Principles of Accounting II (1) - 1-3

PRINCIPLES OF ACCOUNTING II
MODULE
TABLE OF CONTENTS
Contents Page
Chapter One:
Accounting for Inventories 1
1.1. Meaning of inventories................................................................................................1
1.2. Importance of Inventories............................................................................................2
1.3. The Effects of Inventories on Current and Following Period’s Financial Statements.
............................................................................................................................................2
1.3.1 Effect of ending inventory on current period’s financial statements.....................3
1.3.2 Effects of beginning inventory on current period’s financial statements..............4
1.3.3 Effect of ending inventory on the following period’s financial statements...........4
1.4. Inventory Systems: Periodic Vs Perpetual..................................................................5
1.4.1 Periodic inventory system......................................................................................5
1.4.2 Perpetual inventory system....................................................................................6
1.5. Determining Actual Quantities in the Inventory.........................................................7
1.6. Inventory Costing Methods under Periodic Inventory System...................................9
1.6.1 Specific Identification Method..............................................................................9
1.6.2 First-in, First-out (FIFO)......................................................................................10
1.6.3 Last-in first-out (LIFO)........................................................................................11
1.6.4 Weighted Average Method..................................................................................11
1.7. Comparisons of Inventory Costing Methods.............................................................11
1.8 Inventory Costing Methods under a Perpetual System..............................................13
1.8.1 First-in first-out Method......................................................................................13
1.8.2 Last in, First-Out method.....................................................................................15
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1.8.3 Weighted average cost method............................................................................16
1.9. Valuation of inventory at other than cost..................................................................17
1.9.1. Valuation at Lower of Cost or Market (LCM)...................................................17
1.9.2. Estimating Inventory Cost..................................................................................19
Summary.......................................................................................................................22
Self examination questions...........................................................................................23
Chapter Two:Accounting for Plant Assets and Intangible assets........................................25
2.1. The Nature and Cost of Plant Asset.................................................................25
2.1.1 The Nature of Plant Asset............................................................................26
2.1.2 Determining the Cost of Plant Assets........................................................27
2.2. Computation of Depreciation for plant assets...........................................................29
2.2.1 Definition of Depreciation...........................................................................29
2.2.2 Factors considered in Computing Depreciation......................................30
2.2.3 Depreciation Computation Method............................................................31
2.3. Capital and Revenue Expenditures..................................................................38
2.3.1. Capital Expenditures....................................................................................38
2.3.2 Revenue Expenditures...................................................................................40
2.4. Disposal of plant Assets.....................................................................................40
2.4.1. Discarding of Plant Assets..........................................................................40
2.4.2. Sale of Plant Assets......................................................................................41
2.5. Accounting for Intangible Assets and Natural Resources.........................................42
Summary.......................................................................................................................45
Self Examination questions..........................................................................................46
Chapter Three:Accounting for Payroll and short term liabilities.........................................48
3. 1. Definition and Importance of Payroll.......................................................................48
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3.2. Payroll Related Liabilities.........................................................................................49
3. 2.1. Hiring Employees..............................................................................................50
3.2.2. Time Keeping.....................................................................................................50
3.2.3. Preparing Payroll................................................................................................50
3.2.4. Paying the Payroll...............................................................................................51
3.3. Determining the Payroll............................................................................................51
3.3.1. Gross Earning.....................................................................................................51
3.3.2. Payroll Deductions..............................................................................................53
3.3.3 Net Pays...............................................................................................................55
3.4. Recording the Payroll................................................................................................56
3.4.1. Maintaining a Payroll Record.............................................................................56
3.4.2. Recognizing the Payroll Expense, Liabilities and Recording Payment of the
Payroll...........................................................................................................................57
Summary.......................................................................................................................65
Self examination questions...........................................................................................66
Chapter Four:Accounting for Partnership............................................................................68
4.1. Partnerships and their Characteristics.......................................................................68
4.1.1. Definition of partnership.....................................................................................68
4.1.2. Characteristics of a partnership...........................................................................69
4.2. Classification of partnership......................................................................................70
4.3. Advantages and Disadvantages of Partnership..........................................................70
4.4. Recording the Formation of a Partnership.................................................................72
4.5. Division of Partnership Income and Losses..............................................................73
4.6. Financial Statements for a Partnership......................................................................75
4.7. Dissolution (termination) of a Partnership................................................................76
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4.7.1. Admission of a New Partner:..............................................................................76
4.7.2. Retirement or Withdrawal of a Partner.............................................................78
4.8. Liquidation of a Partnership......................................................................................80
Summary.......................................................................................................................85
Self Examination Questions..........................................................................................87
Chapter Five:Accounting for Corporations..........................................................................90
5.1. Definition of corporation...........................................................................................91
5.2 Characteristics of Corporations..........................................................................91
5.3. Advantages and Disadvantages of Corporation........................................................93
5.4 Types of Stock in a Corporation........................................................................95
5.5 Classification of Stock.........................................................................................95
5.5.1. Common Stock..............................................................................................96
5.5.2. Preferred Stock..............................................................................................97
5. 6. Accounting system for Corporations........................................................................98

5.6.1. Issuance of Stocks..........................................................................................98
5.6.2. Sale and Issuance of Capital Stock.........................................................100
5.7. Treasury Stock....................................................................................................104
5.8. Retained Earnings, Dividends and Stock Splits..........................................106
5.8.1 Restrictions on Retained Earnings...................................................................106
5.8.2. Dividends..........................................................................................................108
5.8.3 Stock Splits........................................................................................................113
5.9. Equity per Share.................................................................................................115
Summary.....................................................................................................................117
Self Examination questions........................................................................................119

Answers for self Examination questions....................................................................121
References...................................................................................................................122
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Chapter One
Accounting for Inventories
Overview
Dear students, in the first module, we have tried to seen the first two current assets,
reported on balance sheet: Cash and Receivables. In this Module we will start our lesson
by looking at accounting treatment for inventories. The type and number of inventories are
varied based on nature of the businesses: For example merchandising businesses hold only
one type of inventory, called ‘Merchandising inventory’, where as manufacturing
enterprise have three types of inventories: Raw material inventory, Work in process
inventory and Finished goods inventory. Unlike merchandising and manufacturing
company, Service providing companies did not have inventory. In this chapter, we will
discuss the meaning, importance and effects of inventories on financial statements account,
such as cost of merchandise sold, gross profit and net income. It also discusses the
inventory systems and determining actual quantities in inventories.
Objectives of the chapter:
At the end of this chapter students will be able to:
 Explain the meaning of inventories
 Describe the effect of inventory on the financial statements of the current period
and the following period.
 Describe the two principal inventory systems: Periodic and perpetual inventory
system.
 Understand procedures of determining the actual quantities in inventory.
1.1. Meaning of inventories.
☼Define the term inventories!
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 Inventories are asset items held for sale in the ordinary course of business or goods
that will be used or consumed in the production of goods to be sold. They are
mainly divided into two major categories:
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1. Inventories of merchandising businesses: Merchandising businesses purchase
inventory for resale without changing its original form. These types of inventories are
called merchandise inventories.
2. Inventories of manufacturing businesses: manufacturing businesses purchase raw
materials and different components and convert it in to end products. They normally have
three types of inventories. These are:
 Raw material inventory
 Work in process inventory
 Finished goods inventory
1. Raw material inventory -is the cost assigned to goods and materials on hand but not
yet placed into production. Raw materials include the wood to make a chair or other
office furniture’s, the steel to make a car etc.
2. Work in process inventory-
inventory- is the cost of raw material on which production has been
started but not completed, plus the direct labor cost applied specifically to this material and
allocated manufacturing overhead costs.
3. Finished goods inventory-
inventory- is the cost identified with the completed but unsold units on
hand at the end of each period.
In this Chapter only the determination of the inventory of merchandise purchased for resale
commonly called merchandise inventory will be discussed.
1.2. Importance of Inventories

Merchandise purchased and sold is the most active elements in merchandising business,
i.e. in wholesale and retail type of businesses. This is due to the following reasons:
1. The sale of merchandise is the principal source of revenue for them.
2. The cost of merchandise sold is the largest deductions from sales.
3. Inventories (ending inventories) are the largest of the current assets or those firms.
1.3. The Effects of Inventories on Current and Following Period’s Financial

Statements.
Inventories have effects on the current and the following period’s financial statements. If
inventories are misstated (understated or overstated) the financial statements will be
distorted.
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1.3.1 Effect of ending inventory on current period’s financial statements
Ending inventory is the cost of merchandise on hand at the end of accounting period. Let
us see its effect on current period’s financial statements.
 Income statement
i. Cost of goods (merchandise) sold =Beginning inventory + Net purchase – Ending
inventory
As we can see from the above formula, ending inventory is a deduction in calculation cost
of merchandise sold. So, it has an indirect (negative) relationship to cost of merchandise
sold, i.e. if ending inventory is understated, the cost of merchandise sold will be overstated,
and if ending inventory is overstated, the cost of merchandise sold will be understated.
ii. Gross Profit = Net sales – Cost of merchandise sold
Look, the cost of merchandise sold had indirect relationship to gross profit. So, the effect
of ending inventory on gross profit is the opposite of the effect on cost of merchandise
sold. That is, if ending inventory is understated, the gross profit will be understated and if
ending inventory is overstated, the gross profit will be overstated. This is a direct (positive)
relationship.
iii. Operating income = Gross Profit – Operating Expenses
On the above formula, we can understand that, Gross profit and operating income have
direct relationships. Thus, the effect of ending inventory on net income is the same as its
effect on gross profit, i.e. direct (positive) effect (relationship).
 Balance Sheet
i. Current assets:
assets: - Ending inventory is part of current assets, even the largest. So, it has a
direct (positive) relationship to current assets. If ending inventory balance is understated
(overstated), the total current assets will be understated (overstated). Since current assets
are part of total assets, ending inventory has direct relationship to total assets.
ii. Liabilities:
Liabilities: - No effect on liabilities. Inventory misstatement has no effect on liabilities.
iii. Owners’ equity:
equity: - The net income will be transferred to the owners’ equity at the end
of accounting period. Closing income summary account does this. So, net income has
direct relationship with owners’ equity at the end of accounting period. The effect-ending
inventory on owners’ equity is the same as its effect on net income, i.e. if ending inventory
is understated (Overstated), the owners’ equity will be understated (Overstated).
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1.3.2 Effects of beginning inventory on current period’s financial statements
Beginning inventory is inventory balance that was left on hand in the previous period and
transferred to the current period. Its effect is summarized below:
 Income Statement
i. Cost of merchandise sold=
sold= Beginning inventory + Net Purchases – Ending inventory
As you see, beginning inventory is an addition in determining cost of goods sold. It has
direct effect on cost of merchandise sold. That is, if the beginning inventory is understated
(Overstated), the cost of merchandise sold will be understated (Overstated)
ii. Gross Profit= Net Sales – Cost of merchandise sold
The effect of beginning inventory on gross profit is the opposite of the effect on cost of
merchandise sold, i.e. indirect (negative) relationship. If the beginning inventory is
understated, the gross profit will be overstated and if it is overstated, the gross profit will
be understated.
iii. Net income = Gross Profit – Operating expenses
The effect of beginning inventory on net income is the same as its effect on gross profit.
 Balance sheet
i. Current assets – The inventory included in current assets is the ending inventory. So,
beginning inventory has no effect on current assets.
ii. Owners’ equity-
equity- If the effect comes from the previous year, the beginning inventory
will not have an effect on ending owners’ equity since the positive or negative effect of the
previous year will be netted off by the negative or positive effect of the current year. But if
the error is made in the current period, it will have indirect effect on ending owners’
equity.
1.3.3 Effect of ending inventory on the following period’s financial statements

The ending inventory of the current period will become the beginning inventory for the
following period. So, it will have the same effect as beginning inventory of the current
period. Let us summarize it.
 Income statement of the following period
i. Cost of merchandise sold- direct relationship
ii. Gross profit - indirect relationship
iii. Net income - indirect relationship
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 Balance sheet of the following period
The ending inventory of the current period will not have an effect on the following
period’s balance sheet items.
Ø Activity 1.1:
1. Write the difference between inventories of merchandising and manufacturing
companies.
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2. Write the importance of inventories.
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3. Explain the effect of ending and beginning inventories on current and subsequent
financial statement basically on income statement and balance sheet.
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1.4. Inventory Systems: Periodic Vs Perpetual

Dear students, as we have seen in the fourth chapter of the first module, there are two
principal systems of inventory accounting, periodic and perpetual. In this chapter we will
see the detail of each systems and how they should be used in the determination cost of
ending inventory and cost of goods sold.
1.4.1 Periodic inventory system

In periodic inventory system there is no continuous record of merchandise inventory
account. The inventory balance remains the same throughout the accounting period, i.e. the
beginning inventory balance. This is because when goods are purchased, they are debited
to the purchases account rather than merchandise inventory account.
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The revenue from sales is recorded each time a sale is made. No entry is made for the cost
of goods sold. So, physical inventory must be taken periodically to determine the cost of
inventory on hand and cost of goods sold.
The periodic inventory system is less costly to maintain than the perpetual inventory
system, but it gives management less information about the current status of merchandise.
This system is often used by retail enterprises that sell many kinds of low unit cost
merchandise such as groceries, drugstores, hardware etc.
The journal entries to be prepared are:
At the time of purchase of merchandise:
Purchases XX
Accounts payable or cash XX
At the time of sale of merchandise:
Accounts receivable or cash XX
Sales XX
To record purchase returns and allowance:
Purchase returns and allowance XX
To record adjusting entry or closing entry for merchandise inventory:
Income Summary XX
Merchandise inventory (beginning) XX
To close beginning inventory
Merchandise inventory (ending) XX
Income summary XX
To record ending inventory
1.4.2. Perpetual inventory system

In the case of perpetual inventory system the accounting record continuously disclose the
amount of inventory. So, the inventory balance will not remain the same in the accounting
period. All increases are debited to merchandise inventory account and all decreases are
credited to the same account.
There are no purchases and purchase returns and allowances accounts in this system. At
the time of sale, the cost of goods sold is recorded in addition to Journal entry for the sale.
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So, we can determine the cost of inventory as well as goods sold from the accounting
record. No need of physical counting to determine their costs.
Companies that sell items of high unit value, such as appliances or automobiles, tended to
use the perpetual inventory system.
Given the number and diversity of items contained in the merchandise inventory of most
businesses, the perpetual inventory system is usually more effective for keeping track of
quantities and ensuring optimal customer service. Management must choose the system or
combination of systems that is best for achieving the company's goal.
Journal entries to be prepared are:
At the time of purchase of merchandise:
Merchandise inventory XX at cost
Accounts payable/cash XX
At the time of sale of merchandise:
Accounts receivable or cash XX at retail price
Sales XX
To record cost of goods sold:
Cost of goods sold XX
Merchandise inventory XX at cost
To record the cost of merchandise sold
To record purchase returns and allowances
Merchandise inventory XX
No adjusting entry or closing entry for merchandise inventory is needed at the end of each
accounting period.
1.5. Determining Actual Quantities in the Inventory

The physical count of inventory is needed under both inventory systems. Under periodic
inventory system, it is needed to determine the cost of inventory and goods sold.
The inventory account under perpetual inventory systems is always up to date. Yet events
can occur where the inventory account balance is different from inventory on hand. Such
events include theft, loss, damage, and errors. The physical count (sometimes called
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“taking an inventory”) is used to adjust the inventory account balance to the actual
inventory on hand.
We determine a birr (dollar) amount for physical count of inventory on hand at the end of a
period by: counting the inventory account process follows three basic steps:
Step 1.Counting
1.Counting the units of each product on hand
Step 2.Multiplying
2.Multiplying the count for each product by its cost per unit
Step 3.Adding
3.Adding the cost for all products
At the time of taking an inventory, all the merchandise owned by the business on the
inventory date, and only such merchandise, should be included in the inventory. The
merchandise owned by the business may not necessarily be in the warehouse. They may be
in transit.
The legal title to the merchandise in transit on the inventory date is known by examining
purchase and sales invoices of the last few days of the current accounting period and the
first few days of the following accounting period. This legal title depends on shipping
terms (agreements).
There are two main types of shipping terms. FOB shipping point and FOB destination
 FOB shipping point
point- the ownership title passes to the buyer when the goods are
shipped (when the goods are loaded on the means of transportation, i.e. at the
seller’s point). The purchaser is responsible for freight charges.
 FOB destination – the title passes to the buyer when the goods arrive at their
destination, i.e. at the buyer’s point. The seller is responsible for freight charge.
So, in general, goods in transit purchased on FOB shipping point terms are included in the
inventories of the buyer and excluded from the inventories of the buyer and excluded from
the inventories of the seller. And goods in transit purchased on FOB destination terms are
included in the inventories of the seller and excluded from the inventories of the buyer.
There is also a problem with goods on consignment at the time of taking an inventory.
Goods on consignment to another party (agent) called the consignee. A Consignee is to sell
the goods for the owner usually on commission are included in the consignor’s inventories
and excluded from the consignee’s inventories.
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1.6. Inventory Costing Methods under Periodic Inventory System
The most important decisions in accounting for inventory is determining costs per unit
assigned to inventory items. When all units are purchased at the same unit cost, this
process is simple since the same unit cost is applied to determine the cost of goods sold
and ending inventory. But when identical items are purchased at different costs, a question
arises as to what amounts are included in the cost of merchandise sold and what amounts
remain in inventory. A periodic inventory system determines cost of merchandise sold and
inventory at the end of the period. We must record cost of merchandise sold and reductions
in inventory as sales occur using a perpetual inventory system. How we assign these costs
to inventory and cost of merchandise sold affects the reported amounts for both systems.
We can use the following four methods in assigning costs to inventory and cost of
merchandise sold. These are:
a. Specific identification
b. First-in first-out (FIFO)
c. Last-in first-out (LIFO)
d. Weighted average
Let us see these costing methods under periodic inventory system based on the following
illustration
Example:
Maza Company began the year and purchased merchandise as follows:
Jan-1 Beginning inventory 80 units@ Br. 60 = Br. 4,800
Feb. 16 Purchase 400 units@ 56 = 22,400
Sep.2 Purchase 160 units @ 50 = 8,000
Nov. 26 Purchase 320 units@ 46 = 14,720
Dec. 4 Purchase 240 units@ 40 = 9,600
Total 1200 units Br.59,
Br.59, 520
The ending inventory consists of 300 units, 100 from each of the last three purchases.
1.6.1 Specific Identification Method

When each item in inventory can be directly identified with a specific purchase and its
invoice, we can use specific identification (also called specific invoice pricing) to assign
costs. This method is appropriate when the variety of merchandise carried in stock is small
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and the volume of sales is relatively small. We can specifically identify the items sold and
the items on hand.
Example
From the above illustration, the ending inventory consists of 300 units, 100 from each of
the last purchases. So, the items on hand are specifically known from which purchases they
are:
Cost of ending inventories under specific identification method
Br. 40 x 100 = Br. 4,000
Br. 46 x 100 = 4,600
Br. 50 x 100 = 5,000
300units Br. 13,600
 Cost of Ending inventory = Br. 13,600
 The cost of merchandise sold = Cost of goods available for sale - Ending
inventory
= Br. 59,520 – Br. 13,600 = Br. 45,920
1.6.2 First-in, First-out (FIFO)

First in first out method of inventory valuation assumes that, inventory items are sold in
the order acquired. This means the cost flow is in the order in which the expenditures were
made. So, to determine the cost of ending inventory, we have to start from the most recent
purchase and continue to the next recent. Because the first purchased items (old purchases)
are the first to be sold they are used (included) in the computation of cost of goods sold.
For example, easily spoiled goods such as fruits, vegetables etc., must be sold near the time
of their acquisition. So, the inventory on hand will be from the recent purchases. As an
example, consider the previous Example.
The cost of ending inventory under FIFO method
= Br. 40 x 240 = Br. 9,600
= Br. 46 x 60 = 2,760
300 units Br. 12,360
 Cost of Ending inventory Br. 12,360
 Cost of merchandise sold = Br. 59,520 – Br. 12,360= 47,160
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1.6.3 Last-in first-out (LIFO)
The last in first out of assigning cost assumes that the most recent purchases are sold first.
Their costs are charged to cost of goods sold, and the costs of the earliest purchases are
assigned to inventory. The cost flow is in the reverse order in which expenditures were
made.
In calculating the cost of goods sold, we will start from the earliest purchases.
As an example, take the previous illustration
The cost-ending inventory under LIFO method
=Br.60 x 80 = Br. 4,800
=Br. 56 x 220 = 12,320
300 units
 Ending inventory cost = Br. 17,120
 Cost of merchandise sold = Br. 59,520 – Br. 17,120 = Br. 42,400
1.6.4 Weighted Average Method

Weighted average method assign cost requires by computing the average cost per unit of
merchandise available for sale. That means the cost flow is an average of the expenditures.
To calculate the cost of ending inventory, we will calculate first the cost per unit of goods
available for sale
Average cost per unit = Cost of goods available for sale/ Total units available for sale
Then the weighted average unit cost is multiplied by units on hand at the end of the period
to calculate the cost of ending inventory. Also, the same average unit cost is applied in the
computation of cost of goods sold.
As an example, take the previous illustration
Weighted average unit cost = Br. 59,520/ 1,200= Br. 49.60
Ending inventory cost = Br. 49.60x 300
= Br.
Br. 14,880
 Cost of merchandise sold = Br. 59,520-Br. 14,880 = Br.
Br. 44,640
1.7. Comparisons of Inventory Costing Methods

When the cost of units and prices at which they are sold remains constant, all the four
methods yield the same results. But if prices change, the three methods usually yield
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different amounts for: Ending inventory, Cost of merchandise sold and Gross profit or net
income
1. In periods of increasing prices(inflationary case):
 FIFO yields: higher ending inventory, Lower cost of merchandise sold and
higher gross profit (net income).
 LIFO yields:
yields: Lower ending inventory, higher cost of merchandise sold and
Lower gross profit (net income).
 Weighted average yields the results between the two.
2. In periods of decreasing prices(:
 FIFO yields : Lower ending inventory, higher cost of merchandise sold and
Lower gross profit or net income
 LIFO yields:
yields: higher ending inventory, Lower cost of merchandise sold and
Higher gross profit or net income.
 Weighted average: yields the result between the two
Ø Activity 1.2:
1. Write the difference between periodic and perpetual inventory system.
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2. Explain the four basic methods used to compute cost of ending inventory and cost
of goods sold.
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3. What is the impact of price increase or decrease on cost of merchandise sold,
ending inventory and gross profit or net income, under FIFO, LIFO and weighted average
method?
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1.8 Inventory Costing Methods under a Perpetual System
Unlike cash, Merchandise inventory is a mixed mass of goods. Details of the cost of each
type of merchandise purchased and sold and related transactions must be maintained in a
subsidiary inventory ledger, with a separate account for each type. Therefore, under
perpetual inventory systems we will apply the inventory costing methods each time sale of
merchandise is made. We calculate the cost of goods (merchandise) sold and inventory on
hand at the time of each sale. This means the merchandise inventory account is continually
updated to reflect purchase and sales.
Illustration:
The beginning inventory, purchases and sales of Tokkuma Company for the month of
January fare as follows:
Units Cost
Jan. 1 Inventory 12 Br. 10.00
6 Sale 5
10 purchase 10 Br. 12.00
20 Sale 8
27 Sale 10
1.8.1 First-in first-out Method
The assignment of costs to goods sold and inventory using FIFO is the same for both the
perpetual and periodic inventory systems. The oldest is the same whether we use periodic
inventory system or perpetual inventory system.
Let us calculate the cost of goods sold and ending inventory under perpetual inventory
system from the above illustration.
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Perpetual - FIFO
Date Purchase Cost of merchandise sold Inventory
Qty Unit Total cost Qty Unit Total cost Qty Unit cost Total cost
. cost cost
Jan. 15 Br. 10.00 Br. 150.00
1
5 Br. Br. 50.00 10 10.00 100.00
6 10.00
10 10.00 100.00
10 10 Br. Br.120.00 10 12.00 120.00
12.00
20 8 10.00 80.00 2 10.00 20.00
10 12.00 120.00
2 10.00 20.00
25 8 12.50 100.00 10 12.00 120.00
8 12.50 100.00
27 2 10.00 20.00 2 12.00 24.00
8 12.00 96.00 8 12.50 100.00
2 12.00 24.00
30 15 14.00 210.00 8 12.50 100.00
5 14.00 210.00
23 Br. 25 Br.
246.00 334.00
So, the cost of merchandise sold and ending inventory under perpetual- FIFO method are
Br. 246 and Br. 334 respectively.
Let us see them under periodic - FIFO method:
Units on hand = units available for sale – units sold
= (15 + 10 + 8 + 15) – (5+ 8 + 10)
= 48 - 23 = 25
Cost of ending inventory = Br. 14 x 15 = Br. 210
Br. 12.50 x 8 = 100
14
Br. 12 x 2 = 24
Br. 334
Cost of goods available for sale = Br. 120 + Br. 100 + Br. 210 = Br. 580
Cost of goods sold = Br. 580 – Br. 334= Br 246
So, the same results of cost of gods sold and ending inventory under both periodic
inventory systems.
1.8.2 Last in, First-Out method

Unlike FIFO method, different results may occur under periodic and perpetual inventory
system. The most recent purchases change when new purchase occurs.
Let us calculate first the cost of goods sold and ending inventory for the above illustration
under perpetual inventory system. Then, we will see the results under periodic inventory
system.
Perpetual – LIFO
Date Purchase Cost of merchandise Sold Inventory
Qty Unit cost Total cost Qty Unit cost Total cost Qty Unit cost Total cost
Jan. 1 15 Br. 10.00 Br. 150.00
6 5 Br. 10.00 Br. 50.00 10 10.00 100.00
10 10 Br. 12.00 Br. 120.00 10 10.00 100.00
10 12.00 120.00
20 8 Br. 12.00 Br. 96.00 10 10.00 100.00
2 12.00 24.00
25 8 12.50 100.00 10 10.00 100.00
2 12.00 24.00
8 12.50 100.00
27 8 12.50 100.00 10 10.00 100.00
2 12.00 24.00
30 15 14.00 210.00 10 10.00 100.00
15 24.00 210.00
23 Br. 270.00 25 Br. 310.00
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So, the cost of merchandise sold and ending inventory under perpetual inventory system
are Br. 270 and Br. 310 respectively.
The results under periodic inventory system are:
Cost of ending inventory = Br. 10 x 15 = Br. 150
Br. 12 x 10 = 120
25 Br. 270
Cost of merchandise sold = Br. 580 – 270 = Br. 310
As you see, the results are different under periodic & perpetual inventory systems.
1.8.3 Weighted average cost method.

Under this method, the average unit cost is calculated each time purchased is made to be
applied on the sales made after the purchases. The results may be different under periodic
and perpetual inventory system.
Let us calculate the cost of merchandise sold and ending inventory comes out from the
previous illustration under perpetual inventory system.
Average Cost Method (Moving Average)
Purchase Cost of merchandise sold Inventory
Date Qty Unit cost Total cost Qty Unit Total cost Qty Unit cost Total cost
cost
Jan. 15 Br. 10.00 Br. 150.00
1
6 5 Br. Br. 50.00 10 10.00 100.00
10.00
20 11.00 220.00
10 10 12.00 Br. =
120.00 100+120
10+10
20 8 11.00 88.00 12 11.00 132.00
16
20 11.60 + 232.00
25 8 12.00 100.00 132+100
12+8
27 10 11.60 116.00 10 11.60 116.00

30 15 14.00 210.00 15 13.04 326.00
116+210
10+15
23 Br. 254.00 25 Br. 13.04 Br 326.00
So, the cost of goods sold and ending inventory under perpetual inventory system are Br.
254.00 and Br. 326.00, respectively.
The results under periodic inventory system are:
Weighted average unit cost = Br. 580 = Br. 12.08
48
Ending inventory cost = Br. 12.08 and x 25
= Br. 302
Cost of merchandise sold = Br. 580 – Br. 302
= Br. 278
So, the result is different under periodic and perpetual inventory systems.
1.9. Valuation of inventory at other than cost

As we have seen in the above sections, cost is the primary basis for the valuation of
inventories. However, there are circumstances when cost is valued at other than cost. These
circumstances are: (a) when the cost of replacing items in inventory is below recorded cost,
and (b) when the inventory is not salable at normal sales prices because of imperfections,
shop wear, Style changes, or other causes. Therefore, in the following sections we will see
methods applied for inventory valuation at other than cost.
1.9.1. Valuation at Lower of Cost or Market (LCM)

It was explained how costs are assigned to ending inventory and cost of goods sold using
one of four costing methods (FIFO, LIFO, Weighted average, or specific identification).
However, the cost of inventory is not necessarily the amount always reported on a balance
17
sheet. Accounting principles require that inventory be reported at the market value of
replacing inventory when market is lower than cost. Merchandise inventory is then said to
be reported on the balance sheet at the lower of cost or market (LCM).
In applying LCM, cost is the acquisition price of inventory computed using one of the
historical cost methods - specific identification, FIFO, LIFO, and Weighted average;
market is defined as the current market value (cost) of replacing inventory. It is the current
cost of purchasing the same inventory items in the usual manner. It is important to know
that market is not defined as the sales prices. A decline in market cost reflects a loss of
value in inventory. This is because the recorded cost of inventory is higher than the current
market cost. When this occurs, a loss is recognized. This is done by recognizing the decline
in merchandise inventory from recorded cost to market cost at the end of the period.
LCM is applied in one of three ways:
 Separately to individual item
 To major categories of items
 To the whole of inventory
The less similar the items are that make up inventory, the more likely it is that companies
apply LCM to individual items. Advances in technology further encourage the individual
item application.
Illustration
The following are the inventory of XYZ motor sports, retailer.
Inventory units per unit
Items on hand cost market
Cycles:
Roadster 50 Br. 15,000 Br. 14,000
Sprint 20 9,000 9,500
Off Road:
Trax-4 10 10,000 11,200
Blaz’m 6 16,000 14,500
Let us see LCM computation under the three ways:
 Separately to each individual item
Inventory items Total cost Total market LCM
18
Roadster Br. 750,000 Br. 700,000 Br. 700,000
Sprint 180,000 190,000 180,000
Categories subtotal Br. 930,000 Br. 890,000
Trax-4 100,000 112,000 100,000
Blaz’m 96,000 87,000 87,000
Categories subtotal Br. 196,000 Br. 199,000
Totals Br.1,
Br.1, 126,000 Br. 1,089,000 Br. 1, 1,067,000
 Major categories of items
Inventory Categories Categories LCM
Categories total cost total market
Cycles Br.930, 000 Br. 890,000 Br. 890,000
Off. Road 196,000 199,000 199,000
Totals Br. 1,126,000 Br. 1089,000 Br. 1,086,000
When LCM is applied to the whole of inventory, the market cost is Br. 1,089,000. Since
this market cost is Br. 37,000 lower than Br. 1,126,000 recorded cost, it is the amount
reported for inventory on the balance sheet. When LCM is applied to individual items of
inventory, the marked cost is Br. 1,067,000. Since market is again less than Br. 1,126,000
cost, it is the amount reported for inventory. When LCM is applied to the major categories
of inventories, the market is Br. 1,086,000 which is also lower than cost.
1.9.2. Estimating Inventory Cost

Whenever an inventory amounts cannot be specifically known, an inventory cost will be
estimated to maintain perpetual inventory records.
Example: Monthly income statements are needed. It may be too costly, to take physical
inventory. This is especially the case when periodic inventory system is used.
To estimate the cost of inventory, two methods are used. These are retail method and gross
profit method.
1. Retail method of inventory costing
This method is mostly used by retail business. The estimate is made based on the
relationship between the cost and the retail price of merchandise available for sale.
The steps to be followed are:
19
Step 1.Calculate
1.Calculate the cost to retail ratio:
Cost to retail ratio = Cost of merchandise available for sale
Retail Price of merchandise available for sale
Step2. Calculate the ending inventory at retail price:
Ending inventory at retail price = retail price of merchandise available for sale – Sales
Calculate the estimated cost of ending inventory
Step3.Estimated
Step3.Estimated cost of ending inventory = Cost to retail ration X Ending inventory at
retail
Example
Cost Retail
Sep. 1, beginning inventory Br. 25,000 Br. 40,000
Purchases in September (net) 125,000 160,000
Sales in September (net) 140,000
step1. Cost retail ration = Br. 25,000 + Br. 125,000 = 0.75
Br. 40,000 + Br. 160,000
Step2. Ending inventory at retail = (Br. 40,000 + Br. 160,000) – Br. 140,000 = Br. 60,000
Step3. Estimated ending inventory at cost = 0.75 X Br. 60,000 = Br. 45,000
2. Gross profit method
This method uses an estimate of the gross profit realized during the period to estimate the
inventory at the end of the period. By using the rate of gross profit, the dollar amount of
sales for a period can be divided in to its two components:
(A)Gross profit and (B) Cost of merchandise sold. The later may then be deducted from
the cost merchandise available for sale to yield the estimated inventory of merchandise on
hand.
Example: Assume that the inventory on January 1, is birr 57, 000, that net purchases
during the month are birr 180,000, that net sales during the month are birr 250,000, and
finally that gross profit is estimated to be 30% of net sales. The inventory on January 31
may be estimated as follows:
Estimate of inventory by gross profit method:
Merchandise inventory, January 1……………………….Birr 57,000
Plus: Purchases in January (net)……………………………….180,
(net)……………………………….180, 000
20
Merchandise available for sale……………………………………………Birr 237,000
Sales in January…………………………………..Birr 250,000
Less: Estimated gross profit (250,000*30%)………….75,
(250,000*30%)………….75, 000
Estimated cost of merchandise sold………………………………………………175,000
sold………………………………………………175,000
Estimated merchandise inventory, January 31………………………………..Birr62, 000
Ø Activity 1.3:
1. Explain the method of inventory valuation under perpetual inventory system, such as
FIFO, LIFO and Weighted average methods.
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
2. Write the difference between Lower cost or market (LCM) and Retail method of
inventory valuation.
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
3. Blen Trading value its inventory, shown below, at the lower of cost or market.
Per Unit
Quantity Cost Market
Category I
Item A 200 Br. 5.00 Br. 4.00
Item B 300 4.00 4.00
Item C 400 10.00 8.60
Category II
Item X 500 8.00 9.20
Item Y 300 14.00 14.50
Required: Compute Blen's inventory value using
(i) item – by – item method, and
(ii) (ii) The major category method.
21
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
Summary
Inventories are considered as current asset and reported on balance sheet. It is an asset
items held for sale in the ordinary course of business or goods that will be used or
consumed in the production of goods to be sold. Based on the nature of business
organization inventories are classified as: Inventories of merchandising businesses and
Inventories of manufacturing businesses: Merchandising business hold only one type of
inventory called Merchandising inventory,
inventory, where as Manufacturing enterprises hold three
types inventories: material inventory,
inventory, Work in process inventory, Finished goods
inventory.
There are two basic inventory systems: Periodic and perpetual inventory system. Periodic
inventory system did not continuously record merchandise inventory account, where as
perpetual inventory system continuously record merchandise inventory account. In the
determination of inventory cost, there should be agreement between buyer and sellers on
the payment of transportation cost. These terms are FOB shipping point (Purchaser is
responsible for freight charge) and FOB destination (Seller is responsible for freight
charge).
There are four methods commonly used in assigning costs to inventory and cost of
merchandise sold. These are: Specific identification, First-in first-out (FIFO), Last-in first-
out (LIFO) and weighted average cost.
In addition to using FIFO, LIFO and Weighted average costing method for valuation
assets, there are two method of inventory valuation other than cost. These methods are,
Valuation at lower of cost or market (LCM) and estimating inventory cost. The two
commonly used methods of estimating inventory may use retail method and the gross
profit method. The retail method of inventory estimation is based on the relation ship of
the cost of merchandise available to the retail price of the same merchandise. Where as, the
gross profit method of estimating inventory is based on the historical relationship of the
gross profit to the dollar amount of sales.
22
Self examination questions
Part one: Multiple choices
Choose the best answer from the given alternative
1. The form of inventory, which is mostly held by service business is
A. Raw material inventory C. Finished goods inventory
B. Partially processed goods inventory D. All E. None
2. The inventory system employing accounting records that continuously disclose the
amount of inventory is referred to as
A. Periodic C. Perpetual
B. Physical D. Retail E. None of the above
3. The inventory costing method that will yield the highest net income at the period
of inflation(price level rapidly rising) is:
A. Last in first out (LIFO) B. First in first out (FIFO)
C. Weighted Average Method D. Specific identification method
4. If the merchandise inventory at the end of the year is overstated by Birr 7,500 the error
Will cause:
A. Overstatement of cost of merchandise sold for the year by Birr 7,500.
B. Understatement of gross profit for the year by Birr 7,500
C. Over statement of net income for the year by Birr 7,500
D. Understatement of net income for the year by Birr 7,500
5. The inventory costing method that is based on the assumption that costs should be
charged against revenue in the order in which they were incurred is:
A. First in first out (FIFO) B. Last in first out (LIFO)
C. Weighted Average Method D. Specific identification method
Part Two: Work out
1. The beginning inventory and the purchase of an item during the year were as follows:
Jan1.inventory-------------20 units@78 birr
March 15. Purchase-------15 units@80 birr
June 1. Purchases----------20 units@84 birr
Sept 30.purchase-----------15 units@82 birr
23
Assume that, there are 25 units of commodity in the physical inventory at Dec 31.
Determine the cost of inventory and cost of merchandise sold if periodic inventory system
is used under FIFO, LIFO and weighted average.
2. Beginning inventory, purchase and sales data for commodity ’X’ are as follows
Jan.1 inventory--------------------15 units @40 birr
5 sold-------------------------5 units
10 purchased-----------------10 units @ 41 birr
17sold-------------------------12 units
22 sold-----------------------3 units
30 purchased-----------------10 units @42 birr
Required: Determine the cost of ending inventory and cost of merchandise sold under
FIFO, LIFO and weighted average if the organization uses perpetual inventory system
3. On the basis of the following data, estimate the cost of the merchandise inventory at July
31 by the retail method Cost Retail
July1 merchandise inventory-----------------------283970 417500
July 1- 31 purchases (Net) -------------------------215150 316500
July 1-31 sales (Net) --------------------------------------------------------330000
4. The merchandise inventory of XYZ Company was destroyed by fire on April 29.
The following data were obtained from accounting records
Jan.1 merchandise inventory---------------------110,650
Jan.1-April 29 purchases (Net) -------------------175150
Sales (Net) ------------------------300000
Estimated Gross profit rate------- 35%
Required: Estimate the cost of the merchandise destroyed.
24
Chapter Two
Accounting for Plant Assets and Intangible assets
Overview
In the previous chapter, we have seen about accounting system for inventories.
Inventories are part of current assets and reported on balance sheet. Whereas
plant assets are considered as long lived assets, such assets are a major
investment for most companies. They make up a large part of assets on the
balance sheet and they yield depreciation, often one of the largest expenses on
the income statement. On the other hand intangible assets are considered as
fixed asset but it did not have a physical existence and it will have value for the
business.
Dear students, in this chapter, we will look at the accounting system for plant
assets and intangible assets.
 Understand about the nature of plant Assets.
 Identify the four depreciation methods
 Compute the periodic depreciation and make the necessary adjusting
entries at the end of a fiscal period under depreciation methods.
 Distinguish between revenue and capital expenditures
 Explain how to account for disposal of plant asset.
 Describe and illustrate the accounting for intangible assets.
2.1. The Nature and Cost of Plant Asset

Long lived tangible assets that are of a permanent nature, used in the
operations of the business and not held for sale in the ordinary course of the
business are classified on the balance sheet as plant assets or fixed assets.
Other descriptive tittles frequently used are property, plant and equipment used
either alone or in various combinations. The properties most frequently
included in plant assets may be described in more specific terms as equipment,
furniture, tools, machinery, buildings and Land.
25
2.1.1 The Nature of Plant Asset
☼ How you define plant Assets and what are their classifications?
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
 Plant Assets are tangible assets (resources) that are used in the
operation of the business and are not intended for sale to customers.
These assets are generally long- lived and are expected to provide
services to the company for a number of years. Except for land, plant
assets decline in service potential over their useful lives. Plant assets are
also called property, plant, and equipment, or fixed assets.
 The two basic feature of plant assets are:

1. They are used in operation. This makes them different from, for instance,
inventory that is held for sale and not used in operations. The distinctive
feature here is use and not type of asset. For example, a company that
purchases a computer for purpose of reselling it reports it on the balance sheet
as inventory. But if the same company purchases the same computer for use in
the operations, it is a plant asset.
2. Plant assets have useful lives extending over more than one accounting
period. This makes plant assets different from current assets such as supplies
that are usually consumed in a short time after they are placed in use. The cost
of current assets is assigned to a single period when they are used. Many
prepaid expenses are distinguished from plants by the length of their useful
lives.
 Classification of plant Assets
Plant assets are often subdivided in to four classes:
1) Land, such as a building site
2) Land improvements, such as drive ways, parking lots, fences, and
underground sprinkler systems.
3) Building, such as stores, factories, offices and warehouses.
26
4) Equipment, such as office furniture, factory machinery, and delivery
equipment.
2.1.2 Determining the Cost of Plant Assets

Plant assets are recorded at cost in accordance with the cost principle of
accounting. Cost consists of all expenditures necessary to acquire the asset and
make it ready for its intended use. For example, the purchase price, freight
costs paid by the purchaser, and installation costs are all considered part of the
cost of factory machinery.
Cost is measured by the cash paid in a cash transaction or by the cash or by the
cash equivalent price paid when non-cash assets are used in payment. The cash
equivalent price in equal to the fair market value of the asset given up or fair
market value of the asset received, whichever is more clearly determinable.
Once cost is established, it becomes the basis of accounting for the plant asset
over its useful life. Current market or replacement values are not used after
acquisition. The application of the cost principle to each of the major classes of
plant assets is explained in the following sections.
 Land
The cost of land includes (1) the cash purchase, (2) closing costs such as title
and attorney’s fees, (3) real estate brokers’ commissions, and (4) accrued
property taxes and other liens on the land assumed by the purchaser. For
example, if the cash price is Br60, 000 and the purchaser agrees to pay accrued
taxes of Br4, 000, the cost of the land is Br64, 000.
All necessary costs incurred in making land ready for its intended use are
debited to the Land account. When vacant land is acquired, these costs include
expenditures for clearing, draining, filling, and grading. Sometimes the land
has a building on it that must be removed to make the site suitable for
construction of a new building. In this case, all demolition and removal costs
less any proceeds from salvaged materials are chargeable to the land account.
To illustrate, assume that XYZ Company acquires real estate at a cash cost of
Br200, 000. The property contains an old warehouse that is razed at a net cost
of Br12, 000 (Br15,000 in costs less Br 3,000 proceeds from salvaged
27
materials). Additional expenditures consist of the attorney’s fee, Br1, 000, and
the real estate broker’s commission, Br8, 000. Given these factors, the cost of
the land is Br221, 000, computed as follows:
Land
Cash price of property Br200, 000
Net removal cost of warehouse 12,000
Attorney’s fee 1,000
Real estate broker’s commission 8,000
Cost of land Br221, 000
In recording the acquisition, Land is debited for Br221, 000 and Cash is
credited for Br221, 000 as follows.
Land 221,000
Cash 221,000
 Land Improvements
The cost of land improvements includes all expenditures necessary to make the
improvements ready for their intended use. For example, the cost of a new
company parking lot will include the amount paid for paving, fencing, and
lighting. These improvements have limited useful lives and their maintenance
and replacement are the responsibility of the company. Thus, these costs are
debited to land improvements and are depreciated over the useful lives of the
improvements.
 Buildings
All necessary expenditures relating to the purchase or construction of a
building are charged to the Buildings account. When a building is purchased,
such costs include the purchase price, closing cost (attorney’s fees, title,
insurance, etc.) and real estate broker’s commission. Costs to make the
building ready for its intended use consist of expenditures for remodeling
rooms and offices and replacing or repairing the roof, floors, electrical wiring,
and plumbing.
 Equipment
28
The cost of equipment consists of the cash purchase price, sales taxes, freight
charges, and insurance during transit paid by the purchaser.
2.2. Computation of Depreciation for plant assets.
It is helpful to think of a plant asset as an amount of “usefulness” contributing

to the operation of a company throughout the asset’s useful life. Because the
lives of all plant assets other than land are limited, the amount of usefulness
expires as an asset is used. This expiration of a plant asset’s amount of
usefulness is depreciation.
In this section, therefore, you will study the concept, computation methods
and recording of periodic depreciation.
2.2.1 Definition of Depreciation

☼What is depreciation?
_______________________________________________________________
_______________________________________________________________
____________________________________________________
 Depreciation is the process of allocating to expense the cost of plant asset
over its useful (service) life in a rational and systematic manner.
 Depreciation is process of cost allocation, not a process of valuation.
Accountants make no attempt to measure the change in an asset’s market
value during ownership, because plant assets are not held for resale. Thus
the book value (Cost less accumulated depreciation) of a plant asset may
differ significantly from its market value.
Depreciation applies to three classes of plant assets: land improvements,
buildings and equipment. Each of these classes is considered to be a
depreciable asset because the usefulness to the company and revenue-
producing ability of each class will decline over the asset’s useful life. Land is
not a depreciable asset. Because the usefulness of land is greater over time due
to the scarcity of good land sites.
29
2.2.2 Factors considered in Computing Depreciation
In calculating the amount of depreciable cost that is to be recognized as
periodic depreciation expense, three factors need to be considered: The plant
asset’s (i) initial cost, (ii) Salvage value/residual value, and (iii) use full life.
i. Cost. Considerations affecting the cost of a depreciable asset have been
explained earlier in this Unit (section 1). You will recall that plant assets are
recorded at cost, in accordance with the cost principle of accounting.
ii. Salvage value. Salvage value is an estimate of the asset’s value at the end
of its useful life. The value may be based on the asset’s worth as scrap or
salvage or on its expected trade-in value. Salvage value is an estimate. In
making the estimate, management should consider how it plans to dispose of
the asset and experience with similar assets.
i. Useful life. Useful life is an estimate of the expected productive life,
also called service life, of the asset. Useful life may be expressed in terms of
time, units of activity such as machine hours, or in units of output. Like
salvage value, useful life is an estimate. In making the estimate, management
should consider such factors as the intended use of the asset, its expected
repair and maintenance policies, and its vulnerability to obsolescence. The
company’s past experience with similar assets is often helpful in deciding on
expected useful life.
Ø Activity 2.1:
1. Write the two basic features of plant assets.
____________________________________________________________
____________________________________________________________
_____________________________________________________
2. List the four classifications of Plant assets.
___________________________________________________________
___________________________________________________________
________________________________________________
3. Explain factors considered in computing depreciation.
30
__________________________________________________________
__________________________________________________________
___________________________________________________
2.2.3 Depreciation Computation Method

There are four basic methods for the computation of Depreciation.
1. Straight-line
2. Units-of-activity
3. Declining-balance
4. Sum-of-the-years-Digits
To compare the four depreciation methods, we will base all computations on
the following data applicable to a small delivery truck purchased by Selam Bus
Company on January 1, 2005.
Cost - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - Br. 13,000
Expected salvage value - - - - - - - - - - - - - - - - - -- - - - 1,000
Estimated useful life in years - - - - - - - - - - - - - -- - - - - - 5
Estimated useful life in miles - - - - - - - - - - - - - - - - 100,000
1. Straight Line
The straight-line method is the simplest and the most widely used method of
determining depreciation. Under this method, depreciation is the same for each
year of the asset’s useful life. It is measured solely by the passage of time. In
order to compute depreciation expense, it is necessary to determine depreciable
cost. Depreciable cost is the cost of the asset less its salvage value.
Depreciable cost is the total amount subject to depreciation. Depreciable cost
is then divided by the asset’s useful life to determine depreciation expense. The
formula and computation of depreciation expense is presented as follows:
Periodic depreciation expense= Cost – Salvage Value
Useful life in years
= 13,000 – 1000 = 2,400
5
Alternatively, we can also compute an annual rate at which the delivery truck
is being depreciated. In this case, the rate is 20% (100% ÷5 years). When an
31
annual rate is used under the straight-line method, the percentage is applied to
the depreciable cost of the asset, as shown in the following depreciation
schedule.
SELAM BUS COMPANY
Computation Annual End of Year
Depreciable Depreciation Depreciation Accumulated Book
Year Cost x Rate = Expense Depreciation Value
2005 Br12, 000 20% Br2, 400 Br2, 400 Br10, 600*
2006 12,000 20 2,400 4,800 8,200
2007 12,000 20 2,400 7,200 5,800
2008 12,000 20 2,400 9,600 3,400
2009 12,000 20 2,400 12,000 1,000
* (13,000-2,400)
Note that the depreciation expense of Br. 2,400 is the same each year, and that
the book value at the end of the useful life is equal to the estimated Br. 1000
salvage value.
An adjusting entry to record depreciation expense of 2005 is:
December 31 Depreciation expense 2,400
Accumulated depreciation-truck 2,400
2. Units-of-Activity
Under this method, instead of expressing the life as a time period, useful life is
expressed in terms of the total units of production or use expected from the
asset. The units-of-activity method is ideally suited to factory machinery:
production can be measured in terms of units of output or in terms of machine
hours used in operating the machinery. It is also possible to use this method for
such items as delivery equipment (miles driven) and airplanes (hours in use).
The units-of activity method is generally not suitable for such assets as
buildings or furniture, because depreciation for these assets is more a function
of time than of use.
To use this method, the total units of activity for the entire useful life are
estimated, the amount is divided in to depreciable cost to determine the
32
depreciation cost per unit. The depreciation cost per unit is then applied to the
units of activity during the year to determine the annual depreciation. To
illustrate, assume that the delivery truck of SELAM BUS COMPANY is
driven 15,000 miles in the first year. The formula and computation of
depreciation expense in the first year are:
Step 1= Depreciation cost per unit = Cost – Salvage Value
Total units of activity
13,000 – 1,000 = Br. 0.12
100,000 miles
Step 2= Depreciation expense = Depreciation cost x units of activity
per unit during the year
0.12 x 15,000 = 1,800
Adjusting entry for year 2005 would be:
Dec.31 Depreciation expense - - - - - - - 1,800
Accumulated Depreciation –Delivery truck-- - - -1,800
 Assuming that the delivery truck is driven the following miles each year.
2005 = 15,000
2006 =30,000
2007 = 20,000
2008 = 25,000
2009 = 10,000
The deprecation schedule, using assumed mileage data, is as follows:
SELAM BUS COMPANY

Units of Depreciation Depreciation Accumulated Book
Year Activity x cost/unit = Expense Depreciation Value
2005 Br15, 000 Br.12 Br1, 800 Br1, 800 Br11, 200*
2006 30,000 .12 3,600 5,400 7,600
2007 20,000 .12 2,400 7,800 5,200
2008 25,000 .12 3,000 10,800 2,200
2009 10,000 .12 1,200 12,000 1,000
33
* (13,000-1,800)
The units-of –activity method is not nearly as popular as the straight-line
method, primarily because it is often difficult to make reasonable estimate of
total activity. This method is easy to apply when assets are purchased during
the year. In such a case, the productivity of the assets for the partial year is
used in computing the depreciation.
3. Declining-Balance method
This method produces a decreasing annual depreciation expense over the useful
life of the asset. The method is so named because the computation of periodic
depreciation is based on a declining book value (cost less accumulated
depreciation) of the asset. Annual depreciation expense is computed by
multiplying the book value at the beginning of the year by the declining-
balance depreciation rate. The depreciation rate remains constant from year to
year, but the book value to which the rate is applied declines each year.
A common declining-balance rate is double the straight-line rate. As a result,
the method is often referred to as the double-declining-balance method. If
SELAM BUS COMPANY uses the double-declining-balance method, the
Depreciation rate is 40% (2 x the straight-line rate of 20%). The formula and
computation of depreciation for the first year on the delivery truck are:
Book value at Declining

Beginning of year} x {Balance Rate} =Depreciation Expense
== Br13, 000 *40% = Br5,2000

 The depreciation schedule under this method is as follows:
34
SELAM COMPANY
Computation Annual End of year
Year Book value Depreciat Depreciatio Accumulate Book Value
Cost begging ion n d
of the year Rate Expense Depreciation
2005 Br 13,000 40% Br5,200 Br 5,200 Br7,800
2006 7,800 40% 3,120 8,320 4,680
2007 4,680 40% 1,872 10,192, 2,808

2008 2,808 40% 1,123 11,315 1,685
2009 1,685 40% 685* 12,000 1,000
*computation of Br674 (1,685 x 40%) is adjusted to Br685 in order for book

value to equal salvage value.
You can see that the delivery equipment is 69% depreciated (Br8, 320 ÷ Br12,
000) at the end of the second year. Under the straight-line method it would be
depreciated 40% (Br4, 800 ÷ Br12, 000) at that time. Because the declining-
balance method produces higher depreciation expense in the early years than in
the later years, it is considered an accelerated depreciation method. The
declining-balance method is compatible with the matching principle. The
higher depreciation expense in early years is matched with the higher benefits
received in these years. Conversely, lower depreciation expense is recognized
in later years when the asset’s contribution to revenue is less. Also, some assets
lose usefulness rapidly because of obsolescence. In this case, the declining-
balance method provides a more appropriate depreciation amount.
When an asset is purchased during the year, it is necessary to prorate the
declining-balance depreciation in the first year on a time basis. For example, if
SELAM COMPANY had purchased the delivery equipment on April 1,2005,
depreciation for 2005 would become Br3,900 (Br3,13,000 x 40% x 9/12). The
35
book value for computing depreciation in 2006 then becomes Br9, 100 (Br13,
000 - Br3, 900), and the 2006 depreciation is Br3, 640 (Br9, 100 x 40%).
4. Sum-of-the-years-Digits Method
The sum-of-the-years-digits method yields results like those obtained by use of
the declining-balance method. The periodic charge for depreciation declines
steadily over the estimated life of the asset because a successively smaller
fraction is applied each year to the depreciable cost (original cost less the
estimated residual value).
The denominator of the fraction, which remains the same, is the sum of the
digits representing the year’s life. For the delivery truck with an estimated life
of 5 years, the denominator is 15 as computed below.
S = N [(N+1) ÷2]
Formula: Where S = sum of the digits and
N = Number of years estimated
S = 5 [(5+1) ÷2]
 = 5 [6÷2] = 5x3 = 15
OR S = 5+4+3+2+1
= 15
The numerator of the fraction, which changes each year, is the number of years
of life remaining at the beginning of the year for which depreciation is being
computed. For the first year, the numerator is 5, for the second year 4, and so
on.
The method is illustrated by the following depreciation schedule as follows.
SELAM COMPANY
Depreciable Depreciation Depreciation Accumulated Book
Year Cost Rate Expense Depreciation Value
2005 Br12, 000 20% Br2, 400 Br2, 400 Br10, 600
2006 12,000 20 2,400 4,800 8,200
2007 12,000 20 2,400 7,200 5,800
36
2008 12,000 20 2,400 9,600 3,400
2009 12,000 20 2,400 12,000 1,000
 When an asset is purchased during the year, it is necessary to prorate each
full year, depreciation between the two fiscal years benefited. For example,
if SELAM COMPANY had purchased the delivery equipment on April 1,
2005, the depreciation for 2005 would become Br.3, 000 (12,000 x 9/12 x
5/15).
The depreciation for the second year would be computed as follows.
3/12 x 5/15 x 12,000 = 1.000
9/12 x 4/15 x 12,000 = 2,400
Total, second year Br.3,400
Ø Activity 2.2:
1. Dani, Company purchased a new machine on October 1, 2008, at a cost of Br.96, 000.
The company estimated that the machine will have a salvage value of Br.12, 000. The
machine is expected to be used for 84,000 working hours during its 6-year life.
Required: compute the depreciation expense for the year indicated
(assuming that accounting period ends December 31.) under the following
methods:
i. straight line for 2008
ii. units-of-activity for 2008, assuming machine usage was 1, 700 hours.
_____________________________________________________________
_____________________________________________________________
______________________________________________________
2. A plant acquired on January 2 at a cost of Br. 285,000 has an estimated
useful life of 10 years. Assuming that it will no residual value, determine
the depreciation for each of the first two years:
i. by the declining balance method, using twice the straight – line rate; and
ii. by the sum-of-the –years digits method.
_______________________________________________________________
_______________________________________________________________
_______________________________________________________
37
2.3. Capital and Revenue Expenditures
During the useful life of a plant asset a company may incur costs for
ordinary repairs, additions, and improvements. In recording these added
expenditures, we must decide whether they are capitalized or expensed.
☼What is capital expenditure?

_____________________________________________________________
_____________________________________________________________
______________________________________________________
 Capital expenditures- refers to Expenditures for acquiring plant assets
or for additions to plant assets and expenditures that add to the utility of plant
assets for more than one accounting period. Such expenditures are debited to
the asset account or to a related accumulated depreciation account.
Expenditures that benefit only the current period and that are made in order
to maintain normal operating efficiency are called revenue expenditures.
Such expenditures are debited to expense accounts. Although it may be
difficult to distinguish between capital and revenue expenditures, care should
be exercised so that revenues and expenses will be matched properly. Capital
expenditures will affect the depreciation expenses of more than one period,
while revenue expenditures will affect the expenses of only the current
period.
2.3.1. Capital Expenditures

The accounting for the initial cost of acquiring plant assets was discussed
earlier in the chapter. The accounting for other common capital expenditures
related to plant assets – (a) additions, (b) betterments, and (c) extraordinary
repairs – are discussed in the following paragraphs.
Additions to Plant Assets: Expenditures for additions to existing plant assets
would be debited to the plant asset accounts as discussed earlier in the unit for
the initial costs of acquiring plant assets. The costs of additions would be
depreciated over the estimated useful life of the additions.
38
For example, the costs of adding an air conditioning system to a building-or of
adding a wing to a building would be treated as capital expenditures.
Betterments: Expenditures that increase operating efficiency or capacity for
the remaining useful life of a plant asset are called betterments. Such
expenditures would be added to the plant asset account. For example, if the
power unit attached to a machine is replaced by one of greater capacity, the
cost would be debited to the plant asset account. Also, the cost and the
accumulated depreciation related to the old power unit would be removed from
the accounts. The cost of the new power unit would be depreciated over its
estimated useful life
Extraordinary Repairs: Expenditures that increase the useful life of an asset
beyond the original estimate are called extraordinary repairs. They should be
debited to the appropriate accumulated depreciation account, however, rather
than to the asset account. In such circumstances, the extraordinary repairs may
be said to restore or “make good” 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 book value of the asset and the
revised estimate of the remaining useful life.
To illustrate, assume that a machine costing Br50, 000, with no residual value
and a useful life of 10 years, has been depreciated for 6 years by the straight-
line method (Br5, 000 annual depreciation), If at the beginning of the seventh
year, a Br11, 500 extraordinary repairs increase the remaining useful life of the
machine to 7 years (instead of 4), the Br11, 500 would be debited to
accumulated depreciation. The annual depreciation for the remaining 7 years of
use would be Br4, 500, determined as follows:
Cost of machine …………………………………………………. Br50, 000
Less accumulated depreciation balance;
Depreciation for first 6 years (Br5, 000 x 6) ……… Br30, 000
Deduct debit for extraordinary repairs ………… 11,500
Balance of accumulated depreciation ………………………… 18,500
Revised book value of machine after
39
Extra ordinary repair ……………………………………………. Br31, 500
Annual depreciation (Br31, 500 ÷7 years
Remaining useful life) ………………………………………….. Br 4,500
2.3.2 Revenue Expenditures

Expenditures for ordinary maintenance and repairs of a recurring nature should
be classified as revenue expenditures and debited to expense accounts. For
example, the cost of replacing spark plugs in an automobile or the cost of
repainting a building should be debited to proper expense accounts.
Small expenditures are usually treated as repair expense, even though they may
have the characteristics of capital expenditures. The saving in time and clerical
expenses justifies the sacrifice of the small degree of accuracy.
Maintaining individual plant asset records can be expensive, even in the most
advanced system. For that reason, many companies don’t keep detailed records
for assets costing less than some minimum amount such as Br100. Instead,
these low cost plant assets are treated as revenue expenditure. This practice is
acceptable under the materiality principle. Treating immaterial capital
expenditures as revenue expenditures is unlikely to mislead users of financial
statements.
2.4. Disposal of plant Assets

Plant assets are disposed of for several reasons. In general, plant assets that are
no longer useful may be discarded, sold, or exchanged to other plant assets.
Whatever the method of disposal, at the time of disposal it is necessary to
determine the book value of the plant asset. The book value is the difference
between the cost of the plant asset and the accumulated depreciation to date.
2.4.1. Discarding of Plant Assets

When plant assets are no longer useful to the business and have no market
value, they are, retired (discarded).
 To illustrate the accounting for a retirement of plant assets, assume that
Tokkuma Enterprises retires its computer printers, which cost Br32, 000.
The accumulated depreciation on these printers is also Br32, 000; the
40
equipment, therefore, is fully depreciated (zero book value). The entry to
record this retirement is as follows;
 Accumulated Depreciation – printing
32,000
Equipment
Printing Equipment
32,000
(To record retirement of fully depreciated equipment)
2.4.2. Sale of Plant Assets

In a disposal by sale, the book value of the asset is compared with the proceeds
received from the sale. If the proceeds of the sale exceed the book value of the
plant asset, a gain on disposal occurs. If the proceeds of the sale are less than
the book value of the plant asset sold, a loss on disposal occurs.
Gain on Disposal
To illustrate a gain, assume that on July 1, 2012, 3F Company sells office
furniture for Br16, 000 cash. The office furniture originally cost Br60, 000 and
as of January 1, 2012, had accumulated depreciation of Br41, 000.
Depreciation for the first 6 months of 2012 is Br8, 000. The entry to record
depreciation expense and update accumulated depreciation to July 1 is as
follows
July 1:
Depreciation Expense ………………………………………..8,000
Accumulated Depreciation – Office Furniture …………………..8,000
(To record depreciation expense for the first six months of 1996)
After the accumulated depreciation balance is updated, a gain on disposal of

Br5, 000 is computed as follows:
Cost of office furniture Br60, 000
Less: Accumulated depreciation (Br41, 000 + Br8, 000) 49,000
 Book value at date of disposal 11,000
Proceeds from sale 16,000
Gain on disposal Br 5,000
The entry to record the sale and the gain on disposal is as follows:
41
July 1
Cash ………………………………….. 16,000
Accumulated Depreciation – Office Furniture …...49,000
Office Furniture…………………………………………60,000
Gain on Disposal ……………………………………….5, 000
(To record sale of office furniture at a gain)
 The gain on disposal is reported in the Other Revenues and Gains section of
the income statement.
Loss on Disposal
Assume that instead of selling the office furniture for Br16, 000, 3F Company
sells it for Br 9, 000. In this case, a loss of Br2, 000 is computed as follows:
Cost of office furniture Br60, 000
Less: Accumulated depreciation 49,000
Book value at date of disposal 11,000
Proceeds from sale 9,000
Loss on disposal Br 2,000
The entry to record the sale and the loss on disposal is as follows:
July 1. Cash ……………………………………….9, 000
Accumulated Depreciation – Office Furniture …..49,000
Loss on Disposal …………………………………2,000
Office Furniture………………………………………60,000
(To record sale of office furniture at a loss)
The loss on disposal is reported in the Other Expenses and Losses section of
the income statement.
2.5. Accounting for Intangible Assets and Natural Resources

☼What is intangible asset?
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
42
 Intangible Assets:
Assets: are long-term assets that do not have physical substance and in
most cases relate to legal rights or advantages held.
Intangible assets include: patents, copyrights, trademarks, franchises, organization costs,
leaseholds, leasehold improvements, and goodwill. The allocation of intangible assets to
the periods they benefits is called amortization.
Intangible assets are accounted for at acquisition cost, that is, the amount paid for them.
Some intangible assets such as goodwill and trademarks may be acquired at little or no
cost. Even though they may have great value and be needed for profitable operations they
should not appear on the balance sheet unless they have been purchased from another party
at a price established in the market place.
The, Accounting Principles Board (APB) has decided that a company should record as
assets the costs of Intangible assets acquired from others. However, the company should
record as expenses the cost of developing intangible assets. Also, intangible assets that
have a determinable useful life such as patents, copyrights, and leaseholds, should be
written off through periodic amortization over that useful life in much the same way that
plant assets are depreciated.
Even though some intangible assets, such as goodwill and trademarks, have no measurable
limit on their lives, they should also be amortized over a reasonable length of time (not to
exceed forty years).
Example:
Assume that on January 2, 2012 Coca Cola Soft Drink Bottling Company purchased a
patent on a unique bottle cap for Br. 54,000.
The entry to record the patent would be as follows:
Jan 2. Patent……………………………..54,000
Cash……………………………………….…..54,000
To record the purchase of Bottle cap patent
Assume that Coca Cola’s company management determines that, although the patent for
the bottle cap will last for seventeen years, the product using the cap will be sold only for
the next six years. The entry to record the annual amortization would be as follows:
Amortization Expense………………………..9,000.00
Patent……………………………………………9,000.00
43
To record annual amortization of patent (Br. 54000/ 6 years)
Note that the patent account is reduced directly by the amount of the amortization expense.
This is in contrast to other long-term asset accounts in which depreciation or depletion is
accumulated in a separate contra account.
If the patent becomes worthless before it is fully amortized, the remaining carrying value is
written off as a loss. For instance, assume that after the first two years Coca Cola soft
Drink Bottling Company’s chief competitor’s offers a bottle with a new type of cap that
makes company’s cap obsolete. The entry to record the loss is:
Loss on patent……………………………36,000.00
Patent……………………………………36,000.00
To record the loss resulting from patents becoming worthless
Depletion of Natural Resources
We now turn our attention to another group of long-lived assets natural resources, such as
minerals, oil, and timber or lumber. These natural resources are extracted from the earth.
Depletion is the accounting measure used to allocate the acquisition cost of natural
resources. Depletion differs from depreciation because depletion focuses specifically on
the physical use and exhaustion of the natural resources, while depreciation focuses more
broadly on any reduction of the economic value of a plant or fixed asset. The costs of
natural resources are usually classified as long-terms assets.
Depletion expense is the measure of that portion of long-term assets that is used up in a
particular period.
Example:
Suppose for example, Sunshine Construction has acquired the right to use 10,000 acres of
land in Kibre-Mengist territory to mine for gold at a total cost of, Br. 10,000.000. The
Company estimated that the mine will; provide approximately 500,000 grams of gold. The
depletion rate established is computed in the following manner.
Total cost – Salvage value = Depletion cost per unit.
Total estimated units available
Br. 10,000,000 = Br. 20 per gram
500,000 units
44
If 100,000 grams are extracted in the first year, then the depletion for the year is 2000.000
(1000, 000 x Br. 20.00). The entry to record the depletion is therefore:
Depletion Expense…………………..2,000,000
Accumulated Depletion……………………….2, 000,000
Summary
Plant assets are tangible resources that are used in the operations of the
business and are not intended for sale to customers. Plant assets are recorded at
cost in accordance with the cost principles of accounting.
Because the lives of all plant assets other than land are limited, the amount of
usefulness expires as an asset is used. This expiration of plant asset’s amount
of usefulness is called depreciation. There are many depreciation methods for
allocating a plant asset’s cost over the accounting periods in its useful life. The
methods of depreciation are the straight line, unit’s activity, decaling balance
and the sum of year’s digits method.
During the useful life of plant asset a company may incur cost for ordinary
repairs, additions, and improvements. Expenditures that benefit only the
current period and that are made in order to maintain normal operating
efficiency is called revenue expenditures. Expenditures that increase the
company’s investment in productive facilities are called capital expenditures.
Plant assets are disposed for several reasons. Many assets eventually wear out
or become obsolete. Other assets are sold because of changing business plan.
Sometimes an asset is discarded or sold because it is damaged by plant assets
occur in one of the three ways: discarding (retirements), sale or exchange.
Intangible assets are long-term assets that do not have physical substance and
in most cases relate to legal rights or advantages held. Intangible assets
include: patents, copyrights, trademarks, franchises, organization costs,
leaseholds, leasehold improvements, and goodwill. The allocation of intangible
assets to the periods they benefits is called amortization.
45
Natural resources, such as minerals, oil, and timber or lumber are extracted
from the earth.
Depletion is the accounting measure used to allocate the acquisition cost of
natural resources. Depletion differs from depreciation because depletion
focuses specifically on the physical use and exhaustion of the natural
resources, while depreciation focuses more broadly on any reduction of the
economic value of a plant or fixed asset.
 Self Examination questions

5. The process of systematic periodic transfer of the cost of intangible assets to an
expense account during its expected useful life is:-
A. Depreciation C. Amortization
B. Depletion D. Betterment
6. An example an accelerated depreciation method is:-
A. Straight line C. Units of production
B. S um of the years digits D. none of the above
7. A fixed asset is acquired by trading in similar plant asset that has a book value of
25000. Assuming the trade in allowance of the old asset is 30000 birr and that 70000
cash is paid for the new asset. What is cost of the new asset for financial reporting
purpose?
A. 100000 birr C.70000 birr
B. 95000 birr D.30000 birr E. None of the above
4. Which of the following expenditures incurred in connection with the acquisition of
machinery is a proper charge to the asset account?
A. Transportation cost C. Both A &B
B. Installation cost D. Neither A nor B
5. Which of the following is an example of an intangible asset?
A. Patents C. Copyrights
B. Goodwill D. All of the above
46
Part Two: Work out
Muger Cement Factory, purchases a factory machine at a cost of Birr 36,000
on January 1, 2002. The machine is expected to have a salvage value of Br.
2,000 at the end of its 4-year use full life.
During its useful life, the machine is expected to be used 320,000 hours.
Actual annual hourly use was: year 1, 80,000; year 2, 120,000; Year, 3;
70,000; and Year 4, 50,000.
Required:
 Prepare depreciation schedules for the following methods:
i. The straight- line,
ii. Units-of- activity,
iii. Declining-balance using double the straight line rate
iv. Sum-of-year’s-digits
2. Assume that on September 1, 2012, XYZ Company sells office Equipment
for Br20, 000 cash. The office equipment originally cost Br50, 000 and as of
February 1, 2012, had accumulated depreciation of Br20, 000. Depreciation for
the first 6 months of 2012 is Br8, 000.
Required:
i. Prepare important entry for the depreciation expense.
ii. Calculate gain or loss on disposal of the equipment and prepare
important entries.
47
Chapter Three
Accounting for Payroll and short term liabilities
Overview
Dear students, as you have got some accounting concept in the previous sections, I hope
that you understand a record kept by business enterprise about an economic event such as
purchasing and selling of inventory. In addition to that, business organization may made
payment of salary and wages to workers, the process of performing such activity were
related with payroll. Payroll is related with a current liabilities, Current liabilities are
obligations expected to be paid using current assets or by creating other current liabilities.
They are due within one year, or the company’s operating cycle, whichever is longer.
Current liabilities include accounts payable, short-term notes payable, warranty liabilities,
payroll related liabilities (salaries and wages payables, employee income taxes payable,
pension contribution payable, and others), unearned revenues, and the like.

 Understand the importance of payroll accounting
 Identify and describe payroll deductions and net pay of a given employee
 Prepare payroll register
 Identify and describe payroll records
 Describe accounting system for payroll and payroll taxes
 Describe accounting for short term notes payable
 Describe accounting for other current liability
3. 1. Definition and Importance of Payroll

☼What is the meaning of payroll and it importance?
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
48
 The term payroll often refers to the documents prepared to pay remuneration for
the service rendered in a given period of time.
 The payroll accounting of a time has to be given emphasis of significance for the
following reason:
i. Employees are sensitive to payroll errors and irregularities, and maintaining good
employee moral requires that the payroll be paid on a timely, accurate basis.
ii. Payroll expenditures are subject to various government regulations.
ii. The payment for payroll and related taxes has significant effect on the net income of
most business enterprises.
Payroll and related fringe benefits often constitute a substantial percentage of current
liabilities. In addition, employee compensation is often the most significant expense that a
company incurs. Add to labor costs such fringe benefits as health insurance, life insurance,
disability insurance, and so on, and you can see why proper accounting and control of
payroll are so important.
It should be emphasized that payroll accounting involves more than paying employees’
wages. Companies are required by law to maintain payroll records for each employee file
and pay payroll taxes, and comply with numerous state and federal tax laws applicable to
employee compensation. Accounting for payroll has become much more complex as a
result of these regulations.
3.2. Payroll Related Liabilities

The tem “Payroll” pertains to all salaries and wages paid to employees. Managerial,
administrative, and sales personnel are generally paid salaries, which are often expressed in
terms of a specified amount per month or per year. In contrast, store clerks, factory
employees, and manual laborers are normally paid wages, which are based on a rate per
hour or on a piecework basis (such as per unit of product). Frequently, the terms “salaries”
and “wages” are used interchangeably.
The term “Payroll” does not extend to payments made for personal service by
professionals such as certified public accounts, attorneys, and architects such professionals
are independent contractors, and payments to them are called fees, rather than salaries or
wages. This distinction is important because government regulations relating to the
payments and reporting of payroll taxes apply only to employees.
49
3. 2.1. Hiring Employees
Posting job openings, screening and interviewing applicants, and hiring employees are
responsibilities of the personnel department, from a control standpoint; the personnel
department provides significant documentation and authorization. When an employee is
hired, the personnel department prepares an authorization form.
The authorization form is sent to the payroll department, where it is used to place the new
employee on the payroll. A chief concern of the Personnel department is ensuring the
accuracy of this form. The reason is quite simple; one of the most common types of payroll
frauds is adding fictitious employees to the payroll.
The Personnel department is also responsible for authorizing:
 Changes in pay rates during employment and
 Terminations of employment.
In each instance, the authorization should be in writing, and a copy of the change in status
should be sent to the payroll department.
3.2.2. Time Keeping

Another area in which internal control is important is timekeeping. Hourly employees are
usually required to record time worked by “Punching” a time clock. The time of arrival and
departure are automatically recorded by the employee when he or she inserts the time card
in to the clock.
In large companies, time clock procedures are often monitored by a supervisor or security
guard to make sure an employee punches only one card, at the end of the pay period, the
employee’s supervisor is required to approve the hours shown by signing the time card,
when overtime hours are involved, approval by a supervisor is usually mandatory to guard
against unauthorized overtime.
The approved time card is then sent to the payroll department. For salaries of employees, a
manually prepared weekly or monthly time report kept by a supervisor may be used to
record time worked.
3.2.3. Preparing Payroll

The payroll is prepared in the payroll department on the basis of two sources of input:
i. Personnel department authorizations and
ii. Approved time cards.
50
Because of the numerous calculations involved in determining gross wages and payroll
deductions, it is customary for a second payroll department employee, working
independently, to verify all amounts, and a payroll department supervisor then approves
the payroll. The payroll department is also responsible for preparing (but not signing)
payroll checks, maintaining payroll records, and preparing payroll tax returns.
3.2.4. Paying the Payroll

The payroll is paid by the treasurer’s department. Payment by check minimizes the risk of
loss from theft, and the endorsed check provides proof of payment. For good internal
control, payroll checks should be renumbered, and all checks should be accounted for. All
checks must be signed by the treasurer (or designated agent), and their distribution to
employees should be controlled by the treasure’s department. Checks may be distributed
by the treasurer or paymaster.
If the payroll is paid in currency, it is customary to have a second person count the cash in
each pay envelope and for the paymaster to obtain a signed receipt from the employee
upon payment. Thus, if alleged discrepancies arise, adequate safeguards have been
established to protect each party involved,
3.3. Determining the Payroll

☼What are the factors involved in determining payroll?
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
 Determining the payroll involves computing:
i. Gross earnings
ii. Payroll deductions, and
iii. Net pay
3.3.1. Gross Earning

Gross earning is the total compensation earned by an employee. The gross earnings of an
employee may include wages, salaries, bonuses, overtime earnings and allowances.
51
Wages, Salary and Bonus
The term wages is more correctly used to refer to payments for manual labor that are paid
based on the number of hours worked or the number of units produces, so they are usually
paid when a particular piece of work is completed or for a period less than a month.
The salary for an employee is generally based on a monthly or yearly rate rather than on an
hourly basis. These rates are then applied ratably to the payroll periods used by the
company. Most executive and administrative positions are salaried.
Many companies have bonus agreements for management personnel and other employees.
Bonus arrangements may be based on such factors as increased sales or net income. Bonus
may be paid in cash and/or granting executives and employees the opportunity to acquire
shares of stock in the company at favorable prices (called stock option plans).
It must be clear that when we say an employee, we refer to an individual who worked
primarily to an organization and whose activities are under the direction and supervision of
the employer. Hence, an employee is different from an independent contractor, a self-
employed individual who works on a fee basis to a firm, such as architects, attorneys.
Overtime Earning - Is the amount payable to an employee for overtime work done. In
Ethiopia, in this respect, according to Article 33 of proclamation No.64/1975, the
following is discussed about payment for overtime work.
i. A worker shall be entitled to be paid at a rate of One and one quarter (1 1/4) times
his or her ordinary hourly rate for overtime work performed up to 10 o’clock in the
evening (10 P.M.) beyond his/her regular working hour.
ii. A Worker shall be paid at the rate of One and one half (1 1/2) times his or her
evening (10 P.M.) and six o’clock in the morning (6 a.m.)
iii. Overtime work performed on the weekly rest days shall be paid at a rate of two (2)
times the ordinary hourly rate of payment.
iv. A worker shall be paid at a rate of two and half (2 1/2) times the ordinary hourly
rate for overtime work performed on a public holidays.
Allowance: Money paid monthly to an employee for special reason, which may include:
Position Allowance: - a monthly sum paid to an employee for bearing a particular office
responsibility, e.g. Head of a particular department or division.
52
House Allowance: - a monthly allowance given to cover housing costs of the individual
employee when the employment contract required the employer to provide housing but
fails to do so.
Hardship Allowance: - a sum of money given to an employee to compensate for an
inconvenient circumstance caused by the employer. For instance, unexpected transfer to
different and distant work area or location is sometimes known as disturbance allowance.
Desert Allowance: - a monthly allowance given to an employee because of assignment to a
relatively hot region.
Transportation (fuel) Allowance: - a monthly allowance to an employee to cover cost of
transportation up to the work place if the employer has committed itself to provide
transportation service.
3.3.2. Payroll Deductions

As anyone who has received a paycheck knows, gross earnings are usually very different
from the amount actual received. The difference is attributable to payroll deduction.
Payroll deductions do not result in payroll tax expense to the employer. The employer
serves only as a collection agency, and it subsequently transfers the deductions to the
government and designated recipients.
 Mandatory (required) deductions
These are deductions made from the earnings of employee that is because it is required by
government.
 Income Tax
Employee Income Tax-In Ethiopia every citizen is required to pay income tax from his/her
earnings of employment. In this case, a progressive income tax system that charges higher
rates for higher earnings is applied on the gross earnings of each employee. According to
proclamation No. 286/2002, which further amended the income tax, proclamation No.
107/1994 the first Birr 150 of the earnings of an employee is exempted from income tax.
The money on which person does not have to pay income tax is an exemption.
The income tax proclamation 286/2002 stated the following about employment income tax
and its computations:
The first one hundred fifty (Birr 150) incomes from employment shall be exempted from
payment of income tax in all cases.
53
The Tax on income from employment over one hundred fifty birr (Birr 150) shall be
charged, levied and collected monthly according to the following schedule: -
S. Employment income per Rate of tax (%) Deduction(in birr)
No month
(in birr)
1 0-150 Exempted -
2 151-650 10% 15
3 651-1,400 15% 47.5
4 1,401-2,350 20% 117.5
5 2,351-3,550 25% 235
6 3,551-5,000 30% 412.5
7 Above 5,000 35% 662.5
Generally, taxable income from employment includes salaries, wages, allowances
director’s fees and other personal emoluments, all payments in cash and benefits in kind.
However, the following categories of payments in cash or benefits in kind are exempted
from taxation.
1. Medical costs incurred by employer for treatment of employees.
2. Transportation allowances paid by employer to its employees (not exceeding Birr
300).
3. Reimbursement by employer of traveling expense incurred on duty by employees.
4. Traveling expenses paid to transport employees from elsewhere to place of
employment and to return them upon completion of employment.
5. Pension contribution, provident fund and all forms of retirement benefits
contributed by employers in an amount that does not exceed 15% of the monthly
salary of the employee.
6. Income from employment received by casual employees who are not regularly
employed provided that they do not work for more than one month for one
employer.
54
 Pension
Pension contributions - Permanent employees of an organization the employees of which
are governed by the existing regulations of the Ethiopian Public Servants are expected to
pay or contribute 4% of their basic (monthly) salary to the government pension Trust
Fund. This amount should be with held by the employer from the basic salary of each
employee on every payroll and later be paid to the respective government body.
On the other hand, the employer is also expected to contribute towards the same fund 6%
of the basic salary of every permanent employee of it. This amount is often called as
payroll taxes expense to the employer organization. (i.e. 6% of the total basic salary of all
permanent employees).
Consequently, the total contribution to the pension Trust fund of the Ethiopian
Government is equal to 10% of the total basic salary of all permanent employees of an
organization. (i.e. 4% comes from the employees and the 6% comes from the employer).
This enables a permanent employee of an organization to be entitled to the pension pay
given that the employee has satisfied the minimum requirement to enjoy this benefit when
retired.
 Non-government organizations are also using this kind of scheme to benefit their
employees with some modifications. This is made in some NGO’s and businesses
by keeping a fund known as Provident Fund. Both the employees and the
employer contribute towards this fund monthly. Ultimately, when an employee is
retired or drawn out of work, a lump sum amount is given at once.
 Voluntary Deductions
Employees may voluntarily authorize withholding for charitable, retirement, and other
purposes. The employee should authorize all voluntary deductions from gross earnings in
writing. The authorization(s) may be made individually or as part of a group plan.
Voluntary deductions are such as donations to charitable organization, credit association,
repayment of loan, union dues, health and life insurance.
3.3.3 Net Pays

Net pay is determined by subtracting payroll deductions from gross earnings. It is
sometimes known as take home pay, the amount collected by an employee on the payday.
55
This amount is held in one column of the payroll register representing the excess of gross
earnings over the total deductions of an employee. The column “Net Pay” total tells the
excess of grand total earnings over grand total deduction made from the earnings of
employees.
Ø Activity 3.1:
1. Write factors considered in determination of payroll?
___________________________________________________________________
___________________________________________________________________
___________________________________________________________________
2. Define the terms: basic salary, Gross pay, net pay, and deductions.
___________________________________________________________________
___________________________________________________________________
___________________________________________________________________
3.4. Recording the Payroll

Recording the payroll involves maintaining payroll department records, recognizing
payroll expenses and liabilities, and recording payment of the payroll.
3.4.1. Maintaining a Payroll Record

Basic Records of a Payroll Accounting System Includes:
i. A payroll register (or payroll Sheet).
ii. Individual employees’ earnings records and,
iii. Usually, Pay Check.
These records are generated from a payroll system that is operated manually or using
computer.
 A payroll register (sheet): the entire list of employees of a business along with
each employee’s gross earning, deductions and net pay for particular payroll
period. The basis for the preparation of the payroll register can be the attendance
sheets, time cards or punched cards.
 Employee Earnings Record: It is summary of each employee’s earnings,
deductions and net pay for each payroll period and of cumulative gross earnings
during the year. It is a separate record department for each employee. The
56
individual employee’s earnings record helps the employer organization to properly
summarize and file tax returns.
 Pay Check: A instrument for paying salary if the firm makes payment via writing a
check in the name of each employee for the net pay or a check for the total net pay.
3.4.2. Recognizing the Payroll Expense, Liabilities and Recording Payment of the
Payroll
Payment by check is made either from the employer’s regular bank account or a payroll
bank account. Each check is usually accompanied by a detachable statement of earnings
document that shows the employee’s gross earnings, payroll deductions, and net pay.
Example, Muger cement Factory pays the salary of its employees according to the
Ethiopian Calendar. The forth-coming date relates to the month of Tikimt, 2000.
S. Name of Employee Basic Monthly OT Duration of OT Basic
No Salary Allowance Hours Work Salary
worke Per Hour
d
01 KUSA GALU 2,080 100 10 Up to 10p.m. 13
02 GUTU GUTEMA 640 - 8 10p.m. to 6a.m 4
03 SARA ADUGNA 1,280 - 6 Weekly Rest Day 8
04 URGE SHIBESHI 960 50 - - 6
05 HAGOS GEBRE 480 50 10 Public Holiday 3
Assume that, management of the factory usually expects a worker to work 40-hours in a
week and during Tikimt 2000 all workers have done as they have been expected. Besides,
all workers of this factory are permanent employees except GUTU GUTEMA. The
monthly allowance of HAGOS GEBRE is not taxable. SARA ADUNYA agreed to have a
monthly Birr 200 be deducted and paid to the credit Association of the factory as a
monthly saving.
Directions: Based on the above information;
Prepare a payroll register (or sheet) for the factory for the month of Tikimt, 2000.
1. Record the payment of salary as of Tikimt 30, 2000- using CK. No 41 as a source
document.
57
2. Record the payroll taxes expense for the month of Tikimt; 2000 Memorandum No. 10.
3. Record the payment of the claim of the credit association of he agency that arose from 4.
Tikimt’s Payroll assuming that the payment was made on Hidar 3, 2000.
5. Assuming that the withholding taxes and payroll taxes the month of Tikimt, 2000 have
been paid on Hidar 5, 1996 Via Check. No. 50 recorded the required journal entry.
1. Computations of earnings, deductions and net pay
 OVER TIME EARNINGS:
Over Time Earnings= OT Hrs worked (ordinary hourly rate x OT Rate)
KUSA: 10 hrs x (Br. 13 x 1.25) = Br 162.50
GUTU: 8hrs x (Br. 4x 1.5) = Br. 48.00
SARA: 6 hrs x (Br. 8x2) = Br. 96.00
HAGOS: 10hrs x (Br. 3x2.5) = Br. 75.00
 GROSS EARNINGS:
Gross Earnings = Basic Salary + Allowance + OT Earning
1. KUSA: Br 2080 + 100 + 162.50 = Br.2, 342.50
2. GUTU: Br. 640 + 0 + 48.00 = Br. 688.00
3. SARA: Br. 1280 + 0 + 96.00 = Br. 1,376.00
4. URGE: Br. 960 + 50 + 0 = Br. 1, 010.00
5. HAGOS: Br. 480 + 50 + 75.00 = Br. 605.00
 Deductions and Net Pays:
1. KUSA:
Gross Taxable Income= Br. 2, 342.50
 Employee Income Tax:
Earning X ITR = IT
150.00 0% 0.00
500.00 10% 50.00
750.00 15% 112.50
942.50 20% 188.50
Total 2, 342.50 351.00
 Pension contributions:
Basic Salary x 4%
58
Br. 2080 x4% = 83.20
Income tax 351.00
Pension contribution + 83.20
Total Deductions = 434.20
Gross pay 2, 342.50
Total deductions -434.20
Net Pay Br.1, 908.30
2. GUTU:
Gross Taxable Income= Br.688.00
Earning x ITR = IT
150.00 0% 0
500.00 10% 50.00
38.00 15% 5.70
Total 688.00 55.70
Pension contribution is zero b/c
GUTU is a contractual worker
Income tax 55.70
Pension contribution + 0.00
Gross pay 688.00
Net Pay 632.70
59
3. SARA:
Gross Taxable Income= Br 1,376.00
Earning x ITR = IT
Credit Ass. Pay. =200.00
150 0% 0
500.00 10% 50.00
760.00 15% 108.90
Total 1,376.00 158.90
 Pension contribution:
 Basic Salary x 4%
Br. 1,280 x 4% = 51.20
Income tax 158.90
Pension contribution +51.20
Credit ASS. + 200.00
Gross pay 1,376.00
Net Pay = 965.90
4. URGE:
Gross Taxable Income= Br 1,010.00
Earning x ITR = IT
150 0% 0.00
500.00 10% 50.00
360.00 15% 54.00
Total 1,010.00 104.00
 Pension contribution:
60
Basic Salary x 4%
Br. 960 x 4% = 38.50
Income Tax 104.00
Pension cont. +38.40
Total Deductions =142.40
Gross pay 1,010.00
Net Pay = Br. 867.60
5. HAGOS:
Gross Earning = Br. 605.00
Employee Income Tax:
Earning x ITR = IT
Gross Taxable Income= (his allowance is not subject to tax)
Br 605 –50 = Br.555.50
150.00 0 0.00
405.00 10 40.50
Total 555.00 40.50
 Pension Contribution:
Basic Salary x 4%
Br 480 x4% =19.20
Income tax 40.50
Pension Cont. 19.20
605.00
-59.70
Net Pay = 545.30
N.B. OT = Over Time,
ITR= Income Tax Rate,
IT = Income Tax
61
Muger Cement Factory
A Payroll Sheet
For The Month of Tikimt, 2000
S.No Name of the Gross Earning Total Deduction Total Deduction Net Payment
employee Earnin
Basic Salary Allowan Over Time g Income Pensio Other
ce Tax n s
1 Kusa Galu 640.00 - 48.00 2342.5 351.00 83.20 - 434.20 1908.30
0
2 Gutu Gutema 688.00 55.70 - - 55.70 632.30
3 Sara Adugna 1280.00 - 96.00 1376.0 158.90 51.20 200.0 410.10 965.90
0 0
4 Urge Shibeshi 960.00 50.00 - 1010.0 104.00 38.40 - 142.40 867.60
0
5 Hagos Gebre 480.00 50.00 75.00 605.00 40.50 19.20 - 59.70 545.30
Total 5440.00 100.00 381.50 6021.5 710.10 192.00 200.0 1102.10 4919.40
0 0
Prepared By: _________ Verified By: __________ Approved By: __________
62
Proving the Payroll:
Total Earnings:
Basic Salary………………………….Br. 5, 440.00
Allowance …………………………… 200.00
Over Time…………………………… 381.50
Grand Total Earnings……………….. Br. 6, 021.50
Deductions:
Employee Income Tax……………………Br. 710.10
Pension Contribution…………………………… 192.00
Other……………………………………. 200.00
Total Deduction………………………….Br. 1, 102.10
Net Pays Total…………………………………. 4, 919.40
Total Deduction, and Net Pay……………….. Br. 6, 021.50 thus, it is proved.
2. Recording the Payment of Salary.

Tikimt 30, 2000. Salary Expense………………..6, 021.50
Employee Income Tax Payable…………… 710.10
Pension contribution Payable…………….. 192.00
Credit Association- MCF………………… 200.00
Cash…………………………………………. 4, 919.40 (Ck. No. 41)
3. Recording the Payroll taxes expense for Tikimt. 2000
Muger cement Factory incurred payroll tax expense of Br. 288 during Tikimt, 2000. This
is determined as the product of the basic salary of all permanent employees and 6%. This
is because the agency has to contribute 6% of the basic salary of every Permanent
employee to the government pension trust fund.
Thus:
Total Basic Salary Payroll Taxes Payroll Tax
Of all permanent Employees x6% = Expense
(2,080 + 1, 280 + 960 + 480) x 6% = Br. 288
By the amount of Br.288 the factory’s expense, Payroll taxes expense, and pension
contributions payable increase. Therefore, the following Journal entry is made as of
63
Tikimt 30, 2000 Payroll Taxes Expense 288
Pension cont. Payable 288
(M10)
The source document is an internal office memorandum that indicates the incurrence of
this expense.
Recording the Payment of Deduction from Sara’s earnings to the credit association on
Hidar 3, 2000
Hidar 3, 2000 Credit Association………. 200
Cash………………..200
5. Recording the Payment of Withholding and Payroll taxes to Inland Revenue Authority
on Hidar 5, 2000.
Look at the account balance before payment:
Employee Income Tax Payable Pension cont. Payable
710.10(2) 192.00(2)
288.00(3)
480.00
From the above accounts you can see that the agency has a total liability of Br. 1, 191.10
That is:-
Employee Income Tax…………………… Br. 710.10
Pension contribution……………………….........480.00
Total …………………………………………Br. 1, 190.10
Note also that the total pension contribution payable is equal to 10% of the basic salary of
all permanent employees. That is: Br. 4, 800 x 10% = Br. 480
Then, the payment is recorded as follows:
Employees Income Tax Pay………….710.10
Pension Contribution Payable ……… 480.00
Cash……………………………………1,190.10
Ck. No.50
After the payment of these liabilities have been posted, the above two accounts will have
Zero Balances.
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3.5. Accounting for Other Short Term Liabilities
Accounts Payable
Amounts owed to suppliers for products or services that are purchased on open account
basis.
Short-term Notes Payable
Short-term notes payable are notes payables that are due within one year. Companies often
issue short-term notes payable to borrow cash or to purchase inventory or plant assets.
Current Portion of Long-Term Debt
Some long-term payable and long-term bond payable must be paid in installments. The
current portion of a long-term debt, current maturity, is the amount of the principal that is
payable within one year.
Estimated Warranty Payable
Many merchandising companies guarantee their products against defects under warranty
agreements. The warranty period may extend for any length of time (90 day warranties and
one year warranties are common).
Unearned Revenues
Unearned revenues are revenues collected in advance before the goods are delivered or
services are rendered. Until the goods are provided or services are rendered to customers,
they are current liabilities.
Summary
Payroll includes amount paid for salaries to managerial or administrative employees as
well as wages paid for manual labor. Payroll accounting involves accounting for taxes
withheld from employees, other deductions from employees, and accrual of payroll taxes
that result in liabilities. Separation of duties and definition of responsibilities involving
personnel, time keeping, supervision, payroll accounting, and payment of payroll are
essential elements of internal control over payroll.
A payroll register contain information about the pay and of all employees as a group for a
single payroll period. An employee earnings record is maintained to provide a record of
earnings, deductions, and net pay for a calendar year for each employee.
65
Liabilities are obligations that arose from past transactions and are payable in money,
goods or services in the future. Current liabilities are obligations that will be met within
one year or the current operating cycle, whichever is longer: by the use of existing current
assets or by the creation of other current liabilities.
A contingent liability is a potential obligation that is dependent on the occurrence or non-

occurrence of a future event or events to confirm if as an actual liability. A contingent
liability may be recorded only when: the future event is likely to occur and the liability can
be reasonably estimated.
Self examination questions

1. Which one of the following journal entries are required to recognize payroll tax expense
of the business.
A. Debit, payroll tax expense and credit, cash
B. Debit, payroll tax expense and credit pension contribution
C. Debit tax expense and credit, accounts payable
D. debit account payable and credit, cash
E. None of the above
2. The total compensation earned by an employee, including wages, salary, bonuses,
Overtime earning and allowance is called: _________
A.Net pay B. Gross pays C. Basic salary D. None
3. The Ethiopian income tax system is considered as: _____
A. Proportional B. Regressive C. Progressive D. All
4. A kind of current liability considered as revenues collected prior to delivering of goods
And service is: __
A. Accounts payable B. Unearned revenue C. Notes payable D. Warranty payable
5. The difference between gross earning and total deduction is:
A. Basic salary B. Gross pays C. Deductions D.Net pay
Part Two: Work out
66
1. Ambo mineral water factory pays the salary of its employees according to
Ethiopian
Calendar for the month ended Hamle 30, 2002.
S. Names of Basic Monthly OT hours Duration of
N Employee Salary Allowance worked OT work
1 Getachew Kassa 5,000 200 10 Up to 10pm
2 Abdi Biya 2,300 200 8 10pm to 6 Am
3 Tola Wakayo 1,600 100 12 Weekly rest
4 Lensa Lami 2,400 300 6 day
Weekly rest
day
5 Asegedech Teferi 800 - 10 Public holiday
6 Lamirot Hagos 500 200 - -
Additional information
 A worker expected to work 40 hours a week and during Hamle all workers
have done as they have been expected
 All workers are permanent employees
 All workers monthly allowance is not taxable because it is hardship
allowance
 All workers agree to pay 5% of their basic salary as a saving to the credit
association of the factory
 Ambo Mineral Water is presently governmental organization.
Required:
Prepare payroll register (sheet) and important entries for the month of Hamle 30, 2002.
Chapter Four
67
Accounting for Partnership
Overview
As we have seen in the first part of this course, there are three forms of business
organizations: Sole proprietorship, Partnership And Corporation. A proprietor ship is a
form of business organized by one person; Partnership is form of business established by
two or more than two person, whereas corporation is considered as a share company,
which is operated as an artificial person. In the previous part, we have seen more about an
accounting procedure for proprietorship, in this chapter we will discuss the application of
accounting for partnership form of business.

 Understand the meaning of partnerships and explain their characteristics.
 Describe the advantages and disadvantages of a partnership
 Record the investments made by the partners in forming a partnership.
 Understand the application of various methods of dividing the income or loss of a
partnership.
 Record the admission and withdrawal of a partner(s)
 Understand the concept of liquidation of a partnership.
4.1. Partnerships and their Characteristics

4.1.1. Definition of partnership.
☼What is partnership and what are the characteristics of partnership?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
 Partnership is an unincorporated association of two or more persons to carry a
business for profit as co-owners. This association is based on a partnership agreement
or contract known as the articles of a partnership.
partnership. The partnership agreement should
specify the name location, and purpose of the business; the capital contributions and
duties of each partner; the methods of income and loss division; the rights of each
partner upon liquidation of a partnership, etc. The partnership agreement should be in
68
writing to avoid any misunderstandings about the formation, operation, and
liquidation of a partnership.
 They are common in small retail and service business.
Many professional practitioners also organize their practice as partnership, including
physicians, lawyers, and Accountants.
4.1.2. Characteristics of a partnership

For purposes of accounting, partnerships are treated as separate economic entities. Some
of the important features of a partnership are discussed as follows:
i. Voluntary Association
A partnership is a voluntary association of individuals rather than a legal entity in itself.
Therefore, a partner is responsible under the law for his or her partner’s business actions
within the scope of the partnership. A partner also has unlimited liability for the debts of
the partnership. Because of these potential liabilities, an individual must be allowed to
choose the people who join the partnership.
ii. Limited Life
Because a partnership is formed by the consent of two or more partners, it has a limited
life. This means that, anything that ends the contract dissolves the partnership.
A partnership can be dissolved when (1) a new partner is admitted; (2) a partner
withdraws, retires, dies or becomes bankrupt. At this point, the remaining partners should
sign a new contractual agreement to continue the affairs of the business. In place of the old
partnership a new partnership is formed. Thus, a partnership is said to have a limited life.
iii. Unlimited Liability
Each partner is liable for all the debts of the partnership. When and if the partnership fails
to pay its debts, creditors can seize (take) each partner’s personal assets to satisfy their
claims. Therefore, a partnership creditors’ claims are not limited to the assets of the
business, but is extends to the personal property of the partners. Each partner, then, could
be required by law to pay all the obligations (debts) of the partnership.
Suppose, for example, the liabilities of ABC company (a partnership business) as of a
certain date is birr 600,000, however, the total properties (assets) of ABC company could
only be sold for birr 450,000. Thus, to settle creditors’ claims fully, the house or personal
assets of the partners may have to be sold.
69
iv. Mutual Agency
Each partner is an agent of the partnership within the scope of the business. This means
that partner’s act to any contract is binding on the remaining partners as long as it is within
the apparent scope of the business’ operations.
For example, a partner in a public accounting firm can bind the partnership through the
delivery of accounting services. But this partner cannot bind the partnership to a contract
for delivering (or providing) cars because it is out of the scope of the business.
v. Co ownership of partnership property
Once invested, the properties contributed by the partners become the property of the
partnership and is owned jointly by all the partners. Upon liquidation of the partnership
and distribution of assets, the partner’s claim on the assets is measured by the amount of
the balance in his/her capital account.
4.2. Classification of partnership

Based on the organization characteristics partnership form of business organization is
classified in to two:
two:
i. General partnership:
partnership: A partnership in which all partners have mutual agency
and unlimited liability for partnership debt.
ii. Limited partnership: A partnership that has two classes of partners:
a) Limited partners
b) General partners
a) Limited partners: A partners who have no personal liability for debts of partnership
beyond the amount they have invested in the partnership.
b) General partner: a partner who assume unlimited liability for the debt of the
partnership. Hence, general partner in the limited partnership are responsible for its
management.
4.3. Advantages and Disadvantages of Partnership

A partnership form of business will have its advantages and disadvantages:
A. Advantages of partnership:
A partnership form of business ownership has the following advantages:
70
i. Easy and inexpensive to form than a corporation.
corporation. A partnership is easy to form.
It only requires the consent of two or more parties. Two or more competent
persons simply agree to be partners in some common business purpose.
ii. Advantageous to raise a large amount of capital and managerial skill (talent)
than a sole proprietorship. Because a partnership is formed by two or more
persons, it is possible to raise a large amount of capital and managerial skill than a
single owner.
iii. Not subject to separate taxation as a case in a corporation because each partner
reports his/her own share of partnership income and is individually taxed, and
iv. Not required to observe on many restrictive laws unlike a corporation.
B. Disadvantages
Partnership has the following disadvantages:
i. Partners assume unlimited liability. The liability of the partners is not limited to
what they have in the partnership, but it goes to the extent of their personal
properties (assets).
ii. Disadvantageous if each partner does not exercise his/her good judgment because
one partner’s act can bind a partnership into a contract.
iii. Limited life. Partnerships are subject to possible termination due to many
uncontrollable circumstances such as the death of a partner.
iv. The transfer of ownership from one partner to another person is difficult unless the
remaining partners approve of it.
Ø Activity 4.1:
1. Write the definition of partnership and its characteristics

___________________________________________________________________
___________________________________________________________________
___________________________________________________________________
2. Write the two basic classification of partnership
71
___________________________________________________________________
___________________________________________________________________
___________________________________________________________________
3. List advantages and disadvantages of partnership form of business organization
___________________________________________________________________
___________________________________________________________________
___________________________________________________________________
4.4. Recording the Formation of a Partnership

A separate capital account is maintained for each partner in a partnership. Each partner’s
capital account is credited for the value of their investment upon formation of the
partnership.
Example:
Sara and Tutu decided to form a partnership business, which would provide medical
services in Adama town. They have been in business separately before they form the
partnership. The partnership assumed the liabilities of their separate business. The assets
were valued and recorded at their current fair market value.
The data shown below are the assets contributed and the liabilities assumed by the
partnership at their fair market value.
Sara Tutu
Cash Birr 6.500 Cash Birr 3,300
Accounts Receivable 8,600 Accounts Receivable 4,300
Supplies 21,000 Supplies 12,000
Medical Equipment 3,000 Medical Equipment 150,000
Accounts Payable (2,300) Accounts Payable (3,200)
The journal entry on January 1, 2002 to record the investment of each partner and the
formation of the partnership would be:
Jan.1. 2002, Cash 6,500
A/R 8,600
Supplies 21,000
Medical Equipment 3,000
72
A/p 2,300
Sr. Sara Capital 36,800
Jan.1. 2002, Cash 3,300
A/R 4,300
Supplies 12,000
Building 150,000
Accounts Payable 3,200
Sr. Tutu, Capital 166,400
4.5. Division of Partnership Income and Losses

☼ How partnerships income and Losses are distributed?
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
 A partnership’s income and losses can be distributed according to whatever method
the partner specifies in the partnership agreement. The agreement should be
specific and clear, to avoid later disputes.
If a partnership agreement does not mention the distribution of income and losses, the law
requires that they be shared equally by all partners. Also, if a partnership agreement
specifies only the distribution of income, but is silent as to losses, the law requires that
losses be distributed in the same ratio as income.
The Income of a partnership normally has three components:
1. return to the partners for the use of their capital – called interest on partners’
capital,
2. compensation for direct services the partners have rendered – called partners’
Salaries, and
3. Other income for any special characteristics individual partners may bring to the
partnership or risks they may take.
The breakdown of total income into its three components helps clarify how much each
partner has contributed to the firm.
Income can be shared among the partners in one of the following ways:
73
1. Net income divided in a stated ratio such as:
A. Equally (one to one)
B. agreed upon ratio (other than equally)
C. ratio based on beginning capital balances
D.Net Income divided by allowing interest on the capital investments,
salaries, or both with the remaining net income divided in an agreed ratio.
Example:
Assume that Sara and Tutu partnership had a net income of Birr 60,000
1. A. Assume that the articles of a partnership provides equal share of Net Income or
Loss.
 In this case the capital accounts of each partner will be credited for Birr. 30,000
Income Summary-------------------------------60,000
Sara’s capital-----------------------------------30,000
Tutu’s capital------------------------------------30,000
B. Net income is divided in ratio of 3.2 to Sara and Tutu respectively.
- Income summary-------------------------------------60,000
Sara’s capital (3/5 X 60,000) --------------------------36,000
Tutu’s capital (2/5 X 60,000) ---------------------------24,000
C. Net income is divided in a ratio of partners’ capital account balances at the beginning
of the fiscal period.
Income summary ------------------------------- 60,000
 36800 
 203200  60,000
 
Sara’s capital   -----------------------------10,860
 166400 
 203200  60,000
Tutu’s capital   ------------------------------ 49,134
 36800 + 166400 = 203200
2. Net income is divided by allowing 5% interest on their beginning capital balances, a
salary of Birr. 5,000 to Sara and the remainder are shared equally.
Net Income Division
74
Income to be
Sara Tutu Total Distributed
Net income Birr, 60,000
Interest (5%) 1,840 8,320 10,160 49,840
Salary 5,000 -- 5,000 44,840
Remainder 22,420 22, 420 44,840 -- 0 –
Distribution 29,260 30,740 60,000
Journal entry
Income summary ---------------------------- 60,000

Sara’s capital ----------------------------------- 29,260
Tutu’s capital ----------------------------------- 30,740
4.6. Financial Statements for a Partnership

The income statement of a sole proprietorship and that of a partnership are the same. At the
end of the period a statement of partners’ capital is prepared which summarizes the effect
of transactions on the capital account balances of each partner. The statement of owners
equity for Sara and Tutu using assumed data and the income division shown above is
illustrated below:
Sara and Tutu
Statement of partners’ Capital

For the year ended Dec, 31, 2002
Sara Tutu
Capital Bal. January 1, 2002 Br. 36,800 Br. 166,400
Add: Additional investment 4,200 4,300
Total Br. 41,000 Br. 170,700
Net income distribution 29,260 30,740
70,260 201,440
Deduct: Withdrawals during the year 5,000 5, 000
Capital Bal. Dec. 31, 2002 Br. 65260 Br. 196,440
NB-
NB- The balance sheet of a partnership is different from that of a sole proprietorship only
in the owner’s equity section. In the partnership business since two or more persons
75
owns the business, there are two or more capital accounts whereas for a sole
Proprietorship there will always be one capital account.
4.7. Dissolution (termination) of a Partnership

 Dissolution of a partnership occurs whenever there is change in the original association
of partners. When a partnership is dissolved, the partners lose their authority to
continue the business as a going concern. This does not mean that the business
operation necessarily is ended or interrupted, but it does mean – from a legal and
accounting standpoint – that the separate entity stops to exist.
 The remaining partners can act for the partnership in finishing the affairs of the
business or in forming a new partnership that will be a new accounting entity.
 A partnership is legally dissolved (terminated) when a new partner is admitted or an
existing partner withdraws.
4.7.1. Admission of a New Partner:

The admission of a new partner dissolves the old partnership because a new association has
been formed.
Dissolving the old partnership and creating a new one require the consent of all the old
partners and the ratification of a new partnership agreement.
When a new partner is admitted, a new partnership agreement should be prepared.
 A new partner can be admitted into a partnership in one of two ways:
1. By purchasing ownership right from one or more of the original partners, or
2. By investing assets in the partnership.
1. Admission by Purchase of Ownership Right
When an individual is admitted to a firm by purchasing ownership right from an old
partner, each partner must agree to the change. A journal entry is needed in the partnership
to transfer the ownership right purchased from the capital account of the selling partner to
the capital account of the new partner. The partnership’s assets and liabilities remain
unchanged.
Suppose that Sister Birtukan joins the partnership of Sara and Tutu by buying ownership
right of Br. 8000 from Tutu. The entry to record the admission of Sister Birtukan and the
transfer of the ownership right from the capital account of Tutu to the capital account of
Sister Birtukan in the partnership books shown below
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Journal entry
Tutu ---------------------------------- 8,000
Sr. Birtukan --------------------------------------8,000
The price that sister Birtukan paid to Sister Tutu can be more or less than Br. 8,000 but that
is irrelevant as it wouldn’t be reflected in the record (books) of the partnership.
2. Admission by Investing Assets
Assume that instead of purchasing ownership right from the existing partners, Sister
Birtukan invested cash of Br. 80,000 into the partnership. In this case both partnership
assets and total owners’ equity are increase. The journal entry must record such an
investment and the increase in partnership assets.
Consider the following scenarios as an example:
1- Sister Birtukan receives a 50% ownership right in the partnership. Assume also that
Sister Sara and Tutu capital balance was Br. 25,000 and Br. 55,000 respectively.
Sister Sara and Tutu share income in a ratio of 2:1 respectively.
Journal Entry
Sister Birtukan capital account would be credited for Br. 80,000 i.e., (55,000 + 25,000 +
80,000) X ½.
Cash------------------------------------------80,000
Sister Birtukan’s, Capital------------------------80,000
2- Sister Birtukan receives a one –fourth ownership right upon admission.
Assume everything else as above. In this case Sister Birtukan capital account would be
Credited for birr 40,000 i.e, (Birr 25,000 + Birr 80,000) X ¼.
The difference Br. 40,000, (80,000 – 40,000) would be shared between the remaining two
partners with the income-sharing ratio.
Journal entry
Cash----------------------------80,000
Birtukan’s capital ------------------------40,000
Sara’s capital ------------------------ 26,667
Tutu’s capital ------------------------ 13,333
4.7.2. Retirement or Withdrawal of a Partner

When an existing partner withdraws, there are two basic options:
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1. One partners can sell his/her ownership right or
2. One partner can withdraw assets from the partnership.
Both options are considered below are discussed as follows:
1. Sale of Ownership Right to the Existing Partner
When ownership right is sold by a withdrawing partner to an existing partner, the entry on
the partnership’s books transfers the retiring partner’s capital balance to the buyer’s capital
account.
Example:
Sister Tutu withdraws from the partnership because of a disagreement. She sells her Br.
38,333 ownership right to Sister Sara.
Journal entry
Tutu’s Capital----------------------------- 38,333

Sara’s Capital ----------------------------- 38,333
The amount paid by Sara is not recorded on the partnership books, because the transaction
involves no flow of assets to or from the partnership.
2. Withdrawal of Assets From the Partnership
When a partner withdraws, he/she may be paid above or below the amount shown in
his/her capital balances.
Example:
A. Assume Sister Tutu was paid Br. 50,000 cash when she withdraws from the
partnership of S, T and B. The capital balances of each partner were as follows as of
that date:
Sr. Sara’s capital ---------------------------Br. 100,000
Sr. Tutu’s capital ------------------------------ 50,000
Sr. Birtukan’s capital ----------------------------35,000
----------------------------35,000
Total Equities Birr 185,000
Journal entry
Sr. Masart capital -------------------------------- 50,000

Cash -----------------------------------------------------------50,000
B. Assume Sr. Tutu was paid Br. 56,000 instead of Br. 50,000, the excess amount of Birr
6,000 is charged to the remaining partner’s capital accounts based on the income- sharing
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ratio. (Assume a 3:2:1 income-sharing ratio between Sr. Sara, Sr. Tutu and Sr. Birtukan
respectively).
Journal entry
Sr. Tutu’s capital ------------------------------- 50,000

Sr. Birtukan’s capital ----------------------------1,500
Sr. Sara’s capital -------------------------------- 4,500
Cash ----------------------------------------------------56,000
 The Birr 6,000 excess is shared on the basis of a 3:1 ratio, i.e., Sr. Sara would be
charged for 6,000 X 3/4 = birr 4500, and Sister Birtukan would be charged for
Birr 6000 X ¼= Birr 1500.
Ø Activity 4.2:
1. Write the four basic way of sharing net income among partners.
___________________________________________________________________
___________________________________________________________________
___________________________________________________________________
2. Write the two ways, in which new partners admitted to the existing partners.
___________________________________________________________________
___________________________________________________________________
___________________________________________________________________
3. Write the two basic ways, in which existing partner withdraws from the
partnership.
___________________________________________________________________
___________________________________________________________________
___________________________________________________________________
4.8. Liquidation of a Partnership

Liquidation of a partnership is the process of ending the business, of selling enough assets
to pay the partnership’s liabilities and distributing any remaining assets among the
partners.
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Liquidation is a special form of dissolution. When a partnership is liquidated, the business
will not continue.
 A partnership may be liquidated if:
I. The objectives sought in forming the partnership has been achieved
II. The time period for which the partnership was formed expires (ends)
III. Newly enacted laws have made the partnerships activities illegal,
IV. The partnership becomes bankrupt.
The partnership agreement should indicate the procedures to be followed incase of
liquidation. Usually, the books (records) are adjusted and closed, with the income or loss
distributed to the partners and the assets are sold.
The sale of the assets at the time of liquidation of a partnership is known as realization.
As the assets of the business are sold, any gain or loss should be distributed to the partners
according to the income and loss sharing ratio.
As cash is realized, it must be applied first to outside creditors. Finally, the remaining cash
is distributed to the partners in accordance with the balance of their capital accounts.
Example:
The partnership of Sara, Tutu, and Birtukan is liquidated on September 1, 2002. The
income and loss sharing ratio of the partners is: Sara 40%, Tutu 35%, and Birtukan 25%.
After discontinuing the ordinary business operations of their partnership and closing the
accounts, the following summary of a trial balance is prepared:
S, T and B
Trial Balance
September 1, 2002
Debit Credit
Cash 10,000
Other assets 90.000
Liabilities 10,000
S. Capital 30,000
T. Capital 30,000
B. Capital ________ 30,000
Total 100,000 100, 000
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Based on the information on the trial balance, accounting for liquidation of S, T,
T, and B
partnership will be illustrated using different selling prices for the non cash assets.
Case 1: Gain on Realization
Assume that Sara, Tutu, and Birtukan sell all noncash assets for Birr 95,000, realizing a
gain of birr 5000, (Birr 95,000 – Birr 90,000). The gain is divided among Sara, Tutu and
Birtukan in the income and loss sharing ratio of 40% 35%, and 25% respectively. Then,
the liabilities are paid, and the remaining cash is distributed to the partners according to the
balances in their capital accounts. The entries to record the steps in the liquidation of a
business are as follows:
Cash………………………………95,000
Other assets………………………….90, 000
Gain on sale of assets……………….. 5,000
(Entry to record the sale of non cash assets and the recognition of gain on
realization)
Gain on sale of assets…………… 5,000
S. Cap. (5,000 X 40%)…………………… 2.000
T. Cap. (5,000 X 35%)………………..…. 1,750
B. Cap. (5000 X 25%)……………………... 1,250
To distribute gain on realization
Liabilities……………………….10, 000
Cash………………………………..10,000
To record the settlement of partnership liabilities
After the above entries are posted, the partners’ capital accounts shows:
S’s Beg Bal. 30,000 + 2,000 = Birr 32,000
T’s Beg Bal. 30,000 + 1,750 = Birr 31,750
B’s Beg Bal. 30,000 + 1,250 = Birr 31,250
The cash account now shows a balance of Birr 95,000 (10,000 + 95,000 – 10,000). The
entry recorded upon distribution of this cash among the partners would, therefore, be
S, capital……………………… Birr 32,000
T, capital……………………… Birr 31,750
B, capital……………………… Birr 31,250
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Cash-------------------------------------95,000
To record the distribution of cash among the partners
Case 2: Loss on Realization: No capital Deficiencies
Assume that Sara, Tutu, and Birtukan sell all non cash assets for Birr 70,000, instead of
Birr 95,000, incurred a loss of birr 20, 000,(Birr 90,000 – Birr 70,000)
Journal entry
Cash --------------------------------------70,000
Loss on realization-----------------------20,000
Other Assets-------------------------------------90,000
To record the sale of the assets
S, capital---------------------- (40% X 20,000) -----------------8,000
T, capital----------------------- (35,000 X 20,000) --------------7,000
B, capital ---------------------- (25% X 20,000) --------------- 5,000
Loss on Realization ------------------------------------- 20,000
To distribute the loss on realization
Liabilities ---------------------------------- 10,000
Cash -----------------------------------10,000
(To record the settlement of partnership liabilities)
After the above entries have been posted; the accounts show cash 70,000 S, cap. Birr
22,000 T, cap. Birr 23,000 and B, cap. Birr 25,000. The entry to record the cash
distribution to the partners would, therefore, be as follows:
S, cap --------------------------------- 22,000
T, cap ----------------------------------23,000
B, cap --------------------------------- 25, 000
Cash -------------------------------------- 70,000
(Entry to record the distribution of cash to partners)
Case 3: Loss on Realization with Deficiency in one Partner Capital
Suppose that, the non-cash assets of S,T and B partnership are sold for only Birr 10,200,
incurring a loss of Birr 79,800,( Birr 90,000 – Birr 10,200). The entries to record the
division of loss among the partners and the liquidation to this point are shown below:
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Cash -------------------------------- 10,200
Loss on sale of Assets ----------- 79,800
Other Assets-------------------------- 90,000
(To record the sale of assets)
S, capital (79800 X 40%) ----------------------31,920

T, capital (79800 X 35%) ---------------------- 27,930
B, capital (79800 X 25%) ---------------------- 19,950
Loss on sale of Assets ---------------------------- 79,800
( To distribute loss on realization)
-Liabilities ----------------------------------- 10,000
Cash ------------------------------------------------10,000
(To
(To record settlement of liabilities)
At this stage of the liquidation the capital accounts of the partners have the following
balances
S capital = 30,000 – 31920 = 1,920
T, capital = 30,000 – 27930 = 2,070
B capital = 30,000 – 19950 = 10,050
Only Birr 10,200 cash is available (10,000 + 10200 – 10,000) for distribution to T and B
while the combined balances of their capital accounts is Birr 12,120. Therefore, additional
Birr 1,920, (12120 – 10200) is needed which is the amount owed by S to the partnership.
Therefore, either S will have to pay this amount first and the cash will be distributed to T
and B, or T and B will have to share Birr 1920 loss in their income and loss-sharing ratio
of 35:25.
Let’s assume, the loss was distributed since S couldn’t pay the amount immediately.
Journal Entries:
T, capital (35/60 X 1920) -------------- 1,120.00
B, capital (25/60 X 1920) -------------- --800.00
S capital -------------------------------------1,920
(To
(To charge R’s capital deficiency to M and B)
T, capital -----------------------------------950.00
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B, capital -----------------------------------9,250.00
Cash ----------------------------------------------10,200
To record the final cash distribution to partners
The various entries in the liquidation of S, T, and B partnership are summarized in the
following statement.
S, T, B partnership
Statement of Partnership Liquidation
For period Sept. 1-15, 2002
Non cash = Liabilities + Capital
Cash + Asset
S(40%) T(35% B(25%)
Bal. before realization Birr 10,000 90,000 10,000 30,000 30, 000 30,000
Sales of Assets &
Division of loss +10,200 -90,000 --- -31,920 -27,930
-27,930 19,950
Bal. after realization 20,000 -0- 10,000 (1920) 2,070 10,050

Payment of Liab. – 10,000 --- -10.000
-10.000 --- --- ---
Bal. After payment
Of liab. 10,200 -0- -0- (1920) 2,070 10,050
Division of deficiency --- --- --- 1920 (1120) 800
Bal. After division of
Deficiency – 10,200 -0- -0- -0- 950 9,250
Dist.of cash 10,200 --- --- --- -950 -9250
Balance -0- -0- -0- -0- -0- -0
Summary
There are three forms business organization, proprietorship, partnership and Corporation.
In this chapter we discussed an accounting treatment for partnership of businesses.
businesses.
Partnership is an association of two or more persons to carry on as co-owners of a business
for profit. This association is based on a partnership agreement or contract known as the
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articles of a partnership. A partnership form of business ownership has several
characteristics. From among them are: voluntary association, limited life, unlimited
liability, mutual agency, and co- ownership of partnership property.
The advantages of partnerships include: easy of formation, possible to raise large amount
of capital than a single owner, not subject to separate taxation, and the absence of many
restrictive laws unlike a corporation, etc.
Partnerships have also the following disadvantages: unlimited liability, mutual agency,
limited life, etc.
In accounting for partners’ investment, it is necessary to maintain separate capital and
withdrawals accounts for each partner and to divide the income and losses of the company
among the partners. When recording the investments of the partners, all noncash assets
must be recorded at their fair market value at the time they are transferred to the
partnership. A partnership income and losses can be distributed according to whatever
method the partner specifies in the partnership agreement. The agreement should be
specific and clear, to avoid later disputes.
If a partnership agreement does not mention the distribution of income and losses, the law
requires that they be shared equally by all partners. If a partnership agreement specifies
only the distribution of income, but is silent as to losses, the law requires that losses be
distributed in the same ratio as income.
The income of a partnership normally has three components: (1) return to the partners for
the use of their capital, (2) compensation for direct services the partners have rendered, and
(3) other income for any special characteristics individual partners may bring to the
partnership or risks they may take.
At the end of each fiscal period financial statements are prepared for a partnership
business. Most of the financial statements of a partnership are the same as that of a sole
proprietorship with the exception of the owner’s equity section of a balance sheet.
Dissolution of a partnership occurs whenever there is a change in the original association
of partners. When a partnership is dissolved, the partners lose their authority to continue
the business as a going concern. This does not mean that the business operation
necessarily is ended or interrupted, but it does mean - from a legal and accounting stand
85
point - that the separate entity stops to exist. A partnership is legally dissolved when a new
partner is admitted or an existing partner withdraws.
Liquidation of a partnership is the process of ending the business, of selling enough assets
to pay the partnership’s liabilities and distributing any remaining assets among the
partners. Liquidation is a special from of dissolution. When a partnership is liquidated,
the business will not continue.
A partnership may be liquidated if: (a) the objectives sought in forming the partnership has
been achieved, (b) the time period for which the partnership was formed expires (or ends),
(c) newly enacted laws have made the partnership’s activities illegal, (d) the
partnership ,becomes bankrupt. The partnership agreement should indicate the procedures
to be followed in case of liquidation. Usually, the records are adjusted and closed, with the
income or loss distributed to the partners, and the assets are sold. The sale of the assets at
the time of liquidation of a partnership is known as realization. As the assets of the
business are sold, any gain or loss should be distributed to the partners according to the
income and loss sharing ratio. As cash is realized it must be applied first to outside
creditors. Finally, the remaining cash is distributed to the partners in accordance with the
balance of their capital accounts.
Self Examination Questions

Part one: Multiple Choices
Choose the best answer from the given alternatives
1. The term unlimited liability when used in connection with a partnership refers to the fact
That:-
A. contract entered into by one partner is binding on all partners.
B. Creditors can look beyond the partnership assets to the individual assets of the
partners for satisfaction
C. The partnership has an unlimited obligation to provide professional services.
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D. The partnership is liable for all actions of the partners even when conducting
personal Business.
E. All except D.
2. “A” and “B” agree to form a partnership. ‘A’ contribute birr 60,000 in cash and to
spent one – half time to the partnership. ‘B’ agreed to contribute birr 40,000 and to devote
full time to the partnership. How will A and B share in the division of net income or net
loss?
A.1:2 B.2:1 C.3:2 D.1:1 E. None of the above
3. Which of the following is not a characteristic of a partnership?
A. each partner can act as an agent of a partnership
B. Unlimited life.
C. Easy of formation
D. It is not legally separate from its owners.
4. One of the following can be considered as an advantage of partnership form of business
as compared with sole proprietorship form of business.
A. More capital mobilization
B. Tax advantage
C. Ease of formation
D. Ease of decision making E. All
5. When a partner invests a building or other property in a partnership, she/he does not
retain any personal right to the asset contributed because of the ___________feature of
business.
A. Limited life
B. Unlimited liability
C. Mutual agency
D. Ease of formation
Part Two: Work Out
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1. DANDI and FAYISA formed a partnership. DANDI invested Birr 90,000 and FAYISA
invested Birr 60,000. DANDI is to devote one-half time to the business while FAYISA is
to devote full time.
The following plans for the division of income are being considered:
a) equally
b) in the ratio of original investments
c) in the ratio of time devoted to the business
d) Interest of 12% on original investments and the reminder equally.
e) Interest of 12% on original investments, salaries of Birr 10,000 to DANDI and Birr
20,000 to FAYISA, and the remainder equally.
f) The same as in #5 except that DANDI is also to be allowed a bonus equal to 25%
of the amount by which net income exceeds salary allowances.
Required:
Determine the division of income to DANDI and FAYISA under each plan assuming the
partnership of DANDI and FAYISA earned a net income of:
a) Birr 32,000
b) Birr 150,000
The following balance sheet is related to ABC partnership

ABC Partnership
Balance sheet
Hidar 10, 2000
Assets: Liabilities and Capital

Cash-------------------------Birr 20,000 Liabilities--------------Birr 30,000
Other assets--------------------- 80,000 Capital:
A. capital-------------------- 40,000
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B. capital------------------- 21,000
_______ C. capital------------------- 9,000
Total Liabilities and
Total Assets----------------
Assets---------------- Birr 100,000 Capital-----------------------
Capital-----------------------100,000
100,000
The partners agreed to liquidate the business enterprise by selling other assets and dividing
any remaining cash available in the partnership after settling the debt of the partnership as
of the date of liquidation. All the partners are general partners. Partner A, B and C share
income or loss in the ratio of 20%, 40%, and 40% respectively
Required:
I. prepare a liquidation statement assuming that the other assets were realized for:
A. Birr 80,000
B. Birr 100,000
C. Birr 60,000
D. Birr 50,000
II. Journalize the necessary entries for the business enterprise on the basis of the
liquidation statement prepared for each case.
Chapter Five
Accounting for Corporations
Overview
Corporation is classified as nonprofit or profit seeking organization. Nonprofit
corporations include those organized for recreational, educational, charitable,
religious institutions and other philanthropic purposes where as Profit
corporations are engaged in business activity they depend up on profitable
operation for their continuous existence. A corporation is a form of business
89
that is owned by several investors. The ownership in a corporation is divided
into shares and owners of a corporation are called stockholders (or
shareholders). The investments of stockholders are referred to as the capital
stock (or stock) of the corporation. The corporate form of business is well
suited to raising large amounts of capital because corporations can sell stock to
many thousands of investors. Thus, corporations, generally speaking, are larger
– in terms of earnings, assets owned, and people employed – than sole
proprietorships and partnerships. Accounting for corporations differs from
accounting for other forms of business in the treatment of transactions that
affect stockholders’ equity. In this chapter, we will basically look at
accounting treatment for corporations.
Objectives of the chapters:

At the end of this chapter, students will be able to:
 Understand the definition and characteristics of corporation.
 Discuss the advantages and disadvantages of organizing a business as a
corporation.
 Account for paid-in capital and prepare the equity section of a corporate
balance sheet.
 Contrast the features of common stock with those of preferred stock.
 Explain the significance of par value, book value, and market value of
capital stock.
 Journalize issuance of stock.
 Account for treasury stock transactions.
 Allocate dividends to the different classes of stock and journalize

declaration of dividends, and
 Explain the purpose and the effects of a stock split.
90
5.1. Definition of corporation
☼ Define the term corporation.
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
 A corporation is a legal entity having an existence separate and distinct
from that of its owners. In the eyes of the law there are two persons and
a corporation is an ‘artificial person’ having many of its own rights and
responsibilities.
 A corporation differs from sole proprietorships and partnerships in that many
shareholders own it. Transferable stocks represent ownership in a corporation. A
corporate form of business is preferable to other forms of business in some
respects.
5.2 Characteristics of Corporations

☼ Describe the characteristics of a corporation.
_______________________________________________________________
_______________________________________________________________
_______________________________________________________
 A corporation form of business has certain characteristics that make it different
from other types of business organizations. The most important characteristics with
accounting implication are discussed as follows:-
1. Separate Legal Entity:-A business with a corporate charter is
empowered to conduct business affairs apart from its owners. The
corporation, as a legal entity, may acquire assets, incur debt, enter into
contracts, sue, and be sued—all in its own name. The owners, or
stockholders, of the corporation receive stock certificates as evidence of
their ownership interests; the stockholders, however, are separate and
distinct from the corporation. This characteristic contrasts with
proprietorships and partnerships, which are accounting entities but not
legal entities apart from their owners. Owners of proprietorships and
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partnerships can be held responsible separately and collectively for
unsatisfied obligations of the business.
2. Limited Liability:-The liability of shareholders with respect to
company affairs is usually limited to their investment in the corporation.
Because of this limited liability, laws restrict distributions to
shareholders. To protect creditors, the government controls the
distribution of contributed capital. Distributions of retained earnings
(undistributed profits) are not legal unless the board of directors
formally declares a dividend. Because of the legal delineation of owner
capital available for distribution, corporations must maintain careful
distinctions in the accounts to identify the different elements of
stockholders’ equity.
3. Transferability of Ownership:-Shares in a corporation may be
routinely transferred without affecting the company’s operations. The
corporation merely notes such transfers of ownership in the stockholder
records (ledger). Although a corporation must have stockholder records
to notify shareholders of meetings and to pay dividends, the price at
which shares transfer between owners is not recognized in the
corporation’s accounts.
4. Continuity of Existence: - Because routine transfers of ownership do
not affect the affairs of a corporation the corporation is said to have
continuity of existence. In this respect, a corporation is completely
different from a partnership. In a partnership, any change in ownership
technically results in dissolution of the old partnership and formation of
a new one.
5. Capital-raising Capability:-The limited liability of stockholders and
the ease with which shares of stock may be transferred from one investor
to another are attractive features to potential stockholders. These
characteristics enhance the ability of the corporation to raise large
amounts of capital by issuing shares of stock. Because both large and
small investors may acquire ownership interests in a corporation, a wide
92
spectrum of potential investors exists.
6. Taxation: - As legal entities, corporations are subject to income taxes
on their earnings, whether distributed or not. In addition, shareholders
must pay income taxes on earnings received as dividends. Therefore,
corporate income is subject to double taxation.
7. Regulation and Supervision:- Corporations are subject to greater
degrees of regulation and supervision than are proprietorships and
partnerships. The laws limit the powers a corporation may exercise,
identify reports that must be filed, and define the rights and liabilities of
stockholders. Furthermore, corporations whose stock is listed and traded
on organized security exchanges are subject to the various reporting and
disclosure requirements of these exchanges.
5.3. Advantages and Disadvantages of Corporation

A corporation form of business has many advantages and disadvantages and it is discussed
in detail as follows:-
 Advantages of corporation
I. Continuous existence: A corporation has perpetual existence in that its continuous
existence is not dissolved by the death on retirements of any of its members.
II. No personal liability for owners: Since a corporation is a separate legal entity, the
creditors of a corporation have a claim against the assets of the corporation, not the
personal property of the owners.
III. Separation of managements from ownership: the owners of a corporation (called
stock holders or shareholders) own the corporation but they do not manage it on a
daily basis. To administer the affairs of the corporation, president and other officers
are hired for it. Thus, individual stockholder has no rights to participate in the
management's activity of the corporation unless the stockholder has been hired as a
corporate officer.
IV. Easily transferable ownership shares: ownership of a corporation is evidenced
by transferable shares of stocks. These shares of stocks may be sold by one investor
to another without dissolving or disrupting the business organization.
 Disadvantages of Corporation
93
Some of the disadvantages of the corporation are:
I. Double taxation:- corporate earnings are taxed two times. The earnings are taxed
first as a corporate income taxes and again as personal income taxes if the
corporation. Distributes its earnings to stockholders.
II. Difficulties to control:- since ownership is usually separated from managements,
owners are unable to exercise active control over management actions.
III. Greater regulation:- since a corporation comes into existence according to the law
of the state, the law may provide for considerable regulation of the corporation’s
activities. For example, the withdrawal of funds from a corporation is subjects to
certain limits sets by law.
Ø Activity 5.1:
1. Define corporation and write the difference between corporation and

other forms of business organizations.
_______________________________________________________________
_______________________________________________________________
______________________________________________________________
2. Write the basic features of corporation
_______________________________________________________________
_______________________________________________________________
______________________________________________________________
3. List the advantages and disadvantages of corporation.
_______________________________________________________________
_______________________________________________________________
_________________________________________________________
5.4 Types of Stock in a Corporation

The corporate charter may specify a face value, or par value, for each share of
a stock of any class. Par values are typically set at amounts well below the
stock’s market value at date of issue. Par value today, therefore, has no
economic significance. However, par value may have legal implications. In
some countries, par value may represent the minimum amount that must be
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paid-in per share of stock. If stock is issued at a discount (that is, at less than
par value), the stockholder may have a liability for the discount if creditors’
claims remain unsatisfied after the liquidation of the company. Issuing stock at
a discount is a rare event, because boards of directors have generally
established par values below market values at time of issue.
Par value may also be used in some laws to define the legal capital of a
corporation. The legal capital is the minimum amount of contributed capital
that must remain in the corporation as a margin of protection for creditors. A
distribution of assets to stockholders would not be allowed if it reduced
stockholders’ equity below the amount of legal capital. Given the role that par
value may play in defining legal capital, accountants carefully segregate and
record the par value of stock transactions in an appropriate capital stock
account.
The laws of most countries permit the issuance of stock without a par value—
that is, no-par stock. The company’s board of directors usually sets a stated
value for the no-par stock. In such cases, the stated value will determine the
corporation’s legal capital. Again, the stated value figure is usually set well
below market value at time of issue, but in contrast to par value, the stated
value is not printed on the stock certificate. For accounting purposes, stated
value amounts are treated in a fashion similar to par value amounts. In the
absence of a stated value, the entire proceeds from the issuance of no-par stock
will likely establish the legal capital of the corporation.
5.5 Classification of Stock

The amounts and kinds of stock that a corporation may issue are enumerated in
the company’s charter. The charter also specifies the corporation’s authorized
stock —the maximum number of shares of each class of stock that may be
issued. A corporation that wishes to issue more shares than its authorized
number must first amend its charter. Shares that have been sold and issued to
stockholders constitute the issued stock of the corporation. The corporation
may repurchase some of this stock. Shares actually held by stockholders are
called outstanding stock, whereas those reacquired by the corporation (and not
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retired) are treasury stock. The stocks that are issues and held by the
corporation are referred to as outstanding stock.
5.5.1. Common Stock

When only one class of stock is issued, it is called common stock. Common
shareholders compose the basic ownership class. They have rights to vote, to
share in earnings, to participate in additional issues of stock, and in the case of
liquidation to share in assets after prior claims on the corporation have been
settled. We now consider each of these rights.
As the owners of a corporation, the common shareholders elect the board of
directors and vote on other matters requiring the approval of owners. Common
shareholders are entitled to one vote for each share of stock they own. Owners
who do not attend the annual stockholders’ meetings may vote by proxy (this
may be the case for most stockholders in large corporations).
A common stockholder has the right to a proportionate share of the earnings of
the corporation that are distributed as dividends. All earnings belong to the
corporation, however, until the board of directors formally declares a dividend.
Each shareholder of a corporation has a preemptive right to maintain his or her
proportionate interest in the corporation. If the company issues additional
shares of stock, current owners of that type of stock receive the first
opportunity to acquire, on a pro-rata basis, the new shares. In certain situations,
management may request shareholders to waive their preemptive rights. For
example, the corporation may wish to issue additional stock to acquire another
company. Further, stockholders of firms incorporated in some states do not
receive preemptive rights.
A liquidating corporation converts its assets to a form suitable for distribution,
usually cash, which it then distributes to parties having claims on the corporate
assets. Any assets remaining after all claims have been satisfied belong to the
residual ownership interest in the corporation—the common stockholders.
These owners are entitled to the final distribution of the balance of the assets.
5.5.2. Preferred Stock

Preferred stock is a class of stock with various characteristics that distinguish it
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from common stock. Preferred stock has one or more preferences over
common stock, usually with reference to (1) dividends and (2) assets when the
corporation liquidates. To determine the features of a particular issue, we must
examine the stock contract. The majority of preferred issues, however, have
certain typical features. These features are discussed as follows
I. Dividend Preference
When the board of directors declares a distribution of earnings, preferred
stockholders are entitled to a certain annual amount of dividends before
common stockholders receive any distribution. The amount is usually specified
in the preferred stock contract as a percentage of the par value of the stock or
in dollars per share if the stock does not have a par value. Thus, if the preferred
stock has a Br 100 par value and a 6% dividend rate, the preferred shareholders
receive Br 6 per share in dividends. However, the amount is owed to the
stockholders only if declared.
Preferred dividends are usually cumulative—that is, regular dividends to the
preferred stockholders omitted in past years must be paid in addition to the
dividend of the current year before any distribution is made to common
shareholders. For example, a dividend may not be declared in an unprofitable
year. If the Br 6 preferred stock dividend mentioned above is one year in
arrears and a dividend is declared in the current year, preferred shareholders
would receive Br 12 per share before common shareholders received anything.
If a preferred stock is non-cumulative, omitted dividends do not carry forward.
Because investors normally consider the non-cumulative feature unattractive,
non-cumulative preferred stock is rarely issued.
Dividends in arrears (that is, omitted in past years) on cumulative preferred
stock are not an accounting liability and do not appear in the liability section of
the balance sheet. They do not become an obligation of the corporation until
the board of directors formally declares such dividends. Any arrearages are
typically disclosed to investors in a footnote to the balance sheet.
II. Asset Distribution Preference
Preferred stockholders normally have a preference over common stockholders
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as to the receipt of assets when a corporation liquidates. As the corporation
goes out of business, the claims of creditors are settled first. Then, preferred
stockholders have the right to receive assets equal to the par value of their
stock or a larger stated liquidation value per share before any assets are
distributed to common stockholders. The preferred stockholders’ preference to
assets in liquidation also includes any dividends in arrears.
5. 6. Accounting system for Corporations

There are some differences between accounting for the owners’ equity of a
corporation and for that of a sole proprietorship or partnership. In a sole
proprietorship, only a single owner’s capital account is needed to reflect
increases from capital contributions and net earnings as well as decreases from
withdrawals and net losses. In practice, many sole proprietors keep a separate
drawing account to record withdrawals of cash and other business assets. This
separate record is kept only for convenience, however; no subdivision of the
owner’s capital account is required either by law or by accounting principles.
A similar situation exists in partnerships, which customarily maintain capital
and drawing accounts for each partner. A corporation, on the other hand, is
subject to certain legal restrictions imposed by the law approving its creation.
These restrictions focus on the distinction between contributed capital and
retained earnings and make accounting for the owners’ equity somewhat more
complex for corporations than for other types of business organizations. This
section deals with accounting for corporations.
5.6.1. Issuance of Stocks

Capital stock may be issued at par, above par, or below par. Par value is not an
indicator of market value – it is strictly a legal matter. When stock is issued
above or below par, the excess or deficiency is recorded in a premium
account called Paid-in Capital in Excess of Par, or, if no balance exists in
this account, in a discount account. Stock can be issued for cash, plant assets,
legal services, or on account. Treasury stocks are those shares that are re-
acquired and held by the corporation. The number of shares currently owned
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by stockholders; that is, the number of shares authorized minus the total
number of un-issued shares and minus the number of treasury shares.
To illustrate, assume that the corporate charter of ABC Company specifies
"authorized capital stock, 100,000 shares, par value Br1 per share. Further,
assume that to date, ABC Corporation has sold and issued 30,000 shares of its
capital stock. The stocks can be summarized as follows:
Authorized shares 100,000
Issued shares 30,000
Un-issued shares 70,000
If the corporation has repurchased 1,000 shares to date, the authorized shares,
treasury stocks, un-issued stocks, and outstanding stocks will be as follows:
Authorized shares 100,000
Treasury stock (1,000)
Un-issued shares (70,000)
Outstanding shares 29,000 shares
The stockholders’ equity accounts of a corporation represent the two primary
sources of stockholders' equity:
1. Contributed capital:- from the sale of stock, which is the amount invested
by stockholders through the purchase of shares of stock from the
corporation. Contributed capital has two distinct components: (a) par or
stated value derived from the sale of capital stock and (b) additional
contributed capital in excess of par or stated value. This is often called
additional paid-in capital.
2. Retained earnings: generated by the profit-making activities of the
company. This is the cumulative amount of net income earned since the
organization of the corporation less the cumulative amount of dividends
paid by the corporation since organization.
Most companies generate a significant part of their stockholders' equity from
retained earnings rather than from capital raised through the sale of stock.
5.6.2. Sale and Issuance of Capital Stock

Most sales of stock to the public are cash transactions. To illustrate accounting
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for an initial sale of stock, assume that on January 1, 2005, M Company sold
100,000 shares of its Br 0.10 par value stock for Br 22 per share. The company
records the following journal entry:
Jan. 1, 2005,
Cash (100,000x Br 22)…………. 2,200,000
Common stock (100,000 x Br0.10)………………….. 10,000
Paid in Capital in Excess of par………………………2,190,000
Some corporations do not specify a par value for their stock. In these cases,
depending on the law, common stock is recorded under one of the following
two approaches:
1. The corporation must specify in its bylaws a stated value per share as
legal capital. This stated value is used as a substitute for par value,
and the sale of common stock is recorded in a manner similar to the
previous journal entry.
Jan. 1, 2005
Cash (100,000x Br 22)…………………………………. 2,200,000
Common stock (100,000 x Br0.10)…………………………………….. 10,000
Paid in Capital in excess of stated value……………………………….2, 190,000
Please note that in the stocks issued are proffered stocks, the Preferred stock
account would be credited for Br 10,000 and the Paid in Capital in Excess of
Par: Preferred stock account would be credited for Br 2,190,000.
2. The corporation must record the total proceeds received from each
sale of no-par stock as legal capital. In this case, the total proceeds
are recorded in the Common Stock account and there is no account
called Capital in Excess of Par.
Jan. 1, 2005,
Cash (100,000 x Br 22)……………………. 2,200,000

(100,000 x Br 22)………………………. 2,200,000
Common stock
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5.6.2.1. Capital Stock Sold and Issued for Non-cash Assets and/or Services
One feature common to all start-up companies is a shortage of cash. Because
these companies often cannot afford to pay cash for needed assets and services,
they sometimes issue stock to people who can supply these assets and services.
Indeed, many executives will join start-up companies for very low salaries
because they also earn shares of stock.
When a company issues stock to acquire assets or services, the acquired items
are recorded at the market value of the stock issued at the date of the
transaction in accordance with the cost principle. If the market value of the
stock issued cannot be determined, the market value of the consideration
received should be used. .
To illustrate, assume that during its early years of operations, M Company was
unable to pay cash for needed legal services. The company issued 10,000
shares of stock to a law firm when the stock was selling for Br 15 per share. At
that time, the company recorded the following journal entry:
Jan. 1, 2005,
Legal Fees…………………………….150, 000
Common stock (100,000 x Br 0.10)……………………………. 1,000
Paid-in Capital in Excess of Par…………………………………149, 000
Notice that the value of the legal services received is assumed to be the same
as the value of the stock that was issued. This assumption is reasonable
because two independent parties usually keep negotiating a deal until the value
of what is given up equals the value of what is received.
5.6.2.2. Capital Stock Sold and Issued through Subscription

The stocks could also be issued with the arrangement that the subscribers sign
a contract to effect payment for a specified number of shares in installment and
the shares would be issued to the subscribers upon the final payment.
To illustrate, assume that on Feb 1 2005, M Company signed a stock
subscription agreement to issue 10,000 shares of common stock at Br 10 per
share. A Br 20,000 down payment was collected. The remainder of the
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subscription price is due in two equal installments on March 1, 2005 and April
1, 2005.
On February 1, 20x5, the transaction will be recorded as follows:

Feb. 1, 2005.
Stock Subscription Receivable………… 80,000
Cash ……………………………………..20,000
Common stock Subscribed (10,000x Br0.10)………………….. 1,000
Paid-in Capital in Excess of Par…………………………………199,000
Stock Subscription Receivable Account is a current asset account to be

reported on the balance sheet. The common stock subscribed account is a
temporary capital account to be closed to the common stock account when the
subscriptions are fully collected. The temporary capital account is used to show
that the subscribers do not have the rights of shareholders, as they did not
finalize the transaction of buying the shares.
When the first installment is collected on March 1, 2005, the following entry
would be recorded:
Mar. 1, 2005
Cash [80,000/2]…………………….. 40,000
Stock subscriptions Receivable………………..40, 000
On April 1, 2005, the final installment is collected and the shares are issued to
the subscribers. On this date the following entry is prepared:.
April. 1, 20X5
Cash [80,000/2]………………………… 40,000
Stock Subscriptions Receivable………………………40, 000
Common Stock Subscribed……………….10, 000

Common Stock……………………………………….10, 000
The first entry shows collection of the receivables. And the second entry closes
the temporary capital account of- Common Stock Subscribed since all the
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amounts due from the subscribers are collected.
Ø Activity 5.2:
1. Explain the two basic types of stocks.

________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
2. XYZ Corporation completed the following transactions in 2010. Journalize each
transaction.
January.1 Gave the corporation's promoters 9000 shares of Br 5-par common stock for
their services in getting the corporation organized. The directors valued the services
at Br50000.
1. Sold 1000 shares of Br100 par, 8% preferred stock for Br107000.
February. 1. Signed a stock subscription agreement to issue 5000 shares of common stock
at Br10 per share. A Br20000 down payment was collected. The remainder of the
subscription price is due in two equal installments on September 30 and December
31.
March.19 Issued 2000 shares of common stock in exchange for equipment. The stock is
actively traded in the stock market and had a market price of Br17 per share on this
date. The list price of equipment was Br40000 and discounts from the list price are
frequently given.
April.20. the company's note payable of Br 50,000 (plus interest of Br 4500) was due and
payable on this date. Accrued interest expense has already been recorded and the
lender accepted 10500 shares of common stock in settlement.
May. 30. An installment on the subscription was collected.
June. 31. The final installment on the stock subscription was collected and the shares
were issued.
_______________________________________________________________
_______________________________________________________________
__________________________________________________________
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5.7. Treasury Stock
Capital stock that is reacquired by a corporation is termed treasury stock.
Treasury stock has no voting, dividend, or other stockholder rights. Stock can
be reacquired for various reasons, such as to have shares available for
distribution to employees under bonus plans, and to support the market price of
the stock by stimulating trading in it. If treasury stock is resold, no gain or loss
is recognized on the exchange because the corporation’s primary objective is
not to make profit by trading in its own stock. In addition, the treasury stocks
are not assets; rather they are deductions from stockholders equity.
The recording of the purchase of treasury stock is based on the cost of the
shares that were purchased. Assume that On April 1, 2005, M Company
bought 100,000 shares of its stock in the open market when it was selling for
Br 22 per share. Using the cost method, the company records the following
journal entry:
April. 1, 2005
Treasury stock (100,000 x Br220)………………….. 2,200,000
Cash…………………………………………………………….2, 200,000
Intuitively, many students expect the Treasury Stock account to be reported as
an asset. This is not the case because a company cannot create an asset by
investing in itself. The Treasury Stock account is actually a contra equity
account, which means that it is reported as a subtraction from the total
stockholders' equity. This makes sense because treasury stock is stock that is
no longer outstanding, and therefore, should not be included as part of
stockholders' equity.
If M Company eventually sells its treasury stock; it will not report an
accounting profit or loss on the transaction even if it sells the stock for more or
less than it paid. GAAP do not permit a corporation to report income or losses
from investments in its own stock because transactions with the owners are not
considered to be normal profit- making activities. Based on the previous
example, assume that on April 15, M Company sold 10,000 shares of treasury
stock for Br30 per share. Remember that the company had purchased the stock
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for Br22 per share. M Company records the following entry:
Apr. 15, 2005
Cash (10,000 x Br 30)…………………….. 300,000
Treasury Stock…………………………………..220,000
Paid in capital from sale of treasury stock………….80, 000
If treasury stock were sold at a price below its purchase price (i.e., at ‘loss’),
the Paid in Capital from Treasury Stock Transactions account would be debited
for the amount of the loss. Retained Earnings would be debited for some or the
entire amount of the ‘losses’ only if there were an insufficient credit balance in
the Paid in Capital from Treasury Stock Transactions account.
In some cases a corporation may receive some of its stocks through donation.
The Donated Capital account is credited for the market value of the shares at
the date of acquisition. For example, assume that on March 1, 2005, M
Company received 100 shares form stockholders in donation. If the market
price per share is Br 100, the following entry would be prepared:
Mar. 1, 2005
Treasury Stock…………………………100, 000
Donated Capital [1,000 x Br 100] …………………..100,000
Neither the purchase nor sale of treasury stock affects the number of shares of
stock that are issued or un-issued. Treasury stock affects only the number of
shares of outstanding stock; the basic difference between treasury stock and
un-issued stock is that treasury stock has been sold at least once.
Therefore, the stockholders equity section could be presented as follows:
Paid in Capital:
Common stock Br xxx
Capital in excess of par xxx xxx
Donated Capital xxx
Retained earnings xxx
Less: Treasury stock xxx
Total stockholders' equity Br xxx
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5.8. Retained Earnings, Dividends and Stock Splits
The retained earnings of a corporation may be presented in restricted
(appropriated) and unrestricted (un-appropriated) category. Appropriated
retained earnings indicate the existence of a plan for expenditures, which we
should consider in payment of dividends. Most dividends are cash dividends,
but corporations that wish to conserve cash and still pay a dividend may
declare a stock dividend. A stock dividend is a distribution of a corporation’s
own stock to stockholders of record. Stock dividends are usually distributions
of common stock to common stockholders. Stock splits occur when
management wishes to reduce the market price of stock so that more investors
can afford it. When stock is split, the par or stated value of the stock is reduced
as well as the market value. This section deals with accounting for dividends,
stock splits, and retained earnings.
5.8.1 Restrictions on Retained Earnings

As the result of several types of business transactions, restrictions to retained
earnings limit a company's ability to pay dividends. A typical example occurs
when a business borrows money and banks include a loan covenant that limits
the amount a corporation can pay by placing a restriction on its retained
earnings
The full-disclosure principle requires restrictions on retained earnings to be
reported in the financial statements or in a separate note to the financial
statements. Users are particularly interested in information concerning these
restrictions because of the impact they have on the company's dividend policy.
Most companies report restrictions on retained earnings in a note to financial
statements. An example of such a note on the annual report follows:
Under the most restrictive covenants of long-term debt agreements, Br1.2
million restricted as to the payment of dividends and/or common share
repurchase
This type of note describes other restrictions that were imposed as a result of
debt covenants. These restrictions often include a limit on borrowing and
required minimum balances of cash or working capital. If debt covenants were
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violated, the creditor can demand immediate payment of debt. For this reason,
users want to review these restrictions to be sure that companies are not close
to violating loan agreements.
Another alternative is to record a journal entry, which shows the existence of
the restrictions. Under this alternative there are two retained earnings accounts:
appropriated [restricted] and Un-appropriated [Un-restricted]. For example, the
following entry could be prepared for the restriction mentioned above.
Sept 1, 2005.
Retained Earnings: Un-appropriated………………..1,200,000
Retained Earnings: Appropriated……………………………….1, 200,000
When the loan is fully paid, the restriction is no more relevant and another
entry is prepared:
Dec. 1, 2005
Retained Earnings: Appropriated…………..1, 200,000
Retained Earnings: Un-appropriated…………………………..1,200, 000
If there were restricted retained earnings, the stockholders’ equity section of
the balance sheet would appear as follows:
Paid in Capital:
Common stock Br xxx
Capital in excess of par xxx xxxx
Donated Capital xxx
Retained earnings: Appropriated xxx
Retained earnings: Un-appropriated xxx
Less: Treasury stock xxx
Total stockholders' equity Br xxx
5.8.2. Dividends
The earnings of a corporation that are not retained in the business for growth
and expansion are distributed to the stockholders by means of dividends.
Dividends are paid only when formally declared by the board of directors of a
corporation. A cash dividend results in a decrease in assets (cash) and a
commensurate decrease in stockholders' equity (retained earnings). In contrast,
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a stock dividend does not change assets, liabilities, or total stockholder's
equity. A stock dividend results in a transfer of retained earnings to the
permanent or contributed capital of the corporation by the amount of the stock
dividend. Therefore, a stock dividend affects only certain account balances
within stockholders' equity. There are three important dates in relation to
dividends:
Declaration date this is the date on which the board of directors officially
approves the dividend. As soon as it makes the declaration, it creates a
dividend liability, to be recorded in a journal entry.
Date of record This date follows the declaration date. It is the date on which
the corporation prepares the list of current stockholders based on its
stockholder records. The dividend is payable only to those names listed on the
record date. No journal entry is made on this date.
Date of payment this is the date on which the cash is disbursed to pay the
dividend liability. It follows the date of record as specified in the dividend
announcement.
5.8.2.1. Cash Dividend

Investors who purchase preferred stock give up certain advantages that are
available to investors in common stock. Generally, preferred stockholders do
not have the right to vote at the annual meeting, nor do they share in increased
earnings if the company becomes more profitable. To compensate these
investors, preferred stock offers some advantages not available to common
stockholders. Perhaps, the most important advantage is dividend preference.
You will frequently encounter the following dividend preferences:
1. Current dividend preference.
2. Cumulative dividend preference.
Preferred stock always carries a current dividend preference. It requires that the
current preferred dividend be paid before any dividends are paid on the
common stock. When the current dividend preference has been met and no
other preference is operative, dividends can be paid to the common
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stockholders.
Declared dividends must be allocated between the preferred and common

stock. First, the preferences of the preferred stock must be met, and then the
remainder of the total dividend can be allocated to the common stock.
Cumulative preferred stock has a cumulative dividend preference that states if
all or a part of the specified current dividend is not paid in full, the unpaid
amount becomes dividends in arrears. The amount of any cumulative preferred
dividends in arrears must be paid before any common dividends can be paid.
Of course, if the preferred stock is non-cumulative, dividends never can be in
arrears. Therefore, the preferred stockholders lose permanently any dividends
passed (i.e., not declared). Because preferred stockholders are not willing to
accept this unfavorable feature, preferred stock is usually cumulative.
Dividends are never an actual liability until the board of directors declares
them. Dividends in arrears are not reported on the balance sheet, but are
disclosed in the notes to the statements. The allocation of dividends between
cumulative preferred stock and common stock should be strict in accordance
with the stock contract. But, generally, we follow the steps below:
Step 1: Allocate dividends in arrears to the preferred stock
Step 2: Allocate current year dividend to the preferred stock
Step 3: If the preferred stocks are participating, allocate matching dividends to
common stock. This is dividend comparable to the current year dividend
of the preferred stock. For example, if the current year dividend to
common stock is 5 % of par, the common stock will also be entitled to
5% of their stock’s par value. If the current year dividend to the
preferred stock is Br 2 per share, the comparable dividend will also be
Br 2 per share to the common stock
If the preferred stocks are non-participating, the entire remaining amount after
step 2 will be given to common stock.
Step 4: If there is a balance after step 3, it is allocated to both preferred and
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common stock.
To illustrate, assume the following:
Preferred stock outstanding, 6%, par Br 20; 2,000 shares Br 40,000
Common stock outstanding, par Br10; 5,000 shares 50,000
Assume that the dividends are in arrears for one year, and preferred stocks are
cumulative and participating.
If the amount of cash dividend declared is Br 50,000 it will be allocated as

follows:
Preferred Common Total
Par Value Br 40,000 Br 50,000 Br 90,000
Total Dividend Br 50,000
1. Dividends in arrears [0.06x 50,000] 3,000 (3,000)
Remaining amount 47,000
2. Current year dividend
to preferred 3,000 (3,000)
3. Matching dividend to common stock
[0.05 x 50,000] 2,500 (2,500)
4. To both classes of shares:
[41,500/90,000=0.46]
[0.46 x 40,000; 0.46 x 50,000] 18,444 23,056 (41,500)
Total 24,444 25556 50,000
Notice that all the four steps are applied in this example because there were
dividends in arrears and the preferred stocks were cumulative and
participating.
On the date of declaration of the dividends, say December 31, 20x5, the
following entry is prepared
Dec. 31, 2005
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Dividends…………………………50,000
Dividend Payable: Preferred…………………..24,444
Dividend Payable: Common…………………..25,556
The dividends account would be closed as follows:
Dec. 31, 2005.
Retained Earnings……………….50, 000
Dividends…………………………………50,000
If the dividends are paid out on January 1, 2006, the following entry would be
prepared:
Jan 1, 2006
Retained Earnings………………….50, 000
Dividend Payable: Preferred………………………….24, 444
Dividend Payable: Common…………………………..25, 556
If we assume the preferred stocks are non-cumulative non-participating, the
dividends would be allocated as follows:
Preferred Common Total
Par Value Br 40,000 Br 50,000 Br 90,000
Total Dividend Br 50,000
1. Current year dividend
to preferred 3,000 (3,000)
2. All the remaining amounts to common
Stock _____ 47,000 (47,000)
Total 3,000 47,000 50,000
5.8.2.2. Stock Dividends

Corporations issue stock dividends instead of cash dividends. A stock dividend
is a distribution of additional shares of a corporation's own capital stock on a
pro rata basis to its stockholders at no cost. Stock dividends usually consist of
common stock issued to the holders of common stock. Pro rata basis means
that each stockholder receives additional shares equal to the percentage of
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shares already held. A stockholder with 10 percent of the outstanding shares
receives 10 percent of any additional shares issued as a stock dividend.
The value of a stock dividend is the subject of much debate. In reality, a stock
dividend has no economic value, as such. All stockholders receive a pro rata
distribution of shares; which means that each owns exactly the same portion of
the company both before and after the stock dividend. The value of an
investment is determined by the percentage of the company that is owned, not
the number of shares that are held. If you get change for a dollar, you do not
have more wealth because you hold four quarters instead of only one dollar.
Similarly, if you own 10 percent of a company, you do not have more wealth
simply because the company declares a stock dividend and gives you (and all
other stockholders) more shares of stock. At this point, you may still wonder
why having extra shares of stock does not make an investor wealthier. The
reason is simple: The stock market reacts immediately when a stock dividend
is issued, and the stock price falls proportionally. If the stock price was Br 60
before a stock dividend, normally (in the absence of events affecting the
company) the price falls to Br 30 if the number of shares is doubled. Thus, an
investor could own 100 shares worth Br 6,000 before the stock dividend (100 x
Br 60) and 200 shares worth Br 6,000 after the stock dividend (200 x Br30).
To illustrate, assume that M Company, issues a 100 percent stock dividend

February 25 20x6 to shareholders of record on February 2. M Company has
1,149,819,000 shares outstanding. The market value of the shares was Br 0.10.
Stock dividends are classified as either large or small. A large stock dividend
involves the distribution of additional shares that are more than 25 percent of
the currently outstanding shares. A small stock dividend involves additional
shares that are less than 25 percent of the outstanding shares. Because the M
Company stock dividend was equal to 100 percent of the outstanding shares, it
should be classified as a large dividend. The company makes the following
entry to record a large stock dividend:
Feb 6, 2006
112
Retained Earnings (0.10 x 1,149,819,000)……………. 114,981,900
Common Stock……………………………………….114, 981, 900
Notice that this journal entry moves an amount from Retained Earnings to the
permanent contributed capital of the company. The stock dividend did not
change total stockholders' equity-it changed only the balances of some of the
accounts that constitute stockholders' equity. This process of transferring an
amount from Retained Earnings to Contributed Capital often is called
capitalizing earnings because it reduces the amount of retained earnings
available for future dividends.
The amount transferred from Retained Earnings to Contributed Capital was
based on the par value of the shares issued as a stock dividend. Par value is
used when the stock dividend is classified as large. In those cases, when a
stock dividend is small (i.e., less than 25 percent), the amount transferred
should be the total market value of the shares issued.
5.8.3 Stock Splits

Stock splits occur when management wishes to reduce the market price of
stock so that more investors can afford it. When stock is split, the par or stated
value of the stock is reduced as well as the market value. However, the
amounts in the paid-in capital accounts are not affected. Consequently, no
journal entry – other than a memorandum entry – is needed to record the
split. A stock split affects only the par value of the stock and the number of
shares outstanding; the individual equity account balances are not changed.
Stock splits are not dividends. They are similar to a stock dividend, but are
quite different in terms of their impact on the stockholders' equity accounts. In
a stock split, the total number of authorized shares is increased by a specified
amount, such as a 2-for-1 split. In this instance, each share held is called in,
and two new shares are issued in its place. Typically, a stock split is
accomplished by reducing the par or stated value per share of all authorized
shares so that the total par value of all authorized shares is unchanged. If M
Company executes a 2-for-1 stock split, it reduces the par value of its stock
from Br 0.10 to Br 0.05 and it doubles the number of shares outstanding. In
113
contrast to a stock dividend, a stock split does not result in a transfer of
retained earnings to contributed capital. No transfer is needed because the
reduction in the par value per share compensates for the increase in the number
of shares.
In both a stock dividend and a stock split, the stockholder receives more shares
of stock, but does not disburse any additional assets to acquire the additional
shares, A stock dividend requires a journal entry; a stock split does not require
one. A stock split is disclosed in the notes to the financial statements.
The comparative effects of a stock dividend versus a stock split may be
summarized as follows:
Stockholders' Equity
After a
Before 100% Two-for-One
Stock dividend Stock Split
Contributed capital
Number of shares 30,000 60,000 60,000
outstanding
Par value per share Br 10 Br 10 Br 5
Total par value 300,000 600,000 300,000
outstanding
Retained earnings 650,000 350,000 650,000
Total stockholders' equity 950,000 950,000 950,000
Ø Activity 5.3:
1. What is the difference between stock dividends and stock splits?
114
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
5.9. Equity per Share

Equity per share (EPS) is the ratio of stockholder's equity to the related number
of shares of stock outstanding. If there is only one class of shares (common
stock), equity per share is computed as follows:
EPS= Total stockholder's equity
No. of shares outstanding
If there are both common and preferred shares, we have allocate the total
equity should be the preferred and common stock. The equity to preferred
stock is the liquidation value. The liquidation value is the amount that the
preferred stockholders can claim if the corporation is liquidated. The equity to
preferred stock includes the dividends in arrears. If the equity to the preferred
stock is determined, the common equity is computed by deducting equity to
common stock from the total equity.
Then, EPS would be computed as follows:
Preferred EPS = Equity allocated to preferred stock
No. of outstanding o/s shares of preferred stock
Common EPS = Equity allocated to common stock
No. of outstanding shares of common stock
The Retained Earnings account is a stockholders’ equity account with a normal

credit balance. As a result of net losses, however, a debit balance in Retained
Earnings may occur. Such a balance is called a deficit. The deficit reduces the
total stockholders’ equity of the corporation.
To illustrate, assume that the following balances appear on the balance sheet of
ABC Company:
Common stock, Br 10 par Br 600,000
Paid in Capital excess of par 120,000
Deficit 75, 000
115
Total stockholders’ equity is Br 645,000 (Br 600,000 + Br 120,000 – Br
75,000) and the number of share is 60,000 (Br 600,000/Br 10). The business
has only common stock and hence, the EPS is
To illustrate, assume the following data:
Preferred, 11% stock, Br 50 par Br2, 500, 000
Premium on preferred stock 275,000
Common stock, Br25 par 3,750,000
Deficit 1,240,000
Assume also that Preferred stock has prior claim to assets on liquidation to the
extent of 110% of par.
To compute EPS, let us first split the total equity into the two classes of shares:
Total Equity:
Preferred, 11% stock, Br 50 par Br2, 500,000
Premium on preferred stock 275,000
Common stock, Br25 par 3,750,000
Deficit (1,240,000) Br 5,285,000
Less: Equity to preferred stock (110% x 2,500,000) 2,750,000
Equity to Common Stock Br 2,535,000
Therefore,
Preferred EPS = Br 2,750,000 = Br 55.00 per share
2,500,000/Br 50
Common EPS = Br 2,535,000 = Br 16.90
3,750,000/Br 25
Summary
A corporation is a form of business that is owned by several investors. The
ownership in a corporation is divided into shares and owners of a corporation
are called stockholders (or shareholders). The most important characteristics
corporations are: Separate Legal Entity, Limited Liability, Transferability of
116
Ownership, Continuity of Existence, Capital-raising Capability, Taxation and
Regulation and Supervision. The primary advantages of a corporation are: no
personal liability of stockholders for the debts of the business, the
transferability of ownership shares, continuity of existence, ability to hire
professional management, and the relative ease of accumulating large amounts
of capital. The primary disadvantages are double taxation of earnings and
greater governmental regulation.
When capital stock is issued, appropriate asset accounts are debited for the
market value of the goods or services received in exchange for the stock. A
capital stock account (which indicates the type of stock issued) is credited for
the par value of the issued shares. Any excess of the market value received
over the par value of the issued shares is credited to a Paid-in Capital in Excess
of Par account. The equity section of a corporate balance sheet shows for each
class of capital stock outstanding (1) the total par value (legal capital), and (2)
any Paid in Capital in Excess of Par. Together, these amounts represent the
corporation's total paid-in capital. In addition, the equity section shows
separately any earned capital – that is, retained earnings. Common stock
represents the residual ownership of a corporation. Par value has the least
significance. It is a legal concept, representing the amount by which
stockholders' equity cannot be reduced except by losses. Intended as a buffer
for the protection of creditors, it is usually so low as to be of little significance.
Book value per share is the net assets per share of common stock. This value is
based on amounts invested by stockholders, plus retained earnings. It often
provides insights into the reasonableness of market price. Preferred stock has
preference over common stock with respect to dividends and to distributions in
the event of liquidation. This preference means that preferred stockholders
must be paid in full before any payments are made to holders of common
stock. The dividends on preferred stock usually are fixed in amount.
Purchases of treasury stock are recorded by debiting a contra-equity account

entitled Treasury Stock. No profit or loss is recorded when the treasury shares
117
are reissued at a price above or below cost. Rather, any difference between the
re-issuance price and the cost of the shares is debited or credited to a paid-in
capital account. While treasury stock transactions may affect cash flow, they
have no effect on the net income of the corporation.
118
? Self Examination questions
Part One: Multiple choices
Choose the best answer from the given alternatives
1. Which of the following items is not an advantage of the corporate form of
ownership?
A. Professional management
B. Ease of accumulating capital
C. Limited life
D. Limited liability
E. Ease of transfer of ownership
2. Which of the following accounts is not a part of the paid-in capital section
of the balance sheet?
A. Preferred Stock
B. Retained Earnings
C. Additional Paid-in Capital, Common Stock
D. Common Stock
E. Additional Paid-in Capital, Preferred Stock
3. A corporation purchased treasury stock for Br 50,000 cash. Which of the
following does the journal entry for this transaction include?
A. A debit to Cash and a credit to Common stock.
B. A debit to Treasury Stock and a credit to Cash.
C. A debit to Retained Earnings and a credit to Treasury Stock.
D. A debit to Treasury Stock and a credit to Preferred Stock.
4. Treasury stock purchased by the corporation for Br 50,000 in cash is later
sold for Br 60,000. Cash is debited, and Treasury Stock is credited. What
other account and dollar amount is a part of the journal entry?
A. A debit to Retained Earnings for Br 10,000.
B. A credit to Retained Earnings for Br 10,000.
C. A credit to Gain on the Sale of Treasury Stock.
D. A credit to Additional Paid-in Capital: Treasury Stock Transactions.
119
5. The Owners equity in corporation is called:-
A. Stock holders equity B. Share holders’ investment
B. Capital D. all of the above.
Part Two: Work Out
1. A corporation receives subscription s to 2,500shares of $20 par value common
stock from various subscribers at $ 24per share, with a down payment of 25% of
the subscription price .subsequently; another payment of 25%of the subscription
price was received .Assuming that financial statements are prepared at this point.
Determine the balance of the following items.
a) Subscription receivable
b) Common stock subscribed
c) Paid in capital in excess of par-common stock and
d) Common stock
e) Record the journal entries to show the issuance of certificate
Answers for self Examination questions
Chapter One (Multiple choice)
120
1. E 2.C 3.B 4.C 5.A
Chapter Two (Multiple choice)
1. C 2. B. 3. D. 4. C 5.D
Chapter Three (Multiple choice)
1. A 2.B 3.C 4. B 5.D

Chapter Four (Multiple choice)
1. E 2. C. 3. A. 4. A. 5. B
Chapter Five (Multiple choice)
1. C 2. B 3. B 4. D 5. A
121

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PRINCIPLES OF ACCOUNTING II

Accounting for Inventories 1

1.1. Meaning of inventories................................................................................................1

1.2. Importance of Inventories............................................................................................2

1.3.1 Effect of ending inventory on current period’s financial statements.....................3

1.3.2 Effects of beginning inventory on current period’s financial statements..............4

1.3.3 Effect of ending inventory on the following period’s financial statements...........4

1.4. Inventory Systems: Periodic Vs Perpetual..................................................................5

1.4.1 Periodic inventory system......................................................................................5

1.4.2 Perpetual inventory system....................................................................................6

1.5. Determining Actual Quantities in the Inventory.........................................................7

1.6. Inventory Costing Methods under Periodic Inventory System...................................9

1.6.1 Specific Identification Method..............................................................................9

1.6.2 First-in, First-out (FIFO)......................................................................................10

1.6.3 Last-in first-out (LIFO)........................................................................................11

1.6.4 Weighted Average Method..................................................................................11

1.7. Comparisons of Inventory Costing Methods.............................................................11

1.8 Inventory Costing Methods under a Perpetual System..............................................13

1.8.1 First-in first-out Method......................................................................................13

1.8.2 Last in, First-Out method.....................................................................................15

1.9. Valuation of inventory at other than cost..................................................................17

1.9.1. Valuation at Lower of Cost or Market (LCM)...................................................17

1.9.2. Estimating Inventory Cost..................................................................................19

Self examination questions...........................................................................................23

Chapter Two:Accounting for Plant Assets and Intangible assets........................................25

2.1. The Nature and Cost of Plant Asset.................................................................25

2.1.1 The Nature of Plant Asset............................................................................26

2.1.2 Determining the Cost of Plant Assets........................................................27

2.2. Computation of Depreciation for plant assets...........................................................29

2.2.1 Definition of Depreciation...........................................................................29

2.2.2 Factors considered in Computing Depreciation......................................30

2.2.3 Depreciation Computation Method............................................................31

2.3. Capital and Revenue Expenditures..................................................................38

2.3.1. Capital Expenditures....................................................................................38

2.3.2 Revenue Expenditures...................................................................................40

2.4. Disposal of plant Assets.....................................................................................40

2.4.1. Discarding of Plant Assets..........................................................................40

2.4.2. Sale of Plant Assets......................................................................................41

2.5. Accounting for Intangible Assets and Natural Resources.........................................42

Self Examination questions..........................................................................................46

Chapter Three:Accounting for Payroll and short term liabilities.........................................48

3. 1. Definition and Importance of Payroll.......................................................................48

3. 2.1. Hiring Employees..............................................................................................50

3.2.2. Time Keeping.....................................................................................................50

3.2.3. Preparing Payroll................................................................................................50

3.2.4. Paying the Payroll...............................................................................................51

3.3. Determining the Payroll............................................................................................51

3.3.1. Gross Earning.....................................................................................................51

3.3.2. Payroll Deductions..............................................................................................53

3.3.3 Net Pays...............................................................................................................55

3.4. Recording the Payroll................................................................................................56

3.4.1. Maintaining a Payroll Record.............................................................................56

Self examination questions...........................................................................................66

Chapter Four:Accounting for Partnership............................................................................68

4.1. Partnerships and their Characteristics.......................................................................68

4.1.1. Definition of partnership.....................................................................................68

4.1.2. Characteristics of a partnership...........................................................................69

4.2. Classification of partnership......................................................................................70

4.3. Advantages and Disadvantages of Partnership..........................................................70

4.4. Recording the Formation of a Partnership.................................................................72

4.5. Division of Partnership Income and Losses..............................................................73

4.6. Financial Statements for a Partnership......................................................................75

4.7. Dissolution (termination) of a Partnership................................................................76