Fundamentals of Accounting II

Course Description

Dear Distance Learners, This course is a continuation of fundamentals of Accounting

I. The course is designed to introduce students to the application of accounting
principles and concepts to major balance sheet items. The specific topics includes
internal control over cash, accounting for receivables, accounting for inventories,
accounting for current liabilities, accounting for plant asset, natural resources and
intangibles and accounting for businesses organized as partnerships and companies as
per Ethiopian Commercial Code.
At the end of each sub chapters and chapters, comprehensive set of review material
consisting of questions, exercise, problems with their answer is provided . .

Course Objectives

Dear Distance Learners, The course has the general objective of introducing
students to the accounting basics of recognizing, measuring, and reporting common
balance sheet items.

Upon the successful completion of this course, the students will be expected to:
 Analyze and record payroll transactions in Ethiopian context.
 Utilize and identify the implication of the various methods of valuation in
respect to accounts and notes receivable, inventories, depreciation, tangible and
intangible assets, and natural resources.
 Analyze record and report transactions for businesses organized as partnerships,
private limited companies, and share companies.

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 Fundamentals of Accounting II

CHAPTER ONE
ACCOUNTING FOR INVENTORY

1.0. Chapter Objective

Dear Distance Learners, After completing the chapter you will be able to:
 Describe and illustrate the effect of inventory on the financial statements of the
current and the following periods.
 Identify and elaborate the two principal inventory systems;
 Identify and illustrate the procedures for determining the actual quantities in
inventory.
 Describe and illustrate the:
- Determination of the cost of inventory
- The most common inventory costing method under a periodic system,
including the comparison of the methods on operating results.
- The valuation of inventory at other than cost, including valuation of the
lower of cost or market.
 Identify and illustrate the proper presentation of inventory in the financial
statements.
 Describe and illustrate methods of estimating the cost of the inventory.

1.1 Introduction

Dear Distance Learners, Well come to the first part of principles of accounting II.

The term inventory is used to designate merchandise held for immediate resale in the
normal course of business and materials held to be used in the process of production.
This chapter particularly discusses the determination of the inventory of merchandise
purchased for resale, commonly called merchandise inventory.
The chapter gives emphasis on different concepts, principles, and practices on
inventory valuation; methods to determine the actual cost of inventory on hand; the
effect of different costing methods on the periodic net income and which adversely
affect capital in the balance sheet of the date and also of the following period; other
methods of valuing inventory other than cost, and other alternative methods of
estimating inventory cost.
In all the end of each section and sub-section of the chapter, activity questions that
reinforce the distance learner are presented. These conceptual and practical questions
help the learner to build up his/her knowledge and skills on the topics discussed.

1.2 Importance of Inventories

Dear Distance Learners, Inventories are one of the most significant assets of many
enterprises. They are continually purchased and sold in the operation of wholesale
and retail businesses. The sale of merchandise provides the major source of revenue

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 Fundamentals of Accounting II

for such enterprises. Therefore, their measurement and disclosure demand careful
attention. They are particularly significant because they materially affect both the
income statement and the balance sheet
Inventories are assets 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.

Inventories are commonly considered in the content of merchandising concerns. A

merchandising enterprise purchases its merchandise in a form ready for sale to
customers and report the cost of unsold units left on head at the end of the period as
merchandise inventory. Only inventory account, Merchandise Inventory, appears in
the financial statement of a trading concern. However, all manufacturing firms
whose function is to produce goods normally have three inventory account raw
materials; work is process, and finished goods. The cost assigned to goods and
materials on hand but not yet placed into production is reported as raw materials
inventory. The cost of raw materials on which production has been started, but not
completed, plus the cost of direct labor applied specially to this material, and an
applied share of manufacturing overhead cost constitute the work in process
inventory. The costs identified with the completed but unsold units on hand at the end
of the fiscal period are finished goods inventory.
Inventories are commonly considered in the context of a merchandising enterprise. A
merchandising enterprise ordinarily purchases its merchandise in a form of ready
made for sale to customers and reports the cost assigned to unsold units left on hand at
the end of the period as merchandise inventory.

1.2.1. The Effect of Inventory on the current period's statements

Dear Distance Learners, Inventory determination plays a significant role in matching

expired costs with revenues of the period. The total cost of merchandise available for
sale during a period of time contains two elements. The first element, the cost of the
merchandise determined to be in the inventory will appear on the balance sheet as a
current asset. The other element, which is the cost of the merchandise sold, will be
reported on the income statement as a deduction from net sales to yield gross profit.
An error in the determination of the inventory amount at the end of the period will
cause an equal misstatement of gross profit and net income, and the amount reported
for both assets and owner's equity in the balance sheet will be incorrectly stated by the
same amount. The possible errors that may arise may include wastages, breakage,
theft, improper entry, and failure to proper or record requisitions and any number of
similar situations may cause the inventory records to differ from the actual inventory
on hand. The effect of the understatement and overstatement of merchandise
inventory at the end of the period are demonstrated in the following three sets of
condensed income statements and balance sheets.

The first set of statements is based on correct ending inventory of Birr 28,000; the
second set is based on an incorrect ending inventory of Birr 20,000 and the third set
on an incorrect ending inventory of Birr 36,000. In all three cases, net sales are Birr
280,000. Merchandise available for sale is Birr 200,000 and expenses are Birr 63,000

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 Fundamentals of Accounting II

Case -1 Inventory at end of period correctly stated at Birr 28,000

Income Statement for the Year Balance Sheet at End of the Year
Net sales ……………… Birr 280,000 Merchandise Inventory ………… Birr
28,000
Cost of merchandise sold ….. 172,000 Other assets ……………………..
88,000
Gross profit ………….... 108,000 Total assets………… …….. Birr 116,000
Expenses …………………… 63,000 Liabilities ……………………… Birr
38,000
Net Income …………… 45,000 Owner's equity ………………..
78,000
Total liabilities and owners equity 116,000
Case-2 Inventory at end of period incorrectly stated at Birr 20,000 (understated
by Birr 8,000)
Net sales ………………. Birr 280,000 Merchandise Inventory ………. Birr
20,000
Cost of merchandise sold …. 180,000 Other assets………… 88,000
Gross profit …………….. 100,000 Total assets ……… 108,000
Expenses ……………………. 63,000 Liabilities ………… 38,000
Net Income …….… Birr37,000 Owner's equity…… 70,000

Total liability and owner's equity 108,000

Case-3 Inventory at end of period incorrectly stated at Birr 36,000 (overstated by

Birr
8,000)
Net sales ……………… .Birr 280,000 Merchandise Inventory ………. Birr
36,000
Cost of merchandise sold …. 164,000 Other assets ……… 88,000
Gross profit ……………. . 116,000 Total asset……… 124,000
Expenses ……………………. 63,000 Liabilities ……… 38,000
Net Income …….… Birr 53,000 Owner's equity
86,000
Total liability and owner's equity 124,000
You should note that in the illustration the total cost of merchandise available
for sale was constant at Birr 200,000. It was the way in which the cost was allocated
that varied. It was the way in which the cost was allocated that varied. The variations
in allocating the Birr 200,000 of merchandise cost are summarized as follows:

Merchandise Available
for sale Inventory
Sold

1. Inventory correctly stated ……………… Birr 200,000 Birr 28,000 Birr

172,000

2. Inventory understated by birr 8,000 ……….. 200,000 20,000

180,000
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 Fundamentals of Accounting II

3. Inventory overstated by birr 8,000 ………… 200,000 36,000

164,000
Dear student: In the above illustration, you have seen the effect of the errors on net
income, assets, and owner's equity. Comparison of the financial statements in 2 and 3
with the financial statements in 1 yields the following.
Net Income Assets Owner's
Equity
2. Ending inventory understated Understated Understated Understated

by Birr 8000 Birr 8,000 Birr 8,000 Birr

8,000

3. Ending inventory overstated Overstated Overstated Overstated

By Birr 8,000 ………………… Birr 8,000 Birr 8,000 Birr
8,000

1.2.2 The Effect of Inventory of the following period’s statements.

As noted above, error in taking an inventory in one period affects the
following period also because the inventory at the end of one period becomes the
inventory of the beginning of the next period. Thus, if the inventory is incorrectly
stated the net income of that period will be misstated and so will the net income for
the following period. The amount of the two misstatements will be equal and in
opposite directions. Therefore, the effect on net income of an incorrectly stated
inventory, if not corrected, is limited to the period of the error and the following
period only. At the end of the following period, assuming no additional errors, both
assets and owner's equity will be correctly stated. To illustrate, assume that the
ending inventory for period 1 was understated by birr 14,000, and no other errors are
made. The gross profit and net income would be understated for period 1 and
overstated for period 2 by birr 14,000.
ILLUSTRATION

Period-1 Period-2
No Error Error Error No Error
Net sales Birr 180,000 Birr 18,000 Birr170,000 Birr170,000
Cost of merchandize
sold;
Beginning inventory 50,000 50,000 40,000 60,000
plus Purchasing 140,000 140,000 130,000 130,000
Merchandize available
for sales 190,000 190,000 170,000 190,000
Less ending Inventory 60,000 40,000 56,000 56,000
Cost of merchandize sold 130,000 150,000 114,000 134,000
Gross profit 50,000 30,000 56,000 36,000

Check Your Progress 1-1

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 Fundamentals of Accounting II

I Define the following terms

1. Merchandise Inventory
2. Periodic Inventory System
3. Physical inventory
4. Perpetual inventory system
II Answer the following question
1. If the merchandise inventory at the end of the accounting period was
overstated by birr 15,000, (a) was the effect an overstatement or an
understatement of the gross profit for the year? What items on the
balance sheet at the end of the accounting period were overstated or
understated as a result of the error?
2. The birr 15,000-inventory error in question 1 was not discovered
and the inventory at the end of the following year was correctly
stated.
(a) Will the error cause an overstatement or an
understatement of the gross profit for the following year?
(b) Which items on the balance sheet at the end of the
following year will be overstated or understated as a
result of the error in the earlier year?
3. If an enterprise uses a perpetual inventory system, is it desirable to
take a
physical inventory? Discuss

4. What are the two elements composed in the total cost of

merchandise available for sale?

1.3. INVENTORY SYSTEMS & VALUATION METHODS

Dear Distance Learners, Two principal systems of inventory accounting are identified
of inventory accounting. They are, the period inventory system and the perpetual
inventory system. When the periodic inventory system is used, only the revenue from
sales 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 that has been sold. At the end of the accounting
period, a physical inventory must be taken in order to determine the cost of the
inventory. This is done by making an actual count of goods or items on hand.
Ordinarily, a purchases account is used to record the buying of inventory items and
the balance in the inventory account, which represents the beginning inventory, is
unchanged during the period.

In contrast to the periodic system, the perpetual inventory system maintains

records that continuously disclose the amount of the inventory. A separate account
for each type of merchandise is maintained in a subsidiary ledger. Purchases and
issue of goods are recorded directly in the inventory account as they occur. No
purchases account is used because the purchases are debited directly to the inventory
account. A cost of goods sold account is used to accumulate the cost of issuance from
inventory. The balance of the inventory account at the end of the accounting period
should represent the ending inventory amount. The balance of the account is called
book inventory of the items on hand. Regardless of the care with which the perpetual
inventory records are maintained, their accuracy must be tested by taking a physical

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 Fundamentals of Accounting II

inventory of each type of commodity at least once a year. The records are then
compared with the actual quantities on hand and any differences are corrected.
The periodic inventory system is often used by retail enterprise that sells many
kinds of low cost merchandise such as groceries, hardware, and drug stores. The
expense of maintaining perpetual inventory records may be prohibitive in such cases.
Firms selling a relatively small number of high unit cost items, such as office
equipment, automobiles, or garments, are more likely to use the perpetual system.

1.3.1 Determining Actual Quantities in the Inventory

As indicated in the above lessons, inventory records may be maintained on a
periodic or a perpetual inventory system basis. The primary stage in the process of
taking an inventory is to determine the quantity of each kind of merchandise owned
by the enterprise when the periodic inventory system is used. The counting,
weighing, and measuring should be done at the end of the accounting period.

The details of the specific procedures for determining quantities and

assembling the data differ among companies. A common practice is to use teams
made up of two persons. A one-person count, weighs, measures to determine
quantity, and the other lists the description and the quantity on inventory sheets. The
quantity indicated for high-cost items is verified by a third person at some time during
the inventory - taking period. It is also advisable for the third person to verify other
items selected at random from the inventory sheets.

All of the merchandise owned by the enterprise on the inventory date, and
only such merchandise, should be included in the inventory. It may be necessary to
examine purchase and sales invoices of last few days of the accounting period and the
first few days of the following period to verify who has legal title to merchandise in
transit on the inventory date. This situation is determined by referring to the shipping
terms as to when title passes. When goods are purchased or sold, F.O.B shipping
point, title passes to the buyer when the seller delivers the goods. If the goods are
sold with terms F.O.B destination, title does not pass until the buyer receives the
goods from the common carrier. To illustrate, assume that merchandise purchased
F.O.B shipping point is shipped by the seller on the last day of the buyer's fiscal
period. The merchandise does not arrive until the following period and hence is not
available for counting by the inventory crew. However, such merchandise should be
included in the buyer's inventory because title has passed to the buyer. It is also
evident that a debit to purchases and a credit to Accounts payable should be recorded
by the buyer as of the end the current period, rather than recording it as a transaction
of the following period.
Another example, although less common, will further show the importance of
closely examining transactions involving shipments of merchandise. Manufactures
some times ship merchandise on a consignment basis to retailers who act as the
manufacturer's agent when selling the merchandise. The manufacturer retains title
until the goods are sold. Such unsold merchandise is a part of the manufacture's
(consignor's) inventory, even though the manufacturer does not have physical
possession. It is now evident that the consigned merchandise should not be included
in the retailer's (consignee's) inventory.

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 Fundamentals of Accounting II

1.3.2 Determining the cost of Inventory.

While in determining cost of inventory, it is very important that the right cost
should be assigned. The cost of merchandise inventory is made up of the purchase
price and all expenditures incurred in acquiring such merchandise, including
transportation, custom duties, and insurance against losses in transit. The purchase
can be readily determined, as may some of other costs. Those that are difficult to
associate with specific inventory items may be prorated on some equitable basis.
Minor costs that are difficult to allocate may be left out entirely from inventory cost
and treated as operating expenses of the period.

If purchases discounts are treated as a deduction from purchases on the income

statement, they should also be deducted from the purchase price of items in the
inventory. If it is not possible to determine the exact amount of discount applicable to
each inventory item, a pro rata amount of the total discount for the period may be
deducted instead. For example, if net purchases and purchases discounts for the
period amount to birr 250,000 and birr 5,000 respectively, the discount represents 2%
of net purchases. If the inventory cost before considering the discount is Birr 50,000
the pro rata amount of discount will be Birr 1000(2%of 50,000).

1.3.3 Inventory Costing Methods under Periodic system.

One of the most significant problems a determining inventory cost comes

about when identical units of a certain commodity have been acquired at different unit
cost during the period. In such cases, it is necessary to determine the unit prices of
the items still on hand. To illustrate this problem and its relationship to the
determination of net Income and inventory cost, assume that three identical units of
commodity X were available for sale to these customers during the fiscal year.
Four of these units were in the inventory at the beginning of the year, and the
others were purchased on Miazia 14, and Sene19, respectively, the costs per unit are a
follows.
Unit Total
Commodity Y Units Cost Cost
Hamle 1, Beginning …………… 4 ……… Birr 27 Birr 108
Miazia 14, Purchases ………….. 8 …………… 39 312
Sene 19 Purchases …………… 3…………… 42 126
Total 15 Birr 546
Average cost per unit …………………….. Birr 36.4 (546/15)
During the year 4 of commodity X were sold, leaving 11 in the inventory at
the end of the year. In the illustration, the units are early identified with specific
expenditures because the variety of merchandise carried in stock and the volume of
sales are relatively small. Since these conditions do not usually exist in actual
practice, businesses are not likely to use specific identification procedures except with
the aid of computerized accounting systems and equipments that can read inventory
labels (Bar cods). When specific identification procedures are too costly to justify
their use, it is customary to use an arbitrary assumption as to the flow of costs of
merchandise through the enterprise. The three most common assumptions of
determining the cost of the merchandise sold are as follows: -
1. Cost flow is in the order in which the expenditure were made - first in, first
out.

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 Fundamentals of Accounting II

2. Cost flow is in the reverse order in which the expenditure were made - last
in, first -out.
3. Cost flow is an average of the expenditure.
Continuing the above example, the cost of units sold and remaining on hand
will be:

Commodity X costs

Units available Units sold Units

remaining
1. In order of expenditures
(First - in - first - out) ………… Birr 546 ………. 108 (4*27)
438(8*39)+(3*42)
2. In reverse order of expenditure
(Last - in, first - out) ………….. 546 ………165 (3*42)+(1*39)
381(4*27)+(7*39)
3. In accordance with
Average expenditures …………. 546……… 145.6(4*36.4)
400.4(11*36.4)
The three most widely used inventory costing methods (which correspond to the three
assumptions of cost flows illustrated) are:
1. First - in, first - out (FIFO)
2. Last - in, first - out (LIFO)
3. Average

1.3.3.1 FIRST - IN, FIRST - OUT METHOD

The first in, first out (FIFO) method of costing is based on the assumption that
costs should be changed against revenue in the order in which they were incurred.
Hence the inventory remaining is assumed to be made up of the most recent costs.
The illustration of the application of this method is based on the following data

ILLUSTRATION: Hamle, 1 Beginning 200units at Birr 9 Birr

1,800
Tikimt, 10 Purchase 300 units at 10
3,000
Tahisas 21 Purchase 300 units at 11
3,300
Megabit 18 Purchase 200 units at 12
2,400
Merchandise available for sale during give 1,000
10,500

The physical Inventory on Sene 30 shows that 300 units of the

particular commodity are on hand. In accordance with the assumption that the
inventory is composed of the most recent cost, the cost of the 300 units is determined
as follows.

Most recent costs Megabit18 ……….. 200 units at Birr 12 ……….. Birr 2,400

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 Fundamentals of Accounting II

Next most recent costs Tahsas 21 ……100 units at Birr 11 ……….

1,100
Inventory Sene 31 ……….. 300 Birr
3,500

Deduction of the inventory of birr 3,500 from the birr 10,500 of merchandise
available for sale yields birr 7,000 as the cost of merchandise sold, which represents
the earliest costs incurred for this commodity. The relationship of the inventory at
Sene 31 and the cost of merchandise sold during the year are illustrated in the
following diagram.

Tikimt Thaisas Megabit

Hamle 300 units 300 200
200 units @ Birr10 units units
@ Birr 9
@ 11 @ 12

Merchandise available for sale birr 10,500

Cost of
merchandise Inventory (FIFO)
sold 200 units at 12 ………birr 2,400
Birr 7,000 100 units at 11 …………. 1,100
Total …………… 3,500

In most business, there is a tendency to dispose goods in 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 method is generally in
harmony with the physical movement of merchandise in an enterprise. To the extent
that this is the case, the FIFO method, approximates the results that would be obtained
by the specific identification of costs.

T
o
10 t
a
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…
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Fundamentals of Accounting II …

1.3.3.2 Last in, First - out Method

3
The last in, First - out (LIFO) method is based on the assumption that the most ,
recent costs incurred should be charged against revenue. Hence the inventory 5
remaining is assumed to be composed of the earliest costs. The cost of the 300 unit, in 0
the forgoing illustration, of inventory is determined in the following manner: 0

Earliest cost, Hamle 1 …….… 200 units at Birr 9 ……..… Birr 1,800
Next earliest cost Tikimt 10 …. 100 units at 10 ……….. 1,000
Inventory, Sene 30 …... 300 ……………………… 2,800
Deduction of the inventory of birr 2,800 from the birr 10,500 of merchandise
available for sale yields birr 7,700 as the cost of merchandise sold, which represents
the most recent costs incurred for this particular commodity.
The use of the LIFO method was originally limited to the relatively rare
situations in which the units sold were taken from the most recently acquired stock.

1.3.3.3 Average Cost Method

The average cost method is based on the assumption that costs should be
charged against revenue on the basis of an average, taking into consideration the
number units acquired at each price. The same average unit cost is employed in
computing the cost of the merchandise remaining in the inventory. The average is
determined by dividing the total cost of merchandise available for sale by the total
number of unit of that merchandise available for sale. Assuming the same cost data as
in the preceding illustration, the average cost of the 1,000 units and the cost of the
inventory are determined as follows:

Average cost ……………. Birr10.5 ( Birr 10,500 /1000)

Inventory, Sene 30 ……… Birr 300 at Birr 10.5 …………….. Birr 3,150

Deduction of the inventory of birr 3,150 from the birr 10,500 of merchandise
available for sale yields birr 7,350 as the cost of merchandise sold, which represents
the average of the costs incurred for the merchandise.

For businesses in which various purchases of identical units of a commodity

are mingled, the average method has some relationship to the physical flow of goods.

1.3.3.4 Comparison of Inventory Costing Methods

Each of the three alternative methods of costing inventories under the periodic
system is based on a different assumption as to the flow of costs. If the cost of
commodities and the prices at which they were sold remained perfectly stable, all
three methods would yield the same results. However, prices do fluctuate and as a
result the three methods will ordinarily yield different amount for
 The inventory reported on the balance sheet at the end of the period,
 The cost of merchandise sold for the period, and
 The gross profit and the net income reported for the period.

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 Fundamentals of Accounting II

Using the examples presented in the preceding sections and assuming that net sales
were Birr 20,000, the following partial income statement indicates the effects of each
method when prices are rising.

First - in Average Last - in

First - out Cost First out
Net Sales ………………………… Birr 20,000 …… Birr 20,000…… Birr20,000
Cost of merchandise sold:
Beginning Inventory …….. ………2,000 …………… 2,000 ………… 2,000
plus Purchases…………… 8,500 ………….. 8,500 …………
8,500
Merchandise available for sale... 10,500 …………..10,500 ………….
10,500
Less Ending Inventory ……….. 3,500 ……………3,150 …………
2,800
Cost of merchandise sold…..... …... 7,000 ………..... 7,350 ……..
……..7,700
Gross profit ………………………13,000 ………… 12,650 …12,300

In comparing and evaluating the results obtained in the illustration, it should

be borne in mind that both the amount reported as net income and the amount
reported as inventory are affected. The method that yields the lowest figure for the
cost of merchandise sold will yield the highest figure for the cost the gross profit and
net income reported on the income statement. It will also yield the highest figure for
inventory reported on the balance sheet. Conversely, the method that yields the
highest figure for the cost of merchandise sold will yield the lowest figure for gross
profit and net income and the lowest figure for inventory.

During periods of consistently rising prices, the use of first - in, first - out
yields the highest possible amount of net income. The reason for this effect is that the
earliest costs assigned for cost of merchandise sold are lower than that of the most
recent and the result will be higher gross profit and higher net income. In periods of
declining prices the effect will be the reverse.

During periods of consistently rising prices, the use of last - in, first - out
yields the lowest possible amount of net income. The reason for this effect is that the
cost of the most recently acquired units are at the inflated price. And the
merchandises sold are composed of items purchased at the inflated price.
The average method of inventory cost is, in a sense, a compromise between
FIFO and LIFO. The effect of price trends is averaged, both in the determination of
net income and the determination of inventory cost. For any given series of
acquisition the average cost will be the same regardless of direction price trends.

Check your progress 1.2

Define the following terms
1. First – in, First – out
2. Last – in, First - out

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 Fundamentals of Accounting II

3. Answer the following questions:

3.1 Differentiate between the periodic system and the perpetual system of
Costing
3.2 Which system of inventory system is more costly to maintain?
3.3 What is the meaning of a) physical inventory?
b) Book inventory?

3.4 Define FOB shipping point?

3.5 Define FOB destination?
3.6 Which of the three methods of inventory costing FIFO, LIFO or
average cost- is based the assumption that costs should be charged
against revenue in the reverse order in which they were incurred?
3.7 Which of the three methods of inventory costing FIFO, LIFO, or
average
cost, is based on the assumption that the most recent costs should be
charged
against revenue in which they were incurred?
3.8 The following units of a particular commodity were available for sale
during
the year.
Beginning inventory………………..16 units at birr 111
First purchase ……………………… 20 units at birr 117
Second purchase …………………… 15 units at birr 120

The firm uses the periodic system and there are 14 units of the
commodity on hand at the end of the year. What is their unit cost-
according to a) FIFO b) LIFO c) average cost?

4. WORK OUT
Solve the following problem and show your computation:-
3F Company's beginning inventory and purchases during the fiscal year ended Sene
30, 1995 were as follows.
Hamle 1, 1995………… inventory …… 2,000 birr 100 -
Birr200,000.
Hamle 10, 1995………… Purchase …….. 2,400 birr 105 - birr
252,000
Hidar 30, 1995………… Purchase ………1,600 birr 110 - birr
176,000.
Yekatit 26 1996 ………… Purchase ……...4,000 birr 112 - birr
448,000.
Miazia 15, 1996…………. Purchase ……... 3,000 birr 114 - birr
342,000.
Miazia 30, 1996 ………… purchase ……... 1,400 birr 116 - birr
162,400.
Ginbot 18, 1996 ………… Purchase ………2,700 birr 120 - birr
324,000.
Sene 21, 1996 ………… Purchase ……... 900 birr 124 - birr
111,600.

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TOTAL. ……………… …………….. 18,000 Birr

2,016,000

3F Company uses the periodic inventory system, and there are 12,800 units of
inventory on hand on Sene 30, 1996.
INSTRUCTIONS:
1.) Determine the cost of inventory on Sene 30, 1991, under each of the following
Inventory costing methods,
a) First- in , First- out
b) Last - in , First- out
c) Average cost
2.) Assume that during the fiscal year ended Sene 30,1996 Sales of birr 2,144,000
were
made at an estimated gross profit rate of 40%. Estimate the ending inventory at
Sene
30, 1996, using the gross profit method.

1.4 DEPARTURE FROM COST VALUATION

The discussions that preceded this topic indicated that cost is the primary basis
for the valuation of inventories under certain circumstances. However, inventory is
valued at other than cost. The following two market situations are examples that lead
to the departure from cost.
They are:
1. When the cost of replacing items in inventory is below recorded cost, and
2. When the inventory is not salable at normal sales prices due to imperfections,
shop
wear, style change or Other causes.
The methods commonly used in the above situation are valuation in lower of cost or
market and valuation at net realizable value.

1.4.1 Valuation at lower cost or market

When the price of inventoried in the market are lower than the cost, valuation at lower
of cost or market is used. It should be born in mind that regardless of the methods
used it is first necessary to determine the cost of the inventory. "Market" as used in
the phrase lower of cost or market which ever is lower, is the interpreted to mean the
cost to replace the merchandise on the inventory date based on quantities typically
purchased from the usual source of supply.
If the replacement price of an item in the market is lower than its cost, there is
almost certain to an accompanying declining in the selling price. Recognition of the
price decline, in valuing the item, reduces the gross profit and the net income for the
period in which the declining occurred. There is also an inherent presumption that
when the item is sold in the following period at a reduced price, the sale should yield
approximately the normal gross profit. To illustrate, assume that merchandise with a
unit cost of birr 70 has sold at birr 100 during the period, yielding a gross profit of birr
30 a unit, or 30% of sales. Assume also that at the end of the year, there is a single
unit of the commodity in the inventory and that its replacement price has declined to
birr 63. Under such circumstances it would be reasonable to expect that the selling
price would also decline, if indeed it had not already done so. Assuming a reduction

14
 Fundamentals of Accounting II

in selling price to birr 90, the gross profit based on replacement cost of birr 63 would
be birr 27, which is also 30% of the selling price. Accordingly, valuation of the unit
in the inventory at birr 63 reduces gross profit past period by birr 7 and permit a
normal gross profit of birr 27 to be realized on its sale in the following period. If the
unit had been valued at its original cost of birr 70, the gross profit determined for the
past year would have been birr 7 greater, and the gross profit attributable to the sale of
item in the following period would have been birr 7 less.
It would be possible to apply the lower of cost or market basis (1) to each item
in the inventory (2) to major classes or categories, or (3) to the inventory as a whole.
The first procedure is the one usually followed in practice. To illustrate the
application of the lower of cost or market to individual items assume that there are
300 identical units of commodity in the inventory. Each acquired at a unit cost of birr
10.75. If at the inventory date the commodity would cost birr 11.00 to replace, the
cost price of birr 10.75 would multiply by 300 to determine the inventory value. On
the other hand, if the commodity could be replaced at birr 10 a unit, the replacement
price birr 10 would be used for valuation purposes. The following tabulation
illustrates one of the formats that may be followed in assembling inventory data
Unit Unit
Lower
Description Quantity Cost price Market price Cost
Cost or market
Commodity A 300 Birr 10.75 Birr 11.50 Birr 3,225
Birr 3,225
Commodity B 180 32.00 35.00 5,760
5,760
Commodity C 460 12.00 9.00 5,520
4,140
Commodity D 250 15.00 15.00 3,750
3,750
Birr 18,255
Birr 16,875
Although it is not essential to accumulate the data for total cost as in the
illustration, it permits the measurement of the reduction in the inventory value as a
result of a decline in market prices. When the amount of market decline is known
(Birr 18255-Birr 16875) it may be reported as a separate item on the income
statement. Other wise, the market decline will be included in the amount reported as
the cost merchandise sold and will reduce gross profit by a corresponding amount. In
any event, the amount reported as net income will not be affected. It will be the same,
regardless of whether the amount of the market decline is determined and separately
stated.
1.4.2 Valuation at Net Realizable Value
Obsolete, spoiled, or damaged merchandise and other merchandise that can be
sold only at prices below cost should be valued at net realizable value. For this
purpose, net realizable value is the estimated selling price less any direct cost of
disposition, such as sales commission. To illustrate, assume that damaged
merchandise that had a cost of birr 900 can be sold for birr 750 and a sales
commission of 50 is paid. This inventory would be valued at birr 700 (Birr 750 - Birr
50), which is its net realizable value.

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 Fundamentals of Accounting II

1.5. PRESENTATION OF MERCHANDISE INVENTORY ON

THE BALANCE SHEET
Merchandise inventory is usually presented on the balance sheet immediately
following receivables. Because both the method of determining the cost of the
inventory (FIFO, LIFO, or average) and the method of valuing the inventory (cost, or
lower or market) should be shown. Both are important to the reader. The details may
be disclosed by a parenthesis notation or footnote.

CHECK YOUR PROGRESS 1-3

1. Define the following terms.
1.1 Lower of cost or market
1.2 Net realizable value
2. Answer the following questions
2.1 Discus the two circumstances that arise when inventory is valued at other then
cost.
2.2 In the phrase lower or cost or market, what is meant by ''market''?
2.3 The cost of a particular inventory item is birr 100, the current replacement cost
is birr 95 and
the selling price is birr 140. At what amount should the item be included in the
inventory
according to the lower of cost or market basis?

2.4 On the basis of the data presented below the value of the inventory at the lower
of cost or
Market, assemble the data in the form illustrated on your hand out, in order that
the inventory
reduction attributable to price declines may be ascertained.

Inventory Unit Unit

Commodity Quantity cost market
100 A 400 Birr 10.50 Birr 10
101 B 200 22 22.50
102 C 800 15 10
103 D 600 21 20
104 E 400 15.50 15

1.6. ESTIMATING INVENTORY COST

Dear students, in the discussion above, you have seen the valuation of inventory at
cost, other parameters other than costs, and the presentation of inventory in the
balance sheet. Now, another method which is estimation is discussed as follows.
In practice an inventory amount may be needed in order to prepare an income
statement when it is impractical or impossible to take a physical inventory or to
maintain a perpetual inventory records. For example, taking a physical inventory
each month may be too costly, even though monthly income statements are desired.
Taking a physical inventory may be impossible when catastrophe, such as fire, has

16
 Fundamentals of Accounting II

destroyed the inventory. In such cases, estimating the cost of inventories is required.
The two methods of estimating inventory cost are (1) the retail method and
(2) the gross profit method
1.6.1 Retail Method of Inventory Costing.
The retail inventory method of inventory costing is widely used by retail
businesses, particularly department stores. It is based on the relationship of the cost
of merchandise available for sale to the retail price of the same merchandise. The
retail price of all merchandise acquired are accumulated in supplementary records,
and the inventory at retail is determined by deducting sales for the period from the
retail prices of the goods that were available for sales during the period. The
inventory at retail is then converted to cost on the basis of the ratio of cost to selling
(retail) price for the merchandise available for sale. Determination of inventory by
the retail method is illustrated below.

Determination of inventory by retail method:

Cost
Retail
Merchandise Inventory (Beginning) ………… Birr 38,900 Birr
72,000
Purchases (net) in Hamle ……………………… 85,100
128,000
Merchandise available for sale Birr 124,000 Birr
200,000
Ratio of cost to retail price ………………….. Birr 124,000 = 62%
Birr 200,000
Sales for Hamle (net) ……………………………………………………… Birr
140,000
Merchandise Inventory, Hamle 30 at retail ………………………………….Birr
60,000
Merchandise Inventory, Hamle 30 at estimated cost (60,000X62%) …… Birr
37,200
1.6.2 Gross Profit Method of Estimating Inventories
The gross profit method uses an estimate of the gross profit of the realized
during the period to estimate the inventory cost at the of the period By using the rate
of gross profit, the dollar amount of sales for a period can be divided into two
elements: (1) gross profit, and (2) cost of merchandise sold. The later may then be
deducted from the cost of merchandise on hand.
To illustrate this method, assume that the inventory on Hamle 1 Birr 114,000
the net purchases during the month are birr 360,000, that net sales during the month
are birr 500,000, and finally the gross profit is estimated to be 30% of net sales. The
inventory on Hamle 30 may be estimated as follows.

Merchandise inventory, Hamle 1………………………………. Birr 114,000

Purchases in Hamle (net) …………………………………….. 360,000
Merchandise available for sale ……………………….………. 474,000
Sales in Hamle (net) ………………………...… Birr 500,000
Less estimated gross profit (Birr 500,000 X30%)…. 150,000
Estimated cost of merchandise sold ……………………………. 350,000

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 Fundamentals of Accounting II

Estimated Merchandise inventory, Hamle 30 ………………… 124,000

The estimate of the rate of gross profit is ordinarily based on the actual rate for
the preceding year, adjusted for any changes made in the cost and sales prices during
the current period. Inventories estimated in this manner are useful in preparing
interim statements. The method may also be used in establishing an estimate of the
cost of merchandise destroyed by fire or other disaster.
Check Your Progress 1-4
1. Define the following terms
1.1 Retail inventory method
1.2 Gross profit method
2. Answer the following questions
2.1 Why do we need to make inventory?
2.2 What are the two commonly used methods of inventory cost?
2.3 Explain gross profit method of estimating inventories.
2.4 Determine the inventory on Hamle 30,199X of company X by retail
method based on
the following data
Cost Retail
Merchandise inventory Hamle 1, 38,800 72,000
Purchase in Hamle (net) 1-30 ……… … 85,200 128,000
Ratio of cost to retail 62% ……… Birr 124,000 Birr 200,000
Sales for Hamle (net)……………… 140,000
Merchandise inventory Hamle 30, Birr 36,000

2.5 Simon's company was destroyed by fire. The financial records of the company
revealed the following report. Determine the inventory of the company by Retail
method using
the following given data.

Simon's company
Retail inventory method
19X1

Cost
Retail
Beginning inventory birr 14,000
20,000
Purchases 63,000
90,000
Merchindise available for sale 77,000
110,000
Sales
birr85,000
Ending inventory at retail
85,000

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 Fundamentals of Accounting II

2.6 3F Company's inventory on Hamle 1, 19X1 is birr 114,000 and net purchases
during the month are birr 360,000. Net sales during the month are birr 500,000.
Gross profit is estimated to be 30% of sales. Determine the inventory of the company
using the gross profit method.

2.7 Green Forest Company has beginning inventory birr 60,000 and net purchases of
birr 200,000.
Net sales amount to birr 280,000. The average rate of gross profit (margin) on
selling price for green forest Co. is 30%. Calculate the inventory of the company
using the gross profit method.

1.7 PERPETUAL RECORDS

Dear Students, We are coming to the last part of this chapter perpetual inventory
system. In the discussion above, you have seen how inventory is determined at the
end of a fiscal period using different methods in a periodic inventory system.

Under the periodic inventory systems the inventory account at the beginning
shows merchandise on hand on that date. Purchase account shows purchases for the
period, and sales of merchandise are recorded in the sales account. The cost of
merchandise sold is not determined for each sale; instead, at the end of an accounting
period, when a physical inventory is taken, two adjusting entries are made. With
these entries, the beginning inventory is removed from the merchandise inventory
account and is replaced by the ending inventory. This adjusted balance of
merchandise sold is then determined, and this amount is reported on the income
statement.

Under the perpetual inventory system, all merchandise increases and decreases are
recorded in a manner somewhat similar to the recording of increases and decreases in
cash. The merchandise inventory account at the beginning of an accounting period
reflects the merchandise on hand on that date. Sales are recorded in the sales account
and, on the date of each sale, the cost of merchandise sold is debited and merchandise
Inventory is credited for the cost of the merchandise sold.

Thus, in the perpetual system, the merchandise inventory account. Continuously

(Perpetually) discloses the balance of merchandise on hand. At the end of the period
the balance in merchandise inventory account is reported on the balance sheet, and the
balance in the cost of merchandise sold account is reported on the income statement.

1.7.1 Comparison of period and perpetual systems

The comparison of periodic system and perpetual system is illustrated below.
Consider the following data
Hamle 1, Merchandise Inventory (beginning) ……….. Birr 105,000
1 - 30 Purchase (on account) ……………………….. 52,400
1 – 30 Sales (on account) -- selling price ……………. 99,500
Sales -- cost price ……………………………. 56,000
30 Merchandise Inventory (ending) …………… 101,400

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 Fundamentals of Accounting II

PERIODIC PERPETUAL

a) Hamle, 1, Merchandise Inventory

Merchandise Inventory A/C reflects Merchandise Inventory account

Inventory on hand, Birr 105,000 reflect inventory on hand Birr
105,000

b) Entries to record purchase, Hamle 1 -- 30

Purchase ………….. 52,400 Merchandise Inventory ….
52,400
Accounts payable …….52,400 Accounting Payable ……
52,400

c) Entries to record sales, Hamle 1 -- 30

Accounts receivable ………. 9 9,500 Accounts Receivable …….
99,500
Sales ………………………99,500 Sales ………………………
99,500
Cost of merchandise sold …..
56,000
Merchandise Inventory …
56, 000
d) Adjusting entries for Hamle 30, merchandise Inventory
Inventory summary …………. 105,000 No entries necessary
Merchandise Inventory ……….. 105,000
Merchandise Inventory ……… 101,400
Income summary ……………… 101,400

(e) Reporting cost of merchandise sold in Hamle on Income Statement

Cost of merchandise sold: Cost of merchandise sold ………
56,000
Hamle 1, Inventory 105,000
Hamle Purchases 52,400
Merchand. Avail. for sale 157,400
Less: Hamle 31, Invent. 101,400
Cost of merchandise sold 56,000

f) Reporting merchandise Inventory Hamle 30, on Balance Sheet

Merchandise Inventory ………… birr 101,400 Merchandise Inventory ……. Birr
101,400

17.2 INVENTORY COSTING METHODS UNDER A PERPETUAL SYSTEM

20
 Fundamentals of Accounting II

Unlike cash, merchandise is a mixed mass of goods. Detail of the cost of each
type of merchandise purchased and sold, together with related transactions such as
returns and allowances must be maintained in a subsidiary inventory ledger, with
separate account for each type. Whether this ledger is computerized or maintained
manually it is customary to use one of the three costing methods first –in first – out,
last- in-first-out or average.
In the following paragraph the FIFO ,LIFO and average methods in a perpetual
system are discussed and illustrated.

ILLUSTRATION: The basis for FIFO and LIFO illustration is the

following data for merchandise identified as commodity X
Units Cost
Hamle 1(beginning) …………………….. 20 ………………Birr 20
4 Sales …………………………. 14 ……………… -
10 Purchases …………………….. 16 ………………. 21
22 Sale …………………………… 8 ……………….. -
28 Sale …………………………… 4 ………………...
30 Purchase ………………………. 20 ………………. 22

1.7.2.1 First – in, First – out Method:

To illustrate the first in, first – out method of cost flow in a perpetual inventory
system, the inventory ledger account for commodity X is as follows. The number of
units on hand after each transaction, together with total costs and units appear in the
Inventory section on the account.
Perpetual Inventory account (FIFO) Commodity X

Date Purchases Cost of Goods Sold Inventory

Quantity Unit Total Quantity Unit Total Quantity Unit Total
Price Cost Cost Cost Cost Cost
Ham. 1 20 20 400
4 14 20 280 6 20 120
10 16 21 336 6 20 120
16 21 336
22 6 20 120 14 21 294
2 21 42
28 4 21 84 10 21 210
30 20 22 440 10 21 210
20 22 440

Note that after the 14 units of the commodity were sold on Hamle 4, there was
a remaining inventory of 6 units. On Hamle 10 16 units were acquired at a unit cost
of birr 21, instead of birr 20, and hence could not be combined with the 6 units. The
inventory after the Hamle 10 purchased is therefore reported on two line, 6 units at
birr 20 each and 16 units at birr 21 each. Next, it should be noted that the birr 162
cost of the 8 units sold on Hamle 22 is composed of the remaining 6 units at birr 20

21
 Fundamentals of Accounting II

each and 2 units at birr 21. At this point 14 units remain in the inventory at a cost of
birr 21 per unit. The remaining illustration is explained in a similar manner.

1.7.2 LAST – IN, FIRST – OUT METHOD

When the Last – in, First – out method is used in a perpetual inventory system,
the cost of the units sold is the cost of the most recent purchase. To illustrate, the
ledger account for commodity X prepared on a LIFO basis is as follows:

Date Purchases Cost of Goods Sold Inventory

Quantit Unit Tota Quantit Uni Tota Quantit Uni Tota
y Pric l y t l y t l
e Cost Cos Cost Cos Cost
t t
Haml
e1 20 20 400
4 14 20 280 6 20 120
10 16 21 336 6 20 120
16 21 336
22 8 21 168 6 20 120
8 21 168
28 4 21 84 6 20 120
4 21 84
30 20 22 440 6 20 120
4 21 84
20 22 440

A comparison of the ledger accounts for the FIFO perpetual system and the
LIFO perpetual system indicates that the accounts are the same through the Hamle 10
purchase. Using the FIFO perpetual system, however, the cost of 8 sold on Hamele
22 is the cost of the units from the Hamle 10 purchases (birr 21 per out). The cost of
the 14 units after the sale on Hamle 22 is the cost of 6 units remaining from the
beginning inventory and the cost of the 8 units remaining from the Hamle 10
purchases. The remainder of the LIFO illustration is explained in a similar manner.

1.7.2.3 Average Cost Method:-

When the average cost method is used in a perpetual inventory system, an
average unit cost for each type of commodity is computed each time a purchase is
made, rather than at the end of the period. This unit cost is then used to determine the
cost of each sale, until another purchase is made is called moving average. The
application of moving average cost method for a perpetual inventory system is shown
below.

Purchases Cost of Goods Sold Inventory

22
 Fundamentals of Accounting II

Date Quan Unit Total Quantity Unit Total Quanti Unit Total
tity Price Cost Cost Cost ty Cost Cost
Meg. 2 2,000 4 8,000 2,000 4 8,000
Meg. 15 6,000 4.40 26,400 8,000 4.30 34,00
0
Meg. 19 4,000 4.30 17,200 4,000 4.30 17,20
0
Meg. 30 2,000 4.50 9,000 6,000 4.367 26,20
0

As indicated above, a new average unit cost is completed each time purchase
is made. On Megabit 15, after 6,000 units are purchased birr 26,400. 8,000 units
costing birr 34,400 (birr 8, 00 plus birr 26,400) are on hand. The average unit cost is
birr 34,400 (birr 8,000 plus birr 26,400) are on hand. The average units cost is birr
34,400 divided by 8,000 or birr 4.30. This unit cost is used in costing withdrawals
until another purchase is made, when a new average unit cost is computed.
Accordingly, the unit cost of the 4,000 units withdrawn on megabit 30 a new unit cost
of birr 4.367 is determined, given the purchase of 2,000 units for birr 9,000.

1.7.2.4 Internal control and perpetual Inventory system.

The use of a perpetual inventory system for merchandise provides the most
effective means of control over this important asset. Although it is possible to
maintain a perpetual inventory in memorandum records only or to limit the data to
quantities, a complete set of records integrated with general ledger is preferable. With
the wide spread use of computes, integrated perpetual inventory systems are being
used by more and more companies.
The control feature is the most important advantage of the perpetual system.
The inventory of each type of merchandise is always readily available in the
subsidiary ledger. A physical cogent of any type merchandise can be made at any time
and compared with the balance of the subsidiary account to determine the existence
and sinuousness of any shortages. When a shortage is discovered an entry is made
debuting Inventory shortage and crediting merchandise Inventory for the cost. If the
balance of the inventory shortage account at the end of a fiscal period is relatively
small, it may be included in miscellaneous administrative expense on the income
statement. Otherwise it may be separately reported in the administrative expense
section.
In addition to the usefulness of the perpetual system in the preparation of
intern statements, the subsidiary ledger can be an aid in maintaining inventory
quantities at any optimum level, frequent comparison of balances with predetermined
maximum and minimum levels facilitate the timely recording of merchandise to avoid
both excess inventory and loss of sales.

1.7.2.5 Automated perpetual Inventory systems

A perpetual inventory system may be maintained using manually kept records.
How ever, such a system is often too costly and too time consuming for enterprises
with a large number of inventory items and/or with many purchase and sales
transactions In such cases, because of the mass of data to be processed, the frequently

23
 Fundamentals of Accounting II

recurring and routine nature of the processing, and the importance of speed and
accuracy, the record keeping is often computerized. A computerized inventory
system operates with little human intervention.

1.8 SUMMARY

Inventory determination plays an important role in matching expired

costs with revenues of the period. An error in the determinations of the inventory
amount at the end of the period will cause an equal misstatement of gross profit and
net income. The amount reported for both assets and owners equity in the balance
sheet will also be incorrect by the same amount.

There are two principal system of inventory accounting periodic and

perpetual. In periodic system only the revenue from sales is recorded at the time ,sales
is made. No entry is made until the end of period to record the cost of merchandise
sold. In the perpetual system sales and cost of merchandise sold are recorded at the
time each sale is made in this way, the accounting records continuously disclose the
amount of inventory on hand.

All the merchandise owned by a business on the inventory date as such

merchandise should be included in the inventory. This included merchandise in transit
that is owned and the unsold merchandise in consignment.

The cost of inventory is made up of the purchase price and all expenditures
incurred in acquiring such merchandise, including transportation cost at the end of the
period, it is customary to use an assumption as to the flow of cost of merchandise
through an enterprise. The three most common assumptions of determining the cost
of merchandise sold are as follows:-

First- in, First- out (FIFO) Last - in, First- out (LIFO), and average cost.
Under a perpetual inventory system, sales are recorded in the sales account.
On the date of each sale, the cost of merchandise sold is also recorded by debiting
Cost of Merchandise Sold and crediting Merchandise Inventory. In this system, the
details of merchandise increases and decreases are maintained in a subsidiary ledger
called an inventory ledger, with a separate account for each type of merchandise.

If the market price of an item is lower than the cost, the lower of cost or
market method is used to value inventory. Market, as used in a phrase lower of cost or
market, is interpreted to mean the cost to replace the merchandise on the inventory
date. Merchandise that can be sold only at price below cost should be valued at Net
realizable value, which is the estimated selling price less any direct cost of
disposition.
When it is impractical or impossible to take a physical inventory or to
maintain perpetual inventory records, two commonly methods of estimating inventory
may be used are the retail method and the gross profit method.

24
 Fundamentals of Accounting II

Check your progress 1.5

PERPETUAL RECORDS

1. Work Out
Solve the following problem and show you computation
Highland springs companies beginning inventory and purchases during the fiscal year
indeed Sene 30,19X2 were as

Units
Total
Units Cost
Cost
Hamle 1,19X1 Inventory 500 50
25,000
Nehase 30,19X1 Purchase 600 52. 50
31,500
Mesk. 30,19X2 Purchase 400 55
22,000
Tikimit 30,19X2 Purchase 1,000 56
56,000
Hidar 30,19X2 Purchase 750 57
42,750
Tir 30,19X2 Purchase 350 58
20,300
Megabit30,19X2 Purchase 675 60
40,500
Ginbot 30,19X2 Purchase 225 62
13,950
TOTAL……………………… 4,500 Birr
252,000

Instruction:

Highland Spring Company uses the periodic inventory system, and there are 1600
units of inventory on hand on Sene 30,19X2.

Required:
Determine the cost of inventory on Sene 30, 19X2 under each of the
following costing methods.
a) First -in , First - out
b) Last - in ,First -out
c) Average cost

25
 Fundamentals of Accounting II

Answer Key
Check your progress 1.1
1. Merchandise inventory:- an itemized list of goods on hand showing their value is
called an inventory, and the general ledger account that show's the value of the goods
on hand at the beginning of the fiscal period is called Merchandise inventory.

2. Periodic inventory system:-when the merchandise inventory can be determined

only by physical measurement at specific intervals, the system is called periodic
inventory system.

3. Physical inventory:- an actual count on hand is called physical inventory. It is a

detailed listing of merchandise on hand.

4. Perpetual inventory system: -an inventory record that shows changes in the
amounts on hand as the changes occur (continuously) is called a perpetual inventory
system. The system continuously discloses the amount of the inventory.

II. 1. a) Overstatement of gross profit by birr 15,000

b) The merchandising inventory account and the owner’s equity account are
overstated by the amount.
2. a) understate gross profit, because cost of merchandise will be higher by birr
15,000.
b) Capital account (owners equity account)
3. Yes, it is desirable, because some items may be damaged; stolen obsolete, so
there is a need to check the actual items in the store through physical inventory
to determine that they correspond with the records.
4. Beginning merchandise inventory and net purchase.

Check your progress 1.2

1) First – in, First - out ( FIFO method)
A method of inventory costing based on assumption that the cost of
merchandise sold
should be charged against revenue in the order in which the cost were incurred.
2) Last – in, First – out (LIFO method)
A method of inventory based on the assumption that the most recent costs
incurred should be charged against revenue.
.
3.1 -Periodic inventory system is used to determine inventory cost when identical
units of certain commodity have been acquired at different unit cost price
during the period. In such case, it is necessary to determine the unit prices of
the item still on hand this is done using physical measurement at specific
intervals. The flow of cost of merchandise can be determined using periodic
inventory system. Periodic inventory system is used by retail enterprises that
sale large variety of low unit cost of merchandise such as: - groceries,
hardware, and drug stop

-Perpetual inventory system: - is the system that employs accounting records

that continuously discloses the amount of inventory. Each type of merchandise is

26
 Fundamentals of Accounting II

maintained in a subsidiary ledger. Regardless of the case with which the perpetual
inventory records are maintained, it is necessary to test their accuracy by taking a
physical inventory of the actual quantities and any discrepancies should be
corrected. Firms such as office equipment, automobiles, or fur garments use the
perpetual inventory.

3.2 perpetual system of inventory costing is more expensive than periodic system.

3.3 a. physical inventory:- is the process of detail listing or the merchandise on

hand usually taken at the close of accounting period so that the cost of
inventory can be determine
b. book inventory:-increases in inventory items are recorded as a debit to
the appropriate accounts, and decreases are recorded as credits, the balance
of the accounts are called book inventories.

3.4 FOB shipping point: - terms of agreement between the buyer and the seller
where by ownership passes when merchandise is delivered to shipper and
the buyer absorbs the transportation cost.
3.5 FOB Destination: - is terms of agreement between buyer and seller, where
by ownership passes when merchandise is received by the buyer, and the
seller absorbs the transportation cost.
3.6 First – in, First – out
3.7 Last – in, First – out
3.8 a. FIFO 14 unites at birr 111
b. LIFO 14 unites at birr 120
c. Average cost Total cost 5,916 birr = Birr 116
Total units 51 units

4. WORK OUT SOLUTION

1. a) First - in, first- out method: -

900 units @124…………………………………… birr 111,600.
2,700 units @ 120…………………………………….. 324,000.
1,400 units @ 116 …………………………………… 162,400.
3,000 units@ 114…………………………………….. 342,000.
4,000 units@ 112…………………………………… 448,000.
800 units @110 ……………………………………………88,000.
12,800 units ………………………………… ……… birr1,476,000

2. a) Last - in, first- out method: -

2,000 units @100 …………………………………….. Birr 200,000.
2,400 units @ 105…………………………………….. 252,000.
1,600 units @ 110 …………………………………… 176,000.
4,000 units@ 112…………………………………….. 448,000.
2,800 units@ 114…………………………………………. 319,200.
12,800 units ………………………………… ……… birr1, 395,200

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 Fundamentals of Accounting II

3. C) Average cost method

Average cost per unit birr 2,016,000 ÷ 18,000 units = birr 112
Inventory Sene 30, 1996 - 12,800 units is birr 1,433,600

2) Merchandise inventory, Hamle 1, 1995 …………………… birr 200,000

Purchase (net) Hamle1, 1995- Sene 30, 1996 ………..…………. 1,816,000
Merchandise available for sale……………………………. 2,016,000
Sales net Sene 30, 1996………………. Birr 2,144,000
Less estimated gross profit
(2,144,000 X40 %) 857,600
Estimated cost of merchandise sold………………. 1, 286,400
Estimated merchandise inventory Sene 30, 97 birr 729,600

Check Your Progress 1.3

1.
1.1 The phrase lower of cost or market which ever is lower, is interpreted to mean the
cost to replace the merchandise on the inventory date. To the extent practicable
the market or replacement price should be based on quantities typically purchased
from the usual source of supply.

1.2 Net realizable value is the estimated selling price less any direct cost of
disposition, such as selling commission. Net realizable value is employed when
spoiled, obsolete or damaged merchandise and other merchandise that can be sold
only at price below cost should be valued at net realizable value.
2.
2.1 Inventory is valued at other than cost when two circumstances arise. Such
situations
are:-
1) When the cost of replacing items in inventory is below recorded cost.
2) When the inventory is not salable at normal sales prices because of
imperfections, shop wear, style, charge, or other causes.

2.2 ''Market" is used in the phrase lower or cost or market is interpreted to mean the
cost
to replace the merchandised on the inventory date, based on quantities typically
purchased from the usual source of supply.

Cost Unit Total

2.3 Description quantity price market price cost
lower

Commodity X 1 100 95 100 95

According to the lower of cost or market the inventory must be included as birr 95.
2.4 Cost Unit Total
Description quantity price market price cost lower
100 A 400 birr 10.50 10 4,200 4,000
101 B 200 22 22.50 4,400 4400
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 Fundamentals of Accounting II

102 C 800 15 10 12,000 8,000

103 D 600 21 20 12,600 12,000

104 E 400 15.50 15 6,200

Total … ……………………………..………………….. 39,400
34,400
( The market decline is known as birr 39,400 - 34,400 = 5,000)

Answer keys
Check your progress 1.4
1.1 Retail method of inventory costing is based on the relationship of the cost of
merchandise available for sale to the retail price of the same merchandise. It is
widely used method of inventory costing by retail business, particularly
department stores.
1.2 The gross profit method uses an estimate of the gross profit of the realized during
the period to
estimate the inventory cost at the of the period
2.1 In practice, an inventory amount is needed in order to prepare an income
statement
2.2 a) Retail method of inventory costing
b) Gross profit method of estimating inventories.

2.3 The gross profit method of estimating inventories is method of realizing the
inventory at the end of a certain period.
a) By using the rate of gross profit.
b) Cost of merchandise sold. The later may then be deducted from the cost of
available for sale to yield the estimated inventory of merchandise on hand.
2.4
Cost Retail
Merchandise inventory Hamle1, Birr 38,800 birr
72,000
Purchase in Hamle 1-30 (Net)……………………… 85,200

128,000
Merchandise available for sale ……………….Birr 124,000 birr
200,000
Ratio of cost to retail price 124,000 = 62%
200,000
Sales for Hamle (net……………………………………………………………
140,000
Merchandise inventory Hamle 30 at retail …………………………….
60,000
Merchandise inventory, Hamle 30,
at estimated cost (60,000 X 62%) ……………..……. 37,200

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 Fundamentals of Accounting II

2.5 Simon Company

Retail Inventory method
19 X1
Cost Retail
Beginning inventory…………………… birr 14,000 birr 20,000
Purchases ……………………………… 63,000 90,000
Goods available for sales……………………….. 77,000 110,000
Deduct: Sales ………………………………………………………… 85,000
Ending inventory at retail……………………………………… birr 25,000

Ratio of cost to retail 77,000 = 70%

110,000
Ending inventory at cost (70% birr 25,000) ………………………. 17,500

3F Company
Gross profit method
19X1
Merchandise inventory, Hamle 1 …………………………… Birr 114,000
Purchases in Hamle (net) …………………… ………………. 360,000
Merchandise available for sale …………………………… 474,000
Sales in Hame, (net)………………… Birr 500,000
Less -estimated gross profit
(500,000 X 30%) ……………… birr 150,000
Estimated cost of merchandise sold ……………………………... 350,000
Estimated merchandise inventory Hamle 30, 19x1……….. Birr 124,000

Green Forest Company

Gross profit method
19X1

Beginning inventory ………………………………. Birr 60,000

Net purchases ……………………………………….. 200,000
Goods available ( at cost) ………………… 260,000
Net (sales at selling price) ………………birr 280,000
Less (Gross profit) (30% of 280,000) 84,000
Sales ( at cost)………………………. 196,000
Inventory (at cost) ………… birr 64,000

Check your progress 1.5

1.WORK OUT SOLUTION:-

30
 Fundamentals of Accounting II

a) First-in, First- out method

225 units @ 62 ………………………………. Birr 13,950
675 units @ 60……………………………….. 40,500
350 units @ 58………………………………. 20,300
350 units @ 57 ……………………………… 19,950
1600 units birr 94,700

(b) Last -in, First-out method

500 units @ 50 ……………………………………Birr 25,000
600 units @ 52.50 …………………………………. 31,500
400 units @ 55 …………………………………….. 22,000
100 units @ 56 ……………………………………. 5,600
1,600 units birr 84,100

(C) Average cost method

Average cost per unit birr 252,000 ÷ 4,500 = birr 56
Inventory sene 30, 1996 = 1600 units

 1,600 units X 56 units each = 89,600.

CHAPTER 2
PLANT ASSETS AND
INTANGIBLE ASSETS

31
 Fundamentals of Accounting II

2.0. CHAPTER OBJECTIVE

After completing this chapter, you should be able to describe and illustrate the
accounting for acquisition of plant assets, describe the nature of deprecation and
describe and illustrate:
 The accounting for depreciation
 The composite rate deprecation method
 The accounting for capital and revenue expenditures
 The accounting for plant assent disposals
 The accounting for depletion
 The accounting for intangible assets
 The reporting or depreciation expense, plant assents and intangible assets in
the fanatical statements

2.1. INTRODUCTION

Well come to the second major part of this course – plant assets and intangible assets.
Their accounting treatment is a paramount importance for periodic financial reports.

Almost every business of any size or activity uses assets of a durable nature in its
operation. Long-lived is a general term that may be applied to assets of a permanent
or relatively fixed nature owned by a business enterprise.

In the discussing that follow, proper attention will be given to the nature of plant
assets, install cost of a plant assets, depreciation of plant assets, changes and revisions
of periodic depreciation, capital and revenue expenditure, disposal of plant assets,
depletion of natural resources, and intangible assets and amortization. Wish you good
reading time.

2.2. NATURE OF PLANT ASSETS

Long lived tangible assets that are of a permanent nature, used in the operation
of the business, and not held for sale in the ordinary course of the business are
classified on the balance sheet as plant assets or fixed assets. Other descriptive titles
frequently, used are property, plant, and equipment, the properties most frequently
included in plant assets may be described in more specific terms as equipment,
furniture, trolls machinery, building, and land, Long lived assets that are without
physical characteristics, are not held for sale but are useful in the operation of an
enterprise are classified as intangible asset. This includes include patents, copyrights,
and good will.

Assets acquired for purposes of resale or resale in the normal course of

business can not be characterized as plant assets regardless of their durability or the
length of time they are held. Thus, undeveloped land or other real estate acquired as a
speculation should not be classified as plant assets. When equipment or machines are
removed from service and held for sale, they cease to be plant asset.

The major characteristic of property, plant and equipment are:

32
 Fundamentals of Accounting II

1. They are acquired for use in operation and not for sale. Only assets used in the
normal operation of the business should be classified as plant assets. A
typically example is an idle building, which is more appropriately classified as
investment rather than as plant asset.
2. They are long-term in nature and usually subject to depreciation plant assets
yield services over a number of years. The investment in these assets is
assigned to future periods through periodic depreciation charges.
3. They possess physical substance. Property, plant and equipment are
characterized by physical existence or substances this differentiates them from
intangible assets, such as patents or good will.
Check Your Progress 2.1
Answer the following questions
1. Define plant asset
2. Write down the other descriptive title of plant assets?
3. Outline the properties most frequently included in plant assets.
4. What is the criterion for the classification of plant assets?
5. Write down the major characteristics of plant asset and equipment.

2.3. INITIAL COST OF PLANT ASSETS.

The initial cost of a plant asset is measured by the cash or cash equivalent price of
obtaining the asset and getting it ready for its intended used. The purchase price,
freight cost, and installation cost of a productive asset are considerable as part of the
initial cost of the asset. Similarly, when a second hand asset is purchased, the initial
costs of getting it ready for use such as expenditures for new parts, repairs, and
painting, are properly charged to the asset account. On the other hand, cost associated
with the acquisition of plant assets that do not increase their utility should be excluded
from the asset account. Expenditures resulting from carelessness or errors in installing
the asset, from vandalism, or from other abnormal occurrences do not increase the
utility of the asset and should be allocated to the period as an expense.

The cost of constructing a building includes the fees paid to architects and
engineers for plans and supervision, insurance during construction, and all other
necessary expenditures applicable to the project. Interests incurred during the
construction period on money borrowed to finance the project should be treated as the
cost of the building.
The cost of land includes not only the negotiated price but broker’s
commissions, title fees, surveying fees, and other expenditures connected with
securing title. If delinquent real estate taxes are assumed by the buyer, they also are
chargeable to the land account. If unwanted buildings are located on land acquired
for a plant site, the cost of their razing or removal, less any salvage recovered, is
properly chargeable to the land account. The costs of leveling or permanently
changing the contour are also an additional cost of land.

Other expenditures related to the land may be charged to Land, Buildings or

land improvement depending upon the circumstances. If the property owner bears the
initial cost of paving the public street bordering his land, either by direct payment or
by specialties assessments, the paving may be considered to be as permanent as the
land. On the other hand, the cost of constructing walk ways to and around the building

33
 Fundamentals of Accounting II

may be addend to the building account if the walkways are expected to last as long as
the building. Expenditures for improvements that are neither as permanent as the land
nor directly associated with the building may be separated in a land improvements
account and depreciated in accordance with their varying life spans. Some of the more
usual items of this nature are trees and shrubs, fences, outdoor lighting systems, and
paved parking areas.
Check your progress 2.2
Answer the following question

1. How do we maintain accounting records when we acquire new plant

assets?
2. Hoe do we maintain accounting records when acquire second hand or old
plant assets?
3. How do we record plant assets expenditure resulting from carelessness or
errors in installing the asset, from vandalism, or from unusual occurrence
that do not increase the usefulness of the asset?
4. How do we record the cost of constructing a building?
5. How do we record the cost of land?

2.4. DEPRECIATION OF PLANT ASSETS

With the passage of time, all plant assets except land lose their capacity to yield
services. Accordingly, the cost of such assets should be transferred to the related
expense accounts in an orderly manner during their expected useful life. The periodic
cost expirations are called depreciation.
The factors contributing to decline in utility may be divided into two categories,
physical depreciation, which includes wear attributable to use and deterioration from
the action of the elements, and functional deprecation, which includes inadequacy and
obsolescence. A plant asset becomes inadequate if its capacity is not sufficient to
meet the demands of increased production. Plant asset is obsolete if the commodity
that it produces is no longer in demand or if a newer machine can produce a
commodity of superior quality or at a material reduction in cost, The continued
growth of technological progress during this century has made obsolescence an
increasingly important component of deprecation.

If a plant asset is expected to have no value at the time that it is retired from
service, its entire initial cost should be spread over the expected useful life of the asset
as depreciation expense. Also, if a plant asset’s value at the time of retirement is
expected to be very small in comparison with the cost of the asset, this value may be
ignored and the entire cost spread over the asset’s expected useful life. If a plant asset
is expected to have a significant value at the time that tit is retired from service, the
difference between its initial cost and this value is the cost (depreciable cost) that
should be spread over the useful life of the asset. The plant asset’s estimated value at
the time that it is to be retired from service is called its residual value, scrap value,
savage value or trade in value.

Depreciation may be recorded by an entry at the end of each month or the

adjustment may be postponed until the end of the finical year. The position of the

34
 Fundamentals of Accounting II

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 the contra asset account permits the original cost to remain
undisturbed in the plant asset account, while facilitate the computations of periodic
depreciation, the listing of both cost and accumulated deprecation on the balance
sheet, and the reporting required for property tax and income tax purposes.

In determining the amount of depreciable cost that is to be recognized as periodic

depreciation expense, three important factors need to be considered. They are:
1. The plant asset’s initial cost
2. The plant asset’s residual value, and
3. The plant asset’s useful life.
The relationship between these three factors and the periodic depreciation expense is
illustrated in the following diagram.

FACTORS THAT DETERMINE DEPRECIATION

EXPENSE

(1) LESS Depreciable

Initial (2) Cost
cost Residual
Value

Periodic deprecation expense

(3)
Useful
life

35
 Fundamentals of Accounting II

Neither the period of usefulness of a plant asset nor its residual value at the
end of that period can be accurately determined until the asset is retired. However, in
determining the amount of the periodic depreciation, these two related factors must be
estimated at the time the asset is placed in service.

There are no hard and fast rules for estimation either factor, since both factors
maybe greatly affected by management policies for example, the estimates of a
company that provides its sales representatives with a new automobile every year will
differ from those a firm that keeps its cars for three years. Such variables as climate,
frequency of use, maintenance, and minimum, standards of efficiency will also affect
the estimates.
Life estimates for depreciable assets are available in various trade
association‘s and other’s publication. For federal in come tax purpose, the Inland
Revenue Authority has also established guidelines for life estimates. These guidelines
may be useful in determining depreciation for financial reporting purposes.
In additions to the many factors that may influence that life estimate of an
asset, there is a wide range in the degree of exactness used in the computation. A
calendar month is ordinarily the smallest unit of time used. When this period of time
is used, all assets placed in service or retired from service during the first half of that
month are treated as if the event had occurred on the first day of that month.
Similarly, all plant asset additions and reduction during that second half a month are
considered to have occurred on the first day of the next month.

It is not necessary that an enterprise use a single method of computing

depreciation for all classes of its depreciable assets. The methods used in the accounts
and financial statements may also differ from the methods used in determining
income taxes and property taxes. The four methods used most often are straight line,
units of production, declining balances, and sum of year’s digits.

2.4.1 Straight-Line Method

The straight-line method of determining depreciation provides for equal

periodic charges to expense over the estimated life of the asset. To illustrate this
method, assume that the cost of a depreciable asset is Birr 32,000; its estimated
residual value is Birr2,000; and its estimated life is 5 years. The annual depreciation is
computed as follows:

Birr 32,000 (cost) – Birr 2,000 (estimated residual valued) = Birr

6,000
5 year (estimated life)

The annual depreciation of Birr 6,000 would be prorated for the first and the
last partial years of use. Assuming a fiscal year ending on Sene 30 and first use of the
asset on Maizia 15, the depreciation for that fiscal year would be Birr 1500 (3
months). If usage had begun on Maizia 16, the depreciation for the year would be Birr
1000 (2 months).

The annual straight line deprecation maybe converted to a percentage rate, determined
on the basis of cost and the estimated life of the asset without regard to residual value.
The conversion to an annual percentage rate is accomplished by dividing 100 by the

36
 Fundamentals of Accounting II

number of years of life. Thus a life of 50 years is equivalent to a 2% depreciation rate:

20years equivalent to a 5% rate, 8 years is equivalent to a 12% rate, and so on. The
straight line method is widely used because of its simplicity. In addition it provides a
reasonable allocation of cost to periodic revenue when usage is relatively the same
from period to period.

2.4.2 Units –of-Production Method.

The units-of-production Method yields a depreciation charge that varies with the
amount usage to apply this method, the length of life of the asset is expressed in terms
of productive capacity, such as hour, miles number of units. Deprecation is first
computed for the appropriate unit of production, and the deprecation for each
accounting period is then determined by multiplying the unit deprecation by the
number of units used during the period. To illustrate, assume that a machine with a
cost of Birr 32,000 and estimated residual valued of Birr 2,000 is expected to have
and estimated life of 15,000 operation hours. The depreciation for a unit of one hour
is computed as follows.

Birr 32,000 cost –Birr 2,000 estimated residual valued = Birr 2hourly depreciation
15,000 estimated hours
Assuming that the machine was in operation for 3,000 hours during a
particular year, the depreciation for that year would be Birr 6,000 (2 x 3,000).
When the amount of usage of a plant asset changes from year to year, the units
of production method is more logical than the straight line method. It magnified fair
allocation of cost against periodic revenue.

2.4.3 Declining- Balance Method.

The declining balance method yields a declining periodic deprecation charge over the
estimated life of the asset. The most common technique is to double for straight-line
deprecation rate, computed as explained previously, and apply the resulting rate to the
cost of the asset less it accumulated depreciation. For example, the declining-balance
rate for an asset with an estimated life of 5 year would be double the straight-line rate
of 20%, or 40%. These rates are then applied to the cost to the asset for the first year
of its use and there after to the decline book valued (Cost minus accumulated
deprecation). The method is illustrated in the following table.

Accumulated
Book value at Book value
depreciation Deprecation
Year Original beginning of Rate at end of
at beginning for Year
cost year Year
of year
1 Birr 32,000 - Birr 32,000 40% Birr 12,800 Birr 19,200
2 Birr 32,000 12,800 19,200 40% 7,680 6,480
3 Birr 32,000 20,480 6,480 40% 2,592 3,888

4 Birr 32,000 24,368 3,888 40% 1,555.20 2,332.80

5 Birr 32,000 25,923.20 2,332.80 40% 332.80 2,000.00

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 Fundamentals of Accounting II

Note that estimated residual value is not considered in determining the

depreciation rate. It is also ignored in computing periodic depreciation, except that the
asset should not be depreciated below the estimated residual value. In the above
example, it was assumed that the estimated residual value at the end of the fifth year
would be Birr 2000. If we compute the deprecation expense from the remaining
balance, Birr 2332.80, the periodic depreciation for the fifth year would be Birr
932.82 (.40 x Birr 2332.80) which would leave the book value to be Birr 1400 which
is below the assumed residual value Birr 2,000. This is not possible because a plant
asset should not be depreciated below the residual value.
There was an implicit assumption in the foregoing illustration that the use of
the asset coincided with beginning of the fiscal year. These would seldom counter in
actual practices however, and would necessities a slight variation in the computing for
the first partial year of use. If the asset in the example had been placed in service at
the end of the third month of the fiscal year, only the pro rata portion of the first full
year’s depreciation 9/12 x 40/100 x 32,000) or Birr 9600 would be allocated to the
first fiscal year. The method of computing depreciation for the subsequent year
would not be affected. Thus the depreciation for the second fiscal year, in the
illustration, would be 40% x (Birr 9600) or Birr 22400.

2.4.4 Sum of –The –Year-Digit Method

The sum of-the-year-digit method yields results like those obtained by use of the
decline balance method. The periodic charge for depreciation declines steadily over
the estimated life of the asset because a successively smaller faction is applied each
year to the original cost of the asset less estimated residua value. The denominator of
the fraction, which remains the same, is the sum of the year digits repressing the years
of life. The numerator of the fraction, which changes each year, is the number of years
of life remaining at the beginning of the year for which depreciations being computed.
For an asset with an estimated life of 5 years the denominator is 5+4+3+2+1, or 15.
For the first year, the numerator is 5, for the second yeare4, and son on. The method is
illustrated by the following depreciation schedule for an asset when acquired at a cost
of Birr 32,000, residual valued of Birr 2,000 and life of 5 years.

Book
Accumulated
Depreciable Depreciation value of
Year Rate Depreciation
value for year at end of
at end of year
Year
Birr
5/15
1 Birr 30,000 Birr 10,000 Birr 10,000 22,000
2 Birr 30,000 4/15 8,000 18,000 14,000
3 Birr 30,000 3/15 6,000 24,000 8,000
4 Birr 30,000 2/15 4,000 28,000 4,000
5 Birr 30,000 1/15 2,000 30,000 2,000

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 Fundamentals of Accounting II

When the first use of the asset does not coincide with the beginning of a fiscal year, it
is necessary to allocate each full year’s depreciation between the two fiscal years
benefited.
Assume that the asset in the example was placed in-service after three months of the
fiscal year had elapsed, the deprecation for that fiscal year would be Birr 7500 (9/12 x
5/15 x30,000). The depreciation for the second year would be Birr 8500, computed as
follows:
3/12 x 5/15 x Birr 30,000------------------------------------- Birr 2,500
9/12 x 4/15 x Birr 30,000------------------------------------- Birr 6,000
Total Second fiscal year ------------------------------------- Birr 8,500

2.4.5. Comparison of Deprecation Methods

The straight line method provides uniform periodic charge to depreciation expense
over the life of the asset. The units – production method provides for periodic charges
to depreciation expense that may vary considerably, depending up on the amount of
usage of the asset.
Both the declining- balance and the sum of the years digits method provide for
a higher deprecation charge in the first year of use of the asset and gradually declining
periodic charges thereafter. For this reason they are frequently referred to as
accelerated depreciation methods. These methods are most appropriate for situation in
which the decline in productivity or earning power of the asset is proportionately
grater in the early years of its use than in later years. Farther justification for their use
is based on the tendency of repairs to increase with the age of an asset. The reduced
amounts of depreciation in later years are therefore offset to some extent by increased
maintenance expense.
The periodic depreciation charges for the straight line method and accelerated
methods are compared in the following charts. This chart is based an asset cost of Birr
32,000 an estimated life of 5 years, and estimated residual value of Birr 2.000

Check your progress 2.3

1. Define the following terms

39
 Fundamentals of Accounting II

1.1. Depreciation
1.2. Residual value
1.3. Straight - line method
1.4. Declining balance method
1.5. Sun - of - the - years - digits methods
1.6. Units - of production method
1.7. Accelerated - depreciation method
1.8. Composite - rate - depreciation methods
2. Write down the four methods used frequently for determining depreciation
1. ------------------
2. ------------------
3. ------------------
4. ------------------

2.5: Changes in Estimates and Revision of periodic Deprecation

At the earlier part of this chapter, it was noted that two of the factors that must
be considered in computing the periodic depreciation of a plant asset is salvage value
at the time it is retried from service and its useful life must be estimated at the time
the asset is placed in service. Minor errors resulting from the use of these estimates
are normal and tend to be recurring. When such error occurs, the revised estimates are
used to determent the amount of the remaining undepreciated cost to be charged as an
expense in futures periods.
To illustrate, assume that a plant asset purchased for Birr 3,000,000 and
originally estimated to have a useful life of 30 years and a residual value of Birr
60,000 has been depreciated for 10 years by the straight line method. At the end of ten
year its book values (undepericated cost) would be Birr 80,000, determined as
follows.
Asset cost --------------------------------------------------- Birr 3,000,000
Less accumulated depreciation (Birr 8000 x 10years) 80,000
Book value (Undepericated cost) end of tenth year Birr 220,000
If during the eleventh year it is estimated that the remaining useful life is 10
years, (instead of 30 years) and that the residual value is Birr 30,000 (instead of Birr
60,000) the depreciation expense for each of the remaining 20 years would be Birr
9500 described as follows:
Book value (Undepericated cost), end of twenty year------------- Birr
220,000
Less revised estimated residual value --------------------------------
30,000
Remaining depreciation.-------------------------------- ----------------
190,000
Revised annual depreciation expense (Birr 190,000 /20)---------------------
9,500
Note that the correction of minor errors in the estimates used in the
determination of depreciation does not affect the amount of depreciation expense
recorded in earlier years. The use of estimates and the resulting likelihood of minor
errors in such estimates is inherent in the accounting process therefore when such
error do occur, the amounts recorded for deprecation in the past are not corrected only
future depreciation expense amounts are affected.
40
 Fundamentals of Accounting II

2.5.1 Recording Depreciation

Depreciation may be recorded by an entry at the end of each month, or the adjustment
may be delayed until the end of the year. As noted earlier the part, the entry that
records the decrease in the plant asset is credited to a contra asset account entitled
accumulated deprecation or allowance for depreciation. This facilitates the listing of
both cost and accumulated depreciation on the balance sheet.
An exception to the general procedures of recording depreciation monthly or
annually is often made when a plant asset is sold, traded or scraped. The disposal is
recorded by removing from the all amounts both the cost of the asset and its related
accumulated deprecation as of the date of disposal. Hence it is advisable to record the
additional depreciation on the item for the current period before recording the
transaction disposing of the asset. A further advantage of recording the depreciation at
the time the disposal of the asset is that no additional attention need to be given the
transaction when the amount of the periodic deprecation adjustment for other the plant
assets is later determined.

2.5.2. Subsidiary ledgers for plant assets

When deprecation is to be computed individually on a large number of assets making
up a functional group, it is advisable to maintain a subsidiary ledger. To illustrate,
assume that an enterprise owns about 150 items of office equipment with a total cost
of about Birr 300,000. Unless the business is newly organized, the equipment would
have been acquired over a number of years. The individual cost, estimated residual
value, and estimated useful life would be different in each cases and the make up of
the group will continually change because of acquisition and disposals of the asset.
There are many various forms of subsidiary records. Among that multicolumn
analysis sheet or a separate ledger account maybe used. As an illustration, a
subsidiary ledger is shown below.

Plant Asset Record

Account No: 123-215 General Ledger Account: Office

Equipment
Item: SF 490 Copies
Serial No: AT 47-3926
From whom purchase: Jupiter Trading p/c Depreciation per year: Birr
240
Estimated useful life: 10year Estimated Residual value: Birr
500
Date Asset Balance Accumulated Depreciation
Book
Debit Credit Debit Credit Balance
Value
04/06/90 2,900 2,900

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 Fundamentals of Accounting II

30/12/90 180 180

2,720
30/12/91 240 240
2,480
The number assigned to the account illustrated is made up of the number of
the office equipment account in the general ledger (123) followed by number assigned
to the specific item of office equipment purchased (215). An identification tag or
plaque with the corresponding account number is attached to the asset. Depreciation
for the year in which the asset was acquired computed for nine months on straight line
basis is Birr 180 for the following year it is Birr 240 These amounts, together with the
corresponding amounts from all other accounts in the subsidiary ledger, provide the
figures for the respective year-end adjusting entries debasing the depreciation expense
account and crediting the crediting the accumulated deprecation account.
The sum of the asset balance and the sum of the accumulated depreciation
balance in all of the accounts should be compared periodically with the balances of
their respective controlling accounts in the general ledger. When certain asset is
disposed of the asset section of the subsidiary account is credited and the accumulated
depreciation section is debited. This reduces the balance of both sections to zero. The
account is then removed from the ledger and filed for futures reference.
Subsidiary ledgers for plant assets are useful to the accounting department in,
1. Determining the periodic depreciation expense,
2. Recording the disposal of individual.
3. Preparing tax returns and
4. Preparing insurance claims in the event of insured losses.
The forms may also be expanded to provide spaces for accumulating data on
the operating efficiency of the assets. Such information as number of break down,
length of time out of service and cost of repair is useful in comparing similar
equipment produced by different manufactures. When new equipment is to be
purchased, the data are useful in comparing similar equipment produced by different
manufactures. When new equipment is to be purchase, the data are useful to
management in deciding upon size, models land other specifications and the best
source of supply.

2.5.3. Depreciation of plant Assets of low unit cost:-

Subsidiary ledgers are not usually maintained for classes of plant assets that
are make up of individual items of low unit cost, such as hand tool and other small
portable equipment.
Because of hard usage, brakeage, and pilferage, such assets may be relatively
short lived and may require constant replacement. In such cases the usual depreciation
methods are not practical one common method of determining cost expiration is to
take a periodic inventory of items on hand, estimate their fair value based on original
cost, and transfer the remaining amount from the asset account to an appropriately
titled accounts, such tool expense. Other categories to which the same method often
applies are dies, molds, patterns, and spare part.
2.5.4 Composite Rate Deprecation Method.
In the illustration showed above, depreciation has been computed on each
individual plant asset. And other procedure called the composite rate depreciation
method is used to determine depreciation for entire group of assets by se of a single
rate. The basis for grouping may be similarity in the life estimates or other common

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 Fundamentals of Accounting II

traits, or it may be broadened to include all assets within a functional class such as
office equipment or factory equipment.
When depreciation is computed on the basis of a composite group of assets of
differing life spans, a composite rate based on average must be developed.
This may be done by:
(1) Computing the annual depreciation for each asset,
(2) Determining the total annual depreciation, and
(3) Dividing the sum by the total cost of the assets.
The procedure is illustrated as follows.
Asset Estimated Residual Estimated
Annual
No Cost Value Life
Depreciation
101 Birr 40,000 Birr 8,000 20 years Birr 3,600
102 31,200 3,000 30 years 1,880
-----------------------------------------------------------------------------------------------------

147 82,000 2,000 16 year 10,000

Total Birr 946,800 Birr
99,414
Birr 99,414 (Annual deprecation) = 10.5% Composite rate
Birr 946,800

Although new assets of differing life span and residual value will be added to
the group and old assets will be retired, the mix is assumed to remain relatively
unchanged. Accordingly, a depreciation rate based on averages (10.5% in the
illustration) also remains in changed for an in define time in the future.
When a composite rate is used, it may be applied against total assets cost on a
monthly basis, or some reasonable assumption may be made regarding the timing of
increasing and decrease in the group. A common practice is to assume that all
additions and refinements have occurred uniformly throughout the year. The
composite rate is then applied to the average of the beginning and ending balance of
the account. Another acceptable averaging technique is to assume that all additions
and refinements during the first half of the year occur as of the first day of the year,
and that all addition and retirements during the second half of the year occurred on the
first day of the following year.

When assets with in the comment group are retired, no gain or loss should be
recognized jested, the asset account is credited for thee cost of the asset and the
accumulated account is debited for the excess of the cost over the amount realized
from the disposal. Any deficiency in the amount of depreciation recorded on the
shouter-lived assets is presented to be balanced by excessive deprecation on the
longer-lived assets.

Check your progress 2.4

Answer the following questions
1. What are the two factors that must be considered in computing the periodic
depreciation of a plant asset?

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 Fundamentals of Accounting II

2. Assume that a plant asset is purchased for Birr 130,000 and originally
estimated to have a useful life of 30years and a residual value of Birr 10,000
has been depreciated for 10 years by the straight line method. At the
beginning of the 11th year, it is estimated that the remaining useful life is 25
year instead of 20 years and the residual value is Birr 5,000 instead of 10,000.
Considering the change, determine annual deprecation of the remaining years.
3. How do we record depreciation, explain?
4. Describe the use of subsidiary ledgers for plant assets.

2.6. Capital and Revenue Expenditures.

In addition to the initial cost of acquiring a plant asset, other costs related to its
efficiency or capacity may be incurred from time to time during its service life. It is
often difficult to recognize the difference between expenditures that add to the
bettering of the asset for more than one accounting period and those that benefit only
the period in which they are incurred. Expenditures for acquiring plant assets or for
additions to plant assets and expenditure that add to the utility of a plant assets for
more than one accounting period are called capital expenditure. Such expenditures are
deleted to the asset account or to a related accumulated deprecation account.
Expenditures that benefit only the current period and that are made in order to
maintain normal operating efficiency are called revenue expenditure.

2.6.1 Capital Expenditure

Dear student: We have discussed earlier the treatment of initial cost when a plant asset
is acquired. The accounting for other costs when a plant asset is acquired will be
discussed next. Common capital expenditures related to plant assets are:

(1) Additions,
(2) Betterment, and
(3) Extraordinary repairs

2.6.1.1 Additions to plant assets

Expenditures for additions to existing plant assets would be debited to the
plant asset accounts as discussed earlier in the chapter for the initial cost of acquiring
plant assets. The cost of additions would be depreciated over the estimated useful life
of the adding. For example, the cost of adding an air conditioning system to a building
or of adding a wing to a building would be treated as capital expenditures.

2.5.1.2. Betterments
Expenditures that increase operating efficiency or capacity for the remaining
useful life of a plant asset are called betterments. Such expenditures would be added
to the plant asset. For example, if the power unit attached to a machine is replaced by
one of greater capacity, the cost would be debited to the plant asset account. Also the
cost and the accumulated depreciation related to the old power unit would be removed
from the accounts. The cost of the new power unit would be depreciated over its
estimated useful life.

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 Fundamentals of Accounting II

2.6.1.3. Extra ordinary Repairs

Expenditures that increase that useful life of an asset beyond the original estimate are
called extra ordinary repairs. They should be debited to the appropriate accumulated
depreciation account, however, rather than to the asset account. In such circumstances
the extra ordinary repairs may be said to restore or “make good” a portion of the
depreciation accumulated in prier year. In addition, the periodic deprecation for future
periods would be predetermined on the basis of the revised book value of the asset
and the revised estimate of the remaining useful life.

To illustrate, assume that a machine cost in Birr 100,000 with no residual

value and a useful life of 10 years, has bee depreciated for 7 years by the straight line
method (Birr 10,000 annual depreciation). If at the beginning of the eight year a Birr
26,000 extra ordinary repair increases the remaining useful life of the machine to 8
years (instead of 3) the Birr 26,000 would be debited to accumulated depreciation, the
annual depreciation for remaining 8 years of use would be Birr 7,000, determined as
follows:
Cost of Machine ......................................................................................... Birr
100,000
Less Accumulated depreciation balance:....................................................
Depreciation for the 7 years (Birr 10,000 x7) ............................................
70,000
Deduct debit for extra ordinary repairs ......................................................
26,000
Balance of accumulated Depreciation .......................................................
44,000
Revised book value of machine after
Extra ordinary repair ..................................................................................
56,000
Annual depreciation
Remaining useful life (56,000 / 8 years).....................................................
7,000
2.6.2 Revenue Expenditure
Expenditures for ordinary maintenances and repairs of recurring natures
should be classified as revenue expenditures and debited to expense accounts. For
example, the cost of replacing a bulb light of an office building or the cost of
repairing a building should be debited to proper expense accounts.

Small expenditures are usually treated as repair expense, even though

they may have the characters of capital expenditures. The saving in time and clerical
expenses justifies the sacrifice of the small degree of accuracy. Some businesses
establish a minimum Birr amount required to classify an item as a Capital
expenditure.
Check your progress 2.5
1. Define the following terms
1.1 Capital expenditure
1.2 Revenue expenditure
1.3 Betterments
1.4 Extraordinary repairs
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 Fundamentals of Accounting II

1.5 Additions to plant assets

2. Answer the following questions
A machine acquired 6 years before at accost of birr 100,000 and with no
residual value and estimated useful life of 10 years. At the beginning of the 7th year
Birrr24, 000 extra ordinary repair increases the remaining useful life to 8 years instead
of 4 years. Compute the revised annual deprecation of the remaining year

2.7 Disposal of plant Assets.

Dear students, now we are entering the 6th part of this chapter. In the above
discussi9ons, you have seen the various method of depreciation, and some types of
expenditures made to a plant assets. Following is a discussion regarding removal
(disposal) of a plant asset from service.

A plant asset should not be removed from the accounts only because it has been
deprecated for the full period of estimated life. If the assets are still useful to the
enterprise the cost and accumulated depreciation should remain the ledger. Otherwise
the accounts would contain no evidence of the continued existence of such plant
assets and the control function of the ledger would be impaired. In addition, the cost
and the accumulated depreciation data on such assets are often needed in reporting for
property taxes and income tax purpose. However, when it is believed that a plant
asset is no longer useful, the appropriate disposal measure should be taken. The
disposal of the plant asset could be done by discarding, selling or exchanging for an
other plant asset.

2.7.1. Discarding plant assets

When a plant asset are no longer useful to the business and have no market value,
it will be discarded. If the asset has been fully depreciated, no loss is realized. To
illustrate, assume that an item of equipment acquired at a cost of Birr 20,000 became
fully depreciated at Sene 30, the end of the preceding fiscal year. It is now to be
discarded as worthless. The entry to record the deposal is as follows.

Meskerm 24 Accumulated Depreciation, Equipment 20,000

Equipment 20,000
To write off equipment discarded.
If the accumulated depreciation applicable to the Birr 20,000 of discarded
equipment had been less than Birr 20,000 there would have been a loss on it disposal.
Furthermore, it would have been necessary to record depreciation for the six months
of use in the current period before recording the disposal. To illustrate these
differences, assume that the annual depreciation on the equipment is computer at 10%
of the cost and that the accumulated deprecation balance is Birr 17,000 after the
annual adjusting entry at the end of the preceding year. The entry to record
depreciation of Birr 1,000 for the six months of the current period is as follows:

Tikimt 24 Depreciation Expense – Equipment 1,000

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 Fundamentals of Accounting II

Accumulated depreciation- Equipment 1,000

To record current year deprecation equipment discarded
The equipment is then removed from the accounts and the loss is recorded by the
following entry:
Tikmt 24: Accumulated depreciation- Equipment 18,000
Loss on Deposal of plant Assets 2,000
Equipment 20,000
To writ off equipment discarded
Ordinary losses and gains on the disposal of plant assets are non-operating
items may be reported in the other expense and other income sections, respectively, of
the income statement.

2.7.2. Sale of a plant asset.

The entry to record the sale of a plant asset is like the entries illustrated in the
preceding section, except that it the cash or other asset required must be also be
recorded. If the selling price is more than the book value of the asset, the transaction
results in a gain. If the selling price is less than the book value, there is a loss. To
illustrate some possibilities assume that equipment acquired at a cost of Birr 20,000,
and depreciate at the annual a rate of 10% of cost is sold for cash on Miazia 12 of the
eight year of its use. The accumulated depreciation in the account as of the preceding
Sene 30 in Birr 14,000 the entry to record the deprecation for the nine months of the
current years is as follows:
Miazia12 Deprecation expense -Equipment 1,500
Accumulated deprecation- Equipment 1,500
To record current period deprecation

After the current depreciation is recorded, the book value of the asset in Birr
4500. In general journal form, entries to record the sale under the three different
assumptions as to selling price are as follows:
 Selling a plant asset equal to value for Birr 4500 without gain, or loss
Maizia 12 Cash 4,500
Accumulated depreciation Equipment 15,500
Equipment 20,000
 Sold below book value for Birr 2,000,with loss
Maizia 12 Cash 2,000
Accumulated depreciation –Equipment 15,500
Loss no Disposal of plant asset 2,500
Equipment 20,000
 Sold above book value for Birr 6,000,with gain
Maizia 12 Cash 6,000
Accumulated depreciation –Equipment 15,500
Equipment 20,000
Gain on Disposal of plant assets 1,500

2.7.3 Exchange of plant Asset.

Old equipment is often traded in for new equipment having a similar use. The
trade in allowances is deducted from the price of the new equipment, and the balance
owed (boot) is paid according to the credit terms. The trade in allowance given by the

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 Fundamentals of Accounting II

seller is often greater or less than the book value of the old equipment traded in the
past, it was acceptable for financial reporting purposes to recognize the difference
between the trade- in allowance and the book value as a gain or a loss. For example a
trade in allowance of Birr 2,000 would have yielded a recognized gain of Birr 1000
such treatment is no longer acceptable for financial reporting purpose on the theory
that revenue occurs from the production and sale of items produced by plant assets
and not from the exchange of similar plant assets. However, if the trade in allowance
is less than the book value of the old equipment, the loss is recognized immediately.

Non Recognition of Gain: The acceptable method of accounting for an exchange

in which the trade in allowance exceeds the book value of the old plant asset requires
that the cost of the new asset be determined by adding the amount of boot given to the
book value of the old asset. To illustrate, assume an exchange based on the following
data.

Equipment traded in (old)

Cost of old equipment -------------------------------------------------- Birr 8,000
Accumulated depreciation at date of exchange ----------------- 6,400
Book value at Tahsas 18, date of exchange ------------------ 1,600
Similar equipment acquired (new)
Price of new equipment ------------------------------------------- 12,000
Trade in allowance on old equipment --------------------------- 4,200
Boot given (Cash -------------------------------- ----------------- 7,800

The cost basis of the new equipment is Birr 9,400, which is determined by adding the
boot given (Birr 7,800), to the book value of the old equipment (Birr 1,600). The
compound entry to record the exchange and the payment of cash in general journal
form is as follows:

Tahsas 19 Accumulated Depreciation -Equipment 6,400

Equipment 9,400
Equipment ------------------------------------------------8,000
Cash --------------------------------------------------- 7,800
It should be noted that the non recognition of the Birr 2600 gain (Birr 4,200 trade
in allowance minus Birr 1600 book value) at the time of the exchange is really a
postponement. The periodic depreciation is based on a cost of Birr 9400 rather than
on the quoted price of Birr 12,000. The unrecognized gain of Birr 2600 at the time of
the exchange will be matched by a reduction of Birr 2600 in the total amount of
depreciation during taken during the life of the equipment.

Recognition of loss: To illustrate the accounting for a loss on the exchange of one
plant asset for another which is similar in use, assume an exchange based on the
following data.
Equipment traded in (old)
Cost of old equipment ------------------------------------------------------ Birr 14,000
Accumulated depreciation at date of exchange ---------------------- 9,200
Book value at Megabit 7, date of exchange --------------------------- 4,800
Similar equipment acquired (new)
Price of new equipment -------------------------------------------------- Birr 20,000
Trade in allowance on old equipment ---------------------------------- 4,000

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 Fundamentals of Accounting II

Boot given (cash) ------------------------------------------------------ 16,000

The amount of the loss to be recognized on the exchange is the excess of the book
value of the equipment traded in (Birr 4,800) over the trade in allowance (Birr 4,000),
or Birr 800. The entry to record the exchange, in general journal form is as follows:
Megabit 7. Accumulated Depreciation Equipment 9,200
Equipment 20,000
Loss on Disposal of plant asset 800
Equipment 14,000
Cash 16,000

Federal Income tax regulation: The Internal Revenue code requires that neither
gains nor losses be recognized for income tax purposes if:

1. The asset acquired by the tax payer is given in exchange and

2. Any boot involved is given, rather than received, by the taxpayer.

Thus, the treatment of a non recognized gain corresponds to the acceptable method
prescribed for financial reporting purpose, the boot given being added to the book
value of the old equipment.
In the first illustration, the cost basis for federal income fax purpose
corresponds to the amount recorded as the cost of the new equipment, namely Birr
9,400. The cost basis of the new equipment in the second illustration for federal
income tax purposes is determined in a like manner. The boot given (Birr 16,000) is
added to the book value of the old equipment (Birr 4,800), yielding a cost basis of
Birr 20,800. The unrecognized loss of Birr 800 at the time of the exchange will be
matched by and increase of Birr 800 in the total amount of deprecation allowed for
income tax purpose during the life of the asset.

Check your Progress 2.6

Answer the following Question
1. Why do we dispose plant assets? How do we treat discarding or selling in the
book of accounts? Discus.
2. Assume that an equipment acquired at a cost of Birr 3000 become fully
depreciated on Hamle 30, 1995, and is now to be discarded as worthless. Show
the entry to record the disposal.
3. Assume that an equipment acquired at Birr3,000 and the annual depreciation
on the equipment is computed to be 10% of cost. The accumulated
depreciation balance is Birr 2375 after the annual adjusting entry at the end of
the preceding fiscal year Sene 30. On Meskerem 28, the equipment is
discarded. Show the entry to record the 3-months deprecation and the
discarding of the equipment.
4. Assume that equipment acquired at a cost of Birr 10,000, and depreciated at a
rate of 10% of the cost. The equipment is sold for cash on Megabit 19,1995.
The accumulated depreciation account as of the preceding Sene 30,1994 is
Birr 7,000. Record the entry for current year’s deprecation.
5. Assume that in the above Question 4, the equipment is sold at Book value for
Birr 2250, and there is no gain or loss. How do you record the entry in the
book of accounts?

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 Fundamentals of Accounting II

6. Assume that in the above question 4, the equipment is sold below book value
for birr 1250. How do you record in the book of account?
7. Assume that in the above question 4, the equipment is sold above book value
for Birr 3000, and there is a gain of Birr 750. How do you record the book of
account?

2.8. Depletion of Natural Resources

Dear students in the above discussions you have seen the nature, initial cost, and
depreciation of planet assets, except land, and disposal of the assets and their
accounting treatments. One of the tangible assets is land which is not subject to
depreciation but to depletion.
The periodic allocation of the cost of metal ores and other minerals removed from
the earth is called depletion. Natural resource, often called wasting assets, including
petroleum, minerals, and timber are characterize by two main features:
1) The complete removal (Consumption) of the asset, and
2) Replacement of the asset only by act of nature.
Unlike buildings and machinery, natural resources consumed physically during
the period of use and do not maintain their physical characteristic.
Normally, depletion is computed on the number of units withdrawn during the
period. In adopting this approach, the total cost of the natural resource is divided by
the number of units estimated to be in the resources deposit to obtain cost per unit of
product. This cost per unit is multiplied by the number of units extracted during a
period to compute the period’s depletion.

To illustrate assume that a local oil company has acquired the right to use 500
hectares of land in Gambella to explore for oil. The lease cost is Birr 2,000,000. It is
estimated that the deposit will provide approximately 1,000,000 barrels of oil. The
depletion rate established is computed in the following manner.

Total Cost
= Depletion Cost Rate
Total estimated units available

Birr 2,000,000 = Birr 2.00 Per barrel

1,000,000

If 250,000 barrels are withdrawn in the first year, then the depletion charge for the
year is Birr 500,000 (250,000 barrels at Birr 2, 00)
The entry to record periodic depletion is as follows
Depletion expense ---------------------------------------- 500, 000
Accumulated Depletion ---------------------------------------- 500,000
The accumulated depletion account is a contra asset account and is presented in
the balance sheet as a deduction from the cost of the mineral deposit.

Check your progress 2.7

Answer the following question
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 Fundamentals of Accounting II

1. Define Depletion
2. How do we record depletion in the book of accounts?
3. Assume that the cost of certain mineral rights is 4,000,000 and that the deposit
is estimated at 10,000,000 tons of ore of uranium grade a ton. If Birr 900,000
tons are mined during the year.
a) Calculate the depletion amount, and
b) Record the adjusting entry
4. Assume that National oil Company Ltd record shows the total cost related to
oil deposit was Birr 1,000,000. And it is estimated that the well provide
approximately 1,000,000 barrels of oil. If 250,000 barrels are withdrawn in the
first year
a) Compute the depletion rate
b) Record the depletion entry

2.9. INTANGIBLE ASSETS AND AMORTIZATION:-

Long lived assets useful in the operation of an enterprise that are not held for sale
and have no physical qualities are usually classified as intangible assets. Intangible
asset generally characterized by lack of physical existence, and high degree of
uncertainty concerning future benefits. The basic principle applicable to the
accounting for intangible assets are similar to those described earlier for plant assts.
The major concerns are the determination of the initial cost and the recognition of
periodic cost expiration called amortization, attributable to the passage of time or
declining utility. The value of intangible assets is usually derived from legal rights or
privileges held by an entity.
Intangible assets are ordinarily presented in the balance sheet as a separate section
following plant assets. Intangible assets frequently include patents, copyrights, and
goodwill.

2.9.1 Patents
Manufactures may acquire exclusive rights to produce and sell commodities with one
or more unique features. Such rights are evidenced by patent, which are issued to
inventors by the federal government. They continue in effect for 17 years. An
enterprise may obtain patents on new products developed units own research
laboratories or it may purchase patent rights from others. The initial cost of purchased
patents should be debited to an asset account and then written-off or amortized, over
the years of its expected usefulness. The period of time may be less than the
remaining legal life of the patent, and the expectations are also subject to change in
the future.

To illustrate, assume that at the beginning of its fiscal year, an enterprise

acquires for Birr 200,000 a patent granted 8 years earlier. Although the patent will not
expire for another 9 years, it is expected to be of value for only five years. The entry
to amortize the plant at the end of the fiscal year is as follows:
Sene 30 Amortization Expense -patent 40,000
Patent 40,000
Continuing the illustration, assume that after two years of use, it appears that
the patent will cease to have value at the end of an additional two years. The cost to
be amortized in the third year would be the balance of the remaining two years or Birr
60,00

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 Fundamentals of Accounting II

2.9.2 Copyrights
The exclusive right to publish and sell a literary, artistic or musical composition is
obtained by a copyright. A copyright is granted for the life of the creator plus 50 years
and will be given to the owner’s heirs. The exclusive right to reproduction and sell
artist or unpublished work, copyrights, may be assigned or sold to other individuals,
like patent. The cost acquiring and defending a copyright may be capitalized, but the
research costs involved must be expensed as incurred.

Generally, when the useful life of the copyright is less than the copy right, the
cost should be allocated to the years in which the benefits are expected to be received.
The difficulty of determine the number of years over which benefits will be received
normally encourages the company to amortize these costs over a fairly short period of
time.
2.9.3 Goodwill
In the sense that it is used in business, goodwill is an intangible asset that attaches to a
business as a result of factors such as
 Location
 Production Superiority
 Good reputation
 Superior management team
 Good labor relation
 Favorable tax condition etc.
Its existence is evidenced by the ability of the business to earn a rate of return on
the investment that is in excess of the normal rate for other forms in the same line
of business.
Goodwill is recorded only when an entire business is purchased because goodwill
is a going concern valuation and can not be separated from the business as a whole.
Goodwill generated internally (Sometimes referred to as non purchased goodwill)
should not be capitalized in the accounts; because measuring the components of
goodwill is simple too complex, and associating any cost with future benefits is too
difficult.
Accountants are generally in agreed that goodwill should be recognized in the
accountant only if it can be objectively determined by an event or transaction, such as
purchase or sale of business. Accountants also agree that the value of goodwill
eventually disappear and that the recorded cost should be amortized over the years
during which the good will is expected to be of value. The period of amortizing
should no, however, exceed 40 years.

2.10. SUMMARY
Dear student: we have discussed the important points about the plant assets. To
wind up the discussion, now, we summarize the points
As time passes, all plant assets except land lose their capacity to yield service. The
expiration of the cost of plant assets is called deprecation. The initial cost of plant
assets includes all expenditures necessary to place and make ready to use. In
determining the amount of depreciation, three factors to be considered are initial cost,
residual value and the useful life of the asset. Four methods of depreciation identified
namely are straight line, Units of production declining balance and sum of the year’s

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 Fundamentals of Accounting II

digit methods. The other method of depreciation are composite rate of deprecation are
used for group of assets of differing life spans.
Expenditures made to a plant assert are classified into two, capital expenditure
that increase the value of the asset beyond its estimated life and revenue expenditures
that benefits only the current periods. When plant assets are removed from the
service, they are disposed in three forms i.e. by discarding, by selling, and by
exchanging with similar plant asset. Land as a long lived asset is not subject to
depreciation but is loses its useful mineral resources, and the decrease in the value of
these natural resources termed as depletion.
Finally, some of the long live assets with out physical existence are intangible
assets, like patent, copyrights and goodwill are amortized over their estimated life.

Check Your Progress 2.8

1. Define the following term
1.1 Amortization
1.2 Patents
1.3 Copyright
1.4 Goodwill
2. Answer the following question
2.1 Write down the item classified as intangible assets
2.2 How long do the following intangible assets last?
a) Patents
b) Copyright
c) Goodwill
2.3 Assume that at the beginning of its fiscal year, enterprise ABC Co. acquire
a patent that cost Birr 102,000, and that it will be useful for 17 years, but it
is expected to be of value for only 15 years. Record the entry to amortize
the patent at the end of the fiscal year.

Answer key
Check your progress 2.1
1. Definition of terms
1.1. Long lived tangible assets that are of a permanent nature, used in the
operations of business, and not held for sale in the ordinary course of a
business are classified as plant asset or fixed assets.
1.2. Other descriptive titles of plant asset that are frequently used are -
property, plant, and equipment..
1.3. Properties most frequently included in plant assets may be described
as, equipment, furniture, tools, machinery, buildings, and land.
1.4. Although there are no standard criteria as to the minimum length of life
necessary for classification as plant asset or tangible, the asset must be
capable of repeated use or benefit and ordinarily expected to last more
than a year.
1.5. The major characteristics of property, plant and equipment are.
1. They are acquired for use in operation and not for sale. Only assets
that

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 Fundamentals of Accounting II

used in the normal operation of the business should be classified as

plant
assets. A typical example is an idle building, which is more
appropriately
classified as investment.
2. They are long-term in nature and usually subject to depreciation.
Plant
assets yield services over a number of years. The investment in
these
assets are assigned to future periods through periodic depreciation
changes.
The exception is land, which is not expected.
3. They posses physical existence. Property, plant, and equipment are
characterized by physical existence or substance, thus are
differentiated
from intangible assets, such as patents, or good will.

Check your progress 2.2

1. New fixed assets (plant assets) may be bought either for cash or on credit.
When fixed asset is purchased, it is recorded at the cost price, including
all expenditures necessary to get it in place and ready for use such as sales
tax, transportation charges, insurance on the asset while in transit,
foundation and installation costs should be added to the purchase of the
related plant assets.
2. When a second hand asset is purchased, the initial costs of getting it ready
for use, such as expenditures for new parts, repair, and painting are
debited to the asset account.
3. The expenditure of the asset should be treated as an expense.
4. The cost of constricting a building includes the fees paid to architects and
engineers for plans and supervision, insurance including interest incurred
during construction, and all other needed expenditures related to the
project, including interest incurred during the construction period on
money borrowed t finance construction.
5. The cost of land that is the negotiated price plus broker's commissions,
title fees , surveying fees, and other expenditures connected with securing
title. If real estate taxes are assumed by the buyer, they are also
chargeable to the land account. If unwanted buildings are located on land
acquired for a plant site, the cost of the razing or removal, less any
salvage recovered is properly chargeable to the land account. The cost of
leveling or otherwise permanently changing the contour is also added to
the cost of land. Other expenditures related to the land may be charged to
land, building or land improvements, depending up on the circumstance.

Check your progress 2.3

1. Definition of terms
1.1 Depreciation This periodic cost expiration is called depreciation

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1.2 Scrap value: the estimated market value of a depreciable asset at the
time o it’s removal from service. It is also called residual value, salvage
value, or trade - in value.

1.3 Straight - line – method: the straight line method of depreciation

provides for equal periodic charges to expense over the estimated life of the
asset. Under the straight line method, depreciation is considered a function on
the passage of time.
1.4 Declining - balance method yields a declining periodic depreciation
charge over the estimated life of the asset. The most common technique is to
doubl the straight line depreciation rat. The depreciation rate remains the
same throughout the assets life (assuming no charge in estimates occur)

1.5 Sum - of - the- years - digits method yields results like those obtained
by use of the declining balance method. The periodic charge for depreciation

declines steadily over the estimated life of the asset because a successively
smaller fraction is applied each year to the book value ,original cost of the
asset less the estimated residual value.
1.6 Units of production method: yields a depreciation charge that varies
with the amount of the assets usage. To apply this method, the length of life of
the asset is expressed in terms of productive capacity, such as hours, miles, or
number of units.
1.7 Accelerated depreciation method: these methods are most appropriate
for situations in which the decline in productivity or earning power of the asset
is
proportionality greater in the early years of its use than in later years.
1.8 Composite - rate depreciation method is a method of deprecation for
groups of assets by use of a single rate. The basis for grouping may be
similarity in life estimates or other common traits or it may be broadened to
include all assets with in functional class such as office equipment or factory
equipment.
2. 1. Straight line - method
2. Unit s - of - production method
3. Decline balance - method and
4. Sum - of -the digits method
Check your progress 2.4
1. a) The residual value at the time the plant asset is retired from service , and
b) The plant assets useful life.
2. Plant assets cost ------------------------------Birr 130,000
Less accumulated dep. (4000 x 10) 40,000
Book value at the beginning 11th yea Birr 90,000
If during the 11th year it is estimated that the remaining useful life is 25 years
(instead of 20) and that the residual value is Birr 5000 instead of Birr 10, 000) ,
the depreciation expense for each of the remaining 25 years would be Birr 3100 -
determined as follows:

- Book value (undepericated cost) at end of 10th year ------------- Birr

90,000

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 Fundamentals of Accounting II

- Less revised estimated residual value -------------------------Birr

5,000
- Revised remaining depreciable value -------------------------------- Birr
85,000
- Revised remaining useful life(years)---------------------------------
25years
- Revised annual depreciation expense (Birr 85,000/25 )----------- Birr
34,000

3. Depreciation may be recorded by an event at the end of each month, or the

adjustment may be delayed until the end of the year. An exception to the
general procedure of recording depreciation monthly or annually is often made
when a plant asset is sold, traded or scrapped.
4. When depreciation is to be computed individually on a large number of assets
making up a functional group, it is advisable to maintain subsidiary ledger.
Check your progress 2.5

1.1. Capital expenditure:- an expenditure that adds to the utility of an asset for more
than one accounting period..
1.2. Revenue expenditure:- an expenditure that benefits only the current period
accounts, and they affect the expense of only the current period
1.3 Betterments: - Expenditures that increase the operating efficiency or capacity or
the
remaining useful life of plant asset is called betterment.
1.4. Extraordinary repair:- Expenditures that increase the useful life of an asset
beyond the original estimated are called extraordinary repair. They should be
debited to the appropriate accumulated depreciation account, rather than to the
asset account.
1.5. Additions to plant assets:- expenditures for additions to existing plant asset could
be debited to the plant asset account the cost of addition could be depreciated over
the estimated useful life of the additions.

2. Computation

Cost of machine------------------------------------------------------- Birr 100,

000
Less accumulated depreciate.
- Depreciation for first 6 years ( 10,000 x6) = 60,000
- Deduct debit for extraordinary repair 24,000
Balance of accumulated depreciation 36,000
-Revised book value of machine after extraordinary repair Birr 64,000
 Annual depreciation for the remaining 8 years (Birr 64, 000/ 8) Birr 9000

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Check your progress 2.6

1. When it is believed that a plant asset is no longer useful to the entity, it is

disposed on one of the alternative forms of disposing. It is necessary to remove
the book value of the asset from the account. This is done by debiting the proper
accumulated depreciation account for the total depreciation to the date of
disposal and crediting the asset account for the cost of the asset.
2. Recording discarding plant asset on Hamle 30/1995
Hamle 30 Accumulated Depreciation equipment 3000
Equipment 3000
To write off equipment discarded
3. a) Meskerm 19 Depreciation expense equipment 75
Accumulated Depreciation – equipment 75
Depreciation on equipment discarded
b) Meskerem 19 Accumulated Depreciation – equipment 2450
Loss on .Disposal of plant asset 550
Equipment 3000
To write off equipment discarded
4. Meskerm 19 Depreciation Expense – equipment 750
Accumulated Depreciation equipment 750
To record current year depreciation on equipment sold
5. Meskerm 19 Cash 2250
Accumulated Depreciation equipment 7750
Equipment 10,000
To record sales of old equipment
6. Meskerm 19 Cash 1000
Accumulated Depreciation equipment 7750
Loss on disposal of plant asset 1250
Equipment 10000
To record sales of old equipment
7. Meskerm 19 Cash 3000
Accumulated Depreciation Equipment 7750
Equipment 10,000
Gain on Disposal of plant asset 750

Check your progress 2.7

1. Depletion is the periodic allocation of the cost of metal ores and other mineral
extracted from the earth.
2. The amount of the periodic cost allocation is based on the relationship of the
cost of the estimated size of the mineral deposit and on the quantity extracted
during the particular period.
The accumulated depletion account is a contra asset account is a contra
asset account it is presented in the balance sheet as a deduction from the cost
of the mineral deposit.

3. a) Computation
Birr 4,000,000 ÷ Birr 10,000,000 = Birr 0.4 a ton.

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The depletion amount is 900,000 X 0.4 = Birr 360,000

b) Adjusting entry
Sene 30 Depletion Expense 360,000
Accumulated Depletion 360,000

4. A) Total cost = Depletion cost per unit

Total estimated units available

Birr 1,000,000 = Birr 1.00 per barrel

1,000,000 barrels

b) Depletion Expense 250,000

Accumulated Depletion 250,000

Check your progress 2.8

1.1 Amortization:- is the periodic expense attributed to the decline in usefulness of an
intangible asset or the allocation of cost intangible assets
1.2 Patent:-is the exclusive right that manufactures may acquire to produce and sell
goods with one or more unique features.
1.3 Copyright: - The exclusive right granted to publish and sell a literary, artistic, or
musical composition. Authors, painters, sculptors, and other artists obtained the
right to enjoy their work through copyright.
1.4 Goodwill:- It is an intangible asset that attaches to a business as a result of a
favorable factors as location, product superiority, good reputation, effective
advertisement and managerial skill. Goodwill is considered as one of the most
complex and controversial assets presented in financial statements.
2.1 Items that are classified as intangible assets are
1. Patents
2. Copyright and
3. Goodwill
2.2 a) Patents continue in effect for 17 years
b) Copyright may extend for 50 years beyond the author’s death
c) Goodwill should not exceed 40 years
2.3 Amortization Expense, patent 6800
Patents…………………..…………………680

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CHAPTER 3
CURRENT LIABILITIES

3.0. CHAPTER OBJECTIVE

At the end of this chapter you should be able to describe the following:

 The nature of liabilities

 Short-term notes payable
 Ethiopian Payroll System
 Presentation of liabilities on the balance sheet

3.1. INTRODUCTION

Dear learners ,this chapter comprises : The nature of liabilities, Short-term

notes payable ,the Ethiopian Payroll System and the Presentation of liabilities
on the balance sheet.At the end of the chapter,Summary and check of your
progress are included.

3.2. THE NATURE OF LIABILITIES

A liability is defined as a company's legal financial debts or obligations that arise

during the course of business operations. ... Recorded on the right side of the

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balance sheet, liabilities include loans, accounts payable, mortgages, deferred

revenues and accrued expenses.
A liability is defined as a company's legal financial debts or obligations that arise
during the course of business operations. ... Recorded on the right side of the
balance sheet, liabilities include loans, accounts payable, mortgages, deferred
revenues and accrued expenses.

The nature of an institutional investor's liabilities will dictate the general

investment strategy to pursue. Depository institutions, for example, seek to generate
income by the spread between the return that they earn on their assets and the cost
of their funds.

A liability is a present obligation of the enterprise arising from past events, the
settlement of which is expected to result in an outflow from the enterprise of resources
embodying economic benefits (IASB Framework).

In simple words, liability is an obligation of the entity to transfer cash or other

resources to another party.

Liability could for instance be a bank loan, which obligates the entity to pay loan
installments over the duration of the loan to the bank along with the associated
interest cost. Alternatively, an entity's liability could be a trade payable arising from
the purchase of goods from a supplier on credit.

Liabilities may be classified into Current and Non-Current. The distinction is made on
the basis of time period within which the liability is expected to be settled by the
entity.

Current Liability is one which the entity expects to pay off within one year from the
reporting date.

Non-Current Liability is one which the entity expects to settle after one year from the
reporting date.

Types and examples

Following are examples the common types of liabilities along with their usual
classifications.

Liability Classification
Long Term Bank Loan Non-current
Bank Overdraft current
Short Term Bank Loan current
Trade Payables current
Debenture Non-current
Tax Payable Current

It may be appropriate to break up a single liability into their current and non current
portions. For instance, a bank loan spanning two years and carrying 2 equal
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installments payable at the end of each year would be classified half as current and
half as non-current liability at the inception of loan.

3.3. SHORT-TERM NOTES PAYABLE

Short term notes payable are obligations to pay a specified sum, plus interest,
within one year. These notes payable usually refer to the repayment of loaned
funds in the near term.

A short-term notes payable is a current obligation made in writing to pay a specific

amount within one year or the current accounting period. In other words, it’s written
loan or promissory note between the lender and the borrower to pay the principle
back plus interest on a specific date that is one year or less in the future.

Similar to a check, short-term notes payable are negotiable and can be transferred
between parties by endorsing them over. For example, assume that Bill lends Steve
$1,000. Steve signs a promissory note stating that he must pay Bill the $1,000
principle plus 10 percent interest in six months.

After the first month, Bill decides he wants to consolidate some of his debts, so he
endorses the promissory note from Steve to Todd to pay off his debt to Todd. Now
Steve is obligated to pay the $1,000 plus interest to Todd.

Example

Short term notes payable usually come from business transactions dealing with short-
term assets like inventory. Vendors typically give short-term loans to customers in
order to purchase their annual inventory supplies.

3.4. Ethiopian Payroll System

Payroll System in Ethiopia is normally an integral part of an accounting or finance

department of any organization. It is usually part of a division, section or unit of the
finance function of the organization.

Outsourcing the task of payroll administration to a specialist firm is still unusual in

Ethiopia but the practice is increasing. There are a lot of NGO’s (Non Governmental
Organizations usually attached to the United Nations) in Ethiopia and these

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organizations have a tradition of outsourcing their non core activities to minimize on

headcount.

Payroll preparation is mainly governed by the income tax law of Ethiopia which is
composed of a progressive taxation system which is applied also to all Ethiopia’s
regional governments. As well as tax calculations there are also:
1. Provident fund schemes,

2. Private pension schemes,

3. Government backed pension plans

4. Other statutory deductions such as labor union, Court order, etc.

Some of the sections of the Ethiopian tax laws are very “general” and merely stipulate
that detailed procedures should be issued by the relevant government agencies by way
of directives. These directives sometimes don’t exist and can sometimes be in conflict
with each other.

Taxes on monthly salaries are calculated during the monthly payroll preparation and
have to be paid to tax authorities within one month after having been deducted
from the employee. The same applies also for the various provident funds and pension
schemes. There are stiff penalties for late submission of tax returns and all other
statutory deductions.

The directives for fringe benefits and other income from employment are sometimes
difficult to apply due to inefficient distribution of directives to all stakeholders.

Here in Ethiopia, all income from employment like various allowances like fuel,
representation, cash indemnities etc are taxable. It is not one of those countries where
one can mysteriously reduce taxable income by calling it “housing allowance” or
“transport allowance”!

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The tax rates for payout for accrued, unutilized annual leave during termination
processing are heavy: they are pro-rated over the period of months the income applies
to and are subject to the maximum tax rate.

The tax rate for severance pay, however, is much lighter as it is taxed at a monthly
salary rate to support the concept that the employee may not have financial difficulties
whilst searching for his next employment. Employment contracts whether permanent
or temporary are always copied to the private organization employees’ pension
offices.

The rates applied for provident fund & pension schemes sometimes confuse
accountants and cause inaccuracies as the rates for provident fund varies from
company to company.

Payments for outstanding performance or the award of cash prizes at times like
marriage are not tax effective. They are taxed at the same rate as the normal monthly
salaries.

Most allowances like fuel, representation & house allowances are taxed fully as long
as the whole remuneration package is above a certain level.

The payment of accrued leave is complicated. Accrued annual leave paid on

termination of contract should be prorated over several months and should reflect that
actual income received and the tax rates applicable at time of earnings. It is therefore
strongly recommended to get employees to take their vacation – much simpler all
round!

It is thus tedious & time consuming to compile earnings history if it is not a stored
data on currently used software.

One of the challenges is the fact that monthly information comes from a lot of
different sources, some of which are communicated manually. This makes for
difficulties for the payroll/accounting service, especially when the preparation work
changes hands within the payroll/accounting team.

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Obtaining substantial data from payroll is also made complex and difficult as
salary increments & bonus are usually made retroactively. Retroactive payments of
increments & emulation payments do entail commensurate adjustment payments to
statutory deductions.

Lack of clarity or absence of clear laws on taxation of variety of allowances paid to

employees or Board Directors of private concerns are some of the issues that make
payroll preparation more complex and result in a misunderstanding between the tax
payer & the authorities.

3.5. PRESENTATION OF LIABILITIES ON THE BALANCE

SHEET

The balance sheet is one of the three fundamental financial statements and is key to
both financial modeling and accounting. The balance sheet displays the company’s
total assets, and how these assets are financed, through either debt or equity. It can
also sometimes be referred to as a statement of net worth, or a statement of financial
position. The balance sheet is based on the fundamental equation: Assets =
Liabilities + Equity.

As such, the balance sheet is divided into two sides (or sections). The left side of the
balance sheet outlines all a company’s assets. On the right side, the balance sheet
outlines the companies liabilities and shareholders’ equity. On either side, the main
line items are generally classified by liquidity. More liquid accounts like Inventory,
Cash, and Trades Payables are placed before illiquid accounts such as Plant, Property,
and Equipment (PP&E) and Long-Term Debt. The assets and liabilities are also
separated into two categories: current asset/liabilities and non-current (long-term)
assets/liabilities.

2. When preparing to analyze a company, one of the first things you'll need to do is
to grab a copy of the company's most recent balance sheet. Though it may look
like it's written in a foreign language to many new investors, We'll help you
decipher the code so that you'll be more confident in your investment analysis.
Let's begin with current liabilities. The current liabilities section of the balance

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sheet shows the debts a company owes that must be paid within one year. These
debts are the opposite of current assets.
3.  Current liabilities include things such as short-term loans from banks including
line of credit utilization, accounts payable balances, dividends and interest
payable, bond maturity proceeds payable, consumer deposits, and reserves for
taxes.

4. Below are some of the most common and important current liabilities on the
balance sheet.

5. Accounts Payable: The Most Popular Current Liability

6. Accounts payable is the opposite of accounts receivable. It arises when a company
receives a product or service before it pays for it. Accounts payable, or A/P as it is
often shorthanded, is one of the largest current liabilities a company will face
because they are constantly ordering new products or paying wholesale vendors
and suppliers for services or merchandise. Well-Managed companies attempt to
keep accounts payable high enough to cover all existing inventory. In effect, this
means that the vendors are paying for the company's shelves to remain stocked.

7.  The most effective operators in industries such as discount retailers, Target and
Wal-Mart among them, have turned this into an art. In a very real sense, their
business growth was funded by vendors such as Procter & Gamble and Clorox,
both of which shipped products to the store shelves on credit, giving the
merchants a chance to sell the goods before paying the amount owed to these
wholesalers. It meant both Wal-Mart and Target could use more of the money
they had raised from shareholders, bondholders, and retained profits to fund new
store expansion.

8. Accrued Benefits and Payroll

9. This item in the current liabilities section of the balance sheet represents money
owed to employees as salaries and bonuses that the company has not yet paid.

10. Short-Term and Current Long-Term Debt

11. These current liabilities are sometimes referred to as notes payable. They are the
most important item under the current liabilities section of the balance sheet and

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most of the time; represent the payments on a company's loans or other

borrowings that are due in the next twelve months. Using borrowed funds is not
necessarily a sign of financial weakness; e.g., an intelligent department store
executive may work out short-term loans at Christmas so she can stock up on
merchandise before the seasonal rush.

12.  If demand is high, the store would sell its entire inventory, pay back the short-
term debt, and pocket the difference. This use of leverage can result in higher
returns on equity.

13. How can you ever hope to tell if a company is wisely borrowing money (such as
our illustrative department store), or recklessly going into debt? Look at the
amount of notes payable on the balance sheet (if they aren't classified under the
notes payable section, combine the company's short-term obligations and current
long-term debt). If the amount of cash and cash equivalents is much larger than
the notes payable, you shouldn't have any reason to be concerned.

14. If, on the other hand, the notes payable has a higher value than the cash, short-
term investments, and accounts receivable combined, you should be greatly
concerned. Unless the company operates in a business wherein inventory can be
turned into cash rapidly, this is a serious sign of financial weakness.

15. Other Current Liabilities

16. Depending on the company, you will see various other current liabilities
listed. Sometimes they will be lumped together under the title "other current
liabilities." Normally, you can find a detailed listing of what these "other"
liabilities are buried somewhere in the annual report or 10-K. Often, you can
figure out the meaning of the entry by its name. If a business lists "Commercial
Paper" or "Bonds Payable" as a current liability, you can be fairly confident the
amount listed is what will be paid out to the company's bondholders in the short
term.

17. Consumer Deposits

18. If you are looking at the balance sheet of a bank, you will want to pay close
attention to an entry under the current liabilities called "Consumer Deposits." In

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many cases, this will be listed under other current liabilities, if not lumped with
them. It is the amount that customers have deposited in the bank. If you're asking
why consumer deposits are a liability, the answer is quite simple. Since,
theoretically, all of the account holders could withdrawal all of their funds at the
same time, the bank must list the deposits as a current liability.

3.6. SUMMARY

A liability is defined as a company's legal financial debts or obligations that arise

during the course of business operations. ... Recorded on the right side of the
balance sheet, liabilities include loans, accounts payable, mortgages, deferred
revenues and accrued expenses.
A liability is defined as a company's legal financial debts or obligations that arise
during the course of business operations. ... Recorded on the right side of the
balance sheet, liabilities include loans, accounts payable, mortgages, deferred
revenues and accrued expenses.

Liabilities may be classified into Current and Non-Current. The distinction is made on
the basis of time period within which the liability is expected to be settled by the
entity.

Current Liability is one which the entity expects to pay off within one year from the
reporting date.

Non-Current Liability is one which the entity expects to settle after one year from the
reporting date.

A short-term notes payable is a current obligation made in writing to pay a specific

amount within one year or the current accounting period. In other words, it’s written
loan or promissory note between the lender and the borrower to pay the principle
back plus interest on a specific date that is one year or less in the future.

Payroll System in Ethiopia is normally an integral part of an accounting or finance

department of any organization.

in Ethiopia, all income from employment like various allowances like fuel,
representation, cash indemnities etc are taxable. It is not one of those countries where
one can mysteriously reduce taxable income by calling it “housing allowance” or
“transport allowance”.

The balance sheet is one of the three fundamental financial statements and is key to
both financial modeling and accounting. The balance sheet displays the company’s

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total assets, and how these assets are financed, through either debt or equity. It can
also sometimes be referred to as a statement of net worth, or a statement of financial
position. The balance sheet is based on the fundamental equation: Assets =
Liabilities + Equity.

3.7. CHECK YOUR PROGRESS

Answer the following Questions

1. Define a liability?
2. Liabilities may be classified into Current and Non-Current. What are the
differences between Current and Non-Current liabilities?
3. What is a balanced sheet?

3.7. ANSWER KEY FOR CHECKING YOUR PROGRESS

1. A liability is defined as a company's legal financial debts or obligations that arise

during the course of business operations. ... Recorded on the right side of the
balance sheet, liabilities include loans, accounts payable, mortgages, deferred
revenues and accrued expenses.

2. Current Liability is one which the entity expects to pay off within one year from the
reporting date.

Non-Current Liability is one which the entity expects to settle after one year from the
reporting date.

3. The balance sheet is one of the three fundamental financial statements and is key to
both financial modeling and accounting.

CHAPTER 4
ACCOUNTING FOR PARTNERSHIP

4.0. CHAPTER OBJECTIVE

At the end of this chapter you be able to describe the following:

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- Characteristics of partnership
- Formation of partnership.
- Division of net Income or Net Loss
- Dissolution of partnership
- Liquidation of partnership

4.1 INTRODUCTION

Businesses are organized in various forms. The most commons are classified as
a) Sole partnership
b) Partnership
c) Corporation
Practices of the all the forms the accounting principles of business are much more the
same. The main difference lies in the accounting procedure of the capital of the
business.

In this chapter, you will learn the accounting procedures for a partnership. The
features of a partnership that have accounting implication will be emphasized through
out the discussions.

4.1.2 Characteristics of partnership

Dear students: Before you are acquainted to the characteristics of partnership,

partnership is defined as follows:
''It is an association of two or more persons to carry on as co-owners of a
business for profit.''
The partnership form of business organization is widely used for comparatively
small businesses that wish to take advantage of the combined capital, managerial
talent, and experience of two or more persons. In many cases; the alternative to
securing the amount of investment required on the various skills needed to operate a
business is to adopt the corporate form of organization, which will be discussed
following this chapter.
Most partnership are general partnerships in which the partners have unlimited
liability. Each partner is individually liable to creditors for debts incurred by the
partnership. Thus, if a partnership becomes insolvent, the partners must contribute
sufficient personal assets to settle the debits of the partnership. In some instances, a
limited partnership may be formed, in which the liability of some partners may be
limited to the amount of their capital investment. However, a limited partnership must
have at least one general partner who has unlimited liability. In our discussion that
follow general partnership is focused.
When partnership is compared to a sole partnership, it has the following
characteristics:
(1) Limited life Dissolution of a partnership occurs whenever a partner ceases to
be a member of the firm for any reason, including withdrawal, bankruptcy,
incapacity, or death. Similarly, admission of a new partner to the firm
dissolves the old partnership. In the event of dissolution, a new partnership
must be formed if the operations of the business are to be continued with out
interruption. This is the usual situation with professional partnership; their
composition charge frequently through admission of new partners and
retirements of others.
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(2) Unlimited liability Each partner is individually liable to creditors for debts
incurred by the partnership. Thus, if a partnership becomes insolvent, the
partners are required to contribute sufficient personal asset to settle the debts
of the partnership.

(3) Co-ownership of property. The property invested in a partnership by a

partner becomes the property of all the partners jointly. Upon dissolution of
the partnership and distribution of its assets, each member's claim against the
assets is measured by the amount of the balance in his capital account.

(4) Participation in income: Net income and net loss are distributed among the
partners in accordance with their agreement. In the absence of any agreement,
all partners share equally. If the agreement specifies profit distribution but is
silent as to losses, the losses are shared in the same manner as profits.

(5) Articles of partnership: A partnership is created by voluntary contract. It is

not necessary that this contract be in writing, nor even that its terms be
specifically expressed orally. However, good business practice dictates that
the contract should be in writing and should clearly express the intentions of
the partners. The contract, known as, the articles of partnership or
partnership agreement, should contain provisions regarding such matters as
the amount of investment to be made, in which net income and net loss are to
be divided, and the admission and withdrawal of partners.
(6) Mutual agency meaning each partner is an agent of the partnership, with the
authority to enter into contracts for the partnership. Each partner binds the
partnership for a contract entered by a partner and the contract becomes the
responsibility of all partners.

Partnership form of business organization is less widely used than other

forms, i.e. the sole proprietorship and corporate forms.

A partnership is relatively easy and inexpensive to organize, requiring only

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

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

Check your progress 4.1

4.1 Definition of terms
a) Partnership
b) General partnership
c) Limited partnership

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d) Article of partnership or partnership agreement

e) Co-ownership of partnership property.
5.2 List down the characteristics of partnership that have accounting implications.
5.3 What are the advantages of partnership?
5.4 What are disadvantages of partnership?

4.2 FORMATION OF A PARTNERSHIP

4.2.1 Accounting for partnership

Most of the day-to-day accounting for a partnership is the same as the accounting
for any other form of business organization. The system that was described earlier
may be employed by a partnership with little modification. For example, the
journals illustrated earlier may be used without alteration and the chart of
accounts, with the exception of drawing and capital accounts for each partner,
does not differ from the chart of accounts of a similar business conducted by a
single owner. It is in the areas of the formation, income distribution, dissolution,
and liquidation of the partnerships that transactions peculiar to partnerships arise.
4.2.2 Recording Investments
An adequate accounting system and an accurate measurement of income are
needed by every business. But they are especially important in a partnership
because the net income is divided among two or more persons. Each partner needs
current accurate information on profits so that he or she can made intelligent,
expression of the business, or sale of an interest in the partnership.
Most of the day- to- day accounting for a partnership is the same as the
accounting for any other form of business organization. Partnership accounting is
similar to that in a sole proprietorship, except that separate capital and drawing
accounts are maintained for each partner. A district future of partnership
accounting is that the net income of the business must be divided among the
partners in the manner specified by the partnership agreement.
A separate entry is made for the investment of each partner in a partnership.
The various assets contributed by a partner are debited to the proper asset
accounts, if liabilities are assumed by the partnership, the appropriate liability
accounts are credited; and the partner's capital account is credited for the net
amount.
To illustrate the entry to record an initial investment, assume that Yesuf Ali and
Eyasu Fasil, who are sole owners of competing grocery stores agree to combine
their businesses in a partnership. Each is to contribute certain amounts of cash
other business assets. It is also agree that the partnership is to assume liabilities of
the separate businesses. The entry to record the assets contributed and the
liabilities transferred by Yesuf Ali is as follows:

Cash 14, 400

Accounts Receivable 32, 600
Merchandise Inventory 57,400
Store Equipment 10, 800
Office Equipment 3, 000
Allowance for Doubtful Accounts 3, 000
Accounts Payable 5, 200

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Yesuf Ali, Capital 110, 000

A similar entry would record the assets contributed and the liability transferred by
Eyasu Fasil as of the same data. In the entry, the monetary amounts at which the non
cash assets are stated are those agreed up on by the partners. In arriving at an
appropriate amount for such assets; consideration should be given to their market
value at the time the partnership is formed. The value agreed up on represents the
acquisition cost to the accounting entity created by the formation of the partnership.
These amounts may differ from the balances appearing in the accounts of the separate
businesses before the partnership was organized. For example, the store equipment by
Yesuf Ali could have been recoded at Birr 20,000, with an offsetting credit to the
accumulated depreciation account for birr 9,200, affecting a book value of birr
10,800. But the preferred practice is to record only the net amount agreed upon, as it
represents the acquisition cost to the partnership.

Check Your Progress 4.2

Answer the following question
1. Assume that Ato Mulatu Asrat and Ato Nasir Seid, who are sole owners of a Glass
ware store on Miazia 1,1999 Agree to combine their business in a partnership. Each
is to contribute certain amount of cash and other business assets. It is also agreed
that the partnership is to assume the liabilities of the separate businesses. The
accounting record of the assets contributed and liability of the partners is given
below.
Cash ………………………………………..Birr 14,400
Accounts Receivable……………………. 32,600
Merchandize inventory …………………. 57,400
Store Equipment ………………………. 10,800
Office equipment ………………… ……. 3,000
Allowance for Doubtful accounts……... 3,000
Accounts payable………………………… 5,200
Ato Mulatu, Capital ……………………… 68,000
Ato Nasir, Capital…. ……………………… 42,000
Instruction:
You are required to record the entry of the assets liabilities and capital in general
journal form.

2. As part of the initial investment, a partners contributes office that had been
recorded in his accounts at a cost of birr 40,000, and which the accumulated
depreciation had totaled birr 19,000. The partners agree on a valuation of birr
30,000. How should the office equipment be recorded in the accounts of the
partnership?

3. All partners agree that Accounts receivables of birr 40,000 invested by a partner
will be collectable to the extent of 90%. How should the accounts receivable be
recorded in the general ledger of the partnership?

4. Leykun and Derib decide to form a partnership by combining the asset of their
separate businesses. Leykun contributes the following assets to the partnership.

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Cash birr 11,000, Accounts Receivable with a face amount of birr 65,000 and an
allowance for doubtful accounts of birr 3,800, merchandise inventory with a cost
of birr 45,000 and equipment with a cost of birr 70,000 and accumulated
depreciation of birr 36,000. The partners agree that birr 1600 of the accounts
receivable are completely worthless and are not to be accepted by the partnership
and that birr 3,000 is a reasonable allowance for the uncollectability of the
remaining accounts. They also agreed that the merchandise inventory is to be
priced at birr 20,000. Present the entry, in general journal form, to record Lykens
investment in the partnership accounts.

4.3 DIVISION OF NET INCOME OR NET LOSS

An adequate accounting system and an accurate measurement of income are

needed by every business. These facts are especially important for partnership
because the net income is divided among two or more owners. Each partner needs
current, accurate information on profits, so that he/she can make intelligent decisions
on each question. As additional investment, expansion of business, or sale of an
interest in the partnership could be managed properly.

As in the case of a sole partner, the net income of a partnership may be said to
include a return for services of the owners, for the capital invested, and for economic
or pure profit. Partners are not legal employees of the partnership, nor are their capital
contributions are a loan. If each of two partners is to contribute equal services and
amounts of capital, an equal sharing in partnership net income could be made. But if
one partner is to contribute a larger portion of capital than the other, provision for
unequal capital contribution should be given recognition in the agreement. For
dividing net income if the service of one partner is much valuable to the partnership
than those of the other, provision for unequal service contribution should be given
recognition in their agreement.

Most of the day to day accounting for a partnership is the same as the
accounting for any other form of business organization. Partnership accounting is
similar to that in a sole partnership, except that separate capital and Drawing
accounts are maintained. A distinctive feature of partnership accounting is that the
net income of business must be divided among the partners in the manner specified by
the partnership agreement.
Specifically, transaction peculiar to partnership arise in the areas of
1) The formation of partnerships,
2) Division of net income or net loss
3) Partnership dissolution and liquidation.
To illustrate the division of net income and the accounting for this division, two
possible agreements are to be considered. It should be noted that division of net
income or the net loss among the partners in exact accordance with their partnership
agreement is of the utmost importance. If the agreement is silent on the matter, the
low provides that all partners share equally, regardless of differences in amounts of
capital contributed, of special skills possessed, or of time devoted to the business. The
partners may, however, make any agreement they wish in regard to the division of net
income and net losses.

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4.3.1 INCOME DIVISION RECOGNIZING SERVICES OF

PARTNERS
As a means of recognizing difference in ability and in amount of time devoted to
the business, articles of partnership often provide for the division of a portion of net
income to the partner in the form of a salary allowance. The articles may also provide
for withdraws of cash by the partners in lieu of salary payments. A clear distribution
must therefore be made between the division of net income, which is credited to the
capital account and payments in the partners, which are debited to the drawing
accounts.
Illustration, assume that the articles of partnership of Ato Ayana Gemeda and
Ato Abate Jarra, provide for monthly salary allowance of Birr 5000, and Birr 4,000
respectively, with balance of the net income to be divided equally. And that the net
income for the year is Birr 150,000. A report of the division of net income may be
presented as a separate statement accompanying the balance sheet and the income
statement, or it may be added at the bottom of the Income statement. If the latter
procedure is used, the lower part of the income statement would appear as follows.

Net income------------------------------------------------------------Birr 150,000

Division of Ayana Abate
Net Income Gemeda Jarra Total
Salary allowance---------- Birr 60,000--------Birr 48,000-------- -Birr 108,000
Remaining income-------- Birr 21,000--------Birr 21,000--------- Birr 42,000
Net Income--------------- -Birr 81,000 Birr 69,000 Birr 150,000

The division of net income is rerecorded as a closing entry, regardless of whether

the partners actually withdraw the amounts of their salary allowances. The entry for
the division of net income is as follows:

Sene 30,19 Income Summery 150,000

- Ayana Gemeda, capital 81,000
Abate Jerra, Capital 69,000
If Ato Ayana and Ato Abate had withdrawn the salary allowances monthly, the
withdrawals would have accumulated as debits in the drawing accounts during the
year. At the end of the year, the debit balance Birr 60,000 and Birr48, 000 in their
during accounts would be transferred to their respective capital accounts.

4.3.2 Income Division Recognizing Services of Partners and

Investments
Partners may agree that the most equitable plan of income sharing is to allow
salaries based on the service rendered and also to allow interest on the capital
investments. The remainder is then shared in an arbitrary ratio. To illustrate, assume
that Ato Ayana Gemeda, and Ato Abate jerra (1) are allowed monthly salaries of Birr
5000 and Birr 4000 respectively.(2) are allowed interest of 12% on capital balance to
birr 160,000 and Birr120,000 respectively (3) Divide the remainder of net income
equally. The division of Birr 150,000 net income for the year could then be reported
on the Income statement as follows:

Net Income ---------------------------------------------------------------Birr 150,000

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Ayana Abate
Division for Income Gemeda Jarra Total
Salary allowance------------Birr 60,000 -----------Birr 48,000------ Birr 108,000
Interest allowance---------- 19, 200------------ 14,400-------- 33,600
Remaining Income--------- 4, 200------------ 4, 200---------- 8,400
Net income---------------------Birr 83,400 Birr 66,600 Birr 150,000
On the bases of the information on the foregoing income statement, the entry to
close the Income summery account would be recorded a follows.

Sene 30,19 Income Summery---------------150, 000

Ayena Gemeda, Capital------------------83, 400
Abate Jarra, Capital---------------------- 66, 600

4.3.3. Income Division-Allowances Exceed Net Income

In the Illustration presented thus far, the net income has exceeded the sum of the
allowances for salary and interest. If the net Income is less than the total of the special
allowances, the ''remaining balance'' will be a negative figure that must be divided
among the partners as through it were net loss. The effect of this situation may be
illustrated by assuming the same salary and interest allowances as in the preceding
illustration but changing the amount of net income to Birr 100,000 the salary and
interest allowances to Ato Ayana totaled Birr 79,200 and the comparable figure for
Ato Abate. Is Birr 62,400. The sum of those amounts Birr 141,600 exceeds the net
income of Birr 100,000 by 41,600. It is therefore necessary to deduct Birr 20,800 (1/2
of 41,600) from each partners share to arrive at the net income, as follows:

Net Income -------------------------------------------- Birr 100,000

Ayana Abate
Division of Net Income Gemeda Jara _Total
Salary allowances------------Birr 60,000------------Birr 48,000------
Birr108,000
Interest allowance------------- 19, 200------------- 14,400-------------
33,600
Total---------------- Birr 79,200------- ----Birr 62,400-------Birr
14,600
Excess of allowances
Over Income ------------- ( 20,800)------------- (20,800) ----------
(41,600)
Net Income-------- Birr 58,400 Birr 41,600 Birr
100,000

In closing Income summery, at the end of the year Birr 58,400 would be
credited to Ato Ayana, Capital, and Birr 41,600 would be credited to Ato Abate
Capital.

4.3.4 Partners Salaries and Interest Treated as an Expense

Although the tradition view among accountants is to treat salaries and interest
allowance as allocation of net income, as in the fore going illustrations. Some prefer

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to treat them as expenses of the enterprise. According to this view, the partnership is
treated as a distinct legal entity and the partners are considered to be employees and
creditors of the firm. When salaries for partners services and interest on partners’
investments are viewed as expenses of the enterprise, withdrawals of the agreed
amount are charged to expense accounts rather than to the partners’ drawings. The
expense accounts are then closed into the income summery accounts, and the
remaining net income is allocated among the partners in the agreed ratio. The amounts
paid to partners that are considered to be salary expense and interest expense should
be specifically identified as much on the income statement. Regardless of weather
partner's salary and interest are treated as expenses of the partnership or as a division
of net income, the total amount allocated to each partner will be the same.
4.3.5. Statement for Partnership
Details of the division of net income should be disclosed in the financial
statements prepared at the end of the fiscal period. This may be done by adding to the
income statement, which has been illustrated in the preceding pages, or the data may
be presented in a separate statement.
Details of the changes in the partnership capital during the period should also be
presented in a capital statement. The purpose of this statement and the data included
in it corresponds to those of the capital statement of a sole partnership. There are a
number of variations in form, one of which is illustrated below.
Ayana and Abata
Statement of owners Equity
For year ended sene, 30,19___
Ayana Abate
Gemeda Jerra Total
Capital Tir 30,19__ Birr 160,000 ------------Birr 120,000--------- Birr 280,000
Additional investment
During the year ---------- _____0___---------------- 10,000----------------- 10,000
Total---------------------------- 160,000--------------- 130,000------------- -- 290,000
Net income for the year-------83, 400 -------------------66,600---------------- 150,000
Birr 243,400 Birr 196,600 Birr440, 000
Withdrawals during the year-- 48,000 ---------------- 48,000 -----------------88,000
Capital sene 30,19__ Birr 195,400 Birr 156,600 Birr 352,000

Check your progress 4..3

1. What two principal factors should be considered in arriving at an agreement for the
distribution of net income and net loss between the partners?
2. In the absence of a specific agreement on the matter, how should the periodic net
income or net loss be divided?
3. What accounts are debited and credited, when a partner withdrawals cash in lieu of
salary?
4. What accounts are debited and credited to record the division of net income among
partners at the end of the fiscal period?
5. The article of partnership provides for a salary allowance of birr 3,000 per month to
partners Ato Belay. If Ato Belay withdraws only birr 2,400 per month, would this
affect the division of the partnership net income?

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6. Habtamu and Challa form a partnership with investments of birr 80,000 and birr
120,000 separately. Determine the division of net income of birr 88,000 under the
following conditions:
a) No agreement concerning division
b) Division is mad in the ratio of their original investments
c) Division is made according to the agreement that interest at the rate of 8%
allowed on original investment and the remainder divided in the ratio of 2:1
d) Division is made according to the agreement that salary allowances of birr
30,000 and birr 24,000 respectively and the balance divided equally.
e) Division is agreed to be made that allowance of interest at the rate of 8% and
original investments, salary allowance of birr 30,000 and birr 24,000
respectively, and the remainder divided equally.
7. Determine the participation of Habtamu and Challa in a net income birr 40,000 for
the year according to each of assumption as to income division listed in question 6
above.
8. Assume that Ato Mengistu Dana and Chaltu Gemeda form partnership to provide
for monthly salary allowance birr 54,000 and birr 43,200 respectively, with the
balance of the net income to be divided equally, and that the net income for the
year is birr 135,000. Calculate the net income of Ato Mengistu Dana and Chaltu
Gemeda?
9. Assume that Ato Mulken Adugna and W/ro Ayantu Daba form partnership based
on the following agreement:
a) They are allowed monthly salary allowance of birr 36,000 and Birr
28,800 respectively.
b) They are allowed interest at 7% of capital balance on Tir 1,1999 of the
current fiscal year. Which amounted to birr 100,000 and birr 70,000
respectively.
c) They agree to divide the remainder of net income equally.
d) Net income ins birr 90,000
Calculate the net income that must be divided between Ato Mulken Adugna
and W/ro Ayantu Daba
10. Assume W/ro Tringo Ararsso and W/ro Chaltu Ture have the same salary
allowance and interest allowance as in question 9 aboveand they share the
remaining equally, but the Net income is birr 60,000. Calculate the net income
that must be divided between W/ro Tiringo Ararso And W/ro Chaltu Ture.

4.4. Dissolution of Partnership

Why does a partnership dissolve? How do we treat its dissolution? One of the
basic characteristics of Partnership form of organization is its limited life. Any change
in the personal of the owner ship results in the dissolution of the partnership. Thus,
admission of a new partner dissolves the old firm. Similarly, death, bankruptcy, or
withdrawal of a partner causes dissolution.

Dissolution of the partnership is not necessarily followed by the winding up of

the affairs of the business. For example, a partnership composed of two partners may
admit an additional partner. On the other hand, if one of three partners in a business
with draws, the remaining two partners may continue to operate in the business. In all
cases, when a new partnership is formed and new articles of partnership should be
prepared
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4.4.1 Admission of a Partner

An additional person may be admitted to a partnership enterprise only with the

consent of all of the current partners. It does not follow, however, that a partner's
interest, or part of that interest, can not be transferred to the outside party without the
consent of the remaining partners. If a partner interest is transferred without the
consent of the remaining partners, the partnership will automatically be dissolved.
The person acquiring the interest does not automatically become a partner, however,
and has no voice in partnership affairs unless admitted to the firm.

An additional person may be admitted to a partnership through either of two

procedures.
1 Purchase of an interest form one or more of the current partners.
2 Contribution of assets to the partnership.
If the first technique is followed, the capital interest of the incoming partner is
obtained from current partners, and neither the total assets nor the total capital of the
business is affected.
When the second procedure is followed, both the total assets and the total
capital of the business will increase.

4.4.2 Admission by purchase of an interest

When an additional person is admitted to a firm by purchasing an interest from one
or more of the partners, the purchase price is paid directly to the selling partners.
Payment is for partnership equity owned by the partners as individuals, and hence the
cash or other consideration paid is not recorded in the accounts of the partnership

What entry is required to record admission by purchase amounts of an interest?

The only entry required is the transfer of the appropriate amounts of capital from
the capital accounts of selling partners to the capital account established for the
incoming partner.

As an illustration, assume that partners Ababu and Bekele have capital balances
of Birr 400,000 each. On Tahsas 1, each of them sells on fourth of his capital interest
to Mekuria for Birr 100,000 in cash. The only entry required in the partnership
accounts is shown below.
Tahsas 1 Ababu Yohanes, Capital---------------Birr 100,000
Bekele Demena, capital-------------------- 100,000
Mekuria Degu-------------------------------------------200, 000

The effect of the transaction on the partnership accounts is presented in the

following diagram.

Mekuria, capital
200,000

Ababu, capital
100,000 400,000
Bekele, capital

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100,000 400,000

The foregoing entry is made regardless of the amount paid by Mehuria for the
one-forth interest. If the firm had been earning a high rate of return on the investment
and Mekuria had been very eager to obtain the one-fourth interest, he might have paid
considerably more than Birr 200,000. Had other circumstances prevailed, he might
have acquired the one- fourth interest for considerably less than, Birr 200,000. In
either event, the entry to transfer the capital interest would not affected.

After the admission of Mekuria, the capital of the firm is Birr 800.000, in which
he has a one-fourth interest, or Birr 200,000. It does not necessarily follow that he will
be entered to a similar share of the partnership net income. Division of net income or
net loss will be in accordance with the partnership agreement.

4.4.3 Admission by Contribution of Assets

Instead of buying an interest from the current partners, the incoming partner
may contribute assets to the partnership. In these cases both the assets and the capital
of the firm are increased. To illustrate, assume that Legesse and Mekda are partners
with capital accounts of Birr 140,000 and Birr 100,000 respectively. On Tahsas 1,
Nigatu invests Birr 80,000 cash in the business, for which he is to receive an
ownership equity of Birr 80,000. The entry to record this transaction, in general
journal form, is,

Tahsas 1 Cash----------------------------------------80, 000

Nigatu Mekonen, Capital -----------------------80,000

The essential difference between the circumstances of the admission of n

Nigatu abone and of Mekuria in the preceding example may be observed by
comparing the diagram that is shown below.
With the admission of Nigatu, the total capital of the new partnership becomes
Birr 320.000, of which he has a one interest or Birr 80.000.
The extent of his participation in partnership net income will be governed by the
articles of partnership.
Partnership Accounts

Net assets Legesse, capital Makda, capital Nigatu, Capital

240,000 140,000 100, 000
80,000
80,000

4.4.3.1 Revaluation of Asset

If the partnership assets are not fairly stated in terms of current market price
at the time of admission of a new partner the accounts may be adjusted accordingly.
The net amount of the increase and decrease in asset values are than allocated to the
capital accounts of the old partners in accordance with their income -sharing ratio. To
illustrate, assume that in the earlier illustration for Legesse and Mekda partnership the

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balances of the merchandise inventory account had been Birr 56,000 and the current
replacement price had been Birr 68,000. Prior to the admission of Nigatu the
revaluation would be recorded as follows, assuming that legesse and Mekda share
equally in net income:

Tahsas 1 Merchandise Inventory---------------12, 000

Legesse, Capital--------------------------6, 000
Makda capital-----------------------------6, 000
If a number of assets are revalued, the adjustments may debited or credited to a
temporary account entitled Asset revaluation. After all adjustment are made, the net
balance of the account is closed to the capital accounts.
It is important that the asset be stated in term of current prices at the time of
admission of a new partner. Failure to recognize current prices may result in
participation by the new partner in gains or losses attributable to the period to his
admission to the partnership.

4.4.3.2 Goodwill
When new partner is admitted to the partnership, goodwill attributable to either the
old partnership or the incoming partner may be recognized. Although there are
various methods of estimating good will, such factors as the respective share owned
by the partners and the relative bargaining abilities of the partners will influences the
final determination. The amount of good will agreed upon is regarded as an asset with
a corresponding addition to the appropriate capital accounts.
To illustrate the recognition of good will to the old partners, assume that on
Meskerem, the partnership of Jaffer and Kedir admits Lema, Who is to contribute
cash of Birr 60,000. After the tangible assets of the old partnership have been adjusted
to current market prices, the capital balances of Jaffer and Kedir are Birr 80,000 Birr
96,000 respectively. The parties agree, however, that the enterprise is worth Birr
200,000. The excess of Birr 200,000 over the capital balances of Birr 176,000(Birr
80,000+Birr 96,000) indicates the existence of Birr 24,000 of goodwill, which should
be allocated to the capital accounts of the original partners in accordance with their
income sharing agreement.

The entries to record the good will and the admission of the new partner,
assuming that the original partners share equally in net income, are as follows, in
general journal form.

Meskerem 1 Goodwill-------------------------24, 000

Jaffer Abdu, Capital-----------------------12, 000
Kideir Abas, Capital-----------------------12, 000
1 Cash-------------------------------60, 000
Lema, Capital------------------------------60, 000
If the partner admits a new partner who is expected to improve the fortunes of the
firm, the parties might agree to recognize this high earning potential. To illustrate,
assume that Melaku is to be admitted to the partnership of Wosen and Daddi for an
investment of Birr 120,000. If the parties agree to recognize Birr 20,000 of goodwill
to Melaku ,the entries to record the goodwill is as follows:

Tir 1 cash---------------------------------120, 000

Good will-----------------------------20, 000

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Melaku, capital------------------------140, 000

4.4.4 Withdrawal of a Partner

When a partner retires for some other reason wishes to withdraw from the firm,
one or more of the remaining partners may purchases his interest and the business
may be continued with out apparent interruption. In such cases, settlement for the
purchase and sale is made between the partners as individuals. 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 or partners acquiring
the interest.

If the settlement with the withdrawing partners is made by the partnership,

the effect is to reduce the assets and the capital of the former. In order to determine
the ownership equity of the withdrawing partners, the asset accounts should be
adjusted to bring them into agreement with current market prices. The net amount
of the adjustment should be allocated among the capital accounts of the partners in
accordance with the income ratio. In the event that the cash or other available
assets are insufficient to make complete payment at the time of withdrawals, a
liability account should be credited for the balance owed to the withdrawing
partner.
4.4.5 Death of a Partner
The death of a partner affects the dissolution of the partnership. In the absence
of any contrary agreement, the accounts should be closed as of the data of death, and
the net income for the fractional part of the year should be transferred to the capital
accounts. It is not unusual, however, for the partnerships agreement to stipulate that
the accounts remain open to the end of the fiscal year or until the affairs are wound
up, if that should occur earlier. The net income of the entire period is then allocated,
as provided by the agreement, to the respective period occurring before and after
dissolution.

The balance in the capital account of the deceased partners is then transferred to
a liability account with his estate. The surviving partner or partners may continue the
business or the affairs may be wound up. If the former course is followed, the
procedures for settling with the estate will conform to those outlined for the
withdrawal of a partner form the business.

Check Your Progress 4.4

Answer the following question

1. Alemshet and Desalegn are partners who share net income equally and have capital
balance of
Birr 90,000 and birr 50,000 respectively. Alemshet with the consent of Desalegn
sale one-half of
his interest to Reta. What entry is required if the sale price is:
a. Birr 40,000
b. Birr 50,000

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2. Why is it important to state all partnership assets in terms of current prices at the
time of
admission of a new partner?
3. Explain the difference between the admissions of a new partner
a. By purchase of an interest from another partner and
b. By contribution of assets to the partnership
4. How should the amount of the goodwill, attributable to the old partnership, is
allocated to the
capital accounts of the original partners when a new partner is admitted to a
partnership?
5. The capital accounts of Jemal Mohammed and Kebed Tesema have balance of Birr
120,000 and birr 160,00 respectively. Lemlem and Messelu are to be admitted to
the partnership. Lemlem purchased one-third of Jemal’s interest for birr 40,000.
Messelu contributes birr 80,000 cash to the partnership for which she is to
receive an ownership equity of birr 80,000.
a. Present the entries in general journal form to record the admission to the
partnership of
1. Lemelem and 2. Messelu
b. What are the capital balances of each partner after the admission of Lemlem
and Messelu?

4.5. LIQUIDATION OF PARTNERSHIP

When a partnership goes out of business, it is customarily to sales most of the

assets, pays the creditors, and distributes the remaining cash or other assets to the
partners in accordance with their claims. The winding up process may be referred to
generally as liquidation although liquidation refers specially to the payment of
liabilities; it is often used in a border sense to income to include the entire winding-
up process.
When the ordinary business activates is discontinued, preparatory to liquidation,
the accounts should be adjusted and closed in accordance with the customary
procedures of the periodic summery. The only accounts remaining open will be the
various asset, contra asset, liability, and capital accounts.
The sale of the assets is referred to as realization. As cash is realized, it is
applied first to the payment of the claims of creditors. After all liabilities have been
paid the remaining cash is distributed to the partners based on their ownership equities
as indicated by their capital accounts.
If the assets are sold piecemeal, the liquidation process may extend over a
considerable period of time. This creates no special problem, however, if the
distribution of cash to the partners is postponed until all of the assets have been sold.
As a basis for illustration, assume that Shewatatek Gebre, and Seifu decide to
liquidate their partnership. Their income sharing ratio is 5:3:2. After discontinuing the
ordinary business operations and closing the accounts, the summery of the general
ledger shown at the top of the next page.
Cash----------------------------------------Birr 22,000
All non cash assets----------------------- 128, 000
All liabilities------------------------------ 18,000

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Shewatalek, capital---------------------- 44, 000

Gebre, capital----------------------------- 44, 000
Seifu, capital------------------------------ 44, 000

Accounting for the liquidation will be illustrated by three examples based on

the forgoing statement of facts. In all cases it will be assumed that all non cash assets
are disposed of in a single transaction and that all liabilities are paid at one time. In
addition, Non cash assets and liabilities will be based as account titles in place of the
various asset, contra asset, and liability accounts that in actual practice would be
affected by the transactions.

Gain on realization:
Shewatatek, Gebre, and seifu sell all non-cash assets for birr 144,000 realizing
again of birr 16,000 (Birr 144,000-Birr 128,000). The gain is divided among the
partners in the income sharing ratio of 5:3:2, the liabilities are sold, and the remaining
cash is distributed to the partners according to the balances in their capital accounts. A
statement of partnership liquidation which summarizes the liquidation process as
follow

Asset Liabilities Capital

Cash Non Liability Shewtat Gebre Seifu

cash etake 30% 20%
Assets 50
%
Balance before 22,000 128,000 18,0000 44,000 44,000 44,000
realization

Sale of assets & +144,000 -128,000 +8000 +4800 +3200

division of gain
Balance after 166,000 18,000 52,000 48,800 47,200
realization
Payment of Payment of liabilities -18000 -18,000
Balances after
payment of liability 148,000 52,000 48,800 47,200
Distribution of cash -148,000 -52,000 -48,800 -47,200
to partners
Final balance -0- -0- -0- -0- -0- -0-

The entries to record the several steps in the liquidation procedure are follows, in
general journal form:
1) Sales of the non cash assets
Cash---------------------------------------------144, 000
Non cash Assets---------------------------------------------------128, 000
Loss and gain on realization------------------------------------- 16, 000

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 Fundamentals of Accounting II

2) Division of gain
Loss and gain on realization------------------16, 000
Shewatatek, capital---------------------------------8000
Gebre, capital-------------------------------------- 4800
Seifu, capital-----------------------------------------3200
3) Payments of liabilities
Liabilities---------------------------------------18, 000
Cash---------------------------------------------------------18, 000
4) Distribution of cash to partners
Shewatatek, capital-------------------------52, 000
Gebre, capital--------------------------------48, 800
Seifu, capital---------------------------------47, 200
Cash------------------------------------------148, 000
In the following illustration, the distribution of cash among the partners was
determined by references to the balances of their respective capital accounts after the
gain on realization had been allocated. Under no circumstances should the income-
sharing ratio be used as a basis for distributing the cash in the time of liquidation.

Loss on Realization no Capital Deficiencies

Assume that in the foregoing example Shewatatek, Gebre and Seifu dispose of all
non cash assets for Birr 88,000, incurring a loss of Birr 40,000 (Birr 128,000-Birr
88,000). The steps in the liquidation of the partnership are summarized as follows:

Non cash Shewatatek Taye

Seifu
Cash AssetsLiability 50 % 30%
20%
Balance before realization Birr22,000 Birr128,000 Birr 18,000 Birr 44,000
Birr44,000 Birr44,000
Sale of assets and
Division of +88,000 -128,000 -20,000 -
12,000 -8,000
Balance after Realization Birr110,000 Birr18,000 Birr24,000
Birr32,000Birr36,000
Payment of liabilities -18,000 -18,000
Balances Birr 92,000 Birr24,000
Birr32,000Birr36,000
Distribution of
cash to partners -92,000 -24,000 -
32,000 -36,000
Final balance -0- -0-
-0- -0-

The entire required to record the liquidation are presented below:

Sale of Assets
Cash-----------------------------------88, 000
Loss and gain on Realization------40, 000

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 Fundamentals of Accounting II

Non cash Assets----------------------128, 000

Division of loss
Shewatatek-----------------------20, 000
Gebre------------------------------12, 000
Seifu--------------------------------8, 000
Loss and gain realization------------------------40, 000
Payment of liabilities
Liabilities--------------------------------------18, 000
Cash-----------------------------------------------------18, 000
Distribution of cash to partners
Shewatatek------------------------24, 000
Gebre-------------------------------32, 000
Seifu--------------------------------36, 000
Cash--------------------------------------92, 000
Loss on Realization; Capital Deficiency
In the preceding illustration, the capital account of the partner was more than
sufficient to absorb each share of the loss to the intent of the remaining credit balance
in each capital account. The share of the loss chargeable to a partner may be such that
exceeds the capital balance of the partner’s in the ownership equity. The resulting
debit balance in his capital account, which is referred as deficiency is a claim of the
partnership against the partner. Pending collection from the deficient partner, the
partnership cash will not be sufficient to pay the other partners in full. In such cases
the available cash should be distributed in such a manner that, if the claim against the
deficient partner cannot be collected, each of the remaining capital balances will be
sufficient to absorb the appropriate share of the deficiency.

To illustrate a situation of this type, assume that Shewatatek, Gebre, and Seifu
sell all of the non-cash assets for Birr20, 000, incurring a loss of birr 108,000 (Birr
128,000-Birr 20,000). It is readily apparent that the portion of the loss allocable to,
Shewatatek which is Birr 54,000(50% of Birr 108,000), exceeds the Birr 44,000
balance in his capital account. This Birr 10,000 deficiency is a potentially loss to
Gebre and Seifu and must be tentatively divided between them in their income
sharing ratio of 3:2(3/5 and 2/5). The capital balances remaining represent their
claims on the partnership cash. The computations may be summarized in the manner
presented below:

Shewatatek Taye Seife

50% 30% 20% Total
Balance before realization Birr 44,000 Birr 44,000 Birr 44,000 Birr
132,000
Division of loss on realization -54,000 -32,400 -21,600 -
108,000
Balance after realization Birr(10, 000) Birr 11,600 Birr 22,400
Birr24, 000
Division of potential loss Birr 10,000 -6,000 -4,000
Claims in partnership cash Birr 5,600 Birr 18,400 Birr
24,000

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The complete recording of the various transactions that have occurred thus far
in the liquidation process may then be prepared as follows:
Sale of assets
Cash ---------------------------------------------------------20,000
Loss and gain on Realization---------------------------108, 000
Non cash asset-----------------------------------------------128, 000
Division of loss
Shewatatek, Capital-------------------------------------54, 000
Gebre, Capital-------------------------------------------32, 400
Seifu, Capital--------------------------------------------21, 600
Loss and gain on Realization------------------------------108, 000
Payment of Liabilities
Liabilities------------------------------------------------18, 000
Cash-----------------------------------------------------------18, 000
Division of cash partners
Gebre, Capital------------------------------------------------ 5, 600
Seifu, Capital----------------------------------------------- 18, 400
Cash-------------------------------------------------------------24, 000
The affairs of the partnership are not completely wound up until the claims among
the partners are settled. Payments to the firm by the deficient partner are credited to
his capital account. Any uncollectable deficiency becomes a loss and is written off
against the capital balances of the remaining partners. Finally, the cash received from
the deficient is distributed to the other partners in accordance with their ownership
claims.
To continue with the illustration, the capital balances remaining after the Birr
24,000 cash distribution are Shewatatek, Birr 10,000 debit; Gebre, Birr 6,000 credit;
Seifu, Birr 4,000 credit. The entries for the partnership, in general journal form, under
three different assumptions as to final settlement are presented below.
If Shewatatek pays the entire amount of Birr 10,000 in the partnership (no loss)
the final entries will be:
Receipt of deficiency
Cash-------------------------------------------10, 000
Shewatatek, Capital--------------------------------------------10, 000
Distribution of cash to partners
Gebre, Capital ----------------------------6,000
Seifa, Capital----------------------------- 4, 000
Cash----------------------------------------------------10, 000
If Shewatatek pays Birr 6,000 of his deficiency to the partnership and the
remainder is considered to be uncollectable (Birr 4,000 loss), the final entries will be:
Receipt of part of deficiency
Cash-----------------------------------------6, 000
Shewatatek, Capital--------------------------6, 000
Division of loss
Gebre, capital-----------------------------------2, 400
Seifu, capital---------------------------------- 1, 600
Shewatatek, capital-----------------------------------------4, 000
Division of cash to partners
Gebre, capital-----------------------Birr 3,600
Seifu, capital------------------------ 2, 400
Cash------------------------------6, 000

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If Shewatatek is unable to pay part of his Birr 10,000 deficiencies (Birr 10,000
loss), the loss of the other partners will be recorded by the following entry.

Division of loss
Gebre, capital--------------------------------------6, 000
Seifu, capital---------------------------------------4, 000
Shewatatek, Capital-------------------------------10, 000

The type of error most likely to occur is the liquidation of a partnership is improper
distribution of cash among the partners. Error of this type results from confusing the
distribution of cash with the division of gains and losses on realization.

The following situations must be noted:

 Gains and loss on realization result from the disposal of assets represent
changes in partnership capital and should be divided among the capital
accounts in the same manner as net income or net loss from ordinary
business operations, namely, in the income sharing ratio.
 Distribute of assets to the partners upon liquidation is the exact reverse of
contribution of assets by the partners at the time the partnership was
established. The amount that a partner is entitled to receive from the firm is
equal to the credit balance in their capital account after all gains and losses
on realization have been divided and appropriate allowances have been
made for additional potential losses.

SUMMARY

As we have been discussing, partnership has certain characteristics that have

accounting implication. It is characterized by limited life, unlimited liability, and co-
ownership. Its advantages is noted as being able to draw more capital and managerial
skills as compared to a sole proprietorships. Its limited life and unlimited liability being
some of the disadvantages.

It also noted that the accounting procedures are the same with other forms of
business organization. The division of net income and net loss is specified in the
partnership agreement and may take different forms.

A partnership results in dissolution as a result of a change in the owner of the firm.

When a partnership goes out of business, it usually sells its non-cash asses and settles
its credit and distributes the remaining cash to each partner according to the balances of
the partner's capital accounts.

Check Your Progress 4.5

Answer the following questions

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1. A. Differentiate between “dissolution” and “liquidation” of a partnership.

B. What does “realization” mean when used in connection with liquidation of a
partnership?
2. In the liquidation process,
a. How are losses and gains on realization divided among the partners?
b. How is cash distributed among the partners?
3. Chernet and Daniel are partners, sharing gains and losses equally. At time they
decide to terminate
the partnership, their capital balances are birr 110,000 and birr 70,000 respectively.
After all non-
cash assets are sold and all liabilities are paid, there is a cash balance of birr 200,000
a. What is the amount of gain or loss on realization?
b. How should the gain or the loss be divided between Charnet and Daniel?
c. How should the cash be divided between Charnet and Daniel?
4. Alemu, Belay and Challa are partners sharing income 2:2:1. After dissolution of the
firm’s loss from liquidation, Alemu’s capital account has a debit balance of birr
15,000, If Alemu is personally bankrupt and unable to pay any of the birr 15,000
how will the loss be divided between Belay and Challa?
5. Kefalgn, Yalew and Zergaw are partner-sharing income 2:1:2. After distribution of
the firm’s loss from liquidation, Kefalgn’s capital has a debit balance of birr 22,500.
Kefalgn is personally bankrupt and unable to pay any of the birr 22,500. How should
the loss be divided between Yalow and Zergaw?

6. Belew, Kasew and Dagnachew are partners. And now,they decide to liquidate the
partnership the partners have capital balance of birr 180,000 birr, 135,000 birr and
90,000 birr respectively. The cash balance is birr 45,000 the book value of non-cash
asset total birr 435,000 and liabilities total birr 75,000. the partner share income and
losses is the ration of 3:2:2.
Instruction
Prepare a summary of the liquidation in the form illustrated in our discussion, for each
of to following assumption described below:
1. All of the non-cash assets are sold for birr 540,000 in cash the creditors are
paid, and the remaining cash is distributed to partners.
2. All of the non-cash assets are sold for birr 225,000 in cash, the creditors
are paid, and the remaining cash is distributed to all partners.

7. After closing the accounts on June 1, prior to liquidation of the partnership the
capital accountbalances of Getu, Hirut and Lemma are 26,000 birr 52,000 and birr
62,000 respectively. Cash, non-cash assets, and liabilities total birr 34,000 Birr
166,000 and birr 60,000 respectively. Between June 1, and Jun 30, the non-cash
assets are sold 42,000, the liabilities are paid, and the remaining cash is distributed
to the partners. The partners share net income and loss in the ratio of 1:2:3 prepare
a statement of partnership liquidation for the period June, 1-30.

Answer Keys

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Check your progress 4.1

5.1 a. partnerships is an association of two or more persons to carry on a business as
owners of a business for profit.
b. General partnership: is a type of partnership in which partners have unlimited
liability. The partners are liable to creditors for debts incurred by the
partnership. Thus partners must contribute sufficient personal assets to settle
the debts of the partnership in addition to their capital investments.
c. Limited partnership: is a type of partnership in which partnership may be
formed in which the liability of partners may be limited to the amount of their
capital investment. However, a limited partnership must have at least one
general partner who has unlimited liability.
d. Article of partnership or partnership agreement is a voluntary contract
containing all the elements essential to any other enforceable contract. The
agreement is made in writing, and the terms must be specifically expressed
such matters as the amount of investments, to be made, limitations on
withdrawals of funds, the amount in which net income and net loss are to be
divided; and the admission and withdrawals of partners etc.
e. Co-ownership of partnership property means that the property invested in a
partnership by a partner becomes the property of all the partners jointly. Upon
dissolution of the partnership and distribution of its assets, the partners'
claims against the assets are measured by the amount of the balances in their
capital partnership.
5.2 Characteristics of partnership:
- Limited life
- Unlimited liability
- Co-ownership of properly
- Mutual agency
5.3 Advantages of partnership
- Formation of a partnership is relatively easy inexpensive to organize.
5.4 Disadvantages of partnership
- Its life is limited,
- Each partner has unlimited liability,
- One partner can bind the partnership to contracts,
- Raising large amount of capital is more difficult for a partnership than a
corporation.

Check your progress 4.2

(1) Cash 14,400
Miazia 1, Account receivable 32,600
Merchandize inventory 57,400
Stores Equipment 10,800
Office equipment 3,000
Allowance for doubtful a/c 3,000
Account payable 5,200
Ato Mulato, capital 42,000
Ato Nasir, c apital 68,000

2. The office equipment should be recorded at birr 30,000, the valuation agreed upon
by the partners.

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3. The accounts receivable should be recorded as a debit to Accounts receivable for birr
40,000 and as a credit to Allowance for Doubtful accounts for birr 4000.
4. Cash……………………………………….11,000
Accounts Receivable…………………….. 63,400
Merchandise Inventory………………….. 20,000
Equipment ……………………………….. 34,000
Allowance for doubtful A/c………… 3,000
Leykun, capital ……………………….125,400

Check your progress 4.3

1. The primary factors that should be considered in reaching an agreement as
to the division of net income, or net loss between partners are the (1)
services and (2) capital contributed to the partnership by the partners
2. Equally
3. First approach, debit the partners’ account and credit cash.
Second approach, debit Expense account and credit cash.
4. Debit the income summary account for the amount of the net income and
credit the partner’s capital accounts for their respective shares of the net
income.
5. No. Payments to partners and the division of net income are separate. The
amount of salary allowance does not affect the amount of the division of
net income.
6.
Habtamu Challa Total
a. Net income Birr 44,000 Birr 44,000 88,000
b. Net income Birr 35,200 Birr 52,800 88,000
c. Net income Birr 54,400 Birr 33,600 88,000
d. Net income Birr 47,000 Birr 41,000 88,000
e. Net income Birr 45,400 Birr 42,600 88,000

7.
Habtamu Challa Total
a. Net income Birr 20,000 Birr 20,000 40,000
b. Net income Birr 16,000 Birr 24,000 40,000
c. Net income Birr 22,400 Birr 17,600 40,000
d. Net income Birr 23,000 Birr 17,000 40,000
e. Net income Birr 21,400 Birr 18,600 40,000

8. Net income. ………………………………Birr 135,000

Division of Net income Mengisto Dana Chaltu Gemeda Total
Salary allowance of 54,000 43,200 97,200
month)
Reaming 18,900 18,900 37,000
Net income 72,900 62,100 135,000

Net Income…………………………………………………………… Birr 90,000

9
Muluken Adugna Ayantu Daba Total

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 Fundamentals of Accounting II

Salary allowance Birr 36,000 Birr 28,800 Birr 64,800

(12 months)
Interest allowance Birr 7,000 Birr 4,900 Birr 11,900
Remaining income Birr 6650 Birr 6650 Birr 13,300
Net income Birr 49,650 Birr 40,350 Birr 90,000

10.Net Income ……………………………………. Birr 60,000

W/rTirringo Ararso W/ro Chaltu Ture Total
Salary allowance Birr 36,000 Birr 28,800 Birr 64,800
(12 months)
Interest allowance Birr 7,000 Birr 4,900 Birr 11,900
Total 43,000 33,700 76,700
Excess of allowance over 83,500 83,500 16,700
income
Net income Birr 34,650 Birr 25,350 Birr 60,000

Check your progess 4.4

1. The same for (a) and (b); that is
 Alemshet capital ………………………………..45,000
Reta, capital ………………………………45,000

2. It is important to sell all partnership assets in terms of current prices at the time of
the admission of a new partner because failure to do so might result in participation by
the new partner in gains or losses attributable to the period prior to admission to the
partnership. To illustrate, assume, Admissu and Bitew share net income and net loss
equally and operates a partnership that owns land recorded at and costing birr 40,000.
Chekol is admitted to the partnership and the three partners share income equally. The
day after Chekol is admitted to the partnership, the land is sold for birr 70,000 and
since the laud was not revalued, chekol receives a one-third distribution of the birr
30,000 gain. In this case Chekol participates in the gain attributable to the period parior
to admission to the partnership.

3. a. By purchase of interest, the capital interest of the new partner is obtained from the
old partner and neither the total assets nor the total capital of the partnership
is affected.
b. By investment, both the total assets and the total capital of the partnership are
increased.

4. Goodwill attributable to the old partnership should be allocated to the capital

account of the original partners in accordance with their income sharing
agreement.

5. A. (1) Jemal, Capital ……………..40,000

Lemlem, capital ……….40,000
(2) Cash ………………………… 80,000
Messelu, capital ………80,000

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b. Jemal……………………………….. Birr 80,000

Kebede……………………………… Birr 160,000
Lemlem……………………………. Birr 40,000
Messelu………………………….... Birr 80,000
Check your progress 4.5
1.(A) Dissolution refers to any change in the owner of the partnership that has the
effect of dissolving the partnership.
(b). Liquidation as used in its broad sense, refers to the entire winding up process of a
firm that is
going out of business.
2. Cash is distributed to the partners in accordance with their ownership claims, as
indicated in the credit balances in their capital accounts, after taking into
consideration the potential losses. That may result from the inability to collect from
a deficient partner.

3. (A) Birr 20,000 gain

(b) Birr 10,000 to each partner
(c) Birr 120,000 cash to Chernet;
Birr 80,000 cash to Deaniel,

4. Alemu’s debit of birr 15,000 must be divided between Belay and Challa in the ratio
of 2:1 (2:3 and 1:3) birr 10,000 to Belay and 5,000 to Challa.
5.. Yalew and Zergaw share net income with a ratio of 1:2, so divide the loss of
Kefalgn Birr 22,500 in the following manner.
Yalew ……. 1/3 x 22,500 = Birr 7,500
Zergaw 2/3 x 22,500 = Birr 15,000
Birr 22,500
7.1
Belew Kasu, and Dagnachew
Statement of Partnership Liquidation
For the Period of

Cash Non cash Belew Kasew

Danehaw
Asset Liabilites 3 2
2
Balance Before realization 45,000 435,000 75,000 180,000 135,000
90,000
Sale of non cash assets and
Division of gain +540,000 -435,000 - +45,000 +30,000
+30,000
Belew after realization 585,000 0 75,000 225,000 165,000
120,000
Payment of hab -75,000 - -75,000 _ _
_
Balance after payment
Of Liablites 510,000 0 0 225,000 165,000
120,000
Distribut of cash to

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 Fundamentals of Accounting II

Partners -510,000 - - -225,000 -165,000

-120,000
Final balance 0 0 0 0 0
0

7.2

Belew Kasu, and Dagnachew

Statement of Partnership Liquidation
For Period

Cash none Cash Belew Kasew

Danehaw
Asset Liabilites 3 2
2
Balance Before realization 45,000 435,000 75,000 180,000 135,000
90,000
Sale of non cash assets and
Division of gain +225,000 -435,000 - +90,000 -60,000
-60,000
Balance after realization 270,000 0 75,000 90,000 75,000
90,000
Payment of liability -75,000 - -75,000 _ _
_
Balance after payment
of Liablites 195,000 0 0 90,000 75,000
30,000
Distribution of cash to
Partners -195,000 - - -90,000 -75,000
- 90,000
Final balance 0 0 0 0 0
0

Capital

Cash Non cash Liability Getu Hirut Lemma

Asset
Balance before 34,000 166,000 60,000 26,000 52,000 62,000
realization
Sale of assets and 42,000 166,000 - 20,666.67 41,333.33 62,000
distribution of loss
Balance after 76,000 - 60,000 5,333.33 10,666.67 0
realization
Payments of 60,000 - -60,000 - - -
liability

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 Fundamentals of Accounting II

Balance after 16,000 0 0 5,333.33 10.666.67 0

payment of
liabilities
Distribution of -16,000 - - -5,333.33 -10.666.67 0
cash to partner
Final Balance -0- -0 -0- -0- -0- -0-
The entries to record the liquidation are as follows
Sale of assets
Cash ………………………………….. 42,000
Loss and gain on realization ………….124,000
Non cash assets……………………………..166,000
Distribution of loss
Getu, capital ……………………20,666.67
Hirut, capital……………………41,333.33
Lemma, capital…………………. 62,000
Loss and gain on realization…………..124,000
Payments of liabilities
Liabilities ……………………….. 60,000
Cash……………………………… 60,000
Division of cash
Getu, capital ………………………… 5,333.33
Hirut, capital…………………………10,666.67
Cash………………………………… 16,000

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CHAPTER 5
ACCOUNTING FOR CORPORATION

5.0. CHAPTER OBJECTIVE

At the end of this chapter you should be able to understand the following:
- Characteristics of a corporation
- Elements of stockholders equity
- Characteristics of capital stock
- The types of stocks
- Issuance of capital stock
- Treasury stock
- Equity per share
- Organization cost

5.1 INTRODUCTION
Dear learner, Corporation is an artificial person, created by law and having a
distinct existence, separate and apart from the natural persons who are responsible for
its creation and operation. A may be classified as nonprofit or profit.

Non profit Corporations are corporations that are organized for recreational,
educational, charitable, or philanthropic purposes. They depend upon dues from
their members or upon gifts and grants from the public at large for their continued
existence.

Profit Corporations are corporations that are engaged in business activities. They
depend upon profitable operations for their continued existence. Profit
corporations may be public or non-public. Public corporations are corporations
whose shares of stock are widely distributed and traded in a public market. Non-
public corporations are corporations whose share of stock are owned by small
groups like close families, close friends etc.

5.2 CHARACTERISTICS OF A CORPORATION

As a legal entity, the corporation has certain characteristics that make it

different from other types of business organization.
1. Separate Legal Existence
A corporation may acquire, own, and dispose of property in its
name. It may also incur liabilities and enter into contracts in
accordance with the provision of its charter.

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 Fundamentals of Accounting II

2. Transferable Units of Ownership

The ownership of a corporation is divided into transferable

units called shares or stocks. The owners of the corporation
are called stockholders or shareholders. They may buy and sell
shares without the consent of other stockholders and without
disrupting the activities of the corporations unlike a partner in a
partnership.

3. Transferability ( Liquidity )

A stockholder can convert his/her/its shares of stock into cash

when the stocks of a corporation are sold in the open market. A
stockholder can often borrow money on his/her/its shares of
stock by giving as a security for a loan unlike a proprietor in a
single proprietorship or a partner in a partnership.

4. Limited Liability of Stockholders

A corporation is responsible for its acts and obligations, and

therefore its creditors may not look beyond the assets of the
corporation for the settlement of their claims unlike a proprietor
in a single proprietorship or a partner in a partnership.
Normally, the maximum loss to be incurred by the stockholder
is the amount that was invested to acquire the stock.

5. Continuous Existence (Unlimited Life)

A corporation is assumed to have a continuous existence unlike

the limited life in a partnership. Stockholders may sell or
transfer their share of stocks to others without disrupting
corporate operations unlike a partner in a partnership. In
addition, death, withdrawal, or incapacity of stockholders will
not disrupt corporate operations unlike a partner in a
partnership.

6. Indirect Control Over the management of Corporate

Affairs

Stockholders exercise the control over the management of

corporate affairs indirectly by electing group of persons called
Board of Directors. Board of Directors is responsible to
establish corporate policies, to supervise the overall operations,
and to select officers of the corporation.

7. Government Regulation

Corporations are created by authority of the government unlike

a single proprietorship or a partnership form of business

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 Fundamentals of Accounting II

organization. It has more restrictions than a single

proprietorship in its licensing, limitation of capital etc.

8. Taxes

Corporation is a tax paying entity unlike a single proprietorship

or a partnership. There is double taxation in a corporation. The
corporation as a legal entity pays income tax. Stockholders pay
income tax from the dividend they received. The corporation is
responsible to collect the income tax from stockholders and
remit to the taxing authority.

Check your Progress 5.1

Answer each of the following questions
1. Corporation is an artificial person. Explain?
2. How are corporations classified?
3. How are profit corporation categorized?
4. A corporation has separate existence. Explain?
5. What is the role board of directors?

5.3 Stockholders’ Equity

The equity of stockholders in a corporation is known as stockholders’ equity,
shareholders’ equity, shareholders’ investments or capital
Sources of stockholders equity
- Invested Capital or investments contributed by stockholders called paid in capital
and
- Capital arising from profitable operations and retained in the business, called
retained earning
The paid-in capital is recorded in accounts maintained for each class of stock. If a
corporation has one class of stock, the account is entitled as common stock or capital
stock. If a corporation has two class of stock, the accounts maintained are preferred
stock and common stock.
The retained earnings amount results from transferring the balance of the Income
Summary account, net income\loss, to a retained earnings account. In a corporate
form of business organization, unlike a single proprietorship or a partnership, the
capital arising from profitable operation is kept separately from the invested capital.
The sale of stock above or below par is recorded in Paid-In Capital in Excess of Par
account.
In a corporation that has one class of stock, the stockholders’ equity accounts
maintained are:
-Common Stock
-Paid-In Capital in Excess of Par
-Retained Earnings
-Income Summary

In a corporation that has two class of stock, the stockholders’ equity accounts
maintained are:
-Preferred Stock

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 Fundamentals of Accounting II

-Paid –In Capital in Excess of Par- Preferred

-Common Stock
-Paid-In Capital in Excess of Par-Common
-Retained Earnings
-Income Summary

Check Your Progress 5.2

1. Distinguish between invested capital and capital arising from profitable

operations?
2. Referring to question number 1, how are they treated in ( a) Single
proprietorship or partnership (b) Corporation
3. What stockholders’ equity accounts are maintained when a corporation issue
one class of stock?
4. What stockholders’ equity accounts are maintained when a corporation issue
two class of stock?
5. For what type of transaction is Paid-In capital in Excess of Par account is used
in the stockholders’ equity?

5.4. CHARACTERISTICS OF CAPITAL STOCK

All the shares of a corporation are referred as capital stock. The total amount of stock
that a corporation may issue as it is set forth in its charter is called authorized
capital. The total amount of stock that a corporation has sold is called issued capital.
A corporation may reacquire some of the stock that it has issued and these stocks are
treasury stock. The total amount of stock that is currently owned by stockholders is
called outstanding capital stock.
The shares of capital stock are assigned an arbitrary value known as par. A stock
certificate on which value printed is called par value stock. Stock certificate is the
evidence of each stockholder’s ownership in a corporation. Stocks may also be issued
without par. A stock that has no authorized value stated on stock certificate is called
no par value stock. No par value stock that is assigned a value by a corporation’s
board of directors is called stated value stock.
The creditors of a corporation have no claim against the personal assets of
stockholders as the corporation has limited liability. However, the law requires that
some specific minimum contribution by the stockholders be retained by the
corporation for the protection of its creditors, this amount is called LEGAL
CAPITAL.

Classes of Stock
A corporation may issue two classes of stocks.
They are:
1. Common Stock: - stock issued by a corporation that does not give the stockholder
any
special preferences.
The major rights of common stockholders
 -The right to vote in matter concerning the corporation
 The right to share in distributions of earnings after preferred
stockholders.

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 The preemptive right, which is the right to maintain the same fractional
interest in the corporation by purchasing a proportionate number of
shares of any additional issuance of stock, and
 The right to share in assets upon liquidation, which is the winding up
process when the corporation goes out of business, after creditors and
preferred stockholders.

2. Preferred Stock: - Stock issued by a corporation giving a stockholder preferences

in earnings and other rights. The preference usually relates to
the right to share in distribution of earnings prior to common
stockholders. The earnings are usually a fixed percentage of par
values or stated amount per stock with this regard, the preferred
stockholder is assumed to be owner creditor.
The basic rights of preferred stockholders
(1) The right to share in distributions of earnings before common
stockholders.
(2) The right to share in assets upon liquidation after creditors but
before common stockholders

The board of directors has the sole authority to distribute earnings to

stockholders. The stockholders do not have a right to collect dividends, which is the
amount of corporate earnings distributed to stockholders, from the corporation unless
such dividends have been formally declared by the board of directors. The action of
the board of directors to distribute a definite amount of corporate earnings to
stockholders on specific date is called declaring dividend.

ILUUSTRATION

Assume that Addis Fana Corporation has 10% 3000 shares , Birr 100 par
Preferred Stock and 20000 shares of Birr 25 par common stock outstanding. Assume
also that the corporation has earned net income in the first three years as Birr 45,000;
Birr 65,000 and Birr 90,000 respectively. The board of directors declared dividends
of Birr 40,000, Birr 55,000 and Birr 60,000 during the three–year period respectively.

Details of retained earnings and dividend distribution for each class of stock
are shown below:
First Second
Third
Year Year
Year

Net Income Br. 45000 Br. 65000 Br.

90000

Amounts Retained 5000 10000

30000

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 Fundamentals of Accounting II

Amounts Distributed 40000 55000

60000

Preferred Stock Dividend (10% x100 x3000) 30000 30000

30000

Common Stock Dividend 10000 25000

30000

Dividend per share -Preferred Br. 10.00 Br. 10.00 Br.

10.00

-Common Stock Br. 0.50 Br. 1.25 Br.

1.50
Preferred stock may be participating or non participating. In the foregoing
illustration, preferred stockholders received an annual dividend of Birr 10 per share,
in contrast to common stockholders, whose annual per share of dividend were Birr
0.50, Birr 1.25, and Birr 1.50 respectively. Preferred stockholders’ preferential right
to dividends is usually limited, and isn’t allowed to receive dividends beyond the
normal dividend. Such stock is called non participating preferred stock.
Preferred stock which provides for the possibility of dividends in excess of a
certain amount is said to be participating. Preferred stock that could receive dividends
in excess of specified amount granted by its preferential right is called participating
preferred stock.
Preferred stockholders’ may participate with the common stockholders’ to
varying degrees and the agreement must be determined the extent of this participation.
The agreement may be on comparable basis and ratable (share-to-share) basis
ILLUSTRATION
Assume that the contract covering the preferred stock of the corporation in the
preceding illustration provides that if the total dividends to be distributed exceed the
regular preferred dividend and a comparable dividend on common, the preferred shall
share in the excess ratably (rate-able) on a share-to-share basis with common. Based
on this, Birr 253000 dividend distribution in the fourth year would be allocated as
follows:
Preferred Common
Stockholders’ Stockholder’
Total
Dividend Dividend
Dividend
Regular dividend to preferred stockholders
(10% of 100 x3000 Shares) Br. 30000
Br. 30000
Comparable dividend to Common stockholders
(20000 x 10) Br 200000
200000
Remainder to 23000 shares ratably
( Br. 253000 – 30000 – 200000) = Br. 1 per 3000 20000
23000
÷ 23000 shares share)

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Total Br. 33000 Br .220000

Br.253000

Dividend per share: Br. 11.00 Br. 11.00

-Preferred stockholders (Br 33000 ÷ 3000 shares)
-Common stockholders (Br. 220000 ÷ 20000 shares)

Preferred stock may also be cumulative or non-cumulative. Provision is

usually made, however, to assure the continuation of the preferential dividend right if
at any time the board of directors PASSED ( DO NOT DECLARED) the usual
dividend. This is accomplished by providing that dividends may not be paid on the
common stock if any preferred dividends are in arrears. Such preferred stock is said
to be CUMULATIVE. Preferred stock that is entitled to CURRENT and PAST
dividends before any dividends may be paid on common stock.

ILLUSTRATION

Assume that Dinsho Corporation has 3000 shares of Cumulative preferred 8%

stock of Birr 100 par. In addition, assume that dividends have been passed for the
preceding two years. The board of directors declared a total dividend of Birr 100000.
Share of dividends to Preferred Stockholders is as follows:
Dividend in arrears ( 8% x 100 par x 3000 shares x 2 preceding years)
Br. 48000
Current year dividend ( 8% x 100 par x 3000 shares)
24000
Total
72000
Share of dividends to Common Stockholders (Br 100000– Br 72000)
28000

Preferred stock not having this cumulative right is known as NON-

CUMULATIVE preferred stock. Preferred stockholders will receive only the current
year dividend, Birr 24000 in the preceding illustration. If dividend payments are large,
because most preferred stock is non-participating, preferred stockholders receive a
fixed dividend and the bulk of the large dividend goes to common stockholders. If
dividend payments are small at every declaration, common stockholders may not
receive dividend at all because the dividend declared will always go to preferred
stockholders.

Check your progress 5.3

1. Differentiate between authorized, issued, and outstanding capital stock?
2. Differentiate between par and no par stock?
3. State the classes of stock with their respective rights?
4. Describe briefly (A) participating preferred stock (B) cumulative preferred stock.
5. Describe briefly (A) non- participating preferred stock (B) non- cumulative
preferred stock
6. Which types of preferred stock receives more dividends?
(A) Participating preferred stock (B) non- participating preferred stock

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7. On which type of preferred stock, a preferred stock receives less dividends in case
of dividend
passed? (A) Cumulative (B) non- cumulative
8. Assume that Dil Betigil Corporation has 7% preferred stock of birr 50 Par, 5000
shares and birr
10, par common stock, 50,000 shares outstanding. Assume further that the
corporation declared
birr 220,000 from a net income of birr 300,000 for a fiscal year. Determine the
amount
retained, distributed to preferred stock stockholders and common stock holders,
and dividend
per share for each class of stock.
9. Referring to question number 8, if the preferred stock was cumulative and dividend
have not been paid for two preceding years, determine the amount of dividend to be
distributed to preferred stockholders and common stock holders, and dividend per
share for each class of stock?

10. Referring to question number 8, if the stock was also participating, determine the
amount of dividend to be distributed to preferred stock holders and common stock
holders on comparable and share to share bases. Determine also the dividend per
share for each class of stock

5.5. ISSUING CAPITAL STOCK

The entries to record the investment of capital in a corporation are like

those of other types of business organization, in that cash and other assets
received are debited and any liabilities assumed are credited. However, the
credit to capital differs in that there are accounts for each class of stock.

A corporation may issue capital stock at par, above, or below par. It

may as well issue the stock for cash or for assets other than cash.

ILLUSTRATION

Assume that Fasika Dicor Corporation has 10000 authorized shares of

12% preferred stock of Birr 100 par and 100000 authorized shares of Birr 25
par Common Stock. Assume further that the corporation issued one-quarter of
each authorization at par for cash.

The amount of cash received from the issuance of preferred stock Br. 250,000
(¼ x 10000 x 100)
The amount of cash received from the issuance of common stock 625,000
(1/4 x 100000 x 25)
Total amount received from the issuance of stocks Br.875,000

The entry to record the stockholders’ investment and the receipt of

cash, in general journal form, is as follows:

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Cash 875,000
Preferred Stock 250,000
Common Stock 625,000

The capital stock accounts (Preferred stock, common stock) are

controlling accounts. It is necessary to maintain stockholders ledger, which
records each stockholders’ name, address, and number of shares held in order
to issue dividend checks, proxy forms, and financial reports
The stock of a corporation is often issued at a price other than par.
When it is issued more than par, the excess of the contract price over par is
termed as premium. When it is issued at a price that is below par, the
difference is called discount.
Theoretically, there is no reason for a newly organized corporation to
issue stock at a price other than par. A need for additional stock may arise
long after a corporation has become established. To achieve this, the changing
prospects for its future success or failure may affect the price per share at
which the incorporators can secure other investors.
Generally, the price at which stock issued by a corporation is influenced by
(1) the financial condition, the earnings record, and the dividend record
of the
corporation,
(2) its potential earning power,
(3) the availability of money for investment purposes, and
(4) general business and economic conditions and prospects.

5.5.1 Premium and Discounts on Stock

When capital stock is issued at a premium, cash or other assets are
debited for the amount received. The stock account is then credited for the par
amount and a premium account, paid in capital in excess is credited for the
amount of the premium.

ILLUSTRATION
Assume that Fasika Dicor Corporation issued 1250 shares of Birr 100 par Preferred
stock for cash at Birr 103 per stock.
Amount of cash received from the issuance
of Preferred Stock (1250x103) Br. 128,750
Amount of Preferred Stock (1250 x 100) 125,000
Amount of Paid-In Capital in Excess of Par (1250 x3) -Premium 3750

The journal entry to record the transaction would be as follows, in general journal
form:

Cash 128,750
Preferred Stock
125,000
Paid in capital in Excess of par-Preferred
3,750
When capital stock is issued at a discount, cash or other assets are debited for the
amount received, and a discount account, paid in capital in excess of par is debited for
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the amount of the discount. Then the stock account is credited for the par amount.

ILLUSTRATION
In the preceding illustration, Fasika Dicor Corporation issued 10000 shares of Br. 25
par Common Stock for cash at Birr 23.

Amount of Common Stock (10000 x 25) Br. 250,000

Amount of cash received from the issuance of Common
Stock (10000 x 23) 230,000
Amount of Paid-In Capital in Excess of Par (10000 x 2)-Discount 20,000

The entry to record the transaction would be as follows, in general journal form:

Cash 230000
Paid-In Capital in Excess of Par-Common 20000
Common Stock
250000

Premium and Discount on Capital Stock on the Balance Sheet

Premium and discount on capital stock of Fasika Dicor Corporation in
the Stockholders’ Equity section of the balance sheet is illustrated as follows:
Stockholders’ Equity

Paid-In Capital
Preferred 12% Stock, Birr 100 par (10000
Shares authorized, 3750 shares issued) 375,000
Excess of Issue Price over par-preferred 3,750
378,750
Common Stock, Birr 25 par (100000 shares
Authorized, 35000 shares issued) 875,000
Less Excess of par over issue price 20,000
855,000
Total Paid-In Capital
1,233,750
Retained Earnings
166,250
Total Stockholders’ Equity
1,400,000

Stockholders’ Equity section of a balance sheet with deficit , which is a debit balance
in the Retained Earnings account, is illustrated as follows:

Shareholders’ Equity
Paid-In Capital
12% Preferred stock, Birr 100 par
(10000 Shares authorized, 3750 shares issued) 375,000

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Excess of issue price of over par-Preferred 3,750

378,750
Common Stock, Birr 25 par
(100000 shares Authorized, 35000 shares issued) 875,000
Less Excess of Par over issue Price common 20,000
855,000
Total Paid-In by shareholders
1,233,750
Less deficit in retained earning
33,750
Total Shareholders’ Equity
1,200,000

Issuing Stock for Assets Other Than Cash

When capital stock is issued in exchange for assets other than cash, such as
land, building, and equipment, the assets acquired should be recorded at the asset’s
fair market price or at the fair market price of the stock issued, whichever is more
objectively determinable.

ILLUSTRATION

Assume that Alemeshet Corporation acquired Building for which the fair
market price is not determinable. In exchange the corporation issued 5000 shares of
Br. 25 par common stock with a current market price of Birr 29 per share.

Fair market price of the stock issued (5000 x 29) Birr 145,000
Commons Stock issued (5000 x 250 ) 125,000
Paid –In Capital in Excess of par-premium (5000 x 4) 20,000

The transaction could be recorded, in general journal form, as follows:

Building 145000
Common Stock 125000
Paid-In capital in Excess of par-Common 20000

ILLUSTRATION
Assume that Birhan Lehulu Corporation acquired Equipment for which
the fair market price is not determinable. In exchange the Corporation issued
1250 shares at Birr 40 par common stock with a current market price of Birr
37 per share.

Common Stock issued (1250 x 40) Br. 50,000

Fair market price of the stock issued (1250 x 37) 46,250
Paid-In Capital in Excess of par- discount ( 1250 x 3) 3,750

The transaction could be recorded, in general journal form, as follows:

Equipment 46250
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Paid-In Capital in Excess of par-Common 3750

Common Stock 50000

Issuing No-Par Stock

Preferred and common stock may be issued without par. Preferred stock is
usually assigned a par. When no par stock is issued (1) The entire amount may be
credited to the capital stock account, even though the issuance price varies from time
to time or (2) stated value is assigned and the difference between the issuance price
and the stated value is credited to Paid-In Capital in Excess of Stated Value.

ILLUSTRATION

Assume that Hibrat Corporation issues 8000 no- par Common Stock at Birr 60
for the first time.
The amount of cash received = 60 x 8000
= Birr 480000
The entry to record, in general journal form, would be as follows:

Cash 480,000
Common Stock 480,000

Assume further that the corporation issued 2000 shares of no-par stock at Birr
50 for the second time.
The amount of cash received = 50 x 2000
= Birr 100000
The entry to record, in general journal form, would be as follows:

Cash 100000
Common Stock 100000

ILLUSTRATION

Assume that in the previous illustration for the first issuance the stated value is Birr
50.
The amount of cash received Birr
480,000
Common Stock at Stated Value (8000 x 50)
400,000
Paid-In Capital in Excess of stated value
80,000

The entry to record, in general journal form, would be as follows:

Cash 480,000
Common Stock 400,000
Paid-In Capital in Excess of Stated Value 80,000

ILLUSTRATION

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Assume further that in the previous illustration for the second issuance
the stated value is Birr 45.
Amount of cash received Birr
100000
Common Stock at stated value (45 x 2000)
90000
Paid-In Capital in Excess of stated value
10000

The entry to record, in general journal form, would be as follows:

Cash 100000
Common Stock
90000
Paid-In Capital in Excess of Stated Value
10000

Subscription and Stock Issuance

Initial or subsequent issuance of capital stock of a corporation may be sold to
an underwriter. The underwriter then resells the shares to investors. The entire
amount of the sale will be received without delay and the Corporation is relieved of
the task of marketing the stock.

In other situation, stock is issued under a subscription contract requiring

payment by subscribers at a later date. Generally, the stock certificates are not issued
until the subscription price is collected in full.

When stock is subscribed for at par, the subscription price is debited to the
asset account Stock Subscription Receivable and credited to the capital account, stock
subscribed.

When stock is subscribed for at a price above par, the stock subscription
receivable account is debited for the subscription price. The stock subscribed account
is credit at par and the difference between the Subscription price and par is credited to
paid-in capital in excess of par.
When stock is subscribed at a price below par, the Stock Subscription
Receivable account is debited for the subscription price. The stock subscribed
account is credited at par and the difference between the par and the subscription price
is debited to paid-in capital in excess of par.
ILLUSTRATION

Assume that the newly organized Lion Corporation receives subscription,

collected cash, and issue stock according to the following transaction:
On March 1, 2004 Received Subscriptions to 5000 shares of Birr 30 par
Common Stock at Birr 30, with a down payment of 60% of the subscription price.
The amount of stock subscription receivable (5000 x 30) = Birr 150,000
The amount of down payment (60% of 150000) = Birr 90,000

The entry to record, in general journal form, would be as follows:

Common Stock Subscription Receivable 150000

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Common Stock Subscribed 150000

Cash 90000
Common Stock Subscription Receivable 90000
April 1, 2004 Received 20% of subscription price from all subscribers.

Cash 30000
Common Stock Subscription Receivable 30000
May 1, 2004 Received 20% of subscription price from al subscribers and issued the
stock certificate.

Cash 30000
Common Stock Subscription Receivable 30000
Common Stock subscribed 150000
Common Stock 150000
January 1, 2004 Received to 8000 shares of Birr 50 par common stock from various
subscribers at Birr 53, with a down payment of 40% of the subscription price.
Common Stock subscription Receivable 424000
Common Stock subscribed 400000
Paid-In Capital in Excess of par 24000
Cash 169600
Common Stock Subscription Receivable 169600

March 1, 2004 Received 30% of the subscription price from all subscribers.
Cash 127200
Common Stock Subscription Receivable 127200

June 1, 2004 Received 30% of the subscription price

from all subscribers and issued the stock certificate.
Cash 127200
Common Stock Subscription Receivable 127200

Common Stock Subscribed 400000

Common Stock 400000

April 1, 2004 Received to 10000 shares of Birr 60 par common stock from various
subscribers at Birr 56, with a down payment of 30% of the subscription price.
Common Stock subscription Receivable 560000
Paid-In Capital in Excess of par 40000
Common Stock Subscribed
600000

Cash 168000
Common Stock Subscription Receivable
168000
May 1, 2004 Received 35% of the subscription price from all subscribers.
Cash 196000
Common Stock Subscription Receivable
196000

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June 1, 2004 Received 35% of the subscription price

from all subscribers and issued the stock certificate.
Cash 196000
Common Stock Subscription Receivable
196000
Common Stock Subscribed 600000
Common Stock
600000
A balance sheet prepared after the transaction B of January 1, would list the
common stock subscription Receivable as a current asset and Common Stock
Subscribed and the Paid-In Capital in Excess of Par as follows:
Lion Corporation
Balance Sheet
Jan 1, 2004

Assets Stockholders Equity

Current Assets Paid-In Capital:
Cash 169600 Common Stock Subscribed
400000
Common Stock Sub. Rec.254400 Excess of issuance price
24000
Total Assets 424000 Total Stockholders’ Equity
424000

Check your Progress 5.4

1. In what forms may a corporation issue capital stock?
2. What are the factors that influence the issuance price of a stock?
3. What is entry passed when the two class of stock are issued for cash?
4. What is premium or discount?
5. When a corporation issues stocks for non- cash assets, how is the amount
at which the assets are recorded is determine?
6. On January 1 Metebaber Corporation issued 10000 shares of no par Common
stock having a
stated value of birr 20 for birr 26 for cash.
Feb. 1. Issued 2000 shares of birr 200 preferred stock at birr 210.
1. pass the entry for January 1 and Feb. 1, in general journal form
assuming that the stocks are to be credited with proceeds
2. Pass the entries for January 1 and Feb. 1, in general journal form,
assuming thee proceeds is credited to paid in capital in excess of
par.
7. On March 30, 2004 Kokeb Corporation received its charter authorizing
100,000 shares of birr 15 par common stock. On April 20, the corporation
received subscription to 30000 shares of stock at birr 20. On July 3 received
cash for one- half the subscription price. On July 31, the remaining half was
received from all subscribers and the stock was issued.
Required: 1. Pass in general journal form, to record the transaction on
April 20, July 3, July 31.
6 Feb.10, 2004 Selam corporation received subscription to 5000 shares of Birr
50 par common stock from various subscribers at birr 58, with a down
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payment of 20% of the subscription price. On March 1, 2004 the final 40%
subscription price was received. On may 1 the remaining price of the stock
received and stock was issued.
Required: 1. Pass in general journal form, to record the transaction on Feb,
10
2. Pass entries, in general journal form, to record the Transaction
on March 1
3. Pass entries, in general journal form, to record the Transaction
on May 1
5.6. TREASURY STOCK
Treasury Stock is a corporation’s own outstanding stock that has been reacquired.
A corporation purchases its own stock (1) for resale to its employees, (2) for
reissuance to employees as a bonus, or (3) to support the market price of the stock
Treasury Stock may be applied only to the issuing corporation’s stock that (1)
has been issued and fully paid, (2) has been reacquired by the corporation, and (3)
has not been canceled or reissued. Treasury Stock
- should not be reported as an asset
- has no voting right
- does not have preemptive right
- does not participate in cash dividend
Accounting for Treasury Stock
There are several methods of accounting for the purchase and the resale of
treasury stock, the commonly method used is the cost basis.
When the corporation purchases the stock, treasury stock is debited and cash is
credited for the price paid for it. The par and the price at which the stock originally
issued are ignored.
When the stock is resold, cash is debited for the selling price, treasury stock is
credited at the price paid for it and Paid-In Capital from sale of treasury Stock is
credited or debited for the difference between the selling price and the price paid for
the treasury stock.
ILLUSTRATION
Assume that Star Business Group Corporation has the following Paid-In Capital
accounts:
Common Stock, Br. 50 (15000 shares authorized and issued) Br.
750,000
Excess of Issue Price over Par
250,000
The assumed transactions involving Treasury Stock and the journal entries are as
follows:
1. Purchased 1500 shares of Treasury Stock at Birr 60.
Amount of cash paid (1500 x 60) Br. 90000
Treasury Stock 90000
Cash 90000
2. Sold 700 shares of Treasury Stock at Birr 70.
Amount of cash received (700 x 70) Br. 49000
Cost of Treasury Stock sold (700 x 60) 42000
Amount of Paid-In Capital from sale of Treasury Stock 7000
Cash 49000

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Treasury Stock
42000
Paid-In Capital from sale of Treasury Stock
7000
3. Sold 300 shares of Treasury Stock at Birr 55.
Cost of Treasury Stock Sold (300 x 60) Br. 18000
Amount of cash received (300 x 55) 16500
Amount of Paid-In Capital from sale of Treasury Stock 1500

Cash 16500
Paid-In Capital from sale of Treasury Stock 1500
Treasury Stock 18000
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 total of Paid-
In Capital and Retained Earnings. After completion of the foregoing
transaction, the stockholders’ Equity section of the balance sheet would be as
follows:
Stockholders’ Equity
Paid-In Capital
Common Stock, Br. 50 (15000 shares authorized and issued) Br. 750000
Excess of Issue Price Over Par-Common Stock 250000
1000000
From Sale of Treasury Stock
5350
Total Paid-In Capital
1005350
Retained Earnings
100000
Total
1105350
Deduct Treasury Stock (500 shares at cost Birr 60)
30000
Total Stockholders’ Equity
1075350

Check Your Progress 5.5

1. For what reasons a corporation buys its own stock?

2. What are the cons of Treasury Stock?
3. What is the usual method of accounting for the purchase and resale of treasury
stock?
4. 1000 Treasury Stock that has been purchased for Birr 25 is sold for Birr 30.
Pass the
entry in general journal form?
5. 3000 Treasury Stock that has been purchased for Birr 80 is sold for Birr 70.
Pass the
entry, in general journal form.

5.7. EQUITY PER SHARE

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Equity per share is the ratio of stockholders’ equity to the related number of share
stocks outstanding, when there is one class of stock.

For a corporation with two classes of stock, it is necessary to allocate the total
equity between the classes of stock. In allocating equity per share, consideration must
be given to the liquidation rights of the preferred stock, including any participating
and cumulative dividend features.

After the allocation of the stockholders’ equity between the two classes of
stock, the equity per share of each class of stock may then be determined by dividing
the respective amounts by the related number of shares outstanding.

ILLUSTRATION

Assume that Lalibela Corporation has both preferred and common stocks
outstanding, there are no preferred dividends in arrears, and that the preferred stock is
entitled to receive Birr 58 per share upon liquidation. The amounts of the
stockholders’ equity accounts are as follows:

Stockholders’ Equity
Preferred Br. 11 Stock, Cumulative, Br. 50 par (4000 shares outstanding) Br.
200000
Excess of Issue Price over Par-Preferred Stock
3000
Common Stock, Br. 10 Par (100000 shares outstanding)
1000000
Excess of Issue Price over Par-Common Stock
230000
Total Equity
1500000

Allocation of Total Equity to Preferred and Common Stock

Total Equity
1500000 Allocated to Preferred Stock:
Liquidation Price (58 x 4000)
232000
Allocated to Common Stock
126800
Equity per Share
Preferred Stock: Br. 232000 ÷ 4000 = Br. 58.00 per share
Common Stock: Br. 1268000 ÷ 100000 = Br. 12.68 per share
It is assumed that preferred Stock is entitled to dividend in arrears in the event
of liquidation, and that there is an arrears age of three years, the computation for the
going illustration would be as follows:
Allocation of Total Equity to Preferred and Common Stock

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Total Equity Br.

1500000
Allocated to Preferred Stock:
Liquidation Price (58 x 4000) 232000
Dividend in arrears ( 11 x 3 x 4000) 132000
364000
Allocated to Common Stock
1136000
Equity Per Share
Preferred Stock: Br. 364000 ÷ 4000 = Br. 91 per share
Common Stock: Br. 1136000 ÷ 100000 = Br. 11.36 per share
Equity per share, particularly of common stock, is often stated in corporation
reports and quoted in the financial press. It is one of the many factors affecting the
price at which a stock is bought and sold at a particular moment. However, it should
be noted that (1) earning capacity, (2) dividend rates, and (3) prospects for the future
usually affects the market price of listed stocks than equity per share. On the other
hand, stock in corporations that have suffered severe declines in earnings or whose
future prospects appear to be unfavorable may sell at prices, which are less than the
equity per share.

Check Your Progress 5.6

1. If a corporation has two classes of stock, what considerations are given to
preferred stock to allocate the total equity between the classes of stocks?
2. What is equity per share?
3. What is the equity per share of preferred stock?
4. What are the factors that affect the market price of listed stocks than equity per
share?
5. The stockholders’ equity section of a Corporation are as follows:
2,000, 15% Preferred Stock, Birr 100 par Br.
200000
24,000 Common Stock, Birr 25 par
600000
Paid-In Capital in Excess of par
20000
Retained Earnings
180000
Total Stockholders’ Equity
1000000
Required: 1. Determine the equity per share of each class of stock
assuming that preferred stock is entitled to receive Birr
120 upon liquidation
2. Determine the equity per share of each class of stock assuming
preferred stock is
to receive Birr 120 upon liquidation and dividend in arrears. The
dividend in
arrears was for 2 years.

5.8. ORGANIZATION COST

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Costs incurred in organizing a corporation. Such as legal fees, taxes

and fees paid to the government, and promotional costs are called
Organization Costs. The cost of organizing a corporation enterprise should be
treated as an asset not as an expense. Organization cost is viewed as a
permanent asset that will continue in existence until the enterprise goes out of
business. They are as essential as plant and equipment, for without the
expenditure the corporation could not have been created.
There are two possible accounting for organization costs (1) consider
organization costs as intangible assets or consider organization costs as
expense. In the former, organization costs are amortized over a period of not
less than sixty months (five years period) beginning with the month the
corporation commences business. In the latter, organization costs is an
expense in the period in which the cost is incurred.

Check your progress 5.7

1. What is organization cost?
2. What are the two possible accounting methods used for organization costs?
3. Organization costs are amortized for how many months?
4. Why organization cost is treated as an asset not as an expense?

5.9 SUMMARY

Corporation is a legal entity, that is, distinct and separate from the persons who
own it.
Corporation may be classified as profit or non-profit. Profit corporations are
categorized as public or non-public

As a legal entity, corporations have the following characteristics that

distinguish them from other types of business organization.

- Separate legal existence

-Transferable units of ownership
-Transferability/Liquidity
-Limited Liability of stockholders
-Continuous Existence/Unlimited life
-Tax paying entity
-Indirect control over management by board of directors
-Government Regulations

Invested Capital and capital arising profitable operations are maintained in a

separate account capital account. Invested capital is kept in Capital Stock where
as capital arising from profitable operations is kept in Retained Earnings account.

The ownership in a corporation is divided into units called Stock /shares. All
the shares of a corporation are called Capital Stock. The amount of capital stock
that a corporation may issue is called Authorized capital Stock. The amount of
capital stock that a corporation has sold is called Issued Capital Stock.. The
amount of capital stock that is currently owned by stockholders is called
outstanding Capital Stock.

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The stock certificate, which is the evidence of each stockholder’s ownership in

a corporation, may be par or no-par. No-par stock is assigned a value by a
corporation’s board of directors. No-par stocks are stated value stocks.

A corporation may issue a stock called Common Stock or preferred stock or

both. The basic rights that accompany ownership of stock are (1) the right to vote,
(2) the right to share in corporate earnings, (3) preemptive right, and (4) the right
to share corporate assets upon liquidation. These rights are all applicable to
Common Stockholder, but they are partially applicable to preferred stockholders,
which is the second and the fourth rights.
Preferred Stock may be participating or non-participating. It may as well be
cumulative or non-cumulative.
A corporation may issue stock at par, above par or below par. If it is issued
above par, the difference between Issuance Price and par is called premium, which
is recorded in Paid-In Capital in Excess of par and the class of stock issued.. If it
is issued below par, the difference between the par and the issuance price is called
discount, which is recorded as well in the Paid-In Capital in Excess of par and the
class of stock issued.
The issuance of stock may be for cash or for assets other than cash. When
stocks are issued in exchange for assets other than cash, the assets acquired should
be recorded at their fair market price or the fair market price of the stock issued,
whichever is more objectively determinable.
When no-par stock is issued, the entire proceeds may be credited to the Capital
Stock account or the non-par stock may be assigned a stated value and then the
capital stock is credited by the stated value and the difference between the
issuance price and the stated value will be credited or debited to Paid-In Capital in
Excess of stated value.
A corporation may sell its stocks under purchase plan, that is the purchase may
enter into contract agreement with the corporation to subscribe the stock at a
certain price per share.
When a corporation issue its share on subscription plan, the subscription
price(total) is debited to the class of stock subscription Receivable and credited to
the class of stock subscribed and the difference between the subscription price and
the par value is credited or debited to Paid-In Capital in Excess of par. When the
subscription price is fully collected, the stock will be issued and entry is passed
debiting the class of stock Subscribed and crediting the class of stock issued.
A corporation may purchase the share of its own outstanding stock from
stockholders. Such stock is referred as Treasury Stock. Treasury Stock is debited
at the price paid for it regardless of its par value or originally issuance price.
When Treasury Stock is sold, cash is debited for the amount collected and
Treasury Stock is credited at the price paid for it and paid-in capital from sale of
Treasury stock is debited or credited for the amount of the difference between the
selling price and the par value. Treasury Stock is a deduction from paid-in capital
and Retained Earnings when reported on the stockholders’ equity section of the
balance sheet.
When there is only one class of stock, equity per share is determined by
dividing the stockholders’ equity by the number of stocks outstanding.

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When there is more than one class of stock, the stockholders’ equity must be
allocated between the classes of stocks. The allocation of the stockholders’ equity
to preferred stock is based on the liquidation price, participating dividend and
dividend in arrears. The stockholders equity allocated to preferred stock will be
deducted from the total equity to arrive at the stockholders’ equity allocated to
common stock. Then the equity per share allocated to each class of stock is
divided by the number of stocks outstanding to arrive at the equity per share.
Costs incurred in organizing a corporation are charged to an intangible asset
account called organization cost. The organization costs should be amortized over
the estimated useful life, which is not less than 60 months ( five years) to an
expense account.

ANSWER KEY
CHECK YOUR PROGRESS 5.1
1. Artificial person means the corporation has the right to enter into contract and
to sue and to
be sued like a natural person.
2. Non-profit and profit corporations
3. Public and non-public corporations
4. Like natural person it can acquire, own and dispose of property, sue and be
sued, enter into
contracts, pays income tax incur liabilities.
5. To establish corporate policies, to supervise the overall operation of the
corporation, to
select officers of the corporation

CHECK YOUR PROGRESS 5.2

1. Invested capital is investment contributed by stockholders; profit capital is part

of net
income earned from operations

2. a) In a single proprietorship and partnership they are maintained in one

account
b) In a corporation they are maintained in separate stockholder’s equity
account
3. Common Stock, Paid-In Capital in Excess of par, Retained Earnings and
Income Summary
4. Preferred Stock, Paid-In Capital in Excess of Par –Preferred Stock, Common
Stock, Paid-In
Capital in Excess of par- Common Stock, Retained Earnings, and Income
Summary
5. For sales of stock above or below the par, or stated value.

CHECK YOUR PROGRESS 5.3

1. Authorized capital stock are number of stocks a corporation is authorized to
issue.

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Issued capital stock those are stocks that are sold to shareholders.
Outstanding capital is numbers of stock that are c urrently on stockholders
possesstion.
2. - A stock on which value is printed on a stock certificate
-A stock on with out any authorized value.
3. - A Common Stockholder has voting rights, the right to share in corporate
earnings after
preferred stockholder, preemptive rights, and the rights to share in corporate
assets at time
of liquidation after creditors and preferred stockholders
-A Preferred Stockholder has the right to share in corporate earnings before a
common
stockholder and the right to share in corporate assets after creditors but before
common
stockholders
4. A) A stock which provides for the possibilities of dividends in excess of
the specific amount.
B) Stock on which the specified amount of dividend accumulated.
5. A) Stock whose preferential right to dividend is ordinarily limited to
specified amount.
B) Stock on which no accumulation of dividends is provided for.
6. A) On participating
7. B) On Non-cumulative
8. Net Income Br. 300000
Amount Retained 80000
Amount Distributed 220000
Preferred Stock Dividend (7% of 50 of 5000) 17500
Common Stock Dividend 202500
Dividend per share:
Preferred Stock (Br.17500 ÷ 5000) = Br. 3.50 per share
Common Stock (Br.202500 ÷ 50000 = Br. 4.05 per share
9. Net Income Br. 300000
Amount Retained 80000
Amount Distributed 220000
Preferred Stock Dividend: (7% of 50 of 5000 of 3) 52500
Common Stock Dividend 167500
Dividend per share:
Preferred Stock (Br. 52500 ÷ 5000) = Br. 10.50 per share
Common Stock (Br. 167500 ÷ 50000) = Br. 3.35 per share
10. PS Dividend CS
Dividend Total
Regular Dividend to PS(7%x50x5000) Br. 17,500
Br. 17,500
Comparable Dividend to CS(50000 x 3.50)
Br.175,000 175,000
Remainder to 55000 shares ratably
(220000-17500-175000 = 27500 ÷ 55000
= Br. 0.50 per share) 2500
25,000 27,500

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Total Br.20, 000

200,000 220,000
Dividend per share: Br. 4.00 Br. 4.00
(Preferred: 20000 ÷ 5000
Common: 200000 ÷ 50000)

CHECK YOUR PROGRESS 5.4

1. A) par, above par or below par

2. The financial condition, the earning power record, and the dividend record of the
corporation; its
potential earnings power; the availability of money for investment purposes and
general business
and economic conditions and prospects. .
3. Cash xxxxx
Preferred stock xxxxx
Common stock xxxxx
4. -Premium is the excess of the selling price over the par value of a share. It arises
when stock is
issued at above par value.
-Discount on stock is the excess of the par value of a stock over and above the
selling price of
the stock.
5. When a capital stock is issued in exchange for assets other than cash such as land,
building etc, the asset acquired should be recorded at their fair market price or at
the fair market prices of the stock issued. It is the board of directors that
determines the value to be assigned to the asset.
6. 1) Jan 1. Cash 26000
Common Stock 260000
Feb.1. Cash 420000
Preferred Stock 420000
2. Jan 1. Cash 260000
Common Stock 200000
Paid-In Capital in Excess of stated value 60000

Feb. 1 Cash 420000

Preferred stock 400000
Paid-In Capital in Excess of par 2000
7. April 20 :Common Stock Subscription Receivable 600000
Common Stock Subscribed 450000
Paid-In Capital in Excess of par 150000
July 3 Cash 300000
Common Stock Subscription Receivable 300000

July 31: Cash 300000

Common Stock Subscription Receivable 300000
Common Stock Subscribed 450000
Common Stock 450000

9. Feb. 10: Common Stock Subscription Receivable 290000

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Common Stock Subscribed 250000

Paid-In Capital In Excess of par 40000
Cash 58000
Common Stock Subscription Receivable 58000

March 1: Cash 116000

Common Stock Subscription Receivable 116000

May 1: Cash 116000

Common Stock Subscription Receivable 116000
Common Stock Subscribed 250000
Common Stock 250000

CHECK YOUR PROGRESS 5.5

1. For resale to employees

For re issuance, to employees, as a bonus
To support the market price of the stock
2. Should not be reported as an asset
Has no voting right
Does not have preemptive right
Does not participate in cash dividends
3. Cost basis method
4. Cash 30000
Paid-In Capital from sale of Treasury Stock 5000
Treasury Stock 25000
5. Cash 210000
Paid-In Capital from sale of Treasury Stock 30000
Treasury Stock 240000
6. A deduction from paid in capital and retained earnings

CHECK YOUR PROGRESS 5.6

1. Liquidation rights
Participating dividend
Cumulative Dividend
2. The ratio of stockholders’ equity to the related number of share of stock
3. Liquidation price per preferred stock
4. Earning capacity
Dividend rates
Prospective for the futures
5. 1. Total Stockholders’ Equity………………………………………….
Br1,000,000
Allocated to Preferred Stock at Liquidating price (120x2000)…….
240,000.
Allocated to Common Stock
760,000
Equity per share
Preferred Stock (Liquidation Price) Br. 120 per
share

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Common Stock (760000 /24000) 31.67

per share
2. Total Stockholders’ Equity Br. 1000000
Allocated to Preferred Stock
Liquidation Price (120 x 2000) = 240000
Dividend in arrears (15%x2000 x100) = 30000 270000
Allocated to Common Stock 730000
Equity per Share
Preferred Stock (Br. 270000 ÷ 2000) Br. 135.00 per share
Common Stock (Br. 730000 ÷ 24000) 30.42 per share

CHECK YOUR PROGRESS 5.7

1. Costs incurred in organizing a corporation
2. Intangible assets or an expense
3. for 60-months ( 5 years)
4. It is considered as an asset because it will continue indefinitely until the
enterprise goes
out of business

Reference:

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Fees and Warren. Principles of Accounting ,14 th and 16th Ed. Southwestern
Publishing company.

Niawonger and Fees, Accounting Principles, 11 th Ed, Southwestern Publishing

Company.

Jerry J. Weygandt, Financial Accounting , IFRS edition 2nd , John Wiley & Sons,
Inc
Donald E. Kieso, Jerry J. Weygandt, Terry D. Warfield, Intermediate
Accounting,14th Edition 2011
 commercial code of Ethiopia
 WWW.ifrs.org
 IFRS blue book
 IFRS Green book

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