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• RIFT VALLEY UNIVERSITY

• DEPARTMENT OF
ACCOUNTING AND
FINANCE
PREPARED BY TEMESGEN TEKA
• FUNDAMENTAL OF
ACCOUNTING-II
• INSTRUCTOR: TEMESGEN
TEKA .
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• Course Title: Fundamental of Accounting II
• Course Code: AcFn 2021
• Pre-requisite: AcFn 2023
• Credit Hour: 4hour
• Course Description
• Fundamental of Accounting part- II is a continuation of part-I and has
designed to further develop students knowledge on the accounting recording
and management of inventories, plant assets, intangibles and payroll system.
An in-depth analysis on the accounting concepts and principles will be made.
The characteristics and accounting for different forms of business
organizations, like partnership and corporation will be introduced and
discussed.
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Course Objectives
• After studying and upon completion of this course, students should be able to:
• Demonstrate their understanding of accounting concepts, and shall have a
wider scope on all accounting principles, along with their application on
periodic recognition of income and expenses
• Demonstrate the nature and characteristics of inventory, different accounting
recording methods, year-end costing methods and the impact if accounting
methods on the current, and consecutive year inventory level on Balance
sheet.
• Give an emphasis on the different methods of allocating periodic depreciation
cost and the impact of using the different installation methods on the firm’s
income statement.
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Chapter One: Accounting for Inventories
 1.1 Inventory systems
• 1.2 Determining the cost of inventory under a periodic system
• 1.3 Accounting and reporting at other than cost
• 1.4 Balance sheet presentation of Inventories
• 1.5 Estimating inventory costs under predict and perpetual inventory system
• 1.6 Special valuation of inventories
• 1.7 Estimating inventories cost
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Chapter Two: Plant Assets and Intangible Assets
• 2.1 Nature of plant assets
• 2.2 Determining the cost of a plant asset
• 2.3 Determining depreciation
• 2.4 Accounting for deprecation
• 2.5 Capital and revenue expenditure
• 2.6 Disposal of plant assets and exchange
• 2.7 Natural resources and depletion
• 2.8 Intangible assets and amortization
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Chapter Three: Accounting for payroll system in an Ethiopian context
• 3.1 Definition and importance
• 3.2 Payroll records and components
• 3.3 The Ethiopian payroll system
• 3.4 Nature of earnings
• 3.5 Nature of deductions
• 3.6 Preparation of payroll register
• 3.7 Recording payroll,
Chapter Four: Accounting Concepts and Principles
• 4.1 Generally Accepted Accounting Principles (GAAP)
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Chapter Five: Accounting for Partnership Business
• 5.1 Characteristics of a partnership
• 5.2 Advantages and disadvantages of partnership
• 5.3 Accounting for partnership
• 5.4 Division of net income and net loss
• 5.5 Financial statement of a partnership
• 5.6 Partnership dissolution
• 5.7 Liquidation of partnership
Chapter Six: Accounting for Corporations Business
• 6.1 Character of a corporate form of business organization
• 6.2 Advantages and disadvantages of the corporate form
• 6.3 Balance sheet structure of corporate organizations
• 6.4 Classes of stock acquisitions and resources
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• Instructional methods :
•  Lecture
•  Case studies
•  Debates and Discussions
•  Presentation
• Assessment methods
• Continuous assessment:
• -Quiz--------------------------------20%
• -Test---------------------------------30%
• -Demonstration--------------------20%
• -Final Exam-------------------------30%
• Text book:
Fees and warren, Accounting Principles 16th Edition, South Western Publishing Company.
• References
• • Fees & Warren, principles of accounting 11th -17th USA.
• • Kermit d. Larson, Fundamentals of Accounting principles, 12th Ed, USA.
• • Meigs and Meigs, Accounting: The basic for business decisions, 3-8th Ed. USA
• • Harman son, Edwards & Maher Accounting principles, 5th Ed, 1992, USA
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Chapter 1
Accounting for Inventories.
 INTRODUCTION
• 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:
• Inventories of merchandising businesses
• Inventories of manufacturing businesses
Inventories of merchandising businesses are merchandise purchased for
resale in the normal course of business. These types of inventories are
called merchandise inventories.
Inventories of manufacturing businesses are materials that will be used or
consumed in the production of goods to be sold. Manufacturing businesses
are businesses that produce physical output. Manufacturing businesses
have three types of inventories. These are:
• Raw material inventory
• Work in process inventory
• Finished goods inventory
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•1. Raw material inventory – materials on hand but not yet placed into
production process. Raw materials such as: wood to make a chair or other office
furniture’s, the steel to make a car etc.
•2. Work in process inventory- raw material on which production has been started
but not yet completed or semi finished goods
•3. Finished goods inventory- goods/product produced and
completed but unsold units on hand at the end of each period.
•In this unit only the determination of the inventory of merchandise purchased for
resale commonly called merchandise inventory will be discussed.
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• 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 their sales.
3. Inventories (ending inventories) are the largest current assets in merchandise
business.
Because of the above reasons, 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.
1.3 The Effects of Inventories on Financial Statements.
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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
Cost of goods sold =Beginning inventory + Net purchase – Ending inventory
• As you see from the above formula, ending inventory has an indirect (negative)
relationship to cost of goods sold. Therefore, if ending inventory is understated,
the cost of goods sold will be overstated, and if ending inventory is overstated,
the cost of goods sold will be understated.
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Gross Profit = Net sales – Cost of Goods sold
• Here, the cost of goods 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 goods
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
 Operating income = Gross Profit – Operating Expenses
• 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).
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BALANCE SHEET
• Current 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.
• Liabilities- No effect on liabilities. Inventory misstatement has no effect on
liabilities.
• Owners’ 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
• Cost of goods 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 goods sold. That is, if the beginning inventory is understated (Overstated), the
cost of goods sold will be understated (Overstated)
Gross Profit= Net Sales – Cost of goods sold
• The effect of beginning inventory on gross profit is the opposite of the effect on cost of goods
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.
Net income = Gross Profit – Operating expenses
• The effect of beginning inventory on net income is the same as its effect on gross profit.
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• 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
• Cost of Goods sold = direct relationship
• Gross profit = indirect relationship
• Net income = indirect relationship
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Summary of error in ending inventory on the financial statement of the period in which the error occurs are as follows:
Ending Correctly Understated Overstated
Stated
Inventory
Cost of Unaffected Overstated Understated

Goods Sold
Gross Profit Unaffected Understated Overstated

Net Income Unaffected Understated Overstated

Total Assets Unaffected Understated Overstated

Capital Unaffected Understated Overstated

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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.
• Illustration 1.5: the effect of an error in the determination of ending inventory
on the current period for BB Company. You are given the following data for year
I.
• Net Sales for year I Br 450,000
• Beginning Inventory (January 1, Year I) 75,000
• Net Purchases 420,000
• Other Assets (December 31, Year I) 310,000
• Liabilities (December 31, Year I) 225,000
• Operating Expenses 135,000
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Instruction: Prepare Income Statement and Balance Sheet under the following assumption:
• 1. Ending Inventory is correctly stated at Br 220,000
• 2. Ending Inventory is incorrectly stated at Br 210,000
• 3. Ending Inventory is incorrectly stated at Br 225,000
• Assumption 1: Ending Inventory is correctly stated at Br 220,000
• Income Statement
• BB Company
• Income Statement
• For the year ended December 31, Year I
• Net Sales Br 450,000
• Less: Cost Goods Sold
• Beginning Inventory 75,000
• Net Purchases 420,000
• CMAS 495,000
• Less: Ending Inventory (220,000)
• Cost of Goods Sold (275,000)
• Gross Profit 175,000
• Less: Operating Expenses (135,000)
• Net Income Br 40,000
• Balance Sheet
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Balance Sheet
Assumption 2: COEI is incorrectly stated as Br 210,000 (Understated by Br 10,000)
BB Company
Balance Sheet
December 31, Year I
Merchandise Inventory 220,000 Liabilities 225,000

Other Assets 310,000 Capital 305,000

Total Assets 530,000 Liabilities and OE 530,000

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BB Company
Income Statement
For the year ended December 31, Year I
Net Sales Br 450,000
Less: Cost Goods Sold
Beginning Inventory 75,000
Net Purchases 420,000
CMAS 495,000
Less: Ending Inventory (210,000)
Cost of Goods Sold (285,000)
Gross Profit 165,000
Less: Operating Expenses (135,000)
Net Income Br 30,000
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• If there is no additional error, both total assets and owner’s equity will be
correct during the following period.
• The balance sheet will not be affected by the error of the previous period
• The error of one accounting period set-off against the error of the subsequent
period. The overstatement of items in the income statement of one accounting
period will result in understatement of items in the subsequent in the
subsequent period-set off.
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• Illustration - 1
• The following amounts were reported in BKK Company’s financial statements for three
consecutive fiscal year ended December 31

• 2000 2001 2002

• a) Cost of Goods sold Br. 130,000 Br. 154,000 Br. 140,000
• b) Net income 40,000 50,000 42,000
• c) Total Current assets 210,000 230,000 200,000
• d) Owner’s equity 234,000 260,000 224,000
• In making the physical counts of inventory, the following errors were made:
 Inventory on December 31, 2000, under stated by Br. 12,000.
 Inventory on December 31, 2001, overstated by Br. 6000.
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• Required:
• Determine the correct amount of the items listed above.
• SOLUTION
• 2000 2001 2002
• Cost of Goods sold: Br. 130,000 Br. 154,000 Br. 140,000
• Adjustment of
• 2000 error (12,000) 12,000 _
• 2001 error _ 6,000 (6,000)
• Corrected Br. 118,000 Br. 172,000 Br1`1. 134,000
•
• Net income: Br. 40,000 Br. 50,000 Br. 42,000
• Adjustment of
• 2000 error 12,000 (12,000) _
• 2001 error _ (6,000) 6,000
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•
• Total current assets: Br. 210,000 Br. 230,000 Br. 200,000
• Adjustment of
• 2000 error 12,000 _ _
• 2001 error _ (6,000) _
• Corrected Br. 222,000 Br. 224,000 Br. 200,000
•
• Owner’s equity: Br. 234,000 Br. 260,000 Br. 224,000
• Adjustment of
• 2000 error 12,000 _ _
• 2001 error _ (6,000) _
• Corrected Br. 246,000 Br. 254,000 Br. 224,000
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• 1.4 Inventory Systems
• There are two principal systems of inventory. Those are; periodic and perpetual inventory
system.
• 1.4.1 Periodic inventory system`
• Under this 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.
• 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 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
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Perpetual inventory system
• Under this 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. 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.
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Journal entries to be prepared are:

1. At the time of purchase of merchandise

Merchandise inventory XX at cost

Accounts payable/cash XX

To record cost of goods sold

2. At the time of sale of merchandise

Accounts receivable or cash XX at retail price
Sales XX

To record cost of goods sold

To record the sales
Cost of goods sold XX
Merchandise inventory XX at cost
To record the cost of merchandise sold

3. To record purchase returns and allowances

Accounts payable or cash XX

Merchandise inventory XX
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• Illustration
• In its beginning inventory on Jan 1, 2002, NINI Company had 120 units of merchandise that cost
Br. 8 Per unit. The following transactions were completed during 2002.
• February 5 Purchased on credit 150 units of merchandise at Br. 10 per unit.
• Returned 20 detective units from February 5 purchases to the supplier.
• June 15 Purchased for cash 230 units of merchandise at Br 9 per unit.
• September 6 Sold 220 units of merchandise for cash at a price of Br. 15 per unit. These
• Goods are: 120 units from the beginning inventory and 100 units for February
• December 31 260 units are left on hand, 30 units from February 5 purchases.
• Required: Prepare general journal entries for NINI Company to record the above transactions
and adjusting or closing entry for merchandise inventory on December 31,
• Periodic inventory system
• Perpetual inventory system
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• Solution
• a) February 5 Purchases (150 x Br.10) 1,500
• Account payable 1,500
• 9 Accounts payable (20 x Br. 10) 200
• Purchase returns and allowances 200
• June 15 Purchases (230 x Br. 9) 2,070
• Cash 2,070
• September 6 Cash (220 x Br. 15) 3,300
• Sales 3,300
• December 31 To record or close the merchandise inventory account
• Income summary (120 x Br. 8) 960
• Merchandise inventory (beginning) 960
• _To close the beginning inventory
• Merchandise inventor (ending) 2,370
• Income summary [(30 x Br. 10) + (230 x Br. 9)] 2,370
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• b) February 5 Merchandise inventory 1,500
• Accounts payable 1,500
• 9 Accounts payable 200
• Merchandise inventory 200
• June 15 Merchandise inventory 2,070
• Cash 2,070
• September 6 i) To record the sales
• Cash 3,300
• Sales 3,300
• ii) To record cost of merchandise sold
• = (120 x Br. 8) + (100 x Br. 10)
• = Br. 960 + Br. 1,000 = Br. 1,960
• Cost of merchandise sold 1,960
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• 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 cost of goods sold.
• The inventory account under a perpetual inventory system 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 (some times called
“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 units of each product on hand
• Multiplying the count for each product by its cost per unit
• Adding the cost for all products
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• 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- the ownership title passes too 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.
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• 1.6 Determining the Cost of Inventory
• Inventory Costing Methods under Periodic Inventory System
• One of the most important decisions in accounting for inventory is determining the per unit
costs 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.
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)
Weighted average
• Let us see these costing methods under periodic inventory system based on the following
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• Illustration:
• Beza 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, 520
•
The ending inventory consists of 300 units, 100 from each of the last three
purchases.
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Specific Identification Method
• 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 cost = Br. 13,600
•  The cost of merchandise sold = Cost of goods available for sale - Ending inventory
• = Br. 59,520 – Br. 13,600
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First-in, First-out (FIFO)
• This method of assigning cost to inventory and the goods sold assumes 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.
• 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 illustration on page 21.
• 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
• Br. 47,160
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Inventory Costing Methods Under Perpetual Inventory System
• 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 Nehru Company for the month of January fare as follows:
• Units Cost
• Jan. 1 Inventory 15 Br. 10.00
• 6 Sale 5
• 10 purchase 10 Br. 12.00
• 20 Sale 8
• 25 purchase 8 Br. 12.50
• 27 Sale 10
• 30 purchase 15 Br. 14.00
 •First-in first-out Method

Count…. Perpetual - FIFO

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 10.00 100.00
10 10 Br. 12.00 Br.120.00 10 12.00 120.00
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
15 14.00 210.00
23 Br. 246.00 25 Br. 334.00
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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
• Br. 12 x 2 =24 Br. 334
• Cost of goods available for sale = Br. 120 + Br. 100 + Br. 210 +Br150= 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
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Purchase Cost of merchandise sold Inventory
Da Qty Unit cost Total cost Qty Unit cost Total cost Qty Unit cost Total
te cost

Ja 15 Br. 10.00 Br.

n. 150.
1 00
6 5 Br. 10.00 Br. 50.00 10 10.00 100.
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
20 11.60 + 232.
25 8 12.00 100.00 132+100 00

12+8

27 10 11.60 116.00 10 11.60 116.

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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 x 25=unit on hand =48-23=25
• = Br. 302
• Cost of merchandise sold = Br. 580 – Br. 302
• = Br. 278
• So, the result is different under periodic and perpetual inventory systems.
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1.8 Additional Valuation Problems for Inventories
 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). Yet, the cost
of inventory is not necessarily the amount always reported on a balance 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.
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• 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 ABC motor sports, retailer.
• Inventory units per unit
• Items on hand cost market
• Cycles:505
• Roadster 50 Br. 15,000 Br. 14,000
• Sprint 20 9,000 9,500
• Off Road:
• Trax-4 10 10,000 11,200
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• Let us see LCM computation under the three ways:
• Separately to each individual item
•
• Inventory items Total cost Total market LCM
•
• Roadster Br. 750,000= Br. 700,000 Br. 700,000
• Sprint 180,000 190,000 180,000
• Categories sub total Br. 930,000 Br. 890,000
• Trax-4 100,000 112,000 100,000
• Blaz’m 96,000 87,000 87,000
• Categories sub total Br. 196,000 Br. 199,000
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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.
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• 1.9 Estimating Inventory Cost
• In practice, an inventory amount is estimated for some purposes. When it is
impossible to take a physical inventory or to maintain perpetual inventory records.
• Example
• Monthly income statements are needed. It may b e too costly, to take physical inventory. This is especially
the case when periodic inventory system is used.
• When a catastrophe such as a five has destroyed the inventory. In such case, to ask claims from insurance
companies, the is a need of estimated inventory.
• To estimate the cost of inventory, two methods are used. These are retail method
and gross profit method.
• 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.
 Count…
The steps to be followed are:
• Calculate the cost to retail ratio = Cost of merchandise available for sale
Retail Price of merchandise available for sale
• 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
 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
 Count….
• (1) Cost retail ration = Br. 25,000 + Br. 125,000 = 0.75
• Br. 40,000 + Br. 160,000
• (2) Ending inventory at retail = (Br. 40,000 + Br. 160,000) – Br. 140,000 = Br. 60,000
• (3) Estimated ending inventory at cost = 0.75 X Br. 60,000=Br 45,000
• Gross Profit Method
• This method uses an estimate of the gross profit realized during the period to estimate the
cost of inventory. The gross profit rate may be estimated based on the average of previous
period’s gross profit rates.
• The steps are as follows:
• The gross profit rate is estimated and then estimated gross profit is calculated.
• Estimated gross profit = Gross profit rate X Sales .
• Cost of merchandise sold is estimated
• Estimated cost of merchandise sold = Sales - Estimated gross profit
 Count…
• Calculate the estimated cost of ending inventory
• Estimated cost of ending inventory =
• Cost of merchandise available for sale – Estimated cost of merchandise sold.
• Example
• Oct. 1, beginning inventory (cost) – Br. 36,000
• Net purchases during October (cost) 204,000
• Net sales during October 220,000
• Estimated gross profit rate is 40%
• The ending inventory is estimated as follows:
• Estimated gross profit = 0.4 X 220,000
• = Br. 88,000
• Estimated cost of merchandise sold
• = Br. 220,000 – Br. 88,000
• = Br. 132,000
• Estimated cost of ending inventory
• = (Br. 36,000 + 204,000) – Br. 132,000
Count…
Chapter Two
plant Asset ,Natural Resources and
Intangible Assets
 COUNT….
2.1 Nature of Plant Assets
Plant assets are resources that have
Are Long lived assets usually more than a year.
Are acquired for use in business operations i.e. must be capable of providing
repeated use or benefit
Are not acquired for resale. Any asset that is acquired for resale purpose is not
a plant asset regardless of their durability, nature of the assets, and the length
of time they are held. Example land held for speculation purpose.
Are subject to depreciation i.e. decline in usefulness through passage of time.
Are expected to provide service to the company for a number of years.
Referred to as property ,plant ,and equipment and fixed Assets .
Count …..
2.2. Nature and Accounting for Depreciation
• Plant asset- expected to have a lower value or no value when it is retired from
the service. This is because plant assets decline in usefulness through the time
which we call it depreciation. The difference between the initial cost and the
value remaining when it is retired (Residual Value or Scrape Value or Salvage
Value or Trade in Value) is called depreciable cost that is the cost that should be
allocated over the useful life the assets as a depreciation expense.
• Depreciation -is also the systematic allocation of the cost of a plant asset over its
estimated life. The causes of depreciation are divided into two broad classes:-
• Physical Usage – physical depreciation results from the wear and tear
of plant assets due to operating use and forces of nature such as
earth quake, land slide, storm, etc.
Count…
Functional or economic depreciation– results from obsolescence and
inadequacy.
 Obsolescence – is the process of becoming out of date because of
technological innovation. Example type writing equipment
• Inadequacy – refers to the effect of growth and change in the scale of
a business operation. Inability to meet the demand of customers.
Example small machines held by large business.
 Count….
 Accounting for Depreciation
Factors that affects periodic depreciation expense are the
Initial cost or acquisition cost
Residual value
Useful life or estimated economic life and method of depreciation
Methods of Depreciation
 Usually the following 4 methods are used to allocate the depreciate cost. These are:
 Straight line method
 Declining balance method
 Sum of the year’s digit method and
 Units of production method
 Count…
Straight Line Method (SLM)
This method allocates depreciable cost to each period of the Estimated
Economic Life of the assets equally. Depreciation per year is computed as
follows:
Depreciation per Year = (Acquisition Cost – Residua Value) / Estimated
Economic Life
 Illustration 2.1: assume that a machine is acquired at the beginning of 1991
for Br 100,000 and the residual value of the machine at the end of 5 years of
economic life is estimated at Br 10,000. Instruction: compute the amount of
depreciation allocable to each year and present the necessary adjustment at
the end of each year.
 Count…
 Depreciation per Year = (Br 100,000– 10,000) / 5 Years = Br 90,000 / 5 = Br
18,000
 Depreciation Expense 18,000
 Accumulated Depreciation 18,000
 Count…
Depreciation Schedule
Year Cost Annual Dep. Accumulated Book Value
Exp Dep.
1 Br 100,000 Br 18,000 Br 18000 Br 82,000

2 100,000 18,000 36,000 64,000

3 100,000 18,000 54,000 46,000

4 100,000 18,000 72,000 28,000

5 100,000 18,000 9,0000 10,000

 Count…..
2. Declining Balance Method
• This method yields a decline in periodic depreciation charges over the
estimated life of the assets. The most common techniques are to double the
straight line depreciation and multiply the resulting rate to the cost of the asset
less its accumulated depreciation.
• Depreciation per year = (2 / EEL) * (Acquisition Cost – Accumulated
Depreciation)
 Count…
• Illustration 2.2: CC Corporation purchased equipment on January 1, 2000 for Br
20000 which has an expected life of 5 years and salvage value of Br 1,000.
Instruction: calculate the declining balance rate and the amount of
depreciation for its useful life.
• Cost = Br 20,000
• EEL = 5 years
• Residual Value = Br 1,000
 Count…

Year Cost Accumulated Beginning Double Depreciation Ending

Dep. Exp Book value Declining Expense Book Value
Rate

2000
Br Br 20000 40% Br 8000 Br 12000
20000
2001
20000 8000 12000 40% 4800 7200
2002
20000 12800 7200 40% 2880 4320
2003
20000 15680 4320 40% 1728 2592
2004
20000 17408 2592 1592 1000
 Count….
• In the year 2004 the calculated amount of depreciation is Br 1037 but the
actual depreciation expense is Br 1,592 (Br 2,592 – 1000). The 2,592 is the
difference between Br 20,000 (cost) and 17,408 (accumulated depreciation).
The estimated residual value does not enter into the computation of
depreciation expense until the very end. This is because this method provides
an automatic residual value. If an asset has a Residual Value, this depreciation
method should consider the stated residual value. Thus, in the above example
the depreciation expense for year 2004 is Br 1,592 rather than Br 1,037.
 Count…
• The Sum Of Years Digits(SOYD) Method
• Under this method the periodic charge for depreciation declines steadily or continuously over the estimated life of
the asset because successive small action is applied each year to the original cost less estimated residual value. The
following steps are followed to determine the depreciation charge under this method:
• Estimate the useful life of the asset in the years
• Assign consecutive numbers for each year starting from 1
• Find the sum of these numbers using the following formula: SOYD = [N (N + 1)] / 2. Where N = estimated useful life
of the asset in years
• Determine the numerator which is a number of the economic life of the asset remaining at the beginning of each
accounting period. Year 1= N, Year 2= N – 1, Year 2 = N – 2 , etc
• Compute depreciation using the formula: Annual Depreciation = (AC – RV) * EEL / SOYD
•
• Illustration 2.3: JK Company purchased old building on January 1, 1995 for Br 105,000 and its estimated life is 4
years with a salvage value of Br 5,000 and the physical period ends on December 31, 1995. Instruction: determine
the sum-of-years-digit and calculate the amount of depreciation for its useful life.
• SOYD = [N (N + 1)]/ 2 = [4 (4 + 1)] / 2 = 10
•
 Count….
• 1995 = 4/10 (105,000 – 5,000) = Br 40,000
• 1996 = 3/10 (105,000 – 5,000) = Br 30,000
• 1997 = 2/10 (105,000 – 5,000) = Br 20,000
• 1998 = 1/10 (105,000 – 5,000) = Br 10,000
Count …..
 Depreciation Schedule
Hint Depreciable cost = Cost –Estimated Salvage Value
Year Depreciabl Fractions Annual Dep. Accumulated Book
e Cost (rate) Exp Dep. Value
1 105000 4/10 40000 40000 65000

2 105000 3/10 30000 70000 35000

3 105000 2/10 20000 90000 15000

4 105000 1/10 10000 100000 5000

 Count…
4. Units Of Production Method
This method yields a depreciation charge that varies with the amount of usage. To apply this method the life of the asset is
expressed in terms of production capacity such as machine hours, miles, kilo meters, or no of units, etc. Under this method
depreciation is computed as follows:
 Depreciation Rate = (AC – RV) / Estimated Production Capacity
 Depreciation Expense = Depreciation Rate * Actual Usage of the Asset
Illustration 2.4: XY Company purchased diesel powered generator on January 1, 2000 at Br 50000 and the generator has
estimated economic life of 5 years or a production capacity of 500000 machine hours with no residual value. Assuming that
the generator was used each year as follows:
Year 2000= 100,000 hrs
2001 = 120,000 hrs
2002 = 105000hrs
2003 = 95000hrs
2004 = 80000hrs
Required: Calculate each year depreciation expenses using unit of production method .
Depreciation Rate = (Br 50,000 – 0) / 500,000 hours = Br 0.10 per hour

.
Count…
Depreciation Schedule

Year Actual Depreciation Annual Accumulated Book Value

Usage Rate Dep. Exp Dep.

1 100000hrs Br 0.10 per 10000 10000 40000

hr
2 120000hrs 0.10 per hr 12000 22000 28000
3 105000hrs 0.10 per hr 10500 32500 17500
4 95000hrs 0.10 per hr 9500 42000 8000
5 80000hrs 0.10 per hr 8000 50000 0
 Count….
 Partial Year Depreciation.
To calculate the partial year depreciation, the following are important:
The date of purchase must be known. The number of days in the month in
which the purchase is made affects the depreciation expense in the following
manner:
If it is higher than 50% of the days in the month of purchase, compute
depreciation for the whole month
If it is less than 50% of the days, ignore the whole month
•
 Count…..
• Illustration 2.5: GG Company purchases a delivery truck on April 13, 1991 for Br 180,400. The
expected life of the truck was 4 years or 200,000 KMs and has an estimated salvage value of Br
6,400. During the year 1991 and 1992 the truck was driven for 60,000 and 40,000 KMs,
respectively. The company’s fiscal period ends on December 31 of each year. Compute
depreciation expense for the year 1991 and 1992 under all the methods of depreciation.

Straight Line Method

Annual Depreciation= (180,400 – 6,400)/4 =Br 43,500
1991- Partial Year Depreciation= 9/12 * Br 43,500 = Br 32,625
1992 Depreciation = 3/12 * Br 43,500 + 9/12 * Br 43,500 = Br 43500
Declining Balance Method
Annual Depreciation, 1st Year = 2/4 (Br 180,400 – 0)=Br 90,200
Annual Depreciation, 2nd Year = 2/4 (Br 180,400 – 90,200)=Br 45,100
1991- Partial Year Depreciation= 9/12 * 90,200=Br 67,650
1992 Depreciation = 3/12 * 90,200 + 9/12 * 45,100 = 22,550 + 33,825 = Br 56,375
 Count…
SOYD Method
SOYD = 4 (4 + 1)]/2= 10
Annual Depreciation, 1st Year = 4/10 (Br 180,400 – 6,400)= Br 69,600
Annual Depreciation, 2nd Year = 3/10 (Br 180,400 – 6,400)= Br 52,200
1991- Partial Year Depreciation= 9/12* 69,600 = Br 52,200
1992 Depreciation = 3/12 * 69,600 + 9/12 * 52,200= 17,400 + 39,150=Br 56,550
Units-of Production
Depreciation Rate = (180,400 – 6,400) / 200,000KMs =Br 0.87/ km
1991 Depreciation= 60,000 KMs * 0.87/km= Br 52,200
1992 Depreciation= 40,000 KMs * 0.87/km = Br 34,800
 Count….
• 2.5 Changes in Estimates and Revision of Periodic Depreciation
• Residual value and estimated economic life are estimates. There may be an error in estimates. Thus, estimates
may be revised or changed. The change in estimates is applicable only to the value or cost not depreciated so far
ignoring the portion acquisition cost depreciated in the previous accounting periods. Revision in estimates does
not apply retroactively to the past accounting periods.

• Illustration 2.6: assume that on January 1, 1992 AA Company purchased a delivery truck for Br 52,000. At the
time of purchase the truck was estimated to last 5 years with salvage value of Br 2,000 and it was depreciated
accordingly on the straight line method for two years and at the beginning of the year 1994, the life was
estimated to last 6 more years with a salvage value of Br 2,600. Determine the revised annual depreciation per
annum.

Givens: cost Br 52,000

• Salvage value= Br 2,000
• EEL = 5 Years
• Depreciation/Year = (52,000 – 2,000) / 5
• Depreciation /Year = Br 10,000
 Count….
Depreciation from 1992 to 1993
Accumulated Depreciation = Br 10,000 * 2 years
• Accumulated Depreciation = Br 20,000
Revised Depreciation starting from 1994
• Revised Cost (Carrying Amount) = Br 52,000 – 20,000
• Revised Cost (Carrying Amount) =Br 32,000
• Revised EEL = 6 years
• Revised RV = Br 2,600
• Revised Depreciation = Br 32,000 – 2,600 / 6 = Br 29,400/6=Br 4,900
 Count…
2.6 .Capital and Revenue Expenditures
• Capital expenditures are those expenditures incurred for acquiring plant asset or
for addition to such an asset and that will affect the utility of the plant asset for
more than one accounting period. Such expenditures are debited to the asset
account or to the related accumulated depreciation account. The common
capital expenditures in addition to the initial cost includes the following:
Additions, Betterments and Extraordinary Repairs
• Additions:
• Are those expenditures or costs increase the service potential of the plant asset
• They are debited to the plant asset account
• They would be depreciated over the estimated useful life of the additions
• Example: cost of adding an air conditioning system or an elevator to the building
 Count….
Betterments:
Betterments are expenditures that increase operating efficiency or capacity
for the remaining useful life of the plant asset. These costs will be added to
the plant asset account. Example: substituting the old power point by a new
power unit, substituting the old engine by new one that improves operating
efficiency.
Extraordinary repairs:
These are expenditures that increase the useful life of an asset beyond the
original estimate. These costs are debited to the appropriate accumulated
depreciation account and the periodic depreciation for the future period will
be determined on the basis of the revised book value.
 Count….
• Illustration 2.7: assume a delivery truck costing 190,000 has estimated economic life of 9 years with Br 10,000 residual value. It has
been depreciated over the past 5 years on a straight line basis. At the beginning of year 6 the engine was changed as an
extraordinary repair at Br 40,000 which was expected to increase the estimated economic life the truck to 8 years with the same
salvage value. Required: determine the annual depreciation charge for the remaining life of the asset.
•  Initial Cost: Br 190,000
•  Residual value: Br 10,000
•  Estimated Economic Life: 9 years
•  Annual Depreciation: Br 190,000 – 10,000/ 9 years =Br 20,000
•  Accumulated Depreciation: Br 20,000 * 5 years =Br 100,000
• Extraordinary Repairs: - it is debited to accumulated depreciation account
• Accumulated Depreciation 40,000
• Cash 40,000
• After extraordinary repairs:
•  Cost Br 190,000
•  Accumulated Depreciation (60,000)
•  Book Value Br 130,000
•  Annual Depreciation= (130,000 – 10,000) / 8= Br 15,000
 Count….
• Revenue Expenditure: these are expenditures for ordinary maintenance and
repairing of a recurring nature should be classified as revenue expenditure and
debited to expense accounts.
• Example, cost of repairing a building, a truck, etc
2.7. Disposal of Plant Assets
When an asset is no longer useful to the business, it is retired from the service.
This is called disposal. Disposal refers to discarding, selling, or exchanging plant
assets. To journalize the necessary entries on the date of disposal the following
information are required:
The up-to-date balance of the accumulated depreciation account
The book value of the asset
The loss or gain on disposal
 Count….
Discarding Plant Assets
When a plant asset are no longer useful to the business and has no market or
sales value, they are discarded. Illustration 1: RR Company discarded a
machinery on December 31, 2003, which was fully depreciated. The machine
was acquired at a cost of Br 150,000 before six years.
BV = AC – Accumulated Depreciation The Accounting Entry for this disposal:

BV = Br 150,000 – 150,000 = 0

Accumulated Depreciation 150,000

Machinery 150,000
 Count…..
• Illustration 2.8: RR Company discarded an equipment, which was purchased at a cost of Br
32,000, after it has been depreciated for 4½ years under the straight line method with a
consideration of Br 2,000 salvage value. The estimated economic life of the asset was 5 years.
Journalize the necessary transaction:
• Annual Depreciation = Br 32,000 – 2,000/ 5
• Annual Depreciation = Br 6,000
• Accumulated Depreciation = Br 6,000 * 4.5 years
• Accumulated Depreciation = Br 27,000
• Book Value = Br 32000 – 27,000=Br 5,000
• The loss on disposal is Br 5,000 as the business discards an asset with a value of Br 5,000.
• The Accounting Entry for this disposal:
• Accumulated Depreciation 27,000
• Loss on Disposal 5,000
 Count…
Selling Old Plant Asset
• The entry to record the sale of a plant asset is like the entry of discarding a plant asset except that the cash or other asset to be received must be accounted for.
•  If the selling price > book value, there will be a gain on disposal
•  If the selling price < book value, there will be a loss on disposal

• Illustration 2.9: RA Furniture Company purchased a computer system for Br 34,000 and the system was
expected to last 8 years with a salvage value of Br 2,000. The equipment was depreciated for 6 years
based on the straight line method and sold at the beginning of year 7. Required: Journalize the necessary
entries assuming that the asset was sold for:
• A) Br 15000 B) Br 10000 C) Br 9000

• Acquisition Cost = Br 34,000

• Residual Value = Br 2,000
• Estimated Economic Life = 8 years
• Annual Depreciation = Br 34,000 – 2,000/ 8
• Annual Depreciation = Br 4,000
• Accumulated Depreciation = Br 4,000 * 6 Years
• Accumulated Depreciation = Br 24,000
• Book Value = Br 34,000 – 24,000 = Br 10,000
 Count….
A.Br 15,000 disposal price implies a gain of Br 5,000
• Accumulated Depreciation 24,000
• Cash 15,000
• Equipment 34,000
• Gain on Disposal 5,000
B.Br 10,000 disposal price implies is neither gain nor loss
• Accumulated Depreciation 24,000
• Cash 10,000
• Equipment 34,000
C.Br 9,000 disposal price a loss of Br 1,000
Count….
C.Br 9,000 disposal price a loss of Br 1,000
• Accumulated deprecation---------------------- 24000
• Cash---------------------------------------------- 9000
• Loss on Disposal ---------------------------------1000
• Equipment ------------------------------------------------------------34000
 Count…..
Exchanging or Trading in
• Old plant assets are often traded in for new plant asset having similar use or dissimilar
use. Under this situation a trade-in allowance (TIA) is usually granted on old plant
asset. The trade-in allowance can be considered an agreed selling price for the old
asset. This amount is deducted from price of new asset as consideration for old plant
asset. The balance paid to the seller of the new asset after the trade-in allowance is
deducted from the purchase price is called Boots. The GAIN or LOSS on exchange is
determined by comparing the TIA and the Book Value of the old Asset:
If the TIA > book value, there will be a gain on disposal
 If the TIA < book value, there will be a loss on disposal
• According to GAAP on exchange of similar plant assets, loss should be recognized and
gain should be adjusted to the price the new asset. That is, the new asset exchanged
must be recorded at the book value of the old asset plus the cash paid (Boots) or the
purchase price whichever is lower.
 Count…..
• Illustration 2.10: BB Company acquired a machine at Br 80,000 by trading in a similar
old asset that has a cost of Br 75,000 and up-to-date accumulated depreciation
account balance of this asset was Br 72,000. Make the necessary journal entries if
the TIA was:
• A. Br 4,000 B) Br 3,000 C) Br 2,000
Book Value = Br 75,000 – 72,000 = Br 3,000

A.TIA=Br 4,000
If the TIA is Br 4,000, there is a gain of Br 1,000. But the gain will not be recognized
• Boots = Br 80,000 – 4,000 = Br 76,000
• Purchase Price = Br 80,000
• Boots + Book Value = Br 76,000 + 3,000 = Br 79,000. Thus, the new machine should
be recorded at Br 79,000 because the lower is this amount
Count…..
Machinery (New) 79,000
.

Accumulated Depreciation 72,000

.

Cash 76,000
.

Machinery (Old) 75,000

.
 Count….
B.TIA=Br 3,000
If the TIA is Br 3,000, there is neither a gain nor a loss
Boots = Br 80,000 – 3,000 = Br 77,000
Purchase Price = Br 80,000
Boots + Book Value = Br 77,000 + 3,000 = Br 80,000. Thus, the new machine
should be recorded at Br 80,000 because boots plus book value and purchase price are
the same.
Machinery (New) 80,000
Accumulated Depreciation 72,000

Cash 77,000
Machinery (Old) 75,000
 Count…
C.TIA=Br 2,000
If the TIA is Br 2,000, there is a loss of Br 1,000. This loss is recorded in the accounting
records of the period.
Boots = Br 80,000 – 2,000 = Br 78,000
Purchase Price = Br 80,000
Boots + Book Value = Br 78,000 + 3,000 = Br 81,000. Thus, the new machine should be
recorded at Br 80,000 since the purchase price is the lower amount.
Machinery (New) 80,000
Accumulated Depreciation 72,000
Loss on Exchange 1,000
 Cash 78,000
 Machinery (Old) 75,000
Note: -In the case of Exchange of dissimilar plant asset, both loss and gain should be
recognized.
 Count….
2.8.Accounting for Natural Resources and Depletion
• Natural resources include forests, water, minerals, metal ores, oil, gas, etc.
The costs of natural resources include all the normal, necessary and
reasonable expenditure incurred to acquire these natural resources.
• Intangible assets are those assets which don’t have any physical substance.
However, for accounting purposes intangible assets include patents, copy
rights, trademarks, trade names, and goodwill etc.
• the basic principles of accounting for intangible asset are the determination
of the acquisition costs and the recognition of periodic cost expiration which
is called amortization.
 Count…
A.Patents:- patent are exclusive right to produce and sell goods with one or more unique features.
In USA, Patents have the legal life of 17 years, which is given by the government.
Cost of Patent Right- the cost of patent right includes the purchase price plus related costs.
Amortization of Patent Right: patents have a legally granted period of 17 years. However, it may
lose their usefulness in a period less than 17 years. Thus, amortization of patent should be
computed by comparing the legal life and the estimated life and by taking the lower of the two.
Copy right is an exclusive right granted by the government to protect the production and sale of
literary or artistic materials for the life of the creator plus 50 years. The cost of copy right include
all costs of creating the work plus the cost of obtaining the right.
Goodwill- is an intangible asset that is attached to a business as a result of such favorable factors as
location, product superiority, reputation, managerial skill, etc. Goodwill is recorded normally when
it is purchased from others. And there is no legal life for goodwill, however, it should be amortized
over its useful life or 40 years which ever is the lower. The existence of goodwill is evidenced by
customers’ willingness to pay high price and high return on investment. Note: Goodwill is no more
amortized as of June 30, 2001. FASB changed the rule of goodwill amortization. Instead purchased
goodwill will remain on the balance sheet as an asset and then Impairment Tests should be made
periodically
 Count…
CHAPTER 3
•ACCOUNTING FOR THE PAYROLL SYSTEM
IN AN ETHIOPIAN CONTEXT.
 Count…
• 3.1 The Importance of Payroll and Payroll Accounting
• The term Payroll often refers to any document prepared to pay remuneration to
the employee for the service rendered to an organization in a given period of
time. Payroll accounting is an accounting that is concerned with preparation of
payroll and recording and reporting of remunerations. The payroll accounting of a
firm has significance and has to be given emphasis for the following reasons:
• Employees are sensitive to payroll errors and irregularities, and maintaining good
employee moral requires that the payroll be paid on a timely, accurate basis.
• Payroll expenditures are subject to various government regulations
• The payment for payroll and related taxes has significant effect on the net income
of most business enterprises (salary is the largest expense in most businesses)
 Count…
• Definition of payroll related terms
• Salary or Wages: Salary and wages are usually used interchangeably. However, the term wages is
more correctly used to refer to payments for manual labor that are paid based on the number of
hours worked or the number of units produced. So, they are usually paid when a particular piece
of work is completed or for a period less than a month. On the other hand, compensations to
employees on monthly or annual basis are termed as salaries. It must be clear that when we say
an employee, we refer to an individual who works primarily to an organization and whose
activities are under the direction and supervision of the employer. Hence, an employee is different
from an independent contractor, a self-employed individual who works on a fee basis to a firm.
• The Pay Period: The length of time covered by each payroll payment. Pay periods for wageworkers
are usually a weekly or biweekly period. That is, wage is paid either weekly or biweekly. On the
other hand, for salaried employees, the pay periods are a month, semi-month, quarter, semi-
annual, or a year.
• The Pay Day: The day on which wages or salaries are paid to employees. PAY DAY is usually the
last day of the pay period.
 Count…
• Pay Check:] An instrument for paying salary if the firm makes payment via writing a check in the name of
each employee for the net pay or a check for the total net pay.
• Gross Earnings: The total pay to an employee before deductions for the pay period.
• Payroll Taxes: Are taxes levied against the employer on the payroll of a firm. It is the portion of pension or
social security contribution made by the employer. It is an additional payroll related expense to an
employer.
• Withholding Taxes: These are taxes levied against the earnings of employees of an organization and
withheld by the employer as per the tax laws of the concerned government
• Payroll Deductions: All the reductions from the gross earnings of an employee such as withholding taxes,
union dues, fines, credit association pays, etc.
• Net Pay: The net earnings after subtracting all the deductions. It is sometimes known as take home pay.
The amount collected by an employee on the payday.
•
• In the above definitions of payroll related terms, the three are considered the basic records of a payroll
accounting system. These are: (1) A payroll sheet, (2) Individual employees' earnings records, and (3) Pay
checks. These records are generated from a payroll system that is operated either manually or using
 Count….
• 3.3 Components of a Payroll Register
• Employee number – numbers assigned to employee for identification purpose. It
might be alpha-numeric character when a relatively large number of employees
are included in the payroll register.
• Name of employees – full name of each employee included in the list of payroll
sheet.
• Earnings – a benefit in cash or in kind earned by an employee from various
sources of employment. It may include:
• The basic salary or Regular Earning – a flat monthly salary of an employee that is paid for
carrying out the normal work of employment and subject to change when the employee is
promoted..
 Count…
Allowances: 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.
• House Allowance – a monthly allowance given to cover housing costs of the individual
employee when the employment contract requires the employer to provide housing but
fails to do so.
• Disturbance Allowance – a sum of money given to an employee to compensate for an
inconvenient circumstance caused by the employer. For instance, unexpected transfer to
a different and distant work area or location.
• Desert Allowance – a monthly Allowance given to an employee because of assignment
to a relatively hot region. It is some times known as Hardship Allowance
• 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
 Count….
Overtime Earnings
• Overtime work is the work performed by an employee beyond the regular working hours or days.
Overtime earning is the amount payable to an employee for overtime work done. In Ethiopia, in this
respect, according to Article 33 of proclamation No.64/1975 the following is discussed about payment for
overtime work.
• A worker shall be entitled to be paid at a rate of one and one quarter (1 ¼) times his ordinary hourly rate
for overtime work performed before 10 O'clock in the evening (10 p.m.). (From 6:00 am to 4:00 pm)
• A worker shall be paid at the rate of one and one half (1 ½) times his ordinary hourly rate for overtime
work performed between 10 O’clock in the evening (10 p.m.) and six O’clock in the morning (6 a.m.)
• Overtime work performed on the weekly rest days shall be paid at a rate of two (2) times the ordinary
hourly rate of payment.
• A worker shall be paid at a rate of two and half (2 1/2) times the ordinary hourly rate for overtime work
performed on a public holiday.
• Hence, the gross earnings of an employee may, therefore, include the basic salary, allowances and
overtime earnings. You may find sometimes other form of earnings such as Bonus that is paid to
employees for achieving results better than usual.
 Count….
Deductions
These are amounts to be subtracted from the earnings of employees because they are
required by government (mandatory deductions) or permitted by the employee himself
(voluntary deductions. Mandatory deductions include employment income tax and pension
contribution. In our country, some of the deductions against the earnings of employees are:
 Employee Income Tax
• In Ethiopia every citizen is required to pay something in the form of income tax from
his/her earning 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 save the
first 600 Birr. According to proclamation No. 979/2016 , exempts the first Br 600 of the
earnings of an employee from income tax. The money on which a person does not have to
pay income tax is an exemption. According to the new proclamation, employee income tax
has to be computed based on Schedule “A” as follows:
•
 Range of Tax Per Month Fixed
Employment Income per Month TEI Deduction
Count…
TB Over Birr To Birr Tax Rate

1st 0 600 600 Exempt (0%) 0

2nd 601 1650 1050 10% 60
3rd 1651 3200 1550 15% 142.50

4th 3201 5,250 2050 20% 302.50

5th 5,251 7800 2550 25% 565.00
6th 7801 10900 3100 30% 955.00
7th Above 10900 35% 1500.00
 Count…
• 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, as per Art 13
of Proclamation No. 286/2002 and Art 3 of Regulation No. 78/2002, the following categories of
payments in cash or benefits in kind are exempted from taxation.
• Income from employment received by casual employees
• Income from employment received by diplomatic and consular representatives; and other persons
employed in any Embassy
• Payments made to a person as compensation or gratitude in relation to personal injuries; or the
death of another person.
• Medical Allowance
• Transportation Allowance
• Hardship Allowance
• Per-diem Allowance (Daily Allowance)
• Traveling Expenses
 Count…

• Pension Contribution
• 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 7% 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 11% of the basic salary of every
permanent employee of it. It is this total amount that we called earlier as payroll taxes expense to the employer
organization (i.e. 11% of the total basic salary of all permanent employees). For military forces (police and national
defence members), the employer contributes 22% of the basic salary of every permanent military force.
• Consequently, the total contribution to the pension Trust Fund of the Ethiopian government is equal to 18% of the total
basic salary of all permanent employees of an organization (i.e. 7% comes from the employees and the 11% comes from
the employer as per proclamation No. 908/2015. This enables a permanent employee of an organization to be entitled
to the pension pay given that the employee has satisfied the minimum requirements to enjoy this benefit when retired.
• Non-government organizations are also using this kind scheme to benefit their employees with some modifications.
This is made in some NGO'S by keeping a fund known as Provident Fund. Both the employees and the employer
contribute towards this fund monthly.
 Count….
Other Deductions (Voluntary Deductions)
• Apart from the above two kinds of deductions from employees earnings, employees may
individually authorize additional deductions such as deductions to pay health or life
insurance premiums; to repay loans from the employer or credit association; to pay for
donations to charitable organizations; etc. Each of the major other deductions may be put
in special column in the payroll register. Ultimately, the sum of the employees’ income tax,
pension contributions and other deductions gives the total deductions from the gross
earnings of an employee.
• The column “Total Deductions” shows the total amount to be deducted from the earnings
of employees.
The Net Pay
• This amount is held in one column of the payroll register representing the excess of gross
earnings over the total deductions of an employee. The column 'Net Pay' total tells the
excess of grand total earnings over grand total deductions made from the earnings of
employees. It is the grand total take- home pay.
 Count….
• 3.4 Major Procedures or Activities Involved in Accounting for Payroll
• Gathering the Necessary Data. All the relevant information about every employee should be gathered. This
activity requires reviewing various documents and to do some arithmetic work.
• Including the names of employees along with the gathered data such as earnings, deductions and net pays in
the appropriate columns of the payroll register.
• Totaling and proving the payroll register. It must be proved that the grand total earnings equal the sum of the
grand totals of deductions and net pays in the register.
• The accuracy and authenticity of the information summarized in the payroll should be verified by a different
person from the one who compiles it.
• The payroll is approved by the authorized personnel.
• Paying the payroll either in cash (this may be after cashing a check issued for the total net pay of the payroll)
or issuing a check for every individual employee for the net amount payable to each employee.
• Recording the payment of the payroll and recognition of the withholding tax liabilities.
• Recording the payroll taxes expense of the employer.
• Paying and recording withholding and payroll tax liabilities to the concerned authority, in our case to Inland
Ethio Relief Agency pays the salary of its employees according to the Ethiopian
Count……
Calendar month. The forth coming data relates to the month of Hider, 2011.

Name of Basic Allow OT Hrs Duration of BS per hour

S.No.
Employee Salary ance worked OT work Or OHR

01 Senait Bahiru 12,000 1000 10 6 AM to 10 PM 75

02 Petros Challa 2,400 __ 8 10 PM to 6 AM 15

03 Abdu 8,000 __ 6 Weekly Rest Days 50

Mohammed
04 Leilla Jemal 5,600 500 __ __ 35

05 Kirkos Wolde 4,000 500 10 Public Holidays 25

 Count…
Additional Information:
• Note that management of the agency usually expects an employee to work 40 hours in a week and
during Hidar 2011 all employees have worked as they have been expected. Besides, all workers of this
agency are permanent employees except Petros Chala and the monthly allowance of Kirkos Wolde is
not taxable; Abdu Mohammed agreed to have Br 200 be deducted from his earning and paid to the
Credit Association of the Agency as a monthly saving.
• Instructions: Based on the above information:
• Compute of earnings, deductions and net Pays
• Prepare a payroll register (or Sheet) for the agency for the month of Hidar, 2011
• Record the payment of salary as of Hidar 30, 2011 using Ck. No. 41 as a source documents
• Record the payroll tax expense for the month of Hidar, 2011. Memorandum No.006
• Record the payment of the claim of the credit Association of the agency that arose from Hidar's
payroll assuming that the payment was made on Tahsas 1, 2011
• Record the payments of withholding taxes and payroll taxes of the month of Hidar, 2011
• assuming that they have been paid on Tahsas 5, 2011 via Ck. No. 50
 Count….
Computations of Earnings, Deductions and Net Pays
OVERTIME EARNING:
• Overtime Earning = OT Hrs Worked (Ordinary Hourly Rate x OT Rate)
SENAIT BAHIRU
• 10 hrs (75 x 1.25) = Br 937.5
PETROS CHALLA
• 8 hrs (15 x 1.5) = Br 180
ABDU MOHAMMED
• 6 hrs (50 x 2) = Br 600
KIRKOS WOLDE
• 10 hrs (25 x 2.5) = Br 625
 Count….
GROSS EARNINGS:
• Gross Earnings = Basic Salary + Allowance + OT Earning
SENAYIT BAHIRU
• Br 12000 + 1000 + 937.5 = Br 13937.5
PETROS CHALLA
• Br 2,400 + 0 + 180 = Br 2580
ABDU MOHAMMED
• Br 8,000+ 0 + 600 = Br 8600
LEILLA JEMAL
• Br 5,600 + 500 + 0 = Br 6100
KIRKOS WOLDE
 Count…
• DEDUCTIONS AND NET PAY:
• SENAIT BAHIRU
• Gross Income (Gross Earning) = Br 13,937.5 and Taxable Income = Br 13,937.5
• Deductions:
Employee Income Tax:
• Tax = Taxable Income X Tax Rate _ Fixed Deduction
• Br 13937.5 x 35% _ 1500 = Br 3378.125
• Pensions Contribution = Basic Salary x 7% = Br 12000 x 7% = Br 840
 Count….
 Net Pay:
• Gross Taxable Income……………………….Br 13937.50
• Less: Deductions
• Employee Income Tax………..3378.125
• Pension Contribution…………840.00
• Voluntary Contribution………0.00
• Total Deduction………… 4218.125
Net Pay……………………..Br 9719.375
 Count….
PETROS CHALLA
• Gross Income = Br 2580 and Taxable Income = Br 2580
Deductions:
• Tax = 2580 x 15%-142.5 =244.50
• Pensions Contribution = Br 0.00, he is a Contractual worker
 Net Pay:
Gross Taxable Income…………………………… Br 2580.00
Less: Deductions
Employee Income Tax………224.50
Pension Contribution…………. 0.00
Voluntary Contribution………….0.00
Total Deduction………………...224.50
 Count….
 ABDU MOHAMMED
• Gross Income = Br 8600and Taxable Income = Br 8600
• Deductions:
• Employee Income Tax:
• Tax = 8600 x 30%-955 = Br 1625
• Pensions Contribution = Br 8000 x 7% = Br 560.00
• Voluntary Contribution = Br 200.00 payable to Credit Association
 Net Pay:
Gross Taxable Income……………….Br 8600.00
Less: Deductions
Employee Income Tax………..1625.00
Pension Contribution……….560.00
Voluntary Contribution……….200.00
Total Deduction…………………… 2385.00
Net Pay ………………………………………Br 6215.00
 Count….
LEILLA JEMAL
• Gross Income = Br 6100 and Taxable Income = Br 6100
 Deductions:
Employee Income Tax:
• Tax =6100 x 25%-565= Br 960
• Pensions Contribution = Br 5600 x 7% = Br 392
 Net Pay:
• Gross Taxable Income………………………Br 6100.00
• Less: Deductions
• Employee Income Tax………960.00
• Pension Contribution………. 392.00
• Voluntary Contribution………. 0.00
• Total Deduction……………1352.00
 Count….
KIRKOS WOLDE
• Gross Income = Br 5125 and Taxable Income = Br 5125 – 500 = Br 4625
Deductions:
• Employee Income Tax:
• Tax = 4625 x 20%-302.5 = Br 622.50
• Pensions Contribution = Br 4000 x 7% =Br 280
• Net Pay:
• Gross Taxable Income……………………………Br 5125.00
• Less: Deductions
• Employee Income Tax……………..622.50
• Pension Contribution……………… 280.00
• Voluntary Contribution…………….. 0.00
• Total Deduction…………………………….902.50
Count…
•Preparing a payroll register (or Sheet)
ETHIO RELIEF AGENCY
Payroll Register (Sheet)
For Month of Hidar 2011
Pay Day: Hidar 30,2011
Proving the Payroll:

Earnings Deductions
Ser Name Basic Allow Ove Incom Pensi Oth Gross Net
i. of Salary . r- Gross e on er Ded. Pay
No Employ De
time Earni Tax Ded.
ee ng d.

01 Senait 12,00 1000 937. 13,93 3378. 840 4218.

B. 0 5 8 125 125 9,719
02 Petros 2,400 - 180 244.5 - -
Ch. 2,580 244.5 2,336
03 Abdu 8,000 - 600 1625 560 200
M. 8,600 2385 6,215
04 Leila J. 5,600 500 - 6,100 960 392 - 1352 4,748
05 Kirkos 4,000 500 625 622.5 280 -
W. 5,125 902.5 4,223
Totals 32,00 2000 234 36,34 6830. 2072 200 9102. 27,24
0 2.5 3 125 125 0
Count….
Total Earnings: Proving the Payroll:

Basic Salary Br
32000.00

Allowance 2000.00
Overtime 2342.5.0
0
Total Earnings Br
36342.50
Deductions:
Employee Income Tax Br
6830.125
Pension Contribution 2072.00

Other deductions 200.00

Total Deductions Br
9102.125
Total Net Pays 27240
Total Deductions & Net pay Br
36342.50
 Count…
A. Recording the Payment of Salary on Hidar 30, 2011

Salary 36342.50
Expense
..........................................................................................................

Employee Income Tax 6830.125

Payable
.......................................................................................

Pension Contribution 2072

Payable
.......................................................................................

Credit Association 200

Payable
...........................................................................................

Cash 27240
.......................................................................................

Ck. No. 41

B. Recording the Payroll Tax Expense for Hidar, 2011

Ethio - Relief Agency incurred payroll tax expense of Br 3520 during Hidar, 2011. This is determined as the
product of the basic salary of all permanent employees and 11%. This is because the agency has to contribute
11% of the basic salary of every permanent employee to the government pension trust fund. Thus,

 Payroll Tax Expense = Total Basic Salary of all permanent Employees x 11%

12,000 0.11 1320

2,400 0.11 264

8,000 0.11 880

5,600 0.11 616

4,000 0.11 440

Total 3520
 Count….
By the amount of Br 3520 the agency's expense, payroll taxes expense, and pension contributions
payable increase. Therefore, the following journal entry is made as of Hidar 30, 2011:

Payroll Tax 3520

Expense
..................................................................................................

Pension Contribution 3520

Payable
...............................................................................

The source document is an internal office memorandum that indicates the incurrence of this expense.

A. Recording the payment of the claim of the credit Association

Credit Association 200

Payable
.......................................................................................

Cash 200
....................................................................
 Count…
A. Recording the payments of withholding taxes and payroll taxes of the month

Look at the account balances before payment:

Employee Income Tax Payable Pension Contribution Payable

Br 6830.125 2072.00

=Br 6830.125 3520.00

=Br 5592

Employee Income Tax 6830.125

Payable
.......................................................................................

Pension Contribution 5592

Payable
.......................................................................................

12,422.125
Cash
.................................................................
Ck. No. 50
After the payment of these liabilities have been posted, the above two accounts will have zero balances.
 Count….
Chapter 4
Accounting Concepts and Principles
4.1 Development of Accounting Concepts and Principles.
 Count…
Accounting theory consists of a set of basic concepts and assumptions and related principles
that explain and guide the accountant’s actions in identifying, measuring, and communicating
accounting information. This body of knowledge is referred to as “Principles” or “Generally
Accepted Accounting Principles” (GAAP) and followed as guides for developing and
communicating accounting information. In early stage of an economy, a business enterprise was
often managed by its owner and accounting records and reports were used mainly by the
owner. Banks and other lenders often rely on the personal relationship with the owner rather
than on the financial statements as the basis for making loans for business purpose and if a
large amount was owed to a bank of supplier the creditor often participated in management.
However, as the business grew in size and complexity management and outsiders become more
clearly differentiated. This size and complexity of the business results problems involved in the
issuance of financial statement to users. As a result, this development create an awareness of
the need for a framework of concepts and generally accepted accounting principles to serve as
guidelines for a preparation and auditing of the basic financial statement. These principles help
the financial statement to be reliable, understandable and comparable.
• The most influential organization in developing accounting concepts and principles are:
 Count…
 Financial Accounting Standards Board (FASB)
• The FASB is the primary authoritative body in developing and controlling setting process of accounting
principles and concepts (standards) for business organizations. The board issues statements of financial
accounting standards, which become part of GAAP and interpretations to explain, clarify or elaborate on
existing pronouncements which have the same authority as the standards.
 GASB ( Government Accounting Standard Board)
• The GASB has a responsibility for establishing the accounting standards to be followed by state and
municipal or other government institution.
 Accounting Organizations
• AICPA (American Institute of Certified Public Accountant)
• AAA (American Accounting Association)
• IMA(Institute of Management Accountant
• Each organization publishes monthly or quarterly periodicals and from time to time, issues other
publications in the form of research studies, technical opinions, etc
 Government Organizations
• SEC (Security and Exchange Commission)
 Count…
Basic Accounting Concepts and Principal
• Basic Assumptions
• Economic Entity Assumption- the economic entity can be identified with a particular unit of
accountability. Besides, the business is separate and distinct from its owners. As a result, entity’s assets
and other financial elements are not commingled with those of the owners. The economic entity
assumption is an accounting concept, and not a legal construct. Sometimes departments or divisions of
an entry may be considered separate entries.
• Going Concern Assumption - The business is assumed to continue indefinitely unless terminated by
owners. Following this assumption, in financial accounting:
• The basis of recording financial elements is historical accounting.
• Liquidation accounting (based on liquidation values) is not followed unless so indicated.
• Monetary Unit – Money is the common unit of measure of economic transactions. Because the use of
a monetary unit is relevant, and simple to understand, and it is assumed that the birr is assumed to
remain relatively stable in value.
• Periodicity (Time Period) Assumption – Economic activity of an entry may be artificially divided into
time periods for reporting purposes. Shorter time periods are subject to revisions but may be more
timely.
 Count….
Basic Principles
• The Cost Principle (Historical cost Principle) - requires that transaction be recorded at their acquisition price. Once
transactions are recorded at cost, then cost is not changed to reflect market price. The cost principle applies to assets
and liabilities. Users of financial statements may find current fair value information to be useful as well.
• The Revenue Recognition Principle - According to the revenue recognition principle, revenue is recognized when it is
earned and the amount can be objectively determined. Revenue is recognized at the time of sale. However, there are
exceptions.
• In long term construction (completed ) contracts (revenue is recognized only on completion of
contract)
• Where active markets exist for the product (revenue is recognized end of production and before sale).
• In installment sales contracts (revenue is recognized only on receipt of cash).
The Matching Principle – dictates that efforts (expenses) be matched with accomplishment
(revenue) whenever it is reasonable & practicable to do so.
Expenses in one period are matched to revenues of the same period. There should be a
logical, rational association of revenues and expenses. If an expense does not benefit future
periods, it is recorded in the current period. Both product and period costs must be
 Count….
 The Full Disclosure Principle- Financial statements must report what a reasonable person would need to know to make an
informed decision. Disclosure may be made:
• Within the body of the financial statements. (Asset, liability …)
• As notes to those statements (explains the item presented in the main body), or
• As supplementary information
• Constraints
• The Cost Benefit Rule- Cost- benefit rule states that the cost of providing information should not outweigh the benefit derived. This
rule often becomes difficult to apply because costs and benefits are not always obvious or quantifiable. As a result, sound judgment
must be used in providing information.
• Materiality- refers to an item’s importance to a firm’s overall financial operations. It is used to describe the significance of financial
statement information to decision makers.
• An item must make a difference to be material and be disclosed.
• It is a matter of the relative significance of the element.
• Both qualitative and quantitative factors are to be considered in determining relative significance.
• Industry Practices- the nature of some industries may sometimes require departures from basic accounting theory. If
applications of accounting theory results in statements that are not comparable or consistent, then industry
practices must be examined for possible explanations.
• Conservatism- suggests that the preparer, when in doubt, choose a conservative solution. This solution will be least
likely to overstate assets and income.
• Conservatism does not suggest that net assets or net income be deliberately understated.
• Example- LCM method of valuing inventories.
Count…

Well come to Chapter 5

Accounting for Partnership Form of Business Organizations
 Count….
• 5.1 INTRODUCTION.
• In your previous course you have studied the three most dominant forms of business
organization: sole proprietorship, partnership, and corporation. For accounting
purposes, each form should be viewed as an economic unit separate from its owners,
though legally only the corporation is considered separate from its owners. In the
previous section you have also studied the basic accounting principles and practices
used in accounting for a sole proprietorship form of business organization. The
accounting for corporate form of businesses will be explained in the next unit.
Therefore, the main focus of this chapter is to acquaint the learns with the basics of
accounting for partnerships. As will be explained later in this section, the same
accounting principles that are used in accounting for a sole proprietorship are applied
in partnership form of businesses. However, there are accounting practices that are
unique to partnerships. These unique accounting features relate to the partners’
capital and drawing accounts, division of income (or loss), and changes in ownership of
the partnership.
 Count…
Partnerships and Their Characteristics
A partnership is an association of two or more persons to carry-on as co-owners
of a business for profit. This association is based on a partnership agreement or
contract known as the articles of a partnership.
Partnership Agreement – written contract (voluntary ) that consists :-
 Name and capital contribution of the partnership
Rights and Duties of partners
Basis for sharing net income or net loss
Accounting for a partnership deals with
Formation
 distribution of profit and loss
 change in partnership members
Count….
CHARACTERISTICS OF A PARTNERSHIP
• For purposes of accounting, partnerships are treated as separate economic
entities. The next paragraphs describe some of the important features of a
partnership.
• A) VOLUNTARY ASSOCIATION
• A partnership is a voluntary association of individuals rather than a legal entity in
itself. Therefore, a partner is responsible under the law for his or her partner’s
business actions with in the scope of the partnership. 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
 Count…..
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 with in the apparent scope of the business’ operations.
• For example, a partner in a public accounting firm can bind the partnership
through the delivery of accounting services. redundant. 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
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
 Count….
• 5.3 Advantages and Disadvantages of Partnership
• Advantages:
• A partnership form of business ownership has the following advantages:
• Easy to form than a corporation. A partnership is easy to form. It only requires the
consent of two or more parties. Two or more competent persons simply agree to
be partners in some common business purpose.
• 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.
• 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
• Not required to observe on many restrictive laws unlike a corporation.
 Count…
DISADVANTAGES
• Partnership has the following disadvantages:
• 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).
• Disadvantageous if each partner does not exercise his/her good judgment
because one partner’s act can bind a partnership into a contract.
• Limited life. Partnerships are subject to possible termination due to many
uncontrollable circumstances such as the death of a partner.
• The transfer of ownership from one partner to another person is difficult unless
the remaining partners approve of this
 Count….
• 5.4 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.
• ILLUSTRATION
• Dr. Teklay and Dr.Mamo decided to form a partnership business, which would provide medical services.
They have been in business separately before they form the partnership. The partnership assumed the
liabilities of their separate business. The assets were valued and recorded at their current fair market
value.
• Shown below are the assets contributed and the liabilities assumed by the partnership at their fair market
value.
Dr. Teklay Dr. Mamo
• 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
 Count…
• The journal entry on January 1, 2002 to record the investment of each partner and the
formation of the partnership would be:
• 2002, Jan.1. Cash 6,500
• A/R 8,600
• Supplies 21,000
• Medical Equipment 3,000
• A/p 2,300
• Teklay Capital 36,800
• 2002, Jan.1. Cash 3,300
• A/R 4,300
• Supplies 12,000
• Building 150,000
• Accounts Payable 3,200
 Count….
• Division of Partnership Income and Losses
• A partnership’s income and losses can be distributed according to whatever
method the partners 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:
• return to the partners for the use of their capital – called interest on partners’
capital,
 Count…
• compensation for direct services the partners have rendered – called partners’
salaries, and
• 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:
• Net income divided in a stated ratio such as:
• equally
• agreed upon ratio (other than equally)
• ratio based on beginning capital balances
• Net Income divided by allowing interest on the capital investments, salaries, or
both with the remaining net income divided in an agreed ratio.
 Count…
• EXAMPLE
• Assume that Dr. Teklay and Dr. Mamo partnership had a net income of Birr 60,000
• Assume that the articles of a partnership provides equal share of Net Income or
• Loss.
• - In this case the capital accounts of each partner will be credited for Birr. 30,000
• Income Summary-------------------------------60,000
• Dr. Teklay capital-----------------------------------30,000
• Dr. Mamo capital------------------------------------30,000
• B) Net income is divided in ratio of 3.2 to Dr. teklay and Dr. Mamo respectively.
• - Income summary-------------------------------------60,000
• Dr. Teklay capital (3/5 X 60,000) --------------------------36,000
• Dr. Mamo capital (2/5 X 60,000) ---------------------------24,000
 Count….
 Net income is divided in a ratio of partners’ capital account balances at the
beginning
• of the fiscal period.
• Income summary ------------------------------- 60,000

• Dr. Teklay capital -----------------------------10,866 =(36800/203200 *60000)

• Dr. Mamo capital ------------------------------ 49,134=(166400/203200*60,000)

• 36800 + 166400 = 203200
• 2. Net income is divided by allowing 5% interest on their beginning capital balances,
a
• salary of Birr. 5,000 to Dr. Teklay and the remainder is divide equally.
 Count…
• NET INCOME DIVISION
Income to be
• Dr. Teklay Dr.Mamo Total Distributed
• Net income Birr, 60,000
• Interest (5%) 1,840 8,320 10,160
49,840
• Salary 5,000 -- 5,000 44,840
• Remainder 22,420 22,420 44,840 -- 0 –
• Distribution 29,260 30,740 60,000
• JOURNAL ENTRY
• Income summary ---------------------------- 60,000
• Dr. Teklay capital ---------------------------- 29,260
 Count…
• 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 Teklay and Mamo using assumed data
and the income division shown above is illustrated below.
• DR. TEKLAY AND DR MAMO
• Statement of partners’ Capital
• For the year Ended Dec, 31, 2002
Dr. Teklay Dr. Mamo
• 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
 Count….
• NB- The balance sheet of a partnership is different from that of a sole
proprietorship only
• in the owner’s equity section. In the partnership business since two or
more persons
• owns the business, there are two or more capital accounts whereas for a
sole
• proprietorship there will always be one capital account.
 Count…..
Dissolution of a Partnership
• Dissolution of a partnership occurs whenever there is change in the original
association of partners. When a partnership is dissolved, the partners lose
their authority to continue the business as a going concern.
• 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.
 Count…
• 5.7.1. 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:
• By purchasing ownership right from one or more of the original partners, or
• By investing assets in the partnership
Count….

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, for example, Sister Helen joins the partnership of Dr. Teklay and Dr. Mamo by buying
ownership right of Br. 8000 from Dr. Mamo. The entry to record the admission of Sister Helen and the
transfer of the ownership right from the capital account of Dr. Mamo to the capital account of Sister
Helen in the partnership books shown below
• Journal entry
• Dr. Mamo---------------------------------- 80,000
• Sr. Helen --------------------------------------80,000
• The price that sister Helen paid to Dr. Mamo 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.
 COUNT….
 Admission by Investing Assets
• Assume that instead of purchasing ownership right from the existing partners, Sister Helen invested cash of Br.
80,000 into the partnership. In this case both partnership assets and total owners’ equity are increase. The
journal entry must record such an investment and the increase in partnership assets.
• Consider the following scenarios as an example:
• Sister Helen receives a 50% ownership right in the partnership. Assume also that Dr. Teklay and Dr. Mamo’s capital balance
were Br. 25,000 and Br. 55,000 respectively. Dr. Teklay and Dr. Mamo share income in a ratio of 2:1 respectively.
• JOURNAL ENTRY
• Sister Helen’s capital account would be credited for Br. 80,000 i.e., (55,000 + 25,000 + 80,000) X ½.
• Cash------------------------------------------80,000
• Sister Helen, Capital------------------------80,000
• 2- Sister Helen receives a one –fourth ownership right upon admission.
• Assume everything else as above. In this case Sister Helen’s capital account would be
• credited for birr 40,000 ie, (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.
 Count….
 RETIREMENT OR WITHDRAWAL OF A PARTNER
• When an existing partner withdraws he/she can sell his/her ownership right or he/she can
withdraw assets from the partnership. Both options are considered below.
• 1. Sale of Ownership Right to the Existing Partner
• When ownership right is sold by a withdrawing partner to an existing partner, the entry on the
partnership’s books transfers the retiring partner’s capital balance to the buyer’s capital
account.
• Example:
• Dr. Mamo withdraws from the partnership because of a disagreement. He sells his Br. 38,333
ownership right to Dr. Teklay.
• JOURNAL ENTRY
• Dr. Mamo Capital----------------------------- 38,333
• Dr. Teklay Capital ----------------------------- 38,333.
• The amount paid by Dr. Teklay is not recorded on the partnership books, because the
transaction involves no flow of assets to or from the partnership.
 Count…..
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 Dr. Mamo was paid Br. 50,000 cash when he withdraws from the partnership of T,M&H.
The capital balances of each partner were as follows as of that date:
•
• Dr. Teklay capital ---------------------------Br. 100,000
• Dr. Mamo capital --------------------------- --- 50,000
• Sister Helen capital ----------------------------- 35,000
• Total Equities Birr 185,000
•
• JOURNAL ENTRY
• Dr,Mamo capital -------------------------------- 50,000
• Cash -----------------------------------------------------------50,000
 Count…..
• b) Assume Dr. Mamo was paid Br. 56,000 instead of Br. 50,000, the excess amount of
Birr 6,000 is charged to the remaining partner’s capital accounts based on the
income- sharing ratio. (Assume a 3:2:1 income-sharing ratio between Dr Teklay Dr.
Mamo and Sister Helen respectively).
• JOURNAL ENTRY
• Dr. Mamo capital ------------------------------50,000
• Sister Helen capital ---------------------------- 1,500
• Dr. Teklay capital ------------------------------ 4,500
• Cash ----------------------------------------------------56,000
• The Birr 6,000 excess is shared on the basis of a 3:1 ratio, i.e., Dr. Teklay would be
charged for 6,000 X c/4 = birr 4500, and Sister Helan would be charged for
• Birr 6000 X ¼= Birr 1500.
 Count…
Liquidation of a Partnership
• Liquidation of a partnership is the process of ending the business, of selling enough assets to pay the
partnership’s liabilities and distributing any remaining assets among the partners.
• Liquidation is a special form of dissolution. When a partnership is liquidated, the business will not continue.
• A partnership may be liquidated if:
• the time period for which the partnership was formed expires (ends)
• newly enacted laws have made the partnerships activities illegal,
• 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
I
Ill
llu
ust
stra
Count…..
rattio
ion
n

TThe
he papart
rtne
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rshi
hipp oof
f Re
Resosomm,, Su
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nd TTas
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. T
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and
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 Count….
• CASE ONE: GAIN ON REALIZATION
• Assume that Resume, Sultan, and Tassew 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
Resom, sultan and Tassew 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
 Count…
• - Liabilities……………………….10,000
• Cash………………………………..10,000
• To record the settlement of partnership liabilities.
• After the above entries are posted, the partners’ capital accounts shows:
• R’s Beg Bal. 30,000 + 2,000 = Birr 32,000
• S’s Beg Bal. 30,000 + 1,750 = Birr 31,750
• T’s Beg Bal. 30,000 + 1,250 = Birr 31,250
•
• The cash account now shows a balance of Birr 95,000 (10,000 + 95,000 – 10,000). The entry recorded upon
distribution of this cash among the partners would, therefore, be
•
• R, capital……………………… Birr 32,000
• S, capital……………………… Birr 31,750
• T, capital……………………… Birr 31,250
• Cash-------------------------------------95,000
• To record the distribution of cash among the partners.
 Count…
• CASE TWO: LOSS ON REALIZATION: NO CAPITAL DEFICIENCIES
• Assume that Resom, Sultan, and Tassew 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-----------------------20,00
• Other Assets-------------------------------------90,000
•
• To record the sale of the assets
•
• -R capital---------------------- (40% X 20,000) -----------------8,000
• S capital----------------------- (35,000 X 20,000) --------------7,000
• T capital ---------------------- (25% X 20,000) --------------- 5,000
• Loss on Realization ------------------------------------- 20,000
• To distribute the loss on realization
 Count…
• Liabilities ---------------------------------- 10,000
• Cash -----------------------------------10,000
• To record the settlement of partnership liabilities
• After the above entries have been posted; the accounts show cash 70,000 R, cap.
Birr22,000 S,cap. Birr 23,000 and T, cap. Birr 25,000. The entry to record the cash
distribution to the partners would, therefore, be as follows:
•
• R cap --------------------------------- 22,000
• S cap ----------------------------------23,000
• T cap --------------------------------- 25, 000
• Cash -------------------------------------- 70,000
• Entry to record the distribution of cash to partners.
 Count…
• CASE THREE: LOSS ON REALIZATION WITH DEFICIENCY IN ONE PARTNER
CAPITAL
• Assume the non-cash assets of R,S and T partnership are sold for only Birr 10,200, incurring a loss of Birr 79,800,( Birr
90,000 – Birr 10,200). The entries to record the division of loss among the partners and the liquidation to this point are
shown below:
• Cash -------------------------------- 10,200
• Loss on sale of Assets ----------- 79,800
• Other Assets-------------------------- 90,000
• To record the sale of asset
• R capital (79800 X 40%) ----------------------31,920
• S capital (79800 X 35%) ---------------------- 27,930
• T capital (79800 X 25%) ---------------------- 19,950
• Loss on sale of Assets ---------------------------- 79,800
• To distribute loss on realization
• - Liabilities ----------------------------------- 10,000
• Cash ------------------------------------------------10,000
 Count….
• At this stage of the liquidation the capital accounts of the partners have the following
balances
• R capital = 30,000 – 31920 = 1,920
• S capital = 30,000 – 27930 = 2,070
• T capital = 30,000 – 19950 = 10,050
• Only Birr 10,200 cash is available (10,000 + 10200 – 10,000) for distribution to S and T
while the combined balances of their capital accounts is Birr 12,120. Therefore,
additional Birr 1,920, (12120 – 10200) is needed which is the amount owed by R to the
partnership.
• Therefore, either R will have to pay this amount first and the cash will be distributed to
S and T, or S and T will have to share the Birr 1920 loss in their income and loss-sharing
ratio of 35:25.
• Let’s assume, the loss was distributed since R couldn’t pay the amount immediately.
 Count…
• JOURNAL ENTRIES
• S capital (35/60 X 1920) -------------- 1,120.00
• T capital (25/60 X 1920) -------------- --800.00
• R capital -------------------------------------1,920
• To charge R’s capital deficiency to S and T
• S, capital -----------------------------------950.00
• T, capital -----------------------------------9,250.00
• Cash ----------------------------------------------10,200
• To record the final cash distribution to partners.
R
R
Count….
,
, S,
, T
TPA
PARTNE
NERS
SHIP
P
ST
TA
AT
TEM
ME
ENT
TOF
F PA
PAR
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HI
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UID
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F
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r p
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odd S
Seep
ptt.
. 1
1--1
155,
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0002
2

N
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n c
cas
ash
h =
= L
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abbi
illi
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s +
+ C
Caap
piit
taal
l

C
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shh +
+ A
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sett

R
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(40
0%%)
) S
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Count….
CHAPTER SIX
ACCOUNTING FOR CORPORATIONS.
 Count….
• 1 Introduction
• Assume that you are planning to start a new business. Would you choose a sole proprietorship, a partnership or a
corporation? In principles of accounting 1 and previous chapter of principles of accounting you have studied about
the first two forms of business organizations. In this chapter the importance of corporate form of organization will be
discussed.
• 6.2 Definition of 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.
• 6.3 Characteristics of Corporation
• Among the characteristics of a corporation are:
• a) A corporation is a separate legal entity. According to the law a corporate entity may own property in its own
name, may enter into contract and responsible for its own debts.
• A corporation has a legal status in court. According to the law a corporation may sue and be sued as if it were a real person.
• A corporation has its own charter. A corporation is created by obtaining charter from the state in which the company is to be
incorporated.
• A corporation pays income taxes on its earnings. The income of a corporation is subject to income taxes, which must be paid by the
corporation.
 Count….
• 6.4 Advantages of the Corporate Form of Organization
• A corporate entity has many advantages not available in other forms of organization. Among the
advantages are the following:
• 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.
• 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.
• 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.
• 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
 Count….
• 6.5 Disadvantages of Corporate Form of Organization
• Some of the disadvantages of the corporation are:
• 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.
• Difficulties to control: since ownership is usually separated from managements, owners are
unable to exercise active control over management actions.
• 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.
• 6.6 Formation of A Corporation
• A corporation is created by obtaining a corporate charter. The charter is given from the states
in which the corporation is to be incorporated. To obtain a corporate charter an application
called articles of incorporation are prepared by t he organizers called incorporators and
submitted to the state corporations commissioner or other designated officials.
 Count….
• 6.6.1 Organization costs
• In the process of incorporation, the organizers must pay for necessary costs such as payment
of an incorporation fee to the state, payment of fees to attorneys for their services in drawing
up the articles of incorporation, payment to promoters and variety of other outlays necessary
to bring the corporation into existence. These costs are charged to an asset account called
organization costs. In the balance sheets, organization costs appear under the ‘other assets’
caption.
• 6.6.2 Rights of Stockholders
• The stockholders who are the owners of a corporate entity have the following basic rights:
• The rights to votes: the common stockholders have the right to elect the board of directors,
and thereby to be represented in the management of the business.
• The rights to participate in the earnings of a corporation: Stockholders in corporations may
not make withdrawal of company assets. However, the earnings of a profitable corporation
may be distributed to stockholders is the form of cash dividend. The payment of a dividend
 Count…
• Pre-emptive rights: the current stockholders has the right to purchase the shares of the
corporation on a prorate basis when new stocks are offered for sale. This preemptive rights is
designed to provide each stockholder the opportunity to maintain a proportional ownership in
the corporation.
• 6.7 Authorization and Issuance of Stocks
• The state officials approve the articles of incorporation, which specify the number of shares a
corporation is authorized to issue. The total number of shares that may be issued is known as
the authorized shares. When the corporation receives cash is exchange for stock certificates,
which represents the number of shares issued, the shares become issued shares. Shares that are
issued and held by the stockholders are called outstanding shares. Sometimes a corporation
requires shares from its own shareholders. These shares are called treasury stocks, which reduce
the number of outstanding shares.
• A corporation may choose not to issue immediately all the authorized shares even though it is
customary to have a large number of authorized shares than presently needed. If more capital is
needed, the previously authorized shares will be readily available for issue. A corporation can
apply to the state for permission to increase the number of authorized shares.
 Count….
• 6.7.1 Types of Stocks/Shares
• Many corporations issue several classes of capital stock, each providing investors with
different rights and opportunities. The basic types of stock issued by every corporation is called
common stock. Common stock possessed the traditional rights of ownership such as voting
rights, participation residual dividends, and residual claim to assets in the event of liquidation.
When any of these rights is modified, the term preferred stock is used. Preferred stock specifie
different rights that distinguish it from common stock. Some of the distinctive features for
preferred stocks are priority claims on dividends, cumulative dividend rights, priority as to
assets is the event of liquid action of a corporation and no voting power.
• Stocks according to their nature are classified into par value and no-par stocks. Par value stock
with a designated dollar amount per share as stated in the corporate charter and printed on
the stock certificates. On the other hand, some states allow corporations to issue stocks
without designating a par value. Such stocks are called no-par stocks. When no par stocks are
issued by a corporation, the entire issuance price is viewed as a legal capital, which is subject t
withdrawal. Sometimes some states authorize the issuance of no-par stock with a stated, or
assigned, value per share that is established permanently by the corporate directors and is in
the laws. Most corporations use a stated value for no par stock.
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• 6.7.2 Issuance of Par-value Stocks
• 6.7.2.1 Authorization
• Authorization of par value stocks, specified in the unit may be recorded as a memo entry in the general journal
and in the ledger accounts. Most states require the total number of shares authorized be shown on each stock
certificate, in addition to the number of shares represented by that particular stock certificates.
• 6.7.2.2 Par value stock issued for cash
• When stocks are issued to various investors, a stock certificate specifying the number of shares represented is
prepared for each investor/or stockholder. When par value stock is issued for cash, the capital stock account is
credited with the par value of the shares issued regardless of whether the issuance price is more or less than
par. If par value stock is issued for more than par value (at premium), paid in capital in excess of par account is
credited for the excess of selling price over par. This paid in capital is excess of par does not represent a profit
to the corporation rather it is part of the invested capital. If par value stock is sold by corporation for less than
par (at discount), a negative stockholders’ equity accounts, Discount on common (or preferred) stock, is
debited for the amount of the discount.
• For example, assume that 50,000 shares of Br. 2 par value common stock have seen authorized and that 10,000
of these authorized shares are issued at a price of Br. 10 each. The entry would be:
• Cash………………………………………………………100.000
• Common Stock…………………………………..20,000
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• 6.7.2.3 Par value stock issued on a subscription basis
• During the start-up of a corporation, prospective investors may sign a contract to
purchase a specified number of shares on credits with payments due at one or more
specified future dates. One reason for this procedure is to attract small investors.
Another reason is to appeal to investors who prefer not to invest cash until the
corporation is ready to start business operations. A corporation may also sell its
capital stock on credit after incorporation.
• When stock is subscribed, the company debits stock subscription receivable for the
subscription price, credits capital stock subscribed for the par value of the
subscribed shares, and credits paid in capital in excess of the subscription price over
par value. Later, as cash is collected, the entry is a debit to cash and a credit to stock
subscription receivable. When the entire subscription price is collected, the stock
certificates are issued for the subscribers. The issuance of stock is recorded by
debiting capital stock subscribed and crediting capital stock. The following
illustration demonstrates the accounting procedures for stock subscriptions.
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• Assume that 120,000 shares of RAM corporation common stock, par br. 10, are subscribed for at Br. 12 by Misrak Binda.
The total is payable in three installments. The following entries are processed by RAM Corporation.
• Common stock subscription Receivable 1,440,000
• Common stock subscribed 1,200,000
• Paid-in-capital in excess of par 240,000
• To record receipt of subscription for 120,000 shares
• Cash 480,000
• Common stock subscription receivable 480,000
• To record receipt of 1st payment
• Cash 480,000
• Common stock subscription Receivable 480,000
• To record receipt of final payment
• Cash 480,000
• Common stock subscription Receivable 480,000
• To record receipt of final payment
• Common stock subscribed 1,200,000
• Common stock 1,200,000
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• 6.7.2.4 Non Cash Issuance of Capital Stock
• Corporations sometimes issue capital stock for non-cash assets such as in exchange for real estate. The
current markets value of the stock issued or the non-cash consideration received, whichever is must
reliable, determinable, is used to record the transaction. If the market value of either capital stock issued
or the no cash items are not reliable, the value are established by the corporation’s board of directors.
• 6.7.2.5 Issuance of No-par Stock
• Some states allow corporations to issue stock without designating a par or stated value. When this no
par stock is issued, the entire issuance price is credited to the capital stock account and is viewed as legal
capital not subject to withdrawal.
• 6.8 Accounting for Retained Earnings and Dividends
• 6.8.1 Nature of Retained Earnings
• Capital provided to a corporation by stockholders in exchange for shares of either preferred or common
stock is called paid in capital or contributed capital. The second major type of stockholders’ equity is a
retained earnings. The amount of the retained earnings account at any balance sheet date represents
the accumulated earnings (net income) of the company since the date of incorporation, less any losses
and all dividends distributed to stockholders.
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• 6.8.2 Nature of Dividends
• A dividend is a distribution of earnings to stockholders is the form of assets or shares of the
issuing company’s stock. Type of dividends includes the following.
• Cash dividend
• Cash disbursed
• Property Dividend
• Non cash assets disbursed
• Stock Dividend
• Corporations own stock disbursed
• Liquidating Dividend
• Return of contributed capital
• Scrip Dividend
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• 6.8.3 Relevant dividend dates
• Prior to payment, dividends must be declared by the board of directors of the
corporation. The important dividend dates are:
• Date of Declaration: on this date, the corporation’s board of directors formally approves
and announces the dividend to be distributed. The declaration is recorded on this date
as a debit to dividends and a credit to dividends payable.
• Date of payment: this date is determined by the board of directors and is usually stated
is declaration. At the date of payment the liability recorded at the date of declaration is
debited and the appropriate asset account is credited.
• 6.8.4 Dividend and Characteristics of preferred stock
• A corporation with both preferred stock and common stock may declare dividends on
the common only after it meets the requirements of the stated dividend on the
preferred. The preferred dividend may be stated in monetary terms or as a percent of
par.
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• 6.8.4.1 Participating and non-participating preferred stock
• A participating preferred stock receives a minimum dividend but also receives higher dividend when the
company pays substantial dividends on common shares. The preferred stockholders’ right may be to receive
dividend only a stated amounts. Such stock is said to be nonparticipating.
• To illustrated, assume the following information
• Common stock issued 4,000
• Preferred stock issued 2,000
• Dividend per share of preferred stock Br. 10
• The corporation reported net income of Br. 150,000 for the third year and the BOD declared both of the net
income as dividend. If the preferred stock issued by the corporation is participating, the preferred
stockholders will receive. Br. 30,000 (Br. 20,000 + Br. 10,000), and the common stockholders will receive Br.
60,000 (Br. 40,000 + Br. 20,000)
• 6.8.4.2 Cumulative and Non-cumulative preferred stock
• Cumulative preferred means that if the company fails to pay a preferred dividend, its obligation accumulates
and all omitted dividends must be paid in the future before any common dividends are paid. The cumulative
preferred stockholders would receive all accumulated unpaid dividends (called dividend in arrears) before the
holders of common shares receive anything. Preferred stock not having this cumulative rights is called no
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• For example, assume the following information
• Cumulative preferred, 10% of Br. 100 par (10,000 shares issued)
• Common stock of Br. 90 par (40,000 shares issued)
• The Board of Directors (BOD) did not declare dividend in year 2
• Year 3 dividend declared by the BOD amounts to Br. 320,000.
• Year 1 dividend declared and distributed amounts to Br. 200,000.
• If the preferred stock is cumulative, the preferred stockholders will receive Br. 200,000 (Br. 100,000 + Br.
100,000), and the common stock holders will receive Br. 120,000 (Br. 320,000 – Br. 200,000).
• 6.9 Accounting for Treasury Stocks
• Treasury stock is a corporation’s own stock (preferred or common) that has been issued and required
by the issuing corporation. A corporation may also accept shares of its own stock in payment of debits
owed by a stockholder or as a donation from a stockholder.
• Treasury stock does not reduce the number of shares issued, but does reduce the number of
outstanding shares. The purchase of treasury stock decreases both assets and stockholders’ equity.
Moreover, treasury stock does not carry voting, dividend, preemptive, or liquidating rights and is not
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• 6.9.1 Reasons to acquire Treasury Stocks
• In general treasury steps are to acquire for the following reasons:
• To support (increase) the markets price of the stock
• To increase earnings per share by reducing the number of shares outstanding.
• To reduce dividend payment payments by reducing the number of shares outstanding.
• To provide shares for reassurance to employees as a bonus
• To use the share acquired for stock dividend
• To reissue with a higher price
• 6.9.2 Recording and reporting Treasury stock Transactions
• There are several methods of accounting for the purchase and the resale of treasure stock. A
commonly used method is the cost basis. When the stock is purchased by the corporation,
treasury stock account is debited for the price paid for it. The par and the price at which the
stock was originally issued are ignored. When the stock is resold, treasury stock is credited at the
price paid for it, and the difference between the price paid and the selling price is debited or
credited to an account entitled paid in capital from sale of treasury stock.
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• To illustrate the cost method, assume that Harambe Corporation had 50,000 shares of Br. 10 par
common stock outstanding at the beginning of the current year. The company purchased 500
shares for cash and received 500 shares in settlement of a debt from stockholders. The markets
price of stocks was Br. 30/share. The following entry is required involving the transactions.
• Treasury stock 30,000
• Cash 15,000
• Notes Receivable 15,000
•
• If the company sells 600 shares of the treasury stock for Br. 31 each, the entry would be:
• Cash 18,600
• Treasury stock 18,000
• Paid in capital from sale of 600
• Treasury stock
• Paid in capital from sale of treasury stock is reported in the paid in capital section of the balance
sheet. Treasury stock is deducted from the total of the paid in capital and Retained earnings.
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• 6.10 Equity per Share
• The amount appearing on the balance sheet as total stockholders’ equity can be stated in
terms of the equity per share. When there is only one class of stock, the equity per share
is determined by dividing total stockholders’ equity by the number of shares outstanding.
For a corporation with both preferred and common stock, it is necessary first to allocate
the total equity between the two classes.
• To illustrate, consider the following statements of stockholders’ equity at December 31,
19x1.
• - to preferred stock, Br. 50 par value, authorized 20,000 shares, issued and
• Outstanding 12,000 share Br. 600,000
• - Common stock, no par, stated value Br. 2 per share,
• authorized 500,000 shares, issued 400,000 shares of which 25,000
• shares are held is the treasury 800,000
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• - Paid in capital is excess of per
• -Preferred Br. 50,000
• -Common 1,000,000 1,050,000
• - Retained earnings
2,000,000
• Subtotal Br. 4,450,000
•
• - Less cost of 25,000shares of common stock
• Reacquired and held in treasury
250,000
• - Total stockholders’ equity Br.
4,200,000
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• If the preferred stock is entitled to receive Br. 105 per share upon liquidation and if there is no
preferred dividend in arrears, the computation of earnings per share are as follows:
•
• Preferred EPS = Equity allocated to preferred stock
• Number of o/s shares of preferred stock
• = 105 X 12,000
• 12,000
• = Br. 105/share
•
• Common EPS = Equity allocated to common stock
• Number of o/s shares of common stock
• = 2,940,000
• 375,00
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•RIFT VALLEY UNIVERSITY

•DEPARTMENT OF ACCOUNTING
PREPARED BY TEMESGEN TEKA .
AND FINANCE
•FUNDAMENTAL OF
ACCOUNTING-II
•INSTRUCTOR: TEMESGEN TEKA .