Principles of Accounting II (ACPF 202); Lecture note

UNIT ONE
ACCOUNTING FOR MERCHANDISING INVENTORIES
In a merchandising business, inventory consists of items or commodities owned
and held for sale to customers in the ordinary courses of the business. For
example, in a grocery store, canned goods, dairy products and meats, are among
the inventory items to be held by merchandise business.
Their inventory is usually classified in to three categories:
Finished Good Inventory: consists of completed products ready for sale. This
inventory is similar to merchandise inventory.
Work In Process (Goods in process) Inventory: consists of products in the
process of being manufactured but not yet completed.
Raw Materials Inventory: refers to the goods a company acquires to use in
making products.

Inventory Systems
The two inventory systems are periodic and perpetual.
1. Periodic Inventory System
A periodic inventory system updates merchandise inventory account only at the
end of a period to reflect the quantity and cost of goods on hand and goods sold.

When new merchandise are bought ,it is recorded on a temporary account

called purchase
When merchandise is sold, only revenue/sales is recorded
It does not require continual updating of inventory account
Taking physical count of inventory is mandatory to determine the amount of
inventory on hand
2. Perpetual Inventory System

It is inventory system that keeps a continual record of the amount of inventory at

its purchase and up on each sale.

It uses a merchandise account to accumulate cost of inventory purchased

When an item is sold, the cost of merchandise balance is reduced and cost of
good sold is increased by the amount of merchandise sold.
Cost of good sold is also updated after each sale;

Principles of Accounting II (ACPF 202); Lecture note

The cost of goods sold account at all times equals the cost of merchandise sold
during the period, and the merchandise inventory account at all times equals
the cost of merchandise on hand.
Comparison of Periodic and Perpetual inventory system
Transactions

Journal entries under

periodic system

Journal entries under Perpetual

system

Purchase of
Merchandise on
Account
Sales of
merchandise on
Credit

Purchase -------- XX
Account payable ---XX

Account receivable XX
Sales revenue -----------XX

End of period
entries for
inventory
account

Adjusting entries are necessary

Income summary --------XX
Merchandising inve,beg.-- XX
Merchandising inve. End XX
Income summary ----XX

Merchandising inve.----- XX
Account payable --------- XX

Account receivable --------XX

Sales revenue ---------------XX
Cost of goods sold ----------XX
Merchandising inve. ----- XX
No adjusting entries are needed.
The account merchandise inventory
shows the ending balance

Example: Inventory, purchase and sales date for ABC Company for the year 2007
are given as under:
January 1,2007 Merchandising inventory ( beginning ) --------- Br. 52,500
January 1- 31, 2007 Purchases (on account) ----------------------- 26,200
January 1- 31, 2007 sales (on account) --------------------------- 49,750
Sales - cost price ---------------------------------------------------------- 28,000
January 31 merchandising inventory (ending) ----------------------- 50,700
Journal entries for both periodic and perpetual systems.
Periodic
Perpetual
January 1,
inventory
Jan.1-31
purchase
Jan. 1-31 sales

Adjusting
entry on
jan.31
Cost of
merchandise
sold

Mdse inv. reflect balance of

inventory on hand Br.52,500

Mdse inv. account reflects inventory,

on hand Br.52,500

Purchase -------26,200
Account payable --- 26,200

Merchandise inventory --26,200

Account payable ------26,200

Account receivable 49,750

Sales ----------- 49,750

Account receivable ----49,750

Sales --------------------- 49,750
Cost of goods sold -------28,000
Merchandise inventory -28,000

Income summary --52,500

Merchandise inve. 52,500
Mdse inve. --50,700
Income summary----- 50,700
Jan. 1. inventory --Br.52,500
January purchase-------26,200
Mdse av. for sale ---Br.78,700

No adjusting entry is necessary

Cost of merchandise sold account
balance shows Br. 28,000. Thus,
there is no need of extra
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Principles of Accounting II (ACPF 202); Lecture note

Reports of
mdse on the
balance sheet

Less: Jan.31 inventory----50,700

Cost of goods sold ----Br.28.000
Merchandise inve.--Br.50,700

computation to arrive at the

balance of cost of good sold.
Merchandise inve. ---Br.50,700

Determining Ownership of Goods

Inventories in Transit:
Goods are considered to be in transit when they are in the hands of a public carrier.
A. FOB (Free On Board) Shipping Point
When terms of sales are FOB shipping point:
Ownership of the goods passes to the buyer when the public carrier accepts the
goods from the seller, or
The title passes to the buyer when the seller delivers the merchandise to the shipper.
Goods in transit have to be included in the ending inventory of the purchaser.
Transportation costs and subsequent costs incurred in making ready the
merchandise for sale are borne by buyer.
B. FOB (Free on board) Destination
When terms of sales are FOB destination:
Legal title to the goods remains with the seller until the goods reach the buyer.
The title passes to the buyer when the buyer received the merchandise.
Goods in transit are not included in the ending inventory of purchaser.
Transportation costs and subsequent costs incurred until the buyer received the
merchandise are borne by seller.
Inventory Transferred on Consignment Basis
In some lines of business, it is customary to acquire merchandise on consignment basis. Two
bodies are involved in the consignment process- the consignee and the consignor.
Consignee:
A firm that acts as an agents of another firm.
The holder of goods.
Does not own the goods (never has title to the goods).
The consignee does not own consigned goods;
They should not be included in the consignee's physical inventory count.
The party receiving the goods
Usually work on commission basis
Consignor:
The shipper of the goods
A firm that sales its product through other firm.
Ownership remains with consignor until the goods are actually sold to a customer.
The consignor should include merchandise held by the consignee as part of its
inventory
Determining the Cost of Inventory
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Principles of Accounting II (ACPF 202); Lecture note

The cost of merchandise include among others:
Purchase price or purchase invoice
Transportation costs
Customs duty if imported
Loading and unloading costs
if the term is FOB shipping point.
Insurance in transit
Inventory Cost Flow Assumptions
The three most common assumptions of determining the cost of the merchandise sold are:
1. First-In, First Out.
2. Last In, First Out.
3. Weighted Average of the expenditure.
1) First-In; First -Out Method (FIFO).
Under FIFO cost flow assumption:

Items (goods) purchased first are assumed to have been sold first.

Ending inventory comprises the most recent costs.

It parallels the actual physical flow of merchandise

To illustrate the three-cost flow assumptions let us assume that the following data are taken
from Future Merchandising Business for its TV set.

FUTURE MERCHANDISING BUSINESS

TV SET

Date

Explanation

Jan. 1.
Mar.10
Sep. 21
Nov. 18

Inventory (beginning)
Purchase
purchase
purchase
Total

Units
200
300
400
100
1,000 units

Unit Cost
Br. 9
10
11
12

Total Cost
Br. 1,800
3,000
4,400
1,200
Br. 10,400

Step 1: Determine Cost of Ending Inventory

Solution: - Most recent costs, Nov.18..............100 units x12 =Br.1, 200
Next most recent costs, Sept.21......200 units x 11 = 2,200
Inventory Dec.31..........................

300 units

Br. 3,400

Step 2: Determine Cost of Goods Sold

Costs of goods sold = merchandise available for sale - Ending inventory
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Principles of Accounting II (ACPF 202); Lecture note

CGS =
=

Br. 10,400

3,400

Br. 7,000

2) Last-In; First-Out method (LIFO)

Under LIFO cost flow assumption:

Goods purchased last are assumed to have been sold first.

The ending inventory comprises purchases made earlier in a year.

Based on the illustrative data presented above the cost of the 300 units of inventory is
determined in the following manner.
Step 1: Determine Cost of Ending Inventory
Solution: - Earliest costs, Jan. 1 ...............200 units at Br. 9 ..........Br. 1,800
Next earliest costs, Mar. 10 ....100 units at

10..........Br. 1,000

Inventory Dec. 31 ...................300 units

Br.2,800

Step 2: Determine Cost of Goods Sold

Cost of Merchandise Sold = Merchandise available foe sale - Ending inventory
CGS

Br. 10,400

Br. 7,600

Br. 2,800

3) Average Weighted Method

Under Average cost flow assumption:
o The goods available for sale are homogeneous.
o Average unit cost has to be determined and applied to both ending inventory and
beginning inventory.
Cost of Goods Available for Sale = Weighted Average Unit Cost
Total Units Available for Sale
Average unit cost......... Br. 10,400 1,000 units =

Br.10.40/unit

This shows that each unit of goods sold and unit of inventory on hand is calculated using this
average unit cost.
Step 1: Determine Cost of Ending Inventory
Inventory Dec. 31 ..........

300 units @ Br.10.40..... Br. 3, 120.

Step 2: Determine Cost of Goods Sold

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Principles of Accounting II (ACPF 202); Lecture note

Cost of goods sold = Merchandize available for sale - Ending inventory
=
Br. 10,400
Br. 3,120
=
Br. 7,280
Determining Inventory Cost under Perpetual Inventory system
All of the three inventory costing flow methods described in the periodic inventory system are
equally applicable in a perpetual inventory system (FIFO, LIFO and WA).
To illustrate these cost flow assumptions, late us use the following data related to items XXL of
Aba-Sena Company for the month Novenmber, 2006.
Date
Explanation
Units
Cost per unit
Nov.1
Inventory (Beginning)
Br. 7
Br.18
6.
Purchase
10
19
10.
Sales
10
13.
Sales
3
16.
Purchase
12
20
18.
Sales
6
23.
Sales
5
30.
Purchase
15
24
Required: determine the ending inventory and the cost of goods sold under each method:
FIFO (First-In; First-Out)

Date
Nov.1
6

Purchases
Qty

UC

TC

10

19

190

10
13
16

12

20

Inventory on hand

Qty

UC

TC

Qty
7
7
10

UC
Br.18
18
19

TC
126
126
190

7
3
3

18
19
19

126
57
57

7
4

19
19

133
76

4
12
10

19
20
20

76
240
200

20

100

5
15
20

20
24

100
360
Br.460

240

18

4
2
5

23
30

Cost of goods sold

15
37+7=44

24

19
20
20

76
40
100

360
Br.916

24

Br.456

Units of ending inventory = 5 units + 15 units = 20 units

Cost of Ending inventory = Br.100+ Br.360 =Br.460
Cost of goods(merchandize sold)=126+57+57+76+40+100=Br.456
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Principles of Accounting II (ACPF 202); Lecture note

LIFO (Last-In; First-Out)

Date

Purchase
Qty

UC

TC

Cost of goods sold

Inventory on hand

Qty

Qty

UC

TC

Br. 18

Br. 126

18
19
18

126
190
126

UC

TC

Nov.1
6

10

10

10

19

190

7
10
7

13

18

54

18

72

4
12

18
20

72
240

4
6
4
1
4
1
15
20

18
20
18
20
18
20
24

72
120
72
20
72
20
360
Br.452

16

19

12

20

190

240

18

20

120

23

20

100

30

15

24

37+7=44

360
Br.916

24

Br.464

Cost of Ending Inventory = Br. 72+ Br. 20+ Br. 360= Br. 452
Cost of Goods Sold = Br. 190+ Br. 54+ Br. 120+ Br. 100= Br. 464
Weighted Average Method
Date
Nov.1
6
10
13
16
18
23
30

Purchase
Qty

UC

TC

10

19

190

12
15
37+7=44

20
24

Cost of Good Sold

Inventory on Hand

Qty

UC

TC

10
3

18.59
18.59

185.9
55.77

6
5

19.65
19.65

117.9
98.25

Qty
7
17
7
4
16
10
5
20
20

240
360
Br.916

24

Br.457.75

UC
Br. 18
18.59
18.5
18.5
19.65
19.65
19.65
22.9125

TC
Br. 126
316
130.1
74.33
314.4
196.5
98.25
458.25
Br.458.25

Cost of ending Inventory =Br.458.25

Cost of goods Sold = Br. 186+ Br. 55.8+ Br. 117.9+ Br. 98.25= Br. 457.95
Financial Statement Effects of Cost Flow Methods
Income Statement Effects:
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Principles of Accounting II (ACPF 202); Lecture note

FIFO reports lower cost of goods sold and higher gross profit, which results in higher
net income before taxes.
LIFO reports higher cost of goods sold and lowers gross profit, which results in lower
net income before taxes.
The report of Weighted Average falls in between FIFI and LIFO

Balance Sheet Effects:

FIFO reports higher ending inventory as compared to LIFO
LIFO reports lower ending inventory as compared to FIFO
The report of Weighted Average ending inventory falls in between FIFI and LIFO
Tax Effects:
FIFO cost flow assumption results with higher income tax liability in the period of
raising price. However, in the period of falling price, the report will be reversed.
The Weighted Averages report of tax liability falls between FIFO and LIFO.
Other Methods of Inventory Valuation
a) Valuation of Inventory at Lower of Cost or Market
Inventories are economic resources. Accountants usually valued inventory in the balance sheet
at lower of its historical cost or market value. The lower of cost or market (LCM) rule requires
that inventories be priced at the lower of cost price or market price. Thus, LCM method is
considered as an example of the accounting concept of conservatism.
The benefits attributed to this method of inventory valuation are:
1. The loss, if any, is identified with the accounting period in which it occurred, and
2. Goods are valued at an amount that measures the expected contribution to revenue
of future periods.
Under LCM basis, market value is defined as current replacement cost, not selling price.
The LCM method can be applied to:
1. Each inventory item (individual items of inventory)
2. Major classes of inventory (major categories of inventory
3. Inventory as a whole (total inventory)
Example: MEKO Merchandising Company consists of the following information:
Particulars
Quantity
Cost price
Market price
Category 'A'
Item XA
80
Br.7
Br. 6
Item XB
40
8
9
Item XC
30
10
8
Category 'B'
Item YS
100
4
3
Item YT
150
9
8
Item YU
300
12
14
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Principles of Accounting II (ACPF 202); Lecture note

Preparation of a summary of inventory values for MEKO merchandising Company under the
LCM method can be shown as under:

___________________________________________________________________________________________________

Item

Cost
price

Market
Price

Item
wise

Category 'A'
Item XA
XB
XC

Br. 560
320
300

Br. 480
360
240

Br.480
320
240

SUB TOTAL

Br.1,180

Br 1,080

Br. 1,040

400
1,350
3,600

300
1,200
4,200

Br. 5,350

Br. 5,700

Category 'B'
Item YS
YT
YU
SUB TOTAL

Ground total

Br. 6,530

Br. 6,780

Major
Category

Whole
Inventory

Br. 1,080

300
1,200
3,600
Br 5,10
Br. 6,140

Br. 5,350
Br. 6,430

Br. 6,530

b) Valuation of Inventory at Net Realizable Value Method

Obsolete, spoiled, or damaged merchandise and other merchandise that can be sold
only at prices below cost should be valued at net realizable value. For this purpose,
net realizable value is the estimated selling price less any direct cost of disposition,
such as sales commissions.
NRV=ESP-ESE
WHERE: NRV = Net realizable value
ESP =Estimated selling price
ESE =Expected selling expense
Example: Assume that damaged merchandise that had a cost of Br1,800 can be
sold for only Br.1,200, and direct selling expenses are estimated at Br450. this
inventory would be valued at Br.750 (Br.1,200 Br.450), which is its net
realizable value.
NRV = ESP ESE
= Br.1, 200 Br.450
= Br. 750
Estimating Inventory Cost
Two circumstances explain the reasons for estimating rather than counting
inventories.
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Principles of Accounting II (ACPF 202); Lecture note

1. Management may want monthly or quarterly financial statements but a physical
inventory is taken only annually.
2. A casualty (catastrophe) such as fire, flood, or earthquake may make it
impossible to take a physical inventory.
There are two widely used methods of estimating inventories:
(1) The gross profit method ,and
(2) The retail inventory method.

Retail Method of Inventory Costing:

The following four steps are required in the estimation of inventory cost by the retail method:
1. Find goods available for sale at cost and at retail price.
2. Calculate ratio of cost to retail price.
3. Find ending inventory at retail price.
4. Multiply ending inventory at retail by the ratio of retail price.
The estimated cost of the ending inventory is derived from the formulas:
Step 1. Beg. Inventory + Purchases at retail price=inventory available for sale at retail
Step 2. Goods available for sale at retail - Net sale = Ending inventory at retail
Step 3. Cost of goods available at cost goods available for sale at retail =cost to retail ratio
Step 4. Ending inventory at retail X cost to retail ratio = Estimated cost ending inventory

To illustrate the application of the retail method based on the accounting records
and supplementary data for Ko-Ket Co is shown below.
Cost
Retail
Beginning inventory, Jan.1
Br.25,650
Br.35,000
Net purchase for the month
210,600
340,000
Net Sales
280,000
1. Merchandise available for sale = Br 25,650+ 210.600
= Br.236,250
2. Ratio of cost to retail price:
236,250
375,000 = 63%
3. Merchandising inventory, Jan31, at retail----------------------

Br 35,000+ 340,000
=Br.375,000

375,000-280,000
= Br.95,000

4. Merchandising inventory, Jan31

at estimated cost (Br.95,000*63%)---------------------------------- Br.59,850
Advantage of Retail method:
When only the selling price is available it permits valuation of inventory.
Used to estimate the cost of inventory for interim accounting periods.
Avoid the time- consuming and expensive process of taking a physical
inventory each month or quarter.
Gross Profit Method of Estimating Inventories

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Principles of Accounting II (ACPF 202); Lecture note

The gross profit method estimates the cost of ending inventory by applying a gross
profit rate to net sales. It is used in preparing monthly financial statements when
physical inventories are not taken.
It is the easiest and the simplest but effective method.
It determines (estimates) the gross profit percentage based on past experience in the
business organization.
To use this method, a company needs to know its net sales, cost of goods
available for sale, and gross profit rate.
The gross profit method is used:
a) To control and verify the validity of inventory;
b) To estimate inventory valuation between physical count;
c) To estimate the inventory when the necessary information is not available;
d) When both the inventory and inventory records are lost.
Example: Assume PEACE supermarket has a beginning inventory of Br.45, 000 on October1,
2008. During the month net purchases amounted to Br.18, 500 and net sales total Br.32, 800. If
the gross profit from experience is 35% of net sales, estimate the cost of inventory on hand on
October 31,2008.
Step 1:
Net Sales
Br32,8000
Less: Estimated gross profit (35% X Br32,8000 )
11,480
Estimated cost of goods sold
Br.21,320
Step 2:
Beginning Inventory
Br 45,000
Cost of Goods Purchased
18,500
Cost of Goods Available for Sale
63,500
Less: Estimated Cost of Goods Sold
21,320
Estimated Cost of Ending Inventory
Br 42,180
Alternatively, estimated cost of ending inventory can be computed in the following manner:
Cost of goods available for sale= Beginning inventory + Net purchases.
=Br.45, 000+ Br.18, 500
=Br.63,500
Cost of ending inventory = Cost of goods available for sale - Estimated cost of goods sold
= Br. 63,500 - Br. 21,320
=
Br.42,180

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Principles of Accounting II (ACPF 202); Lecture note

UNIT TWO
ACCOUNTING FOR FIXED ASSETS

The Nature of Fixed Asset

Assets can be classified as: Current assets- include cash, A/R, merchandise inventory, supplies, etc
Fixed assets- include land, equipments, machinery, furniture, etc
Intangible assets- include copy right, good will, patent, franchise, etc
Natural Resources
Natural resource is a site acquired for the purpose of extracting or removing some
valuable resources, such as oil, minerals or timber etc.
Fixed Assets: are also called property, plant, or equipment.
Characteristics of Fixed Assets
1. They are acquired for use in companys operation not for sale;
2. They are long term ( long- lived ) assets
3. They are usually subjected to depreciation;
4. They possess physical substance
Fixed assets are different from other assets by two important features.
Performing Asset Acquisition Procedures
Cost of Fixed Assets: Fixed assets are recorded at cost when purchased. Costs
of fixed asset include:
Invoice price
Transportation costs
Sales tax on the purchase price
Loading and unloading costs
Installation costs etc
The four major classes of fixed assets are: land, land improvements, Building and machinery
and equipment.
Land: - When land is purchased for a building sits, its cost includes:
The total amount paid for the land including any real estate commissions.
Fees for insuring the title
Legal fees
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Principles of Accounting II (ACPF 202); Lecture note

Accrued property taxes paid by the purchaser
Payment for surveying, clearing, grading and landscaping.
Assessment by the local government for items; roadway, sewers, and sidewalks.
The cost of removing the building
Brokers commissions.
The journal entry needed to record the purchase of land will take the following form:
Land ------------------------------------- XX
Cash (liability account) --------------------XX
Land Improvements: Land improvements such as parking lot surfaces, driveways, fences, and
lighting systems have limited life. These improvements have limited useful lives and their costs
can be allocated to the periods they benefit.
The journal entry made to recognize such cost is:
Land improvement ----------------------- XX
Cash (liability account) ---------------------XX
Buildings: - When purchased, the costs of a building usually include:
Its purchase price;
Brokerage fees ;
Taxes;
Title fees and attorney costs;
Any necessary repairs and renovations to prepare the building for use
When a building or any fixed asset is constructed by a company for its own use, its cost
includes:
Material and labor plus a reasonable amount of indirect overhead cost.
Design fees
Building permits, and
Insurance during construction and , etc
Building ------------------------------------- XX
Cash (liability account) --------------------XX
Machinery and Equipment: - The cost of machinery and equipment consists of all normal
and necessary costs to purchase them and prepare them for their intended use.
It includes:Purchase price
Taxes
Transportation charges
Insurance while in transit
Installing, assembling, and testing of machinery and equipment.
The recognition of this cost will take the following form:
Material & Equipment ------------------------------------- XX
Cash (liability account) -----------------------------------XX
Determining Depreciation Expenses
Deprecation- is the process of allocating the costs of plant asset to expense over its useful
(service) life in a rational and systematic manner.
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Principles of Accounting II (ACPF 202); Lecture note

All Tangible fixed assets, with the exception of land, are subjected to depreciation.
Depreciation is the process of allocating costs of fixed assets to expenses.
Depreciation applies to three classes of fixed assets: land improvements,
buildings and equipment. Each of these classes is considered to be a depreciable
asset because the usefulness to the company and revenue-producing ability of each
class will decline over the assets useful life.
The decline in utility of fixed assets is caused by:
1. Physical factors (physical depreciation):- wear and tear from operations, action of
time and other elements, and deterioration and decay.
2. Functional depreciation

Inadequacy- When a fixed asset is incapable of meeting increased demand for

its out put.

Obsolescence- Is usually the result of technology, older assets become less

efficient and there for more expensive to operate. Or a condition where, because of
new inventions and improvements, a fixed asset is no longer useful in producing goods
or services with a competitive advantage.
Example: Typewriter &Black and white television are obsolete assets.
Factors in Determining Deprecation
The Factors that determine depreciation are:
1. Original cost of fixed asset (initial cost);
2. Salvage value (residual value);
3. Estimated useful life (economic life).

Depreciation Method
The most common depreciation methods are:
1. Straight line method
2. Units of production method
3. Declining Balance method (DDB)
4. Sum-of the- Years- Digits (SYD) method
Usually, management selects the method or methods it believes to be appropriate
in the circumstances for allocating of costs of fixed assets to depreciation
expenses.
Depreciation affects the balance sheet through accumulated depreciation and the
income statement through depreciation expense.
To illustrate the comparison of the four depreciation methods, we will base all
computations on the following data applicable to a small machine purchased by
Samson Company on January 1, 2005.
Cost - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - Br. 10,000
Expected salvage value - - - - - - - - - - - - - - - - - -- - - - 1,000
Estimated useful life - - - - - - - - - - - - - - - - - - - - - - - - 5 years
Estimated total units of production - - - - - - - - - - - - - 36,000 units
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Principles of Accounting II (ACPF 202); Lecture note

1. Straight Line Method

The straight-line method is the simplest and the most widely used method of
determining depreciation. Under the straight line method,
o Depreciation expense is the same for each year of the assets useful life.
o It is measured solely by the passage of time.
o In order to compute depreciation expense, it is necessary to determine
depreciable cost.

Depreciable cost is the total amount subject to depreciation. Depreciable cost is

then divided by the assets useful life to determine depreciation expense.
The formula and computation of depreciation expense is presented as follows:
Periodic depreciation expense= Cost Salvage Value
Useful life in years
= Br.10, 000 Br. 1000
5 years
= Br.1,800
The journal entry to record the deprecation expense in this case is:
Deprecation Expense . 1,800
Accumulated Deprecation Machine.. 1,800
Alternatively, we can also compute an annual deprecation rate at which the
machine is being depreciated. To compute annual depreciation rate the following
formula is used:
Straight Line Annual deprecation rate = 100% Expected useful life
Straight-line Rate = 100% 5 years
= 20% per year
OR

Straight line Rate = Annual deprecation Depreciable cost

= Br. 1,800 Br. 9,000
= 20% per year
In this case, the rate is 20% (100% 5 years). When an annual deprecation rate is
used under the straight-line method, the percentage is applied to the depreciable
cost of the asset, as shown in the following depreciation schedule.

Samson Company
Year
2005

Depreciation Schedule(Straight line Method)

Depreciable Deprecation Annual
Accumulated Book
Cost
Rate
Deprecation Deprecation value
Expense
Br. 9,000
20%
Br. 1,800
Br. 1,800
Br.8,200*
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Principles of Accounting II (ACPF 202); Lecture note

2006
2007
2008
2009

9,000
9,000
9,000
9,000

20%
20%
20%
20%

1,800
1,800
1,800
1,800

3,600
5,400
7,200
9,000

6,400
4,600
2,800
1,000

*Br (10,000-1,800) = Br 8,200 (Book Value at the end of first year 1)

Note that the depreciation expense of Br. 1,800 is the same each year, and that the
book value at the end of the useful life is equal to the estimated Br. 1000 salvage
value.[ BV=Br 10,000-Br 9000]
Book Value= Cost Accumulated Depreciation
The adjusting entry to record depreciation expense of 2005 is:
December 31, Depreciation expense
1,800
Accumulated depreciation-Machine
1,800
Depreciation expense reported on the income statement with Br. 1,800 among
operating expense. Accumulated depreciation account is a contra-asset account and
reported on the balance sheet. We will not credit the fixed asset account for
depreciation. Continuing with the above example; the book value of the Machine
on December 31, 2005 will be reported on the balance sheet as follows.
Machine - - - - - - - - - - - - - - - - - - Br, 10,000
Less: Accumulated depreciation - - - - - -- - - - 1,800
Br 8,200
Q. What happens when an asset is purchased during the year, rather than on January 1, as in
our example?
If the fixed asset is purchased during the year, it is necessary to prorate the
annual depreciation for the proportion of time used. For example, assume that the
machine had purchased on May1, the depreciation for 2005 would be: - Br.9, 000
x 20% x 8/12 = 1,200
The journal entry to record the deprecation for the first year (2005) will be:
Deprecation expense . 1,200
Accumulation deprecation .1, 200
The straight-line method provides for uniform
depreciation expense over the life of the asset.

periodic

charges

to

2. Units-of-Activity (Units of Production) Method

Under the units-of- activity method;
Expressing the useful life of asset in terms of the total units of production
or use expected from the asset is needed;

16

Principles of Accounting II (ACPF 202); Lecture note

Is ideally suited to factory machinery: production can be measured in terms
of units of output or in terms of machine hours used in operating the
machinery;
Can also be used for such items as delivery equipment (miles driven) and
airplanes (hours in use).
Is not suitable for such assets as buildings or furniture, because
depreciation for these assets is more a function of time than of use.
The two steps needed in computing deprecation expense under this method
are:
Step 1: Determine depreciation expense per unit of output by using a straight line method.
Step 2: Multiply actual unit produced by depreciation expense per out put.
To illustrate, assume that the machine of Samson Company produced 7,000 units
in the first year. The formula and computation of depreciation expense in the first
year are:
Step 1: Depreciation cost per unit = Cost Residual Value
Total units of activity
= 10,000 1,000
36,000 units
= Br. 0.25/ unit
Step 2: Depreciation expense = Depreciation cost
Per unit
= Br. 0.25/unit
= Br. 1,750

x
x

units of activity
during the year
7,000 units

Adjusting entry for year 2005 would be:

Dec.31 Depreciation expense - - - - - - - - - - - - - - 1,750
Accumulated Depreciation Machine -- - - -1,750
Assume further that the machine produced the following units each year.
Year 2005 = 7,000 units
Year 2006 = 8,000 units
Year 2007 = 9,000 units
Year 2008 = 7,000 units
Year 2009 = 5,000 units
The deprecation schedule, using the above assumed data, is as follows:
Samson Company
Deprecation Schedule(Units of Activity Method)
Year
Number of units Deprecation Annual
Accumulated Book Value
produced
per unit
Deprecation Deprecation
expense
2005
7,000
Br.0.25
Br. 1,750
Br. 1,750
Br. 8,250
2006
8,000
0.25
2,000
3,750
6,250
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Principles of Accounting II (ACPF 202); Lecture note

2007
9,000
0.25
2,250
6,000
4,000
2008
7,000
0.25
1,750
7,750
2,250
2009
5,000
0.25
1,250
9,000
1,000
The units-of activity method is not as popular as the straight-line method,
because it is often difficult to make reasonable estimate of total activity.
When the productivity of the assets varies significantly from one period to
another, the units-of activity method results in the best matching of expenses
with revenues.
It is easy to apply when assets are purchased during the year.
3. Declining-Balance Method
A common declining-balance rate is double the straight-line rate. As a result, the
method is often referred to as the double-declining-balance method.
The formula for computing declining balance rate will be as follows:

The Declining Balance Depreciation Rate =2 x the straight-line rate

Deprecation
Expense

Book value at
Beginning of year

Declining
Balance Rate

Assuming the above data for Samson Company, the declining balance rate and the entire
computation of deprecation expense will take the following form.
Declining Balance Deprecation Rate = 2 X the straight-line rate
= 2 X 20%
= 40%
The depreciation schedule under this method is as follows:

Samson Company
Deprecation Schedule( DDB Method)
Year Book Value at the Annual
End of Year Accumulated Book Value
beginning of the Deprecation
deprecation
deprecation
at end of the
year
Rate
Expense
year
2005 Br. 10,000
40%
Br. 4,000
Br. 4,000
Br. 6,000
2006 6,000
40%
2,400
6,400
3,600
2007 3,600
40%
1,440
7,840
2,160
2008 2,160
40%
864
8,704
1,296
2009 1,296
296*
9,000
1,000
*Year 2009 deprecation expense, Br.296 (Br. 1296-Br. 1000) is simply the
difference between the book value at the beginning of year 2009 and the salvage
value as the book value can not be less than the salvage value.
4. Sum-of-the-Years-Digits (SYD) Method
The sum-of-the-years-digits method yields results like those obtained by use of the
declining-balance method. The periodic charge for depreciation declines steadily
over the estimated life of the asset.
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Principles of Accounting II (ACPF 202); Lecture note

The denominator of the fraction, which remains the same, is the sum of the
digits representing the years life.
The numerator of the fraction, which changes each year, is the number of
years of life remaining at the beginning of the year for which depreciation is
being computed. For the first year, the numerator is 5, for the second year 4,
and soon.
The following formula is used to compute the denominator of the fraction:

S = n (n+1) 2
Where S = Sum of the digits and
n = Number of years estimated
Example: Taking the above data for Samson Company, the denominator of the fraction can be
computed as under:
S = 5 [(5+1) 2]
= 5 [62]
OR;
S = 5+4+3+2+1= 15
= 5x3=15
The method is illustrated by the following depreciation schedule as follows.

Samson Company
Deprecation Schedule(SYD Method)
Year
2005
2006
2007
2008
2009

Depreciable
Cost
Br. 9,000
9,000
9,000
9,000
9,000

Fraction
5/15
4/15
3/15
2/15
1/15

Depreciation
Expense
Br.3,000
2,400
1,800
1,200
600

Accumulated
Deprecation
Br.3,000
5,400
7,200
8,400
9,000

Book Value
Br. 7,000
4,600
2,800
1,600
1,000

When an asset is purchased during the year, it is necessary to prorate each full year,
depreciation between the two fiscal years benefited. For example, if Samson Company had
purchased the machine on May1, 2005, the depreciation for 2005 would become Br.2, 000
(Br.9, 000 x 8/12 x 5/15).
The depreciation for the second year would be computed as follows.
4/12 x 5/15 x 9,000 = 1,000
8/12 x 4/15 x 9,000 = 1.600
Total, second year Br.2,600
Both the declining-balance and the sum-of-the-years digits methods provide
for a higher depreciation charge in the first year of use of the asset and a
gradually declining periodic charge thereafter. For this reason the decliningbalance and the sum-of-the-years digits methods are frequently referred to as
accelerated depreciation methods.
Capital and Revenue Expenditures

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Principles of Accounting II (ACPF 202); Lecture note

Expenditures that benefit only the current period and that are made in order to
maintain normal operating efficiency are called revenue expenditures. Such
expenditures are debited to expense accounts. Capital expenditures will affect the
depreciation expenses of more than one period, while revenue expenditures will
affect the expenses of only the current period.
1 Capital Expenditures
Expenditures for acquiring fixed assets or for additions to fixed assets and
expenditures that add to the utility of fixed assets for more than one accounting
period are called capital expenditures. Such expenditures are debited to the asset
account or to a related accumulated depreciation account.
Example:
roofing replacement
Plant expansion
major overhauls ( repairs) of machinery and equipment
Types of other common capital expenditures related to fixed assets are;
A. Additions,
B. Betterments, and
C. Extraordinary repairs.

Example; assume that a machine costing Br20,000, with no residual value and a
useful life of 5 years, has been depreciated for 3 years by the straight-line method
(Br4, 000 annual depreciation). If at the beginning of the fourth year, a Br.2,000
extraordinary repairs increase the remaining useful life of the machine to 4 years
(instead of 2 years); the Br. 2,000 would be debited to accumulated depreciation.
Accumulated Deprecation Machine --------------- 2,000
Cash/liability account ---------------------------------2,000
The annual depreciation for the remaining 4 years of use would be Br.2, 500,
determined as follows:
Cost of machine .. Br. 20,000
Less: Accumulated depreciation balance;
Depreciation for first 3 years (Br.4, 000 x 3 years) Br.12, 000
Deduct debit for extraordinary repairs .
2,000
Balance of accumulated depreciation ..
10,000
Revised book value of machine after
extraordinary repair ... Br10,00
Annual depreciation (Br. 10,000 4 years
Remaining useful life) Br 2,500
2. Revenue Expenditures
Expenditures for ordinary maintenance and repairs of a recurring nature should be
classified as revenue expenditures and debited to expense accounts.
These are those expenditures such as;
Additional costs of fixed assets that do not materially increase the assets life or
productive capabilities.
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Principles of Accounting II (ACPF 202); Lecture note

They are recorded as expense and deducted from revenues in the current periods income
statement.
They are also called income statement expenditures.
Revenue expenditures include Normal cost of cleaning, lubricating, adjusting, and replacing
(small) parts of a machine like Supplies, fuel, and electric power.
Small expenditures are usually treated as repair expense, even though they may
have the characteristics of capital expenditures.

Recording Disposal of Fixed Asset

Fixed assets are disposed of for several reasons. Regardless of the cause, fixed
assets are no longer useful in operation; they may be disposed through one of the
following methods:
1. Discarding( retirement)fixed assets
2. Sales of fixed assets, or
3. Exchange to other fixed assets.
Whatever the method of disposal, at the time of disposal it is necessary to
determine the book value of the fixed asset. The book value is the difference
between the cost of the fixed asset and the accumulated depreciation to date.
1. Retirement (Discarding) of Fixed Assets
When a fixed asset are no longer useful to the business and have no residual or market value,
they are discarded (retired).
Example 1: Consider the case for Samson Company machine costing Br.10, 000 with
accumulated depreciation of Br.10, 000 and the way to discard it from the book.
The entry required to discard the asset will be:
Accumulated depreciation -Machine--------.10, 000
Machine ----------------------------------.10, 000
(To record retirement of fully depreciated machine)
Example 2: Assume that in the above example, Samson Company discards the
machine that cost Br10, 000 and has accumulated depreciation of Br 9,000 at the
date of retirement (on December 31, 2009). The entry to retire the machine will take
the following form:
Accumulated Depreciation Machine ---------------- 9,000
Loss on Disposal ----------------------------------------- 1,000
Machine -------------------------------------------------------------- 10,000
(To record retirement of machine at loss)
The loss on disposal is reported in the other expenses and losses section of the
income statement.

2. Sale of Fixed Assets

In a disposal by sale, the book value of the asset is compared with the proceeds
received from the sale. The asset may be sold in one of the following three
conditions:
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Principles of Accounting II (ACPF 202); Lecture note

1. Sales with gain: If the proceeds of the sale exceed the book value of the fixed
asset, a gain on disposal occurs.
2. Sales with loss: If the proceeds of the sale are less than the book value of the
fixed asset sold, a loss on disposal occurs.
3. Sales with no gain or loss: If the proceeds of the sale equals the book value of
the fixed asset sold.
To illustrate, assume that on December 31, 2009 Samson Company, wants to
dispose a machine that has original cost of Br.10, 000 and accumulated
deprecation of Br.9, 000. This shows that the book value of the machine on
December 31, 2009 is Br. 1,000 only. And the book value of the asset will be
calculated in the following manner.
Cost of the machine ---------------------- Br. 10,000
Less: Accumulated deprecation -----------------------9,000
Book Value -------------------------------- - Br. 1,000

A. If the machine is sold for Br. 1,500 ( above the book value)
a. Proceed of the sale exceeds the book value of the machine, thus it results in
gain and the gain will be determined as under.
Cost of Machine ----------------------------------Br10, 000
Less: Accumulated depreciation-------------9,000
Book value at date of disposal Br 1,000
Proceeds from sale . 1,500
Gain on disposal
. Br. 500
The entry to record the sale and the gain on disposal is:
Dece.31,2009 Cash ----------------------------------------------- 1,500
Accumulated Depreciation Machine ------- 9,000
Machine ---------------------------------------10,000
Gain on Disposal -------------------------------- 500
(To record sale of machine at a gain)
The gain on disposal is reported in the Other Revenues and Gains section of the income
statement.
B. If the asset is sold for Br. 500 ( below the book value)
Proceed of the sale is less than the book value of the machine, thus it results in
loss and the loss is computed as follows:
Cost of Machine
Br 10, 000
Less: Accumulated depreciation
9,000
Book value at date of disposal
1,000
Proceeds from sale
500
Loss on disposal
Br (500 )
The entry to record the sale and the loss on disposal will take the following form.
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Principles of Accounting II (ACPF 202); Lecture note

Cash --------------------------------------------------------- 500
Accumulated Depreciation Machine ---------------- 9,000
Loss on Disposal
------------------------------------- 500
Machine ----------------------------------------------- 10,000
(To record sale of machine at a loss)
The loss on disposal is reported in the Other Expenses and Losses section of the
income statement.
C. Assume that the asset is for Br. 1,000 ( at book Value)
Proceed of the sale is equal to the book value of the machine, thus it results with
no gain or no loss.
The entry to record the sale of machine at book value will be:
Cash -----------------------------------1,000
Accumulated deprecation ---------- -9,000
Machine -----------------------------10,000
(To record sale of machine at a loss)
ACCOUNTING FOR INTANGIBLE ASSETS
Definition and Characteristics of Intangible Assets
Intangible assets include copyrights, patents, trademarks, goodwill, organization
costs, franchises, leaseholds, and similar items.
Characteristics of intangible assets:
There is generally a higher degree of uncertainty regarding the future benefits
to be derived.
Their value is subject to wider fluctuations because it may depend to a
considerable extent on competitive conditions.
They may have value only to a particular company.
They may have indeterminate (but not necessarily indefinite) lives.
Good will
Goodwill is a poorly understood intangible asset that is potentially very important
for many firms. Conceptually, goodwill includes such characteristics as:
Superior enterprise management; or the marked weakness in management
(or other competitive factor) of a major competitor.
A superior, and yet secret, manufacturing process.
Superior labor relations.
Superior creditor relations.
Superior employee-training programs.
Superior community relations (image).
Superior advertising department and brand image.
Strategic location.
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Principles of Accounting II (ACPF 202); Lecture note

Discovery of natural resources.
Favorable tax condition and/or government regulations.
Favorable strategic association with other firms.
Patent
A patent is an exclusive right granted by the government giving the owner control
of the manufacture, sale, or use of an invention for a certain number of years from
the date of filing. Patents cannot be renewed, but their effective life is often
extended by obtaining new patents on modifications and improvements to the
original invention.
For example, suppose that a patent was purchased for Br 85,000 and was to be
amortized over 10 years (the estimated economic life) with no expected residual
value. The journal entries to record the acquisition and the amortization for the
first year are follows:
Patent
85,000
Cash
85,000
Amortization Expense
8,500
Patent (or Accumulated Amortization- Patent)

8,500

Copyright
A copyright is a grant by the government covering the right to publish, sell, or
otherwise control literary or artistic products for the life of the author plus 50
years. Copyrights cover such items as books, music, and films. Accounting for
copyrights follows the same principles as those used for patents. The cost is
amortized over the economic life (not to exceed 40 years).
It is possible that a fully amortized copyright may develop a significant value,
such as in the case of some old films or music. Under current Generally Accepted
Accounting Principles, which require that assets be recorded at cost, such an
increase in value is not recognized in the financial statements but should be
disclosed in the notes to the financial statements, if material.
Trademarks and Trade Names
Registration of a trademark or trade name with the government office establishes a
right to exclusive use of a name, symbol, or other device used for product
identification. The right is renewable indefinitely as long as the trademark or trade
name is used continuously. Therefore, from a legal standpoint, it may be
considered to have an indefinite life. However, for accounting purposes, the cost
must be amortized over the expected economic life, not to exceed 40 years.
Franchises
Franchises are agreements entered into by two parties in which, for a fee, one
24

Principles of Accounting II (ACPF 202); Lecture note

party (the franchiser) gives the other party (the franchisee) rights to perform
certain functions or sell certain products or services. In addition, the franchiser
may agree to provide certain services to the franchisee. Many franchises exist
between governments and companies, such as a franchise to provide a monopoly
service (e.g., utilities) or to use public property to provide a service. Although
some franchises are granted in perpetuity, the related initial franchise cost must be
amortized over the useful economic life, not to exceed 40 years.

UNIT THREE

Payroll
Payroll: refers to as the total amount paid to employees of a firm as a
compensation for the service rendered to a firm for a give period of a time.

Payroll Register (Sheet): The entire list of employees of a business along with
each employees gross earnings ,deductions and net pay or home take pay for
particular payroll period.
Employee Earning Record: It is a summary of each employees earnings,
deductions and net pay for each payroll period and the cumulative gross
earnings during the year. It is a separate record kept for each employee.
Gross Earning: The total pay to an employee before deduction for the pay
period.

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.
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Principles of Accounting II (ACPF 202); Lecture note

Duration of the work performed

Up to 10 oclock in the evening (10 P.M.)
Between 10 oclock in the evening (10 p.m.)
and 6 oclock in the morning (6A.M)
On the weekly rest days
On a public holidays.

Rate of over time

125% (11/4) times his/her ordinary
hourly rate of payment
150%(11/2) times his/her ordinary
hourly rate of payment
200%(2) times the ordinary hourly
rate of payment
250% (21/2) times the ordinary hourly
rate of payment

Allowance
Allowance: Money paid monthly to an employee for special reason, which may
include:
Position Allowance: - a monthly sum paid to an employee for bearing a
particular office responsibility, e.g. Head of a particular department or division.
House allowance: - a monthly allowance given to cover housing costs of the
individual employee when the employment contract required the employer to
provide housing but fails to do so.
Hardship Allowance: - a sum of money given to an employee to compensate
for an inconvenient circumstance caused by the employer.
Desert Allowance: - a monthly allowance given to an employee because of
assignment to a relatively hot region.
Transportation (fuel) allowance: - a monthly allowance to an employee to
cover cost of transportation up to the work place if the employer has committed
itself to provide transportation service.
Payroll Deductions
Payroll deduction is the difference between gross earning the amount actually
received.
Payroll deductions include:
Employee Income Tax
Pension Contributions
Other Deductions such as:

Pay health or life insurance premiums;

To repay loans from the employer or credit associations ;
To pay for donations to charitable organizations; etc.
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Principles of Accounting II (ACPF 202); Lecture note

1. Employee Income Tax
Taxable Monthly Income (In Birr)
1
2
3
4
5
6
7

Rate of tax (%) on

Every Additional Income
The first birr hundred fifty (Br.150)
Exempted
Over 150 but not exceeding 650 on the next 500 10%
Over 650 not exceeding 1,400 on the next 750 15%
1,401 - 2,350 on the next 950
20%
Over 2,351 - 3,550 on the next 1,200
25%
3,551 - 5,000 on the next 1,450
30%
Over 5,000
35%

The following categories of payments in cash or benefits in kind are exempted

from taxation.
Medical costs incurred by employer for treatment of employees.
Transportation allowances paid by employer to its employees (not
exceeding Birr 300).
Reimbursement by employer of traveling expense incurred on duty by
employees.
Traveling expenses paid to transport employees from else where to place of
employment and to return them upon completion of employment.
Pension contribution, provident fund and all forms of retirement benefits
contributed by employers in an amount that does not exceed 15% of the
monthly salary of the employee.
Income from employment received by casual employees
2. Pension Contributions
Permanent employees of an organization the employees of which are governed by
the existing regulations of the Ethiopian Public Servants are expected to contribute
currently from Hamle 2004 6% of their basic (monthly) salary to the government
pension Trust Fund.
Consequently, the total contribution to the pension trust fund of the Ethiopian
Government is equal to 14% of the total basic salary of all permanent employees
of an organization. (I.e. 6% comes from the employees and the 8% comes from the
employer).
Non-government organizations (NGOs and businesses) are keeping a fund known
as Provident Fund.
3. Other Deductions
Apart from the above two kinds of deductions from employees earning, employees
may individually authorize additional deductions such as deductions to:

Pay health or life insurance premiums;

To repay loans from the employer or credit associations ;
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Principles of Accounting II (ACPF 202); Lecture note

To pay for donations to charitable organizations; etc.

Net Pays
Net pay is determined by subtracting payroll deductions from gross earnings. It is
sometimes known as take home pay, the amount collected by an employee on the
payday.
Maintaining a Payroll Record
Basic records of a payroll accounting system include:
1. A payroll register (or payroll Sheet).
2. Individual employees earnings records and,
3. Usually, Pay Check.
Recognizing the Payroll Expense, Liabilities and Payment of the Payroll
Example: A specific governmental organization in Zeway town pays the salary of
its employees according to the Ethiopian Calendar Month. The following data is
related to the month of Hamle, 2004.

Basic
No. Name of Employee Salary

1
2
3
4
5

Kiyya Lemessa
Bilen Belete
Tsehay Geleta
Shemsu Kelil
Ahmed Usman

OT
Monthly
Hours
Allowance Worked

1,800
2,200
1,440
480
2,400

200
350
150
250

7
6
10
12

Duration of
OT
Work

Up to 10 p.m.
10 P.M. to 6 A.M
Weekly Rest Days
Public Holiday

Basic
Salary
Per Hour

11.25
13.75
8
3
15

ADDITIONAL INFORMATION:

The management of an organization usually expects a worker to work 40-hours

in a week and during Hamle, 2004, all workers have done as they have been
expected.
All workers of an organization are permanent employees except Shemsu Kelil.
The monthly allowance of Tsehay Geleta is not taxable.
Ahmed Usman agreed to have a monthly Birr 200 be deducted and paid to the
credit & saving Association of the organization as a monthly saving.
INSTURCTIONS: Based on the above information;
1. Prepare a payroll register (or sheet) for the month of Hamle 2004.
2. Record the payment of salary as of Hamle 30, 2004 using CK. No .41 as a
source document.
3. Record the payroll taxes expense for the month of Hamle ,2004
Memorandum No. 10
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Principles of Accounting II (ACPF 202); Lecture note

4. Record the payment of the claim of the credit & saving association of an
organization that arose from Hamles Payroll, assuming that the payment
was made on Nahase1, 2004.
5. Assuming that the withholding taxes and payroll taxes the month of Hamle,
2004 have been paid on Nahase 1,2004 Via Ck. No. 50 recorded the
required journal entry.
1. Computations of Earnings, Deductions and Net Pay
OVER TIME EARNINGS:
Over Time Earnings = OT Hrs worked (ordinary hourly rate x OT Rate)
Kiyya Lemessa
Bilen Belete
Tsehay Geleta
Ahmed Usman

:
:
:
:

7 hrs
6 hrs
10 hrs
12 hrs

x
x
x
x

( Br.11.25 x 1.25 )
( Br. 13.75 x 1.5 )
( Br.8 x 2 )
( Br. 15 x 2.5 )

=Br.98.4375
=Br.123.75
= Br. 160
= Br.450

GROSS EARNINGS:
Basic Salary + Allowance + OT Earning= Gross Earnings
1. Kiyya Lemessa : Br

1,800 +

200 +

98.4375 = Br 2,098.4375

2. Bilen Belete

: Br

2,200 +

0 +

3. Tsehay Geleta

: Br

1,440 +

350 +

160

4. Shemsu Kelil

: Br

480

150 +

5. Ahmed Usman

: Br

2,400 +

250 +

450

123.75 = Br 2,323.75
= Br 1,950
= Br 630
= Br 3,100

Deductions & Net Pays:

1. Kiyya Lemessa
Gross Taxable Income = Br 2,098.4375
Employee Income Tax:
Earning
x
ITR = IT

150.00

0.00

500.00

10

50.00

Pension
contribution:
Basic Salary x 6%
Br 1800 x 6%
= Br. 108.00
Br. 302.1875
+ Br.108.00
Total Deductions = Br.410.1875
Br 2,098.4375
- Br 410.1875
Net Pay. =
Br. 1,688.25
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Principles of Accounting II (ACPF 202); Lecture note

750.00
698.4375
Total Br.2,098.4375

15
20

112.50
139.6875
Br.302.1875

2. Bilen Belete
Gross Taxable Income = Br 2,323.75

Employee
Tax:

Earning

150.00
500.00
750
923.75
Total Br 2,323.75

Income

x ITR = IT

0
10
15
20

0.00
50.00
112.5
184.75
Br. 347.25

Pension contribution
Basic Salary x6%
Br.2,200 x 6% = Br. 132
Br.132
+Br. 347.25
Total Deductions = Br. 479.25
Br 2,323.75
-479.25
Net Pay.
Br. 1,844.5

3. Tsehay Geleta
Gross Taxable Income
= Br 1440+160=Br 1,600
Employee Income Tax:
Earning
x TIR = IT
150.00
0
0.00
500.00
750.00
200
Total Br 1,950

Pension contribution:
Basic Salary x 6%
Br 1,440 x 6%= Br.86.4

10

50.00

Total Deductions =

15
20

112.5
40
Br.202.50

Net Pay

Br.202.50
+ 86.4
Br. 288.90
Br.1,950
-288.9
= Br. 11,661.1

4. Shemsu Kelil
Gross Taxable Income
= Br 630
Employee Income Tax:
Earning x TIR = IT

150.00
480
Total Br 630

Pension contribution: is zero as he

is not permanent employee

0.00

Total Deductions

10

48.00
Br.48.00

Net Pay

Br.48.
00
+0.00
= Br.48.00
Br 630
- Br.48.00
30
= Br. 582

Principles of Accounting II (ACPF 202); Lecture note

5. Ahmed Usman
Gross Taxable Income
= Br 3,100
Employee Income Tax:
Earning

x TIR =

Pension contribution:
Basic Salary x 6%
Br 2,400 x 6%= Br.144

150.00

0.00

500

10

50.00

750
950
750

15
20
25

112.5
190
187.5

Total Deductions

Br. 200
Br.144
+ Br. 200
+ Br.540
= Br.884

Br.540.00

Net Pay

Br.3,100
- Br.884
=Br. 2216

Total Br.3,100

Credit Association

31

Principles of Accounting II (ACPF 202); Lecture note

1. A payroll sheet for the month of Hamle, 2004 for a given particular organization

Gross Earnings
Name of the
No
1
2
3
4
5

Employee
Kiyya Lemessa
Bilen Belete
Tsehay Geleta
Shemsu Kelil
Ahmed Usman
Total

BasicAllow Over
Salary
1,800
2,200
1,440
480
2,400
8,320

ance
200
350
150
250
950

Time
98.4375
123.75
160
450
832.188

Deductions
Total

Income

Earning
2,098.4375
2,323.75
1,950
630
3,100
10,102.19

Tax
302.1875
347.25
202.50
48.00
540.00
1439.9375

Total
Pension
108.00
132.00
86.40
144.00
470.40

Net

Others Deduction Payment Sig.

410.1875
479.25
288.90
48.00
200.00 884.00
200.00 2110.3375

Prepared By :________________ Verified By: __________________ Approved

1688.25
1844.50
1661.10
582.00
2216.00
7991.8525

By:_________

32

Principles of Accounting II (ACPF 202); Lecture note

Internal Control for payroll System
1. Proving the Payroll:
Total Earnings:
Basic Salary . . . . . . . . . . . .
Allowance
............
Over Time
............
Grand Total Earnings . . . . . . . . . . . . .

Br. 8,320
950
832.188
.Br. 10,102.19

Deductions:
Employee Income Tax . . . . . . . . . . . Br. 1439.9375
Pension Contribution . . . . . . . . . . . . .
470.40
Other
. . . . . . . . . . . . . . . . . . . 200.00
Total Deduction. . . . . . . . . . . . . .
Br. 2110.3375
Net Pays Total . . . . . . . . . . . . . . . . . .
7991.8525
Total Deduction & Net Pay . . . . . . . . ..Br. 10,102.19
2. Recording the Payment of Salary.
Hamle 30,2004. Salary Expense . . . . . . . . . 10,102.19
Employee Income Tax Payable . . . . . . 1439.9375
Pension contribution Payable
....
470.40
Credit & saving Association . . . . . . . 200.00
Cash . . . . . . . . . . . . . . . . . . . . . . . . . 7991.8525

(Ck.No.41)

3. Recording the Payroll Taxes Expense for Hamle,2004

An Organization incurred payroll tax expense of Br.470.40 during Hamle,2004. This is
determined as the product of the basic salary of all permanent employees and 6%.
7840 x6% = Br. 470.40
Hamle 30,2004

Payroll Taxes Expense.

470.40
Pension cont. Payable .
470.40
(M10)
The source document is an internal office memorandum that indicates the incurrence of
this expense.
4. Recording the Payment of Deduction from Ahmed Usman earnings to the credit
association on Nahase 1, 2004.
Nahase1, 2004

Credit & saving Association . 200

Cash .......................... 200
5. Recording the Payment of Withholding and Payroll Taxes to Inland Revenue
Authority and employees pension contribution to pension trust on Nahase 1, 2004.
Note that the total pension contribution payable is equal to 14% of the basic
salary of all permanent employees. That is: Br 7840 x 14% = Br. 1097.60.
The journal entry to record the payment of liability will be as follows:
Employees Income Tax Pay
Pension Contribution Payable
Cash
(Ck. No. 50)

1439.9375
1097.60
2537.5375

33

Principles of Accounting II (ACPF 202); Lecture note

UNIT FOUR
ACCOUNTING CONCEPTS AND PRINCIPLES
Generally Accepted Accounting Principles (GAAPs)
Generally Accepted Accounting Principle (GAAP) is a set of standards and rules

that are recognized as a general guide for financial reporting purposes. It consists
of the financial accounting and reporting conventions, rules, and procedures that
a business entity must use in preparing financial statement.
The organizations primarily responsible for establishing generally accepted
accounting principles are:
st
1 - The Financial Accounting Standards Board (FASB):
a private
organization that establishes broad reporting standards of general applicability as
well as specific accounting rules.
2nd- The Securities and Exchange Commission (SEC): is governmental
agency that requires company filing financial reports to follow generally
accepted accounting principles.
The FASB developed a conceptual framework to serve as the basis for resolving
accounting and reporting problems.
The FASBS conceptual framework consists of the following four items:
1. Objective of financial reporting
2. Qualitative characteristics of accounting information
3. Elements of financial statements
4. Operating guidelines (assumptions, principles, and constraints)
1. Objective of Financial Reporting
In developing the conceptual framework, the FASB concluded that the first level
of study was to determine the objectives of financial reporting. Determining
these objectives required answers to such basic questions as:
Who uses financial statements?
What information do they need?
Why do they need these information?
How should financial information be reported so that it is best
understood?
2. Qualitative Characteristics of Accounting Information
The accounting practice selected or the policy adopted should be the one that
generates the most useful financial information for making a decision.

34

Principles of Accounting II (ACPF 202); Lecture note

Qualitative Characteristics of Accounting Information are:
Predictive
Relevance

Feedback value

Timely
Verifiable
Reliability

Faithful representation

Neutral
Comparability

Consistency
Relevance:
Accounting information is relevant if it makes a difference in a decision.
Relevant information has either predictive, feedback value and timely.
o Predictive value helps users forecast future events.
o Feedback value confirms and corrects prior expectations.
o Timely information must be available to decision makers before it
loses its capacity to influence decisions.
Reliability
Reliability of information means that the information is free of error and bias; it can be
depended on.
To be reliable, accounting information must be verifiable-we must be able to prove that is
free of error and bias.
The information must be a faithful representation of what it purports to be -it must be
factual. Finally, accounting information must be neutral- it cannot be selected, prepared,
or presented to favor one set of interested users over another.
Comparability
Accounting information about an enterprise is most useful when it can be compared
with accounting information about enterprises.
Comparability results when different companies use the same accounting principles.
Consistency

35

Principles of Accounting II (ACPF 202); Lecture note

Consistency means that a company uses the same accounting principles and methods
from year to year. Thus, if a company selects FIFO as the inventory costing method in
the first year of operations, it is expected to continue to use FIFO in succeeding years.

3. Elements of Financial Statements

The elements of financial statements include: asset, liabilities, equity, revenues,
and expenses.
4. Operating Guidelines
The operating guidelines are well established and accepted in accounting.
These guidelines are classified as assumptions, principles, and constraints.
Assumptions provide a foundation for the accounting process.
Principles are specific rules that indicate how economic events should be
reported in the accounting process.
Constraints on the accounting process allow for a relaxation of the
principles under certain circumstances.
Business entity
Objectivity
Assumptions
Going Concern
Unit of measurement
Periodicity
Operating guide lines

Consistency
Cost principle
Revenue recognition principle
Principles
Matching principle
Adequate (full) disclosure
Constraints

Materiality

Conservatism
36

Principles of Accounting II (ACPF 202); Lecture note

1. Accounting Assumptions
Assumptions provide a foundation for the accounting process. The basic
assumptions underlying GAAP are:
1) The economic entity assumptions,
2) The objectivity assumption,
3) The going concern assumption,
4) The periodicity assumption, and
5) The monetary unit assumption.
2. Accounting Principles

The principles include: 1) The Cost principle 2) The Realization principle, 3)

Matching principle, and 4) The full disclosure principle.

37

Principles of Accounting II (ACPF 202); Lecture note

UNIT FIVE
ACCOUNTING FOR A PARTNERSHIP
A partnership is a voluntary association of two or more persons to carry on, as
co-owners, a business for profit. A partnership is easily formed. The partnership
agreement may be oral, although it is good business practice to have a written
contract, which spells out, among other things, the investment of each partner,
limitations on drawings, and the division of profits. A written partnership
agreement is referred to as the articles of partnership or the partnership
agreement.

Characteristics of a Partnership
1. Mutual Agency
2. Unlimited Liability
3. Limited Life
4. Co-ownership of Property
5. Nontaxable Entity
[

Advantages of a Partnership

A partnership is easier and less expensive to organize and

subject to less government regulation
Fewer reporting requirement (fewer constraints on their actions)
Non taxable entity

Disadvantages of a Partnership

Mutual agency,
unlimited liability,
Limited life.
Lack of ability to raise large amounts of capital

Accounting for Formation of a Partnership

At the formation of a partnership, it is necessary to assign a proper value to the
non-cash assets and the liabilities contributed by the partners. An item
contributed by a partner becomes partnership property co-owned by all partners.
Example, assume that A, B and C contribute Br 10,000, Br 20,000 and Br
15,000 respectively to form ABC partnership.
38

Principles of Accounting II (ACPF 202); Lecture note

Date
2010
Jan. 1

Accounts

Cash
A, capital
B, capital
C, capital
Withdrawal of Assets by Partners

Debit

Credit

45,000
10,000
20,000
15,000

Partners may withdraw cash or non-cash assets from a partnership. Upon

withdrawal of assets by a partner, the Drawing account of the partner
withdrawing the assets would be debited and the assets withdrawn are
credited for the fair value.
For example if partner B made Br. 3,000 cash withdrawal on May 1, 2010, the
entry would be:
Date
2010
May. 1

Accounts

Debit

Credit

B, Drawing
3000
Cash
3000
Allocating Profit or Loss to Partners
Profit/loss is allocated to the partners in accordance with the partnership
agreement. If no partnership agreement exists, profits and losses are to be shared
equally by all partners.
Example: A, B and C share profit/loss in 1:3:2 ratio. ABC partnership earned Br
20,000 during 2011. Distribute the profit to each partner.
A=2000*1/5=Birr 4,000
B= 2000*3/5 = Birr 12,000
C=2000*2/5 = Birr 8000

Partnership Dissolution
Dissolution is the change in the relation of partners usually as a result of:

a new partners admission,

death,
retirement, or
Voluntary withdrawal.

The dissolution of partnership does not necessary mean the partnership

should stop doing business.

39

Principles of Accounting II (ACPF 202); Lecture note

Partnership Liquidation
Liquidation is termination of the affairs of the partnership. Liquidation means

end of the partnership or business affairs.

Liquidation of a partnership- means that the assets are sold, liabilities are paid,
and the remaining cash or other assets are distributed to the partners.
Two concepts are important in setting priority of claims:
(1) The marshaling of assets and
(2) The right of offset.
Marshaling of assets presents the order of creditors rights against the
partnerships assets and the personal assets of the individual.
The order in which claims against the partnerships assets will be marshaled
or satisfied is:
1.
2.
3.

Partnership creditors other than partners

Partners claims other than capital and profits
Partners claims to capital or profits to the extent of credit balances in
capital accounts
The order of claims against the personal assets of individual partners is:
1. Personal creditors of individual partners
2. Partnership creditors for unpaid partnership liabilities, regardless of partners capital balance in partnership

Statement of Partnership Liquidation

Statement of liquidation is the basis of the journal entries made to record the
liquidation. It presents the effects of the liquidation on the balance sheet
accounts of the partnership.
The statement shows the conversion of assets into cash, the allocation of any
gains or losses to the partners, and the distribution of cash to creditors and
partners.
Liquidation could be lump sum of installment.
A Lump sum liquidation of a partnership is one in which all the assets are
converted into cash within a very short time, outside creditors are paid, and a
single, lump-sum payment is made to the partners for their capital interests.
The conversion of non-cash assets into cash is termed as Realization of
assets.
Example: The following are detail information about ABC partnership.
Profit and Loss Percentage
Partnership Capital Accounts

A
40%
Br 34,000

B
40%
Br 10,000

C
20%
Br 16,000
40

Principles of Accounting II (ACPF 202); Lecture note

The three partners also prepare personal net worth statements, including the
expected net capital and loan values of each partners investment in the ABC
Partnership, which show the following:
A
B
C
Personal assets
Br 150,000
Br 12,000 Br 42,000
Personal liabilities
(86,000)
(16,000)
(14,000)
Net worth (deficit)

Br 64,000

Br (4,000)

Br 28,000

This shows that partner A and C are personally solvent. On the other hand, B is
personally insolvent.
Eg. Condensed trial balance of the ABC Partnership in which A, B, and C are
partners, on May 1, 2011, the day the partners decide to liquidate the business
ABC Partnership
Trial Balance
May 1, 2011
Cash
Br10,000
Non-cash Assets
90,000
Liabilities
Br40,000
Loan Payable to Partner C
4,000
A, Capital (40%)
34,000
B, Capital (40%)
10,000
C, Capital (20%)
12,000
Total
Br 100,000
Br 100,000
The partnership liquidation schedule will be prepared and the journal entries
recorded under the following assumptions.
1. Non-cash assets of ABC partnership are sold for Br 80,000 On May 15,2011 .
The outside creditors are paid Br 40,000 on May 20, and the remaining Br
50000 cash is distributed to the partners on May 31, 2011.
Cash

Pre-liquidation balance 10000

Sale of Assets and loss
80000
distribution
9000

L/Sum pyt to partners:

Partners capital
Balance

Noncash
assets
90000
(90000)
0

Liab.

A, Cap.
40%

B,Cap
40%

C, Cap.
20%

40000

34000

10000

16000

40000

(4000)
30000

(4000)
6000

(2000)
14000

(30000)

(6000)

(14000)

(50,000)

The following entries are recorded using the partnership liquidation schedule:

41

Principles of Accounting II (ACPF 202); Lecture note

Date
Accounts
2011
May 15 Cash
A, Capital [4/10 x 10,000]
B, Capital [4/10 x 10,000]
C, Capital [2/10 x 10,000]
Non-cash assets
20 Liabilities
Cash
31 A, capital
B, Capital
C, capital
Cash

Debit

Credit

80,000
4,000
4,000
2,000
90,000
40,000
40,000
30,000
6,000
14,000
50,000

2. The non-cash assets of the partnership are sold for Br 35000 on May 15, 2011
and Br 55000 loss is allocated to the partners capital accounts.
The outside creditors are paid Br 40000 on May 20, 2011.
The remaining Br 5000 cash is distributed to the partners as a lump-sum
payment on May 31, 2011.

Pre-liquidation Balance
Sale of Assets and loss
distribution
Payment to outside
creditors

Cash

Noncash
assets

Liab.

A, Cap.
40%

B, Cap.
40%

C, Cap.
20%

10000
35000

90000
(90000)

40000

10000
(22000
)
(12000
)

16000
(11000)

(12000
)
12000
0
0
-

5000

45000

40000

34000
(22000
)
12000

(40000)

12000
(8000)
4000
(4000)
-

5000

(40000
)
0

5000
5000
-

0
0
-

0
0
-

Dist. of deficit(3:2)
L/Sum Pyt to partners:
Balance

5000

(4000)
1000
(1000)
-

The following entries are recorded using the partnership liquidation schedule:

42

Principles of Accounting II (ACPF 202); Lecture note

Date
2011
May 15

20

31

Accounts

Debit

Cash

35,000

A, Capital [4/10 x 55,000]

B, Capital [4/10 x 55,000]
C, Capital [2/10 x 55,000]
Non-cash assets

22,000
22,000
11,000

Liabilities
Cash

40,000

A, capital [4/6 x 12,000]

C, capital [2/6 x 12,000]
B, Capital

8,000
4,000

A, capital
C, Capital
Cash

4,000
1,000

Credit

90,000

40,000

12,000

5,000

3. Non-cash assets are sold for Br 20,000, and Partner B is personally

insolvent, A and C are personally solvent.
Cash

Noncash
assets
90000
(90000)

Pre-liquidation Balance 10000

Sale of Assets and loss 20000
Date
Accounts
dist
2011
30000
0
May 15 Cash
Dist. of deficit (40:20)
A, Capital [4/10 x 70,000]
B, Capital [4/10 x 70,000]
30000
0
Capital
[2/10 x 70,000]
Contributed by AC,
and
C 10000
Non-cash
40000 assets 0
Pyt to creditors
(40000)
A, capital [4/6 x 18,000]
Post-liquidation balance
0
B, capital0 [2/6 x 18,000]
B, Capital

Liab.

A,
B,
Cap.
Cap.
40%
40%
40000
34000
10000
(28000 (28000
Debit
Credit
)
)
40000
6000
(18000
20,000
)
(12000
18000
28,000
)
28,000
40000
(6000)
0
14,000
6000
40000
0 90,0000
(40000
)
12,000
0
0
6,000 0
18,000

Cash
A, Capital
C, Capital

10,000

Liabilities
Cash

40,000

6,000
4,000
40,000

C,
Cap.
20%
16000
(14000)
2000
(6000)
(4000)
4000
0
0

43

Principles of Accounting II (ACPF 202); Lecture note

dd

UNIT SIX
ACCOUNTING FOR CORPORATIONS

A corporation is a legal entity an artificial legal person created on the approval

of the appropriate governmental authority. To form a corporation, the

incorporators (often at least three are required) must apply for a charter.

Characteristics of Corporations
1. Separate Legal Entity
2. Limited Liability
3. Transferability of Ownership
4. Continuity of Existence
5. Capital-raising Capability
6. Taxation (Double Taxation)
7. Regulation and Supervision
Corporations are subject to greater degrees of regulation and supervision.
44

Principles of Accounting II (ACPF 202); Lecture note

Nature and Types of Stock in a Corporation
Authorized stocks: are the maximum numbers of shares of each class of stock

that may be issued.

Issued stocks: are stocks (Shares) that have been sold and issued to
stockholders constitute the of the corporation. The corporation may
repurchase some of this stock.
Treasury stocks: are shares (stocks) that are reacquired by the corporation.
Outstanding stock: The stocks (shares) that are held by the stockholders.

Classification of Stock
1. Common Stock
When only one class of stock is issued, it is called common stock. Common
shareholders compose the basic ownership class.

Characteristics of common stockholders

They have rights to:
Vote,
Share in earnings,
Participate in additional issues of stock (in the case of liquidation)
Share in assets after prior claims on the corporation have been settled.
Corporations have Preemptive right to maintain his or her proportionate interest
in the corporation.
2. Preferred Stock
Preferred stock is a class of stock with various characteristics that distinguish it
from common stock.

Characteristics of Preferred Stock

Preference over common stock as to dividends
Cumulative dividend rights
Preference over common stock as to assets in event of the liquidation of
the company
Callable at the option of the corporation
No voting power
Preferred stock has one or more preferences over common stock, usually with
reference to
(1) Dividends and
45

Principles of Accounting II (ACPF 202); Lecture note

(2) Assets when the corporation liquidates.

Accounting for Corporations

Issuance of Stocks

Example: the corporate charter of XYZ Company specifies "authorized capital

stock, 100,000 shares, par value Br, 1 per share. Further, assume that to date,
XYZ Corporation has sold and issued 30,000 shares of its capital stock. The
stocks can be summarized as follows:
Authorized shares
Issued shares
Un-issued shares

100,000
30,000
70,000

If the corporation has repurchased 1,000 shares to date, the authorized shares,
treasury stocks, un-issued stocks, and outstanding stocks will be as follows:
Authorized shares
100,000
Treasury stock
(1,000)
Un-issued shares
(70,000)
Outstanding shares
29,000 shares
The primary sources of stockholders' equity are:
1.

Contributed capital from the sale of stock, which

is the amount invested by stockholders through the purchase of shares of
stock from the corporation. Contributed capital has two distinct components:
(a) Par or stated value derived from the sale of capital stock and
(b) Additional contributed capital in excess of par or stated value.
This is often called additional paid-in capital.

2.

Retained earnings generated by the profit-making

activities of the company.
Most companies generate a significant part of their stockholders' equity from
retained earnings rather than from capital raised through the sale of stock.

Sale and Issuance of Capital Stock

Illustration:
1. Assume that on January 1, 2010, ABC Company sold 100,000 shares of
its Br 0.10 par value stock for Br 22 per share. The journal entry would
be:
Date
2010
Jan. 1

Accounts

Debit

Cash
Common stock
Paid In Capital in Excess of par

2,200,000

Credit

10,000
2,190,000

46

Principles of Accounting II (ACPF 202); Lecture note

2. If the corporation specifies in its bylaws a stated value per share as legal capi
tal, then Pass the journal entry:
Date Accounts
2010
Jan. 1 Cash
Common stock
Paid In Capital in excess of stated value

Debit

Credit

2,200,000
10,000
2,190,000

3. The corporation must record the total proceeds received from each sale of nopar stock as legal capital. In this case, the total proceeds are recorded in the
Common Stock account and there is no account called Capital in Excess of Par.
Date
2010
Jan. 1

Accounts

Debit

Cash
Common stock

2,200,000

Credit

2,200,000

Treasury Stock
Capital stock that is reacquired by a corporation is termed treasury stock.
Treasury stock has no voting, dividend, or other stockholder rights.
If treasury stock is resold, no gain or loss is recognized on the exchange
because the corporations primary objective is not to make profit by trading
in its own stock.
The treasury stocks are not assets; they are deductions from stockholders
equity.
The Treasury Stock account is a contra equity account.
Treasury stock is stock that is no longer outstanding, and
47

Principles of Accounting II (ACPF 202); Lecture note

Therefore, should not be included as part of stockholders' equity.
Purchase or sale of treasury stock does not affect the number of shares of
stock that are issued or un-issued.
Treasury stock affects only the number of shares of outstanding stock;
The basic difference between treasury stock and un-issued stock is that
treasury stock has been sold at least once.
Stock can be reacquired for various reasons such as:

To have shares available for distribution to employees under bonus

plans,

To support (boost) the market price of the stock.

Example: Assume that On April 1, 2010, ABC Company bought 100,000 shares
of its stock in the open market when it was selling for Br 22 per share. The
journal entry to record purchase of treasury stock is:
Date
2010
Apr. 1

Accounts

Debit

Treasury stock (100,000 x Br220)

Cash

2,200,000

Credit

2,200,000

Dividends
The earnings of a corporation that are not retained in the business for growth and
expansion are distributed to the stockholders by means of dividends.
There are three important dates in relation to dividends:
1. Declaration date
2. Date of record
3. Date of payment

Cash Dividend
Investors who purchase preferred stock give up certain advantages that are
available to investors in common stock.
Declared dividends must be allocated between the preferred and common stock.
First, the preferences of the preferred stock must be met, and then the remainder
of the total dividend can be allocated to the common stock.
The Steps to allocate dividends:
1. Allocate dividends in arrears to the preferred stock
2. Allocate current year dividend to the preferred stock
3.
If the preferred stocks are participating, allocate matching dividends to
48

Principles of Accounting II (ACPF 202); Lecture note

4.

common stock.
If there is a balance after step 3, it is allocated to both preferred and
common stock.

**If the preferred stocks are non-participating, the entire remaining amount after
step 2 will be given to common stock.
Illustration:
Preferred stock outstanding, 6%, par Br 20; 2,000 shares Br 40,000
Common stock outstanding, par Br10; 5,000 shares Br 50,000
The common stock will also be entitled to 5% of their stocks par value. If the
current year dividend to the preferred stock is Br 2 per share, the comparable
dividend will also be Br 2 per share to the common stock
Assume also that the dividends are in arrears for one year, and preferred stocks
are cumulative and participating.
If the amount of cash dividend declared is Br 50,000 it will be allocated as follows:

Preferred
Par Value
Br 40,000
Total Dividend
1. Dividends in arrears [0.06x 50,000]
3,000

Remaining amount
2. Current year dividend
to preferred
Remaining amount
3. Matching dividend to common stock
[0.05 x 50,000]
Remaining amount
4. To both classes of shares:
[41,500/90,000=0.46]
[0.46 x 40,000; 0.46 x 50,000]

Total

Common
Br 50,000

Total
Br 90,000
Br 50,000
(3,000)

47,000
3,000

(3,000)
44,000
2,500

(2,500)
41,500

18,444

23,056

(41,500)

24,444

25,556

50,000

Notice that all the four steps are applied in this example because there were
dividends in arrears and the preferred stocks were cumulative and participating.
Journal entry is prepared on the date of declaration of the dividends, say
December 31, 2010, as follows:
Date
2010
Dec.31

Accounts

Debit

Dividends

50,000

Dividend Payable: Preferred

Dividend Payable: Common

Credit

24,444
25,556

The dividends account would be closed as follows:

Date Accounts
2010
Dec.31 Retained Earnings
Dividends

Debit

Credit

50,000

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50,000

Principles of Accounting II (ACPF 202); Lecture note

If the dividends are paid out on January 1, 2011, the following entry would be
prepared;
Date
2011
Jan 1

Accounts

Debit

Retained Earnings
Dividend Payable: Preferred
Dividend Payable: Common

50,000

Credit

24,444
25,556

If we assume that the preferred stocks are non-cumulative non-participating, the

dividends would be allocated as follows:
Preferred
Common
Total
Par Value
Total Dividend
1.
Current year dividend
(3,000)

Br 40,000
to preferred

Br 50,000

Br 90,000
Br 50,000

3,000

Remaining amount
2.

47,000

All the remaining amounts to common Stock -

47,000

(47,000)

Total

3,000

47,000

50,000

Stock Dividends
Corporations issue stock dividends instead of cash dividends. A stock dividend is
a distribution of additional shares of a corporation's own capital stock on a pro
rata basis to its stockholders at no cost. Stock dividends usually consist of
common stock issued to the holders of common stock. Journal entry is as
follows:
Date
2011
Feb 6

Accounts

Debit

Retained Earnings
Common Stock

xxx

Credit

xxx

Stock Splits
Stock splits occur when management wishes to reduce the market price of
stock so that more investors can afford it.
When stock is split, the par or stated value of the stock is reduced as well
as the market value.
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Principles of Accounting II (ACPF 202); Lecture note

No journal entry other than a memorandum entry.
A stock split affects only the par value of the stock and the number of
shares outstanding; the individual equity account balances are not
changed.
Stock splits are not dividends.
They are similar to a stock dividend, but are quite different in terms of
their impact on the stockholders' equity accounts.
In a stock split, the total number of authorized shares is increased by a
specified amount, such as a 2-for-1 split.
In contrast to a stock dividend, a stock split does not result in a transfer of
retained earnings to contributed capital. No transfer is needed because the
reduction in the par value per share compensates for the increase in the
number of shares.
In both a stock dividend and a stock split, the stockholder receives more
shares of stock, but does not disburse any additional assets to acquire the
additional shares.
A stock dividend requires a journal entry; a stock split does not require
one. A stock split is disclosed in the notes to the financial statements.

The Statement of Stockholders Equity

The statement of stockholders equity is prepared periodically to summarize the
changes that have occurred in the stockholders equity of the corporation. In
some cases, the statement of retained earnings is prepared instead of the
statement of Stockholders equity.
This represents a fairly typical statement of changes in retained earnings. Under
rare circumstances, you may see a statement that includes an adjustment to the
beginning balance of retained earnings. This adjustment is called a prior period
adjustment, which is a correction of an accounting error that occurred in the
financial statements of a prior period.

Equity per Share

Equity per share (EPS) is the ratio of stockholder's equity to the related number
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Principles of Accounting II (ACPF 202); Lecture note

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

Equity allocated to common stock

No. of outstanding shares of common stock

The Retained Earnings account is a stockholders equity account with a normal

credit balance. As a result of net losses, however, a debit balance in Retained
Earnings may occur. Such a balance is called a deficit. The deficit reduces the
total stockholders equity of the corporation.

To illustrate, assume that the following balances appear on the balance sheet of
ABC Company:
Common stock, Br 10 par
Br 600,000
Paid in Capital excess of par
120,000
Deficit
75, 000
Total stockholders equity is Br 645,000 (Br 600,000 + Br 120,000 Br 75,000)
and the number of share is 60,000 (Br 600,000/Br 10). The business has only
common stock and hence, the EPS is Br.10.75 (645000/60,000)
To illustrate, assume the following data:
Preferred, 11% stock, Br 50 par
Premium on preferred stock
Common stock, Br25 par

Br2,500,000
275,000
3,750,000
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Principles of Accounting II (ACPF 202); Lecture note

Deficit

1,240,000

Assume also that Preferred stock has prior claim to assets on liquidation to the
extent of 110% of par.
To compute EPS, let us first split the total equity into the two classes of shares:
Total Equity:
Preferred, 11% stock, Br 50 par
Premium on preferred stock
Common stock, Br25 par
Deficit

Br2,500,000
275,000
3,750,000
(1,240,000) Br 5,285,000

Less: Equity to preferred stock (110% x 2,500,000)

Equity to Common Stock

2,750,000
Br 2,535,000

1. Preferred EPS = Br 2,750,000 = Br 55.00 per share

2,500,000/Br 50

2. Common EPS = Br 2,535,000 = Br 16.90 per share

3,750,000/Br 25

Exercise:
Case 1
Preferred 9% stock, Br50 par
Br1,200,000
Common stock, Br 50 par
4,000,000
Premium on common stock
340,000
Retained earnings
108,000
Dividends are in arrears for 2 years and preferred stock is entitled to par plus unpaid
dividends to the extent of Retained earnings.
Case 2
Same as Case 1 above except that preferred stock is entitled to dividends regardless of the
balance of retained earnings.
Required: Compute equity per share for the above two cases.

Case 1
Total Equity:
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Principles of Accounting II (ACPF 202); Lecture note

Preferred 9% stock, Br 50 par
Common stock, Br 50 par
Premium on common stock
Retained earnings
Less: Equity to preferred stock:
Par value
Dividends in arrears (.09 x 1,200,000) x 2
Equity to Common Stock

Br1,200,000
4,000,000
340,000
108000

Br 5,648,000

Br 1,200,000
108,000

Br 1,308,000
Br 4,340,000

1. Preferred EPS = Br 1,308,000 = Br 54.50 per share

1,200,000/Br 50
2. Common EPS = Br 4,340,000 = Br 54.25 per share
4,000,000/Br 50
Case 2
Total Equity:
Preferred 9% stock, Br 50 par
Common stock, Br 50 par
Premium on common stock
Retained earnings
Less: Equity to preferred stock :
Par value
Dividends in arrears (.09 x 1,200,000) x 2
Equity to Common Stock

Br1,200,000
4,000,000
340,000
108,000
Br 2,000,000
216,000

Br 5,648,000
Br 2,216,000
Br 3,432,000

1. Preferred EPS = Br 2,216,000

= Br 92.33 per share
1,200,000/Br 50
2. Common EPS = Br 3,432,000
= Br 42.90 per share
4,000,000/Br 50

54