Principles of Accounting 1

CHAPTER 1: ACCOUNTING FOR INVENTORIES 1.1 IMPORTANCE OF INVENTORIES Definition: inventories are: Merchandise held for sale in the normal course of operation in merchandising businesses Materials in process of production or Materials held for production purpose (Raw Materials). But in this chapter the emphasis is mainly on merchandises purchased and held for resale. Objective-the major objective of accounting for inventories is the proper determination of income through the process of matching appropriate cost against revenues. The Importance of inventories includes: Merchandise inventory is one of the most active elements in the operation of a merchandising business because it is continually purchased and sold. The sale of merchandise is the principal source of revenue in both merchandising and manufacturing business. The cost of merchandise sold is the largest deduction from net sales in the determination of net income or net loss. It is the largest portion in the current asset of merchandising businesses The Effect of an Error in the Determination Inventory on the Financial Statements Inventory determination plays an important role in matching expired costs with revenues of the period. An error in the determination of the inventory amount at the end of the period will cause the following errors: Misstatement of gross profit and net income The incorrect amount of inventory i.e. the inventory to be reported in the balance sheet is incorrect amount. Illustration 1: 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. 450000 Beginning Inventory (January 1, Year I) ----75000 Net Purchases------------------------------------- 420000 Other Assets (December 31, Year I) ---------- 310000 Liabilities (December 31, Year I) -------------- 225000 Operating Expenses------------------------------ 135000 Instruction: Prepare Income Statement and Balance Sheet under the following assumption: 1. Ending Inventory is correctly stated at Br. 220000 2. Ending Inventory is incorrectly stated at Br. 210000 3. Ending Inventory is incorrectly stated at Br. 225000 1 Assumption 1: ending inventory is correctly stated as Br.220000 BB Company Income Statement For the year ended December 31, Year I Net Sales---------------------------------------Br. 450,000 Less: Cost Goods Sold Beginning Inventory-----75000 Net Purchases------------420000 CMAS---------------------495000 Less: Ending Inventory (220000) Cost of Goods Sold-------------------------- (275,000) Gross Profit---------------------------------175,000 Less: Operating Expenses----------------(135,000) Net Income---------------------------------- Br. 40,000 BB Company Balance Sheet December 31, Year I Merchandise Inventory----220,000 Other Assets----------------310,000 Total Assets-----------------530,000 Liabilities--------------------225,000 Capital-----------------------305,000 Liabilities and OE--------- 530,000 Assumption 2: ending inventory is incorrectly stated as Br.210000 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 BB Company Balance Sheet December 31, Year I Merchandise Inventory----210,000 Other Assets----------------310,000 Total Assets-----------------520,00 Liabilities----------------------205,000 Capital-------------------------305,000 Liabilities and OE----------- 520,000 2 The effects of understating Ending Inventory by Br.10000 were as follows: 1. In the incomes statement To increase Cost of Goods Sold by Br.10000 To decrease Gross Profit by Br.10000 To decrease Net Income by Br.10000 or Increase Net Loss by Br.10000 2. In the balance sheet To understate total assets by Br.10000 To understate Capital by the Same Amount Assumption 3: ending inventory is incorrectly stated as Br.225000 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 (225,000) Cost of Goods Sold-------------------------- (270,000) Gross Profit---------------------------------- 180,000 Less: Operating Expenses----------------- (135,000) Net Income---------------------------------- Br. 45,000 BB Company Balance Sheet December 31, Year I Merchandise Inventory----225,000 Other Assets----------------310,000 Total Assets-----------------535,000 Liabilities--------------------225,000 Capital----------------------- 310,000 Liabilities and OE---------- 535,000 The effects of understating Ending Inventory by Br.10000 were as follows: 1. in the incomes statement To decrease Cost of Goods Sold by Br.5000 To increase Gross Profit by Br.5000 To increase Net Income by Br.5000 or decrease Net Loss by Br.5000 2. in the balance sheet To overstate total assets by Br.5000 To overstate Capital by the Same Amount Summary of error in ending inventory on the financial statement of the period in which the error occurred are as follows: Ending Inventory Cost of Goods Sold Gross Profit Net Income Total Assets Capital Correctly Stated Correct Correct Correct Correct Correct Understated Overstated Understated Understated Understated Understated Overstated Understated Overstated Overstated Overstated Overstated 3 The understatement or overstatement of ending inventory does not only affect the financial statement of one accounting period. It also affects the financial statement of two subsequent periods. Illustration 2: The effect of an error in the determination of Ending Inventory in year I will have the following impact on the financial statements of the subsequent accounting period. You are given the following data for Year II: Net Sales---------------------------------Br. 600,000 Net Purchases--------------------------- 375,000 Ending Inventory----------------------- 150,000 Operating expenses--------------------- 105,000 Other Assets as of December 31, Y II 300,000 Total Liabilities------------------------- 110,000 Instruction: Prepare Income statement and balance sheet assuming that ending inventory of year I are reported under the three assumptions above for BB Company 1. Ending Inventory(i.e. Beginning Inventory)----220,000 2. Ending Inventory(i.e. Beginning Inventory)----210,000 3. Ending Inventory(i.e. Beginning Inventory)----225,000 Assumption 1: Beginning Inventory is correctly stated as Br.220000 BB Company Income Statement For the year ended December 31, Year II Net Sales---------------------------------------Br.600000 Less: Cost Goods Sold Beginning Inventory-----220,000 Net Purchases------------375,000 CMAS---------------------595,000 Less: Ending Inventory (105,000) Cost of Goods Sold-------------------------- (445,000) Gross Profit---------------------------------- 155,000 Less: Operating Expenses----------------- (105,000) Net Income--------------------------------- Br. 50,000 BB Company Balance Sheet December 31, Year II Merchandise Inventory----150,000 Other Assets----------------300,000 Total Assets-----------------450,000 Liabilities----------------------110,000 Capital-------------------------340,000 Liabilities and OE -----------450,000 4 Assumption 2: Beginning Inventory is incorrectly stated as Br.210000 BB Company Income Statement For the year ended December 31, Year II Net Sales---------------------------------------Br. 600,000 Less: Cost Goods Sold Beginning Inventory----210,000 Net Purchases------------375,000 CMAS---------------------585,000 Less: Ending Inventory (150,000) Cost of Goods Sold-------------------------- (435,000) Gross Profit---------------------------------165,000 Less: Operating Expenses----------------- (105,000) Net Income---------------------------------- Br. 60,000 BB Company Balance Sheet December 31, Year II Merchandise Inventory----150,000 Other Assets----------------300,000 Total Assets-----------------450,000 Liabilities----------------------110,000 Capital-------------------------340,000 Liabilities and OE------------450,000 The effects of understating Beginning Inventory by Br.10000 were as follows: 1. In the incomes statement To understate CMAS by Br.10000 To Understate Cost of Goods Sold by Br.10000 To Overstate Gross Profit by the Same amount Br.10000 To Overstate Net Income by Br.10000 or understate net loss by the amount. Assumption 3: Beginning inventory is incorrectly stated as Br.225000 BB Company Income Statement For the year ended December 31, Year II Net Sales---------------------------------------Br. 600,000 Less: Cost Goods Sold Beginning Inventory----225,000 Net Purchases------------375,000 CMAS---------------------600,000 Less: Ending Inventory (150,000) Cost of Goods Sold-------------------------- (450,000) Gross Profit---------------------------------150,000 Less: Operating Expenses----------------- (105,000) Net Income---------------------------------- Br. 45,000 5 BB Company Balance Sheet December 31, Year II Merchandise Inventory----150,000 Other Assets----------------300,000 Total Assets-----------------450,000 Liabilities--------------------110,000 Capital-----------------------340,000 Liabilities and OE--------- 450,000 The effects of understating Ending Inventory by Br.10000 were as follows: 1. in the incomes statement To overstate CMAS by Br.5000 during year II To overstate Cost of Goods Sold by Br.5000 To understate Gross Profit by Br.5000 To understate Net Income by Br.5000 or decrease Net Loss by Br.5000 Summary of errors in Beginning Inventory (Ending Inventory of the previous accounting period) on the financial statement of the current of period are as follows: Beginning Inventory CMAS Cost of Goods Sold Gross Profit Net Income Correctly Stated Correct Correct Correct Correct Understated Understated Understated Overstated Overstated Overstated Overstated Overstated Understated Understated If inventory amount is stated incorrectly in one period, the effect is limited to the period of the error and the following period only. 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 overstatement in items in the income statement in one accounting period will result in understatement in the subsequent period-set off. 1.2 INVENTORY SYSTEMS Inventory system is a system through which we can determine the cost of merchandise sold and cost of merchandise on hand. Generally, there are two widely accepted inventory system. 1. Periodic Inventory System and 2. Perpetual Inventory System Periodic Inventory System: Only revenue from sales is recorded No effort is made to keep up to date records of either inventory or cost of merchandise sold Purchase of merchandise is debited to purchases account 6 A physical inventory is taken at the end of the period to determine the merchandise on hand i.e. counting merchandise on hand CGS is the difference between CMAS and cost inventory on hand It is used by small businesses which sale many items with low unit cost of merchandise. Perpetual inventory system A separate account or record is maintained for both cost of goods sold and merchandise inventory on hand The inventory account shows the increase, decrease and the balance in the account Provides up to date data about each type of product that the company sells Used by firms which sells relatively small number of item which have high unit cost Physical inventory is taken to compare the balance on the records with the balance on hand Each time inventory is sold, it will be transferred to cost of merchandise sold account The appropriate inventory balance is adjusted to the quantities determined by the physical count. Note: a business may use different inventory system for different items of merchandise. Illustration: record the following transactions. 1.3 DETERMINING ACTUAL QUANTITIES IN INVENTORY In the determination of the quantities of inventory that is physical inventory all goods owned by a business enterprise on the date of physical inventory count must be included. This includes: goods in the store room and warehouse places where merchandise are kept when they received from the port goods in the shelves and sales counter ( show room) goods purchased on terms of FOB shipping point agreement and still on transit consigned goods but not sold by the sales agent or consignee Goods sold on FOB destination agreement are excluded from inventory determination because once it counted sales. If it is included, it will be double counting. The sale is already recorded. Thus, the goods should be excluded from the inventory count. 1.4 DETERMINING THE COST OF INVENTORY Form theoretical point of view the cost of merchandise includes: A purchase price or invoice price All other expenditures necessary to place the items in its proper condition and location such as transportation cost, import duties(custom duties), insurance against loss while it is in transit and store room, cost of receiving and inspection( checking the goods whether it is damaged or not). Any costs which are difficult to associate with specific inventory but related to inventory may be prorated on some equitable basis Any incidental cost which is not material may be excluded from the cost of merchandise and treated as operating expenses. 1.5 INVENTORY COSTING METHODS UNDER A PERIODIC SYSTEM The term cost flow refers to the inflow of costs when goods are purchased or manufactured and to the outflow of costs when goods are sold. The cost remaining in inventories is the difference between the inflow and outflow of costs. The problem often faced by an accountant is determining the cost of merchandise sold and the cost of remaining inventories or ending 7 inventories when merchandise are purchased at different costs. If identical goods are purchased at different costs during the period, there should be an arbitrary assumption as to the cost flow of merchandise through the business such as: 1. FIFO (First In First Out) 2. LIFO (Last In Fits Out) 3. AVERAGE Costing Method 4. SPECIFIC IDENTIFICATION-which is rarely used unless it is large item INVENTORY COSTING UNDER PERIODIC INVENTORY SYSTEM You are given the following data for BB Electronics for the year 2003 for one of its item called CD-RW. Date January 1, 2003 March 31, 2003 April 1, 2003 June 30, 2003 July 1, 2003 September 30, 2003 October 1, 2003 December 31, 2003 Item Inventory Sold Purchases Sold Purchases Sold Purchases Sold Quantity 500 Units 300 Units 1800 Units 600 Units 500 Units 700 Units 200 Units 800 Units Unit Cost Br.10.5 12 12.50 13 Total Cost Br.5250 21600 6250 2600 Required: For the CD-RW of BB Electronics compute the cost of inventory on hand as of December 31, 2003 and cost of merchandise sold under the following cost flow assumptions 1 FIFO Costing Method 2 LIFO Costing Method 3 Average Costing Method FIFO Cost Flow Assumption FIFO cost flow is in the order in which the expenditures were made. FIFO assumes that items acquired first should be sold first to customers. FIFO charges costs against revenue in the order in which they were incurred. Hence: Inventory on hand assumed the most recent costs The merchandise sold assumed the oldest or earliest costs Ending Inventory in Units= 3000- 2400= 600 units Cost of Ending Inventory Cost of Merchandise Sold 200 Units * Br.13----------------2600 CMS= CMAS-EI 400 Units * Br. 12.50----------- 5000 CMS=Br.35700-7600 CMS=Br.28100 OR Cost of Ending Inventory----Br.7600 Cost of Merchandise Sold 500 units * Br. 10.5-----------5250 1800 units * Br.12----------- 21600 100 units * Br.12.5----------- 1250 CMS-------------------------Br.28100 FIFO-Advantage and Disadvantage Advantage-The merchandise inventory to be reported in the Balance Sheet approximates its replacement cost Disadvantage-It matches old costs with current revenue 8 LIFO Cost Flow Assumption LIFO cost flow is in the reverse order in which the expenditures were made. LIFO assumes that items purchased last should be sold first. It charges or deducts the most recent costs against or from revenue. Hence: The ending inventory assumed the oldest purchases or earliest costs and The cost of merchandise sold assumed the most recent costs. Cost of Merchandise Sold Cost of Ending Inventory 500 Units * Br.10.5--------------5250 CMS= CMAS-EI 100 Units * Br. 12--------------- 1200 CMS=Br.35700-6450 OR Cost of Ending Inventory----Br.6450 CMS=Br.29250 Cost of Merchandise Sold 200 units * Br. 13------------ 2600 500 units * Br.12.5------------ 6250 1700 units * Br.12------------ 20400 CMS-------------------------Br.29250 LIFO advantage and disadvantage Advantage-It matches current costs with current revenue Disadvantage-The amount of inventory reported does not approximate its replacement costs THE AVERAGE METHOD This cost flow is an average of the expenditure. It charges costs against revenue according to the waited average unit cost of the goods available for sale. Weighted Average Unit cost = U1*C1 + U2*C2 + U3*C3 + U4*C4 + …. Total Units Weighted Average Unit cost = 500*10.5 + 1800*12 + 500*12.5 + 200*13 500 + 1800 + 500 + 200 Weighted Average Unit cost = Br.35700 = Br.11.90 3000 Cost of Merchandise Sold Cost of Ending Inventory EI= Br. 11.90* 600 units CMS= Br.11.90* 2400 units EI= Br. 7140 CMS= Br. 28560 or CMS= CMAS-EI CMS=Br. 35700-7140 CMS=Br.28560 9 Comparison of the Three Methods Method FIFO LIFO AVERAGE CMAS 35700 35700 35700 LESS: EI 7600 6450 7140 CMS 28100 29250 28560 The higher the unit cost of ending inventory is the higher the total cost of ending inventory which means the lesser the CMS where as the lesser the unit cost of EI is the lesser the total cost of EI which means the higher the CMS. 1.6 ACCOUNTING FOR AND REPORTING INVENTORY UNDER A PERPETUAL SYSTEM Under perpetual inventory system, all merchandises increases and decreases are recorded in a manner somewhat similar to the recording of increases and decreases in Cash account. The merchandise inventory account at the beginning of an accounting period reflects the merchandise on hand on that date. Then purchases of merchandise is debited to merchandise inventory account each time purchase was made and sales are recorded in the sales account and the cost of each sale is recorded by debiting CMS account and crediting merchandise inventory. Illustration: January 1: Merchandise inventory-----------------Br. 60000 January: Purchases----------------------------28000 January: Sales@ Selling Price---------------- 30000 January: Sales@ Cost-------------------------21000 February: Sales@ Selling Price--------------40000 February: Sales @ Cost-----------------------32000 March: Sales@ Selling Price------------------ 20000 March: Sales @ Cost--------------------------14300 Instruction: Record the above transactions assuming that the physical inventory showed Br.20500. Date Periodic System Perpetual System January 1, Merchandise inventory has a Dr. Merchandise inventory has a Dr. balance of Br.60000 balance of Br.60000 Recording Purchases-------28000 Merchandise Inventory-----28000 Purchases Cash/A/Pay-------28000 Cash/A/Pay-------28000 January Recording Sales A/Rec/Cash-----30000 A/Rec/Cash-----30000 January Sales------------30000 Sales------------30000 Recording Cost No Entry Cost of Merchandise Sold----21000 January Merchandise Inventory---21000 Recording Sales A/Rec/Cash-----40000 A/Rec/Cash-----40000 February Sales------------40000 Sales------------40000 Recording Cost No Entry Cost of Merchandise Sold----32000 February Merchandise Inventory---32000 Recording Sales A/Rec/Cash-----20000 A/Rec/Cash-----20000 March Sales------------20000 Sales------------20000 Recording Cost No Entry Cost of Merchandise Sold----14300 March Merchandise Inventory---14300 Adjusting Income Summary---60000 Cost of Merchandise Sold----200 10 Merchandise Inv.---60000 Merchandise Inv.----20500 Income Summary----20500 Merchandise Inventory----200 1.7 INVENTORY COSTING METHODS UNDER A PERPETUAL SYSTEM It is customarily to use the inventory cost flow assumption under perpetual inventory system, too. Illustration: For BB Electronics above compute the cost of Ending inventory and merchandise sold assuming that the company uses perpetual inventory system under: FIFO, LIFO and AVERAGE cost flow assumption. A) FIFO Cost Flow Assumption Date Qty Jan.1 Mar.31 Apr.1 June 30 July 1 Sep 30 Oct.1 200 13 2600 500 12.5 6250 700 Purchases UC TC Sold UC Inventory Qty UC TC 500 10.5 5250 10.5 3150 200 10.5 2100 200 10.5 2100 1800 12 21600 10.5 2100 12 4800 1400 12 16800 1400 12 16800 500 12.5 6250 12 8400 700 12 8400 500 12.5 6250 700 12 8400 500 12.5 6250 200 13 2600 12 8400 400 12.5 5000 12.5 1250 200 13 2600 Br.28100 Br.7600 TC Qty 300 1800 12 21600 200 400 Dec. 31 Total B) LIFO Cost Flow Assumption Date Qty Jan.1 Mar.31 Apr.1 June 30 Purchases UC TC 700 100 Qty 300 Sold UC 10.5 TC 1800 12 21600 600 12 Inventory Qty UC TC 500 10.5 5250 3150 200 10.5 2100 200 10.5 2100 1800 12 21600 7200 200 10.5 2100 1200 12 14400 11 July 1 500 12.5 6250 Sep 30 Oct.1 200 13 2600 500 200 12.5 12 6250 2400 Dec. 31 Total 200 600 13 2600 12 7200 Br.28800 200 1200 500 200 1000 200 1000 200 200 400 10.5 12 12.5 10.5 12 10.5 12 13 10.5 12 2100 14400 6250 2100 12000 2100 12000 2600 2100 4800 Br.6900 C) AVERAGE (Moving Average)-each time there is a purchase new average will be computed and sales after that are made at this new average unit cost. Date Jan.1 Mar.31 Apr.1 June 30 July 1 Sep.30 Oct.1 Dec.31 Total Purchases Qty UC TC Sold UC 10.5 11.85 12.02 Inventory UC TC 10.5 5250 10.5 2100 11.85 23700 11.85 16590 12.02 22840 12.02 14426 12.16 17026 12.16 7298 Br.7298 Qty 300 TC 3150 7110 8414 1800 500 200 12 12.5 13 21600 600 6250 700 2600 800 12.16 9728 Br.28402 Qty 500 200 2000 1400 1900 1200 1400 600 Comparison of the Three Methods CMAS LESS: EI CMS 35700 7600 28100 35700 6900 28800 35700 7298 28402 The results of the FIFO method under both the periodic and perpetual inventory systems produces the same result for cost of EI and Merchandise sold The perpetual inventory system provides the most effective means of control over this important asset-merchandise inventory An automated perpetual inventory system facilitates the processing in the case of large number of inventory items. 1.8 VALUATION OF INVENTORY AT OTHER THAN COSTDEPARTURES FROM COST VALUATION METHODS Cost is the primary basis for the valuation of inventory. However, when the cost of replacing items in inventory is below recorded cost and when the inventory is not salable at normal selling price because of some reason such as: imperfections, shop wear, style changes, or other 12 causes, it is valued at other than the cost. There are two valuation methods other than the cost: valuation at lower of cost or market and valuation at net realizable value. 1. Valuation at lower of Cost or Market (LCM) The LCM method requires that inventory should be valued at the lower of the two values: Cost or Market. The LCM works as follows: Determine the cost of inventory using FIFO, LIFO or AVERAGE Determine the market value or the replacement cost Compare the cost with the market value and take the lower of the two as a value of inventory Illustration: BB Electronics Compile the following data concerning items in its inventory on December31, 2004 Items Quantity Unit Cost Unit Market Price CD-R 10000 Br.4 Br.3.50 CD-RW 4000 12 13 Walkman-Sony 20 150 140 Discman-Sony 50 200 200 VCD Player-Sony 100 500 520 DVD Player-Sony 50 650 640 Instruction: determine the total cost inventory to appear in the balance sheet of BB Electronics as of December 31, 2004 assuming that LCM is applied to To the inventory as a whole To a major category of inventory To each item in the inventory or item by item basis Items Cost Market LCM-II LCM-III A CD-R Br.40000 Br. 35000 35000 CD-RW 48000 88000 52000 87000 87000 48000 B Walkman-Sony 3000 2800 2800 Discman-Sony 10000 13000 10000 12800 12800 10000 C VCD Player-Sony 50000 52000 50000 DVD Player-Sony 32500 82500 32000 84000 82500 32000 Total-I 183500 183800 182300 177800 • If LCM is applied to the inventory as a whole, the lower is the total cost Br.183500 and this amount has to be reported in the balance sheet. • If LCM is applied to a group of inventory, it is resulted in Br.182300 value and this amount has to be reported in the balance sheet. • If LCM is applied to the each item in the inventory, it is resulted in Br.177800 value and this amount has to be reported in the balance sheet. In the application of the LCM rule item by item basis resulted in the lowest inventory value where as the inventory as a whole basis resulted in the highest value of inventory. Many authors recommended that: • Item by item basis shall be used for income tax purposes because it will result in lower 13 income tax • The inventory as whole should be applied for financial accounting purpose to know the actual profit of the businesses. A restriction to the LCM method is inventory should never be carried at an amount that is greater than its net realizable value (NRV) 2. Valuation at Net Realizable Value (NRV) The NRV is the difference between the estimated selling price and any direct cost of disposition (i.e. any anticipated or forecasted selling expense such as sales commissions). Obsolete, spoiled, or damaged merchandise and other merchandise that can be sold at a price below cost should be valued at Net Realizable Value. Illustration: on December 31, 2003 the following data is given for the inventory of item x of AA Company: 100 Units on hand (Cost under FIFO) ------------------Br.5000 Replacement Cost of the items--------------------------- 4500 Selling Price------------------------------------------------ 4500 Sales Commission----------------------------------------200 Instruction: at what amount should the item be presented in the balance sheet on December 31, 2003? NRV = Selling Price – Cost of Disposition NRV = Br.4500 – 500 NRV = Br.4000 What if the replacement cost of the item is Br. 3900- take the lower of the two values that is the lower of the NRV or its current replacement cost 1.9 ESTIMATING INVENTORY COST For companies using a periodic inventory system taking physical inventory to prepare interim financial reports is both expensive and time consuming. There fore, such companies may use estimated amount inventory balance in preparing monthly or quarterly financial statements. There are two methods of inventory estimation: the retail method and the gross profit method. 1. Retail Method It is used by retailers to estimate the cost of inventory on hand. Under this method: • Records are kept for goods available for sale at both selling price (Retail Price) and at Cost • Sales are recorded and total sales for accounting period are deducted from the total value of goods available for sale to determine the ending inventory at selling price. • The EI valued at selling price is changed to estimated cost by multiplying by the cost to retail ratio Illustration: the following data was extracted from MM Corporation for the month of March. Items @ Cost @ Selling Price Beginning Inventory Br.60000 Br.10000 Net Purchases 96000 160000 14 CMAS 156000 260000 Sales 180000 Instruction: Estimate the cost of Ending Inventory by the Retail Method Cost to Retail Ratio = Br. 156000 = 60% 260000 Beginning Inventory-----------------------------100000 Net Purchases-------------------------------------160000 CMAS--------------------------------------------- 260000 Less: Sales--------------------------------------- (180000) Ending Inventory@ Selling Price-------------- 80000 Ending Inventory@ Cost = 60% * 80000 = Br. 48000 2. The Gross Profit Method When the GP rate or percentage is known, the ending inventory can be estimated by the following procedures: • Determine the CMAS from the accounting records. • Estimate the gross profit by multiplying the net sales by the GP rate. • Determine CMS by deducting the gross profit form the net sales • Determine the estimated ending inventory by deducting CMS from the CMAS Illustration: the following data is taken from MM Corporation as to one of its inventory Beginning Inventory------------------------------Br.20000 Net Purchases-------------------------------------- 80000 Sales------------------------------------------------- 90000 Estimated Gross Profit Rate---------------------25% Instruction: determine the estimated ending inventory Beginning Inventory------------------------------------Br.20000 Net Purchases-------------------------------------------- 80000 Cost of Merchandise Available for Sales----------- Br.100000 Less: Cost of Merchandise Sold Sales------------------------------------Br. 90000 Less: Estimated GP (25% * 90000) = (22500) (675000) Estimated Cost of Ending Inventory-----------------Br. 325000 1.10 Presentation of Merchandise Inventory on the Balance Sheet CHAPTER 2: ACCOUNTING FOR PLANT ASSETS 2.1 NATURE OF PLANT ASSETS Plant assets: 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 15 2.2 ACQUISITION OR INITIAL COSTS OF PLANT ASSETS The cost of a plant asset includes all expenditures that are reasonable and necessary for getting the asset to the desired location and ready for use. They are: Purchase price Sales Tax Installation Cost Special foundation Insurance while the asset is in transit For a newly purchased plant asset the acquisition cost may include: Purchase Price Sales Tax Insurance Transportation Cost Special Foundation Installation Costs if it needs For a second hand purchased plant asset the acquisition cost may include: The agreed price Maintenance cost Cost of replacing parts Repairs and Painting costs Costs of building-newly constructed building Fees paid to architects or designers For engineers for plans and supervision Insurance incurred during the construction Other costs like labor, materials and overhead costs Costs of walkways Interest incurred during the construction on money borrowed Cost of old Building Includes: Agreed price Commission Repair and maintenance costs Accrued tax on property Cost of land Negotiated price or agreed price Commission for Brokers Legal fees for title transfer and other expenditures for securing title Fees for Surveying, draining, clearing and grading or leveling the land The cost of razing or removing unwanted building less any salvage recovered. Cost of land Improvement Cost of Driving ways Cost of Fences Cost of Outdoor lighting system Cost of Parking lots Cost of Walkways if it does last as long as the life of the building Cost of Trees and Shrubs Note: Expenditures resulting from carelessness or errors in installing the assets, from vandalism, or from other unusual occurrences don’t increase the usefulness of the asset and should be treated as an expense. 16 2.3 NATURE AND ACCOUNTING FOR DEPRECIATION Plant asset is 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 spreaded 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: 1. Physical Usage-this is physical depreciation resulted from the wear and tear due to the operating use and forces on nature such as earth quake, land slide, storm, etc 2. Functional or economic depreciation-are resulted 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 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 Accounting for Depreciation Method of Depreciation Usually the following 4 methods are used to allocate the depreciate cost. These are: 1. Straight line method 2. Declining balance method 3. Sum of the year’s digit method and 4. Units of production method 1. Straight Line Method 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: assume that a machine is acquired at the beginning of 1991 for Br. 100000 and the residual value of the machine at the end of 10 years of economic life is estimated at Br.10000. Instruction: compute the amount of depreciation allocable to each year and present the necessary adjustment at the end of each year. Depreciation per year = Br.100000– 10000 = Br.90000 = Br. 9000 10 Years 10 years Depreciation Expense--------9000 Accumulated Depreciation--------9000 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 * (Acquisition Cost – Accumulated Depreciation) 17 EEL Example: CC Corporation purchased equipment on January 1, 2000 for Br. 20000 which has an expected life of 5 years and salvage value of Br. 1000. Instruction: calculate the declining balance rate and the amount of depreciation for its useful life. Cost = Br.20000 EEL = 5 years Residual Value = Br.1000 Year 2000 = 2/ 5 * (Br.20000 – 0) = 40% * Br. 20000 = Br. 8000 Year 2001 = 40% * (Br.20000 – 8000) = 40% * Br.12000 =Br.4800 Year 2002 = 40% * (Br.20000 – 12800) = Br.2880 Year 2003 = 40% * (Br.20000 – 15680) = Br.1728 Year 2004 = 40% * (Br.20000 – 17408) = Br.1037 In the year 2004 the calculated amount of depreciation is Br.1037 but the actual depreciation expense is Br.1592 (Br.2592 – 1000). The 2592 is the difference between Br.20000 and 17408. 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 significant RV, depreciation should consider this residual value. Thus, in the above example the depreciation expense for year 2004 is Br.1592 rather than Br.1037 3. 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 annual depreciation using the following formula: Annual Depreciation = (AC – RV) * RV/ SOYD Illustration: JK Company purchased old building on January 1, 1995 for Br.105000 and its estimated life is 4 years with a salvage value of Br.5000 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 Depreciation Expense 1995 = 4/10 (105000 – 5000) = Br.40000 1996 = 3/10 (105000 – 5000) = Br.30000 1997 = 2/10 (105000 – 5000) = Br.20000 18 1998 = 1/10 (105000 – 5000) = Br.10000 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 Example: 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. Instruction: calculate the depreciation expense for the year 2000 and 2001 assuming that the generator was used for 100000 and 120000 machine hours, respectively. Depreciation Rate = Br.50000 – 0 / 500000 hours = Br. 0.10 per hour Year 2000depreciation expense = depreciation rate * actual usage Year 2000 depreciation expense = Br.0.10/ Hr. * 100000 hours Year 2000 depreciation expense = Br. 10000 Year 2001 depreciation expense = depreciation rate * actual usage Year 2001 depreciation expense = Br.0.10/ Hr. * 120000 hours Year 2001 depreciation expense = Br. 12000 2.4 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 of purchase affects 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 Example: GG Company purchases a delivery truck on April 13, 1991 for Br. 180400. The expected life of the truck was 4 years or 200000 KMs and has an estimated salvage value of Br.6400. and during the year 1991 and 1992 the truck was driven for 60000 and 40000 KMs, respectively. The company’ fiscal period ends on December 31 of each year. Compute depreciation expense for the year 1991 and 1992 under all the methods of depreciation. Methods Straight line Declining Balance Annual Depreciation = 180400 – 6400/4 = Br.43500 = 2/4 (Br.180400-0) Br.90200 1991- Fraction = 9/12 * Br.43500 = Br. 32625 =9/12 * 90200 = Br. 67650 1992 =Br. 43500 =3/12 * 90200 + 9/12 * 50%* 90200 = 22550 + 33825 = Br. 56375 =4/10 * 174000 * 3/12 + 3/10 * 174000 * 9/12 = 17400 + 39150 = Br. 56550 = 40000kms * 0.87/km = Br.34800 19 SOYD Method =Soyd = 4 (4 + 1)/2 = 10 = 4/10(180400-6400) * 9/12 = Br.52200 Units-of = 180400 – Production 200000kms 6400/ = 60000kms * 0.87/km = Br.52200 = Br.0.87/ km 2.5 CHANGES IN ESTIMATES AND REVISION OF PERIODIC DEPRECIATION Residual value, estimated economic life are estimates. There may error in estimates. Estimates may be revised or changed. The change in estimates is applicable only to the undepreciable value or cost ignoring the past. It does not work retroactively to the past accounting periods. Illustration: assume that on January 1, 1992 AA Company purchased a delivery truck for Br.52000. at the time of purchase the truck was estimated to last 5 years with salvage value of Br. 2000 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.2600 Givens: cost Br. 52000 Salvage value= Br.2000 EEL = 5 Years Depn/ Year = 52000 – 2000 / 5 Depn/ Year = Br.10000 Depreciation from 1992 to 1993 Accumulated Depreciation = Br.10000 * 2 years Accumulated Depreciation = Br.20000 Revised Depreciation starting from 1994 Undepreciated cost = Br.52000 – 20000 Undepreciated cost = Br.32000 Revised EEL = 6 years Revised RV = Br. 2600 Revised Depreciation = Br.32000 – 2600 / 6 Revised Depreciation = Br.29400/6 Revised Depreciation = Br.4900 20 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 to the building – brings the required humidity by cooling the building 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. Illustration: assume a delivery truck costing 190000 has estimated economic life of 9 years with Br. 10000 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. 40000 which was expected to increase the estimated economic life the truck to 8 years with the same salvage value. Instruction: determine the annual depreciation change for the remaining life of the asset. Initial Cost: Br. 190000 Residual Life: Br.10000 Estimated Economic Life: 9 years Annual Depreciation: Br. 190000 – 10000/ 9 years = Br. 20000 Accumulated Depreciation: Br. 20000 * 5 years = Br. 100000 Extraordinary Repairs: Extraordinary Repairs----------------40000 Cash-----------------------------------40000 Accumulated Depreciation--------40000 Extraordinary Repairs--------------400000 After extraordinary repairs: Cost ---------------------------------Br. 190000 Accumulated Depreciation----------- (60000) Book Value--------------------------Br.130000 Annual Depreciation= Br.130000 – 10000/ 8 years = Br.150000 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 21 When an asset is no longer useful to the business, it is retired from the service. This is called disposal. Disposal refers to: • Discarding or throwing away as useless • Selling • Exchanging To journalize the necessary entries on the date of disposal the following information are required: • The accumulated depreciation account balance • The book value of the asset • The loss or gain on disposal 1. Discarding of 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 its machine on December 31, 2003 which was fully depreciated. The machine was acquired at a cost of Br. 150000 before six years. BV = AC – Accumulated Depreciation BV = Br.150000 – 150000 = 0 Accumulated Depreciation-----------------150000 Machine--------------------------------------150000 Illustration 2: RR Company discarded equipment which was purchased at a cost of Br. 32000 after it has been depreciated for 4½ years under the straight line method with a consideration of Br. 2000 salvage value. The economic life considered was 5 years. Journalize the necessary transaction: Annual Depreciation = Br.32000 – 2000/ 5 Annual Depreciation = Br. 6000 Accumulated Depreciation = Br.6000 * 4.5 years Accumulated Depreciation = Br.27000 Book Value = Br.32000 – 27000 Book Value=Br.5000 this implies that the loss in disposal is Br. 5000 because the business is going to discard with a value the same value. Entry: Accumulated Depreciation-------------27000 Loss in disposal----------------------------5000 Equipment---------------------------------32000 2. Selling old plant asset The entry to record the sale of a plant asset is like the entry of discarding above except the cash or other asset received must be recorded. If the selling price > book value, there will be a gain on disposal If the selling price < book value, there will be a loss in disposal Example: RA Furniture Company purchased a computer system for Br. 34000 and the system was expected to last 8 years with a salvage value of Br.2000. The equipment was depreciated for 6 years based on the straight line method and sold at the beginning of year 7. Journalize the necessary entries assuming that the company received: A) Br.15000 B) Br.10000 C) Br.9000 Acquisition Cost = Br.34000 Residual Value = Br.2000 Estimated Economic Life = 8 years Annual Depreciation = Br.34000 – 2000/ 8 22 Annual Depreciation = Br.4000 Accumulated Depreciation = Br.4000 * 6 Years Accumulated Depreciation = Br.24000 Book Value = Br.34000 – 24000 = Br.10000 A. Br.15000-this implies there is a gain of Br.5000 Accumulated Depreciation--------------24000 Cash----------------------------------------15000 Gain on disposal---------------------5000 Computer System-------------------34000 B. Br.10000- this implies there is neither gain nor loss Accumulated Depreciation--------------24000 Cash----------------------------------------10000 Computer System-------------------34000 C. Br.9000 – this implies there is loss of Br.1000 Accumulated Depreciation--------------24000 Cash----------------------------------------15000 Loss on disposal---------------------------1000 Computer System-------------------34000 3. 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-this is an amount deducted from price of new asset as consideration for old plant asset. This allowance is deducted from the purchase price of the new asset and the balance is called Boots which is payable to the seller. 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 in disposal According to GAAP laws on exchange of similar plant assets, loss should be recognized and gain should be adjusted to the price the new asset. The new asset exchanged is recorded at the book value of the old asset plus the cash paid (Boots) or the purchase price which ever is lower. Example: BB Company acquired a machine at Br.80000 by trading in a similar old asset that has a cost of Br. 75000 and up to date accumulated depreciation account balance of this asset is Br.72000. make the necessary journal entries if the TIA is: A. Br.4000 B. Br.3000 C. Br.2000 Book Value = Br.75000 – 72000 = Br.3000 A. Br.4000 TIA is Br.4000; there is a gain of Br.1000. but the gain will not be recognized Boots = Br.80000 – 4000 = Br. 76000 Purchase Price = Br.80000 Boots + Book Value = Br.76000 + 3000 = Br.79000. Thus the new machine should be recorded at Br. 79000 because the lower is this amount Machine (new) ------------------79000 Accumulated depreciation------72000 Cash---------------------76000 Machine (old) ---------75000 B. Br.3000 23 TIA is Br.3000; there is neither a gain nor a loss Boots = Br.80000 – 3000 = Br. 77000 Purchase Price = Br.80000 Boots + Book Value = Br.77000 + 3000 = Br.80000. Thus, the new machine should be recorded at Br. 80000 because both are the same. Machine (new) ------------------80000 Accumulated depreciation------72000 Cash---------------------77000 Machine (old) ---------75000 C. Br.2000 TIA is Br.2000; there is a loss of Br.1000. this loss is recorded in the accounting records in the period. Boots = Br.80000 – 2000 = Br. 78000 Purchase Price = Br.80000 Boots + Book Value = Br.78000 + 3000 = Br.81000. Thus, the new machine should be recorded at Br. 80000 because the purchase price is the lower amount. Machine (new) ------------------80000 Accumulated depreciation------72000 Loss on exchange-----------------1000 Cash---------------------78000 Machine (old) ---------75000 Note: On Exchange of dissimilar plant asset, both loss and gain should be recognized 2.8 ACCOUNTING AND REPORTING FOR NATURAL RESOURCES Natural resources include forests, water resources, minerals, metal ores, oil and gas. The costs of natural resources include all the normal, necessary and reasonable expenditure. The periodic cost allocation of the natural resources is called depletion. To compute depletion the steps are as follows: Depletion Rate = Cost – the estimated RV/ Estimated Deposit Depletion Expense= Depletion Rate * Extracted Deposit Example: MIDROC Gold Mining Company pays Br.4500000 to acquire its mineral site which is believed to contain 500000 tons of Gold ores. The Residual Value is estimated to be Br.500000. If 12000 tons are extracted during the year, compute the depletion rate and depletion expense. Depletion Rate = Br.4500000 – 500000/ 500000 tons = Br.8 per ton Depletion Expense = Br. 8 / ton * 12000 tons = Br. 96000 Entry: Depletion Expense--------------96000 Accumulated Depletion---------96000 2.9 ACCOUNTING FOR INTANGIBLE ASSETS AND AMORTIZATION 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. A. Patents: patent are exclusive right to produce and sell goods with one or more unique features. Patents have the legal life of 17 years which is given by the government of USA. 24 Cost of patent right – the cost of patent right includes the purchase price plus related costs. Calculating Amortization for Patents: patents have a legally granted period of 17 years. However, it may lose their usefulness in a period less 17 years. Thus, amortization for patents should be computed by comparing the legal life and the estimated life and by taking the lower of the two. Example: a patent is purchased for Br.100000 after 6 years of the legal life have been expired. The patent has an estimated useful life of 10 years. Instruction: compute the amortization expense and record the necessary journal entry Note: amortization expense is calculated based on straight line method The remaining legal life = 17 – 6 = 11 years The estimated useful life = 10 years The lower is the estimated useful life = 10 years Amortization Expense = Cost / Estimated Useful life Amortization Expense = Br.100000 / 10 years = Br.10000 Entry: Amortization Expense-------------------10000 Patent or accumulated amortization----10000 B. 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. C. 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 rules of goodwill amortization. Instead purchased goodwill will remain on the balance sheet as an asset subject to impairment tests. 2.10 PRESENTATION OF PLANT AND INTANGIBLE ASSETS ON THE FINANCIAL STATEMENTS Plant assets and natural resources are reported with the related accumulated depreciation and accumulated depletion on the financial statement. Where as intangible assets may be reported net of the related accumulated amortization or with accumulated amortization 25 Addis Ababa University College of Commerce Accounting Department Principles of Accounting (Acct 202) CHAPTER 4 THE PAYROLL SYSTEM IN AN ETHIOPIAN CONTEXT A. The Importance of Payroll Accounting The term Payroll often refers to the document prepared to pay remuneration for the service rendered in a given period of time. The payroll accounting of a firm has to be given emphases of significance for the following reasons: 1. Employees are sensitive to payroll errors and irregularities, and maintaining good employee moral requires that the payroll be paid on a timely, accurate basis. 2. Payroll expenditures are subject to various government regulations. 3. The payment for payroll and related taxes has significant effect on the net income of most business enterprises. B. 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 selfemployed 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 made on weekly or biweekly. On the other hand, salaried employees' pay periods are monthly or semi-monthly 26 The Pay Day: The day, on which wages or salaries are paid to employees, usually the last day of the pay period, is known as the PAY DAY Basic Records of a payroll accounting system includes: (1) A payroll register (or sheet), 2) Individual employees' earnings records, and (3) Usually, pay checks. These records are generated from a payroll system that is operated manually or using computers. A Payroll Register (Sheet): the entire list of employees of a business along with each employee’s gross earnings, deductions and net pay (or the take home pay) for a particular payroll period. The basis for the preparation of the payroll register can be the attendance sheets, punched (clock) cards or time cards. Employee Earnings Record: It is a summary of each employee's earnings, deductions, and net pay for each payroll period and of cumulative gross earnings during the year. It is a separate record kept for each employee. The individual employees' earnings record helps the employer organization to properly summaries and file tax returns. Pay Check: An instrument for paying salary if the firm makes payment via writing a check in the name of each employee for the net pay or a check for the total net pay. Gross Earnings: 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 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 per the regulations of the concerned government Payroll Deductions: All the reductions from the gross earnings of an employee such as withholding taxes, union dues, fines, credit association pays, etc. Net Pay: The gross earnings after subtracting all the deductions. It is sometimes known as take home pay-the amount collected by an employee on the payday. C. Possible Components of a Payroll Register 1. Employee number -numbers assigned to employee for identification purpose When a relatively large number of employees are included in the payroll register. 2. Name of employees-list of the name of employees. 3. Earnings: money earned by an employee(s) of a firm from various sources. It may include: (a) The basic salary or Regular Earning. 27 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. (b) Allowances: money paid monthly to an employee for special reason, which may include: i. Position Allowance - a monthly sum paid to an employee for bearing a particular office responsibility, e.g. head of a particular department or Division. ii. 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. iii. Hardship Allowance - a sum of money given to an employee to compensate for an inconvenient circumstance caused by the employer. For instance, unexpected transfer to a different and distant work area or location. It is some times known as disturbance Allowance. iv. Desert Allowance - a monthly Allowance given to an employee because of assignment to a relatively hot region. V. Transportation (fuel) Allowance - a monthly Allowance to an employee to cover cost of transportation up to the work place if the employer has committed itself to provide transportation service (c) Overtime Earnings Overtime work is the work performed by an employee beyond the regulaworking hours or days. Overtime earning is the amount payable to an employee for overtime work done. In Ethiopia, in this respect, according to Article 33 of proclamation No.64/1975 the following is discussed about payment for overtime work. (1). A worker shall be entitled to be paid at a rate of one and one quarter (1 1/4) times his ordinary hourly rate for overtime work performed before 10 O'clock in the evening (10 p.m.). (2). A worker shall be paid at the rate of one and one half (1 1/2) 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.) (3). Overtime work performed on the weekly rest days shall be paid at a rate of two (2) times the ordinary hourly rate of payment. (4). A worker shall be paid at a rate of two and half (2 1/2) times the ordinary hourly rate for overtime work performed on a public holiday. 28 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. 4. Deductions. These are subtractions made from the earnings of employees that is because it is required by government or permitted by the employee himself. In our country, some of the deductions against the earnings of employees are: (a) Employee Income Tax: In Ethiopia every citizen is required to pay something in the form of income tax from his/her 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 150 Birr. According to proclamation No. 286/1994 that has become into effect beginning Hamle 1, 1994 E.C. exempts the first Br 150 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 the following schedule. Taxable Monthly Income (In Birr) 1 over 150 but not exceeding 650 on the next 500 Over 650 not exceeding 1,400 on the next 750 Over 1,400 but not exceeding 2,350 on the next 950 Over 2,350 but not exceeding 3,550 on the next 1200 Over 3,550 but not exceeding 5000 on the next 1,450 Exceeding 5,000 Rates of tax (%) on Every Additional Income 10% 2. 15% 3. 4. 5. 20% 25% 30% 6. 35% Generally, taxable income from employment includes salaries, wages, allowances, director’s fees and other personal emoluments, all payments in cash and benefits in kind. 29 However, according to Income Tax Amendment Proclamation No. 30/1992 issued on October 12, 1992 stated that the following categories of payments in cash or benefits in kind are exempted from taxation. 1. Medical costs incurred by employer for treatment of employees. 2. Transportation allowances paid by employer to its employees. 3. Reimbursement by employer of travelling expenses incurred on duty by employees. 4. Travelling expenses paid to transport employees from else where to place of Employment and to return them upon completion of employment. (b) 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 4% of their basic (monthly) salary to the government pension Trust Fund. This amount should be with held by the employer from the basic salary of each employee on every payroll and later be paid to the respective government body. On the other hand, the employer is also expected to contribute towards the same fund 6% of the basic salary of every permanent employee of it. It is this total amount that we called earlier as payroll taxes expense to the employer organization (i.e. 6% of the total basic salary of all permanent employee). Consequently, the total contribution to the pension Trust Fund of the Ethiopian government is equal to 10% of the total basic salary of all permanent employees of an organization (i.e. 4% comes from the employees and the 6% comes from the employer). This enables a permanent employee of an organization to be entitled to the pension pay given that the employee has satisfied the minimum 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. Ultimately, when an employee is retired or drawn out of work a lump sum amount is given at once. (c) Other 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 30 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 deductions made from the earnings of employees. 5. The Net Pay. This amount is held in one column of the payroll register representing the excess of gross earnings over the total deductions of an employee. The column 'Net Pay' total tells the excess of grand total earnings over grand total deductions made from the earnings of employees. It is the grand total take- home pay. 6. Signature Unless some other document is used, the payroll sheet may be designed to allow a column for signature of the employees after collection of the net pay. In general, a payroll register should at least show the earnings, deductions and the net pays along with the names of employees. D. Major Procedures or Activities Involved in Accounting for Payroll. 1. Gathering the Necessary Data. All the relevant information about every employee should be gathered. This activity requires reviewing various documents and to do some arithmetic work. 2. Including the names of employees along with the gathered data such as earnings, deductions and net pays in the appropriate columns of the payroll register. 3. Totaling and proving the payroll register. It must be proved that the grand total earnings equal the sum of the grand totals of deductions and net pays in the register. 4. The accuracy and authenticity of the information summarized in the payroll should be verified by a different person from the one who compiles it. 5. The payroll is approved by the authorized personnel. 6. Paying the payroll either in cash (this may be after cashing a check issued for the total net pay of the payroll) or issuing a check for every individual employee for the net amount payable to each employee. 7. Recording the payment of the payroll and recognition of the withholding tax liabilities. 31 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 Revenue Administration, on time. DEMONSTRATION PROBLEM Ethio Relief Agency pays the salary of its employees according to the Ethiopian Calendar month. The forth coming data relates to the month of Hider, 19X8. Ser Name of Employee No 01 02 03 04 05 Senait Bahiru Petros Challa Abdu Mohammed Leilla Jemal Kirkos Wolde Basic Salary 3,200 1,600 2,400 1,920 1,280 Monthly Allowance 100 --50 50 OT hours worked 10 8 6 -10 Duration of OT work up to 10 p.m. Basic Salary per hour 20 8. 9. 10 p.m. to 10 5 a.m. Weekly 15 rest days -Public Holidays 12 8 N.B. Note that management of the agency usually expects a worker to work 40 hours in a week and during Hidar 19X8 all workers have done as they have been expected. Besides, all workers of this agency are permanent employees except Petros Chala; the monthly allowance of Kirkos Wolde is not taxable; Abdu Mohammed agreed to have a monthly Br.200 be deducted and paid to the Credit Association of the Agency as a monthly saving. Instructions: Based on the above information: Prepare a payroll register (or Sheet) for the agency for the month of Hidar, 19X8. Record the payment of salary as of Hidar 30, 19X8 using Ck. No. 41 as a source documents. Record the payroll taxes expense for the month of Hidar, 19X8. 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 Tahesas 1, 19x8. 5. Assuming that the withholding taxes and payroll taxes of the month of Hidar, 19X8 have been paid on Tahesas 5, 19X8 via Ck. No. 50, recorded the required Journal entry. 1. 2. 3. 4. 32 Computations of earnings, deductions and net Pays. Overtime Earnings: Overtime Earning = OT Hrs worked x (Ordinary hourly rate x OT Rate) 1. Senayit 10 hrs x (20 x 1.25) = Br.250 2. Petros 8 hrs x (10 x 1.5) = Br.120 3. Abdu 6 hrs x (15 x 2) = Br.180 4. Kirkos 10 hrs x (8 x 2.5) = Br.200 Gross Earnings: Gross Earnings = Basic Salary + Allowance + OT Earning 1. Senayit Br.3200 + 100 + 250 = Br 3,550 2. Petros Br. 1,600 + 0 +120 = Br 1,720 3. Abdu Br2, 400+ 0 + 180 = Br2, 580 4. Leila Br1, 920 + 50 + 0 5. Kirkos Br1, 280 + 50 + 200 = = Br.1970 Br1, 530 DEDUCTIONS AND NET PAYS: 1. SENAYIT Gross Taxable income = Employee Income Tax: Earning x ITR = 150.00 x 0 500.00 x 10% 750.00 x 15% 950.00 x 20% 1200 x 25% Total 3,550 Pension contribution: Basic Salary x 4% Br3200 x 4% ... Total Deductions ........... Net pay.................... Br3,550 Income Tax 00.00 50.00 112.50 190.00 300.00 652.50 128.00 780.50 Br.2769.50 33 2. PETROS Gross Taxable Income = Employee Income Tax: Earning x ITR = 150 x 0% 500 x 10% 750 x 15 % 320 x 20% Tot.1, 720 Pension Contribution is zero as he is a Contractual worker Total Deductions Net Pay 3. ABDU Gross Taxable Income = Employee Income Tax: Earning x ITR = Br 150 x 0 500 x 10% 750 x 15% 950 x 20% 230 x 25% Tot. 2,580 Pension Cont.: Br.2400 x 4% = Credit Asso.pay Total deductions................. Net Pay ..................... Br1, 720 Income Tax 00.00 50.00 112.50 64.00 226.50 00.00 226.5 Br 1493.5 Br.2580 Income Tax 00.00 50.00 112.50 190.00 57.50 410.00 96.00 200.00 706.00 1874.00 4. LEILA Gross Taxable Income = Br.1970 34 Employee Income Tax: Earning x ITR = Br 150 x 0 500 x 10% 750 x 15% 570 x 20% Tot. 1970 Pension Cont. Br1, 920 x 4% = Total Deduction ................... Net Pay .......................... Income Tax 00.00 50.00 112.50 114.00 276.5 76.80 353.30 Br.1, 616.70 5. KIRKOS Gross Taxable Income (his allowance is not Subject to tax) = Br.1530– 50 = 1480 Gross Earning.................... Br. 1,530 Employee Income Tax: Income Tax Earning x ITR = 150 x 0 00.00 500 x 10 % 50.00 750x 15 % 112.50 16.00 80 x 20% 178.50 Total 1480 Pension Contr.: Br1, 280 x 4% = 51.20 Total Deductions......................... 229.70 Net Pay............................... Br1, 300.30 ETHIO RELIEF AGENCY 35 Payroll Register (Sheet) For Month of Hidar 19x8 Pay Day: Hidar 30,19x8 Earnings Seri. No Name of Employee Basic Salary Allow. Overtime Gross (total) Earning Deductions Employee Pension income tax deduc. 01 02 03 Senayet Bahru Petros Chala Abdu Mohammed Leila Jemal Kirkos Wolde Totals 3200 1,600 2,400 00 00 00 100 ------- 00 --- 250 120 180 00 00 00 3,550 1720 2,580 00 00 00 652 226 410 50 50 00 128 ---96 00 - 00 04 05 1,920 1,280 10,400 00 00 00 50 50 200 00 00 00 ---200 750 -00 00 1970 1530 11,350 00 00 00 276 178 1744 50 50 00 76 51 352 80 20 00 Proving the Payroll: Total Earnings: Basic Salary.............. Allowance ............... Br 10,400.00 200.00 36 Overtime .................. 750.00 Grand Total Earnings..……………………. Br 11,350.00 Deductions: Employee Income Tax ………. Br 1,744.00 Pension Contribution…………. 352.00 Other............... ……………….. 200.00 Total Deductions .......... Br 2,296.00 Net Pays Total ............... 9054.00 Total Ded, & Net pay ........………………….Br11, 350.00 Thus, it is proved. 2. Recording the payment of salary. 19x8 Hidar 30 Salary Expense …………………….. 11,350 Employee Income Tax Payable …………………. 1,744 Pension Contribution Payable…………… 352 Credit Association-ERA …………………………… 200 Cash………………………………………………… 9054 Ck. No. 41 3. Recording the Payroll Taxes Expense for Hidar, 19X8 Ethio - Relief Agency incurred payroll tax expense of Br 528 during Hidar, 19X8. This is determined as the product of the basic salary of all permanent employees and 6% . This is because the agency has to contribute 6% of the basic salary of every permanent employee to the government pension trust fund. Thus, (Total Basic Salary Payroll Taxes of all permanent Employees) X 6% = Payroll Expense (3,200 + 2,400 + 1,920 + 1,280) X 6% = Br 528 By the amount of Br 528 the agency's expense, payroll taxes expense, and pension contributions payable increase. Therefore, the following journal entry is made as of Hidar 30, 19X8: Payroll Taxes Expense………………………528 Pension Cot. Payable…………………….. 528 Memorandum No. 0006 The source document is an internal office memorandum that indicates the incurrence of this expense. 4. Recording the payment of deduction from Abdu's earnings to the credit association Credit Association ……………………200 Cash…………………………… 200 37 Ck. No. 42 5. Recording the payment of with holding and payroll taxes to the Inland Revenue Administration on Tahessas 5, 19X8: Look at the account balances before payment: Employee Pension Cont. Pay. Income Tax Payable 1,744 (2) 352.00 (2) 528.00 (3) 880.00 From the above accounts you can see that the agency has a total liability of Br 2,639. That is Employee Income Tax Br 1,744.00 Pension Contrib. 880.00 2624 Note also that the total pension contribution payable is equal to 10% of the basic salary of all permanent employees. That is Br 8800 x 10% = Br 880. Then, the payment is recorded as follows: Employees Income Tax Pay …………………………1744 Pension Contributions Payable …………………………880 Cash…………………………………….…………2624 Ck. No. 50 After the payment of these liabilities have been posted, the above two accounts will have zero balances. REVIEW QUESTIONS 1. Discuss the importance of payroll accounting. 38 2. Distinguish between pay period and payday. 3. What are the basic records of a payroll accounting system? Describe them. 4. Enumerate and explain the basic elements of a payroll sheet of a firm. 5. Differentiate payroll taxes expense and withholding taxes. 6. What are the four over time sessions according to article 33 of proclamation No 64/1975. 7. What are some of earnings that are not taxable in an Ethiopian context? 8. What is the over all contribution to government pension trust fund from a permanent government employee's basic salary? 9. How non-government organizations alleviate the problem of social security o pensioned employees? 10. State the required journal entries in relation to a payroll accounting. 11.Is there any principal difference between manual and computerized payroll Accounting system? Why? Explain. EXERCISES EX 1. Payroll data of a government hotel, Andinet Hotel, for the month of Hamle, 1988 are given below: Regular O v e r t i m e In hours Basic Hourly AllowRest HolyName Salary Rate ance up to 10pm 10pm-6am Days days Abera Br600 Br3 Br200 10 4 Abebu 420 2.10 20 10 5 Belete 980 4.90 100 5 8 Abebu is contractual employee and the allowance to Abera is free of income tax. Required: 1. Prepare payroll register. 2. Record on page 10 of a two column general journal: a) The payment of salary on Hamle 30, b) The recognition of payroll tax expense, and c) The payment of the amounts owed in connection with the Hamle, 1988 payroll to the government on Nehassie 5,1988. EX 2. A permanent employee of a government organization with a basic monthly salary of br640.00 and monthly Allowance of br100.00 has worked 20 overtime hours during days in the weekends of the current month. This employee usually works 160 hours in a month to earn his basic salary. Based on the above information answer the following questions: 39 1. The ordinary hourly rate of this employee is equal to_______. 2. The gross earnings of the above employee is _________. 3. The amount of employee income tax and pension contribution deductions are respectively __________________________. EX 3. W/t Kedija, the employee of CMN Agency, gov't owned, has worked 10 hours, 8 hours and 12 hours, during the holidays, after mid night on working days and weekends respectively in a given month. In the same month, she has earned a regular monthly salary of br1, 120 as the result of working 140 regular working hours. Determine her gross overtime earnings for the month. Ex 4 Using the following payroll data of Paradise Restaurant gov't owned, for the month of Sene, 1988, 1. Compute the: a) Income tax deductions from each employee, b) Pension contribution by each employee, and c) Employer’s payroll tax expense 2. Prepare journal entries to record the: a) Payment of salary to employees b) Employer’s payroll tax expense c) Payment of the deductions and payroll taxes to the government at the beginning of the following month. Employee Name Basic Salary OT Earning Derbe Reta Br200.00 Br 50.00 Rahel Amde 400.00 200.00 Michael Girma 300.00 400.00 3. Assuming that the ordinary hourly rate of Rahel is Br2.00 and all of her overtime hours were performed during weekly rest days, how many overtime hours did she perform? Source: A teaching material on Introduction to Accounting prepared by Abubeker Seid, Lecturer, Department of Accounting, AACC, 1997. Revised in September 2002. CHAPTER 4: ACCOUNTING CONCEPTS AND PRINCIPLES 4.1 DEVELOPMENT OF CONCEPTS AND PRINCIPLES 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 40 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: 1. 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. 2. 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. 3. 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 4. Government Organizations SEC (Security and Exchange Commission) IRS (Inland Revenue Service) 4.2 BASIC CONCEPTS AND PRINCIPLES 1. The Business Entity Concepts-states that regardless of the form the organization, the business affairs of the entity must be distinguished from those of the owner. Business resources, records, and reports must be kept separate from that of the owner’s and any other business. 2. Going Concern Concept-the going concern concept or continuity principle assumes that a business entity will continue to exist for an indefinite period of time to carry out present plans and meet contractual commitments. This assumption affects the manner of recording some business transactions and as a result the data reported in the financial statements. The going concern: Provides much of the justification for recording plant assets at cost and depreciating them in an orderly manner without reference to the current realizable value Supports the treatment of prepaid expenses as assets, even though they may not be salable Helps to focus attention on the determination of net income rather than on the valuation of assets 41 The going concern principle does not imply permanence of existence but simply that the enterprise will continue in existence long enough to carry out present plans and meet contractual commitments. When there is conclusive evidence that a business has a limited life the principle used is Quitting Concern and the Financial Statements are prepared accordingly. 3. Objective Evidence Entries in the accounting records and the data reported on the financial statements must be based on objectively determined evidence. Each transaction is described by a business document or paper such as sales invoice, receipts, vouchers, etc that proves the transaction did occur. This principle is subject to verification by independent experts. Without close adherence to this principle, the confidence of the many users of the financial statement could not be maintained. 4. Unit of Measurement (Monetary Principle) Unit of measurement assumption means that money is used as the basic measuring unit for recording transactions and for financial reporting. Limitations: It limits the scope of accounting reports because other factors which can not be expressed in monetary terms will not be reported in accounting. Example: employee-employer relationship, relative strength and defense of competitors, efforts and capabilities of top management, employee’s devotion, customer’s brand loyalty It assumes the stability of the measuring unit like KMs, KGs, etc. But money is not stable. The purchasing power is fluctuating in the market 5. Accounting Period Or Periodicity Assumption A complete and accurate picture of an enterprise’s success or failure and determining the true net income is possible when a business discontinued operations. However, decisions makers need timely information so that it necessary to prepare periodic reports on operations, financial position, and cash flows by dividing the life of the business into periods which have equal intervals specially one year. It is also a requirement of governmental agency. 6. Matching Principle or Matching Revenue and Expired Costs (Expenses) The matching principle or the principle of matching expenses with revenues can be “Stated that revenue from business activities and expenses associated with earning that revenue must be recorded within the same accounting period. The determination of periodic net income is a two-fold problem involving: 1. The Recognition Revenue during the period and 2. The Recognition of Expired costs to be allocated to the period The recognition of revenue Revenue is measured by the amount charged to customers for merchandise delivered or service rendered to them. But, the question is when should revenue be recognized or be recorded in accounting records and reported. Under the assumption of accrual accounting, revenue should be recognized when it is earned. However, earning does not actually take place at a single point in time. It is usually an extended economic process. Revenue should be recognized when objective evidence to support the recording of revenue is produced. Various criteria or methods are acceptable for determining when revenue should be realized. The criteria or methods most frequently used are: A) The point of sale method It is customary to consider revenue from the sale of commodities as being realized at the time title passes to the buyer. At point of sale: The Selling price has been agreed upon 42 The Buyer acquires the right of ownership in the commodity, and The Seller has a legal claim against the buyer B) The Receipt of Payment Method or Cash Basis Criteria of Revenue Recognition When the cash basis or receipts of payment method is adopted, revenue is considered to be realized at the time the cash is collected, regardless of when the sale was made. Cash basis of accounting does not conform to GAAP. C) The Installment Method or Recognizing Revenue In the typical installment sale, the purchaser makes a down payment and agrees to pay the remainder in specified amount at stated intervals over a period to time. This method considers each cash receipts to be revenue and to be composed of partial payment of: The Cost of Merchandise Sold and The Gross Profit on the sale Example: YY Company sold merchandise for Br. 400000 and the Cost of merchandise sold is Br. 240000. The buyer made a down payment of Br. 100000 and the rest is installment sale which were collected as follows: 1st Year---------------Br.140000 2nd Year--------------Br.100000 3rd Year--------------Br.60000 Required: Determine Gross Profit that will be recognized under 1. Point of sale method 2. Installment method 1. Gross Profit = Sales – CMS Gross Profit = Br.400000 – 240000 Gross Profit = Br.160000 2. Percentage or Gross Profit = Sales – CMS / Sales = Br. 160000 / 400000 = 40% st 1 Yea 2nd Year 3rd Year Total Collection 240000 100000 60000 400000 GP Percentage 40% 40% 40% Gross Profit 96000 40000 24000 160000 D) Percentage or Degree of Contract Completion Method Revenue is recognized during the production process in the case of long term construction contracts which will take a long period of time by percentage completion method. The steps are: Estimate the actual work completed in terms of percentage completion at the end of the period. It may estimated by engineers or cost method Percentage Completion = Costs Incurred to Date / Costs Incurred to Date + Estimated cost to complete Calculate the revenue as the percentage of contract price Take the cost actually incurred during the period – rather than the percentage of the original cost estimate Gross Profit recognized revenue on the basis of percentage completion minus related expired costs. Example 1: Tekleberehan Ambaye Construction Company entered a contractual agreement with a ministry of education to construct dormitory and class room for Jimma University. The construction requires 3 years to complete and the contract price is Br.10000000. the total costs 43 estimated to complete the project is Br.8000000 and the construction activities based the engineer’s estimate and the actual costs incurred are as follows: Year Percentage Completed Costs Incurred I 20% Br.1500000 II 40% 3400000 III 40% 3100000 Instruction: recognize the revenue and determine the NI to be realized from the contract each year: Year: Percentage Completed I 20 II 40 III 40 Year I II III IV Year I II III IV Costs Incurred to Date 697000 1935000 3300000 4500000 Contract Price 10000000 10000000 10000000 Amount of Revenue Recognize 2000000 4000000 4000000 Estimated Costs to Total Costs Complete 3403000 4100000 2365000 4300000 1100000 4400000 __ 4500000 The Percentage Completion Costs Incurred During the Year Br.697000 / 4100000 = 17% Br.697000 Br.1935000 / 4300000 = Br.1935000 – 697000 = 45% - 17% = 28% Br.1238000 Br.3300000 / 4400000 = Br. 3300000 – 1935000 = 75% - 45% = 30% Br.1365000 100% Br.4500000 – 3300000= Br.1200000 Note: If the Construction Company is using completed contract method, no revenue will be recognized until the final year of the projects. All the revenue is recorded as revenue of the final year. CHAPTER 5: ACCOUNTING FOR PARTNERSHIP Partnership is defined as a voluntary association of two or more persons to carry on as coowners a business for profit. 44 Characteristics of Partnership Based on a contract- all that is necessary is for two more legally competent people to agree to become partners. This agreement becomes a partnership contract. Limited life-the life of a partnership is always limited. Death, bankruptcy or anything that takes away the ability of one of the partners to contract automatically ends a partnership. Unlimited liability- most partnerships are general partnerships in which each partner is individually liable to creditors for debts incurred by the partnership if it becomes insolvent. Mutual agency – each partner is an agent of the partnership with the authority to enter in to contracts for the partnership, the act of each partner binds the partnership. Participation in income - net income or net loss are distributed among the partners according to agreement Co-ownership of property – the property invested in a partnership by a partner becomes the property of all the partners jointly. Non taxable entity – partnership is not required to pay federal income taxes. ADVANTAGES AND DISADVANTAGES OF PARTNERSHIP Advantages: It is relatively easy and inexpensive to organize partnership. It is requiring only an agreement between two or more persons. Ability to bring together more capital more managerial skills and more experience than would a sole proprietorship It is a non taxable entity Disadvantages: Its life is limited Has unlimited liability One partner can bind the partnership to contract Raising large amounts of capital is more difficult Types of Partnership Limited P’ship: is P’ship in which partners have limited liability and have no active participation in management of the business. It is with at least one general partner. General P’ship: is P’ship in which partners are responsible for the debt of the business and have participated actively in management with unlimited liability. It has all general partners. The partnership contract: Partnership agreement may or may not be written but it is better if it is in writing in order to lesser chances for misunderstanding and future disagreement. A written contract called Articles of Partnership or Partnership Agreement should list at least the following terms: Name, location and nature of the business Names of partners, their duties and rights of each Amount invested by each partner and the procedure for valuing any non cash assets Method of sharing profits and losses Withdrawals to be allowed by partners and the method of withdrawal Provision for insurance on the lives of the surviving partners or beneficiaries. The accounting period to be used Annual audit by CPAs Provision for arbitration of disputes Provision for dissolution. This part may specify a method of computing the equity of a retiring or deceased partner and a method of settlement which will no disrupt the business. ACCOUNTING FOR PARTNERSHIP 45 Partnership accounting requires the use of separate capital account for each partner and withdrawal account for each partner 1. Recording Investments A separate entry is made for the investment of each partner in a partnership. The various assets contributed by the partner are debited to the proper asset accounts. If liabilities are assumed by the partnership, the appropriate liability accounts are credited. All assets other than cash should be valued at fair market values at the date of investment. E.g. assume that Rita and Katherine agreed on January 1, 2002 to form a partnership named RK Company. Rita invested Br.8000 Cash, 35000 furniture, 12000 merchandise and Br.15000 notes payable is assumed by the partnership which is related to Rita. Katherine invested Br.30000 Cash and Br.20000 accounts receivable with the provision for uncollectible accounts of Br.8000.Required: Record the investment by the two owners Rita: Cash--------------------------8000 Furniture--------------------35000 Merchandise Inventory---12000 Notes Payable----------------15000 Rita, Capital------------------40000 Katherine: Cash--------------------------- 30000 Accounts Receivable--------20000 Allowance FDA-------------8000 Katherine, Capital---------42000 The combined entry is as follows: Cash----------------------------38000 Accounts Receivable--------20000 Furniture----------------------35000 Merchandise Inventory-----12000 Notes Payable----------------15000 Allowance FDA---------------8000 Rita, Capital------------------40000 Katherine, Capital-----------42000 2. Division of Net Income or Net Loss If each partner is to contribute equal services and amounts of capital, an equal sharing in partnership Net Income would be equitable. But if one partner is to contribute a larger portion of capital or capital or the services of one partnership, provision for this should be given recognition in the division on net income or net loss, it should be noted that division on net income or net loss among the partners in exact accordance with their partnership agreement is of the utmost importance, if the agreement is silent on the division on net income or net loss, the law provides that all partners share equally, regardless of differences in amounts of capital contributed, or special skill possessed or of time devoted to the business. The partners may however, make any agreement they wish in regard to the division of net income and net losses. A) Income division recognizing services of partners Example: assume that the articles of partnership of Rita and Katherine provides for monthly salary allowances of Br.2500 and Br.1500, respectively with the balance of the Net Income to be divided equally and that the net income for the year is Br.80000 46 Instruction: prepare a schedule of income division and record the income division Net Income-----------------------------------------------------------Br.80000 Division of NI Rita Katherine Total Salary Allowance 30000 18000 48000 Remaining Income 16000 16000 32000 Net Income to each 46000 34000 80000 The division of net income is recorded as a closing entry, regardless of whether the partners actually withdrew the amounts of their salary allowances. The entry for the division of Net Income is closed as follows: Income summary------------80000 Rita, Capital---------------46000 Katherine, Capital--------34000 If they had withdrawn their salary allowances monthly, the withdrawals would have accumulated as debits in the drawing account of each partner during the year. Example: Rita, Drawing-----------2500 Cash--------------------------2500 At the end of the year, the drawing account of Rita and Katherine has accumulated the debit balance of Br.30000 and 18000, respectively. The closing is as follows: Rita, Capital---------------------30000 Katherine, Capital---------------18000 Rita, Drawing-------------30000 Katherine, Drawing------18000 B) Income division recognizing services and partners investment Example: assume that Rita and Katherine: Are allowed a monthly salary of Br.2500 and Br.1500, respectively Are allowed interest at a rate of 10% on their bearing Capital balance as the beginning period Divide the remaining income equally Instruction: prepare a schedule of income division assuming the net income is Br.80000 and record the income division Net Income-----------------------------------------------------------Br.80000 Katherine Total Division of NI Rita Salary Allowance 30000 18000 48000 Interest Allowance 4000 4200 8200 Remaining Income 11900 11900 23800 34100 80000 Net Income to each 45900 The entry for the division of Net Income is closed as follows: Income summary------------80000 Rita, Capital---------------45900 Katherine, Capital--------34100 C) Income Division-Allowances Exceed Net Income When a NI is less than the total of special allowances the remaining negative balance will be divided among the partners as if it is a net loss. Example: assume the above example except that the NI is Br.50000. Instruction: prepare a schedule of income division Net Income----------------------------------------------------------Br.50000 Division of NI Rita Katherine Total Salary Allowance 30000 18000 48000 Interest Allowance 4000 4200 8200 47 Total 34000 22200 56200 Excess Allowance (3100) (3100) (6200) Net Income to each 30900 19100 80000 The entry for the division of Net Income is closed as follows: Income summary------------50000 Rita, Capital---------------30900 Katherine, Capital-------- 19100 STATEMENT OF PARTNERSHIPS Details of the division of net income should be disclosed in the financial statement prepared at the end of the accounting period. Prepare a statement of Partnership for Rita and Katherine assuming that Rita and Katherine Are allowed a monthly salary of Br.2500 and Br.1500, respectively Are allowed interest at a rate of 10% on their bearing Capital balance as the beginning period Divide the remaining income equally The net income is Br.80000 Withdrew all their monthly allowances RK Partnership Statement of Partnership For the Year Ended December 31, 2002 Rita Katherine Capital, January 1, 2002 40000 42000 Additional Investment 0 0 Sub total 40000 42000 34100 Net Income for the year 45900 Sub total 85900 76100 Withdrawals during the year (30000) (18000) Capital, December 31, 2002 55900 58100 Total 82000 0 82000 80000 162000 (48000) 114000 5.2 DISSOLUTION OF PARTNERSHIP The admission on new partner/s; the death of existing partner/s or withdrawals of existing partner resulted in dissolution of a partnership. Dissolution of a partnership does not necessarily mean winding up the affairs of the business rather it is a stepping stone either to wind up the business or introduce changes to partnership. A) Admission of a Partner/s There are two procedures through which a new partner may be admitted to an existing partnership which will be discussed as follows: 1. By Purchase of an Capital Interest In this procedure the capital interest of the incoming partner is obtained from current partners by purchasing an interest which is directly paid to the selling partner/s. by purchasing an interest neither the total asset nor the total owner’s equity of the partnership will be affected. The only entry needed is to transfer the proper amounts of owner’s equity form the capital accounts of the selling partner/s to the capital account established for the incoming partner. Example: Getahun, Tibebu, and Abraham were operating a partnership called GTA Partnership. Asfaw purchased 20% Capital Interest of Getahun at Br.20000, ¼ Capital interest of Tibebu at Br.30000 and 30% of Abraham at Br.40000. the capital of Getahun, Tibebu and Abraham is Br.50000, 80000 and 70000, respectively. 48 Instruction: record the transaction to transfer the capital interest from the current partners to the incoming partner Getahun- 50000 * 20%= Br.10000 Tibebu- 80000 * ¼ = Br.20000 Abraham- 70000 * 30% = 21000 Total to be transferred----Br.51000Entry: Getahun, Capital------------10000 Tibebu, Capital-------------20000 Abraham, Capital----------21000 Asfaw, Capital---------51000 2. By Contribution of Asset Instead of buying an interest from the existing partners, the incoming partner/s may contribute assets to the partnership. In this procedure both the total asset and the total owner’s equity of the firm increased. The contribution of assets is recorded as in the same way of recording investment. Example: Beza and Ruth are partners with capital accounts Balance of Br.50000 and 40000, respectively. On January 1, Zaid invested Br.30000 Cash and Br.10000 equipment in the business. Instruction: record the admission of the new partner. Cash-------------------30000 Equipment------------10000 Zaid, Capital---------40000 In the admission of new partner, always the two common things are revaluation of assets and recognition of goodwill attributed to the incoming or existing partners. If the old partnership has exceptionally high profit earning year after year, the existing partners may require the incoming partner/s to make a higher investment for a lower capital interest (Payment of Bonus to old Partners). Revaluation of Assets If the p’ship assets are not fairly stated in terms of current market value at the time a new partner is admitted, the accounts may be adjusted accordingly. The net income of the increases and decreases in asset values are then allocated to the capital accounts of the old partners according to their incoming sharing ratio. Example: before revaluation the balance of merchandise inventory accounts in A and B P’ship showed Br. 20000. The current market value of the merchandise is Br. 30000 and the income sharing ration is 6:4. Instruction: journalize the necessary entries Merchandise Inventory--10000 A, Capital----------------6000 B, Capital----------------4000 Example 2: what if the market value of the merchandise is Br.150000 A, Capital--------------3000 B, Capital--------------2000 Merchandise Inventory--5000 If number assets are revalued, the adjustment may be debited or credited to a temporary account called Asset Revaluations. Example 3: Before Revaluation After Revaluation Merchandise Inventory Br.20000 Br.30000 Accounts Receivable 30000 25000 Equipment (Net) 40000 30000 49 Building (Net) 80000 100000 Instruction: journalize the necessary entry assuming that the two partners A and B have a profit sharing ration of 6: 4 Merchandise Inventory---------10000 Asset Revaluations---------------10000 Asset Revaluations------------10000 Equipment (Net) -----------10000 Building (Net) ----------------20000 Asset Revaluations----------------5000 Asset Revaluations---------20000 Accounts Receivable---------5000 Asset Revaluations---------------15000 A, Capital----------------------9000 B, Capital-----------------------6000 Recognition Goodwill: When a new partner is admitted to partnership goodwill attributable either to the old partnership or the incoming partner may be recognized. Example 1: Leila is admitted to the partnership of Jemal and Kedir by Investing Br.35000. If the existing partners agreed to recognize Br.5000 Goodwill attributable to Leila, record the recognition of goodwill. Goodwill------------5000 Cash---------------- 35000 Leila, Capital-----------------40000 Example 2: The Income sharing ratio X and Y is 3:7. Mr. Z is admitted to the Partnership by Investing Br.30000 cash and the income partner agreed to recognize a goodwill Br. 5000 which attributable to the existing partners. Record the transaction Cash----------30000 Goodwill------5000 X, Capital----------1500 Y, Capital----------3500 Z, Capital--------30000 Allowing Bonus to former partnership Abebe and Kebede are members of a highly successful partnership. Presently, each has a capital interest of Br.100000. Mary desires to join the firm and offers to invest Br.100000 for a one fourth interest in capital and profit. Instruction: record the admission of Mary. Total Capital of old partners-----------------------------Br.200000 Investment of new Partner-------------------------------- 100000 Total new partnership Equity----------------------------- 300000 Equity of Mary (1/4 * Br.30000) -------------------------Br.75000 Interest in excess of Interest = Br.100000 – 75000 = Br.25000 this the bonus to old partners to be paid shared equally. Cash---------------------100000 Abebe, Capital--------------------12500 Kebede, Capital-------------------12500 Mary, Capital----------------------75000 B) Withdrawal of a Partner When a partner retires or for some other reason wishes to withdrew from the firm, one or more of the remaining partners may purchase the withdrawing partner’s interest and the business may be continued with out interruption. If settlement for the purchase and sale is made 50 between the partners as individuals, in a manner similar to the admission of an new partner by purchase of an interest. Entry: Out going Partner, Capital------xxxx Remaining Partner, Capital----------xxxx If the settlement with the withdrawing partner is made by the partnership, the effect is to reduce the asset and the total owner’s equity of the partnership. In this case: The asset accounts should be adjusted to current assets The net amount of the adjustment should be divided among the capital accounts of the partners according to the income sharing Ratio A payment will be made to the withdrawing partner Example: If the Income Sharing Ratio of A, B and C are 4:4:2, respectively. Pass the necessary journal entries assuming that: The asset revaluation Account has a credit balance of Br.10000 If a Goodwill of Br. 15000 Is Created If Partner C withdrew his Capital which has a beginning Capital Balance of Br.30000 before revaluation and recognition of goodwill and the payment is made the partnership itself. Assets Revaluations--------10000 A, Capital---------------------4000 B, Capital---------------------4000 C, Capital---------------------2000 Goodwill------------15000 A, Capital---------------------6000 B, Capital---------------------6000 C, Capital---------------------3000 C, Capital------------35000 Cash------------------------35000 C) Death of a Partner The death of a partner dissolves the partnership. In the absence of any contrary agreement, the accounts should be closed as of the date of death, and the net income for the fractional part of the year should be transferred to the capital accounts. 5.3 LIQUIDATION OF PARTNERSHIPS The process of winding up or terminating the affairs of the partnership may generally be called liquidation. When a partnership goes out of business, the following activities will occur: It usually sells the non cash assets. The sale of the non cash assets is called Realization Gain or Loss on the Realization is distributed as per income sharing ratio Pays the Creditors and Distributes the remaining cash or other assets to the partners according to their claims Example: Melale, Belule and Rekike agreed to liquidate their partnership named MBR Partnership. The income sharing ration is 2:3:5, respectively. After discontinuing the ordinary business operations of their partnership and closing the accounts, the following summary of the general ledger is prepared: Cash-----------------------13000 Non Cash Assets---------62000 Liabilities-----------------20000 Melale, Capital-----------22000 Belule, Capital-----------22000 Rekike, Capital----------11000 When non cash assets are sold any of these three things will happen up on sale: 1. Gain on realization 2. Loss on Realization with no Capital deficiency 3. Loss on Realization with Capital Deficiency 51 Assuming that all non cash assets are sold from August 1 to August 30, 1997 and all liabilities are paid at one time and the non cash assets are sold: 1. Br.80000 2. Br.50000 3. Br.30000 Instruction: Prepare State Of Partnership Liquidation and record the following circumstances Sale of the non case assets that is the realization The division on gain or loss on realization The payment of liabilities The distribution of Cash to Partners 1. Br.80000 – Gain on Realization of Br.18000 (Br.80000 – 62000) MBR Partnership State of Partnership Liquidation From the period August 1 to August 31, 1997 Cash Non Cash = Liabili Melale Belule Rekike Assets -ties (20%) (30%) (50%) Before Realization 13000 62000 = 20000 22000 22000 11000 Realization & Division of Gain +80000 -62000 +3600 +5400 +9000 Balance After Realization 93000 0 = 25600 27400 20000 Payment of Liabilities -20000 _ -20000 _ _ _ Balance of After Payment Liab. 73000 0 = 0 25600 27400 20000 Distribution of Cash to Partners -73000 _ _ -25600 -27400 -20000 Final Balance 0 0 = 0 0 0 0 A) Sale of the non case assets that is the realization Cash----------------------------------80000 Non Cash Assets-----------------62000 Loss and Gain on Realization--18000 B) The division on gain or loss on realization Loss and Gain on Realization----18000 Melale, Capital----------------------3600 Belule, Capital-----------------------5400 Rekike, Capital----------------------9000 C) The payment of liabilities Liabilities-------20000 Cash---------------20000 D) The distribution of Cash to Partners Melale, Capital----------------------25600 Belule, Capital-----------------------27400 Rekike, Capital----------------------20000 Cash----------------------------------73000 2. Br.50000 – Loss on Realization of Br.12000 (Br.50000 – 62000) MBR Partnership State of Partnership Liquidation From the period August 1 to August 31, 1997 52 Cash Before Realization Realization & Division of Loss Balance After Realization Payment of Liabilities Balance of After Payment Liab. Distribution of Cash to Partners Final Balance 13000 +50000 63000 -20000 43000 -43000 0 Non Cash Assets 62000 -62000 0 _ 0 _ 0 = Liabili Melale Belule Rekike -ties (20%) (30%) (50%) = 20000 22000 22000 11000 -24000 -3600 -6000 = 19600 18400 5000 -20000 _ _ _ = 0 19600 18400 5000 _ -19600 -18400 -5000 = 0 0 0 0 C) The payment of liabilities Liabilities-------20000 Cash---------------20000 D) The distribution of Cash to Partners Melale, Capital----------------------19600 Belule, Capital-----------------------18400 Rekike, Capital------------------------5000 Cash----------------------------------43000 A) Sale of the non case assets that is the realization Cash-------------------------------50000 Loss and Gain on Realization--12000 Non Cash Assets-----------------62000 B) The division on gain or loss on realization Melale, Capital----------------------2400 Belule, Capital-----------------------3600 Rekike, Capital----------------------6000 Loss and Gain on Realization----12000 3. Br.30000 – Loss on Realization of Br.32000 (Br.30000 – 62000) MBR Partnership State of Partnership Liquidation From the period August 1 to August 31, 1997 Cash Non Cash = Liabili Melale Belule Rekike Assets -ties (20%) (30%) (50%) Before Realization 13000 62000 = 20000 22000 22000 11000 Realization & Division of Gain +30000 -62000 -6400 -9600 -16000 Balance After Realization 43000 0 = 15600 12400 -5000 Payment of Liabilities -20000 _ -20000 _ _ _ Balance of After Payment Liab. 23000 0 = 0 15600 12400 -5000 Distribution of Cash to Partners -23000 _ _ -13600 -9400 _ Final Balance 0 0 = 0 2000 3000 -5000 Note: before the distribution of Cash to partners the potential loss the amount that is deficient by a partner/s should be considered first and distributed to the partners with positive balance. C) The payment of liabilities A) The realization Liabilities-------20000 Cash----------------------------------30000 Cash---------------20000 Loss and Gain on Realization-----32000 D) The distribution of Cash to Partners Non Cash Assets-----------------62000 Melale, Capital----------------------13600 B) The division on gain or loss on realization Belule, Capital------------------------9400 Loss and Gain on Realization----32000 Cash----------------------------------23000 Melale, Capital--------------------6400 Belule, Capital---------------------9600 Rekike, Capital--------------------16000 To continue with the above illustration use the following three assumptions: A) If Rekike paid the entire amounts 53 B) If the she paid 50% of the deficiency to the partnership and the remainder is considered uncollectible C) If she is unable to pay any part of the deficiency MBR Partnership State of Partnership Liquidation From the period August 1 to August 31, 1997 Cash Non Cash = Liabili Melale Belule Rekike Assets -ties (20%) (30%) (50%) Balance 0 0 = 0 2000 3000 -5000 Receipts of Cash +5000 _ _ _ _ +5000 Balance After Realization +5000 0 = 2000 3000 0 Distribution of Cash to Partners -5000 _ _ -2000 -3000 _ Final Balance 0 0 = 0 0 0 -0 A) Receipts of Cash Cash-------------------- 5000 Rekike, Capital--------5000 B) Distribution of Cash Melale, Capital------------2000 Belule, Capital-------------3000 Cash-------------------------5000 MBR Partnership State of Partnership Liquidation From the period August 1 to August 31, 1997 Cash Non Cash = Liabili Melale Belule Rekike Assets -ties (20%) (30%) (50%) Balance 0 0 = 0 2000 3000 -5000 Receipts of Cash +2500 +2500 Balance Receipts of Cash 2500 0 = 2000 3000 -2500 Distribution of Loss -1000 -1500 +2500 Balance After distribution of loss 2500 0 = 0 1000 1500 2500 Distribution of Cash to Partners -2500 _ _ -1000 -1500 _ Final Balance 0 0 = 0 0 0 0 A) Receipts of Cash Cash-------------------- 5000 Rekike, Capital--------5000 B) Distribution of Loss Melale, Capital------------1000 Belule, Capital-------------1500 Cash-------------------------2500 C) Distribution of Cash Melale, Capital------------1000 Belule, Capital-------------1500 Cash-------------------------2500 54 B) Br.2500 A) Br.5000 C) No Receipts- All the amount is considered as a loss Br.5000 MBR Partnership State of Partnership Liquidation From the period August 1 to August 31, 1997 Cash Non Cash = Liabili Melale Belule Rekike Assets -ties (20%) (30%) (50%) Before 0 0 = 0 2000 3000 -5000 Distribution of loss = -2000 -3000 +5000 Final Balance 0 0 = 0 0 0 0 Melale, Capital------------2000 Belule, Capital-------------3000 Rekike, Capital------------5000 55 CHAPTER 6: ACCOUNTING FOR ORGANIZATIONS AND OPERATIONS CORPORATIONS: Definition: a corporation is an artificial person, created by law and having a distinct existence separate and a part from the natural persons who are responsible for its creation and operation. A corporation is considered to exist as a “person” separate from its owners. As a “person” a corporation has the right to own property and the responsibility to use that property in a legal way. The corporation can make contracts and otherwise act as a legal. The corporation may be classified as a profit making and not for profit and these are further classified as private and public. Characteristics of a Corporation As a legal entity, the corporation has certain characteristics that make it different from other types of business organizations. The most important characteristics with accounting implications are: Separate Legal Existence: a corporation acquires, owns and disposes of property in its corporate name and may incur liabilities and enter into other types of contracts according the provision of its charter or articles incorporation. Limited liability of stockholders-creditors may not look beyond the assets of the corporation for satisfaction of their claims. Thus, the financial loss that a stockholder may suffer is limited to the amount invested A transferable unit of ownership-the ownership in a corporation is divided into transferable units known as shares of stock. A corporation may have several classes of shares of stock. The transactions that occur daily on stock exchanges are independent transactions between buyers and sellers. Thus, in contrast to the partnership, the existence of the corporation is not affected by changes in ownership. Additional Taxes-as a separate entity, a corporation is subject to double taxes. A corporation is usually required to pay the following types of taxes: 1. Income tax on its earnings; 2. When the earnings remaining after income tax are distributed to stockholders as dividends, they are again taxed as income to the individuals receiving them Government Regulations-being created by law and owned by stockholders who have limited liability, a corporation has less freedom of action than a sole proprietorship and partnership. There are usually government regulations in such matters as: ownership of real, retention of earnings and purchase of its own stock. Separation of Management from Shareholders Most laws require that at least three persons join together to form a corporation. The persons forming the corporation are called its incorporators. The incorporators fill out an application form for a charter (articles of incorporation). The form is then reviewed by the appropriate government office. After the charter has been granted, the incorporators and all subscribers or the owners of the stock of the business (shareholders or stockholders) meet and elect a board of directors who represent the stockholders and have final authority for all corporate actions. The board of directors then meets to select the professional managers and to make any other decisions needed to start the business. STOCKHOLDERS ELECT– BOARD OF DIRECTORS APPOINT – OFFICERS APPOINT EMPLOYEES CORPORATE CAPITAL (STOCKHOLDERS’ EQUITY) The difference between total assets and total liabilities of any business is generally known as capital or owner’s equity. The owner’s equity in a corporation is commonly called shareholders’ equity or 56 stockholders’ equity or shareholders’ or stockholders’ investment. The two main sources of stockholders’ equity are: Investments contributed by the stockholders, called paid in capital Net income retained in the business, called retained earnings The paid in capital includes common stock, preferred stock, PIC in excess of par common stock and preferred stock, common stock subscribed and premium on treasury stock. CHARACTERISTICS OF CAPITAL STOCK The general term applied to the shares of ownership of a corporation is called Capital Stock. Before we discuss characteristics of capital stock, we shall discuss terminologies related to shares and the major rights that accompany ownership of a share of stock. Terminologies related to shares. 1. Authorized stock-is the number of shares that a corporation is authorized to issue in its charter by the government 2. Issued Stock-a number of authorized shares that has been issued to date 3. Treasury Stock-a number of issued stock that are reacquired under various circumstances 4. Outstanding Stock-a number of issued stocks that are currently in the hands of the shareholders (Issued Stock – Treasury Stock). 5. Par- is an arbitrary monetary figure assigned to a stock 6. Stock Certificate – is the evidence of ownership issued to the shareholders 7. No Par Stock – a stock issued with out par value. Most of the time, no par stock is assigned a stated value by the board of directors, which makes it similar to par stock. The Major or Basic Rights The basic rights that accompany ownership of a share of stock are: 1. The right to vote in matters concerning the corporation 2. The right to share in distributions of earnings of receive dividend 3. The preemptive right – the right to maintain the same fractional interest in the corporation by purchasing a proportionate number of shares of any additional issuances of stock and 4. The right to share in assets up on liquidation Characteristics of capital stock There are two classes of stock: common stock and preferred stock Common Stock: Each share of common stock has equal right of voting or the right to vote They have secondary right in the distribution of earnings or receiving dividend They have secondary claim to the asset of a corporation up on liquidation They could be par stock or non par stock Preferred Stock: Preferred stock is usually assigned a par value They have preferential rights in receiving dividends and as to claim to assets of a corporation in case of liquidation. It does not provide the right to vote A corporation with both preferred stock and common stock may declare dividends on the preferred stock which may be stated in monetary terms or as a percent of par. Example: Assume that a corporation has 10000 shares of Br.5 preferred Stock (that is the preferred stock has a prior claim to an annual Br.5 per share dividend). In the first three years of operations net income was Br.80000, 140000, and 2000000 and the BOD decided to retain Br.30000 each year in the business. 57 Instruction: determine the amount of dividend distributed to preferred stockholders and common stockholders and dividend per share. First Year Second Year Third Year Net Income 80000 140000 200000 Retained Earnings (30000) (30000) (30000) Total Dividend 50000 110000 170000 Preferred Dividend (Br.5 * 10000 shares) (50000) (50000) (50000) Common Dividend 0 60000 120000 Dividend per Share: Preferred 50000/10000 = Br.5 50000/10000 = Br.5 50000/10000 = Br.5 Common 0/ 15000 = Br.0 60000/15000 = Br.4 120000/15000 = Br.5 Participating and Non Participating Preferred Stock Most preferred stock is nonparticipating. This means that a dividend to nonparticipating preferred stock is ordinarily limited to a specified amount. Participating preferred stock is a stock which provides for the possibility of dividends in excess of certain or a specified amount. If preferred shares may participate with common shares to varying degrees, the contract must be examined to determine the extent of participation. Example: A corporation has 3000 shares of Br.5 preferred stock and 15000 shares of common Stock. Assuming the dividend declared is Br.180000 and that the contract covering the preferred stock of the corporation provides that if the total dividends to be distributed exceed the regular preferred dividend and a comparable dividend on common, the preferred shall share ratably with the common in the excess dividend, compute the common and preferred dividend. Preferred Common Total Dividend Dividend Dividend Regular for Preferred (Br.5 * 3000) 15000 15000 Comparable for common (Br.5 * 15000) 75000 75000 Remainder (90000/ 18000 shares) 15000 75000 90000 Total 30000 120000 180000 Dividend per Share Br.10 Br.10 Cumulative and Non-cumulative Preferred Stock Most preferred stocks are participating. Provision is usually made, to assure the continuation of the preferential dividend right if at any time the directors pass (do not declare) the usual dividend. This is accompanied by providing that dividends may not be paid on the common stock if any preferred dividends are in arrears or required not paid in prior years. Cumulative preferred stock is a stock on which the specified amount of dividend accumulates. No common share receives dividend before the dividend in arrears on cumulative preferred stock are paid. Non cumulative preferred stock is a stock on which no accumulation of dividends is provided for. Example: A corporation has outstanding 5000 shares of cumulative preferred 7 % stock of Br.100 par and 10000 shares of common stock. Assume that dividends have been passed for the preceding or past three years. The Board declared a dividend of Br.200000 in the year 2004. Instruction: distribute the dividend between the preferred and the common Amount of Dividend----------------------------------------------------------------------Br.200000 Preferred Dividend: 58 Dividend in arrears (7% * Br.100 * 5000 shares * 3 Years) ----Br.105000 Regular Dividend: (7% * Br.100 * 5000 shares) ----------------35000 Total Preferred Dividend ----------------------------------------------------------------- 140000 Common Dividend------------------------------------------------------------------------Br.60000 Dividend per share: Preferred Stock: Br.140000 / 5000 Shares = Br.28 Common Stock: Br.60000 / 10000 Shares = Br.6 ISSUING CAPITAL STOCK The entries to record investments of stockholders in a corporation are like those for investments by owners of other types of business organizations in that cash and other assets received are debited and any liabilities assumed are credited. The credit to stockholders’ equity differs, however, in that there are accounts for each class of stock rather than for each stockholder. The capital stock may be issued: At a price equal to par value At a premium that is at price which greater than the par value At a discount that is at price which less than the par value Example 1: assume that a corporation with an authorization of 10000 shares of preferred stock of Br.100 and 100000 shares of common stock of Br.20 par, issued on half of each authorization at par for cash. Instruction: record the investment Cash---------------------1500000 Preferred Stock----------500000 Common Stock--------1000000 Premium and Discount Par stock is often issued by a corporation at price other than par. When stock is issued for the price more than its par, the stock is said to be sold at a premium and the premium is credited to either premium on common or preferred stock account or PIC in excess of par Common stock or preferred stock account. When stock is issued for a price less than its par value, the stock is said to be sold at a discount. The discount is either debited to Discount of Common stock or preferred stock account or PIC in excess of par common and preferred stock account. Example 2: DMN Share Company issued 5000 shares of Br.20 par preferred stock for cash at Br.30 per share. Record the investment by the shareholders Cash = 5000 shares * Br.30 = 150000 Preferred Stock = 5000 shares * Br.20 = 100000 Cash-------------------------150000 Preferred Stock------------100000 PIC in excess par-PS------ 50000 Example 3: GG Share Company issued 10000 shares of Br.10 par common stock for cash at Br. Record the transaction Cash-------------------------------8000 Discount on common stock----2000 Common Stock------------------10000 ISSUING STOCK FOR ASSET OTHER THAN CASH 59 When a capital stock is issued in exchange for assets other than cash, such as a land, buildings, and equipment, the assets acquired should be recorded at their fair market value of the assets or at the fair market price of the stock issued whichever is more objectively determinable. Example: assume that a corporation acquired land for which the fair market price is not determinable in exchange for 10000 shares of its Br.20 par common stock with a current market price of Br.25 per share. Record the transaction Land-------------------------250000 Common Stock-------------200000 PIC in excess of par-CS ----50000 ISSUING NO PAR STOCK When no par stock is issued, the entire proceeds may be credited to the capital stock account, even though the issuance price varies from time to time. Example 1: Beta Corporation, at the time of organization, issued 20000 shares of no par common stock at Br.50 per share and at a later date issued 5000 additional shares at Br.40. record the investment. Original issuance: Cash-----------------1000000 Common Stock-----------1000000 Subsequent issuance: Cash-------------200000 Common Stock------200000 If no par stock is issued, both discount and premium will not be recognized. No par stock may be assigned a stated value per share and the excess of the proceeds over the stated value is either debited or credited to paid- in capital in excess of stated value account. Assigning a stated value makes it similar with par stock. Example 2: Alpha Corporation, On March 17, 2005, issued 5000 shares of no par common stock with a stated value of Br.10 at Br.14 per share for cash. On June 1, 2005, it issued 2000 shares of the same no par common stock at Br.15. Instruction: record the issuance of no par common stock March 17: Cash---------------------------------70000 Common Stock---------------------50000 PIC in excess of stated value-----20000 June 1: Cash---------------------------------30000 Common Stock---------------------20000 PIC in excess of stated value-----10000 STOCK SUBSCRIPTIONS AND STOCK ISSUANCE When the corporation sells stock directly to investors, the investors first enter into an agreement with the corporation to subscribe to shares (apply to buy shares) at a specified amount per share. This is called subscriptions. If the stock is subscribed for at par, the subscription price is debited to the asset called Stock Subscription Receivable and credited to the capital stock account Called Stock Subscribed. When the stock is subscribed for at a price below or above par the stock subscription receivable is debited for the subscription price and the stock subscribed account is credited for at par and difference is debited to a discount or credited to a premium account. After a subscriber has completed the agreed payment, the corporation issues the stock certificate and stock subscribed account is debited and the capital stock account is credited. Example 1: on January 1, 2004 BCD Corporation received subscription to 10000 shares of Br.10 par common stock form various subscribers at Br.15 with a down payment of 50% of the subscription price. On June 1 and October 1, 2004 the corporation received the remaining 20% and 30%, 60 respectively and the stock certificate was issued on October 1. Instruction: record the stock subscription and the related transaction January 1: Stock Subscription Receivable----------150000 Common Stock Subscribed---------100000 Premium on common Stock-------- 50000 January 1: Cash----------------------------------75000 Stock Subscription Receivable------75000 June 1: Cash----------------------------------30000 Stock Subscription Receivable------30000 October 1: Cash----------------------------------45000 Stock Subscription Receivable------45000 October 1: Common Stock Subscribed---------100000 Common Stock--------------------100000 TREASURY STOCK A corporation may purchase some of its own outstanding stock or may accept shares of its own stock in payment of a debt owned by a stockholder in the manner much the same as acquisition by purchase. The accepted or purchased own stock is called Treasury Stock. Treasury stock is a stock that has been issued as fully paid and has been subsequently reacquired by the corporation but has not been canceled or reissued. The various reasons why a corporation may buy its own stock are: To provide share for resale to employees To provide shares for reissuance to employees as a bonus To support the market price of the stock To increase earnings per share by reducing the number of shares outstanding ACCOUNTING FOR TREASURY STOCK There are several methods of accounting for the purchase and the resale of treasury stock. A commonly used method is known as the cost basis method. When a stock is purchased, the account treasury stock is debited for its cost. When the stock is resold, treasury stock is credited at its cost price for it and the difference between the cost price and the selling or issuance price is debited or credited to an account entitled paid-in capital from sale of treasury stock. Example 1: the paid-in capital of a corporation is composed of common stock issued at a premium and the detail is as follows: Common stock Br.50 par (20000 shares authorized and issued) --------------Br.1000000 Premium on Common Stock-------------------------------------------------------- 300000 Further assume that the following transactions involving treasury stock occurred: 1. Purchased 1000 shares of its own stock at Br.60 per share Treasury Stock----------60,000 Cash-----------------------60,000 2. Sold 200 Shares of treasury stock at Br.70 Cash------------------14,000 Treasury Stock-----------12,000 PIC from sale of TS------2,000 3. Sold 200 Shares of Treasury Stock at Br.55 Cash--------------------11,000 PIC from sale of TS--- 1,000 Treasury Stock------------12,000 61 Prepare Stockholders’ equity section of the balance sheet assuming that there is deficiency of Br.51000 (Retained Earning account has a debit balance of Br.51000) Stockholder’s equity: Paid-in capital: Common Stock Br.50 (20,000 shares authorized and issued) ---1,000,000 Premium on common stock-------------------------------------------- 300,000 1,300,000 PIC from sale of TS----------------------------------------------------1,000 Total Paid-in Capital---------------------------------------------------1,301,000 Retained Earning-------------------------------------------------------(51000) Sub total-----------------------------------------------------------------1,250,000 Deduct: Treasury Stock-----------------------------------------------(36,000) Total Stockholders’ Equity-------------------------------------------1,214,000 The stockholders’ equity indicates that 20,000 shares of stock were issued out of which 600 are held as treasury stock. The number of shares outstanding is therefore, 19400 and any dividend declared would apply to 19400 shares. If sale of treasury stock resulted in a net decrease in PIC, the decrease may be reported as a reduction of paid in capital or it may be debited to the retained earnings account. Treasury Stock: The Par Value Method The accounting for Treasury Stock transactions under the Par value Method is a little more involved than under The Cost Method because journal entry for the acquisition of Treasury Stock uses Additional paid-in capital - Common Stock account. Assume that XYZ Corp. uses the Par value Method to account for treasury stock transactions. XYZ Corp. issued 1 000 shares of 10$ par common stock at 15$ per share. Dr Cash..........15*1000 = 15 000$ Cr Common stock.....................................10*1000 = 10 000$ Cr APIC-CS...................................... (15 - 10) *1000 = 5 000$ The Par Value Method: 1) XYZ Corp. acquires 200 shares for 13$ each. The first step is to debit Treasury Stock account for the amount of the par value of the reacquired shares and APIC – Common Stock account for the amount related to the first issuance of these reacquired shares. Dr Treasury stock........10*200 = 2,000$ Dr APIC - CS.................5*200 = 1,000$ Cr Cash.....................................................................13*200 = 2 600$ Cr APIC-TS (APIC-Treasury stock).......2000 + 1000 - 2600 = 400$ The balancing amount of the first three lines appears on credit side; therefore it is going to APIC-TS account. The credit means the gain (and this is a gain, because purchase price 13$ is less than original sales price 15$. Note that Retained Earnings account can never be credited from treasury stock transactions. 2. XYZ Corp. acquires 300 shares for 20$ each. Dr Treasury stock...........................10*300 = 3,000$ Dr APIC – CS...................................5*300 = 1,500$ Dr APIC – TS...........................6 000 - 4 500 = 400$ (total possible amount) Dr Retained Earnings...6 000 - 4 500 - 400 = 1,100$ (remaining loss) Cr Cash.......................................................................20*300 = 6 000$ 62 The balancing amount appears on debit side therefore it is a loss (and this is a loss, because purchase price 20$ is more than original sales price 15$). First, the loss is taken from APIC-TS account (if there is a balance on it) and the remaining amount is going to Retained Earnings. 3) XYZ Corp. reissues 100 shares for 23$ each. Dr. Cash.................................23*100 = 2 300$ Cr. Treasury stock..........................10*100 = 1 000$ Cr. APIC-TS..........................2 300 - 1 000 = 1 300$ The accounting for reissuance of Treasury Stock under the Par value Method is same as under The Cost Method. The only difference is that the Treasury Stock account is credited at par value amount of reissued shares. Let’s resume: 1. In all stock transactions, no gains or losses are shown on the income statement. 2. The amount that goes into the Treasury Stock account is the Par value of the shares. 3. Gains are credited APIC-TS account. 4. Losses are debited APIC-TS account (if there is a balance in it) and then Retained Earnings account. That is why Retained Earnings account cannot increase by share transactions. EQUITY PER SHARE (EPS) The amount appearing on the balance sheet as total stockholders’ equity can be stated in terms of the equity per share. Equity per share is the ratio of the stockholders’ equity to the number of shares outstanding. Determining EPS: When there is only one class of stock, the EPS is determined by dividing total stockholders’ equity by the number of shares outstanding. EPS = Stockholders’ Equity / No of Shares Outstanding For a corporation with both preferred and common stock, first, the total stockholders’ equity is allocated between the two classes of stock giving consideration to the liquidation rights and then the EPS of each class is determined by dividing the respective amounts by the related number of shares outstanding. Illustration: assume that a corporation has both preferred stock and common stock outstanding that there is no preferred dividend in arrears and the preferred stockholders are entitled to receive Br.120 per share up on liquidation. The amounts of the stockholders’ Equity accounts of the corporation are as follows: Preferred Br.7 stock, cumulative, Br.100 par (1000 Shares Outstanding) ----- 100,000 Premium on preferred stock----------------------------------------------------------2,000 Common Stock, Br.20 Par (50,000 share outstanding) ---------------------------- 1,000,000 Premium on Common Stock----------------------------------------------------------- 100,000 Retained Earnings----------------------------------------------------------------------- 298,000 Total stockholders’ equity------------------------------------------------------------- 1,500,000 Instruction: Determine EPS 63 Allocation of total stockholders’ equity Total Equity-------------------------------------------------------------Br. 1,500,000 Allocated to Preferred Stock: Liquidation Price (Br.120 * 1000 Shares) ------------120,000 Allocated to Common Stock-----------------------------1,380,000 Equity per Share Preferred Stock: Br. 120,000 / 1,000 Shares = Br.120 per share Common Stock: Br. 1,380,000 / 50,000 shares = Br. 27.60 Take the above example and assuming that the preferred stock is entitled to dividends in arrears in the event of liquidation and there is an arrearage of five years, compute the EPS. Allocation of total stockholders’ equity Total Equity-------------------------------------------------------------Br. 1,500,000 Allocated to Preferred Stock: Dividend in arrears (Br.7 * 1000 shares * 5 years) ---Br.35,000 Liquidation Price (Br.120 * 1000 Shares) ------------- 120,000 Allocated to Preferred Stock-----------------------------155,000 Allocated to Common Stock-----------------------------1,345,000 Equity per Share Preferred Stock: Br. 155,000 / 1,000 Shares = Br.155 per share Common Stock: Br. 1,345,000 / 50,000 shares = Br. 26.90 ORGANIZATION COSTS Expenditures incurred in originating a corporation such as legal fees, taxes and fees paid to the state, promotional cost are charged to an intangible asset account entitled organization costs. The organization cost will be amortized equally over a period of not less sixty months beginning with the month the corporation commences business. Example: on the formation of a corporation the legal fee and promotion costs were 40,000 and 60,000 Br., respectively. Record the transaction and the amortization for the first year: Organization Cost--------------------100,000 Cash-----------------------------------100,000 Amortization = Br. 100,000 / 5 Years or 60 Months = Br. 20,000 per year Entry: Amortization Expense----------------20,000 Organization Cost------------------20,000 64