Fundamentals of Accounting II

CHAPTER ONE

ACCOUNTING FOR INVENTORIES

The term inventory is used to express merchandises held for sale in the normal course of the business. Inventory
is considered as a current asset because it is normally expected to be sold within a year’s time or within a
company’s operating cycle. Merchandise inventory consists of all goods owned and held for sale in the regular
course of business. Manufacturing entities maintain other types of inventories: Raw Materials inventory, Work
in Process inventory and Finished Goods inventory.

Management of inventory is one of the most complex and challenging tasks. Inventory represents one of the
largest assets of a merchandising business. The amount of money tied up in inventory must be controlled because
of the high costs of borrowing funds and storing inventory.

A major objective of accounting for inventories is the proper determination of income through the process of
matching appropriate costs against revenues. Its emphasis is on proper determination of income through the
matching of costs and revenues, though the determination of the most realistic inventory value is also important.

The Effect of Ending Inventory on Financial Statements

The amount assigned to ending inventory has a direct effect on the net income. In effect, the value assigned to the
ending inventory determines what portion of cost of goods available for sale is assigned to cost of goods sold and
what portion is assigned to the balance sheet as inventory to be carried over into the next accounting period.
Decisions made regarding inventory usually result in different amounts of reported income. For instance, if ending
inventory is overstated in year 1, it will have effect on the following accounts in year 2:
 Beginning inventory is over stated
 Cost of goods sold is over stated
 Net income is understated
To prepare the proper financial statement, due care has to be given while determining inventory. If we have failed
to determine the inventory properly, its effect distorts all financial statements.
Example:
The first set of statements is based on a correct ending inventory of $60,000. The second set, on an incorrect
ending inventory of 50,000. The third set, on an incorrect ending inventory of 70,000
In all three cases, net sales are 980,000, merchandise available for sale is $705,000, and operating expenses are
$100,000.
Correct ending inventory balance of $60,000
Income statement for the year Balance Sheet at the end of the year
Net sales……………………980,000 Merchandise inventory………. .$60,000
Cost of goods sold………645,000 Other asset……………………..340,000
Gross profit………….....$335,000 Total asset…………..………….400,000
Expenses…………………….100,000 Liabilities……………..120,000
Net income………235,000 Owners equity………280,000
Total ……………………400,000

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 Fundamentals of Accounting II

Incorrect ending inventory balance of $50,000

Income statement for the year Balance Sheet at the end of the year
Net sales……………………..980,000 Merchandise inventory……..…. .$50,000
Cost of goods sold…………..655,000 Other asset…………….….…….340, 000
Gross profit…………......$325,000 Total asset……………..…...…. 390,000
Expenses…………………….100,000 Liabilities……………………………120,000
Net income………………225,000 Owners equity……………………270,000
Total ………………………390,000

Incorrect ending inventory balance of $ 70,000

Income statement for the year Balance Sheet at the end of the year
Net sales……………………..980,000 Merchandise inventory………. .$70,000
Cost of goods sold…………..635,000 Other asset……………..……….340, 000
Gross profit…………......$345,000 Total asset……………..…...… 410,000
Expenses…………………….100,000 Liabilities…………………………120,000
Net income………………245,000 Owners equity……………………290,000
Total ………………………410,000

Exercise 1.1 Saron Hardware reported cost of goods sold as follows.

2020 2021
Beginning inventory Br. 27,000 Br. 40,000
Cost of goods purchased 200,000 235,000
Cost of goods available for sale 227,000 275,000
Ending inventory 40,000 45,000
Cost of goods sold Br.187,000 Br.230,000
Saron has made two errors: (1) 2020 ending inventory was overstated by Br.6, 000, and (2) 2021
ending inventory was understated by Br.11,000.
Required: Compute the correct cost of goods sold for each year.
Inventory systems
Inventory systems are alternative ways of collecting and recording information about cost of goods sold and cost
of goods available for sale. There are two types of inventory systems:
o Periodic inventory system.
o Perpetual inventory system.
Periodic inventory system
This method requires updating the inventory account only at the end of the year to reflect the quantity, and cost
of goods available for sale and sold. It does not require continual updating of the inventory account. The cost of
merchandise is recorded in temporary purchase account.
When company sells merchandise, it records revenue only, not both revenue and cost of goods sold. Instead, when
it prepares financial statements, the company takes a physical count of inventory by counting the quantities of
merchandise available. Then, the cost of existing merchandise is computed by linking the quantities counted to
the purchase records that show each item’s original cost. The cost of merchandise available is then used to
compute cost of goods sold. The inventory account is then adjusted to reflect the amount computed from the
physical count of inventory.

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 Fundamentals of Accounting II

Perpetual inventory system

It keeps continual record of the amount of inventory available. It accumulates the net cost of merchandise purchase
in inventory account and subtracts the cost of each sale from the same inventory account. When a company sales
an item, both its revenue and cost are recorded. Under this system at any time, the balance of inventory is known
just by referring to the inventory account i.e. no need to count as we need to do under periodic system. Similarly,
the balance of cost of goods sold is determined any time by looking at cost of goods sold account.
An inventory valuation involves two major consecutive activities. These are:
A. Taking physical inventory
B. Costing the physical inventory.
A. Taking physical inventory
This includes activities of counting, measuring and weighting to determine quantity of inventory. While counting,
the all inventory that the company owns as of inventory date should be incorporated in the counting. Goods in
transit and on consignments should be properly considered while taking physical inventory.
Merchandises in Transit
Inventories, which are not in the physical possession of the buyer or seller, are said to be merchandises in transit.
These merchandises should be incorporated in the inventory of the party that has ownership right on it. Ownership
of goods in transit is determined based on the shipping agreement, which indicates whether title has passed.
• Outgoing goods (sold and in transit):
• Shipped under FOB destination would be included in the inventory.
• Shipped under FOB shipping point would not be included in the inventory.
• Incoming goods (purchased and in transit):
• Shipped under FOB destination would not be included in the inventory
• Shipped under FOB shipping point would be included in the inventory
In addition to this, if the company (consignor) has sales agent (consignee), unsold goods on the hands of
consignees have to be incorporated in the inventory of the company (consignor).

The title of ownership on goods held on consignment remains with the consignor until the consignee sells the
goods and the goods must not be included in the physical inventory of the consignee; rather they have to be
included in the inventory of consignor.
B. Costing the physical inventory.
Dear colleagues! The primary basis of accounting for inventories is cost, which is generally defined as the price
paid to acquire the assets. Inventory cost includes:
– Invoice price less purchase discounts.
– Freight or transportation cost.
– Taxes
– Insurance while in transit
Prices of merchandise purchased vary throughout the year. Many identical products are be purchased at different
prices. It is often impossible to determine which products have been sold and which are still in inventory. It is
necessary to make an assumption about the order in which items have been sold. The assumption is about the
flow of costs rather than the flow of physical inventory. These assumptions will be discussed in the following
part.

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 Fundamentals of Accounting II

Methods of Inventory costing (Inventory flow assumption):

The first activity in the inventory determination is taking physical inventory or determining goods available in
terms of quantity. Then to prepare financial statements, the determined quantities have to be costed. Therefore,
inventory-costing methods are all about converting determined quantities to costs. There are four possible
inventory cost flow assumptions:
a) Average-cost method.
b) First-in, first-out method.
c) Last in, first-out method.
d) Specific identification method.
Average-Costing Method:
It assumes that cost should be charged against revenue according to the weighted average unit cost of the goods
sold. The same unit cost or average unit cost is computed for all inventory items available for sale during the
period. As per the assumption, cost of goods sold is computed by multiplying the number of units sold by the
average unit cost. Similarly, the cost of ending inventory is computed by multiplying the number of units in
ending inventory by the average unit cost.
Average unit cost is computed by dividing total cost of goods available for sale for total quantities available for
sale.
First-In, First-Out (FIFO) Method
It assumes that inventory items purchased first are sold first. Therefore, inventories (unsold merchandises) are
from recent purchases and earliest purchases are transferred to cost of goods sold. To obtain cost of ending
inventory, take the unit cost of most recent purchase and go upward until all units of inventory are fully costed.
Last In, First-Out (LIFO) Method
It assumes that last purchases are the one to be sold first. Thus, inventories of earliest purchases are kept as ending
inventory and costs of goods sold are from recent purchases. To determine the cost of ending inventory, take the
unit cost of earliest purchase and go downward until all units of inventory are fully costed.
Illustrative Data for the three Methods:
Assume the following information for WW Trading.
Data –for the month of June
June1: Inventory 50 units @ Br1.00 = Br50
June 6: Purchase 50 units @ Br 1.10 = 55
June 13: Purchase 150 units @ Br 1.20 = 180
June 20: Purchase 100 units @ Br 1.30 = 130
June 25: Purchase 150 units @ Br 1.40 = 210
GAFS * 500 units Br 625
Sales 280 units
On hand June 30: 220 units
* Goods available for sale
Periodic Average method
Average unit cost = Br 625
500 units
= Br 1.25 per unit
Ending Inventory:
220 units @ Br 1.25 = Br 275
Cost of goods sold (COGS):
280 units @ Br 1.25 per unit = Br 35 Or

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 Fundamentals of Accounting II

COGS = Cost of goods available for sale - Ending Inventory

Cost of goods available for sale (COGAFS) Br 625
Less: June 30 inventory 275
COG S Br 350
Periodic First-In, First-Out (FIFO) Method
Ending Inventory
150 units @ Br 1.40 from June 25 purchase Br 210
70 units @ Br Br1.30 from June 20 purchase 91
220 units @ a cost of Br 301
Cost of goods sold
Cost of goods available for sale Br 625
Less: June 30 inventory 301
COGS Br 324
Periodic Last-In, First-Out (LIFO) Method
Ending Inventory
50 units @ Br 1.00 from June 1 inventory Br 50
50 units @ Br 1.10 from June 6 purchase 55
120 units @ Br 1.20 from June 13 purchase 144
220 units Br 249

Cost of goods sold

Cost goods available for Br 625
Less: June 30 inventory 249
COGS Br 376
Costing Inventory under the Perpetual Inventory System
Use the following data to illustrate inventory costing under perpetual inventory system using three cost flow
assumptions.
Inventory Data for the month of June.
June 1: Inventory 50 units @ Br 1.00
6: Purchase 50 units @ Br 1.10
10: Sale 70 units
13: Purchase 150 units @ Br Br1.20
20: Purchase100 units @ Br Br1.30
25: Purchase150 units @ Br 1.40
30: Sale 210 units
30: Inventory 220 units
Perpetual Average method
Under perpetual system costing system, since continual record is kept for merchandise transactions, new average
cost is computed after each purchase, rather than at the end of the period. This average unit cost is then used to
determine the cost of each sale until another purchase is made and new average cost is computed. Thus the method
is also called moving average method.

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 Fundamentals of Accounting II

Date Purchase Cost of goods sold Inventory

Quantity Unit Total Quantity Unit Total Quantity Unit Total
cost cost cost cost cost cost
Jun1 50 1 50
6 50 1.1 55 100 1.05* 105
10 70 1.05 73.5 30 1.05 31. 5
13 150 1.2 180 180 1.175 211.5
20 100 1.3 130 280 1.21 341.5
25 150 1.4 210 430 1.28 551.5
30 210 1.28 268.8 220 1.28 281.6
* 50+55 = 1.05
50+50
Cost of goods sold (268.8 +73.5) = Br Br342.3
Cost of Ending inventory = Br 281.6
Perpetual FIFO method

Date Purchase Cost of goods sold Inventory

Quantity Unit Total Quantity Unit Total Quantity Unit Total
cost cost cost cost cost cost
Jun1 50 1 50
6 50 1.1 55 50 1 50
50 1.1 55
10 50 1 50
20 1.1 22 30 1.1 33
13 150 1.2 180 30 1.1 33
150 1.2 180
20 100 1.3 130 30 1.1 33
150 1.2 180
100 1.3 130
25 150 1.4 210 30 1.1 33
150 1.2 180
100 1.3 130
150 1.4 210
30 30 1.1 33 70 1.3 91
150 1.2 180 150 1.4 210
30 1.3 39

Cost of goods sold (50+22+33+180+39) =Br324

Ending inventory (91+210) =Br301

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 Fundamentals of Accounting II

Perpetual LIFO

Date Purchase Cost of goods sold Inventory

Quantity Unit Total Quantity Unit Total Quantity Unit Total
cost cost cost cost cost cost
Jun1 50 1.00 50.00
50 1.00 50.00
6 50 1.10 55 50 1.10 55.00
10 50 1.10 55 30 1.00 30.00
20 1.00 20
13 30 1.00 30.00
150 1.20 180 150 1.20 180.00
20 30 1.00 30.00
150 1.20 180 150 1.20 180.00
100 1.30 130 100 1.30 130.00
25 30 1.00 30.00
150 1.20 180.00
100 1.30 130.00
150 1.40 210 150 1.40 210.00
30 150 1.40 210 30 1.00 30.00
60 1.30 78 150 1.20 180.00
40 1.30 520.00
Cost of goods sold will be (55+20+210+78) =Br363

Cost of ending inventory will be (30+180+52) =Br262

Activity 1.2
Jack’s Appliances uses a perpetual inventory system for its flat-screen television sets. The
January 1 inventory was 3 sets at Br500 each. On January 10, Jack has purchased 6 units at
Br640 each. The company sold 2 units on January 8 and 4 units on January 15.
required:
Compute the ending inventory under (1) FIFO, (2) LIFO, and (3) average-cost

Specific Identification Method

Unlike other cost flow assumptions Specific Identification Method is the method where each item of inventory is
identified with its actual cost any time. In other words, each unit sold and unit on hand at the end of the period
matches with its actual cost. Although such a method might be possible for a business enterprise handling a small
number of items, for example, an automobile dealer, it becomes completely impossible in a complex
manufacturing enterprise when the identity of the individual item is lost. This method identifies unit cost of both

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 Fundamentals of Accounting II

item sold on the date of sale and items remaining in inventory. Therefore, specific identification method relates
physical flow with the cost flow.
Even when specific identification is a feasible method of valuation, it may be desirable from theoretical point of
view. The method permits income manipulation when there are identical items acquired at different unit price. In
other words by choosing to sell the items that were acquired at specific cost, the management may cause material
distortions in income.
Comparison of inventory costing methods
A business must be consistent in its use of a method once it has made a choice. Using FIFO costing method in
the periods of rising prices may cause a business to report more than their true profit and pay more income taxes.
Because as per FIFO assumption ending inventories are from the recent purchases that are of higher price.
Therefore, during inflation FIFO resulted to higher ending balance of inventory. The higher is the ending
inventory, the lower is the cost of goods sold, and the lower is the cost of goods sold, the higher is the net income.
The higher is the net income the higher the income tax. Hence, during inflation the business may have a tendency
of using LIFO to value inventory for its lower income tax. The reverse is true during the period of declining price
or deflation.
Valuing Inventory at Other than Cost
Lower-of-Cost-or-or Net Realizable Value (LCNRV)
In the inventory valuation, cost is usually the most appropriate basis for valuation of inventory. Nevertheless, the
inventory may be valued at lower of cost or market when inventories are declined in price level. This loss may be
recognized by writing the inventory down to market, or current replacement cost. As per the method, both market
value and cost of an item are compared and the item is valued at the lower of the two.
Example:

LCNRV
Description NRV Cost
Item A 3800 4100 3800
Item B 3000 2700 2700
Item C 4650 4800 4650
Item D 3920 3920 3920
Total 15,370 15520 15,070
Valuing Inventory by Estimation
Under periodic inventory system, inventories are estimated when interim financial statements are to be prepared.
Since inventory counting and determining actual inventory balance is time consuming, costly and difficult task,
we may be forced to estimate inventory on hand. In addition to this, if it is impossible to determine actual
inventory, again we may estimate inventory. This is the case where inventories are lost by hazards like theft, fire
and the like. There are two methods of estimating inventory balance: these are the retail and gross profit methods
of valuing inventories.
Retail Method
This method estimates the cost of ending inventory by using the ratio of cost to retail price. Inventory at retail is
the amount of the inventory at the marked selling prices of the inventory items. To estimate inventory using this
method, the following information is required:
• The beginning inventory at cost and at retail.
• The amount of goods purchased during the period both at cost and at retail.
Estimated ending inventory is then, inventory at retail multiplied by cost to retail ratio.

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 Fundamentals of Accounting II

Example:
Dan’s Shoe Store uses the retail inventory estimation method to value its ending inventory. The following were
summarized on Dec31, 2020
Beginning inventory at cost …… Br Br 40,000
Cost of goods purchased at cost …….. 100,000
Net sales ……………………………. 165, 000
Beginning inventory at retail ………… 57,000
Cost of goods purchased at retail … 143, 000
Required:
Estimate ending inventory at cost using the retail method.
Solution
Cost Retail

Beginning inventory …………………..Br 40,000 Br 57,000

Add: Cost of goods purchased ………… 100,000 143,000
Merchandise available for sale Br 140,000 Br 200,000
Cost to retail ratio: 140,000 =70%
200,000
Less: Net sales …………………………………………………..165,000
Merchandise inventory at retail………………………….... …Br 35,000
Estimated inventory at cost
(35,000 X0.7)…………………………………………… ... . Br 24,500
2. Gross Profit Method of Estimation
This method assumes that the ratio of gross margin for a business stays relatively stable year-to-year. Usually, it
is used in place of the retail method when records of the retail prices of beginning and purchases are not kept.
Inventory balance estimated using this method is acceptable for interim financial statements, but not acceptable
for annual financial statements. In addition, it is used to estimate value of inventory lost in cases of fire, theft, or
other hazards.
Example:
Assume That on March 1 the entire inventory of Firaol Company was destroyed by fire. The records of the
company revealed the following data:
Sales Br 105,000, Sales Returns and Allowances Br 5,000, Purchases Br 62,000, Freight-in Br 2,000, and
Purchase Returns and Allowances Br 1,000.
Required:
Estimate the merchandise lost by fire, assuming: A beginning inventory of Br30,000 and a gross profit rate of
40% on net sales.
solution
Beginning inventory................................................ Br 30,000
Purchase………………….62, 000
Less: purchase return…….. 1000
Net purchase…………………………61,000
Add: fright in……………………….... 2000
Cost of goods purchased………………………… 63, 000
Cost of goods available for sale…………………. 93, 000
Net sales……………………… 100,000

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 Fundamentals of Accounting II

Less: gross profit (100,000x.4)… 40,000

Estimated cost of goods sold……………………... 60,000
Estimated inventory destroyed by fire………….. Br 33,000

Exercise 1.3
Dobby Gillis Company reported the following information for the months of
November and December 2021.
November December
Cost of goods purchased Br 600,000 Br 700,000
Inventory, beginning-of-month 140,000 100,000
Inventory, end-of-month 100,000 ????
Sales 1,000,000 1,200,000
The company’s ending inventory at December 31 was destroyed by fire.
Instructions
(a) Compute the gross profit rate for November.
(b) Using the gross profit rate for November, determine the estimated cost of
inventory by fire during the month of December.

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 Fundamentals of Accounting II

CHAPTER TWO
PLANT ASSETS, NATURAL RESOURCES AND INTANGIBILE ASSETS
Classifications of long-lived assets typically found on a balance sheet are:
 Property, plant, and Equipment
 Natural resources
 Intangibles - are used in the operation of the business, but lave no physical substance eg.
Patent, Goodwill,
Fixed (plant) Assets – are tangible long-lived resources that are used in the operation of the business & are not
intended for sale to customers.
Unique features of fixed (plant) assets are:
 Long lived - useful for longer than a year, and permanent in nature
 For use - Not for sale
 Tangible - can be seen & founded, they have physical existence.

Determining the cost of plant assets

Plant assets are recorded at cost in accordance with the cost principle of accounting. Cost consists of all
expenditures necessary to acquire the asset & make it ready for its intended use. For example the purchase, price,
freight costs paid by the purchaser & installation costs are all considered part of the cost of factor machinery.
Thus, all reasonable & necessary costs incurred to get an asset in position & condition ready for use may be
included as part of the cost of the asset.
Some of the common acquisition costs for property, plant and equipment assets are:
Land - is an asset that is considered to have unlimited useful life. It includes costs such as, Purchase price, sales
taxes, permits from government agencies broker’s commissions, title fees, surveying fees, razing or
removing unwanted buildings less any salvage, grading & leveling, paving a public street bordering the
land.
Example:
A business enterprise acquired a piece of land for future construction site. It paid a cash price of Br. 210,000, paid
brokerage fees of Br. 7500 and title fees of Br. 3000, paid Br. 5000 to have unwanted building removed, and Br.
1500 to have the site graded. The business received Br. 2000 salvage from the old building. The cost of the land
is determined as follows:
Cash prices (negotiated price)………………………………………… Br 210,000
Title Fees………………………………………………………………...Br 3,000
Brokerage Fees………………………………………………………......Br 7,500.00
Cost of Grading………………………………………………………..…Br 1,500.00
Cost of removing (demolition) unwanted building Br. 5000
Less: Salvage received……………………..(2000) 3,000.00
Total cost of land………………………………………………Br. 225,000.00

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 Fundamentals of Accounting II

Building - costs of Architect's fees, Engineer's fees, insurance costs incurred during construction, interest on
money borrowed to finance construction, modifying for use, walk way to & around the building.
Machinery & equip – Purchase price, freight costs, installation and testing costs, insurance while on transit,
taxes.
Land improvement - Cost of trees & shrubs, fences, outdoor lighting, paved parking areas and soon.
To illustrate, assume ABC Co. orders a machine at a list price of Br. 10,000 with terms of 2/10, 2/30, sales tax of
Br. 588 must be paid, as well as fright charges of Br. 1,250. Transportation from the rail road station to the factory
costs Br. 150 & installation labor amounts, to Br. 400. One employee with a salary of Br. 800 operates the machine
and the salary paid for the first month of operation was Br. 800. Cost of maintenance materials needed during the
first month of operation was Br.25. Repair cost of Br. 2,000 was paid for damage occurred during unpacking and
installing.
List price of the Machine 10,000
Less cash discount ( 2% x Br. 10,000) 200
Net cash price 9,800
Sales tax 588
Freight 1,250
Transportation 150
Installation labor 400
Cost of machine Br. 12,188.00
The salary of employee is not part of the acquisition cost because it is incurred after the machine become
operational.
The acquisition of the machine is then recorded as follows:

Machinery………………………………………12,188
Salary expense…………………………………..800
Maintenance expense……………………………25
Loss due to employee negligence……………….2,000
Cash…………………………………………………15,013
(To record the acquisition of a machine)
Costs not necessary for getting a fixed asset ready for use don't increase the asset’s usefulness. Such costs should
not be included as part of the asset's total cost.
 Mistake in installation eg. Repair cost incurred which is not covered under insurance Uninsured theft
 Damage during unpacking & installing
 Fines for not obtaining proper permits from government agencies
These costs of such items should be debited to an expense not to the asset account

Lump-sum acquisition
A lump-sum purchase occurs when more than one type of assets is acquired in a single transaction. The lamp-
sum purchase price then must be allocated equitably to the individual components. The most common method of
allocation is based on the relative fair market value of the individual assets.

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 Fundamentals of Accounting II

To illustrate, assume Delta Co. acquired Land, Building & Machinery from ABC Co. for Br. 1,000,000. A
professional appraiser valued each of the assets at the appraised fair mkt. Prices: Land, Br. 800,000; Building
Br560,000 & Machinery Br 240,000. The Br. 1,000,000 is allocated among the assets as follows:

Asset Appraised Fair Percent of Total Appraised Value Purchase Price Cost Allocated to Assets
Market value
Land Br. 800,000. Br.800, 000 / 1, 600,000. = 50% 50% x 1,000,000. Br. 500,000.
Building 560,000. 560, 000 / 1, 600,000. = 35% 35% x 1, 000,000. 350,000.
Machinery 240,000. 240, 000 / 1, 600,000. = 15% 15% x 1, 000,000. 150,000.
Total 1,600,000. 100% 1,000,000.

The entry to record the lump-sum purchase:

Land 500,000
Building 350,000
Machinery 150,000
Cash 1,000,000
(To record acquisition of land building & machinery)

Concept of Depreciation
Depreciation- is the process of allocating the cost of a plant asset over its useful (service) life in a rational and
systematic manner. The basic purpose of depreciation is to provide the proper matching of expense
with revenues in accordance with the matching principle.
 Depreciation is a process of cost allocation, not a process of assets valuation. Accountants make no
attempt to measure the change in an assets mkt. value during ownership, because plant assets are not held
for resale.
 Depreciation does not mean that the business sets aside or accumulates cash to replace assets as they
become fully depreciated. Establishing such a cash fund is decision entirely separate from depreciation.
Accumulate depreciation is that portion of the plant asset's cost that has already been recorded as expense.
Causes of Depreciation
The two major causes of depreciation are physical deterioration & obsolescence.
a. Physical Deterioration – occurs from wear & tear while in use as well as from the action of the weather
(exposure to sun, wind, and other climatic factors)
b. Obsolescence (Function Depreciation) - is the process of becoming out of date before the assets physically
wears out.
In todays rapidly advance in technology, obsolescence is a more important consideration than physical
deterioration. E.g. a personal computer made in the 1980's would not be able to provide an Internet connection.
Assets like computers, other electronic equipment & airplanes may become obsolete before they physically
deteriorate. An asset is obsolete when another asset can do the job better or more efficiently.
Depreciation Methods
There are several alternative methods of computing depreciation. A business need not use the same method of
depreciation for all its various assets.

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 Fundamentals of Accounting II

Depreciation is computed using one of the following different methods:

1. Straight line method
2. Units of output method
3. Declining balance method
4. Sum-of-the-years’-digits method
Depreciation affects the Balance sheet reports through the account of accumulated depreciation, as well as the
Income statement through the account of depreciation expense. Thus, its proper accounting and record is
imperative for financial reporting.
Three factors affect the computation of depreciation:
a. Cost - is the initial cost incurred in acquiring the asset. Cost is measured in accordance with the cost principle
of accounting. Cost is objective fact.
b. Useful Life - is an estimate of the expected productive life, also called service life, of the asset. Useful life
maybe expressed in term of time, units of activity such as machine hours, or in units of output.
c. Salvage Value - also called scrap or residual value is an estimate of the asset's value at the end of its useful
life.
o The full cost of a plant asset is depreciated if the asset is expected to have no residual value.
o The plant assets cost minus its estimated residual value is called the depreciable cost.

1. Straight - Line Method

Under the Straight - Line Method, an equal portion of the cost of the asset is allocated to each period of use;
consequently, this method is most appropriate when usage of an asset is fairly uniform from year to year.
 The Straight Line Method is the simplest & most widely used method of computing depreciation.
 The Straight Line Method depreciation assumed that a business receives equal benefits from an
asset each day of the asset's life. Straight Line, then, allocates an equal part of the total cost to each
day of an asset's useful life.
To illustrate, assume a delivery truck has a cost of Br.17, 000 a residual value of Br 2,000 and an estimated useful
life of five years. The annual computation of depreciation exp. will be as follows:
Straight - Line depreciation per year = Cost - Residual value
Useful life in years
Br. 17,000.00 - Br. 2,000.00
5
Br. 3,000.00
Depreciation Schedule – Straight-line method
Depreciation
Depreciable Rate Depreciation Accumulated
Year Expense Depreciation Book value
Cost

Cost
st
1 15,000. 20% Br. 3,000. Br. 3,000. Br. 17,000.
2nd 15,000. 20% 3,000. 6,000. 11,000.

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 Fundamentals of Accounting II

3rd 15,000. 20% 3,000. 9,000. 8,000.

4th 15,000. 20% 3,000. 12,000. 5,000.
5th 15,000. 20% 3,000. 15,000. 2,000.
15,000.
In the illustration, it was assumed that the asset was acquired on Jan. 1, the beginning of the accounting period.
If the asset had been acquired during the year, on October 1, it would have been in use for only 3 months, or 3/12
of a year. Then, the deprecation expense for the three months would be computed as follows:
Depreciation on December 31 = Br. 15,000.00x20% x 3/12 = 750
The straight-line method predominates in practice. It is simple to apply, & it matches expenses with revenues
appropriately when the use of the asset is reasonably uniform throughout the service life.

2. Unit of Output Method

This method is used for assets whose useful life is limited by physical wear- and -tear rather than obsolescence.
The asset life is expressed in expected units of output, such as hours, miles, or number of units. This method is
appropriate when the service of a fixed asset is related to use rather than time. It is based on the assumption that
an asset depreciates only as it is used. Thus the asset life is expressed in expected units of output such as miles,
To illustrate, assume that the delivery truck in the previous example has an estimated useful life of 100,000 miles,
and in the first year of its usage it is driven 15,000.00 miles. The depreciation for the first year, is then computed
as follows:
Depreciation Per unit of output = Cost - Residual Value
Est. Units of Output (Miles

Br. 17,000. - Br. 2,000.

100,000 Miles
Br. 0.15 Dep. per mile
In the units-of-output method, a fixed amount of depreciation is assigned to each unit of output produced or each
unit of capacity used by the plant assets.
Year 1 depreciation exp. = Br. 0.15 x 15,000miles
= Br. 2,250
Year 1 depreciation exp. = Br. 0.15 x 7,000miles
= Br. 1,050
So, when the amount of use of a fixed asset varies from year to year, the units- of – output method is more
appropriate than the straight –line method. In such a case, the units-of-output method better matches the expense
with related revenue.

3. Declining Balance Method

The basic idea behind the declining balance method is that more service benefits are received in the early years
of an asset's life when it is new, & fewer benefits are received each year as the asset grows older. So this method
assigns more (greater) depreciation exp. to the early years of the asset's life & less to later ones.

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 Fundamentals of Accounting II

To illustrate, consider the previous e.g. of the Br. 17,000 delivery truck.
To depreciate the truck by the double declining balance method, we double the straight-line rate of 20% & apply
the doubled rate of 40% to the book value at the beginning of each year.

Depreciation Schedule Declining Balance Method

Year Computation Annual Dep. exp. Accumulated Book

Book Value Depreciation Depreciation Value
Beg. Of year Rate
0 - - - - Br. 17,000.

1st Br. 17,000. 40% Br. 6,800. Br. 6,800. 10,200.

2nd 10,200. 40% 4,080. 10,880. 6,120.
3rd 6,120. 40% 2,448. 13,328 3,672.
4th 3,672. 40% 1,469. 14,797. 2,203.
th 2,203. 40% 203. 15,000 2,000.
5

 The declining balance method produces a decreasing annual depreciation expense over the useful life of
the asset.
 The method is so named because computation of periodic depreciation is based on a declining book value
(cost less accumulated. depreciation) of the asset.
 The depreciation rate remains constant from year to year, but the book value to which the rate is applied
declines each year.
 Unlike the other depreciation methods, salvage value is ignored in determining the amount to which the
declining balance is applied. Salvage value, however, does limit the total depreciation that can be taken.
Depreciation stops when the asset's B.V. equals expected salvage value.
 Because the declining balance method produces higher depreciation expense in the early years than in the
later years, it is considered an accelerated depreciation method.
If the asset has been acquired on October 1, rather than on January 1, depreciation for only 3 months would be
computed as follows:
40% x Br. 17,000.00 x 3/12 = Br. 1,700
For the next year, the calculation would be, 40% x (17,000 -1,700) =Br. 1,620

4. Sum of the years Digits method

Like the declining balance method, the sum of the year's digit allocates a large portion of the asset cost to the
early years of its use as accelerated depreciation method. The depreciation rate to be used is a fraction, of which
the numerator is the remaining years of useful life (as of the beginning of the year) & the denominator is the sum
of the individual years that comprise total service life.
SYD is an appropriate method for assets that provide more service benefits in the early years of their lives & less
in later years. Many assets are efficient when first purchased but become less efficient as time passes. This

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 Fundamentals of Accounting II

decrease in utility may be caused by technological obsolescence or by accumulated effects of physical wear and
tear. Copying machines & computer are examples of assets that are depreciated by an accelerated depreciation
method
Consider again the example of the delivery truck costing Br. 17,000 having an estimated life of Five (5) years &
an estimated residual value of Br. 2,000.

First the sum of the digits of the years of the asset’s useful life has to be determined through a short cut formula.
Sum of the digits = n (n+1), where n is number of years in the assets life
2
5- Years sum of the digits = 5(5+1) = 5 (3) = 15
2
Computation Annual Dep. Accumulated Book
Year Depreciable SYD exp. Depreciation Value
Cost Fraction
0 - - - - Br 17,000.00
1st Br. 15,000. 5/15 Br. 5,000. Br. 5,000. 12,000.00
2nd 15,000. 4/15 4,000 9,000. 8,000.00
3rd 15,000. 3/15 3,000. 12,000. 5,000.00
4th 15,000. 2/15 2,000 14,000. 3,000.00
5th 15,000. 1/15 1,000. 15,000. 2,000.00
Br.15,000.

If the truck was acquired on Oct 1, since the asset was in use for only 3 months during the first accounting period,
the depreciation to be recorded in the 1st period will be for only 3/12 of a full year. i.e.
3/12 x Br.5, 000. = Br.1, 250
For the second year, Br.15, 000 x 5/15 x 9/12 = Br. 3,750
15,000 x 4/15 x 3/12 = 1,000
Total 4,750
Third year, Br.15, 000. x 4/15 x9/12 = 3,000
Br.15,000. x 3/15 x3/12 750
Total Br. = 3,750

Comparison of the Depreciation Methods

Unit- of- Declining Sum of the years
Year Straight Line output Balance digit
1st Br. 3,000 Br. 2,250 Br. 6,800. Br. 5,000.
2nd 3,000. 1,050. 4,080. 4,000.
3rd 3,000. 3,750 2,448 3,000.
4th 3,000 7,500. 1,469. 2,000.
5th 3,000 450. 203. 1,000.
Br. 15,000 Br. 15,000 Br. 15,000 Br. 15,000.

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 Fundamentals of Accounting II

A comparison of annual & total depreciation expense under each of the four methods is shown above. The yearly
amount of depreciation varies by method, but the total Br. 15,000 depreciable cost becomes total expense under
all four methods.

Revision of periodic Depreciation

Since depreciation involves estimation of useful life & salvage value of an asset, whenever a business learns a
change in the original estimation, the annual depreciation expense needs to be revised. If wear & tear or
obsolescence indicates that annual depreciation is inadequate or excessive, a change in the periodic amount should
be made. When a change in an estimate is required, the change is made in current & future years but not to prior
periods.
To determine the new annual depreciation expense, we compute the depreciable cost at the time of the revision
& divide it by remaining useful life.
To illustrate, assume that a fixed asset purchased for Br. 130,000 was originally estimated to have a useful life of
30 years & a residual value of Br. 10,000. The asset has been depreciated for 10 years by the straight-line method.
During the eleventh (11th) year, it is believed that the remaining useful life is 25 years (instead of 20) because of
its excellent condition, and that the residual value is Br. 5,000(rather than Br. 10,000).
Book Value at the end of 10 years:
Asset cost Br. 130,000
Less: Accum. Deprec. (130,000 -10,000) x 10 years = 40,000
30
Book value (un depreciated cost), end of 10th year = Br. 90,000
Depreciation expense for current & future periods:
Book value end of 10th years Br. 90,000
Less: revised estimated residual value 5,000
Revised remaining depreciable cost 85,000
Revised annual depreciation expense 85,000/ 25 = Br. 3,400

The financial statements of past periods are not revised to reflect changes in the estimated useful lives of
depreciable cost.
Capital Expenditure Versus Revenue Expenditure
The difference between these two types of expenditure can be summarized as follows:
Capital Expenditure Revenue Expenditure
 Increases the operating efficiency, productive - Merely maintains its existing condition or
Capacity, or extend the useful life of the plant assets restore the asset to good working order
 Material in amount and occur infrequently - Fairly small amounts that occur frequently

 Benefits more than one accounting period - Primarily benefits one (the current accounting)
Period

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 Fundamentals of Accounting II

 Such expenditures are debited to the asset - Such costs are debited to expense account
account or to the related accumulated
depreciation account

Examples of Capital Expenditures

Additions – an addition generally results in a larger physical unit and increased productive capacity. Additions are
debited to the asset account to which the expenditure pertains. E.g- cost of adding an air conditioning, major
engine overhaul.
Betterment/Improvements: may result in replacement of a subunit of a productive asset with a new unit. E.g. a
factory machine with a l0 h.p. electric motor may be improved by replacing the
motor in a 15 h.p. motor. The cost of the new unit should then be debited to the
machine account.
Extra Ordinary Reports – an expenditure that increases the useful life of an asset beyond its original estimate
is called an extraordinary repair. Such expenditure should be debited to the
related accumulated depreciation account. In such cases, the repairs are said to be
restore or make good a portion of the depreciation recorded in years. The
depreciation for future periods should be computed on the basis of the revised
book value of the asset and the revised estimate of the remaining unequal life.

To Illustrate, assume that a machine costing Br. 50,000 has no estimated residual value and an estimated useful
life of 10 years. Assume also that the machine has been depreciated for 6 years by the straight-line method. At
the beginning of the seventh year, an extra ordinary repair of Br. 11,500 increases the useful life of the machine
to 7 years (instead of four). The annual depreciation for the remaining 7 years of use would be 4,500, computed
as follow:

Cost of machine --------------------------------------------- Br. 50,000

Less: Accumulated Depreciation Balance:
Depreciation for 6 years (Br.5, 000x6) Br.30,000
Deduct: debit due to extra ordinary repairs 11,500
Balance of Accumulated depreciation ----- 18,500
Revised Book Value of machine after extra ordinary repair 31,500
Annual Depreciation (31,500 ÷ 7, years remaining useful life) 4,500
The revised annual depreciation can also be computed through the following formula by first determining the
revised annual depreciation.
Computation of revised depreciable cost:
Book value prior Capital New Est. Revised
to capital expenditure Salvage Value Depreciable cost

20,000 + 11,500 - 0 = 31,500 ÷ 7 years = 4,500

To illustrate again, assume that Haben Co. makes a Br. 10,000 major repair to factory machinery. This capital
expenditure increases the remaining useful life of the machine to 5 years. In addition, the salvage value is

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 Fundamentals of Accounting II

expected to be Br. 4,000. The book value of the factory machine prior to the major repair is Br. 100,000. Under
the straight-line method, the new annual depreciation for the remaining five years of useful life is Br. 21,200
computed as shown below:

Book value prior to capita expenditure --------------- Br. 100,000

Add: Cost of capital expenditure ----------------------- 10,000
Book value after capital expenditure -------------------- 110,000
Less: New estimated salvage value -------------------- 4,000
Revised depreciable cost --------------------------------- 106,000
Remaining useful life -------------------------------------- ÷ 5
Revised Annual depreciation Br. 21,200

Depreciation Expense -------------------------- 21,200

Accumulated depreciation ------------ 21,200
Effects of Error in Distinguishing between capital and Revenue expenditure
Treating a capital expenditure as revenue expenditure or vice versa creates errors in the Financial Statement.
Suppose a company makes an extraordinary repair to equipment and erroneously expenses this cost. It is a capital
expenditure that should have been debited to an asset account. This accounting error overstates expenses and
understates net income on the income statement. On the balance sheet, the asset (equipment) account is
understated and so is owner’s equity.
On the other hand, capitalizing the cost of an ordinary repair creates the opposite error. Expenses will be
understated and net income will be overstated on the income statement. The balance sheet reports overstated
amounts for assets and owners equity.
These examples indicate that a careful destruction between capital and revenue expenditures is essential to the
attainment of one of the most fundamental objective of accounting - the determination of accurate net income for
each year of operation of a business.

Disposal of Plant Asset

Eventually, a plant asset ceases to serve a Company’s needs. The asset may have become worn out, obsolete, or
for some other reason no longer useful to the business.
Plant assets of various types may be disposed of in three ways:
1. Retirement – the plant asset is scrapped or discarded
2. Sale – the plant asset is sold to another party
3. Exchange – an existing plant asset is traded in a new plant asset.
At the time of disposal, it is necessary to determine the book value of the plant asset. The book value is the
difference between the cost of the plant asset and the accumulated depreciation to date.
If the disposal accounts at any time during the year, depreciation for the fraction of the year to the date of the
disposal must be recorded.

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 Fundamentals of Accounting II

1. Retirement (Discarding) Fixed Asset

Under fixed asset are no longer useful to the business and have no residual or market value, they are discarded.

To illustrate, the accounting for a retirement, assume that ABC Company retires its computer printers, which cost
Br. 32,000.The accumulated depreciation on these printers is also Br. 32, 000; to equip, is therefore, fully
depreciated (zero book value), the entry to record this retirement is:

Accumulated depreciation – printing equip. ------------- 32,000

Printing equip ------------------------------------ 32,000
(To record installment of fully depreciation equip.)

What about if a fully depreciated plant asset is still useful to the company?
Assume that moon light company discards its delivery equipment, which cost Br. 18,000, and has accumulated
depreciation of Br. 14,000 at the date of retirement. The entry to record the retirement is as follows:

Accumulated depreciation-Deliver equip. ------ 14,000

Loss on disposal ------------------------------ 4,000
Delivery equip ------------------------------------- 18,000

2. Selling of Plant Assets

In a disposal by sale, the book value of the asset is compared to the proceeds received for the sale. If the proceeds
received from the sale exceed the book value of the plant asset, a gain on disposal occurs. If, however, the proceeds
of the sale are less than the book value of the plant asset sold, a loss on disposal occurs.
To illustrate, assume that on July 1, 2020 Guna Trading Company sells Office Furniture for Br 16,000 cash. The
Office- furniture originally cost Br. 60,000 and as of Jan 1, 2020, had accumulated depreciation of Br. 41,000.
The yearly depreciation is Br. 16,000.
Depreciation for the first six months of 2020 is Br. 8,000. The entry to record depreciation expense and update
accumulated depreciation to July 1 is as follows:
July 1, Depreciation expense ------------------- 8,000
Accumulated depreciation of furniture ----------- 8,000
(To record depreciation expense for the 1st six months of 2020)
After the accumulated depreciation balance is updated, a gain on disposal of Br.5,000 is computed.

Cost of furniture ----------------------------------- Br. 60,000

Less: Accumulated Depreciation (41,000 + 8,000) 49,000
Book value at date of disposal 11,000
Proceeds from sale 16,000
Gain on disposal Br. 5,000

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 Fundamentals of Accounting II

The entry to record the sale and the gain on disposal is as follows:
July 1. Cash ----------------------------------------- 16,000
Accumulated. Dep. - Office furn. -----------49,000
Office furn. ---------------------------------- 60,000
Gain on Disposal --------------------------- 5,000
(To record sale of office furniture at a gain)
Loss on Disposal
Assume that instead of selling the office furniture for Br. 16,000, Guna trading sold it for Br. 9,000. In this case,
a loss of Br. 2,000 is computed as follows:
Cost of office furniture ------------------------ Br. 60,000
Less: accumulated depreciation.------------- 49,000
Book value at date of disposal --------------- 11,000
Proceeds from sale ----------------------------- 9,000
Loss on disposal ------------------------------- Br.2,000

The entry to record the sale and the loss on disposal is as follow:
July 1. Cash -------------------------------------------- 9,000
Accumulated dep. - office furn. ----------- 49,000
Loss on disposal ----------------------------- 2,000
Office furniture -------------------------------------60,000
(To record sales of office furniture at a loss)

3. Exchanging Fixed Asset

Plant assets may also be disposed of through exchange. Business often exchange (trade – in) their old plant assets
for similar assets that are newer and more efficient. Exchange can be for either similar or dissimilar assets because
exchanges of similar assets are more common; we will focus more on the exchange for similar assets.
Exchange of similar assets involves assets of the same type. This occurs for example, when old delivery
equipment is exchanged for new delivery equipment or when old office furniture is exchanged for new office
furniture.
At the time of exchange, the seller allows the buyer an amount for the old equipment traded in. This amount
called the trade in-allowance may be either greater or less than the book value of the old equipment. The
remaining balance- the amount owed – is either paid in cash or a liability is recorded.
Loss Treatment
When there is a loss, the cost recorded for the new asset should be the market price.
To illustrate an exchange that results in a loss, assume that Roland Company exchanged a set of used trucks plus
cash for a new semi-truck. The used trucks have a combined book value of $42,000 (cost $64,000 less $22,000
accumulated depreciation). Roland’s purchasing agent, experienced in the second-hand market, indicates that the
used trucks have a fair value of $26,000. In addition to the trucks, Roland must pay $17,000 for the semi-truck.

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 Fundamentals of Accounting II

Roland computes the cost of the semi-truck as follows.

Fair value of used trucks $ 26,000
Cash paid $ 17,000
Cost of semi-truck $ 43,000
Roland incurs a loss on disposal of plant assets of 16,000 on this exchange. The reason is that the book value of
the used trucks is greater than the fair value of these trucks. The computation is as follows.
Book value of used trucks ($ 64,000 - $22,000) $42,000
Fair value of used trucks $ 26,000
Loss on disposal of plant assets $16,000
In recording an exchange at a loss, three steps are required:
1. Eliminate the book value of the asset given up
2. Record the cost of the asset acquired, and
3. Recognize the loss on disposal of plant assets.
Roland Company thus records the exchange on the loss as follows
Equipment (new)……………………………..43,000
Accumulated Depreciation—Equipment……..22,000
Loss on Disposal of Plant Assets……………..16,000
Equipment (old)……………………………….64,000
Cash…………………………………………...17,000
(To record exchange of used trucks for semi-truck)
Gain Treatment
To illustrate a gain situation, assume that Mark Express Delivery decides to exchange its old delivery equipment
plus cash of $3,000 for new delivery equipment. The book value of the old delivery equipment is $12,000 (cost
$40,000 less accumulated depreciation $28,000). The fair value of the old delivery equipment is $19,000.
The cost of the new asset is the fair value of the old asset exchanged plus any cash paid (or other consideration
given up). The cost of the new delivery equipment is $22,000, computed as follows.
Fair value of old delivery equipment $19,000
Cash paid $ 3,000
Cost of new delivery equipment $ 22,000
A gain results when the fair value of the old delivery equipment is greater than its book value. For Mark Express,
there is a gain of $7,000 on disposal of plant assets, computed as follows.
Fair value of old delivery equipment $ 19,000
Book value of old delivery equipment (40,000 - 28,000) $ 12,000
Gain on disposal of plant assets $ 7,000
Mark Express Delivery records the exchange as follows.
Equipment (new) 22,000
Accumulated Depreciation—Equipment (old) 28,000
Equipment (old) 40,000
Gain on Disposal of Plant Assets 7,000
Cash 3,000
(To record exchange of old delivery equipment for new delivery equipment)

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 Fundamentals of Accounting II

Natural Resources
The natural assets of some businesses include standing timber and underground deposits of oil, gas, minerals or
other natural resources. As the business harvest or mine and sell these resources, a portion of the cost of acquiring
them must be debited to an expense account. This process of transferring the cost of natural resources to an
expense account is called depletion.
A natural resource as its name implies is a resource existing naturally, not constructed by humans. Examples of
typical natural resources are deposits of coal, oil, and other minerals. These natural resources are typically used
as raw manufacture in the production of other goods. A quantity of natural resource can be considered as
consisting of a total bundle of materials, tons of coal, barrels of oil, etc. As these materials are removed, a part
of the natural resource is used up – depleted.
The acquisition cost of a natural resource is the cash or cash equivalent price, necessary to acquire the resource
and prepare it for its intended use. For already discovered resources such as an existing Coal Mine ,cost is the
price paid for the property.
The systematic write-off of the cost of natural resources is called depletion. The units of activity (output) method
are generally used to compute depletion, because periodic depletion generally is a function of the units extracted
during the year.
Depletion Cost Total Cost - Salvage
Per Unit = Total Estimated Units

Periodic Depletion Depletion Cost Number of Units

Expense = Per Unit X Extracted & Sold

To illustrate, assume that the Global Coal Co. invests Br. 5,000,000 in a mine estimated to have 10 million tons
of coal and no salvage value. In the first year, 800,000 tons of coal are extracted and sold.
Using the above formula, the computations are as follows:
Depletion Cost $ 5,000,000
per unit = 10,000,000
= Br. 0.5 depletion cost per ton.

Depletion expense = Br. 0.5 x 800,000 tons

= Br. 400,000
The entry to record depletion expense for the first year of operation is as follows:
Dec. 31 Depletion expense ---------------- 400,000
Accumulated depletion -------------------- 400,000
(To record depletion expense on coal deposits)
Accumulated depletion, a contra asset account similar to accumulated depreciation, is deducted from the cost of
the natural resources in the balance sheet as follows:
Coal Mines -------------------------------- Br. 5,000,000
Less: Accumulated depletion ----------- 400,000 Br. 4,600,000

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 Fundamentals of Accounting II

Sometimes, natural resources extracted in one accounting period will not be sold until a later period. In this case,
depletion is not expensed until the resource is sold. The amount not sold is reported in the current asset section
as inventory.

Intangible Assets
Long-lived assets that (1) lack physical substance and (2) are not held for investments are classified as intangible
assets.
The acquisition cost of intangible assets is determined by using the same general rule as property, plant, and
equipment.
There are few differences between accounting for intangible assets and accounting for plant assets.

 The term used to describe the write-off of an intangible asset is amortization, rather than depreciation.
 The amortization period of an intangible asset cannot be longer than 40 years.
 Unlike plant assets, all intangible assets are typically amortized on a straight-line basis. The universal use
of this method adds comparability.
The following are some common intangibles.

1. Patent
A Patent is an exclusive right granted by the government for manufacturing, use, and sale of a particular product.
The purpose of this exclusive right is to encourage the invention of new machine and processes. Although patents
may be granted for fixed period time (17 or 20 Years) it may change as technology or consumer tastes change.
So the cost of a patent should be amortized over its legal life or useful life, whichever is shorter.
To illustrate, assume that a patent is purchased from the investor at a cost of Br. 100,000 after five years of the
legal life have expired (its legal life is 17 years). It is estimated that the useful life after purchase is only four
years. The entry to be made to record the purchase and the annual amortization expense would be:
Jan 1, Patent -------------------------------------- 100,000
Cash ------------------------------------- 100,000
(To record acquisition of patent that until have a legal life of 17 years)
Dec. 31 Amortization Expense - Patent --------- 25,000
Patents ----------------------------------------- 25,000
(To amortize cost patent on a straight-line basis and estimated life of four years)

Note that although the remaining life is 12 years, the estimated useful life is only four years., amortization should
be based on this shorter period.

2. Copy right
A copyright is on exclusive right granted by government to protect the production and sell of literary or artistic
materials for the life of the creator plus 50 years. The useful life of a copyright generally is shorter than its legal
life. Similar to other intangible assets, the maximum write-off is 40 years. However, because of the difficulties
of determining the period over which benefits are to be received, copyrights usually are amortized over a relatively
short period of time.

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 Fundamentals of Accounting II

3. Trade mark and Trade Names

A trademark or trade name is a word, phrase, or symbol that distinguishes or identifies a particular enterprise or
product. E.g. Co-Ca Cola, Sony, Dell, Nike etc…
The creator or original user may obtain exclusive legal right to the trademark or trade name by registering it with
the government office.

4. Franchise and Licenses

A franchise is a right granted by a company or a governmental unit to conduct a certain type of business in a
specific geographical area.
When the cost of franchise is small, it may be charged immediately to expense or amortized over a short period
such as five years. When the cost is material, amortization should be based upon the life of the franchise (if
limited) and the amortization period, however, may not exceed 40 years.

5. Goodwill
In business, goodwill refers to an intangible asset of a business that is created from such favorable factors as
location, product quality, reputation, and managerial skill. Goodwill allows a business to earn a rate of return on
its investment that is often in excess of the normal rate for other firms in the same business.
To illustrate how goodwill is determined and accounted consider the following example:

ABC- Hotel
Balance sheet
At. Cost At fair Mkt. Value
Total Assets 4,300.000 6,350.000
Total Liability -1,100.000 -1,100.000
Net Asset 3,200.000 5,250.000

Purchase Price (Cost) ------------------------ - Br. 6,100.000

Less: Fair mkt. Value of the assets -------- 5,250.000
Goodwill -------------------------------------- 850.000

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 Fundamentals of Accounting II

CHAPTER THREE
CURRENT LIABILITIES

Nature of liabilities
Liabilities as creditors’ claims on total assets and as existing debts and obligations.
These claims, debts, and obligations must be settled or paid at some time in the future by the transfer of assets or
services.
The future date on which they are due or payable (maturity date) is a significant feature of liabilities.

Classification of Liabilities
Liabilities are categorized into two types:
Long-term liabilities, also known as non-current liabilities;
Short-term liabilities, also known as current liabilities
A current liability is a debt that the company expects to pay within one year or the operating cycle, whichever
is longer.
Most companies pay current liabilities within one year by using current assets rather than by creating other
liabilities.
Companies must carefully monitor the relationship of current liabilities to current assets.
This relationship is critical in evaluating a company’s short-term debt paying ability.
Types of current liabilities
Current liabilities include
– Notes payable
– Accounts payable, and
– unearned revenues.
They also include accrued liabilities such as taxes, salaries and wages, and interest payable
Notes Payable
Companies record obligations in the form of written notes as notes payable.
Notes payable are often used instead of accounts payable because they give the lender formal proof of the
obligation in case legal remedies are needed to collect the debt.
Companies frequently issue notes payable to meet short-term financing needs. Notes payable usually require the
borrower to pay interest. Notes are issued for varying periods of time.

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Those due for payment within one year of the statement of financial position date are usually classified as
current liabilities.
To illustrate the accounting for notes payable, assume that Commercial Bank of Ethiopia agreed to lend $100,000
on September 1, 2020, if ABC Co. signs a $100,000, 12%, four-month note maturing on January 1.
When a company issues an interest-bearing note, the amount of assets it receives upon issuance of the note
generally equals the note’s face value. ABC Co. therefore will receive $100,000 cash and will make the following
journal entry.
Sept. 1 Cash ----------------- 100,000
Notes Payable ------------ 100,000
(To record issuance of 12%, 4-month note to CBE)
Interest accrues over the life of the note, and the company must periodically record that accrual. If ABC Co.
prepares financial statements annually, it makes an adjusting entry at December 31 to recognize interest expense
and interest payable of $4,000 ($100,000 x 12% x 4/12). ABC Co. makes an adjusting entry as follows.
Dec. 31 Interest Expense ---------- 4,000
Interest Payable ----------- 4,000
(To accrue interest for 4 months on CBE note)
Upon maturity the ABC Co. must pay the face value of the note ($100,000) plus $4,000 interest ($100,000 x 12%
x 4/12). It records payment of the note and accrued interest as follows.
Jan. 1 Notes Payable --------------- 100,000
Interest Payable ------------- 4,000
Cash ---------------------------- 104,000
(To record payment of CBE interest-bearing note and accrued interest at maturity)
Sales Taxes Payable (VAT Payable in Ethiopia)
As a consumer, you know that many of the products you purchase at retail stores are subject to sales taxes (VAT).
Sales taxes are expressed as a percentage of the sales price.
The selling company collects the tax from the customer when the sale occurs.
Periodically, the retailer remits the collections to the government’s department of revenue.
Under most government sales tax laws, the selling company must enter separately on the cash register the amount
of the sale and the amount of the sales tax collected.
The company then uses the cash register readings to credit Sales Revenue and Sales Taxes Payable.

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For example, if the cash register reading for ABC shows sales of Birr 100,000 and sales taxes of Birr 15,000
(VAT rate of 15%), the journal entry is:
Mar. 25 Cash ----------------- 115,000
Sales Revenue ------------ 100,000
VAT Payable -------------- 15,000
(To record sales and sales taxes)
When the company remits the taxes to the taxing agency, it debits VAT Payable and credits Cash.
VAT payable ----------------- 15,000
Cash ---------------------- 15,000
The company does not report sales taxes as an expense. It simply forwards to the government the amount paid by
the customers. Thus, serves only as a collection agent for the taxing authority.
Unearned Revenues
An airline company, often receives cash when it sells tickets for future flights.
How do companies account for unearned revenues that are received before goods are delivered or services are
provided?
1. When a company receives the advance payment, it debits Cash and credits a current liability account
identifying the source of the unearned revenue.
2. When the company recognizes revenue, it debits an unearned revenue account and credits a revenue
account.
To illustrate, assume that the stadium sells 10,000 season football tickets at Birr 50,000 each for its five-game
home schedule. The club makes the following entry for the sale of season tickets.
Aug. 6 Cash -------------- 500,000
Unearned Ticket Revenue------500,000
(To record sale of 10,000 season tickets)
As each game is completed, it records the recognition of revenue with the following entry
Sept. 7 Unearned Ticket Revenue ------ 100,000
Ticket Revenue -------------------100,000
(To record football ticket revenue)

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Current Maturities of Long-Term Debt

Companies often have a portion of long-term debt that comes due in the current year.
That amount is considered a current liability.
Companies often identify current maturities of long-term debt on the statement of financial position as long-term
debt due within one year.
It is not necessary to prepare an adjusting entry to recognize the current maturity of long-term debt.
At the statement of financial position date, all obligations due within one year are classified as current, and all
other obligations as non-current.
Presentation of current liabilities on the balance sheet
Current liabilities are presented after non-current liabilities on the statement of financial position.
Each of the principal types of current liabilities is listed separately.
In addition, companies disclose the terms of notes payable and other key information about the individual items
in the notes to the financial statements.
Companies seldom list current liabilities in the order of liquidity. The reason is that varying maturity dates may
exist for specific obligations such as notes payable.
A more common method of presenting current liabilities is to list them by order of magnitude, with the largest
ones first. Or, as a matter of custom, many companies show notes payable first and then accounts payable,
regardless of amount. Then, the remaining current liabilities are listed by magnitude.

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CHAPTER FOUR

ETHIOPIAN PAYROLL SYSTEM

The Importance of Payroll Accounting

The concept of payroll is often referred to the total amount paid to employees of a firm as a compensation for the
service rendered to a firm in a given period of time. The payroll accounting of a firm has to be given emphases.
1. Employees are sensitive to payroll errors and irregularities, and maintaining good employees moral
requires that the payroll be paid on a timely, accurate basis.
2. Payroll expenditures are subject to various government regulations.
3. The payment for payroll and related taxes has significant effect on the net income of most business
enterprises.
For the foresaid reasons the need for accurate system of handling the payroll of a business is unquestionable.
Definition of payroll & related terms
Salary or Wages: Salary and wages are usually used interchangeably. However, the term wages is more correctly
used to refer to payments for manual labor that are paid based on the number of hours worked or the number of
units produced. Therefore, they are usually paid when a particular piece of work is completed or weekly. On the
other hand, compensations to employees on monthly or annual basis are termed as salaries.
It must be clear that when we say an employee, we refer to an individual who works primarily to an organization
and whose activities are under the direction and supervision of the employer. Hence, an employee is different
from an independent contractor, a self-employed individual who works on a fee basis to a firm.
The pay Period: The pay period refers to the length of time covered by each payroll payment. Payment periods
for wageworkers are usually made on weekly basis. On the other hand, salaried employees’ pay periods are
monthly or semimonthly.
The Pay Day: The day on which wages or salaries are paid to employees, usually the last day of the pay period,
is known as the payday.
A basic record of a payroll accounting system includes:
1. A payroll register (or sheet),
2. Individual employees earning records, and
3. Usually, pay checks.
These records are generated from a payroll system that is operated manually or using computers.

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A Payroll Register (sheet): The entire list of employees of a business along with each employee’s gross earnings,
deductions and net pay (or the take home pay) for a particular payroll period. The basics for the preparation of
the payroll register can be the attendance sheets, punched (clock) cards or time cards.
Employee Earnings Record: It is a summary of each employee’s earnings, deductions, and net pay for each
payroll period and of cumulative gross earnings during the year. It is a separate record kept for each employee.
The individual employees’ earnings record helps the employer organization to properly summarize and file tax
returns.
Pay Check: An instrument for paying salary if the firm makes payment via writing a check in the name of each
employee for the net pay or a check for the total net pay.
Gross Earnings: is the total pay to an employee before deductions for the pay period.
Withholding Taxes: These are taxes levied against the earnings of employees of an organization and withhold
by the employer per the regulations of the concerned government.
Payroll Deductions: All the reductions from the gross earnings of an employee such as withholding taxes, union
dues, fines, credit association pays, etc.
Net Pay: The gross earnings after subtracting all the deductions. An employee on the payday sometimes knows
it as take home pay the amount collected.
Possible Components of a Payroll Register
1. Employee number: Numbers are assigned to employees for identification purpose when a relatively large
number of employees are included in the payroll register.
2. Name of employees: List of the names of employees.
3. Money earned by an employee(s) of a firm from various sources. It may include:
a. The basic salary or Regular Earning: A flat monthly salary of an employee is that paid for carrying
out the normal work of employment and subject to change when the employee is promoted.
b. Allowances: Money paid monthly to an employee for special reason, which may include:
I. Position Allowance: A monthly sum paid to an employee for bearing a particular office
responsibility, e.g. head of a particular department of division.
II. House Allowance: A monthly Allowance given to cover housing costs of the individual employee
when the employment contact requires the employer to provide housing but fails to do so.

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III. Hardship Allowance: A sum of money given to an employee to compensate for an inconvenient
circumstance caused by the employer. For instance, unexpected transfer to a different and distant
work area or location. It is sometimes known as disturbance allowance.
IV. Desert Allowance: A monthly Allowance given to an employee because of assignment to a relatively
hot region.
V. Transportation (fuel) allowance: A monthly Allowance to an employee to cover cost of
transportation up to the work place if the employer has committed itself to provide transportation
service.
c. Overtime Earning: overtime work is the work performed by an employee beyond the regular working
hours or days. Overtime earning is the amount payable to an employee for overtime work done.
In Ethiopia, in this respect, according to Article 33 of proclamation No. 64/1975 the following is discussed about
payment for overtime work.
1. A worker shall be entitled to be paid at a rate of one and one quarter (1 1/2) times his/her ordinary hourly
rate for overtime work performed before 10 O’clock in the evening (10 p.m.).
2. A worker shall be paid at the rate of one and one half (1 3/4) times his/her ordinary hourly rate for overtime
work performed between 10 o’clock in the evening (10 p.m.) and six O’clock in the morning (6 a.m.).
3. Overtime work performed on the weekly rest days shall be paid at a rate of two (2) times the ordinary
hourly rate of payment.
4. A worker shall be paid at a rate of two and half (2 ½) times the ordinary hourly rate for overtime work
performed on a public holiday.
Hence, the gross earnings of an employee may, therefore, include the basic salary, allowances and overtime
earnings. You may find some times other form of earnings such as bonus that is paid to employees for achieving
results better than usual.
d. Deductions: These are subtractions made from the earnings of employees either due to required by
government or permitted by the employee himself.
In our country, Ethiopia, some of the deductions against the earnings of employees are:
a. EMPLOYEE INCOME TAX
In Ethiopia, every citizen is required to pay something in the form of income tax from his/her earnings of
employment. In this case, a progressive income tax system that charges higher rates for higher earnings is applied
on the gross earning of each employee by saving the first 600 birr from taxation. According to proclamation, No.

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979/2016 that is the future amended income tax proclamation No. 286/2002 given below exempts the first Br.
600 of the earnings of an employee from income tax. The money on which a person does not have to pay income
tax is known an exemption.
The amended income tax proclamation issued on 18th August 2016 Negarit Gazeta No. 104 states the following
conditions about employment income tax and its computations:
Proclamation No. 979/2016
A proclamation to amend the income tax Proclamation: whereas, it has become necessary to introduce modern
and efficient tax system that supports the economic development achieved so far;
Whereas, it is found essential to make the tax system fair and bring income that are so far not subject to tax in to
the tax net
Now therefore, in accordance with Article 55 (1) and (11) of the constitution of the federal democratic republic
of Ethiopia, it is hereby proclaimed as follows:
This Proclamation may be cited as the “Income Tax Proclamation amendment No. 979/2016.”
Employee income tax rate

Ser. No. Monthly Income Applicable Income Tax

In Birr Rate
A B
1 0-600 Exempted
2 601-1650 10%
3 1651-3200 15%
4 3201-5250 20%
5 5251-7800 25%
6 7801-10,900 30%
7 10,901 and above 35%

Generally, taxable income from employment includes salaries, wages, allowances, directors’ fees and other
personal employment, all payments in cash and benefits in kind.
However, according to Income Tax amendment Proclamation the following categories of payments in cash or
benefits on kind are exempted from taxation.
1. Medical costs incurred by employer for treatment of employees
2. Transportation allowances paid by employer to its employees.
3. Reimbursement by employer of traveling expenses incurred on duty by employees.

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4. Traveling expenses paid to transport employees from elsewhere to place of employment and to return
them upon completions of employment.
When the number of employees is significant and the payroll is prepared manually then the above method
becomes cumbersome and very difficult to maintain therefore the following short cut is developed.

Gross Taxable Monthly Applicable Income Tax Tax Exemption in Birr

Ser. No. Income Rate
In Birr
A B C
1 0-600 Exempted 0
2 601-1650 10% (AB)-60.00
3 1651-3200 15% (AB)-142.50
4 3201-5250 20% (AB)-302.50
5 5251-7800 25% (AB)-565.00
6 7801-10,900 30% (AB)-955.00
7 10,901 and above 35% (AB)-1500.00

Example
If A person Earns Tax
1. Br 4500/month, then (4,500  20%) - Br 302.5 Br 597.5
2. Br 13000/month, then (13,000  35%) – Br 1,500. Br 3,050
b. PENSION CONTRIBUTIONS

Permanent employees of an organization are governed by the existing regulations are expected to pay or contribute
7% of their basic (monthly) salary to the pension Trust Fund. This amount should be with-held by the employer
from the basic salary of each employee on every payroll and later be paid to the respective government body.
On the other hand, the employer is also expected to contribute towards the same fund 11% of the basic salary of
every permanent employee of it. It is this total amount that we called earlier as payroll taxes expense to the
employer organization (i.e., 11% of the total basic salary of all permanent employee).
Consequently, the total contribution to the pension Trust Fund of is equal to 18% of the total basic salary of all
permanent employees of an organization (i.e. 7% comes from the employees and the 11% comes from the
employer). This enables a permanent employee of an organization to be entitled to the pension pay given that the
employee has satisfied the minimum requirements to enjoy this benefit when retired.
C. Other Deductions

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Apart from the above two kinds of deductions from employees earnings, employees may individually authorize
additional deductions such as deductions to pay health or life insurance premiums; to repay loans from the
employer or credit association; to pay for donations to charitable organizations; etc.
Each of the major other deductions may be put in special column in the payroll register.
Ultimately, the sum of the employee’s income tax, pension contributions and other deductions gives the total
deductions from the gross earnings of an employee.
5. The Net Pay: This amount is held in one column of the payroll register representing the excess of gross
earnings over the total deductions of an employee. The column ‘Net pay’ total tells the grand total
deductions made from the earnings of employees.
6. Signature: Unless some other document is used, the payroll sheet may be designed to allow a column for
signature of the employees after collection of the net pay.
In general, a payroll register should at least show the earnings, deductions and the net pays along with the names
of employees.
Major Procedures or Activities Involved in Accounting for Payroll.
1. Gathering the necessary data: All the relevant information about every employee should be gathered.
This activity requires reviewing various documents and to do some arithmetic work.
2. Including the names of employees along with the gathered data such as earnings, deductions and net
pays in the appropriate columns of the payroll register.
3. Totaling and proving the payroll register: It must be proved that the grand total earning equal the sum
of the grand totals of deductions and net pays in the register.
4. The accuracy and authenticity of the information summarized in the payroll should be verified by a
different person from the one who compiles it.
5. The payroll is approved by the authorized personnel.
6. Paying the payroll either in cash (this may be after cashing a check issued for the total net pay of the
payroll) or issuing a check for every individual employee for the net amount payable to each employee.
7. Recording the payment of the payroll and recognition of the withholding tax liabilities.
8. Recording the payroll taxes expense of the employer.
9. Paying and recording withholding and payroll tax liabilities to the concerned authority, in our case to
Revenue authority, on time.

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ILLUSTRATION
ABC Company has the following information for the month September 30, 2021 and wants to prepare the payroll
register for the month in order to compensate employees.

Basic
Name of Basic Monthly OT Hours Duration of OT Salary
S/No Employee Salary Allowance Worked Work Per
. hour
1. Damenaw Damane 2,080 1,000 10 Up to 10 pm 13
2. Zinabu Zenebe 12,800 1,500 6 Weekly Rest Days 80

3. Gorfu Melese 4,800 500 10 Public Holiday 30

Note that management of the agency usually expects a worker to work 40 hours in a week and during September
2021 all workers have done as they have been expected. Besides, all workers of this Company are permanent
employees; the monthly allowance of Gorfu Melese is not taxable; Zinabu Zenebe agreed to have a monthly
Br200 be deducted and paid to the Credit Association of the Agency as a monthly saving.
INSTRUCTIONS:
Based on the information given above:
1. Prepare a payroll register (or sheet) for the agency for the month of September, 2021.
2. Record the payment of salary as of September 30, 2021 using check. No 41 as a source document.
3. Record the payroll taxes expense for the month of September, 2021.
4. Record the payment of the claim of the Credit Association of the agency that arose from September’s
payroll assuming that the payment was made on October 1, 2021.
5. Assuming that the withholding and payroll taxes for the month of September, 2021 have been paid on
October 5, 2021 via check. No. 50, recorded the required journal entry.
Computations of Earnings Overtime Earnings, Deductions and Net Pays:

Overtime Earning = (OT Hrs worked) x (ordinary hourly rate x OT Rate)

1. Damenaw:
(10hrs) (13) (1.5) = Br 195
2. Zinabu:
(6hrs) (80) (2) = Br 960
3. Gorfu:
(10hrs) (30) (2.5) = Br 750
Gross Earnings
Gross Earnings = Basic salary + Allowance + OT Earnings
1. Damenaw:
Br2080 + 1000 + 195 = Br 3,275
2. Zinabu:
Br 12,800 + 1,500 + 960 = Br 15,260
3. Gorfu:
Br 4,800 + 500 + 750 = Br 6,050

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 Fundamentals of Accounting II

DEDUCTIONS AND NET PAYS

1. Damenaw:
Gross taxable income ………………………………………..Br. 3,275
Employee Income Tax:
Earnings x ITR=IT

600.00 X 0 00.00
1050.00 X10% 105.00
1550.00 X15% 232.50
75 X20% 15
Total 3,275 352.50
Pension Contribution:
Basic Salary x 7%
Br. 2080 x7% ………………………… 145.6
Total Deductions ………..………..………..…………………….Br 498.1
Net Pay ………………………………………………………….Br2,776.9

2. Zinabu:
Gross taxable income……………………………………………Br. 15,260.00
Employee Income Tax:
Earning X ITR =IT
600 X 00.00
1050X 10% 105.00
1550 X 15% 232.5
2050X20% 410
2550X25% 637.5
3100X30% 930
4360X.35 1526
Tot. Br 15,360 Br3,841
Pension Contribution:
Br12,800 X 7%........................................896
Credit Association pays………………..200.00
Total Deductions ……………………………………………………….. 4,937
Net Pay ………………………………………………………………. 10,323.00
3. Gorfu:
Gross taxable income (his allowance is not subject to tax)
Br. 6050 - 500 = Br. 5550.00 …………………………………… Br. 5,550.00
Employee Income Tax:
IT=5550*25%-565=822.5
Pension Cont. Br. 4800 X7%..................336
Total Deductions …………………………………………………..Br 1,158.50
Net pay ………………………………………………………………..Br. 4,891.50

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ITR = Income Tax Rate IT= Income Tax

Proving the payroll:
Total Earnings:
Basic Salary …………….. Br. 19,680.00
Allowance ………………. 3,000.00
Overtime ………………… 1,905
Grand total earnings.. 24,585
Deductions:
Employee Income tax Br. 5,051
Pension Cont. ……………… 1,377.6
Others …………………….…… 200.00
Total Deductions…………… 6,628.6
Net Pays (total)…………….. 17,956.4

The following table shows payroll register

Name of Employee Basic Monthly OT Gross Deduction Net Signature

S/No Salary Allowance Earning pay
1 Damenaw Damane 2,080 1,000 195 3,275 498.1 2,776.9 
2 Zinabu Zenebe 12,800 1,500 960 15,260.00 4,972 10,388.00 
3 Gorfu Melese 4,800 500 750 6050/5550 1,158.5 4,891.5 
taxable/
19,680.0 3000 1,905 24,585 6,628.6 17,956.4
0

1. Recording the payment of salary

Sept 30. Salary Expense………………………………………..24,585
Employee income tax payable…………………………...5,051
Pension Cont. Payable………………………...………....1377.6
Payable to Credit Association…………………………... 200.00
Cash………………………………………………………17,956.4
2. ABC Company incurred pension contribution expense of Br 2,164.8 during September 30, 2021. This is
because the company has to contribute 11% of the basic salary of every permanent employee to the
government pension trust fund. Thus,
Payroll tax expense = Total basic salary of all permanent employees multiplied by 11%
= (2080 + 12800 + 4800) X 11%
= Br 2,164.8
By the amount of Br. 2,164.8, the company’s expense, pension contribution expense, and pension contributions
payable accounts increase. Therefore, the following journal entry is made as of September 30, 2021

Pension contribution expense……………….2,164.8

Pension cont. payable……………………….2,164.8
The source document is an inter-office memorandum that indicates the incurrence of this expense and labor law
or proclamation that requires the employer to make the contributions.

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3. Recording the payment of deduction from Abdu’s earnings to the credit association
Payable to Credit Association………………………..200
Cash …………………………………………………200
4. Recording the payment of withholding and payroll taxes to the Inland Revenue Administration of November
6, 2021:

 Look at the account balances before payment.

Employee Income Pension Cont.
Tax payable Payable
5,051 1,377.6
2,164.8

3,542.4

From the above accounts, you can see that the company has a total liability of Br 8,593.4
That is:
Employee Income Tax …………… Br. 5,051
Pension cont…………………………… 3,542.4
Total………………………………. Br. 8,593.4
Note also that the total pension contribution payable is equal to 18% of the basic salary of all permanent
employees. That is: Br. 19680*18% = Br. 3542.4
Then, the payment is recorded as follows:
Employees Income Tax Payable …………… 5,051
Pension Contribution payable ………………………3,542.5
Cash……………………………………………………. 8,593.4
After the payment of these liabilities have been posted, the above two accounts will have zero balances

Attempt the following Exercise

RAL Company has 10 employees. The pay period of the company is a month. The payroll clerk has contained
the following information for the month of June, 2022

Employee Name Basic Salary Overtime (Br) Allowance (Br)

1. Ahmed Ali 2700 - -
2. Azeb Mengesha 3400 500 -
3. Belay Neger 4200 180 500
4. Mustefa Hussein 5100 600 -
5. Fakiha Nuri 6000 120 1000
6. Eskedar Molla 12850 750 -
7. Fekadu Zewdie 13850 - 2000
8. Ziyad Abdellah 14000 - 1000
9. Solomon Sheger 3100 750 700
10. Hoden Kemal 11350 700 -

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Additional Information:
a. The payroll register of RAL Co. more or less is the same as the payroll register shown in the
illustration. The deduction columns are the following: Income tax, Idir fund, Union fees, Pension
fund and total deductions.
b. All employees are to pay Idir fees of:
i. Birr 20 for all employees whose basis salary is up to Birr 5000.00.
ii. Birr 30 for all employees whose basic salary is above Birr 5000.00
c. All employees are required to pay Union fees of 1% of their basic salaries (assume that all employees
are members of the Labor Union).
d. Ato Belay Nega, W/t Fakiha Nuri, Ato Fekadu Zewdie and W/ro Hoden Kemal contribute 5% of
their basic salaries to the Credit Association of the Company.
INSTRUCTIONS
1. Prepare the payroll register
2. Prepare a journal entry to record the salary expense for the month of June 2021
3. Prepare journal entries to record the payments of amounts withheld to the concerned authorities.

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 Fundamentals of Accounting II

CHAPTER 5
ACCOUNTING FOR PARTNERSHIPS
Definition of Partnership
In simple terms partnership means an association of two or more persons for some specified purpose. For our
purposes however, partnership can be defined as “an association of two or more persons to carry on as co-owners
a business for profit”.
Partnership originates from a contract entered between partners. The contract could be written, oral or implied by
acts of partners. Partnership does not have to be only among persons but also among organizations such as entities
and corporation.
Some countries prohibit corporations from becoming a partner, or certain type of professional services such as
the practice of law, medicine, public accounting from being established as corporations in order to avoid the
formation of professional corporations which may weaken the quality of personal professional knowledge
qualification, and the personal relationship between client and practitioner. Both are vital and important in conduct
of professional practice.
Characteristics of partnership
The essential characteristics of a partnership can be identified as follows:
Limited Life: A partnership may be ended by changes in the composition in the personnel of partners. The former
partnership legally ceases and a new one is established as a result of withdrawal of a partner through death,
retirement, bankruptcy or incapacity from the partnership and the admission of a new one into the partnership.
Unlimited Liability: Even though a partnership can be either general or limited partnership, there will always be
a partner or some partners who will be personally responsible for debts of the firm and have the authority to act
for the firm. Statutes for a limited partnership thus require at least one of the partners be a general partner.
Co-ownership of partnership property: Whatever assets once individual partners invest or contribute to a
partnership, they retain no specific ownership or claim to these specific assets, they only acquire equity ownership
in the total assets of the partnership and thus have claim only on equity ownership interest.
Ownership of partnership Earnings: The earnings of the partnership belong to the partners. Each partner has
an ownership interest in earnings, and thus has the right to participate in profits and losses of the partnership.

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Participation in profits and losses is considered as one of the evidences for the existence of a partnership. This is
notwithstanding the way ownership interest and interest in earnings is computed.
Mutual Agency: Except for acts which may be considered above and beyond normal scope of business operations
each partner has the authority to act on behalf of the organization and enter into contracts that are binding upon it
The partnership Agreement
The written agreement often referred to as the partnership agreement or articles of co-partnership contains such
basic information as the name and location of the firm, the purpose of the business, date of inception, and division
of income and loss etc.
Although partnership may be found on oral agreement or be implied by members’ actions, good business practice
prefers that it to be written, and in most countries including Ethiopia, legal provisions on partnership require the
following points be covered in partnership agreement:-
 The date of formation of partnership, and the duration of the contract
 The names and addresses of the partners, and the name and nature of the partnership
 The assets to be invested by each partner, the procedure for valuing non-cash investments, and the
penalties for failure to invest and maintain the agreed amount of capital.
 Rights and duties of each.
 The accounting period to be used, the nature of accounting records, financial statements and audits by
certified public accountants.
 The plan for sharing net income or loss, including the frequency of income measurement and the
distribution of the net income or loss to the partners.
 The salaries and drawing allowed to partners and the penalties if any on excessive withdrawals.
 Provision for the arbitration of disputes and the liquidation of the partnership at the end of the specified
term of the contract or at the death or withdrawal of a partner. Especially important in avoiding disputes
is agreement upon procedures of valuation of the business and the method of settlement with the estate of
deceased partner.
The Ethiopian Commercial Code (Art. 284) states that the Memorandum of Association drawn by partners
shall contain:-
 The name, address and nationality of each partner
 The firm’s name
 The head office and branches, if any

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 The business purposes of the firm

 The contributions of each partner, their value and the method of valuation
 The share of each partner in the profits losses and the agreed procedure for allocation
 The managers and agents of the firm
 The period of time for which partnership has been established
 Penalties for not meeting capital commitments
Partner‘s ownership Equity Accounts
The first and foremost difference between accounting for a partnership and accounting for a corporation lies in
the sharing of profits and losses, and the maintenance of the owners’ equity accounts. In a partnership instead of
one capital account of the partnership there will be several capital accounts representing ownership equity of each
partner. Furthermore, there will be usually three types of accounts for each partner. The equity accounts thus
consist of: (1) Capital accounts (2) Drawing or personal accounts, and (3) accounts for Loans to and from partners.
Initial investment by each partner in the partnership is recorded by debiting the assets invested, and crediting the
partner’s capital account. Subsequently, the partner’s equity is increased by additional investment and by a share
of the partnership profits. Similarly, the partner’s equity is also decreased by withdrawal of assets and by share
of the partnership losses. Drawings in anticipation of profits which are to be considered salary are recorded by
debits to drawing accounts. But large withdrawals which may be considered as permanent reduction in the
ownership equity of a partner on the other hand are debited directly to the partner’s capital account
At the end of the fiscal period, the net profit or net loss in the profit and loss summary account is transferred to
the partners’ capital accounts in accordance with the partnership agreement on profit and loss sharing. The debit
balance of the drawing accounts are also into the partners’ capital accounts at the end of the year.
Loans to and from partners
When a partner withdraws a substantial amount from the partnership for a long period but with the intention of
repayment, it is considered as loan to the partner from partnership and it is debited to Loans Receivable form
Partner account instead of debiting it to the drawing account. Similarly, when partner advance money to the
partnership, it is viewed as Loan Payable to Partner rather than an increase in the capital account of the partner;
and the transaction is recorded by a credit to a Loans Payable to Partner account. Thus, amounts due from partners
are treated as assets while amounts due to partners are treated as liabilities in the balance sheet.

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Valuation of Investments
All investment by partners other than cash should be valued and recorded at agreed upon current fair value at time
of their investment. Any gains or losses that arise later on as a result of disposal of such assets are then divided
according to planned profit and loss sharing scheme.
Partnership Formation /Recording Investments
When a partnership is formed, a journal entry is made to record the assets contributed by each partner and the
liabilities of each partner that are assumed by the partnership. A separate entry is made for the investment of each
partner in a partnership.
Non-cash assets contributed by individual partners be valued at their fair value on the date they are transferred to
the partnership.
Example
On April 1 of the current year, Fassil and Selamawit agreed to combine their existing business and form a
partnership. The partners are to contribute the assets of their previous business. It is agreed that the liabilities of
the proprietorships will be assumed by the partnership. The contribution made by each partner is as follows.

Amount
Asset contributed Fassil Selamawit
Cash 3,500 5,700
Accounts Receivable 7,600 4,200
Merchandise inventory 15,900 11,000
Supplies 700 300
Equipment 8.500 -
Building - 55,000
Land - 16,000
Liability assumed
Account payable 3,100 -
Notes payable - 19,600
The journal entries to open the accounts of the partnership are:
April 1. Cash 3,500
Account Receivable 7,600
Merchandise inventory 15,900
Supplies 700
Equipment 8,500
Account payable 3,100
Fassil, capital 33,100
(To record the investment of Fassil)

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April 1. Cash 5,700

Account Receivable 4,200
Merchandise Inventory 11,000
Supplies 300
Building 55,000
Land 16,000
Notes payable 19,600
Selamawit, capital 72,600

(To record the investment of Selamawit)

Division of Net income or Net loss
Income division is the manner in which profits and losses are allocated to individual partners. The method of
dividing partnership income should be stated in the partnership agreement. In the absence of an agreement or if
the agreement is silent on dividing net income or net losses, all partners share equally.
Methods to divide income or loss use:
A. Division based on fractional share to each partner.
B. Division based on the ratio of capital invested.
C. Division based on salary allowances. Technically, partners’ salaries are profit shares, not expenses of the
business.
D. Division based on interest allowances.
E. Division based on both salary and interest allowances. Salary and interest allowances exceed the amount
of net income; the excess net income will simply be negative.
Income Division: Services of partners
Salary Allowance
Articles of partnership often provide for the division of a portion of net income to the partners in the form of a
salary allowance taking into account the ability and amount of time devoted to the business.
Example
Assume that the articles of partnership of Alem and Tesfaye provide for monthly salary allowance or $ 2,000 and
$3,000 respectively, with the balance of the net income to be divided equally. The net income for the year is
$90,000. The division of the $ 90,000 net income is a follows. Net income to divide $90,000
Division of net income Alem Tesfaye Total
Salary Allowance $ 24,000 $ 36,000 $ 60,000
Remaining income 15,000 15,000 30,000
Partners shares $ 39,000 $ 51,000 $ 90,000

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The division of net income is recorded as a closing entry, regardless of whether the partners actually withdraw
the amounts of their salary allowances. The entry for the division of net income is as follows.
Dec 31 Income Summary 90,000
Alem, capital 39,000
Tesfaye, capital 5,000
Income Division: services of partners and investment
Partners may agree that the most equitable plan of dividing income is to provide for:
1. Salary allowance and
2. Interest on capital investments.
Any remaining net income is then divided as agreed.
Example
Assume that the partnership agreement for Alem and Tesfaye divides income as follows.
1. Monthly salary allowances of $ 2,000 for Alem and $ 3,000 for Tesfaye
2. Interest of 10% on each partner’s capital balance on January 1
3. Any remaining net income divided equally between the partners
Alem had a credit balance of $ 70,000 in her capital account on January 1 of the current fiscal year, and Tesfaye
had a credit balance of $ 90,000 in his capital account. The $ 90,000 net income for the year is divided in the
following schedule.
Net income $ 90,000
Division of net income
Alem Tesfaye Total
Annual salary allowance $24,000 $36,000 $60,000
Interest allowance 7,000 9,000 16,000
Remaining income 7,000 7,000 14,000
Net income $38,000 $52,000 $90,000
$70.000 x 10% = $7,000
$90.000 x 10% = 9,000
For the above example, the entry to close the income summary account is shown below.
Dec 31. Income summary…………………………$90,000
Alem, capital……………………………………38,000
Tesfaye, capital………………………………….52,000

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Income Division: Allowances Exceed Net Income

In the examples so far, the net income has exceeded the total of the salary and interest allowances. If the net
income is less than the total o the allowances, the remaining balance will be a negative amount. This amount
must be divided among the partners as though it were a net loss.
Example:
Assume the same salary and interest allowances as in the above example, but assume that the net income is
$50,000. The salary and interest allowances total $31,000 for Alem and $ 45,000 for Tesfaye. The sum of these
amounts, $76,000, exceeds the net income of $50,000 by $26,000. It is necessary to divide the $26,000 excess
between Alem and Tesfaye. Under the partnership agreement, any net income or net loss remaining after
deducting the allowances is divided equally between Alem and Tesfaye. Thus each partner is allocated one-half
of the $26,000 and $13,000 is deducted from each partner’s share of the allowances. The final division of net
income between Alem and Tesfaye is shown below.
Net income 50,000
Division of Net income
Alem Tesfaye Total
Annual salary allowance $24,000 $36,000 $60,000
Interest allowance 7,000 9,000 16,000
Total $31,000 $45,000 $76,000
Excess of allowances over income (13,000) (13,000) (26,000)
Net income $18,000 $32,000 $50,000
The entry to close the income summary account
Dec 31 Income summary…………………….50,000
Alem, capital…………………………….18,000
Tesfaye, capital………………………….32,000
Partnership Dissolution
When a partnership dissolves, its affairs are not necessarily wound up. When a partner is added or a partner
withdraws, the old partnership ends. Stills, the business can continue to operate as a new partnership among the
remaining partners.
Admission of a partner
There are two ways a new partner is admitted to a partnership with the consent of all the current partners.
1. Purchasing an interest from one or more of the current.

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2. Contributing investing partners’ cash or other assets to the partnership.

Purchasing an interest in a partnership
The purchase of partnership interest is a personal transaction between one or more current partners and the new
partner.
Example
Assume that partners Abraham and Kebede have capital balance of $100,000 and $75,000 respectively. On
September 1, Abraham sold one-half of his interest for $60,000 and Kebede sold one-fifth of his equity for
$20,000 to Nardos. The exchange of cash is not a partnership transaction and thus is not recorded by the
partnership. The only entry required in the partnership accounts is as follows.
Sept 1. Abraham capital…………………50,000
Kebede, capital…………………..15,000
Nardos, capital…………………….65,000
To record admission of Nardos by purchase.
Partnership Accounts
Abraham, capital Kebede, capital Nardos, capital
50,000 100,000 15,000 75,000 65,000
Investing/contributing Assets to a partnership
Admitting a partner by accepting assets is a transaction between the new partner and the partnership. The invested
assets become partnership property.
N.B: In this case, both the assets and the owner’s equity of the firm increase.
Example: -
Assume that partners Genet (with a $72,000 capital) and Sisay (with a $84,000) agreed to accept Nebyat as a
partner with her investment of $34,000 on March 1. The entry to record Nebiyat’s investment is:
March 1. Cash…………………………..34,000
Nebiyat capital……………………34,000
To record admission of Nebiyat by investment.
Revaluation of Assets
A partnership’s asset account balances should be stated at current values when a new partner is admitted. The net
adjustment (increase or decrease) in asset values is divided among the capital accounts of the existing partners
according to their income-sharing ratio.
Example:

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Assume that in the preceding example for Genet & Sisay partnership, the balance of the merchandise inventory
account is $25,000 and the current replacement value is $29,000. Prior to Nebyat’s admission, the revolution
would be recorded as follows, assuming that Genet & Sisay share net income equally.
March 1. Merchandise Inventory……………………….4,000
Genet, capital………………………………….2,000
Sisay, capital…………………………………..2,000
Partner Bonuses
When a new partner is admitted to a partnership, the incoming partner may pay a bonus to the existing partners
for the privilege of joining the partnership.
Existing partners can pay a bonus to a new partner. This usually occurs when they need additional cash or the
new partner has exceptional or special talents & skill.
The amount of any bonus paid to the partnership is distributed among the partner capital accounts.
Bonus to old partners
Assume that on June 1 the partnership of Asenafi and Dereje is considering admitting a new partner, Hiwot. After
the assets of the partnership has been adjusted to current market values, the capital balance of Ashenafi is
$150,000 and the capital balance of Dereje $30,000. Ashenafi and Derege agree to admit Hiwot to the partnership
for $80,000. In return, Hiwot will receive a 25% share in both equity and partnership income or losses. Hiwot’s
equity is determined as follows:
Equity of existing partners:
Ashenafi $150,000
Dereje 30,000
Investment of new partner, Hiwot 80,000
Total partnership equity $ 260,000
Equity of Hiwot (25% of total) $ 65,000
Contribution of Hiwot $ 80,000
Hiwot’s equity after admission 65,000
Bonus paid to Ashenafi & Derege $ 15,000
The bonus is distributed to Ashenafi and Dereje according to their income-sharing ratio. Assume that Ashenafi
& Dereje share profits and losses in the ration of 5:1; the entry to record the admission of Hiwot to the partnership
is as follows:
June1. Cash……………………80,000
Hiwot, capital……………..65,000
Ashenafi, capital…………..12,500
Derege, capital……………..2,500
(To record admission of Hiwot and bonus to old partners)

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Bonus to New partner

The new partner gets a larger share of equity than the amount invested (contributed).
Example:
Let’s say, from the preceding example, Ashenafi and Dereje agree toaccept Hiwot as a partner with a 25% interest
in both the partnership’s income or loss and equity, but they require Hiwot to only invest 20,000. Hiwot’s equity
is determined as:
Equities of existing partners ( $ 150,000 + $ 30,000) $ 180,000
Investment of new partner, Hiwot 20,000
Total partnership equity $ 200,000
Equiity of Hiwot (25% x $200,000) $ 50,000
Bonus to new partner, (Hiwot) ($50,000-$20,000) = $ 30,000
The entry to record Hiwot’s investment is
June 1. Cash………………………………………20,000
Asenafi, capital ($30,000 x 5/6)…………..25,000
Dereje, capital ($ 30,000x 1/6)…………….5,000
Hiwot, capital…………………….50,000
(To record Hiwot’s admission and bonus)
Withdrawal of a partner
There are several ways in which an individual can withdraw from a partnership. A partner can:
1. Sell his or her interest to another partner or to an outsider with the consent of the other partners, the transaction
is personal.
2. Withdraw assets equal to his or her capital balances (No bonus).
3. Withdraw assets that are less than his or her capital balance (Bonus to remaining partners)
4. Withdraw assets that are greater than his or her capital balance (Bonus to withdrawing partner)
Example
Let’s assume that the capital balances of the partners Abebe, Bekele, and Chala are $86,000, $125,000, and
$60,000, respectively, a total of $271,000. Abebe wants to withdraw from the partnership on March 31.
Required: Record the necessary five offers for his interest.
1. To sell his interest to Bekele for $ 90,000.
2. To sell his interest to Dereje, an outsider, for $100,000

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3. To take cash equal to his equity.

4. To take $70,000 in cash
5. To take $ 102,000 in cash
Liquidation of a partnership
Liquidation of a partnership is the process of ending the business, of selling enough assets to pay the partnership’s
liabilities and distributing any remaining assets among the partners.
Liquidation is a special form of dissolution. When a partnership is liquidated, the business will not continue.
When a partnership is liquidated, its business is ended. Four steps are involved:
1. Non-cash assets are sold for cash and a gain or loss on liquidation is recorded.
2. Gain or loss on liquidation is allocated to partners using their income-and loss sharing ratio.
3. Liabilities are paid.
4. Remaining cash is distributed to partners based on theirs capital balances.
The sale of the assets is called realization. In liquidation, some gains or losses commonly result from the sale of
non-cash assets.
Example: -
Assume that Fassil, Tangut, and Kassa share income and losses in a ratio of 4:4:2 (4/10, 4/10. 2/10). On May 12, 2021
after discontinuing business operations of the partnership and closing the accounts, the following summarized
trial balance was prepared.
Cash 3,000
Non-cash Assets 24,000
Liabilities 6,000
Fassil, capital 10,000
Tangut, capital 8,000
Kassa, capital 3,000
Total $27,000 $27,000
Between May 13 and May 31 required sell all non-cash assets of the year 2021, Fassil, Tangut and Kassa based
on the above facts and taking different selling prices for the non-cash assets, prepared a statement of partnership
liquidation & make the necessary journal entries to account for the liquidating process if the non-cash assets are
sold for:
1. $ 29,000, Gain on realization
2. $ 20,000, Loss on realization
3. $ 4,000, Loss on realization- capital deficiency

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(Note: - capital deficiency means that at least one partner has a debit balance in his or her capital account at the
final distribution of a cash)
a. Partner pays deficiency
b. Partner can’t pay deficiency
Any uncollected deficiency becomes a loss to the partnership and is divided among the remaining partners’ and
is divided among the remaining partners’ capital balances, based on their income-sharing ration.
1. Gain on Realization
Fassil, Tangut, and Kassa
Statement of partnership Liquidation
For Period May 13, 31, 2021
Assets Capital
Non cash = Liabilities Fassil Tangut Kassa
Cash + Assets 40% 40% 20%
Balance before realization $3,000 $ 24,000 $ 6,000 $ 10,000 $ 8,000 $ 3,000
Sale of assets & division of gain +29,000 - 24,000 + 2,000 + 2,000 + 1,000
Balance after realization $ 32,000 $0 $6,000 $ 12,000 $ 10,000 $ 4,000
Payment of liabilities -6,000 - -6,000 - - -
Balance after payment of $ 26,000 $0 $0 $ 12,000 $10,000 $ 4,000
liabilities
Cash distributed to partners -26,000 - - -12,000 -10,000 - 4,000
Final balance $0 $0 $0 $0 $0 $0
The entries to record the steps in the liquidating process are as follows:
Cash……………………………29,000
Non cash Assets………………………24,000
Gain on Realization…………………...5,000
(To record selling of assets)
Gain on Realization………………5,000
Fassil, capital……………………………2,000
Tangut, capital…………………………..2,000
Kassa, capital……………………………1,000
(To record Division of gain from sale of assets)
Liabilities……………………………….6,000
Cash…………………………………………..6,000
(To record Payment of Liabilities)
Fassil, capital………………………….12,000

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Tangut, capital………………………...10,000
Kassa, capital…………………………..4,000
Cash……………………………………………...26,000
(To record Distribution of cash to partners)

2. Loss of Realization
Fassil, Tangut, and Kassa
Statement of partnership Liquidation
For Period May 13-31, 2021
Assets Capital
Cash + Non cash = Liabilities + Fassil Tangut Kassa
Assets 40% 40% 20%
Balance before realization $3,000 $ 24,000 $ 6,000 $ 10,000 $ 8,000 $ 3,000
Sale of assets & division of loss +20,000 - 24,000 - - 1,600 - 1,600 - 800
Balance after realization $ 23,000 $0 $6,000 $ 8,400 $ 6,400 $ 2,200
Payment of liabilities -6,000 - -6,000 - - -
Balance after payment of liabilities $ 17,000 $0 $0 $ 8,400 $6,400 $ 2,200
Cash distributed to partners -17,000 - - -8,400 -6,400 - 2,200
Final balance $0 $0 $0 $0 $0 $0
The entries to liquidate the partnership are as follows
Cash…………………………..20,000
Loss on Realization…………...4,000
Non cash Asets………………………….24,000
(To record Selling of Assets)
Fassil, capital………………………………….1,600
Tangut, capital………………………………...1,600
Kassa, capital………………………………….800
Loss of Realization………………………………………..4,000
(To record loss on realization of assets)
Liabilities……………………………………..6,000
Cash……………………………………………………6,000
(To record Payment of liabilities)

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Fassil, capital……………………………..8,400
Tangut, capital……………………………6,400
Kassa, capital……………………………..2,200
Cash……………………………………………..17,000
(To record Distribution of cash to partners)
3. Loss on Realization- capital Deficiency
Partner pays Deficiency
Fassil, Tangut, and Kassa
Statement of partnership Liquidation
For Period May 13-31, 2021
Assets Capital
Cash Non cash Liabilities+ Fassil Tangut Kassa
40% 40% 20%
Balance before realization $3,000 $ 24,000 $ 6,000 $ 10,000 $ 8,000 $ 3,000
Sale of assets & division of loss +4,000 - 24,000 ____ - 8,000 - 8,000 - 4,000
Balance after realization $ 7,000 $0 $6,000 $ 2,000 $0 $ (1,000)
Payment of liabilities -6,000 - -6,000 - - -
Balance after payment of liabilities $ 1,000 $0 $0 $ 2,000 $0 $ (1,000)
Receipt of deficiency +1,000 - - - - +1,000
Balances $ 2,000 $0 $0 -2,000 $0 $0
Cash distributed to partners -2,000 - - -2,000 - -
Final balance $0 $0 $0 $0 $0 $0
The entries to record the liquidation are as follows:
Cash………………………………..4,000
Loss on Realization……………….20,000
Non cash Assets………………………..24,000
(To record Selling of assets)
Fassil, capital…………………....8,000
Tangut, capital…………………..8,000
Kassa, capital…………………....4,000
Loss on Realization……………………20,000
(To record Division of loss from sale of assets)
Liabilities…………………………………6,000
Cash…………………………………………….6,000
(To record Payment of liabilities)
Cash…………………………………..1,000
Kassa, capital…………………………………..1,000
(To record Receipt of cash from deficient partner)
Fassil, capital…………………………….2,000
Cash……………………………………………..2,000
(To record Distribution of cash to partner)

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CHAPTER SIX
ACCOUNTING FOR CORPORATION BUSINESS
Corporation –is a legal entity distinct and separate from its owners. As an artificial legal being, a corporation
may acquire, own, and dispose of property in its own name. It may also borrow money enter to contract sue ad
be sued.
Characteristics of corporation
A number of characteristics distinguish a corporation from proprietorship and partnership.
1. Separate legal entity- A Corporation acts as an artificial person separate and distinct from their owners who
are called stockholders or shareholders.
2. Limited liability-The liability of stockholders limited in their investment in the corporation, and creditors
have on legal claim on personal assets of the owner.
3. Continuous life and transferability of ownership- The ownership of a corporation is divided in to shares of
stock, which are transferable unit. This makes a corporation to have a continuous life regardless of change in
the ownership of their stock.
4. Corporate taxation-corporations are separate taxable entities .They pay a variety of taxes not required for
proprietorship and partnership
5. Separation of ownership and management-stockholders own the business, but a board of directors elected
by stockholders –appoint corporate officers to manage the business.
Advantages of the corporate form of organization
Several characteristics of corporation may make this form of organization more desirable than either a partnership
or a proprietorship.
1. Greater amount of capital can be raised-large number of individual and institutions can more easily and
efficiently acquire and dispose of ownership interest in a corporation than in a partnership.
2. Owners liability is limited to the amount invested in the corporation
3. Ownership shares area easily transferable –After the initial sale of stock, shares may be transferred in
private sale transaction, traded (soled) on without asking for approval from the Co. Management.
4. Continuity of existence-reefers to the unlimited life of a corporation the transfer of shares does not affect the
corporation’s ability to operate routinely over decades.
5. Professional management –the excellent record of growth and earnings in most large corporation indicate
that the separation of ownership and control has benefited rather than injured stockholders.
Disadvantages of corporate form of organization

i. Double taxation exists –Income of a corporation is taxed twice.

ii. Government regulation exists-corporation is subject more to government regulations than either
proprietorship or partnership.
iii. Not easy to form
iv. Large setting up cost

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Formation of a corporation
Creation of a corporation begins when its organizers, called the incorporators, obtain a charter from the state. The
charter includes the authorization for the corporation to issue a certain number of shares of stock, which are shares
of ownership in the corporation. To obtain a corporate charter, an application called the articles of incorporation
is submitted to the state official.
The application (articles of incorporation) contains the following type of information.
 The name, purpose and duration of the proposed corporation
 Amounts, kinds and number of shares of capital stock to be authorized
 The address of the corporation’s principal office
 The name and the address of incorporators
After the charter is obtained; the stockholders in the new corporation hold a meeting to elect board of directors
and to establish by laws as a guide to the company’s affairs. The directors in turn meetings at which officers of
the corporation are appointed.
The formation and organization of a corporation requires significant costs. Such cost is called organization cost.
Organization costs- are incurred in the formation of a corporation: such costs include: legal fees, taxes, sate
incorporation fees, and promotional costs are debited to an intangible asset account entitled organization costs
and are normally amortized over a five –year period.
Example: On May 1, 2021 East Africa Co. paid the following expenditures at the time of its formation.
Attorney fees……………………………$10,000
Incorporation fees………………………...7,000
Stock certificate printing cost……………..20,000
Other related expenditures 8,000
Total 45,000
To record the payment of cash for organizing the corporation
May 1, 2021 Organization costs……………45,000
Cash………………………….45000
To record the amortization expense at the end of the year
Amortization exp-organ cost…………..6000
Organization cost…………………………6000
In the balance sheet organization cost appear under the “other assets “section.
Rights of stockholders
The ownership of stock in corporation usually carries the following basic rights
 The right to receive a certificate as evidence of ownership interest, and to transfer such shares as they
choose (through either sale or gift).
 The right to vote for board of directors and business matters
 The right to share in profits by receiving dividends
 To share in assets upon liquidation

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Characteristics of stock issuance

In considering the issuance of (or sale) of stock, corporation must resolve a number of basic questions:
 How many shares should be authorized for sales?
 How the stock be issued?
 At what price should be issued?
 Should a par value or no-par value be assigned to stock?
For purposes of discussion, these questions are considered under the following headings:
Capital stock- a corporation issues stock certificates to its owners in exchange for their investment in the
business. The basic unit of capital stock is called a share.
Stock –certificate- proof of stock ownership is evidenced by printed or engraved form known as a stock
certificate.
The face of the certificates shows the name of corporation, the stockholders name, the class and special features
of the stock, the number of shares owned, the signatures of authorized corporate officials
Authorized capital stocks-are the number of stocks that the corporation is authorized to sell. This is indicated in
its character.
Issued capital stocks-are stocks, which are sold to the investors either directly or indirectly through a brokerage
house (that specialization in bringing stocks to the attention of prospective investors.
Outstanding capital stocks-are shares of capital stock issued by the co. and still are being held by stockholders
Par value of the stock –is an arbitrary monetary amount assigned to a single share of stock at the time of
authorization par value represents the legal capital per share that must be retained in the business for the protection
of corporate creditors.
No par value stock –is a capital stock that has not been assigned a value in corporate creditors
*stocks are issued with no par value to prevent confusion by the investors between par value and market value.
No par with a stated value-stated value- serves the same purpose as par value. But since stated value is not
printed on the stock certificate; there is less risk of confusing investors.
 Stated value like par value is not indicative of the market value of the stock.
 In accounting for issuance of stock, the par value or the stated value is recorded in the common stock
account.
Market value of stock – is a selling price of market price of stock.
Some of the factors that affect the market price of stock are:
- Company‘s earnings
- Dividend policy
- Interest rates
- Economic police of board of directors
Corporate capital
The owner’s capital equity in the corporation is termed as stock holder’s equity or corporate capital. Sources of
stock holder’s equity:
Paid in capital (contributed capital) is investment by the stock holders in exchange of capital stock.
Retained earnings- is net income retained in the corporation through profitable operation of the business. Under
corporation net income is recorded in retained earnings by a closing entry in which income summary is debited
and retained earnings is credited

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Example: Assume that net income for east Africa Co. in its first year operation is
$250,000 the closing entry is:
Income summary ----------------------250,000
Retained Earnings -------------------------------250,000
CLASSES OF STOCKS
In order to appeal to as many investors as possible, a corporation may issue more than one kind of capital stock.
The two types of stock s are common and preferred. Stockholders normally acquire one of two basic types of
stock as evidence of their ownership interest.
1. Common stock – is the most basic / primary/ capital stock issue by the corporation to stock holders.
 Common stock holder’s possess all the rights listed earlier
 Common stock holders are the primary owners of the corporation.
 If only one class of stock is issued its common stock.
2. Preferred stock –issued by a corporation to appeal investors who are unwilling to take all the risks
involved in the common stock ownership.
 The rights of common stockholders are modified to provide the preferred Stockholders with
certain advantages not available to common stock holders.
Most Preferred Stocks have the Following Distinctive Features.
 Preferred as to dividends
The preferred stockholders are entitled to receive a dividend of specific amount before any dividend is paid
on the common stock.
The dividend is usually stated as a dollar amount per share or as a percentage of par values.
 Cumulative Dividend Right
The dividend preference carried by most preferred stock a cumulative one. If all or part of the regular
dividend on preferred stock is omitted in a given year, the amount omitted is said to be in arrears and must
be paid in subsequent year before any dividend paid for common stock.
 Preferred as to assets in event of liquidation of the co.
Most preferred stock carry a preference as to assets in the event of liquidation the corporation.
If the business is terminated, the preferred stock entitled to payment in full of its par value or a higher stated
liquidation value before any payment is made on common stock.
 Participating dividend right
The owners of participating preferred stock may receive –that participating in dividend beyond the stated
amount or percentage
 Callable at the option of the corporation
most preferred stock include a call provision. The provision grates the issuing corporation the right to
purchase the stock from the stockholders at stipulated call price.
Conversion privilege
In order to add to the attractiveness of preferred stock as Investment Corporation sometimes offers
conversion privilege which entitles the preferred stockholders to exchange their shares for common stock
in stipulated price ratio

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 Fundamentals of Accounting II

 No voting right
Preferred stockholders dividend give up some of the privileges according to common stockholders. E.g. the
right to vote for member of the board of directors.
Preferred stock very widely with the respect to the special rights and privileges granted.
ISSUANCE OF CAPITAL STOCK
Stocks issued may have
par value
No par value but stated value
No stated value and no par value
Stock may also be issued:
-At par when a stock is issued at the same amount of par
-At premium
-At discount
Issuing common stock at par
This is when a stock is issued at the same amount of par
e.g. suppose WOW Corporation issue 500 share its Birr 10 par common stock for cash equal to its par value.
The stock issuance entry is:
Jan. 10 cash (500×10) ----------------------------- 5000
Common stock ----------------------------------5000
(To record the issuance of common stock at par)
The amount invested in the corporation is called paid in capital or contributed capital. The credit to common
stock records an increase in the paid –in capital of the corporation.
Issuing Common stock at Premium
A corporation usually issues its common stock for a price above par value. The excess amount above par value
is called a premium.
E.g. Assume XYZ Corporation issue 4000 shares its Birr 10 par common stock for a price of Birr 25
January 15 Cash (4000×25) ------------------------------------------ 100,000
Common stock ------------------------------------ 40,000
Paid in capital ------------------------------------- 60,000
(To record issuance of common stock)
The premium on the sale of common stock is not a gain; income or profit to the Co. because the entry is dealing
with its own stockholders.
This illustrates one of the fundamentals of accounting: a Co. can’t earn profit nor it incurs a loss which it sells
its stock or buys stock from its own stockholders.
Paid- in capital
C/ stock, Br.10 par 20,000 shares authorized, 4500shares issued------------- 45,000
Paid-in capital in excess of par -----------------------------------------------------60,000
Total paid-in capital -----------------------------------------------------------------105,000
Retained earnings ------------------------------------------------------------------- 85,000
Total stock holders equity --------------------------------------------------------- 190,000

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Since both par value and premium amounts increase the Co. capital they appear on the stock holder’s equity
section of the balance sheet.
Issuing Common Stock at Discount
stock issued at a price below par is said to be issued at discount
E.g. Assume a corporation issued 1,000 shares of Br 5 par common stock for Br.3 per share. The entry to
record the issuance
Cash (1,000× 3) --------------------------------3000
Discount on common stock (1000× 2) ----- 2000
Common stock (1000 × 5) ---------------------5000
The discount is reported in stockholders’ equity section of the balance sheet immediately after the stock a/c (as
just shown for reporting a premium).However, the discount b/c it has a debit balance is subtracted from the
credit balance par value of the stock issued to figure the capital amount.
The issuance of stock at discount is rare. In fact, it is illegal in most states. When a stock is sold at discount the
stockholders has a contingent liability for the discount amount. The corporation later liquidates; its creditors can
require the original stockholder to pay the discount amount.
Issuing Non par Common Stock
The contingent liability on common stock issued at a discount may why some state laws allow companies to issue
no par stock. If the stock s no par value, there can be no discount and thus no contingent liability.
E.g. stock issuance entry is:. Assume a Co. issues 300 shares of no par common stock for Br.20 per share.
The
Cash (300× 20) ---------------------------- 6000
Common stock -------------------------- 6000
(To issue no par common stock)
Issuing no –par common stock with a stated value
accounting for non- par stock with a stated value is identical to accounting for par value stock. The premium
account for non par common stock is entitled” paid in capital in excess of its stated value- common.’’
Cash……………………………..xxx
Common stock ………………………………….xxx
C/ stock in excess of stated value common ……..xxx
Capital stock may be issued or sold
-For cash
-For non cash assets
-Through subscription
Issuing common stock for assets other than cash
Socks may be issued:
For services (compensations to attorneys, consultants ,and other)or
For non cash assets (land, building, and equipment)
To illustrate, assume that the attorneys for compact inc., agree to accept 4,000 shares of Br .1 par value common
stock in payment of their bill of Br .5, 000 for service performed in helping the corporation to incorporate. At the
time of the exchange, there is no established market price for the stock.

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 Fundamentals of Accounting II

Jan. 5 Organization costs………………………..5,000

Common stock……………………………………..4,000
Additional paid in capital in excess of par…………1,000
(To record issues of 4,000 shares of birr 1 par value stock to attorney)
Assume that Rainbow Inc. is a public held corporation whose birr. 5 par value stock is actively traded at birr 8
per share. The CO. Issues 10,000 shares of stock to acquire land recently advertised for sale at birr 90,000. The
transaction is recorded as follows:
April 18 Land------------------------------80,000
Common stock--------------------------------------50,000
Paid in capital in excess of par value—---------30,000
(To record issuance of 10,000 of birr 5 per value stock for land)
ISSUING PREFERRED STOCKS
Accounting for preferred stock follows the same pattern as illustrated for common stock.
Assume the wow corporations’ charter authorizes issuance of shares of 5%, Br. 100 par preferred stock. On Feb1
the corporation issues 400 shares at a price of Br 110. The issuance entry is:

Feb 1 Cash (400x Br110---------------------------44,000)

Preferred stock (400x Br 100) ---------------------------- 40,000
Paid in capital excess of par- preferred (400x10) -------- 4,000
(To issue preferred stock at a premium)
Like that of a common stock preferred stock often sells at its par value or at a premium but seldom at a
discount. Accounting for no-par preferred stock follow the same pattern illustrated for no par common stock.
Donated capital
Donated capital results when a corporation receives assets as results of a gift or donation from municipalities,
charitable foundations, and other sources. Corporation occasionally receives gifts or donations either in the form
of cash other assets. For example, city council members may offer a corporation free land to encourage it to locate
in their city with the belief that the existence of the corporation will increase local employment.
Suppose Wow Corporation receives 100 hectare of land as a donation from the city municipality. The
current market value of the land is Br 150,000. The receipt of donation is recorded as follows.
June1. Land-----------------------------------150,000
Donation capital----------------------150,000
(To record donation of land from the city)
Donated capital is classified as part of paid in capital in the stockholder s’ equity section of balance sheet
Dividend on preferred and common stock
Definition: dividend is a distribution of earnings of corporation to its shareholder in return for their investment.
The amount of dividend to be distributed may be expressed either in percentage or specified amount Example-
10% or 100 per preferred stock. A corporation must declare a dividend before paying it .The board of alone has
the authority to declare a dividend. The corporation has no obligation to pay a dividend until the board declares
one, but once declared, the dividend becomes a legal liability of the corporation.

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 Fundamentals of Accounting II

Example: Moon Light Corporation has the following classes of stock in its balance sheet on Dec.31, 2021.

8% preferred stock, Br 50 par 10,000 shares authorized, 2000 Shares issued and outstanding Br100,000.
Common stock Br10 par 100,000 shares authorized, 50,000 Shares issued and outstanding……Br 500,000
Total preferred and common stock……………………………………………………………….Br.600,000

If the board of the corporation declares annual cash dividend of Br 150,000. What is the amount of dividend to
allocated (paid) to each class of stock assuming the preferred stock is non-cumulative and non-participative?

Preferred (8% x Br 50 x 2000 shares)……………………………………………..Br8000

Common (remainder: Br150,000 –Br 8000)………………………………………..142,000
Total dividend ……………………………………………………………………. Br 150,000
To an investor, the preferred stock is safer b/c it receives dividend first. That is the common stockholder will
receive only the remaining amount after preferred stockholders obtain first.
However, the earning potential from an investment in common stock is much greater than from an investment in
preferred stock .preferred dividends are usually limited to the specified amount, but there is no upper limit on the
amount of common dividends.

Classification of preferred stock

a) Cumulative but non participative;

Cumulative dividend feature offers preferred stockholders the right to receive both current year dividend
and un paid prior years(s) dividend called dividends in arrears before common stockholders receive
any dividends. If preferred stock is non-cumulative, the corporation is not obligated to pay dividends in
arrears Dividend in arrears are not consider as a liability ,b/c no obligation exists until the board of director
declares the dividends.
Suppose in previews example preferred stock is cumulative, non-participating feature and the corporation
did not declared or pay dividend during 2019 and 2020, the allocation of dividend will be determined as
follows:
Preferred Common Total

Total outstanding stock (par) Br.100,000 Br. 500,000 Br.600,000

Total dividend declared 150000

First, preferred dividend in arrears

(8%xBr 50x2000 sharesx2years) 16000 (16000)

Amount remaining 134,000

second, regular current preferred div.
(8%xBr.50x2000 share) 8000 (8000)
Amount remaining 126,000

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 Fundamentals of Accounting II

Third, remaining allocated to common Br.126,000 (126,000)

amount remaining -0-
Total distribution 24,000 + 126,000 = 150,000
b) Cumulative &Participating

Participating dividend feature gives preferred stockholders the right to receive dividend beyond the specified rate
(amount) by sharing proportionally with common stockholders for any remaining amount

If, however, the preferred dividend is limited to the specified rate (amount) the stock is referred to as non-
participating.

Example suppose in the previous example the preferred stock is both cumulative and participating and the
corporation did not declare dividend during 2019 and 2020. The amount of dividend for each class at the end of
2021 is determined as follows:
Preferred common Total
Total outstanding stock (par) Br.100,000 Br.500,000 Br.600,000
Total dividend Declared 154,000
First, preferred dividends in arrears
(8%xBr.50x2000sh.x2yrs) 16,000 (16,000)
Amount remaining 138,000
second ,regular current preferred dividends
(8%xBr.50x 2,000sh.) 8000 (8000)
Amount remaining Br.130, 000
Third, common dividend
(8%xBr.10x50, 000sh.) 40,000 (40,000)
Amount remaining 90,000
Fourth, remainder allocated each the same
15% percentage (90,000/600,000=15%
15%xBr.100,000 15,000 (15,000)
15%xBr.500,000 75,000 (75,000)
Amount remaining ------ ------- Br 0
Total distribution 39,000 115,000 154,000
Participating preferred stock is rare. In fact, preferred stock is non-participating un less it is specifically
described as participating on the stock certificate and in the financial statement.
Treasury stock

Definition- treasury stock is a corporation’s own stock that has been issued, fully paid for, and reacquired by
the issuing co., but not re-issued.

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 Fundamentals of Accounting II

Reasons for Reacquisition

 To make stock available to issue to officers and employed under bonus plan.

 To support the stock’s current market price by decreasing the Supply stock available to the public

 To increase earnings per share by reducing the number of shares outstanding

 To avoid a take overran outside party

Treasury stock is still consider issued but not outstanding and, therefore, is not include in computing earnings
per share and does not received dividend. The difference between an issued stock and treasury stock is the
treasury stock has been issued and bought back.

-Treasury Shares are issued but are not outstanding because they are no longer in the hand of stockholders
-The purchase of treasury stock decreases the corporation’s assets and its stockholders equity.
-The purchase of treasury stock is usually recorded at accost in treasury stock account.

The stock holders section before purchase of treasury stock is as follows.

Paid in capital

Common stock,Br.1 par, 10,000 shares authorized,8000 shares

issued and outstanding Br.8,000
paid-in capital in excess of par-common 12,000
Total paid -in capital 20,000
Retained earnings 14,600
Total stockholder equity Br.34,000

On sep.10 the corporation purchases 1,000 shares of its Br.1 par common as treasury stock, paying cash
ofBr.7.50 per share
The corporation records the purchase as follows:
Sept. 10. Treasury stock-common (1000x Br.7.50) -------------7,500
Cash----------------------------------------------------7,500
(To record purchase of 1,000 share of treasury –stock at Br.7.5 per share)
Treasure stock is recorded at cost, without reference to the par value of the stock. The treasury stock account is
reported beneath retained earnings on the balance sheet, and its balance is subtracted from the sum of total paid-
in capital and retained earnings, as follows;
Common stock,Br.1 per,10,000 share authorized,
8000 shares issued, 7000 share outstanding Br. 8,000
Paid in capital in excess of par common 12,000
total paid in capital 20,000
Retained earnings 14,600

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 Fundamentals of Accounting II

Total paid in capital and retained earnings 34,600

Less: treasury stock(1,000 shares at cost) 7,500
Total stockholder’s equity Br27,000

Observe that the purchase of treasury stock does not decrease the number of shares issued. The common stock,
paid in capital in excess of par, and retained earnings account remain unchanged

However, total stockholder’s’ equity decreases by the cost of treasury stock. Also, share of outstanding decrease
from 8,000 to 7,000. Only outstanding shares have the right to vote, receive cash dividends, and share in asset if
the corporation liquidates. While shares are hold in the treasury, they do not the right of outstanding shares-they
can’t vote receive dividends.

Re-issuance or sale of treasury stock

Treasury stock is usually reissued or sold at its purchased cost, above its cost or below its cost.
a) Sale of treasury stock at cost-treasury stock may be sold at any price agreeable to the corporation and the
purchaser. If the stock is sold for the same price that the corporation paid to reacquire it, the entry is debit to
cash and a credit to treasury stock for the same amount

Cash xxx
Treasury stock(cost) xxx
b) Sale of treasury stock above cost-If the sale is greater than reacquisition cost, the d/c is credited to the
account paid-in capital from treasury stock.

Suppose in the previous e.g. The co. Resold 200 of its treasury shares for Br.9 per share, the entry is

Dec.10. Cash (200sh. X Br.9) 1800

Treasury stock, common (200sh xbr.7.50) 1500
paid-in capital from treasury stock 300
(To sell 200 share of treasury stock at Br 9/share)

Br. 300 credit in the entry is not made to gain on sale of treasury stock for two reasons:
1) Gains on sales occur when assets are sold and treasury stock is not an asset
2) A corporation does not realize a gain or suffer a loss from stock transfer with its
stockholders.
C) Sales of treasury stock below cost-At the time the re-sale price is less than cost. The d/c between these two
amounts is debited to paid- in capital from treasury stock account, then the co. debits retained earnings to the
remaining amounts.
For e.g. assume the corporation sold 400 share of treasure stock at Br 7 per share. The entry is:

Dec.15. Cash (400sh x Br 7) 2,800

Paid in capital from treasury stock (400sh x Br 0.5) 200
Treasury stock (400sh x Br 7.5 cost) 3000
The sale of treasury stock increase both total assets and total stockholder equity.

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 Fundamentals of Accounting II

Assume, however, that the corporation sold the 400 shares of the treasury stock at Br 5 per share. The entry is:
Dec.15. Cash (400 Shares x Br 5) 2000
Paid in capital from treasury stock 300
Retained earnings 700
Treasury stock, common (400 xBr7.5) 3,000
(To record sales of 400 Shares of treasury stock at Br 7)

Reporting earnings and dividend

Dividends: Are distribution of retained earnings of a corporation in the form of cash, stocks, or, other assets.
For a corporation to declare a cash dividend it considers three factors
1. Retained earnings- since dividends represents a distribution of earnings to the stock holder, the theoretical
maximum for dividends is the total undistributed net income of the corporation represented by the credit
balance of the R/earnings account.
2. An adequate cash (position)-The fact that the co. Reports large earnings does not mean that it has a large
amount of cash on hand. Cash generated from earning may have been invested in new plant and equip or in paying
off debts or in acquiring a larger inventory.
3. Dividend action by the board of directors-even though a co.’s net income is substantial and its cash position
seemingly satisfactorily, dividends are not paid automatically –a formal action by the board of directors is
necessary to declare dividends.
Three dates are important in connection with dividends:
1.The declaration date
2.The record date, and
3.The payment date
Declaration date-is the day that the BOD announces to distribution dividend. The declaration creates a liability
for the corporation
*To illustrate, assume that on Dec1,2021, the board of ABC corporation declared a Br.0.80 per share cash
dividend on 100,000 shares of Br.10 par value common stock. The entry to record the declaration is:
Dec.1 Retained earnings(Br 0.8 x 100,000 shares) 80,000
Dividend payable 80,000
(To record declaration of cash dividend)
1. Record date-is the day that the list of the names and address of the stockholders is compiled. The purpose
of the record date is to identify the persons or entities that will receive dividends, not to determine the
amount of dividend liability .no accounting entry is necessary on the record date because no further
financial transaction or commitment has taken place.
2. Payment date-is the day on which the dividends are sent to the shareholders. The payment of the cash
dividend is recorded at this time.
Dividend payable -------------80,000
Cash --------------------------------80,000

COMPILED BY: GEMEDO T. WAKO (MSC) 67