Fundamentals of Accounting-II

Fundamentals of
Accounting-II Module

Course code: AcFn-

2012

Compiled by: Robel B.(MSc.)

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CHAPTER ONE
ACCOUNTING FOR INVENTORIES
[Link] and classification of inventory

Inventories are asset items held for sale in the ordinary course of business or goods that will be
used or consumed in the production of goods to be sold. How a company classifies its inventory
depends on whether the firm is a merchandiser or a manufacturer. Inventories of
merchandising businesses are merchandise purchased for resale in the normal course of
business. In a merchandising company, inventory consists of many different items. For
example, in a grocery store, canned goods, dairy products, meats, and produce are just a few of
the inventory items on hand. These items have two common characteristics: (1) They are owned
by the company, and (2) they are in a form ready for sale to customers in the ordinary course of
business. Thus, merchandisers need only one inventory classification, merchandise inventory, to
describe the many different items that make up the total inventory.
In a manufacturing company, some inventory may not yet be ready for sale. As a result,
manufacturers usually classify inventory into three categories: finished goods, work in process,
and raw materials. Finished goods inventory is manufactured items that are completed and ready
for sale. Work in process is that portion of manufactured inventory that has been placed into the
production process but is not yet complete. Raw materials are the basic goods that will be used in
production but have not yet been placed into production. For example, Caterpillar classifies
earth-moving tractors completed and ready for sale as finished goods. It classifies the tractors on
the assembly line in various stages of production as work in process. The steel, glass, tires, and
other components that are on hand waiting to be used in the production of tractors are identified
as raw materials.
In this unit, only the determination of the inventory of merchandise purchased for resale
commonly called merchandise inventory will be discussed.
1.1. Internal control of inventories
Two primary objectives of control over inventory are as follows: Safeguarding the inventory
from damage or theft and reporting inventory in the financial statements.

Safeguarding Inventory
Controls for safeguarding inventory begin as soon as the inventory is ordered. The following

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documents are often used for inventory control: Purchase order, receiving report and vendor‘s
invoice. Recording inventory using a perpetual inventory system is also an effective means of
control. The amount of inventory is always available in the subsidiary inventory ledger. This
helps keep inventory quantities at proper levels.
Finally, controls for safeguarding inventory should include security measures to prevent damage
and customer or employee theft. Some examples of security measures include the following:
 Storing inventory in areas that are restricted to only authorized employees.
 Locking high-priced inventory in cabinets.
 Using two-way mirrors, cameras, security tags, and guards

Reporting Inventory
A physical inventory or count of inventory should be taken near year-end to make sure that the
quantity of inventory reported in the financial statements is accurate. After the quantity of
inventory on hand is determined, the cost of the inventory is assigned for reporting in the
financial statements. Most companies assign costs to inventory using one of three inventory cost
flow assumptions.
1.2. IMPORTANCE OF INVENTORIES
Merchandise purchased and sold is the most active elements in merchandising business, i.e. in
wholesale and retail type of businesses. Therefore, the inventory is important for the following
reason:
 The sale of merchandise is the principal source of revenue for them.
 The cost of merchandise sold is the largest deductions from sales.
 Inventories (ending inventories) are the largest of the current assets or those firms.
 A substantial part of merchandising firm‘s resources is invested in inventory

Because of the above reasons, inventories have effects on the current and the following period‘s
financial statements. If inventories are misstated, the financial statements would be distorted.

1.3. Determining actual quantities in the inventory

All companies that using a periodic or perpetual inventory system; need to determine inventory
quantities at the end of the accounting period. There are two principal system of inventory
accounting: Periodic and Perpetual inventory systems.

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Periodic inventory system

 In this system, only the revenue from sales is recorded each time a sale is made.
 No entry will be made to record the cost of merchandise sold at the time of sale.
 Physical inventory will be taken to determine the cost of the ending inventory at the end
of an accounting period.
Perpetual inventory system
 Uses according records that continuously disclose the amount of the inventory.
 The cost of merchandise sold will be recorded each time a sale is made.
Physical inventory is taken to compare the records with the actual quantities on hand. If using a
perpetual system, companies take a physical inventory for two reasons:
To check the accuracy of their perpetual inventory records.
To determine the amount of inventory lost due to wasted raw materials, shoplifting, or
employee theft.

Companies using a periodic inventory system take a physical inventory to determine the
inventory on hand at the statement of financial position date, and to determine the cost of goods
sold for the period. Determining inventory quantities involves two steps: (1) taking physical
inventory of goods on hand and (2) determining the ownership of goods.
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. 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.
Determining Ownership of Goods
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. When goods

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are being shipped from the seller to the buyer, who owns the inventory that is on a truck or
railroad car—the seller or the buyer? If the seller pays for the shipping costs, the arrangement is
known as FOB (free-on-board) destination, and the seller owns the merchandise from the time
it is shipped until it is delivered to the buyer. If the buyer pays the shipping costs, the
arrangement is known as FOB (free-on-board) shipping point, and the buyer owns the
merchandise during transit. Thus, in determining which items should be counted and included in
the inventory balance for a period, a company must note the amount of merchandise in transit
and the terms under which it is being shipped. In all cases, merchandise should be included in the
inventory of the party who owns it; for goods in transit, this is generally the party who is paying
the shipping/transportation costs. If goods in transit at the statement date are ignored, inventory
quantities may be seriously miscounted.
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. However, the
owner is did not count these good during preparation of financial statements. These are called
consigned goods.
For example, you might have a used computer that you would like to sell. If you take the item to
a dealer, the dealer might be willing to put the computer on its lot and charge you a commission
if it is sold. Under this agreement, the dealer would not take ownership of the computer, which
would still belong to you. Therefore, if an inventory count were taken, the computer would not
be included in the dealer‘s inventory.
Illustration: Deng Yaping Company completed its inventory count. It arrived at a total inventory
value of ¥200,000. As a new member of Deng Yaping‘s accounting department, you have been
given the information listed below. Discuss how this information affects the reported cost of
inventory.
1. Deng Yaping included in the inventory goods held on consignment for Falls Co., costing
¥15,000.
2. The company did not include in the count purchased goods of ¥10,000 which were in
transit (terms: FOB shipping point).
3. The company did not include in the count sold inventory with a cost of ¥12,000 which
was in transit (terms: FOB shipping point).
Solution:

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1. Goods of ¥15,000 held on consignment should be deducted from the inventory count.
2. The goods of ¥10,000 purchased FOB shipping point should be added to the
inventory count.
3. Item 3 was treated correctly. Inventory should be ¥195,000 (¥200,000 - ¥15,000 +
¥10,000).
1.4. Determining the cost of inventory

Inventory is accounted for at cost. Cost includes all expenditures necessary to acquire goods and
place them in a condition ready for sale. For example, freight costs incurred to acquire inventory
are added to the cost of inventory, but the cost of shipping goods to a customer are a selling
expense.
One of the most significant problems in determining inventory cost comes about when identical
units of a certain commodity have been acquired at different unit cost prices during the period.
In such a case it is necessary to determine the unit price of the items till on hand. At this time the
ending inventory and cost of goods sold are determined by using inventory-costing methods.
The three inventory costing methods we will illustrate that IFRS allows are: Specific
identification, First-in, first-out (FIFO), and Average cost method.
Specific Identification
If a company 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. For example, 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. 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 keep track of the cost of
each particular item sold, most companies make assumptions, called cost flow assumptions,

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about which units were sold.

1.4.1. Inventory cost flow assumption

A major accounting issue arises when identical units of merchandise are acquired at different
unit costs during a period. In such cases, when an item is sold, it is necessary to determine its
unit cost using a cost flow assumption so that the proper accounting entry can be recorded. There
are two common cost flow assumptions used in business. Each of these assumptions is identified
with an inventory costing method.
Cost flow is in the order in which the costs were incurred-First-in, First-out (FIFO)
Cost flow is an average of the costs-Average Cost
1.4.2. Inventory costing methods under a perpetual and periodic inventory systems
[Link].Inventory costing methods under a periodic inventory system

When the periodic inventory system is used, only revenue is recorded each time a sale is made.
No entry is made at the time of the sale to record the cost of the merchandise sold. At the end of
the accounting period, a physical inventory is taken to determine the cost of the inventory and
the cost of merchandise sold.

The cost of goods sold formula in a periodic inventory system:

Beginning Inventory + Purchases) − Ending Inventory = Cost of Goods Sold
First- In – First- Out Method (FIFO)
The first-in, first-out (FIFO) method assumes that the earliest goods purchased are the first to be
sold. FIFO often parallels the actual physical flow of merchandise. That is, it generally is good
business practice to sell the oldest units first. Under the FIFO method, therefore, the costs of the

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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. Hence, the inventories remain or ending inventory is assumed to be made up
of the most recent costs and the cost of goods sold is made up of the earliest costs.
The physical count on December 31 shows that 45 units of the particular commodity are on
hand. In accordance with the assumption that the inventory is composed of the most recent costs,
the cost of the 45 units is determined as follows:

Deduction of the inventory of 5,800 from the 12,000 of merchandise available for sale yields
6,200 as the cost of merchandise sold, which represents the earliest costs incurred for this
commodity. Alternatively, you also use the other method to compute the cost of goods sold. See
the alternative below:
Earliest cost Jan.1 inventory 10 units at $ 100 $1,000
Next earliest cost Apr. 15 purchase 20 units at $ 110 2,200
Next earliest cost Aug.24 purchase 25 units at $120 3,000
Cost of merchandise sold 55 6,200
In most businesses, there is a tendency to dispose of goods in the order of their acquisition. This
would be particularly true of perishable merchandise and goods in which style or model changes
are frequent. Thus, the FIFO, methods is generally in harmony with the physical movement of
merchandise is an enterprise.

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Average cost method

The average cost methods sometimes called the weighted average method. When this method is
used, cost is matched against revenue according to the weighted average unit costs of the goods
sold. The sum weighted average unit cost are used in determine the cost of the merchandise
remaining in the inventory. The weighted average unit cost is determined by dividing the total
cost of the identical units of each commodity available for sale during the period by the related
number of units of that commodity.

Average unit cost =

Ending inventory =
Cost of good sold =
Average unit cost = $12,000/100 = $120
The cost of ending inventory at Dec 31= 45* $120 = $5,400
Cost of merchandise sold =55 units at 120 = $ 6,600
[Link].Inventory Costing Methods under Perpetual Inventory System

In a perpetual inventory system, all merchandise increases and decreases are recorded in a
manner similar to the recording of increases and decreases in cash. The merchandise inventory
account at the beginning of an accounting period indicated the merchandise in stock on that date.
Debiting merchandise inventory and crediting cash or accounts payable, on the data of each sale
the cost of merchandise sold is recorded by debiting cost of merchandise sold and crediting
merchandise Inventory, records purchases.
Example: The following units of item X are available for sale.
Item –X units cost
Jan 1 inventory 20 $ 20
4 sale 14
10 purchase 18 21
22 sale 8
28 sale 6
30 purchase 20 22
The firm used a perpetual inventor system, and there are 30 units of one item on hand at end of
the year. What is the total cost of goods sold and ending inventory according to: A)FIFO
B)Average Cost Method
First- in, first – out (FIFO) method
Using cost, costs are included in the merchandise sold in the order in which they were incurred.

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Purchases Cost of merchandise Inventory

sold
Quantity Unit Total Quantity Unit Total Quantity Unit Total cost
Date cost cost cost cost cost
1 20 20 400
4 14 20 280 6 20 120
10 18 21 378 6 20 120
18 21 378
22 6 20 120
2 21 42 16 21 336
28 6 21 126 10 21 210
30 10 21 210
20 22 440 20 22 440
Balance $568 $650
Thus cost of merchandise sold = $ 568, cost of ending inventory = $ 650.
Average cost method
When the average cost method is used in a perpetual inventory system an average unit cost for
each type of item is computed each time a purchase is made. This unit cost is then used to
determine the cost of each sale until another purchase is made and a new average is computed.
This averaging technique is called a moving average.
Average cost method:-
Purchases Cost of merchandise Inventory
sold
Quantity Unit Total Quantit Unit Total Quantit Unit cost Total cost
Date cost cost y cost cost y
Jan 1 20 20 400
4 14 20 280 6 20 120
10 18 21 378 24 20.75 498
22 8 20.75 166 16 20.75 332
28 6 20.75 124.5 10 20.75 207.5
30 20 22 440 30 21.58 647.5
Balance $570.5 $647.5
Cost of merchandise sold = $570.5, Cost of ending inventory =$647.5

1.4.3. Financial Statement and Tax Effects of Cost Flow Methods

Either of the two cost flow assumptions is acceptable for use. The reasons companies adopt
different inventory cost flow methods are varied, but they usually involve one of three factors:
(1) income statement effects, (2) statement of financial position effects, or (3) tax effects.

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[Link].Income Statement Effects

To understand why companies choose either FIFO or average-cost, let‘s examine the effects of
these two cost flow assumptions on the financial statements of Lin Electronics. Assume that Lin
sold its 55 units for HK$11,500, had operating expenses of HK$2,000, and is subject to an
income tax rate of 30%.
Note the cost of goods available for sale (HK$12,000) is the same under both FIFO and average-
cost. However, the ending inventories and the costs of goods sold are different. This difference is
due to the unit costs that the company allocated to cost of goods sold and to ending inventory.
Each dollar of difference in ending inventory results in a corresponding dollar difference in
income before income taxes. For Lin, a HK$400 difference exists between cost of goods sold
using FIFO versus average-cost.

In periods of changing prices, the cost flow assumption can have a significant impact on income
and on evaluations based on income, such as the following.
 In a period of inflation, FIFO produces a higher net income because the lower unit costs
of the first units purchased are matched against revenues.
 In a period of rising prices (as is the case in the Lin example), FIFO reports higher net
income (HK$2,310) than average-cost (HK$2,030).

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 If prices are falling, the results from the use of FIFO and average-cost are reversed. FIFO
will report the lower net income and average-cost the higher.

To management, higher net income is an advantage. It causes external users to view the company
more favorably. In addition, management bonuses, if based on net income, will be higher.
Therefore, when prices are rising (which is usually the case), companies tend to prefer FIFO
because it results in higher net income.
[Link].Statement of Financial Position Effects

A major advantage of the FIFO method is that in a period of inflation, the costs allocated to
ending inventory will approximate their current cost. For example, for Lin Electronics, 40 of the
45 units in the ending inventory are costed under FIFO at the higher November 27 unit cost of
HK$130.
Conversely, a shortcoming of the average-cost method is that in a period of inflation, the costs
allocated to ending inventory may be understated in terms of current cost. The understatement
becomes greater over prolonged periods of inflation if the inventory includes goods purchased in
one or more prior accounting periods.
[Link].Tax Effects

We have seen that both inventory on the statement of financial position and net income on the
income statement are higher when companies use FIFO in a period of inflation. Yet, some
companies use average-cost. Why? The reason is that average-cost results in lower income taxes
(because of lower net income) during times of rising prices. For example, at Lin Electronics,
income taxes are HK$870 under average-cost, compared to HK$990 under FIFO. The tax
savings of HK$120 makes more cash available for use in the business.
1.4.4. Using Inventory Cost Flow Methods Consistently

Whatever cost flow method a company chooses, it should use that method consistently from one
accounting period to another. This approach is often referred to as the consistency concept,
which means that a company uses the same accounting principles and methods from year to year.
Consistent application enhances the comparability of financial statements over successive time
periods. In contrast, using the FIFO method one year and the average-cost method the next year
would make it difficult to compare the net incomes of the two years.
Although consistent application is preferred, it does not mean that a company may never change

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its inventory costing method. When a company adopts a different method, it should disclose in
the financial statements the change and its effects on net income.
1.5. Lower-of-Cost-or-Net Realizable Value

The value of inventory for companies selling high-technology or fashion goods can drop very
quickly due to continual changes in technology or styles. These circumstances sometimes call for
inventory valuation methods other than those presented so far. When the value of inventory is
lower than its cost, companies must ―write down‖ the inventory to its net realizable value. This is
done by valuing the inventory at the lower-of-cost-or-net realizable value (LCNRV) in the period
in which the price decline occurs. LCNRV is an example of the accounting concept of prudence,
which means that the best choice among accounting alternatives is the method that is least likely
to overstate assets and net income.
Under the LCNRV basis, net realizable value refers to the net amount that a company expects to
realize (receive) from the sale of inventory. Specifically, net realizable value is the estimated
selling price in the normal course of business, less estimated costs to complete and sell.
Companies apply LCNRV to the items in inventory after they have used one of the inventory
costing methods (specific identification, FIFO, or average-cost) to determine cost. To illustrate
the application of LCNRV, assume that Gao TV has the following lines of merchandise with
costs and net realizable values as indicated. Note that the amounts shown in the final column are
the lower-of-cost-or-net realizable value amounts for each item.

1.6. The effect of inventory errors on the financial statements

Errors are caused by failure to count or price the inventory correctly. In other cases, errors occur
because companies do not properly recognize the transfer of legal title to goods that are in
transit. When errors occur, they affect both the income statement and the statement of financial
position.

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Statement of Profit and Loss

The ending inventory of one period automatically becomes the beginning inventory of the next
period. Thus, inventory errors affect the computation of cost of goods sold and net income in two
periods.
The effects on cost of goods sold can be computed by first entering incorrect data in the cost of
goods sold formula and then substituting the correct data.
Cost of goods sold =Beginning inventory + Net purchase – Ending inventory

So far, the effects of inventory errors are fairly straightforward. Now, though, comes the (at first)
surprising part: An error in the ending inventory of the current period will have a reverse effect
on net income of the next accounting period. As you study the illustration, you will see that
the reverse effect comes from the fact that understating ending inventory in 2016 results in
understating beginning inventory in 2017 and overstating net income in 2017.
Over the two years, though, total net income is correct because the errors offset each other.
Notice that total income using incorrect data is €35,000 (€22,000 + €13,000), which is the same
as the total income of €35,000 (€25,000 + €10,000) using correct data. Also note in this example
that an error in the beginning inventory does not result in a corresponding error in the ending
inventory for that period. The correctness of the ending inventory depends entirely on the
accuracy of taking and costing the inventory at the statement of financial position date under the
periodic inventory system.

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Statement of Financial Position

Companies can determine the effect of ending inventory errors on the statement of financial
position by using the basic accounting equation: Assets = Liabilities + Equity. Errors in the
ending inventory have the following effects.

If the error is not corrected, the combined total net income for the two periods would be correct.
Total equity reported on the statement of financial position for the following period will also be
correct. Thus, the error committed on ending inventory will not have an effect on statement of
financial position (asset and equity) for the following period.
1.7. Estimating Inventory Cost

In practical an inventory amount may be need in order to prepare an income statement when it is
impractical or impossible to take a physical inventory or to maintain perpetual inventory records,
the amount of inventory on hand can be estimated. A business may need to estimate the amount
of inventory for the following reasons:
1. Perpetual inventory records are not maintained.

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2. A disaster such as a fire or flood has destroyed the inventory records and the inventory.
3. Monthly or quarterly financial statements are needed, but a physical inventory is taken
only once a year.
The two commonly used methods of estimating inventory cost are
1. The retail method
2. The gross profit method.

1.6.1. Retail method of inventory costing

The retail inventory method of estimating inventory cost requires costs and retail prices to be
maintained for the merchandise available for sale. A ratio of cost to retail price is then used to
convert ending inventory at retail to estimate the ending inventory cost.
The retail inventory method is applied as follows:
Step 1. Determine the total merchandise available for sale at cost and retail.
Step 2. Determine the ratio of the cost to retail of the merchandise available for sale.
Step 3. Determine the ending inventory at retail by deducting the net sales from the
merchandise available for sale at retail.
Step 4. Estimate the ending inventory cost by multiplying the ending inventory at retail by
the cost to retail ratio.
Example: on the basis of the following data, estimate the cost of the merchandise inventory
at June 30 by the retail method.
Cost Retail
June 1. Merchandise inventory $ 428,300 $ 670,500
1-30 purchasers (net) 608,500 949,000
1-30 sales (net) 1,140.000
Solution:
Cost Retail
Merchandise inventory June 1 $ 428,300 $ 670,500
Purchases in June (net) 608,500 949,500
Merchandise available for sale $1,036,800 $ 1,620,000 step one.
Ratio of cost to retail price: 1,036,800 = 64% step two.
1,620,000
Sales for June (net) (1,140,000)
Merchandise inventory, June 30, at retail 480,000 step three.
Merchandise inventory, June 30, at estimated cost
(480.000*64%)….........................................................307,200 step four.
When estimating the cost to retail ratio, the mix of items in the ending inventory is assumed to be

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the same as the merchandise available for sale. If the ending inventory is made up of different
classes of merchandise, cost to retail ratios may be developed for each class of inventory.
An advantage of the retail method is that it provides inventory figures for preparing monthly
statements. Department stores and similar retailers often determine gross profit and operating
income each month, but may take a physical inventory only once or twice a year. Thus, the retail
method allows management to monitor operations more closely.
1.6.2. Gross Profit Method of Estimating Inventories
The gross profit method uses the estimated gross profit for the period to estimate the inventory at
the end of the period. The gross profit is estimated from the preceding year, adjusted for any
current-period changes in the cost and sales prices. The gross profit method is applied as
follows:
Step 1. Determine the merchandise available for sale at cost.
Step 2. Determine the estimated gross profit by multiplying the net sales by the gross profit
percentage.
Step 3. Determine the estimated cost of merchandise sold by deducting the estimated gross profit
from the net sales.
Step 4. Estimate the ending inventory cost by deducting the estimated cost of merchandise sold
from the merchandise available for sale.
Example: The merchandise inventory was destroyed by fire on October 20. The following data
were obtained from the accounting records.
Jan 1. Merchandise inventory $ 160,000
Jan 1. Oct purchases (net) 850,000
Sales (net) 1,080,000
Estimated gross profit rate 36%
Required: Estimate the cost of merchandise destroyed:
Solution:
Merchandise inventory, January $160,000
Purchase (net) 850,000
Merchandise available for sales $1,010,000
Sales (net) $1,080,000
Less estimated gross profit

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(1,080,000*36%) (388,800)
Estimated cost of merchandise sold ($691,200)
Estimated merchandise inventory, Oct 20 $318,800
The gross profit method is useful for estimating inventories for monthly or quarterly financial
statements. It is also useful in estimating the cost of merchandise destroyed by fire or other
disasters.
1.8. Presentation of Merchandise Inventory on the balance sheet

Merchandise inventory is usually presented in the current asset section of the statement of
financial position. Both the method of determining the cost of inventory (FIFO or average) and
the method of valuing the inventory (LCNRV) should be show. The details may be disclosed in
parentheses on the statement of financial position or in a footnote to the financial statements. The
company may change its inventory costing methods for valid reason. In such cases, the effect of
the change and the reason for the change should be disclosed in the financial statements for
period in which the change occurred.

REVIEW EXERCICE
PRACTICE MULTIPLE-CHOICE QUESTIONS
1. Which of the following should not be included in the physical inventory of a company?
a. Goods held on consignment from another company.
b. Goods shipped on consignment to another company.
c. Goods in transit from another company shipped FOB shipping point.
d. All of the above should be included.
2. As a result of a thorough physical inventory, Railway Company Ltd. determined that it had
inventory worth €180,000 at December 31, 2017. This count did not take into consideration
the following facts. Rogers Consignment store currently has goods worth €35,000 on its sales
floor that belong to Railway but are being sold on consignment by Rogers. The selling price
of these goods is €50,000. Railway purchased €13,000 of goods that were shipped on
December 27, FOB destination, that will be received by Railway on January 3. Determine the
correct amount of inventory that Railway should report.
a. €230,000. c. €228,000.
b. €215,000. d. €193,000.
3. Cost of goods available for sale consists of two elements: beginning inventory and:
a. ending inventory. c. cost of goods sold.
b. cost of goods purchased. d. All of the answers are correct.

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4. Tinker Bell Company has the following:

Units Unit Cost

Inventory, Jan. 1 8,000 £11
Purchase, June 19 13,000 12
Purchase, Nov. 8 5,000 13
If Tinker Bell has 9,000 units on hand at December 31, the cost of the ending inventory under
FIFO is:
a. £99,000. c. £113,000.
b. £108,000. d. £117,000.
5. Davidson Electronics has the following:

Units Unit Cost

Inventory, Jan. 1 5,000 £8
Purchase, April 2 15,000 £10
Purchase, Aug. 28 20,000 £12
If Davidson has 7,000 units on hand at December 31, the cost of ending inventory under the
average-cost method is:
a. £84,000. c. £56,000.
b. £70,000. d. £75,250.
6. In periods of rising prices, average-cost will produce:
a. higher net income than FIFO.
b. the same net income as FIFO.
c. lower net income than FIFO.
d. net income equal to the specific identification method.
7. Factors that affect the selection of an inventory costing method do not include:
a. tax effects.
b. statement of financial position effects.
c. income statement effects.
d. perpetual vs. periodic inventory system.
8. Rickety Company purchased 1,000 widgets and has 200 widgets in its ending inventory at a
cost of HK$91 each and a net realizable value of HK$80 each. The ending inventory under
LCNRV is:
a. HK$91,000. c. HK$18,200.
b. HK$80,000. d. HK$16,000.
9. Atlantis Company‘s ending inventory is understated NT$122,000. The effects of this error on
the current year‘s cost of goods sold and net income, respectively, are:
a. understated, overstated. c. overstated, overstated.
b. overstated, understated. d. understated, understated.
10. Lee Company overstated its inventory by NT$500,000 at December 31, 2016. It did not
correct the error in 2016 or 2017. As a result, Lee‘s equity was:

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a. overstated at December 31, 2016, and understated at December 31, 2017.

b. overstated at December 31, 2016, and properly stated at December 31, 2017.
c. understated at December 31, 2016, and understated at December 31, 2017.
d. overstated at December 31, 2016, and overstated at December 31, 2017.
11. Which of these would cause the inventory turnover to increase the most?
a. Increasing the amount of inventory on hand.
b. Keeping the amount of inventory on hand constant but increasing sales.
c. Keeping the amount of inventory on hand constant but decreasing sales.
d. Decreasing the amount of inventory on hand and increasing sales.
12. Carlos Company SLU had beginning inventory of €80,000, ending inventory of €110,000,
cost of goods sold of €285,000, and sales of €475,000. Carlos‘ days in inventory is:
a. 73 days. c. 102.5 days.
b. 121.7 days. d. 84.5 days.
13. Songbird Company has sales of £150,000 and cost of goods available for sale of £135,000. If
the gross profit rate is 30%, the estimated cost of the ending inventory under the gross profit
method is:
a. £15,000. c. £45,000.
b. £30,000. d. £75,000.
14. In a perpetual inventory system:
a. specific identification is always used.
b. average costs are computed as a simple average of unit costs incurred.
c. a new average is computed under the average cost method after each sale.
d. FIFO cost of goods sold will be the same as in a periodic inventory system.
15. Using the data in Question 4, the cost of the ending inventory under LIFO is:
a. £113,000.
b. £108,000.
c. £99,000.
d. £100,000

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Answer:
1.(a)2. (b) 3.(b) 4.(c) 5.(d) 6.(c)7.(d) 8.(d) 9.(b) 10.(b) 11.(d) 12.(b) 13.(b) 14.(d) 15.(d)

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Chapter Two
Accounting for Plant Assets, Intangible Assets & Natural Resources

Accounting for Plant Assets, Intangible Assets & Natural Resources

Introduction
This unit aims at discussing the meaning and nature of plant assets, acquisition costs, and the

related cost allocation (depreciation) of plant assets. The units also discuss the different

methods of computing depreciation and the accounting procedures involved in recording the

transactions relating to disposal of plant assets.

After having studied and worked through this unit, you will able to be:

 determine the acquisition cost of tangible assets

 compute depreciation for plant assets using various depreciation methods

 record depreciation expense in the accounting records

 distinguish expenses from expenditures that should be capitalized

 differentiate depreciation for financial reporting from depreciation for income tax

 account for disposing of plant assets.

 apply accounting for intangible assets

 apply accounting for natural resources

2.1. Nature of Plant Assets

Most business enterprises hold such major assets as land, buildings, equipments, furniture,

tools, and etc. These assets help produce revenue over many periods by facilitating the

production and sale of goods or services to customers. Because these assets are necessary in a

company’s day-to-day operations, companies do not sell them in the ordinary course of

business. Keep in mind, though; one company’s long-term asset might be another company’s

short-term asset. For example, a delivery truck is a long-term asset for most companies, but a

truck dealer would regard a delivery truck as a current asset merchandise inventory.

Assets that can be used by a business enterprise for relatively long period (usually more

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than one year) are called Long- Term Assets. Long-term assets are divided into

tangible and intangible categories. Intangible assets are assets without a

physical feature that can be charged in the operations of business for long period of time. They
generally consist of rights or advantages held such as goodwill, patents, copyrights, franchise, trademarks,

organization costs (developmental cost), etc.

In contrast, tangible assets (also called plant assets or fixed assets) are assets with physical substance that

can be charged in the operations of business for a relatively longer period of time, usually more than one

year or one operating cycle whichever is longer. We use these terms interchangeably. Property, plant, and
equipment include land, building structures (offices, factories, warehouses), and equipment (machinery,
furniture, tools), trucks, etc. The major characteristics of property, plant, and equipment are as follows.

1. They are acquired for use in operations and not for resale. Only assets used in
normal business operations are classified as property, plant, and equipment. For
example, an idle building is more appropriately classified separately as an
investment. Land developers or sub dividers classify land as inventory.
2. They are long- term in nature and usually depreciated. Property, plant, and
equipment yield services over a number of years. Companies allocate the cost of
the investment in these assets to future periods through periodic depreciation
charges. The exception is land, which is depreciated only if a material decrease in
value occurs, such as a loss in fertility of agricultural land because of poor crop
rotation, drought, or soil erosion.
3. They possess physical substance. Property, plant, and equipment are tangible
assets characterized by physical existence or substance. This differentiates them
from intangible assets, such as patents or goodwill. Unlike raw material, however,
property, plant, and equipment do not physically become part of a product held for
resale.

2.2. Accounting for Plant Assets

It includes the accounting treatment for acquisition cost, depreciation, post-acquisition costs
and disposal.

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2.2.1. Acquisition Cost of Plant Assets

The cost principle requires that companies record plant assets at cost. The acquisition cost
of plant (fixed) assets is the cash or cash-equivalent purchase price, including incidental
costs required to complete the purchase, to transport the asset, and to prepare it for use. For
example, expenditures related to the acquisition of a plant asset such as freight, insurance
while in-transit and installation are included in the cost of the asset because they are
necessary if the asset is to function. According to the matching principle, therefore, such
costs are allocated to the economic life of the asset rather than charged as expenses in the
current period. The following guidelines can be applied.

1. Cost of new plant assets includes Purchase price less any discounts, Transportation
costs, foundation, installation, and testing costs, etc less salvage proceeds.
 All expenditures reasonable and necessary to get the asset in place and ready
for use should be included in costs of plant assets.
 Expenditures such as freight, insurance while in transit, installation and other
necessary related costs are included in the cost of the asset and following the
matching rule they are allocated to the useful life of the asset rather than
charging against current period.
2. Cost of second hand assets includes net invoice price, cost of renovation such as
new parts, repairs, etc less salvage proceeds.
 All avoidable and routine expenditures should be excluded from costs of plant
assets.
3. The cost of plant assets purchased in deferred payment contract is the present value
of future payments discounted at market interest rate.
4. The cost of multiple plant assets purchased at a single price (i. e Basket/ lump sum
purchase) is the product of relative market value of each plant and the basket/lamp
sum price.
5. Operating costs incurred, if any should be expensed.
 Expenditures such as ordinary repair and maintenances are routine and
avoidable expenditures and they should be charged against current revenue.

6. All expenditures made due to carelessness or improper handling of the asset

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should be excluded. E.g. cost of vandalism, damage during installation, Uninsured

loss, Penalty for breaking traffic lines by delivery Truck while delivering the
equipment to the appropriate location.
 The cost of installing and testing the machine is a legitimate cost of the machine
but if the machine is damaged during installation, the cost of repairs is loss and
not treated as an acquisition cost.

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,[Link] property contains an old warehouse that is razed at a net cost of $6,000
($7,500 in 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,[Link] cost of the
land is $115,000, computed as follows. When Hayes records the acquisition, it debits Land
for $115,000 and credits Cash for $115,000

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To illustrate, a business enterprise acquires a piece of land for future site. It pays a cash

price of Br. 210,000, pays brokerage fees of Br. 7500 and title fees of Br. 3000, pays Br. 5,

000 to have unwanted building removed, and pays, Br. 1500 to have the site graded. The

business receives Br. 2000 salvage from the old building. The cost of the land is determined

as follows:

Cash prices (negotiated price) ......................................................... Br. 210,000

Title Fees .............................................................................................. 3,000.00
Brokerage Fees ..................................................................................... 7,500.00
Cost of Grading .................................................................................... 1,500.00
Cost of removing (demolition) unwanted
Building………………….……………Br. 5000
Less: Salvage received…………………… (2000)………….…3,000
Total cost of land…….……………………….…………Br. 225,000

Generally, land is part of property, plant and equipment. If the major purpose of acquiring

and holding land is speculative, it is more appropriately classified as an investment. If the

land is held on a real estate concern for resale, it should be classified as inventory. When

the land has been purchased for the purpose of constructing a building, all costs incurred up

to the excavation for the new building are considered land costs. Removal of old buildings

clearing, grading and filling are considered land costs because these costs are necessary to

get the land in condition for its intended purpose. Any proceeds obtained in the process of

getting the land ready for its intended use, such as salvage receipts on the demolition of an

old building are treated as reductions in the price of the land.

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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 been

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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
TOYOTA vehicles, consists of the cash purchase price, sales taxes, freight charges, and
insurance during transit paid by the purchaser. It also includes expenditures required in
assembling, installing, and testing the unit.

However, TOYOTA 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 TOYOTA 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,[Link] cost of the factory machinery is $54,500, computed
as follows.

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

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cost of the delivery truck is $23,820, computed as follows.

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:

2.2.2. Depreciation of Plant Assets

As plant assets are used in the operations of a business, their value to provide service

decreases through usage and the passage of time. This cost allocation of plant asset, called

depreciation, is recorded in the accounting books periodically. Depreciation is frequently

misunderstood. The term depreciation, as used in accounting, does not refer to the physical

deterioration of an asset or the decrease in market value of asset overtime. Depreciation

means the allocation of the cost of a plant asset to the periods that benefit from the services

of the asset. The term depreciation is used to describe the gradual conversion of the cost of

the asset into an expense.

Depreciation is not a process of valuation. Accounting records are kept in accordance with

the cost principle; they are not indicators of changing price levels. It is possible that,

through an advantageous buy and specific market conditions the market value of a building

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may rise. Nevertheless, depreciation must continue to be recorded because it is the result of

an allocation, not a valuation process.

Four factors affect the computation of depreciation. They are:

 Cost
 Residual value
 Estimated economic (useful) life.
 Depreciable methods
i) Cost- is the net purchase price plus all reasonable and necessary expenditures to

get the asset in place and ready for use.

ii) Residual value- also known as salvage value, disposal value, scrape value, or

trade- in value represents the estimated market value of the asset at the time of its

retirement.

iii) Depreciable cost - represents the difference between the asset cost and its

estimated residual value. For example, an item of equipment that costs Br. 5000

and has a residual value of Br. 500 would have a depreciable cost of Br. 4500,

(Br. 5000 - Br. 500). The depreciable costs must be allocated over the estimated

economic life of the asset.

iv) Estimated economic (useful) life- the estimated economic life of an asset is the

total number of service units expected from the asset. Service units may be

measured in terms of years the asset is expected to be used, units expected to be

produced, miles or kilometers expected to be driven, or similar measures. In

determining the estimated useful life of an asset, the accountant should consider

all relevant information, including (1) past experience with similar repair assets,

(2) the asset‘s present condition, (3) the company‘s repairs and maintenance

policy, (4) current technological and industry trends, and (5) local conditions

such as whether.

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Depreciation methods differ primarily in the amount of cost allocated to each period. A list

of depreciation amounts for each year of an asset‘s useful life is called depreciation

schedule. The most common methods of computing depreciation for plant assets are:

(1) The straight line method

(2) The units of production method

(3) The double-declining balance method, and

Method 1: Straight-Line Depreciation

When this method is used to allocate depreciation, the depreciable cost of the asset is spread

evenly (uniformly) over the useful life of an asset. The straight-line method is based on the

assumption that depreciation depends only on the passage of time. The depreciation expense

for each period is computed by dividing the depreciable cost by the number of accounting

periods in the asset‘s estimated useful life. The depreciation expense to be reported is the

same in each year.

Annual depreciation = Cost - Salvage value

Estimated useful life ( n)
Or
= SLM % * Depreciable Cost
= ( 100 / n)% * Depreciable Cost

The following illustration will help us to understand the Straight-Line method of computing

depreciation.
To illustrate, suppose, for example a business enterprise acquires a new computer (office
equipment) at a cost of Birr 6000. It is estimated that the computer has an estimated residual
value of Birr 1000 at the end of its estimated useful life of 4 years. The yearly (annual)
depreciation would be Birr 1250m computed as follows:

Annual Depreciation = Birr 6000 – Birr 1000 = Birr 1250

4 years

NB. There are three important points to note from the depreciation schedule for

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the straight-line depreciation method. First, the depreciation is the same each year.

Second, the accumulated depreciation increases uniformly. Third, the carrying (Book)

value decreases uniformly until it reach the estimated residual value.

The depreciation to be reported for each of the four years would be as follows:

Depreciation Method- Straight-Line Method

Year Cost Yearly Accumulated Carrying value
Depreciation Depreciation (Book Value)
Beginning of first year Br. 6000 Br. 6000.00
End of first year 6000 Br. 1250.00 Br. 1250.00 4750.00
End of second year 6000 1250.00 1250.00 3500.00
End of third year 6000 1250.00 3750.00 2250.00
End of fourth year 6000 1250.00 5000.00 1000.00

Method 2: Units of Production Method

The production method of depreciation is based on the assumption that depreciation is

mainly the result of use and that the passage of time plays no role in the depreciation

process. If we assume that the office equipment from the previous illustration has an

estimated useful life of 10,000 hours, the depreciation cost per hour would be determined as

follows:

Depreciation = Cost – Salvage value

Rate Estimated units of useful life
Annual Depreciation = Depreciation Rate * Actual Units

= Br. 6000.00 – 1000 = Br. 0.50

10,000 operating hrs
If we assume that the use of the equipment was 2800 hours for the first year, 3600 hours for

the second, 2400 hours for the third, and 1200 hours for the fourth, the depreciation

schedule for the office equipment would appear as follows:

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Under the production method, there is a direct relation between the amounts of

depreciation each year and the units of output or use. Also, the accumulated depreciation

increases each year indirect relation to units of output or use. Finally, the carrying amount

decreases each year in direct relation to units of output or use until it reaches the estimated

residual value.

Depreciation Schedule – Production/Activity Method

Year Cost Hours Deprec- Yearly Accum. Carrying
-iation Per Depr. Depr. value (Book
Hour value)
Beg. of the 1st yr. Br. 6,000 Br. 0.50 Br. 6,000.00
End of 1st year 6,000 2,800 0.50 Br.1,400.00 Br.1,400.00 4,600.00
End of 2nd year 6,000 3,600 0.50 1,800.00 3,200.00 2,800.00
End of 3rd year 6,000 2,400 0.50 1,200.00 4,400.00 1,600.00
End of 4th year 6,000 1,200 0.50 600.00 5,000.00 1,000.00

Under the production method, the units of output or use that is used to measure estimated

useful fife for each asset should be appropriate for that asset. For example, for one machine

number of units produced may be an appropriate measure, for another number of hours may

be a better measure. The production method should be used only when the output of an

asset over its useful life can be estimated with reasonable accuracy.

Method 3: Double Declining Balance Method

This method of depreciation results in relatively large amount of depreciation in the early

years of an assets life and smaller amounts in later years.

This method is based on the assumption of the passage of time. Since most kinds of plant

assets are most efficient when new, and so they provide more and better service in the early

years of useful life. It is consistent with the matching rule to allocate more depreciation to

the early years than to later years if the benefits or services received in the early years are

greater.

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The declining-balance method is the most common accelerated method of depreciation.

Under this method depreciation is computed by applying a fixed rate to the book value of

the asset, resulting in higher depreciation charges during the early years of the asset‘s life.

Though any fixed rate might be used under the method, the most common rate is a

percentage equal to twice the straight-line percentage. When twice the straight-line rate is

used, the method is usually called the double- declining balance method.

DDB% = 2(SLM %) = 2(100%/n)

Depreciation = Book value x DDB %

Charge (at beginning)

Referring to the previous example, the equipment had an estimated useful life of four years.

Consequently, under the straight-line method, the depreciation rate for each year was 25

percent, (100/ estimated useful life of the asset for 100/ 4 years). Therefore, under the

double-declining balance method, the fixed rate is 50 percent (2X 25 percent). This fixed

rate of 50 percent is applied to the remaining carrying value at the end of each year.

Estimated residual value is not taken into account in computing depreciation except in the

last year of an asset‘s useful life, when depreciation is limited to the amount necessary to

bring the carrying value down to the estimated residual value. The depreciation schedule for

this method is as follows:

Depreciation Schedule, Double-Declining Balance Method

Year Cost Fixed Depr. Yearly Accumulated Carrying
Rate Depreciation Depreciation Value (BV)
Date of Br. 6000 50% Br. 6000
purchase
End of 1st year 6000 50% Br. 3000 Br. 3000 3000
End of 2nd year 6000 50% 1500 4500 1500
End of 3rd year 6000 50% 750 5250 750
End of 4th year 6000 50% 250 550 500

NB. The fixed rate of 50% is always applied to the Book value at the end of the previous

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year. The depreciation is greatest in the first year and declines each year after that. Finally,
the depreciation in the last year is limited to the amount necessary to reduce book value to
residual value, Br. 250 = Br. 750 – Br. 500 (i.e. Previous book value minus residual value).

Recording Depreciation

The amount by which a fixed asset decreases is an expense of the business. The amount of

depreciation expense should be recorded each fiscal period. If depreciation expense is not

recorded, the income statement will not contain all the expenses of the business. This will

cause the net income to be reported higher than it should be. Income tax laws allow a

business to deduct depreciation as an expense in determining net income. If depreciation

expenses are not included on the income tax reports, the business will pay more income

taxes than it should be. Depreciation may be recorded by an entry a t the end of each month,

or the adjustment may be delayed until the end of the year.

To record the periodic cost expiration (allocation) of plant asset, the expense account,

depreciation expense is debited and the part of the entry that records the decrease in the

plant asset is credited to a contra asset account entitled Accumulated Depreciation or

Allowance for Depreciation. The use of this contra asset account permits the original cost to

remain unchanged in the plant asset account. This facilitates the computation of periodic

depreciation, the listing of both cost and accumulated depreciation on the balance sheet, and

reporting required for property and income tax purposes.

NB. An exception to the general procedure of recording depreciation monthly or

annually is often made when a plant asset is sold, traded-in, or discarded.

To illustrate, TB Construction Company acquired a new crane for Birr 360,500 at the

beginning of year 1. The crane has an estimated residual value of Birr 35,000 and an

estimated useful life of five years. The crane is expected to last 10,000 operating hours. It

was used 1800 hours in year 1, 2000 hours in year 2 and 2500 hours in year 3. Based on

the information given above:

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1) Compute the annual depreciation and the carrying value for the crane for each

of the first three years under each of the following methods:

a) Straight line method,

b) Units of production method,

c) Double-declining-balance method, and

2) Prepare the adjusting entry that would be made each year to record the

depreciation calculated under the straight line method.

Solution:

1) a) Straight Line Method:

Annual depreciation = Original cost – Estimated salvage value
Estimated Economic life
= Br. 36,500 – Br. 35,000
5 years
= Br. 325,500 = Br. 65,100

Therefore, deprecation for the first year, second year, and for the third year, is uniformly Br.

65,100.

b) Units of Production Method:

Hourly Depreciation Rate = Original Cost – Salvage value
Estimated Operating Hours
= Br. 360,500 – 35,000
10,000 operating hours
= Br. 32.55
During the first year the crane has been in operation for 1800 hours. Therefore, the

depreciation for the first year is Br. 58,590, computed as follows:

Br. 32, 55 X 1800 hours = Br. 58,590

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Second year deprecation = Br. 32.55 X 2000 hours =

Br. 65,100 Third year depreciation = Br. 32.55 X

2500 hours = Br. 81,375

c) Double-declining- balance Method:

To proceed with the double-declining-balance method, first we have to determine the rate.

The double-declining rate for the asset can be obtained by the following formula:

Depreciation Rate = 2 (100) = 40%

5 years
Unlike the other methods, in the declining-balance method the salvage value is not

deducted in computing the depreciation base. The declining balance rate is multiplied by

the book value of the asset at the beginning of each period. Therefore,

First year depreciation= 40/100 X 36,500 = Br.

144,200

Second year deprecation = 40/100 X (360,500 –

144,200)

= 40/100 X 216,300 = Br. 86,520

Third year depreciation = 40/100 (360,500 – 230,720)
= 0.4 X 129,780 = Br. 51,912
Special Depreciation Methods
Some times each of the four depreciation methods discussed so far may not be suitable

because the assets involved have unique characteristics, or the nature of the industry

requires that a special depreciation method be use of these methods, the group and

composite methods are discussed below:

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Group and Composite Methods: Depreciation methods are usually applied to a single

asset. Under some circumstances, however, a number (group) of asset accounts are

depreciated using one rate. For example, an enterprise such as Ethiopian

Telecommunication Corp. might depreciate telephone poles, microwave systems, or

switchboards by groups.

1) Group depreciation - the term ―group‖ refers to a collection of assets that are

similar in nature. The group method is frequently used when the assets are fairly

homogeneous and have approximately the same useful lives. The group method

more closely approximates a single-unit cost procedure because the dispersion

from the average is not as great.

2) Composite-rate depreciation - the term ―composite‖ refers to collection of assets

that are not similar (or dissimilar) in nature.

The composite method is used when the assets are heterogeneous and have different lives.
When depreciation is computed on the basis of a composite group of assets of differing life
spans, a rate based on averages must be developed. This is done by (1) computing the
annual depreciation for each asset, (2) determining the annual depreciation, and (3) dividing
the sum thus determined by the total cost of the assets.
To illustrate, TT Transport share Co. depreciates its group of cars, buses, and trucks on the
basis of composite-depreciation method. The composite-rate depreciation is computed in the
following manner:
Original Residual Depreciable Estimated Annual Dep.
Asset Cost Value Cost Life SLM)
Cars Br.400, 000 Br. 80,000 Br. 320,000 8 years Br. 40,000
Buses 2,400,000 240,000 2,160,000 10 years 216,000
Trucks 1,500,000 150,000 1,350,000 9 years 150,000
Br. 4,300,000 Br. 470,000 Br. 3,830,000 Br. 406,000
Composite depreciation rate = Br. 406,000 = 9.44%
Br. 4,300,000
If no change exists in the asset account, the group of assets will be depreciated to the

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residual or salvage value at the rate of Br. 406,000 (Br. 4,300,000 x 9.44%) a year.

The composite depreciation rate may be applied against total asset cost on a monthly basis,

or some reasonable assumption may be made regarding the timing of increases and

decreases in the group. A common practice is to assume that all additions and retirements

have occurred uniformly throughout the year. The composite rate is then applied to the

average of the beginning and ending balances of the account. Another acceptable averaging

technique is to assume that all additions and retirements during the first-half of the year

occurred as of the first day of the year, and that all additional and retirements during the

second half of the year occurred on the first day of the following year.

NB. If an asset within the composite group is retired before, or after, the average service

life of the group is reached, the resulting gain or loss should not be recognized. This

practice is justified because some assets will be retired (disposed) before the average

service life of the group and others after the average life. For this reason, the debit to

Accumulated Depreciation is the difference between original costs and cash received.

To illustrate, suppose that TANA Transport share Co. in the previous example, sold one of

the trucks with the cost of Br. 75,000, at a selling price of Br. 40,000, at the end of the

fourth year. Therefore, the entry to record the disposal would be:

Solution:
Original cost of the asset .......................................................... Birr 75,000
Less: cash receipts from sale of asset ......................................................... 40,000
Accumulated Depreciation of the asset............................................... Birr 35,000

Journal Entry

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Accumulated
Depreciation………35,000 Cash ............40,000

Cars, Buses, and Trucks ........................ 75,000

Revision of Depreciation Rates
When a plant asset is acquired, depreciation rates are carefully determined based on past

experience with similar assets and other relevant information. The provisions for

depreciation are only estimates, however, and it may be necessary to revise the estimated

economic life and that of salvage value during the life of the asset. Unexpected physical

deterioration or unforeseen obsolescence may make the useful life of the asset less than

originally estimated. Good maintenance procedures, revision of operating procedures, or

similar improvements may prolong the life of the asset beyond the original estimate.

To illustrate, assume that a delivery truck originally acquired for Br. 75,000 is estimated to

have a 16-year life with a residual value of Br. 3000. However, after 10 years of intensive

use, it is determined that the delivery truck will last only 4 more years, (instead of 6 years)

but its estimated residual value at the end of the four years will be Br. 6000, (instead of Br.

3000).

Solution:

Before the revision of the estimated life and the residual value of the asset at the beginning

of the 11th year, the asset account and its related accumulated depreciation account would

appear as shown below:

Delivery Truck Accumulated Depr- Delivery Truck

45,000 Balance
Cost 75,000
at the end of

the Year
th
After the revision, at the beginning of the 11 year, the remaining depreciable cost and the

revised annual depreciation by the straight-line method are computed as follows.

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Original Cost of the truck............................................................... Birr 75,000

Less: Accumulated depreciation already taken ........................................................... 45,000
Remaining cost of the delivery truck ................................................ Birr 30,000
Less: Revised estimated salvage value ....................................................................... 6,000
Revised annual depreciation30,000 - 6000
.................................................................... Birr 6,000
4 years
The new annual periodic depreciation expense is computed by dividing the revised

depreciable cost of Br. 24,000 by the remaining revised useful life of 4 years. Therefore, the

new periodic depreciation charge is Br. 6000. The annual adjusting entry for depreciation

for the next two years would be as follows:

Year 11
Dec. 31, Depreciation Expense - Delivery ...................................... 6000
Accumulated Depreciation - Delivery Truck......................... 6000

Year12
Dec. 31 Depr. Expense-Truck ....................................... 6000
.......................................

Depreciation of partial years

So far, the illustrations of the depreciation methods have assumed that the plant assets were

purchased at the beginning or end of the accounting period. However, business does not

often buy assets exactly at the beginning or end of the accounting period. In most cases,

they acquire the assets when they are needed and sell or discard them when they are no

longer useful or needed. The time of year is normally not a factor in the decision. Thus, it is

often necessary to calculate depreciation for partial years.

To illustrate, assume that a piece of equipment is purchased for Br. 5000 and that it has an
estimated useful life of five years, and an estimated residual value of Br. 500. Assume
further that the equipment is purchased on October 2 and that the yearly accounting period

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ends on December 31. Depreciation must be recorded for three months, October through
December, or 3/12 of a year. This factor is applied to the calculated depreciation for the
entire year. The three months‘ depreciation under the straight-line method is calculated as
follows:
Solution:
Annual depreciation = Original cost – Estimated Salvage value
Estimated useful life
= Br. 5000 – Br. 500 = Birr 900
5 years
Depreciation for partial year (Oct – Dec. 31) is therefore, Br. 900 x 3/12 = Br. 225
If the company used the double declining balance method on the above equipment, the

depreciation on the asset would be: Br. 5000 x 40/100 x 3/12, = Br. 500, depr. For three

months, If the company used the sum-of-years-digits method, the depreciation on the asset

would be: Birr (5000 – 500) x 5/15 x 3/12 = Birr 375, and the depreciation for the second

year would be: (5000 – 500) x 5/15 x 9/12 = Br. 1125 (5000 – 500) x 4/15 x 3/12=

300

Therefore, total 2nd year depreciation Br. 1425

NB. In this specific example depreciation was recorded from the beginning of October. If

the equipment had been purchased on October 16, or thereafter, depreciation would be

calculated beginning November 1, as if the equipment were purchased on that date.

2.2.3. Capital and Revenue Expenditures

Capital Expenditures: are expenditures that improve the operating efficiency (or capacity)

or costs incurred to achieve greater future benefits. In addition to the acquisition of plant

assets, capital expenditures included additions and betterments.

a) Addition is an enlargement to the physical layout of a plant asset. Suppose for

example, if a new wing is added to a building, the benefits from the expenditure

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will be received over several years, and the amount paid for it should be debited to

the asset account.

b) Betterment, on the other hand, is an improvement that does not add to the physical

layout of the asset. Installation of an air conditioning system is an example of

betterment, Replacement of a concrete floor for a wooden floor is also betterment

that will provide benefits over a number of years, so its cost should be charged

(debited) to an asset account.

c) Other types of capital expenditures include extraordinary repairs. Extraordinary

repairs are repairs of a more significant nature. They affect the estimated residual

value or estimated useful life of an asset. For example, a boiler for heating a

building may be given a complete overhaul, at a cost of Br. 3000 that will prolong

its economic life by 5 years. Extraordinary repairs are recorded by debiting the

accumulated depreciation account, under the assumption that some of the

depreciation previously recorded has now been eliminated. The effect of this

reduction in the accumulated depreciation account is to increase the book value of

the asset by the cost of the extraordinary repair. As a result, the new book value of

the asset should be depreciated over the new estimated useful life.

Illustration – 8: Suppose for example, a machine costing Br. 35,000 had no estimated

residual value and an original estimated useful life of ten years, has been depreciated for 7

years. At the very beginning of the 8th year, the machine was given a major overhaul

costing Br. 3000. This expenditure extended the useful life of the machine 3 years beyond

the original estimate. The computation of the new book value and the entry for the

extraordinary repair would be as follows:

Solution

To record extraordinary repair

Jan. 4. Accumulated Depreciation – Machinery ...............................3000.00

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Cash ......................................................................... 3000.00

Extraordinary repair to machinery
The revised annual depreciation for each of the six years remaining in the machine‘s

useful life would be calculated as follows:

Cost of Machine…………………………………………………… Birr 35,000

Accum. Depreciation before extraordinary repair Br. 24,500

Less: extraordinary repair (Debited to Accum. Depr.)….3000 21,500

Book value (carrying value) after extraordinary repair… Br.13,500

Revised Annual periodic depreciation= 13500 ....................................... 2,250

6 years

Revenue Expenditures: are expenditures incurred in order to maintain the normal

operating efficiency of the asset. Among the more usual kinds of revenue expenditures for

plant asset are the repairs, maintenance, lubrication, cleaning and inspection necessary to

keep an asset in good working condition.

 Ordinary repairs are expenditures that are necessary to keep an asset in good

operating conditions. Trucks must have tune-ups, their tires and batteries must be

replaced regularly, and other routine repairs must be made. Offices and halls must

be painted regularly, and broken tiles or woodwork must be replaced. Such repairs

benefits only the current period and therefore must be charged against the revenue

in the current fiscal period.

2.2.4. DISPOSAL OF PLANT ASSETS

This unit aims at discussing the meaning of disposing of plant assets, the different ways of

disposing plant assets, and the accounting procedures involved in recording transactions

relating to the discarding sale and exchange of plant or (fixed) assets.

A plant asset rarely lasts exactly as long as its estimated life. If it lasts longer than its

estimated life, it is not depreciated past the point at which its carrying value equals its

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residual value. The purpose of depreciation is to spread the depreciable cost of the asset

over the economic life of the asset. Thus, the total accumulated depreciation should never

exceed the total depreciable cost. If the asset is still used in the business beyond the end of

its estimated life, its cost and accumulated depreciation remain in the ledger accounts.

Proper records will thus be available for maintaining control over plant assets. If the

residual value is zero, the book value of a fully depreciated asset is zero until the asset is

disposed off. If such an asset is discarded, no gain or loss results. A plant asset may be

disposed by:

(1) Discarding it as worthless; (2) Selling it; or (3) Trading it in on a new asset

Discarding of a Plant Asset- If a plant asset is of no further use to the business and cannot

be sold or traded, and then the plant asset is discarded. If the asset has no book value, (i.e.,

if it is fully depreciated), the plant asset account is credited for the amount of the original

cost of the item being discarded. At the same time, the accumulated depreciation account is

debited for the amount of the total accumulated depreciation of the item being discarded. In

this case neither gain nor loss is realized. On the other hand, if a plant asset has a book

value (if not fully depreciated) at the time it is discarded, the business incurs a loss.

To illustrate, suppose for example, on July 5, year 5, equipment that was acquired On Jan

10, year 1, at a cost of Br. 11,000, is discarded as worthless. The discarded equipment has

a carrying value of Br. 2000 at the time of disposal. The carrying value is computed as the

difference between the cost of asset Br. 11,000 and accumulated deprecation, Br. 9000. A

loss equal to the carrying value should be recorded when the equipment is discarded.

Solution:
The journal entry required to discard the plant asset as of July 5, year 5, is:
Year 5 July 5 Accumulated Depreciation, Equipment .................... 9,000.00

Loss on disposal of plant Asset ........................................................ 2,000.00

Equipment ................................................................... 11,000.

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(Discarding Equipment no longer used in the business)

Sale of Plant Asset: The entry to record the sale of an asset for cash is similar to the one

illustrated above except that the receipt of cash should also be recorded. The following

entries show how to record the sale of equipment under three assumptions about the selling

price. In the first case, the Br. 2000 cash received is exactly equal to the book value of the

equipment (which is equal to Br. 2000).

Case 1: Sold at an amount equal to Book value, Br. 2000, no gain or loss results.
Year 5
July 5. Cash ............................................................ 2000.00
Accumulated Depreciation, Equip 9000.00
Equipment ........................................... 11000.00
Sale of equipment at an amount equal to book value
Case 2: Sold at Br. 1500 cash; Loss of Br. 500, (BV = Br. 2000)
Year 5
July 5. Loss on sale of equipment ........................................ 500.00
Accumulated Depreciation .................................... 9000.00
Cash ........................................................................ 1500.00
Equipment ................................................... 11000.00
Sale of equipment at less than the book value Loss of Br. 500
Case 3: Sold at Br. 3000 cash; gain of Br. 1000, cash received
through Sale less book value of the asset (Br. 3000 – Br.
2000)
Year 5
July 5. Cash .................................................... 3000.00
Accumulated Depr, Equipment.................... 9000.00
Equipment ...........................................................11000.00
Gain on sale of plant asset ............................................ 1000.00
Sale of equipment at more than the book value; gain of Br.
1000, (Br. 3000 – Br.2000) recorded

Exchange of Plant Assets: Ordinarily, companies record a gain or loss on the

exchange of plant assets. The rationale for recognizing a gain or loss is that most

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exchanges have commercial substance. An exchange has commercial substance if the

future cash flows change as a result of the exchange.

To illustrate, Ramos Co. exchanges some of its equipment for land held by Brodhead

AG. It is likely that the timing and amount of the cash flows arising from the land will

differ significantly from the cash flows arising from the equipment. As a result, both

Ramos and Brodhead are in different economic positions. Therefore, the exchange has

commercial substance, and the companies recognize a gain or loss in the exchange.

Because most exchanges have commercial substance (even when similar assets are

exchanged), we illustrate only this type of situation for both a loss and a gain.

Loss Treatment
To illustrate an exchange that results in a loss, assume that Roland NV exchanged a

set of used trucks plus cash for a new semi-truck. The used trucks have a combined

book value of €42,000 (cost €64,000 less €22,000 accumulated depreciation).

Roland‘s purchasing agent, experienced in the secondhand market, indicates that the

used trucks have a fair value of €26,000. In addition to the trucks, Roland must pay

€17,000 for the semi-truck. Roland computes the cost of the semi-truck as follows.

Businesses also dispose of plant assets by trading them in on the purchase of other

plant assets. Exchanges may involve similar assets, such as an old machine traded-in

on a newer model, or dissimilar assets, such as a machine traded-in on a truck. In

either case, the purchase price is reduced by the amount of the trade-in allowance.

Roland incurs a loss on disposal of plant assets of €16,000 on this exchange. The reason is that
the book value of the used trucks is greater than the fair value of these trucks. The computation is
as follows.

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In recording an exchange at a loss, three steps are required: (1) eliminate the book value of the
asset given up, (2) record the cost of the asset acquired, and (3) recognize the loss on disposal of
plant assets. Roland thus records the exchange on the loss as follows.

To illustrate a gain situation, assume that Mark Express decides to exchange its old delivery
equipment plus cash of €3,000 for new delivery equipment. The book value of the old delivery
equipment is €12,000 (cost €40,000 less accumulated depreciation €28,000). The fair value of
the old delivery equipment is €19,000.
The cost of the new asset is the fair value of the old asset exchanged plus any cash paid (or other
consideration given up). The cost of the new delivery equipment is €22,000, computed as
follows.

A gain results when the fair value of the old delivery equipment is greater than its book value.
For Mark Express, there is a gain of €7,000 on disposal of plant assets, computed as follows.

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In recording an exchange at a gain, the following three steps are involved: (1) eliminate the book
value of the asset given up, (2) record the cost of the asset acquired, and (3) recognize the gain
on disposal of plant assets. Accounting for exchanges of plant assets becomes more complex if
the transaction does not have commercial substance. This issue is discussed in more advanced
accounting classes.
2.3. ACCOUNTING FOR INTANGIBLE ASSETS
Intangible Assets: are rights, privileges, and competitive advantages that result from the
ownership of long-lived assets that do not possess physical substance. Evidence of intangibles
may exist in the form of contracts or licenses. Intangibles may arise from the following sources:
 Government grants, such as patents, copyrights, licenses, trademarks, and trade names.
 Acquisition of another business, in which the purchase price includes a payment for
goodwill.
 Private monopolistic arrangements arising from contractual agreements, such as
franchises and leases.

Companies record intangible assets at cost. This cost consists of all expenditures necessary for
the company to acquire the right, privilege, or competitive advantage. Intangibles are categorized
as having either a limited life or an indefinite life. If an intangible has a limited life, the company
allocates its cost over the asset‘s useful life using a process similar to depreciation. The process
of allocating the cost of intangibles is referred to as amortization. The cost of intangible assets
with indefinite lives should not be amortized.
To record amortization of an intangible asset, a company increases (debits) Amortization
Expense and decreases (credits) the specific intangible asset. (Unlike depreciation, no contra
account, such as Accumulated Amortization, is usually used.)

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PATENTS
A patent is an exclusive right issued by a patent office that enables the recipient to manufacture,
sell, or otherwise control an invention for a specified number of years from the date of the grant.
These ―legal lives‖ sometimes vary across countries, but the legal life in many countries is 20
years. A patent is non-renewable. But, companies can extend the legal life of a patent by
obtaining new patents for improvements or other changes in the basic design. The initial cost of
a patent is the cash or cash equivalent price paid to acquire the patent.
Many patents are subject to litigation by competitors. Any legal costs an owner incurs in
successfully defending a patent in an infringement suit are considered necessary to establish the
patent‘s validity. The owner adds those costs to the Patents account and amortizes them
over the remaining life of the patent.
The patent holder amortizes the cost of a patent over its legal life or its useful life,
whichever is shorter. Companies consider obsolescence and inadequacy in determining useful
life. These factors may cause a patent to become economically ineffective before the end of its
legal life.
COPYRIGHTS
Governments grant copyrights, which give the owner the exclusive right to reproduce and
sell an artistic or published work. Copyrights extend for the life of the creator plus a
specified number of years, which can vary by country but is commonly 70 years. The cost
of a copyright is the cost of acquiring and defending it. The cost may be only the small fee
paid to a copyright office. Or, it may amount to much more if an infringement suit is
involved.
The useful life of a copyright generally is significantly shorter than its legal life. Therefore,
copyrights usually are amortized over a relatively short period of time.
TRADEMARKS AND TRADE NAMES
A trademark or trade name is a word, phrase, jingle, or symbol that identifies a particular
enterprise or product. Trade names like Big Mac, Coca-Cola, and Jetta create immediate
product identification. They also generally enhance the sale of the product. The creator or
original user may obtain exclusive legal right to the trademark or trade name by registering
it with a patent office or similar governmental agency. Such registration provides a specifi
ed number of years of protection, which can vary by country but is commonly 20 years. The

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registration may be renewed indefinitely as long as the trademark or trade name is in use. If
a company purchases the trademark or trade name, its cost is the purchase price. If a
company develops and maintains the trademark or trade name, any costs related to these
activities are expensed as incurred. Because trademarks and trade names have indefinite
lives, they are not amortized.
FRANCHISES AND LICENSES
A franchise is a contractual arrangement between a franchisor and a franchisee. The
franchisor grants the franchisee the right to sell certain products, perform specific services,
or use certain trademarks or trade names, usually within a designated geographic area.
Another type of franchise is that entered into between a governmental body (commonly
municipalities) and a company. This franchise permits the company to use public property
in performing its services. Examples are the use of city streets for a bus line or taxi service,
use of public land for telephone and electric lines, and the use of airwaves for radio or TV
broadcasting. Such operating rights are referred to as licenses. Franchises and licenses may
by granted for a definite period of time, an indefinite period, or perpetually.
When a company incurs costs in connection with the purchase of a franchise or
license, it should recognize an intangible asset. Companies should amortize the cost of a
limited-life franchise (or license) over its useful life. If the life is indefi nite, the cost is not
amortized. Annual payments made under a franchise agreement are recorded as operating
expenses in the period in which they are incurred.
GOODWILL
Goodwill represents the value of all favorable attributes that relate to a company that is not
tied to any other specific asset. These attributes include exceptional management, desirable
location, good customer relations, skilled employees, high-quality products, and
harmonious relations with labor unions. Goodwill is unique. Companies record goodwill
only when an entire business is purchased. In that case, goodwill is the excess of cost over
the fair value of the net assets (assets less liabilities) acquired.
Goodwill is not amortized because it is considered to have an indefinite life, but its value
should be written down if impaired. Companies report goodwill in the statement of financial
position under intangible assets.
Research and Development Costs

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Research and development costs are expenditures that may lead to patents, copyrights, new
processes, and new products. Costs in the research phase are always expensed as incurred.
Costs in the development phase are expensed until specific criteria are met, primarily that
technological feasibility is achieved. Development costs incurred after technological
feasibility has been achieved are capitalized to Development Costs, which is considered an
intangible asset.
To illustrate, assume that Laser Scanner Ltd. spent NT$1 million on research and NT$2
million on development of new products. Of the NT$2 million in development costs,
NT$400,000 was incurred prior to technological feasibility and NT$1,600,000 was incurred
after technological feasibility had been demonstrated. The company would record these
costs as follows.

2.4. Accounting for Natural Resources

We now turn our attention to another group of long-lived assets natural resources, such as
minerals, oil, and timber or lumber. These natural resources are extracted from the earth.
Depletion is the accounting measure used to allocate the acquisition cost of natural resources.
Depletion differs from depreciation because depletion focuses specifically on the physical use
and exhaustion of the natural resources, while depreciation focuses more broadly on any
reduction of the economic value of a plant or fixed asset. The costs of natural resources are
usually classified as long-terms assets. Depletion expense is the measure of that portion of long-
term assets that is used up in a particular period.
Illustration – 13: Suppose for example, MIDROC Construction has acquired the right to use
10,000 acres of land in Shakiso territory to mine for gold at a total cost of, Br. 10,000.000. The
Company estimated that the mine will; provide approximately 500,000 grams of gold. The
depletion rate established is computed in the following manner.

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Depletion Rate= Total cost – Salvage value

Total estimated units available

Annual Depletion = Depletion Rate * Actual Units extracted

Br. 10,000,000 = Br. 20 per gram
500,000 units
If 100,000 grams are extracted in the first year, then the depletion for the year is 2000.000
(1000,000 x Br. 20.00). The entry to record the depletion is therefore:
Depletion Expense 2,000,000
Accumulated Depletion 2, 000,000

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CHAPTER THREE
THE PAYROLL ACCOUNTING IN ETHIOPIAN CONTEXT
[Link] Importance of Payroll Accounting
The concept of payroll is often referred to the total amount paid to employees of a firm as a
compensation for the service rendered to a firm in a given period. The payroll accounting of a
firm has to be given emphases of significance for the following reasons.
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.

Moreover, since the payroll related payment is highly subject to certain fraudulent activities it is
imperative that businesses need to properly design their payroll system so that it safeguards the
company‘s assets against unauthorized payments of payroll and the accuracy as well as
reliability of the accounting records is assured pertaining to payroll. Some of the possible frauds
that can be made on the payroll system are the following:
 Adding fictitious employees to the payroll

 Listing terminated employees on the payroll

 Using unauthorized pay rates

 Overstating working hours

 Issuing duplicate payroll checks

 Not deducting employees‘ absent time

 Making incorrect totals on the payroll register

Payroll activities involve four functions: hiring employees, timekeeping, preparing the payroll,
and paying the payroll.

[Link] of Payroll Related Terms

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
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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.
The Pay Period: A pay period refers to the length of time covered by each payroll payment.
Pay period for wage workers are usually made on weekly. On the other hand, salaried
employees‘ pay periods are monthly or semimonthly.
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.
Basic records of a payroll accounting system includes:
1. A payroll register ( or sheet)
2. Individuals employees‘ earnings records, and
3. Usually, pay checks.

These records are generated from a payroll system that is operated manually or using computers.
A. A Payroll Register (or sheet): the entire 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.
B. Employee earnings records: it is a summary of each employees‘ earnings, deductions,
and net pay for each payroll period and of cumulative gross earnings during the year.
It is a separate record kept for each employee. The individual record of employees‘
earnings helps the employer organization to properly summarize and file tax returns.
C. Pay Check: A business can pay payroll by writing a check for the total or individual
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.
D. Gross Earnings: It is the total pay to an employee before deductions for the pay
period.

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E. Payroll taxes: are taxes levied against the employer on the payroll of a firm. It is
additional payroll related expense to an employer.
F. Withholding Taxes: These are taxes levied against the earnings of the employees of an
organization and withheld by the employer per the regulations of the concerned
government.
G. 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.
H. 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.

[Link] Components of a Payroll Register

1. Employee number: Numbers assigned to employees for identification purpose when a
relatively large number of employees are included in the payroll register.

2. Name of employees: List of the names of employees

3. Earnings: Money earned by an employee(s) of a firm from various sources. Earning may
include the following elements.

A. The basic salary or regular earning: A flat monthly salary of an employee that is paid for
carrying out the normal work of employment and subject to change when the employee is
promoted. It can be expressed in an hourly rate:

Hourly pay rate = Monthly basic salary

Regular Working hours per month
B. Allowances: Money paid monthly to an employee for special reasons, which may include.

i. Position allowance: A monthly sum paid to an employee for bearing a particular

office responsibility, head of a particular department or division.

ii. House allowance: A monthly allowance given to cover housing costs of the
individual employee when the employment contract requires the employer to
provide housing but fails to do so.

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iii. 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 a different and distant work area or location. It is sometimes known as
disturbance allowance.

iv. Desert allowance: A monthly allowance given to an employee because of

assignment to a relatively hot region.

v. Transportation (fuel) allowance: A monthly allowance to an employee to cover

cost of transportation up to the work place 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 or days.
Overtime earning is the amount payable to an employee for overtime work done.
In Ethiopia, in this respect, according to Article 33 or proclamation no. 64/1975 the following is
stated about payment for overtime work.
 A worker shall be entitled to be paid at a rate of one and one quarter (1 ¼) times his ordinary
hourly rate for overtime work performed before 10 o‘clock in the evening (10 p.m).

 A worker shall be paid at the rate of one and one half (1 ½) times his ordinary hourly rate for
overtime work performed between 10 O‘clock in the evening (10 p.m.) and six O‘clock in
the morning (6 a.m.)

 Overtime work performed on the weekly rest days shall be paid at a rate of two (2) times the
ordinary hourly rate of payment.

 A worker shall be paid at a rate of two and half (2 ½) times the ordinary hourly rate for
overtime work performed on a public holiday.

Hence, the gross earnings of an employee may, therefore, include the basic salary, allowances
and overtime earnings. You may find sometimes other form of earnings such as bonus that is
paid to employees for achieving results better than usual.
Over time earning = Hours worked x (ordinary hourly rate x OT rate)

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D. Bonus: is an amount paid to employees who achieved better results. Some firms may give
bonus for all employees as a way of motivation. Bonus could be determined based on
employees‘ total earnings or the firm‘s net income for the period.
4. Payroll deduction

Payroll deductions may be mandatory or voluntary. Mandatory deductions include deductions

required by law like income tax and pension contribution. The government legislation requires
employers to withhold from the pay of each employee the applicable income tax due on those
wages and salaries. The employer computes the amounts of income tax withhold deductions
according to a government prescribed formula or withholding tax table. Employees may
voluntarily authorize withholdings for charitable, retirement and other purposes. The
employee should authorize all voluntary deductions from gross earnings in writing.
a. Employee income tax
In Ethiopia, every citizen is required to pay something in the form of income tax from his/her
earnings of employment. In this case, a progressive income tax system that charges higher rates
for higher earnings is applied on the gross earnings of each employee saving the first 600 Birr. In
Ethiopia nowadays, the first Birr 600 of the earnings of an employee is free from income tax. It
is EXEMPTION- money on which a person does not have to an income tax.
According to the Ethiopian Federal income tax proclamation no 979/2016 employment Income
Tax Rates, the rates of employment income tax are:

Income bracket(Birr Range

Rate
Up to 600 _ Exempted
600 - 1650 1050 10%
1650 - 3200 1550 15%
3200 - 5250 2050 20%
5250 - 7 800 2550 25%
7800 – 10900 3100 30%
Above 10900 - 35%

Generally, taxable from employment includes salaries, wages, some allowances, director‘s fees
and other personal employment, all payments in cash and benefits in kind. Once taxable income
is determined from gross earnings, the following formula can be used to determine the income

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tax as an alternative and it‘s called shortcut method.

Taxable
Income bracket (Birr) Formula
< 600 exempted
600-1650 (TI x10%) - 60
1650- 3200 (TI x15%) -142.5
3200- 5250 (TI x20%) – 302.5
5250- 7800 (TI x25%) - 565
7800 - 10900 (TI x 30%) - 955
Above 10900 (TI x35%) - 1500
Where, TI is Taxable Income or Employment Income
60 = (600 X 0.1) – 0
142.5 = [(600 X .15) – 0] + [(1050 X 0.15) – (1050 X 0.1)] and so forth.
Tax free /exempted payment
Art 65 of Proclamation No 979/2016 exempts the following employment income from taxation:
 Income from employment received by casual employees
 Pension contribution, provident fund contributions and all forms of retirement
benefits – not more 15% of basic salary
 Income from employment received by diplomatic and consular representatives; and
other persons employed in any Embassy
 Income specifically exempted from income tax by any law in Ethiopia
 Payments made to a person as compensation or gratitude in relation to personal
injuries; or the death of another person.
 Medical Allowance
 Transportation Allowance (max Br 2200 or 25% of salary whichever is lower)
 Hardship Allowance
 Per-diem Allowance (Daily Allowance) (Daily Allowance) (max Br 225 or 4% of
salary whichever is higher)
 Traveling Expenses
 Board Allowances of public enterprises‘ board members
 Income of persons employed for domestic duties
Pension fund
Permanent employees of an organization, the employees of which are governed by the existing
regulations of the Ethiopian public servants (Proclamation No. 979/2016) are expected to pay or

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contribute 7% of their basic (monthly) salary to the government pension trust fund (Civil service
pension fund). This amount should be withheld by the employer from the basic salary of each
employee on every payroll and later be paid to the respective government body. On the other
hand, the employer is also expected to contribute towards the same fund 11% of the basic salary
of every permanent employee of it. It is this total amount we called earlier as payroll taxes
expense to the employer organization (i.e., 11% of the total basic salary of all permanent
employees). Consequently, the total contribution to the pension trust fund of the Ethiopian
government is equal to 18% of the total basic salary of all permanent employees of an
organization to be entitled to the pension pay given that the employee has satisfied the minimum
requirements to enjoy this benefit when retired.
Non-government organizations are also using this kind of scheme to benefit their employees with
some modifications. This is made in some NGO‘s by keeping a fund known as provident fund.
Both the employees and the employer contribute towards this fund monthly. Ultimately, when as
employee retired or drawn out of work a lump sum amount is given at once.
b. Other Deductions Apart from the above two kinds of deductions from employees
earnings, employees may individually authorize additional deductions such as
deductions to pay health or life insurance premiums; to repay loans from the
employer or credit association; to pay for donations to charitable organization; etc.

Each of the other major deductions may be put in special column in the payroll register.
Ultimately, the sum of the employee‘s income tax, pension contribution and other deductions
gives the total deductions from the gross earnings of an employee.
5. The Net Pay/take home pay: This amount is held in one column of the payroll register
representing the excess of gross earnings over the total deductions of an employee. The column
―Net Pay‖ total shows the grand total deductions made from the earnings of employees.
6. Signature: Unless some other document is used, the payroll sheet may be designed to allow a
column for signature of the employees after collection of the net pay. In general, a payroll
register should at least show the earnings, deductions and the net pays along with the name of
employees.
Entries related to payroll
The journal entry for recording the payroll is based on the column totals from the payroll
register. Note that each account debited or credited is a total from the payroll register.

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 Recording payroll expenses and liabilities

 Recording the payment of the payroll
 Recording employer payroll taxes
 Recording payment of withholdings, payroll taxes, and other deductions to each
respective recipient.
Problem
Payroll accounting illustration
Illustration: Assume XYZ is a governmental agency organized to render public service. It has
the following data related to its employees whose salaries are paid according to the Ethiopian
calendar month of Yekatit, 2009 E.C.
Serial Name of Basic Transportation Over time Duration of Over Time
No. Employees Salary Allowance worked(hr.) work
01 Zerfie Shewa Br.1920 200 4 Up to 10:00 P.M
02 Paulos Chala 2,020 - 8 Weekend
03 Lema kebie 5,300 - - -
04 Tensay Belay 1,470 - - -
05 Haile Garba 2,950 600 6 Public holidays

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 Tensay and Haile

- Lema agreed to contribute monthly Br. 400 and 200 from his salary as saving in the credit
association and as a donation to the homeless children‘s respectively.

- Transportation allowance for Zerfie is non-taxable

- Paulos agreed to contribute monthly Br. 300 from his salary as a monthly saving in the
credit association of the agency.

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- Haile agreed to donate monthly Br. 100 from his monthly salary as aid to orphans
children‘s

Required
a. Prepare a payroll register (sheet) for the agency for the month of Yekatit, 2009 E.C.

b. Record the payment of salary as of Yekatit 30, 2009 E.C using check stub No. 0123.

c. Recognition of payroll tax expense/withholding taxes on Yekatit 30

d. Record the payment of the claim of the credit Association of their agency on Megabit 1,
2009 E.C using check stub No. 0124.

e. Record the payment of donations on Megabit 3,2009 E.C.

f. Record the payment of the withholding taxes and pension contribution to the concerned
government body on Megabit 7, 2009 E.C.

a. Computation of Earnings, Deductions and Net Pay

Gross pay/earning = Basic salaries+ Allowances + Over time earnings + Commissions + Bonuses +
Other earnings.
Overtime earning = OT hrs worked X (ordinary hourly rate X relevant OT rate)
1. ZERFIE:
 OT Earning = 4 hours X Br. 1920 X 1.25 = Br. 60
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
= Br. 1,920
160 Hours
 Therefore, the regular Hourly payment = Br. 12
The regular hourly payment must be multiplied by the appropriate OT rate as follows:
Br. (12 x 1.25) x 4 hours = Br. 60
2. PAULOS
 OT Earning = 8 hours X Br. 2020 x 2 = Br. 202
160 hours

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3. HAILE
 OT Earnings = 6 hours X Br. 2,950 x 2.5 = Br. 276.56
160 hours
GROSS EARNINGS
Gross Earnings = Basic salary + Allowance + OT Earnings
1. ZERFIE
 Gross Earnings = Br. 1,920 + Br. 200 + Br. 60 = Br. 2,180
 Remember taxable income in this case is Br. 1,980 because the transportation allowance
of Br. 200 is not subject to taxation.
2. PAULOS
 Gross Earning = Br. 2,020 + Br. 202 = Br. 2,222
 The Gross Total Earnings of Paulo‘s consists of the Br. 2,020 basic salary plus the
overtime earnings of Br. 202, which is Br. 2,222.
3. LEMA
 Gross Total Earnings = Br. 5,300, which include the basic salary alone
4. TENSAY
 Gross Total Earnings = Br. 1,470, which is the basic salary.
5. HAILE
 Gross Total Earnings = Br. 2,950 + Br. 600 + 276.56 = Br. 3,826.56
 Remember taxable income in this case is Br. 3,826.56 because the transportation
allowance of Br. 600 is subject to taxation.
DEDUCTIONS AND NET PAY
1. ZERFIE:
 Gross Earnings = Br. 1,920 + Br. 200 + Br. 60 = Br. 2,180
 Gross Taxable Income (Br. 2,180 – Br. 200)--------------------Br.1,980

 Employee income tax

Short cut method
(TI x 15%) -142.5
600 x 0% = 0.00 = (1,980 x 15%) -142.5
1050 x 10% =105.00 = 297– 142.5
330 x 15 % = 49.5 or = 154.5
Total 1,980 154.5
Pension contribution:
Basic salary x 7%
= 1920 x 7%
= Br. 134.4
Total deductions = Br. 154.5 + 134.4
= Br. 288.9

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 Fundamentals of Accounting -II

Net pay = Gross earnings – Total deductions

= Br. 2,180 – 288.9
Br. 1891.1
2. PAULOS:
 Gross Total Earning-----Br. 2,222. Short cut method
(TI x 15%) -142.5
 Employee Income tax
= (2,222 x 15%) -142.5
600 x 0% = 0.00 = 333.3– 142.5
1050 x 10% =105.00 = 190.8
572 x 15 % = 85.8
Total Br. 2,222 190.8

Pension contributions
Basic salary * 7% Other deductions
Credit association Br. 300
=2020 * 7%
Total Br.
= Br. 141.4 300
Total deductions = Br. 190.8 + 141.4 + 300 =Br. 632.2

Net pay = Gross earning – Total deduction = Br. 2,222- 632.2 =Br. 1,589.8
3. LEMA:
 Gross Total Earnings------------------------------------Br. 5,300
 Employee Income Tax
600 x 0% = 0 Short cut method
1050 x 10% =105.00 (TI x 25%) - 565
1550 x 15% =232.50 = (5,300 x 25%) - 565
2050 X 20% = 410.00 = 1,325 - 565
50 X 25% = 12.50 = 760
Total Br. 5,300 Br. 760
Pension contribution
Basic salary X 7% Other deductions
= Br. 5,300*7% Donation Br. 200
Credit association 400
=Br. 371
Total Br. 600
Total deductions = Br. 760 + 371 + 600 = Br. 1,731
Net pay = Gross earning – Total deductions
=Br. 5,300 – 1,731 = Br. 3,569

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4. TENSAY:
 Total Gross Earnings ------------------------------- Br. 1,470
 Employee income tax
Short cut method
600 x 0% = 0 (TI x 10%) - 60
870 x 10% =87.00 = (1,470x 10%) - 60
Total Br. 1,470 Br. 87 = 147- 60
Total deduction = Br. 87 = 87
Net pay = Gross total earning – total deduction
=Br. 1,470 – 87
=Br. 1,383
5. HAILE:
 Total Gross Earnings----------------Br. 3,826.56
 Employee income tax
Short cut method
600 x 0% = 0 (TI x 20%) – 302.5
1050 x 10% = 105.00 = (3,826.56 x 20%) – 302.5
1550 x 15% = 232.50 = 765.312 – 302.5
626.56 X 20% = 125.312 = 462.812
Total Br. 3,826.56 Br. 462.812

Other deductions
Total deduction = Br. 462.812 + 100
Donation Br. 100
= Br. 562.812 Total Br. 100
Net pay = Total Gross Earning – Total deductions
= Br. 3,826.56 – 562.812
= Br. 3,263.748
Note: Pension contribution deducted only when the employees are permanent to the
organization. In case, the employees are not permanent pension contribution is not calculated and
deducted from the employees.

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PROVING THE PAYROLL:

Total Earnings:
Basic salary-----------------------------------------------Br. 13,660.00
Allowances--------------------------------------------------------800.00
Overtime-----------------------------------------------------------538.56
Grand Total------------------------------Br. 14,998.56
Deductions:
Employee Income Taxes---------------------------------Br. 1,655.112
Pension Contributions------------------------------------------646.80
Other Deductions----------------------------------------------1,000.00
Total Deductions----------------------------------Br. 3,301.912
Net Pay Total---------------------------------------------Br. 11,696.648
Total Deductions plus Net pays------------------------Br. 14,998.56
XYZ Agency
Payroll Register (sheet)
For the month of Yekatit, 2009 E.C
S. Name of Earnings Gross Deductions Total Net pay Sig
no employee Basic Allo Over Earning Income Pensio Othe deduct n.
salar wan time s tax n r
y ce cont. ded.
01 Zerfie Shewa 1,920 200 60 2,180 154.5 134.4 288.9 1,891.1
02 Paulos Chala 2,020 202 2,222 190.8 141.4 300 632.2 1,589.8
03 Lema kebie 5,300 5,300 760 371 600 1,731 3,569
04 Tensay Belay 1,470 1,470 87 87 1,383
05 Haile Taye 2,950 600 276.5 3,826.56 462.812 100 562.812 3,263.74
6 8
Total
13,66 800 538.5 14,998.5 1,655.11 646.8 1,000 3,301.91 11,696.6
0 6 6 2 2 48
Prepared by: _______________Checked by: ________________Approved by: ___________
b. Yekatit 30, 2009. Salary expense--------------14,998.56
Cash-----------------------------------------------11,696.748
Pension payable---------------------------------- 646.80
Income tax payable------------------------------1,655.112
Credit association payable------------------------700
Donation payable-----------------------------------300

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c. Yekatit [Link] tax expense-------------1,126.4

Pension payable ---------------------------------1,126.4
(11% x basic salary of all permanent employees)
d. Megabit 1. Credit association payable----------------700
Cash------------------------------------------------------700
e. Megabit 3. Donation payable-----------------------300
Cash-------------------------------------------300
f. Megabit 7. Pension payable---------------------646.80
Payroll tax payable----------------1,016.4
Employment tax payable---------1,655.112
Cash -------------------------------------------------3,318.312

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 Fundamentals of Accounting -II

Chapter 4
Accounting for Partnership
4.1. Introduction
A partnership is an association of two or more persons to carry-on as co-owners of a
business for profit. This association is based on a partnership agreement or contract known
as the articles of a partnership.
 The partnership agreement should be in writing to avoid any misunderstandings
about the formation, operation, and liquidation of a partnership.
 It is a voluntary association two or more persons called Partners.
 It is widely used for comparatively small businesses that wish to take advantage of
the combined capital, managerial talent & experience of two or more persons.
 Similarly, if you enter a profession such as accounting, law or medicine, you may
find it desirable to form a partnership with other processionals in your field.
4.2. Characteristics of Partnerships
For purposes of accounting, partnerships are treated as separate economic entities.
Partnerships have several characteristics that have accounting implications. The most
important ones are:
1. Ease of formation. A partnership can be created without any legal formalities. When
two or more persons agree to become partners, such an agreement constitutes a contract
and a partnership is automatically created. The contract should be in writing in order to
lessen the chances or misunderstanding and future disagreement. The voluntary aspect
of a partnership agreement means that no one can be forced to continue as a partner.
2. Voluntary Association. A partnership is a voluntary association of individuals rather
than a legal entity in itself. Therefore, a partner is responsible under the law for his or
her partner‘s business actions with in the scope of the partnership. Thus, the personal
assets, liabilities and transactions of the partners are excluded from the accounting
records of the partnership just as they have in as proprietorship.
3. Mutual Agency. Each partner is an agent of the partnership within the scope of the
business. This means that partner‘s act to any contract is binding on the
remaining

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partners as long as it is with in the apparent scope of the business‘ operations. For
example, a partner in a public accounting firm can bind the partnership through the
delivery of accounting services.
4. Co ownership of partnership property. Once invested, the properties contributed by
the partners become the property of the partnership and is owned jointly by all the
partners. Upon liquidation of the partnership and distribution of assets, the partner‘s
claim on the assets is measured by the amount of the balance in his/her capital account.
5. Limited Life. Because a partnership is formed by the consent of two or more partners, it
has a limited life. This means that, anything that ends the contract dissolves the
partnership. A partnership can be dissolved when (1) a new partner is admitted; (2) a
partner withdraws, retires, dies or becomes bankrupt. At this point, the remaining
partners should sign a new contractual agreement to continue the affairs of the business.
In place of the old partnership a new partnership is formed. Thus, a partnership is said
to have a limited life.
6. Unlimited Liability. Each partner is liable for all the debts of the partnership. When
and if the partnership fails to pay its debts, creditors can seize (take) each partner‘s
personal assets to satisfy their claims. Therefore a creditor claims are not limited to the
assets of the business, but is extends to the personal property of the partners. Each
partner, then, could be required by law to pay all the obligations (debts) of the
partnership. In these characteristics, partnerships can be general or limited partnerships.
 General partnerships. Most partnerships are general partnerships, in which the
partners have unlimited liability. Thus, if a partnerships, becomes insolvent, the
partners must contribute sufficient personal assets to settle the debts of the
partnership. All partners have unlimited liability.
 Limited partnership. It is formed in which the liability of some partners may be
limited to the amount of their capital investments. However, a limited
partnerships must have at least one general partner who has unlimited liability.
7. Non taxability. A partnership is a nontaxable entity like sole proprietorship but unlike
corporations. Thus, it is not required to pay federal income tax. However, individual
partners must report their distributive share of a partnership income on their personal tax
returns to the tax authority.

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8. Participation in Income. Partners participate in income of the partnership. NI and NL

are distributed among the partners according to their agreement. In the absence of any
agreement, all partners share equally.
9. Partners Owner’ Equity accounts. Each partner has an account in this/her name with
an amount of a balance in his/her capital investment.
10. Partnerships Agreement. A partnership is created by a voluntary contract containing all
the elements essential to any other enforceable contract. The contract, known as the
articles/Memorandum of partnerships or partnerships agreement, should be in writing
and should clearly express the intentions of partners‘ provisions such as:
 The name ,location,& nature of the business
 The purpose of the business & date of inception
 Name & Capital contributions of partners
 Method of sharing of profits & losses
 Procedures for the withdrawal or addition of partner
 Provision for arbitration of disputes
 Accounting period to be used
 Annual audit by CPA
 Provision for insurance on the lives of partners, with the partnership or
surviving partners named beneficiaries
 Etc

4.3. Advantages and Disadvantages of Partnership

Advantages
A partnership form of business ownership has the following advantages:
1) Easy and inexpensive to form than a corporation. A partnership is easy to form. It
only requires the consent of two or more parties. Two or more competent persons
simply agree to be partners in some common business purpose.
2) Pooling of capital and managerial skills. Partnership is advantageous to raise a large
amount of capital and managerial skill (talent) than a sole proprietorship. Because a
partnership is formed by two or more persons, it is possible to raise a large amount of
capital and managerial skill than a single owner.

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3) Single taxation. Not subject to separate taxation as a case in a corporation because

each partner reports his/her own share of partnership income and is individually taxed.
Disadvantages
Partnership has the following disadvantages:
1) Unlimited liability. The liability of the partners is not limited to what they have in the
partnership, but it goes to the extent of their personal properties (assets).
2) Mutual Agency. Diisadvantageous if each partner does not exercise his/her
good judgment because one partner‘s act can bind a partnership into a contract.
3) Limited life. Partnerships are subject to possible termination due to many uncon
4) Less freedom than sole proprietorship..
5) Difficulty in transferring ownership.. The transfer of ownership from one partner to
another person is difficult unless the remaining partners approve of this

4.4. Formation of a Partnership

A separate capital account is maintained for each partner in a partnership. Each partner‘s
capital account is credited for the value of their investment upon formation of the
partnership.
 The various assets contributed by a partner are debited to the proper asset accounts. If
liabilities are assumed by the partnerships, the appropriate liability account is credited.
The partner‘s capital account is credited for the net (assets minus liability) amount.
 In each entry, the monetary amounts (values) at which the non-cash assets (assets
other than cash) are stated are those agreed upon by the partners, which are their Fair
Market Value.
 Receivables are recorded at face amount, with a credit to the allowance for
doubtful (uncollectible)
 Accumulated depreciation is not recognized for old plant assets.
 The equity (Capital) of every partner must show the net assets i.e. total assets
minus liabilities contributed to the partnerships, then after it shows additional
investments and withdrawals made by the partners.

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Illustration
Dr. Talky and Dr. Mama decided to form a partnership business, which would provide
medical services. They have been in business separately before they form the partnership.
The partnership assumed the liabilities of their separate business. The assets were valued
and recorded at their current fair market value.

Shown below are the assets contributed and the liabilities assumed by the partnership at
their fair market value.
Dr. Talky Dr. Mama
Cash Birr 6.500 Cash Birr 3,300
Accounts Receivable 8,600 Accounts Receivable 4,300
Supplies 21,000 Supplies 12,000
Medical Equipment 3,000 Medical Equipment 150,000
Accounts Payable (2,300) Accounts Payable (3,200)
Required: Record the necessary journal entries to record the investments made for
partnerships.
Solution
The journal entry on January 1, 2002 to record the investment of each partner and the
formation of the partnership would be:
2002 Jan.1 Cash 6,500
A/R 8,600
Supplies 21,000
Medical Equipment 3,000
A/p 2,300
Talky Capital 36,800
2002, Jan.1 Cash 3,300
A/R 4,300
Supplies 12,000
Building 150,000
Accounts Payable 3,200
Mama Capital 166,400

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4.5. Division of Partnership Income and Losses

A partnership‘s income and losses can be distributed according to whatever method the
partners specify in the partnership agreement. The agreement should be specific and clear,
to avoid later disputes.
 If a partnership agreement does not mention the distribution of income and losses, the
law requires that they be shared equally by all partners. Also, if a partnership
agreement specifies only the distribution of income, but is silent as to losses, the law
requires that losses be distributed in the same ratio as income.
 The Income of a partnership normally has three components:
a) Return to the partners for the use of their capital – called interest on
partners‘ capital,
b) Compensation for direct services the partners have rendered – called
partners‘ salaries, and
c) Other income for any special characteristics individual partners may bring to
the partnership or risks they may take.

The breakdown of total income into its three components helps clarify how much each
partner has contributed to the firm. Income can be shared among the partners in one of the
following ways:
i. Net income divided in a stated ratio such as:
a) equally
b) agreed upon ratio (other than equally)
c) ratio based on beginning capital balances
ii. Net Income divided by allowing interest on the capital investments, salaries, or
both with the remaining net income divided in an agreed ratio.
 Partners are not legally employees of the partnerships; not are their capital
contributions loans.
 The division of NI/NL may be presented as a separate statement accompanying the
business sheet and income statement; or it may be added at the bottom of the income
statement.

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 The division of NI is recorded as a closing entry regardless of whether the partners

actually withdraw the amounts of their allowances (Salary and Interests).
 If the partners withdrawn their salary allowances monthly, the withdrawals would
have accumulated as debits in the drawing account during the year. At the end of the
year, the debit balances in their drawing accounts would be transferred to their
respective capital accounts.
 Salary and interest allowances are not expenses of the partnerships rather they are
allowances paid to consider difference of partners‘ on their ability and time devoted
and capital distributed.
Illustration
1) Assume that Dr. Talky and Dr. Mama partnership had a net income of Birr 60,000
a) Assume that the articles of a partnership provides equal share of Net Income or Loss.
In this case the capital accounts of each partner will be credited for Birr. 30,000
Income Summary 60,000
Dr. Talky capital 30,000
Dr. Mama capital 30,000
b) Net income is divided in ratio of 3: 2 to Dr. Talky and Dr. Mama respectively.
Income summary 60,000
Dr. Talky capital (3/5 X 60,000)-------------------------------- 36,000
Dr. Mama capital (2/5 X 60,000) -------------------------------- 24,000
c) Net income is divided in a ratio of partners‘ capital account balances at the beginning
of the fiscal period.

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d) Net income is divided by allowing 5% interest on their beginning capital

balances, a Salary of Birr. 5,000 to Dr. Talky and the remainder are divided equally.

Net Income Division

Income to be
Dr. Talky Dr. Mama Total Distributed
Net income Birr, 60,000
Interest (5%) 1,840 8,320 10,160 49,840
Salary 5,000 -- 5,000 44,840
Remainder 22,420 22, 420 44,840 -- 0 –
Distribution 29,260 30,740 60,000

Journal
entry
Income summary………………… 60,000
Dr. Talky capital 29,260
Dr. Mama capital -----------------------------------------------30,740
e) Net income is divided by allowing 5% interest on their beginning capital
balances, a Salary of Birr. 55,000 to Dr. Talky and the remainder are divided equally.
Net Income Division
Income to be
Dr. Talky Dr. Mama Total Distributed
Net income Birr, 60,000
Interest (5%) 1,840 8,320 10,160 49,840
Salary 55,000 -- 55,000 (5,160)
Remainder (2,580) (2,580) (5,160) -- 0 –
Distribution 54,260 5,740 60,000

Journal
entry
Income summary……………… 60,000
Dr. Talky capital 54,260

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Dr. Mama capital ------------------------------------------------ 5,740

4.6. Financial Statements for a Partnership

The income statement of a sole proprietorship and that of a partnership are the same. At the
end of the period a statement of partners‘ capital is prepared which summarizes the effect of
transactions on the capital account balances of each partner. The statement of owners‘
equity for Talky and Mama using the income division shown under case (d) above and
assumed Additional Investment and Withdrawal is illustrated below.
Dr. Talky and Dr Mama
Statement of partners’ Capital
For the year ended Dec, 31, 2002

Dr. Talky Dr. Mama

Capital Bal. January 1, 2002 Br. 36,800 Br. 166,400
Add: Additional investment 4,200 4,300
Total Br. 41,000 Br. 170,700
Net income distribution 29,260 30,740
70,260 201,440
Deduct: Withdrawals during the year 5,000 5, 000
Capital Bal. Dec. 31, 2002 Br. 65260 Br. 196,440

NB- The balance sheet of a partnership is different from that of a sole proprietorship only in
the owner‘s equity section. In the partnership business since two or more persons owns the
business, there are two or more capital accounts whereas for a sole proprietorship there will
always be one capital account.

Exercise - 1
1. Helena and Myron agreed to form a partnership. Helena contributed Br. 200,000 in
cash, and Myron contributed assets with a fair market value of Br. 400,000. The
partnership, in its initial year, reported net income of Br. 120,000. Required: Prepare the
journal entry to distribute the first year‘s income to the partners under each of the
following condition.
 Helena and Myron failed to include stated ratio in the partnership agreement.
 Helena and Myron agreed to share income and losses in 3:2 ratios.
 Helena and Myron agreed to share income and losses in the ratio of their

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original investments.
 Helena and Myron agreed to share income and losses by allowing 10 percent interest
on their original investments and sharing any remainder equally.
 Helen and Myron agreed to share NI/NL by allowing 10% interest on their
capital investment, $40,000 salary allowance each & the remainder equally.

4.7. Dissolution of a Partnership

Dissolution of a partnership occurs whenever there is change in the original association of
partners. When a partnership is dissolved, the partners lose their authority to continue the
business as a going concern. This does not mean that the business operation necessarily is
ended or interrupted, but it does mean – from a legal and accounting standpoint – that the
separate entity stops to exist.
 The remaining partners can act for the partnership in finishing the affairs of the
business or in forming a new partnership that will be a new accounting entity.
 A partnership is legally dissolved (terminated) when a new partner is admitted or an
existing partner withdraws.
4.7.1. Admission of a New Partner
The admission of a new partner dissolves the old partnership because a new association has
been formed. Dissolving the old partnership and creating a new one require the consent of
all the old partners and the ratification of a new partnership agreement. When a new partner
is admitted, a new partnership agreement should be prepared. A new partner can be
admitted into a partnership in one of two ways:
(1) by purchasing ownership right from one or more of the original partners, or
(2) by investing assets in the partnership.

1. Admission by Purchase of Ownership Right/Interest

When an individual is admitted to a firm by purchasing ownership right from an old partner,
each partner must agree to the change. Before recording the sale of a capital the seller(s) has
to ask the permission of all other partner(s).
 Purchase from the old partners is a personal transaction so it is not entertained in the
accounting system. Hence, the cash or other consideration paid is not recorded in the
accounts of the partnerships. The purchase price is directly paid to the selling partners.

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 The only entry needed is the transfer of the proper amounts of owner‘s equity from the
capital accounts of the selling partner(s) to the capital account established for the
incoming partner.

 Since the capital interest of the new partner is obtained from current partners, there is
no inflow of assets or capital to the partnerships. Therefore, the total net asset and total
capital of the partnerships remain the name.
 Division of NI/L will be in accordance with the new agreement.
Illustration
Suppose, for example, Sister Helen joins the partnership of Dr. Talky and Dr. Mama by
buying ownership right of Br. 8000 from Dr. Mama. The entry to record the admission of
Sister Helen and the transfer of the ownership right from the capital account of Dr. Mama to
the capital account of Sister Helen in the partnership books shown below
Journal entry
Dr. Mama 8,000
Sr. Helen 8,000

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The price that Sister Helen paid to Dr. Mama can be more or less than Br. 8,000 but that is
irrelevant as it wouldn‘t be reflected in the record (books) of the partnership.

2. Admission by Investing/ Contribution of Asssets

Both the total assets and the total owners‘ equity of the business are increased. Assets of the
partnerships are fairly stated in terms of current market value at the time a new partner is
admitted.
 The net amounts 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.
 It is also important that the assets of a new partner be stated in terms of current prices at
the time of admission.
Goodwill and Bonus
 When a new partner is admitted to a partnership, goodwill or bonus either to the old
partnership or to the incoming partners may be recognized. This happens when the
invested capital of the incoming partners differ from their respective ownership interests
in the entity.
 Goodwill is recognized to the new partner because of the extra special quality,
efficiency and the expectation to improve the fortunes of the firm. Goodwill
determination depends

on the respective shares owned by the partners and the relative bargaining abilities of the
partners.
 The amount of goodwill agreed upon is recorded as an asset with a corresponding credit
to the appropriate capital accounts but bonus is an addition or deduction from the
existing or incoming partners‘ capital accounts depending upon conditions.
Illustration
Assume that instead of purchasing ownership right from the existing partners, Sister Helen
invested cash of Br. 80,000 into the partnership. In this case both partnership assets and
total owners‘ equity are increase. The journal entry must record such an investment and the
increase in partnership assets. Consider the following scenarios as an example:
1. Neither Bonus nor Goodwill. Sister Helen receives a 50% ownership right in the
partnership. Assume also that Dr. Talky and Dr. Mama‘s capital balance was Br.

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25,000 and Br. 55,000 respectively. Dr. Talky and Dr. Mama share income in a ratio
of 2:1 respectively.
Journal Entry
 Sister Helen‘s capital account would be credited for Br. 80,000 i.e., (55,000 + 25,000
+ 80,000) X ½.
Cash 80,000
Sister Helen, Capital …………………………… 80,000
2. Bonus to the Existing Partners. Sister Helen receives a one –fourth ownership right
upon admission. Assume everything else as above. In this case Sister Helen‘s capital
account would be Credited for birr 40,000 i.e., (Birr 55,000+ Birr 25,000 + Birr
80,000) X ¼.
 The difference Br. 40,000, (80,000 – 40,000) would be shared between the
remaining two partners with the income-sharing ratio.
Journal entry
Cash 80,000
Helen capital ---------------------------- 40,000
Dr. Talky capital ------------------------- 26,667
Dr. Mama capital -------------------------- 13,333
3. Bonus to the New Partner. Attempt Case 2.

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4. Goodwill to old Partners. On April 1, the partnerships of Giddy and Helen admit
Jamal, who is to contribute cash of Birr 15,000 and machinery with current market
price of Birr 25,000. The Capital balances of Giddy and Helen after assets are adjusted
to CM price are Birr 50,000 and Birr 64,000, respectively. The partners agree,
however, that the partnership is worth Birr 130,000 considering Good Will to the
partnerships. The old partners have been sharing income in the ratio of 2:3.
a) Record the journal entries on April 1, to record/admission of the new partner.
b) What is the interest of each partner‘s capital balance over the total partnerships
equity?
Solution
 Total OE before Admission ($50,000 + 64,000) 114,000
 Revaluation of the partnerships 130,000
 Goodwill attributable to the partnerships 16,000
Journal Entry
a) Good will 16,000
Giddy, capital(2/5x16, 000) 6,400
Helen, Capital (3/5x16, 000) 9,600
b) Cash 15,000
Machinery 25,000
Jamal, Capital 40,000
c) Total capital =
 Giddy (50,000+6,400) = 56,400
 Helen (64,000+9,600) = 73,600
 Jamal (15,000+25,000) = 40,000
Total Capital 170,000
Interest of G = 56,400/170,000; Interest of H = 73,600/170,000; Interest of J =
40,000/ 170,000

5. Goodwill to New Partner. Ababa and Berkeley are partners with capital balance of
Birr 20,000 and 60,000 respectively. Chili is admitted on Jan. 1 by investing
Birr.

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15,000. If the old partners agree to recognize Birr 5000 of goodwill attributable to
chili his special skill.
a) Record the entry
b) Determine the interest of each partners over the total OE
Solution
Jan. 1 Cash 15,000
Goodwill 5,000
Chili, Capital 20,000
4.7.2. Retirement or Withdrawal of a Partner
When a partner withdraws or retires from the firm, one or more of the remaining partners
may purchase the withdrawing partner‘s interest and the business may be continued without
interruption.
 The only entry required by the partnership is a debit to the capital account of the
partner withdrawing and a credit to the capital account of the partner(s) acquiring the
interest.
 To determine the ownership equity of the withdrawing partner, the asset accounts
should be adjusted to current marketing price. Withdrawal can be at BV, less than BV
or more than book value.
Death of a partner
 Dissolves a partnership, according to their agreement.
 In the absence of any contrary agreement, the accounts should be closed as on 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 accounts of the deceased partner is then transferred to a
liability account with the deceased’s estate.
 When an existing partner withdraws him/she can sell his/her ownership right or
he/she can withdraw assets from the partnership. Both options are discussed below:

1. Sale of Ownership Right to the Existing Partner

When ownership right is sold by a withdrawing partner to an existing partner, the entry on
the partnership‘s books transfers the retiring partner‘s capital balance to the buyer‘s capital
account.

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Example:
Dr. Mama withdraws from the partnership because of a disagreement. He
sells his Br. 38,333 ownership right to Dr. Talky.
Journal
entry
Dr. Mama Capital ………………….3
38,333
Dr. Talky Capital …………………… 38,333
The amount paid by Dr. Talky is not recorded on the partnership books, because the
transaction involves no flow of assets to or from the partnership.

2. Withdrawal of Assets From the Partnership

When a partner withdraws he/she may be paid above or below the amount shown in his/her
capital balances.
Example:
1) Assume Dr. Mama was paid Br. 50,000 cash when he withdraws from the partnership
of T, M &H. The capital balances of each partner were as follows as of that date:
Dr. Talky capital --------------------------------- Br. 100,000
Dr. Mama capital -------------------------------------- 50,000
Sister Helen capital ------------------------------------- 35,000
Total Equities Birr 185,000
Journal entry
Dr, Mama Capital 50,000
Cash 50,000
2) Assume Dr. Mama was paid Br. 56,000 instead of Br. 50,000, the excess amount of
Birr 6,000 is charged to the remaining partner‘s capital accounts based on the income-
sharing ratio. (Assume a 3:2:1 income-sharing ratio between Dr Talky Dr. Mama and
Sister Helen respectively).
Journal entry
Dr. Mama 50,000
capital
Sister Helen capital ---------------------------------- 1,500
Dr. Talky 4,500
capital 56,000
Cas
h

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 The Birr 6,000 excess is shared on the basis of a 3:1 ratio, i.e., Dr. Talky would
be charged for 6,000 X 3/4 = birr 4500, and Sister Helen would be charged for
Birr 6000 X ¼= Birr 1500.
Exercise-2
1. The partnership agreement for Keno and Lemma partnership does not disclose how they
will share income and losses. How would the income and losses be shared in this
partnership?
2. In January 19X1, Sissy, Haiku, Glean & Jolene agreed to produce and sell Soaps. Sissy
contributed Br. 240,000 in cash to the business. Glean contributed the building and
equipment, valued at Br. 220,000 and Birr. 140,000, respectively. The partnership had
an income of Birr 84,000 during 19X1 but was less successful during 19X2, when
income was only Br. 40,000.

(a) Prepare the journal entry to record the investment of both partners in
the partnership
(b) Determine the share of income for each partner in 19X1 under each of
the following conditions:
 The partners agreed to share income equally.
 The partners failed to agree on an income- sharing arrangement.
 The partners agreed to share income according to the ratio of their
capital investments
 The partners agreed to share income by allowing interest of 10% on
their original investments and dividing the remainder equally.
 The partners agreed to share income by allowing salaries of Birr 40,000
for Sissy and Br. 28,000 for Glean, and dividing the remainder equally.
3. Andrew, Ezra, and Wiley has equity in a partnership of Birr 80,000, Birr 80,000, and
Birr 120,000, respectively, and they share income and losses in a ratio of 20%, 20%, and
60%. The partners have agreed to admit Bagboy to the partnership. Instruction:
prepare journal entries to record the admission of Bagboy to the partnership under the
following conditions:
a) Bagboy invests Birr 50,000 for 20% interest in the partnership, and a bonus is

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recorded for the original partners.

b) Bagboy invests Birr 60,000 for a 40% interest in the partnership, and a bonus is
recorded for Bagboy.

4.8. Liquidation of a Partnership

Liquidation of a partnership is the process of ending the business, of selling enough assets to
pay the partnership‘s liabilities and distributing any remaining assets among the partners.
Liquidation is a special form of dissolution. When a partnership is liquidated, the business
will not continue.
 The partnership agreement should indicate the procedures to be followed incase of
liquidation. Usually, the books (records) are adjusted and closed, with the income or
loss distributed to the partners and the assets are sold.
 As the assets of the business are sold, any gain or loss should be distributed to the
partners according to the income and loss sharing ratio.
 In liquidation, the accounts should be adjusted and closed according to the normal
procedures of the periodic summary. The only accounts remaining open then will be
the various asset, contra asset, liability, and owner‘s equity accounts (or balance sheet
accounts)
 Partnership liquidation schedule – is prepared to show the liquidation process and
provide information for users such as creditors, court & others.
 If assets are sold piecemeal, the liquidation process may extend over a considerable
period of time.
A partnership may be liquidated if:
a) The objectives sought in forming the partnership have been achieved.
b) The time period for which the partnership was formed expires (ends)
c) Newly enacted laws have made the partnerships activities illegal,
d) The partnership becomes bankrupt.
Three phases (steps) in liquidation
a) The sale of the assets at the time of liquidation of a partnership is known as
realization.
b) Payment of liabilities

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c) Distribution of the remaining cash or other assets to the partners according to

their capital balances. Moreover, there may be allocation of deficit among partners.

Three different realizations in liquidation

a) Grain one realization
b) Loss on realization, no capital deficiencies
c) Loss on realization, capital deficiency
Journal Entries in liquidation
a) Sale of assets (realization)
b) Division of gain/loss
c) Payment of liabilities
d) Distribution and allocation of cash to partners.
Illustration on Partnership Liquidation
The partnership of Ransom, Sultan, and Tassel is liquidated on September 1,2002. The
income and loss sharing ratio of the partners is: Ransom 40%, Sultan 35%, and Tassel
25%. After discontinuing the ordinary business operations of their partnership and closing
the accounts, the following summary of a trial balance is prepared:
R, S and T
Trial Balance
September 1, 2002
Debit Credit
Cash 10,000
Other assets 90.000
Liabilities 10,000
R. Capital 30,000
S. Capital 30,000
T. Capital 30,000
Total 100,000 100,000

Based on the information on the trial balance, accounting for liquidation of R, S, and T
partnership will be illustrated using different selling prices for the non cash assets.
Case 1: Gain on Realization
Assume that Ransom, Sultan, and Tassel sell all non cash assets for Birr 95,000, realizing a

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gain of birr 5000, (Birr 95,000 – Birr 90,000). The gain is divided among Ransom, sultan
and Tassel in the income and loss sharing ratio of 40% 35%, and 25% respectively. Then,
the liabilities are paid, and the remaining cash is distributed to the partners according to
the balances in their capital accounts. The entries to record the steps in the liquidation of
a business are as follows:
Cash ....................................... 95,000
Other assets .................................... 90, 000
Gain on sale of assets........................... 5,000
(Entry to record the sale of non cash assets and the recognition of gain on realization)
Gain on sale of assets ..................... 5,000
R Cap. (5,000 X 40%) ...........................2.000
S Cap. (5,000 X 35%).............................1
1,750
T Cap. (5000 X 25%) .............................1
1,250
(To distribute gain on realization)

Liabilities .............................. 10, 000

Cash ................................................. 10,000
(To record the settlement of partnership liabilities)
After the above entries are posted, the partners‘ capital accounts shows:

R‘s Beg Bal. 30,000 + 2,000 = Birr 32,000

S‘s Beg Bal. 30,000 + 1,750 = Birr 31,750
T‘s Beg Bal. 30,000 + 1,250 = Birr 31,250
The cash account now shows a balance of Birr 95,000 (10,000 + 95,000 – 10,000).
The entry recorded upon distribution of this cash among the partners would, therefore, be
R, capital................................B
Birr 32,000
S, capital ............................... Birr 31,750
T, capital ...............................Birr 31,250
Cash 95,000
(To record the distribution of cash among the partners)

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Case 2 : Loss on Realization: No capital Deficiencies

Assume that Ransom, Sultan, and Tassel sell all non cash assets for Birr
70,000, instead of Birr 95,000, incurred a loss of birr 20, 000,(Birr 90,000 20,000
– Birr 70,000)

R capital (40% X 20,000) ……………………………………… 8,000

S capital (35,000 X 20,000) …………………………………… 7,000
T capital (25% X 20,000) ……………………………….………5,000
Loss on Realization
(To distribute the loss on realization)
Liabilities 10,000
Cash 10,000
(To record the settlement of partnership liabilities)

After the above entries have been posted; the accounts show cash 70,000 R, cap. Birr 22,
000; S, cap. Birr 23,000 and T, cap. Birr 25,000. The entry to record the cash distribution to
the partners would, therefore, be as follows:
R cap 22,000
S cap 23,000
T cap 25, 000
Cash 70,000
(Entry to record the distribution of cash to partners)
Case 3: Loss on Realization with Deficiency in one Partner Capital
Assume the non-cash assets of R,S and T partnership are sold for only Birr 10,200,
incurring a loss of Birr 79,800,( Birr 90,000 – Birr 10,200). The entries to record the
division of loss among the partners and the liquidation to this point are shown below:
Cash 10,200
Loss on sale of Assets ----------------------------------- 79,800
Other Assets 90,000
(To record the sale of assets)

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R capital (79800 X 40%)----------------------------31,920

S capital (79800 X 35%) ---------------------------- 27,930
T capital (79800 X 25%)-----------------------------19,950
Loss on sale of Assets ----------------------------------- 79,800
(To distribute loss on realization)
Liabilities 10,000
Cash 10,000
(To record settlement of liabilities)
At this stage of the liquidation the capital accounts of the partners have the following
balances
R capital = 30,000 – 31920 = (1,920)
S capital = 30,000 – 27930 = 2,070
T capital = 30,000 – 19950 = 10,050

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Only Birr 10,200 cash is available (10,000 + 10200 – 10,000) for distribution to S and T while
the combined balances of their capital accounts is Birr 12,120. Therefore, additional Birr
1,920, (12120 – 10200) is needed which is the amount owed by R to the partnership. Therefore,
either R will have to pay this amount first and the cash will be distributed to S and T, or S and
T will have to share the Birr 1920 loss in their income and loss-sharing ratio of 35:25.
Let‘s assume, the loss was distributed since R couldn‘t pay the amount immediately.
Journal Entries
S capital (35/60 X 1920) ----------------------- 1,120.00
T capital (25/60 X 1920) ------------------------- 800.00
R capital 1,920
(To charge R’s capital deficiency to S
and T)
S, capital 950.00
T, capital 9,250.00
Cash 10,200
(To record the final cash distribution to partners)

Case 3: Partnership Liquidation Schedule/Statement. The various entries in the

liquidation of R,S, and T partnership are summarized in the following statement.

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Self Assessment Questions

Part I Multiple Choice Questions
1. Which of the following is not a characteristic of a partnership?
A. Taxable entity D. Limited life
B. Co-ownership of E. None of the above
property
C. Mutual agency
2. A partnership agreement should include each of the following except:
A. Names and capital contributions of partners.
B. Rights and duties of partners as well as basis for sharing net income or loss.
C. Basis for splitting partnership income taxes.
D. Provision for withdrawal of assets. E. None of the above
3. Upon formation of a partnership, each partner‘s initial investment of assets should
be recorded at their:
A. Book values. D. Appraised values.
B. Cost. E. None of the above
C. Market values.
4. Ben and Sam Jenkins formed a partnership. Ben contributed Br. 8,000 cash and a used
truck that originally cost Br. 35,000 and had accumulated depreciation of Br.
15,[Link] truck‘s market value was Br. 16,000. Sam, a builder, contributed a new
storage garage. His cost of construction was Br. 40,000. The garage has a market value
of Br. 55,000. What is the combined total capital that would be recorded on the
partnership books for the two partners?
A. Br. 9,000. D. Br. 90,000.
B. Br. 60,000. E. None of the above
C. Br. 75,000.
5. The NBC Company reports net income of Br. 60,000. If partners N, B, and C have
an income ratio of 50%, 30%, and 20%, respectively, C‘s share of the net income is:

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A. Br. 30,000.
B. Br. 12,000.
C. Br. 18,000.
D. Br. 21,000.
E. No correct answer is given.
6. Using the data in (5) above, what is B‘s share of net income if the percentages are
applicable after each partner receives a Br. 10,000 salary allowance?
A. Br. 12,000 D. Br. 21,000
B. Br. 20,000 E. None of the above.
C. Br. 19,000
7. To close a partner‘s drawing account, an entry must be made that:
A. Debits that partner‘s drawing account and credits Income Summary.
B. Debits that partner‘s drawing account and credits that partner‘s capital account.
C. Credits that partner‘s drawing account and debits that partner‘s capital account.
D. Credits that partner‘s drawing account and debits the firm‘s dividend account.
E. None of the above.
8. In the liquidation of a partnership it is necessary to (1) distribute cash to the partners, (2)
sell noncash assets, (3) allocate any gain or loss on realization to the partners, and (4)
pay liabilities. These steps should be performed in the following order:
A. (2), (3), (4), (1). D. (3), (2), (4), (1).
B. (2), (3), (1), (4). E. None of the above
C. (3), (2), (1), (4).
9. Partner LS purchases 50% of LL‘s capital interest in the KK & LL partnership for Br.
22,000. If the capital balance of KK and LL are Br. 40,000 and Br. 30,000, respectively,
Santiago‘s capital balance following the purchase is:
A. Br. 22,000. D. Br. 15,000.
B. Br. 35,000. E. None of the above
C. Br. 20,000.

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10. Capital balances in the MEM partnership are Mary, Capital Br. 60,000, Ellen,
Capital Br. 50,000, and Mills, Capital Br. 40,000, and income ratios are 5: 3: 2,
respectively. The MEMO partnership is formed by admitting Oleg to the firm with a
cash investment of Br. 60,000 for a 25% capital interest. The bonus to be credited to
Mills, Capital in admitting Oleg is:
A. Br. 10,000.
B. Br. 7,500.
C. Br. 3,750.
D. Br. 1,500.
E. None of the above
Part II – Problems
Problem 1: Alex and Blen began a partnership (AB Partnership) by investing Br.78,000 and
Br.52,000 cash respectively. During its first year of operation, the partnership earned net
income of Br.60,000.
Required
A. Prepare computations that show how the income should be allocated to the
partners under each of the following income sharing plans.
1. The partnership agreement remained silent concerning income sharing method.
2. The partners agree to share income in the ratio of original capital investments
3. The partners agree to share income by allowing first yearly salary of Br.12,000
to Blen and Br.18,000 to Alex, then 10% interest on original capital balance of
each partner and, finally, the remainder equally.
B. Assume that AB Partnership incurred Br.20,000 loss during its second year of
operation. Determine the participation of Alex and Blen in this loss according to each
of the three income-sharing assumptions listed in "a" above.
Problem 2: Hindu, Tigu and Birhin began a partnership by investing cash Br.40,000,
Br.60,000 and Br.70,000 respectively. Their article of association states that income and
losses be shared among partners equally. The first year of operations did not go well, and the
partners finally decided to liquidate the partnership. On December 31, after all assets were
converted to cash and all creditors were paid, only Br.20,000 in partnership cash remained.
Required

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1. Calculate each partner's capital account balance after realization and payment of
all creditors.
2. If the amounts owed to creditors total Br.45,000 and, if cash and non-cash assets total
Br.40,000 and Br.175,000 respectively. For how much are the non-cash assets sold?
3. Determine each partner's share in the Br.20,000 available cash
Answer Keys
Chapter 4: Partnerships

1. A 2. C 3.C 4.A 5.B 6. C 7. C 8. A 9. B 10. A

Problem 1
A) 1) Br. 30,000 each
2) Alex = 36,000
Blen = 24,000
3) Alex = 28,000
Blen = 31,700

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Chapter 5
Accounting for Corporation

Learning Objectives
At the end of this unit lesson, you will be able to:
1. Identify the major characteristics of a corporation.
2. Differentiate between paid-in capital and retained earnings.
3. Record the issuance of common stock.
4. Explain the accounting for treasury stock.
5. Differentiate preferred stock from common stock.
6. Prepare a stockholders‘ equity section.

5.1. Introduction
A corporation is a legal entity having an existence separate and distinct from that of its owners.
In the eyes of the law there are two persons and a corporation is an ‗artificial person‘ having
many of its own rights and responsibilities. It may be classified in two common bases.
By Purpose:
1) Profit Corporations are engaged in business activities. They depend upon profitable
operations to their continued existence.
2) Nonprofit corporations include those organized for recreational, educational, charitable
or other purposes. They depend upon dues from their members or upon gifts and grants
from the public at large.
By Ownership:
1) Public Corporations are large profit corporations whose shares of stock are widely
distributed and traded in public market.
2) Nonpublic Corporations are corporations whose shares stock of are owned by a small
group and are called private or closely held corporations. They usually have a few
stockholders and do not offer its stock for sale to the general public.
5.2. Characteristics of Corporation
Among the characteristics of a corporation are:
1) A corporation has its own charter. A corporation is created by obtaining charter from
the state in which the company is to be incorporated

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2) A corporation is a separate legal entity. According to the law a corporate entity may
own property in its own name, may enter into contract and responsible for its own debts.
3) A corporation has a legal status in court . According to the law a corporation may sue
and be sued as if it were a real person.
4) A corporation pays income taxes on its earnings. The income of a corporation is subject
to income taxes, which must be paid by the corporation.
5.3. Advantages of Corporation
A corporate entity has many advantages not available in other forms of organization. Among the
advantages are the following:
1) Limited liability for owners: Since a corporation is a separate legal entity, the creditors
of a corporation have a claim against the assets of the corporation, not the personal
property of the owners.
2) Continuous existence: A corporation has perpetual existence in that its continuous
existence is not dissolved by the death on retirements of any of its members.
3) Separation of managements from ownership: the owners of a corporation (called stock
holders or shareholders) own the corporation but they do not manage it on a daily basis.
To administer the affairs of the corporation, president and other officers are hired for it.
Thus, individual stockholder has no rights to participate in the management's activity of
the corporation unless the stockholder has been hired as a corporate officer.
4) Easily transferable ownership shares: ownership of a corporation is evidenced by
transferable shares of stocks. These shares of stocks may be sold by one investor to
another without dissolving or disrupting the business organization
5.4. Disadvantages of Corporation
Some of the disadvantages of the corporation are:
1) Double taxation: corporate earnings are taxed two times. The earnings are taxed first as
a corporate income tax and again as personal income taxes if the corporation distributes
its earnings to stockholders.
2) Difficulties to control: since ownership is usually separated from managements, owners
are unable to exercise active control over management actions.
3) Greater regulation: since a corporation comes into existence according to the law of the
state, the law may provide for considerable regulation of the corporation‘s activities. For

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example, the withdrawal of funds from a corporation is subjects to certain limits set by
law.
Summary

5.5. Formation of a Corporation

A corporation is created by obtaining a corporate charter. The charter is given from the states in
which the corporation is to be incorporated. To obtain a corporate charter an application called
articles of incorporation are prepared by the organizers called incorporators and submitted to
the state corporations‘ commissioner or other designated officials. These articles of
incorporation specify:
 The purpose of the business,
 Its location,
 The names of the organizers,
 The classes and numbers of shares of capital stock authorized, and
 The consideration to be paid in by the organizers for their respective shares.
The article of incorporation is approved by the state and charter is issued. Once a charter is
obtained a board of directors is elected. The directors in turn hold meetings at which officers of
the corporation are appointed.
5.5.1. Organization costs
In the process of incorporation, the organizers must pay for necessary costs such as payment of
an incorporation fee to the state, payment of fees to attorneys for their services in drawing up
the articles of incorporation, payment to promoters and variety of other outlays necessary to
bring the corporation into existence. These costs are charged to an asset account called
organization costs. In the balance sheets, organization costs appear under the ‗Intangible Assets’
caption.
To illustrate assume the following expenditures were incurred during the process of formation of

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Nile corporation which got its charter and started its operations on January 16, 2005:
Accounting B r. 10,000
Document preparation, processing and printing 15,000
Promotion 20,000
Incorporation fees 12,000
Miscellaneous 13,000
The following entries are prepared to record the costs incurred and the related amortization for
2005 assuming that fiscal year ends on December 31 2005:
Jan 16 Organization costs 70,000
Cash 70,000
Dec 31 Amortization expense - organization cost 7,000
Organization costs 7,000
5.5.2 Rights of Shareholders
The stockholders who are the owners of a corporate entity have the following basic rights:
a) The rights to votes: the common stockholders have the right to elect the board of
directors, and thereby to be represented in the management of the business.
b) The rights to participate in the earnings of a corporation: Shareholders in corporations
may not make withdrawal of company assets. However, the earnings of a profitable
corporation may be distributed to stockholders is the form of cash dividend. The
payment of a dividend always requires formal authorization by the board of directors.
c) The rights to share in the distribution of assets upon liquidation: when a corporation
ends its existence, the creditors of the corporation must first be paid is full; any
remaining assets are dividend among stockholders in proportion to the number of shares
owned.
d) Pre-emptive rights: the current stockholders have the right to purchase the shares of the
corporation on a prorata basis when new stocks are offered for sale. The preemptive
rights are designed to provide each stockholder the opportunity to maintain a
proportional ownership in the corporation.
Exercise -1: Say True or False
When a business is organized as a corporation:
a) Shareholders are liable for the debts of the business.
b) Shareholders do not have to pay personal income taxes on dividend received.
c) Each stockholder has the rights to make managerial decision.
d) Owners cannot withdraw assets from the business at will.

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5.6. Management of Corporations

The authority to manage corporation is given by the stockholders to the board of directors which
in turn appoints corporate officers who actively manage corporate affairs. This means that, the
stockholder, who are, in fact the owners of the corporation, exercise control over management of
corporate affairs indirectly by electing a board of directors. The individual stockholder's right to
participate in management begins and ends with a vote in the stockholders' meeting, where each
stockholder usually has one vote for each share of stock owned.
Normally, a corporation's stockholders held meeting once each year to elect directors and vote on
any other business matters, which according to the corporation‘s bylaws, must be approved by
the stockholders. In many companies, a large number of stockholders do not attend the annual
meetings or get involved in the voting process. Stockholders who do not attend stockholders'
meeting usually can delegate their voting right to an agent. This delegation is done by signing a
legal document called proxy, which gives the agent the right to vote the stock.

A corporation's board of directors is responsible and has final authority to decide on major
business policies of the corporation and for the direction of corporate affairs. Among the duties
of the board of directors are determining corporate policies, selecting officers and managers and
deciding on their salaries, arranging major loans with banks and declaring dividends.

The figure below presents a typical organization chart showing the delegation of responsibility.
The chief executive officer (CEO) has overall responsibility for managing the business. As the
organization chart shows, the CEO delegates responsibility to other officers. The chief
accounting officer is the controller. The controller‘s responsibilities include (1) maintaining the
accounting records, (2) maintaining an adequate system of internal control, and (3) preparing
financial statements, tax returns, and internal reports. The treasurer has custody of the
corporation‘s funds and is responsible for maintaining the company‘s cash position. The
organizational structure of a corporation enables a company to hire professional managers to run
the business. On the other hand, the separation of ownership and management prevents owners
from having an active role in managing the company, which some owners like to have.

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Corporation Organization Chart

5.7. Authorization and Issuance of Shares

The state officials approve the articles of incorporation, which specify the number of shares a
corporation is authorized to issue. The total number of shares that may be issued is known as the
authorized shares. When the corporation receives cash in exchange for stock certificates, which
represents the number of shares issued, the shares become issued shares. Shares that are issued
and held by the stockholders are called outstanding shares. Sometimes a corporation reacquires
shares from its own shareholders. These shares are called treasury stocks, which reduce the
number of outstanding shares.

A corporation may choose not to issue immediately all the authorized shares even though it is
customary to have a large number of authorized shares than presently needed. If more capital is
needed, the previously authorized shares will be readily available for issue. A corporation can
apply to the state for permission to increase the number of authorized shares.
5.7.1 Types of Shares/Stocks
Many corporations issue several classes of capital stock, each providing investors with different
rights and opportunities.

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1) Ordinary Share is the basic type of share issued by every corporation. Ordinary share
possessed the traditional rights of ownership such as voting rights, participation residual
dividends, and residual claim to assets in the event of liquidation.
2) Preference Share specifies different rights that distinguish it from common share. Some of
the distinctive features for preference shares are priority claims on dividends, cumulative
dividend rights; priority as to assets is the event of liquid action of a corporation and no
voting power.
Shares according to their nature are classified into par value and no- par shares. Par value
shares with a designated dollar amount per share as stated in the corporate charter and printed
on the stock certificates. On the other hand, some states allow corporations to issue stocks
without designating a par value. Such stocks are called no- par shares. Sometimes some states
authorize the issuance of no-par stock with a stated, or assigned, value per share that is
established permanently by the corporate directors and is in the laws. Most corporations use a
stated value for no par stock. When no par stocks are issued by a corporation, the entire issuance
price is viewed as a legal capital, which is subject to withdrawal.
5.7.2. Issuance of Par-value Stocks
[Link] Authorization
Authorization of par value stocks, specified in the unit may be recorded as a memo entry in the
general journal and in the ledger accounts. Most states require the total number of shares
authorized be shown on each stock certificate, in addition to the number of shares represented by
those particular stock certificates.
[Link]. Par value share issued for cash
When shares are issued to various investors, a stock certificate specifying the number of shares
represented is prepared for each investor/or shareholder. When par value share is issued for cash,
the capital stock account is credited with the par value of the shares issued regardless of whether
the issuance price is more or less than par. If par value share is issued for more than par value (at
premium), paid in capital in excess of par account is credited for the excess of selling price over
par. This paid in capital is excess of par does not represent a profit to the corporation rather it is
part of the invested capital. If par value share is sold by corporation for less than par (at
discount), a negative stockholders‘ equity accounts, Discount on common (or preferred) stock, is
debited for the amount of the discount.

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1) For example, assume that 50,000 shares of Br. 2 par value common stock have been
authorized and that 10,000 of these authorized shares are issued at a price of Br. 10 each.
The entry would be:
Cash 100.000
Share capital-ordinary 20,000
Share premium-ordinary 80,000
2) For example, assume that 50,000 shares of Br.10 par value common stock have been
authorized and that 10,000 of these authorized shares are issued at a price of Br. 2 each.
The entry would be:
Cash 20.000
Share premium-ordinary 80,000
Share Capital-ordinary 100,000
[Link]. Par value stock issued on a subscription basis
During the start-up of a corporation, prospective investors may sign a contract to purchase a
specified number of shares on credits with payments due at one or more specified future dates.
One reason for this procedure is to attract small investors. Another reason is to appeal to
investors who prefer not to invest cash until the corporation is ready to start business operations.
A corporation may also sell its capital stock on credit after incorporation.
When stock is subscribed, the company debits stock subscription receivable for the subscription
price, credits capital stock subscribed for the par value of the subscribed shares, and credits paid
in capital in excess of the subscription price over par value. Later, as cash is collected, the entry
is a debit to cash and a credit to stock subscription receivable. When the entire subscription price
is collected, the stock certificates are issued for the subscribers. The issuance of stock is
recorded by debiting capital stock subscribed and crediting capital stock. The following
illustration demonstrates the accounting procedures for stock subscriptions.
Assume that 120,000 shares of RAM corporation common stock, par Br 10, are subscribed for at
Br. 12 by MB. The total is payable in three installments. The following entries are processed by
RAM Corporation.
1) Common stock subscription Receivable 1, 440,000
Common stock subscribed 1, 200,000
Paid-in-capital in excess of par 240,000

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(To record receipt of subscription for 120,000 shares)

2) Cash 480,000
Common stock subscription receivable 480, 000
(To record receipt of 1st payment)
3) Cash 480,000
Common stock subscription Receivable 480, 000
(To record receipt of 2nd payment)
4) Cash 480,000
Common stock subscription Receivable 480,000
(To record receipt of final payment)
5) Common stock subscribed 1,200,000
Common stock 1, 200,000
(To record issuance of stock certificate)

[Link] Non Cash Issuance of Capital Stock

Corporations sometimes issue capital stock for non-cash assets such as in exchange for real
estate. The current markets value of the stock issued or the non-cash consideration received,
whichever is must reliable, determinable, is used to record the transaction. If the market value of
either capital stock issued or the non-cash items are not reliable, the value is established by the
corporation‘s board of directors.
For example, assume that 50,000 shares of Br. 2 par value common stock have been authorized
and issued for Equipment having the current value of Br.150, 000. The entry would be:
Equipment 150, 000
Share capital-Ordinary 100,000
Share premium-Ordinary 50,000
[Link] Issuance of No-par Stock
Some states allow corporations to issue stock without designating a par or stated value. When
this no par stock is issued, the entire issuance price is credited to the capital stock account and is
viewed as legal capital not subject to withdrawal.
For example, assume that 50,000 shares of no par value common stock have been authorized and
that 10,000 of these authorized shares are issued at a price of Br. 10 each. The entry would be:
Cash 100.000
Share capital-Ordinary 100,000

5. 8. Accounting for Retained Earnings and Dividends

5.8.1 Nature of Retained Earnings
Capital provided to a corporation by stockholders in exchange for shares of either preferred or

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common stock is called paid in capital or contributed capital. The second major type of
stockholders‘ equity is retained earnings. The amount of the retained earnings account at any
balance sheet date represents the accumulated earnings (net income) of the company since the
date of incorporation, less any losses and all dividends distributed to stockholders.
The balance in retained earnings is part of the shareholders‘ claim on the total assets of the
corporation. It does not, though, represent a claim on any specific asset. Nor can the amount of
retained earnings be associated with the balance of any asset account. For example, a
NT$10,000,000 balance in retained earnings does not mean that there should be NT$10,000,000
in cash. The reason is that the company may have used the cash resulting from the excess of
revenues over expenses to purchase buildings, equipment, and other assets.
Remember that when a company has net income, it closes net income to retained earnings. The
closing entry is a debit to Income Summary and a credit to Retained Earnings. When a company
has a net loss (expenses exceed revenues), it also closes this amount to retained earnings. The
closing entry in this case is a debit to Retained Earnings and a credit to Income Summary.
This closing entry is done even if it results in a debit balance in Retained Earnings. Companies
do not debit net losses to share capital or share premium. If cumulative losses exceed
cumulative income over a company‘s life, a debit balances in Retained Earnings results. A debit
balance in Retained Earnings is identified as a deficit. A company reports a deficit as a
deduction in the equity section.
Retained Earnings Restrictions
The balance in retained earnings is generally available for dividend declarations. In some cases,
however, there may be retained earnings restrictions. These make a portion of the retained
earnings balance currently unavailable for dividends. Restrictions result from one or more of the
following causes.
1. Legal restrictions. Many governments require a corporation to restrict retained earnings for
the cost of treasury shares purchased. The restriction keeps intact the corporation‘s legal capital
that is being temporarily held as treasury shares. When the company sells the treasury shares, the
restriction is lifted.
2. Contractual restrictions. Long-term debt contracts may restrict retained earnings as a
condition for the loan. The restriction limits the use of corporate assets for payment of dividends.
Thus, it increases the likelihood that the corporation will be able to meet required loan payments.

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3. Voluntary restrictions. The board of directors may voluntarily create retained earnings
restrictions for specific purposes. For example, the board may authorize a restriction for future
plant expansion. By reducing the amount of retained earnings available for dividends, the
company makes more cash available for the planned expansion.
Prior Period Adjustments
Suppose that a company has closed its books and issued financial statements. The company then
discovers that it made a material error in reporting net income of a prior year. How should the
company record this situation in the accounts and report it in the financial statements?
The correction of an error in previously issued financial statements is known as a prior period
adjustment. The company makes the correction directly to Retained Earnings because the effect
of the error is now in this account. The net income for the prior period has been recorded in
retained earnings through the journalizing and posting of closing entries.
To illustrate, assume that General Microwave AG discovers in 2017 that it understated
depreciation expense on equipment in 2016 by £300,000 due to computational errors. These
errors overstated both net income for 2016 and the current balance in retained earnings. The
entry for the prior period adjustment, ignoring all tax effects, is as follows.
Retained Earnings 300,000
Accumulated Depreciation—Equipment 300,000
(To adjust for understatement of depreciation in a prior period)
5.8.2. Nature of Dividends
A dividend is a distribution of earnings to stockholders is the form of assets or shares of the
issuing company‘s stock. Type of dividends includes the following.
a) Cash dividend- Cash disbursed
b) Property Dividend-Non cash assets disbursed
c) Stock Dividend- Corporations own stock disbursed
d) Liquidating Dividend- Return of contributed capital
5.8.3. Relevant dividend dates
Prior to payment, dividends must be declared by the board of directors of the corporation. The
important dividend dates are:
a) Date of Declaration: on this date, the corporation‘s board of directors formally approves
and announces the dividend to be distributed. The declaration is recorded on this date as
a debit to dividends and a credit to dividends payable.

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b) Date of record: It is the date when the amount of dividend to be distributed to the
shareholders is computed. It does not require any entry.
c) Date of payment: this date is determined by the board of directors and is usually stated is
declaration. At the date of payment the liability recorded at the date of declaration is
debited and the appropriate asset account is credited.
5.8.4. Dividend and Characteristics of Preferred Stock
A corporation with both preferred stock and common stock may declare dividends on the
common only after it meets the requirements of the stated dividend on the preferred. The
preferred dividend may be stated in monetary terms or as a percent of par.
[Link]. Participating and non-participating Preferred Stock
A participating preferred stock receives a minimum dividend but also receives higher dividend
when the company pays substantial dividends on common shares. The preferred stockholders‘
right may be to receive dividend only a stated amounts. Such stock is said to be
nonparticipating.
To illustrated, assume the following information
 Common stock issued 4,000
 Preferred stock issued 2,000
 Dividend per share of preferred stock Br. 10
The corporation reported net income of Br. 150,000 for the third year and the BOD declared
Br.90, 000 of the net income as dividend. If the preferred stock issued by the corporation is
participating, the preferred stockholders will receive. Br. 30,000 (Br. 20,000 + Br. 10,000), and
the common stockholders will receive Br. 60,000 (Br. 40,000 + Br. 20,000).
[Link]. Cumulative and Non-cumulative Preferred Stock
Cumulative preferred means that if the company fails to pay a preferred dividend, its obligation
accumulates and all omitted dividends must be paid in the future before any common dividends
are paid. The cumulative preferred stockholders would receive all accumulated unpaid dividends
(called dividend in arrears) before the holders of common shares receive anything. Preferred
stock not having this cumulative right is called non-cumulative.
For example, assume the following information
 Cumulative preferred, 10% of Br. 100 par (10,000 shares issued)
 Common stock of Br. 90 par (40,000 shares issued)

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 The Board of Directors (BOD) did not declare dividend in year 2

 Year 3 dividend declared by the BOD amounts to Br. 320,000.
 Year 1 dividend declared and distributed amounts to Br. 200,000.
If the preferred stock is cumulative, the preferred stockholders will receive Br. 200,000 (Br.
100,000 + Br. 100,000), and the common stock holders will receive Br. 120,000 (Br. 320,000 –
Br. 200,000).
Exercise –2
1. State the classification (assets, liability, stockholders‘ equity, revenue or expense) of each
of the following accounts
a) subscription receivable
b) organization costs
c) retained earnings
d) preferred stock
e) paid in capital is excess of par value
2. If a corporation has outstanding 1,000 shares of Br. 9 cumulative preferred stock of Br.
100 par and dividends have been passed for the preceding three years, what is their amount
of preferred dividends that must be declared in the current year before a dividend can be
declared on common stock?
a) Br. 9,000 c) Br. 36,000
b) Br. 27,000 d) None
5.9. Accounting for Treasury Stocks
Treasury stock is a corporation‘s own stock (preferred or common) that has been issued and
reacquired by the issuing corporation. A corporation may also accept shares of its own stock in
payment of a debt owed by a stockholder or as a donation from a stockholder.
Treasury stock does not reduce the number of shares issued, but does reduce the number of
outstanding shares. The purchase of treasury stock decreases both assets and stockholders‘
equity. Moreover, treasury stock does not carry voting, dividend, preemptive, or liquidating
rights and is not assets.
5.9.1 Reasons to acquire Treasury Stocks
In general treasury steps are to acquire for the following reasons:
a) to support (increase) the markets price of the stock

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b) to increase earnings per share by reducing the number of shares outstanding.

c) to reduce dividend payments by reducing the number of shares outstanding.
d) to provide shares for re-issuance to employees as a bonus
e) to use the share acquired for stock dividend
f) to reissue with a higher price

5.9.2 Recording and reporting Treasury stock Transactions

There are several methods of accounting for the purchase and the resale of treasury stock. A
commonly used method is the cost basis. When the stock is purchased by the corporation,
treasury stock account is debited for the price paid for it. The par and the price at which the stock
was originally issued are ignored. When the stock is resold, treasury stock is credited at the price
paid for it, and the difference between the price paid and the selling price is debited or credited to
an account entitled paid in capital from sale of treasury stock.
To illustrate the cost method, assume that Honda Corporation had 50,000 shares of Br. 10 par
common stock outstanding at the beginning of the current year. The company purchased 500
shares for cash and received 500 shares in settlement of a debt from stockholders. The markets
price of stocks was Br. 30/share. The following entry is recorded involving the transactions.
Treasury share 30,000
Cash 15, 000
Notes Receivable 15, 000
If the company sells 600 shares of the treasury stock for Br. 31 each, the entry would be:
Cash 18, 600
Treasury share 18, 000
Share premium-treasury 600
If the company sells 600 shares of the treasury stock for Br. 29 each, the entry would be:
Cash 17, 400
Share premium-Treasury 600
Share capital-Treasury 18, 000
Paid in capital from sale of treasury stock is reported in the paid in capital section of the balance
sheet. Treasury stock is deducted from the total of the paid in capital and Retained earnings.

5 .1 0 . Equity per Share

The amount appearing on the balance sheet as total stockholders‘ equity can be stated in terms of
the equity per share. When there is only one class of stock, the equity per share is determined by
dividing total stockholders‘ equity by the number of shares outstanding. For a corporation with
both preferred and common stock, it is necessary first to allocate the total equity between the two

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 Fundamentals of Accounting -II

classes. To illustrate, consider the following statements of stockholders‘ equity at December 31,
19x1.
 9 % preferred stock, Br. 50 par value, authorized 20,000 shares, issued and Outstanding
12,000 share…………………………………………………………..….. Br. 600,000
 Common stock, no par, stated value Br. 2 per share, authorized 500,000 shares, issued
400,000 shares of which 25,000 shares are held is the treasury 800,000
 Paid in capital is excess of per:
 Preferred……………………….Br. 50,000
 Common…………………………. 1,000,000 1,050,000
 Retained earnings 2, 000,000
Subtotal………………………… …………………………………. Br. 4,450,000
 Less: Cost of 25,000shares of c/s reacquired and held in treasury 250,000
Total stockholders‘ equity……………………………………….………… Br. 4,200,000
If the preferred stock is entitled to receive Br. 105 per share upon liquidation and if there is no
preferred dividend in arrears, the computation of equity per share is as follows:

Preferred EPS = Equity allocated to preferred stock

Number of o/s shares of preferred stock

= 105 X 12,000 = Br. 105/share

12,000

Common EPS = Equity allocated to common stock

Number of o/s shares of common stock

= 2,940,000 = Br. 7.84 /share

375,000
Illustration on Accounting for Corporation
Journalize the following transactions related to stock issuance about ―A‖ corporation.
1) Received a charter authorizing the issuance of 300,000 shares of $1 par value common
stock
 Memorandum Entry
2) ABC printers printed up the stock certificates at a cost of $800. Payment on the account is
due by April 15, 2008.
Organization Costs 800
Accounts Payable 800
3) Issued for cash 60,000 shares of common stock at $2.50 per share.
Cash 150,000
Share Capital-ordinary 60,000

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 Fundamentals of Accounting -II

Share Premium- ordinary 90,000

4) Issued 1,000 shares of $10 par value, 8% preferred stock for $50,000.
Cash 50,000
Share capital-Preferred 10,000
Share Premium: Preferred 40,000
5) Issued 1,000 shares of common stock to attorney in exchange for legal services received
in organizing the company. The fair value of the services was $2,500.
Organization Costs 2,500
Share capital-ordinary 1,000
Share premium: ordinary 1,500
6) Received subscriptions from ten investors for 2,000 shares each of common stock at
$2.50 per share. Each investor made a down payment of $1 per share and promised to pay
the balance by March 31, 2008.
Subscriptions Receivable-ordinary 30,000
Cash 20,000
Share Subscribed-ordinary 20,000
Share premium-ordinary 30,000
7) Purchased some used store fixtures and display tracks at ABB‘s liquidation Emporium.
The store equipment had a cost to the previous owner of $29,000 and had a current fair
market of $15,000. The owner agreed to accept 6,000 shares of common stock as payment
for the equipment.
Store Equipment 15,000
Share capital-ordinary 6,000
Share premium-ordinary 9,000
8) A stockholder sold 500 of the shares he purchased on March 2, 2008, to a friend for $2.90
per share.
 No journal entry
9) Issued 320 share of common stock in settlement of the A/P with ABC printers.
A/P 800
Share capital-ordinary 320
Share premium-ordinary 480
10) Received payment in full from eight common stock subscribers and issued the
shares to them. The remaining two subscribers said they would pay the balance due by
April 6, 2008.
Cash (2000shares x 8 x $1.50) 24,000
Share Subscribed-ordinary 16,000
Subscriptions Receivable-ordinary 24,000
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 Fundamentals of Accounting -II

Share capital-ordinary 16,000

Self Assessment Questions
Part I- Multiple Choice Questions
1. Which of the following is true about a corporation?
A. The stockholders are treated as a separate legal entity from the corporation
B. The stockholders have limited liability
C. The corporation and its stockholders are subject to double taxation
D. All of the above are true E. None of the above is true
2. An advantage of incorporating a new business would be
A. to avoid double taxation
B. because of the ease of formation
C. to have limited liability
D. because a corporation is required to keep the records of the business separate and
apart from the records of the owners
E. All of the above is true
3. Which of the following characteristics is considered to be an advantage of the corporate
form of organization?
A. avoidance of double taxation B. limited liability of stockholders
C. low level of regulation
D. the absence of a perpetual existence
E. all of the above
4. The appropriate journal entry to record the issue of 1,000 shares of Birr1 par-value
common stock, which is issued for Birr4 per share would be:
A. Cash 4,000
Common stock 4,000
B. Cash 4,000
Common stock 3,000
Paid in capital in excess of par 1,000
C. Cash 4,000
Common stock 3,000
Retained earnings 1,000
D. Cash 1,000
Paid in capital in excess of par 3,000
Common stock 4,000
E. None of the above
5. ABC Corporation has 500,000 shares of common stock outstanding. On April 10, the
board of directors declared a Birr0.60 per share cash dividend, to be paid to stockholders
of record on April 25. The dividend was distributed on June 6. The proper journal entry to
record on June 6 is:
A. dividend expenses 300,0000
cash 300,000
B. dividend payable 300,0000

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 Fundamentals of Accounting -II

cash 300,000
C. retained earnings 300,0000
cash 300,000
D. dividend payable 300,0000
retained earnings 300,000
E. retained earnings 300,000
dividend payable 300,000
6. Dividends omitted on preferred shares that must be paid before common shareholders are
entitled to be paid are referred to as:
A. participating
B. callable
C. cumulative
D. in arrears
E. accrued
7. Magic Corporation paid Birr100,000 in dividends. The corporation had 10,000 shares of
common stock outstanding and 5,000 shares of Birr100 par value 5% preferred stock. The
preferred stock was two years in arrears prior to the current year. How much per share was
paid to the common stockholders?
A. Birr 0
B. Birr 25,000
C. Birr 50,000
D. Birr 75,000
E. some other amount
8. Which of the following statements about treasury stock is false?
A. gains are not recorded on treasury stock transactions
B. acquiring treasury stock decreases stockholders‘ equity
C. treasury stock is reported as a deduction from stockholders‘ equity
D. the excess of the sales price of treasury stock over its cost should be credited to paid
in capital from treasury stock
E. all are true
9. Start-up and organization costs
A. are always expensed in the year incurred
B. are capitalized, but never amortized
C. are capitalized and amortized, usually over five years
D. appear on the balance sheet as an asset
10. shares of stock that have been sold or otherwise transferred to stockholders are called
A. issued C. outstanding stock
stock D. treasury stock
B. authorized
stock
11. The Adams Corporation paid a dividend of Birr120,000 at the end of 20x3. At the
beginning of 20x3, there was Birr40,000 of dividends in arrears. How much did Adams
Corporation pay in dividends to its common stockholders if its capital structure was 5,000
shares of Birr100 par, 9 percent, cumulative preferred stock and 10,000 shares of Birr30

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 Fundamentals of Accounting -II

par value common stock?

A. Birr75,0 C. Birr45,000
00 D. Birr30,000
B. Birr35,0
00
12. ABC Corporation exchanged 1,000 shares of its Birr10 par value common stock for land
with a fair market value of Birr28,000. On the day of the transaction, Vericon's common
stock was selling for Birr30 per share. The land would be recorded on Vericon's books at
A. Birr10, C. Birr30,000
000 D. Birr18,000
B. Birr28,
000
13. Fifer Corporation sold 100 shares of Birr10 par value common stock at Birr30 per share.
The journal entry to record this transaction would include a
A. debit to Cash for Birr1,000
B. credit to Common Stock for Birr3,000
C. debit to Paid-in Capital in Excess of Par Value, Common for Birr2,000
D. credit to Common Stock for Birr1,000
14. Treasury stock is disclosed in the financial statements as a
A. Current asset.
B. Note
C. Reduction in total stockholders' equity
D. Current liability

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 Fundamentals of Accounting -II

Part II – Problems
Problem 1: XYZ Company was organized in 2016. The company incurred the following costs
during establishment:
i. Attorney‘s fees, market value of the service Br. 5,000, acceptance of 2,000 shares
of Br. 2 par common stock
ii. Accountant accepted 1,000 shares of Br. 2 par common stock for services that
would normally be billed at Br. 3,600
iii. Paid the state Br. 1,800 for incorporation fees

Required: Prepare journal entries necessary to record these transactions and amortize of
organization costs for the year 2017, assuming that the company elects to write off organization
costs over five years starting from 2017.

Problem 2: Moonlight Company issued 10,000 shares of Br. 20 par value common stock at Br.
32 per share. Later, the company reacquired 3,000 shares at Br. 25 cash each.
Required : Prepare the necessary journal entries to record:
i. issuance of the 10,000 shares
ii. reacquisition of the 3,000 shares
iii. resale of 1,200 shares of treasury stock at Br. 28 per share
iv. resale of the remaining 1,800 shares of treasury stock at Br. 21 per share
Answer Key
Chapter 6: Corporations
1. D 6. D 11. B
2. C 7. B 12. C
3. B 8. A 13. D
4. E 9. C 14. C
5. B 10. A

Chapter 6: Corporation
Problem 1
1. Journal entries:

i. Organization Cost 5,000

Share capital-ordinary 4,000
Share premium-ordinary 1,000
ii. Organization Cost 3,600
Share capital-ordinary 2,000
Share premium-ordinary 1,600
iii. Organization Cost 1,800
Cash 1,800

Amortize of organization costs:

Amortization Expense 2080
Organization Cost 2080
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 Fundamentals of Accounting -II

Problem 2
1. journal entries:
i. Cash 320,000
share capital-ordinary 200,000
share premium-ordinary 120,000
ii. share capital-treasury 75,000
Cash 75,000

iii. cash 33,600

share capital-treasury 30,000
share premium-treasury 3,600
iv. cash 37,800
share premium 3,600
retained earning 3,600
share capital-treasury 45,000

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