PRI II Note CH 1-7

CHAPTER ONE
ACCOUNTING FOR CASH

Controlling over Cash in General: Because of its nature, cash is the most likely to be
diverted and used improperly by employees. Many transactions either directly or indirectly
affect the receipt or payment of cash. Therefore, it is necessary that cash be effectively
safeguarded by special controls.
Effective Systems of Internal Control: Internal control is the organization plan and all the
related measures that an entity adopt to
 Safeguard assets
 Encourage adherence to company policies
 Promote operational efficiency (obtain the best out come at the lowest cost ) and
 Ensure accurate and reliable accounting g records.
The bank Account as a tool for Controlling Cash
Cash is the most liquid asset because it is the medium of exchange. Cash is easy to conceal, easy
to more, & relatively easy to be stolen. One of the major devices for maintaining control over
cash is the use of the bank account. To get the most benefit from bank account
- All cash received must be deposited in the bank
- All cash payment must be made by check.
When such a system is strictly followed, there is a double record of cash, one maintained by the
business (depositor), and the other by the bank. The forms used by the bank in connection with
bank account are
a) Signature card.
b) Deposit ticket.
c) Check
d) Records of checks drawn.
e) Bank Statement
f) Electronic fund transfer
Definition of Check: - A check is a written instrument signed by the depositor, ordering the
bank to pay a certain sum of money to the order of a designated person. There are three parties to
a check
a. The drawer: is the one who signs the check
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b. The payee: is the one to whose order the check is drawn.
c. The drawee: is the bank on which the check is drawn
Bank statement: A bank statement is the document that the bank uses to report what it did with
depositor’s cash. The statement shows the bank account’s beginning balance, checks and other
debits (deduction by bank), deposits and other credits (additions by the bank), and the balance at
the end of the period. The depositor’s checks received by the bank during the period may
accompany the bank statement, arranged in order of payment. Those checks the bank has paid on
behalf of the depositor are called canceled checks.
Electronic fund Transfer (EFT) is a system that relies on electronic communication not paper
documents- to transfer cash. Most businesses today rely on EFT for repetitive cash transactions.
It is much cheaper for a company to pay employees by EFT (direct deposit) than by issuing
hundreds of payroll checks.
The Bank Reconciliation
Where all cash receipts are deposited in the bank and payments are made by checks, the cash
account often called cash in bank. This account in the depositor’s ledger is the reciprocal of the
account with the depositor in the banks ledger. Cash in bank in the depositor’s ledger is an asset
account with a debit balance &, the account with the depositor in the bank’s ledger is a liability
with a credit balance. The books and the bank statement may show different amounts, but both
may be correct. The differences arise because of one or more of the following problems.
A. Delay by either party in recording transactions by
a. Deposit in transit: is an outstanding deposit recorded by the company (depositor) and not
yet by its bank.
b. Outstanding checks: are checks that the company has issued and recorded them on its
books but the bank has not yet
c. Bank collection paid them: banks some times collect money on behalf of depositors. Many
businesses have their customer pay directly to the company bank account. It is known as a
lock –box system, which reduces the possibility of theft and places the business cash in
circulation faster than of the cash had to be collected and deposited by the company
personnel.
d. Electronic fund transfer: The bank may receive or pay cash on behalf of the depositor.
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e. Bank service charge: This is the bank’s fee charged against the depositor’s account for
processing the depositor’s account. Bank commonly bases the service charge on the
account balance and the depositor learns the amount of the service charge from the bank
account. It also includes the cost of printing checks.
f. Interest Revenue on Checking Account: Banks often pay interest to depositors who keep
enough cash in their account. The bank notifies depositors of their interest on the bank
statement.
g. Non-sufficient funds (NSF) Checks received from customers, they are sometimes known
as hot checks. The maker writes a check & gives it to the payee, who deposited the check
in a bank. The payee’s bank adds the receipt amount to the payee’s bank balance on the
assumption that the check is good. If the maker’s bank balance is insufficient to pay the
check, the maker’s bank refuses to pay and sends an NSF notice to the payee’s bank. The
payee’s bank subtracts the receipt amount from the payee’s bank balance & notifies the
payee of this NSF action.
h. Checks collected, deposited & returned to payee by the bank for reasons other than NSF.
Banks return check to the pay if
- The maker’s account has closed
- The date is “stale” (some checks state “void after 30 days”)
- The signature is not authorized
- The check has been altered
- The check form is improper (for example, a counter fit)
B. Errors by either by the company or bank
- All errors should be corrected and the correction will be part of the bank reconciliation.
The process of bringing in to agreement the balance maintained by the bank & the
depositor is called bank reconciliation.
- The reconciliation starts with two figures, the balance shown on the bank statement
(balance per bank) and the balance in the company’s cash account (balance per book).
The following is the format of bank reconciliation
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ABC Company
Bank Reconciliation
Dec 31, 19xy
Bank Balance according to Bank statement --- xxx
Add :- Additions by depositor’s not on bank,
Statement (outstanding deposit) ----------- xxx
- Errors made by banks -------------- xxx --------------------------- xxx
xxx
Deduct – Deductions by depositor not on bank statement xxx
- Bank errors -------------------------------------------------- xxx-----xxx
Adjusted Balance ---------------------------------------------------------------------- xxx
Balance according to depositor’s records (balance per book) ------------------- xxx
Add: - Bank collection of Note ------------------------xxx
- EFT receipt of Note -------------------xxx
- Interest revenue earned -------------- xxx
- Depositor’s errors ---------------------xxx ----------------------- xxx
xxx
Deduct : - Deductions by bank not recorded by the depositor
- NSF checks -----------------------xxx
- Bank service charge –-------------xx
- Depositor’s Error ------------------xx ---------------------------- xxx
Adjusted balance -------------------------------------------------------------------- xxx
Journal Entries: Items that appeared on the depositor side in the bank reconciliation requires
journal entries.
Assume the following data for September 2005 for Nile Corporation to illustrate the preparation
of bank reconciliation:
The ‘cash in bank’ account in the ledger for Nile Inc. shows the following
Balance July 1, year 2005 $ 10,400
Posting from cash receipt journal for July 20,600
Postings from check register for July 18,200
The balance in the bank statement as of July 31, year 2005, shows a balance of $13,963.50.
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The following reconciling factors are given:
1. A deposit of $2,600 indicated on the cash receipt journal is not included on the bank
statement due to the reason that the bank hasn’t yet finished the process.
2. Debit memorandum is accompanied with the bank statement for bank service charged of
$16.50.
3. A credit memorandum included with the bank statement showed that a note receivable
for an amount of $3,000 is collected from customers and credited for $3,050, including
interest revenue of $50.
4. It is discovered that check #212 for $810 is credited as $180 in the depositor’s records.
The check was issued for purchase of office supplies.
5. The following check issued during the month are not cashed by the payees and, thus not
included in the bank statement:
Check #208 $ 1,600
Check #211 900
Check #215 860
6. The check received from Ford Trading and deposited in the bank during the month for an
amount of $2,000 is returned with the bank statement marked ‘Not sufficient fund’.
7. The bank collected $8,000 for Nile Inc. during the month representing maturity value of a
treasury bill. The Treasury bill had been acquired by the bank for Nile Inc. at a discount
of $7,500. However, this collection was not recorded both by the bank and the depositor.
Required?
A. Prepare bank reconciliation for Nile Inc.
B. Record necessarily journal entry.
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Solution
Nile Inc.
Bank Reconciliation
July 31, year 2005
Balance on bank statement –July 31,year 5 13,963.50
Add:
Add: Deposit in transit 2,600.00
Treasury bill collected including interest revenue of $500 8,000.00 10,600.00
Sub- total 24,563.50
Less:
Less: Outstanding checks
Ck # 208 1,600.00
Ck # 211 900.00
Ck # 215 860.00 (3,360.00)
Correct cash balance- July 31, year 2005 21,203.50
Depositor’s balance at July 31, year 2005 12,800.00
Add:
Add: Note and interest collected by the bank 3,050.00
Treasury bill collected including interest revenue of $500 8,000.00 11,850.00
Sub – total 23,850.00
Less: Bank service charge 16.50
Error in recording check # 212 630.00
Not sufficient fund check – Ford trading 2,000.00 (2,646.50)
Correct cash balance July 31, 2005 21,203.50
A. Recording of necessary journal

Accounts Debit Credit
Cash in bank 11,050.00
Miscellaneous expense 16.50
Office suppliers 630.00
Account receivables- Ford trading 2,000.00
Interest revenue (50+500) 550.00
Notes receivable 3,000.00
Short – term investment 7,500.00
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CONTROLLING OVER CASH RECEIPTS
Department stores & other retail business receive cash from two main sources
a. Over the counter from customers
b. By mail from charge customer making payments on account.
c. Cash short & over: A difference often exists between actual cash receipts and the day’s
record of cash received whenever there is difference b/n the record and the actual cash
and no error can be found in the record, it must be assumed that the mistake occurred in
making changes. The cash short or overage is recorded in an account entitled cash short
and over.
Assume that the cash register tape (accounting record) of Xyz Company indicated sales revenue
of $25,000 from sales of sep1, 2003.
Case 1. The actual cash received was $ 24,980
Actual cash < cash show by the record cash show by the record – Actual cash = cash
short Miscellaneous adm. Exp 25,000 –24,980 = 20
Entry: cash 24,980
Cash short & over 20
Sales 25,000
Case2. The actual cash count (received) was $ 25,035
25,035 – 25,000 = 35 =cash over = Other income
Entry: cash 25, 035
Cash short & over 35
Sales 25,000
D. Cash change funds: is a fund of current & coins maintained to make change the fund may be
maintained by draw up a check for the required amount.
Entry: Cash on hand xxx

Cash in Bank xxx
 No additional charges or credits to the cash on hand are necessary unless the amount of
the fund is increased or decreased.
 It should remain in the cash register at the opening of every business day
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Eg, On Jan 15,19x1 cash sales for the day according to the cash register tapes were Br. 942.40.
The actual cash count on that date was or 1,145.10. Besides a change fund of Br 200 was
established and included in the actual cash.
Required
A. Record the established of cash change fund
B. Determine the existence cash short & over
C. Record the entry of sales in general journal form
Solution:
a. cash on hand 200
Cash in bank 200
b. Actual cash count ---------------------------- $ 1,745.10
Less cash change fund ---------------------------- 200.00
Actual cash from sales ----------------- ----------- 945.10
Less cash sales for the day (accounting record) 942.40
Cash over--------------------------------------------- $2,70
c. cash ---------------------------- 945.10
Sales -----------------------------942.40
Cash short over --------------------2,70
INTERNAL CONTROL OVER CASH PAYMENTS
Strong control over
- cash payments by check
- purchasing
- Approval of payments is necessary.
- The use two signatures.
- The use of the voucher system and
- Petty cash disbursements.
The voucher system: Avouched system is made of records, methods and procedures used in
proving & recording liabilities & in making and recording cash payments. It improves control
over disbursements. It is used:
a. Voucher
b. Voucher register
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c. A file for unpaid voucher
d. Check register.
e. A file for paid voucher.
a. Voucher: is any document that servers as a proof of authority to pay cash, such as
invoices approved for payments, or evidence that cash has been paid such as canceled
checks.
b. Voucher register: after approval by a designated official, each voucher is recorded in a
journal known as voucher register. The vouchers are entered in numerical order, each
being recorded as a credit to Account payable or voucher payable and as a debit to the
account or accounts to be charged for the expenditure.
c. Unpaid voucher file: after a voucher has been recorded in the voucher register, it is paid
in unpaid voucher file, where it remains until it is paid.
d. Check register: when a voucher is to be paid, it is removed from the unpaid voucher file
and a check is issued in payment, The date, the number, and the amount of the check are
listed on the back of the voucher for use in recording the payment in the check register.
Paid vouchers and supporting documents are after run thorough a canceling machine to
prevent accidental or intentional re- use.
e. Paid voucher file: after payment, vouchers are usually filed in numerical order in a paid
voucher file. They are them readily available for examination by employees or
independents auditors needing information about certain expenditure.
Petty cash disbursements: It would be uneconomical for a business to write a separate check
for small amount of payments such as executive’s taxi fare, postage due, transportation charge,
purchase of urgently needed supplies at the nearly shop etc, companies maintain small amount of
cash on hand to pay for such minor expenditures. This fund is called petty cash fund. The
business needs the following conditions to establish and replace the petty cash.
1. Estimate the amount of cash needed for small payments during a period (month year)
2. Identify the employee who will administer the petty cash fund (petty casher.)
3. Prepare a check for the amount of the petty cash fund & give it to the petty
cashier .Record the transactions in the cash payment journal.
4. The petty cashier withdraws the cash from the bank & then administers the fund.
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5. When disbursements are to be made from the fund, a petty cash receipt is prepared. The
petty cashier gets the signature of the payee on the receipt as evidence of making
payment & then the payment is made to the payee.
6. When the petty cash fund gets low to a predetermined level, the fund is replenished to
restore its balance to the original level.
Assume that the voucher system is used and that a petty cash fund of $500 is established on
august 1, of the current year. The fund is to be replenished when its balance reaches to $100
Aug2 – 20 summaries of the petty cash receipts indicate that the following payments were made
from the petty cash.
 Supplies -------------------------- Br. 150.00
 Miscellaneous Adm.exp.---------- Br. 90.00
 Delivery expense ---------------------Br 160
Aug 31 – The petty cash balance is Br. 250 summary of the petty cash receipts since the last
replenishment indicates the following expenditures.
- Miscellaneous selling exp ----------150
- Miscellaneous Adm.exp. ------------100
Journal entries
Aug1 . Establishment of petty cash
Petty cash 500
Voucher payable 500
- When the Voucher is approved
Voucher payable 500
Cash in bank 500
Aug20. Replenishment of petty cash
Supplies 150
Miscellaneous Administrative Expense 90
Delivery expense 160
Voucher payable 400
When the Voucher is approved
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Voucher payable 400
Cash in bank 400
Aug30: Miscellaneous selling expense 150
Miscellaneous administrative expense 100
Voucher payable 250
When the Voucher is approved
Voucher payable 250
Cash in bank 250
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CHAPTER TWO
ACCOUNTING FOR RECEIVABLES
Definitions and Classifications of Receivables and payables
 Receivables include all money claims against people, organizations, or other debtors.
 Receivables are acquired by a business enterprises in various kinds of transactions, the most
common being the sale of merchandise or services on credit basis.
Sales for cash
on account (on credit) receivables will be created
By taking the time frame receivables can be divided in to two:-
1. Short-term receivables: receivables that one expected to be realized in cash within a year,
usually less than one year.
 Short term receivables are reported under current asset of the balance sheet become cash
account.
2. Long-term receivables: receivables those are not currently collectable, such as long term loans.
 The period of time usually more than one year long term receivables are reported under a
separate section called "Investments" become the current asset section.
Receivables can be divided in to two based on the agreement that the parties made:
1. Open account: receivables created by oral agreement reported as account receivables. It is
created by trust each other. It is also known as trade receivable (no written evidence).
Promissory note: receivables created by written agreement.
2. Promissory note, frequently referred to as a note.
 Promissory note (note) is a written promise to pay a sum of money on demand or at a definite
time. It is written evidence that shows a clearly the amount to be paid. It refers to as a notes
receivables.
Notes have an advantage over oral promises or open accounts
 It can be endorsed and transferred to a bank
 It can be useful in a court of law as evidence of debt (legality).
 Can be exchange for cash (discountable account)
Notes receivable
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Characteristics of notes receivable
Notes receivables must be signed by a person or firm that makes the promise.
A. DUE DATE (MATURITY DATE): The date on which the note is collected
 The period of time b/n the issuance date and the maturity date of a short-term note may be
stated in either days or months. Issuance date is the date on which the note is written by the
maker or borrower.
 When the term of a note is stated in days, the due date is the specified no. of days after
issuance. When the term of a rate is stated as a certain number of months after the issuance
date, the due date is determined by counting the number of months from the issuance date.
E.g. A three month note dated August 3 would be due on November 3
Example: The due date of the 60 day note presented above may be determined as follows:
Due date
Term of the note -------------------------------------- 60
No. of days in April ----------------------- 30
Date of note (transaction) ---------------- 10
20
No. of days remaining -------------------------------- 40
No. of days in May ----------------------------------- 31
Due date, June ----------------------------------------- 9
Due date June 9
B. INTEREST AND NON-INTEREST BEARING NOTES
Interest bearing note is a note that provides for the payment of interest for the period b/n the
issuance date and the due date. If a note makes no provision for interest, it is said to be non-
interest bearing.
 If the note is interest bearing note the maturity value is greater than the face value.
MV = FV + interest
 In non-interest bearing note the face value is equal to the maturity value. FV = MV
The basic formula for computing interest is as follows: principal x Rate x Time = Interest.
E.g. Birr 2000 at 9% for 60 days
P = 2000 Rate = 9% Time = 60 days
2000 x 9/100 x 60/360 = 30
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C. MATURITY VALUE
 The amount that is due at the maturity date of a note is the maturity value. The maturity value
of an interest bearing note is the sum of the face value and the interest.
 For non-interest bearing note
MV = FV
ACCOUNTING OR NOTES RECEIVABLES
 Notes may be received:
 from the sale of relatively large dollar amount
 from lending money
 from the sale of merchandise or other items on installment basis
 from credit period note than sixty days
 from setting the balance of open account
A. When a note is received from a customer to apply on account; the journal entry will be:
N/R ---------------- XX
A/R -------------- XX
A firm may accept a note receivable from a customer at the time of a sale or when extending
credit on a past due account.
Example
Non-interest bearing not received
Assume that the account of ABC Company, which has a balance of birr 8500 is past due. A 120
day non-interest bearing note for that amount, date Sep. 15, 2001 is accepted in settlement of the
account.
The N/R is recorded at its FV, the journal entry is
Sep. 15 N/R ------------------------- 8500
A/R ----------------------------- 8500
Received 120 day, non-interest bearing note in settlement of an account
 When the 8500 due on the note is collected, the following entry would be recorded in CRJ
Jan 13 Cash -------------------------- 8500
N/R ------------------------------8500
INTEREST BEARING NOTE RECEIVED
Example: - assume that ABC Co. agrees to accept a 60 day, 6% note for birr 1000 from W/ro
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Almaz to cover her past due account. The note is dated Dec. 11, 2001.
Dec. 11 N/R ------------------------ 1000
A/R ----------------------- 1000
Maturity date
Term of the note ---------------- 60
No. days in Dec. ---------- 31
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20
40
No. of days in Jan. 31
Feb. 2002, due date 9
Collection of the note
MV = FV + interest = 1000 X 0.06 X60/360 = 10
MV = 1000 + 10 = 1010
Cash -------------------------- 1,010
N/R ------------------------------1,000
Interest receivable
DISCOUNTING NOTES RECEIVABLE
A Business in need of cash may transfer its notes receivable to a bank by endorsement. Instead of
retaining the note receivable until maturity a note receivable may be transferred to a bank by
endorsement. This transfer to a bank is called discounting notes receivable. The discount
(interest) charged by the bank is computed on the MV of the note for the period of time the bank
must hold the note. i.e Date of transfer (the due date of the note.)
To calculate the discount
Discount = MV x Discount rate x Discount period
Discount: - is the interest deducted from the maturity value.
MV: - is the total money that will be due on the due date
Discount rate: - is the rate used in computing the interest to deduct from MV of a note.
Discount period: - is the period of time b/n the date of transfer and the due date.
Proceeds: - the net amount available from discounting a note.
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The amount of money paid to the endorser is the excess of the MV over the discount.
Discounting: - is the deduction of interest from FV. The rate used in computing the interest may
be termed the discount rate, the deduction may be called the discount, and the
net amount available to the borrower is called the proceeds.
Example: Assume that a 90 day, 10%, note receivable for $2600 dated Nov. 15, is discounted at
the payee's bank on Dec. 20 at the rate of 12%.
Face value of the note dated Nov. 15 ------------------ 2600
Interest on the note for 90 days at 12%
(2600 x 10/100 x 90/360)------------------------------- 65
MV of the note due Feb. 13 -------------------------- 2665
Discount period (Dec. 20 - Feb. 13)
(55 days)
Discount on MV for 55 days at 12%
(2265 x 12/100 x 55/360)---------------------------- 48.86
Proceeds ------------------------------------------------ 2616.14
 When the proceeds is greater than the face value there is interest income.
 When the proceeds is less than the FV there is interest expense.
The journal entry will be:
Dec. 20 Cash --------------------- 2616.14 (proceeds)
N/R --------------------------------------- 2600
Interest income --------------------------- 16.14
If the proceeds < FV Interest expense
Cash -------------------- 2000

Int. exp ----------------- 200
N/R -------------------------- 2200
 The endorser of a note is committed to paying the note if the maker should default. Such
potential obligations that will become actual liabilities only if certain events occur in the future
are called contingent liabilities.
DISHONORED NOTES RECEIVABLE
If the maker of the note fails to pay the debt on the due date, the note is said to be dishonored. A
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dishonored note is no longer negotiable, and for that reason the holder usually transferred the
claim, including any interest due, to the account receivable account.
 If the dishonored is not discounted the journal entry will be:

Example: If the 6000 30 day 12% note received from XYZ Co. on Dec. 21 had been dishonored
at maturity.
The journal entry on Jan 20 will be:
Jan 20 A/R XYZ Xo. ---------------- 6060
N/R ------------------------------ 6000
Interest income ------------------ 60
When discounted note receivable is dishonored, the holder usually notifies the endorser of such
fact and asks for payment.
Example: Assume that the $2600, 90 days, 10% note discounted on Dec. 20 is dishonored at
maturity by the maker.
The journal entry that should be recorded the payment by our endorser is:
Feb. 13 A/R ------------------- 2665
Cash ----------------------- 2665
 In some cases, the holder of a dishonored note gives the endorser a notarized statement of
the facts of the dishonor. The fee for this statement known as a protest fee is charged to the
endorser, who in turn charges it to the maker of the note.
UNCOLLECTIBLE RECEIVABLES
 When merchandise or services are sold on credit, a part of the claims against customers may
prove to be uncollectible.
 The operating expense increased because of the failure to collect receivable is called an
uncollectible account expense, doubtful account expense, or bad debts expense.
 Reasons for uncollectible
1. Bankruptcy of debtor
2. Death of debtor
3. Disappearance of debtor
4. Failure of repeated attempts to collect
5. Barring of collection by the statute of limitations
6. closing of the debtor's business
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There are two methods of accounting for receivables
1. The allowance method (reserve method): provides for advance estimation of uncollectible
receivables
2. Direct write off method or direct charge off method: - recognizes the expense only when
certain accounts are judged to be worthless.A. Allowance (Reserve) Method of Accounting for
Un-collectibles: is a method of accounting for uncollectible receivables, by which advance
provision for the uncollectible is made.
 Adjusting entry is made at the end of the fiscal period for advance provision of future un-
collectibles
Example: The A/R account has a balance of 100,000 at the end of the period. Based on a careful
study, it is estimated that a total of 5,000 will eventually prove to be uncollectible.
Adj. entry
Dec. 31 Uncollectible accounts expense 5000
Allowance for doubtful account 5000
The expected realizable value (net realizable value) is = 100,000 - 5,000 = 95,000
 Uncollectible account expense is generally reported on the income statement as an
administrative expense.
WRITE- OFFS TO THE ALLOWANCE ACCOUNT
When an account is believed to be uncollectible it is written off against the allowance.
Allowance for doubtful accounts ------------ XXX
Account receivable XYZ Co. --------------------- XXX
To write off the uncollectible account
 An A/R that has been written off against the allowance account may later be collected. In such
case the account should be reinstated (exact reverse of write off entry).
A/R XYZ Co. -------------------- XXX
Allowance for doubtful account -------------------- XXX
Up on cash collection
Cash ------------------ XXX
A/R XYZ Co. ----------- XXX
ESTIMATING UNCOLLECTIBLE: We can estimate uncollectible receivable based on:
 Past experience
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 Forecasts of future business activities
 The estimate of the amount of uncollectible
may be based on either: -
1. The amount of sales for the entire
fiscal period (Sales).
2. The amount and the age of the receivable accounts at the end of the
fiscal period. (Aging receivable).
1. ESTIMATE BASED ON SALES
Example: Assume that the allowance account has a credit balance of $900 before adjustment.
From past experience about 2% of credit sales will be expected to be uncollectible from 400,000.
Adj. entry (at the end of the fiscal year) = 400,000 x 0.02 = 8,000
Dec. 31 Uncollectible allowances expense ------- 8,000
Allowance for doubtful accounts ----------- 8,000
 Total sales (sales on account + sales for cash) may be used in developing the percentage.
 The estimate based on sales method of determining the uncollectible accounts expense is
widely used. It is simple and it provides the best basis for charging uncollectible accounts
expense to the period in which the related sales were made.
Estimated based on Analysis of receivables (Aging receivables)
 The process of analyzing the receivable accounts in terms of the length of time past due is
sometimes called aging the receivables. The base point for determining age is the due
date of the account.
 It is classifying accounts according to their age. The more the older the age is the more risky
(the more uncollectible).
Analysis of account receivable
Example
Days past due

Customer Balance Not due 1-30 31-60 61-90 91-180 181-365 Over 365
XYZ Co. 2,000 2,000
ABC Co. 2,600 2,600
Ato Alemu 360 360
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Total 30,000 5,000 4,000 6,000 3,000 7,000 2,000 3,000
Estimate of uncollectible accounts
Age interval Balance Estimated uncollectible accounts
Percent Amount
Not due 5,000 2% 100
1-30 days past due 4,000 5% 200
31-60 days past due 6,000 10% 600
61-90 days past due 3,000 20% 600
91-180 days past due 7,000 30% 2,100
181-365 days past due 2,000 50% 1,000
Over 365 days past due 3,000 80% 2,400
Total 30,000 7,000
Estimated uncollectible account = 7,000
Expected realizable value (is the desired balance of the allowance account after adjustment) =
30,000 -7,000 = 23,000
 The excess of 7,000 over the balance of the allowance account before adjustment is the amount
of the current provision to be made for uncollectible accounts expense.
Adj. entry
Dec. 31 Uncollectible account expense 7,000
Allowance for doubtful account 7,000
B. DIRECT WRITE-OFF METHODS OF ACCOUNTING FOR UNCOLLECTIBLES

We use the direct write -off method when there are situations in which it is impossible to
estimate reasonable accuracy of uncollectible receivables. In such case, it is satisfactory to delay
recognition of un-collectability until the period in which certain amounts are believed to be
worthless and are actually written-off as expense. (No need of adjustment entry).
 The entry to write-off an account when it is believed to be uncollectible is as follows.
Mr. G fails to pay receivable of
Sep. 15, 2000 Uncollectible accounts expense XXX (5000)
A/R - Mr. G XXX (5000)
To write-off uncollectible account
20
 If an account that has been written off is collected later, the account should be reinstated.
 On Dec. 15, 2000 if Mr. G come and pay after you record it as an expense and if the recovery
is in the same fiscal year (2000) as the write-off, the earlier entry should be reversed to
reinstate the account.
(1) Dec. 15, 2000 A/R Mr. G 5,000
Uncollectible account expense 5,000
(2) Dec. 15, 2000 Cash 5,000

A/R Mr. G 5,000
21
CHAPTER THREE
NATURE AND IMPORTANCE OF INVENTORIES
Inventories refer to merchandise purchased for resale. It includes
 Finished goods or Merchandise held for sale in normal course of business.
 Raw Materials in the process of production or held for such use
 Goods in process or work in process
 Supplies, spare parts, components etc….
Importance
The sale of merchandise provides
 The principal source of revenue for merchandising enterprises
 When the NI/NL is determined the cost of merchandise sold is normally the largest
deduction from sales to yield gross profit.
 Merchandise inventory constitutes the maximum of the current asset section of the B/S
for merchandising business.
 Misstatement of inventory will bring misstatement of other accounts; as a result it should
have to be properly determined.
The cost of merchandise includes
 Purchase price
 Insurance against losses in transit
 Custom duty
 Transportation in (FOB shipping point)
The effect of inventory on the current period’s statement
Inventory determination plays an important role in matching expired costs with revenue of the
period. Inventory costs (Goods available for sale) are divided in to two at the end of the period.
Cost of merchandise determined to be in the inventory
(balance sheet)
 Goods available for sale
CGS  Reported in the I/S as deduction from sales to yield
gross profit.
An error in the determination of ending inventory at the end of the period will cause an equal
22
misstatement of gross profit, income & the amount reported for both assets & owner’s equity in
the balance sheet will be incorrect by the same amount.
Ending inventory NI/GP ASSET/Owner’s Equity
Understated
Overstated
E.g. Given (correct amount)
Case 1. Given Balance Sheet
E1 = $100,000 Mdse Inv 100,000
GAS = 500,000 other asset 200,000
CGS = 400,000 Total Asset 300,000
Sales = 700,000
GP = 300,000 Liab 100,000
Operating Exp$ = $150,000 Capital 200,000
NI 150,000 Total liab &cap 300,000
Case 2. Assume that ending inventory is understated by Br 50,000

Balance sheet
E1 = $ 50,000 Mdse inventory 50,000
Sales = $700,000 Other asset 200,000
250,000
GAS= $ 500,000
CGS= 450,000 Liability 100,000
GP = 250,000 Capital 150,000
Oper exp = 150,000 Total Liab.& Capi 250,000
NI 100,000
Case 3 Assume that ending inventory is over stated by Br. 50,000. Given
E1 = $ 150,000 Mdse inven 150,000
GAS = $ 500,000 other asset 200,000
CGS = $ 350,000 350,000
Sales = 700, 000 Liab 100,000
GP = $ 350,000 capital 250,000
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Opera exp. 150,00 Total liab& capital 350,000
Net In. 200,000 -
Merchandise available for sale
Total inventory sold
1. Correctly stated inventory 500,000 100,000 400,000
2. invent- understated by 50,000 500,000 50,000 450,000
3. invent- overstated by 50,000 500,000 150,000 350,000
The effect of inventory on the following period’s statements:
The inventory at the end of one period becomes the inventory for the beginning of the following
period. Thus, if the inventory is misstated at the end of the period, the net income of that period
will be incorrectly stated and so will the net income of the following period. The amount of the
two misstatements will be equal & opposite in direction.
Inventory System
There are two principal systems for inventory. These inventory systems are used to determine the
quantity/unit of inventory on hand.
1. Periodic inventory system: determine the quantity of inventory on hand through physical
count at the end of the year.
Features of periodic inventory system
 The revenue from sales is recorded each time a sale is made
 No entry is made to record CGS at the time of sale
 Physical inventory is used to determine ending inventory
 Purchase of merchandise is recorded in the purchase account and sale of mdse is recorded
in the sales account.
 Used by retail stores that sell many kinds low unit cost merchandise, such as groceries,
hard ware & drugs
2. Perpetual inventory system: continuously discloses the quantity of inventory on hand from
accounting records. The decreases of inventory from accounting records are deducted from the
increase in inventory from the same records.
Features of periodic inventory system
 Uses accounting records that continuously disclose the amount of inventory on hand.
 A separate account for each merchandise is maintained
24
 Increases in inventories are recorded as a debit to the respective inventory account &
decreases are recorded as credits.
 The difference of increases & decreases in the inventory account used to determine
inventory
 Its accuracy must be tested by taking physical inventory at least once a year
 When merchandise is sold two things are recorded
 the sale
 the CGS
 Used by firms selling a relatively small number of high unit items, such as office
equipment, automobiles or fur garment.
Determining actual quantities in the inventory
The first stage in the process of taking an inventory is to determine the quality of each kind of
merchandise owned by the enterprise. Practical procedures common to all business enterprises to
take the physical inventory is:
 Form a crew/group
 Inspect end of period purchases/sales invoices
 Inspect Mdse (goods) in transit under FOB shipping/destination point
 Inspect Goods on consignment basis (part of consignor’s inventory)
Inventory costing methods under periodic inventory system
One of the most significant problems in determining inventory cost comes about when identical
units of a certain commodity have been acquired at different unit cost prices during the period.
There are four inventory costing methods
1. specific identification method
2. cost flow Assumption method
 first in, first out (FIFO)
 last in, first-out (LIFO)
 weighted average/ moving weighted average
3. inventory valuation other than cost method
 net realizable value (NRV) method
 Lower of cost or market method (LCM) METHOD
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4. special inventory valuation
 Retail method
 Gross profit method
Specific Identification Method: determining inventory cost by specifically identifying the cost
of each inventory. It is not practical if business enterprise has large amount of inventory with low
unit cost.
COST FLOW ASSUMPTIONS
First in fist- out method (FIFO): is based on the assumption that costs should be charged
against revenue in the order in which they were incurred. Hence the ending inventory is assumed
to be made up of the most recent costs where as CGS is assumed to be made up of earliest costs.
E.g. Commodity W
Units Unit Cost Total Cost
Beg inventory 10 @ 8.00 80
March 8. purch 10 @ 8.50 85
May 28. purch 20 @ 8.40 168
Aug 12. purch 10 @ 9 90
Oct 12. purch 20 @ 8.80 176
Dec 21. purch 10 @ 9.10 91
Total 80 690
Assume that 20 units are remained to be in the inventory.
Determine the cost of Ending inventory & Cost of Goods Sold.
1. Cost of ending inventory
Dec 21 purchase 10 units @ $ 9.1 $91
Oct 12 purchase 10 units @ $8.8 88
Cost of ending inventory 179
2. Cost of Goods Sold
Cost of Goods Available for Sale $690
Less: Cost of ending inventory 179
Cost of Goods Sold 511
26
Such type of disposing goods in the order of their acquisition is true of perishable merchandise
and goods in which style or model changes are frequent. Thus, FIFO method is generally in
harmony with the physical movement of merchandise in an enterprise.
Last in first-out method (LIFO): is based on the assumption that most recent costs incurred
should be charged against revenue. Hence the ending inventory is assumed to be composed of
the earliest costs. Based on the above data:
Dec 21 beginning inventory 10 units @ $ 8 $80
Oct 8 purchase 10 units @ $8.5 85
The use of the LIFO method was originally confined to the relatively rare situation in which the
units sold were taken from the most recently acquired stock.
Average cost (weighted average) method: is based on the assumption that costs should be
charged against revenue according to the weighted average unit costs of the goods sold. The
same weighted average unit costs are used in determining the cost of mdse remaining in the
inventory.
Weighted average = Total cost = 690 = 8.625
(Average unit cost) Total units 80
1. Cost of ending inventory = $8.625 X 20 = 172.5
Less: Cost of ending inventory 172.5
Cost of Goods Sold 517.5
Inventory costing method under perpetual system
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Since mdse is a mixed mass of goods details of the cost of each type of mdse purchased and sold,
together with such related transactions as returns and allowances, must be maintained in a
subsidiary inventory ledger, with a separate account for each type. The three costing methods
under perpetual inventory system are applied in the following ways.
1. FIFO method:-Is the same as that of FIFO under periodic inventory system, inventory
remains from recent purchase.
E.g. Given Unit Unit Cost Total Cost
Jan 1. Beg inventory 20 units @ 10 $200
Jan 10 sales 5 units @ 14 70
Jan 15 purchases 10 @ 14 140
Jan 22 sales 15 @ 20 300
Jan 31 sales 20 @ 22 440
Jan 24 purchase 16 units @ $ 16 $256
2. LIFO Method: When this method is used in a perpetual inventory system, the cost of the
units sold is the cost of the recent purchase. Based on the above data:
Jan 1 beginning inventory 15 units @ $ 10 $150
Jan 15 purchase 1 units @ $14 14__
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3. Average cost method: when this method is used in a perpetual inventory system, an average
unit cost for each type of commodity is computed each time a purchase is made rather than at the
end of the period. A new average cost is determined after each purchase. Hence the method is
called moving average.
Date Purchases Cost Of Goods Sold Inventory
Units UC TC Units UC T Units UC TC
C
Jan.1 20 10 200
15 10 14 14 20 10 200
0 10 14 140
30 11.33 340
18 5 56.65 11.33 25 11.33 283.25
20 6 15 9 25 11.33 283.25
0 6 15 90
31 12.04 373.25
22 15 180.6 12.04 16 12.04 192.64
24 20 16 32 16 12.04 192.64
0 20 16 320
36 14.24 512.64
20 284.8 14.24 16 14.24 227.84
31
=CGS EI = 227.84
522.07
Internal control and perpetual inventory systems

The use of the perpetual inventory system for merchandise provides the most effective means of
control over this important asset. The control feature is the most important advantage of the
perpetual system. The inventory of each type of merchandise is always readily available in the
subsidiary ledger. A physical count of any type of merchandise available can be made at any
time & compared with the balance of the subsidiary account to determine the existence and
seriousness of any shortage from shrinkages such as breakage, theft, evaporation and waste.
When a shortage is discovered, entry is made.
Inventory shortage XXX
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Merchandise inventory XXX
Inventory shortages  if it is small, reported as part of miscellaneous administrative expense
otherwise it may be separately reported in the administration expense.
 The perpetual inventory system is useful in the preparation of interim statements
(financial statements prepared for periods less than a fiscal year).
 It is also used to maintain inventory quantities at an optimum level (minimum and
maximum).
Valuation of Inventories at Other than Cost
Cost is the primary basis for valuation of inventories. Under certain circumstances, however,
inventory is valued at other than cost. These are
1- valuation at lower of cost or market
2- valuation at net realizable vale
1. Valuation at lower of cost or market
If the market price of an item in the inventory is lower than cost, the lower of cost or market
method (LCM) is used to value inventory. Market as used in the lower of cost or market, is
interpreted to mean the cost to replace the merchandise on the inventory date, based on quantities
typically purchased from the usual source of supply. If the replacement price of an item in the
inventory is lower than its cost, the use of LCM method provides two advantages.
A. the gross profit (NI) is reduced for the period in which the decline occurred
B. Normal gross profit is realized during the period in which the item is sold.
The LCM method is applied
a- To each item in the inventory
b- To major classed or categories
c- To the inventory as a whole
This method is used to minimize net income & maximize CGS by the principles of conservative
Description Unit unit Total
Quantity Cost market
Price price Cost Market LCM
Commodity W 200 $9.00 $ 10.00 $ 1800 $2000 $1800

X 300 10.00 9.50 3000 2850 2850
30
Y 100 8.00 8.50 800 850 800
Z 400 11.00 10.00 4400 9700 4000
$10,000 $ 9700 $ 9700
2. Valuation at net realizable value
Obsolete, spoiled or damaged merchandise & other merchandise that can be sold only at prices
below cost should be valued at net realizable value.
Estimated selling price – costs of disposition = net realizable (NRV).
Eg. A damaged merchandise that has a cost of $ 2000 is sold for $ 1500 and direct selling
expenses are $ 200. The inventory would be valued at
1500-200 = 1300 = Net realizable value
Special techniques of determining the cost of inventory
A company using a periodic inventory system may wish to estimate its inventory for any of the
following reasons
1. To prepare interim financial statements without taking physical inventory.
2. To determine the amount recoverable from any insurance company when inventory is
destroyed by fire.
3. to compare with physical inventories to determine whether shortage exists
 Used to prepare finical statements when it is impractical or impossible to take a physical
inventory or maintain perpetual inventory records.
 When it is costly to take physical inventory
 When it is impossible to take physical inventory due to catastrophe such as fire. The two
commonly used methods are
1. Retail method: this method is used by retail businesses, particularly department stores. It
is based on the relationship of the cost of merchandise available for sale to the retail price
of the same merchandise.
Cost Retail
Eg Mdse inventory, beginning $50,000 $85,000
Purchases during the period $150,000 $235,000
Mdse available for sale $200,000 $320,000
Ratio of cost to retail price= 200,000 x 100% = 62.5%
320,000
Sales for the period (net) 200,000
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Mdse inventory, ending at retail $120,000
Mdse inventory, ending at estimated cost  120,000 X 62,5%) = 75,000
2. Gross profit method: uses an estimate of gross profit realized during the period to
estimate the inventory at the end of the period. This method is used
a. to control & verify validity of inventories
b. to estimate interim inventory valuations b/n physical wants
c. to estimate the inventory cost when necessary information used is cost or
unavailable
There are two kinds of relations in this method. Sales – GP = CGS Now from the above
relation Sales – GP= GAS – EI
Gross profit CGS
Sales CGS GAS GAS – E1= CGS
E1
E.g. Assume that the inventory on January 1 is $ 60,000, the net purchases during the month are
$200,000, net sales during the same month are $ 280,000, and finally gross profit is estimated to
be 30% of net sales. The inventory on January 31 may be estimated as follows.
Mdse inventor, January 1 $ 60.000
Purchases in January (net) 200,000
Mdse available for sale $ 260,000
Sales in January (net $280,000
Less estimated GP (280,000 X 30%) 84,000
Estimated cost of mdse sold 186.000
Estimated mdse inventory, Jan 31 64,000
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CHAPTER FOUR
PLANT ASSETS
Long-lived assets that remain in use for more than one year that includes land, buildings,
equipment, machinery, vehicles, furniture and fixtures, natural resources, minerals and intangible
assets.
Business assets are classified as current or long-lived (long-term) assets. Current assets are
considered to be useful for one year or less. Long-lived assets are expected to be useful longer
than a year. The three major categories of long-lived assets include:
 Plant assets are tangible assets such as land, buildings, and machinery, equipment,
furniture etc.
 Intangible assets are assets such as patents, copyrights, trademarks, franchises,
organization costs, leaseholds, and goodwill.
 Natural resources are assets such as mining properties, oil and gas reserves, and tracts of
standing timber.
Note: The major distinguishing characteristic of plants or fixed assets is that they are used in
the operation of the business and not available for sale in the normal course of operations.
Characteristics of Plant assets
 They are tangible i.e. they have physical substance
 They are acquired for use in business operations,
 They are expected to be used for more than one year, and
 They are subject to depreciation
 They are not incorporated in the final product in the manufacturing business
Plant assets are sometimes reported on the balance sheet as Fixed Assets or as Property, Plant,
and Equipment.
The major accounting problems relating to plant and equipment are:
 Determining the cost of the plant asset.
 Procedures for allocating the cost of a plant asset to accounting periods.
 Recording cost (such as repairs) incurred in using plant assets.
 Recording the disposal of plant assets.
33
A. Initial cost of Plant Assets: The cost of a plant asset includes all are reasonable and
necessary expenditures incurred in acquiring the plant asset and placing it in use and should be
recorded in an asset account. It includes all costs incurred until the plant asset is ready for use.
The cost is divided in to three:
1. Purchase price/negotiated price
2. Subsequent costs such as, sales taxes, freight and handling costs, installation costs, and
insurance prior to the time that the asset is placed in service.
3. Installation and Foundation costs
Note:
1. When a secondhand asset is purchased, the initial cost of getting it ready for use, such as
expenditures for new parts, repairs, and painting, are included to the cost of the asset.
2. Expenditures resulting from carelessness or error in installing the asset, from vandalism, or
from other unusual occurrences are not included as part of the cost of the asset.
Initial cost of land includes:
 Purchase price/negotiated price
 Title transfer fee
 Brokers commission
 Leveling cost etc…
Initial cost of building (self constructed) includes:
 Architect fee/ engineers fee
 Material cost, labour cost
 Fencing cost, warehousing cost etc…
When a building is constructed by the owner, the total cost of the building includes architect fee,
all direct expenditures (labour, materials, building permit, etc.) plus a reasonable estimate of
indirect costs (overhead). Interest costs incurred during the time a plant asset is being constructed
are considered a necessary cost to “acquire” the asset and are therefore capitalized (i.e., debited
to the asset account.)
The cost of an existing building includes the purchase price, brokerage commission, taxes, and
any expenditure to repair or renovate the building to make it ready for use.
Initial cost of machinery and equipment
34
The cost of machinery and equipment includes the purchase price less any discounts, plus
transportation charges, transportation insurance, commissions, and installation costs.
Improvements to land are not part of the cost of land because the usefulness of the
improvement decreases over time. Such improvements include roads, paving, fencing,
driveways, parking lots, and lawn sprinkler systems. Improvements to land should be recorded in
a separate asset account. The costs of improvements to leased assets are called leasehold
improvements.
When a company purchases a group of assets for one single amount (also known as a group
purchase or a basket purchase), the total cost of the assets is allocated to individual assets by
the relative-sales-value method.
Purchasing of Existing Building
When a building is purchased it is purchased with land, as a result the total cost of purchase
should have to be allocated between land and building based on
1. Engineers estimate
2. Assessment for tax purposes
3. Current fair values
Example: XYZ Company purchased building with land costing $200,000. The tax authority
assessed for tax purposes $150,000 and $250,000 for building and land respectively. The
allocation of the cost is as follows.
Land = 200,000 x 150,000 = $75,000
400,000
Building = 200,000 x 250,000 = $125,000
400,000
B. Nature of Depreciation
As time passes, all plant assets with the exception of land lose their capacity to yield services.
This decrease in the usefulness of plant asset is a business expense and is reported on the
income statement as Depreciation Expense. Depreciation also refers to the cost expire of plant
assets.
Factors contributing to a decline in usefulness may be divided into two categories:
1. Physical depreciation: Physical depreciation includes wear from use and deterioration from
the action of the elements.
35
2. Functional depreciation. Functional depreciation includes inadequacy and obsolescence.
Inadequacy: A given plant assts become inadequate if its capacity is not sufficient to meet
the demands of increased production.
Obsolescence: A plant asset is obsolete if the commodity that it produces is no longer in
demand or if a newer machine can produce a commodity of better quality or at a greater
reduction in cost.
Note:
1. Therefore, that physical depreciation arises from the actual use of a plant asset whereas
functional depreciation is due to obsolescence factors such as technological advances and less
demand for a product.
2. Further that the purpose of recording depreciation is to show the decline of usefulness of an
asset, not a decline in its market value.
3. A contra asset account called Accumulated Depreciation is used to record the total amount of
a plant asset’s cost that has been recorded as depreciation expense. The adjusting journal entry to
record depreciation is:
Depreciation Expense ………………………..XXX
Accumulated Depreciation……………………….XXX
Use of accumulated depreciation
1. To determine book value of assets/ unexpired cost of the asset
2. To accumulate the cost expired of plant assets
As accumulated depreciation increases each year, the remaining book value of the asset (cost
minus accumulated depreciation) declines. The final book value of an asset will be its residual
value.
Accounting for Depreciation
To measure depreciation, it is necessary to determine the plant asset’s cost, estimated useful life,
and estimated residual value (salvage value or scrap value).
1. Original Cost: The depreciable cost of an asset is its cost minus residual value.
2. Estimated useful life is the length of service a business expects from the plant asset. Useful
life may be expressed as a length of time, units of output, or other measures. For example, a
computer may be expected to be useful for four years, while a printing press might be expected
to print one billion sheets of paper over its useful life. Normally such factors as climate,
36
frequency of use, maintenance, and minimum standards of efficiency will affect the
economic life of a plant affect. Note that the useful life of an asset is an estimate of the
usefulness of an asset and is not necessarily related to the physical life. For example, an asset
such as a computer may become obsolete (not economically useful) long before it physically
deteriorates.
3. Estimated residual value is the expected cash value of an asset at the end of its useful life. It
is also called scrap or salvage value or trade-in value.
DEPRECIATION METHODS
1. The Straight-Line Depreciation Method (SLDM)
This method allocates the depreciable cost of a plant asset to depreciation expense in equal
amounts per period over the life of the asset. The formula for straight-line depreciation is:
Depreciation Exp. = cost - residual value

useful life
E.g. assume a plant asset with a cost of $1,600 has a residual value of $100 and an estimated
useful life of five years.
Years original cost depreciation expense Accumulated depre Book value
1 $1,600 $300 $300 1,300
2. 1,600 300 600 1000
3 1,600 300 900 700
4 1,600 300 1200 400
5 1,600 300 1,500 100
Recall that the adjusting entry to record depreciation expense each year is:
Depreciation Expense …………………………300
Accumulated Depreciation…………………300
Note that this method is:-
 The simplest and the most widely used method of computing depreciation.
 An equal portion of the cost of the asset (less residual value) is allocated to each period of
use.
 Most appropriate when usage of an asset is fairly uniform from period to period.
2. Double-Declining-Balance (DDB) Method
37
It is an accelerated depreciation method. Accelerated depreciation simply means that a larger
portion of an asset’s cost is allocated to depreciation expense in the early years of an asset’s life,
and a smaller portion is allocated to depreciation expense toward the end of the asset’s useful
life.
To compute double-declining-balance depreciation:
a) Compute the straight-line depreciation rate per year:
(1 / Useful life in years) = X% = 100 = 20%
5
b) Multiply the straight-line depreciation rate per year by 2 (double it) to obtain the double-
declining-balance rate:
DDB rate = (1/Useful life in years) × 2 = 20% X2 = 40%
c) Multiply the asset’s beginning book value for a period (remember that book value equals
cost minus accumulated depreciation) times the DDB rate. Book value will decrease each
period, therefore depreciation expense will decrease each period. Note that the residual
value of the asset is ignored until the net book value of the asset approaches the asset’s
residual value.
Depreciation Expense = DDB rate × book value
d) When the net book value of the asset approaches the asset’s residual value, adjust the
year’s depreciation so that the remaining book value of the asset is equal to the residual
value. The final year’s depreciation amount will be equal to:
Book value at the beginning of the year - Residual value
E.g. assume a plant asset with a cost of $16,000 has a residual value of $1,000 and an estimated
Book value depreciation Accumulated Book value at Year
At the beginning rate expense depreciation end of year
1 $16,000 40% $6400 $6400 $9600
2. 9600 “ 3840 10,240 5760
3 5,760 “ 2,304 12,544 3,456
4 3456 “ 1,382 13,926 2074
5 2074 “ 1074 15,000 1,000
Recall that the adjusting entry to record depreciation expense for 1st year is:
38
Depreciation Expense …………………………6,400
Accumulated Depreciation…………………6,400
3. Sum-Of-The-Years-Digits Method
The sum-of-the-years-digits (SYD) method is another form of accelerated depreciation. The
annual depreciation is calculated by subtracting salvage value from original cost, and multiplying
this figure by a fractional rate of depreciation. The denominator of the fraction is the sum of the
years of useful life; for a life of 5 years, the denominator is = 1 + 2 + 3 + 4 + 5 = 15. The
numerator is the year in reverse order. For the first year, the numerator is 5 and the fraction is
5/15.
E.g. assume a plant asset with a cost of $1,600 has a residual value of $100 and an estimated
Years original cost rate depreciation expense Accumulated depre Book value
1 $1,500 5/15 $500 $500 1,100
2. 1,500 4/15 400 900 700
3 1,500 3/15 300 1,200 400
4 1,500 2/15 200 1,400 200
5 1,500 1/15 100 1,500 100
Depreciation Expense …………………………500
Accumulated Depreciation…………………500
4. Units-Of-Production (UOP) Depreciation Method
This method allocates the cost of an asset to depreciation expense based on the output that the
asset is expected to produce. The plant asset economic life is expressed interms of factors
causing depreciation on that plant asset.
E.g. Building Years/weather
Machinery/Equipment machine hours/ no of units produced
Vehicles miles/km to be driven
Units of usage can be expressed in quantity of goods produced, hours used, number of
cuttings, miles driven or tons hauled.
The formula for units-of-production depreciation is:
39
UOP depreciation per = cost - residual value
unit of output useful life in units
With UOP, the total depreciation expense in a period is:
Depreciation Expense = UOP depreciation per unit of output × units of output in the period
E.g. assume a given machinery with a cost of $105,000 and salvage value of $5,000 has an
estimated capacity to produce 25,000 during its economic life. During the first year this
machinery produced 5000 units of output.
UOP depreciation per = 105,000 – 5000 = $4
unit of output 25,000
Depreciation expense during
Year-1 = $4 X 5000 = $20,000
Depreciation Expense …………………………20,000
Accumulated Depreciation…………………20,000
While the straight-line method could be used for any plant asset, the UOP method is not
appropriate for all assets. Rather, it is used for assets where the life is a function of use rather
than time (for example, an airplane where flying hours is a more accurate measure of life
compared with years).
Some important points to remember:
 You never depreciate below the estimated salvage value.
 Units-of-production ignores time.
 Double-declining-balance ignores salvage value initially.
 Double-declining-balance uses book value, while the other methods use depreciable cost.
 The straight line method provides for uniform periodic charges to depreciation expense
over the life of the asset.
 The units of production method provides for periodic charges to depreciation expense
that may vary considerably, depending upon the amount of usage of the asset.
 Both the declining-balance and the sum-of-the-years-digits methods provide for a higher
depreciation charge in the first year of use of the asset and gradually declining periodic
charge thereafter. For this reason they are frequently referred to as accelerated
depreciation methods. These methods are most appropriate for situations in which the
40
decline in productivity or earning power of the asset is appropriately greater in the early
years of its use than in later years. Further justification for their use is based on the
tendency of repairs to increase with the age of an asset. The reduced amounts of
depreciation in later years are therefore offset to some extent by increased maintenance
expenses.
 If an asset becomes fully depreciated (i.e., book value = residual value) but remains in
use, both the asset and contra asset account should remain in the ledger until the business
disposes of the asset. That means Depreciation is no longer recorded after the book value
of the asset is reduced to the residual value, even if the asset is still in use.
Revision of Periodic Depreciation
Remember that depreciation is computed based on two estimates-useful life and residual value.
These estimates are made at the time an asset is acquired. One, or both, of these initial estimates
may have to be revised as experience with the asset accumulates. When it is clear that either
estimates should be revised, the un-depreciated asset balance at that date should be apportioned,
based on the new estimates, over the remaining estimated life.
Example
Assume the following for a machine
On Jan 1, 1992 ABC Co. purchased a machine for Br 33,000. This machine has estimated
economic life of 10 years with an estimated salvage value of Br 3,000. The Company uses
straight line method of depreciation. Thus annual depreciation will be:-
Annual Depreciation= 33,000-3000= 3,000
10
Further assume that at the beginning of 1998 the initial estimated life was changed to 14 years
while the salvage value was changed to Br 1,000. Thus the revised annual depreciation would
be:-
Un-depreciated balance at the beginning of 1998 is computed as follows:-
Acquisition Cost……………………………....…33,000
Accumulated Depreciation, 1992-1997………….18,000
Un-depreciated Balance………………………15,000
The revised annual depreciation for the remaining life of the machine is computed as follows:-
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Annual Depreciation= 15,000-1000= 1,750
8
Note the following
 The correction of error in estimates used in the determination of depreciation does not
affect the amounts of depreciation expense recorded in previous years.
 Revision of estimates affects only future depreciation expense amounts
Recording Depreciation
Depreciation is recorded by debiting Depreciation Expense and by crediting Accumulated
Depreciation account of each plant asset. Accumulated depreciation is a contra asset account. It
permits the original cost to remain unchanged in the plant asset account. This facilitates the
computation of periodic depreciation and the listing of both original cost and accumulated
depreciation on the balance sheet.
When to record depreciation?
 Monthly or yearly
 When the asset is sold, traded in, or scarped.
Consideration
 Depreciate for a full month all assets acquired before the 15 th of the month. There is no
depreciation for the month on the assets acquired after the 15th.
 Depreciate for a full year all assets acquired before July 1 st. There is no depreciation for
the year on assets acquired after July 1st.
Capital and Revenue Expenditure
Subsequent to the acquisition of plant assets expenditures may be made for ordinary repairs and
maintenance, major repairs, replacement, and additions. These expenditures made after the
acquisition date are called either capital expenditure or capital expenditures.
Capital expenditures are expenditures that significantly affect an asset by 1) increasing the
asset’s productive capacity, 2) increasing the asset’s efficiency, or 3) extending the asset’s useful
life. Examples are:-
 Additions to plant assets: - Expenditures for addition to existing plant assets would be
debited to the assets account.
 Betterments: - are expenditures that increase operating efficiency or capacity for the
remaining useful life of a plant asset. They are debited to the plant asset account.
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 Extraordinary Repairs: - are expenditures that increase the useful life of an asset
beyond the original estimates. They are debited to the accumulated depreciation
account to restore a portion of the depreciation accumulated in prior years. In addition,
the periodic depreciation for future periods would be predetermined on the basis of the
revised estimate of the remaining useful life.
Revenue expenditures are those that maintain the existing condition of an asset or restore an
asset to good working order. Revenue expenditures are debited to an expense account:
Most expenditures related to plant assets are repairs to the assets. Extraordinary repairs are
capital expenditures, while ordinary repairs are revenue expenditures.
C. Disposal of Plant Asset
With the possible exception of land, eventually a plant asset will no longer serve the needs of the
business. The business will generally dispose of the asset by discarding it, selling it, or
exchanging it.
Discarding Plant Assets
The simplest accounting entry occurs when a company discards an asset. If the asset is fully
depreciated with no residual value, the entry to record its disposal is:
Accumulated Depreciation-Asset…………………..XX
Plant Asset………………………………………….XX
If the asset is not fully depreciated, a loss is recorded for the remaining book value:
Accumulated Depreciation-Asset……………………….XX
Loss on Disposal of Asset...……………………………..XX
Plant Asset………………………………………………..XX
These entries have the effect of removing the asset from the books.
Sale of Plant Assets
When an asset is sold, the first step is to update depreciation for the partial year of service.
Depreciation is recorded from the beginning of the accounting period to the date of the sale:
Depreciation Expense ………………………..XX
Accumulated Depreciation-Asset………………XX
The second step is to compute the remaining book value:
Book Value = Cost - Accumulated Depreciation
* If cash received is greater than the remaining book value, a gain is recorded:
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Cash…………………………………………XX
Accumulated Depreciation-Asset……………XX
Plant Asset………………………..………………..XX
Gain on Sale of Asset ……………………………...XX
* If cash received is less than the remaining book value, a loss is recorded:
Cash…………………………………………XX
Loss on Sale of Asset………………………..XX
Accumulated Depreciation-Asset……………XX
Plant Asset…………………………………………XX
Note that gains will increase income and losses will decrease income. Therefore, both gains and
losses are listed on the income statement.
Exchange of Plant Assets
When plant assets are exchanged or traded in, the balance for the old asset must be removed
from the books and the replacement asset must be recorded. When the old asset is exchanged for
similar new asset the trade-in allowance (i.e., the deduction from the purchase price of the new
asset) may be below or above the book value of the book value of the old asset.
 When the trade-in allowance is above the book value of the old asset, the cost of the new
asset is equal to the book value of the old asset plus the amount paid (called the boot) and
no gain is recognized.
 When the trade-in allowance is below the book value of the old asset, the cost of the new
asset is equal to the price of the new asset and loss will be recognized.
Example
Old Equipment
Cost……………………………………………………...40,000
Accumulated Depreciation at date of exchange…………35,000
Book value…………………………………………… 5,000
Price of the new equipment………………………Br 60,000
1. Record the exchange transaction if the old equipment is exchanged for the new
equipment with the trade-in allowance of Br 6,000
Accumulated Depreciation-Equipment………………..35,000
Equipment……………………………………………..59,000
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Equipment……………………………………………..40,000
Cash…………………………………………………...54,000
2. Record the exchange transaction if the old equipment is exchanged for the new
equipment with the trade-in allowance of Br 3,000
Accumulated Depreciation-Equipment………………..35,000
Equipment……………………………………………..60,000
Loss on Disposal of Plant Asset………………………..2,000
Equipment……………………………………………..40,000
Cash…………………………………………………...57,000
LEASING PLANT ASSETS
A business can rent a property for a specified period of time under a contract known as a lease.
The lessor is the owner of the property, and the lessee is the party that has the right to use the
property. The lease may be capital or operating. Leases which extent over most of the asset life,
and which transfer ownership to the lessee at the end of the lease are called capital leases. Assets
held under capital lease must be shown on the balance sheet, and therefore, the Plant Assets is
debited and a lease liability account is credited. Operating leases tend to be more short-term,
and the lessee does not acquire the leased property at the end of the lease.
DEPLETION OF NATURAL RESOURCES
The periodic allocation of the use of natural resources is a called depletion. Mineral deposits,
coal, timber, natural gas, and petroleum are all subject to depletion. Depletion Expense is debited
and Accumulated Depletion is credited for the amount of usage during the period. The usage is
based on current year production as a fraction of total capacity, and the determination is
essentially identical to the unit-of-production depreciation method.
Example
ABC Co acquired certain mineral right for Br 600,000. The deposit is estimated at 2,400,000
tons of ore of uniform grade. During the year the Company mined 200,000 tons. Record the
depletion.
The Depletion Rate= 600,000/ 2,400,000 = Br 0.25 a ton
Depletion expense for the period= 0.25 x 200,000= Br 50,000
Depletion Expense……………………………50,000
Accumulated Depletion……. ………………………..50,000
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INTANGIBLE ASSETS
Intangible assets are assets that do not have physical substance. They are not held for sale, and
they are usually highly valuable to the business. They include patents, copyrights, trademarks,
goodwill, and franchises. Except for goodwill, most intangible assets receive legal protection of
exclusive use. The cost of obtaining legal protection for the intangible asset should be debited to
the intangible asset account. The periodic loss of value of the intangible asset is called
amortization, and is expensed annually.
The acquisition cost of an intangible asset is recorded as:
Intangible Asset……………………….XX
Cash……………………………………XX
The cost of intangible assets is expensed through amortization over the asset’s useful life.
Amortization is usually computed on a straight-line basis, similar to straight-line depreciation.
Amortization is recorded as:
Amortization Expense ……………………XX
Intangible Asset…………………………..XX
Note that the book value of the intangible asset is reduced directly. There is no Accumulated
Amortization account. Additionally, the residual value of most intangible assets is zero. Finally,
the useful life of many amortizable assets is much shorter than the legal life of such assets-for
example, copyrights.
One important type of intangible asset is goodwill. Goodwill is recorded only when another
company is acquired. The amount of goodwill, if any, is equal to the difference between the price
paid for the acquired company and the market value of the acquired company’s net assets (assets
- liabilities):
Goodwill = Price Paid - Market Value of Net Assets
If the purchase price paid is less than the market value of the acquired company’s net assets,
there is no goodwill.
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CHAPTER FIVE
ACCOUNTING CONCEPTS AND PRINCIPLE
Generally Accepted Accounting Principles (GAAPs)
Accounting principles are divided as postulates and concept or principles.
Concepts: Accounting concept is also self-evident statement or truths. Accounting concept is so
basic that people accept them as valid without any questioning. Accounting concept provided the
conceptual guidelines for application of the financial accounting i.e. for recording, measurement
etc…
These concepts provide help in resolving future accounting issues on a permanent or longer basis
rather than trying to deal with each issue on ad-hoc basis.
A. Postulates: Accounting postulates are basis assumption concerning the business environment.
They are generally accepted as self- evident truth in accounting. Postulates are established or
general truth, which do not need any evident to provide them. As basis postulates can be
verified.
B. Principles: Accounting principles are generally decisions rules derived from the accounting
concept accounting to AICPA principles means general law or rule-adopted principles are
concise explanations.
A. Accounting Postulates:
1. Entity Postulate: The entity postulate assumes that the financial statement and other
accounting information are for the specific business enterprise, which is distinct from its owner.
These concepts enable the accountant to distinguish between personal and business transaction
so these concept says that business is a separate entity.
2. Going Concern Postulate: an accounting entity is viewed as a continuing in operation in the
absence of evidence to the contrary. Because of the relative permanence of enterprises financial
accounting is formulated assuming that the business will continue to operate for an indefinite
long period of the future. The going concern concept leads to the proposition on that individual
financial statement report of continues interrelated series statement. These further implies that
data communicated are tentative and that current statement should disclose adjustment to past
year statement revealed by more recent development.
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3. Money Measurement Postulate: A unit of exchange and measurement is necessary to
account for the transaction of the business enterprise in a uniform manner. The common
denominator chosen in accounting is monetary terms or unit. Money is the common denominator
in terms of which the exchangeability of goods and service, including labor and capital are
measured. Money measurement concept holds the accounting is measurement and
communication process of the activity of the firm that is measurable in terms of money.
Money measurement concept implies two limitation of accounting: first accounting is limited to
the production of information, which is limited to expresses in terms of money. Second it does
not record and communicate other relevant about non-monetary record or transaction.
4. Accounting Period Postulate: The financial accounting provides information about the
economic activity of the business of an enterprise for a specified time of period that is shorter
than life of the enterprise. Normally the time lengths are of equal length to facilitate the
comparisons. The time periods are usually 12 month in length some company uses quarterly or
half yearly report. They are considered to be interim and essentially different from annual
statement. Dividing business activity to specific period of time creates a number of measurement
problems in financial accounting as well as in allocation of cost and asset to specific period.
B. Accounting Concept and Principle
1. Cost Principle: The cost principle requires the asset be recorded at their exchange price
acquisition on cost or historical cost. Historical cost is recognized as the appropriate valuation
basis for recognition of the acquisition of all goods and service. Business transactions are
normally measured in terms of the actual prices or costs at the time the transaction occurs.
2. Dual Aspect Principle: This principle lies at the heart of the whole accounting process. The
accountant records events affecting the wealth of a particular entity. Just like Newton II law
which is saying that “for every action there is an equal and opposite reaction.” The duality
concept assures us that in accounting also there is a law, which says, “For every debit there is an
equal and corresponding credit.”
Asset = Liability + Capital
In other word Debit = Credit

These principles are also known as accounting Equations Concept.
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3. Conservatisms Principle: This principle is often described as “anticipates no profit and
provide for all possible loss.” This characterizations might be viewed the reactive version of the
minimum managerial philosophy minimize the chance of maximum loss. The concept of
accounting of conservatism suggests that when and where uncertainty and risk exposure so
warrant.
In its application conservatism encourages the recognitions or all loss that has occurred or is
likely to occur but does not acknowledge gain until it is realized. Conservatism concept is
very vital in the measurement of income and financial poison of a business enterprise. The
accountant avoids the recognition and measurement of income and financial poison of an
enterprise.
4. Consistency Principle: This principle requires that once an organization has decided on one
method it should use the same method for all subsequent transaction and events of the same
nature unless it has sound reason to change method. If accounting methods were frequently
changed it would be very difficult to compare with the last past year statement.
Consistency is necessary to help external users in comparing financial statement of the given
firm over time and in making their decision.
5. Materiality Principle: Materiality concept implies that the transaction and events that
material or insignificant effects should not be record in the financial statement. It is argued that
the recording of the insignificant events cannot be justified in terms of its subsequent poor utility
to users.
6. Full Disclosure Principle: The concept of full disclosure requires that a business enterprise
should provide all relevant information to external users for the purpose of sound economic
decision. This concept implies that no information of subsequent or of interest to the average
investor will be omitted from an entity financial statement.
7. Matching Principle: The matching concept in financial accounting process of matching
revenue with expenses. The determination of net income is two-fold problem involving:
A. The revenue recognize during the period.
B. The expired cost to be allocated to the period.
Recognition Of revenue
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Revenue is measured for the amount to customers for merchandised delivered or service
rendered to them. The problem created by periodicity is one of timing, at what point is revenue is
realized? Various criteria’s are accepted for determining when revenue is to be realized.
Revenue Recognition Criteria:

1. Point Of Sale: Revenue from sale of goods usually determined by points of sale method,
under which revenue will be determined when the title passes to the buyer.
This sale might be cash basis sale or credit sale in revenue can be recognizing at the point of sale.
Example: - Credit sale $ 2,000 to Mr. A
In this example we can record as follows:
Account Receivable 2,000
Sale 2,000
2. At the time we receive revenue payment: The recognition of revenue may be delayed until
payment is made when these criteria issued revenue will be recognize when cash is collected. It
is useful whenever the enterprise uses cash based accounting.
3. Installment method: In some cases it is normal to make sale on installment basis in such case
it is common to recognize revenue we have to collect the cash, which means we will recognize
revenue whenever we receive cash.
You made credit sale on installment 5,000 with down payment 2,000. At first recognize
2,000 as revenue and whenever you received the cash record it. Since recognition is
recording revenue in the formal way.
4. Completion and percentage Completion method:
i. Complete Contract Method: Under this method revenue will be recognizing when the
contract is completed. There are project, which can’t be finished within one year the project of
long building may take three year in this case. You need to choose the method for which to
recognize revenue. Assume that you are using complete contract methods if you are using this
method you have to record revenue only when the contract is completed.
ii. Percentage Completion method: it is a method on which you are using to determine revenue
for the work you have complete during that fiscal period. To determine the amount of revenue to
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apply the following method or formula. Assume that the project end after three years and the
accountant is required to determine the revenue each year to do so.
Year 1 Revenue = Cost incurred to date

Total estimated cost
CHAPTER SIX
ACCOUNTING FOR PARTNERSHIP
Characteristics of Partnerships
A partnership is defined as the relationship that exists between persons carrying on a business for
profit.
Characteristics of partnership
1. A limited life
2. unlimited liability
3. mutual agency
4. co-ownership of partnership property
5. a non-taxable entity
6. Participation in income.
7. Voluntary association
These persons agree to combine some or all of their property, labor, and skills. This relationship
is based on a contract. Although a written agreement is not required by law, all matters of
importance to the partnership should be clearly expressed in written form. This written
agreement is referred to as the articles of partnership or the partnership agreement.
Elements of a partnership agreement include:
1) Name, location, and purpose of the partnership
2) Duties of each partner
3) Rules that determine profit/loss shares
4) Admission and withdrawal of partners
5) Procedure for ending the partnership
What are the Advantages and Disadvantages of Partnership?
Advantages:
 Partnerships allow for a greater amount of money, skill, and other resources to be pooled.
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 They are relatively easy to organize.
 They are subject to limited government regulations and do not face high tax rates.
Disadvantages:
 Partnerships have a limited life.
 Each partner is subject to unlimited liability. This means that if the company fails,
creditors can take action against both the partnership and the persons who are in it.
 Partners have mutual agency. This means that one partner can make decisions without
consulting the other(s).
Accounting for Partnership
Most of the day-to-day accounting for a partnership is the same as that studied earlier for a sole
proprietorship. The same journals and ledgers used by a sole proprietorship can be used by a
partnership. It is in the area of formation and income division that partnership accounting differs
from proprietorship accounting. In a sole proprietorship, there will be a single capital account
and a single drawing account for the owner in the ledger. In a partnership, the ledger contains a
capital account and a drawing account for each partner in order to determine each owner's
interest in the firm. In addition to this, it is the areas of the formation, income distribution,
dissolution, and liquidation of partnerships that transactions peculiar to partnership arise.
Partnership Formation
A partnership is usually formed by two or more persons investing cash or assets in a business. It
is not necessary for each partner to invest the same amount of assets. In fact, it is not necessary
for all partners to make an investment; some partners may be admitted to a firm because of
special skills or special knowledge. Assets other than cash are recorded at their fair market value
at the time of contribution. If liabilities are assumed by the partnership, the appropriate liability
accounts are credited and the partner’s account will be credited for the net amount.
Example 1
Girma Ali and Saba Seifu decide to form a partnership called Girsab trading by combining the
assets of their separate businesses. Girma contributes the following to the partnership: Cash, Br
15,000; accounts receivable with a face amount of Br 60,000 and an allowance for doubtful
accounts of Br 9,000; merchandise inventory with a cost of Br 85,000; equipment with a cost of
Br 125,000 and accumulated depreciation of Br 55,000; and accounts payable of Br 20,000.
The partnership agrees that:-
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 Br 5,000 of the accounts receivable are completely worthless and are not to be accepted
by the partnership and Br 8,000 is a reasonable allowance for the uncollectibility of the
remaining accounts.
 The merchandise inventory is to be recorded at the current market price of Br 81,500, and
 The equipment is priced at Br 85,000
 The accounts payable will be assumed by the partnership at its carrying value.
Required: Present the partnership’s entry to record Girma’s investment.
Cash................................................................15,000
Accounts Receivable......................................55,000
Merchandise Inventory...................................81,500
Equipment.......................................................85,000
Allowance for Doubtful Account................................8,000
Accounts Payable.......................................................20,000
Girma Ali, Capital......................................................208,500
Division of Net Income or Net Loss
The net income of a partnership belongs to the partners, and they are free to make any division of
earnings they choose. As noted already, the division is usually set forth in the articles of
partnership. If the articles are silent as to the division of earnings, the law presumes an equal
division. If the articles provide for a division of earnings but are silent on losses, the law
generally presumes that losses will be shared in the same ratio as earnings. Profit distributions
normally take into account the amount of capital (interest allowance) and/or services (salary
allowance) contributed by each partner. The different methods of sharing income or loss are:
 Equally
 In some other ratio agreed up on
 Based on salary allowance and the remainder equally or in some other ratio
 Based on the ratio of original investment
 Based on salary allowance, interest allowance on the original investment and the
remainder equally or in some other ratio
 Based on interest allowance on the original investment and the remainder equally or in
some other ratio
Income Division equally
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Example 1. The articles of partnership of Abebe and Lakew provide for monthly salary
allowance of Br 5,000 and Br 4,000, with the balance of the net income to be divided equally,
and that the net income for the year is Br 150,000. They agreed to share NI equally.
Required: - allocate the net income
Division of income Abebe Lakew Total
Equally ......................75,000 75,000 150,000
The entry for the division of net income is as follows:
Income Summary.........................150,000
Abebe, Capital.......................................75,000
Lakew, Capital...................................... 75,000
Income division in some other ratio agreed up on
Example1. The articles of partnership of Abebe and Lakew provide for monthly salary allowance
of Br 5,000 and Br 4,000, with the balance of the net income to be divided equally, and that the
net income for the year is Br 150,000. They agreed to share NI in the ratio of 75% to Abebe and
25% to Lakew or 3:1.
In the ratio 112,500 37,500 150,000
Income Summary.........................150,000
Abebe, Capital.......................................112,500
Lakew, Capital...................................... 37,500
Income Division Recognizing Services of Partners
When there is a difference in ability and in amount of time devoted to the business, the articles of
partnership often provide for the division of a portion of net income to the partners in the form of
salary allowance. The article may also provide for the withdrawal of cash by the partners instead
of salary payments. Withdrawals are debited to the drawing accounts.
Example 2 The articles of partnership of Abebe and Lakew provide for monthly salary
allowance of Br 5,000 and Br 4,000, with the balance of the net income to be divided equally,
and that the net income for the year is Br 150,000.
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Salary Allowance.............................60,000 48,000 108,000
Remaining Income.......................... 21,000 21,000 42,000
Net Income.................................. 81,000 69,000 150,000
Income Summary.........................150,000
Abebe, Capital.......................................81,000
Lakew, Capital...................................... 69,000
Income Division Recognizing Service of Partners and Investment
When there is a difference in ability and in amount of time devoted to the business and the
amount of capital invested by each partner, the articles of partnership may provide for the
division of a portion of net income to the partners in the form of salary allowance and interest on
capital investment. Generally, the interest payments are percentages based on their initial capital
investments. The remaining earnings are divided according to an arbitrary ratio.
Example 3 Tessema and Sultan are partners. Tessema invested Br 50,000 into the business and
Sultan invested Br 60,000. The articles of partnership of Tessema and Sultan provide for yearly
salary allowance of Br 25,000 to Tessema and Br 20,000 to Sultan. Besides they each receive an
interest allowance of 10% of their initial capital investment. The remainder net income will be
allocated equally. The net income for this year is Br 80,000. What does each partner get?
Tessema Sultan Total

Salary Allowance...............................25,000 20,000 45,000
Interest Allowance............................ 5,000 6,000 11,000
Remainder Split Equally.................. 12,000 12,000 24,000
Total............................................ 42,000 38,000 80,000
Income Summary.........................80,000
Abebe, Capital.......................................42,000
Lakew, Capital...................................... 38,000
Note: An interest allowance of 10% of their initial investment means that each year they are
given 10% of what they had initially invested. In this case, since Tessema had initially invested
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Br 50,000, his interest allowance was Br 5,000 (Br 50,000 x 10%) per year. Therefore, after all
monies are divided, Tessema gets Br 42,000 and Sultan gets Br 38,000.
Income Division When Allowances Exceeds Net Income

If net income is less than the total of the special allowances, the remaining balance will be a
negative figure that must be divided among the partners as though it is a net loss.
Example 4
Take all the data under example2 except that the net income was Br 100,000 instead of Br
150,000. Allocate the net income based on salary allowance and the remainder equally.
Salary Allowance.............................60,000 48,000 108,000
Remaining Income.......................... (4,000) (4,000) (8,000)
Net Income.................................. 56,000 44,000 100,000

Income Summary.........................100,000
Abebe, Capital.......................................56,000
Lakew, Capital...................................... 44,000
Example 5
Take all the data under example 3 except that the net income was Br 40,000 instead of Br
80,000. Allocate the net income based on salary allowance, interest allowance and the remainder
equally.
Required: Allocate the net income.
Tessema Sultan Total
Salary Allowance...............................25,000 20,000 45,000
Interest Allowance............................ 5,000 6,000 11,000
Excess of Allowance over NI............ (8,000) (8,000) (16,000)
Total............................................ 42,000 38,000 40,000
Income Summary.........................80,000
Abebe, Capital.......................................42,000
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Lakew, Capital...................................... 38,000
Financial Statements for Partnership

The financial statements for partnership are the same as that of sole proprietorship except that
 Details of the division of net income should be disclosed in the financial statements
prepared at the end of the fiscal period. The disclosure may be made by adding a section
called “Division of Net Income” to the income statement or by presenting the data in a
separate statement.
 On the balance sheet of the partnership the capital of each partner will be reported
separately.
 Details of the changes in the owner’s equity of the partnership during the period should
be presented in the statement of owner’s equity.
Alef and Kebede
Statement of Owner’s Equity
For The Year Ended December 31, 1999
Alef Kebede Total
Capital, January1, 1999............................ 40,000 60,000 100,000
Additional Investment During the year..... - 0- -0- -0-
40,000 60,000 100,000
Net Income for the Year............................ 15,000 18,000 33,000
55,000 78,000 133,000
Withdrawal during the Year...................... 5,000 7,000 12,000
Capital, December31, 1999..........................50,000 71,000 121,000
Partnership Dissolution
Dissolution means increase and decrease in the number of member of partnership not winding up
or termination of operation of partnership
Because a partnership is an association of persons, any change in its ownership results in the
dissolution of the partnership agreement, and a new agreement must be formed if the business is
going to continue. Among other causes, a partnership can be dissolved by a partner’s withdrawal,
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death, incapacity, bankruptcy, or retirement. A partnership is also dissolved if a new partner is
admitted to the firm and if the partnership agreement is expired.
Dissolution does not necessarily mean liquidation of the partnership. For example, a partnership
composed of two partners may admit an additional partner. Or if one of the partners withdraws,
the remaining partners may continue to operate the business. In all such cases, a new partnership
is formed and new articles of partnership should be prepared. That is legally the old partnership
is dissolved and a new partnership created, but from the accounting point of view it is more
realistic to make appropriate adjustments in the existing partnership books, rather than close
them off and start afresh.
Reasons for dissolution
 Admission of partnership
 Withdrawal of partnership
Admission of a Partner
Admitting a new partner dissolves the old partnership and creates a new partnership. Because
partnerships have unlimited liability and mutual agency, the admission of a new partner requires
the approval of the existing partners. When this occurs, the partners may also rewrite certain
aspects of the partnership agreement, such as the basis for distribution of earnings. A new partner
may be admitted to a partnership through either of two procedures:-
 Purchase of an interest from one or more of the current partners
 Contribution of assets to the partnership
1. Admission by purchase of an interest from existing partner(s)
New partner may purchase all or part of the interest of one or more of the existing partner by
payment to the existing partner. This is a personal transaction between individuals, not the
partnership. The only entry needed is the transfer of the proper amounts of the owner’s equity
from the capital account of the selling partners to the capital account established for the
incoming partner.
Three things to happen:
 Transfer capital from the selling partner to the purchasing new partner
 This transaction does not change the amount of the assets of the firm
 The amount received is disregarded because the mount relieved is to the pocket of the
selling partner not to the partnership
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Example 6
Gebru, Martha, and Sisay are partners in GMS Trading. Dawit is admitted into the partnership by
purchasing 50% of the ownership interest of Gebru for Br 45,000. When Dawit is admitted into
the partnership the ownership interest of Gebru is Br 60,000.
Required: Record the admission of Dawit
Gebru, Capital.............................30,000
Dawit, Capital.....................................30,000
2. Admission by Contribution of Assets
Instead of buying an interest from the current partners, new partner may invest (or contribute
assets) directly in the partnership organization. The payment of cash or other assets increases the
amount of the partnership’s total assets as well as its total owners' equity.
When partners for a partnership receives a request for admission by a new partner, the
partnership may revalue its assets before admitting a new partner if the partnership structure has
not changed for an extended period of time or when asset values have changed substantially.
If the existing partnership assets have a fair market value in excess of their recorded book values,
the increase in value represents a gain and is distributed to the original partners’ capital accounts
based on their profit and loss sharing agreement. If the fair market value of the assets is less than
their recorded book values, the decrease in value represents a loss and is distributed to the
original partners’ capital accounts based on their profit and loss sharing agreement.
If a number of assets are revalued, the adjustments may be debited or credited to a temporary
account entitled “Asset Revaluation”. After all adjustments are made, the account is closed to the
capital account.
Example 7
Hassen and Kuku partnership has total assets of Br 200,000 and total liabilities of Br 40,000.
Hassen’s and Kuku’s capital are Br 90,000 and Br 70,000, respectively. At the time when
Kibrom is admitted into the partnership it is agreed that the market value and the book value of
all assets are equal except that the market value of merchandise inventory exceeds its book value
by Br 5,000. Hassen and Kuku share gains and losses equally. Prior to the admission of Kibrom
the revaluation would be recorded as follows
Merchandise Inventory..................................5,000
Hassen, Capital.................................................2,500
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Kuku, Capital....................................................2,500
When a new partner is admitted to a partnership, goodwill attributable to either to the old
partnership or to the incoming partner may be recognized.
Example 8
Take the above example and assume that Kibrom and the existing partners agreed that the old
partnership has goodwill of Br 6,000 at the time Kibrom is admitted into the partnership by
contributing Br 38,000 cash. The entries to record the goodwill and the admission of Kibrom are
as follows:
To record the goodwill
Goodwill...............................6,000
Hassen, Capital.........................3,000
Kuku, Capital..............................3,000
To record the admission of Kibrom
Cash..................................38,000
Kibrom, Capital..........................38,000
If the parties agree to recognize Br 2,000 goodwill attributable to Kibrom, it will be recorded
as follows
Cash..................................38,000
Goodwill........................... 2,000
Kibrom, Capital..........................40,000
Withdrawal of a Partner
When an existing partner retires or for some other reason wishes to withdrew from the
partnership, his share of the partnership assets must be calculated and transferred to him. Unless
all the partnership assets and liabilities are correctly valued in the books, the partner’s capital
account total will not show his actual entitlement.
Normally the true worth of the partnership will exceed the book figure of net assets, and so
various assets/liabilities will have to be re-valued and goodwill taken into account, if only on a
temporary basis. When the assets are re-valued, any profit or losses on revaluation are entered, in
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the profit sharing ratio, in the partners’ capital accounts. For the business to continue without
apparent interruption, a partner's withdrawal may occur in one of three ways.
 His or her interest may be purchased by one or more of the remaining partners. On the
partnership books, this involves an exchange of capital only and thus the only entry
required by the partnership is a debit to the capital account of the withdrawing partner
and a credit to the capital account of the partner or partners acquiring the assets.
 His or her interest may be purchased by an outsider seeking admission to the partnership.
For the partnership, this involves an exchange of capital only.
 His or her interest may be purchased by the partnership itself. Its effect is to reduce the
assets and the owner’s equity of the firm. In the event that the cash or the other available
assets are insufficient to make complete payment at the time of withdrawal, a liability
account should be credited for the balance owed to the withdrawing partner.
Reasons for withdrawal
 Death of a partner
 Incapacities of the withdrawing partner
 Disagreement
 Bankruptcy of the withdrawing partner
 Peaceful withdrawal because of different reasons
Death of a Partner
The death of a partner dissolves the partnership. In the absence of any contrary agreement, the
accounts should be closed as of the date of death, and net income for the fractional part of the
year should be transferred to the capital accounts. If the surviving partners want to continue the
business, the balance in the capital account of the deceased partner is transferred to the estate
following the procedure outlined earlier for the withdrawal of a partner from the business.
Liquidation of Partnership
Since a partnership is created voluntarily, it can be terminated at any time the partners choose.
The termination process, known as liquidation, involves selling all non-cash assets (called
realization), paying all debts to creditors, and dividing any remaining cash among the partners.
Any gain or loss resulting from the sale of noncash assets is divided among the partners
according to their distributive shares. The final distribution of cash, however, is made to the
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partners according to the balances in their capital accounts. The steps can be outlined in a
liquidation schedule.
Three steps during liquidation
1. Realization or sell of non-cash asset and dividing NI/NL according to NI/NL
sharing ratio.
2. Payment of liabilities
3. Distributing remaining cash to partner according to their capital balance
Types of Liquidations:
1. Lump sum liquidation = all non cash assets are realized before any distribution is made to
partners.
2. Installment liquidation = payments are made to partners over time as cash is available from
selling non cash assets over time.
The liquidation process is summarized in a statement called Statement of Liquidation
There are three possible scenarios (among others):
 Assets sold for a gain
 Assets sold for a loss but absorbed by capital balances
 Assets sold for a loss when a partner‘s capital is insufficient to absorb the loss
Example 10
Hana, Lulu and Getu are partners in HLG Trading. They share income and loss in the ratio of
4:4:2. On July 18, after discontinuing the ordinary business operations of their partnership and
closing the accounts, the following summary of the general ledger is prepared.
Cash......................................................50,000
Noncash assets...................................100,000
Liabilities..............................................20,000
Hana, Capital........................................70,000
Lulu, Capital.........................................20,000
Getu, Capital.........................................40,000
Consider each of the above cases independently
Gain on Realization
Requirement 1: Assuming that noncash assets are sold for Br 140,000, prepare liquidation
schedule.
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HLG Trading
Statement of Partnership Liquidation
For the Period July
Capital
Cash + NCA = Liabilities + Hana+ Lulu + Getu
Balance Before Realization..........50,000 100,000 20,000 70,000 20,000 40,000
Sell of NCA & division of gain...140,000 100,000 -0- 16,000 16,000 8,000
Balance after Realization............190,000 -0- 20,000 86,000 36,000 48,000
Payment of Liabilities................. 20,000 - 20,000 - - --
Balance after Pym of Liab.......... 170,000 -0- -0- 86,000 36,000 48,000
Cash Distribution to Partners..... 170,000 -0- -0- 86,000 36,000 48,000
Final Balance.................................. 0 0 0 0 0 0
The entries to record the several steps in the liquidation process are as follows:-
To record the sale of assets
Cash....................................140,000
Noncash Assets....................................100,000
Loss and Gain on Realization................ 40,000
To record the division of gain
Loss and Gain on Realization.............40,000
Hana, Capital.........................................16,000
Lulu, Capital..........................................16,000
Getu, Capital.......................................... 8,000
To record payment of liabilities
Liabilities..................................20,000
Cash.................................................20,000
To record distribution of cash to partners
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Hana, Capital.....................86,000
Lulu, Capital................... 36,000
Getu, Capital.................... 48,000
Cash......................................170,000
Loss on realization-No capital deficiencies

Requirement 2: Assuming the noncash assets are sold for Br 90,000, prepare a liquidation
schedule
HLG Trading
For the Period July
Capital
Sell of NCA & division of gain....90,000 100,000 -0- (4,000) (4,000) (2,000)
Balance after Realization............140,000 -0- 20,000 66,000 16,000 38,000
Balance after Pymt of Liab......... 120,000 -0- -0- 66,000 16,000 38,000
Cash Distribution to Partners..... 120,000 -0- -0- 66,000 16,000 38,000
Final Balance.................................. 0 0 0 0 0 0
Cash........................................................90,000
Noncash Assets.............................................100,000
To record the division of loss
Hana, Capital.........................................4,000
Lulu, Capital..........................................4,000
Getu, Capital..........................................2,000
Loss and Gain on Realization....................10,000
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Liabilities..................................20,000
Cash.................................................20,000
Hana, Capital.....................66,000
Lulu, Capital......................16,000
Getu, Capital.................... 38,000
Cash......................................120,000
Loss on realization- Capital deficiencies
Requirement 3: Assuming the noncash assets are sold for Br 20,000, prepare a liquidation
schedule
HLG Trading
For the Period July
Capital
Sell of NCA & division of gain....20,000 100,000 -0- (32,000) (32,000) (16,000)
Balance after Realization............ 70,000 -0- 20,000 38,000 (12,000) 24,000
Balance after Pym of Liab.......... 50,000 -0- -0- 38,000 (12,000) 24,000
Division of Deficiency................ -0- -0- -0- (8,000) 12,000 (4,000)
Claims to partnership cash............. -0- -0- -0- 30,000 -0- 20,000
Cash Distribution to Partners..... (50,000) -0- -0- (30,000) -0- (20,000)
Final Balance.................................. 0 0 0 0 0 0
Cash........................................................20,000
Noncash Assets.............................................100,000
To record the division of loss
Hana, Capital.........................................32,000
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Lulu, Capital..........................................32,000
Getu, Capital..........................................16,000
Loss and Gain on Realization....................80,000
Liabilities..................................20,000
Cash.................................................20,000
Hana, Capital.....................30,000
Getu, Capital.................... 20,000
Cash......................................50,000
Note:
If a partner has a deficit and is personally insolvent then the other partners must make it up by
taking from their own capital accounts according to their profit and loss sharing ratio. These
solvent partners now have a legal claim against the insolvent partner. Partner’s' personal assets
are first used to pay personal creditors and then to pay partnership creditors and then to repay
partners who contributed in their behalf.
Example 10
Assume that the partnership of Girma, Hirut and Esmael discontinued ordinary business
operation and the accounts were closed on march 10. A condensed post closing trial balance
prepared just before liquidation is shown below.
Cash ……………… $ 10,000
Other assets ………… 90,000
Liabilities ……………………. $ 10,000
Girma, Capital ……………….. 30,000
Hirut, capital ………………... 30,000
Esmalel, capital ………………. 30,000
100,000 $ 100,000
The partners share income or losses in the ratio of 40% 35% and 25% for Girma, Hirut & Esmael
respectively. Assume that all non-cash assets are disposed of in a single transaction & that all
liabilities are said at one time.
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Case : Loss on realization and the existence of capital deficiency Assume that non cash assets
are sold for $ 10,200 incurring a loss of Br. 79,800.
Case 3: Loss on realization and the existence of capital deficiency Assume that non cash assets are sold
for $ 10,200 incurring a loss of Br. 79,800.
Total = Girma + Hirut + Esmeal
Balance before realization …………………… 90,000 = 30,000 + 30,000 + 30,000
Division of loss on realization ……………….. 79,800 = 31,920 + 27,937 + 19,950
Balance after division of loss…………………. 10,200 = -1,920 2,070 + 10,050
Distribution of potential
Additional deficiency ………………………… ___-___ = +1,920 + -1,120 + -800
10,200 -0- 950 9,250
Girma, Hirut & Esmael
Statement of partnership liquidation
For period March 11-31,1998
Cash + Non cash assets = Liabilities + Girma + Hirut + Esmael
Balance before realization 10,000 + 90,000 = 10,000 + 30,000 + 30,000 + 30,000
Sales of non cash assets
and division of loss 10,200 + -90,000 -- + 31,920 + 27,000 + -19,950
______ ______ ______ ______ ______ _____
Balance after realization 20,200 = = 10,000 + -1,920 + 2,070 10,050
Payment of liabilities -10,000 -10,000 + ______ + ______ + ____
Balance after pyt. of liab. 10,200 = = + -1,920 + 2,070 + 10,050
Distribution of cash - 10,200 - -950 -9250
______ _____ _____
Balance -0- Dr. 1,920 Cr.1,120 Cr.800
At this stage, the liquidation process is partially completed. They are looking Girma’s Br. 1,920
Girma may pay the whole, partially & unable to pay. If Girmal pays the whole Br. 1,920, Hirut
will get Br. 1,120 and Esmael will get Br. 800.
Assignment
Daniel, Genet and Sofia are partners of DGS Merchandise. They share income and loss in the
ratio of 1:2:1 On December 4, after discontinuing the ordinary business operations of their
partnership and closing the accounts, the following summary of the general ledger is prepared.
Cash....................................................200,000 Daniel, Capital............280,000
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Noncash assets....................................400,000 Sofia, Capital..............160,000
Liabilities..............................................80,000 Genet, Capital.............. 80,000
Required: Prepare liquidation schedule
1. Assuming that noncash assets are sold for Br 560,000.
CHAPTER SEVEN
ACCOUNTING FOR CORPORATIONS
Definition and Characteristics of a Corporation
A corporation is a separate legal entity chartered under law. Basically, upon the creation of a
corporation, a 'new person' is created in the eyes of the law. This 'person' has similar rights and
obligations that a real person would have and is expected to abide by the same laws and
regulations that govern all business activity. In corporations ownership is evidenced by a
transferable share of stock. Owners of a corporation are called stockholders or shareholders or
stock owners.
Corporations may be classified based on their purpose and by ownership. Based on purpose
corporations can be classified as not-for-profit and for-profit. Not-for-profit corporations those
organized for recreational, educational, charitable, or other philanthropic purposes. For-profit
corporations are engaged in business activities. Based on their ownership for-profit corporations
can be classified further into public and non-public corporations. Public corporations are those
whose shares of stocks are widely distributed and traded in public market and may have
thousands of stockholders whereas non-public corporations are those whose shares are owned by
a small group of individuals.
Characteristics That Distinguish Corporations from Proprietorships and Partnerships
Separate legal existence
Limited liability of stockholders
Transferable ownership rights
Ability to acquire capital
Continuous life
Corporation management
Government Regulations
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Additional Taxes or double taxation
Stockholders’ Equity
A corporation is formed by filing articles of incorporation with the concerned governmental
body. The articles contain such information as (i) the name of the corporation; (ii) the purpose of
the corporation; and (iii) the types and number of stock that the corporation is authorized to sell.
A corporation's balance sheet contains assets, liabilities, and a stockholders' equity section.
Stockholders' equity is made up of contributed capital (the stockholders' investment) and retained
earnings (earnings that have remained in the business).
The stockholders' investment (also called paid-up capital) is divided into shares (stocks), and its
owners are called shareholders or stockholders. Ownership in a corporation is evidenced by a
document called a stock certificate, which the shareholder receives when he or she purchases
shares in the corporation.
 The stock certificate shows
 The name of the corporation, the stockholder’s name,
 The class and special features of the stock,
 The number of shares owned, and
 The signatures of duly authorized corporate officials. Stock certificates are pre-numbered
to facilitate accountability.
Characteristics of capital stock
As has been said earlier, the general term applied to the shares of ownership of a corporation is
capital stock. The amount of stock a corporation is authorized to sell is indicated the corporate
charter.
In setting the price for a new issue of stock, the following factors must be considered:
(1). The company’s anticipated future earnings
(2). Its expected dividend rate per share,
(3). Its current financial position,
(4). The current state of the economy, and
(5). The current state of the securities market.
The shares of capital stock are often assigned an arbitrary monetary figure, known as par.
Par value stock is capital stock that has been assigned a value per share in the corporate charter.
No-par value stock is capital stock that has not been assigned a value per share in the corporate
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charter. No-par stock is stock for which par value has not been established; it may be issued with
or without a stated value.
Classes of Stock: The major basic rights that accompany ownership of a share of stock are
 The right to vote in matters concerning the corporations
 The right to share in distribution of earnings
 The preemptive right, which is the right to maintain the same fractional in the corporation
by purchasing a proportionate number of shares of any additional issuances of stock, and
 The right to share in assets upon liquidation
Issuing Capital stock
The entries to record investments of stockholders in a corporation are like those for investments
by owners of other types of business organizations, in that cash and other assets are debited and
the appropriate class of stock will be credited as stockholders’ equity.
Capital stocks can be issued (sold) for cash or other assets. Theoretically, there is no reason for a
newly organized corporation to issue stock at price other than par. If there is a need for an
additional capital long after the corporation is established, the price at which the stock can be
sold by a corporation is influenced by
 the financial condition, the earning record, and the dividend record of the corporation,
 its potential earnings power,
 the availability of money for investment purpose, and
 general business and economic conditions and prospects
When the stock is issued for a price above the par value the difference is called Premium and if
it is sold for a price below the par value the difference is called discount.
When the issuance of common stock for cash is recorded, the par value of the shares is credited
to Common Stock or Preferred Stock and the portion of the proceeds that is above or below par
value is recorded in a Paid-in Capital in Excess of Par account.
Example1- Issuing at Par
Ethio-Slide, Inc., issues 4,000 shares of Br 1 par value of common stock and 1,000 shares of Br 2
par value of preferred stock at par for cash. The entry to record the transaction is:
Cash..............................................6,000
Common Stock................................4,000
Preferred Stock................................2,000
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Example 2- Issuing Above Par
Hafbo Inc., issues 20,000 shares of the Br 0.50 par value common stock for cash at Br 4 per
share. The entry is:
Cash.......................................................80,000
Common Stock..........................................................10,000
Paid-in Capital in Excess of Par Value-Common......70,000
If Hafbo Inc. has retained earnings of Br 30,000, the stockholders’ equity section of the balance
sheet would be: - (note that the asset and liability section of a corporation are the same as that of
sole proprietorship and partnership)
HAFBO INC.
Balance Sheet (partial)
Stockholders’ equity
Paid-in capital
Common stock...........................................................10,000
Paid-in capital in excess of par value.......................70,000
Total paid-in capital.............................................80,000
Retained earnings............................................................. 30,000
Total stockholders’ equity............................................ 110,000
Example 3- Issuing non-par, stated value stock
ABC Company issues 5,000 no-par common stocks with a stated value of Br 1.50 for Br 5. The
entries would be: -
Cash.........................................................25,000
Common Stock............................................................7,500
Paid-in Capital in Excess of stated Value-Common......17,500
If the company issues no-par stock that does not have a stated value, the full amount received is
credited to the Common Stock Account and there is no need for the Paid-in Capital in Excess of
Par Value account.
Example 4- issuing non-par stock without stated value
Omega Ltd issues 30,000 non-par common stocks that don’t have a stated value for Br 4. The
entries would be: -
Cash................................................120,000
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Common Stock...........................................120,000
Capital Stock Issued for Non-cash Assets/Services
When stock is issued in exchange for assets or for services rendered, the stock should be
recorded at the fair market value of the assets or services, unless the fair market value of the
stock is more easily determined.
Example 5
Habtu Company purchased equipment with a fair market value of Br 150,000 by issuing 70,000
common stocks with a par value of Br 2. The entries would be: -
Equipment..................................................150,000
Common Stock.............................................................140,000
Paid-in Capital in Excess of Par Value- Common........ 10,000
Types of Preferred Stocks
As has been said earlier a corporation may issue a class of stock in addition to common stock.
These stocks are called preferred stock. Preferred stock has contractual provisions that give it
preference or priority over common stock. Preferred stockholders do not have voting rights but
they have a priority in relation to:
1. Dividends and
2. Assets in the event of liquidation
Preferred stockholders have the right to share in the distribution of corporate income before
common stockholders. The per share dividend amount is stated as a percentage of the par value
of stock or as a specified amount. For example, BBB Co. may pay a 6% dividend on Br 20 par
value preferred (I.e., Br 20 X 6% = Br 1.20 per share), where as NNN Co may pay Br 0.80 per
share dividend on its Br 10 par preferred stock.
If the dividend rate of preferred stock is Br 5 per share, common shareholders will not receive
any dividends in the current year until preferred stockholders have received Br 5 per share. Once
preferred stockholders have received the annual dividends to which they are entitled, however,
common stockholders generally receive the remainder.
Example 6
Dado Co has 2,000 shares of Br 3 preferred stock (i.e. annual dividend for preferred stockholders
is Br 3) and 8,000 shares of common stock outstanding. The net income, the amount of annual
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dividend declared by the board of directors for 1996, 1997, 1998 and 1999 and the distribution of
dividend is as follows
1996 1997 1998 1999
Net Income................................................... 40,000 35,600 57,000 105,000
Amount Retained....................................... (10,000) (20,000) (15,000) (35,000)
Amount Distributed as Dividend...............30,000 15,600 42,000 70,000
Dividend for Preferred Stockholders
(2,000x3)… 6,000 6,000 6,000 6,000
Amount Left to Common Stockholders.....24,000 9,600 36,000 64,800
Dividend per Share:
Common Stockholders.........................3.00 1.20 4.50 8.10
Preferred Stockholders......................... 3.00 3.00 3.00 3.00
As the above example indicates the preferred stockholders receive constant dividend. On the
other hand, holders of common stock have the possibility of receiving larger or smaller than
preferred stockholders.
The first claim to dividends does not, however, guarantee dividends. Dividends depend on
factors such as adequate retained earnings and availability of cash.
PREFERRED STOCKS ARE CLASSIFIED IN DIFFERENT WAYS
1. Participating and Non-participating preferred stock
2. Cumulative and Non-cumulative preferred stock
Participating and Non-participating preferred stock
Holders of non participating preferred stock will receive only constant amount of dividend as
indicated in the above example regardless of the amount of dividend declared. Holders of
participating preferred stock, on the other hand, will claim additional dividend if there is any
excess dividend after common stockholders receive a given amount of dividend.
Example 7
Cobra Co issued 1,000 shares of Br 2.00 preferred stock and 5,000 shares of common stock. The
contract governing the preferred stock provides that if the dividend per share for common stock
exceeds Br 5.00, the preferred stockholders will share the excess on share-for-share basis (i.e.
equally). The dividend for year 2003 is Br 34,500. The distribution of dividend is as follows: -
Preferred Common
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Dividend Dividend TOTAL
Regular dividend for preferred (1,000 x2).........2,000 - 2,000
Dividend for Common (5,000 x 5).................... 25,000 25,000
Remainder [(34,500-27,000) ÷6,000= 1.25]. 1,250 6,250 7,500
TOTAL....................................................... 3,250 31250 34,500
Dividend per Share........................................... 3.25 6.25
Cumulative and Non-cumulative preferred stock

Preferred stock contracts often contain a cumulative dividend feature. If preferred stock is
cumulative, preferred stockholders must be paid both current-year dividends and any unpaid
prior-year dividends before common stockholders receive dividends. When preferred stock is
cumulative, preferred dividends not declared in a given period are called dividends in arrears.
Example 8
To illustrate dividends in arrears, assume that Star Trading has 40,000 common stocks and
10,000 shares of 8%, $100 par value cumulative preferred stock outstanding. The annual
dividend is Br 80,000 [10,000 x (8% x Br 100 per share)]. The Company didn’t pay dividend
last year. Therefore, dividend is one year in arrears. Current year the Company declared a
dividend of Br 300,000. Since preferred stocks are cumulative preferred stockholders are entitled
to receive dividends of Br 160,000 as shown below before any distribution may be made to
common stockholders.
The Amount of Dividend...................................................... 300,000
Dividend for preferred stockholders: -
Dividends in arrears (Br 80,000 x 1year)............................. 80,000
Current-year dividends.......................................................... 80,000
Total preferred dividends.......................... 160,000
Dividend for Common stockholders................... 140,000
Dividends in arrears are not a liability because no obligation exists until the board of directors
declares a dividend. The amount of dividends in arrears should be disclosed in the notes to the
financial statements. If the preferred stock doesn’t have this cumulative right, the stock is called
non-cumulative preferred stock. For the non-cumulative preferred stockholders, the unpaid
dividends are not carried over to the next period.
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A dividend does not have to be paid at all because it is not debt. With non-cumulative preferred
stock, if no dividend is paid in one year, then the preferred stockholders are never entitled to
receive that dividend in future years. With cumulative preferred stock, then all current dividends
plus any missed dividends from prior years (dividends in arrears) must be paid prior to any
dividends being paid to common shareholders.
SUBSCRIPTIONS AND STOCK ISSUANCE

Sometimes a corporation may sell its stocks directly to investors under stock purchase plan. In
such cases the investor (the buyer) simply agrees to pay a certain price for a certain number of
shares that will be bought in the future. The term may provide for payment in full at some future
date or for installment payments over a period of time. The stock certificate will be issued by the
corporation when the subscriber completed the agreed payment. Stocks can be subscribed at or
above par. When the subscriptions are made, we have the following journal entry:
Example 9 Journalize the following transactions for MMM Company
Apr 3- Received subscriptions to 2,000 shares of Br 10 par common stock from various
subscribers at Br 13
Common Stock Subscriptions Receivable...................26,000
Common Stock Subscribed…………………………….20,000
Paid in Capital in Excess Par- Common Stock................ 6,000
June 17- Received the total subscription amount and stock certificate is issued
Cash.......................................................................26,000
Common Stock Subscriptions Receivable......................26,000

Common Stock Subscribed...........................20,000
Common Stock..................................................20,000
Treasury Stock
Treasury stock is a corporation’s own stock that has been issued, fully paid for, reacquired by
the corporation and held in its treasury for future use. A corporation may acquire treasury stock
to meet the following objectives:
 Reissue the shares to officers and employees under bonus and stock compensation plans
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 Increase trading of the company’s stock in the securities market in the hopes of
enhancing its market value
 Have additional shares available for use in the acquisition of other companies
 Reduce the number of shares outstanding and thereby increase earnings per share.
 Treasury stock may be purchased if management is trying to eliminate hostile
shareholders by buying them out.
There are several methods of accounting for the purchase and resale of treasury stock. A
commonly used method is the cost method. Under the cost method, when treasury stock is
purchased, Treasury Stock is debited for the purchase cost.
Example 10
At the beginning of the current year ABC Company has 20,000 shares of common stock with a
par value of Br 15 per share and issued at Br 20. On May 7, the Company repurchased 3,000 of
its outstanding common stock at Br 40 each. The journal entry is: -
Treasury Stock………………….120,000
Cash..............................................................120,000
The stock may be reissued at cost, above cost, or below cost. When cash received from
reinsurance exceeds the cost, the difference is credited to Paid-in Capital from Sale of Treasury
Stock.
Example 11
Take the above example and assume that on June 14 ABC Company sold 1,000 shares for Br 40.
Reissued shares of treasury stock at cost are recorded as follows: -
Cash............................................................................40,000
Treasury Stock............................................................40,000
On August 19 ABC Company sold 400 shares for Br 50. Sale of shares of treasury stock at above
cost is recorded as: -
Cash.........................................................................20,000
Treasury Stock..............................................................16,000
Paid-in Capital from Sale of Treasury Stock..................4,000
On November 7 ABC Company sold 100 shares for Br 35. Sale of shares of treasury stock at
below cost is recorded as: -
76
Cash.........................................................................3,500
Paid-in Capital from Sale of Treasury Stock.............500
Treasury Stock..............................................................4,000
The original paid-in capital account, Common Stock, would not be affected because the number
of issued shares does not change. Treasury stock is deducted from total paid-in capital and
retained earnings in the stockholders’ equity section of the balance sheet on May 7 follow:
ABC Company
Balance Sheet (partial)
Stockholders’ equity
Paid-in capital
Common stock, Br 15 par value, 20,000 shares
issued and 17,000 outstanding……………...............................Br 300,000
Paid in Capital in Excess of Par........................................................ 100,000
Total Paid in Capital.................................................................... 400,000
Retained earnings.............................................................................. 200,000
Total paid-in capital and retained earnings........................................600,000
Less: Treasury stock (3,000 shares)....................................................120,000
Total stockholders’ equity ................................................................Br480,000
Note
Both the number of shares issued (20,000) and the number in the treasury 3,000) are disclosed.
The difference is the number of shares of stock outstanding (17,000).
Outstanding stock means the number of shares of issued stock that are being held by
stockholders.
Treasury stock is not an asset; rather it reduces stockholder claims on corporate assets.
READING ASSIGNMENT
1. Equity per Share
2. Organization Cost
77
78

PRI II Note CH 1-7

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PRI II Note CH 1-7

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CHAPTER ONE

ACCOUNTING FOR CASH

A. Recording of necessary journal

Entry: Cash on hand xxx

Cash -------------------- 2000

 If the dishonored is not discounted the journal entry will be:

Days past due

B. DIRECT WRITE-OFF METHODS OF ACCOUNTING FOR UNCOLLECTIBLES

(2) Dec. 15, 2000 Cash 5,000

Case 2. Assume that ending inventory is understated by Br 50,000

22 15 180.6 12.04 16 12.04 192.64

Internal control and perpetual inventory systems

Commodity W 200 $9.00 $ 10.00 $ 1800 $2000 $1800

Depreciation Exp. = cost - residual value

Asset = Liability + Capital

In other word Debit = Credit

Revenue Recognition Criteria:

4. Completion and percentage Completion method:

Year 1 Revenue = Cost incurred to date

Tessema Sultan Total

Income Division When Allowances Exceeds Net Income

The entry for the division of net income is as follows:

Financial Statements for Partnership

Loss on realization-No capital deficiencies

Cumulative and Non-cumulative preferred stock

SUBSCRIPTIONS AND STOCK ISSUANCE

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