period, these shares generally do not have
voting rights and face value is higher.

Self-checked question
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 True/false question
1. One of the characteristics of corporation is the liability is un limited
2. Stock issued for assets other than cash should be recorded at the fair market value of the
asset or fair market value of the stock, whichever can be more clearly determined.
3. The shares can be issued either at par, premium or at discount
4. One of the characteristics of preferred stockholder is dividend rate is fixed
5. Non‐cumulative feature confers no right to prior periods’ unpaid dividends if they were
not declared in those prior periods.
6. Par value is an arbitrary amount stated on the face of the stock certificate and represents
the legal capital of the corporation.
Workout questions
7. A corporation is authorized to issue 1000 shares of preferred stock, $10 par, and 10,000
shares of common stock, $20 par. On April 1, one-half of each class of authorized stock is
issued at par for cash.
Required: pass the necessary journal
8. On March 15, Caldwell Company issues 1,000 shares of $50 par preferred stock for cash
at $55.
Required: pass the necessary journal

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 CHAPTER SIX

6. ACCOUNTING FOR PAYROLL

3.1. Introduction

In the previous chapter you have discussed the basic accounting principles and practices that are
useful in accounting for the acquisition, use, and disposal of plant assets, as well as the
accounting for intangible assets and natural resources have also been discussed briefly.

In this chapter you will be acquainted with the basics of accounting for payroll and payroll taxes.
Accounting systems for payroll and payroll taxes are concerned with the records and reports
associated with the employer-employee relationship. It is important that the accounting system
provide safeguard to ensure that payments are in accord with management’s general plans and its
specific authorizations.

All employees of an organization expect and are entitled to receive their remuneration at regular
intervals following the close of each payroll period. Regardless of the number of employees and
the difficulties in computing the amounts to be paid, the payroll system must be designed to
process the necessary data quickly and assure payment of the correct amount to each employee.

The system must also provide adequate safeguards against unauthorized payments to employees
and other misappropriations of funds.

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Various federal, state, and local laws require employers to keep accurate payroll records and to
prepare reports and submit to the appropriate governmental units. The law also requires
employers remit the amounts withheld from its employees and for taxes imposed on it. These
records must be kept for specified periods of time and be available for inspection by those
responsible for enforcement of the laws. Besides, payroll data may be useful in negotiations with
labor unions, in settling employee grievances, and in determining rights to vacations, sick leaves,
and retirement pensions.

Here, in this chapter, you are going to learn intensely and worked through the major concepts
that are common to most payroll systems such as the employee’s earnings record, payroll sheet
(or register), and journal entries related to payroll. Each of these concepts is illustrated and
discussed by taking into account the current tax law of the country. As much as possible the
chapter attempts to give you adequate knowledge about payroll systems in Ethiopia, however, if
you come across any confusion or difficulties you can consult the authorities in the Ministry of
Finance or Inland Revenue Administration in your locality, or refer the various proclamations
especially; Proclamation No. 286 / 2002, the council of ministers regulation No. 78 / 2002. And
Article 33 or proclamation No. 64 / 1975

3.2. Importance of Payroll accounting

Accounting for payroll is particularly important because:

1- Payroll often represents the largest expense that a company incurs.

2- Both federal and state governments require that detailed payroll records be kept and
3- Employees are sensitive to payroll errors or irregularities. To maintain good employee
morale payroll must be paid on a timely and accurate basis.
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3.3. Definitions of Payroll Related Terms

1. Salary and Wages: Salary and wages are usually used interchangeably. However, the term
wages is more correctly used to refer to payments to unskilled-manual labor. It is usually paid
based on the number of hours worked or the number of units produced. Therefore, wages are
usually paid when a particular piece of work is completed or weekly.

On the other hand, salaries refers to payments to employees who render managerial,
administrative or similar services, and they are usually paid to skilled labor on a monthly or
yearly basis.

Both wages and salaries related to an ‘employee’ is an individual who works primarily to one
organization and whose activities are under the direct supervision of employer.

A self-employed person on the other hand works (gives her services) on a fee basis to various
firms.

2. The Pay Period:A pay period refers to the length of time covered by each payroll payment.

3 The Pay Day:The pay day- is the day on which wages or salaries are paid to employees. This is
usually on the last day of the pay period.

4. A Payroll Register (sheet): is the list of employees of a business along with each employee’s
gross earnings; deductions and net pay (take home pay) for a particular pay period. The payroll
register (sheet) is prepared based on attendance sheets, punched (clock) cards or time cards.

5. Pay Check:A business can pay payroll by writing a check for the amount of the net pay. A
check is prepared in the name of each employee and handed to employees. Alternatively a check
for the total net pay can be prepared for employees to the paid by cash at the organization.

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6. Gross Earnings: are taxes collected from the earnings of employees by the employer
organization as per the regulations of the government. These have to be submitted (paid) to the
government because3d employer organization is only acting as an agent of the government in
collecting these taxes from employees.

7. Payroll Deductions:are deductions from the gross earnings of an employee such as

employment income taxes (withholding taxes), labor union dues, fines, credit association pays
etc.

8. Net Pay:Net Pay is the earning of an employee after all deductions have been deducted. This
is the take home pay amount collected by an employee on the payday.

3.4. Possible Components of a Payroll Register

1. Employee Number

Number assigned to employees for identification purpose when a relatively large number of
employees are involved in a payroll register.

2. Name of Employees

3.6. Earnings

Money earned by an employee from various sources,. This may include.

a. Basic Salary- a flat monthly salary of an employee for carrying out the normal work of
employment and subject to change when the employee is promoted.
b. Allowances- money paid monthly to an employee for special reasons, like:

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 - Position allowance- a monthly paid to an employee of earning a particular office
responsibility.
- Housing allowance- a monthly allowance given to cover housing costs of the
individual employee when the employment contract requires the employer to
provide housing but the employer fails to do so.
- Hardship allowance- a sum of money given to an employee to compensate for an
inconvenient circumstance caused by the employer. For instance, unexpected
transfer to aw different and distant work area or location.
- Desert allowance- a monthly allowance given to an employee because of
assignment to a relatively hot region.
- Transportation (fuel) allowance- a monthly allowance to an employee to cover cost
of transportation up to her workplace if the employer has committed itself to
provide transportation service.

C. Overtime Earning: Overtime work is the work performed by an employee beyond the
regular working hours.

Overtime earnings are the amount paid to an employee for overtime work performed.

Article 33 of proclamation No. 64/1975 discussed the following about how overtime work
should be paid:

A worker shall be entitled to the paid at a rate of

i. One and one-quarter (1 ¼) times his ordinary hourly rate for overtime work performed
before 10:00 P.M in the evening.

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 ii. One and one half (1 ½) times his ordinary hourly rate for overtime work performed
between 10:00 P.M and six (6:00 A.M) in the morning.
iii. two times the ordinary hourly rate for overtime work performed on weekly rest days
iv. two and one half (2 ½ ) times the ordinary hourly rate for overtime work performed on a
public holiday.
All in all, the gross earnings of an employee may include the basic salary, allowance and
overtime earnings.

4 Deduction: are subtractions made from the earnings of employees required by the government
or permitted by the employee himself.

a. Employment Income Tax:Every citizen is required to pay employee tax to the

government in almost all countries. In Ethiopia also, income tax is charged on the gross
earnings of the employee at the rates indicated under schedule A of the Proclamation N.
286/2002- Income tax proclamation.

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 The tax rates under schedule A are Presented below:

Employment Income Income

(per month) Tax rate

Over Birr To Birr

Exempt (Free from Tax)
0 600

601 1, 650 10%

1, 651 3,200 15%

3,200 5,250 20%

5,251 7,800 25%

7,801 10,900 30%

Over 10,900 35%

*In computing and withholding tax,

the income tax proclamation dictates
that income attributable to the month
of Nehassie and Pagumen shall be
aggregated
Taxable (added)
income and treated
includes as the or gains in cash or I n kind received from employment by
any payment
anincome of oneincluding
individual, month. income from former employment or otherwise or from prospective
employment.

Short cut to Income Tax Calculation

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Employment Income Income

(per month) Tax Payable

Over Birr To Birr

0 600 No tax

601 1, 650 (10% X EI) – 60

1, 651 3,200 (15% X EI) – 142.50

3,200 5,250 (20% X EI) – 302.50

5,251 7,800 (25% X EI) – 565

7,801 10,900 (30% X EI) – 955

Over 10,900 (35% X EI) – 1500

EI = Employment Income or taxable income

60 = (600 X 0.1) – 0

47.5 = [(600 X .15) – 0] + [(1050 X 0.15) – (1,050 X 0.1)]and so forth

Proclamation No. 286/2002 states that the following are not taxable.

1- income from employment received by casual employees who are not regularly employed
provided that they do not work for more than one month for the same employer in any
twelve months period.
2- Pension contribution, provident fund and all forms of retirement benefits contributed by
employers in an amount that doesn’t exceed 15% of the monthly salary of the employee.
3- Payments made to---- (an employee) as a compensation or gratitude in relation to:

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 o personal injuries suffered by that person
o the death of another person

The council of ministers regulation No. 78/2002

Regulations issued pursuant to the income tax proclamation further exempts the following from
income tax.

1- Amounts paid by employers to cover the actual cost of medical treatment of employees.
2- Allowance in view of means of transportation granted to employees under contract of
employment, i.e., transportation allowance.
3- Hardship allowance
4- Amounts paid by employee in reimbursement of traveling expenses incurred on duty.

4. b. Pension Contribution

Permanent employees a governmental organization in Ethiopia is expected to pay or contribute

7% of their basic salary to the governments’ pension trust fund.

This amount is withheld by the employer from each employee on every payroll and later be paid
to the respective government body.

The employer is also expected to contribute towards this same fund 11% of the basic salary of
every permanent government employee.

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Therefore, the total contribution to the pension fund of the Ethiopian government is equal to 18%
of the basic salary of all of its permanent employees.

That is, 7% comes from the employees and 11% comes from the employer.

This enables a permanent employee of a government organization to be entitled to the pension

pay when retiring provided the employee satisfies the minimum requirements to enjoy the
benefits.

Business and non-governmental not-for profit organization (NGO’s) also have this kind of a
scheme to benefit their employees with some modifications. A fund known as provident fund is
established and both the employer and the employee contribute towards this fund monthly. When
an employee retains or leaves employment, a lump sum amount is paid to him/her.

4.c. Other Deductions

Apart from the above two kinds of deductions, employees may individually authorize additional
deductions such as deductions to pay life insurance premiums, to repay loan from the employer,
to pay for donation to charitable organization, contributions to "ldir" etc.

3.5. Major Activities Involved in Accounting for Payroll

1 Gathering the necessary data - All the relevant information about every employee should be
gathered.

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This requires reviewing various documents such as attendance sheets and doing some arithmetic
work.

2 Entering the names of employees - along with the gathered data such as earnings, deductions
and net pays in the appropriate columns of the payroll register.

3 Totaling and proving the payroll register -the grand total for earnings must be checked if its
equal to the sum of the grand totals of deductions and net pays.

4 The accuracy and authenticity of the information - summarized in the payroll should be
verified by a different person from the one who prepared it.

5 The payroll- should be approved by an authorized personnel (individual)

6 Paying the payroll -either in cash or by writing a check.

7 The payment of the payroll and income taxes - withheld from employees (withhold doing tax
liability) should be recorded in journal entry form.

8 The withholdingtax - must be paid to the relevant government authority in time (promptly) and
this is recorded in journal entry form.

ILLUSTRATION ON PAYROLL REGISTOR

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Godanaye is a government agency recently organized to rehabilitate street children. It has five
employees whose salaries are paid according to the Ethiopian calendar month. The following
data relates to the month of Yekatit, 1995.

Serial Name of Employee Basic Transp. Overtime Duration of

No. __________________ Salary Allowance worked(hr) OT Work

01 AregashShewaBr. ,730 200 4 6:00-10:00 P.M

02 PaulosChala 1020 ___ 8 Sunday(8:30-5:30)

03 Mohammed Modesir 5300 ___ ___ ___

04 Tensay Belay 9,470 ___ ___ ___

05 Haile Olango 10, 950 ___ 6 Public Holiday

Additional Information
- The management of the agency usually expects a worker to work 40 hours in a week and
during Yekatit there are four weeks.
- There were no absentees during the month
- All employees are permanent except and Tinsae and Haile
- Paulos agreed to contribute monthly Br. 300 from his salary as a monthly saving in the
credit association of the agency.

Required

1. Prepare a payroll register (sheet) for the agency for the month of Yekatit, 1995.
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 2. Record the payment of salary as of yekatit 30,1995 using check stub No. 0123.
3. Record the payment of the claim of the credit Association of their agency on Megabit 1,
1995 use check stub No. 0124.
4. Record the payment of the withholding taxes and pension contribution to the concerned
government body on Megabit 7,1995.
5. Compute and recognize the total payroll tax expense for the month of Yekatit, 1995.

Computation of Earnings, Deductions and Net Pay

Gross Earnings = Basic salary + Allowance + Overtime Earning

Overtime Earning
Overtime earning = OT hrs worked X (ordinary hourly rate X relevant OT rate)

1. AREGASH:

 OT Earning = 4 hours X br. 730 X 1.25 = br. 22.81

160 hours

NB Every employee is expected to work 160 hours per month

(i.e. 40 hours x 4 weeks)

 You should compute the regular hourly rate first:

Regular Hourly Rate = Monthly salary (Basic Salary)

Total Hours worked in the Month

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 = br. 730

160 Hours

 Therefore, the regular Hourly payment = br. 4.56

The regular hourly payment must be multiplied by the appropriate OT rate as
follows:
br. (4.56 x 1.25) x 4 hours-------------------br.
hours-------------------br. 22.81

2. PAULOS
 OT Earning = 8 hours X br. 1020 x 2 ----------------br.
----------------br. 102.00
160 hours

3. HAILE
 OT Earnings = 6 hours X br. 10, 950 x 2.5 -------------br.
-------------br. 1026.56
160 hours
GROSS EARNINGS
Gross Earnings = Basic salary + Allowance + OT Earnings

1. AGEGASH
 Gross Earnings = br. 730 + br. 200 + br. 22.81 = br. 952 .81
 Remember taxable income in this case is br. 752.81 because the transportation
allowance of br. 200 is not subject to taxation.

2. PAULOS
 Gross Earning = br. 1020 + br. 102 = br. 1122
 The Gross Total Earnings of Paulos consists of the br. 1020 basic salary plus the
overtime earnings of br. 102, which is br. 1122.

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 3. MOHAMMED
 Gross Total Earnings = br. 5,300, which include the basic salary alone

4. TENSAY
 Gross Total Earnings = br. 9,470, which is the basic salary.

5. HAILE
 Gross Total Earnings = br. 10,950 + 1.026.56= br. 11,976.56

DEDUCTIONS AND NET PAY

1. AREGASH:
 Gross Total Earnings-----------------------------------------br. 952.81
 Gross Taxable Income (br. 952.81 – br. 200)-----------------752.81

Employee Income Tax:

Earnings X Income Tax Rate = Income Tax

0 – 600---------600 0 br. 00.00
601 – 752.81 on 152.81 10% 15.20
TOTAL br. 752.81-----------------------------------------------br. 15,20

Pension contribution:
Basic salary x 7%
= br. 730 x 0.07-------------------------------------------------51.10
0.07-------------------------------------------------51.10
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ÞTotal Deduction (br. 15.20 + br. 51.10)-----------------br. 66.30

NB. The income tax to be deducted from the employee could have been computed by using the
short-cut method as follows:
= (Taxable Income x 10%) – br. 60.
= (br. 752.81 x .10) – br. 60 = br. 15.30

2. PAULOS:
 Gross Total Earning-----br. 1122.
 Employee Income tax
= (Taxable Income x 10%) – br. 60.
= (br. 1122 x .10) – br. 60 = br. 52.20

Pension Contribution (br. 1020 x 0.07) ---------------------71.40

 Credit Association--------------------------------------------300.00
Association--------------------------------------------300.00
 Total Deduction---------------------------------------------
Deduction---------------------------------------------br.
br. 423.60

3. MOHAMMED:
 Gross Total Earnings------------------------------------br. 5300.00
 Employee Income Tax
= (Taxable Income x .25%) – br. 565
= (br. 5,300 x .25) – br. 565 = br. 760.00

 Pension contribution (br. 5300 x 0.07)---------------------- 371.00

 Total Deductions------------------------------------------br.
Deductions------------------------------------------br. 1131.00
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4. TENSAY:
 Gross Total Earnings------------------------------------br. 1470.00
 Gross Taxable Income--------------------------------------1470.00
Employee Income Tax:

= (Taxable Income x .30%) – br. 955

= (br. 9,470 x .30) – br. 955= br. 1,886.00

NB. No pension contributions because she is not permanent employee of the organization.
Therefore, total deduction is the same as Employee Income Tax, br. 1,886.00

5. HAILE:
 Gross Total Earnings--------------------------------------br. 1039.06
Employee Income Tax:
 Employee Income Tax
= (Taxable Income x .35%) – br.1,500
= (br. 11,976.56 x .35) – br. 1,500 = br. 2,691.80

 Pension contribution should not be computed for Haile because he is not

permanent employee of the agency. Thus, the only deduction from Haile’s earnings
is the employee income tax.
NET PAY:

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Net pay = Gross Total Earnings – Total Deductions

1. AREGASH:
Net pay = br. 952.81 – br. (94.62)
Net pay = br. 858.19

2. PAULOS:
Net pay = br. 1122 – br. (461.60)
Net pay = br. 660.40

3. MOHAMMED:
MOHAMMED:
Net pay = br. 5300 – br. (1404.50)
Net pay = br. 3895.50

4. TENSAY:
Net pay = br. 9,470 – br. (1,886.00)
Net pay = br 7,594.00
5. HAILE:
Net pay = br. 11,976.56 – br. 2,691.80
Net pay = br. 9,284. 76

Todanaye

Payroll Register(sheet)

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 For the month of Yekatit,1995

Ser. Name of Earnings Deductions

No. Gross Total Net Sign.
Employee Basic Allo- Over Income Pension Other
salary wanc Earning Deduc. Pay
Time Tax Contr. Deduc.
e

01 AregashShewa 730 200 22.81 952.81 15.20 51.10 ___ 66.30 858.19

02 PaulosChala 1020 ___ 102 1122 52.20 71.40 300 423.60 660.4

03 Mohammed 5300 ___ ___ 5300 760 371.00 ___ 1131 3895.5
Mudesir

04 Tensay Belay 9,470 ___ ___ 9,470 1,886 ___ ___ 1,886 7,594.

05 Haile Olango 10,950 ___ 1026.5 11,976. 2,691.8 ___ ___ 2,691.8 9,284,.7
6 56 0 0 6

Totals 27,470 1,151 213.87 28,821. 5,405.2 493.50 300 6,198.7 22,622.
.37 37 67

Summery
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Accounting systems for payroll and payroll taxes are concerned with the records and reports
associated with the employer-employee relationship. It is important that the accounting system
provide safeguard to ensure that payments are in accord with management’s general plans and its
specific authorizations. All employees of an organization expect and are entitled to receive their
remuneration at regular intervals following the close of each payroll period. Regardless of the
number of employees and the difficulties in computing the amounts to be paid, the payroll
system must be designed to process the necessary data quickly and assure payment of the correct
amount to each employee. The system must also provide adequate safeguards against
unauthorized payments to employees and other misappropriations of funds. Accounting for
payroll is particularly important because payroll often represents the largest expense that a
company incurs, both federal and state governments require that detailed payroll records be kept
and employees are sensitive to payroll errors or irregularities. To maintain good employee
morale payroll must be paid on a timely and accurate basis. Possible components of a payroll
register are Employee Number, Name of Employees, Earnings (Basic Salary, Allowances and
Overtime Earning) and Deduction.

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 Self-checked question

Part one: True /False

1. The term wages is more correctly used to refer to payments to unskilled-manual labor.
2. Position allowance is a monthly paid to an employee of earning a particular office
responsibility.
3. Gross earningsare taxes collected from the earnings of employees by the employer
organization as per the regulations of the government
4. A pay day refers to the length of time covered by each payroll payment
5. Overtime earnings are the amount paid to an employee for overtime work performed.

Problem Questions
1. CHILALO Retail Enterprise, a government owned business, pays its employees salaries
according to the Ethiopian calendar Month. The following data relate to the month of
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 Meskerem, 1995 E.C.

S.No Employee Name Basic Salary

001 AnimutAnley birr 2500
002 NebiyatGirma 1880
003 ErechaMegersa 1790
004 Bekuretsion G/Tensae 1565

Additional information
 All workers are expected to work 40 hours per week and during Meskerem there are 4
weeks. The workers have done as they have been expected.
 NebiyatGirma has worked 10 hours of overtime during Meskerem: 3 hours during
‘Meskel’ and the other 7 hours before 10 p.m.
 ErechaMegersa has also worked 5 hours of overtime: 2 hours during weekly rest days and
3 hours between 10 p.m. – 6 a.m.
 Animut and Nebiyat received a monthly position allowance of br. 350 and br 300
respectively which are both taxable.
 AnimutAnley agreed to have a monthly deduction of br. 250 for credit association.
 All workers are permanent except Bekuretsion G/Tesnae.

Required:
1. Compute the total deductions and net pay for each employee.
2. Compute (calculate) the total:
a) Withholding Taxes
b) Payroll Tax
c) Record the payment of salary as of Meskerem 30,1995.

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 3. Pass the entry to pay the withholding taxes to the appropriate government unit.

2. HABESHA Trading co. is a private business enterprise. The company pays the salary of its
employees according to the Ethiopian calendar month. The following data relates to the
month of Hidar, 1995.

Serial No. Name Basic Salary

A 101 AbejeBelew br. 2710
P 102 HaraguaDelelegn 2500
P 103 ZelekeBelayneh 1800
M 104 ZinashManahlot 4200

Additional information
 The organization expects every worker to work 48 hours in a week and during Hidar
there are four weeks and all workers have done as they have been expected.
 Ato, AbejeBelew and W/r, HareguaDelelegnare entitled to get a monthly allowance of
birr 500 and br. 400 respectively.
 All workers are permanent except W/t, ZinashManahlot, and they are entitled to a total of
15% provident fund of which 10% from the employer and 5% from the employee.
 AtoZelekeBelayneh and W/t ZinashManahlot have worked 12 hours of overtime each on
public holidays.
 According to the company rule, any allowance more than birr 200 is subject to income
tax.

Required: based on the information given above:

1. Compute the income tax for each employee.
2. Compute the total deductions for each employee.
employee.
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 3. Determine the net pay (take-home-pay) for each employee.
4. Compute the total withholding tax for the month.
5. Compute the total payroll tax expense.
6. Pass the journal entry to record the payment of salary as of Hidar 30,1995.

PROBLEM – 3
The following data relates to the payroll of the employees of a privately owned business
organization known as”ALAZAR Retail Enterprise”, for the month of Megabit, 1995 E.C.

Serial Name Basic Overtime Worked

No. Salary Hours Duration
01 Aleme T. br. 4300 4 up to 10 PM
02 Banchayehu S. 960 12 b/n 10PM to 6 AM
03 Chemdessa N. 1450 8 weekly rest days
04 Deniel T. 632 10 public holiday
05 Leilena A. 2000 ___ ____

Additional Information
 The management of the business organization usually expects a woker to work 40 hours
in a week.
 There were no absentees during Megabit.

Required:
1. Prepare a payroll sheet for the month of Megabit
2. Record the payment of salary as of Miazia 1, 1995
3. Record the recognition of the payroll tax expense as of Miazia 1, 1995

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Record the payment of withholding taxes to the proper government units as of Miazia 15, 1995

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